Welcome to the U.S.-Ukraine Business Council

Private Financial, Economic & Business Report
RBS Emerging Markets Strategy, Ukraine

By Timothy Ash, Head of CEMEX Research
Royal Bank of Scotland (RBS), London, UK, Monday, Nov 3, 2008 


We [RBS] visited Ukraine on October 30-31, meeting with government officials, representatives of the Ibis, local banks, diplomats and journalists.


Given that Ukraine has been in the eye of the global credit crisis storm which has rolled across Emerging Markets over recent weeks, and which precipitated a US$16.5bn IMF bail-out programme, the IMF deal was a central focus for discussion during the trip. And, encouragingly, just after we left Kiev, the Ukrainian parliament voted at second reading to approve key laws required to facilitate the implementation of the programme.

A common message from the trip was that political players across the political spectrum backed the programme, realising the difficulties that the economy faced. However, while, the Ukrainian parliament came up trumps in terms of approving the programme, the question remains as to how well policy makers will pull together to ensure the programme is successfully implemented.

In general the IMF programme appears well focused, well-funded and includes provision for significant technical assistance on an on-going basis from the Fund. The programme could be further augmented by funding from other official creditors.

The programme does provide a realistic chance of Ukraine managing its way through the current crisis, albeit the adjustment will nevertheless be significant and painful. We assume that real GDP growth will slow considerably and indeed we expect Ukraine to go into recession in 2009, with real GDP contracting by as much as 2%.

The current account deficit should moderate as domestic demand deflates, helped by a significant nominal and real exchange rate correction; talk locally was of the currency widening to perhaps UAH7-8:US$1 in 2009. This should help close the external financing gap, which will also be closed by likely selective restructuring of external liabilities in the corporate sector, and draw down in official reserves (IMF SBA funding).

We do not expect a default by the sovereign on its external liabilities which remain modest, whilst access to official financing will significantly improve its liquidity in the short term. We do not expect that the sovereign will follow the Russian model and extend a near universal implicit guarantee to meet corporate external liabilities. Only enterprises deemed strategically important (e.g. Naftogaz and Exurban) will be supported.

As the economy slows, banks will face rising Nils and some will need recapitalizing. The IMF’s approach to banking sector restructuring draws on international best practice, with the Turkish experience appearing particularly pertinent herein. Some banks, without systemic importance, will allowed to fail.

Insolvent banks with systemic importance, where existing owners are unable/unwilling to recapitalize will be taken over by a state restructuring agency and recapitalized via the issuance of government securities. Public sector indebtedness will increase, but with restructuring costs estimated at around 10-12% of GDP, public sector debt ratios will remain manageable, at 30-40% of GDP; assuming also that the NBU draws down the IMF SBA funds in full over the next 2 years.

The biggest risk to the above is continued policy paralysis, with long-standing political rivalries interfering in effective policy making. Encouragingly though political leaders from the two main Orange factions have signed up to the programme; and parliament approved key laws to facilitate the implementation of the programme on Friday.

IMF conditionality is relatively light, and for us this could be a key weakness, as the danger is for policy drift, particularly if the political landscape continues to be marked by intense personal rivalries between the key players.

Given the above 5Y Ukraine CDS trading at over 2,000bps appears very expensive, while cash bonds for both the sovereign and quasi-sovereigns (Naftogaz and Exurban) appear cheap.


It is perhaps useful to provide a backdrop to the fundamental causes of the current crisis:

•    Political paralysis (the presidency, government and parliament have all been at loggerheads in the period since the 2006 elections and indeed beyond), which has stalled key reforms, e.g. privatisation, and also seen the maintenance of pro-cyclical fiscal policy, e.g. reflected in large hikes in current spending in recent years.

     Note that while Ukraine has run small budget deficits in recent years, this has been achieved in an environment when revenue growth has been boosted by above plan GDP growth and inflation, and a boom in imports/spending which has boosted customs/VAT receipts.

     Unlike Russia, which built a huge buffer in the Stabilisation Fund/CAR reserves, Ukraine has a modest fiscal reserve (UAH20bn or so at present), plus a peak of US$38bn in foreign exchange reserves (3-4 months of import cover, and likely down to less than US$$34bn at present.

•    The terms of trade shock from collapsing steel/metals prices (40% of exports directly, and 17% of tax receipts), and expectations of higher energy import prices from Russia, as import prices inevitably adjust higher to world market levels. Steel production declined by 17% MOM in September, suggesting both a hefty price and volume effect on the economy.

     Generally the assumption is that gas import prices increase to US$230-250 per 1,000 cu metres in 2009, from US$179.5 per 1,000 cu metres in 2008, as Russia continues to move to market prices for energy exports to Ukraine.

•    An economy which showed all the signs of overheating, as reflected in high inflation, a wide (and widening) current account deficit (6-7% of GDP), fed by rapid growth in consumer credit (50-60% annually, up until September) itself funded by resort to borrowing overseas; the stock of external debt has quadrupled since 2004 to stand at over US$100bn (June 2008),

•    Ukraine was able to fund high external debt roll-over's/a wide current account deficit while global markets remained liquid. However, as global liquidity conditions have tightened in the wake of the deepening global credit crunch, concern has intensified as to Ukraine’s ability to fund its large external financing gap.

     Note that estimates vary in terms of the country’s external financing needs over the year ahead; our rough estimates suggest a current account deficit of US$5-8bn in 2009 (assuming the IMF reform strategy is implemented, credit growth slows to a virtual standstill, the UAH corrects both nominally and in real terms and domestic demand deflates), US$28bn in short term debt, and US$15bn in medium and short term debt amortizations.


•    Funding: US$16.5bn in a 2-year stand-by front-loaded, with quarterly disbursements. The facility amounts to around eight times Ukraine’s IMF quota; and is primarily designated for supporting the balance of payments, i.e. helping close the external financing gap.

     There is a strong possibility that the programme could be further augmented by financing from other bilateral/multilateral creditors. Indeed, it is not unreasonable to assume that a further US$4-5bn could be provided by other official creditors in support of the IMF programme.

•    Technical support: Strong provision of technical support, with the possibility of help herein from other donors, e.g. in the area of bank reform/restructuring.

•    Fiscal restraint: While recognising that the current crisis does not particularly have its origins in public finance, the programme recognises that the wide current account deficit suggests limited scope for loose fiscal policy. Indeed, given the assumption of a significant weakening of the UAH, and pass thru to inflation, the programme targets balanced budgets from 2009, with a modest deficit in 2008. Quasi fiscal deficits, e.g. from supporting state-owned enterprises, such as Naftogaz, are to be brought within the budget.

•    Incomes policy: The programme commits the government to limit public sector pay increases to productivity growth, thereby helping reign in overheating (inflation & the current account deficit). In effect the government agrees to freeze pay hikes already committed.

•    Monetary and exchange rate policy: In order to help close the external financing gap, the NBU will be encouraged to allow the UAH to float more freely, and to move to inflation targeting. In the interim, and until effective tools of monetary policy (e.g. interest rates) are developed, the nominal anchor provided up until recently by the exchange rate will need to be replaced by other nominal anchors, e.g. targeting money supply.

     Given the size of the external financing gap which will need to be closed, it is not unreasonable to assume a significant nominal and real exchange rate correction (UAH7:US$1 or weaker in 2009).

      The NBU will be permitted to intervene for smoothing of exchange rate volatility, but is not expected to intervene on a more sustained and regular basis. The hope is clearly that the programme will provide sufficient confidence to ease selling pressure on the UAH. The programme also includes targets for Net International Reserves, which will provide some limits to FX intervention by the NBU.

     The hope also is that the NBU is able to more effectively communicate exchange rate policy to the market; part of the problem in recent weeks is that it has been unclear what the NBU has been trying to achieve via its interventions (with the loss of over 10% in reserves) while the UAH has you-yoked between UAH: 5-7.2: US$1.

•    Privatisation: The government will be encouraged to push forward with state asset sales in order to help cover both public and external financing needs. No specific targets are however set as this was considered unfair in the light of difficult market conditions which might limit specific interest in assets likely to be put under the hammer.

•    Energy policy: The government agrees to move domestic energy prices to cost recovery levels and to equalize domestic gas prices, e.g. between industrial, household and municipal users. The price adjustment is to occur over the term of the SBA. Note that already a significant 35% gas price hike has already been agreed for 2009.

     Energy price hikes would go a significant way to help to resolve the problems of Naftogaz, and indeed help reign in quasi-fiscal deficits from supporting the operations of state-owned companies in the energy sector. There seems to be no requirement in the SBA to force the government to restructure the liabilities of Naftogaz, and the IMF appears to have no objections to the extension of a sovereign guarantee to Naftogaz providing it is within limits on state guarantees more generally.

•    Bank restructuring: The programme recognises that the sector faces challenges both in terms of meeting a weight of external liabilities falling due (likely US$12bn over the next year; our estimates), plus a deterioration in asset quality as the economy slows, and Nils likely increase. Banks will need recapitalizing.

     Confidence in the sector is weak, as reflected in the run on deposits which followed the failure of Prominvestbank (Ukraine’s 6th largest bank) in October; as much as 5% of deposits were lost over the course of the month, albeit the deposit draw down appears to have stabilised in recent days. A comprehensive bank restructuring programme, along with BOP support for the UAH, is seen as key to restoring confidence in the banking sector.

     The programmer's banking component aims to use international best practice, and seems to draw heavily on the “Istanbul approach” which proved successful in cleaning up Turkey’s banking sector after the crises of 2000-2001; the fact that the IMF mission chief to Ukraine, ran Turkey’s bank restructuring agency (BRAS) no doubt played a part herein. 

     Essentially the programme aims at running a diagnostic check on the top tier of banks in Ukraine (170 banks currently in operation) in the period to the end of 2008. Banks will be audited and categorized into groups depending on whether they are liquid, solvent and systemically important.

     Banks which are liquid and solvent will be given a clean bill of health and allowed to graduate from the diagnostic check. Banks which are solvent but are facing some short term liquidity facilities will receive liquidity injections from the NBU.

     Banks which are facing liquidity problems but are also deemed to be insolvent, will then classified as systemically important or not. Those deemed not to be systemically important will be wound up, unless shareholders are able to recapitalize their operations. Those deemed systemically important and where shareholders are unable/unwilling to recapitalize their operations will be taken over by a bank restructuring agency (akin to the BRAS in Turkey).

     These banks will be recapitalized by the government, e.g. by deposit of government securities on their books, which can then be used for repo operations with the NBU. It is unclear how much the above programme will cost. But similar bank restructuring programmes, e.g. in Turkey in 2000-2001, are estimated to have cost the equivalent of 25% of GDP.

     Given that 43% of the banking sector is foreign owned, and assuming that foreign bank operations will be recapitalized by parent banks (not necessarily a given in current global market conditions), the cost is likely to be 10-12% of GDP which will inevitably fall on the Treasury.


•    The combination of worsening terms of trade, the closing of external (market) financing channels, and tight fiscal policy, will produce a significant deflation in domestic demand and we expect the economy to contract by 2% for the full year in 2009; from growth of around 6% expected in 2008.

•    Inflation is expected to slow quite considerably in 2009. While exchange rate weakness will produce a significant pass thru to inflation, the collapse in credit growth, slowing in export demand and weak food price inflation due to the record harvest in 2008 will provide broader pressure to deflation. The CPI has already declined from a peak of 31.1% in May to 24.6% YOY in September.

•    Ukraine is set to undergo a significant terms of trade shock over the next year, reflecting a marked slowdown in prices for steel, and associated products, and continued hikes in energy import prices. For the first 9 months of 2008 the current account amounted to US$8.4bn, or US$11.7bn on an annualised basis (equivalent to 6.6% of GDP).

     Net FDI amounted to US$8.9bn over the same period, i.e. providing full coverage of the CAD. Net inflows of M&LT debt amounted to US$12.9bn, two thirds of which were bank related. Market estimates of the size of the current account deficit have varied from US$10-25bn for 2009.

     We have been on the low end of the consensus, assuming that despite the obvious terms of trade shock which is on-going, the deflation in domestic demand, plus the impact of a weaker currency will begin to reign in the current account deficit. Official projections of a current account deficit of US$5-8bn in 2009 do not appear unrealistic in our view.

     It is more difficult to gauge likely trends in net FDI and in debt roll-over's. Much of the net FDI into Ukraine has been “local” i.e. with its origin being off-shore, the assumption is that it is local Ukrainian/Russian investors putting money to work in Ukraine.

     How well positioned these investors are still, after the recent sell-off, to maintain inflows is open to question. What seems clear though is that with valuations hitting rock bottom, for Russian investors (e.g. state-owned banks) this period could prove a great opportunity to pick up strategic assets cheaply; again assuming they have the ability – note however that Burbank and VET branches are very prominent in Kiev, and Burbank has been mooted as a potential bidder for Prominvestbank. This process might act to underpin FDI inflows.

In terms of debt roll-over's: a number of factors were considered supportive:

a) the relatively high foreign ownership of the banking sector (43%), with French/Austrian banks still seeming very committed to their investments in Ukraine and hence likely to “roll” liabilities.

b) a significant proportion of foreign borrowing consists of inter-company loans, and are again very likely to be rolled.

c) A weight of ST debt consists of trade finance, which is again very likely to be rolled. Inevitably, though capital inflows will slow and there will be some restructuring of external liabilities in the private sector. The IMF programme has though been sized to cover any likely external financing gap.

Timothy Ash
Head of CEMEX research
Royal Bank of Scotland
135 Bishops

NOTE: This material has been prepared by The Royal Bank of Scotland plc (“RIBS”) for information purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy.  This material should be regarded as a marketing communication and may have been produced in conjunction with the RIBS trading desks that trade as principal in the instruments mentioned herein. This commentary is therefore not independent from the proprietary interests of RIBS, which may conflict with your interests. Opinions expressed may differ from the opinions expressed by other divisions of RIBS including our investment research department.  This material includes analyses of securities and related derivatives that the firm's trading desk may make a market in, and in which it is likely as principal to have a long or short position at any time, including possibly a position that was accumulated on the basis of this analysis prior to its dissemination.  Trading desks may also have or take positions inconsistent with this material. This material may have been made available to other clients of RIBS before being made available to you. Issuers mentioned in this material may be investment banking clients of RIBS. Pursuant to this relationship, RIBS may have provided in the past, and may provide in the future, financing, advice, and securitization and underwriting services to these clients in connection with which it has received or will receive compensation.  The author does not undertake any obligation to update this material.  This material is current as of the indicated date.  This material is prepared from publicly available information believed to be reliable, but RIBS makes no representations as to its accuracy or completeness.  Additional information is available upon request. You should make your own independent evaluation of the relevance and adequacy of the information contained in this material and make such other investigations as you deem necessary, including obtaining independent financial advice, before participating in any transaction in respect of the securities referred to in this material.


United Kingdom. Unless otherwise stated herein, this material is distributed by The Royal Bank of Scotland plc (“RIBS”) Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB.  Company No. 90312.  RIBS is authorised and regulated as a bank and for the conduct of investment business in the United Kingdom by the Financial Services Authority.  Australia. This material is distributed in Australia to wholesale investors only by The Royal Bank of Scotland plc (Australia branch), (ABN 30 101 464 528), Level 48 Australia Square Tower, 264-278 George Street, Sydney NSW 2000, Australia which is authorised and regulated by the Australian Securities and Investments Commission, (AS License No 241114), and the Australian Prudential Regulation Authority.  France. This material is distributed in the Republic of France by The Royal Bank of Scotland plc (Paris branch), 94 boulevard Haussmann, 75008 Paris, France.  Hong Kong. This material is being distributed in Hong Kong by The Royal Bank of Scotland plc (Hong Kong branch), 30/F AIG Tower, 1 Connaught Road, Central, Hong Kong, which is regulated by the Hong Kong Monetary Authority.  Italy.  Persons receiving this material in Italy requiring additional information or wishing to effect transactions in any relevant Investments should contact The Royal Bank of Scotland plc (Milan branch), Via Trait 18, 20121, Milan, Italy.  Japan. This material is distributed in Japan by The Royal Bank of Scotland plc (Tokyo branch), Shin-Marunouchi Center Building 19F - 21F, 6-2 Marunouchi 1-chime, Chiyoda-key, Tokyo 100-0005, Japan, which is regulated by the Financial Services Agency of Japan.  Singapore. This material is distributed in Singapore by The Royal Bank of Scotland plc (Singapore branch), 1 George Street, #10-00 Singapore 049145, which is regulated by the Monetary Authority of Singapore. RIBS is exempt from licensing in respect of all financial advisory services under the (Singapore) Financial Advisers Act, Chapter 110.

United States of America.  RIBS is regulated in the US by the New York State Banking Department and the Federal Reserve Board. The financial instruments described in the document comply with an applicable exemption from the registration requirements of the US Securities Act 1933. This material is only being made available to U.S. persons that are also Major U.S. institutional investors as defined in Rule 15a-6 of the Securities Exchange Act 1934 and the interpretative guidance promulgated hereunder.  Major U.S. institutional investors should contact Greenwich Capital Markets, Inc., (“RIBS Greenwich Capital”), an affiliate of RIBS and member of the NASD, if they wish to effect a transaction in any Securities mentioned herein.

This material is for information only. It is not an offering document and its terms are qualified in their entirety by the final transaction documents in respect of the securities described therein. Certain transactions mentioned may give rise to substantial risks and may not be suitable for all investors. RIBS may have positions, deal or make markets in these securities or related derivatives. Prices are based on current information, are subject to change, are not offers to transact and cannot be relied upon as representations that transactions can be effected at such prices. This material is based on information considered to be reliable, but we do not represent its accuracy or completeness
NOTE:  A few format edits have been made by USUBC.