By Jim Christie

SAN FRANCISCO, Jan 31 (Reuters) - Encouraged by California's improving finances and expectations of balanced budgets, Standard & Poor's upgraded its rating on $73.1 billion of the state's general obligation bonds one notch to A from A-minus on Thursday.

S&P, which put a stable outlook on California, also upgraded $9.3 billion of the state's lease revenue bonds to A-minus from BBB-plus.

The rating agency in a report praised moves by California's leaders over the last two years to balance the state's books.

'We view the alignment between revenues and expenditures as much improved and largely a result of policymakers' heightened emphasis on fixing the state's fiscal structure in the past two budgets,' the report said.

California's economy is expanding again and voters in November approved tax increases. Both are expected to raise revenue for the state government.

California is the most populous U.S. state and would have an economy that would be the world's ninth-largest if it were a country.

The rating agency's upgrades come a few weeks after Governor Jerry Brown said the state budget, long plagued by deficits, could swing to surpluses in coming years.

The upgrade for California leaves Illinois with the lowest rating of any U.S. state rated by S&P. The credit rating agency cut Illinois one notch to A-minus last week and said it could fall further, noting the state needs to tackle its huge unfunded pension liability.

Illinois also has the lowest state rating from Moody's Investors Service, at A2. Moody's rates California A1.

S&P's upgrade of California is long overdue, said Rick Ashburn, chief investment officer of Creekside Partners in Lafayette, California, which oversees about $80 million in municipal bond investments.

Ashburn said S&P never should have rated California A-minus, noting that the state's Constitution protects bondholders by making debt payment a top priority.

UPGRADE DISCOUNTED BY BOND PRICES

The $3.7 trillion U.S. municipal bond market widely anticipated the S&P upgrade.

California's 10-year general obligation bonds yielded 0.37 percent more on Wednesday than top-rated municipal debt, compared with the nearly 2 percent more they offered in 2009.

California State Treasurer Bill Lockyer welcomed the upgrade. He said lawmakers should rally behind Brown's call for restraining spending to help mend the state's finances.

Brown has proposed some spending increases, but is urging fellow Democrats who control the legislature and who would like to restore funds for programs hit by deep spending cuts in recent years to practice 'fiscal discipline.'

California's general obligation bonds could be on track for more positive ratings from S&P if state officials use improving revenue and hold down spending to propel the state budget to surpluses, said S&P Senior Director Gabriel Petek.

'Strengthening revenue performance is also quickly alleviating the state's cash-related stress and is helping eliminate its need to rely on extraordinary cash management measures,' the report said. 'Cash and unused borrowable resources are now approaching pre-recession levels.'

Petek said S&P also is encouraged by Brown's plan to pay the state's $28 billion of internal borrowing and deferred payments used to help close budget gaps over the years.

'The backlog of deferrals means that a significant share of current year spending goes to paying for prior year expenses,' S&P said. 'We expect that the range of possibilities for the state's credit rating would extend higher once it is free of this inflexibility.'

'We think that's a really big deal,' Petek added.

(Reporting by Jim Christie. Editing by Tiziana Barghini and Andre Grenon) Keywords: CALIFORNIA UPGRADE/

(jim.christie@thomsonreuters.com)(Tel: +1-415-677-2539)

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