IMF Deal Brings Political Challenges

BMI View : The Ukrainian government looks increasingly likely to secure IMF financing, allowing the government to avoid default over the coming months. However, the conditions attached will be politically unpopular and may prove destabilising to the fractious government. While IMF financing is positive for near-term stability, Ukraine will also have to normalise relations with Russia if it is to secure its economic future.

The IMF is reportedly preparing to put together a stand-by arrangement (SBA) of around US$18bn for Ukraine and could start making disbursements as early as April. The IMF deal, if successful, would pave the way for further aid packages from the EU. While positive for short-term economic stability, we caution that it is highly probable that the SBA would be conditional on unpopular economic reforms including a de facto devaluation of the hryvnia and a reduction in household gas subsidies. Meeting these conditions will require considerable political resolve, and will risk inflaming the tense political situation, particularly in Ukraine's eastern oblasts. All of this could potentially prove destabilising to the fractious new government.

Since the ousting of former President Viktor Yanukovych in February, Ukraine's interim government has struggled to keep the country from the brink of economic and political collapse ahead of the presidential election, currently scheduled for May 25 this year. The rapid deterioration of relations with Russia following the annexation of Crimea in March has seen the previous US$15bn financial aid package from Moscow cut off, as Russia increases the pressure on Ukraine.

Bulk Of Adjustment Already Completed
Exchange Rate - UAH/US$

BMI View : The Ukrainian government looks increasingly likely to secure IMF financing, allowing the government to avoid default over the coming months. However, the conditions attached will be politically unpopular and may prove destabilising to the fractious government. While IMF financing is positive for near-term stability, Ukraine will also have to normalise relations with Russia if it is to secure its economic future.

The IMF is reportedly preparing to put together a stand-by arrangement (SBA) of around US$18bn for Ukraine and could start making disbursements as early as April. The IMF deal, if successful, would pave the way for further aid packages from the EU. While positive for short-term economic stability, we caution that it is highly probable that the SBA would be conditional on unpopular economic reforms including a de facto devaluation of the hryvnia and a reduction in household gas subsidies. Meeting these conditions will require considerable political resolve, and will risk inflaming the tense political situation, particularly in Ukraine's eastern oblasts. All of this could potentially prove destabilising to the fractious new government.

Since the ousting of former President Viktor Yanukovych in February, Ukraine's interim government has struggled to keep the country from the brink of economic and political collapse ahead of the presidential election, currently scheduled for May 25 this year. The rapid deterioration of relations with Russia following the annexation of Crimea in March has seen the previous US$15bn financial aid package from Moscow cut off, as Russia increases the pressure on Ukraine.

Bulk Of Adjustment Already Completed
Exchange Rate - UAH/US$

So far, the interim administration has yet to make any major policy errors, although public discontent is rising over the failure of the government to oppose Russia's annexation of Crimea more aggressively. Furthermore, the lack of international reserves has forced the authorities to cease intervening in the exchange rate, and despite stringent capital controls, the hryvnia has fallen by around 25% to UAH11.00/US$, which has substantially weakened household purchasing power. While this has gravely undermined Ukraine's growth outlook and credit profile, the devaluation of the hryvnia ahead of the IMF agreement may turn out to be a positive, as a weaker hryvnia will ultimately form part of the IMF's demands in any case.

Klitschko Penalised For Lack Of Experience
Ukraine - Opinion Polling For Presidential Election: First Round (LHS), Second Round (RHS)

The magnitude of the economic challenges facing Ukraine may ultimately sway the outcome of the upcoming presidential election. Support for Vitali Klitschko, the former front-runner, fell to just 12.9% in March, from 22.8% in February, while tycoon Petro Poroshenko took the lead with 36.2% of the vote. The rapid rise in support for Poroshenko may be indicative of a growing preference for experienced candidates, and in particular those with economic expertise, whereas Klitschko's lack of experience in public office may mark him out as a high-risk candidate in the electorate's eyes, despite the credibility won from his engagement in the Euromaidan movement.

Gas Hikes Will Hit Poorest Hard, Unless Blow Is Softened
Household Net Income, percentage of total households

Assuming the IMF signs off on the deal (our core scenario), we expect the government will have to implement a number of major reforms in 2014 as part of a wider austerity package. First, the government will have to implement fiscal tightening, which will include a reduction in gas subsidies. The government has already announced a 50% gas hike for retail customers, which will probably be sufficient to win the approval of the IMF this year, but further subsidy removals will probably be required further down the line. The IMF deal will also be contingent upon exchange rate liberalisation, although this will probably be implemented in stages. The recent devaluation of the hryvnia means that the bulk of the adjustment has already happened.

Going forward, we maintain our core view that Russia will not move troops into mainland Ukraine, and a gradual de-escalation and normalisation of relations will emerge. While there is a high chance that the next Ukrainian president will be EU-leaning, Ukraine still relies on Russia for 100% of its gas imports and to absorb around 30% of its exports. Regardless of which candidate wins the election in May, economic realities dictate that Ukraine will be unable to sever ties with Russia any time soon. Any major disruption of trade flows with Russia would rapidly push Ukraine into a balance of payments crisis, even with EU/IMF financing in place, and Russia will be quick to exert economic pressure on Ukraine, if it feels its interests are being undermined. Ukraine's next president will therefore have to balance both the interests of Russia and the EU in order to secure the country's economic future.

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Sector: Country Risk
Geography: Ukraine
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