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Country Report Ukraine

Country Report


Flag Ukraine

Ukraine’s economy shrank considerably in 2014, triggered by the conflict in eastern Ukraine and thereby also manifesting economic mismanagement of the past years. The country’s outlook remains highly uncertain as the government hasn’t managed to set the economy on the right course yet. And while the resolution of the conflict is of importance for the economic recovery, the progress clearly depends on the effectiveness of the proposed government reforms, availability of external (financial) assistance and success of the debt restructuring initiatives. 

Strengths (+) and weaknesses (-)

(+) Strong agricultural sector

Ukraine has high agricultural potential as it has one of the most fertile soils in the world.

(-) Weak government finances

Government finances are in bad shape, as fiscal policy is weak and the budget balance continuously records deficits. In addition, government debt crossed the critical level of 70% of GDP by the end of 2014, currently exceeding 90%.

(-) Weak external position

The external position is structurally weak, as Ukraine continuously posts current account deficits, while their level of FX-reserves is at a very low level, with import cover being at the critical level of 6 weeks since the end of 2014.

(-) Embedded corruption and weak rule of law

Corruption within the government and business elite is widespread and pervasive. In 2014 Transparency International ranked Ukraine 142nd out of 175 countries, according to its Corruption Perception Index.

Key developments

1. Ongoing armed conflict and pro-western political stance

The conflict in eastern Ukraine that started March 2014 was the outburst of existing political tensions in the region and economic problems in Ukraine. In the past decade Ukraine’s budget balance had consistently been in deficit and on top of that, the country’s level of foreign reserves had been low and declining. As dealing with these problems through fundamental reforms wasn’t feasible due to weak institutional and legal systems, former President Yanukovych started to look for external assistance, both in the West and in Russia, which turned out to be a dangerous play. In November 2013, Yanukovych suspended the preparations for signing the Association Agreement between EU and Ukraine, after being put under Kremlin’s pressure, and opted for a tripartite agreement between EU, Ukraine and Russia that was deemed unacceptable by the EU authorities. Meanwhile, considerable protests had started in Kiev demanding an EU integration, soon to become anti-government protests resulting in resignation of the government and ousting of president Yanukovych who had fled the country in February 2014.

The appointment of Oleksandr Turchynov as interim-president and the pro-European stance of the government triggered pro-Russian demonstrations in Crimea. After a referendum in March, Crimea was incorporated into Russia. In the months thereafter a conflict erupted in the east of Ukraine, as pro-Russian separatists started to fight for independence in the Donetsk and Luhansk regions, where the largest share of the country’s industrial sector is concentrated. Therefore it has seriously undermined the government’s tax base and exports revenues, as the economic activity has been completely disrupted.

It seems plausible that Russia meddles in the conflict, as it wants Ukraine to remain within its sphere of geopolitical influence and prevent it from closer cooperation with the EU and NATO, especially given that it would probably have to give up its naval base in Sebastopol (Russia doesn’t have its own aces to the sea in the region).

The new Ukrainian government, fully supported by parliament, has shown a firm pro-western stance clearly manifested by the progress achieved in the talks regarding the IMF loan programme and the Association Agreement with the EU. Since Ukraine is not likely to change its political course, and Russia is not likely to allow Ukraine to build a relationship with the EU and NATO, a solution for the conflict will be very difficult to find inevitably leading to a frozen conflict at best. This is also illustrated by the fact that the Minsk II Protocol (a cease-fire agreement) signed in February 2015 left room for discussion regarding the status of the territories involved in the conflict, impeding a resolution of the conflict. In the meantime, the death toll passed 6,300 people (May 2015) according to the UN.

2. Progress in the integration with EU and IMF imposed reforms

Current President Petro Poroshenko, elected on 25 May 2014, eventually signed an Association Agreement with the European Union (aimed at convergence of the Ukrainian regulatory regime, including a free trade agreement and potential visa free regime) that was ratified in September 2014 and will enter into force on the 1st of January 2016. It’s worth noting that Russia still demands its postponement with one more year as the new arrangement would sabotage Russia’s existing tariff regime by letting Ukraine re-export European imports without any duties being paid on both sides. However, Europe stands firm on the agreed deadline.

Considerable progress has been made also in the negotiations with the IMF as a revised support programme has been announced in April 2015. Since the announcement of the previous programme in March 2014, the following reforms (as conditioned by IMF) have taken place or are in the process of implementation:

  • Liberalization of the energy sector and cancellation of gas subsidies: gas sector reform approved by the parliament, resulting in a 30% price increase for the industrial consumers (per 1st of April 2015) and 50% increase for the households (per 1st of May 2015)
  • Amendment of Ukraine’s constitution to allow for decentralization of power (this doesn’t imply federalization, but a delegation of power to the regions)
  • Establishment of the Anti-corruption bureau (results are yet to be seen, but looking at the authority granted to it, it is definitely a step in the right direction)
  • Programme for the privatization of state enterprises (it is planned to start the roll out later in 2015).

3. Heavy contraction of the economy

The east of Ukraine accounts for a large share of industrial output and is also important for Ukraine’s export revenue. Due to the conflict, production in the region has fallen considerably, which is a significant drag on Ukraine’s economic performance (figure 2). The current estimates for 2015 point at an economic contraction in the range of 5.5%-7.5%, on the back of the realized 6.8% decline in 2014. The slowdown of production has also led to a decline in tax revenues, while government spending (i.e. military expense) has increased as a result of the conflict. This has put Ukraine’s fiscal balance further under pressure as the Ukraine’s budget deficit in January-February 2015 increased by 170% compared to the same period in 2014. At this point in time there are no suggestions that the situation would significantly improve in 2015 as the conflict most probably will have an ongoing frozen character, meaning that the production will remain at suboptimal levels and military spending will be kept at the current budgeted level of 5% of annual GDP. Ukraine public debt as percentage of GDP has also risen sharply passing the critical threshold of 70% in December 2014 (currently in excess of 90%). After having a fixed exchange rate policy, the National Bank of Ukraine had no choice but to float the Hryvnia freely in February 2014, as it was running out of foreign exchange reserves (figure 1). In the months thereafter, the Hryvnia depreciated considerably, driving up the prices of vital energy imports as well as making foreign currency denominated public debt more expensive to service. In spring 2015 the hryvnia stabilized at slightly above 20 UAH/USD, and the government has lowered mandatory sale of foreign currency proceeds from 100% to 75%, which is still a rather tight currency control.

Figure 1: FX-reserves
Figure 1: FX-reservesSource: National Bank of Ukraine
Figure 2: Production volumes
Figure 2: Production volumesSource: State Statistics Service of Ukraine

4. Debt pressure and funding need

Ukraine, once virtually debt free (in 1991 Russian took on all the Soviet debt), now has sovereign debt levels of more than 90% of GDP, which is unsustainable for its economy. Back in April 2014 the International Monetary Fund agreed to provide Ukraine with a USD 17bn bailout package. Dependent on the IMF loan was an additional USD 10bn package from other entities, including the World Bank, EU, US and Japan. The first IMF tranche of USD 3.2bn was transferred in April 2014, a second tranche of 1.4bn in September 2014. After approving the 2015 budget it became clear that additional funding would be needed to avoid default in 2015. Moreover, there is still the risk that Russia would demand early repayment of a USD 3bn loan to Ukraine (due in December 2015), as Kiev has violated the Debt/GDP covenant set at 60%.

The latest financing gap has been estimated at USD 40bn. After lengthy negotiations an agreement on a new IMF arrangement has been reached in February 2015, implying a USD 17.5bn of new IMF loans to be provided between 2015 and 2018 with an immediate disbursement of USD 5bn on the following conditions:

  • Generate USD 15.3bn savings in public sector financing during the IMF program period (from external debt payments on the sovereign, sovereign-guaranteed and state-owned entities);
  • Bring the public and publicly guaranteed debt-to-GDP ratio under 71% of GDP by 2020;
  • Keep the budget’s gross financing needs (incl. debt amortization) at an average of 10% of GDP in 2019–2025 (maximum of 12% of GDP in any given year).

IMF will conduct its periodic review in May/June 2015 in order to decide about the June tranche. However, achieving the reforms/savings needed to secure the pay outs of the IMF tranches can be challenging, due to the following:

  • In order to tackle corruption, a mindset shift is required, which is difficult to achieve on a such a short term;
  • The Ukrainian shadow economy constitutes nearly 50% of the country’s GDP, where many businesses choose not to pay taxes, eroding the government tax base. Meanwhile an increased tax burden might create a further incentive to avoid taxes;
  • With an average pension of around USD 60 (after recent devaluation) and nearly a quarter of its population living in extreme poverty (according to UNDP), coupled with very limited social guarantees, Ukraine is facing a very unpopular move among the people whose resources are already stretched;
  • The timing of the recently initiated privatization is rather unfortunate, as investor confidence is at an all-time low, therefore privatization gains are expected to be less than initially envisaged. This has been illustrated by the delay in the privatization programme which has been shifted to 2015.

As set out by the IMF, Ukraine would also be required to tap into other international funding sources, as well as restructure its debt in order to meet its estimated financing needs. Thereby the terms & conditions with its existing creditors will need to be renegotiated, and Ukraine will have to ask not only for an extension, but also raise a painful topic of reduction of the interest rate and the notional. In the current stage of negotiations creditors would potentially agree on the tenor extension and interest reduction, however investors still object on a reduction in the face value of the bonds. In response to that, on the 20th of May 2015 the Ukrainian parliament has given powers to the government to suspend foreign debt payments (debt of the state owned enterprises won’t be subject to the moratorium). Looking at the development of the events, Ukraine could become a second Greece, where debt restructuring would be accompanied by tough negotiations, although at the last moment just enough money would be transfered. And it looks like western creditors have nowhere to turn, as letting Ukraine default would mean completely discrediting the existing pro-western government and pushing Ukraine back into the zone of the Russian influence.

Factsheet of Ukraine
Factsheet of UkraineSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

Before its independence in 1991, Ukraine was the second-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 total Soviet agricultural output, and its farms provided substantial quantities of meat, milk, grain, and vegetables to other republics. Since the collapse of the Soviet Union, Ukraine’s GDP per capita plummeted, and even despite the recovery in 2000’s it still represents a mere 1/3 of Poland’s GDP per capita, whereas in 1990 these were at par. Nevertheless, Ukraine while between 659.000 and 921.000 people have been internally displaced and more than 300.000 people have asked for international protection in other countries still remains one of the top ten wheat exporters in the world. Ukraine also has a strong industrial base, which is mainly located in the east of the country. The highly cyclical steel industry is very important for Ukraine, since steel and other non-precious metals are Ukraine’s largest export product. Since the industrial sector is heavily dependent on imported fuel, oil & gas are Ukraine’s largest import products. The industrial sector has been suffering significantly from the conflict in eastern Ukraine (started in March 2014) where pro-Russian separatists are fighting for independence. Whereby the human impact has been also considerable: more than 6,300 people have already been killed in the conflict, while roughly 1.3m have been internally displaced and more than 600,000 people have asked for asylum in other countries. Structural reforms are needed to improve the economy including fighting embedded corruption, developing capital markets, improving the legislative and institutional framework. Finally, Ukraine has various oligarchical political and business elites that are in fierce competition for the country’s leadership, which from time to time results in political turmoil.

Economic indicators of Ukraine
Economic indicators of UkraineSource: EIU
Ksenija Vojevoda
RaboResearch Global Economics & Markets Rabobank KEO
+31 88 726 7864

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