OREANDA-NEWS. August 11, 2015.  Fitch Ratings has affirmed Ukraine's Long-term foreign currency Issuer Default Rating (IDR) at 'CC' and local currency IDR at 'CCC'. The issue ratings on Ukraine's senior unsecured foreign and local currency bonds have also been affirmed at 'CC' and 'CCC', respectively. Domestic foreign-currency bonds are not included in this rating action. The Country Ceiling has been affirmed at 'CCC' and the Short-term foreign currency IDR at 'C'.

KEY RATING DRIVERS
The government is negotiating with bondholders a restructuring of its sovereign external bonds, which Fitch would classify as a Distressed Debt Exchange. Meanwhile, it continues to service external and domestic obligations, paying a USD120m coupon on its 2017 Eurobond on 24 July. On the announcement of a debt restructuring deal Fitch would expect to downgrade Ukraine's Long-term foreign currency IDR to 'C'. Fitch would expect Ukraine to have completed the restructuring before a USD500m Eurobond maturity payable on 23 September and the second review of the IMF programme, also in September. If a timely restructuring is not agreed, Ukraine may declare a moratorium on external Eurobond debt service.

Reaching a debt restructuring agreement with bondholders is a condition of the Extended Fund Facility (EFF) agreement with the IMF reached in March 2015. The deal offers USD17.5bn in IMF financing, plus multilateral and bilateral assistance including from the EU and the World Bank. The government pledged to seek USD15.3bn in balance of payments savings over 2015-2018 from holders of USD23bn in sovereign and sovereign-guaranteed external debt. On 31 July, Ukraine passed the first review of the programme and the IMF board agreed to disburse the second USD1.7bn disbursement.

Growth volatility, fragile external and public finances, weak governance indicators and geopolitical risks constrain the ratings. Domestic debt is not included in the restructuring proposal, but Fitch considers 'CCC' an appropriate level for the local currency rating, given Ukraine's economic and policy challenges. The IMF expects real GDP to shrink 9% in 2015, after a 7% contraction in 2014. Fitch assumes that real GDP will stabilise in 2016 as inflation and interest rates subside and confidence improves, assuming that policy and geopolitical risks do not materially worsen. Conflict between the government and separatists in the eastern regions of Donetsk and Luhansk has caused a humanitarian crisis, damaged the industrial base and curtailed trade with Russia.

The currency has stabilised since the beginning of 2Q15, having lost over 60% of its value against the USD since the National Bank of Ukraine (NBU) abandoned the de facto peg to the USD in 2014. The NBU raised interest rates to 30% in March and introduced capital controls. Hryvnia depreciation and gas tariff hikes have unleashed high inflation, which is now slowing. The macroeconomic shock has also damaged the financial system. There have been a number of bank failures. The NBU is auditing the most important banks, and the government has issued debt to recapitalise them. The government expects bank recapitalisation costs to reach 7.7% of GDP in 2015. State banks have not received more capital in 2015. Confidence in banks is on the mend, judging by a recovery in deposit growth.

The new government formed in December 2014 has shown strong commitment to structural reforms. However, political risks to their implementation - and to the IMF agreement - are high. Reforms to date include reforms to tax administration, and to the charter of the NBU, changes to the mechanism for bank resolution, anti-corruption legislation, and raising household gas tariffs closer to cost recovery levels. Despite the increase in military spending and the severe recession, revenues have outpaced spending, and the general government deficit (not including the costs of support to banks or state-owned energy company Naftogaz) has shrunk year on year to UAH12.6bn or 0.6% of estimated 2015 GDP in 1H15, putting the government on track to meet its full-year 4.2% of GDP target.

Despite fiscal consolidation, recession and currency depreciation are estimated to have pushed the burden of general government direct and guaranteed debt to over 76% of GDP in June 2015, compared with 61% of GDP at end-2014. Government debt will increase further as bank recapitalisation costs materialise. Without external market access, Ukraine is currently dependent on IMF and other official financing to service external debt.

The balance of payments has adjusted sharply, brought about by currency depreciation - the current account recorded a deficit of just USD19m in 1H15, compared with a deficit of USD1.9bn in the previous year. Net private capital flows are negative, while official borrowing and multilateral assistance have increased. Reserves rose from their low of USD5.6bn in January 2015 to reach USD10.4bn in July, still a critically low level. Without IMF support, and the promise of further hard currency inflows, there would likely be a currency collapse.

The risk that the conflict in eastern Ukraine intensifies is a major risk to the outlook. The Minsk II agreement reached in February between parties to the conflict forms a framework for the resolution of the conflict in Eastern Ukraine, but progress has been limited. The provisional approval in the Ukrainian parliament of decentralisation of powers to the regions may help defuse the conflict, although the most recent reports also suggest a rise in violations of the ceasefire.

RATING SENSITIVITIES
The main factors that could, collectively or individually, result in a downgrade are:

For the foreign currency rating:
- The expected announcement of an agreement between the government and bondholders to restructure external sovereign debt.
- The declaration of a moratorium on external debt payments.

For the local currency rating:
- Deviation from policies agreed with the IMF, leading to the suspension of the programme.
- Escalation of the conflict in eastern Ukraine and intensification of economic stress.

We currently do not envisage a situation in the short term in which either the foreign currency or local currency rating would be upgraded.

KEY ASSUMPTIONS
The ratings and Outlooks are sensitive to a number of assumptions:

Ukraine complies with the conditions in its agreement with the IMF, and receives timely disbursements from the IMF and multilateral and bilateral partners.

Ukraine does not succumb to a material escalation of incursions into its sovereign territory, or regional unrest.