ukraine default risk

8/2/2019 Ukraine Default Risk

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Staring Into the Ukrainian Economic

and Political Abyss

26 February 2012

Its been a long time now since Paul Krugman spoke of the Ukrainian economyepitomizing the arrival of what he then termed the second great depression, and its

been an even longer long time since we lay awake at night dreaming about thecoming conquests of the Orange Revolution. Its also been a good time since I looked atand wrote about the country, so now may be as good a moment as any to do so.

Ukraines efforts to seek cheaper natural gas from Russia rather than comply with theterms of a bailout have alarmed investors, propelling the former Soviet republics creditrisk above Argentinas for the first time in two years. The government is shunning theInternational Monetary Fund as it struggles to agree on discounted fuel imports fromRussia, with whom clashes halted European gas transit twice since 2006. Thats fannedconcern over its ability to meet $11.9 billion in debt costs this year, with default riskrising more than any country Bloomberg tracks except Greece in the last six months.


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Ukraine is once more getting into a mess. Part of the problem is political, part of it is economic,

and part is a combination of the two. On top of which Ukraine has one of the most severe

demographic problems in the CEE, which is itself a region of severe demographic problems. So

what we have are a cluster of problems just waiting for the perfect storm to gather.

As is well known, Ukraine was one of the worst affected countries following the onset of the

global financial crisis. Industrial output slid great depression style by more than 30% in a

matter of months (the chart Krugman used was of course mine), largely due to a massive

overdependence on steel, the price of and demand for which had fallen off a cliff.


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The onset of the crisis also brought to light the way the country had been living on anunsustainable credit boom fuelled by short term forex borrowing in the years prior to itsarrival, and as the fund flows which had been financing this rapidly reversed Ukrainewas sent running into the arms of the IMF, and rapidly accepted a $16.5 billion standbyloan in November 2008.

As the IMF put it in their programme documentation:

Ukraines current account and growth performance relied strongly on favourable termsof trade. From 2003 to mid-2008, the price for steel, which accounted for 40 percent ofUkraines export and 15 percent of GDP at the time of the crisis, had increased fourfoldand prices for gas imports were still far below world market prices, providing littleincentive to improve Ukraines dismal inefficiency in energy use. Nevertheless, by2007 the current account had already deteriorated strongly as imports had surged on the

back of a credit and real estate boom and an overheating economy. Private sectorbalance sheet imbalances widened sharply with foreign currency loans accounting for

nearly 60 percent of total loans, often extended to borrowers without foreign exchangeincome, and bank funding increasingly relying on short-term borrowing from abroad.

A Love Hate Relationship With The IMF?

Well, for those familiar with the region there is nothing particularly strange about theimbalances and the credit bust. But as the Fund itself makes clear in its ex-postevaluation of the first crisis programme, relations between the multilateral institution

and the Ukraine administration have been far from easy over the years:


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Ukraine has had long but complicated program relations with the Fund. From 1994 to2005, the Fund supported Ukraine through six arrangements. Completion of reviewstended to be difficult, as only 13 of the envisaged 24 reviews were completed, of which10 with delay or involving waivers. The Ex Post Assessment of Longer-Term ProgramEngagement in 2005 (IMF Country Report No. 05/415) found that Fund-supported

programs had a mixed record in achieving their objectives. While the programs werequite effective in supporting macroeconomic stability, they did not succeed inaccelerating the build-up of more market-friendly institutions.

Unfortunately things did not go that much better this time, and the initial programmewas terminated after the second review and a disbursement of $10.4 billion:

Program implementation was difficult against the backdrop of sharp political divisions.Only two of the envisaged eight reviews were completed, with the first review alreadydelayed by three months due to failure to reach understanding on fiscal and bankingrelated policies in the midst of political wrangling between the president and the prime

minister..After the second review was completed on time in June 2009reflectingsome progress with the bank resolution strategy, announcement of future plans toincrease gas prices, the adoption of a restructuring strategy for Naftogaz, and aslowdown in foreign exchange interventionsthe Fund remained closely engaged withthe authorities. But the program went off track as ownership vanished and fiscal policydiverged further from the program.

In fact here we see three of the key Ukrainian issues all lined up together energyprices and the fiscal deficit, problems in the banking system and constant foreignexchange interventions to maintain a currency peg with the US dollar, a peg whichencourages unnecessary forex borrowing while fuelling inflation at continually high

levels.

Running such consistently high inflation simply leads to rigid monetary policy, high interest

rates, and inadvertently enhances the attractiveness of foreign exchange borrowing (which is

the ultimate undoing of these pegged economies) since interest rates are much lower

elsewhere, the currency is fixed (so wheres the risk) and wages keep going up and up alongwith the inflation. You seem to be getting better off than your peers in the country you peg to,


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but in fact you are simply sliding steadily towards the precipice. In many ways things on the

Euro Areas Southern fringe are only different in terms of degree. I can still remember Spains

now ex-Prime Minister Jos Luis Rodriguez Zapatero telling his compatriots that they were

steadily moving towards the top of the EU per capita wealth league, overtaking Italy, and then

France, just before the bubble burst, and the house valuations which lay behind those

impressive appearances started tumbling.

Frustrated and fed-up, the IMF cannot simply ignore the country. Ukraine is simply toolarge and too strategically situated to be allowed to go AWOL. So when the newUkrainian government requested a further standby arrangement in the early summer of2010 there was little alternative but to agree (shades of Greece and the EU) and make an

additional $15.1 available to the country, bringing the outstanding borrowing to $25.5billion. And here comes the rub: according to the IMF, Ukraine is due to repay $2.4billion this year; $3.5 billion in 2013 and $1.3 billion in 2014. This is quite an onerousschedule for a country which is now struggling to finance itself in the financial markets.Many of the current IMF programmes in Europe have the look of success, until the timecomes to pay back.

Predictably the second programme didnt proceed any more smoothly than the first one,and the first review was only approved after a lengthy tussle about pensions, with theUkrainian government eventually ceding to pressure and in July 2011 passing a pensionreform whereby the female retirement age was raised from 55 to 60, and the duration of

pension contributions needed for entitlement increased by 10 years.We will returnbriefly to this topic, but it is instructive to note that while most economic analyses of the


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current crisis (everywhere, not just Ukraine) fail to mention the underlying demographicissues, the problem of how to pay for pensions keeps cropping up time and time again.The need for the reform was obvious, with a rapidly ageing population the country,despite being poor, had one of the most generous systems on the planet. In 2010, the lastyear before the reform, Ukraine spent 18% of its GDP on pensions and had a pension

fund deficit of UAH 34.4 billion or 3.2% of GDP.

Despite this relations between the fund, the Ukrainian administration failed to improvesubstantially (they have now been bitten too often) and at the end of August 2011 anIMF staff team was sent to Kiev to carry out the second review of the new programme.The review was never formally completed, and the IMF announced on November 4 thatnegotiations had been broken off.

Its All About Gas

Gas prices are an issue everywhere, and especially in election years, but in Ukraine, dueto the geopolitical situation, they take on a special significance. Negotiations betweenUkraine and Russia over the supply and payment of gas and terms of transit for Russiangas to Europe have been a recurrent theme since the end of the Soviet Union. During2011, as gas prices rose by an annual 60%, Ukraine repeatedly sought to renegotiate the10-year contract signed in January 2009. The Ukrainian administration considers thegas price formula unfair and the gas price currently US$416/mcm in 1Q12 too high.The two sides have now been working for some months in an attempt to reach anagreement, but it is still not clear one will be reached.


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Gas is a core issue for both Ukraine and the IMF due to its impact on both the currentaccount deficit and on the level of domestic consumption. It is evident that Ukrainiangrowth is now slowing and coming under threat from rising energy prices. MorganStanley estimates that the country had a nonenergy current account surplus of 8.2% ofGDP in 2011, but since it ran an energy deficit of 14.1% of GDP, the outcome was acurrent account deficit of 5.5% of GDP.

To slow the rate at which this current account deficit is eroding reserves andundermining the stability of the currency, Ukraines central bank has tightenedmonetary policy sharply, which in turn has contributed to the rapid deceleration ingrowth, which consensus forecasts put at around 3.0% in 2012, but which mayeventually turn out to be significantly lower. To put this slowdown in perspective,despite the fact that Ukraines economy has been growing steadily since the 2009 annushorribilis, output levels are still below the pre-crisis peak. As Capital Economics NeilShearing puts it:

Ukraine grew by 5.2% last year, which, on the face of it at least, seems a decentoutturn. But context is crucial. In 2009, output contracted by a whopping 15% a

recession from which the economy is still recovering. Whats more, the pace ofrecovery has actually been somewhat disappointing. Output is still well below its pre-


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crisis peak [see my chart below - EH] yet growth already appears to be slowing. In Q4GDP expanded by 4.6% y/y, down from 6.6% y/y in Q3. At current rates of growth, itwill take another two years for output to return to pre-crisis levels. But even this could

be a tall order given how vulnerable the economy is to a fresh escalation in Europesdebt crisis.

In addition to the energy price constraint domestic consumption in Ukraine is still weighted

down by the indebtedness problems created by the earlier boom. Non-performing loans are

still running at a very high level, although no one really seems to know quite how high, since

there are major question marks hovering over the official figures. The IMFs permanent

representative in Ukraine Max Alier estimated in the spring of 2011 the figure might be as highas 30% of total loans. And with every 1% drop in the value of the hryvnia the proportion rises,

due to the extent of forex borrowing.


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In addition, with many Ukraine banks being owned by parents in other EU countries, the credit

crunch in the west is rapidly transmitted to the east. Corporate lending growth is slow, and the

steady contraction of household borrowing is following a path which looks very similar to that

seen in Southern Europe, or the Baltics.

Ukraine like Hungary badly needs an agreement with the IMF to facilitate thefinancing of debt which needs to be rolled-over this year. These rollovers will putsignificant strain on the system; Neil Shearing estimates something of the order of 34%of GDP.

Meanwhile, Ukraine faces external debt servicing costs of $52.5bn (around 30% ofGDP) this year. A large chunk of this debt is in the banking system, but roughly $5.4bn

is owed by the government ($3.5bn of which is due to the IMF). Put together, weestimate that Ukraines external financing needs are close to $58bn this year equivalent to 34% of GDP.


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Obviously, with so much debt needing to be rolled over, the country is very exposed to

any sudden reversal in risk sentiment, just as it was in 2008. It needs to be under thesheltering wing of the IMF, but this time around the dynamics are rather different. In

particular, countries which once got a large net benefit from IMF lending are nowfacing the moment of truth when they need to start paying back. Unfortunately, andfor whatever reason, the programmes sponsored by the IMF in Ukraine, in Latvia, inHungary, in Romania, in Greece, in Ireland, in Portugal are not yielding the benefitswhich were initially claimed for them by the advocates of the structural reform path,in particular in the growth area.

In addition, years of fiscal austerity are now starting to take their toll on the populationsconcerned. Expectations are not being fulfilled, and a backlash is underway. Regularreaders will be aware that my baseline case in Europe is that thesemisguided/insufficient programmes will steadily destabilise the political systems onEuropes periphery, leading to unstable and unpredictable outcomes. Not the kind ofstuff would-be investors like.

Evidently it would be unfair to blame the Fund itself for the kind of problem whichexists in Ukraine. Clearly it is a very complex and difficult-to-handle situation. But ifyou havent gotten hold of the full extent of the problem in the first place, then it is hardto offer recipes which open a sustainable path forward. Though I read as much as I can,I still fail to be able to find any single mention of the issue that Ukraines dire

demographics presents for future growth prospects in the IMF literature.


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The countrys population is falling steadily, due to a long run excess of deaths overbirths and a steady outflow of working age population leaving to seek a better lifeelsewhere. This is not only causing the population to shrink, it is also leading to adramatic change in the age composition of the population, increasing the average age ofthe workforce, and lowering the number of those employed per person retired. This isthe strategic importance of health and pension system reforms in a country like Ukraine.

Naturally structural reforms are important, but they need to be part of a mix of policies,and among these doing something to address the countrys demographic death-spiralshould be given a great deal more importance than it is presently where in fact theissue is almost absent from economic debate.

At this point it is hard to say how the present standoff between the IMF and theadministration will work out, but as in the Hungarian case I have the feeling that mostmainstream bank analysts are underestimating the capacity of the political system to

produce bad outcomes.

The macabre culebron associated with the apparent medical condition of the countrysformer Prime Minister in prison for having signed the last gas deal only adds to thesense of surreal drama associated with the countrys potential default.


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Ukraines ex-premier Yulia Tymoshenko is ill and in constant pain, Canadian doctorswho examined her in prison said, adding that authorities denied her key blood andtoxicology tests. A team of Western doctors went last week to the prison where MsTymoshenko is held to examine the opposition leader amid complaints about hertreatment and health.The three Canadian and two German medics included a

cardiologist and a nervous system expert, the former Soviet republics penitentiarysystem said in a statement. After meeting and examining Ms Tymoshenko, it was theCanadian opinion that she required confidential blood and toxicology testing, doctorPeter Kujtan said in a letter to Ukraines ambassador in Ottawa, Troy Lulashnyk.Themedical team had been invited by Ukraine to carry out the examination and even

brought along diagnostic equipment which could produce on-the-spot test results, DrKujtan said.But Ukrainian authorities refused to allow its use, stating that we would be

breaking several laws of the land and could face prosecution, he said.

Now heres the official version via interfax:

Ukraines jailed former Prime Minister Yulia Tymoshenko needs no surgery, the StatePenitentiary Service cited a seven-member medical panel as saying on Friday afterTymoshenko had extra checkups on Thursday. The findings of an X-ray test confirmedthe previous diagnosis and meant there was no need to revise the recommendations forher preliminary treatment, while changes that have been detected do not warrantsurgical treatment, a statement from the Penitentiary Service cited the seven doctors assaying in their assessment. Tymoshenko, who had herself requested the additionalcheckups, was examined at a clinic in Kharkiv, the city where her prison is situated. Shehad an X-ray test, a computed tomography scan and a magnetic resonance imagingscan. However, she again refused to have a blood test, the Penitentiary Service said,

adding that foreign doctors would need the results of a blood test for the final diagnosisand treatment recommendations.

Naturally this sort of thing is not new in the country, and anyone with an interest inreading about a similarly surreal situation some years ago might like to read my WillThe Real Ukraine Central Bank Please Stand Up! post.

And if you have the kind of sense of humour I have about technical issues, you mightappreciate this short list of concerns about the way the bank problem resolution issuewas handled by the central bank, as voiced by the IMF in their ex-post first standbyagreement review:

a) Liquidity provided to insolvent banks: As it was difficult to distinguish betweensolvent and nonviable banks, liquidity support was likely extended to the latter.Moreover, the maturities of NBU loans, which originally ranged from 14 to 365 days,were later converted up to seven years providing de facto solvency support.

b) Relaxation of collateral requirements: Banks own shares were accepted as eligiblecollateral despite the significant risk for the NBU.

c) Mandatory purchases of bank recapitalization bonds: The NBU was required topurchase at face value recapitalization bonds issued by the government, a practice that

the Fund staff advised against.


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The first point is an important one in any traditional approach to bank resolution,distinguishing between the rescuable and the un-rescuable, but, of course, none otherinstitution than the ECB itself has now crossed the line, and with the 3 year LTROs(which will, naturally, be extended) the central bank is offering, as the IMF suggest inthe Ukraine case, solvency support to a number of otherwise insolvent banks. On the

collateral side, the ECB isnt accepting bank shares as collateral, yet, although it isaccepting nearly everything else, and this idea of the central bank buyingrecapitalization bonds, wasnt it first tried and tested in Ireland, and hasnt it be appliedto some extent in Greece? Nuff said, I think.

What Cant Go On Forever Will Only Go On As Long

As It Can

So where do we go from here? The IMF have dug their heels in about gas, but this isonly a symptom of a much deeper sense of frustration. The fund has been financing the

Ukraine deficit and cheap gas, but will the money disbursed ever get returned, or willthe can be continually kicked down the road. It is worth remembering that the initialfinancing of 11 billion SDRs was equivalent to 802% of the countrys quota, a verylarge quantity in terms of the standards of 2008. As the fund puts it in the review:

No major shift in policy making occurred and political economy considerationscontinue to drive policy making in Ukraine. Efforts to tackle the underlying structuraland institutional weaknesses stalled. Bank resolution remained incomplete, theexchange rate regime returned to pre-crisis practices, the energy sector remainedlargely unreformed with quasi-fiscal deficits widening, and legal and governance reformfell short of objectives.

Put crudely, the fund was being used to finance cheap energy to win votes for populistgovernments. The frustration to be seen in the above summary suggests to me at leastthat coming to a new agreement wont be as easy as many think. Especially with anumber of other countries looking on. It all used to be called moral hazard I think.

Only industrial users in Ukraine currently pay the full cost of gas. Residential users paysomething like 30% of the cost of the gas they consume. This subsidy is a key cause ofthe loss suffered by the state-owned oil and gas company, Naftogaz, which was UAH21 billion, or US$2.6 billion, equivalent to 1.6% of GDP in 2011. A planned 50% hike

in gas tariffs in April 2011 was negotiated down to 30% hike in two tranches in returnfor unspecific offsetting measures to keep the wider fiscal deficit at 3.5% of GDP.However, eventually, the tariffs were not hiked at all in 2011, widening the actualdeficit to 4.3% of GDP. The result of all this is that the IMF have their foot firmly putdown, and it will be hard to get it lifted again.

So one possibility is that the Ukraine government, seeing their approval ratingsdropping, will consider the political costs of household gas tariff hikes to be too high,and not seriously pursue a renewed IMF deal, hoping that the cut in the current accountdeficit due to the lower gas import price plus any other investment commitments or

payments which would arise from of a Russian gas deal will be enough to reduce

pressure on reserves to a sustainable level. The Bank has spent nearly $7bn or 20%


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of its reserves since last August, and with reserves now approaching $30 billion thisstrategy is clearly becoming unsustainable.

There is, of course, another possibility, and that is that there is no Russia deal and noIMF deal. This could occur if the government balks at both of the possibilities on thetable: either selling a stake in the gas transit corridor to the Russians or raisinghousehold gas tariffs. Under this scenario the Ukraine government could follow in thefootsteps of Hungarys Prime Minister Viktor Orban which involves seeming tocooperate (in this case with both parties) but doing nothing, and in the meantime hopeto muddle through at least in this case till the elections in October. However, against

the backdrop of falling reserves, a rising current account deficit and external fundingmarkets which are closed to Ukraine, a sharp devaluation could become virtuallyunavoidable if there is neither a gas deal nor a resumption of the IMF programme.

Following the decision of the ECB to introduce 3 year LTROs and the agreement on theterms of a second Greek bailout global risk sentiment has improved significantly inrecent weeks, but it would be foolhardy to imagine that this situation will become

permanent. Too many risk elements are still in play, and there are still far too manyloose cannons floating around on the EU upper deck for vigilance to relax. But that isexactly what may happen, in which case, if disaster does strike in Ukraine, it will surely

be disaster.

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