## cr1784 ## Source details **Canonical URL:** [cr1784](https://www.imf.org/-/media/files/publications/cr/2017/cr1784.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr1784.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr1784.pdf.json) --- ### Corruption indicators: Ukraine in international perspective - Multiple sources show exceptionally high corruption in Ukraine relative to peers: - ICRG Corruption Index (June 2016): index varies between 1 and 6; Ukraine’s value is much lower (higher corruption) than averages for “lower and middle income”, “Central, Eastern and Southeastern Europe” (CESEE), and the European Union. - Corruption Perception Index (2015, Transparency International): index varies from 0 to 100; Ukraine scores far worse than comparison groups. - World Bank Control of Corruption indicator (2015): index varies from -2.5 to +2.5; Ukraine is well below comparison averages. - World Bank Enterprise Surveys (2013): bribery incidence and bribery depth are substantially higher in Ukraine than in comparison groups; corruption is widespread across Ukrainian regions and particularly severe in Kyiv; West reports lower levels but still: 65.8 percent of firms in the West consider corruption a major constraint for business. - Cross-source correlation: - Correlation between indicators is extremely high; example: for 2014, correlation between the ICRG indicator and the World Bank Control of Corruption index is 0.95. - Trends: - Over the last 10 years (to 2016), corruption declined in EU-28 and CESEE but showed no improvement in Ukraine. - ICRG index suggests a worsening in Ukraine in 2012; World Bank Control of Corruption shows a very similar pattern through 2015. - Business environment: - Global Competitiveness Report (weighted scores): 2013 — corruption was the second most important obstacle; 2016 — corruption became the most problematic factor for doing business and concerns about policy and government instability increased. - Context and policy note: - High corruption can severely undermine growth by hindering private investment and slowing convergence to the rest of Europe. - Ukrainian authorities adopted measures aligned with some best practices but face challenges including concentration of political and economic power in a small group. *Prepared by Damiano Sandri (RES).* ### Corruption and economic growth (empirical evidence) - Empirical approach: - Uses cross-country scatter of log GDP per capita (PPP) against CPI (2015) and time-series panel regressions using ICRG (longest coverage); one-year lagged corruption used to mitigate reverse causality; regressions include country-fixed effects and controls (lagged growth, lagged level of GDP per capita, lagged secondary school enrollment). - Time-series panel regression results (sample 2005–2015, dependent variable: real growth of per capita GDP): - One-year lagged ICRG coefficient (bivariate, column 1): 0.868** (standard error 0.424). - Interpretation: an increase in the ICRG index by one unit would raise GDP growth by about 0.87 percent within one year. - With controls (column 2): - One-year lagged ICRG coefficient: 0.692** (standard error 0.346). - Lagged per capita GDP growth: 0.194*** (standard error 0.026). - Log of GDP per capita: -15.58*** (standard error 1.217). - Secondary school enrollment: 0.0540*** (standard error 0.020). - Constant: 0.0504 (standard error 1.118). - Observations: 1,060; R-squared: 0.205; Countries: 129. - Accounting for autocorrelation, a one-unit increase in ICRG raises GDP growth by 0.69 percent within one year and by about 0.85 percent after 3 years. - Extending period to 1995–2015 (column 3) makes the ICRG coefficient -0.0821 (standard error 0.145) and statistically insignificant; R-squared falls from 0.20 to 0.07. - Investment growth specifications: - One-year lagged ICRG coefficients reported as 14.001** (standard error 1.719) and 4.268 (standard error 3.140) across specifications; Observations: 985 and 1773; R-squared: 0.089 and 0.003; Countries: 120 and 124. - Cross-country regressions (2005–15; Table 2): - Bivariate (column 1): ICRG coefficient -0.605*** (standard error 0.154); R-squared: 0.105; Observations/Countries: 133. - With controls (column 2): ICRG coefficient 1.352* (standard error 0.729); Initial log GDP per capita: -1.663*** (standard error 0.282); Initial secondary school enrollment: 0.0970*** (standard error 0.028); Initial secondary school enrollment squared: -0.000483*** (standard error 0.000); Constant: 11.27*** (standard error 1.898); R-squared: 0.366; Observations/Countries: 109. - Interpretation: a one-unit increase in ICRG is estimated to increase per capita GDP growth by 1.35 percent in that specification. - Re-estimations over 1995–2005 show weaker or insignificant ICRG effects in some specifications. - Main implications: - Reducing corruption is associated with higher per capita GDP growth and higher investment; lowering corruption in Ukraine to regional levels could raise per capita GDP growth by about 0.85 percent (3-year effect accounting for autocorrelation). - Stronger governance constraints appear more damaging once traditional macro reforms have been implemented. *Prepared by Damiano Sandri (RES).* ### Projections and scenarios for Ukraine’s convergence - Projection assumptions: - Econometric analysis uses an increase of the ICRG index by one unit may raise per capita GDP growth by about 1 percent (used for projections). - GDP per capita measured in PPP; projected relative to EU average. - Projected outcomes for per capita GDP relative to EU average in 2040: - If corruption remains unchanged: about 30 percent of the EU average in 2040. - If corruption is lowered to the highest level prevailing among EU countries (increase of the ICRG index by one unit): about 40 percent of the EU average in 2040. - If corruption is reduced to the EU average (equivalent to a 2.5 increase of the ICRG index): per capita GDP will exceed 50 percent of the EU average in 2040, with sharp convergence afterwards. ### Regional comparison and institutional best practices - Historical comparison: - Poland, Romania, and Latvia started transition with similar GDP per capita in 1992 and by 2015 on average have GDP per capita three times higher than Ukraine. - Poland’s GDP per capita is 70 percent of the EU average; Ukraine is close to 20 percent. - Anticorruption institutional features associated with progress: - Specialized autonomous anticorruption agencies: Romania DNA (2002), Latvia KNAB (2002), Poland CBA (2006). - Leadership perceived as rule-of-law oriented and strong public support. - Publication of comprehensive public officials’ asset declarations: Latvia (1994), Romania (1996), Poland (comprehensive requirement introduced in 2003); ECtHR case WYPYCH v. POLAND (no. 2428/05, ECtHR, October 25, 2005) upheld publication and internet access. - Judicial results and convictions: Romania (2015) — DNA indicted one sitting prime minister, five ministers, 21 members of parliament; ordered seizure of almost half a billion dollars; DNA indictment confirmation rate reached 90 percent; around US$200 million recovered by the Romanian State in 2015. Latvia KNAB confirmation rate exceeded 80 percent. - Civil society and investigative media supported design and public backing. ### Policy implications and recommendations for Ukraine (operational priorities) - Progress to date: - NABU started late 2015; after one year: more than 40 cases sent to court; two court decisions required restitution of US$45 million; NABU seized more than US$200 million in financial assets. - Comprehensive asset declaration system implemented by end-October 2016 (assets legally and beneficially owned, including relatives and assets outside Ukraine). - Civil society estimate: members of parliament collectively declared almost half a billion U.S. dollars in banknotes. - Establishment of the business ombudsman supports anticorruption efforts. - Remaining challenges and public sentiment: - More than three years after Euromaidan, no senior officials had been convicted (as of reporting period). - Assets recovered by state budget from convictions for acts of corruption: less than US$5,000 in 2015 and less than US$3,000 for the first six months of 2016. - December 2016 polls: 89 percent of the population considers authorities’ efforts to address corruption to be a failure. - Recommended actions: - Strengthen NABU’s independence and investigative powers; resist pressures to weaken NABU or revisit its exclusive jurisdiction in high-level cases; give NABU independent wiretapping rights. - Follow up on asset declarations to pursue quick enforcement wins: convict officials who did not file declarations and those with demonstrably false declarations. - Operationalize an anticorruption court (judicial reform legislation adopted in July 2016) ensuring public trust and independence. - Tackle oligarchy and media plurality constraints: address concentrated elite power structures that influence law making, appointments, and media control. ### Foreign enforcement and AML support - Rationale: - Domestic convictions and asset recovery take time; absent short-term enforcement, elites may regain strength and public trust may erode. - Foreign enforcement actions against Ukrainian officials can assist while domestic institutions strengthen; precedent: conviction in the United States, 10 years ago, of a former Ukrainian prime minister for crimes including money laundering and extortion. - Legal pathways: - In many countries, proving property is proceeds of crime does not require a conviction for the predicate offense; this can facilitate foreign prosecutions of laundering of proceeds of acts of corruption by Ukrainian officials regardless of Ukrainian judicial cooperation. - Laundering of proceeds from absence or false asset declarations (a crime in Ukraine) may constitute money laundering in some foreign jurisdictions. - Role of AML frameworks and financial centers: - Effective AML implementation in host financial centers and targeted use of foreign criminal and asset-forfeiture regimes, together with robust AML compliance, can provide enforcement alternatives or complements while domestic capacity is built. ### Relevant fiscal and pension context figures (referenced) - PFU deficit jumped to 6¼ percent of GDP in 2016 following the end-2015 tax reform that reduced social security contributions from an average rate of 40 percent to a flat 22 percent. - Average pension in Ukraine stands at about US$65–70 per month. - Average gross replacement rate: about 39 percent (2015 estimate). - Following expected increase in average wage due to government decision to double the minimum wage from 2017, the replacement rate could drop closer to 30 percent. - Special pension recipients account for less than 10 percent of the total pension population. *Source: IMF staff discussion in cr1784 (excerpt).* ### Pension system: coverage, finances, and reforms - Pensioner population and composition: - Total pensioners: 12.3 million at the beginning of 2016. - About ¾ were old-age pensioners. - About 10 percent were disability pensioners; remainder were survivor and early retirement pensions. - More than seven million pensioners, out of the total of 12 million pensioners, receive the minimum pension. - Preferential treatment and special pensions: - Special pensions assessed according to last or best career years; general regime based on full-career average earnings. - Judges: base salaries set in multiples of 30 to 50 of the minimum wage; pension benefit for judges is 50 percent of total remuneration plus 2 percent for each year of service in excess of 20 years. - Large categorical supplements: war veterans (about 1.1 million as of January 1, 2015) and “children of war” (about 3.3 million); supplements often proportionate to minimum pension or in hryvnia. - Assessment: categorical supplements are poorly targeted transfers; means-testing would improve equity and free resources. - Early retirement and inflows: - About 1.3 million early retirees under hazardous-occupation lists on January 1, 2016. - Minimum prospective retirement age for hazardous occupations: 50 years for list 1 and 55 years for list 2; for women, minimum retirement age of 50 years will be achieved by 2024. - March 2015 reform: retirement age for women in occupations from both lists began increasing gradually by five years; length-of-service requirements also increased by 5 years. - June 2016: lists 1 and 2 revised to remove occupations no longer hazardous; expected to reduce eligible early retirees by about 40 percent over time. - Privileged occupational groups (teachers, doctors, artists, public transportation and tractor drivers, etc.) can retire early under occupation-specific criteria; teachers and doctors presently need at least 26 years of service and be 50.5 years of age to take early retirement. - Employees in healthcare and education account for about 1/3rd of the annual inflow of early retirees. - Several eligibility criteria scheduled to tighten (examples noted in Table 2): minimum years of service and retirement ages for some groups will increase to 30 years and 55 years by 2024 and 2026, respectively, for certain categories. - PFU finances and deficits: - PFU revenues cover only about 2/5ths of its total expenditure. - Revenues consist of social security contributions; about 80 percent, by Cabinet resolution, directed to PFU. - 2016 reform: single flat rate of 22 percent payable only by the employer replaced multiple rates; revenue from contributions dropped by nearly 4 percent of GDP in 2016, of which PFU lost about 3½ percent of GDP; shortfall financed by state budget transfers. - Selected Table 3 figures (UAH billions and percent of GDP, reported): - Revenue (2012–2016 Act./Prel.): 158.0, 166.9, 165.9, 169.9, 112.1 - Expenditure (2012–2016 Act./Prel.): 233.7, 250.4, 243.5, 265.7, 254.8 - Overall balance (2012–2016 Act./Prel.): -75.7, -83.5, -77.6, -95.8, -142.7 - State budget transfer (2012–2016 Act./Prel.): 64.5, 83.2, 75.8, 94.8, 143.8 - Memorandum: GDP (UAH billions) 1,405; 1,465; 1,587; 1,979; 2,280 (2012–2016) - PFU deficits financed by state budget transfers; other financing items include treasury loans (minimal) and other adjustments. - Weak link between benefits and contributions; universality of minimum pension: - Universal support guarantees at least the minimum pension if contribution period is 35 years for men and 30 years for women. - Top-ups for contributory periods between 15 and 35/30 years are proportional and not means tested, reducing incentives to contribute. - Constitution guarantees right for all pensioners to receive pension at level of subsistence minimum for the elderly. - From January 1, 2017 minimum wage will no longer equal the subsistence minimum; minimum pension remains linked to subsistence minimum, increasing pressure to de-link. - Low contribution revenue, informality, and tax policy: - Before reform there were 67 contribution rates in range of 36.76–49.70 percent; effective rate about 40 percent (3.5 percent by employee). - Reform replaced with a single 22 percent employer-paid rate. - Sole proprietors under simplified regime pay 22 percent of one minimum wage irrespective of income, encouraging arbitrage and hiring as sole proprietors. - Pension support ratio is one of lowest in Europe: beneficiaries to contributors ratio of 1:1. - About 18 million in the labor force in 2015 (16.4 million employed); only 12.3 million paying contributions. - Salary underreporting: share of employees reporting salaries below 1 and 2 minimum wages about 30 percent and 60 percent in 2013, respectively. - Doubling of minimum wage effective January 1, 2017 motivated by legalizing informal salaries. - Taxation of pensions: - About 0.1 percent of pensioners subject to income taxation. - From January 1, 2015 threshold for pension income taxation lowered from 10 to 3 times minimum subsistence level for retirees; June 2016 parliament reinstated threshold at 10 times the minimum subsistence level. - Policy-relevant suggestions: - Tighten early retirement options further and improve equity; government has revised lists and increased ages and service requirements. - Increase revenue administration efforts to address low compliance and informality; lowering contribution rates alone had modest effects. - Consider de-linking minimum pension from subsistence minimum. - Means-test categorical pension supplements and consolidate pension legislation. *Source: IMF staff analysis in cr1784 (Pension coverage, finances, and reforms).* ### Demographics and long-term pension projections - Demographic trends: - Fertility dropped to average of 1.2 children per woman during 2000–05; current average fertility rate is 1½ children per woman. - Life expectancy at birth improving but remains quite low (second lowest in Europe). - If fertility and mortality remain unchanged, population would decline by about 30 percent by 2050. - UN medium-fertility scenario limits decline to about 20 percent by 2050. - Old-age dependency ratio doubled between 1960 and 2015 and will increase further. - Projection methodology for pension spending (decomposition following Clements and others, 2014): - Components: Replacement rate (RR) — average pension over average output per worker; Coverage ratio (CR) — share of pensioners in population above retirement age (above 65); Old-age dependency ratio (ODR) — population above 65 over working age population (15–64); Inverse of labor participation (LP) — share of workers in working age population. - Replacement rate used: 39 percent (2015). - Coverage ratio follows population scenario with 2015 age- and gender-specific participation rates. - Key projection results: - Long-term pension spending expected to increase by about 6 percent of GDP under UN medium-fertility scenario. - Under high-fertility scenario spending could be significantly lower; under low-fertility significantly higher. - Stabilizing pension spending without policy changes would require replacement rate to fall to around 28 percent in the long term. - Reform alternatives and quantitative envelopes: - Two main approaches: reduce benefit levels (replacement rate) or reduce coverage (limit inflow of new retirees). - Raising statutory retirement age to 65 (gradual: achieved by 2026 for men and 2031 for women in illustrative scenario) could save about 3½ percent of GDP by 2050 relative to baseline. - Raising retirement age to 63 (gradual) could save about 2 percent of GDP by 2050. - Tightening early retirement options, means-testing categorical supplements, consolidating pension legislation, broadening contribution base, and strengthening compliance are recommended. - Assumptions: - Replacement rate assumed constant at 39 percent for projections unless policy changes modeled. - Savings estimates assume no behavioral changes beyond those explicitly modeled and age- and gender-specific rates remain at 2015 levels. *Source: IMF staff calculations and Ukraine chapter text.* ### Preconditions and prerequisites for IT adoption (Box 1) - General findings on IT adoption: - Success linked to analytical/data infrastructure, political support, and credibility. - Recommendation (not prerequisite): inflation should be in single-digits and central bank should acquire some anti-inflation credibility before “hardening” targets. - NBU institutional steps and timeline: - Since 2014: improvements in processes, communications, and operational framework. - Institutional changes: monetary policy committee (MPC), structured forecasting and policy analysis (FPAS), regular press conferences, quarterly inflation reports. - August 2015: Board proposed guidelines for 2016–20 targeting declining inflation from 12 percent in 2016 to 5 percent from 2019 and commitment to flexible exchange rate. - March 2016: NBU roadmap for IT covering five areas (institutional capacity; monetary policy objectives and instruments; decision-making processes; communications and transparency; financial sector development). - October 2016: FX intervention strategy published. - December 2016: NBU formally adopted IT with five essential elements in place. - Five key elements of IT regimes (Box 2): - 1. Price stability as explicit primary goal. - 2. Public announcement of quantitative inflation targets. - 3. Information-inclusive strategy for setting policy instruments. - 4. Transparent communications on plans, objectives, rationale. - 5. Enhanced accountability mechanisms. - Inflation outcomes and policy stance: - Headline inflation peaked around 60 percent in 2015 and fell to 8 percent by September 2016; core inflation peaked around 40 percent in 2015 and fell to 6 percent by September 2016. - Headline inflation subsequently increased to around 12 percent due largely to adjustment of regulated energy prices; core inflation has remained around 6 percent. - Operational framework and market functioning: - February–March 2016: NBU streamlined operating framework, strengthened policy rate, narrowed corridor. - Remaining issues: volatility of short-term rates, shallow interbank market, dominance of UAH O/N swap in 2016. - IMF TA recommended more active liquidity management to spur interbank activity. - Analytical capacity and communications: - Plans to improve QPM, develop DSGE model, extend forecasting toolkit; IMF TA recommended assessing credibility effects and monetary-fiscal interactions. - NBU preparing technical background documents and public-oriented explanations. - Government support and credibility risks: - De jure independence exists but cooperation and political support lag; examples of parliamentary efforts to reduce independence and doubling of minimum wage with limited analysis. - Recommendation: strong government statement supporting NBU independence and IT, backed by consistent fiscal and wage policies; consider prudent fiscal rules and inflation-indexed securities issuance. - Risks to monetary policy effectiveness: - High dollarization, low financial development, high NPLs, bank recapitalization needs, administrative restrictions and capital controls, and high public debt could constrain transmission and create conflicts. - NBU scores relatively high on de jure independence; NBU Council role and constitutional mandates noted. - 2015 amendments limited government ability to demand NBU profit distribution. *Source: cr1784 - Box 1 and Box 2 (concluded).* ### Financial market development and stability - Market depth and FX exposure: - Stock market size and turnover remain low; private bond market size limited and maturities short. - Banks’ FX mismatch remains a significant vulnerability. - Selected NBU self-assessment scores (staff background): - Financial market development/soundness: NBU score 0.25 ("Partially met/on an improving trend"). - Banks’ CAR: NBU score 1.00. - Stock market size: NBU score 0.13. - Private bond market size: NBU score 0.12. - Stock market turnover: NBU score 0.06. - Banks’ FX mismatch: NBU score 0.00. - Bond maturities: NBU score 0.17. - Dollarization and exchange-rate policy: - High dollarization and FX exposure can produce conflicts between inflation and exchange-rate objectives as liberalization proceeds. - Policy importance: strong prudential regulation, FX loan standards, and promotion of financial development to support IT credibility. - International reserves and FX intervention: - FXI strategy: intervene to smooth excess volatility, not to target a level or path of exchange rate; transparency supports IT credibility. - Adequate reserves support confidence and help reduce dollarization. - Transmission mechanism: - Credit channel: since 2015 banks’ rates responded more to NBU rates but not fully; loan rates sometimes more responsive to deposit or interbank rates; NPLs and weak creditor rights constrain credit growth and interest-rate transmission. - Asset-price channel: shallow FX, interbank, and securities markets limit banks’ willingness to intermediate; government return to market with domestic-currency securities is positive but concentration of demand remains. - Central bank liquidity management and interbank development: - Recommendation: move to more active liquidity management with daily accurate liquidity forecasting and better cooperation with Ministry of Finance. - Current practice: banks borrow from NBU at 200 basis-points above policy rate for short-term shortages; this discourages short liquidity positions and keeps interbank market one-sided. - Instruments: 14-day CDs offered daily are now the key policy instrument; reserve requirement averaging and simplified uniform rates implemented. - Monetary stance and policy calibration: - NBU should stay vigilant and make gradual policy changes when lowering the policy rate to allow adjustment and limit excess liquidity volatility; be prepared to tighten promptly for supply shocks. - Rationale: high commodity weight in CPI, data revisions, and time needed to assess shocks; calibrated gradual path to low inflation recommended. - Progress on operational reforms: - Monetary Policy Committee established December 2014. - Enhanced transparency: regular press releases and Inflation Reports since March 2015; roadmap (March 2016); FX intervention strategy (October 2016). - Interest-rate focused operations strengthened (February–April 2016); single policy rate operationally relevant and corridor narrowed; 14-day CDs and 14/28-day tenders implemented. *Source: IMF staff chapter "4. Financial market development/stability" (cr1784).* *Italic: Source: cr1784 (IMF staff analysis and selected tables and figures from the supplied chapter).* ### 1. Corruption Indicators: Ukraine in International Perspective __________________________ 4 ### 1. Corruption Indicators: Ukraine in International Perspective __________________________ 4 ### A. Corruption indicators and international comparisons - Multiple data sources consistently show Ukraine facing exceptionally high levels of corruption relative to peers: - Panel 1: ICRG Corruption Index (June 2016) — index varies between 1 and 6 (with lower values indicating higher corruption). Ukraine’s value is much lower (higher corruption) than averages for “lower and middle income”, “Central, Eastern and Southeastern Europe” (CESEE), and the European Union. - Panel 2: Corruption Perception Index (2015, Transparency International) — index varies from 0 to 100 (lower values indicate higher corruption). Ukraine scores far worse than the comparison groups. - Panel 3: World Bank Control of Corruption indicator (2015) — index varies from -2.5 to +2.5 (lower values denote higher corruption). Ukraine is well below the comparison averages. - Panel 4: World Bank Enterprise Surveys (2013) — bribery incidence (percentage of firms experiencing at least one bribe request) and bribery depth (percentage of public transactions with a gift or informal payment request) are substantially higher in Ukraine than in comparison groups. - Cross-source correlation: - The cross-country correlation between the various corruption indicators is extremely high. Example: for 2014, the correlation between the ICRG indicator and the World Bank Control of Corruption index is 0.95. - Geographic distribution inside Ukraine (Enterprise Surveys, 2013): - Corruption is widespread across Ukrainian regions, particularly severe in Kyiv. - The West reports lower levels by comparison, but still: 65.8 percent of firms in the West consider corruption a major constraint for business. - Panel data show: - Bribery incidence, 2013: West, North, South, East, Kyiv (percent values shown in figure). - Bribery depth, 2013: West, North, South, East, Kyiv (percent values shown in figure). ### Corruption over time - Time-series evidence (ICRG monthly series from April 1998; World Bank Control of Corruption series to 2015): - Over the last 10 years (to 2016), corruption has declined in EU-28 and CESEE countries, but there has been no improvement in Ukraine. - The ICRG index suggests a worsening of the corruption problem in Ukraine in 2012. - World Bank Control of Corruption index shows a very similar pattern through 2015. ### Most problematic factors for doing business (Global Competitiveness Report) - 2013 (weighted scores): corruption was the second most important obstacle to growth; other top constraints included inefficient government bureaucracy, access to financing, tax regulations, tax rates. - 2016 (weighted scores): corruption became the most problematic factor for doing business; concerns about policy and government instability increased. - Panel lists (figures) show ranked weighted scores for the top ten factors in 2013 and 2016. ### Context and policy note - The level of corruption in Ukraine is exceptionally high and can severely undermine economic growth prospects by hindering private investment. - Reducing corruption is essential to speed up economic convergence to the rest of Europe. - Ukrainian authorities have recently adopted important measures aligned with some best practices, but face specific challenges including concentration of political and economic powers in a small group which may hamper effective anti-corruption efforts. *Prepared by Damiano Sandri (RES).* ### B. Corruption and economic growth - Empirical approach and data: - The analysis revisits literature linking corruption and growth using recent data and both time-series and cross-country identification. - Cross-country scatter (Figure 5) plots log GDP per capita (PPP) against the Corruption Perception Index (CPI, 2015). The quadratic regression line indicates higher CPI values (lower corruption) are associated with higher GDP per capita. Ukraine lies above the regression line, indicating high corruption given its GDP per capita. - Time-series panel regressions use the ICRG index (longest time-series coverage) with yearly data for about 130 countries depending on availability. To mitigate reverse causality, the one-year lagged value of corruption is used. Regressions include country-fixed effects and controls: lagged growth rate of GDP per capita (or investment growth), lagged level of GDP per capita, and lagged secondary school enrollment. - Main findings from time-series panel regressions (Table 1): - Sample period 2005 - 2015, dependent variable: real growth of per capita GDP: - One-year lagged ICRG corruption index coefficient (bivariate, column 1): 0.868** (standard error 0.424). - Interpretation given: an increase in the ICRG index by one unit (equivalent to lowering corruption in Ukraine to the levels in Bulgaria and Romania) would raise GDP growth by about 0.87 percent within one year. - With controls (column 2): - One-year lagged ICRG corruption index coefficient: 0.692** (standard error 0.346). - Lagged per capita GDP growth coefficient: 0.194*** (standard error 0.026). - Log of GDP per capita coefficient: -15.58*** (standard error 1.217). - Secondary school enrollment coefficient: 0.0540*** (standard error 0.020). - Constant: 0.0504 (standard error 1.118). - Observations: 1,060; R-squared: 0.205; Countries: 129. - Accounting for autocorrelation, a one-unit increase in the ICRG index raises GDP growth by 0.69 percent within one year, and by about 0.85 percent after 3 years once the autocorrelation coefficient is taken into account. - Columns and additional specifications: - Column 3 (1995 - 2015) shows the ICRG coefficient becomes -0.0821 (standard error 0.145) and loses statistical significance when extending the period back to 1995. The fit deteriorates: R-squared falls from 0.20 to 0.07 comparing 2005–15 to 1995–2015. - Columns covering real investment growth (columns 4 and 5): - One-year lagged ICRG corruption index coefficients: 14.001** (standard error 1.719) in one specification and 4.268 (standard error 3.140) in another; samples and controls differ (see table). - Investment growth specifications report Observations: 985 and 1773; R-squared: 0.089 and 0.003; Countries: 120 and 124. - Interpretation and implications: - The negative association between corruption and GDP per capita suggests that reducing corruption may boost economic growth. - Panel regressions imply that reducing corruption in Ukraine to regional levels could raise per capita GDP growth by about 0.85 percent (3-year effect accounting for autocorrelation). - The stronger negative impact of corruption on growth in recent years may reflect a greater importance of governance constraints once traditional macroeconomic reforms have been implemented. *Prepared by Damiano Sandri (RES).* ### 12. The panel estimates suggest that lowering corruption may also raise investment. In ### The panel estimates suggest that lowering corruption may also raise investment ### Impact of corruption on investment and growth (panel estimates) - Increasing the ICRG corruption index by one unit is associated with a statistically significant increase in the growth rate of investment by 4 percent (estimated over the 2005–15 period, including control variables). - The coefficient on corruption in panel regressions loses statistical significance if the period of analysis is extended back to 1995. - Cross-country regressions (Table 2) regress country-specific real per capita GDP growth between 2005–15 on the average ICRG corruption index, controlling for: - the average log of GDP per capita in PPP (initial income level), - secondary school enrollment in 2003 and 2004, - squared values of schooling and corruption to capture non-linearities. ### Cross-country regression findings (Table 2) - Simple bivariate regression (column 1, GDP growth 2005–15 on ICRG corruption index): - Estimated coefficient on ICRG corruption index: -0.605*** (standard error 0.154). - R-squared: 0.105. - Observations/Countries: 133. - Controlling for initial income and schooling (column 2): - ICRG corruption index coefficient: 1.352* (standard error 0.729). - Initial log GDP per capita: -1.663*** (standard error 0.282). - Initial secondary school enrollment: 0.0970*** (standard error 0.028). - Initial secondary school enrollment squared: -0.000483*** (standard error 0.000). - Constant: 11.27*** (standard error 1.898). - R-squared: 0.366. - Observations/Countries: 109. - Interpretation: A reduction in corruption equivalent to an increase in the ICRG index by one unit is estimated to increase per capita GDP growth by 1.35 percent. - Adding government spending (column 3): - ICRG corruption index coefficient: 1.392* (standard error 0.729). - Government spending (% GDP) coefficient: -0.0435 (standard error 0.040) — not statistically significant. - R-squared: 0.373. - Observations/Countries: 109. - Re-estimations over 1995–2005 (columns 4 and 5): - Bivariate regression (column 4): ICRG corruption index not statistically significant (coefficient 0.0856, standard error 0.178). - With controls (column 5): ICRG corruption index coefficient: 1.324* (standard error 0.784). - R-squared (column 4): 0.002; (column 5): 0.296. - Observations/Countries: 132 (col 4), 101 (col 5). - Standard errors and significance levels reported: *** p<0.01, ** p<0.05, * p<0.1. - Overall message: Cross-country estimates confirm that lowering corruption tends to have a positive and economically meaningful effect on per capita GDP growth, though statistical significance varies by specification and sample. ### Projections for Ukraine under alternative corruption scenarios (Figure 6) - Econometric analysis suggests that an increase of the ICRG index by one unit may raise per capita GDP growth by about 1 percent (used for projections). - Projected paths of Ukraine’s GDP per capita relative to the EU average (GDP measured in PPP): - If corruption remains unchanged: per capita GDP will be about 30 percent of the EU average in 2040. - If corruption is lowered to the highest level prevailing among EU countries (equivalent to an increase of the ICRG index by one unit): per capita GDP will reach about 40 percent of the EU average in 2040. - If corruption is reduced to the EU average (equivalent to a 2.5 increase of the ICRG index): per capita GDP will exceed 50 percent of the EU average in 2040, with sharp convergence afterwards. ### Regional comparison and best practices (Poland, Romania, Latvia) - Historical context: - Poland, Romania, and Latvia started transition with similar GDP per capita in 1992 and have since outperformed Ukraine. - In 2015, the other three countries on average have a GDP per capita that is three times higher than in Ukraine. - Poland’s GDP per capita represents 70 percent of the EU average, while Ukraine is close to 20 percent. - Anticorruption institutional features associated with progress: - Specialized anticorruption law enforcement agencies with broad autonomous powers: - Romania’s National Anti-corruption Directorate (DNA) in 2002. - Latvia’s Corruption Prevention and Combating Bureau (KNAB) in 2002. - Poland’s Central Anti-Corruption Bureau (CBA) in 2006. - Leadership perceived as rule-of-law oriented and strong public support were critical to secure and strengthen institutions. - Publication of comprehensive public officials’ asset declarations increased public ownership of reforms: - Asset declaration requirements: Latvia (1994), Romania (1996), Poland (comprehensive requirement introduced in 2003). - European Court of Human Rights case (WYPYCH v. POLAND, no. 2428/05, ECtHR, October 25, 2005) upheld the publication and internet access to declarations as serving public interest. - Judicial response and convictions reinforced public support: - Romania (2015): DNA indicted one sitting prime minister, five ministers, 21 members of parliament; ordered seizure of almost half a billion dollars; confirmation rate of DNA indictments through final court decisions reached 90 percent; around US$200 million recovered by the Romanian State in 2015. - Latvia: KNAB confirmation rate through final court decisions reached more than 80 percent. - Civil society and investigative media played supportive roles in design and public backing of anticorruption institutions. ### Policy implications and recommendations for Ukraine - Progress to date: - National Anti-Corruption Bureau of Ukraine (NABU) started late 2015. - After one year: more than 40 cases sent to court; two court decisions required restitution of US$45 million; NABU seized more than US$200 million in financial assets. - Comprehensive asset declaration system for high-level officials implemented by end-October 2016 (declaring assets legally and beneficially owned, including relatives and assets outside Ukraine). - Civil society estimate: members of parliament collectively declared a total of almost half a billion U.S. dollars in banknotes. - Establishment of the business ombudsman to support anticorruption efforts. - Remaining challenges and public sentiment: - More than three years after Euromaidan, no senior officials had been convicted (as of the reporting period). - Assets recovered by the state budget from convictions for acts of corruption: less than US$5,000 in 2015 and less than US$3,000 for the first six months of 2016. - December 2016 polls: 89 percent of the population considers the authorities’ efforts to address corruption to be a failure. - Key policy recommendations and operational priorities: - Strengthen NABU’s independence and investigative powers: - Resist pressures to weaken NABU or to revisit its exclusive jurisdiction in high-level corruption cases. - Strengthen investigative powers, including by giving NABU the right to wiretap independently. - Follow up on asset declarations to catalyze public support: - Use disclosures to pursue quick wins in enforcement, including convicting officials who did not file declarations and those with demonstrably false declarations. - Operationalize an anticorruption court to ensure adequate judicial response: - Ensure the anticorruption court envisaged in the judicial reform legislation (adopted in July 2016) is operationalized in a way that ensures public trust and independence. - Address oligarchy and media plurality constraints: - Recognize that concentration of resources in a small group (state capture by pyramidal elites) impedes anticorruption progress. - Tackle elite power structures that influence law making, appointments, and media control to remove incentives and means for entrenching corruption. *Source: cr1784 - 12. The panel estimates suggest that lowering corruption may also raise investment. In (IMF staff analysis and selected tables and figures from the supplied chapter).* ### 33. In this context, while independent law enforcement and courts are strengthening, ### 33. In this context, while independent law enforcement and courts are strengthening, ### Foreign enforcement can support Ukrainian anticorruption efforts - Foreign enforcement authorities could contribute to support Ukrainian anticorruption efforts while domestic institutions are strengthening. - Based on regional experience, even in the best circumstances, it will take time to achieve a critical number of convictions of high-level officials and asset recovery that would content the public and send a signal that acts of corruption are not tolerated and bear consequences for their authors. - Absent enforcement actions in the short term, elite structures benefiting from corruption may find renewed strength to derail past anticorruption efforts, and the general public may lose interest and trust in the overall reform process. This could lead to public discontent and the rise of political forces opposed to reforms. - Enforcement actions against Ukrainian officials by foreign law enforcement authorities could assist in avoiding such outcome while domestic institutions are strengthening. - The conviction in the United States, 10 years ago, of a former Ukrainian prime minister for crimes including money laundering and extortion is cited as an interesting precedent. ### Legal and prosecutorial pathways in foreign jurisdictions - In most countries, when proving that property is the proceeds of crime, it would not be necessary that a person be convicted of a predicate offence. This could facilitate foreign prosecutions of the laundering of proceeds of acts of corruption by Ukrainian officials irrespective of the level of cooperation of Ukrainian judicial authorities. - With regard to asset declaration framework, while the absence or false declaration is a crime in Ukraine, the laundering of the proceeds of this crime may constitute a money laundering offence in some foreign jurisdictions. ### Anti‑money laundering frameworks and financial centers - The effective implementation of anti-money laundering frameworks in financial centers hosting assets of corrupt Ukrainian officials could contribute to support Ukrainian anticorruption efforts. - Targeted use of foreign criminal and asset-forfeiture regimes, together with robust AML compliance in host jurisdictions, can provide practical enforcement alternatives or complements while Ukrainian domestic enforcement capacity is being built. ### Relevant pension- and fiscal-context figures referenced in the surrounding text - PFU deficit jumped to 6¼ percent of GDP in 2016 following the end-2015 tax reform that reduced social security contributions from an average rate of 40 percent to a flat 22 percent. - The level of average pension in Ukraine currently stands at about US$65–70 per month. - Average gross replacement rate of about 39 percent (2015 estimate). - Following the expected increase in the average wage due to the government’s decision to double the minimum wage from 2017, the replacement rate could drop closer to 30 percent. - Special pension recipients account for less than 10 percent of the total pension population. *Source: IMF staff discussion in cr1784 (excerpt).* ### 12.3 million pensioners in the beginning of 2016, about ¾ were old-age pensioners, about ### cr1784 - 12.3 million pensioners in the beginning of 2016, about ¾ were old-age pensioners, about ### Pensioner population and composition - Total pensioners: 12.3 million in the beginning of 2016. - About ¾ were old-age pensioners. - About 10 percent were disability pensioners. - The remainder were pensioners receiving survivor and early retirement pensions. - Anecdotal evidence suggests poor administration contributes to a large number of pensioners (for example, weak flow of information regarding a pensioner’s death reaches the PFU with delays, causing pension payments to continue). - More than seven million pensioners, out of the total of 12 million pensioners, receive the minimum pension. ### Preferential treatment and special pensions - Preferential treatment of special pension recipients results from benefits being calculated under a different formula: special pensions are assessed according to the last or best few years of new retirees’ careers, while under the general regime they are based on full-career average earnings. - Judges: base salaries set in multiples of 30 to 50 of the minimum wage, depending on the level of the court; total remuneration includes various supplements. Pension benefit for judges is calculated as 50 percent of the total remuneration plus 2 percent for each year of service in excess of 20 years. - Large categorical pension supplements exist for groups such as war veterans (about 1.1 million individuals as of January 1, 2015) and the so-called children of war (about 3.3 million individuals). Other groups include veterans of labor, blood donors, victims of Nazi persecution, Chernobyl catastrophe victims, and people residing in mountainous locations. - Supplements are established in proportion to the minimum pension or in hryvnia (for example, veterans of war receive a supplement between 25 and 50 percent of the minimum pension). - Assessment: these pension supplements are unrelated to contribution performance and function as poorly targeted welfare transfers. The report notes that if categorical pension supplements were means tested, this would make the system more equitable and free up resources for more efficient poverty alleviation. ### Early retirement options and inflows - Widespread occupational early retirement options contribute to the large size of the pensioner population. - About 1.3 million people were early retirees under the two hazardous-occupation lists on January 1, 2016. - Minimum prospective retirement age for hazardous occupations: 50 years for list 1 and 55 years for list 2. (For women, the minimum retirement age of 50 years will be achieved by 2024.) - Example service criteria: men employed in occupations on list 1 need at least 25 years of service of which at least 10 years in a hazardous occupation. - Government reforms: - March 2015: retirement age for women in occupations from both lists began increasing gradually by five years and the length-of-service requirement for men and women was also increased by 5 years. - June 2016: the two lists were revised to better align with modern job nomenclature and to remove occupations that can no longer be considered hazardous; this change should reduce the number of people eligible for early retirement on lists 1 and 2 by about 40 percent over time. - Privileged occupational groups (teachers, doctors, artists, public transportation and tractor drivers, etc.) can retire early if meeting occupation-specific minimum years of service or age/years criteria. - Flight attendants and aviation dispatchers allowed to retire at the age of 50; for others where retirement age applies, the minimum is 55 years. - Teachers and doctors presently need at least 26 years of service and be 50.5 years of age to take advantage of early retirement. - Employees in healthcare and education account for about 1/3rd of the annual inflow of early retirees. - Several eligibility criteria are scheduled to tighten (examples noted in Table 2): minimum years of service and retirement ages for some groups will increase to 30 years and 55 years by 2024 and 2026, respectively, for certain categories. ### Pension Fund of Ukraine (PFU) finances and deficits - The PFU revenues cover only about 2/5ths of its total expenditure. - Revenues consist of social security contributions, of which about 80 percent, by Cabinet resolution, are directed to the PFU and the rest to the other social security funds. - Following the 2015 tax reform, the average effective rate of social security contributions of about 40 percent was reduced to a new level of a flat 22 percent from January 1, 2016. - As a result, revenue from social security contributions dropped by nearly 4 percent of GDP in 2016, of which the PFU lost about 3½ percent of GDP. This revenue shortfall is fully financed by transfers from the state budget. - Table 3 (selected figures, in UAH billions and percent of GDP, as reported): - Revenue (2012–2016 Act./Prel.): 158.0, 166.9, 165.9, 169.9, 112.1 - Expenditure (2012–2016 Act./Prel.): 233.7, 250.4, 243.5, 265.7, 254.8 - Overall balance (2012–2016 Act./Prel.): -75.7, -83.5, -77.6, -95.8, -142.7 - State budget transfer (2012–2016 Act./Prel.): 64.5, 83.2, 75.8, 94.8, 143.8 - Memorandum: GDP (UAH billions) 1,405; 1,465; 1,587; 1,979; 2,280 (2012–2016) - PFU deficits are financed by state budget transfers; other financing items include treasury loans (minimal in recent years) and other adjustments. ### Weak link between benefits and contributions; universality of minimum pension - The government provides universal support to pensioners whose earned pension is below the subsistence minimum. A minimum contribution period of 35 and 30 years for men and women, respectively, guarantees that a person will receive at least the minimum pension. - If the contributory period is less than 35/30 years, but more than 15 years, a person can receive a top-up if the calculated earned pension benefit falls below the minimum pension, with the top-up reduced proportional to the shortfall from the minimum contributory period. - These top-ups are not means tested and effectively reduce incentives to contribute to the pension system. - The constitution guarantees the right for all pensioners to receive a pension at the level of the subsistence minimum. The minimum pension amount is determined by the size of the subsistence minimum for the elderly. - Starting from January 1, 2017 the minimum wage will no longer equal the subsistence minimum, while the amount of minimum pension will still be determined by the size of subsistence minimum for the elderly. This is expected to increase pressure to de-link the minimum pension from the subsistence level as well. ### Low contribution revenue, informality, and tax policy - Key reasons behind insufficient PFU revenues: low contribution rate, a small number of contributors, and a significant underreporting of wages. - Contribution rate changes: - Prior to the reform, there were 67 different social security contribution rates in the range of 36.76–49.70 percent depending on job hazardousness; the effective rate was about 40 percent, of which 3.5 percent paid by the employee and the rest by the employer. - Following the reform, a single rate of 22 percent payable only by the employer replaced the multiple rates. - Effects and issues: - The key motivation behind cutting social security contributions was to reduce informality; evidence suggests only a very modest effect on improved payment compliance in 2016. - Sole proprietors registered under the simplified regime for small taxpayers pay 22 percent of one minimum wage irrespective of income, resulting in lower effective contribution rates and creating an opportunity for arbitrage as it encourages hiring workers as sole proprietors. - Low number of contributors: - Ukraine’s pension system has one of the lowest pension support ratios in Europe, with a ratio of beneficiaries to contributors of 1:1. - Of about 18 million people in the labor force in 2015 (of which 16.4 million are estimated to be employed), only 12.3 million were paying social security contributions. - The key reason behind the low number of contributors is a high degree of unofficial employment. - Under-reporting of wages: - Anecdotal evidence of salary payments in envelopes is corroborated by reported data showing high concentration of salaries below two minimum wages: share of employees reporting salaries below 1 and 2 minimum wages was about 30 percent and 60 percent in 2013, respectively. - The doubling of the minimum wage effective January 1, 2017 was motivated by the need to legalize some informal salaries. - The report notes that for someone with sufficient years of service to qualify for minimum pension, the marginal benefit of reporting salaries above one minimum wage but less than two minimum wages is nearly zero because of existing top-up policy. ### Taxation of pensions - Only about 0.1 percent of all pensioners are currently subject to income taxation. - From January 1, 2015 the government lowered the threshold above which pension income is taxed from 10 to 3 times the minimum subsistence level established for retirees, leaving the majority of pensioners exempt from taxation. - In June 2016 parliament amended the tax code and reversed the pension taxation by reinstituting the threshold at 10 times the minimum subsistence level. ### Demographic pressures and projections - Ukraine is already seeing a decline in its population, unlike elsewhere in Europe where population decline is expected to start from the 2020s. - Fertility and life expectancy: - Fertility rates dropped to an average of 1.2 children per woman during 2000–05; the current average fertility rate is 1½ children per woman, below the world average of 2½. - Life expectancy at birth has been improving but remains quite low (the second lowest in Europe). - Demographic projections: - If fertility and mortality rates remain unchanged from current levels, the population would decline further by about 30 percent by 2050. - The UN’s medium-fertility scenario assumes a continued gradual improvement in fertility rates, limiting the decline in population to about 20 percent by 2050. - Resulting impact: the old-age dependency ratio has doubled between 1960 and 2015 and will increase further as population shrinks and ages. ### Policy-relevant analysis and suggestions (as noted in the source) - Tighten early retirement options further and improve equity of the pension system to limit inflow of early retirees (the government has already taken some steps, for example revising lists 1 and 2 and increasing ages and service requirements). - Increase efforts by revenue administration to address low compliance and informality; lowering contribution rates alone has shown only a very modest effect on payment compliance. - Consider de-linking the minimum pension from the subsistence minimum to reduce pressure on PFU finances. - Make categorical pension supplements means tested to improve equity and free up resources for more efficient poverty alleviation. *Source: IMF staff analysis in cr1784 (Pension coverage, finances, and reforms) from the provided document.* ### 2050. At the same time, the population will age rapidly and the distribution of the population by age ### cr1784 - 2050. At the same time, the population will age rapidly and the distribution of the population by age ### Demographic trends and implications - The old-age dependency ratio is expected to nearly double by 2050, which is broadly in line with other countries in the region, but much above the rest of the world. - Population projections under UN scenarios (medium-, low-, high-fertility) drive markedly different long-term outcomes for pension spending; projections are entirely driven by demographics and assume existing policies remain unchanged and that the replacement rate remains constant at the level of 2015. - The labor participation rate in projections is determined by population dynamics and assumes age- and gender-specific labor force participation and employment rates equal to the average observed during 2010–15. - The replacement rate is assumed constant at the level of 2015 for projections. ### Pension spending projection methodology - Pension spending as a percent of GDP is decomposed into four components (following Clements and others, 2014): - Replacement rate (RR): average pension over average output per worker. - Coverage ratio (CR): share of pensioners in the total population above the retirement age (above 65). - Old age dependency ratio (ODR): ratio of population above 65 to the working age population (15–64). - Inverse of labor participation (LP): defined here as the share of workers in the total working age population. - The replacement rate used for calculations is 39 percent, which is calculated as the ratio of average pension to average economy-wide wage in 2015. - Aggregate coverage ratio follows the respective population scenario and assumes age- and gender-specific pension system participation rates are unchanged from their 2015 levels. - The methodology abstracts from potential behavioral responses (for example, responses from ongoing increases in the retirement age for women). ### Key findings from projections - In the long term, pension spending is expected to increase by about 6 percent of GDP under the UN’s central, medium-fertility scenario. - Pension spending could be significantly lower under a high-fertility scenario or significantly higher under a low-fertility scenario. - Maintaining pension fund spending at its current level without altering other policies under current demographic trends would require a drop in the replacement rate to around 28 percent in the long term. - Demographics—particularly the rising old-age dependency ratio—are the key factor driving higher pension spending. ### Reform options and policy recommendations - A comprehensive reform effort is required; no single marginal change will close the large and growing pension deficit while maintaining adequate pensions. - Two main reform alternatives: - Reducing the level of pension benefits (reducing the replacement rate). - Reducing coverage (limiting inflow of new retirees). - Additional fiscal measures that could be considered: - Increasing pension taxation for upper income groups. - Raising social security contributions — though politically less favored given the government’s inclination to reduce overall tax burden. - Improving payment compliance to address underreporting of wages and reforming the simplified tax regime to broaden the contribution base. - Reducing replacement rate: - Risks increasing old-age poverty because the current system is not generous. - Under current policies, the average replacement rate is likely to decline due to partial inflation indexation, attrition of categorical supplements, and discontinuation of special pensions for new retirees from June 2015. - To avoid natural decline in replacement rates, the government would need to modify current inflation indexation rules. - Reducing the inflow of new retirees (most effective measures): - Raising the statutory retirement age: - Gradually raising the retirement age to 65 (achieved by 2026 for men and 2031 for women in the illustrative scenario) and aligning other relevant retirement ages could generate savings of about 3½ percent of GDP by 2050 relative to the baseline projections. - Gradually raising the retirement age to 63 could generate savings of about 2 percent of GDP by 2050. - Tightening early retirement options: - Bring health and education workers under the general retirement regime. - For hazardous occupations, consider a surcharge on social security contributions payable by employers and accumulate them on personified accounts to finance the gap between early and general retirement. - Increase minimum years of service requirements and create incentives for later retirement and disincentives for early retirement (e.g., reduced benefits for early retirees; higher marginal accrual rates for those who continue working). - Means-testing and consolidation: - Means-testing categorical pension supplements using income and asset criteria would improve equity, increase link between contributions and benefits, and free resources for poverty alleviation. - Consolidate pension legislation across various laws and ensure a single principle for providing pensions without privileges for any occupation. - Broadening contribution base: - Broadening the social security contribution base could boost Pension Fund of Ukraine (PFU) revenues. - Strengthen compliance to reduce underreporting of wages and employment. - Increase the base for taxpayers under the simplified regime who pay social security contributions based on the minimum wage rather than proportional to income. ### Quantitative policy envelopes and scenarios - Replacement rate used in calculations: 39 percent (2015). - Replacement rate required to stabilize pension fund spending without other policy changes: around 28 percent (long term). - Projected increase in pension spending under UN medium-fertility scenario: about 6 percent of GDP (long term). - Savings from raising retirement age to 65 (gradual, illustrative): about 3½ percent of GDP by 2050 relative to baseline. - Savings from raising retirement age to 63 (gradual, illustrative): about 2 percent of GDP by 2050 relative to baseline. - Projections and savings estimates assume no behavioral changes beyond those explicitly modeled and assume age- and gender-specific rates remain at 2015 levels. *Source: IMF staff calculations and Ukraine chapter text.* ### Box 1. Typical Preconditions (Pillars) and Prerequisites for Successful IT Adoption ### Box 1. Typical Preconditions (Pillars) and Prerequisites for Successful IT Adoption ### Preconditions and general findings on IT adoption - Many of these conditions are essential for the success of virtually any systematic monetary policy framework; elements more important for IT include the analytical/data infrastructure, given the information-intensive nature of inflation targeting. - Weaker initial conditions appear to be associated with more frequent misses of inflation target ranges, mainly during an initial phase of disinflation. - Macroeconomic performance improves under inflation targeting even with relatively weak initial technical conditions (IMF, 2005), pointing to the importance of expectations and credibility of the inflation-targeting commitment. - The degree of political support for the framework and adoption of IT as part of a broader package of economic reforms may be critical elements (Sherwin, 2000). - Recommendation (not a prerequisite): inflation should be in the single-digits and the central bank should acquire some anti-inflation credibility before “hardening” targets for inflation (Mishkin and Savastano, 2001). - Rationale: tendency for more misses of inflation targets in the disinflation stage; achieving a target may be more costly (higher interest rates and lower output) if credibility is still lagging (Masson et al, 1997; Alichi, 2009). ### NBU commitment, timeline, and institutional steps - Since 2014, continued improvements in processes, communications, and the operational framework for monetary policy to support key elements of IT. - Institutional and operational changes undertaken: - Establishment of a monetary policy committee (MPC) and a structured forecasting and policy analysis (FPAS) cycle. - Regular press conferences and press releases on monetary policy. - Quarterly inflation reports with inflation forecasts. - August 2015: NBU Board proposed new monetary policy guidelines for 2016–20 including targets for a declining path of inflation (from 12 percent in 2016 to 5 percent from 2019 onwards) and a commitment to a flexible exchange rate. - March 2016: NBU published its roadmap for IT implementation covering five areas: institutional capacity; monetary policy objectives and instruments; monetary policy decision-making processes; communications and transparency; and financial sector development. - October 2016: NBU published its foreign exchange intervention (FXI) strategy clarifying FXI objectives (build reserves, smooth excess volatility, support effectiveness of the policy rate), not to target a level or path of the exchange rate. - December 2016: NBU formally adopted the IT regime with the five essential elements of IT in place (see Box 2). ### Box 2 — The Five Key Elements of IT Regimes - 1. Price stability as the explicit, primary goal of monetary policy; - 2. The public announcement of quantitative inflation targets; - 3. An information-inclusive strategy for setting policy instruments (i.e., not based on only monetary aggregates or only the exchange rate); - 4. Transparent monetary policy strategy that ascribes a central role to communicating to the public on the plans, objectives and rationale for policy decisions. - 5. Enhanced accountability mechanisms. - Source: Centre for Central Banking Studies, Handbook—No. 29, State of the art of inflation targeting—2012. ### Inflation outcomes and policy stance - Following the large depreciation in early 2015, the NBU raised interest rates sharply and kept them high on a real, forward-looking basis; easing of policy began only once inflation fell below 20 percent and forecast inflation was in line with the August 2015 targets. - Inflation path and levels: - Headline inflation peaked around 60 percent in 2015 and fell to 8 percent by September 2016. - Core inflation peaked around 40 percent in 2015 and fell to 6 percent by September 2016. - Headline inflation subsequently increased to around 12 percent—due largely to the adjustment of regulated energy prices to market levels—while core inflation has remained around 6 percent. - Note: core inflation is sometimes used as an operational guide to policy as it tends to be a better predictor of future inflation. ### Operational framework and market functioning - February–March 2016: NBU streamlined its operating framework, strengthening the role of the policy rate and narrowing the interest rate corridor. - Remaining operational issues: - Volatility of short-term interest rates is still relatively high. - Interbank market remains shallow and concentrated on short maturities. - The UAH O/N swap became the dominant form of interbank lending in 2016, overtaking ordinary secured and unsecured interbank transactions in UAH. - IMF technical assistance recommendation: move to more active liquidity management to spur interbank activity and strengthen market interest rate formation. ### Analytical capacity and communications enhancements - NBU plans and actions: - Further improvements envisaged to the quarterly projection model (QPM) (QPM is based on a new Keynesian gap model). - Roadmap envisages developing a DSGE model and extending short-term forecasting toolkit. - IMF TA recommended analysis of credibility effects and monetary-fiscal policy interactions to recalibrate the QPM; evaluate forecasting bias of some short-term econometric models and replace with more advanced VAR methods. - NBU preparing technical background documents on interpretation of the inflation objective, the equilibrium real interest rate, reaction functions to shocks; non-technical versions to be published for public understanding. - Important to clarify short-run trade-offs between achieving inflation targets and output variability as well as the policy horizon. - Recent public material: NBU presentation on modeled impact of a 1 pp change in the interest rate on the inflation target, output, exchange rate, and inflation (reference cited in source). ### Government support, coordination, and credibility risks - Cooperation and effective government support for IT appear somewhat lagging despite NBU operational independence to set price stability objective. - Examples of weak support or conflicting actions: - Recent legislative efforts in parliament to reduce NBU independence and return to a fixed exchange rate. - Doubling of the minimum wage with limited ex-ante analysis of its impact. - Limited cooperation between NBU and Ministry of Finance’s Treasury Department on sharing timely projections of sufficient quality hampers NBU liquidity forecasting and a move to more active liquidity management. - Consequences: - Limited track record and uncertainty on achieving price stability appear reflected in still high inflation expectations despite inflation being within the NBU’s 2016 inflation target range. - Inflation expectations of economic agents have declined but remain above this year’s target; similar expectations appear embedded in yields on government securities (market is thin). - Recommendation: a strong statement from the government in support of NBU independence and IT, backed by consistent and supportive fiscal and wage policies, would help credibility. Consider adopting prudent fiscal rules and issuance of inflation-indexed securities to align incentives. ### Challenges to monetary policy effectiveness and transmission - Comparative strengths and weaknesses: - NBU’s de jure independence and analytical/data infrastructure appear ahead of other EM IT adopters. - Pass-through from exchange rate changes seems to have fallen and exchange rate flexibility is close to the average of other EM IT adopters. - Weaknesses: administrative restrictions and capital controls need gradual liberalization; high dollarization increases vulnerability; low levels of financial development; high levels of non-performing loans (NPLs); ongoing bank recapitalization/restructuring. - Risks and implications: - Economic structure (high exchange rate pass-through, sensitivity to commodity prices, high dollarization) and low financial development can put financial stability objectives in conflict with price stability. - High public debt and gross financing needs raise concerns about fiscal dominance or pressure on the central bank to take actions not aligned with the inflation objective. - With high debt, central bank rate increases can cause risk premiums and demand for foreign assets to increase, leading to depreciation and higher inflation, constraining monetary policy (Blanchard, 2004). - Governance risks: - Risk that government or parliament could change rules or pressure the NBU to favor other objectives, restructure NBU holdings of government securities, or indirectly support directed lending. - The quality of governance plays an important role in the credibility of IT (Bordo and Siklos, 2015); governance improvements would signal respect for rules and support NBU credibility. - Specific institutional observations: - NBU scores relatively high on central bank de jure independence indicators, in particular governor independence and appointment via the double veto principle. - Constitution mandates NBU Council approve monetary policy guidelines and exercise control over implementation; Council is not appointed by the double veto process and retains a strong role, including approving key IT parameters and principles. - De jure deficit financing is prohibited; 2015 amendments eliminated government ability to demand NBU profit distribution greater than provided by NBU Law, giving NBU more control over its balance sheet and money supply. - However, fiscal deficit has been substantially reduced while public debt and gross financing needs remain high; NBU currently holds the bulk of government securities, which may contain risks now but could become more important when market holdings increase. *Source: cr1784 - Box 1. Typical Preconditions (Pillars) and Prerequisites for Successful IT Adoption (concluded).* ### 4. Financial market development/stability ### 4. Financial market development/stability ### Stock and bond market depth; banks’ FX exposure - Stock market size and stock market turnover remain low; private bond market size is limited and bond maturities are short, constraining the asset-price channel of monetary transmission. - Banks’ FX mismatch remains a significant vulnerability and a constraint on financial stability and transmission. - Table assessments (selected entries from IT preconditions, NBU self-assessment): - Financial market development/soundness: NBU score 0.25 (staff assessment and background: "Partially met/on an improving trend"). - Banks’ CAR: NBU score 1.00. - Stock market size: NBU score 0.13. - Private bond market size: NBU score 0.12. - Stock market turnover: NBU score 0.06. - Banks’ FX mismatch: NBU score 0.00. - Bond maturities: NBU score 0.17. ### Risks from dollarization and exchange-rate considerations - High dollarization and FX exposure can lead to effectively having two targets (inflation and the exchange rate) or placing more emphasis on exchange-rate stability, potentially confusing markets and creating objective conflicts as the financial account is liberalized. - Policy importance: - Strong prudential regulation and supervision to ensure banks have adequate buffers and FX loan standards. - Further promotion of financial development to reduce risks to the credibility of inflation targeting (IT). ### International reserves and FX intervention strategy - The NBU’s commitment to an adequate level of international reserves and a clear FX intervention (FXI) strategy can mitigate conflicts between objectives and support the credibility of IT. - Key points on FXI strategy: - Intervene to smooth excess volatility, while not targeting a specific exchange rate level or path. - Transparency and commitment to implement the stated FXI strategy support the credibility of the IT regime. - Adequate international reserves: - Help macroeconomic stability and confidence in the national currency. - Help reduce dollarization and support improvements in the transmission mechanism. ### Transmission mechanism of monetary policy - Credit (bank-lending) channel: - Since 2015, banks’ deposit and loan rates have responded more to changes in NBU interest rates, but not fully. - In early 2016, loan rates appeared more responsive to deposit or interbank interest rates (possibly reflecting liquidity conditions or exchange-rate depreciation expectations) rather than the policy rate. - Recent cuts in policy rates since March 2016 were transmitted to loan rates, although with a delay; new loan rates eventually almost fell in line with declines in the policy rate. - High NPLs and weak creditor rights, along with relatively low reliance on bank lending, may constrain future credit growth and limit the impact of interest-rate changes on investment and consumption. - Improvements conditional on progress with bank recapitalization plans, improvements in creditor rights framework, and continued strengthening of regulation and supervision. - Asset-price channel (market/liquidity constraints): - Shallow and illiquid FX, interbank, and securities markets push banks to hold higher liquidity buffers, limiting credit intermediation. - Low levels of other financial assets and lack of a well-established yield curve constrain the impact of policy-rate changes on longer-term interest rates and other asset prices. - Positive development: government return to the market by regularly issuing domestic-currency government securities, though demand and holdings remain somewhat concentrated. - Needed: gradual liberalization of FX restrictions and a more supportive legal and supervisory framework for securities and derivatives markets. ### Central bank liquidity management and interbank market development - Recommendation: NBU should move to more active liquidity management to foster interbank market development and support monetary transmission. - Current framework: banks facing short-term liquidity shortages resort to the shallow interbank market or borrow from the NBU at 200 basis-points (bps) above the policy rate; this discourages banks from holding short liquidity positions and keeps the interbank market one-sided with limited activity. - Proposed operational change: make interventions dependent on daily, accurate liquidity forecasting (including direction of intervention) so market participants can better anticipate counterparties or NBU intervention. - Greater cooperation with the Ministry of Finance on sharing timely projections of sufficient quality would support the NBU’s liquidity forecasting and active liquidity management. ### Monetary stance and policy calibration - Given uncertainty in Ukraine and the cost of missing targets, the NBU should: - Stay vigilant while making gradual adjustments in the monetary stance. - Move gradually when further lowering the policy rate to give agents time to adjust and to limit excess liquidity volatility. - Be prepared to tighten policy without delay in case of supply shocks that threaten inflation objectives. - Rationale: - Significant weight of food (commodity-related) prices in the CPI. - Historical data revisions and time needed to assess whether shocks are transitory argue for gradualism. - A calibrated model with endogenous credibility suggests the loss-minimizing path to low inflation is more gradual than under full credibility. ### Progress on monetary policy framework and operational reforms - Institutional and operational progress (selected items): - Monetary Policy Committee established December 2014. - Enhanced transparency/communications: regular press releases following board decisions on monetary policy (since December 2014); publication of Inflation Reports (first issued March 2015) that include inflation forecasts and risk assessments; publication of roadmap on IT transition (March 2016); publication of FX intervention strategy (October 2016). - Enhancement of interest-rate focused monetary operations (February–April 2016): - Establishing a single policy interest rate that is operationally relevant (resolution on setting the discount rate published). - Linking other central bank interest rates to the policy rate; narrowing the corridor (symmetric around policy rate +/- 200 bps). - Streamlining the framework by reducing number of absorption instruments (currently just O/N and 14-day facility). - Key instruments implemented: - 14-day CDs, offered daily, are now the key policy instrument (to absorb liquidity). To a much lesser extent the NBU also provides liquidity for 14-day terms through tenders conducted weekly, except every fourth week, when liquidity provision is for a 28-day term. - Reserve requirement averaging and a simplified system (uniform rates for DC and FC) implemented. - 2013 Article IV recommendations and implementation status (selected): - Recommendation: set up a system with two short-term instruments (one to absorb and one to provide liquidity) with rates closely linked to policy rate; over time make absorption instrument (7-day or 14-day CDs) the key instrument. - Status: Implemented; 14-day CDs are offered daily and are now the key policy instrument. *Source: IMF staff chapter "4. Financial market development/stability" (cr1784).* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr1784.pdf_