*    Recession – the economy pushed into
recession in mid-2012, and has remained there, with real gross domestic product
(GDP) declining by around 1.2 percent year-on-year (YOY) in the first half of 2013.
The above reflects weak demand in key export markets (particularly metals) and
partially also the impact of the tight monetary policies run in late-2011/2012
to maintain the hard/fixed hryvnia policy. Since then Ukraine has been
embroiled in a mini trade war with Russia which is likely to have disrupted
trade flows, and also likely served to further depress sentiment and economic
activity. Government officials have suggested that real GDP growth will return
in 2013, and rise to 3 percent YOY in 2014, just ahead of presidential
elections due in March 2015. These forecasts appear highly optimistic.

*    Weak state of public finances – recession
and deflation has taken its toll on budget revenues, while spending has been
elevated by an administration eager to shore up its weak poll ratings. The
budget deficit thus rose to reach Hr 30.3 billion as of July, the widest
deficit for the first seven months of the year on record, with revenues up by
1.8 percent YOY, and spending higher by 9.6 percent YOY. The budget deficit
hence looks on track to exceed the Hr 50 billion full year target, and is
likely to take the consolidated/quasi fiscal deficit up to 5.5-6 percent of
GDP. Note that the Treasury runs an extremely tight cash management regime,
with the single Treasury account having just Hr 2.3bn (less than $300 million)
in funds as of September 1, i.e. only a few weeks of expenditure coverage. The
administration has more recently met ends meet by building arrears, and the
introduction of a new promissory note program. This “hand to mouth” budget
regime is highly disruptive to economic activity, and accentuates the cycle of
decline.

*    The current account is running a
significant deficit – estimated at around 7-8 percent of GDP this year. Earlier
this year the government managed to reduce demand for foreign exchange by
stalling purchases of key energy imports. However, as winter is approaching the
administration now has little choice but to resume these purchases, which will
increase pressure on the hryvnia.

*    A weight of foreign exchange liabilities
falling due – $62.1 billion in short-term debt by remaining maturity as of
April 2013, according to central bank data. Taken together with a likely
current account deficit of $13-14 billion, this suggests a total external
financing requirement of $75-76billion, more than three times foreign exchange reserve
coverage, which leaves the hryvnia hugely vulnerable by any standards.

*    National Bank of Ukraine reserves have been
dwindling in recent months, falling from close to $37 billion in April 2011, to
around $21 billion at present – this provides only around 2.5 months of import
cover, i.e. critically low levels, and insufficient now to support a fixed
exchange rate, under some selling pressure. 

Analysts
have long called the hryvnia’s demise over the past 18 months, but to no avail,
with the currency held around the Hr 8.1:$1 level. The desire of the Ukrainian
authorities to hold the hryvnia seems to have been driven by the assumption
that, in a generally very weak policy/political setting, this is one of the few
anchors for the economy, and population, and that any foreign exchange weakness
would quickly become a rout, extending to the banking sector and creating
systemic problems throughout the economy (the external debt/GDP ratio is
relatively high at around 78 percent, given $136 billion in gross external
debts outstanding). The durability of the hryvnia has been helped by the
willingness of the central bank to expend foreign exchange reserves, their
initial willingness to deflate the economy, the liquid state of global markets,
which allowed the sovereign to tap the Eurobond market, and also foreign exchange
liquidity in the banks (around $9 billion).

Recent
press commentary in Ukraine, however, now leads me to believe that there may be
an imminent change underfoot, and the administration may now be coming to the
realization that the current hard hryvnia policy is no longer sustainable.
Perhaps this change of heart reflects a range of factors, including: 

*    The depletion of scarce foreign exchange reserves,
down to now critical levels;

*    The inability to further tighten monetary
policy given the depth/duration of recession and the close proximity of
elections now;

*    The more challenging global liquidity
conditions from May around market concerns over Federal Reserve tapering;

*    The depreciation of competing foreign
exchange currencies, which has undermined the competitive edge of key
industries in Ukraine, such as metals, which are already facing challenging
market conditions.

*    The worsening relationship with Russia, and
fears over the disruption to trade and the wider economy from a trade war with
Russia.

In
recent days the media in Ukraine have been full of stories, arguing that
Russian banks/analysts are trying to talk down the hryvnia, driven by the larger
political ambitions of Russia over Ukraine – particularly the desire to prevent
Ukraine’s plans to sign the Deep and Comprehensive Free Trade Agreement (DCFTA)
with the EU at the Vilnius summit meeting slated for the end of November. The
danger is that this media frenzy brings a marked change in perceptions towards
the hryvnia amongst ordinary Ukrainians. Clearly once this process starts it is
difficult to stop and the central bank has not enough foreign exchange reserves
to prevent likely extreme pressure on the hryvnia which would likely result.

The
hard hryvnia policy of the central bank had long appeared unsustainable, but I
had assumed the administration’s strategy was perhaps to hold the currency
until the EU summit in November, and then hope to secure an International
Monetary Fund program soon after. Somewhat secured by an IMF program the
administration would then introduce a more flexible foreign exchange regime,
but weakening the hryvnia somewhat, perhaps to Hr9:$1. This was perhaps a “best
case” scenario. However, events now appear to be moving fast in Ukraine, and it
is doubtful in my mind now whether the hryvnia can survive in tact until
November. The danger is that the hryvnia weakens significantly before that
point. Without the underpinning of an IMF program, the move could be extreme.
This might force the administration to go to the IMF much earlier – albeit the
IMF will still likely have stringent demands for such a program, including
retail gas price hikes, fiscal consolidation, further banking sector reform and
greater foreign exchange flexibility. Needs must, and unless the administration
favors a rapprochement with Russia (which I now strongly sense it does not),
and resort to cheap Russian loans/gas this now seems as the only viable option.

Note
that there have been media reports of a $700 million loan facility provided by
Russian banks, which might have bought the Ukrainian authorities some time.
However, negotiations over the latter facility appear to be dragging out, and
against a backdrop of fairly dire relations between Moscow and Kyiv I think
that it is unlikely that such a deal could be concluded. We also think now that
it would be extremely difficult for the Ukrainian authorities to tap the
Eurobond market, especially given concern over the durability of the UAH, and
the rising risk that Ukraine will need to resort to an emergency IMF bail-out.

Timothy Ash is head of emerging markets research at Standard
Bank in London, United Kingdom.