Although a "the worst is behind us" sentiment is starting to emerge gradually, Ukraine's economy will need more time to digest the shocks from 2014 and 1Q15 before it returns to a sustainable growth path. Meanwhile, we downgrade our 2015 GDP projection to -12.4% from -10.1% based on worse-than-expected 5M numbers for key sectors. We now expect 4Q15 to be the first quarter of positive qoq growth after more than two years of declines. Inflation is trending lower although it remained extreme at 57.5% in June; we see it subsiding to 46% by end-2015 as one-off effects related to the hryvnia depreciation and the revision of utility tariffs fade. On the external accounts side, we improve our 2015 C/A gap outlook to USD 1.5 bln (1.9% of GDP) from USD 2.4 bln. With external funding gap to be fully covered through restructuring and loans from IFIs and foreign governments, we see no major risks to exchange rate stability. Admittedly, the Greek factor and local populist laws may temporarily introduce some heightened volatility.

Production settles near a bottom; gradual recovery possible by end-2015

Production data for key sectors of the economy gives little hope for a reversal of the negative GDP trend in the nearest couple of months. Total industrial production dropped 20.7% yoy in May, construction fell 31.7%, and retail trade contracted 25.8%. The current pace of economic decline implies the 2Q GDP contraction may be in-line with the 1Q number of -17.2% yoy (-2.5% to -3.0% in qoq terms). We see GDP contracting another 1.5-2.0% qoq in the 3Q and growth restarting only in the 4Q. Overall, the 5M economic stats are worse than we expected and lead us to downgrade our 2015 GDP projection to -12.4% yoy from -10.1%. We expect analysts and the government to revise their estimates across the board in the coming months.

The declines in 4Q14 and 1Q15 in qoq terms were first and foremost driven by the cutoff of the war-hit eastern territories from Ukraine's economy. However, the factors now in play are different and more fundamental in nature:

- High inflation (+57.5% yoy in June), which has strongly undermined households' purchasing power. Real disposable income decreased 23.5% yoy in 1Q15. Households' propensity to save was nearly zero in 1Q, which implies households are struggling to pay for current needs. On the positive side, households' confidence improved in May and June, according to a regular survey by GFK Ukraine.

- The drastic decline in fixed investments (a trend that began in 2Q13) of -25.1% in 1Q15 against the backdrop of massive uncertainty and the shock that followed the hryvnia's dramatic depreciation in 1Q15.

- The continued turmoil in the financial sector, which was hit by deteriorating loan quality and continued outflows of retail FX deposits. Overdue payments on outstanding loans add up to 16.5% (only the part past due, not total loans) of the total loan book – a historically high share.

Even though a feeling of "the worst is already behind us" is taking hold in the country, we expect it'll take another 4-6 months for the fundamental hurdles to dissolve and for the economy to return to growth. Reforms are instrumental to the country's economic recovery and fortunately the current IMF program makes many of them inevitable.

Inflation continues to track lower after April peak

CPI peaked at 60.9% yoy in April and – somewhat ahead of our expectations in terms of timing – declined to 57.5% in June. All of the major inflation drivers, of which deprecation and the revision of utility tariffs were by far the most important, have already played out. In the 2H, the declining trend should be supported by weak household demand as many producers/importers should revise prices downward following excessive increases in the 1Q. Agricultural output is expected to be strong and come in close to last year's historical record – this lends additional support to our view that the downward CPI trend will continue. We maintain our end-2015 CPI projection of 46% yoy at this point and we tentatively pencil in a 12-14% yoy CPI projection for end-2016.

External accounts improve; FY15E NBU reserves upgraded

Ukraine's C/A account was just barely negative in 5M15 (vs. a hefty USD 1.9 bln deficit in 5M14) as a strong adjustment in imports (-39% yoy in 5M15) outweighed the contraction in exports (-36% yoy) – a direct consequence of the hryvnia's drastic fall in the 1Q. In May, the adjustments in external trade were even more pronounced – commodity exports shrank 42.3% yoy and imports dropped 45.2%. Based on 5M numbers we improve our forecast for the 2015 C/A gap to USD 1.5 bln (1.9% of GDP) from USD 2.4 bln.

The financial account remains under control – Ukraine managed to show a USD 300 mln surplus in May thanks to the sale of a USD 1.0 bln US-guaranteed sovereign Eurobond. The 5M15 F/A shortfall of USD 1.7 bln is reasonable and was supported by massive restructurings of private debt since the start of the year. We improve out projection for the 2015 F/A shortfall to USD 11 bln from USD 14 bln. The gap is entirely manageable, in our view: we expect USD 4.2 bln in sovereign Eurobonds to be restructured (either with or without a haircut) while the remainder should come from the IMF (USD 8.6 bln) and other official sources (USD 8.3 bln from WB, EBRD, EIB and others). Given our upgraded projections for C/A and F/A, we revise our end-2015 NBU gross reserves forecast to USD 16.4 bln from USD 13 bln. This, however, is dependent on smooth and timely inflows of funding from IFIs.

The FX rate should remain relatively stable, but volatility risks are significant

Although Ukraine has its external accounts under control, the key risks to currency stability are currently rooted locally. A series of events that occurred over the past two weeks have brought some nervousness to the population and have boosted demand for hard currencies. The Greek default (and reported limits on cash withdrawals of EUR 60/day) against the backdrop of the ongoing Ukrainian debt restructuring operation has fueled negative sentiment. Additionally, the adoption of a populist law that requires banks to convert all retail loans into UAH at a historical exchange rate added more negative sentiment (note that the president has promised to veto this law). The cash rate currently stands at UAH/USD 23-24 vs. 21-22 just two weeks ago. We view this (still relatively reasonable) exchange rate increase as temporary and expect the NBU will stand ready to respond promptly in the event of a further build-up of sentiment-driven pressure on the currency. We project an end-2015 FX rate of UAH/USD 23.6, unchanged from our previous estimate.

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