Scope Ratings GmbH European agency upgraded the Russian Federation’s long-term local-currency and foreign-currency issuer ratings to BBB from BBB- and revised the Outlook to Stable from Positive. The sovereign’s ratings for senior unsecured debt in local and foreign currency are also upgraded to BBB from BBB-, with the Outlook revised to Stable. The short-term issuer ratings have been affirmed at S-2 in both local and foreign currency with a Stable Outlook.
The drivers for the upgrade of Russia’s long-term ratings are: i) the sovereign’s conservative fiscal policy and improved fiscal policy framework, underpinned by low general government debt and continued fiscal surpluses on the back of higher revenues, which have strengthened budgetary flexibility; and ii) Russia’s improved external economic risk-profile underpinned by high foreign reserve adequacy, a robust external-creditor position and a strong commitment to inflation-targeting. This increases the country’s resilience to external shocks and mitigates the economic impact of a recent tightening in US sanctions. The factors driving the upgrade relate to changes under the ‘Public Finance Risk’ and ‘External Economic Risk’ categories of Scope’s sovereign assessment. The Stable Outlook balances these credit strengths against the challenges stemming from the economy’s low growth potential, governance risks and vulnerability to geopolitical shocks.
The first driver underpinning Scope’s decision to upgrade Russia’s sovereign rating to BBB is the country’s prudent fiscal policy and the strength of its public finances. Low public debt, a fiscal policy focused on rebuilding buffers, structural budgetary improvements, continuous cost control and a conservative budget management have helped to build up substantial cash reserves totalling an estimated 17% of GDP in 2019 that provide greater room for fiscal manoeuvre needed to support the real economy.
With an estimated federal domestic net borrowing of 1.5% of GDP in 2020, Scope expects Russia’s federal debt to rise moderately from an estimated 15% of GDP in 2019 to 16% of GDP in 2020, remaining very low compared to bbb-rated sovereign peers. Going forward, Scope expects that the debt ratio will slightly increase to around 18% of GDP by 2024, thus remaining below the government’s conservative debt ceiling of 20%. Russia also benefits from low levels of maturing debt (totalling only 5% of GDP through 2024) and a lower exposure to currency risk, given the high share of sovereign obligations denominated in rubles (about 75% of total debt as of 2019). Given that Russia’s low financing needs are met predominantly via local borrowing, the government is issuing Eurobonds as a means of facilitating benchmarks for Russian corporates that issue on international capital markets.
Russia benefits from sizeable government savings in the form of cash in deposits with the Central Bank, fully covering its total outstanding public debt as of 2019, which strengthens its budgetary flexibility to enact fiscal spending measures with less recourse required to debt financing. Russia’s government debt net of general government deposits amount to an estimated -2% of GDP at end-2019 (in other words, the government has net assets). Liquid assets in the National Welfare Fund are expected to have exceeded 7% of GDP at the end of 2019, i.e. the minimum threshold that would allow the government to tap the fund, for instance, for infrastructure investment purposes.
Russia’s reformed fiscal policy framework in place since 2018 has weakened the link between increases in oil prices and increases in budgetary expenditure, and has led to continued budget surpluses. After a 2.9% of GDP fiscal surplus in 2018, Russia’s federal budget will likely have recorded a 2.0% of GDP surplus in 2019, supported by conservative budgetary management, increasing tax compliance, continuous cost control, higher-than-budgeted oil prices and lower-than-budgeted public investments due to delays in project implementation. Scope expects Russia’s fiscal policy to remain conservative as guided by the new budgetary rules. Russia is thus expected to maintain modest budget surpluses going forward, averaging around 1% of GDP over 2020−2022, acknowledging planned public investment increases associated with the ‘National projects program’.
Scope estimates that Russia’s federal budget should provide funding for about three-quarters of all National projects over the next several years. Rising budget funding earmarked for the National projects see the latter’s share of the total budget rising from 10% of spending in 2020 to about 12.5% by 2022, mirroring a strengthened capacity of the Russian government to implement significant investment. Reasons for Russia’s strengthened expenditure flexibility include: i) structural budgetary improvements, including lower pension costs as a result of increases in retirement ages; ii) a VAT increase from 18% to 20% in 2019; and iii) an austere fiscal policy, which has also impacted military and regional budgets.
The second driver supporting the rating upgrade to BBB is Russia’s strengthened external economic risk-profile, which forms the basis for the economy’s continued resilience against external shocks and improved macroeconomic stability. This includes Russia’s favorable foreign-exchange-reserve adequacy, its flexible exchange rate, the maintenance of a robust external position and the central bank’s strong commitment to inflation-targeting. These factors underpin the Russian economy’s increased resilience to external shocks.
The accumulation of sizeable reserves has strengthened Russia’s external position, supported by a high current account surplus of 5.2% of GDP in 2019. As a result of foreign-currency purchases under Russia’s fiscal framework, international reserves increased from $470 bln as of the end of 2018 to $540 bln in October 2019, exceeding their pre-crisis level from 2013 and corresponding to around five times the country’s short-term external debt or 18.5 months of import coverage. Going forward, despite an expected decline in the current account balance to a modest surplus of 4% of GDP by 2021, Scope expects Russia to maintain a strong external balance sheet, including a favorable net external creditor position (of 35% of GDP as of 2019).
In addition, Russia’s de-dollarisation strategy along with its build-up of gold reserves has strengthened Russia’s balance sheet against sanctions associated with transactions in US dollars. Following the intensification of sanctions against Russia in 2018, Russia’s share of yuan and euro reserves now exceed 15% and 30% respectively of total reserves. At the same time, the dollar’s share continued to decline from around one-half in 2017 to less than a quarter in 2019, reflecting a structural shift in the composition of reserves and underlying changes in the structure of currency denomination of Russia’s foreign trade with key trading partners.
Further bolstering Russia’s external resilience is the central bank’s credibility. Inflationary pressures have eased after inflation peaked at 5.3% YoY in March 2019, with average inflation likely to remain close to Russia’s inflation target of 4% over 2020-2021. Following the central bank’s response to inflationary effects from the VAT increase, inflation decreased to 3% by the end of 2019, supported by ruble appreciation and a better-than-expected harvest which reduced food price pressures. The Central Bank of Russia has reversed its monetary tightening in the second half of 2019 and brought its key rate to 6.25% in December, marking the fifth consecutive rate cut in 2019 with the rate now at a six-year low. Going forward, Scope expects a continued prudent easing cycle focused on achieving a lower and more predictable level of inflation.
In contrast to these favorable developments, Russia’s ratings are constrained by: i) the economy’s low growth potential, ii) weak governance, and iii) the economy’s high vulnerability to geopolitical risk, which has brought ramifications such as a restricted international market access for the private sector.
The weak growth outlook remains a key credit constraint on Russia’s ratings. Following low growth estimated at 1.2% in 2019, Scope expects the economy to gain traction in 2020 and grow by 1.8% as looser monetary policy and some fiscal stimulus support domestic demand. Scope expects that, with Russia’s current economic structure and institutions, medium-run growth prospects will remain subdued in the range of 1.5%–2.0% per annum, reflecting: i) adverse demographic trends in the form of a shrinking working-age population and a growing elderly population; and ii) a weak business and investment climate, with difficulties in achieving a diversification away from the dominant role of the oil and gas sector in the economy, thus weighing on productivity growth; and iii) deteriorating political and economic relations with the US and EU, which reduce Russia’s trade, investment and innovation potential.
Weak governance is a second constraint on Russia’s credit ratings. According to the World Bank’s Worldwide Governance Indicators, Russia is ranked weakly in its application of the rule of law and control of corruption, reflecting in part ongoing uncertainties in relation to the quality of contract and property rights enforcement. This weighs on business confidence and explains chronic underinvestment. In addition, a complex web of interconnected state-owned companies in mining, manufacturing and services sectors raises questions on the extent to which public power is exercised for private gain, including as it regards corruption. The recent announcement of reforms to Russia’s constitution and replacement of Prime Minister Dmitry Medvedev with a relatively unknown technocrat Mikhail Mishustin underscores Russia’s ongoing governance challenges.
Finally, geopolitical risks related to the Ukraine conflict and the threat of intensified sanctions are weighing on the country’s external financing flexibility, investment and growth prospects. Sanctions in place inhibit systemically important Russian state-majority-owned banks and companies in the oil and gas sector from access to global capital markets and restrict exports to Russia of technology used in oil exploration and production. More general protectionist trends of Russian trade policies have contributed to a weak business and investment climate by discouraging foreign investment in recent years. As a consequence, inbound foreign direct investment to Russia has dropped from an average of $55bln in 2011-2013 to $19 bln in 2015-2018.
The United States has also imposed other sanctions on Russia for reasons not related to the Ukraine conflict, including prohibitions on US financial institutions from participating in new issues of Russian sovereign bonds. In December 2019, the US also passed a law that threatens sanctions on companies and persons participating in the construction of the Nord Stream 2 gas pipeline from Russia to Germany. While Scope views potential short-term implications from these sanctions to be limited, given Russia’s low financing needs, high international reserves and reliance on the roble market for funding, sanctions weigh on longer-term growth prospects through potentially curtailing investment and trade.