Ukraine: Request for Extended Arrangement Under the Extended Fund Facility and Cancellation of Stand-By Arrangement
Author: International Monetary Fund. European Dept.
Publication Date:
12 Mar 2015
eISBN:
9781498353779
Language:
English
Keywords:
ISCR; CR; Ukraine; NBU; fund; FX; private sector; exchange rate; financial support; monetary policy; broad money; Exchange rates; Currencies; Inflation; Global
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This paper discusses Ukraine’s Request for Extended Arrangement Under the Extended Fund Facility (EFF) and Cancellation of Stand-by Arrangement (SBA). Despite tangible progress under the SBA, the crisis in Ukraine has increased its balance of payments and adjustment needs beyond what can be achieved under the current program. The authorities’ new four-year IMF-supported program aims to decisively address these challenges. The program lays out a strategy to restore financial and economic stability and resolve long-standing structural obstacles to growth. In view of Ukraine’s large external financing needs and the authorities’ strong policy commitments, the IMF staff supports approval of Ukraine’s four-year Extended Arrangement under the EFF with access equivalent to SDR 12.348 billion.

Abstract

This paper discusses Ukraine’s Request for Extended Arrangement Under the Extended Fund Facility (EFF) and Cancellation of Stand-by Arrangement (SBA). Despite tangible progress under the SBA, the crisis in Ukraine has increased its balance of payments and adjustment needs beyond what can be achieved under the current program. The authorities’ new four-year IMF-supported program aims to decisively address these challenges. The program lays out a strategy to restore financial and economic stability and resolve long-standing structural obstacles to growth. In view of Ukraine’s large external financing needs and the authorities’ strong policy commitments, the IMF staff supports approval of Ukraine’s four-year Extended Arrangement under the EFF with access equivalent to SDR 12.348 billion.

Introduction

1. Ukraine initiated ambitious reforms under the SBA, but recent developments have weakened the economy and opened up a larger financing gap, requiring an adjustment of policies and financing to restore growth and external viability. In a very difficult environment, the authorities took decisive measures aimed at introducing a flexible exchange rate regime, stabilizing the financial system, securing fiscal sustainability, restructuring the energy sector, and setting the stage for sustainable growth through comprehensive governance and structural reforms. However, geopolitical and economic shocks since the first SBA review have increased Ukraine’s balance of payments (BOP) and adjustment needs (text charts). The escalation of the conflict in August 2014, as well as more recently, led to a significant loss of confidence and disrupted industrial production and exports. BOP outflows and FX interventions depleted official reserves and opened up a large financing gap.

2. Ukraine’s BOP and adjustment needs have increased to levels beyond what can be achieved under the current two-year SBA-supported program. International donor commitments over the next year, although sizable, would not suffice to restore the SBA program reserve targets, and low market confidence prevents quick resumption of growth and market financing. As a result, closing the larger financing gap within the period of the SBA now appears out of reach.

3. To address Ukraine’s more protracted BOP needs and deeper structural problems, the authorities have requested a new four-year program under the Extended Fund Facility (EFF) with exceptional access of 900 percent of quota (SDR 12.348 billion; about US$17.5 billion). The extended arrangement will provide more financing and more time to Ukraine to implement its reform program, including SDR 5.7 billion (US$8.1 billion) of additional net disbursements over 2015–18 (given the longer repayment terms under the extended arrangement). This reflects both the sizeable financing needs and the expected time needed to restore full market access at longer maturities and sustainable rates. The program will build on the reform momentum that began under the SBA while allowing broader and deeper reforms to spread over a longer period to correct structural imbalances.

4. Significant financial support from the international community will supplement Fund financing. The extended arrangement will provide a strong policy framework to catalyze further external financing from multilateral and official bilateral creditors. In addition, the Ukrainian government has announced its intention to hold consultations with public sector debt holders with a view to improving medium-term debt sustainability and addressing financing needs over the program period. As a result, a total financing package of around US$40 billion will support the program over the four-year period, helping to mitigate financial risks. The peaceful resolution of the conflict in the East would be a welcome development reducing political risk and uncertainty, and speeding up prospects for macroeconomic stabilization and growth.

A01ufig1

Ukraine: Revised Macro Projections

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.A001

Source: IMF staff calculations.

Recent Economic Developments

5. Ukraine experienced a sharp output fall in 2014, driven by a deep decline in the East and a more moderate recession in the rest of the country (Figure 1 and Annex I). The escalation of the conflict in August–September 2014 took a significant toll on the real and financial sectors. GDP contracted by 5.3 percent in 2014:Q3, as lower real household income weighed down on consumption, heightened economic uncertainty deterred investment, and the disruption of trade with Russia held back exports, notwithstanding a good agricultural harvest. From the production side, the output decline was broad-based in 2014. Retail sales, industrial production and construction all contributed to the output loss. For the year as a whole, GDP contraction is estimated at 6.9 percent (compared with 6.5 percent at the first SBA review), reflecting a big fourth quarter output drop in Donbass, an important exporting area directly affected by the conflict. However, there was a considerable differentiation in economic performance across regions. Indicators suggest a more moderate decline in Eastern regions outside the conflict areas and a relatively mild output drop in the rest of the country, reflecting a different trade orientation and limited non-energy interlinkages across regions (Annex I: Regional Developments).1 Nonetheless, reflecting the broader decline in economic activity, unemployment is on the rise, reaching 8.9 percent as of end-September, up from 7 percent a year ago.

Figure 1.
Figure 1.

Ukraine: Real Sector Indicators, 2011–14

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.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.

High Frequency Indicators Ukraine and the Eastern Regions

(Cumulative Y-o-Y Growth Rates) 1/

article image
Sources: National authorities; and IMF staff calculations and estimates.

Data from April exclude Crimea and Sevastopol.

A01ufig2

Gross Domestic Product and Components

(Contribution to growth, percent)

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.A001

Sources: Ukrainian authorities; and IMF staff calculations.

6. Inflation reached 24.9 percent at end-2014, driven mostly by the sharp exchange rate depreciation and energy price increases (Figure 2). By end-December, the hryvnia has lost nearly half of its value relative to a year ago, driven by political instability, conflict in the East, and weakening confidence. The depreciation together with hikes in administrative prices, including gas and heating tariffs, caused CPI inflation to accelerate from close to zero at end-2013 to levels not seen since Ukraine’s 2008–09 crisis.

Figure 2.
Figure 2.

Ukraine: Inflation, Monetary, and Exchange Rate Developments, 2011–15

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

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.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.

7. Official reserves fell to US$6.4 billion at end-January 2015 and the exchange rate depreciated sharply in recent weeks. This was in part due to resources provided for debt service payments and to clear gas arrears and import gas in December, but also to earlier intervention to slow hryvnia depreciation. After allowing the exchange rate to adjust in November, the NBU modified the rules for its daily FX selling auction in an effort to dampen exchange rate movements. This, together with the existing capital controls, led to a widening parallel market, with the parallel rate being 30–40 percent more depreciated than the official rate in late January. On February 5, in an effort to eliminate the parallel market, the NBU halted its FX auctions allowing the interbank exchange rate to converge to the parallel market rate. As a result, the hryvnia fell immediately to around UAH 24–25/US$1. Depreciation pressures continued in recent days following recent conflict-related shocks and lack of external financing, with the hryvnia reaching about UAH 29/US$1 on February 23. Staff estimates that the exchange rate has significantly overshot, and the current real exchange rate is significantly undervalued based on macroeconomic fundamentals.

A01ufig3

International Reserves and Exchange Rate

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.A001

Source: National authorities.

8. The current account deficit declined substantially in 2014. Weak domestic demand, including from the ongoing fiscal consolidation, as well as the exchange rate depreciation have reduced imports and the current account deficit substantially (Figure 3). At the same time, exports declined by about 14½ percent, as exports to Russia dropped by some 34 percent in 2014. However, some redirection of exports toward the EU has started mainly in sectors such as metals, mineral products and agriculture. Still, Russia remains an important export market for Ukrainian goods, accounting for about 18 percent of exports (while the EU is now at 31½ percent).

Figure 3.
Figure 3.

Ukraine: External Sector Developments, 2011–14

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

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.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.

9. Banks have come under considerable stress, with worsening asset quality, profitability, and liquidity. By mid-February 2015, the banking system had lost about 27 percent of deposits since their peak in January 2014, or more than 12 percent of GDP. NPLs rose from 12.9 percent of total loans at end-December 2013 to 19 percent at end-December 2014, and are expected to worsen further given recognition lags. These factors, together with losses associated with the holding of negative foreign exchange positions in a context of persistent hryvnia depreciation have brought return on assets to -4.1 percent at end-2014. Banks’ liquidity positions have worsened on account of economic distress and deposit outflows. Large NBU liquidity support has helped banks, reaching about 9 percent of the total system liabilities as of mid-February 2015.

A01ufig4
Source: National authorities.1/ Change since January 22, 2014.

10. Despite the difficult economic situation, recent developments give rise to cautious optimism for the near term:

  • In December, a five-party coalition government including both the president’s and the prime minister’s parties was formed, strongly boosting the political influence of reformist forces. Political leaders have made repeated public commitments to deep reforms and the new parliament has approved the government’s program on reforms to address deep-rooted governance challenges and improve the business climate.

  • The trilateral agreement on a “winter package” for gas supply is being implemented as planned. Naftogaz cleared US$3.1 billion of arrears to Gazprom as agreed and gas import flows have resumed. The arbitration case in Stockholm is ongoing, with decisions now expected in the second half of 2016.

  • Efforts by the international community are underway to find a sustainable solution to the conflict in the East.

Program Objectives and Strategies

11. The proposed four-year EFF-supported program builds on reforms that started under the SBA, while taking into account Ukraine’s more protracted balance of payments and adjustment needs. It aims at:

  • Restoring confidence and economic and financial stability through strong adjustment policies. These are oriented toward stabilizing the foreign exchange market, rebuilding official reserves, repairing bank balance sheets, strengthening public finances, and reforming the energy sector. More specifically, Ukraine will pursue: (i) an appropriately tight monetary policy to anchor expectations and a sustainable exchange rate policy that fosters steady reserve accumulation; (ii) bank recapitalization and resolution measures to strengthen banking system soundness, including measures to reduce related-party lending; (iii) fiscal adjustment consistent with a sustainable debt path; (iv) measures to keep Naftogaz’s deficit on course to be eliminated by 2017, and to restructure Naftogaz to increase efficiency and improve governance.

  • Lifting medium-term growth through deep structural reforms. These will be oriented toward improving competitiveness and enhancing investment and growth potential by strengthening economic governance, transparency, and capacity building. More specifically, Ukraine will pursue: (i) governance reforms, including anti-corruption and judicial reform measures; (ii) deregulation and tax administration reforms to improve business climate; and (iii) a comprehensive reform of state owned enterprises (SOEs) to enhance their financial viability, reduce their fiscal burden, and strengthen corporate governance.

12. The program’s success hinges crucially on three main assumptions: (i) the full and timely implementation of policies under the program; (ii) adequate and timely external financing from the official sector and, via a debt operation, the private sector; and (iii) the non-intensification of the conflict in the East. These assumptions are incorporated in, and are critical for the program. The program includes some buffers in terms of (i) conservative near term projections; (ii) careful attention to the pace of adjustment, including social policies; and (iii) increased economic flexibility, including a floating exchange rate. However, if any of the key assumptions fail to materialize, the macroeconomic outcomes would be at risk (see ¶17 for a detailed discussion of risks).

Financing

A. Financing Gap

13. Ukraine faces an exceptionally large financing gap of about US$40 billion over the program period (2015–18), equivalent to 31¼ percent of the estimated 2014 GDP. About three-quarters of the gap results from the need to gradually strengthen official reserves to adequate levels, in particular, to around US$18.3 billion (66 percent of the IMF composite reserve metric) at end-2015 and US$35.2 billion (about 113 percent of the metric) at end-2018. In 2015 alone, the financing gap is projected at US$21.4 billion, consisting of a reserve build-up of US$10.8 billion and an underlying BOP gap of US$10.6 billion.

  • The US$10.6 billion underlying BOP gap in 2015 is split roughly 4:1 between the financial and current account of the BOP. This projection reflects continuing low confidence and moderate capital outflows, as well as lack of external market access, low FDI, and conservative rollover rates for banks and firms. The current account contribution comes from reduced exports, especially of services, only partly offset by falling imports.

B. Financing Strategy

14. Ukraine’s financing gap will be filled by a combination of official and private funds, in the context of a comprehensive adjustment program. The proposed financing provides for appropriate burden sharing, with just under one-half of the financing gap filled by Fund purchases. With these commitments, financing assurances are in place.

Ukraine: Program Financing

(US$ billion)

article image

Excludes the effect of spending reflected on the current account generated by project loans.

Excludes project loans.

Project financing to the public and private sector.

  • The Fund will provide SDR 7.092 billion (about US$10 billion) towards the 2015 gap, and an additional SDR 5.256 billion (about US$7.5 billion) over the remainder of the program, subject to the successful implementation of the program. About SDR 1.915 billion (about US$2.7 billion) of the first disbursement will be used for budget support to help cover fiscal financing needs in an environment of restricted market access.

  • International donors have committed US$7.2 billion in financing so far. This includes US$1.5 billion of budget support commitments under the SBA, US$5.1 billion of new budget support commitments, and US$0.6 billion of other multilateral support for financing gas payments.2 New commitments include Macro-Financial Assistance of over US$2 billion from EU, guarantees of US$2 billion from the U.S., and other bilateral support that has been assured in the context of the G7 discussions. Additional bilateral support, including for reconstruction purposes, may be forthcoming in future years.

  • Given Ukraine’s high debt levels, resolving its balance of payments problem also calls for private sector involvement through a debt operation. The authorities have announced their intention to hold consultations with holders of public debt with a view to improving medium-term debt sustainability. They have hired financial and legal advisors to help them with this process. While the specific terms of the debt operation would be determined following consultations with creditors, the debt operation would be guided by the following program objectives: (i) generate about US$15 billion in financing during the program period; (ii) bring the public and publicly guaranteed debt/GDP ratio below 71 percent of GDP by 2020; and (iii) keep the budget’s gross financing needs at an average of 10 percent of GDP (maximum of 12 percent of GDP annually) in 2019–2025. The restructuring discussions are expected to begin on the basis of the program’s baseline macro framework. However, the continued applicability of the macro framework informing the operation would be reviewed before the discussions are finalized. The debt operation is expected to be concluded by the time of the first review.

Macroeconomic Framework and Risks

15. The economy is expected to slowly return to growth on the back of strong policies and the unlocking of external financial support. Macroeconomic stabilization, underpinned by a strong monetary anchor, fiscal adjustment, financial sector recovery, and external official financing is expected to take hold in late 2015 and become more entrenched in 2016. This, combined with structural reforms, is expected to attract investment and private capital, and lift economic growth to its potential in 2018.

  • Growth. Strong policies and frontloaded financing in the first half of the year are expected to arrest excessive imbalances in the foreign exchange market and restore quickly a measure of financial stability (see ¶19). Nonetheless, baseline growth projections have been downgraded relative to the first SBA review. Growth is now expected to bottom out in 2015:H1, with GDP contracting by about 5½ percent in 2015 (versus -3.4 percent in the January Consensus Forecasts). This reflects the full year economic impact of the conflict in the East, the expected drag from fiscal adjustment, and the process of bank restructuring underway that leads to bank deleveraging.3 A moderate recovery would emerge in 2016, with GDP projected to rise by 2 percent (versus +2.2 percent in the January Consensus Forecasts). This will be a modest bounce back following a deep recession in 2014–15 (of more than 12 percent) and will be driven by a rising industrial production—after a steady decline for four consecutive years—on the back of a slow recovery of steel production, and manufacturing of chemicals, pharmaceuticals, and machinery and equipment. Domestic trade and agricultural production will also increase moderately, while exports of food and consumer products to the EU will continue to grow, benefiting from the asymmetric treatment of the Ukrainian agricultural exports. While growth will gradually become more broad based and pick up speed over time, real GDP will surpass its pre-crisis level only by 2019, reflecting the depth and scope of the ongoing crises. Overall, growth projections remain conservative by the standards of past crises, falling near or below the bottom quartile compared to historical episodes of post-crisis recovery (text chart on p. 16).

  • Inflation. Inflation is projected to rise to about 27 percent in 2015 due to the pass-through effects of the large exchange rate depreciation, energy price hikes and base effects. Given the large and widening negative output gap, demands for higher wages are expected to be limited. Inflation is projected to recede in 2016 as these one-off effects subside and stabilize to around 5 percent over the medium term as economic and monetary stabilization takes hold and the NBU shifts to an inflation targeting framework.

  • External account. The current account deficit is expected to narrow significantly to 1.4 percent of GDP, from 4.8 percent of GDP as the REER depreciates cumulatively by 35 percent in 2014–15. This decline also reflects lower energy imports, which are expected to continue over time and lower dividend payments, reflecting shrinking corporate profitability and administrative measures. These effects are offset in part by the adverse terms of trade, and conflict-induced decline in transportation and tourism services. Over the medium term, the REER dynamics are expected to reverse some of the recent overshooting on the back of gradual returning capital inflows and rising reserves. Nonetheless, the real exchange rate level is expected to remain significantly below its pre-crisis level, allowing permanent competitiveness gains, with its projected trajectory well below the median of past emerging market crises. This would be necessary to generate small and sustainable current account deficits over the medium term and reduce the high external debt (text chart on p. 16).

  • Financial account. Sovereign market re-access is delayed to late 2017 and expected to be moderate over the medium term. Rollover rates for corporate and bank debt are expected to be around 95–100 percent in 2016–17. The effect of bank restructuring is also factored in via the outflow of bank deposits owing to the negative confidence effect of bank closures. A number of large private companies have initiated restructuring of their external debt on a voluntary basis and the envisaged debt operation would also help reduce pressures over the program period. Under these assumptions, reserves would gradually strengthen reaching almost 100 percent of the Fund’s composite metric by end-2017. Specifically, the reserve target for the end of the SBA (US$26.7 billion in 2016:Q1) is now expected to be reached by 2017:Q3.

  • Debt. Public and publicly guaranteed debt is projected to peak at 94 percent of GDP in 2015, but it is expected to be on a steady downward trajectory afterwards, falling below 71 percent of GDP in 2020. This would be supported by the announced debt operation which is expected to reduce debt service significantly during and after the program period, mitigating debt-related risks (Annex II). With the fiscal adjustment complete and growth restored, the public debt ratio would continue to decline beyond 2020. Private external debt will be reduced by the moderate current account deficits, coupled with the ongoing private debt restructuring as noted above.

16. While the macroeconomic outlook has been revised to reflect recent adverse developments, the uncertainty around these projections remains exceptionally high. While the area where the conflict takes place is relatively limited, its impact on confidence and thereby on financial stability, the balance of payments, and growth prospects is very large. As such, an escalation of the ongoing conflict is a major risk to the program. As noted earlier, the macroeconomic framework incorporates conservative assumptions to buffer the impact of the current conflict on the baseline for 2015 by assuming loss of economic capacity in the conflict regions for an extended period and continued decline in the rest of the Eastern regions. A flexible exchange rate will help absorb moderate shocks. From 2016 on, the authorities’ policies and reforms would start having a positive impact, at least on the part of the country not directly affected by the conflict. Growth is projected to pick up in 2017–18, on the back of stronger investment and consumption, while the negative contribution of net exports will remain moderate relative to historical averages.

17. Risks to the outlook are exceptionally high and predominantly on the downside.

  • Fighting in the East may resume and spread. This would unravel confidence, increase the direct loss of economic and export capacity while military spending may rise sharply.

  • If not smooth, the proposed debt operation could disrupt the fragile equilibrium in the balance of payments of the private sector. In particular, the debt operation, especially if the process turns disorderly, could disrupt the voluntary private debt roll over that is under way (some US$40 billion of short and medium-term private debt service payments are assumed to be rolled-over in 2015).

  • Furthermore, creditor participation in the debt operation may fall short of expectations. Creditors may balk at the terms being offered in the debt operation and holdouts may try to free ride. The negotiations may be protracted, particularly as some creditors have large positions in specific bond issues. At the same time, Ukraine’s continued capacity to service its debts would be contingent on a successful debt operation that ensured sufficient program financing and restored debt sustainability with high probability, and this should help encourage participation.

  • Slippages in program implementation would negatively affect stabilization and growth prospects. Incomplete fiscal and financial sector reforms or delays in implementation of structural measures would undermine public support for reforms, affect growth, and see debt remain at high and likely unsustainable levels.

  • On the positive side, an early resolution of the geopolitical crisis would boost confidence. Also, a faster than envisaged adaptation of production and exports to the new macroeconomic and external environment would support growth.

A01ufig5

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

(T indicates a crisis year)

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.A001

Source: INS; WEO; and IMF staff estimates.

Monetary and Exchange Rate Policy

A. Background

18. Amidst a challenging environment, the NBU has taken several measures in recent months to contain inflation and pressures on the hryvnia. In August, it tightened monetary policy by increasing its overnight refinancing and deposit certificate rates by 250 basis points. In November, the NBU increased its main policy rate by 150 basis points and its longer-maturity deposit rates by 50–100 basis points. It also tightened administrative restrictions and capital controls.4 In early February, the NBU increased its main policy rate by 550 basis points to 19.5 percent. However, against weak confidence, limited external financing, and no buffers for FX intervention, the exchange rate came under significant depreciation pressures in recent weeks.

B. Policies

19. A first priority is to stabilize the foreign exchange market and reduce the pass through to inflation. The program will be anchored initially by very tight monetary policy targets, which together with administrative measures will reduce steadily the demand for foreign currency. In line with this, base and broad money growth will be negative in real terms. In addition, following approval of the program, frontloaded external disbursements in excess of US$10 billion in the first half of year will shore up international reserves and help calm the foreign exchange market. In the first two months, with the Fund and other international partner’s disbursements, gross international reserves are programmed to nearly double. With the exchange rate stabilizing and confidence returning, the supply of foreign exchange will gradually increase, including from seasonal export proceeds. As the situation normalizes, the burden on monetary policy will gradually ease.

  • Monetary policy will continue to be geared toward bringing inflation back to single digits by late 2016. Following an initial spike in inflation in mid-2015, inflation is expected to decelerate rapidly on the back of prudent monetary policy and tight incomes policies which would limit the pass through of the recent depreciation. To this end, the NBU will set its main policy rate (the discount rate) positive in real terms on a 12–18 month forward-looking basis. This should strengthen the signaling role of the discount rate and help anchor inflation expectations. During this period, and in light of the segmented nature of Ukraine’s money market, NBU monetary operations will also play an intermediary role by reallocating surplus liquidity to banks in need through performing weekly two-sided tenders.

  • The authorities will maintain a flexible exchange rate regime to cope with external shocks, while aiming for a gradual rebuilding of FX reserve buffers. The NBU will not sell FX, except for central government needs and critical energy imports in amounts factored into the program. From 2015:Q2, NBU sales to Naftogaz will be phased out. New financing and improving market conditions are expected to allow a gradual build-up in reserves over the medium term. In order to eliminate distortive administrative measures, the authorities will prepare by May 15, 2015 a plan for the gradual removal of the exchange restrictions and capital controls that will be conditioned on sufficient improvement in financial and exchange rate stability and accumulation of international reserves as projected under the program.5

  • The NBU’s institutional foundations will be strengthened, aiming to improve governance, autonomy, and effectiveness. Legislative amendments to the NBU Law will be approved by end-April 2015 (structural benchmark). The reform, being designed in consultation with IMF staff, will focus on modifications to the governance structure of the NBU and strengthening its autonomy, including modalities to safeguard its balance sheet.6 The legislation will also address other concerns raised in the context of the 2014 Safeguards Assessment. The NBU’s organizational structure and communications strategy will also be revamped to further enhance its effectiveness.

20. Efforts toward future adoption of inflation targeting will continue. The NBU will continue strengthening its technical and operational capacity. It will continue to refine its own inflation projection capacity, and has discontinued past practice of using projections developed by the Cabinet of Ministers. Once appropriate macro-financial conditions have taken hold and institutional pre-requisites are in place, the NBU will adopt inflation targeting.

Restoring Banking System Soundness

A. Background

21. Banking soundness has significantly weakened. As of end-January 2015, the banking system’s capital adequacy ratio (CAR) stood at 13.8 percent, down from 15.9 percent at end-June. However, NPLs have not yet peaked, and the recent large exchange rate depreciation is likely to reduce bank profits further. Also, aggregate ratios mask vulnerabilities in individual banks, as evidenced by reported bank losses and confirmed by recent bank diagnostics.

22. Progress was made regarding the recapitalization and restructuring of banks on the basis of the 2014 diagnostic results (MEFP ¶17).

  • Group 1 banks: For the nine large banks that needed a capital increase, and for which: (i) credible recapitalization plans were approved, and (ii) capital shortages were reduced by 25 percent, the recapitalization deadline has been set for end-June 2015. Banks that did not reduce the capital shortage by 25 percent will be put under regulatory constraints, including on asset growth, and will be subject to higher degree of on-site monitoring. One out of the nine large banks, accounting for about 2½ percent of the system assets, failed to submit a credible plan and was resolved.

  • Group 2 banks: All banks in this group of the second largest 20 banks remain on track to complete their recapitalization plans by end-February 2015.

  • Other banks: The NBU has stepped up the resolution of smaller banks. As of end-February 2015, 41 banks were resolved through the Deposit Guarantee Fund.

23. The NBU has also strengthened surveillance and crisis management measures. Parliament recently passed an anti-crisis law that, inter alia, facilitates the use of public funds for bank recapitalization and grants powers to NBU to adopt extraordinary measures to ensure financial stability. A Financial Stability Board has been established to ensure timely identification of systemic risks and recommend measures to minimize their impact on the financial system and the economy.

24. Preliminary information suggests that several institutions intervened by the Deposit Guarantee Fund (DGF) had breached credit limits to insiders. Opaque ownership structures and lending schemes have made it difficult for the NBU to limit effectively banks’ exposures to insiders. This highlights the need to strengthen the supervisory framework to better address related lending. International experience shows that excessive lending to insiders raises the banks’ likelihood of failure and reduces expected recovery in cases where banks turn insolvent and need to be resolved.

B. Policies

Updating the banking recapitalization, restructuring, and resolution strategy

25. The authorities agreed on the need for an updated bank recapitalization strategy (MEFP ¶15). This will take into account updated diagnostic exercises based on a more adverse macroeconomic scenario, as well as the need to gradually unwind related party loans. In particular, the NBU has required revised recapitalization plans that credibly identify the sources of funds to be used for capital injection and specific plans for asset deleveraging. In view of the large shocks buffeting the economy, staff and the authorities agreed that some forbearance on capital indicators was appropriate. To this end, an agreement was reached to allow banks that were solvent to meet a minimum capital adequacy ratio of 5 percent as of end-January 2016 and gradually reach 10 percent no later than end-December 2018.7

26. Taking these factors into account, the cost of bank restructuring in 2014–15 is estimated at 9¼ percent of GDP. This represents an upward revision from the SBA estimate, which reflects the incorporation of potential additional losses associated with the conflict in the East and the higher than expected FX depreciation. Overall, staff believes that capital injections by the private owners remain the best option for bank recapitalization and restructuring. However, given the uncertainties and risks associated with this strategy, the program contains a buffer of nearly 4 percent of GDP in public funds that could be used for bank recapitalization and restructuring. Costs are also estimated conservatively before asset recovery from failed banks.

Enhancing asset recovery and launching forensic audits

27. The management of assets from resolved banks is being strengthened (MEFP ¶18). The authorities stressed that as the balance sheets of intervened banks turned out worse than the books indicated, little value has, so far, been recovered from the assets of failed banks. 8 The authorities and staff agreed that to maximize recovery values, more time is needed to dispose assets of failed banks than the 3 years foreseen in existing legislation. The recovery process would also be further strengthened by introducing unlimited liability for related party loans (¶28). Furthermore, with the assistance of World Bank staff, the DGF will create a specialized unit to consolidate the management of assets from resolved banks and prepare their disposition in a timely and efficient manner. In addition, two pilot forensic audits of failed banks are set to be launched. These would aim to identify bad banking practices (including outright fraud) and draw lessons for bank regulation and supervision and the functioning of the DGF.

Enhancing the regulatory and supervisory framework

28. The authorities have taken decisive steps to bring rules and supervision on related party lending in line with international best practice (MEFP ¶13). As intervened and resolved banks have revealed above-limit credit to insiders, existing legislation and regulation on related parties will be strengthened to: (i) minimize the risk that excessive lending to insiders could undermine the proper functioning of banks in the future; (ii) prevent related party borrowers from receiving better credit conditions than non-related bank customers; and (iii) enhance supervisory surveillance over banks. To this end, the authorities will:

  • Enact key legal amendments. These would include two key elements. First, they would introduce unlimited liability on losses arising from loans granted directly or indirectly to shareholders holding 10 percent or more of total voting shares (prior action). This would create incentives to bank owners to avoid failure and hold capital, reducing moral hazard on related party loans. Second, the amendments will grant legal powers to NBU to presume the existence of economic relationship between banks and borrowers on the basis of objective criteria, unless the banks are able to prove otherwise.

  • Revise the existing related party lending framework. The authorities will analyze the current legal and regulatory framework on related parties and identify loopholes that need to be fixed in the near future with IMF and WB technical support.

  • Allow bank self-assessment. The aim would be to identify exposures that are above limits according to the revised regulatory framework.

  • Conduct a supervisory review of bank reporting and preparation of unwinding plans. The NBU will verify proper reporting with the participation of accounting firms. Banks will be given prudent time to orderly reduce such exposures with the view to smoothly adapt to the new regulatory environment, on the basis of well-structured and credible unwinding plans.

  • Undertake prudential monitoring. The NBU has announced the establishment of a specialized unit to follow up on credit exposures with the banking industry of economically related groups and individuals (financial and non-financial groups).

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Schedule for Unwinding Related Party Lending in 10 Largest Banks

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.A001

Strengthening bank capacity to resolve bad loans

29. The framework for addressing NPLs will be enhanced (MEFP ¶19). The authorities remain committed to supporting a voluntary negotiation process between borrowers and banks for the restructuring of foreign currency denominated mortgage loans serviced by struggling borrowers. By end-March 2015, the NBU will issue a Code of Conduct to guide negotiations between borrowers in difficulty and banks, establish debt restructuring guidelines, and put in place an appeal process to induce fair and balanced negotiations. By end-June 2015, the authorities will establish a coordinated out-of-court restructuring system, in line with international best practice. By end-July, legislation will be submitted to strengthen the framework related to private debt restructuring, on the basis of international best practice and cross-country experience, covering foreclosure procedures, corporate and personal insolvency and tax incentives.

Fiscal Policy

A. Background

30. Despite the deteriorating security situation during 2014, the authorities have met the 2014 general government deficit target with a large margin. Revenues were in line with projections, reflecting measures introduced in July, while expenditures were curtailed, owing to liquidity constraints and stalled budgetary payments to the conflict areas in the East. The cash budget deficit for 2014 is estimated at 4.6 percent of GDP, lower than the targeted 5.8 percent of GDP.9 The fiscal saving was nearly sufficient to offset the higher than expected Naftogaz’s deficit of 5.7 percent of GDP, bringing the combined general government and Naftogaz deficit to 10.3 percent of GDP, broadly as targeted.

31. In December 2014, the authorities adopted a 2015 budget targeting a deficit of UAH 65 billion (3½ percent of GDP). The tax reform package includes significant permanent revenue-increasing measures as well as measures related to tax simplification and reduction in labor tax wedge (Box 1). On the expenditure side, the 2015 budget aims to reduce the size of government as well as inefficiencies (text table). It eliminates subsidies that supported the inefficient coal-mining industry (equivalent to 0.6 percent of GDP in 2014) and reduces budgetary employment by 3 percent. The budget also includes significant pension savings, achieved by effectively freezing pensions during most of 2015, reducing the replacement rate from 70 percent to 60 percent for special pensions, and tightening eligibility for early retirement. The budget continues to provide pensions to all pensioners who relocate from the ATO regions, but does not assume any fiscal revenue from or spending to the areas of active conflict in the East, except military spending which has been increased. The budget also increases outlays on capital investment to fund Ukraine’s immediate reconstruction needs. A more significant scaling up of reconstruction spending will be contingent on additional concessional donor support.

Authorities’ Tax Policy Changes

Parliament has approved a package of significant tax policy reforms. The package is revenue-enhancing, although some key measures are temporary. The main proposed changes could be grouped into three broad categories:

  • Simplification, reduction of labor tax burden and elimination of a distortive tax. These measures include abolishment of a few small revenue-yielding taxes, merging of taxes with similar characteristics and simplification of a single tax. In addition, a reduction in the average social security contribution rate conditional on a significant increase in the reported wage bill. Foreign exchange sales tax for the noncash transactions was abolished. The net negative revenue impact is estimated at 0.3 percent of GDP.

  • Permanent revenue-raising measures. A set of new measures introduced in the tax code are expected to generate additional revenue of 2.3 percent of GDP on a permanent basis. These measures include (i) raising personal income taxation by increasing the progressivity including by taxing high pensions, maintaining the “military tax,” and increasing the rate and expanding the base for the capital income tax; (ii) increasing excise taxation by introducing a new retail sales tax and raising tobacco excises; (iii) increasing property taxation; (iv) increasing royalties on natural resources and (v) various other taxes such as tax on lottery and fixed agriculture tax.1

    Table 1.

    Revenue Measures Adopted as Part of 2015 Budget

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    Sources: Ukrainian authorities; and Fund staff estimates.

    Revenue impact estimates relative to revenues on current policies.

  • Temporary measures. The introduction of a temporary import duty surcharge—although aimed at providing balance of payments relief—will have a significant revenue impact with an estimated yield of 1 percent of GDP in 2015. The tax code amendment will also extend VAT exemption on grain exports for agricultural traders and producers (0.5 percent of GDP).

1 Although the increase in royalties for gas extraction was made permanent, the tax code requires the government to revisit the tax regime and submit its new draft amendment to parliament by July 1, 2015.

Fiscal Measures in 2015 Approved and Supplementary Budgets

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Sources: Ukrainian authorities; and Fund staff estimates.Note: (−) sign implies savings.

Consolidation strategy and program targets

32. The program aims to strengthen fiscal sustainability through expenditure led adjustment and frontloaded price increases to reduce energy subsidies (MEFP ¶22) (Table 2). The primary balance of the combined general government and Naftogaz, a key fiscal anchor, will improve from a deficit of 6.9 percent of GDP in 2014 to a surplus of 1.6 percent of GDP in 2017, setting debt on a firm downward path. This fiscal path implies a combined deficit of 7.4 percent of GDP (general government deficit of 4¼ percent of GDP and Naftogaz deficit of 3.1 percent of GDP) in 2015. This is higher than the envisaged combined deficit of 5.8 percent of GDP at the time of the first SBA review as it reflects the adverse impact of the exchange rate depreciation on the Naftogaz deficit and the budget’s interest bill, as well as the need to provide additional funds for social assistance in view of the higher energy price hikes (see below). The combined deficit will be reduced to 2.6 percent of GDP by 2018 (a general government deficit of 2.6 percent of GDP and a zero Naftogaz deficit already by 2017 (Table 2)). In this regard, the relatively modest headline general government adjustment (2 percentage points of GDP over the program period) masks a very strong effort to reduce the combined fiscal deficit, including a large consolidation in items that expanded fast in 2010–13 (wages, pensions, and subsidies) will make room for necessary increases in social assistance, interest, and capital expenditure (Table 2).

Table 1.

Ukraine: Program Scenario – Selected Economic and Social Indicators, 2013–20

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

Data based on SNA 2008, exclude Crimea and Sevastopol; 2013 and 2014 data are IMF staff estimates.

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

Table 2.

Ukraine: Program Scenario – General Government Finances, 2013–20 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.

Government spending for Naftogaz financing, including through recapitalization bonds. 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.

The balance in 2014 treats part of the military spending and the EU grant as one-off operations. The balance in 2015 treats import duty surcharge, part of military spending and part of the NBU profit transfer as one-off operations.

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Fiscal Deficit

(Percent of GDP)

Citation: IMF Staff Country Reports 2015, 069; 10.5089/9781498353779.002.A001

Sources: Ukrainian authorities and staff calculations.

33. In line with the above, the authorities have agreed to amend the budget to target a deficit of UAH 78 billion (prior action). This was necessary to reflect the updated macroeconomic framework, in particular the lower growth and the sharply depreciated exchange rate as well as to accommodate higher social spending arising from the steep increase in energy prices, net of the partial offset provided by the increased tax revenues from the domestic gas production subsidiary (MEFP ¶23).

34. Additional measures to support the medium-term structural adjustments include:

  • Pensions. Improve the pension system’s long-term fiscal sustainability, while making it more equitable. In particular, tightening early retirement provisions and gradually unifying special pensions’ calculation rules with those of the general system are envisaged, starting in 2015. Moreover, with assistance from the Fund, the authorities plan to review the whole pension system with the goal of reducing the pension deficit and adopt the necessary legal amendments by end-2015.

  • Social Assistance. Increase utility tariffs as detailed below, while protecting the most vulnerable groups of the population (Box 2). In this regard, the existing social assistance programs (privileged housing utilities; means-tested subsidies for housing utilities; and a tariff compensation scheme introduced in 2014) will be consolidated and used to compensate poor households for higher energy bills. The fiscal cost of the compensating measures will be reduced through greater reliance on the general guaranteed minimum income (GMI) program, as it is better targeted to low-income households.

  • Public wages and subsidies. Downsize budgetary employment by 3 percent, including the civil service workforce by 20 percent through closure of redundant regulatory agencies to achieve a smaller but more efficient government. Measures will also include reduced staffing in the SOE through improved budgetary oversight and restructuring of loss-making and inefficient enterprises (¶51).

  • Education and Health Care. Healthcare reform will aim to open up the sector to private financing and gradually move to medical insurance system. Education sector reforms will seek to improve the quality and efficiency of education spending, including by streamlining the extensive network of educational institutions and rationalizing employment to bring it in line with international standards. In these reforms, the authorities will draw from advice provided by the World Bank and other specialized institutions in these areas.

  • Tax policy. Measures will aim to improve the tax base by bringing the agriculture sector fully under the general VAT regime in 2016, yielding a net gain of about ½-¾ percent of GDP. They will also include improving taxation and compliance of high net wealth individuals, elimination of exemptions, and increases in property tax rates.

The Impact of the Crisis on Households

The economic crisis has adversely affected household incomes. The program has sought to help households recover by providing the foundations for economic stabilization, sustainable growth, and job creation. Furthermore, to assist the most vulnerable part of the population, it balances reforms aimed at restoring fiscal sustainability with expanding targeted social programs.

Household real income is expected to deteriorate as the crisis leads to rising inflation, higher unemployment and stagnating incomes. Real wages are declining as inflation is outpacing nominal wage growth in most economic sectors. Growing unemployment, largely reflecting the loss of production capacity, is now projected to increase to 11.5 percent in 2015 from 10.5 percent at end-2014 which will further weigh on household incomes. The economic toll is evident in rising non-performing loans of households, which reached 20 percent at end-2014. These problems are ever more acute in the conflict areas in the East, which has forced many families into displacement both inside and outside Ukraine.

Nevertheless, there are mitigating factors. Wage growth in agriculture, trade and services remains robust. While the nominal wage bill in the budgetary sector will be broadly similar to 2014, it corrects for the rapid growth in previous years. In 2014, the average wage in the budgetary sector exceeded average wage in the economy by 10 percent. Similarly, pension spending has reached unaffordably high levels at over 17 percent of GDP, one of the highest in Europe. Nevertheless, both pensions and budgetary wages are set to increase in December 2015.

The impact of the large depreciation on household balance sheets is also expected to be positive. The household sector has a long foreign exchange position (assets exceeding liabilities by more than twice) and would, on a net basis, benefit from the currency depreciation.

The program seeks to alleviate the negative impact of the crisis on households.

  • In the short-run, compensatory measures to protect the most vulnerable are being stepped up. Total spending on social assistance programs will reach 4.1 percent of GDP in 2015, an increase of 30 percent compared to 2014. Specifically, social assistance with energy bills would more than double. In addition, unemployment benefit spending will rise by 15 percent. The government is also considering strengthening its recently introduced Internally Displaced Person (IDP) support program to cover IDP housing and utility needs. IDP spending would increase by six-fold in 2015, reaching about 1/4 percent of GDP. Given the low uptake of government assistance by IDPs which currently covers only about 40 percent of IDP families, streamlining of administrative requirements to facilitate access to benefits is also underway.

  • In the medium term, policies seek to restore macroeconomic stability through robust and balanced growth. By removing the inflation tax, household purchasing power would be strengthened. Reforms to economic governance and business climate would lay the foundation for more investment and job opportunities. Reducing public debt would also lower the fiscal burden for future generations.

Fiscal Institutional Reforms

35. Fiscal institutions will be strengthened to achieve lasting improvements in revenue collection and expenditure transparency and control (MEFP ¶24). Widespread tax evasion has eroded the fairness of the tax system. At the same time, budgeting and spending controls remain weak. Addressing these issues requires deep restructuring of the revenue administration and the public financial management system. However, these reforms are complex and can take time to deliver results. Early reform implementation should therefore be a high priority.

36. Strengthening the efficiency of tax administration operations is a key pillar of the revenue administration reforms (MEFP ¶25). The authorities intend to prepare, in consultation with Fund staff, a revenue administration reform plan by end-April 2015 to overhaul the state fiscal service (structural benchmark). The plan, inter alia, will include measures to implement governance and institutional reforms that remove large numbers of underperforming officials, and encourage an environment free of political interference in operational decision making. The reform will also clarify the revenue authority’s reporting responsibilities by subordinating the State Fiscal Service to the Ministry of Finance, which will help the ministry better coordinate tax policy and administration. The plan will seek to:

  • Strengthen the organizational structure of the tax administration by ensuring that all taxpayers meeting large taxpayer criteria will be transferred to the Large Taxpayer Office (LTO) by end-December 2015 (structural benchmark), simplifying the taxation of small business, establishing an office for physical persons, and a transfer pricing department or office.

  • Restructuring and rationalizing the tax offices. The authorities will seek to consolidate far-flung operations and local offices, based on a number of criteria, which include territories covered, the size of potential taxpayers, and taxpayer services.

  • Compliance. VAT compliance measures are being implemented such as electronic VAT administration. Moreover, mandatory cash registers in retail establishments will be required starting July 1, 2015.

37. Public financial management reforms will aim to strengthen budgetary framework and cash management over the medium term. Specifically, measures will focus on developing a credible medium-term budgetary framework, including expenditure ceilings, strengthening budget execution controls, and developing a cash management strategy to ensure availability of adequate financing.

Energy Policy

A. Background

39. Progress was made during 2014 in tackling Naftogaz’s deficit, but these gains have been eroded by unfavorable macroeconomic developments. Household gas and heating tariffs were raised in May and July, while industrial gas tariffs have generally been raised in line with import price and exchange rate developments. However, the gains made toward cost recovery were rapidly eroded by the exchange rate depreciation. This, combined with reduced transit revenues and gas prepayments for 2015, led to a higher than expected deficit of 5.7 percent of GDP, compared to 4.3 percent of GDP at the time of the first SBA review.

B. Policies

40. In a decisive effort to break from the past, the Ukrainian authorities have put forward an ambitious and comprehensive reform agenda for the energy sector. The authorities recognize that the loss-making and opaque gas sector in Ukraine weighs heavily on public finances, the external sector, and the overall economy. The very low prices for residential gas and district heating encourage excessive energy consumption and lead to large losses by Naftogaz, drive gas imports up, discourage investment in domestic production, and breed governance problems. To address these problems, the program aims to:

  • bring gas and heating prices to cost recovery based on international gas prices by 2017 and eliminate Naftogaz’s deficit. In the process, domestic wholesale gas prices charged by Naftogaz’s subsidiaries will be raised to cover operational and investment costs;

  • strengthen the social assistance system to assist vulnerable households with energy bills;

  • support Naftogaz’s restructuring to reduce losses caused by governance issues and raise social acceptance of cost-recovery prices;

  • introduce measures to strengthen Naftogaz’ collections of both past and future bills, including through smoothing of bill payments to enhance compliance, and

  • encourage efforts to improve energy efficiency and raise investments in the sector.

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