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Quarterly Report-Debt deflation Я Us

Below is a brief, broad overview of Ukraine's economy as of year-end 2017, and our rationale for the base-case economic projections for 2018-2020.

Economic growth accelerates, but still is under restraint of ongoing debt deflation. Over the course of 2017, Ukraine's GDP growth has gradually decelerated, and we estimate it come in at 2.0% for the whole year. Strong consumer demand, higher fixed asset investment, and stable government consumption were the main driving forces, and they countervailed the negative impact of foreign trade. In 2018, thanks to a better external environment, our projection is now in line with consensus, which is for a +3% real GDP increase for 2018, followed by weak growth of +1.9% in 2019. We argue that Ukraine's economic recovery is restrained by a process of ongoing debt deflation, where sizable defaults are due to past outsized FX lending.

Foreign trade: world commodity markets are changing to less favourable, as we expect oil price growth to accelerate to 17% YoY, while steel and iron ore prices to decline 8-16% YoY in 2018. This puts additional pressure on Ukraine's trade balance, as oil and gas energy resources account for about 25% of Ukraine's imports, while metals and ores still comprise ~30% of Ukraine's exports. Ukraine has already started increasing its energy independence and growing export potential this year, but faces likely shortfalls and delays. We see Ukraine's trade deficit to widen 11% to $7bn in 2018, with significant upside risks.

Sovereign debt: government supply of yield-earning assets widens. For 2018 main debt burden for state budget is amounted to about US$10.4bn, mostly denominated in FX, including US$3.21bn in domestic debt denominated in FX. So, 2018 will be one of decisions on how to navigate the peak in external debt repayments scheduled for 2019-2020, which amount to around US$4.5bn each year. The MoF will try to increase its market presence this year, and will make attempts to issue new Eurobonds or tap UKRAIN 7.375% '32, which was issued in September 2017.

Bank lending: competition for solvent borrowers is heightening. Long-awaited bank lending started to spring out. In 2017, retail loans, mainly credit card and auto loans, demonstrated 30% YoY growth driven by low comparison base and better consumer expectations. This segment will remain the most vibrant alongside the SME lending, as more banks turn into that niche. Mortgages are yet to pick up but we do not expect this to happen until the inflation abates. Corporate lending is growing due to the short-term loans issued by banks with European capital. NPL remain extremely high 54.9%, mainly due to Privatbank's loan portfolio shenanigans and dubious "administrative" lending from state banks. The Ukrainian parliament is about to fully address NPLs problem with a respective new law.

External macroeconomic and financial markets environment appears supportive of Ukraine's economy for now and for the next 12-month period. Despite the fact that the US Fed appears committed to a series of steady interest rate increases, the US dollar has been weakening since early 2017. This trend is projected to extend well into 2018.

UAH's adjustment will take place gradually over 2018. We reiterate our forecast of hryvnia depreciating gradually from average 26.66/USD in 2017 to 28.5/USD in 2018. The key factors influencing hryvnia's soft depreciation are still mostly favourable external financial markets, defensive tactics of Ukrainian authorities in the monetary sphere during the pre-election year, and hryvnia being overvalued according to the real TWI-implied rates.