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Political unrest leads Ukraine into deeper economic crisis

Increased risk of devaluation


Severe political unrest in Ukraine is expected to have negative effects on the already recession plagued economy. Domestic demand prospects for 2014 now look even weaker, although exports will get some support from an expected devaluation the devaluation risk has risen after Kiev took a sudden pause to increased EU integration. We are lowering our GDP growth forecast further, mainly for 2014. GDP is expected to decline by 1.6 per cent in 2013 (-1.4 per cent in Nordic Outlook, November 2013), then rise by a bleak 0.5 per cent in 2014 (1.7 per cent in latest NO). This is clearly below the consensus view -0.8 per cent and +1.1 per cent, respectively.
Ukraines President Viktor Yanukovichs refusal to sign an EU deal in Vilnius last Friday has sparked the biggest protests since the 2004 Orange Revolution. The protests can be read as the peoples will to integrate more and faster with the Western Europe. However, the protests do not mean Ukraine is united in this respective. Since independence, the population of Ukraine has been divided concerning the countrys orientation towards the EU or Russia. Since Yanukovich assumed office February 25, 2010, he seems to have prioritised the ambition to expand Ukraines ties with the EU, while trying to preserve good relations with Russia. But is Yanukovich now rather leading Ukraine towards increased Russian integration? Before the Vilnius summit, where Ukraine was scheduled to sign the EU trade and association deal, Russia exercised trade and energy pressures against Ukraine. President Putin has launched a customs union with Belarus and Kazakhstan and has declared that he want other former Soviet republics to join. The Russian-led CIS customs union is set to be deepened by 2015 into a Eurasian Economic Union. At the Vilnius summit,

however, Yanukovich said that his ambition still is to sign the EU Association Agreement in the spring of 2014. In brief, this is the background to the rising political uncertainty in Ukraine which is now eroding confidence in financial markets and will affect the real economy going forward. On December 2, 2013, the yield on the junk-rated sovereign USD bonds due June 2014 jumped 274 basis points to a record 19.34 per cent.

The economic situation is fragile. Ukraines weak performance since late 2012 turned into a rapidly deepening crisis this autumn. Third quarter GDP was down 1.5 per cent year-on-year: the fifth straight quarter of negative growth. The economy is being squeezed by falling steel exports, lower Russian demand and an overvalued currency. This helps explain why the current account deficit jumped to 8 per cent in 2012 unsustainable in the long term. We expect no major improvement in 2013. Financial market confidence in Ukraine is severely strained and worsened during last summers global turmoil related to future Fed exit policy. On November 1, S&P also lowered Ukraines credit rating to the same junk status (B-) as Greece. The current account deficit and central bank interventions to support the hryvnia this past year have depleted the

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Economic Insights

currency reserve. At USD 5 billion, the third quarter deficit was more than twice that of the second quarter. The reserve is at its lowest in more than six years and barely covers three months imports normally a critical threshold. Making the situation worse is that the government has a large short-term external borrowing requirement, though its debt is low.

uncertainty, not least concerning Ukraines choice in foreign policy: west or east or both?

Mikael Johansson, Head of CEE Research, SEB Economic Research + 46 8 763 80 93 Andreas Johnson, Ukraine and Russia Analyst, SEB Economic Research + 46 8 763 80 32

We are sticking to our forecast in Octobers Eastern European Outlook and in Novembers Nordic Outlook that there will be a devaluation of at least 10 per cent in the first quarter of 2014. Our main scenario is that there will be a controlled devaluation, although risks of an uncontrolled devaluation have risen lately due to rising political uncertainty and the deepening economic crisis. A collapse of the current coalition government, led by Yanukovichs Party of Regions, cannot be ruled out. The expected controlled devaluation is likely to be coupled with a new IMF bail-out loan. In exchange, we expect the IMF to demand lower gas subsidies, among other things. Notably, for years the IMFs Ukraine reports have called for a more flexible exchange rate, instead of todays semipegged system in which the central bank tries to keep the hryvnia stable against the USD. An exchange rate adjustment would thus probably be accepted as part of coming to grips with the current account deficit. However, the possibility of the IMF providing loans may have been reduced after Yanukovichs last minute refusal to sign the EU deal. Devaluation would help stimulate exports in 2014 but risk creating short-term strains in the banking system, since about 40 per cent of borrowing is in foreign currencies and the total percentage of bad loans is relatively high. In the short-term, household purchasing power will be negatively affected by the devaluation. At the moment inflation is low, close to zero, but in 2014 inflation will take off, driven by the devaluation. We expect annual average inflation at 4-5 per cent in 2014. Thus, private consumption will not provide much support to growth next year. At the same time, capital spending will be hampered by the high degree of political