For the rating action annex, click here.

Rating action

Scope Ratings GmbH (Scope) has today downgraded Ukraine’s long-term foreign- and local-currency issuer and senior unsecured debt ratings to CCC from B*, with the ratings placed under review for a developing outcome. The Agency has affirmed short-term issuer ratings of S-4 in local- and foreign-currency, with a Stable Outlook.

Rating drivers

The downgrade of Ukraine’s long-term foreign- and local-currency ratings to CCC reflects:

1. The Russian government’s escalation of military conflict against the Ukraine and associated weakening of the nation’s credit fundamentals. This considers expectation of deep economic recession in the Ukraine this year, weakening of an outlook as regards debt sustainability, a prolonged phase of restricted market access as well as renewed deterioration of external- and financial-sector profiles. Furthermore, this military incursion heightens civil and political instability.

The downgrade of the long-term credit ratings reflects an analytical adjustment under the methodology’s ‘extraordinary circumstances’ to account for war on the sovereign’s territorial grounds, consistent with exceptional adverse credit contingencies.

The CCC foreign- and local-currency issuer ratings of Ukraine remain anchored via significant improvements achieved in macroeconomic policy frameworks and macroeconomic stability over years past, a flexible exchange rate regime and strengthened central banking framework, rebuilding of forex reserves through the end of 2021 and significant reduction of public debt both over the years prior to the Covid-19 crisis as well as since recovery from 2020 Covid-19 crisis peaks. In addition, ongoing relationships with and support from the IMF, European Union, the United States and other concessional multilateral and bilateral creditors have advanced a constructive agenda of reform and remain anchors with respect to provision of foreign-currency liquidity and the meeting of state external financing requirements. Past improvements of banking-system governance and stability further support ratings.

The placement of CCC long-term credit ratings under review for a developing outcome reflects a window for assessment surrounding the conflict’s evolution, the degree of weakening in Ukraine’s credit fundamentals as well as extent of further multilateral and bilateral financial assistance that might anchor the sovereign’s debt repayment capacity. The review represents Scope’s view that the sovereign ratings could be revised during a forthcoming review period of up to six months on basis of how the conflict and associated credit implications develop.

The review could be completed with ratings being lowered further if, individually or collectively: i) regime change were forced, raising risk for prolonged domestic instability that further weakens Ukraine’s credit profile; ii) the external-sector risk profile were significantly impaired, such as acceleration in the depletion of reserves, sharper depreciation of hryvnia, further dollarisation and/or prolongation of restrictions in international market access – raising risk of sovereign default; iii) the outlook as regards debt sustainability were weakened further, for example due to deeper-than-anticipated economic recession and/or severe inhibitions in domestic capital market access; and/or iv) banking-system risks escalated.

Conversely, the review could conclude in affirmation of CCC credit ratings or upgrade of Ukraine’s credit ratings if, individually or collectively: i) the conflict were to reach a momentary armistice and/or fighting to ease – curtailing outstanding stress factors presently impairing the credit outlook; ii) the government’s currently-weakening public-debt trajectory were stabilised; iii) external-sector dynamics are re-anchored, such as stabilisation of official-sector reserves, shoring up of hryvnia, further agreement around significant multilateral financial assistance and/or reestablishment of international market access; and/or iv) banking-system risks eased – such as with respect to alleviating deposit flight, dollarisation as well as ongoing weakening of bank capital adequacy.

Rating rationale

The downgrade of Ukraine’s sovereign credit ratings reflects escalation of conflict after Russian military operations began on 24 February, further encroaching on Ukraine’s territorial integrity and resulting in current weakening of the nation’s credit profile. This concerns weakening of the country’s economic outlook, debt sustainability, market access and external- and banking-sector dynamics – reversing, across multiple such metrics, a trajectory of substantive progress that was achieved over the past years.

The Ukrainian economy is expected to be in deep recession in 2022 – with large-scale disruption of economic activity amid current conflict across expanse of the nation and an evolving refugee crisis. Inflation of 10% YoY as of January 2022 is seen further rising due to depreciation of the exchange rate and recent further increases of natural gas and food prices. The National Bank of Ukraine, after prudently raising the reference policy rate four percentage points since March 2021 to 10%, is expected to further hike rates in support of hryvnia and sustenance of price stability. Amid high inflation and geopolitical uncertainty, the three-year hryvnia yield stands presently around 30%, more than doubling from 13.4% prior to escalation of this crisis – impairing domestic capital-market liquidity.

Under one scenario of equivalent economic severity of a 2014-15 geopolitical crisis during which hryvnia devalued sharply, growth contracted an aggregate of 15.7% over a two-year period while inflation spiked, Ukrainian government debt could rise to 89.8% of GDP by 2024 (from circa 50% as of end-2021), prior to moderation to 78.4% by 2026. On basis of a 7.4-year term to maturity of government securities (near an emerging market average), aggregate government gross financing requirements could furthermore increase under this scenario to 17.5% of GDP by 2022 before averaging 17.2% yearly over 2023-26 – above an IMF 15% “high scrutiny” threshold as regards emerging-market borrowers.

Next, this crisis has markedly raised risk surrounding banking deposit outflow, likely reversed a previous trajectory of reduction of outstanding non-performing loans (after non-performing loans had dropped rapidly to 29.5% of gross loans by January 2022, from a nearly 50% ratio as of May 2020) and undermined banking-system capitalisation, liquidity and profitability. Dollarisation within the financial system, after moderation prior to escalation of this conflict, has risen since January, with deposits in foreign currency edging up to 35% (from 32% in December 2021), and loans in foreign currency of 30% (29% in December 2021) with further dollarisation probable amid demand for hard currency during severe crisis.

Ukraine’s credit ratings acknowledge substantive efforts made by the authorities to bolster the economy’s resilience since 2014-15’s crisis after Russia’s annexation of Crimea. Nevertheless, existing external-sector buffers remain inadequate under a more severe or prolonged crisis given ultimately modest reserve coverage of 56% of short-term external debt as of January 2022. While Ukraine has substantively rebuilt its foreign-exchange buffers over past years, reserves declined USD 1.9bn from Dec-2021 post-2012 peaks to USD 27.5bn during January as geopolitical tensions rose. Since then, the central bank has further sold foreign exchange in easing currency market volatility – which has moderated the degree of weakening in the currency to 10% since November 2021 against euro. However, as reserves are drawn down amid acceleration of capital outflow, currency risks rise.

In this respect, the state debt portfolio of Ukraine remains, critically, exposed to currency risk: foreign-currency-denominated public debt accounts for circa 65% of an aggregate debt portfolio. This is broadly unchanged from an outstanding composition prior to the 2015 Eurobond restructuring¹ and represents a core vulnerability. This is although international assistance provides some degree of foreign-currency cushion: the US government has made available USD 1bn of loan guarantees, with the European Union approving EUR 1.2bn of further macro-financial assistance. In addition, Ukraine has an IMF programme until (at minimum) June 2022 that has USD 2.2bn in undisbursed funding. The government is likely to seek further IMF assistance alongside an extraordinary vehicle of transfer of Special Drawing Rights.

In 2022, state external debt service amounts to USD 4.4bn (3.1% of GDP), after USD 5.4bn in 2021 (2.8% of GDP), including a USD 2.25bn Eurobond due in November this year alongside payments with respect to multilateral loans. Ukraine has temporarily lost international financial-market access, with the five-year dollar bond trading of recent near 1,000bps above US treasuries, an increase from around 400bps as of September 2021.

The downgrade of Ukraine’s credit ratings furthermore acknowledges implications of this unprovoked and unjustified military incursion with respect to escalation of institutional risk – reversing a period of recent years of enhanced political cohesion and piecemeal institutional reform. Any coercive regime change resulting from the conflict may threaten reversal of Ukraine’s past institutional and macroeconomic reform, result in an extended phase of political and civil instability, cut sources of critical Western multilateral and bilateral financing and potentially undermine government willingness to service debt. Moreover, further territorial loss from this conflict might materially impair credit fundamentals.

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 ‘bb+’ for Ukraine. Ukraine receives no adjustment to this indicative rating via the reserve currency adjustment under the sovereign methodology. As such, under the methodology, ‘bb+’ final indicative ratings 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 analysts’ qualitative analysis.

For Ukraine, no relative credit strengths are identified under the QS. Conversely, ‘monetary policy framework’, ‘macro-economic stability and sustainability’, ‘debt sustainability’, ‘debt profile and market access’, ‘external debt structure’, ‘resilience to short-term external shocks’, ‘banking sector performance’, ‘banking sector oversight’, ‘institutional and political risks’, and ‘social risks’ are identified as relative credit weaknesses under the QS.

The combined relative credit strengths and weaknesses under the QS generate a three-notch downside rating adjustment. A further three-notch adjustment was made at rating committee level to account for the escalation of war on the sovereign’s land, representing exceptional adverse credit contingencies. As such, aggregate adjustments signal a sovereign credit rating of CCC for the Ukraine.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope explicitly factors in ESG sustainability issues during its ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the qualitative overlay (QS). Under governance-related factors under the CVS, Ukraine presents weak performance across an aggregate of the World Bank’s six Worldwide Governance Indicators (WGI). Between 2010-15, Ukraine saw weakening WGI rankings across indicators except ‘government effectiveness’. Since year 2015, in view of a significant institutional reform programme, percentile ranks improved across WGI; nevertheless, scores remained comparatively weak especially with respect to ‘political stability’, ‘control of corruption’ and the ‘rule of law’. The downgrade of Ukraine’s credit ratings to CCC significantly reflects governance-associated risk in the implications of this geopolitical crisis and military incursion as regards a prolonged phase of political instability and potential reversal of Ukraine’s past institutional reform under scenario of forced government change. In an assessment of Ukraine’s ‘institutional and political risks’ under the QS, Scope evaluates this qualitative analytical category as ‘weak’ against Ukraine’s ‘bb+’ indicative sovereign peer group – representing a credit rating constraint.

Socially related credit factors are similarly captured under Scope’s CVS quantitative model as well as QS qualitative overlay. In the CVS model, Ukraine receives strong scoring on income inequality (as captured through the ratio of the income share of the 20% of persons with the highest household incomes to the 20% of persons with the lowest household incomes), moderate marks on labour force participation rate (as regards the 15-64 year old age group: 72.8% in 2020), and below-average scoring with respect to an old-age dependency ratio. In addition, comparatively modest GDP per capita (estimated of USD 4,384 in 2021) and a medium level of unemployment (9.6% as of Q3 2021) under international comparisons are evaluated under the CVS. Scope estimates unemployment to have averaged 10% in 2021 prior to 12% during years 2022 and 2023. Declines of the working-age population (-0.8% per annum over 2022-26) weigh upon economic growth potential. In the QS assessment of Ukraine’s ‘social risks’, Scope evaluates this qualitative analytical category as ‘weak’ against a ‘bb+’ indicative sovereign peer group.

Finally, with respect to environmental risk – Ukraine scores poorly on the CVS (quantitative model) on carbon emissions per unit of GDP (a proxy variable for “transition costs” in achieving a greener economic design in the long run) but Ukraine scores strongly in a lesser degree of exposure and vulnerability to natural disaster risk – the latter as measured via the World Risk Index. Ukraine’s marks are, moreover, strong under the CVS on ecological footprint of consumption compared with available biocapacity. Overall, under the CVS, Ukraine performs above a global median on the environmental sub-category of the ESG pillar. Outside of the CVS, Ukraine ranked 60^th on the 2020 Environmental Performance Index of 180 countries² – with scoring having improved over the past ten years on air quality, lead contamination and sustainable agriculture but having worsened as regards ecosystem services provision, climate change and pollution emissions. Ukraine has planned to reduce its emissions slightly while growing the economy, reducing poverty and combating aggression from neighbouring Russia – aiming at curtailing greenhouse gas emissions from 62% under 1990 levels as of 2019 to 65% below 1990 levels by 2030, and thereafter achieve full climate neutrality no later than 2060. Ukraine previously committed to ending coal-fired power generation by 2035 while investing significantly into renewables. Ukraine’s environmental objectives and challenges are also considered within Scope’s QS via an assessment of ‘neutral’ on ‘environmental risks’ as compared with a sovereign peer group.

* On 2 March 2022, a correction was made to insert the former rating level of Ukraine in the rating action paragraph. In the original publication, the first sentence of this rating action did not include the former rating level.

Rating Committee
The main points discussed by the rating committee were: i) economic outlook; ii) inflation and monetary policy; iii) public debt and budgetary outlook; iv) financial stability and banking-system developments; v) sovereign liquidity and repayment requirements; vi) the institutional outlook; vii) implications of any regime change; ix) future scenarios regarding the conflict; and x) peers considerations.

Rating driver references
1. IMF, Ukraine Request for Extended Arrangement under the Extended Fund Facility and Cancellation of Stand-By Arrangement
2. Yale Center for Environmental Law & Policy, Environmental Performance Index

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology: Sovereign and Public Sector, 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-EU. 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    YES
With Access to Internal Documents                                  NO
With Access to Management                                            YES
The following substantially material sources of information were used to prepare the Credit Ratings: public domain and the Rated Entity.
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 Outlook 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.
The Credit Ratings/Outlooks were first released by Scope Ratings on 28 January 2022.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings of Ukraine are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Publication Calendar: Sovereign, Sub-Sovereign and Supranational Ratings" published on 31 January 2022 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for deviation. In this case, the deviation was due to Russia's further military encroachment upon Ukrainian territories, with operations starting on 24 February 2022 – a possibility that Scope has highlighted in the past as a core risk posing severe credit implications. This event has prompted publication of this credit rating action on a date deviating from previously scheduled release dates per Scope’s sovereign release calendar.

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
© 2022 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5 D-10785 Berlin.