Despite the fact the Ukraine administration is resplendent with confidence that the International Monetary Fund is going to release the next $3.4 billion payment under the country’s $16.4 billion lending program with the Fund, things are not so clear. In fact the International Monetary Fund only this week warned Ukraine (25 October) that they might freeze assistance ahead of the forthcoming presidential election if proposals to make populist wage and pension increases move forward.
In a statement issued after talks with Kievâ€™s officials, the IMF said its decision to go ahead with the next $3.8bn in aid would hang on â€œassurances that the wage and pension law approved by Ukraineâ€™s parliament, which is at odds with the objectives of the authoritiesâ€™ programme, will be vetoedâ€. The statement was a clear and explicit warning to President Viktor Yushchenko, who has not yet clarified whether he will sign or veto the law.
Still the Ukraine authorities are giving the impression that everything in the garden is rosy, or at least this is the impression Economy Minister Bohdan Danylyshyn is attempting to send out to the world.
â€œThe payment will help sustain the economy and, to a certain extent, help cover the budget deficit,â€ Danylyshyn said last week in an interview at Ukraineâ€™s New York Consulate. â€œItâ€™s a pretty complicated situation in Ukraine, thatâ€™s why we expect a budget deficit this year and next.â€
In fact he couldn’t have put it better, the situation in Ukraine is pretty complicated, it really is. But behind the scences things don’t seem to be anything like as clear as Danylyshyn is suggesting, and there is plenty of evidence of fund frustration with the administration and of a growing determination to tighten the screw somewhat. So is Ukraine assuming that, not being Latvia, they are too big too fail? And if they are doing so, are they right in their assessment, and if they are not, what might be the final outcome here.
Certainly Ukraine, for its part is now completely dependent on the IMF loan program – from which it has so far received $10.6 billion – to keep itself afloat following the impact of the credit crunch on the internal lending and construction boom and the fall in external demand for the raw material exports, and especially steel, on which it has allowed itself to become so dependent.
One thing which strikes the external observer immediately is the differential treatment Ukraine has been receiving when compared with other East European borrowers like Hungary and Latvia, since unlike the latter two the pressure on the administration to make swinging budget cuts has been fairly muted up to now. In fact the country did meet its end of May fiscal target, but since that time the underlying fiscal situation has worsened considerably. The general government deficit was 1.8 percent of GDP during the first five months of 2009, against an agreed program ceiling of 2.4 percent of GDP. However, according to the IMF this positive outcome largely reflects an increase in VAT refund arrears and advanced tax payments by large enterprises (0.5 percent of GDP).
At end-June, the government deficit stood at 3 percent of GDP, while expansionary fiscal measures are increasingly coming under consideration ahead of next years elections. The government has adopted a moratorium on tax audits and considered a tax amnesty, while parliament adopted modifications to the budget code implying additional transfers to local governments (which could exceed 1 percent of GDP in 2010). A draft law including large increases in public wages and pensions (2 percent of GDP in 2009, and 4 percent of GDP in 2010) has even been suggested by the opposition.
Not unsurprisingly an IMF team is now hard at work in Kiev, trying to assess whether Ukraine still meets the agreed terms of the loan prior to a final decision on the next payment.
And again, not everyone is in agreement that things are going as planned. Ukraine is at â€œserious riskâ€ of veering off track ahead of the coming country review in November, according to a Fitch Ratings statement of October 14.
Fitch argue that Prime Minister Yulia Timoshenko’s government has â€œabandonedâ€ commitments made under the IMF’s second review of the loan program, and the clearest evidence of this abandonment is the evident failure to increase prices for natural gas paid by households and utilities despite the massive subsidies the government is finding itself forced to pay.
In fact JuliaTimoshenko reiterated only last week there will be no increase in natural gas rates this year. Yet low gas prices simply add to the countryâ€™s budget deficit, which the IMF estimate will finally total 8.6 percent of gross domestic product this year, and that is excluding bank restructuring costs. Fitch themselves forecast a deficit of 8.5 percent of GDP, rising to 11.1 percent once the deficit of Nak Naftogaz Ukrainy is added in.
Danylyshyn for his part is much more optimistic, suggesting the deficit this year may fall to 6 percent, and then shrink to around 3.8 percent in 2010.
Naturally the IMF remain unconvinced by Danylyshyn’s forecast, and argue that the outlook for public finances has worsened significantly, and that revised 2009 GDP growth projection implies that, without offsetting measures, the general government deficit is set to increase from 4 to 6.5 percent of GDP in 2009, to which needs to be added an anticipated extra 2.7 percent of GDP for Naftogaz which would send the total public sector deficit (inclusive of Naftogazâ€™ deficit but still excluding bank restructuring costs) up to 9.2 percent of GDP.
Ukraineâ€™s economy is currently struggling to recover from an extremely severe recession which lead GDP fall by an annual 17.8 percent in the second quarter of this year, following a 20.3 percent decline in Q1. GDP may decline as much as 14 percent over the year as a whole (and grow 2.7 percent next year) according to the October IMF forecast, with everything really depending on the average prices of, and demand for, ferrous metals, which are Ukraineâ€™s major export.
In line with the general outlook for the entire CEE region, anything in the way of vigorous recovery is not expected before the second half of 2010, and even then in many cases the vigour may be quite muted. If Ukraine’s economy is to return to growth improvements in competitiveness (following the recent real exchange rate depreciation), a recovery of global steel prices, and increased public and private sector investment in infrastructure and energy projects with a clear external orientation will be the main drivers of the recovery.
Obviously all are agreed that a return of foreign investment to stimulate export activity is the key to recovery, and Danylyshyn expects Ukraine to receive $20 billion in foreign direct investment between next year and 2012 to help it diversify the economy away from exports of raw materials, such as steel and grains, and modernize existing facilities.
But again, at least in the short term, things are not so easy, given that while the current account has adjusted, net capital outflows continue to present an important source of balance of payment pressures.
In the first 8 months of 2009, the current account deficit amounted to USD 1.1 billion, USD 7 billion lower than a year ago. At the same time, external debt roll-over for banks and corporates was 76%, resulting in USD 7.1 billion net outflow over the same period. Additionally, â€˜domestic capital outflowsâ€™ â€“ flight to foreign cash by residents â€“ drained out USD 5.7 billion. The recent IMFâ€™s SDR quota allocation and the Special Borrowing Arrangement have helped to ease what otherwise would have been a major drop of forex reserves. The marginal weakening of the external accounts over the summer, higher demand for forex from corporates and households, on the back of heightened depreciation expectations have placed pressure on the currency since end-July. The depreciation trend also resulted in the leakage of Hryvnia deposits from the banking sector of around 7% during Q3. And indeed multiple exchange rates have once more reappeared following the return to selective National Bank of Ukraine forex interventions.
A Large Output Gap Remains
The economic contraction may have slowed, but a large output gap continues to exist. Industrial output was in fact up 1.9 percent month-on-month in September, with production resuming its upward trend following a 0.9 percent monthly fall in August. Steel output however continued to decline, raising more doubts about where the recovery is headed.
Industrial output fell 18.4 percent in September year-on-year and was down 28.4 percent between January and September when compared with the same period in 2008. Output in the steel sector fell 7.1 percent month-on-month after falling 0.3 percent in August. Year-on-year, it fell 14.9 percent in September. Steel production between January and September fell 36.9 percent against 39.0 percent in the January-August period and 41.2 percent in January-July.
The Industry Ministry forecast that raw steel production will fall to about 30 million tonnes this year from 37 million in 2008 and 42.8 million in 2007.
Economic activity plunged in the last months of 2008 and has continued to fall since. Real GDP fell 20.3 percent year-on-year in the first quarter of 2009, reflecting the deterioration of the global environment and further exacerbated by Ukraineâ€™s pre-existing vulnerabilities. As in many other countries in the region, the recession was led by a drop in export volumes, followed by a very sharp contraction of domestic demand.
The pace of decline in private consumption was broadly unchanged in the second quarter at 11.6 percent year on year, while fixed investments sank by 57.8 percent. The contribution of net exports to growth became larger as real imports declined even faster (-53.5% y/y) than exports (-32.3% y/y). Output indicators point to stronger performance in Q3. In particular, as we have seen industrial production has started to recover gradually in recent months.
Ukraine’s economy is following a typical boom/bust scenario, and following several years of evident overheating characterised by ever more rampant inflation the global crisis final brought the inevitable to pass. The IMF now expect real GDP to decline by 14 percent in 2009, against the 8 percent they expected at the time of their first programme review earlier this year. The downward revision reflects the larger than expected contraction in the first quarter of 2009. Given the pronounced recession in Ukraineâ€™s main trading partners and the likely frail global demand for steel in the coming quarters, the forecast assumes only a very timid recovery in the second half of 2009, followed by a return to GDP growth in 2010, and there are, of course, evident downside risks to this scenario.
Beyond the export and industrial shock output has also been contracting fast in both the construction sector and in retail trade, reflecting the sharp impact of the credit crunch. Price adjusted retail sales were down 22% year on year in September, while construction activity has fallen by over 50% from 2008 levels.
Inflation The Large Fly In The Ointment
One of Ukraine’s greatest headaches in recent years – as can be seen in the chart below – has been the high level of domestically produced inflation, and the total incapacity of fiscal and monetary policy to get to grips with this. Price pressures are, however, now easing fast in Ukraine as the output gap has its impact, and headline CPI inflation has now fallen to around 15 percent year-on-year, down from 22.3 percent in January. Inflation is expected to continue to decline, reflecting the massive excess capacity. However, base effects from the second half of 2008 will slow the decline in headline inflation, which the IMF expect to be still at 14 percent by end-2009.
Ukraineâ€™s inflation rate is, however, still the highest in Europe, and even rose 0.8% month on month in September. This latest rise followed a 0.2% mom decrease in August. Annual inflation did however decelerate from 15.3% in August to 15.0% in September. The most significant contributor to this slowdown has been the slow rate of utility price increases, and this is a clear bone of contention with the IMF as the government refuses to change gas prices significantly given the scale of the recession and the looming elections. For the rest of the year, most observers expect inflationary pressures to remain muted, with annual inflation remaining around its current level of 15%.
The producer price index was however up by a monthly 3.6% in September, notably more than the 1.8% monthly increase registered in August, giving the highest monthly increase since July 2008. As a result the annual PPI turned positive again (up 1.6%) following a 3.7% year on year fall in August. So despite all the pressures inflation is proving extraordinarily resilient and continues to present a major problem for economic management.
Monetary Policy Caught in a Trap
All of which causes significant problems for the operation of monetary policy. The central bank realises the issue – and central bank Governor Volodymyr Stelmakh this summer described double figure interest rates as “far too high” (especially for an economy with a 14% annual contraction) – and has now cut its key discount rate twice since June to the current level of 10.25 percent. The bank justified the cuts by stating that price pressures have â€œeasedâ€ since inflation peaked at 31.1 percent last May, but on the other hand it is evident that inflation is still way to high. But the central bank is under continuous pressure from the government who want the central bank to lower rates further to make loans cheaper.
On the other hand, while base money has picked up significantly, largely on account of the governmentâ€™s conversion of its share of the second IMF disbursement into hryvnia, broad money growth has continued to be weak, reflecting both a strong liquidity preference on the part of banks, and weak credit demand from consumers and companies.
Ukraine’s exchange rate has depreciated by about 35 percent in effective terms (allowing for inflation) since early September 2008 and has been stable in recent months, allowing the NBU to scale back interventions since March 2009. More recently, since late June, however, moderate exchange rate pressures have reemerged.
The Ukraine banking system remains under strain, but deposits have stabilized, signaling some return of confidence. Non performing loans have increased since the onset of the crisis, but many banks are now reporting ongoing restructuring of their credit portfolios. After loosing some 20 percent of deposits between October 2008 and April 2009, aggregate deposits have stabilized in recent months, allowing the authorities to lift the ban on the early withdrawal of time deposits. The stabilization at the aggregate level conceals significant differences between banks, with the recently recapitalized state and foreign owned banks generally gaining deposits, while the domestic banks continue to experience significant outflows. Domestic currency lending has been picking up recently but this is almost entirely on account of lending by the state banks while other banks continue to reduce their credit portfolios.
As we can see, lending to households peaked at the end of last year, and continues to fall.
Household exposure to forex lending is significant in Ukraine, in this case the exposure is to dollars.
Closing Current Account Deficit Pressures Domestic Demand
As has been said, there has been a sharp fall in Ukraine exports since the crsisi began – 32.3% year on year in the second quarter. Q2 exports were up slightly from the first quarter, but nonetheless they remained at a very low level.
At the same time Ukraine’s current account has continued to adjust, registering a small surplus in April-May. Import volumes declined sharply due to contraction of domestic demand offsetting the decline in exports due to continued weak external demand, especially for steel.
As a result of the drop in imports the goods trade deficit has been steadily falling towards zero.
As we can see in the chart below, a significant part of the current account adjustment has been due to the fact that imports have been falling significantly faster than exports.
The current account has continued to adjust, registering a small surplus in April-May. Import volumes declined sharply due to contraction of domestic demand offsetting the decline in exports due to continued weak external demand, especially for steel. The financial account has shown signs of stabilization, despite a sharp decline in FDI. External debt rollover rates for the first five months of the year held up well (about 70 percent for banks and 100 percent for corporations). In addition, outflows of foreign exchange from the banking system have receded in recent months.
The IMF expect the current account balance to swing into a small surplus in 2009 (0.5 percent of GDP). However the drop in both import and export volumes is expected to be larger than previously expected owing to the weaker domestic and external outlook. Lower FDI is broadly offset by lower net outflows of bonds and loans. The take the view that their program remains adequately financed, but they still see risks. Total financing requirements in 2009 are projected to amount to $41 billion, while total financing sources (excluding Fund resources but including $2.3 billion in prospective official financing) amount to $31 billion, leaving a financing need of about $10 billion, which could be fully met by Fund resources. Risks include lower-than expected official financing, renewed foreign currency cash outflows from the banking system, and reduced FDI inflows and rollover rates. If these risks materialize, the IMF suggest the use of reserves buffers and/or additional policy adjustment would be needed.
Ukraine’s Looming Demographic Destiny
Ukraine has a serious demographic problem, raising longer term growth issues, and difficulties for the sustainability of public finance. Ukraine’s population has fallen back from 51.5 million in 1989 to the current 46 million level. And, of course, the decline continues.
Behind the fall in Ukraine population lie two factors, very low fertility and the out migration of the younger population in search of better employment opportunities and higher living standards elsewhere. Ukraine’s total fertility rate hit a low of 1.083 (according to the US Census Bureau) in 2001, and has subsequently rebounded to around 1.252 in 2008, in any event still well below the critical 2.1 tfr population replacement rate.
The â€œtransitionâ€ in transition countries refers, of course, to the political and economic passage of these formerly communist, centrally planned states. But there is an equally profound demographic transition in progress: very low fertility levels and ongoing emigration virtually guarantees that these economies will age more rapidly than any other region. By 2025 more than one Bulgarian in five will be over the age of 65 — up from just 13 percent in 1990. And while countries in other parts of the world are also aging at a phenomenal pace â€“ think Japan, Korea, Germany and Italy — no other region faces the challenge of building a modern, highly productive economy even as the portion of the population eligible for retirement explodes.
The dramatic declines in fertility in the teeth of post-1990 uncertainty are frequently interpreted as a temporary reaction to the uncertainties of economic and political transition. Yet, while there was a slight blip up in the prosperous years of the post-2000 boom, these economies seem to be past the point of demographic return: fertility would have to increase by more than one-third just to replace the existing population.
Ukraine suffers from a chronic problem of low fertility. A strong uptick in births had been noted in 2008 (see chart above), but the impact of the crisis is now evident, and the rate of increase in live births has now fallen back sharply.
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Since the proximate cause of the crisis was to be found in global financial turmoil, it was perhaps only natural that the financial sectors of the countries most dependent on the international flow of funds would be hit first and hardest. In the autumn of 2008, as financial difficulties in the advanced economies led to a decline in global liquidity and a flight from risk, investors begin to differentiate among emerging markets. Ukraineâ€™s high external debt and inflation levels led to a stampede for the exits in mid-October.
Ukraine’s biggest single problem is still the persistent high levels of inflation which the economy produces. Given the application of coherent monetary policy the inflation problem could steadily work its way out of the system, but this is a big “if” given the known political risk factors. Inflation is currently projected by the IMF to hit single digits in 2010 and to remain in the 5â€“7 percent range thereafter.
The current account balance is now likely to remain at financeable levels, and the financial account deficit should narrow as capital inflows recover. Any recovery would be delayed, however, if there were an unexpected further decline in steel prices or another round of stress in global financial markets. On the other hand, a faster global recovery and a return of political stability after the January election could result in a more pronounced rebound of the economy. External and public debt remain sustainable in principal but doubts continue going forward especially in the context of financing constraints.
While Ukraineâ€™s low level of public debt – 20 percent of GDP in 2008 – provides room for letting automatic stabilizers cushion the downturn and absorb part of the bank restructuring costs, fiscal sustainability would increasingly become a concern under unchanged policies, especially if the recession turned out more protracted than currently envisaged. Failure to implement the agreed measures in 2010 (pension-, tax-, and gas sector reform) or new expansionary measures could potentially jeopardize public debt sustainability in the longer run, and this is really what is preoccupying the IMF at the present time. The IMF baseline external scenario shows a rapidly declining external debt ratio but further deterioration in global economic and financial conditions, adverse current account developments, further shortfalls in FDI, or exchange rate overshooting would all negatively affect debt dynamics and create significant problems.
Not an easy picture, but then I guess no one ever thought it was.