OREANDA-NEWS. April 25, 2016. Fitch Ratings has affirmed Russian Republic of Udmurtia's Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'BB-', Short-term foreign currency IDR at 'B' and National Long-term rating at 'A+(rus)'. The Outlooks on the Long-term IDRs and the National Long-term rating are Negative.

The republic's outstanding senior unsecured domestic bonds have been affirmed at 'BB-' and 'A+(rus)'.

The affirmation and Negative Outlook reflect Fitch's unchanged baseline scenario regarding the region's growing direct risk and risk to restoring its current balance to positive territory over the medium-term.

KEY RATING DRIVERS
The ratings reflect Udmurtia's weak operating performance and high level of direct risk. The ratings also take into account a diversified local economy, which has been decelerating since 2014, in line with the national economic downturn, and a weak institutional framework for Russian sub-nationals.

Fitch expects Udmurtia's operating margin will remain weak, but still positive at 1%-2% in 2016-2018, reflecting a sluggish regional economy and rigid operating spending after the 2015 expenditure reduction. In 2015 the republic achieved a positive operating margin of 2.6% (vs. an average negative 3.4% in 2012-2014) as the administration optimised goods and services procurement, contained operating expenditure and received higher tax proceeds from the military industry following increased defence spending by the federal government.

Fitch expects the republic will shrink its budget deficit to 9%-10% of total revenue over the medium-term, from an average of 14.6% in 2012-2015, by restraining both capex and operating expenditure. However, a substantial decrease in capex is unlikely after having reached a low 11.2% of total expenditure in 2015 (vs. an average 15% in 2012-2014).

The budget deficit will continue to lead to increases in direct risk, which we forecast will approach 100% of current revenue by end-2018. In 2015 direct risk increased mildly to 79.4% of current revenue, from 75.4% in 2014, as Udmurtia used accumulated cash to finance part of its deficit. Despite growing debt, interest expenditure is expected to stabilise at 5%-6% of operating revenue due to an increased share of low-cost federal loans in the debt structure. Nevertheless, we forecast current margin will remain weak at a negative 3%-4% over the medium-term, compared with a negative 2.9% in 2015.

Udmurtia is exposed to refinancing pressure as 76% of direct risk matures in 2016-2018. In 2016 the republic faces RUB10.1bn of repayments (22% of direct risk as of 1 April 2016). During 1Q16 the republic received RUB5.9bn of three-year federal budget loans at near-zero interest to replace part of its commercial debt, which helped ease refinancing pressure. The region's remaining 2016 maturities are expected to be covered by a combination of bond issuance, bank credit facilities and federal budget loans.

The republic has a diversified industrial economy with a focus on the oil extraction, metallurgy, machine-building and military sectors. This helps to smooth business cycles and keeps Udmurtia's wealth metrics in line with the national median. In 2015 the republic's GRP contracted 2.4%, slower than the national average decline of 3.7%. Fitch expects national GDP to shrink 1.5% in 2016, which could negatively impact the region's tax base.

Russia's institutional framework for subnationals is a constraining factor on the republic's ratings. Frequent changes in the allocation of revenue sources and the assignment of expenditure responsibilities between the tiers of government limit Udmurtia's forecasting ability and negatively affect its debt and investment management.

RATING SENSITIVITIES
An inability to restore the current balance to positive territory and to ease high refinancing pressure, with direct risk edging towards 100% of current revenue, could lead to a downgrade.