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Ukraine's domestic bond market off to a strong start in 2020 according to ICU's Konstantin Stetsenko

Ukraine's bond market kicked off the year with a strong start with Ukraine raising €1.25bn of new debt at record-low borrowing costs thanks to renewed investor confidence on the back of the country's reform programme.

The 10-year euro-denominated bond was oversubscribed, priced at a yield of 4.375 percent which surprised many analysts and Ukraine watchers. Konstantin Stetsenko, founding partner of ICU, the leading asset manager in Ukraine, noted that Ukraine would not have been able to sell the bond at such a low yield a year before.

Konstantin StetsenkoUkraine has come a long way in the past few years as the reform programme kicks in; the Clearstream link and the opportunity to participate in government bond auctions through the Bloomberg terminal are some of the signs of positive market reform. Investors seem to have taken note, betting that Zelensky's programme of economic growth will reap rewards.

In a speech at Davos in January, he reiterated his commitment to accelerating reforms and a crackdown on widespread corruption, meaning things can only get better for Ukraine, if everything stays on track.

Transparent debt policy from the Ministry of Finance and a link to Clearstream, which opened in May, further increased the attractiveness of local-currency debt says Mr Stetsenko.

International investors' holdings of Ukrainian government local paper rose to UAH117.8bn (US$5bn) in 2019, the highest total on record and up from just UAH6.4bn (US$0.2bn) at the end of 2018. This trend has kept a steady pace with international investors taking up UAH127.2bn (US$5.2bn) of local-currency bonds just for now. Mr Stetsenko believes we can expect this trend to continue this year saying that while activity has slowed somewhat, investor demand remains quite strong.

Last year saw Ukraine's sovereign debt in UAH terms decline, mostly thanks to the 16.6% appreciation of the Hryvnia, which weighed on the FX portion (65% of total debt). Mr Stetsenko assumed that the debt-to-GDP ratio declined to around 51% by the end of 2019 from 61% as of end-2018. 

The Ukrainian government has ambitious plans for 2020 and if the government implements it as planned and the economy grows as ICU forecasts, the debt-to-GDP ratio may further drop to 47% by YE2020.

As borrowing conditions remain favourable for Ukraine and other emerging market countries, 2020 will likely be another year of high borrowings for Ukraine, says Makar Paseniuk, co-founder of ICU. While Ukraine is likely to meet its FX obligations without IMF cooperation, he believes that IMF support remains critical and is an endorsement for international investors that the reforms are progressing.

In 2019, the government sourced US$3.2bn of hard currency through the NBU from FX reserves. As a result of these FX purchases from the NBU in addition to Eurobonds issues, loans under WB guarantee, partial refinancing of USD-denominated bills redemption, and the loan from Cargill FSI, the government should have accumulated about US$800m in hard currency on its accounts as of YE2019. This amount with recent EUR1.25bn Eurobonds issue should cover debt repayments scheduled for 1Q20 according to Mr Stetsenko's estimates. However, the MoF will need to refill accounts by another US$7.6bn for the rest of the year.

According to the budget for 2020, the government will look to raise UAH343bn (US$13bn this year, at the exchange rate included in budget calculations). 70% will be domestic (most likely in Hryvnias), and only 30% from external sources, including Eurobonds and official loans, like macro financial aid from the EU or loans under WB guarantee.

In addition to Eurobonds issued last month, the MoF may acquire hard currency from the NBU's international reserves up to US$5-6bn until FX reserves decline below the comfort level of three months of imports.

The MoF will seek to satisfy foreign investors' appetite in UAH-denominated debt with maturities above two years. Mr Stetsenko believes that the Ministry will continue to offer five-year and seven-year notes and will initiate offerings of 10-year T-notes. He believes that in order to attract foreign inflows into the government's local instruments, the MoF and the NBU will not cap the holdings of foreigners and/or holdings of specific maturities starting from January 2020. This would allow the foreign investor base to widen significantly, and foreign holdings of the government's UAH- denominated paper may grow at least to UAH170bn (US$6.7bn) by YE20 from UAH117.7bn (US$5bn) as of YE19.

With current real rates hovering above 5%, Ukraine's expected decline in real rates in 2020 will bring it closer to its peer group. However, Ukraine's policy rate will remain 200-250bps higher than rates of peer high-yielders, Egypt and Nigeria, and particularly Turkey, which has recently performed aggressive monetary easing. Mr Stetsenko expects that the NBU will continue the cycle of interest rate cuts and lowering the real rate. In the longer run, the NBU could fall to 3-4% real interest rate, which is uncharted territory. 

A successful decrease in interest rates would result in a subsequent drop in government bond yields says Mr Stetsenko. Banks with substantial holdings of government bonds—predominantly state-owned banks—will record an increase of equity as a result of revaluations, he adds.

Konstantin Stetsenko concludes by saying that while the outlook remains positive overall, with Ukraine getting some breathing room in terms of its debt refinancing this year, it is critical to remain on track with the reform programme in order to keep building investor confidence. It is also worth noting that Ukraine's FX-denominated debt repayments remain high at US$9bn and US$6.8bn in 2020 and 2021, respectively. One could argue that Ukraine could potentially just rely on the markets to finance its debt but given the high amount due this year and should the market turn sour, it will leave Ukraine in a precarious situation and that is imperative that Ukraine continues its IMF cooperation.

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