The National Bank of Ukraine (NBU) cut its key policy rate again from 20% to 16% per annum, effective from October 27, as Ukraine’s economy continues to improve, but the outlook for the economy is threatened by mounting funding restrictions by the international donors.

The cut to interest rates comes as inflation continues to fall and the economy starts to pick up, but international funding has also slowed in recent months leading to the central bank burning through $2bn. A growing trade deficit is also undermining the currency and the current good news could prove temporary. (chart)

The NBU said that several factors had influenced its decision to lower rates. First, there are no signs of deterioration in the balance of risks, indicating a stable economic environment. Secondly, market participants have successfully adapted to the new currency regime.

The central bank also flagged investors to more rate cuts in the future provided macroeconomic conditions allow.

Consumer inflation in Ukraine slowed to 8.6% in August thanks to a larger than expected supply of new-harvest vegetables and fruits. The NBU has not provided figures for September’s inflation, but according to the published schedule, inflation slowed to approximately 7%. According to the NBU, the slowdown in inflation will also continue in September, according to their October Macroeconomic and Monetary Survey.

The improving situation with inflation is also reflected in the recovery of economic growth, which has gone back into the black despite the war with Russia. In September, Ukraine's economy grew by more than 9%, the Ministry of Economy recently reported. Growth over the first nine months of this year is estimated at 5.3% compared to the corresponding period last year.

But the NBU also said that a return to a policy of fiscal loosening in 2024 will only be possible once there is a significant reduction in the exchange rate volatility as well as lower inflation. As part of this plan, the regulator intends to lower the discount rate to 15% at the next meeting in December and maintain this rate throughout the entirety of 2024, the regulator said.

US funding doubts get worse

The improving macroeconomic backdrop comes at a time when Ukraine’s funding is in increasing doubt. Half of the funding for expenditure in Ukraine’s 2024 budget will come from international donors and if they fail to deliver that could plunge the country back into an economic crisis and throw the NBU’s optimistic forecasts off track.

The EU became Ukraine's largest donor for the first time in October, after it received the ninth €1.5bn tranche of macro-finance support. As Ukraine’s Prime Minister Denys Shmyhal reports, the EU’s 2023 budget has earmarked a total of €15bn for Ukraine this year.

Funding from the US is much less certain. A $300mn allocation for Ukraine included in an emergency spending bill two weeks ago was removed to allow the passage of the bill that has effectively suspended US financial aid for Ukraine.

The newly elected House Speaker Mike Johnson is a known Ukraine hawk and in his first comments following his election said that he is willing to “negotiate” with Ukraine, but “there will be conditions” on any new funding. Specifically, he is calling for more accountability for the funds sent to Ukraine.

US President Joe Biden remains committed to supporting Ukraine, and has proposed a new $106bn spending package that links aid for Ukraine with aid for Israel, but also contains a 20% cut to the budget support for Ukraine from $1.1bn a month to $825mn at a time when Ukrainian President Volodymyr Zelenskiy has increased military spending in what is increasingly expected to be a long war with Russia until at least the presidential elections next November are over.

The total volume of external financing in 2023 so far is $35.4bn according to Ukraine’s Ministry of Finance. International support next year is anticipated to total $42bn, with the largest sources of funding from abroad next year to include:

·                $16.2bn in macro-financial assistance from the EU

·                $12.7bn from bonds of internal state loans of Ukraine (OVDP)

·                $10.9bn in grants from the US

·                $3.6bn in IMF funds as part of the EEF programme

·                $1.8bn in preferential financing from Canada

·                $2.2bn from the International Bank for Reconstruction and Development

·                $8bn from other sources

But Biden's $106bn package has already encountered strong resistance in the Senate. According to Politico, even before the request has reached the House of Representatives, divisions in the Senate threaten to sink the proposal or radically change it.

Both parties in Congress have actively supported aid to Israel after the October 7 attack by Hamas, however, some Republicans are sceptical about sending more money to Ukraine, while others prefer to fund weapons over humanitarian aid or budget support. Military support stays in the US as most of that money is spent on US-based arms production, whereas humanitarian aid and budget support sees cash exported to Ukraine, and has no impact on the US economy.

Other Republicans want aid to Israel to be separated from aid to Ukraine because "the latter has become politically unpopular with their party's constituents and several Republican lawmakers," Politico reports.

EU €50bn support plan still being debated

The EU is a lot more committed. The President of the European Commission, Ursula von der Leyen, is reportedly planning a trip to Kyiv in early November, just ahead of the publication date of the mooted enlargement report (November 8) which is the precursor to opening of the official negotiations for Ukraine’s membership of the EU.

Kyiv is actively working on preparing a Ukraine Plan with details of reforms needed to get into the EU, with a heavy focus on reducing corruption. The first draft of the plan will be published in November and prepare the final document at the end of November – just ahead of the start of the EU accession talks in December. The plan is also needed to unlock the mooted €50bn four-year financial support package from the EU which is supposed to be approved at the next EU foreign ministers’ summit.

And Ukrainian President Volodymyr Zelenskiy is already angling for more help in anticipation of a reduction of US funds. Speaking via video link at a meeting of the European Council on October 26, he called on European states to expand the long-term support programs for Ukraine, appealing to their sense of ensuring Europe’s security.

“In a confrontation like the one Russia has unleashed, the winner is the one who proposes a long-term strategy. Russia must understand that its aggressive ambitions will endure less than our ability to protect freedom. Therefore, every approved programme of such long-term support for Ukraine is a clear signal to Russia that its aggression is in vain and that no matter how many resources Putin spends on the war, he will not win,” he said.

 “The Russian elite must see and feel this, so that it will be more difficult for the Russian dictator to maintain his position… Therefore, it is worth expanding our experience of long-term support programs. Each of these decisions is not easy. But each of them is the defence of freedom and our Europe. A safe Europe,” the president said as cited by Interfax Ukraine.

The President of the European Council, Charles Michel, has called for further discussion to the EU leaders attending the upcoming summit in Brussels on October 26-27 regarding additional support for Ukraine.

"Among the various aspects of our assistance, I would like us to focus on specific ways of accelerating the provision of military support, progressing our plans to use blocked Russian assets, and intensifying our diplomatic work to ensure the broadest international support for a comprehensive, just and sustainable peace," Michel remarked.

According to him, the meeting will also provide recommendations on revising the multi-year financial framework, however, it remains unclear if the €50bn Ukrainian fund for 2024-2027 will be included in the budget revision.

There has been some resistance amongst EU members to extending more aid to Ukraine. Hungarian Prime Minister Viktor Orban recently called for the sum to be halved to €25bn, and the newly appointed Slovak Prime Minister Robert Fico has already cancelled any new military aid for Ukraine and is likely to oppose more funding as well.

OVDP bond sales holding up

The sale of Ukraine’s Ministry of Finance federal treasuring bonds (OVDP) will be an important source of funding as well. The 2024 budget includes some $12bn of OVDP bond sales, or $1bn a month. Ukraine raised UAH400bn ($11bn) for the budget in the first nine months of this year from OVDP sales, UBN reported on October 4. The National Bank of Ukraine reported that since the introduction of martial law, a total of over UAH650bn has been raised.

In October the Ministry sold a total of UAH23bn ($631mn) bonds as of October 24, putting it on track for a $1bn of sales a month, but they are being sold with an eye watering 19.2% yield or more in September.

The majority of these securities are held by banks, primarily acting as primary dealers in the market. The second-largest holder of these securities comprises individuals and businesses within Ukraine.

Notably, the portfolio of military bonds owned by both individuals and legal entities in Ukraine has seen substantial growth. As of October 1, the total value of military bonds held by these entities amounted to UAH58.3bn, a significant increase from UAH34.5bn at the beginning of the year, UBN reports.

The volume of military bonds owned by non-residents also experienced remarkable growth, increasing by over 400% since the start of the year. As of October 1, non-resident holdings of military bonds were valued at $413.2mn for the three main categories of bonds.

Trade deficit growing

Despite the international aid and bond investments, in recent months the volume of foreign exchange flowing into Ukraine has been falling. This is not an immediate problem as gross international reserves (GIR) are currently at a record high of just under $40bn but given international funding could fall significantly next year, it could turn into a problem.

The fall in currency inflows to Ukraine can be explained by two factors: the deficit of foreign trade and the reduction of financial aid from partner countries. The country’s biggest foreign exchange earner is grain exports, but as bne IntelliNews reported, while production of grain is up this year, exports fell by a third in the first three weeks of September. Currently, Ukraine’s trade balance is minus $2.9bn.

The negative balance of payments in July-August was $2.8bn, but a year earlier, it was positive with a surplus of $3.5bn while the Black Sea Grain Initiative was still functioning, which Russia suspended on July 17.

In August, the situation was aggravated by the delay of a $1.25bn grant from the US. Also, Ukraine's international reserves have fallen by $2bn in the last two months due to a combination of these two factors.

Revenue from partners has decreased significantly due to the recent funding hick-ups: from $3.25-$4.45bn in May-July to $1.65-$2.9bn in August-October. The upshot has been increased pressure on the hryvnia, which the NBU recently returned to a floating rate against the dollar.