Ukraine’s public finances are stable, but vulnerable

The Ukrainian central bank’s recently published report on the country’s financial stability provides an overview of the current condition of Ukraine’s economy in a nutshell. The financial standing of households and businesses is improving but the international situation is changing for the worse.
Ukraine’s public finances are stable, but vulnerable

The NBU headquarters, Kiev, Ukraine (Musia-97, CC BY-SA)

Regardless of the difficulties encountered by the Ukrainian economy, the systemic risks in the financial sector are at historically low levels, assessed the National Bank of Ukraine (NBU). NBU mentions the favorable conditions for banking activities, the stable growth of the funding base, the expansion of lending to households, and the sustained profitability of the banking sector.

Despite the slowing growth rate of the Ukrainian economy, the local macroeconomic conditions are conducive to the development of the banking sector. The key macroeconomic risk identified by the NBU is a possible pause in Ukraine’s cooperation with the International Monetary Fund (IMF). This would make the refinancing of public debt more expensive as the cost of borrowing on the international capital markets would increase. Meanwhile, unrestricted access to these markets is necessary, because Ukraine is currently in a peak of external debt repayments.

According to the NBU, the financial standing of both households and businesses is improving. Household incomes are rising, and the improved consumer sentiment along with strong economic growth are driving the increases in borrowing. As for the business community, the revenues of companies are growing, profitability has stabilized, and corporate leverage ratios have mostly remained at acceptable levels. Companies have been announcing plans to take out new loans for investments, while banks are signaling readiness to increase lending to enterprises.

At first glance Ukraine’s economic situation seems to be pretty favorable. However, detailed analysis paints a less rosy picture.

Growing risk

While analyzing the global trends affecting the Ukrainian economy and financial sector, the NBU notes that geopolitical and geo-economic risks are high and continue to rise. This includes the US Federal Reserve’s activities and its 2018 monetary policy tightening, which resulted in the outflow of capital from developing countries. And there is the continuing economic pressure exerted on Ukraine by Russia. Another important factor is the growing protectionism in the world economy. Additionally, the prices of commodities, which constitute the core of Ukrainian exports, are falling.

According to the NBU, the rate of economic growth in Ukraine’s major trading partners will likely continue slowing down. According to data from the OECD, the Composite Leading Indicators for these economies are already at the lowest level since the Great Recession and continue to decline. All of this poses a substantial threat to the real sector of the Ukrainian economy and to the country’s financial stability.

On top of this, there are also the internal risks to Ukraine’s financial stability — the key source of risk are the possible unfavorable developments concerning Privatbank, which was nationalized in 2016.

The NBU also highlights the risks associated with the high repayments of external debt that Ukraine has to make in 2020 and in 2021. With Ukraine’s limited ability to raise capital on the international capital markets, these repayments could lead to a significant reduction in the country’s foreign exchange reserves.

In these circumstances, securing ongoing access to lending from the IMF and other international creditors is of critical importance. Other significant risks include the possible slowdown in GDP growth, underperforming tax revenues, and the high likelihood that the volume of Russia’s gas transit through Ukraine could be reduced in 2020.

Another source of systemic risk is also the high dollarization of Ukraine’s economy. Even though the share of banks’ the USD denominated assets and liabilities has fallen by over 10 per cent since 2015, the share of the USD deposits and loans is still around 40 per cent. Moreover, many companies have taken out loans in the USD, even though they largely generate their incomes in the UAH, which makes these loans particularly vulnerable to exchange rate fluctuations. The NBU would like to reduce the level of dollarization in this segment to about 20 per cent.

The situation is even worse in the case of a public debt, where the dollarization rate exceeds two-thirds, which the Ukrainian central bank sees as a source of macroeconomic risks.

One possible remedy would be to convince international investors to purchase the UAH denominated government bonds instead of bonds denominated in foreign currencies.

In the assessment of the NBU, consumer lending is highly profitable and attractive to commercial banks. However, these banks should appropriately account for the risks associated with such loans. While estimating the required provisions, the banks utilize models that do not account for a possible sudden deterioration of the macroeconomic conditions. Consequently, their provisions may be too small to cope with such a scenario.

Therefore, the NBU has announced the possibility of increasing the mandatory provisions and appealed to the banks to limit the payments of dividends and to allocate their profits to supplementary capital. “In the coming years, capital requirements will increase significantly, so financial institutions will be required to hold more capital to cover possible losses,” warns the Ukrainian central bank.

The debt, the deficit, and the GDP

Ukraine will have to repay its creditors an average of USD2.6bn per quarter until mid-2020. In total, the country has to repay over USD20bn by the end of 2021.

If no additional sources of lending are provided, the expenses associated with debt servicing will reduce the size of the country’s foreign exchange reserves, because the domestic market for treasury securities is too small relative to the borrowing needs and will not be able to supply the necessary capital.

The central bank expects that enabling non-residents to purchase the UAH denominated treasury bonds will significantly increase the inflows of capital, but this will not be enough to solve the problem in its entirety. The authors of the NBU’s report note that Ukraine’s cost of raising debt is now among the highest in the world (in early June the yield on Ukraine’s the USD denominated sovereign bonds was 7–9 per cent). In their opinion, the government should focus on reducing the budget deficit. One the one hand, this would reduce the current financing needs, and on the other hand, it would also reduce inflation and, consequently, the interest rate on the incurred debt.

The main preconditions for new bond issues include the stabilization of the country’s macroeconomic situation, solid GDP growth, slowdown in inflation, a moderate balance of payments deficit, and a reduction of public debt to 60 per cent of GDP.

However, the latest data published in October 2019 by the Ukrainian Ministry of Finance indicate that Ukraine is still far away from meeting these objectives. It turns out that direct debt and state-guaranteed debt increased by USD1.03bn in September 2019 alone, reaching USD82.95bn, or approximately 67 per cent of Ukraine’s GDP in 2018.

In total in the period from January to September 2019, Ukraine’s debt increased by USD4.64bn, and this was despite the huge repayments of the existing debt due, which constitute an enormous problem for Ukraine’s macroeconomic stability. Meanwhile, over the course of 2018 Ukraine’s overall debt increased by USD2.02bn.

Although the Ministry of Finance informs that the size of the debt denominated in the domestic currency has decreased due to the strengthening of the UAH exchange rate in relation to the USD, this does not change the overall picture, because there has been a simultaneous decline in GDP, as expressed in the domestic currency. This is due to the fact that a lion’s share of GDP is dependent on commodity exports, and as a result of the local currency’s appreciation against the dollar, Ukrainian companies are now getting fewer hryvnias for the same sales volumes.

The NBU predicts that Ukraine’s GDP growth will slow down from 3.3 per cent in 2018 to just 2.5 per cent in 2019. This is despite the sustained increase in domestic consumption driven, among other things, by the significant remittances from emigrant workers. It is also necessary to consider the possible reduction in revenues from the exports of transportation services after the future launch of the Nord Stream 2 gas pipeline. At present, Ukraine earns approximately USD3bn per year on the transit of Russian gas.

Additionally, according to the estimates of analysts, the global slowdown will prevent the growth of Ukrainian commodity exports. In this situation, sustained levels of consumption and fuel imports could lead to the expansion of the current account deficit, which remained at 3.3 per cent of GDP in 2019. The Ukrainian central bank also notes that the profitability of the real sector of the economy had already decreased in 2018.

These developments indicate that external aid could turn out to be the only source of salvation for the economy. If it is possible to continue cooperation with the IMF, the inflows of foreign direct investment and debt raised from external entities will allow Ukraine to finance the deficit. Otherwise, an exchange rate correction, that is, the devaluation of the UAH, would be necessary — predicts the NBU.

Families on the edge

Regardless of the difficult situation in the country’s public finances, the incomes of Ukrainian households are rising. The 2018 minimum wage hike resulted in a 9.9 per cent increase in real wages. However, this growth is not improving the quality of life of ordinary Ukrainians, because it is accompanied by growing expenditures on the increasingly expensive consumer goods.

This situation also affects the banking sector — the savings rate is not growing, and households are mainly keeping their funds in current accounts and short-term deposits. At the same time, the volume of consumer loans is increasing.

Thus far, the Ukrainian household budgets have been successfully supported by the growing amounts of money transfers from emigrant workers. However, in 2018 this growth trend collapsed. While in 2017 foreign remittances increased by 34-36 per cent, in 2018 they only grew by about 12.8 per cent.

The most recent estimates are even worse and indicate that the value of remittances in 2019 will be equal to that recorded in 2018, which means that their cushioning effect on the economy could soon come to an end.

The NBU headquarters, Kiev, Ukraine (Musia-97, CC BY-SA)

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