Fitch downgrades Ukraine as debt restructuring and deferral plans begin

Fitch Ratings lowered Ukraine's credit score after the war-torn nation started the formal process of restructuring $22.8 billion in sovereign debt and deferring payments on external bonds. The country's long-term foreign currency issuer default rating was lowered to C from CCC — only one step before default — the New York-based agency said on Friday. The protracted war is delivering "severe stresses" to Ukraine's macroeconomy, financial position and public and external finances, it added.

Fitch viewed this as the beginning of a distressed debt exchange (DDE) process, consistent with its ratings. The company's sovereign criteria cites that a commercial debt restructuring that entails a material reduction in terms, such as the deferral of interest or principal, and is necessary to avoid a traditional payment default constitutes a DDE.

The agency said severe stresses necessitate debt restructuring, and "even if not accepted, Fitch considers that the risk of missed payments or initiation of an alternative DDE process is high as the government seeks to preserve liquidity in the face of acute military spending pressure". "More generally, we expect [that] a broader restructuring of the government's commercial debt will be required, although the timing remains uncertain," Fitch said.

Kyiv on Wednesday filed a formal request, asking bondholders to agree to a two-year payment freeze and changes to coupons on its so-called GDP warrants by the middle of next month. The country's finance ministry said it “received explicit indications of support” for the plan.

Ukraine's economy is being ravaged by its conflict with Russia, which began in February. Institutes including Ukraine's economy ministry and the Kyiv School of Economics in June have pegged economic losses between $564bn and $600bn, which is almost four times the nation's annual gross domestic product.

The eastern European country's economy is projected to shrink by about 45 per cent this year, but the magnitude of the contraction will depend on the duration and intensity of the war, the World Bank said. The International Institute of Finance had a more conservative estimate, saying that Ukraine's economy will shrink about 35 per cent this year, with the monthly fiscal gap seen between $3bn to $10bn.

Fitch sees Ukraine's 2022 economic decline at 33 per cent, with the damage to infrastructure alone at $100bn, or about three quarters of GDP. Kyiv has projected that reconstruction needs over the next decade will be at $750bn.

The economy of Russia, on the other hand, has already plunged into a deep recession, having been hit by unprecedented international sanctions, with output projected to diminish more than 11.2 per cent this year, it added. The conflict also goes beyond the two countries as economies elsewhere, including emerging and developing countries in Europe and Central Asia, are feeling its negative effects.

Fitch anticipates the war will continue well into 2023, and any negotiated political settlement will remain weak, because Kyiv is unlikely to cede any substantial territory lost to Russia. 'At the same time, it is not clear either side will have sufficient military superiority to deliver on objectives, which could result in a long-drawn conflict," it added.

Only a gradual economic recovery is expected. After the massive contraction expected in 2022, a modest 4 per cent recovery is projected next year, taking into consideration the limitations of seaport access, which prevents the start of any large-scale rebuilding.

However, there has been some sequential pick-up in economic activity since the early stages of the invasion, and the share of pre-war output from territory in which there is currently conflict has fallen to an estimated 12 per cent, Fitch noted.

War-related expenditure drove Ukraine's fiscal deficit to an average of $4bn in the second quarter of 2022, and Fitch is expecting a full-year general government deficit of 29.1 per cent of GDP — a record high for the country. The deficit is expected to remain substantial at around 22 per cent of GDP next year.

Foreign-exchange reserves fell by almost a quarter to $22.8bn at the end of June from $28.1bn at end of March. Inflation, meanwhile, hastened to 21.5 per cent in June, and Fitch expects this to surge to 30 per cent by the end of the year, partly due to the hryvnia's depreciation.

"The ability to meet Ukraine's extremely large financing need into 2023 largely depends on multilateral and bilateral support, which is currently uncertain; and we judge that debt restructuring is a probable condition of continued external support on such a scale," Fitch said.

European ratings agency Scope also downgraded Ukraine's credit score to C. Moody’s Investors Service and S&P Global Ratings rate Ukraine as Caa3 and CCC+, respectively.