Ukraine Watch: Monthly update – economy in war (August 2024)

• Consumer and business sentiment have stopped their declining trend in July, the relative stabilisation in terms of security risks and energy supply risks as well as improving economic expectations being the main factors behind this development.
• The National Bank of Ukraine (NBU) opted to maintain its current monetary policy environment and kept the key rate flat at 13%, despite its previous guidance of further rate cuts. This was in line with the increase in inflation, further inflationary risks (i.e. core inflation still increasing) and hryvnia depreciation. Nevertheless we expect the NBU to cut further to 12.5% by year end.
• The nominal debt burden and costs of servicing the external debt should be reduced siginificantly, following the recent agreement on the restructuring of Ukraine's debt with core creditors of its Eurobond portfolio.
• The latest tranche of IMF funds in July and the inflow of US funds in early August denote a positive break from the lack of sufficient external funding in the first half of 2024. This lack of funding already forced the government to reduce its spending and contributed strongly to the declining trend in FX reserves. The latter being aggravated by the trend of hryvnia depreciation, which the NBU was able to control to a large extent. With the expected uptick in FX reserves, the NBU should remain in control of FX volatility.
• Meanwhile, the NBU also changed its approach to defend hryvnia as USD/UAH approached 41.50. The news on the restructuring of the external debt started positive dynamics in terms of the exchange rate. Our outlook for the coming month being that the NBU should successfully guard the exchange rate against moving higher than the 41.50 benchmark.

Source: LSEG, National Sources, RBI/Raiffeisen Research

Business sentiment stopped its decline in July

Even though we expected a solid slowdown in the negative dynamic of business sentiment in July, we did not anticipate that it may start its gradual recovery already. Indeed, the business expectations index recorded a marginal upturn (by 0.7% mom) in July, which looks rather good under current circumstances, i.e. during the most substantial electricity cut-offs due to hot weather and repairs on base generating nuclear power units. Moreover, growing production costs (especially after a hike in electricity tariffs for business in May and a rather solid hryvnia devaluation in July) have not hampered the improvement in business sentiment last month.

Business Activity Expectations Index (BAEI*) and its components

* in points, 50 = neutral level

Source: NBU, RBI/Raiffeisen Research

A sectoral breakdown of business sentiment showed a positive dynamic of changes in expectations in three out of four core sectors. Indeed, business expectations in the trade sector keep worsening (-4% mom) for the fourth month running, thus dropping to the lowest level over the past six years. We can attribute this path to the constant worsening in consumer sentiment, which limits their potential for expanding consumption. On the other hand, business sentiment in the construction sector recorded the largest upturn among other sectors, with its sectoral sub-index growing by 15% mom, thus closely approaching the neutral level. We think the programs for private housing and still high activity on building the defensive lines are the core factors behind the upturn in business sentiment in the construction sector last month. It was rather promising to see a moderate recovery in the sentiment of the services sector, considering the solid drop in demand for services, especially after intensifying mobilisation measures in Ukraine.

Considering the relative stabilisation on the frontline and state officials' changed rhetoric towards possible peace negotiations coupled with a visible improvement in the electricity supply, we should definitely see a more active recovery in business sentiment in August. Moreover, some sporadic upturn in consumption of durable goods (mostly automobiles due to the intention of the government to raise taxes) should be an additional catalyst for increasing demand for goods and services, thus also supporting improvement in business sentiment this month.

Consumer confidence stopped declining in July

Similar to the dynamic of business confidence, the path of consumer confidence in July was a great surprise to us. Indeed, private consumers last month suffered the hardest electricity cut-offs since winter 2022, with electricity supplies not exceeding 50% per day for several consecutive weeks. However, this was not a reason for consumers to worsen their sentiment further in July, which, on the contrary, elevated by 9% mom. Even though it remains below the May figure, the change in the trend may look promising, thus underpinning the changed outlook of consumers regarding the near-term future. We think some stabilisation of security risks (including the absence of new attacks on energy infrastructure) might have caused the sentiment to improve last month.

A solid upswing in the sub-index of economic expectations (by 10% mom), especially regarding economic development estimates in a year (with the largest monthly increase of 18%), might confirm our assumptions. We also see some calmer consumer reactions regarding potential worsening in core economic indicators in the near term. Consumers' worries about inflation (albeit staying at its 2.5-year maximum) have not expanded further in July, even though inflation started its visible acceleration in June. In addition, even though devaluation expectations of consumers remained on an increasing path, its expansion by just 2% mom in July looks considerably milder than a hike in the corresponding indicator by 10% in June, when hryvnia demonstrated its constant devaluation pattern.

The NBU kept its key policy rate unchanged

Even though the minutes of the previous monetary committee meeting in June clearly reflected the readiness of the NBU to continue its policy rate cuts, we were sure that recent factors might change the opinion of NBU officials when announcing the policy rate this Thursday. Indeed, the rate remained flat at 13%, thus fully corresponding to our and market consensus projections. The NBU's decision was unsurprising, as the unexpected rapid acceleration of inflation in June from 3.3% to 4.8% yoy substantially undermined the arguments for continuing the rate-cutting cycle, at least in the coming month or two. Additionally, relatively strong hryvnia depreciation in recent weeks might be another sound argument for avoiding any cuts in the policy rate and any changes in the operational design of the monetary policy. Finally, a slight but notable deterioration in the NBU's inflation forecast from 8.2% to 8.5% for the end of 2024 should reflect growing concerns regarding the rationale of further rate cuts and the ability to contain inflationary risks efficiently.

The NBU left this year's forecasting trajectory for the policy rate unchanged, thus expecting it to stay at 13%, with the intention set to resume rate cuts by 50bp to 12.5% at the first meeting of 2025. The regulator also improved its economic growth forecast for 2024 from 3.0% to 3.7%, primarily due to an unusually high first-quarter figure significantly exceeding the NBU's previous estimates. However, the NBU downgraded its forecast for GDP growth in 2025 from 5.3% to 4.1%, mostly due to worsening security risks in the medium term. A notable improvement in the NBU's current account deficit forecast (from 20.2% to 14.2%) for 2024 might be tied to the potential receipt of grants from the EU in the second half of the year (which was already approved in the Ukrainian plan) and a better-than-expected situation with external trade in the first half of 2024. However, a downgrade in the NBU's reserves forecast for year-end from USD 43.4 bn to USD 41.2 bn supports our view that the regulator has chosen to raise its FX interventions to support hryvnia rather than to allow it to devalue more substantially.

Even though NBU officials do not see a possibility of cutting its policy rate this year, we still maintain our forecast for the rate at 12.5% by year-end, thus expecting to see an additional 50 bp cut. We believe exchange rate stabilization, unchanged security risks, expected improvement with electricity supplies in the winter season, and increasing volumes of external aid may be the potential triggers for NBU to resume its monetary easing cycle.

Inflation and key rate (in %)

Source: Ukrstat, NBU, RBI/Raiffeisen Research

Inflation inched up again in July, above NBU targeted level

The growing trend in annual inflation (started in the last month of spring) continued in July. Indeed, headline inflation increased from 4.8% to 5.4%, with the acceleration of growth smaller than the month before, yet strong enough to reveal the influence of pro-inflationary factors. This development did not surprise us, as this trend was included in our forecast, while we expected a slightly smaller figure.

Prices remained unchanged month-on-month, although we expected a small decline due to some seasonal patterns. Food prices dropped by 0.8%, while an increase in fruit prices (1.4% mom) did not correspond to seasonal trends. The notable rise in sugar prices (12.1% mom) was also not accounted for in our projections, which probably occurred as a correction of previous downward price trends. Additionally, some upturn in prices came from the segment of public utility services (1.8% mom) and hotels & restaurants (1.2%), which added 0.1 percentage points to the monthly inflation dynamics, according to our estimates.

We understand that the solid acceleration in headline inflation in June was mainly caused by a hike in administratively regulated tariffs (i.e. electricity tariffs for households). Therefore, a smaller quickening in CPI in July looks justified to us. However, the dynamic of core inflation looks more worrisome to us because it preserved its growth momentum last month (i.e. from 5.0% to 5.7%). Therefore, although current inflation trends generally align with our forecast of 7.5% by year-end, we observe potential additional inflationary risks that could materialize by September, prompting us to review our projections. These risks are related to increased tax rates to fund defence needs, which, depending on the scenario, could accelerate inflation over the whole year by 1.0 to 1.4 percentage points.

The government reached a preliminary agreement on restructuring its external debt

Even though Ukraine has almost run out of time to avoid a technical default on its Eurobonds portfolio (which is due in early August), we think this should not influence the country's external debt profile because the government, on the second attempt, reached an agreement with core creditors this week. Even though the parameters of the deal look slightly worse than the initial conditions of the government, we still can treat this as a great success, considering that the value of discounted cash flows on new Eurobonds will represent 40% of the initial ones. That would reduce not only the nominal debt burden (due to haircuts from 25% to 37% depending on long-term economic conditions) but also the volume of servicing the newly restructured debt, especially in the coming few years.

According to the information disclosed by the government, it should save USD 8.2 bn in principal payments over 2024-2029, while interest payments (paid semi-annually) would be substantially below market level (i.e. 1.75-4.50%) in the first three years after the restructuring deal. Therefore, the government expects to save USD 11.4 bn on the servicing of external debt within the coming three years, while this volume would be expanded to USD 22.8 bn by 2033. In any case, the positive effect of restructuring would allow keeping the debt-to-GDP ratio at 82% by 2028 and 65% by 2033, with average needs for additional financing not exceeding 8% of GDP over the period. According to the government, this fulfils the targeted indicators disclosed in the IMF program. Consequently, the IMF should positively assess all parameters of the deal, maintaining good prospects for Ukraine to receive additional tranches from the Fund.

We think the main aim of the restructuring deal (besides just reducing volumes of servicing its debt) is the ability to avoid a real default (where investors might lose all of their holdings), thus preserving positive estimates of investors regarding Ukraine's credit profile. This development potentially may open the door for the government to enter global capital markets with new borrowings already in the first year after the war ends because the flows of external aid would be much smaller in the period between the end of the war and the restoration of foreign investments.

In any case, the deal has yet to be finalized, as it was an agreement with the largest holders owning 25% of the total Eurobonds portfolio, while 75% of owners should consent to finalize all the agreements. However, considering the general investor sentiment, we do not see any difficulties here. Indeed, an upward adjustment in the market price of Eurobonds from 26-28% to the current 30-32% reflects investors' initial underestimation of restructuring conditions. However, we understand that additional time is necessary to close the deal, which may require breaking initial conditions on postponing the payments on Eurobonds until August 2024. Therefore, rating agencies would treat this as a case of technical default, thus reflecting this correspondingly in their rating assessments of Ukraine. For example, Fitch has already lowered the sovereign rating from CC to C. However, in our view, this should not cause any additional negative impacts on the new deal and Ukraine's credit profile because investors have already agreed upon the core elements of the restructuring deal.

Expenditures of the central budget in July at a six-month low

The lack of sufficient external financing in July (i.e. Ukraine received just USD 2.2 bn from the IMF) forced the government to restrain its expenditures due to limited other sources to cover the budget deficit. Even though tax revenues were reasonably high (at 26% yoy), relatively low non-tax revenues prevented a rapid expansion in total budget revenues. According to our estimates, expenditures amounted to around UAH 310 bn in July, which corresponds to a six-month low. However, considering the sufficiently high own revenues of budgetary institutions in the previous two months (UAH 64 bn in May and UAH 90 bn in June) and their targeted use (mainly for restoration and purchases of energy equipment), we cannot say that expenditures for general purposes have substantially deviated from the levels recorded in previous months.

Central budget revenues and deficit by months (in UAH bn)

Source: NBU, RBI / Raiffeisen Research

According to our estimates, the central budget deficit slightly exceeded UAH 140 bn, thus remaining roughly at the same level as in June. The funds from the IMF allowed financing the bulk of it, but this was not enough yet. Hence, the government had to raise further its debt to the Single Treasury Account by an estimated amount of UAH 30 bn in July. Consequently, cumulative debt to the Treasury has already extended to almost UAH 400 bn. Let us recall that financing through this source allowed to compensate for the lack of external funding in the fourth quarter of 2023 (USD 3.2 bn) and at the beginning of this year. Therefore, the proposal of the government to attract additional UAH 500 bn through the reallocation of budget expenditures, tax increases, and additional internal financing would include the repayment of the debt to a Single Treasury Account.

NBU FX reserves followed a further declining path in July (-2% mom to five-month minimum of USD 37.2 bn), thus continuing the trend for the fourth month running. However, we cannot say there was an absence of financial assistance over July. Instead, a provision of the next IMF tranche worth USD 2.2 bn in early July was the core source of external financing last month. However, growing fears of FX market participants on the continuing hryvnia devaluation trend and a corresponding increase in NBU interventions to break the trend caused the highest volume of NBU interventions this year (USD 3.3 bn). It exceeded the net inflow of foreign currency received as international aid in July, thus causing NBU reserves to keep a declining trend. Even though the coverage of NBU reserves declined to less than five months of imports, we still consider it a firm confirmation of the NBU's ability to control the exchange rate in the near-term, thus preventing any dangerous spikes there.

FX Reserves have decreased recently (in USD bn)

Source: NBU, RBI/Raiffeisen Research

We think that there should be a change in the declining trend of NBU FX reserves this month, if considering expected (and already confirmed) inflows of external aid in August. In particular, the inflow of USD 3.9 bn from the US had to change the pattern in NBU reserves already in early August, while we also expect to see EUR 4.2 bn as the first tranche of the Ukraine Facility program. If considering at least the same volume of net NBU interventions (i.e. no more than USD 3.3-3.5 bn) and rather moderate payments on external debt, we will definitely see a solid upturn in NBU FX reserves closer to USD 42 bn by the end of August, thereby raising their coverage back to five months of imports. Definitely, the recent agreement with foreign investors on sovereign Eurobonds’ restructuring would substantially reduce the projected costs of the government on servicing external debt this month, thus softening the pressure of these costs on the reserves’ dynamic.

The current account deficit expanded to a ten-month high in June

It was not surprising to see a significant decrease in exports in June (by 20% mom to USD 0.67 bn), driven by the decline in agricultural exports due to both seasonal patterns (recorded at the end of the marketing year) and more active exports in previous months due to the fears of blocked alternative exporting corridors. That was definitely the core driver of widening the current account deficit from USD 0.5 bn to USD 2.2 bn, the highest figure since September 2023.

Meanwhile, a slight decline in merchandise imports for the second consecutive month seems odd, amid a solid increase in purchases of energy equipment and electricity in June. Nevertheless, this was insufficient to compensate for the drop in exports, thus expanding the merchandise trade deficit to the highest figure (USD 2.7 bn) YTD. On the other hand, the services balance revealed some improvement on a more rapid decline in imports (-9% mom), which just marginally contributed to improvement in the current account balance.

A reduction in income payments to non-resident investors bettered the primary income balance, while a decline in remittances from abroad (to a six-year minimum) worsened the secondary income balance. Hence, the combined result of the primary and secondary income balances lowered to approximately USD 1.0 bn, which is the lowest figure since the start of the war.

As we expected, the financial account returned to a surplus, exceeding USD 1.2 bn. This was mainly due to receiving a tranche of EUR 1.9 bn from the EU under the Ukraine Facility program. Moreover, the balance of financial flows improved slightly in other operations as well. In particular, outflows of foreign currency through the cash channel decreased by 9% mom. Additionally, the balance of trade credits and advances returned to a positive area. The consolidated balance of payments remained negative for the third month, although it narrowed significantly to less than USD 1.0 bn in June due to an improvement in the financial account.

We expect that the balance of payments will return to double the deficit denoted in July (due to a still wide current account deficit and small flows of external aid), amounting to about USD 3 bn. This deficit had to be covered through NBU FX reserves, with interventions in July staying at maximum this year, thus supporting our estimates on the balance of payments.

Banks’ income in June (UAH 43.2 bn) remained close to the record-high levels in May, which is the second-best result historically. Besides solid contributions from interest income and commission charges, trading income (UAH 5 bn) stayed among the largest contributors to the income for the second month running, reflecting increasing opportunities for banks to receive profits on exchange rate volatility observed over recent months. However, banks’ expenses expanded by 12% mom in June to the highest volume in 2024 due to double-digit growth in other operating costs and the highest loan-loss provisions since the start of the year. However, the accumulated volume of provisions over the first half of the year was close to zero, thus indicating that new security risks and the risk of disruptions in energy supply did not impact the quality of banks’ portfolios substantially in the manner they did in 2022.

Net interest & commissions income (in UAH bn)

Source: NBU, RBI/Raiffeisen Research

Net banks' profit amounted to UAH 38.5 bn over the second quarter of this year, 5% smaller in qoq terms but 15% higher yoy. The record-high net interest income was the main factor for this dynamic. We do not see any significant risks for the banking system's profitability in the near term, as their business models remain quite effective despite the declining pattern in the key rate over the first half of 2024 (which caused a corresponding decline in interest rates in the banking system). We do not see any reasons hampering banks from maintaining their solid profitability in July, especially considering that the flat NBU key rate did not cause any additional downward corrections in interest rates, while exchange rate volatility should contribute to increasing volumes of trading income.

NBU changed its approach to defend hryvnia as USD/UAH approached 41.50

Devaluation patterns were dominating July, especially in its first half of the month, where the USD/UAH reached its historical maximum of 41.63 on 18 July, this showing a rather visible 2.3% devaluation since the beginning of the month. We think this was mostly driven by increasing foreign currency demand after the NBU allowed to implement the largest stage of FX market liberalization in May. However, it applied some additional measures in the first half of July by extending back the payback period on returning export proceeds from 90 to 120 days, which caused some reductions in exporting proceeds, at least in the short-term. Moreover, exhausting exporting potential of agriculture products harvested over previous agriculture season and no new solid flows yet from new harvest preserved small export flows. Therefore, the sale of foreign currency from clients has dropped by 13% mom in July. On the other hand, solid imports of energy resources and energy equipment maintained foreign currency demand at rather substantial level.

Weaker exports and rather strong imports widened the gap between foreign currency supply and demand. However, the NBU allowed more flexibility for the market to adjust its imbalances by itself, thus allowing for some exchange rate upward correction, while limiting its daily intervention volumes. However, market correction mechanism did not work properly, because constantly devaluing hryvnia added some speculative mood to the market, thus sharpening near-term devaluation fears and causing more visible speculative trends there. However, this did not last for a long time, because as soon as the USD/UAH crossed the 41.50 benchmark, speculative mood has obtained its additional strength on the market.

Moreover, yoy hryvnia devaluation has exceeded 13% in mid-July, thus approaching (or even exceeding) the benefits investors could obtain from investing into hryvnia financial instruments. This threatened to cause additional elevation of foreign currency demand with corresponding pressure on hryvnia at FX market. We believe this might be a starting point for the NBU to change its approach regarding both interventions and preserving control over FX market stability. Hence, the regulator intensified its foreign currency interventions in the second half of July, thus also adding so-called verbal interventions to calm the market down and, mostly important, to prevent domination of speculative and panic mood on the market. Even though this strategy has caused expansion of NBU interventions in July to maximum level (USD 3.3 bn) this year, this was worth it. Indeed, the USD/UAH has started its downward correction, thus deepening below 41.00 and reaching its local minimum of 40.95 at the end of July.

We believe the news on successful restructuring of the debt on sovereign Eurobonds (which would visibly soften the medium-term debt-servicing costs and consequently reduce potential demand for foreign currency) initiated a positive trend in the exchange rate at the end of the month. Therefore, the news on the receipt of more than USD 8 bn in early August from international donors will strengthen the ability of the NBU to control FX market stability, thus also minimizing speculative pressure on hryvnia, at least in the short-term.

Our outlook for the coming month is mostly backed by our assumption that NBU would guard the exchange rate against moving higher than 41.50 benchmark. However, by facing the hard task of optimizing its market support (through minimization of daily interventions from reserves) in order to save its reserves, the NBU will likely allow volatility in the exchange rate mostly in the range of 41.00-41.50 in August. We still consider hryvnia devaluation above 41.50 as low probable in the near-term, as NBU officials reiterate intention in their monetary policy to keep attractiveness of hryvnia investments over foreign currency instruments. The decision of NBU to keep its key rate unchanged in July might support our assumption regarding near-term NBU tactics.