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Ukraine's economy: In A Tailspin

Pressure are building for the IMF to deal with the country’s finances

August 23, 2014

 

Ukraine is currently going through the most challenging phase in its post-independence history, gripped by a combination of unprecedented political unrest, foreign intervention and deepening recession. In the short term, these developments will damage the macroeconomic environment and market opportunities

 

Overview

Sovereign risk

Ukraine's sovereign risk rating was cut to CC in March because of Russia's annexation of Crimea. Payments capacity is weak, given low levels of reserves and a lack of access to global capital markets. Despite securing a large IMF loan in April, thereby unlocking substantial EU lending, efforts to stabilise the public finances will be hampered by the ongoing separatist conflict.

 

Currency risk

By April the hryvnya had plunged by close to 40% against the US currency since the fixed peg was abandoned in February. After interest rates were raised steeply in response, the hryvnya regained some ground, but the currency fell again in late July. The prospect of another big devaluation remains a risk.

 

Banking sector risk

The effect of the political and economic crisis has started to show on the banking sector, which returned to loss in early 2014 and saw a large outflow of deposits. Capital adequacy in the system is worsening.

 

Political risk

Russia responded to a popular revolt in Ukraine by annexing Crimea and encouraging unrest. The conflict in eastern Ukraine has reached a dangerous peak. The Economist Intelligence Unit thinks that Russia aims to keep a degree of parity between Ukrainian forces and the separatists until Russia's key demands are met, and that Russia is only likely to consider an overt invasion of eastern regions if it appears that the separatists are heading for military defeat.

 

Economic structure risk

Ukraine is reliant on steel exports and is vulnerable to price shocks, owing to Russia’s control of gas supplies and one-quarter of its exports. Russia's promise of a gas price cut in mid-December 2013 has been withdrawn, as has the discount for allowing Russia's fleet to remain in Crimea.

 

Analysis

 

  • Both the IMF and Ukraine’s Western backers have two options to deal with the Ukraine’s economy that is in tatters: the first, best option is to step in with more loans to help the government staunch its fiscal deficit. The second, worst option is premised on the assumption that the $17bn IMF could fall apart, possibly forcing the country to default and restructure its debts. That would further deepen the economic turmoil in Ukraine and stain the reputation and credibility of the fund in the wake of its problematic Greek programme. In other words, if the conflict lingers for another several months in its current form the cost for the Ukrainian economy would be huge.

 

  • The IMF’s bailout was based on the initial assumption that Ukraine’s economy would shrink 5 percent this year before bouncing back in 2015. Given the predictability of a manageable, projected rise of the Kiev government’s debt to GDP ratio-a popular if imperfect gauge of sustainability- the IMF rightly decided not to require Ukraine to restructure its debts.

 

  • It is worth noting that this assessment regarding the sustainability of The Kiev government’s debt was made shortly after Russia annexed Crimea and just as separatists were seizing control in eastern Ukraine. Officials from the IMF who made this assessment did not therefore fully factor in the economic damage that was to follow, making their report looking more like a work of fiction than fact.

 

  • According to the estimates of some prominent local brokerage consultancy like Dragon Capital, the loss of Crimea alone would cut Ukraine’s GDP by 3.7 per cent. The eastern industrial base of the restive provinces of Donestk and Lugansk accounted for about 16 per cent of GDP, and a quarter of exports and industrial goods and services.

 

  • The latest data from the IMF indicate that the Ukrainian economy contracted almost 5 per cent year-on-year by the middle of the year. The final toll is impossible to gauge, not least because half of the economy remain in the shadow. Agriculture, previously a pivotal engine of growth, is not expected to compensate for the struggling eastern steel and machinery sectors as it has in recent years.

 

  • Even with the optimistic IMF adjustment for a more realistic 6.5 percent shrinkage for 2014, some analysts are predicting that the Ukraine’s economy will contract by at least 8 per cent. To add to the worries, the Ukrainian currency is endangering the banking sector. Any further weakening of the hyrvnia will strain bank balance sheets which would in turn require a bailout of at least 5 percent of GDP.

 

  • The cumulative effects of the crisis could shred Ukraine’s finances: debt –to-GDP is rising towards 87 per cent by 2018. That is more than twice the level of earlier this year, exposing the flaw in the IMF’s argument that it is highly confident Ukraine’s debts are sustainable-a requirement for disbursement.

 

  • Other complications are looming. Ukraine owe a $3bn bond to Russia. This loan which Russia structured as a normal Eurobond with a significant tweak was part of a support package for the previous pro-Moscow government of Viktor Yanukovich. If Ukraine’s debt –to-GDP goes above 60 per cent, as is now inevitable, Moscow can demand immediate repayment. Because of cross-defualt provisions, Kiev cannot renege on this bond in isolation, handing Mr Putin a potent economic weapon against the country.

 

  • The political imbroglio that is unfolding within the Ukrainian political establishment is making the task of implementing the austerity and governance measures much more difficult. This will in turn put the economic reforms required by the IMF for aid disbursement at risk. Relative to previous programmes the government’s performance has been stellar, but the pace and extent of reforms remain disappointing. The war is rendering the situation so dramatic to the point where a default is possibly imminent. Such a default could take the form of a precautionary default in which debt falling due over the next three years is forcibly rolled over. If there is a full blown Russian invasion then deeper haircuts may be requitred.

 

  • In all cases, the mainstream view of most economists is of an unbiased assessment of the macroeconomic outlook based on the current information. With the view that downside risks related to the conflict orevail in the current conflict and that difficult times call for different measures, the Ukrainian government remain committed to reforms.

 

The Bottom Line

Ukraine is at the less risky end of the CC band. A downgrade to C would require a large deterioration in the score. Possible causes of this would be a descent into armed conflict with Russia or the secession of other Ukrainian regions to Russia. Failure by the government to secure an IMF loan programme or to adhere to the conditionality of such a programme would also result in a worsening of the score. The rating outlook will improve once the government demonstrates implementation of reforms. An improvement in relations with Russia would also support the rating, although this seems unlikely in the short term. Given the poor outlook for the economy, even under the most benign scenario, cyclical indicators are unlikely to improve in the coming months.

 

Emerging Europe Charts

  

 

Important Disclosures 
SGE’s research and reports are not meant to provide individually tailored investment advice. They have been prepared without regard to the circumstances and objectives of those who receive it.