LOS ANGELES —S&P Global Ratings lauded California Gov. Jerry Brown for setting aside extra reserves and then threw down a caution flag citing the state’s tenuous fiscal condition.

“California’s grasp on long-term fiscal sustainability, while much improved since 2011, remains tenuous,” S&P Managing Director Gabriel Petek and David Hitchcock wrote in a Tuesday report.

The state’s economy is slowing despite a recent revenue surge that left the state with a surplus estimated at $6.1 billion in the Brown budget and $7.5 billion in a Legislative Analyst’s Office report.

“California’s grasp on long-term fiscal sustainability, while much improved since 2011, remains tenuous,” S&P Managing Director Gabriel Petek wrote.
"The budget proposal is favorable from a credit perspective," S&P Global Ratings Managing Director Gabriel Petek said.

The state’s finances, as reflected in Gov. Jerry Brown’s $190.3 billion spending plan released Jan. 10, are stronger than at any point in more than a decade, but the state’s long-term fiscal sustainability remains tenuous, Petek said.

"The budget proposal is favorable from a credit perspective," Petek said, because it would preserve some of the fiscal gains the state has achieved during the past seven years for more difficult economic conditions.

“In the context of a mature economic expansion, now in its ninth year, we view the state’s budget management during these better times as crucial to determining how its finances will perform during the next downturn,” Petek wrote.

By the end of fiscal 2019, the economic expansion – if it persists – would be the longest of the post-World War II era, according to S&P.

The budget proposal includes a substantially “larger-than-required” deposit to the state’s rainy day fund, rather than using it for major new spending initiatives. The effort would have the state hitting the constitutional funding limit in fiscal 2019, if the legislature doesn’t carve away at the large reserve envisioned in Brown’s budget.

In California, the governor presents a budget proposal in January and submits a revised budget in May. The legislature must then pass a budget by June 15, so the governor can sign it by July 1.

The governor’s budget would direct $3.5 billion into the rainy day fund in addition to the $1.5 billion constitutionally required through legislation that created the fund in 2014. That proposal would result in a $13.5 billion rainy day fund, hitting Brown's goal of having 10% of tax revenues in reserve. When the rainy day fund hits the 10% target any additional money would be used to finance infrastructure.

While Petek commended Brown’s efforts to set money aside, the analyst said that even a larger budget reserve would “likely offset only a portion of the revenue loss that would accompany a recession.”

The state remains vulnerable to severe fiscal stress given its dependence on high-income taxpayers and volatile capital gains as a primary revenue source, he wrote. A moderate one-year recession including a 30% stock market correction would cost the state roughly $20 billion in tax revenue, according to Department of Finance estimates.

The state’s large unfunded retiree benefits and uncertainty as to whether federal policy changes will result in increased costs are both concerns. The Department of Finance has said any changes in taxpayer behavior resulting from the recently-passed federal tax bill would be incorporated into the May Revise budget.

While S&P concurs with the state in forecasting 2.5% gross domestic product in 2018 and 2.2% in 2019 for the nation, the rating agency is seeing signs of an economic slow-down nationally and for the state.

“The state is already at full employment growth and advances in quarterly GDP and the average pace of job growth have slowed,” Petek wrote. “The expectation of slower economic growth is also a byproduct of the state’s housing shortage.”

The state holds AA-minus ratings from S&P and Fitch Ratings and Aa3 from Moody's Investors Service.

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