UKRAINE IS BECOMING a key new destination for emerging-market bond investors. For many, it involves believing that the economic fundamentals outweigh the political risks.
The question is whether the picture will become clearer after Leonid Kuchma stands down from the presidency in October after 10 years in office.
Investors are impressed with the country's strong macroeconomic performance, relatively low debt ratios and comfortable external liquidity position. Most analysts expect GDP growth of over 7% in 2004, as was posted in 2003.
This solid platform allowed Ukraine to re-enter the international capital markets last June for the first time since its 2000 restructuring of defaulted debt. It followed this with a successful benchmark seven-year deal in February. A series of other issuers – banks, corporates and municipalities – have been able to access foreign capital in the sovereign's wake.
For emerging-market asset managers, faced with growing funds under management and a thin supply line, Ukrainian bonds have filled the gap nicely. They have had scarcity value and can offer diversification from other emerging-market credits. Perhaps more importantly, they provide a leveraged play on Russia.
Sibling comparison
Russia's economic recovery in recent years, mainly on the back of soaring oil prices, has transformed it into the premier recipient of foreign portfolio debt investment — and it is dragging little sister Ukraine along with it. "Ukraine is Russia two or three years ago," is a common refrain in Kiev banking circles; it is also – as far as international investors are beginning to realize – Russia plus yield.
"Ukraine is not Russia" was one of president Kuchma's catch phrases. But the economic links are strong. "Russia can still tighten and Ukraine is to some extent a Russian play," says Tim Ash, emerging-market economist at Bear Stearns in London. "If the Russian economy does well, so does Ukraine. Ukraine is also a diversification from the rest of the emerging-market asset class."
Nicholas Field, asset manager, global emerging debt, at WestAM in London, agrees. "The way we view Ukraine is somewhat as an adjunct of Russia — in that much of the government's revenues depend on flows from Russia," he says. He refers to the strong energy prices that have been behind much of the recent economic performance – not least because of Ukraine's role as a pipeline for transportation of fuel from Russia. "If Russia does badly, Ukraine will do worse," he adds. "If Russia does well, industrial production in Ukraine will do well and over time Ukraine could become as stable as Russia."
Dmitri Shemetilo, fixed-income emerging-market strategist at Commerzbank Securities in London, accepts the links between the two former states of the Soviet Union but is bullish on Ukraine itself.
"There is not enough research devoted to Ukraine – therefore it has traditionally traded wide to Russia," he says. "But the Ukrainian economy is economically less dependent on oil and gas; it is going to be an export and manufacturing economy. Russia has a huge domestic market but is dependent on oil and gas, whereas Ukraine is dependent on the transit of oil and gas rather than the price."
Shemetilo also believes that Ukraine has distinctive EU accession potential when compared with the other CIS (Commonwealth of Independent States) members. That will become more concrete if the referendum in Cyprus in April goes according to plan and Turkey is given an accession date. Few other countries qualify.
This convergence play on Ukraine would take a long time to come to fruition, though. It is not an argument that excites WestAM's Field. If you consider that Bulgaria and Romania trade at 170 basis points whereas Ukraine is at 320bp, he says, you'd only be making a few basis points a year heading towards accession. By contrast, a major sign or achievement in an overall policy reform could drive spreads on bonds 50bp tighter in the next six months.
Here there are problems peculiar to Ukraine. "The reform process has always been much slower than in Russia, partly because Ukraine did not find itself in the throes of real crisis after 1998," says Field. "Ukraine has the worst of both worlds: it has a president who is very powerful and one who is not very interested in change."
Kuchma's reign should come to an end after presidential elections in late October. That is the easy part. How the power battle to take over pans out remains to be seen. The identity of his successor and how much power he will have are key issues.
Worst of two worlds
"Ukraine's comfortable financial position, as well as the interests of the ruling elite, provide some reassurance that the transition of power from president Kuchma's 10-year rule can be managed without precipitating significant financial distress," says Ed Parker, director in the sovereign group at Fitch in London. "Nevertheless, Ukraine's volatile political history, weak democratic institutions and the massive interests at stake mean that the risk of political instability is relatively high and extreme scenarios cannot be ruled out."
A long-running stalemate in Ukraine's parliament appeared to unravel early in February, when it appeared that a constitutional amendment, which would limit the next president's powers, would pass with the required two-third majority. The short-term positive was that the country would make it through to the election without materially hurting bondholders in the meantime. "This is a market-positive event as the proposed amendments appear acceptable to most political parties," says Shemetilo at Commerzbank.
The problem is that the man most likely to win the next election – the popular reformist Victor Yuschenko – is widely regarded as Ukraine's best long-term hope for structural economic and democratic reform. Hence the long-term negative – the presidency has more chance than before of being something of a lame-duck administration.
Welcome to the world of political risk, Ukraine-style. "Ukraine is slightly unusual," says Fitch's Parker. "The economy is growing very rapidly – it has a strong macroeconomic position – but it is really being constrained by political risks which we judge as being quite high at the moment." He refers to the election in the last week in October. "'This is no ordinary election – it involves a possible change of regime. There is a lot at stake."