Pressure for fresh IMF bailout builds as central bank reserves drop amid broader economic fears

The temperatures will soon be dropping outside, but Ukraine’s political and economic situation hasn’t been this hot for a long time.

While President Viktor Yanukovych is under international fire for the ongoing trial and detention of former Prime Minister Yulia Tymoshenko, global economic conditions are worsening, with developed markets teetering on the brink of another recession, raising concerns about the state of the Ukrainian economy.

Investors were shocked by news this week that Ukraine’s central bank foreign currency reserves reportedly plunged by 8.3 percent in September to $35 billion.Investors were shocked by news this week that Ukraine’s central bank foreign currency reserves reportedly plunged by 8.3 percent in September to $35 billion.

“Chief advisor to National Bank of Ukraine governor Valeriy Lytvytskiy was quoted as saying yesterday that the international reserves stood at $35 billion as of the end of September, which implies a sharp month-on-month drop of $3 billion. Such a drop in reserves seems severe,” Kyiv-based investment bank Dragon Capital said in an Oct. 5 note to investors.

“We will wait for an official NBU statement on September reserves, due on Oct. 7, before making any conclusions regarding potential risks to the hryvnia. But, with markets remaining extremely sensitive to negative news, this report may add to selling pressures on Ukrainian assets,” Dragon added.

The brewing economic storm at Ukraine’s doors moved Deputy Prime Minister Sergiy Tigipko to assert that the country had no choice but to unlock billions of dollars in fresh bailout loans by reviving cooperation with the International Monetary Fund.

“We don’t have options and we should find understanding [with the IMF], as it is difficult to stay eyeball to eyeball with the crisis and without the support of international financial organizations,” he said on Sept. 30 during a televised appearance.

The statement came after the annual IMF meeting on Sept. 23-25, where the lender once again refused to drop its demand for an increase in household heating tariffs that would reduce the deficit for state-owned gas company Naftogaz.

The IMF froze the quarterly $1.5 billion loan tranches, established under a 2010 agreement, in March this year after Ukraine failed to make good on its obligations. The country has since managed to meet three of the four IMF demands: pension reform raising the retirement age, an increase in the central bank’s independence, and development of a foreign exchange swap market.

With Yanukovych and his Party of Regions plunging in polls one year ahead of a parliamentary election, his administration is hesitant to meet the final IMF austerity condition: hefty natural gas tariff hikes for households.

Raising the country’s utility bills could decrease the deficit of state energy company Naftogaz, and in turn, the national budget. But it is arguably the most difficult decision politically, particularly with an opposition that is galvanized by Tymoshenko’s trial and the ensuing statements of international support.

Yet while signs of global recovery and rising currency reserves had previously reduced Ukraine’s need for the IMF loan, at present the economy is coming under pressure from several factors – an upcoming surge in debt repayments, a growing current account deficit, and a potential fall in the hryvnia exchange rate.

At present renewing cooperation with the IMF is vitally important, asserts Alexander Valchyshen, head of research at Investment Capital Ukraine, a Kyiv-based investment bank. He also notes that the huge stress on financial markets in recent weeks saw the dollar strengthen in comparison to East European currencies. This suggests that the national bank of Ukraine’s policy of keeping the hryvnia stable may have left an overhanging correction.

Dmytro Boyrachuk, the executive director of CASE Ukraine, an economics-focused research institute, points to the growing current account deficit, poor business environment and delayed IMF cooperation as the main factors increasing pressure on the hryvnia. He adds that 2013 will be a critical year for renewing cooperation with the IMF, with no prospects of global revival placing Ukraine’s export earnings at risk.

Meanwhile, the government has sought to micromanage itself out of the present predicament.

Two weeks ago the NBU rehashed a 1993 Cabinet of Ministers decision that placed strict restrictions on exchanging foreign currency. At present everyone is required to leave a copy of their passport at the point of exchange, while foreigners can only sell hryvnias if they had previously purchased them, up to the amount of the original exchange.

While officially the move was aimed at fighting against the shadow economy, analysts say its prime purpose is to safeguard the hryvnia exchange rate.

The government also decided to issue hryvnia-denominated, “devaluation-insured” bonds. The principal for these bonds to be repaid will be calculated on their worth in dollars at the exchange rate of the day of issuance (the semi-annual coupons will not be affected). A stronger hryvnia, conversely, would have no impact on the repayment.

With the government aiming to attract Hr 10 billion ($1.25 billion) by the end of the year, the bonds should shore up the hryvnia exchange rate in the short term. However, it leaves the government vulnerable to risks if the hryvnia falls.

With the government aiming to attract Hr 10 billion ($1.25 billion) by the end of the year, the bonds should shore up the hryvnia exchange rate in the short term. However, it leaves the government vulnerable to risks if the hryvnia falls.

The instrument can help only partially help with depreciation pressure, leaving the main problems – the economy’s lack of competitiveness and unpredictable decision-making by the Ukrainian authorities, unchanged, explained Boyrachuk, who expects crawling depreciation with Hr 8.1 per $1 by the end of this year, and Hr 8.5 in the next. He added that the instrument only secures against minor exchange rate fluctuations, however, as a major shock could lead the NBU to fail on its commitments.

“It is a poor idea from local policymakers, in my view. It does not bode well to sustainable economic growth in the local economy. Accepting a foreign exchange risk while borrowing is a bad sign,” Valchyshen said.