CHICAGO – A court mandate on state payroll expenses for union workers adds to Illinois’ fiscal strains as its rating remains one cut away from a speculative grade, Moody’s Investors Service warned.

The Illinois Supreme Court on March 21 declined to hear Gov. Bruce Rauner’s appeal of an appellate court decision that sided with unions by concluding the state must make good on step increases – incremental pay raises based on the years of employee experience -- that were withheld during contract talks.

“In an election year, I don’t think any long-term progress will be made on spending or pensions,” said Brian Battle, director of trading at Performance Trust Capital Partners.

“The Illinois Supreme Court’s refusal to hear an appeal in the case is credit negative because it could complicate Illinois' efforts to devise a balanced budget for the next fiscal year and to address an almost $8 billion backlog of unpaid bills,” Moody’s said in a special commentary published late last week.

Illinois has little wiggle room on its rating. Moody’s rates Illinois Baa3 with a negative outlook. S&P Global Ratings has it at the lowest investment grade level of BBB-minus but assigns a stable outlook. Fitch Ratings has it at BBB with a negative outlook.

The additional expense is likely to be minimal relative to the administration’s proposed $37.6 billion general fund budget but it could erode much of a $351 million projected surplus in Rauner’s proposed budget that he would use to pay down the state’s $8 billion bill backlog.

“Retroactively providing prior-year salary hikes will also translate into pension funding pressures starting in fiscal 2020,” Moody’s added.

While state employee payroll and benefit expenses are overshadowed by the state’s $130 billion pension obligation and bill backlog, the costs remains a budgetary challenge even though state ranks have declined by 18% since 2004.

“The fiscal burden associated with both pay and retirement benefits helps explain the governor's tendency to clash with organized labor, including through a crusade against unions' ability to compel payment of “agency fees” by nonmember workers who work alongside — and arguably benefit from — dues-paying members,” Moody’s said.

The “agency fees” payments refer to an Illinois case pending before the U.S. Supreme Court that was initiative by Rauner over whether non-unions members should be required to pay reduced dues tied to bargaining costs.

The issue of paying the step increases and complying with the court decisions now goes to the Illinois Labor Relations Board. At a public appearance late last week, Rauner said: “I believe there is money in the budget to accommodate what we need to do," citing either budgetary savings from unnamed measures or the projected surplus as a means to cover the expense.

The state’s fiscal prospects headed into the next fiscal year July 1 were already cloudy with Rauner’s proposed budget relying on $900 million of one-shots to achieve balance. They include $600 million of interfund borrowing and $300 million from the long-stalled sale of the state’s downtown Chicago headquarters building.

Rating agencies and investors are watching closely for a return to gridlock. The state’s ratings tumbled and its bill backlog ballooned as a budget impasse nearly extended into a third fiscal year. The stalemate ended last July as some Republicans broke with Rauner and joined the General Assembly’s Democratic majority in passing a budget with $5 billion in tax hikes and then in overriding Rauner’s vetoes.

The impending November state election adds further uncertainty over whether Illinois will at least pass a budget and avert further piling on the backlog which could drive a downgrade.

“In an election year, I don’t think any long-term progress will be made on spending or pensions,” said Brian Battle, director of trading at Chicago-based Performance Trust Capital Partners LLC. “I believe Springfield could limp into budget, on time, to let everyone get back to getting elected.”

The rating agencies have been patient with the pace of progress in the state and the state has fresh revenue from the tax hikes coming in, Battle added. “It would be an historic downgrade to take a state below investment grade, so I understand their caution. I don’t expect a downgrade this year,” he said.

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