Leaving the Worst Behind

5 February 2016, 11:00

2015 was one of the hardest years for Ukraine's economy since its independence. The country found itself at the crossroads of a number of negative trends, both global and local, both old and new. As a result, we faced a whole range of problems at the national scale, the very emergence of which gave rise to the sense of fear and insecurity in the country.

Considerable capital flight, drop in global commodity prices and the loss of a large share of export capacity in Donbas led to a dramatic deterioration of the balance of payments, entailing the collapse of the hryvnia. Strict fiscal consolidation under the auspices of the IMF loan program combined with the slow progress of financial decentralization resulted in the accumulation of significant funds in the government accounts and shrinking aggregate demand, largely contributing to GDP reduction. The process of slowly but surely purging the banking system of insolvent financial institutions that continued throughout the year kept both depositors and borrowers in suspense, resulting in the lack of credit activities and determining the adverse impact of the financial system on the country's economy.

However, as of the beginning of 2016, most of these problems have been left behind. Ukrainians have become noticeably poorer. We have lost a part of the economy. But macroeconomic stability has been achieved, and it seems quite sustainable as of today. This means that we can look confidently to the future (assuming that there will be no escalation of hostilities) and get to analyzing the trends and challenges that the Ukrainian economy is to face in the coming year.

Foreign trends

Most problems and foul winds in 2016 are expected to come from abroad. They will be countered with just a few positive developments. Therefore, the negative pressure on the BoP and the hryvnia will continue.

One of the major global trends that will have an overwhelming impact on Ukraine is the further drop in commodity prices. According to NBU estimates, commodity products account for about 80% of Ukraine's exports and for 40% of its imports. The good news is that the prices for different commodities are falling along different curves. For example, in the first half of January, crude oil traded in the range of USD 30-32 per barrel, which is more than 40% cheaper than a year ago. Investment banks race to lower their price forecasts, and the expectations quoted today are USD 20 or even USD 10 a barrel. Since the oil market hasn't yet reached the bottom, Ukraine will benefit for a few quarters from cheap energy. We will be buying natural gas for less than USD 200 per 1,000 m³ (and the price might drop further), and will also be able to import inexpensive coal. By contrast, the drop in grain prices has not been so dramatic. Some products even reached the bottom last year, with their prices going down to multiyear lows. For example, in the year to mid-January 2016, global corn price in the Gulf of Mexico fell by 13%, and wheat price by 18% in total. Therefore, Ukraine's balance of payments related to commodity trade will be more or less balanced, and the falling commodity prices will not result in a significant shortage of foreign currency in the country.

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Another important trend is trade with regional countries. On January 1, 2016, the FTA agreement between Ukraine and the EU came into effect. Import duties on European goods supplied to the Ukrainian market will be decreased differently and gradually, but some growth in imports can be expected from the very beginning of 2016. Besides, the Parliament has abolished the import surcharge of 5-10%, effective January 1, which should also reduce the cost of imports and contribute to their inflow. This will exert some pressure on the trade balance and the hryvnia towards its devaluation. We can only hope that last year Ukrainian producers did not waste their time and made all the steps necessary to prepare their products to enter the European market in 2016. Time will tell whether these expectations were justified and whether the increased Ukrainian exports to the EU would compensate for the increased flow of commodities into the country. At least, the prospects for entering the European market this year are good: Bloomberg expects the euro zone economy to grow by 1.7%, the same figure is provided by the consensus forecast of British weekly The Economist, integrating the estimates of 23 leading global banks and financial companies. If the European economy is to grow at a solid pace, there will definitely be a niche for Ukrainian producers on the EU market.

This is not quite the case with the Russian market. Since the Kremlin withdrew from the free trade area with Ukraine, further reduction in commodity exchange between the two economies can be expected. According to the State Statistics Service, in 10 months of 2015, Ukrainian exports to Russia amounted to over USD 4 billion, which means that annual exports to Russia totaled about USD 5 billion. Is this a lot? For comparison, in 10 months of 2015, total exports from Ukraine to all countries dropped by USD 14.6 billion. This was due to different reasons, ranging from the destruction of Ukrainian production facilities and logistic sectors to various administrative and bureaucratic barriers to our goods in key target markets, including exchange rates fluctuations in many countries. Compared to these losses incurred last year, the decline in Russian exports does not seem critical and may well be offset by the efforts made in other markets.

The main negative trend that is likely to continue into 2016 will be the repayment of foreign debt by Ukrainian private sector. In 10 months, Ukrainian companies paid USD 4.9 billion net (redemption minus raising new debt) of private foreign debt, which is 39% more than in the same period of 2014, and banks repaid another USD 2.6 billion of foreign debts (three times more than in the same period of 2014). Today the trend still continues, so this year it will also negatively affect the balance of payments. This will be compensated to some extent by the fact that the Ukrainian government, thanks to the debt restructuring deal agreed in 2015, will not have to spend billions of dollars to repay foreign debt (see Debt Relief). On the one hand, this will help to accumulate the funds that Ukraine is likely to receive from the IMF on the NBU foreign exchange reserves. On the other hand, this will create a precondition to decrease borrowing on the domestic financial market, which will ultimately make available some resources in the banking sector that financial institutions will use for lending to the real economy, rather than for purchasing government bonds. Foreign direct investment could become another positive factor for the financial account of the balance of payments. Investment attracted in 10 months of 2015 brought to the country USD 2.2 billion net. It is a modest figure, but this year, subject to favorable conditions and good pace of reform, it may double.

On the whole, the new year promises to be not very favorable in terms of Ukraine's relations with the external sector as reflected in the balance of payments. Scarce currency proceeds are likely to be combined with the NBU policy of gradually eliminating foreign exchange restrictions. If the Central Bank goes ahead with exchange rate flexibility, this will lead to the gradual and not dramatic devaluation of the hryvnia. However, the significant devaluation of the national currency is not to be expected, as there are no serious grounds for it today. However, the loss by the hryvnia of 10-15% of its value as a result of the sum vector of all positive and negative factors seems quite realistic (greater fluctuations are possible during the year, but the rate is bound to return to more stable and moderate values). The important thing is that flexible exchange rate will help create a dynamic balance in the currency market, allowing economic agents to gradually start growing instead of surviving.

Public sector

Last year, the public sector was a factor of economic decline rather than growth. Severe austerity (combined with poorly administered financial decentralization) that Ukraine had to introduce as part of the IMF's Extended Fund Facility has brought a positive result: macroeconomic stabilization. However, it also had a major negative side effect: in the first six months, there was a double-digit drop in GDP.

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In 2016, the public sector will not become a force for progress in the Ukrainian economy either, because the approved budget in its essence is the same document that we have had for many years and that we would prefer to gradually get rid of. However, there will be some changes bringing hope to the new year.

The main positive change in the public sector lies on the surface: it is the large amount of money in the government accounts. As of the early December 2015, the government had accumulated almost UAH 48 billion on the single treasury account (STA). A month later, in early January 2016, only a little over UAH 9 billion were left out of this sum. This means that almost UAH 40 billion were poured into the economy. It is not so important whether they were paid to state employees or used to redeem government bonds held by banks and financial companies. The main thing is that the system received an additional resource, which will help significantly revive the business activity in the first six months of 2016. The effect will be the opposite of what happened a year earlier. Therefore, given the low comparative base and further liquidity injections into the economy, it would not be surprising if in the first quarters of this year the economy shows growth of 3-5%, significantly exceeding skeptical expectations.

Besides the funds in the STA, the government also had over UAH 47 billion in NBU accounts (probably in foreign currency) as of the early December 2015. This money was accumulated in preparation for the foreign debt repayment. However, following the debt restructuring and the refusal to repay Russian Eurobonds, this resource has become available. Therefore, it may well be expected that in 2016 it will be used if not for additional budget expenditures, then at least for advanced repayment of domestic debt or, say, for VAT refunds. It should also be noted that local governments are beginning to benefit from the decentralization, including the possibility of opening their own accounts with commercial banks. As of the early December 2015, such accounts held UAH 10.7 billion (three times more than at the beginning of the year), which may well be put into circulation in 2016 , stimulating the aggregate demand in the country.

The tax reform that was never adopted has become the big disappointment of the last year. The government contented with cosmetic innovations to the tax system, which, like the changes made in 2014 to the 2015 budget, will have no positive impact on the economy. This makes the tax reform and its adoption this year even more important. The country needs a fiscal system reform that would be simple, radical, and friendly to Ukrainians. If it succeeds, its positive effects will be difficult to overestimate. Relevant and adequate taxation system could not only radically improve the investment climate in the country and launch the process of economic development for years to come, but would also raise the meager ratings of the current government and the Prime Minister. A good tax reform could extend the life of the current coalition, while the bad one would trigger the destructive processes in the Ukrainian politics. Of course, it is most likely that the country will see the immediate results of introducing any taxation changes only the next year. However, positive transformations could influence the expectations of the counteragents, making some macroeconomic indicators show positive dynamics already in 2016.

The new year gives two more good hopes to the country. Firstly, electronic public procurement system should start operating at full capacity. It should not be underestimated. It is not only about saving up to UAH50 billion of budget funds annually thanks to this innovation. In an effective country, every link in the chain has to be effective. In this area, the state has traditionally trailed behind, but the electronic procurement is a tool that could trigger a radical change in the situation. At least, there is a hope. Secondly, great hopes should be laid on privatization. The large privatization that was promised by both Yatsenyuk's governments did not happen either in 2014 or in 2015. The reason is obvious: the oligarchic-parasitic lobby. If this year it is overcome, and the privatization process is launched, the country will not only receive additional financial investment (probably from abroad), but also get rid of the many parasites hindering its development. Let's be hopeful for that as well.

In summary, the public sector in 2016 should return to the economy everything it took from it in 2015. This will not be enough to make a breakthrough, but is sufficient to stimulate economic growth at a slightly higher rate than expected.

Financial sector

Last year, the banking sector went negative by almost all indicators: number of banks, loans and deposits, revenues, impact on the economy, etc. By the year end, the decrease in credit and deposit bases practically stopped (see Gaping abyss), giving hope that 2016 will reverse the trend, and the financial institution will start attracting deposits and providing loans. For this to become a reality, the NBU should complete the purging of the banking system, sending a clear message not only to the professional community, but also to the civil society. Currently, the Central Bank continues to remove financial institutions from the market, rarely but regularly, keeping tense both market players and potential investors. Bankers know better than anyone else that money likes stability, and this is exactly what all parties involved in the financial sector currently lack. If there is no stability, there will be no deposits and no lending. In this situation, the financial sector could remain a burden for the economy rather than a growth factor in the new year as well. Unfortunately, the National Bank, despite all its progressive activities, has so far failed to achieve the final result: the resumption of lending.

So, most of the negative factors that shaped the economy last year will no longer exist in 2016. New year gives hope. Ukrainian economy is starting on the path of growth, balanced by moderate hryvnia devaluation, encouraged by the money saved by the government and potential resumption of lending. In this framework, the GDP could well grow by 3-4% annually. And even though the rate of this growth will not yet be satisfactory, it could still beat the skeptics and lay the foundation for a powerful leap forward as soon as the critical mass of reforms is accumulated.

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