Country Report Ukraine
The political situation in the Ukraine is troubling, since President Viktor Yanukovych has embarked on consolidating his executive power and ruling Ukraine in an authoritarian manner. The government cracks down hard on the opposition and corruption remains widespread and pervasive. The country is running twin deficits: government finances are in bad shape and the current account runs continuous deficits due to high prices for its energy imports. Ukraine urgently needs IMF support to meet external debt repayments in 2013, but negotiations with the IMF have stalled. This has led to a loss of investor confidence, capital flight and downward pressure on the exchange rate. Inflation is expected to pick up in 2013 on the back of rising food prices.
Economic structure and growth
Before its independence in 1991, Ukraine was the most important economic component of the former Soviet Union after Russia, producing about four times the output of the next-ranking republic. Its fertile black soil generated more than one-fourth of Soviet agricultural output, and its farms provided substantial quantities of meat, milk, grain, and vegetables to other republics. Currently, Ukraine remains one of the top ten wheat exporters in the world. The country has a diversified heavy industry, produces unique equipment such as large diameter pipes and vertical drilling apparatus used in other industrial sectors and mining sites. A very important sector is the highly cyclical steel industry, since steel and other non-precious metals are Ukraine’s largest export products. Fuel and energy are Ukraine’s largest import product, since the industrial sector is heavily dependent on imported gas to meet its energy needs.
The country’s economic performance in past years has been very volatile. Ukraine’s economic activity contracted by a whopping 14.8% in 2009, as it was heavily affected by the global financial crisis. Besides the fall in gross fixed investments and private consumption, steel prices fell markedly and external demand for the country’s exports waned. While the economy has rebounded in the following years, it is estimated to have only grown by 0.5% in 2012. The main culprit is again falling external demand for the country’s steel and grain exports but domestic demand also slowed.
For 2013, we expect the economy to pick up by growing by 2%, once the government pushes through reforms after the October 2012 parliamentary elections, since hardly any significant reforms were implemented in 2012 before the elections. A large downside risk to this GDP growth forecast remains the uncertain global economy; the Eurozone peripheral debt crisis in particular.
A plethora of structural reforms are necessary to improve the country’s weak domestic economy. Reforms in the labor market are necessary as the economy is especially hampered by the still-shrinking pool of labor. The country is too dependent on expensive imported Russian gas to meet its energy needs and needs to diversify its energy sources. A comprehensive reform to the business environment would encourage investment and would be likely to lead to higher growth. However, foreign investment is deterred by worrisome politics which delay important economic reforms, low transparency and weak consistency of economic policies and high and widespread corruption. Corruption should be tackled; the country is highly corrupt as reflected by its dismal ranking of 134th out of 178 countries on Transparency International’s Corruption Index. The domestic market would improve significantly if the government speeds up privatization of government-owned enterprises. However, despite the pledges of successive governments to privatize over 3,000 companies, only a fraction have gone through the process. Furthermore, the privatizations that have taken place are characterized by corruption scandals. Improvements to the legislative framework and further development of capital markets should further boost the economy in the longer term. Overall, the country’s dependence on gas imports from Russia, exposure to volatile global commodity prices for its export revenues and weak domestic economy due to a lack of significant reform, have made the economy very vulnerable to external shocks. The banking sector is weak, and banks’ fragile balance sheets make them vulnerable to a renewed economic slowdown. It has a high foreign-currency exposure, since about half of the banking system liabilities and 42% of bank loans are in foreign currency. A positive factor is that non-performing loans appear to have stabilized and banks are gradually repaying loans extended by the National Bank of Ukraine (NBU) during the crisis years of 2008 and 2009.
Political and social situation
President Viktor Yanukovych has embarked on consolidating his executive power and ruling Ukraine in an authoritarian manner, ever since his victory in the February 2010 presidential elections. He implemented a successful reversion to the 1996 version of the constitution which transferred more executive powers from the prime minister to the president. He also installed his loyal right hand man, Mr. Azarov, as the prime minister, despite vigorous opposition protests. In the October 2012 parliamentary elections, his Party of Regions (PoR) was the largest victor but on its own it has been unable to secure a majority of votes in the new parliament. But it can count on the support of both the Communist Party of Ukraine (CPU, which has 32 MPs) and a large majority of the nominally independent MPs, even though they have not formed an official coalition with the CPU. This trend of an increasing authoritarian rule is a troubling development and has resulted in a very low level of economic and press freedom in the country.
In October 2011, the government continued to crack down on the opposition by sentencing Yanukovych's formidable enemy, former prime minister Yulia Tymoshenko, to seven years in prison for abuse of power. Ms. Tymoshenko claims that her imprisonment is part of a vendetta by the president against his political foes, with several other leading opposition figures jailed or fleeing the country since he took power in 2011. Relations between him and Ms. Tymoshenko were already sour long before her imprisonment. He won victory against her in the presidential race, but she was one of the leaders of the "Orange Revolution" that nullified Mr Yanukovych's flawed victory in the election in 2004. During the October 2012 parliamentary elections, she had called the Ukrainians to rise up against the ‘’criminal rule’’ of Yanukovich, which resulted in heavy street protests. We believe that Yanukovich will continue to rule in an authoritarian manner, and as such clashes between him and the opposition are likely to be at the root of the future political instability.
Ukraine’s international relations have deteriorated in the past year. Tymoshenko's imprisonment has blocked the signing of Association Agreement with the EU, which insists that the Ukrainian government abandon the use of selective justice against its political opponents. If Ukraine does not heed the EU’s warnings, it is in serious risk of isolation from the west. The Polish and Lithuanian presidents have already publicly warned Ukraine, and other EU countries have even called for a boycott. The economic repercussion could be substantial, as European countries are a large market for Ukraine’s exports. And one of the key points of President Yanukovych's election campaign was restoring good relations with Russia. However, relations with Russia have been overshadowed by the ongoing difficult talks over the 10-year gas supply contract signed in 2009.
The government finances of Ukraine are in bad shape. Fiscal flexibility is limited; expenditure on wages and social benefits absorbs more than 70% of general government spending. The budget deficit recorded 3.5% of GDP in 2012 and is estimated at 3.3% of GDP in 2013. The government aims to finance the deficit through privatization and further borrowing. However, since privatization efforts are slow and rife with corruption, we do not expect significant proceeds. Further borrowing is also met with difficulties. A rise in the sovereign risk premium has forced a rethink of borrowing plans in the international capital markets, and the government has turned to borrowing on the domestic market. The 2012 budget called for the issue of USD3.5bn in Eurobonds, but this has proved impossible to carry out at affordable rates. Borrowing on the domestic markets has not been an easy alternative as even local-currency bond auctions have on occasion failed. Moreover, domestic borrowing is done at tenors of one to three years, creating a bunching of short-term liabilities. While the level of public debt is moderate at 39% of GDP, 56% of public debt is foreign-currency denominated debt, which exposes the government to exchange rate fluctuations.
To meet its debt obligations in 2013, Ukraine is in need of IMF financing. Without this, external financing becomes unsustainable. The government derailed the IMF program by refusing to raise gas prices charged to households, as agreed earlier with the IMF. But after the legislative elections at the end of October 2012, it is likely that the government will move on gas tariffs and unlock IMF financing. Ukraine needs to access IMF financing by early 2013 to refinance heavy repayments to the Fund in 2013 (USD5.7bn shared between the government and the central bank (NBU)) and 2014 (USD3.6bn). To access enough resources to refinance maturities on this scale, the government will need to fulfill IMF conditions for a lengthy period. However, given Ukraine’s past performance under IMF programs, there is a risk that the program might derail again later on.
To counter the downward pressures on the hryvnia (UAH), which has a fixed peg with the USD at UAH/USD 8:1, the government has developed several currency controls. In late November it was introduced that export firms have to sell one-half of their foreign-currency earnings to the authorities. The NBU has said that this will remain in place for six months. Another, more controversial measure, which is currently withdrawn from parliament for further consideration, is a proposed 15% tax on conversion of UAH into foreign currency, to come into force in early 2013. This is an attempt both to deter Ukrainians from buying foreign exchange and to encourage them to convert their foreign-exchange holdings into local denominations to avoid incurring the tax. The downward pressure on the UAH could result in a devaluation and an end to the fixed peg. If the government reaches and agreement on an IMF loan early 2013, this will alleviate external liquidity pressure and could boost investor confidence. If not, capital flight and downward pressure on the UAH are expected to continue.
Inflation is expected to reaccelerate as food costs are growing again as recent consumer spending exceeds domestic supply considerably. To secure the domestic food supply and stem rising domestic prices, the government banned wheat exports in October 2012. The monetary policy of the NBU is weak, as it has not been able to control the very volatile inflation in the country.
Inflation is expected to average 7.9% in 2013, markedly higher than the 0.8% estimated for 2012.
Balance of payments
The current account is in continuous deficit on the back of costly energy imports. The current account deficit was 7.9% of GDP in 2012 and is forecast to decrease only marginally to 7.3% of GP in 2013. The trade balance is the main drag, recording an 11.1% of GDP deficit in 2012. Expensive gas imports from Russia account for 17% of the import bill, and fluctuations in gas prices and volumes are a major determinant of the trade deficit. World market prices for steel and wheat, Ukraine’s main export products, further determine the trade balance. The services and transfer balances are stable contributors, recording surpluses of around 2-3% of GDP in recent years. The income balance structurally posts a slight deficit of 1-2% of GDP.
Ukraine’s balance of payments position will remain very vulnerable through its weak capital account. Heavy foreign borrowing by the private sector in the pre-crisis years and, to a lesser extent, government borrowing during the crisis, has resulted in large principal repayments in the coming years. As net investment inflows via the financial account are insufficient to cover the current account deficit, IMF financing is necessary, as mentioned before to avert a balance of payments crisis.
The economy’s overall net external creditor position is a relative strength, although it relies on private sector external assets. Foreign debt is high at 77% of GDP at end-2012. More worrisome is the country’s external liquidity. The FX-reserves cover imports by only 3 months, which is dismal. FX-reserves only cover debt service by 61% and the liquidity ratio stands at 81, which is very low.
Figure 7: Liquidity indicators