California Ratings, Outlook Unchanged by Recall Vote

S&P notes that the apparent governor-elect will still face a substantial structural deficit in fiscal 2005

The apparent successful vote Oct. 7 to recall California Gov. Gray Davis does not affect Standard & Poor's Ratings Services' 'BBB' general obligation bond rating and stable outlook on the state.

The apparent governor-elect, Arnold Schwarzenegger, will still face a substantial structural deficit in fiscal 2005, currently estimated by the state at about 14% of fiscal 2004 appropriations. This deficit could grow, if pending litigation holds up, by about $12.6 billion of bonding budgeted in fiscal 2004 for budget relief, totaling about 18% of budgeted 2004 revenues.

In addition, budgeted expenditure reductions are not yet fully implemented and assumed revenue increases, backloaded during the fiscal year, will depend on economic forces. A pending class action also could cause the state to reimburse $5 billion of potentially lost property tax revenue for schools in upcoming years.

"Improvement in the state's current bond rating will depend on the ability of the state to reduce its structural deficit using reasonable budget assumptions," says Standard & Poor's credit analyst David Hitchcock.

Mr. Schwarzenegger has publicly indicated an interest in rolling back the state's recent motor vehicle license fee tax increase dedicated to local governments. Such a rollback would cause a major loss of county discretionary revenues and possibly large cuts in social service spending, unless reimbursed by the state. Standard & Poor's will monitor the state's future fiscal direction to determine the impact on its structural deficit, as well as the impact on state and local government.

Substantive budget proposals may take some time to materialize; the governor is required to submit a budget in January. Any mid-year budget changes, as well as the budget for fiscal 2005, will still need to have compromise and agreement from both major political parties due to the state's constitutional requirement of two-thirds approval of the state legislature for budget passage.

A voter initiative is currently having signatures verified for the March ballot to reduce the legislative budget passage requirement to 55%. With the governorship now changing parties, it would appear that this initiative would have less short-term relevance to budget adoption due to the governor's ability to veto a budget. Historically, obtaining agreement within the state legislature has been a major factor in chronically late state budgets.

Another initiative, Proposition 53, was defeated on Oct. 7. This initiative would have set aside general fund monies for infrastructure projects. The failure preserves budget flexibility for the governor, however, its credit impact would have been minimal, even if passed, due to automatic suspension when state finances were weak.

From Standard & Poor's Ratings Direct

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