Special BriefingSpecial BriefingSpecial BriefingSpecial Briefing

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UkraineUkraineUkraineUkraine –––– 7777thththth March 2014March 2014March 2014March 2014 SummarySummarySummarySummary

D&B D&B D&B D&B has has has has downgraded Ukraine’s downgraded Ukraine’s downgraded Ukraine’s downgraded Ukraine’s country risk country risk country risk country risk rating to DB6c rating to DB6c rating to DB6c rating to DB6c ((((in our ‘in our ‘in our ‘in our ‘very high riskvery high riskvery high riskvery high risk’’’’ category) category) category) category) from its from its from its from its already already already already poorpoorpoorpoor score of score of score of score of DB6b (DB6b (DB6b (DB6b (on a on a on a on a scale of 1scale of 1scale of 1scale of 1----7777,,,, with 7 with 7 with 7 with 7 being being being being the the the the highest possible highest possible highest possible highest possible level of level of level of level of operational risk)operational risk)operational risk)operational risk). The downgrade stems from. The downgrade stems from. The downgrade stems from. The downgrade stems from the significant the significant the significant the significant recent recent recent recent deterioration deterioration deterioration deterioration in in in in the the the the country’s country’s country’s country’s business business business business operating environment.operating environment.operating environment.operating environment. IIIIn late February n late February n late February n late February tttthe he he he ppppolitical standoff between the olitical standoff between the olitical standoff between the olitical standoff between the country’s political country’s political country’s political country’s political opposition and the opposition and the opposition and the opposition and the government government government government resulted in the ousting of the presidentresulted in the ousting of the presidentresulted in the ousting of the presidentresulted in the ousting of the president,,,, Viktor Viktor Viktor Viktor YanukovychYanukovychYanukovychYanukovych. . . . The newlyThe newlyThe newlyThe newly----formed successor formed successor formed successor formed successor government government government government hashashashas struggled to extend its struggled to extend its struggled to extend its struggled to extend its full full full full authority authority authority authority ((((and seemingly its legitimacyand seemingly its legitimacyand seemingly its legitimacyand seemingly its legitimacy)))) totototo the Crimea peninsula and the Crimea peninsula and the Crimea peninsula and the Crimea peninsula and some eastern provinces. some eastern provinces. some eastern provinces. some eastern provinces. The G7 joint statemeThe G7 joint statemeThe G7 joint statemeThe G7 joint statement nt nt nt on 2on 2on 2on 2ndndndnd March March March March 2014 2014 2014 2014 condemned the Russian condemned the Russian condemned the Russian condemned the Russian occupationoccupationoccupationoccupation of Crimeaof Crimeaof Crimeaof Crimea and threatened and threatened and threatened and threatened the Russian government the Russian government the Russian government the Russian government with with with with ((((as yet undefinedas yet undefinedas yet undefinedas yet undefined)))) economic economic economic economic sanctions. sanctions. sanctions. sanctions. The current political uncertainty has undermined what we already considered to be a The current political uncertainty has undermined what we already considered to be a The current political uncertainty has undermined what we already considered to be a The current political uncertainty has undermined what we already considered to be a troubled troubled troubled troubled economyeconomyeconomyeconomy, , , , which which which which isisisis suffering fromsuffering fromsuffering fromsuffering from widening widening widening widening twin twin twin twin (fiscal and current account) deficit(fiscal and current account) deficit(fiscal and current account) deficit(fiscal and current account) deficitssss and and and and accelerating accelerating accelerating accelerating inflationinflationinflationinflation. We expect that . We expect that . We expect that . We expect that the the the the bailbailbailbail----out package from international donors will facilitate out package from international donors will facilitate out package from international donors will facilitate out package from international donors will facilitate the muchthe muchthe muchthe much----needed financial needed financial needed financial needed financial stabilization stabilization stabilization stabilization that Ukraine needs to that Ukraine needs to that Ukraine needs to that Ukraine needs to support support support support itsitsitsits fiscal afiscal afiscal afiscal and external nd external nd external nd external imbalancesimbalancesimbalancesimbalances, , , , but implementation of the IMF structural reforms programbut implementation of the IMF structural reforms programbut implementation of the IMF structural reforms programbut implementation of the IMF structural reforms programmemememe is is is is far from far from far from far from guaranteed.guaranteed.guaranteed.guaranteed.

Background and Background and Background and Background and CCCContextontextontextontext

Clashes between opposition groups and the police in the Ukrainian capital, Kiev, were initially sparked in November 2013 by the refusal of President Viktor Yanukovych to sign a free-trade agreement with the EU. These clashes degenerated into violent confrontations by mid-February, culminating in the loss of nearly 80 lives. Following the ousting of President Viktor Yanukovych, Ukraine’s parliament quickly passed a new set of laws. Among these were acts to free Yulia Tymoshenko (co-leader of Ukraine’s 2004 Orange Revolution, who had been imprisoned in 2011), and a return to the 2004 Constitution, which limits the powers of the president in favour of the parliament. Ukraine’s parliament also abolished the law on dual official languages (Ukrainian and Russian) and granted amnesty to the protestors. In addition, parliament approved a new government, in which the majority of seats (including the prime minister), were given to members of the ‘Fatherland’ organisation (led by former Prime Minister Tymoshenko), one of the main opposition parties. Neither UDAR nor ‘Freedom’– two other opposition parties – have so far been granted any representation. The leaders of the original uprising seem to be heavily divided, which is adding to the current political uncertainty. Mainstream opposition leaders such as Arseniy Yatsenyuk, (the former economy minister appointed as prime minister), and Vitali Klitschko, a former boxing champion, seem to have little control over the country’s right-wing nationalist militant groups, which were instrumental in obtaining the opposition’s victory. New presidential elections have been set for 25th May.

Meanwhile, having gained power in the capital and western regions of the country, the new government has experienced difficulties in securing support in some southern and eastern provinces of Ukraine. The most extreme case is in the Crimea peninsular. On 6th March Crimea’s parliament announced its intention to break away from Ukraine and formally become a part of Russia. A proposed referendum in Crimea, which was planned for 30th March and was supposed to ask voters if they want more autonomy from Kiev, will now take place on 16th March and will include a question on whether or not the electorate wants to formally become part of Russia. In the wake of the Russian parliament’s authorization for President Putin to use troops in Crimea in case of an emergency, and in light of unidentified armed groups taking control of regional parliamentary buildings and regional government

offices, the G7 has issued a joint statement condemning the occupation. The statement also suggested some form of future economic sanctions against Russia.

Meanwhile, the escalation of the political crisis has had a severe impact on the Ukrainian economy. Since the beginning of the year the hryvnya has lost 18% of its nominal value relative to the US dollar (based on the exchange rate announced by the National Bank of Ukraine, NBU). After spending USD2-3bn on supporting the local currency in February, and reducing its FX reserves to USD15bn (equivalent to just 1.5 months of import cover, well below the 3.0 months recommended for developing countries by the IMF), the NBU stopped supporting the currency and effectively sent the hryvnya into a free float. The sharp depreciation reflects the inappropriateness of the old currency peg, which was maintained by the previous authorities despite the ballooning current account deficit. The current account deficit amounted to 9% of GDP in 2013, compared to just 2.2% as recently as 2010.

We do not expect any improvement in Ukraine’s external position in 2014, as its exports are likely to be depressed by still-sliding metal prices (especially steel) and volatile conditions for its agricultural exports. The tense confrontation with Russia, by far Ukraine’s major export market, will not help. In fact, from April 2014 Ukraine’s import bill, mostly composed of Russian gas supplies, will go up, as Gazprom, the Russian gas supplier, has already announced a lifting of the gas discount granted to Ukraine as a part of the wider bail-out package in December 2013. Ukraine’s external financial needs also include around USD13bn of scheduled external debt repayments in 2014, which might be increased by the necessity to support its domestic banks. We think the risk of a run on the country’s banks is high given the sharp depreciation of the currency and the expected surge in inflation (which was already hovering around 1% in 2012-13). In our view, a stabilization of Ukraine’s external position can only be achieved with external financial support. The new Ukrainian government has stated that it requires around USD35bn to stabilize the situation. Possible international donors, including the European Union, have announced a bail-out package of USD11bn to date. The US administration has so far committed itself to providing USD1bn in loan guarantees. A full IMF programme, however, is unlikely to be feasible before the presidential elections in May. At this stage it is difficult to estimate the full financing requirement, as there are many variables in play. We have further revised downwards our expectations for economic growth in 2014, mostly due to depressed prospects for household consumption and weakened exports.

OOOOutline utline utline utline SSSScenarios cenarios cenarios cenarios for the for the for the for the NNNNext ext ext ext FFFFew ew ew ew MMMMonthsonthsonthsonths

1. The worstThe worstThe worstThe worst----casecasecasecase scenario:scenario:scenario:scenario: civil war within the country between the western provinces and Kiev, on one side, and the eastern provinces and Crimea, on the other. We assign a low (10%-15%) probability to this scenario. This form of confrontation would inevitably draw in Russia and Western actors, who, in our opinion, have little appetite for such military action.

2. The bestThe bestThe bestThe best----case case case case scenario:scenario:scenario:scenario: a quick economic recovery and political stability in Ukraine following substantial emergency financial support from international donors. We also assign a low probability (10%-15%) to this scenario due to the unfavourable global environment (the end of the commodities super cycle and the prevalence of risk-aversion on global markets) and the deep structural economic and political problems in Ukraine.

3. The most probable scenarioThe most probable scenarioThe most probable scenarioThe most probable scenario:::: a shaky and bumpy process of slowly resolving the troubled political and economic issues facing the country; we assign this a 70%-80% probability. The new government will continue to face difficulties in extending its authority and recognition to eastern and southern provinces, and it is looking increasingly likely that Crimea will gain some form of autonomy or accede to Russia. Any future Ukrainian government will not be able to sustain its substantial budget on subsidies to households and businesses for energy use (which have resulted in Ukraine being one of the most inefficient users of energy in Europe). This will prove to be highly unpopular politically, but will also feature as a key condition of any IMF rescue programme in order to get the fiscal deficit under control. The Ukrainian economy (close to Poland’s in size 20 years ago, now less than half Poland’s size) is still highly dependent on a narrow set of industries (such as steel production and agricultural products) and will face a painful period of restructuring. The economy may benefit from a more formal trading agreement with the European Union in the medium to long term, but it could create further economic stresses in the short term.

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Country Insight Team

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Commercial Commercial Commercial Commercial IIIImplicationsmplicationsmplicationsmplications

We expect payment and credit risk (and by extension bankruptcy risk) to escalate in the short to medium term, especially for businesses that are particularly dependent on imports. Some relief will be felt by exporters with the depreciation of the hryvnya, but the currently unfavourable commodity prices for Ukraine’s major exports might limit this advantage. Transfer risk will be very high. Capital control measures are already in place and are likely to stay for the foreseeable future. Among these are: an order for domestic companies to surrender half of their FX profits; a ban on buying FX for early repayments of FX loans and investments abroad; and an instruction to banks to buy or transfer FX for their clients only within the FX limits with a cap (around UAH50,000 per month, the equivalent of about USD5,000) on FX purchases by individuals (residents and non-residents) for transfer abroad. We expect more restrictions to follow, including a potential moratorium on FX deposit withdrawals given that recent developments have fuelled demand for FX and deposit withdrawals.

RecommendationsRecommendationsRecommendationsRecommendations

• Be prepared to experience extended payment terms, if not complete disruption of foreign trade operations, due to existing capital control measures and expected additional ones.

• Factor in a potential run on the banks, especially ones largely dependent on Ukrainian capital. Consider using international banks (where possible) when dealing with companies in Ukraine.

• Expect long delays in payments on government contracts and/or their cancellation. • Consider introducing CiA terms, as least in the short term, if you have not done so already. • Closely monitor counter-parties for signs of deteriorating payment performance, which may be

an indication of the viability of the company.