Unlike in past crises, Ukraine’s Covid-19 recession will be no worse than regional peers

The current crisis will be very painful for the Ukrainian economy, but the depth will likely not be any worse than for other countries in the region. This is drastically different than in previous crises when Ukraine dropped substantially more than peer countries.

Although uncertainty still dominates the landscape, we currently estimate the FY GDP decline at around 6-7% in 2020. Although the dramatically negative Q2 will be followed by a swift recovery in Q3-Q4 (baseline scenario), a return to pre-crisis output levels seems a distant prospect.

On the external accounts side, the pattern will be relatively favorable for Ukraine – the decline in imports will be much deeper than the fall of exports, which will serve to narrow the C/A deficit to about 2-2.5% of GDP.

If official funding is secured – which is now our base scenario – the C/A gap will be safely covered and exchange rate pressures will be virtually non-existent. Following the practice of other countries, the Ukrainian government has earmarked substantial budget support to households and businesses to maintain consumption and to compensate for quarantine-related losses.

The amended budget now sees a deficit of 7.5% of GDP – unprecedented in decades but still manageable given the prudent fiscal policies Ukraine has pursued in the last few years. The bulk of this deficit is expected to be covered with external borrowing from IFIs.

NBU loosens monetary policy further

In a surprise move in April, the NBU lowered its key policy rate by 2 percentage points to 8%. The central bank cited still weak inflationary pressures and the need to support the economy in times of pandemic and quarantine. Indeed, inflationary pressures remain subdued as CPI edged down to 2.1% in April from 2.3% in March (the CPI target range set by the NBU is 5% +/-1pp).

Looking to the longer term, we believe demand-side pressures will remain extremely weak given the dramatic fall in household incomes and the deterioration in consumer sentiment. The relative stability of the hryvnia exchange rate is also keeping inflation low.

On top of that, the decline in global fuel prices is providing further relief for households, which further pushes CPI down. With this in mind, we believe there is more space for the NBU to loosen its monetary policy stance. We now expect the NBU will lower its key rate to 7%, a neutral nominal rate according to NBU estimates, and then maintain that rate in the coming quarters provided no new external shocks occur.

Banking law is now the lone critical hurdle to opening IMF lending

Ukraine is facing a decisive moment. The renewal of cooperation with the IMF and other IFIs is the only way for the country to muddle through the crisis at a reasonable cost. The plan to fund the huge fiscal deficit is largely based on the availability of funds from external lenders.

Now it seems clear that even back in February, the government didn’t truly intend to restart the lending program despite repeated assurances that it was a priority. Their true intention seems to have been to ride the wave of the healthy external environment and hope for the best. The COVID-19 lockdown was a game-changer – only IFIs now have the capacity and willingness to lend.

The IMF recently announced it switched to an 18-month Stand-By program for Ukraine, saying it’s better suited for the country given huge uncertainties, while the previous plan was to launch a 36-month EFF program. The fund reiterated the prior actions for the program – land reform and amendments to the banking law.

In a milestone vote in April, parliament launched a market for land. Although in a very restricted form, the reform is still a breakthrough given the issue’s high social and political sensitivity.

The banking law now remains the only hurdle for the program. The draft banking law prevents any de-nationalization of Privatbank even if courts eventually rule the nationalization was unlawful (this is still a possibility given weak progress in judicial system reform). It is nearly certain the law will be adopted in May, which will pave the way for generous external support to the quarantine-hit economy.

Banking sector has been resilient thus far, but it will face substantial losses

The first three weeks of the crisis in March proved to be tough for the banking sector, but it weathered the turbulence surprisingly well. Liquidity was abundant in both UAH and FX and early signs of bank runs faded quickly – smooth servicing of obligations comforted bank customers. Retail deposits in hryvnia continue to grow and FX deposits are declining only marginally, which suggest that customer confidence in the banking sector is high.

Overall, banks remain in good shape but they will face material challenges through end-2020. Demand for banking services has declined, which resulted in lower fees and commissions, while operating expenses are robust as cost optimization measures are still to be taken.

The souring quality of loans will be the key test for the banking sector. NPLs still hold an extremely high share (49% in March) and they are more than 90% provisioned, but the current crisis will further pressure asset quality. At this point, any estimates of losses would be premature – the true scale of losses will become clear in 6-9 months.

Still, by our estimates, the capital buffers that most Ukrainian banks managed to accumulate over the past couple of years should be enough to absorb credit losses. Capital adequacy at many banks is twice the minimum requirement. Large bank bankruptcies are highly unlikely during the current crisis, but banks are also unlikely to provide an uninterrupted flow of credit to the economy.

Even in good times, banks’ appetites for new lending has been very limited as creditor protection rights remain poor. The lack of credit may impede the future recovery and the government’s efforts to roll out a credit guarantee scheme for SMEs is critical at this point.

Please contact SP Advisors for more information – info@spadvisors.eu.

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Nick Piazza, CEO, represents SP Advisors on the USUBC Board of Directors.