After enjoying years of 7%-plus growth pre-financial crisis, Ukraine has been mired in recession since Q3 2012 with the economy contracting by 1.5% year-on-year, high unemployment and large twin deficits.
The fundamentals make sober reading. The current-account and fiscal deficits have surged to around 8% and 5% of GDP respectively.
Ukraine also has about $60 billion in short-term external debt, and the increasing difficulty in attracting international capital to plug the gap has forced it to delve heavily into its reserves and seen its borrowing costs soar. The yield on 10-year government bonds has jumped by more than 40% since May.
Yields on short-term dollar debt due in June broke above 20% in recent trade, the largest rise of any emerging market bonds since Fed tapering was first mooted earlier this year. The yield on the dollar-denominated notes was just 7.95% when it was issued last year.
Around $15.3 billion of its debt is scheduled to be repaid in the next two years. According to Capital Economics, the country’s gross external financing requirement amounts to $75 billion – more than 40% of GDP.
Difficulties in attracting external funding have seen reserves halved to around $20 billion since 2011 as the central bank raided its foreign-currency war chest to repay external debt.
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Ukraine’s reserves are now sufficient to cover just 2.7 months’ of imports – below the bare minimum of three month old-school recommendation of the IMF. “It’s struggling to raise any money in international financial markets because of the very high yields on government bonds,” says Liza Ermolenko, emerging markets economist at Capital Economics.
“It’s a very dangerous situation because they’ve had a very sharp slowdown in exports at the same time that they had a very sharp slowdown in investment because of the difficult business environment. Construction output outright collapsed over the past few months.”
Ermolenko says there are also structural imbalances, primarily subsidies on its massive gas imports which are the main reason the current-account deficit is so large, accounting for 80%.
It’s also highly inefficient. Because the government is subsidizing gas for domestic consumers, they use far more than they would otherwise.
Naftogaz, the state oil and gas company, runs massive deficits to the tune of 2% to 2.5% of GDP, which means the government’s real budget deficit might be as high as 7.5% of GDP.
“Raising gas prices is politically very difficult because Ukraine has very cold winters, but it will have to be done at some point because Ukraine has to import all of its gas so it’s in an unsustainable situation,” says Ermolenko.
“Ukraine is basically struggling in every way. I think domestic demand is the only component of GDP that is still growing, but that’s being supported by growing public-sector wages so it’s not really sustainable growth.”
She adds: “It’s already the poorest country in Europe. The economy has done pretty terribly over the past few years and the government hasn’t really done anything to improve the situation.”
Ermolenko says a default is quite unlikely – for now. Analysts say sufficient foreign-exchange liquidity should help pay short-term debt maturities but with around $6.5 billion of sovereign external debt payments coming due next year, Ukraine CDS spreads have jumped to around 1,000 basis points on the 10-year.
If political instability persists, and in the absence of financial support from either the EU/IMF or Russia, Ukraine is likely to remain in recession and could soon slip into a balance-of-payments crisis, accompanied by a sharp drop in the hryvnia and a spike in bond yields.
Anger over the government’s rejection of a €600 million partnership agreement with the EU, which would have initiated a shift away from Ukraine’s close ties with Russia, have triggered a wave of violent protests, with a huge anti-government rally on Sunday culminating in the toppling of a statue of Lenin.
Ukraine experienced a sharp slowdown after president Viktor Yanukovych was ousted in 2004’s bloodless Orange Revolution, only to be re-elected in 2010.
Apart from a poor business environment and excessive red tape, Ukraine is also the most corrupt nation in Europe, according to Transparency International. The group’s just-released 2013 corruption perceptions report ranked Ukraine 144th for public-sector corruption out of 177 countries and the fifth worst of the 11 Commonwealth of Independent States of former soviet republics.
As many as 90% of companies report bribery as commonplace and firms routinely complain about the partisan way contracts are awarded and treatment by tax and customs officials and the courts.
Its performance has been deteriorating since 2006, apart from a blip in 2010 and 2011 when a programme of structural and anti-corruption reforms launched by Yanukovych helped land Ukraine a $15 billion IMF stand-by arrangement.
Measures included amending laws on criminal responsibility for corruption that saw the prosecution of several politicians and hundreds of low-level officials, a ban on civil servants receiving gifts, monitoring of officials, and compulsory asset declarations for officials.
However, the administration’s appetite for the crackdown soon waned. Hopes were further dashed when the introduction of the country’s first tax code had a damaging impact on the stock exchange and small businesses, while favouring big business – Yanukovych’s core support base.
The IMF credit line was suspended in 2011 after the government failed to fully implement gas price rises.
The 2011 imprisonment of opposition leader, former prime minister Yulia Tymoshenko, condemned by the EU as “selective justice”, has been a sore that has soured relations with the west. The EU has made the release of Tymoshenko a pre-condition for concluding the partnership deal.
“On the surface, it’s very close in the short-term to a classic debt and foreign-exchange crisis where there could be a slide in the currency, a sudden return of inflation and the prospects for immediate economic recovery could be wiped out,” says economist Alan Shipman, an adviser to Oxford Economics.
“The economy was already very close to serious economic difficulty and that difficulty is compounded by the political turmoil. But our forecast is still reasonably optimistic. We still have the economy returning to growth, albeit weakly, in 2014, picking up quite well in 2015 and beginning then to reduce its external deficit and bring its wide government-deficit down.
Shipman concludes: “Ukraine is an economy that is too big to fail. The politics being played over it, with both the EU and Russia trying to secure its future political loyalty, and private financial institutions in both blocs exposed means that one side or the other is going to step in with the necessary external financing.”