The war in Ukraine lasts for more than three weeks now and as the first shock from it has passed, the main task for the government is the ability of the economy to adjust to the new reality and to return to work where possible to minimise negative consequences of war on the economy. Inflation could also be an additional concern to consider in the medium-term. At the same time, strict control by the NBU allowed to stabilise the money market and prevent substantial liquidity outflows from banks, while the FX market remains highly regulated. Increasing budget deficit raises the share of international loans as a source for its covering. The decision to synchronise Ukrainian and European energy systems mitigates the risks of sudden cut-offs and provides an opportunity for additional export flows.
The government is active in returning the business to work and simplifying taxation
To encourage business, the government decided on simplification of tax regime by offering to switch to 2% turnover tax instead of VAT and profit tax. Also, the small business received an option either to pay taxes or not, depending on their ability to do that. For sure, these measures would weaken tax revenues of the budget tremendously: we estimate this drop by 40-50% if compared to projections for the coming few months made before the war. Considering that budget expenditure (which before war represented on average 70% of protected items like social and military expenses) have a much lower possibility to be cut, we expect a solid expansion of budget deficit that may reach 10% of GDP or even higher. It is expected to be covered mainly through international financial aid and inflows from donations for army support and the issuance of war bonds. The estimated value of these inflows could cover the potential budget deficit so far.
Inflation would remain a significant concern in the near-term
Even though domestic consumption has dropped by around 7% due to migration, this did not soften the risks of inflation acceleration so far. In particular, estimates of the economy Ministry suggest that consumer prices have inched up by 3.1% over the first week of the war. Probably, disrupting traditional logistic ties during war conditions and the inability of the transport system to adjust quickly to new risks raised the deficit of some products, which accelerated prices' growth for them. Despite there being no free FX market currently, a fixed exchange rate could not be used as a proxy for all imports into the country. Hence, importers had to adjust their prices of non-critical imports in par with exchange rate quotes of the black market.
Additionally, a solid hike in Brent oil price amid the refusal of traders to purchase oil from the country-aggressor influences the cost of fuel domestically. Even though Ukraine cannot export the bulk of its food products, a corresponding skyrocketing in prices of global agriculture commodities could also influence domestic traders to try to raise prices domestically. For example, FAO estimates a hike in global food prices by 8-20% due to the war conflict in Ukraine. Therefore, we are sure that a recent price hike is not the last one. Thus, we expect further acceleration of inflation by an additional 3%-5% in the coming weeks, especially if war conflict remains active. In this view, the imposition of price regulation on core goods due to martial law could not be a fully restraining factor for inflation.
The FX market is still far from a normal recovery
The NBU reports on the gradual recovery of foreign currency operations between banks. However, daily volumes do not exceed USD 10m (8% of total volumes), which cannot be treated as real recovery. The core question is regarding limitations on the market exchange rate because the USD/UAH rate of any transactions (including interbank ones) remains fixed by the NBU from the start of the war. Market operations are also limited to purchasing foreign currency for critical imports only, thus ignoring other operations. Therefore, we would not consider current changes in FC transactions as a start of market recovery. Under current conditions of active war, this can be the only way to keep the FX market functioning.
Nevertheless, the quotes of the USD/UAH from the black market at 32-38 surprised us pleasantly, as they represent just 21% devaluation as a reaction to the shock caused by war. For example, considering the response of the unofficial market in the invading country, the devaluation of local currency there is much higher than in Ukraine. Nevertheless, the domestic FX market remains under solid control and limitations from the NBU, which is unlikely to be eased considerably until the war ends.
Money market liquidity stabilised and remains abundant to keep banking sector stability
Over the past week, domestic banks almost did not ask NBU for additional refinancing loans, while overall liquidity has remained relatively stable. Moreover, the share of funds banks temporarily invested into NBU O/N deposit certificates has expanded recently, thus indicating the absence of liquidity shortages. Banks also report mixed changes in clients' deposits which is not dangerous for liquidity yet. According to the NBU estimate, local currency private deposits have expanded by 16% since the war started, due to active payments of wages and social assistance, which sometimes were paid in advance. Good to see that not all of these funds were immediately withdrawn but remained in the banking system. On the contrary, funds of legal entities have dropped by 5% over the same period, with the almost same reason, i.e. transfers to private accounts to pay wages and social assistance packages. Considering pre-war volumes of deposits on banking accounts, we estimate a slight increase in the total volume of deposits compared to the pre-war period.
Energy synchronisation with Europe may increase export potential
Quite important news came this week from the energy sector, where the Ukrainian power grid was finally connected to the United European system. Ukrainian officials already called this event as joining the energy European Union. We consider it as a quite important step towards energy independence of Ukraine from power supplies by the country-aggressor and its satellites, thus securing business from threats to cut energy supplies any time to weaken economic potential. However, due to active war conflict, a solid portion of large companies either considerably reduced or entirely cut their electricity supplies. As state officials estimate that 50% of business is not working, we think electricity consumption has dropped almost at par. This raised electricity surplus in Ukraine currently, which could be additionally exported into the EU, thus supporting the current account and securing an additional source of FX inflows. In this regard, domestic state-run energy operators have already appealed to European consumers to export Ukrainian electricity to support the country.
International partners continued increasing financial assistance
The package of announced external assistance to Ukraine (to be transferred directly to the budget) has increased from USD 27.5bn to USD 29.5bn over the week, mainly due to a loan from the UK and an extension of funding from the European Investment Bank. However, we have not included a potential new inflow from the IMF approved recently instead of the stand-by loan because the exact amount has not been specified yet. Among the new assistance package, it is worth mentioning USD 13.6bn from the US. Still, we would not treat it as direct financial aid because it mainly focuses on military and humanitarian assistance. But definitely, this package would positively indirectly influence the budget by lowering budget expenditures for these purposes.
Among international loans already disbursed into the budget over the past week, we could mention the tranche from IMF worth USD 1.4bn (disbursed almost immediately upon approval), EUR 300m from the EU's program of macro-financial assistance, EUR 312m from the World Bank and EUR 100m from the European Investment Bank. We think this is a reasonable liquidity buffer for the budget to finance current expenditures, especially on announced tax cuts and shortage of revenues due to devastation of postponement in business activity due to war.
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