by Lucas Romriell of BG Capital

To read dispatches from the foreign press about Ukraine, you might come away with the impression that Ukraine is on the verge of splitting in two and descending into chaos before the week is out. While hysteria seems to dominate the airwaves and media reports surrounding Ukraine's latest elections, investors seem to have taken a more sanguine view.

During the first two months of 2009, they snapped up nearly UAH1.08bn ($13m) in domestic bonds, almost as much as they held prior to the crisis in August 2008, according to the daily Kommersant. Even an off-the-cuff comment by president-elect Viktor Yanukovych that he may restructure Ukraine's sovereign debt barely put a dent in investor interest, with the five-year credit default swap rate (CDS) widening a modest 965 basis points from 950 following the statement. And while Ukraine's sovereign Eurobonds were under some selling pressure in mid-February, the prices of bonds have yet to pass any sort of a major retreat.

What has intrigued investors are yields of nearly 20-24% for domestic treasuries and as high as 10.94% for sovereign Eurobonds. If there is some risk of default, speculators are still willing to take a punt. Even as markets softened for European sovereign Eurobonds as investors fled the Eurozone on the back of growing default risk for Greece and the so-called PIGS (Portugal, Ireland, Greece, Spain), demand for Ukrainian names has remained mostly firm. Some investors are even bidding for distressed names like Nadra and news that the City of Lviv may face restructuring left City of Kiev bonds unchanged.

Underpinning this interest are Ukraine's solid fundamentals that make the chance of a default unlikely. Foreign debt payments by the government are a marginal $2bn this year, or a little under 2% of projected 2010 GDP. The current account deficit is also narrowing and should continue to improve as long as steel markets don't deteriorate significantly. The only thing standing between Ukraine and its next tranche of money from the International Monetary Fund (IMF) is for the government to present a united face and return to the negotiating table. Necessity will make this a reality, regardless of what the next government's attitude is to the IMF. In fact, if investor bullishness persists, the government will likely push ahead with plans for a new bond issue by the end of year. Unless the problems surfacing in the Eurozone become catastrophic, Ukraine should be able to find buyers of a new issue by the end of the year, or early 2011.

Compressed yields for other sovereign debt markets were the primary driver behind investor demand for Ukrainian names – until the Greek problems hit the newswires. With Russia yielding 6-5%, investors were willing to turn to Ukraine for greater income on their investments. Now, the biggest risk to Ukraine demand is probably a Greek default or weakening yields for bonds from Eurozone countries.

No gain without pain

But let's not forget that investors are making a short-term wager. The risk of Ukrainian default may be not be imminent, but that is not to say that it does not exist, nor is it to say that there is no need for substantial economic reform.

Two issues loom large on the horizon for Ukraine over the next six to 12 months: hryvna devaluation and gas market reform. With the strong possibility of parliamentary elections in May, any thought of major reforms is wishful thinking. In the long run, gas payments could sink Ukraine's economic ship. Going back to the table with the IMF will be a walk in the park compared to convincing Ukraine's average citizens of the need to pay market rates for natural gas (they currently pay half). Industrial consumers are likely bear the brunt of the $330 per 1,000 cubic metre price projected for this year, but this can only go on for so long. The next president will struggle to deal with this politically thorny issue, which could, or perhaps more accurately should, include the necessity of dismantling the national gas monopoly Naftogaz. Handing over the country's gas pipelines to Gazprom is also not a solution, as this is a patch that would only postpone the reforms needed to make Ukraine's economy more energy efficient.

Investors may also be overlooking the threat a greater hryvna devaluation would pose for the balance sheets of local banks. A hryvna/dollar exchange rate of UAH9 to the dollar would push non-performing loans (NPLs) in the bank sector up to 30%, even by National Bank of Ukraine's estimates (which persistently underestimates the problem). Our in-house estimates show that banks should be able to weather current NPLs on their operating income alone, but a major shift in the exchange rate could jeopardize these assumptions.

Demand for Ukraine's bonds will persist in the near term, but building Ukraine into an investment-grade country and lowering the cost of borrowing will require deep reform from the new administration.