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Divided Ukraine skirting default

Rising concern that Ukraine, suffering tumbling demand for its exports as the global economy slows down, is heading towards default on its international debt may yet nudge its government to rein in political infighting, even as leading factions position themselves for an election next year.

After giving warning last week, Standard & Poor's on Wednesday cut its credit ratings across the board for Ukraine - ranking it alongside Pakistan - as fears grew that domestic politics could prevent the necessary steps to avoid international financial default later this year.

The ratings agency cut the country's foreign currency credit ratings, both long and short term, from "B/B" to "CCC+/C" (seven levels below investment grade) and its local currency ratings from "B+/B" to "B-/C".

The move followed a downgrading by the smaller Fitch rating company of Ukraine's long-term foreign and local currency rating from "B+" to "B" (five levels below investment grade) and a warning by Moody's that it might also cut ratings of many of the country's major banks.

Much depends on how the country's current negotiations with the International Monetary Fund (IMF) for a US$16.4 billion program develop. The main stumbling blocks are reducing the budget deficit and restructuring the banking sector. As far as the latter is concerned, the World Bank and European Bank for Reconstruction and Development have just announced their readiness to expend $1.35 billion in loans or minority-stake purchases in the banking sector.

The Financial Times believes that bank and corporate defaults are inevitable even if an IMF program is agreed, which should allow the country's foreign debt
to be serviced. However, this does not mean that corporate debt will escape unscathed without restructuring. This is where the fall in the value of the currency, the hryvnia, does not help, as it will continue to encourage depositors to run on the banks while weakening the latter's capital base.

On Tuesday, just one day after the national bank had sold $92 million on the market at 7.90 hryvnia to the dollar, the national currency reached a new intraday low of 9.23 against the dollar. This decline, which is now reaching critical levels, builds on weakness characterized by a bank run last October and a now year-long stock market crash.

The hryvnia recovered to close Wednesday at 9 to the dollar, but some currency specialists nevertheless see a possible low of over 9.7 to the dollar within a month, equaling the all-time low attained last year.

Current estimates of the country's economic performance for 2009 range down to a contraction of 9%, following last year's 2.1% growth rate, itself down from 7.6% the year before. Industrial production is already down over a quarter from the beginning of last year.

For the budget deficit, things are moving very quickly. The deficit was first announced at 5% while it was generally believed that the IMF was insisting on a deficit-free budget. However, late on Tuesday a new deficit estimate of 3% was announced, a figure that Vice Prime Minister Hryhoriy Nemyria said on Wednesday would be acceptable to the IMF. Kiev now hopes for a visit by an IMF delegation within the fortnight.

Credit-default swap quotations - a measure of risk, with higher quotes signaling higher risk of default - were not available on Wednesday due to illiquid market conditions. On Tuesday, they were quoted above 4,000 basis points. By comparison, Iceland's quote was 1,100 basis points at the worst of its troubles a few months ago, and Pakistan is at 2,500 basis points.

Every 100 basis points represents a $100,000 cost for insurance against default of every $10 million held. Bloomberg News, quoting CMA Datavision, reported that the levels imply a market expectation of over a two-in-three chance of default within the next two years and more than a nine-in-10 chance within the next five years.

A default could have significant results for Europe, as it would require a prioritization of debt payments, with no guarantee that Moscow's invoices for natural gas will be high on the list. Total European bank exposure is in the neighborhood of $45 billion.

As Ukrainian parliament speaker Volodymyr Lytvyn told journalists two weeks ago after meeting with European Union officials in Kiev, the European Union is even more worried about the country's political stalemate than Ukrainian politicians themselves are, but "there is no way to reconcile and consolidate the key players before the presidential election in Ukraine".

Ukraine's next presidential ballot is scheduled for mid-January 2010, when Prime Minister Yuliya Tymoshenko is expected to run against President Viktor Yushchenko, with whom she made common cause in the "Orange" revolution at the end of 2004 but has since had fallings-out (see Ukraine goes from orange to red, 22 October 2008).

While some observers think Tymoshenko looks to Russia for a loan to rescue Ukraine, others suspect that Yushchenko may seek to influence the central bank, complicating the situation of Tymoshenko's government on debt repayment, to her political detriment.

This competition and conflict was evident as early as last autumn in the conflict within the highest ranks of the Ukrainian political elite over whether Kazakhstani oil should be permitted to cross the country so as to enter an east-west pipeline from Odessa to Brody that would continue on for export to world markets through a line to be constructed to the Polish port of Gdansk (see Ukraine clash threatens oil to Europe, 2 August 2008.)

Nevertheless, the current trainwreck of Ukraine's international credit ratings may, by focussing the attention of the country's political elite, have helped to avoid a worse catastrophe of sovereign default, at least in the near term. Still, this present conjuncture is likely not even the end of the beginning.

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First published in Asia Times Online, 27 February 2009

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