Standard & Poor's lowered Ukraine's long-term foreign- and local-currency sovereign credit ratings from 'B+' to 'B' with a negative outlook on Friday, the agency said in a press release.

S&P affirmed its 'B' short-term ratings on Ukraine.

It also lowered its long-term Ukraine national scale rating to 'uaA-' from 'uaA+'. The transfer and convertibility (T&C) assessment was revised down to 'B'. The recovery rating on the unsecured foreign currency debt was affirmed at '4,' indicating S&P's expectation of 30%-50% recovery in the event of a default.

The downgrade reflects S&P's opinion that Ukraine faces significant external financing needs in 2013 and beyond, and uncertain prospects for securing sufficient foreign currency. The ratings are supported by Ukraine's large commodity endowment, a fairly diversified economy, and a relatively low, albeit rising, government debt burden.

In S&P's view, the government may face higher borrowing costs and more difficulty securing financing than it has over the past year. In 2012 the government seems to have benefitted from the search for yield in international capital markets, issuing Eurobonds amounting to 2.3% of GDP at an average yield of 8.8%. A change in global conditions or in investor perceptions could further increase the government's cost of borrowing in 2013. The government has also been issuing foreign-currency and U.S.-dollar-denominated Treasury-bills in the domestic market ($2.5 billion as of November 2012 at an average weighted yield of 8.9%) at a similarly high cost.

In 2013 S&P expects the government's gross financing needs to remain high and include a larger component of external financing, mostly due to the maturity of its IMF loans. S&P expects external debt service to increase to 7% of government revenues in 2013, from 6% in 2012. At the same time, the National Bank of Ukraine (NBU; the central bank) also needs to repay $3.5 billion in government guaranteed debt to the IMF in 2013 (15% of estimated international reserves), up from $2.9 billion in 2012. In S&P's view, the deterioration in fiscal and external indicators that accelerated from mid-2012 could complicate the government's access to international financing.

The exchange rate has been de facto pegged since early 2010. In S&P's view, recent policy decisions by the NBU--such as the foreign exchange surrender requirement for exporters--indicate an unwillingness to increase exchange rate flexibility. However, S&P notes that deteriorating economic fundamentals and mounting pressure on foreign currency reserves risk undermining the credibility of the currency peg. Due to still-high dollarization, a sharp depreciation of the exchange rate would increase the indebtedness of the public and private sectors and would likely lead to some deterioration in the financial sector's nonperforming loans (NPLs). S&P notes, however, that most problematic foreign currency loans have been provisioned. S&P currently estimates NPLs at around 40% of total banking system loans, broadly defined.

The IMF recently announced it would send a mission to Kyiv in December 2012 to start negotiating a new SBA. The previous SBA, approved in July 2010 and amounting to 11% of 2010 GDP, was suspended in March 2011 due to Ukraine's noncompliance with the program (which expires Dec. 27, 2012). In S&P's view, key structural benchmarks, which led to the failure of the 2010 program, are likely to remain sticking points in the IMF's upcoming negotiations with the government. These include a hike in domestic gas tariffs, fiscal consolidation, and a more flexible exchange rate regime. As a result, discussions with the IMF could extend well into 2013 and in our view any agreement may prove difficult to implement.

The negative outlook reflects S&P's view that there is at least a one-in-three chance that it could lower its long-term rating on Ukraine over the next 12 months if it views as insufficient the government's strategy to secure foreign currency to meet its elevated external financing needs. A sharp and sustained decline in net foreign currency reserves would put downward pressure on the ratings.

S&P could revise the outlook to stable if the government secures funding to meet external debt service, in a timely manner, either through the international capital markets, or through bi- or multi-lateral loans, while also providing support for net international reserves and setting the economy on a more sustainable growth path.