A financial crisis has begun in Ukraine. The currency is in free fall to the point where the national bank has just ordered exchange kiosks to stop displaying the exchange rate. The government is running a deficit it can’t cover and the leading state-owned companies have started defaulting on their debt. And the economy is on course to contract by over a third by the end of this year – a catastrophic crash, worse than any of the multiple crises seen since the collapse of the Soviet Union.

The war with Russia is the main cause, but the paucity of financial help from the West is making the collapse of Ukraine’s economy worse. As bne IntelliNews has reported, Ukraine is running out of money. During a call on August 1, President Volodymyr Zelenskiy asked his French counterpart Emmanuel Macron to help release the EU’s second tranche of macro-financial assistance to Ukraine worth €8bn. Earlier, European Commission spokesperson Arianna Podesta said there are currently insufficient funds to provide Ukraine with the second tranche. The government has to cover enormous military spending, the fiscal deficit stands at approximately $5bn per month, and without external help, which Ukraine is not getting, it cannot sustain this spending.

According to the estimates of IER experts, real GDP dropped by about 46% year on year in March 2022, and over the next three months, the rate of GDP contraction stabilised at the level of 39-40% y/y. In the worst of the 2014 Euromaidan revolution the economy contracted by 17% in the second quarter of that year, but then began to bounce back and was back in the black by the start of the following year.

In June, the contraction of real gross value added in the agricultural sector accelerated. This was primarily a result of the temporary occupation of the Kherson oblast and part of the Zaporizhia oblast, which substantially contributed to crop production (grain, vegetables and fruits) in June 2021. However, in the second half of this year, the IER forecasts a gradual improvement in the economic situation, depending on how the war goes. As a result, real GDP is estimated to decline by about 30% y/y in 2022.

However, the GDP contraction may be much higher if inflation accelerates further, logistics do not improve and hostilities intensify.

The physical economy is bearing the brunt of the war and has shown itself to have some resilience, but the financial system is starting to buckle. The central bank hiked its prime rate to 25% on June 2 and intends to keep it there for two years. The National Bank of Ukraine (NBU) also devalued the currency on July 21 from around UAH28 to the dollar to UAH36, a drop of 25%, to bring the official rate in line with the cash rate on the street. But the currency immediately fell further to UAH41 and will continue to slide. (chart)

The government is running a deficit of around $5bn a month, which is being financed almost entirely by the NBU’s printing presses. This is not sustainable. The Western donors have sent a total of $12.3bn since the start of the war five months ago – about $2.75bn per month – but this is insufficient to cover the funding gap. The EU and the US have promised another $16bn but the distribution of this money has been dogged by bureaucratic delays, and in the meantime the economy is in a slow crash.

The shortfall is already having an impact on the NBU’s reserves, which have fallen by about $5bn in the last two months, further undermining the value of the hryvnia. And the government has ordered all the state-owned companies to delay their debt payments to “preserve cash.” As a result, Naftogaz defaulted on a $335mn bond, despite having the money to hand and management wanting to pay to preserve the company's credit history.

Grain exports resumed on August 1, which will bring some badly needed revenues, but as grain shipments are only expected to earn some $1bn a month, the numbers still don’t add up. Kyiv got some relief as the Paris Club of sovereign creditors agreed to delay all payments on sovereign debt for at least one year, but the private investors are less enthusiastic. The holders of Naftogaz’s bond were advised to reject the company’s request to delay redemptions and coupon payments as the company was “still a going concern” and had the cash to pay on its balance sheet.

The government is in a very difficult place now. With much of its manufacturing industry and infrastructure damaged or destroyed and with insufficient income to cover the budget, it is in a poor position to sustain what increasingly looks like a long fight. Kyiv is now entirely dependent on the West's supplies, especially materiel, but the West is running down its stocks of ammunition and its manufacturing sector is not able to quickly produce more. The US in particular has compensated by sending more powerful weapons, such as the US M142 High Mobility Artillery Rocket Systems (HIMARS), that have had a devastating effect on Russian forces, but these are not game-changers, as the Russian military machine keeps grinding on.

In two ominous signs in July the Kremlin cancelled the second Russia-Africa Summit, due to be held in November, and at the end of July Kyiv ordered the evacuation of the parts of the Donetsk region it still controls, nominally to avoid problems in the winter. Both suggest that the fighting will continue into November and possibly beyond and that Russia continues to make steady, albeit very slow, progress in its campaign to take control over the whole of the greater Donbas region.

The government has limited capacity to raise resources to cover its funding gap via taxes (the economy is weak) or debt (international capital markets are closed for Ukraine; at the internal capital market, the Ministry of Finance is unwilling to sell debt at new higher interest rates which distort monetary transmission).

This situation is not sustainable. Although the NBU can provide direct support to the government, this comes at a cost of burning foreign exchange reserves at a fast pace. In June alone, the central bank sold approximately $4bn of its reserves to support the hryvnia and the NBU predicted a decrease in international reserves in the second half of 2022 by 8.6% – from $22.8bn to $20.8bn by the end of the year.

With limited resources and instruments, the central bank is caught on the horns of a dilemma, but cannot simultaneously defend the exchange rate, print money (UAH225bn, or $6.1bn, since the beginning of the war) to cover fiscal deficits, and support the stability of the financial system. Something will have to give – and the value of the currency is probably the first thing that will go. In the past few days the NBU has forbidden exchange kiosks from reporting the exchange rate, in an effort to “shield” the population from the rapidly collapsing currency.

A financial crisis is already upon us. The projected funding from the international community for the second half of 2022 is about $18bn. With monthly foreign exchange interventions of about $4bn and external debt payments (principal and interest) of $3bn in the rest of 2022, more defaults are on the cards, otherwise foreign exchange reserves could decline to a dangerously low level of $12-15bn, say experts – far below the level needed to support the value of the hryvnia.

Some of that pressure has been removed after the Paris Club of sovereign creditors gave Ukraine a one-year delay on payments in July, but the private creditors have not been as forgiving, and on July 26 the state-owned gas company Naftogaz defaulted on a $335mn bond redemption, despite having the cash to meet its obligation. The government has ordered the state-owned banks to delay their payments to “preserve cash.”

In addition to the debt another big call on the budget will be the need to buy more gas for the winter. Ukraine currently has the lowest level of gas storage in all of Europe, with the tanks only 22% full as of the last week in July. Naftogaz says it needs to buy another 5bn cubic metres of gas in an extremely tight market at an estimated cost of $7.8bn. It is not clear where the companies will find either the gas or the money to buy it with.

But there is some good news. Economic activity has begun recovering in Ukraine after a significant drop at the beginning of the full-scale invasion, according to Deputy Chairman of the National Bank Serhii Nikolaychuk. This does not mean that the GDP is growing but that the depth of the fall is decreasing, he said in July.

The economy's recovery can be seen in the following indicators: revitalisation of trade networks, increase in restaurant turnover, and a drop in the number of non-working businesses. In addition, exports are also gradually recovering and the end of the blockade on Ukrainian ports should make a very big difference to Ukraine’s balance of payments.

Nevertheless, NBU predicts a 2022 drop in GDP of more than a third and an increase in inflation to more than 30%. The national bank estimates that the economy will decline by 40% in the first half of this year and will end the year down by 30-35%. At the same time, analysts of the regulator believe that the economy of Ukraine will show a recovery of 5-6% in 2023-2024. This will become possible if the active phase of the war ends and the Black Sea ports are unblocked.

The regulator expects inflation to return to the goal of 5% in 2025. According to the NBU forecast, inflation will decrease to 20.7% in 2023 and 9.4% in 2024.