The Case for Supporting Ukrainian Economic ReformsDavid Lipton
First Deputy Managing Director, International Monetary Fund
Peterson Institute, April 7, 2015
As Prepared for Delivery
Good morning. Thank you, Adam, for your kind introduction. I am very pleased to return to the Peterson Institute today. We always appreciate your willingness to provide a setting for informed discussion of global economic issues.
While the IMF Spring Meetings are just around the corner, we are not here to talk about the global economy. Rather, our focus today is Ukraine. Going into the meetings, many will want to have a clear picture of the situation in that country as they seek to understand the risks facing the world, and Europe in particular.
This audience is fully aware of the importance that the IMF places upon helping Ukraine to achieve financial stability and a return to growth. Less than a month ago, the Fund approved $17.5 billion of financing to Ukraine as part of a four-year program under our Extended Fund Facility. The goals of this program are simple, yet challenging: to stabilize Ukraine's deeply destabilized finances; to restore growth that has been stagnant for several years; and to support the long-overdue modernization that has lagged behind peers in the region since independence 23 years ago.
I know some have questioned the Fund’s decision to support Ukraine—including here in Washington—and have doubts about the government’s commitment to reform after so many years of delay. So I would like to lay out for you today what Ukraine faces, how the authorities are aiming to address their problems, and why the IMF stands with Ukraine in this time of economic crisis. I would like to do this by reviewing three themes:
• The uneven evolution of Ukraine’s economic transformation since achieving nationhood;
• How a set of serious, but manageable economic difficulties descended into full-blown crisis in the face of the confrontation in the country’s eastern region;
• And Ukraine’s response to that crisis—both the immediate efforts to stabilize the situation and the longer-term program to restore growth and transform the economy.
Ukraine – The Past
So let’s begin by talking about how Ukraine has reached this turning point.
Ukraine generally enters the global news cycle when it is the story of the day: independence in 1991; the Orange Revolution a decade ago; the Maidan protests early last year; and then the conflict with Russia. Of course, what happens when the world is not watching is often just as important.
Sadly, Ukraine since independence has been a story of too many lost opportunities and too much disappointment; economic mismanagement and half-hearted reforms holding back growth; corruption and oligarchy undermining the market economy; and episodes of voter fraud and abuse of power undercutting democracy. The comparison with many other countries in Central and Eastern Europe is striking. Since 1991, Ukraine has had spurts of growth, but has not been able reach a point where reform truly took hold. Ukraine’s per capital income at independence was higher than Poland’s; in 2013, even before the current crisis erupted, the standard of living had fallen more than 60 percent behind Poland. During this interval, Ukraine entered into eight IMF programs, none of which achieved the objective of prompting sustained reform.
After the most recent 2009/10 program, which ended unsuccessfully, Ukraine's macroeconomic problems intensified. For several years, wages and costs rose, but productivity did not. Eventually competitiveness had slipped so much that GDP stopped rising and exports stagnated. Budget imbalances and gas sector deficits widened enough to add another drag on growth. In early 2013, I visited Kiev to urge the government to address these issues and to warn that Ukraine was slipping toward crisis. Action then might have been possible without crisis and destabilization, but there was not the political will.
Now, Ukraine has the political will, but it has to contend with full-blown economic and financial crisis. And for the first time in a long time a political window of opportunity has opened. The country has elected leaders who are approaching economic policy making with purpose and commitment. President Poroshenko and Prime Minister Yatsenyuk are in sync on the main economic issues. And they can call on a more united political class and general public, now more ready to accept changes they had resisted before.
But since taking office, the government has faced a dangerous and rapidly deteriorating economic situation. Last year's sharp output decline was driven in large measure by the loss of Crimea, the conflict in the Donbass, and a deep recession elsewhere in the Eastern part of the country. As a result, industrial production and construction, retail sales, and household income all have fallen. Unemployment is approaching double digits. Uncertainty has deterred investment. In the fourth quarter of 2014, GDP contracted 14.8 percent from a year earlier.
Ukraine’s financing needs surged. The conflict imposed direct costs, both in terms of output losses and budgetary deterioration. But there also were indirect costs as uncertainties hit the finances of banks and the public sector, and as the foreign exchange market became destabilized. Exports were hit hard by the disruption of trade with Russia and low international prices for grains and steel, major exports. External private financing dried up and capital outflows accelerated. Foreign exchange reserves declined and the exchange rate depreciated sharply. The hryvnia lost two-thirds of its value in the past 15 months. Inflation spiked above 40 percent, reflecting the depreciation but also rising energy prices.
The banking system has come under extreme stress because of fundamental weaknesses in some institutions, but also due to more general financial uncertainty. Deposits fell by 28 percent by end March of this year—and nonperforming loans soared to nearly 20 percent of all loans at the end of 2014. Profitability and liquidity were squeezed, and several banks failed.
The government tried to keep a lid on this very difficult situation. The budget stayed well within its 2014 deficit target. Measures were taken to stabilize the banking system. And governance and structural reforms were initiated. However, the escalation of the conflict in August 2014 and again early this year led to a significant loss of confidence and further disrupted economic activity. Despite gas price increases, the burden of supporting the state-owned energy monopoly Naftogaz and funding energy subsidies equal to more than 7 percent of GDP threatened to drown the government in red ink.
Ukraine – The Present
Following this deterioration, it became increasingly clear that Ukraine’s balance of payments and adjustment needs were more than what could be achieved under the original two year stand-by agreement with the IMF. Responding to the challenges, the government put together an impressive reform blueprint building on its existing macroeconomic program and extending its structural reform effort. The IMF has supported this with a new program approved by the Executive Board on March 11.
From a financing standpoint, the objective of the program is to cover Ukraine’s external financing needs, estimated at about $40 billion over the next four years. While large—equal to nearly one-third of estimated 2014 GDP—most of it is already pledged by the international community, and the rest will take the form of a debt operation under discussion with creditors. This financing will help triple Ukraine’s official reserves to about $18 billion at the end of this year from just $5.6 billion before agreement was reached with the Fund. Reserves then should reach $35 billion by end-2018—slightly more than 100 percent of the Fund’s reserve adequacy metric. This will be an important boost to confidence and should cushion the economy against future external shocks.
This is exactly where IMF financing under the new program is so important. But to release that financing, we needed to see a clear path out of the crisis—and a demonstrated willingness to follow it.
The first economic goal of the program is to stabilize Ukraine’s finances:
That began with the task of restoring stability to the foreign exchange market. By anchoring the program with appropriately tight monetary targets and temporary administrative measures, the hryvnia has stabilized. Using a monetary anchor is the same approach used decisively during the Asian financial crisis and in other successful stabilizations. Recently, the drain on reserves has reversed. With the financing that is already pledged, reserve cover for imports is likely to reach three months by June compared with less than one month’s cover before the IMF agreement. This will result from front loaded Fund disbursements, and bilateral loans and swaps now being arranged.
In addition, a tight monetary stance supported by other policies will help inflation recede toward single digits by end 2016 once the one-off effects from depreciation and gas price hikes subside.
Stabilization will also be supported by addressing the uncertainties that come from Ukraine’s onerous debt burden. The talks that the government is conducting with its creditors to restructure external debt are aimed at that objective. Public and publicly guaranteed debt is projected to peak at 94 percent of GDP in 2015. The aim of the restructuring would be to secure $15 billion in additional financing over 2015-18 to bring debt below 71 percent of GDP by 2020, and avoid bunching the repayment schedule after the Fund-supported program ends.
Ukraine – The Future
But stabilization alone is not enough to address the crisis. Ukraine also needs to restore growth.
The crucial challenge is to restore the competitiveness that was undermined by an overvalued exchange rate. The combination of exchange rate depreciation and flexibility at the hryvnia’s new level is an important step. It is creating the basis for Ukrainian businesses to compete again on international markets.
Similarly, the spending constraints built into the Ukrainian program should restrain the deficits that were crowding out the private sector. This means both the public deficit and the quasi-fiscal deficit imposed by Naftogaz. This, too, is essential to restoring competitiveness.
Here, action on energy prices has been essential. As I’ve indicated, the government has significantly increased household gas prices and heating tariffs. This is important because Ukraine’s gas prices have stood at or below 20 percent of cost recovery. That is well below other energy-importing countries in the region. The remaining 80 percent of costs has added to the broad public sector deficit, and this will now end. To keep this reform from hurting vulnerable members of society, new and strengthened targeted programs are being put in place.
The final step to restore growth is to bring the banking system back to health. The government is working to resolve insolvent banks, including through recapitalization and liquidation. Recapitalization needs are provided for in the program architecture. Going forward, the government will also see that large financial institutions are kept well capitalized by their owners. This should help to reopen the taps to provide sustainable levels of credit to the business community and consumers.
These are all important measures that must be put in place this year. But there are also long-term challenges if Ukraine is to achieve sustained growth into the future and reach a level of development on par with its more successful neighbors. These are the structural reforms needed to create a modern economy that can give renewed confidence to the business community and the general public, and attract needed investment.
For example, there are key structural impediments in the banking system. These include an ownership structure that too often funnels excessive lending to insiders—often with sweetheart deals. The government is starting to address this issue with a strengthened regulatory and supervisory framework intended to bring the banking system into line with international best practices.
There are also a set of needed reforms affecting the business climate. Key policy measures in these areas relate to governance: deregulation and reform of tax administration, transparency, and reforms of state-owned enterprises. Central to this effort will be an independent audit of Naftogaz’s receivables, and a restructuring of the company to separate its transmission and distribution arms.
Finally, nothing is more important than a commitment to tackle corruption. As much as any other grievance, it was this problem that brought the Ukrainian people into the streets during the Maidan protests. The government is addressing the issue with strengthened anti-corruption legislation and measures to enhance the effectiveness of the judiciary. It is also worth noting the recent steps to curb the influence of Ukraine’s oligarchs.
This is an expansive and complex reform effort. Clearly, it will take time and effort to achieve. It is also inevitable that questions will arise about whether the agenda will continue to have the support of the Ukrainian people, particularly those who have been hardest hit by the crisis.
I am impressed that the government has taken steps to address the most vulnerable. Total spending on social assistance programs will reach 4.1 percent of GDP this year, an increase of 30 percent from 2014. Assistance with energy bills—which I mentioned earlier—will in fact quadruple from 6 billion hryvnia in 2014 to 24 billion hryvnia in 2015. Meanwhile, unemployment benefits will rise 15 percent. All this is essential, but at the end of the day it will be sustained and equitable growth that will be most beneficial to the Ukrainian people.
So what about the risks? There is no point in glossing over the situation on the ground in Ukraine. If the conflict in the East of the country intensifies—and we all certainly hope it won’t—then one has to be concerned about the sustainability of the expected recovery. So we can only urge Ukraine and Russia to work with all parties to continue the peace process.
Here in Washington, we are already hearing from critics who question the wisdom of supposedly putting Fund resources at risk in such an uncertain situation. There is only one answer. The Fund’s job is to support members in crisis provided they are trying to put themselves right.
That goal may be hard, but it is not unrealistic. To achieve it, Ukraine must pursue its reform program, and the international community must support that effort. The government has the right plan and the determination to follow through. The program has the backing of the Ukrainian people. So it is only right that we are standing with them. Thank you.