Ukraine is not yet dead, but it’s about to go bankrupt

Not a member of the EU, but adding to its economic woes.
Not a member of the EU, but adding to its economic woes.
Image: Reuters / Gleb Garanich
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Ukraine’s national anthem, the famously morosely titled “Ukraine has not yet died,” gives a pretty good indication of the country’s troubled and tragic history. Unfortunately for Ukrainians, there is mounting evidence that another serious economic crisis is rapidly approaching, and that the country’s structural problems and persistent economic weakness are no closer to being solved. To the extent that Ukraine attracts attention in the West, it has usually been for its political regression under Viktor Yanukovych and his Party of Regions. However, Ukraine’s economy is deteriorating rapidly and if attempts to engineer a smooth landing fail, we could see a messy default at an extraordinarily inopportune time for the European economy.

The first and most urgent crisis is that Ukraine is running out of money. Throughout the course of 2012, its foreign currency holdings went from $31 billion to less than $25 billion, and by June had slumped to roughly $21.7 billion. Even more alarmingly, Ukraine’s level of “import coverage” (the number of months’ worth of imports that it can afford with its current level of foreign reserves) decreased from an already low level of 3.5 months in January 2012 to less than 2 months by the end of May. While there is no perfect “rule” of import coverage, anything less than three months is usually seen as problematic, and Ukraine’s level has been relentlessly ticking down for the last two years.

Why such a rapid run-down in foreign reserves? Well, the Ukrainian Central Bank has been busy defending the hryvnia, which is informally pegged at a rate of roughly 8 to the dollar. The central bank has, so far, refused to allow for devaluation or even to start using a peg based off of a basket of currencies such as the euro and the Polish zloty. By linking its currency directly to the dollar instead of to the currencies of its closest trading partners, Ukraine has effectively strengthened its currency at a time that its economic partners have weakened theirs.

And, unsurprisingly, for a country that has unilaterally strengthened its currency (depressing exports and bolstering imports), Ukraine has run increasingly large current account deficits. Ukraine’s current account went from a respectable deficit of 1.5% of GDP in 2009 to a more than 8% deficit in 2012. It’s true that 2013 has seen some slight improvement, the current account was on pace for a 7% deficit through early 2013, but a country with a shrinking economy and a rapidly shrinking population simply cannot afford to run deficits of such a magnitude for very long.

Ukraine will have a hard time affording much foreign borrowing due to the high yields it must pay on its bonds. Ukraine’s government bonds are rated B, or five levels below investment grade, and the country usually pays somewhere in the range of 7-8% for ten-year notes. If those funds were being used for some sort of productive investment, perhaps in transport infrastructure, such a high interest rate would be acceptable, but since they’re essentially subsidizing consumption, they’re not going to prove sustainable.

As all of the above should make clear, Ukraine is playing on borrowed time: its foreign currency holdings are withering, it has an unsustainable peg to the dollar, its current account deficit is way too big, and its government finances are too shaky to allow large-scale foreign borrowing. The expectation is that the IMF will once again ride to the rescue and provide the country with a bailout sufficient to prevent a messy default. The problem is that the IMFs demands, particularly the demand to reduce subsidies for natural gas, are politically unacceptable to the oligarchs on whose support Yanukovych ultimately depends.

Europe has such an endless litany of economic problems that it almost seems cruel to add Ukraine to the mix. Nonetheless, the country at the crossroads of Russia and the EU is about to experience yet another economic crisis and it anyone’s guess as to how it will turn out.