Moody's Investors Service has downgraded Ukraine's government bond rating to Caa1 from B3 and placed the rating on review for possible further downgrade, the agency said in a press release on September 20.

According to the statement, the action was prompted by heightened concerns over Ukraine's external liquidity position, increased downside risk related to future negotiations with the IMF, and increased political and economic risks due to deteriorating relations with Russia.

Moody's also downgraded the rating of the Ukrainian State Enterprise "Financing of Infrastructural Projects" to Caa1 from B3 and put the new rating on review for downgrade, in line with the sovereign action.

"We'll survive that," Prime Minister Mykola Azarov said at the 10th Yalta Annual Meeting on Saturday, while commenting on the deterioration of the rating.

Moody's said that the primary driver underlying the agency's decision is the further deterioration in the country's external liquidity position since the last downgrade in December 2012. Moody's recalled that Ukraine's foreign-exchange reserves had fallen by 30% year-on-year to around $19.7 billion at the end of August 2013, which implies a coverage of just 2.3 months of 2012 imports.

Furthermore, the pressure on foreign-exchange reserves is likely to increase in the coming months due to increased demand from the domestic population, higher gas imports and downside risks to exports, the agency said.

Moody's also added that sovereign foreign-currency-denominated debt service (principal and interest) amounts to $10.8 billion until end-2014 (including IMF debt due by the central bank). Given that the government's cash balance (deposits at the central bank and commercial banks) is limited, at around $1.8 billion in July 2013, and that its access to international markets is also currently limited, the government foreign-currency-denominated obligations add to reserve pressure.

The second driver of the rating action is Moody's view that downside risks related to future negotiations with the IMF have increased. The Ukrainian authorities recently passed legislation to issue treasury promissory notes, an instrument that the IMF is unlikely to favor. In addition, there is discussion domestically to re-introduce a duty on non-cash foreign-exchange purchases, which was eliminated under a previous IMF program. These issues add to the already stalled progress on highly sensitive key political issues required by the IMF, including a rise in domestic gas prices, a more flexible exchange rate, and fiscal adjustments and a budget based on realistic assumptions. According to the agency, the president and ruling party's declining popularity and nearing presidential elections in March 2015 further add to concerns about reaching agreement on a new IMF program as well as keeping it on track.

The third driver of the rating action is worsening relations with Russia. Russia has been explicit about its disapproval of a potential Ukraine-EU Association Agreement, which is due to be signed at the EU's Eastern Partnership Summit in November 2013.

While Moody's views the prospects of signing this agreement as credit positive for Ukraine in the medium-term given that it will support Ukraine's institutions, economic and political reforms, the short-term credit negative impact of a negative reaction by Russia outweighs these benefits. In this context, Russia recently restricted (or at least delayed) Ukrainian exports by increasing non-tariff barriers for several weeks. Given that Russian exports account for around 25% of Ukraine's total exports, restrictions could impair economic growth and foreign-exchange generation. Disagreements with Russia could also extend to other areas in the economic (e.g., gas imports, gas prices) or the political sphere, with negative consequences for Ukraine.

Moody's said that the review would focus on three main areas: the development of foreign-currency reserves, which are e.g. driven by the population's demand for foreign currency and gas imports, the status of negotiations with the IMF, and the outcome of, and Russia's reaction to, the EU's Eastern Partnership summit.