Highlights. debt markets. manufacturing industries. season. Ukraine: Key economic figures and forecasts. Real Sector e 2013f 2014f

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1 April 213 GDP growth and inflation Highlights Rapprochement with the IMF is conditional on Ukraine s access to the global debt markets. 1 Industrial output fell by.2% yoy in March amid the slump in the - -1 manufacturing industries. Accelerated capital inflows supported Ukraine s external accounts in February GDP (% yoy) f 214f Local FX market currently exhibits low volatility thanks to robust FX supply and diminished depreciation expectations. The first hiccup this year might be due Inflation (eop, % yoy) in May as FX demand is expected to elevate amid dividend repatriation Source: State Statistics Committee, Raiffeisen RESEARCH season. Ukraine: Sovereign ratings LCY rating S&P Moody's Fitch Long-term B B3 B Short-term B Outlook Negative Negative Stable FCY rating Long-term B B3 B Short-term B B Outlook Negative Negative Stable Latest assessment Source: Thomson Reuters, Cbonds Ukraine: Key economic figures and forecasts Real Sector e 213f 214f GDP (UAH bn) GDP (USD bn) GDP (% yoy) Domestic demand (% yoy) Terms of trade (% yoy) CPI (avg, % yoy) CPI (eop, % yoy) PPI (eop, % yoy) Real disposable income (% yoy) n/a n/a Analysts Dimitry Sologoub dmytro.sologub@aval.ua Olga Nikolaieva olga.nikolaieva@aval.ua External Sector C/A Balance (% of GDP) FDI (USD bn) Monetary Sector Base money (% yoy) Broad money (% yoy) , USD/UAH (eop) USD/UAH (avg) EUR/UAH (avg) Fiscal Sector Fiscal balance (% of GDP) Public debt (% of GDP) Source: State Statistics Committee, National Bank of Ukraine, Ministry of Finance, Raiffeisen RESEARCH 1

2 -year CDS (bp) Jan-12 May-12 Sep-12 Jan-13 Source: Bloomberg Ukraine sovereign yield curve Ukraine 1Y 2Y 3Y 4Y Y 6Y 7Y 8Y 9Y 1Y Latest ( ) 2M ago ( ) 4M ago ( ) M ago ( ) 9M ago ( ) Source: Bloomberg Russia, r.h.s Industrial output growth by sector (% yoy) Hungary Poland, r.h.s Jan-Mar 12 to Jan-Mar 11 Jan-Mar 13 to Jan-Mar 12 Economic Policy Benefiting from improved market access, the Ukrainian authorities are not in a hurry to cut the new deal with the IMF. The second IMF mission visit to Kyiv this year did not bring visible result again. The official IMF press-release mentions productive discussions and good progress, and states that dialogue will continue in the coming weeks. Little detail has been provided on the essence of negotiations, except one-sentence message that the new programme would be based on measures to reduce Ukraine s fiscal and external deficits, implement energy sector and banking reforms. Looking back at autumn 212 it seemed obvious that the authorities will have to implement a set of policy measures to tackle mounting economic vulnerabilities right after the end of parliamentary election campaign. However, it has not been the case so far: benefiting from the diminished FX depreciation expectations and improved access to the global debt markets, the authorities are still sticking to the policies, which proved largely successful in In particular, the exchange rate peg at around USD/UAH 8 is maintained by a mix of administrative and market methods, such as restrictions on FX market operations, import-curbing measures (i.e. special import car duty, foreign drug licensing, quotas on coal imports) and new external borrowings to prop up FX reserves. Fiscal stability is backed by alleged debt monetization by the central bank and increasing tax pressure on businesses. We explain current policy stance by the increasing focus on the next presidential elections in early 21. The administration would like to maintain fiscal and external stability and revive economic growth without resorting to unpopular measures (aka tariff hikes) or surrendering political and economic independence (aka joining the Russia-led Customs Union). Therefore, the authorities currently look extremely reluctant to succumb to key IMF demands, like gradual adjustment of domestic gas and heating tariffs to cost recovery levels (including large-scale upfront hike), introduction of greater exchange rate flexibility and reduction of budget deficit to 3% of GDP in 213. Plus, the new growthenhancing measures, namely boost in state guarantees provision and establishment of state-owned development bank, are not likely to be supported by IMF. The success of such strategy is conditional on the economic environment: if Ukraine continues to be able to raise financing in the global markets and, possibly, gets a lower gas price from Russia (in exchange for bilateral gas transit consortium), the authorities will likely prefer sticking to the muddling through approach. The things look good for the Ukrainian authorities at the moment. Total Eurobond issuance (by the sovereign and corporates) amounts to over USD bn year-to-date as the global liquidity glut (further enhanced by latest monetary actions by Bank of Japan) fuels the appetite of yield-hungry investors for high-risk EM credit. Also, the government raised USD 2. bn so far this year via the placement of domestic FX bonds, thus successfully tapping excess FX liquidity of the local banking system. As a result, the authorities smoothly met first repayment peak this year (around USD 3 bn of sovereign external debts have been repaid in Q1 213) and are hoping to raise more FX funds (both domestically and abroad) until the end of 213 to meet outstanding redemptions of nearly USD 7. bn. Therefore, we now expect the deal with IMF to be secured only when Ukraine loses access to the debt markets (albeit, there is a still a tiny chance that IMF steps back from its key demands and would be more flexible dealing with Ukraine). Unless it happens, muddling through remains the name of the game. In the more distant perspective, given the deteriorating economic fundamentals, deepening structural problems and increasing political risk, this short-sighted approach clearly increases the vulnerability to and risk of major economic fallout. Source: State Statistics Committee

3 Inflation (% yoy) Jan-8 Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 CPI Food prices PPI Source: State Statistics Committee Real Economy Industrial output fell by.2% yoy in March amid the slump in the manufacturing industries. Slight improvement (from -6.% yoy in February) is primarily attributed to the turnaround in the energy sector performance: output growth reversed from the fall of 17.2% yoy in February to.% yoy growth last month amid unusually cold weather and heavy snowfall in March. On the other hand, manufacturing output fall deepened to 9.3% yoy (compared to -.6% yoy in February). Almost all manufacturing industries posted poorer results, which only partially can be explained by adverse weather conditions. The worst performers were chemical industry (-23.% yoy), machine building (-2.3% yoy), oil processing (-14.7% yoy) and steel output (-7.% yoy). Mining output growth remained slightly positive (.% yoy) driven by 3.3% yoy increase in metal ores extraction. Cumulative industrial output in Jan-Mar fell by.% yoy. Inflation Balance of payments (USD bn) Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Consumer price inflation continues to rock the bottom. CPI has been flat in mom terms in March, 12-month growth rate stands at -.8% yoy as of end- March. Food price deflation persists.3% mom decline in March, -3.2% in yoy terms. Utility tariffs went down by.2% last month amid.8% fall in hot water and heating tariffs. On the other hand, alcohol and tobacco prices were the fastest growers in March (1.7% mom). Transport prices grew.% mom, driven by 4.1% mom price hike in railway transport services, while fuel prices increased marginally by.3% mom. Producer price growth accelerated to 2.2% mom in March (compared to -1.3% mom in February). The main reason for this is the sharp reversal in energy prices (9.3% mom growth after 8.9% drop in February), following 1% hike in electricity tariffs for wholesale customers. Manufacturing prices stagnated in March (.1% mom, -.3% yoy), while mining prices declined by.3% mom (-9.2% yoy). Annual (end-of-period) PPI growth accelerated to.2% yoy as of end-march. External Sector Current Account Financial Account Balance of Payments Gross external debt (USD bn) Dec-3 Dec-4 Dec- Dec-6 Dec-7 Dec-8 Dec-9 Dec-1 Dec-11 Dec-12 Public sector (incl. NBU) Banking sector Real sector Accelerated capital inflows supported Ukraine s external accounts in February. Balance of payments surplus increased from USD.4 bn in January to USD 1.3 bn in February thanks to the massive capital inflows. In particular, USD 1 bn sovereign Eurobond placement, continued debt inflows into the corporate sector and spike in unclassified capital flows (its nature looks uncertain, albeit we saw similar trend in the same period in the previous years) propped up the capital account in February. Its surplus ballooned from USD 319 mn in January to 2264 mn. Current account has visibly deteriorated compared to January, following traditional seasonal pattern (i.e. the rebound in imports after the holiday season) - the surplus of USD 78 mn turned to the deficit of USD 967 mn. However, in yoy terms C/A deficit shrank by 4% in February thanks to the robust growth in agricultural exports (31.% yoy, improving total export growth rate to 8.1%) and slump in energy imports (-39% yoy). The latter tendency should be (at least) partially attributed to much warmer weather in February this year. As a result, import declined by 7.% yoy. Cumulative balance of payment surplus reached USD 1.7 bn in Jan- Feb 213, which is much better than the deficit of USD.9 bn for the same period last year. The acceleration in debt inflows (from USD 371 mn in Jan-Feb 212 to 1339 mn this year) led to the dramatic improvement in capital account balance (from USD. bn to 2.6 bn), despite lower FDI inflows (4% yoy decline). Plus, the current account deficit declined from USD 1.4 bn in Jan-Feb last year to USD.9 bn in Jan-Feb 213. At the same time, we do not deem the latest improvement in external accounts as sustainable. In particular, imports are expected to surge in March as unfavourable weather conditions stimulated the increase in energy imports, plus car imports reportedly went up by a large margin in anticipation of hike in car import tariffs. Also, the direction of capital flows 3

4 UAH exchange rate Jan-12 May-12 Sep-12 Jan-13 USD/UAH EUR/UAH (r.h.s.) Source: Bloomberg might reverse quickly in case of deterioration in global sentiment for EM assets. Therefore, we continue to pencil in only minor improvement in C/A deficit this year and still believe that certain exchange rate realignment (up to 1%) is necessary to balance the external accounts. Ukraine s external debt amounted to USD 13 bn (76.6% of GDP) as of end-212. Last year external debt went up by USD 8.8 bn, albeit was almost flat in terms of GDP (slightly down from 77.3%). Surging external debt of the corporate sector was the major driver of increasing external indebtedness. It went up by USD 13.6 bn in 212 (to USD 81.3 bn). As we discussed before, short-term trade loans and significant (originally Ukrainian) capital flows from offshore locations play important role in external debt inflows into the corporate sector. In addition, USD 2.1 bn of the total amount has been raised under the state guarantees. The public sector external debt (incl. NBU) fell by USD 1.2 bn in 212 (to 32.2 bn). On the one side, the improvement in market sentiment allowed the sovereign to return to the global debt market in mid-212 and raise nearly USD 4 bn in the second half of the year. On the other side, large payments were coming due last year, like IMF repayment of USD 3.7 bn, Eurobond redemption and partial repayment of VTB loan. The external debt of the banking sector continued to decline (down by USD 3.6 bn to USD 21.6 bn) in the light of the steady de-dollarization of domestic loan portfolios. In total, since the beginning of the crisis (end-sep 28), banks external debt was cut by half, while the share of the banking sector in the total external debt declined from 41 to 16%. Corporate loans dynamics Q1 211 Q2 211 Q3 211 Q4 211 Q1 212 Q2 212 Q3 212 Q4 212 Q % 1% 12% 9% 6% 3% % -3% -6% The volume of short-term external debt (expiring within the next 12 months) increased by USD 1.6 bn to 6.9 bn in 212 and comprises 4% of total external debt at the moment. Largest refinancing needs are in the real sector USD 42 bn, or 7% of total. However, given the nature of these debt inflows (see above) and historically high rollover ratios (above 1%), we do not see refinancing risk here particularly large. The banking sector has to repay USD 11.4 bn in 213, which is roughly equal to the volume of banks FX liquidity at the moment. Therefore, repayments should not be a big problem. The short-term debt of the public sector (incl. NBU) is USD 7.6 bn and the major chunk is USD.8 bn repayment obligations to IMF. The dramatically improved access to the global debt markets in Q1 213 definitely dampened the refinancing risk for the public sector, albeit the market sentiment might quickly reverse. Retail loans dynamics Q1 211 Q2 211 CO loans in LCY (qoq change, UAH bn) CO loans in FCY (qoq change, UAH bn) CO loans yoy growth, % (r.h.s.) Q3 211 Q4 211 Q1 212 Q2 212 Q3 212 Q4 212 Q1 213 PI loans in LCY (qoq change, UAH bn) PI loans in FCY (qoq change, UAH bn) PI loans yoy growth, % (r.h.s.) -2% -4% -6% -8% -1% -12% -14% -16% Monetary Policy and Exchange Rate Ukraine s FX market continues to exhibit very low volatility. The traditional end-month pick-up in FX demand and regular Naftogas FX purchases in the first days of new month drove exchange rate up to in late March, early April, but then hryvnia rebounded as usual, strengthening to the current levels of We see two main reasons for the exchange rate stabilization at the beginning of this year. First is subsided depreciation expectations the supply and demand for cash FX were almost balanced in March, while in the 1st quarter net cash FX demand from households amounted to USD 42 mn 7% yoy decline, almost 9% in qoq terms. Second is the boost in FX borrowings total Eurobond issuance (sovereign and corporate) constituted USD 3.9 bn in Q1 213 (plus, another USD 1.2 bn placement by the government in early April), while the Ministry of Finance also raised USD 2.4 bn via issuance of domestic FX bonds. Large-scale FX borrowings propped up gross FX reserves, despite the negative intervention balance. FX reserves increased by.7% ytd (USD 18 mn) to USD 24.7 bn as of end-march. NBU monthly intervention balance remains negative net FX sales of USD 38 mn in March, USD 827 mn in Q1 (3% decline in yoy terms). The step up in FX borrowings looks an important element of authorities muddling through strategy. The National Bank still seems extremely reluctant to allow more exchange rate flexibility and thus will likely cling to the currency peg at least for some time. The sustained access to FX debt market remains critical, given sovereign s large FX refinancing needs (nearly USD 7. bn for the rest of the year) and high C/A deficit. The Ukrainian FX market historically exhibits clear 4

5 Corporate deposits dynamics Retail deposits dynamics Bank loans and deposits Q1 211 Q1 211 Dec-6 Q2 211 Q2 211 Q3 211 Q3 211 Dec-7 Q4 211 Q4 211 Dec-8 Q1 212 Dec-9 Q1 212 Q2 212 Q2 212 Dec-1 Q3 212 Q3 212 Dec-11 Q4 212 Q4 212 Dec-12 Total loans (UAH bn) Total deposits (UAH bn) Loan to deposit ratio (%, r.h.s.) Q1 213 CO deposits in LCY (qoq change, UAH bn) CO deposits in FCY (qoq change, UAH bn) CO deposits yoy growth, % (r.h.s.) Q1 213 PI deposits in LCY (qoq change, UAH bn) PI deposits in FCY (qoq change, UAH bn) PI deposits yoy growth, % (r.h.s.) Mar-13 % 4% 3% 2% 1% % 3% 3% 2% 2% 1% 1% % seasonality. FX pressures are likely to elevate in May, when the multinational companies are buying FX in large amounts for dividend repatriation, and even more in Aug-Oct with the seasonal rebound in business activity, hike in energy imports and increasing FX demand from importers of consumer goods ahead of holiday season. To cope with this increasing pressure might be a non-trivial task for the central bank, given low level of FX reserves, covering less than 3 months of imports and only 4% of short-term external debt, fragile stability at the global debt markets and increasing political risk. The revival in the lending activity gradually siphons off excess liquidity of the banking system. Banks correspondent accounts fluctuated in the range of UAH bn in the first half of April, which is nearly. bn lower than a month ago and considerably below average volumes of UAH 2-28 bn, observed in Jan-Feb. Money market rates ratcheted up amid liquidity meltdown, but still remain at quite low level - 1m KyivPrime rate is currently quoted at 6%. The National Bank continued to sterilize excess liquidity from the market, though volume of mobilization operations fell from UAH 14.8 bn in February to UAH 1.2 bn in March and contracted even stronger in the first half of April. Monetary aggregates expanded in March, driven by rising cash vault and deposits. Base money grew.% mom, though yoy growth decelerated to 9.9% due to the base effect. Broad money increased by 1.% mom, bringing yoy growth rate to 1.7% as of end-march. Banking Sector CO hryvnia loan portfolio shrank unexpectedly in March, which might be explained by the idiosyncratic factors. CO UAH loans went down by UAH 4.1 bn (-1.% mom) last month, after increasing by UAH 6.2 bn in Jan-Feb. The drop in loan volume looks surprising as the market evidence instead suggests on the gradual rebound in corporate lending activity on the back of falling interest rates. Plus, the start of the agricultural season stimulated an uptick in the demand for loans in this sub-segment. Therefore, we tend to attribute this effect to some bank-specific developments (in one or few banks), possibly related to the loan conversions. In particular, the volume of CO FX loans hiked by UAH 6.7 bn (3.1%) in March well above the normal trend (in Jan-Feb CO FX loans increased by UAH 2.1 bn). PI loan portfolio increased marginally.2% mom in March,.% ytd. We have witnessed a steady increase in LCY consumer lending activity in the first quarter of 213 the volume of PI UAH loans grew 1.3% mom in March, 3.9% ytd. At the same time, PI FX loan book continued to shrink amid the near-prohibition of new FX retail lending. Total loan portfolio of the banking system increased by only 1.2% ytd, while yoy growth rate slightly accelerated from 2.% in 212 to 3.9% as of end-march. Hence, the latest lending developments are generally in line with our growth expectations for 213 (i.e. nearly 1% yoy increase in total loan volume). Large interest rate differential, coupled with subsided depreciation pressures, prompted the visible shift in PI deposit currency structure in Q PI hryvnia deposits were up by 3.4% mom in March, 11.% ytd. At the same time, FX deposits of the households dropped by.9% last month and by the same margin year-to-date. As a result, the share of LCY deposits in total PI deposits increased from % to 3% in Jan-Mar 213. Apparently, the private depositors have been actively converting FX deposits to hryvnia to benefit from (still) high interest rates as the banks have been rather cautious so far in lowering hryvnia deposit rates. The same tendency is observed in CO deposits 2.8% mom increase in LCY deposits vs 2.4% decline in FX deposits of corporates in March. Total deposits grew 1.3% mom in March, 4.1% ytd. Given sluggish loan growth, loan-to-deposit ratio slid further from 143% at end-212 to 139% as of end- March 213 and will go further south in the near future.

6 Acknowledgements This report was prepared by Raiffeisen Bank Aval on 17th April 213 Raiffeisen Bank Aval 9, Leskova Str., 111 Kyiv, Ukraine Tel Fax Call center: 8 8 (toll free within Ukraine) Research Department Head: Dimitry Sologoub ( ) Ludmila Zagoruyko ( ), Olga Nikolaieva ( ) Treasury Head: Vladimir Kravchenko ( ) FX, MM: Alexander Deinega ( ), Yuriy Grinenko ( ) Treasury Sales: Marina Lukashenko ( ), Alexander Korenev ( ), Tatiana Kornienko ( ) Securities: Sergii Shvets ( ), Alexey Evdokimov ( ), Oleg Klimas ( ), Nikolay Vysotsky ( ), Nataliia Nazarenko ( ) Multinational Corporate Customers Head: Oksana Volchko ( ) Relationship Managers: Yuliia Tatasiuk ( ), Anastasia Goncharova ( ), Lesya Byba ( ) Raiffeisen Bank International Research Team Vienna Peter Brezinschek (Head) Aaron Alber Jorg Angele Mario Annau Eva Bauer Bjorn Chyba Gunter Deuber Wolfgang Ernst Christian Hinterwallner Valentin Hofstatter Stephan Imre Christoph Klaper Igor Kovacic Lydia Kranner Nina Kukic Martin Kutny Veronika Lammer Jorg Lange Hannes Loacker Richard Malzer Andreas Mannsparth Johannes Mattner Stephan Memmer Albert Moik Christine Nowak Peter Onofrej Helge Rechberger Matthias Reith Leopold Salcher Andreas Schiller Robert Schittler Andreas Schwabe Connie Schumann Manuel Schuster Gintaras Shlizhyus Alexander Sklemin Gottfried Steindl Martin Stelzeneder Magdalena Szczepanski Jurgen Walter Albania Joan Canaj Valbona Gjeka Belarus Oleg Leontev Vasily Pirogovsky Natalia Chernogorova Bosnia & Herzegovina Ivona Kristic Srebrenko Fatusic Bulgaria Kaloyan Ganev Hristiana Vidinova Croatia Anton Starcevich Zrinka Zivkovic Matijevic Ivana Juric Nada Harambasic Ana Franin Marijana Cigic Czech Republic Jindrich Svatek Michal Brozka Vaclav France Lenka Kalivodova Hungary Zoltan Torok Adam Keszeg Levente Blaho Kosovo Fisnik Latifi Poland Marta Petka-Zagajewska Dorota Strauch Tomasz Regulski Pawel Radwanski Piotr Jelonek Romania Ionut Dumitru Nicolae Covrig Bogdan Campianu Gabriel Bobeica Ana-Maria Morarescu Alexander Combei Iuliana Mocanu Alexandru Neagu Russia Anastasia Baykova Denis Poryvai Anton Pletenev Maria Pomelnikova Pavel Papin Irina Alizarovskaya Konstantin Yuminov Sergey Libin Serbia Ljiljana Grubic Slovakia Robert Prega Juraj Valachy Boris Fojtik Slovenia Primoz Kovacic Ukraine Dmytro Sologub Ludmila Zagoruyko Olga Nikolaieva RCB Company Research Stefan Maxian (Head) Daniel Damaska Oleg Galbur Natalia Frey Jakub Krawczyk Bartolomiej Kubicki Bernd Maurer Dominik Niszcz Markus Remis Teresa Schinwald Bernhard Seilinger Jovan Sikimic Arno Supper Christoph Thurnberger Iryna Trygub-Kainz

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