Ukraine’s Economic and Financial Situation Dr. Edilberto Segura Partner & Chief Economist SigmaBleyzer, The Bleyzer Foundation October 2008 v2
Ukraine- Real Sector
Over the last five years, Ukraine has been one of the fastest growing economies in the region: its real GDP grew by 7.9% per annum.
In 2008 economic growth has continued: during January-September 2008, Ukraine expanded fast at 6.9% yoy, showing resilience to global liquidity tightening, high energy and raw materials prices, high inflation and on-going political controversy.
Source: State Statistics Committee of Ukraine January-September 2008, % yoy GDP 6.9 Agriculture 15.7 Domestic Trade 9.4 Transportation/Communication 10.4 Industrial Output 5.1 Construction -10.3 9.6 7.9 7.3 7.1 7.0 6.3 6.1 5.5 5.1 0 2 4 6 8 10 KZ UA RU SK TR RO BL CZ PL Real GDP growth, % average for 2003-2007 Source: State Statistics Committee of Ukraine, IMF WEO Database April 2008
Economic Growth – Demand Side
On the demand side , in the first half 2008 GDP growth was supported by high domestic consumption and investment growth of 17.4% yoy and 10% yoy respectively.
Over this period, domestic consumption was sustained by a 15% yoy increase in real disposable income, 9% yoy real increase in wages, and 30% yoy real increase in credits (65% yoy nominal).
Growth of investments was encouraged by the growing profitability of firms (48 % yoy in real terms due to higher exports and domestic trade) and by strong foreign currency inflows (FDIs and debt), which compensated for tighter domestic liquidity.
GDP growth by Demand Components, pps Source: State Statistics Committee, The Bleyzer Foundation Final consumption Imports Investments Exports GDP, % yoy 6 .5 7. 6 7 .3 9.6 12.1 2.7 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 2003 2004 2005 2006 2007 1H 2008
Economic Growth – Supply Side
On the supply side , in 2008 agriculture has been the growth engine (16% yoy), harvesting 45 million tons of grains, a 15-year record. This large harvest is due to favorable weather and larger investments in the sector.
Negative growth in construction
(- 10.3% yoy) this year is due to tight economic policies (to control inflation))
Below average growth of industry (5.1% yoy) was due to growing production costs (more expensive energy, raw materials, labor, and transportation) and weaker external demand.
Real GDP is forecasted to grow by 6.3% in 2008 and about 2% - 4% in 2009.
GDP growth by Sectors, percentage points Source: State Statistics Committee, The Bleyzer Foundation 6.9 7.6 7.3 2.7 12.1 9.6 -2.5 0.0 2.5 5.0 7.5 10.0 12.5 2003 2004 2005 2006 2007 9mo 2008 Agriculture Industry S ervices Net taxes Construction GDP at market prices
Macroeconomic Performance - Inflation
Inflation reached 17% in 2007 and surge to 31% yoy by May 2008, caused by increases in aggregate demand and high food prices (poor weather in 2007).
But during July-August 2008, the CPI deflated somewhat due to a good harvest and lower food prices.
In September 2008, price growth resumed, driven by utility tariffs.
In annual terms, inflation continued to slow down to 24.6%.
Alt hough during the last three years fiscal deficits were maintained low at about 1%, budget expenditures grew by 20% per annum in real terms, increasing inflationary pressures.
Nevertheless, exchange rate and monetary policies were at the core of the inflation problem, with large nominal increases in money supply (about 50% pa) and bank credit (about 70% pa).
Therefore, inflation was addressed by tightening monetary conditions.
Source: State Statistics Committee, The Bleyzer Foundation 0 4 8 12 16 20 24 28 32 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep 2007 2008 Foods Utilities
Monetary Policy to Address Inflation
The anti-inflationary program relied heavily on monetary measures by the NBU:
Switching to a managed float in order to reduce forex interventions - the major source of money growth.
Tightening bank reserve & capital adequacy requirements.
Increasing the discount rate to 12%.
Carrying out sizable sterilization operations to slow down credit growth.
As of September 2008, these measures reduced money supply to 38% yoy (from 52% in 2007); and credit growth to 54% yoy (from 74%).
Helped by larger agricultural output, annual inflation may decelerate to 20% in 2008 and may be further reduced to 15% in 2009.
Selected monetary indicators Credit stock, % yoy, RHS Source: NBU, SSC Consumer Inflation, % yoy, LHS Money supply, % yoy, RHS 5 10 15 20 25 30 35 40 45 50 55 60 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep 2006 2007 2008 20 25 30 35 40 45 50 55 60 65 70 75 80
Main Economic Issues facing Ukraine Today
Inflation is no longer the main issue facing the country today.
Ukraine today is facing the possibility of a financial crisis in the next few months as indicated by many international measures of default risk.
One of the most common indicators used by investors of the risk of default of a bond is the premium on its Credit Default Swaps (CDS).
A CDS is an insurance-like contract that promises to cover losses on a bond in the event of default by the bond issuer.
Studies have shown that CDS premiums identify default risks earlier than bond spreads or bond ratings: it is a better leading indicator for defaults.
A premium of more that 1,000 basis points is an indication that investors do expect the bond to be in default.
A few days before their collapses, CDS premiums reached 740 basis points for Bear Stearns and 724 basis points for Lehman Brothers.
Credit-Default Swaps (CDS) Spreads for Selected Countries Other countries with high CDS premiums include Argentina (3,900 bp), Pakistan (3,000 bp), Ecuador (2,600 bp) and Venezuela (2,300 bp). Ukraine: 2803 bp Russia: 1031 bp 0 250 500 750 1000 1250 1500 1750 2000 2250 2500 2750 3000 23-Oct 3-Oct 15-Sep 26-Aug 6-Aug 17-Jul 27-Jun 9-Jun 20-May 30-Apr 10-Apr 20-Mar 29-Feb 11-Feb 22-Jan 2-Jan 12-Dec 22-Nov 2-Nov 15-Oct 23/10/2008 Kazakhstan: 1216 bp
Opinions of International Experts about Ukraine’s Vulnerability
High Level NY bank officer: 80% probability that Ukraine will face a financial crisis during the next few months.
High Level London bank officer: 90% probability that Ukraine will face a financial crisis.
Economist of major investm. bank: A financial crisis in Ukraine is imminent.
Standards and Poor’s September 2008 Review of Ukraine’s Banking sector: Ukraine’s banking sector is in high risk and is listed in Category 10, which is the category for the world’s weakest and most vulnerable banking sectors (along with Bolivia and Venezuela).
US Treasury’s Quarterly Assessment of Financial Risks, September 2008 (Ukraine was placed among the 10 top financial risks in the world): Ukraine …. risks a sharp balance of payments adjustment or crisis within the next one or two years.
Fitch Rating: Ukraine’s sovereign rating downgrade to ‘B+’ reflects concern that the risk of financial crisis in Ukraine… is significant and rising.
In mid-October, S&P’s put Ukraine’s sovereign rating on CreditWatch with a negative outlook.
Three Major Reasons Why the Ukrainian Economy is Vulnerable:
1. Large Current Account Deficits
2. External Debt Burden
3. Banking Sector Weaknesses
- In 2009, the current account deficit is likely to widen to $24 billion (10% of GDP.) This amount will require foreign financing. - Of this CA gap, about $10 billion reflect the likely increase in imported gas price. Current Account Balance and FDI Inflow in $ billion, and CA Balance as % of GDP 1. Large Current Account Deficits Current account balance, % of GDP -25 -20 -15 -10 -5 0 5 10 2001 2002 2003 2004 2005 2006 2007 2008(e) 2009(f) FDI inflow, $ billion Current Account Balance, $ billion CA Balance, % of GDP
2a. Gross External Debt, by Sectors, $ Billion
In the last two years total external debt grew 45% pa to $100 billion.
External private debt grew to $85 billion, $29 billion of which is short-term (classified by original maturity).
Ukraine’s external debt is now above the median value of countries in similar credit rating categories:
At 60 % of GDP, Ukraine’s external debt/GDP is above the 40% median value of similarly rated countries.
At 120% of current account receipts, its ratio of e xternal debt/ CA receipts is also above the 84% median value for similarly rated countries .
2b. Sort-term Component of Gross External Debt, by Original Maturity Breakdown, $ Billion - The actual short-term debt may be much higher than the official number of $29 billion, if we include the short-term part of the medium/long-term debt. - The likely short-term portion of M< private debt is estimated at $10-15 billion, which could bring the total short-term debt to $39 - 45 billion. 29 0 5 10 15 20 25 30 2004 2005 2006 2007 2008 Corporate sector - ST debt Banking sector - ST debt 9.5
2c. Ukraine’s External Financing Requirements in 2009 (in $ billion) 2009 S ort-term private debt repayment s * -29 L ikely short-term portion of medium-term debt -10 Public sector external borrowing need s ** -2 Forecasted current account deficit -24 L ikely external financing requirements -65 L ikely FDI inflow 10 L ikely external debt requirements -55 Available NBU reserves 3 5 * not including the short-term part of M< private debt ** according to 2009 Draft Budget Law
External Financing Requirements
The previous table shows that the 2009 external financing requirements could be $55 billion (adding the short term external debt to the external financing required to cover the CA gap, and subtracting likely FDIs).
A portion of this debt is due by subsidiaries to parent companies or represents more stable trade credits (about $25 billion ).
Under normal circumstances the gap of $30 billion would be manageable.
But if global liquidity continues tight, Ukraine may not be able to secure financing for this amount.
Due to international liquidity constraints, since September 2008 a number of local banks have reported increasing difficulties in rolling over their foreign short term obligations.
The risk of a crises in the near months is now greater, as shown by the current high CDS premiums, with a possible major devaluation.
Although some banks may fail and may even default, government foreign debt (about $15 bn mostly long term) is likely to be timely served.
3a. Money Supply and Banking Sector Credits, UAH billion, 2001-2008 UAH billion Money supply, M3 Loans to private sector
Many studies in EMs have shown that high rates of credit growth lead to high levels of non-performing assets.
In Ukraine, bank credit growth has been high over the last 5 years: 60% pa.
Credit growth was supported by large increases in money supply (M3) of 44% pa and by external debt.
Non-performing Loans in Selected Emerging Markets as % of Total Loans, 2007 Source: IMF Global Financial Stability Report, Jan 2008 0 2 4 6 8 10 12 14 Latvia Estonia Lithuania Belarus Israel Montenegro Bulgaria Hungary Russia Czech Rep. Poland Slovakia Bosnia Albania Turkey Moldova Croatia Macedonia Romania Ukraine
Recent Developments in the Banking Sector
Banking weaknesses and the global financial crisis has intensified concerns over Ukrainian banks’ ability to rollover foreign liabilities.
Furthermore, a shareholders’ dispute over the six-largest Ukrainian bank triggered a run in deposits in the bank.
To support the bank, the NBU provided UAH 5 billion (about $1 billion) of emergency refinancing and later took control over the bank.
Although this situation is under control, it has undermined confidence of the population in the banking system as a whole.
Affected by distrust, commercial banks have also cut or closed their interbank credit operations. This significantly restricted commercial banks’ access to domestic financial resources.
Experiencing some difficulties in withdrawing cash from several commercial banks’ ATMs, many people rushed to empty their current and saving accounts.
According to NBU estimates, this run cost the banking system about UAH18 billion ($3.5 billion) in October.
Ukraine in the Context of Global Financial Crisis
Ukraine is vulnerable due to a combination of large short term debt repayments, high current account deficits, and banking weaknesses due to non-performing loans and high foreign currency bank liabilities.
Separately, each of the above factors looks manageable, but their confluence amid a deteriorating world economy, easing of steel prices, imminent energy price increase, and turbulent domestic politics have notably affected investors risk assessment of Ukraine.
Reflecting these risks, since mid-2008 the premiums for Ukrainian Credit Default Swaps have risen to over 2,600 basis points in mid-October.
High risk perceptions of emerging markets translated into a decline in portfolio capital inflows to Ukraine: the inflow of portfolio capital declined from US$3.3 billion in the first half of 2007 to only $350 million in the same period of 2008.
Partly as a result, the PFTS index has declined by more than 75% year-to-date (as of October 22, 2008), one of the largest declines in the world.
Recent Exchange Rate Developments
During the first half of 2008, significant inflows of short term capital took place to take advantage of high local interest rates and the perception that an immediate devaluation was unlikely.
However, since mid-year, the economic weaknesses of Ukraine and its vulnerability to the current global liquidity crisis became more evident and foreign capital started to move away from Ukraine.
Coupled with lower export earnings and higher demand for foreign currency to repay imports and debt obligations, it caused sharp Hryvnia weakening in the interbank market.
This weakenning took place despite the fact that during October the NBU sold foreign exchange to the extend of about $3.5 billion, reducing its international reserves from $38.5 bn to $35 bn.
The Hryvnia bid-ask rates depreciated in the interbank FX market from 4.60-4.65 UAH/$ in mid-August to 5.77-6.08 UAH/$ on October 24, 2008.
To restore foreign exchange stability, the Government and the NBU are now seeking a loan from the IMF of about $16 bn.
Other Measures to Address the Financial Sector Turmoil
The NBU has also actively supported banking sector liquidity through its refinancing operations. In October, it provided UAH 20 billion (about $4 billion) of liquidity support to a number of banks.
To build confidence, deposit guarantees were doubled to $20,000 and are planned to increase further.
Furthermore, the NBU has imposed a six-month freeze on the early withdrawal of saving deposits from commercial banks.
It introduced tough limitations on commercial banks credit portfolio growth. However, a few days later, the NBU softened its restriction on growing concerns that this credit squeeze was harming economic growth. The only significant restriction is now that foreign currency loans can be made only to borrowers that have foreign currency income.
The NBU strengthened its monitoring of external private debt. In particular, it required commercial banks to supply with data on their and their clients’ external debt obligations maturing each quarter over the next 12 months.
Several state officials have advocated the need to create a stabilization fund, which would work as a government-owned Asset Recovery Company to buy and resolve some of the distressed assets of the banks.
Medium Term Prospects
Although the combination of larger current account deficits, large short term repayments and tight international liquidity may lead to a financial crisis in the next several months, over the medium term, Ukraine’s economic outlook is still bright.
In the medium term, Ukraine should enjoy higher growth in productivity and GDP, and therefore higher asset prices for the following reasons:
The recent membership into the WTO should stimulate exports.
A FTA under negotiations with the EU would further encourage exports and foreign direct investments (FDI).
FDI will also be supported by an abundant and educated labor supply at wages that are one-third of those in Eastern Europe.
Ukraine large population of 46 million people is an attractive market.
Ukraine agricultural potential is quite high and could become one of the world’s largest grain exporters.
Ukraine’s infrastructure is reasonable as compared to other countries in the region.