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Saturday, September 6, 2008

Ukraine's August Inflation Drops Back Slightly While Stocks Fall Sharply

Ukraine's inflation rate declined in August for a third consecutive month as increased supplies of fresh fruit and vegetables from local farms put a brake on the rise in food prices. Annual inflation slowed to 26 percent, still the fastest in Europe, but down from 26.8 percent in July, and significantly down on May's 31.1% peak, according to the latest data from the Kiev-based state statistics office.

Food prices were up  37.2 percent in August, compared with 39 percent in July. Although headline CPI seems now to have peaked, as external energy prices start to ease and food supply improves, inflation and interest rates will probably stay relatively high. The government’s main core index, excluding unprocessed food, fuel and controlled prices, was up 13.1% in the first seven months of the year, not far behind the food-dominated 14.9% of the headline index, and even the Ukraine President's Office now expects it to exceed 18 percent this year, compared with 16.6 percent in 2007.

Further supply-side rises will be increasingly hard to avoid. Kiev’s subsidized bread prices have finally been increased, and household gas prices are due to rise 13-14% in the coming month. Municipal heating companies still buy imported gas at around 25% below the current border price, building losses for Naftogaz that the government acknowledges will require a combination of continuing subsidy and price hikes. Rail freight tariffs are set to be raised 40% by end-2008.

In fact Ukraine's Producer Price Index was up at a 46.9 y-o-y rate in July, so inflation pressures within the price system are evidently still running very high.

At the same time wage growth pressure looks unlikely to slow significantly, especially given the growing demographic squeeze and strong regional demand for Ukraine’s still-cheap labour force. It is not unreasonable, therefore, to project that CPI will still be running above 20% by the end of 2008.

Stocks Slump and Trading Suspended

Ukraine's stocks continue to remain under pressure. One indication of this is that stock market trading had to be suspended for 2 hours on Friday following  a 7 percent slump in values. According to Andriy Kolomiets, spokesman for the PFTS Stock Exchange, "We decided to halt trading after quotes for more than 75 percent of the PFTS stocks fell in today's session." Ukraine's PFTS Index has been  the world's second worst-performing stock index so far this quarter - only behind Russia - falling by 29.1 percent, as the invasion of Georgia and the feud between President Viktor Yushchenko and Prime Minister Yulia Timoshenko gave a hefty shake to investor confidence.

Credit-default swaps on Ukraine's government debt rose 26 basis points to 501 on Friday, according to CMA Datavision prices, after earlier climbing to a record earlier in the day.

Growth Outlook Positive In The Short Term

In the short term Ukraine's growth outlook looks solid enough, and the FX reserve build-up continues apace. Preliminary real monthly GDP growth dropped slightly to 5.4%Y in June but rebounded to 7.3%Y in July – the strongest level yet seen in 2008. Agricultural output has a lot to do with this rebound, and bath agriculture and exports are likely to surge further in the next few months. The government’s grain harvest forecast is currently for  a 53% increase on last year. While oil import prices are falling, steel export prices have so far been firm (steel has accounted for 38% of exports in the year to date), and Russian demand for machinery exports has been strong up to now. At the same time FX inflows have remained very robust, with  FX reserves were up US$2.5 billion in July, an all-time record.

In the mid-term, however, the outlook is clearly becoming more difficult. Despite continuing terms-of-trade gains and unusually low gas imports in the first few months of the year, the current account deficit is widening rapidly, reaching 7.2% of GDP in January to July. Imports in Q1 were up 20.2% year on year in real terms, against just 0.9% year on year real export growth. Real household consumption was up 22.0% year on year. Real fixed investment growth, on the other hand, slowed to a 14.7% year on year rate. Vehicle imports were up 81% year on year in the first half. However, the consumer boom which lies behind all this looks set to become increasingly difficult to sustain. Nominal wage growth remains very strong, up 36%Y in July, reflecting a shrinking and increasingly internationally mobile labor force. Real retail sales growth was up 27% year on year in July.

By way of contrast, domestic industrial production growth in July was at its slowest level in two years, while industrial output was up by 7.3% year on year in the January July period.

At the same time there is now increasing evidence that Russia's economy is starting to slow, and as it does Ukraine's all important steel sector will be among those worst hit.

Ukraine’s overall external financing capacity is clearly still very high, but the risks of deterioration are growing. The financial account surplus in January-July was an impressive US$12.6 billion, or 11.6% of GDP, 80% up on the same period a year earlier (which was before the credit crunch set in)  and 50% above the current account deficit so far this year. Medium-term loans to the banking sector account for 44% of this and are so far holding up better than we had expected. Net foreign liabilities of commercial banks are up an average UAH 7.6 billion in the past three months, still above the 2007 average. However the combination of tighter European funding conditions, a closure of foreign markets to smaller banks and slower credit demand in Ukraine itself may well slow these inflows. 

Net inward FDI, which has ammonuted to US$6.9 billion so far this year, is likely to weaken without progress on privatization or further major bank sales.  While FDI may slow, it is unlikely to come to a halt. The interest of companies like Evraz in Ukrainian steel, coal and transport assets underlines the scope for private sector non-bank inflows, as property rights in the industrial sector settle and investment needs grow. However, in the context of a widening current account deficit, such inflows may prove less supportive.

At 61.1%Y in July, bank credit growth is slowing but remains relatively strong, and it us importabt to bear in mind that recent growth rates are biased downwards by UAH strength. Half of total credit outstanding, and 62% of household credit, is FX-denominated. Bank credit as a share of GDP, at 60%, is high by regional standards, and smaller domestic banks are facing significant funding constraints.