The Ukrainian authorities highly appreciate the cooperation with the Fund and its financial and technical assistance. The authorities have implemented policies broadly as agreed. However, adverse developments beyond the authorities’ control make it advisable to allow a temporary deviation from the initial program targets, while also taking strong compensatory measures to meet key program objectives. The authorities therefore request the completion of the first review, waivers for non-observance of two end-July performance criteria and waivers of applicability for three other end-July performance criteria for which final data are not available yet. Allowing for continued financial support and continued implementation of the program will help restore macroeconomic stability, strengthen economic governance and transparency, and lay the foundation for robust and balanced economic growth.
The Ukrainian government, the National Bank of Ukraine (NBU) and the main political powers are fully committed to a comprehensive economic reform program to correct excessive fiscal and external imbalances and accelerate structural reforms. They remain confident that the policies under the program are adequate to achieve the macroeconomic objectives. In case of deviation from the program’s objectives, the authorities will implement additional measures and policies in close consultation with the Fund staff.
The envisaged sequence of near and medium-term reforms aims at making the external position and public finances sustainable, inter alia, by rationalizing the energy sector; strengthening monetary policy and the financial sector as a whole; and improving the business environment.
To underscore their commitment, the authorities have implemented all prior actions for the first review of the program in a very short period, despite the complex circumstances.
The support from the Fund as well as the World Bank and other partners will be essential for achieving the program’s objectives and implementation of the ambitious reforms.
Recent macroeconomic developments
The Ukrainian economy contracted by 3 percent (y-o-y) in the first half of this year. After a 1.1 percent (y-o-y) decline in the first quarter, the decline accelerated to an estimated 4.7 percent (y-o-y) in the second quarter of this year, despite the strong macroeconomic adjustment measures. Difficulties with access to Russian and other CIS countries markets as well as military actions of the separatists in the Eastern part of Ukraine, caused a continued decline in the industrial output as a whole (by 5.8 percent in the first 7 months of 2014). Industries like machinery and chemicals, which are concentrated in the east of the country, suffered heavily with output declining by 18.9 percent and 15.2 percent respectively. The steep depreciation of the currency did not help avoid a 9.2 percent fall in the output of the export-oriented metallurgy sector. On the positive side, high yields in crops harvesting contributed to the growth of agricultural output by 3.4 percent in the first seven months of the year. On the demand side, a fall in real wages led to a reduction in domestic consumer demand. Declining government capital expenditures, poor financial results of business and overall uncertainty on the back of the military conflict led to a sharp decline of investment demand.
Annual inflation accelerated from 0.5 percent in 2013 to 12.6 percent in July 2014, mainly due to the sharp depreciation of the Hryvnia and hikes in administratively regulated tariffs. Since the beginning of the year, the Hryvnia has depreciated by more than 60 percent. Nonetheless, inflationary pressures are contained because of low aggregate demand and a persistent negative output gap. The exchange rate pass-through affected both core and non-core inflation. Non-core components were the biggest contributors to the headline CPI acceleration. Prices of non-processed food were up by 11.2 percent (y-o-y) mainly due to limited supply of some products and an increase in the price of imported food products. Fuel prices increased by 42.6 percent (y-o-y), mainly due to the depreciation of the currency. Second-round effects of fuel price inflation will push consumer prices more broadly, including because of rising transportation costs. Administratively regulated prices accelerated by 17.3 percent following the increase in tariffs under the Fund supported program.
Balance of payments
The current account deficit has been significantly reduced in the course of 2014. In the wake of the Hryvnia depreciation and the contraction of domestic demand during the first 6 months of 2014, the current account deficit was US$1.9 billion. For 2014 as a whole, the current account deficit is expected to decline to 2.5 percent of GDP (US$3.4 billion), down from a deficit of 4.4 percent projected at the time of the launch of the program, and a deficit of 9.2 percent in 2013.
In contrast with recent years, Ukraine has experienced a strong net outflow of capital, reaching US$2.3 billion during the first 6 months of this year. An unstable geopolitical situation and depreciation expectations are the main drivers of the outflows. However during the most recent months, the situation of the capital account stabilized thanks to the disbursement of official financing and lower demand for FX cash. Yet, inflows of private capital remain subdued. International reserves stood at US$16.1 billion on August 1, 2014, covering 2.4 months of imports of goods and services.
In the first half of 2014 the consolidated budget deficit reached 21 billion Hryvnia or about 1.4 percent of GDP down from 4.3 percent of GDP in the same period of the previous year. This fiscal consolidation was achieved mainly through frontloading the NBU profit transfer and expenditure restraint, in particular capital expenditures. Indeed, consolidated budget revenues performed poorly, because of the decline in economic activity and worsening tax collection in the east.
Monetary policy and financial system
Despite NBUs’ concern about further exchange rate depreciation and corresponding pass-through for inflation and the negative impact on the banking sector, the monetary authorities believe that a flexible exchange rate is critical to protect international reserves, and as a buffer to restore the competitiveness of the economy. Since last March, the NBU has moved to a flexible exchange rate regime and abandoned foreign currency interventions as its main monetary policy instrument. In order to reach the targeted level of NIR, the NBU purchased over US$200 million in July and August (prior action). Policy and legislative measures have been taken in order to achieve price and financial stability in the near future. Among them are: finalizing diagnostic studies of the banking sector; legislation on the conversion of foreign currency deposits; amending the NBU law to strengthen the central bank’s independence; enhancing the coordination between the NBU and the Deposit Guarantee Fund (DGF), and improving the governance of restructuring banks.
The performance criteria for NIR/NDA were recalibrated in light of pressures on the balance of payments beyond the authorities’ control. The NBU’s policy rates remain positive in real terms taking into account expected inflation a year from now.
The NBU is working hard to improve its monetary policy framework and prepare for the introduction of inflation targeting. The strategy includes three stages of preparing the basic legislation, developing all technical prerequisites, and launching inflation targeting. A model-based system of macroeconomic analysis and forecasting has been developed and established by the NBU over the past years in order to support the monetary policy decision-making process. The NBU is establishing its Monetary Policy Committee (MPC) which will set the policy interest rate, consistent with inflation objectives. The NBU will set policy objectives and use its own projections for inflation and other macroeconomic variables in the process of monetary policy decision making.
The authorities will enhance the independence of the NBU as a truly modern central bank, which will be underpinned by non-fiscal dominance, instrumental independence, forward-looking monetary policy based on the NBU’s own macroeconomic forecasting and protecting the NBU from political interference. In particularly, the NBU will prepare legislative amendments to the NBU law (structural benchmark for the end of December 2014), to strengthen the process of decision-making and increase the autonomy of the NBU’s Council and Board. It also authorizes the Council to establish special reserves before any profit distribution. The NBU profits will be passed to the budget every next year after an independent audit.
Financial stability will be the second key pillar of the monetary authorities’ long-term strategy. The main actions for preserving financial stability are enhancing the financial position of the Deposit Guarantee Fund (DGF); ensuring availability of contingent public funds; improving legal bank restructuring tools; enhancing coordination between the NBU and the DGF; ensuring proper governance of banks under restructuring; monitoring state ownership in recapitalized banks; managing the assets left in banks under liquidation. A financial stability unit has been established in the NBU. A Financial Stability Report will be published regularly. A modeling toolkit has been developed for stress-testing the banks.
The NBU provides liquidity to help offset the outflow of deposits from the banking system. Compared with the February-April period, the withdrawal of deposits has slowed down but continues because of the continuing high uncertainties in the geopolitical situation and corresponding expectations.
The authorities continue to push forward the financial sector reforms which will focus on improvement of the banking system’s effectiveness and soundness, while strengthening confidence in the system. The authorities are on track with diagnosing and addressing weaknesses in the banking sector. Diagnostic studies and the review of business plans for the 15 largest banks have been completed (structural benchmark) and the results are being processed. The authorities presented plans to strengthen governance in the restructured banks. The core of the reforms will concentrate on restructuring and recapitalizing banks and the restructuring of NPLs in the banking system, improving the supervisory and regulatory framework, and adopting legislation based on international standards. Particularly, a law to facilitate the resolution of non-performing loans and prevent new NPL’s is under consideration in Parliament (new structural benchmark)
Because the economy is facing exogenous shocks, the authorities, in consultation with the Fund, have recalibrated the path for the general government deficit while maintaining a realistic structural adjustment. The new targets compensate for the additional spending of Naftogaz for so-called reverse gas imports from Europe, the slowdown of both the economic activity and the corresponding tax collection, and some additional military spending. This results in a 5.8 percent of GDP general budget deficit for 2014, compared with 5.2 percent of GDP in the initial program. Spending restraints will continue and additional policy measures will be taken. There will be no discretionary increase of wages, pensions and social assistance; the civil service staff will be significantly reduced, as will be spending on goods and services, subsidies and transfers. The government is stepping up revenue collection efforts as a whole, including measures to combat tax evasion schemes and to widen the tax base by reducing the number of exemptions.
Over the medium-term, the Ukrainian authorities are aiming at a gradual expenditure-based fiscal consolidation to reduce fiscal imbalances and restore credibility.
A gas price dispute with Gazprom has led to accumulation of payment arrears in the second quarter of 2014, and the suspension of gas deliveries by Gazprom since June. An arbitration process to resolve the conflict is ongoing in Sweden. For purposes of immediate payment of overdue bills after the arbitrage, Naftogaz has deposited US3.1 billion in a special account with the NBU (prior action). To prepare for the heating season, Naftogaz has imported and put in storage more gas than assumed at the time of program start. Together with a larger depreciation of the currency, this has led to larger deficits for Naftogaz. The authorities have made several important steps toward energy sector reform. The gas price and heating tariffs for households were raised in May 1 and July 1 correspondingly. The new targeted social safety net which compensates the poorest for energy price hikes has become operational on July 1. The audit company was selected to conduct the quarterly cash flow audits of the Naftogaz accounts. The process of making obligatory distribution accounts is carried out.
The main objectives for the government and Naftogaz are to keep Naftogaz’ deficit to no more than 4.3 percent of GDP in 2014. Energy sector reforms will focus on a step-by-step reduction of fiscal subsidies and increasing efficiency. An important mechanism for achieving these targets will be gradual, but persistent increases in retail gas prices and heating tariffs will be accompanied by further social assistance measures to mitigate the impact on low-income households. The authorities will strengthen efforts to increase payment discipline for Naftogaz clients, which is crucial for improving Naftogaz’ finances.
Looking forward, Ukraine is faced with an extremely difficult economic and financial situation due to internal factors as well as external shocks. However, after a period of uncertainty, the adjustment program provides the basis for the authorities and the people of Ukraine to rebuild the economy and consolidate the society. There is broad consensus in Ukraine that the Stand-By Arrangement helps to maintain the reform momentum, and provides additional security against unforeseen shocks. The considerable progress made so far and the further progress to be reached in the near future will set the stage for strong and sustainable economic developments while maintaining external and internal stability.