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Quarterly Report-Embracing a Goldilocks economy?

Below is a brief overview of our base-case economic scenario for Ukraine vis a vis the global economy for the remainder of 2017 and over 2018-2019.

Why we are sceptical of the "Goldilocks" global economy. Beginning in the summer of 2016, and increasingly since early 2017, there has been a widespread view among economists and analysts that the upbeat performance of the financial markets is a reflection of an overoptimistic "Goldilocks" economy. Headline macro parameters like growth and inflation are at just-right levels, or?as BIS put it in its recent quarterly report?"not too hot, while not too cold."

This development coincides with an across-the-board decline of the USD against several major currencies, most notably the euro (EUR) and the BRICS currencies (BRL, RUB, INR, CNY, ZAR). This lasting decline of the USD, which was interrupted by a correction this September, has supported commodity prices and boosted the fortunes of commodity-driven economies, which had faced collapsing currencies over the past few years, along with the prices of their key export commodities. Ukraine, too, has benefited from the Goldilocks economy. It has spurred economic growth and strengthened the hryvnia, which allowed a successful refinancing of external debt. However, in our view, this notion fails to acknowledge flaws in today's global economy that are quite similar to what eventually led to the global financial crisis of 2007-08. These flaws were also seen in the 1990s and early 2000s, when the US economy was run with troublesome structural imbalances, as evidenced by the lasting deficits of its private sector in 1998-2002 and 2005-08. During those periods, the US private sector dug itself into a financial hole, leveraging itself up until the crises brought it to an abrupt end.

Today, the US private sector is on the same path. With financial deregulation looming, repeating the mistakes of the past may be more likely, and the day of reckoning in terms of reconciling this may finally arrive faster. Ultimately, today's Goldilocks economy could be a harbinger of future financial troubles that could spread quickly across the global financial system. Previously, the Goldilocks economy persisted for several years. This time it really could be different. Our base-case scenario incorporates the assumption that the "Goldilocks scenario" is a medium-term phenomenon, and will last one more year.

Ukraine's political cycle to benefit from Goldilocks economy. As the prevailing sentiment has shifted perspectives from viewing the glass as half-full from half-empty, Ukraine's economy has benefitted. Improved prices for key commodities and easier access to FX funding has bolstered Ukraine's balance of payments, which is necessary to refinance existing sovereign and corporate foreign-currency denominated debt. The economy is therefore running smoothly, and speculation over political upheaval has softened. Also, important, the NBU has been able to effect a heavily managed float of UAH, and facilitate an orderly weakening of the domestic currency, which is misaligned, according to our assessment.

Ukraine's economy: Steady recovery, improving outlook. We revised our 2017 forecast upward towards +1.8% YoY real GDP growth from +1.2% YoY. In 2018, a +3% YoY increase of real GDP is forecast, as our base-case envisages that the government will raise the minimum wage again next year, since this practice paid off this year. Income distribution has shifted from a very acute preference to profits while neglecting wages (47% versus 36% in 2016) towards a less acute structure (see Chart 31 and Chart 32 on p.25). With household consumption accounting for 65% of GDP, this shift should extend, and is on a path to reach a more sustainable structure of 40-45% profits and 40-45% wages, with taxes accounting for the remaining 15%. This has been a natural shift, and one that produces stable growth, since it is not supported by credit. Growth is healthy when consumers spend their wages as opposed to using credit. Hence, consumer-related businesses are likely to benefit from this expected development. Another sector likely to extend double-digit growth is construction, as the government continues to fund civil infrastructure projects.

Inflation: Last spike in headline CPI transitory, sliding towards 10% YoY in 2018. Authorities are running the economy under a quite tight mix of fiscal and monetary policy. The state budget had a record-high primary surplus of 3.9% of GDP on a LTM basis in August. The central bank is committed to pay low, double-digit rates for excess UAH monetary reserves on banks' accounts, and this boosts the attractiveness of UAH assets, and hence, eliminates the negative impact from the FX market on inflation. We expect this to continue well into 2018. Further, in our view, hiking the minimum wage will have a limited impact on inflation, because unemployment continues to be high. There is still a way to go before the labour market tightens, which certainly won't happen over the next year. Our view on inflation is that it will slow gradually over 2018 towards 10%. Hence, the NBU will continue cutting its policy rate in 2Q18 and through rest of the year.

Ukraine: financial flows reveal risky structure of sectoral balances. Before Ukraine's last two financial crises in 2008 and 2014, sectoral balances signaled a warning. Leading up to these two periods, the domestic private sector as a whole had been running financial deficits for a year or two. These deficits coincided with current account deficits, and now, a similar pattern is forming. Since 2005, Ukraine had been a chronic net importer, and now it is returning to this position again. If the country fails to correct the current account deficit by becoming a net exporter, then the situation of an improving economy we observe now will reverse over time, leading to another FX correction. Our base-case scenario calls for gradual FX flexibility and gradual USD/UAH weakening.

UAH: There are a number of supportive factors. We outline three factors that are supportive for relative, FX rate "stability" for the UAH. These will allow orderly movements in the FX market into 2018, similar to 2017. Details are on pp.40.