Scenes from a mon­e­tary mar­riage

What will hap­pen with Ukraine if the IMF walks away?

The Ukrainian Week - - CONTENTS - Li­ubomyr Shaval­iuk

What will hap­pen with Ukraine if the In­ter­na­tional Mon­e­tary Fund walks away?

For more than a year now, Ukraine has not re­ceived any tranches from the In­ter­na­tional Mon­e­tary Fund. Time keeps pass­ing, the coun­try’s need for fund­ing keep grow­ing, and as elec­tions loom, Ukraine’s politi­cians keep los­ing their abil­ity, or de­sire, to meet the in­ex­orable con­di­tions of the coun­try’s main lender. The re­sult is that some are pre­dict­ing an in­evitable cri­sis, de­fault, and UAH 50 to the dol­lar, while oth­ers talk about the “in­sa­tiable mon­ster” that keeps in­ter­fer­ing in Ukraine’s in­ter­nal af­fairs and ex­er­cis­ing “out­side in­flu­ence” over the coun­try. Of course, Ukraine’s po­lit­i­cal class can­not live with­out ex­ag­ger­at­ing re­al­ity. But it leads to this ques­tion: what re­ally awaits Ukraine if it fails to re­store fi­nan­cial re­la­tions with the IMF?

A QUES­TION OF TIM­ING

At the mo­ment, the econ­omy ap­pears to be quite steady. GDP and house­hold in­comes are on the rise, in­fla­tion has fi­nally sub­sided some­what, and the cur­rency mar­ket is more-or-less sta­ble. If we look no fur­ther than to­day, things don’t look too bad. But if we look a bit fur­ther ahead, it be­comes im­me­di­ately clear that the cur­rent sit­u­a­tion is un­likely to con­tinue for long. Ac­cord­ing to Na­tional Bank of Ukraine es­ti­mates, Ukraine has to pay off for­eign state loans worth nearly US $17 bil­lion over 2018-2020 (see Money on the Bar­rel) plus more than US $5bn to ser­vice or pay off govern­ment-guar­an­teed loans made to state-owned cor­po­ra­tions. The NBU cur­rently has a bit over US $18bn in re­serves, mean­ing that there’s not even to just set­tle com­pletely with the coun­try’s cred­i­tors, never mind mak­ing it through this pe­riod of high pay­ments with­out strain. All this quite nat­u­rally raises se­ri­ous con­cerns.

Still, we have to be aware of this con­cern, which means look­ing at the de­tails in depth. The high pay­out pe­riod can be con­di­tion­ally di­vided into three sec­tions. The first is prior to the next pres­i­den­tial elec­tion slated for March 2019. This is ap­prox­i­mately when the cur­rent IMF co­op­er­a­tion pro­gram ends, which means Ukraine can prob­a­bly only count on IMF cred­its dur­ing this pe­riod, since the launch of a new pro­gram is a com­pletely sep­a­rate mat­ter. Ac­cord­ing to the NBU, the three quar­ters that re­main in this par­tic­u­lar slice will re­quire Ukraine to pay out about US $3.8bn in ex­ter­nal govern­ment bonds—not a crit­i­cal amount, but sig­nif­i­cant. The Bank rightly be­lieves that if Ukraine man­ages to get two more tranches be­fore the cur­rent pro­gram ends, there will be no need to re­fi­nance ex­ter­nal debts prior to the pres­i­den­tial vote.

The sec­ond pe­riod is be­tween the pres­i­den­tial and Verkhovna Rada votes. Roughly speak­ing this means QII and III of 2019, dur­ing which Ukraine has to pay out over US $3.9bn more. This time will likely be the hard­est, as the cur­rent IMF pro­gram will have ended and there might be no one to sign the next one with at that point, as that will re­quire a func­tional leg­is­la­ture ca­pa­ble of pass­ing the nec­es­sary leg­is­la­tion to meet IMF re­quire­ments. The Rada’s func­tion­ing is al­ready ques­tion­able, even though the po­lit­i­cal sit­u­a­tion is much clearer now than it will be at that point. More­over, sign­ing a new pro­gram will re­quire spe­cific con­tact per­sons within the Govern­ment to hold talks with the Fund and en­sure its ful­fill­ment. In the cur­rent Cabi­net, Fi­nance Min­is­ter Olek­sandr Danyliuk was that per­son. Since his res­ig­na­tion, there has been no ap­pro­pri­ate chan­nel for co­op­er­a­tion and no one’s in a hurry to re-es­tab­lish one, so far. Things could eas­ily con­tinue like this un­til the next par­lia­men­tary elec­tion, which means it would be good to have some spare fi­nan­cial strength for this pe­riod in the form of sub­stan­tial gold and cur­rency re­serves. That’s, of course, the ideal, while re­al­ity is con­sid­er­ably far be­hind right now.

Now comes the third pe­riod, af­ter the VR elec­tion, where the rest of the pay­ments come due. At that point, the sums will be far more sub­stan­tial but they will be com­ing due at

a point when the po­lit­i­cal sit­u­a­tion is more cer­tain. There is good rea­son to be­lieve that the coun­try will have a com­pletely func­tional pres­i­dent, par­lia­ment and Govern­ment by the end of next year. No mat­ter who is in power at that point, the need to pay off coun­try’s debts means that Ukraine will have to agree a new pro­gram of co­op­er­a­tion with the IMF.

HE WHO HES­I­TATES IS LOST

One or two more tranches be­fore this pro­gram ends rep­re­sent not just US $1-2bn from the IMF for Ukraine but a few mil­lion more from other for­eign cred­i­tors as well. The to­tal amount would not only cover ex­ter­nal fund­ing needs prior to the pres­i­den­tial elec­tion but also pro­vide a com­fort­able cush­ion for the in­ter-elec­tion pe­riod. But Ukraine still has to re­ceive this money. Un­til re­cently, the main stum­bling block was sup­pos­edly set­ting up the Anti-Cor­rup­tion Court. A few weeks ago, the VR adopted a law that es­tab­lishes the mech­a­nism for the ACC to ex­ist and any day now MPs are sup­posed to adopt a bill that launches the ac­tual process of set­ting it up.

At this point, the sec­ond re­quire­ment of the IMF comes to the fore: rais­ing house­hold gas rates to mar­ket lev­els. This is where the ques­tions be­gin to arise. The Govern­ment has been talk­ing for quite a few months now that it is in the process of es­tab­lish­ing a for­mula for the new rate for nat­u­ral gas. How­ever, this for­mula wasn’t filled with in­te­grals or dif­fer­en­tial equa­tions that it took so long to write out. So the prob­lem is that the Cabi­net keeps try­ing to come up with as low as a rate as while the IMF, as usual, is re­lent­less in its re­quire­ments. It’s not easy to find con­sen­sus in this kind of sit­u­a­tion.

Ac­cord­ing to Na­tional Bank of Ukraine es­ti­mates, Ukraine has to pay off for­eign state loans worth nearly US $17 bil­lion over 2018-2020 plus more than US $5 bil­lion to ser­vice or pay off gov­ern­ment­guar­an­teed loans made to state-owned cor­po­ra­tions

The prob­lem is that the Govern­ment is be­ing stub­born and short­sighted. Ob­vi­ously, no one wants to raise house­hold gas rates, and along with them res­i­den­tial ser­vice rates, just be­fore an elec­tion, be­cause it will af­fect the in­cum­bents’ al­ready-low rat­ings. The ques­tion is what stopped them from do­ing this half a year or a year ago? The sub­sidy sys­tem for res­i­den­tial util­i­ties pro­tects a very large share of house­holds any­way, and much of the added in­crease would not re­ally have been no­ticed. At the same time, the prof­its it would bring gas ex­trac­tion com­pa­nies, es­pe­cially state-owned Naftogaz Ukrainy and Ukr­gasvy­dobu­van­nia, which posted nearly UAH 40bn and over UAH 30bn in prof­its last year, would partly cover ad­di­tional bud­get spend­ing to pro­vide larger sub­si­dies. But the Govern­ment did not do so, and now, the like­li­hood that it will do so any time soon, with elec­tions loom­ing, is fad­ing fast.

Nom­i­nally at least, these two re­quire­ments are pretty much all that the IMF wants from Ukraine in or­der to is­sue the next tranche. But there is a third re­quire­ment that al­ways re­mains on the ta­ble—a bal­anced bud­get. Even there, things aren’t quite what they should be to­day, be­cause the Trea­sury re­ports that for the first five months of 2018, the bud­get rev­enue plan was ful­filled 99.4%, but ac­tual spend­ing is some­what higher than an­tic­i­pated. As a re­sult, the deficit is cur­rently above the cap es­tab­lished by the IMF.

As the elec­tions draw close, the pop­ulism keeps grow­ing, in­clud­ing wide­spread talk of yet an­other hike in the min­i­mum wage over 2018 and two more rises to so­cial ben­e­fits are al­ready planned for this year. All of this will merely in­flate the ex­pen­di­ture side of the bud­get and could push the deficit well be­yond the ac­cept­able IMF norm. Will the Fund close its eyes and give Ukraine the next por­tion of money sim­ply to sup­port the cur­rent Govern­ment and its chances of re-elec­tion? It doesn’t seem en­tirely likely.

THE LONG AND SHORT OF IT

If the govern­ment ends up not meet­ing IMF re­quire­ments and get­ting at least one more tranche un­der the cur­rent pro­gram, it will have to look for other op­tions. What choices does Ukraine ac­tu­ally have?

The main al­ter­na­tive un­til re­cently was funds gained from is­su­ing eu­robonds on global cap­i­tal mar­kets. In Septem­ber 2017, Ukraine suc­cess­fully placed 15-year eu­robonds with a coupon value of 7.375%. At that time, de­mand for Ukrainian govern­ment papers was far higher than the sup­ply. But less than a year later and the yields on these bonds are al­ready up to 9% and grow­ing. The longer Ukraine fails to get the next IMF tranche, the more for­eign in­vestors doubt the govern­ment’s abil­ity to ser­vice state debts and the less likely the coun­try will be to at­tract the nec­es­sary cap­i­tal at an ap­pro­pri­ately low in­ter­est rate. An ad­di­tional neg­a­tive fac­tor was the fir­ing of Fi­nance Min­is­ter Olek­sandr Danyliuk, who an­nounced that all his deputies would be leav­ing with him, in­clud­ing the per­son re­spon­si­ble for the 2017 bond place­ment. If this is so, the Govern­ment will lose a work­ing chan­nel linked to world lend­ing mar­kets, con­tacts with fi­nan­cial ad­vi­sors, and so on.

An­other op­tion is fi­nan­cial re­sources on the do­mes­tic mar­ket, al­though there is lit­tle rea­son for op­ti­mism here, too. The main buy­ers of do­mes­tic state bonds or OVDP are the NBU and com­mer­cial banks. The Na­tional Bank has re­jected fis­cal dom­i­na­tion, mean­ing fi­nanc­ing bud­get needs by print­ing money and buy­ing up OVDP in the quan­ti­ties needed by the Govern­ment. If things get re­ally bad, the reg­u­la­tor might soften its po­si­tion, but right now there is no in­di­ca­tion that the Bank is feel­ing flex­i­ble. Mean­while, com­mer­cial banks have been re­duc­ing their OVDP port­fo­lios be­cause they need the money for lend­ing, which of­fers higher in­ter­est rates and is cur­rently ris­ing rapidly again. As a re­sult, the vol­ume of OVDPs in cir­cu­la­tion is shrink­ing: from the be­gin­ning of the year to mid-June, the stock of hryv­ni­ade­nom­i­nated state bonds slipped 0.5%, while the stock of hard cur­rency bonds shrank 1.7% in dol­lar terms. The Govern­ment has been is­su­ing new papers in smaller amounts than it is spend­ing to cover old ones. Right now, it’s not even meet­ing planned fi­nanc­ing for the cur­rent bud­get deficit on the do­mes­tic mar­ket, never mind us­ing such re­sources to cover the short­fall in ex­ter­nal fi­nanc­ing.

A fi­nal op­tion is rais­ing cap­i­tal via pri­va­ti­za­tion. Ev­ery year, the bud­get in­cludes bil­lions in planned rev­enues from the sale of state as­sets, but ev­ery time it ends up bring­ing in noth­ing more than a lot of noise. The same is likely to hap­pen this year. Of course, the sit­u­a­tion with pri­va­ti­za­tion is bet­ter than it was be­fore, be­cause leg­is­la­tion was re­cently passed to sim­plify and prop­erly reg­u­late this process. A few weeks ago, the Govern­ment also ap­proved a list of as­sets for large pri­va­ti­za­tion in 2018, then the State Prop­erty Fund con­firmed it. But the first auc­tion will take place no sooner than in the fourth quar­ter, when cir­cum­stances could be very un­fa­vor­able. More­over, if Ukraine does not re­store co­op­er­a­tion with the IMF by then, in­ter­na­tional in­vestors will have lit­tle con­fi­dence in this pri­va­ti­za­tion.

MONEY CY­CLES AND BLACK SWANS

In short, right now it’s very clear that the al­ter­na­tives to fund­ing from the IMF and other for­eign donors are quite il­lu­sory be­cause there are no guar­an­tees that Ukraine will be able to draw on the nec­es­sary fi­nanc­ing from them. Should events un­fold in an un­fa­vor­able way, the coun­try will have to turn to the NBU’s re­serves un­til the VR elec­tions in 2019. By then, Ukraine will need over US $7.7bn, nearly half of what is in the re­serves to­day.

Here, the de­tails mat­ter. De­mand for hard cur­rency on the in­ter­bank cur­rency mar­ket is cycli­cal (see The In­ter­bank Moguls). In QI-II it tends to be low, so for the last three years, the hryv­nia has tended to strengthen dur­ing this pe­riod and the NBU has been able to sub­stan­tially top up its re­serves. When cir­cum­stances are fa­vor­able, the sums bought up by the Bank dur­ing the first half-year are al­most enough to cover ex­ter­nal pay­ments. In QIII-IV, on the other hand, there is gen­er­ally a short­age of hard cur­rency, which tends to push the dol­lar up and of­ten forces the NBU to sell of part of its re­serves. Over the last few years, this dy­namic did not grow to threat­en­ing pro­por­tions, but in 2018 the sea­sonal short­age of hard cur­rency in the sec­ond half of the year will be com­pounded as the Govern­ment buys more of it up. If this hap­pens on the in­ter­bank cur­rency ex­change, it will lead to a dou­ble deficit, which could, in turn sharply push the dol­lar ex­change rate up­wards: the dol­lar has al­ready crept up slightly, al­though it’s only early July. If the Govern­ment buys it di­rectly from the NBU, there will be a no­tice­able re­duc­tion in the re­serves that could have a neg­a­tive im­pact on the mood among mar­ket par­tic­i­pants, who will then be­gin to spec­u­la­tively hang on to their hard cur­rency. Right now, the Govern­ment has less than US $1bn in hard cur­rency on its NBU ac­count. If no money is forth­com­ing from the IMF, the hryv­nia will be­gin to de­val­u­ate quite rapidly and could cross the UAH 30/USD bar­rier long be­fore the end of the year.

It’s far too soon to talk about UAH 50/USD—cer­tainly in 2018 the chances are al­most none. Still, if re­la­tions with the IMF don’t get back on track this year, it’s quite likely that at the most crit­i­cal mo­ment be­tween the pres­i­den­tial and VR elec­tions, closer to the sec­ond half of 2019, Ukraine will see a cur­rency rush. Ad­di­tional pres­sure will come if the Lon­don court agrees that Rus­sia should get back the US $3bn “Yanukovych loan,” a credit Putin gave Ukraine’s then pres­i­dent ap­par­ently for not hav­ing signed the Ukraine-EU As­so­ci­a­tion Agree­ment. Look­ing at things right now, it seems that no mat­ter what, money will have to be re­turned, but the prob­lem is that this obli­ga­tion could emerge at the most in­ap­pro­pri­ate mo­ment. If that hap­pens, it’s en­tirely pos­si­ble that by the time the VR elec­tion rolls around, Ukraine’s re­serves will look a lot like the min­i­mum that they fell to in early 2015, when the dol­lar spiked. This would set the stage for a fairly se­ri­ous cur­rency panic.

LET’S TALK AC­COUNT­ABIL­ITY

And so, it turns out that con­tin­u­ing co­op­er­a­tion with the IMF is the only sure-fire in­stru­ment for pre­vent­ing yet an­other fi­nan­cial cri­sis in 2018-2019. Only loans from the IMF and other in­ter­na­tional donors can guar­an­tee safe re­fi­nanc­ing for Ukraine’s ex­ter­nal debts over this and next year. All the other op­tions are com­pro­mises, of­ten fairly vir­tual ones at that, that might soften the sit­u­a­tion if they worked, but would do lit­tle to pre­vent a cri­sis.

Un­der the cir­cum­stances, the main is­sue for the coun­try to­day is how many peo­ple are re­ally aware of the threat. Prob­a­bly quite a few be­cause the do­mes­tic press is abuzz with talk about a pos­si­ble crunch. To give credit where credit is due, when the Yanukovych Ad­min­is­tra­tion abruptly stopped work­ing with the IMF af­ter the first tranche, no one said boo about the fact that this could lead to an eco­nomic cri­sis. On the con­trary, all that could be heard then was a cho­rus about “sta­bil­ity and im­prove­ment.” To­day, the sit­u­a­tion is dif­fer­ent, which means the coun­try is chang­ing. There are plenty of peo­ple to­day who are aware of all the risks that the lack of in­ter­ac­tion with the IMF rep­re­sents, al­though they are still in the mi­nor­ity.

Credit should also go to those who have worked cease­lessly to im­ple­ment the IMF re­quire­ments for the last few years. Over 2014-2017, Ukraine re­ceived six tranches worth over US $12.5bn from the Fund within the frame­work of two pro­grams. There were times when the money was came with some in­dul­gence on the part of the IMF, but in other cases dili­gent ef­forts to meet the Fund’s de­mands made it pos­si­ble. Al­to­gether, this has been an un­prece­dented achieve­ment that re­quired enor­mous or­ga­ni­za­tional, hu­man and, above all, men­tal ef­fort. It tes­ti­fies to the fact that Ukraine’s govern­ment ma­chine to­day has plenty of in­di­vid­u­als who are pre­pared to lead the coun­try down the path to a bet­ter fu­ture. At this point, they are not the ones mak­ing key de­ci­sions and are not de­ter­min­ing state pol­icy in many ar­eas. But Ukraine could get to the point where peo­ple like that are in charge. It’s just a mat­ter of time.

One fi­nal com­par­i­son to the past: pre­vi­ously, ev­ery Ukrainian govern­ment played a bal­anc­ing act be­tween eastern and western sources of fund­ing: “If the IMF won’t give it, we’ll take it from Rus­sia.” Of course, there are politi­cians who will hap­pily pro­pose such an ap­proach again or who will at least bring up how well every­body lived dur­ing the times of “sta­bil­ity and im­prove­ment.”

Given the na­ture of Ukraine’s po­lit­i­cal class and the ap­proach­ing cam­paign sea­son, there are con­sid­er­able doubts that even one tranche will come from the IMF be­fore the cur­rent pro­gram runs out. By con­trast, there are none what­so­ever that the dol­lar will cost UAH 30 in a year’s time. Whether this will be a sea­sonal spike, af­ter which the hryv­nia will once again ap­pre­ci­ate in QI 2019, or whether it will be­come the spring­board for a new leap into a mas­sive cur­rency panic should be­come clear pretty quickly.

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