Scope Ratings GmbH has today affirmed the Russian Federation’s long-term local-currency and foreign-currency issuer ratings at BBB- and revised the Outlook to Positive from Stable. The sovereign’s ratings of BBB- for senior unsecured debt in local and foreign currency are also affirmed, with the Outlook revised to Positive. The short-term issuer ratings have been affirmed at S-2 in both local and foreign currency with a Stable Outlook.

For the rating action annex, click here.

Rating drivers

The drivers for the Positive Outlook on Russia’s long-term ratings are: i) the sovereign’s robust public finances underpinned by low general government debt, structural budgetary improvements and sizeable government cash deposits; and ii) Russia’s improved external resilience and high reserve adequacy, underpinned by a strong external position and flexible exchange rate regime. The factors driving the Outlook revision relate to changes under the ‘Public Finance Risk’ and ‘External Economic Risk’ categories of Scope’s sovereign assessment. Under Scope’s evaluation, these collective credit strengths outweigh the still meaningful challenges for Russia stemming from the economy’s low growth potential, governance concerns and vulnerability to geopolitical shocks including heightened risk of intensified sanctions.

The first driver underpinning Scope’s decision to raise Russia’s Outlook to Positive is the strength of the country’s public finances. It is Scope’s opinion that low general government debt, sizeable government cash deposits and structural budgetary improvements have strengthened Russia’s government balance sheet and provided greater room for fiscal manoeuvre, raising the capacity of the Russian government to tolerate somewhat higher debt levels in coming years.

As a result of external debt repayments and decreasing local and regional government debt, Russia’s gross public debt ratio declined to 14.0% of GDP as of 2018, from 16.4% in 2015. Going forward, the IMF projects that the debt ratio will slightly increase to 16.9% of GDP by 2024, thus remaining below the government’s conservative debt threshold of 20%. However, government debt net of general government deposits including National Wealth Fund assets stood at below 1% of GDP at the end of 2018, one of the lowest such net debt ratios in Scope’s rated sovereign universe. Russia also benefits from very low public debt servicing costs at below 1% of GDP in 2019 and manageable foreign currency risks in public debt, reflected in low levels of maturing debt (amounting to just 5% of GDP through 2024) and a high share of sovereign obligations denominated in roubles (around 75% of total debt in 2018). For instance, Scope does not expect that intensified sanctions on Russian sovereign debt, if implemented, would weigh significantly on Russia’s immediate debt servicing ability, given aforementioned low financing needs that could be met via local borrowing and government cash deposits.

Russia’s fiscal policy focused on rebuilding fiscal buffers over past years has significantly improved budgetary performance. Higher than budgeted oil prices and robust tax revenue growth in 2018 resulted in a general government surplus of 2.8% of GDP, Russia’s first headline budgetary surplus since 2012. Key drivers of Russia’s budgetary improvements have included: i) a strict commitment to a new fiscal rule implemented in 2018 alongside higher oil prices since 2016 lows in prices; ii) improvements in tax collection and cost management; and iii) lower pension costs as a result of increases in retirement ages and a VAT increase (from 18% to 20%), which have further enhanced the sustainability of public finances.

Russia’s fiscal policy is set to ease over the medium term. The IMF projects Russia’s general government balance will gradually fall but remain in surplus until 2022, reflecting increased public investments. In order to enhance the country’s potential growth, the government is pursuing a public investment strategy comprising ‘National Projects’ for the period 2019-2024 with an estimated investment volume of EUR 390bn, primarily focusing on transport infrastructure (50% of total spending) alongside social infrastructure including housing, healthcare and education (25%). The projects are.to be 70% funded from the federal and regional budgets, while the remaining portion will be financed by extrabudgetary resources. A EUR 50bn investment fund was set up in 2018, as outlined in presidential decrees. In addition, the government plans to use a portion of the National Wealth Fund to cover infrastructural spending by year 2024.

Russia’s new fiscal framework based on a conservative oil-price benchmark of USD 40 per barrel and requiring the Ministry of Finance to use excess petroleum revenues to purchase FX will increase government savings, strengthening Russia’s budgetary flexibility over time to be able to enact fiscal spending measures with less recourse to debt. In addition, Russian authorities’ oil price assumptions anticipate oil prices to fall to less than USD 60 per barrel by 2020 mainly owing to rebounding global shale gas production. In Scope’s view, the effect on Russian growth of an oil price decline of this scale would be manageable.

The second driver supporting the Positive Outlook is the country’s strengthened external economic risk-profile. This includes a boost to Russia’s foreign-exchange-reserve adequacy, low external financing needs alongside maintenance of an external-creditor position. These underpin the Russian economy’s capacity to cope with external shocks. In Scope’s view, increasing foreign exchange reserves give Russia room to manage the economic impact in the instance of an additional tightening in sanctions. Russia’s foreign exchange reserves amounted to USD 407.6bn or 20 months of goods import cover as of June 2019. The government’s external debt (2.7% of GDP in 2018) is the lowest of major economies in the world and a sovereign net foreign asset position (of 33% of GDP in 2018) strengthens Russia’s external balance sheet.

Despite Scope’s assumption of a falling current account surplus (from 7% of GDP in 2018 to 5% in 2019), Russian oil revenues will remain sufficient for a continued accumulation of foreign currency reserves as the current account surplus will cover in full external debt redemptions through 2019. Scope maintains this expectation even under conditions of continued weak FDI and portfolio investment inflows to Russia. The impact of sanctions on Russia’s external economic risk profile should moreover remain manageable under scenarios excluding a simultaneous major shock to oil prices.

In contrast to these favourable developments, Russia’s ratings are constrained by: i) Russia’s low growth potential, ii) weak governance, and iii) the economy’s high vulnerability to geopolitical risk, which has brought ramifications like restricted international market access for the Russian private sector.

In 2018, the economy posted the fastest growth since 2012, at 2.3%. However, while short-term risks from the 2014-16 oil price shock have diminished as a result of the economic policy response and adaptation of the economy to lower oil price conditions, Russia’s medium-run growth prospects remain nonetheless subdued. Scope expects medium-term growth potential of only 1.5%. In Scope’s view, the weak potential growth is the result of: i) an overreliance on the oil and gas industries, which accounted together for 46% of federal budget revenues and more than 60% of goods exported in 2018, along with high regulated tariffs on natural monopolies, undermining competitiveness; ii) structural challenges posed by weak infrastructure in combination with notable regional economic disparities, constraining investments into value chains; and iii) supply-side bottlenecks due to challenging demographic trends in the form of a shrinking working-age population and a growing elderly population that weigh on productivity growth.

In order to address ageing related challenges, the government adopted a pension reform in October 2018, raising the retirement age by five years to 60 and 65 for women and men respectively. The reform came into initial effect in January 2019 and will be implemented gradually over the next ten years and is expected to increase Russia’s potential rate of growth by 0.3-0.4pp over 2020-2028 via expanding the labour force. In response to Russia’s falling working-age population, President Vladimir Putin approved a State Migration Policy for the period 2019-2025 aimed at attracting Russian-speaking migrants from post-Soviet states. According to World Bank forecasts, Russia’s potential growth could rise by 0.2pp should this migration policy be successfully implemented, increasing annual net inward immigration to 289,000 by 2028.

Weak governance is a second constraint on Russia’s credit ratings. According to the World Bank’s Worldwide Governance Indicators, Russia is ranked low in its application of the rule of law and control of corruption, reflecting in part ongoing uncertainties in relation to the quality of contract enforcement and respect for property rights. 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.

Finally, geopolitical risks linked to the ongoing conflict in Ukraine and the threat of intensified sanctions remain significant event risks – acting as a core constraint on Russia’s credit ratings, already inhibiting systemically important Russian companies from access to global capital markets. Western sanctions have contributed to a deterioration in an already tepid business and investment climate by discouraging foreign investment. While Scope views risks of potentially intensified sanctions on Russia’s sovereign debt issuances to be credit-negative as these would add significantly to the Russian government’s cost of financing, Scope considers Russia’s enhanced resilience to external shocks to be a counter-weight cushioning the potential impact. Scope believes that over the longer term, Russia’s transformation to an economy that produces high-value-added goods rather than relying on its commodities sectors will depend on improvements in the business climate, alongside measures that address underinvestment.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative “A” (“a”) rating range for the Russian Federation. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.

For the Russian Federation, the following relative credit strength is identified: 1) good resilience to short-term external shocks. Relative credit weaknesses are signalled for: 1) growth potential of the economy; 2) economic policy framework; 3) macro-economic stability and sustainability; 4) market access and funding sources; 5) current account vulnerability; 6) recent events and policy decisions; 7) geopolitical risk; 8) banking sector performance; 9) banking sector oversight and governance; and 10) financial imbalances and financial fragility.

Combined relative credit strengths and weaknesses generate a downward adjustment and signal a BBB sovereign rating for the Russian Federation. The lead analyst has recommended a further one-notch adjustment of the indicated rating to BBB- to take into account the ongoing persistence and potentially intensified use of economic sanctions on Russia, weighing on the country’s long-term growth prospects.
The results have been discussed and confirmed by a rating committee.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘Institutional and Political Risk’ under its methodology, on which Russia scores poorly on a composite index of six World Bank Worldwide Governance Indicators versus sovereign peers.

Social factors are reflected in Russia’s relatively low GDP per capita (USD 11,327 in 2018) and low rates of unemployment (4.5% in June 2019). In addition, adverse demographic trends in the form of a shrinking working-age population are key factors that weigh on Russia’s growth potential. According to the most recent data published by Rosstat, the Russian population declined in 2018 for the first time in a decade by almost 100,000 to 146.8mn. Furthermore, the old-age dependency ratio (the number of persons aged 65+ per 100 persons aged 15-64) deteriorated to 21.5 in 2018, from 20.8 in 2017. The UN forecasts that this ratio will deteriorate to 30.5 by 2030. The falling working-age population will weigh on economic performance going forward, unless it is counterbalanced by productivity gains. In response, President Putin approved a State Migration Policy concept for 2019-2025 aimed at attracting Russian-speaking migrants from post-Soviet states. Moreover, population ageing is expected to put pressure on long-term public finances through higher spending on pensions and healthcare.

Finally, environmental factors were considered during the rating process but had no impact on this rating action. Despite its high vulnerability to the impacts of climate change (confirmed by a 2017 report from the Russian Environment Ministry), the country has made little progress in climate action implementation. However, as a positive development, Scope notes that the country, which ranks as one of world’s biggest polluters, plans to ratify the Paris Climate Agreement before September 2019, also in order to foster a long-term development strategy around low greenhouse gas emissions by 2050.

Outlook and rating-change drivers

The Positive Outlook reflects Scope’s view that risks to the ratings are skewed to the upside over the next 12 to 18 months.

The ratings could be upgraded if: i) Russia maintains a prudent fiscal policy, leading public debt ratios on a steady downward trajectory; ii) growth potential improved as a result of structural reforms; iii) further improvements in reserve coverage ratios were realised; and/or iv) economic and/or financial sanctions were removed, reducing constraints on growth potential and market access of Russian entities.

Alternatively, the Outlooks could be returned to Stable or changed to Negative if: i) Russia’s fiscal balance deteriorated significantly, reversing the decline in the public debt to GDP ratio; ii) the economic policy framework was materially weakened, undermining the country’s growth potential; iii) international reserves notably declined; and/or iv) geopolitical risks escalated and/or additional sanctions were put into place that would weigh significantly on Russia’s financial or macroeconomic stability.

Rating committee
The main points discussed by the rating committee were: i) Russia’s economic outlook and growth potential, ii) budgetary performance and debt developments, iii) macroeconomic and fiscal policy framework, iv) external position and resilience, v) the financial sector’s performance, vi) recent political developments, vii) impact of sanctions, and viii) peer considerations.

Methodology
The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com. Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies on www.scoperatings.com. The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the rating process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following material sources of information were used to prepare the credit rating: public domain. Key sources of information for the rating include: ROSSTAT (Russian Federation Federal State Statistics Service), the Ministry of Finance of the Russian Federation, Central Bank of Russia, European Commission, IMF, OECD, and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Jakob Suwalski, Associate Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlooks were last updated on 27.10.2017.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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