Ukraine - review of 2015 and outlook for 2016

Looking back, 2015 was the turning point for Ukraine. It strengthened its military, increased transparency of government and accountability of elected officials, liberalized the natural gas market, started the process of deregulating the economy, rationalized taxes, and began to integrate with the EU. Not least, it secured more than USD 34 bn in aid through 2018. The economy troughed and inflation peaked. 

Looking forward, the IFIs that have provided so much support to Ukraine are paying close attention and keen to get a “return” on their investments. Ukraine must, perhaps above all, make material progress on corruption, still endemic, though more visible. The economy is set to grow, lending should increase, and capital controls should soften. We believe that attractive opportunities exist in public and private equities. 

The beginning of 2015 was marked with violent clashes in Eastern Ukraine, spiraling inflation, local currency devaluation. However, a ceasefire was negotiated at the end of 1Q2015, and a landmark EFF deal from the IMF for a total amount of USD 17.5 bn was secured. This allowed the USD/UAH rate to stabilize at 22-24 and helped stop the economic freefall. 

By the summer of 2015, some signs of economic stabilization were already visible, although inflation was still quite high. The country’s economy was clearly recovering, albeit at a really slow pace, which was confirmed by the 3Q2015 GDP figure (+0.7% q/q). Still, consensus estimates for the Ukrainian economy are for a 10% contraction in 2015,  with inflation running high at 43.3%. 

The Ukrainian banking system underwent a major overhaul over the year, with 43+ banks leaving the market as a result of their insolvency or involvement in fraudulent or risky operations. The central bank also introduced strict policies and regulations for the Ukrainian banks, curbing their risk appetite and demanding to increase capital if the bank’s own reserves weren’t sufficient to cover the losses. 

The successful restructuring of Ukraine’s sovereign debt laid the grounds for the country’s return to capital markets and decreased yields on long-term Eurobonds to 9% from 20%+, while also improving risk perception of investors.

Most of domestic and international experts actually noted significant improvements in reforms (albeit also acknowledging the slow pace of reforms). From the economic policy standpoint, we’ve mostly seen some efforts on deregulation and simplification of bureaucratic processes, with notable results in the area of electronic government. The government increased public transparency and accountability of elected officials, liberalized the natural gas market, started the process of deregulating the economy, rationalized taxes, and began to integrate with the EU. However the general population’s view on the progress was negative or extremely skeptical.  

Large portions of the Ukrainian government is still mired in corruption and determined to stall changes to the status quo. However, since the top level of management is now controlled by professional ministers with business backgrounds, and since the public is closely watching their every move, it has become much harder for the corrupt officials to continue stealing money using the same “schemes” they employed before.

The country also emerged as a much stronger nation both in terms of social coherence and military strength. While it could not hope to fight with Russia in a full-scale war, the country’s military force is certainly ready to stop any attempts of increasing the terrorist-held area (even when done by the professional Russian military groups) and keep them at bay. 

We believe 2016 will be the year of growth for Ukraine, with the year 2015 providing a solid ground for the economy’s takeoff and serving as a platform of deeper and more structural reforms.

Outlook for 2016

Looking ahead we see several issues that could arise/take shape in 2016:

If 2015 was the year of macro stabilization, 2016 should be the year of growth. This means that the NBU will eventually have to loosen its reins on the economy and drop the key lending rate (which is currently standing at 22%) so that banks can lend at lower rates and infuse the economy with cash. At the same time, the business activity should pick up as a result of a relative winding down of the conflict in eastern Ukraine and the opening up of the EU market.

Ukraine’s real GDP should grow by at least 2% this year, while inflation should subside from 43.3% in 2015 to 12-15%, according to the forecasts of Ukraine’s Central Bank, the Economy Ministry of Ukraine, and the IMF. Still, we caution that a dramatic recovery is unlikely, as Ukraine remains deprived of its Donbas industrial base, faced with trade restrictions from the side of Russia, and dealing with a global trade environment that could lend weak support to the country’s trade balance. 

We believe the government is likely to ease capital controls. The country’s official reserves are already adequate, at USD 13.3 bn by end of 2015, as compared with USD 7.5b at the beginning of the year. However, with the government debts restructured and aid flowing, reserves should continue to augment. The gradual revival of export activities, on background of a relative stabilization of the foreign currency market and the Hryvnia exchange rate, also constitute favorable tailwinds. We believe that the government is keenly aware that an easing of capital controls is important for improved trade, investment and growth. 

We see high chances of the government being reshuffled in the course of the first half of 2016, considering the current Cabinet’s failures related to privatization, energy security, anti-corruption initiatives and other controversial topics in 2015.

The anti-corruption reform is up for a boost in 1Q2016 with the new Anti-Corruption Bureau working at its first cases in December 2015. We also expect at least a partial overhaul of the country’s judicial system with judges at several levels taking professional competence tests and some facing charges for unlawful rulings related to the Maidan revolution participants.

In 2016, the country’s leaders should detail economic reforms. This should materialize in the form of a long-term development strategy outlining key growth factors and steps that need to be taken in order to achieve goals. More specifically, the government will have to finalize the Tax Code, haphazardly approved along with the State Budget for 2016 a week before New Year’s Eve. This won’t be easy, as it will have to take IMF’s economic requirements into consideration (including the 3.7% budget deficit for 2016, and the general approach towards equalizing all industries on a taxation level), while at the same time not putting additional stress on the Ukrainian business environment. The adoption of a balanced budget for 2016 in conjunction with a new tax system is the stumbling block. However, we think that the IMF financing will be resumed after some upfront actions of the government in 1Q2016.

We’ll also likely see much closer cooperation with the EU, now that the EU-Ukraine DCFTA Agreement is to be in full force starting from January 1, 2016. With a ten-year transition period, the free trade agreement eliminates tariffs on 97% of Ukrainian goods (some groups as early as 2016). Already in 2015, we’ve seen several Ukrainian food companies receiving the approval to export to the EU, and we expect the process to continue next year.