hsbc ukraine trip notes oct2011

8/3/2019 HSBC Ukraine Trip Notes Oct2011

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abcGlobal Research

The economys resilience to global

turmoil depends on global demand

for steelBalance-of-payments is unsustainable,

FX adjustment is a matter of timeBanks have mostly improved their

balances, yet are exposed to FX risksInternal politics will keep hindering

decision-making on key policiesThe economy: Doing better than expected

Private and quasi-private investment spending related to

the Euro-2012 championship provides some cushion against

the global economic slowdown, keeping economic growth

relatively robust in the baseline scenario. Yet, the Ukrainian

economy would be unlikely to withstand a significant fall in

global demand for steel in the negative scenario.

When will the UAH depreciate?

The current account deficit reached 4.7% (12m ma) of

GDP in August and is on the way to double digits in 2012.

The financial account is exposed to global financial markets

stress. It makes the UAH weakening inevitable and

desirable, in our view. Most likely, it will take place early

next year.

Banks face FX risk challenge

Banks have a UAH65bn net short FX position (IAS

definition) and have regulatory troubles in covering it on the

FX market. Significant UAH depreciation might trigger the

need for another round of banks recapitalization.

Fallen popularity hinders needed reforms

The popularity of the ruling Ukraines Regions Party has

substantially declined since the last elections, posing a threat

of losing control in the Parliament after the October 2012

elections. Therefore, such unpopular decisions as hikes in

natural gas and communal services tariffs, which are the key

stumbling blocks for resumption of lending from the IMF,

have been being compromised.

Economics

CEMEA

Ukraine Trip Notes

Preparing for challenging times

14 October 2011

Alexander Morozov

Chief Economist

HSBC Bank (RR) (Limited Liability Company)

+7495 783 8855 [email protected]

Artem Biryukov

Economist

HSBC Bank (RR) (Limited Liability Company)


View HSBC Global Research at: http://www.research.hsbc.comIssuer of report: HSBC Bank (RR) (Limited Liability Company)

Disclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of it
http://www.research.hsbc.com/http://www.research.hsbc.com/http://www.research.hsbc.com/


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We had a fruitful client trip to Ukraine on October

5-6. During the trip we met with officials,

international financial organizations, banks and

corporates, and think tanks. Below are our major

takeaways from the trip. We have selected those

that appear to be the most topical these days.

The economy is resilientfor now

Accounting for recent trends and the likelydynamics of growth factors in 2012, we are

slightly revising our GDP growth projections for

Ukraine. We foresee GDP of 4.9% in 2011

(4.5% before) and 4.5% in 2012 (5.1% before).

After some moderation in 2Q, GDP growth in

Ukraine has accelerated to 7.5% y-o-y and to c5%

y-t-d in July on rich agricultural crops, according

to the NBUs and governments estimates.

Although steel prices and steel exports from

Ukraine are exposed to downside risks taking into

account the uncertainty about global economic

outlook, at the moment Ukrainian metallurgy

seems to be doing quite well. Private consumption

is still recovering from the crisis and is still

supporting strong growth of retail sales.

Preparing for challengingtimes

Chart 1. GDP growth and steel prices

-24

-18

-12

-6

0

6

12

Q22005

Q42005

Q22006

Q42006

Q22007

Q42007

Q22008

Q42008

Q22009

Q42009

Q22010

Q42010

Q22011

Q42011

Q22012

Q42012

%, y-o-y

100

150

200

250

300USD/tonne

GDP (LHS) GDP (fo recast, LHS) Global Steel IDX (RHS)

Source: State Statistics Committee of Ukraine, Reuters


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The slowdown of economic growth and imports

growth in Russia that we expect in 2012 is likely

to temper Ukrainian exports growth and to

restrain GDP growth next year. The Ministry of

Economic Development and Trade (MOEDT)

expects that spending related to the EURO2012

football championship that Ukraine will co-host

with Poland will boost GDP growth by 0.6-1.0pp

to 5.0% in 2012.

Agreeing with the MOEDT on that, we expect

much higher growth of imports to Ukraine than

the MOEDT. Correspondingly, negative

contribution of net exports to GDP growth will be

higher in our baseline scenario for Ukraine.

Depreciation risks priced in

We expect that the UAH will be allowed to weaken

through a series of mini-devaluations beginning in

Chart 2. Retail sales and real wages

-40

-30

-20

-10

0

10

20

30

40

Apr-07

Jun-07

Aug-07

Oct-07

Dec-07

Feb-08

Apr-08

Jun-08

Aug-08

Oct-08

Dec-08

Feb-09

Apr-09

Jun-09

Aug-09

Oct-09

Dec-09

Feb-10

Apr-10

Jun-10

Aug-10

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

%, y-o-y

-40

-30

-20

-10

0

10

20

30

40

%, y-o-y

Retail trade turnover Real wages

Source: State Statistics Committee of Ukraine

Chart 3. FX rates

0.85

0.90

0.95

1.00

1.05

1.10

1.15

1.20

1.25

Jan-11 Feb-11 Mar-11 Apr-11 May -11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11

Index

appreciation

depreciation

UAH EUR RUB TRY PLN

Source: Reuters, HSBC


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early-2012. We revise upward to UAHUSD9.9

from UAHUSD9.5 our end-2012 forecast.

The hryvnya (UAH) is pegged to the USD with

almost no fluctuations allowed de facto. So, while

most EM and DM currencies depreciated versus

the USD over past weeks, the UAH has not.

Should and will it? We think it should and will.

The centre of discussion among locals is mostly

focused on the issue of sustainability of the

current market turmoil and EM currency

weakness. It is almost a consensus view locally

that current levels of cross-rates would trigger

UAH depreciation at some point, if sustained.

Yet, there is general belief that if the USD

weakens relative to other currencies, the

depreciation of UAHUSD could be removed from

the policy agenda.

Trade balance projections that we have seen

reflect expectations of the same or even narrowingtrade and current deficit in the coming quarters if

external conditions that existed in mid-2011 are

restored. We think that these projections

significantly underestimate imports growth. We

see both trade deficit and current account deficit

staying on an unsustainable track, even if the

situation on global financial markets and global

economy improves. According to the NBU, the

12-month rolling current account deficit has

already widened to 4.7% of GDP in August. We

foresee it widening further to double-digits in

2012, which would pose a serious threat to the

currency stability even if global financial markets

are in good shape.

Therefore, withstanding this trend stemming fromthe fundamental factors would be a mistake, in

our opinion.

The present market situation just accelerates the

trend, making imports cheaper and adding

depreciation pressures arising from the financial

account of balance-of-payments to pressures

arising from current account. The NBU has lost

more than USD3bn of reserves in September and

is likely to keep losing them down the road.

If the UAH is on its road to devalue then the

key questions are the following: When? And by

how much?

Chart 4. Trade balance and current account

-5

-4

-3

-2

-1

0

1

2Q2006 4Q2006 2Q2007 4Q2007 2Q2008 4Q2008 2Q2009 4Q2009 2Q2010 4Q2010 2Q2011

USD bn

-15

-12

-9

-6

-3

0

3% of GDP

Current account (% of GDP, RHS) Trade balance (% of GDP, RHS)

Current account (LHS) Trade balance (LHS)

Source: National Bank of Ukraine


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Since the authorities are not fully convinced at

present of the necessity of the UAH devaluation

and strong pressures on the NBUs reservesemerged only in September, we think it is quite

likely that the NBU will be slow in adjusting the

UAHs value. The significant short FX position of

the banking sector (see next section), the public

commitment to maintaining stable currency until

year-end made by the NBU, and negative political

repercussions of any UAH devaluation (see last

section) hinder the decision-making process on

the currency.

Yet, waiting for too long is very costly.

Devaluation expectations will not go away easily

and the pressures on the NBUs reserves will most

likely be sustained. Losing reserves month by

month is not the best strategy to follow when

international reserves cover less than five months

of imports.

Besides, in order to offset the pressures the NBU is

forced to keep the UAH liquidity low, and local

interest rates high. It spoils the local bond market,

not allowing the MOF to borrow at acceptable

yields. An issuance of USD-linked bonds can

provide only a partial solution to this problem.

Banks lending and overall economic growth could

also be compromised as a result of such policies.

All factors considered, we think that the UAH will

depreciate in early-2012.

Devaluation can be done in various ways. In order

to make the devaluation credible, it ought to be

significant, close to market expectations, made as

a one-off move (in the case of fixed currencies).

Kazakhstan did it with success in 2009.

However, the way we believe the Ukrainian

authorities are mostly likely to follow would be a

series of mini-devaluations complemented by

restrictive measures for FX market participants.

Therefore, it might take the whole 2012 for the

UAH to devalue to UAHUSD9.9 by end-2012.

This is our new forecast, slightly revised upward

from UAHUSD9.5 that we had before. We also

expect that after parliamentary elections that are

to be hold in October 2012, the UAH will be

allowed to weaken to a greater degree than in the

previous quarters.

Chart 5. International reserves

0

2

4

6

8

May-08

Jul-08

Sep-08

Nov-08

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Jul-11

Sep-11

months of imports

20

25

30

35

40

USD bn

International reserves (RHS) International reserves/months of imports (LHS)



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We think that the UAH will continue to weaken

in 2013 but at a slower pace since we believe the

current account deficit is likely to start

narrowing by then.

Banks recovery at risk

Existing regulations forced Ukrainian banks to

accumulate a net short FX position of UAH67bn

at present, which represents a significant risk for

banks capital if the UAH depreciates.

Ukrainian banks have started recovering from the

2008-09 crisis after being recapitalized. A steady

inflow of deposits has been taking place since

March 2010 and the steady increase in banks loan

books (mostly, to large corporates and small

businesses) has been occurring since January 2011.

The loan-to-deposit ratio for the banking sector at

large stays high, above 170%. However,

occasional evidence suggests that the ratio should

Chart 6. UAH NDF outright

12-Oct-11

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

1M 2M 3M 6M 9M 1Y 18M

UAH/USD 12-Oct-11

Source: Reuters

Chart 7. Loans and deposits

200

300

400

500

600

700

800

Apr-08

Jun-08

Aug-08

Oct-08

Dec-08

Feb-09

Apr-09

Jun-09

Aug-09

Oct-09

Dec-09

Feb-10

Apr-10

Jun-10

Aug-10

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

UAH bn

1.5

1.6

1.7

1.8

1.9

2.0

2.1

2.2

2.3

2.4

2.5

Loans (LHS) Deposits (LHS) Loan-to -deposits ratio (RHS)



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be close to 100% for new loans. Old loans,

including restructured ones, are not backed by the

deposit base. Local experts on the banking sector

estimate NPLs at 20-25% or higher (if

restructured loans are included). The good news is

that these NPLs fall on the pre-crisis loan book

and have been identified.

Writing off of problem assets is still a problem

despite recent positive changes in the legislation

to this matter. Banks have concerns regardinghow this legislation will be enforced.

A key challenge that banks face these days is their

high exposure to FX risks. The banking sector has

a net short FX position of cUAH67bn, a study of

Forum for Leading International Financial

Institutions has revealed. This net short FX

position emerges when International Accounting

Standards (IAS) are applied. From a local

regulator perspective, however, banks have an

almost balanced FX position.

This problem emerged when the NBU has

disallowed making FX provisions against FX

assets forcing banks to form them in the UAH.

Now it may backfire to the detriment of the

stability of the banking system as banks can not

close their net short FX position or hedge it on the

FX market due to the regulatory restrictions on

such operations.

According to a stress-test performed by EBRD on

a pool of the local partner banks, banks should beable to withstand the UAH devaluation up to 20%.

Greater devaluation would make it necessary to

recapitalize some banks. It is important that while

the UAH exchange rate remains stable, the

regulator together with banks find a credible

solution to the problem of banks high FX

exposure. An issuance of USD-linked government

bonds is just a part of the solution, in our view.

Chart 8. Political preferences

If parliamentary elections were held next Sunday how would you vote?

0

10

20

30

40

Yulia

Tymoshenko

Bloc

Svoboda

(Tiahnybok)

Communist

party of

Ukraine

(Sym onenko)

Party of

Regions

UDAR

(Klychko)

Sylna

Ukrayina

(Tihipko)

Front Zmin

(Yatseniuk)

Against all Would not

vote

Hard to say

%

Apr 2010 Aug 2010 Oct 2010 Feb 2011 Apr 2011 May 2011

Source: Razumkov Centre


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Uneasy politics and the IMFThe diminished popularity of the coalition

government led by Regions of Ukraine Party

has significantly reduced space for policy

manoeuvres and put on hold the stand-by program

with the IMF.

The popularity of the coalition government has

fallen since spring 2010 on the hardships related

to slow recovery from the economic crisis and

socially painful fiscal tightening. If Regions ofUkraine fails to improve its political ratings by the

time of the October 2012 parliamentary elections,

the elections could unpredictably transform

political landscape in Ukraine bringing to power a

coalition of opposition parties.

Enacting pension reform that inter alia includes an

increase in pension age and an increase in

minimum length of services the government has

improved the sustainability of the state Pension

Fund. It was one of the key structural conditions ofthe stand-by program with the IMF. Yet, the

government failed to hike communal tariffs and

natural gas prices for households, which is another

key structural condition of the stand-by program.

We understand that the IMF does not consider it

possible to compromise on that issue, given that

overall gas price subsidies in Ukraine amount to 5-

6% of GDP and Ukraine has a poor track record on

delivering gas price hikes in the past. Specifically,

Ukraine has to increase natural gas tariffs forhouseholds by 30%, and heating tariffs by 50% in

order to comply with the program.

In this respect, the imprisonment of the former

PM Yulia Timoshenko, who was also the key

rival of President Yanukovich at the last

presidential elections, may spoil Ukraines

economic relations with the Western countries.

As a result, getting official funding could be more

difficult than before.

We think that in the end Ukraine will have to raise

gas and communal tariffs as financial markets are

unlikely to be ready to provide much funding for

Ukraine any time soon and there is no real

alternative to IMF funding. We believe that the

tariff hike will occur either in early January 2012

or in 2Q when the heating season is over in order

to minimize an impact on the housing bill from

higher natural gas and heating tariffs.

Budget deficit and public debt

While market based budget deficit financing and

public debt refinancing have become troublesome,

the government seems sufficiently covered with

resources in the near-short term. Yet, the medium-

term fiscal and debt sustainability remains

uncertain, given still rising debt-to-GDP ratio and

political uncertainties in Ukraine.

Chart 9. Budget revenues performance

0

50

100

150

200

250

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

UAH bn

Rev enues 2009 Rev enues 2010 Rev enues 2011

Source: MOF


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Ukraine has to repay USD2bn to Russian VTB

bank and USD0.6bn on maturing Eurobonds in

4Q. Ukraine should be able prolong the loan to

VTB for another six months, though most likely at

a higher interest rate. Better than planned revenue

performance and substantial cash balances that the

MOF accumulated should help to make debt

payments this year even if international financial

markets remain closed.

The government should be able to close any

remaining cash gap in the budget this year

through cuts of non-essential budget spending

and/or issuance of dollar-linked bonds, which are

in good demand by local banks that need them in

order to hedge FX risks.

In the absence of energy tariffs hikes for

households so far this year, the state-owned

Naftogas is likely to have a cash gap of UAH8bn

(USD1bn). It leaves the government with the

challenge of meeting 3.5% of GDP consolidated

(i.e. including Naftogas) budget deficit target this

year. More importantly, Naftogas faces a cash gap

of UAH21bn (USD2.6bn) in 2012 as well, of

which only UAH12bn (USD1.5bn) has been

provided as state subsidy to Naftogas in a draft

state budget for 2012.

We think that the Naftogas cash gap in 2012

potentiall could be even higher. If FX risks

materialize as we expect, the UAH denominated

cash gap would increase because Ukraine

consumes mostly imported natural gas. Besides,

the currently poor collection rate in the communal

sector of c70% would likely decline with any rise

in gas prices. We understand that this factor has

not been accounted for in the official fiscal

projections at the moment. Therefore, reaching

2.5% of GDP budget deficit target in 2012 could

become a more serious challenge for the

government than the 3.5% deficit target this year.

We think that Ukraine can get substantial discounts

from the price of imported natural gas from Russia

during the ongoing negotiations with the Russian

side only at the expense of serious political and/or

economic concessions, which could compromise its

WTO membership and move back prospects of

closer economic integration with the EU. It is notvery likely, we reckon.

Chart 10. Fiscal performance has improved

-40

-30

-20

-10

0

10

20

30

40

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Jul-11

UAH bn

-20

-15

-10

-5

0

5

10

15

20

UAH bn

Defic it ()/ surp lus (+) (RHS) Revenues (LHS) Expenditures (LHS)

Source: Ministry of Finance of Ukraine


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The longer-term fiscal and public debt outlook

remains uncertain, in our opinion. At present,

public and publicly guaranteed debt exceeds 40%

of GDP and still remains on the rising track. In

2012-13 Ukraine will have to repay over USD5bn

to the IMF, which would not be easy to replace

with market-based funding.

Apart from local banks demand for local dollar-

linked bonds, the rest of the market would be

unlikely to be eager to buy local governments

bonds or Eurobonds until after the UAH

depreciation. Unfortunately, in the process of the

ongoing civil service reform, the State Debt

department of the MOF lost qualified staff.

This has reduced the capacity of the Ministry to

negotiate with market participants. Besides, after

Chart 11 External public debt

0

10

20

30

40

50

Q1

2005

Q2

2005

Q3

2005

Q4

2005

Q1

2006

Q2

2006

Q3

2006

Q4

2006

Q1

2007

Q2

2007

Q3

2007

Q4

2007

Q1

2008

Q2

2008

Q3

2008

Q4

2008

Q1

2009

Q2

2009

Q3

2009

Q4

2009

Q1

2010

Q2

2010

Q3

2010

Q4

2010

Q1

2011

Q2

2011

USD bn

0

10

20

30

40

50

% of GDP

General government (LHS) Monetary authorities (LHS)

Central government guarantees (LHS) Public debt to GDP (RHS)

Source: MOF, NBU, HSBC

Chart 12. Internal public debt

-5

0

5

10

15

20

25

Q1

2005

Q3

2005

Q1

2006

Q3

2006

Q1

2007

Q3

2007

Q1

2008

Q3

2008

Q1

2009

Q3

2009

Q1

2010

Q3

2010

Q1

2011

USD bn

-3

0

3

6

9

12

15% of GDP

Central government debt (LHS) NBU loans to central government (LHS)Central government guarantees (LHS) State Domestic Debt to GDP ratio (RHS)

Source: MOF, HSBC


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2012 parliamentary elections the overall decision-

making process in the country could be

compromised. All this speaks for the presence of

significant fiscal risks in the medium-term.

Conclusion

Ukraine faces challenging times economically,

financially and politically. This can only partially

be attributed to global factors. The good news is

that the outlook for Ukraine does not suggest the

repetition of the abysmal 2008 crisis. The bad news

is that Ukraine is likely to need to face FX

adjustment, hike energy tariffs and ensure political

stability after next years parliamentary elections.

We think that the Ukrainian sovereign credit is

likely to remain distressed until natural gas tariffs

are increased, the exchange rate is adjusted to a

sustainable level, and IMF funding is resumed.


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Disclosure appendix

Analyst Certification

The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the

opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their

personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific

recommendation(s) or views contained in this research report: Alexander Morozov and Artem Biryukov

Important DisclosuresThis document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the

clients of HSBC and is not for publication to other persons, whether through the press or by other means.

This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer

to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this

document is general and should not be construed as personal advice, given it has been prepared without taking account of the

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Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment

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For disclosures in respect of any company mentioned in this report, please see the most recently published report on that

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Additional disclosures

1 This report is dated as at 14 October 2011.2 All market data included in this report are dated as at close 13 October 2011, unless otherwise indicated in the report.3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its

Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Researchoperate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrierprocedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or

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Global

Stephen KingGlobal Head of Economics+44 20 7991 6700 [email protected]

Karen WardSenior Global Economist+44 20 7991 3692 [email protected]

Madhur Jha+44 20 7991 6755 [email protected]

Europe & United Kingdom

Janet HenryChief European Economist

+44 20 7991 6711 [email protected]

Astrid Schilo


GermanyLothar Hessler+49 21 1910 2906 [email protected]

FranceMathilde Lemoine


North America

Kevin LoganChief US Economist+1 212 525 3195 [email protected]

Ryan Wang+1 212 525 3181 [email protected]

Stewart Hall+1 416 868 7523 [email protected]

Asia Pacific

Qu HongbinManaging Director, Co-head Asian Economics Research andChief Economist Greater China+852 2822 2025 [email protected]

Frederic NeumannManaging Director, Co-head Asian Economics Research


Leif EskesenChief Economist, India & ASEAN+65 6239 0840 [email protected]

Paul BloxhamChief Economist, Australia and New Zealand


Donna Kwok+852 2996 6621 [email protected]

Trinh Nguyen+852 2822 6975 [email protected]

Ronald Man+852 2996 6743 [email protected]

Sun JunweiAssociate

Sophia MaAssociate

Global Emerging Markets

Pablo GoldbergHead of Global EM Research


Bertrand DelgadoEM Strategist+1 212 525 0745 [email protected]

Emerging Europe, Middle East and Africa

Murat UlgenChief Economist+44 20 7991 6782 [email protected]

Alexander Morozov+7 495 783 8855 [email protected]

Simon Williams

+971 4 507 7614 [email protected] Martins


Latin America

Andre LoesChief Economist, Latin America+55 11 3371 8184 [email protected]

ArgentinaJavier FinkmanChief Economist, South America ex-Brazil+54 11 4344 8144 [email protected]

Ramiro D BlazquezSenior Economist


Jorge Morgenstern

Senior Economist+54 11 4130 9229 [email protected]

BrazilConstantin JancsoSenior Economist


Marcos Fernandes


MexicoSergio MartinChief Economist


Claudia NavarreteEconomist+52 55 5721 3284 [email protected]

Central AmericaLorena DominguezEconomist+52 55 5721 2172 [email protected]

Global Economics Research Team
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]

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