Emerging

Two months to forge a deal

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Ukraine

Two months to forge a deal

The pace of economic contraction accelerated to 17.2% year-on-year in Q1 2015. We expect real GDP to contract by 13-14% this year before starting to recover very gradually in 2016. Despite dangerously high-levels recently reached by CPI rates, the conditions for the hyperinflationary spiral are not in place for the moment. The economy’s downfall further weakened the government’s finances, enhancing the need to cut debt servicing costs. Despite several months of discussions, creditors have persistently rejected any principal write-downs. The next state debt principal repayment is due in September: Ukraine and its creditors have therefore two months to forge a deal.

Double-digit recession on cards

The Ukrainian economy has entered its second year of recession. In 2014 real GDP contracted by 6.8% and the pace of contraction accelerated at the end of the year. The first quarter of 2015 pointed to further deepening of recession, with real GDP down by 17.2% y/y.

On the production side, all sectors posted double-digit declines in Q1 2015. Mining and quarrying fell by 29.6% y/y while industrial production contracted by 25.6%. Both sectors are severely hit by the ongoing military conflict in Donbass, the region where the key mining and metallurgical facilities are located. Available estimates point to a contraction in industrial output by 88% y/y in Luhansk and by 51% yoy in Donetsk in May. Supply constraints affected exports, which fell by 35% y/y in nominal terms over the first four months of 2015, enhancing the external financing constraint (see below). The agriculture sector is contracting at a slower pace, but fails to “compensate” for the drop in the industry. Over the first five months of 2015, agricultural output contracted by 5.4% yoy. The construction sector suffered the most from revenue and liquidity squeezes, showing the deepest contraction among key sectors (-31.2% y/y over January-May 2015).

On the expenditure side, consumer spending plunged by 20.7% in Q1 2015 and the contraction in retail sales accelerated to 24.7% over the first five months of 2015. Fixed capital investment contracted by 25.1% over Q1 2015. Conversely, government consumption increased by 5% y/y in Q1, reflecting mainly growing military expenditures. But this has not been enough to compensate for the contraction in private demand so far.

On the revenue side, real wages contracted by 22.5% y/y over the first five months of the year. Corporates made an aggregate loss of UAH354bn, and only 53% of the total big and mid-sized enterprises generated profits over the first five months of the year. Prospects are negative for both consumption and investment. Moreover, the drop in revenues will seriously affect the state’s tax revenues in the coming quarters, further hampering the government’s capacity to support domestic demand.

1- Exchange rate and inflation

CPI inflation, % ▬ Exchange rate, variation, % (r.s.)

Sources: Datastream, BNP Paribas

Inflation approaches dangerously-high levels

Inflation peaked at 60.9% y/y (+14% mom) in April before decelerating to 58% y/y (+2% mom) in May. The jump in inflation was primarily due to the 34% currency devaluation (chart 1) followed by the 109.7% hike in utilities’ tariffs in April. The currency depreciated from UAH/USD15 to UAH/USD33 in February, before recovering to 21UAH/USD in May and staying at about the same level ever since.

The observed correlation between the exchange rate and CPI dynamics let us conclude that the pass-through of the currency shock is behind us. Moreover, despite dangerously- high levels reached by CPI rates recently, the extremely tight domestic liquidity prevents a formation of a hyperinflationary spiral. The state budget was in surplus in the first five months of 2015, and monetary policy stays highly restrictive: the policy rate has doubled since the beginning of 2015 to reach 30% in March and the monetary base has contracted since May.

This lack of liquidity limits the magnitude of the price-wage spiral. Wages adjust imperfectly to the prices: while the CPI expanded by 44% yoy over the first five months of the year, nominal wages expanded by only 13% over the same period. Recent trends show some stabilization in wage growth (+1% mom in May) as a result of a decline in monthly inflationary dynamics after the shock of March-April. Obviously, in the short term, the resulting drop in real wages and the credit crunch contribute to domestic demand contraction.

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Debt restructuring: two months to forge a deal

Of the aggregate USD40bn assistance package agreed in March 2015, USD15.3bn was supposed to be generated through reduced payments on Ukraine’s foreign debt liabilities.

Further IMF conditionality under the agreed bailout included slashing the public debt-to-GDP ratio to 71% by 2020. Ukraine has come out with an initiative to restructure USD19bn of its foreign debt held by private lenders. Proposed steps included debt principal reductions (a 40% haircut has been voiced by the Ministry of Finance), extension of maturities, lower coupon rates and, later on, an option of GDP-linked notes tuned to reduce the initial haircut (if any) if Ukraine’s macroeconomic performance exceeds initial projections.

Meanwhile, the status of the USD 3bn bonds held by Russia’s sovereign National Wealth Fund remains unclear. While Ukraine has included it inside the perimeter of the proposed debt restructuring, the Russian government insists the USD 3bn issue is official debt (thus refusing to participate in restructuring talks). This viewpoint seems to be shared by the IMF according to its staff’s preliminary view of June 22. The issue will obviously remain a “bargaining point” in the broad political negotiations between Russia and Ukraine. At the time of this writing the scenario of an orderly repayment of this bond looks the most likely as it will remove any controversies on the way to further IMF funding.

Despite several months of discussions, creditors have persistently rejected any debt principal write-downs, insisting the 71% debt-to-GDP threshold could be achieved without any haircuts. The group has also proposed to lower the coupon rates, as well as to postpone repayments until 2019 and beyond.

As the impasse in talks hardened, the IMF has effectively took

Ukraine’s side, signalling that, as long as Ukraine sticks to all other bailout conditionality, the Fund will continue supporting Ukraine. Therefore the current deadlock should not hamper the IMF’s next disbursement, which is expected by mid-July 2015. Furthermore, as Ukraine’s nearest Eurobond principal repayment falls due in September this year, this effectively gives Ukraine two more months to forge a deal without

2- State debt burden

State debt, % of GDP ▬ State debt servicing cost, % of GDP (r.s.)

defaulting on its foreign debt liabilities

Still, given the IMF back-up, the government may choose to raise pressure on creditors by imposing a moratorium on its foreign debt payments (the relevant option has been legislated by the Ukrainian parliament in May 2015 and may well be triggered as soon as on July 24 when Ukraine is to pay its next Eurobond coupon). Moreover, as Ukraine has largely gone through all the effects of a full-scale default (sharp currency depreciation, capital and deposit run with further capital controls imposed), the short-term impact of a payment freeze is likely to be limited. This decision would however raise a series of claims to accelerate repayments and may encourage the IMF to revise its position on the continuation of support.

For the time being, our base-case scenario envisages a comprehensive debt restructuring plan reached in Q3 this year. The gain from the debt restructuring for Ukraine would not be as high as initially expected in the IMF program and probably insufficient to put its debt on a sustainable path.

Outlook

Assuming a relative economic stabilisation in the coming quarters, we project a 13-14% GDP contraction this year. Risks are clearly on the downside and are tied to security (escalation of the conflict in the East), political (the deterioration of the population’s living standards may catalyse the discontent) and financial (risk of uncontrolled default followed by a new currency devaluation) issues. In the medium term, austerity measures that will be necessary to reduce the fiscal deficit (including that in the energy sector) and reduce the public debt load (in line with the IMF conditionality) will obviously be costly in terms of growth, but this is the price to restore macroeconomic stability.

Anna Dorbec, Ievgenii Orudzhev anna.dorbec@bnpparibas.com ievgenii.orudzhev@ukrsibbank.com

Forecasts

f : forecasts BNP Paribas

Sources: CBRT, BNP Paribas.

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