Ukraine
2005 Article IV Consultation and Ex Post Assessment of Longer-Term Program Engagement: Staff Reports; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
28 Nov 2005
eISBN:
9781451839067
Language:
English
Keywords:
ISCR; CR; government; exchange rate; debt; monetary policy; GDP; U.S. dollar; Ukrainian authorities; real GDP; foreign currency; Currencies; Inflation; Global
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This paper focuses on Ukraine’s 2005 Article IV Consultation and Ex Post Assessment of Longer-Term Program Engagement. After four years of strong activity, annual growth has slowed sharply, from a peak of about 12 percent in 2004 to 3 percent for January–September 2005. Fiscal policy in 2005 has aimed at a significant fiscal tightening, with the supplementary 2005 budget targeting a general government deficit of 2½ percent of GDP compared with the 4½ percent of GDP realized during 2004, and the 6–7 percent of GDP implicit in the original 2005 budget.

Abstract

This paper focuses on Ukraine’s 2005 Article IV Consultation and Ex Post Assessment of Longer-Term Program Engagement. After four years of strong activity, annual growth has slowed sharply, from a peak of about 12 percent in 2004 to 3 percent for January–September 2005. Fiscal policy in 2005 has aimed at a significant fiscal tightening, with the supplementary 2005 budget targeting a general government deficit of 2½ percent of GDP compared with the 4½ percent of GDP realized during 2004, and the 6–7 percent of GDP implicit in the original 2005 budget.

I. Introduction

1. The consultation discussions focused on the policy requirements for restoring and maintaining macroeconomic stability, as well as improving medium-term growth prospects. Following a generally strong macroeconomic performance during 2000-04, recent inflation rates have persistently exceeded their target, while GDP growth has slackened. And, notwithstanding the remarkable growth spurt during 2000-04, Ukraine’s economy remains highly inefficient in using its available human and physical resources. This mainly reflects slow progress in building more market-friendly institutions, and it also highlights the significant scope for accelerated growth once a political consensus on the necessity of reforms is established.

2. Discussions took place against a fluid political background, and significant uncertainties remain. Following last year’s tumultuous elections, President Yushchenko was inaugurated in January 2005 on a reform platform that pledged to tackle pervasive corruption and rent seeking. Following a close policy dialogue during the first half of 2005 (Box 1), the Article IV discussions in Kyiv were held during July 25-August 2, but shortly thereafter, on September 8, the president dismissed the government led by then-Prime Minister Tymoshenko. Prime Minister Yekhanurov was confirmed by parliament in a second-round vote, and a new cabinet has taken office. Constitutional amendments that will shift power from the president to the prime minister and parliament are scheduled to take effect early next year, giving the March 2006 parliamentary elections added importance.

II. Background

A. Recent Growth and Inflation Developments

The short-term macroeconomic situation has deteriorated.

3. GDP growth has slowed significantly. During 2000-04, real GDP growth averaged 8½ percent, peaking at about 12 percent in 2004 (Table 1). However, during the course of this year, growth has progressively decelerated. Externally, the combination of a slowing a global economy, an appreciating real exchange rate, and flat terms of trade has abruptly reversed the impetus behind the recent boom. As for domestic demand, monetary policy has remained loose, while massive hikes in public pensions and wages have provided an expansionary boost to consumer demand. Moreover, by raising the tax burden to pay for these social payments, the 2005 budget has effectively re-allocated income from the (higher-saving) corporate sector to the (lower-saving) household sector. And, at the same time, drifting structural policies and the budget’s sharp hike in the tax burden have dampened private investment demand.

Table 1.

Ukraine: Selected Economic and Social Indicators, 2001–06 1/

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

An updated version of this table can be found in the Staff Supplement.

Based on policy intentions by the authorities and staff’s real GDP projections.

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.

uA01fig01

Output growth has slowed sharply.

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A001

Sources: Ukrainian authorities; and staff estimates.

Impact of Recent Staff Advice

A 12-month Stand-By Arrangement, treated as precautionary by the authorities, expired in March 2005. Relations with the Fund through March 2005, including the effectiveness of policy advice, are discussed in the Ex Post Assessment (EPA) of long-term use of Fund resources. This box covers the impact of more recent staff advice since President Yushchenko took office, a period characterized by close policy dialogue and extensive provision of technical assistance.

On fiscal policy, staff argued for a significant tightening of the stance in 2005, cautioning in particular against going ahead with already-approved large hikes in public pensions, and recommending overall restraint on recurrent spending combined with broadening of tax bases. In the event, the 2005 supplementary budget adopted in March 2006 targeted a deficit in line with staff recommendations (2½ percent of GDP). In addition, tax loopholes were closed and pension hikes were partly rolled back. Nevertheless, the remaining increase in pensions has left the pension fund in a precarious financial imbalance. And, against staff’s advice, nominal public wages were raised by more than 50 percent, providing a strong additional impetus to inflation.

On monetary and exchange rate policy, staff noted that monetary conditions are loose and recommended tightening while also advocating a shift to more exchange rate flexibility. In this context, the NBU welcomed staff’s attempt to provide detailed analysis of policy options and risks. The NBU argued that it has taken adequate steps to control inflation, including by stepping up sterilization operations, tightening reserve requirements, and allowing some nominal appreciation of the hryvnia. Although agreeing in principle with the need for more exchange rate flexibility, the NBU prefers a very gradual approach, which it considers to be more in tune with Ukraine’s specific economic and political circumstances.

On structural reforms, the Ukraine-EU Action Plan provides a sweeping blueprint for structural reforms, many of them long advocated by the Fund. Staff also called for a speedy resolution of the debate on past privatizations of state-owned enterprises that started in February 2005, which, however, continued to linger, aggravating an already difficult investment climate.

The recent policy dialogue, combined with intensive technical assistance, seems to have fostered internal debate and reflection, even when the authorities and staff have disagreed.

4. Inflation has risen well into double digits. Since 2000, with the monetary policy framework centered on defending the de facto peg to the U.S. dollar, inflation has remained unanchored, decelerating initially when growth took off, but trending upward again since early-2003. The lack of an effective anchor is indicated by the high persistence of inflation in Ukraine (Figure 1).1 Recent inflationary pressures are mainly rooted in strong domestic demand, particularly consumer demand for food items, fuelled by large increases in social spending and wages. At the same time, pressures on producer prices have been receding somewhat, mainly owing to a slowing economy. Efforts to fight inflation by narrowly targeted administrative measures, such as price caps in the food and energy markets, may have contained some pressures on the headline rate, at least temporarily.

Figure 1.
Figure 1.

Ukraine: Inflation, 2002–05

(Year-on-year change in percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A001

Sources: Ukrainian authorities; and staff estimates.1/ This measure of persistence quantifies the long-term impact on the price level of a 1 percent shock to inflation, during January 2000 to June 2005, assuming that central banks’ targeted inflation rate remained constant.

B. External Sector Developments

The impetus from favorable external demand and prices is fading.

5. Export growth, vibrant during 2000-04, has lost momentum. Ukraine’s economy is highly open, with exports heavily concentrated in metals (Figure 2). Several factors combined to underpin booming exports during 2000-04: strong price and cost competitiveness; significant idle capacities; and strong external demand for Ukraine’s main export items. More recently, however, exports have slowed markedly, reflecting an appreciating real exchange rate and slowing global demand, including for metals.

Figure 2.
Figure 2.

Ukraine: External Sector Developments, 2000–05

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A001

Sources: Ukrainian authorities; Bloomberg; and staff estimates and projections.1/ Emerging Market Bond Index (EMBI).

6. ukraine has benefited from favorable terms of trade, but this external impulse leveled off in 2005. Metal prices in particular have skyrocketed since 2003, and are presently about 50 percent above their long-term trend (Figure 2). While energy prices have also increased substantially, the overall movement in the terms of trade during 2003-04 has been strongly in Ukraine’s favor, boosting corporate profits and accounting for most of the increase in the current account surplus during 2003-04 (Table 2). But, in 2005 the upward trend in the terms of trade came to an abrupt halt, as metal-price increases leveled off and energy prices soared.2

Table 2.

Ukraine: Medium-Term Balance of Payments, 2001–10

(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.

7. Capital inflows have been subdued since 2000, and foreign investor interest, while picking up, remains cautious. The persistence of market-unfriendly institutions has weighed heavily against capital inflows, notwithstanding booming growth and reasonable prospects of macroeconomic stability. In particular, per capita FDI inflows during 1998-2004 remained very low; among transition economies, only the Kyrgyz Republic, Turkmenistan, and Uzbekistan have fared worse (Figure 2). But foreign interest is rising: rating agencies have upgraded Ukraine, noting its low external public debt (19 percent of GDP in 2004) and promising growth prospects; and sovereign spreads have narrowed significantly. Foreign portfolio investors, also attracted by a perceived undervaluation of the hryvnia, have returned for the first time since 1998 to purchase most of the government’s T-bills. But uncertainty about the direction of policies, combined with a dearth of attractive financial assets, continues to constrain inflows.

C. Macroeconomic Policies

Recent policies have lacked consistency.

8. The 2005 budget, while aiming at a significant fiscal tightening, massively raised public pensions and wages, offsetting the spending hike by a similarly large increase in the tax burden. The 2005 supplementary budget targets a state budget deficit of 1¾ percent of GDP (Table 3). This is equivalent to a general government deficit of 2½ percent of GDP, well below the 4% percent realized during 2004, and the 6-7 percent implicit in the original budget for 2005. The targeted fiscal tightening reflects a series of measures, including the closure of tax loopholes, improved tax administration, higher state-enterprise dividends, and steep cuts in capital spending. However, the supplementary budget largely accommodated the previous government’s pension increases, and boosted the public wage bill, raising average public pensions and wages by over 50 percent (against an inflation target of just under 10 percent). Public pension spending in 2005 is projected to approach 15 percent of GDP, up by 3½ percent of GDP compared with 2004—one of the world’s highest ratios (Figure 3).

Table 3.

Ukraine: General Government Finances, 2003–06

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Sources: Ukrainian authorities; and staff estimates and projections.
Table 3.

(cont’d). Ukraine: General Government Finances, 2003-06

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

Based on state budget expenditure appropriations, IMF staff macroeconomic and revenue estimates, and IMF staff estimates of budget transfers necessary to fill financing gaps in the pension and social funds.

Staff projections exclude Hrv 6.3 billion (1.5 percent of GDP) in offsets from both revenues and expenditures.

Clearance of VAT refund arrears is reflected in the consolidated government balance (cash basis) through a reduction of net VAT cash revenues

Excludes US$ 98 million of non-cash property income paid annually by Russia in exchange for amortization of Ukraine’s debt to Russia.

Figure 3.
Figure 3.

Ukraine: Fiscal Policy, 2000–05

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A001

Sources: Ukrainian authorities; IMF World Economic Outlook; OECD; and staff estimates and projections.1/ Projection for Ukraine for 2005.2/ Data are for 2001.

9. Budget implementation during the first half of 2005, however, was on track. Through end-June, the general government deficit, including VAT refund arrears, was 1 percent of annual GDP (the total stock of VAT refund arrears at end-June amounted to about Hrv 3 billion, or ¾ percent of GDP). In the same period, expenditures were broadly in line with targets. Apart from increased VAT refund arrears, buoyant cash revenue collections mainly reflect the tax measures introduced in the 2005 budget. Corporate tax receipts have been particularly buoyant (but may also reflect the lagged impact of last year’s boom), as have customs revenues (reflecting an anti-smuggling program, and the shift of energy-related tax collections to the border).

10. Monetary conditions have remained loose. Apart from a short-lived episode during last year’s financial near-crisis, the NBU has continued to purchase foreign exchange, while sterilization efforts remained limited. The largest liquidity-absorbing support for monetary policy has come from the government, which has issued new T-bills to buy back higher-yield restructured securities held by the NBU, and which has built up deposits by maintaining a tight fiscal stance (Table 4). The NBU’s own liquidity-absorbing operations, on the other hand, were relatively limited, even when accounting for an increase in reserve requirements effective September 1. As a result, there is high excess liquidity in the banking system, and all interest rates, including banks’ lending rates, are now negative in real terms (Figure 4). Monetary aggregates have expanded more slowly than in 2004, but this comes against a backdrop of sharply decelerating money demand as inflation has risen into double digits.

Table 4.

Ukraine: Monetary Accounts, 2001–06

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Sources: National Bank of Ukraine; and Fund staff estimates and projections.

Historical data for NIR are at actual exchange rates. Projected NIR are at projected 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.