OREANDA-NEWS. Fitch Ratings has affirmed the Republic of Karelia's Long-term foreign and local currency Issuer Default Ratings (IDRs) at 'B+' and its National Long-term rating at 'A(rus)'.

The agency has 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 affirmed at 'B+' and at 'A(rus)'.

The affirmation reflects Fitch's unchanged baseline scenario regarding Karelia's weak fiscal performance along with the republic's stabilised credit metrics that are commensurate with its ratings.

KEY RATING DRIVERS

The 'B+' rating reflects Karleia's weak fiscal performance, material direct risk, and weak liquidity amid a deteriorated macro-economic environment in Russia. The ratings also factor in our expectations of weak operating performance in 2015-2017 and a negative current balance due to increasing interest expenses. We do not expect its direct debt (bank loans and bonds) to increase significantly in 2015-2016, remaining at about 45%-50% of current revenue (2014: 42%).

We do not expect restoration of the republic's operating surplus until 2016, estimated at about 1%. The potential rebound in fiscal performance would be driven by expected 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 a 5% annual growth of taxation in 2014.

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 narrowing of deficit by 2017 is likely to be driven by restored profitability of the republic's key tax payers. The republic's interim deficit before debt variation shrank to 8% of total revenue at end-July 2015 from 11% a year earlier. The republic's expenditure is rigid with inflexible current transfers exceeding 80% of opex in 2013-2014. Karelia's ability to reduce capex is also limited, which was down only at 10% of total revenue in 2014 (2013: 12%).

The republic's direct debt (in nominal terms) may increase up to RUB14bn in 2016 from RUB10.5bn in 2014. The increase is in part attributed to budget loans, as Karelia received RUB3.9bn worth of federal budget loans with subsidised rates in June 2015, replacing some of its bonds and bank loans maturing in 2015. We expect Karelia's interest charges to increase to up to 7% of operating revenue over the medium term, from 4% in 2014, due to greater volatility of the domestic debt capital markets.

Karelia's tax base has historically been sound; however, fiscal changes introduced in 2012-2013 by the federal government have had a profound negative effect on its fiscal capacity. In addition prospects for a swift recovery of Russia's economy remain weak; in its restated macro forecast Fitch expects the national economy to contract 4% yoy in 2015, compared with the 3.5% contraction forecasted previously.

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 expects the region's dependence on financial support from the federal government 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.