Politics is once again getting in the way of the economy in Ukraine. Foreign investors are being made nervous by another round of campaigning and the strain it is causing in relations with the IMF. But 2010 could bring a recovery for Ukraine, writes Julian Evans.

Visitors to Kiev may have noticed that, for the last five years, it always seems to be election time. Kreschatyk, the main street in Kiev, always seems to be filled with the orange, blue and white flags of the three main parties, with loudspeakers blaring slogans, and campaigners’ tents pitched in Independence Square, just as they were in the Orange Revolution back in January 2005.

Ukraine has been in a state of permanent revolution ever since that month. Or rather, permanent electioneering. The revolution split Ukraine into Orange Ukraine (the Ukrainian-speaking west of the country) and Blue Ukraine (the Russian-speaking east of the country), and it also gave the country a new constitution, which delicately balanced power between the president and the prime minister.

Unfortunately, the new constitution balanced power too equally, with the result that the president can block the prime minister’s policies, the prime minister can block the president’s policies, and the parliament can block both.

As a result, for the last five years, the three main political players in Ukraine – president Viktor Yushchenko of the Our Ukraine party, prime minister Yulia Timoshenko of the Timoshenko bloc, and Viktor Yanukovich of the Party of the Regions – all of whom hate each other, have been locked in a bitter and inane battle for power, which has seen endless campaigning, endless mutual accusations of corruption, and very little actual policy-making.

The country has had presidential elections in 2004 (twice), parliamentary elections in 2006 and in 2007, local elections in 2008, and now has another presidential election in February 2010.

Nervous investors
This chronic paralysis of the political system was not much of a problem from 2005 to 2008, because the economy was still growing by around 7% a year. However, now that Ukraine’s GDP is shrinking – by around 15% in 2009 – the lack of political leadership in the country is causing investors serious concern.

Gerhard Boesch, deputy chairman of Raiffeisen Aval, which is the second biggest bank in the country and the largest foreign-owned bank, says: “The politicians here fight 24/7. The political agenda the three main parties pursue is not so different: they all want to join the EU, they all support market capitalism. Yet despite this, they cannot agree on any common strategy. The lack of predictability and political stability is the main obstacle to the country attracting further foreign investment.”

With another election around the corner, the political elite is again jostling to try and stay in power.

Natalya Selyakova, partner at the law firm Salans in Kiev, says: “The economy hasn’t hit a bottom yet because of the elections. The leading politicians are doing their best to stay in power, and are taking decisions to promote their short-term popularity rather than the long-term good of the country.”

For example, the Ukrainian parliament, which is dominated by Viktor Yanukovich’s Party of the Regions, passed a law in November 2009 to increase the minimum wage by 20%, despite the fact that state-owned companies are defaulting on their debt and the IMF, which is supporting the country with a US$16.5bn emergency loan, warned that any increase to the minimum wage would jeopardise the disbursement of the final tranche of the loan.

The fund complains that Ukraine has not introduced any significant budget cuts. It doesn’t even have a finance minister – he resigned early in 2009, in protest against the government’s fiscal policies.

The EU is also losing patience with Ukraine’s political elite. It relies on Ukraine for the transit of Russian gas, which supplies the EU with 25% of its gas needs. However, a long-running dispute between Russia and Ukraine, and Ukraine’s inability to pay its gas bill, has led to frequent stand-offs between the two countries, and to sudden gas shortages in the EU.

The EU and the EBRD lent the government €600mn in August to pay its gas bills, but on the condition that the government raise national gas tariffs so the state gas company, Naftogaz Ukraine, isn’t forced into bankruptcy. However, the government then failed to restructure the sector, and Naftogaz defaulted on its debt in September. The EU then froze the loan in December. “It seems to us quite often that the promises of reforms are only partially respected,” complained EU commission president Jose Manuel Barroso.

This cooling of relations between Ukraine, the EU and the IMF is troublesome for investors, because they had once thought of Ukraine as a potential EU candidate. Boesch of Raiffeisen Aval says: “When we bought Aval for US$1bn back in 2005, the accession of Ukraine to the EU seemed almost guaranteed. Now it seems a long way away.”

The nervousness of foreign investors has been compounded by the debt problems of two state-owned enterprises: Naftogaz Ukraine, which missed a principal payment on a US$500mn Eurobond in September 2009; and Ukrzaliznytsa, the state railways company, which initiated restructuring of a US$550mn syndicated loan in November.

The market’s suspicion that the government was running out of cash has been compounded by the problems of Nadra Bank, one of the top 10 banks in the country, which is trying to restructure around US$1bn in Eurobond, syndicated loan and trade finance debt. The bank is under government administration, and is waiting to receive a promised equity re-capitalisation from the government.

However, Igor Tykhonov, head of financial institutions at West Finance and Credit Bank, says: “It appears to be very difficult for the government to inject fresh capital into Nadra Bank this year. Hopefully it will happen after the election in 2010.”

Nadra has already successfully negotiated the restructure of US$175mn in Eurobonds, but analysts say it is still very close to going under, and that investors only accepted the 85% haircut offered by the restructuring because they were worried the bank was about to go bankrupt.

Potential default
The troubles of these state-owned or state-controlled institutions has led some investors to fear that the sovereign itself could be about to default. CDS spreads on the short-end of the sovereign’s curve climbed to 2,100 basis points in early December, making Ukraine the riskiest debt in the world, and implying a very high probability of a sovereign default.

However, fears of a sovereign default could be overdone. Firstly, the government was quick to point out that neither Naftogaz’s Eurobond nor Ukrzaliznytsa’s loan had a state guarantee. Secondly, Naftogaz successfully negotiated a quick restructuring with its creditors, and swapped its old Eurobonds into US$1.6bn in new Eurobonds which did have an explicit state guarantee. The National Bank of Ukraine still has US$27bn in reserves, and the hryvnia appears to be stabilising.

Morgan Stanley thinks the very high spreads at which Ukrainian sovereign and state-guaranteed debt is now trading presents an investment opportunity for those with strong stomachs: “We believe that Ukraine external debt is likely to remain volatile in the short term; however, we do not anticipate an extreme credit event in the sovereign sector. Although we cannot rule out further upward pressure on yields and spreads in the coming three months, we still see value on a medium-term basis, particularly at the long end of the curve,” the bank said in a research note in December.

Beyond the state sector, the private sector of the economy still looks very messy. Selyakova of Salans says: “Just about every locally-owned bank is restructuring its debt. Every real estate company is restructuring its debt. Just about every large metals company is restructuring its debt. In short, most Ukrainian companies are restructuring their debt. Even companies that are able to service their debt are restructuring. It has become a popular way of trying to reduce the price.”

The metal sector has high levels of foreign currency debt, and steel prices fell 50% in the second half of 2008, and haven’t risen much since. Ukrainian metals companies were slow to adjust to the change in market conditions, and initially over-produced, before reducing output by 70% in the fourth quarter of 2008. Output fell by a further 30% in the first eight months of the year. Steel exports dropped by 34% in the fourth quarter of 2008, which helped lead to a 14% decline in GDP that quarter, and the 60% devaluation of the hryvnia that quarter.

Ukrainian metals companies lost 90% of their market capitalisation in 2008. Many companies struggled to pay their debt, and almost all of them initiated restructuring negotiations with foreign creditors, including top conglomerates like Interpipe and Industrial Union of Donbas (IUD). Interpipe, for example, which is the biggest pipe manufacturer in Ukraine, is struggling to restructure its loans without triggering a cross-default on its Eurobond.

In some cases, high levels of foreign debt are forcing local owners to sell assets. IUD, for example, which is one of the largest steel and coke producers in Ukraine, is restructuring several billion dollars in unsecured debt, and has started selling off assets in the EU, and analysts say it could be forced to sell some Ukrainian assets, including potentially its prize asset of Alchevsk Steel.

Other over-leveraged metals companies which could become potential M&A targets include Zaporizhstal, one of the country’s largest steel companies; Kominmet, a pipe manufacturer owned by the Privat Group; and Mariupol Ilyich Steelworks.

Debt raising
Some of the companies are unlikely to be able to access new financing in the near future. “I don’t know when IUD will next be able to raise debt,” says one banker in Moscow, “but it won’t be anytime soon.”

However, other companies in the sector look in better shape. LSE-listed Ferrexpo managed to raise US$230mn in pre-export financing in December, and has a well-diversified network of international buyers. Its share price has risen 600% in 2009. Metinvest, owned by Rinat Akhmetov’s System Capital Management, has also avoided restructuring its debt, and is likely to be able to raise new debt financing when it wants to.

Boris Jaquet, distribution at Deutsche Bank, which lead-managed the deal, says: “We managed to attract 11 lenders into the deal, some with big tickets, others with much smaller. The fact we got so many banks, and were able to increase the deal from US$200mn to US$230mn, shows that liquidity is still there for the right names.”

Jaquet says of Ferrexpo: “They’ve been able to go through the crisis quite nicely, shifting their buyer base, showing flexibility during a downturn. They didn’t have much debt to begin with, and were one of the few companies in the Ukraine which did not go through any restructuring or waiver process during the crisis.”

SCM’s bank, First Ukraine International Bank, has initiated a restructuring of US$275mn in Eurobonds. However, local bankers say the terms of the restructuring were quite favourable to investors, with no haircut, and creditors have already agreed to the new terms.

On a knife edge
The banking sector in general is by no means out of the woods. The sector is struggling with non-performing loans that could be as much as 30% of loan portfolios, according to estimates of the IMF and local bankers, and banks are likely to need to raise more equity. With the sector owing an estimated US$37bn in foreign debt, more debt restructurings are likely in 2010.

Julia Tsepliaeva, CIS analyst at Bank of America Merrill Lynch, says: “We expect to see more foreign restructurings across other Ukrainian banks. Indeed, Ukrainian authorities are encouraging banks to take this path. We also cannot rule out not only defaults but more bankruptcies in this sector.”

Ukraine is, as Bank of America Merrill Lynch puts it, “on a knife edge”, and could easily go into a double dip recession, or a new devaluation, or even a sovereign default. Right now, bankers are holding their breath, and hoping that the presidential elections will lead to a strong government with a clear reform agenda. But judging by the last five years, that is the last thing Ukraine is likely to produce.