Olga Pogarska and Edilberto Segura of SigmaBleyzer -

Summary

1. Over January-November, GDP grew by 6.7% on year. Robust economic growth in 2006, despite the price hike on imported energy resources, gives reason to be optimistic about Ukraine's economic performance in 2007.

2. In December, the 2007 State Budget Law was adopted; however, it is likely to be amended early next year.

3. The ongoing tariffs adjustment was the primary cause of consumer price inflation soaring to 11.6% on year in November.

4. Though the cumulative merchandise trade deficit continued to deteriorate, current account performance has been improving. In the third quarter, the current account balance returned to a surplus of $460m, bringing the cumulative deficit to less than 0.5% of period GDP.

5. Ukraine has demonstrated generally good reform progress in 2006 despite a long period of political instability. However, the progress in deregulation and liberalization was uneven.

Economic growth

Ukraine continued to enjoy rapid economic growth. According to preliminary data from the State Statistics Committee (SSC), the Ukrainian economy advanced by 8.2% on year in November, bringing cumulative growth to 6.7% on year. The growth was supported by vigorous consumption and robust investment activity.

Private consumption was fuelled by an ongoing, though decelerating, rise in real household disposable income (up by 17% on year over 10 months of the year), and booming consumer credit. In addition, it was favoured by the postponement of a gas price pass-through on utility tariffs to the second half of the year.

Though political uncertainty persisted beyond the parliamentary elections and formation of the new government, it seemed to be outweighed by the growing pressures to modernize existing production capacities and invest in energy-saving technologies.

Investment growth is underpinned by improving access to domestic banking services (commercial banks lending to businesses grew by 49.3% on year in January-November) and borrowing from abroad. Over the first nine months of the year, the growth of investments into fixed capital accelerated to 16.1% on year, up from 12.2% on year in 1H 2006.

Accordingly, robust private consumption growth favoured domestically oriented sectors and industries, such as retail trade, food, production of vehicles, and residential housing construction. At the same time, favourable external conditions and a rise in investment activity sustained growth in machine-building, metallurgy, industrial building construction and wholesale trade.

Following a deceleration in October, industrial output growth posted a marked acceleration in November. That month, industrial production picked up by 8.3% on year, bringing the year to date total to 5.6% on year. The largest contributors to industrial output growth were metallurgy, food processing, and machine-building. Together, they contributed more than 80% of industrial output growth.

Though world steel prices have been generally on a declining trend since September, price developments were rather sluggish on Ukraine's major steel export destination markets, remaining at a rather high level. Moreover steel prices on EU and Asian markets even slightly increased in November compared with the previous month. Facing also stronger domestic demand due to robust growth in construction and machine- building, metallurgy reported a 8.5% on year increase in output over January-November.

Despite price hikes on energy resources, the Ukrainian economy demonstrated good economic performance during 2006. Though some of the factors (such as booming consumption and high world steel prices) that helped to absorb the shock in 2006 are likely to be considerably weaker this year, we expect GDP to grow by 5-6% on year in 2007 despite a 37% increase in imported gas prices.

Fiscal policy

Robust growth of domestic trade, rising household incomes and improving enterprise performance allowed the government to over-fulfil revenues to the general fund of the state budget by 3.3% in January-November.

This translates into a more than 20% nominal increase compared with the respective period last year. As in the previous periods, VAT proceeds showed the largest rate of increase. However, it was achieved on the back of growing VAT refund arrears. Just in August-November, VAT refund arrears rose by 25% to reach almost UAH7bn (about $1.4bn) at the end of November.

At the beginning of December, the parliament adopted the 2007 Budget Law, which envisaged a state budget deficit at UAH15.72bn ($3.1bn), or 2.6% of forecasted GDP. The targeted state budget deficit is 18.6% higher than in 2006. State budget revenues are set to increase by 16% on year to UAH 147.9bn ($29.3bn), while expenditures will be 15.4% on year up to UAH 161.8bn ($32bn).

However, a few days later, the president vetoed the budget law and returned it to the parliament. The new version of the budget was signed by the president only after the parliament adopted a resolution that obliged the government to develop amendments to the budget law envisaging upward revision of the minimum subsistence level and minimum wage based on economy and budget performance in the first quarter of 2007. Most likely, the 2007 budget law will be amended at the beginning of the second quarter of 2007.

The 2007 budget law envisages that about two-thirds of the targeted deficit will be financed by receipts from privatization. Though the parliament adopted a list of about 560 enterprises to be privatized in 2007, which includes several potentially interesting enterprises such as Ukrainian telecommunication monopoly Ukrtelekom, Odessa port plant and government shares in 12 energy-distribution companies (oblenergo), the targeted amount may be hard to achieve.

Moreover, at the end of December, the president vetoed the law arguing that it violates some constitutional provisions and shareholder rights. According to the president, the parliament defines the list of enterprises that are not subject to privatization. The adoption of the privatization list makes it impossible to privatize enterprises not included in the list without respective amendments to it by the parliament.

This will make the privatization process more cumbersome and time-consuming. Moreover, an important innovation of next year's privatization was the sale of government shares in the enterprise together with the land that belongs to that particular enterprise.

According to the law, a buyer of a more than 25% government stake in a joint stock company accrued the right to become a single purchaser of the entire land that belongs to the enterprise. This provision violates other shareholder rights and is in conflict with international standards of corporate governance.

The absence of a clear privatization plan makes successful budget execution in 2007 a rather challenging task.

Monetary policy

In November, the annual growth in consumer prices soared to 11.6% on year, driven by ongoing service tariffs adjustment and some agricultural products. In particular, housing and utility tariffs grew by 9.3% month-over-month (on month), which translated into 83.2% annual growth.

The weight of monetary factors in inflation dynamics continued to decline. In November, the growth of the monetary base and money supply slowed to 17.2% on year and 35.7% on year respectively (down from 22.4% on year and 36.4% on year a month before).

In monthly terms, the monetary base advanced by a meager 0.2% on month, which was the result of lower central bank net foreign exchange purchases on the interbank market ($227m in November compared with $363m in the previous month) and accumulation of government cash balances on the account with the National Bank of Ukraine (up by 9.4% on month.) The slowdown in annual money supply growth may also be attributed to continuing deceleration of deposits rate of increase (39.8% on year in November compared with 41.8% on year a month before).

Though decelerating, the growth of deposits remained at a decent level, which accompanied by active borrowing from abroad, allowed commercial banks to further gather momentum in lending activities.

Gradually declining lending rates and increasing demand for financial resources from both households and companies stood behind 68.6% on year expansion in credit. Consumer lending was an important contributor to overall credit growth. In November, more than one third of all loans were issued to households. A 135.7% on year increase in consumer credit was supported by growing purchasing power, a gradual shift of consumer preferences towards durable goods, booming real estate prices, and increasing competition on the consumer credit market, which manifested itself through the reduction in credit costs.

Though hryvnia-denominated loans grew at a robust 50.2% on year in November, foreign currency loans grew considerably faster. Expanding by 93.4% on year over the period, the share of loans issued in foreign currency grew to 49% in November, up from 43% at the beginning of the year. Thus the exposure of the banking sector to foreign exchange risks has been increasing.

The share of forex-denominated loans issued to households reached 64% in November, which raises even more concerns as household incomes are mainly hryvnia-denominated. Though the national bank has addressed banking sector risks through differentiation of reserve requirements, tightening of capital requirements, additional measures are required to respond to rising banking sector vulnerability.

International trade

In October, merchandise exports increased by about 18% on year, bringing cumulative growth to 11.2% on year. At the same time, vigorous domestic consumption and growing investment demand continued to fuel imports expansion. Rising by 25.7% on year in October, merchandise imports reported 22.6% on year growth since the beginning of the year. As a result, the fob/cif merchandise trade deficit increased to $4.6bn at the end of October, which is equivalent to 5.9% of period GDP.

Despite a general improvement, export performance by select industries was rather mixed. Robust external demand stimulated exports of machines, equipment and transport vehicles, which expanded by about 15% on year over January-October (up from 13.8% in January-September).

Though world steel market conditions were deteriorating, the growth of exports of metallurgical products accelerated to 14.7% on year. The acceleration became possible thanks to wide differentiation of steel price developments at various markets (steel prices on EU markets, though slightly decelerated, remained at a very high level; though prices on Asian markets revealed signs of an increasing trend, their level was significantly lower than the 2005 average) and the diversified geographical structure of Ukraine's metal exports.

On the import side, imports of mineral products (the weightiest group in total goods imports) were on the decline due to lower import volumes.

In October, imports of energy resources reported only 7.6% on year growth (down from an almost 39% on year increase in the previous month) due to a more than 35% on year decline in crude oil imports. The decline in crude oil imports is closely linked to poor coke and oil-refining industry performance. Due to high world crude oil prices and record high duties on Russia's crude oil exports, gasoline imports have been displacing domestic production.

For these reasons, Ukraine's exports of gasoline products have deteriorated in 2006. Since the increase in gasoline imports did not fully compensated the decline in crude oil imports, cumulative imports of energy resources decelerated from 15% on year in January-September to about 14% on year in January-October despite almost 22% on year increase in the natural gas imports over the period. Robust investment activity and rising household income stimulated imports of machines, equipments and vehicles, which expanded by 34% on year in January-October.

Though the cumulative merchandise trade deficit continued to deteriorate, the current account performance has been improving. According to the recent central bank report, the merchandise trade deficit constituted $770m in 3Q 2006, slightly up from a $876m deficit registered in the previous quarter. On the back of growing surpluses in foreign trade of services ($885m in 3Q 2006) and net transfers ($846m) accounts, the current account balance returned to a surplus of $460m, which was equivalent to 1.6% of period GDP. As a result, the cumulative current account deficit declined to less than 0.5% of nine month GDP.

The capital and financial accounts balance (analytical representation) has also demonstrated an impressive improvement, as it moved from a $1.6bn deficit in 1Q 2006 to a $0.85bn surplus in 3Q 2006. The improvement was due to record high growth of net foreign direct investment (FDI) and intensification of private borrowings from abroad.

For the first three quarters of this year, net FDI reached $3.7bn. The bulk of this sum was achieved thanks to a number of mergers and acquisitions in the banking sector. The growing involvement of foreign banks in Ukraine will bring new know-how and managing technologies to the sector, increase competitiveness and bring down interest rates.

Other developments and reforms affecting investment

In 2005, Ukrainian authorities announced an extensive reform programme aimed at strengthening the country's democracy, sustaining economic growth and preparing Ukraine for eventual EU membership. Aspirations to join the EU were behind the outstanding achievements in macroeconomic performance and public policy reforms in candidate countries.

Following declaration of the strategic goal of EU membership in early 2005, the three-year Ukraine-EU action plan was scheduled. At the beginning of December 2006, the European Commission positively assessed the implementation of the action plan, emphasizing fair and transparent parliamentary elections in spring 2006, high-level cooperation in the foreign policy arena, tighter observance of human rights and the supremacy of the law, and progress on adopting legislation necessary for Ukraine's accession to the WTO.

Currently, the European Commission and Ukraine have been negotiating directives for the new Enhanced Agreement. The Commission proposed that the new agreement should go beyond the existing Partnership and Co-operation Agreement wherever possible.

One of the key elements of the new agreement will be creation of a free trade area, negotiations for which will start shortly after Ukraine completes its WTO accession process.

Despite the long periods of political instability before and after the elections, Ukraine made good progress on structural reforms in 2006.

At the same time, the capacity to influence domestic market developments through market-based mechanisms remained rather weak. Some of the recent government actions revealed a tendency to intervene in the economy.

In particular, the government negotiated fixation of gasoline prices with major players on the market and attempted to intervene with price-setting mechanisms for selected foods.

In September, observing rapid growth of bread and bakery products on the back of accelerating grain exports and revised downward grain harvest estimates, the government introduced grain export licensing, which was replaced by export quotas in mid-October. In addition to considerable losses to grain producers and traders, the introduction of quantitative restrictions contradicts WTO principles, provides ample opportunities for rent-seeking activities and negatively affects the investment climate as a whole.

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