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.
The Executive Board of the International Monetary Fund (IMF) today approved a two-year Stand-By Arrangement (SBA) for Ukraine. The arrangement amounts to SDR 10.976 billion (about US$17.01 billion, 800 percent of quota) and was approved under the Fund’s exceptional access policy. The authorities’ economic program supported by the Fund aims to restore macroeconomic stability, strengthen economic governance and transparency, and launch sound and sustainable economic growth, while protecting the most vulnerable.
The approval of the SBA enables the immediate disbursement of SDR 2.058 billion (about US$3.19 billion), with SDR 1.29 billion (about US$2 billion) being allocated to budget support. The second and third disbursements will be based on bi-monthly reviews and performance criteria, and the remainder of the program period will be subject to standard quarterly reviews and performance criteria.
Following the Executive Board’s discussion, Ms. Christine Lagarde, Managing Director and Chair, said:
“Deep-seated vulnerabilities—together with political shocks—have led to a major crisis in Ukraine. The economy is in recession, fiscal balances have deteriorated, and the financial sector is under significant stress.
“Showing unprecedented resolve, the authorities have developed a bold economic program to secure macroeconomic and financial stability and address long-standing imbalances and structural weaknesses to lay a firm foundation for high and sustainable growth. The program focuses on (i) maintaining a flexible exchange rate to restore competitiveness; (ii) stabilizing the financial system; (iii) gradually reducing the unaffordable fiscal deficit; (iv) eliminating losses in the energy sector, while enhancing social safety nets; and (v) decisively breaking with problematic past governance practices.
“Following the floating of the hryvnia, the authorities are committed to maintaining a flexible exchange rate regime and focusing monetary policy on domestic price stability. With Fund technical assistance, they plan to adopt inflation targeting by mid-2015.
“The authorities are determined to stabilize the financial system, maintain confidence in banks, and strengthen balance sheets and financial regulation and supervision. To this end, they have launched diagnostic studies of the largest banks and started reforms which are critical to restore confidence and stem deposit outflows.
“Recognizing the need for fiscal consolidation, the authorities have put in place a package of revenue enhancements and expenditure restraints. Over the program horizon, they target a structural fiscal adjustment of 2 percent of GDP, which will appropriately balance the need to keep public debt on a sustainable path while minimizing the adjustment costs to the economy. To preserve competiveness, the authorities also aim to keep the minimum wage and public wage growth in line with productivity.
“The authorities plan to eliminate the large quasi-fiscal losses of Naftogaz by 2018 and strengthen the company’s transparency and governance. To this end, they have embarked on the path of meaningful, broad-based, and sustained gas and heating increases over several years, starting from May 2014. Enhancing social assistance to protect the most vulnerable from energy price adjustments is a crucial element of the reforms. In this context, it is important to reach an early agreement on repayment of accumulated arrears and the gas price dispute with Gazprom to prevent disruptions in energy trade between Russia and Ukraine.
“A strong and comprehensive structural reform package is critical to reduce corruption, improve the business climate, and achieve high and sustainable growth. The authorities have already enacted a new public procurement law, reducing room for misuse of public resources. They have begun addressing governance issues in state-owned companies and are seeking recovery of stolen assets. They are also planning to build capacity to more effectively conduct enforcement of anti-money laundering and anti-corruption legislation, as well as enhance the effectiveness of the judiciary and tax administration.
“Risks to the program are high. In particular, further escalation of tensions with Russia and unrest in the east of the country pose a substantial risk to the economic outlook. Steady and rigorous implementation of policy measures, while maintaining broad public support, will be critical for the program’s success and would unlock sizable international official assistance and private capital inflows. The authorities’ program is an appropriate response to present challenges and constraints and deserves strong support.”
Recent economic developments
Inconsistent macroeconomic policies pursued in recent years aggravated deep-seated vulnerabilities that made the economy susceptible to economic and political shocks and led to the second major economic crisis in six years. The pegged and overvalued exchange rate led to a deterioration of competitiveness and slower export growth. Together with a rising fiscal deficit and sizeable losses in the energy sector, this drove the current account deficit to over 9 percent of GDP in 2013 and slowed economic growth. Public debt rose to 41 percent of GDP, while external debt remained elevated at 79 percent of GDP. With significant external payments and restricted access to international debt markets, international reserves fell to a critically low level of around two months of imports.
In a first important break with past policies, with mounting pressures on the hryvnia and reserves at a critically low level, the National Bank of Ukraine (NBU) allowed the exchange rate to float in February. This change in the exchange rate regime, along with increased emergency financing to the budget and the banking system, helped stabilize financial markets. Nonetheless, the economic and political environment remains uncertain. 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. Early presidential elections are scheduled for May 25, 2014.
The authorities’ economic reform program aims to restore macroeconomic stability, strengthen economic governance and transparency, and launch sound and sustainable economic growth while protecting the vulnerable groups in society. The program will focus on reforms in the following key areas: monetary and exchange rate policies; financial sector; fiscal policies; energy sector; and governance, transparency, and the business climate.
Monetary policy will focus on domestic price stability while maintaining a flexible exchange rate regime. To this end, the authorities will initially adopt a money-based monetary framework. With IMF technical assistance, the authorities plan on adopting inflation targeting by mid-2015.
Financial sector reforms will aim to maintain confidence in the financial system and strengthen the infrastructure for financial regulation and supervision. Assisted by independent diagnostic studies, the NBU will assess bank resilience to economic shocks and ensure that banks strengthen their balance sheets as necessary. In addition, the authorities will review and upgrade the regulatory and supervisory framework, and take steps to facilitate restructuring of banks’ non-performing loans (NPLs).
Fiscal policy will seek to meet near-term spending obligations and gradually reduce the fiscal deficit over the medium-term. The authorities have already put in place a package of measures to stabilize revenue and start on a medium-term expenditure adjustment path that distributed the burden equitably. For 2015–16, further gradual expenditure-based fiscal adjustment—proceeding at a pace matching the economy’s speed of recovery—will aim to reduce the fiscal deficit to about 3 percent of GDP by 2016.
Energy sector reforms will focus on reducing the sector’s fiscal drag and enhancing its efficiency and transparency. The objective to bring Naftogaz’s deficit to zero by 2018 will be accomplished by policies to raise its revenue and reduce costs. To this end, gradual, but meaningful and broad-based increases in the very low gas and heating retail tariffs will be accompanied by enhanced social assistance measures to mitigate the impact on the poorest. Structural and governance reforms in Naftogaz will improve its governance and reduce operational costs.
Reforms to strengthen governance, enhance transparency, and improve the business climate will be critical elements of the program. Policy measures in these areas will include capacity building to reform public procurement and tax administration, strengthen anti-money laundering activities, and fight corruption. These measures will help improve the business climate and alleviate long-standing barriers to growth in Ukraine.
In the current difficult environment, real GDP is expected to contract by about 5 percent in 2014 amid weak investor and consumer confidence. Inflation is expected to spike temporarily in response to the exchange rate depreciation and gas and heating tariff increases, reaching 16 percent at end-2014. The current account deficit should fall to about 4½ percent of GDP on the back of the exchange rate adjustment and subdued domestic demand. Replenished by international assistance, gross international reserves will stabilize at around 2½ months of import coverage. The currency devaluation and official borrowing (to help finance a still-wide government deficit) are expected to push public sector debt up to 57 percent of GDP and external debt to just below 100 percent of GDP.
Ukraine’s economic prospects will improve in the medium-term. Real GDP growth is expected to rebound to 2 percent in 2015, rising to 4–4½ percent in the medium term. The unemployment rate, which reacts to economic recovery with a lag, will gradually decline from 8½ percent in 2014 to 7½ percent by 2016. Buoyed by the restored competitiveness, exports are projected to grow by over 6 percent a year in 2015–16. By end-2016, inflation will fall to about 6 percent and the NBU will build its international reserves to cover nearly 4 months of imports.