Ukraine

Highlights and Key Issues

* Strong industrial production is keeping GDP growth above 7% this year, but higher fuel prices and an undervalued exchange rate have lifted inflation to around 12%. Food price rises have added to H2 inflation and imported gas will give a further boost in H1 2008, so efforts to stabilise prices will require a gradual slowdown in growth from 2008-11.

* Denied a chance to let the UAH exchange rate strengthen, the central bank is seeking to restrain domestic credit growth. But this will be kept high by foreign capital inflows as FDI accelerates and the government and large corporations borrow more abroad and an increasingly foreign-owned banking sector lend more in foreign currencies.

* There is a downside risk to industrial growth in 2008 as Russia raises gas prices towards the limit that main users view as affordable, and inflation erodes the export advantage from the UAH depreciating against the EUR. Growth drivers could shift from investment towards consumption as households defy monetary restraint, and relatively low public debt lessens the urgency of fiscal tightening.

* A coalition of parties that fought the 2004-05 revolution will return to power next month, with the peaceful transfer of power further lowering political risk. But tension will remain between the president and the likely prime minister, estranged ally Yulia Tymoshenko, whose poor relations with Russia could also worsen re-emerging ownership disputes.

Overview

Growth rate stays above 7% in Q2...

* The growth rate remains on course to match last year's 7.1% as strong export demand for machinery and processed materials helps industry to pass on the impact of higher fuel prices and capital inflows keep up the investment rate. Initial estimates put GDP growth at 7.3% in January-October, with industrial production up 11 % on the year - double last year's rate - and steel output volume running about 5% higher. However, a slowdown is on the way in 2008 as monetary and fiscal policy adjust to tackle seriously above-target inflation and as gas import prices strain the ability of heavy industries to export and invest. The economy ministry has admitted that rising energy prices are likely to drag down growth in 2008 below the official forecast of 7.2%.

...but inflation breaks revised target

* A 2.9% rise in consumer prices in October brought the rise to 11.7% after ten months, compared with an initial official target of 7.5% (now raised to 10.8%) for the full year. After being driven by gas and oil prices in H1, inflation has been kept above last year's levels in H2 by food price rises - 4% during October - as serious drought reduces output of grain, exports of which have been stopped until end-year. The economy ministry has warned of a further boost in 2008 from the next rise in Russian gas prices, from the present US$130 per thousand cubic metres; it is bargaining for a price just over US$140, although Gazprom has mentioned figures as high as US$160.

* The inflation overshoot has increased pressure for an upward adjustment of the exchange rate, which would help to hold down prices of imported inputs. The present fix at UAH5.05 to the US$ has meant a depreciation against other currencies as the US$ slides, and no insulation against rising US$-priced mineral imports. The rise in official reserves to US$30.7bn by end-September, as the UAH was sold to keep its value down, reinforces the case for a stronger currency. But while the central bank governor has sounded in favour of revaluation in its recent statements, President Viktor Yushchenko remains forcefully opposed to it. Bank council head Petro Poroshenko, a presidential ally, has defended the present fluctuation band, which allows the hryvnia to go no stronger than UAH4.95 to the US$.

Capital inflows finance wider deficit

* Although a weaker exchange rate might lift export competitiveness in the longer term, its initial impact has been to worsen the external deficit. The visible trade gap reached US$6.7bn in January-September, up from US$4.3bn last year, as import growth stayed well ahead of exports. With the current account deficit consequently widening to US$2.5bn after nine months from below US$0.3bn last year, upward pressure on the currency has been driven by capital inflows. Foreign direct investment (FDI) is around 60% higher on the year, at US$5.2bn in Q1-Q3 (from US$3.1 bn in 2006), and capital inflows were lifted by a US$700m ten-year eurobond in November. FDI continues to be boosted by foreign acquisitions, despite a serious dispute with Russia's Tatneft over ownership of the biggest oil refinery.

* Yushchenko also suggests that a stronger UAH would devalue domestic US$ savings, and wants inflation tackled by fiscal and monetary means. Plans to absorb US$ savings through UAH bond sales have dropped behind schedule in H2 and, although a further UAHIbn issue will be attempted, the message from the markets is that savers will only be interested if domestic interest rates rise. Monetary policy is gradually tightening, with a rise in reserve requirements on foreign currency loans from 20 November aimed at curbing the growth in hardcurrency borrowing by foreign-owned banks that counters efforts to sterilise foreign inflows. Even with these measures, the official target of 6.8% inflation in 2008 already looks unattainable.