Mykhailo Kukhar – Basic Macroeconomic Forecast for 2019-2021
The first slide presents a basic forecast for the development of Ukraine’s economy next year. This is what our colleagues from the International Monetary Fund present annually. The only settlement line is the exchange rate, because the IMF usually publishes forecasts of the level of inflation (a deflator) and real GDP growth rates. Here it is important to single out two main trends. IMF experts believe that inflation will decline, moreover, very significantly – to only 5.3% – 5.8% in 2021-2022. As for the exchange rate, the hryvnia will devaluate smoothly by 5%-7% per year. In general, the IMF made a similar rate projection two years ago. It should be noted, however, that the actual average annual devaluation is traditionally lower than what is forecast. Accordingly, the growth rate of dollar GDP is indicated by conservative forecasts.
We at IMF Group Ukraine are more optimistic. Pay attention to the green curve – this is the IMF forecast for October 2016. And the blue curve is the forecast of our group was presented in this same room two years ago. The IMF has now realized their predicted growth rates two years ago were overly pessimistic. In its last update, the IMF significantly “pulled” them up. We continue to believe that they still underestimate Ukraine’s growth potential.
On the third slide you can see our forecast of real and dollar GDP growth rates, inflation and the exchange rate until 2021. We, as before, on the basis of established trends, believe the GDP deflator (general inflation) will remain below double digits. Moreover, according to our forecast, it will be approximately twice as high as our IMF colleagues predict. Based on this, the calculated value of real GDP growth will be slightly lower. However, if the National Bank of Ukraine (NBU) manages to maintain exchange rate stability (and we predict that by the end of 2021, the NBU can keep the exchange rate steady), the exchange rate will hardly reach the level of UAH 31 hryvnia/1$. This will allow us to reach the same level we aimed for before the crisis – even without parts of Russia-occupied eastern Ukraine and Crimea. It’s worth recalling that when Russia invaded Ukraine in early 2014 the country’s annual GDP was $180 billion.
What makes me chuckle standing here on the stage as I make such bold predictions is the dramatic unfolding of the global financial crisis everyone expects to unfold. My colleagues today will state their opinion. Mine is that an economic crisis awaits us at the end of the world cycle, according to the Global Commodities Price Index in 2022. I estimate the probability of this at 90%. We estimate there is a 60% chance that the growth trend will be disrupted in 2021. The probability may well be lower. If this occurs, you can see for yourselves the forecast size of our economy.
The next slide, beloved by me and my colleagues, is the Global Commodities Price Index that determines the pace of our growth by more than 90%. We have in this hall the distinguished economist Eric Nyman, our colleague, whose charts show the correlation to be even higher. We can argue later about higher mathematics, but for now at least we are talking about minor deviations. It is clear the Global Commodities Price Index is the most important tool for forecasting Ukraine’s economic future.
Using today’s event, I proudly present a new tool developed by IMF Group Ukraine. We took out of the World Commodities Price Index all the values which predetermine the growth or decline of our economy and harmonized their specific weights according to the structure of Ukraine’s exports.
As you can see, these are two large segments – “non-precious metals” – we are talking about ferrous metallurgy – and the agricultural sector. We will publish monthly our calculated value and forecasts of the Ukrainian commodities price index and two sub-indices: ferrous metallurgy (mining and metallurgy) and agricultural products.
The key question: Why is our exchange rate forecast so bullish? This is an issue that worries everyone. Many of you have probably read the terrible news that Ukraine’s payments on its foreign debts next year will amount to either $9, or $15 billion. In fact, they slightly exceed $7 billion. But that’s not the point. This is our payment calendar and our forecast showing how Ukraine will meet its debts next year. We believe that the net sale of currency by the population will hardly change, since two factors are in play here. Current incomes of the population have been increasing for the third consecutive year. People are already starting to buy foreign currency, not to sell it. But since we have three million foreign Ukrainian workers sending $11 billion back to the country annually… According to our NBU colleagues, some of this money is spent by their families for current consumption, which prevents falling below the $2-$2.5 balance of payment threshold on net sale of currency by the population.
You see a rather conservative forecast of growth in direct investments and loans. I will tell you honestly that in 2019 and in 2020 they take into account the balance of money that will come as investments. We estimate about $2-$2.5 billion, which will arrive prior to parliamentary and presidential elections. As for consumer goods imports, they are increasing. Please, refer to our forecast. We use the term increase in net exports of raw materials, which, fortunately, is indeed growing. If you were a central banker and saw inflows of $1.8 – $1.3 – $5.3 – $5.9 billion a year, plus the current account balance, you would not be worried about currency devaluation. The reason is because exporters would have dealt with you in the parliament. Therefore, our exchange rate forecast remains unchanged – UAH 26-31 for 2019-2021.
In this slide you see a more detailed currency rate forecast matrix. I showed you a similar prediction last year. You will recall the forecast was correct at the extremes, but not in the middle. That’s because we could not have have imagined the NBU, by its decision related to government bonds, would lower the “summer rate” to 25.5%, as we all remember. The changing rates masquerade is repeated every year. The NBU prefers not to spend money on interventions. It gently allows the exchange rate to be revalued at the beginning of the year and to strengthen by December. This will be repeated in 2020 and in 2019, as we have predicted.
Now, for our baseline forecast for 2021. In three years, our country will be a country with a pre-crisis GDP of $184 billion. I will make a special political proviso, although I do not like them myself. This will be possible without conducting any reforms, even without fighting against corruption. Why? Because the dollar GDP growth rates you see are not based on reforms and fighting corruption, even though we were assured four years ago that there were two main scenarios for success.
Ukraine can still introduce and implement reforms. Our group is convinced that the main one is land reform. Cumulatively, in four years, if introduced, for example, at the start of 2019, land reform can bring in (using a multiplier of 2.6 and the same foreign investment forecasts) an extra $2 billion a year. Cumulatively, it can lift GDP growth by $11 billion over this period. And then Ukraine will be a country with slightly different indicators, including a higher average salary.
But we can also introduce a second reform, one that people know but will hear about for the first time. The fact is that only five countries in the world have a legal framework for putting crypto currency under the jurisdiction of its financial watchdogs. Ukraine can become the sixth. We sincerely do not understand why we have not done this all year. Although, to be honest, everyone you ask says they are in favor of the idea. Our modest calculation is that it could bring in at least $3 billion into Ukraine’s current account in capital inflows. Then we would become a country with $200 billion GDP by the end of 2021, after only three years. It’s not such a long time.
The third scenario for accelerating economic growth is, of course, tax reform. I am talking now not only about the tax on the withdrawal of foreign capital. It is obvious that it is a shame to be the last country in Europe where there are no legal salaries in a many sectors of the economy. It makes no sense to also list liberal tax reform standing in front of this audience. Tax reform is best described in the concept of Verkhovna Rada deputy Nina Yuzhanina’s liberal Tax Code No. 3357. Since its adoption, it has been improved and transformed. Colleagues, such as Danilo Monin, who is present here today, are constantly working on this, as is the Way of New Forces leader Yuriy Derevianko, whom I also see in the hall. Many of our colleagues in the audience today are busy continually improving the model of future liberal tax reform. We constantly update our calculations, but we do not see the political will to introduce the needed reforms before national elections. But if we do introduce changes, Ukraine will become a country with annual GDP of nearly a quarter of a trillion dollars. We will become a completely different country, one where the legal average salary is $700… in just three years!
Report # 2
Grigory Kukuruza – Risks for exchange rate stability and payments for GDP-warrants during 2021-2040
If we lived in the United States, we would not be in this lecture hall today. We would have held in on December 17. Why? Because on December 13 there was a meeting of the National Bank of Ukraine’s (NBU) Board regarding changes in the discount rate. While this is still not a key indicator, it plays a much larger role than is commonly thought.
Most people attending this lecture have probably faced sky-high interest rates on loans. Even if you are a state-owned enterprise with appropriate guarantees, a 100% collateral loan and increasing profitability, you will be offered 23-25% interest per annum loan. If you are an ordinary businessman with a good credit history, then it’s 30%. If something is bad, then someone is to blame. Who can we blame for these high interest rates? Should we blame the NBU for maintaining a high discount rate? In the classic sense, the discount rate affects the overall level of interest rates extremely indirectly, because, first and foremost, lending rates are determined by the cost of raising funds by the bank, that is, by deposit rates.
In the case of Ukraine, however, the discount rate is determined not only by the cost of raising funds, but also the possible profitability of their risk-free placement. We are talking about the profitability of certificates of deposit and government securities. The former are directly connected to the discount rate and now bring 18% return (two-week).
The latter – government bonds – are connected in the same way, only by the laws of finance. If you raise the general level of interest rates, debt securities with fixed coupon payments drop in price. Their effective yield levels off at a new, higher level of rates. This is clearly seen from the dynamics of the weighted average yield of hryvnia-denominated government securities, which already exceed 19% and do not show any signs of dropping. Obviously, a breakthrough in real (inflation-weighted) profitability of government securities cannot help change the structure of banking system assets. The state, in essence, is completely crowding out business from the credit market.
Pay close attention to the rapid decline in the share of business loans – from 55% at the end of 2014 to the current 34.2%. Considering that the ratio of assets of the banking system to GDP has been falling for the consecutive year, lending as a way to raise capital in the domestic market is today an exception to the rule rather than the main instrument. In the general account, risk-free government securities now make up 32% of bank net assets. The total loan portfolio is only slightly higher — only 42%. I agree with the thesis that the banking system today is more stable than before 2014. However, in terms of its structure of operation, this is no longer classic banking.
It is the high level of interest rates that lets the NBU sterilize more than half of the banks’ free liquidity and restrain the exchange rate. How is the exchange rate set? It is the ratio of issued hryvnia to the volume of foreign currency in the country. Until 2014, we lived according to the currency board principle: the rate (of course, with minor deviations) was determined by the ratio of the monetary base (all hryvnia cash and the amount of bank correspondent accounts at the NBU) to foreign exchange reserves. The mechanism of exchange rate formation now remains the same. By raising interest rates, you take out the hryvnia for some time, which puts pressure on the exchange and maintains a low devaluation rate. Pursuing such containment strategy is extremely expensive. It costs at least UAH 20 billion in annual budget expenditures and freezes crediting. Today, in real terms, only the segment of consumer loans is growing, but there the rates are from 35% per annum.
The overhang from free liquidity of the banking system, which is now connected by exorbitantly high rates of return on government securities, is constantly mounting. This is UAH 40 billion, certificates of deposit and up to one third of the government securities in bank portfolios (the total amount of banks’ investments in government securities as of December 14, 2017 was UAH 353 billion). In fact, we are dealing with a devaluation that has already occurred. It is just not so noticeable. In the last three months of 2018, the gap between the actual and estimated value of the rate increased to UAH 7.8. Does this mean that the exchange rate will be UAH 35/$1?
The answer, obviously, is no. This is because monetary authorities are not going to ease up this Spring. But if we do not provide an inflow of at least $4-5 billion to compensate for the existing pressure on the rate of this sterilized hryvnia, resumption of lending will continue to be actively restrained.
This means our economy will become more dependent on raw materials and inflation targeting will increasingly become a risky endeavor.
Restructuring of public debt in 2015, Value Recovery Instruments (VRI) payments
In 2015, Ukraine’s Finance Ministry restructured Eurobond payments for a total amount of $16.2 billion (including five additional issues for debt restructuring of the Kyiv budget, road fund and others). Of these, 20% (or $3.2 billion), commonly called write-offs, were actually converted into VRI – payments which are linked growth rates of our economy until 2040. The VRI topic is one of the most mythologized issues facing Ukraine’s economy.
How much should we pay our creditors?
VRI payments are tied to our growth rates as follows: if real GDP grows lower than 3%, there are no payments at all. If GDP growth is in the range of 3% to 4%, then we pay 15% of the amount of growth of exclusively real GDP. If growth is exceeds 4%, then already 40%, also from the growth of real GDP exclusively. Why do I place such an emphasis on the fact that payments are calculated solely on real GDP? The dynamics of the dollar equivalent of GDP (which is for us the main indicator of growth) in developing commodity countries are determined mainly by the level of dollar inflation and not the rate of actual growth. For example, last year, real growth was only 2.5%, and growth in foreign currency – 20.5%. Ukraine’s GDP has increased from $93 billion to $112 billion.
Accordingly, VRI payments actually comprise 15% and 40%, depending on the actual growth rate. If we start from the dollar equivalent, it is only 1.5% and 4% of payments from GDP, which are absolutely not critical for the budget.
In order to calculate the final VRI payment rate, we predicted both the dynamics of real GDP in Ukraine and the dollar, taking into account all possible cycles of recession, when we will not have obligations to pay.
Ukraine’s economy is commodity-based. The country’s growth rate is more than 90% determined by the fluctuations of global commodity prices and all other industries function as outsourcing structures. In the near future, this dependence on raw materials will remain steady. We will continue to look up prices for wheat, ore and oil in order to predict future incomes. But the future of raw materials is extremely uncertain. This is not an assumption, but a fact that cannot be avoided. We have already seen this in 2018.
We are not talking about the next five years but about the next twenty. Industry will continue to be crowded out by the services sector. These are Engel’s microeconomic trends: if incomes grow in our country, we do not consume all the products evenly anymore. The structure of consumption has completely been changed, skewed in the direction of some services which previously were not even in the set of consumption.
I would also like to note that, in contrast to the 40 to 90 years of the last century, recession cycles are long-term. They will last three to four years, instead of the previous one-year recessions. A key question is this: How can government regulators – central banks, finance ministries and other agencies, instantly disrupt the trend? After the Second World War, the United States had a huge gold reserve. There was an opportunity to cut rates, until we approached the existing 2-3%, which in the U.S. is already considered a limitation on economic growth. But now we are in a liquidity trap – a reduction in interest rates does not affect the growth rate anymore.
If Ukraine remains a raw material country, then our prospects are extremely murky.
There are also fundamental factors of a shift towards ‘catch-up growth’ in first-tier countries. Despite the fact that we are not members of the EU, the EU receives already 42% of our exports. Economic relations of Ukraine and the EU are becoming closer.
It is important at the same time to view the EU is a large team of locomotives with small outsourcing enterprises. Poland will never become Germany, but during periods of active growth in Germany or France, it will grow with a certain multiplier, like all recent EU members. On average, 1% real GDP growth in Germany or France is accompanied by a 2.5% growth in new EU members.
Europe itself is today facing a number of significant challenges. Recent events in the EU may seem very unexpected, but a pattern has emerged. Growth rates in the EU since the 1980s are declining. If in the early 2000s, the GDP of EU locomotives grew by at least 2%-2.5%, today, on average, only by 1.1%. During the 1980-1990s, average growth was not lower than 3.5-4%.
Even if leading EU countries do not reform and continue to post declining, but positive growth rates, Ukraine has tremendous opportunities to catch up. Up to a trillion dollars by 2040. Ukraine, of course, is not Czechia and cannot immediately reorient itself to EU economic cycles. Since Ukraine is a large commodity-based economy, the beneficial effect for us will only be in a certain areas and of rather low proportions. I assume that now we are 90% dependent on raw materials and 10% on EU cycles. If everything goes smoothly, as it is the case now, by 2040, up to 40% of Ukraine’s economy will be synchronized with EU cycles and 60% will still depend on raw materials.
If we build on the weighted average scenario (40% – EU, 60% – raw materials) then by 2040 the dollar equivalent of Ukraine’s GDP will increase to $423 billion, and the average real GDP growth rate will be 2.1%. Under such a scenario, the effective rate of return on VRI will not exceed 2.06%. By comparison, in the latest issues of Eurobonds placed in November 2018, we managed to attract money only at 9%-9.75% per annum.
The Independent group of macroeconomic analysis and forecasting (IMF Group Ukraine) is a private nonprofit organization based on the principles of free membership of the economists participating in group work on the creation of macroeconomic forecasts of Ukraine’s economic development, independent from state and corporate interests.