Ukraine: Milking both cows

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July 27, 2010, 11:36 a.m. | Op-ed — by Timothy Ash

Timothy Ash

Timothy Ash is head of emerging market research for Standard Bank in London.

Timothy Ash, the Head of Emerging Markets Research at the Royal Bank of Scotland, writes:We visited Kyiv on July 21 - 23, 2010, meeting with the Minister of Energy, officials from the Ministry of Finance, the central bank, the International Monetary Fund, the City of Kyiv, alongside various local banks/corporates, journalists and diplomats. Summary

Presidential elections in January/February have improved political stability, and the policy making environment is now more assured. This should be reflected in the staff-level agreement on a new 30-month $15 billion IMF standby agreement which is expected to be approved by the IMF board on July 28.

In signing up to the IMF agreement the government has agreed to significant fiscal adjustment, and importantly structural reforms particularly to the energy sector, but also extending independence of the National Bank of Ukraine. IMF funding should cover any shortfall in budget financing for 2010, and well into 2011. IMF funds, combined now with an current account surplus (H1 2010), and much reduced debt service costs suggests appreciation pressure on the hryvnia which is likely to be met with the accumulation of foreign currency reserves.

These are politicians who know, inside out, the workings of government and politics in Ukraine, and are well versed to regional geopolitics. They are an administration which can deliver on a legislative agenda, the only question remains as to how reform-minded that agenda will be.

The economy looks set to bounce back strongly in 2010, with 5-6 percent real gross domestic product growth expected. Sustaining this growth beyond this date will though be dependent on the ability of the new government to sustain broader structural reforms, particularly those aimed at improving the business environment and attracting increased inflows of foreign direct investment.

Banking sector development is expected to be slow-moving, a reflection of high non-performing loans which suggests banks will be risk averse going forward. The sector is, however, liquid and now better capitalized, and the former should act to underpin efforts by the government to raise budget funds domestically.

Political stability – more assured

The political landscape has undergone a sea change following the election of Viktor Yanukovych as president in February, in a second round run-off vote with Yulia Tymoshenko. Political power is now effectively concentrated around Yanukovych, whose Regions of Ukraine (RU) party now controls a sizeable and stable coalition in parliament (~ 245 deputies, out of 450) and the government, in alliance with the Lytvyn Block, elements of former President Viktor Yushchenko's Our Ukraine faction, plus also defectors from the Yulia Tymoshenko grouping.

The Regions-led administration is proving more effective than its predecessor in getting key legislation through parliament, as reflected in the speedy approval of a reform package required to secure IMF approval for a new 30-month $15 billion Stand-by arrangement. The package included controversial aspects including budget spending cuts, but also hikes in gas and energy prices.

The opposition still seem to be reeling from Tymoshenko's defeat in the presidential election. Tymoshenko herself is struggling to rally the opposition, a situation not helped by the fact that she currently does not hold a seat in parliament (limiting her platform), and by divisions within the opposition itself.

Recent changes to the electoral law, could well hinder the performance of opposition parties in local elections in October; the law is biased against newer parties whose candidates will likely struggle to secure registration to participate in the polls.

With the opposition split and appearing weak at present, the focus is turning more to political machinations within the Regions-led administration itself. Rumors are rife of a potential cabinet reshuffle with suggestions that Sergiy Tigipko, the current deputy prime minister in charge of the economy, might be removed.

Tigipko is not a member of RU, and ran in the presidential election first round as a challenger to Yanukovych. He also lacks a powerbase in parliament, as he has only recently formed a political party; evidently his usefulness to Regions' has hence waned somewhat.

Tigipko is though seen as one of the dynamos for reform in the cabinet, having been central to negotiations with the IMF over a new program. His departure would hence disappoint the market. Tigipko’s departure might also change the balance of power within the administration and within Regions itself.

Herein note that Regions is itself a broad coalition of oligarchic interests, with prominent factions ranged around President Yanukovych, including billionaire backer Rinat Akhmetov, gas tycoon Dimitry Firtash and energy minister Yuriy Boiko, as well as former deputy prime minister and businessmen Andriy Kluyev. The incumbent premier, Mykola Azarov, presents something of a arbiter between the various oligarchic interests in the coalition.

Of note President Yanukovych is now seen as having established his own powerbase/authority – many had suggested previously that Yanukovych was in the shadow of Akhmetov, in particular. This no longer seems to be the case, and the patronage of the presidency appears to have worked to increase his own power and authority within the administration.

Many argued that with the opposition appearing weak and divided, a more interesting dynamic to watch is that between the presidency and the government. Yanukovych's has appointed a highly respected heavy-weight in Irina Akimova to his presidential administration in charge of economic policy, and this is already being felt in the delineation of more longer run economic policy planning/priorities being set, e.g. over privatization.

There is concern that the government might be focused on a shorter-term agenda, reflective if the fact that parliamentary elections fall within the next two years, whereas Yanukovych has a five year term in office.

The Yanukovych administration is currently focused on the need to revamp the constitution, to alleviate the threat of the policy paralysis which marked the previous Yushchenko administration, where the presidency was invariably at odds with the government and indeed parliament.

The problem is that constitutional reforms enacted after the Orange Revolution of 2004 created a presidential-parliamentary democracy, with the lines of power often blurred between the two. One option currently favored by the Yanukovych team seems to be to return to the 1996 constitution, which was in essence a strongly presidential-style system.

Members of the diplomatic community appeared relatively sanguine/supportive of the move, arguing that it would counter the policy paralysis which so often dogged previous Orange administrations. There have been suggestions that the move to revise the constitution might require a referendum, albeit an easier means to revise the constitution might be via the courts; apparently the reforms instigated in 2005 were riddled with technical errors, which are likely to be nullified if referred to the Constitutional Court.

Clearly, moves to revise the constitution more towards a presidential system, and which would inevitably boost the position of President Yanukovych would likely be challenged by the opposition, in particular by Tymoshenko’s grouping.

However, with support likely from Brussels and Washington for constitutional reform, and given the past 5-year track record of pro-Western Orange parties, we assume that the chances of mass demonstrations/opposition to the changes as per the Orange Revolution are likely to be lower this time around.

With a move to a more concentrated presidential form of rule, the hope will be that the Yanukovych administration manages these with some respect for the strides in democracy made in Ukraine over the past 4-5 years; one of the great and hopefully lasting achievements of the Orange revolution. Note in this latter respect, that amongst CIS countries, Ukraine is very much considered to be the one that most closely adheres to Western democratic norms; the recent Presidential elections were considered to be free and fair (universally the view of the Western diplomatic corp), and the press remains essentially fair.

International relations – milking both cows

Much has been made of the Yanukovych administration's alleged pro-Russian policy bias. Critics of the administration herein will no doubt highlight agreements reached in recent months which they would argue would affirm this, including the extension of Russia's lease over the Sevastopol naval base, and the energy price/sector agreement reached between the two countries.

Assuming that the IMF board agrees on the new $15 billion standby agreement, this would suggest further appreciation pressure on the Hryvnia, which the NBU looks set to stem via foreign currebncy purchases, trying to keep the Hryvnia stable in nominal terms and as an anchor for inflation. Indeed, stability seemed to be a common buzzword for policy makers we met during the trip.

However, it is important to remember that Regions' pro-Russian vent has its limits. Indeed, while Regions' oligarchic powerbase values the normalization of relations with Russia, to ensure stable trading relations, access to Russian financing, and the assurance of energy supplies to Russia, it is still eager to maintain Ukraine's independence from Moscow.

Regions' is thus eager to limit the extension of Russian influence and control back over Ukraine. Oligarchs within Region's, and indeed in Ukraine more generally, are fearful that any extension of Russian influence over Ukraine will see Russian business interests dominate over their own. And at present, oligarchs within Regions continue to enjoy substantial political control/influence within Ukraine, something which their Russian counterparts have seen steadily reined-in by the Putin regime.

They thus have no interest in Ukraine being subsumed into a new pan-CIS entity, inevitably dominated by Russia. That said, Regionsis well aware that by balancing (or perhaps "playing off") the interests of Russia against those of the EU/US, Ukraine can extract considerable concessions from Moscow.

Herein, the recent gas price agreement between Ukraine and Russia, which secured a $100 per 1,000 cubic meters discount for Ukraine, the $2 billion bridging loan secured from Russian state-owned banks for Ukraine, and promises of $4 billion for the modernization of Ukraine's nuclear power capacity, are all reflective of this.

Concessions from Ukraine, including rowing back from NATO membership aspirations - not supported by the general population in any event, and the Black Sea Fleet agreement – are seen as small concessions by comparison. Interestingly, suggestions from Moscow that the Russian and Ukrainian gas transit companies are merged provoked the quip from Ukrainian officials that Ukraine would struggle to digest Russia's own gas transit system, which would make any such drive a long run objective!

Regions seem to have no intention of surrendering political or indeed economic control of Ukraine to Russia. Indeed, the policy will likely be a continuation of that of the former Leonid Kuchma presidential administration of keeping Russia sweet but distant, while at the same time extracting maximum economic concessions from its Eastern neighbor to the advantage of business in Ukraine.

Yanukovych's first foreign trip on assuming the presidency was to Brussels which perhaps suggested a desire to maintain the drive to EU accession. In reality Western diplomats noted very slow progress in terms of negotiations over an Association Agreement and also in terms of the much touted Free Trade Agreement with Ukraine.

One complaint heard was that the Yanukovych administration appeared to lack a clear understanding of the benefits of deepening ties with the EU, which perhaps explains the relatively low priority still afforded to them. More charitably, the argument could be made that with limited institutional capacity, and with more pressing concerns, the administration has instead focused on the priority of securing a new agreement with the IMF; arguably the benefits of a new IMF agreement were more clear-cut, i.e. $15 billion in new financing, against only limited and vague promises of financial assistance from the EU – often linked to difficult and more time-consuming structural reforms.

Policy environment – New/old faces suggests an ability to get things done

While some doubt exists over the reform credentials of the new administration – Tigipko and Akimova notwithstanding – there is general acceptance that the cabinet comprises a wealth of experience and with the large majority enjoyed by the coalition in parliament, and with the support of the presidency, the new administration has scope to deliver on the policy reform front. Already this has been reflected in the government's ability to secure parliamentary approval for a raft of IMF-compliant legislation (see below).

Reviewing the new cabinet it is indeed bestowed with a wealth of experience. The prime minister, Mykola Azarov, previously served as deputy prime minister, finance minister, and head of the tax administration in the previous Yanukovych government. Similarly, Yuriy Boiko, returns to the position of energy minister, which he held until 2007, and there are few people in Ukraine with as much inside information as to the workings of the energy sector as Mr Boiko.

These are politicians who know, inside out, the workings of government and politics in Ukraine, and are well versed to regional geopolitics. They are an administration which can deliver on a legislative agenda, the only question remains as to how reform-minded that agenda will be.

Relation with the IMF

On July 3, the government announced a staff-level agreement with the IMF over a 30-month $15 billion Stand-by arrangement. The IMF had demanded a number of prior actions as a condition for the new program, including:

1) Budget austerity measures, equivalent to 1.6 percent of GDP, and sufficient to reign in the budget to a deficit target of 6.5 percent of GDP for 2010, made up of a general government deficit of 5.5 percnet of GDP, with a 1 percent deficit agreed for the state gas transit company. For 2011 the government agreed to trim the deficit to 3.5 percent of GDP, with the state gas transit company running a balanced budget;

2) A 50 percent hike in domestic gas prices as of August 1, 2010, which will help close the deficit at the state gas transit company;

3) Approval of a new gas law, facilitating the creation of a new energy sector regulator, which national control over energy pricing; and

4) Approval of a new NBU law, increasing/assuring the independence of the central bank.

IMF board approval for the new program is expected on July 28, with credit disbursements expected to be front-loaded; around $2 billion in IMF budget financing is expected to be extended for 2010. The latter is also expected to leverage the release of $300-500 million in EU/World Bank financing for the budget for 2010. For 2011, the bulk of IMF financing is expected to be to provide BOP support.

The first review under the new program is expected in October. This will allow the IMF to review end-September performance criteria and also to monitor the 2011 budget process which kicks off apace in mid-September.

Budget financing

The 2010 budget targets a deficit of Hr 54 billion which with Hr 24 billion in debt maturing suggests a financing requirement of Hr 78 billion. The MOF aims to cover this gap via a combination of Hr 36 billion in internal funding, and Hr 30 billion in external funding, with the balance covered via project financing and privatization receipts. As of July, the finance ministry had managed to raise Hr 26 billion in domestic debt issuance, i.e. more than two thirds of the total to be raised from this source. In terms of external financing, the finance ministry secured a $2 billion 6-month bridge loan from a Russian state owned bank in June. The government has an option to extend this by a further two years, which seems likely barring additional market financing.

Assuming the IMF board approves the staff level agreement on a new $15 billion facility, this could see the disbursement of $2 billion in IMF budget support to year end, with an additional $500 million in World Bank/IMF monies.

In effect this suggests that budget financing needs to year end would be covered. The above perhaps explains the government's decision to scale down plans contained in the earlier budget draft to generate Hr 10 billion from privatization receipts in 2010, to a lower figure now of HR 6.3 billion, plus the government's decision to stall in coming to market with a new Eurobond issue; the latter having road-showed in July.

In terms of sovereign market debt falling due, the service schedule remains modest for 2010, with only the 2010 Samurai issue falling due in December, and even then only for a sum of $400 million or thereabouts.

One pressing issue for the finance ministry remains the large arrears accumulated on value added tax (VAT) refunds to exporters. Various estimates have put this around the Hr 20 billion mark. Herein the government has announced plans to securitize these liabilities, with plans to issue new 5-year, amortizing bonds in 5 annual installments, which will pay a coupon of 5.5 percent. A final decision on the program is expected on July 28, i.e. in parallel with the expected IMF board decision. Thus far holders of HR 17.7 billion in VAT arrears have registered for the program.

Note that Prime Minister Azarov ran a similar scheme to cover VAT arrears during his first stint as prime minister, just prior to the Orange Revolution. Last time around the VAT bond scheme proved highly successful.

Fiscal performance thus far in 2010 has been disappointing, with the revenue side coming in under expectations – surprising given that real GDP growth has been running well ahead of expectations. Revenue performance does though appear to have stepped up a gear in Q2 2010, as the tax administration has sought to boost tax compliance; anecdotal evidence herein from some business leaders we spoke to did suggest more focus by the authorities herein.

Indeed, part of the explanation for the poor Q1 performance might be efforts by the outgoing Tymoshenko administration to encourage tax prepayment late in 2009, presumably to help boost revenues in advance of the presidential elections. Nonetheless, officials conceded that reducing the budget deficit from the 11 percent + run in 2009 to 5.5% in 2010 (inclusive of the Naftogaz deficit), and to just 3.5 percent of GDP by 2011 would be challenging.

Note that alongside the Hr 18-20 billion in debts assumed by the sovereign from the VAT refund program, the costs of bank recapitalization would likely add a further Hr 20 billion in public sector liabilities; half the total estimated cost of bank recapitalization in 2010.

That said, public sector debt ratios would remain relatively light, albeit increasing at a rapid pace; from 20 percent of GDP as of the end of 2008, to 35-36 percent as of the end of 2009, to around 40 percent at the end of 2010.

Energy policy

The government's decision to hike gas prices by 50 percnet from August 1 (with a further 50 percent increase slated from April 1), and to introduce a new independent national-level energy regulator/pricing board are landmark decisions. The fundamental problem for the energy sector in Ukraine was that the country imported gas at a much higher price than energy companies were able to charge domestically, partly as the domestic energy pricing issue had become hugely political.

Despite the expected upturn in industrial consumption as the economy rebounds, domestic consumption and imports are likely to remain broadly flat at current levels over the near term as household consumption likely declines.

Up unto the latest gas price hike the state-run gas transit company was slated to import gas at an average price of around $230 per 1,000 cubic meters, and to sell these domestically to households at around one-half this price, with the result being a quasi fiscal deficit from this source of around 2.5 percnet of GDP.

Efforts, meanwhile, to hike domestic gas prices to municipals – large uses of gas for local heating use – was typically thwarted by opposition from local politicians. With this latest move, the power to set gas and indeed energy prices more generally will move to the central government. This move should enable gas price hikes to be rolled out more effectively, better targeting/management of subsidies and also the reining-in of energy arrears.

Hikes in energy prices will continue to drive energy conservation. For 2010 gas imports are expected to total 36.5 bcm (billion cubic meters), with a gas price agreed with Russia of around $230 per 1,000 cubic meters (reflective of a $100 per 1,000 maximum discount). Imports are already lower from the average 50 bcm imported over the past decade. Consumption has, meanwhile, fallen to just over 50 bcm at present from well over 70 bcm per year over the previous decade.

Despite the expected upturn in industrial consumption as the economy rebounds, domestic consumption and imports are likely to remain broadly flat at current levels over the near term as household consumption likely declines. Over the longer term there remains significant scope for energy conservation, which will help the balance of payments and the finances of the state run gas transit company.

A significant further challenge for the new government comes from the recent Stockholm Arbitration Court ruling in favor of Swiss-registered RosUkrEnergo (RUE). The court ruled that the state owned energy company needs to return 11 bcm in gas to RUE, and pay 1 bcm in compensation for gas it illegally took control of after the state took over control of gas transit from RUE in 2009. The ruling potentially saddles the state owned energy company with a $3 billion bill, which it would clearly struggle to cover given its current very limited means.

Government officials appeared relatively relaxed in terms of their ability to resolve the issue and suggested that the issue was likely to be resolved without having to stump up the cash/gas in the short-term; no details were indicated as to the shape of any forthcoming agreement. Critics argue that the owners of RUE might be offered assets in exchange for gas, perhaps as part of looming state asset sales.

Banking sector

Some more favorrable trends are emerging in the banking sector, but significant challenges still remain. In particular, the sector remains pretty liquid at present, as reflected in the fact that interbank rates have collapsed. This is obviously helping the sovereign, which has seen its funding rates drop precipitously, and as banks are still reluctant to lend to the real economy the sovereign has a large captive domestic audience for domestic government debt issuance.

Much of this improvement in liquidity has been driven by the return of deposit growth while in parallel banks have been reluctant to extend balance sheets because of over-riding concerns over the level of credit risk. Indeed, non-performing loan ratios of 30-35 percent are indicative that the institutions around credit simply did not work in Ukraine when the global crisis hit with full force in 2008-09.

Given the unseasoned nature of many borrowers this suggests that banks will be slow to re-extend credit growth over the medium to long term, and the lack of credit is likely to remain a key impediment on economic development going forward.

Russian banks are increasingly prominent in Ukraine, viewing the malaise across the Ukrainian banking sector as offering an opportunity for their expansion in a market which they view as their home/backyard, and which they perhaps have more understanding of than their Western counterparts.

Interestingly, as the crisis has stress-tested borrowers, and many have failed the test, banks all tend to be targeting now the same customers, who have managed to remain current through the crisis. Borrowers in the food/agro industries have proven best able to remain current with their liabilities, with those in real estate, construction and retail most likely to run into difficulty with repayments.

Banks are also now much better capitalized, a reflection of foreign parent banks willingness to recapitalize their local subsidiaries, and the government's on-going efforts to recapitalize those domestically-owned banks which have been taken under state administration; Hr 20 billion was earmarked for this in 2009 and a further Hr 40 billion in 2010.

Foreign banks, nevertheless, complained that the process of recapitalizing their operations has proven painstakingly slow, and often has not been helped by foot-dragging by minority domestic shareholders who have been reluctant to accept the dilution of their equity stakes albeit they have themselves been reluctant to stump up additional capital; instead hoping to assume a free ride on the back of the foreign stake-holders.

Technicalities in completing the formal recapitalization process have been overcome by the regulators willingness to accept temporary parent company guarantees. A number of foreign banks are nevertheless known to still want to exit the market, but as yet there appears to be a shortage of prospective buyers.

Russian banks are increasingly prominent in Ukraine, viewing the malaise across the Ukrainian banking sector as offering an opportunity for their expansion in a market which they view as their home/backyard, and which they perhaps have more understanding of than their Western counterparts. Interestingly though while Russian banks are in the stage of acquisition, and are taking a greater share of deposits, they are still not actively expanding their balance sheets via the loan market; they seem similarly risk averse as their Western foreign counterparts.

Interestingly, we noticed a reluctance from some Ukrainian corporates to open full banking relations with Russian entities, noting a reluctance to place deposits with these institutions, instead preferring the "off-shore" safety of foreign "western" institutions.

In general the assumption is that the crisis will see significant consolidation in the banking sector, with the number of banks likely to shrink from 180 or so at the outset of the crisis, to around 70. The larger banks are likely to get stronger, and indeed this is already apparent with foreign owned banks benefitting from being able to raise deposit money at the lowest cost, versus their domestic counter-parts.

Some domestic banks are still offering very high rates on domestic deposit accounts (8-10% on dollar deposits), presumably still viewing this funding source as relatively cheap, especially given frequent assumed connected party lending by many of these banks; which obviously still presents possible systemic problems/risks for the sector going forward.

Growth and inflation

The economy is clearly in "bounce-back" mode, benefitting from a) the low base period effect from 2009, when real GDP declined by 15 percent year-on-year) a still competitive exchange rate, as the real effective exchange rate is still lower than it was just before the collapse of Lehman; c) the recovery in key exports markets, particularly metals/steel. Half year data suggests real GDP growth of in excess of 6 percent, which is close to double official projections.

Inflationary pressures, meanwhile, appear pretty muted, with headline inflation dropping to 6.9 percent as of June, down from 15 percent one year earlier, and the recent peaks of over 25 percent reached in mid-2008. The NBU noted that inflation was likely to muted, and reflected in 3 straight months now of MOM deflation (April - June). Herein the impact of expected hikes in gas/utility prices is expected to be offset by the still wide output gap, a lack of credit growth, the strength of the Hryvnia and still supportive food price pressures.

Balance of payments and exchange rate

The NBU reports that the current account has continued on an improving trend in 2010. Thus, for the period January through May 2010 the NBU indicated that the current account posted a surplus of $318 million, which compares with the deficit of $765 million over the corresponding period of 2009, and the 6-7 percent of GDP deficit reported in 2008. Still relatively subdued growth in import demand (+21.3 percent year-on-year), plus the bounce back in merchandise exports (+27.3 percent year-on-year Jan-May) – particularly for metals – continues to underpin the improvement.

The surplus on services also more than tripled over the first 5 months of 2010 to $1.6 billion, which also went some way to explain the significant year-on-year improvement in the headline current account position. Ukraine continued to run a sizeable surplus on transfers (+$1.1 billion) for the first 5 months of the year, which more than made up for the $643 million income deficit – the latter largely reflecting the still large ($100 billion+) stock of external debt.

As elsewhere in the region, net FDI continues to disappoint, posting a surplus of just $1.5 billion for the first 5 months of the year, down from $1.9 billion from the year earlier period, albeit this combined with the сurrent account surplus suggests a sizeable surplus (~2 percnet of GDP) on the basic balance.

Debt flows posted a modest $460 million net outflow for the first 5 months of the year, which compares with a net outflow of $4.7 billion over the same period of 2009. Meanwhile, "other investment flows", essentially flight capital actually posted a net inflow of $279million.

All told the above enabled a $1.6 billion accumulation in foreign currency reserves by the NBU over the first 5 months of the year. The latter excludes the US$2 billion in monies borrowed by the finance ministry from a Russian state-owned bank, and which pushed the NBU's foreign currency reserve stock over the $30 billion mark as of July.

Assuming that the IMF board agrees on the new $15 billion standby agreement, this would suggest further appreciation pressure on the Hryvnia, which the NBU looks set to stem via foreign currebncy purchases, trying to keep the Hryvnia stable in nominal terms and as an anchor for inflation. Indeed, stability seemed to be a common buzzword for policy makers we met during the trip.

Timothy Ash is the Head of Emerging Markets Research at the Royal Bank of Scotland.
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