Moody's announced late on Friday evening that it was downgrading Russia’s government bond and local currency ratings one notch to Ba1, from Baa3, and retaining the negative outlook.
The rationale behind the downgrade was threefold: i) weakening expectations of Russia's economic strength and growth prospects; ii) the deterioration of the government's financial strength as a result of fiscal pressures and the continued erosion of Russia's FX reserves; and iii) the rising risk of a decision by the Russian authorities that directly or indirectly undermines timely payments on external debt service (i.e. capital controls).
Moody's economic projections differ substantially from our own baseline as the agency expects a deeper and more protracted recession through both 2015 (-5.5% GDP) and 2016 (-3.5%). In contrast, we expect a rather deep recession this year (-4.5%) followed by a moderate recovery in 2016 (+2.5%). In any case, the deterioration in growth outlook could hardly have been behind the downgrade as Moody's actually left its growth projections unchanged from the previous update in January. Nor has the risk of capital controls increased that significantly as to initiate a rating downgrade, in our view.
Therefore, it looks like the second driver (fiscal pressures and the erosion of FX reserves) was the key reason for the downgrade. The agency left its projections for general government deficit unchanged for 2015 (-2.0% of GDP) and increased it only for 2016 (from -1.7% of GDP to - 3.1%), arguing that in an environment of protracted recession the government would yield to demands for fiscal easing next year. Given that the agency did not alter its growth projections, it appears that its perception of the policy reaction must have changed for some reason since January, despite the authorities signalling their readiness to cut fiscal spending and achieve a balanced budget by 2017 with oil at USD 70/bbl.
That said, the changes to the fiscal deficit and debt metrics projections were rather benign and so it appears that a reassessment of the external balances was the main rationale behind the rating downgrade. Indeed, the rating agency marked up its expectation of the FX reserves drawdown to USD 175bn (from January's assessment of USD 125bn) despite an expansion of the CA surplus (8.2% of GDP). Taken together, the two projections (FX reserves and CA surplus) imply USD 270bn of net capital outflows in 2015 (vs. USD 150 bn in 2014). Given USD 50-60bn of external debt redemptions, Moody's appears to assume more than USD 200bn of domestic capital outflow. This seems to be rather extreme as it would comprise more than 80% of the overall local currency term deposits in the banking system (at USDRUB of 70 which the agency forecasts for 2015). In contrast, we expect capital outflows to moderate to USD 80-90bn as the intensity of savings dollarisation is likely to decline in an environment of stabilising devaluation expectations and high interest rates.