Default Possibilities in Ukraine

The drought of foreign capital is beginning to wreck many economies in Central and Eastern Europe. Currencies, shares and bonds are tumbling, and some economists fear that one or more of these countries could default on its foreign debts. Emerging-market crises have a nasty habit of spreading as investors flee one country after another.

The decision of the credit ratings agency Standard & Poor’s (S&P) to cut Ukraine’s main rating, its long-term foreign-currency rating, by two notches to CCC+, putting the country deeper into junk territory. S&P also maintained a negative outlook, indicating that further downgrades were possible turned out to be a significant shock for the stability of Ukrainian financial system.

Ukraine insists it has the funds to avoid default, in the wake of a sharp downgrade by an international ratings agency and credit default swaps (CDS) spreads, a form of insurance against default, that suggest a 70% likelihood of default. Ukraine’s sovereign repayments this year are affordable, but the state could be landed with much-larger obligations from the private sector. Thus relations with the IMF are critical, but these have stumbled on a dispute over the 2009 budget, which rests on highly optimistic assumptions and still fails to deliver the promised zero-deficit. Evidently the government is unwilling to make further spending cuts, and prefers to cover the deficit with bilateral loans. The IMF’s attitude to this is uncertain.

Markets agree with S&P’s assessment. Spreads on CDS have risen from around 400 basis points in August 2008 to over 3,500 today. According to Bloomberg, citing CMA Datavision, spreads at the current level imply a 69.6% chance of default in two years and a 91.8% chance in five years.

Markets are pessimistic about Ukraine for two reasons. First of all, the state could ultimately be saddled with the obligations of Ukrainian companies, which are due to repay an estimated US$43bn this year in foreign loans. Their ability to pay is open to serious doubt. The country’s banks, which borrowed heavily abroad in recent years, have been frozen out of international credit markets and are suffering losses at home as the property market tanks and private consumption falters. Industry has been hit hard by the contraction in world trade and sharply lower prices for the country’s main exports, steel products and chemicals. The other main industry branch, machine-building, is suffering from the swift downturn in Russia. With high levels of short-term debt, Ukraine’s overall debt profile looks much more worrying than its sovereign debt profile.

The second reason for concern centers on relations with the IMF, which rode to Ukraine’s aid in late 2008 with an unprecedentedly large US$16.4bn facility. Although the first US$4.5bn tranche was promptly disbursed, problems became apparent before the end of the year. Lacking Unitarian policy of the President and Prime Minister it is extremely hard to fulfill obligations of IMF.

The passage of the 2009 budget, however, brought matters with the IMF to a head. Part of the deal was for Ukraine to produce a balanced budget for this year, yet the one passed by parliament targets a deficit equal to 3% of GDP. As a result, the IMF mission left Ukraine in early February without reaching an agreement with the government to trigger disbursement of the US$1.8bn second tranche. This was a major factor behind the S&P downgrade, even though Ukraine does not immediately need the US$1.8bn; seemingly, it has barely dipped into the first US$4.5bn. The worry for investors is that the failure to secure IMF approval means that Ukraine’s fiscal policy is on a trajectory that will court disaster.

Given the unremittingly gloomy stream of data since the IMF deal was concluded—industrial output contracted by around 24% year on year in the final three months of 2008, and by 34.1% year on year in January—a zero-deficit budget might not be appropriate or politically feasible. However, to shift from a balanced budget to a 3% deficit is a sizeable leap for the Fund to make.

Moreover, there are very strong reasons to doubt whether the 3% deficit target, which in cash terms is HRN31.1bn (US$3.7bn), is achievable—for it rests on highly optimistic assumptions. GDP is forecast to rise by 0.4%, whereas the mid-February consensus estimate was -5.4% and the Economist Intelligence Unit forecasts -8%. Consequently, the budget’s revenue projections look hopelessly optimistic. The revenue target of HRN239bn (US$28.2bn) implies an increase of 3% compared with 2008, whereas in light of the stinging economic contraction underway most independent observers would expect a double-digit fall. The forecast for a 1% increase in value-added tax receipts on foreign purchases appears outlandish, given the steep drop that is expected in imports in 2009. Moreover, the government had originally planned to raise a significant amount of revenue from the local budgets through the introduction of a real estate tax. Although the initiative fell through, revenue targets were not adjusted to take this into account.

Such pessimistic tendencies are extremely harmful for the Ukrainian economy recovering. It is in a significant need of the foreign investments to cover the decline of local financial potential. And S&P’s rates are key factor in potential investors decision-making, pushing Ukraine out of the pool. Unitarian governmental policy along with significant support to the local businesses is critically important for overcoming of the latest stresses.

S&P

Bloomberg.com

Theeconomist.com

Ukrstat.gov.ua

IMF.com