UKRAINE SNEEZES, HAVING CAUGHT THE GLOBAL ECONOMIC COLD

UNCLAS SECTION 01 OF 02 KYIV 001959 SENSITIVE SIPDIS DEPT FOR EUR/UMB, EB/OMA TREASURY PLEASE PASS TO TTORGERSON E.O. 12958: N/A TAGS: EFIN ECON XH UP SUBJECT: UKRAINE SNEEZES, HAVING CAUGHT THE GLOBAL ECONOMIC COLD SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION ¶1. (SBU) Summary. Despite Ukraine's expansion in trade and industry over the past several years, the global financial crisis has generated knock-on effects, potentially harming the country's economic prospects. In contrast to the first quarter of 2008, when analysts pointed to risks of rampant credit growth and an overheated economy, senior government officials, national bankers, and private financiers are now seeking to mitigate Ukraine's susceptibility to external shocks. Negative trends show that Ukraine may not be impervious to contagion after all. End Summary. Immune Altogether... -------------- ¶2. (SBU) Ukraine has had a strong run, with bullish consumption, credit availability doubling annually over the past five years, and strong profits from export commodities. The National Bank of Ukraine (NBU) amassed foreign currency reserves of $38 billion, and sustained real GDP growth and investment profits made Ukraine an attractive capital destination, prompting some to assert that the economy, together with other emerging markets, was "decoupled" from its neighbors' more volatile business cycles. ...Or Suffering from Contagion? -------------- ¶3. (SBU) Macroeconomic trends are now rapidly reversing. Ukraine received $5.5 billion in FDI during the first half of 2008, but a slowdown in financial inflows is expected to affect both banks and the diminutive stock market. Over 80 percent of investors on the illiquid and insider-controlled Kyiv stock exchange (known as the PFTS) are foreign funds that have sold shares to cover losses in other markets. The sell-off caused the PFTS index to fall a record 14.1 percent on September 16, 2008; it is down more than 68 percent for the year after gaining 130 percent in 2007. The precipitous rise and fall of the PFTS highlight risks in a CIS-region market, where investors are vulnerable to low volumes and chronic valuation swings. ¶4. (SBU) Aggressive borrowing and lending practices that had fueled higher imports, corporate investment, and household spending -- on everything from apartments to automobiles to apparel -- are now seen as hazardous. Banks are hustling to roll over maturing external debt (no precise data is available, but in the range of $25-30 billion),as well as curtail the financial effects of a projected $22 billion current account shortfall in 2009 (an estimated 9.8% of 2009 GDP, according to the IMF). A September 29-30 bailout of Prominvest Bank may be a harbinger of things to come. The Kyiv-based institution received an NBU injection of $200 million and a credit line of up to $1 billion, after 30 percent of its deposits were wiped out in a run. Ukraine's foreign banks and corporate investors are scrutinizing their risk exposure, as roughly 70 percent of the country's external banking debt (i.e. $9-10 billion) is owed to parent financial institutions, mostly located in Europe. One banking analyst told EconOff that liquidity shortages may lead to a collapse in the equity and asset markets, with high default rates in the urban housing sector to result. Even the Association of Ukrainian Banks, an industry lobbyist, expressed concern to its members about recent data on credit quality and the potential for a sharp reduction in foreign capital. Currency, Ratings, and Terms of Trade -------------- -- ¶5. (SBU) The NBU has not intervened in the recent sell-off of the hryvnia (UAH),which has fallen significantly in recent weeks. At currency booths in Kyiv, the exchange rate reached 5.04-5.11 UAH to the dollar, exceeding the NBU's established corridor (4.85 UAH to the dollar, +/- 4 percent). If declines worsen, the NBU might still aggressively defend its band, but ICPS -- a respected Kyiv think tank -- has concluded that to be an unlikely scenario. ¶6. (SBU) Standard and Poor's rating agency has reported that the dissolution of the Ukrainian parliamentary coalition will not affect the country's sovereign rating. But Fitch recently adjusted Ukraine's outlook to negative, and local experts believe domestic and regional instability will decrease confidence in the Ukrainian economy, tightening credit and further threatening the country's economic health. Ukraine's sovereign spreads, according to J.P. Morgan, recently reached as high as 868 basis points, relative to the Emerging Markets Bond Index. ¶7. (SBU) Analysts unanimously agree that the Ukrainian current account deficit will increase in 2009, with higher energy and lower KYIV 00001959 002 OF 002 commodity prices affecting industries that comprise roughly 50 percent of exports. A leading private equity firm estimates that Russian imported gas prices will rise in 2009 from $180 to roughly $360 per 1,000 cubic meters, adding about $8 billion to the current account deficit. Relying on Russian fuel imports for energy-intensive manufacturing, Ukraine's terms of trade will also be adversely affected by lower global prices for metals and chemicals. ¶8. (SBU) A dismantled Tymoshenko-Yushchenko coalition in parliament (Verhovna Rada) has made matters worse. Public sector wages, increasing beyond productivity and inflation growth, have contributed to a decline in the real exchange rate and may contribute to a wage-price spiral. Necessary fiscal discipline requires consensus in the Rada, as well as political will on budget matters from top echelons in the government. Neither appears forthcoming in the midst of general political paralysis. Continuing uncertainty about the likelihood of a third set of snap parliamentary elections in as many years and the seeming inability of Tymoshenko and Yushchenko to put national interests before political gaming only increases the growing mood of cynicism. ¶9. (SBU) Comment: Bankers and think tankers, having observed trends in Ukraine since the 1990s, are reluctant to use the term "crisis" to define Ukraine's current macroeconomic climate. But, by every standard, the country's markets have entered into a period of instability, likely caused by the global financial slowdown and domestic political troubles. External vulnerabilities and sagging investor confidence could be a double blow to the economy, as Ukraine needs foreign direct investment to sustain growth and shore up the current account deficit. It is wishful thinking to assume that today's Ukraine is immune from the doleful effects of contagion. End Comment.