Ukraine: Second Review Under the Extended Fund Facility and Requests for Waivers of Non-Observance of Performance Criteria, Rephasing of Access and Financing Assurances Review—Press Release; Staff Report; and Statement by the Executive Director for Ukraine

The authorities have continued to make progress in implementing the program. Notwithstanding the delay in completing this review, mainly related to a difficult approval process of the 2016 budget and political tensions culminating in a change in government in April 2016, important policy measures have been taken since the last review. This includes a sizable fiscal adjustment; a successful completion of the debt operation with private bondholders; the increase in gas and heating tariffs to full cost recovery; and decisive steps to rehabilitate the banking system. However, progress in tackling corruption, privatizing state-owned enterprises (SOEs), and advancing pension reform has been slower than envisaged against significant political resistance.

Abstract

The authorities have continued to make progress in implementing the program. Notwithstanding the delay in completing this review, mainly related to a difficult approval process of the 2016 budget and political tensions culminating in a change in government in April 2016, important policy measures have been taken since the last review. This includes a sizable fiscal adjustment; a successful completion of the debt operation with private bondholders; the increase in gas and heating tariffs to full cost recovery; and decisive steps to rehabilitate the banking system. However, progress in tackling corruption, privatizing state-owned enterprises (SOEs), and advancing pension reform has been slower than envisaged against significant political resistance.

Introduction

1. Following a deep recession, macroeconomic stabilization is taking hold. While the crisis inflicted a significant cost on Ukraine—compressing incomes, straining the financial system, and setting public debt on an unsustainable path—the worst of the economic storm seems to be over. High frequency indicators point to a broadening revival of economic activity and inflation is receding. Gross reserves have doubled to over US$14 billion and bank deposits in domestic currency are on the rise. Growth is expected to reach 1.5 percent in 2016, supported by recovering consumer and investor confidence and a gradual easing of credit conditions. This economic turnaround is a major achievement for Ukraine—and one that was not fully assured at the outset of the program given the size of the shocks that had hit the economy.

2. Much of this progress reflects the authorities’ efforts under the Fund-supported program and the strong support of the international community. Amid a very challenging environment—both domestically and externally—progress has been made in correcting imbalances that were exacerbated by the crisis. The budget deficit has been drastically cut amid efforts to rebalance the tax burden. The banking sector is being repaired with the closure of weak banks and the recapitalization of remaining banks. Steps have been taken to advance deregulation and SOE reform and new institutions have been set up to improve governance. Much more remains to be done, however, to create an environment conducive to domestic and foreign investment, which is critical for achieving robust and sustainable growth. In particular, tackling corruption and reducing the influence of vested interests on policy making remain key challenges, despite recent renewed efforts following encouragement from the international community.

3. Multilateral and bilateral creditors have continued to support the authorities’ reform efforts with significant financing and technical assistance. Even though delays in reform implementation deferred some financing from 2015 to 2016, disbursements since the program approval from other multilateral and official bilateral creditors reached US$3.6 billion, and a further US$1.8 billion is expected to become available soon after completion of this review. In addition, in January 2016 the Association Agreement with the EU, including its trade component (DCFTA), entered into force, opening new trade and investment opportunities for Ukraine. However, the free trade agreement with Russia was suspended and trade and transit restrictions between the two countries have increased.

4. The completion of the debt operation with private bondholders has also been an important milestone. The debt exchange of sovereign and sovereign-guaranteed Eurobonds, launched in September 2015, provided significant debt service relief for the next four years and was a major step toward restoring debt sustainability and securing adequate financing of the program. Russia did not participate in the debt exchange and the Russia-held Eurobond, which has been recognized as an official bilateral claim by the Fund, is now in arrears. Litigation is underway in London, while in parallel the two sides have been discussing the restructuring of this bond.

5. A new government was appointed in April 2016, following the fracture of the government coalition. Political tensions arose in late 2015 and came to a head in mid-February 2016, when the government narrowly survived a no-confidence vote, but subsequently lost its majority after two smaller parties left the coalition. A new coalition was formed in March and a new government was appointed in April. The new government stressed its commitment to accelerate the pace of economic reforms. However, the two-party coalition has a slim and fragile majority in parliament, which could challenge policy making and leaves the risk of early elections.

Economic Developments and Outlook

A. Emerging from Crisis After a Sharp Adjustment of External and Internal Imbalances

6. While the 2015 recession proved more severe than initially expected, the economy has now turned the corner. Following a sharp decline in output by nearly 16 percent in the first half of 2015—on top of output losses of close to 10 percent in the second half of 2014—economic activity started to recover in the second half of the year. In particular, industrial production benefitted from improving confidence and regained competitiveness, and the deescalation of the conflict in the East, which contributed to an increase in coal and metals production. At the same time, better-than-expected output in agriculture and consumer-related sectors, such as retail trade, showed that the recovery is gradually becoming more broad-based. While these trends continued in the first half of this year, terms-of-trade shocks and the political uncertainty led to somewhat softer rebound in economic activity than initially expected (Figure 1, Table 1).

Figure 1.
Figure 1.

Ukraine: Real Sector Indicators, 2013–16

Citation: IMF Staff Country Reports 2016, 319; 10.5089/9781475543384.002.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.
Table 1.

Ukraine: Selected Economic and Social Indicators, 2015–21

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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.

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

A01ufig1

Real GDP and Industrial Production

(quarter-on-quarter percent change)

Citation: IMF Staff Country Reports 2016, 319; 10.5089/9781475543384.002.A001

Sources: State Statistics Service of Ukraine; Haver; and IMF Staff Estimates.

7. Labor market conditions have started to improve. Unemployment is estimated to have peaked at around 9.9 percent in Q1 2016 (from 7.3 percent in 2013). Real wages declined by 18½ percent in 2015, as labor cost adjustment primarily took place through wage compression, bringing wages in dollar terms to around 30 percent of their peak in 2013. With the economic turnaround, real wages have started to recover, albeit from low levels.

A01ufig2

Inflation and Core Inflation 1/

(percent)

Citation: IMF Staff Country Reports 2016, 319; 10.5089/9781475543384.002.A001

Sources: State Statistics Service of Ukraine; Haver; and IMF Staff Estimates.1/ Staff projections from 2016Q3 onwards

8. Inflation continues to decelerate sharply as one-off effects wane. After peaking at 61 percent year-on-year in April 2015, reflecting the large exchange rate depreciation and energy tariff increases, inflation has been on a steady downward path. Weak demand, a relatively stable exchange rate, and tight monetary policy brought 12-month inflation down to 7.9 percent in July 2016 (Figure 2).

Figure 2.
Figure 2.

Ukraine: Inflation and Exchange Rate Developments, 2013–16

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

Citation: IMF Staff Country Reports 2016, 319; 10.5089/9781475543384.002.A001

Sources: State Statistics Committee of Ukraine; International Centre for Policy Studies; National Bank of Ukraine; Bloomberg; http://fin.biz.ua; and IMF staff calculations.1/ Broad core excludes unprocessed food, fuel, and administrative services.2/ 12-months ahead inflation expectations. For businesses from Business Outlook Survey, conducted by the NBU. For households from GfK-Ukraine Consumer Confidence Survey.

9. The NBU’s firm control of monetary policy was instrumental to achieving these results. Targets for net domestic assets and base money were met comfortably, with the National Bank of Ukraine (NBU) absorbing banks’ excess liquidity mainly through the issuance of certificates of deposit. With inflation and inflation expectations trending down, the NBU started easing monetary policy in April 2016, after keeping rates on hold since the summer of 2015, bringing the discount rate gradually down to 15.5 percent in July 2016. In line with program commitments, key interest rates have remained positive in real terms on a forward-looking basis (Figure 5).

Figure 3.
Figure 3.

Ukraine: External Sector Developments, 2013–16

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

Citation: IMF Staff Country Reports 2016, 319; 10.5089/9781475543384.002.A001

Sources: National Bank of Ukraine; State Committee of Statistics; Bloomberg; and IMF staff estimates and calculations.1/ Includes residents’ conversion of hryvnia cash to foreign currency held outside the banking system.
Figure 4.
Figure 4.

Ukraine: Debt and Rollover of Debt, 2013–16 1/

Citation: IMF Staff Country Reports 2016, 319; 10.5089/9781475543384.002.A001

Sources: National Bank of Ukraine; Bloomberg; Ministry of Finance; and IMF staff estimates.1/ 2016 are projections.
Figure 5.
Figure 5.

Ukraine: Banking Sector Deposits and Credit, 2014–16

Citation: IMF Staff Country Reports 2016, 319; 10.5089/9781475543384.002.A001

Sources: National authorities; and IMF staff calculations.

10. The current account position improved significantly in 2015, but on the back of a severe trade contraction. The current account deficit narrowed to about 0.3 percent of GDP in 2015, from 4 percent in 2014. However, both exports and imports shrunk by about a third during the year. The decline in exports was due to a sharp fall in steel prices in the second half of the year and subdued demand from trading partners. Imports were compressed on the back of weak household demand, the currency depreciation, the import surcharge, as well as lower gas imports (Figure 3, Table 3). The introduction of the free trade agreement with the EU in January 2016 is expected to open new trade opportunities for Ukraine.1 This will be somewhat mitigated, however, by the intensification of trade restrictions between Ukraine and Russia. The impact of these restrictions on Ukraine’s trade balance is moderated by the continued reduction of trade between the two countries and the gradual reorientation of Ukraine’s exports.

Table 2.

Ukraine: General Government Finances, 2014–20 1/

(in billions of Ukrainian hryvnias)

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

National methodology, cash basis.

Domestic bonds have been adjusted to reflect discrepancy between the above-the-line and the below-the-line deficits.

Government spending on Naftogaz financing and recapitalization, including through T-bills issuance.

Includes external and domestic net disbursements, trade credits, and deposit drawdowns.

For the calculation of these balances, it is asumed that the unidentified measures are on the expenditure side

The balance in 2015 treats import duty surcharge, part of the NBU profit transfer, January 2016 pension advancement and nonpayment of pensions for working pensioners in civil service as one-off operations. The latter two factors are also part of structural balance calculations for 2016.

Table 3.

Ukraine: Balance of Payments, 2014–20 1/

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

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

Based on BPM6 starting from the EFF Second Review. Column “1st Review” is based on BPM5 accounting, but with signs comparable to BPM6.

Official capital transfers are reported below the line.

Includes banks’ debt for equity operations in 2015 and 2016.

Reflects currency swap transactions.

Mainly reflects residents’ conversion of UAH cash to FX held outside the banking system and its usage to finance informal trade.

Only reflects principal amortization. Disbursements from the World Bank, IFC, EU, EIB, EBRD, and official bilaterals are recorded below the line.

Includes clearance of Naftogaz potential arrears to Gazprom in 2017.

Includes project financing to the public and private sector. The Eurobond issuance of US$2 billion with U.S. guarantees is included above the line in portfolio investment: liabilities, debt securities, and general government.