Newsletter #1

2023 economic growth beat all forecasts

Real GDP increased by over 5% in 2023

War infused uncertainty weighed on Ukraine’s economic outlook throughout the year 2023. The peak of pessimism was reached in March 2023, when it became apparent that the assumption of a soon end of the russian aggression against Ukraine is no more valid. On top of that, Ukraine faced first troubles with exporting its grains as the functioning of the seaborne export routes was compromised. The weaker harvest projections from the Ministry of Agrarian Policy and Food of Ukraine also added to the gloom.

Although the protracted war has become a new normal for most of Ukraine’s fellow citizens and businesses, other doom & gloom projections have not materialized. By the end of 2023 grain exports in back on the growth track as Ukraine was able to sustain its Black Sea grain corridor while harvest proved 35% better than initially forecasted. The local economy was boosted by record-high government consumption which is driven by international financial support.?

As a result, throughout 2023 real GDP growth forecasts were gradually revised upward from up to +1.5% in early spring to +3.5% in the summer and eventually to 5.2% at the moment.?

Agricultural Sector

Gloomy expectations for harvests and exports did not come to fruition

In early 2023, Ukrainian officials had very conservative expectations for the agricultural sector’s performance in 2023/2024, with an expected 16% YoY decline in harvest volumes. These expectations assumed a decline in harvested area and crop yields, due to security risks, as well as uncertainty regarding crop exports and worsening agricultural technology.

Such forecasts proved to be irrelevant, as farmers have quickly adjusted to their new reality and improved crop growing technologies to pre-war levels. As a result of this, plus favorable weather, the latest expectations of the 2023/24 harvest have improved to a 12% YoY increase.

Another factor that would have affected the performance of the farming sector—the risk of limited grain-exporting capacity for 2023—also did not come to pass. After Russia exited the so-called "Grain Deal" in July 2023, there was a risk that Ukraine wouldn't be able to export its grain via Black Sea routes. However, in September 2023, Ukraine was able to establish a new Black Sea grain corridor without russian involvement and has managed to radically increase soft commodity exports since then.?

The economy demonstrated resilience in 2023

Adjusted for territorial, labor, and capital losses, the Ukrainian economy is reaching pre-war levels

Ukraine’s economic potential has decreased approximately 21-23% as a result of the russian invasion as:?

• About 19-21% of its pre-war population has left the country or lives in areas currently not controlled by the government.
• About 11.5% of its pre-war territory is currently occupied and another 9-10% is located in high-risk areas vulnerable to the aggressor's artillery.
• Among the biggest damages, Ukraine has lost over 40% of its steel production capacities and over 25% of its power generating capacities. Also, its port and railway infrastructure is functioning at less than half of pre-war levels.

In 3Q23, Ukraine’s real economy decreased by 23% compared to 3Q21, thus demonstrating substantial resilience. That means that despite the surge in security risks, the economy has managed to recover most of the supply chains that had been damaged by the war.

Among the most resilient components is consumer demand for non-durable goods. This demand, fueled by increased budget outlays (including payments to soldiers), has gone on to boost the recovery of retail trade to nearly pre-war levels in 3Q23, as well as supported output of non-durables.?

Taking into account Ukraine’s increasing investments in the defense sector, it is expected that machinery will be the next sector to recover rapidly in the near future. Meanwhile, the production of steel and iron ore (which used to be among the biggest export items before the russian invasion), collapsed due to an inability to export hard commodities by sea. That said, it does have the potential to recover once Ukraine manages to establish a fully functional sea corridor for all export items, as it did for soft commodity supplies in 2023.

2024 economic outlook

Official forecasters foresee over 3.5% growth

Ukraine’s state budget for 2024 has been approved based on the assumption of 4.6% YoY growth of real GDP — and this is the most aggressive estimate of economic growth among official forecasters. Meanwhile, the International Monetary Fund assumes Ukraine’s economy will grow by 3% to 4% this year. Other reliable sources provide their economic growth estimates in the same range.

The predictions for Ukraine's 2024 GDP vary widely, just like the 2023 estimates, showing a lot of uncertainty about the country's recent economic performance.

As explained above, Ukraine’s economy has restored its position to nearly pre-war levels, if adjusted for capital and labor losses. As such, 2024 growth will be smaller than in 2023, unless russia fully withdraws its forces from the country this year. That said, it is expected a realistic range of economic recovery in 2024 between organic growth by 1-2% and an increase of up to 5% if Ukraine is able to fully restore sea routes for hard commodities exports soon.

The key driver of economic growth will be a further increase in consumer demand, which is mostly based on high budget outlays for military and social needs.

A key risk for these forecasts is whether Ukraine gets enough foreign financial aid, which made up about 24% of its GDP in 2023. If the planned support of around $35-37 bn isn't enough, Ukraine's economic growth will be less strong.

Real 2023 and 2024 GDP estimates

State Budget

Defense expenditures rise 7x, with domestic sources covering about 40% of budget outlays in 2H23

Ukraine has had to significantly raise its security and defense expenditures, while limiting all other costs since 2022. A surge of defense-related expenditures by roughly 7x in 2H23 as compared to 2H21 cannot be covered by Ukraine’s domestic sources (e.g. income taxes and domestic loans). Therefore, nearly 60% of Ukraine’s budget outlays is being financed by external sources: financial loans, grants, and foreign military support (categorized as "other incomes" of state entities).

The current level of non-defense outlays of the state budget is about $3.0bn per month, which is fully covered by domestic sources of budget revenue (about $3.3bn). In order to increase domestic tax collections, Ukraine returned pre-war tax rates for business in July 2023 and introduced an additional taxation on its profitable banking system.

Domestic loans covered the maturity of local debt by 170% in 2H23, becoming an important source of financing military expenditures.

Nevertheless, Ukraine needs about $3.5bn of international financial assistance every month—and about the same amount of military assistance—to balance the budget, comply with its external debt obligations? and invest in a tangible military success.

Financing the Budget Gap

International support is no more regular, uncertainty for 2024 persists

Since mid-2022, the American government has been a key supporter of Ukraine–providing massive financial grants.?

From November 2022 to July 2023, international financial support became regular, with at least $2.8bln provided monthly from the U.S. (grants of $1.3bn per month, on average) and the EU (€1.5 bn loans monthly).

The American support has become irregular starting August 2023, which has resulted in a decline of total international financial aid for Ukraine since then.

Total international financial support amounted to $42.6 bn in 2023 (after $31.1bn in 2022).?

In 2024, Ukraine’s budget will need about $35-37 bn of international financial support—the sources of which are yet to be secured.?

Among the potential providers of financial assistance in 2024:?

• The U.K., Japan and Canada could collectively provide $4-5 bn (after $3.4bn in 2022 and $6.4bn in 2023).
• The IMF foresees $ 5.4bn in financing this year.
• The EU could provide up to €18bn, according to the government's most optimistic plans, but is more likely to provide about €12-15bn.
• The U.S., according to the IMF forecast, could conservatively provide $8.5bn (up to $11bn in the best case scenario).

Trade balance

Deficit is narrowing on recovery of food imports

Ukraine’s trade balance has undergone significant changes since February 2022:

• The blockade of sea routes in early 2022 caused a sharp decline in exports of food, steel (metals) and iron ore (mineral products). With the opening of a grain corridor in July 2022, food exports have recovered. At the same time, supplies of steel and iron ore remained depressed.?
• IT services became the second-largest export item since March 2022, replacing metallurgical exports.
• Massive outflow of refugees resulted in a surge of "imports of travel services" (spending of refugees abroad), which has become the biggest import item in 2022 and early 2023. The latter "import item" has stayed at around $1.3bn over the last six months.
• Since June 2023, machinery has become the biggest import item, with current import levels comparable to pre-war figures.

In April-July 2023, food exports were on a downward trend; by that time Ukraine had already exported most of its carryovers from the 2021 bumper harvest and the country faced new export challenges, including grain corridor interruptions. However, food exports began to recover with the August harvest and the new Black Sea corridor in late September. Increased food exports in November resulted in a narrowing of Ukraine’s trade deficit to $2.7bn, from the level of $3.5bn observed in the previous four months. In December, food exports were increasing 32% month-to-month.

Gross NBU reserves

At a safe level, thanks to ample international support

Ukraine’s gross international reserves increased in March-July as the NBU intervened to keep the UAH/$ rate stable (amounting to approx. $2.0bn per month) and government spending on debt? (using up to $1.0bn monthly) was offset by over $4.0bn monthly receipts of foreign currency in the form of international loans and grants.?

In August-November, the NBU’s reserves were shrinking as its ForEx interventions increased (to $2.7bn, on average) on the wider trade deficit, while international financial assistance fell (to $2.3bn, on average). However, in December, Ukraine received over $5.2bn in international support, and as such,? its gross reserves increased to a level that exceeds 5.5 months of future imports ($40.5bn). As a result, the 2023 annual increase of gross reserves was $12.0bn, or 42%.

Notably, since the russian invasion, gross reserves have consistently been at a safe level of over three months of future imports.

The most important step in curtailing demand for foreign currency since the russian invasion was when the NBU introduced tough control on capital flows. The postponed demand for hard currency withdrawal related to loan servicing and repatriation of dividends is increasing, which threatens enormous foreign currency outflow (up to 1/3 of the current level of gross reserves) once the restrictions are lifted.?

Exchange rate & ForEx market

The NBU allowed hryvnia to devalue?

In early October 2023, the National Bank decided to move away from fixing the UAH/$ rate that it had implemented in the first hours of russian invasion. Instead, it introduced a policy of "managed flexibility" of the rate. In the environment of a structural deficit of foreign currency, this policy still assumes heavy interventions of the NBU to keep the ForEx market balanced.?

The National Bank committed to a "currency stability" strategy, meaning the devaluation of the hryvnia will be low enough to keep UAH deposits in the banks (yielding 10%-12% after tax for 12M) more profitable than investments into cash dollars. In December, when demand for cash dollars was peaking seasonally, the NBU allowed for a 4.3% devaluation of the hryvnia to UAH 38.0/$.

It is expected that the NBU will keep the current dollar exchange rate for most of 2024, allowing for some appreciation of the hryvnia in the first half of the year and some depreciation closer to the year’s end. That said, it is expected the NBU to remain committed to its "currency stability"? policy in 2024.

Consumer prices

A bumper harvest and tight monetary and exchange policy led to sharp deflation

After peaking at 26% YoY in October 2022, consumer inflation lost momentum and began to rapidly decline in February 2023. In November, CPI slowed to 5.1% YoY —, its lowest level since the russian invasion.

Food prices, the biggest component of the consumer basket, have been steadily declining since November 2022, which is mostly a result of weaker global soft commodity prices and a strong 2023 harvest in Ukraine. Other important factors of rapid deflation were a tight monetary policy and optimistic expectations for a stable hryvnia.

Meanwhile, a one-off 70% increase in household electricity rates since July 2023 has been contributing to inflation. Notably, other regulated utility prices (natural gas, heating, water) have been fixed since the beginning of the russian invasion. Such capped regulated prices, therefore, are accumulating their inflation potential.

In 2024, consumer inflation is expected to speed up, primarily to be fueled by increased hryvnia devaluation expectations.?