As the global economy slows, Ukraine could face a tight economic squeeze.
There are two key questions: Will the crisis and its impact on Ukraine be as serious as 2008-2009, and are the authorities better prepared and more able to react this time around?
The economy grew at a brisk pace in 2010, and over the first eight months of 2011, driven by a combination of base-period effects, a recovery in metals exports, a better harvest and some recovery in credit growth.
Official projections suggest 5 percent real gross domestic product growth in 2011, and similar levels of growth in 2012. These projections look set to be revised down, and we would suggest that a more realistic growth assumption would be for growth in the range from 0 to 2 percent. The economy might even push back into recession.
Key determinants of the pace of any slowdown will be the pace of decline in metals export prices and volumes, the resilience of the key Russian market and the outlook for the grain harvest.
The near-record harvest in 2011 suggests a higher base, albeit problems in grain procurement, pricing and exports have suggested that the agricultural sector is in a poor shape as it goes into this year’s planting season.
More broadly, the impression remains that the business environment remains very difficult for both domestic and foreign investors, with high levels of red tape, bureaucracy and corruption.
There is some considerable concern as to how the large external financing requirement will be covered in 2012, while Ukraine could suffer a significant further terms of trade shock if the global slowdown brings a marked slowing in metals prices.
If the global economy takes a turn for the worse, the danger is that prices for metals, which make up 40 percent of exports, will dip. This could lead to a terms-of-trade shock as happened in 2008, meaning fewer dollars coming into the country, making imports more expensive and putting pressure on the hryvnia.
Given difficult global market conditions, international capital markets will remain all but closed to sovereign and corporate borrowers this year, leaving options for President Viktor Yanukovych’s administration as limited to domestic deflation, exchange rate correction, the depletion of foreign currency reserves, or resort to multilateral financing – likely a combination of all these. Our sense is that the authorities are increasingly aware of all of these threats.
Ukraine is currently working under a $15.6 billion International Monetary Fund bailout loan program, albeit at present this remains off track. However, the IMF have made clear what would be required in order for it to resume lending: hiking natural gas prices for households by 30 percent this year, and providing details to how budget targets will be met for 2011-2012.
On the plus side the ruling pro-presidential Party of Regions enjoys a large majority in parliament suggestive that it could react through legislative means much quicker than in 2008. Next year’s parliamentary elections are a complication, and the government seems reluctant to hike gas prices for fear of undermining its already lowly public standing.
Instead, the government is focused on trying to secure a gas price discount from Russia, which could delay the need for domestic gas price hikes, albeit also stalling an IMF agreement in the process.
The danger is that time (and markets) run out for the government. Budget financing also looks strained to year end, and it is difficult to see how the government will be able to cover budget financing needs, with likely limited market access and given the likely demands of pre-election spending.
Unless new IMF budget financing is secured, the danger is that some spending items are not met. The pressure point will be the domestic currency, with the central bank likely to be forced to allow the hryvnia to weaken to Hr 9-10 to the U.S. dollar by the end of the year.
This will be balanced against possible pressure on the domestic banking sector. Domestic banks, which have aggressively expanded their balance sheets again over the past year, could prove vulnerable and this might result in a repeat of the 2008-09 experience where banks needed recapitalization by the state.
Policymakers need to move very fast to shore up their defenses.
Timothy Ash is global head of emerging markets research at the Royal Bank of Scotland in London. This article is an abridged version of a note circulated to investors on Oct. 7 after a visit to Ukraine.
