UKRAINE TRIP NOTES
By Timothy Ash, Analyst, Nomura International
Economic policy outlook; IMF Relations; the Economy
London, UK, Thu, May 19, 2016
I visited Kyiv on May 16-19 meeting with various current and former government and NBU officials, politicians (Yatseniuk) representatives of the IFIs, diplomats, journalists, local bankers and analysts.
Summary views: I remain constructive overall. We think the Groysman government should sustain in office for the next year and recommit in the near term to an IMF reform agenda, with the resumption of IMF lending in July.
The Yatseniuk government, and the NBU, made some very notable reform achievements, ranging from fiscal adjustment, BOP adjustment, energy sector, banking, monetary/exchange rate reform, NBU administrative reform, police reform, and reform of public procurement.
This seems to have set the stage for macroeconomic stabilisation, the stabilisation of the banking/financial system, and for a return to real GDP growth this year, albeit modest and from a low base. Russia seems to have taken a temporary respite in the east, focusing perhaps on "opportunities" which might present themselves from Brexit and the US elections.
This has given Ukraine another window for further reform and recovery. The new cabinet has received mixed reviews but should be given the benefit of the doubt and judged by results.
They have made some brave initial moves, for example in liberalising gas prices. Risks include the fact the government only has a situational majority in the Rada, and uncertainty over longer term Russian policy towards Ukraine. I would also watch for near term risks related to the management of issues related to large, privately owned but systemically important banks.
That said, Ukrainian Eurobonds pay over 9%, offering relative value in my view, as near term debt service risks have been moderated by the recent PSI, while Western financial backing seems strong/resilient assuming the reform agenda is maintained.
The country's long term growth trajectory will be determined by success, or otherwise, in the rule of law agenda, which means reining in corruption and improving the business environment. Ukraine and the IFIS needs to improve their messaging if they are to succeed in attracting FDI, pushing forward with rule of law related reforms, but at the same time highlighting huge achievements made over the past 12-18 months of the reform front.
Domestic political stability
Obviously after the recent change of government there was lots of focus during the trip on trying to gauge the durability and reform orientation of the new Groysman government. The obvious concern is that after recent political changes the Groysman government lacks a strong majority, indeed it seems only able to sustain situational majorities, with shifting support based on case by case voting on particular bills.
That said given the current low poll ratings of the two main ruling parties, the Block Petro Poroshenko (BPP) and the People's Front (PF) of now former prime minister, Arseny Yatseniuk, this suggest that neither party will likely want to rush to early elections.
Indeed, opinion polls suggest that early elections would play into the hands of more populist and less reformist forces, such as Tymoshenko's Fatherland faction, and Oleh Lyashko's Popular Party, plus the Opposition Block of former Yanukovych supporters.
Likely the Groysman government can get support for key reform votes related to getting the current IMF progamme back on track from the now opposition Samopomnich faction of the mayor of Lviv, Andriy Sadoviy, and independents albeit political capital and some pork might need to be deployed.
Further along keeping divided and possibly an unruly Rada in check could prove difficult, and perhaps now is the main risk to the durability of the government and the IMF reform agenda. The risk is that after a flurry or reforms related to kick starting the stalled IMF EFF, policy thereafter could drift with the IMF programme going off track for an extended time.
I expect former PM Yatseniuk's PF to be relatively loyal to Groysman at this stage. Relations between Yatseniuk and Groysman seem to be reasonable. As noted, Yatseniuk has little incentive to push for early elections which could see his party decimated in terms of parliamentary representation if opinion polls are to be believed.
Meanwhile, while Yatseniuk took no cabinet position for himself in the new government, his party is well represented, and he remains as head of the party. Party discipline in the PF is also strong - much more so than BPP - and Groysman will need Yatseniuk still to line up his loyal MPs behind the reform vote.
Yatseniuk himself seems happy to take something of a time out, to allow the reforms his government enacted to finally reap rewards in terms of recovery and he hopes that this will yield rising poll ratings for him and his party, and hence his political resurrection. He still has an interest in the Groysman government, of which the PF is part, succeeding.
I heard talk during the trip of the risks of impeachment efforts against President Poroshenko, stemming from recent revelations, and perhaps more to come, linked to the Panama papers. We see the risks herein as limited, as the impeachment process in Ukraine is unclear, and we don't see sufficient support in the Rada for this. We also do no see a high risk of a popular uprising against the Poroshenko presidency, akin to the EuroMaydan, unless that is we see the regime using hard hand tactics against any opposition.
The popular mood at the moment seems to be frustration at the lack of progress in the rule of law agenda, and meaningful improvement in the economy (jobs, rising living standards), but most people seem to be knuckling down, and trying to survive/hunker down. The arrival of spring/summer should also serve to ease social tensions and pressures.
Net-net i expect the Groysman cabinet to endure for the next year or so, but the key challenge will be in ensuring continued support for a reform agenda from the Rada which appears increasingly fractured.
Relations with Russia
The consensus from those I met - and indeed my own view - is that Russia is willing to wait on the sidelines, and limit further near term intervention in Ukraine, waiting to see how the US elections, the Brexit referendum and domestic Ukrainian politics plays out.
Moscow likely assumes that a Trump presidency could see a reset in relations with the US, and the potential for deal making between the US and Russia in redrawing the security map of Europe, and therein concessions to Russian strategic interests in Ukraine. Moscow also assumes that Brexit will weaken the European Union, and particularly its ability to maintain a united front over policy towards Ukraine and sanctions on Russia.
An EU decision on extending sanctions on Russia, over its intervention in Donbas, is expected at the EU council meeting in June. The assumption is that EU unity is maintained until then and sanctions are rolled - albeit there is some uncertainty as to whether this will be for 6 months or less. Indeed, the US is expected to maintain pressure on European allies to retain the status quo until the US elections at least - the assumption is no easing in Western sanctions on Russia until the inauguration of the new president in the US in early 2017, albeit Brexit could yet impact on this.
The assumption is that sanctions are hurting the Russian economy, and are an embarrassment for the Putin regime and the Russian elites, and they are eager to have them removed - this suggests continued "restraint" by Russia in/over Ukraine at least until the EU Council meeting in June.
It will though be interesting to see what strategy Moscow adopt sin the run up to the NATO Warsaw meeting in July, where the US is expected to push for the forward deployment of NATO battalions in Eastern Europe. This is likely to irritate Moscow and could herald a counter reaction.
I heard mixed views as to whether Moscow has finished with its military intervention in Eastern Ukraine. One view is that Moscow's earlier military intervention largely failed, or proved less than effective, against stubborn and unexpected Ukrainian resistance.
Meanwhile, Ukraine continues to build its own defences, currently increasing defence spending to the equivalent of 5% of GDP, with as many as 100,000 troops now deployed in the East. This would suggest the risks for Russia of further military intervention have only increased - and if Moscow was unwilling to tolerate large-scale casualties in Ukraine from earlier interventions they are surely less so now.
That said, Russia still has an array of options by which to destabilise Ukraine, including manipulation of Ukrainian domestic politics, use of the energy, economy and financial cards, albeit the effect of these latter options has surely reduced as Ukraine adopts countermeasures and adjusts over time.
The consensus still though is that Putin has not finished with Ukraine, and the long term agenda remains to pull Ukraine back into Russia's geopolitical orbit - only the main focus now might be working to exploit the fluidity and change in Western politics to deliver on its agenda.
The concern from the Ukrainian perspective from the potential lifting of Western sanctions on Russia is that this will remove potential deterrence against future Russian re-escalation in eastern Ukraine and limit prospects for Russia complying with the Minsk II ceasefire agreement. In effect it would signal "open season" for Russia in Ukraine.
Note though that this assumption that Moscow moderates its approach towards Ukraine pending the results of the US elections, obviously depends on the outcome therein. A victory by Hilary in November might see Moscow more quickly moving back into "offensive" mode, while a Trump victory might extend the "lull" until US policy towards Russia becomes clearer, and likely late in 2017.
I would add here that my own personal view is that US policy towards Ukraine will not change commensurately even under a Trump presidency, as I assume Trump moves to the centre and mainstream to defeat Hilary, and is then subsumed by the DC establishment if he actually wins the presidency.
I would add that whilst much has been made of the fact that his new campaign manager was also an adviser to former President Yanukovych, the former Regions' regime was hardly pro-Russian but more pro-Ukrainian oligarchs, and the agenda was trying to retain reasonably favourable relations with Russia (cheap gas/financing) while keeping Russian business and political interests at bay.
Net-net ultimately Moscow is likely to be also disappointed by a Trump presidency in terms of what it is willing and able to deliver to Russia in/over Ukraine. This might suggest that through the course of 2017 we are likely to similar outcomes in terms of Russia-US policy in either US presidential outcome.
Assuming though that Moscow is willing to take a back seat in Ukraine until at least US elections in November, this suggests some further breathing space for Ukraine to further push on with implementing and embedding economic reforms and in shoring up its defences in the East.
On Minsk II I also expect no substantial progress until the US elections. The problem still is that the two sides are still far apart in terms of the basis for a longer term solution - essentially, and failing the election of a Moscow-compliant regime in Kyiv, Russia wants a Federal solution in Donbas, where the regions have a veto over national policy, and therein to halt Ukraine's current Western orientation. Any such solution is absolutely unacceptable to the current or any likely, government to emerge in Kyiv.
Economic policy outlook
I guess the key question is how reform oriented is the new Groysman administration as compared to the outgoing Yatseniuk team - a question is also if the latter was doing so well why the need to change?
The Groysman cabinet has clearly seen the clearing out of the high profile, market friendly foreign (English speaking) names such as Jaresko, Abromoviscius et al. And I guess if one goes back to the original crisis in February which brought down the government - amid claims that some in the cabinet, and presidency, were not doing enough to fight corruption and address rule of law issues - what has changed now? Some indeed have expressed disappointment at Groysman's cabinet line up, and the relative absence of "stars".
In responding to the above I would argue that it is perhaps too early to tell, and we should give the Groysman team the benefit of the doubt, and ultimately judge them by results.
Groysman himself is beginning to talk the talk of reform, and seems eager to get the IMF programme back on track, to secure the next disbursement of IMF funds, which will require delivery on IMF reform conditionality. His is young, ambitious, pragmatic and practical by nature.
He was successful in his time as mayor of Vinnitsa where he delivered some results. He also brings experience from his time as Rada speaker, which might play well in lining up political support from the various Rada groupings for key reform votes. His youth and regional political background also to a certain extent means that he is less Kyiv "establishment" than some of his political peers.
In the near term his lack of central government policy making experience, and reform credentials means that he needs to get the IMF programme back on track to cement his own economic policy credibility. The resumption of IMF lending would be a signal by the West of support for him, helping to cement him in his position. The IMF can and will surely lever off this in the latest SBA review to push for more, in terms of delivery on prior action and commitments.
Poroshenko also now has more pressure to ensure delivery on reform, change and economic recovery. Groysman is viewed as Porshenko's man, and the buck now squarely falls on Poroshenko and Groysman for delivery - there is no longer an option for Presidency and prime minister to blame the other for reform failings.
Poroshenko, and his man Groysman, are now responsible. The buck stops with them, and they will be held to account eventually in the next presidential elections for Poroshenko at least in 2019, and perhaps earlier for Groysman in parliamentary elections if he survives that long.
Oleksandr Danyluyk's appointment as finance minister is another key role. Danylyuk lacks ministerial experience, but he served a long stint as economic policy chief in the presidential administration, and hence should be able to hit the ground running. He has international experience with McKinsey, and has made much of his desire to bring project management experience into the MOF.
Priorities for the MOF will be improving the effectiveness of budget planning, reform of the State Revenue Service, the Customs Service, pension reform, and financial decentralisation, amongst others.
But his ability to identify/prioritise projects, define their scope, hire talent to lead specific projects, and then delegate will be key to his success. His McKinsey experience should be tested to the full, but he brings new and different impetus to the MOF, which likely needs change.
Communication will be key, both with his cabinet colleagues, the population and IFIs/investors - he may need support therein. Importantly though, the agenda this year does not seem to be dominated by tax reform - the reforms last year need to be bedded in with some minor tweaking, but it's about improving tax compliance.
My sense is that Western donors/IFIs are willing also to give the new administration the benefit of the doubt, and to continue to support, and push for reform, and judge by results. This seems entirely fair/prudent given Ukraine's checkered track record in terms of IMF compliance.
The IMF were in Kyiv during the time of our visit, for discussions over the completion of the latest review under the SBA. On May 18 the IMF announced a staff level agreement with the Ukrainian government, pending further progress achieved on a range of stated areas including rule of law, SOE reform, financial stability, and further fiscal reform/consolidation, amongst others. The IMF noted the hope for final completion of the review by July.
My read of the above is that the IMF is nervous over the ability of the Groysman administration to sustain IMF related reforms over an extended period given the political setting. The Groysman government's decision to bring forward plans for energy sector liberalisation - unifying household gas prices with corporate prices from May 1, as opposed to 2017 was encouraging, and a welcome gesture, but not enough in itself to ensure sign off on the review.
There is perhaps a sense that the Groysman government needs to prove its reform credentials by completing a number of further prior actions - there is also perhaps recognition that Groysman also needs to secure an agreement with the IMF to boost his own credibility.
The IMF hence has some leverage, and a willingness, with G7 backing, to use this. The decision to give the government until July to deliver on reform, reflects the fact that some of the legislative requirements might be difficult to get through the Rada. The review commitments are clearly ambitious, but there is hope that Groysman can deliver on them.
Pointedly we were told that the Rada typically always delivers its most difficult legislative reforms just prior to going off on summer vacation from the third Thursday in July - deputies never want to be held back/recalled from their summer vacations in the Maldives, and elsewhere!
In terms of what the IMF seems likely to push for we assume commitments/legislative action on reform of the State Fiscal Service, the Customs Authority, Pension reform (parametric reforms to the first pillar), SOE reform (independent boards, appointment of competent management teams by open competition, privatisations - steps to sale of Odessa Sea Port, and perhaps Centrenergo), plus also continued efforts in cleaning up the banking sector, and wealth declarations/process with anti-corruption institutional setting.
On the issue of pension reform, the government will need to address the fact that pensions outlays account for 14% of GDP (EU average is around 8-9%), the pension fund is still running a deficit of 7% of GDP and dependent on budget transfers which are clearly not sustainable. The decision also to half social security contributions this year, to 22%, in an effort to "whiten" the economy, also raises further concerns over the sustainability of the social security fund.
The problems are similar to other countries, in that the current system is too generous in terms of entitlement, given a retirement age of 60, an ageing population and various early retirement preferences given to various categories of employees. The retirement age needs to be raised, and entitlements reduced to allow the remaining pensioners to be paid a reasonable pension - a matter of social justice. As everywhere, such issues are politically charged, and especially now in Ukraine with difficult economic conditions playing into the hands of populists.
Worryingly perhaps, on landing back at Heathrow I learned that two key bills required for reform of the State Fiscal Service (SFS) failed to make it on to the Rada's agenda, securing only 145 votes. That said I do think that Groysman has the political capital to deliver to the IMF agenda by the July deadline, rallying the BPP, PF, and perhaps Samopomnich. This should then see release of the latest UAD1.7bn in IMF EFF funds, a green light for the issuance of the next USD1bn US loan guarantee, and EU financial support (EUR600m).
Perhaps the single biggest challenge for the administration this year, in my view, will be addressing challenges presented by Ukraine's single most dominant and systemically important private bank, Privatbank. Privatbank has around 15 million customers, around 30% of the deposit base, assets equivalent to around 10% of GDP, but it's key vulnerability remains unusually high (>80%) related party exposure to the Privat group of companies.
As with many banks in Ukraine, FX devaluation and recession has seen NPLs rise, eroding the bank's capital base. After conducting stress tests and AQRs, the NBU is working with all banks to clean up the sector, and to ensure banks are able to meet minimum capital requirements, and comply with sound banking practices including limiting risks associated with related party lending. The NBU will have agreed with Privat measures to reduce related party lending, and ensure capital reaches minimum requirements.
However, a question much be raised as to whether Privatbank's owners are able to raise capital and reduce related party lending as per the agreed timeframe. Failure to do so would raise the spectre of nationalisation, which would seem the most likely course of action given the systemic important of the bank. However, given the political connections of its owner (Kolomoisky), with strong ties to a number of factions in the Rada, the question is has the NBU the political backing should scenarios such as nationalisation arise.
For the credibility of the NBU, the signalling in terms of encouraging best bank practice, and issues related to the rule of law, the spotlight will be on the NBU and the Poroshenko administration to deal with potential issues around such large and systemically important banks in an even handed, fair and transparent way.
Some might argue that with an improvement in the security situation in the east, some evidence of macro-stabilisation, and broader banking sector reform delivering real and significant results, a window is appearing for addressing the lingering challenges related to such large, systemically important banks.
A further reason to deal with this particular issue is that some would argue that the business model of such banks - dominating the deposit market by paying a premium to collect deposits, and then the dominance of related party lending, causes broader distortions in money markets, and undermines the NBU's efforts to move to inflation targeting by weakening the monetary transmission effect.
Some would argue that the government and NBU's willingness to face head on the challenge presented by large, systemically important private banks, with large related party exposures, will be a key test of its willingness to drive forward with a rule of law agenda - of which application of a level playing field, and equal application of the law /regulations is key. Perhaps this could present greater near term signalling of reform intentions then any likely near term developments at the Prosecutor General's Office.
On the rule of law related issues, the jury is still out. The population are clearly eager/desperate to see progress, and some see the appointment of Yuriy Lutsenko, a Poroshenko ally with no formal legal training as Prosecutor General, as merely an effort to buy time, and kick the can over such issues.
During the trip we heard of efforts towards "de-offshorisation" which seems to be shaping around some form of wealth declaration, amnesty and then windfall tax - talk of 10% on assets held offshore and 5% if held overseas. To some extent this seems to be driven by the furore over the Panama Papers.
Standing back a bit I think it is important perhaps to get some perspective on reform achievements for Ukraine, and I think the Ukrainians needs to be a bit cleverer in their communication strategy all around, particularly when talking to foreign investors.
At the outset we should accept that the two most difficult challenges for Ukraine are: a) encouraging Russia to stay out/adopt a neutral approach towards Ukraine and to refrain from continually acting to destabilise the country so as to ensure delivery on its long run strategic objectives.
Russia needs to be persuaded to give Ukraine a chance. b) delivering on the rule of law agenda, which was central to the EuroMaydan revolution and ultimately will determine the rate of Ukraine's long run growth and development, and therein in attracting domestic and foreign investment.
On the first of these, there is some sense that Russia is currently content to put the conflict in/with Ukraine on the back burner, pending outcomes for Brexit and then the US elections, which could well play to Moscow's advantage. This gives Ukraine time to build its defences and push forward with key economic reforms - albeit Moscow could easily return to the script of conflict again further down the line.
n the second I think it is important to recognise that, after years of neglect, instilling and entrenching the rule of law will be a long term project. Structural reforms are never easy, and typically they require sustained reform/focus over a long time period. Therein look at the experiences of Bulgaria, Croatia and Romania, countries which have still struggled on this agenda, even with EU membership.
This is not negating the importance of these reforms, but I think some realism is needed in terms of deliverables - true many Ukrainians would argue that there have been next to no deliverables in terms of indictments and convictions for wrong doing, past and present. The Poroshenko administration needs to prove delivery, but should be judged still over the medium to longer term.
I guess it is also important that slow progress on the rule of law agenda/fighting corruption does not overshadow some of the real progress and achievements made in other reform areas, which are truly revolutionary in some cases and have been made against the odds and in very difficult (near impossible) circumstances. Herein I would highlight:
* Macro stabilisation, with the economy set to post real GDP growth this year, inflation down to single digits, the UAH stabilised, FX reserves rising above 3 months of import cover, the fiscal and and current account deficits slashed.
* Debt restructuring, and the reduction in the nominal stock of public sector debt, which has given Ukraine space to breath and crack ahead with other reforms.
* Banking sector restructuring - closure of one third of banks, and reform towards a situation where the banking sector no longer presents systemic risks to public finances or the broader economy.
* NBU reform, introduction of inflation targeting.
* Energy sector reform, with the energy deficit slashed and zero dependency now on imports of gas from Russia, with BOP and fiscal benefits.
* Police reform.
* Public procurement reform.
None of these reforms were particularly easy, faced huge vested interest opposition typically, but we're done nonetheless.
The problem is that too little effort is being spent heralding these achievements. All too often the narrative told on Ukraine is of a bankrupt political system, corruption and graft and the message that Ukraine is simply unreformable. The evidence suggests that this is simply wrong and is being used by Ukraine's opponents abroad to its disadvantage. More should be done to buoy domestic opinion and support for further reforms and telling the good news to foreign investors by heralding the good news on key reforms as noted above.
Sure, it is good to strive for more and better reforms, and a reluctant administration needs to be continually pushed on the really difficult challenge over the imposition of the rule of law. But some balance needs to be taken in terms of what the message should be and to which audience.
Sending the message only that Ukraine is failing in the fight against corruption, without highlighting the achievements will undermine domestic popular and political support for reform, undermine official creditor support for Ukraine, and deter foreign direct investment. The latter of which is key for long term development.
The consensus seems to be that the macroeconomic situation is stabilising. Low base effects, a cheap currency, some recovery in key metals markets, expectations of a good harvest are suggestive of real GDP growth of 1-2% this year, close to existing IMF forecasts. Higher frequency indicators also point to a recovery/bounce. A high base, disinflation/deflationary trends still, and recent FX stability is helping drive inflation lower - to just 9.8% as of April from highs of close to 60% a year or so ago.
Utility price hikes should put some upward pressure on inflation, but it is still expected to come in around the 10% level for the year. The UAH seems relatively well supported by an improved CAD position (deficit of 2-3% of GDP), with FX reserves rising to over USD13bn now, over 3 months of import cover. With IMF disbursements set to bolster FX reserves later in the year, the NBU is expected to further ease up on emergency administrative FX controls imposed over the past two years, and this should help boost trade and growth/recovery.
Assuming peace in the east, continued adherence to IMF related reforms, and with favourable global market conditions, near term growth of 2-3% seems attainable. Whether longer term growth is 3% or 5% depends on efforts to improve the business environment, imposing the ruling law and hence stimulating domestic and foreign investment.
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