Ukraine: heading into recession

In the runup to Ukraine’s October 28 parliamentary election, polls show that the majority of Ukrainians want change, a break from the autocratic rule of President Viktor Yanukovich. They aren’t alone.

Ukraine is heading into its second recession in four years. Businesses and investors on the ground see the investment climate getting much worse for everyone – except Yanukovich’s billionaire oligarch backers.

Next week’s election is for parliament only – the presidency won’t be contended until 2015. But by voting in large numbers for the opposition, Ukrainians are expected to voice a deepening dissatisfaction with the Yanukovich regime.

“In 3Q Ukraine went into a recession. We downgrade our real GDP forecast for 2012 to 0%. GDP dynamics in 3Q and 4Q will be negative,” Austria’s Erste Bank said in a note to investors this week.

Source: IMF, Bloomberg, Erste Group Research

“[Economic] activity is sluggish as foreign demand remains weak and maintaining the UAH:USD [currency] peg is coming at an increasing cost to the economy,” added Olena Bilan, chief economist at Kiev-based investment bank Dragon Capital.

The downturn is expected to be much milder than the whopping 15 per cent plunge in GDP that hit Ukraine during the 2009 global recession. But the current economic pain is not winning over any friends for Yanukovich, his government or the ruling Party of Regions.

“Investors have been spooked by looming fiscal pressure, corruption, and general uncertainty in the run up to October’s parliamentary elections,” the Kiev-based European Business Association said when it published its investment attractiveness index this month.

Source: European Business Association

What’s causing the economic downturn?

Global demand for steel, Ukraine’s top export, is drying up. Added to that, “Persistently tight banking system liquidity is pushing bank lending rates to prohibitively high levels, depressing economic growth,” said Bilan at Dragon Capital. With the Euro 2012 football championship in the past, multi-billion-dollar state spending on infrastructure has dried up. The government is redirecting precious resources to a populist, pre-election spending splurge.

This from London-based Capital Economics:

Ukraine’s large external financing requirement and its heavy dependency on industrial exports to Western Europe make it among the most vulnerable countries in Emerging Europe to a re-escalation of the euro-crisis. This, coupled with the potential for political instability following this month’s parliamentary elections, means that growth is likely to disappoint and the [domestic currency] is likely to come under renewed pressure.

With such dark clouds on the horizon, will Ukraine’s leadership re-engage with the International Monetary Fund to unlock billions of dollars of low-interest loans that have been frozen since last year amid lacklusture reform efforts?

Andriy Klyuyev, national security chief and head of the Party of Regions’ election campaign, downplayed the recession threat. “There will be no recession,” he told beyondbrics, while blaming the downturn on deeper troubles in the eurozone. “There will be small growth.”

Ukraine is keen to renew cooperation with the IMF, Klyuyev said, but would not implement one major IMF condition: raising gas prices on households to market levels by cutting costly subsidies that have strained state finances. He called for a compromise.

Deep in election mode, Klyuyev was confident his party would win on October 28, adding that the nation’s cash-stripped citizens simply could not afford to pay higher prices.

In fact, an IMF working paper calls on Ukraine to increase gas prices mostly on the rich, protecting the poor with targeted support. That would go some way to allaying suspicions that subsidised gas is being diverted from households to private business.

Bilan at Dragon Capital predicted that Ukrainian policymakers would – when the election is over and reality sets in – become more “flexible in addressing macroeconomic problems by bringing the IMF program back on track, allowing the currency to adjust and tightening fiscal policy.”

We shall see.