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Global Economic Outlook
Ukraine: 2011 Outlook
By David Rogovic and Rachel Ziemba
- Economic growth will pick up moderately in 2011 led by fixed investment. However, a fragile banking system and fiscal austerity will prevent a broader recovery in domestic demand.
- The renewal of Ukraine’s IMF loan program eased external financing risks in 2010. However, strict targets in 2011 could knock the program off track.
- Inflation is set to accelerate on the back of higher energy and food prices.
Growth Dynamics: Slower Growth Ahead
After returning to growth in H1 2010 Ukraine’s economic recovery is now being held back by credit constraints and IMF program conditionality. Since the September Outlook update, growth slowed to 3.5% y/y in Q3 2010 as a poor summer harvest increased food prices and hit consumer spending. Consequently, RGE forecasts 4.2% growth for 2010, slightly lower than our previous forecast. In 2011, a recovery in fixed-asset investment ahead of the 2012 European soccer championship will bring growth to 4.4%, slightly higher than in 2010. However, fiscal austerity and financial sector fragility will restrain other components of domestic demand, even as external demand, especially for steel, stabilizes.
Helped by a recovery in commodity prices and global demand, the manufacturing and mining industries led growth in H1 2010. Higher steel prices—Ukraine’s largest export—boosted net exports and improved Ukraine’s external balance. Consistent with RGE’s expectations for slower global growth in H1 2011, industrial production and export growth will decelerate. Meanwhile, as the domestic economy recovers, higher import demand implies net exports will become a drag on 2011 growth.
Figure 1: Real GDP Growth and Industrial Production Growth (% change, y/y)
IMF loan conditionality will shape both the speed and drivers of growth in 2011. The renewal of Ukraine’s IMF loan program in July 2010 eases external financing risk by providing an external policy anchor and US$15 billion worth of official support. Meeting fiscal targets will create a drag on growth and be politically difficult. Given that two-thirds of government spending goes to pensions and social expenditures, political conditions imply that government investment, not social spending, will be cut, restraining public infrastructure investment and long-term growth.
Private consumption, the largest component of domestic demand at over 60% of 2009 GDP, will support growth in 2011, buoyed by wage gains and a reduction in precautionary savings. After contracting 18% in 2009, retail sales growth turned positive in May 2010 and accelerated to 5.8% y/y in October 2010. However, rising inflation will be a constraint on private consumption. Higher food prices from a poor summer harvest and a 50% increase in gas prices scheduled for April 2011 will weigh on consumer confidence and spending.
Figure 2: Retail Sales and Real Wage Growth (% change, y/y)
Investment activity will recover in 2011 and gain momentum as construction activity benefits from spending ahead of the 2012 European soccer championship, which Ukraine will co-host with Poland. A weakened financial system will, however, remain an obstacle to investment growth and prevent a broader-based recovery. Supply constraints emanating from a large stock of problem loans limit banks’ willingness to lend and keep interest rates elevated, dampening credit demand.
Risks: Political Change Threatens Recovery, IMF Loan
Political risks threaten Ukraine’s growth outlook as political uncertainty could dampen consumer and business confidence. Since taking office in early 2010, President Viktor Yanukovich pushed through unpopular economic reforms necessary to renew the country’s IMF loan. Yanukovich has done so by centralizing power. In October 2010, Yanukovich’s Party of Regions (PoR) won regional elections in an election deemed unfair and undemocratic by international observers. If the economic recovery stalls and political support fades, a return to populist policies would undermine investor confidence. An early warning of this risk arose in late November 2010 when, pressured by public protests, Yanukovich vetoed changes to the tax code approved by parliament.
In 2011, stricter program targets—including a 3.5% deficit target, pension reform and a 50% increase in household gas prices—will test the government’s resolve and commitment to the IMF loan program. In November 2010, the IMF approved the disbursement of Ukraine’s latest loan tranche worth US$ 1.6 billion. The first test is in mid-December when parliament must approve pension reform. Meeting the IMF’s 3.5% of GDP budget target for 2011 will require reining in public expenditures and could pose a downside risk to our assumptions on investment growth as the government may consider social transfers a political necessity. Suspension of the IMF program would raise doubts about policy credibility and increase external financing costs.
These risks are amplified by the slow recovery of capital flows to Ukraine. Improved risk appetite allowed Ukraine to return to the Eurobond market in September after delaying a planned summer offering. However, the government remains reliant on IMF funding, and a widening current account deficit in 2011 will amplify external financing needs.
Given uncertainty over the speed of recovery and limited cross-border financing, banks remain reluctant to lend. Nonperforming and restructured loans account for over half of some banks’ loan portfolios and limit credit supply. So far, corporate lending has outperformed retail lending, which continues to contract y/y. Strong deposit growth in 2011, combined with lower borrowing costs, would ease credit constraints, and a revival in credit growth represents a key upside risk.
Policy Implications: Inflationary Pressures Build
Despite a large output gap and weakness in the domestic economy, inflation is set to rise due to non-monetary factors. After bottoming out in July, a 50% increase in household gas prices in August as well as higher food prices will keep inflation elevated throughout the remainder of 2010 averaging 9.6%. Ukraine is particularly vulnerable to a food-price shock since food items account for over 50% of the CPI. An additional hike in gas prices, scheduled for April 2011, as well as limited fiscal consolidation will keep average inflation around 10.9% in 2011. Given heightened inflationary pressures, the National Bank of Ukraine (NBU) is unlikely to cut rates again and may opt for modest currency appreciation to stem inflation.
Figure 3: CPI and Food Price Inflation (% change, y/y)
Source: National Bank of Ukraine