Ukrainian assets have posted a remarkable performance in recent months:
- Ukrainian sovereign Eurobonds have rallied hard by close to 200 basis points across the curve since the International Monetary Fund signed off the last review under the Extended Fund Facility program in April.
- Ukrainian GDP warrants have posted a stunning performance, rallying from just 30 cents, to 58 cents as of writing, so close to doubling your money. On issuance I argued the structural was inappropriate for Ukraine – and I think this is now showing effect – as buy back costs continue to rise.
- The hryvnia – which had been expected to depreciate to 28-29/$1 by year end, has actually rallied back to 25.5/$1, as reverse currency substitution feels full effect.
It is a bit hard to fully justify the strength of the above rally on the back of the stand-alone Ukrainian story, and likely the bigger factor has been the clement global environment, and the global hunt for yield, with Ukraine offering strong relative value, from a sold off position, relative to some of its peers.
But just reviewing the stand-alone Ukraine story, let’s consider the pros/cons:
(+) There has been some stabilization in the domestic political situation at least compared to the first quarter of 2017, as the Donbas blockade back then was weighing on economic indicators and sentiment. The ad hoc blockade run by opposition parties/forces was eventually lifted, in exchange for a formalization of trade restrictions with DPR and LPR.
Hawks keep Trump tough on Russia
(+) I guess earlier in the year it was unclear where Ukraine stood with respect to the new Donald J. Trump administration, with real fears that the friendly personal rhetoric from the president towards his Russian counterpart would translate in the lifting of sanctions on Russia – a green light for further Russian encroachment into Ukraine – and also much less political and economic backing for Ukraine. Trump’s difficulties over Russia-gate forced him to “prove” his hawkish Russia credentials which has meant he has surrounded himself with Russia hawks – James Mattis as defense secretary, H.R McMasters as national security adviser, Kurt Volker as special Ukraine envoy, Fiona Hill as adviser. U.S. policy is aligning quite closely with that under the previous U.S. President Barack Obama administration. It might be even argued that policy is tougher given allegations of Russian interference in the U.S. elections yielded the U.S. congressional codification of sanctions on Russia. Trump has in effect been hemmed in on Ukraine/Russia policy, and this seems to be benefitting Ukraine. This has been seen by a steady stream of senior Trump administration officials paying pilgrimage to Kyiv in recent weeks, including U.S. Secretary of State Rex Tillerson, Mattis, Volker, and even Energy Secretary Rick Perry was supposed to be in Kyiv this week, albeit cancelling at the last minute on account of Hurricane Harvey. DC is certainly showing Kyiv its love at the moment – with the administration going out of its way to show support for Ukraine and even the issue of providing defensive military aid to Ukraine has resurfaced again in recent weeks.
Moscow pulling its punches
(+) Despite the hawkish rhetoric, and actions, from Washington, D.C., Moscow at present still seems willing to stay on the back burner in Ukraine, or at least not further escalating from a still fairly hot conflict in the Donbas. Russia agreed to support the latest bread and back to schools’ ceasefires – which admittedly are not holding that well – and the Volker – Vladyslav Surkov bilaterals between the U.S. and Russia over Ukraine kicked off with some relatively upbeat mood music. Moscow seems to be struggling to figure out the Trump administration – not giving up yet on an appeasement strategy from Trump towards Russia, and hence not willing to rock the boat by being too difficult/controversial in Ukraine. Russia staying on the sidelines in Ukraine is good, as it gives Ukraine some space to get on with much needed economic reforms. Russia even managed not to rock the boat again during Ukraine’s annual independence date celebrations on Aug. 24 – contenting itself instead on watching bridge structures falling into place to link Crimea to Russia.
Reforms run out of steam
(-) That said, it is hard to be that enthused by reform momentum in Kyiv, which if anything seems to be running out of steam as the allure of the elections in 2019 increasingly dominates attention.
Hopes of an early sign off on the fourth review of the IMF program in May evaporated with the heat of the summer as Rada deputies focused on their own priorities and business class seat allocations to various exotic holiday destinations. The only thing on the IMF wish list which got done was a first reading on pension reform – two more need to be done as the Rada comes back to business in September. Not much was achieved on the land reform agenda – albeit the IMF seems willing to cut some slack at least until the end of the year. There was backtracking on energy price reform/adjustment. And now we are into preparation for the 2018 budget, which will likely be a big focus for discussions with the IMF. Little was achieved on the anti-corruption agenda – still few/if anyone has been brought to account for wrongdoing during the ex-President Viktor Yanukovych era, or since, albeit there has been a flurry of PR-type arrests or some lower hanging officials. Actually some in the administration seem more interested in targeting the anti-corruption campaigners with anti-corruption campaigns, and the allegations lodged against the finance minister, Alex Danyliuk seem politically motivated – and disappointing in many respects because he has achieved a lot in his short time in the position.
Central bank governor needed
Meanwhile, the National Bank of Ukraine still has no governor, close to five months after the resignation of the former governor, Valeria Gontareva. This seems perverse, for a country like Ukraine, facing huge challenges still, and on an IMF program. I cannot think of a precedent in my 20-odd years covering countries with IMF program. Okay, I bought some of the line earlier in the year that the position was being kept warm for Raiffeisen Aval chief Volodymyr Lavrenchuk, who was only available from September. But then we hear that two candidates will be announced by Oct. 5. Really? This is an important job, and frankly, if Lavrenchuk wanted the job, he should have been shooed in in May/June, at the latest. Why the delay? The concern is that this is going to be a political placement again, or the whole issue will be used as a bargaining chip with the IMF during the next review. This might also be the case with Danyliuk, with his position being put under threat again as a negotiating chip with the IMF. This all smacks of the old Ukraine, not the new Ukraine that reformers are supposed to be building. Sad and disappointing.
In any event there is now a lot of unfinished business for the IMF, and getting the review passed this side of year end will be difficult, if now unlikely.
My fear in all this is that the administration really does not want to do the one thing that the country is calling out for – anti-corruption reforms/action, which is key to improving the business environment, and getting investment and growth moving. And elaborate games are just being played, again, to stall what really needs to be done. Perhaps this is all about playing for time, to stall the IMF on the politically difficult stuff (at least in the Rada) until elections.
Tough love needed
I would argue that this suggests that Ukraine needs some tough love at this point, with the IMF, and the international community, playing hardball with Ukraine – no more IMF disbursements until we see real delivering on the anti-corruption agenda, pension reform, energy price hikes, stop messing around over the NBU governorship and the Ministry of Finance, et al. Enough people at the IMF still have the scars and experience from previous and numerous failed IMF programs to get it, but I hope that in the new Trump administration’s attempt to prove its support and hawkish Russia credentials, we don’t see more pressure to take the foot off the back of this Ukrainian administration – which has proven it can do difficult reforms when it has to. Western officials need to be vocal in support of Ukraine’s reformers – and there are plenty of excellent officials still in key positions.
Ukraine doesn’t need IMF as much
(+/-) I guess the IMF is not helped by the state of the global market, and the fact that Ukraine could now easily come to the Eurobond market and borrowing relatively cheaply – 10 year, sub-7.5 percent is possible. The problem is that given the easy global financing conditions and the strong budget performance to date, that Ukraine does not really need IMF money at this point. So some in the administration will be saying, don’t bow to the IMF, we know better, and we need to focus on domestic politics and the 2019 elections instead. The danger is that Ukraine repeats what it did in 2011-2013, playing the IMF for a mug, and against the market.
Strong tax revenues
(+) Ukraine’s fiscal position is strong. For the period January to July the budget surplus was Hr 29 billion, with revenues running 10 percent above target, helped by Naftogaz dividend transfers and also NBU profits. Recent weeks have seen a bevvy of sales of state minority stakes in oblenergos, which should generate a few billion hryvnias n revenues for the treasury, while the assumption was that the deficit would be 3 percent of GDP or thereabout this year, it is likely to be much lower than this, maybe 1-2 percent. This gives the government some flexibility on the financing side, and perhaps a desire to do some early fiscal pump priming into an election campaign.
Sluggish economic growth
(+/-) Broader macroeconomic indicators are mixed. First-half 2017 real GDP growth came in at 2.5 percent according to the Ministry of Economy, which is just above the 2.3 percent growth posted in 2016. Now this might seem solid when considering the blockade in the first quarter, stresses still in terms of difficult trade relations with Russia, and that Ukraine has managed through the early year stressed from the PrivatBank nationalization. But the base is still very, very low, given the 17-20 percent real GDP contraction in 2014-2015. One might have expected a much stronger rebound, and given the stellar performance from the agro-food sector, and an uptick seen in the metals sector. Investment seems to be lagging, which likely relates to frailties still in the banking sector, and the weak business environment.
Inflation still high
Inflation has been less well–behaved, surprising perhaps given the hryvnia strength, but reflective of food price inflation, core inflation pressures (strong real wage growth, reflecting difficulties hiring skilled labor) and administered price hikes. Hence, headline inflation has backed up to 15.9 percent as of July, from the low of 12.2 percent n April, and hopes then of single digit inflation this year. For the NBU this has created something of a quandary as they want to support growth by further cutting their key policy rate further from 12.5 percent at present, but under their new inflation targeting regime they are constrained. The NBU likely hopes upside inflation pressure is short lived, and one off factors fall out of the index, helped by another good harvest, but without government focus on structural reforms, inflation could prove sticky, damaging longer term growth prospects.
Balance of payments solid
The balance of payments, meanwhile, looks pretty solid. The upturn in growth has brought a widening in the current account deficit, but it still looks manageable and well -funded, as reflected in the appreciation pressure on the hryvnia, and rising NBU reserves. The current account deficit hence came in at $2.2 billion for January to July, up from $1.4 billion one year earlier, and equivalent to 3.8 percent of GDP, but net foreign direct investment was $1.4 billion, so covering 60 percent of the current account deficit, a decent coverage ratio. Reverse currency substitution seems to have been strong reflecting improving confidence. NBU reserves thus hit $16.8 billion as of the end of July, up by around $600 million since the last IMF credit tranche dispersal in April. The strength of the hryvnia and reserves has further allowed the NBU to ease restrictions around foreign exchange convertibility – a positive in terms of helping improve transact-ability, economic activity and confidence.
But again, with little pressure on the budget financing position or balance of payments, the administration is under little pressure to do difficult IMF reforms – especially where they entail political risk and capital being expended in the Rada. We have been there so many times over the past 20-odd years with Ukraine, we all hoped this time was different. Maybe we were wrong. Ukraine has a window for reform, given geopolitics with Russia on the back foot – it cannot waste this on domestic political intrigue and individual interest coming to the fore with respect to the anti-corruption agenda.
Moody’s long-overdue upgrade
(+) Moody’s upgraded Ukraine’s sovereign rating one notch to Caa2 on August 25, which has helped the external bondholder feel good factor. Ukraine has had to wait a long time since the debt restructuring agreement was reached in November 2015 – and Caa2 already seems harsh and still two notches’ below Fitch and S&P’s B-. One has to think that upgrades from both Fitch and S&P must also be in the pipeline. S&P has held its B- rating since October 2015 and Fitch its B- since November 2016. There have been many improvements in Ukraine’s credit fundamentals in my view since then.
