Ukrainian assets have posted a remarkable performance in recent months:

• Ukrainian sovereign Eurobonds have rallied hard, by close to 200 basis points across the curve since the IMF signed off the last review under the EFF in April.
• Ukrainian GDP warrants have posted a stunning performance, rallying from just 30 cents, to 58 cents as of writing, so close to doubling your money. On issuance, I argued the structure was inappropriate for Ukraine. This is now showing effect – as buy back costs continue to rise.
• The UAH – which had been expected to depreciate to UAH28-29:$1 by year end, has actually rallied back to UAH25.5:$1. Reverse currency substitution is taking effect.

It is a bit hard to fully justify the strength of the above rally on the back of the stand-alone Ukrainian story. Likely, the bigger factor has been the clement global environment, and the global hunt for yield. Ukraine offers strong relative value, from a sold off position, relative to some of its peers.

Dolce Vita: Singer Svetlana Tarabarova and friend Artem Gagarin take selfies atop Tsum department store Wed. night at the kickoff part for Mercedes-Benz Kiev Fashion Days. UNIAN/Valdemar Gorlushko)

Reviewing the stand alone Ukraine story, let’s consider the pros/cons:

(+) There has been some stabilization in the domestic political situation at least compared to Q1 2017. Back then, the Donbas blockade was weighing on economic indicators and sentiment. The ad hoc blockade run by opposition parties/forces was eventually lifted, in exchange for a formalization of trade restrictions with DPR and LPR.

(+) Earlier in the year, it was unclear where Ukraine stood with respect to the new Trump administration. There were real fears that the friendly personal rhetoric from the President toward his Russian counterpart would translate in the lifting of sanctions on Russia. This would have been a green light for further Russian encroachment into Ukraine and for much less political and economic backing for Ukraine. In the event, Trump’s difficulties over Russia-gate, forced him to “prove” his hawkish Russia credentials. This means he has surrounded himself with Russia hawks – Mattis, McMaster, Volker, Fiona Hill. US policy is aligning quite closely with that under the Obama administration. It might be argued that the policy is tougher. Allegations of Russian interference in the US elections yielded the US Congressional codification of sanctions on Russia. Trump has been hemmed in on Ukraine/Russia policy, and this is benefitting Ukraine. This has been seen by a steady stream of senior Trump administration officials paying pilgrimage to Kyiv in recent weeks, including Tillerson, Mattis, Volker. Even Energy Secretary Rick Perry was to be in Kyiv this week, although he cancelled at the last minute on account of Hurricane Harvey. DC is showing Kyiv its love at the moment – with the Administration going out of its way to show support for Ukraine. Even the issue of providing defensive military aid to Ukraine has resurfaced again.

(+) Despite hawkish rhetoric, and actions from DC, Moscow still seems willing to stay on the back burner in Ukraine, or at least not further escalate a still fairly hot conflict in the Donbas. Russia agreed to support the latest Bread and Back to Schools’ Ceasefires, which admittedly are not holding that well. The Volker – Surkov bilaterals between the US and Russia over Ukraine kicked off with relatively upbeat mood music. Moscow is struggling to figure out the Trump administration – not giving up on an appeasement strategy from Trump towards Russia. Hence, Moscow is not willing to rock the boat by being too difficult/controversial in Ukraine.

Russia staying on the side-lines in Ukraine is good. It gives Ukraine space to get on with much needed economic reforms.

Russia even managed not to rock the boat again during Ukraine’s annual independence day celebrations on August 24th – contenting itself instead with watching bridge structures falling into place to link Crimea to Russia.

Prime Minister Groysman briefs the Cabinet of Ministers on Tuesday of the five priority reform bills for this fall's Rada session. UNIAN/Vladislav Musienko)

(-) That said, it is hard to be that enthused by reform momentum in Kyiv. It seems to be running out of steam as the 2019 elections increasingly dominate attention.

Hopes of an early sign off on the 4th review of the IMF EFF in May evaporated with the heat of the summer. Rada deputies focused on their own priorities and business class seat allocations to exotic holiday destinations. The only thing on the IMF wish list which got done was a first reading on pension reform. Two more need to be done when the Rada comes back to business in September. Not much was achieved on the land reform agenda. Although the IMF seems willing to cut some slack there, at least till year end. There was back tracking on energy price reform/adjustment. Now we are into preparation for the 2018 budget, which will likely be a big focus for discussions with the IMF.

Little was achieved on the anti-corruption agenda. Few, if any, have been brought to account for wrong-doing during the Yanukovych era. Although there has been a flurry of PR-type arrests or some lower level officials. Some in the administration seem more interested in targeting anti-corruption campaigners with anti-corruption campaigns. Allegations lodged against the finance minister, Alex Danylyuk, seem politically motivated – and disappointing because he has achieved a lot in his short time in the position.

Meanwhile, the NBU still has no governor, close to five months after the resignation of the former governor, Valeria Gontareva. This seems perverse, for a country like Ukraine, facing huge challenges and on an IMF program. I cannot think of a precedent in my 20-odd years covering countries with IMF programs. Okay, I bought some of the line earlier in the year that the position was being kept warm for Aval chief Volodymyr Lavrenchuk, who was only available from September. But then we hear that two candidates will be announced by October 5. Really? This is an important job, and frankly, if Lavrenchuk wanted the job, he should have been shooed in in May/June, at the latest. Why the delay? The concern is this is going to be a political placement again. Or the whole issue will be used as a bargaining chip with the IMF during the next review. This might also be the case with Danylyuk, with his position b put under threat, again as a negotiating chip with the IMF. This all smacks of the old Ukraine, not the new Ukraine that reformers are supposed to be building. Sad and disappointing.

In any event, there is now a lot of unfinished business for the IMF. Getting the review passed this side of year end will be difficult, if now unlikely.

My fear in all this is that the administration really does not want to do the one thing that the country is calling out for – anti-corruption reforms/action, which is key to improving the business environment, and getting investment and growth moving. Elaborate games are being played again to stall what really needs to be done. Perhaps this is all about playing for time, to stall the IMF on the politically difficult stuff (at least in the Rada) until elections.

I argue this suggests that Ukraine needs some tough love at this point. The IMF, and the international community should play hard ball with Ukraine: no more IMF disbursements until we see real delivery on the anti-corruption agenda, pension reform, energy price hikes. Stop messing around over the NBU governorship and the MOF, et al.

Enough people at the IMF still have the scars and experience from previous and numerous FAILED IMF programs to get it. I hope that in the Trump administration’s attempt to prove its support and hawkish Russia credentials, we don’t see pressure to take the foot off the back of this Ukrainian administration. It has proven it can do difficult reforms when it has to. Western officials need to be vocal in support of Ukraine’s reformers. There are plenty of excellent officials still in key positions.

(+/-) The IMF is not helped by the state of the global market, and the fact that Ukraine could easily go to the Eurobond market and borrow relatively cheaply – 10Y, sub-7.5% is possible. The problem is that given easy global financing conditions and strong budget performance to date, Ukraine does not really need IMF money at this point. So some in the administration will be saying: ‘don’t bow to the IMF. We know better. We need to focus on domestic politics and the 2019 elections instead. The danger is that Ukraine repeats what it did in 2011-2013, playing the IMF for a mug -- and against the market.

Worker at new Electrocontact plant inaugurated Wed. by President Poroshenko in Brody, Lviv region. Ukrainians are impatient with low salaries and low level of economic growth. Labor migration to the EU is growing. (UNIAN/Ruslan Gumenyuk)

(+) Ukraine’s fiscal position is strong. For the period January to July the budget surplus was UAH29bn, with revenues running 10% above target, helped by Naftogas dividend transfers and also NBU profits. Recent weeks have seen a bevvy of sales of state minority stakes in the regional energy companies, which should generate a few billion UAH in revenues for the treasury. Net-net, the assumption was that the deficit would be 3% of GDP or thereabout this year. It is likely to be much lower than this, maybe 1-2%. This gives the government some flexibility on the financing side, and perhaps a desire to do some early fiscal pump priming into an election campaign.

(+/-) Broader macro indicators are mixed. H1 2017 real GDP growth came in at 2.5% according to the Ministry of Economy, which is just above the 2.3% growth posted in 2016. This might seem solid when considering the blockade in Q1, stresses from difficult trade relations with Russia, and that the early year stresses of the Privatbank nationalization. But the base is still very, very low, given the 17-20% real GDP contraction in 2014-2015. One might have expected a much stronger rebound, given the stellar performance from the agro-food sector and an uptick in the metals sector. Investment seems to be lagging. This likely relates to frailties in the banking sector, and the weak business environment.

Inflation has been less well–behaved. This is surprising given the UAH strength, but reflective of food price inflation, core inflation pressures (strong real wage growth, reflecting difficulties hiring skilled labor) and administered price hikes. Hence, headline inflation has backed up to 15.9% as of July, from the low of 12.2% in April. Hopes are gone of single digit inflation this year. For the NBU this has created something of a quandary as they want to support growth by further cutting their key policy rate further from 12.5% at present, but under their new inflation targeting regime they are constrained. The NBU likely hopes upside inflation pressure is short lived, and one off factors fall out of the index, helped by another good harvest. But without government focus on structural reforms, inflation could prove sticky, damaging longer term growth prospects.

Balance of payments look pretty solid. The upturn in growth has brought a widening in the current account deficit. But it still looks manageable and well -funded, as reflected in appreciation pressure on the UAH, and rising NBU reserves. The current account deficit hence came in at $2.2bn for January to July, up from $1.4bn one year earlier, and equivalent to 3.8% of GDP. But net FDI was $1.4bn, so covering 60% of the CAD, a decent coverage ratio. Reverse currency substitution seems to have been strong reflecting improving confidence. NBU reserves thus hit $16.8bn as of the end of July, up by around $600m since the last IMF credit tranche dispersal in April. The strength of the UAH and reserves further allowed the NBU to ease restrictions around FX convertibility. This is positive in terms of helping improve transact-ability, economic activity and confidence.

But again, with little pressure on the budget financing position or BOP, the administration is under little pressure to do difficult IMF reforms – especially where they entail political risk and capital being expended in the Rada. We have been there so many times over the past 20-odd years with Ukraine. We all hoped this time was different. Maybe we were wrong. Ukraine has a window for reform, given geopolitics with Russia are on the back foot. It cannot waste this on domestic political intrigue and individual interest coming to the fore with respect to the anti-corruption agenda.

(+) Moody’s upgraded Ukraine’s LT sovereign rating one notch to Caa2 on August 25. This helped the external bondholder feel good factor. Ukraine has had to wait a long time since the debt restructuring agreement was reached in November 2015. Caa2 already seems harsh and still two notches’ below Fitch and S&P;’s B-. One has to think that upgrades from both Fitch and S&P; must also be in the pipeline. S&P; has held its B- rating since October 2015 and Fitch its B- since November 2016. There have been many improvements in Ukraine’s credit fundamentals since then.

Timothy Ash is senior sovereign analyst for Blue Bay Asset Management in London

Posted Aug. 31 2017