Ukraine's Trade Deal About-Face From EU to Russia Fraught With Risk

Repercussions are echoing throughout the Ukrainian economy. Not only has Russia acted to ban imports of chocolate from Roshen, a Ukrainian producer, but it has tightened border checks on other imports from the country. Its steelmakers are worried over the abandonment of the EU deal, since the EU was one of its key markets and Russian steelmakers have sought to have imports of Ukrainian steel limited to protect their own production.

Bond yields are up, on concerns that the country could default—its cash reserves are only equal to about three months’ worth of its scheduled debt payments—and its credit default swaps are up as well. Currency took a hit as protests swelled, providing the potential for a second “Orange Revolution”. The first took place in 2004–2005 and there is also the potential for capital curbs, which would make it difficult even for bondholders to receive coupon payments if hard currency is limited or halted from leaving the country.

While all appears bleak on the economic front for Ukraine at present, amid all the turmoil is a bright spot, as pointed out by Charles Seville, director, sovereigns at Fitch Ratings. In research Seville said, “Ukraine’s announcement that it was halting preparations to sign an Association Agreement with the European Union threatens to leave in limbo a process that, if fully implemented, would strengthen Ukraine’s credit profile,” according to Fitch Ratings. But the retreat may also reduce the more immediate risk of Russian economic retaliation, which has already affected Ukraine’s exports in 2013, said Fitch.

Still, there are troubled waters ahead. Fitch had already downgraded Ukraine’s credit outlook to negative months ago, saying, “Ukraine has one of the lowest external liquidity ratios among ‘B’ rated sovereigns and this is a key credit weakness.” It also downgraded Ukraine “to ‘B-’ from ‘B’ this month. This reflected the sovereign’s fragile external financing position and constraints on its ability to borrow in foreign currency to refinance heavy external debt repayments in 2014-2015, in the absence of an IMF agreement. These remain key rating drivers, and the risks they present are reflected in the continuing Negative Outlook on the rating.”

While the EU agreement would have brought progress on a number of fronts, there is a lessening of negatives to the country’s turning its back on the EU at present. “Signing and implementing the EU agreement, which includes a deep and comprehensive free trade agreement (FTA), would be positive for Ukraine’s sovereign credit profile. The FTA includes ambitious reforms in areas such as standards and public procurement that could unlock efficiency savings, promote FDI [and therefore ease pressure on reserves], and boost flagging exports to Europe. These benefits would exceed those of Customs Union membership,” said Seville.

However, by not signing the EU deal, Ukraine probably avoids additional Russian pressure on its exports and its current account deficit, which stood at 8.2% of GDP in September, according to Seville.  Russia’s share of Ukraine’s exports dipped in the first nine months of 2013, as a result of trade disputes. Last year, goods exported to Russia were worth USD17.6bn, slightly exceeding exports to the whole of Europe, which were worth USD17.4bn (including exports to non-EU member states). Russia takes most of Ukraine’s higher value-added goods, Seville said.

“Ukraine could be offered another opportunity to sign the EU Association Agreement at some point. Its call for three-way talks involving the EU and Russia indicates that the government wants to keep an EU deal as an option and capitalize on the legislative preparations it has already made,” he said, warning that such an event was not likely to occur for some time, thanks to European Parliamentary elections in 2014 and Ukraine’s own presidential election set for April of 2015.

That is, unless the demonstrators get their way.