This article in Forbes Russia predates yesterday’s surprising news that Ukrainian President Yanukovych has signed a $15 billion deal with Russia that has Russia buying Ukrainian government bonds and has Russia slashing the cost of natural gas from $400 per 1,000 to $268.5 per 1,000 cubic meters. As the BBC notes, this will not be enough to have Ukraine avoid default in the long term, and will anger the opposition.
This articles explores the depth of Ukraine’s financial problems that are the background to this crisis. — Ed.
Many years of populism, corruption, and an enslaving gas deal with Russia led to “Euromaidan”.
Viktor Yanukovych has lost his way in the economic woods. He has sacrificed the investment climate in Ukraine for the sake of wealth and strengthening his personal power. Trying to hold on to the people’s loyalty, he has fallen into debt and squandered the reserves. In order to pay off his creditors, he refused to sign the trade agreement with Europe. The Ukrainian economy is in a severe crisis, which is developing into a financial one. This is going to render the survival of Yanukovych’s regime impossible.
The refusal to sign the trade agreement with the European Union, and the use of force against protesters has led to the rapid erosion of political trust in Ukraine. Viktor Yanukovych’s regime, with which frustration was growing regardless, is now leaping and bounding towards its finale.
It is time to take stock.
Political motives lie at the heart of the unfolding confrontation in Kiev. But the country has simultaneously entered a systemic financial crisis. They can only spread their loans, which neither Russia nor the IMF want to give to Ukraine.
The IMF, the thread from which Ukraine has dangled since 2008, proposes, as credit conditions, the freeing up of the hryvnia’s exchange rate, freezing salaries and pensions, and increasing gas prices. This scenario is suicidal for Yanukovych, but there are no visible alternatives. It was only out of unprofessionalism that the Yanukovych team had hoped to get money from the EU as payment for integration. Money from China isn’t solving the problems – these are long term projects. The condition for Russian loans could be association with the Customs Union and military-industrial cooperation. This scenario would also be suicidal for Yanukovych as it would be a direct path to early elections.
The pure necessity to borrow immediately explains the Ukrainian government’s refusal to sign the agreement with the EU. Loans are needed to maintain the budget and prevent the devaluation of the hryvnia. With his European manoeuvre, Yanukovych hoped to make Vladimir Putin more pliable, in order to retain economic stability until the elections in 2015. But even if Russia does give money, this feint will no longer work. An ordinary trade agreement with Europe has become a symbol for Ukrainians of another life: of a social and economic order based not on cronyism, privileges and kickbacks, but on fair and equal rules for all players.
The economic crisis
The Ukrainian economy is undergoing a full-fledged crisis. In the first half of 2013 GDP fell by 1.3% while over 10 months industry fell by 5.2%. There has been no economic growth since the spring of 2012. Prices haven’t risen for two years, neither consumer nor industrial. This is slowing the growth of wages and incomes. Between January and November, car production fell by 39.8% and that of steel pipes by 22%. The government has no money to stimulate demand, consumption, or investment. Ukrainian exports fell by 6.5% between January and September. Since 2005 Ukraine has never finished a year with a positive balance of accounts. In the first 9 months of this year imports exceeded exports by 15.5%, in 2012 by 15.9%. A devaluation of the hryvnia by 15-25% could rectify the situation. It would increase the competitiveness of Ukrainian goods and tourism while reducing the attractiveness of imports. But this move threatens the budget and banks with problems. The population feels that something is wrong with the economic policy. Because of this, Yanukovych’s economic team has made the stability of the hryvnia the primary aim, preferring the depletion of National Bank reserves to a correction of the exchange rate.
Since the end of 2010 Ukraine’s international reserves fell by almost half: from $34.6 billion to $18.7 billion. But the exchange rate between the hryvnia and the dollar has barely changed since 2009. The stability of the hryvnia provides Yanukovych with a few percentage points of popularity, but it deprives the economy of competitiveness and the financial system of sustainability. The deficit can be balanced with investments and loans. But direct foreign investment had previously been small, and, in the first half of this year, decreased by 2.7 times to $1.4 billion.
Ukraine cannot pile on any more foreign debt. Between 2006 and 2012 aggregate debt increased almost fourfold, from $39.6 billion to $135.1 billion (last year’s GDP was $176 billion). Foreign debt is 1.5 times higher than even last year’s record exports (for comparison, Russia’s ratio is 1:35). Since the spring of 2012, when economic growth stopped, the growth of external debt has almost ceased. The state no longer issues bonds, and corporations and banks are not risking increasing loans while devaluation approaches.
The Ukrainian economic crisis has several internal and external causes.
1: Low ferrous metal prices. Between January and September 2013, export revenues from metal sales decreased by 9.6% compared with the same months in 2012. Metals account for around a third of Ukrainian exports. Their estimated prices on the IMF index have fallen by 30% since the beginning of 2011. The price of iron ore is now 27 % lower than at the beginning of 2011, and aluminium is 34% lower.
2: The super-high price of Russian gas. Ukraine pays more for gas than Europe. This is the result of Yulia Tymoshenko’s friendship with Putin, which led to the signing of an agreement which was disadvantageous to Ukraine. It defines the price of gas per quarter as $410 per thousand cubic metres (and this includes a discount of $100) – at the level of Eastern European countries or slightly more expensive. In Armenia Russian gas costs $189, in Belarus, $163. Tymoshenko is paying the price for this deal in prison. Efforts to reduce gas consumption, increase domestic production, and establish a reverse supply from Europe are having little effect.
Contrary to formal logic, the ill-fated deal, during the preparation of which Putin, according to Ukrainian gas tycoon Dmitry Firtash, outplayed everyone, although Tymoshenko played along with him, has proved unprofitable for Russia. The extortionate conditions have driven Gazprom’s Ukrainian partners into debt; they put off payments but require an advance fee for the transit of Russian gas into Europe. Winter gas supplies to Europe are in jeopardy. But in the long run, Ukraine wants to wean itself off Russian gas (deliveries have already halved) and at some point will achieve this.
3: An excessive state burden on the economy
The cumulative burden (state and regional budgets, pensions and social funds) is approaching 50% of GDP. The burden of tax is unevenly distributed: small businesses, agriculture, metallurgy, and petrochemicals receive tax breaks. Income taxes amount to 36% – the strongest incentive to avoid them. In the stagnant economy, regional budgets failed to receive 7.5% of revenues between January and November, while the state budget lost 10%. Although investments have already been slashed, current expenditure accounts for 95% of the spending budget. Borrowing is needed.
Ukraine’s public debt doesn’t seem huge; the total is 17.2% of GDP. However, when one takes the regional authorities and government guarantees into account, it approaches 35% of GDP. In the past 9 years, the average size of the budget deficit has been 2.8% of GDP.
Distrust of the government is so great that, under zero inflation, the Ukrainian Ministry of Finance is forced to raise capital in hryvnia at a rate of 14.3% per annum, while in dollars, the rate is 7.75%. Loans have to be taken from friendly banks, no-one fights for them at auctions. The remaining banks are occupied scouring for money for clients who want to take their cash out. Otherwise a bank run will begin. The problem is not limited to external debt: since 2011 the government has been forced to borrow both in foreign currency and on the domestic market (in the first six months this made up a little over half of loans). Because of this, devaluation will dramatically increase the debt of the spending budget.
The energy sector, as in Russia until the crisis in 1998, is dominated by defaults. The state budget is bound to local budgets for heating facilities and water supplies. These organisations need energy suppliers, and further along the chain, gas suppliers. Lacking money, Yanukovych is trying to unlink this chain using bills with a 5% rate of return. This is an attempt to reduce debt and avoid a large-scale issuing of hryvnia, leading to devaluation. This approach does not improve the financial situation for the companies, and it reduces their payments to the budget. Salary arrears to state employees and officials are growing.
In November the government permitted the state pension fund to pay pensions using loans leveraged by commercial banks. This has all the features of a pyramid scheme.
Budgetary constraints are not getting in the way of the state authorities and courts buying expensive furniture, or local authorities helping businessmen withdraw land from taxation. A third of the Euro 2012 budget was pilfered. The average salary in Ukraine is $403, while the Donetsk prosecutor’s office, on the basis of one position, costs the taxpayer $1597 per month. Having been caught with their hands in the till while buying Italian chestnut trees for Kreschatyk, Kiev city administration officials booked themselves a trip to Italy: to find out who switched the chestnuts.
Ukraine cannot support an inefficient and cancer-ridden state in which officials show off more than oligarchs.
5: An unfavourable climate for business.
In Transparency International’s ranking of countries by perception of corruption, Ukraine came 144 out of 177, while Russia was at number 127. The customs and habits of the officials who haven’t eaten their fill are stuck in the mid-1990s. The standards of behaviour of the bureaucracy are set by the political leadership of the country. In the case of Ukraine, this consisted of privatising the most beautiful areas around Kiev and the Crimea, and erecting gigantic fences around them, followed by the construction of palaces.
All of this detracts from the business climate. High taxes which are only optional. Oppressive laws that can be evaded through connections. Risks of having property seized with the involvement of law enforcement agencies. Public procurements come exclusively from relatives, friends, and acquaintances. The judicial system is biased. Officials can wield enormous influence on any business. Public bodies work poorly for businesses in terms of permits, licences, and leases. “All small and medium businesses belong to the prosecutor” says a participant in a survey conducted by CASE Ukraine. “If they don’t have prosecutorial protection, they’ll be driven out.”
Lilit Gevorgyan, a political analyst at IHS Global Insight is right: “The country’s current troubles are not a result of pro-or anti-EU policy choices. They are a result of years of economic mismanagement, populist economic policies both by current and previous [Tymoshenko – B.G.] governments, and failure to deal with underlying issues like monopolistic economic structures, corruption, and build a politically independent judiciary.”
The financial crisis
The deplorable state of the economy is literally developing right now into a financial crisis. It will have three components: debt, currency, and banks.
In 2014 Ukraine must repay $3.7 billion to the IMF, $1.2 billion of which must be paid in the first quarter. In April $1 billion must be paid in Eurobonds.
In total, Ukraine needs at least $7.3 billion in 2014, just to refinance its debt, and during the next two years, according to Bloomberg’s calculations, it will have to pay nearly $17 billion. Therefore, as the First Deputy Prime Minister Sergei Arbuzov said, Ukraine is trying to borrow $10 billion.
Within the first 11 months of this year, Ukraine has cleared $4.7 billion of foreign debt. Foreign debt markets for the country have practically closed. Naftogaz is accumulating debt. With the advent of the protests, the yield of government securities redeemable in 2014 rose to a record 21.2% while those redeemable in 2023 are at 10.9% per annum. Ukrainian default insurance has soared to a four-year high. Yanukovych proudly states that he needs no IMF loans if they come with any conditions.
In a few days he will have no such option.
Investors believe that there will have to be a major restructuring of government debt. The government still denies this. Perhaps 2014 will begin without the approval of a budget by the Supreme Rada [parliament]. The final version has not been published yet, but previous versions were based on unrealistic macroeconomic assumptions.
For a week already Ukrainians, having seen the inevitability of the devaluation of the hryvnia, are unable to change their savings into dollars and euros at the official exchange rate. Bureaux de change are out of money. The hryvnia’s exchange rate on the interbank market (8.28hrn to $1) is further and further separated from the official one (7.99). 3-month forward contracts estimate the value of the hryvnia in mid-March as 8.87 to the dollar. Liquidity in hrynia is evaporating quickly – the National Bank is putting all available funds on hold against the devaluation of the hryvnia.
The state of the banks is causing ever greater concern. The stability of the hryvnia until the start of autumn has been a cruel practical joke on savers. Between January and October deposits in banks grew by 18% ($8 billion) to 429 billion hryvnia ($53.7 billion). In this case, 94% of this increase was in hryvnia, de-dollarization is always particularly active before a crisis in developing countries. Obviously, savers will soon begin to regret their decision, which threatens a full-on banking run. They already lack the liquidity: the rates on interbank transactions soared overnight from 2%, back in June, to 20.8% per annum. Over the past week, the outflow of deposits from the system has been, according to rumours, around 5 billion hryvnia – about 1.2%.
Soon the National Bank will be forced, as in 2008-2009, to bring in a time limit on bank withdrawals, and a moratorium on the recall of fixed-term deposits. But across a couple of quarters in the winter of 2008/2009, even with such controls, the banking system lost a quarter of deposits. Public deposits make up 34.5% of bank liabilities. Ukraine does not have the resources to maintain this situation without devaluing: if, at the end of 2008, the National Bank reserves were twice the size of deposits in hryvnia (which people would want to exchange for cash), then now the population’s accounts are 1.5 times the size of the National Bank’s currency reserves. Under such conditions it is quite plausible that a withdrawal of even 10% of deposits would lead to a full collapse of the banking system. Fortunately for the banks, only 20% of the population’s savings are demand deposits. But such accounts held by companies account for 57% of funds in banks ($27 billion).
The National Bank will have to run a printing press to provide banks with liquidity But a 20% devaluation would be a very bad scenario for the budget: it would dramatically increase spending on debt repayments. Naftogaz’s deficit is growing and the national debt could reach 45% of GDP. The government will have to introduce austerity measures.
En route to Europe, Ukraine will have to go through severe fiscal and financial crises. The result should be the formation of new rules for the game. The country is unable to feed the state-parasite, sucking the juices out of half the economy. So Maidan, an attempt to re-establish the state on a new basis is completely rational economic behaviour. Otherwise they will turn down the road leading to the abyss.