Ratings On Ukrainian Capital City of Kyiv Affirmed At 'B-'; Outlook Stable


  • Kyiv continues to benefit from its agreement with Ukraine's Ministry of Finance to decrease intergovernmental debt once its infrastructure projects are completed.
  • The city aims to continue its infrastructure development by providing guarantees to its transport and utility government-related entities (GREs).
  • We are affirming our 'B-' long-term rating on Kyiv.
  • The outlook is stable.

Rating Action

On May 17, 2019, S&P Global Ratings affirmed its 'B-' long-term issuer credit rating on the Ukrainian capital city of Kyiv. The outlook is stable.

Outlook

The stable outlook reflects our expectations that Kyiv's sound operating surpluses and moderate cash buffers will enable it to withstand uncertainties stemming from Ukraine's very volatile institutional framework. These should also allow the city to provide financial support to its GREs if needed. The outlook also factors in our assumption that the city will keep its tax-supported debt low.
Downside scenario
We might lower the rating if we were to lower our sovereign ratings on Ukraine; if the city's financial performance were to substantially weaken, leading to debt accumulation materially above what we envisage in our base-case scenario; or if the city's liquidity sources were to reduce.
Upside scenario
We could raise our rating on Kyiv if we observed an improvement in its debt and liquidity management and a strengthening of the financial planning. An upgrade would also be contingent on a similar rating action on Ukraine.

Rationale

Our rating on Kyiv remains constrained by the very volatile and centralized Ukrainian institutional framework for local and regional governments (LRGs), and its low wealth levels. At the same time, we believe that the city will continue reporting a relatively high, but gradually declining, operating surplus, as well as moderate deficits after capital accounts. This will allow the city to keep tax-supported debt below 30% of consolidated operating revenues through to year-end 2021. Kyiv's weak payment culture, with a track record of defaults, continues to weigh on the rating.
A volatile framework, low wealth levels, and weak financial management are the main constraints on Kyiv's credit quality
We assess Kyiv's economy as weak compared with peers, due to still relatively low wealth levels by international standards. At the same time, Kyiv's economy is well diversified and is Ukraine's most prosperous region. Kyiv contributes more than 20% of the national GDP and enjoys the lowest unemployment rate in Ukraine. Nevertheless, Kyiv remains highly dependent on state transfers and the very centralized public finance system, prompting us to use the national GDP per capita (about US$2,600) in our base-case calculations. We expect the city's growth will mirror Ukraine's, at 2.8% on average annually, over 2019-2021.
The city operates in a very volatile institutional framework. Kyiv's budgetary flexibility and performance are significantly affected by the central government's decisions regarding key taxes, transfers, and expenditure responsibilities. The framework changes frequently, which notably affects the stability of both the city's revenue sources and its spending mandates. Visibility on future systemic changes remains low, undermining reliable long-term planning at the municipal level. Most taxes are regulated by the central government, which means that modifiable revenues make up less than 20% of Kyiv's operating revenues. Moreover, we believe that the city's ability to adjust modifiable revenues is limited. Furthermore, Kyiv's substantial investment requirements and high share of social expenditures continue to restrict its spending flexibility. We expect a slight increase in capital expenditure (capex) in the next few years, mainly related to infrastructure and transport.
The quality of financial management also constrains the city's creditworthiness. We observe only emerging long-term planning, as well as weak management of debt and liquidity and a track record of a weak payment culture. Frequent deviations from legislated budgets, as well as the limited oversight of the city's GREs, also put pressure on our assessment.
Spending pressures will likely gradually weaken budgetary performance, but the debt burden will remain low
Although we believe that Kyiv's operating budgetary performance will generally remain sound over the coming three years, we expect a gradual weakening of balances owing to accumulated underfinancing of public services, ongoing minimum wage increases, and somewhat slower revenue growth. We assume that the operating budgetary surplus will drop to about 9% of operating revenues on average in 2019-2021. This compares with an exceptionally strong 15% posted in 2014-2017, when Kyiv's revenues benefitted markedly from high inflation-driven tax revenue growth and additional revenue sources allocated to LRGs in the context of the local government reform--with expenditure growth simultaneously lagging somewhat. Central government grants (mostly earmarked public wage-related transfers), which contribute up to one-quarter of operating revenues, will continue to support the city's finances.
Weaker operating balances and existing capex pressures will dent the city's balances after capital accounts. After a few years of containing investment costs, the city has committed to a number of large infrastructure projects (such as the construction of bridges and metro lines). We believe Kyiv will continue to fulfill its investment needs in our forecast period. We also expect that the city will continue its infrastructure development by providing guarantees to its transportation and utility GREs. The projects are planned for over a 20-year horizon and include upgrades to transportation facilities, repair of the city's heating supply, and bridge renovations.
We expect the city will post moderate budget deficits after capital accounts in 2019-2021. However, we note that service underfunding and capex pressures are projected to remain high.
We expect that Kyiv's tax-supported debt will remain low and unlikely to exceed 30% of consolidated operating revenues through 2021. The city's direct debt consists of the Eurobond placed in 2018, reflecting the restructuring of the 2015 Eurobond, and intergovernmental debt liabilities to the central government. The intergovernmental liabilities mirror the terms of the foreign debt (Eurobonds) that the central government assumed from the city in 2015. The formal issuer of these bonds is the Ukrainian Ministry of Finance. Given that the city's direct debt is denominated in U.S. dollars, we note that Kyiv's debt burden will be subject to exchange rate volatility.
According to an agreement between the city and the central government, if the city invests in municipal transport infrastructure, the government will write off an equal amount from the city's intergovernmental obligations. As we understand, some of Kyiv's obligations have already been reduced ahead of schedule after it completed some construction projects. We expect the city to continue benefitting from this agreement in 2019-2020. The official settlement will take place in 2019-2020. We therefore project the city will not need to resort to market borrowing to refinance or repay these intergovernmental obligations. We also believe that, should this agreement be derailed or cancelled, Kyiv could postpone some of its capex to generate the required funds.
In addition to direct debt, our assessment of Kyiv's total debt burden (tax-supported debt) includes liabilities of municipal GREs, which require budget assistance from the city budget. In particular we factor in all debt of GREs explicitly guaranteed by Kyiv (Kyivpastrans, Kyivmetro, GVP Energy Saving Company, Kyivavtodor, and Kyivenergo) and Kyivpastrans (not guaranteed liability), as well as the commercial debt of the water utility, given that repayments of most of these liabilities are made directly from Kyiv's budget. We also include in the tax-supported debt the liabilities that arise from the lawsuit against Kyiv's subway company Kyivmetro, because the city might be required to support the entity.
The accumulated payables at the city's utility and transportation companies--which still run significant arrears--comprise the main elements of Kyiv's contingent liabilities. These liabilities come from the fact that tariffs for municipal services are set by the central government below their cost recovery, with the state not fully compensating for the gap. We expect that Kyiv might provide financial assistance by increasing subsidies or injecting capital. We also include in the city's contingent liabilities the Ukrainian hryvnia (UAH) 3.7 billion in central government loans received before 2014 to finance mandates set by the central government. Although the city will have to meet these obligations, we do not think the payments will materially affect its liquidity position, and we anticipate potential support would not exceed 15% of Kyiv's operating revenues.

Kyiv has partly depleted the material amount of cash accumulated over the years of budget surpluses. Still, the amount remains sound and provides the city with a liquidity buffer should budgetary performance weaken or a portion of contingent liabilities migrate to Kyiv's balance sheet. We apply a 50% haircut to the city's cash reserves because the city keeps them in the central treasury and we believe that access to these reserves could be interrupted, given the central government's track record with regard to default. Nevertheless, we assume that Kyiv's liquidity position will remain solid and comfortably cover its annual debt service over the next 12 months. Under our current projections, the coverage ratio will sharply decrease when the city's debt liabilities in 2020 and 2021 are due. We also view the city's access to external liquidity as uncertain, reflecting the weaknesses of the Ukrainian capital market and its banking sector.
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