Timothy Ash (STANDARD BANK PLC)

We visited Ukraine on November 17-20 meeting with the Minister of Foreign Affairs, Pavlo Klimkin, the Governor of the NBU, Valeria Gontareva, the deputy Minister of Finance, Vitali Lissovenko, alongside meeting the IMF, members of the diplomatic corps, business leaders, journalists, corporates, banks and analysts.

Summary view: The political scene continues to be dominated by the on-going conflict in Donbas, which shows little sign of abating. Indeed, the risks of further escalation and a Russian military intervention are not insignificant. The latter risks/concerns continue to strain the domestic political scene, acts as a distraction to the economic policy debate, and undermines economic confidence. Parliamentary elections brought a resounding victory for pro-EU parties. However, squabbling between the two main reform parties appears to have delayed the formation of a new reform coalition government. This latter delay has further sapped confidence, and is likely to stall the release of much needed Western financing. Concerns over security and political stability have weighed on the UAH, and depleted scarce FX reserves still further. The UAH has now lost close to half its value over the past year, and could well fall further as evidence suggests deleveraging is reducing roll-over ratios on USD45bn plus of short term debt liabilities, plus outright capital flight. The weakening UAH threatens to boost NPLs in the banking sector, risks a non-payment problem throughout the economy, and ultimately will increase the cost to the sovereign balance sheet from the likely resulting bank recapitalisation. The existing USD17bn IMF programme now appears insufficient to close the external financing gap, and may need to be significantly re-profiled and augmented - perhaps increasing to USD30bn. Western creditors appear to be slow moving in recognising the scale of the problem, and are perhaps nervous over rising public sector indebtedness (debt sustainability), domestic political instability and the security situation on the ground - understanding Ukraine's financing needs are also made difficult by uncertainty over the security situation and the future structure of the state, i.e. who will be repaying official financing going forward. Without the speedy provision of additional official financing, the external financing gap will likely be closed by further exchange rate adjustment and/or restructuring of external debt liabilities - this is already happening with some corporate/bank liabilities. It is clear that the NBU does not have sufficient FX reserves to defend the UAH at present in any meaningful way. It may well be forced to resort to further administrative tools to slow the UAH's descent, but these are unlikely to slow the underlying trend, and will prove very disruptive to broader economic activity - in effect just shifting the problem elsewhere, e.g to the banking sector, and into fiscal space. What is now clear is that Ukraine needs significant additional official financial support or else it will face a serious, and likely systemic, economic and financial crisis, with likely significant longer term economic, political and geopolitical implications.  

Political outlook

Parliamentary elections on October 26 saw victory for pro-EU reform parties, which took over 300 seats in the 450-seat Verkovna Rada, and importantly a two thirds constitutional majority. However, hopes that this strong reform vote would quickly see the emergence of a pro-EU reform coalition government have been disappointed. One month after these elections and negotiations over the formation of a new government continue. The complication is that while the People's' Front (PF) of incumbent prime minister, Arseniy Yatseniuk, topped the popular vote, with around 21%, the For Petro Poroshenko Party of President Poroshenko secured twice the number of seats in parliament as compared to PF but with less votes, a reflection of the dual PR/Constituency based electoral system. Yatseniuk has assumed that the fact his party topped the popular vote gives him the mandate to form and head the government, a point seemingly initially accepted by the Poroshenko. Subsequent wrangling appears to have been over the allocation of ministerial portfolios - with Poroshenko seemingly pushing for control over more portfolios, and beyond his current right as president to nominate the minister of foreign affairs and the head of the national security council. Particular strains have appeared over the choice of minister of interior and speaker of parliament - the latter of which is being coveted by the former acting President, and PF member, Oleksandr Turchynov. 

Beyond dispute over ministerial portfolios there does appear to be concern with reform parties, other than For Petro Poroshenko, as to the potential centralising tendencies of 
Potroshenko, and whether he will look to force future constitutional changes to move more powers back to the presidency, from parliament. The Poroshenko team, meanwhile, seem to be nervous that a broad reform coalition, including Yatseniuk and PF, will be difficult to manage, and it might just be easier for For Petro Poroshenko to try and go it alone in parliament with the help of independents and perhaps one or two of the smaller pro-EU parties. In the latter scenario Poroshenko may be forced to scale back his plans for constitutional reform, albeit it might make the implementation of key economic reform legislation easier in the short term.

Moscow might be more appreciative of a narrower coalition formed around For Petro Poroshenko, and excluding PF, and Yatseniuk. Yatseniuk appears to have particularly grated with Moscow during his stint in office, and Poroshenko is viewed by Russia as a more compromising figure. That said, excluding PF and some of the other pro-EU reform parties might risk a future and possibly early backlash from the Maydan movement - and indeed from Maydan supporters within For Petro Poroshenko. 

The most likely scenario still would appear to be a broad pro-EU coalition, including For Petro Poroshenko and PF - we would attach a 70% probability to such a scenario. However, the delay in forming a new coalition government is disappointing given the enormous challenges facing the country on both the economic front, and in terms of the security situation along its Eastern border. It is also somewhat worrying in terms of what it suggests in terms of the future outlook for cooperation and harmony within the coalition. It should be noted that few people we met saw much difference in the likely economic policy orientations of For Petro Poroshenko and PF. Several respondents we met were of the opinion that any coalition between For Petro Poroshenko and PF would unlikely be long lasting, perhaps surviving only through until the Spring.

The security situation

The ceasefire agreement reached in Minsk on September 5 remains fragile, with a daily stream of casualties still - over 1,000 dead since the ceasefire was agreed, according to estimates from the OSCE. Both sides (the Ukrainian government forces and separatists) complain of persistent ceasefire violations on the opposing side, and of escalation. Ukrainian government forces appeared to re-enforce positions in early November in response to what they argued were illegal elections held in LPR and DPR on November 2. This move, alongside the severing of fiscal transfers and banking services to LPR and DPR appears to have been a move by the government in Kyiv to isolate the conflict to these small regions (perhaps 2-3% of Ukraine's territorial mass) and to allow the rest of the Ukrainian economy to normalise. Perhaps the attempt was to try and isolate the 'frozen conflict' to these specific regions limiting collateral damage to the rest of the economy. There was also perhaps an attempt to raise the stakes/price of further Russian intervention in Ukraine, by sending a message to Moscow that if it wanted these Ukrainian territories, it would need to fully maintain and pay for them - this comes at a time when the Russian economy is already weak/suffering from the effects of weak oil prices and Western sanctions, and struggling to cover the costs of maintaining annexed Crimea.

There was much debate during the visit over Russia's next move with respect to Ukraine, i.e. was it content already with gains already made on the ground in Ukraine - (annexation of Crimean and the peeling off of LPR and DPR from Ukraine proper), or was further Russian intervention likely. The latter intervention could comprise various forms. e.g. a moderate attempt to further consolidate the territories of LPR and DPR, perhaps by capturing key infrastructure assets (utilities, transport hubs), or more ambitious strategies for forging a land corridor to Crimea or even Transdniestr. Military strategists seemed to conclude that existing Russian/separatist military assets in theatre were likely insufficient as yet to deliver on these more ambitious military objectives. However, existing separatist/Russian military assets could likely easily be increased to pose a threat that these more ambitious military targets could be achieved.

The consensus seemed to be that any Russian decision on its next step militarily will likely be shaped by assumptions on the ability of the Ukrainian military to defend their existing positions, and the risks of further Western sanctions in response. We heard varied views in terms of the capabilities of the Ukrainian military - but there was a consensus that even if Russia could launch a successful military campaign to deliver on its more ambitious military objectives in Ukraine, it would struggle to sustain any such gains against likely sustained and significant Ukrainian resistance. The point was made that while Russia could easily enter Ukraine, it could not easily exit once it opted for any more ambitious military agenda, with the Afghanistan comparison often raised.

There was much debate about whether there was scope for a compromise deal to build a most lasting peace than has proven to be the case with the Minsk ceasefire agreement. The universal consensus from the Ukrainians we met was that room for compromise was very limited given that their perception was that President Putin's ultimate objective was to ensure the failure of an independent Ukraine, and the Maydan movement. Again the consensus from the Ukrainians we met (diverse spectrum of Russian and Ukrainian speakers from across the country) was that the core values of the Maydan, European values of a pluralistic market democracy, rule of law, press freedom and human rights were worth defending at any cost, and even at the risk of the further disintegration and splintering of Ukraine in the face of further Russian intervention. These Ukrainians suggested that they would not give up on the ideals of Maydan, the European and reform orientation. 

Interestingly we heard a common view that Europeans were just eager now to sweep the Ukraine crisis under the carpet, and eager to force Ukraine to compromise with Russia, at any cost. An example herein was pressure put on Ukraine earlier last month to conclude a gas deal with Moscow, and forcing Ukraine to clear debts to Gazprom, despite the fact that no financing was provided, and indeed that this served to seriously erode Ukraine's FX position and is partly to blame now for the pressure being felt on the UAH. The overwhelming message from the Ukrainians we met was again that the Western values/principals which were a cornerstone of the Maydan were not negotiable and simply put Ukraine would not bow to Putin's "Soviet-style" domination.

If you believe the Ukrainian interpretation that Russian intervention in Donbas, and Crimea, is ultimately about destabilising and undermining the Maydan reform movement, and Ukraine's European integration, then the obvious question is does Moscow believe it has done enough to cripple that movement already to be content with the status quo on the ground in Donbas and Crimea? If it has, then this might hence suggest some stabilisation. However, by the same logic, the danger then is once the Maydan reform movement shows signs of succeeding the risks of Russian intervention would again pick up pace. Perhaps Russia will instead opt to keep a "hot peace" in Donbas, with persistent but lower level conflict on the ground, and persistent troop movements to continue to pose a threat sufficient to distract the government in Kyiv from reform efforts, and to undermine confidence in the economy by weighing on the chances of the Maydan reform movement succeeding.  

Simply put few people, apart from President Putin and a handful of his advisers, know Russia's strategic and tactical game plan in Ukraine. We can only guess.

Our own sense/read is though that the current status quo on the ground is not sustainable, and further escalation is likely - only the scale of such escalation is hard to determine. We say unsustainable as the economic situation in Crimea, LPR and DPR is very difficult, and seemingly worsening. Crimea, in particular, faces a hard winter, with limited re-supply by ferry only from mainland Russia. The longer Russia waits also the more likely the military balance on the ground in Ukraine will turn against it, as Ukrainian forces regroup, re-arm and re-train. The latter could well be assisted by a likely decision by the new Republican-dominated US Congress to vote to arm Ukraine sometime in mid 2015 - unlikely to be vetoed by President Obama. Perhaps the hope is that Russia still hopes that it can ensure its strategic objectives are met in Ukraine through the political process - e.g. by securing some form of leverage within/over a future Poroshenko dominated ruling coalition government in Kyiv.

Moscow has indeed hinted that it would favour a broad coalition government forged in Kyiv, inclusive of its own interests, or representatives. This could perhaps mean that Russia would favour the inclusion of the Opposition Party in Ukraine in any such ruling coalition. The Opposition Party, polled just short of 10% in October's parliamentary elections, and is led by Yuri Boyko, the former deputy PM and minister of energy in the Yanukovych government. Historically Boiko had closer ties to Moscow, albeit has been eager to distance himself from the separatist movement in DPR and LPR. However, inclusion of any prominent former Yanukovych ministers in a future Ukrainian governing coalition would be anathema to the Maydan movement, and would significantly risk Maydan III. We doubt that President Poroshenko would risk any such strategy - in effect spurning a coalition with Yatseniuk for a deal with Boiko. It is hence inconceivable at this point that such a coalition government, favourable to Moscow, could be formed in Kyiv, without risking further and domestic political instability in Ukraine. Many would indeed view the latter scenario as ultimately providing a another pretext for further Russian intervention/annexation in/of parts of Ukraine.

Suffice to say the political and security risks and challenges facing Ukraine are extreme.

The economy/economic policy environment

Ukraine's macro setting looks increasingly challenging in our view, with risks moving from focus on the extent of the economic collapse caused by the conflict in the Donbas, budget financing pressures, more to concerns over the sustainability of the exchange rate and feed through into extreme pressures now being felt on the banking sector.

The UAH is currently the battle ground, with the currency losing half its value already this year, but continuing to test new lows. From one perspective the depreciation of the UAH has helped rein in the bloated current account deficit, from 9-10% of GDP in 2013, to a few percentage points of GDP this year, and even with the prospect now of running a small surplus. The adjustment has also been helped by the massive deflation of domestic demand as the recession has bit. The problem for the UAH is that the currency is suffering a crisis of confidence reflecting a combination of:

Concerns over the security situation in Donbas, as perhaps quite naturally each time perceived risks grow of an escalation in violence, locals buy FX as an assurance;
Parallel rouble weakness, which creates "contagion" risks while undermining the REER depreciation benefit for the UAH. Perhaps also Ukrainians are mindful that if the CBR has not been able to stop the RUB weakening and they have over USD400bn in FX reserves then what hope the NBU;
Recognition that the NBU has insufficient reserves to defend the UAH, and understanding of the move to a free float;
Prior forced market unfriendly policy actions by the NBU, including restrictions on FX withdrawals from banks, FX surrender requirements for exporters, et al. All this puts a premium on FX, as it creates expectations of further unfriendly administered measures;
Pressure put on Ukraine to clear gas debts to Russia and to meet foreign private sector debt liabilities falling due in full, which both depleted FX reserves. Official IMF financing has in effect just flown out in payments to private creditors and to Russia for disputed gas debts.

The above crisis of confidence in the UAH is reflected in a step up in retail buying of FX, but also much reduced roll-over ratios on the approximate USD45bn of short term external debt falling due. In the original IMF programme the Fund assumed a rollover ratio of around 90%, but banks indicated that this ratio may have now fallen to 70% or below. This could suggest a net FX outflow of USD9bn through this means alone, and explains further downward pressure on the UAH, and continued and sustained selling pressure on the UAH. Anecdotal reports suggests that FX is still in short supply with hoarding activity dominant - exporters delay selling FX under the NBU's compulsory surrender requirement on expectation of further UAH weakness. All this create a a vicious/self fulfilling cycle of UAH weakness.

Unfortunately such large scale FX weakness and scarcity, risks creating bottlenecks throughout the payments system. Debt service on FX borrowings spirals and become unaffordable, boosting NPLs in the banks, and forcing broader non payments problems in the system. The latter could prove disruptive to economic activity, deepening the recession, and offsetting any positive uplift to net exports from the weaker UAH. For the banks higher NPLs erode already weak capital buffers, raises recapitalisation needs, risks bank failure and ultimately put further pressure on the sovereign balance sheet.

Banks we spoke to found it impossible to predict exchange rate trends, with likely binary outcomes suggested for the UAH in a 12 - 25 range. If the IMF et al come through with more financing, and quickly, and the conflict in Donbas eases, the currency could rally back to UAH12:USD1, but equally a failure of either of the above positive events to transpire could see the other end of the range hit, with potentially devastating and long term systemic problems resulting.

Policy reform/focus

Fiscal policy has been reasonably tight in recent months, and officials were reasonably confident that end year targets for the general budget deficit were broadly within reach - i.e. just under 6% of GDP. Revenue performance has surprised to the upside - tax compliance might be improving, while higher inflation than expected might be bolstering the revenue side. Spending restraint might reflect the considerable "fat" in the budget, and scope still for significant cuts.

The big problem still on the fiscal side remains the bloated Naftogas deficit, not helped obviously by the deprecation of the UAH which has totally eroded the benefits for the earlier year IMF inspired hikes in household gas prices. Indeed, household gas prices remain at around 15% of cost recovery levels which is again likely to push the broader deficit out still further. My own back of the envelope calculations assumed 20bcm of gas bought by households at an average price of USD350 per tcm and supplied at 15% of cost recovery would leave a USD6bn shortfall, or around 5% of GDP. This might be a conservative assumption given losses elsewhere from nonpayment, the costs of technical gas, et al. But this would suggest a budget deficit for the year of more like 11-12% of GDP on a consolidated basis, which will again put upward pressure on the ratio of public sector debt/GDP.

The NBU has been subject to much criticism over exchange rate policy and management, but it is difficult to be too critical given the near impossible task the bank has faced given the extreme pressure felt on the UAH, the limited monetary policy tools available (a reflection of years of neglect on the policy reform front in the last), lack of FX reserves, and the broader issues which have been driving UAH weakness as noted above. The IMF appear generally supportive, and the NBU seems to have been getting significant technical policy advice. The NBU seems eager to reduce administrative controls, but clearly the impact therein is uncertain given the acutely difficult backdrop. We did hear some consider criticism of attempts by the NBU pre-election to try and hold the UAH around the UAH12.95 level through use of "persuasive coordination" with local banks. Critics argued that this smacks of the political manipulation of the NBU and exchange rate policy under the former Yanukovych regime and undermined NBU independence and credibility.

More charitably the NBU has now detailed an impressive administrative restructuring plan, with very ambitious targets to cut the bank's headcount from 11,500 at present to 5,000 by 2015 (saving as much as UAH5bn which ultimately will be transferred to the state budget), and just 1,500 by 2017. Gontareva has brought in some well respect senior managers from the private sector to drive the process forward, and despite strong initial opposition the process now seems to be being rolled out. Recent and new hires in the offing are of international standard, and Gontareva appears determined to significantly raise institutional capacity of the NBU which is long overdue.

The NBU is also rolling out an equally ambitious reform plan for the banking sector, tightening supervision and regulation, oversight, reporting, and ultimately forcing rationalisation across the sector. The NBU is enforcing new regulations to establish compulsory reporting of the ultimate beneficial owner of banks, which they hope will help to eradicate issues over connected party lending also help speed the recapitalisation and resolution process in troubled banks. Already the number of banks has reduced significantly - by 26 this year, with more to come.

Note that the NBU does seem to be emerging as a focal point and leader in the structural reform agenda - while progress in other ministries seems to be slow- moving as new ministers struggle against vested interests and the weight of Soviet-era/style red tape and bureaucracy which is a haven for inefficient and corrupt practices, but also suggest huge scope for budget savings in the future.

We heard much criticism that the Yatseniuk administration had actually achieved little in terms of more meaningful structural reform, in reigning in corruption, red tape and bureaucracy and in improving the business environment. They would perhaps argue that they are new in office still, were an interim acting administration with a limited mandate given the move to early elections, while the war in the East diverted focus away from reform. Critics still argue that these are poor excuses and the war in the East just accentuates the need for radical reform, to cut excess government spending, justifies budget austerity to help divert resources to the war effort.

Both the Poroshenko presidency and the Yatseniuk acting government are promising more radical reform once the new administration is formed. Poroshenko has unveiled a reform plan for 2020 (a 60-odd page programme), targeting to have Ukraine prepared for EU membership by this date. Yatseniuk has detailed a much narrower reform plan of a few pages. The two sides are still trying to work the two documents together towards a common coalition agreement.

Relations with the IMF/official creditors  

An IMF technical mission arrived in Kyiv on November 11 and is slated to remain until November 25 to undertake preparatory work on the latest (2nd) review under the USD17bn IMF SBA. The decision to undertake a technical review, rather than a formal review mission reflected uncertainty over the outcome of parliamentary elections and whether a new government would be in place and would be able to discuss its new policy programme with the IMF. The assumption was that a second mission would be dispatched to Kyiv prior to year end, assuming that a new government was formed speedily in November, and then able to negotiate the completion of the latest review. As is, and with no government yet approved, it seems unlikely that a return IMF mission can be scheduled in time to allow completion of the review, and in time for the last IMF board meeting in December. It now seems more likely that the IMF board will only meet to agree the completion of the latest review and any credit augmentation or dispersal, later in January, and presumably after the Orthodox Christmas break, i.e. in mid-late January. Note that this is also contingent on agreement over completion of the review and possible prior actions, including passage of the budget for 2015. The latter document, by law, should have been tabled before parliament in Mid-September, but is yet to be forthcoming.

Our sense is that the IMF is understanding that the original IMF programme is now in need of extensive review, revision, and augmentation. Recent extreme selling pressure on the exchange rate, and reserve depletion, suggests that large external financing gaps have appeared which were not envisaged in the original programme. Quantifying these is difficult, especially given that the security situation is almost impossible to call. NBU governor Gontareva has noted that only USD4.6bn of the original USD17bn SBA credits have been disbursed, suggesting that USD14bn is still available for disbursement. The problem is that the original SBA was front loaded in terms of conditionality and backloaded in terms of disbursements. One potential solution would be to re-profile disbursements, bringing more forward - the second review under the SBA, in any event, combined the 3rd and 4th reviews, with the next disbursement slated to total USD2.6bn. This is now likely too small to "touch the sides" and especially if it is only forthcoming in late January by which time NBU reserves may have fallen to less than USD10bn, I.e. just over one month of import cover. The real problem now is that while the UAH might appear cheap from a trade/current account perspective, it is currently suffering from a broader crisis of confidence. Just bringing disbursements forward may not be enough, and the market might well need a bigger ticket confidence booster in terms of the re-sizing of the overall programme. Government officials indicated that they thought that another USD10-15bn in IFI credits was likely now needed, and we would tend to concur, and especially now given the holes appearing in the capital account and with likely substantial needs now in terms of bank recapitalisation. Overall we think that an enhanced IMF programme of USD30bn or so should be able to instil some confidence. Critics may well respond though that this may still not help when weak confidence is driven partially also by uncertainties in terms of the security situation which is hardly likely to disappear, even with a revamped financially augmented programme. That said without further Western financial support, financial and economic collapse - raising systemic issues - will be likely, which is hardly likely to make the security situation easier, arguably it could accentuate security risks by depleting focus and resources on national defence.

IMF shareholders are likely still mindful of past failed IMF programmes for Ukraine, and a poor track record of compliance prior to the current programme. Ownership of the current programme by Ukraine's political and policy elite does, however, appear much stronger this time around while the population appear much more willing to bite the reform bullet in the interests of guaranteeing Ukrainian statehood. Arguably it is now a case of now or never in terms of prospects for a Ukrainian government to deliver on a meaningful and indeed potentially transformational reform agenda. It is, however still unclear in my mind whether key IMF shareholders get this. Also note that another potential issue is now appearing in the form of rising public sector indebtedness, and the growing weight of official (multilateral and bilateral) lending in the total - after the prospect of USD30bn in IMF disbursements, and with the ratio of public sector debt/GDP also at risk now of hitting 70% at the end of 2014, and perhaps over 80% in 2015. This appears unsustainably high in the Ukrainian context and might weigh on shareholders' willingness to commit larger financial sums to Ukraine - it could well spur another debate about PSI, or burden sharing domestically in Ukraine to its own oligarchic elites.

Beyond the IMF, the Ukrainian government has requested a further EUR2bn in loans from the EU, on top of an existing USD1.6bn facility - of which USD860m has already been disbursed. This EU money has not yet been agreed upon, but would require approval of the 2015 budget, sign off from the IMF on the latest review under the SBA, and likely also agreement from the European Parliament. The latter could take some considerable time, and might not be forthcoming until mid-2015.

Similarly debate continues over the US extending Ukraine another loan guarantee, in addition to the USD1bn issued earlier this year. There has been discussion of perhaps increasing the size of such issuance, perhaps to several billion dollars in several tranches. A looming constraint though now is the underlying cost of risk insurance paid for by the US government as part of this facility for Ukraine, which is becoming precipitously high, and might well raise concerns in Congress - it may also suggest that it might make more sense to simply extend the support facility as grant aid, albeit this would then eat into grant aid budgets elsewhere.

There is also discussion on-going of a Ukrainian donor's conference in 2015 - perhaps in February, and this could serve as a focal point for EU, US and indeed IMF financing augmentation initiatives. The danger there is that this puts off talk of more immediate efforts to "upsize" financial support to Ukraine when the deteriorating situation on the ground would suggest that much more urgency is needed. We would still argue that the longer the West leaves it in terms of deciding on committing further loans to Ukraine, the greater the risk of further UAH weakness and damage to the banking sector and broader economy which will have much longer term impact. Ultimately delaying upsizing existing support could ultimately increase the longer term cost to the West of supporting the West.