I was invited to write a year head opinion piece on the outlook for Ukraine in the Kyiv Post. The link is attached, and the text below for those as yet to sign up for a subscription.

As we start the New Year thoughts inevitably turn to prospects for the year ahead. In Ukraine’s case, at least from the macro economic perspective, it is fair to suggest that these are decidedly mixed, which admittedly was very much the case for the year that has just gone. Indeed, if 2017 could be described as the year when growth struggled to take off because of disappointment on the reform front, 2018 is likely see even less reform progress due to the Poroshenko administration’s likely increasing focus on re-election in 2019, or perhaps sooner.

There will inevitably be a temptation to sacrifice some of the hard won achievements on fiscal consolidation with fiscal pump priming so as to bolster poll numbers, which might flatter to deceive the growth performance this year, and perhaps will just store up problems for the future, beyond the next elections.

But let’s first just review the score sheet for basic macroeconomic performance and try and look as to what this might suggest in terms of the year ahead:

Real GDP growth: After dropping 17% in real terms over the period 2014-2015 due to conflict, revolution, foreign intervention/annexation, real GDP grew 1.6% YOY in 2016, and the expectation was that favourable base period effects, foreign financing support, and a positive reform story would see real GDP growth accelerate thereafter. Unfortunately the economy has struggled to gain much traction, with first to third quarter growth in 2017 realising YOY growth rates of 2.5%, 2.3% and then 2.1%, respectively.

Somewhat disappointing first quarter growth cold perhaps be explained by the impact of the blockade in the East, but slowing growth since then perhaps reflects a disappointing agricultural season, more internal political flux, and lack of sustained progress on the reform front, as reflected in the stalled IMF programme.

At present Ukraine lacks a consistent reform message to sell to foreign and domestic investors who largely remain on the sidelines, and the lack of meaningful reform on the key anti corruption agenda is lynch-pin therein in my opinion. 

For 2018 it is hard to see much of this changing, given what seems to be a fundamental unwillingness from the Poroshenko administration to meet demands of IFIs and NGO/Civil society and international business to do what it takes to create a clean business environment, and therein tackle the lynchpin issue of corruption.

I can see growth momentum picking up steam to perhaps 2.5-3% in 2018 but only on the back of fiscal pump priming which, arguably, is not sustainable. This will all be a short term tactical election play, without much strategic thinking for the economic long term.

Inflation: despite the stellar best efforts of the NBU in tightening policy, inflation has remained sticky and elevated, holding in double digits, and reaching 13.6% in November, with the NBU revising its end year inflation forecast now to 12.2% from 9.2% previously.

Higher food price inflation due to the poorer harvest, and unfavourable base period effect, higher oil/energy prices, but also perhaps poor quality growth - consumption/domestic demand driven, plus weaknesses in the labour market - actually skilled labour shortages, a reflection of outmigration of skilled/younger workers, reflects a key vulnerability.

Surely the fact that 1.2 million Ukrainians now work in Poland, and many more (5 million?) elsewhere in Europe, is a reflection of the lack of economic prospects at home/frustrations, but represents a huge loss to the domestic economy notwithstanding the benefits from remittance inflows. It is hard to see many of the above factors changing in 2018, indeed, with fiscal stimulus likely a pre election strategy, we are likely to see inflation anchored in the teens which will ultimately be bad for long term growth and development.

I guess the one plus is that stalled administrative price reform will limit pressure from that source, albeit rising economic distortions, resource mis-allocation and only likely building up imbalances elsewhere, particularly in the budget.

Fiscal policy/performance: has been one bright spot in recent macro performance, helped by the fiscal reforms instigated since 2015 and also helped recently on the revenue side by above plan inflation. Compared to a deficit target of over UAH80bn for the year in 2017, as of November the consolidated budget was running a surplus of just under UAH34bn, albeit somewhat massaged by NBU profits and one off receipts from the reclamation of Yanukovych assets.

Likely heavy end year spending will have pushed the budget into deficit for the full year in 2017, and this was also evident from the massive drop in the cash balance on the single Treasury account, from UAH54.1bn at the end of November, to just UAH5.1bn as of early January 2018.

I expect fiscal deterioration in 2018 in the run up to elections as the Poroshenko administration tries to ensure re-election - likely deficit of 3-4% of GDP. In terms of funding this, and absent an early resumption of IMF lending, I assume an early re-entry on to international capital markets, or more domestic issuance, and likely a deterioration in debt ratios.

To assuage international institutional investors there will be lots of warm words about renengagement with the IMF even if there will be little practical progress in getting the programme back on track as the positions of the two sides on the anti corruption agenda, et al, remain just too far apart. We might also see a sweetener for institutional investors with more talk of liability management at the short end of the bond curve to further cut the debt service peak in 2019-2020.

But overall the strategy will be similar to that of 2011-2013 under Yanukovych of using international capital markets to fill any shortfall left by the lack of official financing - and all this depends on international capital markets remaining liquid and forgiving of backtracking on reform. So far that appears to be the case, given the liquid state of global markets, but that can easily change.

Balance of payments: The UAH proved stronger than expected for much of the past year, reflective of earlier year official disbursements, then Eurobond issuance and reverse currency substitution. For the period January to November 2017 the current account deficit flat-lined around USD3bn an annualised basis.

But disappointingly net FDI dropped from USD3.2bn to just USD2.1bn for the year. While the 2016 data is flattered somewhat by foreign bank recapitalisation efforts, the fact that FDI failed to take off is reflective still of the difficult business environment (corruption) and still challenging political and geopolitical setting for Ukraine.

Foreign investors still need to question why Ukraine and not somewhere else in the region, e.g. Poland, where ironically they can still access cheap Ukrainian guest labour. For 2018 I would expect some deterioration in the current account position as the Poroshenko administration looks to stimulate domestic demand this side of elections and this boosts import demand.

Higher oil and energy prices globally will also put upside pressure on imports. Meanwhile, and despite the relatively competitive UAH I do not see enough to suggest a take off in exports, and therein this is a structural issue which requires investment.

All this could put some downward pressure on the UAH, albeit likely countered by some NBU intervention as the authorities look to use the UAH as an anchor for stability/confidence. NBU reserves will be under downward pressure, depending on market access and IMF/official financing.

But the overall strategy will be trying to hold the line until elections, try and maintain a semblance of macro stability in terms of the currency, while most of the big ticking time bombs in the banking sector (Russian owned banks, Privatbank) have been diffused for the time being, and then provide a fiscal kicker through hikes in pension and public sector wages, plus road building and capital investment, plus the 2018 budget again introduced plenty of tax preferences again for connected businesses which the combined hope will be for some feel good factor just before elections.

All the above looks very disappointing, as elites put their personal political careers ahead of the country. Indeed, with Putin seemingly focused on his own re-election in the East, and the FIFA World Cup in June, Russia seems set to be on the back foot over Ukraine at least for the first half of 2018. This would have suggested a window of opportunity for Ukraine to push ahead with the still challenging reform agenda, to get the economy in a position where it is more durable and able to withstand likely future pressure from Moscow.

And it seems almost inevitable in my mind that Putin has not finished with Ukraine yet. Going back to the comparison to 2011-2013, backtracking on reform this year, and focus on fiscal pump priming will just store the problems up for the period after elections, when the risks will likely emerge again of macro imbalances which could threaten macro stabilty. If this comes at the time of another push by Moscow against Ukraine, politicians and policy makers might then come to regret the opportunities lost in 2018.

LINK: https://www.kyivpost.com/article/opinion/op-ed/elites-look-set-block-reform-anti-corruption-fight-2018.html


** Please note that any views expressed herein are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions. The views expressed do not reflect the opinions of all portfolio managers at BlueBay, or the views of the firm as a whole. In addition, these conclusions are speculative in nature, may not come to pass and are not intended to predict the future of any specific investment. No representation or warranty can be given with respect to the accuracy or completeness of the information. Charts and graphs provided herein are for illustrative purposes only.”


Article Distributed By:  Morgan Williams, President
U.S.-Ukraine Business Council (USUBC)
1030 15th Street, N.W., Suite 555 W
Washington, DC 20005
mwilliams@usubc.org; (202) 437-4707