Ukraine: Staff Report for the 2013 Article IV Consultation and First Post-Program Monitoring
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International Monetary Fund. European Dept.
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Publication Date:
11 Jun 2014
eISBN:
9781498351027
Language:
English
Keywords:
ISCR; CR; government; energy company Naftogaz; CDS spread; NBU intervention; staff appraisal; gross reserve; deficit monetization; Exchange rates; Loans; Global; Eastern Europe; Europe; public finance; foreign exchange; banking system; short-term debt; burdensome government regulation
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1. Incomplete transition to a market economy holds back Ukraine’s economy. While significant progress has been made in establishing basic markets and reducing poverty, extensive state presence in the economy—a large state budget, distorting price regulation, and pervasive governance deficiencies—weighs heavily on economic growth, deterring the best use of abundant natural and human resources. The recovery from the global crisis in 2008–09, which hit Ukraine particularly hard, has been lagging behind that of peers (Figure 1). Progress with structural reforms has been slow (Figure 7) and the business climate—although improved in some areas—is considered difficult by local and foreign businesses alike.

Abstract

1. Incomplete transition to a market economy holds back Ukraine’s economy. While significant progress has been made in establishing basic markets and reducing poverty, extensive state presence in the economy—a large state budget, distorting price regulation, and pervasive governance deficiencies—weighs heavily on economic growth, deterring the best use of abundant natural and human resources. The recovery from the global crisis in 2008–09, which hit Ukraine particularly hard, has been lagging behind that of peers (Figure 1). Progress with structural reforms has been slow (Figure 7) and the business climate—although improved in some areas—is considered difficult by local and foreign businesses alike.

Context

1. Incomplete transition to a market economy holds back Ukraine’s economy. While significant progress has been made in establishing basic markets and reducing poverty, extensive state presence in the economy—a large state budget, distorting price regulation, and pervasive governance deficiencies—weighs heavily on economic growth, deterring the best use of abundant natural and human resources. The recovery from the global crisis in 2008–09, which hit Ukraine particularly hard, has been lagging behind that of peers (Figure 1). Progress with structural reforms has been slow (Figure 7) and the business climate—although improved in some areas—is considered difficult by local and foreign businesses alike.

Figure 1.
Figure 1.

Ukraine: Performance Among Peers, 2000–12 1/

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.A001

Sources: IMF, World Economic Outlook; and IMF staff calculations.1/ CEE includes Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Czech Rep., Estonia, Hungary, Latvia, Lithuania, Macedonia, Montenegro, Poland, Romania, Serbia, Slovak Rep.,and Turkey. CIS includes Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Rep., Moldova, Mongolia, Russia, Tajikistan, Turkmenistan, and Uzbekistan. The 5th and 95th percentiles include the entire CEE and CIS samples excluding Ukraine.2/ CIS, 5th, and 95th percentiles exclude Mongolia.
Figure 2.
Figure 2.

Ukraine: Real Sector Indicators, 2009–13

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.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 3.
Figure 3.

Ukraine: Inflation, Monetary, and Exchange Rate Developments, 2009–13

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

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.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/ Narrow core excludes food, fuel, and all services.3/ Inflation expectations are surveyed and compiled by the NBU.
Figure 4.
Figure 4.

Ukraine: External Sector Developments, 2008–13

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

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.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 5.
Figure 5.

Ukraine: Debt and Rollover of Debt, 2008–13

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.A001

Sources: National Bank of Ukraine; Bloomberg; Ministry of Finance; and IMF staff estimates.
Figure 6.
Figure 6.

Ukraine: Financial Sector Indicators, 2009–13

(Billions of Ukrainian hryvnias, unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.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.
Figure 7.
Figure 7.

Ukraine: Structural Reforms

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.A001

Sources: World Bank, Doing Business Indicators; Transparency International, Corruption Perceptions Index; Heritage Foundation, Index of Economic Freedom; World Bank, World Governance Indicators, World Economic Forum Global Competitiveness; and IMF staff calculations and estimates.1/ Index from 1 (the worst) to 7(the best performer).2/ The “frontier” represents the highest performance observed for each indicator across all economies in Doing Business. Scale from 0 (the lowest performance) to 100 (the frontier).3/ The higher the rank the worse the score. Rank “1” indicates the best performer.4/ Score indicates the perceived level of public-sector corruption. A high score corresponds to high perception of corruption.5/ CESEE includes Estonia, Czech Rep., Poland, Turkey, Lithuania, Latvia, Slovenia, Hungary, Bulgaria, Russia, Slovak Rep. Montenegro, Ukraine, Romania, Croatia, Bosnia and Herzegowina, Serbia.6/ Calculated as the normalized average of five indices from the World Bank Governance Database: rule of law, political stability and absence of violence, control of corruption, government effectiveness, regulatory quality, and voice and accountability.

Ukraine and Selected Peers: Real Gross Domestic Product

(Index, 2007=100)

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.A001

Source: Haver Analytics.

2. Inconsistent macroeconomic policies generate deep-seated vulnerabilities and recurrent crises. Ukraine has long relied on an effectively pegged exchange rate as a nominal anchor, accompanied by loose fiscal policy and sizable quasi-fiscal losses ultimately covered by the budget (and monetized by the NBU, which holds over 60 percent of domestic government debt). This policy mix results in an overvalued exchange rate, large twin deficits, a steady rise in indebtedness, recurrent difficulties with external financing, and low international reserves. Such vulnerabilities make the economy especially susceptible to external shocks and balance of payments crises, as in 1998 and 2008–09.

3. Political polarization, the upcoming presidential elections, and pressures from vested interests limit the authorities’ policy space. The ruling coalition led by the Party of Regions remains in power after the parliamentary elections in October 2012. The majority and the opposition have cooperated in passing legislation necessary for concluding the association agreement with the EU. However, the unexpected government decision to suspend preparations for signing the agreement as planned on November 29 prompted large-scale mass protests not seen since 2004. Tensions remain high and may increase further in the run-up to the presidential elections in March 2015. Vested interests, notably in the energy sector, continue to act as a drag on needed reforms.

Recent Developments

4. The economy has been in recession since mid-2012. Although a 15 percent budget wage hike in 2012 boosted private consumption, weak external demand and falling investment dragged activity down after the positive effects of co-hosting the Euro 2012 Soccer Cup had dissipated (chart below). GDP contracted by 1.3 percent y-o-y in January–September 2013, but unemployment remains below its long-term average at 7.5 percent in mid-2013 (Figure 2). Consumer prices stayed flat in 2013 (Figure 3), held down by falling food prices and tight monetary policy. The 12-month rolling current account deficit was 8 percent of GDP by end-September 2013, essentially unchanged from end-2012 despite the 22 percent reduction in natural gas imports in January–September 2013 (Figure 4).

Contribution to Real GDP Growth, 2008–13

(Percent; year-on-year)

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.A001

Sources: State Statistics Committee; and IMF staff calculations.1/ Difference between GDP growth and sum of components accounted for by taxes minus subsidies.2/ Industry includes mining, manufacturing, and energy.

5. Tight monetary policy has stemmed pressures on the foreign exchange market. In late 2012, devaluation expectations rose and demand for foreign currency spiked. Defending the 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. Persistent devaluation expectations and zero inflation kept real hryvnia interest rates in double digits (Annex III). The high rates prompted a 30 percent increase of hryvnia deposits in the year to September 2013. The banks used deposit inflows mainly to buy government securities and repay loans to the NBU, while credit to the economy expanded only by 7 percent y-o-y. Private balance sheets have maintained their moderate short foreign currency position since end-2012, with both loans and deposits in foreign exchange stagnating. In an attempt to relax monetary conditions while safeguarding reserves, the NBU lowered its main policy rate from 7.5 percent to 6.5 percent over the summer but raised the reserve requirements on foreign currency deposits by several percentage points.

Ukraine: Devaluation Expectations and NBU Interventions, 2011-13

Citation: IMF Staff Country Reports 2014, 145; 10.5089/9781498351027.002.A001

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

6. Ukraine’s market access has become much more difficult and international reserves are running low. In two Eurobond issues in early 2013, Ukraine raised US$2.25 billion at yields of about 7½ percent. Since late May, yields have hovered in the 8½–15 percent range. This led the authorities to postpone further Eurobond issuance, while tapping domestic banks and NBU’s international reserves for financing in foreign currencies. The recent downgrades of the sovereign by Moody’s to Caa1 and S&P and Fitch to B- led to renewed spikes in the bond and CDS spreads (Figure 4); the bond yield curve inverted. By end-October, reserves fell to about 2.5 months of imports and 36 percent of debt service in 2014. Meanwhile, foreign banks have continued to reduce their exposure to Ukraine, but this has been more than offset in 2013 by asset repatriation by domestic banks to purchase government US$-denominated bonds.

7. The fiscal stance loosened in 2012, contributing to the buildup of vulnerabilities. Large pension and wage increases, generous energy subsidies, and soccer cup spending led to a widening of the general government deficit to 4½ percent of GDP in 2012, an expansion of 1½ percent of GDP in structural terms. The combined structural deficit of the government and the state-owned company Naftogaz, a perennial source of quasi-fiscal losses, rose to 6¾ percent.

8. To cope with fiscal pressures, the authorities have been increasingly resorting to off-balance sheet activity, non-cash settlements, and low quality measures. As rising wage and entitlement spending squeezes the budget, the authorities are trying to buoy public investment by extending large amounts of state guarantees. In 2012, the guarantees exceeded 5 percent of GDP, and could reach up to 3.5 percent of GDP in 2013 according to the budget law, although only about 0.7 percent of GDP has been allocated by end-October. In October, the parliament approved the use of the so-called promissory notes (government IOUs) for about 1¼ percent of GDP for repayment of overdue VAT refunds and expenditure arrears. The notes would be accepted as payments to Naftogaz. Finally, as budget revenue has been falling short of expectations, the central government has cut transfers to local governments and postponed low-priority budget spending.

9. Energy-related quasi-fiscal losses are mounting and large contingent liabilities may be looming. Despite lower gas imports, Naftogaz’s losses in 2013:H1 more than doubled. The losses are generated by very low prices on sales to households and district heating companies and declining share of sales to the profitable commercial enterprise market. Naftogaz’ shortage of funds has also led to delays in paying for gas imports despite restructuring of a US$2 billion loan from Russia’s Gazprombank. As reduced imports defy the “take-or-pay” terms of its contract, Gazprom has announced an US$7 billion claim on Naftogaz for 2012, but has not taken legal steps to collect.

10. Ukraine’s future trade and economic relations with the EU and Russia are unclear. In August-October 2013, the Ukrainian authorities intensified their efforts to meet the conditions for signing an association and free trade agreement with the EU. In this context, Russia’s authorities announced that a free trade agreement with the EU would preclude Ukraine from participating in the regional Customs Union (including Russia, Belarus, and Kazakhstan). The Ukrainian authorities and businesses report that since August 2013, Russia’s authorities have been tightening customs procedures and controls for Ukrainian exports. Moreover, Russian officials have stated that to prevent re-export of EU goods to the Customs Union, the current essentially free trade regime with Ukraine may revert to WTO’s most favored nation status should Ukraine sign a free trade agreement with the EU. On November 21, the Ukrainian authorities unexpectedly suspended preparations for signing the agreement with the EU citing the need to sort out trade and economic relations with Russia and the Customs Union first and calling for trilateral discussions between Ukraine, the EU, and Russia on the matter. As of the time of issuance of the staff report, the authorities’ further intentions regarding economic relations with the EU and Russia remain unclear.

11. Meanwhile, the technical discussions on a possible new Fund-supported program continue. When the program supported by an SBA expired in December 2012 (Box 1), the authorities expressed their interest in a new arrangement with the Fund. Two missions visited Kyiv in early 2013, but the authorities were not able to commit to a set of policies that would adequately deal with Ukraine’s deep-seated problems. In the context of the 2013 Article IV consultations, the authorities re-affirmed their interest in an arrangement with the Fund. Technical discussions with staff are ongoing to ensure that policy commitments are sufficient to address Ukraine’s challenges.

Ukraine: Stand-By Arrangements in 2008–12

In November 2008, the Executive Board approved a two-year, SDR 11 billion SBA with Ukraine (802 percent of quota). The primary objectives of the SBA-supported program were macroeconomic stabilization and adjustment amid the heavy impact of the global economic crisis of 2008–09. The program mitigated the effects of the steep currency devaluation in late 2008, while still allowing the exchange rate to find its market-driven equilibrium that dramatically improved the external position of the country. The program also helped stabilize the banking system and created preconditions for economic recovery. However, little ownership and insufficiently strong policy implementation amid political turmoil prevented tackling fundamental structural and institutional weaknesses of the country (IMF Country Report 11/325). Under that arrangement, two reviews were completed and SDR 7 billion disbursed before it went off track and was cancelled in mid-2010 upon the approval of the next arrangement.

In July 2010, the Executive Board approved a 29-month, SDR 10 billion (729 percent of quota) SBA. This SBA-supported program aimed to set public finances on a sustainable path, eliminate quasi-fiscal losses in the energy sector, facilitate transition to a flexible exchange rate regime, and further strengthen the financial sector. Its main achievements included a pension reform in 2011, initial energy tariff adjustments, and restoring international market access for Ukraine. Again, the authorities’ program policy ownership waned, particularly in the key areas of energy tariff adjustment and exchange rate flexibility, and only one review was successfully completed. Two purchases totaling SDR 2.25 billion were made before the program went off track in 2011 and expired in December 2012.

External Stability Assessment

12. Competitiveness is weak and the REER overvalued (Annex I). High real wage growth amid slow productivity rise has eroded the gains from the 2009 devaluation, and the real exchange rate remains significantly misaligned (by 14–16 percent). Economy-wide unit labor costs and the ULC-based REER have exceeded their high 2008 levels. Staff estimates indicate that even if fiscal policy gaps were closed while maintaining the current exchange rate level, the need for a significant devaluation would persist.

13. Large gross financing needs pose substantial risks. Debt rollover risks are high with external debt above 75 percent of GDP and a gross external financing requirement of 37 percent of GDP in 2014 (Table 4). The rollover risks are mitigated to some extent by the fact that a large portion of the debt represents significant inter-company lending and transfer pricing operations. The NBU’s international reserves are low against several common metrics (Annex I).

Table 1.

Ukraine: Baseline Selected Economic and Social Indicators, 2009–18

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

Excludes unprocessed food, fuel, and administrative services.

The general government includes the central and local governments and the social funds. In 2013, the general government deficit includes recognized arrears (1.3 percent of GDP).

Government and government-guaranteed debt (includes debt to IMF).

For 2013, average of rates for the first ten months.

Table 2.

Ukraine: Baseline General Government Finances, 2010–18

(Billions of Ukrainian hryvnia)

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

Numbers are based on actual local governments’ budgets.

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

Government and government-guaranteed debt (includes debt to IMF).

Table 3.

Ukraine: Baseline Balance of Payments, 2010–18

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

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

Assumes gas import price of US$405 per tcm in 2013 and in line with global oil price developments beyond.

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

Includes trade credit and arrears, including those related to RUE settlement (2010 and 2011).

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.

Table 4.

Ukraine: Baseline Gross External Financing Requirements, 2010–18

(Billions of U.S. dollars)

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

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

For the projection period (2013–18), financing from official sources is recorded below the line.