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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)
+7495 721 1515 [email protected]
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/8/3/2019 HSBC Ukraine Trip Notes Oct2011
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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)
Source: National Bank of Ukraine
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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)
Source: National Bank of Ukraine
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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
objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice,
consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek
professional investment and tax advice.
Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may
not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of
the investment products mentioned in this document and take into account their specific investment objectives, financialsituation or particular needs before making a commitment to purchase investment products.
The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an
investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls
in value that could equal or exceed the amount invested. Value and income from investment products may be adversely
affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative
of future results.
Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment
banking revenues.
For disclosures in respect of any company mentioned in this report, please see the most recently published report on that
company available at www.hsbcnet.com/research.
* HSBC Legal Entities are listed in the Disclaimer below.
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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Disclaimer
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