A SUPPLEMENT TO EUROMONEY/APRIL 1998: EASTERN EUROPE
In November, as Ukrainian government officials huddled around a table conferring about the country’s escalating fiscal crisis, the Asian crisis seemed at best an annoying aside. Indeed, some sitting at the table expected that if the IMF was willing to help countries such as Korea, then it would certainly help Ukraine – which is, after all, the third-largest recipient of US aid.
“They were saying ‘Korea? How many people do they have anyway? And they got $57 billion. If they got it, we’ll get it too,'” recalls one western adviser who attended those talks.
Reality since then has been rather different. Now, rather than lavishing fresh money on Ukraine, both the IMF and the US are playing hardball. They are both demanding that the country act immediately on its liquidity crunch, persisting budget deficit, mounting payroll arrears and unfriendly habits toward foreign investors – or face a damaging loss of financial help.
With nowhere else to turn at the moment, the government has sought temporary refuge in the international bond markets. In February, Ukraine made its debut issue in the Eurobond markets, offering Dm750 million ($410 million) for three years through joint lead managers Merrill Lynch and Commerzbank at an eye-popping yield of 16.2%.
The spread may be extraordinary even by emerging-market standards, but for Ukraine it was a bargain. In its domestic market, which collapsed late last year, the government would have paid a yield of around 50%. Indeed, the government has been so pleased with its ability to get quick cash at such an apparently low price that it has already issued again. On March 9, Ukraine unveiled a two-year, Ecu500 million ($544 million) issue, priced at 15.06%, through lead underwriter SBC Warburg. While few institutional investors bothered with the first issue, 80% of the latest issue was sold to institutional investors, mostly in the UK and Italy. German and Swiss retail investors were also buyers.
Is this the beginning of an international issuing spree? Sergii Tihipko, the deputy prime minister of economic reform, believes much will depend on what happens with the country’s domestic market. “We have a budget deficit which we can cover by inner or outer market borrowings,” he says. “It’s difficult to talk about the distribution of these figures. That will depend on the internal markets.”
Meanwhile, Olexander Moroz, the speaker of Ukraine’s parliament, a presidential candidate for the 1999 elections and a seasoned critic of the government, condemns the international borrowings. He has criticized the government for digging itself deeper into a borrowing hole by simply swapping domestic for international debt.
Seated at the head of a long, empty assembly table in the chambers of the Supreme Rada (parliament), Moroz says: “This is a method of transferring internal debt into external debt. The credit resources of the banks are undermined. Domestic production is bloodless without working capital. Such an economic policy has no prospect at all. It’s just destroying the economy.”
But pressed for cash, the government seems to have no other immediate alternative but to cover short-term debt with longer-term obligations. Last year, foreign investors poured into the nascent domestic bond market, buying $4.1 billion in treasury bills, an increase of 155% over 1996. The treasury-bill market supplied enough money to meet budget-deficit financing targets easily. But as the Asian contagion spread investors vanished. And now it is pay-up time. A March report by the Kiev office of MFK Renaissance says that a total of $3.3 billion in redemptions is coming due this year.
A senior western banker who is involved in negotiations with the Ukraine government suggests the IMF is for the moment viewing the visit to the international markets as a “refinancing”. But he says there’s also a recognition that “this country is approaching the edge of crisis. The macroeconomic stability they have gained could all be lost. They will have to refrain from continuing to borrow from abroad”.
Indeed, the IMF’s patience looks to be running shorter by the hour. In mid-March, the IMF withheld the latest tranche of a $585 million stand-by loan due for February, in part because Ukraine had failed to meet stipulated macroeconomic targets (the facility had been agreed in August with monthly payments of $50 million). Talks are resuming in April and Ukraine will still be eligible to get the loan if it meets the IMF’s demands.
Douglas Helfer, a fund manager with Foreign & Colonial in London, says the Eurobond markets are at best a flimsy bandage. “Each issue only buys them two to three weeks. In a way, it’s not necessarily to their benefit that they’re able to do these Eurobond issues now,” he says. Helfer suggests the issues are only deflecting from the underlying economic reality, and that unless the government gets a grip on policy soon, it is courting the possibility of a currency devaluation or the return of hyperinflation.
Given the IMF’s recent unhappiness over Ukraine’s economic progress, it is unclear how talks will go over another, much more substantial IMF loan. A $2.5 billion extended fund facility could kick in as soon as April, should negotiations satisfy the IMF.
Last year Ukraine failed to qualify for the loan because of problems meeting criteria, including budget-deficit targets. In early March, during US secretary of state Madeleine Albright’s one-day visit to Kiev, the US threatened to cut its annual $250 million assistance in half by April 30 unless the Ukraine responded to US investor complaints.
As though this were not pressure enough, Ukraine has continued to accumulate debt arrears with Gazprom, Russia’s gas monopoly. Ukraine owes Gazprom $900 million of overdue payments for natural-gas supplies. Although Gazprom has grown visibly impatient with Ukraine, the two countries have recently agreed to terms which give Ukraine more breathing room and more shipments of gas. In the past, Gazprom has pressed the Ukrainian government to swap its liabilities for equity stakes in Ukrainian enterprises, something the government has steadfastly refused to do. Russia is reluctant to force Ukraine too far into a corner, or into the arms of other suppliers, because when Ukraine’s economy finally turns the corner, the country could prove a lucrative customer indeed.
Vira Nanivska, executive director of a Kiev-based think-tank, the International Centre for Policy Studies, believes Ukraine will continue to find it difficult to meet the west’s demands for speedy reform. She says there is still an underlying mistrust of privatization both in the government and in parliament, primarily because there’s a lack of understanding about the economic sense of such a process.
Many older Ukrainians are tired of waiting for their economic fortunes to improve. A good number think life was better under the Soviets. When asked about his life since 1991, one taxi driver who was trained as an engineer says: “It is painful to talk about this.”
Nanivska laments that there has been very little analysis done spelling out the benefits of privatization for Ukrainians, how it can enhance corporate profitability and contribute to the growth of capital markets. In her view, foreign demands for reform have not been adequately coupled with hands-on technical assistance. “I see the main problem as a need to understand what privatization actually means,” says Nanivska. “The enormous, insurmountable challenge is that we are changing the whole system. In the Ukraine the difference between reformers and non-reformers is very small. We don’t have the knowledge and procedures.”
Most Ukrainians harbour a deep distrust of privatization. Partly, this is based on the dismal outcome of the country’s voucher privatization programme. One parliamentary official in his late 50s recalls that a friend received a voucher in a small privatized company five years ago. “He’s earned less than 87 kopeks since then,” the official says, drawing dejectedly on his cigarette. “Eighty per cent of the economy doesn’t work now. The old system somehow worked.”
But if the government doesn’t move quickly to distance itself once and for all from old centrist nostalgia, its financial difficulties could soon come to a boiling point. “If a serious start to privatization is not apparent by early in the second quarter, the possibilities for economic growth in 1998 will be significantly reduced, if not eliminated,” warns the MFK Renaissance report. What’s more, it adds: “Given Ukraine’s relatively haphazard external-liability management of the past year, the prospect of post-communist Europe’s first liquidity crisis since November 1991 is a distinct possibility.”
Ukraine has been one of only three countries of the Commonwealth of Independent States (CIS) which since 1991 has failed to achieve positive economic growth. In 1997, the country’s GDP fell by 3.2% – it’s best year yet. In 1996, the economy declined by 10% while in 1995 it fell 12.2%. The year before that it had fallen by 22%. While observers say Ukraine has done an impressive job as far as monetary policy goes, wrestling inflation down from 10,155% in 1993 to 10.1% last year, it has failed to back that policy up with essential reform of the economy.
“What the Ukraine has done over the past two years is implement a successful monetary policy,” says John Tedstrom, senior analyst with US think-tank Rand Corp. “They’ve gotten inflation down and kept it down. But that monetary policy was not underpinned by a programme to privatize and restructure industry. The budget was coming under big pressure to finance the Soviet dinosaur companies, and in 1997 the contradiction of these two policies came to a head in December and January.” It was in late January 1998 that president Leonid Kuchma signed a special decree, under pressure from the IMF, to press ahead with structural and financial-sector reform.
Ukrainian analysts suggest, meanwhile, that some of Kuchma’s presidential opponents, including Moroz, have a serious chance of seizing office in 1999 unless Kuchma manages to make a material difference to the state of the economy over the next 18 months. The prospect of a Moroz victory unnerves some foreign investors, impatient as they are with Kuchma’s slow progress on reform.
Moroz is known for his opposition to the country’s privatization process and to the government’s approach to reform. He has also been critical of the government’s link with the IMF. “The government until now has not had its own programme of action,” he says. “It’s completely governed by the IMF. I’m not speaking against the IMF – they have their own agenda. I’m speaking about the government, which is not able to conduct its own policy. I’d like to see reforms which include a mixed-market economy with state regulations.”
But one Kiev economist wryly observes: “Moroz and the Rada have failed to understand that the government’s problem is that it hasn’t listened to the IMF.”
These political and economic uncertainties, meanwhile, are keeping investors away. The stock market remains at a relatively small capitalization of $4 billion, although analysts suggest it could double or treble in size if the full privatization programme is completed this year.
So far, the country has also had a bleak record of attracting foreign direct investment, with just $2 billion since 1991. Given Ukraine’s size, that’s one of the poorest records in the region. Deputy prime minister Tihipko admits candidly that “Ukraine has only itself to blame for this”. He says he’s hopeful a list of new reforms, including deregulation, administrative reform and faster privatization, will turn the tide.
But investors first want to see how effective these reforms will be, and what further steps the government will take on tax reform – crucial for increasing budget revenues. The government has unveiled a new tax reform for business, but has yet to lift the crippling 48.5% personal tax rate which has driven an estimated 50% to 60% of the economy into the informal sector. Investors also want to see how things go after the March 29 parliamentary elections, and whether or not the next parliament will try to stymie the government’s reform strategy.
“It’s politically too uncertain to get involved yet,” says Rupert Rucker, a fund manager at Robert Fleming in London. “There’s also fiscal weakness and the non-payments crisis. We won’t touch it yet.” But the analyst acknowledges that Ukraine holds future promise if it manages to weather its current political and economic storms. “They need to embark on a fuller programme of privatization. There are companies we’d like to invest in. And there will be an enormous consumer sector.”
Ukraine, with 52 million people, is one of the biggest countries of the CIS. It was also, until independence in 1991, the bread basket of the region, accounting for more than 20% of the grain, potato, and meat production in the USSR. But between 1991 and 1992 it became a net importer of grain. There are some signs that industry is beginning to recover, though slowly, with agriculture now accounting for 33% of the country’s GDP. Still, obstacles persist; they include the Rada’s opposition to private land ownership and its insistence on retaining collective and state-owned farms.
Foreign investors will also be watching what happens as a result of Ukraine’s recent economic accord with Russia, which remains the country’s main strategic partner. Most of the oil and gas imported by Ukraine comes from Russia. At the beginning of March, Russia and Ukraine signed an accord which will more than double mutual trade. But this has raised concern in the west, and in Ukraine, that the country could disappear into the pockets of Russian companies as the final stage of privatization unfolds.
But Ukraine is under serious financial pressure to re-establish closer links with Russia. After the agreement was signed, Kuchma told business leaders that Ukraine had lost $3 billion in trade with Russia last year because of restrictions that made Ukrainian goods uncompetitive. The current agreement lays the groundwork for large-scale Russian investment in Ukraine and will, among other things, create transnational industrial groups.
Tedstrom says: “Ukraine needs to have a strongly-based and productive relationship with at least one central European country. This is [also] a bow to what the Ukraine’s political elite feels needs to be done. There are 25 million Russians within the CIS, outside Russia, and many of these are in Ukraine, where there’s a psychological identity crisis.”
Western bankers are more concerned, however, about the country’s potential financial crisis if the government doesn’t pull together on pushing reforms through and meeting fiscal targets. Some are worried about Kuchma’s ability to make this happen.
Ronald Spitz, who heads corporate finance at MC-BBL Securities in Kiev believes that resistence to form is deeply engrained. “You basically have to understand that Kuchma doesn’t have an administration to execute what he tells them to do,” he says. “He can scream and shout, but once it gets down to regional governments, they don’t necessarily care what he says.” That is why a good deal may depend on the outcome of the parliamentary elections, and the power structure which emerges from them.
Tihipko, meanwhile, is one of the country’s principal instigators of reform. But observers worry that he may be unduly burdened with other responsibilities, as he heads up some 20 committees.
“Tihipko is good at organizing, but it’s hard to implement his efforts,” a western banker says. In the meantime, as the banker puts it, Ukraine has “delayed and delayed and delayed. They have to act very quickly now”.
Foreign & Colonial’s Helfer suggests that a crisis may in fact be the best recipe for change. He believes Ukraine will yet fulfil the rich promise that so many read into the economy two years ago. It’s just a question of when.
“Anyone who invested in Hungary and Czechoslovakia sees that Ukraine is going to make it. But it may take a crisis to do that,” Helfer says. “We’re watching very closely. These markets, when they turn, turn quickly.”
