Ratings On Ukraine Affirmed At 'B-/B'; Outlook Stable
(The following statement was released by the rating agency)
• The International Monetary Fund's April disbursement to Ukraine highlights the progress the government and the National Bank of Ukraine have made toward economic reforms.
• While a recovery in investment and a bumper harvest gave economic growth a boost in 2016, the recent trade blockade in the Donbass region will drag on the economy in 2017.
• Large external debt repayments due in 2019 coupled with potential contingent liabilities, especially stemming from the Naftogaz/Gazprom arbitration due to be ruled on in June 2017, are still a risk to timely debt service.
• We are affirming our 'B-/B' ratings on Ukraine.
• The stable outlook reflects our view that over the next 12 months the Ukrainian government will maintain access to official creditor support by pursuing reforms on the fiscal, financial, and economic fronts.
On May 12, 2017, S&P Global Ratings affirmed its 'B-/B' long- and short-term foreign and local currency sovereign credit ratings on Ukraine. The outlooks on the long-term foreign and local currency ratings are stable. At the same time, we affirmed the 'uaBBB-' Ukraine national scale rating.
The affirmation balances improved macroeconomic fundamentals and significant progress made in financial and energy sector reforms against the risks stemming from large principal and interest payments due over our forecast horizon through 2020. In 2016, the Ukrainian economy saw a strengthening recovery after a significant contraction in 2015, as well as a sharp decline in inflation. The government also implemented key reforms that saw the International Monetary Fund (IMF) disburse a new financing tranche in April 2017. At the same time, our 'B-' long-term rating captures the significant debt repayments Ukraine faces over the forecast horizon, political challenges that could slow the pace of reforms, and the growth-slowing blockade in the east of the country.
A key drag on the ratings are the large principal and interest repayments coming due over 2017-2020 of more than US$20 billion (about 21% of 2017 GDP). We expect that Ukraine will fulfil its short-term sovereign debt obligations in 2017 (US$2.6 billion) and 2018 (US$3.9 billion) given donor funds, existing foreign exchange and hryvna balances held by The National Bank of Ukraine (NBU), and the government's ability to issue in both domestic and international markets. However, debt repayments in 2019 (US$7.5 billion)--mostly the principal repayment of the sovereign Eurobond and repayments to international financial institutions (including US$1 billion to United States Agency for International Development)--remain dependent on the government's ability to pass the reforms required by the IMF and its ability to refinance some debt on the international market. This year, we expect the Ukrainian government will issue a Eurobond to test the market. The effective interest rate on the entire outstanding stock of general government debt has increased with the increase in debt, although so has the weighted average maturity of Ukraine's debt stock.
Large contingent liabilities, including two court cases relating to a US$3 billion Eurobond issued to Russia and a $31.8 billion litigation case filed by Gazprom against Naftogaz (for nonpayment in a potential take-or-pay contract), threaten the fiscal outlook (although Naftogaz has countersued Gazprom for a similarly large amount) and debt sustainability. The Naftogaz arbitration ruling is due on June 30, 2017, while the conflict over the Russia-bought Eurobond may drag on for longer. However, we understand that even an unfavorable ruling for Ukraine regarding the bond would not impair its ability to service its restructured and newly-issued bonds because a court-ordered freeze on these payments is not legally possible.
Positively, Ukraine's economy registered a moderate recovery in 2016, after a significant contraction in 2015. Real GDP grew by 2.3%, driven by a strong recovery in investments and a bumper grain harvest in the fourth quarter. We forecast growth of 1.9% in 2017, despite challenging conditions in light of the recent blockade in the east of the country. We expect consumption will strengthen over the forecast horizon on the back of higher minimum wages, decelerating inflation, and gradual labor market improvements. We expect continuing growth as reforms boost investment in key sectors such as agriculture and construction, likely leading to GDP growth averaging 2.7% per year in 2017-2020. In addition, the Deep Comprehensive Free Trade Agreement with the EU, which came into force in 2016 and has partly compensated for the declining exports to Russia, could support export growth in the medium term.
We think the government will attempt pension and land reforms (upon which further IMF disbursements hinge) despite the politically sensitive nature of such reforms. We also believe Ukraine's western partners will remain engaged. However, we note uncertainty around the adoption of land reform given strong vested interests and the degree to which some opposition parties are not in favor of the reforms.
At the same time, the one-year shield protecting Prime Minister Volodymyr Groysman from a vote of no confidence expired in April, giving rise to the risk of early elections or a potential cabinet reshuffle. We note risks to reform progress and possible delays in IMF disbursements if the current coalition government of the Petro Poroshenko Bloc and the People's Front falters or early elections are called. Moreover, corruption in Ukraine remains pervasive and progress in the fight against it is only gradual. In addition, tensions with Russia and the quasi-separatist areas in the east remain and have deteriorated since our last review. The resultant trade blockade in the Donbass region will drag on growth this year.
In 2016, Ukraine's current account deficit widened to US$3.8 billion (4.1% of GDP), from US$189 million (0.2% of GDP) in 2015. This sharp increase stemmed from accelerating imports as investments recovered, and imports, particularly of machinery and equipment, subsequently increased. However, we forecast that the current account will consolidate gradually over the forecast horizon owing to increasing exports in both nominal and real terms. At the same time, a potential slowdown in key steel export markets introduces an element of volatility.
As the economy continues its recovery and exports pick up, we forecast the current account deficit will average 3.3% of GDP in 2017-2020, financed by a mix of foreign direct investment, donor funds, and foreign borrowings. Still, we forecast external debt net of liquid assets to average 131% of current account receipts in 2017-2020, while gross external financing needs as a percentage of current account receipts and usable reserves, our key external liquidity measure, will also stand at 137%. Both ratios will likely start declining, however, because the growth of current account receipts will remain supported by sound export performance.
Ukraine's Extended Fund Facility (EFF) with the IMF officially ends in March 2019, but disbursements are already behind schedule. The IMF has so far disbursed over US$8.32 billion of the $17.5 billion available. Our ratings on Ukraine assume that the government will remain broadly on course with the IMF program and engaged with development partners, albeit with some continued lags. The next tranche of IMF funds, along with the associated external donor funds, is likely to be disbursed in the second half of 2017 if Ukraine progresses with key land and pension reforms. While the bulk of IMF funds are lent to the NBU to boost foreign exchange reserves, continuation of the program requires fiscal prudence and fulfilling IMF requirements to unlock funds from the EU and other donors.
Ukraine has achieved a strong fiscal adjustment over the last two years with the general government deficit declining to 2.2% of GDP in 2016 from almost 10% in 2014. The increase in energy tariffs has helped government finances as it resulted in Naftogaz (a state owned enterprise) recording its first profit (on a cash basis) in 2016 and has led us to equalize the central and general government balances. We note ongoing risks to public finances, however, including the conflict in the east, which has seen defense spending double in 2016 (to at least 5% of GDP) compared with 2014. Additionally, there is a risk of fiscal slippage in the run-up to the presidential elections in 2019. We expect a budget deficit of 3.3% in 2017, averaging 3.0% over the forecast horizon. Budget deficit numbers do not include the debt-increasing effects of bank recapitalization (which we consider a one-off) and currency depreciation. As a result, change in government debt will be significantly above the budget deficit recorded during 2014-2017.
The fiscal outlook remains critically dependent on reforms and the EFF. Politically sensitive reforms are still needed, especially in the public sector, where the pension deficit is estimated at 6% of GDP (one of the highest in Europe). The government has prioritized the privatization of state-owned enterprises (SOEs), and may reattempt to privatize the Odessa portside plant this year (after being unsuccessful in 2016). We should see a boost to revenues from mid-2017 as smaller SOEs are privatized using the government's Prozorro platform (online auction platform) and measures to improve tax collection bear fruit. The government expects that the decision to double the minimum wage at the beginning of the year will increase tax and social security revenues as more workers are lifted out of the shadow economy.
Moreover, we understand that the government has committed to use any surplus fiscal revenues to prepay corporate tax receipts, increase investment, or for saving.
Ukraine's net general government debt now includes the City of Kyiv's debt that the central government has taken on outright. Initially, this debt amounted to US$449 million but was reduced in a restructuring effort to US$351 million, which is now included in state debt. Net general government debt remains high for a low-income economy, although we forecast it will decline to72.6% by 2020 after peaking at 88.7% in 2017. In our view, the high level of debt means that targeting continued fiscal consolidation while retaining access to relatively cheap official financing via the IMF and other donors is critical to timely debt service.
Since the February 2015 lows, official reserve assets increased by $10.7 billion to $15.5 billion as of end-December 2016, reflecting IMF foreign currency loan inflows, reduced external debt payments, and continued but easing use of capital controls. Rising reserve assets have bolstered the NBU's credibility and promoted hryvnia stability, notwithstanding a further weakening over 2016. Since the start of 2017 the hryvnia has appreciated against the U.S. dollar, although we expect a slight depreciation by the end of the year. Recent currency appreciation reflects buoyant steel prices abroad, as well as a more stable macroeconomic picture domestically.
Some capital controls remain, although the NBU has begun a partial liberalization. We expect foreign exchange liberalization will progress slowly throughout the year as the NBU weighs the burden these controls have on investment flows against the risks that lifting them poses to the exchange rate. The NBU has effectively tempered the high inflation levels of 2015, and its target of 12% plus/minus 3% in 2016. This symbolized an important step toward inflation targeting, which further aided monetary policy credibility and indicated an improving but still weak monetary transmission mechanism. However, the recent resignation of the central bank governor has increased uncertainty about the NBU's course while the search for a successor continues.
Conditions in the financial sector have improved, but further recovery will be slow due to high levels of nonperforming loans in the system. Of the country's 180 banks, 87 have closed because of weak asset quality (due to prevalent related-party lending). The nationalization and subsequent recapitalization of Ukraine's largest bank, PrivatBank, which accounts for 36% of all domestic deposits, was key to avoiding a financial sector crisis (see "Ukrainian PrivatBank Upgraded To 'CCC+/C' From 'SD'; Outlook Stable," April 26, 2017).
However, the capitalization has added to the government's balance sheet at an initial cost of around 7% of GDP in 2016, and a subsequent recapitalization is expected in the coming months, albeit smaller than the first. 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. We note that a new corporate governance framework and more prudent NBU stress tests are being implemented and that liquidity in the banking sector has largely improved. Public confidence and economic growth will hinge on the authorities ensuring that banks operating in Ukraine meet capital and regulatory requirements.
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 required reforms on the fiscal, financial, and economic fronts; specifically, that the Rada (parliament) is able to broadly pass key pension and land reforms as set out by donors, thereby maintaining reform momentum this year.
Downside risk to the ratings could build if Ukraine fails to effectively implement further reforms required by the IMF for further funding, if sizable contingent liabilities crystalize on the general government balance sheet, if the central bank's independence is called into question, or if we conclude that a further debt exchange is likely. We could consider a positive rating action if economic growth significantly outperforms our expectations, alongside falling fiscal and external deficits, and there is no further deterioration in the situation in the east of the country.