## _cr0515

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---

### Executive Summary
- Real GDP grew by 9.4 percent in 2003; growth is projected to reach 12½ percent in 2004.
- Current account surplus projected at 10 percent of GDP in 2004.
- Consumer price index (CPI) inflation is likely to reach 9–10 percent by year’s end 2004.
- A precautionary 12-month Stand-By Arrangement (SBA) was approved on March 29, 2004; review discussions could not be completed because of policy slippages.
- Key policy-discussion issues:
  - Sustainability of the current economic boom.
  - Immediate risks from rapid expansion.
  - Need for prudent macroeconomic policies and further structural reforms.
- Authorities and staff disagreements:
  - Risk of overheating: authorities viewed risk as relatively remote.
  - Fiscal stance for 2004: staff could not support amended budget with substantial procyclical loosening.
  - Time frame for exiting the de facto peg to the U.S. dollar.
- Staff recommendations:
  - A 2004 consolidated government deficit limited to the original program target of 1.8 percent of GDP.
  - Greater exchange rate flexibility to help restrain credit growth and inflationary pressures and reduce incentives for foreign currency-denominated debt.
  - Monetary tightening to contain inflationary pressures; extent of sterilization and interest rate increases dependent on willingness to let the exchange rate appreciate.
  - Strengthen the role of the private sector by addressing tax distortions, corruption, red tape, and inadequate implementation of the legal framework.
- Lack of agreement and incomplete implementation of key structural measures prevented completion of the review.

### Background and Outlook
- Growth and macro performance:
  - Over 2000-04, GDP growth averaged 8.4 percent.
  - Projected peak growth of 12.5 percent in 2004.
  - Recovery follows a pronounced 1990s output contraction compared with most transition countries.
- External sector and exports:
  - Annual export growth averaged 25 percent since end-2002.
  - Export-driven surge supported a current account surplus and foreign reserve accumulation.
  - Exporters’ profits helped fuel an investment and construction boom.
- Labor market:
  - Official unemployment ~4 percent since 2001, but unreliable due to hidden unemployment.
  - ILO definition unemployment about 9 percent in 2004 (down from 12 percent in 1999).
- Inflation and wages:
  - 12-month CPI: -0.6 percent in December 2002 → 8.2 percent in December 2003 → 9.9 percent by August 2004.
  - PPI inflation reached 22.2 percent in August 2004; “core” PPI inflation would exceed 10 percent excluding energy and metals.
  - Average nominal wage for the entire economy in June 2004 was 26.3 percent above its level the previous year.
- Capital markets and sovereign financing:
  - Ukraine issued a $600 million seven-year Eurobond in March 2004, and a $500 million five-year floating rate Eurobond in August 2004; both contain collective action clauses.
  - Spreads ~360 basis points; correlated with Russia.
  - Standard and Poor’s upgraded long-term sovereign credit rating to B+; Moody’s raised outlook to positive.
- Public debt and fiscal performance:
  - Public debt ratio fell from 61 percent of GDP to a projected 27 percent at end-2004.
  - Revenue gains from personal income and payroll taxes and state enterprise dividends offset spending rise from 34 percent to almost 38 percent of GDP.
  - Consolidated government cash deficit: 0.7 percent of GDP in 2003; 0.2 percent of annual GDP through end-June 2004 versus end-June adjusted program ceiling of 0.9 percent (but accumulation of VAT refund arrears masks underlying deficit).
- Monetary context and exchange rate:
  - De facto peg to the dollar; strong money growth consistent with single-digit inflation amid remonetization and modest tightening.
  - NBU interventions led to strong net international reserves accumulation.
  - From May 2004, NBU tightened policy via issuance of certificates of deposit (CDs) and raising reserve requirements; discount rate raised by 50 basis points to 7.5 percent.
  - In the 12 months to June 2004, real effective exchange rate depreciated by 4 percent.
- Competitiveness and wages:
  - Competitiveness remains strong; average wages remain less than half Russia’s wages.

### Policy Discussions and Risks
- Main policy concerns:
  - Overheating risk tied to rapid growth, credit expansion, and fiscal loosening.
  - Need to contain inflationary pressures emerging in 2004.
- Specific risks highlighted:
  - Procyclical fiscal loosening in the second half of 2004 could exacerbate inflation.
  - Rapid credit growth and increasing foreign exchange exposures in the private sector could raise vulnerability to external shocks.
  - Political cycle (run-up to October presidential elections) heightens uncertainty; however, no major policy change was expected irrespective of electoral outcome.

### Fiscal Policy and Reform
- Fiscal stance 2000–H1-2004:
  - Consolidated government cash deficit 0.7 percent of GDP in 2003; 0.2 percent through end-June 2004 (with caveats on VAT arrears).
  - State replaced senior management in the state tax administration in June 2004 due to VAT administration problems.
- Staff fiscal recommendations:
  - Limit 2004 consolidated government deficit to 1.8 percent of GDP (original program target).
  - Preserve space for increased social and capital spending while avoiding procyclical loosening.
- Structural reform needs:
  - Improve VAT administration.
  - Accelerate structural reforms to improve investment climate.
- Staff recommendations on near-term fiscal stance:
  - Save additional resources stemming from higher growth and privatization proceeds, or at least confirm the original program fiscal stance in 2004—a deficit of 1.8 percent of GDP.
  - Under the original 1.8 percent of GDP target, nominal revenues boosted by growth would allow new spending of about HRV 3.6 billion (1.1 percent of GDP) during the second half of the year versus HRV 8 billion (2.4 percent of GDP) envisaged under the amended budget.
  - Under the tighter scenario: cover approved wage increase, provide full repayment of VAT refund arrears, and allow for significant accumulation of deposits at the NBU; excess privatization proceeds would not be spent.
- Staff concerns about the 2004 fiscal loosening (if limited to 3 percent of GDP):
  - It would increase the deficit despite a booming economy; additional resources should be saved to allow future countercyclical fiscal policy.
  - Additional fiscal expansion exacerbates inflationary pressures.
  - Only 20 percent of the extra spending could clearly be identified as one-off—about one-third appears recurrent—risking undermining the 2005 fiscal target and contributing to higher borrowing costs.
- Medium-term fiscal reform and resource needs:
  - Authorities estimate about 3½ percent of GDP in additional annual resources may be necessary to address obsolete and depreciated public infrastructure.
  - Staff estimated that spending initiatives to address civil service, pension, education, and health problems—if not matched by equivalent measures—could result in some 8-9 percent of GDP a year in additional spending.
  - To finance reforms and possible tax cuts (e.g., reduce VAT rate by 5 percentage points by 2006), extensive base-broadening is needed; costs could amount to 2-3 percent of GDP annually.
  - Scope exists to eliminate more VAT exemptions totaling about 1 percent of GDP even after envisioned rate reductions.
  - Staff supported the authorities’ revised VAT regime for agriculture but cautioned against allowing producers to retain VAT collected for their own use and stressed need to eliminate fraudulent refund claims.
  - Much scope to improve tax administration: address poor management practices, badly targeted audit program, internal control problems undermining tax compliance.
- Public expenditure and state enterprise management priorities:
  - Improve project appraisal, selection, and execution before accommodating one-off investment costs.
  - Fully develop and use the medium-term expenditure framework to reprioritize spending.
  - Match civil service pay increases to employment reductions.
  - Use parametric pension fund changes (including a higher retirement age) to support higher pensions.
  - Target industrial and agricultural subsidies for cuts.
  - Better management of almost 4,000 state enterprises: subject them to better monitoring and control and extend new reporting templates to all public enterprises.

### Exchange Rate and Monetary Policy
- Exchange rate regime and recommendation:
  - De facto peg to the U.S. dollar in place.
  - Staff recommended greater exchange rate flexibility to moderate credit growth and inflation and to reduce foreign currency debt incentives.
- Monetary policy actions and recommendations:
  - NBU raised the discount rate by 50 basis points to 7.5 percent and tightened reserve requirements; issued CDs in small volumes.
  - Staff recommended monetary tightening; extent of interest rate increases and sterilization depends on exchange rate flexibility.
- Staff appraisal:
  - Staff argued the real exchange rate was substantially undervalued.
  - Prefer nominal appreciation rather than inflation; recommend shift towards a more flexible exchange rate regime in the run-up to an inflation-targeting framework.
  - Absent greater exchange rate flexibility, staff recommends the NBU step up sterilization operations and raise interest rates.

### Financial Sector Soundness and Reform
- Banking sector indicators and risks:
  - Credit-to-GDP ratio at 29.5 percent in 2004 versus 12.4 percent in 2000.
  - Loans increased to about two-thirds of bank assets.
  - Nonperforming loans (past due criteria) estimated at 8 percent of total loans.
  - Ratio of regulatory capital to risk-weighted assets stood at 15.2 percent in June 2004; for the 10 largest banks it was about 1½ percentage points above the minimum requirement.
  - Provisions as a share of total loans have fallen steadily despite tighter loan classification in mid-2003.
  - Bank profitability reported low; tax avoidance tactics affect official profitability data.
- Financial market developments:
  - Access to international capital markets improved with Eurobond issuances in March and August 2004.
  - Risk spreads and equity prices improved, though correlated with Russian market movements.
- Staff guidance:
  - Continue strengthening prudential regulation and banking supervision.
  - Monitor credit quality and ensure bank capital and provisions keep pace with credit expansion.
  - Directors and staff encouraged raising the minimum capital adequacy ratio to 12 percent; contain risk from foreign currency loans; adopt tighter accounting and reporting standards for corporations.
  - Regrets that draft amendments to the Banking Act to identify bank owners and tighten related-party lending had not been adopted by parliament.

### Structural Issues and Business Climate
- Barriers to investment:
  - Tax distortions, corruption, red tape, and inadequate implementation of the legal framework hinder private-sector development.
- Structural reform progress and outstanding actions:
  - Several actions under program conditionality—concerning related-party lending, tax preferences and exemptions, and VAT refund arrears—have not been completed.
  - Legislation on joint-stock companies has lingered in parliament.
  - European Commission requires further progress on legal framework for bankruptcy and eliminating state influence on prices for market economy status.
- Staff recommendation:
  - Strengthen the role of the private sector by addressing the foregoing constraints and accelerating structural reforms.
  - Encourage prompt passage of the energy debt restructuring law and the joint-stock company law.
  - Improve transparency in privatization procedures and governance.
  - Reduce licensing and inspection burdens; strengthen judiciary and contract enforcement.

### Box 1 — Competitiveness
- Summary findings:
  - Various indicators suggest Ukraine’s exchange rate is significantly undervalued.
  - Ukraine’s current account has shown in the last few years persistently high surpluses; in 2004 the surplus stands alone relative to other (non-energy-producing) transition economies.
  - Signs of overheating in the export sectors have emerged.
  - Average wages remain less than half the wages in Russia.
- Formal empirical estimates:
  - Large cross-country panel-data model 1990-2000 across 85 countries suggests equilibrium real exchange rate (RER) is less than half that of many other transition countries.
  - Even considering lower equilibrium, Ukraine’s RER was undervalued by about two-thirds in 2002.
  - An earlier study found Ukraine’s RER was only 28-33 percent of its equilibrium value in 1995.
  - A PPP-based estimate suggests the exchange rate may be undervalued by as much as 80 percent.
- Caveats and policy implications:
  - Cross-country heterogeneity cautions over precision and pace of adjustment.
  - Results suggest sustained upward pressure on real exchange rate over the medium term.
- Central bank stance:
  - NBU viewed undervaluation as more modest and allowed currency to appreciate by 0.4 percent vis-à-vis the U.S. dollar since the beginning of the year.
  - Staff argued for more flexible exchange rate to control inflation and reduce financial sector risks.
- Reserve and liquidity indicators:
  - Ratio of gross reserves to short-term debt (by residual maturity) and broad money is 2.5 and 0.6, respectively.
  - Import coverage is 3½ months.

### Safeguards Assessment and Stand-By Arrangement Review
- Safeguards Assessment:
  - Completed on July 14, 2004; found NBU strengthened safeguards framework but further improvements needed in financial reporting and legal structure/independence.
  - Main recommendations:
    - NBU Board resolution to adopt International Financial Reporting Standards.
    - Detailed review of the NBU Law and other legislation to strengthen independence.
    - Semi-annual audits by NBU’s internal audit function of monetary data reported to the Fund.
  - NBU responses: Board approved an action plan; six-month audit of NIR and NDA completed.
- Stand-By Arrangement review status:
  - Review could not be completed due to program slippages.
  - All end-June quantitative performance criteria, except that on VAT refund arrears, were met.
  - Pending conditions for completion: government assurances that fiscal policy, including the 2005 budget, remains consistent with program; actions to observe structural performance criteria and benchmarks.

### Staff Appraisal — Policy Implications and Recommendations
- Internal balance and inflation risks:
  - Fast pace of growth is putting pressure on inflation; evidence of emerging bottlenecks.
  - Fiscal expansion embedded in the amended budget will exacerbate inflationary pressures.
- External imbalance:
  - Very large external imbalance poses challenges to monetary authorities’ inflation objectives; reliance on exports increases vulnerability.
- Fiscal policy recommendations:
  - Resist short-term pre-electoral policies; set policies on realistic projections.
  - Save this year’s overperformance rather than spend it.
  - Stick to the original program fiscal target to facilitate management through 2005.
  - Maintain a prudent fiscal stance in 2005 and beyond; staff urges tightening fiscal policy in 2005 as envisaged in July’s budget resolution.
  - Use low debt ratio opportunity to finance urgent medium-term fiscal structural reforms without jeopardizing debt sustainability.
  - Tighten control over spending to ensure effectiveness and reduce tax loopholes and evasion.
- Monetary and exchange rate recommendations:
  - Allow for greater exchange rate flexibility; prefer nominal appreciation rather than inflation.
  - Tighten monetary policy given upside inflation risks; step up sterilization and raise interest rates if exchange rate flexibility is not allowed.
- Banking and financial stability recommendations:
  - Continue strengthening prudential banking regulation, supervision, and institutional environment.
  - Raise minimum capital adequacy ratio to 12 percent.
  - Contain risk from foreign currency loans.
  - Adopt tighter accounting and reporting standards for corporations.
- Privatization and governance:
  - Use privatization proceeds to retire existing debt or invest to increase productive capacity.
  - Improve privatization transparency; strengthen governance across tax collection, public procurement, law enforcement, and divestment of public assets.
- Data and surveillance:
  - Statistical data broadly adequate; quality and timeliness improved with SDDS subscription in 2003.
  - Data weaknesses remain in national accounts and balance of payments.
  - Recommend next Article IV consultation be held per July 15, 2002 decision on consultation cycles.

### Medium-Term Outlook, Scenarios, and Risks
- Baseline scenario:
  - Staff projects growth at 6 percent in 2005, and at around 5 percent in the outer years.
  - Baseline assumes average increase in private investment to GDP ratio by 1½ percentage point over next four years and additional FDI of about $8 billion until 2008.
  - Fiscal deficit targeted at 1½ percent over the medium term; public debt projected to fall below 20 percent starting in 2006.
  - Hryvnia assumed to appreciate gradually; current account surplus expected to turn into a deficit from 2007.
  - Gross international reserves projected to exceed 4 months of imports.
- Risks and stress scenarios:
  - Exports account for around 60 percent of GDP; vulnerability to external demand.
  - Scenario: if exports decline by 4 percent compared to 2004, GDP growth could drop to 1 percent in 2005 (5 percentage points below baseline).
    - For largest 25 banks, if one third of adversely classified loans not repaid and recovery value 25 percent, additional bank capital of about HRV 7½ billion would be required.
    - If government bore such costs, fiscal costs could be about 1.2 percent of GDP over two years.
    - Debt ratios could rise to 29 percent of GDP by 2006—compared to projected 19 percent under baseline—before reverting to consolidation path.
  - Sensitivity analyses:
    - Large output shock (negative real growth rates of 6.9 percent for two years) could push public debt-to-GDP ratio to nearly 40 percent.
    - One-time 30 percent depreciation in 2005 could raise public debt-to-GDP ratio by 12 percentage points above baseline.
- Immediate vulnerabilities:
  - Credit and exchange rate risk in banking sector from large share of foreign-currency loans and rapid credit growth.
  - External shocks: Russia close to 20 percent of all exports; downturn in Russia would affect about one fourth of Ukraine’s exports (~12 percent of GDP).
  - Large share of metallurgical products in exports (~one third) raises vulnerability to price reversals.
  - Loss of domestic confidence via inflationary pressures or political uncertainties could trigger capital flight.

### Supplement (post-staff-report developments)
- Inflation and monetary response:
  - Annual CPI inflation rose to 10.7 percent in September (double digits first time since June 2001).
  - Annual PPI inflation reached 23.2 percent.
  - Staff projects CPI inflation could reach 11 percent by year end; authorities maintain inflation will revert to single digits.
  - NBU raised discount and overnight refinance rates by 50 basis points in October; discount rate raised by 50 basis points to eight percent in early October.
- Fiscal developments and election-related spending pressures:
  - Government approved increase in minimum monthly pension from HRV 130 ($25) to HRV 284.6 ($54), effective retroactively September 1, 2004.
  - Pension increase boosts monthly pension bill by 36 percent for remaining four months of the year, raising government expenditure by about 1¼ and 3 percent of GDP in 2004 and 2005, respectively.
  - Government cleared wage arrears at state and bankrupt agricultural enterprises, and increased social spending.
  - Leading presidential candidates announced plans for aggressive tax rate reductions and additional compensation for lost savings from early 1990s hyperinflation, increasing fiscal uncertainty.
- Consolidated budget projections and financing (2004–05):
  - Without corrective measures, consolidated government deficit would rise to about 4½ percent of GDP in 2004.
  - Government secured approval to spend HRV 4 billion of additional privatization proceeds, staff estimates this adds about 1¼ percent of GDP to 2004 consolidated deficit.
  - In September alone, budget deficit was 1 percent of annual GDP.
  - Authorities intend to limit consolidated deficit to 3 percent of GDP in 2004 and expect approved 2005 budget will limit consolidated deficit to about 2 percent of GDP; staff projects larger gaps and calls for corrective measures of some 4½ percentage points of GDP to achieve 2005 target.
- Offsets, VAT refunds, and arrears:
  - Authorities budgeted tax offsets in 2005 totaling HRV 7.4 billion (2 percent of GDP).
  - VAT refund arrears declined to HRV 295 million at end-August due to securitization, netting, and increased rejections (40 percent rejected in July–August vs 9 percent in H1).
  - Staff cautions uncertainty over sustainability of improved VAT refund performance.

### Key Statistics (selected, preserve original numeric values)
- Real GDP growth: 9.4 percent in 2003; projected 12½ percent in 2004.
- CPI inflation (selected): -0.6 percent (Dec 2002); 8.2 percent (Dec 2003); 9.9 percent (Aug 2004); likely 9–10 percent by end-2004; annual CPI inflation rose to 10.7 percent in September (supplement).
- PPI inflation: 22.2 percent (Aug 2004); annual PPI inflation reached 23.2 percent (supplement); “core” PPI >10 percent excluding energy and metals.
- Average nominal wage growth (June 2004 vs June 2003): 26.3 percent.
- Current account surplus: projected 10 percent of GDP in 2004.
- Consolidated government deficit target for 2004 (staff recommended): 1.8 percent of GDP.
- Discount rate: increased by 50 basis points to 7.5 percent (May action); raised to eight percent in early October (supplement).
- Credit-to-GDP ratio: 29.5 percent (2004); 12.4 percent (2000).
- Nonperforming loans: estimated 8 percent of total loans.
- Regulatory capital to risk-weighted assets: 15.2 percent (June 2004).
- Eurobond issuances in 2004: $600 million seven-year (March); $500 million five-year floating rate (August).
- Sovereign credit rating: Standard and Poor’s B+; Moody’s outlook positive.
- Public debt-to-GDP ratio: declined from 61 percent to projected 27 percent at end-2004.
- Export growth: averaged 25 percent since end-2002.
- Real effective exchange rate: depreciated by 4 percent in the 12 months to June 2004.
- Official unemployment ~4 percent since 2001; ILO unemployment ~9 percent in 2004.
- VAT refund arrears: declined to HRV 295 million at end-August (supplement).
- Pension increase: minimum monthly pension from HRV 130 ($25) to HRV 284.6 ($54); pension bill increase by 36 percent for remaining four months of the year; raises government expenditure by about 1¼ and 3 percent of GDP in 2004 and 2005, respectively.
- Fiscal table highlights (consolidated government, percent of GDP):
  - 2003 Revenues: 37.0; Expenditures: 37.7; Overall balance: -0.7.
  - 2004 Est. Revenues: 37.3; Expenditures: 39.0; Overall balance: -1.8.
  - 2004 Year (proj.) Revenues: 35.5; Expenditures: 38.9; Overall balance: -3.4.
  - 2005 Proj. Revenues: 33.7; Expenditures: 35.3; Overall balance: -1.6.
- Public sector debt (percent of GDP): 2002: 35.7; 2003: 30.3; 2004: 27.1; 2005: 21.6; 2009: 16.4.
- Share of foreign-currency denominated public debt (percent of GDP): 2002: 27.2; 2003: 21.9; 2004: 18.4; 2005: 15.2.
- Gross reserves (end of period, in billions of U.S. dollars): 1.1 1.5 3.1 4.4 6.9 7.8 11.9 13.6 (1999–2005 excerpt).
- Selected banking system indicators (Table 6 highlights):
  - Number of banks (Dec-00 to Jun-04): 153 152 157 158 157 158.
  - Regulatory capital to risk-weighted assets: 15.5 20.7 18.0 15.2 14.8 15.2 (2000–Jun-04).
  - Share of foreign currency loans in total lending (percent): 41.4 41.3 39.5 38.5 38.5 38.1 (2000–Aug-04).
  - Share of non-performing loans in total loans (percent): 29.6 25.1 21.9 28.3 27.5 (2000–Jun-04).

*IMF mission report summary based on the 2004 mission and Executive Summary contained in the source text.*

### 2004. The mission met with First Deputy Prime Minister and Minister of Finance Azarov,

### _cr0515 - 2004. The mission met with First Deputy Prime Minister and Minister of Finance Azarov,

### Executive Summary
- Real GDP grew by 9.4 percent in 2003; growth is projected to reach 12½ percent in 2004.
- Current account surplus projected at 10 percent of GDP in 2004.
- Consumer price index (CPI) inflation is likely to reach 9–10 percent by year’s end 2004.
- A precautionary 12-month Stand-By Arrangement (SBA) was approved on March 29, 2004; review discussions could not be completed because of policy slippages.
- Key policy-discussion issues:
  - Sustainability of the current economic boom.
  - Immediate risks from rapid expansion.
  - Need for prudent macroeconomic policies and further structural reforms.
- Authorities and staff disagreements:
  - Risk of overheating: authorities viewed risk as relatively remote.
  - Fiscal stance for 2004: staff could not support amended budget with substantial procyclical loosening.
  - Time frame for exiting the de facto peg to the U.S. dollar.
- Staff recommendations:
  - A 2004 consolidated government deficit limited to the original program target of 1.8 percent of GDP.
  - Greater exchange rate flexibility to help restrain credit growth and inflationary pressures and reduce incentives for foreign currency-denominated debt.
  - Monetary tightening to contain inflationary pressures; extent of sterilization and interest rate increases dependent on willingness to let the exchange rate appreciate.
  - Strengthen the role of the private sector by addressing tax distortions, corruption, red tape, and inadequate implementation of the legal framework.
- Lack of agreement and incomplete implementation of key structural measures prevented completion of the review.

### Background and Outlook
- Growth and macro performance:
  - Over 2000-04, GDP growth averaged 8.4 percent.
  - Projected peak growth of 12.5 percent in 2004.
  - Recovery follows a pronounced 1990s output contraction compared with most transition countries.
- External sector and exports:
  - Annual export growth averaged 25 percent since end-2002.
  - Export-driven surge supported a current account surplus and foreign reserve accumulation.
  - Exporters’ profits helped fuel an investment and construction boom.
- Labor market:
  - Official unemployment ~4 percent since 2001, but unreliable due to hidden unemployment.
  - ILO definition unemployment about 9 percent in 2004 (down from 12 percent in 1999).
- Inflation and wages:
  - 12-month CPI: -0.6 percent in December 2002 → 8.2 percent in December 2003 → 9.9 percent by August 2004.
  - PPI inflation reached 22.2 percent in August 2004; “core” PPI inflation would exceed 10 percent excluding energy and metals.
  - Average nominal wage for the entire economy in June 2004 was 26.3 percent above its level the previous year.
- Capital markets and sovereign financing:
  - Ukraine issued a $600 million seven-year Eurobond in March 2004, and a $500 million five-year floating rate Eurobond in August 2004; both contain collective action clauses.
  - Spreads ~360 basis points; correlated with Russia.
  - Standard and Poor’s upgraded long-term sovereign credit rating to B+; Moody’s raised outlook to positive.
- Public debt and fiscal performance:
  - Public debt ratio fell from 61 percent of GDP to a projected 27 percent at end-2004.
  - Revenue gains from personal income and payroll taxes and state enterprise dividends offset spending rise from 34 percent to almost 38 percent of GDP.
  - Consolidated government cash deficit: 0.7 percent of GDP in 2003; 0.2 percent of annual GDP through end-June 2004 versus end-June adjusted program ceiling of 0.9 percent (but accumulation of VAT refund arrears masks underlying deficit).
- Monetary context and exchange rate:
  - De facto peg to the dollar; strong money growth consistent with single-digit inflation amid remonetization and modest tightening.
  - NBU interventions led to strong net international reserves accumulation.
  - From May 2004, NBU tightened policy via issuance of certificates of deposit (CDs) and raising reserve requirements; discount rate raised by 50 basis points to 7.5 percent.
  - In the 12 months to June 2004, real effective exchange rate depreciated by 4 percent.
- Competitiveness and wages:
  - Competitiveness remains strong; average wages remain less than half Russia’s wages.

### Policy Discussions and Risks
- Main policy concerns:
  - Overheating risk tied to rapid growth, credit expansion, and fiscal loosening.
  - Need to contain inflationary pressures emerging in 2004.
- Specific risks highlighted:
  - Procyclical fiscal loosening in the second half of 2004 could exacerbate inflation.
  - Rapid credit growth and increasing foreign exchange exposures in the private sector could raise vulnerability to external shocks.
  - Political cycle (run-up to October presidential elections) heightens uncertainty; however, no major policy change was expected irrespective of electoral outcome.

### Fiscal Policy and Reform
- Fiscal stance 2000–H1-2004:
  - Consolidated government cash deficit 0.7 percent of GDP in 2003; 0.2 percent through end-June 2004 (with caveats on VAT arrears).
  - State replaced senior management in the state tax administration in June 2004 due to VAT administration problems.
- Staff fiscal recommendations:
  - Limit 2004 consolidated government deficit to 1.8 percent of GDP (original program target).
  - Preserve space for increased social and capital spending while avoiding procyclical loosening.
- Structural reform needs:
  - Improve VAT administration.
  - Accelerate structural reforms to improve investment climate.

### Exchange Rate and Monetary Policy
- Exchange rate regime and recommendation:
  - De facto peg to the U.S. dollar in place.
  - Staff recommended greater exchange rate flexibility to moderate credit growth and inflation and to reduce foreign currency debt incentives.
- Monetary policy actions and recommendations:
  - NBU raised the discount rate by 50 basis points to 7.5 percent and tightened reserve requirements; issued CDs in small volumes.
  - Staff recommended monetary tightening; extent of interest rate increases and sterilization depends on exchange rate flexibility.

### Financial Sector Soundness and Reform
- Banking sector indicators:
  - Credit-to-GDP ratio at 29.5 percent in 2004 versus 12.4 percent in 2000.
  - Loans increased to about two-thirds of bank assets.
  - Nonperforming loans (past due criteria) estimated at 8 percent of total loans.
  - Ratio of regulatory capital to risk-weighted assets stood at 15.2 percent in June 2004; for the 10 largest banks it was about 1½ percentage points above the minimum requirement.
  - Provisions as a share of total loans have fallen steadily despite tighter loan classification in mid-2003.
  - Bank profitability reported low; tax avoidance tactics affect official profitability data.
- Financial market developments:
  - Access to international capital markets improved with Eurobond issuances in March and August 2004.
  - Risk spreads and equity prices improved, though correlated with Russian market movements.
- Staff guidance:
  - Continue strengthening prudential regulation and banking supervision.
  - Monitor credit quality and ensure bank capital and provisions keep pace with credit expansion.

### Structural Issues and Business Climate
- Barriers to investment:
  - Tax distortions, corruption, red tape, and inadequate implementation of the legal framework hinder private-sector development.
- Staff recommendation:
  - Strengthen the role of the private sector by addressing the foregoing constraints and accelerating structural reforms.

### Key Statistics (as reported)
- Real GDP growth: 9.4 percent in 2003; projected 12½ percent in 2004.
- CPI inflation: -0.6 percent (Dec 2002); 8.2 percent (Dec 2003); 9.9 percent (Aug 2004); likely 9–10 percent by end-2004.
- PPI inflation: 22.2 percent (Aug 2004); “core” PPI >10 percent excluding energy and metals.
- Average nominal wage growth (June 2004 vs June 2003): 26.3 percent.
- Current account surplus: projected 10 percent of GDP in 2004.
- Consolidated government deficit target for 2004 (staff recommended): 1.8 percent of GDP.
- Discount rate: increased by 50 basis points to 7.5 percent.
- Credit-to-GDP ratio: 29.5 percent (2004); 12.4 percent (2000).
- Nonperforming loans: estimated 8 percent of total loans.
- Regulatory capital to risk-weighted assets: 15.2 percent (June 2004).
- Eurobond issuances in 2004: $600 million seven-year (March); $500 million five-year floating rate (August).
- Sovereign credit rating: Standard and Poor’s B+; Moody’s outlook positive.
- Public debt-to-GDP ratio: declined from 61 percent to projected 27 percent at end-2004.
- Export growth: averaged 25 percent since end-2002.
- Real effective exchange rate: depreciated by 4 percent in the 12 months to June 2004.
- Official unemployment ~4 percent since 2001; ILO unemployment ~9 percent in 2004.

*IMF mission report summary based on the 2004 mission and Executive Summary contained in the source text.*

### 11.      The pace of structural reforms has slowed. After progress in late 2003–early 2004,

### _cr0515 - 11.      The pace of structural reforms has slowed. After progress in late 2003–early 2004,

### Structural reform progress and outstanding actions
- Several actions under program conditionality—concerning related-party lending, tax preferences and exemptions, and VAT refund arrears—have not been completed.
- Legislation on joint-stock companies has lingered in parliament for quite some time.
- The European Commission has announced that, to be granted market economy status, Ukraine needs to make further progress implementing the legal framework for bankruptcy and eliminating state influence on prices.
- According to the World Bank, the UN Millennium Development Goal regarding the prevention of HIV/AIDS and tuberculosis is the only goal that is unlikely to be met by 2015.

### Monetary and exchange rate developments (selected observations)
- Stronger-than-expected purchases of foreign exchange by the NBU have fueled rapid growth of monetary aggregates.
- Owing to rising money demand and tight fiscal policy, inflationary pressures remained subdued until recently despite lack of sterilization.
- Exchange rate indicators presented include bilateral rates (Hrv/U.S. dollar, Hrv/euro, Hrv/ruble) and Real Effective Exchange Rate indices (CPI-based, PPI-based, ULC-based).

### Banking sector developments and risks
- Rapid credit growth has recently decelerated somewhat but has been among the highest in the region.
- The credit boom was funded mainly by deposits, but increasingly also by foreign borrowing.
- Indirect exchange rate risks arise from the large share of foreign currency-denominated loans (fx loans to total loans; fx loans % of total bank assets).
- Credit quality needs to be monitored: NPLs ("substandard," "doubtful," and "loss") in % of total loans shown for Dec-00 through Jun-04.
- Concerns exist about capital adequacy and provisioning: regulatory capital to risk-weighted assets (in percent) and specific provisions to total loans (in percent) tracked through Jun-04.
- The NBU estimates that about 94 percent of "substandard" loans are serviced in a timely fashion.
- The increase in nonperforming loans in 2003 is largely due to a change in loan classification rules.
- Accompanying selected issues paper: “Credit Boom in Ukraine: Risks for Banking Sector Stability.”

### Energy sector quasi-fiscal deficit
- The energy sector quasi-fiscal deficit has narrowed.
- Improved payments discipline and a buoyant economy have strengthened cash-collection ratios in both the electricity and gas sectors.
- Both sectors have remained current on their tax obligations and have lowered their tax arrears.
- Accompanying selected issues paper: “Energy Sector Quasi-Fiscal Deficit.”

### Authorities’ view of Fund advice
- Authorities indicated Fund recommendations helped focus and coordinate macroeconomic policy, particularly tax reform and banking prudential regulation and supervision.
- Dialogue with the Fund fostered internal debate even when authorities and staff disagreed.
- Key policy commitments under successive Fund-supported programs have not been fully followed through.

### Macroeconomic outlook, projections, and staff vs. authorities views
- Staff projects growth at 6 percent in 2005, and at around 5 percent in the outer years.
- Authorities projected growth at 8.6 percent in 2005 and averaging 6.5 percent over the medium term.
- Staff noted that, given Ukraine’s shrinking labor force, a 5 percent growth rate over the medium term will require an investment/GDP ratio higher than the current 20 percent level, and stronger factor productivity growth.
- A substantial current account surplus is projected for 2004: projected at 10 percent of GDP in 2004.
- Staff noted the current account surplus is likely overstated in light of the large negative errors and omissions.
- Staff stressed that over the medium term sustained investment growth and tapping foreign savings will be required to upgrade productive capacity.
- Staff warned the economy may be operating close to potential in some sectors; inflation could reach 9-10 percent this year and rise further in 2005 depending on budget implementation and NBU actions.
- The authorities remained committed to single-digit inflation for this year and the medium term and did not share staff’s urgent tightening recommendation.

### Risks
- Ukraine remains vulnerable to a sudden reversal in external conditions: exports account for around 60 percent of GDP.
- Net private debt stood at about one-fifth of GDP at end-2003; external private sector assets may be underreported.
- Large share of short-term debt: 70 percent, increasing rollover risk.
- Staff encouraged building buffers against contingent liabilities and cautioned against basing policies on optimistic growth assumptions.
- Accompanying selected issues paper: “Assessing Ukraine’s Vulnerabilities from a Balance Sheet Perspective.”

### Fiscal policy developments, projections, and staff recommendations
- In June the authorities relaxed the fiscal stance for 2004; the June budget amendment raised the 2004 deficit target by at least 1 percent of GDP.
- Authorities expected the deficit not to exceed 3 percent of GDP, citing technical constraints in capital spending; staff noted the deficit could still reach about 3½ percent of GDP under certain assumptions.
- Parliament approved a 2005 budget resolution providing for a central government deficit ceiling of 1 percent of GDP, consistent with a consolidated budget deficit of about 1.6 percent of GDP.
- In mid-September authorities submitted to parliament a 2005 budget that aims at a somewhat larger budget deficit. The government has also more recently increased significantly pensions, making it difficult to achieve the 2005 deficit target.
- Staff will prepare a supplement assessing the 2005 budget, the fiscal impact of the pension increase, and risks to attainment of fiscal targets.

Ukraine: Fiscal Policy (Consolidated Government), 2003-05 (In percent of GDP)
- 2003 Revenues: 37.0; Expenditures: 37.7; Overall balance: -0.7; Financing: 0.7; External: 0.8; Domestic: -1.2; Privatization: 1.1.
- 2004 Est. Revenues: 37.3; Expenditures: 39.0; Overall balance: -1.8; Financing: 1.8; External: 0.4; Domestic: 0.5; Privatization: 0.8.
- 2004 Prog. H1 (est.) Revenues: 16.0; Expenditures: 16.1; Overall balance: -0.1; Financing: 0.1; External: 0.4; Domestic: -2.1; Privatization: 1.7.
- 2004 Prog. H2 (proj.) Revenues: 19.5; Expenditures: 22.8; Overall balance: -3.3; Financing: 3.3; External: 1.3; Domestic: 1.2; Privatization: 0.9.
- 2004 Year (proj.) Revenues: 35.5; Expenditures: 38.9; Overall balance: -3.4; Financing: 3.4; External: 1.7; Domestic: -0.9; Privatization: 2.6.
- 2005 Proj. Revenues: 33.7; Expenditures: 35.3; Overall balance: -1.6; Financing: 1.6; External: 0.4; Domestic: 0.0; Privatization: 1.2.
- Sources: Ukrainian authorities; and Fund staff estimates and projections.

Staff recommendations on near-term fiscal stance
- Save additional resources stemming from higher growth and privatization proceeds, or at least confirm the original program fiscal stance in 2004—a deficit of 1.8 percent of GDP.
- Under the original 1.8 percent of GDP target, nominal revenues boosted by growth would allow new spending of about HRV 3.6 billion (1.1 percent of GDP) during the second half of the year versus HRV 8 billion (2.4 percent of GDP) envisaged under the amended budget.
- Under the tighter scenario: cover approved wage increase, provide full repayment of VAT refund arrears, and allow for significant accumulation of deposits at the NBU; excess privatization proceeds would not be spent.

Staff concerns about the 2004 fiscal loosening (if limited to 3 percent of GDP)
- It would increase the deficit despite a booming economy; additional resources should be saved to allow future countercyclical fiscal policy.
- Additional fiscal expansion exacerbates inflationary pressures.
- Only 20 percent of the extra spending could clearly be identified as one-off—about one-third appears recurrent—risking undermining the 2005 fiscal target and contributing to higher borrowing costs.

Medium-term fiscal reform and resource needs
- Authorities estimate about 3½ percent of GDP in additional annual resources may be necessary to address obsolete and depreciated public infrastructure.
- Staff estimated that spending initiatives to address civil service, pension, education, and health problems—if not matched by equivalent measures—could result in some 8-9 percent of GDP a year in additional spending.
- To finance reforms and possible tax cuts (e.g., reduce VAT rate by 5 percentage points by 2006), extensive base-broadening is needed; costs could amount to 2-3 percent of GDP annually.
- Scope exists to eliminate more VAT exemptions totaling about 1 percent of GDP even after envisioned rate reductions.
- Staff supported the authorities’ revised VAT regime for agriculture but cautioned against allowing producers to retain VAT collected for their own use and stressed need to eliminate fraudulent refund claims.
- Much scope to improve tax administration: address poor management practices, badly targeted audit program, internal control problems undermining tax compliance.
- Authorities expect to implement bulk of new VAT measures in the autumn once parliament reconvenes.

Public expenditure and state enterprise management priorities
- Improve project appraisal, selection, and execution before accommodating one-off investment costs.
- Fully develop and use the medium-term expenditure framework to reprioritize spending.
- Match civil service pay increases to employment reductions.
- Use parametric pension fund changes (including a higher retirement age) to support higher pensions.
- Target industrial and agricultural subsidies for cuts.
- Better management of almost 4,000 state enterprises: subject them to better monitoring and control and extend new reporting templates to all public enterprises.
- Accompanying selected issues paper: “Medium-Term Fiscal Priorities.”

### Exchange rate and monetary policy
- Staff argued the real exchange rate was substantially undervalued, highlighted by wage and price levels very low compared with other transition countries and by large current account surpluses.
- Staff concurred with the NBU that surpluses helped strengthen international reserves but noted that further sharp increases in official international reserves were no longer desirable given context.
- Inflationary pressures are emerging: staff warned inflation could reach 9-10 percent this year and rise further in 2005 depending on fiscal and NBU actions; authorities remained committed to single-digit inflation and did not see urgent need to tighten policies.
- Figure evidence: CPI and PPI inflation series and ratio of PPI to CPI (2002-04) indicating spillover risks from PPI to CPI.

*IMF staff report content unit: _cr0515 - 11.      The pace of structural reforms has slowed. After progress in late 2003–early 2004,*

### Box 1. Competitiveness

### Box 1. Competitiveness

### Summary findings on exchange rate valuation and competitiveness
- Various indicators suggest Ukraine’s exchange rate is significantly undervalued.
- Ukraine’s current account has shown in the last few years persistently high surpluses; in 2004 the surplus stands alone relative to other (non-energy-producing) transition economies.
- Signs of overheating in the export sectors have emerged.
- Average wages remain less than half the wages in Russia.
- A more formal analysis of wage levels is detailed in the Selected Issues Paper on “Competitiveness, Convergence, and the Equilibrium Real Exchange Rate”.

### Formal empirical estimates
- Estimates are based on a large cross-country panel-data model, using data from 1990-2000 across 85 countries.
- Results suggest that the equilibrium real exchange rate (RER) is less than half that of many other transition countries, reflecting Ukraine’s economy’s lower capital stock and level of development.
- However, even considering this lower equilibrium, Ukraine’s RER was undervalued by about two-thirds in 2002 (the appreciation since then has been modest).
- An earlier study found that Ukraine’s RER was only 28-33 percent of its equilibrium value in 1995.
- A PPP-based estimate of the equilibrium RER suggests that the exchange rate may be undervalued by as much as 80 percent.

### Caveats and medium-term implications
- Given possible problems associated with cross-country heterogeneity, such results should be treated cautiously, and they say little about the pace of adjustment to equilibrium.
- These results suggest that Ukraine will likely experience sustained upward pressure on its real exchange rate over the medium term.

### Central bank stance and recent movements
- The NBU conceded that the exchange rate was competitive but viewed the undervaluation as more modest than staff estimates, and had already allowed the currency to appreciate by 0.4 percent vis-à-vis the U.S. dollar since the beginning of the year.
- Staff argued that a shift towards a more flexible exchange rate would be helpful in controlling inflation and in reducing risks to the financial sector.
- The peg to the U.S. dollar, if kept at a level regarded by staff as substantially undervalued, exacerbates the NBU’s challenge to meet its inflation objective and provides an implicit exchange rate guarantee with attendant financial sector risks.
- The first-best policy response recommended by staff was to switch to a more flexible exchange rate regime in the run-up to an inflation-targeting framework, allowing the exchange rate to appreciate faster.
- The authorities preferred only extremely gradual appreciation, citing concerns about adverse expectations, temporary nature of current account receipts, and adequacy of international reserves.

### Related reserve and liquidity indicators (as reported)
- The ratio of gross reserves to short-term debt (by residual maturity) and broad money is 2.5 and 0.6, respectively.
- Import coverage is 3½ months.

*Source: Box 1. Competitiveness, _cr0515 - Box 1. Competitiveness_*

### 34.      As mandated under Fund policies, the NBU was subject to a safeguards

### _cr0515 - 34.      As mandated under Fund policies, the NBU was subject to a safeguards

### Safeguards Assessment of the NBU
- Assessment completed on July 14, 2004 found that the NBU has in recent years strengthened its safeguards framework.
- Identified further improvements needed in:
  - Financial reporting.
  - Legal structure and independence.
- Main recommendations:
  - (i) An NBU Board’s resolution to adopt International Financial Reporting Standards.
  - (ii) A detailed review of the NBU Law, and other legislation affecting the NBU, aimed at strengthening its independence.
  - (iii) Semi-annual audits, by the NBU’s internal audit function, of the monetary data reported to the Fund.
- NBU responses:
  - Board approved an action plan to implement the recommendations.
  - A six-month audit of NIR and NDA had already been completed.

### Stand-By Arrangement: Review Status and Conditions
- Review could not be completed as originally scheduled because of slippages in program implementation.
- Staff view: the procyclical amended 2004 budget was inconsistent with policies agreed under the program.
- Quantitative performance criteria outcome:
  - All end-June quantitative performance criteria, except that on VAT refund arrears, were met (Table 10).
- Pending conditions for completion of the review:
  - Government to provide concrete assurances that fiscal policy, including the 2005 budget, remains consistent with its undertakings under the program.
  - Government to take the actions required to observe the structural performance criteria and benchmarks.

### Staff Appraisal — Recent Macroeconomic Developments
- Key observations:
  - Growth has been booming.
  - The external current account surplus has reached record levels.
  - Gross official international reserves are likely to rise by 75 percent this year.
- Contributing factors:
  - Prudent policies and structural reform over the last few years.
  - Favorable external environment.
  - Domestic factors: the credit boom and an undervalued exchange rate.
- Concern:
  - Inflation is creeping upward, hovering in the high single digits.

### Staff Appraisal — Policy Implications and Recommendations
- Internal balance and inflation risks:
  - Fast pace of growth is putting pressure on inflation; evidence of emerging bottlenecks.
  - The fiscal expansion embedded in the amended budget will exacerbate inflationary pressures.
- External imbalance:
  - Very large external imbalance poses challenges to achieving monetary authorities’ inflation objectives.
  - Reliance on exports to support current activity increases vulnerability to external shocks.

- Fiscal policy recommendations:
  - Authorities should resist short-term pre-electoral policies and set policies on the basis of realistic projections.
  - Save this year’s overperformance rather than spend it:
    - The procyclical loosening of fiscal policy in 2004 is inappropriate.
    - Although the increase in the deficit is not debt creating, spending privatization receipts adds to demand and contributes to inflationary pressures.
    - Only a small portion of the additional spending can clearly be identified as one-off.
    - Resources from the sale of public assets should be used to retire existing debt or invested to increase the economy’s productive capacity.
  - Stick to the original program fiscal target to facilitate economic management through 2005 and to keep the 2005 budget in line with the already-approved budget resolution.
  - Maintain a prudent fiscal stance in 2005 and beyond; staff urges authorities to tighten fiscal policy in 2005, as envisaged in July’s budget resolution.
  - Use low debt ratio opportunity to finance urgent medium-term fiscal structural reforms without jeopardizing debt sustainability.
  - Tighten control over spending to ensure effectiveness and reduce tax loopholes and evasion.

- Fiscal structural reforms encouraged:
  - Further develop a medium-term budget framework to help prioritize expenditure.
  - Balance tax rate reductions with tax base broadening by:
    - Eliminating privileges and exemptions.
    - Improving tax administration.
  - Staff welcomes permanent elimination of some VAT tax exemptions and encourages bolder action.
  - Caution against implementing rate reductions until VAT administration performance improves.
  - Find resources for further structural reforms by better managing state enterprises.

- Monetary and exchange rate policy recommendations:
  - Allow for greater exchange rate flexibility:
    - At prevailing exchange rate, a significant current account surplus will persist and the real exchange rate is bound to appreciate.
    - Prefer nominal appreciation rather than inflation.
    - Staff commends authorities’ attention to the level of international reserves but notes opportunity costs of further sizable increases in reserves.
  - Tighten monetary policy given upside inflation risks:
    - NBU’s recent increases in reserve requirements and imposition of stricter lending terms are welcome.
    - Absent greater exchange rate flexibility, staff recommends that the NBU step up sterilization operations and raise interest rates.

- Banking sector and financial stability recommendations:
  - Continue strengthening prudential banking regulation, supervision, and institutional environment to ensure stability.
  - Staff commends actions to improve monitoring of credit growth, banks’ risk management, and banks’ capital.
  - Regrets parliament has not yet approved draft amendments to the Banking Act to identify bank owners and tighten related-party lending.
  - Urges authorities to address banking sector vulnerabilities given large exposure to credit risk.
  - Encourages:
    - Raising minimum capital adequacy ratio to 12 percent.
    - Containing risk from foreign currency loans.
    - Adopting tighter accounting and reporting standards for corporations to facilitate banks’ loan evaluations.

- Privatization and private sector role:
  - Stronger role for the private sector is crucial to sustain medium-term growth.
  - Privatization has accelerated but procedures remain nontransparent; urges alignment with best international practices.
  - Welcomes recent reduction in the energy sector quasi-fiscal deficit and encourages passage of the energy debt restructuring law to enable further privatization in the electricity sector.
  - Other steps to improve the business climate:
    - Eliminate tax distortions.
    - Strengthen banking and corporate sector.
    - Reduce licensing and inspection burdens.
    - Strengthen judiciary and contract enforcement.
    - Pass the joint-stock company law.

- Governance:
  - Governance should be strengthened; rent-seeking and lack of transparent procedures are widespread across tax collection, public procurement, law enforcement, and divestment of public assets.
  - Authorities should address these issues as they deter domestic and foreign investment.

- Data and surveillance:
  - Statistical data broadly adequate for surveillance; quality and timeliness improved with Ukraine’s subscription to the Special Data Dissemination Standard (SDDS) in 2003.
  - Data weaknesses remain, particularly in national accounts and balance of payments.
  - Staff recommends the next Article IV consultation be held in accordance with the July 15, 2002 decision on consultation cycles.

### Key Quantitative Findings and Selected Indicators (preserve original numeric values)
- Growth, prices, and GDP (Table 1 / Table 8 highlights):
  - Real GDP (annual change in percent) series excerpt: -0.2 5.9 9.2 5.2 9.4 6.0 12.5 6.0 (as presented in Table 1 and Table 8).
  - Nominal GDP (in billions of hryvnias): 130.4 170.1 204.2 225.8 264.2 292.0 328.5 379.5 (1999–2005 excerpt).
  - Consumer prices, period average: 22.7 28.2 12.0 0.8 5.2 7.1 8.3 8.1 (1999–2005 excerpt).
  - Consumer prices, end of period: 19.2 25.8 6.1 -0.6 8.2 6.0 9.0 7.0 (1999–2005 excerpt).

- Fiscal (consolidated budget, percent of GDP; Table 1 / Table 8):
  - Revenue: 31.9 33.4 33.5 36.0 37.0 37.3 35.5 33.7 (1999–2005 excerpt).
  - Expenditure (cash basis): 34.2 34.7 35.1 35.5 37.7 39.0 38.9 35.3 (1999–2005 excerpt).
  - Cash balance 2/: -2.4 -1.3 -1.6 0.5 -0.7 -1.8 -3.4 -1.6 (1999–2005 excerpt).
  - Public debt and arrears (in percent of GDP) 4/: 66.7 47.0 38.6 35.7 30.3 27.7 27.1 21.6 (1999–2005 excerpt).

- Money, credit, and reserves (Table 1 / Table 5):
  - Broad money (end of period, percent change): 40.4 45.5 41.9 41.8 46.5 24.1 43.8 26.7 (1999–2005 excerpt).
  - Credit to nongovernment (end of period, percent change): 43.5 61.3 40.5 47.3 63.4 25.1 32.5 28.9 (1999–2005 excerpt).
  - Gross reserves (end of period, in billions of U.S. dollars): 1.1 1.5 3.1 4.4 6.9 7.8 11.9 13.6 (1999–2005 excerpt).
  - NBU net international reserves (Table 5, selected points in millions of U.S. dollars): 1,297 2,615 4,785 5,743 4,897 7,521 5,304 10,203 (Dec-00 to Dec-03 / selected projections).

- External sector and balance of payments (Table 2 highlights):
  - Current account balance (in percent of GDP): 3.7 7.5 5.8 3.7 10.2 4.1 1.8 0.2 -0.7 -1.6 (2001–09 projection excerpt).
  - Exports (annual change in percent): -3.7 19.2 8.7 9.2 27.2 6.3 38.7 3.1 7.0 8.0 (2000–09 excerpt).
  - Imports (annual change in percent): -20.5 15.4 13.0 6.3 33.7 8.4 25.0 10.8 10.7 11.1 (2000–09 excerpt).
  - Gross international reserves (end of period, in billions of U.S. dollars): 3,089 4,417 6,939 7,806 11,851 13,624 15,714 17,604 19,385 20,921 (2001–09 excerpt).

- Banking system indicators (Table 6 highlights):
  - Number of banks (Dec-00 to Jun-04): 153 152 157 158 157 158.
  - Regulatory capital to risk-weighted assets: 15.5 20.7 18.0 15.2 14.8 15.2 (2000–Jun-04).
  - Share of foreign currency loans in total lending (percent): 41.4 41.3 39.5 38.5 38.5 38.1 (2000–Aug-04).
  - Share of non-performing loans in total loans (percent): 29.6 25.1 21.9 28.3 27.5 (2000–Jun-04).

### Structural Conditions, Prior Actions, and Missed Benchmarks (Table 7 highlights)
- Prior Actions (all marked Done):
  - A1: Suspension of VAT exemptions and zero-ratings extended to newly-built housing construction, aircraft production, and shipbuilding.
  - A2: Reduction in the stock of VAT refund arrears by at least HRV 500 million between end-2002 and end-2003.
  - A3: Parliamentary approval to postpone the minimum wage increase planned for July 2003.
  - A4: NBU decree to increase minimum risk-weighted capital adequacy ratio from 8 percent to 10 percent, effective March 1, 2004.
  - A5: Enactment of a 2004 budget law providing for clearance of entire stock of VAT refund arrears, on market terms, and other TMU provisions.

- Structural performance criteria and benchmarks (selected):
  - B1 (Performance criterion): Enactment of changes to the VAT law eliminating sectoral VAT preferences, effective no later than January 2005, reducing fiscal cost to at most HRV 3.2 billion (based on 2003 estimates). Status: Aug 15, 2004 — Missed. Enacted legislation fell short by HRV 200 million.
  - B2 (Performance criterion): Submission to parliament by the NBU and enactment of amendments to the Law on Banks and Banking to strengthen related-party lending provisions (identification of ultimate owners; eliminate exceptions; prohibit concerned parties’ involvement; require disclosure). Status: Aug. 15, 2004 — Measures (a) and (b) missed. NBU’s amendments submitted to parliament but not yet approved.
  - B3: Steps to develop domestic securities market (enhance marketability of restructured T-bills held by NBU; develop debt management guidelines). End-Jun 2004 — Measure (a) done Aug 10, 2004; Measure (b) missed.
  - B4: Adoption of monitoring system of quasi-fiscal operations in electricity, gas, and coal sectors, including analysis for 2005 budget submission. End-Oct 2004 (status not indicated in excerpt).
  - B5: Reduce total fiscal cost of remaining VAT preferences (including agriculture) effective 2005 to at most HRV 2.9 billion (based on 2003 estimates). End-Jan 2005 — Missed.

### Quantitative Performance Criteria and Targets (Table 10 excerpt)
- Selected end-period stocks and targets (cumulative changes from end-2003; in millions of hryvnias, unless otherwise indicated):
  - Ceiling on the cash deficit of the general government: 1,327 ... 3/-836 2,847 647 (presented as table entries).
  - Ceiling on stock of VAT refund arrears: 1,828 -1,000 -810 -1,500 991 (end-period changes).
  - Ceiling on net domestic assets (NDA) of the NBU: 12,885 -1,092 ... 6/-4,496 -511 -8,288 (presented as table entries).
  - Floor on net international reserves (NIR) of the NBU (in millions of U.S. dollars): 5,103 362 ... 1,098 528 2,908.
  - Indicative targets and adjusters include base money, nonearmarked state cash revenue, total cash collection ratios for electricity and Naftogaz, and project financing adjusters (detailed in Table 10).

*International Monetary Fund staff report content as presented in the source PDF excerpt.*

### 1. Population below $1 a day (%)... ... 2.9...

### Table 11. Ukraine: Millennium Development Goals

### Goal 1. Eradicate extreme poverty and hunger
- Population below $1 a day (%)... ... 2.9...
- Poverty gap at $1 a day (%)... ... 0.6...
- Percentage share of income or consumption held by poorest 20%... ... 8.8...
- Target 2: Halve, between 1990 and 2015, the proportion of people who suffer from hunger.
- Prevalence of child malnutrition (% of children under 5)... ... 3.0...
- Population below minimum level of dietary energy consumption (%)... ... ... ...

### Goal 2. Achieve universal primary education
- Target 3: Ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primary schooling.
- Net primary enrollment ratio (% of relevant age group)... ... ... ...
- Percentage of cohort reaching grade 5 (%)59.1... ... ...

### Goal 3. Promote gender equality and empower women
- Target 4: Eliminate gender disparity in primary and secondary education preferably by 2005 and to all levels of education no later than 2015.
- Youth literacy rate (% ages 15-24)99.899.999.999.9
- Ratio of girls to boys in primary and secondary education (%)... ... ... ...
- Ratio of young literate females to males(% ages 15-24)100100.1100.1100.1
- Share of women employed in the nonagricultural sector (%)... ... ... ...
- Proportion of seats held by women in the national parliament (%)... 488

### Goal 4. Reduce child mortality
- Target 5: Reduce by two-thirds, between 1990 and 2015, the under-five mortality rate.
- Under-five mortality rate (per 1,000)22.024.020.019.8
- Infant mortality rate (per 1,000 live births)18.020.017.016.4
- Immunization , measles (% of children under 12 months)90.097.099.0...

### Goal 5. Improve maternal health
- Target 6: Reduce by three-quarters, between 1990 and 2015, the maternal mortality ratio.
- Maternal mortality ratio (modeled estimate, per 100,000 live births)... 45.0... ...
- Births attended by skilled health staff (% of total)... 99.999.9...

### Goal 6. Combat HIV/AIDS, malaria and other diseases
- Target 7: Have halted by 2015, and begun to reverse, the spread of HIV/AIDS. Have halted by 2015, and begun to reverse, the incidence of malaria and other major diseases.
- Prevalence of HIV, female (% ages 15-24)... ... 0.9...
- Contraceptive prevalence rate (% of women ages 15-49)... ... 71.6...
- Number of children orphaned by HIV/AIDS... ... ... ...
- Incidence of tuberculosis (per 100,000 people)......78.8...
- Tuberculosis cases detected under DOTS (%)............

### Goal 7. Ensure environmental sustainability
- Target 8: Integrate the principles of sustainable development into country policies and programs and reverse the loss of environmental resources. Halve, by 2015, the proportion of people without sustainable access to safe drinking water. By 2020, to have achieved a significant improvement in the lives of at least 100 million slum dwellers.
- Forest area (% of total land area)16.0... 16.5...
- Nationally protected areas (% of total land area)... 1.61.63.9
- GDP per unit of energy use (PPP $ per kg oil equivalent)1.51.31.4...
- CO2 emissions (metric tons per capita)11.58.37.5...
- Access to an improved water source (% of population)... ... 98.0...
- Access to improved sanitation (% of population)... ... 99.0...
- Access to secure tenure (% of population)... ... ... ...

### Goal 8. Develop a global partnership for development
- Target 9: Develop further an open, rule-based, predictable, non-discriminatory trading and financial system. Address the Special Needs of the Least Developed Countries. Address the Special Needs of landlocked countries and small island developing states. Deal comprehensively with the debt problems of developing countries through national and international measures in order to make debt sustainable in the long term. In cooperation with developing countries, develop and implement strategies for decent and productive work for youth. In cooperation with pharmaceutical companies, provide access to affordable, essential drugs in developing countries. In cooperation with the private sector, make available the benefits of new technologies, especially information and communications.
- Youth unemployment rate (% of total labor force ages 15-24)... 14.3... ...
- Fixed line and mobile telephones (per 1,000 people)... 161.2256.4...
- Personal computers (per 1,000 people)1.98.318.3...

### General indicators
- Population51.9 million    51.5 million    49.1 million    48.7 million
- Gross national income ($)83.0 billion     49.0 billion     35.3 billion     37.7 billion
- GNI per capita1600950720770
- Adult literacy rate (% of people ages 15 and over)99.499.599.699.6
- Total fertility rate (births per woman)1.91.41.21.2
- Life expectancy at birth (years)70.167.168.268.2
- Aid (% of GNI)0.30.71.4...
- External debt (% of GNI)0.617.534.3...
- Investment (% of GDP)27.526.721.320.4
- Trade (% of GDP)56.497.2109.3110.2

*Source: World Bank Millennium Development Goals website, April 2004.*

### 1.      The World Bank Country Assistance Strategy (CAS) for Ukraine was approved on

### _cr0515 - 1.      The World Bank Country Assistance Strategy (CAS) for Ukraine was approved on

### World Bank Country Assistance Strategy (CAS) overview
- Approved on October 23, 2003; covers fiscal years 2004–2007.
- Major focus: support the “European choice” agenda of Ukraine, including institutional developments to create a business-friendly environment and a more inclusive and responsive government.
- Emphasis on building Ukraine’s European aspiration:
  - From the top: reform of institutions and policies.
  - From the bottom: strengthening civil society to increase public sector accountability.
- Proposed lending envelopes:
  - Base Case lending program: US$2.4 billion.
  - High Case lending program: up to a maximum of US$3 billion.
- CAS is results oriented: amount and content of financial assistance conditional on Government achievement of relevant benchmarks.
- Strategy timing and conditionality:
  - Before elections: concentrate on implementation of ongoing reforms and activities to increase the voice of civil society.
  - Following the presidential elections: possibility of a High-Case lending scenario based on Ukraine’s ability to achieve substantial advances in the energy sector, agriculture, financial sector, public sector accountability, and social sector reform.
  - A CAS Update will review the High-Case possibility in early FY06.

### World Bank program — portfolio and instruments
- Project portfolio:
  - 12 operations under implementation.
  - 9 projects under preparation.
- Programmatic Adjustment Loans (PALs):
  - Sequence of loans totaling up to US$1.45 billion, with disbursements depending entirely on performance.
  - PAL covers five cross-sectoral issues: (i) financial accountability; (ii) regulatory framework; (iii) property rights; (iv) public sector accountability; and (v) social and environmental risk management.
  - PAL I: US$250 million, approved September 20, 2001; fully disbursed in two tranches of US$150 million and US$100 million.
  - PAL II: US$250 million, approved December 9, 2003; first tranche of US$75 million disbursed; second tranche of US$175 million contingent on agreed benchmarks.
  - Indicative benchmarks defined for proposed PAL III.
- Public sector projects (selected):
  - Treasury System Project: US$16.4 million — assist in creating an efficient budget management system; in final stage of implementation.
  - State Tax Service Modernization Project: US$40 million — currently under implementation.
  - Statistical System Modernization Project: US$30 million — approved March 2004.
- Agriculture sector:
  - Seeds Development Project: US$32 million — improve agricultural productivity via private production of high quality commercial seeds.
  - Agricultural Sector Adjustment Loan: US$300 million — supported trade liberalization, privatization of land and agricultural enterprises, and farm restructuring.
  - Rural Land Titling and Cadastre Development Project: US$195 million — approved June 2003.
  - Proposed Rural Finance project: US$200 million — in late stages of preparation; aims to increase access to financial services in rural areas.
- Energy sector:
  - Coal Pilot Project: US$15.8 million.
  - Coal Sector Adjustment Loan: US$300 million.
  - Hydropower Rehabilitation and System Control Project: US$114 million — increased production of environmentally clean energy.
  - District Heating Projects:
    - Kyiv District Heating Improvement Project: US$200 million.
    - Kyiv Public Building Energy Efficiency Project: US$18.29 million — rehabilitate district heating systems and improve energy efficiency in public buildings.
- Infrastructure:
  - Lviv Water and Wastewater Project: US$24.25 million — became effective February 2003.
  - Municipal Development Loan Fund: US$150 million — under preparation to provide loans to local governments.
- Private sector and financial sector development:
  - Enterprise Development Adjustment Loans I and II: US$310 million and US$300 million — assisted mass-privatization and capital markets strengthening.
  - Private Sector Development Loan: US$30 million — approved March 2002.
  - Export Development Project: US$70 million — implemented to promote export capacity and strengthen Ukreximbank.
  - E-development project: approved May 2003 — enhance Government decision-making for public procurement, foster private sector development, strengthen civil society via ICT solutions.
  - Bank restructuring support: World Bank assisting with a restructuring plan for a commercial bank.
- Social sector:
  - Social Investment Fund Project: US$50 million — approved late 2001; supports community-based social services for vulnerable groups.
  - Tuberculosis and AIDS Epidemic Control Project: US$60 million — approved December 2002.
  - Social Protection Reform Administration Project and Education Reform Project — in preparation.
- Environment and GEF grants:
  - Two GEF projects on biodiversity completed satisfactorily.
  - Third GEF project addressing Ozone-Depleting Substances nearing completion.
  - New GEF grant for preserving the Azov-Black Sea wetlands: US$6.9 million — approved.
- Non-lending support and capacity building:
  - People's Voice Program — builds civil society and municipal integrity by strengthening citizen groups and responsive public organizations.
  - Global Development Learning Network Project — strengthens administrative and institutional capacity by providing access to global learning facilities.
  - Economic research covering tax policy, regional policy, intergovernmental reform, pension policy, public expenditures and the budget process, poverty, financial sector and corporate governance, procurement system, financial accountability, health, education, energy, and agriculture.
  - Reports under preparation: new CEM, a Trade Study, and a package of policy notes linked to the PAL program.
- World Bank contact: Paul Bermingham, Country Director (Tel.: 473-3985).

### Ukraine — Relations with the EBRD (September 2004)
- Membership and mandate:
  - Ukraine joined the EBRD in 1992.
  - EBRD activities: funding projects in public and private sectors, equity investments, technical cooperation, and policy dialogue (including membership of the Foreign Investment Advisory Council and co-chairmanship of the Energy Sector Task Force).
- Country strategy history:
  - First country strategy approved October 1992; revised November 1993 — emphasized financing private sector projects, developing financial sector, rehabilitating infrastructure.
  - June 1997 strategy — added emphasis on energy sector restructuring; established Energy Sector Task Force (ESTF).
  - August 2000 revised strategy — focused on strengthening financial sector, supporting SMEs, commercialization and structural reform of public utilities, improving energy efficiency, transition of the enterprise sector (especially agribusiness), nuclear safety, and conditions for K2R4 financing.
  - September 2002 country strategy — expand activities, build on rapid economic growth and sectoral reform progress; operational elements included:
    - Encouraging privatization and commercialization of major utilities.
    - Encouraging energy efficiency in state and private sectors.
    - Providing funding through banks to develop small business sector while strengthening banking sector.
    - Providing direct financing to private corporate sector.
    - Commencing funding for agricultural sector via working capital.
    - Continuing nuclear safety mandate implementation (Chernobyl initiatives and K2R4 negotiations).
  - Program of Co-operation signed April 2003 identified priority public sector projects in transport, energy, and municipal infrastructure; emphasized nuclear safety and private sector/banking sector development.
- K2R4 project:
  - Approved by EBRD Board in July 2004 and signed later that month.
  - EBRD lending: US$42 million.
  - European Commission contribution: US$83 million.
  - Purpose: finance post start-up safety and modernization measures at two nuclear reactors; approved conditional on attainment of previously agreed safety levels and internationally accepted standards for remaining safety features.
  - Loan condition: tariff levels within the nuclear sector should be sufficient to enable establishment of a decommissioning fund and other funds to commence safety upgrades at the other 13 nuclear plants.
  - Project scaled smaller than originally considered in late 2000–2001; since then most construction of the two plants completed and Energoatom’s financial position improved due to large increases in collection ratios and adoption of an appropriate tariff methodology.
- EBRD portfolio and financing statistics (as of end-July 2004 unless otherwise stated):
  - Portfolio growth: from 5 projects in 1994 to 62 by end-July 2004.
  - Historical net business volume: EUR 1,492.9 million.
  - Portfolio (operating assets plus undrawn commitments): EUR 900.0 million.
    - 70 percent assigned to private sector: EUR 632.8 million.
    - 30 percent assigned to state sector: EUR 267.1 million.
  - Operating assets: EUR 575.5 million at end-July 2004.
  - Outstanding commitments to Ukraine: almost 5.9 percent of EBRD’s commitments to all countries of operation.
  - Technical Cooperation (TC) activities: 216 projects with commitments of almost EUR 44.6 million.
  - Sectoral composition of commitments:
    - Financial sector: slightly over 25 percent (including sovereign-guaranteed loans to support SME development via participating banks).
      - First SME credit line: EUR 96.2 million — signed end-1994; fully disbursed.
      - Second credit line: EUR 70.1 million — signed May 1998; approved by the Rada in early 2000; almost fully committed.
    - Energy sector: 19 percent (largest single project in power sector; other projects in oil and gas, gas transit, energy efficiency).
    - Manufacturing, including agribusiness: 32 percent.
    - Transport and shipping: 18 percent.
    - Telecommunications: 1.4 percent.
    - Municipal infrastructure: 2.4 percent.
    - Tourism and property: 2.2 percent.
- Forward plan:
  - EBRD to prepare a new country strategy for Ukraine during the first quarter of 2005.

### Statistical Issues — Appendix (summary of key points)
- General improvements and milestones:
  - Data module of the ROSC prepared in 2002 and disseminated on IMF’s website on August 19, 2003, assessing Ukraine’s data dissemination practices against the IMF’s Special Data Dissemination Standard (SDDS).
  - On January 10, 2003, Ukraine became the first CIS country to subscribe to the SDDS.
  - Ukraine’s first international investment position compiled by the NBU in 2002.
  - The country’s IFS page published since July 1996.
- Role of technical assistance and outstanding deficiencies:
  - Fund technical assistance significantly reduced in recent years; multilateral and bilateral sources continued to play an important role.
  - ROSC recommended strengthening independence of the State Committee on Statistics (SCS).
  - Remaining statistical deficiencies: national accounts (methodological problems), balance of payments data, delayed publication of external debt data.
- Timeliness:
  - Key statistical data generally provided in a timely manner (summary reference in text).

### Real sector (national accounts)
- Framework and source data:
  - 1993 SNA is the general framework for compiling national accounts.
  - Classifications largely in accordance with international standards.
  - Source data from extensive SCS survey program, supplemented by administrative and other sources.
  - Main survey report forms revised significantly to align with national accounts definitions, scope, classifications, and new chart of accounts.
- Remaining weaknesses in national accounts:
  - Lack of published time series of real GDP showing its level relative to a given reference year.
  - Quarterly data are not seasonally adjusted.
  - Fourth quarter national accounts are not compiled from source data consistent with first three quarters.
  - No proper quarterly price indices for exports and imports, although development of these indices has started.
  - Methodology covering the informal economy needs revision and improvement.
  - Need to revive the Statistical Council to provide guidance, inter alia, to the SCS on statistical series quality and improvement strategies.
  - Need for greater use of sample surveys and improved data flow management and processing.

### Government finance statistics (GFS)
- Progress and coverage:
  - Ministry of Finance (MoF) and State Treasury (STU) made considerable progress in compiling fiscal data.
  - MoF publishes monthly data on central and regional government operations within 25 days of the reference period.
  - Economic classification and classification of outstanding debt consistent with GFSM 1986 methodology.
  - From 2002, functional classification consistent with GFSM 2001.
  - All central government transactions and local government revenue transactions recorded in the Treasury Single Account (TSA).
  - Starting in 2004, local government expenditures will also be covered in the TSA.
- ROSC findings and recommendations:
  - GFS are available monthly but do not provide the coverage recommended in GFSM 1986.
  - Data formats more suited to short-term budget execution monitoring than statistical analysis.
  - Authorities partially complied with ROSC recommendations and reported central and local government data for 1999-2002 in GFSM 2001 format for publication in the GFS Yearbook.
  - Authorities encouraged to publish more extensive information on definitions, sources, and methods used in fiscal data compilation.
  - Reporting on arrears (receipts and payments) should be improved in coverage and quality.
  - Significant delays remain in reporting operations of social special funds.

### Money and banking statistics
- Technical assistance and progress:
  - Ukraine received extensive technical assistance in money and banking statistics; substantial improvements achieved.
  - ROSC recommended improved timeliness of analytical accounts of the central bank using daily accounting records excluding internal organizations.
  - Staff urged authorities to meet SDDS timelines for these accounts rather than use flexibility options.
  - SDDS allows up to two flexibility options on some data categories; Ukraine uses both flexibility options for financial sector data categories: (i) timeliness of analytical accounts of the banking sector; (ii) timeliness of analytical accounts of the central bank.
- Ongoing work and recommendations:
  - Authorities working on disseminating information on compilation of monetary data, including major aggregates and differences from internationally accepted standards.
  - Establishing a migration plan to adopt recommendations in the Monetary and Financial Statistics Manual (MFSM).
  - ROSC recommendations include:
    - Expand coverage of monetary data, including nonbank financial institutions issuing deposit substitutes.
    - Enhance internal consistency of monetary data.
    - Separately identify information on financial derivatives.
    - Verify consistency of monetary statistics and government finance statistics on a regular basis.

### Balance of payments statistics
- (Section heading present; detailed balance of payments issues discussed following this heading in the source text.)

*Source: _cr0515 - 1.      The World Bank Country Assistance Strategy (CAS) for Ukraine was approved on*

### 12.      Ukraine’s balance of payments statistics are compiled in broad conformity with the

### _cr0515 - 12.      Ukraine’s balance of payments statistics are compiled in broad conformity with the

### Balance of payments compilation and data sources
- Ukraine’s balance of payments statistics are compiled in broad conformity with the conceptual framework of the BPM5 and are reported to STA on a quarterly basis with a lag of about ten weeks.
- Principal data sources:
  - a closed ITRS,
  - administrative data sources,
  - a survey of enterprises.
- Post-ROSC actions:
  - The authorities have expanded the survey on inter-enterprise arrears to include information relevant for balance of payments purposes.
  - The authorities intend to implement lower reporting thresholds for banks.
- Unimplemented improvements due to lack of financing:
  - Travelers’ surveys to improve shuttle trade, compensation of employees, and travel estimates have not been implemented.
- Methodological issues noted:
  - Some methodological weaknesses exist in private portfolio and FDI surveys.

### Dissemination, coordination, and external-debt reporting
- The authorities have made progress in disseminating international reserves data; the release of monthly data, in line with the Fund’s reserve template, started in mid-2002.
- Cooperation between government agencies has improved, but coordination problems persist among the National Bank of Ukraine (NBU), the SCS, and the MoF, particularly regarding short-term external debt.
- Ukraine still does not disseminate external debt data that meet all SDDS requirements.

### Core statistical indicators (selected observations as of August 31, 2004)
- Date of latest observations include:
  - Exchange Rates: August 30, 2004
  - International Reserves 1/: August 2004
  - Central Bank Balance Sheet: July 31, 2004
  - Reserve/Base Money: July 31, 2004
  - Broad Money: July 31, 2004
  - Interest Rates: August 30, 2004
  - Consumer Price Index: July 2004
  - Exports/Imports: May 2004
  - Current Account Balance: Q1 2004
  - Overall Government Balance: March 2004
  - GDP: Q1 2004
  - External Debt: July 2004
  - Debt Service: July 2004
- Frequency and reporting modes summarized in source tables (D-daily, M-monthly, Q-quarterly, etc.; source: direct reporting by National Bank, Ministry of Finance, Ministry of Statistics).

### Medium-term outlook — Baseline scenario (summary)
- Growth and investment:
  - Staff estimates real GDP to grow by 5 percent per year over the medium term.
  - Baseline assumes an average increase in the private investment to GDP ratio by 1½ percentage point over the next four years.
  - Additional FDI of about $8 billion until 2008 is assumed.
- Fiscal policy and public debt:
  - Fiscal deficit targeted at 1½ percent over the medium term.
  - Public debt stock projected to fall gradually to below 20 percent starting in 2006.
  - Shift towards domestic debt financing projected given the large share of foreign debt (72 percent of total public debt at end-June 2004).
- External sector and reserves:
  - Hryvnia assumed to appreciate gradually, contributing to unwinding of the current account surplus and reduction of external debt.
  - Current account surplus expected to turn into a deficit from 2007 as investment and import demand increase.
  - Capital account projected to strengthen as portfolio outflows subside and FDI increases.
  - Gross international reserves projected to exceed 4 months of imports.
- Under the baseline scenario:
  - Public debt is projected to fall to about 17 percent by 2009, 60 percent of which would be external debt.

### Risks to the baseline scenario and stress outcomes
- Dependence on external demand:
  - Exports contribute to 60 percent of GDP.
  - Scenario: if exports decline by 4 percent compared to 2004, GDP growth could drop to 1 percent in 2005 (5 percentage points below baseline).
  - Under that shock:
    - For the largest 25 banks, if one third of adversely classified loans (“substandard”, “doubtful” and “loss”) would not be repaid and achieve a recovery value of only 25 percent, additional bank capital of about HRV 7½ billion would be required.
    - If the government bore such banking sector costs, fiscal costs could be about 1.2 percent of GDP over two years.
    - Debt ratios could rise to 29 percent of GDP by 2006—compared to the projected 19 percent under the baseline—before reverting to consolidation path, assuming appropriate handling.
- Sensitivity analysis highlights:
  - A large output shock—negative real growth rates of 6.9 percent for two consecutive years—could push the public debt-to-GDP ratio to nearly 40 percent.
  - With fiscal policy responses, debt would reverse to about 35½ percent by 2009; without fiscal prudence, debt ratios could rise to over 60 percent by 2009.
  - A one-time 30 percent depreciation in 2005 could raise the public debt-to-GDP ratio by 12 percentage points above the baseline.
  - Under most other scenarios, debt ratios converge to below or close to 30 percent of GDP by 2009.

### Immediate vulnerabilities identified
- Credit and exchange rate risk in the banking sector:
  - Rapid credit growth, including foreign-currency denominated loans, exposes banks to significant credit risk given limited risk management capacities and relatively weak financial conditions for some banks.
  - Institutional weaknesses include weak accounting and reporting requirements for corporations and weak corporate governance.
- External shocks:
  - Russia accounts for close to 20 percent of all exports; accounting for other CIS countries, a downturn in Russia would affect about one fourth of Ukraine’s exports, equivalent to about 12 percent of GDP.
  - The large share of metallurgical products in exports (about one third) raises vulnerability to world price reversals.
- Loss of domestic confidence:
  - Reemerging inflationary pressures, political uncertainties, or developments detrimental to investment climate could trigger capital flight and currency confidence losses.

### Key fiscal and debt numbers (selected rows from the public sector debt table, in percent of GDP unless noted)
- Public sector debt (public sector debt 1/):
  - 2002: 35.7
  - 2003: 30.3
  - 2004: 27.1
  - 2005: 21.6
  - 2006: 18.7
  - 2007: 17.6
  - 2008: 16.8
  - 2009: 16.4
- Foreign-currency denominated share of public debt (percent of GDP):
  - 2002: 27.2
  - 2003: 21.9
  - 2004: 18.4
  - 2005: 15.2
  - 2006: 12.3
  - 2007: 11.2
  - 2008: 10.5
  - 2009: 9.8
- Change in public sector debt:
  - 2002: -2.9
  - 2003: -5.4
  - 2004: -3.2
  - 2005: -5.5
  - 2006: -2.9
  - 2007: -1.1
  - 2008: -0.8
  - 2009: -0.4
- Primary deficit (percent of GDP):
  - 2002: -1.8
  - 2003: -0.3
  - 2004: 2.4
  - 2005: 0.6
  - 2006: 0.7
  - 2007: 0.7
  - 2008: 0.7
  - 2009: 0.7
- Revenue and grants (percent of GDP), 2002–2009:
  - 2002: 36.0
  - 2003: 37.0
  - 2004: 35.5
  - 2005: 33.7
  - 2006: 33.6
  - 2007: 33.6
  - 2008: 33.6
  - 2009: 33.6

*Source: IMF staff calculations.*

### 1.      This supplement provides information on developments since the staff report was

### This supplement provides information on developments since the staff report was issued.

### Inflation developments and monetary response
- Annual CPI inflation rose to 10.7 percent in September, hitting double digits for the first time since June 2001.
- Since May seasonally-adjusted monthly inflation has remained, at 1 percent, more than double the average over the first four months of the year.
- Annual PPI inflation reached 23.2 percent.
- Recently released data show a sharp acceleration of household expenditure in August.
- The staff projects that CPI inflation could reach 11 percent by year end. The authorities maintain that inflation will revert to single digits.
- In response to rising inflation, the National Bank of Ukraine raised its discount and overnight refinance rates by 50 basis points in October.
- Earlier monetary tightening measures: issuance of Certificates of Deposit (CDs) in low volumes, raising reserve requirements; discount rate raised by 50 basis points to eight percent in early October.

### Fiscal developments and election-related spending pressures
- The government approved an increase in the minimum monthly pension from HRV 130 ($25) to HRV 284.6 ($54), effective retroactively September 1, 2004.
- This pension increase boosts the monthly pension bill by 36 percent for the remaining four months of the year, raising government expenditure by about 1¼ and 3 percent of GDP in 2004 and 2005, respectively.
- The government decided to clear wage arrears at state and bankrupt agricultural enterprises, and to increase social spending.
- Leading presidential candidates have announced plans for more aggressive tax rate reductions and additional compensation for lost savings from the early 1990s hyperinflation, increasing uncertainty about future fiscal policy stance.

### Consolidated budget projections and financing (2004–05)
- Without corrective measures, the consolidated government deficit would rise to about 4½ percent of GDP in 2004.
- To finance pension increases and clear wage arrears, the government secured approval to spend HRV 4 billion of additional privatization proceeds, estimated by staff to add about 1¼ percent of GDP to the consolidated budget deficit.
- In September alone, the budget deficit was 1 percent of annual GDP.
- Authorities reiterate intentions to limit the consolidated budget deficit to 3 percent of GDP through improved tax administration, spending delays, and under-spending of budget limits; authorities expect the approved 2005 budget will limit the consolidated deficit to about 2 percent of GDP.
- The draft 2005 budget submitted in mid-September targeted a consolidated budget deficit of 1.8 percent of GDP but does not incorporate recently approved measures (notably the pension increase).
- Staff assessment indicates that:
  - The pension increase will add about 3 percent of GDP to the deficit in 2005.
  - Staff projects local government expenditure to be ¾ percent of GDP above budget projections.
  - Staff projects consolidated overall budget revenues will fall short of budget target by ¾ percent of GDP, reflecting less optimistic assumptions about VAT administration improvements.
  - Altogether, achieving the 2005 budget target would require corrective measures of some 4½ percentage points of GDP.
  - The necessary adjustment would become larger if authorities reduced VAT rates (rate cut from 20 percent to 17 percent was envisaged in July discussions and would account for 0.8 percent of GDP in 2005 per staff report assumptions).

### Fiscal table excerpts (percent of GDP and levels preserved)
- Revenues: 37.3 35.5 35.6 33.7 35.7 35.0 (columns as in source)
- Expenditures: 39.0 38.9 40.2 35.3 37.5 41.2
  - o.w. pensions: 9.9 9.7 10.9 9.7 9.3 12.2
- Corrective measures to be identified: ...............4.4
- Overall balance (1+2+3): -1.8 -3.4 -4.6 -1.6 -1.8 -1.8
- Financing: 1.8 3.4 4.6 1.6 1.8 1.8
  - External: 0.4 1.7 1.7 0.4 0.1 0.5
  - Domestic: 0.5 -0.9 -0.2 0.0 0.6 0.1
  - Privatization: 0.8 2.6 3.1 1.2 1.1 1.1
- Memorandum items (percent of GDP):
  - Revenues: 11.4 19.5 21.0 9.5 17.0 12.2
  - Expenditures: 14.5 28.5 34.0 4.7 8.9 19.4
  - Pensions: 31.9 44.3 64.3 13.8 -0.4 31.0
- GDP (in billions of hryvnias): 292.0 328.5 332.0 379.5 387.3 387.1
- Sources: Ukrainian authorities; and Fund staff projections.

### Offsets, VAT refunds, and arrears
- Authorities budgeted substantial tax offsets in 2005 totaling HRV 7.4 billion (2 percent of GDP). Examples:
  - Netting communal services arrears or a portion of the ratepayer’s current bill against a small portion of lost savings from the 1990s hyperinflation.
  - Netting agriculture sector tax arrears against a contribution to food stock building.
  - Netting Naftogaz tax arrears against efforts by Naftogaz to improve metering.
- Based on past experience, staff cautions these offset transactions may add to, rather than correct, arrears problems because new arrears can facilitate participation in additional offset rounds.
- VAT refund arrears declined to HRV 295 million at end-August due to:
  - Large surge in securitization of claims, virtually exhausting the 2004 securitization scheme.
  - Increased use of netting against other taxes.
  - Increase in rejections of new VAT refund claims (40 percent rejected in July and August versus 9 percent in first half of the year).
- Staff notes uncertainty whether the improved VAT refund performance in July–August will be sustained.

### Staff appraisal and policy recommendations
- Recent fiscal developments require prompt correction.
- The significant increase in recurrent government spending, particularly pensions, resulting from the amended budget’s use of one-off privatization receipts is inappropriate and places public finances on less firm footing, compromising the 2005 budget.
- The authorities’ objectives of cutting the VAT rate, spending more on infrastructure and social needs, raising pensions, and reversing the fiscal expansion are incompatible.
- The staff urges the authorities to adopt corrective measures as soon as possible to prevent hard-won stabilization gains—particularly low inflation—and a sound fiscal outlook from slipping away.

### Selected economic indicators (extracts from Table 1, preserved values)
- Real GDP (annual change in percent): -0.2 5.9 9.2 5.2 9.4 6.0 12.5 6.0
- Nominal GDP (in billions of hryvnias): 130.4 170.1 204.2 225.8 264.2 292.0 328.5 379.5
- Nominal GDP (in billions of U.S. dollars): 31.6 31.3 38.0 42.4 49.5 54.8 61.7 75.1
- Unemployment rate (ILO definition): 11.9 11.7 11.8 10.1 9.1 .........
- Consumer prices, end of period: 19.2 25.8 6.1 -0.6 8.2 6.0 9.0 7.0
- Producer prices, end of period: 15.7 20.6 0.9 5.7 11.1 5.5 20.0 7.0
- Consolidated budget (Revenue, percent of GDP): 31.9 33.4 33.5 36.0 37.0 37.3 35.5 33.7
- Consolidated budget (Expenditure, cash basis, percent of GDP): 34.2 34.7 35.1 35.5 37.7 39.0 38.9 35.3
- Cash balance: -2.4 -1.3 -1.6 0.5 -0.7 -1.8 -3.4 -1.6
- Privatization proceeds (percent of GDP): 0.6 1.3 1.3 0.5 1.1 0.8 2.6 1.2
- Public debt and arrears (percent of GDP): 66.7 47.0 38.6 35.7 30.3 27.7 27.1 21.6
- Consumer prices, period average: 22.7 28.2 12.0 0.8 5.2 7.1 8.3 8.1
- Hryvnia per U.S. dollar, end of period: 5.2 5.4 5.3 5.3 5.3 .........
- Current account balance (in percent of GDP): 5.2 4.7 3.7 7.5 5.8 3.7 -10.2 -4.1
- Gross reserves (end of period, in billions of U.S. dollars): 1.1 1.5 3.1 4.4 6.9 7.8 11.9 13.6

*Public Information Notice (PIN) No. 05/7 — IMF Executive Board Concludes 2004 Article IV Consultation with Ukraine (January 24, 2005).*

### 29.5 percent compared to 12.4 percent in 2000. While credit expansion has decelerated since

### _cr0515 - 29.5 percent compared to 12.4 percent in 2000. While credit expansion has decelerated since

### Banking, credit, and financial vulnerabilities
- Loans have increased to about two-thirds of bank assets.
- Nonperforming loans classified by past due criteria are estimated at eight percent of total loans.
- Credit expansion has decelerated since early 2004, but banks’ portfolios had expanded significantly.
- Directors encouraged the authorities to:
  - raise the minimum capital adequacy ratio to 12 percent;
  - contain risk from foreign currency loans;
  - adopt tighter accounting and reporting standards for corporations.
- Directors welcomed:
  - the NBU’s increasing efforts to drain liquidity;
  - continued progress in strengthening prudential banking regulation and supervision;
  - the inclusion of collective action clauses in Ukraine’s 2004 Eurobond issues.
- Directors regretted that draft amendments to the Banking Act, which would allow identification of bank owners and tighten related-party lending, had not yet been adopted by parliament.

### Fiscal policy, public finances, and privatization proceeds
- Directors expressed concern about the fiscal expansion underway in the context of an already rapidly growing economy and stressed the need to return to a more prudent fiscal stance.
- The surge in the deficit in 2004 was largely financed through higher-than-expected privatization proceeds, but significant increases in recurrent government spending, particularly pensions, compromised the 2005 budget and placed public finances on a less firm footing.
- Directors emphasized that resources from the sale of public assets would be better used to retire existing debt to build room against future contingencies and for medium-term public spending needs, including infrastructure.
- Directors urged prompt corrective measures to restore a sound fiscal outlook and to avoid a sizable slippage with respect to the original fiscal target for 2004—a consolidated budget deficit of 1¾ percent of GDP.
- A large correction was also needed to achieve the consolidated budget deficit envisaged in the draft 2005 budget of 1¾ percent of GDP.
- Directors encouraged expenditure prioritization through further development of a medium-term budget framework, but cautioned against hasty tax rate reductions before the tax base was broadened and tax administration strengthened.
- While welcoming the recent sharp reduction in VAT refund arrears, Directors remained cautious about the sustainability of this performance and saw significant scope for further improving VAT administration.

### Monetary policy and exchange rate regime
- Directors noted that monetary conditions remained too loose to ensure attainment of the original inflation objective in 2004 and beyond.
- In the face of additional government spending, mounting inflationary pressures and absent greater exchange rate flexibility, Directors felt that the NBU should tighten monetary policy further to achieve its objective of bringing inflation back to single digits.
- Directors noted that the real exchange rate would be subject to appreciation pressures in the medium term and considered a move toward a more flexible exchange rate regime more beneficial to Ukraine.
- Directors felt that the de facto peg to the U.S. dollar was now exacerbating the challenge for the NBU to achieve its inflation objective, contributed to a distorted saving-investment position, and provided an implicit exchange rate guarantee with attendant risks for financial stability.
- Many Directors referred to the vulnerability of the banking system and suggested that the pace of movement toward flexibility should be left to the judgment of the authorities.

### Structural reforms, governance, and investment climate
- There has been progress in the structural reform agenda:
  - Income taxes have been cut and the tax base broadened by eliminating some exemptions;
  - the pension system reformed;
  - collection ratios in the energy sector have improved.
- However, several actions under program conditionality—concerning related-party lending, tax preferences and exemptions, and VAT refund arrears—have not been completed.
- Directors noted governance problems remained widespread, ranging from tax collection and public procurement to law enforcement and divestment of public assets.
- Directors regretted that, while privatization had recently accelerated, procedures remained nontransparent.
- Directors advised:
  - prompt passage of important legislation such as the energy debt restructuring law and the joint-stock company law;
  - a reduction in the burden of licensing and inspection regimes;
  - a strengthening of the judiciary and of contract enforcement.

### Data, statistics, and surveillance
- Directors noted that, while broadly adequate for surveillance, statistical data could be improved, particularly with regard to the national accounts and the balance of payments.

### Key statistics and selected economic indicators (as reported)
- Nominal GDP (in billions of hryvnia): 170.1; 204.2; 225.8; 264.2; 332.0; 387.1
- Real GDP growth: 5.9; 9.2; 5.2; 9.4; 12.5; 6.0
- Consumer price index (period average): 28.2; 12.0; 0.8; 5.2; 8.8; 9.5
- Consumer price index (end of period): 25.8; 6.1; -0.6; 8.2; 11.0; 7.0
- Consolidated government budget balance, cash basis (in percent of GDP): -1.3; -1.6; 0.5; -0.7; -4.6; -1.8
- Primary balance (in percent of GDP): 1.8; 0.4; 1.8; 0.3; -3.6; -0.9
- Revenue (in percent of GDP): 33.4; 33.5; 36.0; 37.0; 35.6; 35.7
- Expenditure (in percent of GDP): 34.7; 35.1; 35.5; 37.7; 40.2; 37.5
- Public debt and arrears (in percent of GDP): 47.0; 38.6; 35.7; 30.3; 26.9; 21.8
- Base money (percent change): 40.1; 37.4; 33.6; 30.1; 50.5; 21.4
- Broad money (percent change): 45.5; 41.9; 41.8; 46.5; 45.3; 27.5
- Credit to nongovernment (percent change): 61.3; 40.5; 47.3; 63.4; 31.3; 28.4
- Velocity (annual GDP divided by end of period broad money): 5.3; 4.5; 3.5; 2.8; 2.4; 2.2
- Current account balance (in percent of GDP): 4.7; 3.7; 7.5; 5.8; 10.2; 4.1
- External public debt (in percent of GDP): 33.1; 26.6; 24.0; 21.9; 19.0; 15.1
- Debt service (in percent of exports of goods and services): 10.4; 8.7; 5.7; 6.3; 4.8; 5.2
- Terms of trade (annual change in percent): -8.2; 1.3; 1.6; 8.6; 13.0; -6.1
- Gross reserves (end of period, in months of next year's imports of goods and services): 0.9; 1.7; 1.9; 2.4; 3.8; 3.9

*Source: IMF Staff estimates and projections and Ukrainian authorities, as presented in the Staff Report for the 2004 Article IV Consultation with Ukraine.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0515.pdf_