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Rating Action:

Moody's upgrades Ukraine's rating to Caa1 from Caa2; outlook changed to stable from positive

21 Dec 2018

New York, December 21, 2018 -- Moody's Investors Service ("Moody's") has today upgraded Government of Ukraine's issuer and senior unsecured bond ratings to Caa1 from Caa2. The outlook on these ratings has been changed to stable from positive.

Excluded from the upgrade is the rating on the $3 billion Eurobond that Ukraine sold exclusively to the Russian government in December 2013, which is in default due to the military and political dispute between the two governments. Russia has sued Ukraine for repayment of the bond in English courts, under whose jurisdiction the bond was issued, and the case is set for trial. Moody's has affirmed the rating on that bond at Ca.

The key drivers for the upgrade to Caa1 from Caa2 are the following:

1. The anticipated improvement in external strength as a consequence of the new Stand-by Arrangement reached with the IMF, including the likelihood of renewed capital market access that will reduce the risk of default;

2. Our expectations that recently adopted reforms will make incremental progress on reducing corruption, one of the country most credit-negative institutional weaknesses;

3. An incremental improvement in Ukraine's resilience to the ongoing conflict with Russia.

The stable outlook balances these developments against the fact that Ukraine is still a country that is heavily dependent on the IMF for funding as well as for reform impetus. While Ukraine's external position is improving, its external vulnerability remains high, and official financial support crucially depends upon the IMF's imprimatur over the economic policies that the country implements. Furthermore, the country remains highly exposed to risks of renewed geopolitical confrontation and disorderly political transition, as well as a change in leadership that could result in a delay or partial reversal of the reform progress.

Concurrently, Moody's has withdrawn the Caa2 backed issuer rating of the Financing of Infrastructural Projects (FIP), which had previously issued debt with the full and unconditional guarantee of the government of Ukraine. FIP's Eurobonds were restructured at the same time as the rest of the sovereign Eurobonds were restructured in November 2015. The entity thus currently has no Eurobonds, nor does it benefit any longer from the government's guarantee. Hence, Moody's is no longer in a position to apply a credit substitution approach with respect to the backed issuer rating as the guarantee is no longer in place. In this context, Moody's no longer has the needed information to rate the entity and has therefore taken the business decision to withdraw the rating.

Moreover, concurrent with today's rating actions, Moody's has raised the country ceiling for foreign currency bonds to B3 from Caa1, whereas the country ceiling for foreign currency deposits has been raised to Caa2 from Caa3. Ukraine's short-term foreign currency ceilings for debt and deposits remain Not-Prime (NP). The country ceilings for local currency debt and deposits have been raised to B3 from Caa1. Country ceilings generally determine the highest rating that can typically be assigned to obligations of an issuer resident within a given country.

RATINGS RATIONALE

RATIONALE FOR THE UPGRADE OF UKRAINE'S RATINGS TO Caa1 from Caa2

FIRST DRIVER: ANTICIPATED REDUCTION OF EXTERNAL VULNERABILITY SUFFICIENT TO LOWER THE RISK OF DEFAULT

The first driver for the upgrade is the reduction foreseen in the government's external vulnerability because of its new $3.9 billion, 14-month Stand-by Arrangement (SBA) reached with the IMF. An immediate disbursement equivalent to $1.4 billion will lead directly to a modest replenishment of the central bank's foreign exchange reserves (boosting them closer to $18.8 billion at year-end 2018, from $16.7 billion at the end of November) but more importantly, it will provide the stamp of approval for the government's macroeconomic and political reforms that was needed to unblock new funding from other official sources to the government.

In addition, Moody's expects that the government will be able to return to the global capital market to sell Eurobonds, potentially allowing it to extend the maturity structure of their bonds coming due in 2019-20 and thereby easing its repayment burden. As a consequence, the new external financing made available to Ukraine as a result of the IMF agreement will reduce the risk of default in the next two years, enough to be better reflected in a Caa1 instead of a Caa2 rating.

The process of agreeing the fourth review of the previous IMF Extended Fund Facility (EFF), which was replaced by the SBA, was long and drawn-out. Many criteria needed to be fulfilled in the review that were domestically controversial and unpopular. In addition, the country's fragmented parliament needed to approve multiple elements of these reforms. As a consequence of this delay and others that had preceded it, Ukraine would have left undrawn roughly $8.7 billion (at current exchange rates) that were scheduled to be disbursed during the four years of the program had they not finally fulfilled the terms set in the fourth review of the EFF. By qualifying now for the SBA, the government has the possibility of cutting that undrawn amount nearly in half.

Moody's also said Ukraine has a somewhat better chance of completing at least one of next year's reviews despite being an election year with presidential and parliamentary elections in March and October, respectively. The program is designed to allow the authorities to progress with difficult but credit-strengthening reforms that will not require parliamentary approval, which might have been problematic the closer the time comes to the October election.

SECOND DRIVER: EXPECTATIONS THAT RECENT REFORMS WILL GRADUALLY REDUCE CORRUPTION AND STRENGTHEN INSTITUTIONS

The second driver relates to the recently adopted reforms which Moody's expects to advance incremental progress on reducing corruption, one of the country most credit-negative institutional weaknesses. New, independent institutions focused on combating corruption, namely the National Anti-Corruption Bureau (NABU), the Specialized Anti-Corruption Prosecutor's office and more recently, the Anti-Corruption Court, were created during the course of the IMF's last program.

The Special Prosecutor's office and NABU are already operational but in the absence of the relevant court, the prosecutors have tended to settle cases rather than try them. The court itself will take months or even years to become operational. Still, parliament's approval of a truly independent court knocked down a major hurdle in the comprehensive strategy to tackle corruption that in turn is a critical element in Ukraine's overall economic and political reform strategy.

Moody's noted that vested interests as well as notions around the concept of sovereignty were particularly challenged by the anti-corruption reforms that the government had to adopt in the context of the IMF program, and these interests remain very strong. Accordingly, conflicts erupted even between the new institutions, which are proving detrimental to their progress. The Special Prosecutor's office has opened multiple criminal cases against the director of NABU. In response, Western officials who have championed Ukraine's anti-corruption reforms are defending the work being done at NABU and they have asked instead for the Special Prosecutor to step down because of suspicion that he undermined several high-profile corruption investigations.

While Moody's expects these and other clashes between and with the new anti-corruption agencies to continue as the efforts to eradicate corruption continue, gradual but slow progress is expected, at least as long as the government is dependent on multilateral and financial support. At some stage, the IMF and Western governments anticipate that such reforms will become more entrenched, but that stage has not yet arrived, one of the reasons that the rating remains in the Caa-range.

THIRD DRIVER: IMPROVED RESILIENCE TO GEOPOLITICAL RISK STEMMING FROM THE CONFLICT WITH RUSSIA

The ramifications of the outbreak of Russian-backed separatist uprisings in Crimea and the eastern provinces of Luhansk and Donetsk continue to weigh on Ukraine's economic and fiscal performance, but Moody's believes these risks are somewhat attenuated at this point. In Moody's view, therefore, Ukraine's economic resilience to an escalation of geopolitical risks has modestly strengthened.

Ukraine's government cut off trade with the breakaway regions in 2017, which means that the residual direct risk to economic activity in areas under Kyiv's control is greatly reduced at this point. Efforts to complete the economic isolation of the occupied areas in eastern Ukraine is estimated to have cost around 1% of GDP in lost output, incurred mainly in 2017. Absent significant escalation of the conflict, Moody's expects that future economic costs stemming from it will be related mainly to subdued investment and elevated defense spending.

Russia's more recent seizure of Ukrainian military ships bound for the port of Mariupol as well as sailors on those ships is likely to have minimal impact on Ukraine's already high geopolitical risks unless further escalation takes place, which Moody's thinks is unlikely. Moody's noted that the de facto blockade of Ukrainian ports on the Sea of Azov followed months of increasing interference with Ukraine-related maritime traffic passing through the Kerch Strait. Ukraine's imposition of limited martial law after this incident has had very little effect on consumer or investor confidence, as indicated by a very brief bout of hryvnia depreciation that reversed within days, and has not disrupted the upcoming presidential election. While interference with commercial traffic continues, the outright blockade has been lifted. Should it be reinstated, once again paralyzing Ukrainian ports on the Azov Sea, downside economic risks for the country are still manageable because less than 10% of Ukraine's seaborne exports originate from those ports and their traffic can be largely rerouted through Black Sea ports.

RATIONALE FOR CHANGING TO THE STABLE OUTLOOK

The stable outlook balances the constructive developments mentioned above against the fact that Ukraine is still a country that is heavily dependent on the IMF, other multilaterals and bilateral lenders for funding as well as for reform impetus. While Ukraine's external position is improving, its external vulnerability remains high and official financial support crucially depends upon the IMF's imprimatur over the economic policies that the country implements. Private sector investors similarly demand very high yields to provide Ukraine with credit in the absence of a functioning IMF program. Long delays in meeting IMF program criteria beyond deadlines suggest that domestic ownership of economic and political reforms is elusive. Furthermore, the country remains highly exposed to risks of renewed geopolitical confrontation and disorderly political transition as well as a change in leadership that results in partial reversal of its reform progress.

WHAT WOULD CHANGE THE RATING UP/DOWN

Moody's would likely change to a positive outlook to Ukraine's rating should progress on the anti-corruption reforms gain speed, with evidence of material improvement in the rule of law and control of corruption. Also positive would be ongoing fiscal and monetary discipline such that the macroeconomic situation remains well balanced, with sustainable reductions in external deficits and timely repayments of foreign currency debt obligations that would lower Ukraine's high external vulnerability and further declines in government indebtedness. A reduction in geopolitical tensions would support these positive trends.

Moody's would likely change to a negative outlook to or downgrade Ukraine's rating in the event that compliance with the commitments to keep the primary fiscal balance in surplus are meaningfully compromised due to overspending during the election season, putting at risk Ukraine's access to funding and threatening its ability to pay down or refinance its large debt payment obligations. Negative ratings pressure would also derive from a further escalation of geopolitical tensions that would have spillover impact on Ukraine's credit profile, as well as from government attempts to limit the independence of the central bank and its monetary or exchange rate policy framework, or otherwise impair the nascent improvement of Ukraine's banking system.

GDP per capita (PPP basis, US$): 8,754 (2017 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 2.5% (2017 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 13.7% (2017 Actual)

Gen. Gov. Financial Balance/GDP: -1.4% (2017 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -2.2% (2017 Actual) (also known as External Balance)

External debt/GDP: 102.9% (2017 Actual)

Level of economic development: Very Low level of economic resilience

Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.

On 19 December 2018, a rating committee was called to discuss the rating of Ukraine, Government of. The main points raised during the discussion were: The issuer has become less susceptible to event risks. Expectation of an improvement in control of corruption and institutions.

The principal methodology used in these ratings was Sovereign Bond Ratings published in November 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Kristin Lindow
Senior Vice President
Sovereign Risk Group
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 1 212 553 0376
Client Service: 1 212 553 1653

Yves Lemay
MD - Sovereign Risk
Sovereign Risk Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Releasing Office:
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 1 212 553 0376
Client Service: 1 212 553 1653

No Related Data.
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