Ukraine on the brink of collapse and default

By bne IntelliNews February 19, 2014

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Ukraine may have been hoping to jump out of the frying pan of mass civil unrest in the first half of February, but whether that bid succeeds or not, it looks like it's falling into the fire of economic collapse.

On February 17, Russia said it would transfer a second tranche of $2bn to Kyiv from a total of $15bn promised this year. A Ukrainian government source said at the same time that state gas company Naftogaz has paid back $1.3bn of its 2013 debt to Russian gas monopoly Gazprom, although it still owes $1.5bn.

The same day, Kyiv's amnesty for arrested protestors came into force. Meanwhile, demonstrators left the City Hall, which they had been using as a headquarters. It seemed as if both sides had made consolatory gestures and a peaceful resolution to the conflict was possible.

But the next day, Berkut riot police clashed violently with crowds and as many as 26 on either side were reported dead by the end of the day. More violence is now expected and the chances of compromise look slim. Wide spread street fighting is not good for any economy, but Ukraine was already perilously close to a meltdown before the demonstrations started in November, provoked by President Yanukovych's refusal to sign a pact with the EU.

The government desperately needs cash to prop up the hryvna, which has lost some 10% of its value since the start of the year, and was trading at just under UAH9/$1 at the end of January. Kyiv has a step debt repayment schedule, with some $8bn of sovereign bonds coming due every year from now through to 2018. The central bank said at the start of February that reserves had fallen to $17.75bn - or about 2.3 months of import cover. Meanwhile, the state's total liabilities run to about $80bn.

That leaves the economy on the edge of a potential abyss. "Ukraine ran a current account deficit of 8.9% of GDP in 2013 (the largest in the region according to my reckoning)," says Tim Ash at Standard Bank. "[It] has over $60bn in short term debt falling due, has low import reserve cover, and has seen large deprecations (10-25%) by some of its main trade partners over the past few weeks. With limited reserves, and in the absence of external support, the currency sell-off could easily spiral out of control, creating systemic risks in the banks, public finances and across the broader economy."

With reserves covering no more than about 25% of total external debt (cover should be closer to 100%) the risks of devaluation and/or default are now "off the scale," the analyst suggests. "We have reviewed the probability of default in Ukraine, and conclude that the risks are being under-estimated," he summed up.

Just how things will play out from here is not clear. The EU has made noises about coming up with a financial rescue package, but given its penchant for talk rather than action, Brussels has lost almost all creditability in Kyiv. Russia could make a huge difference if it resumes its promised lending programme. The entire $15bn was due to be paid out this year, but the Kremlin has said it will wait to see the make up of a new government before making a decision. Following the resumed street fighting, the Kremlin was hinting on February 19 that its claim two days earlier of a forthcoming $2bn tranche could be reversed.

Something has to give. Economists agree that the hryvna's fair value is probably closer to UAH12/$1, but when currencies start collapsing they tend to overshoot. That threatens crisis in the banking sector. One of Ukraine's top 20 banks, Brokbiznesbank, has already had to be bailed out, and if the currency does collapse, the temptation for the government to default on its debt and wipe the slate clean ahead of the February 2015 elections will be very tempting.

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