KYIV - The sovereign debt turmoil in developed EU countries has affected the bond performance of the world’s emerging and frontier markets differently. Based on economic fundamentals, many developing nations emerged stronger after the crisis of 2008-09 compared to peripheral euro-zone countries.

As part of a countries distribution, we analyzed the relative strengths and weaknesses of Ukraine’s economy compared to benchmark group. Our major economic indicators in describing a country’s risk profile consist of government debt/GDP, and public and current account deficits. The second group of factors includes economic growth and structural reforms. (see the LINK: http://www.usubc.org/site/files/PHNC_FI_Report_July_12_2011.pdf for the Phoenix Capital Research, Fixed Income Report (FIR), with a considerable number of charts and graphs.)

The sovereign debt turmoil in developed EU countries has affected the bond performance of the world’s emerging and frontier markets differently. Based on economic fundamentals, many developing nations emerged stronger after the crisis of 2008-09 compared to peripheral euro-zone countries.

As part of a countries distribution, we analyzed the relative strengths and weaknesses of Ukraine’s economy compared to benchmark group. Our major economic indicators in describing a country’s risk profile consist of government debt/GDP, and public and current account deficits. The second group of factors includes economic growth and structural reforms. (see the attachment to this e-mail for the Phoenix Capital Research, Fixed Income Report (FIR), with a considerable number of charts and graphs.)

Meeting growth expectations. Ukraine's economy delivered robust growth performance in 1H11, outpacing most of its regional peers. Healthy GDP expansion contributed also to high replenishment of budget coffers, thus capping the fiscal gap within the required limit of 3.5% of GDP for this year. In addition, smooth access to domestic and foreign debt markets allowed the Ministry of Finance to balance government revenues and expenditures.

Better-than-expected growth figures came at a cost of widening current account (CA) deficit and intensified inflation pressure. Accounting for latest economic data, Ukraine’s government upgraded its GDP growth forecast to 4.7% Y-o-Y and closer to our initial estimate of 5% Y-o-Y.

Pushing forward on promised reforms. Pension reform, one of the milestones of Ukraine's economic austerity, was passed by parliament on July 8, 2011. In pushing forward on spending cuts, Ukraine’s government is paving the way for securing its next IMF credit tranche. Yet the other important step awaiting adoption is an increase in domestic natural gas prices. Both measures apart from contributing to renewal of IMF cooperation will set the path for structural changes in the economy.

Nil exposure to peripheral EU bonds. Ukraine’s banking system, having legal restrictions on overseas securities, has virtually no exposure to the debt markets of Greece and other EU peripheral countries. Hence, the nation’s financial system will not need to write off impairments in case of further deterioration in peripheral euro zone nations.

Stronger in the long term. While Ukraine is not immune from intensification in global risk aversion stemming from EU sovereign debt problems, its economic position is relatively balanced based on our comparison review. With Ukraine’s debt risks are primarily in the short-to mid-term horizon, in the long term the economy is expected to emerge stronger compared to many of the considered benchmark countries. Current economic achievements create a basis for robust relative performance in the coming years.

Balancing Ukraine’s economic recovery
Ukraine’s economy in 1H11 maintained strong momentum with a growth rate exceeding 5% Y-o-Y, we estimate. Strengthening domestic demand was the major driving factor behind GDP expansion. At the same time, advancing consumer expenditures led to higher demand for imports and thus a wider CA deficit.

Nonetheless, with the CA shortfall covered by capital inflows and the central bank boasting record-high reserves, the UAH exchange rate was little changed, a tendency we expect to maintain for the next 12M. The public finances gap, on contrary, set on a downward trend as the government followed its predetermined plan of tightening spending.

Economic growth
In 1Q11 Ukraine’s economy generated a 5.3% Y-o-Y growth rate, one of the largest growth measures among countries in eastern Europe and the CIS region. Economic dynamics saw noticeable acceleration in the beginning of 2011 compared to a 3.3% Y-o-Y increase in 4Q10. Such a tendency is attributed to a pickup in sectors oriented on domestic demand. Meanwhile export-driven industries recorded a slight moderation from impressive expansion rates seen in 2010. The National Bank of Ukraine (NBU) estimated for 5M11 economic growth of 5% Y-o-Y.

The GDP breakdown revealed important structural change – while factory data showed signs of moderation, momentum in consumer-related industries accelerated as propelled by rebounding domestic demand. In 2H11 consumer and investment demand will strengthen further, benefiting partially from a more beneficial comparative base effect.

Ukraine’s industrial production posted a growth rate of 8.5% Y-o-Y in 5M11, slowing from double-digit expansion. Despite some slowdown, export-driven sectors remained strong: machinery advanced at 22.5% Y-o-Y in 5M11, chemicals added 20.9% Y-o-Y, light industry increased 16.5% Y-o-Y, and machinery grew 7.9% Y-o-Y.

Importantly, factory data remained robust despite global economy slackening. Among the base industries considered by the State Statistics Committee, construction and retail trade showed 13.2% Y-o-Y and 15.5% Y-o-Y growth respectively (see Figure 2) which points to a healthy rebound in investment and consumer demand.

Ukraine’s economy is expected to maintain healthy growth momentum in 2H11, propped up by domestic demand. GDP growth will reach 5% Y-o-Y in 2011, we estimate. Recent data on Ukraine’s economy confirms this viewpoint. Among other economic projections, the government upgraded its growth estimate to 4.7% Y-o-Y (+0.2 p.p.) while the World Bank improved its figure to 4.5% Y-o-Y.

Compared to the benchmark group of countries, Ukraine’s GDP growth forecast for 2011 falls in the upper quartile of the distribution with most other countries placed below the 5% Y-o-Y range. We expect Ukraine will maintain a pace of economic expansion close to 6% Y-o-Y for the coming years. A higher growth rate is needed also to recover the GDP slump of 2009. In particular, industrial production is equivalent to the level observed in 2006.

Budget deficit
Ukraine’s Ministry of Finance boasted of a healthy budget execution in 5M11, outperforming its fiscal schedule in the respective period. In particular, the central government collected a total of UAH 119 bln in revenue, which is nearly 27% higher compared to the analogous period of the previous year. The strong expansion in budget revenues was primarily driven by tax receipts (+51.2% Y-o-Y in 5M11) and explained by general economic recovery. The budget’s general fund revenue was 5.1% ahead of schedule during 5M11.

A further noticeable development in 2011 was privatization of the fixed-line telecommunication monopoly Ukrtelecom, allowing the Ministry of Finance to reach its annual target of selling state assets. However, the government aims to sell more assets in the power generation and distribution industry, which is estimated to provide UAH 2-3 bln in additional revenue.

As an important prerequisite for fiscal consolidation, government expenditures expanded less significantly compared to revenues with debt servicing being among the key exceptions. Debt interest payments accounted for 6.4% of total revenue in 5M11.

 As a result, the Ministry of Finance managed to slash the fiscal deficit to UAH 1.5 bln, approximately 6x lower compared to the planned budget shortfall. The public fiscal gap should reach UAH 35.3 bln ($ 4.4 bln), or 2.8% of GDP (the ratio increases to 3.5% of GDP when including the payments deficit of state gas monopoly Naftogaz of Ukraine), according to the revised 2011 budget.

Compared to the benchmark group, Ukraine’s budget deficit in 2011 is below the median estimate. The adopted budgetary resolution for 2012 envisages a contraction in the fiscal gap to 2.5% on the back of acceleration in economic growth to 6.5% Y-o-Y (both factors contribute to tightening in the country’s leverage). The expected renewal of IMF cooperation will secure adherence to the adopted fiscal tightening path.

Given that the financing of the State Pension Fund deficit remains one of the main hurdles in reducing the government shortfall, recently adopted changes to pension legislation – such as increasing the retirement age for women – are a positive signal in ensuring a balanced fiscal position in the coming years.

Public debt and GDP
Ukraine’s public debt in 2011 will expand faster compared to nominal GDP growth, resulting in incremental growth in the total government debt/GDP ratio. We expect government indebtedness will swell to 42% of GDP by the end of this year (including guaranteed debt) before experiencing contraction in 2012.

With the state succeeding with fiscal consolidation and economic recovery, public leverage metrics will set on a downward trend beginning next year.
Similar to benchmark analysis on the budget deficit, Ukraine’s total government debt/GDP ratio (39.5% in 2010) is ranked below the group’s median measure and the generally accepted safety threshold of 60%.

According to government regulation (#170 dated March 2, 2011), public debt (excluding its guaranteed portion) should constitute 28% of GDP in 2013. Furthermore, this year’s state budget limits public debt at UAH 308.3 bln ($ 38.5 bln) as of Dec. 31, 2011. In addition to fiscal consolidation and strengthening economic growth, smooth access to foreign and domestic debt markets underpin the Ukrainian government’s creditworthiness.

Current account and capital flows
Stronger economic growth in Ukraine came at a cost of a widening CA deficit and higher inflation risks. The CA shortfall is expected to widen to 3.5% of GDP this year, or $ 5.4 bln. The two major factors behind expanding deficits are rising energy prices (reflected in natural gas imports from Russia) and increasing consumer demand for imported motor vehicles and home appliances.

Deterioration in CA is expected to be fully covered with inflows to the financial account, providing an additional $2-3 bln FX supply on the market (above CA deficit). Thus, the NBU’s international reserves should remain at close to record levels and reach $ 38 bln at the end of the year owing in part to an expected renewal of IMF credit support.

A relative analysis shows that Ukraine’s economy runs a CA deficit below the average level forecasted for the benchmark group of countries in 2011. Ukraine’s central bank undertakes tentative steps to curb consumer demand, which is mostly channeled to imported goods. Special regulation should be adopted placing sizable limitations on consumer lending apart from mortgages.

Managing structural reforms
Passing changes to pension legislation marks an important milestone for Ukraine’s development. The legislation envisages a gradual increase in the retirement age for women by 5 years to 60 years. While the primary goal of the pension reform is to reduce State Pension Fund and central government budget deficits, future reforms will create a foundation for creating personal pension saving accounts. With this system introduced Ukrainian financial market will receive a significant boost, providing for domestic investor base.

Pushing forward on promised reforms, Ukraine’s government is paving the way for securing the next IMF credit tranche. Yet the other important step awaiting adoption is an increase in domestic natural gas prices. An IMF mission is scheduled to visit Ukraine in the beginning of autumn with a possible disbursement of the next tranche in October. 

Credit implications
Having analyzed the most recent data and comparing it to benchmark group of countries, we currently see Ukraine’s economy with mostly balanced aggregate public and external accounts and good growth momentum. While the recovery is still dependent on the global economy, the larger impact of domestic demand and more favorable comparative base effect will shore up growth in 2H11.

Public indebtedness remains at a level below the benchmark group average. Expected fiscal consolidation and GDP advancement will cap the leverage ratios below 50% in the coming years, in our view.
With the risks for Ukraine’s debt concentrated primarily in the short to mid-term horizon, in the long-term the economy is expected to emerge stronger compared to many considered benchmark countries. Current economic achievements create a basis for robust relative performance in the coming years.

NOTE:  For the complete Phoenix Capital Research, Fixed Income Report (FIR), July 12, 2011, including a considerable number of charts and graphs see the attachment to this e-mail.  The Analyst Certification and the Disclaimer are also found in the attachment. 

NOTE:  Phoenix Capital, Kyiv, Ukraine, is a member of the U.S.-Ukraine Business Council (USUBC), Washington, D.C., www.usubc.org.