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Rating action

Scope Ratings GmbH (Scope) has today confirmed Ukraine’s long-term foreign- and local-currency issuer and senior unsecured debt ratings at CCC, and assigned a Negative Outlook, concluding a period of the ratings under review. The Agency has affirmed short-term issuer ratings of S-4 in local- and foreign-currency, with Outlooks Stable.

Rating drivers

The assignment of a Negative Outlook for Ukraine’s CCC ratings, concluding a review for a developing outcome initiated on 1 March 2022, reflects pursuant two credit-rating drivers:

1. Severe economic recession, high degree of uncertainty around future evolution of the war, and significant increase of risk to government near- and long-run debt sustainability. Challenges with respect to meeting near- and long-run financing shortfalls raise likelihood of debt relief being contemplated and the private sector being potentially called on to contribute on comparable terms.
    
2. Weakening of Ukraine’s external-sector resilience and ongoing trends in direction of dollarisation of the government debt-profile and of the general economy.

An assumed lengthier conflict moving ahead raises military and humanitarian costs for the national government while likewise delaying prospects of fuller economic recovery. In addition, a long-run reconstruction bill diminishes debt sustainability even after recovery gathers further traction. Furthermore, the war is impairing the health of the banking system.

CCC foreign- and local-currency issuer ratings of the Ukraine remain anchored by significant international financial support in the form of loans and grant monies from a range of multilateral and bilateral donors. However, an acceleration of international financial assistance and a much more substantive share of grant financing may be required moving ahead to preserve debt sustainability and support ratings at present levels. Secondly, the ratings are anchored via speedy administrative controls and policy adaptations as coordinated by the National Bank of Ukraine (NBU) in support of macroeconomic and financial-system stability since the start of the crisis. Finally, substantive improvements of macroeconomic policy frameworks and macro-financial cushions achieved over years pre-crisis support ratings – having advanced institutional preparedness ahead of the war’s escalation.

The Negative Outlook represents Scope’s view that risks to the sovereign ratings are skewed to the downside over a forthcoming 12-18 months.

The ratings could be downgraded if, individually or collectively: i) the likelihood were to increase of debt restructuring involving losses for private-sector creditors, such as under a scenario Ukraine’s outlook for debt sustainability further weakens; ii) a multilateral initiative requesting suspension of Ukraine’s foreign debt service – including servicing of debt to commercial creditors – were to gather traction in provision of short-run liquidity relief; iii) a renewed escalation of the conflict with Russia were to adversely raise debt-sustainability and institutional risk; iv) the external-sector risk profile were significantly impaired, such as acceleration in depletion of reserves, sharper depreciation of an unofficial hryvnia cash rate and/or further dollarisation, raising balance-of-payment risk; and/or v) banking-system fragilities escalated, such as furthering of sovereign-bank interlinkage.

Conversely, the Outlooks could be stabilised or revised to Positive if, individually or collectively: i) the conflict were to reach a momentary ceasefire – significantly reducing underlying challenging factors that impair the credit outlook; ii) the government’s debt-sustainability outlook meaningfully improved, such as commitment of significant further international assistance for Ukraine, especially in grant money, and/or should a presently weakening public-debt trajectory be stabilised; iii) debt relief involving private-sector participation were to seem less likely; iv) external-sector dynamics are re-anchored, such as stabilisation of reserves, shoring up of hryvnia and/or reestablishment of international market access; and/or v) banking-system risks eased – such as with respect to alleviation of deposit flight, of dollarisation and/or of weakening of capital adequacy.

Rating rationale

The assignment of a Negative Outlook for Ukraine’s CCC sovereign credit rating reflects deep economic recession and significant increase of risk to the sustainability of government debt after Russia’s escalation of the war. Challenges with respect to meeting a significant near- and long-run funding gap raise likelihood of foreign debt relief being part of a long-run solution and the private sector being possibly called upon to participate on comparable terms.

After estimated output growth of 3.4% in 2021, Ukraine’s economy is expected to face a severe 37.5% economic contraction in 2022 (in Q1, output declined circa 15.1% Y/Y), prior to a rebound of output in 2023 of nearly a fifth, as activity recovers in regions where the conflict eases, but with output next year remaining 27% under a 2021 pre-crisis level.

The conflict’s escalation and decline of output have seen reversal of a strong pre-2022 declining trajectory of government debt and placed substantive strain on an outlook as regards debt sustainability. Under a baseline economic scenario, the general government debt ratio may reach 88% of GDP in 2022, from 48.9% in 2021, prior to edging sideways to conclude a forecast horizon (to 2027) above 90%. Under such a baseline setting, an assumption is made with respect to a headline budget deficit widening to 17.6% of GDP this year, reflecting a sharp increase from a pre-crisis 4.0% deficit last year, followed by an average general government deficit of 14.7% over subsequent years 2023-27, accounting for high reparation costs of destroyed infrastructure and physical capital. The Ministry of Finance of Ukraine and Kyiv School of Economics have estimated such costs of Ukraine’s reconstruction as up to USD 600bn (277% of average 2023-27 GDP)¹, with Ukraine suffering USD 4.5bn of damages each week of the war. Scope’s baseline expectations of public debt, moreover, assume an elevated inflation over the forecast horizon and eventual re-alignment of a fixed official exchange rate to a weaker unofficial cash-market rate – raising the foreign-currency debt ratio as a share of GDP upon such devaluation of hryvnia. Under an adverse scenario of more severe economic losses, wider deficits, more extensive exchange-rate losses and/or crystallisation of contingent liabilities, public debt can rise to above 100% of GDP.

After Russia’s invasion of Ukraine and annexation of Crimea during February 2014, Ukrainian debt rose to 99% of GDP by February 2015 – from 40% in January of 2014 – prior to a USD 15bn restructuring of the external debt late 2015 under auspices of an IMF Extended Arrangement. Debt levels are seen reapproaching such levels. Given significant international goodwill for Ukraine amid calls for equivalent of a new Marshall Plan, official-sector debt relief is anticipated, with potential of longer-run debt cancellation. Whether foreign bondholders participate under debt relief hinges on how long the war endures, its ultimate cost and the degree to which multilateral and bilateral assistance alone can prevent Ukraine’s debt burden from impeding sustainable recovery.

In addition to long-run debt sustainability, the war has brought substantive short-run financing shortfalls – estimated by the government of USD 5-7bn a month (3-5% of GDP per month). Gross financing requirements are estimated of above 35% of GDP for 2022 before remaining above 20% over 2023-27 – above an IMF threshold of 15%, above which fiscal space is considered restricted. Substantive international financial support helps bridge immediate liquidity risk; however, the United States House of Representatives recently passed a debt payment relief act² calling, moreover, upon US Treasury to coordinate suspension of debt service on foreign debt of Ukraine. While it remains to be seen whether and when any such liquidity provision via debt-service suspension might be coordinated by international financial institutions with Ukraine’s Finance Ministry dismissing at this stage any external debt restructuring as unhelpful with external public debt repayments covered for the rest of this year and Ukraine needing engagement of investors to finance war debt, deliberation around debt-service suspension nevertheless raises nearer-term risk to ratings.

Outstanding risks for the sovereign’s liquidity have been exacerbated by restricted international debt capital market access. Yield premia for Ukraine 5-year USD bonds over same-tenure US treasuries are circa 850bps – having risen earlier from around 400bps as of late September 2021. In addition, domestic capital market access remains hindered with banks stretched under current macroeconomic conditions in capacity to further extend exposure to the sovereign. The government has borrowed USD 3.4bn via local government bond tenders since 24 February from domestic and foreign banks, but with a further USD 6.9bn of war bonds covered by purchases of the NBU under momentary extraordinary monetary financing operations³. Reduced market access, higher local borrowing rates after the NBU’s rate hike and monetary financing reflect an unsustainable funding backdrop – highlighting growing fiscal and balance-of-payment risks absent acceleration of international assistance and/or an earlier end of the conflict.

Ukraine's fiscal sustainability also observes risk medium run from GDP-linked warrants issued to enhance private-sector participation during the 2015 debt restructuring. Subject to certain conditions, Ukraine is required to pay 15% of additional economic output it generates if output growth were above 3% and 40% if real growth were above 4%. Elevated reconstruction-led economic growth in 2024 could result in high pay-outs on such instruments from 2026, once 1% of GDP payment caps no longer apply.

Secondly, assignment of a Negative Outlook reflects weakening of Ukraine’s external-sector resilience and an ongoing trend in direction of dollarisation of the general economy.

Approximately 59.6% of Ukraine’s public and publicly-guaranteed debt was externally borrowed as of end-2020 (aggregating to USD 56.5bn). Domestic debt accounted for the other 40.4% of public debt but with above 13% of domestic debt denominated in foreign currency. On such basis, entering this crisis, Ukraine’s debt portfolio was already materially exposed to forex risk with foreign-currency-denominated public debt of around 65% of the aggregate debt stock. Such dollarisation of the government liability structure raises risk under conditions of future hryvnia depreciation.

Dollarisation of bank deposits has increased recently, with deposit flight to foreign- from domestic-currency. Before such developments, the share of bank deposits in foreign currency had earlier dropped 3.5pps since January to 31.3% as of April 2022, with loans in foreign currency likewise having declined 3.6pps over a same period to 26.1%. Recent re-dollarisation trends raise external vulnerabilities and brought a 15pp hike of the key interest rate of the central bank to 25% earlier this month in shoring up confidence in the national currency.

Ukraine’s foreign-currency reserve stock stood at USD 22.3bn as of May 2022 – remaining above dangerous levels at this stage (as an example, as compared with a nadir of USD 4.7bn in February 2015) but having nevertheless gradually declined from a cyclical peak of USD 29.4bn as of December 2021 – amid FX-market interventions of the NBU to offset pressure on the currency. External-sector cushions are unsustainable on current trajectory given modest reserve coverage of 45% of short-term external debt liabilities (on a remaining maturing basis) as of May 2022, declining from 62% at the end of 2021. This raises balance-of-payment risks.

The NBU’s significant rate increase has reintroduced a positive real policy rate, after inflation rose to 18% YoY in May, with the NBU hoping the surprise move eases forex, reserve and dollarisation pressure. A further hike(s) of rates might be necessary to defend value of hryvnia and ease financial-system risk. The official hryvnia exchange depreciated against euro only 4% since November 2021; however, an unofficial hryvnia remains 18% off official rates, even after rallying since the rate hike.

The full-scale invasion has meaningfully compromised Ukraine’s export capacity and brought imposition of goods-import restrictions. However, narrower goods-trade deficits due to import contraction, remittances inflows, alongside barred dividend payment align with a modest current-account surplus expected in this year, after a current-account deficit of 1.3% of GDP in 2021. Ukraine’s net international investment position had been bolstered from an ebb of -50.2% of GDP in Q3 2015, reaching -11.4% by Q4 2021, with gross external debt reduced to 65.3% of GDP by Q4 2021, from 131.5% as of Q4 2015 – however, such external-debt deleveraging has presumably reversed since the war’s escalation.

The war has as well stressed banking-system health. System-wide tier 1 capital had declined to 11.7% of risk-weighted assets already pre-escalation as of January 2022, from 15.1% in October 2021, amid clean-up of the banking system and new loan-loss provisioning of UAH 21.6bn has been needed to address expected losses since February. 75% of such provisioning was recognised in March, resulting in a decline of system profitability, with return on equity dropping to -0.2% from levels of circa 30% as of end-2021. Moving ahead, materialisation of credit risk will have an effect on financial standing of banks. Elevated non-performing loans (NPLs) as banks recognise deterioration of loan quality since the start of this year, sectoral concentration risks and growing sovereign-bank linkage – including funding dependence of the sovereign on the central bank – reflect credit challenges.

Ukraine’s CCC credit ratings are supported by multiple crucial credit strengths.

Firstly, Ukraine’s credit ratings are anchored by very significant international financing support. In addition to USD 1.4bn received from the International Monetary Fund via a Rapid Financing Instrument⁴ during March, the Ukrainian government seeks a new IMF programme and has received international financial assistance on concessional bases from many multilateral and bilateral benefactors: the EU has already disbursed EUR 1.2bn in the form of long-term loans under a further Macro-Financial Assistance programme; the EU has as well suggested bond issuance guaranteed by its member states to assist Ukraine with EUR 9bn of emergency loans alongside outlining of a ‘RebuildUkraine’ reconstruction programme of non-repayable grants and loans bringing together G20 and multilateral financiers. The US finalised in May military and humanitarian assistance of USD 40bn, while the World Bank has mobilised a USD 925m rapid financing sleeve, part of USD 3bn of support the World Bank intends to set aside for the Ukraine over coming months. The IMF’s and World Bank’s establishment of multi-donor administered accounts have packaged grants and loans from varying international multilateral and bilateral institutions. The Ministry of Finance expects to receive USD 4.8bn of aggregate external financing this month, nearly meeting a monthly financing requirement, and USD 25bn by conclusion of the year. If so, this could assist Ukraine to rebuild around 3% of GDP each month. However, financing of Ukraine has relied heavily on loans, increasing sovereign debt. A much more significant share of grant financing will be needed to preserve debt sustainability.

In the long run, US and European policy makers have contemplated co-opting of around USD 300bn of frozen Russian reserves and even the liquidation of seized Russian oligarch assets to pay or serve as collateral for reconstruction funding. Such action would be credit positive for Ukraine although there are valid questions over whether this could undermine due process and whether reserves might serve better as bargaining chips in talks to end the conflict.

Secondly, the CCC ratings of Ukraine are bolstered by speedy administrative and capital controls of the central bank adopted upon escalation of hostilities to preserve availability of foreign-exchange reserves, limit drain of cash from the banking system and prevent banking crisis while reducing uncertainty with respect to the exchange rate – demonstrating preparedness for the crisis. To further support financial stability, the NBU established a liquidity facility and adopted regulatory forbearance. Such measures have anchored confidence in the banking system, with deposit funding in domestic currency remaining strong: between the full invasion and end-May, retail deposits rose around 19%, with corporate deposits in hryvnia rising 4%. The outflow of deposits in foreign currencies halted. Term-deposit outflows slowed in May and are smaller than those observed during the crisis of 2014.⁵

Finally, CCC ratings acknowledge substantive efforts made by authorities to bolster the economy’s resilience since 2014-15’s geopolitical crisis. This reflects a pre-crisis track record of general government debt having been brought on a sustained downward trajectory prior to the Covid-19 crisis as well as during an initial Covid-19 recovery. Inflation eased substantively (to lows of 1.7% by May 2020 after peaks of above 60% during early 2015), with international reserves rebolstered over these periods. Alongside continued IMF involvement, a flexible exchange-rate framework (which Ukraine intends to return promptly to) had been reinforced with de-facto inflation targeting introduced since early 2016. A less volatile and stronger growth profile developed.

Pre-crisis reforms furthermore reflect an enhanced central banking macroprudential policy framework, alongside clean-up of the domestic banking system, enhancing system-wide liquidity in domestic currency. System-wide NPLs remain elevated: 27.4% of gross loans as of April 2022, but time-bound NPL reduction strategies had resulted in hasty improvement from a nearly 50% ratio as of May 2020 – bettering resilience entering this crisis. 2021 stress testing of 30 large banks⁶ revealed capital risks had declined as compared with 2019 results. Financial-system reform has been guided by a financial sector development programme for the period to 2025, furthermore anchored by the EU-Ukraine Association Agreement as well as other international commitments. After Ukraine applied for EU membership at end-February, the European Commission has formally recommended candidature status for the Ukraine – beginning a process of the nation’s accession ambitions.

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 ‘b+’ for Ukraine. Ukraine receives no adjustment to this indicative rating via the reserve-currency adjustment under the sovereign methodology. As such, under the methodology, ‘b+’ 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, the following relative credit strength is identified under the QS: ‘monetary policy framework’. Conversely, ‘macro-economic stability and sustainability’, ‘debt sustainability’, ‘debt profile and market access’, ‘resilience to short-term external shocks’, ‘banking sector performance’, ‘social risks’, and ‘institutional and political risks’ are identified as relative credit weaknesses compared with Ukraine’s sovereign peers in the QS.

The combined relative credit strengths and weaknesses under the QS generate a two-notch downside rating adjustment. A further one-notch adjustment to CCC was made at rating-committee level to account for unique geopolitical risk relevant to the sovereign linked to ongoing conflict with the Russian Federation, representing an adverse contingency for the long-term outlook of the ratings. 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). However, since year 2015, in view of a significant institutional reform programme, percentile ranks improved across WGI. Ahead of parliamentary elections not later than October 2023, President Volodymyr Zelenskyy’s political group has seen support increase appreciably due to the President’s leadership since Russian military operations began on 24 February. In an assessment of Ukraine’s ‘institutional and political risks’ in the complementary QS, Scope evaluates this qualitative analytical category as ‘weak’ against Ukraine’s ‘b+’ indicative sovereign peer group – representing a credit-rating constraint. The assignment of a Negative Outlook significantly reflects governance (‘G’)-associated risk in implications of the conflict for the aggregate credit profile of Ukraine.

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, and below-average scoring with respect to an old-age dependency ratio. In addition, Ukraine’s comparatively modest GDP per capita (estimated of USD 4,828 in 2021) as a lower-middle-income economy and a medium (under a global comparison) level of unemployment (10.9% as of Q4 2021 for those of working age) are evaluated under the CVS. Declines of the working-age population weigh upon economic growth potential (estimated of 2.5%). The UN estimates 4.9m refugees have departed Ukraine by 9 June (around 11% of the population); a further 7.1m are internally displaced as of 23 May – although down nearly 900,000 since 3 May. The number of persons returning to their homes after having been displaced rose to 4.5m. In the QS assessment of Ukraine’s ‘social risks’, Scope evaluates this qualitative analytical category as ‘weak’ against the government’s ‘b+’ indicative sovereign peer group.

Finally, with respect to environmental risk – Ukraine scores poorly on the CVS on carbon emissions per unit of GDP (a proxy variable of “transition costs” in achieving a greener economic model in the long run) but Ukraine scores strongly on lesser degree of exposure and vulnerability to natural-disaster risk – the latter as measured by the World Risk Index. Ukraine’s marks are, moreover, strong under the CVS on ecological footprint of consumption compared with the country’s available biocapacity. Outside of the CVS, Ukraine ranked an improved 52nd on a 2021 Environmental Performance Index of 180 countries⁷. Ukraine plans to reduce emissions while growing the economy, reducing poverty and simultaneously combating aggression from neighbouring Russia – aiming to curtail greenhouse gas emissions from 62% under 1990 levels as of 2019 to 65% below 1990 levels by 2030, and thereafter achieve full climate neutrality not later than 2060. However, the conflict is triggering sizeable, long-lasting environmental and climate damage in terms of waterways, air and soil pollution, forest destruction, and increase of carbon footprint via the use of weapons, which contribute to raising greenhouse gas emissions. In summer 2021, Ukraine constructively took first steps towards inauguration of a green bond market. Ukraine’s environmental objectives and challenges are also considered within Scope’s QS via an assessment of ‘neutral’ on ‘environmental risks’ as compared with indicative sovereign peers.

Rating Committee
The main points discussed by the rating committee were: i) debt-sustainability outlook and likelihood of debt relief; ii) international financial assistance; iii) expectations for the conflict’s development; iv) external-sector dynamics; v) government-bond repayment schedule; vi) debt-ownership structure; vii) banking-system risk; viii) local- vs foreign-currency risk; and ix) peers considerations.

Rating driver references
1. Kyiv School of Economics, Direct damage caused to Ukraine’s infrastructure during the war 
2. US Congress, H. Rept. 117-317 – Ukraine Comprehensive Debt Payment Relief Act of 2022
3. Ministry of Finance of Ukraine, Ukraine’s State Budget Financing Since the Beginning of the Full-scale War 
4. IMF, Ukraine: Request for Purchase under the Rapid Financing Instrument and Cancellation of Stand-by Arrangement 
5. National Bank of Ukraine, (information provided by the management)
6. National Bank of Ukraine, Financial Stability Report, December 2021 
7. Yale Center for Environmental Law & Policy, Environmental Performance Index 

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 8 October 2021) is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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 agents. The 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 material sources of information were used to prepare the credit rating: 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 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: Dennis Shen, Director
Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 28 January 2022. The Credit Ratings/Outlooks were last updated on 1 March 2022.

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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