5 Feb 2010 19:16

Default "far from inevitable" in Ukraine

MOSCOW. Feb 5 (Interfax) - Ukraine's public finances will in continue to be pressured during 2010 (foreign currency rating CCC+/Stable/C; local currency B-/Stable/C) in the absence of more rigorous reforms to both the energy sector and the pension system, Standard & Poor's said in a special report "Ukraine's Public Finances: Reading Between The Lines."

Even so, while the budget for 2010 is still undecided and the second round of presidential elections has yet to take place, Standard & Poor's remains of the opinion that default is far from inevitable, the agency said.

In November of 2009 Ukraine's parliament, the Rada, rejected the proposed budget and demanded a considerably higher expenditure envelope for 2010 (requesting an additional Ukrainian hryvnia (UAH) 300 billion or 30% of GDP in spending proposals). Since then, no agreement on the 2010 budget has been reached. As a consequence, the 2009 expenditure envelope has been carried forward into 2010, without any line item stipulations. What this means in practice is that at least for the first quarter of 2010, the next government will be able to execute expenditures at its own discretion inside a lower expenditure envelope; hence, expenditures could actually fall in real terms assuming that inflation averages 14% during 2010 as the National Bank of Ukraine (NBU) anticipates.

While a budgetary stand-still may provide some immediate cash flow relief, it is unlikely to restore confidence in Ukraine's economic management as it signifies a prolongation of the electoral period and hence the possibility of a further delay in any rapprochement with the International Monetary Fund.

he consolidated public sector budget deficit for 2009 looks to have ended the year slightly over 8% of GDP. This estimate excludes 2.3% of GDP in capital injections into the ailing financial system (these were monetized by the NBU as stipulated by the IMF Standby Program) but includes an estimated 0.6% of GDP increase in central government lending to the pension system during 2009, as well as 2.4% of GDP transfers to Naftogaz. This figure also, of course, excludes generous (and in our view unaffordable) hikes to pensions passed by the Rada last October. Depending on which workers would benefit from the Rada's decision to raise minimum wage levels (and hence pensions), the cost to the budget of the implementation of this 'Social Standards Law' could range anywhere from 2.5%-7.0% of GDP.

Meanwhile, Ukraine's government is facing quite serious cash flow pressures, not least due to depressed domestic demand and the second round impact this is having on the indirect tax take. Cash flow problems could, under various scenarios, further increase the influence of powerful oligarchs within the government. There are also related concerns that the economic crisis has lead to an increase in the size of the grey economy, and hence has cut into the tax base.

With the appetite of local banks for government debt more or less sated, external markets closed, the IMF agreement on hold, and $2 billion in Special Drawing Rights (SDRs) from the IMF quota already used up to make 2009 Gazprom payments, the outlook for financing during 2010 continues to be tight. The NBU still has about an additional $2 billion that it could use to enable Naftogaz to make gas payments for the first few months of 2010. As a result, during the first quarter of 2010, financing pressures are unlikely to be intense, and funding could come from advance payments to the state by state-owned enterprises. By spring, however, state financing pressures could intensify, particularly as the level of maturing treasury bills increases beginning in May of this year.

Ukraine's Finance Ministry continues to cooperate closely with the IMF, but, as in the past, the relentless electoral calendar, and unpredictability of institutions have lead to a suspension of the previously scheduled $3.3 billion loan disbursement. With only $5.5 billion in disbursements remaining in the IMF package, it could at a maximum provide only 5.5% of GDP in budgetary funding. Other sources will have to be found, but are not readily apparent.

One risk is that fresh pressure will be put on the NBU to monetize the deficit. A new governor will be appointed by the new President later this year; indeed the current governor's term already formally expired in December of 2009). So far the NBU has staunchly resisted any pressure to do so, only agreeing to monetize the capitalization of banks (as agreed under the IMF arrangement). Standard & Poor's base line scenario is that the Social Standards Law will be scrapped, while arrears funding will continue to be substantial up until the IMF program is restarted possibly sometime during late spring or early summer. Under such a scenario, the prospects for public finances to gradually improve are genuine, particularly if GDP growth picks up toward 4% as we anticipate. But given the political uncertainties there remains a substantial risk that these developments will either be delayed or prevented.