This paper discusses Ukraine’s Request for a Stand-by Arrangement. Ukraine’s economy had been in recession since mid-2012. Inconsistent macroeconomic policies pursued in 2012–2013 aggravated deep-seated vulnerabilities and eventually generated a balance-of-payment crisis. Key objectives of the authorities’ program are to restore macroeconomic stability, strengthen economic governance and transparency, and lay the foundation for robust and balanced economic growth. To achieve these objectives, the government will implement immediate measures aimed at securing stability, combined with deeper reforms to achieve and sustain external sustainability, ensure financial stability, restore sound public finances, rationalize the energy sector, and improve the business environment.


This paper discusses Ukraine’s Request for a Stand-by Arrangement. Ukraine’s economy had been in recession since mid-2012. Inconsistent macroeconomic policies pursued in 2012–2013 aggravated deep-seated vulnerabilities and eventually generated a balance-of-payment crisis. Key objectives of the authorities’ program are to restore macroeconomic stability, strengthen economic governance and transparency, and lay the foundation for robust and balanced economic growth. To achieve these objectives, the government will implement immediate measures aimed at securing stability, combined with deeper reforms to achieve and sustain external sustainability, ensure financial stability, restore sound public finances, rationalize the energy sector, and improve the business environment.


1. Ukraine is experiencing its second major economic crisis in six years. As detailed in the staff report for the 2013 Article IV consultation, an overvalued exchange rate, a substantial budget deficit, and sizable losses in the energy sector had put Ukraine on a highly unsustainable course with a large and rising current account deficit and a rapid loss of foreign exchange reserves. Intermittent discussions between the previous Government and the Fund on a package of corrective policies that could be supported by a stand-by arrangement were unsuccessful. In a first important break with past policies, with significant external and public sector payments falling due, mounting pressures on the hryvnia and reserves at critical levels, the NBU allowed the exchange rate to float in February 2014. This change in the exchange rate regime, along with other stabilization measures, has eased reserve pressures, but large depreciation, heightened uncertainties, and geopolitical risks have weakened bank and corporate balance sheets, triggered bank deposit withdrawals, and fueled capital flight. Economic activity is contracting, and international debt markets are closed. The fiscal situation is challenging, as government revenues have fallen on the back of political uncertainty and weak economic performance. The political situation in some regions of the country remains tense after the change in government in Kyiv was followed by a secessionist movement in Crimea and tensions in the East.

2. To overcome the crisis and restart growth, the authorities have requested a Stand-By Arrangement. The new government that took office in late February after intensive political turmoil has quickly taken steps to secure macroeconomic and financial stability and to concentrate resources on critical spending needs. It has also embarked on a comprehensive and ambitious reform program designed to address Ukraine’s long-standing macroeconomic imbalances and structural weaknesses. Specifically, the program aims to restore external solvency, replenish international reserves, improve governance, and lay a firm foundation for sustainable growth. In support of these objectives, the authorities have requested Fund assistance under a two-year SBA.

3. The authorities are confident that Fund support would lend credibility to their program and help unlock official and private financing. They see their program as a historical break with the past of crony capitalism, pervasive corruption, and poor governance that weighed heavily on the economy. They believe that the political regime change has given them a mandate to launch bold and ambitious reform aimed at transforming Ukraine into a dynamic and competitive emerging market economy with transparent government and vibrant business environment and they are keen to take advantage of the political momentum for change by front-loading critical measures. They believe that a Fund arrangement would lend credibility to these plans and help unlock sizable official bilateral and multilateral—and eventually private—financing. Strong program implementation is expected to restore access to international capital markets and facilitate private capital inflows for a much needed resumption of robust private investment.

4. The success of the program depends critically on the authorities’ unwavering commitment to macroeconomic adjustment and reforms. Two previous Fund-supported programs in the past six years went off track relatively early on. Ex-post evaluations highlighted lack of ownership and weak governance as the main reasons for the poor program performance. By implementing a set of strong and comprehensive prior actions, the authorities have demonstrated their ability to conduct reform-based policy adjustments. Their staunch commitment to economic transformation despite resistance from entrenched vested interests will be key for the program’s ultimate success.

Build Up of Imbalances and Vulnerabilities Before the Crisis

5. Inconsistent macroeconomic policies pursued in 2012–13 aggravated deep-seated vulnerabilities and eventually generated a balance of payment crisis. Ukraine had long relied on an effectively pegged exchange rate as a nominal anchor. However, this was accompanied by loose fiscal policy and sizable losses in the state-owned gas company Naftogaz ultimately covered by the budget (and monetized by the NBU, which holds about 60 percent of domestic government debt). This policy mix had resulted in overvalued exchange rate, large twin deficits, a steady rise in indebtedness, recurrent difficulties with external financing, and depletion of international reserves. Such vulnerabilities made the economy especially susceptible to shocks of economic and political nature that eventually led to the current crisis.

6. Facing persistent devaluation pressures, the authorities tightened monetary policy and intervened in foreign exchange market (Figures 2, 5). Devaluation expectations rose from late 2011, when the first signs of currency overvaluation appeared. Defending the pegged exchange rate, the NBU intervened heavily, intensified foreign exchange controls, and squeezed bank liquidity. This prompted banks to raise deposit and lending rates and tighten credit conditions, exacerbating the recession in 2012–13. Persistent devaluation expectations and tight monetary policy pushed real hryvnia interest rates into double digits in 2013, despite zero consumer price inflation. The high rates prompted a 50 percent increase of hryvnia deposits during 2012–13. The banks used deposit inflows mainly to buy government securities and repay loans to the NBU, while credit to the economy expanded only by 14 percent over two years.

Figure 1.
Figure 1.

Ukraine: Real Sector Indicators, 2009–14

Citation: IMF Staff Country Reports 2014, 106; 10.5089/9781484340370.002.A001

Sources: State Statistics Committee of Ukraine; Haver; Bloomberg; GFK Ukraine; International Centre for Policy Studies; and IMF staff calculations.1/ Consumer confidence index is based on survey respondents’ answers to questions that relate to personal financial standing, changes in personal financial standing, economic conditions over the next year, economic conditions over the next five years, and propensity to consume. Index values range from 0 to 200. The index equals 200 when all respondents positively assess the economic situation. It totals 100 when the shares of positive and negative assessments are equal. Indices of less than 100 indicate the prevalence of negative assessments.2/ Values above 100 indicate that more respondents expect unemployment to rise than fall over the next one to two months. Values can vary from 0 to 200.
Figure 2.
Figure 2.

Ukraine: Inflation, Monetary, and Exchange Rate Developments, 2009–14

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

Citation: IMF Staff Country Reports 2014, 106; 10.5089/9781484340370.002.A001

Sources: State Statistics Committee of Ukraine; International Centre for Policy Studies; National Bank of Ukraine; Bloomberg; and IMF staff calculations.1/ Broad core excludes unprocessed food, fuel, and administrative services.2/ Inflation expectations are surveyed and compiled by the NBU.
Figure 3.
Figure 3.

Ukraine: External Sector Developments, 2008–14

(Billions of U.S. dollars, unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 106; 10.5089/9781484340370.002.A001

Sources: National Bank of Ukraine; State Committee of Statistics; Bloomberg; and IMF staff estimates and calculations.1/ Includes residents’ conversion of hryvnia cash to foreign currency held outside the banking system.
Figure 4.
Figure 4.

Ukraine: Debt and Rollover of Debt, 2008–13

Citation: IMF Staff Country Reports 2014, 106; 10.5089/9781484340370.002.A001

Sources: National Bank of Ukraine; Bloomberg; Ministry of Finance; and IMF staff estimates.
Figure 5.
Figure 5.

Ukraine: Financial Sector Indicators, 2009–14

(Billions of Ukrainian hryvnias, unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 106; 10.5089/9781484340370.002.A001

Sources: National Bank of Ukraine; and IMF staff calculations.1/ Included NPLs that were classified as doubtful and loss until December 2012, when the NBU changed its classification of reported NPLs, which resulted in series break.2/ Included NPLs that are classified as substandard, doubtful, and loss. From December 2012 estimated by staff using NPL data published by NBU according to new methodology, which resulted in series break

Ukraine: Devaluation Expectations and NBU Interventions, 2011–14

Citation: IMF Staff Country Reports 2014, 106; 10.5089/9781484340370.002.A001

Sources: NBU; Bloomberg; and staff estimates.1/ Derived from 12-month NDF contracts on hryvnia.

7. The economy had been in recession since mid-2012 (Figure 1). Generous wage and pensions hikes supported private consumption and domestic demand. However, overvalued exchange rate and poor business climate weighed on industrial production and investments. In late 2013, a bumper harvest gave a boost to GDP and briefly lifted the economy out of recession.

8. A ballooning fiscal deficit and rising quasi-fiscal losses in the energy sector contributed to the buildup of vulnerabilities. Large pension and wage increases and generous energy subsidies widened the general government deficit to 4¾ percent of GDP by 2013. Disregarding rising gas import prices, the authorities kept domestic retail gas and heating prices fixed at the lowest levels in Europe. As a result of price disparities and persistent governance problems, the operating deficit of Naftogaz reached 1.9 percent of GDP in 2013, sapping public resources and leading to the accumulation of gas payment arrears to Gazprom.

9. Amid deepening economic imbalances, Ukraine lost market access (Figures 3 and 4). Renewal of program discussions with the Fund helped the authorities place two Eurobond issues in early 2013 and raise US$2.25 billion at yields of about 7½ percent. After the program discussions stalled in May 2013, the international debt markets effectively closed for Ukraine. As the current account deficit was on course to its print of 9.2 percent of GDP and reserves declined to a critically low level, sovereign debt yields went into double digits and CDS spreads widened sharply. International rating agencies downgraded Ukraine to pre-default levels by end-2013. At the same time, private external debt roll-over rates remained high, as a large part of this debt reflected intercompany lending.

10. Short-lived assistance from Russia was not put to good use. In mid-December, the authorities signed a set of economic agreements with Russia and received assurances of financial assistance amounting to US$15 billion in two-year loans and a gas price discount of about 30 percent. The first tranche of US$3 billion arrived in late 2013 and the gas price was reduced in 2014:Q1. However, with no fundamental change in policy, the authorities continued to defend the de facto exchange rate peg. This policy, together with external sovereign debt service and partial clearance of gas payment arrears by Naftogaz, quickly depleted reserves. The cut in the price of imported gas was passed through to industrial and budget energy consumers, even though Naftogaz was well behind on payments to Russia’s Gazprom. Following the government resignation in January, Russia put its financial assistance on hold and in April Gazprom steeply raised its demanded import price (Box 1).

Recent Developments and Challenges

11. By late February, the NBU could no longer defend the exchange rate. The NBU’s international reserves dropped to US$15½ billion, covering only about two months of imports and equivalent to 28 percent of the remaining external debt service in 2014. In response, the NBU abandoned its de facto exchange rate peg and switched to a flexible exchange rate regime. After significant volatility in thin trading, by early April the exchange rate had depreciated by over 35 percent from its end-2013 level, hovering around UAH 11–11.5/US$1.

Ukraine’s Dire Energy Finances

Overall energy subsidies in Ukraine, on- and off-budget, amounted to 7½ percent of GDP in 2012 with relatively well-off households capturing the larger share of the benefits. Ukraine is one of the most energy-intensive countries in Europe, with use of energy per unit of GDP 10 times above the OECD average (IEA (2012), “Energy Balances of Non-OECD Countries”, (Paris, OECD/IEA).

Extremely low prices on sales of gas to households and district heating companies—a small fraction of prices in other energy-importing countries in the region—strongly contributed to large Naftogaz cash deficits and inability to pay for imported gas. By end-March 2014, Naftogaz had built up arrears of about US$2.2 billion (1½ percent of GDP) to Gazprom and significantly depleted its stored gas reserves. Despite the ongoing build-up of arrears, Gazprom has continued gas deliveries so far, but is warning that supplies may be cut if arrears are not cleared soon.

The government, as the sole owner, frequently raises Naftogaz’s capital by issuing bonds, which places a large burden on the budget. Moreover, the lack of funds deters maintenance of the existing infrastructure—which in turn generates large technical losses—as well as needed investment in extraction of domestic gas. Another complicating factor for Naftogaz finances in 2014 is the fact that gas transit fees are currently very low because of pre-payment by Gazprom in 2012–13.

In April 2014, Gazprom cancelled the gas price discount provided under the December 2013 agreements, citing the build-up of arrears and reverting to the 10-year gas supply contract signed in 2009 (which neither Russia nor Ukraine has published). This has raised the gas import price to US$385.5 per thousand cubic meters (tcm), a level envisaged in the program framework. However, Gazprom later also announced the cancellation of another US$100 discount linked to the 2010 agreement on the Russian naval base in Sevastopol, recently cancelled by Russia following events in Crimea. As a result, Gazprom is now asking Naftogaz to pay as much as US$485/tcm from April 2014. The Ukrainian authorities dispute this price and have indicated they will appeal to arbitration.

12. Fiscal balances have deteriorated. The 2014 budget approved in January allowed for increases in wages and social spending that are unaffordable, being based on highly unrealistic revenue assumptions. In fact, tax revenues are down 8½ percent y-o-y in January–February, on account of sharp deterioration of compliance amid the political turmoil. While the resulting gap has been partly filled up with profit transfers from the central bank, the Single Treasury Account has experienced intermittent payment difficulties. Meanwhile, local market financing has become limited to a handful of banks, including the state-owned financial institutions.

13. The financial sector is under significant stress. The banking system lost about 12½ percent of deposits in the two months to end-March. Reduced bank liquidity has made several banks vulnerable and dependent on emergency liquidity support from the NBU. Facing liquidity shortages, many banks have imposed ATM withdrawal limits. Exchange rate depreciation and economic contraction has hit banks with negative open foreign exchange positions and put loan portfolios at risk. The system’s capital adequacy ratio (CAR) dropped to 14.8 percent at end-March, 3.5 percentage points less than at end-2013, while the NPL ratio inched up to 13.3 percent. In March, four banks accounting for about 3 percent of the system deposits disclosed capital shortfalls and—after their owners refused to provide extra capital—were moved under temporary administration by the Deposit Guarantee Fund (DGF). The 22 largest banks (accounting for over 70 percent of the system deposits) reported meeting the minimum of 10 percent CAR as of mid-March. Adjusted for exchange rate movements, credit to the economy still grew by 3 percent in real terms in March relative to a year ago.

14. In these crisis circumstances, the NBU has taken a number of extraordinary measures. In addition to floating the exchange rate, it has adjusted monetary policy to accommodate emergency financing to the budget and the banking system. Thus, the NBU accelerated its profit transfers to the budget and back-stopped government T-bond placements by purchasing similar bonds from the secondary market. The NBU also introduced new facilities for providing liquidity to banks, allowing them to pledge as collateral not only government debt securities, but also loans to companies, at a sizable discount. Specifically, the NBU introduced (i) a special facility at a penalty rate, with access limited to the size of deposit outflows; and (ii) an emergency liquidity assistance (ELA) facility that lends at a high penalty rate against nonstandard collateral (corporate and household loans) at a 65–75 percent haircut. In late February, the NBU limited households’ FX deposit withdrawals from banks to an equivalent of UAH 15,000 per day—but allowed households to withdraw all deposited amount if converted into hryvnia.

15. The near-term economic situation is challenging. The economy is in recession. Industrial production continues to contract (-5 percent y-o-y in Q1) on the back of declining manufacturing, in particular export-oriented industries. Retail trade growth so far remains relatively strong (7.7 percent up in real terms in Q1 y-o-y), driven by still positive, if decelerating, wage growth (in real terms, 3.6 percent in February y-o-y). Consumer price inflation is only moderately picking up (3.4 percent y-o-y in March) from low levels as the effect of the exchange rate depreciation is likely to start feeding into domestic prices with a lag. In January-February exports of goods contracted by 9½ percent y-o-y driven by a drop in exports in chemicals and machinery and equipment, as well as intermittent customs restrictions imposed by Russia. Imports of goods declined by 16 percent y-o-y, reflecting mainly a drop in gas and machinery imports.

16. Crimea accounts for a relatively minor share of Ukraine’s economy. Crimea, which is included in the data for Ukraine, accounts for relatively modest 3.7 percent of Ukraine’s GDP, while its 2.3 million residents represent some 5 percent of the country’s population. The exposure of the banking sector in the region is limited to 2.3 percent in terms of deposits and 1.9 percent of the issued loans, and recently the majority of Ukrainian banks are winding up or selling their branches. One state-owned domestic gas extraction company, accounting for 14 percent of Naftogaz output is in Crimea, but its output is broadly equal to the region’s gas consumption. The effect for the budget is likely to be essentially neutral as well, as Crimea is a slight net recipient of fiscal transfers from the central government.

Policy Discussions

A. Program Objectives and Strategy

17. Ukraine—and the authorities’ program—is facing unprecedented risks (¶¶46–49). Traditionally, policy implementation risks have been significant in Ukraine, and the issue may resurface with the coming presidential elections in May 2014. In the same vein, vested interests could be expected to resist governance reforms. The program is addressing these risks by seeking upfront implementation of a critical set of prior actions, balancing decisive policy action with measures to sustain public support for the reforms, and securing broad political support for program objectives and policies. In addition—and perhaps more prominently—the unfolding developments in the East and tense relations with Russia could severely disrupt bilateral trade and depress investment confidence for a considerable period of time, thus worsening the economic outlook. Should the central government lose effective control over the East, the program will need to be re-designed.

18. Notwithstanding these significant risks, the authorities’ policy package deserves strong support. In the midst of severe economic, financial, and geopolitical risks, the authorities have shown an unprecedented resolve to put Ukraine’s economic policies on firm ground and decisively break with controversial past governance practices. If this momentum is harnessed and appropriately supported by the Fund, other IFIs, and bilateral contributions, the authorities’ success could mark a watershed moment in transforming Ukraine into a dynamic economy with rising living standards. However, if strong support is not delivered and reform momentum is lost, the full force of the current crisis could devastate Ukraine, perpetuating the vicious dynamic of bad policies followed by catastrophic crises. Thus, notwithstanding the significant risks, Ukraine is in urgent need of Fund support, which would unlock additional assistance from Ukraine’s other international partners.

19. In this context, the program aims to restore macroeconomic stability, strengthen economic governance and transparency, and on this basis lay the foundation for robust and balanced economic growth. This will be achieved by restoring competitiveness while maintaining financial stability, and resolving the remaining balance of payments needs by unlocking external financing. In parallel, deep-reaching structural reforms will aim to reduce imbalances durably, improve governance and the business climate—Ukraine’s long-standing weaknesses—and lead to resumption of balanced growth driven by consumption, investment, and exports. Given the difficult context Ukraine finds itself in, careful attention has been paid to the pace of adjustment, protection of the most vulnerable, and to flexibility in program design (in the form of adjustors to the performance criteria). Moreover, the program strategy includes a focus on capacity building with the aim of addressing the legacy of ad hoc policy design and implementation in Ukraine.

20. The main policies of the proposed program are as follows:

  • Maintain a flexible exchange rate and focus monetary policy on domestic price stability. Adopt initially a money-based monetary policy framework, with strict targets for the NBU’s net domestic assets (NDA) and net international reserves (NIR). Introduce inflation targeting within the course of the program.

  • Stabilize the financial system. The program will help maintain confidence in banks and develop a plan for strengthening balance sheets and financial infrastructure.

  • Meet near-term fiscal obligations and gradually reduce the structural fiscal deficit. Stabilize budget revenues and embark on an expenditure-led medium-term fiscal adjustment path that distributes the burden of adjustment equitably.

  • Modernize and restructure the energy sector to increase its efficiency and reduce its fiscal drag. Begin staged increases in end-user energy prices, while enhancing the social safety net, and follow with deep-reaching structural and governance reforms in Naftogaz and the broader energy sector.

  • Implement comprehensive structural reforms to help reduce imbalances, reduce corruption, improve the business climate, and achieve high and sustainable growth.

B. Macroeconomic Framework

21. Under the program baseline, policies and reforms are expected to support higher and more durable growth, keep inflation under control, and reduce vulnerabilities.

  • Real GDP is expected to contract by 5 percent in 2014, modestly rebound by 2 percent in 2015, and grow by 4–4½ percent in the medium term. This projection is broadly consistent with GDP indicators in the past emerging market crises over the last 25 years (Figure 6). In 2014, growth is being hindered by a weak banking sector that constrains credit for the economy, subdued investor and consumer confidence, restricted wage growth, and fiscal tightening. All these factors will result in a significant contraction in domestic demand, led by dropping private consumption and investment declining to historically low levels (Table 1). Net exports’ positive contribution to growth only stems from a sharp contraction in imports (driven by the exchange rate adjustment and restrained domestic demand), and a less pronounced drop in exports (as the positive effect of the exchange rate depreciation will take time to materialize). In 2015, after the economy has stabilized, a moderate investment- and export-driven recovery should ensue. In the medium term, successful implementation of program policies to improve governance and the business climate should lead to a rapid investment rebound, restored competitiveness should enable robust export growth, and—on the basis of these two effects—rising incomes will support a recovery in private consumption.

  • In 2014–15 inflation will remain elevated, driven by the depreciation of the hryvnia and hikes in energy tariffs. On the other hand, the sharp demand contraction in 2014 and a slow rebound in 2015 should cap the price increases. Supported by prudent macroeconomic policies, price growth is expected to fall within the authorities’ inflation target range in the medium term.

  • The current account deficit is expected to fall to more sustainable levels in 2014 and decline further over the medium term (Table 3). The exchange rate adjustment and subdued domestic demand will result in sharp reduction of the current account deficit to 4½ percent of GDP in 2014, while the decline of the economy’s net interest bill owing to both low-interest official financing, and a smaller debt burden for the private sector will reduce it further over the medium term. At the same time, an expected deterioration in Ukraine’s terms of trade (over the near term) will keep current account improvements relatively muted. Official financing, augmented over time by private capital inflows, will cover the external financing needs in 2014 and create preconditions for replenishing the NBU’s international reserves from 2015 onwards.

Figure 6.
Figure 6.

Economic Indicators during Past Emerging Market Currency Crises, 1990–2014

Citation: IMF Staff Country Reports 2014, 106; 10.5089/9781484340370.002.A001

Source: INS; WEO; Laven and Valencia (2012); and IMF staff estimates.
Table 1.

Ukraine: Program Scenario–Selected Economic and Social Indicators, 2011–19

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Sources: Ukrainian authorities; World Bank, World Development Indicators; and IMF staff estimates.

The general government includes the central and local governments and the social funds.

Government and government-guaranteed debt.

For 2014, average of rates for January-March.

Table 2.

Ukraine: Program Scenario–General Government Finances, 2011–19 1/

(Billions of Ukrainian hryvnia)

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

National methodology, cash basis.

Numbers are based on actual local governments’ budgets.

Government spending on Naftogaz financing and recapitalization, including through T-bills issuance. In 2014, includes repayment of a US$1.6 billion Eurobond.

Includes external and domestic net disbursements, trade credits, deposit drawdowns, as well as company receivables.

Preferred to cyclically-adjusted primary balance, as two-thirds of the interest bill relates to domestic debt.

Government and government-guaranteed debt.

Table 3.

Ukraine: Program Scenario–Balance of Payments, 2011–19

(Billions of U.S. dollars, unless otherwise indicated)

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

Gas import prices for 2012 and 2013 were US$427 and US$371 per tcm, respectively. For 2014, the price of US$357 per tcm is projected. For 2015–19, projected gas prices are: $385, $366, $354, $347, $341, respectively.

Financing from World Bank, EU, and EBRD is recorded below the line.

Includes repayment of Naftogaz Eurobond in September 2014.

Includes trade credit and arrears, including those related to Naftogaz arrears owed to Gazprom.

Mainly reflects residents’ conversion of hryvnia cash to foreign currency held outside the banking system.

The IMF composite measure is calculated as a weighted sum of short-term debt, other portfolio liabilities, broad money, and exports in percent of GDP, with different weights for “fixed” and “floating” exchange rate regime. Official reserves are recommended to be in the range of 100–150 percent of the appropriate measure. For Ukraine “fixed weights are used until 2013, and “floating” weights are used from 2014 onwards.