Ben Aris in Berlin -

Ukraine had a remarkable year in 2007. The economy continued to power ahead, oblivious to the domestic political chaos at home as the public voted for yet another parliament and turbulence outside as the US credit markets went into meltdown. The country faces several serious challenges in the form of high inflation and a growing trade deficit, but the sheer enthusiasm of domestic and foreign investors means the country has built up enough momentum to flatten out most bumps on the road for the foreseeable future.

Ukraine hasn't really had a functioning government since President Viktor Yushchenko ousted the incumbent political coterie during the Orange Revolution three years ago. "It doesn't matter," reckons Tomas Fiala, director and co-founder of Dragon Capital. "All the parties have the same pro-business platform and because no one is really in charge, there are none of the political risks that some places like Russia have."

The economy, like the electorate, has simply decided to ignore the feuding politicians and get on with life - in stark contrast to 2005, when the Tymoshenko government and Orange hangover caused growth to slump from 12% in 2004 to 2.6% in 2005.

The collywobbles are past and domestic fixed investment grew very fast in 2007, up by a record-breaking 23% in 2007, according to the think-tank ICPS. Much of this is coming from industrial enterprises - mostly in the processing sector - real estate and transport companies. The result was GDP growth beat all expectations, ending 2007 up 7.3%, and the economy is expected to grow by 6.8% this year to bring the nominal size of the economy to UAH921bn ($184bn).

"Most forecasters were guessing growth of about around 5.5% at the start of 2007 - our forecast was 6.9% - and later were updating this to about 6.5%, and so the actual growth of 7.3% is very good news," says Valentyn Zelenyuk, an economist with Millennium Capital in Kyiv. "In fact, Ukraine was virtually unaffected by the discontent on the global financial markets in 2007 and we believe the influence will remain negligible and indirect in 2008."

One of the reasons why Ukraine remains relatively immune to the problems on the international credit markets is that Ukraine has borrowed only lightly on the global capital markets. The country's total external debt grew by little more than a third over the first nine months of 2007 to $74.3bn, with the state's share of that increasing through the issuance of two Eurobond issues worth a total of $1.2bn. The bank sector accounted for the biggest part of this debt and was the fastest growing, reaching $25.7bn, up 82% over the same period. However, by international standards the total debt remains very modest. This year both the banks and government are intending to tap the domestic markets instead, with the state issue of domestic bonds set to double to $1.54bn.

Deficit damage

Swelling export revenues have funded part of this newfound prosperity. Over the last three years, Ukraine has experienced a surge in foreign trade turnover, which was accompanied by a widening in the trade deficit.

Metal remains by far the biggest export commodity and accounts for 40% of all exports by value. The export of metal has benefited from the high prices for commodities on international markets and earned the country $17.6bn in the first 11 months of 2007. However, other products like machinery, food and chemicals are also important export products.

On the incoming side of the trade equation, the major component is energy. Ukraine still relies heavily on the import of Russian gas and the Kremlin's decision to force a price rise on Ukraine last year is weighing heavily on the balance of payments. From running a healthy surplus, the country now has a deficit that was about $10.8bn at the end of 2007, or 7.8% of GDP.

Analysts worry that the deficit poses a potential threat to the country's longer-term prospects. "Continued deterioration of the merchandise trade balance raises questions about the nature and sustainability of the trade gap as the growing mismatch between imports and exports has to be covered by either capital inflows or NBU reserves," say analysts at Dragon Capital. "However, we think even this wider gap will be covered by currency inflows in the coming years."

The deficit is at most an inconvenience for the moment, as the gap in the government's finances was covered by the rising tide of foreign investment in 2007, which was up by over 80% year-on-year to an estimated $10bn - a third of which was used by foreigners to buy banks.

Likewise, the government has gone from running healthy budget surpluses to a small deficit of 1.4% of GDP at the end of 2007. However, tax collection has improved immeasurably; the strong growth and low levels of borrowing by the government mean the state can easily finance the shortfall. State budget revenues totaled UAH166bn ($33.2bn) in 2007, up by a quarter year-on-year, led by VAT and corporate tax receipts, which made up UAH93bn of the total. This year, the government is predicting a deficit of 2.1% of GDP on revenues of $42.6bn and spending of $46bn.

Inflation - taming of the shrew

The biggest bugbear is rapidly rising inflation that has walloped all the countries in the region. Inflation hit an eight-year high of 19.8% by the end of January, largely driven by steep rises in energy and food prices, which account for 55% of the consumer price basket. "Against a generally favourable economic backdrop in 2007, rapidly rising inflation has become the most important economic issue in Ukraine. CPI inflation reached 16.6% on year by year-end, and PPI a staggering 23.3%," says Renaissance Capital.

The cabinet hasn't revised its 2008 inflation forecast yet, leaving it at the level of 9.6% for 2008, but both the investment banks and the World Bank are expecting inflation to remain high and finish the year at about 13.8%.

Some worry that Prime Minister Yulia Tymoshenko's $1.2bn handout to the depositors of Ukraine's Soviet-era savings bank Oschadbank, who lost their life savings to hyperinflation in the early 1990s, will only pour oil on the fire.

Shopping out of trouble

With the exception of inflation, all of Ukraine's macroeconomic problems are mild and pale into insignificance compared to the seeming unstoppable locomotive of consumer spending.

Traditionally, Ukraine made its money from exporting steel, but in the last few years the power of the hryvna in punters' pockets has taken over as the most powerful force for growth. Ukraine is amongst the best examples of the "consumer spending cascade" effect. The foreign currency flowing into the country in the form of FDI and export revenues starts a virtuous circle of higher wages, spending, profits, reinvestment and more work.

With aggregate personal incomes up by 32% in 2007 year-on-year to $2,700, this has led to a boom in retail turnover, which was up by a record 29.1% in the same period. A boom in retail credit, which totalled $15bn in 2007 (or about $300 per head), has accelerated the trend.

The results can be seen across the board: corporate earnings are up by almost two-thirds, housing prices have soared and fixed investment is growing strongly - all of which is feeding the strong economic growth. "Domestic demand is becoming the key economic driver in Ukraine. Income growth has seriously outperformed last year's inflation, providing for the solid, real growth of personal incomes," say analysts at Dragon. "Also, the fact that the growth of savings was much higher than the growth of income signifies that every additional income directly contributes to the development of the middle class in Ukraine."

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