After the sharp recession in 2014 and the first half of 2015, the economy has started to recover. Despite some signs of de-escalation, the geopolitical conflict in the East of Ukraine continues to hold back the pace of the recovery, creating uncertainty for investors and markets. Political tensions in late 2015 led to the appointment of a new government in April 2016. Regardless of this challenging environment, the authorities implemented difficult measures aimed at strengthening the fundamentals of the economy, restoring sustainable growth and financial stability. The authorities strive to achieve price and financial stability under the flexible exchange rate, establish a prudent, strong banking system, sound public finances, fight corruption, and implement comprehensive structural reforms in the public sector and state-owned enterprises.
Despite some delays due to the challenging environment and political uncertainty, all performance criteria and prior actions have been met, except for those on NIR for end-December 2015, the non-accumulation of external debt payment arrears, and the non-imposition of exchange restrictions. However, the progress on the program implementation has been impressive. Economic growth picked up, inflation has been drastically brought down, the banking system recovered, international reserves doubled relative to the beginning of the program, the 2016 fiscal deficit and the current account deficit are thus far in line with the program objectives, following a significant over-performance in 2015, and the debt operation with private bondholders has been completed. The authorities are committed to reach an agreement on the broader sovereign debt restructuring as soon as possible, in good faith and in line with the agreed program objectives.
The authorities remain strongly committed to continue with the program implementation and are determined to fulfill all obligations under the program, in order to achieve the program’s long-term goals. The authorities are well aware of the risks and challenges ahead, and of the importance of a comprehensive approach and timely implementation of the reform agenda.
The Ex-Post Evaluation of Exceptional Access Under the 2014 SBA provides a useful assessment of the 2014 SBA. The authorities share the main findings of the report that, although the focus of the program was rightly on the immediate and medium-term objectives and important steps were taken under the program, the intensification of the conflict in the East and the loss of confidence led to unattainable program goals. Although the SBA clearly served as an anchor for the economic reform program in very difficult economic and political times, the replacement with an EFF allowed for more financing for a longer period, to support the authorities’ deeper reform plans.
The authorities broadly share staff’s analysis of the economic outlook. In Q1 2016, for the first time since the Q4 2013, real GDP increased in annual terms and is projected to grow by 1.5 percent in 2016. However, this is somewhat weaker than expected, predominantly due to worse performance in selective service sectors. Industrial production also recovered more slowly than expected (by 1.7 percent in the first seven months of 2016 compared to the same period last year), because of difficulties in the mining and steel industries. Foreign trade is currently the main driver of economic growth, despite the intensification of restrictions in trade with Russia. Domestic investment increased in the first half of 2016 while private consumption remained subdued. Labor market conditions have started to improve with recovering real wages but unemployment remained high at around 10 percent. Inflation slowed to 8.4 percent in August 2016 due to moderate aggregated demand, prudent monetary policy, stabilization of the foreign exchange market and ample supply of food products. The current account balance improved noticeably due to the climbing grain export and higher-than-expected commodity prices. For some time, import remained in line with the program assumptions. In sum, the current account returned to a surplus in Q2 2016 of around US$1.0 bln. and remains in line with the program. International reserves increased to US$14.1 bln. in August 2016, almost double the amount of end of 2014.
Fiscal policy, tax and pension reforms
The government budget performed well in 2015 and 2016, as the authorities controlled spending. Debt interest payments declined following the debt restructuring. Revenues increased. Fiscal targets were met with large margins. The authorities are determined to further reduce the fiscal deficit to ensure debt sustainability, which is critical for financial stability. The parliament approved the 2016 budget in line with the program, supported by a new tax code as agreed with staff as a prior action. Parliament adopted a comprehensive package of tax policy reforms as required under a prior action for this review. A new electronic system of government procurement makes procedures more transparent and efficient, and public investment and services less expensive. Significant progress has been made with improving the tax and customs administration.
Pension reform is the cornerstone of the structural reform agenda, and critical for fiscal sustainability. The population is rapidly aging and the pension fund has a structural deficit that needs to be addressed. The authorities started with the reform agenda by eliminating special pensions to privileged groups. They also extended withholding pension for people that continue to work after reaching the retirement age and reduced the number of people eligible for early retirement (based on their occupation) by at least 40 percent (a prior action). As a new structural benchmark, the authorities will further reform the pension system and social security contribution.
Monetary and exchange rate policy and financial stability
In June 2015, the parliament amended the NBU law, thereby increasing the NBU’s institutional and financial independence and allowing for implementation of policies to secure monetary and financial stability, reduce inflation and build up reserves. The flexible exchange rate helps adjusting to domestic and foreign shocks. The NBU intends to continue with foreign exchange auctions to further increase its reserves. The NBU has built up reserves of around US$3 bl. on a net basis since the end of February of 2015. The NBU also agreed on temporary swap/credit lines with the Riksbank and National Bank of Poland equivalent to US$1.5 bln.
The NBU, together with the IMF, developed a road map for further gradual and controlled removal of the administrative restrictions. The optimal strategy, which is a trade-off between the control of foreign currency outflow to ensure financial stability and the negative effects of the administrative restrictions, will be further developed. Strengthened communication with market participants is key to anchor expectations.
A strategy is implemented to adopt best practices of inflation targeting. The NBU board explicitly defined and announced the path of disinflation to reach in the medium term an inflation target of 5 percent associated with price stability. Last year, the NBU has set up a decision-making system based on a regular macroeconomic forecast, switched to a new operational framework with key policy rate as main instrument, and launched regular and systemic communications aimed at anchoring the inflationary expectations. Inflation is now an indicative target of the program. The authorities propose, on the occasion of the next review, the inflation as an indicative target of the program. For the next review, the authorities propose switching to inflation-based conditionality under the EFF program.
The monetary policy transmission mechanism will be gradually improved by narrowing the interest rate corridor and by ensuring that interbank rates remain close to the targeted policy rate. In addition, the NBU keeps the policy interest rate in the positive territory and stands ready to absorb excess liquidity if necessary.
Another key objective of the reform program is the sound and effective functioning of the banking system. The NBU made important progress with the rehabilitation of the banking system. Confidence was restored. The second stage of the diagnostics for the 20 largest banks was completed and recapitalization plans were submitted by the 16 banks which require additional capital. The NBU is currently monitoring the implementation of 14 plans. Capital requirements were increased and non-viable banks have been resolved. New legislation was introduced to limit lending to related parties and ensure transparent ownership of the banks. The Related Parties Monitoring Office (RPMO) has been staffed to monitor outstanding loans to related parties and reports regularly to the NBU Board. To solve the NPL problem, the authorities are working on strengthening the legal framework for private debt restructuring, adopting an out-of-court restructuring arrangement for corporate debt, and sponsoring a voluntary approach for the foreign currency denominated mortgage loans restructuring.
Banking regulation and supervision have significantly improved, in particular by conducting more risk-based supervision and new regulation on credit-risk activities. The NBU has started to work with a Registry of Borrowers which allows monitoring credit risks and related-party loans. Since December 2015, the NBU introduced monthly reports on potential problem banks, based on a revised Early Warning System (EWS). The Ministry of Finance, as the main shareholder of the state banks, made the commitment to run these banks on a commercial basis. The authorities have developed the Principles of State Banking Sector Strategic Reforms which provide a framework for transparency, improvement in management and a sound financial position of these institutions.
Structural reforms and anticorruption program implementation
The authorities made significant progress with reforming the energy sector. In particular, Naftogaz’s finances were improved and its cumulative cash deficit reached 0.9 percent of GDP in 2015, which is better than the program target. The authorities remain committed to eliminate Naftogaz’s deficit by end-2017. The retail gas tariffs were unified at the full-cost recovery level since May 1, 2016, as were the heating tariffs since July 1, 2016 (a prior action).
The authorities are implementing the anticorruption and judicial reform agenda. The National Anti-Corruption Bureau of Ukraine (NABU) finalized the recruitment process for competent staff and has started to operate. The management of the NABU is implementing the action plan, which was prepared by and agreed upon with foreign specialists, and supported by donors. The authorities have also established a specialized anticorruption prosecution function. The head of the anticorruption prosecutors and two deputies have been appointed in a transparent procedure (a prior action). The parliament adopted a law which requires that high-level officials will report their assets and income in an electronic declaration system. This information will also be publicly available online. Administrative reforms were launched with the traffic police, and many other public services and institutions underwent a clean-up procedure. The Ministry of Finance is implementing a framework for AML reporting and the NBU introduced risk-based off-site and on-site AML supervisory tools. The political influence in the judicial process remains a challenge. To address this problem, the parliament proposed amendments to the Judges’ Organization. The preliminary draft was supported by the Venice Commission. These amendments will enhance the judicial independence, introduce standards and procedures for recruitment, and strengthen the management of the judiciary. Public administration reform has reduced the size of state working places. The reform in the civil service will reduce the wage bill and the size of the public administration thereby enabling higher wage levels to attract higher quality staff and reduce corruption.
The authorities continue with the reform of the state-owned enterprises. A privatization schedule for the 10 biggest SOEs was adopted. The government has initiated a review of the existing portfolio of SOEs to identify the non-operating ones for subsequent liquidation.
Despite the external and internal challenges, the Ukrainian authorities remain committed to continue with the difficult but necessary reforms. The new government is determined to reform the economy and lay the foundation for sustainable growth and prosperity of the country. There is broad support and agreement that this is the only way forward. The authorities are grateful for the cooperation with and support from the Fund, other IFIs and the international community.