Research

Research

Ukraine Economy: The painful adjustment continues

Recent macro stats releases show the Ukrainian economy has been hit harder than expected by the war, its related effects and broad structural adjustments. GDP contracted 17.6% yoy in 1Q15 while inflation surged to 60.9% in April – a one-two combo Ukraine last faced during its painful transition to a market economy in the ‘90s. The economy is unlikely to see any signs of sustainable recovery through end-2015, but provided reforms gather pace and the military conflict doesn't escalate, 1Q16 will be the turning point.

Weakening domestic demand will drag on economy through end-2015

GDP fell 17.6% yoy and 6.5% qoq in seasonally adjusted terms in 1Q15. The results came in worse than our expectations, and they clearly show Ukraine is facing more severe challenges than anyone expected at the start of the year. However, additional April data show the downward trend has flattened – the economy contracted materially, but it has likely reached the bottom. Monthly industrial production slumped 21.7% yoy in April (vs. 21.1% in March) and retail trade turnover shrank 29.6% yoy (vs. -31.3%). In assessing the state of the economy we need to keep in mind the substantial statistical omissions due to the inability to properly collect data in the war zone.

The factors behind the sharp drop in production are numerous, but the effects of the war and the related production closures have dominated thus far. Looking forward, however, we believe weakening domestic private demand will be the key drag on economic activities in 2H15. An uptick in inflation that has put a dent in households' real income, numerous banks bankruptcies that have fueled a one-off decline in the stock of wealth (and this is still not the end of the story), and weak consumer sentiment all bode badly for private demand – we project a real decline of 15-18% in 2015 (vs. -9.6% in 2014). Investment activities have been put on hold completely across the economy due to the monumental uncertainties and lack of credit funding. We expect investments will fall by more than 30% yoy in 2015 following a 23% contraction in 2013. The only positive facet of the trend is that shrinking demand will hurt imports foremost while the effect for local producers should be less pronounced.

We downgrade our 2015 GDP projection to a 10.1% decline vs. our previous estimate of -8.6%. We now expect economic growth to return to positive territory (in yoy terms) only in 1Q16, against our previous expectation of a 4Q15 resurgence. The downgrade in the GDP projection carries little implication for our view of the economy's mid-term prospects. With the high base effect (i.e. one that included the war-affected zone) set to fade in the coming quarters, the economy will see a modest 2-3% pickup in 2016. Mid-term growth prospects are dependent on the pace of reforms and Ukraine's ability to contain the war in the east.

Inflation spikes on exchange rate, structural adjustments

Inflation surged to 60.9% yoy in April – the highest pace of price growth in more than 15 years in Ukraine. By our estimates annual inflation will accelerate further in the coming months and reach a peak at 62-63% in August before starting to subside. We downgrade our 2015 eop inflation projection to 46% vs. 34% previously. By our estimates, the return of CPI to single digits is possible no sooner than in 2H17.

While CPI skyrockets, any spiral wage-price effects are highly unlikely, in our view. The current growth in consumer prices is driven by two factors: the sharp hryvnia depreciation over 1Q15 and the adjustment in administratively regulated utility tariffs. The current surge in prices is mainly the result of huge imbalances (a C/A shortfall and the Naftogaz deficit) accumulated in the past and are broadly a reflection of structural adjustments working their way through the economy.

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