Risk drivers and outlook

Poland and Ukraine are co-hosting the Euro 2012 football championship in the upcoming weeks. The organisation of this prestigious tournament should highlight both countries’ progress since they shook off socialism about two decades ago. However, a dissection of Poland and Ukraine reveals another picture: that of a stable country with a resilient economy, moving fast towards the European centre one the one hand and a wobbly country with a troubled economy, ailing at Europe’s fringes on the other.

Facts & figures


  • Balanced, resilient economy
  • Well-capitalised, liquid banking system
  • Stable, mature political framework
  • Important beneficiary of EU support


  • Excessive red tape hampers business environment
  • Exposed (through Germany) to potential eurocrisis escalation

Main export products

  • food products (7.3% of current account receipts), business services (4.1%), tourism (4.1%), transportation (4.0%)

Income group

  • high income

Per capita Income (USD)

  • 12,440


  • 38.2m

Country risk assessment

The path chosen since independence

When it gained independence upon the dissolution of the Soviet Union end 1991, Ukraine was one of the poorest Soviet Republics. As under Soviet rule the agrarian economy underwent a forced (over)industrialisation, Ukraine started its economic transition with relatively good infrastructure and high capital stock so that there were good hopes in 1991 that in time Ukraine would become a free market democracy with a European future. Things turned out quite different with hindsight.  As of 2000, following the economically devastating and lawless 1990s, Ukraine grew along with the region, without outperforming despite the huge output loss suffered. What’s more, growth was largely based on transient dynamics such as cheap Russian gas and favourable external conditions resulting in improving terms of trade, but thwarting modernization of Ukraine’s economy. The deep 2008-09 crisis (see infra) has changed little in this regard, though it demonstrated how fragile the Ukrainian economy is.

Poland had never been as tightly integrated in the Soviet empire as Ukraine. The starting position of both countries was therefore quite different. With a cheap and well-educated workforce at the doorstep of Europe’s largest economy, Poland was well positioned for foreign investors. While the country lacks well-known brands and major international companies, investors appreciate Poland for its qualified labour force and the country’s vast potential for further productivity gains. A big challenge will now be to move up the value chain and foster the service sector as for labour-intensive manufacturing, Poland is no match for cheaper European countries such as Bulgaria and Romania.

Over the past two decades Poland had realised vast economic strides, gradually narrowing the economic gap with Western Europe. In 1991, Poland’s GDP/capita reached less than 30% of Germany’s. Currently the ratio stands at about 55% and the gap with the rest of Europe is set to narrow further in upcoming years given the strong economic performance. From a comparable level to Poland’s twenty years ago, Ukraine saw its GDP/capita plunge, only to return slowly to about 35% of the Polish purchasing power per capita.

Poland_Ukraine_Graph1EN Poland_Ukraine_Graph2EN

Poland’s place at the European table

Following the fall of communism, Poland chose quickly and resolutely to sail a European course and joined the European Union in 2004. It has the 7th largest economy among the EU’s 27 member states, and the 6th largest population and its strong economic record should translate into increasing political weight within the EU. In fact, under PM Donald Tusk, Poland has adopted a staunchly pro-European stance with the aim of turning Poland into a key European decision maker. This does not only mark a departure from the previous government’s position, it makes Poland also much more European oriented than Hungary or the Czech Republic, for example. The eventual adoption of the euro would emphasize Poland’s position at the centre of Europe, though joining the battered single currency will not happen before 2015 – no official target has been set yet. Also, the Polish public opinion is currently not in favour of adopting the euro, which should not be a surprise.

Warsaw has been careful over the past year not to fall in Europe’s ‘second league’ as it has moved anxiously to ensure that Warsaw would not be among the outsiders in case of a reinforced Eurozone. Despite being heavily criticized by the conservative opposition, the Polish government plans to participate in the Fiscal Compact, the enhanced European supervision of public finances.

With Poland now tightly embedded in European structures, the traditional suspicious stance towards Russia has shifted slowly towards more pragmatic relations. With Germany, its natural enemy of the past, Warsaw enjoys increasingly good relations. The country is steadily becoming for Germany’s east what France is to its west: a natural, indispensable economic and political partner.

Economic performance during crisis years

When the crisis arrived late 2008, Poland was still growing strongly following its 2004 EU accession. The country was the only in the EU to avoid recession in 2009. A combination of luck and sound policy-making was helped by a lower importance of exports towards Western Europe given the large domestic market, healthy corporate and household balance sheets and a strong banking system. During 2009 Warsaw executed substantial stimulus to keep the economy going. Since the end of 2008, the Polish GDP has grown by more than 10% thanks to strong consumer spending and steady exports to countries like Germany, with Poland becoming increasingly integrated into the German supply chain.

Over 2011, Poland’s GDP grew by a robust 4.3%. While holding up quite well in comparison to other countries in Central and Eastern Europe (CEE), Poland is evidently not immune for the Eurozone turmoil. Following resilient data at the beginning of 2012, economic indicators have deteriorated somewhat lately with especially industrial production weakening. Nevertheless, the central bank raised its benchmark interest rate in May as inflation runs at about 4%, compared to a target rate of 2.5%. A slowdown in construction would be little surprising as many public investment projects were driven by the approaching Euro 2012. While down from last year, with a growth forecast of 2.7%, Poland will still outpace the rest of Europe. Domestic demand remains the main growth driver, but the focus is expected to shift further from consumption to investment: as Polish companies have been hitting capacity limits, investment has been rising.

Poland’s current account deficit has been stable in recent years at about 2-3% of GDP, down from over  5% in 2007-08 and largely financed by inward FDI. Moreover, thanks to solid growth in service and good exports – in the slipstream of a resilient German economy – the Polish deficit has been narrowing in recent months. As this trend is expected to continue, Poland’s external deficit would contract further to below 2% of GDP. Also the strong rise in EU transfers – these will amount to 2% of GDP this year, twice the 2009 level – helps to limit the deficit. As a matter of fact, over the 2007-13 EU budget period, Poland will receive €67bn in spending through the EU Structural Funds, while the 2014-20 budget could bring Poland another €67-82bn in European spending.



Ukraine’s GDP grew by 5.2% last year but the growth pace was heavily skewed to domestic consumption and this continues to be the case with exports and investments weak. Compared to the final quarter of 2011, economic activity contracted by 0.3% during the first three months of 20112. On an annual basis this means growth has dropped from 4.7% in 4Q2011 to 1.8% in 1Q2012.

Before the 2008-09 crisis, Ukraine experienced robust economic growth but its institutions remained weak. From 2000 to 2007, real GDP growth averaged 7.5% of GDP. At the same time, vulnerabilities in the balance of payments as well as in the banking sector were building up. With steel prices running high and prices for gas imports still far below world market prices, Ukraine had little incentive to improve the dismal energy inefficiency of its industry. Nevertheless, by 2007 the current account had already deteriorated strongly as imports had surged on the back of a credit and real estate boom and an overheating economy.

Private sector imbalances widened sharply with foreign currency loans accounting for nearly 60% of total loans, often extended to borrowers without foreign exchange income, and bank funding increasingly relying on short-term foreign borrowing. At the same time, the government’s sharp expansionary income policies fuelled consumption further and contributed to the deterioration in the current account.

As a consequence of this accumulation of weaknesses, Ukraine was one of the countries the hardest hit  by the global economic and financial crisis. Steel prices tumbled by 80% and Russia raised gas prices, causing a balance of payments crisis. Capital flows reversed abruptly and pressure on the currency was exacerbated by the dwindling confidence in the banking system and the burst of the real estate bubble. Despite low public debt levels, a fiscal crisis rapidly emerged on the back of a sharply contracting economy– Ukraine’s real GDP dropped by a massive 15% during 2009 –, the realization of contingent liabilities, and the lack of market access. As a result, Ukraine was forced to seek IMF support in order to finance its accumulated twin deficit. However, IMF support always comes with strings attached and the programme went off track in the autumn of 2009 as commitment vanished completely ahead of the 2010 presidential election. While a new programme was initiated following the elections, this programme went quickly off track as well, as short term political gains outweigh by far all other considerations.

Significant debt repayments to the IMF are falling due this and next year, driving up the country’s financing needs, the more as the current account deficit has widened again recently. The latter reached 5.6% of GDP last year and is expected to widen further this year. With access to private capital markets lost and the IMF programme suspended, Ukraine is heavily exposed to a new balance of payments crisis.

The prospects of a resumption of IMF support are bleak. Faced with repeated non-respect of programme conditions in the past, the IMF is sticking to its point and demands several conditions to be fulfilled before financial assistance could restart. The main points of disagreement are a sharp price increase of domestic gas prices to cost-recovery levels and a more flexible exchange rate policy, which would most likely entail  a substantial hryvnia depreciation. In an attempt to avoid having to raise domestic gas prices, the Ukrainian authorities have over the past year put all their hopes on obtaining a more favourable gas import price from Russia (see below).

The price to pay for lower gas prices

Heavily dependent on increasingly expensive gas imports from its eastern neighbour, Kiev has been pushing hard for a price discount. Under the existing 10-year contract, Ukraine has to pay around $415 per 1000m³ of natural gas this year, one of the highest prices for Russian gas in Europe. The prospect of a cheaper gas supply has been used by Russia to entice Ukraine into joining its customs union with Kazakhstan and Belarus and force the country into releasing control over its strategic gas-transit network. The latter currently handles about 80% of total Russian gas exports to the EU and is Ukraine’s only bargaining chip in its negotiations with Russia. But Gazprom has announced that it will re-route about half of its gas exports through Ukraine to its Nord Stream pipeline and the Belorussian pipeline network.

Ukraine is therefore losing the little leverage it holds over Russia. The more as Gazprom is set to make a final decision on starting construction of South Stream, an expensive and theoretically unnecessary pipeline that would bypass Ukraine via the Black Sea and could be operational by 2015. As a consequence, Moscow can play the waiting game, assuming that ultimately Ukraine will have no other option left than succumbing to its demands. The recent experience of neighbouring Belarus provides a cautionary tale. Forced by a deep financial crisis, Minsk had to give up full control over its pipeline system to Gazprom. In turn it was bailed out by Russia and obtained the cheapest gas supply in Europe: $166 per 1000m³. Cheap gas therefore comes with a price for countries like Belarus and Ukraine: a serious loss of sovereignty and economic independency. As a matter of fact, during his election campaign, Russian president Putin stated he sees the re-integration of the post-Soviet space as a priority.

Until so far, Russia’s terms are a bridge too far for Ukrainian politicians who fear an electoral backlash if they seized control over the transit system. Joining the customs union would also imply that the trade agreements with the EU are off the table. But reaching a compromise sooner than later is in Ukraine’s interest as its negotiating position will only weaken. Most likely, Kiev will play for time and postpone a broad agreement until after the October elections.

The situation at the political front

Economic stability has nurtured political stability, with Poland outshining many Western European countries as well as ever wobbly Ukraine. The resilient economy steered PM Tusk’s Civic Platform towards victory in last October’s elections and allowed him to continue his centrist coalition. It was the first time in modern Poland that a sitting PM managed to secure re-election, an indication of the coming of age of Polish politics – the smooth transition of power following the death in 2010 of President Lech Kaczynski and a bunch of other senior officials in an airplane crash is another example. His historic second term gives Tusk the opportunity to make up for what many came to see as the main shortcoming of his first tenure: the lack of realising politically trying structural reforms. Last month, Tusk’s government pushed through pension reforms, including a phased-in increase in the pension age for both men and women to 67. While deeply unpopular and met with heavy resistance from the opposition and trade unions, these pension reforms will help safeguard public finances in the long run. Also, by setting aside short term political considerations and pushing through reforms of which only its successors will reap the benefits, the Tusk government has demonstrated its ability to tackle the problems hidden by the economy’s decent performance.

The contrast with Ukraine is harrowing. When he defeated then PM Yulia Tymoshenko two years ago in what were considered free and fair elections, Ukrainian President Viktor Yanukovych announced his intention to modernize the country, start a sweeping crusade against corruption and make Ukraine an investors’ paradise. So far, not so good. Announced reforms have been implemented only partially, with the bulk of reforms yet to come. While the government may change in Ukraine, its policies basically don’t. The same happened after the 2004 Orange Revolution, when laws and institutions did not change materially, despite international hope and incentives in this regard.

While the chronic political instability leaves Ukraine with short-sighted policies, lately things seem to have taken a turn for the worse. Since claiming the presidential office, Mr Yanukovych has been consolidating power in the hands of ‘the Family’, as his entourage is commonly referred to, putting Ukraine’s fragile democracy on a slippery slope to Russian-style authoritarianism. He strengthened the presidency through the return to a previous constitution, he delayed local elections and moved to eliminate political opponents through judicial actions. The highest profile among the latter is undoubtedly Ms Tymoshenko, whose ‘elimination’ has stirred mounting international criticism.

Ms Tymoshenko was convicted to seven years imprisonment last year, based on shady accusations of abuse in office in connection with gas contracts she signed as PM with Russia in 2009. Recent reports that she’s being mistreated in prison caused outrage by EU countries. German chancellor Angela Merkel even branded Ukraine a dictatorship, a label usually reserved for Belarus. Several European leaders have also said they will not attend matches held in Ukraine during Euro 2012 – Kiev hosts the final. The high-level political boycott already forced Ukraine to call-off an East European summit last month.

All the same, Europe still wields the carrot of concluding the closest and deepest co-operation agreement with any former Soviet state, including substantial financial benefits. Both an Association Agreement and a Deep and Comprehensive Free Trade Treaty have been initialled in recent months, but ratification is frozen until Kiev makes progress on a number of key issues: ending selective justice (and thus release Ms Tymoshenko), assure next October’s general elections are free and fair and make a start with deeper reforms. With elections scheduled for October and her popularity having soared thanks to her martyrdom and his own popular support plummeted, Yanukovych will think twice before releasing the former hero of the Orange Revolution quickly. Imprisoning his arch-rival has turned out to be a capital mistake, setting in motion a process he no longer controls. Sending her abroad for treatment of her hernia could be a potential, face-saving alternative.

Shape of financial sector is key explaining factor for economic situation

Influenced by a general trend of retrenching from CEE as they are forced to improve capital requirements, Western European banks – which control about two thirds of the Polish banking sector – may opt to sell profitable Polish activities in order to strengthen their balance sheets. This would accelerate the on-going consolidation in the sector and increase the position of domestic banks. As Poland’s well capitalized banks are highly profitable, interest from strong international banking groups can be expected to be solid.

Pressured by the Polish regulator, many banks have been making it harder to borrow lately though. During the height of the financial crisis late 2008, capital outflows and liquidity strains were limited for Polish banks. Liquidity is largely based on deposits and this serves as a shock-absorber for external shocks. A bigger worry might be the 700,000 Poles who took Swiss franc-denominated mortgages before the crisis as this seemed an easy win given the lower interest rates and the appreciating zloty at the time. While the weakened zloty evidently strengthens Poland’s export position, it can cause problems for the repayment of these mortgages. But contrary to many other countries in CEE – with Ukraine being probably the most notorious example – Polish banks had been properly targeting foreign currency lending to more affluent borrowers. This helps to explain why Poland largely escaped the crisis in 2009 and why non-performance is still higher for zloty-denominated than for foreign currency-denominated mortgage loans.

Quite another template applies to the Ukrainian financial system. The banking sector was among the very few sectors in which foreign players got involved. During the 2000s Ukraine experienced a credit boom like many other countries in the region. The ratio of credit to GDP leaped from below 10% to almost 80% as foreign banks channelled cheap external liquidity into Ukraine. The 2008 financial crisis left the Ukrainian banking sector with a painful hangover. IMF support stabilised the situation in the sector, but the resolution of problem banks has remained incomplete. According to data from the National Bank, non-performing loans reach 20% of total assets, while loans labelled ‘problematic’ reach 50%. A new economic downturn would thus inflict another lethal blow on many banks and it remains to be seen whether foreign parent banks would (again) recapitalise daughter banks given their own concerns and their past experience in Ukraine.

The National Bank of Ukraine (NBU) defends a rigid exchange rate as it tries to keep the hryvnia close to 8UAH/USD. This strategy entails a high liquidity risk as heavy intervention to defend the hryvnia results in a fast exhaustion of the NBU’s international reserves. Currently Ukraine’s reserves represent three months of import, which would allow the NBU to defend the current hryvnia rate until the elections in October, though a depreciation is unavoidable.

In contrast, Poland allows the zloty to move freely. Not (yet) being part of the Eurozone has been a blessing for Poland as a proper currency helps a country to absorb external shocks. A weaker zloty rate shielded the Polish economy in 2008-09. Despite strong economic data, the zloty fell by 15% against the euro during the second half of 2011, as general sentiment towards the region worsened with the intensification of the eurocrisis and problems in Hungary. Since January, the zloty has regained ground, reflecting the massive liquidity injections into European banks by the ECB. Yet, the new escalation of problems in the Eurozone has halted this appreciating trend.


Public finances: the consequences of 2008-09

The Tusk government has singled out the public finances as its key priority. In 2007 the budgetary deficit hit a low of 1.9% of GDP, before jumping to 7.8% in 2010 as the government provided ample stimulus spending. Last year the number was pushed back to 5.1% on the back of a strong economy. The Polish authorities have recently reiterated their ambitious plans to push the deficit to 2.9% this year – and exit the EU’s excessive deficit procedure – and then bring it gradually to 0.9% of GDP by 2015. Though the pull-back in public investments for Euro 2012 will help, a deficit of 3-3.5% seems more likely.

Government debt has increased from 45% of GDP in 2007 to almost 55%. Poland has three successive legal debt thresholds: 50%, 55% and 60% of GDP, each corresponding to tougher obligations for the government to reduce the deficit. Also, Poland has a spending rule that limits increases for non-mandatory spending to 1% in real terms. This mixture of debt triggers and spending rules provide ample assurance regarding the sustainability of Polish public finances, while allowing for sufficient budgetary leeway during an economic slowdown as witnessed in past years. It should therefore be of little surprise that Warsaw has no problem whatsoever to place its debt. At the beginning of 2012, Poland had already managed to place about a fifth of its total debt requirements for this year. This is reflected in the yield on Polish 10y government bonds, which has been stable in recent years and stands currently at about 5.5%.

While at the surface, Ukraine’s public finances seem in good shape, a deeper analysis reveals another picture. The 2008-09 crisis has put hefty strains on Ukraine’s public finances. At 40% of GDP, public debt is limited, but stands nevertheless three times as high as in 2007. Furthermore, Kiev struggles to roll over its external debt. The deficit has been reduced from over 6% in 2009 to below 3% of GDP, but loss-making state banks and companies make the actual situation less rosy. Also, Ukrainian authorities have stepped up social spending to bolster their chances in upcoming elections – while public investment is extremely low, despite the many bottlenecks in public infrastructure. This higher spending, 16% above the original budget plan, could increase the deficit considerably from last year. With the authorities already confronted with funding problems, this could cause more problems and force authorities to revise policies again before the elections.

With the NBU resorting to financing the fiscal deficit through the purchase of treasury paper, Ukraine will probably be able to muddle through until after Euro 2012 and the October elections. While it probably has the foreign reserves to do so, there’s nevertheless a risk of reserve depletion and an ensuing crisis. This will make inevitable adjustments such as a hike in the domestic retail gas price all the more painful when eventually executed and exert a larger drag on economic activity.

Business environment indicators sum it all up

When one compares Ukraine and Poland from an investor’s point of view, Ukraine comes out poorly. The business environment in the country is undermined by a weak rule of law and a lack of independent courts. While Poland stands much higher in international rankings, there’s certainly still room for improvement compared to many other EU countries. Excessive red tape is generally regarded as the main obstacle for the country’s investment climate. Poland also still struggles with the lack of a national highway network and a general problem of infrastructure bottlenecks. In the run up to the European football championship, authorities were racing to finish key infrastructure projects. The stepped-up European funds should help to tackle this problem over the next decade.



Twenty years have passed since its independence, but Ukraine in many regards still needs to start the transition. While constant political intrigue provides excellent material for political thrillers, the cynical political situation can be considered the country’s main weakness as it impedes deep-running problems from being tackled. Given the little action initiated since disaster struck in late 2008, Ukraine is now ill prepared would new external pressure arise. By focusing continually on stopgap solutions, the eventual reform measures will only be more drastic and painful. Without a lower gas import price, both the fiscal and the current account deficit should be expected to widen this year, assuming weak foreign demand and no shift in policy making as elections will be held in October. Still recovering from the last crisis, more problems thus seem in the making for the country, especially as government finances and bank balances are still digesting previous shocks and now stand much weaker than before the crisis of 2008-09. With IMF lending suspended and access to capital markets lost, something will have to give.

In point of fact, the European football championship will only highlight the striking dissimilarities with co-host Poland, a country that has fared much better over the past two decades. Poland enjoys some of Europe’s strongest growth numbers and stands out as a safe haven in the CEE region thanks to its balanced economy and stable political outlook. Economic resilience is set to continue this year. Compared to 2008, Poland has less budgetary room for manoeuvre. Further intensification of the crisis in the Eurozone would thus be harder to offset by Polish authorities through fiscal stimulus. Private consumption seems however well-entrenched and able to provide pushback in case of external gloom, as it has been doing in previous years.

Analyst: The Risk Management Team, f.thiery@credendogroup.com