Ben Aris in Moscow -

As bne went to press, the outlook for Ukraine in 2014 remained very uncertain. Ukrainian President Viktor Yanukovych clearly recaptured the initiative with the deal he struck with Russian President Vladimir Putin on December 17. Other than the headline $15bn of investment into Ukrainian bonds and a 33% discount on the price of natural gas, little else is known about the terms of the Russo-Ukrainian deal. But the protestors on Maidan Nezalezhnosti (Independence Square) expressed their displeasure and are settling in for the long haul. That's bad news, as Ukraine looks set to follow the "Bulgarian scenario" of economic stagnation and endless protests until the next elections in 2015.

GDP

Ukraine's economy is in a mess and was in its third recession at the end of 2013 but with some prospect for a mild recovery in 2014, especially following the Russian deal on gas price discounts and credits signed on December 17. Russia has agreed to buy $15bn worth of Ukrainian government bonds, and cut gas prices by 33%.

"We forecast growth at -1.2%Y in 2013 and 1.3%Y in 2014," says Morgan Stanley in its 2014 outlook.

The main impact of the Russian deal will be to remove the immediate danger of a sharp devaluation. The National Bank of Ukraine (NBU) has held the UAH/USD rate at about 8.14 for most of the last couple of years, but on the eve of the Russian deal it had begun to slide and was down to 8.30.

The state's hard currency reserves had halved from a high of $36bn to $18.8bn by November, giving Ukraine just over two months of import cover, which implies a devaluation of 15% or more for the national currency.

"Using a NFA approach to determining hryvnia's fair value, we estimate that the currency is 25-30% overvalued relative to fundamentals. This suggests a fair value for the USD/UAH of around 10," said Ivan Tchakarov, an economist with Citibank.

However, miraculously, a devaluation has so far been avoided and the fresh access to capital the Russians have provided means the NBU will probably try to maintain the currency at the previous rate in 2014.

That could be a mistake. One of the key demands from the International Monetary Fund (IMF) was to introduce more flexibility in the exchange rate as the hryvna is overvalued and depressing economic activity.

"On the current policy of holding the hryvna, Ukraine risks stagnation, as it keeps policy tight, and potentially a crisis, if it runs out of reserves and there is an uncontrolled weakening in UAH," Morgan Stanley said in its 2014 outlook.

Budget deficit

Ukraine's public finances are also in a mess. The federal budget was running a deficit of about UAH50bn ($6.1bn) in 2013 or 4% of GDP, almost twice as much as it ran in 2012.

The government is able to finance about UAH16bn ($2bn) of this on the domestic bond market and the Russian deal means it will be able to fund a lot more in 2014, with more domestic government bond issues in the pipeline.

"Net domestic issuance will likely be much higher [in 2014], not only because of the possible need to finance the wider budget deficit but also accounting for [state-owned national gas company] Naftogaz's capitalisation efforts," VTB Capital said in its 2014 outlook.

And the pressure will come off somewhat following the Russian decision to cut gas prices by 33% on December 17, which will cut Ukraine's gas bill by an estimated $7bn a year.

Balance of payments

Ukraine's main economic headache is the fall in commodity prices: metal exports account for some 60% of export revenue. The outlook for commodity prices in 2014 is poor and the Bloomberg consensus estimates for the average 2014 price for steel are actually below the prices in 2013.

Ukraine was running a current account deficit for most of 2013 and was expected to end the year with a deficit of 8.5% of GDP. The country was losing about $1bn a month, which varied depending on the amount of gas imported from Russia. The only reason it was not worse was that imports have fallen at about the same pace as exports thanks to the slowing economy.

However, the Russian deal of December 2013 has improved the outlook for trade somewhat as the threatened increase in tariffs will now not appear, removing a great deal of uncertainty for business.

The disruption in trade with Russia in the run up to the Russian deal had already cut Russian-Ukraine trade by some 25%, Prime Minister Mykola Azarov said in November 2013.

Ukraine exports about $25bn a year to Russia and this trade will probably expand now that Kyiv has made the choice to side with Moscow over Brussels.

The $15bn of bond buying Russia promised at the December 17 meeting will probably be enough to cover Ukraine's balance of payments gap for about two years, Capital Economics says.

Industrial production slumps

"The last time Ukraine was in such a long, though much deeper, recession was in 2H08-2009. Back then, industrial production was in the red for 15 months in a row, with contraction peaking at over 30% year-on-year. In August 2013, the decline in industrial output reached 12 months in a row," says VTB Capital.

The difference between then and now is that in 2008 the slump was caused by turmoil on the international markets, whereas in 2013 the problems were caused by internal turmoil.

As in Russia, Ukrainian business confidence has been crushed and the outlook for 2014 is very uncertain as the political situation looks equally unpredictable. However, industry will likely stage some sort of recovery as 2013 is turning out to be the annus horribilis for all the countries of the CIS.

Debt redemption and funding

Ukraine squeaked through 2013 meeting all its obligations, but it has a fairly heavy year of debt redemptions ahead in 2014 that will keep the pressure on the government.

Citibank argues that the size of the repayments due in 2014 mean that the muddle through policy the government has followed in the last years will no longer work. Ukraine faces the following repayments in 2014: $3.7bn to the IMF, $1.6bn on a Naftogaz Eurobond, $1bn on a sovereign Eurobond and $1.2bn on domestic FX bonds.

"The quarterly distribution of these repayments, along with the continuing pressures on the broad balance, suggest that Ukraine FX reserves may reach 2 months of imports (around $15bn) already by end-March [if there is no Russian help]," says Citibank.

As of the end of 2013, Ukraine's gross public external debt was $32.1bn, which is expected to decline, and gross commercial debt was $102.8bn, which is expected to climb in 2014.

Russia's promise of a $15bn purchase of Ukrainian bonds will cover most of this borrowing.

Chance of a change of government

Despite the fervour of the protest on Maidan at the end of 2013 and the resolve of the opposition, the chances of a change of government or early presidential elections remain low.

Yanukovych was democratically elected - indeed, the 2010 elections were among the most democratic in the whole of eastern Europe since the collapse of the Soviet Union - and there is no legal way for the opposition to oust the government.

At the time of writing there was speculation about a government reshuffle and while this is likely, again it will be window dressing designed to split the opposition and give Yanukovych an excuse to claim that he taking the opinion of the protestors into account. However, there is unlikely to be a substantial change in the power of the ruling elite in 2014.

Moreover, given the government stole regional re-run by-elections in December, winning four out of five seats when exit polls said the ruling Regions party would only win two, there is a high chance that Yanukovych will use extensive "administrative resources" to ensure his re-election in 2015, which will lead to more civil unrest and protests.

The political outlook for Ukraine over the next two years looks highly unstable.

Some have speculated there may be an unconstitutional change of government in the meantime, but Morgan Stanley says this is unlikely for four reasons:

i) President Yanukovych and the Rada are internationally recognised as democratically elected, in accordance with the Constitution;

ii) All parties and opposition leaders in Ukraine are committed to constitutional order;

iii) The presidential election is scheduled for March 2015, giving the electorate the opportunity to express their verdict on the Yanukovych administration in the foreseeable future in accordance with the Constitution; and

iv) President Yanukovych has made no decision on EU association or Customs Union membership, and has promised that there should be a referendum on any such decision.

The chances of Yanukovych calling early elections have also diminished since the Russian deal was signed in December. One of the few really powerful cards the opposition could play was to drive the economy into an economic collapse and so force the government to deal with them. However, after the Russian deal the chances of a crisis has fallen substantially. There is now no reason why Yanukovych cannot serve out his term and wait until March 2015 to hold the next elections.

Corruption and reform

Despite the short-term benefits of the Russian deal in staving off a collapse, long-term the decision to go with Russia instead of the EU is a negative for the country. Unlike the IMF money, the Kremlin's cash comes with no strings attached and so there is no incentive for the government to embark on the structural reforms the country so desperately needs. The Yanukovych administration has proven to be more interested in filling its own pockets than those of its people.

In December, corruption watchdog Transparency International slammed Ukraine as 'most corrupt country in Europe' in its annual corruption perception index.

Ukraine shot passed Russia in the ranking and fell to rank 144th out of a total of 178 on the list on a par with the African state of Cameroon.

Ukraine has launched an anti-corruption programme, the State Programme on Prevention and Combating Corruption for 2011-2015, but so far this programme has mainly been used as a political weapon as only politicians from the opposition parties have been subjected to investigation. Most famously former Ukrainian Prime Minister Yulia Tymoshenko was jailed for seven years as part of the programme on 'abuse of office' charges. Conversely, Yanukovych's son has somehow managed to earn $300m from his job as a dentist.

The regime's reluctance to truly tackle the problem of corruption was underscored by its refusal to sign up to the anti-corruption initiative of the European Bank for Reconstruction and Development in November 2013.

The Corruption Perceptions Index is not the only ranking where Ukraine fared poorly. Ukraine also slumped in the World Economic Forum's global competitiveness index released in September 2013, coming in at 84th out of 143 countries, and 112th in the World Bank's 2014 Ease of Doing Business Report.

In short the country is headed on a path to 'frozen banana republic' status unless there is a change of government in 2015.

Fixed income

Bond investors have been a lot more confident about a resolution to the crisis and were piling into Ukraine's local debt in December.

Likewise, Mark Mobius's Templeton took a $5bn bet on Ukraine at the end of August when it bought nearly a fifth of the country's sovereign debt, a bet that must have been handsomely rewarded following the Russian deal, which sent Ukrainian bond prices soaring.

Bond spreads were widening dramatically at the end of 2013, but they will tighten again as Ukraine puts the worst of the crisis behind it.

However, there will be a lot of uncertainty to reckon with in 2014. Russia has said it will buy $15bn worth of government debt as the main channel for providing funding. However, it is not clear how fast this money will arrive. At the time of the deal press was reporting that the first $3bn could arrive within a week, but analysts say that the Kremlin is unlikely to bail Kyiv out completely until it has a signature on the Customs Union deal. Yanukovych is likely to try and avoid signing off on this document until after the 2015 elections are past, as that would only inflame the protests further and as long as it is not signed he can muddy the waters with more talk of joining the EU "eventually". Kremlin is therefore likely to drip feed its financial support to Ukraine and keep it in a perpetual state of "almost crisis".

Equity

In the years before the 2008 crisis Ukraine's stock market was several times the best performing equity market in the world and began to develop and expand.

The market infrastructure was improved when Russia's MICEX exchange bought a local exchange and set up the UX market, quickly replacing the PFTS trading system.

However, since the economic crisis and subsequent political crisis the market has fallen back into insignificance. Several of the leading brokerages like Renaissance Capital have shut up shop, and even the dominant investment house, Dragon Capital, has been struggling.

In the market's halcyon days, trading volumes rose to several tens of millions of dollars, but have since sunk back into single digits. Currently it is possible to move the Ukrainian index using nothing more than a credit card.

The tiny trading volumes make the indices' performance irrelevant and many of the gains on the market are due to price manipulation by local pension funds and speculators. The question portfolio managers need to ask if they are thinking of investing into Ukrainian equities is not "what to buy" but "when to buy". If there is any resolution to the various crises the country faces, or a clear long-term reform plan is put in place then that is the time to buy. Neither of these things is likely to happen before 2015, if then.