Ukraine economy is recovering but the slow pace of that recovery has disappointed.
The economy generated lackluster growth of just above 2% over the past two years. Industrial production was flat in 2017, supported by stronger domestic and foreign demand, but undercut by the suspension of trade with the occupied territories in Eastern Ukraine. Agriculture output declined 3% y/y largely due to unfavorable weather effects. Construction delivered the year’s strongest growth at 21%, driven by infrastructure investments. Retail trade was up 9% (and 16% in December), a sign of the strength of domestic private consumption.
On the demand side, growth was driven by private consumption and investment demand. Investment demand surged more than 20% in 2016 and 15% (est.) in 2017 after a steep decline during the crisis, but that pace of growth is unlikely to be maintained in 2018.
Household demand is poised to accelerate on generous increases in wages and social payments in the pre-election year. The fiscal stimulus will boost the economy, but only temporarily. The contribution of net exports to economic growth will remain negative as imports will cover a large portion of internal demand. Overall, analysts see the economy growing 3.1% y/y in 2018.
But inflation remains a problem. The year-end 2017 inflation of 13.7% was well above the NBU’s target range of 8% +/-2%. Inflation trends have been affected by factors that are beyond the scope of the NBU’s available instruments, such as food price spikes driven by poor weather and increased exports. That said, core inflation also picked up considerably to 9.5% y/y in December – a sign that demand-side pressures are growing.
The NBU in 4Q17 raised the key policy rate twice by a combined 200 bps to 14.5% at a time when the market expected no hikes or only a moderate increase. Even more aggressively, the NBU hiked the rate by another 150 bps to 16% in January.
The NBU looks to be signaling to the government that an aggressive fiscal expansion through a possible increase in the minimum wage (on top of a 16% increase at the start of 2018) will hurt the credibility of economic policies, hinder the deceleration of CPI, and fuel FX market jitters. Since 2018 is a pre-election year, further hikes in the minimum wage and social standards are almost certain.
Regulated tariffs are another CPI-related topic in the spotlight. The government skipped a scheduled increase in October last year and the question is whether the increase will happen any time soon. IMF has remained tough on the issue and concessions are unlikely.
The Ukrainian economy will likely continue to enjoy a favourable external environment. Prices for Ukraine’s key export commodities are high, while private capital markets are ready to provide funding, provided a reform agenda is in place. The current account deficit for 2017 is estimated at less than 3.5% of GDP, and given the flexibility of the exchange rate it is poised to remain within 4% of GDP for the next couple of years.
The key risks, again, lie in possible delays to funding from IFIs. Without the funds, Ukraine will not be able to leverage the favourable external environment and smoothly navigate the election cycle.
Ukraine has approximately $16bn in external sovereign debt redemptions in 2018-20; without funding, the exchange rate and economic growth will be affected.
Currently, analysts base case scenario sees Ukraine securing one new tranche from the IMF of up to $2bn in 2018. That would leave Ukraine’s net repayment to the IMF in 2018 at near zero. Private capital markets will be open to Ukraine and yields will be favourable for new borrowings. Financial account inflows would then fully cover the moderate deficit of the C/A. In this way, the NBU would keep reserves broadly unchanged at approximately $18-19bn through 2018.
The dilemma that Ukrainian authorities face is whether to pursue painful reforms ahead of the coming elections (2019 will see two elections: a presidential vote in March and parliamentary vote in October) to secure funding from IFIs or hold off on reforms and hope that favorable external capital markets will help the economy survive the year.
Despite President Poroshenko’s strong messaging at Davos that Ukraine is fully committed to further cooperation with the IFIs, it looks as though a final political decision has not yet been made and the odds look even at this point. Developments over the past several months are worrisome for the authorities – the IMF and the World Bank have both made it clear they will remain tough on the pre-conditions that need to be met to re-launch lending programs.
The establishment of an anti-corruption court is the key issue and the authorities’ determination to quickly move on that reform will be the key thing to watch over the coming months.
Two other outstanding issues are the pension reform and household gas rates. In the IMF’s view, the pension reform law that was adopted in late 2017 “does not fully ensure a fair and sustainable pension system.” IFIs may therefore request changes to the law.
Gas rates remains the most sensitive issue, as any price increase would hit household budgets with the start of the next heating season in October 2018, just a few months before the election. Even though poorer households are generously subsidized and the state covers the bulk of their utility payments, a rate hike would still be perceived as anti-social.