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The economy’s resilience to global turmoil depends on global demand for steel Balance-of-payments is unsustainable, FX adjustment is a matter of time Banks have mostly improved their balances, yet are exposed to FX risks Internal politics will keep hindering decision-making on key policies The economy: Doing better than expected
Private and quasi-private investment spending related to the Euro-2012 championship provides some cushion against the global economic slowdown, keeping economic growth relatively robust in the baseline scenario. Yet, the Ukrainian economy would be unlikely to withstand a significant fall in global demand for steel in the negative scenario.
Ukraine Trip Notes
Preparing for challenging times
When will the UAH depreciate?
The current account deficit reached 4.7% (12m ma) of GDP in August and is on the way to double digits in 2012. The financial account is exposed to global financial markets’ stress. It makes the UAH weakening inevitable and desirable, in our view. Most likely, it will take place early next year.
14 October 2011
Alexander Morozov Chief Economist HSBC Bank (RR) (Limited Liability Company) +7495 783 8855 email@example.com Artem Biryukov Economist HSBC Bank (RR) (Limited Liability Company) +7495 721 1515 firstname.lastname@example.org
Banks face FX risk challenge
Banks have a UAH65bn net short FX position (IAS definition) and have regulatory troubles in covering it on the FX market. Significant UAH depreciation might trigger the need for another round of banks’ recapitalization.
Fallen popularity hinders needed reforms
The popularity of the ruling Ukraine’s Regions Party has substantially declined since the last elections, posing a threat of losing control in the Parliament after the October 2012 elections. Therefore, such unpopular decisions as hikes in natural gas and communal services tariffs, which are the key stumbling blocks for resumption of lending from the IMF, have been being compromised.
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Chart 1. international financial organizations.Economics CEMEA 14 October 2011 abc Preparing for challenging times We had a fruitful client trip to Ukraine on October 5-6. LHS) Global Steel IDX (RHS) USD/tonne 300 250 0 -6 -12 150 -18 -24 Q2 2005 Q4 2005 Q2 2006 Q4 2006 Q2 2007 Q4 2007 Q2 2008 Q4 2008 Q2 2009 Q4 2009 Q2 2010 Q4 2010 Q2 2011 Q4 2011 Q2 2012 Q4 2012 100 200 Source: State Statistics Committee of Ukraine. and think tanks.5% in 2012 (5.5% before) and 4.9% in 2011 (4. y-o-y 12 6 GDP (forecast. banks and corporates. we are slightly revising our GDP growth projections for Ukraine. GDP growth in Ukraine has accelerated to 7.1% before). The economy is resilient for now Accounting for recent trends and the likely dynamics of growth factors in 2012. GDP growth and steel prices GDP (LHS) %. according to the NBU’s and government’s estimates. Although steel prices and steel exports from Ukraine are exposed to downside risks taking into account the uncertainty about global economic outlook. Private consumption is still recovering from the crisis and is still supporting strong growth of retail sales.5% y-o-y and to c5% y-t-d in July on rich agricultural crops. During the trip we met with officials. Below are our major takeaways from the trip. We foresee GDP of 4. at the moment Ukrainian metallurgy seems to be doing quite well. Reuters 2 . We have selected those that appear to be the most topical these days. After some moderation in 2Q.
85 Jan-11 Source: Reuters.10 1. Correspondingly.95 0. y-o-y 40 30 20 10 0 -10 -20 -30 -40 Dec-07 Dec-08 Dec-09 Real wages %. y-o-y 40 30 20 10 0 -10 -20 -30 -40 Dec-10 Oct-07 Oct-08 Oct-09 Feb-08 Feb-09 Feb-10 Oct-10 Feb-11 Jun-07 Aug-07 Jun-08 Aug-08 Jun-09 Aug-09 Jun-10 Aug-10 Jun-11 Source: State Statistics Committee of Ukraine The slowdown of economic growth and imports growth in Russia that we expect in 2012 is likely to temper Ukrainian exports growth and to restrain GDP growth next year.0% in 2012.05 1. Retail sales and real wages Retail trade turnover %.90 0.25 1.0pp to 5.Economics CEMEA 14 October 2011 abc Chart 2.00 0. FX rates UAH Index 1.6-1. The Ministry of Economic Development and Trade (MOEDT) expects that spending related to the EURO2012 football championship that Ukraine will co-host with Poland will boost GDP growth by 0. Agreeing with the MOEDT on that.20 appreciation ← → depreciation 1. negative contribution of net exports to GDP growth will be higher in our baseline scenario for Ukraine. we expect much higher growth of imports to Ukraine than the MOEDT. Depreciation risks priced in We expect that the UAH will be allowed to weaken through a series of mini-devaluations beginning in Chart 3.15 1. HSBC EUR RUB TRY PLN Feb-11 Mar-11 Apr-11 May -11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Aug-11 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 3 .
It is almost a consensus view locally that current levels of cross-rates would trigger UAH depreciation at some point. the depreciation of UAHUSD could be removed from the policy agenda. the UAH has not. We think that these projections significantly underestimate imports growth. We see both trade deficit and current account deficit staying on an unsustainable track. We foresee it widening further to double-digits in 2012. Trade balance and current account Current account (% of GDP. which would pose a serious threat to the currency stability even if global financial markets are in good shape. the 12-month rolling current account deficit has already widened to 4.5 our end-2012 forecast. even if the situation on global financial markets and global economy improves. If the UAH is on its road to devalue then the key questions are the following: When? And by how much? Chart 4.7% of GDP in August. withstanding this trend stemming from the fundamental factors would be a mistake. RHS) Current account (LHS) USD bn 1 0 -1 -2 -3 -4 -5 2Q2006 4Q2006 2Q2007 4Q2007 2Q2008 4Q2008 Trade balance (% of GDP. making imports cheaper and adding depreciation pressures arising from the financial account of balance-of-payments to pressures arising from current account. Yet. Should and will it? We think it should and will. while most EM and DM currencies depreciated versus the USD over past weeks. The centre of discussion among locals is mostly focused on the issue of sustainability of the current market turmoil and EM currency weakness. According to the NBU.Economics CEMEA 14 October 2011 abc early-2012. We revise upward to UAHUSD9. The present market situation just accelerates the trend. Trade balance projections that we have seen reflect expectations of the same or even narrowing trade and current deficit in the coming quarters if external conditions that existed in mid-2011 are restored. So. if sustained. RHS) Trade balance (LHS) % of GDP 3 0 -3 -6 -9 -12 -15 2Q2009 4Q2009 2Q2010 4Q2010 2Q2011 Source: National Bank of Ukraine 4 . The NBU has lost more than USD3bn of reserves in September and is likely to keep losing them down the road. there is general belief that if the USD weakens relative to other currencies. in our opinion. The hryvnya (UAH) is pegged to the USD with almost no fluctuations allowed de facto. Therefore.9 from UAHUSD9.
Banks’ lending and overall economic growth could also be compromised as a result of such policies. made as a one-off move (in the case of fixed currencies). slightly revised upward from UAHUSD9. it ought to be significant. and negative political repercussions of any UAH devaluation (see last section) hinder the decision-making process on the currency. An issuance of USD-linked bonds can provide only a partial solution to this problem. In order to make the devaluation credible. in order to offset the pressures the NBU is forced to keep the UAH liquidity low. Kazakhstan did it with success in 2009. All factors considered. It spoils the local bond market. This is our new forecast.Economics CEMEA 14 October 2011 abc Chart 5. the way we believe the Ukrainian authorities are mostly likely to follow would be a series of mini-devaluations complemented by restrictive measures for FX market participants.9 by end-2012. Therefore. close to market expectations. not allowing the MOF to borrow at acceptable yields. We also expect that after parliamentary elections that are to be hold in October 2012. the UAH will be allowed to weaken to a greater degree than in the previous quarters. 5 . Losing reserves month by month is not the best strategy to follow when international reserves cover less than five months of imports. Yet. we think it is quite likely that the NBU will be slow in adjusting the UAH’s value. waiting for too long is very costly. However. International reserves International reserves (RHS) months of imports 8 International reserves/months of imports (LHS) USD bn 40 6 35 4 30 2 25 0 Jul-08 Mar-09 Jul-09 Mar-10 Jul-10 Mar-11 Sep-08 Jan-09 Sep-09 Jan-10 Sep-10 Jan-11 Jul-11 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Sep-11 20 Source: National Bank of Ukraine Since the authorities are not fully convinced at present of the necessity of the UAH devaluation and strong pressures on the NBU’s reserves emerged only in September. it might take the whole 2012 for the UAH to devalue to UAHUSD9. and local interest rates high. The significant short FX position of the banking sector (see next section).5 that we had before. we think that the UAH will depreciate in early-2012. Devaluation expectations will not go away easily and the pressures on the NBU’s reserves will most likely be sustained. Devaluation can be done in various ways. Besides. the public commitment to maintaining stable currency until year-end made by the NBU.
5 Dec-09 Oct-09 Dec-10 Oct-10 Apr-08 Apr-09 Apr-10 Feb-09 Jun-08 Aug-08 Jun-09 Aug-09 Feb-10 Feb-11 Jun-10 Aug-10 Apr-11 Jun-11 Source: National Bank of Ukraine 6 Aug-11 .0 7.5 10.0 9. occasional evidence suggests that the ratio should Chart 7.0 10. Banks’ recovery at risk Existing regulations forced Ukrainian banks to accumulate a net short FX position of UAH67bn at present.0 1. However.5 2.2 2.5 11.8 1.1 2.4 2. which represents a significant risk for banks’ capital if the UAH depreciates.Economics CEMEA 14 October 2011 abc Chart 6.5 9. Loans and deposits Loans (LHS) UAH bn 800 700 600 500 400 300 200 Dec-08 Oct-08 Deposits (LHS) Loan-to-deposits ratio (RHS) 2. above 170%. to large corporates and small businesses) has been occurring since January 2011.0 8.5 1M Source: Reuters 12-Oct-11 12-Oct-11 2M 3M 6M 9M 1Y 18M We think that the UAH will continue to weaken in 2013 but at a slower pace since we believe the current account deficit is likely to start narrowing by then.7 1.9 1. A steady inflow of deposits has been taking place since March 2010 and the steady increase in banks’ loan books (mostly.3 2. UAH NDF outright UAH/USD 11. Ukrainian banks have started recovering from the 2008-09 crisis after being recapitalized.5 8.6 1. The loan-to-deposit ratio for the banking sector at large stays high.
banks have an almost balanced FX position. Writing off of problem assets is still a problem despite recent positive changes in the legislation to this matter. Political preferences If parliamentary elections were held next Sunday how would you vote? Apr 2010 Aug 2010 Oct 2010 Feb 2011 Apr 2011 May 2011 % 40 30 20 10 0 Yulia Bloc “ Sv oboda” Communist party of Ukraine (Sy monenko) Source: Razumkov Centre Party of Regions “UDAR” (Kly chko) “Sy lna Ukray ina” (Tihipko) “Front Zmin” Against all (Yatseniuk) Would not Hard to say v ote Ty moshenko (Tiahny bok) 7 . A key challenge that banks face these days is their high exposure to FX risks. This net short FX position emerges when International Accounting Standards (IAS) are applied. Now it may backfire to the detriment of the stability of the banking system as banks can not close their net short FX position or hedge it on the FX market due to the regulatory restrictions on such operations. are not backed by the deposit base.Economics CEMEA 14 October 2011 abc be close to 100% for new loans. a study of Forum for Leading International Financial Institutions has revealed. Banks have concerns regarding how this legislation will be enforced. It is important that while the UAH exchange rate remains stable. An issuance of USD-linked government bonds is just a part of the solution. Old loans. Chart 8. banks should be able to withstand the UAH devaluation up to 20%. Local experts on the banking sector estimate NPLs at 20-25% or higher (if restructured loans are included). however. in our view. The good news is that these NPLs fall on the pre-crisis loan book and have been identified. The banking sector has a net short FX position of cUAH67bn. From a local regulator perspective. According to a stress-test performed by EBRD on a pool of the local partner banks. This problem emerged when the NBU has disallowed making FX provisions against FX assets forcing banks to form them in the UAH. including restructured ones. Greater devaluation would make it necessary to recapitalize some banks. the regulator together with banks find a credible solution to the problem of banks’ high FX exposure.
It was one of the key structural conditions of the stand-by program with the IMF.Economics CEMEA 14 October 2011 abc Uneasy politics and the IMF The diminished popularity of the coalition government led by Regions of Ukraine Party has significantly reduced space for policy manoeuvres and put on hold the stand-by program with the IMF. the mediumterm fiscal and debt sustainability remains uncertain. We understand that the IMF does not consider it possible to compromise on that issue. As a result. Yet. the imprisonment of the former PM Yulia Timoshenko. Rev enues 2009 UAH bn 250 200 150 100 50 0 Jan Source: MOF Rev enues 2010 Rev enues 2011 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 8 . getting official funding could be more difficult than before. the government seems sufficiently covered with resources in the near-short term. In this respect. the government failed to hike communal tariffs and natural gas prices for households. who was also the key rival of President Yanukovich at the last presidential elections. We believe that the tariff hike will occur either in early January 2012 or in 2Q when the heating season is over in order to minimize an impact on the housing bill from higher natural gas and heating tariffs. The popularity of the coalition government has fallen since spring 2010 on the hardships related to slow recovery from the economic crisis and socially painful fiscal tightening. given that overall gas price subsidies in Ukraine amount to 56% of GDP and Ukraine has a poor track record on delivering gas price hikes in the past. Enacting pension reform that inter alia includes an increase in pension age and an increase in minimum length of services the government has improved the sustainability of the state Pension Fund. If Regions of Ukraine fails to improve its political ratings by the time of the October 2012 parliamentary elections. Specifically. We think that in the end Ukraine will have to raise gas and communal tariffs as financial markets are unlikely to be ready to provide much funding for Ukraine any time soon and there is no real alternative to IMF funding. given still rising debt-to-GDP ratio and political uncertainties in Ukraine. which is another key structural condition of the stand-by program. Budget revenues performance Ukraine has to increase natural gas tariffs for households by 30%. and heating tariffs by 50% in order to comply with the program. Budget deficit and public debt While market based budget deficit financing and public debt refinancing have become troublesome. Yet. Chart 9. may spoil Ukraine’s economic relations with the Western countries. the elections could unpredictably transform political landscape in Ukraine bringing to power a coalition of opposition parties.
5% of GDP consolidated (i. The government should be able to close any remaining cash gap in the budget this year through cuts of non-essential budget spending and/or issuance of dollar-linked bonds. We understand that this factor has not been accounted for in the official fiscal projections at the moment.5% of GDP budget deficit target in 2012 could become a more serious challenge for the government than the 3. Naftogas faces a cash gap of UAH21bn (USD2. It is not very likely. the currently poor collection rate in the communal sector of c70% would likely decline with any rise in gas prices. though most likely at a higher interest rate. More importantly. Therefore. which could compromise its WTO membership and move back prospects of closer economic integration with the EU. reaching 2. If FX risks materialize as we expect. Better than planned revenue performance and substantial cash balances that the MOF accumulated should help to make debt payments this year even if international financial markets remain closed.6bn on maturing Eurobonds in 4Q. the state-owned Naftogas is likely to have a cash gap of UAH8bn (USD1bn). In the absence of energy tariffs hikes for households so far this year. We think that Ukraine can get substantial discounts from the price of imported natural gas from Russia during the ongoing negotiations with the Russian side only at the expense of serious political and/or economic concessions. Fiscal performance has improved Deficit (–)/ surplus (+) (RHS) UAH bn 40 30 20 10 0 -10 -20 -30 -40 Mar-10 Mar-09 Sep-09 Revenues (LHS) Expenditures (LHS) UAH bn 20 15 10 5 0 -5 -10 -15 -20 Mar-11 Jul-10 Sep-10 Jan-10 Jan-11 Jul-09 May-10 May-09 Source: Ministry of Finance of Ukraine Ukraine has to repay USD2bn to Russian VTB bank and USD0. which are in good demand by local banks that need them in order to hedge FX risks. Ukraine should be able prolong the loan to VTB for another six months. It leaves the government with the challenge of meeting 3.5bn) has been provided as state subsidy to Naftogas in a draft state budget for 2012. including Naftogas) budget deficit target this year.e.6bn) in 2012 as well. We think that the Naftogas cash gap in 2012 potentiall could be even higher.Economics CEMEA 14 October 2011 abc Chart 10. May-11 Nov-09 Nov-10 Jul-11 9 . of which only UAH12bn (USD1.5% deficit target this year. we reckon. the UAH denominated cash gap would increase because Ukraine consumes mostly imported natural gas. Besides.
This has reduced the capacity of the Ministry to negotiate with market participants.Economics CEMEA 14 October 2011 abc Chart 11 External public debt General government (LHS) Central government guarantees (LHS) USD bn 50 Monetary authorities (LHS) Public debt to GDP (RHS) % of GDP 50 40 40 30 30 20 20 10 10 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 2005 2005 2005 2005 2006 2006 2006 2006 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 Source: MOF. NBU. Internal public debt Central government debt (LHS) Central government guarantees (LHS) USD bn 25 NBU loans to central government (LHS) State Domestic Debt to GDP ratio (RHS) % of GDP 15 20 12 15 9 10 6 5 3 0 Q1 -5 2005 Q3 2005 Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 Q1 2010 Q3 2010 Q1 2011 0 -3 Source: MOF. after Chart 12. in our opinion. which would not be easy to replace with market-based funding. HSBC 10 . Unfortunately. At present. Besides. In 2012-13 Ukraine will have to repay over USD5bn to the IMF. the rest of the market would be unlikely to be eager to buy local government’s bonds or Eurobonds until after the UAH depreciation. the State Debt department of the MOF lost qualified staff. public and publicly guaranteed debt exceeds 40% of GDP and still remains on the rising track. in the process of the ongoing civil service reform. Apart from local banks’ demand for local dollarlinked bonds. HSBC 0 The longer-term fiscal and public debt outlook remains uncertain.
This can only partially be attributed to global factors. financially and politically. The good news is that the outlook for Ukraine does not suggest the repetition of the abysmal 2008 crisis. All this speaks for the presence of significant fiscal risks in the medium-term. 11 . hike energy tariffs and ensure political stability after next year’s parliamentary elections. We think that the Ukrainian sovereign credit is likely to remain distressed until natural gas tariffs are increased. and IMF funding is resumed. the exchange rate is adjusted to a sustainable level.Economics CEMEA 14 October 2011 abc 2012 parliamentary elections the overall decisionmaking process in the country could be compromised. Conclusion Ukraine faces challenging times economically. The bad news is that Ukraine is likely to need to face FX adjustment.
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