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S&P downgrades Russia, central bank hikes rates

Standard & Poor's cut its foreign and local currency rating on Russia, as capital continues to flow out of the country amid heightened tensions with the West, risking Russia's growth prospects.

Later on Friday morning, Russia's central bank raised its key interest rate from 7 percent to 7.5 percent in a scheduled meeting, citing rouble weakness and high inflation risks.

The bank said the move would enable it to lower inflation to 6 percent by the end of 2014 and added it did not plan on cutting rates in coming months.

S&P downgraded Friday Russia's foreign currency rating to one notch above "junk" status to 'BBB-/A-3' from 'BBB/A-2', as well as cutting local currency local-currency long-term rating to 'BBB' from 'BBB+'.

"In our view, the tense geopolitical situation between Russia and Ukraine could see additional significant outflows of both foreign and domestic capital from the Russian economy and hence further undermine already weakening growth prospects," the ratings agency said, warning that further downgrades were possible if the West imposes tighter sanctions against Moscow.

Russian shares, which have traded lower this week, fell further following the downgrade, with the MICEX stock index slipping over 1.6 percent.The rouble, which has lost nearly 8 percent against the dollar this year was trading 0.3 percent lower against the U.S. currency and 0.4 percent lower against the euro.

Read MoreUkraine crisis escalates: What this means for investors

A unit claiming to Cossack and other citizen pro-Russian volunteers arrive to take up position outside a Ukrainian miltary base where heavliy-armed unidentifed soldiers have surrounded Ukrainian soldiers inside as Russian flag flies behind in Crimea on March 3, 2014 in Perevalne, Ukraine.
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A unit claiming to Cossack and other citizen pro-Russian volunteers arrive to take up position outside a Ukrainian miltary base where heavliy-armed unidentifed soldiers have surrounded Ukrainian soldiers inside as Russian flag flies behind in Crimea on March 3, 2014 in Perevalne, Ukraine.

The central bank's decision to raise its key lending rate follows a rate hike in March, when the bank announced it was "temporarily" hiking rates to 7 percent from 5.5 percent.

S&P said the downgrade reflects the risks of further large financial outflows observed in the first quarter of 2014, during which time the size of Russia's financial account deficit was almost twice that of the current account surplus.

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The Russian economy minister responded to the downgrade by describing S&P's decision as "politically motivated".

The downgrade follows a revision of its "outlook" for Russian last month to "negative" over fears of intensified U.S. and European Union economic sanctions following the annexation of Crimea.

Moody's and Fitch, who together with S&P make up the "big three" rating agencies both put the outlook for Russia's debt on review in March, and analysts now expect they will follow the decision to downgrade.

Head of emerging market research at Standard Bank, Timothy Ash said the move from S&P had been a long time coming, given the threat of sanctions.

Read MoreAs Ukraine ends truce, is Russian invasion next?

"I am only surprised at the sanguine stance of the rating agencies thus far for what I view as now a serious risk to the Russia story built over the past decade," said Ash

"Junk status looming any time soon? If the crisis in Ukraine deteriorates further, and we see sustained capital flight and pressure on the rouble and Russian markets further, then it is possible. I would expect the other rating agencies to begin to follow S&P's move" he added.

Separately, S&P upgraded the long-term rating of Cyprus to 'B', adding the outlook was positive but warning that the external risks to the Cypriot economy would increase if there was an escalation in the EU sanctions on Russia.

Russia and Ukraine that will lead to an "external shock" to the Cypriot economy.

Read MoreWho are the separatist rebels destabilizing Ukraine?

S&P said a decline in Russian tourism to Cyprus would "adversely affect" economic growth in the country, especially when coupled with a weaker rouble.

S&P said it expects Russia's current account surpluses to disappear by 2015, as imports are rising faster than exports. But further rouble weakness could weigh on imports, the ratings agency said, postponing or even preventing the current account from shifting into deficit.

Rival ratings agency Fitch also upgraded Cyprus, but did not expect any escalation in developments between

"Economic growth in Russia slowed to 1.3 percent in 2013, the lowest rate since 1999, excluding the economic contraction in 2009. In our view, if geopolitical tensions do not subside in 2014, there is significant downside risk that growth will fall well below 1 percent," S&P said.

Read More How traders can prepare for a worsening Ukraine crisis

S&P also said Russia's fiscal dependence on commodities has intensified and the oil price needed to balance the country's budget this year would be close to $110 per barrel.

CEO of global advertising firm WPP Sir Martin Sorrell told CNBC that he was "worried" about events in Russia and is not expecting things to improve.

"The agreement between the West and Russia doesn't seen to be holding and sticking. Recent events are not pretty and do not look like they're going to get any better," he said.

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