Baku, Azerbaijan, Feb.21
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On Feb. 21, 2014, Standard & Poor's Ratings Services lowered its long-term foreign currency sovereign credit rating on Ukraine to 'CCC' from 'CCC+'.
At the same time, S&P affirmed the short-term foreign currency sovereign rating at 'C'.
In addition, S&P affirmed the long- and short-term local currency sovereign credit ratings at 'B-/B'. The outlook is negative.
"The downgrade reflects our view that the political situation in Ukraine has deteriorated substantially," S&P said. "We believe that this raises uncertainty regarding the continued provision of Russian financial support over the course of 2014, and puts the government's capability to meet debt service at increasing risk."
When the agency lowered the long- and short-term foreign currency ratings on Ukraine to 'CCC+/C on Jan. 28, 2014, it indicated that it could lower the ratings again if political turmoil further reduced the government's administrative capacity to meet debt service, or if Ukraine did not receive the expected financial support from Russia or find alternative funding sources.
"The expected financial support from Russia is becoming increasingly uncertain and dependent on the outcome of the deteriorating political situation in Ukraine," S&P said.
"The clashes between protesters and security forces that began on Feb. 18 lead us to conclude that a conciliatory end to the political stand-off is now out of reach," S&P said. "We consider that the future of the current Ukrainian leadership is now more uncertain than at any time since the protests began in November 2013. We believe that the Russian government's support for Ukraine is tied to the current leadership and its political orientation away from the EU and toward Russia. As a result of the intensifying political turmoil in Ukraine, we consider that continued Russian support up to the committed $15 billion is increasingly uncertain. Should Russian financial support fall short of Russia's commitments, we expect the government of Ukraine to default on its foreign-currency obligations."
"S&P estimates that the government, National Bank of Ukraine (NBU; the central bank), and state-owned gas company Naftogaz have about $13 billion in foreign currency debt service to make in 2014," S&P said. "Ukraine's international reserves fell to $17.8 billion in January 2014 from $20.4 billion in December 2013. At the same time, Ukraine's large current account deficit, at about 9% of GDP in 2013, and elevated household demand for foreign currency will also put pressure on Ukraine's foreign currency reserves."
"S&P had understood that the $15 billion of direct Russian financial support to Ukraine would be fully disbursed before the second half of 2014," according to the statement. "This amount constitutes about 8% of Ukraine's 2014 GDP, and $3 billion has been disbursed to date. However, the deterioration in the political situation in Ukraine, resulting in the loss of at least 25 lives, suggests to us that opposition to the Ukrainian government's current financing arrangements--and to President Yanukovych remaining in power--could be sufficient to prevent Russia from providing the committed funding. In our view, this would result in the Ukrainian government being unable to meet its debt service in a timely manner. No alternative funding sources have yet been found."
"S&P notes that Russia suspended the disbursement of $2 billion in January 2014, and has delayed disbursement of the same amount that was expected on Feb. 19, 2014, in light of political developments in Ukraine," according to the statement. "Russia only announced the support package in December 2013."
"S&P expects that alternative financial assistance from the U.S., EU, or IMF to be tied to likely conditions associated with a formal IMF lending program, including increased exchange rate flexibility, policies to strengthen the financial sector, fiscal consolidation, increases in domestic energy tariffs, and comprehensive structural reforms to improve the business climate and support growth," according to the statement. "In our view, the incumbent Ukrainian government is disinclined to endorse this policy direction. Should the current leadership fall as a result of the political conflict engulfing the country, we have little visibility of what government might follow and what its policy priorities might be. The opposition and protestors appear to be less cohesive than the opposition movement during the Orange Revolution in 2004-2005, and so far no obvious leader with a similarly broad authority and credibility to the current leadership has emerged."
"As a result of the political turmoil, the economic situation in Ukraine continues to deteriorate and, in our view, the likelihood of a forced devaluation of the Ukrainian hryvnia has significantly increased," according to the statement. "With over half of the government's debt denominated in foreign currency, a significant devaluation could further undermine the government's debt service capabilities. The potential magnitude of this has also increased in light of the government's defense of the exchange rate. The NBU spent $1.7 billion of foreign currency reserves in January alone to defend the currency."
"S&P views Ukraine's gross external financing needs as the highest among the large emerging markets, estimated at 156% of current account receipts and usable reserves in 2014 (see our sovereign risk indicators at www.spratings.com/sri)," according to the statement. "We expect that, to cover those financing needs, rollovers of trade financing and other private sector debt will need to complement direct bi- or multi-lateral financial support. Ukraine's large current account deficit, elevated household demand for foreign currency since November 2013, and no end to the political crisis in sight, lead us to expect a devaluation of the hryvnia against the U.S. dollar in 2014 to 10, from 8 in 2013."
The hryvnia has depreciated by about 11% to close to 9 so far this year. The NBU revised its official exchange rate to 8.7 from 8.0 in July 2012, allowing for +/- 2% fluctuation around the official level. We project that foreign currency reserves held at NBU will fall below two months of current account payments in 2015, from 2.4 months in 2013, according to the statement.
"S&P estimates that the change in Ukraine's general government debt will average about 6% of GDP in 2014-2017, and that general government net debt will reach 43% of GDP in 2014, up from 36% in 2013, with 5% of GDP of that increase related to our devaluation assumption," according to the statement. "About 55% of government debt is currently denominated in foreign currency."
"S&P expects local currency financing of the general government deficit to continue to come largely from the NBU and state-controlled banks," according to the statement. "The NBU held 58% of local currency debt as of December 2013, while banks held a further 32%, which is about 7% of commercial bank assets. We therefore expect that financial repression will provide additional flexibility for the government to honor its local-currency debt, reflected in the two-notch distinction between our long-term local- and foreign-currency ratings on Ukraine."
The negative outlook reflects our view that there is at least a one-in-three chance that we could lower our ratings on Ukraine over the next 12 months.
"If we were to view a sovereign default as becoming almost inevitable within six months, absent significantly favorable changes in circumstances, which we do not anticipate," according to the statement. "A downgrade could also occur if bi- or multi-lateral funding were not forthcoming."
"S&P could revise the outlook to stable if we were to gain sufficient comfort that Ukraine were to meet external financing needs with bi- or multi-lateral lending and the acute political crisis were to make way for a more stable and predictable institutional and governance outlook," according to the statement.
"Under our Banking Industry Country Risk Assessment (BICRA) methodology, we classify Ukraine's banking sector in group '10', our weakest category," according to the statement. "We view the banking system as an impediment to monetary policy flexibility and the functioning of the transmission mechanism. Problem loans, including nonperforming and restructured loans in the banking system, are very high, at about 30%-40% of total loans. They could rise further should our expectation of additional hryvnia devaluation materialize, as 34% of bank loans were denominated in foreign currency as of December 2013."
"S&P estimates Ukraine's GDP per capita at $3,900 in 2014. We project the population will continue to decline by about 0.5% per year," according to the statement. "Medium-term pressure on age-related expenditures remains largely unaddressed, in our view. Due to weak external demand for Ukraine's metals and machinery exports, and a continued decline in industrial production, we forecast trend GDP growth--as defined by our criteria--at 1.8%."