Short-term (0-6 months)

Recommendation 2.1:⁹ Adopt a government resolution on preparing budget projections for 2015, including: (i) an MTFF for 2015-17; and expenditure ceiling for KSUs (binding for 2015, and indicative for 2016 and 2017).

Recommendation 2.2: In relation to the above, issue new budget instructions to KSUs to identify in their budget submissions the impact of changes in current policies, as defined in the supplementary budget, on future years and the cost-efficiency gains of new policies.

Recommendation 2.3: Ensure the work on 2015–17 budget projections is closely coordinated with the comprehensive plan for structural reforms and rationalization of expenditure in key sectors planned to be prepared by end-September.

Recommendation 2.4: Amend the existing PFM action plan to center budget preparation reforms on introducing an MTBF.

Current situation

17. Article 21 of the Budget Code of Ukraine (BCU) provides the legal basis for developing budget forecasts for the two budget periods following the planned one. The code stipulates that the medium-term budget forecasts should be prepared on the base of a macroeconomic framework, explicitly identifying indicators such as nominal and real GDP, consumer price indices and producer price indices, annual average official exchange rate of the hryvnia and the official year-end exchange rate, enterprises’ profits, payroll, unemployment level, exports and imports of goods. The code also appropriately defines the main actors in this exercise in the face of the MoF, MoEDT, and the NBU.

18. However, this provision of the code has been enforced only once when projections for 2013 and 2014 were prepared during the 2012 budget preparation process. No medium-term budget projections have been approved by the government since 2012, allegedly because of the absence of an agreed and adopted medium-term macroeconomic framework. At the same time, as required by the MoF, the KSUs continue to prepare their budget submissions for three years. However, under the circumstances, this has been only a formal requirement with no material impact on the annual budget process.

19. According to Article 21 of the BCU, the projections for the outer two years should be approved by government, after the approval by parliament of the annual budget law. The idea seems to be that the macroeconomic and macro-fiscal projections could change as a result of the parliamentary deliberation on the annual budget that would lead to changes in the medium-term budget projections. Therefore, regardless of the soundness of the changes in the macroeconomic framework, the government should feel compelled to revise the medium-term fiscal projection to reflect these changes. Indeed, the government’s resolution on budget projections for 2013 and 2014 were approved subsequent to the approval of the Law on the State Budget for 2012.

20. There are significant problems with the existing approach to preparing the MTBF. In particular, it fragments the budget process, undermines the credibility of both the annual budget and medium-term budget projections and undermines the top-down process in which the projections set the framework within which budget decisions are then taken. In addition, it increases the possibility of political interference in the macro forecasting process. This, among other factors, explains the significant forecasting errors in the macroeconomic and fiscal projections for 2012-13 that reflected in significant deviation between the planned and actual fiscal balance, as illustrated in Figure 1.

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Ukraine: Balance Forecast Deviation

Citation: IMF Staff Country Reports 2016, 030; 10.5089/9781513523781.002.A001

(Percent of GDP, Actual - Forecast)

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21. Despite the absence of a good track record to build upon, the implementation of the recommended short-term measures could provide a solid base for the start of the MTBF exercise. To this end, this section further elaborates on: (i) the status of important preconditions for the successful implementation of an MTBF; (ii) actions needed to adopt a medium-term fiscal framework (MTFF) and use it as a foundation of the MTBF; and (iii) implementation strategy for introducing an MTBF.

Preconditions for a successful MTBF

22. There are four main preconditions for the successful implementation of an MTBF. These include: (i) a credible and predictable annual budget; (ii) accurate medium-term macroeconomic projections; (iii) established fiscal objectives and rules; and (iv) a comprehensive, unified, top-down budget process. As indicated in Table 3, these preconditions remain to be met. The forecasting errors in both macroeconomic projections and fiscal aggregates are still significant and undermine the credibility of the annual budget. There are no well established fiscal objectives or rules to anchor fiscal policies, and expenditure ceilings are limited in coverage and not binding.

23. The IMF-supported program provides a framework to meet these preconditions in the short run. The program includes macroeconomic and fiscal projections subject to regular reviews. It is important that these are fully incorporated in the internal macroeconomic and macro-fiscal forecasting process. The program also provides fiscal objectives and targets to anchor fiscal policies, and to introduce binding expenditure ceilings with the 2015 budget. As discussed in the previous subsection, the specific actions required include the adoption of a supplementary budget for 2015, and adoption of a new government resolution and new budget instruction of the MoF on the preparation of the 2015 budget.

Table 3.

Ukraine: Preconditions for Successful Implementation of a MTBF

Table 3.

Ukraine: Preconditions for Successful Implementation of a MTBF

Precondition	Current Status	Required Action
Credible Annual Budget	Forecasting error for revenue, expenditure, and the fiscal balance remains significant, and was further adversely affected by the ongoing economic and financial crisis	In the short run: Fully align the annual budget projections, including for 2014 and 2015, with the fiscal projections under the IMF-supported program
Accurate medium-term macroeconomic framework	Forecasting error for GDP remains significant was further adversely affected by the ongoing economic and financial crisis, and it is not insulated from political interference	In the short run: Fully align the existing macro projections with the macroeconomic framework agreed under the IMF-supported program. In the mid-term: Ensure independent oversight of the fiscal forecasting process
Established fiscal objectives and rules	A debt rule setting a debt-to-GDP ratio of 60 percent is included in the existing Budget Code, and specific fiscal targets are defined in the annual budget guidelines, but they are not effectively used as an anchor of fiscal policies in the mid-term	In the short run: Define fiscal objectives and targets in line with the IMF-supported program. In the mid-term: Consider introducing fiscal rules through the Budget Code and enforce them following the expiration of the IMF-supported program. Technical assistance to design the rules may be required
Comprehensive, unified, top-down budget process	MoF releases expenditure ceilings but they are limited in coverage only to current expenditure and are not binding	In the short run: Approve with the 2015 MTFF binding expenditure ceilings covering all expenditures for 2015 and indicative expenditure ceilings for 2016 and 2017

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Table 3.

Ukraine: Preconditions for Successful Implementation of a MTBF

Precondition	Current Status	Required Action
Credible Annual Budget	Forecasting error for revenue, expenditure, and the fiscal balance remains significant, and was further adversely affected by the ongoing economic and financial crisis	In the short run: Fully align the annual budget projections, including for 2014 and 2015, with the fiscal projections under the IMF-supported program
Accurate medium-term macroeconomic framework	Forecasting error for GDP remains significant was further adversely affected by the ongoing economic and financial crisis, and it is not insulated from political interference	In the short run: Fully align the existing macro projections with the macroeconomic framework agreed under the IMF-supported program. In the mid-term: Ensure independent oversight of the fiscal forecasting process
Established fiscal objectives and rules	A debt rule setting a debt-to-GDP ratio of 60 percent is included in the existing Budget Code, and specific fiscal targets are defined in the annual budget guidelines, but they are not effectively used as an anchor of fiscal policies in the mid-term	In the short run: Define fiscal objectives and targets in line with the IMF-supported program. In the mid-term: Consider introducing fiscal rules through the Budget Code and enforce them following the expiration of the IMF-supported program. Technical assistance to design the rules may be required
Comprehensive, unified, top-down budget process	MoF releases expenditure ceilings but they are limited in coverage only to current expenditure and are not binding	In the short run: Approve with the 2015 MTFF binding expenditure ceilings covering all expenditures for 2015 and indicative expenditure ceilings for 2016 and 2017

24. Looking forward, steps need to be undertaken to insulate the macro forecasting process from political interference. This could be achieved through independent oversight of the fiscal forecasting process. To this end different options could be explored, including: (i) establishing a fiscal council following relevant experiences in the EU member countries (not necessarily appropriate at the moment but could be considered in the future); (ii) publishing the model used to make forecasts (possibly in the context of the preparation and approval of the Fiscal Strategy Document as further discussed in the report) to allow other stakeholders (banks, think thanks etc.) to review methodologies; and (iii) publishing comparisons of government forecast to those of other independent forecasts (IMF, EC).

Medium-term fiscal framework

25. The MTFF is the foundation for developing a sound MTBF. The MTFF can be defined as a rolling plan that establishes integrated multi-year policy-based limits or targets for key fiscal aggregates—debt, financing, primary balance, revenues, and expenditures—consistent with and supportive of the overall macroeconomic framework. As such, it is a critical tool in strategic fiscal management, and provides the foundation for the resource allocation facet of budget preparation under an MTBF.

26. The Budget Policy Guidelines issued by government usually in April do not include an MTFF.¹⁰ The guidelines are focused on the upcoming fiscal year, and provide only information on key macroeconomic assumptions such as GDP growth and inflation, and broad fiscal targets such as budget deficit and debt-to-GDP ratio.

27. In order to strengthen the strategic and policy orientation of the budget the Budget Policy Guidelines need to be replaced by a Fiscal Strategy Document. Such a recommendation was made by the 2012 FAD mission, but no steps had been made for its implementation. The Fiscal Strategy Document should include in contrast to the current guidelines: (i) an MTFF; and (ii) aggregate expenditure ceilings for KSUs. A possible outline for a Fiscal Strategy Document for 2015 to incorporate an MTFF, and the current status of information sources for its preparation is presented in Table 4.

28. As shown in Table 4, a significant part of the information for the preparation of the Fiscal Strategy Document is available. Therefore, a first Fiscal Strategy Document could be prepared in the context of the recommended government resolution on the 2015 budget. In addition to the Fiscal Strategy Document, the government should also approve expenditure ceilings by KSUs. The design and implementation of the expenditure ceilings is discussed in detail in the 2012 FAD report, and could be referred to as needed.

Table 4.

Ukraine: Possible Outline for Fiscal Strategy Document

Table 4.

Ukraine: Possible Outline for Fiscal Strategy Document

Topic	Status and Sources of Information
A. Macroeconomic Section
Brief narrative on recent developments and challenges; set out targets and major policies; note on the Government’s recent track record of achieving objectives or forecast errors	Done partially in the Budget Policy Guidelines more needed on economic policies; need track record section and explanation of deviations
Table with projections for the key indicators in the real, external, monetary sectors	Derive from the MEFP
Note on the major forecast risks, and results of sensitivity of key economic variables to changes in assumptions (e.g., oil prices, European economic outlook, tourism arrivals)	Prepare on the base of the MEFP and the macroeconomic forecasts of the MoEDT
Brief write-up of the “optimistic” and “pessimistic” scenarios	Use the MEFP and further consult with staff under the IMF-supported program
Note on the internal consistency of the macroeconomic framework, (attesting to coordinated monetary and fiscal policies, and realism of and consistency of projections)	Use the MEFP and further consult with the IMF staff
B. Fiscal Section
Narrative on recent developments with focus on track record of having achieved or not major policy objectives and targets	This should be prepared by the Budget Department of the MoF
Statement on fiscal sustainability being key to macro-stability; lead in to setting out complete set of fiscal targets (including debt and primary balance ratios), and also: size of government (i.e., for total domestic revenue (tax plus non-tax), and the desired medium-term structure of revenues (tax vs. non-tax; taxes on incomes vs. taxes on consumption, etc.) for capital investment to GDP for the Government’s wage bill other key fiscal targets	Ditto. Done only partially in the Budget Policy Guidelines. Need to be extended for: the key fiscal aggregates beyond the upcoming fiscal year; the intended path of total revenue and its structure (targets for the various aggregated revenue ratios and sub-aggregates); and targets for key recurrent spending components e.g. Wage bill
Tables and write-up on the results of the baseline projections (focus on main fiscal aggregates)	Use the MEFP and further consult with the IMF staff
Note and table on the magnitude of the gaps with respect to the targets	This should be prepared by the Budget Department to show the magnitude of the gap between what the government intended to collect and spend and the actual figures for the last three years
Main elements of fiscal strategy: decisions (& the motivation) on relative contributions of revenue and expenditure measures to “close the gaps” and timeframe for implementation details on each of the specific revenue or expenditure measures and impact they will have on taxpayers, ministries, public servants, or the public	Derive from the MEFP and the draft supplementary budget for 2014
Annotated charts juxtaposing for the major fiscal aggregates, the baseline and the active scenario values, and with brief notes to direct the reader’s attention	May be introduced from 2016
Note on what this means for: the overall resource envelope (i.e., total expenditures) Statutory expenditures (e.g. social programs, pensions) Capital expenditure (total) Interest payments Wage bill Non-wage primary recurrent expenditure (Total Goods and Services plus Transfers and Subsidies) - areas of focus in Budget allocation process)	Ditto
Tables, charts and write-ups of the “active” scenario	Derive from the MEFP. The fiscal tables (output of the policy scenario in the MTFF) represent the synthesis of the upstream budget preparation work
C. Fiscal Risks
Assessment of macroeconomic risks	Need to include discussion of the sensitivity of fiscal forecasts to major macroeconomic assumptions. Derive from the MEFP and the risk statement prepared by the MoEDT
Assessment of specific risks, including attendant claims on the contingency fund; asset and liability management; state guarantees; and PPPs	MoF and MoEDT. Done only partially. Need to be extended to other specific fiscal risks
Assessment of political and security risks	Derive from the risk statement prepared by the MoEDT
Assessment of risks associated with public enterprises	As a minimum, all transfers between the government and public corporations should be disclosed. This would also involve brief account of the results of the work of the State Property Fund and sectoral ministries
Assessment of fiscal risks associated with local governments	Information on the financial condition and performance of local governments, including of communal enterprises. May require input from MoRD, the Association of Ukrainian Cities, and selected municipalities (e.g., Kiev municipality)
Fiscal risks related to pensions or other demographic factors	This would require input from the Pension Fund

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Table 4.

Ukraine: Possible Outline for Fiscal Strategy Document

Topic	Status and Sources of Information
A. Macroeconomic Section
Brief narrative on recent developments and challenges; set out targets and major policies; note on the Government’s recent track record of achieving objectives or forecast errors	Done partially in the Budget Policy Guidelines more needed on economic policies; need track record section and explanation of deviations
Table with projections for the key indicators in the real, external, monetary sectors	Derive from the MEFP
Note on the major forecast risks, and results of sensitivity of key economic variables to changes in assumptions (e.g., oil prices, European economic outlook, tourism arrivals)	Prepare on the base of the MEFP and the macroeconomic forecasts of the MoEDT
Brief write-up of the “optimistic” and “pessimistic” scenarios	Use the MEFP and further consult with staff under the IMF-supported program
Note on the internal consistency of the macroeconomic framework, (attesting to coordinated monetary and fiscal policies, and realism of and consistency of projections)	Use the MEFP and further consult with the IMF staff
B. Fiscal Section
Narrative on recent developments with focus on track record of having achieved or not major policy objectives and targets	This should be prepared by the Budget Department of the MoF
Statement on fiscal sustainability being key to macro-stability; lead in to setting out complete set of fiscal targets (including debt and primary balance ratios), and also: size of government (i.e., for total domestic revenue (tax plus non-tax), and the desired medium-term structure of revenues (tax vs. non-tax; taxes on incomes vs. taxes on consumption, etc.) for capital investment to GDP for the Government’s wage bill other key fiscal targets	Ditto. Done only partially in the Budget Policy Guidelines. Need to be extended for: the key fiscal aggregates beyond the upcoming fiscal year; the intended path of total revenue and its structure (targets for the various aggregated revenue ratios and sub-aggregates); and targets for key recurrent spending components e.g. Wage bill
Tables and write-up on the results of the baseline projections (focus on main fiscal aggregates)	Use the MEFP and further consult with the IMF staff
Note and table on the magnitude of the gaps with respect to the targets	This should be prepared by the Budget Department to show the magnitude of the gap between what the government intended to collect and spend and the actual figures for the last three years
Main elements of fiscal strategy: decisions (& the motivation) on relative contributions of revenue and expenditure measures to “close the gaps” and timeframe for implementation details on each of the specific revenue or expenditure measures and impact they will have on taxpayers, ministries, public servants, or the public	Derive from the MEFP and the draft supplementary budget for 2014
Annotated charts juxtaposing for the major fiscal aggregates, the baseline and the active scenario values, and with brief notes to direct the reader’s attention	May be introduced from 2016
Note on what this means for: the overall resource envelope (i.e., total expenditures) Statutory expenditures (e.g. social programs, pensions) Capital expenditure (total) Interest payments Wage bill Non-wage primary recurrent expenditure (Total Goods and Services plus Transfers and Subsidies) - areas of focus in Budget allocation process)	Ditto
Tables, charts and write-ups of the “active” scenario	Derive from the MEFP. The fiscal tables (output of the policy scenario in the MTFF) represent the synthesis of the upstream budget preparation work
C. Fiscal Risks
Assessment of macroeconomic risks	Need to include discussion of the sensitivity of fiscal forecasts to major macroeconomic assumptions. Derive from the MEFP and the risk statement prepared by the MoEDT
Assessment of specific risks, including attendant claims on the contingency fund; asset and liability management; state guarantees; and PPPs	MoF and MoEDT. Done only partially. Need to be extended to other specific fiscal risks
Assessment of political and security risks	Derive from the risk statement prepared by the MoEDT
Assessment of risks associated with public enterprises	As a minimum, all transfers between the government and public corporations should be disclosed. This would also involve brief account of the results of the work of the State Property Fund and sectoral ministries
Assessment of fiscal risks associated with local governments	Information on the financial condition and performance of local governments, including of communal enterprises. May require input from MoRD, the Association of Ukrainian Cities, and selected municipalities (e.g., Kiev municipality)
Fiscal risks related to pensions or other demographic factors	This would require input from the Pension Fund

Implementation strategy

29. The introduction of an MTBF has three main objectives: strengthening a sustainable macro-fiscal development, promoting more effective allocation of resources, and encouraging more efficient use of resources. First, as discussed in the previous subsection, strengthening the sustainability of public finance on a macro level can be achieved with an MTFF. To this end, the MTFF is the foundation for the development of a full-fledged MTBF. Second, an MTBF supports the more effective allocation of resources with a more comprehensive budget process. The medium-term perspective of budget allocations would help identify fiscal problems the KSUs face at an early stage and set policy earlier than it can be done in the context of the standard annual budget process. Third, a well-functioning MTBF can promote more effective use of resources by creating more stable and predictable conditions under which KSUs can plan their expenditures. An MTBF with sectoral ceilings offers greater predictability to KSUs as to the extent of resources available to them, thereby supporting multiyear planning.

30. Under the circumstances, it is clear that all the main objectives of the MTBF cannot be achieved at once. Therefore, a phased approach to the introduction of the MTBF should be adopted. In the short term, including in the context of the 2015 budget, the focus should be predominantly on the first objective: strengthening the sustainability of public finance on a macro level, while the ongoing work on developing a performance management framework under the PPB reform to support achieving the other two objectives may need to be phased in. Certain design features of an MTBF, such as special treatment of expenditure items, budget margins, carryover rules, and mechanisms for accountability, will need further technical discussions and regulatory support, and may also need a bit more time to be introduced (see 2011/2012 FAD reports and Table 5).

31. The preparation of an MTFF as a key element of a broader Fiscal Strategy Document would be an appropriate starting point. At the same time, the need of short-term expenditure rationalization requires the release of binding ceilings for 2015, and indicative ceilings for 2016 and 2017 to ensure that the expenditure measures are effectively enforced. The following implementation strategy should be considered:

• Adopt in the context of the preparation of the 2015 budget an MTFF and expenditure ceilings for 2015-17, as an initial step and foundation of the MTBF. The MTFF should be based on the fiscal objectives defined in the MEFP;

• Update the MTFF in early 2015 in the context of the preparation of the Fiscal Strategy Document, and release expenditure ceilings for line ministries to guide their budget submissions for 2016-18;

• Integrate the development of the MTBF in the budget calendar starting with the preparation of the 2017 budget; and

• Develop the design features of the MTBF, as recommended in the 2011 and 2012 FAD reports and further discussed in this section, in order to introduce a full-fledged MTBF with the 2018 budget.

Table 5.

Ukraine: Design Features of an MTBF

Table 5.

Ukraine: Design Features of an MTBF

Design Feature	Recommended Treatment
Budget Preparation
Aggregate expenditure ceiling	Implement an aggregate ceiling for 3 years and make them binding when the fiscal position stabilizes
Expenditure ceilings by KSUs	Implement comprehensive ceilings covering all primary expenditures which are binding for the first year and indicative for the outer two years
Special treatment of expenditure items mitigating uncertainty	Limited budget items for special treatment should be identified and allocation mechanism defined
Budget Process
Incorporate a strategic budget phase	Start the budget calendar with the issuance of a Fiscal Strategy Document and KSU expenditure ceilings in April
Macroeconomic framework	Integrate it with the preparation of the Fiscal Strategy Document
Budget Execution
Tight and regular controls	Focus on ceilings and shift away from line-items
Regular updates of medium-term expenditure projections	Mid-year update or two times a year
Budget margin	Analyze circumstances during the initial phase based on which rules for size, level of budget, and use of the margin should be established
Carryover rules	Analyze carefully concerning adverse effects
Multiyear expenditure commitments	Establish commitment registration system for non-capital expenditure
Reporting and Accountability
Reporting on the achievement of the ceilings in budget execution	Prepare an annual report on ceilings displaying any deviations between multiyear plans and expenditure outcomes
Mechanisms for accountability	Analyze experience in the initial phase and decide on appropriate mechanisms

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Table 5.

Ukraine: Design Features of an MTBF

Design Feature	Recommended Treatment
Budget Preparation
Aggregate expenditure ceiling	Implement an aggregate ceiling for 3 years and make them binding when the fiscal position stabilizes
Expenditure ceilings by KSUs	Implement comprehensive ceilings covering all primary expenditures which are binding for the first year and indicative for the outer two years
Special treatment of expenditure items mitigating uncertainty	Limited budget items for special treatment should be identified and allocation mechanism defined
Budget Process
Incorporate a strategic budget phase	Start the budget calendar with the issuance of a Fiscal Strategy Document and KSU expenditure ceilings in April
Macroeconomic framework	Integrate it with the preparation of the Fiscal Strategy Document
Budget Execution
Tight and regular controls	Focus on ceilings and shift away from line-items
Regular updates of medium-term expenditure projections	Mid-year update or two times a year
Budget margin	Analyze circumstances during the initial phase based on which rules for size, level of budget, and use of the margin should be established
Carryover rules	Analyze carefully concerning adverse effects
Multiyear expenditure commitments	Establish commitment registration system for non-capital expenditure
Reporting and Accountability
Reporting on the achievement of the ceilings in budget execution	Prepare an annual report on ceilings displaying any deviations between multiyear plans and expenditure outcomes
Mechanisms for accountability	Analyze experience in the initial phase and decide on appropriate mechanisms

32. The introduction of the MTBF will have a significant impact on the overall PFM reform agenda. Table 5 summarizes key design features of an MTBF and recommendations for their possible treatment made in the FAD 2011/2012 and this report. The introduction of the MTBF, therefore, should be closely coordinated with other relevant PFM reforms, including in the areas of budget execution, accounting and reporting.

33. Finally, the MTBF process will need to be further institutionalized. This would require changes to the BCU in order to provide a legal backing for the MTBF reform. A number of specific required changes with focus on the Fiscal Strategy Document and expenditure ceilings are listed in Table 2. The introduction of an MTBF may also require further strengthening the macro-fiscal forecasting capacity of the MoF.

Recommendation

Management of social and pension fund balances

38. Some earmarking of balances held on sub-accounts in the TSA is currently practiced. These mainly relate to the unified social fund balances. These funds are not swept into the consolidated TSA although they contain substantial balances that could be used for government liquidity management purposes (as at June 1, 2014 the balances was UAH 6.6 billion or US$ 553 million) provided there are strict rules on reallocation to the social funds as and when they are needed (this will also require strong cash flow planning to ensure funds are available in the consolidated TSA.

39. The mission is led to understand that the government is not legally entitled to borrow these funds for liquidity management purposes and therefore their balances tend to lie idle unremunerated in the TSA. It is also possible that some of central government commercial bank deposits identified in the monetary survey (see paragraph 39) may be the result of the social funds seeking to earn a return on their cash balances.¹³ If this is the case, one option could be to enter into contracts with the social and pension funds that allow for their surplus funds to be lent to the STU for cash management purposes in return for an agreed rate of interest. Obviously, formal rules would need to be developed requiring the STU to return the funds as required by the social funds to meet their obligations. This will also require detailed cash plans (see cash planning section below) to be prepared by the social funds identifying when their contributions and obligations will be collected/disbursed so that the treasury can ensure resources are available to repay the social funds.

Commercial bank accounts of central government entities

40. There is evidence in the monetary survey that some central government deposits are leaking into the commercial banks, despite assurance that this is not the case. While the amounts are not very large, relatively speaking, averaging around UAH 4 billion (US$341 million)¹⁴ between June 2013-May 2014 (see Table 1), it does indicate that there may not be full transparency of the accounts under the control of government agencies in the commercial banks. The STU indicated that these amounts may relate to foreign exchange accounts held by spending units in the commercial banks, as the TSA is a domestic currency system and KSUs need foreign currency accounts for their spending operations. However, this does not fully explain the amounts on deposit. As at April 1, 2014, balances of foreign currency accounts in commercial banks amounted to UAH 1 billion (US 85 million)¹⁵ while balances in the commercial banks amounted to UAH 3.6 billion (US$ 306 million) as at the end of March 2014 (Table 6).

41. Even if foreign currency accounts make up the bulk of the funds on deposit, it is unclear why KSUs should need foreign currency accounts in the commercial banks. It should be possible for the STU to purchase foreign currency on behalf of KSUs where needed and deduct the equivalent amount in UAH from their accounts in the TSA. This would be far more efficient and negate the need for these accounts however small they appear at present.

Table 6.

Ukraine: General Government Deposits in Commercial Banks, June 13–May 14, 2014

Source: NBU Monetary Statistics

Table 6.

Ukraine: General Government Deposits in Commercial Banks, June 13–May 14, 2014

	June	July	August	September	October	November	December	January	February	March	April	May
Central Government	4,420	4,878	4,413	4,504	5,058	4,552	2,761	2,843	3,505	3,560	3,645	3,248
Local Government	1,064	1,034	1,001	1,061	1,147	1,064	189	195	157	169	145	199
Total	5,484	5,912	5,414	5,565	6,206	5,615	2,950	3,038	3,661	3,729	3,790	3,447

Source: NBU Monetary Statistics

View Table

Table 6.

Ukraine: General Government Deposits in Commercial Banks, June 13–May 14, 2014

	June	July	August	September	October	November	December	January	February	March	April	May
Central Government	4,420	4,878	4,413	4,504	5,058	4,552	2,761	2,843	3,505	3,560	3,645	3,248
Local Government	1,064	1,034	1,001	1,061	1,147	1,064	189	195	157	169	145	199
Total	5,484	5,912	5,414	5,565	6,206	5,615	2,950	3,038	3,661	3,729	3,790	3,447

Source: NBU Monetary Statistics

42. However, it also appears that the STU may also have some cash in the commercial accounts. The chart of accounts in the STU would also indicate that as at June 10, 2014 account number 1222 contained balances of UAH 1.4 billion (US$ 123 million) in cash accounts in the commercial banks, while account number 1224 also appears to have balances of UAH 527 billion (US$62) million in the commercial banks.¹⁶ To ensure that all budgetary funds are available for liquidity management purposes, the STU should conduct a review of its accounts with a view to consolidating remaining government accounts in the TSA.

Foreign currency accounts in the NBU

43. The current practice of “ring-fencing” foreign currency denominated deposits in the NBU should be reviewed to improve daily liquidity management needs. Large foreign currency denominated cash balances being held on deposit in the NBU, are earmarked to pay off foreign currency obligations and in particular foreign currency denominated debt repayments. While understanding that there is a reluctance to convert foreign exchange balances to UAH when there are large foreign currency obligations on the horizon (as at end June 2014 foreign currency deposits were sufficient to finance two month’s worth of foreign currency debt redemptions), it would appear to make little sense for these funds to by lying idle (earning no interest in the NBU) while cash rationing takes place during budget execution. It would be more sensible to sell the foreign exchange to the NBU who could include them as part of their reserves and use at least a part to contribute to government liquidity management. These foreign currency balances would provide a substantial boost to resources available for liquidity management purposes.

44. Any move to convert foreign exchange balances would need to be accompanied by significant strengthening of existing cash forecasting capacity. Accurate cash planning would be needed to ensure that sufficient resources would be available in UAH to repurchase the foreign exchange when required to meet upcoming foreign currency denominated debt redemptions and the foreign currency obligations (see Section C). It will also require close communication with NBU to ensure that they are aware of all upcoming requests for purchase of foreign currency to finance these obligations.

Local Government accounts in the TSA

45. The shortage of liquidity in the TSA is causing difficulties for Local Governments (LG), as their accounts are, for the most part maintained in the TSA. In addition to budget transfers from central government, LG’s are also required to deposit their own revenues (OR) in accounts in the TSA. These funds are being used by the ST to finance ongoing liquidity needs in the consolidated account which conceptually is not problematic provided the fund are made available to the LGs when they need to meet their own obligations. However, the STU is frequently, especially in the current environment, unable to reimburse the LGs when they seek to use the funds to pay their obligations financed from their own revenues.

46. The lack of availability of LGs OR impacts in two ways: (i) it limits their incentives of LGs to collect OR; and (ii) reduces their ability to plan and execute their budgets based on their own forecasts also contributing to arrears accumulation. The requirement for the STU to pay protected expenditures is the main cause of this problem, as the lack of realism witnessed in the budget planning stage squeezes out any non-priority expenditures including those financed by OR of the LGs. Better cash planning and commitment control (see Section C) could also help to alleviate this problem and ensure that resources are available to meet obligations of all levels of government, when they are needed.

47. LGs have in the past been offered access to short and medium-term loans from the STU to cover any shortfalls in their budgets. These loans have traditionally been offered to offset shortfalls caused by lack of realism in budgets and the problem of underfunded responsibilities devolved to LG and financed by central government transfers. There are two types of such loans: short-term loans that must be repaid within the fiscal year; and medium-term loans that may be outstanding past the end of the year. In the case of short-term loans the ST can and does deduct outstanding balances from their share of revenue to ensure they are repaid, but MT loans have largely tended to accumulate especially over the last few years (see Figure 2) to a situation where there are currently approximately UAH 9.5 billion (US$ 810 million or 0.6 Percent of GDP) outstanding as at mid-2014.

48. The loans are frequently granted to compensate for underfunding of legally mandated devolved competencies reliant on central government transfers. The increasing balance is symptomatic of the level of central government underfunding of LG activities.

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Ukraine: Medium-term Loans Outstanding from Short-term to Local Governments 2009–June 2014 (UAH ‘000s)

Citation: IMF Staff Country Reports 2016, 030; 10.5089/9781513523781.002.A001

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49. It is significant that the level of issuance and repayment has dropped significantly in 2014 following rapid accumulation in 2013. This is probably due to the lack of resources available to the STU to grant such loans, given the current liquidity constraints and the inability of the LGs to repay the loans, but it does not mean that the underfunding problem has been solved. This situation is likely to lead to a rapid accumulation of arrears if LGs cannot access funding and unless the grants to LGs are urgently reviewed to ensure that funding is commensurate with the expected level of service delivery in areas of responsibility devolved to LGs.

Reducing volatility in government balances

50. Government cash balances on the TSA are volatile. Balances frequently approach or reach zero in the middle of the month when many expenditures fall due. Revenues on the other hand are largely received at the end of the month (see Figure 3). This mismatch in the timing of receipts and payments could, over time, be reduced by seeking to better align revenue and expenditure patterns by ensuring that large ticket items (such as wage payments) are aligned with large revenue receipts.

51. Aligning expenditure and revenue items will take time. This cannot happen overnight but should be considered as part of a medium-term strategy to reduce the level of volatility on the TSA. This would also help the NBU in managing liquidity in the system as the smaller the volatility of government balances on the TSA the less intervention the NBU has to make in the markets to sterilize government activity in the market.

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Ukraine: Daily Consolidated TSA Balance, June 2013–June 2014

Citation: IMF Staff Country Reports 2016, 030; 10.5089/9781513523781.002.A001

(UAH million)

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Recommendations

Recommendations

Recommendations

Current situation

65. The State Treasury of Ukraine (STU) is responsible for overseeing budget execution. STU is an independent body but operates within the administration of the MoF. The STU performs budget execution transaction services on behalf of budget spending units. It undertakes budget execution control during these transactions and produces reports on budget execution. STU has a head office in Kiev, 27 main departments in each of the 24 regions (plus Kyiv, Sevastopol, and Crimea), and 633 local administrative centers with 16,000 staff in total.

66. The STU’s bespoke information technology system called E-KAZNA supports its operations. This system was developed with assistance from the World Bank and implemented with assistance of the IMF. In the past there were separate systems for revenue and expenditure but these have recently been combined into a “unified” system. The software is operated on a de-concentrated basis by STU offices at all three levels, with data transferred between the databases of the district and the regional offices and between regional offices and the central database in the STU head office. Major revenue and spending agencies each have their own separate accounting software to support their operations. These systems are not directly connected to the E-KAZNA system. In the past this has required that all transactions be initiated and recorded at a STU site but manual systems of data interchange between STU and its clients have begun to be introduced.

67. STU has a direct connection to the payments system managed by the NBU. Access to the interbank clearing system has enabled the STU to undertake electronic transactions for both revenue collection and processing of payments. As a result, almost all revenues are collected via transfer of funds from commercial banks—acting as collection agents—and almost all payments are made by electronic funds transfer (96 percent).

68. The Budget is classified according to administrative unit, program, and economic classification. A functional classification is used in budget preparation and reporting but is not used for budget execution control. The economic classification specified is quite detailed, equivalent to a 4-digit GFS economic classification (but not fully compliant with GFSM 2001). As an example, the approved budget for a program within a spending unit has an economic line item for “purchase of electricity,” which is a sub-set of “utilities,” which as sub-set of “goods and services.” Budget execution is controlled at this level of detail, where agencies cannot spend more, for example, on purchase of electricity than specified in their allocated budget.

69. Virement controls limit the movement in the structure of the approved budget. Agencies may request approval for transferring the approved budget between economic categories of expenditure and between programs. The MoF must approve any transfer between the recurrent (operating) economic categories of expenditure and the CoM, and the Budget Committee of the Rada must approve proposed transfer of appropriation between programs and/or movement between development and operating classifications within a program. Adjustments of the budget between spending units requires changes to the annual budget law as these represent changes to the appropriations. The Budget Department is responsible for administering virement and informs STU of approved adjustments.

70. Once the budget is approved, the approved budget is allocated according to a monthly breakdown of planned budget execution. In accordance with Article 23 of the BCU, at the start of the year, agencies provide a proposal for the timing of their expenditures based on the expected timing of their expenditure obligations (known as a “Rozpys”). For agencies participating in program budgeting, these plans must be consistent with the approved program “passport” that elaborates a range of details regarding the purpose of the program as well detailed expenditure plans. On a monthly basis, the STU releases budget allotments to enable expenditures according to these Rozpys plans. Where agencies have administrative sub-units (such as Oblasts), these entities provide STU with a proposed allotment of their released budget amount between their sub-units.

71. There are “protected” items identified in the budget that receive special treatment in the process of budget release. Protected categories, specified in Article 55 of the BCU include salaries, payroll, utilities, debt servicing, transfers to households, transfers to local government, purchase of medicines, and tertiary education. Protected items are released by the STU on a monthly basis according to the Rozpys. The release of unprotected items are not automatically released according to the Rozpys but rather the release of allotment for these items is more closely subjected to the short term availability of liquidity in the TSA. Allocation for unprotected items is released on weekly basis.

72. There is a distinction in the budget between the General Fund and Special Funds and this distinction impacts on budget execution. The General fund budget consists of all revenues used to fund budgeted expenditures of general government agencies that have not been earmarked to a special fund budget line. Special funds include revenues that are earmarked for a specific purpose, including some own-source revenues, donor funded activities and certain borrowings. For these special funds, there is a direct link between the value of revenue and the value of expenditure—where expenditure generally cannot exceed the revenue and expenditure is directed to a specific activity. The allotment of the approved budget for Special Funds thus depends on the actual timing of the revenue received.

73. A form of budget obligation control exists, where agencies are required to record in the STU system the value of the invoices they have received in executing the budget. Procedures exist for electronic transmission of data regarding these obligations from spending agencies to the STU. The STU performs budget control on these obligations and will not record any commitment in excess of the allocated budget.

74. Expenditures are initiated by the STU and controlled against the approved budget. Spending units initiate expenditures by taking the required paperwork to a Treasury office. The Treasury office checks the validity of the documents, ensure the relevant authority has approved them, confirm that the expense is properly classified, and the amount of proposed expenditure is within the approved budget. Where an obligation is recorded in the Treasury system, the expense is controlled and recorded against the relevant commitment.

Issues to be addressed

75. The manner in which financing is controlled against the budget is a key weakness of the current budget execution process. CoM Resolution 404 appears to explicitly allow borrowing by agencies to fund capital expenditure in excess of budget appropriations. In addition, the practice of Treasury lending to sub-national governments involves release of cash from the central budget to the local budget in the absence of an appropriation. In simple terms, all cash flows out of the funds of the National Government should be covered by an appropriation and the fact that there is a TSA does not obviate this requirement. These practices, of releasing cash in the absence of an appropriation, breach fundamental principles of sound public financial management i.e., that funds should only be spent if approved in the budget. This principle is also embedded in the Constitution of Ukraine.

76. Weaknesses in the operation of the STU are highlighted by payment arrears accruing during the current period of unplanned fiscal imbalance. In response to low balances in the TSA, the STU is not paying all of the invoices presented by spending agencies for payment. As at June 2014, arrears totaled 4.18Bn UAH (0.3 percent of GDP). These arrears represent the value of invoices recorded in the STU system as obligation but have not been paid. The composition of the arrears is set out in Table 7. This amount includes only arrears in the unprotected expenditure and thus potentially underestimates the true value of arrears as anecdotal evidence suggests the possibility that there are unpaid invoices for protected items that are not recorded in the STU system. Total arrears, including unpaid VAT refunds, is 7.8Bn UAH.

77. A core function of the STU is to ensure sufficient cash to pay the expenditures approved in the budget. Over the long term, the key component of the solution to this problem is ensuring that that the expenditure side of the budget is realistic having regard to accurate revenue forecasts (see Chapter III). A further solution to the problem of payment arrears is to enhance cash management practices, the primary purpose of which is to ensure sufficient liquidity so that all payment obligations can be met (see Chapter III). Nonetheless, the current crisis also points to the need for the government to have greater capacity to manage the rate at which it is incurring expenditure obligations during the year.

Table 7.

Ukraine: Accumulated Payment Arrears at June 28, 2014

(mln. UAH)

Source: MoF

Table 7.

Ukraine: Accumulated Payment Arrears at June 28, 2014

(mln. UAH)

State Budget		1,715.7
	General fund	378.1
	Special fund	1,337.6
Local budgets		2,430.9
	General fund	941.7
	Special fund	1,489.2
Social Welfare Funds		34.2
	Employment fund	31.7
	Industrial accident and occupational disease social insurance fund	2.1
	Temporary disability social insurance fund	0.4
Total Payment Arrears		4,180.8

Source: MoF

View Table

Table 7.

Ukraine: Accumulated Payment Arrears at June 28, 2014

(mln. UAH)

State Budget		1,715.7
	General fund	378.1
	Special fund	1,337.6
Local budgets		2,430.9
	General fund	941.7
	Special fund	1,489.2
Social Welfare Funds		34.2
	Employment fund	31.7
	Industrial accident and occupational disease social insurance fund	2.1
	Temporary disability social insurance fund	0.4
Total Payment Arrears		4,180.8

Source: MoF

78. The current allotment process is not effective in restraining the rate at which expenditure obligations are incurred. During the current crisis, the government has been issuing internal directives to reduce expenditure by eliminating certain types of purchases as well as not paying the invoices received for purchase of unprotected items. However, a more robust systematic approach is required for managing budget execution to avoid incurring arrears during times of poor liquidity in the TSA.

79. Commitment control should be introduced to support effective budget execution control and cash management operations. A “commitment” is a decision made by a program manager to ear-mark certain budget funds for a specific purpose. For example, if a manager issues a purchase requisition to commence the procurement of blankets for a hospital, this action represents a commitment of budget funds. Once this commitment is entered, it flags an intention that an obligation will soon exist for this specific purpose. Many modern Treasury systems support the recording of commitments at the time they are incurred. Many IFMIS systems with purchasing modules automatically record a commitment when the system-generated purchase requisition is prepared. As some payment types are regular and obligatory in nature—such as salaries paid to permanent staff—a commitment should be automatically registered when funds are allocated for this purpose.

80. The current budget execution process includes recording of obligations but these are normally recorded after contracts are signed or goods purchased. Therefore they come too late in the budget process to be used for controlling expenditures and preventing the incurrence of arrears resulting from insufficient appropriations to cover committed expenditures. Agencies are already required to record their accounts payable as soon as invoices are received, meaning that there is information currently available on obligations (although outside the STU system). A practical solution to introducing commitment control is to require that, instead of obligation being recorded when the legal obligation arises, that this be converted into a commitment recording process, where the spending agency records the obligation/commitment in the treasury system at the stage just prior to commencement of procurement.

81. Commitment control improves budget execution control and helps to avoid expenditure arrears during a time of poor liquidity.¹⁸ Having information regarding commitments assists in cash forecasting as it is a source of intelligence regarding the timing of future expenditures. Recording of commitments is also a potential budget execution control mechanism as commitments can be controlled against budget allocations. With commitments being recorded and controlled against the budget, managing the release of budget allocation will control the incurrence of liabilities. In this way, where there is a forecast cash shortfall, restricting allocations will constrain the value of the commitments agencies can enter and thus also restricts the incurring of obligations. Using such controls enables the rate of spending to be managed without incurring arrears.

82. Irrespective of the processes put in place to prevent future arrears, a strategy may be needed to deal with the existing stock of arrears, if they cannot be repaid from existing budget appropriitons for individual budget agencies.¹⁹ The following key factors should guide an arrears clearance strategy:

• Comprehensiveness. The arrears clearance strategy should apply to all outstanding payments incurred by all parts of the public sector, whether in the central government, sub-national governments, or state-owned enterprises.

• Transparency. The clearance of arrears should proceed according to a public timetable, and criteria for prioritizing clearance should be transparently stated and adhered to.

• Credibility. To demonstrate commitment to addressing the root causes of the problem, the strategy should include measures to avoid the accumulation of new arrears, and ministries or agencies that fail to implement these measures should be penalized appropriately.

• Realism. The government’s annual budget and medium-term fiscal projections should make adequate provision for the cash cost of arrears clearance.

• Verification. Arrears should be verified to ensure that only valid claims are cleared.

83. The distinction between protected and unprotected items is not appropriate in the medium term. Once fiscal stability is restored, advanced cash management tools are implemented, and commitment controls introduced, it should be possible to avoid cash rationing. The current process of deliberately holding back payment of “unprotected” items undermines the whole system of public finance as it impacts on the revenues of private sector suppliers, inflates the costs of government purchasing, and is encouraging local government and semi-autonomous agencies (such as universities) to seek approval to establish their own STU operations. As soon as possible, the Government should formally eliminate the distinction between protected and unprotected items and commit to executing payment for all items included in the budget in a timely manner.

84. Seeking to control expenditure at a highly detailed level (by program and detailed economic classification) creates severe rigidity in budget execution. In budget planning, it cannot be expected that any agency can predict with precise detail the exact amounts that will be spent on individual economic line items. It is inevitable that the context in which the budget is executed will change, often due to external factors, and managers must have flexibility to respond. Evidence provided by spending units is that the lack of flexibility in the budget execution regime in Ukraine prevents managers from responding to opportunities and threats in managing service delivery programs and contributes to the incurring of payment arrears.

85. Most developed countries, including within the region, have moved towards budget execution regimes that provide greater flexibility in budget execution. There are two ways in which this can be done. One way is to give spending agencies flexibility to transfer their budget between economic categories without needing higher-level approval. This authority is often restricted, for example by placing a limit on the size of the total value of such transfers and/or by restricting transfers in or out of some major categories (often these restrictions are on salaries).

86. Another alternative is to record transactions at the detailed level of the CoA but roll-up the value of these to be controlled against a higher level in the CoA. For example, rather than controlling expenditure on “purchase of gas,” all utility purchases could be automatically added together by the STU system (“rolled up”) and controlled against the total budget for “utilities.” Schedule 3 of the annual budget law includes such summary level detail for each of the general fund (as shown in Table 8) and the special fund programs. This would be an appropriate level at which to control budget execution.

87. Future enhancement of Treasury operations is dependent on the capacities of its IT system. As part of current Public Finance Modernization Project (PFMP), supported by the World Bank, the Government has been pursuing the purchase of an Integrated Financial Management Information System (IFMIS). This IFMIS system is intended to be a web-based solution that supports a broader range of transactions and services within the STU as well as supporting budget preparation, debt management, procurement, donor assistance management, and human resource management. However, following successive unsuccessful procurement actions and the pending completion of the PFMP, it is possible that the FMIS will not be acquired as planned. The inability to acquire a functioning IFMIS posses a substantial barrier to future reform of public financial management and is particularly damaging to the future enhancements to the efficiency of the STU.

Table 8.

Ukraine: Outline of Schedule 3 of Budget Law 2013

Table 8.

Ukraine: Outline of Schedule 3 of Budget Law 2013

Department/Program				General Fund
				Total	Consumption Expenditures	Of which		Development Expenditures
						Salaries	Utilities
				−	−	−	−	−
TOTAL				−	−	−	−	−
	Ministry			−	−	−	−	−
		Department		−	−	−	−	−
			Program	−	−	−	−	−

View Table

Table 8.

Ukraine: Outline of Schedule 3 of Budget Law 2013

Department/Program				General Fund
				Total	Consumption Expenditures	Of which		Development Expenditures
						Salaries	Utilities
				−	−	−	−	−
TOTAL				−	−	−	−	−
	Ministry			−	−	−	−	−
		Department		−	−	−	−	−
			Program	−	−	−	−	−

88. The government should work closely with its development partners to determine an appropriate strategy for acquiring a more advanced STU system as soon as practical. In terms of STU operations, the objective should be to have a robust system that is available to both STU and spending units, supports online transactions though the interbank clearing system, enables automatic reconciliation of accounts, supports appropriate internal controls, has robust security and audit functions, has a general ledger that supports accounting and reporting in accordance with accounting policy and interfaces with other financial management systems. There are available off-the-shelf IFMIS packages that include these features in their core financial management modules and also have available budget preparation, procurement, debt management, payroll, and human resources modules. While expanding the functionality of the existing STU is technically feasible, acquiring an off-the-shelf IFMIS package may be less complicated and potentially a more efficient way to quickly acquire the functionality required whilst also supporting other key PFM functions.

Recommendations

Accounting Chamber (External Audit)

90. The Accounting Chamber of Ukraine (ACU) is the Ukraine’s external audit institution and reports directly to the Verkhovna Rada. It is established by Section 98 of the Constitution of Ukraine to undertake “control over the receipt of finances to the State Budget of Ukraine and their use on behalf of the Verkhovna Rada of Ukraine.” Recent constitutional amendments have clarified that the ACU has a broad role in auditing both the revenue and expenditure sides of the budget—addressing previous uncertainty about the ACUs scope to audit revenue collection.

91. The ACU is governed by a Chamber comprising a Chairman, two deputies, a Secretary and Chief Controllers. The members of the Chamber are elected by a majority secret vote of the Verkhovna Rada and they have a seven-year term.

92. The ACU performs it role by undertaking ex post audit of the execution of the budget. An audit plan is independently developed each year by the ACU. Members of the Verkhovna Rada may request a specific audit to take place (if endorsed by at least 150 members) but such requests have been rare. The ACU performs compliance audits but its broad mandate and goal of engaging “on all issues concerning effective and transparency in management of budget resources” has allowed it to undertake broader examinations of program effectiveness and efficiency. The ACU provides reports on its audit findings, including audit recommendations to the Verkhovna Rada and often directly to the COM and the President as well as issuing information bulletins for the benefit of budgetary institutions. In addition, the ACU provides an audit opinion on the Annual Report on Compliance with the Budget Law (the annual financial statements) published by the STU as well as quarterly reports on debt revenue and expenditure developments as required under Article 110 of the Budget Code and Article 27 of the Law on the Accounting Chamber. The ACU has been seeking to improve the effectiveness of its operations. ACU is a member of EUROSAI and INTOSAI, and with assistance of these bodies and international development partners, including the German and UK supreme audit institutions; it is working toward full implementation of INTOSAI standards.

93. The ACU has prepared a new draft of its legislative framework. The draft provisions seek to protect the ACU from impositions on its independence through inadequate funding. At present the ACU budget is prepared in the same manner as any other budgetary institution—through the budget process coordinated by the MoF. The ACU is seeking to avoid this budget process by presenting its budget proposal directly to the Verkhovna Rada each year. In addition, the ACU is seeking to gain a clear mandate to undertake ex ante control activities where it perceives there is risk to the budget—for example, to verify the validity of revenue administration rulings before they are issued. The ACU would also like to formalise its role in providing the Verkhovna Rada with advice on macrofiscal forecasting during the budget process. However, these proposals are expected to be quite controversial.

94. While it is important that the ACU be free from interference through inadequate funding, completely avoiding the budget preparation process is not an ideal solution. The problem with avoiding the early stages of the budget process is that it provides a large unknown externally determined hole in the draft budget—making it more difficult for the government to formulate aggregate fiscal strategy. It would be better to seek the required independence mandating that the ACU submit a draft budget in the usual way but have the legal right to provide a brief to the CoM, Budget Committee, and the Verkhovna Rada to justify its budget request. This would make any changes to the budget submission made by MoF highly transparent.

95. Any move by ACU to engage in ex ante control and policy development functions might undermine its independence. If ACU gets engaged in advising the Verkhovna Rada on fiscal policy during the budget preparation processes, competing with MoF and Ministry of Economy and trade on issues such as economic forecasting, its loses its ability to be an independent and objective surveyor of the processes. In addition, the assessment of fiscal policy requires very different skills to those of a traditional auditor. Similarly, the ACU needs to be seen to be independent and objective in auditing the validity of administrative decisions made by government and may lose this if it starts to engage in the making of such decisions. The ACU has a key role to play in enhancing transparency and accountability and may lose this capacity if it becomes part of the government policymaking and administration apparatus.

96. The ACU is concerned about the implications of the 2014 Supplementary Budget Law, as this is understood to place a limit on external audit activities during the remainder of this year. The Government should not seek to limit the powers and actions of the ACU through legislative instrument, as this will inevitably raise the issue of violation of the Constitutional mandate of the ACU. It is also poor public financial management practice to allow a period where there is less accountability for effective execution of the budget. The ACU should be seen as a source of advice to the CoM on effective internal control systems and independently verifying the effective implementation of such controls.

Financial Inspection service

97. The State Financial Inspection of Ukraine (SFI) is an executive body that undertakes ex post review and audit of budget execution. The SFI’s executive authority is directed and coordinated by the Cabinet of Ministers of Ukraine through the Minister of Finance. Key appointments to the SFI are appointed and dismissed by the CoM on the basis of proposals of the Minister of Finance. The SFI reports to the Verkhovna Rada, the CoM, and the MoF on the outcomes of their activities assessing budget units compliance with the budget law. The SFI has a central office with 390 staff and regional offices with a combined staff of over 6,000.

98. SFI undertakes both inspection and auditing activities. The inspection function is a process of ex post fiscal control, where the SFI checks the compliance of certain transactions after they are processed. Where non-compliance is observed, the SFI seeks to identify who was responsible for violations and imposes administrative sanctions, makes referrals to law enforcement agencies (and the prosecutor if appropriate) and directs actions to redress non-compliance. Through such action, SFI is not seeking to identify or address any systematic weaknesses in the internal control environment that contributed to the violation but rather identify and address the specific act of non-compliance. The SFI estimates that these control activities add significant value to the budget with a return to the state budget misappropriated funds and implementation of the agreements in the amount of 370 million. UAH since the beginning of 2014.

99. The financial auditing activities of the SFI are essentially performance-type audits. These audits seek to identify areas of ineffective and inefficient use of public funds in the implementation of budget programs. Unlike the inspection actions, the audit findings do not seek to apportion responsibility and the findings and recommendations are non-binding.

100. The scope of the SFI activities has recently been expanded to include ex ante control. Resolution 214 of the COM has provided SFI a mandate to undertake operational audits of the 36 largest SOEs. These will essentially involve SFI having a presence in these SOE and undertaking selective ex ante control over certain operations of these SOEs. The intention of this action is to avoid violations within SOEs and is particularly focused on areas, such as procurement, where previous audits have identified instances of non-compliance. A risk based approach is to be taken, with the initial intention to undertake ex-ante control over purchases of goods with a value of more than 300,000 UAH and any procurement of works with a value of more than 1 million UAH. In addition to these SOE focused actions, SFI was tasked with conducting a one-off audit of all of the payments of all budgetary institutions recorded as being in arrears in the Treasury system.

101. Since 2005 SFI has embarked on a reform program directed at introducing an internal audit function in all budgetary institutions. SFI has been receiving substantial assistance from international development partners in progressing these reforms. Legislation has been passed, regulations issued and substantial training delivered, and 75 ministries and central executive bodies now have IA units in place. In addition, internal audit units have been formed in all regional administrations.²⁰ The objective is to roll out the IA function, starting from the central agencies, then the oblasts and then the other local bodies.

102. Ukraine is at an important cross road in the development of its control regime. On the one hand, it has been progressing towards the international norms (such as the EU Public Internal Financial Control (PIFC) regime) which seek to strengthen management control and accountability within agencies. Internal audit and accrual accounting are key elements of this reform. At the same time, the recent efforts by the ACU to engage in ex ante control and the expanded scope of the SFI to undertake ex ante control runs contrary to good practice. It is understandable that increased control is sought during the current period of military conflict and associated fiscal challenges. However, international experience suggests that seeking to strengthen the internal control framework within budgetary institutions—where managers are given greater flexibility but in an environment of robust transparency and accountability—is the best solution to promoting good public financial management outcomes. Ukraine has made large strides in this direction and should not lose its way by reverting to the command and control systems of the past.

103. The key elements of a strong modern internal control regime are:

• (i) Enhanced flexibility for managers in executing their budgets.

• (ii) A shift away from control over inputs toward attainment of outcomes. This should be reflected in both the budget process and reporting regime.

• (iii) A clear legal requirement for the senior managers in budgetary institutions to establish a sound internal control regime, including functioning internal audit, separation of duties, delegation of authorities, and risk based controls.

• (iv) Strengthened reporting regime, requiring agencies to produce a publicly released annual report with Annual Financial Statements (AFS) produced according to accounting standards as well as reporting on the outputs produced, efficiency indicators and reporting on outcomes achieved from use of public resources.

• (v) External audit of the annual reports of all agencies, including an audit opinion (according to INTOSAI standards)

104. The transition towards more decentralized control can be managed in a structured manner. Some countries have established a formal certification process, where greater flexibility in budget execution and freedom from ex-ante controls is given only once strong internal control regimes are in place in that agency, as proven by achieving unqualified external audit by the ACU of that agencies AFS.

Recommendations

Recommendation

Recommendations

The decentralized model

The consolidated model

137. The last decade has seen more and more governments merging the exercising of ownership rights with that of financial monitoring into one single ownership management entity, as recommended by the OECD.³⁹ Such a consolidated vehicle was either set up as a government entity or as an independent ring-fenced holding company at arm’s length distance from the government—a National Wealth Fund (‘NWF’).

Political insulation

148. The unitary enterprise is not required to have a board of directors, independent directors, a supervisory board or other corporate governance bodies such as an annual general meeting, and is, in principle, governed by a single civil servant within its governing body. In practice, this means that the civil servant makes every important business and operational decision and is fully involved in day-to-day business. This results in the absence of political insulation and separation between policy and commercial objectives.

149. Managers of unitary enterprises are meant to be selected on a competitive basis by the governing body, with competitive remuneration as an important instrument to attract professional people. However, according to a recent study the government does not seem to have been effective in attracting top candidates, despite legislation to grant adequate remuneration packages. Nor does the evaluation system applied to monitor their performance seem to have had much impact on company performance or management turnover.⁴⁵

Governing bodies

The need to introduce a clear financial objective

157. In the absence of a clear objective, financial indicators established by the MoEDT, are limited to monitoring the state assets from a fiscal and compliance perspective. The reality is that performance management will only become meaningful when a clear financial objective has been established such as value maximization, harmonizing with the established practice in the private sector. The inherent conflict of interest between regulatory, political, and ownership issues with regards to the state asset portfolio, is not addressed within the government from either a policy, organizational, or practical perspective.

Transparency considerations

158. The Constitution, the Law on Information, and the Law on Access to Public information, establishes the basic framework for public access to information. Information is generally classified either as open or limited access. Information determined to be of limited access is further designated as confidential or of significant national importance (state secret), which is subsequently governed by the Law on State Secrets.

159. Governing bodies primarily exercise their state assets oversight function through the approval of financial plans and formal comparison of actual versus budgeted performance. There is little emphasis on transparency in current oversight and monitoring processes. This is mainly due to the governance objective being limited to and focused on the compliance with legal requirements, policy issues, and financial plans. Mixing conflicting objectives does not allow operational efficiency to be measured or benchmarking with similar operations internationally, preventing the government from understanding the true effectiveness of its operations, as well as the fiscal risk with its ownership.

The privatization process

160. Ukraine began implementing a privatization program in 1992 with the objectives of increasing the private sector’s share of the economy, generating foreign direct investment and contributing funds to the State Budget. From 1992 to June 30, 2009, Ukraine raised more than UAH 40 billion in privatization receipts, divesting more than 120 thousand assets, including around 28 thousand assets from central government and more than 90 thousand from local government. Attracting foreign direct investments has proven to be a challenge and since 2009 privatizations has largely stalled.

Legal reform

162. Reforming the legal structure governing state assets should aim to reduce and eliminate overlapping structures and conflicting objectives, creating clear dissemination of responsibility and accountability unified under the single objective of value maximization. Delegating responsibility and accountability to the boards of directors best capable of managing assets and simultaneously vesting the ownership responsibility with a consolidated ownership vehicle and thereby building the professional capacity capable to manage and develop the portfolio from an ownership perspective.

163. In practice this would require a comprehensive reform to a number of existing laws and subsidiary regulations, including specifically the Code and Property Law. This in turn would require other legislation to be brought in line with these amendments. Legal reforms should aim to eliminate differences in the legal framework between state assets and those applicable to private sector equivalents. However, this might also require a reform of corporate laws applicable to the private sector to ensure good international practice, is observed with the objective of improving the governance and management structure in the entire economy.

Ownership rights management

164. The centralized ownership models that have been developed in other countries and that are described above are not feasible to introduce at the present time given the political and fiscal constraints that the government is currently facing. However, a centralized ownership model with a clear mandate to maximize value of the state asset portfolio should be the ultimate objective when the necessary prerequisites are in place including a complete overhaul of the legal framework, the governance, accounting and reporting structures surrounding the state asset portfolio.

165. However, there is clearly a need to move towards a consolidated model of ownership, as recommended by the OECD and demonstrated by successive governments. The actual vehicle can take a number of shapes dependent on political will and ambition. The main purpose is to institutionalize political insulation and allow capacity to be developed to help maximize value and minimize fiscal risks.

166. The appropriate short-term solution is to build up capacity to manage the fiscal risks associated with the consolidated portfolio and centralize the oversight function, through establishment of a dedicated unit within the MoF. The unit’s primary objective in the short term would be to address the need for transparent and comprehensive assessments of financial plans and to identify and propose measures to mitigate fiscal risks. This initial step would require preparation and publication of a consolidated annual report for the portfolio of state assets acting in effect much like a virtual holding company.

167. Separation of commercial and non-market assets will be essential in attempting to apply a value maximization objective for the portfolio of commercial assets. Clearly defining remaining subsidies or policy objectives and quantifying, and transparently identifying them is the first step towards transforming each asset to a solely commercial basis.⁴⁹ All policy costs when identified and quantified should be procured under competitive tender by either the entity or by a central procurement authority within the government or the relevant line ministry. Ultimately the entity should be relieved from dealing with policy issues and focus solely on its core business.

168. In the medium term, once the necessary prerequisites are in place, it would be desirable to gain full ownership control of all state assets by merging the SPF and the MoF’s oversight unit. The objective would be to consolidate full responsibility for active ownership, financial control, and privatizations through an independent division within the CoM or the MoF. Such a move would considerably improve the credibility of the state as an owner towards all stakeholders, including international investors. This unit would have the sole responsibility for any privatization and would be held accountable for ensuring the selection and preparation of assets prior to sale to maximize shareholder value.

169. When sufficient capacity is developed and when the political environment is conducive, the Ownership Management Unit could be converted into an independent, properly ring-fenced holding company. This would place it at arm’s-length from the government, reporting directly to the CoM.

Transparency policy

170. Transparency policy should ensure that all stakeholders including international investors understand the nature and the status of the assets held and managed by the state. The quality and reliability of information has to be regarded as credible for any marketable initiative to be viable, including the retention of any independent auditing and valuation of the assets.

171. In the short term, the objective should be to identify the financial position of the consolidated portfolio of state-assets. This can be achieved quickly through:

• The compilation and publication of an Annual Review of the state asset portfolio - This aggregate compilation by sector, including the real estate assets, similar to the Lithuanian and Latvian Annual Reviews would be published in English and available on the government’s website.⁵⁰ With the proper resources in place this annual review can be compiled and published within six months from commencement.

• Simultaneously, establishing a single and comprehensive database of all state assets - This should include real estate, enabling independent valuations of each asset, establishing relevant dividend policy, as well as overall risk management.

• Implementing a new comprehensive Transparency Policy – This should oblige the government to publish a consolidated Annual Report of all state assets, audited by an internationally recognized auditing firm. This report should consolidate the annual reports of individual state assets. Each Annual Report would therefore provide a fair picture of the development of the Portfolio and each major holding, its business activities, position and result in accordance with laws and usual practice, including description of its business, risks and risk management, major investments, R&D, the work of the board and its composition during the year, compensation to leading executives and description of the incentive program etc. such as that of Solidium in Finland.⁵¹ Subsidies directly attributable to state assets resulting from a requirement to charge non-market prices should be separately identified.

172. Reporting polices should be analogous to those of a publically listed vehicle and regular communications to the public should be issued in the form of published annual consolidated reports and quarterly portfolio reviews. The operational objectives of each corporate asset should be published in the annular report of each respective holding together with financial targets and operational goals, to ensure that the invested capital is managed to the benefit of the shareholders and within the limits of the core business.

173. The boards of the state-owned commercial assets should be made responsible for compliance with accounting and reporting standards. Larger holding or holdings of strategic importance should, in addition to current accounting legislation and generally-accepted accounting principles, also comply with international practice of listed companies.⁵² State-owned companies should also be required to submit their reports in an appropriate format to the MoF to enable consolidated reporting of the SOE sector and consolidation in public sector reports as required by international accounting standards.

174. The large state assets should be required to publish their annual reports and financial statements audited by a reputable company, in Ukrainian and in English. The ownership vehicle should also have a dedicated website in English, as well as in Ukrainian publishing its annual report and audited financial statement, as well as quarterly financial data aiming for the best international practice. This requirement should apply for all state-owned companies with annual turnover in excess of UAH 50 million.

175. To assess the potential value of state-owned real estate, a stock take should be performed and all information consolidated in a database ensuring harmonization and transparency of data. Increased transparency will allow the government to proceed with more professional management through the accurate definition of different sectors/sub-sectors of assets. Real estate information should be published in the annual report of the ownership vehicle, including periodic external valuations by independent appraisers.

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