Is Another Default In The Cards?
Each of the previous three defaults was triggered by events in Russia, historically Ukraine's most important trading partner and its largest creditor. Contagion from Russia's 1998 devaluation and banking crisis led Ukraine to default that year, and again in 2000. The most recent default in 2015 followed Russia's March 2014 incorporation of Crimea and the subsequent conflict in Donbass, one of Ukraine's most industrialized regions.
The key early indicators of sovereign default are external debt stock imbalances and political conflict, according to historical data (see "Common Characteristics of Rated Sovereigns Prior To Default," published Jan. 17, 2014). Both factors featured in Ukraine during the years preceding its 2015 default. Although events in Russia contributed to that default, Ukraine's underlying susceptibility to default dates back over a decade.
Russia appears to be pressing ahead with its efforts to retain influence in Eastern Ukraine and keep the border open, as Ukrainian nationalists continue to cause supply interruptions to steel and mining exports. Earlier this month, the Organization for Security and Cooperation in Europe blamed combined Russian-separatist forces for reigniting the conflict in Luhansk. And it is unclear to what extent the EU and the new U.S. government are able and willing to take a stand against Russia's latest infractions. We believe the instability will ultimately interfere with the fledgling economic recovery in Ukraine, despite an improvement in the price of Ukraine's key export, iron ore, although much will also depend on the external context. At 73% of GDP, general government debt remains high, and sensitive to exchange rate movements, given that over two-thirds is denominated in foreign currency. The IMF program has enabled Ukraine's foreign currency reserve to double to $15.5 billion as of end-February 2016, representing nearly five months of imports. However, that level of reserves covers only about 37% of expected short-term external debt maturing this year.
External Imbalances Are An Early Indicator Of Susceptibility To Default
The accumulation of external imbalances that can lead to a sovereign's default typically stems from public- or private-sector excesses. In the case of Ukraine, the principal excess was an externally financed credit boom, with credit growth averaging over 60% between 2003 and 2008. Ukraine was not alone in experiencing a credit boom and bust during the years preceding the global financial crisis. Similar foreign-financed consumption booms played out across eastern Europe, from Estonia in the North to Serbia and Bulgaria in the South. When credit growth reversed and demand declined, the shocks to employment and budgetary performance destabilized the economy. Yet, of these Eastern European sovereigns, only Ukraine defaulted on its public debt.
We think the reason for this lies partly in Ukraine's weak institutions and the disruptive effect of the conflict in Donbass on the real economy. Located in Eastern Ukraine, Donbass is the core of the country's industrial sector, representing 16% of its GDP and around 27% of exports (see chart 1). Another factor contributing to Ukraine's limited capacity to contend with the aftershocks of a credit boom was its relatively low wealth. Even at its 2013 peak, per capita GDP was below $4,000, and only just over two-fifths of Romania's. When credit conditions reversed, households and companies had limited retained earnings to draw on to maintain spending levels.
But the most important difference between Ukraine and Central Europe is that Ukraine's economy is considerably more concentrated, and hence volatile. As recently as 2014, 30% of Ukraine's exports--representing about 15% of GDP--consisted of low-value-added steel and iron products, largely produced in Donbass. Last year, iron ore prices were still only just over one-third of 2013 levels, although they have since rallied, an improvement that remains contingent on policy decisions affecting the supply of and demand for metals in China. As a consequence of decreasing export prices and volumes since 2012, Ukraine's foreign currency receipts fell by $30.4 billion, or 33% of GDP, between 2012 and 2016. Such volatility of key export prices has led to large drops in the U.S. dollar value of Ukraine's GDP. During the boom period in 2003-2008, Ukraine's GDP in dollars more than tripled, enhancing its external debt ratios. Today, real GDP in Ukrainian hryvnia and dollars is, respectively, 30% and 48% lower than eight years ago. Such a plunge in foreign currency incomes is a strong indicator of a narrow economic base and diminishing debt-servicing capacity and, despite the ongoing recovery in GDP, there is little evidence that Ukraine's economy has meaningfully diversified (see chart 2).