Ukraine
2003 Article IV Consultation—Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Ukraine.
Author: International Monetary Fund
Publication Date:
19 Jun 2003
eISBN:
9781451838961
Language:
English
Keywords:
ISCR; CR; government; government program; budget legislation; government intervention; consumer price inflation; exchange rate; Ukrainian authorities; reform program; foreign currency; government finance; collection ratio; Energy sector; Arrears; Global
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This 2003 Article IV Consultation highlights that real GDP of Ukraine grew by more than 4½ percent in 2002, marking the third year of Ukraine’s economic expansion following the 1998/99 financial crisis. As in 2001, growth was not only supported by robust consumer spending, reflecting large wage increases, but also by an increase in net external demand. Consumer price inflation fell to near zero in 2002, reflecting primarily the good harvests in 2001/02 and the resulting sharp drop in food prices. Low inflation was also supported by a tightening of fiscal policy and delays in increasing administered prices.

Abstract

This 2003 Article IV Consultation highlights that real GDP of Ukraine grew by more than 4½ percent in 2002, marking the third year of Ukraine’s economic expansion following the 1998/99 financial crisis. As in 2001, growth was not only supported by robust consumer spending, reflecting large wage increases, but also by an increase in net external demand. Consumer price inflation fell to near zero in 2002, reflecting primarily the good harvests in 2001/02 and the resulting sharp drop in food prices. Low inflation was also supported by a tightening of fiscal policy and delays in increasing administered prices.

I. Background to the Discussions

1. A new government, headed by Prime Minister Yanukovich, and a new central bank governor were appointed in late 2002. The government is currently supported by a relatively small majority in parliament. Presidential elections are scheduled for October 2004.

Ukraine: Key Economic Indicators, 2000–2003

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Sources: Ukrainian authorities; and Fund staff estimates.

2. GDP grew strongly for the third year running. Ukraine’s output decline during the 1990s was more severe and lasted longer than in most other countries in the region, and was followed by a strong recovery starting in 2000 (Figure 1). Real GDP growth was about 4½ percent in 2002, driven by continued strength in industry and domestic trade. Preliminary data for the first quarter of 2003 point to continued strong GDP growth. As in 2001, growth was supported by robust consumer spending, reflecting large wage increases, but also by an increase in net external demand. Investment demand fell substantially, reflecting a very large decline in inventories (mostly grains), while real fixed investment increased in line with GDP growth, Unemployment declined, reaching an average rate of about 10 percent in 2002, based on ILO methodology (Table 1).

Figure 1.
Figure 1.

Ukraine: Real GDP Level, 1991–2003 (1991=100)

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Source: Fund staff estimates.1/ Simple average of the CIS (excl. Turkmenistan) and Baltic countries.
Table 1.

Ukraine: Selected Economic Indicators, 1998–2004

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

Staff projections.

Cash balance adjusted for the net accumulation of expenditure arrears on wages, pensions, social benefits, utility payments, and VAT refunds.

Annual GDP divided by period-average broad money (M3).

Government and government-guaranteed debt, and NBU debt. Excludes debt by state-owned enterprises. Historic debt data are preliminary.

After rescheduling.

Period average. Staff estimates using INS database. Based on CPI and average trade weights for 1995–2001.

3. Inflation declined to very low levels in 2002, partly reflecting temporary factors. Consumer price inflation fell to near zero in 2002 (Figure 2), reflecting primarily the good harvests in 2001/02 and the resulting sharp drop in food prices, which account for almost two-thirds of the CPI. Low inflation was also supported by a significant tightening of fiscal policy and delays in increasing administered prices, as well as by continued exchange rate stability and rapid remonetization. However, consumer price inflation picked up in late 2002 and early 2003, following an earlier increase in producer price inflation.

Figure 2.
Figure 2.

Ukraine. GDP Growth and Inflation, 1999 Q1–2002 Q4 (year-on-year growth)

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.

4. The current account surplus increased significantly. The trade balance was boosted by a sharp increase in exports of grain, following good harvests in 2001/02, and oil products, reflecting the upgrading of oil refineries. Recently imposed anti-dumping measures by some trading partners led to a reorientation of metals exports (Ukraine’s largest export sector) to markets in Asia. The service balance surplus increased substantially, partly reflecting increased receipts from travel and a decrease in construction-related expenditures. Current transfers were boosted by workers remittances and World War II compensation payments.

5. Private sector portfolio outflows increased in 2002 (Table 3). In early 2003, the NBU introduced new licensing requirements to reduce loopholes for capital flight (such as share sales and repurchases at differential prices), while liberalizing procedures for obtaining foreign loans. In late 2002, the government tapped the international capital markets, augmenting its 2007 Eurobond series by about US$350 million on a net basis, at a spread of about 750 basis points over U.S. treasury bonds. More recently, spreads have declined and narrowed the margin over Russia (Figure 3). Following principal payments of almost US$900 million, external debt of the government and the NBU fell to about 25 percent of GDP at the end of 2002, low by regional comparison (Figure 4). Ukraine completed all bilateral debt rescheduling agreements with its Paris Club creditors, and an agreement on comparable terms is being discussed with Turkmenistan. Gross international reserves increased to 2¼ months of imports of goods and services by end-2002, moving rapidly towards the regional average.

Figure 3.
Figure 3.

Ukraine: Eurobond Spreads for Ukraine, Russia and Emerging Markets, July 2000–March 2003

(Basis points)

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Source: Datastream.
Figure 4.
Figure 4.

Ukraine and the Region: Economic Indicators, 1997–2003 1/2/

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Source: Ukrainian authorities; and Fund staff estimates.1/ Regional data are the simple average of the CIS (excluding Turkmenistan) and Baltic countries.2/ 2003 numbers are projections.3/ Includes foreign currency deposits.

6. NBU interventions kept the hryvnia constant against the U.S. dollar (Figure 5). Following the sharp adjustment of the exchange rate in the wake of the 1998/99 financial crisis, the real effective exchange rate has remained broadly stable (Figure 6). In 2002, it depreciated by about 3 percent in terms of consumer prices and appreciated by about 1½ percent in terms of producer prices. When based on unit labor costs, the real effective exchange rate is estimated to have depreciated modestly, reflecting very high unit labor cost growth in Russia. The strong improvement in Ukraine’s trade and services balance suggests that competitiveness remains adequate. In 2002, the average monthly wage in Ukraine was about US$70, compared to US$140 in Russia, and an average of about US$400 in EU accession countries.

Figure 5.
Figure 5.

Ukraine: Nominal Exchange Rate, January 1998–March 2003

(period average)

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Source: National Bank of Ukraine.
Figure 6.
Figure 6.

Ukraine: Real Effective Exchange Rates, 1995–2002

(1995=100)

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

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

7. Monetary aggregates continued to grow rapidly, accommodating a large increase in money demand. Base and broad money grew by 34 and 42 percent respectively in 2002, well above the regional average, fuelled by over US$1.7 billion in unsterilized net foreign exchange purchases by the NBU (Figure 7). In response to falling consumer price inflation in 2002, the NBU reduced the refinancing rate, from 12½ percent to 7 percent, and lowered reserve requirements. The strong growth in money demand, evidenced by the large balance of payments surplus, reflected growing public confidence and the continued remonetization of the economy, with nonmonetary transactions falling to below 20 percent of industrial sales in 2002 and enterprise arrears stabilizing at lower levels (Figure 8).

Figure 7.
Figure 7.

Ukraine: International Reserves and NBU Intervention, January 1995–February 2003

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.
Figure 8.
Figure 8.

Ukraine: Nonmonetary Transactions and Arrears, January 1999–December 2002

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Source: Ukrainian authorities.

8. The monetary expansion contributed to rapid loan growth in the banking sector. Banking credit to the economy grew by almost 50 percent in 2002 (Figure 9), following similar growth rates in the two preceding years. The FSAP mission found that this has weakened banking sector capitalization and contributed to increased credit risk (see FSSA and Box 3). A large share of the new loans was extended for trade financing and working capital, and most loans had maturities of one year or less. Despite the very rapid credit growth, preliminary official data indicate that the share of nonperforming loans decreased only modestly in 2002, to about 22 percent. The shares of foreign currency-denominated loans and deposits remained broadly unchanged in 2002, at about 40 percent and 33 percent respectively. Interest rates decreased (Figure 10), but lending rates and spreads still remained high, partly reflecting high credit risk.

Figure 9:
Figure 9:

Ukraine: Money and Credit Developments, January 1999–February 2003

(year-on-year growth)

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.
Figure 10.
Figure 10.

Ukraine: Interest Rates, January 1998–February 2003

(in percent)

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Source: National Bank of Ukraine.

9. Strong revenue performance contributed to a significant fiscal adjustment. The consolidated budget turned from a cash deficit of 1½ percent of GDP in 2001 to a surplus of ½ percent of GDP in 2002. Revenues increased by about 3 percentage points of GDP. High wage growth contributed to sharp increases in local government (income tax) and pension fund (payroll tax) revenues. VAT and excise revenues also rose markedly, partly reflecting improved tax policy and administration for imports. However, the stock of VAT refund arrears increased by 40 percent in 2002, reaching 1¼ percent of GDP, and by another 9½ percent in the first two months of 2003.

10. Financing constraints limited the increase in expenditures implied in the 2002 budget. Privatization receipts fell about 2 percent of GDP short of the budget target. Moreover, despite the strong overall revenue performance, nonearmarked cash revenues of the central budget were lower than budgeted, partly due to low nominal GDP growth. With wage and pension increases of 15–20 percent, significant cuts in non-protected central government spending were implemented through generalized cash rationing. There was also a small accumulation of social expenditure arrears. Moreover, due to slow progress on structural reforms, the government did not receive planned multilateral project and adjustment loans and, facing domestic financing constraints, tapped the much more costly international debt market instead.

11. Some reforms were implemented in the fiscal area. The single treasury account was fully implemented in mid-2002. Some tax privileges were eliminated at the beginning of 2003 (Box 2). Tax arrears increased from 3 percent of GDP at end-2001 to 6¾ percent of GDP at end-2002, mainly reflecting noncompliance in the energy sector and the inability to collect installments for tax arrears restructured under the 2001 tax amnesty. Unfunded social mandates were reinstated at the beginning of 2002, adversely affecting the financial position of communal enterprises. However, eligibility criteria were recently tightened, targeting improved, and administration strengthened, based on country-wide registration of beneficiaries.

12. There has been little progress on energy sector reform in the last two years. The restructuring of energy debts and the privatization of the remaining state-owned electricity distributors have been delayed. Cash collections reportedly increased to about 85–90 percent for gas and electricity (Figure 11), but the energy sector accumulated significant tax arrears in 2002.1 The staff estimates that the quasi-fiscal deficit in the energy sector was about 2½ percent of GDP in 2002, as reflected in the increase in arrears to suppliers and the tax authorities (Table 8). In addition, the coal sector receives budgetary subsidies of about 1 percent of GDP annually. The stock of debts and arrears of state-owned energy companies amounted to an estimated 12 percent of GDP in 2002.

Figure 11a.
Figure 11a.

Ukraine: Average Electricity Tariff, 1999–2002

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

Source: Ukrainian authorities.1/ Total cash collection divided by total consumption by final consumers.
Figure 11b.
Figure 11b.

Ukraine: Average Gas Tariff, 1999–2002

Citation: IMF Staff Country Reports 2003, 172; 10.5089/9781451838961.002.A001

13. Progress on other structural reforms has been mixed. According to the EBRD’s transition indicators, Ukraine has gradually made progress on structural reform, but remains behind many other transition countries—not only EU accession candidates, but also Russia and Kazakhstan. An important achievement has been progress on land reform, supporting growth in the agricultural sector. However, the privatization process slowed down and privatization receipts fell in 2002, partly reflecting the lack of any large sales to strategic investors. Modern civil and economic codes were recently adopted, strengthening contract enforcement and property rights.

II. Policy Discussions

14. The 2003 Article IV discussions focused on economic policies for 2003/04 and the medium-term outlook. While there was broad agreement in many policy areas, there were some differences on the assessment of risks associated with high monetary growth and bad loan portfolios in the banking sector, the NBU’s new long-term lending facility, tax policy and VAT refund administration, public sector wage policy, and energy reforms.

15. Understandings have not yet been reached on an economic program that could be supported under a precautionary standby arrangement. While the broad macroeconomic trends have been positive and the overall macroeconomic policy stance broadly appropriate, there were uncertainties about the authorities’ structural reform agenda in several macro-critical areas. Key issues include the need to address the growing problem of VAT refund arrears, to specify tax reforms aimed at eliminating exemptions and reducing tax rates, and to enhance transparency and reduce quasi-fiscal operations in the energy sector. The authorities recently submitted a comprehensive economic reform program to parliament, which highlights the need to accelerate structural reforms in many areas, including on wage policy, pension reform and social protection, privatization, competition policy, financial sector reform, tax reform, expenditure management, international cooperation, agricultural reform, and energy sector reform. The program is broadly consistent with the staff’s assessment in its recent Country Strategy Paper (Box 1), although it lacks some specificity on the policies to achieve the stated reform objectives. The staff is awaiting more concrete evidence of broad-based ownership of the authorities’ reform program, including passage by parliament of key economic legislation.

A. Economic Outlook and Vulnerabilities

16. Notwithstanding the weak global environment, Ukraine’s near-term economic outlook is favorable (Table 1). Staff projects real GDP growth of about 4½ percent in 2003, supported by continued strength in consumer spending and a relaxation of the tight fiscal stance of last year. The authorities felt that higher GDP growth, up to 6 percent, might be attainable, considering the strong outturn in the first quarter of 2003. Staff noted that its projections partly reflect the weaker outlook for agriculture, but agreed that GDP growth could be higher if external conditions or the investment climate improved. Inflation is expected to rebound to about 6 percent in 2003, reflecting the reversal of several temporary factors in 2002. Higher investment and import demand are projected to lead to a reduction in the current account surplus, while portfolio outflows are projected to subside. Gross international reserves are expected to increase to about 2½ months of imports by end-2003.

Lessons from the EFF-supported program

Following the expiration of Ukraine’s economic program support under the EFF arrangement in September 2002, the staff prepared a Country Strategy Paper to draw lessons and highlight future priorities. The paper was discussed with the authorities during the mission in October/November 2002 and has been the basis for discussions of a precautionary stand-by arrangement.

Key lessons from the EFF-supported program include:

  • Fiscal discipline is central to alleviating macroeconomic risks. Exchange rate-based stabilization, as practiced until the 1998/99 financial crisis, bears significant risks, especially if fiscal discipline is limited. The reversal of the short-term capital flows that helped finance a large fiscal deficit in 1997 led to the near exhaustion of Ukraine’s international reserves in 1998 and subsequently to a very large depreciation of the currency. Since 2000, fiscal tightening and prudent debt policies have substantially. reduced macroeconomic vulnerabilities.

  • Lack of program ownership inhibits progress on structural reform. While implementation of structural benchmarks under the program was satisfactory, overall reform progress was limited, especially in cases where the ultimate objectives of reform were opposed by vested interest and positive reform steps were partly offset by subsequent counterproductive measures.

  • Streamlining of structural conditionality helps focus on macro-critical issues. From 2000 onwards, Fund conditionality focused more narrowly on fiscal and central bank reforms, leaving the coverage of many other areas to the World Bank. The failure to implement several prior actions for the final reviews under the EFF in 2002 showed that streamlining alone is not sufficient to achieve ownership.

  • Long-term growth requires substantial progress on strengthening governance and transparency in order to improve the investment climate. Key challenges include tax reform (to create a level playing field), financial sector reform (to alleviate credit risk), and energy sector reform (to reduce quasi-fiscal operations).

The authorities broadly agreed with the staff’s analysis, including with the emphasis on program ownership and structural reform. They discussed future challenges with staff. The authorities subsequently drafted their own economic reform program, for parliamentary approval.

17. Intensified structural reforms are necessary to sustain high economic growth over the long term. The economic recovery that followed the deep output slump in the 1990s was made possible by the sharp real depreciation in the wake of the 1998/99 financial crisis and by the establishment of macroeconomic stability, which encouraged rapid remonetization and export growth. A combination of low wages and large excess capacities supported the recovery of the industrial sector. There were also some structural shifts driven by land reform and the emergence of small- and medium-sized enterprises, boosting agricultural production and trade. However, these factors are not sufficient to ensure sustained economic growth over the long run, as labor costs continue to rise and the existing capital stock ages. Investment and productivity growth will require an improvement in the investment climate, which is currently constrained by a distorted tax system, banking system weaknesses, quasi-fiscal activities in the energy sector, as well as problems with governance, transparency and the rule of law. The authorities stressed that their economic program envisages an acceleration of structural reforms in these areas.

18. Ukraine’s financial position is projected to improve further. On the basis of the authorities’ envisaged structural reform program, the staff’s medium-term baseline scenario projects annual average real GDP growth of 4 percent (Table 2).2 The scenario assumes a small primary surplus throughout the forecast period and reflects the authorities’ intention to keep new external borrowing in line with external amortization, supporting the continued decline in public and external debt ratios. With accelerated structural reforms, private sector investment and import demand would increase, unwinding the current account surplus. The capital account is projected to improve as outflows of private capital subside and foreign direct investment increases (Table 3), assuming a gradual improvement in the investment climate. The relatively strong balance of payments position would allow the NBU to achieve its gross reserves target of 3 months of imports by mid-decade.

Table 2.

Ukraine: Medium-term Macroeconomic Framework, 2000–2008 1/

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Sources: Ukrainian authorities and Fund staff estimates.

Baseline scenario, based on current macroeconomic policies and the authorities’ plans to accelerate structural reforms.

Government and government-guaranteed debt, and NBU debt. Excludes debts by state-owned enterprises.

Period average. Staff estimates using INS database. Based on CPI and average trade weights for 1995–2001.

Table 3.

Ukraine: Medium-term Balance of Payments, 2000–2008

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

Includes lease receipts and offsetting repayments under the Black Sea Fleet debt swap agreement.

Public and publicly-guaranteed debt. Historic debt data are preliminary.

Change in outstanding stock of arrears stemming from natural gas imports as reported by Naftogaz.

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

Estimates in 2000 and 2001 include goods-arrears swap transactions with Russia in 1999 and 2000.

19. The mission discussed economic risks and vulnerabilities. Under baseline assumptions, public and external debt ratios are relatively low and declining, and could absorb some temporary economic shocks (Appendix IV). To assess risks to debt sustainability under more adverse conditions, the staff prepared a low-case scenario (Table 4), which assumes slower progress on structural reforms and a looser fiscal stance (reflecting the risk of continued high wage growth and tax rate reductions with only limited elimination of exemptions). Sensitivity analysis shows that temporary economic shocks-such as a sharp real depreciation, increase in interest rates, or decline in growth—would jeopardize fiscal sustainability in this scenario. Staff also warned that liquidity problems could emerge in the event of fiscal slippages, spillovers of energy debts, financial sector problems, and/or a loss of domestic confidence. In addition, the possibility of sustained higher oil prices, a delayed global recovery, loss of access to the international debt markets, and sustained anti-dumping restrictions could adversely affect the balance of payments. Vulnerability indicators are summarized in Table 5.

Table 4.

Ukraine: Medium-term Scenarios, 2000–2008

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Sources: Ukrainian authorities and Fund staff estimates.

Compared to the baseline, the high-case scenario assumes more rapid progress on structural reforms, an improved investment climate, and a more favorable external environment.

Compared to the baseline, the low-case scenario assumes slower pace of structural reform, a looser fiscal policy, lower privatization receipts, higher interest rates, and more capital flight.

Government and government-guaranteed debt, and NBU debt Excludes debts by state-owned enterprises.

Table 5.

Ukraine: Indicators of Vulnerability, 1998–2003

(In percent of GDP, unless otherwise indicated)

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Sources: Ukrainian authorities; Moody’s Investors Service; Data Stream; and Fund staff estimates and projections.

Domestic and external debt contracted by the general government and the NBU.

Data include amortization of public debt falling due within the year, central bank short-term liabilities, short term financial liabilities of the commercial banks, and treasury bill holdings of non-residents. There are no reliable data on private capital flows and some capital inflows may be misclassified as current account transactions.

An appreciation is indicated by a positive growth rate; period average; CPI-based.

Based on the average weighted price (in US dollars) of common shares of issuers meeting Ukraine’s First Stock Trading System (PFTS) listing requirements with the highest liquidity. The index base is 100 as of October 1, 1997.

Moody’s Investors Service rating.

Relative to yield on U.S. treasury bonds.

20. The authorities stressed that progress on structural reform could produce higher GDP growth than projected in the baseline scenario, thus alleviating vulnerabilities. Staff agreed that Ukraine’s economy could continue to expand rapidly in the near term, but felt that the poor investment climate would constrain industrial restructuring and productivity growth, implying limited upside potential for GDP growth over the long run (high-case scenario in Table 4).

B. Fiscal Policy and Reform

21. The 2003 budget is consistent with debt sustainability, while relaxing the ex-post tight fiscal stance of 2002. The authorities stressed that the budget is realistic and prudent, with a central budget deficit of only ¾ percent of GDP. The staff noted that the deficit may turn out somewhat lower, as external project financing and related expenditures are likely to fall short of the budget assumption. On this bases, the consolidated deficit is projected at about 1 percent of GDP (Table 6), taking into account borrowing plans of the city of Kyiv and the government’s intention to ensure the financial balance of all social insurance funds. The authorities and staff agreed that the privatization process was currently too slow to achieve the budget receipt target of 1 percent of GDP and that additional domestic borrowing may be needed to finance the shortfall. Even in this case, total government and NBU debt would still decline by about 3 percentage points of GDP in 2003, to 32 percent of GDP.3

Table 6.

Ukraine: Consolidated Government Finances, 1998–2003

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Sources: Ministry of Finance; NBU; and Fund staff estimates and projections.

Starting from 2001, includes the newly-created Accident Fund.

Reported on a cash basis. Due to a new budget classification, expenditure data beginning in 2002 are not comparable to earlier years.

Cash balance adjusted for the net accumulation of overdue VAT refunds, energy and utility payment arrears, and social payment arrears.