UKRAINE: Q&A ON POLITICS, GAS AND DEFAULT PROBABILITIES

By Timothy Ash, RBSMarketplace
Emerging Markets Strategy  | EM Alert | CEEMEA
Royal Bank of Scotland, London, UK, Thu, Nov 19, 2009

LONDON  - Ukraine seems to be flavour of the month at the moment in terms of the number of investor calls I seem to be fielding. These seem to be driven by two main motivations/concerns.

[1] First, there is a sense that all the negatives are now in the price, and with yields back up at 14-15% the question on investors minds is whether it is finally worth a punt now rather than waiting until after the presidential elections.

[2] Second there is concern that attempts to restructure a loan by the state-owned railways company, Ukrzaliznytsya, could trigger cross default clauses into other debt of the company which has sovereign guarantees and thereby trigger a sovereign default.

Given that many of the questions I am fielding are of a similar vein I thought it might be simplest to give my responses in a Q&A format.

Here goes:

Q? Do you expect the Constitutional Court (CC) to over-rule parliament/the presidency and throw out the bill which hiked wages/pensions last month by 20%, thereby derailing the IMF programme?

Answer: Don't hold your breath. The CC has a tendency to sit on the fence/procrastinate at the best of times. I sense they are likely to do so this time around. Even then, the CC works in strange and mysterious ways at the best of times, but I really doubt they would do something which runs against "popular sentiment" in the country this close to elections. In the past it has been widely criticised for being overly politicised, and herein I doubt that the voices of reason this time around will weigh in behind the government. I also doubt that the government could garner a majority on the bench.

Q? What is the chance of the government and the opposition (including herein supporters of the president) cutting a deal at the last minute to bring the IMF programme back on track?

Answer: Ukraine is currently in the midst of election campaign so I do not see any incentive for the opposition to make life easy for the incumbent government. Arguably the whole reason that the opposition and supporters of President Yushchenko approved the wages/pension hikes was to make life difficult for the government by in effect cutting off external funding for the government. Members of the presidential administration had previously complained that the IMF was being too political, in allowing the soft interpretation of its own conditionality, so as to maintain funding to the government.

The opposition complain that the IMF in effect were pump-priming the government in the run up to the election. With approval of the wages/pension bill it has been impossible for the government to push an IMF-compliant budget through parliament, and in effect it has made it impossible for the IMF to continue to lend to Ukraine, at least this side of presidential elections.

Q?  What do you think will be the impact of the looming confidence motion on the Tymoshenko administration?

Answer: My base case is that the motion will fail as the Regions opposition are just short of a majority, while I am not sure if enough members of Our Ukraine will be willing to line up behind Regions to bring the minority Tymoshenko administration down. In the event I am not sure it actually makes that much difference, as even if the Tymoshenko's administration loses the confidence vote it will still have to serve in an acting capacity until after the presidential elections.

Perhaps more worrying are suggestions by Regions that they might resume a boycott/blockage of parliamentary activity, albeit I doubt much will be achieved by parliament this side of presidential elections anyway. I doubt that a budget for 2010 can be approved, and if not the budget will be run on the basis of the 2009 budget, pro-rata.

Q?  Is there any chance that the IMF will give Ukraine a break, and just resume lending to Ukraine without approval of the 2010 budget?

Answer: Cat and Hell do immediately spring to mind. The IMF has been very charitable in my mind thus far in its dealings with Ukraine, e.g. appearing to allow the government to stall on gas price hikes this side of presidential elections. But even the new touchy feely IMF has its limits. At the minimum it would need a reasonably achievable, fundable budget for 2010, and with the pension/wage hikes boosting the deficit by 7% of GDP or thereabouts the figures simply do not add up.

Q? So when do you anticipate the IMF programme resuming?

Answer: For some time now I have been working on the assumption that the IMF would return to Ukraine soon after the presidential election, resuming a programme/disbursements once a new government is in office. I hold by that forecast. The IMF (and key IMF shareholders) is clearly supportive of Ukraine, it sees the country as strategic to the region, given its importance to regional gas transit. Ukraine's banking sector reform programme is also going reasonably well, Fund officials have committed a lot of time to the programme, and want to ensure its successful completion.

Q? So what's your call on the outcome of the presidential election?

Answer: The leader of the opposition, Regions of Ukraine, Viktor Yanukovych is leading in the polls, with a rating of 25-28%. Yulia Tymoshenko is next with 15-20%, and the former speaker of parliament, Arsenyi Yatseniuk, is polling third with 5-7%. Incumbent President Yushchenko is miles behind with a low single digit rating.

This is essentially going to be a two horse rate. Yanukovych will win the first round vote, but will then face a run-off with Tymoshenko. Despite his ten point lead at present, Yanukovych lacks pan-Ukrainian appeal, while Tymoshenko tends to poll well across Ukraine.

Yanukovych will be unable to pick up many votes in more nationalist Western Ukraine. Tymoshenko is also a dynamo on the election trail, which is probably worth a good 10% points. And ultimately the Orange vote will tend to line up behind Tymoshenko. Also notable this time around is that Tymoshenko is likely to be backed both by the EU/US, and also by Russia. The West appreciate the fact that she has a pro-EU agenda, but also bit the bullet in making difficult decisions over the IMF programme.

Interestingly, while Yanukovych and Regions are typically seen as being pro-Russian, Russia has cultivated relations this time with Tymoshenko. Moscow sees Tymoshenko as being much more open to deal making, whereas historically the Regions camp have used the pro-Russian mantra but not really delivered much in reality on Russia's agenda.

Herein, arguably the oligarchs behind Regions need good relations with Russia to ensure cheap energy and access to markets but want to keep Russian capital out of Ukraine which they see as a threat to their own dominance over the domestic scene. Tymoshenko will the second round vote 52:48.

Q? And what's the likely outcome in terms of forming the next government?

Answer: The problem for much of the past four years has been there has been an uncomfortable unstable equilibrium in relations between Tymoshenko, Yushchenko and Yanukovych. Frequently, Tymoshenko and Yushchenko wanted to cut deals with Regions but were wary of losing the Orange vote in a future presidential election.

With the presidential election out of the way, I don't think any of the parties will be averse to deal making. Remember in terms of policy there isn't a huge gap between the three parties. They are all generally pro-business, with a tendency towards populism. Tymoshenko is marginally more pro-Western, but understands that this has to be balanced against the need to maintain reasonably normal relations with Moscow.

The most likely scenario is cohabitation between a Tymoshenko presidency, and a Yanukovych led government. This could prove quite stable, with the main issue being the distribution/allocation of political patronage between the various business groups which support the two factions.

The coalition might though prove surprisingly stable, and we might actually see progress on the IMF front, and on issues such as privatisation, previously stalled by President Yushchenko. Perhaps the key challenge would be figuring out the best form of cooperation with Russia, with Tymoshenko likely to be willing to give more concessions than Yanukovych.

Q? Do you expect another energy war with Russia this winter?

Answer: There is no reason for a conflict. Ukraine has enough gas in storage to ensure supplies. Russia has no real reason to use the political card given that its arch nemesis, President Yushchenko, is set to lose the presidential election. Russia also now needs the FX from energy exports given its own economic situation is not as favourable as several years back.

Gas consumption has dropped dramatically in Europe, and Russia faces more competition in the market. It wants to prove it is now a reliable supplier to Europe and hence is eager to ensure gas supplies to Europe. From Ukraine's perspective, technically there seems no reason for problems in gas transit, given that Ukraine bought around 25bn cu metres of gas into storage over the summer. It does need to cover the monthly bill for gas bought from Russia of around US$500m.

Clearly with the government failing to agree to hike domestic gas prices as originally agreed with the IMF, this leaves the gas transit/supply company, Naftogaz short of funds, and in need of state support. Budget finances are clearly stretched at the moment, but given that this has to be a number one strategic priority for the country, resources should be made available from the NBU.

With US$27bn in FX reserves at the NBU, and given the IMF programme is already off-track, meeting a US$500m monthly bill for energy imports from Russia should not be problematic. Even we cannot believe that the IMF would be too upset if FX reserves were used for such a strategic priority given it also assures energy supplies to Europe.

All this said the issue is clearly complicated by domestic politics in Ukraine, and whether President Yushchenko, through his effective control of the NBU, might seek to block gas payments for some political purpose. However, even herein, recent comments by members of the presidential administration have suggested that they are supportive of NBU resources being used to assist in meeting the cost of the monthly gas bill to Russia.

Note that PM Tymoshenko has threatened to double the price it charges Russia for gas transit through Ukraine from the current rate of US$1.7 per 1,000 cu metres over 100km. However, we think that such an increase was precluded by the gas price deal reached with Russia last year. This might though all be part of the negotiating process, as Ukraine seeks to manage down the high take or pay agreement (41 bn cu metres) which potentially leaves the country exposed to high additional charges for gas.

Q? Will Ukraine default on its sovereign liabilities?

Answer: Never say never. It should not, as sovereign liabilities falling due over the next year are light, i.e. up to US$3bn, and the NBU still has US$27bn in FX reserves. And indeed my base line is no such scenario over the next year at least. That said it is sometimes difficult to figure out exactly what the agendas are of all the interested parties are in Ukraine.

For example, with the Naftogas restructuring I still cannot figure out how this was in the best interests of Ukraine. If you are going to run such a restructuring which almost inevitably damages the reputation/credit worthiness of the country/company, the benefits should be significant. In this instance the NPV reduction was hardly worth the effort in my mind. But Ukraine is always unpredictable.

Q? So what's your take on the Ukrzaliznytsya saga.

Answer: Well this company is state-owned, and it seems to be struggling to cover the payments on part of its external liabilities which do not carry a sovereign guarantee. The company has other external liabilities which have a sovereign guarantee. So the question then is are there cross default clauses back between these two separate liabilities and then back to the sovereign? If there are, are they likely to be triggered by creditors? Herein the situation gets very murky. We have failed to get a clear cut answer on the first of these.

But assuming that there are cross default clauses which can stand up in court (not clear in my mind), I still don't see the rational for creditors on the part of the companies' liabilities with a sovereign guarantee to trigger a formal default and accelerate. One hopes herein that the sides in charge of negotiations though are fully aware of all the facts; not a given.

And, given that the sovereign still has resources to cover the payments if they fall due, and have to be paid, we still do not see why they would allow a chain of events to occur that would eventually lead to a sovereign default, especially given that the sums of the outstanding loans are relatively small, and the sovereign's liabilities falling are relatively modest this year.

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