bne IntelliNews -

Moody's Investors Service on February 20 downgraded Russia's sovereign debt rating from investment-grade Baa3/Prime-3 to speculative Ba1/Not Prime (NP) with a negative outlook. It was the second rating agency downgrading Russia's rating to junk after Standard & Poor's, which will mean that some international funds will not be able to hold Russian debt.

Russian Finance Minister Anton Siluanov called the downgrading “beyond reason” and "guided primarily by political factors”.

Moody's said the move was driven by the continuing crisis in Ukraine, coupled by oil price and exchange shocks undermining Russian economic strength and medium-term growth prospects. Moody's also saw the government's financial strength diminishing under fiscal pressures and continued erosion of FX reserves in light of ongoing capital outflow and restricted access to international capital markets.

Finally, although still very low, the agency sees rising risks of an international response to the conflict in Ukraine triggering Russian authorities to directly or indirectly undermine timely servicing of external debt. 

The negative outlook reflects potentially more severe economic and political shocks, related either to the conflict in Ukraine or a renewed decline in oil prices, further undermining Russia's public and external finances.

Moody's expects a deep recession in 2015 and continued contraction in 2016, with decline in confidence and incomes constraining domestic demand and exacerbating “already chronic” underinvestment. The agency does not believe that policymakers will be able to address the multi-faceted dilemmas of a falling exchange rate, large capital outflows, declining economic activity, and rising inflation.  

Monetary authorities face conflicting objectives of keeping interest rates high enough to restrain exchange rate decline and curb inflation, and low enough to support growth and banking solvency. Rapid key interest cuts are expected to heat up currency depreciation and inflation, further weighing in on purchasing power.

Meanwhile, and despite preparing budget consolidation strategy at lower oil prices, fiscal authorities will remain inherently vulnerable to new volatility that might trigger fresh capital flight and downward pressure on the exchange rate and the balance of payments.

The agency expects fiscal and foreign exchange buffers to erode further, despite planned fiscal measures currently taken at face value. Consolidated government deficit is expected at RUB1.6 trillion (2.6% of GDP in 2015), while the non-oil deficit is expected to widen, which would be financed by drawing from the Reserve Fund.

If the recession persists into 2016 and the government has to turn to the domestic market to finance at least a share of the deficit, the debt-to-GDP ratio could increase to 20%. Sovereign FX assets of the central bank and the government are expected to more than halve from approximately $330bn as of end-2014 due to continued capital flight and restricted access to international capital markets.