Alfa Bank -
Ukraine's imports have declined dramatically, bringing its trade balance into surplus in February. In addition, the country should see inflows of FDI from privatization, the Euro 2012 football championships and bank bailouts. These factors should bring Ukraine's external operations back into equilibrium even without further tranches from the International Monetary Fund (IMF).
From deficit to surplus
We expect a $2.5bn current account surplus this year compared with the $12.9bn deficit in 2008, owing to lower imports. Capital inflows to Ukraine led to a marked increase of 460% in loans to households between 2005 and 2008, and imports grew dramatically. As a result, Ukraine's current account deficit last year was a record $12.9bn, or 10.5% of GDP. Given capital outflows and credit tightening, we now expect imports to drop by $46.4bn and the current account to be in surplus by $2.5bn this year. Lower imports already brought the current account into balance in February.
We expect Ukraine to refinance $10.4bn of its $21.2bn in foreign debt outstanding in 2009. This is because around $10.4bn of this year's foreign debt payments is due to Ukrainian corporations' affiliates abroad and foreign banks with Ukrainian subsidiaries, and we expect this amount to be fully refinanced. Therefore, we expect only $10.8bn to leave Ukraine this year rather than the full amount of foreign debt due.
We have developed three scenarios to stress test Ukraine's 2009 balance of payments against various levels of foreign direct investment (FDI). Our best-case scenario is an inflow of $13.1bn, and our worst case is an inflow of $1.5bn. Under our best case, National Band of Ukraine reserves will grow $4bn in 2009 versus shrinking $7.7bn under our worst case. Also under our worst case, NBU reserves only cover three and a half months of imports, which could put pressure on the hryvnia.
We believe FDI will help Ukraine get through the crisis even without IMF support, at least through 2009. If the government manages to secure the FDI expected this year for Euro 2012, privatization and bank bailouts, Ukraine will not need more tranches from the IMF. However, the risk of a financing deficit in 2010-2011 is still significant, and if political instability hinders the inflow of FDI, the country could regain its appetite for foreign debt and for IMF bailout money to support the national currency.
Built-in cures for the balance-of-payments
After being recognized as a market economy by the US and EU in 2006, $10bn of short-term capital flowed into Ukraine's banking system. This imported capital financed purchases of consumer goods (themselves mostly imported) with a multiple close to 5x, according to our estimates. In other words, $1 of short-term capital imported by the Ukrainian banking system financed $5 of purchases of imported consumer goods.
In 2006-2008, Ukrainian banks preferred to finance households rather than businesses, because of the higher profitability of retail lending (reflecting higher risk). As a result, consumer loans grew twice as fast as business loans, financing a rising inflow of merchandise imports, which mushroomed 250% over the last three years. The resulting trade deficit of $13bn was a direct consequence of this process, as the annual increase in merchandise imports swelled from $7.1bn in 2005 to $24.9bn in 2008.
The onset of the global financial crisis reversed the growth of leveraged consumer goods purchases, as inflows of short-term capital came to a halt. This worked as an automatic stabilizer for the trade balance, which returned to equilibrium in February after merchandise imports contracted by 52.8%. We expect this situation to persist at least until the end of this year, as lending to households is unlikely to resume by then.
Capital account surplus possible
According to the NBU, the total volume of short-term capital outflows from Ukraine this year will be $21.2bn. However, the data for the first two months of the year suggest that figure may be too high. Of the $21.2bn of short-term external debt outstanding as of January 1, 2009, $4bn is owed by Ukrainian corporations to their affiliated companies abroad. $6.4bn of short-term bank loans will most likely be refinanced or extended, as they are owed by foreign-owned banks to their parent companies, which have confirmed their commitment to developing their businesses in Ukraine. Therefore, we expect $10.4bn in short-term loans to still be outstanding on January 1, 2010, with only $10.8bn of the $21.2bn total to be repaid by the end of this year.
We believe the outflow of short-term capital from Ukraine will be offset by an inflow of FDI, which should increase owing to preparations for Euro 2012, state support for the banking system, privatization and modernization of the country's gas transportation system. According to our estimates, FDI inflows for 2009 should total about $13bn, which should fully compensate for the outflow of short-term capital.
Reducing short-term external debt by $10.8bn would bring it to late 2005 levels, or close to 10% of gross external debt. In this case, merchandise imports should fall to $46.4bn, bringing the 2009 current account into surplus by $2.5bn. The capital account may also see a surplus of $1.5bn if the expected FDI inflows materialize, but only under the best-case scenario, as FDI flows are heavily dependent on political decisions. We consider these political factors in the next section.
In order to secure the financing expected for Euro 2012, further improvements need to be made to Ukraine's legislation governing property rights (including land). In order for privatization to be successful, competing forces in parliament will need to reach a consensus. The amount of assistance provided by international financial organizations to the banking system depends on the government's ability to reach an agreement with the IMF.
Even the modernization of the gas transportation system could be delayed if Ukraine is unable to agree with Russia on all the issues involved.
We have developed three scenarios for FDI inflow to Ukraine. Under our best-case scenario, political issues will not hamper capital inflows this year, and Ukraine will receive the total expected FDI of over $13bn. Our base-case scenario assumes that political interference will reduce FDI inflows by half to $6.5bn. Finally, the worst-case scenario sees investors waiting for better times to enter the country, when political risks are eliminated or substantially reduced, which lowers FDI to $1.3bn. We summarize the impacts of the three scenarios on Ukraine's reserves and balance of payments in the table below.
Why Ukraine may no longer need IMF cash
According to the IMF's website, "The standby arrangement [that the IMF provided to Ukraine] is designed to help countries address short-term balance-of- payments problems." Our estimates show that, starting from the second quarter, Ukraine's balance of payments may well return to equilibrium. They also show that the first tranche of IMF funds allocated to address Ukraine's short-term balance-of-payments problems has worked, so no more tranches may be needed.
Even without a second tranche from the IMF, Ukraine is likely to run both current and capital account surpluses in 2009, which will restore the NBU's foreign reserves. This process could begin as early as April, with the reserves figure expected to increase from $26.5bn to $30.5bn by the end of 2009, if FDI inflows are in line with our best-case scenario.
Even under our worst-case assumptions for FDI, and in the absence of a second tranche from the IMF this year, NBU reserves are unlikely to fall below $18.7bn. This level will be sufficient to keep reserve-adequacy ratios above critical levels. Under our worst-case FDI inflow scenario, we estimate the Reserves/Short-term Debt ratio will remain at 1.8x (the critical level is 1x), the Reserves/M2 ratio will fall to 0.3x (the critical level is 0.2x), and the ratio of reserves to months of imports will remain at 3.5x (the critical level is 3x).
According to our estimates, Ukraine passes the stress test of our worst-case FDI inflow scenario combined with the simultaneous failure to obtain a second tranche of the IMF loan. Moreover, we believe that the Ukrainian government will not need more tranches from the IMF, as the expected FDI inflow for this year will be sufficient to finance the capital account. However, if the government fails to secure the planned investment in 2009, the risk of a financing deficit in 2010-2011 will return, and the country could regain its appetite for foreign debt and for IMF bailout money to support the national currency.
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