The Ukrainian Enigma

Just what is the fascination of Ukraine?

Originally published in the November 2007 issue

Ukraine, which was one of the richest parts of the old Soviet Union, arguably lost the first decade of the transition process due to poor leadership. The break-up of the USSR at the end of 1991 threw the country into a period of severe economic crisis. Like many former Soviet countries, Ukraine experienced a period of sharp and prolonged industrial decline, a dramatic drop in living standards and hyperinflation. The economy took off in 2001 but it was the Orange Revolution in the winter of 2004-2005 that really pulled the country out of its slumber.

However, the orange champions, Viktor Yushchenko and Yulia Tymoshenko, failed to jumpstart reforms once in office as president and prime minister and caused widespread confusion among businessmen with re-privatisation talk in 2005. As a result, the economy plummeted and the two fell out with one another creating a rift within the orange camp. That rift, which among other things led to the dismissal of Tymoshenko as Prime Minister, opened up for a remarkable come-back by Viktor Yanukovych, who was humiliatingly beaten by Yushchenko during the Orange Revolution. Yanukovych beat the orange powers in the general election and became prime minister in 2006. Politics remained turbulent as the two arch-rivals had to govern the country together and agree exactly how to distribute the powers of the state between the executive and the legislative. All while the skilful but populist Tymoshenko remained in opposition criticising both.

This could have been the story of any emerging economy with a fragile albeit democratic system. But as the political turmoil exacerbates even further in late 2006 and throughout 2007, with a constitutional battle leading to the dismissal of parliament and early elections in September with the comeback by Tymoshenko, Ukraine becomes really interesting and unique. During this period, economic growth and investment resumed and the stock market boomed. Almost all major international forecasters had to upgrade the growth projections for Ukraine as the economy rebounded from 2.7% in 2005 to 7.1% in 2006 and it looks like the growth for 2007 will stay over 7%. At the same time, the Ukrainian stock market has been the strongest one in Eastern Europe and one of the best in the world so far this year. By mid-October, the Ukrainian market has gained a stunning 129% (in USD terms as of 12 October). The year-to-date performance is even more extraordinary given the fact that it has been a year with almost constant domestic political turmoil as well as two market corrections on the back of external financial turmoil.

The complex status quo

Although the market has managed to lift itself above the tumultuous political life in Ukraine there are a number of tough challenges facing the new government. These include but are not limited to, maintaining fiscal discipline, keeping inflation under control, industrial restructuring, reform of the social security system, and a bureaucracy overhaul. The domestic economy is also facing the challenge of much higher prices for natural gas, which is being imported from Russia and Turkmenistan, and just recently had to pay a USD2 billion bill for unpaid gas deliveries. Ukraine’s most important sectors are metallurgy, transportation, machinery and agriculture, which are all based on the country’s natural resource base, geographical position and the skills of its labour force.

The complexity of Ukrainian politics is no longer surprising anyone. The fact that the economy and market have done very nicely although the Rada has been largely ineffective since the Orange Revolution is partly because the growth is coming from a low base. The gap to even the closest neighbours in Central Europe and Russia is still very wide. In order to make this growth sustainable in the longer term, Ukraine needs to start implementing a wide range of economic and institutional reforms. Although there is a clear understanding of what needs to be done, and plenty of lessons learned from the neighbouring transition countries in Central and Eastern Europe, it is not certain that the three main political groups – represented and personified by Yushchenko, Yanukovych and Tymoshenko – can unite around a common reform agenda. On the negative side, the fractious and populist elements of Ukrainian politics have been as evident as always during the recent election campaign. On the positive side, the large and politically powerful, albeit competing, financial industrial groups seem to have grown weary of the political deadlock.

Equity markets not easy to invest in but worth the effort

The foundation for Ukraine’s equity market was laid in the early 1990s through the country’s privatisation process. Since 1991, Ukraine has privatised nearly 25,000 medium and large-sized companies, with the majority sold at special auctions through a voucher system. The government still controls several thousand companies, 350 of which are large (>1,000 employees), and also retains minority stakes in 1,500 companies, primarily in the defence, energy, electricity, transport, utilities and telecom sectors. Ukrainian stocks are mostly traded over the counter (OTC). As the Ukrainian securities market matures, organised exchanges are expected to play a more central role, as financial intermediaries expand their market share at the expense of the OTC market. PFTS, an association of 205 banks and securities dealers, established in 1995, is the largest exchange. The PFTS reported volumes of USD2.8 billion in 2006. PFTS volumes do not include trading in Ukrainian ADRs and GDRs and OTC deals, which together account for an estimated 50 % of total turnover in Ukrainian stocks. The valuations of Ukrainian equities became extremely high lately, more expensive than many other markets. On the other hand, some sectors, like electricity generation and distribution, retail and consumer products still offer reasonable valuations based on assets or sales volumes. As of today, the local market’s capitalisation is USD80 billion. The Ukrainian market is still far from fully utilising its potential as a capital-raising opportunity for Ukrainian companies. In addition to the existing sovereign and company-specific risks, the market is hampered by low liquidity in most stocks, caused by their small free float. All sectors of the domestic economy are currently still relatively under-penetrated. Therefore, we believe that such sectors exposed to the domestic economy presently offer the best value to investors.

It is also important to keep the perspectives. Although the Ukrainian market has experienced a tremendous ride lately, the market and the economy as a whole is still growing from very low levels. There is a big potential for long-term investors that understand the domestic market to capitalise on that structural catch-up story. East Capital started investing on the Ukrainian market already back in 2002 and today has EUR305 million invested in Ukraine, making it the firm’s fourth largest market in terms of asset under management. It is without doubt one of the most interesting markets but also one with relatively low liquidity. It is therefore a good idea to combine private and public equity investments, such as the East Capital Bering Ukraine Fund, in order to get full exposure to the opportunities on the fastest growing market in Eastern Europe.

Looking forward

Investor confidence is being raised by the improving laws on corporate governance, but the legislation is still weak, as is the protection of minority rights. Overall, the Ukrainian capital markets landscape is very similar to the situation among Russian second and third-tier stocks two-three years ago. Gradually, companies are becoming more investor-friendly. Furthermore, many local stocks, despite their incredible rally over the past year, still have the potential to trade higher. In addition, value search in the second and third-tier segments may still produce new growth stories. The highest potential for new ideas is concentrated in the mining, machinery, consumer goods, construction and metallurgy (pipe) sectors. IPOs and private placements represent another important growth driver for the local stock market. The Ukrainian market’s long-term growth depends on the new government’s ability to accelerate economic reforms and ensure macroeconomic stability as well as legislation protecting minority shareholders’ rights.