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Russia & CIS

Ukraine needs further reform before investors consider opportunities

Investors remain sceptical about Ukraine despite the government’s request that state officials declare all of their assets in a transparency-driven push to implement IMF reforms. In addition, the hold up of numerous reforms is unlikely to drive investors to the country any time soon.

Nov 1, 2016 // 5:51PM

An IMF-imposed deadline, requiring all Ukrainian government officials to upload detailed information concerning their private assets onto a new open-access database, has passed with some officials still to disclose assets.

The e-declaration system, launched on September 1 under the backing of a UN Development Programme and the Danish government, has progressed in a stop-and-go fashion as many government workers were reluctant to provide details of their personal finances.

But tens of thousands of officials, led by Ukrainian President Petro Poroshenko, have already complied with the new regulation, albeit with some reluctance. Poroshenko himself has been critical of certain aspects of the procedure, but eventually published a full breakdown of his wealth, which included over 100 companies and a UAH62mn annual income.

Public attention has been focussed on a handful of politicians and oligarchs who revealed staggering amounts of cash and assets in their possession, while others attempted to sabotage the process. Sergey Melnichuk, a former army commander and now Rada MP, initially declared assets worth UAH1tn (US$40bn), before admitting that it was a joke intended to expose the weakness of the new system.

Others have notably declared luxury watches, Faberge eggs and even a private church.

While the shift towards higher state transparency in the country, currently ranked 130 in the global corruption perception index, is generally seen as positive step, observers remain unconvinced.

“I think that some of the initiatives so far, contrary to attracting investors, have actually exposed cracks in the government and internal wrangling. These power struggles attract little sympathy from potential investors,” said Ondrej Schneider, the IIF’s chief economist for Ukraine, Russia, Poland and the Czech Republic.

“From an outside investor’s point of view, [the reforms] have been somewhat disappointing,” noted Raymond Zucaro, CIO at RVX Asset Management. “I went to Ukraine in the summer; it is clear that they are making progress and investment is encouraged by the anti-corruption campaign, but it is not quite running at the pace foreign investors would like to see.”

“Compared to Georgia, which saw revolutionary changes after the pro-Western government came to power in mid 2000s – including an overhaul of the police system and a crackdown on bribery – Ukraine has been much slower. The interested parties are much more ingrained, which puts a drag on reform,” he added.

Ukraine’s economy has struggled to recover in the aftermath of the second pro-European Maidan protest that resulted in the arrival of the newly elected pro-European government, and the conflict with pro-Russian rebels in the Donbass region.

In addition, bondholders have struggled to make returns on Ukrainian credit. Although the economy expanded 1.7% in Q2 2016 – its fastest growth since 2013 – at US$90.5bn in size, it remains far from the US$125.4bn it has to reach before Ukraine has to pay out its creditors under the terms of a restructuring, after which special ‘growth-linked bonds’ will start paying out.

As its economy grows, Ukraine’s debt burden rises. By the end of September, total government debt stood at US$68.6bn, rising by nearly US$2bn in just four weeks. This includes the US$3bn still owed to Russia over gas imports – a situation that most investors see as political rather than economic.

Whilst the US$3bn owed to Russia will not necessarily impact the delivery of an IMF loan, it certainly adds unnecessary tension in an already downbeat market.

“The Russian bond is a political issue, and investors understand that it is beyond market forces. Ukraine will never pay it and Russia will not accept a restructuring, so they will go to court, which will take years,” Schneider stated.

Legal complications are not the only factors causing concern for investors in Ukraine. The quality of the country’s credit remains noticeably poor.

Moody’s recently reaffirmed Ukrainian iron ore pellet exporter Ferrexpo’s credit rating at Caa3 – which is similar to most other corporates and sovereign Eurobonds. Other agencies also see substantial risk for investors, with Fitch’s judging Ukraine at CCC and S&P Global Ratings at B- with a negative outlook.

In addition, slow progress in adhering to the IMF’s demands – not just in the fight against corruption, but also in privatisation, banking sector reform and land and pensions reforms – pose further problems.

Privatisation is essential for opening Ukraine up for business and foreign capital, but the government’s efforts so far have been bungled and inconsistent.

State gas and oil giant Naftogaz, arguably the country’s biggest asset, was nearly stripped of its transport arm, Ukrtransgaz, by the Ministry of Economy. After being reprimanded by foreign lenders for going against the Third Party Package agreement aimed to divest ownership, the government backed down, but their rash actions did little to instill confidence in investors.

The next big target for privatisation is the Pryportovyi ammonia plant in Odessa, the partial sale of was initially expected generate UAH17bn for the 2017 budget. However, lack of demand in the initial auction held in June meant that the state was forced to reassess its valuation down to just UAH5.16bn. This inevitably raises questions about the value of other state assets – and concerns about a lack of buyers.

“Privatisation has not really taken shape yet. Whether this is because of pressure from the parliament or from pure incompetence, it is hard to say. I think that privatisation ought to happen quite quickly, particularly regarding land, as so far the land reform bill has been repeatedly blocked in parliament,” Schneider noted.

Land reform has been a long and painful battle for a country whose vast agricultural potential once lead to former US ambassador Steve Pifer to label it, “the big answer to the question of how to feed the world.”

During a tough 2015 Ukraine did manage to sell US$7.6bn of bulk agricultural commodities worldwide, quintupling its revenue from a decade earlier and putting it in the global top three exporters of such products, behind only Brazil and the US.

The conflict in Donbass has been one of the problems holding up the land reforms, with vast chunks of arable land going off-limits for the industry due to fighting. But low efficiency is an even bigger stumbling block, as experts estimate about one-sixth of arable land is not being farmed, with only about a quarter reaching yields on the level of those in the developed world.

Foreign capital and expertise could aid the development of an inefficient and badly mismanaged industry, exemplified by local farming company Mriya – now US$1.1bn in debt, but the Rada’s (Ukranian parliament’s) reluctance to pass a bill that allows foreign ownership of land has been a major roadblock.

“One of the huge natural advantages this country has is its arable land, but the continued ban on foreign ownership means that local groups dominate the market. This situation delays the revitalisation of a very important sector that could drive Ukraine forward, and vested interests prevent this from changing,” noted Zucaro.

Still, some of the big players have made more progress than others according to Zucaro – namely, poultry producer MHP and mining giants MetInvest and DTEK. According the World Bank, cutting red tape and implementing other initial reforms helped Ukraine move up to 83 in the ratings for ‘Doing Business’ – up from 152 in 2012.

Nevertheless, foreign investment remains at meagre US$62bn, dwarfed by Poland’s US$287bn. While observers put Ukraine in the same category as Brazil or Argentina in terms of ‘recovery potential’, that has not yet been realised, and investors are sceptical about the short-term prospects for foreign investment.

“To get to the markets you need a good success story, but Ukraine does not have that yet. They will not tap the markets until they feel they can get a good deal, so I do not think that bond issuances are on the agenda until at least 2017,” Schneider concluded.

During the intense period of turmoil and conflict with Russian-backed rebels in the East, Ukraine’s strong desire to change may have given it the benefit of the doubt.

But, as is becoming increasingly clear, lip service and superficial measures in response to Western creditors’ demands will no longer suffice. 

Russia & CIS Macro

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