Ukraine: Ex Post Assessment of Longer-Term Program Engagement

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. This Ex Post Assessment (EPA) focuses on three main issues:

  • Accounting for Ukraine’s macroeconomic record: In particular, why did Ukraine during the 1990s turn in what was likely the weakest growth performance among transition economies unaffected by internal or external strife? But also, why did the economy, starting in 2000, stage an almost equally-surprising growth rebound?

  • Accounting for the Fund’s role in Ukraine’s difficult transition: What were the Fund’s contributions during Ukraine’s economic rollercoaster experience? In particular, why did Fund-supported programs often not achieve their objectives?

  • Drawing lessons for future Fund involvement: What can be learned from the past record under Fund-supported programs? And how can the Fund best contribute to Ukraine’s further transition?

2. The EPA draws on a number of disparate sources, including IMF documents since Ukraine became a Fund member in September 1992 as well as studies by academics and by World Bank and Fund staff, including a 2002 Country Strategy Paper. The EPA also draws on interviews and discussions with Fund and Bank staff and with present and former government officials of Ukraine.

3. The report is structured as follows. Section II recounts Ukraine’s macroeconomic record, moving from the traumatic years of 1991-99 that witnessed a dramatic output decline to the more recent strong-growth years of 2000-04. Section II also reports on the key features of IMF-supported programs and their tendency to often go awry. Section III tries to account for Ukraine’s macroeconomic record. It attributes the precipitous output decline during the 1990s to slow institutional reforms. At the same time, it credits the growth turnaround since 2000 in part to the consequences of the 1998 financial crisis—these included a large real devaluation, improved fiscal discipline, and limited but well-targeted structural reforms. Section IV looks at the role of the IMF, asking in particular why the Fund almost consistently stayed engaged in program mode, at least before 2001, notwithstanding the programs’ limited success in fostering reforms. Finally, Section V takes stock and reflects on what lessons to draw for future Fund engagement in Ukraine.

II. What Happened?

4. Ukraine’s economic development since independence and the Fund’s role in shaping policies fall into three distinct phases (see also the period averages in Table 1):

Table 1.

Ukraine: Selected Economic and Social Indicators, 1992–2004

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Sources: Ukrainian authorities; and Fund staff estimates.

From 2003, 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.

  • The first phase, spanning 1992-94, was characterized by incoherent policies, rampant inflation, and collapsing output. During this period, the Fund acted mainly as an educator and provider of technical assistance.

  • The second phase, 1995-99, saw a fitful drive toward macroeconomic stabilization amidst continued output declines, while structural reforms were lagging behind. This phase was brought to an end by the financial crisis in 1998, which shattered foreign-investor confidence in Ukraine. During this phase, the Fund played a high-profile role in shaping policies through consecutive Fund-supported programs and by providing large amounts of technical assistance.

  • The third phase, stretching from 2000-04, brought a strong rebound in growth, together with an all-around strengthening of Ukraine’s financial fundamentals. Improved fiscal discipline and massive relative price shifts in favor of corporate sector profitability, combined with a difficult investment climate, transformed Ukraine into a “savings overhang” economy with little need for IFI financing. In this setting, progress on building more market-friendly institutions remained slow, stymied by lack of political consensus. Nevertheless, the Fund and the authorities maintained an intensive policy dialogue, punctuated by attempts to rekindle a formal program relationship.

A. The Macroeconomic Record: Some Snapshots

5. Ukraine’s economy has undergone a rollercoaster experience, but still has relatively low official income levels despite the recent upswing. Initially, output slid cumulatively by 55 percent over eight consecutive years, followed by a cumulative output gain of 50 percent during 2000-04 (Figure 1). While Ukraine’s output trajectory since independence shares a common component with the trajectories of other former Soviet Union countries, particularly during the rebound phase, the steepness and duration of Ukraine’s output collapse during the 1990s seems unmatched by any other transition economy unaffected by internal or external strife.2 In 2004, official gross national income per capita amounted to only $6,250, significantly below levels in neighboring Poland ($12,640) and Russia ($9,620), but clearly above Moldova ($1,930) and several other CIS countries.3

Figure 1.
Figure 1.

Economic Slump and Recovery in Transition Economies

Real GDP index (1991=100)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF International Financial Statistics.

6. Ukraine’s low per capita income reflects very low efficiency in using available resources. In particular, cross-country data suggest that Ukraine has been using its abundant real and human resources poorly, especially when compared with industrial countries but also relative to other transition economies (Figure 2).4 In fact, Ukraine’s production efficiency in 2000—measured as the distance between a country’s actual output per worker and the “best practice level” conditional on a country’s real resources—is one of the lowest among transition economies. And, even after taking account of the 2000-04 growth rebound, Ukraine’s income level remains at a fraction of its long-term potential.

Figure 2.
Figure 2.

Ukraine: Efficiency and Output, 2000

(US$, 1985 prices, PPP)

Global production possibility frontier 1/

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: Tiffin (2005).1/ The frontier represents the implicit output that could be obtained if a country were to employ all its resources efficiently, using global best practices.

7. Other social indicators suggest that Ukraine’s transition experience has left deep scars in its social fabric. As regards health standards, perhaps most striking, and mirroring Russia’s experience, is the dramatic drop in male life expectancy since 1991 (Table 2). While spending on education in Ukraine has remained robust, enrolment ratios for secondary education seem not to have kept pace with those in Eastern European countries.5 Birth rates have declined sharply, and, also reflecting high emigration rates, Ukraine’s population has shrunk by 4 million since independence. Though only patchy measures are available on the distribution of income and wealth, the gap between the rich and the poor seems to have widened dramatically during the transition. Finally, survey data on life satisfaction, while also to be taken with a grain of salt, consistently rank Ukraine at the extreme bottom in crosscountry comparisons (see, for example, Sanfey and Teksoz, 2005).

Table 2.

Social Indicators in Transition Economies1/

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Source: Unicef TransMONEE database 2004.

Unweighted averages.

In percent of GDP.

Gross rates in percent of relevant population.

8. Over time, Ukraine’s control of inflation has improved gradually, but the goal of keeping inflation low and stable has remained elusive. Following two brushes with hyperinflation—monthly CPI inflation rates exceeded 50 percent in 1993 and again in late-1994—monetary control over inflation was broadly established by late-1996, notwithstanding the continued output decline until 1999 (Figure 3).6 But inflation rates during recent years have shown little tendency to converge to a low and stable inflation rate, first veering toward deflation in 2002, and, since 2004, surging back into double-digits.

Figure 3.
Figure 3.

Inflation in Transition Economies

(Percent change)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF International Financial Statistics.

9. The 1998 financial crisis marked the beginning of a shift to high national savings and persistent external surplus positions. After pressing up against tight external and domestic financing constraints for most of the 1990s, fiscal policy from 2000 onward adopted and broadly maintained a tight stance, reflected in a shift toward higher public savings. Private savings also increased, mainly driven by improved corporate profitability following a sharp real devaluation and favorable shifts in the terms of trade. The level of investment (as a percent of GDP) has remained fairly steady throughout the transition, reflecting a difficult investment climate, so the external current account surplus has ballooned (Figure 4).

Figure 4.
Figure 4.

Ukraine: Investment-Savings Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF International Financial Statistics.

10. External and public debt positions improved significantly following the 1998 financial crisis. In fact, the World Economic Outlook (WEO) classifies Ukraine as a net creditor country, i.e., its cumulated current account balances since 1992 have been positive.7 However, official data indicate an unusually high level of private external debt (29 percent of GDP, Figure 5) raising questions about the consistency of external flow and stock data. Public external indebtedness in 2004 was low (19 percent of GDP), and interest rate spreads have narrowed from more than 2,000 basis points in 2001 to only about 175 basis points in August 2005. Nevertheless, sovereign ratings are still three notches below investment grade.

Figure 5.
Figure 5.

Ukraine: Public and External Private Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Sources: Ukrainian authorities; and staff estimates.1/ Private external debt is only available from 2000 onward.

11. The 1998 financial crisis also proved a watershed for financial sector development. On the one hand, in the period since the crisis re-monetization of the economy and re-intermediation by banks accelerated (Figure 6). For example, the loan portfolio of Ukrainian banks, which had contracted to only 9 percent of GDP by 1998 has since surged on average by 3 percentage points per year, bringing it to a level similar to that of more advanced transition economies, such as Poland and Bulgaria. On the other hand, the 1998 financial crisis proved to be a major setback for developing more sophisticated financial markets and instruments. In particular, measures introduced to stabilize the foreign exchange market in 1998, such as export surrender requirements and the prohibition of forward transactions, were only lifted in 2005. And it took several years to revive a rudimentary market for government securities.

Figure 6.
Figure 6.

Ukraine: Monetization and Financial Intermediation

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF International Financial Statistics.

B. The IMF Program Record: Objectives and Outcomes8

12. Ukraine has had Fund-supported programs for most of the past 10 years, with the most recent disbursement occurring in 2001. Ukraine first borrowed under the Systemic Transformation Facility (STF) (October 1994-April 1995), went through three Stand-By Arrangements (SBA) (April 1995-April 1996, May 1996-February 1997, and August 1997-August 1998), an Extended Fund Facility (EFF) arrangement (September 1998-September 2002), and following a program lull, a one-year precautionary SBA that expired in March 2005 (Figure 7). The Fund’s exposure vis-à-vis Ukraine peaked at about 200 percent of quota at end-November 1998 and has since declined to 67 percent of quota as of end-July 2005.

Figure 7.
Figure 7.

Ukraine: Fund Relations and Key Financial Indicators

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Sources: Ukrainian authorities; and International Monetary Fund.1/ The hryvnia replaced the karbovanets at a rate of 100,000 to l; the exchange rate is shown for Hrv/US$ for the entire period.

13. Ukraine’s program compliance was generally weak. Ukraine was late in obtaining financing through the STF, despite the facility’s more lenient conditionality. Four Fund-supported programs covered the next seven years almost continuously, but only three out of 13 reviews were completed on time and without waivers (Table 3). Measured by the number of reviews, programs were off-track for more than 85 percent of the time, or, if programs with delayed reviews are considered as still on track, 45 percent. Ukraine drew 68 percent of the approved amounts (excluding the recent precautionary SBA).

Table 3.

Ukraine: Program Compliance

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Source: IMF Staff Reports.

Total share of disbursement excludes the precautionary SBA.

14. The early programs aimed at restoring macroeconomic stability. The programs’ focus was threefold: (i) limiting central bank financing of the fiscal deficit; (ii) eliminating directed lending to so-called priority sectors; and (iii) preparing the ground for structural reforms. However, lack of policy resolve during mid-1995 delayed stabilization, depleted the NBU’s international reserves, and pushed the first SBA off track. Financial stability was restored under the second SBA, with most quantitative performance criteria observed. But while the second SBA seems to stand out as a relative success—inflation was brought down to 25 percent by early-1997 and the fiscal deficit reduced to 3.2 percent of GDP in 1996 (from 4.9 percent in 1995)—the authorities achieved the latter mainly by running arrears. To address this problem, the next SBA established ceilings on arrears as new conditionality. When fiscal adjustment continued to lag, the new program went promptly off-track.

15. After scoring some gains on macroeconomic stability, programs increasingly sought to tackle underlying institutional weaknesses. A comprehensive medium-term reform agenda to be supported by an EFF arrangement was discussed in 1997. But it did not find political support in the run-up to the parliamentary elections in March 1998, and the authorities and the Fund instead agreed on a one-year SBA (approved in August 1997), with focus on structural reforms. When the political deadlock was resolved after the elections, new discussions for an EFF arrangement finally succeeded. The choice to move from short-to medium-term Fund-supported programs reflected the view that institutional shortcomings were the major obstacles for turning Ukraine’s growth performance around. The outbreak of the Russian financial crisis, which occurred only days before the scheduled Board meeting to discuss the request for the EFF arrangement, did not change the Fund’s assessment that a medium-term program would be the appropriate tool to support Ukraine’s transition. Nevertheless, the EFF arrangement was adjusted to reflect short-term stabilization needs. The structural measures under the program included a wide range of areas, including: privatization; public, tax and customs administration; treasury operations; pension system; public employment; energy and agricultural sectors; external trade; and the banking sector. In contrast to programs with most other transition economies at the time, but in line with Russia’s program, Ukraine’s case placed much more weight on structural reforms in non-Fund core areas, particularly privatization (Table 4).

Table 4.

Distribution of Structural Program Conditions and Implementation Rates by Sector of Reform1/

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Source: MONA database.

SBA and EFF arrangements, excluding prior actions.

Index ranges from 0 to 2 (0=no implementation, 1=partial implementation, 2=full implementation).

16. Stabilization policies were broadly appropriate under the EFF arrangement, but the program was derailed by lagging structural reforms. After a short period of determined stabilization efforts in the immediate aftermath of the Russian financial crisis to counter inflationary pressures from the depreciation, and relatively quick progress in restructuring government debt, the EFF reviews came to a halt after twelve months. Progress on structural reforms stalled again, and a major misreporting incident cast a long shadow on already difficult relations with the Fund (Box 1). The Fund briefly disengaged, and, when it reengaged in December 2000, sought to assure program ownership with a new strategy. Structural measures followed a much more streamlined approach and, when program performance remained poor, the Fund interrupted the arrangement. Only one delayed review was completed before the program expired in September 2002. Major sticking points were the accumulation of VAT-refund arrears; failure to reduce tax exemptions and export taxes; the slow pace of banking sector reforms; delays in privatization; and poor transparency.

Misreporting International Reserves

While under IMF Stand-By Arrangements during 1996-98, Ukraine consistently misreported its levels of foreign reserve assets. The misreporting arose from numerous incidents of counting as reserves items that did not meet performance criteria definitions under the programs. This included “round-tripping operations,” in which NBU deposits in foreign banks were on-lent to domestic banks, which in turn deposited them in foreign banks, leading to double-counting of NBU reserve assets. Subsequent audits, commissioned by the NBU, found no evidence of misappropriation of Ukraine’s reserves.

Blame had to be shared all around. The Fund’s Executive Board concluded in September 2000 that, as a result of misreporting reserve assets, Ukraine had breached its obligations under the Articles of Agreement. At the same time, it was also observed that, on the Fund’s side, a willingness to work under rushed and disorganized circumstances and a climate of forbearance to “make the programs work” had played a role in allowing the misreporting to go on for a prolonged period.

The misreporting incident, which was highly publicized in the international financial press, temporarily cooled relations between the Fund and the authorities. While the amounts of noncomplying purchases were relatively small, the attitudes that led to the incidents—on the authorities’ side, a cavalier attitude toward complying with program undertakings; on the Fund’s side, a willingness to cut corners—led to a period of re-assessment of relations. The EFF arrangement was offtrack from September 1999 to December 2000, partly due to slow reform progress, but perhaps more importantly because the Fund and the international community were no longer willing to settle for waivers and modifications of programs given an apparent lack of commitment and ownership by the authorities.

17. But Ukraine managed to restructure its public debt, including through private sector participation—one of the first cases encouraged by a Fund-supported program (Box 2). Ukraine faced serious cash-flow problems in the wake of the financial crisis and resorted to selective debt restructuring with private creditors between 1998 and early 2000. But the extent of relief proved insufficient, and the authorities sought a comprehensive debt restructuring agreement, including a request to the Paris Club, which eventually entered into force after the completion of the fifth and sixth review under the EFF arrangement in September 2001.

Public Debt Restructuring

The initial debt restructuring strategy, which focused on selected creditors and instruments, did not succeed in restoring debt sustainability. In August 1998, the government agreed with domestic banks on a voluntary exchange of short-term T-bills for long-term bonds. An exchange of T-bills for non-resident investors for a Eurobond and the restructuring of a fiduciary loan by Chase Manhattan followed. But as negotiations, strongly encouraged by the Fund, with ING Barings for debt falling due in June 1999 stalled, the second review of the EFF arrangement in May 1999 called for the completion of a financing review before the next purchase. As negotiations were prolonged beyond the completion of the financing review in June, the Board issued a statement at end-June 1999 insisting on an agreement with private creditors on terms comparable to those of recent agreements with other creditors, thus strongly urging private sector involvement in debt restructuring before resorting to official financing.1/

Later on, a comprehensive restructuring effort succeeded in lowering debt levels, but the initiative was launched relatively late, a year and a half after the financial crisis. At the third review of the EFF arrangement in August 1999, the Board concluded that the selective debt restructuring efforts had not resulted in medium-term sustainability. Ukraine then launched a comprehensive exchange with a 99 percent participation rate, which involved the swap of four Eurobonds and three Gazprom bonds maturing in 2000-01 for four Eurobonds maturing in 2007. Between 2000 and 2002, Ukraine restructured its external debt with Paris Club creditors, and with other bilateral creditors, most importantly Turkmenistan. The total debt restructuring operation covered US$2.5 billion of external debt and US$0.3billion of domestic debt, representing about 9 percent of GDP. Debt restructuring together with the rapid economic growth and fiscal discipline combined to bring the public debt down from 67 percent of GDP in 1999 to 25 percent of GDP in 2004.

1/ For an account of the private sector involvement, see International Monetary Fund (2001).

18. The recent precautionary SBA sought first to establish a track record, but nevertheless failed to meet most key objectives. Agreement on the latest Fund-supported program, which aimed at sustaining stabilization gains in a year of presidential elections, came after an extended period of negotiations and attempts to build ownership and political consensus. Structural reforms were considered as having advanced in a few areas, including the introduction of a new budget code, public administration and pension reform, reforms in the banking sector, and trade liberalization. In addition, five prior actions were met, including: various measures to reduce VAT refund arrears; a delay in a minimum wage increase; and an increase in banks’ minimum capital adequacy ratio. Nevertheless, the program went quickly off-track, mainly derailed by a massive loosening of fiscal policy in the run-up to the presidential election, a renewed buildup of VAT refund arrears, and little follow-up on structural reforms; in fact, none of the structural performance criteria were observed.

C. IMF-World Bank Cooperation

19. The World Bank also found it difficult to make headway on structural reforms. Like the Fund, the World Bank engaged relatively late in Ukraine through project and program lending. Initially, the Bank focused its engagement mainly on sectoral developments, in particular the enterprise, coal, agricultural, and financial sectors. But implementation of its 1996-99 Country Assistance Strategy (CAS) was disappointing—disbursement ratios were significantly lower than in other CIS countries; many of the prepared projects did not materialize; and the Bank’s resource cost in supervising projects and programs were 50 percent higher than the regional average (World Bank, 2000a). In 2000, the World Bank approved a new CAS that shifted from a strategy of separate sector adjustment operations, which was viewed as a major shortcoming (World Bank, 2000b), to an approach that would address institutional and governance issues that cut across sectors. While progress was slower than envisaged, and disbursements calibrated upon progress, achievements were made in World Bank supported areas, including better financial discipline, budget system and treasury reform, stepwise tax reform, passage of a laws for secured interest and mortgage finance, establishment of regulatory agencies for non-bank financial institutions and telecom, financial sector reform, and the legislative basis for pension reform. Nevertheless, many objectives of the strategy were not achieved and Bank disbursements, particularly for project lending, fell far short of the envisaged envelope.

20. The Fund and the Bank proceeded generally in a coordinated fashion, but the two institutions’ roles changed over time. Overlapping conditionality was used for key reforms (such as conducting an audit of the state energy company, selling gas through cash auctions, completing audits of the largest banks, and resolving or rehabilitating problem banks), and the combined leverage helped to achieve some progress in these areas. Different timings in engagements by the two institutions, however, complicated program relationships with Ukraine. When in 1998 progress stalled under the Bank’s first CAS and the disbursements under the Bank’s adjustment program halted until the redesigned Programmatic Adjustment Loan (PAL), the Fund stepped up its efforts to promote structural reforms. At the same time, the Fund drew heavily on World Bank expertise in formulating and monitoring policies in non-core Fund areas. A shift in responsibilities back toward the World Bank occurred in 2000 when the World Bank approved its new CAS. The timing of the new World Bank strategy coincided with the Fund’s approach of streamlining conditionality. In 2003 and 2005, the World Bank opted to financially support Ukraine through a PAL and a Development Policy Loan, respectively, while the Fund had no formal program relationship. But, the Fund’s assessment letters, on both occasions, were one factor that the World Bank took into account when considering design and loan amounts in the lead-up and during Board discussions.

III. Accounting for the Macroeconomic Record9

A. Accounting for the Trauma Years: 1992–99

21. Ukraine’s initial conditions were unfavorable. Prima facie, several potential tailwinds seemed to augur well for Ukraine’s transition prospects: a well-educated population; excellent conditions for agriculture; a favorable geographic position; and an international community eager to provide support, not least to address security issues, particularly nuclear weapon stockpiles and Chernobyl. But two Soviet legacies proved to be major impediments:

  • First, as in other CIS countries, external shocks caused an initial output collapse, reflecting primarily the loss of supply links to traditional trading partners and a sharp terms of trade deterioration. This combined with the fact that Ukraine was dependent on heavy, energy-intensive industries, including a large military goods sector.

  • Second, Ukraine’s knowledge base for managing the transition from plan to market was thin. Ukraine not only had to build its own state institutions almost from scratch, but its capacity for planning, implementing policies was weak.

22. Nevertheless, the length and severity of Ukraine’s economic downturn during the 1990s was very much unexpected. For example, while the WEO projected Ukraine’s real GDP to remain roughly stable between 1994 and 1999 (measured in terms of cumulative one-year-ahead WEO forecasts of real GDP growth), growth fell short of projections year after year, resulting in a record cumulative forecast error of more than 40 percent during 1994–99 (Table 5, Figure 8).

Table 5.

Ukraine’s Unexpected Output Slump, 1994–991/

(Cumulative growth; in percent)

article image
Source: IMF World Economic Outlook.

Projections in the October WEO for the next year.

Figure 8.
Figure 8.

Ukraine: Forecast Errors for Real GDP Growth 1/

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF World Economic Outlook.1/ Projections in the October WEO for the next year.

23. Although lessons were initially learned the hard way, monetary policy gradually succeeded in reducing inflation. The wrenching experience of very high inflation, which was fuelled by large monetized fiscal deficits and directed credits to state enterprises while accompanied by steep output declines, helped refute claims that a loose monetary policy was needed to protect the economy’s supply side. At the same time, repeated bursts of hyperinflation undermined society’s confidence in state institutions and policy making, and may in part account for later difficulties to build more market-friendly institutions. Nevertheless, by 1995, the National Bank of Ukraine (NBU) had a broad political mandate and had acquired the tools to counteract inflation by controlling money growth, even though fiscal policy once again relied heavily on NBU deficit financing in the run-up to the 1998 financial crisis (Figure 9). The introduction of a new currency—the hryvnia—in 1996 and its use as an exchange rate anchor contributed to stabilization.

Figure 9.
Figure 9.

Ukraine Inflation and Base Money Growth

(Y-o-y, in percent)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF International Financial Statistics.

24. However, fiscal discipline took longer to establish. Modern budgetary institutions and practices (treasury, budget code) emerged only slowly. At the same time, fiscal discipline, as measured by deficit outcomes, seemed broadly maintained (Figure 10). But repeated GDP growth shortfalls, an ingrained culture of tax and spending arrears, high quasi-fiscal deficits, and sales of high-yield but short-term T-bills to non-residents created a potent mix for destabilizing the economy in case of adverse shocks. Nevertheless, when the 1998 financial crisis hit, and Ukraine was temporarily unable to roll over its short-term external debt, it proved to be a liquidity crunch rather than a solvency problem.

Figure 10.
Figure 10.

Ukraine: Fiscal Targets and Outcome

(In percent of projected GDP)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF Staff Reports.

25. Slow reform of market-enhancing institutions acted as the ultimate bottleneck for growth (Box 3). Econometric analysis indicates that relatively market-unfriendly institutions—proxied by variables that capture the security of property rights, degree of corruption, competence of civil servants, and regulatory quality—account for Ukraine’s large efficiency gap in producing output (Figure 11).

Figure 11.
Figure 11.

Efficiency and Institutions, 2000

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: Tiffin (2005).1/ Measures how closely (in percent) a country operates to the global production possibility frontier shown in Figure 2.2/ Measured using the principal component of the indices compiled by Kaufman and others (2004) (ranging from -2.5 to +2.5) comprising rule of law, political stability, control of corruption, government effectiveness, and regulatory quality.

Institutions, Growth, and Macroeconomic Stability: Three Lessons

Institutions are the rules of the game that shape economic actions. In the context of Ukraine’s transition, it is useful to distinguish two broad types of institutions:

  • Market-stabilizing institutions include monetary, fiscal, as well as financial sector prudential and supervisory arrangements. While these institutions are sometimes relatively easy to legislate—e.g., adopting a modern central bank law or budget code—, effective implementation can be difficult, creating gaps between formal and informal institutions. With strong support from the Fund, Ukraine made gradual but consistent progress on strengthening its market-stabilizing institutions, particularly following the 1998 financial crisis.

  • Market-enhancing institutions are needed to allow markets to work efficiently, including by establishing secure property rights, enforce contracts, and regulate markets. These rules of the game are generally hard to legislate directly as they are the outcome of diffuse processes that also reflect the political and judicial systems. Moreover, in the case of Ukraine, formal laws and regulation are sometimes unclear or inconsistent (e.g., the Economic and Civil Codes). The indicators in Kaufmann and others (2005) are widely used to measures the strength of market-enhancing institutions.

Against this backdrop, the recent literature on institutions, growth, and macroeconomic stability has highlighted three cross-country lessons, all of which seem pertinent for Ukraine:

  • First, the strength of market-enhancing institutions is strongly positively correlated with countries’ income levels and productive efficiency in the longer term (see the crosscountry evidence in International Monetary Fund, 2003, and Figure 11). Ukraine’s own growth experience since 1992 seems consistent with this first lesson.

  • Second, growth accelerations can occur without a broad-based strengthening of market-enhancing institutions (see the cross-country evidence in Hausmann and others, 2004). Such growth spurts may, for example, be initiated by limited market-enhancing reforms or favorable external shocks. Ukraine’s strong growth rebound during 2000-04 seems to fit this category. But the cross-country experience also suggests that growth rebounds that remain unsupported by broader institutional reforms tend to peter out as productive dynamism can not be maintained in the longer term.

  • And third, progress on market-stabilizing institutions that is not complemented by progress on building market-enhancing institutions is unlikely to ensure durable macroeconomic stability (see the cross-country evidence in Acemoglu and others, 2003). Thus, notwithstanding Ukraine’s marked progress in building effective market-stabilizing institutions, this third lesson suggests that macroeconomic stability in the medium term needs to be anchored by progress in broader institution building.

26. Mass privatization resulted in dispersed ownership and may have contributed to the protracted output decline. For political and historical reasons, the Ukrainian privatization mechanisms used during 1992-98 involved mainly transfer of ownership to large numbers of individuals or to holdings of broadly-held financial intermediaries. In a legal environment that did not much support to minority shareholders, such dispersed ownership structures led to pilfering of enterprise assets by insiders, which may have undermined economic activity.10 At the same time, allowing widespread strategic foreign ownership, perhaps the most promising alternative privatization method, was not the preference of the authorities and, in any case, would have been difficult to implement given the adverse investment climate.

27. The economy responded to lagging market-enhancing institutions by creating further inefficiencies, setting in motion a vicious circle:

  • Activities migrated into the shadow economy—estimated to make up more than half of official GDP in 1997 (Figure 12). To maintain fiscal revenues, the government had to levy a high tax burden on the formal economy, driving even more activities underground.

  • Given insufficient fiscal revenues and little scope to cut spending, the government resorted to financing through arrears. Wage, pension, and other payment arrears amounted to 3 percent of GDP in 1996, surging to 6 percent in 1999 after external financing had dried up during the financial crisis. With the government leading by example, a non-payment culture became ingrained.

  • Lingering doubts about the solidity of the currency and lack of trust in the poorly supervised financial institutions led to demonetization of the economy and sharply restricted the availability of bank loans to newly privatized enterprises.

Figure 12.
Figure 12.

Ukraine: Shadow Economy

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: Ukrainian Ministry of Economy.

28. But why did reforms of market-enhancing institutions not take off? There seem to be four interlocking reasons:

  • No strong private sector lobbies for institution-building emerged. Initially, the post-independence elite seemed more focused on consolidating its hold on power than on economic reform. As a result, there was no serious effort to limit the looting of state enterprises or to prevent rent-seeking. This led to the creation of powerful insider groups bent on state capture and with a vested interest in maintaining a relatively disorganized and lawless situation.

  • The political system was fractured. Early on there was little institutional clarity on the roles of the executive, legislative, and judicial branches. Moreover, policy making was hampered by the slow buildup of legal foundations11 and a rapid succession of governments (Appendix IV). As regards parliament, vested interests came to dominate decisions, as up to one half of the members had no or only loose party affiliation, representing specific business or regional interests. Frequent switching between party lines added to instability and unpredictability of parliamentary majorities.

  • Policy making remained within a Soviet-style managerial framework (Box 4). Government decision making at the highest levels was mainly focused on micro crises—for example, clearing wage arrears to teachers, closing specific coal mines, or dealing with the fate of specific enterprises—leaving little time or energy for pursuing the more strategic task of putting in place laws and regulations needed for the operation of a market economy. This focus on a managerial rather than a strategic mode of policy making partly reflected incentives: ministers and senior officials could expect most rewards from being seen pulling on available levers of power to resolve micro crises, which, in turn, tended to proliferate in an economy unmoored by agreed and credible rules of the game.

  • And Ukraine suffered from a version of the natural resource curse. The dominance of heavy industries, including coal and steel, and large energy and agricultural sectors provided a ready habitat for corruption and rent-seeking activities (Box 5). A small set of people benefited from asset-stripping and brazen insider deals in these sectors, casting a shadow on the security of property rights as ownership structures came to be viewed as illegitimate by a large part of the population. This in turn provided incentives to the owners to invest heavily in political capital, re-enforcing the existing fracturing of the political system.

Retooling Ukraine’s Policy-Making Machinery

Sundakov (1997, 2000) observed that, as a legacy of Soviet-era holdovers, policy making in Ukraine tended to focus on perpetual fighting of micro crisis, preventing the government from focusing on key strategic policy priorities. He identified three key issues that would need to be addressed to improve policy making at the government level:

  • Establishing a government agenda that focuses on strategic priorities. With the government machinery prone to generating and responding to a multitude of specific issues, gaining control of the agenda would require that the government controls its policy agenda by restricting decision making to properly constituted meetings with a pre-announced and transparent agenda.

  • Preparing policy papers to inform policy meetings on options and risks. Sundakov (2000) in particular noted that government decision making was largely based on draft legislation acts, which by their nature did not facilitate discussions of the different policy options and the risks entailed by these options.

  • Building requisite policy analysis skills. Assuring the quality of papers underlying policy decisions would require a medium-term program to develop and upgrade the analytical and strategic skills of ministry staff involved in preparing policy background papers.

The Energy Sector: From Rent- to Profit-Seeking

Ukraine started its transition with a highly energy-dependent economy. In 1991, measured on a per dollar of output basis, Ukraine’s energy use surpassed that of other transition economies. Most energy needs were covered by imports, originally at a fraction of the world price. As a consequence, sharp rises in energy prices would impose immense adjustment costs on producers and consumers.

The energy sector became the fulcrum of industrial and social policies that led to a massive redistribution of rents. As energy prices rose, industrial lobbies pressed to delay an otherwise imminent output decline and the restructuring of their industries. Given intensive political pressures, state-owned energy companies failed to introduce hard budget constraints on enterprises and households, and arrears rapidly piled up. On several occasions, arrears were formally transformed into government debt (with the largest operation involving a $3.3 billion gas settlement with Russia and Turkmenistan in March 2005). Energy traders and other enterprises engaged in intransparent barter strategies, both inside and across Ukraine’s borders, that quickly worsened governance problems in the energy sector while giving rise to the emergence of powerful and rich elites.

Quasi-fiscal activities in the energy sector declined substantially after reforms were introduced during 1999-2000. The cash collection ratio for electricity increased rapidly from a 15 percent in 1999 to 50 percent by end-2000 and over 90 percent by end-2004. However, the economy remains highly energy-intensive and governance in energy markets remains weak, constituting a potential source of economic instability. A key test will come once prices for gas supplies from Russia and Turkmenistan, which are still sold far below market rates, adjust to international levels.

B. Accounting for the Growth Turnaround: 2000-04

29. The growth turnaround came as a big surprise to forecasters. Given limited progress on institution-building, there seemed to be little basis for a sustained growth turnaround. Thus, Ukraine’s growth boom during 2000-04 confounded most observers’ expectations, this time in line with positive growth surprises for other CIS countries (Table 6). GDP during 2000-04 increased cumulatively by some 50 percent, while one-year-ahead WEO forecasts added to an increase of only about 19 percent, leaving a cumulative forecast error of 31 percent

Table 6.

Ukraine’s Underestimated Output Recovery, 2000–041/

(Cumulative growth; in percent)

article image
Source: IMF World Economic Outlook.

Projections in the October WEO for the next year.

30. Why did growth rebound with such unexpected vigor?

  • Rising demand met idle capacities. By the late-1990s, Ukraine had a large stock of unused capacities, and the growth rebound faced few supply constraints as soon as demand started to take off.

  • Massive relative price shifts turned the enterprise sector profitable (Box 6). The sharp devaluation and fall in real wages following the financial crisis raised the competitiveness of Ukraine’s products (Figure 13). Thus, the real devaluation, combined with the consolidation of previously dispersed ownership structures, effectively encouraged managers to behave in ways that spurred economic growth, even without far-reaching governance reforms. By then, enterprises had also learned how to make traditional products more marketable (see Berengaut and others, 2002). Subsequently, sharp terms of trade gains added to this growth momentum as Ukraine benefited from rapid increases in global prices for its exports of steel, other metals, and chemicals.

  • Limited but well-focused structural reforms also played a role. These reforms—including successful insistence on cash payments for energy, withdrawal of the state from providing agricultural inputs, and the reduction in social arrears—by the new government led by then-Prime Minister Yushchenko tackled the nonpayment culture in the energy and other sectors (Figure 14) and raised efficiency in the agricultural sector.12

Figure 13.
Figure 13.

Ukraine: Relative Prices

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Sources: IMF International Financial Statistics ; and staff estimates.1/ Based on CPI and average trade weights
Figure 14.
Figure 14.

Ukraine: Indicators of Non-Payment

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: Ukrainian authorities.

31. While the growth rebound facilitated fiscal discipline, tight external and domestic financing constraints also played a key role in keeping fiscal deficits in check. Repeated positive growth surprises helped to meet budget deficit targets (Figure 10). At the same time, access to external and domestic financing was severely constrained during 2000-02, as demand by foreign and domestic investors for government securities had dried up and privatization revenue remained subdued (Table 1). But quasi-fiscal deficits, particularly in the energy sector, also started to decline sharply in 2001, while fiscal institution-building gathered momentum. By 1998, an interim treasury account that recorded most central government cash and noncash expenditure had become operational; and a modern Budget Code was introduced in 2001.

32. Maintaining low and stable inflation rates has remained elusive. Inflation declined sharply after 2000, notwithstanding continued robust nominal money growth (Figure 9). Rapid re-monetization of the economy and the nominal peg to the U.S. dollar seemed to have ushered in a period of low and stable inflation. But, following a phase of deflation in 2002, inflation started to trend upward again in early-2003, reflecting a complex mix of shocks, including: rapid economic growth since 2000; large terms of trade gains that boosted current account surpluses and incomes; supply-side disturbances to Ukraine’s rigid food markets; and hikes in public wages and pensions in 2004 and 2005. However, the final impact and persistence of these multiple shocks on inflation was enhanced by a monetary policy framework primarily devoted to defending the peg to the U.S. dollar, a framework that left medium-term inflation outcomes seemingly unanchored.

33. The main driving forces behind the recent growth spurt are waning. Capacity bottlenecks have emerged, in particular since investment activity remained relatively subdued during the growth rebound. Also, the recent surge in inflation, combined with some nominal appreciation so far in 2005, has partly corrected the hryvnia’s real undervaluation. Finally, prices for Ukraine’s major exports, which had climbed rapidly since 2001, have started to reverse.

34. At the same time, the crux of Ukraine’s growth problem—weak market-enhancing institutions—remains unaddressed. The World Bank’s broad indicators of institutional strength point to no significant improvements in governance since 1998 (Figure 15). Moreover, in 2004, Ukraine still ranked 122 out of 146 countries in the corruption index compiled by Transparency International. And the business climate remained difficult during 1998-2004, as indicated by the miniscule cumulative FDI flows to Ukraine. Among transition economies, only the Kyrgyz Republic, Turkmenistan, and Uzbekistan have fared worse in FDI per capita terms (Figure 16).

Figure 15.
Figure 15.

Ukraine: Indicators for Institutional Strength, 2004 vs. 1998 1/

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: World Bank, Governance Indicators Data Base.1/ Ukraine’s percentile rank vis-à-vis all other countries.
Figure 16.
Figure 16.

Foreign Direct Investment in Transition Countries

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Source: IMF International Financial Statistics.

IV. The Role of the IMF

35. Ukraine proved a difficult counterpart for the Fund, but there were successes as well as disappointments. IMF-supported programs were instrumental for supporting the authorities’ gradual drive toward macroeconomic stability. But programs also had little traction as commitment devices for the authorities and were not able to permanently tip the balance toward accelerating the pace of building more market-friendly institutions. As a consequence, during most of the 1990s output kept declining, rendering gains on macroeconomic stability tenuous. As discussed in the previous section, the Russian financial crisis and its fallout “resolved” Ukraine’s growth problem, albeit in a second-best manner and most likely only temporarily. This section first reviews the main obstacles that made it difficult for Fund-supported programs to play a more effective role in Ukraine’s transition. The section further discusses issues related to program implementation and design that may also have diminished program effectiveness. Finally, it highlights that the Fund played a crucial role in the transition of the Ukrainian economy by: (i) transferring knowledge about macroeconomic policy making and implementation through a continuous policy dialogue; (ii) facilitating coordination and communication of the authorities’ policy agenda; and (iii) helping to block, or at least mitigate, errant policy initiatives.13

36. At the outset, it is also important to keep in mind that policy developments and Fund advice in Ukraine (and other CIS countries) often shadowed trends in Russia. For example, the move toward, and then away from, a long list of structural conditions in Ukraine almost exactly mirrored the pattern in Russia.

A. Political and Administrative Obstacles to Program Effectiveness

37. Lack of political consensus to pursue market-friendly reforms was the main cause for repeated program failures. Ukraine started the reform process with a strong degree of resentment against outside recommendations on how to move to a market economy. After the wrenching experience of hyperinflation and output collapse in 1992-94, the authorities became more receptive—albeit reserved-subscribers to IFI advice, a change of mind no doubt also driven by a pressing need to obtain external financing. But, while there was no lack of sweeping structural reform visions as early as in 1994, these visions were never anchored in a broad political consensus. In particular, parliament, riddled with special interest groups, often proved a stumbling block for reform initiatives. This lack of political consensus set Ukraine not only apart from many Eastern European and Baltic countries, many of which could rely on European integration as an external anchor or commitment device, but also from Russia, where reformers were able to push their agenda more effectively.

38. Implementation of programs was hampered by weak administrative capacities. It took Ukraine much longer than other CIS countries to raise the quality of its administrative apparatus, establish decision-making capacities, and create mechanisms of communication among the various public institutions, all of which hampered its ability to implement reforms. For example, the World Bank, in its 2000 Country Assistance Evaluation report (2000a, p. 19) concluded that “one consistent weakness has been an over-estimation of … the government’s implementation capacity.”

39. Unfunded social promises may also have undercut policy making and commitments. Ukraine started its transition with a comprehensive set of social protection programs that quickly proved fiscally unsustainable. Given the hardships that radical changes to this system would have meant, social mandates were maintained, or even extended, notwithstanding the government’s rapidly shrinking fiscal room for maneuver. When funding proved insufficient, adjustments either took the form of arrears, or more often, the social mandates were simply ignored. As a result, there was always an unresolved tension between legislated social promises and fiscal reality, adding to the population’s mistrust in the country’s political institutions. Moreover, the accumulated “social mandates overhang” also meant that there would always be strong incentives for the government to use fiscal resources procyclically and strategically for political aims, as indeed happened in the case of the massive public pension hikes during the run-up to the 2004 presidential elections (Box 7).

Ukraine’s Social Mandate Overhang

A surprise hike of public pensions in 2004 brought actual pension practices in line with the legal obligations—at substantial fiscal costs. In September 2004, during the run-up to the presidential elections, in a snap decision taken without consulting the Fund as agreed under the program, the government raised monthly pensions to the subsistence minimum level of Hrv 284. The massive pension hike was rationalized by noting that it fulfilled (for the first time in Ukrainian history) the social mandate guaranteed by Article 46 of Ukraine’s Constitution, which states that no pension should be below the subsistence minimum level. Staff estimates suggested that the annualized budget cost of the decision was about 3½ percent of GDP. Together with a further increase in the subsistence level later in the year, pension spending rose by 5 percent of GDP to an estimated 14 percent of GDP in 2005. As a further side effect, the pension hike decision also derailed the shift to a multi-pillar pension system, as foreseen by legislation approved in 2003, nullifying many years of pension reform efforts.

Ukraine’s Constitution and other laws include many other social mandates that are either only partially fulfilled or simply ignored. They include guarantees of the right to free education, healthcare, and public housing. According to some estimates, the costs of fulfilling all these social mandates could amount to about 10 percent of GDP. At the same time, the potentially most costly unresolved social promise is the compensation for the savings lost during the hyperinflation periods. While a law to recognize those losses as public debt was vetoed by the President in June 2005, the proposal could resurface and create additional official government debt up to about 30 percent of GDP.

B. Additional Factors Hampering Program Effectiveness

40. At least until 1999, the authorities’ perception of the Fund’s willingness to be engaged in a continuous program relationship may have undermined program effectiveness. The Fund’s strong interest in supporting Ukraine was reflected in the nearly uninterrupted program coverage during 1994-99, the large number of missions, and other efforts including delivery of copious technical assistance (Table 7). Additionally, Fund management was generally closely involved in program negotiations and reviews. The aim of tipping the balance toward reformers was the main driving force behind the desire to stay involved—a goal which was shared by the Fund’s shareholders whose security and strategic considerations also lent support for Fund engagement. However, major shareholder pressure, while existent, was considered by interviewees to have played a much less prominent role than in the case of Russia.14 At least at the time of the 1998 financial crisis, the Fund was also concerned about regional contagion given Ukraine’s size and trade links. Against this backdrop, failure to implement agreed program commitments may have seemed to the authorities to carry little practical consequences in terms of delaying program approvals and disbursements. Some staff involved in Fund operations at that time suggested that almost uninterrupted access to Fund (and other IFIs) financial support may well have delayed reform efforts before 1999.

Table 7.

Ukraine: Number of Missions and Resident Advisors, 1994–2005

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Sources: Travel Information Management System; IMF Staff Reports; and IMF Independent Evaluation Office Report on Technical Assistance.

Combined with program review.

Combined with program negotiations.

As of October 10, 2005.

There were also two FSAP missions in 2002.

41. In the face of a truly unique challenge, the design of structural conditionality in early transition programs may have lacked focus. The Fund entered uncharted territory, particularly in the CIS, with challenges not well understood and with little practical experience. It is therefore not surprising that program design itself underwent a learning and adjustment process over time. For example, the early programs did not include conditionality on arrears buildup, or the establishment of more effective fiscal institutions, while they did place much emphasis on numerical targets for privatization. In hindsight, the early programs focused on a set of reforms that were already on the government’s own agenda, while not tackling the authorities’ creative ways of evading fiscal discipline and delaying the buildup of more effective fiscal institutions. At the same time, and again judged with the benefit of hindsight, the early programs’ focus on the speed, rather than the modus and quality, of mass privatization may have been misplaced.15

42. On the other hand, in later programs, structural measures proliferated. To step up the pace of institutional reforms, the EFF-supported program introduced a large policy matrix with the objective of providing the authorities with a step-by-step action plan. However, the policy matrix, which included 88 measures (and 150 sub-measures), proved unwieldy, taxing the staffs and the authorities’ limited capacities to monitor implementation. The matrix included many measures in non-core Fund areas, including the energy sector and privatization—areas viewed as critical for triggering an economic rebound, even though progress under earlier World Bank programs had been unsatisfactory.16 But some interviewees noted that, with Fund staff struggling to properly monitor these non-Fund core areas, attention and resources had to be diverted from core areas.17 Finally, the fact that none of the measures were performance criteria under the original program (four of the measures later became structural performance criteria) may have been viewed by the authorities as a signal that there was substantial leeway to waive progress in reforms for completion of reviews. The staff sought to remedy this problem by introducing a large number of prior actions for completing reviews, an approach, however, that came to be seen by the authorities as an arbitrary shifting of goalposts.

43. At the same time, the detailed policy matrix was welcomed by the authorities at a technical as well as at a political level, but without necessarily strengthening weak program ownership. On a technical level, the policy matrix was not unlike the central plans sent from Moscow during Soviet times, providing guidance and serving as a coordination tool. However, at a political level, the matrix was a convenient device for deflecting criticism to the Fund when implementation faced heavy political opposition or was bungled at the administrative level.

44. In the event, Ukraine’s EFF supported-program became a leading example of excessive structural activism. In response to an initiative by Fund management to streamline structural conditionality, at the second review the structural policy matrix of the EFF arrangement was reduced from 88 to 36 measures. Views within the Fund on whether the smaller number of structural measures remained excessive or not differed, however, and pressures for further streamlining continued. In particular, the conditionality on reducing the export tax on sunflower seeds became a rallying cry for those arguing that the Fund had drifted toward excessive micromanaging, although based on its merits the case seems less than straightforward (Box 8). The recent precautionary SBA-supported arrangement shifted to a highly parsimonious approach on structural conditionality, including only five structural measures (in addition to five prior actions), all clearly located in Fund-core areas (see Appendix VI).

45. Finally, there were also claims that the Fund made mistakes in its policy advice, in particular because it lacked sufficient insight into the workings of the krainian economy and politics. The authorities felt that the Fund’s insistence in 1997-98 on the government letting T-bill rates to be market-determined and avoiding restrictions on purchases by non-residents contributed to the severity of the 1998 financial crisis. Regarding structural reforms, interviewees that were involved on the Ukrainian side suggested that the Fund not only overestimated the political support for reforms, but that in a few cases measures were ill-advised and had later to be adjusted, providing ammunition for reform opponents. Two specific examples mentioned were the increase in housing and rental tariffs in 1995 (a structural benchmark of the 1995 SBA), which led to large arrears buildup, and the increase in the alcohol excise tax in 1998 (a prior action of the EFF arrangement), which caused sharp increases in smuggling. The Fund’s underestimation of the rapid remonetization after the 1998 financial crisis and repeated calls for more exchange rate flexibility—including a call for tighter monetary policy in 2001 when, as it turned out later, Ukraine was in fact on the brink of deflation—were singled out as telling examples of how the Fund would sometimes cling to unduly dogmatic positions (Box 9). While these and other examples may confirm that the Fund made policy mistakes, the criticism appears to single out individual measures, without acknowledging that these measures were part of a much broader policy package advised by the Fund.

Why was the IMF Concerned About Sunflower Seeds?

An export tax on sunflower seeds turned into a well-publicized test case on enforcing highly specific structural conditionality. Ukraine is one of the world’s largest producer and exporter of sunflower seeds. In August 1999, in a clear breach of the EFF-supported program undertaking to refrain from introducing any new restrictions on exports, Ukraine imposed a 23 percent export tax on sunflower seeds. Fund staff strongly argued for eliminating the export tax, arguing that the tax was emblematic of the ability of powerful groups (in this case, domestic oilseed crushing plants) to bend the rules of the game to their advantage at the expense of weaker groups (in this case, growers of sunflower seeds). Moreover, the tax not only redistributed income but also imposed a significant deadweight cost. At the same time, it was difficult to make a compelling case that reducing the tax was critical for achieving key program objectives. And some policy-relevant aspects of the tax—particularly to what extent it could be avoided or evaded—remained unclear, and staff spent much time trying to clarify the situation. In the event, in December 2000, an EFF review was completed without the tax having been eliminated, but a structural benchmark to reduce the tax to 10 percent was agreed. In June 2001, the tax was reduced to only 17 percent, but the sunflower seed issue was quietly dropped from the agenda. In July 2005, to fulfill a precondition for WTO accession, parliament adopted legislation to lower the tax by 1 percentage point per year upon WTO membership.

Disagreements on Exchange Rate Policy

The exchange rate has been the monetary policy anchor over the past 10 years. The NBU steered the hryvnia within a band against the U.S. dollar from June 1996 but had to shift the band upward three times during the financial crisis. The hryvnia floated briefly between May 1999 and February 2000 but remained de facto fixed until April 2005 when the NBU allowed it to appreciate by 5 percent.

uA03fig01

Ukraine: Exchange Rate Policy 1/

Citation: IMF Staff Country Reports 2005, 415; 10.5089/9781451839067.002.A003

Sources: Ukrainian authorities; and staff estimates.1/ The hryvnia replaced the karbovanets in 09/96 at a rate of 100,000/1.

The authorities early on developed a strong affinity for a peg, while the Fund frequently called for more exchange rate flexibility. Controversy already surrounded the timing of the initial introduction of the exchange rate band. While the authorities intended to adopt it in 1995, the Fund insisted to delay it to mid-June 1996 after central bank financing had become less rampant and inflation had come down somewhat. Once the regime was introduced though, the Fund, though often reluctantly, no longer made exchange rate policy a sticking point to its program support. In hindsight, it appears that before the crisis the hryvnia was overvalued as the real effective exchange rate appreciated and institutional reforms had stalled. A more gradual depreciation might have contributed to an earlier recovery, but the effects were difficult to gauge at the time when the focus was predominantly on closing the reform gap. During the financial crisis, the Fund agreed to defend the exchange rate including through administrative controls—a mistake in hindsight as the NBU lost substantial amounts of reserves and ultimately had to float the currency. After the crisis, the Fund strongly favored a more flexible regime but accepted the authorities’ choice of a de facto peg partly because a peg had also been agreed under the Fund-supported program for Russia. Over the coming years, the Fund regularly pointed at the risks that rapid reserve accumulation under the peg would pose for inflation and the lack of incentives to hedge bank lending in foreign currency, but the de facto peg generally served Ukraine well by disciplining fiscal policy and serving as an external anchor. The uncertainty about the speed of remonetization, which allowed inflation to remain relatively low until 2004, and the strength of the U.S. dollar explains why the exchange rate regime did not become a hurdle under the EFF arrangement and the precautionary SBA (even though it became a key issue under the SBA program review).

Today the authorities favor a very gradual approach to more exchange rate flexibility. The Fund has argued for some time that the peg has outlived its utility (see IMF Staff Report 2004), but the Ukrainian authorities have been cautious and have emphasized that the Fund underestimates the risks and unique features of the Ukrainian economy.

C. Other Impacts of Fund-Supported Programs and Involvement

46. Despite their mixed record as commitment devices, Fund-supported programs, and Fund involvement more generally, played important roles in Ukraine’s transition. Even when programs were off track, the frequent attempts to reconcile assured that the Fund stayed involved in addition to the technical assistance provided (Table 7). More broadly, within and outside the program context, the Fund served three valuable functions in Ukraine: transferring knowledge, coordinating policies, and advising on policy initiatives. In fact, particularly during the 1990s, the Fund may have faced a trade-off between running the risk of repeated program disappointments and exercising these valuable functions.

47. Perhaps the most-widely appreciated role of the Fund’s engagement in Ukraine was transferring economic knowledge. Interviewees, including the authorities, stressed the positive impact of the continuous policy dialogue in establishing a more widespread understanding of the requirements for a market economy, and the functioning and interaction of macroeconomic policies. The knowledge transfer was viewed as highly beneficial by policy makers as well as at the technical level. The Fund was also instrumental in setting up key policy-making institutions, such as the central bank, and has continuously supported the buildup and strengthening of the banking supervisory function. Another example is the Fund’s guidance in preparing statistics according to market economy standards—in fact, in 2003 Ukraine became the first CIS country to subscribe to the Fund’s Special Data Dissemination Standard (SDDS). While the Fund’s functional departments supplied technical support, the area department helped in identifying technical assistance needs and priorities. It also used the EFF arrangement as leverage to foster progress in some areas that were supported by technical assistance, such as tax collection, the creation of a single treasury account, setting up of fiscal analysis and forecasting, strengthening bank supervision, and dealing with banks in distress. The findings of the Financial Sector Assessment Program (FASP) were used to formulate one prior action and conditionality under the precautionary SBA. However, according to the Independent Evaluation Office (2005), this link between program conditionality and technical assistance may have impaired effectiveness of technical assistance by blurring technical and policy decisions.

48. As a coordinator, the Fund had some success in facilitating the policy dialogue among the government agencies. Fund-supported programs introduced the authorities to the need for consistent macroeconomic frameworks that take into account the interlinkages between monetary and fiscal policies. They also facilitated the sometimes difficult communication among different policy makers, including the NBU and the Ministry of Finance. The Fund’s role as a coordinator, however, often took time to yield results. For example, fiscal policy interfered for quite some time with monetary policy, either through NBU deficit financing or the directing of credit.

49. As an advisor, the Fund commented on a wide range of policy initiatives, sometimes trying to fend off errant ideas. The Fund’s close engagement served as a constant reminder of the need to conduct appropriate macroeconomic policies, particularly during times when there were no programs in place. The Fund was particularly useful in screening potentially detrimental policy proposals, for example the introduction of new tax exemptions and amnesties, proposals that have had a tendency to proliferate in Ukraine’s political environment. The Fund was also partially successful in shielding particular policy areas. For example, quite recently, it helped to fend off government pressure on the NBU to provide cheap refinancing loans to banks for on-lending to the agricultural sector when it made the elimination of this practice (which had been introduced against the recommendation of the NBU) a precondition to complete discussions of the precautionary SBA.

V. Lessons

A. Taking Stock

50. Ukraine’s transition to a market economy has—so far—not worked out as well as expected. The sustained rebound in output that got underway in 2000 seems to owe much to exceptional and temporary conditions. And Ukraine’s income levels remain relatively low, reflecting an economy that is highly inefficient in using its available resources. Ukraine’s disappointing transition experience is ultimately rooted in lagging progress in adopting more market-friendly institutions. While the growth turnaround since 2000 has been underpinned by clear progress on structural reforms at important margins, as illustrated by the rapid re-monetization of the economy over the last few years, available indicators suggest that Ukraine’s institutional landscape has seen little fundamental improvement during 1998-2004.

51. Thus, while Fund-supported programs were broadly successful in supporting macroeconomic stabilization, they tried hard but did not succeed in accelerating reform of market-enhancing institutions. High inflation and excessive fiscal deficits were gradually but successfully reigned in from the mid-1990s, as Fund-supported programs redirected monetary and fiscal policies to focus on macroeconomic stability. By contrast, the programs’ other key objective—to initiate sustained reforms of the institutions needed for a well-functioning market economy—was not achieved. For this outcome, the main blame has to fall on the lack of a reform-oriented political consensus within Ukraine. Until 1999, the Fund’s perceived eagerness to stay in a continuous program relationship, and program designs characterized by perhaps excessive structural activism were unhelpful but not decisive in delaying reforms.

52. Against this backdrop, President Yushchenko has put reforms at the top of his government’s agenda. The President has stressed that Ukraine’s market-unfriendly institutions are the root cause of its disappointing economic performance, pledging in particular to tackle corruption and rent-seeking. He also argued that Ukraine’s chances to succeed would be maximized by anchoring its reform drive within closer integration with the EU and global markets (see, for example, Yushchenko, 2005).

53. The main payoff for Ukraine from Fund involvement may well have come from successful knowledge transfer. Ukraine started its transition from plan to market with a thin economic knowledge base. In addition to wide-ranging technical assistance, the close and continuous policy dialogue between the Fund and the authorities, within and outside program contexts, helped provide the authorities with the tools for macroeconomic analysis and policy making.

B. Lessons for Future Fund Engagement

54. What role could an IMF-supported program in the near-term play? Under plausible baseline projections, Ukraine has no immediate external financing need. In this setting, a potential Fund-supported program could have two major benefits. First, together with the EU-Ukraine Action Plan and other IFI engagement, it could help anchor and coordinate the authorities’ reform agenda, particularly by reestablishing a coherent macroeconomic framework that aims at bringing inflation back into the single-digits. And second, a program could provide some insurance given Ukraine’s exposure to external shocks. For example, a sharp decline in metal prices and export demand, uncertainty about foreign direct investment and short-term capital flows, and a potential convergence of energy import prices to world levels constitute key external risks for Ukraine’s economy. At the same time the banking sector, which has taken on large credit and indirect foreign exchange risks during the rapid growth years, also remains vulnerable to a slowdown of the economy.

55. But what conditions would need to be in place for more successful Fund program engagement? This paper’s review of past program experiences points to the following checklist for assessing the risks to program effectiveness:

  • Is there sufficient political support behind a program? Strong program ownership and political support would be the key preconditions. In the past, underestimating political constraints led to program failures. In this context, President Yushchenko’s vision of the need for sweeping institutional reform is encouraging. So far, the present parliament has been reluctant to adopt proposed reform legislation. The upcoming March 2006 parliamentary election should clarify the extent of political support for a strong structural reform agenda. In this context, the Ukraine-EU Action plan could be viewed as a blueprint, serving the authorities as a compass for where they want to go during the program period and beyond.

  • Are the policy-making capacities to implement a program in place? The present authorities’ decision-making process seems to exhibit many of the tendencies noted by earlier observers as inhibiting government effectiveness (Box 4). In particular, there may still be too much focus on addressing micro crises (reflected in recent heavy-handed interventions in fuel, meat, and sugar markets) at the cost of focusing the government’s energies on achieving strategic goals (such as WTO accession).

  • Is the program sufficiently focused on addressing the key obstacles to sustained growth? Currently, the main issues to be addressed in a Fund-supported program would seem to comprise: (i) as regards monetary and exchange rate policy, tightening loose monetary conditions and re-orienting the monetary framework toward achieving low and stable inflation, including through a shift to a more flexible exchange rate regime; (ii) as regards fiscal policy, maintaining a tight fiscal stance, restoring a viable public pension fund, systemic tax reform, and strengthening the transparency of fiscal and quasi-fiscal operations; (iii) as regards the financial sector, strengthening the resilience of the banking sector and developing domestic capital markets; and (iv) improving the investment climate through stronger governance and institutions. Past experience suggests that measures would need to be kept streamlined and focused on critical institutional bottlenecks. This paper’s analysis and the authorities’ own diagnostics leave little doubt that building more market-friendly institutions remains the key to relaunching sustained catch-up growth, and closing the institutional gap should therefore play a key role in a Fund-supported program. In marked contrast to earlier programs, such a structural reform agenda could be anchored externally in the Ukraine-EU Action Plan.

56. What form should a Fund program engagement take? Given no immediate external financing needs, the program would likely be a low-access, precautionary arrangement. Moreover, to be able to address the medium-term challenges for Ukraine’s economy, a Fund-supported program would have to consider a duration that exceeds one year. At the same time, given Ukraine’s circumstances and uncertain prospects for closer EU integration, it will be difficult to design a credible exit strategy. Before re-engaging in a program, and to address potential concerns about ownership given the past record, the Fund could therefore ask first for a demonstrated track record of good macro policies and prior implementation of key structural reform measures that serve to demonstrate that the authorities command the political consensus needed to see a program through. Potential candidates for such prior actions could be long-delayed measures to strengthen transparency in the financial sector (such as making ownership structures more transparent) or to improve corporate governance (such as adopting a market-friendly joint-stock company law).

57. What would be the benefits of a Fund-supported program over Fund surveillance and technical assistance for Ukraine? A program could serve the authorities as an additional external anchor, both in terms of jumpstarting structural reforms, including through prior actions, and staying the course during the program period. The Fund played a similar role in Bulgaria’s and Romania’s EU accession process, but these experiences also suggest that the Fund’s leverage was closely linked to the status and progress in EU membership negotiations. Whether an additional anchor has merit for improving policy making in Ukraine will ultimately be the authorities’ decision, but the success of a future program will clearly rest on their willingness and ability to implement agreed policies. As an alternative, the Fund could remain engaged through a close policy dialogue and technical assistance, an option that would allow it to continue to provide valuable support through transferring knowledge and advising on policies.

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Appendix I. Ukraine: History of Lending Arrangements

(In millions of SDRs)

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Source: International Monetary Fund.

The percent share of the total amount drawn includes the precautionary SBA.

Appendix II. Ukraine: Performance Under Fund-Supported Programs

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Sources: MONA and IMF Staff Reports.

Systemic Tranformation Facility (STF) program approved October 1994 is not included since it did not have performance criteria or formal prior actions, though it did have eight structural benchmarks.

Does not include the two quarterly quantitative structural benchmarks that were part of the EFF arrangement (but not Ukraine’s other Fund-supported programs).