bne -

The crisis year was horrible for Ukraine, which was harder hit than nearly any other country in the Commonwealth of Independent States. The combination of collapsing steel prices, devaluation of the national currency, bank sector woes, political instability and, worst of all, mismanagement of public finances all contributed to the tumbling GDP.

In 2010, much depends on the outcome of presidential elections slated to begin in January, but that could take until April to come to a definitive conclusion. Much has already been written about how the various presidential hopefuls could affect the country's prospects, however, the conclusion of the elections itself is probably the most significant event, as all of the prospective candidates are pro-business. An end to the infighting would have the biggest impact on the country's prospects.

Ukraine's analysts are all in agreement that the economy will return to growth in 2010, albeit at a slower pace, and the stock market, which has recovered most of its losses, still has another 25% of upside over the year, driven largely by improving earnings that come on the back of economic recovery. Some are even more optimistic, as despite all its problems, Ukraine remains one of the most attractive investment destinations in the CIS. "We believe that Ukraine could well be the surprise performer in the first quarter. Elections in January will more than likely restore a government better able to manage the balance between the West and Russia. This in turn will ease tension over gas pipelines, and provide a government to which the IMF can reasonably lend. In this scenario, debt in particular looks attractive, with equity likely to follow the trend of declining spreads. We forecast 25% upside potential in the PFTS Index in 2010," say analysts with Renaissance Capital.

Stock market

The PFTS Index was the worst performing index in 2008, losing more than 50% of its value (against Russia's 46% fall). But it had a very strong run in 2009, up over 100%. "This is remarkable considering the degree to which the country has been buffeted by the crosswinds of default fears, gas disputes, a severe GDP contraction and uncertainty about the upcoming presidential election," says Renaissance Capital.

Like the other countries in the region, the PFTS had stabalised at the end of 2009, but share prices will track the economy upwards over 2010, with a possible sharp uptick following the elections, but smaller movements before hand.

GDP and global recovery

Ukraine's economy was the hardest hit of any country in the region by the crisis, but it was already bouncing by the end of 2009. The recovery will continue in 2010, but at a slower pace than with the other countries in the region. The bne consensus growth is for 3.8% growth in 2010.

The vertiginous fall of the GDP in Ukraine was truly horrific: down 20.3% in the first quarter, 17.8% in the second, and 15.9% in the third quarter of 2009. Analysts estimate that the total decline for 2009 will come in at about 12-13%. "While the economic contraction continues to ease, there are few signs of a fully fledged recovery any time soon. Producer confidence remains low and private consumption is subdued due to falling income and uncertainty over the exchange rate," says Elina Ribakova of Citigroup.

Ukrsibbank agrees and says that Ukraine will depend on an export-led recovery, as consumers are too shell shocked to deliver much in the way of economic stimuli and the main source of support for the consumer sector has become government largesse. "Earlier in the decade, against the backdrop of rising exports, Ukraine became an attractive market, absorbing billions in debt and direct investment. This triggered a skyrocketing growth in domestic incomes and significant increase in wages. Since 2005, a large chunk of growth was generated by domestic demand, accelerated by rapid increases in consumer credit. Since financial flows to the country have collapsed last year, growth pattern has turned upside down. Nominal wage has stumbled recently, pulled down both by sharp fall in corporate earnings and rising unemployment. Double-digit inflation gnaws real incomes," says Ukrsibbank.

Clearly the fall was slowing as 2009 came to an end and the economy may return to growth, but most analysts assume will take at least two years for the economy to regain all the ground lost in 2009.

Ukraine has also been plugged into the global demand recovery story more than most. With 50% of its GDP reliant on exports (especially steel), equity revaluation has been far more a function of global trends than domestic drivers. The official position is that the economy will grow between 3.0% and 3.7% regardless of what happens outside of Ukraine. "There will be a figure of 3% or a figure of 3.7%, and compared to the fall that we have in 2009, this figure is really achievable no matter how the situation develops," Economy Minister Bohdan Danylyshyn said in December.

Retail and consumers

Retail has also risen a little over the year from first-quarter lows, but the increases are in line with the small rises in income over the same period so no momentum is being built in this sector and growth remains a function of state largesse. "The retail trade has shown stable month-on-month growth since May (with September the only exception), but the year-on-year decline, at -20.7%, is still very large. In our view, the population is not ready to spend its accumulated savings (outside the banking system) in light of uncertainty about further income, mainly, in turn, reflecting uncertainty surrounding the upcoming presidential elections in January," says Renaissance Capital.

Analysts estimate that the population is holding some $55bn in cash outside the banking system and remain reluctant to spend this money until some clarity about the future appears.

Ukraine's consumers are in a much more difficult position than their Russian counterparts as about half of the mortgage borrowing was done in dollars. The devaluation of the national currency has significantly increased the cost of repaying those loans as well as putting extra pressure on the banks and exacerbating the non-performing loans problems. Together these problems will hold back the recovery of both consumption and consumer lending.

Industrial production

Industrial production recovery remains tied to the recovery of commodity prices - and especially steel. However, while steel prices are up, analysts are unsure about the sustainability of the increase.

Industrial production recorded contraction of just 6.2% in October 2009 comparing to nearly 30% decline earlier this year. There are two fundamental factors driving the industrial recovery - an improvement in global demand and weakness of Ukrainian currency, which allows domestic companies to reap more benefits from global growth.

Metallurgy, currently representing about 20% of Ukrainian industrial production, has been the key recovery driver so far, creating demand for coke, ore and electricity. It will remain the backbone of the local economy in the mid-term, but it's also the most dependent on global trends.

The food industry is a bright spot both from the perspective of export capacities and strong local demand. The sector offers prospects provided that necessary capital and technology would arrive there on time. Local currencies of Ukraine's neighbours appreciated versus the hryvnia, creating exports opportunities to the EU and Russia, a large market with population over 150m. Food industry key problems are painful de-leveraging, which froze investment projects across the industry, and some delays with certification of Ukrainian foodstuffs resulting from insufficient quality of inputs.

Investment

The contraction in capital investments is even greater than those of the sectors and the lack of investment will remain a drag on recovery. Capital investment was halved over 2009 and until the political uncertainty is resolved there is little prospect for its recovery.

Investment is well positioned to increase in 2010-2011, but this is subject to structural reforms that Ukraine has yet to begin. Currently investment is very modest, representing only UAH22bn, or close to 11% of country's GDP. It is well below the emerging market average of 30-40% GDP. "Fixed capital investment contracted sharply, by over 57% on year in the first half of 2009, and we expect it will remain squeezed owing to the lack of credit and overall economic uncertainty. In turn, the government ability to stimulate the economy is limited by the considerable deterioration of budget revenues," says Citi's Ribakova.

Inflation

In 2008, Ukraine was reporting the highest inflation rates in the region and amongst the highest rates in the world as inflation topped 31% in May 2008. The result of the crisis has been to depress demand and bring the rates down, but inflation remains high at an estimated 13-14% for 2009.

The central bank forecasts the rate will come down to 10% in 2010, but the government has promised several measures that could send the rate up again.

A social spending bill is in the Rada that would increase wages. Tymoshenko has also said that she will restart the payouts of defaulted deposits in Oschadny Bank. And the government has promised the International Monetary Fund (IMF) to hike domestic gas tariffs, which are half that the government pays Russia for the gas. "While delays in gas tariffs for households and heating companies should help to limit consumer inflation this year, we believe domestic gas prices will eventually be adjusted in accordance with IMF recommendations after the presidential elections, set for January. Combined with the expected expansion of social spending and wage indexation, as well as the high level of monetisation of the fiscal deficit, this should prevent consumer price inflation from dropping significantly," says Citi.

Budget

The budget has been whacked by the crisis and the government has done little to tackle the issue. Initially agreeing to pass a zero deficit budget for 2009 as part of the IMF deal to tap $16.4bn of stand-by loans, the pressure of looming elections meant the government under PM Tymoshenko continues to spend freely. The IMF has proven to be incredibly soft on Kyiv (unlike its attitude towards the equally troubled Latvia) and finally the fund caved in to allow a 3% deficit.

However, the government overshot even this target and Citi analysts estimate that the deficit ended 2009 closer to 6%, but will fall to 4% in 2010. In fact, considerable confusion surrounds exactly what the government is spending and how the picture will look next year. Several investment houses in Kyiv have reported that the official reports on state spending are clearly wrong and it appears the government has been cooking the books in an effort to keep the IMF money flowing while it muddles through to the elections in early 2010. "While analysis of public finances is complicated by the lack of reliable data on budget execution, available information provides some grounds for concern. The economic crisis has resulted in a considerable deterioration of budget revenues. Given this trend, the revenue target could be a major challenge. While the state budget deficit reached UAH24bn during the first nine months of 2009 and is below the UAH31.2bn level budgeted for this year, data published by Ministry of Finance in compliance with cash accounting do not show growing volumes of VAT arrears and tax payments made by Ukrainian companies in advance," says Citi's Ribakova, in one of the more restrained comments.

This confusion is highlighted in bne's consensus prediction for the level of the deficit in 2010, which is 4.9%, but estimates range from 4% to 6%. Whatever it ends up at, it is clear the deficit is too high.

However, Ukraine's companies are not helping, as many are sitting on their tax money and tax payment discipline has broken down while the government is distracted with elections. While the state budget deficit reached UAH24bn during the first nine months of 2009 and is below the UAH31.2bn level budgeted for this year, the amount of VAT arrears had reached UAH20bn by October.

And even Citi analysts, which estimates the 2010 deficit to come in at 4%, say this is unlikely and the deficit will go much higher. One the main unknowns is if the wage and social payments law that was passed at the end of 2009 is implemented, then the minimum wage will be increased by some 40% over 2010, adding UAH71bn to the budget spending bill, which would massively drive up the deficit unless some new sources of financing it can be found.

Balance of payments

Ukraine's current account has registered a deficit for the past three years, reaching a peak of $11.9bn in 2008. This reflected significant growth in consumption of goods other than commodities, while imports of oil and gas comprised only 10-15% of total imports. Exports of ferrous metals amounted to about 40% of total exports. The trade balance in commodities was in surplus in 2008. 2009 saw a sharp drop in non-commodity imports thanks to a collapse in demand that has brought the balance of payments into balance and the country was even showing a small surplus in the last months of 2009, says Renaissance Capital.

External debt

Ukraine has built up significant amounts of external debt in 2009 as it cast about for ways to pay its gas bill. In all, it has to repay some $40bn in 2009 - equivalent to the country's hard currency reserves and then some. However, the state did manage to restructure some $19bn of debt repayments and the fears of an impending default receded in the last months of 2009 - a trend analysts expect to continue through 2010.

The Eurobonds redemptions schedule in 2010 will be tight for the corporate and banking sectors, while the sovereign area has a year-long pause till December 2010. Total volume of redemptions in 2010 will be approximately a third less than in 2009 that would result in -$6.3bn of net repayments. According to "Fundamentals of monetary policy for 2010" published by the central bank, total payments on external debts in 2010 are estimated at $20.3bn, more than $18bn would make payments on corporate debts, around $2.3bn payments on state and state guaranteed debts, says Ukrsibbank.

Concorde Capital thinks that the level of total external debt will fall slightly in 2010 from 93% of GDP at the end of 2009 to 90% of GDP by the end of 2010. Renaissance Capital believes that the amount of external debt will fall faster in 2010 to about $30bn, with the same high level of rollovers as in 2009. At the same time the pressure will be taken off by the resumption of FDI, of which $4.5bn is expected to arrive and should pick up as the year wears on and investment sentiment improves.

Bank sector

The Ukrainian banking system has escaped the horror scenario for now. One important achievement is that it has survived a bank run and de facto collapse of three large banks, one of which was the leading financial institution in transactions and cash management. The consequences of this have been moderate, compared to what one could've expected, perhaps due to the low level of financial system development.

Ukrsibbank says that the majority of top-tier Ukrainian banks had excessive liquidity as of the end of 2009 as deposit runs stopped in the summer and the willingness of domestic banks to generate new loans was very limited.

Money market rates have been low for the most of this year, reflecting strong cash preference by domestic banks. To some extent, this preference can be explained by a) unwillingness to lend to real economy; b) strict conditions of NBU's refinancing loans (the central bank often demands additional restrictions); and c) there is no wide interbank market.

New lending barely exists, and commercial loans are rare and expensive - the interest rates on new six-month to one-year loans are typically ranging from 25% to 30% and there is still very limited number of banks offering lending products as of the end of 2009.

Non-performing loans (NPLs) are a big problem and will get worse. As of the third qurater, total credit portfolio of local banks was at UAH747.8bn, while amount of provisions stood at UAH92.7 bn. Ukrsibbank expects NPLs to reach 20% of the total loan portfolio which means full provisioning would require an additional UAH56.7 bn.

As of the third quarter, the capital of Ukrainian banks was at UAH118.0 bn. Subtracting additional provisioning would leave UAH61.1bn of net equity, which would be an equivalent of around 6.9% CAR. This compares to the healthy 15.6% reported in the beginning of October 2008. Given that some of the banks are extremely well capitalized (eg. state giant Oschadbank), the capitalization of selected banks could be significantly below the industry average. "Ukrainian banks should be able to clean the mess of troubled assets over the course of 2010, but some serious handicaps are there, including weak local legal system which allows borrowers to delay or even avoid cession of the collateral in some cases. Tier III and Tier IV banks are well positioned to be the first to restart lending as they are better capitalized than Tier I and Tier II financial institutions," says Ukrsibbank.