Russia Foreign Currency Ratings Lowered To 'BBB-/A-3' On Risk Of Marked Deterioration In External Financing; Outlook Neg
Publication date: 25-Apr-2014 01:25:07 EST
In our view, the large capital outflows from Russia in the first quarter of 2014 heighten the risk of a marked deterioration in external financing, either through a significant shift in foreign direct investments or portfolio equity investments. We see this as a risk to Russia's economic growth prospects.
We are therefore lowering our foreign currency ratings on Russia to 'BBB-/A-3' from 'BBB/A-2', lowering our local-currency long-term rating to 'BBB' from 'BBB+', and affirming our local-currency short-term rating at 'A-2'.
The outlook on both the foreign and local currency ratings remains negative. If we perceived increased risks to Russia's creditworthiness stemming from much weaker medium-term economic growth or due to reduced monetary policy flexibility, we could lower our sovereign ratings on Russia further. We could also lower our ratings on Russia if tighter sanctions were to result in additional weakening of Russia's net external position.
On April 25, 2014, Standard & Poor's Ratings Services lowered its long- and short-term foreign currency sovereign ratings on the Russian Federation to 'BBB-/A-3' from 'BBB/A-2'. At the same time, the long-term local currency sovereign rating was lowered to 'BBB' from 'BBB+', while the short-term local currency sovereign rating was affirmed at 'A-2'. The outlook on both long-term ratings is negative.
We also revised down the transfer and convertibility (T&C) assessment to 'BBB-' from 'BBB'.
At the same time, we affirmed our 'ruAAA' long-term national scale rating on Russia.
On March 20, 2014, we said that we could reassess the risks to Russia's creditworthiness based on its deteriorating external profile. Today's downgrade reflects the risk we perceive of a continuation of the large financial outflows observed in the first quarter of 2014, during which the size of Russia's financial account deficit was almost twice that of the current account surplus.
In our view, the tense geopolitical situation between Russia and Ukraine could see additional significant outflows of both foreign and domestic capital from the Russian economy and hence further undermine already weakening growth prospects.
Over the past decade, current account surpluses in Russia have averaged about 6% of GDP. Nevertheless, Russia's net external position vis-à-vis the rest of the world has been volatile, ranging from a net asset position of about 43% of current account receipts (CARs) in 2008 to a marginal 4% in 2010. This is explained by net outflows of private sector capital, resulting from what we view as a weak business environment. These outflows have averaged $57 billion annually in the five years to 2013, and $51 billion already in the first quarter of 2014 (or $64 billion including foreign currency transactions between Russian banks and the central bank), in our view largely due to the increased geopolitical tensions.
We expect Russia's current account surpluses to disappear by 2015, owing to imports rising faster than exports. We note however, that further ruble weakness could weigh on imports and postpone or even prevent the current account from shifting into deficit. Dependence on commodity exports results in terms-of-trade volatility, although past experience has shown that imports tend to adjust strongly, offsetting part of a commodity price-induced drop in export revenues.
Measured in terms of narrow net external debt, that is, external debt minus liquid external assets held by the public and banking sector, we expect Russia to be in a marginal net asset position by 2017, from a relatively strong net asset position of 23% of CARs in 2014. Although we expect some accumulation of external assets resulting from capital flight, we largely attribute these assets to the nonfinancial private sector. We view these assets as less liquid and do not include them in the calculation of narrow net external debt. We estimate that gross external financing needs (CARs plus short-term external debt by remaining maturity) will amount to about 75% of CARs and usable reserves in 2014-2017.
We estimate Russia's usable foreign exchange reserves at about $450 billion in 2014, sufficient to cover about 70% of total external debt. We adjust headline foreign exchange reserves down to take account of about $30 billion in required reserves for banks' foreign currency deposits, central bank foreign currency swaps, repurchase agreements, and corresponding accounts of resident banks that are counted as reserves. We have also revised our treatment of Russia's international investment position following the Central Bank's application of the sixth edition of the International Monetary Fund's Balance of Payments and International Investment Position Manual.
Economic growth in Russia slowed to 1.3% in 2013, the lowest rate since 1999, excluding the economic contraction in 2009. Under our base case, we expect GDP growth to average 2.3% in 2014-2017, well below the pre-financial-crisis years of 2004-2007, when growth averaged around 8%. We anticipate that real domestic demand growth is likely to remain weak, averaging about 3% over 2014-2017, having averaged about 8% over the earlier strong growth period of 2004-2007. In our view, if geopolitical tensions do not subside in 2014, there is significant downside risk that growth will fall well below 1%.
In our view, the Russian central bank's management of the ruble exchange rate has increased following a change in the parameters that result in an automatic shift in the floating operational band within which the currency is expected to trade. On March 3, the central bank increased the amount of sales or purchases that would automatically result in a shift in the band to $1.5 billion from $350 million. However, we continue to expect the central bank to transition to a floating exchange rate regime by 2015. If political or financial market volatility hinders these plans, and we were to view the transition to a fully flexible exchange rate as having stalled, we could lower the local currency sovereign ratings on Russia and equalize them with our foreign currency sovereign ratings.
At an extraordinary meeting on March 3, 2014, the central bank announced that it was "temporarily" increasing the key interest rate to 7% from 5.5%, aimed at preventing the risks of inflation and financial instability arising from increased financial market volatility. We view the central bank as being confronted with increasingly difficult policy decisions with regard to addressing inflationary pressures resulting from financial market volatility, while at the same time attempting to support sustainable GDP growth.
Over the past several years, fiscal dependency on commodity receipts has intensified. Whereas in 2008 the budget was balanced at an average oil price of about $55, we estimate that the oil price necessary to balance this year's budget would be close to $110.
In 2013, to mitigate this vulnerability, the government instituted a fiscal rule, which caps government spending based on long-term historical oil prices. This fiscal rule is designed to lead to the accumulation of assets in times of high oil prices, and to the drawing on fiscal assets in times of low oil prices, reducing the procyclicality of fiscal policy. As suggested in our March 20, 2014, rating action, in our view, the government's commitment to this fiscal rule will likely be significantly tested by the recent further deterioration in growth prospects.
We estimate Russia's 2013 general government budget will have recorded a deficit of 0.6% of GDP. Based on our expectation that commodity revenues will decline somewhat on the back of a slightly weaker oil price, we think the general government deficit will gradually worsen, reaching 1.5% of GDP by 2016, just outside the level targeted by the current fiscal rule, and implying an average annual change in general government debt of 1.5% of GDP over 2014-2017. We expect the Brent oil price to fall to about $95 by 2015 (see "Standard & Poor's Revises Its Crude Oil And Natural Gas Price Assumptions," published Nov. 20, 2013, on RatingsDirect). We estimate that the Urals oil price has traded at an average discount to Brent of about $1 during the past five years. Nevertheless, low levels of gross debt imply low general government interest payments, at about 2% of revenues during 2014-2017.
In our view, Russia's political institutions remain comparatively weak and political power is highly centralized. Protesters, opposition members, nongovernmental organizations, and liberal members of the political establishment have come under increasing pressure. We do not expect the government to decisively and effectively tackle the long-standing structural obstacles to stronger economic growth over our forecast horizon (2014-2017). These obstacles include high perceived corruption, comparatively weak rule of law, the state's pervasive role in the economy, and a challenging business and investment climate.
The negative outlook reflects our view that we could lower our ratings on Russia over the next two years should we assess the risks to Russia's creditworthiness as having increased, based on much weaker economic growth than we currently expect. If we were to view the sovereign's ability to coordinate monetary policy with fiscal and other economic policies to support economic growth as having weakened, it would put downward pressure on the ratings, as would a significant increase in inflation beyond 10% annual growth. We could also lower the ratings if tighter sanctions were to be imposed on Russia and further significantly weaken the country's net external position.
In addition, if we were to perceive that Russia's transition toward a more flexible exchange rate regime had stalled, we could lower the local currency ratings on Russia and equalize them with the foreign currency ratings.
We could revise the outlook to stable if Russia's economy proved resilient to the current challenges, if its external and fiscal buffers remained in line with our current expectations, and we were to view the monetary authority as able to fulfill its mandate of price stability alongside sustainable economic growth.