Nation's economy faces currency risks as foreign reserves drop

After half a year of recession, Ukraine’s economy received more bad news on July 5, when the National Bank of Ukraine (NBU) announced that foreign currency reserves fell to a six-year-niinimum of $23.1 billion, the lowest level since the global crisis hit. This time, however, the decline is driven by a $1.1 billion Eurobond repayment, according to the NBU.

The level of foreign currency reserves has been below adequate since the 2008 financial crisis. After a

short recovery in 2010, reserves again started falling in mid-2011, stabilizing at $25.5 billion only in April of this year, according to a May report by a German Advisory Group, a consultancy advising the government.

The country has recently benefited from favorable market conditions, with Eurobond rates falling to a two-year low. But this changed in May after the U.S. Federal Reserve announced plans to slow its quantitative easing, spooking investors. On July g Ukraine’s credit rating was revised from stable to negative by global rating agency Fitch.

With an increasingly tough market ahead, an International Monetary Fund loan deal on hold and $5 billion in debt left to pay this year, experts see big currency risks.

"By the end of the year Ukraine will have to pay $2.9 billion externally and $1.4 billion domestically (excluding interest costs) in foreign cash. Those numbers pose serious currency risks for the second half of 2013," says Alexander Paraschiy, head of research at leading investment bank Concorde Capital.

While authorities will try to keep the hryvnia-dollar exchange rate stable ahead of the 2015 presidential elections, Ukraine could face a 20 percent devaluation by end-2013, according to Paraschiy, who sees two possible scenarios for this autumn.

"If authorities are able to raise enough funds externally and are able to beat internal devaluation sentiments, Ukraine has a chance to survive with Hr 8.2 for $1 till 2014 (probability near 40 percent)," he says. "At the same time, we see near 60 percent probability that pressure will be much stronger than defending capacities and external funding is unavailable - in this case we expect the hryvnia to decline 20 percent by year’s end."

While the situation is critical, some experts still hope for an IMF deal, while others are betting on further dollar-denominated debt issues.

The government can withstand potential global credit market jitters and limit the drain on NBU reserves by tapping the domestic banking sector’s sizable foreign currency liquidity, currently estimated at $g billion, according to Olena Bilan, chief economist at Dragon Capital.

"The government will likely return to the Eurobond market as soon as investors are again ready to accept a single-digit yield for exposure to sovereign risk such as Ukraine’s," Bilan says.

According to the German Advisory Group report a new IMF program is the best solution to increase reserves in the near term, coupled with a move to a more flexible exchange regime. In the longer run, structural policies to attract foreign capital and boost reserves should follow, including export facilitation, attracting investments and transparent privatization, the report reads.

But Paraschiy says Ukraine has already missed its chance for an IMF deal.

"The IMF will not give money for free while the deal’s political price is unacceptable for the ruling group," Paraschiy says. "Even with an IMF loan Ukraine will be requested to relax hryvnia control, which will result in devaluation. That is, it will be painful anyway."