I visited Kyiv on June 28-30 meeting with government officials, the NBU, politicians, diplomats, journalists, bank and analysts.

Summary view: As always with Ukraine there is lots of political noise, and I think the chances of early elections are high. I also think structural reforms are stalling, and I cannot see another IMF tranche being delivered this year. But I guess Ukraine in the end is a high beta trade, while short term macro gives some assurance and durability on the financing front.

The economy is set to grow 2-3% this year, remarkably the budget is in surplus, the BOP is manageable with the UAH still looking cheap, and a CAD of 3-4% of GDP is covered by some net FDI, reverse currency substitution. FX reserves are rising, and back over USD17bn, or 4 months of import cover.

This year Ukraine does not need IMF money to meet its financing needs - which is why pressure to deliver on the structural reform front is lagging. Likely we will see some minimum reforms, such as pension reform, and a new supplementary budget delivered and perhaps even a new market friendly NBU governor.

And likely that will be enough to ease market concerns that the IMF programme is going off track - but the programme will be seen as a backstop.

Indeed, all this reminds me of 2012 under the former Yanukovych administration. In many respects the longer term structural reform trends are not encouraging, but I think the market will just be focused on yield/carry, and will close their eyes to the rest.

The situation in the East is not great, and locally accusations abound that Putin has stepped up pressure on Ukraine via assassination attempts and cyberattacks - a new twist in the conflict.

But I think the desire to engage with President Trump will keep Putin relatively contained in terms of his Ukraine strategy. And there is just a chance of some positive news from the G20 summit, as Putin has to give some concessions to Trump to head off Congressional pressure to codify sanctions.

I don't think any of this solves longer term challenges in the Russia - Ukraine relationship, but it all might still buy Ukraine a bit more time to get through this year, and potentially to early elections.

Introduction

I arrived on Constitution Day, June 28, and Kyiv certainly had a mood of vacation and summer about it. There has been lots of talk of a big reform push in July, but I find it difficult to see the Rada working in overdrive for the two day legislative sittings on July 11 and July 13.

There has been some talk of parliament’s recess being delayed, or parliament recalled, but I just cannot see that. Rada deputies are either already on holiday or in no mood to sit through long and arduous legislative sittings over really complex bills.

At the most we are likely to see a supplementary budget for 2017 passed, as given the strength of the revenue side this allows increased spending.

A first reading of the pension reform bill is also possible (50:50 as one very well informed observer quipped) - again because the draft allows for pensions to be increased this year so few deputies will want to be seen to vote against such a bill and especially with the talk of early elections in the air.

It is also possible to see a Rada vote to finally accept the resignation of Valeria Gontareva as NBU governor, and perhaps a market friendly replacement in the form of Volodymyr Lavrenchuk, albeit that is still not set in stone.

Beyond that I see little appetite for difficult and potentially unpopular reforms such as land reform, healthcare and education reform, plus pushing on with the anticorruption agenda with agreement on the creation of anti-corruption courts.

Simply put there is little immediate pressure to push on quickly with these reforms, as the budget and balance of payments positions seem solid, and Ukraine is in no immediate need of IMF financing.

What seems more likely is that all these reforms will be pushed out to late in the year, and with his it hopes of the early sign off of the next IMF review.

I guess this does raise a question as to whether the current administration is still committed to delivering on the structural reform agenda - particularly reforms such as the anti corruption agenda where there is a need for the political leadership to expend a large amount of political capital against entrenched vested interests.

I have my doubts, especially where talk of early elections is on the increase, and might just be too enticing for President Poroshenko.

A delay in the structural reform agenda would be a disappointment, as in many respects Ukraine is at a key turning point with some key reforms delivered (banking, energy, NBU, fiscal), macro stability achieved and as Anders Aslund of the Peterson Institute recently noted, the economy is poised for take off.

But unfortunately that take off requires domestic and foreign investment and I just cannot see that as being forthcoming in any size unless key structural reforms are completed, and especially real progress in delivering on the anti corruption agenda. 

On the anti corruption agenda progress to date just seems like window dressing. Various institutions (NABU, e-declarations) have been created to identify corruption and graft, alleged wrong doers identified and some arrested and charged. But there have been next to no prosecutions completed and few have been jailed.

The common perception is that the judicial system is totally corrupt, and simply not up to task. And plans for the creation of special anti corruption courts seem to be being stalled, with legislation put out to graze with the Venice Commission. Vested interests seem to be stalling action at every turn, and there are doubts as to whether there is political will at the highest level to deliver real change.

Efforts to force NGOs to declare assets just appears aimed at weakening the one part of the system which seems to be working - civil society - albeit even there the (corrupt) system is fighting kicking and screaming to retain the status quo.

All the above comes back to a conclusion and perhaps question as to whether the system is just too corrupt, and un-reformable though the existing approach. Too many people within the system have been touched by corruption and they are resisting change at every turn.

Perhaps the only answer is a truth and reconciliation process, and some form of amnesty with a windfall levy/tax. But perhaps Ukraine’s elites think they can get away completely Scot free by playing the West, by going through the motions of pretending to create institutions, but ultimately knowing that they will fail, and eventually the West and IFIS will be worn down, and that normal ‘rent seeking’ and corrupt behaviour can resume.

Relations with the IMF

The IMF has been clear in its last review as to what needs to be done to deliver the next credit tranche - progress on pension reform, land reform, privatisation, and on the anticorruption agenda. Also a prior action of the third review was a government agreement to announce half year gas price hikes on July 1, for application on October 1.

The latter is likely to be the first test of the reform intentions of the Groysman administration, as the prime minister earlier this year claimed their would be no gas price hikes.

As noted above, it is possible to see a first reading of the pension bill, but I don't see much else being achieved before the Rada breaks for summer recess on July 14. This suggests the completion of the next review under the IMF EFF will be pushed back to the autumn, and perhaps next year if, as I suspect, we see early elections. 

Macro outlook

Part of the problem is that the macro position remains favourable, and the government is not in urgent need of IMF financing:

Growth: From a low base, the economy is expected to post real GDP growth of around 2% this year. Earlier year disruption from the blockade in the East has been navigated as Ukrainian industry has proven agile. There has been some recovery in trade with Russia, and favourable terms of trade still have helped alongside continued strength in the agricultural sector.

Inflation: Base effects are expected to cut inflation from 12-13% at present into single digits by year end.

Budget: Solid nominal real GDP growth and improved revenue collection has helped the revenue side of the budget. Dividend receipts from SOEs (Naftogas) and one off asset seizures from the former Yanukovych regime, plus NBU profits has buoyed the budget and ensured a record budget surplus for the first six months of the year.

BOP: The current account deficit seems contained at 3-4% of GDP, which with some modest FDI, portfolio inflows, and official financial inflows, and strong de-dollarisation has held the UAH stable, even creating nominal appreciation and enabling the NBU to accumulate FX reserves to over USD17bn, or over four months of import cover. Debt restructuring has cut debt amortisation at least for the period to 2019.

Eurobond financing: Ukraine has benefitted from the broader hunt for carry with yields on hard currency debt collapsing from 12% on the cusp of the 2015 restructuring to 7-8% as of writing. It is now entirely possible to see Ukraine’s reentry onto international capital markets, the only real question is timing and what price the MOF is willing to pay.

The MOF has spoken about delaying a new issue until key reforms are passed and the next IMF review is completed. However, given my expectation that key reforms will be delayed along with the next tranche of IMF money, I think the allure of securing market access will just be too great. Likely this will be part of some liability management exercise to reduce the debt hump in 2019.

Domestic politics

Tensions seem to be running quite deep in the ruling coalition, with rivalries appearing between the Presidency and the team of PM Groysman. To a certain extent this always tends to be the case in Ukraine’s parliamentary/presidential system, but is seems likely that at the minimum President Poroshenko will look to bring Groysman into line by instigating a cabinet reshuffle which could be quite extensive even going to the very top.

Already vacancies are present in the ministries of Agriculture and Health, which have to be filled, alongside the need to appoint a new NBU governor. The cabinet reshuffle might be delayed until September, and could also be used by Poroshenko as a pretext to call early elections - Groysman did say that he would resign unless he delivered pension reform, which might be used as the rod by Poroshenko to ultimately beat his prime minister. 

As noted elsewhere (see my piece from Friday) I do think there is now a high chance of early elections, likely in October/November under the pretext of needing to secure a fresh mandate for structural and perhaps even constitutional reform related to the status of the Donbas. Cynics would argue that this is just a ruse by the administration to stall/delay delivery on those reforms.

International affairs

Ukraine has seen some notable “wins” in recent months:

Macron’s victory in the French presidential elections ensured defeat for the avowedly pro-Russian Le Pen. Macron appears set to adopt a much more hawkish approach towards Russia, more in line with Ukraine’s interests. He also seems eager to take a prominent role in the Normandy peace process.

Naftogas’s surprise preliminary victory against Gazprom over the “take or pay” case in the Stockholm courts was a positive. It alleviated the risk of a major, multi billion award against Ukraine, and potentially creates the prospect of a significant award for Ukraine. Ukraine could also secure compensation in the related transit case likely ruled on towards year end.

The Dutch parliament finally negotiated around objections expressed in the referendum on the AA/DCFTA which now looks set to be ratified across the EU, and fully implemented.

The EU decision to provide visit free travel for Ukrainians is popular in Ukraine, albeit could create longer term challenges in terms of a brain drain.

The Trump-Poroshenko meeting was hailed as a coup for the Ukrainian side, with both sides getting something from the visit, but I think laying aside irritation in the Trump team over the strong support given the HRC by the Poroshenko administration in the US elections.

On the latter point, Trump’s own problems with Russia-gate has given Ukraine an opportunity to secure benefit. Trump needs to show his hawkish credential on Russia, which partly ensured the invitation to Poroshenko to visit the White House. Being supportive of Ukraine is hence the reverse image of being seen to be hawkish on Russia.

This has been seen in the latest iteration of maintenance sanctions on Russia, and in Congress might have pushed the GOP towards codification of Russian sanctions. There is even talk again of the US arming Ukraine with defensive military capability.

I often heard the quip in Kyiv, that while the Obama administration gave lip service to supporting Ukraine, actual real support was limited - no defensive arms, and only moderate sanctions lodged against Russia.

There is though a sense that the Trump administration is under more pressure to demonstrate real and substantive support for Ukraine. The announcement by the Ukrainian authorities that they had found no evidence of illegal (under Ukrainian law) payments to Trump’s former campaign manager, Paul Manafort, undoubtedly helped improve the mood music in the run up to the DC visit.

In terms of the conflict in Donbas, I sense a feeling that the combination of new presidents in the US and France is creating an opportunity for movement. Most people would accept that the Minsk II agreement is not currently working and the forty-odd ceasefire agreements since 2014 have largely failed.

US officials are eager to point out that the conflict in the East is far from frozen, indeed its intensity has increased thus far in 2017 with hundreds of deaths reported, many more injured and tens of thousands of live fire incidents.

The message is that the status quo is not working and there is a need for change and new approaches. There is perhaps a need for new types of engagement with Putin and Russia.

Therein Poroshenko’s visit to DC, and then maintenance sanctions rolled out by the US Treasury may have have given Trump space now to sit down with Putin around the looming G20 in Germany and negotiate. Arguably Congressional efforts to codify sanctions, has improved Trump’s hand to negotiate with Putin.

If Putin cannot offer concessions over Ukraine to Trump, e.g. a meaningful and lasting ceasefire, then he risks putting Trump in a position whereby he cannot stop the Congressional move to codify sanctions which would be very bad news for the Russian economy, and for a very long period.

Arguably for Putin heading into tricky presidential elections he also needs a win, and I wonder if he also might just be willing to offer some form of concession to Trump.

The prospect of early elections in Ukraine, and a new focus on constitutional reform in Ukraine by the Poroshenko administration might just be a sop by the latter administration to the Trump administration, trying to give Trump some wiggle room to negotiate even though delivery on a constitutional reform set up in Ukraine which would satisfy both Ukraine and Russia is fraught with difficulty and

I think under the current leadership in the Kremlin bound to end in failure. That said, any deal which yields even a short term respite in violence has to be commended. Ultimately I guess this is all going to be a test of Trump’s real interest in Ukraine, and whether he really is the master of the deal.

But I think both Trump and Putin currently need wins - albeit any deal that Trump might offer in the end has to be deliverable in Ukraine, and Trump needs to tread carefully so as not to inflame his political opponents back home who remain hawkish on Russia. I can though imagine some new ceasefire agreement to give a window for a revamped Nuland-Surkov peace process to get off the ground.

For Putin conceding to a ceasefire is not much of a concession, as given the substantial forces in the theatre, it is all too easily to re-escalate almost on a whim. 

** Please note that any views expressed herein are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions. The views expressed do not reflect the opinions of all portfolio managers at BlueBay, or the views of the firm as a whole. In addition, these conclusions are speculative in nature, may not come to pass and are not intended to predict the future of any specific investment. No representation or warranty can be given with respect to the accuracy or completeness of the information. Charts and graphs provided herein are for illustrative purposes only.”

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