Ukraine’s Banking System Vulnerable To Currency Devaluation, Slowdown In Capital Inflows

Ukraine’s banks were hit hard during the 2008 financial crisis, ultimately forcing the government to spend around 5 percent of gross domestic product supporting the weakest institutions. While the state of the Ukrainian banking system has improved substantially in the past few years, a severe devaluation in the hryvnia (the national currency) or a slowdown in capital inflows could still mean serious trouble for the fragile banking sector.

The ex-Soviet republic is also struggling with an economic contraction, a widening trade deficit, dwindling reserves of foreign currency, and debt coming due that needs to be repaid with it.

The good news is that the cash-poor country’s share of foreign currency-denominated debt has fallen, the loan-to-deposit ratio has risen and banks’ external debt has decreased.

“All this makes Ukraine’s banks less exposed to a drop in the hryvnia or a deterioration in the external funding environment,” Liza Ermolenko, an emerging-markets economist at Capital Economics, said in a note to clients.

Nonetheless, banks’ vulnerabilities have not gone away completely, Ermolenko warned.

Even though foreign currency-denominated loans have fallen, they still account for nearly 40 percent of total lending, leaving banks exposed to movements in the hryvnia. A weaker hryvnia would push up the local currency cost of servicing foreign currency-denominated debt, potentially leading to a rise in default rates on these loans.

The nonperforming loan-ratio has already risen to more than 15 percent, up from under 3 percent at the start of 2008, according to the official data. Unofficial estimates suggest that it could be as high as 30 percent.

“Ukraine’s external imbalances are becoming increasingly unsustainable,” Ermolenko said.

Foreign currency reserves are now equivalent to less than three months of imports -- the minimum prudential level recommended by the International Monetary Fund. The government will need to repay around $5 billion (2.8 percent of GDP) of external debt over the next 12 months. But borrowing on global markets remains prohibitively expensive -- with the yield on Ukrainian 10-year eurobonds rising from around 6 percent in January to nearly 10 percent -- and there has been no progress in talks with the IMF.

A previous $15 billion loan program with the IMF was frozen in early 2011 after the Kiev government refused to raise heavily subsidized household gas and heating prices.

“A hryvnia devaluation looks likely and we have penciled in a 10 percent fall against the U.S. dollar by end of 2014,” Ermolenko said, adding that a more severe adjustment and even a currency crisis remain possible.

Mounting external vulnerabilities only add to the reasons to expect the economy to disappoint. Ukraine is still struggling to recover from the most recent global crisis, with output more than 10 percent below its pre-crisis peak.

Ukraine's GDP declined by 1.1 percent and 1.3 percent in the first and second quarters of this year, respectively, from a year earlier, according to the State Statistics Service.

In the second half of this year, the World Bank projects a slight increase in real GDP growth because of good agricultural harvest and a low statistical base. Even with this improvement, given the decline in the first half of the year, the 2013 growth rate is projected to be close to 0 percent.

Ukraine’s state statistics committee will report third-quarter GDP on Oct. 31.

On Sept. 20, Moody’s downgraded Ukraine’s credit rating to Caa1 -- seven steps below investment grade -- citing souring relations with Russia, which accounts for a quarter of Ukraine’s exports. Ukraine, a country of 46 million people, now joins the Triple-C club alongside Cuba, Ecuador, Egypt and Pakistan.

Five days later, Moody's downgraded the ratings of 11 Ukrainian banks.

“We expect that the bad loans in Ukrainian banks will reach 35 percent of the total loan amount at the end of 2013, putting downward pressure on the overall capital adequacy ratio of the banking system,” the rating agency said in its latest report.

Moody's said Ukraine's deteriorating ties with Russia over its planned agreement on free trade with the European Union may exert a negative effect on the capitalization, asset quality and liquidity of Ukrainian banks.

“Even if the banking system does muddle through, credit growth is unlikely to accelerate much beyond its current pace. Lending to household will remain especially restrained,” Ermolenko said. “This only adds to reasons to expect Ukraine’s economy to disappoint.”