2019, marked by presidential and parliamentary elections

Five years after the Maidan revolution that led to the resignation of President Viktor Yanukovych and was followed by an outbreak of conflicts in the Donbass and the annexation of Crimea by Russia, a relative stability has returned even if no resolution of the conflicts is in the cards. However, the seizure of Ukrainian naval ships in the Kerch Strait on 25 November – a major escalation – highlights that tensions remain high and could rapidly escalate.

The government elected in 2016 has pledged an ambitious and wide-ranging reform agenda. Some important reforms were adopted such as establishing anti-corruption agencies but powerful vested interests continue to hinder the reforms process. As presidential and legislative elections are approaching, due in March and October 2019 respectively, the adoption of reforms is becoming more difficult. Given the fragmentation of the political scene, it is very difficult to predict the outcome of the elections. On the positive side, an IMF agreement will help maintain macroeconomic stability during the election year.

Rising hope for an IMF programme

In October this year, the IMF Staff and the Ukrainian authorities reached an agreement on economic policies for a new programme. This programme would replace the existing one that went off track, as did the 2008-10 and 2010-12 IMF programmes. Before getting the IMF Executive Board’s approval, Ukrainian authorities must approve a 2019 budget in line with the IMF recommendations and increase household gas and heating tariffs to reflect market developments, an unpopular measure ahead of the elections. The parliament approved the 2019 budget on 23 November but details are not yet public.

Implementation of an IMF programme would help Ukraine maintain macroeconomic stability and avoid fiscal slippages during the election year. Indeed, even if the overall government deficit remains limited (lower than 3% of GDP) and the public debt-to-GDP ratio is expected to decrease to around 70% of GDP in 2018, from its peak of more than 80% of GDP in 2016, public finances remain Ukraine’s weakness, with a large repayment due and a large share of its public debt denominated in foreign currency (and thus vulnerable to currency fluctuation). What is more, state-owned enterprises (SOE) historically weight on public finances given governance issues and the fact that some are not viable. Progress to address SOE issues is slowly moving forward. A revised version of the law on privatisation was adopted in January, but so far no major privatisation has taken place.

Securing IMF assistance would help Ukraine to unlock loans from the World Bank and the EU and improve investors’ perceptions. This would be a welcome step as the authorities – which have very limited access to the financial markets (they were able to raise USD 3 bn in November 2017) – have large external financial needs as highlighted by the short-term funding at very high rate raised by the government in September. Since then, Ukraine returned to the markets with the issuance of bonds for USD 2 bn. This along with IMF disbursements would help the government to reverse the downward trend of foreign exchange reserves (cf. graph 1).

Economy in better shape than in 2014

That said, even if gross foreign exchange reserves are slightly under pressure, the liquidity situation is not comparable with the early 2014 situation. At that time, the foreign exchange reserves plunged as the authorities were maintaining a fixed exchange rate vàv the USD. Now, the exchange rate is more flexible and remains under pressure (cf. graph 2). In 2014, the authorities adopted capital controls and foreign exchange restrictions. Since then, restrictions have been gradually lifted, a move which is likely to continue. Indeed, the authorities adopted in July 2018 a new law “on currency and currency operations” which replaced the obsolete regulations and paves the way for a gradual phase out of currency restrictions while maintaining financial stability. Last but not least, the liquidity situation – reflected by Credendo’s short-term political risk category 5 – is also much more favourable, partly as the short-term external debt and the current account deficit are lower than in the end of 2013.

Looking ahead, the dynamic of the current account balance depends on various factors stemming of course from domestic demand and external conditions. Apart from the rising importance of food exports (partly cereals given Ukraine’s large endowment in arable land) as source of current account receipts and the decreasing importance of manufactured exports (since important industries are located in eastern Ukraine), two other drivers of the current account balance are worth being highlighted. The first is the importance of gas for Ukraine as the country remains an important importer of fuels on the one side, and on the other side gas transit is also a source of hard currencies (and geopolitical tension). The second driver is the rising importance of labour income that now accounts for around 14% of current account receipts up from around 7% in 2014. This reflects the intensification of migration which, on the negative side, led to labour market pressures in Ukraine.

The economy continues to recover following the 2014-15 sharp recession. According to the IMF, real GDP growth has further accelerated this year to 3.5% (from 2.5% last year) before slowing to 2.7% in 2019. That said, the nominal GDP in M USD remains below its 2013 level.

Following a surge in 2014-15, inflation has declined but remains close to 10% (9.5% yoy in October 2018).  In order to stem inflation pressures, the central bank hiked its benchmark interest rate to 18% in last September. The high policy rate weighs on corporate lending costs in domestic currency that are close to 20%, a high level in nominal terms but a somehow more moderate level in real terms.  Thanks to the authorities’ consolidation efforts (closure of the weakest banks, recapitalisation and strengthening of the legal framework), the banking sector has stabilised. Credit to the private sector returned to positive territory in nominal and real terms, indicating that private sector access to credit has improved.

Last but not least, on the back of a sharp drop in nominal GDP and current account receipts in USD, the debt stock and services ratios surged in 2015. As the economic recovery is gaining pace, those ratios decrease and are expected to further improve in the coming years. If this trend continues, Credendo might upgrade its MLT political risk rating to category 6 from currently category 7.

Analyst: Pascaline della Faille - P.dellaFaille@credendo.com