Despite the fact that economic activity in Ukraine started to recover in the second half of the year, risks to its economy remain large, the International Monetary Fund (IMF) said in its staff report published on October 3.

“On the domestic front, the main risk emanates from political instability, including possible early elections, policy reversals and slow program implementation,” the document says.   “Moreover, impatience with the speed at which living standards improve and corruption is addressed could cause the public to lose confidence in the authorities’ reform program. In addition, a more protracted and volatile bank resolution process could weigh on financial stability.”

According to official data, the national economy grew at its fastest rate since 2013 in the second quarter of this year, expanding by 1.3% compared with a year earlier, and with the IMF now expecting 2.5% growth in 2017. Ukraine’s industrial output grew by 3.4 y/y in August following a 0.2% year-on-year increase in July and 3.5% y/y fall in the prior month.

Industrial production benefitted from improving confidence and regained competitiveness, and the deescalation of the conflict in Ukraine’s eastern Donbas region, which contributed to an increase in coal and metals production, the IMF believes. At the same time, better-than expected output in agriculture and consumer-related sectors, such as retail trade, showed that the recovery is gradually becoming more broad-based.

“While these trends continued in the first half of this year, terms-of-trade shocks and the political uncertainty led to somewhat softer rebound in economic activity than initially expected,” the report reads.

The IMF also underlines that while the nominal ceasefire underway in the Donbas is broadly holding, despite occasional interruptions, a potential escalation of the conflict could destabilise expectations and the recovery of the country’s economy.

Ukrainian authorities demand control over the Ukrainian-Russian border in the East to prevent supplies of Russian weapons and personnel, prior to holding local elections in areas held by the separatists, a key goal of the Minsk peace accords reached in 2015. The Kremlin rejects any security preconditions, demanding that the local elections go ahead in the Donbas.

“Externally, key risks include a renewed weakening of the terms of trade and a weaker global recovery, particularly a slowdown in major emerging markets that could affect Ukraine through trade and commodity price channels,” the IMF report warns.

The multinational lender forecasts real GDP to grow by 1.5% in 2016. Economic activity will be supported by a de facto loosening of the fiscal stance (following the unanticipated tighter stance last year), increased consumer and investor confidence, gradually rising real incomes, and a gradual easing of credit conditions, as inflation continues to fall and monetary policy can be gradually relaxed.

At the same time, external conditions “are expected to remain a drag on growth, leaving the outlook depending crucially on the strength of domestic demand”, the reports adds.

Inflation is projected to pick up slightly to around 13% toward the end of 2016, owing to the increase in gas and heating tariffs, before gradually tapering off as one-off effects subside and economic stabilisation takes stronger roots, according to the IMF.

The current account deficit is expected to widen to 1.5% of GDP in 2016 (broadly in line with earlier projections).

“With limited private capital inflows but strong support from disbursements by official creditors, gross reserves are projected to increase to US$16.75bn by end-2016, and to US$31bn by end-2018. This would be somewhat lower than envisaged at the time of the program request and the first review, largely reflecting some use of reserves to buffer the adjustment to the worsened terms of trade,” it says. “Medium-term reserve adequacy will remain at broadly similar levels given the downward revision in imports.”

According to official data, Ukraine’s current account deficit widened to $414mn in August from $354mn the previous month. The National Bank of Ukraine (NBU) forecasts the current account deficit at around $1.8bn by the end of the year.