UKRAINE SNEEZES, HAVING CAUGHT THE GLOBAL ECONOMIC COLD

UNCLAS SECTION 01 OF 02 KYIV 001959

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SUBJECT: UKRAINE SNEEZES, HAVING CAUGHT THE GLOBAL ECONOMIC COLD

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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
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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

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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.