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.
1. This supplement provides information on developments since the staff report was issued. These developments, particularly the successful re-sale of the Kryvorizhstal steel combine, point to an improvement in the investment climate, which is in line with staff’s assumption that investment activity would pick up to support growth in 2006. At the same time, uncertainties regarding the use of the windfall proceeds from the Kryvorizhstal re-sale strengthen the staff appraisal’s concern that fiscal policy may turn out insufficiently tight to support disinflation in 2006.
2. Recent high-frequency indicators are broadly in line with staff’s short-term projections. The sharp deceleration of real GDP growth during 2005 came to a halt in September; GDP growth over January-September has declined to about 3 percent (over the same period last year). Annual CPI inflation in October slowed to 12.4 percent, following a deceleration to 13.9 percent in September, suggesting that end-year CPI inflation is now likely to reach 12 percent, somewhat lower than projected in the staff report (14 percent). Nevertheless, assuming full execution of fiscal spending plans and continued rapid growth of household incomes and spending, inflation is likely to remain in double-digits through early-2006. While annual base and broad money growth slowed somewhat in September (to 27 percent and 31 percent, respectively), reflecting declining intervention pressure in the foreign exchange market, credit expansion has picked up (44 percent), financed increasingly through borrowing from abroad. With declining excess liquidity in the banking system, overnight interbank rates have been trending upward to 4½-6½ percent in September and October, but most interest rates remain negative in real terms. On the external side, the third-quarter current account was weaker than previously envisaged, and the staff forecast for the full-year surplus has been revised down to 4.8 percent of GDP (from 6 percent of GDP). The weakening of the current account is likely to be more than offset by the impact of the Kryvorizhstal re-sale on the capital account, and, as a consequence, gross official reserve accumulation for 2005 could be higher than previously envisaged.
3. Budget implementation has remained on track. Cash revenue through September 2005 remained buoyant, including for VAT and profit tax collections. At the same time, the stock of VAT refund arrears was reduced to ½ percent of GDP at end-September (from ¾ percent of GDP at end-June). To ensure foreign financing of the budget, the government issued in October a ten-year EUR 600 million eurobond yielding 4.95 percent, consistent with a spread of only 155 basis points above the German benchmark bond. Parliament has approved a supplementary 2005 budget, which incorporates unbudgeted pension spending amounting to some ¾ percent of GDP (already anticipated in the staff’s projections) and spending of ¼ percent of GDP to re-capitalize the two state banks. At the same time, recent data point to a significant underexecution of spending, which, if maintained, could broadly compensate for the additional spending measures. Against this background, the general government deficit target of 2½ percent of GDP for 2005 could still be within reach, or be exceeded by only a small margin.
4. The re-auction of the Kryvorizhstal steel combine fetched an unexpectedly high price. In a transparent auction, Mittal Steel acquired an equity stake of about 93 percent of the Kryvorizhstal steel combine for $4.8 billion (5 ¾ percent of GDP). This amounted to six times the price paid at last year’s privatization auction, which was widely viewed as rigged. Observers have interpreted the re-auction outcome as signaling improved confidence by foreign investors in Ukraine’s economic prospects, notwithstanding that parliament twice voted to stop the re-sale. After repaying Kryvorizhstal’s previous owners $0.8 billion, net revenue to the budget from the sale will amount to about Hrv 20 billion (or 5 percent of GDP), significantly exceeding budgeted privatization revenue for 2005 (1 ¾ percent of GDP). The government and Mittal Steel have agreed that payments will be completed before end-2005.
5. A wide range of options is being discussed for using the privatization windfall, with some options calling for adjustments in the macroeconomic policy mix. According to staff estimates, 1½ percent of GDP of the proceeds will be needed to cover the remaining gross financing needs of the state budget in 2005 (assuming no additional borrowing takes place during the rest of the year), leaving a net windfall of 3½ percent of GDP. Government officials have stressed the need to restrict the use of the additional financial resources for operations that broadly preserve the net worth of government, particularly repaying debt and investing in public infrastructure. On the other hand, with parliamentary elections looming in March 2006, other leading politicians have advocated increasing recurrent spending, including social transfers and subsidies for agriculture and mining. Since additional recurrent spending would add to inflationary pressures, it would call for an offsetting monetary policy response. Moreover, even without changes in the fiscal stance, a shift in the budget’s financing structure, for example from domestic debt toward the use of privatization receipts, could still impact liquidity conditions and require a compensatory monetary policy response.
6. The outcome of the 2006 budget process remains uncertain. Parliament rejected the government’s draft budget during the first reading and proposed to increase revenue projections, including by removing proposed tax cuts, raise spending, and increase the deficit ceiling by about 1 percent of GDP. The unexpected privatization windfall has added to pressures to raise spending and the deficit ceiling. However, government officials have consistently noted that there is no good reason to increase the deficit and that there is a need to reduce the tax burden. In a repeated first reading on November 1, parliament approved a revised government budget proposal that kept the deficit ceiling unchanged, but parliamentary pressures to raise spending and the deficit are likely to remain strong.
7. The new government has made some headway toward tackling structural reforms. The Cabinet of Ministers approved a new draft law on strengthening minority shareholder rights (three previous drafts were, however, rejected by parliament). The government is also considering eliminating the Economic Code, parts of which contradict the more business-friendly Civil Code. Moreover, parliament adopted two more bills required for WTO accession, while the EU Commission has confirmed that it will grant market economy status to Ukraine at the beginning of December. Finally, indicating progress toward more market-friendly institutions, the latest 2005 Transparency International corruption perception index upgraded Ukraine, which ranked 107th out of 158 countries in 2005, to be compared with 122nd out of 146 in 2004.
Staff Appraisal
8. The transparent re-auction of Kryvorizhstal is welcome, but the proceeds should be used wisely. The authorities should avoid using the additional financial resources in ways that could further complicate macroeconomic management, particularly by increasing inflation pressures through higher recurrent spending, such as social transfers or subsidies. Accordingly, the authorities should allocate the windfall proceeds primarily for debt redemptions that do not aggravate the domestic liquidity overhang, and, to a limited extent, for well-targeted spending on public infrastructure programs. Such a strategy would help avoid fuelling significant inflationary pressures, broadly preserve the government’s net worth, and build room against future contingencies as well as for the country’s sizable medium-term fiscal needs. Nevertheless, monetary policy makers would need to be vigilant to counteract in a timely manner any relaxation of monetary conditions entailed by the use of the Kryvorizstal privatization proceeds.
Ukraine: Selected Economic and Social Indicators, 2001-06
Based on policy intentions by the authorities and staff’s real GDP projections.
The 2006 projections assume that the proceeds from the re-sale of Kryvorizhstal are held in the government account with the NBU.
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. Clearance of VAT refund arrears is reflected in the consolidated government balance (cash basis) through a reduction of net VAT cash revenues.
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.
Ukraine: Selected Economic and Social Indicators, 2001-06
| 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | ||||
|---|---|---|---|---|---|---|---|---|---|
| Proj. | Prel. | Baseline scenario 1/ | Adjustment scenario | ||||||
| Real economy (percent change unless indicated otherwise) | |||||||||
| Real GDP | 9.2 | 5.2 | 9.6 | 12.1 | 4.0 | 5.5 | 5.0 | ||
| Nominal GDP (in billions of hryvnias) | 204.2 | 225.8 | 267.3 | 344.8 | 415.5 | 499.8 | 486.5 | ||
| Unemployment rate (ILO definition; percent) | 11.8 | 10.1 | 9.1 | 6.1 | … | … | … | ||
| Consumer prices, period average | 12.0 | 0.8 | 5.2 | 9.0 | 13.7 | 12.9 | 10.5 | ||
| Consumer prices, end of period | 6.1 | -0.6 | 8.2 | 12.3 | 12.0 | 13.0 | 9.0 | ||
| Average monthly wages, annual average | 35.2 | 21.0 | 22.8 | 27.5 | … | … | … | ||
| Public finance (in percent of GDP) 2/ | |||||||||
| Cash balance | -1.6 | 0.5 | -0.9 | -4.4 | -2.9 | -3.2 | -2.3 | ||
| Revenue 3/ | 33.5 | 36.0 | 35.9 | 35.0 | 39.7 | 38.4 | 38.4 | ||
| Expenditure (cash basis) | 35.1 | 35.5 | 36.8 | 39.4 | 42.7 | 41.5 | 40.7 | ||
| Primary balance (cash basis) | 0.4 | 1.8 | 0.1 | -3.5 | -2.1 | -2.1 | -1.2 | ||
| Commitments balance 4/ | -1.5 | 0.2 | -0.1 | -3.6 | -2.8 | -3.1 | -2.2 | ||
| Privatization proceeds | 1.3 | 0.5 | 1.1 | 3.1 | 5.3 | 1.8 | 1.8 | ||
| Net domestic financing | -0.1 | -0.3 | -1.2 | -0.1 | -2.9 | 0.8 | -0.1 | ||
| Net external financing 3/ | 0.4 | -0.7 | 1.0 | 1.4 | 0.6 | 0.5 | 0.6 | ||
| Public debt and arrears 5/ | 38.6 | 35.7 | 27.7 | 25.1 | 21.1 | 18.5 | 17.1 | ||
| o.w. external debt | 26.6 | 24.0 | 21.6 | 19.2 | 15.6 | 12.5 | 12.3 | ||
| Money and credit (end of period, percent change) | |||||||||
| Base money | 37.4 | 33.6 | 30.1 | 34.1 | 42.1 | 24.5 | 21.8 | ||
| Broad money | 41.9 | 41.8 | 46.5 | 32.3 | 41.0 | 27.9 | 25.1 | ||
| Credit to nongovernment | 40.5 | 47.3 | 63.4 | 31.2 | 49.5 | 28.6 | 25.5 | ||
| Velocity 6/ | 4.46 | 3.48 | 2.78 | 2.75 | 2.34 | 2.20 | 2.19 | ||
| Balance of payments (in percent of GDP) | |||||||||
| Current account balance | 3.7 | 7.5 | 5.8 | 10.5 | 4.8 | 1.0 | 0.9 | ||
| Foreign direct investment | 2.0 | 1.7 | 2.8 | 2.7 | 4.7 | 2.4 | 2.6 | ||
| Gross reserves (end of period, in billions of U.S. dollars) | 3.1 | 4.4 | 6.9 | 9.5 | 18.9 | 21.4 | 21.6 | ||
| In months of next year’s imports of goods and services | 1.7 | 1.9 | 2.4 | 2.7 | 4.7 | 4.8 | 4.8 | ||
| Debt service (in percent of exports of goods and services) | 6.7 | 5.4 | 6.2 | 4.8 | 4.9 | 5.1 | 5.1 | ||
| Merchandise exports (annual volume change in percent) | 7.0 | 7.1 | 14.1 | 16.5 | 2.2 | 7.9 | 7.4 | ||
| Merchandise imports (annual volume change in percent) | 12.8 | 5.9 | 30.4 | 15.7 | 14.2 | 10.3 | 9.8 | ||
| Merchandise exports | 45.0 | 44.0 | 47.4 | 51.4 | 45.8 | 40.4 | 39.6 | ||
| Merchandise imports | 44.4 | 42.4 | 47.9 | 46.3 | 45.6 | 43.2 | 42.3 | ||
| Share of metals in merchandise exports (in percent) | 39.3 | 38.2 | 35.8 | 39.1 | … | … | … | ||
| Net imports of energy (in billions of U.S. dollars) | 5.0 | 4.9 | 5.1 | 6.6 | … | … | … | ||
| Savings and investment (in percent of GDP) | |||||||||
| Foreign savings | -3.7 | -7.5 | -5.8 | -10.5 | -4.8 | -1.0 | -0.9 | ||
| Gross national savings | 25.5 | 27.7 | 27.8 | 29.9 | 25.6 | 22.1 | 22.1 | ||
| Nongovernment | 24.0 | 24.2 | 24.2 | 28.0 | 24.9 | 21.7 | 20.7 | ||
| Government | 1.5 | 3.5 | 3.6 | 1.9 | 0.7 | 0.4 | 1.3 | ||
| Gross investment | 21.8 | 20.2 | 22.0 | 19.4 | 20.8 | 21.1 | 21.2 | ||
| Nongovernment | 18.7 | 17.2 | 17.7 | 13.1 | 17.2 | 17.5 | 17.6 | ||
| Government | 3.1 | 3.0 | 4.3 | 6.3 | 3.6 | 3.6 | 3.6 | ||
| Exchange rate | |||||||||
| Exchange rate regime | de facto peg to U.S. dollar | ||||||||
| Hryvnia per U.S. dollar, end of period | 5.3 | 5.3 | 5.3 | 5.3 | … | … | … | ||
| Hryvnia per U.S. dollar, period average | 5.4 | 5.3 | 5.3 | 5.3 | … | … | … | ||
| Real effective rate, (percent change) 7/ | 6.0 | -4.1 | -6.3 | -0.9 | … | … | … | ||
| Social indicators | |||||||||
| Per capita GDP: US$ 1,366 (2004); Poverty (percent of population): 27.3 (2004; national headcount index); | |||||||||
| Life expectancy at birth: 68.2 years (2004); Infant mortality (per 1,000): 9.5 (2004); Child malnutrition (percent of children under 5): 3.0 (2001); | |||||||||
| Income/consumption distribution (Gini index): 29.0 (2004); Gross primary enrollment (percent of school-age group): 87.9 (2004) | |||||||||
Based on policy intentions by the authorities and staff’s real GDP projections.
The 2006 projections assume that the proceeds from the re-sale of Kryvorizhstal are held in the government account with the NBU.
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. Clearance of VAT refund arrears is reflected in the consolidated government balance (cash basis) through a reduction of net VAT cash revenues.
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.
Ukraine: Selected Economic and Social Indicators, 2001-06
| 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | ||||
|---|---|---|---|---|---|---|---|---|---|
| Proj. | Prel. | Baseline scenario 1/ | Adjustment scenario | ||||||
| Real economy (percent change unless indicated otherwise) | |||||||||
| Real GDP | 9.2 | 5.2 | 9.6 | 12.1 | 4.0 | 5.5 | 5.0 | ||
| Nominal GDP (in billions of hryvnias) | 204.2 | 225.8 | 267.3 | 344.8 | 415.5 | 499.8 | 486.5 | ||
| Unemployment rate (ILO definition; percent) | 11.8 | 10.1 | 9.1 | 6.1 | … | … | … | ||
| Consumer prices, period average | 12.0 | 0.8 | 5.2 | 9.0 | 13.7 | 12.9 | 10.5 | ||
| Consumer prices, end of period | 6.1 | -0.6 | 8.2 | 12.3 | 12.0 | 13.0 | 9.0 | ||
| Average monthly wages, annual average | 35.2 | 21.0 | 22.8 | 27.5 | … | … | … | ||
| Public finance (in percent of GDP) 2/ | |||||||||
| Cash balance | -1.6 | 0.5 | -0.9 | -4.4 | -2.9 | -3.2 | -2.3 | ||
| Revenue 3/ | 33.5 | 36.0 | 35.9 | 35.0 | 39.7 | 38.4 | 38.4 | ||
| Expenditure (cash basis) | 35.1 | 35.5 | 36.8 | 39.4 | 42.7 | 41.5 | 40.7 | ||
| Primary balance (cash basis) | 0.4 | 1.8 | 0.1 | -3.5 | -2.1 | -2.1 | -1.2 | ||
| Commitments balance 4/ | -1.5 | 0.2 | -0.1 | -3.6 | -2.8 | -3.1 | -2.2 | ||
| Privatization proceeds | 1.3 | 0.5 | 1.1 | 3.1 | 5.3 | 1.8 | 1.8 | ||
| Net domestic financing | -0.1 | -0.3 | -1.2 | -0.1 | -2.9 | 0.8 | -0.1 | ||
| Net external financing 3/ | 0.4 | -0.7 | 1.0 | 1.4 | 0.6 | 0.5 | 0.6 | ||
| Public debt and arrears 5/ | 38.6 | 35.7 | 27.7 | 25.1 | 21.1 | 18.5 | 17.1 | ||
| o.w. external debt | 26.6 | 24.0 | 21.6 | 19.2 | 15.6 | 12.5 | 12.3 | ||
| Money and credit (end of period, percent change) | |||||||||
| Base money | 37.4 | 33.6 | 30.1 | 34.1 | 42.1 | 24.5 | 21.8 | ||
| Broad money | 41.9 | 41.8 | 46.5 | 32.3 | 41.0 | 27.9 | 25.1 | ||
| Credit to nongovernment | 40.5 | 47.3 | 63.4 | 31.2 | 49.5 | 28.6 | 25.5 | ||
| Velocity 6/ | 4.46 | 3.48 | 2.78 | 2.75 | 2.34 | 2.20 | 2.19 | ||
| Balance of payments (in percent of GDP) | |||||||||
| Current account balance | 3.7 | 7.5 | 5.8 | 10.5 | 4.8 | 1.0 | 0.9 | ||
| Foreign direct investment | 2.0 | 1.7 | 2.8 | 2.7 | 4.7 | 2.4 | 2.6 | ||
| Gross reserves (end of period, in billions of U.S. dollars) | 3.1 | 4.4 | 6.9 | 9.5 | 18.9 | 21.4 | 21.6 | ||
| In months of next year’s imports of goods and services | 1.7 | 1.9 | 2.4 | 2.7 | 4.7 | 4.8 | 4.8 | ||
| Debt service (in percent of exports of goods and services) | 6.7 | 5.4 | 6.2 | 4.8 | 4.9 | 5.1 | 5.1 | ||
| Merchandise exports (annual volume change in percent) | 7.0 | 7.1 | 14.1 | 16.5 | 2.2 | 7.9 | 7.4 | ||
| Merchandise imports (annual volume change in percent) | 12.8 | 5.9 | 30.4 | 15.7 | 14.2 | 10.3 | 9.8 | ||
| Merchandise exports | 45.0 | 44.0 | 47.4 | 51.4 | 45.8 | 40.4 | 39.6 | ||
| Merchandise imports | 44.4 | 42.4 | 47.9 | 46.3 | 45.6 | 43.2 | 42.3 | ||
| Share of metals in merchandise exports (in percent) | 39.3 | 38.2 | 35.8 | 39.1 | … | … | … | ||
| Net imports of energy (in billions of U.S. dollars) | 5.0 | 4.9 | 5.1 | 6.6 | … | … | … | ||
| Savings and investment (in percent of GDP) | |||||||||
| Foreign savings | -3.7 | -7.5 | -5.8 | -10.5 | -4.8 | -1.0 | -0.9 | ||
| Gross national savings | 25.5 | 27.7 | 27.8 | 29.9 | 25.6 | 22.1 | 22.1 | ||
| Nongovernment | 24.0 | 24.2 | 24.2 | 28.0 | 24.9 | 21.7 | 20.7 | ||
| Government | 1.5 | 3.5 | 3.6 | 1.9 | 0.7 | 0.4 | 1.3 | ||
| Gross investment | 21.8 | 20.2 | 22.0 | 19.4 | 20.8 | 21.1 | 21.2 | ||
| Nongovernment | 18.7 | 17.2 | 17.7 | 13.1 | 17.2 | 17.5 | 17.6 | ||
| Government | 3.1 | 3.0 | 4.3 | 6.3 | 3.6 | 3.6 | 3.6 | ||
| Exchange rate | |||||||||
| Exchange rate regime | de facto peg to U.S. dollar | ||||||||
| Hryvnia per U.S. dollar, end of period | 5.3 | 5.3 | 5.3 | 5.3 | … | … | … | ||
| Hryvnia per U.S. dollar, period average | 5.4 | 5.3 | 5.3 | 5.3 | … | … | … | ||
| Real effective rate, (percent change) 7/ | 6.0 | -4.1 | -6.3 | -0.9 | … | … | … | ||
| Social indicators | |||||||||
| Per capita GDP: US$ 1,366 (2004); Poverty (percent of population): 27.3 (2004; national headcount index); | |||||||||
| Life expectancy at birth: 68.2 years (2004); Infant mortality (per 1,000): 9.5 (2004); Child malnutrition (percent of children under 5): 3.0 (2001); | |||||||||
| Income/consumption distribution (Gini index): 29.0 (2004); Gross primary enrollment (percent of school-age group): 87.9 (2004) | |||||||||
Based on policy intentions by the authorities and staff’s real GDP projections.
The 2006 projections assume that the proceeds from the re-sale of Kryvorizhstal are held in the government account with the NBU.
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. Clearance of VAT refund arrears is reflected in the consolidated government balance (cash basis) through a reduction of net VAT cash revenues.
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.