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2 February, 2012  ▪  Ildar Gazizulin

Under the Macroscope

Even successful industries in Ukraine will have to tighten their belts in two years unless the government revises its economic policy in 2012

Ukraine will face a slew of unpleasant surprises in 2012, due to its excessively open economy and the lack of diversity in its industry. The processes will occur against the backdrop of a global recession, but with a certain national hue. It is doubtful that output will plummet again, the way it did in August 2008, but the economic growth rate will slow down in 2012. In Q4’11, oil, steel, grain and other agricultural product prices already began to fall on commodities markets. The decline in export revenue will have an adverse impact on the hryvnia rate and domestic consumption. But overall, economic growth factors willnot differ significantly from those of the past two years. In 2012, Ukraine will not see the record-breaking harvest it had in 2011, since farmers say they will have to replant over 50% of winter grains as a result of the bad weather last year. Euro 2012 will be an economic benefit, but there is little likelihood that it will significantly improve the difficult situation in the construction and other sectors.

GDP: NOMINAL GROWTH
In 2012, consumption and the gross accumulation of fixed capital will grow by 5% and 6% respectively. Export and import growth will slow down to 3.8% and 6% respectively against the backdrop of the global recession. As a result of the export deflator exceeding the import deflator, the difference in nominal turnover growth rates will be lower. In 2012, the industrial output growth rate will be at a level of 7%. Demand for raw materials will grow much slower compared to the pre-crisis period, resulting in relatively stable global prices for resources. As in 2011, steelworks and mechanical engineering will remain the biggest contributors to 2012 growth.

There is the risk that the ever- worsening situation on international markets than expected, will lead to a significantly slower economic growth rate than indicated in Ukraine. For one thing, this will be a result of the lack of diversity in Ukraine’s industry. It essentially centers around three to four key branches. This state of affairs has remained the same since 2000 when Ukraine’s economy began to recover after its collapse in the 1990s. Secondly, Ukraine’s economic vulnerability to external shocks can be explained by its excessive openness. Assuming that the global economy will be balanced in the long-term, the expected share of Ukraine’s foreign trade will account for about 1/3 of the exports: GDP ratio. Over 2005-2010, this index was at a level of 48% which was significantly higher than the balanced indicator. Thus, demand for Ukrainian exports could plummet during the recession in 2012.

On the one hand, the situation in Ukraine is not yet critical, since its export covers a relatively vast geography. Ukraine’s foreign trade is evenly distributed between the CIS, EU and other markets, including those in Asian and African countries. By contrast, there are some countries in the world that rely on just one market, such as Poland, the production of which is oriented towards old Europe. On the other hand, though, Ukrainian products are apparently not competitive enough. Its export-oriented industries are energy consuming; increasing energy prices hit producers hard, leading to negative consequences.


INVESTMENT EXPECTATIONS: PESSIMISTIC

No matter how the US, EU, China, Russia and other countries respond to the continuing crisis, the next wave will surely not come as a surprise to investors. A lot has been said about the further escalation of the crisis in late 2011, particularly on the level of international financial institutions. Business owners had the opportunity to adjust their production and investment plans. The steep downturn in Ukraine in the autumn of 2008 was largely caused by an unexpected factor: most export contracts were short-term and terminating them was no problem. As a result, the Ukrainian economy plunged steeper and deeper in comparison to other countries.

In recent years, direct foreign investments have been bypassing Ukraine, maintaining a level of nearly USD 5bn which is half of the pre-crisis rate. In 2011, though, there was a sudden jump in capital investment, following two years of decline. However, it’s doubtful whether this trend will continue, in view of the likely decline of corporate income and more restricted access to loans in 2012. A 6% increase in the gross accumulation of investment capital will be due to the private sector while public investment will shrink.

PRICE EXPECTATIONS: AGFLATION

The increase in food prices is the key inflation factor. In this context, Ukraine can expect at least two additional obstacles, including a worse harvest compared to 2011 and the focus of exporters of agricultural products on excessive profits, coupled with increasing food prices on foreign markets after the fall in 2011prices.

The situation in the industrial sector is predictable. Debt problems in the Eurozone and losses in the global banking system lead to decreased lending, which in turn restricts investment activity, growth in the construction industry and global demand for steel. Under these circumstances, it is worth realizing that Ukraine’s balance of payments deficit will increase, as will its trade deficit. Foreign investment in Ukraine will shrink considerably compared to 2009 while corporate players and the government will have a harder time finding lenders and restructuring short-term foreign liabilities. All prerequisites for the devaluation of the hryvnia are apparent.

NATIONAL CURRENCY: DEVALUATION

In 2011, the NBU managed to maintain the hryvnia rate through the sterilization of liquidity, particularly via tough administrative leverages, first and foremost, the regulation of retail currency exchange transactions. Will these measures be sufficient for 2012?

According to ICPS estimates, the hryvnia will devalue against the US dollar. This trend will result from the earlier reinforcement of the real rate and the reduction in gold and currency reserves in 2012-2013. In the best-case scenario, the average annual hryvnia rate will be UAH 8.3:USD 1, falling to UAH 8.6:USD 1 by the end of the year. On the one hand, the devaluation could help the industry reduce costs. On the other hand, to a certain extent, it would make imported goods less attractive, which would improve Ukraine’s balance of payments. But in actual fact, the problem is the growing demand for imported goods, including gas and other energy resources that accompanies the increasing export income in Ukraine rather than the fact that hryvnia exchange rate is not at its best. Even if export markets provide a favorable background, the balance of payments will still deteriorate. Ukraine does not produce many products, which means that it is forced to spend a significant share of its national income on imports. This is a vicious circle and it’s doubtful whether it can be broken in 2012. So far, the innovations in the economy have not been productive. As a result, the balance of payments is mostly kept up with foreign loans, which is a way to nowhere. If this sort of management continues for another couple of years, even relatively successful industries will have to tighten their belts.

JUST POSSIBLE

Fiscal pressure on the real sector will increase in Ukraine, reinforced by the global recession.  The Cabinet of Ministers is counting on collecting UAH 480mn more from individual income tax, UAH 5.44bn more from corporate tax and UAH 18.57bn more from VAT in 2012 compared to the plan for 2011. The decriminalization of economic crimes allows regulators new loopholes to fill the budget with fines.

The national debt will hit a record level of UAH 415.3bn by December 31, 2012, compared to UAH 375.6bn at the end of 2011.

According to the NBU, Ukraine will have to repay USD 53.5bn of short- and long-term loans to non-residents by July 1, 2012. This includes both national and corporate debt. According to the Finance Ministry, the government is going to repay UAH 47.8bn and UAH 55.2bn of national debt in 2012 and 2013 respectively.

State-owned corporations will also live beyond their means. The government is going to issue government bonds to purchase the additionally issued shares of NJSC Naftogaz of Ukraine.  

Ukraine’s trade deficit will continue to grow. Under these conditions, the government will look for currency injections from either Russia (one option – RUR loans to pay for imported gas) or the IMF which may not continue its cooperation with Ukraine due, first and foremost, to economic factors. It is doubtful whether official Kyiv will agree to the IMF’s requirement to increase gas price for the public prior to the upcoming election.   

The hryvnia will devalue against the US dollar. In late 2011, the NBU did everything possible to prevent the devaluation of the hryvnia to UAH 11:USD 1. Many companies have noted this exchange rate in their budgets for 2012.

The inflation of the hryvnia will exceed official and even expert projections. According to a survey of entrepreneurs by the NBU, the real sector expects a 14% increase in prices in 2012.

Ukraine will actively sell off state-owned property. The government is expecting budget revenues of UAH 10bn from privatization. However, either this amount is significantly understated, or the companies will be sold through tenders at knock-down prices with previously-determined winners. The government’s four-year Draft Privatization Program provides for income from the sale and management of state-owned property in the amount of UAH 50-70bn, with a reduction of the state-owned share in the economy from 37% in 2010 to 25% in 2014.

Entities awaiting privatization include the Odesa Port Plant, as yet unsold state-owned stakes in oblast energy supply companies, gas distribution networks, distilleries and aircraft factories, Artem - a state joint- stock holding producing guided missiles and coal plants. New privatization schemes might emerge, such as the fragmentation of share packages that can subsequently be sold on stock exchanges. Companies owned by Dmytro Firtash and Rinat Akhmetov are key candidates for the purchase of state-owned property.

The real sector and private individuals will have less access to loans, since foreign banks will withdraw from many business areas in Ukraine and risks will be hard to evaluate under global economic uncertainty. Over the past six months, several big foreign capital entities have folded their retail business in Ukraine, a trend that is likely to intensify in 2012. 67.6% of entrepreneurs surveyed by the NBU at the end of 2011 said that interest rates on loans were too high.
 
Banks will increase interest rates on deposits to deal with the liquidity crisis. This process began in late 2011. Some financial institutions offer 25%-28% on short-term hryvnia deposits. By comparison, the pre-crisis 2008 interest rates peaked at nearly 20%. Some banks may go bankrupt.

Relative socio-economic stability will last until the conclusion of Euro 2012. Customs borders are likely to be opened for importers of the goods required for the championship. This could result in uncontrolled goods turnover.

Ukrainian financial and industrial groups will continue to monopolize markets, particularly those for raw materials. The law on the decriminalization of economic crimes could lead to a new wave of raider attacks on businesses and the grabbing of state-owned property.

The portion of those in power who are involved in highly-profitable business will increase. The owners of well-known trademarks could close down in Ukraine as a result of demands to sell them at knock-down prices. In late 2011, information emerged of the closure of GSC Game World, the developer of the “Cossacks” and “S.T.A.L.K.E.R” computer games, while Nemiroff’s majority shareholders have re-registered their company in the US, to avoid problems in Ukraine.


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