Swedbank Baltic Sea Analysis No.

27 y 18 November 2010

Ukraine
The economy is stabilising, but the recovery is
threatened by inflation and political concerns
• The economic slowdown brought on by the international
financial crisis appears to have bottomed out, and Ukraine’s
growth has accelerated in 2010. We are revising our forecast
for 2010 upward to 4.0% and predict continued but, compared
with our previous projection, moderate growth of 4.3% in 2011.
Significantly higher growth is needed to regain what was lost
during the crisis.
• The biggest risks in the short term are higher inflation and
continued expansive fiscal policies. Price increases have
reached over 10% and concerns are spreading to the
exchange rate market, where the central bank has been forced
to step in and buy hryvnia. The government will find it tough to
tighten fiscal policy to prevent increases in food and energy
prices from spreading through the economy, which would
doubly hurt households.
• In the medium term the pace of reform must be intensified to
raise productivity and growth. This will require extensive
reforms, not least the liberalisation of key markets such as
energy. The government is likely to face strong resistance from
entrenched interest groups. In addition, it has to create enough
budget flexibility to increase public infrastructure investment
without letting the deficit grow.

Since the election in February, President Viktor Yanukovych has Presidential power
consolidated his power. An amendment to the constitution gives has increased since
him more opportunity to control parliament, at the same time that the election
the opposition has splintered and faces accusations of corruption
during its time in power. In terms of foreign policy, the new

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740
e-mail: ek.sekr@swedbank.com Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720.
Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897
leadership is balancing Russia's need for influence in the region
with the importance of maintaining good relations, especially
economic, with major Western economies.

Economic developments in 2010 have been favourable for Global demand and
Ukraine. High growth in countries like Germany and China has increased interest from
created demand for Ukrainian input goods, especially in the capital markets have
metals industry. Increasing liquidity in international financial been positive for
markets has at the same time led to a return of capital inflows. In Ukraine
September Ukraine successfully placed a government-
guaranteed Eurobond for infrastructure investments at a lower
interest rate than for example Greece. Clear indications from the
IMF that Ukraine met its lending conditions for September sent
further positive signals to the market.

A rebound in growth, but from low levels

During the first half of 2010 Ukraine’s economy again began to Ukraine is growing
grow. The growth rate was nearly 5% during the first three again
quarters, compared with the same period in 2009, although this
was from exceptionally low levels. As a whole, GDP fell by
slightly over 19% between the third quarter of 2008 and the end
of 2009 and by mid-2010 had only returned to the level it had
reached four years earlier.

Real GDP level and growth, QI 2006 – QIII 2010

130 15
125 10
120 5
115 0
110 -5
105 -10
100 -15
95 -20
90 -25

GDP level (2005=100)

GDP growth (annual in %; right hand scale)
Source: State Statistics Committee of Ukraine.

Growth impulses are mainly coming from external demand. Industrial production is
Demand for input goods, which benefits Ukraine’s traditional benefiting from global
industry structure, is growing in Germany and Asia’s emerging demand
economies. This is reflected in rising prices and growing
production. Steel production has bounced back strongly after a
steep decline in late 2008 and early 2009, and the industrial
sector as a whole has grown by nearly 15% in 2010. There is still
far to go before returning to the production levels before the
crisis, which indicates that there is probably considerable
unutilised capacity in Ukrainian industry. At the same time,
however, there is a risk that the country’s production structure
has become outdated and that many companies have dropped

2 Swedbank Baltic Sea Analysis No. 27 • 18 November 2010

out of the market during the financial crisis. It could be difficult
therefore to quickly adapt production levels to growing demand.

Development in the steel sector, Jan 2006 – Sep 2010

4500 250
4000 200
3500
150
3000
2500 100
2000 50
1500
0
1000
500 -50
0 -100

Steel production (volume)

Steel production (annual growth in %; right hand scale)
Steel prices, 2005=100; right hand scale)
Source: Ecowin.

Domestic demand has also rebounded in 2010, but to a Falling real

somewhat more limited extent. Wage earners have been hit hard wages are hurting
by falling real wages, and unemployment rose from around 6% to Ukrainians more
9.5% of the labour force. The number of registered unemployed than unemployment
was around 400 000 in September, compared with 540 000 in the
same period of 2009. Lower inflation has led to rising real wages
and has stabilised consumer confidence. After a major downturn
in 2009, consumer spending again began to rise in mid-2010,
which is also reflected in growing retail activity.

Domestic demand and unemployment, Q1 2007 – Q3 2010

25
20
15
10
5
0
-5
-10
-15
-20

Real consumption (annual change in %)

Real wages (annual change in %)
Unemployment rate (% of labour f orce)
Source: Ecowin.

The political landscape continues to be dominated by conflict. Political hostility

President Viktor Yanukovych’s party gained ground in local cemented
elections in late October, while the biggest opposition party, led
by Yulia Tymoshenko, lost support. Accusations of election fraud
were widespread. The European Union and the US have officially
issued protests, but thus far there have been no serious local
protests.

Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 3

International relations have also showed signs of improving. New IMF programme
Ukraine and the IMF reached a new loan agreement in the requires more austerity
summer of 2010 after the previous programme went off-track and liberalisation
during the presidential election campaign in 2009. The new loan
of around USD15bn will be paid out in quarterly instalments
through 2012. However, Ukraine must meet the following
conditions:

• Reduce the budget deficit to 2.5% by 2012. The aim is to

eventually shrink government debt and boost confidence in
Ukrainian fiscal policy. In 2009 the budget deficit was about
8.5% of GDP, and austerity measures are being introduced,
mainly through spending cuts representing about 4% of GDP.

• Continued reforms in the gas sector. Monopolisation and

administrative price setting have created inefficiencies and
considerable losses for the public sector. Reforms and
liberalisation will lead to major price increases at the
consumer level, and price subsidies for other sectors will be
reduced as well.

• Stabilise the financial sector by recapitalising the banks and

strengthening oversight.

• Shift the emphasis of monetary policy to price stability, which

would create more exchange rate flexibility.

Large parts of the IMF programme will be a hard sell politically. Implementation of the
Fiscal austerity will hurt Ukrainians through lower social spending IMF programme is
and higher taxes. Gas prices at the consumer level will rise, and politically controversial
exchange rate flexibility creates uncertainty. A recent review
indicated that the programme is progressing as planned.
Authorities are worried about the political risks of a more volatile
exchange rate, however. Many households and companies still
have a large share of their loans denominated in dollars, and a
market-based exchange rate increases risks for many stake
holders in the economy.

Considerable macroeconomic imbalances

Notwithstanding the relatively positive economic development in Significant challenges
2010, considerable economic challenges remain for Ukraine. In remain before
the short term rising inflation and exchange rate concerns are the economic stability
biggest threats to continued growth. The financial sector is can be achieved
shackled as well by doubtful receivables and volatile financing.
The global economy, which is likely to slow next year, could pose
another challenge to Ukraine’s economic policies.

Although the annual inflation rate fell to 10.1% in October, price Inflation could
stability is threatened by expansive fiscal policies and substantial accelerate
increases in food and energy prices. Gas prices at the consumer
level rose by 50% in August, with another 50% increase planned
early next year. At the same time local food prices are affected
by global markets, despite the introduction of export restrictions
after the wild fires in Russia last summer.

4 Swedbank Baltic Sea Analysis No. 27 • 18 November 2010

Inflation and exchange rates, Jan 2005 – Oct 2010
14.0 35

12.0 30

10.0 25

8.0 20

6.0 15

4.0 10

2.0 5

0.0 0

EUR/UAH USD/UAH Inflation (annual change in %; right hand scale)

Source: Ecowin.

Growing price uncertainty has also weakened confidence in the An appreciation of the
hryvnia. Many households and businesses have decided to real exchange rate and
reduce their exposure to the local currency, and Ukraine's central falling competitiveness
bank has been forced to increase purchases of the hryvnia to are long-term threats
keep the exchange rate stable against the dollar. The IMF’s
demand to increase exchange rate flexibility probably also plays
a role. Growing capital inflows, including from the IMF, are
strengthening the ability of the central bank to defend the
exchange rate in the short term. At the same time higher inflation
pressures could erode Ukraine’s competitiveness and lead to a
weakening of the hryvnia over time.

The financial sector remains under pressure and lending A long way to go
continues to shrink. Due to uncertainty about the solvency of before the financial
many borrowers, many banks are limiting their lending volumes, sector normalizes
which have contracted since late 2009. Even though the share of
loans denominated in foreign currency has shrunk from 60% at
its peak to 47% in September of this year, this is still a
considerable risk for banks, especially considering uncertainty
about the exchange rate. A recently conducted survey of the 60
largest banks indicates that they need around 40 billion hryvnia in
additional capital, nearly half by state-owned financial institutions.
It is unlikely that the private sector will show a substantial pick up
before the banking sector is reformed and consolidated.

Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 5

Credit expansion, Jan 2006 – Sep 2010
80.0 1000
70.0 900
60.0 800
50.0 700
600
40.0
500
30.0
400
20.0 300
10.0 200
0.0 100
-10.0 0

Credit (annual change in %) Credit volume (UAH bn.; right hand scale)

Source: Ecowin.

Despite a further reduction of the current account deficit, Ukraine Ukraine is highly
is still vulnerable to external market forces. In terms of energy, it dependent on the
is dependent on gas imports from Russia, and exports are rest of the world
concentrated in a few sectors. During the financial crisis
commodity and input good producers faced falling demand, while
the agricultural and food sectors managed better. At the same
time foreign debt has increased substantially, from around 55%
of GDP in 2008 to nearly 90% at the end of 2009. The Ukrainian
economy is, thus, becoming increasingly dependent on capital
market fluctuations and sentiment.

Export composition
(USD billions)
80000
70000
60000
50000
40000
30000
20000
10000
0
2007 2008 2009
Base metals Mineral, paper and chemical products
Machinery Agriculture and food
Textiles and clothes Other

Source: State Statistics Committee of Ukraine.

Consistent growth requires discipline and

reforms
We are revising our growth forecast for 2010 upward from 3.5% Our forecast indicates
to 4.0%, but at the same time lowering our forecast for 2011 to slightly lower growth
4.3% (vs. 4.5% in our August forecast). The Ukrainian industrial and higher inflation in
sector is the biggest short-term beneficiary of stronger market coming years
demand, especially for metals. As the impact of inventory
spending and the fiscal stimulus wanes in 2011, external demand
will decrease. We are also forecasting that inflation will reach

6 Swedbank Baltic Sea Analysis No. 27 • 18 November 2010

 11% in 2010, in no small part due to administrative price
increases in the gas sector, which are likely to affect the overall
price level as well. The exchange rate is expected to remain
stable, even if the hryvnia depreciates slightly against the dollar
at the end of the period as a result of higher inflation and more
flexible exchange rate policies. The budget deficit is shrinking,
but probably not enough to meet the IMF’s demands. This could
delay loan payments, which would create additional concerns
and more volatility for Ukraine’s economy.

Ukraine: Key economic indicator projections

2007 2008 2009 2010 2011 2012
proj. proj. proj.

Real GDP growth (%)
Inflation (%, ave)
Inflation (%, eop)
Unemployment rate (% of labour force)
Current account (% of GDP)
Fiscal deficit (% of GDP) *
Government debt (% of GDP)
USD/UAH (eop)
8.1 2.8 -15.2 4.0 4.3 4.8
12.8 25.3 16.0 11.7 10.0 8.5
16.6 22.3 12.3 11.0 9.0 8.0
6.4 6.4 8.8 8.0 7.5 7.0
-3.7 -7.1 -1.5 -1.0 -2.0 -3.0
-2.0 -3.2 -6.2 -5.7 -4.0 -3.0
12.3 19.9 34.6 40.0 42.0 43.0
5.1 7.8 7.9 8.0 8.2 8.5

* Excludes Naftogaz Ukraine

Sources: Authorities, IMF and Swedbank's projections.

Consistent growth in the medium term will require not only short- A more aggressive
term economic stabilisation, but also that the reform process is reform process will
sped up and extended. A fiscal consolidation which leaves room be critical to growth
for investments in public infrastructure could lead to renewed potential
confidence in Ukraine’s growth potential among both private
domestic investors and international players. At the same time
Ukrainian policies have to become more predictable and the
arbitrariness has to be reduced. Corruption and bureaucratic
inefficiencies are major obstacles to private sector development.
Stronger oversight, together with deregulation, would also lead to
greater competition and a needed increase in economic growth.

Magnus Alvesson

Economic Research
Department
SE-105 34 Stockholm Swedbank Baltic Sea Analysis is published as a service to our customers.
Telephone +46-08-5859 1000 We believe that we have used reliable sources and methods in the
ek.sekr@swedbank.se
www.swedbank.se
preparation of the analyses reported in this publication. However, we cannot
guarantee the accuracy or completeness of the report and cannot be held
Legally responsible publishers responsible for any error or omission in the underlying material or its use.
Cecilia Hermansson,
Readers are encouraged to base any (investment) decisions on other
+46-8-5859 7720
material as well. Neither Swedbank nor its employees may be held
responsible for losses or damages, direct or indirect, owing to any errors or
Magnus Alvesson, +46-8-5859 3341 omissions in Swedbank Baltic Sea Analysis.
Jörgen Kennemar, +46-8-5859 7730
ISSN 1103-4897

Swedbank Baltic Sea Analysis No. 27 • 18 November 2010 7