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Global Research
The economys resilience to global turmoil depends on global demand for steel Balance-of-payments is unsustainable, FX adjustment is a matter of time Banks have mostly improved their balances, yet are exposed to FX risks Internal politics will keep hindering decision-making on key policies The economy: Doing better than expected
Private and quasi-private investment spending related to the Euro-2012 championship provides some cushion against the global economic slowdown, keeping economic growth relatively robust in the baseline scenario. Yet, the Ukrainian economy would be unlikely to withstand a significant fall in global demand for steel in the negative scenario.

Ukraine Trip Notes

Preparing for challenging times

When will the UAH depreciate?

The current account deficit reached 4.7% (12m ma) of GDP in August and is on the way to double digits in 2012. The financial account is exposed to global financial markets stress. It makes the UAH weakening inevitable and desirable, in our view. Most likely, it will take place early next year.

14 October 2011
Alexander Morozov Chief Economist HSBC Bank (RR) (Limited Liability Company) +7495 783 8855 alexander.morozov@hsbc.com Artem Biryukov Economist HSBC Bank (RR) (Limited Liability Company) +7495 721 1515 artem.biryukov@hsbc.com

Banks face FX risk challenge

Banks have a UAH65bn net short FX position (IAS definition) and have regulatory troubles in covering it on the FX market. Significant UAH depreciation might trigger the need for another round of banks recapitalization.

Fallen popularity hinders needed reforms

The popularity of the ruling Ukraines Regions Party has substantially declined since the last elections, posing a threat of losing control in the Parliament after the October 2012 elections. Therefore, such unpopular decisions as hikes in natural gas and communal services tariffs, which are the key stumbling blocks for resumption of lending from the IMF, have been being compromised.

View HSBC Global Research at: http://www.research.hsbc.com Issuer of report: HSBC Bank (RR) (Limited Liability Company)

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

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Preparing for challenging times

We had a fruitful client trip to Ukraine on October 5-6. During the trip we met with officials, international financial organizations, banks and corporates, and think tanks. Below are our major takeaways from the trip. We have selected those that appear to be the most topical these days. After some moderation in 2Q, GDP growth in Ukraine has accelerated to 7.5% y-o-y and to c5% y-t-d in July on rich agricultural crops, according to the NBUs and governments estimates. Although steel prices and steel exports from Ukraine are exposed to downside risks taking into account the uncertainty about global economic outlook, at the moment Ukrainian metallurgy seems to be doing quite well. Private consumption is still recovering from the crisis and is still supporting strong growth of retail sales.

The economy is resilient for now

Accounting for recent trends and the likely dynamics of growth factors in 2012, we are slightly revising our GDP growth projections for Ukraine. We foresee GDP of 4.9% in 2011 (4.5% before) and 4.5% in 2012 (5.1% before).

Chart 1. GDP growth and steel prices

GDP (LHS) %, y-o-y

12 6

GDP (forecast, LHS)

Global Steel IDX (RHS) USD/tonne

300

250 0 -6 -12 150 -18 -24 Q2 2005 Q4 2005 Q2 2006 Q4 2006 Q2 2007 Q4 2007 Q2 2008 Q4 2008 Q2 2009 Q4 2009 Q2 2010 Q4 2010 Q2 2011 Q4 2011 Q2 2012 Q4 2012 100 200

Source: State Statistics Committee of Ukraine, Reuters

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Chart 2. Retail sales and real wages

Retail trade turnover %, y-o-y

40 30 20 10 0 -10 -20 -30 -40 Dec-07 Dec-08 Dec-09

Real wages %, y-o-y

40 30 20 10 0 -10 -20 -30 -40 Dec-10

Oct-07

Oct-08

Oct-09

Feb-08

Feb-09

Feb-10

Oct-10

Feb-11

Jun-07

Aug-07

Jun-08

Aug-08

Jun-09

Aug-09

Jun-10

Aug-10

Jun-11

Source: State Statistics Committee of Ukraine

The slowdown of economic growth and imports growth in Russia that we expect in 2012 is likely to temper Ukrainian exports growth and to restrain GDP growth next year. The Ministry of Economic Development and Trade (MOEDT) expects that spending related to the EURO2012 football championship that Ukraine will co-host with Poland will boost GDP growth by 0.6-1.0pp to 5.0% in 2012.

Agreeing with the MOEDT on that, we expect much higher growth of imports to Ukraine than the MOEDT. Correspondingly, negative contribution of net exports to GDP growth will be higher in our baseline scenario for Ukraine.

Depreciation risks priced in

We expect that the UAH will be allowed to weaken through a series of mini-devaluations beginning in

Chart 3. FX rates

UAH
Index 1.25 1.20 appreciation depreciation 1.15 1.10 1.05 1.00 0.95 0.90 0.85 Jan-11
Source: Reuters, HSBC

EUR

RUB

TRY

PLN

Feb-11

Mar-11

Apr-11

May -11

Jun-11

Jul-11

Aug-11

Sep-11

Oct-11

Aug-11

Apr-07

Apr-08

Apr-09

Apr-10

Apr-11

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early-2012. We revise upward to UAHUSD9.9 from UAHUSD9.5 our end-2012 forecast. The hryvnya (UAH) is pegged to the USD with almost no fluctuations allowed de facto. So, while most EM and DM currencies depreciated versus the USD over past weeks, the UAH has not. Should and will it? We think it should and will. The centre of discussion among locals is mostly focused on the issue of sustainability of the current market turmoil and EM currency weakness. It is almost a consensus view locally that current levels of cross-rates would trigger UAH depreciation at some point, if sustained. Yet, there is general belief that if the USD weakens relative to other currencies, the depreciation of UAHUSD could be removed from the policy agenda. Trade balance projections that we have seen reflect expectations of the same or even narrowing trade and current deficit in the coming quarters if external conditions that existed in mid-2011 are restored. We think that these projections significantly underestimate imports growth. We see both trade deficit and current account deficit

staying on an unsustainable track, even if the situation on global financial markets and global economy improves. According to the NBU, the 12-month rolling current account deficit has already widened to 4.7% of GDP in August. We foresee it widening further to double-digits in 2012, which would pose a serious threat to the currency stability even if global financial markets are in good shape. Therefore, withstanding this trend stemming from the fundamental factors would be a mistake, in our opinion. The present market situation just accelerates the trend, making imports cheaper and adding depreciation pressures arising from the financial account of balance-of-payments to pressures arising from current account. The NBU has lost more than USD3bn of reserves in September and is likely to keep losing them down the road. If the UAH is on its road to devalue then the key questions are the following: When? And by how much?

Chart 4. Trade balance and current account

Current account (% of GDP, RHS) Current account (LHS) USD bn

1 0 -1 -2 -3 -4 -5 2Q2006 4Q2006 2Q2007 4Q2007 2Q2008 4Q2008

Trade balance (% of GDP, RHS) Trade balance (LHS) % of GDP

3 0 -3 -6 -9 -12 -15 2Q2009 4Q2009 2Q2010 4Q2010 2Q2011

Source: National Bank of Ukraine

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Chart 5. International reserves

International reserves (RHS) months of imports

8

International reserves/months of imports (LHS) USD bn

40

35

30

25

0 Jul-08 Mar-09 Jul-09 Mar-10 Jul-10 Mar-11 Sep-08 Jan-09 Sep-09 Jan-10 Sep-10 Jan-11 Jul-11 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Sep-11

20

Source: National Bank of Ukraine

Since the authorities are not fully convinced at present of the necessity of the UAH devaluation and strong pressures on the NBUs reserves emerged only in September, we think it is quite likely that the NBU will be slow in adjusting the UAHs value. The significant short FX position of the banking sector (see next section), the public commitment to maintaining stable currency until year-end made by the NBU, and negative political repercussions of any UAH devaluation (see last section) hinder the decision-making process on the currency. Yet, waiting for too long is very costly. Devaluation expectations will not go away easily and the pressures on the NBUs reserves will most likely be sustained. Losing reserves month by month is not the best strategy to follow when international reserves cover less than five months of imports. Besides, in order to offset the pressures the NBU is forced to keep the UAH liquidity low, and local interest rates high. It spoils the local bond market, not allowing the MOF to borrow at acceptable yields. An issuance of USD-linked bonds can

provide only a partial solution to this problem. Banks lending and overall economic growth could also be compromised as a result of such policies. All factors considered, we think that the UAH will depreciate in early-2012. Devaluation can be done in various ways. In order to make the devaluation credible, it ought to be significant, close to market expectations, made as a one-off move (in the case of fixed currencies). Kazakhstan did it with success in 2009. However, the way we believe the Ukrainian authorities are mostly likely to follow would be a series of mini-devaluations complemented by restrictive measures for FX market participants. Therefore, it might take the whole 2012 for the UAH to devalue to UAHUSD9.9 by end-2012. This is our new forecast, slightly revised upward from UAHUSD9.5 that we had before. We also expect that after parliamentary elections that are to be hold in October 2012, the UAH will be allowed to weaken to a greater degree than in the previous quarters.

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Chart 6. UAH NDF outright

UAH/USD
11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 1M
Source: Reuters

12-Oct-11 12-Oct-11

2M

3M

6M

9M

1Y

18M

We think that the UAH will continue to weaken in 2013 but at a slower pace since we believe the current account deficit is likely to start narrowing by then.

Banks recovery at risk

Existing regulations forced Ukrainian banks to accumulate a net short FX position of UAH67bn at present, which represents a significant risk for banks capital if the UAH depreciates.

Ukrainian banks have started recovering from the 2008-09 crisis after being recapitalized. A steady inflow of deposits has been taking place since March 2010 and the steady increase in banks loan books (mostly, to large corporates and small businesses) has been occurring since January 2011. The loan-to-deposit ratio for the banking sector at large stays high, above 170%. However, occasional evidence suggests that the ratio should

Chart 7. Loans and deposits

Loans (LHS) UAH bn

800 700 600 500 400 300 200 Dec-08 Oct-08

Deposits (LHS)

Loan-to-deposits ratio (RHS)

2.5 2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 1.5

Dec-09

Oct-09

Dec-10

Oct-10

Apr-08

Apr-09

Apr-10

Feb-09

Jun-08

Aug-08

Jun-09

Aug-09

Feb-10

Feb-11

Jun-10

Aug-10

Apr-11

Jun-11

Source: National Bank of Ukraine

Aug-11

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be close to 100% for new loans. Old loans, including restructured ones, are not backed by the deposit base. Local experts on the banking sector estimate NPLs at 20-25% or higher (if restructured loans are included). The good news is that these NPLs fall on the pre-crisis loan book and have been identified. Writing off of problem assets is still a problem despite recent positive changes in the legislation to this matter. Banks have concerns regarding how this legislation will be enforced. A key challenge that banks face these days is their high exposure to FX risks. The banking sector has a net short FX position of cUAH67bn, a study of Forum for Leading International Financial Institutions has revealed. This net short FX position emerges when International Accounting Standards (IAS) are applied. From a local regulator perspective, however, banks have an almost balanced FX position.

This problem emerged when the NBU has disallowed making FX provisions against FX assets forcing banks to form them in the UAH. Now it may backfire to the detriment of the stability of the banking system as banks can not close their net short FX position or hedge it on the FX market due to the regulatory restrictions on such operations. According to a stress-test performed by EBRD on a pool of the local partner banks, banks should be able to withstand the UAH devaluation up to 20%. Greater devaluation would make it necessary to recapitalize some banks. It is important that while the UAH exchange rate remains stable, the regulator together with banks find a credible solution to the problem of banks high FX exposure. An issuance of USD-linked government bonds is just a part of the solution, in our view.

Chart 8. Political preferences

If parliamentary elections were held next Sunday how would you vote?
Apr 2010 Aug 2010 Oct 2010 Feb 2011 Apr 2011 May 2011

%
40

30

20

10

0 Yulia Bloc Sv oboda Communist party of Ukraine (Sy monenko)

Source: Razumkov Centre

Party of Regions

UDAR (Kly chko)

Sy lna Ukray ina (Tihipko)

Front Zmin Against all (Yatseniuk)

Would not Hard to say v ote

Ty moshenko (Tiahny bok)

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Uneasy politics and the IMF

The diminished popularity of the coalition government led by Regions of Ukraine Party has significantly reduced space for policy manoeuvres and put on hold the stand-by program with the IMF. The popularity of the coalition government has fallen since spring 2010 on the hardships related to slow recovery from the economic crisis and socially painful fiscal tightening. If Regions of Ukraine fails to improve its political ratings by the time of the October 2012 parliamentary elections, the elections could unpredictably transform political landscape in Ukraine bringing to power a coalition of opposition parties. Enacting pension reform that inter alia includes an increase in pension age and an increase in minimum length of services the government has improved the sustainability of the state Pension Fund. It was one of the key structural conditions of the stand-by program with the IMF. Yet, the government failed to hike communal tariffs and natural gas prices for households, which is another key structural condition of the stand-by program. We understand that the IMF does not consider it possible to compromise on that issue, given that overall gas price subsidies in Ukraine amount to 56% of GDP and Ukraine has a poor track record on delivering gas price hikes in the past. Specifically,
Chart 9. Budget revenues performance

Ukraine has to increase natural gas tariffs for households by 30%, and heating tariffs by 50% in order to comply with the program. In this respect, the imprisonment of the former PM Yulia Timoshenko, who was also the key rival of President Yanukovich at the last presidential elections, may spoil Ukraines economic relations with the Western countries. As a result, getting official funding could be more difficult than before. We think that in the end Ukraine will have to raise gas and communal tariffs as financial markets are unlikely to be ready to provide much funding for Ukraine any time soon and there is no real alternative to IMF funding. We believe that the tariff hike will occur either in early January 2012 or in 2Q when the heating season is over in order to minimize an impact on the housing bill from higher natural gas and heating tariffs.

Budget deficit and public debt

While market based budget deficit financing and public debt refinancing have become troublesome, the government seems sufficiently covered with resources in the near-short term. Yet, the mediumterm fiscal and debt sustainability remains uncertain, given still rising debt-to-GDP ratio and political uncertainties in Ukraine.

Rev enues 2009 UAH bn 250 200 150 100 50 0 Jan

Source: MOF

Rev enues 2010

Rev enues 2011

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

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Chart 10. Fiscal performance has improved

Deficit ()/ surplus (+) (RHS) UAH bn

40 30 20 10 0 -10 -20 -30 -40 Mar-10 Mar-09 Sep-09

Revenues (LHS)

Expenditures (LHS) UAH bn

20 15 10 5 0 -5 -10 -15 -20 Mar-11

Jul-10

Sep-10

Jan-10

Jan-11

Jul-09

May-10

May-09

Source: Ministry of Finance of Ukraine

Ukraine has to repay USD2bn to Russian VTB bank and USD0.6bn on maturing Eurobonds in 4Q. Ukraine should be able prolong the loan to VTB for another six months, though most likely at a higher interest rate. Better than planned revenue performance and substantial cash balances that the MOF accumulated should help to make debt payments this year even if international financial markets remain closed. The government should be able to close any remaining cash gap in the budget this year through cuts of non-essential budget spending and/or issuance of dollar-linked bonds, which are in good demand by local banks that need them in order to hedge FX risks. In the absence of energy tariffs hikes for households so far this year, the state-owned Naftogas is likely to have a cash gap of UAH8bn (USD1bn). It leaves the government with the challenge of meeting 3.5% of GDP consolidated (i.e. including Naftogas) budget deficit target this year. More importantly, Naftogas faces a cash gap of UAH21bn (USD2.6bn) in 2012 as well, of which only UAH12bn (USD1.5bn) has been

provided as state subsidy to Naftogas in a draft state budget for 2012. We think that the Naftogas cash gap in 2012 potentiall could be even higher. If FX risks materialize as we expect, the UAH denominated cash gap would increase because Ukraine consumes mostly imported natural gas. Besides, the currently poor collection rate in the communal sector of c70% would likely decline with any rise in gas prices. We understand that this factor has not been accounted for in the official fiscal projections at the moment. Therefore, reaching 2.5% of GDP budget deficit target in 2012 could become a more serious challenge for the government than the 3.5% deficit target this year. We think that Ukraine can get substantial discounts from the price of imported natural gas from Russia during the ongoing negotiations with the Russian side only at the expense of serious political and/or economic concessions, which could compromise its WTO membership and move back prospects of closer economic integration with the EU. It is not very likely, we reckon.

May-11

Nov-09

Nov-10

Jul-11

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Chart 11 External public debt

General government (LHS) Central government guarantees (LHS) USD bn

50

Monetary authorities (LHS) Public debt to GDP (RHS) % of GDP

50

40

40

30

30

20

20

10

10

0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 2005 2005 2005 2005 2006 2006 2006 2006 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011
Source: MOF, NBU, HSBC

The longer-term fiscal and public debt outlook remains uncertain, in our opinion. At present, public and publicly guaranteed debt exceeds 40% of GDP and still remains on the rising track. In 2012-13 Ukraine will have to repay over USD5bn to the IMF, which would not be easy to replace with market-based funding.

Apart from local banks demand for local dollarlinked bonds, the rest of the market would be unlikely to be eager to buy local governments bonds or Eurobonds until after the UAH depreciation. Unfortunately, in the process of the ongoing civil service reform, the State Debt department of the MOF lost qualified staff. This has reduced the capacity of the Ministry to negotiate with market participants. Besides, after

Chart 12. Internal public debt

Central government debt (LHS) Central government guarantees (LHS) USD bn

25

NBU loans to central government (LHS) State Domestic Debt to GDP ratio (RHS) % of GDP

15

20

12

15

10

0 Q1 -5 2005 Q3 2005 Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 Q1 2010 Q3 2010 Q1 2011

-3

Source: MOF, HSBC

10

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2012 parliamentary elections the overall decisionmaking process in the country could be compromised. All this speaks for the presence of significant fiscal risks in the medium-term.

Conclusion
Ukraine faces challenging times economically, financially and politically. This can only partially be attributed to global factors. The good news is that the outlook for Ukraine does not suggest the repetition of the abysmal 2008 crisis. The bad news is that Ukraine is likely to need to face FX adjustment, hike energy tariffs and ensure political stability after next years parliamentary elections. We think that the Ukrainian sovereign credit is likely to remain distressed until natural gas tariffs are increased, the exchange rate is adjusted to a sustainable level, and IMF funding is resumed.

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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Alexander Morozov and Artem Biryukov

Important Disclosures
This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this document is general and should not be construed as personal advice, given it has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek professional investment and tax advice. Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of the investment products mentioned in this document and take into account their specific investment objectives, financial situation or particular needs before making a commitment to purchase investment products. The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls in value that could equal or exceed the amount invested. Value and income from investment products may be adversely affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative of future results. Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research. * HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures
1 2 3 This report is dated as at 14 October 2011. All market data included in this report are dated as at close 13 October 2011, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

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Disclaimer
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Global Economics Research Team

Global
Stephen King Global Head of Economics +44 20 7991 6700 stephen.king@hsbcib.com Karen Ward Senior Global Economist +44 20 7991 3692 karen.ward@hsbcib.com Madhur Jha +44 20 7991 6755 madhur.jha@hsbcib.com

Global Emerging Markets

Pablo Goldberg Head of Global EM Research +1 212 525 8729 pablo.a.goldberg@hsbc.com Bertrand Delgado EM Strategist +1 212 525 0745

bertrand.j.delgado@us.hsbc.com

Emerging Europe, Middle East and Africa

Murat Ulgen Chief Economist +44 20 7991 6782

Europe & United Kingdom

Janet Henry Chief European Economist +44 20 7991 6711 janet.henry@hsbcib.com Astrid Schilo +44 20 7991 6708 Germany Lothar Hessler +49 21 1910 2906 France Mathilde Lemoine +33 1 4070 3266 astrid.schilo@hsbcib.com

muratulgen@hsbc.com

Alexander Morozov +7 495 783 8855 alexander.morozov@hsbc.com Simon Williams +971 4 507 7614 Liz Martins +971 4 423 6928 simon.williams@hsbc.com liz.martins@hsbc.com

lothar.hessler@hsbc.de

Latin America
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mathilde.lemoine@hsbc.fr

North America
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Asia Pacific
Qu Hongbin Managing Director, Co-head Asian Economics Research and Chief Economist Greater China +852 2822 2025 hongbinqu@hsbc.com.hk Frederic Neumann Managing Director, Co-head Asian Economics Research +852 2822 4556 fredericneumann@hsbc.com.hk Leif Eskesen Chief Economist, India & ASEAN +65 6239 0840 leifeskesen@hsbc.com.sg Paul Bloxham Chief Economist, Australia and New Zealand +61 2925 52635 paulbloxham@hsbc.com.au Donna Kwok +852 2996 6621 Trinh Nguyen +852 2822 6975 Ronald Man +852 2996 6743 Sun Junwei Associate Sophia Ma Associate donnahjkwok@hsbc.com.hk trinhdnguyen@hsbc.com.hk ronaldman@hsbc.com.hk

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sergio.martinm@hsbc.com.mx

claudia.navarrete@hsbc.com.mx

lorena.dominguez@hsbc.com.mx