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Sunday, October 12, 2008

Ukraine Wobbles As The Financial Ground Beneath It Trembles

by Edward Hugh: Barcelona

The medium-term outlook is sensitive to external developments and policy responses. A benign external environment, featuring even higher steel prices and FDI, could produce growth in excess of 7 percent, but inflation could prove hard to control under a peg. Under an adverse external outlook, by contrast, the peg could lead to external sustainability problems.
IMF 2006 Article IV Consultation Staff Report (February 2007)

Ukraine's economy is in trouble, there is no doubt about it. The cost of protecting debt against a sovereign default by Ukraine's government soared to a record on Friday, following the arrival of a twin storm of both political and financial uncertaintly. The Ukraine president Viktor Yushchenko announced earlier in the week (only to be challenged on Saturday by his perpetual rival Julia Tymoshenko) that he was going to call what would be the country's third parliamentary elections in as many years just as the central bank found itslef forced to step in and take control of the country's sixth-largest bank while the country's currency - the hyrvnia - went for a nose-dive. With the benefit of hindsight the IMF forecast cited in the paragraph above has been extremely prescient. During the "benign external environment stage" Ukraine's economic growth has been substantial, steel prices have been high, and FDI flows (especially into the banking sector) strong. As a result inflation went through the roof. Now we have entered the "adverse external environment" stage, and steel prices are falling while bank and other external finance flows reverse direction. The sustainability issues are evident, and the coming days are going to be critical.

Ukraine is not alone in having problems at this point (but here there is no strength or consolation to be found in company), and stock markets around the globe fell dramatically last week. Ukraine's PFTS bourse was, thus, only one among several that found themselves complelled to suspend rading. Ukraine's stockmarket was closed for the second time in the week on Wednesday (trading had previously been suspended on Monday) following an 11 per cent drop in shares on Tuesday (with banks plummeting between 22 and 26 per cent, and metal producers slumping from 13 to 16 per cent). Trading did recommence again on Thursday, only to see an additional 14 percent in value wiped out, and the doors firmly barred again on Friday. Markets will now remain closed until Monday, when, at the time of writing, they are scheduled to open once more. The PFTS index has now lost 41 percent since the start of September, when the large scale investor pull-out from Russia really got underway, and is down 73 percent since the start of the year, a rollercoaster performance following the 130 percent rise last year. The MSCI Standard Core Index for Ukraine is down 18.86% so far this month, 57.58% over the last three months, and 73.81% since the start of this year. To get a comparison, if we look at the MSCI emerging markets index as a whole (although it should be pointed out that Ukraine is still classified as a frontier market) the fall so far this year is 52.48%, and the Emerging Markets Eastern Europe drop over the same period is 60.9%.

Credit Default Swaps Soar

Credit-default swaps on Ukraine's $14.9 billion state debt jumped by 473 basis points to 1,700, the biggest one-day advance, according to CMA Datavision prices in London. Ukraine now is priced as having the highest risk of default among Europe's emerging markets.

Ukraine is highly dependent on foreign investment at a time when credit markets around the world are frozen. Ukraine's current account deficit has surged strongly this year to a projected $7.7 billion (up from about $2 billion). At the same time annual inflation soared to a record 31 percent in May and was still stuck at 25 percent in September.

The central bank has already spent an estimated $1 billion supporting the hyrvnia after it fell as much as 12 percent against the dollar during September and early October. The intervention reduced foreign reserves to $36.5 billion yesterday and pared the decline in the hryvnia, which strengthened by 6.6 percent on Friday to reach 4.9987 per dollar. This followed a drop to 5.9 to the dollar on Wednesday (or a cummulative 20% devaluation since early the start of September). All these numbers are large, whichever way you look at them. And this kind of intervention is expensive, and while Ukraine is not on the brink of bankruptcy (yet) it cannot continue for that long. Reserves already fell in terms of months of next period imports from 4 months to 3.7 between Q1 and Q2 2008 according to central bank data. At the same time Ukraine's external financing requirements have risen sharply in recent years (see chart below).

Banks Take A Beating

The National Bank of Ukraine also took over the management of Prominvestbank during the week, and imposed a moratorium on payments to creditors for six months, triggering generalised credit rating downgrades.

The move came after nearly a week of local media reports, which were followed by queues outside banks and in front of ATMs, that Prominvestbank was in difficulties due to heavy involvement in Ukraine metal and real estate industries - both good earners until as late as last month, but now sectors which face massive losses due to falling international commodity prices and more costly credit.

Moody's investor services expressed concern about the ability of Kiev-based Prominvestbank - which had a reported 27.6 billion hryvnia ($5.1 billion) of assets as of Sept. 30 " to continue its operations as a viable stand-alone entity". In a report written by analyst Yaroslav Sovgyra, and was published Thursday, the ratings agency said "Prominvestbank's franchise and the overall credit profile have been significantly impaired in light of the recently experienced run on deposits by the bank.'' Moody's cut its foreign-currency deposit grade for Prominvestbank to Caa2, the fourth-lowest ranking, and down from B2.

Fitch Ratings cut Ukraine's credit outlook to ``negative'' from ``stable'' on Sept. 25.

Ukraine's banks owed a total of $38.4 billion as of July 2008, according to central bank data. To put things in perspective, this could be compared with the estimated $61 billion owed by Iceland's three collapsed banks. But the foreign indebtedness of Ukrainian banks has grown rapidly in recent years, doubling in 2006 to $13.87 billion, from $6.75 million in 2005. Much of the lending (around 50%) is forex denominated, and although the total private debt to GDP ratio (65%) is comparatively low, lending has been rising at a very fast rate (75% per annum).

Around 30% of Ukraine's total foreign debt ($128 billion or around 65 percent of GDP in 2008 according to IMF estimates) is owed by commercial banks.

In an attempt to address the crisis, the Ukraine central bank has injected 7.795 billion hryvnia into the banking system since the beginning of October, following 5.96 billion lent to banks during September. The problem is much more extensive than Prominvestbank itself, with shares in Raiffeisen Bank Aval, Ukraine's second-biggest bank by assets, also down 74 percent this year. Shares in AKB Ukrsotsbank, the country's fourth-biggest bank, have slumped 79 percent.

Ukraine's banking sector appeared even more shaky following the Prominvest decision than it did before it, with numerous banks formally applying for government assistance. Acoording to intefax a total of 25 loan institutions have filed requests for low- interest credits or other state financing.

Local newspaper Kommersant-Ukraina named Narda bank (another in the top ten) as one of the banks seeking government financing. Narda are set to receive a 290 million dollar bail-out package to cover approximately 230 million dollars of external debt, according to the report.

Other Ukrainian banks reported to be asking for help on Thursday were Rodovidbank, Alfa-Bank, Kreditprombank, and Finansi i Kredit bank, according to an article in Economicheskie Izvestia. The article said that the central bank had already approved 23 of 25 assistance package requests - and that they were worth in total around 620 million dollars,. Banks applying for cash injections account for something like 25 per cent Ukraine's banking sector.

Apart from Kazakhstan, Ukraine is currently the only government among Europe's emerging markets with credit-default swaps currently trading above the 1,000 basis points level. But even Kazakhstan debt is way below the UKraine equivalent, with contracts on Kazakhstan jumping to 1,050 basis points from 759 basis points on Friday as the government increased sevenfold the limit on retail bank deposits guaranteed.

The problem is most certainly becoming a regional one, and extending across Eastern Europe, with contracts on Russian government debt up 179 basis points (to 559), their highest level since at least 2004. Credit-default swaps on Turkey rose 138 points to 552 points, while those on Hungary increased 116 points to 458.

As I have argued in a number of previous posts (here, here, here and here) Ukraine is evidently suffering from a wide variety of problems, including institutional chaos and ongoing population decline, and it is not really surprising that it should be singled out as the country destined to lie at the heart of the forthcoming CEE "correction".

Strong GDP Growth

“The growth forecast for 2008 reflects strong performance during the first half of the year, terms-of-trade gains, and indications of a bumper harvest,” the October 2008 IMF World Economic Outlook report stated. “Going forward, growth is projected to decelerate markedly, reflecting weaker export market growth, slowing real wage increases, moderating terms-of-trade gains, and higher financing costs.”

The current events in Ukraine may well take some observers by surprise, since the general impression has been that the economic performance has been solid and GDP growth has been strong in recent years, and this has given the impression that the underlying reality was sound, which it basically hasn't been. The country has been bedevilled by constant infighting, while at the same time a combination of strong migration of Ukraine workers to external destinations and very long term low fertility has meant that the country endemically suffers from acute labour shortages as the population both ages and declines comparatively rapidly. Hence, in my view, the absurdly high levels of inflation we have been seeing.

Nevertheless, real GDP has grown by 7.5 percent a year on average since 2000, in line with other CIS countries, and indeed that rate has been higher than in most other transition economies: whether or not this growth was built on sand is what we are now all about to find out.

GDP was up at a 7.1% y-o-y rate in the January to August period, and in fact the expansion has even been accelerating in recent months largely, due to the good harvest and the increase in agricultural output - up 24.4% January to August. Manufacturing output has also been doing well, driven by a seemingly unquenchable thirst for steel in Russia, and was up 7.3% y-o-y in the January-August period. Construction, on the other hand, has now been in recession for some time, with output down 5.3% y-o-y in the first eight months of the year. The decline in construction is a reflection of the growing credit difficulties the economy has been having, and the slowdown has been making its presence felt in domestic consumption generally, with the rate of retail sales increase (while remaining strong) starting to taper off, falling from 10.4% y-o-y in Q1 to 8.2% in Q2. And as we know, the recent Russian tank excursion through the Roki tunnnel has meant that Russia is now nothing like so thirsty for steel (see below), and as a result, we should expect to see headline Ukraine GDP growth dropping fairly rapidly (we could be down to a 3 or 3.5% annual rate by the end of Q4, with more downward movement to follow as we move into 2009), as the country gets caught in the twin pincer of an internal credit crunch (sudden stop) and a sharp drop in external demand for its key product.

Overheating and The Inflation Problem

Evidently the Ukraine economy was pushed well beyond its short term capacity limits by a combination of expansionary fiscal and incomes policies (real, inflation adjusted, income was up 13.4% y-o-y in January-August) and high steel prices (both of which fuelled very strong domestic demand growth), and these were simply reinforced by very rapid money and credit growth. These factors, together with rising food and energy prices, lifted CPI inflation to a peak of 31% percent in May (see chart below), since which time the rate has fallen back, but only as far as the 24.6% rate registered in September.

Core inflation has also risen - with producer prices still rising at an annual rate of 42.7% in September (having peaked at 46.3% in July, see chart below), while real wage growth continues to be substantial, and inflation expectations remain at a very high level.

Current Account Deterioration

The Ukraine current account deficit has deteriorated sharply because of the very strong domestic demand growth and, more recently, the eroding competitiveness of Ukraine manufacturing industry. This has loss of competitiveness has occurred despite significant improvements in the terms of trade. This favourable situation is now coming to an end and in all probability even reversing as steel prices drop substantially. Capital inflows, and especially FDI, which have been strong, may now well reverse. Private external debt and debt rollover have risen sharply, leaving the economy more sensitive to balance-sheet risks and deteriorating global liquidity conditions, according to the most recent staff report by IMF economists.

The IMF estimate (October 2008, WEO) that this years current account deficit will rise from 3.7% of GDP in 2007 to 7.2%.

Fiscal policy has been dangerously expansionary in the face of the rising inflationary pressures and the deteriorating current account position. Nominal spending has risen by an average over 30 percent a year since 2003, stimulating domestic demand and increasing the size of the government sector. This growth reflected rapidly rising public-sector wages and social transfers and, in 2008, partial restitution of Soviet-era bank deposits that had been wiped out by hyperinflation.

Deficits have been moderate, as spending growth has been paid for by inflationary revenue windfalls that fiscal policy itself has helped bring about. Nevertheless, the fiscal stance has been procyclical and Ukraine is one of the few countries in Eastern Europe to have increased its fiscal deficit as capital inflows have surged.

Steel Dependent Economy

In what is now a sign of the times Ukraine's biggest steel mill, owned by the ArcelorMittal group, reduced steel output by 10.5 percent to 5.471 million tonnes in January-September 2008, according to Ukraine news agency reports last week. The reports suggested the ArcelorMittal mill had decreased rolled steel output by 12.4 percent to 4.663 million tonnes so far this year, while pig iron output fell by 9.3 percent to 4.935 million. The company had previously increased steel output to 8.103 million tonnes in 2007 from 7.6 million in 2006.

Just over the border, OAO Severstal, Russia's largest steelmaker, also announced last week plans to slash output in Russia, the U.S. and Europe by as much as 30 percent in October and review full-year forecasts. Production is to be cut 30 percent in the U.S. and Italy, and 25 percent in Severstal's home town of Cherepovets in Russia.

Steelmakers from China and South Korea to Austria and Russia are curbing output as demand for cars and buildings weakens, and as banks withdraw funding for new plants. OAO Magnitogorsk Iron & Steel, Russia's third-largest producer, Posco, Asia's biggest stainless steel maker, and Voestalpine AG, Austria's top steel company, all signaled cuts in production plans this week.

The production and export of steel is an important pillar of the Ukrainian
economy, and steel production accounts for more than a third of total goods exports (equivalent to some 12 percent of GDP). Thus real GDP growth in Ukraine is closely linked to steel prices. During the global economic upswing of the past few years, along with a wider surge in metals valuations, steel prices have risen dramatically, thus underpinning Ukraine’s mostly favorable export performance and impressive GDP growth ever. Although steel prices had been holding up till very recently, the current global financial turmoil is having a dramatic impact on car, construction and investment activity, all of which impact steel prices and we may therefore expect significant adverse effects on Ukraine growth and export receipts. A key issue for the future is, of course, how Ukraine’s economy can be made less dependent on such global price volatility in one key product.

Sharp Steel Downturn

As recently as Sept. 4 OAO Severstal had been suggesting that output would rise 31 percent to 23 million metric tons this year, so the slowdown has been very rapid indeed. Goldman Sachs Group Inc. yesterday cut its 2009 steel price forecast by 29 percent. Global export prices for hot-rolled coil steel, a benchmark, have declined 19 percent since July, according to Bloomberg Metal Bulletin data.

And the slump doesn't only affect current output, investment is also affected. Thus Austrian steelmaker Voestalpine announced during last week that it is considering delaying a decision on building a new steel plant on the Black Sea due in part to the financial crisis. Voestalpine had been planning to build a plant with a 5.5 million tonne capacity in either Bulgaria, Romania, Turkey or Ukraine, with a cost which investment analysts estimate to be in the 5 to 6 billion euros ($6.7-8.2 billion) region.

Hyrvnia Under Pressure

While the official exchange rate is set as Hr 4.95 – plus or minus eight percent – to the U.S. dollar, some exchange booths were offering Hr. 5.5 to Hr 6 for $1.
Kiev Post Report

The hyrvnia - Ukraine's national currency fell to an eight-year low last Wednesday, following the decision of the National Bank of Ukraine to widen the currency's trading band.

The National Bank, which has $38 billion in foreign exchange reserves, is now engaged in a delicate balancing act since while on the one hand officials are promising “strong interventions” to keep the hryvnia at roughly five to the dollar, international financing sources are drying up and Ukraine is running a growing current account deficit, which hit nearly $8 billion in July.

The strategy appears to be not to waste foreign exchange reserves, defending an arguably un-defendable exchange rate, but to conserve reserves to support banks and corporates to meet external debt service payments falling due and, also, to more generally prop up the banking sector. The problem is that the NBU can either support the currency, or support the banks and corporates but it does not really have enough foreign exchange reserves to do both at once.

Ukraine's central bank has weakened the currency's official rate against the dollar and widened its trading limits on October 7. The currency's new official rate until the end of the year was weakened to 4.95 per dollar from 4.85 and it will be allowed to rise or fall 8 percent from that level, compared with the previous 4 percent.

The hryvnia has slumped 18 percent against the dollar since Sept. 2, when President Viktor Yushchenko's party broke from its coalition with Prime Minister Yulia Timoshenko. Yushchenko dissolved the parliament yesterday, calling for new elections.

The managed currency is also being pushed down by demand for dollars from local banks and companies who need to pay down debt which they can't refinance so they have to buy dollars and pay back now. Exporters seeing this situation are also postponing selling dollars hoping for more local weakness down the road.

Nationalnyi Bank Ukrainy, which kept the hryvnia little changed against the dollar throughout 2007 and 2006, allowed it to trade more freely this year to help combat inflation, now at 26 percent. The bank strengthened the hryvnia's official rate by 4 percent to 4.854 per dollar in June, after leaving it at 5.05 per dollar since April 2005.

Declining Population The Root Of All Evil?

One of the things we should all now be learning as we look out across what is currently happening right across Eastern Europe (and I do mean right across) is that what we have is an environment where a number of long term underlying problems persist. These range from a lingering and heavy state presence in the economy, high and enduring inflation which steadily eats into the export competitiveness of manufactured goods and services, wage pressures which stem from labour supply shortages produced by out-migration and long term low fertility, and heavy balance sheet exposure due to an extensive euro- or dollarization of the banking sector (the later being the Ukraine case). The large current account deficits which follow from the above, and the consequent ongoing dependence on the arrival of substantial capital inflows can create a vulnerability to short term shocks which puts the entire macroeconomic framework at risk. The current credit crunch is, of course, almost a text book example of just such a short term shock.

This danger of a strong correction in adverse times becomes even greater (as we are now seeing) if measures are not taken (which they weren't in Ukraine's case, see this post) to drain excess liquidity from the system (by running a fiscal surplus for example), to loosen labour supply constraints by facilitating inward migration of unskilled workers, and to accelerate the pace structural reforms - and particularly those which facilitate the development of "greenfield" investment sites which help channel capital flows towards productivity-enhancing uses and in so doing raise exports. Unfortunately, at least this time round, it would seem it is a little late in the day for this kind of advice.

So to answer the question I somewhat provocatively inserted at the head of this section, Ukraine's declining population is not 100% of the problem, not by a long stretch it isn't, but it is an important component, and does form a context in which the other parameters need to be situated, and this dimension of the current crisis in Ukraine is all the more important since it is one which is normally ignored, and even more to the point, has been left unattended for so long that it has become an issue which it is very hard to address.

A Declining and Ageing Population

According to data from the State Statistics Committee , Ukraine's population fell by 290,220 in 2007. That is a rate of only just short of a million people less every 3 years. Simply there are more people dying every year than are being born, with 472,657 births being registered (up 12,000 from 460,368 for 2006) and 762,877 deaths (down slightly from 758,093 in 2006). What this means is that Ukraine's population is now falling very fast, at an annual rate of 0.675%. And remember this is the natural decline, not counting out migration. As we can see in the chart below the Ukraine population peaked in 1993, and has been in some sort of free-fall ever since.

There are a number of factors which lie behind this dramatic decline in the Ukrainian population. One of these is fertility, which is currently in the 1.1 to 1.2 Tfr range. In fact Ukraine's fertility actually dropped below the 2.1 replacement level all the way back in the 1980s, but somehow people haven't seen fixing this "bust" as being in any way particularly important.

A second factor which is also important is life expectancy, and in the Ukraine case the trend in male life expectancy has been most preoccupying, since it has been falling rather than rising in recent years. In particular male life expectancy which is currently running at around 64. Apart from stating the obvious here, we should note that the deteriorating health outlook which this low level of life expectancy reflects places considerable constraints on the ability of a society like Ukraine to increase labour force participation rates in the older age groups, and this presents a big problem since increasing later life employment participation is normally though to be one of the princple ways in which a society can compensate for a shortage of people in the younger age groups.

The third factor influencing population dynamics is obviously migration. Ukranian out-migration since the turn of the century is distinguished by two key tends: a) a reduction in intensity when compared with the very dramatic population movements which were so characteristic of the 1990s, and b) a significant change in destinations. From migrating East the Ukranians are now moving West. There is little in the way of systematic data here, but there is national level data on the numbers of Ukranians who now live and work in Portugal, Spain and Italy, together with plenty of anecdotal information about Ukranian migrant workers in Latvia, the Czech Republic, Poland and elsewhere in the EU 10.

According to information provided by Ukrainian diplomatic missions, 300,000 Ukrainian migrants may be working in Poland, 200,000 each in Italy and the Czech Republic, 150,000 in Portugal, 100,000 in Spain, 35,000 in Turkey, and another 20,000 in the US. According to official information based on the number of permits issued by the Russian Federal Migration Service, some 100,000 Ukrainian citizens currently work in Russia, although the real number of Ukrainians working there is often estimated to be more in the region of 1million.

With Fewer and Fewer People Available For Work

This out migration is very significant from the economic point of view, since the majority of those working abroad send money back on a regular basis (see chart below which shows World Bank estimates for Ukraine remittance flows) while at the same time are not present in the country to offer themselves for the work which this extra money creates. So out migration and the accompanying remittances are one thing in a high fertility, growing population like that which is to be found in Ecuador or the Philipinnes, and quite another in the long term low fertility, declining population environment of Central and Eastern Europe. Hence all that demand driven wage inflation. As we can see from the data in the chart below (which the World Bank Economists themselves recognise if surely a substantial underestimation) the flow of remittances into Ukraine has increased steadily in recent years. According to the World Bank remittances amounted to approximately 1% of Ukraine GDP in 2007, a number which seems rather small given the number of migrants involved, and one may suspect here that the data is rather underestimating the scale of the flows, but even as it is this amounts to a fiscal stimulus of 1% of GDP as a minimum.

As a result unemployment has been falling steadily over the last two years:

According to data from the Ukraine statistics office the official rate of unemplyment stood at 1.8% of the economically active population in August 2008 (down from 2.4% in January). Now these numbers are undoubtedly an underestimate of the true levels of unemplyment (the ILO compatible rate is the much higher 6.2%, but given the very special health situation in Ukraine we need to ask ourselves just how many of those who are formally included in the ILO classification are actually fit for work in a modern economy) but they do give an indication of the trend, and it is clear that some parts of the Ukraine labour market have been suffering from acute labour shortages, and hence the wage-push inflation the country has been experiencing. Wages have been rising (see chart below) at a rate which has been way above the combined inflation and productivity increase levels for many years now, and although wages did start from a very low level, and some degree of "catch up" was not only inevitable but also desireable, the complacency of the relevant authorities (both nationallly and interbationally, IMF, World Bank etc) in the face of such levels AFTER inflation really started to take off really does strike the external observer as quite extraordinary.

In many ways Ukraine could be considered to be a rather important strategic component in the whole Eastern labour supply and demographic puzzle, as we are no about to see, since many have been hoping against hope that as the recent expansion steadily drained labour supply resources across the whole region, then Ukraine would simply be able to step up to the plate and offer countries as diverse as the Baltics, Poland, Hungary, the Czech Republic and Russia the labour they needed to keep their own inflation in check. This view implied, in my opinion, that Ukraine was to become some kind of "fish farm" for the rest of Eastern Europe, and that view as we are seeing was always based on a huge misunderstanding, since a low fertility society simply cannot export labour indefinitely, and if it does try to do so, then internal wages simply explode.

In Conclusion

Of course, such demographic considerations may well seem to be rather distant from the very real and pressing drama which is breaking out in Ukraine. Obviously there are a great many lessons to be learned from the current "undoing" of the Ukraine economy. One of these is undoubtedly the desireability of moving away from dependence on one or two key commodities (steel, agriculture) whose prices are known to be very volatile and tied-in intimately with the global business cycle. Another would be the belated recognition that while FDI inflows are vital, such flows into the banking and financial sectors are not the same as inflows to fund greenfield industrial site development, and that an economy which is dependent on one or two primary commodities on the one hand, and construction associated business and financial services on the other simply is not a balanced or a stable one.

It is also clear that, whatever the well-wishing we would all like to make towards a rise in living standards for the Ukranian people, it is now abundantly clear that this cannot be achieved via a lack of vigilance towards the dangerous impact of spiraling wage-cost inflationary pressure, not can policy be adequately conducted under such circumstances by a central bank whose main priority is steering the value of a currency. Laxity and tolerance towards the inflation menace ultimately comes at a very high price, especially when it is allowed to get out of control in the way it has been in the Ukraine.

Finally, even if in fighting the short-term battle for survival which is now going to confront the Ukraine economy and its banking sector longer term demographic concerns are inevitably going to take a back seat, I think we need constantly to keep in mind that a failure to come to grips with this key ingredient in Ukraine's problem set will surely only lead to more of the same at some point in the future. So if you don't especially like suffering - and who does - then act, and act now.