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Ukraine – the current state of play

Emerging markets senior sovereign strategist, Timothy Ash, discusses Ukraine’s domestic affairs, foreign policy, economy and managing risk exposure from an investors standpoint.

How do you read domestic politics in Ukraine at the moment?

Messy – as always tends to be the case in Ukraine. President Petro Poroshenko seems to be positioning for elections – whether they are early or not is an open question. But in recent months he seems to have taken action to eliminate two political rivals – Andriy Sadoviy, the Mayor of Lviv and leader of the Samopomnich Party, and Mikheil Saakashvili, the former President of Georgia. I think by doing so, sending a message to others that Ukrainian politics can get very dirty, and to play at the top table you have to be ruthless.

Who is your top pick for the next presidential elections?

Poroshenko has the benefits of incumbency but is trailing the former prime minister, Yulia Tymoshenko, in the polls. Tymoshenko has proven, over a long political career stemming two decades now and including two spells in jail, that you can never rule her out. But I think Ukrainians are hankering for a fresh face and in past presidential elections, candidates coming from the left field have had a tendency to do well. I still think Svyatoslav Vakarchuk, Ukraine’s best-known pop star (of Okean Elzy fame), is the dark horse to watch, albeit he might be looking to keep his powder dry for the election after next.

What would you watch out for at this stage in terms of domestic political risks?

We are in the summer lull but political action will resume with full force in September. I would watch for tensions between the current prime minister, Volodymyr Groysman and President Poroshenko. I think Poroshenko sees Groysman as a potential rival – getting above his stature, perhaps. I don’t buy the line that Groysman does not have political ambitions –Ukraine has a long history of rivalry between presidents and their prime ministers. However, keeping Groysman might still be a less risky option for Poroshenko, albeit he will surely want to cut his prime minister down to size somewhat – perhaps letting him walk to the gallows, just before giving him the last gasp reprieve to show who the boss is. This might still require a disruptive cabinet reshuffle.

What’s the current situation with the new National Bank of Ukraine (NBU) governor?

It is quite remarkable that it has been four months now since the incumbent governor, Valeria Gontareva, resigned, that Poroshenko has not yet named a successor. This role and institution are key. The charitable interpretation is that he is just biding his time until the leading reform candidate, Volodymyr Lavrenchuk; currently CEO of Aval Bank is ‘available’ – supposedly in September. But this is not an internship; this is the NBU governorship position, so I don’t think it is particularly encouraging that the market is being left in limbo. The fear and risk are that Lavrenchuk’s nomination could get lost amid broader politicking around early elections, or a cabinet reshuffle and some less-reform minded candidate might emerge.

And what about the IMF programme?

In any event it seems unlikely in my mind that we get a speedy sign off on the next IMF review, and this could even push out to 2018. Part of the problem therein is that Ukraine does not currently need IMF cash. It is fair to say the budget is looking in a rude state of health – which is why I have a sneaking suspicion still that Poroshenko might just go for early elections. The danger is a repeat of 2011-2013 for Ukraine, where strong budget/financing conditions allowed the country to go off-piste on the IMF front, structural reforms lag, but eventually do come back to haunt Ukraine, as they did in 2013, and eventually was a factor in the Euromaidan.

How would you sum up the current state of the economy?

In the first half of 2017, real GDP growth is estimated at 2.5% by the ministry of economy, which is close to the NBU’s production index outcome of +2.7% YOY. This is solid, given the travails at the beginning of the year over the blockade in the East. The base is low, which obviously helps, and the strength of the agricultural sector remains enduring. It reflects its stellar competitiveness and great long term prospects.

Despite the strength of the Ukrainian hryvnia, inflation remains a problem, rising steadily since the recent low of 6.9% in June 2016, to 15.6% this June. Low base effects, food price inflation on a slightly poorer harvest and rising domestic demand are pushing prices higher. Net-net, rising inflation, real FX appreciation, just underlines why Ukraine needs to crack on with the implementation of a radical/ambitious structural reform agenda to boost competitiveness. Macro looks okay for the time–being, and this stability is another reason why early elections might just be tempting for Poroshenko.

What about the structural reform agenda, is progress being made?

We have seen strong progress in certain fields, including energy sector reform, banking reform, NBU reform, et al. Plans for pension reform are encouraging, albeit let’s see if the Rada bites the bullet in the autumn. The mood music is good around healthcare reform, but we are waiting to see on delivery. The government has unveiled plans for privatisation, albeit I’m not sure how much value is left in remaining assets, aside from land – 10 million hectares in state ownership, if sold, could be a cash cow for the Treasury.

But bigger question marks still hang over the anti-corruption agenda, where progress is being made in creating institutions, but we are long overdue impact in terms of bringing corrupt individuals to account and crucially changing behaviour at the micro level.

What is the probability of a re-escalation of the conflict in Eastern Ukraine?

The sad reality is that there has already been an upsurge in fighting and with it casualties this year so far – with reported ceasefire violations running around twice the year earlier level. That said, the conflict is still running at a much lower intensity than in the peak of military operations in mid-2014 and 2015, around the landmark battles of Illovaisk and Debeltseva, and both sides have to a certain extent learn how to adjust to the current (even high) level intensity of the conflict. The Ukrainian economy, for its part, is moving on, and becoming more insulated against developments in the East.

It is now generally understood/accepted that large scale military action by the Luhansk People's Republic/Donetsk People's Republic is only with the agreement/approval of its backers in Moscow. Therein Moscow still seems unwilling to move just yet to larger-scale intensification. I think this reflects an understanding that intensification risks greater casualties – more likely now given that the Ukrainian military has undergone extensive re-equipment, and training assisted by NATO.

But I think it is important that Putin’s strategic objectives in Ukraine have not changed – to bring Ukraine back under its strategic umbrella, and within its ‘sphere of influence’. This means the presence of a government in Kyiv which is deferential to Russian interests. It is hard at present to imagine any Ukrainian politician delivering on this agenda – at least given current opinion polls. But as long as Moscow thinks that such an outcome is possible, over its desired time frame (who knows what that is), it is more likely to hold back from a higher risk fuller scale military intervention.

Where are we in terms of the US arming Ukraine with defensive military capability?

Kurt Volker the new US representative to Ukrainian peace talks indicated last month in a BBC interview that the issue was still being evaluated in the US – and appeared to play down the risks that this could be viewed as an escalation by Russia. Some in the US administration might see some use in keeping this issue warm – the mere threat of the US arming Ukraine, might yet encourage a more conciliatory approach from Moscow towards Ukraine. Much though now also depends on whether post the codification of Russian sanctions by Congress, Putin has just given up on the Trump presidency, and looks to meet US pressure, with more pressure.

So how is Bluebay managing its exposure in Ukraine?

I think with a credit like Ukraine, with many moving parts, you have to have an active investment strategy, which ideally suits Bluebay’s profile and investment ethos. Ukraine is relatively high yielding – which compensates for the risks at times, but things can change quickly. In terms of the positives, the macro environment now looks manageable, at least for this year. The fiscal deficit is much reduced, the Treasury cash balance has grown and there is no real financing need for IMF disbursements. The current account deficit looks manageable for the time-being – as reflected in FX reserve accumulation and appreciation pressure on the Ukrainian hryvnia. Of course the conflict in the East remains an ever present threat/danger, and has shown in the past how it can easily destabilise the macro in Ukraine.