Ben Aris in Moscow -

Ukraine had a terrible crisis, but with a $15bn standby agreement with the International Monetary Fund (IMF) in place and an end to political instability, the country is in a better position to bounce back than it has been for at least half a decade.

The experiment with genuine democracy has come to an end, as under President Viktor Yanukovych the system has reverted to some extent to its old ways. Yanukovych has ruthlessly seized control of both the presidency and parliament, the Verkhovna Rada. Even so, last decade's Orange Revolution wasn't for nothing - despite his strong grip on power, the president remains accountable and the population politically active.

The is now critical for the government to push through badly needed reforms, a process that should pick up momentum in 2011. If Yanukovych is successful, then not only will the country flourish, but it should also begin the process of decoupling from Russia. Until real and sweeping reforms are implemented in Ukraine, the Ukrainian capital markets will simply follow Russia's volatile bounces.

In the meantime, the economic growth that was already gathering pace as 2010 came to a close, driven by internal demand, is expected to accelerate in 2011, although the rate is comparatively modest given the very low base of 2009. The consensus forecast for GDP growth in 2011 is 4.6%, with the main risks to growth internal factors related to tariffs and fiscal policies, as well as the stability of the banking system.

Inflationary pressures are to be slightly less pronounced next year due to the smaller budget deficit (around 6%) and the National Bank of Ukriane (NBU) probably allowing greater hryvna flexibility.

As the Russian stock market is expected to grow strongly by between 20% and 45% (depending on what happens to the global story), Ukraine should follow suit.

Economic reforms in motion to a better Ukraine

A major plank of the IMF deal is a commitment to pushing through reforms.

The government took the first bite of the unpalatable menu by hiking gas tariffs by 50% in the summer of 2010, which the previous regime had shied away from.

And the government followed through by launching a dramatic administrative reform just before the holiday season. The reforms certainly sound draconian - 112 government bodies down to 63, including 20 ministries cut to 16; the number of deputy ministers allowed reportedly limited to two rather than seven or eight; and the cabinet of ministers' staff halved from the current 1,174.

Analysts are confident that the government will maintain the reform effort for at least the next two years - just staying within the budget parameters would be enough to earn the government a lot of brownie points from the IMF and international investors. "Should the reforms aimed at reducing bureaucracy and corruption, increasing the attractiveness of Ukraine for foreign investors and restructuring the economy be maintained (and this is our base case scenario), that would lay a solid foundation for robust economic growth in the coming years," say analysts at Art Capital.

Ukraine is due to co-host the Euro 2012 football championships with Poland, and with the key unpopular changes scheduled to finish in 2011, the middle of 2012 could become a watershed between the old and the new, improved Ukraine.

Some of the reforms that are on the agenda for 2011, at the IMF's insistence, are:

• administrative

The sackings of December were written off by many commentators as little more than a reshuffle, with key players such as Prime Minister Mykola Azarov staying in place. But Yanukovych's chief of staff, Serhiy Lyovochkin, promised in a meeting with journalists that this is just the start of a comprehensive reform programme, which will include local administrative overhauls and a new package of anti-corruption laws. Without these additional elements, the changes could have limited positive effects.

• pensions

Social spending weighs heavily on the state budget and a reform of the system is due to start in 2011. This is likely to be controversial, as there are reports that the state will attempt to raise the retirement age.

The bill on the first phase of the pension reform, which the government will soon submit to the Rada in line with its agreements with the IMF, will contain a proposal for a gradual increase in the retirement age for women to 60, the first deputy head of presidential administration, Irina Akimova, said in December.

Yanukovych criticized the large gap between the minimum and maximum pension in the country also in December and clearly there is a lot of work to do here. "It is unnatural that one receives a minimum pension of UAH 40, and another UAH60,000. That's inadmissible!" he told a meeting of a committee on economic reform in Kyiv in December.

• tax reform

Protestors were out in force in December to protest against a new tax code that increased taxes on small- and medium-sized enterprise while reducing them on big business.

Russia's Vladimir Putin also kicked off his first term as Russia's president with a tax reform, but the Russian version was the other way round, slashing taxes on the ordinary people, while increasing them on the oil companies.

The Rada has retained the relaxed taxation system for individual businessmen whose annual turnover does not exceed UAH300,000 ($37,500), or UAH600,000 for businesses with cash registers and four hired employees, or eight employees for restaurant businesses.

According to the approved articles, tax rates are set every year by local government bodies, depending on the type of economic activities, per calendar month in the following range: for settlements with populations over 500,000 people from UAH20 to UAH600, with populations from 150,000 to 500,000 from UAH20 to UAH400, and for other settlements from UAH20 to UAH200.

The sum of incomes received over the annual turnover limit for individual businessmen paying the single tax (UAH300,000 and UAH600,000 with cash registers) is to be taxed at a rate of 15%.

Local taxes were also added. Cash foreign currency trades at currency exchange outlets, trading with goods, activities in the entertainment sphere (apart from conducting state money lotteries) and some services provided on a fee-paying basis are to be taxed with an additional local tax.

GDP outlook

The average forecast by experts for Ukraine's GDP growth in 2011 was downgraded in November to 4.6% from 4.8% in July, according to a posting by the Economy Ministry.

The medium-term prospects for growth are good too, with the government predicting growth rates of about 6.5% from 2012-2013, a prediction most analysts concur with.

Inflation

The government's official inflation forecast for 2011 is 8.9%, while independent analysts put the figure higher at about 10.7%.

Ukraine has been plagued by high inflation in recent years, driven up by heavy government spending in the numerous elections over the last five years. One of the first benefits of the political stability (and the IMF programme) has been more responsible management of the public finances. Oleg Ivanets of Art Capital says: "Planned inflation is low enough, counting all anticipated tax hikes. But there are a series of factors which will enable the government to ensure such a low level of inflation including strict control over prices of foodstuffs and introduction of floating exchange rate."

Unlike Russia, Ukraine has not abandoned administrative controls on major macroeconomic variables and price controls will be realised through capping commercial surcharges and limiting exports.

Still, bankers think the government will only be partially successful and Art Capital is predicting inflation in 2011 to reach 9.5%.

Industrial production

Industry is recovering nicely in Ukraine. Industrial output was up by 10.2% on year in October, unchanged from the previous month's year-on-year record and the Bloomberg consensus (+8.5%) estimates. Growth in the first 10 months stood at 10.7% on year, estimates Dragon Capital.

Industrial recovery was driven by export-oriented sectors. Metallurgical enterprises performed well and machine-building companies maintained a robust growth pace of 32% on year , remaining the major contributor to overall industrial growth in 2010.

The construction sector was one that stood out, showing clear signs of improvement boosted by increased government spending. Construction output surged by 15.2 on year in October, narrowing its 10-month annual decline to 9.0% from 12.6% in the first nine months and should perform well in 2011, reckon analysts.

Agriculture production was flat in 2010, as Ukraine was relatively unaffected by the fires and drought that afflicted Russia, but should continue to grow on the back of growing demand in 2011.

Consumption

Consumer spending was also recovering as 2010 came to a close, but doing less well than industry, hindered by a slowdown in real wage growth and weaker consumer confidence.

Growth in organized retail turnover remained little-changed in October, at 10.7% on year (versus 10.4% in September) and growth in 2011 will depend on overall economic activity. But in general, confidence was improving amongst the population as most people overestimated the impact of this crisis because the last one in 1998 was so bad. "With the absence of realistic economic grounds for optimism, consumer confidence growth in autumn 2010 is evidence that the public overestimated the risks in summer," International Centre for Policy Studies Deputy Director Maksym Boroda said in November.

Real disposable income grew by a strong 11.8% in the second quarter, after falling 8.3% a year earlier, but the growth rate is from a low level and incomes are still less than pre-crisis levels. Household income remains low, with GDP per capita at about $2,500, versus around $15,000 in Russia and $31,000 in the EU.

The unemployment rate was 9.2% as of the second quarter, but is expected to fall as the recovery continues. Going forward, some drag on real disposable income growth might come from inflation, partly fuelled by the 50% gas-price hike in July, which was connected with Ukraine receiving loans from the IMF, says Moody's.

2011 budget

The previous Yulia Tymoshenko government cooked the books in 2008 and 2009, promising the IMF a balanced budget but actually spending enough to send the deficit into double figures.

Since taking over, Yanukovych's administration tried to hold the deficit to 6% in 2010 and has set a budget deficit of 3.08% for 2011. "As regards budget deficit, it ought to be cut down - at least nominally - to below 3.5% of GDP (the IMF requirement)," says Ivanets of Art Capital.

Budget revenues next year are estimated at UAH281.5bn ($35.2bn), stipulating growth of 11.4%. "However, taking into account the possibility that in 2010 budget revenues may be under-funded by UAH10bn-20bn, revenues in 2011 would be higher by 16-21% than the real figure over 2010. With the rather modest economic growth expected in the budget (4.5%) coupled with 8.9% inflation, growth in budget revenues by 16-21% year on year looks overly optimistic and might be achieved only by either improved tax collection or businesses moving into the official economy," say analysts at ING.

The draft version of the state budget for 2011 adopted by the parliament in the first reading in December stipulates borrowings of UAH91.6bn ($11bn) for the budget (down 8.6% compared with the 2010 budget), which analysts say is reasonable, but the domestic rates and/or yields will have to rise to make this fulfilling the domestic quota of 53% of the total (against 66% in 2010). "Although the government expects to issue US$11bn [in 2011] via both domestic and external debt, total public debt will expand only moderately as 68% of the funding will be used to repay existing debts. With expected growth in public debt by 15% year on year in 2011, this should be offset by GDP growth in nominal terms of 19.5%. Thus, we expect a reduction in the ratio of public debt to GDP from 39.4% in 2010 to 37.5% in 2011," say analysts at ING. "In our view, the government's plans for financing pose no significant threat to its ability to service its current debts, as the public debt to GDP ratio should be lower in 2011. About 68% of debt issuance in 2011 will be used to finance repayments due in 2011."

• Privatisation

One of the big contributors to financing the government deficit will be the restart of the privatisation process.

In December, President Viktor Yanukovich cancelled the ban on selling strategic enterprises, which was imposed by President Victor Yushchenko back in May 2008. This ruling gives the green light to the privatisation of several big enterprises in 2011-12. In particular, stakes in Turboatom, Dniproenergo, Centrenergo, Zapadenergo, Donbassenergo, Odessa Port Plant and Krivorozhsky GOK of Oxidized Ores can now be offered for sale.

The authorities plan to raise up to $1.5bn from privatisations in 2011 (about UAH12bn, on par with the 2010 plan if accounting for the privatisation of Ukrtelecom).

Hryvnia and capital controls

"We recommend that investors maintain exposure to stocks and that they select the most liquid securities. We maintain our view that the hryvnia will neither notably devaluate or appreciate in 2010; thus, the exchange rate factor should be neutral for investment into Ukrainian stocks," say analysts at ING.

Worried about hot money flowing into the country, the government says it intends to impose some capital controls to limit this. Again, the government is resorting to administrative controls to manage the more difficult factors it faces in economic management.

In December, President Yanukovych ordered the government and the NBU to draft and submit to parliament a bill allowing the central bank to order mandatory foreign exchange sales by exporters that could go into effect in 2011. Analysts at Dragon Capital say: "We think this will give the central bank more room for manoeuvre with the UAH:USD exchange rate next year. We currently forecast the hryvnia's end-of-period and average exchange rates for 2011 at UAH7.90/USD and UAH7.95/USD, respectively."

Equity outlook

Bonds dominated the action on the domestic capital markets in 2010, but after the frenzy died down investors had begun switching into equities by the end of the year.

Over the last two months of the year, the UX index gained 13.7% versus growth of just 2% over the summer and has yet to win back all that was lost during the worst of the crisis in early 2009.

Bond outlook

Bonds had a great year in 2010, with the government's VAT bonds proving especially popular. However, the bond rally ran out of steam in the autumn and attention began to switch to equities towards the close of the year. By the end of October, Ukrainian bonds were performing poorly versus the other emerging markets and the EMBI+ Ukraine index spread widened by 2.8% or 15 points to reach 536 points, while the EMBI+ Global index spread narrowed by 11.5% or 32 points to 251 points.

Still, analysts say that fixed income will remain an attractive asset in 2011. "Ukrainian sovereign Eurobonds are becoming increasingly attractive, especially on the long end of the curve in terms of obtaining trading income," say analysts at Astrum. "Yield levels in the Ukrainian segment remain the highest among countries in the region (with the exception of Belarus) and also compared with most other securities in emerging markets."

• domestic bonds

The 2011 budget calls for UAH49bn ($6bn) of domestic borrowing in 2011, which analysts say won't be possible without an increase in yields or NBU refinancing. The latter scenario is more likely. "Taking into consideration that this year the government sold around UAH40bn of government bonds mostly at rates above 10-15%, it is unlikely to achieve a higher targeted amount without an increase in yields or without state-owned banks participating. Thus, we believe a significant part of local debt may be bonds for recapitalisation purposes and for lending to state companies (as it was this year). In particular, in 2011 the government plans to issue up to UAH5bn in government bonds for the needs of the Agrarian Fund as well as for financing to Naftogaz and the banks," say analysts at ING.

"Therefore, it is highly possible that a significant portion of the proceeds from the bonds sold will not come from the market, but will be refinancing loans from the NBU. If the bulk of bonds issued next year will be NBU refinancing with only a small portion being sold to the market, it is possible the government will keep bond yields almost flat or increase them only marginally, following its cost-reduction strategy. Thus, we believe local government bonds will not provide great upside potential for investors in 2011," says ING.

A big part of the fixed-income market in 2010 was the government's move to solve its VAT refund arrears by issuing special bonds to companies. These bonds were then resold by companies to investors and the market yield of VAT bonds at the end of 2010 was down at 11.5-12.0%. The volume of VAT bonds sold by exporters reached UAH11.2bln, which corresponds to 70% of the issue volume, and was nearly exhausted by the end of the year. Thus, the entire volume of the potential primary supply was about UAH5.2bln. Dragon analysts expect that yields on the VAT bonds will continue to decline throughout 2011. At the same time, the rate of price growth should be significantly lower and should be determined not only by market forces, but by dynamics regarding Ukrainian sovereign risk ratings. "In the short term, we expect that there will be price stagnation and we do not rule out the possibility of a correction (a yield increase) by up to 50 [basis points] in 2011," says Dragon.

As the market for VAT bonds fades away, analysts say the more interesting sector is the corporate bond segment, which is seen growing in 2011.

• foreign bonds

The 2011 budget plans for $4.5bn external borrowings that analysts say looks realistic.

Ukraine's Eurobond 2 Ukraine will come due in early April and means the government will have to refinance it with a new issue in the first quarter. The significant volume of Eurobond issuance may require an additional premium to current Eurobond issues. "We believe that Ukraine's risk is still priced excessively compared to peers and should come down in the medium term with accelerating economic growth backed by reviving domestic consumption and investment demand as well as an improved investment climate and lower political volatility," say analysts at ING.

Banking sector

Ukraine's bank sector was badly maimed by the crisis with half a dozen banks having to be rescued by the state. Most of 2011 will be spent trying to repair damage done to balance sheets and the sector is not expected to return to profit until at least the second half of 2011.

Banks' profitability will remain weak in 2011 and net results have suffered severely because of high loan-loss provisioning charges and declining revenues. Most Ukrainian banks will be either loss-making or only marginally profitable in 2010, and Moody's only expects the system to break-even in 2011.

"The banks will continue building up reserves [to cover toxic assets] until at least the end of the first quarter of 2011 and will be able to show profit no earlier than the second half of 2011," Viacheslav Yutnik, the first vice governor at Kyiv-based Prominvestbank was quoted by Interfax as saying. Other bankers predict the sector won't return to profit until 2012.

Asset quality continued to deteriorate in 2010, says Moody's, which expects problem loans (overdue loans plus restructured loans) to be a very high 40% of total loans at the end of 2010 and then start to gradually decrease in 2011.

Weak asset quality reflects excessive pre-crisis loan growth in combination with poor underwriting criteria and was exacerbated by the double-digit contraction of Ukrainian GDP in 2009 and the more than 60% depreciation of the local currency during the crisis, which boosted the debt service burden of the more than 50% of debtors that have borrowed in foreign currency.

The lack of capital remains a severe problem and the need to clean portfolios of toxic assets will remain a major issue for the banks in 2011. Banks that can't boost capitalization will have to build up reserves against problem assets for another two or three years.

Still, the problems are beginning to retreat now and the capitalisation of Ukrainian banks has improved, mainly due to capital injections from the government and foreign parent banks. The capital level of the system as a whole is sufficient to absorb both expected credit losses and worse-than-expected losses, says Moody's.

Also the funding base of Ukrainian banks has improved due to deposit inflows into the banking system during 2010, which restored the deposit base to pre-crisis levels. Banks also hold higher cushions of liquid assets than before the crisis, which leaves them better-able to absorb any renewed market stress.

"However, we note that the banking system remains prone to deposit runs due to still-low depositor trust in the banking system, as evidenced during the 2008-09 global financial crisis," says Moody's

The NBU reported in December that Ukrainian banks' net losses January through October 2010 ran at UAH10.6BN, which was 2.2x down on the same period of 2009 (UAH23.6bn).

In contrast to Russia and a reflection of the lack of depth in the Ukrainian market, corporate loans are likely to recover faster than retail loans, says Moody's. The state and social payments still play too big a role in the sources of income for households. "We expect the recovery in the performance of retail loans to be sluggish, as the financial condition of the corporate sector will have to improve in order for private households to benefit from wage increases or social benefits, for example," says Moody's.

The fact that so many Ukrainians took loans tied to foreign currencies in contrast to other countries in the region, making the devaluation extra painful, will also delay the recovery of retail lending. The share of forex-denominated retail loans (of total retail loans) was a high 70% as of October. The NBU banned forex lending to individuals in November 2009.

Ukraine has relatively high household leverage for a low-income country. Due to very fast pre-crisis loan growth, the share of household debt/GDP rose to around 30%. This share is twice as high as the average of the four-largest CIS countries, says Moody's, and at the same level as the CEE average, where per capita/GDP is five times higher than in Ukraine.

All said and done, Moody's predicts that Ukrainian banks will be able to absorb the losses on the way and there won't be another system-wide meltdown under the rating agency's base-case scenario, which should allow banks to build up capital through earnings retention.