You're reading: SigmaBleyzer’s report on Ukraine’s macroeconomic conditions in May

Editor's Note: The following was published by the U.S.-Ukraine Business Council in Washington, D.C. on July 9. It was prepared by the SigmaBleyzer private equity investment management firm and The Bleyzer Foundation. The complete May 2013 analytical report, including several color charts and graphs, can be found at the following link: http://www.sigmableyzer.com/wp-content/uploads/Ukraine_EU_5_1_13.pdf


SUMMARY:

(1) Real Gross Domestic Product (GDP) declined by 1.1 percent year-on-year in the first quarter of 2013 amid feeble external demand
and investment activity.

(2) The decline in industrial production moderated to 2.2 percent year-on-year in April,
confirming that the Ukrainian economy has been gradually strengthening.

(3) Private consumption continued growing at a robust pace, fueled by
strong real wage growth and benefiting domestic demand driven sectors.

(4) Public finances remained under strain amid falling budget revenues
and increasing social expenditures. But thanks to solid domestic and
external borrowings, the overall fiscal situation remained
manageable.

(5) Annual inflation stayed at -0.8 percent in April, unchanged from March.

(6) Banking sector resource base continued to improve, supported by
strong deposit growth and growing money supply. However, credit growth
remained anemic.

(7) Ukraine’s current account gap narrowed in April thanks to resumed
export growth and an ongoing decline in energy imports. The country also
enjoyed robust foreign capital inflows, which
helped slightly replenish gross international reserves.

(8) Balance of Payments improvement and favorable purchasing power
parity estimates point to diminished hryvnia exchange rate depreciation
pressures.

EXECUTIVE SUMMARY

The fragile external environment and weak bank lending activity continued to be a
drag on economic growth in Ukraine. Weakness in external demand, feeble industrial
production and March’s bad weather conditions drove a decline in GDP by 1.1 percent year-on-year in the first quarter of 2013. Quarterly data and soft business sentiment indicators, however, suggest
that economic activity may have already bottomed out and a recovery to growth may be
expected in the second half of 2013.

Real sector data for April confirmed that the Ukrainian economy has been gradually
strengthening. The decline in industrial production moderated to 2.2 percent year-on-year in April
amid eased rates of contraction in metallurgy, manufacturing of transport vehicles
and chemicals. Moreover, pharmaceuticals, food manufacturing and agriculture
demonstrated solid growth rates.

In addition, thanks to improvements in the industrial sector, the decrease in
wholesale trade turnover slowed to 4.2 percent year-on-year over January-April 2013. However, a more
modest and slower than expected improvement in the EU economy, in addition to a
constrained domestic credit supply, led us to revise our real GDP growth forecast
for Ukraine downwards to 1 percent year-on-year in 2013.

Despite signs of improving economic performance, Ukraine’s fiscal challenges seem to
be mounting. State budget revenues fell by 6.5 percent year-on-year in nominal terms in April, while
expenditures increased by almost 18 percent year-on-year, causing a sharp widening in the budget
deficit. The cumulative deficit was almost four times higher than in January-April
of last year. At the same time, the fiscal situation remains manageable thanks to
solid domestic and external borrowing. However, comprehensive consolidation measures
are necessary to sustain public finances in the longer term.

Consumer inflation remained low in Ukraine in March and April 2013. Annual inflation
stayed at -0.8 percent in April, unchanged from March, reflecting declining fuel prices,
mostly flat utility tariffs and falling food prices. Furthermore, the monetary
impact on inflation remained subdued despite an observed acceleration in money
supply growth over the last few months.

Given current price developments, good prospects for the agricultural harvest and
government efforts to find ways to avoid a painful adjustment to the natural gas
tariff adjustment for the population, consumer price growth should be contained at
around 4 percent year-on-year at the end of the year.

Following some deterioration in March 2013, Ukraine’s current account gap narrowed
in April. In March 2013, exports fell by almost 10 percent year-on-year, affected by weather-related
transportation disruptions and Russia’s new trade restrictions. In April, however,
exports resumed growth amid higher shipments of mineral and chemical products. In
contrast, imports declined in both March and April, affected by government efforts
to reduce energy imports.

In addition, Ukraine continued to enjoy robust foreign capital inflows, benefiting
from loose international liquidity and revival of foreign investors’ risk appetite
and likely larger repatriation of Ukrainian funds from offshore centers due to
recently increased safety concerns. These funds were sufficient to cover Ukraine’s
foreign financing needs and slightly replenish its gross international reserves to
$25.2 billion at the end of April.

Lower inflation dynamics in Ukraine since 2010 (compared to its main trading
partners) have made purchasing parity estimates quite favorable for the country.
Coupled with Balance of Payments improvement, this points to a diminished need for
exchange rate adjustment. As a result, we believe the NBU will continue to target hryvnia exchange rate stability over the next few years, allowing a maximum
depreciation of about 5 percent.

ECONOMIC
GROWTH

The fragile external environment and weak bank lending activity continued to be a
drag on economic growth in Ukraine. In March 2013, the impact of these factors was
amplified by adverse weather conditions. Indeed, heavy snow during the month caused
disruptions in supply chains, affecting manufacturing, transportation, and exports.

The decline in manufacturing deepened to 9.3 percent year-on-year in March 2013, led by machine
building, metallurgy, chemicals, and oil-refining. The real value of cargo
transportation and wholesale trade turnover edged down by 9.3 percent year-on-year and 5.4 percent year-on-year,
respectively, over January-March 2013. The construction sector suffered particularly
from cold and snowy weather with the real value of construction works down by almost
14 percent year-on-year in the first quarter of 2013.

The weakness in external demand, feeble industrial production and March’s bad
weather conditions drove a decline in GDP by 1.1 percent year-on-year in the first quarter 2013. Quarterly data,
however, suggests that economic activity may have already bottomed out. Contraction
in economic activity slowed compared to the last quarter of 2012. Moreover, the National Bank of Ukraine (NBU) survey indicators of business expectations continued to improve in the first quarter of 2013, showing
that stabilization took place in the first quarter of 2013 and a recovery to growth may be expected in
the second half of 2013.

Real sector data for April confirmed that the Ukrainian economy has been gradually
strengthening. Indeed, the decline in industrial production moderated to 2.2 percent year-on-year in
April amid eased rates of contraction in metallurgy, manufacturing of transport
vehicles and chemicals (including production of fertilizers) to less than 5 percent year-on-year,
20 percent year-on-year and 12 percent year-on-year, respectively.

As world steel prices continued to trend downwards, the improvement in metallurgy
may be attributed to the resumption of operations by two ferroalloy producers, which
suspended work in December 2012 amid rising electricity prices and buoyant imports.

Better results in the domestic car manufacturing industry were caused by the
imposition of a special duty on imported cars in mid-April. Although both
measures (protectionist import duty and producers’ tariff prices) may stimulate
domestic production in the short-run, they may not outweigh output and welfare
losses in the long run, as they will dampen investments in modernization,
innovation, and quality improvement.

Production of pharmaceutical and food products, as well as agricultural goods,
remained on the rise. A 27 percent year-on-year increase in medical drug manufacturing over the
first four months of 2013 may be the result of harmonization of Ukraine’s
legislation with EU requirements on compulsory licensing of pharmaceutical patents
and introduction of licensing for imported drugs. According to estimates, the share
of imported drugs accounts for about 80 percent of the Ukrainian retail pharmaceutical
market.

Although Ukraine has its own drug manufacturers, they mostly concentrate on
production of lower-priced generics and vitamins. Approval of the compulsory
licensing legislation will allow for production of more affordable medicines that
still have unexpired patents.

Manufacturing of foodstuffs rose by 1.6 percent year-on-year in April, supported by a solid increase
in agriculture and buoyant consumption. Indeed, agricultural output was up by 5.1 percent year-on-year over January-April 2013, while retail sales, often used to gauge the consumption
growth pattern, expanded by 12.7 percent year-on-year over the period, underpinned by a 10.2 percent year-on-year
real wage growth. Thanks to improvements in industrial production, the decrease in
wholesale trade turnover slowed to 4.2 percent year-on-year over January-April 2013.

Although there were clear signs of easing downturn of the Ukrainian economy, more
modest and slower than expected improvements in the EU economy and constrained
domestic credit supply led us to revise the real GDP growth forecast for Ukraine
downwards to 1 percent year-on-year in 2013. The positive momentum in private consumption is
forecast to be the main driver of economic growth in 2013 and 2014. Consumer
spending will be sustained by diminished inflation expectations and a more stable
exchange rate.

Although budget spending is forecast to grow at a more reserved pace, fiscal
consolidation is likely to exert a greater toll on government consumption and
investment rather than expenditures on the public wage bill, social welfare and
protection. A gradual strengthening of the external environment of Ukraine’s main
trading partners and entering a Free Trade Agreement with the EU should support
Ukraine’s exports in 2014.

In addition, solid improvements in agricultural production over the last few years
and growing investment in the agricultural sector may signal that Ukraine has been
gradually unlocking its high agricultural potential.

As a result, agriculture may be a strong driver of both production and export growth
over the medium-term, though its impact may fluctuate depending on weather
conditions. In turn, imports are forecast to be contained by government efforts to
reduce the volume of energy imports, the weightiest commodity group in total
imports. All in all, the Ukrainian economy is forecast to pick up by about 3-4 percent year-on-year
in 2014 and should be able to grow by about 4-5 percent per annum over the medium-term.

FISCAL POLICY

Despite signs of improving economic performance, Ukraine’s fiscal challenges seem to
be mounting. State budget revenues fell by 6.5 percent year-on-year in nominal terms in April, while
expenditures rallied at almost 18 percent year-on-year. As a result, the state budget deficit
widened sharply that month, while the cumulative deficit was almost four times
higher than in January-April of 2012.

April’s fiscal developments were additional evidence that government revenue
requirements are unlikely to be met this year. Lower than forecast economic growth
and inflation weighed on budget revenues. Thus, despite booming consumption, VAT
collections were only 0.3 percent year-on-year higher in January-April of this year. Proceeds from
import taxes reported a moderate 7.3 percent year-on-year growth over the first four months of the
year as weak investment demand and government efforts to reduce energy imports
outweighed the increase in import duties.

April is a seasonally weak period for corporate profit tax collections. In addition,
a 2 percentage point reduction in the corporate profit tax rate to 19 percent was enforced
at the beginning of the month. As Ukrainian enterprises pay profit tax in advance, the decline in the tax rate was felt in April. Receipts from the corporate
profit tax were only 2.5 percent year-on-year higher that month compared to a 28.5 percent year-on-year increase
over the first quarter of 2013.

On the expenditure side, social security and public debt-related spending were the
main drivers of state budget expenditure growth over the first four months of the
year. In particular, social security and protection outlays rose by 42 percent year-on-year, while
public debt service payments were up by almost 30 percent year-on-year over January-April. Although
these spending increases were partly offset by expenditure savings on public
investment and other discretionary spending, budget outlays grew much faster than
receipts.

Despite growing fiscal pressures, however, the fiscal situation remained manageable
thanks to solid domestic and external borrowings. Taking advantage of loose
international liquidity and a revival of investors’ risk appetite, Ukraine issued
$1.25 billion 10-year Eurobonds in mid-April at a 7.5 percent coupon rate, 12.5 basis
points and 30 basis points lower than the yield rates of the February 2013 and
November 2012 Eurobond placements, respectively.

Moreover, benefiting from improved banking sector liquidity and diminished hryvnia
depreciation pressures, Ukrainian authorities were very active in attracting funds
in national and foreign currency on the domestic debt market.

Over the first four months of 2013, Ukraine issued Hr 16.1 billion (around $2
billion) of hryvnia-denominated and $2.4 billion of dollar-denominated domestic bonds.
The attracted funds were sufficient to cover the widening fiscal deficit and to meet
Ukraine’s foreign public debt liabilities, even in the absence of IMF financing.
However, despite favorable Monthly State Budget Execution, not seasonally adjusted
current picture, further consolidation measures are necessary to sustain public
finances.

Government officials have already announced that they’ve been developing budget
revision proposals. Although the details were not available, we believe a mix of
revenue increases (e.g., by further raising excise taxes) and spending cuts will be
proposed, which would help narrow the general public sector deficit to around 4 percent of
GDP in 2013.

MONETARY POLICY

Consumer inflation remained low in Ukraine in March and April 2013. Annual inflation
stayed at -0.8 percent in April, unchanged from March, reflecting declining fuel prices,
mostly flat utility tariffs and falling food prices, which offset higher prices on
alcohol and tobacco, communication and other services. In addition, clothing and
footwear prices were down by 2.7 percent year-on-year, and furniture and household equipment by 0.2 percent year-on-year in April.

Due to a high share of imported goods, the price decrease in these commodity groups
may be attributed to diminished hryvnia depreciation pressures. Furthermore, the
monetary impact on inflation remained subdued, despite the observed speed-up in
money supply growth over the last few months.

Inflation is forecast to slightly accelerate in the second half 2013 amid a fading favorable base
effect and eventual adjustment of utility tariffs. However, the government has been
actively seeking ways to sustain Naftogaz financing without a painful adjustment to
natural gas tariffs for the population. As a result, the tariff increase may be
rather gradual or may apply to only select households. Hence, given current price
developments and likely moderate tariff adjustment, consumer price growth is
expected to be contained at around 4 percent year-on-year at the end of the year.

Money supply growth continued to gain momentum in March and April. An almost 17 percent year-on-year
increase in M3 monetary aggregate in April 2013 was the result of acceleration in
monetary base growth and a buoyant increase in deposits. Thus, annual growth of the
monetary base increased to 12.8 percent year-on-year in April, up from about 10 percent year-on-year in March. The
speed-up mainly reflected improvements in banking sector liquidity, underpinned by
lower NBU sterilization operations and greater refinancing activity.

Although government cash balanced with the NBU rose in March and April, the impact
of their increase was outweighed by large NBU purchases of government securities.
The NBU remained the principal buyer of government bonds over the first four months
of 2013; its portfolio of government bonds grew by 19 percent over the period.

The volume of deposits in the Ukrainian banking system kept growing, adding almost
20 percent in April on an annual basis. Corporate deposits gained 22.8 percent year-on-year over the
period, which may be an additional signal of reviving economic activity and the
improving financial stance of Ukrainian enterprises. At the same time, it may also
point to subdued investment activity, as money is deposited in commercial banks
rather than invested. Household deposits rose by 18.5 percent year-on-year in April, underpinned by
robust real wage growth, attractive deposit rates and diminished hryvnia
depreciation pressures.

Despite improved banking sector liquidity and low inflation, interest rates on
deposits have reported moderate declines since the beginning of the year, as
household deposits are among the most important source of funding for Ukrainian
banks. On the downside, however, high deposit rates and credit risk are keeping
lending rates high, adversely affecting demand for loans. Hence, despite a
strengthening deposit base and improved banking sector liquidity, lending to the
private sector remains weak. The stock of loans rose by less than 4 percent year-on-year as of the
end of April.

Faster growth in monetary aggregates may also be related to a stable foreign
exchange market. Targeting exchange rate stability, Ukrainian monetary authorities
usually tighten money supply to contain depreciation pressures. Since the beginning
of 2013, the hryvnia exchange rate has been fluctuating within a relatively narrow
margin of UAH 8.10-8.16 per USD, which allowed for some easing of monetary
conditions in an attempt to stimulate credit growth.

At the same time, despite the recent acceleration, money supply growth still
compares favorably to the over 40 percent increase before 2008. We believe the monetary
impact on inflation will remain subdued over 2013-14.

Relative hryvnia exchange rate stability was achieved thanks to continued NBU
support of the hryvnia exchange rate, though much less sizable than in the fall of
last year, and weakening population demand for foreign exchange. The latter was a
considerable drag on both the capital account of Ukraine’s Balance of Payments and
the hryvnia exchange rate over the last few years.

Amid an improving macroeconomic environment and strengthening consumer confidence,
population purchases of foreign currency exceeded sales by only $2.7 million in
March, while in April the population bought less foreign currency than it sold, for
the first time in four years.

Ukraine’s purchasing power parity estimates also point to diminished hryvnia
depreciation pressures. Due to subdued price growth since 2010, inflation in Ukraine
was and is forecast to stay lower than in its main trading partners. This signals
that the country has restored its international competitiveness lost during the high
inflation pre-crisis years. Given these favorable estimates as well as good
prospects for Balance of Payments improvement, we believe the NBU will continue
maintaining the hryvnia exchange rate peg to the US dollar over the next few years,
by allowing a marginal devaluation of about 5 percent.

INTERNATIONAL TRADE AND CAPITAL

Following some deterioration in March 2013, Ukraine’s current account gap narrowed
in April. In March 2013, exports fell by almost 10 percent year-on-year, affected by weather-related
transportation disruptions and Russia’s new trade restrictions. As these causes
proved to be short-lived, Ukraine’s merchandise exports reported a 3 percent year-on-year increase
in April. Thus, exports of machinery and transport vehicles grew by 2.7 percent year-on-year in
April, compared to a 16 percent year-on-year reduction in March.

Almost 70 percent of this commodity group’s exports are destined for Russia and other former Soviet countries, which makes it vulnerable to trade relations with these countries.
Indeed, Russia’s suspension of the quality production certificate for a major
Ukrainian producer of railcar castings weighed on rail machinery production and
exports during the first four months of 2013. Although the certificate was
reinstated at the beginning of April, output limits were imposed. Additionally,
given slowing economic growth in Russia, the rate of expansion of this commodity
group’s exports is likely to remain subdued.

Economic weaknesses in the European Union, one of the key overseas markets for Ukraine, and
ongoing downward trend of world steel prices, weighed on exports of metallurgical
products, which decreased by about 6.5 percent year-on-year in March and April. In addition, exports
of agricultural and food products were almost 10 percent lower in March-April 2013,
compared to the corresponding period last year.

A high base effect and wheat export restrictions imposed at the end of last year
were the main reason for the decline. Indeed, the government and grain traders
agreed to ban grain exports following their rapid growth amid a moderate harvest in
2012. As the ban was lifted at the end of April, agricultural exports may improve in
the coming months.

On the upside, Ukraine’s exports of mineral products rose by 47 percent year-on-year in April,
mainly on account of higher shipments of iron ores. Strong foreign demand for iron
ores and international supply disruptions due to adverse weather conditions in
Australia and export restrictions in India helped drive Ukraine’s exports. In
addition, exports of chemical products (fertilizers in particular) grew by 13 percent year-on-year
in April.

In contrast to exports, imports kept declining in March and April. A 6.4 percent year-on-year and an
almost 8 percent year-on-year reduction in imports over these two months, respectively, was mainly
the result of government efforts to reduce energy imports. Indeed, foreign supplies
of mineral goods to Ukraine went down by 14 percent year-on-year in March and 30 percent year-on-year in April. The
Ukrainian authorities have been taking steps to reduce energy imports by
diversifying natural gas supplies, substituting imports with domestic fossil fuels
and stimulating energy savings.

As export performance improved while imports continued to decline, Ukraine’s current
account gap in April was almost 30 percent lower than last year, while the first four
months deficit stood at $2.4 billion, about $0.6 billion lower than in the
corresponding period of 2012. Moreover, Ukraine has been generating solid capital
account surpluses this year, benefiting from loose international liquidity, revival
of foreign investors’ risk appetite and likely larger repatriation of Ukrainian
funds from offshore due to recently increased safety concerns.

The inflows of foreign capital helped cover Ukraine’s current account deficit, meet
its foreign debt liabilities and slightly replenish its gross international
reserves. The latter grew by 2.1 percent month-on-month to $25.2 billion at the end of April. Although
the reserves stayed slightly below three months of imports, the overall Balance of
Payments trends this year look encouraging, supporting our view of diminished
pressures for exchange rate adjustment.