Risk drivers and outlook

In 2014-15, Ukraine was hit hard by the conflict in its eastern region and the weak external environment. As a result and due to existing structural weaknesses, the GDP contracted sharply, the hryvnia depreciated substantially, foreign exchange reserves were under pressure and the central bank put exchange restrictions in place. Since then, the situation has improved somewhat. Indeed, foreign exchange reserves and the exchange rate have stabilised. GDP growth is expected to be positive this year. Moreover, since 2016, the central bank has gradually eased its exchange restrictions. Taking the improved liquidity situation into account, Credendo Group has decided to upgrade its short-term political risk to category 6 and to resume cover for short-term transactions (outside Crimea and the Donbass). The systemic commercial risk remains in the highest category as access to credit is limited, the lending rate is elevated, the hryvnia is weak and the business environment is difficult.

The medium-/long-term political risk remains in category 7 as external debt and debt service are at an alarming level, public finances are in a dire situation and the banking sector is weak. The domestic political situation remains characterised by a lack of trust between the heads of the ruling parties, which hold only a slim majority in parliament. Hence, the adoption and implementation of critical institutional reforms – requested by the IMF and expected by the population following the Maidan revolution – is likely to continue to be slow. In the eastern region, even though heavy fighting in the Donbass has ceased following the Minsk II agreement concluded in February 2015, the conflict remains unresolved and sporadic surges in violence occur.

Facts & figures

Pros

  • Gradual removal of exchange restrictions
  • Improved liquidity and moderate current account deficit
  • Flexible exchange rate
  • GDP growth likely to be positive in 2016

Cons

  • Very high short-term debt
  • Difficult business environment and weak governance
  • High external and public debt and weak banking sector
  • Unresolved conflict in the Donbass, no administrative control in the Donbass and Crimea

Main export products (in 2014)

  • Manufactured exports (41.4% of current account receipts), food (23.2%), transport services (8.7%), ores and metals (6.8%), tourism (2.2%) and private transfers (1.3%)

Income group

  • Lower-middle

Income per capita

  • USD 3,560

Population

  • 45.4 m

Head of State

  • President Petro Poroshenko

Description of electoral system

  • Presidential: 5-year term, last election: May 2014
  • Legislative: 5-year term, last election: October 2014

Head of government

  • Prime Minister Volodymyr Groysman

Country risk assessment

Ukraine lost administrative control of part of its territory

Since the removal of President Yanukovych in February 2014, Ukraine has changed dramatically. Indeed, Russia annexed Crimea in March 2014 and the separatist rebels, allegedly supported by Russia, took control of the Donbass (Donetsk and Luhansk regions). Heavy fighting in the Donbass has ceased following the Minsk II agreement concluded in February 2015. However, the ceasefire is frequently violated and there are sporadic eruptions of violence. Other measures agreed in Minsk have not been implemented yet. Indeed, Kiev has not yet granted the special status requested by the Donetsk and Luhansk regions – a move unpopular in the rest of the country – while the transfer of border control between Ukrainian rebels backed by Russia and Kiev has not yet taken place. Hence, the situation in eastern Ukraine is likely to remain tense in the coming months. In this context, relations with Russia are likely to remain strained.

Critical institutional reforms requested by the IMF and expected by the population

After having survived a vote of no confidence in February 2016, Prime Minister Yatsenyuk resigned in April. A new government was formed, led by Volodymyr Groysman, former speaker of parliament and member of the party Petro Poroshenko Bloc. The key task of the new government – formed by Petro Poroshenko Bloc and ex-Prime Minister Yatsenyuk’s People’s Front – is to push forward the critical reforms required by the IMF. The adoption of legislation aimed at tackling corruption in the judicial system in June 2016 led to the signature of a USD 1 bn loan guarantee by the United States. It is also a good signal to the IMF, which delayed the second review of its Extended Fund Facility programme, due in September 2015. Indeed, the IMF stressed in May 2016 that “steadfast implementation of structural and institutional reforms is now critical to turn the recent recovery into strong and sustainable growth, with unwavering determination in the fight against corruption emerging as a litmus test for the government’s ability to retain broad domestic and international support for its policies.” Despite this recent positive development, the challenges ahead – e.g. privatisation of public enterprises, adoption of unpopular legislation to give the Donbass more autonomy, improved governance, fighting of corruption and vested interests – are huge for a government that holds only a slim majority in parliament. Moreover, relations between the heads of the two ruling parties are strained (cf. resignation of ex-PM Yatsenyuk, who continues to support the ruling coalition). In this context, early elections cannot be ruled out. Given the very high expectations after the Maidan revolution, there is a risk that the electorate will again be disillusioned with the lack of reforms as was the case in 2010. Indeed, at that time Viktor Yanukovych defeated Yulia Tymoshenko partly because the electorate was disillusioned with the constant conflicts between former Prime Minister Tymoshenko and President Viktor Yushchenko (2005-10), the two leaders of the 2004 Orange Revolution. Neither leader ever agreed to push forward their pledges of reducing corruption, closer integration with the European Union and reform of the business environment. On the contrary, the post-Orange-Revolution government was marked by political instability.

Positive GDP growth expected this year following a sharp contraction

Ukraine_Graphe1EN

Ukraine’s economy was hard hit by conflict in the east – the industrial stronghold – and the weak external environment. As a consequence, GDP contracted by 6.5% in 2014 and 9.9% in 2015. The GDP growth projection is more positive for this year as the IMF (WEO April 2016) is expecting growth of 1.5%.

The eastern provinces were an economic powerhouse alongside the capital, Kiev. In 2012, the regions of Donetsk and Luhansk accounted for around 15% of GDP. A large part of the industrial production (heavy industry, including coal mining, ferrous metallurgy, engineering and machine-building) is located in these regions. In the first quarter of 2014, both regions accounted for more than 20% of goods exports and were net contributors to the central budget. Crimea accounted for only a small share of Ukraine’s GDP and was a net recipient of fiscal transfers from the central government. Hence, its annexation by Russia is unlikely to have had a major impact on Ukraine’s economy.

The sharp deterioration of relations with Russia – along with Russia’s economic woes – has also dampened economic conditions. Indeed, in 2013, Russia accounted for around a quarter of Ukraine’s goods exports and was a key supplier of gas. Hence, trade disruption (e.g. the road cargo disruption in February 2016) and Russia’s economic woes have hit Ukraine hard as the share of goods exports to Russia dropped to less than 15% in the third quarter of 2015. The EU is unlikely to be a substitute for Russia in the short term, despite the Association Agreement signed in 2014. Indeed, its entry into force has been delayed first by Russia and now by the Dutch referendum rejecting the Netherlands’ ratification of the EU Association Agreement. The Dutch government is expected to make a final decision on this issue by September.

Moderate current account deficit and exchange rate stabilisation

Ukraine_Graphe2EN

Before 2014, Ukraine’s current account balance was characterised by a high deficit, partly due to the fixed exchange rate and loosing fiscal policy. Since then, the current account balance has reduced substantially (see graph) as energy prices and domestic demand drop sharply. As a result, imports have dropped more rapidly than exports. This year, with an expected rebound in domestic demand and the gradual ease of foreign exchange restrictions, the current account deficit is expected to widen again compared to last year. Despite some improvement, the current account balance remains a source of concern. Indeed, current account receipts have dropped dramatically (by nearly 40% between 2013 and 2015). Moreover, Ukraine needs to attract enough capital flows (such as FDI, portfolio inflows and loans) to finance its current account deficit, which is not an easy task given the poor perception of Ukraine among foreign investors. In this context, an approval by the IMF of the second tranche of its EFF programme would be very positive news, not only as it would lead to new IMF funding but also as it would unlock additional official support and could improve foreign investors’ confidence somewhat.

Ukraine_Graphe3EN

In early 2014, the central bank abandoned its fixed exchange rate with the USD. As a result and due to severe shocks – conflict in the east and a weak external environment – the Hryvnia depreciated sharply in 2014 and in 2015. Since then it has stabilised somewhat (see graph). In this context, and given the higher level of foreign exchange reserves (see graph), the National Bank of Ukraine has begun to gradually ease the exchange restrictions that were put in place in 2014-15.

Ukraine_Graphe4EN

Elevated external and public debt and weak banking sector a source of concern

The level of external debt (short-term and total debt) remains a source of concern. Indeed, though short-term debt has decreased markedly in absolute terms, it has increased in relative terms and accounts for more than 50% of current account receipts, which is very high, especially for a country like Ukraine which has very limited access to capital markets and where refinancing capacity is very limited. Total external debt is also very elevated – more than 100% of GDP – as is debt service.

Public finances were also hit hard by the severe economic crisis. The overall public deficit, including Naftogaz, reached 10.1% of GDP in 2014 and public debt increased substantially. However, thanks to the fiscal consolidation undertaken under the auspices of the IMF programme, the budget deficit has decreased somewhat. Indeed, energy subsidies, which amounted to 7.5% of GDP in 2012, have been reduced and gas prices have been freed up. A large privatisation plan has been announced, including the sale of Odessa Portside Plant – the first privatisation of a state-owned enterprise – but the latter has been criticised by the IMF and EBRD for falling short of international standards. The fiscal outlook remains challenging as public debt is expected to reach more than 90% of GDP this year – a very high level.

The banking sector – which has a negative foreign asset position and was hit hard by the 2008 global financial and economic crisis – has not been immune to the impact of economic woes. As a result of a sharp rise in non-performing loans, a large number of banks have gone bankrupt. Hence, as the banking sector is slowly stabilising, companies still have limited access to credit. Moreover, lending rates are very high. This, along with the weak growth, weak currency and difficult business environment, is keeping commercial risk in the highest category.