Andrii Parkhomenko of Concorde Capital -

The global downturn has revealed innate imbalances in the Ukrainian economy and instigated a sharp economic decline, with severe currency devaluation. Ukraine is fast sinking into its fiercest recession since 1991-1996.

The Orange Revolution of 2004/05 changed the mentality of the Ukrainian people, creating a European mindset: more wealth, middle class hopes and abundant credit. But at the same time, neither the political system nor the economy changed much. The economy remains overly energy-consuming and commodity-based; Ukraine has the second-worst ratio of energy supply to GDP in the world, and commodities account for two-thirds of Ukrainian exports.

Although the economy has grown at an average annual rate of 6.4% since 2004, the direction was squandered. Capital flew into the first attractive pot - the financial sector (more than 50% of foreign direct investment inflow). The financial services boom stimulated consumption via bank loans (average annual growth of 59% in 2004-2007). The last four years were a lost opportunity for economic diversification.

Throughout this time, the country has struggled to find a political force or personality that can consolidate the nation. The incessant bickering has left Ukraine without a clear strategy to battle the crisis. Its established UAH50bn (5% of GDP) stabilization fund remains empty and sources to fill it up look questionable (privatization, domestic borrowings, land sales).

The 2009 state budget passed by parliament envisions an unreasonably optimistic deficit of UAH28.1bn. Moving closer to consensus forecasts, based on our assumptions of a decline in GDP of 7%, a fall in external trade by 30% and an average UAH/USD rate of 8.50 in 2009, the deficit won't be less than UAH60bn (6% of GDP). In order to cover the fiscal shortfall, Ukraine could simply either resort to printing money (increasing the risk of hyperinflation markedly) or issuing bonds and raising loans, though it's doubtful Ukraine will find sufficient demand to raise the entire amount. The state could also cut budgetary expenses, but all political parties would fight for every penny, as reduced expenditures equal fewer votes.

After plunging 41% in the fourth quarter of 2008, the hryvnya has been relatively stable in the first few months of 2009. We think that the UAH/USD rate will average 8.50 in 2009, but could experience substantial deviations from the mean. The direction of the exchange rate will be vital in 2009. With 59% of bank loans denominated in foreign currency, the higher the exchange rate, the larger the share of non-performing loans - a key threat to banking system stability in 2009. Conversely, the shift in the exchange rate, together with weakening demand and restrained credit, has helped curb imports: in December, Ukraine only imported $5.5bn of goods compared with the monthly average of $8.3bn in the summer of 2008.

There's been much speculation about a sovereign default - talk that is exaggerated. In 2009, the government has to pay $2.4bn on external debt and $2.9bn on internal debt. Given the need to finance sizeable balance-of-payments and budget deficits, and to maintain its borrower's credibility, the state will find sufficient resources to pay off its debts. As of end-January, central bank reserves were $28.8bn.

Shock therapy

On a positive note, the crisis should function as shock therapy for Ukraine. Only efficient companies will survive, while the shift in the exchange rate will serve to stimulate Ukraine's competitiveness. However, Ukraine must learn the lesson of the 2008 commodity bubble, and implement policies to diversify exports toward more value-added and less price-volatile products.

Prime Minister Yulia Tymoshenko hailed the new gas deal with Russia signed in late January as giving Ukraine a one-year break to reform. The contract provides for a steep price hike in the first quarter, to twice that in 2008 ($360/'000 cm), but a decrease to $162/'000 cm in the fourth (according to Naftogaz estimates). The gas price is linked to the price of oil products over the last nine months, thus in 2010 the average gas price may be even lower than in 2009.

In mid-February, Tymoshenko announced a programme to promote biogas production in Ukraine, which is expected to reduce gas consumption by 14%. The programme would need to be implemented by a team of strong crisis managers - which with looming elections in January 2010 and constant political backstabbing is improbable, at best.

In the meantime, the domestic Ukrainian equity market has virtually frozen: it is very illiquid, with huge spreads. This year is set to be the year of the speculator, with liquid names traded abroad offering good prospects, while long-term investors have time to cherry-pick stocks for survivors and buy them for cheap: the price/earnings ratio of Ukraine's benchmark PFTS index is 4.6 (as of February 13), one of the lowest in the world.

We see the fixed-income asset class now as much more attractive than equities. Ukrainian sovereign and bank Eurobonds, trading at discounts of 30-70%, are likely to outperform equities over the next 12-24 months.

Andrii Parkhomenko is an economist at Concorde Capital

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