Research Update:

Ukraine Downgraded To 'B-' On Government's Lack Of Strategy To Secure Foreign Currency Funding; Outlook Remains Negative
Primary Credit Analyst: Trevor Cullinan, Dubai (971) 4372-7113; trevor.cullinan@standardandpoors.com Secondary Contact: Kai Stukenbrock, Frankfurt (49) 69-33-999-247; kai.stukenbrock@standardandpoors.com Analytical Group Contact: SovereignEurope; SovereignEurope@standardandpoors.com

Table Of Contents
Overview Rating Action Rationale Outlook Key Statistics Related Criteria And Research Ratings List

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Research Update:

Ukraine Downgraded To 'B-' On Government's Lack Of Strategy To Secure Foreign Currency Funding; Outlook Remains Negative
Overview
In our view, the Ukrainian government has yet to implement a strategy to secure sufficient foreign currency to meet its elevated external financing needs. We are therefore lowering our long-term sovereign credit ratings on Ukraine to 'B-' from 'B'. We are affirming our 'B' short-term ratings. The outlook remains negative, reflecting our opinion that there is at least a one-in-three likelihood of a downgrade over the next year if Ukraine's net international reserves decline faster than we currently expect and external and fiscal commitments become increasingly difficult to meet.

Rating Action
On Nov. foreign 'B'. At remains 1, 2013, Standard & Poor's Ratings Services lowered its long-term and local currency sovereign credit ratings on Ukraine to 'B-' from the same time, we affirmed the short-term ratings at 'B'. The outlook negative.

We also lowered the long-term Ukraine national scale rating to 'uaBBB-' from 'uaA-'.

Rationale
The downgrade reflects our view that the government's strategy is increasingly unlikely to secure sufficient foreign currency to meet its elevated external financing needs. In May 2013, we stated that favorable conditions on international capital markets could prove fleeting and further accentuate Ukraine's external funding pressures. This has been the case, as the inversion of the government's yield curve at the end of September 2013 shows. The ratings are constrained by our view of political uncertainty, financial sector stress, and weak external liquidity. The ratings are supported by Ukraine's still relatively low, albeit rising, government debt burden and fairly diversified economy. Foreign currency reserves held at the National Bank of Ukraine (NBU; the central bank) fell by 26% year-on-year in September 2013, having declined by

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Research Update: Ukraine Downgraded To 'B-' On Government's Lack Of Strategy To Secure Foreign Currency Funding; Outlook Remains Negative

23% during 2012. Absent longer term official financing or a significant improvement in current account performance, we expect foreign currency reserves to fall further to below three months of current account payments and to less than 30% of external short-term debt (by remaining maturity) in 2013. We anticipate they will continue to decline over the forecast horizon. Officials are increasingly using foreign exchange controls in an effort to bolster reserves. Repatriation and surrender requirements, which require conversion of 50% of exporters' foreign currency into hryvnia, have been extended to include all legal entities and people (excluding banks' drawing of interbank loans) receiving foreign exchange. Under our base case, we do not expect Ukraine to commit to broad-based reforms. This makes an agreement on a multi-lateral external financing program unlikely. Such a program would probably involve reforms including some combination of the following: fiscal consolidation, making the domestic gas market more market-oriented, accelerating the resolution of nonperforming loans in the financial sector, and increasing exchange-rate flexibility. In our view, devaluation of the Ukrainian hryvnia has become more likely. The potential magnitude of this has also increased in light of the government's defense of the exchange rate through the depletion of foreign currency reserves, while we estimate the economy will contract in 2013. We assume a managed devaluation of the hryvnia against the U.S. dollar in 2014 to 9.5, from an estimated 8.2 in 2013. We note that the domestic foreign currency market has been relatively calm in 2013, with hryvnia deposits at commercial banks accelerating at a faster pace (averaging 23% in the first nine months) than foreign currency deposits (14%). As a result, our devaluation assumption is now for 2014. We view the weakness of the banking system as an impediment to monetary policy flexibility. The banks refinanced at the NBU at an average weighted rate (on all instruments) of 6.6% in September 2013 compared with an average weighted interest rate on loans to households and business at 15.2%. Nonperforming loans in the banking system are around a very high 40% and could rise higher if a sharp devaluation occurred as 35% of bank loans were denominated in foreign currency as of September 2013. Uncertainty remains as to whether or not Ukraine will sign an association agreement with the EU at the Vilnius Eastern Partnership Summit on Nov. 28-29, 2013, as negotiations about the status of jailed former prime minister Yulia Tymoshenko are ongoing. In our view, signing the agreement would be positive for Ukraine's trade over the long term, but there could be short- to medium-term negative implications largely related to Russia's reaction. Russia would likely respond by imposing trade restrictions on Ukraine similar to those of August 2013. Exports to Russia would likely fall as a result. Russia accounted for 26% of Ukrainian commodities exports in 2012 and 39% of services exports.

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Research Update: Ukraine Downgraded To 'B-' On Government's Lack Of Strategy To Secure Foreign Currency Funding; Outlook Remains Negative

We see limited prospects for fiscal consolidation in Ukraine. Our estimate of the average change in general government debt over 2013-2016 is just over 6% of GDP. We expect the general government net debt burden to increase to 40% of GDP in 2014 from 34% this year, with the devaluation adding several percentage points of GDP to the debt stock above the headline deficit. About 52% of gross debt is denominated in foreign currency, although mostly on concessional terms. We include the promissory notes that we expect the government to issue in 2013 (largely to fund arrears on VAT refunds and heating bills) in our estimate of the government's 2013 debt (just over 1% of GDP). We expect the government's local currency debt and general government deficit to continue to be financed largely by the NBU and state controlled banks. The NBU holds 60% of local currency debt as of August 2013 while banks hold 32%, which is about 8% of commercial bank assets. Ukraine's GDP per capita is estimated at $4,000 in 2013. We project the population to continue to decline by around 0.5% per year until 2016. Due to weak external demand for Ukraine's metals and machinery exports and continued declines in industrial production, we now expect trend growth. Our criteria define this as a weighted 10-year average of real GDP per capita growth at around 1.8%.

Outlook
The negative outlook reflects our view that there is at least a one-in-three chance that we could lower our ratings on Ukraine over the next 12 months if we were to view net foreign currency reserves as declining at a sharper and more sustained rated than we currently expect. We could revise the outlook to stable if we were to assess external pressures as easing materially.

Key Statistics
Table 1

Ukraine - Selected Indicators

2006 Nominal GDP (US$ bil) GDP per capita (US$) Real GDP growth (%) Real GDP per capita growth (%) Change in general government debt/GDP (%) General government balance/GDP (%) General government debt/GDP (%) Net general government debt/GDP (%) 108 2,296 7.4 8.2 0.5 (1.4) 12.1 8.7 2007 143 3,060 7.6 8.2 0.7 (2.0) 9.9 7.7 2008 180 3,881 2.3 2.9 6.3 (3.2) 13.8 12.4 2009 117 2,540 (14.8) (14.3) 10.5 (8.7) 24.9 23.8 2010 138 3,001 4.2 4.6 8.8 (7.0) 29.6 27.2 2011 163 3,570 5.1 5.5 2.6 (4.0) 27.4 26.2 2012 176 3,864 0.2 0.5 3.0 (5.6) 28.3 27.8 2013e 181 3,981 (1.0) (0.5) 6.7 (5.1) 33.9 33.5 2014f 186 4,124 1.5 2.0 9.0 (6.2) 39.2 38.8 2015f 198 4,402 3.5 4.0 4.8 (4.8) 39.2 38.8 2016f 229 5,118 3.5 4.0 4.0 (4.0) 37.9 37.6

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Research Update: Ukraine Downgraded To 'B-' On Government's Lack Of Strategy To Secure Foreign Currency Funding; Outlook Remains Negative

Table 1

Ukraine - Selected Indicators (cont.)

General government interest expenditure/revenues (%) Oth dc claims on resident non-govt. sector/GDP (%) CPI growth (%) Gross external financing needs/CARs +use. res (%) Current account balance/GDP (%) Current account balance/CARs (%) Narrow net external debt/CARs (%) Net external liabilities/CARs (%) 1.5 46.8 9.1 107.4 (1.5) (2.9) 47.4 36.0 1.2 61.4 12.8 116.6 (3.7) (7.3) 52.4 37.2 1.2 79.5 25.2 121.1 (7.1) (13.4) 60.5 43.1 2.7 80.3 15.9 130.4 (1.5) (2.8) 100.5 64.5 3.4 67.9 9.4 132.9 (2.2) (3.9) 84.6 49.7 4.4 62.8 8.0 131.0 (6.3) (10.3) 77.3 48.4 5.0 59.8 0.6 136.9 (8.4) (14.6) 88.1 58.9 5.6 60.4 (0.5) 147.4 (8.0) (15.7) 110.4 78.5 6.6 56.3 8.5 150.6 (6.0) (11.4) 110.6 83.0 7.7 51.8 10.0 155.5 (7.5) (14.4) 112.8 91.5 8.0 47.0 8.0 155.2 (7.1) (14.1) 107.0 93.3

Other depository corporations (dc) are financial corporations (other than the central bank) whose liabilities are included in the national definition of broad money. Gross external financing needs are defined as current account payments plus short-term external debt at the end of the prior year plus nonresident deposits at the end of the prior year plus long-term external debt maturing within the year. Narrow net external debt is defined as the stock of foreign and local currency public- and private- sector borrowings from nonresidents minus official reserves minus public-sector liquid assets held by nonresidents minus financial sector loans to, deposits with, or investments in nonresident entities. A negative number indicates net external lending. CARs--Current account receipts. The data and ratios above result from S&Ps own calculations, drawing on national as well as international sources, reflecting S&Ps independent view on the timeliness, coverage, accuracy, credibility, and usability of available information.

Related Criteria And Research

Sovereign Government Rating Methodology And Assumptions, June 24, 2013 Methodology For Linking Short-Term And Long-Term Ratings For Corporate, Insurance, And Sovereign Issuers, May 7, 2013 Criteria For Determining Transfer And Convertibility Assessments, May 18, 2009 Sovereign Defaults And Rating Transition Data, 2012 Update, March 29, 2013 Report Card: Lack Of Reform And Inefficient Energy Industries Constrain Growth For CIS Sovereigns, May 16, 2013 Banking Industry Country Risk Assessment Update: May 2013, May 6, 2013 Long-Term Rating On Ukraine Lowered To 'B' On External Financing Needs; Outlook Negative, Dec. 7, 2012 Ukraine 'B/B' Ratings Affirmed; Outlook Remains Negative On Continued Pressure On External Financing Needs, May 16, 2013

In accordance with our relevant policies and procedures, the Rating Committee was composed of analysts that are qualified to vote in the committee, with sufficient experience to convey the appropriate level of knowledge and understanding of the methodology applicable (see 'Related Criteria And Research'). At the onset of the committee, the chair confirmed that the information provided to the Rating Committee by the primary analyst had been distributed in a timely manner and was sufficient for Committee members to make an informed decision.

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Research Update: Ukraine Downgraded To 'B-' On Government's Lack Of Strategy To Secure Foreign Currency Funding; Outlook Remains Negative

After the primary analyst gave opening remarks and explained the recommendation, the Committee discussed key rating factors and critical issues in accordance with the relevant criteria. Qualitative and quantitative risk factors were considered and discussed, looking at track-record and forecasts. The chair ensured every voting member was given the opportunity to articulate his/her opinion. The chair or designee reviewed the draft report to ensure consistency with the Committee decision. The views and the decision of the rating committee are summarized in the above rationale and outlook.

Ratings List
Downgraded; Ratings Affirmed To Ukraine Sovereign Credit Rating Ukraine National Scale Transfer & Convertibility Assessment Senior Unsecured B-/Negative/B uaBBB-/--/-BBFrom B/Negative/B uaA-/--/-B B

Complete ratings information is available to subscribers of RatingsDirect at www.globalcreditportal.com and at spcapitaliq.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column. Alternatively, call one of the following Standard & Poor's numbers: Client Support Europe (44) 20-7176-7176; London Press Office (44) 20-7176-3605; Paris (33) 1-4420-6708; Frankfurt (49) 69-33-999-225; Stockholm (46) 8-440-5914; or Moscow 7 (495) 783-4009.

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