UKRAINE: Long way home

Ukraine’s new president faces the unenviable task of keeping a crippled economy above water. It will take more than an IMF deal to resolve Ukraine’s underlying difficulties

  • By Simon Pirani
  • 14 May 2010
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Ukraine is struggling. Its new president, Viktor Yanukovich, has been able with surprising ease to appoint a government that he can work with – but has inherited a spending gap that will take more than one IMF lending programme to bridge.

Yanukovich appears to have only a limited appetite for the reforms the IMF is demanding. And despite his pro-Russian credentials, Moscow is equally unlikely to offer financial help without imposing conditions.

The economic outlook is only slightly less grim than the fiscal one. Prices for steel, Ukraine’s main export, are rising, and agriculture may also be a source of growth. But trade, industrial output and the banking sector have been ravaged by one of eastern Europe’s deepest recessions, and will return to health only slowly.

Ukraine has emerged from the crisis with a gap in its consolidated budget. Closing it will be a long, painful process that will go far beyond the current IMF lending programme, economists warn.

That programme, launched in October 2008, envisaged $14.6 billion of loans from the IMF, of which $10.6 billion had been disbursed by the end of last year. The programme was put on ice as the election approached and candidates offered voters ever more generous forms of social support. Talks on disbursing the final $4 billion are underway.

An IMF mission visited Kyiv to talk to the new government just before Easter, and Max Alier, the fund’s resident representative, said afterwards that “significant progress” had been made on “understanding 2010 budget priorities” – but that “a number of outstanding issues remain, notably with regard to fiscal policy”. Talks resumed in late April, and both IMF chief Dominique Strauss-Kahn and prime minister Nikolai Azarov have expressed optimism about the outcome.

The IMF is unlikely to scrap the programme, and, even if it did, Ukraine is unlikely to go bankrupt this year. The much greater dilemma is how the budget deficit will be reduced over the next three or four years, and how the government will satisfy IMF demands for cuts without provoking social protest.


The only public external liability this year is a ¥35.1 billion ($376 million) bond falling due in December; a dollar bond matures in March 2011. The market for hryvna-denominated Treasury bills ballooned in the second half of last year, with interest rates hitting 25–30% at one stage: in mid-February about 12.9 billion hryvna ($1.6 billion) was outstanding, more than 90% falling due in the first half of this year. But local banks have an appetite for this debt and it can be refinanced.

So markets no longer think in terms of imminent default: one-year CDS (credit default swap) spreads on Ukrainian state debt, which peaked at above 7,000 basis points early last year, have come down below 1,000bp.

Koon Chow, analyst at Barclays Capital emerging markets research, says: “We are quite pessimistic, medium term, about the sustainability of this government and the quality of its decision making. But we do not think Ukraine requires heroic or unrealistic efforts to avoid a debt-market accident.” Credit spreads have further room to compress, Barclays Capital says in a research note.

While the government is likely to string together a short-term package with the IMF, it seems just as far as its predecessors were from a strategy to tackle the deficit.

The consolidated budget deficit – which includes outlays on bank recapitalization, and budget support for the state oil and gas company Naftogaz Ukrainy (to pay higher gas import prices) and the pension fund (which has been borrowing from the treasury all last year) – is estimated by SigmaBleyzer, a US-based private equity firm that invests in Ukraine, at 11% for 2009 [see table]. Other economists, including the IMF, use similar figures.

The IMF says it wants the consolidated deficit to be cut to 6% in 2010, but no one can see how. The fund reportedly has public-sector wages, and extensive subsidies for gas and heating, in its sights. But Irina Akimova, deputy head of the presidential administration and one of the leading economists in Yanukovich’s team, said during last month’s talks that the authorities envisage a 10% gap this year.

Olga Pogarska, chief economist at SigmaBleyzer in Kyiv, says: “The government has promised a substantial increase in public-sector wages and pensions, and although it is trying to play some tricks that will reduce their scale, this will be a big liability each year.” Finance ministry officials say that even the most limited version of the wage increase will cost 24 billion hryvna this year.

“The government is trying to please the population – its voters – on the one hand, and the IMF on the other”, says Pogarska. “No one sees how it can reduce the deficit to meet IMF requirements this year. Painless measures will not be sufficient. And local elections are due, later this year or early next.”

Iryna Piontkivska, senior economist at Troika Dialog investment firm in Kyiv, says: “The government says it hopes to increase revenue, through new taxes, rather than cutting spending. But there is limited room for this in the Ukrainian economy.”

In fact profit tax receipts will be lower this year, by up to 17 billion hryvna, because some corporates pre-paid last year to help out the previous government; a government promise to business to slash its notorious VAT refund arrears could cost another 20–25 billion hryvna. And the economics ministry says that the untaxed economy has grown to 32–36% of the total – up from around 28% before the onset of recession.


It is hard to see international debt capital markets opening to Ukraine in a hurry. But could Russia – which is pleased to see the back of Viktor Yushchenko’s pro-Nato presidency and eager to reset relations with Ukraine – provide an alternative source of funds?

On April 1, Russian finance minister Aleksei Kudrin, in the latest of a series of conciliatory gestures, said that “all CIS countries... and that includes Ukraine” are invited to join the $10 billion Evrazes anti-crisis fund, set up by Russia, Belarus, Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan. Mechanics of the fund’s disbursement have not yet been made public. But presumably Russia, which funds Evrazes, would want, at least, improved access to Ukrainian assets – in the aviation, atomic and telecoms sectors, for example – in exchange for any substantial financial help.

Ukraine will face similar problems when it comes to paying its gas bill. For the first time this year, Naftogaz is paying import prices linked to those in Europe, without discounts – meaning that the import bill for the year will total around $9–10 billion.

The Yanukovich team expressed optimism that they would be able to renegotiate contracts, put in place after the January 2009 gas war, to bring down import prices. But initial trips to Moscow yielded no concessions – only a promise to revisit the possibility of establishing a Russo-Ukrainian-European consortium to manage Ukraine’s gas transit network.

A deal is likely, but it will probably not depart from the principle that Ukraine should pay European-linked prices, and will probably mean part-ownership, or control, of the pipelines by Gazprom of Russia.


Another factor that curbs Ukraine-watchers’ enthusiasm is that, while the new government is likely to work better than the previous one, its ability to push through reforms may be constrained by its close links with powerful business interests. “The government is too large and has too many political groupings in it to be as effective as it needs to be,” says Andrew Wilson, a senior policy fellow of the European Council on Foreign Relations.

Azarov and Yanukovich have long worked together, and a rift of the type that opened up in the last three years between Yushchenko and prime minister Yulia Tymoshenko is highly unlikely. But how the pair will deal with conflicting interest groups in the Party of Regions that they head is another matter.

Dmitry Firtash, the gas, chemicals and media billionaire who lost out when RosUkrEnergo was pushed out of the Russo-Ukrainian gas transit business at Tymoshenko’s behest, has surprised observers with the considerable influence he wields in the new cabinet. Firtash’s friend Yury Boiko has returned as energy minister, and a management team full of Firtash allies and former employees has been installed at Naftogaz.

Deputy prime minister for energy Andrei Klyuev also has his own business interests to defend (including power and nuclear sector assets). And neither of these camps is always aligned with that of steel-to-telecoms magnate Rinat Akhmetov, Ukraine’s richest man, who will find a voice in government via Boris Kolesnikov, the minister in charge of the state property fund, the anti-monopoly commission and preparations for the Euro 2012 football tournament.

It remains to be seen whether pro-European economic reformers such as Serhiy Tihipko, who came third after Yanukovich and Tymoshenko at the polls and is not affiliated to the Party of Regions, will make their voices heard amid these tensions.

One saving grace from a European standpoint is that Yanukovich is more pragmatic in his approach to the EU than his reputation would suggest. Wilson says that Yanukovich’s strong pro-Russian credentials may make it easier for him to sell rapprochement with Europe to Russian-speaking Ukrainians, rather in the way that the anti-communist US president Richard Nixon sold detente with China to Americans in the 1970s.

“Yanukovich might even become something like Ukraine’s Richard Nixon – not because he is corrupt, though that is also a danger, but because like Nixon he may be able to reposition Ukraine in geopolitical terms,” Wilson says.

But there are aspects of Ukraine’s economic recovery – and the living standards of its long-suffering citizens who depend on it – that will depend neither on the IMF, nor Russia, nor the country’s politicians. One such area is the agricultural sector, which last year kept growing counter-cyclically. Another is the steel industry.

The real economy certainly has a long way to come back. In 2009, reductions of 21.9% in industrial output, 46.2% in investment, 14% in private consumption, 40% in exports and 45% in imports, were registered.

Output for the steel sector should grow by 15% year-on-year Ivan Kharchuk, metals analyst at Troika in Kyiv, says, and will regain pre-crisis levels only in 2012–13. Strong world prices may boost steel companies’ revenues – and since the industry accounts for almost one-third of industrial output and a higher proportion of export, this will be an important driver of the economic recovery, he says.

The news from the banking sector and its ability to help restart the wider economy is mostly bad, however. Non-performing loans are estimated at 25%, and the government’s banking sector restructuring programme is moving slowly. “Slow credit growth will constrain economic growth, for sure,” says Pogarska at SigmaBleyzer. She forecasts 3% GDP growth this year.

Chow at Barclays Capital says: “There will be no return to a credit-driven boom.” No. By all accounts, the next one will have to be based on something more substantial.

  • By Simon Pirani
  • 14 May 2010

All International Bonds

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1 Citi 313,852.39 1175 8.95%
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3 Bank of America Merrill Lynch 281,869.72 974 8.04%
4 Goldman Sachs 214,547.99 704 6.12%
5 Barclays 205,147.76 790 5.85%

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1 Deutsche Bank 31,971.88 102 6.87%
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4 BNP Paribas 24,679.63 135 5.30%
5 SG Corporate & Investment Banking 22,195.55 122 4.77%

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4 UBS 13,028.25 52 6.86%
5 Goldman Sachs 11,994.74 65 6.31%