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Memorandum of Economic PoliciesFor July 1, 1998–June 30, 2001
August 11, 1998
1. Since the government and the National Bank of Ukraine (NBU) embarked on the first economic reform program in October 1994, inflation has been reduced substantially and stabilization of the exchange rate has been achieved. Progress has also been made in structural reforms, especially in privatization, liberalization of prices, and the trade and the exchange systems. However, public finances have remained under pressure, and, as a result the stock of official debt has increased sharply and financial stability remains fragile. This, combined with the turbulence in international capital markets in recent months, has contributed to considerable financial difficulties. In addition, further structural reforms are necessary to put the economy on a sound footing and reverse the decline in domestic output and living standards of the population.
2. To address these difficulties, in close collaboration with the staff of the International Monetary Fund, the government and the NBU have adopted a comprehensive and ambitious macroeconomic and structural adjustment program for the period July 1, 1998–June 30, 2001 that aims at achieving sustained economic growth and accelerating transition to a market economy. Under this program, we intend to strengthen public finances to ensure progress in stabilization is sustainable, give priority to public administration reform to create a smaller and more efficient government, and accelerate deregulation to significantly reduce obstacles to private economic activity. Financial sector reforms, an acceleration of privatization; the restructuring of key economic sectors; and policies to improve competition and efficiency will also be important elements of our medium-term program. These reforms will be accompanied by improvements in the social safety net to provide assistance to the most vulnerable segments of the population.
Macroeconomic objectives and policies
3. After seven years of output decline, the primary goal of our medium-term strategy is to achieve sustainable economic growth. Following an expected turnaround in 1998, output is projected to grow at an annual rate of 3–5 percent in 1999–2001, driven mainly by exports and increased domestic and foreign investment. Inflation is targeted to be contained at about 10 percent in 1998 and reduced to below 8 percent per year over the medium term.
4. As economic recovery gathers momentum, the share of investment by nonbudgetary organizations in GDP is expected to increase. Measures will be taken to promote private savings, e.g., through financial sector reform, and the higher private investment will also be financed by an expected increase in foreign direct investment and private capital inflows. Government net savings also will have to increase to finance the necessary investment while maintaining a viable balance of payments. Our gross official foreign exchange reserves are targeted to increase from the equivalent of around four weeks of imports to about eight weeks by 2001. This reserve level is needed to provide us with a more comfortable cushion to maintain a broadly stable exchange rate and service our foreign obligations in a timely manner.
5. To maintain financial stability, a further reduction of the fiscal deficit is necessary. Accordingly, we have targeted a reduction in the cash deficit of the general government to the equivalent of 3.3 percent of GDP in 1998, and to about 2 percent of GDP thereafter. The underlying deficit will be much tighter in 1998–99, reflecting the elimination of arrears on wages, pensions and social benefits during that period. In order to achieve these ambitious targets, we have set an equally ambitious fiscal reform agenda. This will include a reform of the tax system, expenditure reorientation and control, improvements in the budgetary process, budget execution and tax administration, and rationalization of the social welfare system.
6. Several improvements to the tax system (including new laws on VAT and enterprise profit tax) were made in 1997 and we intend to continue this effort. During the next three years, we intend to lower the overall payroll tax rate from 49 percent in 1997 to below 38 percent, expand the tax base and improve transparency by eliminating exemptions, amending the personal income tax law, and eliminating taxes to finance the Road Fund and the Innovation Fund. A modern tax code will be introduced to define taxpayers’ rights and obligations in a transparent manner. These reforms will reduce the tax burden on private economic activity and the incentives for operating in the informal economy. Overall, tax revenue is projected to decline from 36 percent of GDP in 1998 to 33 percent in 2001.
7. Given that the tax burden needs to be reduced, the fiscal adjustment during the program period will rely heavily on rationalizing government expenditures. In addition to reducing total expenditure relative to GDP, we realize that public spending is highly skewed toward social welfare payments, subsidies, and wages, and thus needs to be reoriented. To achieve this, we have started to reduce the size of the public sector, including in the health and education sectors, and will continue this in 1999–2001. This, together with pay reforms, should allow us to reduce the budgetary wage bill despite a real increase in wages of budgetary employees. In view of the resource constraints, most subsidy programs will be scaled back or eliminated. Over the medium term, these measures, together with reform of the social protection system, will make room for expenditure on infrastructure and restructuring costs arising from, inter alia, reforms in the energy sector, a possible rise in open unemployment, and bank restructuring. The social protection system will be rationalized and streamlined to eliminate general subsidies and improve the targeting of assistance to the truly needy. In this context, we will eliminate most budgetary privileges, and review the benefits provided by the Chernobyl Fund,1 the Social Insurance Fund, and the Employment Fund,2 aiming at streamlining and rationalizing their activities. Finally, during the program period, in addition to arrears on wages, benefits, and social benefits, we intend to eliminate or restructure, in consultation with the staffs of the Fund and the World Bank, all other budgetary arrears.
8. To establish a pension system that will be financially sustainable and provides adequate social protection, we are introducing several reforms. A draft legal framework, which would improve the current system (envisaging amongst others the introduction of personal savings accounts within the mandatory system) and introduces nonstate pensions, has already been submitted to parliament. Furthermore, with the assistance of the World Bank, during 1998 we intend to further develop a more comprehensive pension reform for implementation in the future.
9. Improving fiscal transparency will be an important objective of our program. All extrabudgetary funds (except the Pension and Social Insurance Funds) will be included in the budget starting in 1999. Financial relations between the central government and the local governments will be reorganized and clearly defined during the program period to develop an efficient local government revenue base commensurate with its responsibilities. Furthermore, we will take significant steps to improve and streamline tax and customs administration and to further develop the treasury.
10. Monetary policy will continue to aim for low inflation, reducing the financing channeled to the budget, while allowing a gradual increase in banking system financing for the economy. Over the medium term, we intend to improve the efficiency of the money market operations and expand the use of indirect monetary instruments in the management of liquidity and steering interest rates. Clear financial relations will be established between the government and the NBU, including the transfer of central bank profits/losses to the budget, and NBU direct purchases of securities will be gradually reduced to short-term maturities and amounts required only for monetary policy operations. Moreover, we intend to phase out NBU purchases of treasury bills at the primary auctions as financial stabilization takes hold.
11. Maintaining a stable exchange rate of the hryvnia will be a key objective of our reform strategy and, to that end, interest rate policy will continue to be used actively throughout the program period. Nevertheless, with the reduced budget financing requirements and a return of confidence in the markets, interest rates are expected to come down significantly during the program period. A well functioning financial sector will be crucial during the next several years and, therefore, we will continue to reinforce the institutional capacity of the NBU to supervise banks while deregulating banking operations at the same time. This will require improving monitoring and regulation of banks and tightening of bank licensing. We will enact a new NBU law and a new commercial bank law that facilitates liquidation of banks. Over the medium term, we also plan to introduce a deposit insurance scheme in which only healthy banks will participate.
12. Ukraine’s current account position is expected to remain in deficit at around 3.0–3.5 percent of GDP through 2001, with both real exports and imports increasing by about 5–8 percent annually. With the expected return of confidence, capital outflows should be reversed and foreign direct investment should gradually increase. However, it is expected that large financing needs from markets will persist, although gradually declining during the program period.
13. External debt obligations in the next two–three years are large. Events in international capital markets in late 1997 and the first half of 1998, and the associated problems we experienced in obtaining external as well as domestic budget financing, have made us keenly aware of the need to pursue a prudent debt strategy and to reduce borrowing cost and exposure to short maturities. We will strive to change the composition of our external debt to lesser dependence on expensive borrowing. With international assistance, we intend to improve our debt reporting and management system, including on all foreign debt guaranteed by the government and short-term private sector borrowing. Furthermore, we will ensure that any borrowing by local governments will be consistent with the overall borrowing program.
14. In order to improve our ability to analyze and forecast economic trends, we will continue to improve the quality and transparency of macroeconomic data, expand the availability of data to the public, and strengthen our ability to interpret economic data. To achieve these objectives, we request continued technical assistance from the Fund, the World Bank and other donors.
15. While continued macroeconomic adjustment is a necessary condition for a successful transition to a market economy, the government recognizes that systemic reforms must underpin these policies. While we recognize that there are many areas that need to be addressed, we believe that the focus of our program should be on four broad areas. These are: deregulation and public administration reform, privatization and demonopolization, banking sector reform, and reforms of the agricultural and energy sectors.
16. In this context, we will consolidate the recent gains in reducing licensing requirements and simplifying business registration and inspection procedures and further eliminate unnecessary barriers. This will be combined with rationalization of the government structure, including merging different government institutions, eliminating overlapping functions, improving the intragovernmental policy coordination, and separating the regulatory and commercial functions of public entities. With the assistance of the World Bank, we will reform the civil service to increase its quality and strengthen the government’s administrative capacity.
17. To promote competition and private sector activity and accelerate the transition to a market economy, the transfer of ownership of enterprises into private hands will play a key role. We are determined to expand and continue the process of government divestiture, with a view to completing the privatization process by the end of the three-year program period, and with international assistance, we intend to sell government’s residual shares in enterprises that are not of strategic interest. Foreign investors will be encouraged to participate in our privatization program. In order to facilitate post-privatization restructuring and improve corporate governance, we will foster the development of a stock market to facilitate ownership consolidation and strengthen outsider control of enterprises, and we will continue to improve the framework of bankruptcy proceedings. Furthermore, we will remove barriers to entry and exit by demonopolizing the economy and breaking up enterprise groups whose size is not required for efficient operation. In restructuring natural monopolies, we will reinforce our efforts to separate the potentially competitive segments of these industries from those with natural monopoly characteristics.
18. The government will also maintain an open trade and payments system, thereby fostering foreign competition. Significant progress has been made in recent years in opening up the economy but, nevertheless, further liberalization of our trade regime will be an important element in our outward-oriented growth strategy. We have recently offset the tariff increases of early 1998 by reducing significantly the tariff level on a wide range of products so that the average weighted tariff (using 1996 weights and excluding energy products) remains unchanged from the January 1998 level of 7.50 percent; the average including energy products is much lower, at about 5 percent. Looking forward, on the import side, we will continue to rationalize the structure of tariffs by reducing their dispersion and the overall level of import tariffs so as to increase import competition. In this regard, we will focus on three areas, namely reducing the maximum tariff, reducing the simple arithmetic average tariff, and limiting modifications to the tariff regime. The maximum tariff rate will be lowered according to a phased plan from 30 percent to 20 percent by December 31, 2000, and the exceptions to the maximum tariff will be lowered from 1 percent to 0.5 percent of total imports (see attached matrix). The arithmetic average tariff will be lowered in incremental steps from the current level of 12.74 percent to 10 percent by December 31, 2000. Finally, in order to improve transparency and enhance confidence, the Cabinet of Ministers passed a resolution on August 3 that would limit changes to import tariffs to once every six months until end-1999. Subsequent modifications to import tariffs will be limited to once every year. The only exceptions to this frequency of modifications are commodities covered under chapters 1 to 24 of the harmonized tariffs system for which the parliament has established seasonal tariffs.
19. On the export side, we have recently introduced an advance export deposit on sunflower seeds because of concerns about shortages in the domestic market. The deposits are now remunerated at market rates and will be eliminated by December 31, 1998. Moreover, the remaining export duty on animal skins and hides will be eliminated by November 15, 1998. During the three-year program period, the government will not introduce new administrative procedures aimed at discouraging exports, and no new restrictions on exports will be introduced except for products subject to actual antidumping actions, voluntary export restraints, or international agreements. We will also continue to ensure that certification rules and procedures for imports are WTO consistent and nondiscriminatory.
20. The government intends to accelerate reforms in the agricultural sector. In agriculture, our efforts will focus, first, on speeding up land reform and farm restructuring to increase allocative efficiency, with the objective of developing an active land market over the medium term. Second, measures will be taken to accelerate restructuring of the agro-industrial sector through privatization and dismantling of monopolies in agricultural input supply, output marketing, and agro-processing. And, third, we will reduce budgetary support for the agricultural sector and eliminate interference in procurement and distribution decisions, letting market forces play a greater role, especially in the grain market.
21. In the energy sector, a number of reforms have already been initiated, aimed at commercializing the supply of energy, separating nonmonopoly elements from activities with natural monopoly characteristics, and increasing payment discipline among customers. These efforts will be intensified over the medium term, including in the context of the implementation of a Plan of Financial Rehabilitation for the Electric Energy Sector, elaborated with the World Bank and other donors. In the gas sector, we have already liberalized imports and domestic sales to commercial and industrial enterprises. We intend to further develop a competitive gas market with an appropriate regulatory framework over the medium term, starting with the auctioning of part of the gas received as transit fee. We intend to award to a consortium of Ukrainian and foreign companies, through an open and competitive tender, the management of the gas transmission system. Finally, with the assistance of the World Bank, we will continue our efforts to reform the coal sector. Budgetary subsidies for the sector will be directed to finance mine restructuring and phased out over time. In the next few years, most nonviable mines are expected to be closed.
22. Within the medium-term framework outlined above, we have designed a program for the period July 1, 1998–June 30, 1999. Key policy measures that we have implemented as prior actions, as well as other specific measures we intend to implement during the first year and beyond (including those that will constitute structural benchmarks), are shown in Table 1. Quantitative performance criteria shall apply to: net domestic assets of the NBU, net international reserves, the consolidated budget deficit, the stock of budgetary arrears on wages, pensions and social benefits, and nonconcessional external borrowing. With a view to enhancing monitoring of the program, indicative targets shall apply to nonearmarked state cash revenues, base money, and the NBU’s gross purchases of treasury bills from the primary market. A structural performance criterion shall apply to the reduction to 25 in the number of commodities subject to combined ad valorem/specific tariffs, by end-December 1998, and quantitative benchmarks will apply to the collection rate for domestic gas payments and to the reduction of the number of employees in budgetary organizations. Measures that constitute structural benchmarks are indicated in Table 1. Performance criteria for the period January 1–June 30, 1999 will be proposed, after consultation with Fund staff, at the time of the first review of the program.
Fiscal policy and reform of the social welfare system
23. Given the limited availability of nonconcessional external financing, and the significant debt repayments that are falling due in 1998, we intend to lower the fiscal deficit to Hrv 3.3 billion (3.3 percent of GDP) in 1998 and Hrv 2.2 billion (2.0 percent of GDP) in 1999. Within these targets we will reduce budgetary arrears on wages, pensions, and social benefits by Hrv 1 billion in 1998 and eliminate them by end-1999. However, if privatization receipts in 1998 exceed our program assumption, in consultation with the Fund staff, we would use these proceeds to eliminate additional arrears. In addition, we have completed a survey of all other outstanding budgetary arrears (mostly related to energy purchases), and intend to draw up a plan for their restructuring in consultation with Fund and World Bank staff. Restructuring of these obligations will be linked to sectoral reforms, and will ensure that their immediate budgetary impact is consistent with our program targets. We have already strengthened treasury operations and improved expenditure control, and, thus, we believe that we shall be able to prevent the recurrence of arrears. Taking into account the clearance of arrears on wages, pensions, and social benefits, the underlying consolidated budget deficit is targeted to narrow from about 5.2 percent in 1997 to 2.3 percent of GDP in 1998 and to 0.5 percent in 1999. A supplementary budget for 1998, which is consistent with these targets, has been put into effect by presidential decree.
24. To improve transparency of fiscal operations, several extrabudgetary funds have been eliminated or incorporated in the main budget accounts, and in 1999 we intend to incorporate all remaining extrabudgetary funds, including those at local government levels (with the exception of the Pension Fund and the Social Insurance Fund). Also, all fees and fines by ministries and agencies will be transferred to the treasury. The Leasing Fund will be privatized in 1999, and no new extrabudgetary funds will be introduced during the three year program period. Furthermore, as a large decline of cash revenue has severely constrained our ability to conduct fiscal policy, we have taken steps to increase cash revenue, particularly for the state budget. A presidential decree forbidding all budgetary netting-out operations was issued in early 1998 and the mechanism for these operations was eliminated. Moreover, part of the earmarked revenues of various funds have been unearmarked for use by the Ministry of Finance accompanied by similar reductions in associated expenditures incurred by these funds.
25. Lowering the tax burden on enterprises to stimulate economic activity, but at the same time expanding the tax base, and reducing distortions, will be important elements of our tax policy. We have already lowered the overall payroll tax rate from 49 to 44 percent, on account of a 5 percentage points reduction in the rate paid to the Chernobyl Fund. In 1999, we intend to eliminate the Chernobyl tax, reduce the tax paid to the Social Insurance Fund by 1 percentage point and eliminate all local payroll taxes. Furthermore, several tax exemptions have been eliminated (including from VAT on gas for households, local transportation, and most critical imports) and exemptions from VAT on imports of gas, electricity and coal will be abolished in the context of the 1999 budget. We will not introduce new tax exemptions, and will refrain from providing tax privileges to particular industries without consultation with the Fund staff. Excise taxes now only apply to tobacco, alcoholic beverages, petroleum, automobiles, and jewelry. At the same time, excise tax rates on tobacco, fuel and alcohol have been increased substantially, which is expected to significantly boost revenues. We also intend to enact the new personal income tax law, which lowers the top marginal tax rate from 40 percent to 30 percent, reduces the number of tax brackets from five to three and makes previously exempted professions and occupations subject to income tax. To further extend the tax base to small enterprises a new presumptive tax has been introduced.
26. Strengthening of tax administration will play a crucial role in improving revenue performance. With assistance from the staffs of the World Bank and the IMF, we will further modernize the State Tax Administration (STA) and improve the operations of the State Customs Service (SCS). Specific measures include the implementation and expansion of "Large Tax Payers Units" (LTU), reorganization of the SCS, and further development of accounting and auditing procedures. Details of these measures and their timing are provided in Table 1. By end-1998, we will seek parliamentary approval of a new Customs Code that is consistent with international standards. Finally, by December 1998, with the assistance of the World Bank, we will develop an action plan to reform intergovernmental fiscal relations, specifying amongst others, the revenue and expenditure assignments of the central and local governments.
27. To rationalize the government’s expenditure program, tariffs for communal services and transportation, have been adjusted and all subsidies to cover the difference between full and actual cost coverage have been eliminated. We will ensure that periodic adjustments will be made in the future to maintain full cost recovery. In addition, several subsidy programs for the agricultural sector have been curtailed. The government further intends to eliminate the majority of budgetary privileges and other implicit subsidies guaranteed by legislation, including on rent, communal services, sanitoria, gas, health care, and transportation. The remaining privileges will be better targeted to protect the most vulnerable groups. We have started the process of downsizing of budgetary institutions, aiming at reducing the number of public employees by 300,000 by end-1998 and a medium-term action plan for public administration reform will be developed with the assistance from the World Bank by September 1998. This will include reform programs for the health and education sectors. Specific targets for the first half of 1999 will be discussed at the time of the first review. Because we realize that implementation of our fiscal policies to a large extent will depend on the administrative capacity of the Ministry of Finance, we are in the process of designing a far reaching reorganization of the Ministry, which will be in place by end-1998. In tandem with work on public administration reform, during the first program year, the government intends to develop a plan for civil service and pay reform. Finally, budgetary allocations for the replenishment of the State Reserve Fund have been eliminated together with the state order system for agricultural products.
28. Social outlays compose a large share of expenditures and there is a need for streamlining these expenditures. In reforming the social safety net, particular emphasis will be placed on improving the targeting of assistance to the most vulnerable groups in the population. A plan for streamlining and better targeting the system of family benefits is being prepared. A new system of wage-replacement rates for sickness benefits will be introduced, which aims at reducing prolonged sick leave, and the cost of the initial two weeks of sick leave will be shifted to enterprises, with the reduction in the payroll tax rate paid to the Social Insurance Fund as of 1999. The government will reduce expenditures incurred by the Chernobyl Fund, particularly under its investment program, in tandem with the reduction in the contribution rate. We will ensure that the Employment Fund will refrain from incurring expenditure not related to its functions. In the context of the increase in communal service tariffs, to limit the cost on the budget, we have raised the eligibility criterion for the housing subsidy from 15 to 20 percent of income, except for families consisting solely of nonworking pensioners, young children, or invalids in categories I and II, whose per capita income is less than the minimum cost of living.
29. The government attaches great importance to pension system reform. While we need more time to prepare the ground for more fundamental reform, in the meantime, we have submitted draft legislation to improve the current pension system. Our proposals include scaling down preferential pensions and rationalizing pensions to working pensioners, as well as measures to encourage later retirement, and the introduction of differential pensions that are financed from personal savings accounts. In tandem with this, we have submitted draft legislation to allow nonstate pension funds. By end-1998, in cooperation with the World Bank, we intend to further develop a comprehensive reform program that would include a fully funded pension component and a gradual increase in the pension age. Starting from January 1, 1999 we will shift all nonpension related expenditures from the Pension Fund to the budget.
30. Treasury operations will be strengthened in line with the recommendations of the staffs of the Fund and the World Bank as specified in Table 1, focusing on extending coverage, centralizing all government payment accounts, and improving accounting and operating procedures. The three-month spending ceilings for spending units which we started issuing in April, should help tighten expenditure control and this system will be further refined. We will also seek parliamentary approval of the "Law on Budgetary System and Budgetary Process" in order to strengthen the legal framework for budget management, and in the context of the 1999 budget, we will significantly reduce the number of key spending units.
Monetary and exchange rate policies and banking sector reform
31. Maintaining a stable exchange rate will be an important objective of our program. At the beginning of 1998 the NBU announced an exchange rate band of Hrv 1.8–2.25 per U.S. dollar for 1998 and we stand ready to tighten monetary policy, including by the active use of interest rate policy to protect this band. We will increase interest rates if the exchange rate comes under pressure. In case of significant capital inflows, we will not resist an appreciation of the hryvnia within the band, to safeguard our gains in containing inflation. We will carefully monitor developments in the foreign exchange market and closely consult with Fund staff on exchange rate policy.
32. Because of the unfavorable situation in international capital markets and the resulting pressures on the hryvnia, our international reserves have declined sharply. One of our main objectives will be to start rebuilding these reserves in the latter part of 1998 and beyond. At the same time, we will have to allocate more resources from the NBU than we had earlier in the year envisaged to finance the budget deficit in 1998. Taking this into account, the program foresees broad money expanding by about 16 percent during the period January–December 1998. In line with this target, banking system credit to enterprises and households is projected to increase by 4 percent in real terms. With lower government borrowing in the domestic financial market in 1999, we expect substantially higher growth in real credit from the banking system, which would be considered adequate to support the recovery in economic activity without jeopardizing our stabilization objectives. At the same time, the NBU will extend credit to the budget only through purchases of government securities. The volume of direct purchases of treasury bills will gradually be reduced.
33. We will ensure that no measures are taken that would undermine the NBU’s independence and will continue to improve its capacity to formulate and execute monetary policy, which will be easier with the expected approval of a new Law on the National Bank in late 1998. The NBU will manage the liquidity of the banking system through open market operations and two standing facilities (the Lombard Facility and the Deposit Facility), so as to maintain a positive real refinance rate. Reserve requirements will be strictly enforced, and will not be changed without consultation with the Fund staff. The use of treasury bill holdings to meet reserve requirements will be phased out by October 1998. The NBU will continue to transfer profits/losses to the budget in accordance with the New Enterprise Profit Tax Law.
34. To improve the operations of the treasury bill market, we are announcing in advance a timetable of treasury bill sales; have reduced the number of auctions to two a week; and are issuing treasury bills in benchmark format. The frequency of auctions will be further reduced as of October 1998. We realize that it will be important to vigorously promote purchases of short-term maturities to attract more market participation. Furthermore, we have removed the double taxation of treasury bill earnings and intend to remove the tax on earnings altogether as well as the stamp duties on secondary market transactions. In order to normalize the relation between the government and commercial banks, government liabilities to commercial banks will be securitized subject to verification. Neither the government nor the NBU will intervene administratively in lending and investment decisions by commercial banks, and the NBU will refrain from issuing directed credits itself or reissuing existing directed credits as they are repaid.
35. As an important part of our strategy to restore public confidence in the banking system, we will further strengthen banking supervision. With the assistance of outside experts, we intend to complete a comprehensive analysis of the financial position of large banks by end-1998. The study will focus on asset quality, adequacy of provisions, liquidity positions and quality of financial statements and management. To facilitate this study, the NBU has established a "large bank department." Based on the results of the study, the unit will develop a supervisory action plan for the banks, as necessary, by end-February 1999. In addition, international standard audits of the 30 largest banks will be conducted by end-1998. Bank loan-loss provisioning was made tax-deductible in the new Enterprise Profit Tax Law adopted in 1997 and the necessary procedures to facilitate full provisioning will be put in place by October 1998. Finally, we will raise standards of information disclosure and accountability to improve governance in banks and ensure that commercial banks improve their internal clearing and liquidity management systems.
36. To facilitate bank restructuring, in consultation with the private sector, we have prepared a new "Law on Banks and Banking." We will seek parliamentary approval of this law by end-1998. In the meantime, the NBU will conclude enforcement agreements with the banks under its Bank Resolution Unit and initiate liquidation procedures for at least three insolvent banks by end–1998. The intention is to increase the number of liquidations in 1999. Compliance with the NBU’s minimum capital requirement will be enforced by removing the licenses of all banks that failed to meet the requirement of ECU 1 million.
37. We are taking a number of measures to promote competition among banks and encourage financial intermediation. First, we have eliminated restrictions on cash withdrawals by enterprises and, by end-1998, we intend to abolish the limit on the number of accounts that can be held. The kartoteka system is now only used for tax purposes. Second, we have shifted to International Accounting Standards (IAS) at the NBU and started IAS reporting by commercial banks. The conversion to IAS in commercial banks will be completed by end-December, 1998. Third, to prepare for the introduction of a viable deposit insurance scheme, a study has been conducted and a Presidential decree on the formation of a deposit insurance fund has been issued. The deposit insurance scheme will exclude banks that to do not meet certain reporting and soundness standards. Fourth, we will further reduce barriers to the entry of foreign banks by simplifying licensing procedures and lifting the limit of 15 percent on total foreign capital participation in the equity ownership of the Ukrainian banking system.
Other structural policies
38. To promote private economic activity, deregulation and administrative reform is a high priority in the government’s reform agenda. We have substantially reduced the number of business activities subject to licensing requirements, simplified business registration procedures, and significantly reduced the number of inspections of enterprises. We aim to complete a review of all normative acts related to licensing and registration by end-1998 to further liberalize the regulatory framework. The Committee for Entrepreneurial Development3 will be strengthened to accomplish these tasks. Furthermore, all fees and fines collected by government agencies will be included in the budget. To streamline government operations and improve economic management, a general strategy for public administration reform has already been adopted, and with assistance from the World Bank, we intend to work out the details for implementation starting in late 1998. Restructuring plans for the Ministry of Finance and the Ministry of Economy have been developed; as already mentioned, the Ministry of Finance will be restructured by end-1998, and implementation of the plan for the Ministry of Economy will start by January 1, 1999. On the basis of functional reviews of other ministries and committees, steps will be taken to consolidate state committees, agencies and ministries, and merging overlapping agencies.
39. With small-scale privatization virtually complete and substantial progress in voucher privatization of medium and large enterprises, the government will concentrate its efforts on (i) completing the process of government divestiture under the mass privatization program; and (ii) accelerating the case-by-case privatization for cash of large and attractive enterprises including those in telecommunications, air transportation, and the energy sector. We aim at reaching the target of privatizing 70 percent of the shares in at least 8,500 medium and large enterprises (cumulatively since the beginning of 1995) by end-September, and 9,500 by end-December 1998. It is expected that the mass privatization program will be virtually completed by end-1998. To accelerate the process of case-by-case privatization, with outside assistance we have now established clear and transparent tender procedures and before December 1, 1998, we intend to offer at least 20 of the largest enterprises for sale. A significant portion of the state-owned share in 31 electricity distribution/generation companies are being sold through tender or stock exchange auctions. The government also intends to sell the state shares in 500 joint stock companies through the stock exchange or through auctions. By September 1998, we will submit a draft law on the privatization of Ukrtelecom to parliament for consideration. At present the company is being restructured. The first phase of restructuring will be completed by end-1998. In the second phase, assuming parliament approves the draft law, the company will be corporatized by end-March 1999 and it is envisaged that the sale of shares will start by July l, 1999.
40. In order to foster corporate governance, during 1998, with the assistance of multilateral and bilateral donors, we will introduce changes to the bankruptcy methodology and court procedures, and clarifications for writing-down and writing-off debt, so as to provide a workable framework for financial restructuring and liquidation of loss-making enterprises. Two pilot projects will be completed before the end of the year to identify any remaining problems, and to work out the procedures for restructuring and writing off the arrears of insolvent enterprises. By that date, we also expect to submit to parliament a revised bankruptcy law. A functioning capital market is expected to play an important role in post-privatization ownership consolidation. With support of the World Bank, during 1998 and 1999 we intend to further improve the legislative framework for market regulation and develop the capital market infrastructure. The transfer of share registries for medium and large enterprises to independent share registrars will be completed and shareholder lists will be made available to the public. The Securities Commission will be strengthened to regulate all capital markets activities of banking institutions and depositor and clearance mechanisms will be further developed, together with regulations improving disclosure of information on new share issues and secondary share trades.
41. Privatization will be pursued in tandem with efforts to improve the competitive environment in Ukraine. The process of demonopolizing the grain sector was initiated in 1997 and will continue in 1998, including the break-up and privatization of "Bread of Ukraine." We aim at completing the privatization of 443 (all but 100) grain procurement enterprises and silos under this structure by June 30, 1999. Moreover, we will liquidate (reorganize) at least five large enterprise groups with monopolistic market power that operate on the national market by end-1998. The state order system for grain was abolished with the 1998 budget and we will ensure that all procurement in excess of Hrv 10,000 by budgetary organizations and by enterprises financed from budgetary resources or foreign credits guaranteed by the government will take place on a competitive basis. We will submit legislation to parliament by October 1998 to provide the legal basis to prevent local and regional governments from reintroducing state orders at the local and regional levels and from imposing restrictions on the movement of goods.
42. The government will reinforce its efforts to promote private activity in the agricultural sector. In addition to dismantling monopolies in the agro-industrial complex noted above, our 1998–99 program concentrates on accelerating land reform. In cooperation with the World Bank, we are actively working to improve the system of land registration. We have further introduced changes to legislation to simplify procedures for the withdrawal of land, and to authenticate joint ownership. We also intend to make every effort to adopt legislation on the use of land as collateral by end-October 1998. Leasing of land is already allowed for a period for 50 years and the lessee has the priority right to renew the lease agreement at the end of its term. Finally, with the assistance of the World Bank, by October 1998 we will develop a plan of action to restructure the sugar sector, and this plan will be implemented starting in 1999.
43. In the gas sector, we intend to work with the World Bank and other donors to establish a competitive domestic gas market. We have freed imports of gas, and prices for commercial and industrial users are now market determined. Furthermore, we have started to auction a share of the gas received as transit fee and produced domestically for cash. In 1998 we aim to auction about 6 billion cubic meters of gas and by end-1998 we will develop a plan to increase this share during the next two years. In this context, a regulatory framework to liberalize the price of gas supplied to households, budget organizations and communal services will be established by end-1998. We will separate the transmission network from production and other activities of Ukrgazprom and establish it as a joint stock company by mid-1999. To improve the financial position of gas sector enterprises, measures will be taken to accelerate gas meter installation for the budgetary organizations (with the aim to complete the process by November 1998), to install heat meters for these organizations and to raise the bill collection ratio for gas, supplied to budgetary organizations to 100 percent and to households to 80 percent. Gas companies will be allowed to enforce payments discipline by cutting off delinquent consumers and if necessary we will propose changes to legislation to achieve this. We will continue to refrain from providing any payment guarantees for gas deliveries.
44. Achieving financial viability is equally important for the electricity sector. Electricity prices have been adjusted and will be market based, ensuring full cost recovery. Throughout the program period we will implement the Plan of Financial Rehabilitation for the Electric Energy Sector, agreed with the World Bank and others, which includes measures to strengthen payments discipline and reduce expenditures. As part of the plan, a mechanism will be worked out for the settlement of past arrears of major customers and to fuel suppliers.
45. As regards the coal sector, we have already started to close down nonviable mines, with the aim of closing down at least 20 mines each year between 1998 and 2001. In 1998, 17 additional mines will be transferred to UDKR for closure and another 7 in the first half of 1999. In the meantime, we will limit total budgetary subsidies to the coal sector to the ceilings provided for under the program and ensure that budgetary funding for mine closure and restructuring will not be diverted to subsidize production. By December 31, 1998, we will terminate the provision of production subsidies to nonviable mines in category I. The government will not provide grants or loans (including guarantees) for investments in new mines, except for those approved in the 1998 budget.
46. We also intend to further improve the transparency of the trade regime. On the import side, the number of commodity positions (at the four digit level) subject to mixed specific/ad valorem import tariffs will be reduced from 217 to no more than 25, replacing the mixed tariffs by either ad valorem or specific ones. This will be a structural performance criterion for end-December 1998. Also, we have eliminated all import duty exemptions with the exception of those on imports directly related to Chernobyl programs, bilateral and multilateral technical assistance programs, humanitarian assistance, and five special foreign investment projects that had already been approved. If protection measures are necessary to prevent injury to domestic producers (of a product or a close substitute) from imports, they will be price based, precisely defined, temporary, and nondiscriminatory, and will be introduced only after appropriate procedures consistent with WTO rules (and with free trade agreements with other CIS countries) are followed, taking into account the costs to consumers and users of such protection. While the government intends to adhere to the above trade policy commitments, any changes due to unforeseen developments will be introduced only after close consultation and coordination with the Fund staff.
Balance of payments and external financing
47. Notwithstanding the resolution of our trade difficulties with Russia, trade is only slowly recovering in 1998. Moreover, lower international prices for metal and energy products should contribute to a slowdown in the growth of both exports and imports. Overall, we expect a significant deterioration in the balance of payments in 1998. The current account position is likely to deteriorate because of the large interest payments, and the capital account is affected by the continued uncertainties in international markets.
48. As a result, gross foreign exchange reserves are projected to decline significantly in 1998. However, in the program period July 1998–June 1999, we expect a return in confidence and a gradual improvement in our foreign exchange position. The program targets gross reserves at about US$1.7 million by end-June 1999. Based on our projections, Ukraine is expected to have a financing gap of about US$2.5 billion in 1998/99. This gap, while large, is expected to be financed largely by resources from the Fund, World Bank, EU, EBRD, and private capital markets. Resources from bilateral creditors for program financing are expected to be limited.
49. In recent months, Ukraine has relied heavily on short-term borrowing, some at costly rates and, as a result, the debt level and debt service obligations have increased significantly. The external debt service ratio is projected to increase from 9 percent in 1997 to 20 percent in 1998, largely on account of nonresident borrowing of treasury bills, but also on account of the issuance of external bonds. In 1999, the debt service ratio should be considerably lower. Nevertheless, in view of this, the government’s strategy is to change the composition of debt by reducing borrowing from the capital markets. This should contribute to a better maturity structure of our debt at more favorable terms. We also intend to strengthen our debt management department by merging the departments that deal with domestic and external debt management and by establishing a specialized unit to monitor local borrowing. External borrowing by subnational public entities will be strictly controlled and require explicit approval of the Ministry of Finance. We also intend to develop a debt reporting system that includes all foreign debt guaranteed by the government and the NBU and also monitor short-term private sector foreign borrowing. We have set quarterly ceilings on the amount of nonconcessional external loans contracted or guaranteed by the government and the NBU. Neither the government nor the NBU will provide guarantees on loans in any foreign currency in excess of amounts under the external borrowing ceiling. During the period of the program, neither the government nor the NBU will accumulate arrears on any external payment.
50. During the period of the program, we will not: (i) impose or intensify restrictions on payments or transfers for current international transactions; (ii) introduce multiple currency practices; (iii) conclude bilateral payments agreements that are inconsistent with Article VIII of the Fund’s Articles; or (iv) impose or intensify import restrictions for balance of payments reasons.
1Formally known as "Fund for Carrying out Measures to Eliminate the Consequences of the Chernobyl Disaster."
2Formally known as "State Fund for the Promotion of Employment of the Population."
3Formally known as "State Committee of Ukraine on Issues of Entrepreneurial Development."