A quiet recovery

Обзор облигаций 24.05.2016 Below is a brief overview of our base-case scenario of Ukraine's economy for 2016-18. State of the economy: The economy will recover, albeit slowly. Our analysis of the monthly data on the key economic sectorssuggests that a recovery is taking hold. Official reading of the preliminary data for 1Q16 showed the economy contracted 0.7% on seasonally adjusted and quarter-on-quarter terms, adding a mere 0.1% YoY. Despite this weakness in the first quarter, we expect a slight acceleration after 2Q16, allowing us to forecast an increase of 2.1% YoY for full-year 2016. This represents a mere 0.5ppt decline from the previous forecast of +2.6% YoY in our March 1 Quarterly Report. This decline in our forecast came on the back of a worse-than-expected performance of fiscal and monetary policies that were quite restrictive in the face of uncertain conditions in both international financial markets and domestic politics. For the next two years, our forecast is broadly in line with the previous one of 2.3% and 2.8% real GDP increases for 2017 and 2018, respectively. On average, this forecast yields a 2.5% real GDP increase per year for 2016-18, the same as our previous call (see Quarterly Report "Fortifying a fragile economy", dated 1 March 2016). Domestic politics & geopolitics: We forecast a lull. Newly appointed PM Groysman appears determined to make breakthroughs on at least two fronts. First, on the social front, his fiscal policy should show slightly higher spending than the previous administration, which was forced to operate in a quite challenging environment of daunting external-financing requirements. The current environment is more amenable to increased spending for PM Groysman. Second, regarding the IMF, Groysman followed through with raising natural-gas tariffs, thus winning the approvals of official lenders, namely of the IMF. Because of this, the IMF program should resume as early as this June. As Groysman's administration has one year of immunity from a no-confidence vote in the parliament, he will have from 2Q16 to late 3Q16 until dirty politics continue in the fall as is routine before elections. Global economy: A slowdown still is our base-case scenario despite the recent upswing in commodity prices and an EM rally. We maintain our previous call that the global economy is experiencing a slowdown that will force the US Fed to maintain a softened stance on the pace of increasing the Fed funds rate. The dollar lost some weight versus major currencies in both developed and emerging economies, which helped produce a rally in commodities. As prospects improved for some EM economies, Ukraine in particular, the expected recessions in others, namely Russia, are likely to be a bit shallower than previously anticipated. Indeed, Russia has tamed its militaristic stance for a while, as it aims to stage parliamentary elections this September. The next political target for the authorities will be presidential elections in early 2018. Between these dates, it is rational to assume that the Kremlin could revert to its militarist intervention agenda to bolster prime news at state-run TV channels for a short period of time (likely in late 2016 or 1H17). Despite the recently observed marginal improvements among EM economies, our base-case scenario is wary of future increased risks, as key parts of the global economy now are running at their limits. As an example, while Germany's current-account surplus has reached another record high level in April, its surplus relies on the likely overextended deficits in other economies. Money in the Ukraine's economy: Debt deflation to reverse in 2H16. The money creation process over 2014-15 and 1Q16 relied solely on the authorities, as banks saw their balance sheets contract via the process of debt deflation. The NBU's strict stance on eradicating the past practice of lending to related parties is a prime cause of the debt deflation, another is the slow-paced recapitalisation of the top banks (despite the increase of FDI flows into banks, see Chart 32 on p.25). The government is likely to turn to a deficit from 2Q16, after maintaining a surplus in 1Q16. Our base-case scenario envisages that the budget deficit in 2016 will reach 3.7% of GDP, the limit allowed under the IMF program. This deficit level is still considered to be safe, as it allows for a primary surplus because debt servicing is forecast at 4% of GDP. Eventually, this budget stance will allow for a gradual reduction of public debt toward 80% this year. The same assumption applies for the next two years. Money creation by banks, which was non-existent in 2014-15 and 1Q16, is likely to come back in 2H16 as was assured by the NBU back in 2015. Although our previous view was more optimistic, and assumed banks would resume lending in 1H16 or earlier than 2H16, we are now aligned with the central bank's stance. Overall, renewal of bank lending and net spending by the government-hence, more active money creation and broad money-supply growth-is likely to be supportive of economic activity for the remainder of 2016. Inflation, NBU policy rate: Softer stance ahead. Our previous inflation forecast turned wrong as faster-than-expected disinflation unfolded over January-April, sending both headline CPI and PPI into a nosedive below 10%. Our current projections for CPI and PPI assume that there will be a rebound of year-on-year inflation in 4Q16 and early 2017 back into double-digit territory (10-15% range). Before that inflation is likely to tread inside high single-digit territory during 2Q16 and 3Q16. This should provide some space for the NBU to lower its key policy rate that now stands at 19% toward 15% later in this year. External balance: Continued weakness. We expect the country's external accounts to remain weak as exports continue to underperform (partially due to Russia's continued hostility to Ukraine's trade flows). The current-account deficit in 1Q16 of US$0.9bn turned larger than in the same period last year of US$0.5bn. This, together with our analysis of sectoral balances in 1Q16 (see "Sector balances: What they say to us", p.18-19), indicates that a macro adjustment could take place in 2016, quite likely via FX rate weakness, which would reduce demand for foreign goods. This could occur despite the much-anticipated resumption of the IMF program and further increases in official FX reserves to US$19bn as of the end of 2016 (see "External balance: Weakness still there " on p.24 and Table 3 on p.26). UAH view: Previous stance revised due to a bit stronger hryvnia. We revised our view on the hryvnia, and see it a bit stronger relative to the US dollar. There rationale: (1) lower-than-expected inflation in 1Q16, which pushed down our forecast for 2016-18, and (2) the softened stance of the US Fed on its policy of normalization, which should push the US dollar lower versus other major currencies including the currencies of Ukraine's main trade partners. We forecast a UAH/USD rate at 28 as of the end of 2016 and see an average yearly rate of 26.34 for 2016, instead of our previous forecast of 32 and 29.25, respectively. More details are in "View on UAH: Upward revision" on p.27.