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Pinned Again? Focus Scope Ukraine Economics Quarterly Report Pinned again? Alexander Valchyshen Kiev, +38 044 2200120 [email protected] April 2012 PLEASE READ THE DISCLOSURES SECTION FIRST FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION April 2012 Quarterly Report Pinned again? Contents Executive summary 4 Geopolitics 7 Issues relevant to Ukraine‘s economy ........................................................................... 7 Conclusions and ongoing developments ..................................................................... 10 Ukraine’s politics 12 The 2010-12 political cycle comes to an end ............................................................... 12 Mapping the political landscape ................................................................................... 13 The next political cycle of 2012-15 approaches ........................................................... 15 Conclusions ................................................................................................................. 16 Global economy 18 Activist central banking ................................................................................................ 18 Indicators vital to Ukraine‘s economy........................................................................... 21 Ukraine’s economy 24 Still below pre-crisis level and lagging behind .............................................................. 24 Today‘s characteristics of domestic demand ............................................................... 25 Why mineral imports matter ......................................................................................... 30 Ukraine‘s energy balance: Natural gas as key component .......................................... 34 Naftogaz as a vehicle in supporting the economy ........................................................ 35 Fiscal policy: Sizable consolidation did take place in 2011 .......................................... 40 Monetary policy: NBU among activists......................................................................... 41 External balance: External shock extended ................................................................. 43 UAH: Our view on the currency ................................................................................... 51 Yearly forecast for 2012-14, base-case scenario ......................................................... 55 Quarterly forecast for 2012-14, base-case scenario .................................................... 56 Appendices: Thematic charts & tables 57 Ukraine‘s political map after October 2012 .................................................................. 58 Quarterly GDP: Reported statistics and ICU‘s calculations .......................................... 62 ICU consumer basket: Observation of Kiev, New-York and Moscow prices ................ 64 Ukraine‘s energy balance in 2010 ................................................................................ 67 NBU‘s balance sheet size: Absolute and relative terms, 2002-12 ................................ 69 Schedule of external public debt due in 2012-14 ......................................................... 70 Projections of 2012 balance of payments under different scenarios ............................ 72 Ukraine‘s top 42 banks‘ key financial figures, 2009-11 ................................................ 73 3 April 2012 Quarterly Report Pinned again? Executive summary “Economic forecasters divide into two groups. There are those who cannot know the future but think they can – and then there are those who recognise their inability to know the future.” Lawrence Summers, former US Treasury Secretary, in his op-ed article for the Financial Times, 26 March, 2012 Our view on the economy and its perspectives in the 2012-14 period is comprised of the following key viewpoints: Slowdown in sight, risks of recession low. Eventually, a slower pace of economic growth will be taking place in 2012, as the global economic slowdown materialises. Our base-case scenario envisages 2% YoY growth in both quarters of the 1H12, then acceleration will follow, resulting in 3.5% YoY, full-year, real GDP growth. In our view, Ukraine‘s industrial sector will speed up domestic economic activity, as demand for Ukraine‘s exports will be set on recovery trajectory starting in the 2H of the year. There are myriad risks surrounding the global economy, starting from the Eurozone debt crisis and high crude oil price that threatens a pick-up in inflation and aggravation of growth momentum. However, the activist monetary policy of the central banks of leading developed economies as well as by Chinese authorities should work on supporting demand in their economies from slipping into recession. In Russia, the economy benefits from a high oil price and fiscal stimulus of the newly elected president. Ukraine’s economy is still below its pre-crisis level. Our calculations show that despite quite vigorous GDP growth in 2010-11, by 4.2% YoY and 5.2% YoY, the economy‘s size is still well below its pre-crisis level. It would take nearly two years at growth rates of our base-case scenario for the economy to fully recover from the deep recession of 2008-09. This factor characterises broad economic demand in Ukraine as being relatively weak if compared to pre-crisis demand, which was supported by bank lending. This contrasts with the economic recovery seen in some of Ukraine‘s main trading partners like Russia, Turkey, and Poland, which have totally recovered from the recession of 2008-09. Lasting external price shock. Our research shows that Ukraine‘s economy has been functioning in an environment of protracted external price shock, which itself stems from dependence on natural gas imports by the economy. This started in early 2011 and spilled over into 2012, as the crude oil price remained well above US$100 a barrel. Our adjustment of trade data for the USD monetary effect shows that the current external price shock from the high oil price has been stronger than that in 2008 (see Table 2 on page 29 in the section ―Today‘s characteristics of domestic demand,‖ which starts on page 25). This leads us to conclude that the current trade deficit is in large part driven by energy imports, and particularly by natural gas imports. We project the current account to widen from US$9.0bn (5.4% of GDP) in 2011 to US$11.4bn (6.6% of GDP) in 2012, sliding over the next two years down to 3.4% in 2013 and 1.1% in 2014. Naftogaz as prime victim. State-run company Naftogaz appears to be the prime victim of the lasting external price shock, as its deficit has been widening alongside the trade deficit since early 2011. Politics are to blame here. The upcoming parliamentary 4 April 2012 Quarterly Report Pinned again? elections do not allow reform of regulated tariffs, which would otherwise breathe new life into the price elasticity of demand for natural gas. Our calculations show that over the last three years, the average growth rate of the import price of natural gas grew by 19.9% YoY, while imports of natural gas in physical terms contracted by a mere 0.2% YoY (see Chart 25, pp.32). Naftogaz‘s deficit in 2011 amounted to UAH45bn (3.4% of GDP), and will stay elevated in 2012 at UAH65bn (4.5% of GDP) under our base-case scenario. Economic policymaking to keep an eye on Naftogaz. Fiscal policy in 2011 was one of the bright spots of Ukraine‘s macro picture: since August, the government has been running a practically zero primary deficit, representing a noticeable fiscal consolidation. This was partially in preparation for creation of fiscal scope for the president‘s pre-election initiatives that were announced this March, and to cost 1.0- 1.5ppt of GDP. We project fiscal policy to consolidate in early 2013-14 to allow fiscal room for the next wave of pre-elections social spending, to be unveiled by the president, who will seek re-election in early 2015. Monetary policy in 2012 is going to be pro-growth to support fiscal policy and narrow the fiscal deficits under additional social spending, as well as to provide assistance to the government in solving the Naftogaz liquidity issue. Kremlin and IMF: Evolving talks. Given the higher deficits in foreign trade and of state-run Naftogaz, Ukraine‘s authorities will expedite their talks on both of these fronts. Talks with the Kremlin will be held at an accelerated rate, while a bit more slowly with the IMF, due to elections this fall. However, our base-case scenario as for the outcome of the talks with the Kremlin assumes that the talks will continue. Making concessions to the Kremlin is costly, both politically and business-wise. Hence, the current price formula has not changed under our base-case scenario, under which the volume of imports is lowered to 30bcm in 2012. In parallel, talks with the IMF will continue to prepare the gradual normalisation of the domestic tariff system on natural gas consumption. This may also accelerate after the parliamentary elections, in order to persuade the IMF to modify its rigid position and resume or even reframe its lending programme. Ukraine‘s active play in global geopolitics may help: it recently supported the US‘s calls for international cooperation in nuclear security, as well as in the Internet copyright issue; hence, it would likely seek renewed support from the US to back its bid at the IMF. Politics: Next presidential elections are a top priority. While this year‘s parliamentary elections do hold some intrigue, in our view, the incumbent ruling parties led by
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