Global Financial Crisis – A Test for Ukraine

Before discussing future implications of the global financial crisis for Ukraine’s economy, let us consider if it has already affected us. The national economic system is integrated into the world economy closely enough to be involved in the global processes. The eroded macro-stability of international markets could not but impact internal developments in Ukraine. The global financial crisis of 2007-2008, as any other, has been unfolding in several waves. We have survived the first two without big losses, although not without mistakes.

The first wave rose in 2007, when stock indices of the world’s leading banks and financial institutions went down. Under the circumstances, risk capital looking for stable yet high-profitability markets moved from developed to emerging markets, which continued to show high growth rates and profitability. According to financial experts, the risk to profitability ratio in those emerging markets was fairly attractive. As a result, stock markets in respective countries grew in 2007, China and Ukraine being leaders of such growth.

The inflow of credits was also substantial: in 2007, Ukrainian economy borrowed USD 24.3 billion in middle- and long-term credits.

The second wave started in early 2008, when the ongoing fall in the world stock markets re-directed cash flows from one class of assets to another, in particular to commodities and energy resources. These assets became more marketable, and commodity prices soared up. In January-July, average metal prices in eight regions of the world rose by 81%; “Brent” oil price rose by 32%. By the time first favourable forecasts appeared as to the global gross grain harvest in 2008/2009 marketing year, wheat prices (USA, FOB) for 2007/2008 marketing year had grown by 79%, on average.

Ukraine’s economy responded to the above challenges in the following way.

The overall inflationary background intensified. Inflationary spiral, set spinning in 2007, has been in motion in 2008. Political instability affected economy. Over the first eight months of 2008, industrial manufacturers’ prices grew by 36.5%, especially in such sectors as mining of mineral resources (except for fuel-and-energy ones) by 70.4%; metallurgy and metal works by 68.1%, coke production by 64.3%; and the chemical industry by 55.9%. All of these sectors are oriented towards foreign markets or towards servicing export-oriented production.

The convergence factor (resulting from openness of the Ukrainian economy to global trends, e.g. to the 2008 consumer price rise in most countries of the world) also accelerated inflation processes in the domestic consumer markets. In September CPI amounted to 101.1% (in January-September it amounted to 116.1%), but it was much less than in 2006 and 2007, when it grew by 2.0% and 2.2%, respectively. So in general, in Q3 Ukraine had the lowest rate of price rise in the last four years – as low as 0.5%. The overall inflation was driven, first and foremost, by rising prices (tariffs) for services.

The role of export-oriented production in the country’s economic growth increased. In early 2008, production growth in export-oriented sectors accelerated, and the financial resources of the national economy were re-distributed, in particular through the banking system, from other sectors into commodities and export-oriented ones. Thus, in the first seven months of 2008, production growth in metallurgy was 3.5%; in the chemical industry it was 5.2%. It accounted for relatively high growth rates in industry at large –7.3%.

Over the same period, the share of profitable companies in the total number of enterprises increased from 65.1% in January-July 2007 to 66.9% in January-July 2008, and their profits boosted by 71.7% as compared to the corresponding period of 2007. Leaders of profitability growth were coke production and oil refinement (by 5.7 times), the mining industry (by 2.2 times), and chemical and petrochemical industries (by 2.5 times).

Lending also increased, especially in such sectors as agriculture (135.1%), coke production and oil refining (132.5%), machine building (132.1%), chemical and petrochemical industries (130,6%).

In early 2008, the Ukrainian economy remained attractive for foreign investors. The growth of total foreign capital investments in the national economy was 2.7 times as rapid as in the corresponding period of 2007. And again, most essential capital investments went to well-performing sectors: agriculture (149.7%), banking and financial activity (142.1%), coke production and oil refining (123%).

Against a backdrop of positive balance of payments and excessive supply of hard currency, the official exchange rate of hryvnia to the US dollar decreased by 3.96% to reach 4.85 UAH/USD in late August. In January-August, foreign currency reserves augmented by USD 56 billion – to USD 38.1billion.

The second wave of the global financial crises set off ripples in the Ukrainian stock market. The PFTS index lost 43.5% in the first seven months of 2008, primarily due to the withdrawal of some foreign investors (the so-called ‘jobbers”) from Ukrainian, as well as from the global, markets and to political instability in Ukraine.

Almost all companies listed on PFTS suffered a decline in share and securities prices. Under the conditions of free capital flows, the Ukrainian economy demonstrated market-driven tendencies to seeking super-profits, which enhanced its export-oriented and commodity components, especially given intensified commodity drivers in the global markets.

The third wave of the global financial crisis is unfolding before our eyes.

It has already caused a series of bankruptcies of the world’s leading financial companies and financial crisis rollover to the real economy sector, drop in demand on global markets and, as a result, plummeting commodity prices and stagnation of leading economies. In August-September, average metal prices in eight regions of the world fell by 18.3%, and oil prices fell by 26.5%.

The Ukrainian economy has not yet felt the consequences of the third wave in full. At this juncture, it is hard to estimate their severity and duration, but some impact has been obvious.

Thus, in August, for the first time since October 2002, industrial production decreased by 0.5% (y-o-y), in particular in metallurgy – by 8.6%, the chemical industry – by 9.1%, and coke production and oil refining – by 4.9%.

In other words, a set of external shocks, coupled with the export-oriented companies’ strategy geared towards searching out niches in foreign markets while underestimating domestic ones, slowed growth, which, in the first eight months of 2008, was as low as 2% in metallurgy and 3.5% in the chemical industry. In general, rates of industrial production growth fell to 6.3% in the first eight months of 2008.

The PFTS index continued to go down, losing another 43% in the last two months. Bad news from mining industries and metallurgy had an adverse impact on the PFTS index, too.

In view of the above, the GPD growth of 7.1% was achieved at the expense of other sectors, chiefly, agriculture, where the harvest was unusually rich.

Devaluation processes became manifest in the currency market, and in September foreign currency reserves reduced by USD 0.6 billion. Negative inflation expectations contributed to the overall turmoil. A negative balance of sale/purchase of cash foreign currency by the population amounted to USD 1,321 million.

The third wave of global financial crisis forced governments in the world’s largest economies to revise their policy vis-à-vis financial markets. In particular, the governments of the USA, the UK, Germany, Russia, the Benelux States and other countries decided to support some of the troubled financial institutions.

Investors expect the government of Ukraine to take similar measures. However, the drivers of mortgage and financial crises in the USA and other developed economies and those forming potential negative tendencies in Ukraine’s economy are different.

In order to find solutions allowing for mitigation of the influence of the global crisis on the Ukrainian economy, we should analyze the most likely channels of this influence.

As matters stand, the channel relating to global stock markets is not the most powerful and painful for Ukraine’s economy. Of course, it puts certain pressure on the currency market as the risk (speculative) capital flows out, but it will hardly affect the development of the real economy sector in Ukraine. For one thing, the organized stock market is underdeveloped – only 4.66% of all transactions take place on it. For another thing, foreign investors and other sources of funding, including stock market funds, account for as little as 5%-7% of all investments.

There are other channels of influence, more deeply-felt by the Ukrainian economy.

The first channel is foreign trade. Widespread financial problems have already undermined demand in the international markets. Recession in the world’s leading economies will be accompanied by the decreasing investment demand and poorer dynamics of construction. This, in turn, will continue to drive down prices for metallurgy and machine building products.

Since the Ukrainian economy is highly dependent on exports making up more than 47% of the country’s GDP, the above trends in the global markets will be harmful for the development of export-oriented sectors, with subsequent repercussions on industries relying on exports directly and indirectly.

The second channel is the banking system. The penetration of foreign capital into Ukraine’s financial institutions is considerable. The financial sector is one of the national leaders in attracting foreign direct investments (19% of total accumulated foreign capital). The share of foreign capital in the banking sector amounts to 37.2% of total capital, which exceeds the threshold of economic security established at 30%; in the insurance sector it approaches the threshold value, currently constituting 28.1%.

Given the large share of transnational financial corporations on the Ukrainian banking sector, the global financial crisis could have an indirect adverse impact if mother companies suffer great losses or have liquidity problems.

In this context, it is noteworthy that investments and development of Ukrainian manufacturing companies hinge more on lending than on the stock market: 16% of investments in fixed assets are funded from loans. The most credit-dependent sectors are agriculture, construction, processing industries, including the chemical and petrochemical industry, the food industry, coke production and oil refining.

The third channel of influence is debt. In June 2008, gross foreign debt made up 59.9% of GDP at USD 100.06 billion. Almost 85% of this debt was that of the private sector. According to IMF data, the maximum limit of foreign debt for low and middle income countries is set at 49.7% of GDP; once this limit is exceeded, the probability of financial crisis increases to 70%.

Deteriorating liquidity in global financial markets could slow up lending to the Ukrainian economy. As a result, Ukrainian borrowers will have difficulty refinancing their credit liabilities in external markets.

Furthermore, the share of short-term capital in foreign debt is large (28.2% as of late June 2008). Over the first six months of 2008, the ratio of short-term foreign debt coverage with reserves fell by 15% to 1.258. This capital, in the event of its sudden outflow could contribute to destabilization of the national currency exchange rate.

The current conditions of the national economy development differ a great deal from those of 1998 when Ukraine was also hit by a profound global financial crisis. Now the national economic system is less resistant to financial shocks. Whereas in 1997-1998 corporate debt was small and the corporate sector did not rely so heavily on foreign funding, today the national financial system is more dependent on external cash flows.

If worst comes to worst, and all of the above channels start working at once and in their full capacity, the global financial crisis will have grave consequences for Ukraine:

— the deficit of foreign trade balance will increase sharply to go beyond 10% of GDP, which is critical for emerging economies;

— the positive balance of account of capital transactions and financial transactions will dwindle;

— the positive balance of payments, maintained over the last few years, will turn into a negative one.

In order to prevent dramatic devaluation, the National Bank of Ukraine will have to sell hard currency from its reserves. And yet, it will be a difficult task to achieve. Under the circumstances, GDP growth could slow down to 2.5%- 3%, CPI will go beyond 20%.

It is not about mere situation modeling, other things being equal. Nor is it about analyzing scenarios based on the “what if” principle. Since the 1998 crisis, the national economy has become much more integrated into international financial markets; its structure and development characteristics have changed significantly. Today economic growth is determined by domestic potential, rather than external factors. Households’ consumer demand is growing rapidly, together with investments in renovation of fixed assets and introduction of modern technologies. Ukraine has become an international market player.

In light of the escalating global financial crisis, the government and National Bank have taken a number of measures allowing for the reduction of the risk of its profound destructive influence. They include a package of anti-inflation initiatives, steps to enhance banking sector stability and to minimize the impact of the global financial crisis on Ukraine’s economy. In early 2008, the National Bank passed a resolution toughening requirements to calculating the banks’ regulatory capital adequacy (long-term asset transactions with time of floatation exceeding the time of funding should be additionally risk adjusted at 50% rate and so on), which enabled banks to adjust and improve their position.

In addition, Ukraine has an “insurance police” of sorts in the form of Euro- 2012. If the planned scope of work is fulfilled, the country will get a guaranteed inflow of foreign direct investments, mid-term and long-term loans, because investors worldwide view such events as image-building, promotional projects with low financial risks.

As a popular saying goes, hope for the best and prepare for the worst. The current challenges and threats require that public authorities and the private sector address them effectively and take additional preventive measures.

What can the government do?

Given the risks of reduction in export-oriented production due to weakening global demand and problems with payments under export transactions, the government should work to stimulate domestic demand for the group of export goods and, thus, enhance the role of domestic production. It can start with launching new infrastructure and residential construction projects funded from the state budget. The government should prevent a sharp decline in grain prices by urging the Agrarian Fund to purchase grain of this year’s harvest. It will provide agricultural producers with sufficient resources to prepare and carry out the sowing campaign. It will also support, directly and indirectly, the development of metallurgy, coke production, the mining industry, oil refining, the chemical industry, the food processing industry, trade and transport.

In order to manage the financial instability risk, it is strongly advisable to revise the draft 2009 budget so as to increase capital expenditures, including in construction, without increasing the budget deficit. It is also important to set up a Stabilization Fund that will cover all governmental guarantees, which will gain more confidence in the governmental commitment to pursue a well-balanced and sound budget policy.

In times of financial crisis, the government’s strategy is to encourage investments into the real sector of the economy. To this end, alongside accelerating the implementation of projects related to Euro-2012, we should unblock privatization processes. The government cannot do that alone, we need support from the Verkhovna Rada to get the State Privatization Programme adopted. Parliament should also pass a package of laws drafted by the government and geared towards boosting Ukraine’s investment attractiveness.

What can NBU do?

In order to prevent a banking crisis, NBU should establish principles of refinancing commercial banks that have short-term liquidity problems for the period of financial crisis. A currency crisis can be averted with a series of measures precluding the exchange rate destabilization by speculators. NBU should continue to pursue the policy of increasing the rate volatility in order to reduce risks to the balance of payments.

What can businesses and investors do?

Given the limited financial resources inside the country and shrinking access to foreign loans, businesses face a difficult choice: either to suspend production and lose markets, maintaining high prices in expectation of better times, or to reduce prices trying to restore demand and keep consumers. The latter option is for those manufacturers who care about their future, expansion and economy of scale; the former is for profiteers who make large money quickly and drop the production.

The government can undertake to hold consultations aiming to sign memoranda with investors and large businesses on reducing prices for goods and services.

Only the concerted efforts of the government and National Bank, supported by Parliament and the business community will enable the Ukrainian economy to pass the maturity test in times of global financial crisis.

Advertising