Ben Aris in Moscow -

Like the rest of Europe, Ukraine's fate in 2012 depends heavily on how the crisis in the Eurozone and beyond plays out and its impact on commodity prices. However, most of the investment banks are assuming Europe will muddle through and there will not be a second wave of the global financial crisis.

Ukraine's economy was recovering well in 2011 with growth rising on the back of a recovery in consumer confidence and falling inflation. Moreover, growth was supported, and will be supported in 2012, by a record harvest in 2011 and the ongoing improvement in the farm sector. As agriculture is quickly becoming a strategic sector, farming will go some way to towards ameliorating Ukraine's other problems.

Despite the good news on the macroeconomic front, international financial institutions are almost universally pessimistic on the prospects for 2012 due to the increasingly political irresponsibility of the government.

The bottom line is that the government has planned for a budget deficit of 2.5% of GDP in 2012, which is based on extremely optimistic forecasts, and which the government will struggle to fund without the help of the International Monetary Fund - but an IMF deal will only be struck if Ukraine is on the brink of a crisis.

With a key general election slated for October 2012, where President Viktor Yanukovych clearly intends to consolidate his control over the Rada in the face of his plummeting popularity, it is highly unlikely that he will push through the reforms that the IMF is demanding, especially the hikes in household gas tariffs. Depending on how egregious the electoral fix is (and it looks at the end of 2011 that it will have to be pretty extensive), there is even the possibility of mass protests.

The government is seeking to avoid any and all painful reforms at a time when the economy is not strong enough to put off such reforms for that long. Still, economists say that the economy is in better shape than at the start of 2008 and the government has some wiggle room. "Even without an agreement with Russia [on gas prices], only a major deterioration of global prospects will force the government to accept higher domestic gas prices in exchange for IMF money. Hence, we still believe that Ukraine will opt to re-engage with the IMF before the elections only as a last resort to prevent an economic implosion. This, of course, is not the best option, and we believe the optimal policy path would be to a strike deal with the IMF now to calm the markets and ensure an uneventful transition into what promises to be a difficult 2012," says Renaissance Capital's Ivan Tchakarov.

Commentators all agree that political risks are likely to intensify in 2012, which extract an economic cost in the form of elevated pressure for higher fiscal spending. Put in simpler terms: the government is putting off all reforms until the elections are passed, while the National Bank of Ukraine (NBU) is artificially restricting the population's access to hard currency and choking the banking sector off from liquidity to stave off a mild devaluation that will hurt economic growth.

As for the stock market, the uncertainties have seen the daily volumes on the Ukrainian Exchange sink to the point where the market is basically simply ticking over. The discount to emerging market peers rose to April 2009 peaks at the end of 2011. The market is cheap, but unlike the heady days following the Orange Revolution, "there is no investment story to sell," sighs one senior investment banker in Kyiv. The market performance is likely to be lacklustre until the market finds a new narrative.

Return of political risk?

Politics have taken a turn for the worse in Ukraine since Viktor Yanukovych was elected in 2010. At the start of 2011, Vice Premier Minister Sergiy Tigipko did the rounds of investment conference promising to "do a Georgia" and push through a long list of radical reforms. As the year comes to a close, none of these initiatives that should have allowed the economy to bloom have been put in place, nor even been discussed, and only about half of the government's wider reform programme has been implemented.

Instead, Yanukovych has spent most of the year either throwing his political opponents in jail - most notably Ukrainian opposition leader and former Prime Minister Yulia Tymoshenko - in the name of an anti-corruption drive or doing what it takes to persuade the IMF to pay out on its latest tranche of loan money. A few real reforms to things like the pension system have thus been reluctantly enacted (and caused protests by veterans and Chernobyl workers amongst others who saw their benefits cut).

At bne, we don't see any attempt to move Ukraine forward as long as Yanukovych's political consolidation continues. In December, the Rada pushed through a government-sponsored election reform that returns Ukraine to a proportional representation system. Yanukovych's parliamentary Party of Regions won some 33% in the last elections, but the popularity of both the president and the party have dropped like a stone since.

According to a poll in October, only 10% of voters fully support the president's actions (down from 21.5% a year earlier), while his disapproval rating surged to 54.6% (up from 35.2% a year earlier). Meanwhile, the prime minister is supported by 5.1% of respondents, with 61.8% fully disapproving of his activity. "In this situation, it hard to believe that the ruling authorities will be able to secure enough voter support in the 2012 parliamentary elections to form a single-party majority in a democratic fashion," says Iryna Piontkivska of Troika Dialog.

It seems clear that the president has no intention of contesting the election in a "democratic fashion." The new election law means half of the 450 seats in the Rada now go to party lists. The Party of Regions is now expected to "win" at least a clear majority in the 2012 general election despite its plummeting popularity.

Democracy has gone backwards. As a sign of how bad things have got, the conservative US think-tank the Heritage Foundation ranked Ukraine almost at the bottom of its annual "Economic Freedom Index" in October, nestled between Uzbekistan and Turkmenistan.

Yanukovych seems more interested in building his new presidential residence at a cost of millions of dollars than he does doing anything about the economy.

GDP drivers for 2012

Despite the political problems, Ukraine's economy has actually been performing relatively well. "GDP grew about 6% year on year in the third quarter of 2011 owing to robust domestic demand, or about 3% in seasonally adjusted terms, according to NBU estimates. In September, retail trade picked up 14% year on year, supported by growing real wages. Investment activity improved on the back of preparations for the Euro 2012 football championships. Construction growth stood at 11% year on year in January-September, as compared to minus 13% a year ago," say analysts at Citigroup.

But as we head into the new year, bankers think the economy will lose momentum as the macro problems begin to weigh on people's confidence. Increasing financial instability and tightening credit access will stymie investments, and growth of household consumption will remain below 4-5%, according to Citi.

• Hryvnia devaluation on the cards?

The main risk to the economy is another possible devaluation of the hryvnia in 2012. The currency has already lost about a third of its value since the crisis broke in 2008, but economists anticipate it could lose another 5%-10% in 2012. "While we believe that hryvnia weakness is unavoidable, it will most likely contrast with 2008 in terms of scale (we expect a modest 6% devaluation to UAH8.5/USD1) and should be more of a quick burst than a drawn-out event," reckons Troika.

Certainly the population is worried and bought about $2bn in hard currency in September and $1.4bn in October as a hedge, forcing the central bank to impose administrative barriers to buying foreign currency as a way of slowing the haemorrhaging that threatened to undermine the currency as reserves dropped sharply. "To hold the current exchange rate, the NBU has tightened rather dramatically, while the finance ministry has taken to issuing dollar-indexed T-bills, since the yields investors demanded on hryvnia paper were unsustainably high," says Jacob Neil of Morgan Stanley.

The NBU has consistently denied that it intends to allow another devaluation of the hryvnia and intervened in the market in the autumn to support the currency. Still, analysts say that some sort of devaluation is inevitable, although banks like Deutsche Bank say the government will be able to support the currency through all of 2012, or at least until elections are passed.

In the meantime, the government is looking for ways to ease the pressure and has, for example, agreed with Moscow in December to pay for its gas imports from Russia using rubles, not dollars.

The only bright spot in a possible devaluation scenario is that Ukraine's many metals and mining companies would materially benefit from a devaluation (as their hryvnia costs are cut while their export revenues stay the same) and their stocks are favoured by some banks as a defensive play in 2012.

• Current account deficit

The hryvnia is under pressure due to the widening current account deficit, which reached $7bn in the first 10 months of 2011, up from $1.4bn in the same period a year earlier.

The soaring cost of Russian gas was a big contributor to this and remains the main bone of contention in Ukraine's external relations. Under the terms of a deal brokered by Tymoshenko in 2009 while she was still in office, the cost of gas imports to Ukraine are linked to oil prices. The trouble was she cut the deal in the depths of the crisis when all the forecasts were for oil prices to fall or stay low; instead, they soared quickly, recovering to around $100. At the time Tymoshenko's deal made perfect sense, but it has saddled the government with a steadily rising and extremely expensive gas bill that the Yanukovych government has desperately been trying to wheedle out of, but to little avail.

In addition, Ukraine has seen an increase in the import of capital equipment to the tune of $6bn that is being driven by the infrastructure associated with preparations for the European Football Championship that Ukraine will co-host in 2012.

The upshot is that Ukraine has been eating into its hard currency reserves, which had fallen in 2011 by a little less than $1bn to $34.2bn by the end of October. The state was due to pay $2.6bn to redeem short-term debt by the end of 2011 and was expected to end the year with $31bn.

In the new year, the state has another $1.9bn of commercial redemptions due in 2012 plus another $3.5bn due to the IMF, which, if no gas deal with Russia is struck and no IMF money is forthcoming, means the government will end 2012 with $24.5bn, according to Renaissance's estimates.

This is a steep drop in reserves, but it's still more than the requisite three months of import cover that most countries hold. However, if you include the private sector, then Ukraine has a total of $53.5bn of debt coming due in 2012 (equivalent to 1.6-times the government's hard currency reserves). And on top of this is the $700m to $1bn a month home owners with mortgages denominated in foreign currency need to meet their obligations.

In terms of funding the budget deficit, the government has three options: do a deal with the IMF, borrow abroad (Russia), or privatization (the budget assumes UAH10bn, or about $1.25bn, of sales).

Ukraine can deal with all this in 2012, but economists say that if there is no IMF money or a deal with Russia on gas tariffs, all that will happen is the problem will be shunted off into 2013 when it will be a lot more serious. And doing nothing still leaves the government with $6.5bn funding gap, says Renaissance Capital. "With Ukraine's limited reserves and high devaluation concerns, we think that Ukraine will require significant external support, probably a Russian and an IMF deal, to avoid an uncontrolled devaluation," says Jacob Nell of Morgan Stanley.

• Economy should be strong

If it weren't for the other problems Ukraine would have put in a stellar year in 2011 and should have been looking forward to more.

Domestic demand was surging towards the end of 2012 with fixed investment up a very impressive 21.2% in the first ten months of 2011 and retail sales up 14.1% in the same period.

At the same time, inflation fell to a historical low of 5.4%Y in October 2011 (it was over 25% pre-crisis), as this year's good harvest drove food inflation down sharply, which accounts for half of the consumer's shopping basket, to a low of 2.6%.

Taken all together preliminary growth figures show the economy accelerated to 6.6% year-on-year in the third quarter of 2011 compared to 3.8% year-on-year in the second quarter, and is expected to end the year at 4.7%.

But the government has done nothing to maintain the momentum. The government downgraded the GDP outlook for 2012 from 5.5% to 4% in the last months of the year, which is also the consensus forecast from the likes of Dragon Capital, Deutsche Bank, Citi and the IMF.

The story with inflation is slightly better with the IMF predicting the inflation rate in Ukraine will reach about 10% in 2011 and a bit below 10% in 2012, according to the International Monetary Fund's Resident Representative in Ukraine Max Alier.

• Little hope of an IMF deal

As Ukraine's economic situation deteriorates it is becoming increasingly dependent on help from the IMF and hoping to secure a resumption of credit from the IMF under a $15bn aid program, which was suspended at the beginning of 2011 after Kyiv delayed structural reforms.

The IMF had two key demands: cut pension benefits and increase the household gas tariff. While Yanukovych caved on the first, he has been very reluctant to accede to the second. Instead a comedy of errors has been played out as Ukrainian politicians shuttle back and forth between Kyiv and Moscow trying to renegotiate Tymoshenko's gas deal. On the one side the Ukraine claimed (almost daily) that a new gas deal had "nearly" been signed, while on the other the Russians doggedly insisted that no deal has been agreed.

The government did make some concessions on the need for pension reform. The authorities increased the retirement age and extended the qualification period for receiving full pension benefits. The Ministry of Finance forecasts the pension fund deficit in 2012 will be close to zero as a result of the pension reform and higher revenues due to widening of the tax base, but the IMF and bankers remains unconvinced, forecasting the deficit will grow further.

The gas tariff was the main bone of contention for most of 2011, but in November a new and even more serious argument broke out over the government's proposed budget deficit in 2012, which bankers in Kyiv now say has superseded the gas tariff as the main problem. With slowing growth and no IMF money on the horizon the question growing in urgency is how the government can finance the expected budget deficit in 2012.

The deficit was contained in 2011, but will still end 2011 at 3.5% GDP. And 2012 will be even more difficult. Naftogaz is running at a huge loss as is the state-owned pension fund.

According to Citi the government face a litany of woes. Ukraine failed to meet its obligation imposed by the IMF to hike gas prices by 20% in April and by another 10% in July. Budget transfers to Naftogaz and compensation for the difference in tariffs to local budget amounted to UAH6.2bn ($0.8bn). In addition, the government injected $8.5bn to support Naftogaz's capital position this year. The pension fund deficit, which could reach UAH21bn growing from UAH14bn in the first eight months, is likely to exceed the UAH17bn target this year.

The 2012 budget penciled in a 2.5% of GDP deficit (including 0.8% for state-owned gas company Naftogaz that pays for the Russian gas) and $3.5bn net borrowings from external markets, which was adopted in October. According to the plan, the deficit will reduce to UAH24bn or 2.5% GDP - in line with IMF requirements - in 2012.

Assuming 5% GDP growth and average inflation of about 7.9%, the government forecasts 13% growth in revenues (to UAH338bn/$42bn) next year while planning to limit expenditure growth to 7% (to UAH362bn/$45bn). The government plans to borrow about $3.5bn net on external markets and UAH10bn net in national currency. However, these estimates were in question from the off as the government itself has already downgraded its own growth forecast to 4%.

An IMF team visited Kyiv in November but left early and no money was forthcoming. Although no details of the discussion were released it is clear the IMF has lost its confidence on government promises to restrain spending when it has repeatedly lied to the fund in recent years (especially when Tymoshenko was prime minister), indulging instead in cooking the books to mask its largess. With political uncertainty rising borrowing on the international capital markets to plug the hole will be at best expensive.

One interesting development is in December bne sources in Kyiv said that Moscow and Kyiv were on the cusp of agreeing on a deal where Ukraine would sell its gas transport pipeline, that carries 80% of Russia's gas exports to western Europe, to Russia in exchange for cash and reduced gas prices, which would dramatically improve Ukraine's fiscal position. Russia cut a similar deal with Belarus in 2011, which was in equally dire straights, taking control of Beltransgaz in December.

In November Ukraine's media reported that Russia and Ukraine have agreed to reduce the gas price by nearly half to $220-230/mcm from $355/mcm in the third quarter of 2011 and an estimated $400/mcm in 4Q11 saving $500m per month for Ukraine according to PM Nikolai Azarov, which might be part of the acquisition of the pipeline, but in any case was typical of the endless "almost there" newsflow on a deal.

• Relations with EU frozen

Ukraine has been working hard to balance the power of its big two neighbours by getting closer to the Europe, but its hopes of negotiating a free trade agreement (FTA) with the EU have been dashed by Tymoshenko's jailing.

The European Commission took Tymoshenko's arrest and conviction badly and has tied the case to Ukraine's application for a trade deal. On the flip side Ukraine's parliamentarians dug their heels in and refused to decriminalise the charges that Tymoshenko was convicted on, which would have meant she was barred from running in the 2012 election, but wouldn't have been incarcerated. Ukraine's EU aspirations now look dead in the water for the foreseeable future.

Some commentators have suggested that the closing of the door to Europe will only drive Ukraine through an open door to Russia. But has bne argued in a piece, Kyiv, the new Minsk, this is to give Yanukovych too much credit: we don't believe Ukraine has any strategy at all, but instead is turning in on itself to resemble Belarusia's authoritarian regime. As Renaissance Capital's chief economist Ivan Tchakarov puts it: "early policy successes have turned into policy procrastination."

"The key difference between [meeting with government officials in November] and our previous meetings was the sense of a lack of direction that dominated our recent discussions," says Tchakarov. "The government had initially sprung a surprise or two by holding its ground against Russia and passing a number of important reforms, including those on pensions, land cadastre, government procurement and the handling of corruption. However, it has since lost focus and momentum, leading to visible frustration in the IMF when it comes to the possible resumption of all-important relations between Ukraine and the global lender."

Banking sector improving but still in the woods

Ukraine's banking sector remains particularly vulnerable to a second wave of the financial crisis in Europe. That said banks have managed to attract more deposits and are slowly climbing out of the hole and indicating some return of trust by the populous in the banking sector.

Despite heavy borrowing in euros and dollars abroad to cheaply finance a booming mortgage sector pre-crisis, the closure of the international credit markets in 2008 did relatively little damage to the Ukrainian banking sector in 2008 and 2009 as although these loans went bad the sector was propped up by the European parent banks that bought assets in Ukraine so enthusiastically between 2006 and 2007.

"The banking system is still exposed, albeit less so than in 2008. The loan-to-deposit ratio is still high at about 170% and FX loans account for 45%. Banking system assets to GDP are 86%, with state controlled banks accounting for some 20% and foreign banks for around 40%. At the same time, correspondent accounts fell to an all-time low despite 20% year-on-year nominal GDP growth in 1H 11, as the NBU tried to limit pressure on the hryvnia," say analysts at Citi.

If there is a second wave then the sector will not get off so lightly. As those same European banks will this time be at the centre of the storm they will be unable and unwilling to come to the aid of the subsidiaries, many of which could go to the wall, sparking a systemic collapse.

It is the mortgage lending that makes the banks so vulnerable, half of which were taken out in foreign currency; the 30% devaluation of the hryvna during the crisis has sent borrowers' monthly payments soaring while house values have dropped like a stone. Unable to pay the bills or sell their houses to recoup their investment, many Ukrainians have chosen to simply default. Banking sector non-performing mortgage loans are estimated to top 40%.

Those foreign banks that could sell already have, with Russia's Renaissance group selling off its Ukrainian retail arm in 2010. But most of the rest are stuck and have taken to closing their retail arms, but retaining their corporate banking divisions in a classic rear guard action for markets in trouble. In the meantime some big names have booked heavy losses and the Bank of Georgia closed its Kyiv-based investment bank BG Capital completely in November.

The big winners from this brouhaha have been the Russian banks that opened branches in the last two years. The huge state-owned Sberbank and VTB Bank are both in Kyiv and with abundant liquidity at home, VTB closed a deal to lend SCM $500m at the end of October - by far the biggest deal this year - as the Russian banks are now the only game in town.

Equities uncertainty

The Ukrainian stock market has been trounced by the troubles at home and abroad. It is not so much that the market has lost value (it has) but that international investors have largely abandoned the market which has seen its daily turnover fall off to a few million dollars a day, down from its peak in 2008 when it when the turn over was in the tens of millions a day.

"While the market is clearly cheap, the fundamental catalyst for it to break out remains elusive," says Troika somewhat understating the issue.

The market bottomed out in about November 2011 when the UX index broke back through the psychologically important 1500 level. There was some talk of an end of year rally as devaluation fears receded as the year came to a close. But the market is still hostage to events in western Europe, say analysts. Still, most banks have simply refused to set a target as the next six months is simply too uncertain to call.

Along with Russia, Ukraine has an almost pariah status amongst international investors with the discount on the market to other emerging markets having reached their April 2009 highs, or over 50%. Analysts at Troika Dialog expect the market to trade sideways and to remain volatile into the new year.

In 2012 the market could recover somewhat simply because it can't fall much further. Troika is predicting an end-2012 target for the UX index of 1,730, but concedes the uncertainty could leave it as low as 1,536 or as high as 1,932.

And the market is very cheap with an average price/earnings ratio of 6.0x predicted for 2012, but in the deteriorating business environment bankers say even these numbers are becoming less meaningful. "Transfer pricing and tax optimization schemes create difficulty and are a shortcoming when determining a proper P/E level for the Ukrainian market. They are then further exacerbated by the ever-increasing detachment from fundamentals and a lack of conviction as to the proper risk level," say Troika's analysts.

All this smacks of Russia in the 1990s, but having said that, there are still some gems amongst the listed stocks, with chicken farmer MHP, egg-producer Avangard and steel pellet producer Ferroexport all remaining favorites.

As 2011 came to a close, Ukraine has had a bumper harvest, surpassing even the 2008 record year and up by half on the year before to 55m tonnes of grain. Yields creeping up as the leading producers become more professional. According to the State Statistics Service, total agricultural output in Ukraine was up 16.5% year on year in January-November, with growth of 20.4% at agricultural enterprises and 13.4% at private farms and gardens. Grain production in Ukraine contracted 14.7% last year from the year before to 39.27m tonnes.

MHP, the largest poultry company in the country, is the darling of the sector and Troika had its shares marked with 102% upside as 2011 came to an end. "MHP should also be able to deliver 13% output growth due to more efficient usage of capacity. Longer-term growth will come from the Ladyzhyn project, which should increase processing capacity some 60% by 2014. The company's 2012E net debt/EBITDA ratio remains around 2.0, with short-term debt of $86m as of end of June being fully covered by forex revenues, which should reach $300m this year," says Troika.

Likewise, Avangard was already the largest Ukrainian producer of shell eggs and egg products and in 2011 became the second largest producer of eggs in the world. According to World Poultry magazine the company's 22m hens is second only to giant Cal-Maine Foods of the US with 29m hens. Troika expects Avangard's revenues to surge 36% on year in 2011 to $598m and 18% in 2012 to $704m, driven mainly by shell egg output growth.

Ferrexpo is a leading Ukrainian exporter of pellets; its iron ore base is among the largest in the world, estimated at 7bn tonnes and the company is expected to report record high Ebitda of $869m in 2011. However in 2012, Ebitda is expected to drop by 22% due to the slowdown in Europe and falling iron prices. As a commodities company, its stock price has been especially vulnerable to volatility and its share prices sold off heavily in the third quarter of 2011, trading at half of its historic highs as 2011 came to an end. Still, the company plans to double its capacity to 18m tonnes by 2018, and the next announcement on capex plans in March could be a trigger for the stock, reckons Troika.

Other sectors that interest investors include the automotive (Motor Sich) and utilities, where the government plans to sell off stakes in some key power producers. (A 53% stake in Centrenergo should be privatised in 2012.)