Economic stability secured, but political infighting threatens Ukraine reforms

Economic stability secured, but political infighting threatens Ukraine reforms
By Sergei Kuznetsov December 21, 2015

Ukraine's economy bottomed out in 2015, with the estimated full-year contraction being put at between 11.5% and 13.0%. With the government securing macroeconomic stabilisation mainly through a support programme agreed with the International Monetary Fund (IMF), experts predict a rebound of GDP in 2016 of between 2.0% and 2.5% growth. But risks remain high, as high-level political infighting flares in Kyiv, which could lead to the derailment of reforms at any moment.

"This year was actually much better than expected," Dmytro Sologub, deputy governor of the National Bank of Ukraine, tells bne IntelliNews in an interview. "But there are new risks – political risk is rising so investors are not sure if reforms will take hold, there could be delays in the IMF programme and the global background remains unkind."

Peter Bobrinsky, managing director of Dragon Capital agrees: "We can say with a fair bit of credibility that the worst is behind us. Not wishing to be trite, but we are cautiously optimistic. All the elements are in place that we can see light at the end of the tunnel – lets just hope it's not an oncoming train."

After Ukraine's GDP declined by 6.8% in 2014, the European Bank for Reconstruction and Development (EBRD) is forecasting that the country's war-torn economy will shrink by 11.5% in 2015. "There is cautious hope that the economy bottomed out in mid-2015 and that the output level will stabilise in the second half of the year, amid domestic and regional risks which remain material," the EBRD said in a report published in November.

Local experts are in a slightly more negative mood. According to Kyiv-based brokerage Investment Capital Ukraine (ICU), the country's GDP will drop by 13.1% in 2015. However, ICU forecasts a 2.7% rebound in economic growth in 2016, thanks to the macroeconomic stabilisation achieved during 2015, and a relative stabilisation of the domestic security situation on the back of a sizeable scaling back of Ukraine's defensive activities in the conflict-ridden Donbas region, the country's industrial heartland.

"Another factor that is going to aid the rebound in 2016 is an increase in bank lending on the back of declining interest rates and a general restoration of the creditworthiness of banks and the businesses they deal with," ICU believe, pointing out that from 2017 the annual growth rate of the Ukrainian economy is projected to settle at 2% in real terms.

Financial stabilisation

Ukraine's domestic currency, the hryvnia, lost two-thirds of its value against the dollar between January 2014, when pro-European protests in Kyiv were at their height, and the end of 2015. The official exchange rate has stabilised at around UAH23 per dollar as of mid-December, mainly due to a set of administrative restrictions imposed by the central bank.

According to ICU's estimates, the hryvnia is set to weaken further during 2016, perhaps reaching an exchange rate of UAH32 per dollar by the end of 2016. "In our base-case scenario, the hryvnia stabilisation occurs in 2017-18 on the back of inflation moving toward single-digit territory and the current trend of a strong dollar being reversed as US monetary policy becomes more easy (after the period of tightening that is gathering pace now)," ICU believes.

The country's current account deficit decreased sharply from 9.1% of GDP in 2013 to approximately 4.0% in 2014. According to ICU's outlook, the current account balance could reach a surplus of 0.7% in 2015. "This year's collapse in foreign trade is yielding a near-balanced current account ... This is a temporary phenomenon, as Ukraine's economy is not in a position to run sustained external surpluses (as measured by current account balance)," the brokerage notes.

"There are prospects of weak foreign demand for Ukraine's exports, resulting from the deflationary Chinese economy as well as the recession in the Russian economy and the stagnant state of the EU, where macroeconomic adjustments are pushing member states to run current account surpluses," it adds.

Kyiv-based experts believe that the current account deficit could decrease to 0.5% in 2016, according to a base-case scenario.

Over the past year, Ukraine has been able to restore its international reserves from $5.6bn in February, the equivalent of approximately one month's worth of import coverage, to $13bn in December, mainly due to inflows of international financial assistance.

Timothy Ash, a credit strategist with Nomura International, believes that Ukraine's public sector and infrastructure (PSI) have made cuts of $12bn-13bn in their external financing needs over the period of the current IMF programme. Despite this figure, debt sustainability issues "have not been adequately addressed," Ash said in a note to clients published in early December.

Moreover, he believes that the value recovery instruments (VRIs) issued by Kyiv within the framework of a debt-restructuring operation in 2015 are still "a ticking time bomb" for future governments. VRIs or GDP warrants guarantee additional payments to bondholders in the event that Ukraine's GDP rebounds strongly in the future.

Political infighting

While the military conflict in Ukraine's eastern regions has subsided, another fight is now raging, this time in Kyiv. Different political factions that are formally members of the pro-European ruling parliamentary coalition are trying to wrest power from each other. The teams of President Petro Poroshenko and Prime Minister Arseniy Yatsenyuk are front and centre of this process.

"We have two decision makers of equal weight, a bi-polar system," says Alexander Paraschiy, head of research at Concorde Capital. "Poroshenko wants to weaken the power of the prime minister and his power is rising."

Meanwhile, Western backers seem to be losing their patience with Kyiv's inability to fight corruption and graft. "There is not yet the political will at the highest levels to address issues related to the rule of law, and in particular to apply the laws as it is to people who occupy the highest echelons and thereby to make examples of high-profile individuals," Ash wrote in a note.

On December 11, Yatsenyuk lost his statutory immunity from votes of no confidence. In an attempt to calm the political infighting in Kyiv, which was triggered by this vote, the president, prime minister and parliamentary speaker Volodymyr Hroysman signed a joint statement in which they underlined that, "the issue of the resignation of the prime minister is not on the agenda".

The possible resignation of Yatsenyuk could lead to a collapse of the ruling coalition and snap parliamentary elections, would which inevitably trigger a wave of political and economic populism that could undermine the current IMF support programme and derail the war-torn economy.

"The international community is also aware of this. The world has a certain fatigue concerning Ukraine, and all the talk about potential snap elections only increases this feeling," Ihor Kononenko, first deputy head of Poroshenko's eponymous bloc in parliament, said on December 5.

None of this does much to attract investors back to Ukraine, which will be essential to getting the country back on its feet. There will be at least two privatisations next year, of the utility Centrenergo and petrochemical maker Odessa Port Plant, which the government hopes, in public at least, to attract major foreign investors. But many fear it that even though the world be watching, will be business as usual in this corruption-ridden country.

"Privatisation will happen, but who will participate? I worry [the elite] will privatise everything between themselves," says Andriy Stelmashchuk, managing partner of Vasil Kisil & Partners.