In Urgent Need Of External Financial Aid

BMI View: Ukraine is on the brink of a major credit event and urgently requires external assistance in order for the government to meet its financial commitments. While we expect the West may provide a small interim loan to allow the country to avoid defaulting on its repayments in April and June, larger financing packages will be on a conditional basis, and we see risks that the government will be unable to implement the associated reforms. The recent devaluation of the hryvnia has also substantially worsened the sovereign credit profile.

In line with our expectations, Ukraine's fiscal situation has deteriorated quite dramatically since our last quarterly update, and we maintain our core assessment that the risk of a credit event over the coming quarters in Ukraine remains extremely high. The fiscal deficit arrived wider than our forecasts in 2013, at UAH63.6bn versus our forecast for UAH54.4bn, or around 4.3% of GDP, primarily due to the US$3bn tranche of financial aid which Ukraine received from Russia in the fourth quarter. We do not expect any further tranches of Russian aid will be disbursed to the current government.

Ukraine remains cut off from international bond markets, with yields on short-end government notes in excess of 25% and is therefore reliant on dwindling FX reserves for external debt servicing. We estimate international reserves dropped below two months import cover to US$14bn in February - a dangerously low level relative to short-term external financing requirements - as the increasingly unstable political situation and weakness in the hryvnia has driven Ukrainians to convert their hryvnia savings into hard currency. International reserves are now so low the authorities have abandoned FX interventions and have instead resorted to capital controls to stabilise the currency.

Austerity Looms Ahead
Ukraine - Government Budget Balance, UAHmn

BMI View: Ukraine is on the brink of a major credit event and urgently requires external assistance in order for the government to meet its financial commitments. While we expect the West may provide a small interim loan to allow the country to avoid defaulting on its repayments in April and June, larger financing packages will be on a conditional basis, and we see risks that the government will be unable to implement the associated reforms. The recent devaluation of the hryvnia has also substantially worsened the sovereign credit profile.

In line with our expectations, Ukraine's fiscal situation has deteriorated quite dramatically since our last quarterly update, and we maintain our core assessment that the risk of a credit event over the coming quarters in Ukraine remains extremely high. The fiscal deficit arrived wider than our forecasts in 2013, at UAH63.6bn versus our forecast for UAH54.4bn, or around 4.3% of GDP, primarily due to the US$3bn tranche of financial aid which Ukraine received from Russia in the fourth quarter. We do not expect any further tranches of Russian aid will be disbursed to the current government.

Austerity Looms Ahead
Ukraine - Government Budget Balance, UAHmn

Ukraine remains cut off from international bond markets, with yields on short-end government notes in excess of 25% and is therefore reliant on dwindling FX reserves for external debt servicing. We estimate international reserves dropped below two months import cover to US$14bn in February - a dangerously low level relative to short-term external financing requirements - as the increasingly unstable political situation and weakness in the hryvnia has driven Ukrainians to convert their hryvnia savings into hard currency. International reserves are now so low the authorities have abandoned FX interventions and have instead resorted to capital controls to stabilise the currency.

Hryvnia Weakness Damaging Debt Ratios
Ukraine - Impact of Exchange Rate On Public Debt Load, % GDP

Despite capital controls, the hryvnia has devalued to around UAH9.0/US$ and is at risk of further decline as capital flight and domestic demand for hard currency place the exchange rate under pressure. The devaluation of the hryvnia has worsened Ukraine's sovereign credit profile, increasing debt servicing costs and driving up the external debt to GDP ratio. As the chart above shows, a devaluation to UAH12/US$ would push up the government debt/GDP ratio by 6.2 percentage points by our estimates, to 44.6% of GDP. Furthermore, the recent spate of deposit flight from the banking sector has created acute liquidity shortages, leading to failed local debt auctions for the treasury.

A Large Gap To Fill
Ukraine - Estimated External Financing Requirement, US$bn

Our core view is that Ukraine will receive an emergency tranche of financing from the EU and IMF which will likely not exceed US$4bn to cover its May IMF payment and June eurobond redemptions. We estimate Ukraine's 2014 external financing needs at US$20bn at the very least ( see chart). However, larger financial aid will remain contingent upon implementing a comprehensive reform package, including unpopular measures such as the partial removal of household gas subsidies and pension reform. These measures will be extremely difficult for the government to pass given the volatility of the political environment, particularly in the eastern regions.

We have adjusted our 2014 budget deficit forecast to 3.3% of GDP, from 4.3% previously, as the government will face major difficulties in financing the deficit. Furthermore, while we expect that Ukraine will probably receive a partial bailout from the EU/IMF at the very least this year, we expect the financing will be contingent on removal of gas subsidies and possibly also pension reform, leading to lower government spending. We emphasize that without external financial assistance, the government will probably default on its hard currency debt this year.

Risks To Outlook

The eurobonds recently issued to Russia as part of the first tranche of the bailout contain a covenant that is broken if public debt/GDP breaches 60%. When the bonds were issued at the end of 2013, public debt/GDP was around 35%, but as around half of Ukraine's public debt is FX denominated, the combination of the collapse in the hryvnia and the need for an external bailout from EU/IMF could actually lead Ukraine to technically default. If the hryvnia falls to around UAH12.0/US$, then the US$20bn bailout it needs this year could push the public debt ratio above 60% by the end of the year, implying a possible covenant breach.

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Sector: Country Risk
Geography: Ukraine
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