A sustained improvement in macroeconomic fundamentals has helped Ukraine to shake off the label of ‘basket case’ and global markets are once again viewing the country with interest. While there is certainly upside potential for asset prices over the next couple of years, a volatile geopolitical and domestic political backdrop means that investors in the country will need a strong stomach.
Few emerging economies have had a more turbulent past few years than Ukraine. Since early 2014, a prolonged military conflict with Russia, domestic civil unrest and commodity market gyrations have taken a heavy toll on national income. Measured in gross domestic product (GDP) terms, Ukraine’s economy shrank by a massive 15% in 2014-15.
Yet, more recent activity indicators have been encouraging. The country exited recession in 2016 and annual GDP growth stabilised at 2.5% in the first half of this year. Ukraine has seen a marked improvement in inflation and public finances, and continues to adhere to the requirements of an International Monetary Fund (IMF) loan arrangement penned in 2015. Signs of greater macroeconomic stability have been recognised by external investors; in September, the government successfully placed $3bn in international debt.
Primed for an influx of overseas capital?
Verisk Maplecroft’s new Dynamic Macroeconomic Index (DMI) suggests that Ukraine’s fundamentals are as good as at any point since 2010. Updated once a fortnight, the index gives investors an indication of the economic health of over 20 major emerging markets. With an aggregate DMI score of 7.0/10 (where 10 is best), Ukraine currently outperforms all five of its regional peers.
Admittedly, the breakdown of the data paints a more nuanced picture. While Ukraine’s growth and inflation dynamics have stabilised and are in line with long-run trend rates, the country scores less favourably (4.0/10) when it comes to trade (the ‘External’ pillar). Exports plummeted in 2014 and, at just over $3bn per month, still only generate half as much income as they did prior to the armed conflict in the east.
The question for investors is: is the worst now over and has Ukraine become an interesting proposition from a value perspective? Asset prices are undoubtedly very low relative to pre-conflict levels. The benchmark PFTS equity index is 70-75% lower than in early 2011 and the hryvnia has lost a similar amount against the US dollar. Neither market has seen any tangible upside in 2016-17, despite an improving growth and inflation backdrop.
Political risk and corruption weigh on investment potential
In our view, however, there are three reasons why investors should retain a healthy dose of caution when it comes to Ukraine.
First, the country’s improved macro-financial position could, ironically, undermine the reforms needed for medium-term growth and stability. Many of these necessary structural changes are politically unpopular, and will touch on vested interests. The recent upturn has given the administration of President Petro Poroshenko extra breathing room and reduced its dependence upon Ukraine’s bilateral lenders. This, in turn, has eased the pressure to enact reform measures such as removing a moratorium on agricultural land sales and overhauling the pension system.
Ukraine’s land laws have resulted in the development of a parallel, de facto market in agricultural land accessible only to connected insiders, inhibiting competition in the agribusiness sector. Despite continued pledges to reform the sector, parliament has repeatedly extended the moratorium on land purchases. And despite IMF fears that the state pension fund’s $5bn deficit is unsustainable, parliament voted to increase pension payments in October this year. The decision was taken in the knowledge that Kyiv could cover its outstanding debts without IMF help. In short, the IMF no longer has a carrot, meaning it can no longer use the stick.
Second, the ongoing conflict in the east is a clear and present security risk for foreign operators with exposure to Ukraine. In this region of the country, trade blockades and restricted access are a major source of disruption for the highly important agricultural sector. And while most of Ukraine’s major industrial hubs are not directly affected by the fighting at present, a sudden escalation in the conflict could pose a threat to foreign personnel, business operations and capital assets in other areas of the country.
Third, corruption and crony capitalism continue to distort the playing field for overseas companies. Many industries are dominated by a clique of politically connected oligarchs who are able to game the system and erect sizeable barriers to entry for new participants. Shortcomings in the rule of law mean that foreign operators have limited legal recourse and are less likely to be treated fairly in the event of a commercial dispute.
Accordingly, foreign businesses looking to take advantage of Ukraine’s strengthening economic fundamentals should carefully consider the structural risks that remain an inherent part of Ukraine’s political and institutional landscape. As far as short-term investors are concerned, we see definite potential for upside in asset prices over the next 12-18 months. Nevertheless, amid geopolitical tensions and considerable domestic political uncertainty, local market investors will need a strong stomach.
Michael Henderson is chief economist and Daragh McDowell is principal analyst – Europe at global risk consultancy Verisk Maplecroft.