IMF Loan No Guarantee Of Stability

BMI View: While the approval of a USD17.0bn Stand-By Arrangement from the IMF (including USD3.2bn for immediate disbursal) is positive for Ukraine's near-term debt servicing prospects, we remain sceptical that the interim government will be able to accomplish the IMF required reforms given the considerable political challenges facing the country.

The IMF approved a USD17.0bn two-year Stand-By Arrangement (SBA) for Ukraine on April 30, with USD3.2bn to be disbursed immediately. This is broadly in line with our expectations for a small up-front payment to be distributed in order for Ukraine to meet its financing obligations over the next three months ( see 'In Urgent Need Of External Financial Aid', 6 March 2014).

While positive for solvency over the coming quarter, the SBA falls short of our estimates for Ukraine's external financing needs in 2014, which we place at around USD20bn alone (the IMF payments will be spread over two years). It is possible that the recent devaluation in the hryvnia to UAH11.5/USD will narrow the current account deficit beyond our baseline forecasts as imports collapse, reducing the hard currency requirement. However, by our estimates a devaluation to UAH12.0/USD would push up the government debt/GDP ratio by around 6.2 percentage points, to 49.1% of GDP (excluding the latest tranche of IMF SBA debt).

Removal Of Gas Subsidies Will Be Painful
Regional Household Gas Prices Per Cubic Metre, USD

IMF Loan No Guarantee Of Stability

BMI View: While the approval of a USD17.0bn Stand-By Arrangement from the IMF (including USD3.2bn for immediate disbursal) is positive for Ukraine's near-term debt servicing prospects, we remain sceptical that the interim government will be able to accomplish the IMF required reforms given the considerable political challenges facing the country.

The IMF approved a USD17.0bn two-year Stand-By Arrangement (SBA) for Ukraine on April 30, with USD3.2bn to be disbursed immediately. This is broadly in line with our expectations for a small up-front payment to be distributed in order for Ukraine to meet its financing obligations over the next three months ( see 'In Urgent Need Of External Financial Aid', 6 March 2014).

While positive for solvency over the coming quarter, the SBA falls short of our estimates for Ukraine's external financing needs in 2014, which we place at around USD20bn alone (the IMF payments will be spread over two years). It is possible that the recent devaluation in the hryvnia to UAH11.5/USD will narrow the current account deficit beyond our baseline forecasts as imports collapse, reducing the hard currency requirement. However, by our estimates a devaluation to UAH12.0/USD would push up the government debt/GDP ratio by around 6.2 percentage points, to 49.1% of GDP (excluding the latest tranche of IMF SBA debt).

Removal Of Gas Subsidies Will Be Painful
Regional Household Gas Prices Per Cubic Metre, USD

Furthermore, we remain sceptical that the unelected interim government in Kiev will be able to push through the unpopular austerity package that is necessary to unlock further tranches of the SBA without exacerbating political unrest. There is a real risk that higher household gas tariffs will play into the hands of pro-Russia protestors, fuelling secessionist tensions in eastern Ukraine. Many of the IMF's desired reforms will also have an immediate negative impact on the economy. Reducing household gas subsidies will force households to cut spending elsewhere. Exchange rate flexibility (amounting to a de facto endorsement of the recent devaluation) is another key goal of the SBA, suggesting that we are unlikely to see a sharp reversal of the hryvnia in the foreseeable future. Hence, we expect to see sizeable feed-through inflationary effects from the shift in exchange rate, forecasting CPI to grow by 14% y-o-y by end-2014.

Devaluation Slamming Capital Ratios
Ukraine - Banking Sector Aggregate Capital Adequacy Ratios, %

Beyond inflationary pressures, the devaluation in the exchange rate has damaged the stability of the already weak banking sector. With 42% of loans denominated in FX as of March, the devaluation has driven a sharp rise in risk-weighted assets as the FX loan book increases in local currency terms, wiping off almost 3.5 percentage points off aggregate capital adequacy ratios. Non-performing loans also increased by around 2pp in Q114, to 9.3%, and will rise further as FX borrowers struggle with higher debt servicing costs and a contracting economy. Capital ratios are therefore likely to fall further as banks absorb greater losses over the coming quarters, leading to tight credit conditions for the private sector, and creating debt auction challenges for the government due to tighter liquidity.

The slowdown has already begun, with recently released data indicating that the economy contracted by 1.1% in the first quarter of 2014. Soaring inflation, substantially tighter government spending, diminished purchasing power and extremely tight credit conditions all point towards a sharp recession in 2014, and we expect real GDP to contract by 4.4% this year. While the IMF loan may help to instil some confidence in Ukraine's debt servicing abilities over the coming quarters, the associated austerity measures and economic reforms will push the economy into contraction.

On balance we think it is unlikely that Ukraine will receive the full USD17bn. The political challenges to implementing the painful reforms set out by the IMF are considerable, particularly in light of unrest in the east, and the country has a poor history of staying on track with the Fund's programmes, even when the government has been relatively stable. We have also yet to see a significant improvement in relations with Russia, which remains another considerable impediment to the IMF programme: reducing household gas subsidies will have limited impact on budget sustainability if Russia continues to raise the wholesale price of gas to unsustainable levels. Consequently, while the approval of the SBA and the disbursement of the first tranche is positive for sovereign debt servicing over the coming quarters, the situation seems likely to get worse before it gets better.

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