Ben Aris in Berlin -

After gaining 135% in 2007, Ukraine was the world's best performing equity market. After the PFTS index lost 58.8% since the start of this year, it is now the worst hit of all emerging markets, giving up all last year's gains and most of those from 2006 too.

All emerging markets were hurt badly by the gathering financial tornado at the start of September, but as Ukraine's market was still finding its feet after two years of heady gains, it was the first to lose them again when the storm hit. The PFTS has not had enough time to build up big volumes of either investment or trading that would have offered some protection from the gale blowing through the market. "How can you make prices where there are no bids?" wailed one distraught trader in Kyiv the day after US investment bank Lehman Brothers collapsed. "Currently, the entire market is a 'buy' at these prices but what good is that when the equity risk of Ukraine has effectively gone to infinity."

Investors have been caught in a bind. Traders in Kyiv report that many of their investors are still convinced of the Ukrainian story but, facing margin calls and redemptions, a "death spiral" began where they were forced to offload stock at any price. On September 16, the PFTS was forced to suspend trading for the second time in two weeks as the index plummeted towards 400 from over 1000 at Christmas.

Ukraine is particularly vulnerable to the selling pressure. With liquidity on the market of just $10m-20m a day, trading volumes are extremely low in comparison to more mature markets like Russia, where the daily volumes are in the billions of dollars. It only takes one or two million-dollar sale orders to drop the whole market and everyone was selling at the start of September.

The prospects for recovery in the near future are poor. Investors were unsettled by the start of a fresh political crisis on September 2, when Prime Minister Yulia Tymoshenko teamed up with her erstwhile enemy Viktor Yanukovych and his Regions of Ukraine party to vote through laws that strip President Viktor Yushchenko of much of his power. However, by the middle of the month, the official collapse of the ruling coalition was only so much noise in the background to the roar of destruction for the equity market. Analysts at Dragon Capital believe that the market won't find bottom until the first quarter of 2009, based on a comparison with previous collapses.

In a historical analysis of other crises, Dragon found that over the last 20 years developed markets suffered an average drop of 27% during financial crises with a standard deviation of 14%, whereas emerging markets have suffered an average drop of 51% with a standard deviation of 20% in these same crises. Ukraine's market has already dropped by more than 50%, but Dragon found in the very worst cases - such as the so-called Tequila crisis in Mexico in 1993 and the Russia default in 1998 - emerging markets have fallen to just 10-20% of their peak values.

The duration of a crisis is also highly variable, lasting from 30 days to over three years. The average for emerging markets from the last 20 years (excluding the current crisis) has been 393 days, approximately 80 days longer than for developed markets' 313 days. "While these figures do not allow us to predict the length of the current or subsequent crises with absolute certainty, given the current crisis has already lasted more than 200 days, a full market recovery is still another 100-200 days away," says Dragon head of research Andriy Bespyatov.

Banks in danger

Tanking equity markets are painful, but as Ukraine's stock market remains so small, it has little impact on the wider economy. A much bigger danger is the pressure that the banking sector is feeling.

This has been a difficult year for Ukraine's banking industry. With inflation soaring, the National Bank of Ukraine has been curbing the sector's access to liquidity in an effort to contain prices and cool red-hot growth. Although the bank sector has made enormous progress in the last few years, Standard & Poor's released a report at the start of September warning that the country's banking sector is still fragile. "Ukrainian banks remain highly vulnerable to potential shocks due to rapid, untested loan growth in recent years, amid macroeconomic and political uncertainty," Standard & Poor's credit analyst Ekaterina Trofimova wrote. "Also burdening the sector are still-substantial single-name and industry concentrations, significant dollarization of operations, questions on enforcement of credit rights, insufficiently robust underwriting practices and risk management, as well as regulatory and supervisory responses lagging behind market developments."

Despite the political turbulence and inflationary pressures, the bank sector has been bolstered by strong growth in the last few years. And even with the international credit markets in turmoil, the economy is still playing catch-up with the rest of the world: the State Statistics Committee said Ukrainian GDP grew by 10.9% from the month before in August, putting the economy on course for a 7.1% growth in 2008.

And a bumper harvest - the best in a decade - has both bolstered growth and will help knock a big hole in inflation, which topped 25% in the first half of this year, but should slow to 9.5% next year, according to the state's budget: food makes up over half of Ukraine's consumer price index basket.

The influx of foreign banks in a wave of mergers and acquisition will also help support the local market. The share of foreign capital in the Ukrainian bank sector was up to 36.7% by the end of the first half of this year. "Strategic foreign investors cannot fully eliminate still-high credit risks and potential market downturns, but they are expected to take the lead in avoiding a hard landing," added Trofimova.

Portfolio investors maybe heading for the Borspil airport, but they are likely to bump into foreign direct investors getting off planes. The appeal of a European country and a population of 47m people remains as strong as ever and the NBU estimated FDI was up 32% over the first seven months of this year to $6.9bn, lead by investments into the financial sector, which still accounts for half of the total.

Still, Ukraine has a long way to go. The new government budget for 2009 assumes a deficit of 2.2% after years of surpluses and there is a danger of the current account deficit, which reached $7.7bn over the first seven months of this year, or 7.2% of GDP, widening if commodity prices continue to fall.

This crisis came too soon for Ukraine. Despite all the progress made in the last four years, there has not been enough time for the government to push through the badly needed reforms that would have made the economy robust enough to withstand September's storm. For all its liberal rhetoric, Ukraine remains an even harder place to do business than Russia, ranking 145 out of 181 countries in the World Bank's "Ease of Doing Business" survey released in September.

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