States face continued austerity this year even as their credit should remain stable, Standard & Poor's says.

State governments made difficult decisions to get through the last few years, analysts Robin Prunty and John Sugden wrote in a report, "For U.S. State Budgets, Austerity Is Here to Stay."

State and local governments cut 579,000 jobs, seasonally adjusted, from June 2008 to November 2011.

Despite those tough decisions, "fiscal conditions for the sector remain strained, and budget reserves are significantly depleted, which somewhat limits flexibility," the analysts said. "The ability and willingness to adjust to economic volatility, revenue contraction, and potential funding or policy changes at the federal level will determine credit direction heading into fiscal 2013."

However, "we expect the sector as a whole to retain its strong credit profile," they said in the report issued Thursday.

During the 2001 recession, states issued $30 billion for funding operating deficits, they said. By comparison, during the current downturn, states have issued some $18 billion for the same purposes. "Only about a dozen states have used debt to partially close a budget gap and many are prohibited from doing so," the S&P analysts said.

Stimulus funding aided states in the recent recession, they noted.

Over the past decade, "many states have developed debt affordability guidelines or models, which we regard as a positive development," the report said.

Since 2008, states have also introduced other management improvements, including "increased budget reserve levels, multi-year financial projections, enhanced mid-year budget adjustment capabilities, debt affordability initiatives, and pension and other liability reform," the analysts said.

The overall fiscal climate has led policymakers to reduce capital spending in fiscal 2012. Some are turning to public-private partnerships to reduce expenditures.

Many states have improved their liquidity. This has allowed them to reduce short-term borrowing and maintain better cash balances.

In recent months, state revenues have benefited from economic growth. Tax revenues were up 5.6% in the third quarter of 2011 compared to the third quarter of 2010. This is the seventh consecutive quarter of year-over-year growth.

The analysts offered predictions for the next 18 months.

"Given the disparate nature of state economies, differing levels of reliance on federal funding, and varying management capabilities and financial flexibility across the sector, we anticipate the effects on credit quality from the sequestration mechanism under the Budget Control Act of 2011 will likely be felt unevenly across the sector," they said.

The euro zone sovereign debt crisis could affect states with large exports to Europe. "To the extent that the financial markets react to developments in the Euro Zone, it could result in greater revenue volatility for income-tax-dependent states and affect pension fund returns."

The slow economic recovery could continues to curb issuance through fiscal 2013, they said.

The report also includes state-by-state discussions of recent budget developments. It is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. Non-subscribers may purchase copies by calling 212-438-7280.

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