Sanctions will Depress Russia’s Reserves and Growth, says Fitch

Fitch Ratings has affirmed Russia’s long-term foreign and local currency issuer default ratings (IDR) at BBB, while the outlooks are negative. The short-term foreign currency IDR has been affirmed at F3. The issue ratings on Russia’s senior unsecured foreign and local currency bonds have also been affirmed at BBB, while the country ceiling is lowered to BBB from BBB+.

In its accompanying commentary, the credit ratings agency (CRA) notes that the deteriorating security situation in Eastern Ukraine has put relations between Russia, the European Union (EU) and US under strain.

The US recently tightened sanctions and both the EU and US will likely respond to the downing of a Malaysia Airlines jet on 17 July by imposing further penalties. This will depress capital inflows to Russia, and potentially lead to higher capital outflows, putting downward pressure on reserves and growth.

Fitch says that at present, Russia’s strong balance sheet, a key support to the rating, is still largely intact, with reserves standing at US$477bn on 11 July, down 6.5% year to date. Sovereign net foreign assets are 23% of gross domestic product (GDP). External pressures eased in 2Q14. Net private sector capital outflows adjusted for commercial banks’ foreign exchange (FX) swaps with the Central Bank of Russia (CBR) dropped back to US$12bn in Q214 from US$62bn in Q1, and reserves stabilised.

The CBR has not sold FX to stabilise the rouble (RUB) since mid-May, and was able to partly increase the flexibility of the exchange rate bands, which it had reduced in March.

On 16 July, the US imposed the most meaningful tightening in sanctions on Russia since March, by preventing two major corporates (Rosneft and Novatek) and two banks (VEB and Gazprombank) from raising debt and/or equity in the US market. This will increase investor risk aversion towards Russia and likely close the window for international bond issuance which opened in late June. Corporates will look to domestic sources of financing to substitute for external issuance.

Without an improvement in external borrowing conditions, and based on an assumption that net private sector capital outflows exceed US$120bn in 2014 and US$100bn in 2015, Fitch expects reserves to decline to US$450bn by end-2014 and US$400bn by end-2015. The deterioration in Russia’s net external debt position will be less severe, as the stock of private sector and bank external debt declines in tandem. Over the first half of 2014, all the growth in private sector external debt came from intercompany lending (over one-third of the total), while the stock of foreign loans and bonds was flat in US dollar terms.

Sanctions and international tensions will also have costs in terms of growth, potentially pushing Russia into an outright recession. Russia avoided a technical recession in Q214, with gross domestic product (GDP) flat on the previous quarter. GDP was up 1.1% year on year in H114. Since the last rating review in March, Fitch has revised down its growth forecasts for 2014 and 2015 to 0.5% and 1.5%, respectively.

Dependence on oil revenue aside, government finances remain a strength, given low government debt of 11% of GDP, and manageable government debt service. The authorities reforecast the 2014 budget in June to take into account a weaker currency and higher than expected oil prices and production. The effect was to raise the projected federal balance to a surplus of 0.4% of GDP from a deficit of 0.5% in the previous version of the budget. However, the consolidated general government will run a deficit thanks to imbalances in the regions.

Prolonged slow growth is also testing the authorities’ commitment to their policy framework. While the government is still adhering to the fiscal rule introduced in 2012, there will be an off-budget loosening as the National Wealth Fund (NWF) distributes up to 60% of its resources to infrastructure projects and deposits in VEB, a state-owned bank.

Other structural factors are weak relative to rating peers. Commodity dependence is high. Oil, petroleum products and gas account for 68% of goods exports and half of federal government revenue, exposing the balance of payments and public finances to external shocks. Governance is a relative weakness, manifested in the World Bank (WB) governance indicators.

Fitch’s lowering of the country ceiling by one notch to BBB from BBB+ means that with a few exceptions, Russian entities’ foreign currency IDRs will be constrained at the sovereign level of BBB. While the Russian authorities continue to maintain an open capital account, Fitch believes that potential sanctions and deteriorating relations with the EU and US pose risks to Russia’s financial integration with the rest of the world, increasing transfer and convertibility risk.

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