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- In our view, the Russian Federation's monetary policy flexibility has weakened, as have its economic growth prospects.
- We are therefore lowering our foreign currency sovereign credit ratings on Russia to 'BB+/B' from 'BBB-/A-3' and our local currency sovereign credit ratings to 'BBB-/A-3' from 'BBB/A-2'.
- At the same time, we removed these ratings from CreditWatch, where they were placed with negative implications on Dec. 23, 2014.
- The outlook is negative, reflecting our view that Russia's monetary policy flexibility could diminish further. We could lower the ratings if external and fiscal buffers deteriorate over the next 12 months faster than we currently expect.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the Russian Federation are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Calendar Of 2015 EMEA Sovereign, Regional, And Local Government Rating Publication Dates," published Dec. 30, 2014, on RatingsDirect). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation.
In this case, the reason for the deviation is a significant change in our perception of Russia's monetary flexibility over the 2015-2018 forecast horizon and the effect we expect Russia's weakening economy to have on its financial system. As a result, we have revised downward our expectations on key macroeconomic indicators.
The next rating publication on Russia is scheduled for April 17, 2015, according to our calendar.
On Jan. 26, 2015, Standard & Poor's Ratings Services lowered its long- and short-term foreign currency sovereign credit ratings on the Russian Federation to 'BB+/B' from 'BBB-/A-3'. We also lowered the long- and short-term local currency sovereign credit ratings to 'BBB-/A-3' from 'BBB/A-2'. In addition, we removed these ratings from CreditWatch, where they were placed with negative implications on Dec. 23, 2014. The outlook on the long-term ratings is negative.
At the same time, we revised the transfer and convertibility (T&C) assessment on Russia to 'BB+' from 'BBB-'. We affirmed the long-term national scale rating on Russia at 'ruAAA'.
The downgrade reflects our view that Russia's monetary policy flexibility has become more limited and its economic growth prospects have weakened. We also see a heightened risk that external and fiscal buffers will deteriorate due to rising external pressures and increased government support to the economy.
We believe that Russia's financial system is weakening and therefore limiting the Central Bank of Russia's (CBR's) ability to transmit monetary policy. In our opinion, the CBR faces increasingly difficult monetary policy decisions while also trying to support sustainable GDP growth. These challenges result from the inflationary effects of exchange-rate depreciation and sanctions from the West as well as counter-sanctions imposed by Russia. We project Russia's real GDP per capita growth to average less than economies with comparable levels of per-capita income over our 2015-2018 rating horizon.
In December 2014, the CBR increased its key interest rate by 750 basis points over five days to 17%. This was to stem the sharp depreciation of the ruble and curb inflation. The ruble briefly appreciated against the dollar but has since continued to depreciate, reaching about 66 rubles to the dollar (as of Jan. 26, 2015), compared to about 35 a year ago. The interest rate on interbank loans increased substantially, to well above the key rate--although it has since moderated. We see such movements in financial instrument rates as strong indicators of a weakening monetary transmission mechanism. We expect that credit to the economy will be curtailed, which will likely further undermine growth.
We also understand that during 2014 the Russian public had been converting rubles into foreign currency, thereby fueling depreciation. Given the pass-through of more expensive imports to domestic prices generally, we now expect that inflation will rise above 10% in 2015.
We anticipate that asset quality in the financial system will deteriorate given the weaker ruble; restricted access of key areas of the economy to international capital markets due to sanctions; and economic recession in 2015. Asset quality deterioration may not be immediately apparent in reported figures, however, due to temporary measures introduced by the CBR that allow Russian banks to apply more favorable exchange rates when valuing foreign-currency denominated assets and apply more flexible provisioning policies.
We project that the economy will expand by about 0.5% annually in 2015-2018, below the 2.4% of the previous four years. We see this muted projected growth partly as a legacy of a secular economic slowdown that had already begun before the recent developments in the Ukraine. It also reflects a lack of external financing due to the introduction of economic sanctions and the sharp decline in oil prices. Ruble depreciation will subdue GDP per capita in dollar terms, which we forecast at $8,600 in 2015. We also expect that declining domestic purchasing power as a result of exchange rate depreciation and rising inflation will likely hamper Russia's growth prospects.
Balance-of-payment pressures have hit the economy; Russia is experiencing a severe terms-of-trade shock (see "Standard & Poor's Revises Its Crude Oil And Natural Gas Price Assumptions," published Jan. 9, 2015). We nevertheless expect that Russia's current account will remain in surplus over 2015-2018 due to import compression (a consistent drop in import demand).
In our view, balance-of-payment pressures center on the financial account. Private-sector net capital outflows averaged $57 billion annually during 2009-2013; they increased to $152 billion in 2014. Stresses could mount for Russian corporations and banks that have foreign currency debt service requirements without a concomitant foreign currency revenue stream.
We estimate Russia's gross external financing requirement for 2015 at close to 85% of current account receipts (CARs) plus usable reserves. We expect that some of this requirement will be accommodated by dollar sales by the CBR, potentially exerting additional downward pressure on CBR reserves. Our figure for CBR usable reserves deducts from the CBR's reported foreign currency reserves:
- Investments made by the CBR on behalf of the government;
- The CBR's foreign currency swaps;
- Funds received under repos with nonresidents;
- and Accounts of domestic banks that are counted as reserves.
By this definition, we forecast that reserve coverage of current account payments will decline to about three months by 2017, from seven months in 2014.
That said, Russia maintains a net external asset position. We expect a narrow net external asset position of about 9% of CARs over the 2015-2018 forecast horizon (liquid external assets held by the public and banking sector minus external debt).
On Nov. 10, 2014, the CBR modified its exchange rate regime. It moved from an operational band--with regular interventions on and outside the borders of the band against a dual currency basket--to a freer float, with foreign currency interventions permissible in case of financial stability threats. This change should afford the CBR greater ability to conserve reserves. Historically, there is usually a strong correlation between the external value of the ruble and oil prices; this has once again been the case over the past 12 months.
To mitigate oil-price vulnerability, in 2013 the government instituted a fiscal rule that caps government spending based on long-term historical oil prices, while targeting a central government deficit of less than 1% of GDP. This rule is designed to lead to asset accumulation when oil prices are high, and to allow the government to draw on assets when prices are low, hereby reducing the pro-cyclicality of fiscal policy. We expect fiscal policy to significantly loosen as the sharp decline in oil prices, compared to historical prices, allows for higher deficits.
Ruble depreciation supported the government's fiscal position in 2014 because about half its revenues come from hydrocarbons and are priced in U.S. dollars. The U.S. dollar oil price decline of 55% since the start of 2014 was only 10% in ruble terms. As a result, we estimate that the central government posted a small deficit of 0.5% of GDP last year. However, we expect a deterioration in local and regional government balances, which bear the brunt of the government's increased spending on public-sector wages. Overall, we estimate that the general government will post a deficit of 1.3% of GDP in 2014 and an average annual deficit of 2.5% over 2015-2018. Support to the banks through the placement of RUB1 trillion (about 1.4% of GDP) in government bonds was approved in 2014 and is accounted for in government expenditure, though not yet utilized.
We view the modest general government net debt position as a rating strength, as we do its low interest burden as a percentage of revenues. The central government's Reserve Fund and National Wealth Fund, together total about 14% of GDP (although we believe about 1% of GDP of this is invested in non-liquid domestic assets). In our opinion, the central government will progressively use these two funds to increase its support to the economy and the financial system. We understand that RUB500 billion (about 0.7% of GDP) will be taken from the Reserve Fund and put on Ministry of Finance deposit accounts with the domestic banks to improve their liquidity. In our view, this will add to the non-liquid portion of the government's reserve assets, although we understand that at some point in the future these funds could be used for deficit financing.
We view Russia's institutional and governance effectiveness as a rating weakness. Political power is highly centralized with few checks and balances, in our opinion. We do not currently expect that the government will be able to effectively tackle the long-standing structural obstacles (perceived corruption, the weak rule of law, the state's pervasive role in the economy, and the challenging business and investment climate) to stronger economic growth over our 2015-2018 forecast horizon.
The negative outlook reflects our view that Russia's monetary policy flexibility could diminish further.
For example, the imposition of exchange controls, if implemented, could further hamper monetary flexibility. We could also lower the ratings if external and fiscal buffers deteriorated at a materially faster pace over the next 12 months than we currently expect.
We could revise the outlook to stable if Russia's financial stability and economic growth prospects were to improve.