With markets getting increasingly nervous about the stability of Ukraine, Arjen Thiescheffer, associate director, Omni Bridgeway, examines the likelihood that the country could default.

On April 17, 2009, the IMF decided to release the second instalment of US$2.8bn in loans to Ukraine under the standby arrangement from November 2008.

An approval by the Ukrainian lawmakers on some legislative changes, which were regarded by the IMF as necessary to ensure a sustainable economic growth, has made it possible to resume payments as initially agreed upon.

After a doubling of the current account deficit, inflation moving up almost 10% to 25-30%, a sharp decline in the hryvnia and a major capital outflow, Ukraine had to turn to the IMF for a rescue package to prevent a full default on its payment obligations.

The IMF package consists of a standby arrangement of about US$16.4bn with the aim to restore confidence and financial and macro-economic stability to Ukraine. At the time when the IMF decided to aid Ukraine, it expected the Ukrainian economy to grow again at an estimate rate of 5-6% by 2011 with inflation coming down to single-digit levels, assuming that the global economy starts recovering in the second half of 2009. Recent remarks from the IMF indicate that their views concerning a recovery in 2009 are now more negative.

The main question is whether the IMF package is sufficient to avoid a hard landing of the economy of Ukraine and avoid a potential default by Ukraine on its external debt.

Macroeconomic developments from 2005-2008
The gross domestic product (GDP) of Ukraine has accelerated since 2005 and more than doubled in the period 2005-08. However, the growth was mainly propelled by the large amount of capital available during the credit boom in recent years. This partly caused inflation to exceed 30%, wages to grow at 30-40% annually and imports to surge at an annual rate of 50-60%.

At the same time, the commodity boom benefited trade as prices for steel and grain, two of the major export products of Ukraine, sky-rocketed.

Unfortunately Ukraine had not diversified its economy and the banking system was mainly reliant on external short-term funding. The gains of the high steel prices were for a large part spent on higher wages and the national and local governments failed to invest the additional proceeds in a sustainable growth.

The threefold rise in external debt was largely caused by excessive borrowing by Ukrainian banks. The external debt position from the banks moved up from US$1.7bn at the beginning of 2004 to more than US$42bn at the end of 2008, while the general government and monetary debt only moved up from US$11bn in 2004 to US$14bn in 2008. The other Ukrainian debtors (large Ukrainian corporates and local government entities) owe short-term trade credits for the amount of about US$15bn and long-term loans for the amount of about US$24bn to their external creditors.

The credit crunch and the commodity collapse
As the credit crunch moved over from the US to Europe and the commodity boom came to an abrupt end with the steel prices dropping by more than 75% since July 2008, Ukraine’s economy was hit severely.

The current account deficit, already moving up in recent years due to the surge in imports, ballooned to more than US$12bn due to the lower exports caused by a lower demand and lower prices, increasing Ukraine’s financing needs in a period where the access to capital has virtually diminished due to the credit crunch.

Also, the rise in prices of gas imports from Russia will have a further serious impact on the current account deficit. The gas war between Russia and Ukraine since the beginning of 2009 has finally been settled on January 20, whereby Ukraine will obtain a 20% discount compared to the European gas price and US$1.70 per 1,000 cubic metres. In spite of the discount, the rise in the price for imported Russian gas in 2009 is about 30% compared to 2008.

Next to that, as a result of the deteriorating confidence in the Ukrainian economy and rumours of a devaluation and potential default, the hryvnia plummeted from an average of hryvnia/US$ at 0.21 (or US$/hryvnia at around 5.00) till September 2008 to a low of 0.108 (or US$/hryvnia at 9.30) on February 27, 2009.

The restrictions introduced by the central bank in early April on how banks should trade the hryvnia and the recent IMF decision have resulted in an upward move to 0.125 (Or US$/hryvnia at 8). However, some analysts still expect the hryvnia to lose more of its value and as such it could potentially move down to 0.10 (or US$/hryvnia at 10).

The price of a five-year credit default swap, ie the cost of insuring Ukrainian debt against restructuring or default, rose to above 5,000 basis points (bp) at the beginning of March 2009, meaning an investor buying protection for US$10mn of Ukrainian debt must pay more than US$5mn a year during five years. The latest quotes for credit default swaps for Ukraine have moved down to 2600bp.

In addition, the yield on some of the sovereign bonds peaked at the end of February/beginning of March at around 60%, also reflecting the investors’ view on a potential default on the payment obligation by Ukraine on its coupon payments and final repayments. Since the end of February, the yield requirements have moved down to around 30% annually, most probably due to the fact that Ukraine did not default on its coupon payment on February 26 and due to the positive signals from the IMF. Still, as per information from Bloomberg, about US$1.4bn in total is due during 2009 and the remainder of about US$5.3bn is due by 2018. Should we see any default or payment delay, we might see the yield requirements move back to the peak levels again.

Banks in trouble

After Prominvest, the sixth largest bank of Ukraine, was put under receivership in early October 2008, at least US$3bn was withdrawn from Ukraine during the first three weeks of October 2009. During the remaining months of 2008, a massive reverse from a capital inflow to a capital outflow took place which has had a very large impact on the ability of Ukraine, mainly its banking system, to fund its financing requirements. Standard & Poor’s estimated in June 2008 that the gross external financing needs as a percentage of current account receipts will rise to 145% from 117% until the end of 2009. However, since June, the prices of steel, which account for 40% of the export, have moved down sharply, resulting in an even higher percentage nowadays.

Political developments
The political playing field of Ukraine is divided into two sides. The first side, headed by President Yushchenko, is pro-European, while the other side, headed by Prime Minister Timoshenko, is pro-Russian.

The large differences between the two sides in their views on how to run the country and its economy have resulted in several clashes, the delay or cancellation of several important political decisions and structural reforms, and are not benefiting the investors’ confidence in a stable investment environment. Even the governor of the National Bank of Ukraine is quoted as blaming the government’s “bungling work” for bringing the country to a point where it may face a default.

The recent dispute with Russia on the terms of Russian gas delivery to Ukraine and transportation to Europe is harming the image of Ukraine as a trustworthy trading partner. Next to that, the price of the imported Russian gas has moved up significantly as a result of the negotiations between Russia and Ukraine. This will not only negatively influence the current account deficit, but will also further increase the mounting losses of state-owned oil and gas distributor Naftogaz of Ukraine. Standard & Poor’s estimated these losses in June 2008 at 6% of GDP, which will rise until the government equalises the residential gas tariff with the rise of costs of Russian gas imports.

Implications for holders of defaulted trade claims
The latest economic update from the World Bank shows a shift from a year-on-year real GDP growth of 11% in August to a year-on-year decline of 14% in November 2008, mainly caused by a sharp decline in industrial production. ING and UniCredit recently predicted Ukraine’s economy to contract by about 9% during 2009. The lower output will have a major influence on the cash flow available to the producers to repay the external creditors. It will also have a serious impact on the tax income of the government, making it more difficult to stimulate the economy without seriously increasing the budget deficit.

Next to that, the sharp decline of the hryvnia will make it more difficult for domestic producers to repay their foreign trade credit.

The Ukrainian banks have mainly invested domestically, which could result in difficulties repaying their loans to external banks.

This concern was initially confirmed by Moody’s Investor Service’s downgrade of the credit rating of two major banks, Nadra and Ukrpombank, on January 22, 2009. But a recent decision of Ukraine to recapitalise seven large banks in Ukraine is another confirmation of the difficulties which the Ukrainian banks are facing.

As per the information from Standard & Poor’s, the government of Ukraine is also facing the final settlement of depositor claims from losses incurred from hyperinflation in the early 1990s. Standard & Poor’s estimated in June 2008 that these settlements could approach 24% of GDP.

At the end of 2009, political processes in Ukraine will most probably radicalise in view of the economic and political crisis and the upcoming presidential elections in 2010. Another electoral year will also shape the behaviour of the two sides and their leaders. As a result, it is unlikely that populism will decrease, which adds yet another risk to the total of negative factors.

We at Omni Bridgeway expect that the political uncertainty will have a negative, if any, impact on a recovery of the Ukrainian economy in 2009.

The chance of a sovereign default is lower than a corporate and/or bank default. However, a sovereign default is still possible. In spite of the low external debts, the sufficient foreign currency reserves and the aid from the IMF, the Ukrainian central government might have difficulties in the mid-term future to repay their external payment obligations due to a much lower (tax) income from the real economy, and they might be faced with difficulties obtaining fresh capital on the international capital markets for refinancing purposes.

The chance of a large-scale corporate and bank default in the Ukraine is much higher. The deterioration of the terms of trade for Ukraine, ie the rising costs of imported goods and energy due to the higher costs of gas and the lower hryvnia and the lower volume and price of export – mainly steel – will put a lot of pressure on the real economy.

The vulnerability of the banking sector might worsen if the capital outflow continues, if difficulties occur when the Ukrainian banks are trying to obtain the necessary refinancing and if the exchange rate of the hryvnia deteriorates again.

The expected rising (bad) debt service costs of the banking sector due to the worsening corporate balance sheets and the worsening households’ incomes will also negatively influence the repayment capabilities of the banking sector.

The Ukrainian central government, with the support of the IMF aid programme, can help the Ukrainian economy to stabilise and move the economy towards a recovery in 2010 with wise fiscal, monetary and financial policies, together with some structural reforms.

Alternatively, a delayed and/or bad response with poor implementation of the policies as set out by the government and the IMF may trigger an even sharper downturn and delay the recovery significantly. Naturally, this will have negative implications for the holders of Ukrainian (defaulted) trade claims.

Despite the IMF’s decision to arrange payment of the second instalment and the actions of the Ukrainian central bank to support the hryvnia, we still believe the chances are high that the ongoing worsening of the world economy and the difficulties in the capital markets will negatively influence the recovery of the Ukrainian economy in 2010.

Ukraine is very dependent on international trade and commodity prices, as well as on the international capital markets. Our expectation is that, in spite of the recent rise in confidence from investors, there is still a larger chance that we will encounter several defaults of large Ukrainian corporates and banks during 2009, together with a rising chance of a sovereign default.