A year ago, Fitch Ratings had a negative outlook on states, but now it has a stable outlook for the coming year.

“The operating environment is clearly still challenging,” said Laura Porter, managing director of public finance for state ratings. However, Fitch believes that the states are in a good position to handle the challenges, she said.

“The stable outlook for state ratings in 2012 reflects the recurring budget measures that most states took this year and the expectation of their continued commitment to budget balance in an environment of continued slow economic and revenue recovery,” Fitch said in a report entitled “2012 Outlook: U.S. States.”

“Since gaps were closed [in 2012] without undue reliance on one-time solutions in most cases, the shortfalls to be addressed for the coming year are meaningfully lower,” Fitch said.

Funding Medicaid is expected to be the biggest challenge in the next few years, Fitch said. Medicaid is states’ second-largest expenditure. “The rate of growth of these programs has been well above that of the states’ revenue streams,” Fitch said. With Medicaid, the states are constrained by federal mandates, it said.

While states will continue to be exposed to potential federal funding cuts, Fitch said it expects they “will have time to react to federal plans,” adding that “the risk to near-term budgets is fairly limited.”

The biggest risk is a deterioration in the U.S. economy, Porter said.

Two other possible risks for states are that they may have hit the limit of spending control, the report said. If there are legal or practical limits to continued tight control on spending, this could be a problem.

If there are steep cuts in federal spending, this could also reduce state’s credit strength.

“States are required to seek, if not achieve, budget balance,” the agency said. “Fitch is confident that they will continue to do so. … State debt burdens, with a median at about 3% of personal income, have remained largely stable in the downturn, and Fitch expects to see very little deficit financing in the coming year.”

Fitch downgraded three states — Hawaii, Minnesota, and New Jersey — one notch each in 2011. This compares to five states in 2009 and three states in 2010. It upgraded West Virginia one notch in 2011.

California is the lowest-rated state, with an A-minus.

Currently, 7% of the 43 states that Fitch rates have a negative outlook and 5% have a positive outlook.

At a press conference Wednesday, Amy Laskey, Fitch’s managing director for public finance for local governments, talked about the local government situation.

Fitch has no single outlook for the local governments. However, localities face two big concerns, Laskey said.

First, Fitch expects an inflation-adjusted 13% decline in property values. Taken together with the fact that assessments are catching up with previous declines, Fitch expects further declines in property tax revenues for local governments.

These declines may pressure some local bonds, Laskey said.

Labor costs is localities’ other big challenge, she said. About two-thirds of local government spending is for labor. The easy cuts to other sorts of spending have already been made, she said. Governments might be considering salary cuts.

What happens with labor costs will have the most impact this coming year on local governments’ financial situation, Laskey said.

Whereas cuts to public safety previously were off the table, localities are now starting to consider that possibility, Laskey said.

Meeting pension obligations is an even bigger problem for localities than it is for states, she said.

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