Rating action

Scope Ratings GmbH (Scope) has today upgraded the Russian Federation’s long-term issuer and senior unsecured debt ratings to BBB+ in both local and foreign currency with a Stable Outlook. Short-term issuer ratings have been affirmed at S-2 in local and foreign currency, with a Stable Outlook.

For the rating action annex, click here.

Summary and Outlook

The upgrade of Russia’s long-term sovereign ratings to BBB+, from BBB, reflects the following two core drivers:

• A track record of effective macroeconomic policy making, underpinned by the sovereign’s conservative, rules-based fiscal framework, a flexible exchange rate, and strong commitment to inflation targeting. This policy mix helps to anchor Russia’s macroeconomic stability and boost fiscal and economic resilience to external shocks, including those arising from potential further tightening of international sanctions and/or declines in petroleum prices.

• Robust external liquidity on top of continued current account surpluses and higher-than-budgeted oil prices, which strengthen the sovereign balance sheet and result in high foreign currency reserve adequacy, alongside a significant net external-credit position.

The upgrade reflects updates in Scope’s assessments under the ‘public finance risk’ and ‘external economic risk’ categories of its sovereign ratings methodology.

However, Russia’s credit ratings remain constrained by outstanding short- and longer-term credit weaknesses relating to: i) low economic growth potential in view of adverse demographic developments and structural economic bottlenecks, with a lack of far-reaching reform to date to diversify from the oil and gas sector’s dominant role in the economy; ii) weak governance, weighing on business confidence and leading to persistent underinvestment; and iii) the economy’s high vulnerability to geopolitical risk, including to further strengthening of sanctions upon international market access of the private and public sectors, further impairing an already weak business climate by discouraging investment.

The Stable Outlook represents Scope’s opinion that risks to the sovereign ratings are balanced over the forthcoming 12-18 months.

The ratings/Outlooks could be upgraded if, individually or collectively: i) Scope sees a significant further build-up of fiscal and external buffers, due to developments such as sustained high commodity prices and/or an improved short- to medium-term outlook for the volume of commodities exports; ii) economic growth potential improves as a result of structural reforms and/or persistently higher investment in the economy; and/or iii) geopolitical risk, including as associated with risk of economic and financial sanctions, were significantly eased, reducing constraints on Russia’s growth potential and market access of Russian entities.

Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) the macroeconomic policy framework, including policy credibility, were to weaken, undermining growth and public finance outlooks; ii) geopolitical risks were to escalate and/or additional sanctions are put in place, weighing on financial or macroeconomic stability; and/or iii) persistent deterioration in Russia’s public finances and/or the rouble leads to a significantly higher public debt-to-GDP ratio and undermines the sovereign’s shock-absorption capacity.

Rating rationale

The first driver of the upgrade of Russia’s sovereign ratings to BBB+ reflects the economy’s track record of effective fiscal, monetary and exchange-rate management. This record has helped to anchor Russia’s macroeconomic stability and promote fiscal and economic resilience to external shocks. In Scope’s view, such stability and resilience has enhanced Russia’s capacity to withstand imposition of international sanctions, periods of declining oil prices and economic downturns such as the Covid-19 crisis.

Russia’s prudent and conservative fiscal management has strengthened its government balance sheet and supported low levels of public debt. Near-term developments have supported a stronger-than-anticipated recovery of public finances, given the rebound in oil prices and potential for higher energy exports. Scope projects general government debt will fall to around 18% of GDP in 2021 from 19.3% of GDP in 2020, low compared with that of sovereign peers with a BBB+ rating. Reduced debt is underpinned by decline in the general government deficit to an estimated 0.5% of GDP this year, down from 4% of GDP in 2020, supported by a strong economic recovery short term. Scope expects the debt ratio will stabilise slightly under 20% of GDP by 2023 on the back of balanced budgets and planned fiscal consolidation. This would keep the debt ratio under the government’s conservative debt ceiling of 21.4% of GDP by 2023. In addition, Russia benefits from low levels of maturing debt (totalling only around 1% of GDP annually¹ through 2023) and low exposure to currency risk, given the high share of sovereign obligations denominated in rouble (around 80% of total debt as of October 2021). Russia’s low government financing requirements are predominantly met via local borrowing through the domestic banking system.

Russia benefits from sizeable government savings in form of cash deposits with the central bank that cover a large portion of outstanding public debt. This strengthens budgetary flexibility in enacting fiscal spending measures with less recourse to debt financing. In addition, the new fiscal framework adopted in 2017 has weakened, but not eliminated, dependence of budget expenditure on volatile tax revenue from commodity exports and led to a more stable budgetary outlook. The government plans² to return to the fiscal rule’s standard constraints from 2022 on. These standard rules stipulate that when oil prices are above a given level (USD 44.2 per barrel for 2022), additional oil and gas revenues are to be reserved in the National Wealth Fund (NWF). In addition, the government plans³ to limit spending from the NWF to help mitigate the negative impact on government finances from potential energy revenue declines longer term. Under the proposition, the NWF could be tapped only once the liquid portion of fund assets (that is, monies in the accounts of the Russian central bank) reaches 10% of GDP, more robust than a current threshold of 7% of GDP. This excludes USD 36bn from the NWF already earmarked for investment in local infrastructure between 2022-24. As of 1 October, liquid FX savings in the NWF amounted⁴ to USD 113.8bn, or 7.2% of projected GDP for 2021 (making up 60% of total fund assets), up from USD 99.1bn (or 5.4% of projected GDP for 2020) at the start of 2020. Scope projects a further increase of 3pps of GDP as concerns the NWF by 2023 due to higher energy export volumes and adjustment to oil and gas taxation.

Russia’s rules-based fiscal policies have centred on rebuilding fiscal buffers during the past several years. This has materially improved the government’s capacity to cope with external shocks under a context of volatility in global commodities demand and prices. The 2022-24 medium-term draft budget framework continues fiscal consolidation, projecting a balanced fiscal position and helping keep general government debt at close to 20% of GDP over this period. The draft budget is built around a conservative assumption of a decline in the Urals oil price to USD 62.2 per barrel in 2022 from USD 66 per barrel this year, followed by further decline to USD 58.4 and USD 55.7 per barrel in 2023 and 2024 (the average price of Urals oil was USD 72.5 per barrel in September). As a result of conservative fiscal planning, the draft budget expects oil and gas revenue to decline from 38.1% of total federal budget revenue in 2022 to 33.2% by 2024, or from 7.2% of GDP to 5.7% of GDP, with the budget nonetheless remaining balanced. This decline in revenue is offset by higher expenditure flexibility due to structural budgetary improvements, including savings on pension costs achieved via an increasing retirement age and continued cost control that impacts federal and regional budgets.

The Central Bank of Russia (CBR)’s policy stance supports the credibility of monetary policies and stability of the rouble. The CBR has appropriately hiked its policy rate six times thus far in 2021, resulting in a cumulative increase of 3.25 percentage points, to 7.5%. The hikes come in response to elevated inflationary pressure due to faster growth in demand and temporary supply-side bottlenecks (7.4% year-on-year inflation in September against a target of 4.0%). The CBR has announced the possibility for further rate hikes going forward if the situation develops in line with its baseline forecasts. Scope expects inflation to return to near-target levels by end-2022.

The second driver of the rating upgrade to BBB+ is Russia’s resilient external finances, which underpin the economy’s continued strength and macroeconomic stability despite vulnerability to external shocks. This driver includes favourable foreign exchange reserve adequacy supported by a floating exchange rate policy. The latter cushions FX reserves and serves as an important shock absorber, helping exports and government finances adjust to volatility in commodity prices. In addition, FX purchases and sales operations under the fiscal rule have reduced exchange rate volatility due to oil price fluctuation.

The accumulation of sizeable FX reserves has strengthened Russia’s external position, supported by increases in the price of gold, which makes up 21% of reserves⁵, and a high current account surplus that Scope expects at 7% of GDP in 2021. The latter is helped by higher near-term oil and gas exports, which have benefitted from the surge in oil prices and higher export volumes, alongside continued gradual easing of OPEC+ restrictions. International reserves increased to USD 614bn in October 2021 from USD 554bn at the beginning of 2020. Latest reserves are equivalent to around five times short-term external debt (on remaining maturity basis) or 22 months of import cover. Scope expects Russia to maintain a strong external balance sheet going forward, including a significant net external creditor position (30% of GDP as of Q2 2021), despite expected moderation in the current account surplus to 4.5% of GDP by 2022-23.

In addition, a de-dollarisation strategy has strengthened the sovereign balance sheet against sanctions risks associated with transactions in US dollar. Russia has fully de-dollarised⁶ the NWF since July, which today comprises of euros (40%), renminbi (30%), gold (20%) as well as the pound and yen (5% each). Similarly, the share of dollar in the CBR’s international reserves has continued to decline, to 20.9% in Q1 2021 from 23.7% in Q1 2020, and down from 43.7% in Q1 2018. New US sanctions imposed under the Joseph Biden administration in April, which bar US financial institutions from purchasing newly issued rouble and non-rouble denominated sovereign bonds on the primary market, have had a limited impact on financial stability. This is partly due to moderate participation of non-residents in primary treasury bond markets (forming around 20% of investors thus far in 2021), adequate liquidity in the banking system (banks’ liquid assets amounted to 117% of short-term liabilities as of Q2 2021) and strong public finances. Although sanctions restrict the sovereign's access to international capital markets, Russia issued a EUR 1bn bond in 2021 (maturing in 2036 at a yield of 2.65%) as means to facilitating benchmarks for Russian corporates issuing on Eurobond markets.

Despite these credit strengths, Russia’s ratings remain constrained by significant credit weaknesses.

Firstly, weak growth prospects remain a key credit rating constraint. Scope projects Russia’s annual growth potential over the medium run of a tepid 1.5-2% despite comparatively low per capita income. This is result of: i) adverse demographic developments, with the share of the working-age population (aged 15-64) having declined to 66.4% in early 2021 from 69.1% in 2016⁷ with further declines anticipated; ii) an absence of far-reaching reform to materially lower the Russian economy’s reliance on the oil and gas industry and curtail the state’s significant role in the economy, which has brought a lack of domestic competition and economic inefficiencies, affecting long-run productivity growth; and iii) structural challenges presented by weak physical infrastructure, high income inequality and inefficient social safety nets, weighing on the health of public finances and private investment.

According to the draft budget, social spending ought to amount to an average of 12% of GDP over 2022-24, or one third of total budgetary spending. In addition, real disposable income of Russian households declined by nearly 10% between 2013-20. Scope projects real growth of 4.5% in 2021 before 2.7% in 2022, supported by strong domestic consumption and higher commodity prices and production. Although the government is unlikely to reintroduce significant restrictions on mobility, Scope considers a current severe wave of Covid-19 in Russia to pose substantive risk to the economic recovery. Scope projects Russia’s growth to return to a more subdued potential rate of 1.5-2% by 2023.

Secondly, weak governance affects business and investment conditions and drives chronic underinvestment. At 23% of annual GDP over the past five years, total investment in the Russian economy is low compared with that of many peer countries rated ‘BBB+’. According to the World Bank’s Worldwide Governance Indicators, Russia is ranked poorly in its application of the rule of law and control of corruption. This is reflected to some extent in lingering uncertainties with regard to the quality of contract enforcement and property rights enforcement. The presence of interconnected state-owned companies in mining, manufacturing and services sectors raises concerns over the extent to which public power is exercised for private gain and how this might affect the business climate. Levelling the playing field between state-owned enterprises and the private sector is key to enabling sustainable long-run growth. However, this has been politically challenging to implement, given relative competitiveness of these industries versus that of other tradeable sectors short term.

Implementation of a USD 360bn programme of national projects has been sluggish thus far, even allowing for the economic shock from the pandemic. The investments are planned until 2030 and aim at raising medium-run growth by boosting public spending on infrastructure, education, health care and regional development. As of 1 October⁸, the government has only executed 67% of planned annual budget allocations for national projects. Delays in implementation of national projects weigh on the long-run health of the economy.

In addition, the Russian economy’s structural reliance on energy exports and the government’s lack of an ambitious policy mechanism to address climate change expose growth and public finance outlooks to risks from global policies limiting carbon emissions. This exposure could substantially increase transition-related costs for Russia’s main exporting sectors.

Finally, geopolitical risk related to the Ukraine conflict and threat of more punitive sanctions weigh on external financing flexibility, investment and growth prospects. Scope believes sanctions risks remain high. At the same time, Scope does not expect wide-ranging sanctions affecting the Russian energy sector after completion of the Nord Stream 2 gas pipeline, or a ban on Russian banks from doing business in US dollar. Sanctions already in place inhibit systemically important Russian state-owned banks and companies in the oil and gas sector from accessing global capital markets and restrict exports of technology used in oil exploration and production to Russia. Existing sanctions and risk of further sanction adoption have discouraged foreign investment over recent years. Inbound foreign direct investment has dropped from an annual average of USD 55bn in 2010-13 to USD 20bn in 2015-20.

Although Scope views potential short-run implications of sanctions to be limited given Russia’s low financing requirements, high international reserves and reliance on funding in domestic markets in rouble, sanctions affect longer-term growth by curtailing foreign investment, trade and innovation.

Core variable scorecard (CVS) and qualitative scorecard (QS)

Scope’s core variable scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides a first indicative rating of ‘a+’ for Russia. Russia receives no adjustment to this indicative rating under the reserve currency adjustment under the methodology. As a result, the ‘a+’ indicative rating can be adjusted by up to three notches under the qualitative scorecard (QS), depending on the size of relative qualitative credit strengths or weaknesses compared with a peer group of countries.

Scope has identified the following QS relative credit strength for Russia: i) debt sustainability; and ii) resilience to short-term external shocks. By contrast, the following QS relative credit weaknesses have been identified: i) growth potential of the economy; ii) macro-economic stability and sustainability; iii) debt profile and market access; iv) current account resilience; v) banking sector oversight; vi) financial imbalances; vii) environmental risks; viii) social risks; and ix) institutional and political risks.

The QS generates a two-notch downward adjustment on aggregate. An additional one-notch negative adjustment has been applied to capture risk of further sanctions and transition risks, indicating BBB+ long-term ratings for Russia.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG sustainability issues during the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar. This pillar has a 20% weighting in the quantitative model (CVS) and the qualitative overlay (QS). In terms of governance-related factors in the CVS, Russia scores poorly versus sovereign peers on a composite index of six World Bank Worldwide Governance Indicators. In the QS, Russia receives a further negative adjustment under the ‘institutional and political risks’ assessment category.

Credit factors related to social criteria are captured in Scope’s CVS and designated via rising old-age dependency, high income inequality and low income levels. These quantitative variables weigh on the ratings. However, the CVS score also reflects supportive contributions from Russia’s comparatively low rate of unemployment. The qualitative assessment of social factors is reflected in the ‘social risks’ assessment category under the QS, under which Russia is assessed as ‘weak’ compared with sovereign peers due to high poverty, high regional inequality and elevated risk for social exclusion.

Environment-related credit risks remain substantial and are captured under Scope’s CVS via elevated CO2 emissions, and under Scope’s QS via a negative adjustment under the ‘environmental risks’ category. Russia is the world’s fourth largest carbon emitter, accounting for 4.7% of the globe’s CO2 emissions. The country still relies heavily on fossil fuels (60%) for energy production. The large scale of Russia’s emissions makes its economy and budget vulnerable to Western environmental legislation. Importantly, Russia’s exports to the EU may be materially affected by the EU’s proposed new carbon border adjustment mechanism, which aims to incentivise a switch to a low-carbon energy mix and could place downward pressure on global demand for fossil fuel products. Assessments of the potential costs for Russia are around EUR 5.5-6bn a year (roughly 0.5% of 2020 GDP). This impact is still small as a share of the Russian economy but could increase should the EU expand the mechanism to include oil and gas.

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 frameworks, iv) external position and resilience, v) recent political developments, vi) impact of sanctions, and vii) peers considerations.

Rating driver references
1. Ministry of Finance of the Russian Federation
2. Ministry of Finance of the Russian Federation
3. Government of Russia
4. Ministry of Finance of the Russian Federation
5. Bank of Russia
6. Ministry of Finance of the Russian Federation
7. Federal State Statistics Service
8. Ministry of Finance of the Russian Federation

Methodology
The methodology used for these Credit Ratings and/or Outlooks, ‘Rating Methodology: Sovereign Ratings’, 8 October 2021, is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months. 

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation      NO
With Access to Internal Documents                                   NO
With Access to Management                                             NO
The following substantially material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Levon Kameryan, Senior Analyst
Person responsible for approval of the Credit Ratings: Alvise Lennkh, Executive Director
The Credit Ratings/Outlooks were first released by Scope Ratings on January 2003. The Credit Ratings/Outlooks were last updated on 17 January 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures 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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