Dec 23 2013, 4:47pm CST | by Forbes
On November 22nd of this year, Ukrainian President, Viktor Yanokovych, backed out of a financial cooperation and support agreement with the European Union. Since that time, large-scale protests in Ukraine’s capital city of Kiev have gained international attention as the country’s 46 million people publicly debate the state of their government and its relationships with Russia and the EU. On December 17th, a deal between Ukraine and Russia was signed giving financial support in the form of Russian purchases of $15 billion of Ukrainian government bonds and significant discounts on Russian natural gas. In essence, Ukraine is deciding which sphere of influence it will be beholden to in the near future – that of “Mother Russia” or a move away from Warsaw Pact times and into greater European dominance of Ukrainian domestic affairs. This has broad implications for Europe, markets, and for the idea of austerity.
The original negotiation between Ukraine and the EU was a way to deal with a sovereign debt problem and general economic malaise in Ukraine. Although Ukrainian debt to GDP ratios look to be reasonable, domestic growth is lacking, industrial and corporate development is non-existent, and wages have not kept up with bouts of inflation. Third quarter GDP fell by 0.4% after having fallen the previous quarter by 0.5%. Forecasts for next year’s growth in the Ukraine are tepid at best with the average of a 1.5% growth rate.
Ukraine has limited foreign reserves on hand and is currently in its third recession in five years which is why Fitch Ratings recently lowered its foreign and local currency debt rating to B- with a negative outlook. With global investors awash in liquidity courtesy of central banks, higher yielding Ukrainian bonds looked attractive as did the Ukrainian stock market. From January 2009 to May 2011 the Ukrainian PFTS stock index gained 250%. However, the Ukraine now has to pay back $15 billion of sovereign debt in the next two years which would be very problematic absent new external liquidity flows or a rescue package.
Enter the Russians to their generous cash! Prior to the Russian deal, Ukraine sought assistance in the form of financing from the EU, just like the European PIGS (Portugal, Ireland, Greece and Spain). However, the EU’s offered terms came with strict repayment conditions, structural economic reform, and IMF involvement. All of these terms seemed bitter pills for a President and political party that have tended towards their Russian relations and where corporate cronyism between Russian and Ukrainian elites is embedded.
The backdrop to Ukraine’s current plight is geopolitics. Russia desperately wants to exert its control in a westerly direction. Losing Ukraine to further EU influence would certainly hurt Russian pride and would be thought of as an unwanted economic incursion. Russia views western meddling in its geographically closest former Soviet Union countries as interloping which is why Russia masterfully offered Ukraine a bailout program at the last minute. The idea of expanding NATO further east is the one thing that brings disparate Russians to the table in denunciation of the west and EU. In addition, to enjoying Ukraine as the “bread basket” of Eastern Europe and holidays at fine resorts, Russian politicians are worried about Russian domestic unrest especially with the Sochi Olympics approaching and President Putin’s somewhat weaker popularity at home. Preventing unrest in Ukraine from becoming a template for internecine Russian squabbles is tantamount to actually helping an old Soviet ally.
While emerging market investments are obviously fraught with risks, Ukraine is a perfect illustration of the theoretical becoming the actual risk. When Ukrainian GDP was growing or stable (far too infrequently) and the political landscape of Ukraine was more hospitable towards closer relations with Europe, there were logical reasons to own Ukrainian assets. That was especially true of carry trades funded by generous central bank liquidity. Those investment notions of high yield, but “safe” emerging market bonds have been severely eroded by Federal Reserve tapering and in the case of Ukraine, intensely messy domestic politics.
In the last ten days, credit traders have profited handsomely by selling Ukrainian credit default swap protection or buying Ukrainian bonds as the snap-back on prices was dramatic after the Russian agreement was announced. For example, Ukrainian dollar-denominated bonds saw their yields go from more than 15% to less than 9% in a handful of trading sessions. That type of volatility is likely to dissipate as the market re-prices sovereign default risk and traders focus on next steps in Ukrainian politics.
Ukraine is a country with massive agricultural potential. It has a special type of black soil which makes agribusiness efficient and profitable when run on industrial scales. In addition to farming and other agribusiness, Ukraine has tremendous industrial potential and is frequently thought of a type of a type of “Poland in waiting” for further industrial-manufacturing development.
Notwithstanding Ukraine’s potential, it is the political atmosphere including the rule of law, corporate transparency, and electioneering that must change if Ukraine is to attract more emerging market investment managers and greater foreign direct investment. Year to date, Ukrainian stocks are down almost 10% and have returned almost nothing over the past five years. That negative performance indicates investor nervousness about future volatility in financial and real Ukrainian assets.
Until Ukraine aligns itself closer to Europe or until a strong rule of law is established, retail investors are probably wise to avoid Ukrainian financial assets. For large institutions or hedge funds, there may be some justification to owning Ukrainian bonds at these levels as a future deal with the EU, although not imminent, is also not outside of the realm of possibility. To a certain extent, the EU needs Ukraine to “play nicely in the sandbox” with Russia as EU countries nervously receive huge quantities of Russian natural gas through Ukrainian pipelines. The best case scenario for Ukraine is snap elections (not likely), immediately political reform (also not likely) and the implementation of business-friendly and investor-friendly laws (possible). The upside-optionality trade is that Ukrainian politicians will embrace the EU much sooner than consensus believes.
Macro style investors seeking longer term exposure to Eastern Europe, would do well to investigate, Polish real assets instead of trying to thread the economic and political environment of Ukraine. Polish real assets seem moderately attractive, especially if the Polish Zloty strengthens. Alternatively, if investment managers must put money to work in Ukraine, highly liquid and transparent assets should be the first choice, even if they trade at a premium.
Disclaimer: Nothing herein should be relied upon to make an investment decision and nothing herein is intended as investment advice or a recommendation.
Source: Forbes Business
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