Economic developments and outlook of Ukraine in 2014 and 2015 are unusually for open economy determined mostly by domestic than purely external factors. In particular, the situation in the Eastern Ukraine became the key reason for economic recession in Ukraine. Military conflict in Donbas already resulted in sharp drop in industrial output in the third quarter of the year, disrupted supply chains including coal deliveries to power plants, damaged infrastructure and intensified fiscal imbalances. Though we assume that full-scale war with Russia will not start and the situation will calm down by the end of 2014, economic output in Donbas is unlikely to recover next year. Trade tensions with Russia are likely to continue resulting in low demand for Ukraine’s products by Russia. However, we expect that newly elected government will continue reforms that will enable assistance from international donors. Although economic situation will hopefully improve next year as compared to second half of 2014 annual real GDP is forecasted to decline in 2015.
Major factors behind downturn in 2014
Recently the Government, international organisations and experts downgraded their forecasts of real GDP developments in 2014 due to sharp drop in economic activity in Donbas. Military conflict resulted in stoppage or termination of operation of many companies in the area of hostilities (estimated at 18000 sq. km or 2.8% of total Ukrainian area, which includes cities of Donetsk and Luhansk and surrounded towns). Industrial plants that stopped working include significant proportion of installed capacity in steel and chemical industry. Large part of coal mines were forced to reduce or stop their operation. As a result of supply chain disruptions, some companies in other regions also terminated or reduced their operations. As a result, industrial output in September dropped by 16.6 % yoy. It should be noted that decline in industrial production is much milder in the other 23 regions than in Donetsk and Luhansk oblasts (between January and September industrial production dropped by estimated 3.0% yoyreflecting reallocation of production and continued external demand).
Deepening recession led to increasing fiscal gap due to low tax collections and higher demand for social assistance. This forced newly elected government to revise budget and tax laws twice through the year: in March and July. In order to ensure higher fiscal revenues, the Government raised rates of rent payments on natural resources and excise duties, introduced a “military” surcharge to personal income tax (PIT), closed some tax loopholes and cancelled some exemptions including tax free interest income. Still, revenues will still likely fall short of the target in 2014. The Government is also unlikely to raise financing necessary to maintain planned spending levels due to cancelled privatisation and lack of commercial external borrowing. As a result, the Government will have to cut discretionary spending.
High fiscal pressure and heavy financial constraints of companies impacted negatively private consumption and investments. In particular, wages are likely to decline in real terms (due to frozen social standards, low nominal wage increases in private sector against the background of accelerated inflation), while unemployment will increase. Moreover, underemployment will also increase as companies are increasingly shifting their employees to unpaid administrative leaves or shortened work schedule. Frozen social standards such as minimum wage and minimum pension as well as fixed social assistance payments in 2014 will also result in lower purchasing power of Ukrainians. At the same time, households will have to repay much more on foreign currency credits. High recurrent fiscal expenditures and need to increase funding of defence and security will result in sharp contraction of fiscal capital outlays. Companies also delayed their modernisation plans due to financial problems and high economic and political uncertainty. As a result, the drop in gross fixed capital outlays is estimated to reach 30% in 2014.
Over the year hryvnia lost over 38% of its value against US dollar and exchange rate was very volatile. The NBU extensively used administrative measures to contain hryvnia volatility that increased in August. This contradicts approved goal of monetary policy to shift to inflation targeting. Interbank exchange rate stabilized over the last few weeks, although administrative measures led to lower interbank market liquidity and black market for cash foreign currency
At the same time, hryvnia depreciation resulted in imports substitution. Real imports also declined due to lower real consumption and investment demand. Trade tensions with Russia, distortions of production in the East and weak demand of third countries resulted in drop of exports. Still, net real exports contribution to real GDP growth is likely to be positive in 2014.
Real GDP is expected to decline in 2014 and 2015while inflation will remain high
According to the Institute’s forecast real GDP is expected to decline by 7.6% in 2014 and 2.2% in 2015. It should be noted that GDP projected for the next year represents significant improvement of economic activity as compared to the second half of 2014 and we expect that most regions of Ukraine will be able to increase their output in the 2015. However, risks of the forecast remain high. The major risk of escalation of military conflict would result in larger disruptions in production and infrastructure and deficits of critical goods. At the same time, full-scale wartime mobilization (in particular if coupled with external assistance) may provide boost to the output.
Demand side. Real wages in August dropped by 12.7% yoy and decline in wages may accelerate by the end of 2014. Such wage contraction is explained by military conflict in Donbas, frozen public wages, financial constraints of companies and high inflation. Wage decline and increase in unemployment rate (expected to reach 9% according to the ILO methodology) will result in drop of real wage income. Moreover, income from social assistance will also decline due to frozen social standards and inflation. Net bank lending will remain negative, while households will pay more taxes due to introduction of military fee and deposit interest tax. As a result, according to the Institute’s forecast real private final consumption in 2014 will drop by 9.9%. It is expected to further decline in 2015 as according to the Government preliminary plans social standards will further decline in real terms in the framework of fiscal consolidation efforts. Private companies will still face financial constraints and will try to allocate slightly more funds for delayed investments, while labour market is expected to remain weak.
In particular, most companies delayed investments plans in 2014 against high political and economic uncertainty and financial constraints (at 5.2 p.p.). Drop in real gross fixed capital accumulation is expected to reach 30% in 2014. However, volatile economic situation and restricted funding will limit investments in 2015 to most essential projects. Bank lending to private sector will remain weak as political and economic risks will remain high. Fiscal financing of infrastructural projects will also remain limited. As a result, according to the IER forecast real gross fixed capital outlays are estimated to increase by only 1.1% in 2015.
At the same time, net real exports in 2014 is likely to make positive contribution to real GDP growth in 2014 as real imports sharply declined due to lower real private consumption and investments against the background of reduced purchasing power as well as imports substitution explained by sharp hryvnia depreciation. Besides, minerals imports contracted due to lower purchases of natural gas from Russia. Exports also declined due to trade tensions with Russia, weak demand in third countries as well as production disruption in the East of Ukraine. Net real exports contribution to real GDP growth in 2015 will be again negative reflecting higher demand for gas and continued disruption of trade with Russia.
Production side. Industrial output over 9 months of 2014 declined by 8.6% yoy with a drop in manufacturing by 9.4% yoy. Decline in manufacturing pared back to 11% yoy in September (from 19% yoy in August) reflecting one-off effect of earlier processing of sugar beetsinto sugar. At the same time, production also grew in a number of other subsectors including pharmaceuticals, textiles, several branches of food industry, furniture, electrical equipment and specialized machinery. This reflected import substitution, low statistical base and maybe some increase in economic activity in September. Still, in September coke and oil refinery output halved, while output declined by 28.3% yoy in metallurgy and 22.8% yoy in machine building.Highest contraction was observed in Donetsk and Luhansk oblasts where many companies had to stop operation or stopped reporting (mostly food industry in the area of hostilities). Overall, these all trends are likely to continue by the end of 2014 and in the beginning of 2015. Later in 2015 we expect Ukrainian exporters to better cover the demand for Ukrainian exports in all major trading partners, which is expected to be stable or increase moderately through lower trade barriers (except for Russia) Food industry will benefit from autonomous preferences by the EU and progress in certification of Ukrainian products in the EU. Production in Donetsk and Luhansk oblasts are unlikely to recover next year. As a result, real gross value added (GVA) in industry will decline by by 13.7% and 2.0% in 2014 and 2015, respectively.
Agriculture will remain the sector that supports economic growth in 2014. In particular, yields of major crops increased likely due to good weather conditions. Livestock production also continues growing. The IER estimates growth of real GVA in the sector by 4.3% in 2014. However, as such weather conditions are unlikely to repeat real GVA in agriculture is forecasted to decline by 2.1% in 2015.
Decline in domestic demand and industrial production is expected to result in contraction of real GVA in trade by 12.4% in 2014 and 4.5% in 2015. Real GVА in transport is estimated to decline by 6.4% in 2014 in line with lower trade due continued decline in transit, but it was supported by longer supply routes forced by hostilities . Continued adaptation of supply routes will preserve real GVA in the sector in 2015 at 2014 level.
Real GVA in construction is expected to fall by over20% in 2014 due to cut-off or sharply reduced funding for commercial property and engineering works. Increase in demand for residential housing and limited reconstruction in Donbass will allow GVA in the sector to increase by 1.0% next year.
Inflation. In 2015 inflation will remain moderately high. Two rounds of depreciation in 2014 mean that in the beginning of the year it may exceed 20% yoy and inflation expectations will likely be high. Still, we expect CPI growth may come down to single digits by the end of the year even taking into account planned increases in utility tariffs for households including gas, water and electricity and low slack in retail and producer margins (i.e. some producers and retailers reduced their margins to keep market share in challenging environment but will try to recoup lost profits at earliest opportunity). The key reason for expecting swift disinflation is weak nominal demand and favourable external conditions. We expect stable or falling global commodity prices (including food and energy) and stable or some appreciate exchange rate. This will provide external anchor for price level. On domestic side previous experience shows that inflation pressure is disproportionally affected by changes in spending of low-income households. Low nominal increase in social standards and weak labour market will sharply limit domestic inflation pressure. As a result, consumer inflation may come down to 8.5% yoy in December 2015 (from 18.9% yoy in December 2014).
Fiscal vulnerability increased
Budget 2014.The Government had to make tough decisions in raising revenues and prioritizing spending in 2014 while having to work under restrictions of the IMF program. In particular, in spring the first revised budget was approved with more realistic revenue targets, higher taxes and spending cuts. In particular, planned central fiscal revenues were reduced by 5.7% even as t the Government increased VAT and PIT rates for some taxpayers and hiked excise tax rates and natural resource charges. For example VAT with a rate of 7% was introduced for medicines and medical products (previously it was 0%), while 0.5% tax on purchases of foreign currency earmarked for the Pension Fund was reintroduced. This tax had damaging effect on foreign exchange market liquidity.
At the same time, on the expenditure side, the cuts were made to most programs including social spending and capital outlays. Previously planned subsistence minimum and, thus, minimum pension and minimum wage increases were cancelled and these social standards were fixed in nominal terms for the entire year. It should be noted that people actually receiving minimum wages or pensions did receive income increases tied to officially reported inflation. However, expenditures for housing and utility subsidies were increased as the gas tariffs for population and heating generating companies were raised (by more than 50% in 2014.
Revised budget and new public procurement law were among the conditions of the SDR 11.0 bn (USD 17.1 bn at current exchange rate) Stand-by Arrangement (SBA) with the IMF for Ukraine. By now Ukraine has already received two tranches of the loan both for budgetary purposes as well as for support of international reserves of the NBU. However, on the net basis Ukraine may receive only USD 0.9 bn from IMF in 2014 if the IMF does not approve next disbursement of the loan by the end of 2014. Currently it is expected in late December or January 2015.
However, economic downturn turned out to be deeper, while security spending ballooned as fighting in Donbas intensified. As a result, second revised budget had to be approved in the end of July with further tax increases and higher security and defence spending. In particular, ‘military’ fee and taxation of deposit interest were introduced since August. At the same time, deeper discretionary spending cuts were approved.
However, even newly revised revenue targets may be missed resulting in further expenditure cuts. In particular, during eight months of 2014 central fiscal expenditures (general fund) were under-executed by 7.6% of target due to lower than planned revenues and deficit financing.
According to the preliminary data central fiscal revenues (excluding central bank profit transfer) in September are estimated to increase by 9.3% yoy. Tax revenues were supported by VAT refunds and tax rate increases. Sharp hryvnia depreciation resulted in higher revenues from VAT on imports and excise duties. However, this still will not be sufficient to cover increased spending needs.
Overall, fiscal vulnerability increased substantially in 2014 due to sharp hryvnia depreciation and huge subsidies to state gas monopoly Naftogaz covered by government debt. As a result, state debt is likely to approach risky 70% of GDP by the end of 2014. It should be noted that public debt excluding government debt held by the Central bank is substantially lower at near 50% of GDP.
Budget 2015. The Government did not submit the draft 2015 Budget by September 15 as required by the Constitution and it is likely that 2015 draft budget will be submitted by the new government formed after elections. This happened as the Parliament refused to approve revenue measures proposed in connection with Budget. In particular, the Government suggested to reduce number of taxes, decrease the rate of Unified social tax as well as expand simplified system of taxation (use of single tax). These measures were expected to result in de-shadowing of economic activity and wage payments, which would result in higher revenues. At the same time, temporary revenue measures approved only for 2014 were to be extended for entire 2015. Amendments to the Budget Code included shift in distribution of spending and revenues between central and local budgets.
Although the government’s budget plan is not public, some parameters were published and unreleased budget may serve as a basis for budget proposals by the new government. In particular, the Government plans to continue implementation of fiscal consolidation measures, but increase spending for defence and security. Subsistence minimum and, thus, minimum pension and minimum wage, were announced to be increased by 3.4% on average in 2015 and 5.4% yoy in December, while inflation is may remain at two-digit level on average in 2015.
Moreover, the Government preliminary announced plans to start coal industry restructuring in 2015. This is expected to result in lower subsidies to coal mines. Taking into account the situation in Donbas this might be a right timing for changes. Gas tariffs for population and heating generating companies are likely to be increased according to approved schedule, which would result in lower subsidies to the Naftogaz. Still, energy market reforms will have to continue implemented to put the Naftogaz on sustainable footing. The IER estimates consolidated fiscal deficit (without taking into account recapitalisation of banks and companies and the deficit of the Naftogaz) to remain near 4% of GDP in 2015 and deficit of the Naftogaz may reach additional 2-3% of GDP.
According to the Institute’s estimates fiscal capital outlays will remain below 2% of GDP in 2015, while international practice suggests that the Government should support this spending at near 4% of GDP to stimulate sustainable economic growth. This creates risks for economic recovery in the future especially if the government does not try to cover the lack of public investment through public-private partnerships.
Overall, fiscal challenges remain high in 2015 as the Government has to increase defence and security spending and finance high recurrent expenditures but improve fiscal management.
Current account and exchange rate
In 2014 the Institute expects that current account deficit to shrink 4.3% of GDP against the background of overall external trade reduction and exchange rate depreciation. Between January and September hryvnia exchange rate vs US dollar changed from UAH 8 per USD to UAH 13 per USD. The Ukraine’s central bank (NBU) was unable to maintain exchange rate peg to US dollar due to low international reserves, decrease in capital inflows and huge current account deficit (at 9.0% of GDP in 2013). The NBU initially allowed flexibility in the exchange rate but in August exchange rate volatility increased sharply and the NBU used increasingly harsh administrative measures and limited foreign exchange interventions to stabilize exchange rate. This was modestly successful over the last few weeks.
Under normal conditions, hryvnia depreciation and trade preferences from the EU would have been sufficient to balance international trade or reach small surplus. However, impact of Donbas conflict on exports capacity, trade disruptions with Russia, loss of tourist revenues from Crimea will likely maintain significant current account deficit in 2014.
In 2015 current account deficit is expected at 5.1% of GDP or USD 6.3 bn, while trade turnover will continue to shrink. This will happen under broadly stable exchange rate asthe NBU will buy any excess capital inflows and expected increase in external capital inflows will make further depreciation unlikely. Rollback of administrative measures will also depend on low exchange rate volatility.
Real exports is expected to decline at faster pace than imports in 2015, while terms of trade are expected to improve. Merchandise exports is forecasted to decrease by 5.5% in dollar terms despite slight projected increase in exports prices. Key reasons for lower exports is that companies in occupied territories of Donbas are not likely to recover their production and trade tensions with Russia will continue. Food exports is also likely to decline in line with lower agricultural output. Positive effects of autonomous trade preferences by the EU will contribute positively but will not offset lost trade with Russia. Imports of goods is projected to decline by 1.7% in nominal terms due to lower domestic demand, but will be supported by higher coal and gas imports.
In 2014 financial account deficit is expected at 3.0% of GDP or USD 3.8 bn. We expect FDI outflows will be balanced by recapitalization of banks and other subsidiaries of foreign owners. Debt inflows of public sector will reflect loans and project financing from international donors. However, net loans and bonds balance of real sector will remain negative due to restricted access to foreign financing.
Demand for cash foreign currency was volatile in 2014 (high in the first quarter of 2014, much lower afterwards, but again higher in summer as hryvnia continued to depreciate). Overall foreign cash outflow from banking sector is expected at USD 3.0 bn as administrative measures will contain elevated demand. As a result, financial account deficit will accompany current account deficit. To cover the deficits the NBU will use its international reserves, which were supported by the IMF financing.
Next year is expected to be more successful in terms of financial account results. Financial account balance is forecasted to shift to surplus at 6.3% of GDP or USD 7.8 bn, exceeding current account deficit. Lower economic and political uncertainty and improved investment climate are expected to result in net FDI inflows at UDS 2.5 bn, which is still lower that pre-crisis level of 2013. Official borrowing is to continue as we assume that Ukraine will receive all negotiated foreign assistance. Also private sector will be able to attract external financing. As a result, in 2015 total result for loans and bond operations is projected at 5.5 bn, significantly exceeding the level of 2014. Demand for foreign cash outside banks is projected to decrease as we expect stabilization of exchange rate expectations.
Overall, in the end of 2014 and in 2015 the situation in the Eastern Ukraine will likely be a major factor determining development of Ukraine’s economy. Private and public sector companies will continue to work in uncertain political and military situation, under shifting tax regulations and limited availability of credit. On the bright side, the Government will need external financing to make ends meet and this means that it will have strong external anchor in conducting reforms. This may improve medium-term growth outlook and investment climate in Ukraine towards the end of 2015.
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