OREANDA-NEWS. Fitch Ratings has downgraded Ukraine's Long-term local currency Issuer Default Rating (IDR) to 'CCC' from 'B-' and affirmed its Long-term foreign currency IDR at 'CCC'.

The issue ratings on Ukraine's senior unsecured local currency bonds were downgraded to 'CCC' from 'B-' while the senior unsecured foreign currency bonds were affirmed at 'CCC'. The Country Ceiling has been affirmed at 'CCC' and the Short-term foreign currency IDR at 'C'.

KEY RATING DRIVERS
The downgrade reflects the following factors and their relative weights:

HIGH
Ukraine is part-way through a political transition that began in February when popular protests ousted former president Viktor Yanukovych. A new administration has signed a stand-by arrangement with the IMF and embarked on a programme of economic reforms. Polls indicate new elections in October could lead to stronger parliamentary backing for this programme, but economic and political risks could derail it.

The government has been fighting separatists in the eastern regions of Donetsk and Luhansk beginning in April, leaving over 2,000 dead and hundreds of thousands displaced. Although the government has recaptured territory from the rebels, conflict may persist or intensify, delaying economic revival and damaging productive assets.

Instability in the east and disputes with Russia are affecting the economy. Fitch forecasts real GDP to shrink at least 6.5% in 2014, much worse than the agency had expected in February, and assumes zero growth in 2015 and 2016. Exports to Russia, the largest export market and source of energy imports, plunged 24% in 1H14. Gazprom cut gas supplies to Ukraine in June amid a payment dispute. Energy shortages are a risk.

Government solvency has deteriorated. The consolidated fiscal deficit, including losses of Naftogaz, the state energy company, will reach 10% of GDP in 2014. The government aims to cut this to 6% of GDP in 2015. Direct and guaranteed debt will surpass 65% of GDP in 2014 - above the level envisaged in the IMF programme - but could stabilise in 2015 if energy subsidies are reduced as planned. Refinancing sovereign debt remains a challenge.

The reserves position remains fragile and only public foreign-currency borrowing under the IMF programme stands in the way of a renewed external financing crisis and probable default. The hryvnia has depreciated more than 37% against the USD since end-2013, leading to a sharp external adjustment. Fitch expects the current account deficit to narrow to less than 5% of GDP in 2014 from 9% in 2013, following currency depreciation and a sharp fall in imports.

MEDIUM
Currency depreciation, recession and conflict in the economically important east of the country will have damaged the banking system's asset quality. The government has budgeted up to UAH30bn (1.5% of GDP) to support state banks, private banks and the deposit guarantee fund. Fitch believes eventual recapitalisation needs could be higher. Bank deposits fell sharply in 1Q14 but have since stabilised. The National Bank of Ukraine has provided greater liquidity to banks, and has begun to close down weaker institutions.

RATING SENSITIVITIES
The main factors that could, individually or collectively, result in a downgrade:
-Intensification of political and/or economic stress, potentially leading to a default on government debt

The main factors that could, individually or collectively, could result in an upgrade:
-Improvement in political stability
-Progress in implementing economic policy agenda agreed with the IMF
-Improvement in external liquidity

KEY ASSUMPTIONS
Ukraine continues to receive disbursements from the IMF and retains support from the EU and other multilateral organisations.

Ukraine avoids a full-scale invasion.