The Extended Fund Facility (EFF) that Ukraine secured from the IMF in late February is based on optimistic external account projections. The IMF/NBU see Ukraine's external financing gap (EFG) at USD 11.3 bln in 2015 vs. last year's USD 17.3 bln. We project the EFG at USD 16.6 bln. In both cases the shortfall should be covered comfortably with new money from the IMF (net USD 8.6 bln) and other international donors (USD 8.3 bln), as well as with USD 5.2 bln saved through sovereign and quasi-sovereign debt restructuring. The IMF program essentially requires the NBU to abstain from sizable FX market interventions. Yet, we believe the NBU will have to spend net USD 5.0-5.5 bln this year on hryvnia stability and to maintain the current exchange rate broadly unchanged which would result in end-2015 gross reserves of USD 13.0 bln, equal to 2.9 months of future imports – an entirely comfortable amount.

IMF program effectively prohibits FX interventions by NBU

The EFF program is based on optimistic external account expectations: the IMF sees the external funding gap narrowing substantially to USD 11.3 bln (C/A deficit of USD 1.2 bln and F/A deficit of USD 10.1 bln) in 2015 vs. USD 17.3 bln in 2014 (shortfalls of USD 5.3 bln and USD 11.8 bln, respectively). The program is based on three major funding sources:

• USD 8.6 bln in net IMF lending;
• USD 8.3 bln in funding from IFIs and foreign governments (incl. USD 2.0 bln in US-guaranteed Eurobonds, a USD 1.8 bln loan from the EU, and USD 1.0 bln from the World Bank).
• USD 5.2 bln in exceptional funding, which basically means the restructuring of sovereign (USD 4.2 bln) and quasi-sovereign Eurobonds (the USD 250 mln City of Kyiv Eurobond and USD 750 mln Ukreximbank Eurobond).

Based on those numbers, end-2015 NBU gross international reserves would stand at an impressive USD 18.3 bln. Clearly, all available funding from the IMF program (including money saved through external debt profiling) should serve a single purpose – to increase gross foreign reserves. Based on the numbers in the IMF Memorandum, we conclude that the NBU is prohibited (not advised) to spend significant funds to support the hryvnia and should keep all the new money in its accounts. That basically means the international funding should help Ukraine re-build confidence via growth in NBU reserves.

We don't share the IMF's optimism regarding the external accounts and outline our view below. We expect both the C/A and F/A not to adjust as expected by the IMF. This suggests the NBU will have two options:

• Allow an even stronger hryvnia depreciation (probably to UAH 25-27/USD) from the current UAH 23.4/USD (official rate) to further improve the C/A balance (and probably even turn it positive) and meet the IMF's net foreign reserves targets. That is far from an ideal scenario as it risks spurring a new wave of inflation, panic in the FX market, and a fresh run on deposits.
• Use some reserves to prevent a more substantial weakening of the hryvnia. This would be a violation of the IMF-set target on reserves, and the NBU would thus have to re-negotiate the targets with the IMF. All in, we believe the NBU would prefer the second scenario.

Current account balance improves but will stay negative

We expect the C/A shortfall will narrow to USD 2.4 bln (vs. USD 1.2 bln projected under the IMF Memorandum) this year from last year's USD 5.3 bln. Exports and imports both dropped by 33% in 2M15 (for a C/A gap of USD 0.8 bln): imports were restrained by the hryvnia depreciation and tough administrative restrictions, while exports were negatively affected by the destruction in the industrialized east. We expect a similar trend through end-2015. A possible recovery of some production capacity in the east is the key upside risk to our projections. Uncertainty with imported gas volumes and prices is the key downside risk.

Financial Account deep in the red as debt markets will remain closed

International capital markets will remain closed for Ukraine's private sector throughout 2015. Furthermore, many borrowers will experience difficulty making timely repayments and will seek to extend external facilities. Forced restructurings will be a reality of life in Ukraine, and in most cases external creditors have no choice but to accept new debt terms. Ukraine's largest private borrowers – DTEK, Ferrexpo, First Ukrainian International Bank – obtained consent from Eurobond holders to reschedule a part or all debt to later periods. We expect 85% external debt rollover ratios for both the banking and corporate sectors, which implies they will jointly repay c. USD 8.8 bln to foreign creditors in 2015.

We estimate public debt coming due this year at USD 5.7 bln (incl. the USD 3.0 bln Eurobond held by Russia). Factoring in another USD 1.0 bln that will be needed to keep the FX cash market balanced, as well as FDI inflows of USD 1.4 bln (mainly used to recapitalize European and Russian bank subsidiaries), we see the financial account gap at USD 14.2 bln, much larger than the USD 10.1 bln projected by the IMF.

Based on the above assumptions, we see the external funding gap at USD 16.6 bln. This is an improvement from our January expectation of USD 18.7 bln. The upgrade comes on a more optimistic FDI forecast; we previously expected zero direct investment. Nevertheless, our calculations suggest the IMF/NBU projection of USD 11.3 bln is far too optimistic.

Our EFG projection is USD 5.3 bln higher than the IMF/NBU number. That is basically the amount that will need to be spent to prevent a new wave of hryvnia depreciation. We therefore see end-2015 reserves at USD 13.0 bln vs. an IMF/NBU projection of USD 18.3 bln. This provides for 2.9 months of future imports, an entirely comfortable level, in our view.

No strict conditionality from the IMF on successful debt restructuring

We believe new credit from donors will be raised in full, as assumed by the IMF program, and we see no material risk of major delays or refusals. That said, sovereign debt restructuring remains an issue. Ukraine expects to "re-profile" about USD 15.3 bln in sovereign and quasi-sovereign (Ukreximbank, Oschadbank, Ukrzaliznytsia, City of Kyiv, Financing of Infrastructure projects) debt due in 2015-18. The money saved (not repaid in 2015) through restructuring is fully accounted for in the end-2015 projections for NBU reserves. In the most optimistic scenario Ukraine hopes to agree on Eurobond principal haircuts and/or a material cut in coupon rates and an extension of maturities. The IMF-Ukraine program doesn't contain specifics on developments if restructurings are not successful. Given that USD 3.0 bln of debt due in 2015 originates from Russia (who can spoil the entire re-profiling process), a negative outcome should not be fully discounted. We, however, do believe the most likely consequence of a delayed/rejected debt deal would be a revision of NBU reserves targets/projections, which should not pose a major threat to macroeconomic stability.

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