Calm… before the storm?

July 2012  
Calm… before the storm?  
Economic activity is getting stuck: growth and inflation are approaching zero. “Twin deficits” problem remains: the rise in  
social spending endangers the fulfilment of deficit targets, while the increase in gas import prices weighs on external  
imbalances. UAH became more volatile recently. The exchange rate correction, followed by the change in the currency  
regime looks increasingly likely.  
No growth, no inflation.  
No growth, no inflation  
GDP expanded by 2% year on year (y/y) in the first quarter,  
slowing down substantially from the growth rate of 5.3% y/y  
registered in 2011. Industrial growth almost stalled: over the  
first five months of 2012 industry expanded by only 0.7%, which  
is negligible, compared with the growth of 7% demonstrated in  
yoy growth rates  
Industrial production growth ; --- Consumer price index  
2011. Activity slowed in agriculture as well: after an exceptional  
9% in 2011, agriculture delivered a more modest growth of  
0.5% y/y (Chart 1).  
Inflation has reached record lows. Driven by food price  
decrease, CPI inflation stood at only 1.7% y/y over the first five  
months of 2012. This deceleration is impressive, especially if  
we remember that last summer inflation was in double-digits  
Demand indicators “mechanically” benefit from low inflation.  
Retail sales expanded by 15.5% y/y in real terms over the first  
five months of the 2012, while investment posted a record  
Source : UkrStat  
23.2% growth.  
The budget program for 2013 envisages reducing fiscal deficit  
to 0.8-1% of GDP and is in line with the stand-by program’s  
commitments. It is based on the relatively optimistic assumption  
for real GDP growth (4.5% y/y) and the expected inflation of  
5.9%. Budget revenues are expected to grow by 17% in  
nominal terms, while spending growth will moderate to 11.6%.  
Government finances: pre-electoral spending hike  
may prove destabilizing  
The government deficit has been contained at UAH3.3bn over  
the first five months of the year (1.4% of GDP) and even posted  
a surplus in May. Revenues expanded by 14%, while  
expenditures grew by 17% in nominal terms. The government  
successfully rolled over its debt, borrowing UAH36bn and  
redeeming UAH17bn. This performance is however darkened  
by losses made by state-owned operator Naftogaz. The  
company lost UAH20bn (US$2.5bn, 2% of GDP) in 2011 and  
UAH4bn (US$500mn) in Q1-2012.  
Gas negotiations deadlocked  
Since 2010, the Ukrainian authorities have multiplied efforts to  
renegotiate the gas agreements signed with Russia in 2009. In  
2010, they obtained a 30% discount, in exchange for the  
prolongation of the rent of the Sebastopol port for Russian Black  
Sea fleet. But the oil price, to which the gas import price is indexed,  
has increased since. In 2011, gas import price attained  
US$329/1000cm, increasing by more than 26% y/y, and is set to  
reach US$432 in Q3-2012. Until now, despite the frequent  
meetings that involve gas companies and politicians of both  
countries, the two sides failed to reach an agreement. Gazprom  
offered a substantial discount (reportedly reducing the price to  
Prospects for the coming months look less promising. The  
economic slowdown will weight on revenue growth. Gas import  
price keeps rising and will deepen the deficit of Naftogaz further.  
The amendments to the 2012 budget, that boost social  
spending in a run-up to October legislative elections will  
deepen the deficit by 1%-1.5% of GDP. A new wave of  
reimbursement of lost Soviet-era savings will increase budget  
expenditure by about UAH6bn or 0.4% of GDP. Besides, the  
increase in pensions will add 4% to the pension fund’s  
expenditures and will cost additional UAH5.6bn (0.4% of GDP)  
to the budget this year.  
200$-250US$/thcm) in exchange for the ownership of the pipeline  
system, but Ukraine is unwilling to loose control over this strategic  
asset. The solution that looks more acceptable for the Ukrainian  
side - the sell of the pipeline system to a three-party consortium  
that will also include European gas companies, in which Ukraine  
will keep 34%; seems not satisfactory for Gazprom.  
The rationale of this spending hike is uneasy to explain to the  
IMF that remains sceptical about the ability of the authorities to  
fulfil the deficit target (1.8% for 2012) and did not approved the  
disbursement of new stand-by loan tranches.  
As the negotiations are not progressing, Ukraine is trying to find  
alternative solutions to reduce the price of gas deliveries. In  
early June, Ukraine announced that it agreed to buy up to 5bcm  
of gas at spot price (that is currently lower than that of  
July 2012  
Gazprom) from RWE of Germany. At the same time, gas  
imports contracted, which means that Ukraine is not purchasing the  
gas to store it until the winter consumption peaks. As Gazprom is  
liable to be able to deliver sufficient volumes of gas to its EU  
counterparts (and it is technically impossible to deliver all the gas to  
cover peak demand in winter), it had no choice but to pre-finance  
them, providing a loan of US$2bn to Naftogaz. But Gazprom sticks  
so far to the “take or pay” clause of the 2009 agreements and  
refuses to lower the volumes of annual gas purchases, which  
substantially limits the capacity of Ukraine to diversify gas  
purchases. Currently, Ukrainian authorities are willing to order only  
„ The currency depreciated slightly  
After 2 years of “reunification”, when the interbank exchange  
rate had remained very close to the official quotation, the rates  
have disconnected again in 2012 (Chart 2). Market exchange  
rate peaked at UAH8.13/1US$ on June 11th, before adjusting  
slightly downwards to 8.09 on June 25th. The official rate had  
remained at 7.99 over this period. The NBU was almost absent  
in the currency market in May, which indicates that the strategy  
of nominal exchange rate stability may be under revision. In  
May and June, liquidity conditions tightened substantially,  
reflecting increased global market risk aversion (Chart 2). In  
reaction to this tighter environment, the NBU has eased  
conditions of its refinancing operations. The maximum maturity  
of the refinancing lines available was extended from 90 days to  
360 days and for the REPO transactions - from 60 to 90 days.  
27bcm for 2013 (the same amount as in 2012). But Gazprom’s  
head Alexey Miller declared that the agreements stipulates the  
annual purchase of 52 bcm in 2013 claiming that this volume is  
necessary to Ukraine avoid disruptions during the winter  
consumption peaks. The two sides look not ready to find an  
agreement, unlikely before the elections of October.  
May it hold?  
The task of balancing foreign exchange market is becoming  
extremely delicate. Official foreign reserves reached  
US$30.8bn end-May, contracting by 19% y/y. External debt  
redemptions remain substantial, while global markets’ appetite  
towards Ukraine is low. Obviously, greater exchange rate  
flexibility is in the interest of Ukraine in the medium run. But in  
current conditions (approaching elections, substantial  
dollarisation of residents’ balance sheets and stress on global  
markets), the NBU is likely to avoid substantial exchange rate  
fluctuations. Maintaining exchange rate stability may require  
sharp liquidity tightening and even restrictions on convertibility  
for companies or banks. As the access to the dollar is a highly  
sensitive issue, we believe that restrictions will not be imposed  
to households.  
The gas factor will be pivotal: the agreement allowing cheaper  
gas imports will ease the “twin deficit” problem, provide new  
FDIs and open the way for the IMF to continue the Stand-by  
program. But global markets’ attitude towards risk (that  
currently governs prices for a wide range of assets, from steel  
to emerging currencies) remains the key uncertainty at the  
moment. Hryvnia’s fundamentals are not strong enough to  
resist the long-running period of global risk aversion.  
Peg’s fundamentals are not very strong  
The persistent current account deficit, high dollarisation (capital  
outflows) and insufficient attractiveness for foreign investors  
underline the fragile currency. Over the first five months of the  
year, the current account posted a deficit of US$2.6bn or 4% of  
GDP. Exports expanded by a modest 5% y/y. Steel exports  
disappointed, contracting by 12% y/y. The 6% expansion of G&S  
imports hided diverging trends as well: the 23% contraction in  
gas imports somewhat compensated for the 48% expansion in  
imports of vehicles.  
Despite on-going privatisations, FDI contracted by 36% y/y in  
January-May, reaching US$1.8bn, and net borrowings attained  
US$1bn. While the government was desperately looking for new  
external loans, households continued to purchase foreign  
currency cash: residents’ FC cash holdings expanded by  
US$2.6bn over the first five months of 2012. In June, the MinFin  
agreed with Russian VTB on a private US$1bn Eurobond  
placement. This de facto partly rolls over the US$2bn loan that  
was redeemed earlier this month. However, external liquidity  
remains precarious.  
Disconnected again ?  
Anna Dorbec  
Interbank rate (o/n), %, right scale  
Market exchange rate (UAH/US$) left scale ;  
Official NBU exchange rate (UAH/US$) left scale  
Summary of forecasts  
010 2011 2012f 2013f  
Real GDP growth (%)  
Inflation (CPI, year average, %)  
Gen. Gov. balance / GDP (%)  
Gen. Gov. debt / GDP (%)  
Current account balance / GDP (%)  
External debt / GDP (%)  
Forex reserves (USD bn)  
Forex reserves, in months of imports  
Exchange rate UAH/USD (year end)  
f : BNP Paribas Forecasts  
Jun 11 Jun 12  
Sep 11  
Dec 11  
Mar 12  
Sources : Global insight, Datastream, National bank of Ukraine, BNPP  
QUI SOMMES-NOUS ? Trois équipes d'économistes (économies OCDE, économies émergentes et risque pays, économie bancaire) forment la Direction des Etudes Economiques de BNP Paribas.
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