Welcome to the U.S.-Ukraine Business Council

Stratfor logo

The Recession in Ukraine

May 12, 2009 | 2220 GMT
special series recession revisited
Moody’s credit rating agency downgraded Ukraine’s sovereign bond rating to B2 from B1 on May 12, with a “negative” outlook. Ukraine’s dire economic situation offers lessons to other emerging Europe markets struggling amid the global recession, but Kiev’s economic woes are made worse by political tensions in the run up to a presidential election.

Moody’s, one of the world’s premier credit rating agencies, downgraded Ukraine’s sovereign bond rating to B2 from B1 with a “negative” outlook on May 12, the same day that the International Monetary Fund (IMF) approved a $2.8 billion tranche of a $16.43 billion loan to Ukraine.

Moody’s decision was influenced by Ukraine’s deteriorating macroeconomic situation and, according to Moody’s Vice President Jonathan Schiffer, capital controls imposed by the Ukrainian National Bank (UNB) to ration foreign currency which are making it difficult for banks to repay their foreign loans.
Ukraine’s declining economic fortunes — particularly the warning from Moody’s about the UNB’s capital controls creating uncertainty about the stability of the currency and economy — are an example for emerging market economies struggling to deal with capital outflows during the current global recession.
While there are lessons other emerging market economies can learn from Kiev, the Ukrainian situation is greatly exacerbated by the country’s political divisions, which are heightened ahead of the upcoming presidential election.

Liberal capital flows underpin the current global economic system. Free movement of capital allows investors to move money from the developed world to the emerging markets and vice versa. In times of plenty, such as the global credit-rich environment from 2002-2008, investors seek out emerging markets because they often have a higher return on investments.

Emerging markets do not have much capital because either the depositor base is too small or the financial sector is underdeveloped. However, they have plenty of investment opportunities — from infrastructural development (often from scratch) to retail banking that can tap a consumer base that wants to spend but does not have access to capital.
In capital-rich developed countries, there are high levels of investment saturation and competition, so it becomes desirable to carry capital to emerging markets where opportunities are more plentiful and the competition with other investors is less heated.

In Ukraine, as in much of emerging Europe, Western investors moved in primarily to tap the repressed consumer base through retail and corporate bank lending. Loans denominated in foreign currencies (the Swiss franc, euro and U.S. dollar) became prevalent through foreign financial institutions’ heavy presences and led mortgage lending to increase from 0 percent of gross domestic product (GDP) in 2001 to more than 15 percent of GDP in 2008.

Retail loans as a category exploded in value, from insignificant levels in 2005 to nearly 50 percent of total outstanding loans of the banking sector in 2008, and roughly 50 percent of retail loans were made in foreign currencies.


However, when the global financial crisis accelerated in September 2008, investors lost their appetite for risk and began a massive flight to safety. This meant that countries like Ukraine, previously considered attractive investment opportunities in a capital-rich environment, turned into liabilities on balance sheets overnight. Capital flight led to a 20 percent loss in the hryvnia’s value compared to the U.S. dollar between September and November 2008 alone; the currency stabilized by January at only about 60 percent of its September 2008 dollar value.

Daily Exchange - Hryvnia vs. Dollar

The hryvnia’s depreciation is a serious problem for foreign currency denominated consumer and corporate loans, as the base loan value appreciates by the amount that the currency depreciates. This leads to a rise in non-performing loans, a figure that the European Bank for Reconstruction and Development estimates to be as much as 20 percent in emerging Europe (and potentially higher for Ukraine considering the hryvnia’s dramatic fall in value, although no official statistics have been released).

Furthermore, Ukraine’s banks are constantly facing depositor flight due to instability and lack of confidence, with a 2 percent deposit outflow in March after a 5.6 outflow in February (the slowdown in outflows was probably created by a perceived increase in currency stability).

This is only complicating Ukrainian banks’ foreign indebtedness, estimated at $80 billion, of which approximately $46 billion (equal to 32.7 percent of GDP) is due in 2009. Because of the banking system’s high indebtedness, the government was forced to take over eight banks between February and March, and four banks had been nationalized earlier.

Due to capital flight and fears that the hryvnia could deprecate more, thus further deteriorating the ability of consumers and private banks to service their foreign loans, the government has imposed capital controls. The rate at which the banks are allowed to buy and sell hryvnia is set by policy makers each day while the general population is allowed to buy foreign currency at teaser rates so they can service their foreign currency denominated mortgages and loans.

As a result, however, foreign currency reserves were down to $24.5 billion in April, following a decline by a third (approximately $12 billion) between September 2008 and February. The pace of decline of foreign currency reserves has slowed, however, as the hryvnia has stabilized.
Nonetheless, the recapitalization of the country’s private sector could cost the government as much as 4.5 percent of its GDP, according to IMF estimates, and will result in a year-on-year public debt increase of up to 52 percent, to $37 billion, in 2009 (or approximately 40 percent of GDP for 2009 compared to around 20 percent of GDP in 2008).

Capital controls, however, are having the negative effect of making it more difficult for Ukraine’s banks — already facing uncertainty and depositor runs at home — to service their foreign loans without direct government aid.

Moody’s pointed to Alfa Bank Ukraine, which was unable to service its foreign loans due to the central bank limits on purchasing dollars on the interbank market, as an example of the problems the country could face in the short term.
In the long term, capital controls could also make Ukraine a less attractive investment locale as investors worry whether they will be able to disentangle their capital from the country. Kiev will also face pressure to keep capital controls in place out of fear that once the controls are removed, whatever foreign capital is left will rush out.

This financial instability comes as Ukraine’s economic fundamentals are extremely weak. Exports fell 43 percent year-on-year in February due to declining global demand for Ukraine’s main export, steel (exports of Ukrainian steel have declined by half). This led to slumps in industrial production and retail sales, which in turn led Ukraine’s overall tax revenue to drop.

Ukrainian GDP is expected to decline between 9.5 and 11 percent in 2009, and the country’s budget deficit could approach 4 percent of GDP. Increased macroeconomic instability means that raising capital on the international market is becoming nearly impossible for Kiev since Ukrainian sovereign debt is already the most expensive to insure against default in emerging Europe.

While the IMF’s decision to release the second tranche of $2.8 billion is sorely needed, it is doubtful that the country’s volatile political situation is conducive to handling the highly complex economic problems facing Kiev.

Presidential elections are currently set for late October, which means that the next five months will see intensive campaigning between incumbent President Viktor Yushchenko and Prime Minister Yulia Timoshenko, who are both involved in the race along with a number of other rivals (including pro-Russian political forces who may not be as concerned about the country’s credit rating to begin with).

Yushchenko and Timoshenko are the only two forces in Ukraine who have the requisite political power to deal with the crisis, but as they are at each others’ throats, the situation is dire. The two have already sparred on a number of economic issues, from taking a $5 billion Russian loan (which Timoshenko supported) to whether the UNB governor Volodimir Stelmakh — a Yushchenko ally — should keep his job.

Considering the mountain of problems facing Ukraine it is simply inconceivable that its parliament, divided among a number of factions, and its president, whose approval rating is under 5 percent, will be able to keep the ship steady.

The inability to handle the economic crisis will only add stress to the political system, as the recession could lead to social unrest on top of the existing political tensions in the starkly divided Ukraine.