While tax revenue collections will slow and expense pressures will remain elevated in the short run, robust levels of rainy-day and other funds have prepared states to face a rainy season.
Based on data from the National Association of State Budget Officers (NASBO), state fund balances including state rainy-day funds (also known as budget stabilization funds) as well as other spendable funds (which include funds unassigned to funds that are restricted for certain uses) have surged to their highest levels in over two decades . This provides a sizable ballast of fiscal strength to offset potentially adverse impacts of an economic slowdown on credit quality. States utilized these reserve funds during 2001–03 and 2008–10 to navigate challenging economic environments and the associated decline in revenues. A key difference this time is the sheer size of these funds relative to expenditures. For example, states entered the 2008–09 recession with total fund balances of approximately 10% of general fund expenses. In fiscal 2022, that ratio is estimated to be three times at around 30%. State budget officers project that in fiscal 2023, the ratio will decline to approximately 24%, still a high number by historical standards.
While overall fund balances are robust and the highest on record, there is significant variation between states. That said, investors should note that in the two decades prior to the pandemic, the ratio of total fund balance to general fund expenses averaged around 10%. Per fiscal 2022 estimates from NASBO, barring a few exceptions, the vast majority of states meaningfully exceed that long-term average.
As economic conditions tighten, we expect states to face budget shortfalls within the next two fiscal years (given municipal finances typically demonstrate a material lag to prevailing economic conditions). States with a larger share of more volatile revenue sources, such as personal and corporate income taxes, will likely experience revenue declines sooner. Look no further than California, where Governor Gavin Newsom unveiled the fiscal 2024 budget on 10 January, projecting a substantial shortfall of USD 22.5 billion. The state expects to manage the shortfall through a range of measures including expenditure cuts, delays, and deferrals. The cuts are primarily in climate and transportation programs, while health and education expenditures will largely be maintained. The key point here is that the state administration does not expect to draw on reserve funds, but should it need to, then an estimated USD 50 billion in total fund balances was available as of fiscal 2022 and over USD 40 billion is projected to be available in fiscal 2023. That robust fund position provides a solid foundation of support for the state's credit quality.
In the longer term, demographics, pensions, and economic competitiveness are all important drivers of state credit quality. However, in the short run, especially given the expectation of an economic slowdown and perhaps even a recession (although we expect it to be mild) later this year, the most important factor driving state credit quality is financial flexibility. These large fund balances provide exactly that and in ample amount, positioning states well to navigate the changing economic weather and face some rainy days ahead.
Main contributor - Sudip Mukherjee
Content is a product of the Chief Investment Office (CIO).
Original report - States are ready for a rainy day, 24 January 2023.
