The unprecedented economic challenges Ukraine encountered in 2014 pose severe survival
risks not only for the country itself, but also for its supporters, for whom the situation has farreaching
economic and financial implications. Moreover, the present condition also carries
risks for further instability in Russia: a major nuclear state and global energy supplier. It is
obvious that the current situation is a complete lose-lose game for all parties involved, which
means it is not sustainable.
The way out may lie in an internationally negotiated compromise, which may, among other
conditions, include the following elements: sustainable ceasefire and continued peace talks in
the Minsk format; Ukraine’s neutrality reinstated in parallel to a new multilateral security
guarantee agreement for Ukraine; commitment by all sides to contribute to Donbas rehab
project and restore mutually beneficial economic, investment and trade links; and sanctions to
This may seem like the only win-win situation for all parties involved, namely Ukraine,
Russia and the West.
For Ukraine, it is a chance to digest the impact of too many internal and external shocks, to
partially recapture a much-needed Russian market and to win time and breathing space for
competitiveness reforms, thus avoiding the risk of an escalating economic crisis and,
possibly, of another revolution with a real threat of disintegration.
For Russia, whose economy has been severely aggravated by falling oil prices and
suffocating sanctions, it is a chance to prevent an economic collapse and partially regain
Ukraine’s much-needed market, as well as to save face and avoid humiliation in the near
For the West, it is a chance to prevent what now seems to be a real threat of a broader (and
possibly nuclear) war, to avoid dangers lying in the possible disintegration of the second
largest nuclear state, to restore trade and investment links with Russia, as well as to
substantially reduce an increasingly unaffordable bill for Ukraine’s bailout.
The assessment of the bailout’s true scale serves as the basis for such a conclusion. Ten
shocks – increasingly interwoven and aggravated in 2014 – are now economically destroying
Ukraine, undermining Russia and creating a significant political and financial liability for the
These are: 1) the shock of “forgotten” reforms and weak competitiveness; 2) the “27 minus
4” shock; 3) the exports and market loss shock; 4) the budget shock; 5) the energy shock; 6)
the currency devaluation shock; 7) the income shock; 8) the balance of payments shock; 9)
the banking crisis shock; and 10) the debt shock.
The Ten Shocks
How much do these shocks cost Ukraine and, for that matter, the country’s external
1) The shock of “forgotten” reforms and low competitiveness
The shock of “forgotten” reforms and low competitiveness boils down to the fact that
Ukraine is the only post-Soviet country in Europe that has yet to reach its 1990 level of output. Ukraine’s 2014 GDP is expected to represent only 64% of that level. This economic
lag has happened as a result of the lost opportunities for due reforms and of the complete
dominance by the extremely resistant rent-and-oligarch commodity- and export-driven model
of the economy. Becoming incubators for the country’s oligarchs, privately-owned
commodity-based low value-added industries – such as metallurgy (40% of export revenues),
chemical industry (fertilizers), extraction industry (iron ore and coal), and agriculture – have
been driven by the cheap natural gas subsidized through the growth of public debt, high
corruption and rent-seeking activities. These industries are underpinned by gas import
dependence and overall energy inefficiencies.
The model, fundamentally lacking in innovation and human capital, has rested on: 1) high
GDP reliance on commodity exports; 2) under-developed domestic market; 3) extremely high
income differentiation with a gap between upper and lower deciles reaching 1200% (for
comparison, Germany – 690%, Belarus – 680%, Canada and Japan – 370% and Sweden
270%)1; 4) rent- and corruption-driven redistribution of the national income through the state
The failure to dismantle this model against the backdrop of all other shocks and risks would
most likely lead to a chronic depression (a lost decade phenomenon), even if the world
economic outlook improves in the medium term. That may mean that Ukraine would have to
rely in the nearest 10 years on substantial external support to make ends meet.
2) The “27 minus 4” shock
The “27 minus 4” shock emerged as a result of territorial losses (Crimea, Sevastopol, parts of
Donetsk and Lugansk provinces), which significantly downsized the GDP, industrial output,
exports and human resources. Since peace prospects so far remain obscure, this shock is
likely to wield its negative impact, not only upon the provinces affected, but also on other
oblasts and related industries.
Eastern provinces accounted for 16% of the country’s GDP, 25% of the industry and 7% of
agriculture. They also accounted for 77% of coal production, 23% of iron ore, 44% of pig
iron, 27% of steel, 29% of fertilizers, 23% of machine-building, and 21% of energy
production. This shock, which is “disabling” up to 20% of the country’s GDP, has already
greatly contributed to a sharp economic slump in 2014 estimated at 7% drop in the country’s
3) The exports and market loss shock
Ukraine’s exports – accounting for 40% of GDP – shrank last year due to both the military
conflict and the shrinking of the Russian market by almost 15%, which shaved off more than
USD 10bn of foreign exchange revenues (or 0.7% of GDP). Russia and CIS absorbed 40% of
Ukraine’s exports, mainly in machine building, chemical and agribusiness sectors. The
country’s trade with Russia dropped by 35% in 2014, and this decline, which is detrimental to
the existence of key export sectors, is set to continue in the nearest future. Among the biggest
losers are Ukraine’s iron and steel industry, railway and heavy machinery output, pipe
production, electronic engineering as well as agriculture.
This shock is aggravated by the fact that Ukraine has also become critically dependent on
imports: the share of Ukraine-made goods in its domestic trade dropped, in our estimate,
from 70% in 2005 to 55% in 2014.
Can the EU-Ukraine Free Trade Agreement compensate for the exports and market-loss
shock? Yes, but only partially and within a much longer timeframe. The Oxford Economics
assessment of 2012 suggests that the total cumulative FTA effect for Ukraine could reach
3.3% of GDP by 2025 (or 4.3% provided Russia is not actively counteracting this growth).2
In the meantime, the effects of this shock could cost the country up to 1% of GDP, creating a
USD 10-15 bn gap in the current account.
4) Budget shock
Budget shock, one of the most ruinous, has been caused by a chronic and growing deficit in
the public finances. The consolidated government fiscal deficit (including bailouts of the state
energy company Naftogaz and Pension Fund), which reached a critical 10.3% of GDP in
2014, is projected in 2015 at 7.4%.3 This fiscal gap would require more than UAH 90 bn of
debt financing. In our view, provided the ongoing conflict, a hard squeeze on household
incomes and unaffordability of further increases in tariffs, this forecast already seems too
Apart from traditional budget “black holes” (energy subsidies and budget support for the state
Pension Fund), four additional public bills of significant size emerge: 1) a hike in military
and war-related spending, which would amount to UAH 170 bn (a 25% growth compared to
2014 and accounting for more than 5% GDP in 2015), 2) a substantial increase in UAHdenominated
debt service due to Hryvna’s devaluation, 3) a growing bailout burden for the
budget resulting from a failing banking system and 4) costs to socially protect circa 1.1
million internally displaced persons, 60% of whom are pensioners.
Facing a tax revenue squeeze due to recession and economic shocks, the government is on
the path of fiscal activism (i.e. taxing pensions, introducing tax on farming) and dramatic cuts
to social expenditures, including incomes, that could have otherwise supported already weak
domestic consumption. Dramatic “tightening of belts” would delay recovery and intensify the
social frustration and outrage.
5) Energy shock
The energy shock has been the result of a chronically unreformed and highly corrupt sector
where energy intensity is among the highest in the world. Suffice to say that most billiondollar
fortunes in the country – which has one of the highest oligarch rates in Europe
combined with the poorest population – have been linked to this sector. This shock results in
the disproportionately high share of GDP, budgetary expenditures and forex revenues that
have been re-distributed to the benefit of foreign producers, creditors, as well as corrupt
In 2012-2014, the negative contribution of loss-making and unreformed Naftogaz to the
quasi-fiscal deficit grew 16 times – from 0.5% of GDP to more than 8%! In 2010-2013, the Naftogaz annual budget subsidy (recap) was UAH 4 – 8 bn, whereas in 2014 it soared up to
UAH 70 bn. At the same time, insiders leaked that alleged bribes (kickbacks) reached up to
75% of the bloated value of public procurement contracts tendered by this state-controlled
Apart from natural gas imports from Russia, the country has become also critically dependent
on coal imports for electricity generation, also mainly from Russia. The annual coal import
bill could rise an additional USD 1.5–2.0 bn., increasing overall energy dependence on
Thus, the direct financial impact of the energy shock could be estimated as follows: 1)
imports of natural gas – USD 11 bn; 2) imports of coal – USD 1.5–2.0 bn; 3) budget subsidy
to Naftogaz – around UAH 100 bn, including USD 3.1 bn payment to Gazprom. It all boils
down to the exorbitant costs (est. UAH 300 bn or close to 20% of GDP), which the country
now simply cannot afford.
6) Devaluation shock
Devaluation shock has become one of the major threats to macroeconomic stability, real
incomes and soundness of the banking system. The IMF-prompted decision by the central
bank in early 2014 to freely float the exchange rate and simultaneously provide unlimited
liquidity to the banking sector has triggered, against the backdrop of mounting instability and
conflict in Donbas, a devaluation inflationary spiral that has become highly resistant to
regulatory and administrative action.
During 2014, Ukrainian currency depreciated by almost 100% against the US dollar, by
March 2015 – by 186% thus breaking all records. The devaluation “pass-through” effect on
inflation is assessed at 30% of the devaluation rate. The official CPI by end-2014 already
reached 25% and by March 2015 reached 28.5% year-over-year.
Official inflation data seems to significantly depart from reality. Prof. Steve H. Hanke from
Johns Hopkins University insists that Ukraine has already entered into the dangerous
hyperinflation zone with monthly CPI growth exceeding 50%.4 Based on devaluationinflation
pass-through effect, our estimates suggest an inflation rate on year-over-year basis at
more than 80%. However, Prof. Hanke may not be far from reality later this year when retail
utility tariffs for the population are to be raised by another 285%,5 which, in our view, would
further feed the devaluation-inflationary spiral, worsen financial instability and may lead to
Two more sources fuel the devaluation-inflationary spiral: 1) the central bank’s liquidity
support (refinancing) to commercial banks (outstanding portfolio of UAH 110 bn), and 2)
monetization by the central bank of the government short-term debt (more than UAH 160 bn
Hryvna devaluation in 2015 will cost the budget an estimated extra UAH 30 bn in debt
service. In addition, if the Hryvnia exchange rate were to remain below 20:1, it will have a further detrimental effect on key macroeconomic fundamentals: nominal GDP may fall, as a
result, by estimated 10-15 bps, gross capital formation – by 25-30 bps, industrial output – by
20-30 bps, real wages – by 15-20 bps and exports – by 10-15 bps.
7) Income shock
Income shock, which gained full momentum since Q4 2014, has become another factor
severely aggravating the overall situation. As a result of inflation and loss of bank deposit
incomes, last year alone the real household disposable income shrunk by an estimated 30%
thus affecting the purchasing power and consumption patterns of almost all income groups.
Provision of basic food and medicines has become the main priority for most families, and
UN experts have already sounded a loud alarm warning about a surge in the poverty rate to
Household and business income losses due to withdrawal of bank deposits (more than UAH
160 bn during 2014 alone) could be gauged at minimum UAH 10 bn, while the low and
lower middle classes were particularly hit hard due to the surge in inflation, devaluation,
account freezes and multiple bank failures.
The income shock experienced by households is putting a downward pressure on private
consumption (estimated to have fallen 10% in 2014 and fall another 10-15% this year), which
in turn could cost Ukraine, in our view, up to 2% in GDP growth in 2015-2016.
8) Balance of payments shock
Balance of payments shock affects the economy through the sharp drop in foreign exchange
earnings, mass capital flight as well as divestiture.
One major channel is the country’s persistent current account deficit. Despite a massive
devaluation of the local currency, the BOP imbalance has not been eliminated. Even though
the current account deficit last year fell to 4% of GDP from 8.7% a year earlier, positive
balances on services (tourism and transportation) as well as private transfers noticeably
shrank. The government’s forecast of a 1.5% current account deficit in 2015 may be
overoptimistic due to ongoing military conflict affecting some key export sectors and adverse
external conditions. We would put this deficit at minimum 2-3% of GDP provided the
situation doesn’t deteriorate.
Another channel is linked to downward FDI dynamics. For the first time in Ukraine’s history,
the FDI stock in 2014 fell by more than USD 10 bn – from USD 59 bn to 48 bn, of which
physical net outflow is estimated at more than USD 1.0 bn. The largest investors that account
for more than 50% of all foreign investment in Ukraine originate from offshore jurisdictions
(mainly Cyprus) and tax optimizers (The Netherlands, the UK, Luxembourg and Switzerland)
with the bulk of this investment having Ukrainian or Russian roots. Russia with USD 3.6 bn
in investment stock comes in second after Germany.
Given the current circumstances, it is unlikely for Ukrainian and Russian investors to make
significant investments in the short term, thus any tangible FDI growth in 2015-2016 should
theoretically be linked to EU and US investors. However, existing regulatory, tax, arbitrary
justice and corruption issues in Ukraine would likely cause these Western investors to abstain
from any sizeable investment decisions until the war risks and political tensions subside. The
IMF-supported ambitious deregulation, anti-corruption and investment climate reforms by
the government face significant resistance from insider-vested interests as well as lack of
room for maneuver in terms of popular support Another feeder for the balance of payments shock is persistent capital flight from Ukraine.
During 2000-2008, more than USD 82 bn left Ukraine, roughly 9-10 bn a year. The trend
persisted unabated in 2009-2014, which easily puts the total figure of Ukraine’s flight capital
at more than USD 140 bn, a figure exceeding the country’s GDP!
The deficit for capital account in 2014 amounted to USD 8.1 bn (against the USD 18 bn
surplus in 2013), which brought the overall balance of payments gap to more than USD 13 bn
financed mainly through the reduction of the country’s foreign exchange reserves that now
barely cover one month of critical imports.
Thus, this shock’s impact already reached almost 10% of GDP (USD 13 bn), and the
prospects for improved balance of payments outlook in the next two years remain
problematic. In 2015, even if this shock were to persist at a slightly lower level (e.g. USD 8-
10 bn), the country would still require sizeable external support.
9) Banking crisis shock
Banking crisis shock emerged in 2014 as a the result of: a) the toxic assets surge in the banks’
balance sheets; b) mass deposit outflows and resulting liquidity shortages; c) impact of the
devaluation shock; d) massive bank insolvencies, e) growing financial burden of the bank
bailouts and deposit insurance for the state budget.
The toxic assets’ share in the bank portfolios has exceeded 50-55%, while the ongoing
deposit withdrawals by households reached by end-2014 a startling figure of UAH 200 bn or
more than 30% of the total.
According to a previous IMF assessment, the banking sector, under the 12:1 UAH-USD
exchange rate scenario would require budget support of no less than 5% of GDP. With the
exchange rate already above 20:1, this figure should be dramatically revised.
The cumulative effect of the banking shock, including the bank recapitalization, funding of
the state deposit insurance scheme and losses of income by households and businesses, could
in 2015-2016 easily exceed UAH 150 bn (or 7.1% of GDP).
10) Debt shock
Debt shock or sovereign insolvency risk has become one of the most serious threats. In 2009-
2014, the public and publicly guaranteed debt increased from USD 40 bn to almost 73 bn or
1.8 times. With the 21:1 exchange rate applicable recently, this figure denominated in
Ukrainian currency equates to almost 100% of nominal GDP expected this year. The
country’s gross debt estimated at USD 153 bn in 2015 would become equal to more than
230% of nominal GDP!
Additional financial burden of debt repayment and debt service would in 2015 alone exceed
UAH 290 bn (or 20% of GDP), in which the devaluation component has now grown from
UAH 62 bn at end-2014 to more than UAH 80 bn.
With such perilous debt and debt service to GDP ratios, the only way for Ukraine to avoid
insolvency is to achieve successful debt restructuring with holders of the country’s external
debt. The government has already outlined its debt restructuring objective to bring by 2020
public and publicly guaranteed debt under the 71% in debt/GDP ratio mainly through
additional budget savings on the repayment and service of USD 15.3 bn government and
government-guaranteed debt. While the debt restructuring is still at early consultation stages, there are several risks to this process already identified: a position of the Russian Federation
on the USD 3.0 bn eurobonds; adverse impacts of growth and real exchange rate shocks on
the overall debt sustainability.
Findings and Conclusion
In a nutshell, what does this analysis imply?
1) Ukraine’s economy has been severely crippled by the 2014 shocks. These shocks carry a
specific price tag in terms of Ukraine’s GDP, a loss of foreign exchange revenues, a squeeze
on disposable incomes and domestic demand, and a further contribution to already negative
growth. Their combination may cost Ukraine up to 20-30% of its GDP and lead to a
conservation of the low income “European Pariah” status with dire social and human costs.
The country’s capacity to quickly recuperate, rejuvenate economic activity and improve
social standards is now dependent on external assistance and genuine transformation of the
economic model. Ukraine may be running the risk to become Europe’s only straightforward
failure case unless the war is stopped, ambitious reforms implemented, damage to industrial
base repaired, some trade relations with Russia restored and sufficient external financing
support granted in a timely manner.
2) External aid is now needed not only to cover critical imports and debt service needs but
also to compensate for domestic imbalances, which resulted from the above shocks. Without
external support for the budget, the government would have to revert to massive printing of
money, which would quickly lead to hyperinflation and social chaos.
Under the recently approved IMF’s Extended Fund Facility, the financing gap in 2015-2018
is expected at USD 40 bn, which, for the time being, is to be covered by a 17.5 bn IMF loan, 7.2 bn – from other multi and bilateral donors and 15.3 bn via the debt restructuring.6 By end
2015, Ukraine (see Table 1) can expect up to USD 10 bn from the IMF and about USD 3.5 bn
from official creditors.7
It becomes apparent that the rest of the financing should come from restructuring Ukraine’s
external debt (Eurobonds and notes) held by the private sector. With the proposed overall
burden of the 2015-2018 bailout package clearly shifting from official donors to the
international markets, with terms of restructuring still unknown and many risks to the
country’s solvency still omnipotent, it would be premature to consider this source of
financing as guaranteed. It is especially uncertain since Ukrainian authorities intend to
include into the restructuring package the notorious USD 3 bn bonds financed by Russia and
due for redemption in December 2015.
That said, this still leaves the country with a USD 20 bn financing gap for the current year
and another 10-15 bn, in our estimate, for 2016-2018. Provided that the debt restructuring
(15.3 bn) and a receipt of additional official aid (3.7 bn) is successful, the financing gap in
2016-2018 could still be expected at USD 11-16 bn.
3) The above financing gap amount doesn’t take into account the Donbas economic and
social rehabilitation needs, which may involve a similar figure when these needs can be dealt
with. The failure of the West to urgently make necessary financial commitments might
create, apart from economic collapse, a huge social whiplash against Ukraine’s EU
To lose Ukraine economically would be a much sadder outcome than to lose it politically. All
this, therefore, warrants an extraordinary anti-crisis, internationally supported action plan.
Currently, the occasional bilateral commitments fall significantly short of the real financing
needs, which can only be achieved through a comprehensive, full-scale, well-coordinated
4) Further deterioration of the already alarming situation, including a broader European war,
would increase, apart from incalculable loss of human life, the bailout costs exponentially
and commit the Western alliance to what it is reluctant to do – to put Ukraine on its payroll
for indefinite period of time with uncertain outcome. The war option, which may become a
dreadful reality if Ukraine is supplied with weapons, will make all economic predictions
irrelevant and the costs immeasurably higher for all sides involved.
Thus, the only way out is a way towards a compromise. It seems that this notion has already
gained traction in Europe. As the old folk wisdom goes, any bad peace is better than any
Kiev. March 13, 2015.