One of the interesting differences between Ukraine and countries with developed market economies and independent National Banks is what an independent national bank does.

The United States National Bank, called the Federal Reserve, which is composed of 12 regional reserve banks, studies the American economy to forecast what might occur if it changed monetary policy. These studies are published rather than held in secret as is the case in Ukraine, and publicly discussed. The whole process of monetary policy is public. The result is that monetary policy while far from perfect is predictable and understood. In Ukraine monetary policy is neither and depends on who is in power and what they want to achieve, whether personally or for the national financial system.

The US, as we have reported has been enjoying a farm boom, as prices for agricultural commodities, including farmland have been rising steadily over the last eight years. In part this has fueled by Ukraine’s agricultural policies which artificially create shortages through export bans. However the low cost of producing food in Ukraine driven in large measure by almost free land has meant that the agricultural sector here has been booming as well. The consequence of a farm boom in both countries has been growing farm debt. As we reported two weeks at the end of 2010 outstanding farm debt in Ukraine stood at 27 billion hryvnia, of which, according to the Ukrainian Agrarian Confederation President, Leonid Kozachenko, 9 billion was in arrears.

The situation in the US is different in part because of monetary policy. According to a new report out from the Kansas City Federal Reserve Bank which studied the relationship between debt, farm income and farm financial stress, farmers have been increasing their debt levels at a rate of five percent per year since 2004, the fastest level since the 1980s farm crisis.

"The primary determinants of financial stress are the level of debt, its cost or interest rate, and the amount of farm income available to service the debt."

The study concluded that over the past year, historically low interest rates and rising incomes have allowed farmers to service elevated debt levels that are concentrated among a few farm types. A financial shock—an increase in farm interest rates, a decline in farm income, or both—could increase financial stress quickly, especially among livestock producers and young operators. A surge in financial stress among livestock producers, who hold half of all farm debt, would be of particular concern to agricultural lenders.

Looking at hypothetical changes the bank calculated which farms would be stressed if farm incomes fell 30 percent or if interest rates went up to 18%. Most Ukrainians believe that in developed market economies interest rates are forever below 10%, whereas in the late seventies and early eighties farm loans reached as high as 18% in the US and 21% in Canada. At the same time farm incomes were falling and in both countries more than 10% of farms went bankrupt.

The results of the hypothetical review looking at a drop in farm income, an increase in interest rates, and a combination of the two together found, without surprise that financial stress would increase significantly amongst livestock producers and young farmers. If the combination of the two occurred simultaneously in the US then over 60% of all farms would be under financial stress and 11% under severe financial stress leading to probable bankruptcy.

Ukraine’s agro holdings, although having significantly more income than the average American farm, and typically more sophisticated financial managers than the average American farmer, could be compared to young American farmers. The reason is both started from very little and have grown rapidly through raising money, including through debt, equity and cash flow. In the US farm debt has been growing by 5% a year since 2004. Ukrainian agro holding debt has been growing more rapidly, and we estimate by 10% per annum. Fortunately cash flow has grown more rapidly as a result of increased production volumes and growing commodity prices.

However as we have seen with agro holdings that grew very rapidly using mostly debt, especially a combination of Hryvnia and Dollar loans taken from Ukrainian banks, when rates rose in response to the financial crisis and commodity prices fell some of them completely disappeared, LandWest, and others still haven’t recovered and may soon be acquired, Rise Invest. The question for investors is not whether these will be good acquisitions, or even their low cost. The issue is what will be the finance mechanism and level of leverage used by the acquiring entity.

Investors watch their money very closely if they have gone long with holdings looking to grow by using Euro Bonds as growing inflation will continue driving rates up, and eventually consumption down, leading to the situation of rising costs and lower returns. A better bet would be holdings that are growing through secondary share issues. Although ownership becomes diluted holding value will grow, and when rates rise and income falls, there will be far less debt to service.

The last word of caution that can be drawn from the study is that debt accumulates faster amongst livestock producers. The reason is fairly simple. Livestock production requires more capital than crop production. Ukraine’s government justifies in part its export quota policy through its purported aim of increasing value added production, particularly livestock production. However in the not to distant future Ukraine will be able to almost completely substitute imported animal products with domestic production. We estimate that this could occur as soon as within three years, but no later than five years. Further we believe that most of the increased production will occur as a result of farms taking on increased debt and justifying the borrowings by growing meat prices and supportive government policies.

When domestic livestock production starts reaching near equilibrium with demand then domestic meat prices will fall or rise based on domestic demand. This has certainly been a problem plaguing US industry giants such as Tysons and Pilgrims Pride, two large US poultry producer, who in the last financial crisis faced severe financial stress as a result of being overleveraged. We are certainly reaching equilibrium in poultry products, and we believe that supply and demand, rather than shortages, will begin dictating price. Without developing export markets or capturing value further down the chain, Ukraine’s current agro giants, Avangard and MHP, may face the same problems as Tysons and Pilgrims Pride, and become like them, potential takeover targets.

UkrAgroConsult