Last week, S&P deemed Ukraine so likely to default that it downgraded its short-term foreign currency sovereign credit ratings to CCC+/C from B/B, seven notches below investment grade, and local currency ratings to B-/C from B+/B. This puts the Ukraine on par with Pakistan as a default risk. Ukraine’s CDS spreads spiked up to 3,500 basis points suggest a 70% chance of default – an outcome the Ukraine demurs of course. So what happened to boost Ukraine’s default risk so much, How likely is it to default and what might the implications of such a move be, for Ukraine and the global Economy?
Ukraine is one of several countries in Eurasia whose banks and corporations borrowed heavily abroad in recent years and now the bill is coming due. Unlike its neighbors in Europe, it lacks access to EU measures, even if those are limited, and unlike some of the oil exporters in the same boat, it lacks past savings to draw on to meet its mounting financing needs. It has though received some funds from international institiutions, most notably the IMF and the EBRD.
The current escalation in default risk was prompted in part by delays on the part of the IMF in releasing the latest tranche of funding it promised the Ukraine. Meanwhile, with attention on the vulnerabilities of the most-indebted members of emerging Europe and the large exposure of European banks to these countries (including the Ukraine) any default from the Ukraine (or a large number refinancing requests from corporate debt) could add to vulnerabilities in the region, making how international institutions respond to the Ukraine a key test case for the region. In fact it is the private sector not public sector liabilities that pose the greatest risk, the actual chance of a sovereign default on the part of the Ukraine still seems unlikely. However, the withdrawal of credit, sharp reduction in exports and domestic demand is putting Ukraine at risk of a high single-digit growth contraction even as political and economic uncertainty seem to be feeding on each other.
Rising Risk of Default
According to the Finance Ministry, Ukraine’s cumulative state (direct) and secured debt grew by 40% in 2008 to $24.598 billion equaling 19.8% of GDP or well below the internationally recognized safety threshold of 60%. But the government’s official liabilities are only part of the story. Like in countries like Russia, the Ukrainian government might have to implicitly assume the liabilities of the corporate sector. Sovereign external debt is US$15bn, in addition to US$42bn owed by banks and US$44bn taken out by corporates nearly half of which is due in 2009. Global Insight estimates Ukraine’s total external debt obligations in 2009 are US$57 billion, including debt amortization, short term debt equaling US$51 billion. The bulk share of these debt obligations will be rolled-over since most of the debt is related to lending between foreign parent banks and local subsidiaries.However if parent banks rescind their lines of credit as they could do under their own financial stress, this could sharply boost the Ukraine’s vulnerabilities. The IMF estimates a financing gap of US$10bn in 2009, mainly on the corporate debt side.
Aggressive lending by banks was financed by heavy borrowing abroad, contributing to Ukraine’s ballooning private sector external debt. As in Eastern, Europe, Western European banks are most exposed – Austrian, French, Swedish, Italian and German banks have a collective exposure of around EUR 30 billion to the Ukraine. Speculation is rift of a looming Ukraine default so much so that spreads on credit default swaps (CDS), a form of insurance against default, have risen from around 400 basis points in August 2008 to over 3,500 today. According to Bloomberg, spreads at the current level imply a 69.6% chance of default in two years and a 91.8% chance in five years. Some analysts believe that Ukraine will be able to repay the debt by borrowing from multilateral lenders. Russia which recently cut off gas supplies in a pricing and repayment dispute has offered a $5bln loan however the political cost of this loan for Ukraine might be far greater than the conditions put forth by the IMF. Despite the vulnerabilities, a sovereign default seems unlikely yet the government’s contingent liabilities are rising. And surely the Ukraine will have to pay a lot more for its financing than it has done in the past.
Uncertain IMF Bail-Out?
Ukraine turned to the International Monetary Fund for a $16.4 billion loan in Nov and the economy is now surviving on the first tranche of $4.5bln however disagreements between the two parties have made the future of this deal uncertain. The standoff revolves around the budget, especially the difficult cuts needed to balance the budget, a condition of the IMF loan. The Ukrainian budget estimates a 3% deficit in 2009 which resulted in postponement of the second tranche of the loan. The IMF has insisted that money from the first tranche be used to shore up the banking sector and a freeze on social spending. While at time of writing, the IMF and the Ukraine seem likely to come to terms many of the economic, financial and political dynamics which brought the economy to this impasse look likely to persist.
With presidential elections scheduled for this year, there is reluctance to curb social welfare benefits. A compromise is necessary to avoid further exacerbating the economic fallout for Ukraine. The country has also turned to US, Russia, China, Japan and the EU for loans to fill a shortfall in budget revenues for 2009.Ukraine would prefer loans from countries rather than the IMF as, they will allow the government to cover the budget deficit while the loan from the IMF cannot be used directly for this. With the exception of Russia so far, these countries have not been very forthcoming. Many face grave capital needs at home to support their financial systems and their domestic economies. In the case of the EU, the liabilities of the Ukraine may pale in comparison to those of EU members in central and eastern European. Furthermore, the U.S. Japan and EU might also seek economic conditions like those of the IMF or wait for the IMF ‘seal of approval’. Japan in particular prefers to channel funds through a larger IMF rather than lend to emerging economies directly. However, given the possible contagion, the incentive to avoid a Ukrainian default is rising. The EBRD and the World Bank have agreed recently to provide Ukraine with new loans and foreign banks with operations in Ukraine have announced plans to inject $2 bln-3 bln to their Ukrainian affiliates.
Ukraine’s political uncertainty adds to the economic and financial uncertainty and its credit risk – Rating Agencies have cited Ukraine’s political divisions as one of the factors in triggering the downgrades. Ukraine politics has been engulfed in a two way power struggle for years at the cost of its fragile economy. Last summer divisions erupted on how to tackle inflation limiting policy responses making difficult budget cuts even more unpalatable. Prime Minister Yulia Timoshenko’s government has survived two no-confidence votes in Parliament since July and continues to bicker with rival President Viktor Yushchenko.Yushchenko supports hands-off monetary policy and reductions in state spending; and Tymoshenko proposes massive government intervention in industry, and state support to the national currency the hryvna. Both of them are now highly unpopular with 57% of Ukrainians calling for Yushchenko to step down.
The two are deeply divided over the IMF loan with Yushchenko calling for close Ukrainian adherence to IMF loan conditions; and Tymoshenko supporting redirection of already-received IMF money to social service programs. Earlier this month Finance Minister Viktor Pynzenyk resigned, citing his frustration with political interference in the budget process. Ukraine now finds itself without a Finance Minister at crucial time in negotiating with the IMF for its next tranche which has been delayed.
The Weakening Hryvnia
The 50% plunge in the value of the hyrvnia (from June to December) is putting pressure on Ukraine’s economy, increasing the domestic costs of the external corporate debts, which might increase defaults and lead to a pattern of non-payments. Furthermore it has put pressure on the banking system that has been frozen out of international credit markets and is suffering losses as the property market tanks and private consumption falters.
Ukraine is the only country in Central and Eastern Europe to tie its currency to the dollar which forced the NBU to pursue a loose monetary policy.
Steel’s slump is one of several causes of the currency depreciation. Steel which accounts for 40% of exports has been on a downward slump through 2008 and the outlook is unlikely to improve given global overcapacities. The Ukraine’s efforts to slow the currency depreciation have limited its foreign exchange firepower to the extent that Ukraine’s reserves, which slid almost 9% to $29 billion in January, exceed the debt coming due this year. With the economy set to shrink by at least 6% in 2009, delays in the IMF tranche, gas disputes with Russia and domestic political instability the Hryvnia is likely to weaken further through 2009. However, there is one silver lining, the fall in the Hyrvnia does reduce the demand for imports, which have shrunk dramatically. Yet the pressures on the banks and potential for the currency depreciation to keep imported inflation high may outweigh this benefit.
Slump In Industrial Output
Ukraine’s growth outlook keeps worsening even if the pace of economic deterioration in manufacturing has slowed. Ukraine’s industrial output has been falling for five consecutive months led by steel. Industrial output shrank by more than one-third in January to 34.1% y/o/y and 16.1% m/o/m. The January data represents a temporary freeze of production in the first half of the month owing to the cut in gas supplies from Russia. However with falling global demand, declining prices for steel and a weakened Hryvnia industrial production is likely to continue a declining trend in 2009 putting tens of thousands of workers on unpaid leave. Thus Ukraine’s vulnerabilities are now shifting from the external sector to already collapsing domestic demand. With job losses mounting and purchasing power falling, consumption will face further declines, meaning that Ukraine will face a challenge digging itself out from the economic hole. Yet, allowing a default would make this even harder. As with its neighbors Ukraine faces a sharp and painful adjustment in the face of constrained external credit.