War Severs Ukraine’s Industrial Arteries as Economy Sinks

The bloody conflict in Ukraine’s east
is severing the arteries that connect the nation’s economy.

The effects are being felt hundreds of miles from the
unrest in industries as different as electricity and food
processing. Power plants at the other end of the country are
being starved of coal because of disruptions to mining, while in
Kyiv, one of Ukraine’s biggest poultry producers is looking
abroad for incubatory eggs after output was halted at its
facility near the war-ravaged city of Donetsk.

Months of fighting have left pro-Russian rebels in control
of a swathe of Ukraine’s easternmost regions, which generated
almost a quarter of industrial output at the start of the year.
The knock-on effects of idle factories are seeping through an
economy at risk of a 10 percent contraction in 2014, according
to Ukraine’s central bank. The International Monetary Fund says
$17 billion may not be enough to avert a default.

“Everything is interlinked and companies in the rest of
Ukraine will suffer,” Liza Ermolenko, an analyst at London-based Capital Economics Ltd., said by e-mail. “That’s on top of
the indirect channels through which the conflict in the east
affects the rest of the economy — the currency, banks,
inflation and confidence channels.”

Power Cutoffs

The Donetsk and Luhansk regions that border Russia are home
to the bulk of Ukraine’s steel mills and coal mines. August
industrial production plunged 85 percent in Luhansk and 59
percent in Donetsk from a year earlier, resulting in a
nationwide contraction of a fifth, the most since 2009,
according to Ukraine’s statistics office.

DTEK B.V., Ukraine’s largest private energy company, needs
a type of coal that’s only mined in Luhansk to fuel about half
of its power stations, according to Chief Executive Officer
Maxim Timchenko. Without that, or alternative supplies from
Russia, there’s a risk to household electricity flows, he said.

“The mines are located in the southern part of Luhansk,”
which is out of the government’s control, Timchenko said in a
Sept. 18 interview. “The main problem is how to get it out of
that area and ship it to our power plants.”

While a cease-fire signed by President Petro Poroshenko is
holding in the two regions, known as Donbas, billionaire Rinat Akhmetov’s DTEK cut electricity to industrial customers in the
capital, Kyiv, last week. About a third of Donbas, whose total
population is 6.5 million, has been handed over to separatist
control for three years after lawmakers granted rebel-held areas
special status last month.

‘Significant Deterioration’

Production costs at London-listed poultry company MHP SA (MHPC)
have risen as much as 8 percent since its egg farm closed,
prompting it to seek some imports from Germany and Hungary,
Anastasia Sobotyuk, an investor relations officer, said Sept. 19
by phone. Shelling has prevented the company from visiting to
assess the damage, which risks a permanent shutdown, she said.

“It won’t be so easy to restart production in many of the
facilities that have been damaged,” Erik Berglof, the European
Bank for Reconstruction and Development’s chief economist, said
Sept. 17. The economy faces “a significant deterioration,
reflecting both the immediate decline of production in Donbas
but also the broader impact on the economy.”

The ripple effect of the business shutdown in the east
presents another challenge to a government facing a laundry list
of economic woes as a result of the war. The fighting has helped
shut off trade with and energy flows from Russia, exacerbating
what’s already the worst recession since a 2009 meltdown. It’s
also sent investors fleeing from Ukrainian assets, stoking
borrowing costs for the nation of 43 million.

‘Really Drastic’

Ukraine, whose gross domestic product was originally
forecast by the IMF to shrink 5 percent this year, has seen a
“really drastic deterioration of economic conditions,” central
bank Governor Valeriya Gontareva said Sept. 13. An extension of
the armed conflict through end-2015 could leave a $19 billion
hole in Ukraine’s finances, the fund said Sept. 2.

“We are assuming that that the conflict will begin to
subside in the coming months, but the balance of risks appears
to be tilted to the downside,” Poul Thomsen, acting director of
the IMF’s European Department, said Sept. 2 on the fund’s
website. If that assumption doesn’t hold, “the program’s
viability could hinge on larger assistance from Ukraine’s
international partners.”

Hryvnia Plunge

The central bank’s currency reserves have tumbled toward a
nine-year low as the hryvnia plunged 36 percent this year, the
most in the world according to data compiled by Bloomberg. The
yield on the government’s $2.6 billion of bonds due 2017 has
jumped 4.91 percentage points in 2014, with 2.9 percentage
points of that coming since the truce was signed.

Ukraine has more than $15 billion of principal and interest
payments coming due through end-2015, according to data compiled
by Bloomberg.

International funds will continue to prop up the economy,
even as the conflict harms the government’s ability to meet the
IMF’s fiscal targets, according to Otilia Dhand, an analyst at
Teneo Intelligence in London.

“If Ukraine falls behind on the program, the
conditionality will just be relaxed and they’ll be given a
second chance,” Dhand said Aug. 22 by phone. “The only thing
the U.S. and the EU are willing and able to do for Ukraine is
literally to throw money at it. They aren’t going to get
involved militarily in the conflict and they’ll be
overcompensating by helping Ukraine financially.”

Restructuring Specter

International aid may come in unison with a government debt
restructuring, according to David Spegel, head of EM sovereign
corporate strategy research at BNP Paribas. Restructuring is a
matter of when, not if, and investors are pricing in a two-thirds chance they’ll lose 50 percent-55 percent of the value of
their holdings, Spegel said in a Sept. 17 report.

Ukraine isn’t considering restructuring “at all,” Halyna Pakhachuk, head of Finance Ministry’s debt department, said
Sept. 24 by e-mail.

The durability of the cease-fire may be key to meeting that
pledge. In a sign of its fragility, the Ukrainian military said
Sept. 29 that nine servicemen had died in the last day, while
the army killed 50 militants. The conflict has cost more than
3,500 lives, according to the United Nations.

Without a stable backdrop the supply chains that link east
and west can’t be reconnected. An end to hostilities is needed
to get Ukraine’s economy back on track, according to Simon Quijano-Evans, the London-based head of emerging-market research
at Commerzbank AG.

“Peace is the most crucial thing,” he said Sept. 18 by e-mail. “Without that, any detrimental economic, financing
scenario can be envisaged.”

To contact the reporters on this story:
Agnes Lovasz in London at
alovasz@bloomberg.net;
Daryna Krasnolutska in Kyiv at
dkrasnolutsk@bloomberg.net

To contact the editors responsible for this story:
Balazs Penz at
bpenz@bloomberg.net
Andrew Langley