UKRAINE: TRIP TO KYIV NOTES
Economic Policy Outlook, IMF, Default Risk, Banking Stability, Growth, Inflation

ANALYSIS & COMMENTARY: by Timothy Ash, RBS GBM 
Royal Bank of Scotland (RBS), London, UK, Wed, Mar 3, 2010 

LONDON - We visited Kiev on March 1-3, meeting with officials from the MOF [Ministry of Finance], the NBU [National Bank of Ukraine], IFIs [International Financial Institutions] along with local banks, diplomats, journalists and local political analysts/pundits.
 
SUMMARY VIEW 
We retain our constructive view on Ukraine, which partly reflects the fact that after a disastrous year in 2009 on the political/economy front, from a very low base 2010 has to get better. More importantly, the presidential elections seem to have cleared the air on the political front, and we expect a new pro-presidential majority to be formed over the next month.

With the presidency, government and parliament controlled by the same coalition the policy outlook should improve. We expect the new government to quickly move to get the IMF programme back on track; indeed we may well see a new/revamped programme. We would expect the new government to bite the bullet on difficult reform issues (e.g. gas pricing/reigning in budget spending) early in its term.

The new administration should also be helped by a more supportive economic backdrop, with the low base expected to generate some growth momentum in 2010 (real GDP could grow by ~ 5%), and a much improved balance of payments position; the current account deficit is small and fully covered via net FDI inflows, while debt amortisations have been significantly "rolled".

Under this scenario the UAH should remain stable, enabling the NBU to replenish FX reserves and budget financing should be helped by strong foreign interest in the high carry on local debt (20%+).

Assuming the government gets the IMF programme back on track quickly, we should see Ukraine tap international capital markets in mid year. The debt service schedule is light, and we think concerns over public sector debt sustainability in 2010 at least are overblown; the risk of a sovereign default seems limited in reality.
 
DOMESTIC POLITICAL OUTLOOK

Presidential elections appear to have clarified the outlook on the domestic political front. Viktor Yanukovychs victory in the February poll was sufficiently robust as to begin to crystalise parliamentary backing for a new ruling coalition formed around Yanukovychs Regions of Ukraine (RU). Already the Litvin Block has withdrawn its support from the coalition with the Block Yulia Tymoshenko BYut), the incumbent administration lost a confidence vote on March
3.

The assumption is that RU would only have scheduled the confidence motion if they were sure of securing a majority to defeat Tymoshenko and indeed go on to form a majority coalition; under the current constitution if a government survives a confidence motion it cannot be removed for a further 6 months, which would have allowed the Tymoshenko administration to limp on to September.
 
It is assumed that RU (172-Mps) has secured a majority of deputies in Our Ukraine  Peoples Self Defence (70-odd deputies) and with 20-odd deputies from the Litvin Block it should be able to form a ruling coalition.

Under the terms of the current constitution, once a ruling coalition is voted out of office, a new governing coalition should be formed in parliament within 30 days otherwise the President can call early parliamentary elections. Once a majority coalition
in parliament is formed, the majority then has 30 days to form a government and receive majority backing via a second vote in parliament.
 
The fact that Tymoshenko has chosen to resign with immediate effect as prime minister, preferring not to follow convention and serve in an acting capacity until the new governing coalition is formed will likely drive the process of coalition-building forward.
 
We think the chance of early parliamentary elections has receded. During campaigning in the presidential election Yanukovych did threaten to call mid-term elections, albeit this was perhaps more aimed at disciplining deputies in parliament (OU-PSD, the Litvin Block and the Communists might all see their share of seats diminish in mid-term elections).

This was also perhaps aimed at extending an olive branch to supporters of the third ranked runner in the presidential election, Serhiy Tyhipko, in order to secure his backing in the second round poll. Given that Yanukovych secured victory without the support of Tyhipko it does not now seem logical for RU going to early parliamentary elections, especially given that Tyhipkos natural constituency is close to that of RU.

Early parliamentary elections might also risk the return of former President Yushchenko to parliament. We doubt that RU would seriously want to give a new platform to the outgoing president; indeed Yushchenko remains anathema to Moscow, and with Yanukovych currently appearing eager to rebuild bridges, and importantly a new gas consortium with Moscow, we doubt that this would be much appreciated.
 
Key to forming a new ruling coalition will be allocation of ministerial portfolios and political patronage more generally. Herein the problem is that both OU-PSD and RU are broad coalitions, and hence there are numerous individuals to please. The most pressing problem will be the choice of prime minister. Various names have been mentioned in dispatches, but amongst these are:
 
[1] ARSENYI YATSENIUK: Ran as president but ended up a disappointing fourth place in the first round vote. He is an articulate, English speaking economist, and is young (late 30s). His CV is impressive having served as deputy governor of the NBU, minister of economy, foreign minster and speaker of parliament.  Formerly he was close to President Yushchenko, but subsequently distanced himself from his former boss.

He has fought off allegations that his election campaign was funded by oligarchs such as Pinchuk and Firtash. He is perhaps still too closely associated with Yuschenko for the liking of many within Regions. However, his oligarchic backing, and the assumption that politically he has proven less of a threat at the ballot box could ultimately see him winning the day.
 
[2] SERHIY TYHIPKO: From nowhere in the polls just months earlier, he secured third place in the first round of the presidential election in February, with a respectable 13%.. Tyhipko would be reviewed as a reform candidate as prime minister, given his support base amongst the urban middle class, and particularly in Eastern Ukraine. He has close ties with Regions, serving as President Yanukovychs campaign manager in the 2004 presidential election.

He did though move closer to Tymoshenko over the past year, so is now more independent in outlook. Tyhipko might be too independent for Yanukovych and his oligarchic supporters in RU. Arguably Tyhipko over played his hand after the first round presidential vote, by failing to back Yanukovych in the second round vote.

Also Tyhipko might be seen as something of a threat to elements within RU, and in particularly to RU in any mid-term parliamentary elections as his support base is significantly centred on the RU heartland in Eastern Ukraine. One option for Yanukovych would be to nominate Tyhipko as governor of the NBU, given that the incumbent, Stelmakh is due to retire.

However, if Regions wanted to present the new government as a reform administration, and perhaps wanted a "fall-guy" for potentially unpopular austerity measures which would likely come with getting the IMF agreement back on track, Tyhipkos face might just fit.
 
[3] YURI YEKHANUROV: is seen as the compromise candidate, given he previously served as a technocrat PM under Yushchenko, and is not thought to be a particular political threat to the main players. If all else fails, and if there is a serious threat of early parliamentary elections, Yekhanurov might be acceptable to all; or at least have fewest enemies.
 
[4] VICTOR YUSHCHENKO: Victor Yushchenkos name has been mentioned again  by RU spokesperson German most recently  as another potential candidate as prime minister. We would though be amazed if Yushchenko resurfaced as prime minister, given his strained relations with Moscow.

Moscow already appears to have been irritated by President Yanukovychs decision to head off to Brussels for his first foreign policy trip, and not Moscow; President Medvedev failed to attend Yanukvychs inauguration which was seen as something of a snub to the new presidency in Ukraine.

Yushchenkos appointment as prime minister would clearly appease Our Ukraine deputies, but would likely be highly destabilising for Ukraine and its international relations more generally. Similarly with so many difficult decisions to be made, arguably Ukraine needs a reformer and capable and hands on manager/administrator in the position of prime minister. The danger is that Yushchenko would be too "presidential", "hands-off" and indeed "political" in
any such role.
 
[5] MYKOLA AZAROV, the former finance minister has been touted as another possible contender as prime minister. However, Azarov would likely fail to secure backing of Our Ukraine, especially given his lack of Ukrainian language skills. Azarov is most likely to re-emerge as minister of finance; in his previous stints first as head of the tax inspectorate and finance minister he proved adept at bolstering the revenue side of the budget, which is clearly a huge priority at present.
 
Net-net our best guess is that either Yatseniuk or Tyhipko will be appointed as prime minister, and either candidate would be seen as "market-friendly".

Arguably Tyhipkos appointment would perhaps offer the best chance of more radical reform, albeit as noted above, this could expose tensions within RU and with/within OU.
 
RELATIONS WITH RUSSIA 

Moscow learned much from the mistakes it made during the 2004 presidential election whereupon it put all its eggs in one basket (backing Yanukovych) while its perceived interference in the political process more generally proved counter-productive with the Ukrainian electorate, and was one factor in driving forward the Orange Revolution. This time around it has cultivated relations both with the Yanukovych and Tymoshenko camps.
 
Yanukovych has traditionally been seen as the pro-Russian candidate, albeit this black and white interpretation misses important nuances. Yanukovych and Regions have their support base amongst ethnic Russian in Eastern Ukraine, and have played up their "better" ties with Moscow. However, this outward appearance of being pro-Russian masks a real desire for Ukrainian business interests not to be overwhelmed by Russian business and state interests.

Regions and its supporters like Ukraines independence from Moscow, but are eager to extract any geopolitical capital from this "ethnic connection" with Moscow. For its part Moscow is distrustful of Regions, given what its sees as its failure to deliver across a broad range of policy priorities in the past.
 
During the election campaign Regions promised increased language rights for ethnic-Russians, promised to join the Customs Union with Russia, Belarus and Kazakhstan and also promised to renegotiate in Ukraines favour the existing gas supply contract with Moscow. Delivering on this agenda is going to prove difficult in practice.
 
More generally we expect Russia to demand improved access to the Ukrainian market, particularly for Russian capital. Regions did promise in the run up to the elections to sign up to the Customs Union with Russia, Kazakhstan and Belarus. However, this seems incompatible at present with commitments under its WTO membership and also made to the EU in terms of the Free Trade Agreement currently being negotiated.

In recent weeks Regions politicians have begun to downplay the importance of the Customs Union with Russia, and we expect Ukraine to "play hard to get" in this respect. Ukraine is still likely to try to play Russia off against the EU, to extract maximum concessions from both sides: "milking both cows", an expression we heard frequently in Kiev this time around. The question is whether Moscow is willing to play tough with the new administration in Kiev to finally secure delivery on its agenda.
 
THE GAS SUPPLY CONUNDRUM 

It is unclear how the new administration will go about re-negotiating the exiting gas supply agreement with Moscow, given that Russia has suggested it is happy with the exiting contract negotiated in January 2009. Under the current 10 year agreement Ukraine pays market prices for gas, with payment made a week after the delivery.

It is a take or pay agreement, with Ukraine contracted to buy around 42 billion cu metres of gas annually. In 2009 Ukraine imported only around 33 billion cu metres of gas from Russia, and Moscow appeared flexible in  not holding Ukraine to the original contract, which could have forced Ukraine to pay for an additional 9 billion cu metres of gas (cost of ~ US$2.5bn).

Ukraine is paid transit fees by Moscow for the ~ 100bn cu metres of gas transported across Ukraine to market in Europe, at a rate of US$2.7 per 1,000 cu metres over 100km. Arguably this is low by international standards, and for 2010 gas import prices are expected to rise to around US$335 per 1,000 cu metres for Ukraine from around US$210 in 2009.
 
The balance of power in the global gas supply business has, however, changed over the past year, with demand in Europe lower given the weak growth environment, plus the emergence of rival suppliers, e.g. LNG, and recent developments with gas shale technology. Given Russias own domestic economic problems its interest now seems to be in ensuring supplies of gas to key markets in Europe, and ensuring timely payment from Ukraine.

The gas price agreement reached with the Tymoshenko administration in January 2009 has generally worked well, with Ukraine remaining current on monthly payments for gas to Russia.

It is unclear why Russia would want to change the current arrangement. Perhaps the only "enticement" for Russia would be some greater control over gas transit assets in Ukraine, and herein the Yanukovych administration has suggested a new gas supply consortium, albeit a re-vamped version of the Ros-Ukr-Energo (RUE) set-up could hardly be deemed to be a step forward.

Meanwhile, any attempt to give Russia more control over the domestic gas transit network in Ukraine could create problems within the ruling coalition, particularly with Our Ukraine which is more nationalist in vent.
 
One of the most pressing issues for the incoming government will be domestic gas pricing. The basic problem for Ukraine is that it imports gas at the border with Russia at US$335 per 1,000 cu metres, and sells it domestically to households/utilities at a price close to US$110 per 1,000 cu metres. This results in a substantial loss to the state gas supply/transit company, Naftogaz, which currently runs at the equivalent of around 2.5% of GDP.

Given that this has been covered via a combination of subsidies from the state budget and loans from state-owned banks (essentially duty losses), this enlarges the quasi-fiscal deficit; the problem is set to become more onerous in 2010 given the move to import gas at market prices.
 
The outgoing administration had promised, as per the IMF programme, a series of gas price rises in 2009 (September and October) but these were not implemented due to the close proximity of presidential elections; the government actually attempted to implement some hikes but these were stalled by trade unions in the courts. The issue of domestic gas pricing is indeed highly politicised, with all factions tending to use this as a political tool.

Most neutral observers though accept that there is little alternative to domestic gas price liberalisation (both for fiscal sustainability but also from an energy efficiency perspective), and that the social impact can be contained via careful targeting of subsidies to the poor.
 
It is still unclear whether the IMF would force the issue of domestic gas price hikes, given their relative flexibility in 2009. The Fund seems eager to stress that this is ultimately a decision for policy makers in Ukraine, i.e. if they want to maintain low domestic gas prices, then savings will need to be made elsewhere in the budget so as to ensure budget sustainability.

It would make sense in our minds for the incoming government to implement hikes in domestic gas prices early in its terms, when it still has some considerable political capital to expend, albeit thus far various Regions officials have suggested that they will hold to election promises to hold down domestic gas prices for the population.

The governments flexibility to hold gas prices lower would obviously be improved if it was able to secure preferential pricing from Moscow, albeit it is unclear (as noted above) what it could offer in exchange for Moscow.
 
One potential problem looming on the energy front is the legal action on-going  by RosUkrEnergo against Naftogaz and the government over 11 billion cu metres of gas which was in storage at the time that the then Tymoshenko administration transferred gas supply rights from RUE back to Naftogaz. A ruling by courts in Stockholm is expected over the next few months.

If the ruling comes down against Naftogaz and the government this would leave both facing a significant need for cash to cover the likely compensation claim, i.e. several billion US dollars.
 
ECONOMIC POLICY OUTLOOK 

Clearly the most pressing issue for the incoming government will be reigning-in the bloated fiscal deficit. For 2009 the budget deficit is thought to have come in at 6-6.5% of GDP for the state budget, with an additional 2.5% of GDP deficit run up by Naftogaz, and perhaps another 2.5% of GDP via the recapitalisation of banks, suggesting a deficit of 11-12% of GDP.

Arguably given the collapse in real GDP in 2009 (minus 15%), this out-turn was not that bad, especially considering similar deficits were run by the UK/US which suffered a much more sedate rate of real GDP decline.

The challenges facing the incoming administration are accentuated by a number of additional factors: first, the outgoing government built up significant arrears on VAT refunds (UAH23bn), while parliament also voted budget-busting hikes in wages and pensions (+20%) late last year, which could boost the budget deficit by anywhere between 2% and 7% of GDP depending on how the government implements these scheduled increases.

Working in the governments favour is the expectation that real GDP growth could "bounce" back in 2010 given the very lose base period of comparison, while inflation is still in double digits which could both work to boost revenues. And already in January there seems to have been something of a pick up in the revenue side of the budget  helped by a +7% real GDP increase in that month albeit whether this better performance will sustain is open to question.
 
In recent weeks some Regions politicians have indicated that they will honour the wage/pension hikes agreed late last year, alongside other populist promises made in the budget.

However, once a new ruling coalition is formed, and a new government is in place, and importantly the risk of early parliamentary elections recedes, we expect the new government to begin to impose fiscal austerity, sufficient to enable the resumption of IMF lending.
 
Perhaps significant with respect to the above were comments made by Irina Akhimova, the newly appointed deputy head of the presidential administration and President Yanukovychs chief economic adviser. Akhimova warned this week that Ukraine faced a technical default on its domestic debt liabilities.

Akhimova is a respected economist, and is expected to have a leading role in the new administrations economy team. We do not think that Akhimova seriously thinks that a domestic debt default is imminent, but we think her comments were meant to send a warning to the population that public finances are in a state of crisis and that unless action is taken, imposing an austerity programme, the currently theoretical risk of a default by the sovereign could become a practical reality.
 
We think that Akhimova, and indeed Mykola Azarov, who we expect to return as finance minister, are understanding of the challenges on the fiscal front and will act early in the new governments term to implement austerity measures to bring the budget more in line with IMF targets.
 
RELATIONS WITH THE IMF

Indeed, all sides seem to realise the importance of getting the IMF programme back on track. Assuming a new coalition and government is put in place by the end of March, it is possible to see an IMF team return to Kiev in early April, and this could open the way for the resumption of IMF lending as early as May.

The new government may well want to shape the resumption of lending into a new programme, possibly a 2-year agreement, perhaps with additional funding. This would obviously allow them to take better "ownership" of the programme which might improve implementation.
 
The Fund continue to signal their intention to remain engaged with Ukraine albeit noting the conditionality attached to the current programme, particularly the need to agree a sustainable budget for 2010. At present the budget for 2010 has yet to be agreed; previously the IMF targeted a deficit of around 4% of GDP for 2010. Pre/post election pledges suggest a deficit of nearer to 10% of GDP.

This does suggest a very significant fiscal adjustment will be required to manage the deficit down and ensure adequate financing. The Fund seem more flexible on the issue of gas pricing, albeit noting that if the government opts not to hike domestic gas prices other means have to be identified to cover the shortfall in the budget of Naftogaz which ultimately is covered by the central government via subsidies.
 
There does not appear to be many alternatives to a revamped IMF programme. Ukraine could possibly look to Russia to secure funding but this would likely come with significant strings attached. The government might also look to the NBU to provide financing for the budget, albeit technically this is precluded by law, albeit financing can be provided by the backdoor via state-owned banks. Clearly this is potentially inflationary.
 
DEFAULT RISKS ARE MODEST FOR 2010

Despite Akhimovas comments above, we think the chances of a default by the sovereign are low for 2010, and also for 2011. Total state debt service due in 2010 amounts to little more than US$6bn, which seems manageable given US$26bn in FX reserves (around US$13bn net) and around US$2.5bn still in the fiscal reserve.

The domestic banking sector, meanwhile, currently is reasonably liquid, with deposits rising, and with banks still reluctant to lend to the real economy given concerns over high NPLs/ and with it concern over credit quality. These banks will provide a strong local bid for bonds, which we expect to be further augmented by increasing foreign interest attracted by the prospect of a stable/stronger currency and 20%+ local rates.
 
One thing to watch for over the next year will be increased debt issuance. We expect the incoming government to look to securitise some of the arrears accumulated over the past year, e.g. on VAT refunds. We would also expect some additional costs of bank recapitalisation which will also be funded via securitisation.

Ukraine is also expected to return to international capital markets this year, albeit the question herein is whether it will be able to tap markets with/without an IMF programme; current market pricing suggests the sovereign could issue a new 5Y bond just in single digits.

We would tend to argue though that the current rally in Ukrainian sovereign debt has been driven by positive expectations on the political/policy front and on the assumption that the IMF programme is put back on track quickly. We think that investors would first want to see a new government in place before committing to lend new funds to Ukraine.
 
BANKING SECTOR STABILITY 

The banking sector seems to have stabilised to an extent, with the drain of deposits having been stemmed and indeed deposits are rebuilding gradually. NPLs remain high and rising still, suggesting further need for provisioning and indeed further recapitalisation.

Estimates of NPLs range from official forecasts of less than 10%, to 30-35% by banks themselves; one foreign bank recently announced NPLs of over 50% in their operations in Ukraine, and losses of over US$1bn.

Foreign banks have, however, generally recapitalised their local operations and "rolled" debt falling due which is encouraging. The sector is also increasingly foreign owned, with a growing presence from Russian banks. The banking sector is clearly still in intensive care, and the state continues to administer a handful of failed private banks which are expected to continue to be a drain on public finances via the need for increased recapitalisation.

Generally though the IMF-backed bank recapitalisation process seems to be going well, and the official creditors appear eager to finish the process. The sector is unlikely to be a driver for growth going forward for some considerable time in the future, given that the crisis has seriously damaged perceptions of credit worthiness/standing at the household and corporate sector in Ukraine.
 
THE ECONOMY  

GROWTH: The economy was clearly brutally impacted by the global recession that followed the collapse of Lehman brothers. Ukraines vulnerability was heightened by its overdependence on exports of commodities and semi-finished products, particularly steel and non-ferrous metals, and also its large external financing requirements, a reflection of a wide current account deficit at the on-set of the crisis and a weight of external debt liabilities (~US$45bn) which fell due in 2009.

The combination of the export demand shock, plus the withdrawal of credit, combined with on-going domestic political instability, resulted in a brutal recession. Indeed, data released this week suggests that real GDP contracted by 15% for the full year in 2009, the largest contraction of any of the Transition economies, barring only Latvia.
 
For 2010 the outlook for growth appears more upbeat, itself a reflection of a) the very low period of comparison; b) some recovery in demand for key exports, particularly metals; c) the fact that the UAH remains around 20% lower in real terms than its pre-crisis level, which should act both to provide something of a stimulus to exports, whilst also capping import demand.

Already there is some evidence of a "bounce" with exports posting modest YOY growth in the final few months of 2009 (from a low base) while NBU activity indicators suggest real GDP growth of as much as 7% YOY in January 2010.

The government and IFIs remain relatively cautious in terms of their growth assumptions for 2010, predicting 3-4% growth, a reflection of the still weak global recovery trend, the assumption that fiscal policy will likely be tightened in the year ahead to ensure fiscal/debt sustainability, plus also by the fact that the banking sector is unlikely to act as a conduit for credit to the real economy given high NPLs and concern over credit risk.
 
Manufacturing output appeared to rebound robustly in late-2009/early 2010, as did mining and agriculture has proved relatively durable though the crisis, but construction and retail trade remain depressed.
 
INFLATION: The recessed state of the domestic economy (wide output gap), plus recent exchange rate stability, has acted to suppress inflationary pressures. The CPI which hit a YOY rate of over 30% in mid-2008, eased back to 11.1% in January 2010, and the NBU seemed confident that it would continue to ease back and push into single digits over the course of the year.

At least half of CPI inflation comes from administered/food price inflation. Core inflation has eased back from around 13% in early 2009, to around 6% at present
 
Balance of payments and the exchange rate: Reflective of the depressed state of domestic demand, and the large nominal and real (still ~20% weaker YOY) exchange rate depreciation, the merchandise trade and current account balances have improved markedly through the crisis. For 2009 the current account deficit came in at around US$1.9bn, around one-tenth the year earlier level, as the collapse in imports more than made up for the collapse in exports.

Net FDI halved but at US$4.5bn still more than covered the CAD. For 2010 a small current account deficit is expected (~US$3-4bn) but should again be full covered from net FDI; the CAD will likely be bolstered by higher energy import prices, which could add several billion US dollars to the deficit over the year. The financial account posted a US$11.8bn deficit in 2009, covered via the draw down in NBU reserves.
 
Banks are estimated to have rolled around 70% of external liabilities falling due, with a 100% roll-over ratio seen in the corporate sector  albeit this reflects restructuring to an extent.
 
The debt service burden is thought to have reduced to around US$30bn in 2010, from US$45bn in 2009; of the former total around US$20bn comprises short term debt liabilities.
 
The UAH is not seen as "over-valued", perhaps the opposite. Assuming the government manages to get the IMF programme back on track, the UAH should remain stable, even appreciate, allowing the NBU to rebuild reserves. Indeed, note that in recent weeks the NBU has been buying dollars again to prevent appreciation pressures.
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2.  UKRAINE: CURRENT ACCOUNT DEFICIT (CAD) SHRINKS TO FIT

Analysis & Commentary: By Timothy Ash
Emerging Markets Strategy | EM Alert | CEEMEA  
Royal Bank of Scotland, London, UK, Fri, 26 Feb 2010

LONDON - The NBU has released balance of payments data for Q4 2009 and for the full year in 2009. This shows that a combination of the 35% nominal exchange rate depreciation (~ 20% in real terms) and a huge deflation in domestic demand (real GDP growth declined by around 15% for the full year in 2009), the current account deficit has shrunk to fit.

HIGHLIGHTS INCLUDE: 

[1] The current account deficit narrowed from US$12.8bn (~ 7% of GDP) for the full year in 2008, to just US$1.8bn (~1.6% of GDP) for the full year in 2009.

[2] Much of the improvement in the CAD reflected a marked narrowing in the deficit on merchandise trade. Indeed, the deficit on merchandise trade shrunk from US$16.3bn in 2008, to US$5.3bn for the full year in 2009. Exports by dollar value shrank by 41% YOY, albeit this was more than made up for by a 46% YOY collapse in imports.

Note that there was evidence of a pick up in exports (and imports) in the final few months of 2009, largely reflecting the low base period of comparison but also a small pick up in demand for key exports such as metals.

[3] The surplus on services (a large part of which is gas transit fees) increased to US$2.7bn for the full year in 2009, from US$1.9bn in 2008.

[4] The deficit on the income account rose to reach US$2.3bn in 2009, up from US$1.5bn one year earlier, a reflection of the larger stock of external debt and higher interest costs associated with higher perceived risks.

[5] Transfers posted a US$3.1bn surplus in 2009, marginally lower over the year earlier period.

On the capital/financial account:

[1]  Net FDI eased back to US$4.5bn (a still respectable 4% of GDP) for the full year in 2009, from US$9.9bn in the year earlier period. However, this still provided more than double coverage of the current account deficit, versus 70% in the year earlier period.

[2]  Portfolio flows were negligible in 2009, after US$1.3bn flowed out in 2008; essentially the stock of foreign portfolio money invested in Ukraine is now negligible.

[3] Debt obligations posted a net outflow of US$9.3bn in 2009, essentially as debt was paid down. This compares with a net inflow of US$4.9bn in 2008. For 2009 banks paid down US$3.1bn in liabilities, and short term debt was cut by US$4.9bn (US$4.7bn of which comprised payments by banks), while other sectors saw a small net repayment; albeit the bulk of the gross inflows of US$10bn from this source appears to come from official credits (e.g. the IMF). In total banks paid down over US$15bn in liabilities (net).

[4] Other capital/errors and omissions posted a net outflow of US$7.1bn in 2009, compared to a net inflow of US$0.5bn in 2008.

[5] Reserve assets declined by US$13.8bn in 2009, which compares with a net increase of US$1.1bn in 2008. Reserve depletion peaked at US$5.3bn in Q1 2009, moderating to just US$1.6bn in Q4 2009.

CONCLUDING REMARKS 

Ukraine was brutally impacted by the collapse in global trade and financing which followed the collapse of Lehman brothers. The impact on the real economy was severe, as reflected in the 15% real GDP contraction in 2009. Problems funding an enlarged current account deficit, a weight of external debt amortisations and capital flight brought extreme downside pressure on the exchange rate, and saw a large drain on NBU reserves.

NBU reserves declined from a peak of US$38bn in mid 2008 to around US$26bn at present, while NBU reserve asset data suggests a draw down of US$18.6bn, this also reflects the fact that reserves were augmented via the draw down of IMF funds.

The 2009 balance of payments series does though suggest that the current account deficit has now shrunk to fit and no longer appears unsustainable. Indeed, with a much depreciated exchange rate, full coverage of the CAD via net FDI inflows, and with debt liabilities managed lower, there is much to suggest a more stable outlook for the balance of payments and indeed the UAH for 2010.

The UAH no longer appears fundamentally undervalued, indeed assuming IMF funding comes back on track over the next few months, metals exports/prices prove resilient, and we also see progress on the privatisation front, we could see appreciation pressure on the exchange rate. Local rates at over 20% could also begin to attract foreign portfolio inflows.

NOTE: This material is for information only. It is not an offering document and its terms are qualified in their entirety by the final transaction documents in respect of the securities described therein. Certain transactions mentioned may give rise to substantial risks and may not be suitable for all investors. RBS may have positions, deal or make markets in these securities or related derivatives. Prices are based on current information, are subject to change, are not offers to transact and cannot be relied upon as representations that transactions can be effected at such prices. This material is based on information considered to be reliable, but we do not represent its accuracy or completeness.
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Promoting U.S.-Ukraine business relations & investment since 1995.
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