Inflation in check but currency risk still elevated
After the National Bank of Ukraine (NBU, the central bank) abandoned the peg of the UAH to the USD (at 1:8) in February 2014, the currency experienced a sharp downward correction and heavy volatility. At the end of 2016, it had lost around -70% in value. Since then, the UAH has more or less stabilized in line with the economy, recording reasonably small losses in 2017-2018 and a +5% gain in 2019. In the wake of the global Covid-19 crisis – and also due to the government reshuffle in March 2020, which shook investor confidence – the currency then lost -16% vs. the USD in the first nine months of 2020, reflecting that the exchange rate will remain vulnerable to external shocks. Bouts of currency volatility will also continue to be likely in response to significant political events and/or surprising economic data.
As the UAH had steadied in 2017, by and large, headline consumer price inflation decelerated rapidly and has been in single-digit territory since mid-2018. It fell to a temporary low of 1.7% y/y in May 2020, before slightly picking up to 2.5% y/y by August 2020, mainly driven by imported inflation in the wake of the weakening of the UAH. Meanwhile, after a period of monetary tightening until September 2018, the NBU cut its key monetary policy interest rate successively by a cumulative 1,200bp to 6% between April 2019 and June 2020, in line with the fading inflationary pressures. Looking ahead, we expect the currency weakening to cause a pick-up of inflation, moving it into the 5% ± 1pp target range of the NBU until the end of 2021. Hence, until then, the room for further monetary easing by the NBU is limited to another 50bp or so.
Public finances remain a concern
Public finances rapidly deteriorated in the wake of the 2014 crises, with the fiscal deficit surging to a peak of -10.1% of GDP in 2014 and public debt rising to 81% of GDP in 2016 (up from 37% in 2011). Since May 2014, financial support from the IMF, the EU and other bilateral and multilateral partners, as well as a debt restructuring of USD15bn or so with 13 private creditors, helped to stabilize public finances. Against this background, the annual fiscal deficit narrowed and came in below -3% of GDP from 2015 to 2019 and public debt fell to 57% of GDP at end-2019.
Declining nominal GDP and Covid-19-related fiscal stimulus will widen the fiscal deficit again to an estimated -6.5% of GDP in 2020 and -4% in 2021. This will increase public debt to around 65% of GDP in 2021, a ratio posing some refinancing concerns and a risk to the recovery in the medium term.
The IMF approved a USD5bn support package in June 2020, which also paved the way for approximately USD3bn from the EU and the World Bank. Ukraine signed an agreement with the EU on 23 July 2020 to provide EUR1.2bn. The funds are part of an EU macro-financial assistance package of EUR3bn for ten neighboring countries to tackle the Covid-19 crisis.
The funds of international donors could enable Ukraine to finance the state budget and service its debt in the next two years or so. However, the IMF and the EU are making loan tranches dependent on the further progress of the reform process. Key points are the guarantee of the independence of the NBU and improvements in the fight against corruption and the judicial system. Due to current trends in politics, there remains a significant uncertainty about the further disbursement of tranches. After all, Ukraine has historically a poor record with regard to completing IMF programs.