09:39 12.12.2015

Ratings on Ukraine affirmed at 'B-/B', outlook stable - S&P

12 min read
Ratings on Ukraine affirmed at 'B-/B', outlook stable - S&P

Standard&Poor's Ratings Services has affirmed its 'B-/B' long- and short-term local and foreign sovereign credit ratings on Ukraine, reads a posting on the website of the rating agency.

"The outlooks on the long-term foreign and local currency ratings are stable," according to a statement.

"At the same time, we affirmed the 'uaBBB-' Ukraine national scale rating on the country," the agency said


The affirmation reflects the progress Ukraine has made during 2015 in restructuring its debt, while passing major reforms. For example, the government has cut household energy subsidies, solidified the independence of the National Bank of Ukraine (NBU, the central bank), and revised an overly complex value added tax (VAT) system. At the same time, our 'B-' long-term rating captures the economic and political challenges that Ukraine faces. These include widespread corruption, the unpredictable security situation in the east of the country, as well as parliamentary opposition to the adoption of a tax reform program compatible with the finance ministry's proposed 2016 general government budgetary target of 3.7% of GDP. As of our publication date, with 20 days remaining in 2015, the Rada (Ukraine's parliament) has yet to pass a 2016 budget. We also note the possibility that the opposition may attempt to bring down the government via a no-confidence vote before year end. Despite this, we are maintaining our baseline expectation that by early next year, the parliament will pass a budget that is roughly compliant with the International Monetary Fund (IMF) general government deficit target of less than 4% of GDP.

At an estimated 70% of GDP by the end of this year, Ukraine's net general government debt remains high for a low-income economy, even after the public debt restructuring in October. We estimate that public and publicly guaranteed debt outside of the general government perimeter amounts to an additional 24% of GDP. In our view, such a high level of public debt means that targeting a higher primary budgetary surplus and retaining access to relatively cheap official financing via the IMF are of critical importance for debt sustainability in Ukraine alongside GDP growth.

Although Ukraine's economy returned to positive growth in the third-quarter 2015, increasing 0.7% quarter on quarter, growth prospects remain challenging in light of security risks, the weak domestic business environment, and the troubled financial sector. We expect quarterly growth in the fourth quarter will be about zero, given the depressive effect on consumption from the large increase in energy tariffs for households in November. In 2016, we project that GDP will recover to 2%, in line with the government's forecast, assuming that the security situation in eastern Ukraine does not deteriorate further. However, we think the drag from further expected fiscal consolidation next year will be substantial.

Our ratings and stable outlook on Ukraine factor in our assumption that the government will remain generally on course with the IMF program, which would mean it will receive a further $11 billion in installments by year-end 2018 and that gross (though not net) reserves will increase toward $27 billion by the same date.

Since the beginning of this year, the IMF has disbursed over one-third of the $17.5 billion available under the four-year Extended Fund Facility (EFF) program. The disbursements carry an average interest rate of 1.05% and cover most of Ukraine's net government borrowing requirements through 2018, now that commercial debt redemptions have been extended beyond 2018 as a consequence of the exchange. One important outcome of Ukraine's debt restructuring in October was the agreement by holders of Ukraine's international law bonds to a moratorium on interest payments from now until 2019. This concession will lower the effective interest rate on the entire outstanding stock of general government debt from close to 11.0% this year to an estimated 7.7% in 2016 and 7.0% in 2017, giving Ukraine four years during which it can try to improve debt dynamics by increasing the primary fiscal surplus and enacting reforms to boost growth.

Whether or not the primary fiscal position will improve next year is not yet clear, however, because the Rada has so far delayed passage of an IMF-compliant 2016 budget. The key fiscal debate is currently taking place in parliament centers on two separate tax reform proposals. The first is the Cabinet/Finance Ministry plan to simplify the tax framework and establish a uniform 20% tax rate for the four principal rates - personal, corporate, VAT, and payroll. If implemented, in our view, the measures, particularly the proposed sharp reduction in the payroll tax, would facilitate whitening of Ukraine's large (and untaxed) informal economy. The alternative proposal from the parliament's tax committee involves much larger tax cuts, and would, by our estimates, lead to a fiscal deficit next year exceeding 10% of GDP. We assume in our baseline scenario that an amended version of the Finance Ministry's proposal will be passed by end-December, and that the budget will comply broadly with the IMF targets. Under this scenario, we still project a deviation from the government's target budget deficit of 3.7% of GDP in 2016. We think the deviation will be a modest 0.8% of GDP given that there is a hard budgetary financing constraint for the public sector in 2016. This means that the IMF has only committed to financing a budgetary deficit of less than 4% of GDP, although arrears financing (technically capped under the IMF program), and additional monetization of the deficit are alternative sources of a budgetary overrun next year. We forecast a budgetary deficit of 4.5% of GDP in 2016, but this still represents significant underlying fiscal tightening of about 1.7% of GDP given the loss of extraordinary revenues from dividends paid by the NBU (an estimated 1.4% of GDP), as well as the loss of 0.7% of GDP in receipts from the expired temporary import surcharge in 2015.

The Rada is also considering important budgetary reforms to the pension system (including the elimination of special pensions), scrapping the VAT payment exemption on agricultural production, and reforms to revenue administration that have already been rolled out nationally for VAT collection. In another positive development, state-owned oil and gas company Naftogaz could break even by next year, reducing the need for transfers from the central government. Lastly, if the Finance Ministry's proposal on introducing a uniform 20% rate across all major tax rates is implemented, this would, in our view, be a major step toward broadening what is currently a narrow, porous tax base. For this reason, the introduction and implementation of tax reform along these lines would lead us to reconsider our current assessment that Ukraine's flexibility to raise revenues is limited. There's a risk that the Finance Ministry's proposed tax reform will not pass in the parliament, if the government is caught up in a potential no-confidence vote and, in an extreme scenario, falls. If this occurs, we would expect extended delays in the disbursal of IMF funds, with negative effects on confidence and growth.

In 2015, the NBU used its powers of monetization extensively:

To recapitalize Naftogaz (via treasury bond purchases worth UAH 29.7 billion [about $1.2 billion] or just over 1.5% of GDP).

To shore up funds in the Individuals' Deposit Guarantee Fund and to recapitalize domestic banks (via government bond purchases of an estimated UAH 36.5 billion or $1.5 billion or a little bit less than 2% of GDP).

As a consequence, between year-end 2013 and October 2015, the NBU's balance sheet has more than doubled in size via the purchase of government debt and the provision of liquidity support to the banks. This quasi fiscal role of the NBU has not been recorded in the budget. However, the ensuing monetary expansion has, alongside the rise in publicly administered tariffs, pushed up inflation, which was 49.5% year on year in October, according to the State Statistics Service of Ukraine. We expect inflation will decelerate markedly during the rest of 2015 and into 2016 (to about 20% versus the 12% official forecast), as quasi fiscal financing abates, and the pace of tariff hikes recedes. Nevertheless, we still project 20% inflation for 2016, the third-highest projected level of inflation of the 131 sovereigns we rate, after Venezuela and Argentina.

Capital controls, which the government partially lifted in June 2015, remain in place. The NBU has put a limit on daily cash withdrawals (although it relaxed them somewhat over the summer) and has required exporters to convert 75% of foreign currency revenues into local currency. Also in place are daily caps on wholesale market foreign currency purchases, as well as other surrender and transfer regulations, which were updated in September of this year. We expect capital controls will remain in place throughout 2016 in an effort to minimize any further exchange-rate volatility.

Since end-2014, official reserve assets (including swap arrangements with Sweden's Riksbank and the People's Bank of China) have increased by $5.4 billion to $13.0 billion as of end-October, reflecting IMF foreign currency loan inflows, reduced external debt payments, the imposition of capital controls, and the shift of the current account into balance (due to an even sharper contraction in U.S. dollar-denominated imports versus exports). With the debt exchange completed, public gross external financing requirements are low - at $3.4 billion and just under $4.0 billion in 2016 and 2017 respectively (about 4.5% of GDP for both years, depending on exchange-rate developments), by our estimates. However, overall gross external requirements, including trade credit, deposits, and other short-term debt, over the next several years remain very high - at $55 billion (62% of GDP) and $58 billion (57% of GDP) for 2016 and 2017, respectively, by our estimates. We assume that foreign lenders will roll over all external trade financing, which account for just above one-third of this requirement. However, whether non-residents will roll over all or part of the remaining $30 billion of gross external financing requirements in 2016 and 2017, split between short-term maturities and maturing medium- and long-term debt is uncertain. Rollover rates on medium- and long-term debt in 2015 have so far been well below 50% (versus the EFF program assumption for next year of just over 80%). An alternative financing source for private sector external redemptions next year and in 2017 would be a combination of reserve depletion and private sector default. If state-owned and private-sector companies and banks continue to default on foreign debt, we assume this will not have any additional destabilizing effect on the economy but will proceed via negotiated debt restructurings (as has occurred in 2015).

Conditions in the financial sector appear precarious, with confidence in the system strained. We classify Ukraine's banking sector in group '10' ('1' being the lowest risk, and '10' the highest) under our Banking Industry Country Risk Assessment (BICRA) methodology. Foreign currency deposits are still down by more than 20% this year, although they have started to stabilize over the past few months.

The NBU officially floated the hryvnia in February 2015, and high refinancing rates (22%), and strict currency controls are propping it up. Although the IMF program gives us greater confidence in the near-term ability of the Ukrainian government to meet its borrowing requirement as long as it stays in the program, we think the government may face legal challenges to external bond issuance when the program ends, if it has not resolved any creditor disputes that may still persist.

In 2013, Russia lent Ukraine $3 billion, in the form of a tradable U.K.-law eurobond. Holders of this $3 billion eurobond due December 20, 2015 (which we now rate 'D') decided not to tender the security in the October debt exchange. We assume one of two treatments for this obligation:

The Ukrainian government will pay the obligation out of its international reserves, because governments occasionally pay in full creditors who have not participated in an exchange offer to place the episode behind them; or The Ukrainian government will not pay the obligation, and will let it remain in default until another solution is found or the debt is repudiated.

We understand the IMF amended its policy on lending into arrears on December 8, 2015, allowing it to continue to disburse loans to Ukraine under its $17.5 billion, four-year EFF program ending in 2018, regardless of whether the defaulted debt is deemed to be official or private.


The stable outlook reflects our view that over the next 12 months the Ukrainian government will maintain access to its official creditor support by pursuing needed reforms, albeit with a lag, on the fiscal, financial, and economic fronts. Specifically, the stable outlook also factors in our assumption that an IMF-compliant 2016 budget is passed by early next year, although we acknowledge that risks to this outcome are substantial.

We foresee possible ratings upside in the event of the passage of the proposed tax and tax administration reform that would simplify and widen the government's revenue base, alongside reforms to the business environment and the judiciary. We could also consider an upgrade if key state-owned banks and other enterprises, including Naftogaz, cease their reliance on budgetary and quasi fiscal support.

Although not our base case, downside risk to the ratings could build if Ukraine doesn't stay on track with the IMF program, its conflict with the Russian Federation deepens, very sizable contingent liabilities migrate to the general government balance sheet, or if we conclude that a further debt exchange was inevitable.