Vitaliy Vavryshchuk of Dragon Capital -

Following years of buoyant growth, Ukrainian banks have recently found themselves operating in much tougher market conditions after the National Bank of Ukraine (NBU) switched to a restrictive monetary policy. Over the last three years, Ukrainian banks have enjoyed strong inflows of funding, with NBU foreign exchange interventions being the key hryvnia supply channel for the sector.

Pursuing a de facto currency peg, the NBU had to intervene regularly to buy out foreign currency surpluses and inject more hryvnia into the economy. In 2007, the central bank purchased $7.6bn from the market, in exchange providing the banking system with a largely unsterilized UAH38.4bn (5.4% of 2007 GDP) and thus creating a strong growth base for banks.

The NBU's balancing interventions on the forex market proved favourable for banks as they received a virtually unlimited source of hryvnia funding. Yet the policy of exchange rate targeting undermined the efficiency of monetary policy instruments, loosening the NBU's control over the monetary supply and, in effect, over inflation.

Shifting to a restrictive monetary policy, the NBU aimed to lessen its forex interventions from March, making hryvnia resources scarce. Over the first eight months of 2008, the NBU bought $6.6bn (5.2% of first-half GDP) from the interbank market as compared to $6.1bn (7.4% of GDP) in the same period a year ago. The NBU's more restrictive measures, aimed at curbing inflationary pressures, prompted a hryvnia deficit at local banks; money market interest rates peaked at an average of 17% in the second quarter from the usual 2-5% in 2007.

The situation with money market liquidity normalized in July as the NBU temporarily resumed interventions in the forex market, though many banks again faced a funding deficit in August as manifested by rising money market rates. The liquidity squeeze has already adversely affected bank lending expansion: corporate lending growth slowed from 68% on year in January to 56% in August, while growth in the retail segment slowed from 100% to 65%.

The forex market's role in supplying hryvnia funding to the banking system will become even less significant in coming years. We expect capital inflows through the balance of payments financial account will only marginally cover the current account deficit in 2009 and will likely fall short of the current account gap further on. We do not rule out the NBU having to start selling foreign currency from its reserves at some point in 2009-2010 to smoothen exchange rate fluctuations, thus taking hryvnia out of the banking system.

In view of its changing monetary policy approach, the NBU has to increasingly use other policy instruments to regulate liquidity, ie. open market operations and refinancing. We expect most of liquidity supply in coming years to come from NBU refinancing facilities. Since the beginning of 2008, the NBU has issued over UAH2.2bn of long-term (over 300 days) funding through tenders, with interest rates standing at 15.2-16.4%. Banks are expected to increasingly tap this source in the future if the NBU leaves the interbank market and stops injecting foreign currency-backed hryvnia into the economy.

Still a lot of room for growth

Despite its phenomenal growth over the past five years, the Ukrainian banking sector still lags its Central and Eastern European peers in terms of market penetration. Ukraine's banking assets/GDP ratio stood at 78% as of end-May versus more than 100% of GDP for many CEE countries. Similarly, Ukraine's loans/GDP ratio, despite being comparable with that of Poland and the Czech Republic, is still far lower than that of other regional peers. Low penetration of the domestic banking sector thus reveals its strong expansion potential for the next decade. In the mid-term perspective, one of the sources to achieve asset growth for the banks can also be achieved through deeper financial intermediation.

The domestic banking system has substantially improved its financial intermediation, which is reflected by growth in the money multiplier from 1.90 as of end-2000 to 2.81 by end-August 2008. The still-low money multiplier in Ukraine based on an international comparison largely reflects the fact that large volumes of money are still circulating outside the banking sector, reducing its potential to attract new deposits and issue loans. For example, in August the share of cash in Ukraine's M2, the monetary aggregate that includes cash outside banks and bank deposits, stood at 28% compared with less than 15% in the CEE region as a whole.

We expect local banks to step up their efforts to attract new money from the cash segment by offering new deposit programmes and implementing new technologies for non-cash settlements in the retail sector. On the other hand, ongoing economy de-shadowing and high alternative costs of holding money outside the banking system should stimulate businesses and households to switch from cash money to demand deposits.

Overall, in view of the ongoing liquidity tightening we see the banking system's asset growth decelerating to 38% in 2008 and 36% in 2009 from a record high of 76% in 2007. Such a slowdown should have positive implications, allowing banks to improve asset quality and introduce more rigid lending requirements. We thus consider the forecasted growth pace as quite healthy and believe the slowdown won't undermine the sector's strong fundamentals.

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