Ukraine
Fifth and Sixth Review under the Extended Arrangement: Staff Report; Staff Supplement and News Brief on the Executive Board Discussion

Ukraine's economic performance has been impressive with strong growth and declining inflation under the Extended Fund Facility (EFF). Executive Directors appreciated the macroeconomic performance, and emphasized that continued prudent monetary policies in combination with exchange rate flexibility will be essential to maintain low inflation. They urged the need for accelerating structural reforms, liberalizing the agriculture sector, restructuring the bank, and strengthening the transparency and governance in the energy sector. They agreed that the country has completed the fifth and sixth reviews under the EFF.

Abstract

Ukraine's economic performance has been impressive with strong growth and declining inflation under the Extended Fund Facility (EFF). Executive Directors appreciated the macroeconomic performance, and emphasized that continued prudent monetary policies in combination with exchange rate flexibility will be essential to maintain low inflation. They urged the need for accelerating structural reforms, liberalizing the agriculture sector, restructuring the bank, and strengthening the transparency and governance in the energy sector. They agreed that the country has completed the fifth and sixth reviews under the EFF.

I. Introduction

1. In the attached letter, the Ukrainian authorities describe the measures they have taken to keep the EFF-supported economic program on track and, on that basis, request the completion of the fifth and sixth reviews under the EFF-supported program, including the establishment of performance criteria and benchmarks for September and December 2001. In view of the delays in completing the reviews, the authorities also request a rephasing of the remaining purchases under the arrangement.

II. Recent Developments

2. Following real GDP growth of 6 percent in 2000 (Table 1), the broad-based recovery of the Ukrainian economy continued, with real GDP growth reaching 9 percent in the first six months of 2001. The economic rebound was supported by: (i) strong growth in Ukraine’s main export markets, in particular Russia; (ii) improved competitiveness of Ukraine’s economy; and (iii) utilization of substantial idle capacity. The improved economic environment also contributed to an increase in private investment, including foreign direct investment. The external current account surplus reached 4.7 percent of GDP in 2000, up from 2.6 percent in 1999.

Table 1.

Ukraine: Selected Economic Indicators, 1997–2002

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Sources: Ukrainian authorities; and Fund staff estimates and projections.

Cash balance adjusted for the net accumulation of payments arrears on wages, pensions, and social benefits, and, in 2000, for the settlement of interest arrears to the National Bank of Ukraine (NBU).

Domestic financing includes purchases of treasury bills by nonresidents, and privatization proceeds.

Annual GDP divided by period-average broad money.

Includes Black Sea Fleet debt swap and repayments, and debt stock and actual payments under the commercial debt rescheduling of April 2000.

Historic debt data are preliminary.

After rescheduling.

From 1999 onward, the savings-investment balance reflects revised gas prices.

For the year 2001: January-July.

For the year 2001: January-May.

3. The nominal exchange rate has remained broadly stable since April 2000 at around Hrv 5.4 per U.S. dollar (Figure 1). NBU purchases of significant amounts of foreign exchange in the interbank market allowed a build-up of usable gross international reserves to a level equivalent to five weeks of imports by end-July 2001. Annual inflation, as measured by the consumer price index (CPI) on an end-of-period basis, fell to 5.3 percent in June 2001. This reflected the effects of the good harvest on food prices, which are expected to be partially reversed in the second half of the year. Mainly as a result of the annual inflation rate of almost 26 percent in 2000, the real effective exchange rate has appreciated by 12 percent between December 1999 and May 2001, partly reversing the real depreciation in 1998–99.

Figure 1.
Figure 1.

Ukraine: Exchange Rate Developments 1/

Citation: IMF Staff Country Reports 2001, 216; 10.5089/9781451838985.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ An increase indicates depreciation.

4. Program implementation has been satisfactory as regards macroeconomic policies, but was mixed in the structural area. All performance criteria for end-December 2000 and for end-March 2001 were met. The indicative targets for end-June 2001 were met, with the exception of base money, which also exceeded the indicative targets for end-December 2000 and end-March 2001 by a wide margin, reflecting the impact of the largely unsterilized foreign exchange purchases by the NBU. However, there were concerns about the implementation of the fiscal program related to the granting of a wide-ranging tax amnesty. Also, the structural program was implemented with delays. The finalization of a strategy to resolve the problems at Bank Ukraina took place only in June, and the export tax on sunflower seeds was reduced in June from 23 percent to 17 percent instead of to 10 percent, which was a structural benchmark for end-December 2000. At the same time, significant progress in other areas of trade liberalization was made, mainly in the context of the government’s efforts to join the World Trade Organization. The targets for cash collection ratios in the electricity and gas sectors through June 2001, which constituted quantitative structural benchmarks under the program, were achieved, but there were delays in the provisioning of full data on the gas sector.1

5. The consolidated budget deficit (cash basis) in 2000 was limited to 1¼ percent of GDP, below the program target of 1½ percent of GDP (Table 2).2 This was achieved primarily through strict expenditure control. Tax revenue was higher than projected in nominal terms, although it was ¼ of one percentage point of GDP below program. The December 2000 target for nonearmarked state cash revenue, a performance criterion under the program, was exceeded by Hrv 678 million (½ of one percent of GDP). Expenditure was kept in check throughout the year but was increased in the last quarter, in line with available financing, including from privatization and the World Bank. Social arrears were reduced by 1 percent of GDP, Hrv 256 million more than programmed, with payments arrears on pensions eliminated at end-August. Energy and utility arrears were reduced as well, and the recourse to non-cash offsets was eliminated, as programmed.3

Table 2.

Ukraine: Consolidated Government Finances, 1998-2002

(In millions of hryvnia)

(In millions of hryvnia)Sources: Ukrainian authorities; and Fund staff estimates and projections.

Revised budgetary projection discussed with the authorities during the February 2001 mission.

After debt rescheduling.

Includes the discrepancy between above-the-line and financing data.

The commitment balance is the cash balance adjusted for the net accumulation of arrears on wages, pensions, and benefits (social arrears), and, in 2000, for the settlement of interest arrears to the NBU.

6. Budget execution in the first half of 2001 has been broadly on track. Revenue performed very strongly in the first quarter but started to weaken in May, as a result of the implementation of a broad tax amnesty (see Annex I, para. 6). At the same time, privatization receipts were higher than projected, allowing expenditure to take place broadly as planned. At end-June, the budget recorded a small cash deficit of 0.2 percent of GDP, within the program ceiling. Social arrears were sharply reduced through March, but local governments accumulated new arrears on wages starting in April; the relevant end-June benchmark was met with a margin of Hrv 1 million.

7. Monetary policy in 2000 and the first half of 2001 has been dominated by sizable, largely unsterilized foreign exchange interventions by the NBU. As a result, base and broad money increased during 2000 by 40 percent and 45 percent, respectively, significantly more than programmed (Tables 3 and 4, and Figure 2), and have continued to expand during the first half of 2001, rising by 13 percent and 15 percent, respectively. The NBU bought about $1.6 billion in the foreign exchange market in 2000 and about $1.1 billion in the first seven months of 2001, boosting gross usable reserves to the level of $2 billion at end-July (Figure 3). These purchases were made possible by the current account surplus, as well as significant private sector inflows to finance purchases of state enterprises and the monetization of the economy. By the end of 2000, the NBU had strengthened its capability to absorb liquidity through reverse repurchase operations and the sale of certificates of deposit (CDs). The extent of sterilization remained modest and varied from $170 million in January 2001 to close to zero in April. The first half of 2001 has also been marked by a further sharp expansion of bank credit to the economy, which rose by 25 percent over the period December 2000–June 2001, driven in large part by increased lending to the agriculture sector.

Table 3.

Ukraine: Monetary Survey, 1998-2002

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Sources: Ukrainian authorities; and Fund staff estimates and projections.

Deflated by the CPI.

Annual average; for March, June, and September 2001, annualized quarterly GDP divided by the average stock of money during the quarter.

Figures for March, June, and September 2001 refer to changes from previous quarter.

Table 4.

Ukraine: Accounts of the National Bank of Ukraine and of Deposit Money Banks, 1998-2002

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Sources: Ukrainian authorities; and Fund staff estimates and projections.

Figures for March. June, and September 2001 refer to changes from previous quarter.

Figure 2.
Figure 2.

Ukraine: Monetary Indicators, January 1996-June 2001

Citation: IMF Staff Country Reports 2001, 216; 10.5089/9781451838985.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ New accounting standards introduced January 1, 1998.2/ End of month observations; yearly rate deannualized.3/ End of month observations; yearly rate divided by 12.
Figure 3.
Figure 3.

Ukraine: International Reserves and NBU Intervention, July 1997-July 2001

Citation: IMF Staff Country Reports 2001, 216; 10.5089/9781451838985.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ From December 1998 defined as gross usable reserves.

8. The authorities’ decision to undertake only limited sterilization efforts reflected their judgment that the strong monetary expansion accommodated an increase in money demand, because of the real economic growth and the increasing importance of cash transactions. The share of industrial production, including energy, sold for cash increased from 48 percent in 1999 to around 72 percent in 2000, and the share of industrial production sold on barter agreements declined from some 33 percent to around 17 percent. Also, the prevalence of barter agreements in international trade declined considerably in 2000. In view of the slowdown in annual inflation from October 2000, the NBU progressively lowered the rediscount rate from 27 percent at end-September 2000 to 17 percent as of August 9, 2001. The NBU also continued its policy of gradually reducing reserve requirements (Annex I, para. 13) and, despite concerns voiced by the staff, introduced a system of multiple reserve requirements.4

9. Despite some delays, the authorities have made progress in implementing their structural reform agenda. The pace of privatization picked up considerably in 2000, with receipts from the sale of enterprises totaling Hrv 2.3 billion, equivalent to 1.3 percent of GDP, as compared to Hrv 820 million (0.6 percent of GDP) in 1999. However, no large enterprise was sold using financial advisors and sales of minority stakes on the stock exchange accounted for more than a third of total privatization receipts.5 Thus far, execution of the 2001 privatization program has proceeded largely as planned, and six regional electricity distribution companies (oblenergos) were privatized in April in a transparent manner. However, the sale of several other high-profile enterprises has been marred by political disputes, bidders for a significant number of enterprises could not be found, and further sales of oblenergos have been temporarily suspended pending an assessment of previous oblenergo sales. To enhance the transparency of the privatization process, an ex-post review of operations in 2000, carried out by independent experts, was completed, providing recommendations for strengthening procedures. In addition, comprehensive information on privatizations covering the same period has been placed on the website of the State Property Fund (SPF). The SPF law, which would clarify the legal framework governing privatization, was adopted by parliament in July, but vetoed by the President citing constitutional concerns relating to the issue whether the SPF would report to the legislative or executive branch of government.

10. In the energy sector, further progress was made in increasing payments discipline. The trend toward greater cash payments, which had slipped in the latter part of 2000 and in January 2001, has since picked up again and average cash collection ratios for electricity and gas in the first half of 2001 reached 59 percent and 85 percent, respectively. A strict policy of cutoffs of nonpayers has contributed to this improved performance. The agreement between the government and Naftogaz on regular payments by Naftogaz of gas transit royalties and by budgetary organizations of their bills for gas consumption is being partially implemented as of mid-February 2001.

11. Bank Ukraina’s banking license was finally withdrawn on July 16, 2001. However, only limited progress was made in restructuring a number of other large banks, which do not meet many prudential and regulatory requirements (Box 1). The new Law on Banks and Banking Activities was enacted in January 2001, providing the legal base for strengthening the supervisory capacity of the NBU and its ability to deal with problem banks.

Banking Sector Developments

As of June 1,2001, the Ukrainian banking system consisted of 192 banks, 153 of which were operating, while the remaining 39 were under rehabilitation schemes monitored by the NBU. The eight largest banks comprise more than 50 percent of net assets of the sector, almost 20 percent of deposits, and about 60 percent of outstanding loans. The banking system shows increasing competition from new private-owned banks. There are seven foreign-owned banks that mainly serve foreign corporations. Partly because of complex foreign exchange regulations, the banking sector’s access to foreign financing is, however, constrained. The improved macroeconomic situation in combination with monetary easing has contributed to the expansion of the banking sector, as indicated by the growth of the credit portfolio of the banking system by 60 percent on a yearly basis in June 2001. However, the level of financial intermediation remains low, with total net assets of the banking system standing at only 22 percent of GDP, while total bank lending equals about 13 percent of GDP.

The health of the banking system is weak, mainly because of the adverse impact of past government interference in the operations of former state banks. Bank Ukraina was declared insolvent and its license removed on July 16, 2001. The two remaining state-owned banks, Savings Bank and State Export-Import Bank, are undergoing major rehabilitation programs. As of end-June 2001, 25 banks were not complying with one or more prudential regulations. Nonperforming loans amounted to 11 percent of the total loan portfolio, concentrated in the group of large banks, including the former state-owned banks. Although the reported overall capitalization of the sector is strong, the two large state-owned banks did not comply with the minimum capital requirements. While the weighted average interest rate for hryvnia loans dropped from 40 percent in June 2000 to 32 percent in June 2001, interest rate spreads remain high, at 20 percentage points (Figure 4).

Figure 4.
Figure 4.

Ukraine: Interest Rates on Commercial Bank Credits and Deposits, January 1998-May2001

Citation: IMF Staff Country Reports 2001, 216; 10.5089/9781451838985.002.A001

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

III. Policy Discussions

12. The policy discussions focused on measures that could enable the authorities to keep the 2001 fiscal program on track, ensure that the monetary expansion remains non-inflationary, and accelerate the execution of the structural program. The discussions earlier in the year took place against the background of mounting political unrest and uncertainty. In late April, parliament voted out the government, and a new government was appointed in late May. The political situation has subsequently calmed somewhat, and relations between the government and parliament have generally improved. The president and the presidential administration appear to have assumed a more active role in policy making than was the case under the previous government. Political activity may pick up again later in the year in anticipation of the next parliamentary elections in March 2002.

13. The macroeconomic framework for 2001 envisages a continued broad-based recovery. Real GDP is projected to grow by 6 percent, reflecting the expected slowdown of export growth in the second half of the year, and a strengthening of domestic demand driven by recent wage and pensions hikes, further repayments of social arrears, and increasing investment. Economic growth will also be supported by further market-oriented reforms, notably in the agricultural and energy sectors. With prudent fiscal and monetary policies, the annual inflation rate is targeted not to exceed a level of about 12 percent. The external current account surplus is expected to narrow to some 2¾ percent of GDP in 2001, as exports are projected to grow at a somewhat slower rate in the second half of the year in light of projected lower growth rates in Ukraine’s main trade partners (Table 5). The current account surplus is projected to decline to about 1 percent of GDP by 2005. The public external debt is projected to stabilize in dollar terms in the coming years, implying a decline from a level of more than 30 percent of GDP at end-2000 to 23 percent of GDP by 2005. The composition of public debt is programmed to continue to shift from commercial to multilateral and bi-lateral debt.

Table 5.

Ukraine: Medium-term Balance of Payments, 1998-2006

(In millions of U.S. dollars)

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Sources: Ukrainian authorities; and Fund staff estimates and projections.

Before 1999; the imports of gas are reported at a decreed price rather than actually observed price.

Includes Black Sea Fleet debt swap and repayments; and debt stock and actual payments under the commercial debt rescheduling of April 2000.

As reported by Naftogaz; creditors claim larger arrears. These are considered private arrears.

The definition of gross reserves excludes unusable reserves. Gross reserves at end-1998 were reported as US$949 million before this exclusion.

Rescheduling by the Paris Club and other bilateral creditors (on comparable terms).

Historic debt data are preliminary.

Official external program financing, largely from the World Bank and the European Union.

A. Fiscal Policies

14. The 2001 consolidated government budget targets a deficit of 3 percent of GDP (Annex I, para. 4). Compared with the 2000 outcome, revenues were projected to decline by more than 3½ percentage points of GDP,6 while expenditure was targeted to decline by more than 2 percent of GDP, partly due to lower domestic interest payments and lower social arrears clearance. At the same time, the budget provided for a basic wage increase of 25 percent for budgetary employees as of March 1, 2001, and a pension increase of 5–13 percent starting in February.7 In addition, starting this year, expenditures include project loans that are on-lent to enterprises. The budget deficit is to be fully financed by privatization receipts, originally projected at Hrv 5.9 billion, or 3 percent of GDP.

15. Based on developments so far in 2001, the authorities have revised their fiscal projections. The main revision is related to privatization receipts, which are now projected to amount to Hrv 3.5 billion, or 1.3 percent of GDP below the budgeted amount, due to expected delays in the execution of the privatization program. Since the program does not allow for any additional net domestic financing other than to offset net external financing, the deficit target was revised to 1.7 percent of GDP.8 Revenue is projected at 0.5 percentage point of GDP above the budget target, largely on account of strong economic activity and targeted tax administration measures. The remaining gap of close to 1 percent of GDP will be closed through expenditure cuts, mainly in capital spending and sectoral subsidies, that were projected in the original program to take place in the fourth quarter, as well as lower-than-projected interest payments.

16. The discussions on the 2002 budget focused on the need to ensure medium term sustainability, in order to end as soon as possible the recourse to privatization proceeds for deficit financing, and to improve the structure of expenditures in line with the government’s program of meeting the population’s basic social needs.9 Against this backdrop, it was agreed that the budget to be submitted to parliament would target a deficit of no more that 1.7 percent of GDP, financed by privatization receipts. The staff will discuss with the authorities 2002 budget contingencies in the context of the next program review. The proposed deficit would fit within a three-year strategy under which privatization proceeds will be used solely to retire debt starting in 2003.

17. In the structural fiscal area, the Budget Code was enacted on July 11, 2001, thus introducing a modern and effective budget management tool, defining expenditure and revenue assignments of lower level governments, and regularizing intergovernmental financial relations (see Box 2). Legislation was enacted in February to modernize tax collection procedures by replacing the distortionary Kartoteka II system by a number of judicially-based provisions that allow the State Tax Administration (STA) to seize assets of delinquent taxpayers. However, other parliamentary acts, which were often enacted in defiance of government wishes, worsened the structural basis of the budget. As part of the replacement of the Kartoteka II system, parliament passed a wide ranging tax amnesty; it also continues to enact exemptions.10 The government acknowledged that the granting of the tax amnesty was a reason for concern, but noted that attempts to limit the scope of the amnesty had been rejected by parliament. The Ministry of Finance has taken a number of specific administrative measures to offset, at least partly, the adverse impact of the amnesty. In addition, it has undertaken a comprehensive inventory of all existing tax exemptions and privileges, as part of the government plan to gradually phase them out. Efforts to improve the tax administration are also underway, and the STA is planning to establish two new Large Taxpayers Offices by year-end, including in Kyiv. On the expenditure side, the single treasury account is being implemented with technical assistance from the Fund, and should be in place by the end of the year. The implementation of the formula-based intergovernmental transfer system has partially begun in the context of the 2001 budget, and should be fully operational as of 2002, following the adoption of the new Budget Code.

The Budget Code

The Budget Code of Ukraine, signed into the law by the President on July 11, 2001, introduces a number of key reforms consistent with a model Organic Budget Law:

Macroeconomic management

  • Distributing budgeting powers between the executive and legislative branches. The government submits the guidelines for the macroeconomic and budgetary policies for the next year to parliament on June 1, the beginning of the budgetary cycle.

  • Setting a three-year financial planning horizon with clearly defined targets.

  • Promoting prudent fiscal management. The government is required to carry out economic surveys and reports on budget execution on a monthly basis and, if need be, to initiate changes to the annual budget law which then need to be approved by parliament.

  • Explicit legislative constraint on the size of public debt, equal to 60 percent of nominal GDP.

  • Extrabudgetary accounts are banned. Special funds are allowed, but the government is required to explain their rationale in advance.

  • Increasing parliament’s responsibility for sound fiscal policies. Bills proposed by the budget committee with a potential fiscal impact require an accompanying statement from the Ministry of Finance (MoF).

Budgetary process

  • The role of the MoF in the budget process is substantially increased, and relations between the MoF and line ministries are clearly defined.

  • The Code defines the key elements of the appropriation process.

  • The Treasury is expected to play the key role in budget execution, including at the local level. Further, only the MoF has the right to defer tax payments.

  • Program-based budgeting is introduced.

  • Transparency. The government is required to publish the draft annual budget law not later than one week after its official submission to parliament.

  • Time frame of the budget process. The annual budget law should be passed by December.

Intergovernmental finance reform.

The Budget Code defines the expenditure responsibilities of all levels of government, and matches them with the revenue assignments. Transfers from the central government are allocated on a formula basis and are made directly to the 700 local budgets. The major modification in revenue assignments is the significant strengthening of the revenue base of local budgets by assigning them the land tax.

Assessment

The Budget Code is in line with the key requirements for effective budget management laws. It enforces responsible macroeconomic management; protects the role of the executive in the budget process; increases its transparency; and launches intergovernmental reform. The main weakness is the absence of clear provisions regarding compliance, accountability, and sanctions. To complete the reform, legislation in these areas should be adopted.

B. Monetary and Exchange Rate Policies

18. The NBU will closely monitor monetary aggregates with a view to ensuring that the annual inflation target is met, and credit policy will be guided primarily by the program ceiling on the net domestic assets of the NBU (Annex I, para. 3). While the authorities underlined the importance of a stable hryvnia to their stabilization efforts, they noted their intention to manage the exchange rate flexibly and let foreign exchange market intervention be guided primarily by the external reserves target of the NBU. The targets for net international reserves have been increased to take account of the overperformance in 2000, recent economic developments, and in view of the need to strengthen further the external reserves position of the NBU. In this context, the NBU is committed to using the available money market instruments at its disposal to ensure that the impact of foreign exchange purchases on money supply is consistent with programmed inflation.

19. The NBU has initiated the implementation of measures to enhance the effectiveness and transparency of its operations, financial reporting framework, and internal control system. The internal audit department has started implementation of a program to audit most headquarter-based departments and functions, with priority assigned to those operations and units that may pose higher risks. The foreign exchange department has already been audited and the audit report, which includes recommendations for remedial actions and a follow-up plan, has been presented to the governor. In the area of risk management, an independent risk management unit, reporting directly to the governor, became operational in April of this year and presented its first report in early July. Regarding NBU budgeting and accounting, dividends will be distributed to the Treasury only after the audited NBU accounts for 2000 are approved by the NBU Council. The externally-audited 2000 financial statements of the NBU and the auditor notes were published in early August 2001.11 Although currently the NBU does not fully provide for impaired and doubtful assets in its own financial statements, it intends to achieve full provisioning for nongovernment loans by end-2002. The full implementation of these measures would further enhance the safeguarding of Fund resources (see also Box 3).

Safeguards Assessments—Summary of Conclusions

Under its current arrangement with the Fund, Ukraine is subject to the transitional procedures governing safeguards assessments. These procedures require the NBU to demonstrate that it publishes annual financial statements that are independently audited in accordance with internationally accepted auditing standards. The NBU cooperated fully in providing Fund staff with the required documentation needed to make such an assessment.

The staff has reviewed the documentation provided and noted that the NBU publishes annual financial statements that are audited by an international accounting firm in accordance with International Standards on Auditing. Based on this review, the staff has concluded that the Bank of Ukraine’s external audit mechanism meets internationally accepted standards.

The documentation provided by the NBU includes information on other areas of control and governance. The external auditor’s management letter—dated October 11, 2000—noted several weaknesses in the National Bank of Ukraine’s financial reporting framework and internal controls system, including the internal audit mechanism. Under the safeguards framework, the identification of vulnerabilities in these areas is not the primary purpose of the staff’s review for countries subject to the transitional procedures. Nevertheless, the weaknesses identified in the documentation suggest that safeguards in these areas may not be adequate. The authorities have taken steps to address many of these concerns in conjunction with the current EFF program. However, in light of these vulnerabilities, for the time being the staff supports the continuing commitment by the authorities to keep Fund disbursements in Ukraine’s SDR account.

C. Structural Policies

20. The authorities are committed to moving ahead forcefully in the area of privatization (Annex I, para. 8 and Box 4). The initial target for privatization receipts in 2001 has been revised downward in light of anticipated delays in finalizing the sale of the national telecommunications company (Ukrtelecom) in 2001 and the temporary suspension of further oblenergo sales. At the same time, a financial advisor to assist in the privatization of the remaining state-owned oblenergos has been selected and preparations for their sale continue. Preparations for the sale of Ukrtelecom are also proceeding, following the selection of a financial advisor in June; meanwhile, the authorities are considering to separately put up for sale Ukrtelecom’s stake in the mobile telephone company UMC.

21. Open and transparent privatization procedures form an important element of the policy agenda. Although important strides have been made in improving the privatization process in the context of the 2000-02 privatization program, the difficulties in successfully privatizing larger and profitable enterprises demonstrate that more progress is needed. Ongoing efforts to strengthen privatization procedures will be undertaken in consultation with the World Bank, and will preserve the central role of the State Property Fund (SPF) in managing all sales. Open bidding procedures, independent tender commissions, and the use of financial advisors are central to ensuring transparent privatizations, and the authorities are aware of the need to clearly define the role of the government and minimize undue political interference in the privatization process to bolster its credibility. To this end, a system of semi-annual reviews to be carried out under the supervision of the privatization advisory group, which includes the World Bank, will be continued, as will measures to improve the investment climate in general, in order to enhance interest in enterprises to be privatized.

22. In the energy sector, sustained improvement in payments discipline is essential to ensure the financial viability of the sector, reduce the fiscal burden, contribute to the normalization of financial transactions in the economy, and ensure external viability. To this end, cash collection ratios are targeted to rise further this year; full payments by budgetary organizations for energy in 2001 should contribute to this enhanced payments performance. To ensure progress in this area, the authorities intend to resist recent legislative initiatives to restructure the wholesale electricity market.

23. To improve transparency in the gas sector, Naftogaz has finalized the terms of reference for the second stage of its audit, which is now underway. This stage will include audits of the three key subsidiaries of Naftogaz, and will provide an estimate of Naftogaz’s production and transportation costs. In the electricity sector, monthly audit reports are being prepared of the central distribution account and the regional distribution accounts.

24. The discussions on the banking sector focused mainly on efforts to resolve the problems at Bank Ukraina. The authorities originally intended to transfer household deposits, which total about Hrv 270 million, to other banking institutions; however, this has been stalled by parliament’s refusal to approve the government’s issuance of T-bills to back these deposits. Deposits up to Hrv 500 (which cover more than 90 percent of depositors) will be reimbursed by the deposit insurance fund at a cost of about Hrv 60 million. In the meantime, the authorities are moving ahead on implementing bankruptcy procedures for Bank Ukraina. In addition, the authorities intend to set up a new financial institution to service the agricultural sector, including the distribution of government subsidies. Staff have urged the authorities to work closely with the World Bank on this issue.

25. Limited progress has been achieved in restructuring a few large banks, and significant concerns remain as to the long-term sustainability of these banks. For one of these banks, the NBU has prepared several resolutions imposing additional measures to safeguard its operations, but the ceilings on its exposure to the energy sector have been exceeded. The authorities were largely satisfied with the pace of restructuring efforts in other large banks. However, the high interest rate spreads and operating costs of banks in an environment of rapidly declining inflation, as well as the substantial bad loans portfolio pose serious vulnerability risks for the financial sector. These issues are particularly important in light of the rapid increase in credit to the economy in 2000 and the first half of 2001.

Structural Conditionality Streamlining Assessment

1. Coverage of Structural Conditionality under the Current Program

Structural conditionality under the program is set out in the Letter of Intent (Annex I, Table 10). The measures are critical for achieving the macroeconomic objectives of the program and cover the following areas:

  • Fiscal reform: A performance criterion on formula-based transfers to local governments and a benchmark on the single treasury account support the fiscal objectives of the program. The authorities will avoid any recourse to non-cash offsets;

  • Financial sector. A prior action on the withdrawal of the banking license for Bank Ukraina sends a strong signal that the authorities will deal firmly with financial sector weaknesses;

  • Trade liberalization: A prior action on the liberalization of trade in agriculture products supports the efficiency of markets and promotes agriculture output;

  • Transparency: A prior action on full provision of data (in particular regarding the gas sector), and benchmarks on the posting of the NBU’s financial statements and the completion of the audit of Naftogaz will promote improved transparency in these areas;

  • Privatization: A benchmark on publishing information on privatizations in 2000 aims to enhance transparency of the privatization process;

  • Energy Sector: Quantitative targets are set for cash collection ratios for electricity and gas.

2. Status of Structural Conditionality from Earlier Reviews

The only structural condition from the fourth review under the EFF that was not implemented was the reduction in the export tax on sunflower seeds. The tax was lowered to 17 percent rather than 10 percent, but “give-and-take” or tolling schemes for sunflower seeds were eliminated, increasing trade restrictiveness.

3. Structural Areas Covered by World Bank Lending and Conditionality

Recent World Bank adjustment operations have included conditionality in the financial and coal sectors. The Programmatic Adjustment Loan (PAL), which is currently being finalized, will include conditionality in the following areas: payments discipline; improvements to the business environment; strengthening the legal framework; agriculture sector reform; intergovernmental finance; public administration reform; improvements to the delivery of social services; and the environment. The PAL will also include conditionality on audits of Naftogaz, and on a defined number of transparent privatizations. In addition, the EBRD maintains substantial conditionality in the electricity sector.

4. Structural Conditions not Included in the Current Program

The current program does not include conditionality on communal tariffs, which were raised in 2000. The areas of private sector development and the agriculture sector are covered by World Bank conditionality. Conditionality related to specific privatization operations has not been included.

26. In other structural areas, although the reduction of the export tax on sunflower seeds was not what had been envisaged, the authorities have also taken a number of further trade liberalization measures (Annex I, para. 17). The authorities reported that communal tariffs are now close to cost recovery levels in almost all areas of the country, and that a mechanism is in place to ensure that tariffs are adjusted on a regular basis. The review of Free Economic Zones and Special Investment Regimes called for the closure of one zone and the restriction of activities in a number of others. In the meantime, the government will resist recent initiatives to establish new special zones. Efforts to strengthen the climate for private sector development continue; in this context, the draft laws on certification and standardization have been enacted. The ongoing reform of the agriculture sector, which is transforming land ownership and liberalizing the sector, will be continued.

IV. Medium-Term Outlook and Program Financing

27. The authorities have made significant steps towards achieving a sustainable external position. Following the rescheduling of public debt to commercial banks in early 2000, Ukraine has now also been granted a rescheduling of its official bilateral debt by Paris Club creditors. An agreed minute was signed on July 13, 2001 in which creditors committed to reschedule principal in arrears and falling due during the period of the Extended Arrangement in the amount of $580 million (for details, see Annex I, para. 20). The government has also entered discussions with other bilateral creditors, notably Turkmenistan, in order to seek rescheduling on similar terms, while taking into account that some of this debt was previously rescheduled. On the basis of these agreements, external debt service payments in the medium term are projected to remain broadly constant at a level of about 6 percent of exports of goods and services. Progress is also being made with regard to rescheduling of the large payments arrears for gas imports. The outstanding arrears are being treated as private sector arrears.

28. Another cornerstone for achieving external viability involves further increasing external reserves. Over the medium term, the program targets an increase in gross foreign reserves to about 3 months of imports (excluding transit gas) through gradual but significant purchases of foreign exchange by the NBU. This target is also expected to ensure adequate coverage of short-term external debt obligations. To help the NBU achieve this target, the government will commence to repay in 2002 a $1.3 billion loan from the NBU. Moreover, to the extent privatization receipts and foreign budgetary assistance would be higher than the budgeted amounts, the government intends to reduce its net indebtedness to the NBU, thereby allowing a more accelerated reserve buildup. Close coordination between the government and the NBU is needed to achieve the inflation and reserve targets of the program.

29. The program is fully financed for the remainder of 2001, while the higher level of external reserves indicates some strengthening in Ukraine’s capacity to repay the Fund (Tables 6 and 7). The ratio of payments to the Fund to gross reserves in the next few years is now lower than at the time of the fourth review but noneth