Olena Bilan of Dragon Capital -
After enduring a sharp adjustment in the fourth quarter of 2008 and first quarter of 2009, Ukraine's real sector has started to show clear signs of stabilization.
Export-oriented sectors, hit first by the global downturn, bottomed out early in the year, helping to stabilize the monthly rate of decline in industrial output at around -30% in year-on-year terms. Furthermore, steel and its related sectors showed early, albeit weak, signs of output recovery in response to stronger foreign demand. The adjustment in domestically oriented consumer sectors took several months longer, but was less severe, thanks in part to only a moderate fiscal contraction that prevented real wages from falling more than 12% year on year in real terms and also reflecting a devaluation-related imports substitution effect.
Although a weaker hryvnia negatively affected the domestic banking system, it also boosted Ukraine's price competitiveness after the latter deteriorated rapidly over the past several years undermined by high domestic inflation. The CPI-based exports-weighted real effective exchange rate declined by an estimated 25% on year in August, implying a proportional gain in price competitiveness for exporters and a corresponding decline in the price attractiveness of imports.
Confirming the latter phenomenon, the share of imported goods in domestic retail trade turnover narrowed by 4 percentage points on year to 32% in the first half of the year. A shift in the consumption pattern from imported to domestic goods and services boosted domestically oriented sectors, enabling second-quarter real GDP to advance by 6.2% from the quarter before in seasonally adjusted terms and narrow its year-on-year decline to 17.8%, according to official data (the actual drop in economic activity wasn't as strong as reported officially due to Ukraine's large shadow economy which, according to different estimates, is equivalent to 30-50% of official GDP).
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The depreciation in the currency also helped Ukraine narrow its trade and current account deficits this year. While merchandise exports almost halved in year-on-year terms, led primarily by steel, the slump in imports was steeper, even despite a higher gas price, due to weaker domestic consumption and investment demand as well as a weaker hryvnia. As a result, Ukraine's current account balance is expected to narrow to 1.2% of GDP in 2009 from 7.2% of GDP last year.
While the economy's relatively high openness and strong exposure to commodity cycle did it a disservice amid the global downturn, these features will be a huge advantage when global commodity markets turn on a sustainable upward trend. Ukraine's exports equal more than 50% of its GDP, and commodities comprise two-thirds of total exports, one of the largest ratios globally, with steel alone accounting for 40% of overall exports - the largest share compared to the country's regional peers. Due to strong interconnection between the steel sector and other domestic industries (iron ore, electricity, cargo transportation and wholesale trade), shifts in foreign demand for steel produce a big multiplicative effect on the overall economy.
Thus, the high responsiveness of Ukraine's export-oriented industries to shifts in foreign demand and their strong links with other major economic sectors make the country prone to a faster upturn than its peers even if the global economic recovery proves sluggish, which is a widely held view today. In addition, the real sector is likely to get a boost from bank lending, which we expect to take off as soon as banks are sure that the creditworthiness of their customers isn't going to deteriorate further. Stronger foreign demand, along with a low comparison base this year, create grounds for a fast recovery in Ukraine next year, which we currently expect to translate into 4% GDP growth (compared with a decline of 12.5% expected this year).
Before the economic recovery begins, the country will have to go through a tough period of presidential elections scheduled for January 17, 2010, which will definitely affect its economic policies as well as relations with the International Monetary Fund (IMF), the government's largest lender this year. The Fund has disbursed $10.6bn to the country over the past year, channelling more than half of total funding to the state budget, which was quite an unorthodox step given that the IMF typically provides balance of payments support. The IMF further manifested its lenient stance towards Ukraine by overlooking the government's lack of progress in structural reforms and its stubborn unwillingness to adjust its expansionary fiscal policy.
The proximity of presidential elections will make domestic economic policies more populist, minimizing chances for any structural reforms before 2H10. That may also lead the IMF to postpone disbursement of its $3.8bn next loan tranche. Yet, with the incumbent prime minister being a top contender in the presidential race, the government will remain extremely interested in preserving economic stability. This particularly concerns the F/X market, whose dynamics typically has a large impact on domestic consumer and business confidence. Regardless of the IMF decision on the next tranche, the authorities are set to do their best to avoid any large currency adjustment, though the hryvnia is likely to remain volatile in the coming months led by changing sentiment of domestic economic agents.
Mitigation of political risks in the post-election period and improved economic outlook will be major triggers for the renewal of foreign portfolio and strategic investment inflows to Ukraine. Foreign direct investment (FDI) is also set to be boosted by the relocation of production facilities from neighbouring countries to Ukraine in industries that benefit from import substitution (eg. food-processing) as well as by infrastructure projects related to the Euro 2012 football championships. Furthermore, economic recovery will create the conditions for currency appreciation. The latter should be driven first by fundamental factors, such as higher export receipts, moderation in foreign debt repayments and improvement in FDI inflows, and then be reinforced by domestic economic agents selling their forex savings accumulated during the turbulent times.
Olena Bilan is an economist for Dragon Capital
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