Ukraine Cut to 'CCC-' by S&P, Outlook Negative (FXE) (UUP)

(Updated - December 19, 2014 11:52 AM EST)

RATING ACTION

On Dec. 19, 2014, Standard & Poor's Ratings Services lowered its long-term foreign currency sovereign credit rating on Ukraine to 'CCC-' from 'CCC', and its long- and short-term local currency ratings to 'CCC+/C' from 'B-/B'. At the same time, we affirmed the foreign currency short-term sovereign credit rating at 'C'. The outlook is negative.

We also lowered the Ukraine national scale rating to 'uaB+.

RATIONALE

We had previously anticipated that IMF disbursements would be paid to Ukraine in 2014, but these have been delayed. In our view, this delay, coupled with significantly reduced foreign currency official reserves, increases the risk that the Ukrainian government might not be able to meet its obligations. A default could become inevitable in the next few months if circumstances do not change, for instance if additional international financial support is not forthcoming.

Full disbursement of the IMF program and related multilateral lending, which is meant to enable the government to meet its foreign currency obligations over the next year, has not been running to schedule. The second and third tranches of the program were not disbursed as expected in 2014. The timing of the next disbursement--a combined $2.7 billion disbursement of the second and third tranches--remains unclear, at this point. While the formation of a new pro-reform government, following the October parliamentary elections, supports a continuation of the IMF program, we consider that the program itself remains at risk of not going ahead: Ukraine's macroeconomic outlook has deteriorated and, as a result, external financing needs are greater than we previously expected. There have been significant deviations from the program's base-case assumptions.

We estimate the government's foreign currency debt repayment obligations in 2015--including foreign currency domestic issuance, external official and commercial debt obligations, and the servicing of government guaranteed debt--will amount to $11 billion. The government expects to meet its debt repayment obligations next year with IMF sources, some of which it hopes to use for budgetary rather than balance-of-payments support. Other funding sources include potential concessional loans from other multilateral lending institutions and the European Commission (EC), and the issuance of an additional U.S.-guaranteed Eurobond.

There is $10.7 billion available in 2015 under the April 2014 IMF program, if the second through seventh tranches are all disbursed next year. While this money could cover the government's foreign currency debt payments, we see significant risks to this scenario; there could be further delays with the disbursements. In our view, all of the program's funds would have to be used for budgetary purposes. We also note that the $10.7 billion would not be enough to cover Naftogaz payments to Gazprom should the government have to service those. Therefore, we think it is highly likely that Ukraine will need additional funding support.

The government will have less than $1 billion in its account with the National Bank of Ukraine (NBU) at the start of 2015. Its debt payment burden increases toward the end of the year, when a $3 billion Eurobond due to Russia (specifically to Russia's sovereign wealth fund) matures. In the first quarter of 2015, $1.6 billion, including interest payments, is due. This could be met if the next two tranches of the IMF program are disbursed beforehand, and if they are used for fiscal support. We note a risk that if the government does not receive IMF money in the first quarter it may use central bank reserves to cover government obligations, thereby further pressuring reserve levels.

In our view, the currently available IMF funding (under the April 2014 program) and other committed multilateral funding would not be sufficient to boost the NBU's foreign currency reserve levels during 2015. We believe the central bank will only be able to maintain a very low level of reserves, next year, of just over one month of imports. If all the program funding comes through it will support the economy's gross external financing needs, assuming some--but less than 100%--roll-over of private-sector debt and continued net debt outflows on the financial account.

Foreign currency reserves have dropped from $16.3 billion in May 2014 (the start of the IMF program) to just over $9 billion at end-November, including gold reserves decreasing to less than $1 billion, from $1.6 billion. Over the past two months alone, reserves have dropped by nearly 40% ($5.7 billion) due to Naftogaz paying off debt for natural gas deliveries owed to Gazprom; the servicing of other public sector debt; and the NBU's interventions in the foreign exchange market. In October, the bank sold nearly $1 billion, which helped it maintain a stable exchange rate at that time. We note this occurred in the lead-up to the parliamentary elections. Following the elections, the exchange rate depreciated by 12% to the dollar in November. We expect reserves will deplete further because of an additional $1.65 billion payment Naftogaz has to make to Gazprom by year end. This is part of the October agreement in which the two sides, under EU-mediation, agreed to settle $3.1 billion in debt
by the end of 2014. The agreement also includes a set price for Russian gas, in place until March 2015, with Naftogaz pre-paying for gas deliveries each month.

Due to a sharp depreciation in the exchange rate--by almost 50% since the beginning of the year--and a contraction in domestic demand, imports have significantly contracted. The current account deficit has narrowed to an estimated 4% of GDP in 2014. Despite the smaller current account deficit, dollarization and capital outflows--including cut-backs in trade credit and reduced demand for foreign currency deposits and private debt outflows--have led to outflows on the financial account. This has placed pressure on the exchange rate and reserves, despite foreign currency controls being in place since February 2014.

In 2015, we expect the current account deficit to narrow slightly due to recession, depreciation, and inflation putting pressure on imports, as well as a narrowing income deficit. However, we believe that capital outflows, stemming from the ongoing reduction of private sector external liabilities and deposit outflows, will continue. This leaves the country extremely vulnerable to any shock, including further significant exchange rate depreciation, an escalation in fighting, worsening of trade relations with Russia, and higher than expected gas payments. Any such shock would leave Ukraine with little ability to keep servicing its debt and import goods and services from abroad.

We believe the fiscal deficit (including support for Naftogaz and bank recapitalization costs) will reach 8.5% of GDP next year, given large bank losses due to recession and hryvnia depreciation. That said, we expect the new government will make a considerable effort at fiscal consolidation. We anticipate the local currency financing of the general government deficit will likely continue to come largely from the NBU and state-controlled banks. Indeed, the NBU holds around 60% of local currency debt, with banks holding more than 30%.

The situation in the financial sector is precarious. Standard & Poor's classifies the banking sector of Ukraine in group '10' ('1' being the lowest risk, and '10' the highest) under its Banking Industry Country Risk Assessment (BICRA) criteria. Deposit withdrawals continue across the country, especially in eastern Ukraine. The system as a whole has seen a nearly 30% outflow of household deposits in the year to date. More than 30 banks have been declared insolvent or put under temporary administration. As part of the IMF program, independent asset quality reviews were conducted for the 35 largest banks. The NBU estimates recapitalization costs of Ukrainian hryvnia 66 billion (4% of GDP). In our opinion, government participation in the recapitalization may have to be more substantial than planned if private shareholders do not invest the amounts expected following the viability studies (see "Banking Industry Country Risk Assessment: Ukraine," published Sept. 4, 2014 on RatingsDirect).

On Dec. 2, the parliament approved a new cabinet of ministers, proposed by a new coalition of five pro-European political parties elected in October. The new government, led by Prime Minister Arseniy Yatseynuk (who served as interim prime minister), has strong support. A number of key positions, including the Minister of Finance and Economy, are held by technocrats who are not politically affiliated. The composition, in our view, indicates a strong commitment to implement reforms and maintain good relations with donors. That said, we note that the delay in forming the coalition may signal that the ongoing weaknesses affecting Ukraine's governance and institutional capacity could limit any positive effects of the government's economic reform.

The conflict in eastern Ukraine remains relatively contained in the areas of Donetsk and Luhansk, regions whose economies and infrastructure have been severely damaged by the fighting. Tensions remain high despite a September ceasefire, which has been being frequently violated, with over 1,000 killed since September according to the UN (more than 5,000 have been killed since fighting began in April). The self-proclaimed People's Republics of Donetsk and Luhansk held local elections in November, after which Kyiv abolished the "special status law" as agreed in the September ceasefire, and shut down state institutions in the territories. A new ceasefire was agreed on Dec. 9. In our view, the conflict is becoming increasingly "frozen." We expect it will remain localized to the areas that are already out of government control.

OUTLOOK

The negative outlook on the ratings reflects our view that there are significant risks of Ukraine defaulting if additional financial support is not forthcoming. Any further substantial delay in IMF disbursements would make it extremely difficult for the government to meet its debt obligations in the short term. We note that, even with continued disbursements, the program only buys Ukraine a limited amount of time. Further significant depreciation of the exchange rate, a more severe recession, and larger-than-expected deterioration of the fiscal and external balances, would place a lot of pressure on Ukraine's ability to meet its gross financing needs without additional international financial support.

The ratings could improve if additional financing was provided, sufficient to enable Ukraine to meet its external financing needs over the next year.

KEY STATISTICS

Table 1

RATINGS SCORE SNAPSHOT

Table 2

You May Also Be Interested In

• Dollar drop does not look too sustainable - ING
• US Dollar set to consolidate, analyst says
• SEI Investments (SEIC) PT Lowered to $69 at Piper Sandler