Request for Stand-By Arrangement-Staff Report; Staff Supplement; and Press Release on the Executive Board Discussion

This paper examines Ukraine’s Request for a Stand-By Arrangement (SBA). The authorities have requested a 12-month SBA, which they intend to treat as precautionary. Their economic program for 2004 aims to sustain recent stabilization gains and advance some important structural reforms. Key objectives are to support economic growth; keep inflation under control; bolster debt sustainability; maintain an adequate level of international reserves; reduce credit risk in the banking sector; and improve the investment climate, including through wide-ranging tax reforms.


This paper examines Ukraine’s Request for a Stand-By Arrangement (SBA). The authorities have requested a 12-month SBA, which they intend to treat as precautionary. Their economic program for 2004 aims to sustain recent stabilization gains and advance some important structural reforms. Key objectives are to support economic growth; keep inflation under control; bolster debt sustainability; maintain an adequate level of international reserves; reduce credit risk in the banking sector; and improve the investment climate, including through wide-ranging tax reforms.

I. Background

1. The Ukrainian authorities have requested a 12-month stand-by arrangement, which they intend to treat as precautionary, with total access of SDR 411.6 million. Their economic program is aimed at sustaining recent stabilization gains and momentum on structural reform. Discussions were initiated in late 2002, on the basis of a country strategy paper prepared by Fund staff, summarized in Box 1 of the 2003 Article IV staff report (SM/03/133). Given past difficulties in implementing key structural reforms under the EFF-supported arrangement, time was allowed to build ownership and make progress on key structural reforms prior to the arrangement. The authorities implemented several prior actions relatively quickly, but it took until late 2003 to make sufficient progress on VAT exemptions, partly reflecting resistance in parliament, and on VAT refund arrears, partly reflecting governance weaknesses. At the same time, two envisaged structural benchmarks were implemented ahead of schedule.

2. Macroeconomic performance has improved substantially since the 1998-99 financial crisis, but vulnerabilities remain. The sustained economic recovery that followed the deep output slump in the 1990s was supported by the sharp real exchange rate depreciation in 1998-99 and by the establishment of macroeconomic stability, in particular the maintenance of a prudent fiscal stance. This allowed a sharp reduction in public debt ratios, rapid remonetization, and the rebuilding of international reserves. These favorable trends have also been seen in other countries in the region (Figure 1). Ukraine has regained access to international capital markets and there is no immediate balance of payments need. However, international reserves adequacy could be jeopardized in case of a loss in confidence resulting from potential political instability, banking sector problems, or external shocks. Moreover, to sustain strong economic growth over the medium term, the investment climate would need to be improved, including by strengthening governance and pushing ahead with market-oriented reforms.

Figure 1.
Figure 1.

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

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.1/ Regional data are the none average of the CIS (excluding Turkmenistan) and Baltic countries.2/ Includes foreign currency deposits.

3. The government’s economic reform agenda has found support in parliament. In 2003, parliament approved the government’s comprehensive economic reform strategy; wide-ranging tax reforms; anti-money laundering legislation; pension reform; new civil and commercial codes; and laws that strengthen the legal framework for financial intermediation.

4. Presidential elections are scheduled for October 2004, implying likely changes to the cabinet. Ukraine’s constitutional court recently ruled that president Kuchma could run for another term, but he has repeatedly stated that does not intend to do so. Parliament has cast a vote in favor of a constitutional reform that would shift some powers from the president to parliament. Changing the constitution would require a two-thirds majority in parliament. At this stage, it is uncertain whether the reform will pass.

5. Real GDP grew by an estimated 8½ percent in 2003, despite the poor grain harvest, completing the fourth year of Ukraine’s strong economic recovery (Figure 2). The expansion was driven by an 18 percent increase in manufacturing (especially metals, machinery, vehicles, and food processing), double-digit growth of transport services and domestic trade, as well as a sharp rebound in construction. Aggregate demand was supported by buoyant consumer spending, reflecting continuing strong wage growth (Table 1), and by a rebound in private investment, supported by an improved economic outlook.

Figure 2.
Figure 2.

Ukraine: Real GDP Level, 1991-2003


Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Source: Fund staff estimates.1/ None average of the CIS (excl. Turkmenistan) and Baltic countries.
Table 1.

Ukraine: Selected Economic Indicators, 1999–2004

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

Assumes an exchange rate of 5.33 Hrv/US$.

From 2003 onwards, based on an accounting treatment that excludes offset-based amortization to Russia, which decreases revenues and increases net external financing (and the budget deficit) by 0.2 percent of GDP relative to previous years.

Cash balance adjusted for the net accumulation of expenditure and VAT refund arrears, as well as for non-cash property income.

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

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

Period averages; (+) represents real appreciation; based on CPI and average trade weights for 1996-2002.

6. Inflation rose considerably in 2003 (Figure 3), largely due to supply-side factors. Consumer price inflation, on a 12-month basis, rose from near zero at end-2002 to about 8 percent at end-2003, as poor weather conditions in agriculture led to a sharp increase in food prices, which account for almost two-thirds of the CPI. Excluding the most volatile food items, the 12-month inflation rate was 4½ percent at end-2003, up by less than 2 percentage points from end-2002. Producer price inflation increased to 11 percent at end-2003, partly as a result of higher food, oil, and metals prices. Continued strong growth in money demand and a tight fiscal policy helped keep inflation in the single digits, despite the very high rates of money growth.

Figure 3.
Figure 3.

Ukraine: GDP Growth and Inflation, 1999 Q1-2003 Q4

(year-on-year growth)

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.

7. The balance of payments recorded a large surplus in 2003. The current account surplus remained high, at an estimated 6 percent of GDP. Both exports (especially energy products and chemicals) and imports (especially food) increased significantly. The capital account was boosted by US$1 ¼ billion in foreign direct investment and US$1 billion in sovereign 10-year Eurobond issues in June and October 2003. The issues, which contained a collective action clause, sold for a yield of 7.65 percent, benefiting from low spreads over U.S. treasury bonds (Figure 4). Two rating agencies upgraded their sovereign risk ratings for Ukraine in 2003. Gross international reserves increased to almost US$7 billion, about 3 months of imports and 3 ½ times one-year official external debt service, driven by over US$2 billion in net foreign exchange purchases by the NBU (Figure 5). Gross external debt of the government and central bank increased modestly in U.S. dollar terms as a result of the depreciation of the U.S. dollar against other currencies.

Figure 4.
Figure 4.

Ukraine: Eurobond Spreads for Ukraine, Russia and Emerging Markets, Dec. 2000–Dec. 2003

(Basis points)

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Source: Datastream.
Figure 5.
Figure 5.

Ukraine: International Reserves and NBU Intervention, January 1998–December 2003

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Sources: Ukrainian authorities; and fund staff estimates.

8. NBU interventions have kept the hryvnia constant against the U.S. dollar (Figure 6). The exchange rate has remained competitive, as reflected in relatively low wage levels and the continued large surplus on the trade and services balance. Ukraine’s real effective exchange rate has remained broadly stable since the 1998-99 financial crisis (Figure 7). The annual average of the CPI-based real effective rate depreciated by almost 7 percent in 2003, partly reflecting the depreciation of the U.S. dollar against the euro and the real appreciation of the Russian ruble against the hryvnia.

Figure 6.
Figure 6.

Ukraine: Nominal Exchange Rate, January 1998–December 2003

(period average)

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Source: National Bank of Ukraine.
Figure 7.
Figure 7.

Ukraine: Real Effective Exchange Rates, 1995–2003


Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Sources: Ukrainian authorities; WEO; and Fund staff estimates.1/Estimates for 2003.

9. Large unsterilized foreign exchange purchases continued to fuel rapid money and credit growth (Figure 8). Base and broad money grew by 30 and 47 percent respectively in 2003. Deposits in commercial banks increased by 63 percent. Banking credit to the economy grew by 64 percent in 2003, raising the credit-to-GDP ratio to 28 percent at end-2003, from just under 20 percent a year earlier. The share of foreign currency loans declined only modestly, to 39 percent at end-2003. imterest rates on hryvnia loans continued to decline, but still remained high, at about 18 percent on average in December 2003 (Figure 9). Responding to rising inflation, the NBU raised its overnight rate from 8 to 8½ percent in January 2004.

Figure 8.
Figure 8.

Ukraine: Money and Credit Developments, January 2000–December 2003 (year-on-year growth)

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Sources: Ukrainian authorities; and Fund staff estimates.
Figure 9.
Figure 9.

Ukraine: Interest Rates, January 2000–December 2003

(in percent)

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Source: National Bank of Ukraine.

10. The 2003 FSSA found that the rapid rate of credit growth had weakened banking sector capitalization and contributed to high credit risk (SM/03/148). To enhance banking sector capitalization, the NBU has strengthened loan classification rules and decreed to increase the minimum capital adequacy ratio from 8 to 10 percent, effective from March 2004.

11. Budget execution improved significantly in 2003, resulting in a consolidated deficit of ¾ percent of GDP. Revenues were boosted by stronger-than-expected economic growth and central government expenditures reached the overall budgeted level, a major break with Ukraine’s long history of expenditure sequestration. The public sector wage bill continued to rise faster than nominal GDP, partly due to the need to restore relative wage scales, following the January 2003 minimum wage increase. The government contained future wage growth by obtaining parliamentary approval of postponing the 28 percent minimum wage increase planned for July 2003 to December 2003, and reducing it to 11 percent. Pension increases were broadly in line with inflation.

12. Progress has been made in addressing VAT refund arrears. For the first time in years, the stock of refund arrears was reduced in 2003, to about ¾ percent of GDP. The size of the reduction (almost ½ percent of GDP) was well above the floor specified as a prior action under the program. The government has embarked on a one-off securitization of the remaining arrears, offering taxpayers 5-year interest-bearing bonds as payment. Arrears on wages and social assistance for families, which had increased in 2002, were almost fully cleared.

13. Ukraine’s tax and pension systems are being overhauled. Effective January 2004, the corporate income tax rate was reduced from 30 percent to 25 percent, and the progressive personal income tax schedule was replaced with a single 13 percent rate. The tax base has been broadened significantly with the elimination of many tax preferences1 (Box 1). Parliament also approved laws on mandatory state pensions and voluntary private pensions, after more than four years of preparation. The laws reform the current pay-as-you-go pension system, improving its equity and rationalizing privileges, and establish a framework to allow for a gradual transition to a three-pillar pension system.

14. Progress on energy sector reform has been modest. Quasi-fiscal operations in the energy sector remain significant, although the cash collection ratio increased in the electricity sector in 2003 (91 percent compared to 83 percent in 2002) and in the gas sector (91 percent compared to 89 percent in 2002). The state-owned gas company Naftogaz paid its obligations to the budget in full for the first time in years, largely reflecting the introduction of a zero VAT rate for imports of natural gas. Efforts to privatize electricity distribution companies and address the large stock of debts in the energy sector have been delayed.

15. Ukraine’s legal system has been strengthened. Creditor rights and the legal framework for financial intermediation were improved by the adoption of new civil and commercial codes, as well as a law on mortgages. The recently adopted telecommunications law sets up an independent regulator and provides a legal basis for future privatization and regulation of the sector. Privatization receipts in 2003 were boosted by the sale of a mobile phone company.

II. Policy Discussions on the 2004 Program

A. Program Objectives and Risks

16. The authorities’ economic program for 2004 Ukraine: Key Economic Indicators, 2001-2004 aims to sustain Ukraine’s recent macroeconomic stabilization gains and maintain the momentum on growth-oriented structural reforms. No immediate balance of payments need is expected, although potential domestic or external shocks (discussed below) could undermine international reserve adequacy. Moreover, the Sources: Ukrainian authorities; and Fund staff estimates and projections. authorities believe that a Fund-supported program would facilitate the coordination of macroeconomic policies and help signal a strong commitment to achieving their economic goals.

Ukraine: Key Economic Indicators, 2001–2004

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

17. The main program objectives are to:

  • Support sustained economic growth. The 2004 budget is based on a conservative projection of about 5 percent real GDP growth. Higher growth is quite possible, given the improved business outlook. To sustain economic growth over the medium term, the authorities aim to improve the investment climate by strengthening governance, reforming the tax system, strengthening the financial sector, and achieving WTO membership.

  • Keep inflation under control. The objective for 2004 is to reduce consumer price inflation to the mid-single digits. This is likely to require a tighter monetary policy and the maintenance of prudent fiscal policies, although the high volatility of food prices implies significant uncertainty about the CPI outlook.

  • Reduce vulnerabilities. Executing the 2004 budget and maintaining a low deficit thereafter will support the continued reduction in public debt ratios, providing a safety net for potential fiscal costs of future structural reforms or economic shocks. Addressing the financial problems of the energy sector will help reduce quasi-fiscal deficits and contingent liabilities. The authorities’ international reserves target of 3 months of import coverage is equivalent to about 4 times external official debt service and to about two times foreign currency deposits in the banking sector. To reduce credit risk in the banking sector, the NBU is strengthening prudential regulations and banking supervision with a view to discourage imprudent lending practices.

18. Achieving these objectives will enhance prospects for medium-term growth and stability. Under the baseline scenario, real GDP growth would average about 4 percent per year during 2005-2008 (Table 2), almost 5 percent on a per capita basis. The current account surplus would gradually unwind, as investment and foreign capital inflows increase over time (Table 3). International reserves are targeted at 3 months of imports, which should ensure adequate coverage of official debt service. Public debt ratios would continue to decline, from 32 percent of GDP in 2003 to below 20 percent of GDP in 2008.

Table 2.

Ukraine: Medium-term Scenarios, 2003–2008

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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 slate-owned enterprises.

Table 3.

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

(In millions of U.S. dollars; unless otherwise indicated)

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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.

Arrears stemming from natural gas imports as reported by Naftogaz.

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

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

World Bank, European Union, and central government commercial borrowing.

19. Most vulnerability indicators have improved (Table 4), but stabilization gains could be reversed in case of banking sector problems, political instability, and/or external shocks.

  • A key area of risk is Ukraine’s banking sector. A sustained lending boom, a limited role played by international banks, inadequate regulation of connected lending, extensive foreign-currency denominated lending in the context of a de facto fixed exchange rate – these are features that have eventually led to banking crises in a number of other countries. While the program addresses this problem in part by raising minimum capital adequacy requirements and tightening insider lending rules, the rapidly expanding banking sector will remain a significant source of risk.

  • Political risk remains substantial, especially in the context of the proposed constitutional reform and the run-up to the October 2004 presidential elections. A politicized environment could undermine macroeconomic management and is likely to slow down the structural reform process. In the short term, this could weaken domestic confidence and put pressure on international reserves and/or the exchange rate. Over the medium term, if combined with fiscal loosening and/or a large-scale assumption of non-government debt (such as energy sector debt), it could jeopardize economic growth and debt sustainability (Appendix IV).

  • External shocks, such as lower demand for Ukrainian exports or a deterioration in international capital market sentiment, could lead to a sharp reversal in the balance of payments position, jeopardizing reserve adequacy.

Table 4.

Ukraine: Indicators of Vulnerability, 1998-2003

(In percent of GDP, unless otherwise indicated)

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Sources: Ukrainian authorities; Moody’s Investors Service; DataStream; and Fund staff estimates.

Domestic and external debt contracted by the general government and the NBU; includes budgetary arrears;

VAT refund arrears data only begin in 2001.

Series break due to new classification rules in 2003.

Data include amortization of public debt falling due within the year, central bank short-term liabilities, short-term financial liabilities of 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 and average trade weights (1996-2002).

Based on the average weighted price (in U.S. 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. Note that on June 25, 2003 Fitch upgraded Ukraine’s long term sovereign rating from B to B+.

Relative to yield on U.S. treasury bonds.

B. Fiscal Policy and Reform

20. The government intends to maintain a prudent fiscal policy stance. The 2004 budget law provides for a central government deficit of 1½ percent of GDP, and the program aims to keep the consolidated cash deficit of the general government at about 1¾ percent of GDP.2 The deterioration in the consolidated balance of about 1 percent of GDP is broadly explained by the acceleration in arrears clearance, the projected increase in foreign project financing, and an increase in interest expenditure (Table 5). Taking into account arrears clearance, the consolidated deficit would be about ¾ percent of GDP, implying a primary surplus on a commitments basis. Under baseline assumptions, this would reduce total debt of the government and central bank from about 32 percent of GDP at end-2003 to about 28 percent by end-2004.3 The reduction in public debt ratios during the current economic expansion will create room to finance future structural reforms and to cope with the fiscal consequences of a potential economic downturn. The authorities intend to submit a 2005 budget that would allow for a further consolidation of debt sustainability. The size of the deficit, to be discussed at the time of the review, will depend on the outlook for aggregate demand, the speed and cost of structural reforms, and the revenue outlook based on recent and planned tax reforms.

Table 5.

Ukraine: Consolidated Government Finances, 2000-2004

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

Starring 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, social payment arrears, and noncash property income (i.e. netting of debt owed to Russia with Russia’s payment for use of black seaport facilities).

Excludes offset with Russia involving US$ 98 million amortization for 2003–2004 (for both budget and program data).

Ukraine: Consolidated Government Finances, 2001–2004

(In percent of GDP)

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Cash balance adjusted for net change in arrears and non-cash property income.

21. The sweeping tax reforms (Box 1) imply greater than usual uncertainty about the fiscal revenue outlook for 2004. Aiming for revenue neutrality, the government delayed the envisaged reduction in the VAT rate, while suspending some key sectoral VAT exemptions already this year. On this basis, the steep reductions in corporate and personal income tax rates, effective since January 2004, are projected to be broadly offset by the reduction in tax exemptions (Box 1) and additional revenue measures, including a heating surcharge and higher customs fees.

22. Non-interest expenditure of the consolidated budget is projected to grow in line with GDP. The budget provides for a reallocation of spending, with additional spending on capital spending (including road construction) and social spending. Direct subsidies for coal and agriculture have also been increased, to about ¼ percent and 1 percent of GDP respectively, while spending on goods and services has been curtailed. Despite the reduction in public debt, interest expenditure is set to rise this year, due to the inflation indexation of restructured treasury bills held by the NBU and the securitization of VAT refund arrears.

23. The government intends to clear the entire stock of VAT refund arrears in 2004. Staff welcomed this intention and stressed the importance of remaining current on refund claims, in order to address governance concerns, strengthen tax compliance, and remove distortions in international trade. In early 2004, the government initiated a one-off securitization of VAT refund arrears, offering taxpayers interest-bearing five-year government bonds with equal annual amortization payments for all valid refund arrears outstanding prior to November 1, 2003. The interest rate is currently about percent, based on a markup over the NBU discount rate (currently 7 percent). The secondary market value of the bonds is expected to be below face value, given a relatively illiquid domestic securities markets and an average yield on 18-month treasury bills of 11 ½ percent in 2003. To remain current on refund claims, the authorities will employ more risk-based audits of tax payers and allow greater automaticity in making refunds. The staff welcomed some of the proposals, while cautioning against the introduction of individual taxpayer VAT accounts, given the additional administrative burden. The staff also questioned whether the authorities’ action plan would suffice to resolve the arrears problem, stressing the need to strengthen governance in the tax administration, including by holding it more accountable for processing valid claims on time and improving the coordination between the relevant government agencies.

Tax Reforms

Effective January 2004, the corporate income tax rate has been reduced to 25 percent, from 30 percent. The rate schedule of the personal income tax, with a top marginal rate of 40 percent and an effective tax rate of about 17 percent, has been replaced by a single rate of 13 percent and a tax credit equivalent to 30 percent of the minimum wage. The VAT rate is scheduled to be reduced from the current 20 percent to 17 percent in 2005, and 15 percent in 2006.

At the same time, tax preferences have been cut significantly in 2003 and 2004, reducing their fiscal costs to 2¾ percent of GDP in 2004, compared to 4 ½ percent of GDP in 2002. The main profit tax exemptions were eliminated or suspended by the 2003 and 2004 budget laws. The personal income tax base has been broadened to include interest income and a wider definition of capital gains, while occupation-based tax exemptions have been replaced by equivalent budgetary payments to beneficiaries. Many sectoral VAT exemptions have been suspended, including for aircraft production, housing construction, shipbuilding, and some pharmaceutical goods.

Tax Preferences 1/

(in percent of GDP)

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Sources: Finance Ministry, State Tax Administration, and staff estimates

Excludes exemptions for social security contributions; uses new tax rates in 2004.

The reforms of the corporate and personal income tax regimes are estimated to result in a net revenue loss of about 1 percent of GDP, reflecting a loss of about 2 percent of GDP due to rate reductions and about 1 percent of GDP gained through base broadening. The planned VAT rate reduction in 2005 would reduce revenue by about 1 percent of GDP, which is projected to be largely offset by the elimination of VAT preferences, while the additional rate reduction in 2006 would reduce the revenue base by another ½ percent of GDP.

24. The authorities intend to continue reforming the tax system. The revenue impact of the reduction in the VAT rate scheduled for January 2005 would be partly offset by a reform of the highly preferential VAT regime for agriculture and the elimination of other sectoral VAT exemptions. To make the cost of the remaining tax preferences transparent, the authorities will continue to include a tax expenditure budget for information in the annual budget submission. As one option to reduce the shadow economy, the authorities have considered the possible legalization and taxation of previously undeclared assets and income, but have not decided whether to pursue such a scheme. Staff cautioned about the risks to future tax compliance, and the authorities stressed that they will not write off existing tax obligations (tax arrears were equivalent to about 5 percent of GDP at end-2003).

25. Expenditure controls are to be strengthened further. As of January 2004, the treasury system covers all local governments. A system of monitoring social entitlements is also being introduced. The government intends to address the problem of unfunded social entitlements and rationalize eligibility for social benefits by defining the principles for replacing in-kind benefits with cash subsidies.

26. Wide-ranging pension reforms have been initiated. Based on the recently approved law on mandatory pensions, pensions in the existing pay-as-you-go system are recalculated based on a new framework that uses lower accrual rates, lengthens the period for determining pensionable income, introduces below-wage indexation of pensions, and tightens eligibility for disability pensions and early retirement. Combined with measures to widen the contribution base, this would allow for a sustainable pension system, even though the reform does not address the low retirement age (60 for men and 55 for women). The recalculation of pensions should result in a one-off increase in expenditure in 2004, due to the abolition of pension ceilings. The envisaged transition to a three-pillar system will be phased in gradually at a later stage, in line with progress on strengthening the institutional environment.

C. Monetary Policy and Financial Sector Reform

27. The authorities are aiming to preserve single-digit inflation. The NBU remains confident that the rapid expansion of monetary aggregates in recent years has been consistent with money demand growth (Box 2). In the authorities’ view, the increase in inflation in 2003 resulted from one-off supply-side factors, in particular the effect of a poor grain harvest on food prices, and should be partly reversed in 2004. However, if inflation pressures mount, the NBU is prepared to tighten monetary policy, including by issuing certificates of deposits and/or scaling down the pace of foreign exchange purchases, which may require exchange rate flexibility. The NBU also intends to keep its overnight refinancing rate above inflation. These policies should ensure that inflation returns to the mid-single digits by end-2004.

28. The NBU does not foresee a change in its exchange rate policy in the near term. The staff recommended to introduce greater exchange rate flexibility, especially in the context of a relatively strong balance of payments position. Exchange rate flexibility would help discourage imprudent lending practices, and may become necessary if inflation pressures rise, credit risk in the banking sector worsens, or in case of a negative balance of payments shock. The authorities felt that the current exchange rate regime was adequate for the time being and that the introduction of alternative monetary policy regimes, such as money or inflation targeting, would be premature, given uncertainties about money demand and the absence of a stable transmission mechanism. They agreed, however, that exchange rate flexibility may become necessary in case of economic shocks.

29. The monetary program for 2004 entails a slowdown in money and credit growth (Table 6). Given the difficulty in projecting money demand in Ukraine, the timing and speed of the slowdown are subject to significant uncertainty. The program ensures that base money growth will continue to reflect primarily the build up in net international reserves of the NBU, while net domestic assets are kept broadly constant.

How Problematic is the High Pace of Money and Credit Growth?

In the three years to end-2003, broad money grew by an average of 43 percent per year, while inflation remained in single digits, as velocity declined from 5.3 to 2.7. The increase in demand for hryvnia was evidenced by the large balance of payments surplus, which was the main driver of base money growth. Key factors underlying the remonetization process were: (a) renewed confidence in the hryvnia, due to the restoration of macroeconomic stability following the 1998-99 crisis; (b) the rapid decline in noncash payments (Figure 10); (c) the public’s greater confidence in the banking sector; and (d) repatriation of capital, supported by the improved macroeconomic outlook. Looking ahead, money demand growth is likely to slow down, as the scope for further sizeable reductions in velocity without significant deepening of the financial sector appears limited. Combined with a modest relaxation of the fiscal stance, this would imply the need for a deceleration in monetary growth to keep inflation low.

Figure 10.
Figure 10.

Ukraine: Velocity and Noncash Payments

(March 1999 - December 2003)

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Sources: Ukrainian authorities and Fund staff estimates

Whereas inflation has remained broadly under control, years of rapid monetary and credit growth have raised serious concerns about credit risk in the banking sector, as highlighted in the 2003 FSSA. The authorities see the recent credit boom primarily as a result of a “catch-up” process, following the 1998-99 crisis. However, Ukraine’s credit-to-GDP ratio is now well within the average range of the more advanced transition countries and above average for transition countries with similar institutional quality in the financial sector (Figure 11). This observation remains broadly true even when GDP is corrected for the underestimation of the shadow economy. Going forward, it implies that continued high credit growth cannot easily be justified on the basis of any catch-up mechanism.

Figure 11.
Figure 11.

Transition Economies: Credit-GDP Ratio 1/ and Financial Sector Reform

Citation: IMF Staff Country Reports 2004, 129; 10.5089/9781451839005.002.A001

Sources: International Financial Statistics: EBRD Transition Report 200); and Fund staff estimates.1/ Nongovernment credit, excluding credit to nonbank financial institutions.

More importantly, the speed of the recent credit expansion entails significant risks, irrespective of the overall level of credit. The increase hi Ukraine’s credit-to-GDP ratio over the last three years, at an annual average of about 5 percentage points, was among the highest of the transition countries. While the increase in credit was primarily funded through rapid deposit growth, there was also an increase in short-term foreign borrowing by Ukrainian banks. Lending booms of similar scale have preceded some of the financial sector crises in other emerging markets, partly because risk assessments of individual loans tend to suffer in times of very rapid loan growth. Imprudent lending practices are of particular concern in Ukraine because of insider lending practices (to be addressed under program conditionality) and extensive foreign currency-denominated lending in the context of a de facto fixed exchange rate, including to borrowers without significant foreign exchange income. The continuously high share of nonperforming loans (defined as substandard, doubtful, and loss) in Ukraine, at about 26 percent of total loans at end-August 2003, suggests that new loans have continued to be extended to risky borrowers. Banking supervision is still in need of strengthening and the share of foreign ownership in the banking sector is low (at about 11 percent of statutory capital) compared to other transition economies.

Table 6.

Ukraine: Monetary Accounts, 2000-2004

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

Historical data for NIR are at actual exchange rates. From end-March 2004 onwards, NIR is based on end-Dec. 2003 exchange rates.

NDA are calculated as the difference between base money and NIR.

Deflated by the CPI.

Based on nominal GDP over the last four quarters.

In percent of total bank loans to the economy.

In percent of total bank deposits.