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Monday, May 12, 2008

Ukraine Inflation April 2008

Ukraine's inflation rate was once more up sharply in April - passing the threshold of the 30% annual rate - as the bickering continued between Prime Minister Yulia Tymoshenko's government and the office of President Viktor Yushchenko over economic policy and how to handle the problem. Inflation was up 3.1 percent month on month (an incredible 37.2 annualised rate), and although that was lower than the 3.8 percent registered in March (which was a 9-year record) it was still higher than most analysts were expecting.

Annually, inflation reached a huge 30 percent - aided by an almost 50 percent jump in food prices - and the cumulative price rise for the first four months of this year was 13.1 percent, a 'mere' 3.5 percentage points above the government's whole year 2008 target of 9.6% which the government has yet to revise its 2008.

The Ukraine central bank has been trying to soak up hryvnia liquidity since the start of the year, twice raising the refinancing rate (which is now at 12 percent, up from 8 percent at the end of last year) and issuing a large amount of depository certificates. It has in recent weeks started to allow the hryvnia to strengthen outside a previous strictly kept band of 5.00-5.06/$ and beyond a wider target of 4.95-5.25 (although the bank still maintains that the broader band remains in place).

All of this however is far too little far too late. With inflation running at 30%, even 12% interest rates are far from sufficient (since there is still a negative 18% incentive to borrow against inflation). The figures thus simply add to the pressure on the National Bank of Ukraine to take stronger action, from further hikes in key interest rates to letting the hryvnia appreciate rapidly against the U.S. dollar.

“We are standing at the threshold behind which the NBU would let the hryvnia
half free float within the [currency trading] band,” Iryna Kryuchkova, a deputy
economy minister, said in an interview with Kontrakty newspaper. “There is no
other way out. Everyone understands that.”

The NBU met on April 24 to consider the idea of letting the hryvnia appreciate against the dollar, but decided to postpone the matter indefinitely. And it isn't only consumer prices which are causing concern, producer prices were up at a 37.6% annual rate in April, suggesting that there is still plenty of fuel left in the inflation pipeline, and that the fire is still set to burn for some months to come.

Part of the problem which existis in addressing the inflation issue is the level of in-fighting in the government itself, with Tymoshenko under constant criticism from the Yushchenko camp, the present government's better known policies have included raising wages and social benefits and paying compensation for lost Soviet-era savings. Budget finances - which the government has yet to amend despite having set themselves a March deadline to do this - are currently uncertain as most of the privatisation plans which are potentially worth billions of dollars have been suspended by Yushchenko.

The economy - which has been growing in the 6% to 7% annual rate in recent quarters -continued to grow in the first quarter of 2008 (at a 6% year on year rate) but it is obvious the economy is now slowing (although a bumber harvest expect for 2008, and high wheat prices, may give the headline number a little 'bounce' as we move forward).

Foodstuffs constitute about 50-60 percent of the Ukraine CPI basket and in March they were up by 5.6 percent month-on-month, with a 14.4 percent rate over the first quarter. The ministry reported that bread in April alone grew 1.2-2.9 percent, flower 3.6 percent, rice 18.2 percent, beef 13.4 percent, chicken meat 3.5 percent and sausages 7.2 percent.

Some prices did fall back however - egg prices were down 5.9 percent, sunflower oil 4.1 percent, sugar 2.3 percent, milk 1.1 percent and cream 1.2 percent.

The poor 2007 harvest continues to exact a toll on agriculture and food processing industry performance. Over the first three months of the year, agriculture reported a meager 0.4% year on year increase in value added. Output in the food processing industry grew by 10.3% year on year over the period, slightly accelerating from 10% year on year growth in 2007.

The acceleration in food prices is largely the result of strong food demand (see this post here for a much more detailed explanation of all this), both domestically and externally (food exports were up by 52% year on year in January-February 2008), while shortages of some agricultural products on the domestic market were partially compensated for by growing imports (particularly livestock products and vegetables).

High grain and forage prices explain the continuing reduction in the Ukraine livestock population (cattle and pig stock declined by 10.5% year on year and 17.7% year on year over the first two months of the year, respectively), and this slaughter of the livestock population lead to an increase in the output of meat and meat products.

In the short term the agricultural situation may be about to improve, since economic analysts (and CEE specialists) 4Cast are predicting a significant recovery in agricultural performance across the region this year, driven by a massive rise in crop yields and farming output.

They say weather conditions this year are favourable in many countries across the region. Gábor Ambrus, an analyst at 4Cast in London believes the effect will be most visible where the share of farming is high, i.e.: Ukraine and Romania, while Poland slightly may not benefit especially as it was spared from much of the regional draught in 2007.

He sees Romania and Ukraine as particularly likely to benefit from this effect. (The share of Romanian agriculture in GDP is 7-8%, hence even a 30% increase in farming output (may boost GDP by 2pp above expectations.)

The effect on Ukraine is expected to be even more pronounced with agriculture having something like a 17-18% share in GDP. The crop estimates of UkrAgroConsult indicate we coupd see something like a 35% increase in crops, and this could boost GDP by a quite significant value over 2008, offsetting much of the slowdown which coming from other sources, according to Ambrus' forecast.

Apart from food, the current inflationary wave has undoubtedly been fuelled by very strong wage rises across the economy, wage rises which are undoubtedly partly produced by the fact that - after years of low fertility and strong outward migration - Ukraine's "fit and available" domestic labour supply is strongly constrained. This has put a strong upward pressure on wages, given the vigorous expansion the economy has seen, but as inflation has accelerated this has started to burn strongly into the real values of those increases, and while it is still too early to call really, the chart below does seem to be indicating that the wave is now begining to lose momentum.

Loose monetary conditions as well as large private sector borrowing from abroad have given rise to rapid increases in commercial bank credit, which have averaged a 70% per annum growth rate over the last three years. In January 2008, commercial bank credit portfolios were up by an extraordinary 78% yoy. High loan growth rates were reported for both corporations and households.

Annual growth in loans to households grew at a faster pace than those to the corporate sector. In 2007, bank credits to households grew by 98% yoy. In just two years, their share of total credit has grown from around 25% at the end of 2005 to 37.6% at the end of 2007. Almost 70% of all household loans were for immediate consumer purposes, and the high growth rate in these consumer loans has undoubtedly contributed to strong consumption growth and thus added to inflationary pressures.

At the same time, the measures the NBU has been taking since the end of 2007 to contain rapid credit growth (as a key part of their strategy to reduce aggregate demand and thus tame inflation) have now started to bear fruit, and the expansion in bank credit has been slowly but steadily losing speed, increasing at a 76.1% year on year rate in March, down from 78% year on year in January.

The combined impact of the NBU`s tightening of reserve requirements and capital adequacy norms in November 2007, the rise in the discount rate by 400 base points to 12% since the beginning of 2008, the sizable sterilization operations (since November 2007, NBU has absorbed about $12 billion of excess liquidity),and the impact of the global liquidity tightening, all of these have meant that pressure on consumer credit has been mounting, and we are now see the consequences.

At the same time, a significant proportion of domestic credit is in non-hryvnia denominated loans. The strong inter-bank competition which has existed following the entry of a number of foreign banks into the Ukrainian banking system in the last two years has only aggravated the situation here. The attraction of such loans is, of course, that they are much cheaper than the hryvnia denominated ones, and with all the talk being of a coming upward revaluation in the currency, short term currency risk may be seen as slight. Should however the Ukraine economy come in for a hard landing at some point, and should this hard landing be accompanied by a sharp downward adjustment in the value of the hryvnia (which might well be anticipated following all the inflation) the situation would be rather different, and household distress and non-performing loans could become a serious problem. The increase in the cost of hryvnia denominated loans from a weighted average credit rate of 13.9% in January to 15.2% pa in March 2008 compares with the rate on on forex-denominated loans which still stood at 10.8% pa in March 2008 (which was up slightly compared with February but still down on January 2008 and December 2007 which were 10.9% pa and 11.2% pa respectively.

Another disturbing feature of the current Ukraine situation is the existence of a trade deficit. Gooods exports were up by a strong 28% year on year in the first quarter, underpinned by a 26.5% yoy increase in the export of metallurgical products, 20.2% yoy in chemical goods, and about a 45% yoy increase in agricultural and food commodities. Export of machinery and transport vehicles recorded impressive 53% yoy growth.

However, continuing high growth in domestic demand, surging energy and raw material prices, and rising transportation costs caused even higher growth in imports. In particular, CIF merchandise imports grew by almost 35% yoy.

On a positive note, capital goods amounted to about 17.5% of total merchandise imports. In addition, intermediate goods hold another significant share in imports, suggesting that the widening trade deficit was partly investment-driven.

Driven by sharp deterioration of the merchandise trade deficit, Ukraine`s current account deficit widened to $5.9 billion in 2007, representing 4.2% of GDP. Despite the widening CA gap, the strong capital inflow allowed for not only covering the gap but also replenishing international reserves.

According to BoP data, the net FDI inflow amounted to a record high $9.2 billion, partially thanks to a number of acquisitions in the banking sector and food processing.

Moreover, despite global financial turbulence, Ukraine received $5.75 billion of portfolio investments in 2007, while its external private debt grew by more than 70%. As a result, the financial account surplus (analytical representation of balance of payments) reached 11.2% of GDP, which allowed the NBU to raise its international reserves to $32.5 billion, a level sufficient to cover more than 4.5 months of future import of goods and services.

Buoyant growth of world steel and food prices promises another year of robust export growth for Ukraine in 2008. However, export performance was somewhat disappointing in January as it reported a rather moderate 14% yoy increase.

The slowdown should be primarily attributed to slower growth in metals exports, the weightiest component of Ukraine`s exports. Accounting for about 42% of total merchandise exports, metallurgical products exports grew by a meager 1.8% yoy in January, which was closely related to poor metallurgical industry performance at the beginning of the month.

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