Overview -- The Ukrainian city of Dnipropetrovsk continues to deliver strong operating margins in line with our base case, thanks to economic growth and state support. -- Despite existing and planned borrowing, tax-supported debt is likely to stay low. -- We are affirming our 'B' and 'uaA-' ratings on Dnipropetrovsk and the recovery rating on the city's bond is unchanged at '4'. -- The stable outlook reflects our view that city's adherence to cautious expenditure and debt policies and continued central-government support will likely result in moderate budgetary performance and low tax-supported debt. Rating Action On Sept. 17, 2012, Standard & Poor's Ratings Services affirmed its 'B' long-term issuer credit rating and 'uaA-' Ukraine national scale rating on the Ukrainian city of Dnipropetrovsk. The outlook is stable. The recovery rating on Dnipropetrovsk's senior unsecured debt remains at '4'. Rationale The ratings on Dnipropetrovsk reflect Ukraine's very weak public finance system, which results in low financial flexibility and predictability for the city, as well as material contingent liabilities related to municipal utilities and a poor and concentrated economy. These constraints are mitigated by Dnipropetrovsk's low debt burden and strong financial support from the central government. The central government's control over the lion's share of Dnipropetrovsk's revenues and expenditures, and what we consider as Ukraine's "volatile and underfunded" system of public finance, significantly reduce Dnipropetrovsk's financial predictability and flexibility. Material overdue payables of the city's municipal enterprises continue to present one of the key rating constrains. Dnipropetrovsk's municipal heating, water, and transport companies account for most of the accumulated payables, the amount of which has not decreased over the last few years. By year-end 2011, they totaled slightly more than 30% of the city's total budget revenues. The city is not directly responsible for the obligations of these companies. The central government regulates municipal tariffs, which continue to be artificially low. Nevertheless, in the event of financial stress, moral obligations might lead the city to provide help by increasing subsidies or capital. We think Dnipropetrovsk's budgetary performance will likely be characterized by strong, although volatile, operating margins in the medium term. Despite the ongoing experiment, under which the financing of the city's healthcare was assumed by the central government and the share of personal income tax entering the city budget was lowered to 50% from 75%, we still think operating surpluses will exceed 5% of operating revenues in the medium term. This will likely be supported by state operating support and the management's adherence to cautious spending policies, as was the case in 2011. Moreover, notwithstanding strong pressure on the central budget, the central government has demonstrated willingness and ability to support Dnipropetrovsk's vital infrastructure projects, such as the construction of motorways, a new bridge, and a subway system. These projects will result in consistently high capital spending, but will translate into only modest (over 5% of revenues) deficits after capital accounts, in our view. Despite existing and proposed borrowings, Dnipropetrovsk's tax-supported debt will not likely exceed 30% of consolidated operating revenues by 2014, in our view. The city's debt burden will consist of minor direct obligations (a small bank loan and a proposed bond) and the commercial debt of the municipal companies, which is partly guaranteed by the budget. Due to stronger capital support from the central government, Dnipropetrovsk's borrowing plans will remain constrained. In late 2011, the central government guaranteed the long-term loan to the city's metro company from the European Bank for Reconstruction and Development (EBRD; AAA/Stable/A-1+) for EUR152 million. Contrary to our previous expectations, Dnipropetrovsk did not have to coguarantee the loan and is responsible only for interest payments. We therefore do not include the EBRD loan in the city's tax-supported debt. Dnipropetrovsk's wealth levels are somewhat above the Ukrainian average, but the city's economy is concentrated on the steel and machine-building industries. After a crisis-driven drop, the city benefited from a rapid recovery of output and investment in 2010-2011. We expect growth to continue, albeit at a slower pace in 2012-2013. Liquidity Dnipropetrovsk's liquidity position is "neutral" according to our criteria. Average cash on accounts will comfortably exceed the expected debt service in the next 12 months, which consists of interest payments on a bank loan and a minor midterm treasury loan. As of July 1, 2012, free cash in the city's accounts stood at Ukrainian hryvnia 144 million ($18 million). However, according to our methodology, we adjust our assessment of the city's liquidity position by its "uncertain" access to external liquidity. This is due to what we regard as the undeveloped domestic capital markets and weak banking systemic in Ukraine (see "Banking Industry Country Risk Assessment: Ukraine", published May 15, 2012, on RatingsDirect on the Global Credit Portal). For operating-cash shortages, Dnipropetrovsk has access to 60-day state treasury loans, as other Ukrainian cities do. Yet Ukraine's treasury might face technical difficulties when under stress, as was the case in early 2010, when it experienced difficulties processing payments. Recovery analysis We rate Dnipropetrovsk's UAH100 million bond due in 2015 at 'B/uaA-'. The recovery rating on this bond is '4', indicating our expectation of "average" (30%-50%) recovery in the event of a payment default. The recovery rating factors in the city's very weak financial flexibility, lack of large assets available for sale, spending pressures, and only average priority of debt service against other expenditures. Very limited support from the sovereign under a systemic default scenario also pressures the recovery rating. The recovery rating is supported by Dnipropetrovsk's only modest debt and debt service over the next few years. Outlook The stable outlook reflects our expectation, according to our base-case scenario, that despite a possible slowdown in economic growth and tax revenues, Dnipropetrovsk's adherence to cautious expenditure policies, coupled with continued central-government support, will likely result in operating surpluses above 5% and only modest deficits after capital accounts over the medium term. It also reflects the city's low tax-supported debt and debt service in 2012-2014. We would likely take negative rating actions on Dnipropetrovsk if operating expenditures, weaker revenues, or the municipal companies' financial positions put additional stress on the city's operating performance, resulting in sustained operating deficits and a weaker liquidity position. The deterioration of the city's liquidity resulting from short-tem debt accumulation could also put pressure on the rating. We could take positive rating actions if the city displayed stronger budgetary performance in line with our up-side scenario, in particular when combined with a clear and structural reduction of the payables of the city's GREs. In the longer run, positive rating actions will likely depend on the city formally adopting debt and liquidity policies, coupled with improvements in Ukraine's institutional framework. Ratings upside would also depend on our rating actions on Ukraine. Related Criteria And Research All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated. -- Methodology For Rating International Local And Regional Governments, Sept. 20, 2010 -- Methodology And Assumptions For Analyzing The Liquidity Of Non-U.S. Local And Regional Governments And Related Entities And For Rating Their Commercial Paper Programs, Sept. 15, 2009 Ratings List Ratings Affirmed City of Dnipropetrovsk Issuer Credit Rating B/Stable/-- Ukraine National Scale Rating uaA- Senior Unsecured B Senior Unsecured uaA- Recovery Rating 4 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.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.