This paper reviews economic developments in Ukraine during 1996–99. Output decline continued in 1997 and 1998, especially following the August 1998 crisis in Russia. During this period, Ukraine made substantial progress in reducing inflation, mainly through the implementation of a monetary policy that aimed at keeping the exchange rate broadly stable. However, the fiscal situation remained difficult, despite a sizable adjustment in 1998. Throughout the period, economic policy was influenced by developments in international capital markets.


This paper reviews economic developments in Ukraine during 1996–99. Output decline continued in 1997 and 1998, especially following the August 1998 crisis in Russia. During this period, Ukraine made substantial progress in reducing inflation, mainly through the implementation of a monetary policy that aimed at keeping the exchange rate broadly stable. However, the fiscal situation remained difficult, despite a sizable adjustment in 1998. Throughout the period, economic policy was influenced by developments in international capital markets.

I. Introduction

1. Since regaining independence, Ukraine has made uneven progress in the implementation of economic adjustment and market reform policies. During the first three years following independence (1992–94), Ukraine implemented inflationary policies which resulted in a sharp depreciation of the currency (inflation peaked at 10,200 percent in 1993) and in a rapid decline of the economy. In mid–1994, the new government decided to change course and to embark on a program of adjustment and reforms which sought to correct the mistakes of the past and liberalize the economy. The international community provided substantial financial support for this program. Benefits from this new course followed rapidly in 1995 and 1996: inflation fell sharply, the exchange rate began to stabilize; the budget deficit was reduced by cutting subsidies and other government expenditure; foreign trade benefitted from the elimination of export restrictions and the unification of exchange rates; exports to non–BRO countries increased significantly; the decline of GDP slowed down and some industrial sectors began to record a recovery of output; foreign investment started to increase from a very low level; and the public expressed its confidence in the new currency introduced in 1996. Despite these first signs of progress, substantial problems remained at the end of 1996 and had to be addressed by renewed efforts to reform and adjust the economy. The lack of control on budgetary expenditure was a particularly worrying problem, as witnessed by the increase in budgetary arrears on wages, pensions, and social benefits. Excessive regulation, a continuously changing tax and legal system, corruption, and general uncertainties created an unfriendly business environment and encouraged the growth of the underground economy. Reforms also had to be pursued in the areas of privatization, the energy and agricultural sectors, public administration, and banking sector restructuring.

2. Output decline continued in 1997 and 1998, especially following the August 1998 crisis in Russia. During this period, Ukraine made substantial progress in reducing inflation, mainly through the implementation of a monetary policy that aimed at keeping the exchange rate broadly stable. However, the fiscal situation remained difficult, despite a sizeable adjustment in 1998. Throughout the period, economic policy was influenced by developments in international capital markets, first as foreign investors sought outlets in emerging markets and capital flowed in, and subsequently when market sentiment changed in the wake of the crisis in Asia and investors pulled out of Ukraine. As explained below, the pace of economic reforms slowed down considerably, and although some progress was made in 1997 and 1998, this fell short from what was needed to restore the conditions for economic growth and reduce macroeconomic imbalances.

3. Inflation declined from 40 percent in 1996 1 to 10 percent in 1997, and to 7 percent at end–August 1998. Inflation picked up in September and October of 1998, mainly as a result of the sharp devaluation that took place during September in the wake of the crisis in Russia. It slowed down in November as the exchange rate stabilized and the National Bank of Ukraine (NBU) continued to pursue a tight monetary policy. For 1998 as a whole inflation was 20 percent. 2 The real GDP decline showed signs of bottoming out. After a decline of about 3 percent in 1997 (period–average basis), output did not fall during the first eight months of 1998 compared to the same period in the previous year. Price stability and signs of output recovery were supported by a favorable grain harvest and by a pick–up in construction activity. However, the global financial crisis, and particularly developments in Russia, compressed international trade, choking off the nascent output recovery. In the event, real GDP fell by about 2 percent during 1998.

4. The fiscal situation remained difficult throughout 1997 and 1998. The cash deficit of the general government surged from 3.2 percent of GDP in 1996 to 5.6 percent in 1997, financed in significant measure by nonresident purchases of treasury bills and external borrowing. At the same time, the government reduced the stock of arrears on wages, pensions and social benefits by around 0.4 percent of GDP. In the event, the deficit on a commitment basis fell by one percentage point to 5.2 percent of GDP in 1997. 3 Following the departure of nonresidents from the treasury–bill market starting in August 1997, the authorities borrowed from international capital markets at increasingly high interest rates. This served to delay the needed fiscal consolidation and increased Ukraine’s vulnerability to external shocks. The cash deficit was trimmed significantly to 2.7 percent of GDP in 1998 despite weak revenues, although expenditure arrears increased and the budget deficit reached 3.0 percent on a commitment basis. In the second half of 1998, the authorities successfully restructured part of the domestic and foreign debt maturing in 1998. The weak financial position of the government reflected the difficulties in collecting cash revenues and in rationalizing government expenditures. Cash revenue performance was adversely affected by the general economic decline, an increasing reliance of economic agents on barter trade, and the netting–out operations carried out by the government. The expenditure reduction program was hampered by lack of clear priorities and slow structural reforms, often reflecting the inability of government and parliament to reach consensus on difficult issues.

5. Short–term capital inflows in the first half of 1997 (mostly in the form of treasury–bill purchases by nonresidents) and borrowing from domestic banks made it easier for the authorities to postpone adjustment and to finance a budget deficit that was not sustainable. As the underlying factors affecting the public finances were not addressed, the fiscal situation became increasingly difficult in late 1997 and early 1998, and debt service payments became a significant burden for the budget. The change in market sentiment toward emerging markets compounded this problem, requiring the government to offer increasingly high interest rates to encourage investors to roll over their treasury–bill holdings. Even after nonresidents started to withdraw from the treasury–bill market, Ukraine was able to obtain resources through the placement of Eurobonds in the first half of 1998. However, as borrowing from international and domestic creditors came to a halt, the government reduced the fiscal deficit in the last three months of 1998, but also accumulated budgetary arrears, and resorted to heavy borrowing from the NBU.

6. Prudent monetary policy in support of an exchange rate band and a favorable external environment contributed importantly to price and exchange rate stability until the summer of 1997. During this period, base money grew moderately as the NBU purchased significant amounts of foreign exchange associated with sizeable purchases of treasury bills by nonresidents. Starting in August–September 1997, however, the capital outflows associated with the pull–out of investors from the treasury–bill market put pressure on the exchange rate and led to a sizeable loss of NBU reserves during the remainder of 1997 and the first several months of 1998. Given the loss of access to international capital markets and the substantial decline in international reserves, the NBU ceased to sell foreign exchange to protect the exchange rate in late August 1998. Credit policy was expansionary for most of 1998 due to the government’s heavy reliance on the NBU. Nevertheless, monetary expansion was relatively limited due to the loss of foreign reserves, and for the year as a whole, base and broad money increased by 22 and 25 percent, respectively.

7. These developments were reflected in Ukraine’s external reserve position which, after improving sharply during the first half of 1997, deteriorated significantly in 1998. By end–December 1998, gross reserves of the NBU had declined to just under $1 billion (about 2 weeks import coverage), lower than at end–1996 and about one third of the peak level in mid–1997.

8. As noted, the NBU pursued a policy of net sales of its international reserves during the latter part of 1997 and the first several months of 1998, while gradually widening the exchange rate band, in order to keep the exchange rate broadly stable at Hrv 2–2¼ per dollar. As reserves declined, the authorities could no longer protect the stability of the hryvnia, especially after the crisis in Russia. In early September 1998 the NBU tightened monetary policy by increasing the required reserve ratio, moved the exchange rate band to Hrv 2.5–3.5 per dollar, and introduced administrative measures 4 to control the demand for foreign exchange. The hryvnia depreciated rapidly to Hrv 3.4 per dollar by end–September following the introduction of the new band, although it was kept broadly stable at Hrv 3.43 per dollar during the remainder of 1998.

9. Throughout the period, structural reforms continued, although progress was modest in a number of important areas. Small–scale privatization was basically completed. Privatization of medium and large enterprises moved ahead—on occasion at a slow pace—but it was not complemented by other reforms to promote restructuring of newly privatized enterprises. Progress was also made in the areas of rationalizing the size of budgetary organizations, deregulation of business activity, demonopolization, and trade liberalization. In the energy and agricultural sectors, however, little restructuring was undertaken. Steps were taken to develop a market in the electricity sector but the coal sector remained a significant drain on the economy and the budget. In the gas sector, while some reforms were introduced, steps to create a more transparent market were not successful. Agriculture continued to be hampered by extensive formal and informal state controls and, as a result, production declined. Insufficient structural reform made it more difficult for the authorities to adjust quickly to the worsening external environment.

10. The parliamentary elections—held on March 29, 1998—dominated the political scene for most of the second half of 1997 and the first quarter of 1998. 5 Of the many factions that were elected to parliament, none had a controlling majority (either directly or through a coalition). As a result, the election of the new Speaker took nearly two months. Despite efforts to improve working relations, difficulties between parliament and the government continued to complicate the outlook for economic reform.


11. Output fell by 3 percent in 1997 and, despite signs of an economic recovery early in the year is estimated to have declined by about 2 percent in 1998. Inflation fell to 7 percent in the 12 months ending in August 1998, before rising to 20 percent at end–December due to the depreciation of the hryvnia in early September. While output and price developments in part reflected external shocks, they also stemmed from the lack of progress in fiscal consolidation and structural reform, particularly in the agricultural and energy sectors.

A. Overview

12. The decline in real GDP that had started in 1991 decelerated gradually from over 8 percent in the first quarter of 1997 (with respect to the first quarter of 1996) to a virtual standstill in the first half of 1998. 6 Output started to recover in some industrial and service activities in 1997, and this spilled over to a number of other sectors in early 1998, mainly due to relatively stable prices, and an export–led recovery in the metals sector. Furthermore, for most of 1997, there was greater availability of working capital, as credit to the economy grew in real terms. 7

13. Following the global financial crisis in late 1997 and 1998, demand for Ukrainian products declined in several important markets in Asia. This was compounded in August–September 1998 by the crisis in Russia, which led to a sharp drop in exports and an increase in input prices due to a sharp devaluation of the hryvnia. 8 Furthermore, imports of intermediate goods fell due to the introduction of exchange restrictions in September 1998. As a result, real GDP declined by about 2 percent in 1998 (Text Table 1).

Table 1.

Ukraine: Basic Economic Indicators

(In percent)

article image
Source: State Statistics Committee of Ukraine.

14. Considerable progress was made in 1997 and most of 1998 in reducing inflation. Consumer price inflation was contained to about 10 percent in 1997, despite a significant increase in the money supply, as money demand rose. During the first eight months of 1998, inflation was less than 3 percent, partly due to the seasonal impact of food production, but also because of a limited increase in the money supply. Inflation picked up in September–December 1998 due to the depreciation of the hryvnia. The consumer price index (CPI) increased by 20 percent in 1998.

15. Registered unemployment roughly doubled during the 18 months that ended in December 1998, but the rate continued to be low (under 4 percent of the labor force). 9 Real wages declined in 1997 and the first nine months of 1998. 10

B. Output Developments

16. The decline in real GDP decelerated in late 1997 and early 1998; output grew by 0.1 percent during the first half of 1998, for the first time since Ukraine’s independence in 1991 (Table 11). 11 These positive developments were reversed in the second half of 1998, although some of the underlying factors had already started to manifest themselves earlier. In particular, export performance started to deteriorate (See Chapter V) as markets in Asia, and subsequently in Russia, weakened. Furthermore, with a significant decline in external financing, imports started to contract, reducing the availability of inputs. The import squeeze was amplified by the depreciation of the hryvnia and the ensuing exchange controls introduced by the NBU in September 1998. As a result, output performance deteriorated markedly starting in August 1998, especially in industries that were closely linked with traditional trading partners (such as metallurgy, machine–building and chemicals, see below). The decline was somewhat mitigated by the good performance of the food–processing industry, which benefitted from availability of raw agricultural commodities, partly due to a temporary export ban.

17. During 1997, there was no increase in private investment, and the national savings rate dropped by about 2 percentage points of GDP, entirely due to a decline in net government saving. 12 The lower savings rate was reflected in a decrease in gross investment, which contracted by about 1½ percentage points to about 21 percent of GDP (Table 13). 13 Available information indicates that net investment continued to decline in real terms in 1998 (Table 14). Foreign direct investment and bank lending to the economy together accounted for less than 2 percent of GDP, as investors showed more interest in purchasing treasury bills. 14 Moreover, most firms classified as profitable (e.g., in the power generation and fuel sectors) could not invest their profits because a considerable part of their earnings was in the form of claims associated with arrears (Appendix II).

The Unofficial Economy and Data Quality in Ukraine

According to most observers, the unofficial economy plays an important role in Ukraine, although estimates of its size fluctuate widely from between 20 to 80 percent of official GDP.1 This would be in addition to the official estimate of GDP, which already includes some measure of informal activity. The higher range of estimates is based on the evolution of most easily observable indicators, like power generation. On the other end, an attempt is made to estimate the shadow economy directly by deriving estimates of activities that are not believed to be adequately covered by official statistics, subsequently aggregating them with the official data.

In recent years, Ukraine’s State Statistics Committee has improved its efforts to estimate the informal economy, by adjusting the official data for the information provided by household budget surveys, surveys of activity in informal markets, and more extensive coverage of agriculture through the use of a number of imputed measures. Official GDP for 1996 included such estimates for informal activity, with an overall impact of 12 percent, with the largest entries for agriculture (50 percent) and retailing (30 percent). Preliminary GDP estimates for 1997 incorporated some measures of economic activity that were not recorded previously, including 2 percent in industrial production, 3 percent in trade, and 2 percent in transport and other services.

However, further improvements in estimating the formal and informal economic activities are necessary. First, GDP estimates in Ukraine still rely in large measure on complete censuses of enterprises. However, information provided by enterprises (except for small enterprises) is presumed accurate and thus aggregated without significant adjustments. Misreporting (most likely understating economic activity) is not strongly discouraged. The pervasiveness of the indicators of the noncash economy introduces another bias in GDP estimates, probably overstating these relative to the estimates in a would–be cash–based economy. In addition, household budget survey data likely understate true expenditures by households as they appear to capture inadequately expenditures by the wealthiest part of the population. Finally, some methodological problems persist with a number of official indicators that enter into the GDP calculation, including quarterly GDP estimates, constant price measures for industrial production, and valuation adjustments for inventories. While the authorities are working to correct these problems, this will take some time.

In view of these considerations, a constrained–best estimate of total, informal and formal, GDP should ideally be obtained with the use of full raw information, on the basis of a reconciliation of expenditure–and production–based GDP measures according to economic criteria and an assessment of the relative quality of these measures. 2 For Ukraine, a number of independent observers have estimated that the size of the total economy at 120–130 percent of measured GDP, with the informal economy accounting for up to half of the total. 3

1 In addition, Johnson, Kaufman and Shleifer (1997) estimated that Ukraine’s informal economy is larger than that of the neighboring countries (Figure 1).2 An outline of the methodological approach for arriving at such estimates is given in Bartholdy K. (1996) “Old and New Problems in Estimating National Accounts,” in G. Mureddu and M. T. Salvemini (Eds.) “Russia in the World Economy,” University of Rome “La Sapienza”, S/D 1996.3 “Virtual Statistics,” HIID–CASE, November, 1998, mimeo.

18. There were no significant changes in the composition of output (Table 15). The contribution of net exports to aggregate demand declined by about 1 percent of GDP during 1997, in contrast to some other successful transition economies. In that year, only ferrous and nonferrous metals industries exhibited some output growth due to increased exports (Table 16), while agricultural exports declined significantly. At the same time, Ukraine continued to import energy, and remained one of the most energy–intensive economies in the world, 15 partly because penalties for failure to pay energy consumption have not been enforced widely.

Figure 1.
Figure 1.

Ukraine and Neighboring Countries: Share of the Unofficial Economy, 1989–95

(In percent of official GDP)

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Source: Johnson, Simon, Daniel Kaufmann, and Andrei Shleifer. “The Unofficial Economy in Transition.” Brookings Papers on Economic Activity, Fall (2) 1997, pp. 159–239.

19. The slow pace of structural reforms appears to have contributed to the difficult economic conditions. Little progress has been made in hardening enterprise budget constraints. Reforms in the energy and agricultural sectors have been slow and distortions persist. The heavy borrowing by government and weaknesses in the commercial banking system have reduced resources for the private sector, which has remained small and continues to be affected by red tape and other obstacles. While progress was made in privatization during 1997–98, the benefits from these reforms accrue with a substantial lag. 16

20. The size of the noncash economy continued to increase as suggested by interenterprise arrears and barter (Appendix II). These trends were an indication of soft budget constraints and cross–subsidization, since the most (notionally) profitable sectors such as energy and transportation accumulated net receivables vis–à–vis other sectors, including metallurgy and agriculture. Furthermore, arrears and barter continued to interfere with the development of market–based price signals.

Sectoral output developments

21. Total industrial output is estimated to have declined by about 2 percent in 1997 and recovered slightly (0.7 percent) during the first half of 1998, before starting to decline in September 1998. Performance was uneven across industrial sectors (Table 16, Figure 2). In 1997, only a few sectors (mainly ferrous and nonferrous metals) exhibited growth. By early 1998, the chemical and petrochemical industries, wood and pulp, construction materials, consumer–oriented industries (such as food and apparel) also experienced positive growth rates. By mid–1998, machine building remained the only industrial sector where output had not increased with respect to any comparable period since independence, although, even for this activity, the annual rate of decline had slowed down significantly. Since September 1998, industries such as chemicals, fuels, ferrous metallurgy, and machine building, relapsed into double–digit year–on–year output declines.

Figure 2.
Figure 2.

Ukraine: Industrial Production by Sector, 1995–98

(Index, 1995=100)

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.

22. Interenterprise arrears and barter transactions in the industrial sector continued to increase as a share of GDP. At end–November 1998, industrial arrears were Hrv 68 billion, or about 65 percent of 1998 GDP. 17 Electricity was the only major industrial sector with positive net receivables vis–à–vis the rest of the economy (Appendix II). Most other industrial sectors were net debtors, with ferrous metallurgy the largest in volume terms. Barter transactions in the economy grew from about 35 percent of sales of industrial output in early 1997 to slightly over 40 percent by late 1998 (Table 17). The share of barter transactions appeared to be highest in construction materials, fuels, and wood and pulp industries and lowest for nonferrous metals and food industries.

23. Agriculture accounted for about 11 percent of official GDP during 1997–98. 18 It is also a significant source of inputs to the large food processing industry, as well as demand for machinery and other industrial goods. Agricultural output, which by 1996 was less than 60 percent of its 1990 level, decreased further in 1997 and 1998. Despite the significant weather–related improvement in the grain harvest, which rose by more than 40 percent, total output declined by 2 percent–in 1997 (Tables 18 and 19). The livestock sector continued to contract, with the output of milk and meat declining by more than 10 percent, in part due to the lagged impact of the large drop in the production of fodder in 1996. In 1998, agricultural output decreased by more than 8 percent. While there was some increase in livestock–related activity, plant–growing suffered a major slump. The grain harvest was 26.5 million tons (preliminary estimate), some 25 percent lower than in 1997; the relative share of fodder crops was small. 19

24. Trends in agricultural productivity and marketing have been alarming. In 1998, yields for cereals and sunflower decreased by 13 percent and 17 percent, respectively. Sugar yields also deteriorated significantly. The decline in productivity is mainly due to the use of outdated equipment and insufficient or substandard fertilizer. Productivity indicators for livestock also continued to plummet, although there was some improvement in 1998 as noted above. Ukrainian agriculture continued to experience high harvest losses (7 percent, compared to 2 percent in western Europe), largely because of a lack of proper equipment and poor infrastructure. Barter continues to be the prevalent form of trade (ninety percent of sugar beet production). Storage losses and trade margins have been high. The role of futures trade continues to be very limited, mainly because of the difficulties with contract enforcement.

C. Price Developments

25. During early 1997 and the first half of 1998, the Ukrainian economy made significant progress in reducing inflation. Consumer and producer price inflation rates were reduced to single digits, mainly due to a monetary policy that aimed at keeping the exchange rate stable. The ensuing devaluation of the hryvnia in early September 1998 rekindled inflationary pressures, but the initial passthrough into prices appears to have been modest.

26. Consumer price inflation in 1997 was 10 percent on an end–period basis, and fell further to 7 percent in the twelve–month period that ended in August 1998 (Tables 20 and 21, Figure 3). The CPI broadly followed the normal seasonal pattern, with inflation subsiding to virtual price stability in the summer months of both years. This pattern is attributable to the behavior of food prices, which have a weight of about 50 percent in the CPI and usually decline during the summer. 20 Food prices, after increasing by almost 19 percent in 1996, grew by 3 percent during 1997 and actually declined during the first eight months of 1998. This performance could in part be explained by increased production of certain agricultural products (e.g., fruits), as well as some trade restrictions that contributed to an oversupply of food products in the domestic market. 21 The prices for nonfood items were broadly unchanged during the first eight months of 1998, as maintenance of a broadly stable exchange rate helped stabilize prices of imported goods. The prices of services, after increasing by 113 percent in 1996 on an end–period basis (nearly three times faster than the change in CPI), grew by only 8 percent (less than the CPI) in 1997, and accelerated to over 10 percent in 1998, due in part to the administrative price increases for electricity and gas in May 1998.

Figure 3.
Figure 3.

Ukraine: Components of the CPI, 1995–98

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.

27. Producer price inflation declined from 52 percent in 1996 to 8 percent in 1997, and to 5 percent through mid–1998. 22 Historically, producer prices have been somewhat less closely related to the seasonality of the agriculture cycle than consumer prices, but more closely related to the maintenance of government subsidies to the enterprise sector, as well as exchange rate changes. 23 During 1997 and the first eight months of 1998, producer price changes were relatively uniform across sectors, except that prices of meat products rose more sharply in 1997, which probably reflected the sharp contraction in their supply.

28. The depreciation of the hryvnia in September 1998 led to an acceleration of inflation. Consumer prices increased by about 4 percent in September and by over 6 percent in October, and 3 percent per month in November and December. Prices of food and nonfood products increased at a faster pace than the CPI, while prices for services increased by only 1–2 percent per month. Producer prices rose by 9 percent in September, 11 percent in October, and 3½ percent in November. The exchange rate passthrough was 70–100 percent for tradables prices such as ferrous and nonferrous metals, oil, and gas. Electricity prices also increased roughly in line with the depreciation.

D. Labor Market Developments

29. Developments in the labor market continued to indicate substantial rigidities, as manifested in a slow reallocation of labor to new economic activities and growing wage arrears. Labor market trends during 1997 continued much as in 1996 (Tables 2226). Total employment decreased by 3 percent. The share of employment in the state sector declined from 41 percent to 38 percent, while the share of employment in the private sector increased from 20 percent to 23 percent reflecting both privatization and the emergence of new enterprises.

30. Officially recorded unemployment, which is based only on those who register with state employment centers, remained very low but increased, from about 1½ percent (of a labor force of about 28 million) at the beginning of 1997 to nearly 4 percent in December 1998. However, there has been little labor–shedding, in large part because enterprises continue to be responsible for many social services—schooling, housing, medical care—so that workers prefer to remain notionally employed even if they are not being paid on time, if at all. Also, workers who are laid off must be given three months’ notice, effectively at full pay, paid by enterprises. As a result many workers are placed on unpaid leave since it is too costly for firms to lay them off. The household survey conducted every October shows that the unemployment rate increased from 5.6 percent in 1995 to 7.6 percent in 1996 and 8.9 percent in 1997, with substantial regional variations. Even the household surveys underestimate the true unemployment rate inasmuch as persons over 55/60 are deemed to be inactive whereas in fact the incidence of unemployment may be higher among such workers, and the full extent of underemployment was not adequately captured. Indeed, in 1997 nearly 23 percent of employed workers were either on forced leave (at some point during the year) or were working less than full time.

31. Real wages (deflated by the CPI) fell by about 2 percent in 1997 and 17 percent in 1998 (Table 25, Figure 4). In addition, wages were frequently not paid on time. The stock of wage arrears at end–November 1998 is estimated at Hrv 6.7 billion (of which about Hrv 1 billion was owed to budgetary workers), compared to Hrv 5.8 billion at end–1997.

Figure 4.
Figure 4.

Ukraine: Real and Dollar Wages, 1995–98

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ Average of Estonian, Latvian, and Lithuanian dollar wages.

E. Structural Reforms


32. Privatization of medium and large enterprises slowed in early 1997 but recovered later in the year, bringing the number of privatized units during 1997 to 2,123 (Figure 5). 24 One reason may have been that demand for compensation certificates, which can be used for privatization, fell after parliament passed a law that authorized direct cash compensation for lost savings. 25 Also, shares were sold mainly through nontransparent tenders, thereby discouraging investors from participating in the process. Finally, parliament intervened actively in privatization during 1997 including by moving oversight for privatization from the State Property Fund (SPF) to parliament and by stopping the sale of strategic enterprises through international tenders.

Figure 5.
Figure 5.

Ukraine: Mass Privatization of Medium and Large Enterprises, 1992–98

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities.

33. Momentum was reestablished in mid–1997. However, in late 1997 and 1998, the government sought to raise as much revenue as possible through cash privatization (via stock exchange sales, commercial cash tenders and starting in July 1998 “mass cash” auctions) which led to a reduction in the number of enterprises offered through certificate auctions and in the number of shares sold. The problem was that the government was reluctant to offer for privatization significant shares of large and attractive enterprises. Some analysts have argued that it would have been more efficient to follow through with plans to offer the many less attractive enterprises through certificate auctions as envisaged in the mass privatization program and at the same time implement plans to offer for sale share packages in large and attractive enterprises through transparent international tenders.

34. In the event, 9,504 medium and large enterprises (defined as those with fixed assets exceeding Hrv 1 million) were privatized (at least 70 percent of shares were sold) between January 1995 and December 1998, 26 in addition to the 1,240 enterprises privatized before the mass privatization program was instituted in 1994. According to official data, privatized enterprises accounted for about 60 percent of industrial production and more than 50 percent of industrial employment in the first quarter of 1998.

35. Progress was made in privatizing the agro–industrial sector although further reform is needed to promote competition in this sector. Of the 6,000 medium and large AIC enterprises currently in the mass privatization program, 5,600 had begun share sales, and 4,800 had sold more than 70 percent of their shares, as of end–December 1998. Furthermore, some 443 grain processing, storage, and distribution enterprises, which until recently belonged to the Khlib Ukrainy (Bread of Ukraine) state grain sector monopoly and which represent some of the largest AIC enterprises (grain elevators), are undergoing privatization. 27 According to the SPF, 227 of the grain silos and procurement enterprises under the Khlib Ukrainy had been privatized (at least 70 percent of shares) by end–December 1998. A decision has now been made to sell 100 percent of shares (instead of 70 percent) in 100 of these enterprises.

Privatization: Developments Prior to 1997

From 1992 to 1994 Ukraine’s privatization program involved mainly lease buy–outs by employees and managers of medium and large enterprises. There was little public participation in the privatization process and only 1,240 enterprises were privatized during the period. In October 1994, a Presidential decree was issued implementing a new privatization program, referred to as “mass privatization,” that involved the privatization of 8,000 medium and large industrial enterprises through auctions and to be paid for using newly issued “privatization certificates.” The objective was to distribute shares of public enterprises rapidly and equitably to the public, develop capital markets, and create a critical mass of privately owned enterprises to allow restructuring under the direction of the new owners. Generation of revenue for the state budget was not an objective of the mass privatization program.

Subsequent progress was impeded by parliamentary opposition, administrative delays in the supply of enterprises to certificate auctions, and by enterprise directors and regional officials, so that 1,332 enterprises were privatized (meaning at least 70 percent of shares were sold) during 1995. The mass privatization program was refocused in 1996 including through organizing share auctions with no floor price and using “compensation certificates” which were distributed in February 1996 to those citizens who held savings accounts, the value of which was destroyed by hyperinflation during the previous four years; the first auction was held in April 1996. With more active support by the Cabinet of Ministers and leadership of the SPF (the government agency responsible for privatization), the number of enterprises privatized during 1996 rose to 1,999.

While the principles for privatization of enterprises in the agro–industrial complex (AIC) were similar to those for industrial enterprises, certain differences appeared following passage of a law covering such privatization in 1996. First, 51 percent of shares were distributed free to the enterprise’s suppliers, a process that could take up to four months; next employees and management were given an opportunity to purchase shares on preferential terms, with the average share allocation having been 30 percent; preferential share sales (for certificates) to employees were allowed for up to one year. If unsold shares remained, they could be sold in certificate auctions or for cash. The state could retain shares in “strategic” enterprises (including AIC enterprises) for up to five years.

36. Case–by–case privatization gained momentum during the latter part of 1998. Reflecting this, 24 large enterprises were offered for sale through non–commercial tenders by end–1998, including five from the top–200 most attractive industrial enterprises. Although the SPF did not use the international tender procedures recommended by a working group in 1998, it did employ its own revised tender procedures, which were much improved from the regulations issued in 1997. Notwithstanding these improvements, the SPF’s revised procedures use noncommercial selection criteria including willingness of the bidder to invest in the company, willingness to pay back wages, and proposed business plan. So far, few units have been sold.

37. Finally, the small–scale privatization program was virtually completed in 1998 with about 49,000 (about 95 percent) shops and other small retail establishments (defined as those with fixed assets of less than Hrv 1 million) sold via lease/buy out agreements to employees and sold through cash auctions. 28


38. Development of private business in Ukraine continued to be hampered by excessive regulations, red tape, and cumbersome inspection procedures. A good basis for significant progress in deregulating the economy was laid with a Presidential decree in February 1998, which emphasized simplifying registration procedures, cutting down on activities subject to licensing, limiting inspection and control procedures, simplifying customs procedures, and the need to provide gradual and stable regulation of enterprises. The decree also established the State Committee of Ukraine on Entrepreneurship Development which was given the power to review and implement changes in regulations of state and local governments that affect entrepreneurship, with the aim of mitigating excessive state regulation. Based on the decree, a review of all normative acts related to licensing and registration has been completed. This involved analyzing the regulatory environment of the Ministry of Transport, State Construction Committee, Ministry of Foreign Trade and Economic Relations, Ministry of Internal Affairs, and State Standards Committee. The effort by the Committee resulted in important changes in the regulatory environment but much more work remains to be done, including by undertaking comprehensive reviews of each economic sector (for instance public transportation and rail and truck transport), and by conducting pilot projects at the local level.

39. On July 3, 1998, the President of Ukraine issued a decree that simplified taxation and accounting procedures for small businesses. To improve transparency, most license fees were transferred to the treasury during the second half of 1998. Another presidential decree, issued on July 23, 1998, regulated scheduled and unscheduled inspections of businesses. Inspections can now only be carried out once a year, the company must be notified 10 days in advance, and inspections by different agencies (including the tax administration, customs, state treasury and auditing department) must be conducted on the same day. While this represented a significant step forward, there have been problems with implementation, especially because of simultaneous efforts to improve tax payment compliance.


40. Significant progress was made in late 1997 and 1998 in establishing independent agencies to regulate the activities of natural monopolies, in breaking up some state monopolies, and in separating out other activities from natural monopoly enterprises in order to improve competition (Table 28). With regard to regulation, the National Energy Regulatory Commission was given responsibility for regulating natural monopolies in the oil and gas sector in April 1998. Considerable preparatory work was also done to establish independent agencies to regulate natural monopolies in telecommunications and in transportation. Five large state monopolies were either liquidated or reorganized, mostly in the agricultural sector (Ukragrokhim Ukrkhlibprom, Ukrptakhoprom, Ukragrotekhsevice, and Khlib Ukrainy). However, as noted above, Khlib Ukrainy still retains substantial market power despite a weakened financial position and a sell–off of some of its enterprises. In addition, hundreds of monopolies operating in regional markets have been broken up. Finally, the government has taken steps to separate natural monopoly from participating in related activities in order to promote competition, including for communications and air and rail transport sectors. There are now 15 operators in the communications sector, and 43 in the air transport sector; the necessary regulatory framework has also been put in place in the rail transport sector.

Bankruptcy Procedures

41. Bankruptcy procedures have been improved with the assistance of the World Bank, TACIS, and other donors. A workable bankruptcy procedure, in line with international practice, was put in place in 1998 by Presidential decree, and a draft law based on this decree was adopted in the second reading by parliament in November 1998. Final passage is expected shortly. This procedure represents a considerable improvement in the bankruptcy law enacted in 1992 since the earlier law did not explicitly specify the steps in the bankruptcy process or the timing of these steps, and did not identify the rights of parties to an arbitration hearing. Also, a Presidential decree was issued that instructed oblasts to commit a certain number of judges to bankruptcy cases, and seminars with international experts have been held to improve levels of training and skills of bankruptcy judges. Finally, the government completed two pilot projects, with the assistance of TACIS, that have resulted in the successful restructuring of two enterprises (in the optics and ceramics sectors). As a result of these reforms, and also reflecting the general economic situation, the number of bankruptcy cases has grown from about 5,000 in 1996 to 8,000 in 1997 and to 9,000 in 1998.

Agricultural Sector

42. The slow pace of reforms, especially in the areas of land market development, domestic trade liberalization, and demonopolization and privatization of agricultural enterprises, appears to have contributed to deterioration of the agriculture sector in 1997–98 (Appendix III). While some progress was made in reducing central government regulations in 1997 and early 1998, reforms in this sector stalled following the March 1998 parliamentary elections. Recent difficulties include a series of controversial decisions taken in 1998 at all levels of government regarding operations in the markets for agricultural products. Furthermore, during 1997 and 1998, local governments continued to interfere in the distribution of crops.

43. Ongoing land reform in Ukraine has not produced a workable market for land and the role of the private sector in agriculture remains limited. While some progress was made in transferring ownership from the state to collective farms, and with the issuance of land share certificates to farm members, the actual transfer into private individual ownership of land plots was only barely started with the adoption of the law on leasing of land in September 1998. However, plots of land used by private farmers are still not allowed to be either sold or used as collateral for loans, and this severely limits the availability of financing. As a result, independent private farming as a share of arable land increased only marginally from 2 percent at end–1995 to 2.6 percent at end–1997 (Table 29). The productivity of new private farms is only marginally better than Ukraine’s average, mostly because of the small size of land plots. 29 The bulk of private sector activity in agriculture continues to be generated by small household farms that operate on small plots dating back to the days of the former Soviet Union. There are 11.5 million of these small farms but they account for only 14 percent of total arable land (Table 29). Nevertheless, more than half of livestock, and the bulk of potatoes, fruits, and garden vegetables are grown by these farms.

Energy Sectors

44. Developments in the gas sector continued to indicate a low level of efficiency. While total consumption of natural gas has fallen from 115 billion cubic meters in 1990 to about 80 billion cubic meters in 1997, 30 Ukraine has continued to be one of the most gas–intensive economies in the world. Domestic production declined from 28 billion cubic meters in 1990 to 18 billion cubic meters in 1997 (Table 30). Ukraine imported 62 billion cubic meters of natural gas in 1997, of which about 30 billion cubic meters was received as a fee from RAO Gazprom for the transit of natural gas through Ukraine to Europe; Ukraine is on the main export route from Russia to the rest of Europe. The proceeds of the in–kind transit fee were not generally transferred to the Ukrainian budget because domestic payments discipline remained weak, especially for households, budgetary organizations, and district heating plants. RAO Gazprom reportedly has argued that the Ukrainian government is responsible for the arrears accumulated by private traders because the traders were pressured by central and local government officials to maintain supplies to certain customers in oblasts assigned to them. A poor record of payments to RAO Gazprom and Turkmenistan led to a reduction in supplies of gas to Ukraine in 1997. Turkmenistan stopped all supplies to Ukraine in 1997, but in December 1998 agreed to resume shipment of 20 billion cubic meters in 1999. RAO Gazprom is to supply 55 billion cubic meters in 1999. Furthermore, an agreement between RAO Gazprom and Ukraine was reached in late 1998 on the repayment of gas arrears accumulated in 1997 and 1998. Under the agreement Ukraine will deliver over $1 billion in goods to Russia in 1999.

45. Reform of the gas sector is incomplete as pressures to establish vertically integrated, opaque, and monopolistic market structures have competed with those favoring a transparent, competitive gas market. Until recently, Ukrgazprom (a state–owned company) was the main domestic gas producer and operated the gas transmission and storage facilities. Gas transmission and distribution pipelines formally belong to the SPF and cannot be privatized under a 1994 parliamentary decision. Oblast and city based distribution companies were responsible for the distribution networks and Ukrgaz (an association of gas distribution companies) managed state–owned shares in the distribution companies. Following a change of government in mid–1997, the gas market was segmented into two parts, namely: industrial consumers, whose supply was assigned to private traders with no price restrictions (Table 31); and others (households, budgetary organizations, and district heating companies), whose supply was assigned to gas distribution companies selling Ukrgazprom’s domestically produced and transit–fee gas at prices fixed by the Ministry of Economy. The SPF sold majority shares in several gas distribution companies at very low prices during 1997.

46. In early 1998, the authorities established the Naftogaz Ukrainy, a company whose assets include all state–owned assets in the oil and gas industry including those of Ukrgazprom. Following discussions with the World Bank, an action plan was agreed in May 1998 that called for gas sector reform during 1998–2001, including: quarterly gas auctions by Naftogaz; establishment of a state–owned company to operate the transmission network in 1998 and appointment of a consortium of domestic and foreign companies to manage the company’s shares starting in 1999; separation and privatization of production activities of Ukrgazprom and exploration activities of the State Geology Committee; and improved collection by gas distribution companies. Several gas auctions were held in the second half of 1998, but only 27.5 million cubic meters of gas were sold, partly because the minimum price was set too high to attract buyers and also because consumers had little incentive to pay in cash as long as they could rely on barter and arrears. However, 575 million cubic meters of gas were sold during January–March 1998.

47. Reforms are ongoing in the coal sector, financed by a $300 million World Bank Coal Sector Adjustment Loan (of which $150 million has been disbursed), although progress has been slow. A detailed plan for restructuring the coal sector was drawn up in early 1996 that called for closure of 20 mines per year (out of a total of276 coal mines, the great majority of which are not economically viable according to the World Bank), payment of statutory benefits (including severance and back pay) for miners displaced as a result of mine closures, and the transfer of social assets to municipalities or industry associations. This involved utilizing economic criteria for selecting mines for closure and establishment of a separate agency for mine closure (UDKR). The agency was set up and 20 mines were closed and budgetary support was somewhat refocused on restructuring, with $300 million earmarked in the 1997 budget to cover the restructuring. In the event, there was a shortfall in funds for restructuring the coal sector in 1997 as funds instead were allocated to production subsidies and there were pressures to reverse the reforms. Little restructuring took place during 1998, although later in the year, the government decided to revitalize the process in 1999. As of end–December 1998, a total of 28 mines had been closed and orders had been issued for closure of an additional 17 mines. The coal sector has been an important drain on the economy and the government budget.

48. A wholesale electricity market was established in early 1997 but cash collection has remained low and the financial position of the sector has deteriorated. Retail tariffs do not yet fully reflect the wholesale market price. A Financial Recovery Plan (FRP) for the electricity sector, developed in consultation with the World Bank and other international agencies, was approved by the Cabinet of Ministers in April 1998. The plan contained 23 actions designed to reduce costs, raise retail tariffs to cost–recovery levels by end–1998, strengthen payments discipline through cutting off nonpayers, reduce customer arrears, privatize regional electricity distribution companies (oblenergos), and improve management. While good progress was made in August 1998 in raising retail tariffs to competitive levels, owing to the depreciation of the hryvnia in September, tariffs (which are set in hryvnia) have again fallen below cost–recovery levels as input costs are mostly priced in dollars. On September 23, 1998, parliament adopted a law banning an increase in prices for public utilities (and transportation), including residential electricity tariffs. An appeal regarding the constitutionality of this law was presented by the President to the Constitutional Court in November 1998, and the appeal was upheld in March 1999. Substantial progress has been made in privatizing oblenergos (with over 25 percent of shares sold), but little progress has been made in privatizing the four energy generation companies.


49. In 1997, with growing interest by nonresidents in Ukrainian treasury bills, and Ukraine gained access to international capital markets, the cash fiscal deficit increased sharply from 3.2 percent of GDP in the previous year to 5.6 percent The deficit increased partly due to shortfalls in cash revenue, accompanied by weak expenditure controls and reluctance to reduce expenditures. While the higher cash deficit allowed for some repayment of arrears, its financing made Ukraine very vulnerable to developments in international capital markets. In 1998, despite the continued weak revenue performance the overall fiscal deficit was reduced to 2.7 percent of GDP on a cash basis and 3.0 percent on a commitment basis. Due to resource constraints, the government—in discussions with the creditors—restructured most of the debt falling due to commercial nonresidents in 1998. Progress has been made in improving the transparency of government operations and reducing the tax burden, but difficult decisions on reform of government expenditure programs have been postponed, and there has been some backtracking on tax policy reforms.

A. Overview

50. The fiscal position deteriorated markedly in 1997, in part because the availability of financing weakened fiscal discipline in wake of parliamentary elections scheduled for early 1998 (Figure 6). Despite a significant revenue shortfall, the government did not undertake sufficient fiscal and structural adjustment. As a result, the cash deficit of the general government widened by nearly 2½ percentage points in 1997. Budgetary arrears, however, fell modestly, as government used the foreign financing to pay arrears on wages, pensions, and other social expenditures.

Figure 6.
Figure 6.

Ukraine: Fiscal Indicators, 1995–98

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ Defined as government payments arrears on wages, pensions, and social benefits more than 30 days overdue.

51. The picture changed considerably in 1998 as access to international capital markets dried up and the treasury–bill market became dormant except for the NBU’s participation. To preserve the stabilization gains achieved in the previous year, in response to continued weak revenues, the cash budget deficit of the general government was reduced by nearly 3 percentage points to 2.7 percent of GDP in 1998. However, progress toward fiscal consolidation was not uniform during the year. Fiscal performance deteriorated markedly during the first quarter due mainly to the parliamentary elections in March and the deficit reached the equivalent of about 1.3 percent of annual GDP. Following this, as sources of financing other than the NBU dried up, expenditures were cut dramatically and the deficit was reduced considerably. Overall, expenditures were cut by nearly 6 percentage points of GDP in 1998, although difficult decisions regarding reforms in education, energy, and agriculture, and to a lesser extent health, law and order, and defense were postponed. At the same time, some new budgetary arrears accumulated.

B. Fiscal Developments During 1997

52. The 1997 budget, which was approved by parliament only in late–June 1997, projected revenues optimistically at 42 percent of GDP and targeted a deficit of 4.6 percent of GDP. This implied a substantial improvement in revenue performance, during the second half of the year. However, cash revenue did not improve during the second half of 1997. In response, the government focused on borrowing and on daily cash management instead of cutting expenditures. As a result, the cash deficit of the general government reached 5.6 percent of GDP in 1997 (Tables 32 and 33). At the same time, budgetary arrears on wages, pensions, and social benefits were reduced by about 0.4 percent of the 1997 GDP (Table 34). 31 Adjusted for payment of these arrears, the deficit amounted to 5.2 percent of GDP in 1997, compared to 6.1 percent in 1996.

53. Revenues increased from 36.7 percent of GDP in 1996 to 38.0 percent in 1997, thus remaining relatively high, compared to other BRO countries (Tables 32 and 35, Figure 7). However, the share of cash revenue in total revenue declined substantially, from 80 percent in 1996 to 70 percent in 1997, as the volume of netting operations increased. While some of the revenue increase was due to incorporating three extrabudgetary funds into the budget (the road, environment, social protection funds), it also reflected an increase in nontax revenue. Revenues from income and profit taxes fell, due mainly to reduced royalties from oil and gas transit fees. However, this was more than offset by a strong increase in revenue from taxes on goods and services (mostly related to inclusion of the Road Fund in the budget). At the same time, tax arrears increased sharply from 3.6 percent of GDP at end–1996 to 5.3 percent at end–1997 (Table 36).

Figure 7.
Figure 7.

Ukraine: Consolidated Revenues, 1995–98

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.

54. Total expenditures rose by almost 4 percentage points of GDP, to 43½ percent in 1997 (Tables 32, 37, and 38). This was accompanied by a shift away from outlays to support the national economy and for investment, and toward social activities. Indeed, social spending returned nearly to 1995 levels following the decline in 1996. Most of this shift in the pattern of spending reflected the fact that expenditures had been artificially contained during 1996, albeit through accumulation of arrears. While expenditure for the coal sector increased considerably, substantial cuts were made in other programs designed to support the national economy, and in investment expenditures. At the same time, social spending increased significantly compared to 1996. Expenditures in the health sector were lower than in 1995 and 1996 as a result of expenditure rationalization measures (some fees were introduced and means–testing for selected programs was implemented at the end of 1996). Finally, defense spending remained at its 1996 level (Figure 8).

Figure 8.
Figure 8.

Ukraine: Expenditures, 1995–97

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ Includes balances of extrabudgetary funds and statistical discrepancy with financing.

55. Unofficial data suggest that the accumulation of total budgetary arrears slowed considerably during 1997, increasing by less than Hrv 1 billion compared to an increase of Hrv 4 billion during 1996 (including Hrv 1.9 billion of arrears on wages, pensions and social benefits). The central government appears to have reduced arrears by a small amount; virtually all of the arrears accumulated during 1997 were liabilities of local governments. 32

C. Fiscal Developments During 1998

56. The 1998 budget was approved early in the year, for the first time allowing meaningful budget planning. Faced with limited budgetary financing and weak revenues, a substantial fiscal consolidation was achieved during 1998. However, budget implementation was uneven during the year, and in the first quarter, which was dominated by parliamentary elections, the budget deficit actually reached about 1.3 percent of annual GDP, while for the year as a whole, the cash deficit fell by nearly 3 percentage points to 2.7 percent of GDP. 33 This was accomplished by reducing expenditure by nearly 6 percentage points of GDP, more than enough to offset the drop in revenue of nearly 3 percentage points. Notwithstanding these accomplishments, budgetary arrears on wages, pensions, and social benefits rose somewhat (by around Hrv 300 million) so that the commitment deficit shrank by around 2 percentage points of GDP in 1998. 34

57. While total revenue increased by 4 percent during 1998, there was a sharp decline in state budget revenues. 35 In particular, VAT collection (the major revenue source for the state budget) fell during the first quarter because fraudulent VAT refund claims increased. 36 While the central government made some effort to contain netting operations, local governments continued these operations on an ad hoc basis. The central government’s efforts, however, faltered in the last three quarters and netting operations increased, from 13 percent of revenues collected by STA during the first quarter, to 28 percent for the year as a whole. 37 Encouraged by a generous tax amnesty for the agricultural sector and frequent individual tax restructuring by STA, tax arrears (excluding the Pension Fund) more than quadrupled, from Hrv 2.3 billion at end–December 1997 to Hrv 10.3 billion at end–December 1998, mostly on account of the VAT and the enterprise profit tax. In order to reduce tax arrears, a Presidential decree was introduced in March 1998 that allows for tax liens, seizure and sale of property, and arrangement of installment plans. The STA started to implement this decree during the fourth quarter of 1998.

Intergovernmental Finance

Ukraine has a unitary system of government, which includes (in addition to the central government) 24 oblasts, two city districts, one autonomous republic, 480 rayon district governments, 139 cities and almost 30,000 villages and settlements. Oblasts and rayons have a somewhat decentralized role acting as agents of the central administration through a centrally–appointed executive. At the same time, they also play a coordinating role for the smaller local self–governments through democratically–elected councils (radas). Over the course of the transition, local governments have been assigned increasing responsibilities. Oblasts focus on items that are oblast–wide in scope such as special hospitals and schools, and local villages and settlements are concerned largely with expenditures that directly affect their communities such as provision of water, primary and secondary education, etc. Most social protection spending is done by local governments.

The share of revenues for the oblast budgets has fallen from about 50 percent of consolidated revenues at the time of independence to 41 percent in 1997. In 1998, the local budgets were assigned either the majority or the full amount of the following revenues: corporate and personal income taxes; motor vehicle tax; licences; land tax; and the Road Fund tax, though they have no control over the rate or base of the tax. Local governments have discretion concerning some 16 local taxes, but these are generally nuisance taxes and amount to only 2 percent of local government revenues. In addition, most local governments receive transfers from the central government. The system of transfers lacks transparency and is determined through budget negotiations on an annual basis. Transfers are also subject to drastic mid–year corrections, as was the case in 1998, when transfers were reduced by some 50 percent in response to the fiscal crisis. Some local governments frequently resorted to netting operations and mutual settlements as a source of finance. In addition, imbalances between expenditure responsibilities and revenue availability led to a considerable arrears problem.

Budget planning at the lower levels is difficult because annual budgets, which determine allocations to oblasts, are sometimes passed after the current budget year has started. The 1997 budget was not passed until June 1997, while the 1998 budget was approved in early 1998. In addition, execution and implementation of the budget is weak. Revenues are directly transferred from STA to the local budgets. Oblasts outperformed the central government in revenue collection during 1997, collecting 24 percent more than budgeted.

Efforts to address the imbalance in the system of intergovernmental finance and to improve its predictability, transparency, and implementation, are being undertaken with the help of the World Bank and other donors. Key measures will be clarifying the roles and responsibilities of different levels of government, establishing incentives for increasing local government revenue sources, moving toward a formula–based system of transfers, improving for budget implementation, building local government capacity for expenditure control, and strengthening the legal and regulatory framework to enhance control over subnational borrowing.

58. Significant improvements were made in the area of tax policy during 1998, 38 although there was some backsliding as well. Given the high rate of overall payroll taxes in Ukraine, the reduction from 49 to 39 percent through eliminating the contribution rate to the Chernobyl Fund was an important step forward. 39 In addition, several changes in the VAT came into effect in October 1998, including the elimination of tax exemptions on transportation, some critical imports, and gas for households. This also specified the transition to the accrual accounting method effective October 1, 1998 and changed the rules for VAT registration. Notwithstanding these favorable developments, in December 1998 parliament passed a two–year moratorium on all taxes paid by the agricultural sector, and a Presidential decree exempted agriculture from VAT for 5 years. Also, there were a number of legislative acts introducing tax exemptions in the context of special economic zones (including for Sivash, Donetsk, Azov, Slavutych and Yavoriv). Finally, the President raised excise tax rates on alcohol, tobacco, and petroleum products in August, although parliament subsequently lowered some of them; a proposed decrease for petroleum products was vetoed by the President in January 1999.

59. Central government expenditures were constrained throughout 1998, although local government spending expanded somewhat in response to buoyant revenues. Faced with reduced financing and a shortfall in revenues, the central government made very substantial cuts in expenditure during 1998. Given parliamentary opposition to such cuts, the President issued reduced expenditure limits by decree to spending agencies. In addition, the MoF controlled spending on a monthly basis through setting cash limits and developed a list of priority cash expenditures (including wages, benefits, interest payments, and allocations for medicine, food, clothing, and science) for which approval was given on a daily basis. In the event, the majority of expenditure cuts occurred in nonpriority expenditure items, with some cuts also in the areas of health, education, and the social safety net. While these cuts were made under increasingly difficult circumstances, they were not always accompanied by policy reforms that promoted attainment of a sustainable fiscal position. For instance, the government was not successful in limiting direct and indirect government subsidies to the agricultural sector. 40 Also a coal miners’ strike forced the authorities to increase allocations to the coal sector substantially. It is estimated that the coal sector received about Hrv 2 billion of direct and indirect (i.e., channeled through allocations to other ministries) cash payments during 1998, compared to its annual budget allocation of Hrv 1.5 billion.

60. Public sector employment was reduced substantially, especially during 1998. In 1997, almost 5 million people, or 10 percent of Ukraine’s population, were employed by budgetary organizations. Most public employees worked for the education (1.6 million), health (1.2 million) and defense and internal security sectors (around 1 million); less than 10 percent were in public administration. Public sector employment has fallen by more than 1 million since 1994, with an additional substantial decrease of about 280,000 in 1998. Notwithstanding these accomplishments, there is still scope for further reductions. In the education sector, the pupil–to–teacher ratio of 13.5 is still substantially below the OECD average of 17. Moreover, the 0.5 ratio of teaching personnel to nonteachers is far below international standards. Similarly, for the health sector, the number of physicians per thousand is about four to six times higher than in OECD countries. While wages in public administration are higher than the average wage in the economy, budgetary employees in other sectors receive below–average wages.

61. An interim treasury that records most central government cash and noncash expenditures is now fully operational, although spending by the Pension Fund is not monitored. From May 1, 1997 onward, budgetary payments were progressively taken over by the treasury, and ministerial and departmental bank accounts were closed. The treasury now executes all budgetary payments except for three security agencies (the State Security Service, the Main Department of Government Communications, and the Presidential Committee of Intelligence Affairs), although there were some delays in completing this transition. In addition, many spending agencies kept accounts outside the treasury. The flow of revenues and expenditures through these extrabudgetary accounts is estimated to have been about 2½ percent of GDP in 1998. The treasury developed interim software to handle and record central government transactions in treasury ledgers and to link with the client–bank payments system of the NBU. The number of commercial banks authorized to handle budgetary transactions was reduced from 17 to 6. Finally, a cash management unit was established in June 1998 to improve the system of cash forecasting, and in October 1998 the same unit appointed staff to implement a system of operational cash management. The treasury produced an expenditure report by economic categories and a first compilation of accounting–based data on expenditure arrears in November 1998. However, expenditure data on a commitment basis are not yet available.

D. Financing of the Consolidated Deficit

62. Interest by foreign investors in Ukrainian treasury bills started in 1996 and steadily grew. As a result, during the first seven months of 1997, the treasury–bill market became the major source of financing for the budget, apart from a disbursement of $100 million from the World Bank. During this period, domestic institutions and nonresident investors purchased some Hrv 800 million of treasury bills on average per month. Over time, however, due to the increasing loss of confidence in transition economies, this instrument became less attractive and investors started to pull out or were interested only in hedged operations. This prompted Ukraine to seek access to international capital markets. Ukraine made its debut and floated its first Eurobond in August 1997. Despite the instability in the international capital markets, Ukraine borrowed again in October 1997 although the amount was smaller and the terms were less favorable.

63. During 1998, activity in the treasury–bill market came to a halt. Domestic banks and nonresidents, concerned with the sustainability of the fiscal position, were increasingly reluctant to purchase treasury bills, and the government had to rely on the NBU to finance the budget deficit and service public debt. In early 1998, Ukraine borrowed three times from international capital markets but increasingly had to use the proceeds to repay obligations to treasury–bill holders and external creditors. In mid–1998, finally Ukraine lost its access to all external markets while debt payments created a significant cash–flow problem for the budget. During the latter part of 1998, the authorities successfully negotiated voluntary exchange programs with domestic and external creditors for the conversion of short–term debt into longer–term government bonds. It also negotiated a fiduciary loan.


64. Domestic and foreign creditors continued to enjoy unrestricted access to the treasury–bill market during 1997 and the amounts borrowed from the treasury–bill market increased nearly three–fold compared to 1996 and covered the major portion of financing needs of the budget. 41 The bulk of the treasury bills were bought by nonresidents. The MoF placed some Hrv 8.7 billion of treasury bills in the primary market, 42 through conducting multiple–maturity auctions on most days of the week. Receipts from the auctions were used to cover the daily cash needs of the budget. While the frequent auctions raised the necessary resources, they did not help promote an efficient market; participants had an incentive not to make their best offer given the option to wait for subsequent auctions. In addition, the development of a secondary market was adversely affected by the differential tax treatment of securities purchased in the primary and secondary markets. 43 In August 1997, parliament unified the tax treatment, and income from treasury bills was taxed at a 30 percent rate.

65. The interest of investors in the treasury–bill market remained high during the first nine months of 1997. The MoF took the opportunity to lengthen the average maturity and the placement of 3–month bills was discontinued in May, 44 while the threshold price below which investors’ bids were rejected was progressively increased. As a result, treasury–bill yields declined significantly, from around 60 percent (for 12–month treasury bills) at end–1996 to about 22 percent at end–September 1997 (Table 42).

66. The rapid accumulation of government obligations, together with the turbulence in Asian markets, affected investors’ assessment of the Ukrainian economy and reduced their interest in the treasury–bill market. In an effort to preserve investors’ interest the MoF allowed yields to rise progressively to about 45 percent at end–December. Despite this, foreign investors appeared concerned about the sustainability of the authorities’ policies and the outlook for the exchange rate, and became increasingly reluctant to purchase treasury bills without hedging or some type of forward contract. In December 1997, the MoF issued Hrv 750 million of 9–and 12–month maturity treasury bills denominated in hryvnia, with coupons on the bonds linked to the exchange rate according to a formula that guaranteed a minimum yield of 22 percent in dollar terms. At end–1997, foreign investors held 45 percent of the outstanding stocks of treasury bills, while banks held 28 percent and the NBU, whose share had started rising in September, held 24 percent.

67. Ukraine accessed international capital markets for the first time in August 1997, raising $396 million from a one–year Eurobond issue at a 12 percent interest rate. In October, the MoF raised an additional $99 million through a one–year fiduciary loan organized by Chase Manhattan Bank at a 10 percent interest rate. In addition, during the year, Ukraine borrowed $310 million from international institutions. 45 External borrowing was about sufficient to cover foreign amortization that amounted to about $680 million. Net external financing covered only 5 percent of the 1997 deficit (Text Table 2).

Table 2.

Ukraine: Financing of the Budget Deficit, 1997

(In millions of hryvnia, unless otherwise specified)

article image
Source: Ukrainian authorities; and Fund staff estimates.


68. Ukraine raised $1.1 billion in the international capital markets during the first half of 1998. It issued a three–year Eurobond equivalent to DM 750 million at a 16 percent interest rate in February, a two–year Ecu 500 million Eurobond with a 14.75 percent annual yield in March, and in May floated a second tranche of the February Eurobond for DM 260 million with a three–year maturity and a yield of 14.99 percent. Foreign borrowing covered the $700 million of foreign amortization falling due and offered temporary relief to the budget at a time when proceeds from the treasury–bill market were dwindling (Text Table 3).

Table 3.

Ukraine: Financing of the Budget Deficit, 1998

(In millions of hryvnia, unless otherwise specified)

article image
Source: Ukrainian authorities; and Fund staff estimates.

The presentation differs from the authorities’ in that the reschedulings of domestic and foreign debt are treated as new financing.

69. The departure of investors from the treasury–bill market that started in 1997, continued in 1998. This, combined with the reluctance of banks to purchase significant amounts of treasury bills put the budget under significant strain. On a net basis, the primary market, excluding the effect of the NBU’s participation, drained resources from the budget.

70. On several occasions, the MoF tried to promote investor participation, including by raising yields to about 60 percent at end–June and by issuing certain short–term maturities. In addition, the MoF started to announce the dates of the auctions, the maturities of the securities, and the amount of cash it wished to raise during the following week, in advance, in an effort to disseminate more information to the market. Nevertheless, activity remained depressed. Operations continued to be nontransparent, maturities were often longer than what the market was prepared to buy, and the price was determined administratively. Investors’ departure from the treasury–bill market was accelerated by their loss of confidence in Ukraine’s ability to repay.

71. As a result, to cover budgetary financing needs, the NBU became the primary participant in the treasury–bill market. The MoF placed Hrv 4.5 billion of treasury bills through the auctions during the first six months of 1998, 65 percent of which were purchased by the NBU. 46 Even taking account of the NBU’s participation, the treasury–bill market did not provide any funds to the budget on a net basis. 47

72. Obtaining budgetary financing became increasingly difficult starting in the summer of 1998. Efforts by the MoF to borrow from the international capital markets in July and early August were only partially successful. In early August, the MoF obtained $150 million through a treasury–bill placement organized by ING Barings. The treasury bills had a maturity of 10 months, carried an interest rate of 55 percent in hryvnia terms, and a featured coupon that guaranteed a minimum dollar return of 17.5 percent. That amount only partly covered repayment of the $450 million Eurobond that matured on August 9. The MoF started facing a serious liquidity shortage as the servicing of domestic and external debt absorbed significant budgetary resources. Furthermore, the debt service profile was skewed toward the last part of 1998.

73. In 1998, the MoF placed some Hrv 9.0 billion in the treasury–bill market. The NBU purchased Hrv 6.0 billion (about 73 percent of the total). Commercial banks purchased Hrv 1.6 billion. Nonresidents purchased less than Hrv 0.6 billion (mostly in the first nine months of the year).

Debt conversion

74. Starting in August, the MoF negotiated with three major groups of creditors regarding a voluntary conversion of short–term instruments into longer–term ones. On August 28, the MoF agreed with domestic commercial banks on a voluntary program for the exchange of short–term treasury bills with long–term hryvnia–denominated government bonds. The annual return offered to participants under this exchange program was 40 percent during the first year, followed by a yield linked to a floating benchmark interest rate. The bonds were scheduled to mature during 2002–04. Commercial banks agreed to exchange Hrv 803 million of treasury bills (one–third of their portfolio).

75. In September 1998, the MoF notified nonresident holders of treasury bills that the government had decided to launch a voluntary exchange program. Those nonresident investors that had instruments carrying an exchange–rate guarantee, or that had entered into forward contracts with the NBU, were eligible to receive an up–front cash payment equivalent to 20 percent of the present value of their treasury bills as well as a two–year dollar denominated Eurobond for the remaining 80 percent. Nonresident holders of unhedged treasury bills were offered the same dollar Eurobond but no up–front cash payment. Investors agreed to exchange Hrv 1.1 billion (out of an eligible stock of Hrv 1.3 billion). The remainder was paid into blocked accounts at the NBU. The Eurobond carried an annual yield of 20 percent. The face value of the bond was estimated at about $500 million. The MoF made an up–front cash payment of $76 million.

76. This was followed in October 1998 by the rescheduling of a fiduciary loan that Chase Manhattan Bank had placed with the MoF in October 1997. Chase Manhattan clients agreed to receive an up–front cash payment of 25 percent of the original loan ($27.3 million) and to roll over the remaining 75 percent ($81.8 million) into a new instrument with an interest rate of 16.75 per annum and a maturity of two–years. 48

E. Social Safety Net

77. A viable and effective social safety net is essential for the success of Ukraine’s economic transformation. While Ukraine has made improvements in the structure of social protection programs in recent years, many of the programs remain poorly targeted and complex. These deficiencies, combined with severe financing constraints, have limited the provision of assistance to those most in need.

78. In order to preserve a minimum standard of living for all pensioners, the pay–as–you–go Pension Fund system was allowed to degenerate over the last several years into a system that effectively amounts to a minimum pension system. The average pension in 1998 amounted to Hrv 57 per month, below the official poverty line of Hrv 73.7 per month. In response to parliament’s decision to increase the minimum monthly pension from Hrv 16.6 to the poverty line (which would have required a considerable increase in outlays of the Pension Fund), the authorities raised pensions in April 1998 for almost half of pensioners by around Hrv 10 per month. The Pension Fund is financed through payroll contributions, as well as direct transfers from the central government for the Chernobyl Fund and military pensions (Tables 43 and 44). Despite recent attempts to enforce payment contributions by noncompliant enterprises, total debt to the Pension Fund doubled, from Hrv 1.5 billion at end–1996 to Hrv 3.6 billion at end–December 1998. At the same time, pension arrears increased from Hrv 0.8 billion to Hrv 1.5 billion (of which around Hrv 600 million was a direct liability of the Pension Fund; the other arrears were related to the Chernobyl Fund and budgetary pensions). The share of in–kind revenues in total revenue of the Pension Fund increased during 1997, particularly from the agro–industrial sector (more than 400 thousand tons of grain were collected during 1997). In 1998, the Pension Fund collected Hrv 8.9 billion, or 91 percent of its 1998 budget projection of Hrv 9.8 billion. The Pension Fund is usually close to balance; it was in a slight surplus in 1997 and 1998. A Presidential decree issued in June 1998 called for a major overhaul of the pension system, including the introduction of a fully–funded element, individual record keeping, and an increase in the pension age. While at present there is no consensus for a major pension reform, two draft laws that would offer some improvements in the current system have been submitted to parliament during the third quarter of 1998 (on private pension funds and on improving the compulsory state pension insurance).

79. The Chernobyl Fund–, founded to absorb the human and environmental costs of the nuclear accident of 1986, generated and spent funds equivalent to about 2 percent of GDP in 1997, The number of registered Chernobyl victims reached more than 3 million at end–1997. The vast majority of the fund’s expenditures are for social protection, including compensation payments, social insurance and pension payments (around 80 percent of total expenditure in the first half of 1998). The fund also finances some capital investments for housing, urban infrastructure, schools, and hospitals in the affected areas and in other oblasts as part of the resettlement program. As noted previously, the 10 percent payroll tax which financed the fund was completely eliminated by January 1, 1999, leaving the central government budget with the responsibility for the social outlays of the fund. To assure resources, a portion of the VAT tax revenues is now earmarked for this purpose.

80. The extrabudgetary Social Insurance Fund, which is administered by trade unions and financed through payroll contributions, had a balanced budget of more than 1 percent of GDP in 1997. The bulk of the fund’s expenditure is for sickness benefits (more than half) and the maintenance of sanatoria and health resorts (around 30 percent). However, since the Social Insurance Fund pays the wages for sick workers, enterprises are able to shift some wage costs to the Social Insurance Fund. This appears to be used in lieu of laying off workers. Moreover, the benefit covers up to 100 percent of the wage for as much as four months at a time, thus encouraging frequent use of sick leaves. The provision of medical rehabilitation/recreation services is inefficient and nontransparent. Vouchers for these services are often provided to workers at substantial discounts (the average rate of cost recovery for vouchers is estimated at around 10–12 percent), with the remainder being financed by the Social Insurance Fund. There may also be some arbitrariness in the determination of the voucher price since the enterprise trade union committee fixes the price based on the earning and employment record, age and family status, previous use of the facilities, and other qualitative criteria.

81. The Employment Fund provides mainly unemployment benefits (limited to 12 months paid over a three year period), but also training and job creation activities. While the latter accounted for more than 20 percent in 1996, an increase in registered unemployment from 351,000 in 1996 to over 1 million by end–December 1998 forced the fund to shift its focus more toward financing unemployment benefits. However, unemployment benefits are only extended to a small fraction of the truly unemployed, since Ukrainian enterprises avoid laying off workers and instead place them on unpaid leave, sick leave, or involuntary part–time work. The fund’s revenues stem from a 2 percent payroll tax rate which yielded revenues of almost ½ percent of GDP in 1998. The Employment Fund was balanced in 1997.

82. Households receive direct and indirect support for housing services (including for heating, water, sewage, rent, and transportation). Prices of these services were increased to 80 percent cost recovery in August 1996; the difference between the price charged and cost is financed by local governments. The central government’s attempt to increase housing payments to full cost recovery was blocked by parliament, as noted in Chapter II. In addition to the subsidized pricing, housing payments by households are capped at 20 percent of household income 49 through a targeted housing subsidy program which was introduced in May 1995 (around Hrv 1 billion was envisaged in the 1998 budget). About 4.7 million households participated in the program, including in rural areas where the housing program assists families with their annual purchase of liquid gas and solid fuel. There are some indications that arrears to the communal services sector have accumulated, although there are no official data on such arrears and, in any event, it is possible they were settled through netting operations by local governments.

83. There is a complex system of budgetary privileges which, if paid, would require budgetary resources of more than 10 percent of GDP. While these privileges are granted under a plethora of social laws, very few were actually funded or paid. The privileges cover activities in the health, education, culture, and transport sectors and apply to various groups of the population, including adolescents, military personnel, and war and labor veterans.


84. The financial crisis that hit many Asian economies during August and September 1997 disrupted the favorable external environment that had facilitated Ukraine’s progress toward financial stabilization. Until summer 1997, Ukraine had experienced significant capital inflows encouraged by stable and open foreign exchange markets. During this period, base money expanded moderately, largely due to capital inflows to purchase treasury bills. By September 1997, year–on–year inflation had fallen to around 10 percent The reversal of investor sentiment in fall 1997, and the ensuing capital outflows the latter part of1997 and the first nine months of1998, put financial policy and external reserves under considerable pressure. With little or no access to international or domestic creditors, the government relied heavily on borrowing from the NBU to finance the deficit and service public debt The decision to support the hryvnia, at a time of substantial downward pressures on the exchange rate, required heavy intervention by the NBU in the foreign exchange markets. In September 1998, the NBU stopped selling foreign exchange to the market, introduced a number of administrative measures to control the foreign exchange market, and moved the exchange rate band to Hrv 2.5–3.5 per dollar.

A. Overview

85. Ukraine made further progress toward financial stabilization during the first nine months of 1997. The NBU maintained a relatively tight credit policy while the strong participation of nonresidents in the treasury–bill market allowed the budget to be financed without recourse to borrowing from the NBU. Base money grew by 32 percent, mostly due to the NBU’s unsterilized purchases of foreign exchange, reflecting increased demand for hryvnia (Figure 9). Accordingly, the 12–month inflation rate in September 1997 dropped to 10 percent, from 40 percent at end–December 1996. Nominal interest rates fell gradually following the decrease in the inflation rate. The openness of the foreign exchange market and the stability of the exchange rate during this period encouraged significant inflows of foreign capital. Commercial banks and nonresidents found treasury bills an attractive investment as real returns remained high despite the gradual decline in yields.

Figure 9.
Figure 9.

Ukraine: Monetary Indicators, 1995–98

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ End of month observations.

86. Government borrowing, however, delayed fiscal adjustment and structural reforms. This, coupled with the financial crisis that hit many Asian economies during August and September 1997, influenced investor perceptions of Ukraine. The foreign exchange and treasury–bill markets became increasingly nervous during the fourth quarter of 1997, as investors started withdrawing due to concerns regarding the stability of the exchange rate and Ukraine’s ability to repay.

87. Indeed, capital outflows, associated mostly with repatriation of nonresident investment earnings, drove monetary developments during the September 1997 to August 1998 period. Throughout this period, the NBU sold a considerable amount of foreign reserves to protect the exchange rate (Figure 10). In January 1998, a new band of Hrv 1.80–2.25 per dollar was announced 50 that the authorities hoped would bolster market confidence in the stability of the hryvnia and thereby would help relieve pressure on the exchange market. In the event, nonresidents continued to leave the treasury–bill market. However, during the first five months of 1998, the authorities were able to sell two Eurobonds for a total of $1.1 billion, thus switching their exposure from domestic currency denominated instruments to foreign currency denominated instruments. The Eurobonds provided financing to the budget and temporarily replenished NBU reserves.

Figure 10.
Figure 10.

Ukraine: Money, Prices, and Gross Reserves, 1995–98

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.

88. During the third quarter of 1998, continuing loss of investor confidence in Ukraine’s domestic economic policies, combined with the crisis in Russia, eliminated Ukraine’s access to international capital markets. In the absence of international borrowing but with sizable external debt service obligations, the NBU’s international reserves declined to less than $1 billion at end–August 1998, compared to $2.4 billion at end–1997. During this period, the NBU became the primary source of credit to government and net domestic assets (NDA) of the NBU expanded rapidly, albeit from a low base. The effect of growth in NDA on base money was largely offset by the loss of international reserves, as the NBU tried to keep the exchange rate broadly stable. During the first eight months of 1998 inflation remained subdued, averaging less than ½ percent per month.

89. In response to the loss of access to international capital markets and in order to prevent further loss of international reserves, the NBU stopped selling foreign exchange to protect the exchange rate band and announced a number of administrative measures in early September 1998 to suppress demand for foreign exchange. At the same time, it also moved the band to Hrv 2.5–3.5 per dollar. Absent foreign exchange sales by the NBU, and despite the other measures, the hryvnia depreciated sharply in September 1998 (Table 45, Figure 11). Subsequently, the rate stabilized in October at about Hrv 3.4 per dollar. As noted in Chapter II, reflecting the depreciation, consumer prices increased moderately; the comparatively modest passthrough effect of the exchange rate depreciation was largely due to tightened financial policies. However, some temporary price controls were imposed on selected products.

Figure 11.
Figure 11.

Ukraine: Exchange Rate Developments, 1996–98

Citation: IMF Staff Country Reports 1999, 042; 10.5089/9781451838930.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.

90. During 1997, the NBU made some progress in improving its operations, including through greater reliance on indirect monetary instruments, the lifting of some restrictions on banking activity, and development of an accounting system consistent with international accounting standards. However, these reforms stalled in 1998. Also, while the NBU continued to strengthen its capacity for banking supervision, no major banking sector reforms were implemented during 1998.

B. Monetary and Exchange Rate Developments

91. Monetary and exchange rate developments during 1997–98 may be divided into three periods. First, the period from January to September 1997 was characterized by stable financial markets, capital inflows, and the introduction of certain reforms by the NBU. Second, the period from October 1997 to August 1998 was marked by the NBU’s efforts to lessen pressures on the hryvnia stemming from persistent capital outflows, while aiming at a stable exchange rate; the NBU’s reform efforts were suspended during this period. Finally, the most recent period, September to December 1998, was characterized by changes in the foreign exchange regime, the introduction of administrative controls, and a sharp depreciation of the hryvnia.

January–September, 1997

92. The main features during the first three quarters of 1997 were significant capital inflows and persistent upward pressures on the hryvnia. The capital inflows, to a large extent associated with purchases of treasury bills by nonresidents, reflected increased confidence in the hryvnia, stability in international financial markets, the liberalization of capital account restrictions, and unrestricted access of foreign residents to the treasury–bill market. Throughout this period, the NBU kept the exchange rate near the edge of the band of Hrv 1.7–1.9 per dollar. 51

93. The NBU let the hryvnia appreciate only temporarily against the dollar, from Hrv 1.89 in January to Hrv 1.83 in mid–March 1997, in view of its concern that appreciation of the currency would erode competitiveness. Starting from mid–March, and despite the inflows, the NBU moved the rate to Hrv 1.857 at end–June, where it remained until late August. Although the hryvnia appreciated by about 1 percent against the dollar during the first nine months of 1997, it strengthened considerably in nominal terms vis–à–vis the currencies of two of its major trading partners, Russia and Germany (by 6 percent and 13 percent respectively). Reflecting these developments, the real effective exchange rate rose by 7 percent during this period. Nevertheless, as noted in Chapter V, export growth to western countries remained strong, indicating that Ukrainian products remained competitive internationally.

94. To help stem upward pressure on the hryvnia and build reserves, the NBU intervened regularly in the foreign exchange market. Purchases of foreign currencies by the NBU totaled $190 million during the first quarter of 1997, $490 million during the second quarter, and $100 million during the third quarter. Foreign reserves increased to almost $3 billion in August 1997, before declining to about $2.5 billion at end–September.

95. Given the success in reducing inflation, the NBU began to gradually reduce interest rates. The refinance rate fell, from 40 percent per annum in late 1996 to 16 percent in early August, and the Lombard rate moved from 45 percent to 25 percent over the same period. The weighted average credit rate fell from 61 percent to 42 percent, and the deposit rate from 24 percent to 15 percent (Table 42). Treasury–bill yields tracked the declines in the refinance rate, falling from 60 percent for one–year maturities at the beginning of 1997, to 22 percent at end–September. Notwithstanding these developments, the yields remained high in real terms reflecting the size of domestic borrowing needs of the budget as well as the risk premium needed to attract investment into Ukraine. Throughout this period, Ukrainian treasury bills continued to offer a premium over Russian GKOs.

96. Growing activity in the domestic treasury–bill market made it possible to finance the budget without recourse to borrowing from the NBU. While the NBU did purchase a limited amount of treasury bills, to some extent this reflected the need to build up a stock of treasury bills for repo operations. In fact, at end–September 1997, the NBU held less than 20 percent of the outstanding stock of treasury bills. This stable environment allowed the NBU greater flexibility in conducting its credit and monetary policies than had been the case in previous years (Box 4).

Monetary Policy Instruments at the Disposal of the NBU in 1997

  • Reserve requirements: the NBU unified the required reserve ratio at 11 percent in April 1997;

  • Credit auctions: widely used in 1996, but their use declined gradually in early 1997;

  • Bilateral repos: they were largely operated as a standing facility providing collateralized credit to banks;

  • Reverse repos: the NBU used them mostly in March 1997 to sterilize its purchases of foreign reserves;

  • Repo tenders: they were introduced in the first half of 1997. The NBU intended to use them as the primary open market operations tool, gradually replacing the credit auctions;

  • Lombard credit: a discretionary standing facility. The interest rate on Lombard finance had traditionally been 1,000 basis points higher than the refinance rate;

  • Foreign exchange operations: with the NBU as a regular participant in the foreign exchange market, a bank in need of liquidity could sell foreign exchange knowing that the NBU was prepared to step into the market and provide hryvnia.

97. During the first nine months of 1997, broad money increased by over 30 percent and the NBU welcomed the build–up of real balances from the depressed levels of previous years (Tables 46 and 47). The expansion in monetary aggregates reflected greater confidence in, and demand for, hryvnia, thereby limiting inflationary pressures. In particular, hryvnia deposits grew by 27 percent while foreign currency deposits remained flat. The share of foreign currency deposits to total deposits declined and thereafter remained at around 30 percent, as a part of business activity continued to be conducted in foreign currency while a significant portion of household savings were held in dollars. Reflecting partly banks’ increased willingness to lend to the economy, net credit to nongovernment from the banking system increased by 24 percent (13 percent in real terms) (Table 48). Notwithstanding these favorable developments, the financial system remained weak and demand for cash from the shadow economy continued to grow, as reflected in the nearly 50 percent growth of cash held outside banks.

C. Developments during October 1997–September 1998

October–December, 1997

Exchange rate and reserves

98. Owing to a lack of progress in fiscal reform and the financial turmoil in Asia, the capital inflows that Ukraine enjoyed for about one year came to an abrupt halt in September 1997. For the first time that year, the NBU started to sell dollars to support the hryvnia. 52 At end–October, the authorities announced a number of measures to ease pressures in the foreign currency market and thereby help keep the hryvnia within the band (Box 5).

Measures to Ease Pressure on the Hryvnia

October 31,1997
  • the refinance rate was increased to 17 percent from 16 percent;

  • treasury–bill yields increased to 35 percent from 27 percent (12–month bills);

  • the NBU announced that starting January 1, 1998, the exchange rate band would be moved to 1.75–1.95 and be in effect until June 30,1998;

  • the government announced a lower budget deficit target for 1998.

November 14,1997
  • the refinance rate was raised to 25 percent and Lombard rate to 27 percent;

  • reserve requirements were tightened by lowering the share of cash counted in required reserves from 30 to 20 percent;

  • treasury–bill yields increased further to 38 percent (12–month bills).

November 20,1997
  • the refinance rate was raised to 35 percent and the Lombard rate to 37;

  • reserve requirements were raised to 15 percent. To encourage banks to purchase treasury–bills, banks could count against the required reserves the amount of treasury–bills they purchased after November 17;

  • the NBU started auctions of deposits to attract funds from commercial banks;

  • bank credits in foreign currencies were prohibited except for foreign trade transactions;

  • short–term (one–month) treasury–bills were introduced;

  • banks could not have open positions in foreign exchange at the end of any business day.

These included increased interest rates, tightened reserve requirements, large–scale open market operations, and measures to enhance the attractiveness of treasury bills (including by lowering the cut–off price and shortening their maturity). These measures, however, were not sufficient to stem the loss of reserves associated with the decision to maintain the band. During the fourth quarter of 1997, net international reserves declined by about $250 million. Base money grew by 2.5 percent, largely due to the expansion of NBU’s net credit to government by 11 percent (Tables 48 and 49). In the 12 months to December, broad money increased by 34 percent while inflation was contained to about 10 percent. Broad money as a percent of GDP increased from 11 percent in 1996 to about 14 percent in 1997 as some remonetization took place, especially during the first part of the year. 53

January–August 1998

99. In early 1998, as investors continued to leave the treasury–bill market, the exchange rate remained under pressure. The NBU’s external position continued to deteriorate due to the government’s external loan repayments and the authorities’ intervention to support the hryvnia (Text Table 4). The NBU was increasingly under pressure to provide large amounts of budgetary financing through the treasury–bill market given the weak demand for treasury bills. In the event, the NBU raised interest rates and reduced banks’ liquidity in order to ease pressures in the exchange market and thereby limit the need for intervention.

Table 4.

Ukraine: Government’s External Debt Payments

(In millions of U.S. dollars)

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Source: National Bank of Ukraine; and Fund staff estimates.

Exchange and interest rate policies

100. The pressure on the exchange rate that had become evident in 1997 continued in 1998. On January 21, in view of instability in financial markets and the large volume of capital outflows, the NBU announced a new band of Hrv 1.80–2.25 per dollar. 54 The authorities believed that, on the one hand, by adopting a wider band instead of letting the hryvnia float, markets would be reassured regarding the authorities’ commitment to a stable exchange rate while, on the other hand, the wider band would reduce the need to intervene in the foreign exchange market and thus minimize any loss in reserves.

101. To support the new band, the NBU again tightened liquidity by limiting the extension of refinance credit to banks. In addition, on February 12, the NBU increased the refinance rate to 44 percent and resumed daily auctions of deposits. 55, 56 However, the substantial amount of maturing treasury bills held by commercial banks posed difficulties for the conduct of monetary policy. The treasury–bill redemptions were a constant source of liquidity for the banks that decided not to roll over partly because the government decided to restrict yields on newly–issued bills. Also, increases in the official refinance rate did not always succeed in raising the interbank rates by equivalent amounts. Finally, the auctions of deposits were only partially effective because the NBU was reluctant to raise the rates offered on deposits substantially. 57

102. New pressures appeared again in late May, following the financial difficulties in Russia. To help defend the exchange rate band, the NBU raised the discount and Lombard rates by 4 percentage points (to 45 and 50 percent respectively) on May 20. These two rates were each raised by an additional six percentage points on May 28 following the tripling of the refinance rate in Russia.

103. During the first six months of 1998, the NBU continued to intervene regularly to control the hryvnia’s depreciation within the band. 58 The NBU’s reserves were replenished when the MoF issued two Eurobonds in February and March for a total of about $1.1 billion. 59 Investors, increasingly concerned with the stability of the hryvnia, switched their exposure from domestic currency denominated treasury bills to foreign currency denominated Eurobonds. Despite this, the NBU’s reserves fell from $2.4 billion at end–December 1997 to $1.9 billion at end–June 1998. This decline was largely due to the heavy external debt service payments that amounted to about $1.4 billion during the first six months (Text Table 4). The large budgetary needs for foreign exchange drained the reserves of the NBU while the lack of economic reforms deferred foreign investment that could have been a source of foreign exchange. In the event, the hryvnia depreciated by about 9 percent (in domestic currency terms) to reach Hrv 2.064 per dollar at end–June.

104. In July, the financial environment again worsened partly due to increasing uncertainty concerning developments in the region. Ukraine’s efforts to raise additional resources in international capital markets were not successful. On July 7, the NBU raised the refinance rate to 82 percent while allowing the exchange rate to depreciate faster within the band (Text Table 5). Subsequently, in mid–August, the economic situation deteriorated further following the onset of the financial crisis in Russia. In response, the NBU increased the Lombard rate from 82 to 92 percent and let the exchange rate move to the limit of the band, Hrv 2.25 per dollar. On a few occasions, at end–August, the rate moved outside the band and operation of the foreign exchange market was temporarily interrupted.

Table 5.

Ukraine: Interbank and Refinance Rates, 1998

(In percent)

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Source: National Bank of Ukraine.

Credit to the government, NDA, and monetary aggregates

105. As noted previously, credit policy during the January–August 1998 period was influenced by the government’s financing needs and its ability to borrow from the treasury–bill and international financial markets. Domestic and foreign investors’ interest in the treasury–bill market remained weak, partly because of the uncertain economic environment, but also because of the government’s reluctance to let the yields rise to levels that would be attractive to market participants and to issue short–term maturities. As a result, the NBU provided budgetary financing by its purchases of a significant amount of treasury bills. In the first quarter of 1998, the NBU purchased Hrv 1.7 billion of treasury bills (or 80 percent of all treasury bills placed in the primary auction) and Hrv 1.2 billion in the second quarter (Text Table 6). As a result, net credit to government grew by 32 percent during the first half of 1998.

Table 6.

Ukraine: Purchases of Treasury Bills in the Primary Market

article image
Source: National Bank of Ukraine.

NBU holdings of treasury bills at end–December 1997 were 24 percent of total.

106. Given the substantial expansion of credit to the government, the NBU reduced credit to banks in an effort to tighten the amount of banks’ liquidity. During the first quarter, net credit to banks was reduced by approximately Hrv 300 million, and remained flat during the second quarter. Overall, NDA of the NBU grew by 21 percent during the first half of the year. Nevertheless, reflecting the large loss of reserves, base money grew by only about 3 percent and broad money by 7 percent during the first six months of 1998 (although base money was broadly unchanged during the first quarter). The remonetization of the Ukrainian economy, which appeared to have begun during 1997, leveled off during 1998.

September–December 1998

107. In early September, to attempt to safeguard the already low level of international reserves, the NBU introduced a number of administrative measures to restrict the demand for foreign exchange. 60 The exchange rate band was moved to Hrv 2.5–3.5 per dollar and monetary policy was tightened further by increasing the required reserve ratio from 15 percent to 16.5 percent. 61 Despite these measures, in the absence of net intervention by the NBU, the hryvnia depreciated sharply to Hrv 3.4 per dollar by end–September.

108. So far, the depreciation of the hryvnia does not appear to have had a severe impact on the banking system. Despite a withdrawal of household deposits during the first few weeks of September, hryvnia deposits remained stable in October and grew somewhat during the remainder of the year (Tables 51 and 52). Foreign currency deposits remained stable in dollar terms, after having dropped in September.

109. Exchange rate pressures eased temporarily in October and November. This, coupled with the rescheduling of external debt falling due in the fourth quarter, enabled the NBU to purchase a significant amount of foreign exchange. However, following the restructuring of treasury bills in late August, the NBU was the only participant in a dormant treasury–bill market. Reflecting the expansion in NDA, base money increased by 14 percent during the fourth quarter.

110. Substantial redemptions of treasury bills, combined with exchange restrictions that prevented banks from taking the money out, contributed to creating excess liquidity in several banks during October–December 1998. Although the NBU refrained from providing refinance credits to banks, it was not able to absorb liquidity successfully. Interest rates in the interbank market dropped below 15 percent during the first weeks of December. Under political pressure, in mid–December, the NBU lowered the refinance rate from 82 to 60 percent and the Lombard rate from 92 to 70 percent. In addition, the required reserve ratio was reduced to 15 percent, effective January 1,1999. 62

111. Despite the loosening of monetary policy in December, administrative measures allowed the NBU to keep the hryvnia stable at Hrv 3.43 per dollar. However, the offshore parallel market, that had disappeared briefly in late October and early November, reappeared in late November. Rates in this market were quoted as high as Hrv 4.1 per dollar in late December.

D. Banking Sector

112. Ukraine’s banking system appears so far to have withstood the high interest rates and the depreciation of the hryvnia, despite weaknesses such as low levels of capital and high proportions of nonperforming loans. During 1997 and early 1998 there was progress in introducing reforms particularly in banking system supervision. At end–1998 renewed efforts to restructure the banking system were underway with the assistance of international experts and donors, including from the IMF. These developments are described in more detail in Appendix IV.

113. Ukraine has a large number of banks although the level of financial intermediation is low. At end–June 1998, there were 221 banks registered by the NBU, of which two were state–owned banks (Exim Bank and Oschadny Bank), 131 were created as open joint stock companies, 52 as closed stock companies, and 36 were limited liability companies. There were a total of 28 banks founded as joint ventures with foreign capital participation (including 8 banks with 100 percent foreign ownership) but these banks mostly focused on corporate financing and were not engaged in retail banking. The number of active banks was 186. There were 53 problem banks, of which 17 were under various rehabilitation programs and 34 were earmarked for liquidation. Despite the large number of banks, their role as financial intermediaries continued to be constrained by the weak public trust in banks.

114. The seven largest banks continued to dominate the Ukrainian banking system and accounted for 58 percent of the assets, 64 percent of deposits and 61 percent of total lending (Text Table 7). These banks also account for many problems of the banking sector and will be key in future restructuring efforts.

Table 7.

Ukraine: Overview of Banking Sector Structure, July 1, 1998

(In millions of hryvnia, unless otherwise indicated)

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Source: National Bank of Ukraine.

115. The NBU’s supervisory capacity has been strengthened over the past two years with the assistance of international donors. In June 1997, the NBU endorsed a detailed plan for reorganization of the Banking Supervision Department. New departments were set up63 and the NBU’s Deputy Governor became responsible for the banking supervision functions of the NBU.

116. In late 1997, the NBU improved its monitoring of the financial status of banks and adopted an improved version of the NBU’s core prudential regulation, Regulation 10, which provided norms and instructions to banks and defined 18 prudential ratios. These included 4 ratios on capital regulations, 64 3 ratios on liquidity regulations, and 11 ratios on risk regulations. In addition, the NBU developed an early warning system and introduced a Uniform Performance Report that summarized information on the financial performance of all commercial banks. Overall, steps to restructure the banking system were not comprehensive and a number of weak banks continued to operate. While procedures for bank liquidations are in place and have been implemented, to a limited extent by the Bank Resolution Unit of the NBU, the legal basis for effective workouts remains weak.

117. The prevailing accounting practices continued to obscure the true financial position of banks. Additional efforts were needed to increase the reliability of data submitted to the NBU, improve banks’ procedures for credit classification, and ensure adequate provisioning for bad loans. The NBU began on–site examinations in 1997; by June 1998, three banks had undergone on–site inspections. As the seven largest banks represented the largest part of banking activity, in the second half of 1998, the NBU conducted full diagnostic analyses of these banks in an effort to assess their financial strength and develop a strategy for strengthening the banking system with technical assistance from a team of 35 foreign experts65 under IMF coordination. Preliminary results of the studies suggest that several of the seven banks face serious difficulties.

V. External sector

118. Both the current account and the overall balance of payments were broadly unchanged during 1997. However, this masks significant changes in some accounts; in particular, while exports to nontraditional trading partners continued to perform well, exports to traditional partners (particularly Russia) declined substantially. Moreover, short–term capital flows were positive during the first half of the year, turning negative thereafter as nonresident investors in government treasury bills decided not to roll over their investments. During the first nine months of 1998, the overall balance of payments deteriorated significantly, despite heavy borrowing from international capital markets during the first quarter, due to the intensification of short–term capital outflows and the financial crisis in Russia. As a result, there was a substantial loss of reserves and exchange restrictions were imposed in an attempt to defend the exchange rate. Trade policy remained generally liberal during 1997–98. The response to the crisis in Russia has been to attempt to liberalize the export regime further, while the changes in the exchange system have effectively restricted imports.

A. Overview

119. The current account deficit was broadly unchanged during 1997, with a modest improvement in the trade balance and an increase in current transfers having been offset by an increase in nonfactor service payments (Table 53). Both overall exports and imports—including energy imports—declined slightly and trade with traditional partners fell significantly, in large part due to a trade dispute with Russia. 66 Trade with nontraditional trading partners, however, continued to increase; exports and imports grew by 28 percent and 13 percent, respectively. As a result, the trade balance with these countries moved from a deficit of $224 million in 1996 to a surplus of $773 million in 1997. The share of barter transactions in total trade declined from 15 percent in 1996 to 9 percent in 1997.

120. The capital account strengthened by nearly $500 million in 1997, largely reflecting higher disbursements from credit lines as well as project disbursements. Net foreign direct investment remained modest, at $581 million (or 1.2 percent of GDP). There was a net short–term capital inflow of $264 million, despite significant outflows (of about $500 million) during the second half of the year as nonresident investors in Ukrainian treasury bills began to leave the market. The outflows may have been larger given that errors and omissions were negative.

121. For the year as a whole, gross reserves increased by nearly $400 million (to $2.4 billion, or 6 weeks of imports). The reserve increases were concentrated in the first six months of 1997, as reserves were drawn down in the latter part of the year to help support the exchange rate. The improvement in the reserve position was largely due to the exceptional financing received during the year, including the proceeds from Ukraine’s first Eurobond in August 1997.

122. Preliminary data for the first nine months of 1998 point to a significant deterioration in the balance of payments. Much of the deterioration in the first half of the year stemmed from the withdrawal of nonresidents from the domestic treasury–bill market that contributed to short–term capital outflows exceeding $1 billion. As a result, gross reserves fell by more than $600 million at end–June 1998 relative to end–December 1997, despite a significant increase in external financing from international capital markets during the first quarter and a slight improvement in the trade account due to a sharp reduction in energy imports from Russia.

123. While it is too early to assess the impact of the financial crisis that emerged in Russia in August 1998, the immediate impact during the third quarter was a sharp contraction in both exports to Russia and non–energy imports from Russia of about 30 percent in value terms relative to the same quarter of 1997. Trade with other countries was also depressed, as exports continued to suffer from declining international commodity prices and imports were constrained by the slowdown in economic activity as well as the introduction of exchange controls. However, as discussed in more detail in Section III.D., Ukraine was able to reach agreements with the majority of its nonresident creditors to roll over debt obligations falling due during the second half of 1998. As a result, Ukraine has managed to avoid the emergence of arrears on its debt obligations to nonresidents.

B. Trade and Current Account

Merchandise trade

124. While total exports declined slightly during 1997, exports to nontraditional trading partners continued to expand very rapidly, increasing by around 30 percent (Table 54). In contrast, exports to BRO countries declined by more than 20 percent. As a result, the share of BRO exports in total exports declined to less than 50 percent for the first time since Ukraine’s independence. While a steady shift in exports away from the BRO had been occurring in previous years—reflecting the gradual weakening of pre–independence trade links—a sharp decline in such trade started in late 1996, as a result of a dispute between Ukraine and Russia over the collection of value–added tax (VAT) and of excise duties as well as over the imposition of import tariffs on sugar and other items. Nonetheless, Russia remained the single largest export market, accounting for nearly 25 percent of total exports. Exports to most of the other BRO countries (except Turkmenistan and Lithuania) performed well during 1997. 67 China, Turkey, and Germany remained the key export markets among the nontraditional trading partners; indeed, China surpassed Belarus in 1997 as the second biggest market for Ukrainian exports. In terms of the composition of exports, the importance of ferrous and nonferrous metals continued to increase, accounting for more than 40 percent of total exports in 1997 (Table 55). At the same time, the share of food items and raw materials—commodities for which Ukraine has traditionally been a major producer and exporter—fell from 21 percent in 1996 to 13 percent in 1997. Policy shortcomings explain part of the decline in food production and exports, in particular the absence of a functioning land market and the generally slow pace of agricultural reform. The trade dispute with Russia also had a significant impact.

125. Despite the apparent resolution of the trade dispute with Russia in early 1998, 68 preliminary data for the first six months of 1998 show that Ukraine’s exports to the BRO performed poorly, even before the financial crisis in Russia during the third quarter. While it will take time before trade returns to normal levels, some export market share may have been lost permanently as alternative sources were found. The latter effect appears to have been particularly pronounced for sugar exports. There has also been a deceleration in the growth of exports to nontraditional trading partners, particularly of metal products, as a result of lower prices stemming from reduced demand in the Asian market. In value terms, exports to nontraditional partners declined by 7.5 percent during the first nine months of 1998 relative to the same period in 1997, including a decline of more than one third in exports to China. The decline was concentrated in the third quarter.

126. Ukraine’s imports also fell slightly during 1997, largely on account of an 8 percent decline in imports from BRO countries; imports from nontraditional partners increased by 13 percent (Table 56). The decline in imports from the BRO is entirely due to lower imports from Russia and Turkmenistan, which are the major sources of Ukraine’s energy imports. Gas imports (which account for 65 percent of Ukraine’s energy imports) fell in volume terms by over 12 percent in 1997 (Table 57), with the decline of gas imports from Turkmenistan being particularly large. 69 This decline is due to lower demand (energy consumption has declined by 26 percent since 1991), 70 nonpayment of energy bills by Ukrainian enterprises which forced foreign suppliers to reduce their exports, 71 and pricing differences. Accordingly, the share of imports from nontraditional partners increased from 32 percent in 1996 to 40 percent in 1997. Leading imports include machinery and equipment, chemicals, and some food and agricultural items (Table 58).

127. During the first nine months of 1998, non–energy imports declined by 12 percent in dollar terms, due to the depreciation of the hryvnia, the general weakness of global commodity prices, the disruption of trade with Russia, and the introduction of administrative controls on foreign exchange allocation. Energy imports declined even more sharply, by over 25 percent relative to the same period of 1997, reflecting a combination of lower world prices for oil products and lower domestic demand. Gas imports declined by almost 20 percent in volume terms as a result of the hardening of enterprise budget constraints. Imports of gas from Turkmenistan were halted during 1998 as a result of the dispute between Russia and Turkmenistan on the terms of access to the pipeline network.

Nonfactor services

128. Nonfactor service receipts increased by about 3 percent in 1997 despite a slight decline in the pipeline fees that Ukraine collects for gas transit (Table 59). 72 Other nonfactor service receipts, including notably freight services, increased by about 15 percent. The increase in nonfactor service receipts was more than offset by a 40 percent increase in nonfactor payments. There was a large increase in payments for construction services but the bulk of the increase in 1997 is recorded in the “other” category and likely reflects modifications to the statistical methodology used to estimate them as well as to estimate private transfers. Nonfactor service receipts declined further during the first nine months of 1998, reflecting further declines in the pipeline fees received for transit of gas from Russia in response to the decline in world gas prices.

Investment income

129. Total interest payments during 1997 were $646 million, of which $261 million was to Russia (including RAO Gazprom) and $108 million to the IMF—Russia and the IMF are the two largest creditors (Table 60). Beginning in 1997, the interest payment entry includes payments to nonresident holders of domestic debt. These amounts were relatively small ($85 million) in 1997 but increased substantially (by over $200 million) during the first nine months of 1998 as treasury bills issued in 1997 matured. 73 As a result of the Black Sea fleet agreement74 interest payments to Russia amounted to only $100 million during 1998 because Ukraine’s debt service obligations to Russia (except for the Gazprom bonds) were effectively wiped out.

Current transfers

130. Current transfers in 1997 are estimated to have increased by over 60 percent. However, revisions to the statistical methodology used to estimate private transfers likely explain a large part of this increase. Official transfers consisted primarily of security–related aid (including nuclear disarmament and defense conversions), the decommissioning of the Chernobyl nuclear power plant, and other technical assistance.

C. Capital Account

Medium–and long–term loans

131. Disbursements of medium–and long–term loans (excluding exceptional financing which is included below the line as a financing item75) increased from $234 million in 1996 to nearly $700 million in 1997. Trade credits from Germany, United States, and Japan—as well as project support from the EBRD and the World Bank—accounted for nearly 90 percent of new loans (excluding exceptional assistance) during 1997.

132. The structure of external financing changed in 1997 following Ukraine’s entry into international capital markets. While the largest source of exceptional financing had been the IMF followed by the World Bank and the EU prior to 1997, the largest source during 1997 was from private creditors. Financing from private creditors amounted to nearly $400 million in 1997, followed by financing from the IMF under two stand–by arrangements ($286 million), 76 the World Bank ($200 million), the EU ($110 million), and other creditors, including Japan ($35 million).

133. Reliance on financing from international capital markets increased dramatically during the first half of 1998 with the issuance of two Eurobonds totaling around $1.1 billion; however, new financing from private capital markets subsequently dried up. Reflecting the difficult conditions in emerging markets worldwide and perceived policy shortcomings, the terms of the bonds were very expensive. At the same time, exceptional financing from other creditors, particularly international financial institutions, fell significantly (to $50 million).

134. Repayments of principal to Russia and Turkmenistan represented nearly 80 percent of all principal repayments during 1997, mostly on account of the debt arising from consolidation of gas debts (to Russia and Turkmenistan) and overdrafts early in independence (to Russia only). Payments on bilateral loans, all of which have a government guarantee, amounted to $163 million, with more than half going to Germany. In theory the final borrower (Ukrainian enterprises) rather than the government is expected to pay the debt but, in the event, the government’s guarantee was exercised in servicing nearly the entire amount. 77 In 1998, the bulk of debt service payments was made to private creditors as the bond placements organized by Nomura, Merrill Lynch and Chase Manhattan all matured. However, as described in Section III.D, creditors in the latter two placements did roll over the bonds as they matured, albeit with an up–front cash payment.

Direct investment

135. Foreign direct investment grew, albeit from a low base, by about 10 percent during 1997. Gross investment flows into Ukraine amounted to $746 million, while overseas investment by Ukrainian residents amounted to $122 million. Investment flows during the first nine months of 1998 were slightly higher than in the same period of 1997. Total recorded foreign direct investment since Ukraine’s independence was $2.5 billion, or less than $50 per capita, as of end–June 1998. As noted in chapter IV, foreign direct investment inflows into Ukraine are among the lowest in the region on a per capita basis (Text Table 8). 78

Table 8.

Ukraine: Foreign Direct Investment Inflows, 1991–97 1

(In millions of U.S. dollars)

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Source: WEO database, December 1998.

Data refer to foreign direct investment into the reporting country. Per capita data are calculated relative to population estimates for 1997. Data sources and compilation methods differ by country.

136. The largest sources of foreign direct investment into Ukraine have been the United States (17.4 percent), the Netherlands (9.5 percent), Germany (7.9 percent), and South Korea (7.5 percent), followed by the United Kingdom, China, and Russia. Food processing, wholesale and retail trade, machine–building, and metal industries have attracted the largest shares of foreign direct investment. There has also been a small amount of foreign direct investment overseas by Ukrainian enterprises; this amounted to $122 million during 1997, or about one sixth of foreign direct investment inflows.

Short–term capital flows

137. The $264 million net inflow of short–term capital during 1997 masks considerable fluctuations within the year and, in particular, the significant outflows during the second half of the year. These outflows continued during 1998. In the first half of 1997, net capital inflows amounted to over $750 million, largely reflecting nonresident purchases of treasury bills (about $950 million). Increased confidence in monetary and exchange rate policies as well as substantial margins over dollar–denominated securities, contributed to the inflow of foreign capital. However, nonresidents gradually started to leave the domestic treasury–bill market during the second half of 1997. Inconsistent fiscal policy, uncertainties regarding parliamentary elections, and the financial turmoil in Asia contributed to a net capital outflow of $500 million during the second half of the year, of which about $450 million was accounted for by nonresidents’ unwillingness to roll over their treasury–bill holdings. The situation worsened during the first half of 1998 as the fiscal stance, combined with financial difficulties in Russia and domestic political uncertainties, resulted in further capital outflows. Net capital outflows during the first half of 1998 amounted to nearly $1.3 billion, of which more than $700 million was accounted for by nonresidents leaving the treasury–bill market. Consequently, the stock of domestic debt held by nonresidents fell from $1.6 billion at end–1997, to $0.9 billion at end–June 1998. Net capital outflows continued at a high rate during the third quarter of 1998 as the financial crisis in Russia added to existing pressures on emerging capital markets.

External debt

138. The outstanding stock of government and government–guaranteed debt increased to $11.8 billion at end–1997, principally due to the sharp increase in borrowing from international capital markets (Table 60). 79 The debt stock actually declined in 1998 as a result of the withdrawal of nonresident investors from the domestic treasury–bill market. As discussed in Section III.D., the relatively short maturity and expensive terms of the debt obtained from international capital markets, compounded by the shift in investor sentiment away from emerging markets, contributed to the liquidity crisis experienced during the second half of 1998. Nonetheless, the size of the debt stock (24 percent of GDP at end–1997) is not high relative to other developing or transition countries (Text Table 9).

Table 9.

Ukraine: Comparison of External Debt Stocks and External Debt Service in Transition and Other Countries

(In percent of GDP)

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Source: WEO database and WEO, October 1998.

D. Trade Policies

139. Ukraine maintained a relatively liberal trade regime during 1997 and 1998. However, while export restrictions were generally absent and average import tariffs were not high by regional standards, a variety of nontariff barriers (including the recently reintroduced export surrender requirements and the new administrative mechanism for foreign exchange allocation (see Appendix V for more details) served to complicate the regime and make its operation nontransparent.

140. On the export side, there were no quotas except on goods for which Ukraine has international obligations under voluntary export restraints or orderly market arrangements (primarily for steel and textiles). The only remaining export taxes (which ranged from 30 percent to 75 percent) were on exports of live animals and skins, which accounted for less than 1 percent of total exports. An advance deposit requirement for exports of sunflower seeds was introduced in mid–1998 but was eliminated in early September.

141. On the import side, the weighted average tariff rate was 7.5 percent as of end–1997 (1996 weights) and the simple average (excluding energy, which is exempt from import tariffs) was 11.52 percent. Less than 0.5 percent of all imports were subject to tariff rates in excess of 30 percent. While it is difficult to undertake cross–country comparisons of trade regimes, it would appear that Ukraine’s trade restrictiveness falls in the middle of the group of BRO countries, although it is somewhat more restrictive than the transition countries in eastern and central Europe (Text Table 10).

Table 10.

Ukraine: Comparison of the Restrictiveness of Trade and Exchange Regimes in Transition Countries1

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Source: “Growth Experience in Transition Economies”, IMF SM/98/228.

These indexes are based on the EBRD’s trade and exchange system indicator. A value closer to one represents a more liberal regime.

142. Throughout most of 1997, trade policy aimed to achieve greater liberalization: the number of mixed (specific and ad valorem) tariffs was reduced from 251 to 80 (at the four–digit level of the tariff schedule); the number of tariff bands was reduced to six (except those covering less than 1 percent of total imports); and excise taxes on domestic and foreign production were harmonized (except for a few alcoholic and other products that by legislation could not be changed until the years 2000 and 2001).

143. As the balance of payments weakened in late 1997, the trend toward liberalization was reversed somewhat, with increases in some tariff rates and an increase in the number of commodities subject to mixed tariffs. In October 1997, parliament passed the “Law on State Regulation of Agricultural Imports,” which increased the number of commodities subject to mixed tariffs to 217. Furthermore, tariff rates on a wide variety of products were increased in three steps during early 1998. In total, tariff rates for 5–10 percent of total non–energy imports were increased, resulting in an increase in the weighted average tariff rate to 7.7 percent (using 1996 weights). Subsequently, the government reversed these tariff increases so that the weighted average tariff rate was reduced to about 5 percent (using 1996 weights). The weighted average tariff rate excluding energy products was reduced to 7.5 percent and the simple average tariff rate was reduced to 12.7 percent. However, the rate of trade protection was increased in May 1998 due to the introduction of a system of seasonal tariffs for imports of key agricultural products at rates equal to double the existing tariff rates. The seasonal duties were designed to be in effect during the local harvest periods of the products, typically a three–month period. In order to provide greater stability and transparency to the tariff regime, a decree was issued that limits the frequency of revisions to the tariff schedule to once every six months.

144. The initial trade policy response to the Russian crisis has been to liberalize exports further. To this end, the number of commodities subject to indicative prices has been reduced to three (those for which anti–dumping concerns have been raised, such as steel) and draft legislation has been prepared to reduce registration requirements further. Another step toward liberalization was taken in December 1998, when the number of commodities subject to mixed tariffs was reduced to 25. However, as discussed in detail in Appendix V, a number of administrative measures were introduced in the foreign exchange market to counter mounting pressure on the exchange rate. One impact of these measures has been to restrict trade.

E. Exchange Arrangements

145. Ukraine accepted the obligations of Article VIII of the Fund’s Articles of Agreement in September 1996. This acceptance signaled the authorities’ intention not to restrict convertibility of the hryvnia for making international payments for current account transactions. The authorities were able to maintain this commitment until August 1998 when, in the face of mounting pressure on the exchange rate and dwindling reserves, the authorities reimposed a number of restrictions on current payments (see Appendix V). Capital account transactions are subject to registration/licensing requirements.

146. Prior to August 1998, the bulk of foreign exchange transactions were conducted in an interbank market between licensed banks. The interbank market covered both convertible and nonconvertible currencies. In addition, formal foreign exchange auctions were conducted at the currency exchanges located in Kyiv and Crimea.

Table 11.

Ukraine: Gross Domestic Product, 1995–98

(In billions of hryvnia; at current prices) 1/

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Sources: Ukrainian authorities; and Fund staff estimates.

Data in billions of hryvnia, introduced September 1996, where Krb 100,000 = 1Hrv.

Preliminary Fund staff estimates, based on the official Goskomstat unrevised estimate of 1998 GDP at Hrv 103.9 billion, and the observed historical pattern of upward revisions.

Table 12.

Ukraine: Retail Turnover in Goods and Services, 1996–98 1/

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Sources: Ukrainian authorities; and Fund staff estimates.

Retail trade of all registered enterprises in the state and cooperative sectors.

Table 13.

Ukraine: Utilization of Gross Domestic Product, 1995–98

(In billions of hryvnia; at current prices) 1/

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Sources: Ukrainian authorities; and Fund staff estimates.

Data in billions of hryvnia, introduced September 1996, where Krb 100,000 = 1Hrv.

Preliminary Fund staff estimates, based on the official Goskomstat unrevised estimate of 1998 GDP at Hrv 103.9 billion, and the observed historical pattern of upward revisions.

Table 14.

Ukraine: Investment, 1995–98

(In millions of hryvnia)1/

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Sources: Ukrainian authorities; and Fund staff estimates.

Data in millions of hryvnia, introduced September 1996, where Krb 100,000 = 1Hrv.


Deflated by Producer Price Index.

Table 15.

Ukraine: Gross Domestic Product by Sector, 1995–98

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Sources: Ukrainian authorities; and Fund staff estimates.

Preliminary Fund staff estimates, based on the official Goskomstat unrevised estimate of 1998 GDP at Hrv 103.9 billion, and the observed historical pattern of upward revisions.

Data in billions of hryvnia, introduced September 1996, where Krb 100,000 = 1Hrv.

Table 16.

Ukraine: Gross Industrial Production, 1995–98

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Sources: State Statistics Committee of Ukraine; and Fund staff estimates.

Preliminary data.

Data in billions of hryvnia, introduced September 1996, where Krb 100,000 = 1Hrv.

Fuel and energy complex includes fuel and nuclear energy.

Percentage change over corresponding period of