|Author: Oleksandra Betliy & Vitaliy Kravchuk|
МACROECONOMIC RISKS REMAIN HIGH IN UKRAINE
The global economy is expected to grow faster in 2013. The European Central Bank, the US Federal Reserve and Bank of Japan all are planning new rounds of monetary easing to boost their economies. The ECB promised to buy more bonds of vulnerable countries in support of their restructuring efforts. Additional financing of investment projects by Chinese government could keep country’s economy from further slowdown. However, success of these measures is not guaranteed. Thus, global economy remains vulnerable to risks, resulting in continued uncertainties for Ukraine’s economic development in 2013. Besides, economic development of Ukraine’s economy indicates that the country will start the new year with two main challenges: pressure on the exchange rate and insufficient fiscal revenues. Overall, real GDP growth is expected to reach 1.3% in 2013.
Challenges of 2012
The fourth quarter of 2012 appeared to be more difficult for Ukrainian economy than consensus suggested in the first half of the year. The problems in external and fiscal sectors escalated requiring rapid government action. However, due to weak institutions in Ukraine most ad hoc decisions appeared to be arguable and might put under pressure future economic growth of Ukraine.
In the first part of November hryvnia depreciated by around 2% at the interbank market as the NBU did not cover gap between demand and supply by interventions. At the same time, the NBU kept official exchange rate unchanged. To improve the situation at the interbank foreign exchange market several policy steps were approved. In particular, the NBU shortened the period for repatriation of exports revenues from 180 days to 90 days and reintroduced requirement to sell 50% of repatriated exports revenues to ensure foreign exchange supply on interbank market. Also, the NBU proposed 15% tax on cash sales of foreign currency with the aim to decrease short-term operations with foreign currency (foreign currency withdrawn from banking deposits or received as remittances was intended to be exempt from the tax according to the draft law submitted to the Verkhovna Rada). Net purchases of cash foreign reached USD 10.0 bn in eleven months of 2012 and were the important source of depreciation pressure.
Administrative measures are generally ineffective in the medium-term and increase distortions of the market in the short term. However, in the current situation they calmed the market. This could be an indicator that at least in part surge in demand for foreign currency was caused by short-term speculation. There is some likelihood that the NBU will be encouraged by initial success of administrative measures to try to keep the exchange rate for longer time. However, we believe that the NBU will still allow higher hryvnia flexibility within the next few months.
Another problem faced by the Government in the end of 2012 is enormous fiscal gap resulted from unrealistic fiscal revenues projections given government macroeconomic forecast as well as deterioration of economic activity in the second half of 2012. As a result, the Government faces fiscal gap at near UAH 25-30 bn in addition to planned consolidated fiscal deficit (without recapitalisation of state companies) at UAH 37 bn. Therefore, there is a trade-off between higher borrowings and under-execution of planned fiscal expenditures. The likelihood of financing all planed fiscal expenditures is close to impossible as the liquidity at the domestic markets is limited. Capital expenditures are likely to be severely under-executed undermining future economic growth in the country. In particular, it leads to worsening of infrastructure required for improved investment conditions. Overall, consolidated fiscal deficit (without recapitalisation of state companies) could reach 3% of GDP. Another tricky issue relates to pension payments, which are largely financed at the expense of non-transparently provided loan of the State Treasury. In particular, these loans are estimated to reach UAH 15 bn in eleven months of 2012, which is equal to annual Fund’s deficit target.
Therefore, the economic situation in Ukraine in the beginning of 2013 will be challenging. To ensure economic growth (give improved external situation) the Government should continue with reforms aimed at sustainable growth. It will have to increase gas tariffs for population and energy generating companies, which would improve fiscal situation.
Real GDP growth will remain low in 2013
Demand side. Assuming that the global economy does not weaken the Institute expects marginal improvement of economic situation in Ukraine in 2013. Real private consumption will remain major driving force of real GDP growth even though its growth is forecasted to decelerate from 12.2% in 2012 to 4.0% in 2013. It will be attributed to slower growth of real disposable income (at 4.4%), which is likely to be explained by deceleration of wage and pensions growth. In particular, nominal minimum wages and pensions will increase in line with inflation, which will restrict growth of real income from these sources. Still, wage income is likely to grow in real terms likely to some wage de-shadowing and higher wages paid in public sectors. Another factor determining the real private consumption growth in 2013 relates to higher households banking deposits. Net banking lending to households are likely to be positive only marginally. At the same time, the households are expected to reduce cash purchases of foreign currency. Overall, we expect slight decrease in the saving rate in 2013.
Investments are likely to remain weak next year being limited by financial constraints. In particular, the approved State Budget Law for 2013 envisages cuts in capital outlays. We expect that banking credit of real sector will increase as compared to 2012, but also will remain limited due to several reasons. First, the banking liquidity remains low, while risks are high. Second, state domestic borrowings are planned to be high, which is likely to crowd out investments. In particular, banks remain the major player on the state domestic bonds market. Still, slightly improved economic prospects will allow companies to devote more funds to investments, primarily into modernisation projects and technologies. However, continued economic uncertainty and negative investment climate will limit growth in gross fixed capital formation. As a result, real gross fixed capital formation is expected to grow by 3.1% in 2013 and it will be by 8.6% lower than in 2004.
Increased consumption and investment demand will support real imports growth. In particular, imports of machinery products is likely to increase; however, it will not repeat high pace growth of 2012, when it was backed by projects related to the EURO-2012 football championship. Imports of mineral products could remain close to 2012 levels due to improved energy efficiency and larger use of domestic coal. At the same time, hryvnia devaluation is expected to lead to some imports substitution for food items and light industry products. Overall, real imports growth is expected to decelerate to 3.7%.
Expected acceleration of global economy growth would result in higher Ukrainian exports in 2013. Demand is forecasted to grow for most exports commodities. At the same time, real exports of food products, including grain, is likely to remain at the level of 2012. Services exports is likely to be supported by IT and tourism services exports, while gas and oil transit could remain at 2012 level. As a result, real exports of goods and services is forecasted to grow by 2.4. Overall, negative contribution of real net exports is likely to narrow to 0.8 p.p. in 2013.
Production side. Increase in domestic and external demand will support development of all economic sectors. Real gross value added (GVA) in manufacturing is expected to resume growth at 2.1% in 2013. All manufacturing sectors are expected to increase GVA. Export-oriented sectors’ performance is likely to be supported by price competitiveness additionally gained due to hryvnia devaluation. At the same time, food sector is forecasted to grow partially due to imports substitution.
Real GVA in agriculture is likely to remain at 2012 level under the assumption of neutral weather conditions. In particular, the grain harvest is not expected to change, while livestock sector could keep growing at 1-2%.
Deceleration of real consumption growth would result in slowdown of retail trade growth. At the same time, wholesale trade would benefit from growing industrial sectors. As a result, real GVA in trade will increase by 3.9%. The sector of transport and communication will increase real GVA by 3.1% in 2013 reflecting recovery in industries as well as higher demand for communication services.
Fiscal pressure will be high in 2013
The draft Budget Law for 2013 was approved by the Verkhovna Rada on December 6 in violation of the Budget Code. It was adopted only three days after its submission to the Rada without following prescribed procedure and any careful consideration of proposed budget was obviously impossible. Rushed schedule was caused by the possibility that newly elected Rada may fail to approve budget in December. In this case, financing expenditures at one twelfth of fiscal expenditures of previous year would not be sufficient in 2013. It could result in further delays and arrears in wage and pension payments. At the same time, final parameters of the State Budget Law for next year were finalised after voting due to last-minute changes that were not incorporated to the Draft. This created possibilities for changes not approved by the Rada. So far the President has not signed the draft Budget and final text of the Budget is not available.
By the end of 2012 the fiscal revenues will definitely be lower than planned due to problems with planning as well as higher slowdown in economic activity. As a result, the planned central fiscal revenues in draft 2013 budget are by 3.3% lower than annual target for 2012. To make up for low revenues the State Budget Law envisages increase in state guarantees and quasi-fiscal operations. The Draft State Budget for 2013 is based on more optimistic macroeconomic scenario out of two scenarios approved by the Cabinet of Ministers. In this scenario real GDP will increase by 3.4%, which is higher than the IER forecast at near 1.3%. CPI growth is estimated at 4.8% yoy in December 2013, which is lower than the Institute’s forecast. As a result, our forecasts of nominal GDP, which is the most essential parameter for fiscal purposes, are close. At the same time, according to our estimates the plan for tax revenues (in particular, collections of EPT and VAT) is too optimistic. Thus, it is highly unlikely that the Government follows best international practice and uses conservative macroeconomic scenario for planning fiscal revenues. Moreover, to ensure additional revenues the Government requires the NBU to transfer its profits in 2013 quarterly at least at the amount of UAH 4 bn each quarter.
As the Government will not have enough financing for capital spending the Budget envisages providing state guarantees at 3.2% of GDP. The allocation of these guarantees is delegated to the Cabinet of Ministers while the Law defines only total limit without any breakdown, which reduces fiscal transparency. Moreover, state guarantees increase fiscal vulnerability as decentralization of government borrowing may lead to higher borrowing costs and less fiscal discipline. Higher guarantees are partly related to the permit to budget entities to attract financing for capital outlays above the amount of approved budget allocations. In particular, envisaged expenditures for development (which is broader term than capital spending) are by 24% lower than plan for 2012 approved in December 2011. Therefore, if budget entities will have difficulties obtaining financing, capital outlays could be lower in 2013, resulting in even worse situation in infrastructure sectors as well as such important sectors as health care and education. Still, state banks could be compelled to provide such loans to budget entities, which would expand quasi-fiscal operations and lead to deterioration balances of these banks.
At the same time, share of recurrent expenditures will increase further in 2013, which will limit possibilities for cutbacks by the Government if situation worsens. Higher minimum pension and minimum wage, which will be raised by 7.4% yoy in December 2013, will result in higher transfer to the Pension Fund and larger public wage bill. Base rate of the Unified Tariff Scale for public employees will increase to 74.3% of minimum wage for eleven months of the year and to 76.2% in December leading to larger increase in public sector wages. Wage differentiation in public sectors is likely to increase, but wages will still remain lower than average in economy. Overall, wages in public and private sectors will grow slower than in 2012 leading to corresponding slowdown in pension contributions and PIT revenues. Therefore, local budgets could again face difficulties in financing health care and education in 2013.
Facing low revenues the Government plans to increase central fiscal deficit from UAH 31 bn planned in 2012 to UAH 50.4 bn in 2013. The deficit at near 3.2% of GDP will consist of privatisation receipts and borrowings. The plan of privatisation receipts at UAH 10.9 bn is ambitious and the Government will have to sell several of few remaining state-owned blue chip companies to receive these funds. External borrowings are planned at near USD 5 bn and will be used mostly for rolling over maturing debt (including USD 2.5 bn of IMF loan). Net domestic borrowings are expected at UAH 32.3 bn, which may crowd out real sector lending, undermining potential economic recovery. The state debt will also increase due to so-called recapitalisation of state banks and companies. Such recapitalization is used to exclude bond issues from official deficit. In particular, the draft State Budget Law envisages UAH 14.7 bn of government bonds issued using this scheme. They are likely to be bought by the NBU.
Overall, the procedure of approval State Budget Law violated Ukrainian legislation as well as best budgeting practices. The approved budget carries higher risks for fiscal sustainability and increases state guarantees as well as direct state debt. As a result, fiscal vulnerability increases. Taking into account all risks and high central fiscal deficit the Budget is likely to be criticized by the IMF. Negotiations to be held in January could result in State Budget Law amendments in the first several months of the year. Possible compromise may entail cuts in tax privileges to certain sectors, which heavily undermine a VAT and EPT revenues.
Balance of payment will remain in deficit in 2013
In 2013 current account deficit is projected to narrow to 6.4% of GDP. Weaker hryvnia relative to dollar will lead to limited improvement in competitiveness as wages and other costs will continue to grow faster in Ukraine than in trading partners. External demand and commodity prices are projected to increase somewhat. Overall, exports of goods and services is expected to grow by 5.4% in dollar terms in 2013. Imports growth at 6.1% in dollar terms 2013 reflects higher import volumes as well as somewhat higher import prices. Weaker hryvnia is expected to have some impact on imports growth, but demand is unlikely to react strongly to small hryvnia depreciation. If global economy worsens Ukrainian exports is expected to fall significantly, but limited access to foreign financing will restrict Ukraine's ability to pay for imports and run current account deficit.
Financial account surplus is expected to increase somewhat to 5.5% of GDP. FDI inflows in Ukraine are expected to decline due to unfavourable investment climate. Net FDI may be higher than in 2012 as significant FDI outflows are unlikely to be recorded by the NBU two years in a row. Better access to global financial markets will allow companies to borrow more from abroad. At the same time, inflows from foreign subsidiaries of Ukrainian companies will likely fall, while foreign banks are unlikely to supply a lot of financing to Ukrainian subsidiaries. Besides, high level of external debt will limit net inflows.
Overall, financial account surplus is projected to be sufficient to finance most of the current account deficit in 2013.
CPI growth will remain in single digits in 2013
In December 2013 consumer inflation is expected to accelerate to 7.6% yoy reflecting continued adjustment in exchange rate and in utility tariffs. However, low demand pressure and slow growth of commodity and food prices will help contain inflation. Average inflation in 2013 is forecasted to accelerate to 4.6%. High degree of transmission of foreign exchange shocks experienced during previous occurrences mean that price level and inflation will to the large extent depend on the exchange rate observed in the next year.
Next big question mark in the outlook remains increase in the utility prices in general and gas and heating tariffs in particular. Government over the last months provided signals that it wants to come to terms with the IMF. Desire for the IMF assistance is probably caused by the necessity of large repayment of IMF funds in 2013 as well as crucial role of the IMF for external funding. Any successful agreement with the IMF will likely entail significant one-off increase in gas prices for population and a number of scheduled increases later. At the same time, the Government continued to promise no significant increases in tariffs. Overall, increase in gas prices is more likely than not in 2013 but remains highly uncertain proposition.
Some flexibility is expected in exchange rate for 2013
The NBU was widely expected to allow hryvnia to depreciate and gradually increase its flexibility after October elections. But after surge in demand for foreign currency in October and November the NBU did the opposite and introduced a number of administrative measures to keep hryvnia exchange rate fixed. It also threatened to introduce 15% tax on cash sales of the foreign currency. In the short run these measures were effective in keeping exchange rate fixed. Currently administrative measures are set to expire in May 2013, although the NBU promised to repeal them earlier if pressure on hryvnia subsides.
As a result, future path of exchange rate regime in Ukraine became more uncertain. Previous factors were the pressure on the exchange rate and negotiations with the IMF as well as unclear path to more flexible exchange rate. Now short-term success of administrative measures may convince the NBU that there is no urgency in transition towards flexible exchange rate while political bargaining for the vacant post of the NBU governor may lead to abrupt changes in the NBU policymaking. Barring full-blown exchange rate crisis (which is possible but not very likely) we believe that base scenario for 2013 is wider band for exchange rate movements supported by the IMF program after administrative measures to support exchange rate are cancelled. As a result, we project UAH/USD exchange rate to be on average at UAH 8.39 per USD fluctuating in UAH 8.1-8.7 range in the second half of 2013. Again under baseline scenario the NBU will not be forced to allow more flexibility of the exchange rate.
If global economy worsens exchange rate will have larger adjustment. As a result, exchange rate may move in the range of UAH 9-11 per USD in 2013.
Therefore, in 2013 the global economic situation is expected to improve, which would result in acceleration of real GDP growth to 1.3%. Real private final consumption will remain major contributor to the growth. Investments will grow moderately due to lower uncertainty and need to finance modernisation of equipment and technologies. Real net exports will again make negative contribution to the growth as external demand for Ukrainian products will remain weak but negative impact of net exports will be lower than in 2012. On production side, manufacturing will be growing by 2.1%, while major contribution to growth will be made by trade and transport.
Longer than expected recession in the EU and slower growth of other trading partners will result in stagnating demand for Ukrainian exports. Economic development in Ukraine might be further worsened by political uncertainty and bad investment climate. Delayed reforms, including lack of transmission to the flexible exchange rate as well as absent increase in gas prices for population will further threaten the economic situation in Ukraine. Under such pessimistic scenario real GDP is expected to decline in 2013.