With the fiscal cliff looming, federal government action — or inaction — is the most significant credit risk to states in 2013, according to Fitch Ratings.

"While Fitch expects continued slow economic and revenue growth for 2013, the fiscal cliff is a significant near-term threat to that forecast. The risk that the fiscal cliff presents to the overall economy is the biggest concern for state credit, as state revenue systems quickly reflect changing economic conditions," said Laura Porter, managing director.

"In addition, any meaningful federal deficit reduction is likely to lower state funding, forcing program elimination or backfilling. Positively, state planning efforts would benefit from more clarity on federal deficit reduction and many states are developing contingency plans to prepare for possible federal action. Moreover, Medicaid, by far the largest area of federal funding to the states, has been protected from automatic cuts."

The flexibility to eliminate or self-fund programs facing federal cuts will be key in Fitch's analysis. Decisions that shift cost of services from the federal to state governments, while requiring the states to provide the same level of services, would be most concerning.

Cuts in Medicaid funding — which would add the most strain — could result in reductions in K-12 education and public safety, or higher state taxes to backfill federal dollars, in the absence of related mandate relief. A Medicaid program restructuring that reduces the pace of growth, maintains federal participation, and increases state control over program parameters could be positive.

States have reported 10 straight quarters of revenue growth after severe declines during the recession. Although growth remains slow, it has stabilized the states' financial position and Fitch has observed financial cushions being rebuilt. Assuming the federal government takes action that preserves the current slow economic recovery, Fitch believes that state ratings will remain stable in 2013.

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