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UKRAINE: MACROECONOMIC ANALYSIS

In August, retail gas prices rose by 50%.

Ukraines government finally resolved to raise retail gas pricesby 50% on 1 August. This represents a crucial violation ofone of President Viktor Yanukovychs key election promises,and could dent his popularity ratings deeply, especially if theeconomy fails to improve during the second half of 2010.However, the price increase is a key requirement for aresumption of the IMF programme. It will spur inflation onlytemporarily.

Key macroeconomic events

Amendments to the Tax code will be discussedin the Parliament.

The amendments draft to the tax code were approved by thecabinet and are now being discussed in parliament. The newtax code foresees cuts in income and VAT tax rates between

2011 and 2014. Moreover, small and medium-sized businesses will receive better treatment while the tax for agriculturalproducers will remain unchanged.

IMF Board of directors approves new credit pro-gram and recommends further reforms.

International Monetary Fund (IMF) board decided to grantUkraine a new 29-month stand-by program debt totaling SDR10 billion (USD 15,2 billion at the current exchange rateUSD / SDR). The first tranche amounting to SDR 1,25 billion(USD 1,9 billion) is available immediately after the adoption ofthis decision. Validity of previous stand-by program totalingSDR 11 billion (approved in November 2008) is stopped. Arapidly widening fiscal deficit and soaring public debt willrequire austerity measures in the nearest future.

Ukraine joins European Free-Trade Association(EFTA).

Ukraine has signed the protocol for joining EFTA, a Europeanfree trade club which currently consists of Switzerland,Norway, Iceland and Liechtenstein, but which has severalfree-trade agreements with other countries in emergingEurope, the Middle East and North Africa. Ukraine hopes theEFTA agreement might serve as a stepping stone for a free-trade agreement with the EU.

CAPITAL TIMES LTD. 2

Ukriane

August 18th 2010

Macroeconomics

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Ukraine: macroeconomic analysis August 18th 2010

CAPITAL TIMES LTD. 3

Source: IHS Global Insight

Macroeconomic trends of Ukrainian economy

Ukraines economy and financial markets will benefit from the new loan dealas confidence is strengthened and investment will increase. Though a robustrecovery will not ensue in the second half of 2010. Quite in contrast, with baseeffects from the global crisis ending off, annual growth rates will slow down,

while on the quarter the economy will post modest expansion. Due to theeuros weakness, Ukrainian industrys cost competitiveness will be reducedmodestly, but exports will still remain the driving force for the recovery. Pri-

vate domestic demand will be joining the fray in 2011. There will hardly beany major stimulus from the government, which will rather have to continue toconsolidate the state budget. The countrys outlook is still fraught with seriousstability risks. Consumption and especially investment will remain weak inthe near term. A forceful rebound of investment is expected for 2011.

Base effects, which are driving GDP growth in the first half of 2010, the econ-omy will barely gather traction until midyear. We anticipate, though, that acritical minimum of confidence will be maintained by the markets that willhelp facilitate the fragile recovery starting in the second half of the year. By

now, though, the Eurozone's debt crisis is clouding Ukraines short-term out-look. The key factors of influence include:

1. Strong hryvnia appreciation against the Euro;

2. Strong demand from major European markets which will likely falter asfiscal austerity measures are set in place.

As you can see on the chart of the dynamics of real GDP in Ukraine, thegrowth in 2012-2014 will not be so significant due to these key factors.

Since domestic demand will lumber on at a relatively low level in 2010 underthe pressure of the protracted financial crisis in the country, the deceasedbanking sector, high unemployment, fiscal consolidation, and further gas-pricehikes, a broad-based recovery is possible in 2011 at the earliest. Investment

will grow again in 2010, only because the 2009 level has been extremely low,

but it will visibly increase in 2011. Demand from Ukraines major markets Russian Federation and the European Union will be the single biggest forceto pull the economy out of the depression in the short term. Nevertheless,growth in those markets will likely remain flat in 2010 before gathering trac-tion further out.

The new credit program of theIMF will strengthen the inves-tors confidence, but unlikelylead to rapid economic growth

in the 2H2010.

Ukrainian economy will startrecovering in the second halfof 2010.

Ukrainian economy substan-tially depends on export de-mand, while consumptionsrecovery will start in 2011 andinvestment will grow from a

very low level.

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Dynamics of consumer and wholesale-producer inflations, 2005-2020


Inflation will become a major point of concern again, but remain below 10% in2011. It will be lower than anticipated prior to the new gas deal with Rus-sia, but higher gas prices combined with accommodative monetary policy willensure that the price wheel keep spinning. Bank lendingif possible at all

with around 30% of total loans already nonperformingwill still be constrainedas banks consolidate their balance sheets. With bank restructuring makingsome progress at least, we expect that the situation will improve toward theend of 2010, however, allowing banks to resume lending again.

Falling prices for several food staples have forced us to reduce our inflationoutlook considerably for 2010 and 2011. Moreover, the trend of moderatinginflation is supported by the virtual absence of demand-side pressures. Never-theless, a great deal of uncertainty is associated with the governments nextsteps on administered and regulated prices. The combination of rising regu-lated prices, namely for gas, of excise tax hikes, and relatively loose monetarypolicy will force prices upward again; the retail gas price hike in August willbe one major step, which could be followed by more price changes. Even so,inflation from our current point of view will not rise into the double-digit level

again in 2011.

Remote upside risks are associated with a possible relapse of the hryvnia.Moreover, our forecast could be raised again if energy prices recover furtherand if such price hikes are eventually passed on to the retail level. Upon theInternational Monetary Funds insistence, the government is obliged to raiseretail gas prices in gradual increases to cost-recovery levels during the nexttwo years. It remains to be seen whether the government will raise gas pricesfurther following the first substantial hike in August 2010.

Ukraines producer price level will continue to be driven by global commodi-ties prices, mainly metals and steel in particular, and therefore reflect the paceof the global and especially the European recovery. Since global commodities

prices are not expected to surge much further from the current level, we pro-ject a marked slowdown of producer price inflation in Ukraine for 2011. Never-theless, gas and power tariffs adjustments could still lead to short-term spikes.

After a significant inflationdecline in the first half of 2010, a sharp inflation increasewill resume only by the middle

of 2011, if the prices of staplefoods doesnt increase or thetariffs for gas will not beraised again.

The rise of retail gas priceswill still push inflation upwardin 2011.

Producer prices will be formedon the basis of world trendsin commodity markets.

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Dynamics of foreign direct investments, mln. USD, 2005-2020


Ukraine was able to boost foreign direct investments (FDI) inflows significantlyduring 2005-2008, although FDI was largely confined to the financial sector.

Western interest was rising, not least due to Ukraines World Trade Organiza-tion accession in May 2008. Nevertheless, many investors quickly unwound

their projects in the wake of the economic crisis.

The inauguration of the new president and the formation of a new majority inparliament have rekindled hopes that the political stalemate has ceased. Evenso, fixed investment will stay on a fairly weak level in 2010, although it willshow a rebound in the second half of the year due to base level effects. Fur-ther out, investment will rapidly gather traction, as Ukraines financial crisis ismitigated and the investment environment improves. Bank lending will remaina bottleneck even if the International Monetary Fund (IMF) rescue program or

World Bank and European Bank for Reconstruction and Development sup-

port provide additional funds to inject fresh capital into the system, but thesituation will improve in 2011. Indeed, with the IMF getting back in the boat,it will inject a critical dose of confidence that might help to resume invest-ment inflows, force interest rates down, and kick off bank lending again.

The currently ailing construction sector could be revived in the medium term,not least because Ukraines plan to co-host the European football champion-ships in 2012 with Poland pose a huge challenge in terms of infrastructure in-

vestment (stadiums and transport networks) for the country. Indeed, given cur-rent circumstances, it is hard to imagine which sources will be able to financethe program because the Ukrainian state can barely afford additional large-scale spending plans at the moment. The finances of a key government sup-

port are in question. The UEFA has voiced serious concerns about Ukrainesreadiness and will likely rethink the decision unless preparation efforts areaccelerated.

Despite the unstable politicalsituation in the country, manyforeign investors viewed theUkraine in 2005-2008 as a mar-

ket with good prospects.

The stabilization in politicsmay inspire more favorableinvestment environment.

Ukraines hosting of EuropeanFootbal l Championship(EURO-2012) will provoke anew wave of investment inthe country, but this event isstill under question.

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Foreign and domestic trade operations


Ukraine: major trading partnersEXPORTS IMPORTS

CountryBillionUS$

Share(%)

CountryBillionUS$

Share(%)

Russia 15.736 23.527 Russia 19.414 22.698

Turkey 4.633 6.927 Germany 7.165 8.377Italy 2.913 4.355 Turkmenistan 5.632 6.584

Poland 2.338 3.496 China 5.602 6.549

Belarus 2.106 3.148 Poland 4.280 5.004

Kazakhstan 1.833 2.740 Belarus 2.810 3.285

Egypt 1.560 2.332 Japan 2.796 3.269

Hungary 1.367 2.044 Italy 2.433 2.844

USA 1.949 2.914 Kazakhstan 3.119 3.646

Germany 1.837 2.747 USA 2.813 3.289

Source: IMF, Direction of Trade, 2008

Ukraine imports oil and natural gas from Russia andTurkmenistan and technology from Western Europe. Italso imports lumber and paper. Its main export productsare steel, chemicals, and machinery and equipment. The

structure of Ukrainian exports makes Ukraine sensitiveto changes in world-making conditions. Exportprospects will continue to be strongly dependent onaggregate demand trends in Russia and elsewhere in theCIS, but it should be noted that Ukraine is already mak-ing significant inroads into additional markets, including

Western Europe and developing countries. WTOmembership enables Ukraine to broaden its export base;secure trade routes and lay the foundation for morebalanced economic growth in LT, diversifying away fromthe current dominance of big industries, such as steel.

Ukraine: trade profile

Ukraines current account is improving as exports benefit from the relativelystrong recovery of major export markets. Combined with a solid surplus inservices trade, the current account will thus post a small, but growing, surplusin 2010, which will widen in the medium term as exports gain further traction.Some hope is coming from steel prices, which have soared in early 2010 andare expected to remain relatively high. But rising oil prices bear risks for thetrade deficit to widen again, with the gas import price being tied to the oil-price level. Nevertheless, the gas price discount offered by Russias Gazprom

will help to restrict imports in value terms.

Although the current-account improvement and the fact that capital flightslowed down visibly during the first quarter of 2010 are important achieve-ments, liquidity risks are still significant. Ukraines banks and companies faceliquidity and solvency issues, as debt-service costs have shot up with thehryvnias demise. Moreover, the state, which had to subsidize import gas pay-ments, needs financial support to cover the deficit. Since market-based financ-ing is still difficult to obtain, with the placement of a Eurobond having beenpostponed until later in 2010 , the resumption of the IMF lending program in

Ukraine's current account willgenerate a surplus in 2010even accounting for weak do-mestic demand and a new gasagreement with Russia.

Despite the recent financialstabilization, stand-by loanfrom the IMF is still a critical

factor for maintainingUkraines external liquidity.

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Note: Base of Gross Industrial Output index is 100 points which is calculated from 2007, while other indexes from

Dynamics of key production indexes



Note: Bases of the indexes are 100 points which are calculated from 1990.

Brief characteristics of Ukrainian industry


Much of Ukrainian industry is obsolete, and fairly energy intensive. Spe-cifically, the important mining sector still suffers from outdated equip-ment and inefficiency. Although the huge potential of Ukraine is not indoubt, short-term and medium-term risk for all investors other than themost specialized remains high, and there is much progress to be madebefore a viable and convincing structural reform program is in place.

Because of the emphasis in the Soviet Union on heavy industry, Ukraineremains one of the most industrialized economies in Europe, at least interms of industry's share in total gross value added. Moreover, almostone-third of all workers are employed in the industrial sector.

Light industries remain undeveloped, however, and the industrial sectorneeds to be restructured and modernized. Heavy industries like metals,including steel production, dominate the scene, while chemicals produc-tion, as well as machinery and equipment, play an important role, too.

Much of Ukraine industry isobsolete and energy intensive.

Ukraine remains one of themost industrialized economiesin Europe

Industrial sector needs to berestructured and modernized.

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Dynamics of leading segments of Ukrainian economy


Economy segment 2005

Agriculture 0.10

Food industry, agriculture processing + tobacco 13.70Production and distribution of energy, gas and water 2.90

Retail and other trade 23.00

Paper-pulp, printing & publishing industry 12.70

Wood-processing 19.50

Metallurgy and metal working (1.5)

Production of other non-metallic mineral goods 14.30

2009

(1.8)

(6.1)(11.1)

(15.7)

(18.8)

(24.9)

(26.6)

(38.4)

2006

2.50

10.006.70

26.40

10.30

13.90

8.90

12.80

2007

(6.5)

10.003.20

29.30

10.60

22.10

8.30

16.90

2008

17.10

(0.9)(2.5)

18.60

7.30

9.60

(10.6)

4.30

Machine building 7.10 11.80 28.60 8.60 (45.1)

Construction (6.6) 9.90 15.60 (16.00) (45.9)

Source: The Ministry of Economy of Ukraine, State statistical Committee

GDP structure (2009), %

Source: The Ministry of Economy of Ukraine, State statistical Committee

Agriculture

Agriculture, which includes forestry and fishing, accounted for around 8% of GDP in 2009Agriculture roseagain during the recession, but will resume a declining trend during the recovery. Primary crops are

wheat, corn and sugar beets. Raising livestock (cattle, hogs, sheep, and goats) is also common.

The sector employs some 20% of the workforce. The heritage of Ukraines Soviet past is still seen in theorganization of agricultural production: collective cooperatives and state-owned farms remain common,although most fruit and vegetables crops are produced on small private plots. Even though agriculture

continues to be heavily subsidized by the government, sectoral output remains lower compared with thelevel achieved under Soviet planning.

Forestry (in the Carpathian Mountains in the west) has declined since excessive timber harvesting in the1950s and 1960s, and Ukraine now needs to import most of its lumber and paper. The fishing industry hasalso been a sharp decline since independence.

Metallurgy/Steel Production

The global crisis in 2008 has hit Ukraine particular hard, as it is a country with a strong structural biastoward low value-added commodities such as steel. Indeed, Ukraines metals and steel sector epitomizesthe pluses and minuses of the economy; moreover, it is fairly important for the economy in general, as itgenerates about 40% of export revenues.

The sector thrived following the global commodities boom since 2003, but it has virtually collapsed as the

tide from international markets turned again. The main disadvantage is very low energy efficiency, ascompanies are soaking up much more energy resources than their competitors elsewhere in the world.

With energy becoming dearer, this problem obviously gets more important.

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Features of doing business in Ukraine

Types of Entities most commonly used by foreign investors in Ukraine

Joint-stock company Establishing and operating a joint-stock company involves more registrationrequirements and formalities compare to limited liability company.

Limited liability company Both types embody the concept of limited liability for investors.

Tariffs for Electricity & Heat energy, UAH

Electricity for enterprises 0.65 per kW/h (I class of voltage above 27.5 kW, incl. VAT)

0.82 per kW/h (II class of voltage up to 27.5 kW, incl. VAT)

Heat energy 113.57 per Gcal (for housing and service organizations , incl. VAT)

481.32 per Gcal (for budget organizations, incl. VAT)

676.15 per Gcal (for other consumers, incl. VAT)

Source: JSC "Kyivenergo"

TaxationCorporate profit tax: 25%

Value added tax (VAT): 20%;

0% for the export of goods and attendant services

Personal income tax: 15%

Payroll taxes: employers contribution

Pension Insurance:

Temporary Disability, Birth, and Burial Insurance:

Unemployment Insurance:

Disability Insurance:

33.2%

1.4%

1.6%

0.6%

Payroll taxes: employees contribution

Pension Insurance:

Social Security:

Unemployment Insurance:

2.0%

0.5% or 1.0%

0.6%


5 interesting facts about Ukraine

1. Ukraine is the largest country in Europe (excl. Russia) by territory.

2. Ukraine is # 25 in the world by population (45.96 mln people).

3. 1/3 of all Ukrainian export (in money terms) is ferrous metals.

4. Ukraine occupies 8th place in the world by the number of tourists visiting (source: WTO).

5. From the 7 countries bordering Ukraine, 4 are EU members.

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