ICU Weekly Insight – Monday, June 6, 2022: National Bank Hikes Key Interest Rate to 25%

Bonds: Hryvnia bond market looks to reboot

The recent decline in borrowings and a sharp increase in the NBU’s key policy rate may lead to a reboot of the military bonds market very soon.

Last week, the Ministry of Finance attracted only Hr 3.1bn for the state budget, of which just Hr 2.6bn was in local currency.

At the same time, one of the two two-month bonds offered last week was not military and, thus, cannot be resold on the secondary market.

See the details in the auction review.

According to the NBU, foreigners bought a small portion of bonds in the primary market, increasing their combined portfolio by almost Hr 50m for the first time in three weeks. Most likely, they bought non-military paper.

At the same time, the total volume of hryvnia-denominated bonds traded on the secondary market declined to Hr 0.9bn. The main reason was expectation ahead of the NBU Board meeting and a revision of the key policy rate for the first time since the beginning of the full-scale invasion by Russia.

ICU view: The NBU’s decision to raise the key policy rate to 25% (see comment below) came as a surprise to the Ministry of Finance. It decided not to react immediately and announced that interest rates at the primary auction on Tuesday, June 7 will remain unchanged. Thus, the primary auction on June 7 will reveal the readiness of banks and other investors to maintain their demand.

We think that the bond market is waiting for a reboot following the NBU’s decision. Most likely the cost of new borrowings will increase soon. The Ministry of Finance will have to find a new level of interest rates that is acceptable to both investors and the budget.

Interest rates on short-term bills can rise close to the key rate, while longer maturities can react less significantly as investors expect that NBU may start decreasing its key policy rate later this year or at the beginning of the next year.

Therefore, it will take some time for the market to decide where new fair yields for longer maturities might lie.

The yield curve will, thus, become inverted.

Bonds: Eurobond prices stabilize

Information from the front did not change much last week, which led to a further moderate decline in Eurobond prices. In general, the prices of Ukrainian Eurobonds were little changed on the week, fluctuating near the level of the previous Friday. Mostly, the decline was less than one cent. Only VRIs have risen by almost one cent to nearly 38 cents.

ICU view: The lack of important positive news is dampening the interest of investors in Ukrainian Eurobonds. They will continue to closely follow  information about the hostilities and assess the prospects for a change in the situation on the frontline.

FX: Hryvnia cash exchange rate stabilizes

Last week, the hryvnia’s cash exchange rate stabilized and even strengthened somewhat after fairly significant volatility observed immediately after the NBU lifted the ceiling on the maximum exchange rate allowed for retail clients.

The hryvnia cash exchange rate in banks appreciated on average from Hr 35.3‒36.5/$ a week ago to Hr34.6‒35.8/$ last Friday. However, the exchange rate for card transactions remained almost unchanged in the Hr 30‒33/$ range.

ICU view: The FX market is gradually getting used to the new conditions and has found a relative temporary equilibrium. The hryvnia exchange rate should remain close to current levels with small fluctuations in the absence of negative news.

Economics: NBU increases key rate by 1,500 bps

The NBU has decided against maintaining the key rate unchanged at 10% throughout the war and raised it to 25% in order to tackle the inflation and stabilize market FX rate. The magnitude of this decision came unexpectedly as the market anticipated a much more modest rate hike. The regulator expects interest rates on Hr government bonds and deposits to increase in order to prevent economic agents from converting local currency into FX and reduce consumption. Interest on NBU CDs will be 23%, while interest on refinancing loans will be 27%.

ICU view: Such a drastic move indicates the seriousness of the situation in the economy, which is yet to live through the lengthy war. This decision creates challenges for the Ministry of Finance, which now will have to increase the yields on its bonds. Should they go for a substantial rise in yields, it will encourage larger demand from both individual investors and corporate sectors. Banks will enjoy a greater interest income on CDs and are likely to engage in price competition for the deposits. However, the amount of liquidity is going to shrink as banks will be repaying loans with floating interest rates that they obtained from the NBU during the COVID crisis.

Economics: Ukraine’s public debt broadly unchanged YTD

In March, Ukraine’s public debt increased by 0.8% MoM to an equivalent of $97.6bn, but this is marginally below the end-2021 level of debt. Local debt was up 4.3% MoM, and the growth was mainly driven by Hr 50bn worth of bonds that the NBU directly purchased from the government. External debt was slightly down, as the amount of new foreign loans was relatively small in April compared to March.

ICU view: We estimate the debt also remained little changed in May, but it is likely to start to grow significantly in June largely on new external borrowings. The average monthly increase in public debt till the end of 2022 may be up to $2.0-3.0bn, as G7 countries started gradual disbursement of their $19.8bn aid package (about 60% of it is reportedly in the form of loans), and the EU is finalising its EUR 9.0bn macro-financial loan. Ukraine’s public debt is, therefore, expected to increase significantly through to the end of the year.

Economics: Current account remains in hefty surplus in April

Ukraine’s current account (CA) remained highly positive in April thanks to grants and humanitarian aid, but the financial account continues to deteriorate. Trade in goods balance turned marginally negative, as imports recovered fast narrowing its YoY decline to 46% in April vs 66% in March. Exports remain depressed being only half of last year’s volumes.

Trade in the services balance turned hugely negative since March and remained such in April, the key explanation being an upsurge in expenditures of Ukrainian refugees abroad.

Migrant remittances (a component of primary income) are holding up fairly well and were down by only 15% YoY. The largest positive contributor to the CA surplus was grants from foreign governments and humanitarian aid.

Overall, Ukraine’s CA surplus came to $1.1bn in April and $1.6bn over the 12 months to April.

In the meantime, net capital outflows reached $1.9bn in April, driven by capital flight from the private sector. The largest contributor was the build-up of trade credit, as Ukrainian exporters delayed the transfer of revenues, and importers made prepayments for future imports.

The second most important contributor to capital outflow was the withdrawal of FX cash by Ukrainians abroad from their hryvnia card accounts.

The total amount of such operations increased to $1.0bn in April from $0.9bn in March.

Net capital inflows to the state sector were positive thanks to new loans from Ukraine’s international partners.

ICU view: April’s numbers show rapid recovery of imports, which we expect to continue in the coming months. We, therefore, expect the trade balance to continue deteriorating through till the end of 2022.

Still, the CA will remain in surplus thanks to generous grant support provided to Ukraine by foreign governments. Such support is going to be upscaled in the coming months.

Financial aid from foreign governments and IFIs in the form of loans will also support Ukraine’s financial account.

The latter, however, will remain negative as capital flight from the private sector continues despite strict capital controls imposed by the NBU since the start of the war.

To date. significant misbalances in external accounts caused by the war have been largely compensated by international financial aid. This situation is hardly sustainable and the authorities may be forced to let the hryvnia exchange rate also play its role in balancing the market.

It is worth noting, as a side comment, that the overall quality of the trade in goods balance remains quite poor due to gaps in import registration procedures.

Balance of Payments data should, in that respect, be interpreted carefully.

RESEARCH TEAM  Vitaliy Vavryshchuk, Alexander Martynenko, Taras Kotovych, Mykhaylo Demkiv

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