Ukraine winners face tough economy decisions after election

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By Olzhas Auyezov | November 2, 2012 8:07 PM EST

Ukrainian President Viktor Yanukovich's ruling party finds itself with a small window of opportunity to carry out painful but badly needed changes to streamline the economy.

The issue following elections that helped the party retain control over parliament is whether it will bite the bullet and take long-delayed steps such as raising household gas prices.

Or, with an eye to Yanukovich's re-election in 2015, will reforms to cut debt and promote growth be held off?

"While the new majority will likely back possible government reforms... the passing of unpopular measures would still require significant political will," brokerage VTB Capital said this week.

"This would be especially so, as the strong results of the opposition (in the latest vote)... point to a tough campaign for the 2015 presidential elections."

The former Soviet republic's economy, dominated by steel exports, is shrinking. Its budget deficit is surging and large foreign debt repayments are looming.

Ordinary Ukrainians, meanwhile, have been betting against their own hryvnia currency by converting savings into dollars. The hryvnia touched a 3-year low on Thursday as banks and ordinary Ukrainians rushed to buy dollars, forcing a state-run savings bank to intervene.

"A looming external financing gap and the prospect of presidential elections in 2015 mean that the next Ukrainian government has limited time to deliver key reforms following this week's parliamentary elections," rating agency Fitch Ratings said in a report this week.

After Yanukovich came to power in February 2010, the government announced an ambitious agenda that included reducing state debt, reforming the crumbling pension system and improving business climate.

But it pulled up sharply on implementing unpopular planks of the programme -- such as raising gas and heating prices -- in 2011 in the face of this year's parliament vote.

This cost Kiev financial support from the International Monetary Fund which insists, in particular, on the government raising the price of subsidised gas and heating for households.

For a while, this did not seem to be much of a problem as Ukraine's economy was recovering fast from a 15-percent recession of 2009, aided by strong commodity prices and accessible capital markets.

But starting from late 2011, the euro zone crisis and global economic downturn caused demand for Ukrainian steel to plunge, forcing local producers to cut output and eat into export revenues that used to support the hryvnia.

Rather than let the currency slide and thus correct the trade balance, the authorities stuck to the peg, saying that allowing depreciation would lead to panic.

The government issued its largest and most expensive Eurobond ever in July, borrowing $2 billion at 9.25 percent, and the central bank has spent about $3 billion so far this year on supporting the hryvnia's peg to the dollar.

In what it described as measures to boost domestic demand, the government also added $3 billion to budget spending this year, raising wages and pensions.

This helped Yanukovich's Party of the Regions, campaigning under the slogan "From stability to welfare", to secure a majority in the election together with traditional allies such as the communists.

CRUNCH TIME

But, as a result of these policies, the government now faces multiple challenges: reviving growth, adjusting the exchange rate and sorting out state finances to avoid a debt trap.

Ukraine's economy shrank by 1.3 percent in the third quarter in its first contraction since 2009.

The country's largest steel producer Metinvest reported a 71-percent drop in January-June net profit on Thursday as its crude steel output fell 8 percent year-on-year.

The firm, owned by billionaire industrialist Rinat Akhmetov who is one of Yanukovich's main supporters, cut investments by 31 percent in the same period.

"We do not expect any significant improvement (in market conditions) in 2013 compared to 2012," Metinvest's Chief Financial Officer Sergiy Novikov said, adding that the market was glutted by mainly Chinese producers.

The government itself is under growing financial pressure.

"Despite its ability to access the bond markets this year, Ukraine's external financing position is precarious," Fitch Ratings said on Thursday.

"The external financing requirement will grow in 2013, as repayments due to the IMF rise sharply to $6 billion, combining government and central bank repayments. Fitch believes this probably exceeds the government's capacity to borrow externally and will require partial refinancing by the IMF itself."

DEVALUATION?

There is some anticipation in markets that the government will now allow the hryvnia to fall further against the dollar.

Allowing the currency to depreciate would please the IMF, and help Ukrainian exporters as their costs would fall in dollar terms while revenues would remain stable or even rise.

"A devaluation (of the hryvnia) would be a very positive factor for us," Novikov of Metinvest said.

But such a move would hurt those who borrowed in dollars, including both ordinary Ukrainians and the government which stepped up issuance of dollar-linked domestic debt this year.

As for gas price hikes, Ukraine had hoped to avoid them by getting a discount on Russian gas supplies, but talks on the price have failed to produce any results and only strained Kiev's ties with Moscow.

A decision whether to go ahead with the hikes and other unpopular moves needs to be made soon, analysts say.

But policy uncertainty is reinforced by speculation that Prime Minister Mykola Azarov, a 64-year-old government veteran who has held the post since March 2010, may soon be replaced by central bank governor Serhiy Arbuzov, 36, whose mother heads a bank owned by Yanukovich's son.

"Ukraine's record of domestic political considerations over-riding policy commitments to international financial institutions suggests this pattern could be repeated ahead of the 2015 presidential election," Fitch said.

"Effectively, there may be little more than a year to enact these reforms."

(Reporting by Olzhas Auyezov; Editing by Richard Balmforth/Jeremy Gaunt)

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