By Dennis Shen, Director, Sovereign Ratings

Uncertainty around the state of the Ukrainian economy is huge, but we assume output will partially rebound by around a fifth in 2023 as activity recovers in regions where the conflict eases. Output next year would potentially remain 30% below 2021 levels, speaking to the scale of the reconstruction task at hand.

The severe decline of output places enormous strain on debt sustainability. We see debt-to-GDP gradually climbing to above 90% by 2027, from 48.9% end-2021. However, Ukraine’s debt outlook would be far bleaker were it not for government measures and significant international financial assistance.

Compared with the sharp rise in debt during the 2014-15 Crimea crisis, the government has this time supported debt dynamics through administrative controls while the National Bank of Ukraine (NBU) has fixed the exchange rate. The move has limited hryvnia depreciation to 5% against the euro since November 2021 although unofficial rates are circa 22% below official ones at this stage. As the NBU has sold foreign currency, reserves have declined, however, to USD 24.0bn in April from USD 29.4bn in December 2021.

Ukraine’s funding gap is in the range of USD 5-7bn a month. Official-sector support has been vital for bridging this gulf. The US has finalised military and humanitarian aid of USD 40bn. The EU has proposed bond issuance guaranteed by member states to assist Ukraine with EUR 9bn of emergency loans alongside a ‘RebuildUkraine’ programme of non-repayable grants and loans modelled on its Covid-19 recovery fund. The IMF’s and World Bank’s establishment of multi-donor administered accounts have packaged grants and loans from varying international multilateral and bilateral benefactors.

Nevertheless, Ukraine faces the daunting cost of rebuilding the economy, which the government estimates at USD 560bn for repairing destroyed infrastructure and physical capital. The government’s budget deficit will rise to 15% of GDP this year from 4% in 2021. Over 2023-25, the deficit will remain above 10% of GDP a year.

Longer run, US and European policy makers have contemplated co-opting around USD 300bn of frozen Russian reserves and even the liquidation of seized Russian oligarch assets to pay or serve as collateral for reconstruction funding. One precedent is the US seizure of Afghan reserves after 9/11. Such action would be credit positive for Ukraine although there are valid questions over whether this undermines due process and whether reserves might serve better as bargaining chips in talks to end the conflict.

Domestic funding is more limited, even though Kyiv has sold more than USD 2bn of war bonds since March – mostly in hryvnia, with support from the temporary monetary financing activities of the NBU.

Debt relief is a complementary option. The IMF regards Ukrainian debt as sustainable under current projections. However, this can change. After Russia’s invasion of Ukraine in 2014, Ukrainian debt rose to 99% of GDP by February 2015 – up from 40% in January in 2014 – prior to a restructuring of debt late in 2015. Debt levels are seen reapproaching such levels.

Ukraine’s Finance Ministry has dismissed external debt restructuring at this stage, seeking foreign market participants to re-engage and support funding of the war and recovery via initiatives such as the “peace bond”.

Given international goodwill toward Ukraine amid calls for the equivalent of a new Marshall Plan, official-sector debt relief is expected, such as a potential suspension of debt service nearer term and/or possible longer-run debt cancellation. Whether foreign bondholders support debt relief hinges on how long the war endures, its ultimate cost and the degree to which international multilateral and bilateral assistance alone can prevent Ukraine’s debt burden from becoming an impediment to sustainable recovery.

Scope downgraded the sovereign credit rating of Ukraine to CCC early March, from B/Negative before the full invasion, and placed ratings under review for a developing outcome.