January 4, 2013
The slowdown in the Ukrainian economy intensified in August-September, affected by further weakening of the external environment and softening domestic demand. Ukraine’s industrial output fell by 4.7% yoy in August and 7% yoy in September. Slipping global demand for steel and iron ore weighed on the steel and mining industries. In addition, production of machinery equipment and transport vehicles suffered from increased trade tensions with Russia, the largest consumer of Ukraine’s machinery products. In particular, output production in the machine-building industry fell by almost 17% yoy on average over August-September as the Ukrainian government failed to negotiate an exemption from the utilization fee introduced by Russia on imported cars.
Domestic demand has also been cooling. A steep decline in the construction sector (by about 9% yoy over January-September 2012) signaled the subdued investment activity. Due to strained public finances, an ongoing credit squeeze and restricted access to foreign financing, the current level of investment spending cannot fill the gap left after the completion of large infrastructure projects related to the Euro 2012 football championship. Moreover, a deceleration in retail sales growth to 16% yoy over January-September indicates that private consumption has started to ease. While a deceleration in real wage growth to 11.7% yoy in September contributed to softening demand, consumer spending was likely affected by growing political and economic uncertainties. Due to weaker external and internal growth factors, the Ukrainian economy is forecast to increase by about 1% yoy in 2012.
Worsening real sector performance adversely affected budget revenues, which rose by a nominal 8.7% yoy over the first nine months of 2012. At the same time, expenditures kept gaining momentum on higher social spending ahead of parliamentary elections, causing sharp state budget deficit widening. Although slower economic growth and lower inflation, as well as the practice of collecting tax payments in advance, leaves little room for revenue improvement, the government delayed the fiscal adjustment measures until after the parliamentary elections. On the contrary, during the second half of September and October, the state budget law was amended several times, increasing the state budget deficit target by almost 24% to 2.1% of GDP. Given these developments, we have revised our full-year public sector deficit (including Naftogaz and the Pension Fund) to 5% of GDP in 2012, but believe the necessary adjustments will be made for next year’s budget. The arrival of the technical IMF mission to Ukraine at the end of October to discuss the 2013 budget and the Ukrainian government’s reform measures increases the chances that the IMF program may be resumed at the end of this year/the beginning of 2013.
Ukraine’s inflation remains at a decade low level. In September, consumer prices stayed flat compared to a year ago thanks to continuing reduction in the cost of foodstuffs and beverages, downward adjustment in public transportation tariffs and virtually unchanged utility tariffs. As a result, annual inflation may stay below 4% yoy at the end of 2012. Despite eased inflationary pressures, monetary policy remains tight. The National Bank of Ukraine continues to use a mix of its policy measures (banking sector liquidity regulation, forex interventions, and administrative restrictions) to suppress Hryvnia foreign exchange fluctuations. A relative
stability of the exchange rate, however, was achieved at the cost of subdued bank lending activity. Indeed, the stock of bank loans rose by only 1.2% from January to September this year.
A good agricultural harvest, large grain stockpiles ahead of a new marketing year and elevated world grain prices supported Ukraine’s exports of agricultural products, which expanded by about 50% yoy on average over August-September this year. This improvement, however, could not compensate for weaker exports of other key commodity groups (metallurgy, machinery, minerals). As a result, exports slowed to 1.1% yoy in August and fell be about 3% yoy in September. While imports also eased, Ukraine’s current account stood high at about $1.4 billion in August and September. The nine month gap amounted to $9.2 billion and is forecast to reach 6.5% of GDP this year. Growing external imbalances, high external debt financing needs amid turbulent international financial markets and strong population demand for foreign currency generate depreciation pressures. Moderate Hryvnia depreciation may be allowed after parliamentary elections to prevent depletion of gross international reserves beyond three months of imports and improve competitiveness.