71298 UKRAINE Economic Update THE WORLD BANK July 19, 2012  Weaker external demand and crisis in Euro area slow 20 Real GDP, % change y/y Ukraine’s growth in 2012. 15 10  Loosening of fiscal policy and rigid monetary policy 5 increase Ukraine’s vulnerabilities, while downside 0 risks remain high. -5 -10  Restoring macroeconomic equilibrium and advancing -15 structural reforms are key for regaining investors’ -20 -25 confidence. 2004q3 2005q1 2005q3 2006q1 2006q3 2007q1 2007q3 2008q1 2008q3 2009q1 2009q3 2010q1 2010q3 2011q1 2011q3 2012q1 2004q1 Recent Economic Developments Economic activity in Ukraine slowed due to lower external demand and turmoil in the Euro area. Real GDP growth decelerated from 4.5 CAB and External Debt, % GDP 20 104 percent y/y in 2011Q4 to 2 percent y/y in 2012Q1. Growth was driven by Current Account External debt [RHS] 99 domestic demand expansion, as consumption grew by 7.9 percent, and 15 94 89 fixed investments increased 7.6 percent, while real exports declined by 10 84 79 6.8 percent. Slower external demand continues to be a drag on 5 74 69 production growth in 2012Q2, as shown by almost flat industrial output 0 64 59 performance, with a decline of 1.5 percent in steel industry. Meanwhile, -5 54 double digit growth of real wages and retail turnover over Jan-May 2012 -10 49 44 imply continued, if not accelerated, expansion of domestic demand in 2004q1 2004q3 2005q1 2005q3 2006q1 2006q3 2007q1 2007q3 2008q1 2008q3 2009q1 2009q3 2010q3 2011q1 2011q3 2012q1 2010q1 Q2. But the decline in food prices due to last year’s good harvest, postponed utility tariffs adjustments, and a tighter monetary policy stance anchored in defense of the de facto peg of hryvnia to the USD led to consumer price deflation of 1.2 percent y/y in June. CPI and M3, y/y change While the current account (CA) deficit stabilized with lower gas 60 50 purchases, investors’ risk aversion and debt repayments led to 40 worsening foreign exchange reserves position. The CA deficit was 30 USD 2.6 billion for the period of Jan-May 2012 (unchanged y/y). 20 Significantly lower imports of natural gas contained the overall import bill 10 expansion, as growth of export value slowed in line with weaker demand 0 from trade partners and softer commodity prices. FDI declined by a third -10 CPI Money Supply M3 y/y. Despite net external debt repayments by commercial banks, 2005m7 2006m1 2006m7 2007m1 2007m7 2008m1 2008m7 2009m1 2009m7 2010m1 2010m7 2011m7 2012m1 2005m1 2011m1 government and the National Bank, net inflows to corporate sector more than compensated for the outflows. The NBU continued to defend the UAH/USD rate with minor fluctuations, and lost USD 2.5 billion of its gross international reserves in 2012H1. Monetization and Reserves Despite better revenue performance, lack of adjustment of 150 70 Naftogaz’s structural deficit and recent spending hikes keep the overall fiscal position strained. The government kept the state budget 100 50 deficit low since the beginning of the year. It relied on domestic bond 30 financing (including in forex and forex-linked), as external financing was 50 NBU int.reserves / base money, % M3 / GDP, % [RHS] tight and expensive. Meanwhile, a higher price of imported gas in 10 combination with unchanged non-industrial tariffs led to an expansion of 0 -10 Naftogaz’s operational deficit. Since May, the implementation of the 2005m1 2005m7 2006m1 2006m7 2007m1 2007m7 2008m1 2009m1 2009m7 2010m1 2010m7 2011m7 2012m1 2008m7 2011m1 ‘social initiatives of President Yanukovych’ has increased expenditure and implies a higher overall deficit for the year. Medium Term Outlook We revise our base case growth forecast down from 2.5 percent to 2 percent in 2012. The latest World Bank Global Economic Prospects expects Euro area GDP to contract by 0.3 percent in 2012. Growth in the Eastern Europe and Central Asia region is projected to decline from 5.6 percent in 2011 to 3.3 percent in 2012, the largest slowdown among the six World Bank regions, due to the strong trade and financial links to the troubled European economies. While Ukraine’s exports are projected to remain weak in 2012H2, growth will be maintained by the fiscal stimulus of over 2 percent of GDP, introduced by budget amendments. Pension, wage and social program increases on the back of low inflation will drive up consumption expenditure. While boosting growth, this policy is expected to lead to expansion of the overall fiscal deficit (including Naftogaz) to 5 percent of GDP in 2012. As the statistical base effect of last year’s record harvest phases out, the fiscal stimulus will also reverse the consumer inflation trend. Under the assumption of a continuation of current policies, the balance of payments will continue to be under pressure. Instability in international markets and low appetite for risk, as well as delays with implementation of the IMF’s Stand-By Arrangement make financing of the current account deficit challenging. Growth is projected to accelerate to 3.5 percent in 2013, but the economy will need to be rebalanced. This scenario assumes slow but orderly resolution of the crisis in Europe, with the Euro area returning to growth of 0.7 percent. Further improvement in the external environment in 2014 will enable Ukraine’s GDP growth to pick up to 4 percent in 2014. Higher external demand will help the Ukrainian economy to accelerate, but this alone will not be sufficient to restore macroeconomic equilibria and stabilize expectations. We assume a return to a tightening of fiscal policy and a shift to a more flexible exchange rate policy to improve the ability to better withstand the external shocks. Fiscal consolidation would involve a gradual reduction of large quasi-fiscal deficits in the gas and utility sectors as well as aligning wage and social spending increases with underlying productivity growth. Anchoring expectations with a credible policy mix is a key element of securing the financing to cover external imbalances and reducing external funding costs. Equally important is the need to improve the investment climate and to advance implementation of structural reforms to boost longer-term economic growth, in particular, as outlined in Presidential Economic Reform Program. The deepening crisis in Europe (with potential negative indirect effects from softer commodity prices and lower demand from Russia), still fragile balance sheets of the banking sector, Ukraine’s failure to implement macroeconomic rebalancing and reinvigorate structural reforms represent important downside risks for this outlook. Table 1: Key Macroeconomic Indicators 2007 2008 2009 2010 2011 2012F 2013F 2014F Nominal GDP, UAH billion 720.7 948.1 913.3 1082.6 1316.6 1466.5 1648.3 1836.0 Real GDP, % change 7.9 2.1 -14.8 4.1 5.2 2.0 3.5 4.0 Consumption, % change 13.6 9.0 -12.2 6.4 10.7 3.6 1.8 3.5 Fixed Investment, % change 23.9 1.6 -50.5 3.9 10.1 0.2 1.3 4.1 Export, % change 3.3 5.2 -22.0 3.9 2.2 1.5 5.7 5.2 Import, % change 21.5 17.1 -38.9 11.3 16.8 4.3 1.9 4.4 GDP deflator, % change 22.7 29.2 13.0 15.0 15.7 9.2 8.6 7.1 CPI, % change eop 16.6 22.3 12.3 9.1 4.6 6.1 9.5 5.9 Current Account Balance, % GDP -3.7 -7.0 -1.5 -2.2 -5.5 -6.9 -5.3 -5.5 Terms of Trade, % change 9.8 6.1 -6.8 4.9 9.8 -0.1 1.0 0.1 Budget revenues, % GDP 42.3 44.3 42.3 43.3 42.4 42.4 41.5 41.2 Budget expenditures, % GDP 44.3 47.4 51.0 50.7 46.7 47.4 44.4 43.5 Fiscal balance (with Naftogaz, -2.0 -3.1 -8.7 -7.4 -4.3 -5.0 -3.0 -2.3 w/o bank recap), % GDP External debt, % GDP 58.6 83.6 90.8 85.0 76.6 73.6 78.5 78.6 Public and Guaranteed Debt, % GDP 12.4 20.0 35.4 40.5 36.0 34.9 36.6 35.8 Source: Ukrainian Authorities, WB projections Contact info: Ruslan Piontkivsky (380 44) 490 66 71/2/3 e-mail: rpiontkivsky@worldbank.org www.worldbank.org.ua