Ukraine-2004 IMF Article IV Consultation -- Preliminary Conclusions
August 3, 2004
An IMF mission visited Kyiv during July 19-August 3, 2004 to conduct the 2004 Article IV consultation and review of the precautionary stand-by arrangement. The mission would like to thank the authorities for their cooperation and for the constructive discussions. These are the mission's preliminary findings and policy recommendations.
I. Developments in 2003-04
1. Six years after the 1998 financial crisis, Ukraine continues to recover strongly. In 2003 real GDP grew by 9.4 percent, despite a poor harvest (Table). Through June 2004, GDP increased by 12.7 percent on an annual basis.1 Growth in 2003-04 has been prompted by favorable external demand, a competitive cost structure, and dynamic domestic demand. Rapid growth in China has produced a remarkable increase in the price of Ukraine's steel exports, while continued growth in Russia has benefited Ukraine's machinery exports. Export growth has averaged 25 percent (year-on-year) since end-2002, yielding a sizeable current account surplus. Exporters' profits have helped fuel an investment and construction boom, which in turn has boosted manufacturing through increased demand for machinery. In addition, a sharp increase in credit to the private sector and rising disposable incomes have supported domestic demand. Despite the strong growth, unemployment remains high at about 9 percent, according to International Labor Organization's definitions.
2. Inflation has remained moderate, but strong upward pressures are emerging. From a low of -0.6 percent in December 2002, the 12-month CPI rate climbed to 8.2 percent in December 2003 and declined very modestly to 8 percent in June 2004. Much of the increase in 2003 reflected supply-side factors-the impact of a poor harvest on food prices-which have dissipated this year. PPI inflation has increased sharply, reaching 22.2 percent in June 2004. Much of the PPI increase reflects higher world prices for energy and metals; excluding these items, the "core" PPI inflation rate would be 11.2 percent. Wages continue to grow strongly. As of end-June 2004, the average nominal monthly wage for the entire economy was 26 percent above its level the previous year.
3. Fiscal policy has remained prudent during 2003 and the first half of 2004. The consolidated government ran a small deficit of 0.7 percent of GDP in 2003. Through end-June this year the authorities achieved a cash deficit of about 0.2 percent of (annual) GDP versus an end-June adjusted program deficit ceiling of 0.9 percent of GDP. However, the outturn reflects the non-payment of VAT refund arrears; including these, the adjusted deficit would have been 1 percent of GDP. Moreover, revenues were significantly lagging behind the GDP overperformance, suggesting continued problems in tax administration.
4. Given continued remonetization, strong money growth has been consistent with single-digit inflation. To maintain the de facto peg to the US dollar, the NBU intervened heavily in the foreign exchange market, but the large build-up of government deposits helped contain base money growth. Starting in May, the NBU has taken steps to tighten monetary policy by (i) issuing certificates of deposits (although in low volumes); (ii) raising the discount rate by 50 basis points to 7.5 percent (although still negative in real terms); (iii) increasing its overnight lending rates to 10.5 percent for collateralized loans and 12 percent for unsecured loans; (iv) excluding the use of cash-in-vault for reserve requirements; (v) tightening conditions for access to NBU loans; and (vi) introducing, and subsequently increasing, banks' daily balances required to meet reserve requirements.
5. Competitiveness remains strong. In the 12 months to end-June 2004, the real effective exchange rate depreciated by about 5 percent, reflecting mainly Ukraine's lower inflation vis-à-vis Russia, together with the strengthening Euro. The sustained current account surpluses and low wages provide evidence that the exchange rate is undervalued.
6. Despite the NBU's ongoing steps to strengthen prudential regulation and banking supervision, credit expansion and credit quality remain a concern. Following a few years of rapid growth, credit to GDP ratio now stands at 29.5 percent compared to 12.4 percent in 2000. Even though credit expansion decelerated somewhat since the beginning of the year, loans to the economy have increased over time to about 66 percent of total bank assets-higher than in most other transition economies-owing to the dearth of investment opportunities. The NBU has responded by improving the regulatory and supervisory framework-by increasing the minimum capital adequacy ratio, tightening the definition of capital and facilitating the issuance of new capital, tightening related-party lending, introducing a real time monitoring system for interbank activities, and enhancing risk assessment practices. Notwithstanding these recently adopted measures, the banking system remains susceptible to credit risk. Banks risk management capacities differ widely; weak accounting and reporting standards for corporates inhibit proper risk assessments; and institutional weaknesses impact seizure of collateral and enforcement of contracts. Moreover, a large share of loans (37.4 percent), even though slowly declining, is still denominated in foreign currency and relatively high, but also falling, non-performing loans continue to burden the banking system. Non-performing loans classified by past due criteria are currently estimated at 8 percent of total loans, while about 19 percent are classified as substandard, but serviced timely. The decrease in the ratio of regulatory capital to risk- weighted assets has reversed since early 2004 and stood at 15.2 percent at end-June.
7. There has been progress on the structural reform agenda, but tax administration remains a concern. The prudential regulation and supervisory framework has been strengthened, income taxes have been cut (and tax bases broadened), the pension system reformed, and collection ratios in the energy sector have improved. However, in the tax administration area, VAT refund arrears have increased in the first half of 2004 by Hrv 1.6 billion (or 0.5 percent of GDP). Gross VAT collections have also sagged. In response, a program has been launched to overhaul VAT administration, and expand the eligibility of VAT arrears for securitization (with existing limits maintained). Management of the STA was replaced.
II. Macroeconomic Outlook
8. Economic growth in 2004 will be much stronger than anticipated. Reflecting exceptionally buoyant exports, economic activity this year may reach 12½ percent. With appropriate policies, a slightly higher-than-expected CPI inflation-7 percent-can still be achieved. However, depending on the implementation of the amended budget, including in particular the extent of spending of privatization receipts, and the steps that the NBU adopts to counter the fiscal impulse, inflation could be significantly higher and would spill-over into 2005. The current account surplus is projected at 10 percent of GDP, although it is undoubtedly overstated in light of the large negative errors and omissions. This will result in a sharp accumulation of foreign exchange reserves.
9. With appropriate financial and structural policies, Ukraine's medium-term outlook remains favorable. Although recent growth rates are unlikely to be sustained, solid non-inflationary economic expansion could continue with appropriate financial policies and substantial structural reforms, which could improve the business environment and income distribution. In this scenario, real per capita growth could average about 5 percent, while CPI inflation will gradually stabilize to low single digits. Sustained strong investment growth, financed to a larger extent by FDI, however, is required to upgrade Ukraine's productive capacity and will absorb an increasing share of domestic savings. Further expansion of the financial sector may contribute to finance higher consumption while rising incomes and convergence of the exchange rate toward its equilibrium level are expected to raise the propensity to import. As a result, the current account surplus will gradually shrink.
10. Against this background of strong economic performance, the economy faces numerous vulnerabilities. In the short run, the main risk is that expansionary financial policies contribute to inflationary pressures, in an economy that is already showing signs of overheating in some sectors. Also a sudden stop in economic growth-including as a result of a weakening in Ukraine's main trading partners' demand-would have a negative impact on the banking system. In the longer term, the main risk is that structural reforms may not proceed fast and deep enough to support economic growth.
III. Macroeconomic Policies for 2004 and 2005
11. There is considerable uncertainty on the stance of fiscal policy for 2004, since the Cabinet of Ministers intends to return to parliament in September with additional spending requests, and since the outlook for VAT revenues is clouded by recent tax administration developments. The authorities have indicated that they expect the deficit not to exceed 3 percent of GDP. Assuming the government spends all privatization proceeds, and clears all VAT refund arrears (but cannot improve gross collections markedly), the consolidate budget deficit would be considerably higher. Based on alternative assumptions, namely (i) not all privatization proceeds will be spent, (ii) not all VAT refund arrears will be repaid in full, and (iii) not all capital spending will be implemented due to technical constraints, the mission estimates that the consolidated budget deficit would reach about 4 percent of GDP in 2004.
12. The loosening of the fiscal policy, even if the deficit is limited to 3 percent of GDP, is inappropriate. First, the increase in the deficit would occur at a time when the economy is booming. Increased resources should be saved to allow for future counter-cyclical fiscal policy. Second, additional fiscal expansion exacerbates inflationary pressures. Third, the substantial amount of extra spending, much of which could turn out to be recurrent, could undermine plans for the 2005 budget. Reaching the government's fiscal target for 2005 (1 percent of GDP), as well as implementing the reduction in the VAT rate (from 20 to 17 percent) may require substantial nominal spending cuts. This would run counter to the expansion of spending programs envisioned in the government's 2005 budget resolution.
13. Against this backdrop, the mission recommends the following fiscal stance for 2004-5. For 2004, the mission recommends that the authorities implement no more than Hrv 3.6 billion (or 1.1 percent of GDP) of the Hrv 8 billion (or 2.4 percent of GDP) envisaged under the amended budget, and that none of the excess privatization proceeds be spent. This would leave the fiscal stance unchanged relative to the program (at a 1.8 percent of GDP consolidated general government deficit) and would allow full repayment of VAT refund arrears. It is worth noting that, given the first-half outturn, implementation of the original budget involves a sizeable fiscal expansion in the second-half of 2004. For 2005, the mission views the government's budget resolution, recently approved by parliament, as reasonable, and notes that the central government deficit ceiling of 1 percent of GDP would be consistent with a consolidated budget deficit of about 1.6 percent of GDP. This keeps the public debt ratio on a slightly downward trend. The spending restraint in 2004-5 would also provide a source of funding for future fiscal structural reforms.
14. A change in exchange rate and monetary policy is needed to safeguard the inflation objective. Buoyant foreign exchange inflows and bank credit, reversed dollarization, and a looser fiscal policy pose risks to the achievement of the inflation target this year. While the current exchange rate regime has served the authorities well, the de facto peg to the US dollar exacerbates these challenges, including by providing an implicit exchange rate guarantee with attendant risks for the stability of the financial sector. Moreover, the need for further sharp increases in official international reserves is no longer necessary. First-best policy response is to switch to a more flexible exchange rate regime now in the run-up to an inflation targeting framework. Given currently strong market conditions, exchange rate flexibility would mean allowing the currency to appreciate, which would counteract inflationary pressures and excessive credit growth.
15. The objective of monetary policy should be price stability. The role of interest rate policy will depend on the extent to which the authorities are willing to let the exchange rate appreciate. Maintaining the peg to the US dollar would require tighter monetary policy, including higher interest rates, to achieve the inflation objective in the face of rapid growth in monetary aggregates, a loosening fiscal stance and further reserve accumulation.
IV. Structural Reforms
16. Careful budget management will be needed to generate resources for key fiscal structural reforms. The mission took note of plans to reform communal services and the civil service, and also sees a pressing need to improve the provision of education and health care. Funding these initiatives will require substantial resources-about 13 percent of GDP for the first two alone-and the mission encourages maintaining and further developing a medium-term budget framework (called for in the budget systems law), to assist in expenditure reprioritization. It will also be important, however, to maintain the present revenue ratio. In this context, needed tax rate reductions will have to be balanced by tax base broadening, both by eliminating privileges and exemptions, and by improving the tax administration. Efforts in the latter area are particularly important in view of 2004 developments, and the mission supports the thrust of the tax administration reforms now being developed (and stands ready to comment on specifics). Resources for structural reforms can also be found by better management of state enterprises. Here, while there has been progress in reducing the energy-sector quasi-fiscal deficit, the almost 6,000 state enterprises must be subject to better monitoring and control.
17. Continuous progress in strengthening prudential banking regulation and supervision as well as the institutional environment is needed to ensure the stability of the banking system. The authorities should continue monitoring closely developments in credit growth and ensure the adequacy of banks' risk management practices. Adoption of the draft amendments to the Banking Act, which allow to identify ultimate bank owners and tighten related-party lending, is key. The mission welcomes NBU initiatives to contain risk from foreign currency loans. In addition to their implementation, the mission, in line with previous recommendations, encourages the authorities to raise the minimum capital adequacy ratio to 12 percent. Adopting tighter accounting and reporting standards for corporates would facilitate banks loan evaluations.
18. A favorable climate for the private sector is crucial to sustain growth in the medium term. Privatization has progressed and should be accelerated, but procedures must be in line with best international practices. Regrettably, this has not been the case with the last two privatizations, in which proceeds have totaled more than $1 billion. Other important measures to improve the business climate include further reducing the burden of licensing and inspection regimes at all levels of the public administration, introducing a code of conduct for public officials, improving transparency in the use of public resources while eliminating the scope for corrupt practices, strengthening the judiciary and contract enforcement, and passing the joint-stock company law.
V. The Stand-by Arrangement
19. The review cannot be completed as originally scheduled because of slippages in program implementation. Staff indicated to the authorities that the pro-cyclical amended 2004 budget is inconsistent with agreed policies under the program. Moreover, several actions in the fiscal and banking areas have not been completed as agreed under the program. Completion of the review will be pending until the government (i) provides concrete assurances that fiscal policy, including the 2005 budget, remains consistent with its undertakings under the program, and (ii) takes the actions required to observe the structural performance criteria and benchmarks.
1 Official GDP statistics may be capturing the hitherto unrecorded economy, thus overstating GDP growth.