For the rating action annex, click here.

Rating action

Scope Ratings GmbH (Scope) has today downgraded the Russian Federation’s long-term issuer and senior unsecured debt ratings to C from CCC in both foreign and local currency and placed them under review for a developing outcome. Short-term issuer ratings have been left unchanged at S-4 in both foreign and local currency with under review for downgrade.

Summary and Outlook

The downgrade of Russia’s sovereign ratings reflects Scope’s view that there is a high risk of a default in the short term due to:

1. Scope’s reassessment of Russia’s willingness to honour its debt obligations following the tightening of capital controls, including through the Presidential Decree of 5 March, which could lead to a redenomination of payments on foreign-currency-denominated sovereign bonds into roubles for investors in specified countries. Should Scope observe that a debt obligation was paid in roubles rather than the original currency and the underlying contracts do not provide for such currency conversions, Scope may consider the payment to constitute a change of contractual terms, including due to the potential for exchange rate-related losses for investors and, all things being equal, deem the change a selective default under our criteria, following further analysis of the circumstances surrounding the actual payment.
   
   In addition, Scope understands that since last week a regulation imposed by the Bank of Russia has restricted the transfer of coupons on the 2024 OFZ bond to non-resident investors. Should Scope conclude that non-resident investors de facto were unable to access their coupon transfers during the stipulated grace period (which Scope understands is typically 10 working days for OFZ bonds), it would deem a selective default to have occurred under our criteria.
   
   In Scope’s view, such policy measures reflect the severe negative impact of the international sanctions on Russia’s economy and raise significant questions surrounding the Russian Federation’s willingness to service its debt owed to foreign residents, regardless of the issuing currency.
    
2. The severe and rapidly strengthening economic and financial sanctions by the US, EU, UK and other international partners in response to Russia’s rapid and prolonged escalation of military intervention in Ukraine, which is further undermining Russia’s credit fundamentals and the Russian sovereign’s ability to ensure timely debt service. Recent sanctions include the US’s ban on imports of Russian oil, liquefied natural gas, and coal. Sanctions hold further adverse implications for Russia’s economy and financial stability, making the country more vulnerable to banking and liquidity crises in the near term. The acute loss of investor confidence, as reflected by the removal of Russian securities from major stock market indices, including MSCI Emerging Markets, FTSE Russell, S&P Dow Jones as well as from JPMorgan fixed income indexes, underlines Scope’s assessment.
    
3. Scope’s view that the economic, financial and political consequences of the current crisis will further undermine Russia’s medium-run macroeconomic outlook, financial stability, institutional credibility and already weak investment conditions, leading to a severely curtailed access to foreign capital and financial markets, higher capital outflows, tighter financial conditions and weaker financial buffers.

The placement under review for a developing outcome reflects the uncertainty surrounding Russia’s willingness to service its debt in full and on time.

The downgrade reflects changes in Scope’s assessments in the ‘external economic risk’, ‘financial stability risk’ and ‘ESG risk’ categories of its sovereign methodology.

The ratings could be downgraded if Scope observed a failure of the Russian Federation to honour commercial debt obligations in full and on time, including within specified grace periods and contractual terms.

Conversely, the ratings could be affirmed/upgraded, and the Outlooks revised to Stable if Scope observed resumed willingness of the Russian Federation to service its debt in full and on time, alongside continued ability to service external debt.

Rating rationale

Today’s downgrade reflects Scope’s view of the high risk of a Russian default in the short term, including as a result of stronger capital controls by Russian authorities. Scope understands that the Presidential Decree of 5 March grants Russian issuers a temporary right to pay debt obligations in roubles to investors in specified countries. The application of this decree could lead to a redenomination of payments on foreign-currency-denominated sovereign bonds into roubles for these investors. Furthermore, the Central Bank of Russia ordered depositories and registrars to temporarily prohibit the transfer of payments on domestic securities to foreign investors. Scope understands that the application of this regulation has restricted the transfer of coupons on the 2024 OFZ issuance to non-resident investors since last week. Such policy measures significantly raise the risk of a default event in the short term.

The Central Bank also banned write-offs of Russian securities on the accounts of foreign investors and banned brokers from executing orders made by foreign clients to sell securities. In Scope’s view, such policy measures drastically undermine the Russian sovereign’s willingness to service its debt owed to non- residents, regardless of the issuing currency. They materially curtail Russia’s policy predictability, significantly weakening the country’s policy and governance framework and thus eroding previously assumed institutional strengths.

The downgrade also reflects Scope’s view that the current geopolitical crisis and the resulting cumulative impact of strict economic and financial sanctions from the US, EU, UK and other international partners, including, more recently, the ban¹ on importation into the United States of Russian crude oil and certain petroleum products, liquefied natural gas, and coal, are weakening Russia’s medium-run macro-financial outlook and eroding credit fundamentals.

The consequences of the crisis will further constrain Russia’s medium-run growth outlook, fiscal and external finances and severely restrict its financing flexibility. The potential for a further tightening of sanctions has increased because of elevated and prolonged geopolitical risk, including following Russia’s decision to put nuclear forces on high alert.

To date, the sanctions cover: i) Russia’s central bank; ii) certain Russian banks’ access to the SWIFT network; iii) the Russian public sector’s access to international capital and financial markets; iv) Russian systemically important financial institutions; v) energy sector and trade; and v) parts of the Russian leadership.

Scope views the prohibition² of the US, EU and UK of financial transactions involving the Bank of Russia, restricting Russia’s access to a major part of its international reserves, as unprecedented. In Scope’s view, this measure materially undermines Russia’s external buffers, putting pressure on its currency and hindering the country’s financial flexibility and monetary policy framework. In addition, the sanctions prohibit US transactions with Russia’s National Wealth Fund and Ministry of Finance.

The sanctions restrain Russian systemically important financial institutions from processing payments through the US financial system³ and undermine the capacity of the Russian banking system to act as a financial intermediary for Russian foreign trade because several Russian banks are cut off from the SWIFT network. In Scope’s view, this will have a material negative impact on Russia’s financial stability and banking system liquidity.

The sanctions also curtail the ability of the Russian public sector to access the US’s and EU’s⁴ capital and financial markets, including the US’s extension of existing prohibitions covering participation in the secondary market for sovereign bonds issued after 1 March 2022⁵. In Scope’s view, this will further undermine Russia’s fiscal flexibility.

Other measures include controlling technological exports to Russia, which is estimated to interrupt more than half of Russia’s high-tech imports⁶ and have a negative impact on Russia’s medium-run growth outlook.

As a result, Scope believes that the current geopolitical crisis will impair Russia’s already weak investment environment and investor sentiment, further discouraging investment into the Russian economy and leading to even higher capital outflows because of reduced domestic confidence and liquidity pressures. Net outflow of private capital from Russia was already accelerating, to USD 72bn in 2021 from USD 50.3bn in 2020 and USD 22.5bn in 2019. Inbound foreign direct investment had also already fallen from an annual average of around USD 55bn over 2010-13 to around USD 20bn over 2017-20. Moreover, Scope believes that an acceleration in European policy efforts to diversify energy imports away from Russia could exacerbate Russia’s medium-run economic challenges given the lack of an ambitious government policy to address the economy’s structural reliance on energy exports. Sanctions will also weaken Russia’s already moderate medium-run growth potential, which Scope had estimated at 1.5%-2% before the crisis.

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 weaknesses: 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 performance; vi) banking sector oversight; vii) financial imbalances; viii) environmental risks; ix) social risks; and x) institutional and political risks.

The QS generates a three-notch downward adjustment on aggregate.

An additional eleven-notch negative adjustment has been applied to capture: i) the imposition and strengthening of capital controls by Russian authorities, which raise significant questions surrounding the Russian Federation’s willingness to service its debt owed to foreign residents (-4 notches); ii) elevated geopolitical and sanction-related risks, the impact of severe and rapidly strengthening international sanctions on Russia’s macro-financial stability (-3 notches); iii) curtailed access of the public and private sector to foreign capital and financial markets, and the impaired use of Russia's international reserves (-2 notches); and iv) weakened macroeconomic outlook, higher inflation, reduced fiscal flexibility and higher transition risks not captured by the scorecards (-2 notches).

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. Additional governance-related factors include the multi-notch downward adjustment to capture the credit impacts of major capital controls imposed by the Russian authorities and the elevated geopolitical and sanction-related risks.

Credit factors related to social criteria are captured in Scope’s CVS and designated via the 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 the country’s 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 the 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 scale of Russia’s emissions makes its economy and budget vulnerable to Western environmental legislation. Importantly, Russia’s exports to the EU could be materially affected in the immediate future by sanctions but also in the medium term through the EU’s proposed carbon border adjustment mechanism, whose aims to incentivise a switch to a low-carbon energy mix could place downward pressure on global demand for fossil fuel products. Assessments of the potential costs for Russia of the carbon border adjustment mechanism are around EUR 5.5bn-6bn a year (less than 0.5% of 2021 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 willingness to honour its debt obligations; ii) Russia’s macroeconomic outlook; iii) geopolitical and sanction-related risks; iv) public finance outlook; v) policy framework; vi) external position; vii) financial stability risks; viii) ESG; and ix) peers.

Rating driver references
1. The White House
2. United States Department of the Treasury
3. United States Department of the Treasury
4. European Council
5. United States Department of the Treasury
6. The White House

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021) is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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 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.
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 4 March 2022.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings of the Russian Federation 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 31.01.2022 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 the deviation. In this case, the deviation was due to rapidly strengthening economic and financial sanctions on Russia, as well as due to strengthening capital controls by Russian authorities, including Presidential Decree of 5 March, which could potentially lead to a redenomination of payments on foreign-currency sovereign bonds into local currency for investors in specified countries. These events have prompted the publication of the credit rating action on a date that deviates from the previously scheduled release dates per Scope’s release calendar, published at www.scoperatings.com.

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.