Sergei Kuznetsov in Kyiv -

The International Monetary Fund (IMF), which approved the disbursement of its second tranche of aid to Ukraine on August 29, said that the success of its support programme will depend on how fast the fighting with pro-Russian rebels in the eastern regions abates, and that additional measures will be necessary.

“The conflict in the eastern part of the country is taking its toll on the economy and society, and compensatory measures will be critical to achieve key programme targets agreed for 2014 and beyond. The programme remains highly challenging and continues to hinge crucially on the assumption that the conflict will subside in the coming months,” the IMF said in a statement.

On August 29, the IMF executive board approved the disbursement to Ukraine of a $1.4bn tranche of the $17bn two-year support package agreed in April. The board also agreed to Ukraine’s request to merge the third and fourth tranches (totalling about $2.2bn), which will be paid later this year. Ukraine has already received a first tranche of $3.2bn.

The disbursement is a lifeline for Ukraine, but the government is under no illusions about the challenges it still faces. “The decision [to provide the second tranche] and this significant resource received by Ukraine will allow Ukraine to live. It is rather hard for us. There is war in the country. The fact that we are receiving no revenues from Donetsk and Luhansk is nothing compared to those billions of dollars of losses we are suffering from war, ignited by the Russian aggressor and the Russian state,” Arseniy Yatseniuk, the prime minister of Ukraine, said a couple of hours before the lMF announced its decision.

Growing pressure

The Ukrainian economy contracted by 3.3% between January and July this year, compared with the same period in 2013. The Ministry of Economic Development and Trade predicts that this decline could accelerate to 6% by the end of the year. The IMF is even more pessimistic. In July, it said that the country’s economic prospects have deteriorated notably, and GDP is now expected to contract by 6.5% in 2014, compared with 5% when the programme was adopted.

Yatseniuk said in August that Russia aims to destroy Ukraine both politically and economically. According to the prime minister, pro-Russian rebels, “whose shots are fired on Russia’s command,” are targeting the most sensitive objects of infrastructure, in particular, mines, power stations, grids and transport infrastructure. “It is absolutely clear that these are planned actions designed to stifle our economy. Russia is aware that to restore the Donbas we will need not billions of hryvnia [the Ukrainian currency], but billions of dollars that will need to be found somewhere,” Yatseniuk said.

The continuing conflict in eastern Ukraine and the worsening of the economy could force the country to seek further support. Alexander Paraschiy, head of research at Kyiv-based Concorde Capital, tells bne that the necessity of extra funding “will depend on the ability of Ukraine to generate forex earnings”. “Since a large part of the economy is suffering a temporary impact, it is very possible that there will be a temporary need for additional support during this difficult period,” he adds.

“The possible reaction of Ukraine’s businesses and people is also very important. The outflow of deposits (UAH8bn in January-July) and the buying up of foreign currencies by residents exert additional pressure on Ukraine’s foreign exchange reserves and on the hryvnia. In other words, if we observe a rapid deterioration in the balance of payments, the extension of external support will be very useful,” Paraschiy says.

Valeriia Gontareva, the governor of the Ukrainian central bank, underlined in early August that the IMF bailout programme stipulated that, “military operations should be completed within the three next months, one of which has already passed.” This could mean that the IMF will review the existing aid package after the middle of October.

The Ukrainian authorities expect to receive the second tranche of the IMF loan by September 3. At approximately the same time, the World Bank’s loan of $500m for measures “to strengthen the stability, efficiency, and resilience” of Ukrainian banks should arrive. “The package of reforms supported by this operation will help improve the performance of Ukraine’s banking system and its resilience to both domestic and external risks,” Qimiao Fan, World Bank country director for Belarus, Moldova and Ukraine, said in August.

Mykhailo Obolonskyi, an advisor to Ukraine's minister for economic development and trade, believes that  Ukraine should extend its cooperation with international financial institutions “given the situation of a lack of reserve funding and an unstable microeconomic environment.” 

He argues that, in particular, the country should “seize the moment” to restructure its debt. “It should seek to write off of its debt to the participants of the Budapest Memorandum [on security assurances to Ukraine],” Obolonskyi tells bne.

In the first quarter of 2014, Ukraine’s current account deficit stood at $1.932bn, while the country's international reserves stood at just $16bn at the end of July, the equivalent of two months' import cover. This is below the three months' level that is regarded by economists as necessary to maintain the stability of the domestic currency. Ukraine faces huge debt repayments in 2014 and 2015 and would struggle to raise the money on  international markets.

Free-fall

Following the intensification of fighting in the Donbass region of eastern Ukraine, the hryvnia’s official exchange rate slid to almost 14 per dollar at the end of August, having stood at 11.7 per dollar in mid-June. Paraschiy says that panic has set in. “The Donbass contributes a quarter of the country's export earnings, and the military actions create serious problems for national exports,” he says.

"We need fast and effective solutions for the economy of the country to stabilise the situation on the currency market", Yatseniuk said at the end of August, adding that an acceptable exchange rate for the economy is 12 hryvnia per dollar. ”We cannot bear a higher rate,” he said.

The IMF suggested in April that an exchange rate in the UAH10-13 per dollar range is consistent with Ukraine’s fundamentals over the medium term. “Should the hryvnia trade within the 10-11 per dollar range, the impact would be manageable for banks, firms, and households; balance sheets would take a stronger hit if the exchange rate settled in the 12-13 per dollar range,” it said.

Last week, Gontareva met twice with representatives of the largest banks in an attempt to stabilise the situation on the forex market. "It is clear that today's meeting… will allow us to see the rate at 12.5-13 per dollar within a few days," she said on August 29, adding that the central bank is ready to perform “both verbal and monetary interventions.”

“The most likely scenario is that the central bank will use administrative measures. The market has negative expectations, and the regulator can’t affect the exchange rate by market-based instruments,” Paraschiy says.

Liberals on the retreat

Ukraine’s task is being made more difficult by disputes within the government. In August, Pavlo Sheremeta, the minister for economic development and trade of Ukraine, announced his resignation after his deputy was appointed without his consent.

The government advisor Obolonskyi says the Ukrainian cabinet that was created after the ousting of former president Viktor Yanukovych has never been “a monolithic team”. “There are some officials that are focusing more on their own interests, as well as officials from the old system. Therefore it is to be expected that people who are not from the system will be squeezed out,” he underlines.

According to Obolonskyi, similar circumstances surrounded the resignation in August of Tetiana Chornovol, the government’s representative for anti-corruption policy, who claimed that “there is no political will in Ukraine to carry out a hard-edged, large-scale war against corruption".

Andrei Marusov, chairman of Transparency International in Ukraine, tells bne that the new government was formed mainly from representatives of the parties that were victorious in the fight against Yanukovych, and that it can hardly be described as a liberal team. “In particular, the [far-right nationalist] Svoboda (Freedom) party obtained a lot of places in the government. However, we can scarcely say that Svoboda is a liberal party,” Marusov says.

He also associates Chornovol’s resignation with the campaign for the parliamentary elections that began recently. “According to unofficial information, Chornovol will be included in the electoral list of the Batkivshchyna party [Fatherland, led by former prime minister Yulia Tymoshenko],” Marusov adds.

Christine Lagarde, the IMF’s managing director and chair, said in a statement published on August 29 that the Ukrainian authorities intend to press ahead with critical structural reforms to address governance issues and improve the business climate. “Work continues on the establishment of a strong anti-corruption agency, enhancing the anti-money laundering framework, and simplifying the regulatory environment,” she added.