Timothy Ash: Making sense of Ukraine today
It might be useful to provide an update with my bigger picture views on Ukraine, and a Q&A format is always easier.
Q: How is the economy performing through the coronavirus?
A: The Ukrainian economy has surprised on the upside through the Covid crisis, I think in recognition of the success of reforms instituted since 2014, including an independent central bank with inflation targeting and a floating foreign exchange, a cleaned-up banking sector, better run Ministry of Finance and now a Debt Management Office.
Just looking at the numbers, but real GDP growth only fell by around 4% at the end of 2020, and expectations are that it will recover to post 3-4% growth in 2021.
Real GDP growth was helped in 2020 by relatively light lockdowns and terms of trade benefits, as Ukraine benefitted from high global metals and grains prices.
The latter is reflected in the remarkable turnaround in the current account position from a deficit of 2.7% of GDP in 2019 to a surplus of 4.3% of GDP in 2020. The latter helped support the hryvnia and National Bank of Ukraine reserves. The budget deficit did more or less triple in 2020 to over 6% of GDP but was lower than some earlier estimates that had suggested 8% of GDP or above. Obviously, a shallower economic contraction and improved export receipts helped therein, plus relative spending restraint despite Covid.
Note on the current account front, the resilience and even growth of worker remittances have been remarkable both in Ukraine and across other emerging markets. In Ukraine, they rose around 1.7% YOY in 2020 to $12 billion, and were up by a further 7% year-on-year for the first two months of 2021 to $4 billion.
Now despite the slowdown in the EU, either Ukrainian overseas workers managed to retain their jobs or dug into savings to maintain dependents back home. But the durability of these flows is a major positive for the balance of payments, and let’s hope they endure. Guess the downside is that in the old pre-2014 days Ukraine used to export semi-finished products to Russia, now it exports workers to Western Europe (and less so Russia).
For 2021, the assumption is that the current account surplus will disappear as domestic demand recovers and terms of trade deteriorate slightly, but that the deficit will remain modest.
Q: What’s the state of play with the International Monetary Fund and what are the chances of a near-term deal over the first review under the loan agreement?
A: Well IMF-Ukraine relations tend to be tortuous, and this loan agreement is proving to be no different. Let’s not forget that the current special drawing rights $3.6 billion program was agreed in June 2020, actually June 9, and a year later and there has only been one disbursement, of SDR $1.5 billion initially.
We are still waiting for the first review to be completed. I think there have now been 11 IMF programs since 1995, and typically they have only tended to see a couple of credit disbursements, if that. It does not feel like this program is much different, and I think it is touch and go whether we see any further disbursements under this program.
The problem from the fund perspective is that while the loan agreement was light on conditionality, the past year has seen backtracking on reform conditionality which had supposedly been delivered as part of past programs and indeed even very modest commitments made, or assumed, for this program – be that central bank independence, energy pricing, state-owned enterprises governance, and the anti-corruption agenda – have gone backward.
And as time goes by, and we get closer to September, the fund I think will want to get more clarity over 2022 budget plans before agreeing to any further credit disbursements. This could all make it very difficult to see prior actions delivered on any staff-level agreement to get required IMF board approval before year-end.
Perhaps the biggest sticking points at present relate to the anti-corruption agenda, and the agreement still needs to be reached on legislative changes to guarantee the independence of the National Anti-Corruption Bureau (NABU) and the Higher Council of Justice (HCJ), the latter of which is the body established to select judges.
The IMF and other international financial institutions want to ensure that the selection process for NABU heads and HCJ justices is sufficiently independent, and the debate is therein the role or casting vote powers of foreign members of the HCJ.
The fear is that elites will just ensure that these institutions are captured to ensure that no serious efforts are really made to appoint independent members/judges and to take any meaningful action against corruption. The HCJ is arguably mission-critical to having a body of judges in the country who are clean, without that assurance the whole anti-corruption architecture created since 2015 will not be up to task, and a complete waste of time and resources. Seemingly the issue of fully restoring criminal liability for e-declarations has also not been fully resolved. On this latter point, the Rada voted this week on a bill restoring criminal liability, but Zelensky then vetoed it arguing that the penalties imposed were too light. I had assumed this issue had been resolved with the IFIs, but seemingly not now. It might be back to the drawing board which would again raise question marks as to whether this program can be put back on track any time soon, and unlikely before year-end.
Legislation covering NABU and the HCJ has been passed at first reading in the Rada, but are not as yet compliant with recommendations made by the Venice Commission, generally being viewed as the neutral arbiter herein. The government is promising to revise the bills in the second reading to meet commission objections in first reading, and then get IMF sign-off.
I have to say that I have my doubts, given past experience in Ukraine. Vested interests from those in the Rada who have benefited from corruption and state capture are likely to resist any revisions to the bills which ensure independence for NABU and the HCJ. I doubt that Zelensky has a majority in the Rada at this stage for fully compliant bills – add in their asset declarations also now.
What is likely to happen is something will be passed in the second reading by the Rada, without getting prior sign-off from the Venice Commission or IMF (same gig as happened with asset declarations). It will then be presented to these same institutions as a fait accomplis, or the best that the Zelensky administration can do.
The administration will then ask the IMF and other IFIs to accept the bills as are, and allow things to move on. Likely this will all be left in limbo, likely for some weeks/months yet until someone backs down. Given the importance of the anti-corruption agenda and the central role of NABU and the HCJ, I hope the IFIs stand firm, but who knows the geopolitical setting – if Russian tanks are rolling again in Donbas by September, then maybe Western donors will give a prod to the IMF. Maybe that is the Zelensky team game plan – well that the West will eventually crack, and that they need Ukraine (or need to be seen to be helping Ukraine) more than the other way around. Previous reviews of past IMF programs have suggested when the IMF has rolled over, outcomes have been bad. I hope IMF staff re-read these documents, as do their political masters.
Q: What about the new special drawing right allocation?
A: Well the good news is that Ukraine is likely to get close to $2.7 billion in special drawing rights allocation as its share in the total $650 billion new SDR allocation to shareholders. This is pretty much free money – well a small interest rate is payable, but there is low conditionality attached, and the money never has to be repaid. It can also be used for FX reserve support or fiscal financing, and it is up to the recipient country to make the determination how it wants to spend the cash.
Likely in Ukraine’s case it will go to budget financing. This will help cover any likely budget shortfall should the SBA remain stalled. Indeed, the SDR allocation will cover nearly the entire SBA allocation plus other IFI monies linked therein. It will hence go a long way to covering the pretty hefty debt redemptions that fall due in September – close to $3 billion in FX, and total debt redemptions of closer to $6 billion.
The bad news I think is the availability of the SDR allocation means that there is likely to be little real pressure on the Zelensky administration or the Rada to push through legislative changes required by the SBA. Likely difficult structural issues now will have to await the future shape of IMF – Ukraine relations, which means a new EFF to be agreed sometime in late 2021 or 2022.
The SDR allocation sounds great on paper but there is a moral hazard risk herein, that by providing condition-free cash to countries, those on IMF programs which need to be pushing reforms head to sustain longer term macro stability and growth, actually do less reform as a result.
Note that there is also talk about re-allocation of developed market SDR allocations also back to other needy emerging markets, which could mean multiples of the initial SDR allocations ($2.7 billion mentioned above in Ukraine’s case) also find their way to these economies. This sounds great in theory but the practice risks stalling much-needed reforms so this reallocation process needs to be really well thought thru. The better scenario would be to create a new program structure with actual conditionality attached to further SDR reallocations.
Q: Does Ukraine still need the IMF?
A: Ukraine’s macro-economic story is much improved with the return to real GDP growth, prudent monetary policy keeping inflation contained in single digits, a flexible exchange rate ensuring the current account is still in surplus, while the budget deficit is being maintained in reasonable proportions of likely 5-6% of GDP this year.
The NBU has managed to build a decent buffer of FX reserves, over $28 billion, more than five times the low of 2015.
That’s the good news, but with a public sector debt/GDP of still close to 60%, a high share of FX debt in that total and relatively short maturity structure means that government’s annual gross financing need (GFN) is high at close to 15% of GDP.
That is a ratio that is on the cusp of what the IMF view as being sustainable. And, arguably without the IMF backstop, the MOF’s ability to cover this ratio in the market would be in question, if not made punitively expensive. An IMF programme thus ensures the availability of cheaper market financing, which ultimately will be key to ensuring higher levels of investment and growth.
Ukrainian politicians and policymakers would be well not to get too confident or arrogant yet, as 2021 is not that indicative I think of how global financing will pan out over the medium term, and especially if we see the Fed and other DM central banks finally begin to normalise monetary policy in what now seems to be a clear threat from inflation.
Q: Will foreign portfolio investors continue to fund Ukraine?
A: As long as there is some IMF engagement, yes. The macro looks much improved, but I think investors will still have an eye on that large GFN/GDP ratio and need the backstop of the IMF to keep lending large sums to Ukraine. The financing picture looks fine for 2021 now because of the SDR allocation, assuming the Russians don’t go back into Donbas, but what about 2022 plus?
Net, net the Ukrainian side cannot be complacent and should look to lock in a new IMF arrangement soon. I think the desire on the part of the Fund to lock in reform conditionality means that they will want a longer-term arrangement, likely an extended facility fund.
Q: Can Ukraine come to market?
A: Absolutely, global liquidity is such that investors seem willing to look thru the problems with the IMF, while I think government officials are experienced enough that they can spin relations with the IMF to the extent that investors believe that IMF money is coming, and to be fair the SDR cash is coming. I worry longer term that this is just a repeat of 2013, where portfolio investors closed their eyes, held their noses, and pumped the Yanukovych administration with cash – rewarding him in effect for bad policy. Ultimately this sustained bad policies for long enough that imbalances resurfaced and eventually this ended in default and debt restructuring in 2015. Foreign portfolio investors can be very short sighted.
Q: Does Zelensky want a new program?
There will likely be those around Zelensky, likely in the industrial lobby, arguing that Ukraine can survive without an IMF arrangement. They will highlight the improved macro, cheaper market financing and access and perhaps highlight that with elections looming that Zelensky might want more freedom to run a more pro-growth economic policy. I think some of these lobbyists will no doubt also be nervous about some of the structural reforms, particularly, on the anti-corruption agenda, which the IMF will want to promote. Zelensky might just take the bait, but it think that would be a huge risk. It risks that foreign portfolio investors will be less willing to fund Ukraine, and cheaply, and also that with the structural reform agenda slowed, progress on things like fighting corruption lag, and ultimately this stalls the acceleration of real GDP growth.
I found myself in a strange place last week, having to explain to another foreign portfolio investors why fighting corruption was important in Ukraine – that investor had made the point that the current IMF program is much more austere on the anti-corruption agenda than any other IMF programme in any other country he has followed. The latter point is true. But I did highlight that IMF programs post-2014 are big on fighting corruption as successive Ukrainian governments have said that they should be big on fighting corruption, and the population consistently say that fighting corruption is the number one priority for Ukraine, alongside ending the war in the East.
Remember, why Ukrainian GDP per capita is one third that of Poland or other Emerging European economies? Because it never really addressed the corruption/business environment issue, and real GDP growth has been sub par because Ukraine is a difficult place for foreign direct investors to invest. That needs to change, and only by addressing the corruption issue can Ukraine raise its long term growth potential. So fighting corruption is key to achieving higher longer-term growth.
Q: What do you make to Zelensky’s new deoligarchisation initiative?
A: Oligarchs are a huge problem in Ukraine as they are part and parcel of the corruption/state capture problem. Zelensky was elected in a mandate to rein them in, but frankly thus far has not done much in this regard. They all still seem to be flourishing.
Zelensky did make a bold step with the recent sanctions rollout on Viktor Medvedchuk and his allies, albeit this looked more political/geopolitical than perhaps a generic move against oligarchs.
Maybe it was the first step, a warning shot to other oligarchs to get into line – a bit like Vladimir Putin’s move against Boris Berezovsky and Mikhail Khodorkovsky in Russia.
The new deoligarchisation bill is another encouraging sign, albeit why has it taken so long to announce – halfway into Zelensky’s presidency?
And as anti-corruption campaigners have highlighted, the Zelensky administration has enough legislative and regulatory authority to rein in oligarchs already but they seem reluctant to use the powers they already have. At the end, acting against oligarchs requires political will, and the question is does Zelensky really have that to act?
He has the political support I think in the country, but in waiting two years to act he has eroded his majority in the Rada which leaves him with less real political capital or ability to act. Remember oligarchs still are a strong, even dominant force in the Rada, and likely will fight a fierce rearguard action to defend their interests. Does Zelensky understand the system (political, state administration, legal, economy) enough to be able to take the oligarchs on, and win? I am not sure. It has taken him two years to figure that out when I think he could have hired plenty of good people who understood the system and could have made an impact. His hiring and firing strategy has fallen way short.
Q: Is Zelensky really serious about reform, and fighting corruption?
Answer: He says he is, and was elected on that mandate, but so far he has not done very much in reality either to push back on oligarchs or corruption. Yes he removed immunity from prosecution for Rada deputies, but have any serious corruption cases begun, or has anyone gone to jail? For an outside observer, the PrivatBank case is pretty emblematic and looked like low-hanging fruit given the offshore cases which seemed to provide so much evidence. Why has no serious prosecution case been launched for the $5bn plus losses suffered by the state therein? Even Medvedchuk is under only house arrest. Now this might not be because of a lack of trying but simply because corruption is so entrenched and the system is now so captured and it’s hard to actually make an impact. Zelensky also suffers from the fact that he is an outsider, in terms of understanding how the state administration, legal system and political system operate and has struggled to get things done. I will give him the benefit of the doubt, but so far results are disappointing. Maybe that will change now.
Q: What about Russia, is the threat from the east gone?
A: If you are asking me to get into Putin’s mind, that’s a hard one. But the fact that he marched 100,000 troops up to the border this spring is significant. Ok, he eventually pulled back, but he still has a huge military force on the border with Ukraine.
And now likely given developments in Belarus, the Moscow game plan is to open a second front with Ukraine from the north. All this is meant to intimidate Ukraine and the West to make sure they roll over to his agenda.
That agenda is pretty clear cut in my view, it’s reining in Ukrainian sovereignty to the extent there is no Western orientation.
True, Putin’s dream scenario is deeper integration back with Russia, akin to how he is pushing Belarus, a proper Eurasian Union, centred on that. But the minimal Putin would accept is for Ukraine to go back to the no-mans -and reality of Ukraine under Viktor Yanukovych, the broken bridge between East and West, which we all know was just not working for Ukraine, albeit it was working for Putin.
I still would not put it past Putin for a major re-escalation over the summer, as he still has objectives like securing water supplies for Crimea, getting his buddy Medvedchuk out of house arrest, and forcing Ukraine back to Minsk 2 talks. Longer-term I still worry about the prospect of a defining military conflict between Ukraine and Russia.
I just don’t think that when two countries undertake a major military build-up as is happening on the Ukraine-Russia border that it ends without some kind of major conflict. Ukraine has something close to 250,000 troops aligned east, and Moscow something comparable, or more westwards facing. Think of the recent Armenia-Azerbaijan conflict – as a possible guide here, but the forward movement would be by Russia.