Agshin Mirzazade and Oleksandr Shkurpat of Foyil Securities -

Though rising inflation has hit the whole of Central and Eastern Europe, Ukraine is suffering more than most. Analysts expect the rate to top 20% this year, but if the National Bank of Ukraine summons up the courage and acts decisively, the spike in prices can be brought quickly under control.

A combination of soaring food prices, a step-up in the cost of energy imported from Russia and cash injected into the economy through the banking sector has driven up Ukrainian inflation faster than elsewhere in the region, turning it into a major headache.

Ukrainian inflation at the moment is primarily cost-based inflation. We should not exclude, though, the negative impact on inflation from the demand side, which is being driven by the increasing social welfare spending of the government (a 31% rise in the minimum wage in 2008 and a return of the €770m in lost savings in the former Soviet Savings Bank, Oschadbank). However, given the strict monetary policy conducted of the National Bank of Ukraine (NBU) since the beginning of the year, which sterilized UAH18bn (€2.31bn) and raised the NBU's discount rate by 2 percentage points to 10% since January 1, the impact of rising demand has been overshadowed.

Monetary austerity doesn't seem to be the right instrument for curbing inflation, since CPI growth in the first quarter of this year accelerated to 9.7% growth on year even as the monetary base declined by 3.9%. At the same time, we observed the negative impact of monetary tightening on industrial production, which in March decelerated by 5.7 points to 5.8% growth on month, largely as a result of the rising costs of domestic financial resources.

The vicious circle of curbing inflation at the expense of economic growth could be broken by the simple mechanism of revaluing the currency. However, given the current exchange rate policy of maintaining the US dollar peg within the UAH/USD 4.95-5.25 corridor, this remains an unlikely solution for the meantime.

The main argument against currency revaluation - that the current exchange rate stability is needed to support domestic exporting industries - is not persuasive, however. The real effective exchange rate of the hryvnia rose by 3.87% over the first two months of this year, thereby worsening foreign trade conditions for Ukrainian exporters. Another argument against currency revaluation is the lack of political consensus on this issue between the ruling coalition of national democrats and the nominally pro-Russian, statist opposition, as well as among the coalition members themselves.

Nevertheless, weak economic results over the first quarter of the monetary policy of the NBU should help push the central bank authorities to allow formal currency revaluation in order to reduce inflationary pressures.

Taking into account the increasing contribution of the domestic market to economic growth and the need for technology imports for the modernization of the Ukrainian economy, we think the NBU should allow for a 2-3% currency revaluation during the second and third quarters. This should result in a relative decline in the value of oil and gas imports, which would translate into declining pressure of PPI inflation (12.4% on year in the first quarter), thereby compensating for the possible reduction of Ukrainian exports.

Investing improvement

Apart from the current negative economic trends, the Ukrainian investment climate has significantly improved, allowing the Ukrainian economy to attract $9.2bn of FDI in 2007, according to NBU statistics. Moreover, the Ukrainian government was investor-friendly back in 2005 when the strategic sale of Kryvorizhstal steel mill to Arcelor-Mittal was completed and hailed as a transparent and market-based auction. At the same time, problems like smuggling have been reduced by the government's effort to increase the transparency of the Ukrainian customs services that used to distort domestic competition.

Another significant impulse for improving the Ukrainian investment climate and attracting FDI in 2008 should come from the finalization of the country's WTO accession, which is expected in the first half of May. In our view, adoption of common foreign trade principles should stimulate foreign companies to increase investments in Ukraine, despite the current problem with inflation, driven primarily by the prospects of long-term growth on the back of increasing domestic demand and countrywide infrastructure modernization and development in the course of preparations for the Euro 2012 European football championship.

In our opinion, the NBU should not engage in further monetary tightening and allow a 2-3% revaluation of the national currency during the next two quarters. This should result in the slowing of PPI inflation followed by a similar effect on CPI inflation and an acceleration of industrial production growth to 9.2% in 2008. A less restrictive monetary policy would allow for 6.5% real GDP growth in 2008, though annual inflation should increase to 21%. We believe the 2008 inflation hike wouldn't continue in 2009, as we expect commodity and energy resources prices to cool down on global markets as a result of the global economic slowdown predicted in 2008. Thus, by the beginning of 2009, inflation should start to decelerate and fall below 10% in 2010.

Agshin Mirzazade is deputy head of research and Oleksandr Shkurpat is equity research analyst at Foyil Securities

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