The FINANCIAL -- Fitch ratings has affirmed the Italian Autonomous Region of Sardinia's Long-term foreign and local currency ratings at 'AA-' respectively and Short-term foreign currency rating at 'F1+'.

The Long-term rating Outlooks are Stable. The rating action affects approximately EUR2.3bn of outstanding debt, as well as future borrowing.

The ratings reflect Sardinia's special status which translates into a favourable funding system and wider responsibilities compared to Italy's ordinary status regions. The ratings also reflect stable operating performances and moderate debt levels, although the latter is expected to grow over the medium term. The ratings also take into account Sardinia's sluggish economic growth with per capita GDP still 20% below the EU-27 average. Over the medium term, downward rating pressure could arise from weaker-than-expected debt service coverage ratios as a result of debt growth beyond Fitch expectations. Conversely, a positive rating action could be triggered by a tighter grip on operating spending, especially in the healthcare sector, coupled with a catch-up of socio-economic indicators to EU27 levels.

Sardinia's special status entitles it to receive fixed shares of national taxes generated in its territory, including, as of 2010, 90% of the VAT, up from about 15% until 2006, to fully self-finance the public transport and the healthcare sectors, with the latter absorbing about 50% of the current budget. While the new tax sharing system should provide higher predictability of tax revenue, as the latter will be less dependent on annual budgetary allocations from the national government, potential benefits on regional budgets could be limited by expected sluggish economic growth over the next few years.

Sardinia's economy is suffering from the general economic downturn. Fitch expects GDP to grow at a modest 0.5% in 2010 after the contraction of 3% in 2009. Although growing sectors, such as tourism, should partly offset challenged traditional industries, such as aluminum and oil refinery, employment growth is expected to remain weak with unemployment rate forecasted to rise to 15% in 2010 from 13% in 2009.

With operating revenues expected to have been flat in 2009, Sardinia's operating margin is likely to have deteriorated to 7%. This is mainly due to healthcare spending, which Fitch expects to have grown by about 5%. Fitch expects the operating margin to hover around 7% through to 2012, reflecting anaemic average GDP growth of 0.8% against rising costs of about 2%-3% per year due to new responsibilities. Given that the new funding system will provide the region with additional EUR500m VAT revenue, it is likely the central government could require Sardinia to take over the funding of its cities and provinces, for the same amount, a scenario which Fitch has already factored in its 2010-2012 forecasts.

As Sardinia is being phased out from accessing EU structural funds, Fitch expects the region's new investments to decline to about EUR1bn per year over 2010-2012, leading to a likely balanced budget. Investments mainly relate to train and bus fleet renovations, as well as about EUR250m of tax allowances and guaranteed loans to local SMEs to support local economic development. Sustained investment spending over 2005-2009 of EUR7bn, principally involving roads and hospitals, which were rolled over pending their execution, led to a persistent fund balance deficit of about EUR2bn during this period.

The partial financing of the fund balance deficit and new investments could reverse the downtrend of Sardinia's debt, which declined to EUR2.3bn in 2009 from EUR3bn in 2006. Although Fitch expects debt to gradually increase to about EUR3bn by 2012, Sardinia's debt should stabilize at about 40% of operating revenue. The sustainability of debt is expected to remain strong as the operating margin should continue to cover debt service by about 1.5x while debt can be repaid by the current balance in seven years, against an average life of debt of about 10-11 years.

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