Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Ukraine

November 11, 2005

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On November 9, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ukraine.1


After four years of strong activity, annual growth has slowed sharply, from a peak of about 12 percent in 2004, to 3 percent for January-September 2005. In part, the decline reflects a somewhat less favorable external environment—export growth has fallen from 41 percent in 2004 (in nominal terms) to about 9 percent over the first half of 2005; while import growth remained roughly unchanged from 24 percent to 23 percent respectively. However, the fall in domestic growth also reflects the impact of continuing political uncertainty on domestic investment.

Inflation has been trending upward since mid-2003. From a low of
-0.6 percent in 2002, the 12-month Consumer Price Index (CPI) reached 12.3 percent by end-2004, peaked at 14.9 percent in August 2005, and declined somewhat to 12.4 percent in October 2005. Much of the recent surge in inflation has been concentrated in select food-related items, reflecting in part the impact of higher pensions and wages on consumer demand. Prices at the wholesale level, however, have eased from the highs of last year; the Producer Price Index (PPI) reached a peak of about 25 percent toward the end of 2004, and has since fallen to 12.9 in October 2005 owing to a slowing economy. Wages continue to grow strongly. In July 2005, the average nominal monthly wage was 38 percent above its level the previous year, representing an increase of about
20 percent in real terms.

Fiscal policy in 2005 has aimed at a significant fiscal tightening, with the supplementary 2005 budget targeting a general government deficit of 2½ percent of GDP; compared to the 4½ percent of GDP realized during 2004, and the 6-7 percent of GDP implicit in the original 2005 budget. However, the budget allowed for a substantial increase in public pensions and wages, and offset this additional spending by a large increase in the tax burden, partly reflecting the closing of tax loopholes, and steep cuts in capital investment. The spending provisions have helped raise average public pensions and wages by over 50 percent (against an inflation target of just under 10 percent), with a noticeable impact on household income and consumer prices. Budget implementation in 2005 has been on track. Cash revenue through September have been buoyant, reflecting tax measures introduced in the 2005 budget, while recent data point to a significant underexecution of spending at the central government level. If maintained, it could compensate for the unbudgeted pension spending pressures that have materialized (some ¾ percent of GDP) and should put achieving the general government deficit target of 2½ percent of GDP within reach. The stock of value added tax refund arrears amounted to ½ percent of annual GDP at end-September 2005. The re-auction of the steel company Kryvorizhstal resulted in unexpectedly high net privatization revenues (after repaying the previous owners) of $4 billion (5 percent of GDP), significantly in excess of the overall budgeted privatization revenue for 2005 (1¾ percent of GDP).

Monetary conditions have remained loose. Apart from a 5 percent nominal appreciation of the hryvnia against the U.S. dollar during the first four months of the year and, more recently, a somewhat reduced presence in the interbank foreign exchange market, the NBU has continued to purchase foreign exchange rather than allow the exchange rate to appreciate. Moreover, sterilization efforts have remained limited. The largest support in absorbing liquidity has come from the government; which has issued new T-bills to buy back the higher-yield restructured securities held by the National Bank of Ukraine (NBU), and which has built up deposits by maintaining a tight fiscal stance. With continued foreign exchange inflows, there is excess liquidity in the banking system, and most interest rates are now negative in real terms. Monetary aggregates have expanded more slowly in 2005, compared to 2004, but this comes against a backdrop of decelerating money demand, as inflation has risen into double digits.

Reflecting high domestic inflation, the real exchange rate has appreciated markedly; with the real effective rate rising by about 12 percent during the 12 months to end-July 2005. However, all indicators, including cross-country wage data, suggest that price competitiveness of Ukrainian exporters remains strong.

The NBU has taken tentative steps toward greater nominal exchange rate flexibility, and has relaxed a number of foreign exchange restrictions, including Ukraine's export surrender requirements and the provision that non-residents predeposit the full amount of their auction T-bill bids. In August, the NBU allowed banks to operate on both sides (buy/sell) of the foreign exchange market within the same day, and also allowed forward operations. Together with the 1.5 percent foreign exchange transaction tax, which the draft 2006 budget envisages to halve, these restrictions were the main elements impeding development of Ukraine's foreign exchange markets and instruments. In contrast, however, the NBU has introduced a new, but likely non-binding, restriction on purchases by non-residents of government securities with original maturities of less than one year (government papers generally have original maturities that exceed one year) and a 20 percent reserve requirement on foreign currency loans with a maturity of up to 180 days from non-residents.

The banking system weathered last year's political turmoil well. However, credit expansion and credit quality are still a concern. Credit growth remained high at 44 percent in September 2005, after some deceleration in late 2004 and early 2005. Banks are refocusing their lending on household-sector loans (their share in total loans has increased from 5 percent at end-2001 to 20 percent by end-September 2005), including mortgage lending to the buoyant housing market. The non-performing loans ratio of the banking system is declining, but remains high.

Executive Board Assessment

Executive Directors noted that Ukraine made impressive economic gains during 2000-04, largely as a result of favorable external factors and prudent macroeconomic policies. However, the period since late 2004 has been a turbulent time for Ukraine, involving political uncertainties and major shifts of policy that adversely affected business confidence and investment. In tandem with less favorable external conditions—notably on the terms of trade—and slow progress on structural reforms, this turbulence led to a significant weakening in economic performance in 2005: growth slowed sharply, inflation accelerated, and the current account surplus halved. Directors welcomed the tentative signs of stabilization of the macroeconomic situation in recent months.

Directors stressed that a focused effort by the authorities to restore macroeconomic stability and implement structural reforms to complete the transition to a full-fledged market economy will be needed to unleash the economy's significant untapped potential. They considered that Ukraine's medium-term growth outlook is highly favorable, provided the right policies are put into place. Against this background, Directors welcomed the authorities' expressed commitment to fiscal discipline and their progress in implementing a sound fiscal policy in 2005, as well as their initial steps toward greater exchange rate flexibility, their commitment to market-strengthening structural reforms, and their efforts to resolve lingering uncertainty regarding property rights in Ukraine.

Directors observed that the relaxation in the fiscal stance during the run-up to the 2004 presidential elections, together with the large increases in public pensions and wages in the supplementary 2005 budget, contributed significantly to recent inflationary pressures. While this has been partly offset by targeting a reduced 2005 fiscal deficit of 2½ percent of GDP, higher spending has necessitated a significant increase in the overall tax burden, although in good part through the welcome closing of tax loopholes and improvements in taxpayer compliance. Directors commended the prudent budget implementation in 2005, noting that the authorities seem broadly on track toward achieving their 2005 general government deficit target, and encouraged the authorities to clear all legitimate VAT refund arrears.

Looking ahead, Directors underscored the need for a fiscal stance that supports disinflation. They urged the authorities to continue to resist strong pressures to raise spending, particularly on social transfers and subsidies, and the fiscal deficit in the run-up to elections in 2006. They recommended that the general government deficit not exceed 2¼ percent of GDP in 2006, underpinned by a freeze on recurrent expenditure in real terms and realistic macroeconomic assumptions. In line with this target, Directors called on the government to allocate the Kryvorizhstal privatization windfall primarily to debt redemptions that do not add to domestic liquidity, and to resist pressures to re-open the tax loopholes that were closed in the 2005 budget. Such a fiscal strategy would avoid fuelling inflationary pressures, and would increase the authorities' ability to address future contingencies as well as Ukraine's sizeable medium-term fiscal needs, including spending on public infrastructure.

Directors considered the reestablishment of a viable public pension fund to be a key medium-term priority. They noted that the recent massive pension hikes have put the pension fund in a precarious financial position, requiring large budget transfers to cover contribution shortfalls and constraining the authorities' scope for reducing the high tax burden on labor. Directors encouraged the authorities to improve the targeting of the minimum pension subsidy, raise effective retirement ages, and prune privileged pension regimes.

Directors stressed that tighter monetary conditions are needed to help contain inflation, while acknowledging both the limitations of interest rate policy given the absence of a developed monetary transmission mechanism and the need to pay attention to ongoing relative price adjustments. They urged the NBU to reduce further the excess liquidity in the banking sector through a deceleration in money growth. Directors cautioned against the NBU's tentative plans to support bank intermediation by establishing a long-term credit facility, since the NBU's main role should be to provide liquidity rather than long-term credit.

Directors broadly agreed that a gradual shift to increased exchange rate flexibility and inflation targeting would increase the NBU's ability to achieve low and stable inflation, particularly in the context of strong foreign investor interest and a competitive exchange rate. They therefore welcomed the NBU's recent steps toward a more flexible exchange rate regime. However, they stressed the need for the NBU to communicate its policies and intentions more consistently, and to ensure that the appropriate preconditions and technical capacity for a successful policy shift are in place. In this regard, they encouraged the NBU to build on its recent efforts to deregulate the foreign exchange market and further strengthen its operational framework, while developing financial markets. Directors noted Ukraine's low productivity relative to potential, and stressed that competitiveness is best enhanced through productivity-boosting reforms and prudent policies to lower inflation.

Directors saw a strong case for improving macroeconomic policy coordination, and welcomed the recent NBU initiative to reach a more formal understanding on policy coordination between the NBU and the government.

Directors welcomed the authorities' vision of sweeping structural reforms. They observed that Ukraine's lagging growth performance since 1992 relative to that of most other transition economies—even accounting for the strong growth rates of 2000-2004—in large part reflects long-standing difficulties in reaching a political consensus to build the more market-friendly institutions that would allow Ukraine to use its resources more efficiently. They stressed, in particular, the importance of reforms to strengthen public administration, fight corruption, and establish a stable and predictable business environment. In this context, Directors welcomed the Ukraine-EU Action Plan, which commits Ukraine to a wide range of structural policy actions and anchors the authorities' reform drive within the process of closer integration with the EU and global markets. They urged the authorities to launch an aggressive campaign to educate the public on the benefits of these reforms.

Directors encouraged a rapid resolution of the debate on past privatizations. The recent presidential memorandum guaranteeing property rights, the government's efforts to clearly and quickly identify those state enterprises to be privatized, the official commitment to fully comply with privatization legislation, and the transparent re-auction of the Kryvorizhstal steel mill were all seen as important steps in the right direction. Directors noted, however, that a credible legislative proposal that outlines the full scope of possible challenges to past privatizations may still be needed to address lingering investor concerns.

Directors welcomed the government's ambitious trade-policy agenda. While the liberalization achieved so far this year constitutes important and tangible progress, Directors considered that early implementation of the remaining measures needed for WTO membership should remain a priority.

Directors viewed the development of domestic capital markets as key in strengthening the monetary policy transmission mechanism and improving risk management and financial intermediation. In line with Fund and World Bank recommendations, the authorities should establish benchmarks for government securities, set up a coherent debt management strategy, and swiftly adopt a Joint Stock Company Law.

Directors noted that there are continuing fragilities in the financial sector, and encouraged the authorities to strengthen further the supervisory framework. They commended the NBU for tightening regulations, including those pertaining to foreign-currency loan-loss provisioning, open foreign currency positions, limits for related-party lending, and the definition of bank capital. They welcomed the submission to Parliament of revised legislation that would allow limits on early withdrawal of deposits during financial emergencies. However, Directors regretted the delay in amending the Banking Act, and encouraged the authorities to consider short-term measures to shore up the banking system until the new legislation is approved—including raising the minimum capital adequacy ratio to 12 percent. They also encouraged a switch from the highly procedural supervision methods to a more risk-based framework, and a strengthening of the bank resolution process.

Directors welcomed the progress in improving statistics. Although these are broadly adequate for surveillance, shortcomings remain. In particular, stock data on sectoral financial assets and liabilities need to be reconciled with flow data, especially on the external side; and the quality of labor market data, particularly on wages and employment, could be improved.

Directors welcomed the candid Ex Post Assessment (EPA) of Ukraine's longer-term program engagement with the Fund. They welcomed the EPA's findings that Fund-supported programs were quite effective in supporting macroeconomic stability, and that the continuous policy dialogue between the Fund and the authorities influenced important policy decisions and resulted in a beneficial transfer of knowledge to Ukrainian policy makers. At the same time, Directors noted that Fund-supported programs did not succeed in accelerating the pace of reform of more market-friendly institutions, which ultimately explains Ukraine's relatively poor program compliance. In light of this, they concluded that stronger program ownership, rooted in stronger political consensus, would be key to maximize the chances of success of any future program.

Ukraine: Selected Economic Indicators









(Percent change, unless indicated otherwise)

Production and prices


Nominal GDP (billions of hryvnia)







Real GDP growth







Consumer price index (period average)







Consumer price index (end of period)








(In percent of GDP)

Public finance


Consolidated government budget balance, cash basis 2/







Primary balance






















Public debt and arrears (in percent of GDP)








(Percent change, unless indicated otherwise)

Money and credit


Base money







Broad money







Credit to nongovernment







Velocity (annual GDP divided by end of period broad money)








External sector


Current account balance (in percent of GDP)







External public debt (in percent of GDP)







Debt service (in percent of exports of goods and services)







Terms of trade (annual change in percent)







Gross reserves (end of period, in months of next year's imports of goods and services)







Sources: Ukrainian authorities; and IMF staff estimates and projections.
1/ Based on policy intentions and staff's real GDP projections. Assumes that the proceeds from the re-sale of Kryvorizhstal are held in the government account with the NBU.
2/ The consolidated government budget balance includes the central government, local governments and social funds. It excludes US$ 98 million of non-cash property income paid annually by Russia in exchange for amortization of Ukraine's debt to Russia, which are included in the authorities' official figures. Paid VAT refund arrears are reflected as a reduction in total revenues in the consolidated government balance (cash basis).

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.


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