Ukraine -- 2005 Article IV Consultation, Preliminary Conclusions of the IMF Mission
August 2, 2005
1. The new authorities have articulated a vision of sweeping structural reforms. Over the last 13 years, Ukraine has posted perhaps the most disappointing growth performance among transition economies unaffected by internal or external strife. It is true that output has rebounded strongly since 2000, but this turnaround started from a very low base and owed much to favorable external shocks, including booming trade and metal prices. In the past, Ukraine's lagging performance was ultimately rooted in a lack of political consensus to build the necessary institutions for Ukraine to use its resources efficiently—these institutions include secure property rights, the rule of law, and well-functioning markets. Thus, there can be little doubt that an agenda focused on far-reaching institutional reforms charts the right course forward. In fact, the Ukraine-EU Action Plan commits the authorities to a wide range of actions, anchoring the authorities' reform drive within closer integration with the EU and global markets.
2. However, achieving this vision requires a cohesive and well-communicated strategy to restore and maintain macroeconomic stability. Over the past year, the macroeconomic situation has deteriorated: inflation has surged into double digits; and real GDP growth has decelerated. Bringing inflation back into single-digits will require both a tightening of monetary conditions and fiscal discipline. And re-launching robust growth calls for tangible steps to improve the investment climate. While there has been progress on several policy fronts, there is also a widespread sense that the authorities' policies remain adrift, as illustrated by the introduction and subsequent reversal of price caps on gasoline. Thus, it will be important for the authorities to converge on a shared view on the forces driving the macroeconomic situation and the appropriate policy remedies, and communicate this shared view transparently and consistently to the public.
The Macroeconomic Situation
3. Since 2004, inflation pressures have mounted while real growth has slowed:
- Annual CPI inflation has been on an upward trend since early-2003, and is currently approaching 15 percent. These rising inflation pressures reflect increasingly tight capacity constraints and a complex mix of shocks: large terms of trade gains that boosted export revenues and disposable incomes; supply-side disturbances to Ukraine's rigid food markets; and massive hikes in public wages and pensions. At the same time, the impact and persistence of these shocks on inflation has been enhanced by a monetary policy framework that tends to transmit exchange rate market pressures directly into changes in monetary conditions.
- Real growth has eased from the remarkable, but unsustainable, rate of 12 percent in 2004 to 4 percent in the first half of 2005. Cutbacks in public investment together with continuing uncertainty about policy intentions have caused a substantial fall in investment demand, and the contribution of net exports has also declined.
4. Despite some NBU efforts to tighten policy, monetary conditions are loose. The NBU has continued to accumulate significant net international reserves, owing to a large current account surplus, and, more recently, capital inflows attracted by appreciation expectations. There have been some efforts to sterilize these inflows—through liquidity-absorption operations; tighter reserve requirements; and the early repayment of restructured government securities held by the NBU. Moreover, in April the NBU has taken the first steps toward more exchange rate flexibility. But despite these combined efforts, banks are flush with liquidity, and real lending rates have fallen to very low levels (about 1½ percent). At the same time, there are indications that the trend increase in real money demand has slowed significantly.
5. Fiscal policy has been tightened since the elections and many tax loopholes closed, but large increases in public pensions and wages have stoked inflationary pressures. Through end-June, the general government deficit amounted to 1 percent of annual GDP (taking into account a surge in VAT refund arrears since the beginning of 2005). This is well below the 4½ percent of GDP deficit realized during the second half of 2004. Moreover, the budget framework for the full year would be consistent with a general government deficit of 2½ percent of GDP. This reflects a series of tightening measures introduced in the March supplementary budget, including most importantly the closure of tax loopholes. However, the supplementary budget failed to appreciably roll back last year's public pension increases, and, in addition, it hiked public wages by over 50 percent. At the same time, the budget's spending structure has been rendered more rigid, raising recurrent spending by 3¾ percent of GDP.
6. Looking ahead, the mission projects that growth should rebound in the second half of 2005, easing to a more sustainable rate in 2006. Assuming a speedy resolution of uncertainty about the government's reprivatization plans, investment should rebound, albeit at a relatively cautious pace. Strong consumption will be supported by rising household incomes, while strong demand from Ukraine's trading partners will help maintain exports. In 2006, however, terms of trade are likely to decline, reducing export-related incomes, and counteracting otherwise improved investment conditions. Real GDP growth is projected to reach 5½ percent in 2005, slowing to 5 percent in 2006.
7. However, without policy changes, inflation will remain in double digits. With high levels of overall liquidity likely to persist in 2005-06, and no further moves toward more exchange-rate flexibility, the strength of consumer demand will continue to put pressure on the CPI. In 2005, these pressures will be bolstered by budget-related social spending, particularly in the final quarter.
8. There are downside risks to the short-term outlook. The growth projection depends critically on a revival of investment demand. On the external side, a larger than projected decline in metal prices in 2006 could depress exports and domestic demand. Also, continued increases in energy prices might add to domestic price pressures.
9. Ukraine's generally positive medium-term outlook will depend in large part on government policies, but will also face several external risks. Our baseline medium-term outlook projects robust growth of about 5 percent, along with low and stable inflation, reflecting the maintenance of macroeconomic stability as well as some progress on structural reforms. If the authorities were to implement more sweeping structural measures, medium-term growth might even exceed 5 percent over the medium term, including by attracting foreign direct investment. Again, the main external risk factors include sharper-than-projected declines in the terms of trade or a slump in metal export volumes. Ukraine's public and external debt burdens are relatively low and appear sustainable, even in light of potential shocks. However, full recognition as public debt of the savings lost during the 1990s would pose a serious threat to sustainability.
Monetary and Fiscal Policy Requirements
10. Tighter monetary conditions are necessary to help contain inflation. The NBU should actively reduce excess liquidity in the banking sector, by increasing sterilization operations and constraining money growth to rates consistent with reaching single-digit inflation in 2006. In particular, the mission views the NBU's envisaged base money growth as too expansionary. Instead, we recommend some slowdown in base money growth during the remainder of this year, followed by a significant deceleration in 2006. Containing the accumulated liquidity overhang would provide a safeguard against possible further inflationary shocks, without inhibiting the prospects for growth.
11. The NBU should also adopt a monetary framework that provides better tools to achieve its stated inflation goals. The peg served Ukraine well in stabilizing inflation following the Russian crisis, but it now fails to provide an anchor for maintaining low and stable inflation. Current-account related inflows are likely to continue to result in reserve accumulation under a maintained peg, as the real exchange rate still seems undervalued. Moreover, and in line with Ukraine's substantial investment needs, sound macroeconomic policies and institutional reforms could attract significant capital inflows. A more flexible exchange rate would also have other advantages: it could help absorb shocks to Ukraine's highly open economy; stem speculative capital inflows attracted by perceptions of an undervalued currency; and discourage balance sheet mismatches within the private sector.
12. The mission recommends a move to a managed float, and, ultimately, to inflation targeting. While this shift would be neither simple nor risk free, Ukraine would move from a position of relative strength and could proceed gradually. The modalities of the new regime would need to be explained to the public to avoid misunderstandings. In the interim, the NBU should continue to strengthen the pre-conditions for more exchange rate flexibility, including: developing the foreign exchange markets, in particular by allowing banks daily to trade foreign currency in both directions; and permitting forward operations. The high taxation of foreign exchange transactions should also be reconsidered.
13. Fiscal policy should support disinflation efforts by maintaining a mildly contractionary fiscal stance during 2005 and 2006:
- For 2005, the mission agrees with the authorities that they should seek to achieve the budget deficit target of 2½ percent of GDP (consistent with a state budget deficit of 1¾ percent of GDP). However, the recent pace of VAT refund claims, possible shortfalls in transfers from state enterprises, and expenditure pressures in the social funds point to a possible fiscal gap of ¾ percent of GDP (assuming all legitimate VAT refund arrears are cleared by end-year). As a result, it may prove necessary to also restrain discretionary spending to achieve the budget target.
- For 2006, the mission recommends maintaining a tight fiscal stance, and targeting a general government deficit of 2¼ percent of GDP (consistent with a state budget deficit of 1½ percent of GDP). In formulating the 2006 budget, it will be important to forecast budget revenues conservatively, using a realistic and internally consistent macroeconomic framework. It will also be important to ensure that wage and pension increases are in line with projected inflation in 2006, to avoid a squeeze on other budget items and improve the budget structure. Even with this as backdrop, it appears that there is very little room for tax or spending initiatives. Tight discretionary spending policies will be necessary (no growth in real terms); and current plans for costly new initiatives, for instance pension bonuses for "children of war veterans," or cuts in social fund contribution rates, need to be reconsidered. If new initiatives are introduced, for instance tax rate cuts or higher public investment, the best way to finance them would be through efficiency-enhancing measures to broaden the tax base or a cut in subsidies.
Other Policy Requirements
14. Restoring a viable public pension fund could open significant room for higher public investment and lower taxes in the medium-term. The recent pension hikes have effectively dismantled the system envisaged by the 2003 reform. Ukraine's pension-GDP ratio is now one of the highest in the world (14½ percent of GDP), and a budget transfer of some 5 percent of GDP is needed to cover contribution shortfalls. Furthermore, each contributor to the pension fund is already effectively supporting nearly one pensioner, suggesting that higher labor taxation will not be the solution. Ukraine's difficult demographic outlook also points to a need for early reforms. The focus should be on better targeting the minimum pension subsidy, lifting retirement ages, and pruning privileged pension regimes.
15. A rapid resolution of the reprivatization debate is needed to enhance immediate growth prospects. The mission welcomes the recent presidential memorandum guaranteeing property rights, as well as the government's efforts to identify state enterprises to be privatized, and the official commitment to fully comply with privatization legislation. However, the authorities need to clearly delineate the scope and modus of possible future re-privatizations to eliminate investor uncertainty and strengthen the prospects for successful new privatizations.
16. Many other specific steps would help improve the difficult investment climate. At present, entrepreneurs and investors are forced to negotiate a daunting array of red tape, along with excessive, opaque, and discretionary regulations. The commitments in the Ukraine-EU Action Plan, the World Bank's Development Policy Loan, and the measures outlined during the recent World Economic Forum meeting in Kyiv all provide practical and concrete frameworks for action.
17. The authorities' ambitious trade policy agenda is highly welcome. Increasing and diversifying trade will be key in allowing Ukraine to better exploit its comparative advantages, leading to the creation of new and better-paid jobs, and helping improve corporate transparency. The trade liberalization achieved so far this year constitutes an important step, but implementing the remaining measures needed for WTO membership by end-2005 should remain a priority.
18. Development of domestic capital markets is important. In line with earlier IMF and World Bank recommendations, the focus should be on establishing benchmark issues for government securities, setting up a coherent debt management strategy, and swiftly adopting a Joint Stock Company Law.
19. Continued efforts to strengthen the financial sector's supervisory framework are recommended. The mission acknowledges regulatory changes to tighten foreign currency loan-loss provisioning requirements and the definition of capital, and welcomes the authorities' intentions to further address concerns about bank capitalization and related-party lending. For the latter, it is essential to approve the long-delayed amendments to the Banking Act, which would require identification of bank owners. Revisions to the Civil Code and the Banking Act to limit early withdrawal of deposits should also be a priority to safeguard against a future liquidity crisis. The mission further urges the authorities to move from the current highly procedural supervision methods to more risk-based supervision. Improving the quality of capital is key. Until this is achieved, the mission recommends raising the minimum capital adequacy ratio to 12 percent. Also, the foreign exchange market needs to be developed to allow hedging of foreign exchange exposures by banks as well as their clients.
20. The mission would like to thank the authorities for organizing these discussions, and we look forward to a continued close and constructive policy dialogue in the future.