OREANDA-NEWS. April 21, 2015. Fitch Ratings has downgraded the Republic of Karelia's Long-term foreign and local currency Issuer Default Ratings (IDRs) to 'B+' from 'BB-' and its National Long-term rating to 'A(rus)' from 'A+(rus)'.

The agency also affirmed the republic's Short-term foreign currency IDR at 'B'. The Outlook on the Long-term IDRs and National Long-term rating is Stable. Karelia's outstanding senior unsecured domestic bonds have also been downgraded to 'B+' from 'BB-' and to 'A(rus)' from 'A+(rus)'.

KEY RATING DRIVERS

The downgrade reflects the following rating drivers and their relative weights:

HIGH

Fitch changed its baseline scenario regarding Karelia's credit profile after direct risk rose to 76% of current revenue at end-2014 from 60% in 2013, against our previous expectations of 65%-70%. The steep increase in debt was driven by a structural fiscal deficit in 2013-2014. Weak fiscal performance has led to a consistently negative current balance that is insufficient for debt service and debt metrics that are no longer commensurate with a 'BB-' rating.

The Stable Outlook is supported by our expectation that Karelia's market debt (bank loans and bonds) is unlikely to increase significantly in 2015-2016, remaining at about 45%-50% of current revenue (2014: 42%). In nominal terms, however, the republic's direct debt may increase up to RUB14bn in 2016 from RUB10.5bn in 2014. Further, the republic expects to receive budget loans from the federal government with subsidised rates and extended maturities to replace its market debt maturing in 2015 and to fund its budget deficit.

Fitch expects Karelia's deficit before debt variation to reach 13% of total revenue in 2015 before gradually declining to less than 10% in 2016-2017. The republic's budget is marked by rigid expenditure with current transfers exceeding 80% of opex in 2013-2014. The region's ability to reduce capex is also limited, which was down at 10% of total revenue in 2014 (2013: 12%).

Fitch does not expect the republic to restore its operating surplus until 2016, estimated at about 1%. The rebound in operating performance is expected to be driven by taxation recovery and opex restraint. Karelia's fiscal performance was hit in 2013 by the introduction of consolidated groups of taxpayers for large corporations. That led to a 15% yoy decline in taxes in 2013 and only 5% annual growth of taxation in 2014.

MEDIUM

The republic estimates its economy to have grown 1.5% yoy after contracting 1% a year earlier. Karelia's industrial economy supports healthy wealth indicators; GDP per capita 5% exceeded the nation's median in 2013, while average salary in 2014 was in line with the Russian median. The republic's government expects the local economy to grow 1%-2% yoy in 2015-2017.

Karelia's ratings also reflect the following key rating drivers:

Russia's institutional framework for subnationals is a constraining factor on the republic's ratings. Frequent changes in allocation of revenue sources and assignment of expenditure responsibilities between the tiers of government limit the republic's forecasting ability and negatively affect its fiscal capacity and financial flexibility. Fitch notes that the region's dependence on financial support from the federal government is likely to increase in 2015-2017.

RATING SENSITIVITIES

The republic's inability to sustainably curb growth of direct risk above 80%-85% of current revenue, and a negative operating balance for two years in a row, would lead to a negative rating action.

A positive rating action could result from stabilised fiscal performance with operating surpluses leading to sufficient coverage of interest costs.