Ukrainians pray for swift bounce-back for embattled hryvnia

In a year in which Ukrainians have seen their currency the hryvnia lose nearly 50% of its value against the dollar, making it one of the worst-performing currencies of 2014, there is little cause for cheer.

Its total external debt to GDP is 130%, while short-term debt-to-GDP is running at around 60%, with some 40% held by non-bank private sector institutions, and the other 20% by the government and banks.

At the end of 2013, Capital Economics was already predicting a 1% contraction for Ukraine for 2014, but the year has been far worse than those predictions, with the economy contracting by 5% this year, and Capital Economics predicting another 2% decline in 2015.

The weakening hryvnia has pushed up inflation, which stands at close to 20%, making imported goods – in an economy with a limited manufacturing base – costly and further savaging consumption and production.

The banking sector faces substantial costs, with FX depreciation triggering a jump in non-performing loans (NPLs). The IMF estimated NPLs were around 30% in the middle of the year, and since then unofficial estimates put the figure at between 40% to 50%.

“In April, the IMF was warning that an exchange rate of 12.5/$ would mean huge costs for the banking system, but since then the hryvnia has fallen to 15/$,” says Liza Ermolenko, emerging markets economist at Capital Economics.

The weaker hryvnia has also increased the cost of servicing Ukraine’s large external debt, afflicting the state and private sectors, pushing the government closer to the brink of default.

Oleg Kouzmin, economist for Russia and the CIS at Renaissance Capital (RenCap) in Moscow, says: “The east of Ukraine, Donetsk and Luhansk, are important regions for Ukraine’s economy. Donetsk and Luhansk accounted for around 23% of Ukraine’s exports in 2013. The two regions together export around $9 billion worth of goods, and import around $2.5 billion. So the region is crucial for Ukraine’s current account.”

This year, Ukraine’s exports have declined by 20% year-on-year in dollar terms.

With economic activity in these regions disrupted by the fighting with Russia, it is hard to determine what fair value for the hryvnia is. “The level of hryvnia will depend largely on whether these regions stay in Ukraine,” says Kouzmin.

Capital Economics’ Ermolenko adds: “It wouldn’t be fair to say that this has been entirely due to the political crisis. The big picture is that Ukraine’s huge economic imbalances looked worrying even before the war in the east – it was running a large current-account deficit and external competitiveness deteriorated sharply.”

High gas prices have not helped in a country that is among the most inefficient energy users in the world. Its current-account deficit is largely driven by its thirst for imported energy, and the weaker the hryvnia gets, the more it pays for its gas and the larger the deficit. Crucial to Ukraine’s turnaround will be finding a way to reduce its dependence on energy.

Even without the escalation of hostilities on the border with Russia, therefore, Ukraine needed some devaluation in the hryvnia. “Ukraine previously maintained a tight peg to the dollar [around Hrn8 to the dollar], but this year has seen the currency move much closer to its true level,” says RenCap’s Kouzmin.

 Source: Capital Economics

The situation in Ukraine is now so volatile and fluid that it isn’t possible to identify a specific exchange rate, with Bloomberg terminals, local brokers and agents in the black market quoting different rates.

With trust in the hryvnia at a low, Ukraine is awash with dollars and euros as people look to protect the value of their own wealth. The National Bank of Ukraine has banned the use of the rouble, but demand for the currency was already modest given the problems that currency has faced in recent months.

Meanwhile, liquidity has fallen precipitously, even considering the relatively light trading seen in the currency in the absence of a crisis. The hryvnia is not on the radar of most financial institutions, though there is still trading among some frontier-market specialists and others.

“The currency is one way to play the recovery story, though fixed-income instruments like sovereign bonds and CDS would be a more attractive way to trade this theme for most investors,” says Kouzmin.

Easing pressure

The situation has pushed the central bank to strengthen capital controls to manage the shortage of available cash and ease the pressure on the exchange rate. These include limits on how much can be withdrawn at any time and limits on how much can be exchanged for dollars.

However, these measures have proved relatively ineffective and have only driven up the discrepancies between the different exchange venues.

“The problem now is that the central bank’s FX reserves have fallen to dangerously low levels and the authorities simply cannot afford to support the currency,” says Ermolenko. Further falls in the hryvnia are therefore a real possibility, she says.

Kouzmin adds: “The National Bank of Ukraine has around $10 billion of reserves excluding gold left, which is perhaps enough to cover the interest payments on its debt for a couple of months. But it has a very limited ability to defend its currency now.”

In the short term, the sovereign’s principal lifeline is an injection of cash from the EU or the IMF. According to the ministry of finance, it has already received around $8 billion of external financing this year from various sources, including the EU and a government bond guaranteed by the US.

“More than anything it needs those institutions to help it strengthen its political institutions which is a prerequisite if it is going to keep the FDI coming in and maintain its access to credit,” says Kouzmin. “It needs to be able to monitor exactly what money is being spent on.”

However, Kouzmin concludes on an optimistic note: “The big advantage the ex-Soviet states have is that when there is an FX crisis, or GDP and living standards fall, these things happen fast – and then they rebound fast. Compare that to Eastern Europe where you might see these things drawn out, leading to years of recession and weak recovery.

“So yes, the civil war has been painful for Ukraine, but once there is a resolution the economy might be able to bounce back as quickly as it fell.”

That is not to say the end to hostilities with Russia – whenever that comes – will spell the end of Ukraine’s economic woes. Its problems run far deeper than that.