Fitch Affirms Russia at ’BBB’; Outlook Stable

KEY RATING DRIVERS

Low government debt (11% of GDP) and sovereign net foreign assets of 23% of GDP support the rating, although the sovereign balance sheet has largely stopped strengthening. The government will transfer a surplus USD6bn (0.3% of GDP) to the Reserve Fund, the main fiscal buffer, in early 2014, but this is smaller than it was before the 2008 crisis.

Russia is running a small fiscal deficit, which it aims to keep below 1% of GDP through 2016. The federal government recorded a deficit of 0.5% of GDP in 2013, 0.3pp below target. Fitch believes non-oil revenues are overestimated in 2014 and the deficit will exceed its target of 0.5% of GDP. However, rouble depreciation will have a countervailing effect, increasing the local currency value of oil revenues.

The authorities estimate real GDP grew just 1.4% in 2013, half the official forecast at the start of the year. A decline in investment and the inventory cycle contributed to the slowdown, but these effects are likely temporary. Fitch expects growth to reach 2% in 2014, driven by private consumption, but does not expect a dynamic recovery. A shrinking labour force and lack of structural reform constrain long-term growth.

The Central Bank of Russia (CBR) plans to move to full inflation targeting in 2015 and is prioritising its 5% inflation target (2015: 4.5%) over stimulating growth. A more flexible rouble will help absorb external shocks. Despite widening the exchange rate bands, the CBR has sold USD28.6bn to support the currency since April 2013 (up from USD5.4bn in 2012). As intervention falls away, the rouble is likely to become more volatile and is liable to depreciate given the balance of payments fundamentals.

The current account (CA) is narrowing and it is likely to move into deficit in 2015. The CBR estimates that the CA surplus was USD33bn (1.5% of GDP) in 2013. The oil and commodities outlook precludes substantial export growth. Russia will remain a net external creditor for around 17% of GDP, but in view of the USD95bn increase in external debt in 2013, this position is eroding.

Commodity dependence is high. Oil and gas account for 67% of goods exports and half of federal government revenue, exposing the balance of payments and public finances to external shocks. The non-oil fiscal deficit fell by 0.3pp of GDP to 10.1% of GDP in 2013, indicating efforts to reduce fiscal oil dependence. However, there has been little diversification of exports.

Governance is a relative weakness, manifested in the World Bank governance indicators. Incremental reforms to the business climate resulted in Russia climbing 19 places to 92nd in the 2014 edition of the World Bank Doing Business ranking.

The banking system is a contingent liability of the sovereign. Banks’ capital cushions are thinning, although remain above regulatory norms, and overall non-performing loans are 6% of lending. The CBR withdrew 32 banking licences, all from small banks, in 2013. The economic slowdown and growing consumer indebtedness has led to some deterioration in asset quality. Partly in response to regulatory tightening by the CBR, unsecured retail lending growth has slowed to 28% from a peak of 44% in mid-2012.

RATING SENSITIVITIES

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

Future developments that could individually or collectively, result in positive rating action include:

 A reduction in vulnerability to oil price shocks, either via fiscal reform or gradual building of the Reserve Fund as a buffer.

 A longer track record of lower inflation and management of the flexible exchange rate regime would reduce vulnerabilities to external shocks.

Future developments that could individually or collectively, result in negative rating action include:

 A steep and prolonged oil price fall that had a material impact on the economy and the public finances.

 Fiscal slippage that damaged the long-term sustainability of the public finances.

 A weakening in the balance of payments leading to a substantial fall in reserves.

 Prolonged growth underperformance.

KEY ASSUMPTIONS

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

Fitch assumes that the government and monetary authorities avoid stimulus measures that would endanger macroeconomic stability or the sustainability of the public finances.

Fitch assumes that oil prices do not diverge significantly from the agency’s base-case projection of USD100/barrel on average over 2014-2015.

Fitch assumes that Russia continues to enjoy broad social and political stability.