ICU Weekly Insight: July 11, 2022 – NBU reserves decline notably in June

Bonds: Activity in local bond market remains low

Last week, the Ministry of Finance was only able to borrow Hr 128m. Turnover on the secondary market also remained very low.

At the primary auction held Tuesday, July 5, the Ministry of Finance invited bidders to disclose their desired interest rates for Hr-denominated bonds. This occurred for the first time since the NBU increased the key policy rate to 25%. Therefore, the vast majority of bids were submitted at rates significantly higher than what the Ministry of Finance is ready to pay.

As a result, less than 5% of demand was satisfied, and so the vast majority of bonds were sold under non-competitive bids. See details in the auction overview.

Activity on the secondary market also remains low. Trading in hryvnia bonds increased by 26% and remained below Hr 0.5bn. A total of 6,606 deals were concluded, which is just 581 more than the week before.

The most stable investors, who have been steadily amassing investments in military bills, are individuals. They increased their portfolios by Hr 348m, but this is still significantly less than in May. Last Tuesday, foreigners bought slightly less than individuals, just Hr 223m. Banks reduced their portfolios by Hr 1bn, and non-banking institutions increased their investment in military bonds by just Hr 59m.

ICU view: The market expects that the Ministry of Finance may respond to participant’s demands after they disclosed their desired rates last week. Therefore, if yields do not increase, any significant demand for military bills is highly unlikely. The Ministry of Finance probably plans to compensate for the low volume of Hr-denominated instruments by placing FX-denominated securities. They will be offered on July 12 with three tenors ranging from three to 11 months.

Insufficient volumes of market borrowing can again be compensated via direct sale of military bonds to the NBU at a floating interest rate

Bonds: Eurobonds prices approaching minimum

Last week, the prices of Ukrainian Eurobonds continued to fall and came close to their early-March minimums in response to a series of news stories.

On the one hand, last week, a Ukraine-dedicated conference was held in Lugano, where a plan for economic recovery was presented. A joint commitment by Ukraine’s allies was made to support Ukraine on its road toward recovery after Russia’s aggression.

On the other hand, rumours about the possible restructuring of Ukraine’s external debt continue to do the rounds on the market. Rumours were reinforced by Naftogaz’s announcement that the company is currently assessing its liquidity and operational needs. Holders of the company’s bonds, due to be redeemed as early as next week, interpreted the announcement as a signal of a potential debt restructuring. This news was taken extremely negatively, and just like a few weeks ago, Naftogaz assured investors that the repayment of Eurobonds would be made on time and in full. Although Naftogaz Eurobonds are not covered by state guarantees, the possible restructuring of the company’s debt will send a clear and near unambiguous signal that sovereign Eurobonds, including the Eurobonds due in September of this year, are also in line for restructuring.

Against the backdrop of a practically unchanged situation on the battlefield, the pressure on the prices of Ukrainian Eurobonds has increased. By the end of the week, prices mostly fell to 21‒23 cents per dollar, close to their lows recorded in early March after Russia’s full-scale invasion. Only bonds maturing in September are significantly above their March levels, at nearly 48 cents on the dollar.

ICU view: Investors largely expect that rumours may materialize, and the government will initiate formal negotiations with bondholders. As we indicated in the review of pros and cons of restructuring, developments around Naftogaz Eurobonds set the mood for the market last week and will remain indicative of government’s intentions to restructure sovereign debt.

FX: Hryvnia weakening again

During the past week, the hryvnia exchange rate against the US dollar weakened again both for cash and card transactions.

Last week, Privatbank, followed by several other banks, increased their rates for card transactions, bringing them closer to the exchange rate on the cash market. Meanwhile, the exchange rate on the cash market weakened too.

The average exchange rate for card transactions weakened from Hr 30.1‒32.9/$ to Hr 31‒33.6/$, and the exchange rate on the cash market weakened from Hr 34.9‒35.6/$ to Hr 35.3‒36.1/$.

In the interbank market, demand for hard currency also remains high, and the NBU had to sell almost $1bn of reserves again last week. Moreover, almost half of this volume was sold on Tuesday, July 5, when the market closed deals delayed from Monday, July 4 due to Independence Day in the US.

ICU view: The NBU expected that the reintroduction of import taxes and duties might weaken demand for hard currency. Unfortunately, these expectations have not materialized so far. Meanwhile, cash hryvnia started to weaken again last week probably driven by hikes in exchange rates on card transactions by the largest banks. All these factors combined implies that the expectations of gradual hryvnia depreciation will be reinforced. We, therefore, expect a turbulent FX market this week.

Economics: Inflation jumps to 21.5% in June

Annual inflation accelerated notably in June and reached 21.5%, up from 18.0% in May. Core CPI accelerated to 15.2% YoY from 13.8%.

The MoM inflation reached 3.1% as food prices continued to accelerate and contributed nearly 1.4pp to monthly inflation. The growth in prices for food staples was broad-based and is largely a reflection of increasing producer input costs. Transportation was the second most significant inflation driver and contributed about 1.0pp to monthly inflation as fuel prices surged 21.3% MoM and 90.9% YoY.

ICU view: A surprisingly large acceleration of inflation in June implies the end-2022 CPI may be closer to the upper bound of our end-year CPI projection range of 25-30% YoY. Inflationary pressures in Ukraine remain high due to growing producer costs and significantly more expensive transportation. We expect inflation will remain high, in the range of 25-30%, as the economy will be adjusting to hryvnia depreciation and energy price shocks over the next 18-month horizon.

Economics: NBU reserves continue to decline at an alarming rate

The NBU gross international reserves fell 9.3% in June to $22.8bn, following a 6.8% contraction in May.

Heavy NBU interventions drove the decline of the reserves – the central bank had to sell almost $4.0bn to meet the excessive demand in the FX market. The reserves were supported by the government borrowings in the amount of $2.8bn while the government and the NBU jointly made $1.0bn payments on their FX debts.

ICU view: The pace of decline of NBU reserves is alarming. The need for sale interventions by the NBU has been much larger than we expected so far. Meanwhile, the inflows of international financial aid remain far below what is needed to maintain the central bank reserves flat. The significant and persistent FX market misbalances strengthen the case for a managed hryvnia depreciation. The NBU has so far not provided any indication about when this might happen.

RESEARCH TEAM: Vitaliy Vavryshchuk, Alexander Martynenko, Taras Kotovych

Complete report here  (8 pages, 366KB)