Last weekend, after the first round of Ukrainian presidential elections, veteran Eastern European investor Harvey Sawikin said that despite the free elections, investors should remain wary of investing in the country. He claimed that money can be made in corrupt autocracies or free democracies, but never in corrupt democracies. But is he right? Has Ukraine really made no progress under President Petro Poroshenko? Is there no money to be made? Or is Ukraine just still too risky?
Positive developments
Last year was net positive for Ukraine’s investment picture. Gross domestic product in 2018 grew at its fastest rate in seven years —3.3 percent — pushing the country’s total output to $131 billion. Agricultural productivity, coupled with strong consumption and investment, drove the acceleration in growth. Similarly, retail was strengthened on the back of wage growth and consumer demand.
But consumers were not alone—large companies such as Metinvest saw their profits surge by over 90 percent in 2018. Even Ukraine’s largest bank PrivatBank, which was caught with a hole in its ledger to the tune of Hr 148 billion (roughly $5.5 billion, or 4 percent of total Ukrainian GDP at the time) just a few years ago, returned to profitability last year, and is on track to earn even more in 2019.
These positive developments, along with several others, contributed to a favorable outlook for Ukrainian public markets. The PFTS Stock Exchange, Ukraine’s stock market, was among the top performers worldwide in 2018, rising just over 80 percent in 2018. The MSCI Emerging Market Index by comparison was down over 14.5 percent in the same time frame.
But there are also several developments that will help to sustain growth over the long term. For one, the National Bank of Ukraine and Clearstream—an international central securities depository (ICSD)— signed an agreement on March 13th. Clearstream gives international investment managers uninhibited access to Ukrainian local debt, thereby increasing liquidity, diversity of ownership, and transparency.
Secondly, Horizon Capital a private equity firm, raised $200 million for its latest Ukraine-focused fund — a sizable sum relative to the country’s GDP. It will concentrate on opportunities in the manufacturing, agribusiness, and services sectors. The size of the fundraising round points to increasingly positive investor sentiment towards Ukraine.
Lastly, Brussels and Kyiv plan to cooperate in investing $60 billion into infrastructure projects in the country by 2030, which will surely be a net positive for foreign money flows.
As long as the macro picture remains clouded for U.S. equity and fixed income securities, emerging markets like Ukraine stand to benefit. Low U.S. interest rates should contribute to a weaker dollar, which in turn will support greater exports, effectively increasing revenues for commodity-dependent Ukraine.
Still, reason for hesitation?
Despite the short term optimism, perhaps there is reason to be wary. Inflation has only mildly improved to a mediocre 8.6 percent. GDP growth, though strong last year, is expected to slow to 2.5-2.9 percent. These indicators may give investors pause for thought, but will not be enough to dissuade those excited about Ukraine’s turn-around story and high yields.
The major pitfall to investing in Ukraine remains the banking sector—beginning with the NBU, which was dealt a horrible hand—all the way down to retail banks.
The NBU’s foreign reserves, while increasing, remain dangerously low. Foreign reserves are vital in the central bank’s fight against inflation, currency depreciation, and other monetary woes. Low reserves are especially menacing in Ukraine’s case because it has experienced sky-high inflation several times since independence.
The country as a whole also requires significant foreign financing, effectively making it dependent on the grace of outside countries and institutions. But most importantly, the country has a lot of debt to pay back. In 2019 alone Ukraine will need to pay nearly $15 billion in debt obligations. In 2020 and 2021, a further $21 billion will be due. The country’s economy may have begun churning last year, but not fast enough for anyone to confidently predict that Kyiv can handle its massive debt burden.
Ukraine’s retail banking sector has also experienced turbulence. Between 2014 and 2016, banking sector capital was cut by nearly 50 percent, and in 2016, the sector’s total operating deficit stood at US $11.8 billion. The value of its assets in the fourth quarter of 2016 amounted to a mere $45.7 billion. Though the sector is improving and on track for its best year this decade, sustained banking competence, stability, and transparency is essential to encourage greater foreign capital flows.
Despite PrivatBank’s resurgence, there are still questions surrounding Ukraine’s financial sector. The NBU’s high 18 percent interest rate will likely hinder the growth of corporate lending books. Despite strong household demand for credit, non-performing loans remain extremely high — just under 60 percent — and may cripple banking balance sheets. Because of weak lending discipline, the banking sector continues to carry excess risk in the foreseeable future. And, if the banks themselves are at risk of a crisis, the entire investment landscape could also become a house of cards.
Waiting for further reform
An investment in the banking sector of an emerging or frontier economy is a common bet on the economic growth of a given country. But as long as the Ukrainian banking sector looks unstable, investors, despite encouraging macro developments, may sit on their hands and wait, and in the process dissuade further investment from entering the country.
In the days leading up to the final round of the election, it will be important to hear how presidential candidate and comedic actor Volodymyr Zelenskiy and Poroshenko plan to strengthen the banking sector to give investment managers renewed confidence in the country. Only when the banks are tightly and effectively regulated, can Ukraine’s fundamentals be fully unlocked. But for now, as Sawikin notes, Ukraine’s system brings too much corruption with it for the country to become mainstream for outside financiers.
