Ukraine: Request for Stand-by Arrangement and Cancellation of Arrangement Under the Extended Fund Facility—Press Release; Staff Report; and Statement by the Executive Director for Ukraine
Author: International Monetary Fund. European Dept.
Publication Date:
08 Jan 2019
eISBN:
9781484392676
ISBN:
9781484392676
Language:
English
Keywords:
ISCR; CR; heating tariff; macro-economic stability; prudent fiscal policy; regime; capital market; inflation targeting; foreign exchange; balance of payments; banking system; Exchange rates
Download PDF (3.2 MB)

Request for Stand-By Arrangement and Cancellation of Arrangement Under the Extended Fund Facility-Press Release; Staff Report; and Statement by the Executive Director for Ukraine

Abstract

Request for Stand-By Arrangement and Cancellation of Arrangement Under the Extended Fund Facility-Press Release; Staff Report; and Statement by the Executive Director for Ukraine

Introduction

1. The Ukrainian authorities have been able to restore macro-economic stability and growth following the severe economic crisis of 2014–15, with strong support also from the international community. The economy was hit hard by the conflict in the eastern part of the country and the ensuing disruption in trade and production and loss of confidence. In the midst of a deep recession and a sharp exchange rate depreciation, banks came under severe strains, public debt moved to an unsustainable path, and international reserves dropped to critically low levels. Much has been achieved since then, owing to the authorities’ efforts, supported by an arrangement under the Extended Fund Facility (EFF) approved in 2015 (see Box 1), including prudent fiscal and monetary policies and a shift to a flexible exchange rate regime, which sharply reduced fiscal and current account deficits. Reserves have been partly rebuilt and confidence has strengthened.

2. However, with some notable exceptions, efforts to create a more dynamic, open, and competitive economy have fallen short of expectations. Beyond macro stabilization, the EFF arrangement was also designed to help Ukraine transform its economy—a key objective of the authorities after the Maydan revolution. Despite some initial success in advancing energy and banking sector reforms, and setting up anticorruption institutions, reforms increasingly faced resistance (e.g., anticorruption efforts, restructuring and privatization of state-owned enterprises (SOEs), land reform), causing delays in the completion of reviews. Only three reviews were completed under the EFF arrangement, instead of the originally planned 15. With the EFF arrangement set to expire in March 2019, insufficient time remained to fulfill the objectives of the arrangement.

3. The economy continues to face important challenges. Growth is still too low to recover the incomes lost during the crisis and for incomes to catch up to levels seen in regional peers. The business environment is still weak, discouraging investment, the banking system has yet to address the burden of legacy non-performing loans (NPLs), and external financing conditions have become tighter and more volatile. Importantly, disappointed with domestic economic conditions, outward migration has increased significantly, with an estimated 2–3 million Ukrainians working abroad.

4. Valuing the role of a Fund-supported program in anchoring economic policies, the authorities request a new Stand-By Arrangement (SBA) to succeed the EFF arrangement. The authorities believe that a new program can play a crucial role in anchoring policies during the upcoming election period and until a new government is expected to be formed by end-2019 (presidential elections will be held in March 2019 and parliamentary elections in October 2019), by preserving recent economic gains against an unsettled external environment. A new program would help cover Ukraine’s balance of payments needs by bolstering confidence and unlocking external financing and supporting the needed adjustment. The program will focus primarily on maintaining economic and financial stability and advancing reforms that are within the authorities’ capacity. The authorities have already implemented some key actions to set the program off to a good start, including adopting a sound 2019 budget, raising gas and heating tariffs, and adopting legislation to improve governance in state-owned banks.

Progress Under the EFF Arrangement

Prudent economic policies resulted in a dramatic reduction in the country’s external and internal imbalances and a return to economic growth. Notably, the adoption of a flexible exchange rate regime, strict income policies, and an impressive fiscal consolidation led to a sharp reduction in Ukraine’s twin deficits. The current account deficit fell sharply from over 9 percent of GDP in 2013 to 2 percent of GDP in 2017. The overall fiscal deficit—including the energy sector’s quasi-fiscal deficit—which had swelled to 10 percent of GDP in 2014, declined to just above 2 percent of GDP in 2017, supported by bold increases in energy tariffs in 2015 and 2016. Notwithstanding a deeper recession in 2015, as the conflict in the east took a larger than expected toll on economic activity, with stronger policies confidence was gradually restored and the economy started to grow again in 2016. On the back of strong fiscal discipline and tight monetary policies, a more stable economic environment, as well as a debt operation with private creditors, public debt declined from its peak of 85 percent of GDP in 2014 to below 70 percent by the end of 2018. However, international reserves remained significantly below projections, reflecting slower than expected official disbursements, while inflation has been above targets.

These broadly positive results mask some continuing deep underlying challenges. After initial progress, delays in reform implementation led to frequent program interruptions. While the first review under the EFF was completed broadly on time, the second review was delayed by 9 months, mainly related to a drawn-out approval process of the 2016 budget, political tensions culminating in a change in government in April 2016, and delays in appointing NABU management. The third review was completed two years after the program started, following delays in adopting an automatic gas tariff adjustment mechanism, resolving a systemically large but insolvent bank, and implementing asset declaration requirements for high-level officials. Programs of other institutions suffered from similar delays in the implementation of policy commitments.

Overall, progress in structural reforms has been uneven. Initially, impressive progress was made in strengthening the independence and governance of the NBU and cleaning up the banking system, with many insolvent banks resolved and weaker, but solvent, banks recapitalized. In the energy sector, gas and heating tariffs were brought closer to market levels with bold increases in 2015 and 2016—also reducing opportunities for corruption—but soon after, the authorities suspended the implementation of the automatic formula once international prices started to rise again, opening a gap with import-parity prices, despite a generous utility subsidy system that supports vulnerable households. Progress on structural fiscal reforms was more contentious, with the authorities favoring deep tax cuts, while delaying the implementation of pension reform until the fall of 2017 and revenue administration reform has yet to start in earnest. Following pressure from civil society and with international support, new independent institutions were set up to tackle corruption, with the establishment of the National Anticorruption Bureau of Ukraine (NABU) and a Special Anticorruption Prosecutor’s Office (SAPO), and recently the approval of legislation to set up an anticorruption court. However, no cases of high-level corruption have so far been adjudicated, deepening the public perception that not much has effectively changed. Also, although a new legal framework was adopted to facilitate privatization and numerous regulations were streamlined, ensuring property rights and the rule of law, improving the business environment, and the restructuring of the large and inefficient public sector—including through privatization—have remained incomplete. Importantly, the opening up of markets, including by creating a competitive gas market and a market for agricultural land, have also yet to happen.

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Sources: Ukrainian authorities, IMF staff calculations.

Program Objectives and Financing

5. The authorities request a new 14-month SBA in the amount of SDR 2.8 billion (about US$3.9 billion, 139 percent of quota) to succeed the EFF arrangement, which will be cancelled. Policies under the program will focus primarily on maintaining economic and financial stability. Specifically, policies will aim at: (i) continuing the ongoing fiscal consolidation to keep public debt on a steady downward path; (ii) further reducing inflation to within the central bank’s 5±1 percent target range, while maintaining a flexible exchange rate regime; (iii) strengthening the banking system, promoting asset recovery, and reviving bank lending; and (iv) advancing a limited set of structural reforms, particularly to improve tax administration and governance. The attached Letter of Intent (LOI) and Memorandum of Economic and Financial Policies (MEFP) set out the authorities’ detailed policy commitments.

6. With the policy mix committed under the SBA and prospective financing, including from other IFIs and capital markets, Ukraine should be able to meet its sizable financing needs. Access, both in terms of annual purchases and outstanding credit, would remain below exceptional access thresholds, and would help to maintain reserves at a level equivalent to three months of imports. Despite sizable foreign exchange purchases by the National Bank of Ukraine (NBU) so far in 2018 and targeted also for 2019, reserves will remain well below the level equivalent to 100 percent of the composite metric that had been targeted under the EFF arrangement, also impacting the pace of the removal of remaining restrictions and capital flow measures (see paragraphs 24 and 43). Firm financing commitments are in place for the duration of the arrangement to support the authorities’ reform efforts. This includes the European Union’s new Macro Financial Assistance program (€1 billion) and a new World Bank Policy-Based Guarantee that will enable the authorities to raise US$1 billion. Strong program implementation will also help unlock additional capital market financing in 2019. Despite the increased volatility in financial markets, Ukraine recently raised US$2 billion in capital market financing.

Ukraine: Program Financing

(US$ billion)

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The World Bank will provide a guarantee (PBG) of USD750mn in 2019.

7. The authorities are committed to continuing efforts to resolve the outstanding official arrears consistent with the requirements of the policy on lending into arrears to official bilateral creditors. A lawsuit filed by Russia in the UK courts is ongoing.1 Staff’s assessment is that the Ukrainian authorities have continued to pursue good-faith efforts. In terms of process, they have offered to meet with the Russian authorities in the context of a substantive dialogue to reach an out-of-court agreement on the restructuring of the US$3 billion bond. The terms offered by the Ukrainian authorities are in line with the financing and debt objectives set at the time of the restructuring, which are an important assumption underpinning the present program. The terms offered to Russia are proportionate to the contributions made by other official bilateral creditors at the time of the restructuring. Furthermore, for the reasons outlined in Box 4 of IMF Country Report No.16/319, a decision to provide financing despite the arrears is not expected to have an undue negative effect on the Fund’s ability to mobilize official financing packages in future cases. Moreover, prompt financial support from the Fund is considered essential for Ukraine to maintain an adequate level of reserves, while it pursues appropriate policies and undertakes reforms to support its economy and address balance of payments needs. Thus, in staff’s view, the conditions have been met for the Fund to proceed with providing financial support to Ukraine.

8. The program’s success hinges crucially on three key assumptions: (i) the full and timely implementation of policies under the program; (ii) timely external financing from the official sector and continued capital market access; and (iii) the non-intensification of the conflict in the eastern part of Ukraine. These assumptions are incorporated in, and are critical for, the program.

Macroeconomic Outlook and Risks

9. The current economic recovery is expected to continue. Growth reached 2.5 percent in 2017 and is expected to reach 3.3 percent this year, on the back of strong domestic demand. The latter, together with some moderate real exchange rate appreciation, also contributed to a pick-up in imports and a widening of the current account deficit to 3.3 percent of GDP this year. Reacting to the sharp hike in policy rates, inflation has been slowly declining this year, after having peaked at 16.5 percent in September 2017 following large wage and pension increases and food price shocks. Inflation is expected to reach 10 percent by the end of 2018, due inter alia to higher energy prices (including higher gas and heating tariffs) (Tables 1–6).

Table 1.

Ukraine: Selected Economic and Social Indicators, 2017–2023

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

Data based on SNA 2008, exclude Crimea and Sevastopol.

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

Table 2a.

Ukraine: General Government Finances, 2017–2023 1/

(Billions of Ukrainian hryvnia)

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

National methodology, cash basis.

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

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

Advanced pension payments and part of the NBU profit transfer are considered one-off operations.

Table 2b.

Ukraine: General Government Finances, 2017–2023 1/

(Percent of GDP)

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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.

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

Advanced pension payments and part of the NBU profit transfer are considered one-off operations.

Table 3.

Ukraine: Balance of Payments, 2017–2023 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.

Official capital transfers are reported below the line.

Includes banks’ debt for equity operations.

Table 4.

Ukraine: Gross External Financing Requirements, 2017–2023

(Billions of U.S. dollars)

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

Reflects changes in banks’, corporates’, and households’ gross foreign assets as well as currency

The IMF composite measure is calculated as a weighted sum of short-term debt, other portfolio and investment liabilities, broad money, and exports. Official reserves are recommended to be in the range of

Table 5.

Ukraine: Monetary Accounts, 2017–2023

(Billions of Ukrainian hryvnia, unless otherwise noted)

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

Includes purchases of Naftogaz and PrivatBank recapitalization bonds and DGF financing.

Includes claims for recapitalization of banks.

Includes regular liquidity provision operations in the forecast period.

Deflated by CPI (eop), at current exchange rates, year-on-year percent change.