OPINION: Ukraine heads into choppy political waters as economy continues shaky recovery

OPINION: Ukraine heads into choppy political waters as economy continues shaky recovery
Ukraine, always noisy and highly competitive, won’t be any different this coming year.
By Oleksandr Valchyshen in Kyiv December 5, 2017

From an economic point of view, the global outlook for 2018 is relatively tranquil, with a positive bias. The US stock market is booming, having successfully bet on corporate tax reduction, and there is synchronised growth among developed and emerging economies. And, so far, international politics hasn’t derailed this feel-good environment.

In 2018, Ukraine will be gearing up for presidential elections scheduled for early 2019. The political scene, always noisy and highly competitive, won’t be any different this coming year. Quiet, behind-the-scenes manoeuvres are about to burst into full display early in the year. The recent wave of protests—an attempt to mimic Maidan 2013-14 — are bound to fade, partly due to their own irrelevance, and partly due to successful micromanagement by the Poroshenko administration.

A key strength of this administration is that it handles political jolts in its stride, downplaying them by not over-reacting, and by being innovative. Take, for example, the blockade of cargo transit with the occupied Donbas territories in early 2017. This event destroyed the growth momentum of Ukraine’s then-accelerating economy. President Poroshenko reacted by taking the opponent’s side and dominating the public discourse. Expect the same innovative, out-of-the-box reaction to whatever political jolts occur over the coming year – and there are sure to be a number.  

Against this background, Ukraine’s economy will begin 2018 with expected economic growth accelerating towards 3%, up from less than 2% in 2017. Leading up to the elections, expect the authorities to reflate an economy that has suffered a massive shock from the Russian military aggression that began in 2013 and continues through to today.

Ukraine’s economy underwent a massive structural shift over 2014–16. It is most evident in the structure of income distribution, ie the division of national income (GDP) between wages earned by wage earners, and profits retained by business owners, both private and public, with the remainder being taxes withdrawn by the government. The chart below highlights the dramatic shift in favour of profits and away from wages. Before the 2014–15 recession, the usual structure —illustrated by the time-series on the average wages–profits proportion—was 48% wages to 38% profits, with taxes accounting for the other 14%. There was a clear bias of income distribution towards wages. Over 2014–16, the bias shifted to profits. By the end of 2016, wages’ share of the income distribution declined by 10ppt to an all-time low of 36.8%, while profits’ share rose 6.4pp to 46.5%, an all-time high.

Such a dramatic shift in income distribution was due to many factors, the most obvious of which were the currency devaluation, and tariff policy liberalisation, which aimed to turn Ukraine’s Naftogaz, a net importer of natural gas, into a creditworthy entity. It comes as no surprise that gross capital formation —a good proxy for fixed investment by private businesses—has been rising noticeably since late 2015.

However, such an income distribution structure is inherently unstable and ultimately will be short-lived. The most important reason is that business investment is one of the most volatile components of GDP, and Ukraine’s economy is not an exception to this rule. Government and household consumption, which are driven by state transfers and wages, are more stable components of GDP. An economy that favours profits over wages has a built in constraint to economic growth, in addition to the obvious social, and therefore political, ramifications.

A reversal of this lop-sided structure has been taking place since early 2017.  Wages’ share has started to recover, increasing to 38% as of the end of the third quarter, which was thanks to the government’s aggressive push via legislation to double the minimum wage. This trend is expected to continue in 2018, although a much smaller minimum wage increase of 16% has been built into the state budget law.  Poroshenko’s preference was for an increase of 28%.

This is fundamentally immune to politics because any administration would do the same. That is why, in my view, this year’s protests, with calls for “breakthrough reforms”, will not get very far. Fundamentally, the protesters are calling for economic austerity, which means income suppression, and this will be seen as more of the same.

Another important part of Ukraine’s recovery story, and one that is frequently neglected, is unemployment. Unemployment hovered around 10% in 2017, after having been 9.3% in 2016. Before the 2014–15 recession, it was in the 7-8% range, and even at that level, it was fuelling public discontent. It is now an even more acute issue for the authorities. With elections on the horizon, austerity-driven reforms are unlikely, and, in fact, the official forecast has the unemployment rate declining closer to 9% in 2018. This appears a logical path for an economy that is in urgent need of expansion.

However, there will still be constraints on Ukraine’s economic growth in 2018. One is inflation, and another is the exchange rate. Both are seen by the wider public as major indicators of economic health. Hence, authorities tend to tread cautiously as far as monetary issues are concerned. For this reason, it is reasonable to conclude that Ukraine’s central bank will stick with double-digit interest rates for the whole of 2018. Currently, NBU’s policy rate is 13.5%. Just paying more than 10% on commercial banks’ local-currency reserves with the central bank provides support to the hryvnia’s exchange rate versus the US dollar.

My view of a tranquil global economy is based on a US dollar valuation (as measured by the dollar index DXY) that is projected to move downward; ie the index will move closer to 90 points from today’s 93. This will boost the valuation of all other major currencies. For Ukraine’s hryvnia, due to high inflation that eroded past competitiveness gains, dollar weakness is not enough. The hryvnia has to be supported by the authorities, including by double-digit interest rates paid by the NBU, and by a primary surplus by the Ministry of Finance.

The 2018 state budget law envisages a 0.2-0.5% primary surplus (depending on current proposals for the final vote), which is very much welcomed by the investors in Ukraine’s sovereign external debt. As long as 2018 does not see a major shake-up in the global economy and financial markets, and Ukraine’s government is able to maintain growth by micro-managing the domestic situation, including unemployment and inflation, prospects for 2018 are favourable.

Overall, 2018 should be a year of economic tranquillity. I expect noisy, but not destructive domestic politics, high interest rates of 10%+ on UAH-based instruments, and an exchange rate preserved via very limited floating. The economy will be supported on the one hand by business-friendly, liberal rhetoric of government officials and, on the other hand, by a very sober, risk-wary approach by the authorities, who will micro-manage a shaky economic recovery.

Oleksandr Valchyshen is Head of Research at ICU, a Kyiv-based financial-services group co-founded by Valeriya Gontareva that provides investment banking, securities trading and asset management for private and institutional investorsHe was formerly head of Macro/Fixed Income Research for ING in Ukraine. Follow him on Twitter at @AlexValchyshen