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Scope Ratings GmbH has today 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.

Rating drivers

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 16.0% 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 roubles (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 programme’.

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 favourable 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 USD 470bn as of the end of 2018 to USD 540bn 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 favourable 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 4.0% over 2020-2021. Following the central bank’s response to inflationary effects from the VAT increase, inflation decreased to 3.0% by the end of 2019, supported by rouble 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 favourable 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 USD 55bn in 2011- 2013 to USD 19bn 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 rouble market for funding, sanctions weigh on longer-term growth prospects through potentially curtailing investment and trade.

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

The rating committee reviewed Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals and assigned 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 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. Relative credit weaknesses are captured in the Qualitative Scorecard (QS) and signalled for: i) recent events and policy decisions; and ii) geopolitical risk.

Social factors are reflected in Russia’s relatively low GDP per capita (USD 11,163 in 2019) as well as its low unemployment rates (4.5% in November 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. Relative credit weaknesses are captured in the Qualitative Scorecard (QS) and signalled for: i) growth potential of the economy; ii) economic policy framework; and iii) macro-economic stability and sustainability.

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. Russia’s falling working-age population will weigh on economic performance going forward, unless it is counterbalanced with productivity gains. 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.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that risks to the ratings are balanced over the next 12 to 18 months.

The ratings/outlooks could be upgraded if: i) the economy’s growth potential improved as a result of structural and/or governance reforms; and/or ii) economic and/or financial sanctions were significantly eased, reducing constraints on growth potential and the market access of Russian entities.

Alternatively, the ratings/outlooks could be downgraded if: i) Russia’s fiscal balance deteriorated, leading to a significantly higher public debt to GDP ratio; ii) the economic policy framework materially weakened, undermining the country’s growth potential and/or leading to a notable decline in international reserves; and/or iii) geopolitical risks escalated and/or additional sanctions were put into place that 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) recent political developments, vi) impact of sanctions, and vii) 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/outlook were first assigned by Scope as a subscription rating in January 2003.The ratings/outlooks were last updated on 26 July 2019.

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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