SEB MERCHANT BANKING COUNTRY RISK ANALYSIS 28 September 2016

Higher foreign reserves and lower financing needs following the debt restructuring in 2015 have
reduced external vulnerability. In addition, there has been a very gradual improvement in several key
macro indicators. Significant risks loom over the economy, including a faltering commitment to the
economic reform programme and an escalation of the conflict in the East.

Summary
The long delayed decision from the IMF to release a USD 1 bn loan tranche in late
September was not as much of a boost of liquidity as it was a boost of comfort to
those having doubts about the direction of the Ukrainian economy. Following
drawn-out political bickering during the spring, one of the reasons for the delay,
some stabilisation of the political situation has followed. Fulfilment of the IMF
programme remains a key assumption underlying our view on country risk.
Ukraines track record in this respect is weak. While there is an explicit, strong
commitment to the economic programme from the government much uncertainty
remains. With a very fragile majority in parliament, the pace of reform going ahead
is expected to be very piecemeal and political set-backs should be expected.
Nevertheless, the country has come a long way since the revolution. Helped by a
relatively strong civil society and press, it is not likely to fall back to square one.

The economy has continued to stabilise. Following a GDP contraction of nearly 10%
last year, growth should pick up to about 1%this year. Inflation has come down and
despite an expected rise in the second half of 2016 there is even a risk that the
central bank might undershoot the 8% inflation target for 2017. Government
finances ended last year on a more positive note than expected although
government debt has been rising rapidly.

The current account was roughly in balance by the end of 2015 but is likely to show
small deficits in the near term as exports fail to pick up. Financing of the deficit will
come through external credits and FDI which have started to recover from low
levels. The improved external position has allowed the authorities to start easing
FX market restrictions.

All major credit rating agencies upgraded Ukraines sovereign rating in late 2015
following the agreement with holders of the countrys Eurobonds.
Recent economic developments
Delayed IMF disbursement finally is made. With economic reforms progressing
slower than planned, disbursements under Ukraines USD 17.5 bn IMF programme
had been put on hold. However, following a positive assessment by the IMFs
Board in mid-September USD 1 bn was finally made accessible to Ukraine, making
the total amount disbursed so far just above USD 7 bn. The disbursement should
unlock loan guarantees from the US as well as EU and other complementary funds
which are necessary to fill the governments financing gap.

The countrys financing needs eased significantly following the Eurobond

restructuring in 2015 which postponed about USD 11.5 bn in principal payments
falling due in 2015-2019. This makes it unlikely that any new restructuring would
happen before 2020. Still, as the hair-cut taken by bond holders was relatively small
(about 20%), Ukraines debt woes cannot be regarded as completely cured.
Fulfilment of the IMF programme remains a key assumption underlying our view
on country risk. The governments commitment to the programme appears strong
although we do envisage political setbacks on the way.

Economic activity has recovered.

Following a contraction in real GDP of
9.9% in 2015, the economy is on a
recovery trend. Actually, growth rates
started improving in the second
quarter of 2015. Growth is not export
led as would normally be expected
following a sharp depreciation of the
exchange rate. A permanent loss of
demand from Russia and a contraction
of production in the East are important
restraining factors. Instead growth is
domestically driven. Real wage growth
has picked up recently although low
household incomes and poor sentiment are producing only a gradual recovery in
household spending.

Inflation has come down. The surge in inflation following the plunging exchange
rate and removal of energy subsidies pushed average inflation to nearly 50% in
2015. This surge is now over and inflation has come down to around 8% helped
also by lower food prices. The continued deregulation of utility prices is expected
to boost inflation in the coming months which should lift the average inflation rate
this year well into double digit territory again.

Improved external position. The balance of payments situation continued to

improve in 2015 with the current account ending the year roughly in balance. In
early 2016, the deficit has grown slightly again on the back of a poor export
performance. International reserves have been boosted, initially largely by IMF
borrowing, but subsequently by a reasonably healthy balance of payments. Gross
international reserves have surpassed USD 14 bn, up from 13.3 bn at the end of last
year. The accumulation of reserves has been slower than projected under the
programme but faster than we expected a year ago. The increase and the lower
 financing needs following the debt restructuring have reduced external
vulnerability.

Financing of the deficit in the near-term should not pose any serious challenge. IMF
funds are being complemented by inter-governmental loans while foreign direct
investment (FDI) also recovered during 2015. We note however that FDI flows are
still lower than their historical average. Finally on this point, the improved external
accounts have allowed the rolling-back of some of the capital controls and
administrative measures that were imposed during the exchange rate turbulence.
Most observers expect that these restrictions will be fully eliminated in the next few
months.
Economic policies
Fiscal policy roughly in line with IMF programme. Despite some improvements
last year, the fiscal situation remains relatively dire. The economic contraction, the
loss of tax revenues from the Eastern parts of the country and the depreciation of
the currency has put pressures on government finances. Nevertheless, the budget
posted a smaller than expected deficit of 1.7% of GDP in 2015. This was an
improvement compared to the average deficit of more than 4% of GDP in the
previous five years. The budget for 2016 targets a deficit of 3.7% of GDP which
most observers feel has become a challenge to reach. Furthermore, the government
recently presented its 2017 budget which aims at a 3% headline deficit assuming
(slightly optimistically) a 3% GDP expansion.

Government debt has been rising rapidly. The recession combined with the
exchange rate depreciation and large financing needs in the state owned companies
have produced a rapid rise in government debt. At about 80% of GDP it has
roughly doubled since end- 2013. Although this is less than projected by the IMF, it
is a high level for a low-income country. The authorities target a ratio of 71% in
2020. However, in the near-term, debt is expected to continue rising.

Public sector external debt has risen in the past couple of years following IMF
payments. Consequently, despite significant deleveraging among private
corporations and banks, the countrys overall external debt has risen as a share of
GDP to around 140%.
Monetary easing continues. Taming
inflation is the National Bank of
Ukraines (NBU) top priority. The
target is 12% (+-3%) for 2016 and 8%
for 2017. The gradual drop in
inflation in the past year has allowed
the bank to cut interest rates in
several steps to 15%, down from 22%
in April this year. Further cuts are
expected as real interest rates are still
relatively high.

While inflation targeting is the top

policy priority, the NBU is also
committed under the IMF
 programme to accumulate foreign reserves. As noted, reserves have increased in
the past year bolstering somewhat the Banks credibility and reducing the
economys external vulnerability.

Banking sector is still very vulnerable. Following the deepest banking crisis since
independence in 2014-2015, the resilience of the sector is now gradually improving.
Deleveraging is progressing and liquidity is rising. Improved confidence in the
sector is reflected in rising deposits. This being said, the improvement comes from
an extremely poor level. Hence, the banking system remains very vulnerable.

The quality of banks loan portfolios

were at a historical low in 2015 and
non-performing loans in the sector
was still close to 50% of total loans in
March 2016 by some standards.
Provisioning may be inadequate and,
although many banks have been
recapitalised following stress tests,
the sectors average regulatory
capital is low. Furthermore, bank
lending is still very weak as high
corporate indebtedness and
questionable solvency of many
business sectors weigh on both
supply and demand for credit.

Political situation
Some stabilisation following a turbulent spring. Following a long period of more
turbulence than usual in the political arena, a new coalition government was
formed in April. The coalition is headed by President Poroshenkos close ally and
new Prime Minister Groysman who succeeded Mr Yatsenyuk. While the
reshuffling helped to avoid new elections and did stabilise the political situation,
political risk remains high. The new coalition is fragile and holding just one seat
more than required for a ruling majority in parliament.
Outlook
Growth to gradually gain pace. The very gradual economic recovery should lift
GDP by about 1% this year. This is in line with government expectations.
Consensus expectations for GDP growth in 2017 have recently been hiked.
However, medium-term growth is expected to be subdued given productivity
constraints from public sector inefficiencies, poor infrastructure and low
investment.

External accounts to turn slightly negative. The exchange rate depreciation is not
likely to lead to any near-term export-led recovery. Headwinds in the form of trade
curbs from Russia and indirect Brexit effects are likely to be complemented by
domestic supply constraints. Consequently, we expect the current account to swing
into a deficit in 2016 and remain there in the medium-term barring any surprises in
the form of weaker imports.

Failure to keep IMF programme on track is a key risk. The very incremental pace
of reforms has barely kept the IMF programme on track and many challenging
conditions still remains to be fulfilled. For example, corruption remains rampant
and long neglected problems such as the inefficient pension system needs to be
tackled. There is a clear risk that reform implementation will slow after 2017 as
coalition divisions become increasingly apparent and the opposition regroups.
Hence, there is a risk that there will be more delays in the flow of external support.
Still, external political support for Ukraine remains strong. This implies that
funding from the IMF and EU is quite likely to be forthcoming in the medium-term
despite possible small deviations from the agreed Fund programme.

In an alternative scenario, it may turn out that challenges could prove too
demanding for Ukraine, forcing it to abandon the IMF programme as it did with
Fund programmes in 2002, 2009 and 2013. An interrupted IMF programme would
mean losing an important economic policy anchor, deter foreign investment and
produce a rise in country risk.

Stepped up military conflict is another downside risk. An underlying assumption

to our overall risk assessment is that the military conflict in the eastern regions does
not escalate and that it subsides in the medium term to what most observers view
as a frozen conflict. Here lies a significant downside risk. Should the military
conflict spread or intensify it would risk dampening sentiment and delaying any
recovery in industrial production and exports.