Ukraine Country Report Dec17 - December, 2017

December 4, 2017

Ukraine's real GDP grew 2.1% year-on-year in July-September, the Ukrstat state statistics agency reports which while encouraging is still well under potential.

The population are still mired in misery after incomes have fallen by 36% since the Maidan protests in 2014. While consumption is starting to recover its is from a low base.

Ukraine's real GDP grew 2.3% y/y across April-June, according to official data. In the first quarter, Ukraine's GDP grew by 2.5% y/y. Ukraine's economy grew 2.3% y/y in 2016 owing to booming investments in fixed assets (20.1% y/y growth) and reviving private consumption (1.8% y/y).

The National Bank of Ukraine (NBU) has revised its economic forecast for this year upward from 1.6% y/y to 2.2% y/y saying that the nation's economic growth in 2017 will be stronger than expected. This was the result of a more favourable than expected effect from both internal and external factors on the economic performance of most sectors in the second and the third quarters of the year. High commodity prices, especially steel prices, added to revenues.

Ukraine’s economy is approaching the end of 2017 at low power, with growth still hindered by the consequences of the crisis. Household and business sentiment is starting to improve, but it remains far from clearly optimistic.

Despite material progress in areas like pension reform, the government has frozen other key initiatives, making a near-term resumption of lending under the IMF program highly unlikely.

Still, key macro indicators show the economy balancing well. The exchange rate is fluctuating in a reasonable range of less than 5%, with minimal involvement from the NBU. The C/A deficit is tracking below 4% of GDP for the 4th consecutive year and inflows via the financial account are also healthy

Growth remains uneven across economic sectors – agriculture and industrial production are drifting around zero, while construction (+23.8% y/y in 9M17) and retail trade (+8.6%) are recovering robustly.

Adverse weather conditions earlier this year affected the agriculture sector and total output is expected slightly below last year’s record.

Industry is being held back by several factors, including the lingering effects of the suspension of trade with the non-controlled territories in eastern Ukraine and the lower supply of agricultural inputs for the food industry.

Private household demand and investment demand are gaining strength and will remain key growth drivers in the years to come.

Real exports will be virtually unchanged y/y in 2017, but may contribute to economic growth next year. SP Advisors forecast real GDP growing 2.2% this year and accelerating to 3.5%-4.0% in 2018 as the post-crisis wounds heal.

Inflation slowed to 14.6% in September, but it remains well above the NBU’s 8% +/-2% target range for the end of 2017.

Growth in food prices remains the largest single factor behind the overshoot (food accounts for 40% of the consumer basket). That growth has been driven by two factors: poor weather conditions earlier in the year undercut the fruit and vegetable harvest, while growing exports of agricultural products have kept meat and dairy prices elevated.

The effect of these temporary factors will slowly fade until the next harvest, which will push CPI lower as long as the weather shock is not repeated.

Meanwhile a new risk to inflation is emerging – the government’s continued upward revision of pensions (+23% on average since October) and minimum wages (expected one-off increase of 16% since the start of 2018).

Salaries in the private sector are being driven higher by competition for quality labour. All of this adds up to stronger demand and the consequent inflationary pressures. A pick-up in core inflation to 8.1% at the end of October underscores that pull factors will be an issue in 2018.

In response to that outlook, the NBU increased the key policy rate by 1pp to 13.5% in late October. We see inflation decelerating to 12.7% by end-2017. The probability of a CPI slowdown to within the NBU’s 2018 target range of 6% +/-2pp is high, as long as monetary policy remains tough and no external shocks occur.

The C/A balance dipped in September on a $0.5bn sovereign Eurobond coupon payment, but the 9M17 tally widened by only $0.3bn y/y to $3.0bn. Growth in imports of goods marginally outpaced exports (21.9% vs. 20.7%) as Ukraine shifted the purchase of natural gas (the country’s largest single import item) for the winter season to 2Q and 3Q from last year’s 4Q purchases.

The C/A deficit is projected at 3.5%-4.0% of 2017E GDP, broadly unchanged from 2016. While heavy consumer and investment imports will keep imports growing in 2018, the increase should be offset by higher sales from the recovering industrial sector.

Financial account inflows spiked by $1.3bn on a Eurobond placement in September, representing the portion of proceeds exceeding the $1.7bn used to refinance debt maturing in 2019-2020.

The FX market has stabilized after the hryvnia’s 3% depreciation over the third quarter and October. The NBU intervened a few times to signal its support, but the central bank remains broadly committed to the flexible exchange rate policy.

The prospects for a continuation of lending under the IMF program look slim over the next half-year. The government’s credibility has been heavily undermined after it failed to hike household gas prices in October. Even if gas prices are raised next spring after the end of the heating season, the IMF is unlikely to be satisfied and is likely to request a long list of prior actions rather than focus on structural benchmarks, which the government has frequently ignored.

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