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Ukrainian macro-economic policy is highly professional and the current world financial crisis will affect Ukraine’s economy to a very limited extent, if at all.

Fitch Ratings revised the outlook for Ukraine and nine major banks in the country from stable to negative on Sept. 25. These negative rating actions by Fitch have not found much understanding with leading Ukrainian economists. For many of them, Ukrainian macroeconomic policy is highly professional and the current world financial crisis will affect Ukraine’s economy to a very limited extent, if at all.

Ukraine’s economy grew by more than 7 percent in the first eight months of 2008, the rate of inflation was negative in July and August, and net foreign direct investment capital flows amounted to more than $1 billion just in August alone.

What else is needed to show that Fitch, to put it mildly, has exaggerated the seriousness of the situation?

Fitch’s actions will nonetheless make external borrowing more expensive for Ukrainian banks. Taking into account that Ukrainian borrowers have to repay $8.1 billion to foreign creditors in the second half of 2008, one can understand why the National Bank of Ukraine moved fast last month to simplify borrowing procedures by banks from abroad and to reduce loan reserve requirements. Otherwise, a number of Ukrainian banks could have had some difficulties meeting their external obligations. Supposedly, liquidity problems have stood behind a number of banks jacking up their lending rates.

However, these developments cannot shake the optimism of some Ukrainian leading economists. According to Valeriy Lytvytsky, top advisor at the National Bank of Ukraine, last August’s current account deficit was a mere $600 million, but net capital inflows during that month amounted to about $2 billion. Unfortunately, a year consists of 12 months. Fitch’s prediction regarding Ukraine’s 2008 current account deficit is one of the most optimistic around: 7 percent of gross domestic product in 2008, which is a large number by any standards.

Some find it comforting that Ukraine has not had persistent current account problems. The current account surplus was 10.6 percent of GDP in 2004, 2.9 percent in 2005, 1.5 percent in 2006 and 4.2 percent in 2007. However, many economists look at the growing current account deficit from a more bleak perspective.

An avalanche of foreign funds descended upon Ukraine in 2006-2008. As a result, in 2007, the net foreign indebtedness of Ukraine, a country with a 2007 GDP of $140 billion, grew by $30 billion. Significant amounts of the relatively cheap money were used by banks for extending pricey loans to high-risk Ukrainians, thereby feeding a major consumption boom. As of Jan. 1, 2008, funds borrowed from non-residents made up 29 percent of all bank liabilities. Taking into account the fact that private deposits made up 31 percent, one can understand the importance of non-resident funds to the Ukrainian banking system.

The more money came in, the worse Ukraine’s current account deficit became. Prices for steel products (the major Ukrainian export goods) went through the roof and the national currency weakened in line with the falling dollar, thereby making Ukrainian exports more attractive to many foreign countries. Consumption of foreign goods skyrocketed in Ukraine as a result of accessible bank loans.

Exorbitant effective lending rates were the solution on the part of banks to the difficult task of giving out tens of billions of dollars to people having no credit histories. More often than not, borrowers were not aware of how much they were going to pay for the loan. Banks added all sorts of fees to their loans, with effective lending rates being as high as up to 100 percent.

The current global financial crisis is the result of regulatory failure to guard against excessive risk-taking. Mortgages with no down payment or with teasing rates are the first to come to mind when one thinks of the bursting housing bubble in the United States. Lenders used a great deal of bait to entice sub-prime borrowers into taking out a mortgage.

Unfortunately, many Ukrainian banks borrowed not only money from abroad but the lending techniques as well. The share of mortgages in Ukrainian banks’ credit portfolios is still comparably small – 10.6 percent as of Jan. 1. But it is disturbing that almost 80 percent of outstanding mortgages are denominated in foreign currencies. A devaluation of the hryvnia would make many mortgage borrowers insolvent simultaneously.

Problems in the U.S. financial markets began when the housing prices faltered. Ukrainian housing prices, fueled by huge capital inflows, rose until very recently. What waits for them in the nearest future?

If the U.S. Federal Reserve Bank keeps on pumping hundreds of billions of dollars in the global financial system, then another soaring of Kyiv’s housing prices is possible. If, at some point, the Fed realizes that its attempts to inflate out of the recession are futile and it is time to swallow the bitter pill, then capital flows to Ukraine will dry up and commodity prices will drop, leading to a recession in Ukraine.

At the same time, Ukraine’s foreign debt of more than $100 billion may indicate that its financial sector is too big for current conditions. If so, a correction is unavoidable. Transition countries with a high level of corruption, a failed judicial system, weak institutions and poor governance have higher chances of facing a major economic crisis.

Time will show whether Ukraine is one of them.

Pavlo Prokopovych is a senior economist at the Kyiv Economics Institute and an assistant professor at the Kyiv School of Economics.