2020 started with the Ukrainian fixed income market seeing large demand from international investors. But with the COVID-19 pandemic foreigners began to withdraw funds from hryvnia denominated bonds. However, the end of 2020 saw a return of their interest to UAH debt. Konstantin Stetsenko, co-founder of ICU, an independent asset management, private equity and investment advisory firm specialising in the emerging markets of Central and Eastern Europe, believes that in 2021 foreign investors will increase their exposure to UAH government debt, but in volumes much lower than in 2019.
From the peak of UAH128bn (US$5.3bn at market exchange rate) in February 2020, foreigners’ portfolios fell to UAH75bn (US$2.6bn) at the end of November 2020. Their bonds were partially redeemed and some were sold to locals, Mr. Stetsenko explains.
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Thus, in 2020, Ukrainian banks increased portfolios of UAH bonds by UAH166bn (US$5.9bn), and became the largest bond holders with 48% in total outstanding. Abundant banking sector liquidity, the National Bank of Ukraine (NBU) lowering interest rates, and the ability to receive NBU refinancing loans at the key policy rate fuelled demand for local bonds, as since the end of August.
Meanwhile, already in December, foreigners started to return to Ukrainian bond market. During the last month of the year, their holdings of UAH bonds grew by UAH10bn (US$0.4bn), and the purchases continued in January.
The underlying reasons are resilience of Ukrainian economy and currency to corona crisis amid a gradual increase of bond rates by Ukraine’s Ministry of Finance (MoF) in recent months.
In November, all rates in the primary market jumped to double-digit levels as the MoF struggled to fill its coffers in advance of December expenditures. “Sizable financial needs and the lack of demand from foreign investors in previous months resulted in a high premium to the NBU key policy rate”, says Mr. Stetsenko. In December and at the beginning of January, this premium was from 400 bps for three-month bills and up to 615 bps for instruments with 3.5-year maturity.
In 2021, taking into account sizable debt redemptions, Mr. Stetsenko estimates that the MoF will issue c.UAH350bn of UAH-denominated bonds compared with the UAH251bn the government was able to borrow via UAH bonds in 2020. “That is quite an ambitious target, but still lower than envisaged in the budget,” says Mr. Stetsenko. Moreover, to borrow this amount next year, the government has to find out how to incentivise banks to purchase larger amounts of bonds and to make them more attractive to foreigners.
The demand from foreigners for bonds will be the most important factor, according to Mr. Stetsenko. In the global low-yield environment, the current interest rate provides foreign investors with a quite attractive risk-reward ratio, especially taking into account declining expectations for depreciation of the UAH. Thus, Mr. Stetsenko expects that in 2021 foreigners will increase their exposure to UAH government debt, however in volumes that are much lower than in 2019.
This will offset the impact from the sizable financial needs of the Ukraine government and keep the spread between yields and the NBU’s key policy rate relatively steady or even narrowing. Mr. Stetsenko expects that in the primary auctions rates for bills with one-year maturity will fluctuate in the range of 11 – 12% during 2021. Meanwhile, the term premium will remain elevated, therefore he projects yields for the two-year bills in the range of 12– 13% by the end of 2021. Additional underlying reason for this slight increase in yields is the expected hike in NBU’s key policy rate by 100 bp to 7% during 2021.
External sources will also continue to play important role in covering sizable financial needs of the government. As the IMF programme gets back on track, Mr. Stetsenko expects that major undisbursed official financing will be received in 2021. He predicts that c.US$3bn can be provided by the IMF, World Bank, EBRD, and EU. In addition, US$3bn can be borrowed from commercial sources. “That will allow the government not only to smoothly meet the period of large external debt repayments that peak in September, but also to use the FX funds it receives for covering domestic payments,” says Konstantin Stetsenko.
In addition, the private sector should also accelerate its efforts in the acquisition of foreign debt and investment capital, which almost disappeared in 2020, according to Mr. Stetsenko. “Looking ahead, we predict against the background of positive news about the vaccines and Biden’s victory in the US presidential election that the appetite of foreign investors for emerging markets assets will sharply improve,” says Mr. Stetsenko.
However, the net capital inflows to private sector will be lower than before the pandemic, according to Mr. Stetsenko. “Due to post-pandemic uncertainty, we expect that the private sector will behave more cautiously, and inflows of investment and debt capital will be rather moderate, below pre-pandemic amounts,” he adds.
Mr. Stetsenko predicts that an increase of foreign assets will slow sharply as the accumulated amounts will be spent more actively on imports and foreign tourism this year. Overall, however, net capital inflows will become positive again and reach US$5.6bn. Due to the resilience of Ukrainian external accounts to pandemic effects, in 2020 the current account surplus exceeded capital outflows marginally, compared with a balance of payments (BoP) surplus about US$3bn on average during 2016 – 19. “In 2021, we expect the return to a US$3bn BoP surplus amid recovering capital inflows. Factoring in disbursements from the IMF, we project further growth of reserves to US$31bn. As a result, they should exceed 100% of the IMF Aggregate Reserve Adequacy metric for the first time since the global financial crisis,” comments ICU’s cofounder.
In the short-term, Mr. Stetsenko see the FX risk balance tilting to the upside as resurging COVID-19 cases may slow consumption recovery and bring back additional constraints on foreign travel. That said, downside risks are also high and stem mainly from surging fiscal payments and high devaluation expectations. “In 1H21, UAH is likely to moderately strengthen, supported by exporters’ higher activities and larger inflows of external capital amid improved domestic sentiment. In 2H21, the market balance should tilt towards more UAH depreciation pressure from an expanding current account deficit,” Konstantin Stetsenko explains.
The medium-term fundamentals provide evidence of potential real appreciation of Ukrainian’s currency, says Mr. Stetsenko: “First of all, the main arguments are solid external accounts represented by a large current account surplus this year (and still low and sustainable current account deficit next year), and improved reserves position over the last five years. Second, public finance metrics exceed those of most peers. And last, but not least, improved global sentiment towards EMs provide the basis for UAH real strengthening.”
In terms of his global outlook for 2021, Mr. Stetsenko is expecting a sharp recovery of the domestic economy, which will be primarily driven by external demand against the background of improving the pandemic situation through vaccination, especially in developed countries.