The Ukrainian economy is growing at a healthy rate, slightly ahead of analysts expectations, but still well below its potential especially following such a deep contraction in 2015. However, GDP growth will slow in 2019 as political uncertainty takes hold ahead of presidential and parliamentary elections next year.
Inflation has slowed on the back of a bumper harvest, but fundamental downside pressures are persisting, prompting the NBU to keep its monetary policy tight. The central bank has been forced to hike rates despite the cooling effect this has had on already lackluster growth.
The FX market has been turbulent in August and the hryvnia has dipped to close to UAH28 to the dollar. The absence of official external funding is a notable risk that could aggravate the situation rapidly in the coming months and a full blown currency crisis is possible in the autumn.
The return of the IMF and disbursement of a new loan tranche is critical for the economy to function smoothly through the end of 2019. The IMF mission will visit Ukraine in September and it’s hard to overestimate the importance of that visit.
GDP growth picked up to 3.6% y/y in Q2 (+0.9% q/q, seasonally adjusted), beating the market’s expectations. An early start to the harvest campaign and the resulting increase in crop production partially explains the pick-up.
The second quarter growth was broadly even across the economy, with trade (+ 5.7% y/y) the one outperformer that is consistently outpacing other key sectors. That robust trend is largely being driven by growing consumer and investment imports.
On the demand side, the growth is mainly supported by private household consumption. Rapid growth in nominal incomes (salaries grew 26% y/y in 1H18) and migrant remittances (estimated at more than +30% growth y/y in 1H) against decelerating inflation is fueling increased spending.
Consumer confidence is also improving – the GfK index rose 6.2 points y/y to 65.6 in June. Investment demand has remained robust as companies focus on maintenance capex after the 2014-16 crisis.
However, new greenfield investments will be limited given the substantial political uncertainty ahead of the March 2019 presidential election. SP Advisors have upgraded its 2018 GDP growth forecast to 3.4% y/y from 3.1% previously. However, in 2019, weaker consumer and investment spending will depress GDP growth to below 3%.
Another welcome development was inflation’s dip into single digits in the second quarter and will remain stable through the year-end. CPI slowed to 8.9% y/y in July, the lowest reading in almost two years as inflationary pressures have eased substantially in recent months.
Good weather conditions, in contrast to last year’s late frosts, have resulted in a bumper harvest, which in turn, has pushed food price growth down to 7.1% y/y. However, fundamental inflationary demand-side pressures are still material because of the high growth of salaries and other incomes.
The NBU’s tight approach to monetary policy (the regulator raised its key rate to 17.5% in mid-July) is gradually pushing commercial rates up. As a result, a larger proportion of incomes is flowing into deposit accounts rather than being spent on current consumption. Looking ahead, a possible increase in regulated gas prices could significantly contribute to inflation. SP Advisors maintain its end-2018 CPI forecast at 8.9%.
The risk to external accounts is minimal, as long as IMF cooperation restarts. Ukraine’s external accounts remain fairly balanced for now. The 12-month trailing C/A deficit remains just above 2% of GDP, substantially better than the historical average. The gap is still being covered by financial account inflows to the private sector.
The current level of the C/A gap looks sustainable, as the widening of the trade balance is being offset with larger migrant remittances. However, the financial account is at risk; a significant amount of state debt is to be redeemed in 2H18 and 2019, which could push the financial account into deficit and require a significant adjustment of the hryvnia exchange rate. With no external official funding available to Ukraine since 1H17, the authorities have used NBU reserves (-5.6% YTD) to repay sovereign debt. Recent FX market imbalances have resulted in a 5% depreciation of the hryvnia since the start of July. The prospects for the hryvnia exchange rate and broader FX market stability are largely dependent on Ukraine’s return to the IMF-backed reform path, which would unlock the next loan tranche.
September’s IMF mission represents Ukraine’s last chance to relaunch the stalled loan program. The current turbulence in the FX market, tolerable for now, combined with government liquidity pressures (both in hryvnia and foreign currency) are a signal that the situation could turn on a dime at any time through the end of 2018 if the IMF’s return is delayed.
The IMF mission will visit Ukraine in September, which could mean that a compromise on the contentious gas price deal is on the table. However, the risk is still substantial that the mission will not attain its goal. That would spell the end of the current IMF program.
The stakes for Ukraine are huge – the World Bank has reiterated that it will only provide its loans and guarantees to Ukraine if the IMF program is on track. The statement from the IMF visit in late September will be a key milestone to watch.
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