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Swedbank Baltic Sea Analysis - No.27


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Swedbank Baltic Sea Analysis - No.27

  1. 1. Swedbank Baltic Sea Analysis No. 27 18 November 2010 Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740 e-mail: Internet: Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720. Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897 Ukraine The economy is stabilising, but the recovery is threatened by inflation and political concerns • The economic slowdown brought on by the international financial crisis appears to have bottomed out, and Ukraine’s growth has accelerated in 2010. We are revising our forecast for 2010 upward to 4.0% and predict continued but, compared with our previous projection, moderate growth of 4.3% in 2011. Significantly higher growth is needed to regain what was lost during the crisis. • The biggest risks in the short term are higher inflation and continued expansive fiscal policies. Price increases have reached over 10% and concerns are spreading to the exchange rate market, where the central bank has been forced to step in and buy hryvnia. The government will find it tough to tighten fiscal policy to prevent increases in food and energy prices from spreading through the economy, which would doubly hurt households. • In the medium term the pace of reform must be intensified to raise productivity and growth. This will require extensive reforms, not least the liberalisation of key markets such as energy. The government is likely to face strong resistance from entrenched interest groups. In addition, it has to create enough budget flexibility to increase public infrastructure investment without letting the deficit grow. Since the election in February, President Viktor Yanukovych has consolidated his power. An amendment to the constitution gives him more opportunity to control parliament, at the same time that the opposition has splintered and faces accusations of corruption during its time in power. In terms of foreign policy, the new Presidential power has increased since the election
  2. 2. 2 Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 leadership is balancing Russia's need for influence in the region with the importance of maintaining good relations, especially economic, with major Western economies. Economic developments in 2010 have been favourable for Ukraine. High growth in countries like Germany and China has created demand for Ukrainian input goods, especially in the metals industry. Increasing liquidity in international financial markets has at the same time led to a return of capital inflows. In September Ukraine successfully placed a government- guaranteed Eurobond for infrastructure investments at a lower interest rate than for example Greece. Clear indications from the IMF that Ukraine met its lending conditions for September sent further positive signals to the market. A rebound in growth, but from low levels During the first half of 2010 Ukraine’s economy again began to grow. The growth rate was nearly 5% during the first three quarters, compared with the same period in 2009, although this was from exceptionally low levels. As a whole, GDP fell by slightly over 19% between the third quarter of 2008 and the end of 2009 and by mid-2010 had only returned to the level it had reached four years earlier. Real GDP level and growth, QI 2006 – QIII 2010 -25 -20 -15 -10 -5 0 5 10 15 90 95 100 105 110 115 120 125 130 GDP level (2005=100) GDP growth (annual in %; right hand scale) Source: State Statistics Committee of Ukraine. Growth impulses are mainly coming from external demand. Demand for input goods, which benefits Ukraine’s traditional industry structure, is growing in Germany and Asia’s emerging economies. This is reflected in rising prices and growing production. Steel production has bounced back strongly after a steep decline in late 2008 and early 2009, and the industrial sector as a whole has grown by nearly 15% in 2010. There is still far to go before returning to the production levels before the crisis, which indicates that there is probably considerable unutilised capacity in Ukrainian industry. At the same time, however, there is a risk that the country’s production structure has become outdated and that many companies have dropped Global demand and increased interest from capital markets have been positive for Ukraine Ukraine is growing again Industrial production is benefiting from global demand
  3. 3. Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 3 out of the market during the financial crisis. It could be difficult therefore to quickly adapt production levels to growing demand. Development in the steel sector, Jan 2006 – Sep 2010 -100 -50 0 50 100 150 200 250 0 500 1000 1500 2000 2500 3000 3500 4000 4500 Steel production (volume) Steel production (annual growth in %; right hand scale) Steel prices, 2005=100; right hand scale) Source: Ecowin. Domestic demand has also rebounded in 2010, but to a somewhat more limited extent. Wage earners have been hit hard by falling real wages, and unemployment rose from around 6% to 9.5% of the labour force. The number of registered unemployed was around 400 000 in September, compared with 540 000 in the same period of 2009. Lower inflation has led to rising real wages and has stabilised consumer confidence. After a major downturn in 2009, consumer spending again began to rise in mid-2010, which is also reflected in growing retail activity. Domestic demand and unemployment, Q1 2007 – Q3 2010 -20 -15 -10 -5 0 5 10 15 20 25 Real consumption (annual change in %) Real wages (annual change in %) Unemployment rate (% of labour force) Source: Ecowin. The political landscape continues to be dominated by conflict. President Viktor Yanukovych’s party gained ground in local elections in late October, while the biggest opposition party, led by Yulia Tymoshenko, lost support. Accusations of election fraud were widespread. The European Union and the US have officially issued protests, but thus far there have been no serious local protests. Falling real wages are hurting Ukrainians more than unemployment Political hostility cemented
  4. 4. 4 Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 International relations have also showed signs of improving. Ukraine and the IMF reached a new loan agreement in the summer of 2010 after the previous programme went off-track during the presidential election campaign in 2009. The new loan of around USD15bn will be paid out in quarterly instalments through 2012. However, Ukraine must meet the following conditions: • Reduce the budget deficit to 2.5% by 2012. The aim is to eventually shrink government debt and boost confidence in Ukrainian fiscal policy. In 2009 the budget deficit was about 8.5% of GDP, and austerity measures are being introduced, mainly through spending cuts representing about 4% of GDP. • Continued reforms in the gas sector. Monopolisation and administrative price setting have created inefficiencies and considerable losses for the public sector. Reforms and liberalisation will lead to major price increases at the consumer level, and price subsidies for other sectors will be reduced as well. • Stabilise the financial sector by recapitalising the banks and strengthening oversight. • Shift the emphasis of monetary policy to price stability, which would create more exchange rate flexibility. Large parts of the IMF programme will be a hard sell politically. Fiscal austerity will hurt Ukrainians through lower social spending and higher taxes. Gas prices at the consumer level will rise, and exchange rate flexibility creates uncertainty. A recent review indicated that the programme is progressing as planned. Authorities are worried about the political risks of a more volatile exchange rate, however. Many households and companies still have a large share of their loans denominated in dollars, and a market-based exchange rate increases risks for many stake holders in the economy. Considerable macroeconomic imbalances Notwithstanding the relatively positive economic development in 2010, considerable economic challenges remain for Ukraine. In the short term rising inflation and exchange rate concerns are the biggest threats to continued growth. The financial sector is shackled as well by doubtful receivables and volatile financing. The global economy, which is likely to slow next year, could pose another challenge to Ukraine’s economic policies. Although the annual inflation rate fell to 10.1% in October, price stability is threatened by expansive fiscal policies and substantial increases in food and energy prices. Gas prices at the consumer level rose by 50% in August, with another 50% increase planned early next year. At the same time local food prices are affected by global markets, despite the introduction of export restrictions after the wild fires in Russia last summer. New IMF programme requires more austerity and liberalisation Implementation of the IMF programme is politically controversial Significant challenges remain before economic stability can be achieved Inflation could accelerate
  5. 5. Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 5 Inflation and exchange rates, Jan 2005 – Oct 2010 0 5 10 15 20 25 30 35 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 EUR/UAH USD/UAH Inflation (annual change in %;righthand scale) Source: Ecowin. Growing price uncertainty has also weakened confidence in the hryvnia. Many households and businesses have decided to reduce their exposure to the local currency, and Ukraine's central bank has been forced to increase purchases of the hryvnia to keep the exchange rate stable against the dollar. The IMF’s demand to increase exchange rate flexibility probably also plays a role. Growing capital inflows, including from the IMF, are strengthening the ability of the central bank to defend the exchange rate in the short term. At the same time higher inflation pressures could erode Ukraine’s competitiveness and lead to a weakening of the hryvnia over time. The financial sector remains under pressure and lending continues to shrink. Due to uncertainty about the solvency of many borrowers, many banks are limiting their lending volumes, which have contracted since late 2009. Even though the share of loans denominated in foreign currency has shrunk from 60% at its peak to 47% in September of this year, this is still a considerable risk for banks, especially considering uncertainty about the exchange rate. A recently conducted survey of the 60 largest banks indicates that they need around 40 billion hryvnia in additional capital, nearly half by state-owned financial institutions. It is unlikely that the private sector will show a substantial pick up before the banking sector is reformed and consolidated. An appreciation of the real exchange rate and falling competitiveness are long-term threats A long way to go before the financial sector normalizes
  6. 6. 6 Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 Credit expansion, Jan 2006 – Sep 2010 0 100 200 300 400 500 600 700 800 900 1000 -10.0 0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0 Credit(annual change in %) Creditvolume (UAH bn.;right hand scale) Source: Ecowin. Despite a further reduction of the current account deficit, Ukraine is still vulnerable to external market forces. In terms of energy, it is dependent on gas imports from Russia, and exports are concentrated in a few sectors. During the financial crisis commodity and input good producers faced falling demand, while the agricultural and food sectors managed better. At the same time foreign debt has increased substantially, from around 55% of GDP in 2008 to nearly 90% at the end of 2009. The Ukrainian economy is, thus, becoming increasingly dependent on capital market fluctuations and sentiment. Export composition (USD billions) 0 10000 20000 30000 40000 50000 60000 70000 80000 2007 2008 2009 Base metals Mineral,paper and chemical products Machinery Agriculture and food Textiles and clothes Other Source: State Statistics Committee of Ukraine. Consistent growth requires discipline and reforms We are revising our growth forecast for 2010 upward from 3.5% to 4.0%, but at the same time lowering our forecast for 2011 to 4.3% (vs. 4.5% in our August forecast). The Ukrainian industrial sector is the biggest short-term beneficiary of stronger market demand, especially for metals. As the impact of inventory spending and the fiscal stimulus wanes in 2011, external demand will decrease. We are also forecasting that inflation will reach Ukraine is highly dependent on the rest of the world Our forecast indicates slightly lower growth and higher inflation in coming years
  7. 7. Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 7 11% in 2010, in no small part due to administrative price increases in the gas sector, which are likely to affect the overall price level as well. The exchange rate is expected to remain stable, even if the hryvnia depreciates slightly against the dollar at the end of the period as a result of higher inflation and more flexible exchange rate policies. The budget deficit is shrinking, but probably not enough to meet the IMF’s demands. This could delay loan payments, which would create additional concerns and more volatility for Ukraine’s economy. Ukraine: Key economic indicator projections 2007 2008 2009 2010 2011 2012 proj. proj. proj. Real GDP growth (%) 8.1 2.8 -15.2 4.0 4.3 4.8 Inflation (%, ave) 12.8 25.3 16.0 11.7 10.0 8.5 Inflation (%, eop) 16.6 22.3 12.3 11.0 9.0 8.0 Unemployment rate (% of labour force) 6.4 6.4 8.8 8.0 7.5 7.0 Current account (% of GDP) -3.7 -7.1 -1.5 -1.0 -2.0 -3.0 Fiscal deficit (% of GDP) * -2.0 -3.2 -6.2 -5.7 -4.0 -3.0 Government debt (% of GDP) 12.3 19.9 34.6 40.0 42.0 43.0 USD/UAH (eop) 5.1 7.8 7.9 8.0 8.2 8.5 * Excludes Naftogaz Ukraine Sources: Authorities, IMF and Swedbank's projections. Consistent growth in the medium term will require not only short- term economic stabilisation, but also that the reform process is sped up and extended. A fiscal consolidation which leaves room for investments in public infrastructure could lead to renewed confidence in Ukraine’s growth potential among both private domestic investors and international players. At the same time Ukrainian policies have to become more predictable and the arbitrariness has to be reduced. Corruption and bureaucratic inefficiencies are major obstacles to private sector development. Stronger oversight, together with deregulation, would also lead to greater competition and a needed increase in economic growth. Magnus Alvesson Economic Research Department SE-105 34 Stockholm Telephone +46-08-5859 1000 Legally responsible publishers Cecilia Hermansson, +46-8-5859 7720 Magnus Alvesson, +46-8-5859 3341 Jörgen Kennemar, +46-8-5859 7730 ISSN 1103-4897 Swedbank Baltic Sea Analysis is published as a service to our customers. We believe that we have used reliable sources and methods in the preparation of the analyses reported in this publication. However, we cannot guarantee the accuracy or completeness of the report and cannot be held responsible for any error or omission in the underlying material or its use. Readers are encouraged to base any (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in Swedbank Baltic Sea Analysis. A more aggressive reform process will be critical to growth potential