Ukraine: Staff Report for the 2013 Article IV Consultation and Post-Porgram Monitoring—Informational Annex
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INTERNATIONAL MONETARY FUND

Abstract

INTERNATIONAL MONETARY FUND

Title Page

INTERNATIONAL MONETARY FUND

December 2, 2013

UKRAINE

STAFF REPORT FOR THE 2013 ARTICLE IV CONSULTATION AND POST-PORGRAM MONITORING—INFORMATIONAL ANNEX

Prepared By

European Department in Consultation with Other Departments

CONTENTS

  • FUND RELATIONS

  • RELATIONS WITH THE WORLD BANK

  • RELATIONS WITH THE EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT

  • STATISTICAL ISSUES

FUND RELATIONS

(As of October 31, 2013)

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Latest Financial Arrangements:

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Projected Payments to Fund:1

(SDR Million; based on existing use of resources and present holdings of SDRs):

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Exchange Arrangements:

In September 1996, the authorities introduced the hryvnia (UAH) at a conversion rate with the previous currency karbovanets (Krb) of KrB 100,000 to UAH 1. The NBU influences the exchange rate without announcing a specific path or exchange rate target by intervening in the interbank foreign exchange market, applying foreign exchange regulations and controls, and through moral suasion. Since 2009 the official exchange rate has remained close to UAH 8.0 per U.S. dollar, and from July 2012 it has been fixed at 7.993 UAH/USD. The average-weighed interbank market rate for U.S. dollar, as calculated by the NBU, did not deviate by more than 2 percent from the official NBU rate since September 2009 (but interbank or cash exchange rates quoted by market sources often exceeded this threshold). Effective February 2, 2009, the classification of the de facto exchange rate arrangement was changed from managed floating with no predetermined path for the exchange rate to other managed arrangement, retroactively to April 30, 2008, due to the revision of the classification methodology. Since March 1, 2010 it has been classified as stabilized arrangement. Meanwhile, the NBU has been developing a more robust monetary policy framework focused on domestic price stability with greater exchange rate flexibility. A transition to a free floating exchange rate is planned when the financial system recovers and the transmission mechanisms mature.

On September 24, 1996, Ukraine accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement. Ukraine currently maintains two multiple currency practices arising from (i) the use of the official exchange rate for certain government transactions; and (ii) the requirement that a Ukrainian resident who sells the previously purchased foreign exchange not used within 10 days (including when FX was returned to the resident because the counterpart failed to fulfill its obligations under an import contract) shall transfer 100 percent of the positive difference from the sale price, on a quarterly basis, to the State budget.

FSAP Participation:

A joint World Bank-International Monetary Fund mission conducted an assessment of Ukraine financial sector as part of the Financial Sector Assessment Program (FSAP) in 2003, and the Financial Sector Stability Assessment (FSSA) report (IMF Country Report No. 03/340) was considered by the Executive Board on May 14, 2003. The observance of the following standards and codes was assessed: Basel Core Principles for Effective Banking Supervision; Code of Good Practices on Transparency in Monetary and Financial Policies; CPSS Core Principles for Systemically Important Payment Systems; OECD Principles for Corporate Governance; Accounting and Auditing Practices; World Bank’s Principles and Guidelines for Effective Insolvency and Creditor Rights System; and AML/CFT Methodology.

An FSAP update was undertaken in 2007. The observance of the following standards and codes was assessed: Basel Core Principles for Effective Banking Supervision; and IOSCO Core Principles of Securities Regulation. A Financial Sector Stability Assessment (FSSA) was considered by the Executive Board as part of the 2008 Article IV consultation.

The next FSAP for Ukraine has been scheduled for the second half of 2014 prior to the 2014 Article IV consultation.

ROSCS

A Data ROSC Module was conducted in April 3–17, 2002, and was considered by the Executive Board on August 5, 2003 (IMF Country Report No. 03/256). A Fiscal Transparency Module (experimental) was issued in September 1999, and an update in April 2004 (IMF Country Report No. 04/98).

Safeguards Assessments:

The most recent safeguards assessment of the NBU was completed on February 1, 2011. The assessment found that the NBU has strengthened its safeguards framework since the 2008 assessment by implementing the majority of the related recommendations. However, the deferred implementation of some provisions under the new NBU law enacted in 2010 weakens its effectiveness. The assessment also found that new financial risks have emerged because of special legislation and resolutions impairing the NBU’s autonomy. Steps are being taken to address these issues, including with the approval of a law repealing the requirement that bank recapitalization bonds are subject to mandatory repurchase at their face value by the NBU.

UFR/Article IV Consultation:

Ukraine is on a 12-month consultation cycle. The last Article IV consultation was concluded on June 29, 2012 and a report was published on our external website: www.imf.org.

RELATIONS WITH THE WORLD BANK

(October 2013)

Country Partnership Strategy

The World Bank Group’s Country Partnership Strategy (CPS, 2012-16) was discussed by the Board of Directors on February 16, 2012. The CPS aims to assist Ukraine in overcoming implementation bottlenecks identified in the Presidential Program and thus help make progress in the ambitious reform and EU integration agenda. The World Bank Group will adjust its policy dialogue, lending, investment, and technical assistance to respond to the government’s demonstrated commitment. The CPS is organized around two pillars, both emphasizing importance of improved governance. Pillar I supports relations between government and citizens, focused on improving public services, sustainability and efficiency of public finances, and a more transparent and accountable use of public resources. Pillar II supports productive cooperation between government and business by focusing on growth, competitiveness and job creation, improvements in business climate, promotion of domestic and foreign direct investments to achieve productivity improvements, and channeling public investment into critical public infrastructure.

The World Bank Group’s assistance to Ukraine in the new CPS will be calibrated to match the scope and instruments of support to the strength of the authorities’ commitment, capacity and track-record in key areas of potential engagement. Specifically, investment loans will be offered where governance risks are manageable, where a track record of implementation has been established and capacity built and where there is broad consensus on general policy framework. Analytical and advisory services will be offered to help strengthen reform consensus and build capacity. Development policy lending will be contingent on a sustainable macroeconomic framework and progress in tackling key governance weaknesses.

World Bank Program

The current investment lending portfolio includes nine operations totaling US$ 1.9 billion, of which almost 50 percent has been disbursed. Among the projects in the public sector are a Public Finance Modernization Project (US$50 million) and a Statistical System Modernization Project (US$42 million). The Hydropower Rehabilitation Project and additional financing (US$166.0 million) were approved in June 2005 and November 2009, respectively, and the Power Transmission Project (US$200 million) was approved in August 2007. The Board approved an Energy Efficiency Project (US$200 million) in 2011. In infrastructure, the Bank’s Board approved a Roads and Safety Improvement project in 2009 for US$400 million and Second Roads and Safety Improvement Project for US$450 million in 2012 (both currently under implementation). The Bank also has an Urban Infrastructure Project (US$140 million), designed to provide financing to local governments and utilities for priority investments in water and wastewater. In the financial sector, the Second Export Development Project (EDP2; US$154 million plus additional financing of US$150 million), which builds on the success of the first project, promotes the export sector access to finance.

The investment lending program for the first two years of the CPS envisages base level support in the range of US$500 million per annum. The current investment lending pipeline for FY14 includes an operation to support scaling up targeted social assistance, a second Urban Infrastructure project and a District Heating Energy Efficiency Project for a total of US$850 million, which may change based on the government’s demand and the Bank’s lending capacity. In FY15–16, additional investment lending may be envisaged in the following areas: (i) transport and trade facilitation; (ii) energy efficiency and energy security; (iii) municipal services and governance; (iv) health services and financing; and (v) private sector development and access to financing.

The calibrated engagement leaves room for an upward revision of lending amounts through Development Policy Lending (DPL) should reforms accelerate and consistent progress on governance be made. The Programmatic Financial Sector DPL series and cross-sector DPL series supporting improved economic governance and competitiveness could be launched subject to the government’s request for IBRD resources, a sustainable macroeconomic framework, tangible progress on governance/structural issues, IBRD’s financial capacity, and global economic developments.

All areas of engagement will build on strong diagnostic work and technical assistance, with focus on building consensus in society regarding policies and processes to tackle key structural challenges. Main areas for analytical and advisory assistance (AAA) will be: (i) the investment climate, including advice in key policy areas such as agriculture, land, business regulations; (ii) fiscal, tax and PFM; (iii) energy efficiency and governance (including gas sector modernization); (iv) financial sector stability and development; (v) municipal governance and service delivery; (vi) social reforms (targeted social assistance and pension reform); and (vii) health sector reforms. Partnerships in policy dialogue and AAA with the European Commission (EC), the International Monetary Fund (IMF), United Stated Agency for International Development (USAID), European Bank for Reconstruction and Development (EBRD) and other bilateral donors will continue and be expanded where possible.

Indicative IBRD Knowledge Services, FY13–14

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Bank-Fund Collaboration

According to Joint Management Action Plan on Fund-Bank collaboration on Ukraine, the staff teams agreed that the Fund and Bank would support Ukraine’s efforts to: (i) pursue fiscal consolidation whilst finding fiscal space to increase public investments needed to support private sector growth and to tackle pressing social issues; (ii) move forward with energy sector and utility tariff reforms whilst protecting the poor; (iii) complete rehabilitation and strengthen oversight of the banking system; (iv) strengthen the monetary policy framework; and (v) improve the investment climate. The teams agreed to the following division of labor and coordination:

  • Restoring confidence and fiscal sustainability: Strengthening public finances and tackling long-standing problems through advancing structural reforms would underpin medium-term fiscal sustainability and growth. The Fund program and the Bank’s assistance are designed to support the authorities’ efforts to lower budget deficits and to: (i) tackle key budgetary rigidities to gradually reduce the footprint of the public sector on the economy; and (ii) support reallocation of resources from transfers and other current spending toward growth-enhancing capital investments and better targeted social support. To this end, the Bank, in coordination with the Fund, has recommended a series of structural measures to reform the pension system. The Fund and Bank teams work closely through their programs to push the implementation of a sequence of reforms aimed at putting the pension system on sound financial footing and reducing its strain on public finances. In the context of administrative reforms in Ukraine, the Bank and Fund will continue to provide advice aimed at ensuring a leaner and more efficient public service. The Bank will continue to provide project financing for the public sector, including a Public Finance Modernization Project, a Statistical System Modernization Project, and the ongoing investments to modernize social assistance services. The Bank also plans to focus on improving the efficiency of public spending. The Bank and Fund will also coordinate on supporting the authorities’ efforts to strengthen debt management.

  • Reforming and modernizing the energy sector whilst improving targeting of safety nets: Energy sector reforms will continue to aim at improving energy efficiency of the economy, eliminating the need for budgetary support to Naftogaz, and encouraging investment in gas exploration, extraction, and transportation. The Bank’s support for the authorities’ energy sector reforms will continue to focus on infrastructure modernization through a sequence of investment loans, including in areas of hydropower rehabilitation, power and gas transmission, and energy efficiency. The Fund will focus on supporting efforts to phase out Naftogaz’s deficit, including through a program of steady gas prices and utility tariff increases to advance cost recovery and reduce fiscal and quasi-fiscal deficits generated by the company. The Bank and the Fund will continue to work together on supporting reforms that depoliticize price-setting mechanisms of public utilities and improve payment discipline. To improve transparency of reporting in the gas sector, the Bank will support and advise the authorities on Extractive Industries Transparency Initiative. The Bank team will continue its advice on improving targeting of social assistance to protect poor households from higher utility tariffs and other necessary fiscal reforms. The Bank and Fund teams will work closely to support implementation of this reform agenda.

  • Preserving banking sector stability while deepening financial intermediation: In light of macroeconomic risks, preserving stability of the banking system and deepening healthy financial intermediation are key policy priorities in the financial sector. The Fund and the Bank will continue to coordinate closely in advising the National Bank of Ukraine on improving the regulatory and institutional supervisory framework aimed at making Ukrainian banking system more resilient to shocks. The Fund and the Bank will also provide well-coordinated policy advice and technical assistance to the authorities on strengthening the crisis preparedness framework, including analysis of evolving risks, preparation of contingency plans for the system and specific institutions, and enhancing resolution tools. The teams will also work closely on supporting further development of a framework that recognizes and facilitates resolution of impaired loans, including development of a strategy to pro-actively address barriers to nonperforming loans’ effective resolution and any necessary changes to the existing legislation and regulations, including tax treatment. The Bank will continue its technical assistance to other financial sector regulators on select issues in improving the regulatory and supervisory regime for non-bank financial institutions.

  • Developing a more robust monetary policy framework: Focusing monetary policy squarely on domestic price stability with greater exchange rate flexibility under a more independent NBU will facilitate inflation reduction, discourage dollarization and excessive risk-taking, and provide a buffer against frequent external shocks. The Fund will lead in this area, including through policy advice, and also by providing technical assistance on strengthening monetary policy and operations frameworks and establishing necessary preconditions for moving toward inflation targeting regime over the medium term. The Fund will continue to provide technical assistance as needed for implementing the authorities’ strategy for liberalization of the foreign currency market. It will also work with the authorities as needed on addressing remaining shortcomings in the governance of the NBU identified in the context of the recent Safeguards Assessment.

  • Improving investment climate: Deep and sustained improvements of the business environment are key for generating strong and sustained economic growth fueled by private sector. In support of this objective, the Bank Group will lead in this area supporting measures and reforms to reduce entry and exit barriers to enable creation of new businesses and to allow a faster reallocation of resources in the economy. The Bank would also support measures to improve fair competition and to overcome governance and regulatory barriers to trade and FDI. The Fund will provide support for the authorities’ efforts as appropriate.

World Bank Contact: Lalita Moorty, Lead Economist; Anastasia Golovach, Economist; (Tel.: 380-44-490-6671).

Ukraine: Bank and Fund Activities in Macro-Critical Structural Reform Areas, September 2013-December 2014

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RELATIONS WITH THE EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT

(November 2013)

Since Ukraine joined the EBRD in 1992, the Bank has been active in supporting the country’s transformation towards market economy. As of end-October 2013 the EBRD’s portfolio in Ukraine reached €4.8 billion (with 2013 signings of €630 million) with most of it being in the private sector. The Bank’s country exposure in Ukraine is its second largest after Russia, accounting for approximately 1/8th of the Bank’s overall portfolio. The portfolio represents roughly an equal exposure across the Bank’s three main industry sectors: Industry & Commerce, Financial Institutions and Energy & Infrastructure. The EBRD’s focus in Ukraine is to achieve a transition impact through funding of projects (debt and equity) in both private and public sectors. This has been supported by a range of technical cooperation and policy dialogue.

During the financial crisis of 2008–09, the EBRD pursued a country specific crisis response program for Ukraine in coordination with various stakeholders, including the authorities, other IFIs and international donors. In 2009, despite the increased country risk, the EBRD invested €1.1 billion in Ukraine, a record level for the country. Almost two-thirds of the total amount was invested in the banking sector to help support stability and confidence. During the crisis, the EBRD also undertook a complete reassessment of business needs in the corporate sector, which suffered from a terms-of-trade shock and financial sector de-leveraging, which resulted in investments of over €250 million in 2009. A further €220 million was invested in the infrastructure and energy sectors. During 2010 and 2011 total investments remained at roughly €1.1 billion, but were more equally balanced across the Bank’s main sectors. Starting from 2012, however, the Bank has noticed a marked decline in the demand for development loans—particularly in the nonagribusiness corporate sector—due, in a large part, to the deteriorating investment climate. In response, the Bank has become increasingly involved in coordinating key players (including the IMF) to address corruption and unfair business practices in Ukraine as a key policy initiative to improve the business climate

The Bank’s country strategy for 2011–14 was approved in April 2011. It focuses on addressing Ukraine’s important transition challenges in all key sectors, including (i) sustainable energy through energy efficiency and renewable energy, as well as on energy security; (ii) unlocking Ukraine’s agricultural and industrial potential; (iii) providing good quality and reliable infrastructure; and (iv) dealing with the legacy of the crisis in the financial sector. The Bank is currently working on the country strategy for 2014–18.

The Bank has also been active in developing the local private sector and encouraging inflows of FDIs and it has also supported a number of medium and large local clients, including Nibulon, MHP, Ukrplastic and Lugzentrokuz. Small and medium-size enterprises have been reached via credit lines offered to them via partner banks. The Bank has actively participated in financing several leading international investors (including Lafarge, Air Liquide, Multi Developments and Louis Dreyfus) and cross-border transactions with sponsors from other countries of operation.

The EBRD has continued its support to SMEs through its Small Business Support program (SBS) through advice and mentoring at the enterprise level and development of a sustainable infrastructure in the country for business advisory services. In May 2010 the Bank rolled out in Ukraine its hallmark Business Advisory Services (BAS) Programme, which supported nearly 200 small and medium-size enterprises to improve production quality and market performance, business processes and organizational structures. International operational and technical know-how has also been made available to Ukrainian SMEs through the Enterprise Growth Programme (EGP). Manufacturing companies with high value added benefited from international expertise bringing improvements in corporate governance, business transparency and corporate social responsibility. The Bank may consider further expansion of its advisory services in Ukraine’s regions.

The EBRD has been actively working with the government of Ukraine to enable the Bank and other IFI’s to provide loans denominated in Hryvna. On July 30 2013, President Yanukovych signed a law that allows the EBRD, the International Finance Corporation and other international financial institutions to issue bonds in Hryvna through which the IFI’s can fund their local currency lending, particularly for the SME and municipal borrowers. Parliament had adopted relevant amendments to the law on securities and the stock market on July 4, 2013. Operating regulations guiding the implementation of the law still need to be issued by appropriate financial sector regulators in Ukraine in order to allow the EBRD to actually issue locally.

The EBRD has also been working with the Ukrainian authorities to develop new derivatives legislation which would allow hedging of foreign exchange risk and enable swap transactions and introduce important concepts, such as netting and close-out netting. The final draft is now with the Cabinet of Ministers, and the EBRD is largely satisfied with its content. The next step will be the submission of the draft to the Rada for adoption.

In the Agribusiness sector the Bank has been actively involved in policy dialogue in grain sector; promoting greater transparency and predictability of policy interventions and better policy making and coordination between the government and the private sector. Two round tables involving public and private sector stakeholders were organized and resulted in a creation of a working group, which was instrumental in advising the government that grain export quotas deter much needed investments into the sector. The EBRD would like to build on this positive experience in the grain sector and is looking at possibilities of supporting efforts to launch policy dialogue in the dairy sector between the key dairy market regulators and the industry.

The Bank continues to pursue its strategic goal of supporting sustainable development in respect of environment, natural resources and energy. Together with other IFIs, the EBRD continues to explore mechanisms for supporting the authorities as they pursue modernization of the Ukraine’s gas transit system and implementation of the March 2009 EU-Ukraine memorandum of understanding, which is the cornerstone of EU-Ukraine cooperation in the field of energy. In particular, the Bank is assisting with the modernization and rehabilitation of the main trans-European energy networks of Ukraine and investments in modern and energy efficient generation, transportation and distribution of energy. These aims are complemented by a support to reforms in the energy sector to advance its liberalization and promote private sector involvement. In addition, the Bank is actively supporting diversification of supply sources and promoting alternative fuels and development of renewable energy sector in Ukraine—having signed five private deals (solar, wind, biomass) for the total amount of €54 million over the last year alone—and in natural resources, the Bank extended USD 70 million loan to Coal Energy, a private independent Ukrainian coal producer, which was the first project for the Bank in Ukraine that includes investment in coal mining along with strong health and safety and energy efficiency components.

In the area of nuclear safety, the Bank is working to improve the safety standards at the existing nuclear power plants and in 2013 signed a €300 million Nuclear Safety sovereign loan with Energoatom as part of a major €1 billion project to be co-financed by Euroatom, the safe decommissioning of Chernobyl NPP and the creation of a safe confinement for its Unit 4.

In the municipal sector the Bank signed four loans for a total amount of €50 million during 2012–2013 with Ukrainian municipal utilities for the upgrade and modernization of district heating and water systems. These represent the first loans under municipal but without sovereign guarantees, following the amendment of the budget framework promoted by the Bank which removed critical hurdles in the financing of municipal investment projects by means of lending under municipal guarantees. The projects will benefit from a substantial grant co-financing of €25 million from E5P Fund and Swedish SIDA. Further, in the municipal sector the Bank provided a €152 million sovereign loan to finance Dnipropetrovsk Metro completion project, which is to be co-financed by the European Investment Bank. The EBRD has a strong pipeline of municipal projects, first of all in the district heating sector, where the country has a huge potential for efficiency improvements, but the scope of further investments will largely depend on progress with the tariff reform.

In transport, the Bank continued to promote commercialization of major state operators providing two nonsovereign loans for a total amount of €99 million to the national railways for renewal of the freight rolling stock and to the air navigation service provider for the system modernization. In addition, the Bank continued financing of the rehabilitation of the main pan-European road corridors and supporting independent private transport companies.

STATISTICAL ISSUES

(November 2013)

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Ukraine: Table of Common Indicators Required for Surveillance (November 12, 2013)

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Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

Foreign, domestic bank, and domestic nonbank financing.

The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

Including currency and maturity composition.

Daily (D); Weekly (W); Monthly (M); Quarterly (Q); Annually (A); Irregular (I); or Not Available (NA).

Reflects the assessment provided in the data ROSC published in August 2003 and based on the findings of the mission that took place in April 2002 for the dataset corresponding to the variable in each row. The assessment indicates whether international standards concerning (respectively) concepts and definitions, scope, classification/sectorization, and basis for recording are fully observed (O), largely observed (LO), largely not observed (LNO), or not observed (NO).

Same as footnote 7, except referring to international standards concerning (respectively) source data, statistical techniques, assessment and validation of source data, assessment and validation of intermediate data and statistical outputs, and revision studies.

1

When a member has overdue financial obligations outstanding for more than three months, the amount of such arrears will be shown in this section.

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