It’s been a long time now since economist Paul Krugman spoke of the Ukrainian economy epitomizing the arrival of what he then termed the “second great depression” when industrial output collapsed at the end of 2008.

But the country’s economy is again reaching the edge of a cliff.

Bloomberg reported earlier this month that Ukraine’s default risk had risen more than any other country in the last six months than Greece.
Part of the problem is political, part of it is economic, and part is a combination of the two.

Ukraine was one of the worst affected countries following the onset of the global financial crisis. Industrial output slid – great depression style – by more than 30 percent in a matter of months.

As the fund flows that had been financing a credit boom rapidly reversed, Ukraine was sent running into the arms of the International Monetary Fund and rapidly accepted a$16.5 billion standby loan in November 2008.

That program went off track amid political infighting, but the new government under President Viktor Yanukovych agreed a new program in 2010.

This program ground to a halt last year when Ukraine refused to raise household gas prices. Ukraine has tried to negotiate cheaper gas supplies from Russia in order to put off a price hike, but to no avail as of yet.

Gas is a core issue for both Ukraine and the IMFdue to its impact on both the current account deficit and on the level of domestic consumption. It is evident thatUkrainian growth is now slowing and coming under threat from rising energy prices.

In addition to the energy price constraint, domestic consumption inUkraine is still weighed down by the indebtedness problems created by the earlier boom.

Non-performing loans are still running at a very high level, although no one really seems to know quite how high, since there are major question marks hovering over the official figures.


Ukraine was one of the worst affected countries following the onset of the global financial crisis.

The IMF’s permanent representative in UkraineMax Alier estimated in the spring of 2011 the figure might be as high as 30 percent of total loans.

In addition, with many Ukraine banks being owned by parents in other EU countries, the credit crunch in the West is rapidly transmitted to the east.

Corporate lending growth is slow, and the steady contraction of household borrowing is following a path which looks very similar to that seen in Southern Europe or the Baltics.

Ukraine badly needs an agreement with the IMF to facilitate the financing of debt which needs to be rolled-over this year. These rolloverswill put significant strain on the system, estimated by economists at around 34 percent of gross domestic product.

With so much debt needing to be rolled over, the country is very exposed to any sudden reversal in risk sentiment, just as it was in 2008. It needs to be under the sheltering wing of the IMF.

So where do we go from here? The IMF has dug its heels in about gas, but this is only a symptom of a much deeper sense of frustration. The fund has been financing the Ukrainian deficit and cheap gas, but will the money disbursed ever get returned, or will the can be continually kicked down the road?

The fund has been used to finance cheap energy to win votes for populist governments. The frustration evident from IMF statements suggests to me at least that coming to a new agreement won’t be as easy as many think, especially with a number of other countries looking on.

Only industrial users in Ukrainecurrently pay the full cost of gas. Residential users pay something like 30 percent of the cost of the gas they consume. This subsidy is a key cause of the loss suffered by the state-owned oil and gas company, Naftogaz, which was Hr 21 billion or $2.6 billion, equivalent to 1.6 percent of GDP in 2011.

A planned 50 percent hike in gas tariffs in April 2011 was negotiated down to 30 percent in two tranches in return for unspecific “offsetting measures” to keep the wider fiscal deficit at 3.5 percent of GDP.

However, eventually, the tariffs were not hiked at all in 2011, widening the actual deficit to 4.3 percent of GDP. The result of all this is that the IMF has put its foot firmly down, and it will be hard to get it lifted again.

One possibility isthat the Ukraine government,seeing their approval ratings dropping, will consider the political costs of household gas tariff hikes to be too high.

It would then not seriously pursue a renewed IMF deal, hoping that the cut in the current account deficit due to the lower gas import price plus any other investment commitments or payments which would arisefrom of a Russian gas deal will be enough to reduce pressure on reserves to a sustainable level.

The National Bank has spent nearly $7 billion – or 20 percent – of its reserves since last August,and with reserves now approaching $30 billion this strategy is clearly becoming unsustainable.

There is, of course, another possibility – that there is no Russia deal and no IMF deal. This could occur if the government balks at both of the possibilities on the table: either selling a stake in the gas pipeline to the Russians or raising household gas tariffs.

Under this scenario the Ukraine government could follow the path of seeming to cooperate with both parties but doing nothing, and in the meantime hope to muddle through – at least until elections in October.

However, against the backdrop of falling reserves, a rising current account deficit and external funding markets that are closed to Ukraine, a sharp devaluation could becomevirtually unavoidable if there is neither agas deal nor aresumption of the IMF program.

In other words, Ukraine is on the edge of a cliff, even if the policymakers don’t seem to realize it.

Edward Hugh is an economist based in Barcelona, Spain.