Quarterly Report-The patched road to reconstruction

​Below is a brief overview of our base case scenario of Ukraine's economy for rest of 2016 and 2017-18. 

The economy: Growth momentum built in 2H15 receded in 1H16, amidst small fiscal stimulus. Based on our reading of key economic-sector performance statistics, the economy again experienced recessionary conditions in the first half of 2016. Real GDP contracted 0.7% in 1Q in seasonally adjusted, quarter-on-quarter, non-annualised terms (QoQ SA). In 2Q, according to official statistics, the economy rebounded by 0.6% QoQ SA, and, hence, escaped technical recession. In the first quarter of 2016, government reduced its consumption by 2.0% in QoQ SA terms after two previous quarters of expansion in spending. Amid weak household consumption and weak fixed investments, this restrained a potential recovery in very early 2016, and economy stumbled. In the second quarter, fixed investments rebounded by 9% QoQ SA after contracting in 1Q. Household consumption, which has been gradually recovering, was a bit stronger, and this propped up the economy over 1H16. In our view, PM Groysman's new government that assumed power in early 2Q has been moving toward a looser fiscal stance by spending slightly more actively than did the previous government. One key feature of Groysman's pro-growth fiscal stimulus has been the broad launch of civic road repairs that can be seen by all. Groysman's government is likely to continue such projects in 2H16 (and in 2017 as well). However, this stimulus is relatively small, as it is limited by the size of deficit allowed under current state budget law and also under the IMF programme. As was noted above, performance of the economy in 2H16 depends on further fiscal support-budget expenditures are set to increase in nominal and real terms both versus 2H15 and versus 1H16-as well as on whether recovery in household consumption and fixed investments takes hold. After a sluggish first half, we expect a more vibrant second half of the year, which would allow real GDP growth of 1.6% YoY for full-year 2016.

Fiscal balance: A turnaround from previous tight stance. The government has been relaxing the super-tight fiscal stance adopted by the previous cabinet, which had run a primary surplus of 2-3% in 2015 and 1Q16. During 2Q16, the consolidated state budget, excessive primary surplus fell to 2%. It is likely to be lower in 3Q16 and remain within the 0-0.5% range at the end of 2016 and continue at the same level through 2017-18. Given real GDP growth, even at our modest forecast, and a GDP deflator in the high single-digit area over 2016-18, public debt is set to decline gradually, as borrowing costs for the government are projected to slide thanks to low inflation and lower NBU key lending rates. As of the end of 1H16, public debt-comprised of local debt held by the central bank-was at 81%. It should decline to 80% by year-end and decline further during 2017-18 to 76-78%.

Cooperation with the IMF. IMF financing was resumed this September. It had been stalled for nearly a year, which had raised concerns over authorities' willingness to proceed within the IMF's guidelines. Despite the prolonged delay, the Groysman government has made the most vital step required to unlock the tranche flow: in April it raised regulated tariffs, which should appear in households' utility bills later this fall. At end 3Q16, a US$1bn tranche from the IMF is scheduled to be added to FX reserves (booked in NBU's accounts), which will be followed by a US$1bn, US-backed Eurobond issue (booked in the accounts of Ukraine's government). The government's eventual push for IMF funding was motivated by, among other reasons, a drop of its FX balance: as of July it was as low as US$1.3bn, a volume of FX that could only cover future government's external debt due through December and no more, and then only if the government had stopped borrowing FX from local banks (currently only entities wishing to exchange their own FX deposits for FX claims on own government). In our view, the IMF's next tranche will arrive next year, as required conditions (pensions system reform) will face what has become a ritual of delay.

Money in Ukraine's economy: Persistent debt deflation should reverse in 2H16. Bank lending was still very sluggish in 2Q16, as the flow of credit to the non-government (private) sector was still negative in 2Q. Moreover, credit contraction was even stronger in 2Q compared with the previous quarter (see Chart 49, p.31). The debt-deflation trend that began in 1Q14 has subsided, but it remains resilient. Although the economy has contracted, the gradual reduction of the NBU's refinancing rate should lower general lending rates and induce businesses to borrow. We expect private-sector credit to expand, helping the poor growth, eventually halting the 2.5-year trend of credit contraction.

Inflation & hryvnia interest rates: More NBU policy rate cuts ahead. Despite rapid disinflation in 1H16, headline CPI is set to edge higher in 2H16 after slowing to 7% this summer; it should end this year a bit below the 12% target set by the central bank. We attribute such a fast pace of disinflation over past year to weak domestic demand, which is likely to recover rather slowly, hence, the central bank is more likely than not to hit its inflation target of 8% set for next year. With the key policy rate currently at 15.0%, the NBU is expected to cut the rate further because of the following: (1) there is social, political pressure on the authorities (government as well as central bank) to turn around the economy rapidly after a lengthy recession, and lowering hryvnia borrowing costs would aid in this desired outcome, and (2) despite the rate cuts made over 9M16, the NBU has paid to banks (via increasing their reserves with central bank) a total of UAH8.6bn through instruments aimed at draining excess liquidity, which is more than UAH7.8bn paid over full year 2015 (p.30). This would put the NBU at risk of greater public scrutiny and subject it to criticism that it engaged in excessive, unproductive money creation.

External balance: Tight current-account balances expected in 2016-18. Based on a weaker global economy and global trade (see "Global trade conditions indicate deflationary bias", p.7) as well as domestic weakness, our trade projections yield a current-account deficit of less than 1% of GDP, enabling authorities to accumulate FX reserves given the slow-paced fulfillment of the IMF program in 2016.

UAH view: Current forecast eyes softer hryvnia weakness than previous forecast. This is based upon our real, trade-weighted analysis of two factors: (1) faster-than-expected disinflation caused by weak demand, and (2) US economy underperforming (with real GDP growth about 1% SAAR) for the third consecutive quarter through 2Q16. We forecast a UAH/USD rate at 27 as of the end of 2016, up from 288 (details are in "View on UAH: Again upward revision vs. previous call" on p.32 and "Quarterly forecast for 2016-18, base case scenario" on p.37).