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Independence Square Kiev, Ukraine.  Focus of economic reform includes eliminating losses in the energy sector, while enhancing social safety nets to protect the most vulnerable (photo: Ian Trower/Robert Harding/Newscom)

Independence Square Kiev, Ukraine. Focus of economic reform includes eliminating losses in the energy sector, while enhancing social safety nets to protect the most vulnerable (photo: Ian Trower/Robert Harding/Newscom)

INTERVIEW WITH REZA MOGHADAM

Ukraine Unveils Reform Program with IMF Support

IMF Survey

April 30, 2014

  • IMF Approves $17.01 billion to support Ukraine’s economic reform program
  • Focus on five key areas: exchange rate flexibility, banking stability, fiscal policy, energy policy, and governance
  • Government launching new social protection program to cushion the impact on low-income families

Ukraine unveiled a comprehensive program of economic reforms, backed by a $17.01 billion IMF loan approved on April 30 by the institution’s Executive Board.

The loan, under a two-year Stand-By Arrangement, backs a policy program that aims to restore macroeconomic stability, promote sustainable growth, and strengthen economic governance and transparency. The IMF approval makes $3.2 billion immediately available to Ukraine with the remainder subject to frequent reviews. The Stand-By Arrangement entails exceptional access to IMF resources, amounting to 800 percent of Ukraine's IMF quota.

The program also is expected to unlock additional and sizable international official assistance, and help restore confidence among private investors.

In an interview, Reza Moghadam, Director of the IMF’s European Department, emphasizes the needs for Ukraine to address deep-seated structural problems and vulnerabilities. He also notes that the Ukrainian authorities have taken ownership of economic reforms, which are long overdue and urgently needed. “The government’s implementation of a comprehensive set of program actions up front demonstrates strong commitment to reform policies and objectives,” Moghadam said.

IMF Survey: What are the key challenges facing Ukraine today?

Moghadam: Ukraine is experiencing its second major economic crisis in six years. An overvalued exchange rate accompanied by loose fiscal policy and sizable losses in the state-owned gas company Naftogaz resulted in large twin deficits, a steady rise in indebtedness, recurrent difficulties with external financing, and depletion of international reserves. Such vulnerabilities made the economy especially susceptible to economic and political shocks that eventually led to the current crisis.

The new government that took office in late February has quickly taken steps toward restoring macroeconomic and financial stability. However, in addition to entrenching macroeconomic stability, Ukraine needs to undertake deep-reaching structural reforms to reduce imbalances, improve governance and the business climate––Ukraine’s long-standing weaknesses––and move toward balanced growth. An emphasis on capacity building is critically needed to address the legacy of ad hoc policy design and implementation.

IMF Survey: What are the main elements of Ukraine’s economic reforms?

Moghadam: Faced with a number of urgent challenges, including dwindling official foreign exchange reserves and the possibility of Ukraine not being able to meet its external obligations, the authorities have embarked on a comprehensive and ambitious reform program designed to address Ukraine’s macroeconomic imbalances and structural weaknesses. In terms of key reforms, the authorities have committed to:

Maintain a flexible exchange rate to restore competitiveness and foster accumulation of reserves, and focus monetary policy on domestic price stability. Going forward, support competitiveness by keeping public and minimum wage increases in line with productivity growth.

Maintain confidence in the financial system and strengthen the infrastructure for financial regulation and supervision. Ensure that banks strengthen their balance sheets as necessary.

Meet near-term fiscal obligations and gradually reduce the fiscal deficit. Stabilize budget revenue and embark on a medium-term fiscal adjustment path that distributes the burden of adjustment equitably.

Achieve a self-sustained energy sector and reduce its fiscal drain by eliminating Naftogaz’s deficit by 2018 as a key benchmark toward the goal of energy independence.

Implement comprehensive structural reforms, including in the areas of public procurement and tax administration, to help reduce corruption, improve the business climate, and on this basis, achieve high and sustainable growth.

IMF Survey: Does the program envisage too much fiscal austerity?

Moghadam: It’s important to recognize the starting point. Without measures, the combined deficit of the government and Naftogaz would have reached an impossible-to-finance 12 percent of GDP in 2014, undermining confidence in public finances.

The program targets a moderate structural fiscal adjustment. Furthermore, the pace of the proposed fiscal adjustment is carefully calibrated to restore confidence in public finances without being overly contractionary. In fact, the budget deficit will increase between 2013 and 2014, taking into account the weaker economy this year, while retaining some upfront consolidation to reduce large funding needs, build confidence, and support the external adjustment.

In 2015-16 the emphasis will be on a gradual expenditure-led fiscal consolidation, combined with measures to enhance public sector efficiency. This approach will place public debt firmly on a declining path from 2015 on.

IMF Survey: What are the chief measures to reduce the fiscal deficit?

Moghadam: The authorities have proposed that the initial phase of fiscal adjustment rely on a mix of expenditure and revenue measures, with emphasis on the former.

Expenditure restraint will be exercised through the suspension of unaffordable wage and pension increases planned by the previous government, public employment reduction through attrition, savings on government purchases enabled by a new procurement law, and rationalization of social assistance spending through better targeting and means testing.

Enhanced revenues and collections will be sourced from the elimination of fraudulent tax evasion schemes, a shift to uniform (and thus less abuse-prone) excises on fuel, higher excises on alcohol and tobacco, and closing of value-added tax loopholes.

IMF Survey: What does the energy sector reform entail?

Moghadam: Again, the starting point is key. Overall energy subsidies in Ukraine are estimated to have been 7½ percent of GDP in 2012 with relatively well-off households capturing the larger share of the benefits. Naftogaz’s shortage of funds has also led to large arrears to Russia’s Gazprom, which exacerbate balance of payments problems, while vested interests continue to act as a drag on needed reforms.

The energy sector reform proposed by the authorities will focus on reducing the energy sector’s fiscal drag, while enhancing efficiency and promoting transparency. The objective to bring Naftogaz’s deficit to zero by 2018 will be accomplished by policies to raise its revenue and reduce costs. To this end, gradual, but meaningful and broad-based increases in the very low gas and heating retail tariffs will be accompanied by enhanced social assistance measures to mitigate the impact on the poorest.

Structural and governance reforms in Naftogaz will improve its governance and transparency as well as reduce operational costs.

IMF Survey: How significantly will gas and heating tariffs increase?

Moghadam: Energy prices in Ukraine are exceptionally low. Currently, the gas price for households in Ukraine is $85 for one thousand cubic meter. In Russia—a gas producing and exporting economy—the price is $158 for one thousand cubic meter. The regional differences are even larger with prices in Ukraine being 4 to 9 times lower than in neighboring gas-importing economies.  In January 2014, Romania’s citizens paid about $ 414, Moldova’s $ 432, and Poland’s $ 687 for one thousand cubic meter.

The envisaged gas and heating tariff increases will lead to comparatively moderate increases in the share of household budgets spent on utilities. Even after the programmed increases in 2014, the price of gas and heating for the population will remain several times lower than in other gas-importing European countries.

IMF Survey: How will the most vulnerable be protected under the program?

Moghadam: Although energy price increases are moderate and from a low starting level, it is important to cushion the impact on low-income families, so the government has embarked on an ambitious new social protection program. Eligible families will receive a benefit equal to the difference between pre-and post-increase gas and heating bills. In total, 4.5 million families—about 27 percent of the total—will be receiving government support to shield them from tariff increases through existing and new social assistance schemes.

Additionally, in cooperation with the World Bank, social assistance benefits will be re-prioritized to move to a well-targeted means-tested framework. As present, the majority of social assistance is captured by higher-income households who consume the largest share of gas and heat. For a fraction of the cost of the existing utility subsidies, the government could fund additional social assistance programs that would substantially reduce poverty.

IMF Survey: How will corruption be addressed in the program?

Moghadam: Given long-standing challenges that have weakened Ukraine’s economy, strengthening governance, enhancing transparency, and improving the business climate will be central elements of the program. Policy measures in these areas will include the adoption of a new procurement law to reduce exemptions from regular competitive procedures, measures to facilitate value-added tax refunds for businesses, and high-frequency audits of Naftogaz’s accounts.

To assist the authorities, the IMF will shortly prepare a comprehensive diagnostic study to assess the current governance arrangements and frameworks, identify areas for strengthening and reform, rank the relative importance of the areas emanating from the diagnostic findings, and propose specific remedial measures and time frames for their implementation, likely to be supported in the context of the program with the IMF.

IMF Survey: How confident are you of the authorities’ commitment to the reforms? How much ownership does it have? Do they have sufficient implementation capacity?

Moghadam: The authorities see the program as a historical break with a past marked by crony capitalism, pervasive corruption, and poor governance which weighed heavily on the economy. They believe that there is a window of opportunity for bold and ambitious reforms in order to transform Ukraine into a dynamic and competitive emerging market economy with a transparent government and a vibrant business environment.

Clearly there are considerable uncertainties and risks—both from outside (e.g., geopolitical tensions) and within. We have worked together with the authorities to build in measures to help mitigate these risks.

We are encouraged that the authorities have taken strong ownership of economic reforms, which are long overdue and urgently needed. Up front action on major elements of the program is a good sign in terms of their capacity for successful implementation. Ultimately, the program’s success hinges on the authorities’ unwavering commitment to economic transformation despite resistance from entrenched vested interests.



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