Ukraine Quarterly: Q3 Macro Review - "Where does He go from here?...” (INITIATION OF COVERAGE)

AYA Group is pleased to announce the initiation of coverage of Ukraine’s macroeconomics. The document enclosed is our first issue on macro research to be followed by a series of further quarterly studies. Moreover, we’ve prepared a complementary “bundle” of detailed side-notes offering a thorough examination of related subjects in politics and economics.

\"In spite of fears of Ukraine slumping into pro-Eastern centralization mode, recent changes in the political arena lead us to foresee a greater probability of a “status quo” scenario. Such gridlock, similar to that experienced by previous ruling parties may result in non-transparent political and economic actions in Q3’11 (probability of Mr. Azarov’s dismissal, UAH devaluation, bargaining with the IMF, etc). Furthermore, fiscal policy may remain too expansionary, as long as ruling party is listening to the vox populi under such a scenario (due to upcoming race for 2012 parliamentary elections). That will lead the Government away from the IMF austerity program, with a likely worsening of sovereign risks perceptions by foreign investors. Meanwhile, the economic growth rates may moderate in the medium term, driven mostly by external demand...

▪ Recent political changes and perceived consequences of the four political scenarios defined in our side-note on politics (“Status Quo”/ European Style Democracy /Centralization of Power /Social Unrest) imply high probability of the “Status Quo” scenario. Within its course, we believe that:
1. The Prime Minister may be dismissed in the medium term.
2. Chances are high for a return to populist rhetoric in autumn, with the unofficial start of race for October 2012 elections.
3. There are increased chances that the economy may disappoint investors, at least over the medium term.
4. The liquidity of Ukrainian capital markets will remain low, due to a lack of institutional reforms.
5. There will be less political uncertainty in the medium term due to high possibility of political cycle lengthening.

▪ We believe economic growth will most likely be driven more by exports in the middle term than by domestic consumption, with the engineering sector outpacing other sectors’ growth again.

▪ We see high chances of a budget deficit in excess of the official target for 2011 (3.1% of GDP) and project that it will reach at 3.5% of GDP. Should most of the IMF program claims come to fruition, we expect further improvements of sovereign ratings and tightening of CDS premiums in the medium term. However, it seems likely that the IMF program will be suspended.

▪ We are bearish on UAH vs USD in the medium term with a forecasted band of 8.00-8.20 USD/UAH as of 2011 year-end. There are signs that the central bank may accept moderate UAH devaluation to support competitiveness of Ukrainian exporters. Nevertheless, 2011 economic growth prospects would continue to attract capital flows in Ukraine that should mirror C/A deficit.

▪ Closing negative output gap raises our concerns on inflation. The latter is expected to be driven both by supply and demand side in 2H’11, while the CPI growth rate may climb above 8.9% e–o–p official target in 2011. According to our projections, consumer prices may increase by 10.5% this year.\"