IMF Executive Board Concludes 2006 Article IV Consultation with UkrainePublic Information Notice (PIN) No. 07/5
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 January 12, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ukraine.1
After nose-diving in 2005, real activity staged a surprise rebound in 2006. Fiscal policy in 2005-06 reshuffled resources from higher-saving businesses (mainly by raising tax collections) to lower-saving households (mainly by raising public pensions and wages), touching off a consumption boom, which has been reinforced by rapid credit expansion. In 2005, this boom helped to offset the drag on the economy from marked real currency appreciation, weaker steel exports owing to intensified third-country competition, higher business-tax collections, and post-Orange-Revolution reforms, which clamped down on tax loopholes, smuggling, and corruption. In 2006, robust consumption has been matched by stronger export markets, including resurging steel prices, and more buoyant investment, as reforms began to bear fruit in attracting higher foreign direct investment (FDI).
Inflation moderated through most of 2006, but has recently climbed back into double digits, boosted by energy-price pass-through. Notwithstanding booming consumption, high CPI inflation started to moderate in mid-2005, reflecting slowing real activity, low import price inflation, and a host of one-off factors, including cuts in import tariffs and temporary Russian import bans on Ukrainian meat and dairy products. However, as pass-through of energy import price hikes accelerated in late-2006, inflation surged back into the double digit range. Domestic price pressures, as measured by the GDP deflator and labor costs, have remained significant throughout this period.
Ukraine's steep terms-of-trade gains came to an abrupt halt in 2006. Ukraine's cumulative terms-of-trade improvement during 2003-05 amounted to some 20 percent, as skyrocketing prices for steel—Ukraine's main export—offset sharply higher oil prices. However, amid a dispute with Russia in early-2006, the price of imported natural gas was hiked by 65 percent. As one of the most inefficient users of energy among transition economies and as a heavy net energy importer, this price hike was enough to offset the impact of still higher average metals prices and a higher fee for transit of gas. As a result, the terms of trade deteriorated by about 1 percent.
The current account has switched from large surpluses into deficit, but capital flows have picked up and international reserves have reached healthy levels. With domestic demand booming, export volumes slumping, and the terms of trade reverting, the current account shifted from a surplus of 10½ percent of GDP in 2004 to a likely deficit of about 1 percent of GDP in 2006. At the same time, capital inflows, FDI in particular, have been buoyant, reflecting improved perceptions of Ukraine as an investment location. As a result, foreign exchange reserves have more than doubled to about 4½ months of imports and are projected to exceed the level of short-term external debt at end-2006.
The authorities have proven adept at hitting low fiscal deficit targets, and explicit public debt has plunged. In 2005, despite a slowing economy and no financing constraints (privatization receipts reached 5 percent of GDP), the tight general government cash deficit target of 2½ percent of GDP was met. Preliminary data for 2006 indicate that the general government cash deficit may have reached only 1¼ percent of GDP, compared the 2006 deficit target of about 3 percent of GDP, reflecting robust Value Added Tax collections and expenditure restraint. A combination of strong nominal growth and low deficits will reduce explicit public debt (including government-guaranteed debt) to a projected 17 percent of GDP by end-2006, down from over 60 percent in 1999. However, contingent liabilities remain at a still high 30 percent of GDP, largely reflecting claims from the so-called lost savings deposits from the early 1990s hyperinflation.
Reflecting a redistributionist shift in fiscal policy, recurrent spending and tax collections from businesses have both been ratcheted upward. In 2005, average public wages and pensions were raised by over 50 percent (against an inflation target of just under 10 percent). As a result, pension spending commitments soared from 12 percent of GDP in 2004 to about 17 percent in 2005. To finance this recurrent-spending boom, while reducing the fiscal deficit, the government curtailed capital spending by some 1¾ percent of GDP and raised tax collections by some 6 percent of GDP, the latter especially through an across-the-board cancellation of tax breaks for the free economic zones and administrative improvements. The 2006 budget largely preserved the thrust of these policies.
Monetary conditions have continued to adjust passively to the requirements of the exchange rate peg. Although the National Bank of Ukraine (NBU) has allowed the interbank exchange rate to fluctuate within a narrow band of Hrv/US$5.00-5.06, the exchange rate regime has remained a de facto peg. In this setting, base money growth has been mostly driven by foreign-exchange interventions and changes in government deposits at the NBU. During most of 2006, the NBU's reaction function implied an automatic tightening of the monetary stance, partly softened by the NBU lowering reserve requirements and its main refinancing rate. More recently, however, monetary conditions have loosened again, reflecting a pickup in foreign reserve accumulation and drawdown of government deposits.
A long-lasting credit boom has increased the balance-sheet vulnerabilities of banks and their borrowers. Real credit growth has averaged about 40 percent since 2001. The corporate sector's debt (two thirds of which is denominated in foreign currency) now exceeds 50 percent of GDP. Household sector debt, mostly in foreign exchange, has also surged over the past 18 months, partly driven by banks' fierce competition for market share. The boom has created substantial credit risk, in particular indirect foreign-currency risk, since most borrowers are unhedged. It has also raised banks' foreign exchange liquidity risk as banks have increasingly relied on foreign funding, much of which is at short maturities. While an influx of foreign banks since 2004 has improved credit-risk management practices in some parts of the banking system, recent financial soundness indicators, particularly declining capital-adequacy ratios, suggest that the sector as a whole remains vulnerable.
Financial markets remain underdeveloped, reflecting history, deficient policies, and lagging legal frameworks. The government securities market remains illiquid and shallow with no significant primary issuances between August 2005 and October 2006. Equities markets also remain illiquid due to the delay in passing a joint-stock company law that would protect minority shareholders. Domestic corporate bond issuance has been more buoyant, but starting from a low level. A key tax barrier to financial sector development, the foreign exchange transactions tax, has been reduced marginally, but remains in place.
Executive Board Assessment
Executive Directors noted that Ukraine's economy has proven resilient over the last year in the face of higher energy prices and domestic political uncertainties. Directors also noted that the economy had become better balanced externally, with the current account now near balance after several years of large surpluses. However, They also observed that rising prices for imported energy have rekindled short-term macroeconomic tensions, while uncertainties about future steel export prices and capital flows loom large.
Directors stressed that Ukraine also needs to address three longer-standing challenges. First, while welcoming recent progress in adopting more market-friendly institutions, they noted that structural reforms still lag considerably. Second, Directors thought that the present monetary framework could face increasing difficulties in achieving internal and external balance given Ukraine's volatile macroeconomic fundamentals. And third, Directors expressed concern that the sustained credit boom and heavy private-sector external borrowing had created balance-sheet vulnerabilities, raising risks to the banking sector.
Turning to policies, Directors considered that a gradual move toward greater exchange rate flexibility would facilitate external adjustment and help improve control of inflation. A more flexible exchange rate could also help stem financial dollarization while providing incentives to develop markets to hedge foreign-exchange risks. Several Directors cautioned, however, that the pace of transition needs to be managed carefully and be kept aligned with the development of supporting conditions. Directors therefore welcomed the preparatory steps taken by the NBU toward introducing inflation targeting, and encouraged the authorities to move forward with the transition.
Directors stressed the importance of stepping up the implementation of policies that will support increased exchange rate flexibility. These should include measures to develop the foreign-exchange market, including by eliminating the foreign-exchange transactions tax, and domestic securities markets, particularly by adopting a government financing strategy that relies more on domestic debt issuance. Moreover, an appropriately restrained incomes policy would reduce the pressure for large nominal exchange rate movements in the face of a highly uncertain external environment.
Directors underscored the criticality of more proactive regulation and supervision of the banking sector. They therefore welcomed the NBU's recent steps to improve regulatory and supervisory safeguards. Most Directors considered that capital-adequacy should be strengthened until banks' risk management practices improve and, in this regard, noted that consideration should be given to increasing the capital-adequacy ratio from 10 to 12 percent. In this context, Directors welcomed the envisaged Financial Sector Assessment Program update in 2007 as timely.
Directors viewed the authorities' fiscal framework as broadly appropriate. The authorities' intention to target a general government deficit close to 2½ percent of GDP would keep explicit debt low, providing a prudent cushion given significant contingent fiscal liabilities. At the same time, plans to reverse the recent surge in recurrent spending over the medium term would create fiscal space for tax cuts and public investment.
Directors urged the authorities to implement policies consistent with this fiscal framework. In particular, they emphasized to do more to restrain recurrent spending in the 2007 budget. Increases in sectoral subsidies and the reopening of tax breaks in the free economic zones should be avoided, as they could encourage rent seeking. Directors also stressed that opening significant fiscal space would require tackling large public pension fund imbalances, although pension reforms were also imperative for demographic reasons.
Directors commended the authorities for passing through recent energy import price hikes to domestic users and urged them to continue pass-through in 2007 and beyond. This would help avoid rising quasi-fiscal deficits and provide incentives to improve Ukraine's very low energy efficiency.
Directors stressed that raising growth in Ukraine required improvements in the country's difficult investment climate. They particularly noted the pressing need to adopt legislation to strengthen investor rights, clarify inconsistencies between the economic and civil codes, reactivate a transparent and fair privatization process, and reform the energy sector.
Directors welcomed the passing of legislation towards WTO accession in 2007, but urged reversing recent retrograde actions against exporters, particularly the introduction of restrictions on grain exports.
While noting that official statistics were broadly adequate for surveillance, Directors saw a need to improve data on trade prices, the state-owned enterprise sector, and sectoral financial flows and stocks.