Ukraine faces an acutely challenging balance of payments position. This is among the most important of findings after visiting Kyiv on Oct. 4-6, meeting with officials from the National Bank of Ukraine, the Ministry of Finance, the International Monetary Fund, the World Bank, European Union, alongside meeting local banks, private sector analysts and diplomats.

The current account deficit is running at around 3-4 percent of gross domestic product and widening, while over the next year external debt payments falling due amount to in excess of $50 billion, suggesting an external financing requirement of $55-60 billion. Foreign currency reserves at the central bank stand at around $35 billion, but declined by around $3 billion in September and individuals are reported to have converted around $6 billion into foreign currency in the year to date.

With the global economy slowing the danger is that metals (40 percent of exports) prices dip which when combined with structural rigidities in energy import prices suggests a significant terms of trade shock to the economy which could worsen the current account position still further. The question is 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 might even push back into recession. “

Our sense is that the authorities are increasingly aware of the threats, but recent changes in the state administration suggest some institutional weakness. Ukraine is currently working under an International Monetary Fund loan program, albeit at present this remains off track. However, the IMF have made clear the prior actions which would be required 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. The electoral cycle is though 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 – e.g. the risk of a return of value added tax arrears.

We assume the pressure point will be the domestic currency, with the central bank likely to be forced to allow the hryvnia to weaken, balancing this 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.

In summary, policy makers need to move very fast to shore up their defenses. Indeed, it is sad that we see little fundamental improvement in Ukraine’s position over the period since 2008-2009 – indeed, arguably in terms of democratic development progress/development there has been a significant deterioration as reflected in the trial of the main opposition leader, Yulia Tymoshenko.

Political risk outlook

President Viktor Yanukovych and his Party of Regions dominate the main levers of power now in Ukraine, controlling the presidency, parliament, and the state administration. The positive from this situation is that decision and law making can be effective – i.e. once the administration makes decisions, legislation can ensue quickly (most recently over pension reform). This contrasts with previous president’s tenures in office, e.g. the War of Laws under former President Kuchma, and the paralysis between the Tymoshenko government and Viktor Yushchenko presidency. This does though assume that policy making is market and business friendly – which is not necessarily a given.

Support for President Yanukovych and the Party of Regions is declining. Opinion polls show support for the president having collapsed over the past year from over 50 percent, to around 20 percent, with Regions polling around similar levels. Given that parliamentary elections are due to be held in October 2012 this has meant that the administration is increasingly focused on the impact of policy choices on its poll ratings. The tendency is thus towards populism, as evidenced by the government’s unwillingness to push through gas price hikes as demanded by the IMF as a condition for the resumption of lending under the current Stand-by arrangement.

While support for the president’s camp is waning opposition parties are struggling to take advantage of this, with general apathy on the part of the population on the increase. Opinion polls suggest that more than 50 percent of people express no particular party allegiance. The main opposition party, Block Yulia Tymoshenko (BYuT) is polling around 13 percent, with Arseny Yatseniuk’s Front for Change on around 10 percent, then a number of other parties polling in the 3-10 percent range; currently there is a 3 percent hurdle to secure parliamentary representation.

Diplomats expressed some concern at two developments:

First, the arrest and trial of Yulia Tymoshenko under article 365 of the criminal code, on charges that during her time as prime minister in 2009 she took decisions which exceeded her authority and which resulted in losses to the Ukrainian state; albeit no personal benefits are being claimed and it is accepted that this was unintentional. If convicted this could bar Tymoshenko from running in the 2012 parliamentary elections. A court ruling on the Tymoshenko case is expected on Oct. 11, 2011, with a widely held assumption from those we met being that the court would rule against her.

The case against Tymoshenko has been criticized as political, and something of a political miscalculation on the part of the administration as it risks resurrecting her political career, after her loss in last year’s presidential election.

Second, a new electoral law is being devised which would move the system towards a dual proportional/constituency based system, from the current fully proportional system. The head of the electoral commission has warned that the proposed new system could end up with a party securing just 20 percent of votes in the election (Regions, presumably) securing 60 percent of seats in parliament.

International relations

The European Union has signaled that Tymoshenko’s prosecution and bar from running in elections could derail work on agreeing a Free Trade Agreement with the EU, as it raises serious questions over the rule of law, and the fairness of elections. Concern is also now being expressed over the freedom of the media, given Regions’ increasing domination over state-run media channels.

On the issue of the FTA, good progress seems to be being made on technical preparations on what would be the deepest, most far reaching FTA offered by the EU to any potential accession member state. Both sides appear committed to signing the deal, albeit the Tymoshenko case could well stall progress. In the case of Ukraine, the government seems eager to further Ukraine’s integration into the European economy (the FTA is central to this), furthering its EU accession bid, while Ukrainian business appears eager to gain from market access, plus the considerable benefits from the FTA being agreed in terms of market standardization measures.

Assuming the Tymoshenko case is resolved negotiations on the FTA could be concluded by year end, with the signing of the agreement likely by the middle of 2012, just prior to the parliamentary elections in Ukraine. This would then take 18-24 months for ratification in EU member states. Note that if the Tymoshenko case is not resolved this could delay both the signing and ratification of the FTA.

One possible solution to the problem over the Tymoshenko case, in the event of her being found guilty on Oct. 11, would be for a change of the law to decriminalize the offense for which she currently faces charges. This would then allow her to run in the parliamentary elections. This might then be sufficient to allow continued progress on the FTA front albeit some EU member states might still opt to stall ratification if they felt parliamentary elections were still not conducted in a fair manner (issues over the new electoral rules and media freedoms).

Relations with Russia

Relations with Russia remain mixed but continue to be dominated by the energy issue. The Yanukovych administration has asked for Russia to offer discounts on energy supply contracts – which would enable it to stall with domestic gas price hikes. Moscow at present seems content with the gas price agreement signed by former Prime Minister Tymoshenko in January 2009; and which are the basis for the criminal case she currently faces. Kyiv has threatened to refer the latter agreement to the international courts. Moscow in turn argues that the agreement is legal and appears happy with the current agreement which has worked well in terms of ensuring the uninterrupted supply of energy to Europe, and the regular payment for gas supplied to Ukraine; Ukraine pays on the 7th of each month following the supply of gas.

Russian leaders are expected to visit Ukraine on Oct. 18, and the hope is then that some broader renegotiation of gas supply contracts can be agreed. The assumption is that without a gas price agreement the Yanukovych administration would need to hike domestic gas prices to ensure compliance with the existing IMF program, to ensure much needed IMF disbursement to cover holes appearing in the balance of payments and now even on the budget front.

Note that cynics argued that the case against Tymoshenko is being driven by a broader desire to undermine the legal basis for the 2009 gas price agreement.An added complication to the on-going dispute between Russia and Ukraine over energy pricing is that a $2 billion loan facility from a Russian state owned bank to the government of Ukraine falls due in December.

As ever in Russo-Ukrainian relations broader business/strategic interests come into play. Russia’s interest is in ensuring regular energy supplies to Europe – perhaps more important given the uncertain outlook for the global economy and energy/commodity prices – securing payment for energy supplied, but also control of assets in Ukraine. There have been suggestions that the Yanukovych administration might be able to offer Russia greater controlling interest in energy assets in Ukraine, e.g. in the much talked over energy/gas consortium.

Past experience though would suggest that for Moscow to offer Ukraine concessions on gas pricing this time around, it would need hard assurances in terms of the benefits it will realize in terms of control of energy/strategic assets in Ukraine. From a Russian perspective at least, previous promises herein have rarely fulfilled expectations suggesting that Moscow will continue to play hard ball with Ukraine this time around.

It will be interesting to see how Russia’s own electoral cycle plays into the challenges facing Ukraine. Will Putin’s drive to retake the presidency in Russia in the election in March 2012 encourage a more adversarial or conciliatory approach from Moscow. Moscow does seem eager to build on the Customs Union between Belarus, Russia and Kazakhstan, extending this to Ukraine, but membership of the latter entity appears to preclude a FTA with the EU.

This suggests that the price of receiving any gas price discount from Moscow might be a movement away from the West, which itself might have significant domestic political consequences for the Yanukovych administration – while mass protests in opposition to the arrest/trial of Tymoshenko do not appear likely, a common groundswell could build if the government threatened Ukraine’s drive for greater integration with the EU which seems genuinely popular.

Energy gas balance

Ukraine is contracted to import a minimum of 33 billion cubic meters of gas from Russia, but hopes to cut this to 29 bcm given declining demand domestically. Current import prices stand at around $350 per 1,000 cu meters, and are expected to rise to around $400 per 1,000 cu meters in Q4 2011, based on existing agreements which link the gas price to lagged oil prices. Ukraine argues that the current pricing deal unfairly penalizes Ukraine, relative to prices being paid by West European economies, and is looking to renegotiate the deal.

Ukraine argues that it should pay at least $80 per 1,000 cu meters less than Germany, for example, given closer proximity, hence lower transport costs. Transit fees paid by Russia amount to around $2.7 per 1,000 cu meters, transported over 100 kilometers, and again Ukraine argues that these are low by regional standards – Ukraine is expected to transport around 100 bcm of gas from Russia to Ukraine, but capacity could double with modest investment thereby alleviating the need for alternative transit projects, e.g. North and South Stream and the Southern (Nabucco) pipeline project.

Ukraine currently consumes around 54 bcm domestically, down from over 70 bcm 4-5 years ago and the assumption is that with energy conservation efforts that this total could reduce significantly still further. Direct household consumers use around 8 bcm of gas, district heating companies 12 bcm, with "technical" gas likely consuming another 6 bcm leaving 28 bcm consumed by industry. Households current pay Hr 850 ($106.5 per 1,000 cu meters), district heating companies Hr 1,250 ($156) and corporates pay market prices.

Household gas prices have only doubled over the past 3-4 years, but seem to be covered by the 20 bcm covered by domestic Ukrainian gas production. A key problem remains high non-repayment rates by district heating companies – around 65 percent, which produces a shortfall of around $600 million in gas payments half the overall level of subsidies paid to Ukraine’s gas transit company from the state budget (targeted at 0.9 percent of GDP this year). Plans are afoot to enable district heating companies which do not pay for gas supplied to be cut off, but the issue remains highly sensitive as these companies supply heating to communal users such as hospitals and schools – it hence seems doubtful that this problem will be addressed in a meaningful way this side of elections.

The combination of low household gas prices, large arrears from district heating companies and rising gas import prices suggests that the IMF imposed target of keeping the subsidy paid to the state gas transit company to 0.9 percent of GDP will be difficult to keep in practice – as will the plan to reduce the subsidy to zero in 2012.

Growth outlook

The economy grew at a brisk pace in 2010, and over the first 8 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. The economy does, however, appear vulnerable to a slowing in global growth, and particularly metals prices.

Official projections suggest 5 percent real GDP 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 zero to 2 percent range. 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 (expect some fiscal pump priming ahead of the elections there) plus also the outlook for the harvest. On this latter score, the near record harvest in 2011 suggests a higher base, albeit that said 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.

“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 seems to have been little, if not improvement across these fields in recent years – indeed, a common complaint we heard was of further deterioration.”

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 seems to have been little, if not improvement across these fields in recent years – indeed, a common complaint we heard was of further deterioration. These factors will continue to weigh on long run growth and Foreign Direct Investment.

Agriculture seems to be in a particular poor state of health at present – remarkable perhaps given the near record harvest this year. Complaints surround the grain/agricultural procurement process, and government measures introduced to manage exports, including the adoption of export tariffs. The reform appears to have depressed farm gate prices, subdued exports and risks leaving a lot of the harvest to either rot in the field or silos.

There is a general concern that farms remain short of working capital now to complete autumn sowing, and this suggests 2012 could be a much more difficult agricultural season with implications for growth. There is also much unease over plans to lift the moratorium on land sales – and while positive in terms of creating a market for land there are concerns as to whether farmers will be able to buy land they actually farm, or whether third parties will instead prosper from sales which would somewhat defeat the object of the reform.

Budget financing & debt management

The Treasury’s cash balance is reported to stand at around Hr 30 billion, made up of foreign currency reserves of Hr 23 billion ($2.875 billion) and local currency reserves of Hr 6.8 billion.

Ukraine needs to raise around Hr 42 billion by the end of the year to meet its financing needs. Even assuming that it draws down its fiscal reserve this still suggests (all other things equal) that it must raise an additional Hr 12 billion. Clearly the financing position would be alleviated should the government opt to roll-over the Russian bank loan of Hr 2 billion (Hr 16 billion) albeit there is some concern as to the likely cost, and that a further and final 6 month roll-over would then see a major "lump" in external financing in the middle of 2012 given a Eurobond also falls due in the middle of next year.

Encouragingly, this week Ukraine borrowed Hr 860 million from local banks (mostly foreign owned) through a U.S. dollar indexed bond (indexed principal only), which offers investors gains in the event that hryvnia depreciates against the US dollar but no losses if it appreciates.

For 2012, the budget deficit is targeted at 2.5 percent, according to IMF methodology. Therein there is an expectation of privatization receipts of Hr 10 billion, coming mostly through sale of energy sector assets. Given the challenges on the budget financing front key privatization might be fast-tracked, albeit at the price of likely much lower investor interest/bid prices. As in the past this could leave the government exposed to accusations that it sold the family silver too cheaply; memories herein of the last Yanukovych administration dating back to 2003/04.

In 2012, in addition to funding the budget deficit, Ukraine will have to refinance domestic debt redemptions of Hr 44.2 billion and external debt redemptions of Hr 14.2 billion, for a total of Hr 58.4billion.

On the positive side, Ukraine’s small reliance on non-residents to buy its hryvnia denominated bonds means that any outflows from emerging market funds will barely have an effect on Ukraine’s foreign currency reserves ($38 billion). Non-residents own only Hr 5 billion ($625 million) of hryvnia bonds out of a total Hr 146 billion, with 80-90 percent of those holdings in VAT bonds.

For 2012 and through the end of 2011 a question mark remains over budget trends against a backdrop of a weakening growth outlook, which could suggest pressure on the revenue side of the budget and an enlarged deficit which would then require additional financing.

“Government and central bank officials seemed to understand the threats currently facing the economy and the importance of securing the resumption of IMF financing. There is though still no firm commitment to hike domestic gas prices, and without this fiscal targets for 2011 and 2012 appear challenging.”

The Finance Ministry indicated an unwillingness to tap international capital markets at any price, and thought that current implied interest rates were unappealing – borrowing at more than 8 percent going into an election year was perceived to be politically unpalatable. Arguably though international capital markets are already closed for Ukraine – with 5-year Ukraine credit default swaps trading at over 900 basis points, and it is debatable how quickly they would re-open even with provision of IMF financing.

Overall this still suggests a challenging budget financing environment for the Finance Ministry, which is likely to have to make very difficult choices in terms of prioritizing spending, and perhaps raising taxes which will be difficult in an election year.

Balance of payments

The current account deficit is expected to widen to 3.5-4 percent of GDP in 2011 and perhaps 5 percent of GDP in 2012. Short term debt and medium and long term debt liabilities falling due over the next year amount to around $53 billion, suggesting an external financing requirement for the year ahead of as much as $60 billion.

The NBU estimates that net FDI could total $5-6 billion in 2011, and as much as $7.5 billion in 2012. This seems unrealistically high for 2012, albeit $4.5 billion had been received in the year to date as of August. Most foreign portfolio funds are thought to have exited Ukraine in recent months, and the existing stock is hence modest.

There had been a reported $6 billion in retail foreign exchange purchases over the first 8 months of the year, while September is reported to have seen a $3 billion drawdown in foreign currency reserves, taking the stock of reserves down 8.3 percent in one month to $35 billion. Further downward pressure on reserves is expected. Note that in 2012 the NBU has to repay $3.2 billion in funds provided by the IMF. Foreign currency purchases earlier in the year are thought to have been driven by concern over currency weakness in neighboring Belarus.

A large part of the debt liabilities falling due over the year ahead consists of private sector liabilities, and a question remains as to what share of these will be rolled. Foreign banks are likely to look to reduce the roll-over ratio to less than 100 percent, as they continue to reduce risk exposure in the region – and Ukraine is considered amongst the higher risk locations still. In a difficult risk environment domestic banks/corporates might struggle to refinance loans and this might see a repeat of the restructurings which followed the 2008 crisis.

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. While the weight of energy imports should provide something of a hedge over the longer term, in the short term this will be limited due to rigidities in energy import contracts.

Given difficult global market conditions, and concern over Ukraine’s own credit story, we assume that international capital markets will remain all but closed to sovereign and corporate borrowers this year, leaving options for the 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.

The NBU has appeared sufficiently concerned by the pressure on the hryvnia and reserves as to introduce new regulations requiring increased documentation for foreign currency transactions.

Given the large external financing needs for the year ahead, risks of a marked downward correction in the economy, limited foreign currency reserves, and the weakening foreign currency bias across the region, we assume that the NBU will look to allow more (downside) foreign currency flexibility. It will though look to manage reserve loss against the scale/pace of the foreign currency depreciation and potential risks to the banking sector via deposit flight.

Our expectation is that the hryvnia ends the year in the range of Hr 9-10 relative to the U.S. dollar.

Relations with the IMF

Ukraine retains access to IMF funds via the existing facility, albeit the program has been stalled for some months now due to Ukraine’s failure to complete recent reviews. Of the 4 prior-conditions detailed for the IMF to resume lending, two remain outstanding: a requirement to hike domestic gas prices by 30 percent (revised down from a previous requirement to hike by 50 percent) and agreement over steps for the budget to meet the 2011 budget target of 3.5 percent of GDP and the 2012 target of 2.5 percent of GDP.

An IMF mission had been slated to visit Ukraine in August, but was surprisingly delayed at the behest of the government. A new mission is being scheduled for later in October. The assumption is that even if prior-conditions for the resumption of lending are met, that Fund flows could not be disbursed until December at the earliest.

Government and central bank officials seemed to understand the threats currently facing the economy and the importance of securing the resumption of IMF financing. There is though still no firm commitment to hike domestic gas prices, and without this fiscal targets for 2011 and 2012 appear challenging. Indeed, given our expectation of the need to significantly revise macro targets (e.g. 5 percent target growth for 2012 down) existing budget plans may need significant revision which could take considerable time.

The danger, meanwhile, is that the government looks to delay agreeing to meet IMF prior actions until resolution is reached with Russia over energy pricing. There may also be expectations within the administration that given difficult global conditions the IMF might soft peddle with respect to the demand to hike energy prices. We would argue that any delay herein risks leaving the Ukrainian economy exposed, given significant challenges on the budget/external financing fronts. Indeed, experience from 2008 suggests that confidence can soon evaporate, leading to extreme pressure on the hryvnia and reserves.

A further question in terms of relations with the IMF, is would the government be willing to agree to an austere new fiscal plan from the IMF in an election year. This could end up making negotiations on the resumption of lending difficult in practice.

Banking sector

There has been some evidence of a pickup in loan demand/credit in recent months. This might reflect the upturn in growth/recovery, but also perhaps pre-financing by corporates mindful of difficult global market conditions.

The banking sector can generally be split into 3 sectors: foreign (Western), foreign (Russian) and domestic banks.

Foreign (Western) banks still appear to be managing down their exposure in Ukraine with a number of higher profile departures recently – ability to exit is constrained though by the lack of buyers. Foreign banks thus continue to be in risk averse mode, looking to work on balance sheet cleansing.

Foreign (Russian) banks have been looking to expand aggressively in Ukraine, and had up unto recently been looking to expand their corporate and household client bases in Ukraine. The deterioration in the global environment has, however, seen this Russian bank expansion moderate in recent weeks.

A number of local domestic banks are aggressively expanding, paying high rates to attract deposits and also re-expanding balance sheet in areas such as consumer credit. This obviously raises concern over their risk management, and indeed the ability of the NBU to adequately regulate/supervise such aggressive expansion.

The concern remains as to whether the regulatory/supervisory capability of the NBU has improved that much since 2008. Non-performing loan levels remain high, at 30 percent through the sector, but up to 70 percent for some banks. A downturn in the Ukrainian economy would likely put upward pressure on NPLs and might require some banks to further recapitalize.

The deposit base has thus far proved resilient, albeit with some evidence of switching from hryvnia to U.S. dollar. It will be interesting to see how sticky deposits remain should the hryvnia come under more sustained selling pressure.

Timothy Ash is global head of emerging markets research at the Royal Bank of Scotland in London. The following is a note to investors that he circulated early on Oct. 7 after a visit to Ukraine.