The international credit rating agency Fitch Ratings has revised the Outlook on Ukraine's Long-Term Foreign-Currency Issuer Default Rating (IDR) to Positive from Stable and affirmed the IDR at 'B'.
KEY RATING DRIVERS
The revision of the Outlook reflects the following key rating drivers and their relative weights:
MEDIUM
Ukraine's credit fundamentals have been relatively resilient to the coronavirus shock, and we expect public debt/GDP to fall in 2021 on the back of budget outperformance and recovering GDP. Foreign exchange reserves have trended up, and Ukraine has retained access to commercial and IFI external finance, despite uneven progress against the IMF stand-by arrangement (SBA). There has been a consolidation of the credible policy framework, underpinned by exchange rate flexibility, commitment to inflation-targeting, and prudent fiscal policy, which has supported greater macroeconomic stability and a marked reduction in general government debt since recovery from the 2014-2015 geopolitical and economic crises.
Fitch forecasts the general government deficit narrows 1.7pp in 2021, to 4% of GDP, below the government state deficit target of 5.1% and the 'B' median deficit of 6.2%. The state budget deficit fell sharply in 1H21 to 1.8% of GDP (annualised) with 1pp of revenue outperformance, and a larger expenditure under-execution, which we assume reverses in 2H21. However, there is somewhat greater reliance on government guarantees in this year's budget, totalling close to 1.8% of GDP. New tax-raising measures for 2022, which are yet to receive legislative approval, amount to 0.9% of GDP, helping offset recurrent expenditure pressure, and we project the general government deficit falls further to 3.2% of GDP in 2022, and 2.9% in 2023.
Near-term financing risks have reduced somewhat. Government cash holdings of USD2.0 billion at end-July (82% of which are in foreign-currency) were helped by issuances of Eurobonds in April and July totalling USD1.75 billion, and resumption of non-resident inflows into the domestic market of USD1 billion (0.6% of GDP) in 1H21. In addition, Ukraine's IMF special drawing rights allocation of USD2.7 billion and available liquidity in the domestic banking sector provide more financing space to meet higher budget needs in the remainder of 2021 (including USD2.2 billion external amortisation in September).
Moderate progress has been made on the reform agenda since our last review in February, including legislation to restrict the activities of oligarchs and to amend High Council of Justice selection processes, demonstrating the administration's somewhat greater ability to command majority support in the Rada. However, there has yet to be IMF agreement on the first review of the SBA, which could release two USD0.7 billion tranches this year (out of a total USD2.9 billion undisbursed funds), and the remaining USD0.6 billion of EU Macro-Financial Assistance may also depend on at least staff-level IMF approval. Our base case is for only partial release of these tranches in 2021, and that the SBA (due to expire in December) is extended into 2022.
General government debt is projected to fall 3.9pp in 2021 to 50% of GDP (57% including guarantees) below the 'B' median of 67.8%. This is supported by deficit reduction, growth in nominal GDP, and 3% appreciation of the hryvnia against the US dollar. The coronavirus shock temporarily reversed the marked decline in general government debt from 69.2% at end-2016 to 44.3% at end-2019. The share of foreign-currency denominated debt has been stable at 61%, and slightly below the 'B' median of 63%. Fitch projects general government/GDP edges down in 2022-2023 to 48.9%. Large outperformance relative to the government's deficit target in 2020 (of 2.3pp) and in 1H21, together with a somewhat lower risk that the economic recovery is derailed, provide greater confidence in the target to return to a primary surplus by 2023.
Ukraine's external position has remained resilient, with FX reserves broadly flat this year, at USD29.0 billion at end-July, up from USD25.3 billion at end-2019 (and USD17.7 billion in December 2018). High commodity prices contributed to a 6pp improvement in the 2020 current account to a surplus of 3.3% of GDP (offseting private sector capital outflows). Fitch forecasts less favourable terms of trade from 2H21 and strengthening domestic demand drive a narrowing of the current account surplus to 0.5% of GDP in 2021, and to a deficit of 2.4% in 2023, but more than covered by net capital inflows. FX reserves are projected at 4.8 months of current external payments at end-2021, up from 3.4 months at end-2019 and in line with the 'B' median.
The banking sector has absorbed the pandemic shock better than initially expected and its credit fundamentals have improved in recent years. Non-performing loans (NPL), which are mostly at state banks, declined to a still-high 37.8% of gross loans at end-5M21, from 48.4% at end-2019. The shock is not yet fully reflected in problem loan recognition but is balanced by robust pre-impairment profit and an adequate core capital ratio (16.8%). The high NPL provisions ratio, of close to 90%, and a more supportive legislative framework are also expected to drive good progress towards targets to lower the NPL ratio by near 15pp over the next three years. The deposit dollarisation ratio has fallen 3pp since end-2019 to 38%, but still compares unfavourably with the 'B' median of 31%.
Ukraine's 'B' rating also reflects the following rating drivers:
The rating is supported by Ukraine's credible macroeconomic policy framework, record of multilateral support, favourable human development indicators, net external creditor position of 11% of GDP, and lower public debt than the 'B' median. Set against these factors are weak governance indicators and exposure to geopolitical risk, low external liquidity relative to a large sovereign external debt service requirement, and legislative and judicial risk to policy implementation.
Fitch forecasts GDP growth of 4.1% this year, helped by a pick-up in agriculture and 12.9% real wage growth yoy in June, with short lockdowns in January and April subtracting an estimated 0.6pp from annual growth. The vaccination rollout has quickened over the last month but is low, at 13 doses per hundred people, and represents a downside risk to our forecast. We project GDP growth of 3.9% in 2022, slowing to 3.5% in 2023, which is close to our assessment of Ukraine's trend rate. Inflation has risen sharply, to 9.5% in June, from 5.0% in December 2020, due to temporary supply-side factors but core inflation also increased to 7.3%. We forecast inflation remains elevated at 9.2% at end-2021 (with a further 50bp policy rate increase to 8.5%) and declines to 6.0% at end-2022, the upper end of the target range. Last year's replacement of the NBU governor has increased the downside risk of looser-than-projected monetary policy, in our view.
There has been a mixed picture on progress against the IMF SBA over the last six months. A key prior action implemented was reinstating criminal liability for falsifying asset declarations, and the most challenging legislation outstanding is on the selection process for the head of the anti-corruption agency. Measures in these two areas were required because of unexpected Constitutional Court rulings in 4Q20, which underlines the risk of further policy reversals by the judiciary. The government's removal in April of Naftogaz's head by first suspending its appointment board has added to governance concerns and could further complicate the remainder of the SBA. In terms of the Russian-Ukrainian conflict, the heightened tensions following the build-up of Russian troops on the border in April were de-escalated with their withdrawal, but substantial near-term progress towards a resolution is unlikely, in our view, and the relationship continues to be subject to downside risk.
Despite the improved near-term financing position, continued engagement with the IMF remains key to maintaining access to external financing over a longer period. Sovereign external debt amortisations are relatively high, averaging USD5.0 billion in 2021-2023, albeit down from USD7.0 billion last year. Ukraine's external liquidity ratio improved 10.5pp in 2018-2020 to 85.1% but remains well below the 'B' median of 139.9%. There is also uncertainty over the capacity for the domestic banking sector to absorb higher government debt issuance over an extended period, despite its current ample liquidity.
RATING SENSITIVITIES
FACTORS THAT COULD, INDIVIDUALLY OR COLLECTIVELY, LEAD TO NEGATIVE RATING ACTION/DOWNGRADE:
- Macro and External Finances: Increased external financing pressures, sharp decline in international reserves or increased macroeconomic instability, for example stemming from IMF programme disengagement due to deterioration in the consistency of the policy mix and/or reform reversals.
- Public Finances: Persistent increase in general government debt/GDP, for example due to fiscal loosening, weak GDP growth, or currency depreciation.
- Structural: Political/geopolitical shocks that weaken macroeconomic stability, growth prospects and Ukraine's fiscal and external position.
FACTORS THAT COULD, INDIVIDUALLY OR COLLECTIVELY, LEAD TO POSITIVE RATING ACTION/UPGRADE:
- External Finances: Reduction in external financial vulnerabilities, for example due to a sustained increase in international reserves, strengthened external balance sheet, greater financing flexibility, or greater confidence in the ability to maintain IMF programme engagement and market access.
- Public Finances: Sustained fiscal consolidation that places general government debt/GDP on a firm downward path over the medium term.
- Macro and Structural: Increased confidence that progress in reforms will lead to improvement in governance standards and higher growth prospects while preserving improvements in macroeconomic stability.
KEY ASSUMPTIONS
Fitch does not expect resolution of the Russian-Ukrainian conflict or escalation of the conflict to the point of compromising overall macroeconomic performance.
Fitch assumes that the debt dispute with Russia will not impair Ukraine's ability to access external financing and to meet external debt service commitments.
ESG CONSIDERATIONS
Ukraine has an ESG Relevance Score of '5' for Political Stability and Rights as WBGI have the highest weight in Fitch's SRM and are highly relevant to the rating and a key rating driver with a high weight. A major escalation of the conflict in the east of Ukraine represents a risk. As Ukraine has a percentile below 50 for the respective Governance Indicator, this has a negative impact on the credit profile.
Ukraine has an ESG Relevance Score of '5' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as WBGI have the highest weight in Fitch's SRM and in the case of Ukraine weaken the business environment, investment and reform prospects; this is highly relevant to the rating and a key rating driver with high weight. As Ukraine has a percentile rank below 50 for the respective Governance Indicators, this has a negative impact on the credit profile.
Ukraine has an ESG Relevance Score of '4' for Human Rights and Political Freedoms as the Voice and Accountability pillar of the WBGI is relevant to the rating and a rating driver. As Ukraine has a percentile rank below 50 for the respective Governance Indicator, this has a negative impact on the credit profile.
Ukraine has an ESG Relevance Score of '4' for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Ukraine, as for all sovereigns. As Ukraine has a fairly recent restructuring of public debt in 2015, this has a negative impact on the credit profile.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg
Additional information is available on www.fitchratings.com
