UNIQA Capital Markets Weekly
The macroeconomic situation improved considerably since a perfect storm hit the economy in 2015.
Long-run development depends critically on technological catch-up.
Financial stability increased but remains dependent on international financial support.
The macroeconomic situation
Ukraine has been recovering since a perfect storm hit the economy in 2015 owing to the crisis in the Eastern part of the country. At the end of last year, gross domestic product grew by 1.8 % (after 2.1 % y/y in Q3). During the total of 2017, real GDP expanded by 2.2 % being comparable to the preceding year. The recovery has been driven by rising household consumption and investment (+5.3 % and +15.8 % y/y in Q3) while net exports put a drag on growth. According to income data from the national accounts, real compensation of employees started to increase in Q2 2017 (11.6 % y/y) after a sharp income loss since 2014 (Figure 1 - see pdf).
Public sector wage increases led a rise in nominal and real wages in 2016 and 2017. Last year, public sector wages increased by above 40 % in real terms giving a boost to household incomes and expenditures. In line with the economic recovery sentiment (GfK surveys) improved since 2014 and peaked last November although a gradual retreat was visible since December. On the other side, real retail sales showed a continuously strong expansion (9.6 % y/y in January). Growth will remain driven by the recovery in domestic demand and we project real GDP to expand by up to 3 % and 3.2 % in 2018 and 2019.
Ukraine witnessed migration outflows since the political and economic crisis that culminated at the end of 2014 when ex-President Yanukovych was ousted from politics and the conflict in Eastern Ukraine oblasts Donetsk and Luhansk and Crimea escalated. In 2016, almost 600.000 persons received residence permits in the EU with most migrants moving to Poland and in total around 1.3 million residence permits were recorded since 2014 (Figure 2 - see pdf).
Following, the number of economically active persons remained in decline until last year. At the same time, the unemployment rate increased gradually by 2.2 % to 9.4 % in Q3 17. Long-term demographic prospects are adverse as the active population (age 20-64 years) is currently projected to decline on average by more than 1 % per year.
We consider development indicators from the World Bank to get a picture about the productivity catch-up. Since 2015, Ukraine improved its overall ranking in the Ease-of-doing-business indicator from 87 to 76. For example, the position for starting a business and procedures to enforce a contract improved from 70 to 52 and from 98 to 82. With regards to governance, we compare Ukraine’s percentile rank in 2004 (at the onset of the ‘Orange Revolution’), 2013 (before the Eastern Ukraine conflict) and latest figures from 2016 (Figure 3 - see pfd).
It stands out that only visible progress was made in voice & accountability (participation in selecting the government, freedom of expression and associations and free media) and obvious political stability & absence of crime & terrorism encountered a backdrop since 2013 while overall results did not improve significantly over the total period.
The selection of indicators suggests overall slow development progress. One of the main sources undermining economic development is corruption. Although since 2012 the country improved its ranking in the corruption perception index (Transparency International) from 144 to 130, the level corruption remains exceptionally high and its reduction is an essential ingredient to speed up economic convergence.
According to a recent estimate, reducing corruption to levels seen elsewhere in the region (for example Bulgaria and Romania, hence, a level plausibly within reach) could raise per capita GDP growth by 0.9 % and even up to 1.3 %. A previous paper emphasized the potential of Ukraine to be a very wealthy country amid a generally well-educated work force, vast agricultural land and supply of hydrocarbons and minerals and a relatively well-developed infrastructure. Failure to tap the full potentials is mainly a result of weak institutions and the need for structural reform.
We employ a Solow growth model to explore different paths of convergence. Fixed capital per worker (‘capital intensity’) was roughly 25 % of the United States (often assumed the world technological frontier) in 2014. The growth rate of labor productivity average 3.6 % annually during the last 20 years (‘low’ case). As mentioned, demographic trends are detrimental and the labor force is expected to decline on average by 1.2 % per anno over the next 80 years.
At the current pace of technological progress Ukraine will remain a relatively poor country in the long run. Capital accumulation is too slow to make the country wealthier in the foreseeable future. Hence, Ukraine must improve in productivity and efficient use of available technology. Triffin calculated that in such a “high-case” growth scenario technological progress (total factor productivity) could increase by almost 8 % annually, while in a “baseline” scenario productivity growth of almost 5 % was estimated (‘medium’ case).
Figure 4: Long-run growth
What should be done? During the last two years, an anticorruption bureau (NABU) and a comprehensive asset declaration mechanism were established. The comprehensive asset declaration conducted in October 2016 required high-level officials to declare legally and beneficially owned assets including assets owned by relatives and abroad. Members of parliament collectively declared a total of almost half a billion USD in banknotes.
Particularly, the establishment of an anticorruption court is a pending action conditioning continuing support under the Extended Fund Facility (EFF) with the International Monetary Fund (IMF). By mid of the year, the implementation would trigger the payment of the fifth tranche under the EFF.
Inflation and financial stability
It is broadly honoured that Ukraine made considerable progress in the implementation of an independent central bank operating in an inflation targeting framework including a flexible exchange rate regime. For 2018 the inflation target was set to 6 % to move to a long-term inflation target of 5 % afterwards. However, consumer price inflation reaccelerated during last year (Figure 5 - see pdf).
In January, the consumer price inflation was 14.1 %. The rise was recently driven by volatile price segments of food (17.8 %) and energy prices (10.7 %) as well as services prices (11.7 %). Against that background, the National Bank of Ukraine (NBU) had to resume a rate hiking cycle since last October, first, to offer a reasonable real interest rate to foreign investors and, second, to restore and underline credibility in switching to an inflation targeting regime. The main policy rate was brought from 12 % in October of last year to 17 % in February. Inflation expectations of economic agents remain high in the country. The NBU believes that after several policy rate increases, the current monetary conditions are sufficiently tight to bring inflation back to its mid-term target (March statement). Continuation of the IMF programme is also key for financial and foreign exchange stability. FX reserves increased to 18.4 bn USD in January from below 10 bn USD during 2015 (Figure 6 - see pdf).
Total foreign debt had peaked in 2015 at almost 70 % of GDP. Foreign government debt amounted to 38.9 bn USD and foreign indebtedness of the corporate sector was 6.5 bn USD, while direct investment has been declining to 9.3 bn USD in Q3 2017. In total, foreign debt amounted to 52 % of GDP (Figure 7 - see pdf).
Overall public debt to GDP is estimated at 74 % and the budget deficit was in line with the IMF requirement of 1.5 % of GDP in 2017 (Ministry of Finance).
Developments in the banking sector have been stabilizing. Lending to private households recovered last year and increased by 6.6 % (y/y) in December, while corporate lending turned only marginally positive by year-end 2017 (+1.0 % y/y). According to data from the NBU, average local currency lending rates remained very high for households (~30 %) while firms are charged with interest cost around 15 %. Interbank lending has overall come down but increased recently (15.4 % unsecured overnight loans & deposits). UAH deposits were increased by ~20 % (y/y) in December indicating rising confidence in the local currency and the banking sector (Figure 8 - see pdf).
In summary, the macroeconomy stabilized and a recovery has been underway. Ukraine witnessed a heavy emigration wave since 2015 and long-term demographic change appears detrimental to potential growth and convergence. That said, development remains critically dependent on technological catch-up. Particularly, the fight against corruption has been highlighted recently snatching some low hanging fruits for medium-term convergence. Financial stability – a precondition for growth – increased in recent years.
Martin Ertl Franz Zobl
Chief Economist Economist
UNIQA Capital Markets GmbH UNIQA Capital Markets GmbH
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