Ukraine
2006 Article IV Consultation: Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion

This 2006 Article IV Consultation highlights that Ukraine’s fiscal policy in 2005–06 reshuffled resources from higher saving businesses to lower saving households, touching off a consumption boom, which has been reinforced by rapid credit expansion. In 2005, this boom helped to offset the drag on the economy from marked real currency appreciation, weaker steel exports owing to intensified third-country competition, higher business-tax collections, and post-Orange-Revolution reforms, which clamped down on tax loopholes, smuggling, and corruption. The authorities have proven adept at hitting low fiscal deficit targets.

Abstract

This 2006 Article IV Consultation highlights that Ukraine’s fiscal policy in 2005–06 reshuffled resources from higher saving businesses to lower saving households, touching off a consumption boom, which has been reinforced by rapid credit expansion. In 2005, this boom helped to offset the drag on the economy from marked real currency appreciation, weaker steel exports owing to intensified third-country competition, higher business-tax collections, and post-Orange-Revolution reforms, which clamped down on tax loopholes, smuggling, and corruption. The authorities have proven adept at hitting low fiscal deficit targets.

I. Introduction

1. Since the last Article IV discussions, Ukraine’s economy has proven surprisingly resilient. With growth having slowed sharply through 2005, the economy was hit by a 65 percent hike in the price of imported natural gas in early-2006. Political developments were also inauspicious: parliamentary elections in March 2006 triggered drawn-out political wrangling, and a new government took office only in August. In this setting, the authorities and IMF staff expected another year of below-potential economic performance. In the event, growth rebounded, spurred in part by resurging export prices for steel—Ukraine’s main export—while CPI inflation moderated through most of 2006, helped by administrative delays in pass-through of higher energy prices.

2. Ukraine’s macroeconomic challenges remain massive, however. Ukraine lags in its transition, and the new government’s overarching objective is catching up with the income levels of its more advanced transition peers. At the same time, external risks to macroeconomic stability, particularly a sharp decline in the terms of trade, loom large. Further hikes in import prices for gas are in the offing, while export prices for steel could decline significantly from their present historical highs. As regards financial sector risks, a long-lasting domestic credit boom, increasingly in foreign currencies, and heavy external borrowing by the private sector have raised concerns about the banking sector’s ability to cope with downside risks. Against this challenging backdrop, IMF staff and the authorities have continued to conduct a close policy dialogue (Box 1).

uA01fig01

Ukraine has yet to catch up with its peers.

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Source: IMF International Financial Statistics.

Reactions to IMF Advice

While the authorities generally concur with IMF policy advice, implementation, particularly on structural issues, has been slow or uneven. This record may reflect an ingrained preference for gradualism but also a polarized body politic that has found it difficult to reach and sustain consensus on implementing market-friendly policies.1

Fiscal policy. In 2005, the authorities met the recommended cash deficit target of 2½ percent of GDP. For 2006, they targeted a higher deficit than recommended (3¼ versus 2¼ percent of GDP), but may well undershoot their original target. At the same time, staff has been critical of the large increases in recurrent spending during 2005–06, mainly in public pensions and wages.

Monetary and exchange rate policy. While agreeing in principle with the staff’s longstanding case for greater exchange rate flexibility, the NBU favors a very gradualist approach. But, IMF advice, particularly through technical assistance, has been instrumental in facilitating steps in liberalizing the foreign-exchange market and enhancing the NBU’s policy-making capacity.

Financial sector. The NBU has been responsive to IMF advice. However, past staff proposals to hike the minimum capital-adequacy ratio from 10 to 12 percent have been rejected. Moreover, political consensus on various legal initiatives that would enhance transparency of banks’ ownership structures and strengthen minority shareholder rights remains elusive.

Structural reforms. There were several recent advances in leveling the playing field for businesses and liberalizing foreign trade (see Table 1 for details). However, progress in other areas, including reforming the energy sector, tax administration, and public procurement, has stalled or even backtracked.

1Ukraine: Ex Post Assessment of Long-Term Use of Fund Resources (2005), available at www.imf.org, discusses the effectiveness of IMF policy advice over the last 15 years.
Table 1.

Ukraine: Structural Reforms: Progress Report

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Measures listed above have been drawn from the Ukraine-EU Action Plan, and World Bank, OECD, and Fund recommendations.

II. Background

Recent growth and inflation developments have been better than expected.

3. After nose-diving in 2005, real activity staged a surprise rebound in 2006, with growth returning to par with regional peers. This volatility reflected several cross-currents (Figure 1):

Figure 1.
Figure 1.

Ukraine: Indicators of Real Activity, 2001-06

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: Ukrainian authorities; IMF International Financial Statistics; and staff estimates.1/ Private and public consumption.
  • Temporary impacts of post-Orange-Revolution policies. Activity in trade and construction in particular contracted sharply in 2005, reflecting a clampdown on tax loopholes, smuggling, and corruption, as well as cutbacks in public-sector investment. Moreover, a re-privatization debate temporarily chilled investor sentiment, delaying some private investment into 2006.

  • Temporary export shocks. Export volumes slumped in 2005, reflecting a marked real currency appreciation, higher business-tax collections, and intensified third-country competition in steel markets. However, pulled along by resurgent steel prices and robust trading-partner growth, exporters regained their footing in 2006.

  • A fiscal-policy-driven consumption boom, reinforced by rapidly expanding household credit. While respecting low deficit targets, fiscal policy in 2005–06 reshuffled resources from higher-saving businesses (mainly by raising tax collections) to lower-saving households (mainly by raising public pensions and wages). Over the same time period, household credit expanded by well over 100 percent. As a result, private and public consumption have boomed, and the national savings rate is likely to have dropped by some 8 percent of GDP.

uA01fig02

Output growth has been highly volatile.

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: Ukrainian authorities; and staff estimates.

4. Inflation moderated through most of 2006, but has recently climbed back into double digits, boosted by energy-price pass-through. Monthly CPI headline inflation has swung widely over the last two years, even by regional standards (Figure 2). Notwithstanding booming consumption, high CPI inflation started to moderate in mid-2005. This reflected slowing real activity, low import price inflation, and a host of one-off factors, including temporary Russian import bans on Ukrainian meat and dairy products. However, as pass-through of energy import price hikes accelerated in late-2006, inflation accelerated back into the double-digit range. Domestic price pressures, as measured by the GDP deflator and labor costs, have remained significant throughout this period.

Figure 2.
Figure 2.

Ukraine: Indicators of Inflation, 2001-06

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: Ukrainian authorities; IMF International Financial Statistics; and staff estimates.
uA01fig03

After CPI inflation had come down in line with food price inflation, it has accelerated again.

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: Ukrainian State Statistics Committee; and staff estimates.

External fundamentals have become better balanced but remain in flux.

5. Ukraine’s steep terms-of-trade gains came to an abrupt halt in 2006. Prices for steel exports have skyrocketed, rising well above trend since 2003 (Figure 3). While import prices, particularly for oil, also increased sharply through 2005, the cumulative terms-of-trade improvement during 2003–05 still amounted to about 20 percent, boosting the current-account surplus by some 10 percent of GDP. However, in early-2006, amid an acrimonious dispute with Russia, the price of imported natural gas was hiked by 65 percent. For 2007, another price hike of some 35 percent has already been agreed, but Ukraine’s gas import prices would still have to rise by over 50 percent to reach projected prices for Western Europe. This continued external vulnerability comes against the backdrop of highly inefficient energy use and an energy trade deficit that is already one of the highest among transition economies.1

Figure 3.
Figure 3.

Ukraine: Terms-of Trade and Energy Dependence Indicators

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: National Bank of Ukraine; International Energy Agency; Bloomberg; UN Comtrade Database; IMF International Financial Statistics; and staff estimates.1/ Bloomberg index for export steel prices of hot rolled steel in the EU.2/ Goods terms of trade.3/ Kilotonnes of oil equivalent per unit of purchasing-power-parity-adjusted GDP.
uA01fig04

Despite large increases in 2006-07, Ukrainian gas import prices will remain significantly below Western European levels.

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: National Bank of Ukraine; and IMF, World Economic Outlook.1/ Transit fees make up about US$40 of the difference to Ukrainian prices in 2006-07.

6. The current account has switched from large surpluses into deficit, but capital flows have picked up and international reserves have reached healthy levels. With domestic demand booming, export volumes slumping, and the terms of trade reverting, the current account shifted from a surplus of 10½ percent of GDP in 2004 to a likely deficit of 1 percent of GDP in 2006 (Table 3, Figure 4). At the same time, capital inflows, FDI in particular, have been buoyant, reflecting improved perceptions of Ukraine as an investment location. As a result, foreign-exchange reserves have more than doubled since end-2004 to about 4½ months of imports and are projected to exceed the level of short-term external debt at end-2006, mitigating external vulnerabilities.

Table 2.

Ukraine: Selected Economic and Social Indicators, 2003-07

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Sources: Ukrainian authorities; and staff estimates and projections.

Authorities’ policies under the baseline external outlook. Policies include: (i) a fixed exchange rate; (ii) full pass-through of rising energy import prices to industry, but zero pass-through to consumers; (iii) a fiscal deficit target of 2.9 percent of GDP; and (iv) growth in the minimum wage of 12.5 percent.

Staff recommended policies under baseline external outlook. These include (i) increased flexibility in the hryvnia/U.S. dollar exchange rate; (ii) full pass-through of rising energy import prices to both industry and consumers; (iii) a fiscal-deficit target of 2.5 percent; (iv) end-period minimum wage growth of 8 percent; and (iv) a monetary policy that aims to reduce core inflation.

From 2003 onward, 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 GDP deflator and INS trade weights (1999-2001).

Table 3.

Ukraine: Medium-Term Balance of Payments, 2003-11

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

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Sources: Ukrainian authorities; and staff estimates and projections.

The authorities’ policies are assumed to include: (i) a fixed exchange rate through 2009, followed by a gradually widening exchange rate corridor; (ii) full pass-through of rising energy import prices to industry, but zero pass-through to consumers; (iii) a general government fiscal deficit of 2.9 percent of GDP in 2007 and 2.5 percent thereafter; and (iv) annual real wage growth of 5 percent.

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

Public and publicly-guaranteed debt.

Figure 4.
Figure 4.

Ukraine: Current and Capital Account Indicators, 2001-06

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: National Bank of Ukraine; Bloomberg; Moody’s Investors Service; and staff estimates.

7. The hryvnia’s real undervaluation has narrowed considerably. Staff work in 2004 suggested that the hryvnia was heavily undervalued in real terms, although quantitative estimates varied widely. A re-assessment using the latest data and based on the IMF’s macroeconomic-balance approach points to a much reduced gap between Ukraine’s actual and estimated equilibrium current account (Figure 5).2 This analysis suggests a real effective exchange rate undervaluation of between 3 and 15 percent. Alternative approaches based on purchasing-power-parity and dollar-wage comparisons across countries are broadly consistent with this assessment. However, these approaches also highlight that Ukraine’s real effective exchange rate should be expected to appreciate substantially over the longer term as its per capita income catches up with more advanced economies.

Figure 5.
Figure 5.

Ukraine: Indicators of External Competitiveness, 1995-2006

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: Ukrainian authorities; IMF International Financial Statistics; and staff estimates.1/ The estimated equilibrium current account is the level of the current account consistent with external balance over the medium term. For more details see Selected Issues Chapter II “Monetary and Exchange Rate Policy Framework—Where to go From Here?”2/ Average monthly wages in manufacturing.

Notwithstanding low fiscal deficits, spending and tax policies have shifted the economy on to a high-consumption path.

8. The authorities have proven adept at hitting low fiscal deficit targets, and explicit public debt has plunged. The 1998 financial crisis, which was triggered by the government’s inability to roll over its short-term debt, has left fiscal-policy makers with an acute sense of vulnerabilities related to high deficits and debt. Thus, in 2005, despite a slowing economy and no financing constraints (privatization receipts alone reached 5 percent of GDP), the tight general government cash deficit target of 2½ percent of GDP was easily met. Through November 2006, the authorities seemed on track to undershoot the 3 percent of GDP annual deficit target (Table 5). The combination of low deficits and strong nominal growth has reduced explicit public debt to about 17 percent of GDP, down from over 60 percent in 1999. However, contingent liabilities remain high at some 30 percent of GDP, largely reflecting the so-called lost-savings deposits (Box 2), but also implicit contingent liabilities of state enterprises.

Table 5.

Ukraine: General Government Finances, 2004-07 1/

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

Based on state budget expenditure appropriations, IMF staff macroeconomic and revenue estimates.

Staff’s estimate of the general government budget based on state budget, social funds, and partial local government budget data.

Authorities’ policies (see Table 2, footnote 1) under the baseline external outlook and macroeconomic framework.

Staff recommended policies (see Table 2, footnote 2) under the baseline external outlook and macroeconomic framework.

In 2005, includes Hrv 2.3 billion in advanced pension payments paid in December, due in January 2006.

In 2004–06, includes pensions on army, interior, emergency services, penitentiary, tax police and security paid directly by the State budget. Administration of these payments was transferred to the Pension Fund from 2007 onwards.

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

9. Reflecting a redistributionist shift in fiscal policy, recurrent spending and tax collections from businesses have both ratcheted upward. In 2005, average public wages and pensions were raised by over 50 percent (against an inflation target of just under 10 percent). As a result, pension spending commitments soared from 12 percent of GDP in 2004 to about 17 percent in 2005, likely the world’s highest ratio (Figure 6). To finance this recurrent-spending boom, while reducing the fiscal deficit, the government curtailed capital spending by some 1¾ percent of GDP and raised tax collections by some 6 percent of GDP, the latter especially through canceling tax breaks for the free economic zones (FEZs) and administrative improvements. The 2006 budget largely preserved the thrust of these policies.

Figure 6.
Figure 6.

Ukraine: Indicators of Fiscal Policy, 1999-2006

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: Ukrainian authorities; IMF World Economic Outlook; OECD; and staff estimates.1/ Estimated contingent liabilities from the so-called lost-savings deposits (see Box 2).2/ 2005 for Ukraine, including military pensions.3/ Data are for 2001.

Ukraine’ Lost-Savings Problem

The savings deposits of Ukrainian citizens depreciated to almost nothing during the early-1990s hyperinflation. But the deposits were recognized as a government liability in 1996, amounting then to about 160 percent of GDP. However, the law only requires a minimum annual repayment of about 0.1 percent of GDP, and since the liability was neither indexed nor paid interest, it has shrunk to some 24 percent of GDP. Recently, there have been several proposals to speed up repayment, which, if implemented, could significantly ratchet up the fiscal cost of resolving the lost-savings problem.

Ukraine: Net Present Value of Lost Savings Repayment Proposals

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Source: Staff estimates.

Calculation assumes real GDP growth of 5 percent, nominal GDP growth of 11 percent, and a nominal interest rate of 12 percent.

The monetary framework has remained anchored by a de facto peg.

10. Monetary conditions have continued to adjust passively to the requirements of the peg and are currently loose. Although the NBU has allowed the interbank exchange rate to fluctuate within a narrow band of Hrv/US$5.00–5.06, the exchange-rate regime has remained a de facto peg. In this setting, base money growth has been mostly driven by foreign-exchange interventions and changes in the government’s deposits at the NBU (Figure 7, Table 6). During most of 2006, the NBU’s monetary reactions implied an automatic tightening of its stance, only partly off-set by lower reserve requirements and a cut in NBU interest rates. More recently, monetary conditions have loosened again, reflecting a pickup in foreign-reserve accumulation and drawdown of government deposits. Real short-term interest rates have remained highly negative throughout this period.

Figure 7.
Figure 7.

Ukraine: Monetary Policy Indicators, 2004-06

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: National Bank of Ukraine; and staff estimates.
Table 6.

Ukraine: Monetary Accounts, 2003-07

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

Authorities’ policies (see Table 2, footnote 1) under the baseline external outlook and macroeconomic framework.

Projected NIR are at projected exchange rates.

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

Based on nominal GDP over the last four quarters.

Booming credit and increasing loan dollarization have heightened banking-sector risks.

11. A long-lasting credit boom has increased the balance-sheet vulnerabilities of banks and their borrowers.3 With real credit growth of about 40 percent annually since 2001, Ukraine’s domestic credit boom has been one of the fastest among transition economies (Figure 8). At the same time, corporates and banks have continued to borrow heavily abroad. As a result, overall corporate sector debt—two thirds of which is in foreign currency—now exceeds 50 percent of GDP. Household sector debt, also mostly in foreign currency, has surged over the past 18 months, albeit from a low level. These developments have translated into substantial indirect foreign-currency risk for banks since most borrowers are unhedged. Banks are also faced with rising foreign-currency liquidity risk, reflecting their increased reliance on short-term foreign funding (Table 7). While an influx of foreign banks since 2005 likely had a beneficial effect on credit-risk management practices, recent financial soundness indicators, particularly declining capital-adequacy ratios, suggest that the sector as a whole continues to be vulnerable to downside risks.

Figure 8.
Figure 8.

Ukraine: Indicators of Banking Sector Risks, 2001–06

Citation: IMF Staff Country Reports 2007, 050; 10.5089/9781451839111.002.A001

Sources: National Bank of Ukraine; and staff estimates.1/ Bank loans and external debt; June 2006 for Ukraine.2/ September 2006 for Ukraine.
Table 7.

Ukraine: Financial Soundness Indicators for the Banking Sector, 2002-06

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Sources: National Bank of Ukraine; and staff estimates.

NPLs are those classified as substandard, doubtful, and loss.

Increase in nonperforming loans (NPLs) in 2003 partly due to new classification rules.

The NBU estimates that as of end-March 2004, 6.2 percent of loans classified as substandard were being timely serviced.

About half of the drop in the provision to NPL ratio from end-2002 to end-2003 is due to new loan classification rules.