A loom­ing cash crunch?

Why are Ukraine's pub­lic fi­nances start­ing to look shaky?

The Ukrainian Week - - CONTENTS - Li­ubomyr Shaval­iuk

James Freeman Clarke’s fa­mous state­ment, “A politi­cian thinks about the next elec­tion, while a states­man thinks about the next gen­er­a­tion,” is a good way to de­scribe the sit­u­a­tion in Ukraine to­day. The coun­try is nowhere close to suc­cess­fully com­plet­ing its many re­forms and it’s bur­dened by sub­stan­tial pub­lic debt that it needs a ma­jor in­jec­tion of cap­i­tal to re­fi­nance over the next two years. And th­ese are not the only national-scale prob­lems Ukraine is cur­rently fac­ing. Its states­men have barely be­gun to cope with the chal­lenges—ex­cept that Ukraine has no one of that cal­iber to han­dle them. It’s estab­lish­ment is largely politi­cians and not states­men. As elec­tions draw near, they are busy op­er­at­ing on the po­lit­i­cal sur­face, like the cheese on Rocky the Rat in the Dis­ney car­toon Chip 'n Dale: Res­cue Rangers work­ing to hyp­no­tize and dis­com­bob­u­late vot­ers. Politi­cians are start­ing to get hung up on rat­ings and are com­pletely ig­nor­ing the coun­try’s myr­iad of com­pli­cated prob­lems, leav­ing an ad­min­is­tra­tive vac­uum. This threat­ens to turn Ukraine’s mod­est achieve­ments of the last few years to dust.

A GROW­ING DEFICIT

Take the sit­u­a­tion with pub­lic fi­nances to­day. Ac­cord­ing to the Trea­sury, the rev­enue side of the state bud­get was 96.9% ful­filled dur­ing QI’18, which means pub­lic cof­fers were about 3.1% off planned, or nearly UAH 6.2 bil­lion. Is this nor­mal or some­thing to worry about? On one hand, this short­fall in col­lec­tions could be caused by a sub­stan­tial jump in VAT re­funds, which went up 25% or UAH 6.7bn com­pared to QI’17, as the sys­tem has been au­to­mated in that time. Mean­ing this could re­flect a short­fall in the abil­ity of those who were plan­ning to do their math prop­erly.

On the other hand, the bud­get was un­der-ful­filled at a time when ac­tual in­fla­tion for the quar­ter was 13.8%— nearly dou­ble the 7% set in the 2018 bud­get for the en­tire year. Had it been lower, bud­get spend­ing could have been lower as well. The se­ri­ous­ness of the sit­u­a­tion is also re­flected in the slower growth of rev­enues, both com­pared to last year and com­pared to what was used in draw­ing up the bud­get. Both tax and cus­toms in­comes have been be­low planned. In short, this gap can­not sim­ply be sloughed off: it could be the first in­di­ca­tion of a down­ward trend that could even­tu­ally threaten the coun­try’s fi­nan­cial sta­bil­ity.

The re­sult has been a rel­a­tively high bud­get deficit of UAH 20.6bn for QI, which is 111% higher than for the same pe­riod of 2017—and al­ready 25.4% higher than the planned deficit for the en­tire year. This kind of sit­u­a­tion is ex­tremely rare, given that the first months of most years typ­i­cally post a sur­plus. And it con­sti­tutes an­other warn­ing bell. As the elec­tion sea­son draws nearer, the level of pop­ulism in do­mes­tic pol­i­tics will only grow, which means that most politi­cians will be less con­cerned about a bal­anced bud­get than about in­creas­ing so­cial ben­e­fits, re­gard­less of whether the Trea­sury ac­tu­ally has the nec­es­sary funds. This will sig­nif­i­cantly in­crease the bud­get deficit over what was planned, espe­cially as the NBU puts all its ef­forts into slow­ing in­fla­tion. The govern­ment will also fail to meet the frame­work in­di­ca­tors in the IMF pro­gram and for­feit re­newed co­op­er­a­tion with the Fund, putting ex­ter­nal fi­nanc­ing at risk and lead­ing to fur­ther de­te­ri­o­ra­tion in donor and in­vestor trust in Ukraine.

COSTLY EX­TER­NAL DEBT

Un­til re­cently, there was a cer­tain level of trust among for­eign in­vestors to­wards Ukraine, but it is slowly be­ing lost, as the sit­u­a­tion with govern­ment eu­robonds am­ply il­lus­trates. In Septem­ber 2017, Ukraine suc­cess­fully placed sov­er­eign eu­robonds with a yield of 7.375%. By mid-May, yields on this is­sue had al­ready climbed to 8.0%, and even 9.0% on cer­tain days (seeRates on the rise), while the bonds them­selves went down in value over 7% of the nom­i­nal rate. Most of th­ese losses were in re­cent weeks, as well. All of this, of course, can be blamed on the US’s re­stric­tive mon­e­tary pol­icy, the grow­ing cost of money around the world, and grow­ing yields on US Tbills. But when the top class of bonds is get­ting cheaper, bonds with junk-level rat­ings like Ukraine’s face con­sid-

er­able cau­tion among in­vestors and de­mand for them— and their value—col­lapses from time to time.

In short, an un­pleas­ant mo­ment of reck­on­ing looms. The 2018 bud­get was based on at­tract­ing more than UAH 108bn in ex­ter­nal fi­nanc­ing, but QI saw only a tiny frac­tion of this, UAH 0.9bn. This is un­sur­pris­ing, given that the break in IMF credits has lasted for over a year and, un­less co­op­er­a­tion is re­stored, other in­ter­na­tional donors will not pro­vide fi­nanc­ing, ei­ther.

A few months ago, Fi­nance Min­is­ter Olek­sandr Dany­lyuk an­nounced calmly that his min­istry was feel­ing con­fi­dent and pre­pared to qui­etly look for the best time to place an­other is­sue of ex­ter­nal eu­robonds in 2018. Now, it looks like that mo­ment has slipped away. Yields are ris­ing and, af­ter a se­ries of crashes on global fi­nan­cial mar­kets in Fe­bru­ary, the sit­u­a­tion has be­come tense and is slowly get­ting worse. This means that any is­sue of eu­robonds will be au­to­mat­i­cally costly for the bud­get and ipso facto spoil the in­vest­ment mood, sig­nal­ing, as it does, that the Ukrainian Govern­ment is try­ing to put out fires that it can’t put out in a more nor­mal fashion us­ing other in­stru­ments. Un­like 2017, such a place­ment is likely to be the trig­ger for cap­i­tal to flee the coun­try, rather than a way to at­tract in­vestors. And that could bring on a new fi­nan­cial cri­sis like the one Ukraine went through four years ago.

TRICKY DO­MES­TIC DEBT

Al­to­gether, this year’s bud­get an­tic­i­pates a net bal­ance of for­eign debt, mean­ing bor­row­ing mi­nus set­tling, of UAH 46.5bn although the Govern­ment ac­tu­ally paid off UAH 8.4bn more in QI than it is­sued. It’s be­come clear that, with­out IMF as­sis­tance, fi­nanc­ing th­ese kinds of num­bers is quite un­re­al­is­tic. The­o­ret­i­cally, Ukraine could try to switch to do­mes­tic bonds, but it’s not clear if that’s any more re­al­is­tic.

Anal­y­sis shows (see Un­re­li­able support) that things are not look­ing so good on this mar­ket, ei­ther. Key coun­ter­par­ties have re­duced their hold­ings of do­mes­tic govern­ment bonds. The NBU is do­ing this in support of its in­fla­tion-tar­get­ing pol­icy, which re­quires re­ject­ing the kind of fis­cal dom­i­na­tion, where the cen­tral bank is forced, un­der pres­sure from the Govern­ment, to buy up govern­ment bonds in suf­fi­cient vol­umes by print­ing more money. The Bank has re­fused to buy such bonds and is, on the con­trary, re­duc­ing its port­fo­lio by grad­u­ally pay­ing out the pa­pers it has. If the sit­u­a­tion should be­come crit­i­cal, the reg­u­la­tor might soften its po­si­tion, but so far the NBU is hold­ing very firm.If the ad­di­tional fac­tor of loom­ing elec­tions is taken into ac­count, when any money that is printed will go to cover pop­ulist prom­ises—good luck with bonds.

Since Jan­uary 2018 do­mes­tic banks have also not been ex­pand­ing their do­mes­tic bond port­fo­lios. In the last few years, they were buy­ing up do­mes­tic bonds be­cause they had no other op­tions for plac­ing their money. Right now, lend­ing to the pub­lic and to busi­ness has picked up pace, so the main fi­nan­cial re­sources of com­mer­cial banks are go­ing to that.

Un­der the cir­cum­stances, the vol­ume of do­mes­tic bonds in cir­cu­la­tion has been shrink­ing. This places the Govern­ment’s ca­pac­ity, not just to cover the short­age of ex­ter­nal fi­nanc­ing by bor­row­ing on the do­mes­tic mar­ket, but even to meet its ob­jec­tives for strictly do­mes­tic bor­row­ings, un­der con­sid­er­able doubt. The pace at which the cir­cu­la­tion of do­mes­tic bonds has been de­clin­ing would be much higher if for­eign spec­u­la­tors hadn’t taken ad­van­tage of the ex­pen­sive dol­lar to buy up govern­ment bonds in the first months of 2018. This al­lowed them to pick up hryv­nia pa­pers and get high coupon yields. This led to the sale of nearly UAH 10bn in do­mes­tic govern­ment bonds in early 2018. As soon as the hryv­nia grew stronger, how­ever, such spec­u­la­tors be­gan to cover their po­si­tions and to­day only UAH 3bn of this amount is still in cir­cu­la­tion. By fall, there’s likely to be only a mar­ginal amount left on non-res­i­dent ac­counts.

Trea­sury re­ports that the rev­enue side of the state bud­get was 96.9% ful­filled dur­ing QI'18, which means pub­lic cof­fers were about 3.1% off planned—nearly UAH 6.2 bil­lion

Sig­nif­i­cantly, none of th­ese coun­ter­par­ties are at­tracted by high in­ter­est rates, which have been creep­ing up­ward as the NBU raises the prime rate (see Rates on the rise). So far, this has done noth­ing to stop the de­cline in the vol­ume of do­mes­tic govern­ment bonds in cir­cu­la­tion. Mar­ket play­ers say that de­mand for new is­sues is even lower than the size of the pay­out that coun­ter­par­ties are get­ting on their old bonds.

This is yet an­other wor­ri­some sig­nal that the rev­enue curve il­lus­trates per­fectly. Un­der nor­mal cir­cum­stances, the higher the term of a bond, the higher the yield on it, be­cause longer-term bonds are per­ceived as a greater risk than short-term ones. How­ever, when the sit­u­a­tion is un­cer­tain, short-term bonds have higher yields be­cause of the con­cen­tra­tion of risks as­so­ci­ated with them in the near­est term. Ac­cord­ing to Dragon Cap­i­tal, the yields on 90-day bonds are al­most an en­tire per­cent­age point higher than on 24-month ones. This means that in­vestors are al­ready see­ing risks in the state bud­get that are likely to make them­selves known over the next few months. Given all th­ese fac­tors, MinFin will have a very hard time get­ting do­mes­tic debt in the nec­es­sary vol­umes.

THREE NOT-SO-LIT­TLE RISKS

In short, Ukraine’s pub­lic fi­nances face three ma­jor risks to­day. First is that bud­get rev­enues will be overly low as in­fla­tion goes down but the econ­omy fails to pick up pace quickly enough. This will ef­fec­tively ex­pand the deficit.

Sec­ond is the ap­proach of elec­tions, which will fos­ter a grow­ing pop­ulism in the cur­rent Ad­min­is­tra­tion through a push­for ex­or­bi­tant raises to pen­sions, min­i­mum wages and the sub­sis­tence min­i­mum. This will also ex­pand the bud­get deficit. A few weeks ago, Premier Groys­man said in an in­ter­view that there were no means to raise the min­i­mum wage to UAH 4.200 from its cur­rent UAH 3.723. This was a very strong state­ment, given that politi­cians nor­mally never pub­licly ad­mit that the bud­get might be fac­ing con­straints. There’s the im­pres­sion that the Govern­ment has fi­nally come down to earth, and de­cided to fi­nally stop the race to so­cial pop­ulism and make the pace of growth of ben­e­fits con­tin­gent on eco­nomic growth. But this state­ment could also just be an el­e­ment in po­lit­i­cal bar­gain­ing, in a con­flict be­tween the pres­i­dent and his PM that has been widely ru­mored lately. It’s pos­si­ble that, as soon as Poroshenko and Groys­man agree to their re­spec­tive spheres of in­flu­ence and come to an agree­ment about their start­ing po­si­tions in the next elec­tions, the pop­ulist race will be on again.

And the third and fi­nal risk: the lack of fi­nanc­ing to cover the bud­get deficit suf­fi­ciently. This risk has a num­ber of com­po­nents, the great­est of which is con­tin­u­ing un­cer­tainty about whether co­op­er­a­tion with the IMF will be re­stored. Min­is­ter Dany­lyuk keeps ex­press­ing con­fi­dence that, any time now, Ukraine will re­ceive its next tranche. But the money keeps not com­ing in, mak­ing his con­fi­dence look more like bluffing with a bad hand. For the IMF’s con­di­tions to be met, the coun­try needs a work­ing leg­is­la­ture. But with the ap­proach­ing elec­tions, both pres­i­dent and premier are slowly los­ing their abil­ity to con­sol­i­date a ma­jor­ity in the Rada to en­sure that the nec­es­sary leg­is­la­tion is passed. The con­flict be­tween Poroshenko and Groys­man, added to the pres­i­dent’s low per­sonal rat­ings, is a real de­mo­ti­vat­ing fac­tor for law­mak­ers, who are scat­ter­ing like sheep with­out their shep­herd and more con­cerned now with op­tions for their own po­lit­i­cal fu­tures.

In short, the chances that nec­es­sary poli­cies will still be adopted, when they didn’t make it while the po­lit­i­cal sit­u­a­tion was far more fa­vor­able, are not good. Land re­form, an over­haul of the ju­di­ciary, the launch of pri­va­ti­za­tion and other changes are a nec­es­sary con­di­tion for the econ­omy to pick up, in­vest­ment to come in and GDP to grow. And all of those are nec­es­sary for the bud­get to see more rev­enues. A govern­ment that failed to push for­ward on th­ese is­sues when times were eas­ier is un­likely to push now, no mat­ter how much money the IMF prom­ises.

A fi­nal nega­tive fac­tor is the like­li­hood that the bud­get deficit will grow be­yond the lim­its es­tab­lished in the Fund’s cred­it­ing pro­gram. For the IMF, this will be the last straw, espe­cially if the deficit is caused by a wave of pop­ulist so­cial poli­cies.

NOW WHAT?

Based on the­o­ret­i­cal pro­jec­tions, the threat that all three risks will co­in­cide is for­tu­nately very low.But if they do, what­ever sur­plus the Trea­sury has will soon dis­ap­pear. In­deed, by early May this year, the con­sol­i­dated Trea­sury ac­count had only UAH 5.5bn, an amount that is cycli­cally the low­est since the 2014 cri­sis (see Go­ing aground). By the end of this year, the sit­u­a­tion is likely to only get worse. More­over, the Govern­ment could find it­self reach­ing into the pock­ets of cen­tral and lo­cal ex­ec­u­tive bod­ies, which have been al­lowed through the de­cen­tral­iza­tion process to keep their funds in com­mer­cial banks. At that point, it will be clear that the coun­try is in a fis­cal cri­sis— which will do lit­tle for the rat­ings of the top politi­cians go­ing into the elec­tions.

So far, the worst has not hap­pened, but it’s high time to think about why this is hap­pen­ing. The minute the threat of an eco­nomic crash re­ceded, the pop­ulist race was on. Ukraini­ans haven’t for­got­ten­how then-PM Vik­tor Yanukovych dou­bled pen­sions in the fall of 2004 dur­ing his first pres­i­den­tial bid, bring­ing eco­nomic growth down from 12% to 8%. In 2015, then-PM Arseniy Yat­se­niuk raised so­cial ben­e­fits two months ear­lier than planned in or­der to im­press vot­ers in the run-up to lo­cal elec­tions. And the cur­rent PM used the funds from pen­sion re­form to raise pen­sions rather than to cover the Pen­sion Fund deficit. They all thought they would get away with it—but they didn’t. Now we can see the story that the num­bers tell and soon it will be ev­i­dent to the naked eye.

Could the govern­ment not have been less caught up in pop­ulism, see­ing as it was still far to the elec­tions, both last year and the year be­fore? Of course, it could. But it wasn’t, and the re­sult is quite pre­dictable: the pol­i­tics of ir­re­spon­si­bil­ity, short­sight­ed­ness and lucky charms are an in­cur­able dis­ease among Ukraine’s politi­cians. The only thing that will elim­i­nate it is for a new gen­er­a­tion to come to pol­i­tics, this time real states­men. The ques­tion is, where to cul­ti­vate and find them? And it’s a rhetor­i­cal one.

In the end, there could be a peace­ful trans­fer of power af­ter the 2019 elec­tions... and the new lead­er­ship will find the Trea­sury quite empty. This would not be the first time Ukraine has faced such a sit­u­a­tion. It will sim­ply be the lat­est con­fir­ma­tion that the coun­try’s po­lit­i­cal faces may change but the po­lit­i­cal class does not. The one good thing that might come out of all this is that the new team will be forced to work with in­ter­na­tional donors sim­ply be­cause it won’t have any money. In that case, re­forms could get a new shot in the arm. The coun­try will go through yet an­other eco­nomic cri­sis but this time it won’t stop grow­ing.

The 2018 bud­get planned on at­tract­ing over UAH 108bn in ex­ter­nal fi­nanc­ing, but QI saw only UAH 0.9bn come in

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