You're reading: Business Sense: Ukraine survives worst of recession; banks need help

Political instability remains the greatest threat to the country's economy.

Ukraine, perhaps more than any of its ex-Soviet neighbors, is a barometer of the global economy: demand falls for the metals and other commodities it exports when the world is under the weather, and it picks up again when the global outlook turns sunnier. The challenge for Ukraine’s leaders was to make sure its financial system did not collapse before it could emerge from the downturn to reap the benefits of the global recovery, and, after a stormy few months, they seem to have just about managed to do that.

It may be too early to rejoice, but there are signs that Ukraine has put the worst of the economic turbulence behind it. Production at steelmakers has stopped plummeting; traders have started buying the hryvnia again after months of ditching the sinking currency for dollars; the central bank’s foreign exchange reserves are growing and analysts’ forecasts are less gloomy.

“With its export-driven economy, Ukraine was always going to suffer from the global downturn,” said Boris Krasnyansky, managing partner at PricewaterhouseCoopers Ukraine. “The crucial factor is that the country appears to have weathered the storm. Ukraine needs to keep its financial system stable. If it can do that, then all the reasons that made it vulnerable to a global downturn will make it well-placed to profit when the world economy recovers.”

In the five years since Ukraine’s Orange Revolution swept in a new leadership committed to reform and integration with the West, political turbulence has dominated the outside world’s perception of this country of nearly 46 million people. Infighting between President Victor Yushchenko and Prime Minister Yulia Tymoshenko, former “Orange Revolution” allies, has hampered government, while bouts of wrangling with Russia over gas supplies has added to the instability.

What has attracted less attention is that away from the political fireworks, Ukraine’s economy has been growing steadily. Gross domestic product grew by about 7 percent in 2007, and Ukraine was the third biggest destination for foreign direct investment – after Russia and Kazakhstan – in the 12-nation Commonwealth of Independent States.

That achievement is all the more significant because Ukraine has few of the oil and gas reserves that have driven foreign investment and economic growth in Russia and in Kazakhstan. What Ukraine does have is heavy industry. The chemical and steel plants inherited from the Soviet Union have made it the region’s second biggest industrial power after Russia.

Ukraine is the world’s eighth largest steel producer and the metal accounts for 30 percent of its exports. Before the slowdown, high demand from countries like China for steel to use in their booming construction industries brought orders rolling in.

But there are other factors besides its industrial might that make Ukraine a solid, long-term investment. While integration with the West has been slower than promised in the heady days of the Orange Revolution, Kyiv joined the World Trade Organization last year – ahead of Russia – and Ukraine has a partnership agreement with the European Union.

The country’s location on the eastern edge of the European Union, and its deep sea ports on the Black Sea, help too. Costs for shipping steel, chemicals and grain to world markets are lower than for competitors in Russia.

The growth of the steel industry in Ukraine owes much to strong global demand but also bears testament to the good conditions inside Ukraine for doing business. Home-grown firms such as Metinvest and Industrial Union of Donbass – the biggest and the second biggest Ukrainian steel producers respectively – have expanded to make major acquisitions abroad, while in 2005 the world’s biggest steelmaker, ArcelorMittal, bought the country’s biggest steel mill for $4.8 billion in a privatization auction.

There is little doubt that political turmoil in Kyiv has hampered the economy: analysts say government decision-making is slow and reforms have been hesitant. But some investors see a silver-lining even here. They say the government has been too divided to push through a proposed re-privatization of former state enterprises which, if it had gone ahead, could have made the investment climate more uncertain.

And investors note that the rival factions in the government and presidential administration were able to bury their differences for long enough to negotiate a $16.4 billion loan program with the International Monetary Fund. The loan has played a crucial part in restoring some stability to the financial system.

An acquisition by Ukrainian steelmaker Metinvest could be a sign of things to come. The firm concluded a deal in April to buy U.S. coal miner United Coal to help keep its smelters supplied with coking coal. In Ukraine, it seems, some firms are already looking beyond the storm clouds towards a brighter future in the long term.

But in the short term, big challenges remain. Will Ukraine capitalize on the opportunity to restructure the banking sector?

The initial response of the Ukrainian authorities to the ongoing financial crisis was promising. With the help of the IMF and World Bank, the Ukrainian authorities were quick to conduct diagnostics of the biggest banks and place into administration those banks which could not withstand the events of the fourth quarter of 2008.

The central bank was active in providing the necessary liquidity to commercial banks, having provided approximately $7.8 billion in loans to commercial banks in the first half of 2009. This amount of liquidity support should be measured against the total customer deposit base of the banking sector as a whole, which as of July 30 totaled some $60 billion compared with $58 billion in early 2009.

There are currently 185 banks licensed in Ukraine. This number has been relatively stable over the last 10 years. In contrasting the Ukrainian banking sector with that of other countries in central and Eastern Europe, this statistic alone differentiates Ukraine from its neighbors.

Despite the aggressive entry of many foreign banks into the market over the last five years, with nine of the top 20 banks (representing 70 percent of total banking sector assets) being majority owned by foreign banks, the smaller Ukrainian banks have shown remarkable resilience. For many years Ukrainian banking sector analysts have predicted consolidation and the recent events gave extra weight to the logic behind this expectation. However predictions of wholesale closures of smaller banks which lack the support of strong shareholders have yet to materialize.

The current approach to bank recapitalization demonstrates the determination by authorities to maintain the sector in its current form. There are 14 banks currently under administration of the central bank, three of which are nationalized. The largest of the 12 banks in administration is the 11th biggest bank by total assets, with a share of 3 percent of total banking system assets. One of the three banks which was recapitalized is ranked 44th by total assets, with only 0.45 percent of total banking system assets.

The primary objective of recapitalization is to protect depositors by providing the banks with the liquidity to meet there obligations to depositors. On July 14, the government finalized the process of taking stakes of between 81-99 percent in three banks after investing on average $415 million in each. The amounts to be invested appear to be high given that the retail (individual) deposit base of each bank range from $399 million to $617 million. The government has stated that it will sell these stakes to investors once the sector has rebounded in 3-5 years.

The approach taken by the authorities to bank recapitalization raises a number of questions:

After recapitalization and exiting from administration, will these banks remain viable businesses? The Ukrainian banking sector has seen a period of intense competition, with a large number of banks fighting for market share. Would customers return to banks whose brand may be seen as permanently damaged?

Even if the banks are able to retain or attract a customer base, would investors be prepared to pay such amounts to enable the government to recover its investment? Given the acquisition activity in the banking sector between 2005-2008, one may conclude that anyone who wanted to be present in the Ukrainian market is already present. Second and third tier banks which were sold in the boom period fetched less than $400 million, even when multiples were at levels far higher than we would expect to see in the coming years.

Regardless of the outcome for individual banks subject to recapitalization, the overriding question is whether the sector will emerge stronger from the crisis as a result of quick action by authorities. Certainly the presence of foreign banks has provided some much needed stability and with the on-going commitment by authorities to work with the international agencies, confidence is returning to the sector.

Jock Nunan is a partner PricewaterhouseCoopers Ukraine. He can be reached at [email protected].