Ukraine: Recession deepens in Q1 throwing scale of bailout into question
June 8, 2015
The Ukrainian economy plummeted in the first quarter of 2015, contracting 17.6% over the same period last year (Q4: -14.8% year-on-year). The result marked a deeper contraction than the Central Bank’s estimate of a 15.0% drop. In addition, the figure shows that the country’s recession is worsening, despite efforts by the Ukrainian government and international agencies to halt the economy’s growth trajectory. The military conflict in the east has pushed the economy into a downward spiral characterized by skyrocketing inflation and double-digit contractions in industrial production; it has also resulted in large amounts of capital flight.
The worse-than-expected drop in the first quarter throws into question the scale and effectiveness of the International Monetary Fund’s (IMF) USD 17.5 billion bailout that was approved on 11 March. The bailout was designed with the assumption of a 5.5% contraction in 2015 and a current account deficit of 1.4% of GDP, however, the drastic drop in Q1 GDP renders the macroeconomic framework of the bailout highly unlikely even under a very optimistic scenario. Moreover, one of the IMF’s conditions to releasing more financing is a successful debt restructuring with private lenders, designed to plug part of Ukraine’s financing gap. However, negotiations have progressed slowly. Ukraine is pushing for a haircut on debt repayments, which has been met by strong resistance from bondholders. In a move viewed largely as a negotiating tacit, the Ukrainian parliament passed a law on 19 May allowing the government the ability to suspend foreign debt payments—in essence, the ability to default if needed.
Complicating matters further, Russia is the second-largest holder of Ukrainian debt and Moscow has refused to participate in the joint restructuring talks. There are legal uncertainties surrounding the status of Russia’s USD 3 billion loan, largely concerning whether it would violate IMF regulations if Ukraine is unable or unwilling to repay it. The payment is due in December and considering Ukraine’s dire financial situation, it is not clear if the country will be able to make good on its loan. Further, given the severe levels of austerity being imposed, political pressures may prevent the government from making the payment, especially since Russia is viewed as the aggressor in the conflict. Significantly, if withholding payment to Russia is considered a violation of IMF regulations, it would be very challenging for the IMF to continue assisting Ukraine going forward.
Ukraine’s outlook is grim. The country’s financing gap is large and increasing the already substantial IMF bailout or finding new creditors could be problematic. Moreover, it is unlikely for the economy to turnaround without a lasting resolution to the conflict in the east of the country, but fighting continues to escalate and threatens the shaky progress that has been made toward a deal. Lubomir Mitov, Chief CEE Economist at UniCredit adds:
“While the war and the uncertain prospects for a durable resolution make it virtually impossible to come up with a credible medium-term outlook, the recent sharp deterioration in economic performance has made it very difficult to avoid haircuts if the IMF-mandated debt-servicing targets are to be met. Assuming a frozen conflict for the next two years, Ukraine’s economic and financial situation would remain difficult. Growth should resume in 2016, but is unlikely to exceed 3-4% over the medium term. At this pace, real GDP would return to its 2013 level only by 2022. Meeting the IMF targets – especially on debt service – would require, in our view, a haircut of 35% to 40%, assuming average borrowing costs of 5%.”
The consistent flow of negative news has caused FocusEconomics panelists to downgrade Ukraine’s 2015 economic outlook each month for the past year. Panelists now expect GDP to plummet 7.4% in 2015, which is down 1.1 percentage points from last month’s forecast. For 2016, panelists expect the economy to rebound to a 1.8% expansion.