Mission Concluding Statement 

Ukraine -- Concluding Statement of the 2003 IMF Article IV Consultation Mission

February 27, 2003

An IMF mission visited Kyiv during February 13-27, 2003 to conduct the annual Article IV consultation discussions. The mission's findings are summarized below. The mission would like to thank the authorities for their excellent cooperation and for the very constructive discussions.

1. Macroeconomic trends remained positive in 2002, on account of prudent demand management policies and favorable external conditions. Real GDP grew by about 4 percent in 2002, driven by continued strength in industry and domestic trade. Growth was supported by robust consumer spending, reflecting large wage increases, and by higher net external demand, more than offsetting the slowdown in investment growth. Unemployment appears to have declined somewhat, reaching a rate of about 10 percent in the first three quarters of 2002, based on ILO methodology.

2. Inflation remained low, partly reflecting temporary factors. End-year consumer price inflation was near zero, reflecting primarily a sharp drop in food prices, while producer price inflation was almost 6 percent. Low inflation was supported by a significant tightening of fiscal policy, rapid remonetization, and delays in increasing administered prices.

3. The balance of payments remained in surplus. The current account surplus increased, reflecting higher transfers and a sharp increase in exports during the second half of the year. Weak investment demand had a moderating impact on import growth. The capital account turned negative, due to capital flight in the form of portfolio outflows. Gross international reserves increased to 2¼ months of imports of goods and services.

4. NBU interventions kept the hryvnia constant against the U.S. dollar. The CPI-based real effective exchange rate depreciated by about 3 percent in 2002, whereas the PPI-based rate remained broadly stable. The real exchange rate appreciated in terms of unit labor costs, due to very high wage growth in Ukraine. However, the strong improvement in the trade and services balance in 2002 suggests that the margin in competitiveness, as measured by relative wage levels, remains adequate.

5. Monetary aggregates continued to grow rapidly, accommodating the strong growth in money demand, as evidenced by the large balance of payments surplus. Base and broad money grew by 34 and 41 percent respectively, driven by over US$1.7 billion in unsterilized net foreign exchange purchases by the NBU. This contributed to rapid growth in banking sector loans and deposits. In response to falling consumer price inflation, the NBU reduced the refinancing rate and lowered reserve requirements. Bank lending rates and spreads decreased, but still remained very high, reflecting weaknesses in the banking sector.

6. Financing constraints contributed to a consolidated budget surplus of ½ percent of GDP. Privatization receipts fell about 2 percent of GDP short of the budget target. Given large wage and pension increases, the central government had to implement significant cuts in non-protected discretionary spending through generalized cash rationing. There was also a small accumulation of social expenditure arrears. Revenues increased strongly, especially for local governments and the pension fund, partly reflecting high wage growth, but also more comprehensive reporting of earmarked revenues. VAT and excise revenues improved markedly, in part because of improved tax policy and administration for imports. However, the stock of VAT refund arrears increased further, to Hrv 2.9 billion (1.4 percent of GDP), and nonearmarked cash revenues of the central government were lower than budgeted.

7. Progress on structural reform remained uneven. Treasury management was strengthened by fully implementing the single treasury account. Tax administration reforms continued through the expansion of large taxpayer offices and the implementation of a modern revenue collection law. While some new tax privileges were introduced in 2002, some other privileges were recently eliminated, including tax breaks for metallurgical companies and free economic zones. Unfunded social mandates were reinstated at the beginning of 2002, undermining the financial position of communal enterprises, although eligibility criteria for recently tightened. The pace of privatization slowed down considerably. Cash collections in the energy sector reportedly increased to 85-90 percent, but the sector accounted for most of the increase in tax arrears in 2002.

II. Macroeconomic Outlook

8. Prudent macroeconomic policies and an acceleration of structural reforms are required to sustain economic growth in 2003 and 2004. The mission's baseline scenario projects average real GDP growth of 4 percent (Table 1), assuming a small primary surplus of the consolidated budget, prudent monetary policy, and an acceleration of structural reform. Higher growth would be possible if the business environment improved or export demand exceeded expectations. By contrast, lack of reform progress or a relaxation of fiscal and monetary policies could lead to inflationary pressures and a further slowdown in GDP growth. In the baseline, consumer price inflation is expected to rebound to 5-6 percent in 2003, reflecting the reversal of temporary factors in 2002, although the projection may change once tariff policies are determined. Higher investment and import demand is projected to lead to a gradual reduction in the current account surplus in 2003, while the capital account is assumed to strengthen as portfolio outflows subside and FDI increases. The overall balance of payments position should allow an increase in the NBU's gross international reserves to 2¾ months of imports by end-2004.

9. Notwithstanding recent macroeconomic trends, significant uncertainties and vulnerabilities remain. In case of a slower pace of structural reform and a somewhat looser fiscal stance (illustrated in the low case scenario in Figure 1), investment would be constrained, debt service costs would increase, and capital outflows would reduce the scope for remonetization and an accumulation of international reserves. As a result, GDP growth would be lower and the public debt-to-GDP ratio would increase rather than decline, as in the baseline. Sensitivity analysis performed by the mission shows that the fiscal position is vulnerable to economic shocks, such as a sudden depreciation, in the low case scenario. Moreover, liquidity problems could emerge in case the balance of payments deteriorates or domestic confidence is lost, which could trigger a flight into foreign currency. A delay in the global recovery and the persistence of external uncertainties could negatively affect foreign trade and the prospects for the planned issuance of Eurobonds.

10. The recent pace of structural reform has been insufficient to support sustained long-term economic growth. The investment climate is constrained by a distorted tax system, an underdeveloped banking sector, quasi-fiscal deficits in the energy sector, and serious problems with governance, transparency, and the rule of law. With an acceleration of structural reform, medium-term real GDP growth could average about 4 percent, taking into account a possible decline in employment caused by demographic trends. A higher long-term growth target would require very drastic improvements in the investment climate.

III. Macroeconomic Policies for 2003 and 2004

11. The 2003 budget relaxes the ex-post tight fiscal stance of 2002. To support the authorities' growth and inflation objectives, the mission would recommend to target a small primary surplus of the consolidated budget, which could be secured by adjusting the policies of extrabudgetary funds to ensure their financial balance. The macroeconomic assumptions underlying the 2003 budget are more conservative than last year, which may reduce the risk of repeating last year's expenditure sequestration. However, there are still risks of shortfalls on privatization receipts and central government revenue. To support the authorities' macroeconomic objectives over the medium term, the mission would encourage the authorities to maintain a small primary surplus in 2004.

12. The large public spending increase in 2003 may constrain the scope for fiscal reforms. The 2003 budget implies an increase of expenditures of the consolidated budget by about 2 percent of GDP, primarily driven by large wage increases. This may create rigidities that could constrain the scope for tax and expenditure reforms. In addition, the recently approved minimum wage law, currently not fully provided for in the budget, directly affects public sector wage scales and could raise the annual wage bill by as much as 3 percent of GDP between 2002 and 2004. The mission would advise the authorities to restrain as much as possible the increase in the wage bill in 2003 and link future wage increases to public sector reforms.

13. Given the projected fiscal expansion and the likely reversal of several temporary factors, a tightening of monetary policy will be required to maintain low inflation in 2003 and 2004. In order to allow for the continued accumulation of international reserves, net domestic credit of the NBU will need to be restrained. The objective of lowering interest rates and lengthening loan maturities should be pursued through structural reform aimed at strengthening creditor rights and the banking sector, rather than through the proposed extension of long-term financing from the NBU to commercial banks.

14. The mission believes that the primary objective of monetary policy should be low inflation. To this end, it will be important to ensure central bank independence and make the objective of monetary policy transparent. The mission also believes the NBU should allow for greater exchange rate flexibility to absorb shifts in the balance of payments and money demand. This would also help reduce the risks associated with the perception of a fixed exchange rate regime, which can lead to imprudent lending practices. Interventions in the foreign exchange market should be guided primarily by the NBU's target for net international reserves. Given uncertainty about money demand, the NBU should continue to monitor inflation developments carefully and be prepared to adjust monetary policy if necessary. Over the longer term, the authorities may consider moving to an explicit inflation targeting regime, but this would require further development of monetary instruments, strengthening of financial markets, and a more predictable transmission mechanism of monetary policy to inflation.

IV. Structural Reforms

15. A significant acceleration of structural reform is required to sustain economic growth. The principal goal should be an improvement in the investment climate, by increasing the transparency of public institutions, making government policy more rules-based, and reforming the legal framework. The authorities are right to focus on tax system, given that tax exemptions and privileges are a major distortion of the business environment and amounted to an estimated 30 percent of central government tax revenues in 2002. However, reforms are also urgent in the banking sector and in the energy sector. Moreover, the mission would strongly encourage the authorities to accelerate the privatization process and make it more transparent. Finally, the mission welcomes the authorities' objective to further liberalize the trade regime and achieve accession to the WTO in 2004.

16. To minimize the adverse revenue impact of tax reform, reductions in tax rates should be linked to base broadening and the substantial elimination of tax exemptions. The mission welcomes the recent amendments to the enterprise profit tax law, which have been a step in this direction. The authorities should continue to work with parliament to eliminate VAT privileges. The mission would encourage the authorities to reduce not only personal income tax rates, but also payroll taxes. Apart from base broadening and elimination of exemptions, spending cuts will be necessary to finance the envisaged rate reductions, in order to prevent a widening of the budget deficit, especially given the proposed sharp reduction in income tax rates. To provide a more stable tax environment, the mission would recommend to enhance the accountability of the state tax and customs administrations and to eliminate the stock of VAT refund arrears, which would be an important signal to reinforce the rule of law.

17. The mission would encourage the authorities to press ahead with the introduction of targeted social transfers and with pension reform. The mission urges the authorities to replace unfunded social privileges with income-linked cash transfers. In order to ensure the sustainability of the pension system, the authorities should implement the first phase of pension reforms aimed at strengthening the pay-as-you-go mechanism.

18. The mission urges the authorities to implement the key recommendations of the 2002 FSAP missions. Very rapid credit growth, including foreign-currency denominated loans, has contributed to increased credit risk and reduced capitalization in the banking sector. In the current favorable macroeconomic environment, this has so far not translated into financial distress, but the mission would strongly recommend a tightening of prudential regulations, including by raising the capital adequacy ratio, and their enforcement to guard against risks that could emerge in case of an economic downturn. The authorities should also make progress on strengthening the financial positions of the Savings Bank and Ukreximbank. The mission would caution against the proposal to set up a new state-owned development bank, given poor experience in other countries.

19. The mission estimates that the operational deficit in the energy sector was about 2-3 percent of GDP in 2002. The quasi-fiscal deficit would be considerably higher if investment needs were taken into account. Despite the reported improvement in cash collections in the electricity and gas sectors, tax and suppliers arrears increased, pointing to inadequate tariff levels and/or poor governance. The mission estimates that the stock of debt of state-owned energy monopolies amounts to at least 13 percent of GDP. In order to create the conditions for sector restructuring and privatization, the mission would encourage the authorities to make progress on settling these debts. To control the flow of new debts, the authorities would need to raise the transparency of the major state-owned energy companies.

20. The mission commends the authorities for becoming a member of the SDDS, though many data challenges remain. The coverage of private sector short-term external debt and of the balance of payments could be improved. The mission estimates that GDP is significantly underestimated, primarily on account of the shadow economy. The mission would encourage the authorities to follow up on the findings of the recent data ROSC and participate in a fiscal transparency ROSC. In particular, it the mission would recommend to develop a more comprehensive measure of public debt, to encompass state-owned enterprises.