Ben Aris in Moscow -

While the rest of Europe is showing signs of recovery, Ukraine is sliding backwards. The endless political imbroglios ahead of January's presidential elections has paralysed the government, leaving the country open to the real possibility of suffering a second wave of the crisis.

The economy is in a complete mess. Estimates for economic growth this year run from minus 15% to minus 20%, and the best analysts can point to in Ukraine is an end to the economic collapse. "Ukraine was hit harder by the crisis than any other country in Europe. Going into the crisis, it was a highly unbalanced with very high economic growth, but also high credit growth and the highest inflation rate in Europe. When the crisis hit there was no way the economy could cope," says Lars Tranberg Rasmussen, a senior analyst with Danske Bank. "I believe the economy is close to bottom now, but there are no indicators pointing upwards yet."

The succession of elections since the change of guard during the 2004-05 Orange Revolution has left the country rudderless, while those that held office indulged in populist politics in an effort to consolidate their hold on power.

Nowhere is the government's lack of backbone clearer than with domestic gas prices: the government imports gas from Russia for $250-300 per 1,000 cubic metres (cm), but sells it domestically at $100-150/'000 cm. Given that gas payments is the country's main economic headache, the International Monetary Fund has insisted on a hike in the gas price on September 1 and then again on October 1, but nothing has happened. Conveniently for presidential candidates, the legality of any raise in the gas price is bogged down in the courts.

And the endless political squabbling keeps destabilising what is already a wobbly situation. After the devaluation of the national currency at the start of the year, by the summer money was returning to bank accounts - only to leave again when politicians started speculating about the chance of a second devaluation. "We saw money coming back to our accounts in the summer as the population started trusting banks again. But then in the early summer, politicians started talking about devaluation and there was another outflow - not as bad as at the start of the year, but it still caused us problems," Ukrsibbank's chairman, Sergiy Naumov, told a conference organised by Concorde Capital in Kyiv at the end of September.

Second wave?

The government's apparent unconcern with the economic problems has put the economy in real danger of a second wave of the crisis. Vitaliy Masyura, first deputy at Delta Bank, summed it up nicely: "The panic is over, but the future is uncertain."

None of the senior bankers at the Concorde conference would be drawn on either the possibility of a further devaluation of the hryvnia or how high banking non-performing loans (NPLs) will go, as both events are palpably close to happening.

According to the most recent figures from the National Bank of Ukraine (NBU), NPLs were up to 6.8% of total bank sector credits in August, but the true level of bad debt (using international accounting standards) is thought to have already reached 30%, the highest level in the CIS, according to analysts at Raiffeisen International.

The NBU's governor, Petro Poroshenko, said at the Concorde event that three-quarters of credits given by Ukrainian banks have been restructured since the start of this year. However, all this means is that many of the "restructured" loans are still bad, just the demand to repay them has been delayed to "later." This is especially true for those loans denominated in foreign currency, as bankers are hoping against hope for the hryvnia to regain some ground lost during the devaluation.

At some banks, NPLs already make up more than half their loan book, says Raiffeisen. But leading bankers say they have the issue of bad debt under control, as at least they now understand which are the risky loans and have stopped offering these credits. But that still doesn't help them with the bad debt already on their books. Uksibbank's Naumov echoed calls from many in the sector to set up a "bad bank" into which all these toxic assets can be dumped. "These bad debts need to be financed, as they are a burden on the balance sheet that prevents us from lending," says Delta's Masyura. "What will the banks do if there is a second wave [of the crisis]? Who will refinance the restructuring of these problem assets? Now all the banks are fighting on their own with mixed results."

What's next?

Ukraine's problems are manifest in the repayment of national gas company Naftogaz' Eurobond, which is due on September 20.

Arguably the most important company in the country (certainly the biggest single taxpayer), Naftogaz is responsible for paying Ukraine's monthly gas bill to Russia, but has been living hand to mouth for most of this year. The company was due to pay off $1.9bn on September 20, which when set against total public sector external liabilities of around $25bn, is not that much, but the government has annoyed everyone by asking bondholders to restructure the bond - especially given that the IMF included cash in its stand by loans to meet this obligation. "There is nothing worse than not paying your liabilities when you are perceived to have the ability to pay, as it implies the willingness to pay is lacking," says Timothy Ash, head of research at Royal Bank of Scotland. "Ukraine still has foreign exchange reserves of around $27bn, with $3.3bn recently disbursed from the IMF, of which a large chunk was slated to cover public sector external liabilities falling due over the next few months."

Ash worries that the government is sending out a very poor signal if the biggest company in the country that is completely owned by the state starts mucking about with debts it could cover simply so the government can hang onto some extra cash. It begs the question, what would be next?

Work on rebuilding Ukrainian's battered economy is on hold until the January elections pass. In the meantime, the key task is not to make things any worse in the last months before the president is (almost certainly) replaced; campaigning officially starts on October 19, but Ukrainian Prime Minister Yulia Tymoshenko has already promised to raise public servants salaries by 20% next year and campaigning has never really stopped since the last elections last year.

The fiscal situation is already bad, but the key will be to curtail spending as we go into the election. The fourth IMF tranche of $3.5bn is due in the middle of November and the Fund has been making noises about not paying out. However, the IMF has been forced to cave in several times already and probably will again, as the alternative is complete economic collapse; from initially insisting on a balanced budget, the IMF has now accepted a deficit of 6.5% of GDP - and 9.2% if the state takes on Naftogaz' debt. "What needs to happen to make the economy work normally again?" asks Andrey Bobyshev, deputy CEO of Alfa Bank Ukraine. "We need liquidity in the system and more bank capital. The NBU did a good job in the first half of this year recapitalising the banks... but we need more liquidity in the system and it is not clear where this is going to come from. The NBU is running a tighter monetary policy, the money base is shrinking and banks are not lending to each other. We won't see new lending in any significant amount any time soon."

The best that the NBU's Poroshenko had to offer during his conference call was that things should improve after the presidential elections are passed, as it is only then Ukrainians can expect to have a government that is not fixated on imminent elections. "After the elections there will be real budget figures. The Rada will take steps to stimulate the economy and provide support to trade through trade financing measures and export promotion," said Poroshenko.

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