Ukraine’s economy needs business plans, not champagne

by Simon Pirani

After the party, business is hoping that Ukraine’s new reformist government will make good on promises to reform corrupt, ramshackle bureaucracy and develop the primitive stock market. Economic potential is there to be realised – although it will take more time than the revellers expect.

Some party it’s been, too. The “Orange revolution” that brought reformist president Viktor Yushchenko to power was celebrated as wildly on Ukraine’s fledgling markets as in the streets. Most of last year’s three-fold increase in the country’s stock index followed the street demonstrations that erupted in Kyiv in November. The over-the-counter PFTS index rose to 260 by the year end and reached 346 last month. Daily turnover, estimated to be 70-80% of total share trading, rose from around $1-3 million a day early last year to $7 million in December, and $11 million recently.

Food products group Ukrprodukt basked in the lingering glory of the political shift last month when it became the first international listing by a Ukrainian company. On 11 February, its first day of trading on London’s Alternative Investment Market, the shares rose 13%, from 53.5 pence to 60.5 pence. Recently it was trading at 57-59 pence. Dmitry Dragun, IPO manager, says: “other fast-growing medium-sized Ukrainian companies in the consumer, electronics and other sectors, could soon follow suit”.

Individual investors, impressed by political changes, are driving the surge in Kyiv. “If the revolution had lasted two days instead of three weeks, ABC News would hardly have picked it up, and things might have been different,” says John Suggitt, managing director of Concorde Capital, a leading Kyiv broker. “All the major investment funds have been here for 18 months. Since December, individual investors have come in. Many of them are Russians – which is as much a result of events in Moscow as of those here.” In January, the Ukrainian PFTS index rose 16%, on top of a 204% gain in 2004. Meanwhile the the key Russian index, RTS, gained 1.8% in January after rising 8.3% last year. The main cause of the Moscow market malaise is the government assault on Yukos, once the prime stock and Russia’s biggest oil producer, now a bankrupt wreck.

Ukraine’s stock market is no substitute for Russia’s of course, more of a resting-place for the disconcerted. It is tiny: the aggregate market capitalisation of all PFTS-listed stocks is about $15 billion, roughly the same as Russia’s leading telecoms stock, MTS, on its own. Tomas Fiala, managing director at Dragon Capital, Ukraine’s largest broker, says the stock market has “long been undersupplied”. The shortage will be eased, he believes, by the new government’s privatisation programme, by the large business groups putting some of their share capital on the market and by the flotation of some of the dynamic medium-sized companies that have mushroomed in the last five years.

Some observers conclude that the share market is heading for a bumpy correction. “Ukrainian stocks surging on low volume look like a bubble in the making”, Alex Kantarovich, strategist at Aton Capital in Moscow, says. He sees a “classic case of the market getting far ahead of itself”, as it did when the Greek conservatives won the 1990 elections and when Boris Yeltsin was re-elected in Russia in 1996. “To be fair,” he says, “Ukraine has double-digit growth, an impressive trade surplus and rising reserves, along with a sober, economically-literate president, and is far better positioned than Russia circa 1997.” Nevertheless, Ukrainian valuations are “stretched”, even trading at a premium to similar-quality but more transparent, established and liquid Russian names.

A more accurate reflection of reality than the stock indices are falling yields on Ukrainian bonds, on both European and domestic markets. Margins on Ukrainian 2013 eurobonds, at a par with Turkey’s six months ago, were in early February more than 70 basis points tighter (176 bps and 250 bps over 6-month Libor respectively). The situation “suggests that Ukraine deserves a further upgrade”, Dmitri Shemilo, emerging markets analyst at Commerzbank in London, says. It’s the same story on the Ukrainian domestic bond market, which mainly comprises T-bills. Fiala explains: “A large amount of money came in chasing yields, and on the back of currency appreciation. That has brought government bond yields down by about 2.5%.” Yield on the government’s first domestic issue of the year, a 543 million hryvna ($102 million) five-year bond, fell from 11.94% in the first auction on 5 January to 11.22% on 18 January, and is expected to keep going down.

However the stocks party ends, some issues are not in doubt. Yushchenko’s victory has opened up exciting possibilities for reform, and the Ukrainian economy, which in 2000 started recovering from one of Europe’s worst ever slumps, is full of potential. Three questions to ponder are first, how the government will implement reforms, what difference its pro-western orientation will actually make on the ground; and third, how business will capitalise on the economic revival.

The government has at least two sets of problems to tackle. First, budgetary and monetary policy must be brought under control, without disappointing pensioners and underpaid state employees, who received hefty pre-election handouts from former president Kuchma, along with promises of more. Second, it must take on corruption, bureaucratic barriers to business and the erratic legal system.

Ukraine-watchers are focusing on the new draft 2005 budget that the government will bring to parliament on 15 March. Finance minister Serhii Teriokhin says a gap of 32 billion hryvna ($6.03 billion) has to be filled – and president Yushchenko said earlier this month he expected to raise the money from reviewing untransparent privatisations (25 billion hr), scrapping flawed tax breaks and loopholes (7 billion hr) and cutting waste in public companies (9 billion hr).

Reversing dodgy privatisations will test the government’s relationships with Ukraine’s most powerful businessmen. The first deal the government annulled was the sale in June last year of Krivorozhstal, Ukraine’s largest steelworks, to a holding company controlled by Donetsk metals magnate Rinat Akhmetov, reputedly Ukraine’s richest man, and steel-pipes-to-TV entrepreneur Viktor Pinchuk, the son-in-law of ex-president Leonid Kuchma. The price was $800 million, while bids of up to $1.5 billion from Russian and west European steelmakers were ignored.

But where will it stop? Yushchenko earlier suggested that “thirty or forty” companies would be looked at, and no more. The head of parliament’s commission on privatisation, Valentina Semeniuk, has called on prosecutors to look, among others, at the privatisation sale to Russian companies of Ukraine’s largest alumina and aluminium producers.

Here Ukraine has a dilemma. The review of bargain-basement privatisations is both popular and just – but the more wide-ranging the challenge, the less chance of luring back investment capital that fled the country, funds that vastly outweigh foreign direct investment. Boris Timokhin, president of Ukrsotsbank, warns there is a danger of discouraging investment in the real economy, and that “emotional statements” about reprivatisation could destroy the timid beginnings of the return of flight capital seen since 2000. “It is important that Ukrainian business puts money into the Ukrainian economy. The return of flight capital is a more important issue than the speculative ups and downs of the stock market, which at this stage is more an indicator of sentiment than a real source of funds for the economy.”

Stock market participants point out that the first step towards bringing capital-hungry companies together with asset-hungry investors is the establishment of a proper exchange which requires trades to be reported.

The consensus in Kyiv’s business community is that Ukraine’s medium- and long-term economic health depends less on the privatisation issue than on the authorities’ broader fiscal and currency management, and on progress in combating corruption and bureaucracy. Johann Jonach, vice president of Raiffeisenbank Ukraine, says: “The government has expressed many good intentions. But structural changes to the administrative chains of command, which are the most important, take time.”

Trond Moe, cfo of the mobile phone company Kyivstar, says that a country the size of Ukraine can not be transformed overnight, despite some succesful reforms, such as changes so far in the energy sector. “The economy is in good shape and some reforms, such as those in the energy sector, have been succesful. It’s good, too, that people believe in the future”, he says. “But it is hard to see how the government can meet all the people’s expectations.” For example, he notes that curbing corruption will require salary increases for government employees.

Economists draw attention to the difficulty of striking a balance between fiscal and currency policies. Sonal Desai, emerging markets economist at Dresdner Kleinwort Wasserstein, says that the handouts to Ukraine’s poorest people – a promise by Kuchma on which Yushchenko has agreed to deliver – “not only put pressure on the budget, but could also add to inflationary pressures”. Annual inflation rose from zero in 2000 to 12.8% by the end of last year. A report from Standard & Poors noted that the political crisis around the elections had increased inflationary expectations, and that intervention by the National Bank of Ukraine to prevent the hryvna from appreciating had “injected excessive liquidity into the banking system”.

Business unequivocally welcomes the pro-western orientation of Ukraine’s new leaders. “President Yushchenko is a fine statesman”, Jacques Mournier, president of Calyon Bank Ukraine, the foreign-owned bank with the longest history in the country, says. “It appears that in very key positions, either in the government or in other administrations, he has nominated so far his own supporters who are individuals known for their capacity to resist temptation. Western European companies were getting ready to invest in Ukraine even before the elections: now they are even more optimistic.”

That said, Yushchenko’s desire to bring Ukraine into the EU is unlikely to have any practical consequences for some years. One Kyiv-based foreign banker said that a long period of accession, during which Ukraine would benefit from being a neighbour of the EU but not get entangled in its regulations, might be beneficial.

Fears that Yushchenko’s enthusiasm for western Europe would make his relationship with Moscow have largely been dispelled. The Putin administration has signalled that it will adopt a pragmatic attitude. Yushchenko hinted to journalists last month that Russia had promised not to pursue criminal charges against his prime minister, Iuliia Timoshenko, relating to her business activities in the mid-1990s, when she headed the gas trading company United Energy Systems of Ukraine (UESU). Likewise, a deputy ceo of the Russian gas monopoly Gazprom said it is writing off a $280 million debt from UESU.

Ukraine’s economic revival began in 2000, long before the elections, and is expected to continue regardless of further political twists. The challenge for the government and business is to consolidate the recovery. There is consumer market potential to be tapped. Moe at Kyivstar says: “Demand for mobiles has grown constantly since 2000 and is currently growing faster than expected. We have reached 30% market penetration and there is no doubt we will get to 100%, albeit more slowly than Russia does.” Similar stories can be told of fast-moving consumer goods, personal credit and, to a lesser extent, real estate in Kyiv.

There are also the rich possibilities offered by Ukraine’s industry and agriculture. Its most significant export sector, non-ferrous metallurgy, is looking healthier than usual after the unprecedented increase in steel prices of the last two years, but there is life, too, in other sectors such as chemicals – and the return since 2001 of Ukraine, once the Soviet Union’s “bread basket”, to grain export markets.

Cleary, it’s time to put away the champagne and work on the business plans.
 

Top ten Ukrainian companies by market capitalisation

    capitalisation
$ million
Mariupol metallurgical plant non-ferrous metals 3 351.52
Ukrtelekom telecoms 3 225.86
Azovstal non-ferrous metals 2 455.51
Ukrnafta oil production 1 662.67
Zaporizhstal non-ferrous metals 1 162.05
Stirol chemicals 465.74
Tsentrenergo power 432.83
Sumskoe machine-building works machines 402.37
Zakhidenergo power 386.13
Dniproenergo power 333.1

Source: PFTS

This story first appeared in Institutional Investor magazine, March 2005.
Posted March 2005; © 2005 Simon Pirani

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