Ukraine, Country Outlook - July 2005

LONDON, England -- Viktor Yushchenko's victory in the presidential election in late 2004 has begun to translate into greater political openness and faster economic reform. However, policy missteps and government in-fighting will continue--as seen in recent months--to limit the extent of improvements possible. Moreover, the 2006 parliamentary election and the planned switch to a more parliamentary political system will be significant distractions.

Viktor Yushchenko After Winning Election in 2004

The Economist Intelligence Unit expects real GDP growth to decelerate to 6% in 2005 and to below 6% in 2006. Year-end inflation is forecast to slow to 8% by 2006. The currency will remain broadly stable in nominal terms against the US dollar in 2005-06, with only a slight appreciation expected. The current-account surplus reached a record high in 2004, but will decline in 2005-06 as export growth diminishes.

Both the president, Mr Yushchenko, and the prime minister, Yuliya Tymoshenko, continue to enjoy solid support and are expected to continue to co-operate with one another during the rest of the 2005-06 forecast period. The risk of political instability and inefficacy will nevertheless continue to be high.

Ukraine's new leadership has already provided several reminders that it remains an uneasy coalition of heterogeneous political forces, and that strong disagreements persist over policy and the division of responsibilities. These differences will become harder to contain as the March 2006 parliamentary election approaches, and as the debate heats up over the implementation of constitutional changes that are scheduled to come into effect by early 2006.

The tone of relations with Western governments and institutions has improved considerably with the departure from power of the previous president, Leonid Kuchma, particularly as the new administration is much more committed to closer Western integration. In 2005-06 Ukraine's relationship with the West will remain better than it was during the Kuchma era.

Despite the recent rejection of the EU constitutional treaty by Dutch and French voters--which has produced a backlash against enlargement--Ukraine will continue to prioritise its relationship with the EU and push ahead with implementing the commitments contained in the EU-Ukraine Action Plan signed earlier in 2005.

However, the Ukrainian leadership will undoubtedly continue to be frustrated with the EU's hesitant stance, and there is a risk that the Action Plan will be an even less effective policy anchor than before.

The election of Mr Yushchenko as president in late 2004 has given new impetus to the process of economic liberalisation, and his appointment of Ms Tymoshenko as prime minister has confirmed his willingness to accelerate reforms. Ms Tymoshenko is one of Ukraine's most outspoken critics of shadow economic structures and of the economic role played by vested oligarchic interests, and her government is by far the most reform-minded in Ukraine to date.

We therefore expect greater progress on key issues than in the past: privatisation sales are likely to become more transparent, fiscal policy will be rationalised, energy sector reform will resume, and a more concerted effort will be made to bring businesses out of the shadow economy.

With economic policy being tightened in a number of countries and high levels of debt weighing on consumers, companies and governments, a global slowdown is in prospect for 2005-06. We forecast a deceleration in world GDP growth on a purchasing power parity (PPP) basis, from an estimated 5.1% in 2004 to 4.2% in 2005 and 4% in 2006.

A fall in oil prices later in 2005 and in 2006 will lead to slower real GDP growth in Russia, Ukraine's largest export market, although Russian import demand will remain relatively strong. The prospects for Ukraine's terms of trade more generally are mixed. Ukraine will benefit from a reduction in the cost of oil imports.

However, this will be more than offset by a decline in prices for steel, which is Ukraine's most important export commodity. Average steel prices are expected to fall by almost 30% in 2006. The slump in steel prices will reflect slower growth in demand and the coming on stream of new production capacity.

Ukraine's economy has cooled rapidly so far in 2005. Real GDP growth fell to 5.4% year on year in the first quarter of the year, and then slowed further to 4.7% in January-May, down from a post-independence record of over 12% for 2004 as a whole. The slowdown reflected less buoyant external conditions, as well as sluggish investment trends--prompted by political instability and concerns over the government's plans to review previous privatisations.

However, investment is expected to pick up somewhat in the second half of 2005, assuming that the government still manages to clarify its re-privatisation plans. Moreover, household consumption is expected to be buoyant, as a consequence of rising consumer confidence and the generous wage and benefit increases included in the 2005 budget.

Consumer price inflation rose above 12% at end-2004 and stood at 14.6% year on year in May 2005. Inflation is expected to remain high, owing to sharply rising incomes and an ongoing increase in producer prices, which is at least in part being passed on to consumers. A rise in administered prices, which were generally kept down in 2004 because of the approach of the election, will also add to inflation.

The currency's recent strengthening against the US dollar will nevertheless contain the pressure on prices, as it is expected to permit a slightly tighter monetary policy. Moreover, the government's fiscal policy in the second half of 2005, although remaining lax, will at least be more prudent than during the year-earlier period. Inflation is expected to fall to around 12% by the end of 2005 as a result, and then to drop more steeply, to around 8%, by end-2006.

During the past three years the National Bank of Ukraine (NBU, the central bank) had often intervened on the interbank market to keep the hryvnya's exchange rate against the US dollar essentially unchanged. The central bank signalled a shift in policy in April 2005, when it allowed the hryvnya to appreciate by 3%. Since then the exchange rate of the hryvnya to the US dollar has remained stable.

The April appreciation is so far proving to be a one-off attempt by the NBU to mitigate risks inherent in the continued large-scale inflows of export earnings and increased interest from foreign investors in the Treasury-bill market. The volumes of US dollars that these inflows were forcing the NBU to purchase, in order to keep the exchange rate stable, were having an increasingly inflationary effect.

However, a further sharp shift in the exchange rate of the hryvnya to the US dollar is not expected. The hryvnya is now forecast to remain broadly stable, appreciating only moderately in 2005-06. This will translate into a real effective appreciation, in view of inflation differentials and the expected greater stability of the US dollar against the euro.

Ukraine's current-account surplus is expected to fall from the high of 10.5% of GDP recorded in 2004. Steel prices in 2005 will not enjoy the same growth recorded in 2004. The increase in export revenue will slow accordingly--a trend that will be reinforced by some easing in Russian import demand.

The rise in import expenditure will therefore outpace export growth and lead to a narrower current-account surplus, which we forecast at the equivalent of 6% of GDP. The current-account surplus is set to narrow further, to around 2.4% of GDP, in 2006, when prices for steel are forecast to drop by almost 30%.

Source: The Economist Intelligence