A Love Hate Relationship With The IMF?
"Program implementation was difficult against the backdrop of sharp political divisions. Only two of the envisaged eight reviews were completed, with the first review already delayed by three months due to failure to reach understanding on fiscal and bankingrelated policies in the midst of political wrangling between the president and the prime minister.....After the second review was completed on time in June 2009—reflecting some progress with the bank resolution strategy, announcement of future plans to increase gas prices, the adoption of a restructuring strategy for Naftogaz, and a slowdown in foreign exchange interventions—the Fund remained closely engaged with the authorities. But the program went off track as ownership vanished and fiscal policy diverged further from the program".
Gas is a core issue for both the Ukraine and the IMF due to its impact on both the current account deficit and on the level of domestic consumption. It is evident that Ukraine growth is now slowing and coming under threat from rising energy prices. Morgan Stanley estimate that the country had a nonenergy current account surplus of 8.2% of GDP in 2011, but since it ran an energy deficit of 14.1% of GDP, the outcome was a current account deficit of 5.5% of GDP.
To slow the rate at which this current account deficit is eroding reserves and undermining the stability of the currency, the Ukraine central bank has tightened monetary policy sharply, which in turn has contributed to the rapid deceleration in growth, which consensus forecasts put at around 3.0% in 2012, but which may eventually turn out to be significantly lower. To put this slowdown in perspective, despite the fact that Ukraine's economy has been growing steadily since the 2009 annus horribilis, output levels are still below the pre crisis peak. As Capital Economics' Neil Shearing puts it:
"Meanwhile, Ukraine faces external debt servicing costs of $52.5bn (around 30% of GDP) this year. A large chunk of this debt is in the banking system, but roughly $5.4bn is owed by the government ($3.5bn of which is due to the IMF). Put together, we estimate that Ukraine’s external financing needs are close to $58bn this year – equivalent to 34% of GDP."
Obviously, with so much debt needing to be rolled over, the country is very exposed to any sudden reversal in risk sentiment, just as it was in 2008. It needs to be under the sheltering wing of the IMF, but this time round the dynamics are rather different. In particular, countries which once got a large net benefit from IMF lending are now facing the moment of truth - when they need to start paying back. Unfortunately, and for whatever reason, the programmes sponsored by the IMF - in Ukraine, in Latvia, in Hungary, in Romania, in Greece, in Ireland, in Portugal - are not yielding the benefits which were initially claimed for them by the advocates of the "structural reform path", in particular in the growth area.
In addition, years of fiscal austerity are now starting to take their toll on the populations concerned. Expectations are not being fulfilled, and a backlash is underway. Regular readers will be aware that my baseline case in Europe is that these misguided/insufficient programmes will steadily destabilise the political systems on Europe's periphery, leading to unstable and unpredictable outcomes. Not the kind of stuff would-be investors like.
Evidently it would be unfair to blame the Fund itself for the kind of problem which exists in Ukraine. Clearly it is a very complex and difficult-to-handle situation. But if you haven't gotten hold of the full extent of the problem in the first place, then it is hard to offer recipes which open a sustainable path forward. Read as much as I can, I still fail to be able to find any single mention of the isssue Ukraine's dire demographics presents for future growth prospects in the IMF literature.
The country's population is falling steadily, due to a long run excess of deaths over births and a steady outflow of working age population, leaving to seek a better life elsewhere. This is not only causing the population to shrink, it is also leading to a dramatic change in the age composition of the population, increasing the average age of the workforce, and lowering the number of those employed per person retired. This is the strategic importance of health and pension system reforms in a country like Ukraine.
Naturally structural reforms are important, but they need to be part of a mix of policies, and among these doing something to address the country's demographic death-spiral should be given a great deal more importance than it is presently - where in fact the issue is almost absent from economic debate.
At this point it is hard to say how the present stand off between the IMF and the adminstration will work out, but as in the Hungarian case I have the feeling that most mainstream bank analysts are underestimating the capacity of the political system to produce "bad outcomes".
The macabre "culebron" associated with the apparent medical condition of the country's former Prime Minister - in prison for having signed the last gas deal - only adds to the sense of surreal drama associated with the country's potential default.
Ukraine’s ex-premier Yulia Tymoshenko is ill and in constant pain, Canadian doctors who examined her in prison said, adding that authorities denied her key blood and toxicology tests. A team of Western doctors went last week to the prison where Ms Tymoshenko is held to examine the opposition leader amid complaints about her treatment and health.The three Canadian and two German medics included a cardiologist and a nervous system expert, the former Soviet republic’s penitentiary system said in a statement.“Now here's the "official version" via interfax:
After meeting and examining Ms Tymoshenko, it was the Canadian opinion that she required confidential blood and toxicology testing,” doctor Peter Kujtan said in a letter to Ukraine’s ambassador in Ottawa, Troy Lulashnyk.The medical team had been invited by Ukraine to carry out the examination and even brought along diagnostic equipment which could produce on-the-spot test results, Dr Kujtan said.“But Ukrainian authorities refused to allow its use, stating that we would be breaking several laws of the land and could face prosecution,” he said.
Ukraine's jailed former Prime Minister Yulia Tymoshenko needs no surgery, the State Penitentiary Service cited a seven-member medical panel as saying on Friday after Tymoshenko had extra checkups on Thursday.The findings of an X-ray test confirmed the previous diagnosis and meant there was no need to revise "the recommendations for her preliminary treatment, while changes that have been detected do not warrant surgical treatment," a statement from the Penitentiary Service cited the seven doctors as saying in their assessment. Tymoshenko, who had herself requested the additional checkups, was examined at a clinic in Kharkiv, the city where her prison is situated. She had an X-ray test, a computed tomography scan and a magnetic resonance imaging scan. However, she again refused to have a blood test, the Penitentiary Service said, adding that foreign doctors would need the results of a blood test for the final diagnosis and treatment recommendations.Naturally this sort of thing is not new in the country, and anyone with an interest in reading about a similarly surreal situation some years ago might like to read my "Will The Real Ukraine Central Bank Please Stand Up! " post.
And if you have the kind of sense of humour I have about technical issues, you might appreciate this short list of concerns about the way the bank problem resolution issue was handled by the central bank, as voiced by the IMF in their ex-post first standby agreement review:
a) Liquidity provided to insolvent banks: As it was difficult to distinguish between solvent and nonviable banks, liquidity support was likely extended to the latter. Moreover, the maturities of NBU loans, which originally ranged from 14 to 365 days, were later converted up to seven years providing de facto solvency support.The first point is an important one in any traditional approach to bank resolution, distinguishing between the rescuable and the un-rescuable, but, of course, none other institution than the ECB itself has now crossed the line, and with the 3 year LTROs (which will, naturally, be extended) the central bank is offering, as the IMF suggest in the Ukraine case, solvency support to a number of otherwise insolvent banks. On the collateral side, the ECB isn't accepting bank shares as collateral, yet, although it is accepting nearly everything else, and this idea of the central bank buying recapitalization bonds, wasn't it first tried and tested in Ireland, and hasn't it be applied to some extent in Greece? Nuff said, I think.
b) Relaxation of collateral requirements: Banks’ own shares were accepted as eligible collateral despite the significant risk for the NBU.
c) Mandatory purchases of bank recapitalization bonds: The NBU was required to purchase at face value recapitalization bonds issued by the government, a practice that the Fund staff advised against.
What Can't Go On Forever Will Only Go On As Long As It Can
So where do we go from here? The IMF have dug their heels in about gas, but this is only a symptom of a much deeper sense of frustration. The fund has been financing the Ukraine deficit and cheap gas, but will the money disbursed ever get returned, or will the can be continually kicked down the road. It is worth remembering that the initial financing of 11 billion SDRs was equivalent to 802% of the country's quota, a very large quantity in terms of the standards of 2008. As the fund puts it in the review:
"No major shift in policy making occurred and political economy considerations continue to drive policy making in Ukraine. Efforts to tackle the underlying structural and institutional weaknesses stalled. Bank resolution remained incomplete, the exchange rate regime returned to pre-crisis practices, the energy sector remained largely unreformed with quasi-fiscal deficits widening, and legal and governance reform fell short of objectives".Put crudely, the fund was being used to finance cheap energy to win votes for populist governments. The frustration to be seen in the above summary suggests to me at least that coming to a new agreement won't be as easy as many think. Especially with a number of other countries looking on. It all used to be called moral hazard I think.
Only industrial users in Ukraine currently pay the full cost of gas. Residential users pay something like 30% of the cost of the gas they consume. This subsidy is a key cause of the loss suffered by the state-owned oil and gas company, Naftogaz, which was UAH 21 billion orUS$2.6 billion, equivalent to 1.6% of GDP in 2011. A planned 50% hike in gas tariffs in April 2011 was negotiated down to 30% hike in two tranches in return for unspecific "offsetting measures" to keep the wider fiscal deficit at 3.5% of GDP. However, eventually, the tariffs were not hiked at all in 2011, widening the actual deficit to 4.3% of GDP. The result of all this is that the IMF have their foot firmly put down, and it will be hard to get it lifted again.
There is, of course, another possibility, and that is that there is no Russia deal and no IMF deal. This could occur if the government baulks at both of the possibilities on the table: either selling a stake in the gas transit corridor to the Russians or raising household gas tariffs. Under this scenario the Ukraine government could follow in the footsteps of Hungary's Prime Minister Viktor Orban which involves seeming to cooperate (in this case with both parties) but doing nothing, and in the meantime hope to muddle through - at least in this case till the elections in October. However, against the backdrop of falling reserves, a rising current account deficit and external funding markets which are closed to Ukraine, a sharp devaluation could become virtually unavoidable if there is neither a gas deal and nor a resumption of the IMF programme.
Following the decision of the ECB to introduce 3 year LTROs and the agreement on the terms of a second Greek bailout global risk sentiment has improved significantly in recent weeks, but it would be foolhardy to imagine that this situation will become permanent. Too many risk elements are still in play, and there are still far too many loose cannon floating around on the EU upper deck for vigilance to relax. But that is exactly what may happen, in which case, if disaster does strike in Ukraine, it will surely be disaster.
This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".