After the Revolution

Global Finance, Jun 2005 by Neville, Laurence

With the shockwaves from last year's election debacle subsiding, Ukraine is poised to embark on a phase of explosive-and potentially traumatic-growth.

In the space of just six months, the world's view of Ukraine has changed beyond recognition. Before November 2004 few people knew much about the country, and those who did saw it as a politically corrupt backwater that was too close to Moscow for comfort. But the Orange Revolution has put an end to such characterization. Now the talk is of eventual membership in the EU and of financial reform.

The man at the heart of this transfermation is Viktor Yushchenko, a former governor of the central bank of Ukraine, who received an award from Global Finance in 1997 as one of the six best-performing central bankers in the world-a fact he cited in his official presidential campaign biography. Yushchenko is no stranger to power. In addition to his stint as central bank governor, he was Prime Minister from 1999 to 2000 and was widely credited with laying the foundations of Ukraine's current economic success.

However, it is his most recent actions that have inspired the world. Having been denied power in the almost-universally condemned November 2004 presidential election,Yushchenko galvanized the people into action. Thus, more than a decade after the fall of communism, Ukraine was once again protesting for its freedom. In a re-run of the election in December, Yushchenko won and, despite being deliberately poisoned during the campaign, took office to global applause.

Of course, Yushchenko's election is not a panacea. According to RZB, the investment banking arm of Raiffeisen Bank, economic growth slowed considerably in late 2004 and early 2005.The country remains vulnerable to a fiscal deficit of 6%-7%-not least as a result of last-minute election-related increases in pensions and minimum salaries-unless serious action is taken to stem it.

But the problems should also not be overstated. In 2004 Ukraine's GDP grew by 12%, and it is likely to grow by 8% this year, according to RZB. German investment bank WestLB more conservatively estimates growth of 6.5%-still impressive by European standards. Similarly, the government has promised to accelerate its privatization program, which should bring the budget deficit down to 2%. Inflation is expected to fall from 12.3% in 2004 to 9.5% in 2005 and 5.5% in 2006, according to WestLB.

On May 11 Standard & Poor s raised its long-term foreign currency sovereign credit rating on Ukraine to BB- from B , reflecting improved creditworthiness and an enhanced political and policy environment, according to credit analyst Helena Hessel. She notes that Yushchenko advocates transparency, the rule of law and democratic values, which over time should lead to the implementation of political, institutional and structural reforms that are necessary to transform Ukraine into a country with an open, democratic political system and a market-based economy.

Tomasz Balamut, economist in the treasury department at WestLB, says there are a number of explanations for Ukraine's growth. "Part of the reason is because the country experienced a deeper recession than most other postCommunist countries, and when the stabilization of the late-1990s arrived, there was further to climb. In addition, Ukraine has also benefited from the strong market for steel, which is the country's main industry."

Opportunities and Problems

Despite a slowdown, Balamut remains optimistic about prospects for GDP growth and says the broad growth of both the export and domestic consumption markets bodes well for the future. "This is certainly a great place to invest in terms of accessing growth," he says. "The wages are around $120 a month, making it comparable with China but with the German market on the doorstep. Already we are seeing Polish manufacturers moving factories to the Ukraine to take advantage of wage rates. It's not an easy step for everyone though; you would need to be confident of being able to cope with Sovietstyle bureaucracy," he adds.

Indeed, the slow pace of reform at the grassroots level remains a problem. "The Ukraine has a big challenge in order to make conditions more attractive for investors. It is at the bottom of FDI per capita tables," says Balamut. "There is a real need for better administration and decision-making procedures in government." Similarly, while the tax code and legal structure of Ukraine appear attractive to foreign investors, there continue to be problems with implementation and government organization.

A further disincentive to investment is the fact that the local currency, the hryvnia, is not fully convertible. Gerhard Lechner, country analyst at RZB, says that although the government has yet to make full convertibility a pledge, it is generally accepted to be a long-term objective. In the meantime, investors must cope with a steadily appreciating currency and the prospect of a change in policy in the future.

The currency has appreciated in recent years primarily because ferrous and nonferrous metals account for a huge percentage of Ukraine's economic product. As a result of the strong demand for metals, the country's current account surplus has ballooned from around 4% of GDP in 2000 to 9% last year. That has had a predictable effect on the hryvnia currency, which has appreciated from around 5.44 to the dollar in 2000 to 5.33 last year to around 5.20 this year. WestLB is predicting a rate of 5.15 by the end of the year, but some commentators say an official change to a 5.10 rate is possible. If the currency is revalued, there is likely to be a decline in the rate of growth, according to Lechner. "There is a great need to revalue in order to slow inflation, but it would affect growth, which in a country as poor as Ukraine is desperately needed," he says. "It's a tough trade-off."