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Spotlight switches back to the debt burden in Ukraine

Even if the Ukrainian government rides out popular protests against its decision to turn away from the EU, the sovereign and state gas company debt repayments due in 2014 will challenge its financial position.
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Spotlight switches back to the debt burden in Ukraine

As Ukrainians took to the streets late in 2013, protesting against their president's decision not to sign an association agreement with the EU, politics quickly took centre stage and problems with the economy were forced back on to the margins. But as tempers cool, the state of the Ukrainian economy is coming back into the spotlight, with many observers worried about the country's ability to repay its debt.

The street protests sent the cost of insuring against default on Ukraine's debt soaring. On November 22, after president Viktor Yanukovych's announcement that his country would not sign the EU association agreement, but before the Vilnius summit at the end of the month – during which the agreement was meant to have been signed – the spreads on Ukraine's five-year credit default swaps (CDS) were 995 basis points (bps).

On December 3, after the summit came and went with no agreement, and as tens of thousands of people crowded the streets demanding Mr Yanukovych's resignation, spreads had jumped to 1070bps. By comparison, Egypt's CDS spreads at the time were just less than 650bps, while spreads on Venezuelan debt were about 1300bps.

Choosing sides

Even before this, many had warned that Ukraine, caught between the EU and Russia – geographically as well as politically – was in danger of defaulting. The country's conflicting priorities came into focus just before the date for signing the EU trade deal. It now looks as if Ukraine's government must find a way out of a situation that is as much of its own making as it is a consequence of two global powers fighting over the country.

The EU had asked for the former prime minister Yulia Tymoshenko, currently serving time in prison for alleged abuse of power – charges that she and many in the West say were politically motivated – to be released in order to be treated in a German clinic for chronic back problems. With days to go before the Vilnius summit, the Ukrainian parliament postponed debating legislation that would allow this, in an early sign that the EU agreement was off.

It then emerged that the Ukrainian president had held secret talks with Russian president Vladimir Putin about the sanctions that Russia planned to impose on Ukraine if it signed. Since mid-2013, Russia had imposed harsh conditions on imports from its neighbour, leading to a slump in Ukrainian exports.

Ms Tymoshenko – who went on hunger strike on November 25, in solidarity with protesters who were demanding that the president sign the EU partnership – warned Mr Yanukovych in an open letter that he was making "the biggest mistake of his life".

"You want cheap gas and money from one party and international legitimisation of your authoritarian rule from the other. But you are wrong in thinking that you are clever enough to play Russia and Europe against each other," Ms Tymoshenko wrote in the letter. "The democratic Western world will simply not play the bribe game as you practise it. Instead, you will be left alone with Russia, and you will have to live all your life according to its diktats."

Tough choice

The choice between Russia and the EU is not a simple one for the Ukrainian government.

"By improving economic ties with the EU, Ukraine would gain much more in the long term than by siding with Russia. But if Ukraine had signed this treaty now, it would have hit its economy because Russia had threatened to raise customs duties on Ukrainian goods," says Tatiana Orlova, Russia and Commonwealth of Independent States analyst at RBS.

Siding with Russia is easier in the short term. Signing the EU association agreement would probably have brought a swift accord with the International Monetary Fund (IMF), because the fund's European directors would have warmed to the country, but painful reforms would have had to be introduced. Without an agreement with the IMF, investors, even those with a remit in the region, stay on the sidelines.

"I am worried because of the macroeconomic situation in Ukraine, because of the lack of reform caused by the political feud that is going on. It is undermining the confidence of investors in Ukraine," says Erik Berglof, the European Bank for Reconstruction and Development's (EBRD) chief economist. "For us, it is extremely important to have a framework that stabilises the economic environment. We co-invest with private investors. If private investors are not confident in the framework, it's very hard for us to do things. So this is clearly influencing what we can do."

The country's central bank has managed to keep the currency's exchange rate pegged at a level of about 8 hryvnia to the US dollar but at an enormous cost: foreign exchange reserves cover only about two-and-a-half months of imports, and are dwindling fast. Without an infusion of cash, Ukraine is staring at a balance of payments crisis. Investors were hoping that salvation would come from the IMF.

Energy crisis

The biggest stumbling block is energy sector reform. Under the current set-up, all households in Ukraine benefit from implicit subsidies for the gas they consume, a situation which, the IMF and other experts have warned, drains the country's budget.

A recent World Bank study showed that Ukrainian households on average pay about 20% of the full import price of gas, and this is costing the country about 7% of gross domestic product (GDP) in subsidies. This is because state-owned gas monopoly Naftogaz imports expensive gas from Russia and has to cover the price difference from the state's pocket.

Mr Yanukovych has repeatedly said that he would not sign an agreement with the IMF, reasoning that the lifting of energy subsidies would hit the poor. The IMF did not respond to The Banker's requests for comment, but a World Bank study, as well as analysts, point out that it is not the poor who actually benefit most from the subsidies.

"In most countries such as Ukraine... the subsidies on energy go mostly to those who are not poor, to those who are in the middle class or above," says Alexander Pivovarsky, the EBRD's lead economist for eastern Europe and the Caucasus. "There is ongoing discussion in Ukraine about who actually consumes this household gas; it is likely that a significant share of it is used for other purposes so it's a kind of subsidy to some potentially very wealthy people."

The World Bank's study shows that the top 20% of the Ukrainian population in terms of income get about 27% of the subsidies for gas and district heating, as they consume more. The poorest 20% benefit from only 13% of the subsidies.

"It appears very clear that the low domestic gas prices are not there to support the low-income population," says Simon Quijano-Evans, head of emerging markets research at Commerzbank. However, he adds: "An IMF agreement should clearly include energy subsidisation plans for people with really low incomes, otherwise they will be the first to be hit from gas price rises even if they are currently not really the largest beneficiaries of lower than market prices".

Under pressure

The situation is all the more urgent since Ukraine is paying one of the highest prices in Europe for the gas it imports from Russia and is, at the same time, among the highest consumers of gas on the continent. This goes a long way to explain why the country pays so much attention to Russia's opinion when it comes to external alliances.

The current crisis has reminded Ukrainian officials that they need to do something to cut their country's dependence on their big, energy-rich but very demanding neighbour. 

"For the past 20 years, Ukrainian governments have not been focused on reducing the dependence on Russia, so they import huge amounts of gas from Russia each year. Now they have started to look more seriously at diversifying away from Russian gas supplies," says Simon Pirani, senior research fellow at the Oxford Institute for Energy Studies.

In the 1960s, Ukraine used to supply other parts of the Soviet Union with gas. In the 1970s, just as gas production in Ukraine began to fall, it had begun to rise in Siberia and by the time the Soviet Union collapsed in 1991, the country saw itself significantly tied to Russia because of its reliance on imported gas.

Few alternatives

Ukraine is currently relatively poor in alternative sources of energy. Nuclear power accounts for about 45% of electricity production, but since the nuclear disaster in Chernobyl in 1986, nuclear energy capacity has risen very slowly. The country also has some coal mining and hydro power.

The country is currently trying to import gas via so-called reverse flows – Russian gas that has been delivered to western Europe at cheaper tariffs and is re-transmitted to Ukraine either via Poland or Hungary at a price that works out about 10% cheaper than the price it pays under the terms of the current agreement signed with Russia.

It is also trying to exploit its own shale gas, with a swathe of international companies such as Shell, Chevron and Eni involved in the sector. But these resources sometimes take years to become significant. "There's a real strategic dilemma for Ukraine, in that it can't do entirely without Russian gas. It is cutting the amount of gas that it imports from Russia but to stop it completely is impossible," says Mr Pirani.

The World Bank study argues that if Ukraine were to cut the implicit subsidies on the consumption of gas by all households and only give subsidies to the people who really need them, this would increase efficiency, cutting waste. But such a system would be far from easy to implement in a country where, out of a population of 46 million, 18 million are pensioners. The country is also plagued by administrative problems.

"Determining for each household, whether it is rich or poor, in a country infamous for the high levels of corruption and red tape, is quite a barrier. The government would have to raise tariffs for everyone and decide then which households qualify and which not," says Ms Orlova of RBS. "From the point of view of popularity ratings, it is much easier not to hurt anyone."

Currency worries

Ukraine has undertaken some reforms, most notably cutting red tape in the construction sector, which helped it advance by more than 20 places in the World Bank's most recent Doing Business rankings, becoming the fastest improving country in 2013. But apart from the energy sector, agriculture – where producers are allowed to retain value-added tax in order to invest it in further production rather than pay it to the exchequer – is also a source of worry for analysts, as the system of implicit subsidies is opaque and difficult to control.

Ensuring predictability in the legal system is another fundamental reform that needs to be implemented, as is the relaxation of various constraints put on the currency regime to keep the exchange rate peg.

Under the existing currency controls, companies must sell half of their foreign currency revenue on the domestic market the day the payments for their exports are received. Companies must also obtain the permission of the central bank before opening accounts with foreign banks. The central bank must be notified of any foreign loans and there is a cap on the interest rate the foreign lender can charge. This may have encouraged deleveraging in the banking system, already hit by a high level of non-performing loans.

"To protect the exchange rate, they adopted policies that make the financial system less willing to lend and make it shrink," says the EBRD's Mr Pivovarsky. "You need a more flexible regime where part of the adjustment would happen through the exchange rate, not through the banking system."

A devaluation of the currency would help narrow the current account gap, which is running at about 8% of GDP, as it would boost exports. But it would also hit the government, directly and indirectly. "The government has increasingly borrowed in the domestic market via US-dollar denominated Treasury bills. In the event of hryvna devaluation, it would be harder to repay these T-bills. They have been bought mainly by state banks," says Ms Orlova.

Ukraine's government debt is low compared to other European countries, at less than 40% of GDP, but the country remains deep in recession, with output about 10% below the peak before the 2008 crisis.

Because of its multitude of problems, Ukraine has virtually no access to foreign markets and faces payments of more than $8bn in 2014 for sovereign and quasi-sovereign debt, including the debt of state-owned gas monopoly Naftogaz. Its current account deficit for 2013 is likely to amount to $12bn.

"Eight billion dollars plus $12bn is exactly the amount of foreign exchange reserves we have right now. The government has to find the answer to this equation," says one Kiev-based banker, who wanted to remain anonymous because of the political sensitivity of the issue.

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