Renaissance Capital -

Over May 8-14, we surveyed 34 investors, with total available limits in Ukrainian stocks and bonds of approximately $10bn. Over 50% of our respondents represented financial institutions, primarily funded by foreign capital.

-- Stocks are the most attractive instrument. The survey results indicate that investors find the stock market to be the most attractive segment of Ukraine's financial market. More than half of the respondents invest in the Ukrainian stock market and 25% in Ukrainian corporate and sovereign bonds.

-- Inflation is the main challenge. Investors consider inflation as the main risk for investments in the Ukraine financial market. Moreover, they highlight political challenges and worsening balance of payments as a threat to the country's financial markets.

-- Ratings review is not on the agenda. Most investors do not expect the sovereign ratings of Ukraine to be reviewed in 2008. Although the number of respondents expecting a downgrade slightly exceeds those who are optimistic about an upgrade sometime in the future, they have a positive view on the Ukrainian sovereign rating future.

-- Hryvnia to appreciate. Almost one half of the respondents expect the hryvnia to increase against the dollar during 2008, and only 20% think the hryvnia will depreciate during 2008. Most investors estimate the hryvnia rate to be UAH4.5-4.7 to the dollar by the end of this year.

-- Low issuer transparency. Only 30% of respondents named currency exchange tax as a major hindrance to the growth of Ukraine's domestic bond market. Many of those surveyed cited the lack of transparency of bond issuers and a weak market infrastructure as obstacles.

-- Fair yields of OVGZ. We asked investors to assess fair yields of hryvnia-denominated government bonds (OVGZ) with various maturities. Because the Ukrainian domestic bond market does not represent an attractive investment opportunity currently, only one-third of respondents provided estimates of 12.0% (on average) for a fair yield for a one-year OVGZ and 13-15% (on average) for five-year government bonds.

Why is the domestic bond market so unattractive?

Investors view inflation as the main risk for investments in Ukraine's financial markets (CPI rose 13.1% during January-April). Moreover, they highlighted political challenges and the worsening balance of payments also a threat. Only 20% of respondents were concerned about a slowdown of Ukraine's economic growth. It is clear to us that spiraling inflation together with growing political risks are likely to be major reasons prompting rating agencies to lower the sovereign ratings (BB-/B1/BB-).

Currently, the leading agencies hold different views on the prospects of Ukraine's rating. On August 2, 2007, S&P confirmed the 'Negative' outlook of its sovereign rating of Ukraine (BB-), pointing out political risks, lax budget discipline and a growing current account deficit. Moody's decided in March to place Ukraine's 'B1' rating on 'Positive' watch, citing prudent economic policies of the government, low debt and growth prospects on the back of impending WTO accession. On the other hand, on May 14, Fitch changed its 'Positive' rating outlook of Ukraine (BB-) to 'Stable' due to the monetary authorities' slow move to contain inflation. Interestingly, the majority of respondents do not expect any changes in Ukraine's sovereign credit ratings in 2008. On the other hand, the number of investors forecasting downward revisions is slightly higher than those who expect Ukraine's ratings to be upgraded.

We were most interested in investors' answers regarding their expectations concerning further hryvnia performance this year. Almost half of the respondents think the hryvnia/dollar exchange rate will strengthen in 2008, while only one-fifth believe it will weaken. Many respondents share the opinion that the rate will be UAH4.5-4.7 at year-end. Investors' expectations have been met over the past few days. With the central bank uninvolved in the forex market, the hryvnia strengthened to UAH4.55 as of May 21.

We believe that the central bank is likely to liberalise the exchange rate in the near term in order to fight inflation, which could cause the hryvnia to strengthen further. However, this strengthening is likely to be only short term and in the second half of the year we expect the hryvnia to depreciate on the back of a worsening current account deficit. However, the period of hryvnia appreciation will probably be short lived, and in the second half of the year we could see the hryvnia weakening on the back of growing current account deficit.

We forecast the hryvnia/dollar exchange rate to be 5.3 in 2009. We found the breakdown of answers interesting regarding the major obstacles to foreign investment growth on the Ukrainian domestic bond market. Notably, only 30% of respondents named currency exchange as a principal hindrance. Many of those surveyed responded with the lack of transparency of bond issuers and a weak market infrastructure as obstacles. Almost all respondents who chose the 'Other' category as an answer mentioned the extremely low liquidity of hryvnia-denominated bonds.

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