Vitaliy Vavryshchuk of Dragon Capital -

Ukraine enjoyed a period of positive current account balances from 1999 to 2005 following the financial crisis of 1998 and an abrupt 60% devaluation of the hryvnia against the dollar during the year. A cheaper local currency helped to boost exports while imports decelerated notably.

This period was also marked by the revival of Ukraine's export-oriented industries as major enterprises in the steel and chemical sectors were privatized and received private capital to modernize their production capacities and boost output. Increasing global demand for metals and chemicals combined with greater openness of the Ukrainian economy also favoured growth in Ukrainian commodity exports. However, export-oriented sectors have been unable to keep up with a rapid increase in imports in the past several years, with the current account posting a lower surplus in 2005, slipping into negative territory in the following year and reaching a record high negative value of $5.9bn in 2007, which was 4.2% of GDP.

Growth in the merchandise trade deficit has been a key reason behind negative current account balances that Ukraine has experienced since 2006. Last year, the goods trade deficit fell to $10.6bn (up 103.5% on year and 7.6% of 2007 GDP) as imports of commodities (up 36.9% on year) continued to outpace exports (up 30.0% on year).

Similarly, a negative balance on the income account increased to $2.1bn (up 22.9%) on larger volumes of income repatriation by non-residents. Those deficits were only partly offset by a surplus in service trade and a positive balance of current transfers. The service trade surplus increased in 2007 to $2.7bn (up 26.8%) mainly on account of strong exports by transportation and tourism sectors. The current transfers account posted a surplus of $4.1bn (up 28.4%) thanks to rising remittances by Ukrainians working abroad.

The breakdown of Ukraine's merchandise trade deficit by commodity type provides useful insight into the nature of the country's trade misbalances and current account deficit. Imports of energy materials and machinery have been a key deficit driver since 2005. The upsurge in machinery imports has been led mainly by increased demand for foreign investment goods (which now account for about 25% of overall merchandise imports). Investment demand is set to remain a growth driver for the current account deficit as domestic companies increasingly modernize their production capacities, but this should eventually enhance the economy's export potential.

Unlike machinery imports, the growth in the value of energy imports was entirely down to higher prices. The value of energy imports totalled $10.7bn in 2005 (29.5% of total imports) and surged to $16.0bn (26.3% of imports) in 2007. More specifically, natural gas imports rose from $3.9bn in 2005 to $6.6bn last year as the price of imported gas surged from $50 per 1,000 cubic metres to $130/'000 cm over the period, but import volumes didn't change insignificantly.

With global steel prices surging by 46% over the last three years, for Ukraine the role of metal exports in mitigating the current account deficit has been crucial. As steel prices are expected to jump by another 40% in 2008, metals will still help to offset a great deal of negative merchandise and current account balances.

The current account deficit this year will continue to be driven by buoyant investment demand and growing household consumption on the back of income expansion fuelled by the government's generous welfare policies. As local producers are unlikely to keep apace with surging domestic demand, market misbalances will be covered by imports. Separately, the 38% gas price increase in 2008 will alone add some $2.5bn to this year's current account deficit. Overall, merchandise trade deficit will reach $17.9bn in 2008 (up 69.3%), pushing the current account balance further into the red to $12.6bn (up 112.5%), or 6.8% of GDP.

Forecasting current account trends for 2009 is a complicated task due to uncertainly over the price of imported gas for Ukraine, which is usually negotiated between Ukrainian authorities and Russia's Gazprom several months before the beginning of a new year. Our base case scenario, which assumes a price of $250/'000 cm of gas on the Ukrainian border (up 39.3%), puts the current account deficit at 7.4% of forecasted 2009 GDP as compared with 5.8% of GDP were gas prices to stay unchanged. The pessimistic scenario ($350/'000 cm) translates into a current account deficit of 10.7% of GDP, still comparable with CEE statistics. It should be noted that calculations assume that metal prices will go up by 10% in 2009, thus partly offsetting the expected surge in energy prices.

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