Erste Group -
• Ukraine to enter 2009 in recession, yet economic growth expected to rebound in the second half of the year
• Economy is more resilient to cyclical shocks, while fiscal and monetary policies remain vulnerable points
• IMF loan to secure overall banking system stability
• Positive long-term outlook envisions GDP growth of 5-6% in 2010 and single-digit inflation
Recession projected for first half of 2009
The short-term outlook for the Ukrainian economy has dramatically changed in recent months and the country is now most likely heading into the recession next year. On the one side, external factors such as the global financial crisis, weakened global demand and especially falling commodity prices have adversely hit the Ukrainian economy. On the other side, Ukraine also had to face problems of a local origin. The Ukrainian central bank had to prevent a run on the banks through implementation of some administrative measures. The main aim of these measures has been to stabilise the market, but in the long run will have an adverse effect on the Ukrainian economy. That is why technical support provided by the International Monetary Fund (IMF), which goes alongside the financial support, will very likely moderate those initial measures and help set up structural reforms, which would be beneficial for the financial sector and economy. "Ultimately, Ukraine might come out from the crisis much healthier than it jumped in, but in the meantime the situation will be more challenging," assesses Juraj Kotian, co-head of macroeconomics and fixed income in CEE at Erste Group.
Decline in GDP will be strongly dependent on steel prices and demand
Erste analysts project a recession of 2.5% of GDP in 2009, with economic growth returning in the second half. The current account is likely to shrink to just 3% of GDP in 2009, as slowing demand, the credit freeze and dropping commodity prices will hurt imports. The introduction of a floating exchange rate will result in local currency devaluation, which is supposed to support the real sector of the economy. The optimal level of the UAH/USD will depend on steel prices. At current metal price levels, Erste analysts project the optimum level to be around UAH7 per dollar, with the hryvnia gradually moving towards this level. During the next several months, the hryvnia rate will depend on the National Bank of Ukraine's (NBU) actions - imposing the floating rate and administrative market regulation. Also, much will depend on liquidity in the banking system, with the tense situation in the sector keeping money market rates high.
Economy is more resilient to cyclical shocks
"By many measures, Ukraine is currently much more immune to cyclical shocks: forex reserves have increased substantially, foreign capital increased its share on the local financial market (which is now well capitalized and profitable), the fiscal system has a strong budget code (with defined roles and responsibilities in the budget process) and the WTO has liberalized external trade," Maryan Zablotskyy, macroeconomist at Erste Bank Ukraine, points out.
The weak points in Ukraine's economic policy are its fiscal and monetary policy. On the one hand, the state budget has had a good balancing influence on fiscal policy - since 2000, the average budget deficit has stood at just 0.75% of GDP. However, budget planning was only conducted for one year, which meant that the government has tended to increase spending in nominal terms during times when steel prices and growth were increasing. Such a budget spending policy tends to amplify the economic cycle and the impact of steel price volatility on the economy.
Central bank propels the implementation of floating exchange rate
For the last seven years, the local currency has been relatively unchanged versus the dollar, the currency to which the hryvnia is officially tied. In practice, this means that the hryvnia exchange rate has been administratively regulated, with the NBU having to make heavy use of its FX reserves. 2008 brought a break from the past, once the NBU started accelerating the shift towards a flexible currency rate. The main advantage entailed by this move is that floating rate regimes are thought to be more efficient in offsetting effects of term-of-trade shocks than fixed-rate regimes. Thus, a depreciating local currency caused by a floating exchange rate will not lead to a decline in nominal wages, nor will it offset negative effects on exporters.
Low budget deficit has preserved safe level of public debt
The gross external debt of Ukraine stands at $100bn (at end-June). Short-term debt and inter-company lending together amount to $32bn, which is fully covered by forex reserves. The government policy of keeping low budget deficits has led to one of the lowest public debt levels in the CEE region. Prior to the IMF loan, public debt stood at 8-9% of 2008 projected GDP. In addition, Ukraine has one of the highest levels of GDP distribution through the consolidated state budget, which now stands at 38% of GDP. According to Erste analysts, this indicates that "public debt is well within the safety zone and that the government has a lot of space to cut spending and issue guarantees for corporate debt."
IMF loan to secure overall banking system stability
On November 5, the IMF approved a $16.4bn, two-year standby loan. As part of its agreement with the IMF, the parliament adopted a law on "Countering the effects of the global financial crisis" that touches on fiscal, monetary and inflation policies and banking regulation. Regarding fiscal policy, Ukraine is to cut spending to meet declining incomes in 2009. Ukraine will keep its inflation rate at 17% by end-2009, while nominal wages and social benefits are to increase only to cover the inflation rate. On the point of monetary policy, Ukraine is to impose a floating currency exchange rate regime, which will ultimately result in devaluation, at least during the first half of 2009.
One substantial impact of the IMF agreement will be borne by the banking system. Since the credit crunch could deepen the cyclical economic downturn, providing support to the banking sector became a stringent matter. Thus, one measure entailed by the IMF agreement is the creation of a UAH40bn stabilization fund, which will be used for issuing loans and conducting bailouts of banks. The government also received the right to borrow money in foreign currency on the local market and use government bonds to buy troubled banks. These, alongside the increase in the state fund guarantee for deposits from UAH50,000 to UAH150,000 (covering 99% of individual accounts) and the increase in refinancing activities by the NBU are meant to secure overall banking system stability, which is likely to go through a period of large-scale evolutionary changes. The IMF and Ukraine have effectively agreed on driving further consolidation in the banking sector. Even with minimum capital requirements twice those in Europe, Ukraine has some 170 banks, a number that could fall by as much as 30% in 2009 and 2010.
Positive long-term outlook
The current cyclical shock does not present any significant difficulties for the Ukrainian government in terms of meeting its foreign financial obligations due to the low public debt ratio. "Ukraine will keep up with payments on its public debt, which will improve the country's image and investor confidence. The anti-crisis measures taken by the government (to get the IMF loan) will cause changes in the financial system that will make the Ukrainian economy more resilient to cyclical effects in steel demand and prices in the future," envisions Maryan Zablotskyy.
The steel industry will continue to invest heavily in production efficiency programmes. The local steel industry has great potential for cutting production costs, as Ukraine has one of the world's biggest layers of iron ore and large layers of coal. The recent introduction of steel price futures on the London Metals Exchange (and plans to introduce them on the New York Mercantile Exchange) will bring new hedging possibilities for steel producers. The banking system will also strengthen after a period of consolidation and an increase in the share of foreign capital. In the future, Ukraine will remain influenced by cyclical downtrends in steel demand, but will be much more resilient to them, than it is now (compared to just several years ago). "GDP growth will return to its potential growth of 5-6% in 2010, while inflation is likely to come down to a single-digit figure," conclude Erste analysts.
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