Ukraine's sovereign credit rating unaffected by expected default on Russian-held debt

Ring-fenced and anticipated technical default

On 18 December, Ukrainian prime minister Arseniy Yatsenyuk ordered a moratorium on the repayment of the USD3-billion Eurobond held by Russia's National Wealth Fund (NWF). The moratorium also applied to around USD507 million owed by two Ukrainian state-run companies to Russian banks. Russian prime minister Dmitry Medvedev, prior to the default by Kiev, had already indicated that his government is preparing for a legal battle over the outstanding debt. However, the Russian authorities are expected to wait until early January 2016, since parties may try to find an out of the court solution to the dispute.

Ukraine had indicated its intention of restructuring the Russian held debt as early as May 2015, when the country's Finance Ministry invited its private bondholders to consider a 40% "haircut" of the principal and extension of maturities. The proposal included 14 Eurobonds with the total value of USD18.8 billion. The package also included a single issue of USD3 billion, entirely held by Russia's NWF. Russia did not take part in the subsequent debt talks, arguing that the NWF was acting as an official creditor. Russia argued that the USD3 billion was part of a wider USD15-billion bailout package extended to the government of former president Viktor Yanukovych in December 2013. Since the aid funds for Ukraine were not budgeted into the Russian Federation's fiscal plans, the NWF served as a channel. However, the Fund is restricted from making investments in bonds that are not investment grade. Therefore, a government order was required to allow the NWF to buy the first USD3-billion Eurobond. Moscow therefore argued that the NWF acted on behalf of the government, making the credit official and not private. Russia abandoned its bailout plans for Ukraine following the 2014 change of government on the back of a popular uprising. Whilst refusing to take part in debt restructuring talks, Russia also sought the opinion of the International Monetary Fund (IMF) on the dispute.

Several months after the Russian request, on 16 December the Executive Board of the IMF backed Moscow's position by classifying the debt as official, but the classification came days after the Fund also decided to revisit its lending criteria. Specifically, the IMF lifted its policy of non-tolerance of arrears to official creditors. The Fund stated that the decision was as a result of process that started in 2013 with the view to eliminate double standards with which default of private and official debt was treated. Thus, prior to the streamlining of its procedures, the IMF could lend to countries that had defaulted on their private debt, but no official. The timing of the decision, however, triggered a sharp criticism from Russia with Finance Minister Anton Siluanov calling the decision biased and politically motivated. Russian prime minister Dmitry Medvedev said that following the IMF decision Ukraine is unlikely to pay back the debt "because they are crooks", adding that Russia's Western partners not only did not help, but interfered.

Outlook and implications

The negative fallout for Ukraine from not paying the Russian debt is effectively neutralised, firstly due to the changes to the IMF lending criteria. This implies that Kiev will continue to receive the IMF's USD17.5-billion Extended Fund Facility agreed in March 2015. The IMF credit will also unlock the instalments of the remaining bailout funds extended by the EU, US and other international donors to the tune of USD22.5 billion.

Secondly, after completing its privately held debt restructuring, Ukraine has removed the threat of default across all its bonds. Therefore, the technical default of Ukraine on the Russian held Eurobond is safely ring-fenced, with no material impact on Ukraine's sovereign credit rating. In our latest November review, IHS upgraded Ukraine's short-term rating by two notches, to 50/100 (equivalent to BB- on the generic scale), with a Positive outlook, lifted from Negative. The medium-term rating was raised by one notch, to 60 (B- on the generic scale), switching the outlook to Stable from Negative. This aligns the IHS medium-term rating and outlook with that of S&P, which is currently at B- (60/100 on the IHS numerical scale, Very High Payments Risk), with a Stable outlook. Following recent upgrades, Fitch now has the lowest rating for the Ukrainian sovereign bonds, at CCC or 65 on the IHS scale, with a Negative outlook. Moody's shares Fitch's rating, at Caa3 (or 65) but it has a Stable outlook. Thus IHS and S&P have the most favourable rating and outlook for Ukraine's sovereign bond.

Ukraine will remain under pressure from the IMF to find an amicable solution with Russia. Ukraine has previously insisted that Russia had to agree to the same terms of restructuring, as Ukraine's other private debt-holders. This included a 20% write-down of the principal, four-year extension of maturities, starting from 2015, and exercising value recovery instruments, such as GDP-indexed securities. However, after the IMF decision to classify the Russian debt as official, Kiev may have to find another compromise with Russia. The latter has already offered an incremental repayment of the debt, which could start in 2016, but have to be guaranteed by the EU and US.

Regardless the outcome of the dispute, it will be regarded as an isolated bilateral dispute with no material implications for Ukraine's creditworthiness.