UKRAINE'S 2010 ECONOMIC OUTLOOK: UNCERTAINTY REMAINS AFTER

UNCLAS SECTION 01 OF 04 KYIV 000226

SENSITIVE
SIPDIS

STATE FOR EUR/UMB, EEB/OMA

E.O. 12958: N/A
TAGS: EFIN EREL ELAB ECON ETRD PGOV PREL XH UP
SUBJECT: UKRAINE'S 2010 ECONOMIC OUTLOOK: UNCERTAINTY REMAINS AFTER
THE COLLAPSE

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SENSITIVE BUT UNCLASSIFIED, NOT FOR INTERNET DISTRIBUTION


1. (SBU) Summary. Ukraine suffered one of Europe's worst recessions
in 2009, with real GDP declining nearly 15%. The economic slump was
prompted by a sharp fall in global demand for steel and chemical
products, combined with the global credit crunch and vulnerabilities
in the Ukrainian financial sector. The GOU's reaction to the
crisis, which included demanding advanced tax payments from
corporQons and non-payment of overdue VAT refunds worth over $1.5
billion, further harmed investor confidence. As the January 2010
presidential election approached, Prime Minister Tymoshenko refused
to increase gas prices, reduce industrial subsidies, or reform the
pension system. Ukraine's 2010 outlook depends on the pace of
political consolidation after the presidential election, external
demand for Ukraine's key export products, and implementation of
reforms that bring back the IMF, prompt investment, and facilitate
lending. End summary.

UKRAINE'S GDP FREE FALL
--------------


2. (U) Ukraine's real GDP plummeted an estimated 14.8% in 2009,
while overall industrial production declined 21.9%, according to
recently released data from the State Statistics Committee and the
National Bank of Ukraine (NBU). Key labor intensive industries
constituting 55% of the overall economy were hardest hit, with
machine building suffering the largest decline (65.1%),and
metallurgical and chemical sectors falling 26.6% and 23.2%,
respectively.


3. (U) In 2009, real household incomes fell 6.8% percent; the
exchange rate, which depreciated over 40% from the start of the
crisis, continued to fluctuate; and consumer lending froze up. As a
result, Ukraine's construction and retail sectors shrunk by 48% and
16.6%, respectively. The only bright spot in the economy was
agriculture, whose 0.1% growth resulted from a bumper crop and
steady domestic demand.

FISCAL WOES
--------------


4. (SBU) Ukraine's 2009 total budget deficit reached an estimated
10% of GDP, due to a collapse in revenues and the failure of
Tymoshenko's government to cut spending. A substantial portion of
the fiscal gap was monetized by the NBU, which bought UAH 34.89
billion ($4.36 billion) in domestic treasury bills in 2009. Loans
provided by the IMF and World Bank, in addition to the conversion of
IMF special drawing rights, proved fungible sources of extra cash.
The GOU also filled the budget gaps by requiring businesses to make
enterprise profit tax payments in advance and by arm-twisting the
NBU into transferring UAH 4.6 billion ($575 million) in expected
future profits to government accounts.


5. (SBU) By the end of 2009, the GOU had accumulated UAH 19 billion
($2.38 billion) in outstanding VAT refund claims. Of that figure,
overdue (more than 60 days) payments are at the "record" level of
UAH 12 billion ($1.5 billion),according to Kyiv-based experts.
Embassy contacts have confirmed that the Tymoshenko government,
under severe budget pressure, issued instructions in the fourth
quarter of 2009 to withhold VAT refunds until after the presidential
election.


6. (SBU) An internal Cabinet of Ministers' memo, leaked to local
media sources on January 27, showed that the GOU failed to pay
significant sums to numerous ministries in 2009. The overall
shortfall was UAH 2.41 billon ($301 million),of which UAH 344
million had been dedicated to the swine flu prevention effort, UAH
480.43 million for election preparation, UAH 91.9 million for
defense programs, UAH 121.4 million for the Ministry of Internal
Affairs, and UAH 106.89 million for the Ministry of Agrarian Policy.


DOMESTIC BORROWING SPIKED
--------------


7. (SBU) Attempting to finance the budget deficit in 2009, the GOU
placed particular emphasis on expanding the domestic debt market.
It sold UAH 18.8 billion ($2.35 billion) in short-term domestic
treasury bills at primary auctions in 2009. Weighted yields
averaged 20.7% but spiked to 25% in December 2009, when the GOU
struggled to make wage and pension payments while also rolling over
maturing domestic securities. The latest auction on February 2
raised UAH 1.16 billion ($145 million) for domestic debt payments,
with six-month bills sold at 23% and 32-month bills purchased at
26%.


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8. (SBU) Analysts expect that the short-term treasury bills will
create debt servicing problems as early as the second quarter of
2010, when the GOU needs to repay UAH 8.1 billion ($1.01 billion).
To roll over these maturing domestic securities, the GOU may need to
issue more treasury bills, possibly at higher interest rates.
Another concern is that high bond yields will continue to "crowd
out" investment in the real economy.

FRAGILE BANKING SECTOR
--------------


9. (SBU) Large volumes of non-performing loans accumulated by banks
(often exceeding 30%),combined with speculative pressure on the
domestic currency, forced the NBU to tighten monetary policy and
reserve requirements in 2009. Banks have also fought against low
consumer confidence, reporting an overall 8.3% decline in deposits.
New lending remains extremely limited, with loan portfolios posting
only 5% nominal growth in 2009, most of it to state-owned
enterprises. Mortgage loan volumes decreased ten-fold from 2008
levels, according to industry sources. Progress in creating bank
restructuring mechanisms was offset by ongoing uncertainties over
Nadra and Ukrprombank, two major financial institutions that have
been under temporary administration for the past year.


10. (SBU) Statistical indicators show that Ukraine's banking sector
remains dangerously unstable. Seven of the top eighteen banks in
Ukraine have a capital adequacy ratio (CAR) of less than 10%,
according to non-published statistics passed to the Embassy. NBU
refinancing has been doled out unevenly and in large quantities,
with 11 of the top 18 banks receiving liquidity injections that
constitute more than 10% of their total hryvnia-based credit
portfolio. Of Ukraine's top tier banks, 13 maintain provisions
equal to at least 10% of their total credit portfolio, with three
holding provisions at more than 40%. Eight major banks rely on
foreign currency lending for at least 60% of their credit portfolios
and are thus heavily exposed to exchange rate fluctuations.

IMBALANCE OF PAYMENTS
--------------


11. (U) Ukraine's current account deficit moved to $1.9 billion in
2009, an improvement over the $12.8 billion deficit registered in

2008. This shift reflected a significant decline in imports of
manufactured and consumer products for the year, combined with
growth in steel and chemical exports during the second half of 2009.



12. (U) The financial account worsened in 2009, due to the stoppage
of foreign capital flows, foreign debt repayments by the banking
sector, and a surge of hard currency purchases. Compared to the
same period in 2008 when inflows were $9.6 billion in surplus, 2009
financial account figures indicated a deficit of $11.8 billion.


13. (SBU) Ukraine's population continues to horde hard currency,
especially dollars, as a store of wealth and as a hedge against
currency depreciation. In an uncertain political environment and
where trust in the banking sector remains low, Ukraine's total hard
currency purchases were $9.6 billion in 2009. The NBU covered the
imbalance with its gross currency reserves, which stood at $26.5
billion at the end of 2009, equivalent to roughly five months of
imports.

EXTERNAL MARKETS MODERATE EXPORT DECLINES
--------------


14. (SBU) Ukrainian steel and chemical exports were supported by
currency depreciation, transportation subsidies for steel producers,
and energy subsidies for steel and chemical plants. Although steel
and chemical exports for the year fell significantly, recovery in
the markets of Ukraine's major trading partners, particularly Russia
and China, provided some relief by the end of the year.


15. (U) All major steel indicators fell sharply in 2009. Crude
steel production plummeted 20% to 29.8 million tons, pig iron fell
17% to 25.7 million tons, and finished rolled steel output declined
15% to 26.9 million tons, according to government statistics.


16. (SBU) Steel producers have told Embassy officials that
short-term orders from Russia and East Asia helped Ukraine register
a jump in industrial production in recent months, with statistics
benefitting from low 2008 base numbers. December industrial output
grew 7.2%, year-on-year, with metallurgy advancing 27.3% and
chemicals gaining 17.4%. January 2010 steel output also jumped
significantly, with finished rolled steel production up 20%, y-o-y,
to 2.4 million tons. Without much external demand, however, the
machine building sector was stagnant, with no signs of recovery in

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the fourth quarter and a 2.5% decline in December, y-o-y.

MODERATE INFLATON
--------------


17. (SBU) Ukraine had comparatively moderate price growth in 2009.
Its lower than expected 12.3% inflation rate reflected the
government's decision to postpone most major increases in utility
rates, particularly residential gas rates that had been slated to
rise toward cost recovery levels. Utility rates grew only 8.2% in
2009, as opposed to 28.2% in 2008. The bulk of the price increases
(6.9%) was registered in the first four months of 2009, mostly
driven by inflation in imported products and sharp currency
depreciation at the end of 2008. As Ukraine's currency stabilized
and demand for consumer products fell, inflation moderated during
the latter half of 2009. Ukraine's strong 2009 harvest limited food
price growth to 10.9%, down from 24.5% in 2008. Public
transportation rates grew only 10% in 2009, as opposed to 46.6% in

2008.


18. (SBU) Expected increases in 2010 transportation and residential
gas rates will likely add 3-6 percentage points to inflation,
according to Kyiv-based analysts at Astrum Investment and Concorde
Capital. As a result, experts project Ukraine's 2010 inflation
could exceed 2009 levels, contrary to the official forecast of 9.3%.


2010 ECONOMIC OUTLOOK
--------------


19. (SBU) Ukraine's 2010 outlook depends on the pace of political
consolidation after the presidential election, external demand for
Ukraine's key export products, and implementation of reforms to
bring back the IMF, prompt investment, and facilitate lending. A
protracted Tymoshenko challenge of the second round presidential
election results, despite the apparent victory of Viktor Yanukovych,
would postpone the formation of a new government and delay needed
economic reform. This, in turn, would place significant pressure on
the IMF, which has put off its engagement until political
consolidation yields a slate of authorities with which it can
negotiate.


20. (SBU) Budget problems are likely to remain the largest concern
for the GOU in 2010. After the presidential election, the new
government may have more political maneuverability to address its
deficit by passing a sound budget and enacting tough reforms to
address gas pricing and the pension system. However, the state
cupboard is now bare, making broad first quarter budget arrears all
but inevitable.


21. (SBU) Ukraine's difficult business environment, which has only
worsened during the 2009 fiscal crisis, will continue to have a
negative impact on investment in 2010. The obligation to pay back
accumulated VAT refund arrears will also be a challenge for
Ukraine's cash-strapped government. The Ministry of Finance has
already announced it will allocate only UAH 1.3 billion monthly to
pay VAT refunds during the first quarter of 2010, lower than the
2009 minimum monthly refund of UAH 2 billion. Further accumulation
of VAT arrears has severely limited corporate working capital and
poisoned the well for potential investors.


22. (SBU) To improve investor confidence and bring back the IMF and
other external lending, the new President and government will have
to push through a major, and painful, reform package in the early
days after the inauguration. Without reforms that put the IMF
program back on track, investment and bank lending will continue to
be absent. Investors are wary, but many still think some of
Ukraine's key sectors (especially agriculture, pharmaceuticals, and
food processing) are excellent medium-term bets.


23. (SBU) Most experts project modest economic growth in 2010,
including 2.7% GDP forecast by the IMF and 3% GDP growth foreseen by
the EBRD. The revival of Ukrainian metallurgy sector is expected to
be the largest economic driver and will also contribute to shrinking
Ukraine's current account deficit. However, factors causing an
imbalanced 2009 financial account (i.e. a sharp decline in
investment inflows and increased corporate payments to external
creditors) will likely continue in 2010. Any political uncertainty
could ward off sources of financing and further distress investors
and the banking sector.

COMMENT
--------------


24. (SBU) In an environment where fiscal pressures will likely lead
to significant payment arrears in March, a signal from the IMF that

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it is reengaging is considered vital. On the other hand, the IMF
will run into reputational risks if it comes back too early or if
Yanukovych follows through on a budget-busting promise to raise
state sector wages and pensions. IMF and World Bank-supported
reforms will likely be accepted by the public and are unlikely to
lead to large-scale social unrest. Our baseline expectation is that
investment numbers will not increase notably until later in 2010.
Business investors will be watching for the new President's economic
reform agenda, anxious to see signals of commitment before coming
back to Ukraine in anything but a very tentative fashion.

TEFFT