Fitch downgrades Russia to 'B'; on rating watch negative

3 Mar 2022 , 08:14 AM

Fitch Ratings has downgraded Russia’s Long-Term Foreign Currency Issuer Default Rating (IDR) to ‘B’ from ‘BBB’. The ratings have been placed on Rating Watch Negative (RWN).

Under EU credit rating agency (CRA) regulation, the publication of sovereign reviews is subject to restrictions and must take place according to a published schedule, except where it is necessary for CRAs to deviate from this in order to comply with their legal obligations. Fitch interprets this provision as allowing us to publish a rating review in situations where there is a material change in the creditworthiness of the issuer that we believe makes it inappropriate for us to wait until the next scheduled review date to update the rating or Outlook/Watch status.
The next scheduled review date for Fitch’s sovereign rating on Russia will be 27 May 2022, but Fitch believes that developments in the country warrant such a deviation from the calendar and our rationale for this is set out in the first part (High weight factors) of the Key Rating Drivers section below.

This action relates to a committee held on 1 March and therefore does not reflect any subsequent developments, including announcements relating to not paying local currency debt coupons, which Fitch will assess further.

Key Rating Drivers
The downgrade and RWN reflects the following key rating drivers and their relative weights:

High

Severe Shock to Credit Fundamentals: The severity of international sanctions in response to Russia’s military invasion of Ukraine has heightened macro-financial stability risks, represents a huge shock to Russia’s credit fundamentals and could undermine its willingness to service government debt. Developments will weaken Russia’s external and public finances, severely constrain its financing flexibility, markedly reduce trend GDP growth, and elevate domestic and geopolitical risk and uncertainty. The RWN reflects the high degree of volatility in international relations, including the potential for further sanctions tightening and uncertainty over Russia’s policy response such as not servicing its debt, and the risk of a more acute loss of domestic economic confidence.

Rapidly Tightening Sanctions: Announced US and EU sanctions prohibiting any transactions with the Central Bank of Russia (CBR) will have a much larger impact on Russia’s credit fundamentals than any previous sanctions. Full implementation could render much of Russia’s international reserves unusable for FX intervention, and a large proportion could be subject to asset freezes. 32% of Russia’s FX reserves are denominated in euros and 16% in US dollars, and more than half are held in countries participating in sanctions (as of end-June 2021). Sanctions also prohibit US transactions with the National Wealth Fund or the Ministry of Finance.

More Uncertain Willingness to Pay: The sanctions could also weigh on Russia’s willingness to repay debt. President Putin’s response to put nuclear forces on high alert appears to diminish the prospect of him changing course on Ukraine to the degree required to reverse rapidly tightening sanctions. We assume US sanctions prohibiting transactions with the Ministry of Finance will not impede the servicing of Russia’s sovereign debt but this is unclear and the risk of such a severe measure has increased markedly.

Further Banking Sector Sanctions Likely: Fitch expects further ratcheting up of sanctions on Russian banks. Measures announced are already severe, including a ban on Sberbank transacting in US dollars, asset freezes at VTB through its inclusion in the SDN list, and exclusion from the SWIFT payments system of some banks. Their impact will depend on the extent to which foreign-currency payments could be re-routed through other Russian banks and exposures switched to other currencies or settled with foreign counterparties. However, we now anticipate widening of these measures to other banks, limiting such mitigants, with large costs through severe short-term disruptions and more lasting constraints to the efficiency of executing transactions.

Heightened Macro-Financial Risks: Announced sanctions and sharp rouble depreciation will fuel greater macro-volatility, and markedly increase the risk of a broad-based loss of domestic confidence triggering bank deposit outflows and dollarisation. Foreign-currency-denominated bank deposits (predominantly in US dollars) are near USD200 billion (25% of total deposits) and their outflow would represent a greater risk to the stability of the system, given the CBR’s capacity to support banks with rouble liquidity. CBR has raised the policy interest rate to 20% from 9.5%, and announced some capital controls.

Lower Trend GDP Growth: The shock to domestic confidence and policy tightening will have a sharply negative impact on near-term economic activity. Sanctions will also markedly weaken Russia’s GDP growth potential relative to our previous assessment of 1.6%, partly through constraining the ability to clear trade payments, with 55% of Russian exports denominated in US dollars and 29% in euros. In addition, trade partners will seek substitutes for imports from Russia, particularly in the energy sector (which accounted for USD241 billion or 44% of Russia’s exports in 2021). To a lesser extent, much weaker prospects for foreign investment and technological transfer will also weigh on trade and productivity.

Other Financing Flexibility Constraints and Fiscal Risks: The extension of sanctions to cover secondary market sovereign debt and non-US dollar issuances, including the euro, further reduces Russia’s financing flexibility. Sanctions tightening will also reduce the private sector’s ability to refinance its external debt. In addition, Russia’s fiscal balance will be negatively impacted by weakening economic activity, and to a lesser extent, the direct fiscal cost of the conflict in Ukraine. Contingent liability risks from the banking sector have also increased, although their near-term impact will be mitigated by regulatory forbearance.

Political and Geopolitical Risk and Uncertainty: Fitch considers Russia’s full-scale invasion of Ukraine, particularly in the event of protracted conflict, as well as weaker economic growth, have the potential to result in greater domestic political uncertainty and instability. The collapse in international relations and greater unpredictability in policy-making, in our view, also add to geopolitical risks in the short and medium term.