A looming cash crunch?
Why are Ukraine's public finances starting to look shaky?
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.
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