The renewal of cooperation with the IMF and the launch of a new loan program remains the key determinant of market expectations domestically and internationally. The deal will allow the government to remain current on its maturing debt through 2019 and allow NBU reserves to remain at healthy levels. Economic growth remains robust at above 3%, while inflation is likely to accelerate by end-2018 to near 10%, fueled by buoyant private demand. Unexpectedly, the C/A deficit widened recently, leading us to downgrade our outlook for the FY C/A shortfall to 3.8% of GDP from 2.1% previously.

Economic growth remains robust at above 3%

GDP growth has been robust, but the 2H will be softer than 2Q’s 3.8% yoy increase, which was driven largely by an early harvest. Growth remains uneven – industrial production has dipped back to negative territory yoy since July after the subtle growth of 1H. Weakness in external markets and transportation problems are among the factors at play. Meanwhile, domestic-oriented sectors are growing at a healthy pace – in particular, retail sales continue to grow more than 5% yoy in real terms. Private household demand will remain the key growth driver in the near term; however, imports will cover much of that demand. FY GDP growth is close to delivering our projection of 3.4%. We continue to expect a material deceleration next year on the back of tighter fiscal policy and election-related uncertainty.

CPI to accelerate by end-2018 on strong private demand

Inflationary pressures remain elevated as CPI came in at 8.9% yoy in September (down from 9.0% in August), still growing faster than we had expected. Both fundamental factors and one-offs remain at play. Growth in nominal salaries continues to hover above 20% yoy – a direct result of the fierce competition for qualified and unqualified labor. Surging salaries are adding to price pressures in many service segments. Demand-side pressure are manifested through an elevated core inflation – 8.7% yoy at end-September. Additionally, more expensive global crude oil (before the price reversal of recent weeks) spilled into the local market, pushing fuel prices (almost 4% of the consumer basket) up 5.4% mom and 22.7% yoy. Looking ahead, we expect demand-side pressures to persist over at least the next two quarters, however, a deceleration in salaries looks inevitable though to end-1H19. The IMF-advocated 23.5% hike in household gas rates and a related increase in heating prices will be a significant one-off that will contribute up to 1pp to annual inflation over the long-run. Against this backdrop we now expect end-2018 inflation at close to 10% (up from our current forecast of 8.9%).

The NBU held its key policy rate at 18% in late October, arguing that it is sufficient (in nominal and real terms) to combat inflation. At the same time, the central bank acknowledged CPI would slip into its target range (5% +/-1pp since end-2019) no sooner than in early 2020 as the current inflationary pressure will take time to subside. We expect no loosening of monetary policy before end-1H19.

C/A gap widens on accelerated imports

In 3Q18, the current account deficit nearly tripled yoy to USD 3.5 bln. The 12-month trailing deficit is USD 4.8 bln, nearly 3.7% of GDP. The widening of the C/A gap in recent months is related in large part to greater imports of consumer goods. Importers have increased purchases in anticipation of a seasonal depreciation of the hryvnia – typical for the 4Q. This, in turn, shifted the weakening of the hryvnia to the summer months. The hryvnia slipped about 8% against the USD and EUR in the 3Q, but remained broadly stable in October. With private household demand buoyant and fueled by growing incomes, the C/A deficit is set to exceed our earlier projections. We now revise out forecast for the 2018 C/A gap to 3.8% of GDP from 2.1%. Over the mid-term, we see no change to our forecast of a shortfall in the range of 3.0-3.5% of GDP, with no threat to macro stability.

New IMF program ensures government liquidity through end-2019 and stable NBU reserves

The pre-announced launch of the new USD 3.9 bln IMF stand-by program instills confidence that Ukraine’s external position will remain manageable in the near future. Ukraine regained access to global debt markets by placing USD 2 bln in Eurobonds, albeit at unfavorable rates of 9.0% for 5Y paper and 9.75% for 10Y paper. The proceeds allowed Ukraine to immediately repay a USD 725 mln bridge loan. The government’s decision to yield to the IMF’s request and swiftly implement the program’s prior actions, including the gas price hike, is a sign they were skeptical about the country’s ability to smoothly navigate the election cycle without IFI support. The delay of the socially painful gas hike until 5 months before the presidential election will have consequences; this same decision made 18 months ago may have gone unnoticed and any negative political effects would have fully faded by now.

The renewal of cooperation with the IMF (pending the approval of the 2019 state budget) unlocks loans from the World Bank and the EU to cover the budget deficit. Those loans will allow the government to service maturing debt, but will not leave room for any fiscal loosening, which will be a good disciplining factor ahead of the elections. Ukraine’s ability to smoothly roll over its maturing debt in 2019 and 2020 will depend on its ability to maintain uninterrupted cooperation with the IFIs. This should help ensure that the winners of the next year’s election will be less likely to roll back the recent changes and instead to stick by Ukraine’s recent commitments.

Factoring in the first tranche of the IMF loan and funding from other IFIs, we confirm our projection for end-2018 NBU reserves of c. USD 19 bln.