IMF Executive Board Concludes 2008 Article IV Consultation with UkrainePublic Information Notice (PIN) No. 08/68
June 12, 2008
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 June 2, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ukraine.1
Growth remained strong in 2007. Real GDP growth reached 7.6 percent, on par with the average since 2000, and in line with other CIS countries. Production and investment have been resilient despite an uncertain political climate and supply-side shocks (a doubling of imported natural gas prices since 2005 and a poor 2007 agricultural harvest).
Rapid domestic demand growth pushed the economy beyond its capacity in 2007-08, leading to accelerating inflation. The demand expansion, fed by fiscal and incomes policies and a capital-inflow driven surge in money and credit growth, in combination with rising food and energy prices, gradually lifted CPI inflation to over 30 percent by end-April 2008. Core inflation has also risen, nominal wage growth is very high, and inflation expectations have drifted up.
The current account deficit continued to deteriorate in 2007, due to very strong domestic demand growth, but it remains broadly consistent with fundamentals. The deterioration has occurred despite terms of trade gains, which may reverse as gas prices rise and if steel prices revert toward their historical trend. If domestic demand
and inflation are not contained, a further erosion of cost competitiveness would move the hryvnia toward real overvaluation.
Capital inflows, including foreign direct investment (FDI), remain strong, but private external debt and debt rollover have risen sharply. The economy has become more sensitive to balance-sheet risks and deteriorating global liquidity conditions. However, some external debt may be held by Ukrainians (i.e. misrecorded) and some offset by unrecorded foreign exchange assets in Ukraine. International reserves remain at comfortable levels.
Banks' credit risks have increased, reflecting very high lending growth, including in foreign exchange to unhedged borrowers. Surging liabilities to non-residents, although in part reflecting the presence of foreign banks, point to growing liquidity risks. And, with house prices high relative to incomes, credit risks on mortgages have grown.
The effects on Ukraine of international financial market turbulence have begun to recede. Reflecting Ukraine's vulnerabilities, external spreads rose sharply beginning in mid-2007 and euro-bond issuance dried up. However, eurobond spreads have been falling since late-March 2008, while access of banks and corporates to longer term external financing has resumed, facilitating rollover of debt maturities.
The fiscal stance has been procyclical. Nominal spending has risen by over 30 percent a year since 2003, reflecting rapidly rising public-sector wages and social transfers and, in early 2008, partial restitution of Soviet-era deposits that had been wiped out by hyperinflation in the early 1990s. General government deficits have been kept moderate, as spending growth has been paid for by inflationary revenue windfalls. This has allowed the public debt to decline to just over 10 percent of GDP.
Monetary conditions have tightened somewhat of late. The National Bank of Ukraine (NBU) stepped up sterilization and imposed new reserve requirements on banks' foreign borrowing beginning in late 2007, instituted new prudential measures in early 2008, and since March 2008 has allowed the exchange rate to appreciate outside the previous de facto Hrv/$ 5.00-5.06 band. Excess banking system liquidity has fallen considerably, interest rates have risen sharply, notably on the interbank market, and lending in foreign currency has slowed significantly. Nevertheless, real interest rates remain negative and overall credit growth is still very high-76 percent year-on-year in March.
Progress has been made on the structural reform agenda, but much remains to be done. WTO accession was a significant achievement, but compared to other transition economies Ukraine lags in energy efficiency, internal price liberalization and has notable weaknesses in its business environment, especially in the area of tax administration. Development of the high-potential agricultural sector remains constrained by the lack of a market for agricultural land.
Executive Board Assessment
Executive Directors commended Ukraine's continued strong economic growth and increased overall resilience to shocks. They noted that reserves have increased substantially, the fiscal position is sustainable, the financial sector appears well capitalized and profitable, and foreign direct investment is strong. These developments would support Ukraine's considerable long-term growth potential, the realization of which will require the steady pursuit of sound macroeconomic policies and growth-enhancing structural reforms.
Directors also expressed concern that some macroeconomic vulnerabilities have increased. Significantly higher inflation and a wider external current account deficit reflect volatility in world commodity prices, but mainly strong domestic demand growth. Directors cautioned that rapid domestic lending growth, including in foreign exchange to unhedged borrowers, and high house prices have increased credit risks. They welcomed the authorities' efforts to mitigate liquidity risks arising from growing external borrowing and debt rollover needs in the context of the global financial market turbulence.
Directors noted uncertainties regarding growth prospects, but agreed that further tightening of policies will be required to buttress macroeconomic stability. In this context, they welcomed the authorities' intention to tighten fiscal policy, which will be critical for restraining domestic demand and reducing inflationary pressures. They encouraged the authorities to aim for a near-balanced budget-or tighter-in 2008. At the same time, Directors considered that, should growth slow significantly and inflationary pressures ease, a larger fiscal deficit could be accommodated if financing is available. Directors also saw merit in taking steps to strengthen the fiscal framework more generally to improve fiscal policy formulation and assessment, in particular by broadening fiscal coverage, and adopting a medium-term fiscal framework.
To achieve the desired fiscal tightening, Directors suggested that growth in social transfers will need to be reined in, and increases in minimum wages and public sector wages scaled back. In addition, further restitutions of depreciated Soviet-era bank deposits should be spread over a number of years. To shore up revenues, administration of the value added tax should be strengthened, and the tax itself preserved. Tax cuts, while desirable as part of an overall reduction in the size of government, should be fully offset with spending cuts or tax base broadening. Gas prices should be fully passed through to final consumers, with vulnerable groups protected by better-targeted social programs.
Directors underscored the importance of a tight monetary stance to fight inflation. Directors generally considered that a shift to a more flexible exchange rate would enhance the effectiveness of monetary policy, and welcomed the 2008 monetary guidelines, which call for a gradual transition to a flexible exchange rate and ultimately to inflation targeting. They were encouraged by the authorities' recent actions to allow greater exchange rate flexibility, and encouraged the authorities to communicate clearly and consistently to the markets and the public about the move.
Directors generally felt that if recent flexibility were allowed to continue in the context of a wider official trading band, it would help underscore the two-way risk to domestic borrowing in foreign currency. A few Directors were not persuaded of the desirability of exchange rate flexibility leading to inflation targeting. Directors stressed the importance of developing foreign exchange and money markets, in particular noting a weak interest rate channel of monetary policy transmission. While some Directors noted the uncertainties surrounding the assessment of the current level of the real exchange rate, Directors generally agreed that the real exchange rate appears to be broadly consistent with fundamentals.
Directors stressed that decisive government support for a new inflation targeting regime will be fundamental, particularly in the form of a clear inflation-targeting mandate and operational independence for the monetary authorities. It would also be important for the government to abolish the tax on foreign exchange transactions, securitize its debt to the National Bank of Ukraine, issue more public debt in domestic currency, and further liberalize domestic prices to provide monetary policy maximum leverage over inflation.
Directors welcomed the authorities' progress in implementing the Financial Sector Assessment Program recommendations, noting that financial indicators have improved further. However, they noted that Ukraine's financial sector vulnerabilities remain. In this context, they supported recent measures to identify bank owners, raise minimum capital requirements, improve risk management practices, and curb banks' foreign borrowing. They encouraged efforts to fully develop consolidated supervision, improve banks' stress testing and risk management capabilities, intensify on-site examinations, and impose stronger prudential requirements on banks with deteriorating liquidity positions.
Directors suggested that productivity-enhancing structural reforms should play a significant role in boosting growth and restraining inflation over the medium term. In particular, they looked forward to the positive impact of Ukraine's WTO accession on enhancing market competition and economic efficiency. They encouraged the authorities to push forward in improving the business environment and the legal framework.