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Rating Action:

Moody's upgrades Ukraine's rating to Caa2 from Caa3, outlook changed to positive from stable

Global Credit Research - 25 Aug 2017

New York, August 25, 2017 -- Moody's Investors Service (Moody's) has today upgraded the government of Ukraine's local and foreign currency issuer and senior unsecured ratings to Caa2 from Caa3, and changed the rating outlook to positive from stable. Consequently, Moody's has upgraded to Caa2 from Caa3 the ratings of Ukraine's nine senior unsecured eurobonds issued in the context of the government's debt exchange operation in November 2015.

At the same time, Moody's affirmed the Ca senior unsecured rating of the government's USD3 billion bond sold to Russia in December 2013. The bond is currently in default.

Moody's also upgraded the backed long-term foreign-currency issuer rating of Financing of Infrastructural Projects (Fininpro) to Caa2 from Caa3, and changed the rating outlook to positive from stable. Fininpro's debt is fully guaranteed by the Ukrainian government.

The upgrade of Ukraine's government ratings to Caa2 from Caa3 is based on the following key drivers:

1. The cumulative impact of structural reforms that, if sustained, are expected to improve government debt dynamics;

2. The significant strengthening of Ukraine's external position.

The rating upgrade was constrained to one notch because Ukraine faces a heavy external debt servicing burden over the next several years that will require additional foreign currency funding beyond what official lenders are likely to provide. Moreover, both domestic politics and geopolitical tensions could disrupt Ukraine's access to private capital markets as well as weaken the currency, with corresponding adverse implications for the government's debt metrics and economic stability.

Still, the positive rating outlook captures the momentum of reforms that, if sustained, could lead to further improvements in Ukraine's public and external debt sustainability. Such reform momentum would also support Ukraine's renewed access to global capital markets, which would provide an easier route to refinancing significant external debt payments from 2019 onward. Ukraine could also anticipate those payments through proactive debt management operations.

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

RATING RATIONALE

RATIONALE FOR UPGRADING UKRAINE'S ISSUER RATING TO Caa2 FROM Caa3

FIRST RATING DRIVER: STRUCTURAL REFORMS LIKELY TO IMPROVE DEBT DYNAMICS

The first driver for the rating upgrade is the impact of structural reforms already undertaken in the natural gas sector, public procurement system, taxation and banking sector and those still to be implemented, including pension reform, which together are expected to improve government debt dynamics. In Moody's view, the current government remains determined to press forward on reforms even though it faces considerable headwinds from powerful vested interests, in particular regarding land reform and privatization. Civil society is also strongly backing reform, especially the government's anti-corruption efforts and the associated strengthening of the judicial and law enforcement systems, where progress is piecemeal but nonetheless crucial if the reform agenda is to succeed in the longer term.

Whereas Ukraine's government debt is very high at about 81% of GDP as of the end of 2016, Moody's expects the debt trend to improve against the backdrop of significant consolidation efforts. The introduction of new fiscal rules and medium-term spending ceilings will be incorporated into the 2018 budget plan. On this basis, the rating agency projects primary budget surpluses of about 1% of GDP in the next few years, which would be consistent with a downward trajectory in government debt absent a further substantial weakening of the exchange rate.

The most important of the public finance-related changes adopted since the start of the IMF Extended Fund Facility (EFF) in March 2015 was the rapid shift of gas tariffs to a full cost-recovery basis, eliminating the quasi-fiscal deficit of the state-owned gas enterprise Naftogaz, which had heretofore added up to eight percentage points of GDP to the general government's borrowing requirements annually.

Tax reforms adopted in connection with the 2017 budget are a significant driver of the robust revenue performance this year. The reforms include the simplification of the tax payment system and the automation of VAT refunds. In addition, revenues were boosted by one-offs such as a significant central bank profit and the seizure of USD1.4 billion from the bank accounts of associates of former President Yanukovych. Still, Moody's forecasts the deficit for the whole year to come in near the budgeted 3% of GDP due to seasonal spending considerations.

With respect to Ukraine's pension reform, Moody's expects the respective legislation to be approved at the second reading in September -- potentially freeing up the USD1.9 billion tranche associated with the fourth review of the IMF program. The reform is envisaged to cut in half the current pension deficit to roughly 3% of GDP within a decade.

SECOND RATING DRIVER: THE SIGNIFICANT STRENGTHENING OF UKRAINE'S EXTERNAL POSITION

The second driver of the rating upgrade reflects Ukraine's significantly strengthened external position. At the time the IMF program was signed in early 2015, Ukraine's central bank had less than USD5 billion in foreign exchange reserves, the external vulnerability indicator (EVI) -- measuring the country's external debt service requirements relative to foreign exchange reserves -- was approaching 700% and Moody's rating on Ukraine was Caa3, anticipating an imminent default, which occurred later that year. Now, the central bank has about USD15 billion in liquid foreign exchange reserves, which covers roughly three months of imports, and the EVI has come down to 200%-250%, which reflects a still high but more manageable level of external vulnerability.

The improvement in Ukraine's external position derives mainly from substantial disbursements from IFIs and bilaterals as Ukraine largely complied with reforms specified in the IMF program. In addition, the current account deficit narrowed sharply, initially due to the exchange rate depreciation and recession. More recently, exports have risen strongly, benefitting from a pickup in trading partners' demand and improved competitiveness afforded by the depreciation, but imports have also increased and the current account widened again to roughly 4% of GDP last year, where it is likely to remain assuming adequate capital account financing.

In addition, Ukraine's external debt service requirements were eased when the government restructured USD15 billion in official Eurobonds at the end of 2015 -- which Moody's classified as a distressed exchange and hence a default -- and obtained a 4-year grace period on the new bonds. The corporates and banks that had Eurobonds outstanding in 2015 concluded restructurings as well. Also, as the exchange rate stabilized over the last year, excess foreign currency liquidity allowed the central bank to buy USD3 billion in the domestic market.

In Moody's opinion, the government's willingness to continue with reforms will support Ukraine's renewed access to the global bond market. The government's return to the private bond market in 2017 is a feature of Ukraine's IMF program that is meant to improve the government's external debt sustainability through credit risk repricing as well as partial early repayments.

FACTORS CONSTRAINING UKRAINE'S RATING AT Caa2

The rating upgrade was limited to one notch because Ukraine faces a heavy external debt servicing burden in 2019-21 that will require additional foreign currency funding beyond what official lenders are likely to provide over that period. The debt service for those years includes paying off the first three of the bonds issued in the 2015 debt restructuring. The risk that Ukraine will be unable to achieve a smooth refinancing of these debt obligations due to an unexpected domestic or external financial shock is a key risk, keeping the rating at Caa2 at present.

Other factors constraining Ukraine's rating upgrade include domestic politics and geopolitical tensions, either of which could disrupt Ukraine's access to private capital markets as well as weaken the currency, with adverse implications for the government's debt metrics and economic stability. While the conflict in Ukraine's Donbas has not prevented the economy from recovering and local financial markets from normalizing, a potential new escalation could deter investors and undermine Ukraine's economic stability. Domestic politics could also interfere: while the current administration is pursuing reforms, presidential and parliamentary elections are scheduled for March and November 2019, respectively. The political challenges that come with the election calendar add to the uncertainties over Ukraine's ongoing compliance with the IMF program, which is scheduled to end in mid-2019.

RATIONALE FOR CHANGING THE RATING OUTLOOK TO POSITIVE FROM STABLE

The positive outlook captures the momentum of reforms that, if sustained, could lead to further improvements in Ukraine's public and external debt sustainability. Should the program continue, Ukraine would likely be eligible to receive sizeable additional disbursements from the IMF, other IFIs and bilateral creditors. Such reform momentum could also support more substantial access to global capital markets, facilitating the refinancing and even the prefinancing of large external debt payments over the medium to longer term.

WHAT WOULD CHANGE THE RATING UP/DOWN

An upgrade of Ukraine's issuer rating would require a further strengthening of the official foreign exchange reserves, meaningfully reducing Ukraine's refinancing risk, and in such a scenario, Ukraine's government rating could be better placed at Caa1 than Caa2.

Conversely, Moody's could change Ukraine's rating outlook to stable if the IMF program terminates early, leaving substantive elements of the reform agenda incomplete, which in turn could endanger debt sustainability.

Moody's could downgrade Ukraine's issuer rating if the government was unable to strengthen its foreign reserves position and to refinance its external obligations sufficiently to avoid a situation that could lead to a default in 2019 and beyond.

GDP per capita (PPP basis, US$): 8,305 (2016 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 2.3% (2016 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 12.4% (2016 Actual)

Gen. Gov. Financial Balance/GDP: -2.2% (2016 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -4.1% (2016 Actual) (also known as External Balance)

External debt/GDP: 121.7% (2016 Actual) (also known as Foreign Debt)

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 23 August 2017, a rating committee was called to discuss the rating of the Ukraine, Government of. The main points raised during the discussion were: The issuer's institutional strength/framework, have materially increased. The issuer's governance and/or management, have materially increased. The issuer has become less susceptible to event risks. Strengthening of external position.

The principal methodology used in these ratings was Sovereign Bond Ratings published in December 2016. 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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