OREANDA-NEWS.  Fitch Ratings has affirmed Russia's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB-' with a Negative Outlook. The senior foreign currency and local currency unsecured debt ratings have been affirmed at 'BBB-'. The Country Ceiling has been affirmed at 'BBB-' and the Short-term rating at 'F3'.

KEY RATING DRIVERS
Russia's 'BBB-' ratings balance a strong sovereign balance sheet and low sovereign financing needs against structural weaknesses (commodity dependence and governance risks), high growth volatility and geopolitical tensions.

Fitch forecasts Russia's economy will contract in 2015 by 3.5% after being hit by multiple shocks in 2014: a fall in oil prices, depreciation of the rouble and the imposition of sanctions by the US and EU in response to the conflict in Ukraine. Having contracted by 2.2% in 1Q15, the economy will contract further in 2Q15. Fitch expects real GDP to grow by 1% in 2016. Russia has recovered some competitiveness, but the medium-term growth outlook is the weakest of major emerging markets, at 1%-2%.

The Central Bank of Russia's (CBR) policy response and a recovery in oil prices have stabilised the rouble and begun to lead to falling inflation. The CBR has cut rates by a cumulative 550bps since December 2014's emergency rate hike, and expects inflation to reach single digits in early 2016. Inflation was 15.4% year on year in May but decelerated to 0.4% month on month in April and May.

After falling in 1Q15, partly driven by currency moves, international reserves have remained steady in nominal US dollar terms at around USD360bn since March. The current account is forecast to record a surplus of USD75bn (5.7% of GDP) in 2015, slightly higher than in 2014. Capital outflows abated in 1H15. Scheduled external debt repayments by the private sector will pick up to USD65bn in 2H15 and net capital outflows from this source will likely exceed the current account surplus even assuming high rollover rates on intercompany debt. Fitch still expects international reserves to decline in 2H15, although by less than in its previous forecast, despite the recent introduction of foreign exchange purchases.

In mid-May, the CBR began to make daily interventions of USD100m-USD200m to buy FX on the market in support of a five to seven year goal of getting reserves back to USD500bn. By the end of June, it had bought USD6.2bn in this way. The CBR considers that such interventions do not invalidate the flexible exchange rate policy or inflation targeting, introduced in December, and will help rebuild buffers against external shocks.

A sharp rise in dollarisation and outflows from the financial system have partially reversed, and the authorities have offered timely capital and liquidity support to banks. Together these developments have assuaged financial stability concerns, although the recession will still damage underlying asset quality. Non-performing loans are rising, particularly at small and medium-sized banks. The system-wide regulatory capital ratio has declined but most banks' capital is above the (N1) regulatory minimum of 10%. The authorities rolled back some regulatory forbearance measures at the beginning of July.

The weaker rouble has cushioned the fiscal blow from lower oil prices, but Fitch expects the federal government deficit to widen to 3% of GDP in 2015. This will be largely financed from the reserve fund, which contained USD76bn or 5.5% of GDP in May, down USD11.6bn on December 2014, reflecting both withdrawals and currency valuation changes. While the government has allowed the deficit to widen this year, it has also reduced spending relative to the original budget for 2015. It froze civil service salaries, leading to a real-term fall in wages.

While the 2016-2018 budget is still at the draft stage, Fitch understands that the finance ministry aims to reduce the deficit by 1pp per year until it achieves a deficit of below 1% of GDP in 2018. This will necessarily involve real-term cuts to public sector wages and pensions, indicating the government's willingness to implement unpopular measures. Pension reform, including increases to the retirement age, is starting to be discussed, but will not take place before 2018, which is a presidential election year.

Despite the economic shock and the use of the Reserve Fund to finance the budget, Russia's sovereign balance sheet remains strong relative to peers. Government debt was 12.7% of GDP at end-2014. Sovereign net foreign assets were USD372bn (20% of GDP). However, under Fitch's projections, Reserve Fund assets could fall to 1% of GDP in 2017, from 5.5% of GDP today, reducing the buffer available to deal with future shocks. Part of the National Wealth Fund has been deployed to finance infrastructure projects and banks.

Alongside ever-present oil price risks, a worsening in geopolitical tensions remains the biggest risk to the stabilisation of the Russian economy. An imperfect ceasefire between separatists and the Ukrainian army brokered in February has prevented an escalation in violence in Eastern Ukraine. However, the parties to the conflict have made little progress towards fulfilling the Minsk II accords. A renewed upsurge in violence would probably trigger a tightening of sanctions.

Structural factors are weak relative to peers. Commodity dependence is high: energy products account for almost 70% of merchandise exports and 50% of federal government revenue, exposing the public finances and the balance of payments to external shocks. Governance is a relative weakness. Russia scores badly on World Bank and Transparency International indicators, for example. Russia's score in the World Bank's Doing Business survey has improved, but the business environment has long hampered diversification outside the energy sector and encouraged capital flight

RATING SENSITIVITIES
The following risk factors individually, or collectively, could trigger a negative rating action:
- A renewed bout of exchange rate volatility, leading to broader financial sector instability requiring greater public financial support to the banking sector.
- A return to low oil prices and/or continued recession in 2016, complicating the task of fiscal consolidation.
- Faster than forecast depletion of international reserves, reflecting larger than expected capital flight and/or accelerated dollarisation domestically.
- An intensification of sanctions or a geopolitical risk event.

The Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change.

Future developments that could individually, or collectively, result in a stabilisation of the Outlook include:
- A reduction in tensions with the international community, resulting in an unwinding of sanctions and renewed access for Russian entities to international capital markets.
- A sustained recovery in the oil price, coupled with an easing of macroeconomic and financial stress.

KEY ASSUMPTIONS
Following the decision of European heads of government on 22 June, Fitch assumes that EU and US sanctions remain in place for the medium term.

Fitch assumes that oil prices average USD65/b in 2015, USD75/b in 2016 and USD80/b in 2017.