Ukraine : The spectre of default

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The spectre of default

Pro-European parties came out on top in Ukraine's early elections (presidential and parliamentary), stabilising the political situation. However, the economy is sinking: GDP is falling and prices are soaring. External liquidity is continuing to dwindle: reserves have reached critical levels and the currency remains on the slide. Fears of a sovereign default have emerged again. The IMF has said that the Ukrainian government needs another USD 15bn to meet its financial obligations. A debt restructuring can no longer be ruled out. The only way of avoiding would involve the Ukrainian authorities showing very strong commitment and international creditors taking a generous approach.

Pro-European parties in power

Ukraine's early elections – presidential on 16 June and parliamentary on 26 October 2014 – stabilize the political situation. As it was largely expected, they were won by pro- European parties. Arseniy Yatsenyuk's Popular Front led the way with 22.1% of the vote, followed very closely by the Petro Poroshenko Bloc (21.8%). After a delay that many found rather long, parliament approved Mr Yatsenyuk as prime minister. Ukraine's president Petro Poroshenko has now a full support from the parliament and the cabinet to put in place the reforms the country needs crucially, notably to continue receiving financial support from international institutions. In particular, the European Commission wants to see a strong, sustained commitment to reform as regards governance, the harmonisation of legislation and standards, and the strong commitment to reform the energy sector (energy saving measures, gas transportation and nuclear safety). The Commission is waiting for the new cabinet to announce its reform strategy before organising its donors' conference, which is vital if Ukraine is to cover its immediate financial needs. The IMF programme is conditional on fiscal consolidation, which is currently impossible without major anti- corruption efforts and an overhaul of tax, social transfers and pensions system. Implementing those reforms at a time when the economy is contracting will obviously be painful and could be costly for the new government's popularity. As a result, the current greater cohesion between today's ruling political forces is a necessary condition for pushing through the reforms, but probably not a sufficient one.

A sinking economy

GDP has been contracting since Q3-2012, if we ignore the exceptional and unexplained 3.7% year-on-year jump seen in Q4-2013. As expected, the contraction has accelerated in 2014. In Q3-2014, GDP shrank by 5.3% year-on-year.

Industrial production has also been falling since 2012, when it declined 0.7%, followed by a 4% drop in 2013. The manufacturing sector has become a hostage to the conflict in Donbass, and its contraction has deepened in 2014, with output down 16.3% year-on-year between January and October. Manufacturing has slumped 60% in the Donetsk region.

1 - Inflation and exchange rate

Inflation, yoy, left scale — UAH, yoy, right scale

Source: Datastream, BNPP

Agriculture seems to be performing surprisingly well against the bleak backdrop in other sectors, with output rising 26% annualised in Q3-2014. However, that figure was probably biaised by seasonal effects, since the 2013 harvest took place later in the year. At the end of the 2014 harvest season (mid- December), the cereals harvest totalled 64m tonnes, up 2.6% relative to 2013.

Consumer spending has cracked, falling 13.2% in Q3 after a 2.3% contraction in Q2. Public-sector consumption is showing greater resilience at the moment, falling 0.8% year-on-year in Q3 after rising 7% in Q2. However, given the government's current financial situation, the effect may be only temporary. Investment has ground to a halt, and fell 30% year-on-year in Q3-2014 after contracting 18% in the first half of the year. Foreign trade is also falling. Exports were down almost 20% in Q3-2014, after declines of 2.3% in Q1 and 7.4% in Q2. Imports fell by a third year-on-year in Q3-2014, due to the contraction in domestic demand and Ukraine's weakening currency.

The price stability that Ukraine experienced in 2013 was short lived. Inflation has been in the double digits since May 2014 and hit 22% in November. Despite a good harvest, food price inflation is running at 20%. The cost of public services is rising at a rate of around 33% on average, with increases of 63% for gas prices, 43% for heating, 47% for water and 69% for wastewater treatment. Inflation has therefore been pushed higher by devaluation (figure 1) and rising energy prices.

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Deteriorating financial position

Despite the fall in imports, the current account is still in deficit. In the first 10 months of 2014, the deficit amounted to USD 4bn (3.5% of GDP). Although it has shrunk relative to 2013 (USD 16bn or 9% of GDP), it remains a problem, since Ukraine is unable to attract private-sector financing.

The Ukrainian currency has lost almost half of its value in the last year, with one US dollar now buying UAH 15.7 as opposed to UAH 8 a year ago. Currency reserves are now being used to repay debts (USD 897mn in November) and pay for "critical" imports (USD 1.45bn to repay debts owed to Gazprom, which should allow supplies to continue over the winter). As a result, currency reserves have fallen constantly, and amounted to USD 9.9bn at 1 December 2014.

Between now and the end of the year, Ukraine will have to make overdue payments to Gazprom (USD 1.65bn) and redeem maturing market debts (USD 283m). In 2015, it will have to repay USD11 bn (in various currencies), equal to 8.6% of GDP, including USD8.3 bn (6% of GDP) of foreign- currency debt and USD1.5 bn (1% of GDP) of IMF debt. Clearly, with the ongoing current-account deficit, almost no access to private-sector financing and very low currency reserves, the Ukrainian government cannot make all those payments without help.

Ukraine is receiving macro-financial support from the

European Commission. It has received €1.8bn (USD2.3 bn) under two macro-financial assistance programmes (MFA I and

II), and can draw a further €250 m (USD309 m) in the next few months. The IMF programme (USD17 bn) also has potential. So far, Ukraine has been able to draw USD4.4 bn but has had to repay USD3.3 bn to the IMF over the same period, and so the IMF's net support has been only USD1 bn.

Renewed fears of a sovereign default

Against the background of increasing uncertainty about the real economy's ability to withstand multiple shocks (armed conflict and destruction of manufacturing facilities in the East, currency depreciation, serious pressure on domestic and

1- Ukraine CDS spreads: the markets are worried about default

Basis points

Spreads CDS 5Y, Government of Ukraine

external liquidity), Ukraine's CDS spread surged to 2,608bp on 11 December (figure 2). That figure reflects pressure on liquidity and the markets' justified concern about the government's solvency.

According to Finance Ministry figures, fiscal income increased 2% year-on-year in nominal terms in the first 10 months of 2014. Spending increased 4% in the same period, and so the Ukrainian government has been running a deficit equal to 3% of GDP this year. Although the deficit figures do not look huge, the fiscal equation appears increasingly difficult to solve. The 2015 budget is still being discussed. The IMF delegation left Ukraine before signing any memorandum, leaving little chance of new financing before the end of the year. According to the IMF's estimates, the country could need its programme extending by up to USD 15bn to cover repayments of external debts.

Three scenarios may be viewed as possible. The first, which may be defined as optimistic, would require the government to adopt extreme austerity, running a primary budget surplus of around 2-3% of GDP in the short and medium term. With regular monitoring from the IMF and with international creditors providing de facto refinancing of maturing debt in the next 1-2 years, Ukraine could avoid a debt restructuring. The most difficult task will probably be to convince creditors that austerity efforts are credible. Such efforts would carry obvious socio-political risks that have always prevented the implementation of austerity policies in the past. The second scenario would involve an "orderly" debt restructuring supervised by the IMF, followed by a conservative fiscal policy. Thirdly, given the difficulties experienced by the authorities and creditors in reaching agreements acceptable to both sites, along with possible problems in getting creditors (which include Russia) to agree among themselves, the scenario of a "disorderly" default cannot be ruled out.

Anna Dorbec anna.dorbec@bnpparibas.com

Summary of forecasts

f: BNP Paribas forecasts

Source: Datastream

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