Ukraine Economic Insights: Slow vaccination and spike in inflation

A third pandemic wave and a slow vaccination weigh on Q1 growth. Still, Ukraine's economy is seen to grow almost 4% in 2021. Inflation skyrocketed to almost double digits, which may trigger additional rate hikes. Lack of IMF progress and geopolitics pose challenges 2021.

Key financial figures
UAH 2018 2019 2020 2021 2022
Real GDP (% yoy) 3.4% 3.2% (4.0)% 3.8% 3.5%
CPI Inflation (eop, % yoy) 9.8 4.1 5.0 8.9 5.1
Unemployment (avg, %) 8.6 8.2 9.4 8.7 8.5
Budget Balance (% of GDP) (1.9) (2.2) (6.0) (4.3) (2.7)
Public Debt (% of GDP) 60.9 50.3 60.8 58.8 56.7
Current Account Balance (% of GDP) (4.3) (2.7) 4.0 (0.6) (1.7)
FX Reserves with Gold (USD bn) 20.8 25.3 29.1 30.5 32.0
Gross Foreign Debt (% of GDP) 76.8 70.7 66.4 59.6 53.8
USD/LCY (eop) 27.7 23.6 28.2 28.0 28.5
EUR/LCY (eop) 31.6 26.4 34.4 34.2 35.1
Policy Rate (% eop) 18.0 13.5 6.0 7.5 7.0

The Third wave of Covid-19 had a negative impact on economic activity in Q1'21

The third wave of coronavirus infection turned out to be the "deadliest", and for some time, Ukraine was on the top of this sad European rating. The vaccination rate remained low, and in the nearest future, its dynamics will be checked by the limited access to vaccines. Gradually, the main focus of monitoring the current trends in development of the global pandemic is shifting from dynamics of new infection cases to vaccination rate. Having reached the maximum in early April, there was a certain decrease in the number of new infection cases. However, the extremely low vaccination rate (about 1.7% in early May) gives no reasons for optimism. The easing of quarantine-related restrictions could worsen the situation again. In the near future, certain acceleration in the pace of vaccination is expected due to deliveries under Covax global initiative. A dramatic improvement in this situation could be possible only by establishing regular supply of vaccines from different manufacturers and optimizing the vaccination processes.

Chart 1 - GDP dynamics and forecast
Ukrstat, RBI/Raiffeisen Research

Ukraine's GDP shrank by 4% in 2020, faring slightly better than the previous estimate of -4.2%. The State Statistics Committee has improved its estimate of GDP dynamics in the first, second and fourth quarters, and also, adjusted upwardly the GDP deflators for all quarters. The nominal GDP amounted to UAH 4194.1 billion. After adjustments, quarterly indicators of nominal GDP, economic growth rates and GDP deflators were recalculated upward. As a result of a significant revision of the GDP deflator for the fourth quarter (from 11.2% to 17.5%), the annual deflator was raised to 9.8%. It contributed to an increase in nominal GDP, and as a result, this figure turned out to be higher than our expectations, amounting to UAH 4194.1 billion or, according to the average annual exchange rate, USD 155.6 billion. Therefore, despite the economic downturn the GDP, calculated in US dollars, even slightly increased comparing to 2019.

The tourism, food service, entertainment and transportation subsectors of the service sector were affected by the coronavirus crisis the most. Agriculture has suffered from unfavorable weather conditions. In the sectoral context, as we forecasted, the largest decline in business activity was observed in the restaurant and hotel business (-28.5%), transportation (-16.4%) and other services (-23.1%). At the same time, the largest contribution to the GDP decline was made by the transportation (-1.1 pp), agricultural (-1.0 pp) and manufacturing (-0.6 pp) sectors. Despite the general downward trend, growth was recorded in certain sectors: construction (+ 5.2%), trade (+ 4.9%), information and telecommunications (+ 2.3%) and healthcare (+ 2.2%). Considering its high share in the structure of GDP, trade made the largest positive contribution to dynamics of the annual GDP (+ 0.6 pp).

Chart 2 - Contributions to GDP growth: production side (pp)
Ukrstat, RBI/Raiffeisen Research

The low dynamics of vaccination rate amid the worsening epidemiological situation, the increase in new infection cases and Covid-19 mortality rate, and the imposition of additional restrictions in certain regions do not contribute to an early economic recovery, and as before, we expect the real GDP to slightly decrease in the first quarter (by about 1.5%) and rise by 3.8% in 2021. Thus, Ukraine (almost) recovers its losses in GDP this year.

The central bank provided monetary restrictions as a response to the spike in inflation.

The CPI increased by 1.7 mom in March, which was the highest monthly increase since 2018. Thus,inflation reached 8.5% per annum. In March 2021, the CPI increased by 1.7% comparing to February 2021, reaching 8.5% in annual terms. The core CPI rose by only 1.6% m/m, or by +5.9% from March 2020. Despite the astounding figures, such inflationary dynamics were more likely due to seasonal factors. Moreover, there was an economic shock from the raise of the minimum wage in January, but it was less dominant than the seasonal one. On the other hand, government regulation of natural gas and electricity prices dampened major pro-inflationary processes.

The largest price growth in annual terms was observed for food and energy, which was due to theeffect of a low comparative base, global market trends and an increase in consumer spending. Food and beverage prices rose by 2.1% mom to 10.4% yoy due to depletion of the current supply of raw foods, such as fruits and vegetables. Another reason for the rise in prices for raw foods was the strong demand from exporters. For example, the sunflower oil price rose the most (by 9.7% m/m). Prices for alcoholic beverages and tobacco products continued to drift into the positive territory, having increased by 0.7% m/m as a result of increasing excise tax, which increased the prices for tobacco products by 1.2% m/m.

Chart 3 - Inflation and Key rate dynamics, %
NBU, RBI/Raiffeisen Research

The current trend of accelerated price growth contributed tothe revision of our previous forecast towards a slight worsening of inflation indicators. We expect some pro-inflationary trends to be temporary. On the other hand, low vaccination rates in Ukraine and its major trading partner countries do not indicate possible deflationary pressures, as high commodity prices and prior fiscal measures dominate the current CPI dynamics. Considering current trends, we changed our inflation forecast, expecting that after it reaches the maximum by the end of the third quarter, the annual inflation trend will reverse and by the end of the year, the CPI will be 8.6%, while the average annual inflation rate is estimated at 8.7%.

The National Bank of Ukraine raised the key rate by additional 100bp to 7.5% (overall 150bp this year so far), demonstrating determination to contain further growth in inflation expectations, while inflation reached 8.5% in March. Contrary to expectations of many analysts, the National Bank of Ukraine raised its key rate from 6.5% to 7.5% (we forecasted 7%), responding quite toughly and ambiguously to the accelerating inflation, which in March amounted to 8.5% yoy, exceeding the upper limit of the target corridor (5% ± 1 pp) already by 2.5 pp. The NBU also expects the key rate to be higher than the future long-term trend only for some time, in order to prevent the further worsening of inflation expectations.

In our opinion, the desire to "anchor" inflationary expectations was the main motive behind the NBU’s decision. The NBU demonstrates, by its previous statements and the current decision, determination to make every effort to curb pro-inflationary processes, since painful episodes of high inflation are still fresh in the minds of market participants and Ukrainian residents.

We do not exclude further hikes in the key rate in response to the CPI’s possible deviation from the forecast trajectory in the coming months. The NBU's policy somewhat echoes its decision of last year’s June, when, unexpectedly for many analysts, it lowered the key rate by 200 basis points at once, from 8% to 6%. After that decision, the discount rate remained unchanged until the meeting in March 2021. According to the updated baseline trajectory of the NBU forecast for the key interest rate, it should remain at around 7.5% until the meeting in April 2022. After that, the discount rate will return to 7% by the end of 2022, which is in line with the baseline trajectory of the previous forecast. We generally agree with the NBU’s point of view on this. Nevertheless, we believe that, given the government's propensity for populist decisions and high geopolitical risks, the likelihood of the discount rate being revised upward again remains quite high.

Chart 4 - Inflation and Key rate forecast
Ukrstat, RBI/Raiffeisen Research

Public budget and Fiscal Policy: positive dynamics but uncertainty with IMF

The trend of "overfulfilling" the plan for state budget revenues continued in March, and as a result, this figure in the first quarter turned out to be 5.2% higher than planned. In the first quarter, state budget revenues showed very positive dynamics, having increased by 19.2% comparing to the last year’s figures. However, this growth was largely due to the effect of low comparison base: revenues in the first quarter of 2021 were 19.4% higher than in 2019. At the same time, the additional funds amounted to UAH 10.5 billion, and its indicator has even slightly increased comparing to the previous month.

Chart 5 - State budget revenues (UAH bn)
MFU, RBI/Raiffeisen Research

The balance of the Single Treasury Account (STA) as of the beginning of April remained practically unchanged; however, significant debt settlement payments amid the sharp decrease in the amount of funds raised by issuing government bonds in the first half of April may lead to its drastic decline. The balance of the STA as of the end of March practically did not change comparing to February, amounting to UAH 30.1 billion as of 1 April. At the same time, there are serious concerns whether the balance will remain sufficient at the beginning of May, in view of the not-very-successful placements of government bonds in the first half of April, the unavailability of external financing since the beginning of the year, increasing pension payment expenses and the resumption of one-time aid payments to sole proprietors and hired employees (UAH 8,000) with the simultaneous slowdown in the dynamics of revenues as a result of quarantine-related restrictions. The situation of 2018 may well repeat itself, when, after pensions were indexed for the first time under new rules, the balance of the STA remained low until the beginning of September.

Chart 6 - Single treasury account (UAH bn)
MFU, RBI/Raiffeisen Research

On April 26, Ukraine successfully placed USD 1.25bn 8-year Eurobonds at a fairly acceptable yield of 6.875%, considering the sovereign rating. This will create a small buffer to solve the problem of repayment of foreign liabilities in September.

The lack of visible progress in ascertaining the prospects of further cooperation with the IMF generates risks for the funding of budget expenditures. The gradual withdrawal of nonresidents from government bonds amid the worsening geopolitical situation has immediately exposed the “fragility” of the existing system of raising funds to finance the budget deficit and payments on government debt. Although the Verkhovna Rada has opened the way for "Big privatization", which can help finance the budget deficit, experience suggests that this source of revenue could be unreliable. Another "lifesaver" could be the IMF’s decision to allocate USD 650 billions to increase reserves and help economies recover from the pandemic. A similar decision was made in 2009, when Ukraine received almost USD 2 billion out of USD 250 billion. It is expected that Ukraine can receive about USD 2.7 billion as part of the additional distribution of SDR. At the same time, the main purpose of this decision will likely be to support foreign-currency reserves, not financing the budget deficit.

–°urrent account remains on positive territory in 2021

Dynamics of the balance of payments in the first months of 2021turned out to be slightly better than our expectations, and high prices for the main export goods in foreign markets were maintained mainly by the news factor and economic recovery in many European countries. And we still see no reasons for a significant decline in prices for agricultural products, metals, oil and gas in the coming months. The growth in exports of goods in January-February 2021 amounted to 4.5% year-on-year, comparing to the corresponding period of 2020. This growth in exports was due to the more active start of the year in Europe, which in turn, boosted demand and led to an increase in Ukrainian exports of mineral products, in particular, products for the manufacturing and construction industries. Exports of mineral products grew by 57.5% to USD 1.2 billion, out of the total exports of USD 8.5 billion. Also, the export of oils and fats increased by 12% to USD 1.1 billion, going mainly to Asian countries.

Chart 7 - Export / Import monthly dynamics (USD mln)
NBU, RBI/Raiffeisen Research

The outflow of foreign direct investments continued, recording a net outflow of USD 250 million. On the other hand, this trend was partially offset by an inflow of portfolio investments in the amount of USD 300 million. In general, dynamics of the balance of payments remained stable, without significant imbalances. The current account continued to show surplus, which amounted to almost USD 1 billion in January-February. We expect that the quarantine introduced in April will reduce the volume of incoming and outgoing flows on the main items of the balance of payments, but it will be short-term in nature and will not lead to a change in long-term trends.

Chart 8 - Export, import, CA dynamics and forecast (USD bn)
NBU, RBI/Raiffeisen Research

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Oleh Klimov is working in Raiffeisen Bank Aval from beggining 2020. His expertise mainly lies on capital markets that helps him to analyze and cover regional bonds and interest rates markets in Ukraine. Also, he helps other local analysts on monetary policy, inflation, commodities market and balance of payments of Ukraine. From 2018 he was working as a quantitative researcher on FX and rates markets in the Kyiv School of Economics. His other experience includes being trader on macro desk in Geneva-based MKS Switzerland and Head of Trading for IGR in Dubai providing service for institutional clients on Asian and European rates and commodities markets . He has BSc in telecommunications engineering and MA in economics from the Kyiv School of Economics.