Moody’s Investors Service has today downgraded Russia’s government bond rating to Baa3/Prime 3 (P-3) from Baa2/Prime 2 (P-2). The rating was also placed on review for further downgrade.
The key drivers behind the downgrade are:
- Moody’s expectation that the substantial oil price and exchange rate shock will further undermine the country’s already subdued growth prospects over the medium term; and
- Moody’s nearer-term concerns over the negative impact on the government’s financial strength of the erosion in official foreign exchange buffers and fiscal revenues.
In the review for further downgrade, Moody’s will assess the resiliency of the government’s balance sheet, in particular its foreign currency reserves cushion, to both the rating agency’s baseline forecast for oil prices and to the risk of a further decline in oil prices at a time when international market access is restricted for Russian borrowers due to sanctions. The review will also focus on the efficacy of policy actions that the Russian central bank and fiscal policymakers may take to address the oil and exchange rate shock in an effort to preserve economic and government financial strength.
Moody’s also lowered Russia’s country ceilings for foreign currency debt to Baa3/Prime 3 (P-3) from Baa2/Prime 2 (P-2) to align it with the sovereign rating, and reduced the long-term country ceilings for local currency debt and deposits to Baa2 from Baa1, while leaving unchanged the country ceiling for foreign currency bank deposits at Ba1/Non Prime (NP).
RATIONALE FOR DOWNGRADE TO Baa3
FIRST DRIVER: OIL PRICE AND EXCHANGE RATE SHOCKS WILL FURTHER UNDERMINE RUSSIA’S ECONOMIC GROWTH PROSPECTS
Moody’s one-notch downgrade to Baa2 in October 2014 balanced an increasingly subdued growth outlook — in part reflecting Russia’s weak institutional strength and the challenging geopolitical environment — against the government’s still extremely strong balance sheet. The negative outlook reflected the fragile nature of that balance, with both the growth outlook and the government’s fiscal position exposed to further shocks that could more profoundly undermine consumer and investor confidence, hastening the erosion of fiscal and foreign currency buffers.
As evidenced by the recent further steep falls in oil prices and the exchange rate, these shocks have materialized. According to Moody’s, the severe — and likely to be sustained — oil price shock, alongside Russian borrowers’ highly restricted international market access due to ongoing sanctions, is undermining economic fundamentals and increasing financial stresses on both the public and private sectors. In its updated growth outlook for Russia, Moody’s now expects real GDP contractions of around 5.5% in 2015 and 3% in 2016, bringing real growth over the 10 years through 2018 to virtually zero.
The hike in interest rates that took place in December and rapidly rising inflation, which will inhibit the central bank from easing rates in the coming months, will further squeeze consumers’ disposable incomes. In addition, the capacity of the banking sector to provide credit is impaired, causing credit to be scarce, and expensive when available. Moody’s expects that even if interest rates are lowered over time, lending will remain constrained; asset quality and profitability problems in the banking system will likely escalate the longer that the recession lasts despite efforts by the government to bolster the system’s capital and funding base.
The high level of uncertainty is likely to cause the savings rate to rise, thereby further undermining consumption and economic recovery, in contrast to a situation in which households believe that the recession would be short-lived.
SECOND DRIVER: NEGATIVE IMPACT ON GOVERNMENT’S FINANCIAL STRENGTH OF ERODING FOREIGN EXCHANGE BUFFERS AND FISCAL REVENUES
Although the rating agency expects Russia’s current account to stay in surplus due to import compression and continued capital flight, the ongoing repayment of external debt by the corporate, banking and public sectors and the outflow of direct investment will likely increase the speed of erosion of official foreign reserves, says Moody’s.
In Moody’s view, Russia’s nominal FX reserves could fall by at least as much this year as they did in 2014, when they declined by around $125 billion. These estimates are based on the pattern and levels of public and private sector debt amortization, and on assumptions regarding the private sector’s drawdown of its accumulated cash reserves and capital flight.
Moody’s notes that an additional erosion of FX reserves would not in itself be critical for the government’s capacity to service its debt. Russia — especially the government — is not heavily indebted and its debt maturity schedule is relatively elongated after the maturities falling due in 2014-15 have been paid. However, while the loss of reserves will probably not endanger the government’s capacity to service its own debt, significant uncertainty exists over the future dimension and direction of foreign reserves. That uncertainty is an important driver of the decision to move the rating down to Baa3.
Moody’s also expects that the oil price shock, and the ensuing recession, will cause the government’s fiscal position to worsen. Although the impact of the drop in oil prices on ruble-denominated government revenues will be partly offset by the depreciation of the exchange rate, and high inflation will likely limit the impact on non-oil revenues, Moody’s expects that the government’s revenues will nonetheless fall significantly over the course of next year as Russia’s economy contracts. Set against that, it is likely that some form of fiscal stimulus will be implemented either this year or next to mitigate the economic and political consequences of the crisis. Together, Moody’s expects these influences to widen the fiscal deficit, with the result that government debt will rise over the next two to three years, albeit from very low levels.
Added to that, the risk of politically-motivated actions which either directly or indirectly raise risks to creditors is rising in the context of current geopolitical tensions. Even if that risk remains low, its rise further shifts the delicate balance identified at the time of the last rating action to the downside.
Moody’s notes that the government’s balance sheet remains ostensibly very strong, with very low debt levels and a recent track record of fiscal prudence. Even with a significant further weakening of the country’s reserves position, Russia’s liquidity ratios such as Moody’s external liquidity indicator (EVI) would remain relatively strong. At the end of 2015, the 1-year EVI is estimated at 28.9% (measuring debt obligations falling due in the year against official foreign reserves levels). Import coverage of foreign currency reserves would also remain adequate, although that number is somewhat flattered by the expected import compression.
RATIONALE FOR REVIEW FOR FURTHER DOWNGRADE
The government’s ability to sustain its financial strength, which is the main factor supporting the country’s investment grade rating, rests on a large number of assumptions regarding, for example: oil prices and the exchange rate; the longevity of sanctions; capital flows; the effect of import compression on the current account balance; the impact of recession and inflation on the government’s fiscal position; and the policy response to domestic or external financial pressures. Small changes in assumptions could imply a more severe decline of reserves and a more rapid accumulation of debt by the government.
The review of Russia’s Baa3 government rating for downgrade will examine all of these assumptions in order to form a definitive view of the resilience of the economy and the government’s balance sheet to further shocks. The review will focus, inter alia, on the resilience of the government’s foreign currency reserves buffer to both our baseline forecast for oil prices and to more conservative scenarios. Should oil prices fail to recover in 2016 and beyond, or even drop further, Russia’s recession would likely persist beyond 2016 and the loss of investor and consumer confidence would be even more profound, leading to continued capital flight. The rating agency will examine the options available to the central bank and the government to support the economy in such circumstances.
In particular, Moody’s will focus on whether foreign currency reserves can be maintained at a level sufficiently higher than similarly rated peers with stronger institutional strength and policy predictability. In addition, the review will examine the extent to which the potential need to provide financial support of the corporate and banking sectors may erode the sovereign’s financial strength and increase its susceptibility to event risks by reducing the central bank reserves, increasing the government budget deficit and/or increase the use of government guarantees.
WHAT COULD CHANGE THE RATING — UP
Given the review for downgrade of the government’s rating currently in effect, limited upward pressure is likely in the next 12-18 months. Moody’s would confirm the current rating of Baa3 if the scenario analysis undertaken during the review were to show resilience in the country’s external and fiscal position.
WHAT COULD CHANGE THE RATING — DOWN
Russia’s ratings would be downgraded should Moody’s conclude, following the review, that the combination of risk factors identified above would likely lead to a more pronounced erosion of the government’s external buffer and/or fiscal balance, leading to a loss of financial strength to a level inconsistent with its current rating. In that event, the most likely outcome would be a one notch downgrade, although more severe outcomes cannot be ruled out in the current volatile environment.
GDP per capita (PPP basis, US$): 24,298 (2013 Actual) (also known as Per Capita Income)
Real GDP growth (% change): 1.3% (2013 Actual) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 6.5% (2013 Actual)
Gen. Gov. Financial Balance/GDP: -1.3% (2013 Actual) (also known as Fiscal Balance)
Current Account Balance/GDP: 1.6% (2013 Actual) (also known as External Balance)
External debt/GDP: 35.1% (2013 Actual)
Level of economic development: Moderate level of economic resilience
Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.