UKRAINE'S ECONOMIC

W H E R E O P P O R T U N I T I E S E M E R G E

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Ukraine’s Economic and Financial Situation

Dr. Edilberto SeguraPartner & Chief Economist

SigmaBleyzer, The Bleyzer FoundationOctober 2008

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W H E R E O P P O R T U N I T E S E M E R G EW H E R E O P P O R T U N I T I E S E M E R G E

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Over the last five years, Ukraine has been one of the fastest growing economies in the region: its real GDP grew by 7.9% per annum.

In 2008 economic growth has continued: during January-September 2008, Ukraine expanded fast at 6.9% yoy, showing resilience to global liquidity tightening, high energy and raw materials prices, high inflation and on-going political controversy.

Ukraine- Real Sector

January-September 2008, % yoy

GDP 6.9Agriculture 15.7

Domestic Trade 9.4

Transportation/Communication 10.4

Industrial Output 5.1Construction -10.3

Source: State Statistics Committee of Ukraine

9.6

7.97.3 7.1 7.0

6.3 6.15.5 5.1

0

2

4

6

8

10

KZ UA RU SK TR RO BL CZ PL

Real GDP growth, % average for 2003-2007

Source: State Statistics Committee of Ukraine, IMF WEO Database April 2008


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Economic Growth – Demand Side On the demand side, in the first half 2008 GDP growth was supported by high domestic consumption and investment growth of 17.4% yoy and 10% yoy respectively.

Over this period, domestic consumption was sustained by a 15% yoy increase in real disposable income, 9% yoy real increase in wages, and 30% yoy real increase in credits (65% yoy nominal).

Growth of investments was encouraged by the growing profitability of firms (48% yoy in real terms due to higher exports and domestic trade) and by strong foreign currency inflows (FDIs and debt), which compensated for tighter domestic liquidity.

GDP growth by Demand Components, pps

Source: State Statistics Committee, The Bleyzer Foundation

Final consumptionImports

InvestmentsExports

GDP, % yoy

6.5

7.6

7.3

9.612.1

2.7

-15

-12

-9

-6

-3

0

3

6

9

12

15

18

21

24

2003 2004 2005 2006 2007 1H 2008


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Economic Growth – Supply SideOn the supply side, in 2008 agriculture

has been the growth engine (16% yoy), harvesting 45 million tons of grains, a 15-year record. This large harvest is due to favorable weather and larger investments in the sector.

Negative growth in construction (- 10.3% yoy) this year is due to tight

economic policies (to control inflation))Below average growth of industry (5.1%

yoy) was due to growing production costs (more expensive energy, raw materials, labor, and transportation) and weaker external demand.

Real GDP is forecasted to grow by 6.3% in 2008 and about 2% - 4% in 2009.

GDP growth by Sectors, percentage points


6.97.6

7.3

2.7

12.1

9.6

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

2003 2004 2005 2006 2007 9mo2008

Agriculture IndustryServices Net taxesConstruction GDP at market prices


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Macroeconomic Performance - Inflation Inflation reached 17% in 2007 and surge to

31% yoy by May 2008, caused by increases in aggregate demand and high food prices (poor weather in 2007).

But during July-August 2008, the CPI deflated somewhat due to a good harvest and lower food prices.

In September 2008, price growth resumed, driven by utility tariffs.

In annual terms, inflation continued to slow down to 24.6%.

Although during the last three years fiscal deficits were maintained low at about 1%, budget expenditures grew by 20% per annum in real terms, increasing inflationary pressures.

Nevertheless, exchange rate and monetary policies were at the core of the inflation problem, with large nominal increases in money supply (about 50% pa) and bank credit (about 70% pa).

Therefore, inflation was addressed by tightening monetary conditions.


0

4

8

12

16

20

24

28

32

Jan

Feb

Mar

Apr

May Jun

Jul

Aug Sep Oct

Nov

Dec Jan

Feb

Mar

Apr

May Jun

Jul

Aug Sep

2007 2008

FoodsUtilities


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Monetary Policy to Address Inflation The anti-inflationary program relied heavily on monetary measures by the NBU:

• Switching to a managed float in order to reduce forex interventions - the major source of money growth.

• Tightening bank reserve & capital adequacy requirements.

• Increasing the discount rate to 12%.• Carrying out sizable sterilization

operations to slow down credit growth.

Selected monetary indicators

Credit stock, % yoy, RHS

Source: NBU, SSC

Consumer Inflation, % yoy, LHS

Money supply, % yoy, RHS

5

10

15

20

25

30

35

40

45

50

55

60

Jan

Feb

Mar

Apr

May Jun

Jul

Aug Sep Oct

Nov

Dec Jan

Feb

Mar

Apr

May Jun

Jul

Aug Sep Oct

Nov

Dec Jan

Feb

Mar

Apr

May Jun

Jul

Aug Sep

2006 2007 2008

20

25

30

35

40

45

50

55

60

65

70

75

80

As of September 2008, these measures reduced money supply to 38% yoy (from 52% in 2007); and credit growth to 54% yoy (from 74%).

Helped by larger agricultural output, annual inflation may decelerate to 20% in 2008 and may be further reduced to 15% in 2009.


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Main Economic Issues facing Ukraine Today Inflation is no longer the main issue facing the country today. Ukraine today is facing the possibility of a financial crisis in the next

few months as indicated by many international measures of default risk. One of the most common indicators used by investors of the risk of

default of a bond is the premium on its Credit Default Swaps (CDS). A CDS is an insurance-like contract that promises to cover losses on a

bond in the event of default by the bond issuer. Studies have shown that CDS premiums identify default risks earlier

than bond spreads or bond ratings: it is a better leading indicator for defaults.

A premium of more that 1,000 basis points is an indication that investors do expect the bond to be in default.

A few days before their collapses, CDS premiums reached 740 basis points for Bear Stearns and 724 basis points for Lehman Brothers.


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Credit-Default Swaps (CDS) Spreads for Selected Countries

Ukraine: 2803 bp

Russia: 1031 bp

0

250

500

750

1000

1250

1500

1750

2000

2250

2500

2750

3000

23-O

ct

3-O

ct

15-S

ep

26-A

ug

6-A

ug

17-J

ul

27-J

un

9-Ju

n

20-M

ay

30-A

pr

10-A

pr

20-M

ar

29-F

eb

11-F

eb

22-J

an

2-Ja

n

12-D

ec

22-N

ov

2-N

ov

15-O

ct

23/10/2008

Kazakhstan: 1216 bp

Other countries with high CDS premiums include Argentina (3,900 bp), Pakistan (3,000 bp), Ecuador (2,600 bp) and Venezuela (2,300 bp).


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Opinions of International Experts about Ukraine’s Vulnerability

High Level NY bank officer: 80% probability that Ukraine will face a financial crisis during the next few months.

High Level London bank officer: 90% probability that Ukraine will face a financial crisis.

Economist of major investm. bank: A financial crisis in Ukraine is imminent. Standards and Poor’s September 2008 Review of Ukraine’s Banking sector:

Ukraine’s banking sector is in high risk and is listed in Category 10, which is the category for the world’s weakest and most vulnerable banking sectors (along with Bolivia and Venezuela).

US Treasury’s Quarterly Assessment of Financial Risks, September 2008 (Ukraine was placed among the 10 top financial risks in the world): Ukraine …. risks a sharp balance of payments adjustment or crisis within the next one or two years.

Fitch Rating: Ukraine’s sovereign rating downgrade to ‘B+’ reflects concern that the risk of financial crisis in Ukraine… is significant and rising.

In mid-October, S&P’s put Ukraine’s sovereign rating on CreditWatch with a negative outlook.


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Three Major Reasons Why the Ukrainian Economy is Vulnerable:

1. Large Current Account Deficits

2. External Debt Burden

3. Banking Sector Weaknesses


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- In 2009, the current account deficit is likely to widen to $24 billion (10% of GDP.) This amount will require foreign financing.

- Of this CA gap, about $10 billion reflect the likely increase in imported gas price.

Current Account Balance and FDI Inflow in $ billion, and CA Balance as % of GDP

-25

-20

-15

-10

-5

0

5

10

2001 2002 2003 2004 2005 2006 2007 2008(e) 2009(f)

FDI inflow, $ billionCurrent Account Balance, $ billionCA Balance, % of GDP

1. Large Current Account Deficits

Current account balance, % of GDP


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2a. Gross External Debt, by Sectors, $ Billion- In the last two years total external

debt grew 45% pa to $100 billion.- External private debt grew to $85

billion, $29 billion of which is short-term (classified by original maturity).

- Ukraine’s external debt is now above the median value of countries in similar credit rating categories:

- At 60% of GDP, Ukraine’s external debt/GDP is above the 40% median value of similarly rated countries. - At 120% of current account receipts, its ratio of external debt/CA receipts is also above the 84% median value for similarly rated countries.

2. External Debt Burden

0

15

30

45

60

75

90

105

2004 2005 2006 2007 2008

Intercompany Lending

Corporate SectorBanking Sector

Public Sector $43

$4

$15

$38


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2b. Sort-term Component of Gross External Debt, by Original Maturity Breakdown, $ Billion

- The actual short-term debt may be much higher than the official number of $29 billion, if we include the short-term part of the medium/long-term debt.

- The likely short-term portion of M&LT private debt is estimated at $10-15 billion, which could bring the total short-term debt to $39 - 45 billion.

29

0

5

10

15

20

25

30

2004 2005 2006 2007 2008

Corporate sector - ST debtBanking sector - ST debt

9.5


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2c. Ukraine’s External Financing Requirements in 2009 (in $ billion)

* not including the short-term part of M&LT private debt

** according to 2009 Draft Budget Law

2009Sort-term private debt repayments* -29Likely short-term portion of medium-term debt -10Public sector external borrowing needs** -2Forecasted current account deficit -24

Likely external financing requirements -65

Likely FDI inflow 10

Likely external debt requirements -55

Available NBU reserves 35


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External Financing Requirements The previous table shows that the 2009 external financing requirements

could be $55 billion (adding the short term external debt to the external financing required to cover the CA gap, and subtracting likely FDIs).

A portion of this debt is due by subsidiaries to parent companies or represents more stable trade credits (about $25 billion).

Under normal circumstances the gap of $30 billion would be manageable. But if global liquidity continues tight, Ukraine may not be able to secure

financing for this amount. Due to international liquidity constraints, since September 2008 a number

of local banks have reported increasing difficulties in rolling over their foreign short term obligations.

The risk of a crises in the near months is now greater, as shown by the current high CDS premiums, with a possible major devaluation.

Although some banks may fail and may even default, government foreign debt (about $15 bn mostly long term) is likely to be timely served.


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3a. Money Supply and Banking Sector Credits, UAH billion, 2001-2008UAH billion

Money supply, M3 Loans to private sector

• Many studies in EMs have shown that high rates of credit growth lead to high levels of non-performing assets.

• In Ukraine, bank credit growth has been high over the last 5 years: 60% pa.

• Credit growth was supported by large increases in money supply (M3) of 44% pa and by external debt.

3. Banking Sector Weaknesses

0

100

200

300

400

500

600

2001 2002 2003 2004 2005 2006 2007 2008Sept


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Bank Credit breakdown – August 2008

UAH bn %Total bank Credit 547 100% Credit to Financial Corporations 8 1%

Credit to Non-Fin Corporations 331 60% Retail and Wholesale Trade 124 23%

Manufacturing 83 15%Real Estate 36 7%Construction 31 6%Agriculture 23 4%Transport and Utilities 18 4%

Credit to Households 208 39%Consumer Credit 144 26%Mortgages 59 12%Other 5 1%


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3b. Banking Sector Assets & Liabilities in Foreign Exchange

50

100

150

200

250

300

350

2005 2006 2007 1H2008

Bill

ion

UA

H

Assets in foreign currencies Liabilities in foreign currency

- As of September 2008, foreign liabilities represented 51% of Total Liabilities.- Moreover, as of September 2008, foreign currency denominated loans

accounted for more than 51% of total commercial bank credits, lion share of which were issued to unhedged borrowers.

- Thus, even moderate currency depreciations may impair the ability of banks’ clients to pay their debts on schedule.

Source: NBU Financial Soundness Indicator Database.


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3b. Commercial Banks Credit Quality: Non-Performing Loans

Source: NBU Financial Soundness Indicator Database, NBU Annual Banking Supervision Reports for 2006-2007.

4.5 3.4 2.5

15.0 14.410.7

39.3 40.8

39.5

0

10

20

30

40

50

60

2005 2006 2007

Doubtful and Loss Substandard Watch


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Non-performing Loans in Selected Emerging Markets as % of Total Loans, 2007

0

2

4

6

8

10

12

14

Latv

ia

Est

onia

Lith

uani

a

Bel

arus

Isra

el

Mon

tene

gro

Bul

garia

Hun

gary

Rus

sia

Cze

ch R

ep.

Pol

and

Slo

vaki

a

Bos

nia

Alb

ania

Turk

ey

Mol

dova

Cro

atia

Mac

edon

ia

Rom

ania

Ukr

aine

Source: IMF Global Financial Stability Report, Jan 2008


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Recent Developments in the Banking Sector Banking weaknesses and the global financial crisis has intensified

concerns over Ukrainian banks’ ability to rollover foreign liabilities. Furthermore, a shareholders’ dispute over the six-largest Ukrainian bank

triggered a run in deposits in the bank. To support the bank, the NBU provided UAH 5 billion (about $1 billion)

of emergency refinancing and later took control over the bank. Although this situation is under control, it has undermined confidence of

the population in the banking system as a whole. Affected by distrust, commercial banks have also cut or closed their

interbank credit operations. This significantly restricted commercial banks’ access to domestic financial resources.

Experiencing some difficulties in withdrawing cash from several commercial banks’ ATMs, many people rushed to empty their current and saving accounts.

According to NBU estimates, this run cost the banking system about UAH18 billion ($3.5 billion) in October.


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Ukraine in the Context of Global Financial Crisis

Ukraine is vulnerable due to a combination of large short term debt repayments, high current account deficits, and banking weaknesses due to non-performing loans and high foreign currency bank liabilities.

Separately, each of the above factors looks manageable, but their confluence amid a deteriorating world economy, easing of steel prices, imminent energy price increase, and turbulent domestic politics have notably affected investors risk assessment of Ukraine.

Reflecting these risks, since mid-2008 the premiums for Ukrainian Credit Default Swaps have risen to over 2,600 basis points in mid-October.

High risk perceptions of emerging markets translated into a decline in portfolio capital inflows to Ukraine: the inflow of portfolio capital declined from US$3.3 billion in the first half of 2007 to only $350 million in the same period of 2008.

Partly as a result, the PFTS index has declined by more than 75% year-to-date (as of October 22, 2008), one of the largest declines in the world.


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Recent Exchange Rate Developments During the first half of 2008, significant inflows of short term capital took

place to take advantage of high local interest rates and the perception that an immediate devaluation was unlikely.

However, since mid-year, the economic weaknesses of Ukraine and its vulnerability to the current global liquidity crisis became more evident and foreign capital started to move away from Ukraine.

Coupled with lower export earnings and higher demand for foreign currency to repay imports and debt obligations, it caused sharp Hryvnia weakening in the interbank market.

This weakenning took place despite the fact that during October the NBU sold foreign exchange to the extend of about $3.5 billion, reducing its international reserves from $38.5 bn to $35 bn.

The Hryvnia bid-ask rates depreciated in the interbank FX market from 4.60-4.65 UAH/$ in mid-August to 5.77-6.08 UAH/$ on October 24, 2008.

To restore foreign exchange stability, the Government and the NBU are now seeking a loan from the IMF of about $16 bn.


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Other Measures to Address the Financial Sector Turmoil

The NBU has also actively supported banking sector liquidity through its refinancing operations. In October, it provided UAH 20 billion (about $4 billion) of liquidity support to a number of banks.

To build confidence, deposit guarantees were doubled to $20,000 and are planned to increase further.

Furthermore, the NBU has imposed a six-month freeze on the early withdrawal of saving deposits from commercial banks.

It introduced tough limitations on commercial banks credit portfolio growth. However, a few days later, the NBU softened its restriction on growing concerns that this credit squeeze was harming economic growth. The only significant restriction is now that foreign currency loans can be made only to borrowers that have foreign currency income.

The NBU strengthened its monitoring of external private debt. In particular, it required commercial banks to supply with data on their and their clients’ external debt obligations maturing each quarter over the next 12 months.

Several state officials have advocated the need to create a stabilization fund, which would work as a government-owned Asset Recovery Company to buy and resolve some of the distressed assets of the banks.


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Medium Term Prospects Although the combination of larger current account deficits, large short

term repayments and tight international liquidity may lead to a financial crisis in the next several months, over the medium term, Ukraine’s economic outlook is still bright.

In the medium term, Ukraine should enjoy higher growth in productivity and GDP, and therefore higher asset prices for the following reasons:• The recent membership into the WTO should stimulate exports.• A FTA under negotiations with the EU would further encourage

exports and foreign direct investments (FDI).• FDI will also be supported by an abundant and educated labor supply

at wages that are one-third of those in Eastern Europe.• Ukraine large population of 46 million people is an attractive market.• Ukraine agricultural potential is quite high and could become one of

the world’s largest grain exporters.• Ukraine’s infrastructure is reasonable as compared to other countries

in the region.

UKRAINE'S ECONOMIC

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