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Newsroom / Press Reports Ukraine: promise and possibility April 28, 2005 Euromoney Ukraine is enjoying a huge re-evaluation in the eyes of outsiders, thanks to its Orange Revolution. President Viktor Yushchenko has set out an ambitious and investor-friendly reform programme but it is not clear that the government is capable of implementing it. UKRAINE WAS FOR decades considered a backwater of Russia. Its very name suggested as much – it derives from the word for "outskirts", "border" or, by extension "the sticks" in Russian. Its standards of political and corporate governance were likened to those of other Russian backwaters, such as Belarus or Armenia. But it's not a Russian backwater any more. Despite a reputation for being apathetic and fatalist, Ukrainians suddenly seemed to wake from a long sleep, to reject Viktor Yanukovich's version of Russian president Vladimir Putin's "managed democracy" and demand instead western standards of democratic governance. "I have often compared my country to a sleeping elephant," said the newly inaugurated president, Viktor Yushchenko, at Renaissance Capital's investment conference in Kyiv in February. "It has now awoken, and in a brief time, you will see Ukraine as a modern European market." It was a remarkable awakening. The people who first took to Maidan Square in Kyiv to protest against the outcome of what they concluded had been rigged elections were students, assembled by an NGO called Pora, which means "it's time". Using civil disobedience techniques copied from Serbia's Otpor disobedience movement, which successfully toppled Slobodan Milosevic in 2000, Pora built a small village of tents in the square, set up a stage for rock bands, and dug in to see how the ruling government would respond. Vladimir, a waiter in a wine bar near Maidan, was one of the 3,000 or so students who gathered in the first days of the revolt. His band played on the stage. He says: "The first days were the scariest, when it was just a few of us, and we didn't know if the government would clamp down on us." But then the revolt rapidly gained critical mass. The number of protesters grew to hundreds of thousands, and foreign governments added their voices to the protest. Students, professors, lawyers and bankers swelled the ranks of those demanding a reorientation west. "This was a bourgeois revolution", says one bank analyst. So it can be compared to the revolutions in Serbia and Georgia – even to the recent événements in Lebanon, which have already been dubbed the "Gucci revolution", so bourgeois are its participants. Johann Jonach, deputy chairman of Raiffeisen Bank Ukraine, says: "Our own staff took to the streets to protest. They had the feeling they were fighting to determine the country's principal course of development – authoritarian, or more western and civilized." Catching up with Europe In Kyiv early last month there was a palpable sense of pride and self-respect, springing from a new awareness of popular power, and of the ability to demand more from the government. The streets are still full, bands play, fireworks go off, orange flags and scarves are waved from cars and houses, people dance drunkenly in the snow. Igor, a clothes salesman, says: "We are too poor here. We need to catch up with Europe. Who knows, maybe we will now." Another man, who is selling orange scarves as tourist mementoes, seizes my hand. "You are English? We are like you, you see? We are civilized too, European, white," he says. His comment was echoed by Yushchenko at the Renaissance conference. "Our government's chief strategic goal is to join the EU," he said. He nodded to Viktor Chernomyrdin, the former Russian prime minister and now ambassador to Ukraine, and said: "Russia is our eternal strategic neighbour. Unique strategic interests of Ukraine take shape there. It would be folly to ignore it." But, he continued: "Our border with the EU is six times bigger than our border with Russia. The EU is one of the strongest markets in the world, and we want to be part of it. I am a European. Ukraine is a European nation with a rich spiritual tradition, with the first written constitution. I know we are Europeans and I insist on it." The EU, slowly and perhaps reluctantly, seems to be in agreement with Yushchenko. The European parliament voted to offer Ukraine an avenue to EU accession in January. And in March, Danuta Huebner, the Polish EU commissioner for regional aid, said Ukraine could hope to join the EU in 2015, together with Turkey. Convergence play Dragon Capital, one of Ukraine's leading brokerages, is now talking seriously about the country being the next market play on convergence with the EU. In its 2005 outlook it says: "Our underlying assumption is that Ukraine can realistically hope to converge towards CEE markets in the mid-term." It believes sovereign debt risk will decline by about 150 basis points over the next 10 years, down to 100bp to 200bp over Euribor, and that equity risk premiums will decline by 100bp to 200bp, to 4%, over the next five to nine years. Even if Ukraine never achieves full EU membership, argues Dragon Capital CEO Tomas Fiala, the improvement in Ukraine's credit status will be significant. "It's not that important to become a fully fledged member," he says. "It's the process of convergence that is important." It also implies the downplaying of an age-old relationship. "Ukraine throughout history has been totally oriented to Moscow," Hans-Joerg Rudloff, chairman of Barclays Capital, tells Euromoney. "Now the government and people are changing their direction to become western-oriented." Because of this, Ukraine's markets are decoupling from Russia's. Its equity and debt markets have traditionally tracked Russia's, trading at a premium. Thus, in the third quarter of 2004, Ukraine's stock market was hit by the Yukos debacle, even though that story had nothing to do with Ukraine. But in December, after Ukraine's supreme court had ruled in favour of Yushchenko, the stock market rallied by 181% in a month. Thanks to this, the Dragon Capital-Kyiv Post index, made up of the top blue chips, rose by an annual 205%, while the main PFTS index, which is less reliable, rose 500%. Key blue-chip stocks, such as chemicals company Stirol or electricity company Dniproenergo, rose by between 300% and 500%. These gains helped make Ukraine the best-performing emerging-market stock market in 2004. Russia, by contrast, was one of the worst performers, rising by just 8%. Russian debt has performed much better, thanks to its strong reserves and stabilization fund, but here too Ukraine has caught up, closing the premium between Ukrainian and Russian sovereign debt to about 50 basis points. Ukraine has been helped in this by the strong build-up of foreign reserves over the past few years. And in terms of democratic and liberal reforms, Ukraine is set to overtake Russia as the most progressive government in the Commonwealth of Independent States. In his speech to the Renaissance conference, Yushchenko gave what Roland Nash, head of research at RenCap, called "the most encouraging speech I have heard from a top government official in this part of the world in a long time". The new president laid out an eight-point plan, which warrants assessing point by point. Corruption came high on the list. Yushchenko said: "From dawn to dusk, the president and the prime minister will try to stop corruption." According to Transparency International's Corruption Perception index, Ukraine is ranked 106 out of 133, in line with Serbia, Sudan and Zimbabwe. Foreign investors testify to this. Jonach of RZB Ukraine says: "It's pretty obvious here. If you need any government approvals or licences, you either pay a bribe or you wait a very long time." Because of the difficulties in dealing with government officials, many companies and individuals go for the easier option of avoiding contact with the government – working in the shadow economy without proper licences or paying taxes. Criminal losses Yushchenko points out that 55% of GDP comes from the shadow economy. "All Kyiv restaurants work at a loss. All oil refineries work at a loss. All airlines work at a loss," he says. "These aren't economic losses, just the way things work in a criminal environment." Because companies aren't paying taxes, only about 25% of GDP is disbursed through public finances, as opposed to more than 40% in Lithuania, for example. "So people don't feel the benefit of GDP growth. Or only five or six families do," Yushchenko says. The great beneficiaries of corruption are the 10 or so oligarch-led financial-industrial groups that have been more or less running Ukraine for the past decade. Edilburto Segura, chief economist at SigmaBleyzer, the largest private-equity fund active in Ukraine, explains: "Former president Kuchma thought the best route to economic growth was to concentrate power in a few hands. It was basically an elitist dictatorship model of government." Under this model, economic power came from the strength of an individual's political connections. Thus Viktor Pinchuk, one of the richest men in Ukraine and owner of the Interpipe holding group, was helped in his business dealings by his having married Leonid Kuchma's daughter-in-law. Rinat Akhmetov, the baron of Donetsk and controller of the System Capital Management holding group, saw his interests represented through his influence with Viktor Yanukovich, a former governor of Donetsk. Segura says: "The new government wants to abandon this model in favour of political and economic democracy." Anatoly Kinakh, deputy prime minister and the man Yushchenko has appointed to tackle corruption and administrative reform, says: "We want business competitiveness to be defined by how efficient a company is, not how close it is to the cabinet." But can Yushchenko's government undermine or bypass this system? Some sceptical investors believe that the new government is itself made up of oligarchs. William Browder, CEO of Hermitage Capital, the manager of the biggest equity fund in Russia, says: "The Ukrainian elections were never a fight between good and evil but rather one between two compromised candidates supported by powerful oligarchs." He points to the chequered past of Yulia Timoshenko, the heroine of Maidan Square and the new prime minister. Timoshenko does indeed have a mixed background. She rose to power as an ally of former prime minister Pavel Lazarenko, and became CEO of the nation's energy monopoly. Lazarenko was recently indicted on charges of fraud and money-laundering in the US, and Timoshenko and her family were also under investigation in Ukraine. She claims the investigation was politically motivated. Local journalists in Kyiv, however, point to her success when working for Yushchenko in the late 1990s, when he was prime minister, particularly in bringing reforms to the gas sector. She clearly has an ability to reinvent herself as often as her hairstyles, and seems dedicated to serving her current manifestation as "La Passionara de la Democracia" as one banker characterizes it, referring distantly to a Marxist heroine of the Spanish Civil War. Yushchenko himself is accounted by journalists and businessmen in Kyiv as one of the cleaner politicians in Ukraine. However, as Ralph Sueppel, emerging-market debt strategist at Merrill Lynch, points out, Yushchenko and many of the key figures in his government held senior positions in the Kuchma government – including Timoshenko, Kinakh, the finance minister Viktor Pynzenyk, and the central bank governor. So it is not totally a case of "out with the old, in with the new". What the government has so far done, at least, is to send a strong message, from the top, that corruption won't be tolerated at any level. "Police in this country will not be taking bribes. Don't offer a bribe to anyone here – that's the one request I'm making of foreigners," the new president says. Top managers at state-run companies who were seen to be on the take have already been fired. All state officials now have to declare any business affiliations. The government is also moving to slash the number of government officials and the number of government licences required. Yushchenko says: "As long as you have unnecessary government functions, you will have corruption." Murder investigation The government is also moving ahead quickly in the long-running and controversial investigation into the murder in 2000 of journalist Georgy Gongadze. Gongadze was a vocal critic of the corruption of Kuchma's government. After he was murdered, unidentified sources handed in a digital tape to local media, which appeared to record Kuchma complaining to his interior minister about Gongadze and telling him to "throw him to the Chechens". It is unlikely the digital tape can be used as evidence. But arrests have already been made and as a result of this and other cases senior members of Kuchma's regime could go to prison. This is a real sign that the new government is moving to distance itself from the old regime and punish its worst crimes. Dragon Capital's Fiala says: "The old regime retains very little power. Some elements of it could certainly be investigated and convicted. Some have already fled the country." The old regime seems to be taking the new investigations seriously. And the interior minister whose voice is also allegedly on the tape was found dead early last month. Two more of Yushchenko's policies illustrate an attempt to curb oligarchic excesses. The first involves the closure of the 24 special economic zones, which allow the companies based in them to import and export without paying taxes. Yushchenko says: "The zones all opened up where the clans are. It has created black holes in the national budget. Around 80% of all imports are into these zones." These zones have now been abolished, which will help the government decrease its large fiscal deficit. Yushchenko has also called for the nationalization and subsequent reprivatization of several companies. This refers to a number of privatizations that occurred last year, when oligarch clans – perhaps in exchange for supporting Yanukovich – were allowed to buy key state assets at knock-down prices. The most controversial example was Kryvorizhstal, one of Ukraine's biggest steel mills. Many foreign companies, including Arcelor and Russia's Severstal, prepared to participate. However, the tender was structured in such a way that only Ukrainian companies could bid. Local oligarchs Viktor Pinchuk and Rinat Akhmetov bought the mill for $800 million, despite their bid being much lower than rival bids. Yushchenko says that around 30 such privatizations will be renationalized and then sold off again. The more radical Timoshenko, by contrast, has said that 3,000 deals will be investigated and possibly reversed. Yushchenko's more moderate hand is likely to prevail. He says: "I won't allow a revision of all privatizations because I respect owners and I respect their businesses. However, we won't look with ease on any cases of utter lawlessness. Kryvorizhstal, for example, was stolen, and we won't put up with it. We will create a list of companies that will be reprivatized. The list will not be open-ended and afterwards we will accept everything as it is." The news has been taken relatively calmly in Ukraine, compared with the terror that grips Russian businessmen when the word nationalization comes up. Dragon's Fiala says this is because, unlike with Yukos, not all the oligarchs' assets will be seized, and there is widespread trust that the government is not reappropriating assets out of venality, which some suspect is the case in Russia. Foreign companies hope that the new privatizations will be fair and open, and many multinationals say they are interested in putting in new bids for Kryvorizhstal. Segura of SigmaBleyzer says: "The expectation is that the new government will show that you can have confidence in this country, that the past history of arbitrary privatizations is over, and that you can bid for assets on an even playing field with local companies." The forthcoming sales of Kryvorizhstal and possibly Ukrtelecom will be good indicators of whether the government can fulfil its pledges here. Yushchenko is keen to attract foreign direct investment as well as re-run some privatizations, hence his notion of a council of foreign investors. Ukraine has an FDI rate of $105 per capita, compared with Russia's $265 and the Czech Republic's $4,200. Yushchenko says: "Unless we can build a good rapport with investors – foreign and domestic – no matter what policies we introduce we won't succeed." Segura of SigmaBlezyer says: "The economy requires significant FDI just to return to Soviet Union levels of productivity." He says that Ukraine's GDP last year, after five years of 8% annual growth, was still only at 66% of its pre-independence levels. It's too early to judge whether the new government will succeed in attracting big FDI projects, but early signs are good, and it's certain it will do better than Yanukovich would have done. Barclays Capital's Rudloff says: "I hold president Yushchenko in the highest regard. I went to Ukraine in October, and made it clear to our counterparts that Barclays Capital would only be interested in coming to Ukraine in a changed political environment." Russia's door to the EU Rudloff adds that Kyiv is already full of Russian businessmen looking for opportunities to invest. He says: "For the Russian business community, it is probably the most important place to invest, because they see it as their door into the EU." Andrei Illarionov, economic adviser to Russian president Vladimir Putin, also recently said that some Russian businesses were likely to relocate to Ukraine because "the political climate is warmer there than here". Nonetheless, the benevolence of one busy president is not enough to guarantee that foreign direct and portfolio investment will continue to flow into Ukraine. Many investors are wary of what they see as the weak institutional and legal framework. Yushchenko is trying to address this in two other proposals, involving the judicial system and the financial markets. "I'm ashamed that in our country it is very difficult to find a just court," he admits. "Our utmost task is to ensure the independence of Ukrainian courts. It can't be resolved in one go, but we are aware of the problem and know how to fix it." Again, this is a daunting reform. But one positive sign of a new attitude in the judiciary itself was the supreme court's annulment of the original, rigged, election in December. The president also says he plans reforms of the financial markets infrastructure, including the introduction of a centralized depositary system and a single financial regulator. A lot of work is needed here. Investors say legal protection for investors in Ukraine is limited. "Investors are getting way ahead of themselves with the Ukrainian stock market," says Hermitage's Browder. "Our team performed a candid assessment of shareholder protections in Ukraine, and the conclusions were grim. I am afraid the investors now rushing to Kyiv think Ukraine is the new Poland or Hungary, when in fact it is light years behind even Russia in the development of any notions of market fairness and transparency." The government is in the process of passing a new law on joint-stock companies, which might offer investors better protection. The market is opaque. Ian Hague, chief strategist at Firebird Management, one of the biggest Russian fund managers, says: "The infrastructure's very weak. Electronic order matching allows traders to post prices, which obscures the fact that the price can include a spread of 100% or more for the trader." The market is also illiquid, with only 7% of all listed equity in free float, compared with 30% in Russia and 74% in Hungary. Here, the government could help the market, by listing some of the upcoming privatizations, such as Ukrtelecom, on the stock market. In the short term, portfolio investors should be wary. The equity market is close to fair value, with some stocks probably already overpriced. "There's every danger we could go straight through fair value into some kind of bubble," says Nash of Renaissance Capital. In the debt markets, the country's generally good economic fundamentals and strong foreign reserves have led to a rally in Eurobond debt. Jerome Booth, head of research at Ashmore Investment Management, says: "A lot of the upside has already been priced in, but it's clearly an improving credit." Ashmore, like many other emerging-market debt investors, is investing in local-currency sovereign debt, to take advantage of the expected appreciation of the hryvnia. It is "probably the most undervalued currency in Europe," says Merrill Lynch's Sueppel. Investors should probably steer well clear of the domestic corporate bond market, which boomed last year. Some of the credits were not of high quality. "The next few years may see major defaults," says one Kyiv banker. Other market commentators, including the IMF, are also concerned about the lending boom. Bank lending has risen by 50% since the start of the year, and Sueppel thinks this might lead to a banking crisis, particularly as 37% of all loans are in foreign currency. Yushchenko's goal of assuring macroeconomic stability seems the least ambitious, compared with a reformed judicial system or reprivatizations. In fact, it might prove to be the hardest. After the emerging-market crisis of 1998, Ukraine learnt the lesson of avoiding large fiscal deficits. However, in the last months of the Kuchma regime, those lessons were abandoned, as the Yanukovich government tried to spend its way to victory. As a result, the fiscal deficit for 2004 rose from a planned 1.7% to 3.3%. Unrealistic expectations The new government has inherited these problems. "The fiscal outlook for 2005 raises concerns," says SigmaBleyzer's Segura. The parliamentary budget passed in December estimated that fiscal revenues would increase this year by 24% year on year and that the deficit would fall to 2.2%. Sergura says this is unrealistic. He adds: "If not adjusted, the state budget might end up with up to a 5% to 6% GDP deficit, which is unsustainable. Thus it is evident that the new government will have to amend the 2005 budget." The government plans to finance the deficit through privatizations and external borrowing. The signs are not too bad here – debt investors seem well disposed to the sovereign. Booth of Ashmore says: "The amount of political momentum there is in Ukraine, I expect everything on the reform programme will be done." Other lenders are jumping at the chance to extend credit – in February, Deutsche Bank extended a $2 billion credit line to state-owned energy company Naftogaz, the largest loan ever extended to a Ukrainian company. However, there are some sceptics in the emerging-market debt community. Merrill Lynch recently moved underweight Ukrainian debt, citing the uncertainties inherent in the ambition of the reform agenda and instability of political support in parliament. Merrill's Sueppel notes that, possibly as early as September, some presidential power will pass to parliament, under agreements made between opposition groups during the election. This could lead to a stand-off between the executive and legislature. Despite the strong popular support for Yushchenko, the Ukrainian parliament is much more divided than might be thought, Sueppel suggests, and easily swayed by financial incentives. "The reality is that the political landscape is very much in flux," he says. "This makes it harder to predict political pitfalls for economic policy than in central Europe, Russia or Turkey." Finally, as the main step in its programme, the government has pledged to try to join the EU. The Polish EU commissioner says the country could join in 10 years, but then again, the Polish commissioner was always going to support Ukraine's bid. Other EU member states might be harder to win over, particularly in view of Ukraine's large and poor agricultural sector. It's a remarkably ambitious reform programme. It would be easy to be cynical and point out that revolutions inevitably lead to disillusionment, that this was the experience with most central European countries in the early 1990s and with Serbia at the beginning of this decade, and is in danger of being the case with Georgia. But the government seems to be responding to the extraordinary support it received from the people, and there is a real sense of urgency in its reforms. Yushchenko himself seems to be stepping up to the challenge of reforming his country. One banker says: "There were some questions about him being too soft before the election. But no-one claimed that after he survived the poisoning." In the short term, there is a danger that the equity markets are getting ahead of themselves. Some managers are thought to be in the process of raising and investing large new Ukraine equity funds. Investors should be careful – there are probably better times to enter the market than now. The new joint stock law is also an important reform to watch. In the medium term, the support of parliament for the reform programme is critical, as is the continued sympathy of foreign investors to finance the fiscal deficit. Nonetheless, it does appear that a profound change is taking place in Ukraine. The country is proving it is no longer merely the outskirts of Russia. That might finally benefit Russia. The Orange Revolution showed that Slavs are not fundamentally different to western Europeans, that they do not always passively accept authoritarian governments and managed democracy, and that they can aspire to join what George W Bush has called the European community of values. Already, there are signs that Russians, looking enviously and nostalgically at the demonstrators in Kyiv, are starting to feel the protest bug too. |
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