## _cr05415 ## Source details **Canonical URL:** [_cr05415](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05415.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05415.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05415.pdf.json) --- ### Executive summary - Real GDP growth slowed from "8½ percent" during 2000–04 to about "3 percent" for January-August 2005. - Inflation has been hovering around "15 percent" for most of 2005; inflation persistence is high by regional standards. - Fiscal policy tightened relative to 2004 but massive hikes in public pensions and wages—raising average public pensions and wages by "over 50 percent"—have fuelled inflation pressures. - Monetary conditions remain loose despite some attempted tightening by the NBU; monetary aggregates and excess liquidity expanded, leaving most interest rates negative in real terms. - Exports are heavily concentrated in metals; metal prices are about "50 percent" above their long-term trend. - Public external debt was "19 percent of GDP" in 2004. - Short-term projection: GDP growth projected at "4 percent" in 2005 and "5½ percent" in 2006 under a rebound of investment but with stronger external headwinds. - Staff view: tighter and more coordinated fiscal and monetary policies are needed to bring inflation back into single digits during 2006. ### Fiscal outcomes and 2005 budget implementation - 2005 supplementary budget targets: - State budget deficit of "1¾ percent of GDP". - Equivalent to a general government deficit of "2½ percent of GDP" (compared with "4½ percent" realized in 2004 and "6-7 percent" implicit in the original 2005 budget). - Composition and effects: - Supplementary budget accommodated pension increases and boosted the public wage bill. - Public pension spending in 2005 projected to approach "15 percent of GDP", up by "3½ percent of GDP" compared with 2004. - Targeted tightening relied on closure of tax loopholes, improved tax administration, higher state-enterprise dividends, and steep cuts in capital spending. - Budget implementation through end-June 2005: - General government deficit (including VAT refund arrears) was "1 percent of annual GDP". - VAT refund arrears at end-June: about "Hrv 3 billion, or ¾ percent of GDP". - Buoyant cash revenue collections reflected 2005 tax measures; corporate tax receipts and customs revenues were particularly buoyant. - Supplementary 2005 budget (parliament approved) incorporated unbudgeted pension spending amounting to some "¾ percent of GDP" and spending of "¼ percent of GDP" to re-capitalize two state banks. ### Monetary policy, liquidity, and exchange rate measures - Monetary conditions: - NBU continued to purchase foreign exchange; sterilization efforts were limited. - Increase in reserve requirements effective "September 1" noted; nevertheless high excess liquidity persisted and all interest rates are negative in real terms. - Monetary aggregates: base money growth (Dec-2005) "42.1 percent"; broad money growth (Dec-2005) "41.0 percent". - NBU actions toward flexibility: - Relaxed export surrender requirements; removed predeposit requirement for non-resident T-bill bids. - In August lifted ban on banks operating both buy/sell sides of FX market within same day and allowed forward operations. - Introduced a "1.5 percent" foreign exchange transaction tax (draft 2006 budget proposes to halve it). - Restricted purchases by non-residents of government securities with original maturities of less than one year; introduced a "20 percent" reserve requirement on foreign currency loans with maturity up to "180 days" from non-residents. - On "April 20" allowed the hryvnia to appreciate by almost "3 percent" and occasionally withdrew from the market thereafter. - Real exchange rate and competitiveness: - Since "August 2004" real exchange rate appreciated by "about 11 percent" due to domestic inflation surge and modest nominal re-valuation. - U.S. dollar wages in manufacturing increased by "almost 40 percent". - Updated indicators suggest the real exchange rate remains below equilibrium, though estimates vary. ### External sector and capital flows - Export composition: metals account for a large share (share of metals in merchandise exports "39.1 percent" in 2004). - Terms of trade: - Metal prices skyrocketed since 2003 and are about "50 percent" above their long-term trend. - Terms-of-trade impulse that boosted current account surplus in 2003–04 leveled off in 2005; staff assume terms of trade drop of about "6 percent" in 2006. - Capital inflows and investor interest: - Capital inflows subdued since 2000; per capita FDI during 1998–2004 very low (only Kyrgyz Republic, Turkmenistan, and Uzbekistan fared worse). - Foreign investor interest picking up after upgrades and narrower sovereign spreads; sovereign EUR 600 million ten-year bond issued in October 2005 yielding "4.95 percent" (spread 155 bps over German benchmark). - Current account projections: - Current account surplus projected to shrink: full-year 2005 forecast revised to "4.8 percent of GDP" (from "6 percent"). - Staff project current account around "1.2 percent" of GDP in 2006 Prel./Proj. series; baseline current account around "1.1 percent" in 2006. ### Financial sector vulnerabilities and developments - Banking sector resilience and risks: - Banking system weathered prior political shocks but near-crisis exposed prudential and supervisory shortcomings. - Credit growth high: "42 percent" (August 2005) and "44 percent" (September 2005) reported; credit expansion financed increasingly through borrowing from abroad. - Household share of total loans rose from "5 percent" at end-2001 to "19 percent" (end-August 2005) / "20 percent" (end-September 2005). - Mortgage lending and booming housing market: U.S. dollar housing prices in Kyiv rose markedly; housing prices quadrupled over past 3½ years. - Remaining banking concerns: - Capitalization, risk management, related-party lending, widening maturity mismatches, and still-high (albeit declining) non-performing loans ratio. - Low profitability partly owing to tax avoidance constrains internal capital replenishment. - Recommendations: strengthen supervisory framework, approve Banking Act amendments (identify owners), move to risk-based supervision, consider raising minimum capital adequacy ratio to "12 percent" until capital quality improves. - Financial soundness indicators (select): - NPLs to total loans: Dec-04 "30.0"; Jun-05 "23.1". - Regulatory capital to risk-weighted assets: Jun-05 "15.2". - Loans in foreign currency to total loans: Jun-05 "38.4". - Return on assets (after tax): Jun-05 "1.2". ### Structural policies, privatization, and investment climate - Structural reform progress: - Ukraine-EU Action Plan contains sweeping reform agenda; progress limited outside trade policy. - Notable actions: WTO-related bills adopted; tariff cuts; adoption of permit simplification legislation; establishment of a telecommunications regulator. - Investment climate constraints: - Debate over reconsidering past privatizations increased property-rights uncertainty and dampened investment. - Heavy-handed interventions in fuel, meat, and sugar markets contributed to perceived policy drift. - Mass privatization during 1992–98 produced dispersed ownership and weak minority shareholder protection, contributing to asset pilfering and a sizable shadow economy. - Privatization windfall (Kryvorizhstal re-auction): - Mittal Steel acquired about "93 percent" stake for "$4.8 billion (5¾ percent of GDP)". - After repaying previous owners "$0.8 billion", net revenue to the budget about "Hrv 20 billion (or 5 percent of GDP)" — exceeding budgeted privatization revenue for 2005 ("1¾ percent of GDP"). - Staff estimate financing needs of "1½ percent of GDP" covered by proceeds; net windfall remaining "3½ percent of GDP". - Staff recommended allocating proceeds primarily to debt redemptions that do not aggravate domestic liquidity and limited well-targeted infrastructure spending, avoiding higher recurrent spending that would fuel inflation. ### Medium-term scenarios and public debt sustainability - Medium-term baseline: - Baseline assumes sustained structural reform but allows for delays; trend growth about "5 percent" under moderately successful reform. - Baseline assumes move to inflation targeting and bringing average inflation into single digits in 2007. - Higher-growth scenario: - Full implementation of authorities’ reform agenda could yield medium-term growth as high as "8-9 percent". - If debt-GDP ratio held at about "16 percent", higher growth could free up about "2 percent of GDP" annually for fiscal reforms. - Public debt and contingent liabilities: - Recognition of lost savings could be up to "30 percent of GDP"; recognizing these as debt could more than double public debt. - Baseline public sector debt path: 2004 "25.1 percent of GDP"; 2005 Prel. "22.8"; 2006 Prel. "19.9"; 2006 Baseline "18.5". - External position: - Baseline expects return to moderate current account deficits financed by FDI and private long-term borrowing; gross reserves projected to remain adequate. - External risks: sharper-than-projected reduction in world metal prices, slowdown in metal markets, and convergence of energy import prices to world levels. ### Policy recommendations (staff views and mission advice) - Fiscal policy: - Achieve 2005 general government deficit target of "2½ percent of GDP". - Target a general government deficit of "2¼ percent of GDP" in 2006 and base the 2006 budget on a realistic macro framework. - Freeze real recurrent spending in 2006; ensure wage and pension increases do not exceed projected inflation. - Eliminate provision allowing spending of excess privatization receipts without prior parliamentary approval. - Fiscal package options to reach adjustment target up to "1½ percent of GDP" could include: - Expenditure cuts ("3,580 Hrv million; 0.7 percent of GDP"), tax preference reductions ("3,024 Hrv million; 0.6 percent of GDP"), pension fund measures ("1,200 Hrv million; 0.2 percent of GDP"); total "Sum of fiscal measures (1+2+3) 7,804 1.6". - Monetary and exchange rate policy: - Tighten monetary stance; NBU should absorb excess liquidity, limit money growth consistent with end-2006 inflation goal of about "9 percent". - Staff recommended base money growth slowdown to about "32 percent" for remainder of 2005 and to about "22 percent" in 2006 (staff judged NBU’s envisaged end-2005 base money growth target of "38-43 percent" too expansionary). - Move gradually to a managed float and ultimately to inflation targeting; prepare technical prerequisites in 2006 and consider implicit inflation targeting in 2007 if progress adequate. - Improve communication of the NBU’s main policy rate and strengthen liquidity-management operations. - Financial sector: - Strengthen regulation and supervision; approve Banking Act amendments to identify owners; move to risk-based supervision; strengthen bank resolution process. - Improve capital quality; consider raising minimum capital adequacy ratio to "12 percent". - Avoid reintroducing long-term NBU lending facilities that interfere with monetary policy. - Structural reforms: - Prioritize market-friendly institutional reforms to improve investment climate: property-rights clarity, anti-corruption measures, removal of excessive regulations (target some "3,000" unhelpful regulations for elimination), adopt Joint Stock Company Law. - Complete WTO accession-related measures and implement Ukraine-EU Action Plan commitments. - VAT refunds and tax administration: - Resolve VAT refund arrears; reconsider risk-based audit approach to a simpler design; strengthen reporting systems to detect fraud earlier. ### Near-term outlook and risks - Growth and inflation: - GDP growth: projected "4 percent" in 2005 and "5½ percent" in 2006 (staff baseline), with alternative 2006 Baseline "5.0" in some tables. - Staff projected 2005 CPI inflation end-year outcome around "14 percent" (later supplement indicates end-year now likely to reach "12 percent"). - Under adjustment scenario (general government deficit "2¼ percent of GDP", real freeze on recurrent spending, slower money growth, and more flexible exchange rate), staff projected inflation could be reduced to "9 percent" in 2006 with little impact on growth. - Downside risks: - External: terms-of-trade shock, weaker global demand, rapid rise in energy import prices. - Domestic: difficult investment climate, political uncertainty, fiscal loosening, and financial-sector vulnerabilities. - Policy coordination: - Past policies were not well coordinated; recommendation to improve coordination between government and NBU and to communicate policy objectives clearly. ### Key numeric highlights (select exact figures from source) - Real GDP growth: 2004 "12.1"; 2005 Prel. "4.0"; 2006 Prel./Proj. baseline "5.5"; 2006 Baseline "5.0". - Nominal GDP (Hrv billions): 2004 "345.9"; 2005 Prel. "415.5"; 2006 Baseline "499.8". - Consumer prices (period average): 2004 "9.0"; 2005 "14.2"; 2006 Prel. "14.4"; 2006 Baseline "12.1". - Consumer prices (end of period): 2004 "12.3"; 2005 "14.0"; 2006 Prel. "13.0"; 2006 Baseline "9.0". - General government deficit targets and outcomes: 2004 realized "4½ percent" of GDP; 2005 target "2½ percent of GDP"; staff-recommended 2006 target "2¼ percent of GDP"; authorities’ draft 2006 budget target "2½ percent of GDP". - Public pension spending in 2005: projected to approach "15 percent of GDP"; up by "3½ percent of GDP" from 2004. - VAT refund arrears: end-June 2005 "Hrv 3 billion, or ¾ percent of GDP"; end-September 2005 reduced to "½ percent of GDP". - Kryvorizhstal sale: purchase price "$4.8 billion (5¾ percent of GDP)"; net revenue to budget "Hrv 20 billion (or 5 percent of GDP)" after repaying previous owners "$0.8 billion". - Monetary growth (base money, end-period percent change): 2005 "42.1"; 2006 Prel. "24.5"; 2006 Baseline "21.8". - Broad money (end-period percent change): 2005 "41.0"; 2006 Prel. "27.9"; 2006 Baseline "25.1". - Credit growth: Aug-2005 "42 percent"; Sep-2005 "44 percent". - Gross official reserves (end-period, US$ billions): 2004 "9.5"; 2005 Prel./Dec "16.0"/"15,962"; 2006 Prel./Proj. "18.2"/"18,216". - Public sector debt (percent of GDP): 2004 "25.1"; 2005 Prel. "22.8"; 2006 Prel. "19.9"; 2006 Baseline "18.5". - Share of metals in merchandise exports: 2004 "39.1 percent". - Lost savings recognition: could be up to "30 percent of GDP". *IMF Staff Report — Executive Summary and supplementary materials (Ukraine), July–November 2005 (content unit _cr05415).* ### Executive Summary ...................................................................................................... ### Executive Summary ### Background: recent macroeconomic developments - Real GDP growth slowed sharply from 8½ percent during 2000–04 to about 3 percent for January-August 2005. - Export growth has decelerated; investment has slumped; private consumption has been fuelled by rising wages and social transfers. - Inflation has been on an upward trend since early-2003 and has been hovering around 15 percent for most of 2005. - Fiscal policy was tightened relative to 2004, but massive hikes in public pensions and wages—financed by a concomitant increase in the tax burden—have fuelled inflation pressures. - Monetary conditions remain loose despite some attempted tightening by the NBU. - The Ukraine-EU Action Plan contains a sweeping agenda for structural reforms; progress has been limited outside trade policy. ### Growth and inflation analysis - Output: the boom impetus from strong external demand, idle capacities, and cost competitiveness has reversed; domestic demand expansion (partly from large pension and wage hikes) and a higher tax burden reallocated income toward the lower-saving household sector and damped private investment. - Inflation dynamics: - Inflation persistence is high by regional standards. - Recent inflationary pressures are mainly rooted in strong domestic demand—especially food—while producer price pressures have eased in line with slowing economic activity. - Administrative price measures (price caps) may have contained some headline pressures temporarily. ### External sector and capital flows - Export composition: exports are heavily concentrated in metals. - Terms of trade: - Metal prices skyrocketed since 2003 and are presently about 50 percent above their long-term trend. - The favorable terms-of-trade impulse that boosted the current account surplus in 2003–04 leveled off in 2005 as metal-price increases leveled off and energy prices rose. - Capital inflows and investor interest: capital inflows have been subdued since 2000; per capita FDI inflows during 1998–2004 remained very low (only Kyrgyz Republic, Turkmenistan, and Uzbekistan fared worse among transition economies). Foreign investor interest is picking up, rating agencies upgraded Ukraine, sovereign spreads narrowed, and foreign portfolio investors returned to purchase government T-bills; nevertheless, uncertainty about policy direction and a dearth of attractive financial assets constrain inflows. - Public external position: public external debt was 19 percent of GDP in 2004. ### Outlook and risks - Short-term projections: - GDP growth is projected to slow to 4 percent in 2005, before picking up to 5½ percent in 2006. - The projection assumes a rebound of investment but also stronger external headwinds, particularly lower terms of trade. - Inflation outlook: - Inflation is likely to exceed the authorities’ end-2005 objective. - Tighter and more coordinated fiscal and monetary policies will be needed to bring inflation back into single digits during 2006. - Downside risks: - External sector risks (terms of trade, global demand). - A generally difficult investment climate and political uncertainty. ### Policy recommendations and discussions - Fiscal policy: - Staff argued the authorities’ 2005 deficit target (2½ percent of GDP) needs to be met. - The 2006 budget needs to be tight (staff-recommended deficit target of 2¼ percent of GDP) to support disinflation. - A key measure is to ensure that wage and pension increases do not exceed projected inflation in 2006. - Staff urged basing the 2006 budget on a realistic and consistent macroeconomic framework. - Authorities’ draft 2006 budget aims at a slightly higher deficit target (2½ percent of GDP) but its macroeconomic framework seems optimistic; the budget could be significantly changed in parliament. - Monetary and exchange rate policy: - Staff argued monetary policy needs to be tightened. - Staff recommended the NBU adopt a more flexible exchange rate regime to allow better control of inflation. - The authorities have taken some steps but prefer a slow, gradual approach given political circumstances. - Financial sector: - Both sides expressed concern about financial-sector vulnerabilities and capacity to manage shocks. - Progress has been made on regulation and supervision, but key legislation remains stuck in parliament and much remains to be done. - Structural and institutional reforms: - Reforms that foster more market-friendly institutions are key to sustaining catchup growth; the investment climate is a particular concern. - The key bottleneck to reform is reaching political consensus. - Impact of recent staff advice (summary of observed outcomes): - A 12-month Stand-By Arrangement treated as precautionary expired in March 2005. - Fiscal policy: staff advised significant tightening in 2005 and caution on large pension hikes; the 2005 supplementary budget adopted in March 2006 targeted a deficit in line with staff recommendations (2½ percent of GDP), tax loopholes were closed and pension hikes were partly rolled back; the remaining increase in pensions left the pension fund in a precarious financial imbalance; nominal public wages were raised by more than 50 percent, adding strongly to inflationary pressures. - Monetary policy: staff recommended tightening and more exchange rate flexibility; the NBU stepped up sterilization, tightened reserve requirements, and allowed some nominal appreciation of the hryvnia but favors a very gradual move to flexibility. - Structural reform: the Ukraine-EU Action Plan aligns with many Fund recommendations; debate over past privatizations continued, aggravating the investment climate. ### Financial sector vulnerabilities - Financial sector oversight: regulatory and supervisory progress has been made, but significant legislative gaps remain. - Capacity to manage shocks: vulnerabilities and shock-absorption capacity were key concerns in discussions. ### Medium-term prospects - Under a strong reform scenario, Ukraine’s medium-term growth outlook should be bright, contingent on political consensus to implement market-friendly institutional reforms and improvements in the investment climate. *Source: IMF Staff Report — Executive Summary (Ukraine), Article IV mission materials, July–August 2005.* ### 8. The 2005 budget, while aiming at a significant fiscal tightening, massively raised ### _cr05415 - 8. The 2005 budget, while aiming at a significant fiscal tightening, massively raised ### Fiscal outcomes and composition (2005) - The 2005 supplementary budget targets a state budget deficit of "1¾ percent of GDP". - This is equivalent to a general government deficit of "2½ percent of GDP", compared with "4½ percent" realized during 2004 and the "6-7 percent" implicit in the original 2005 budget. - The supplementary budget accommodated the previous government’s pension increases and boosted the public wage bill, raising average public pensions and wages by "over 50 percent" (against an inflation target of "just under 10 percent"). - Public pension spending in 2005 is projected to approach "15 percent of GDP", up by "3½ percent of GDP" compared with 2004. - The targeted fiscal tightening relied on: closure of tax loopholes, improved tax administration, higher state-enterprise dividends, and steep cuts in capital spending. ### Budget implementation through end-June 2005 - Through end-June, the general government deficit, including VAT refund arrears, was "1 percent of annual GDP". - The total stock of VAT refund arrears at end-June amounted to about "Hrv 3 billion, or ¾ percent of GDP". - Expenditures were broadly in line with targets in H1 2005. - Buoyant cash revenue collections mainly reflect tax measures introduced in the 2005 budget. - Corporate tax receipts and customs revenues were particularly buoyant; customs gains reflect an anti-smuggling program and shifting of energy-related tax collections to the border. ### Monetary conditions and liquidity (NBU actions) - Monetary conditions remained loose; the NBU continued to purchase foreign exchange apart from a short-lived episode during last year’s near-crisis. - Sterilization efforts by the NBU remained limited; largest liquidity-absorbing support came from the government issuing new T-bills to buy back higher-yield restructured securities held by the NBU and building deposits via a tight fiscal stance (Table 4). - The NBU’s own liquidity-absorbing operations were relatively limited, even when accounting for an increase in reserve requirements effective "September 1". - Result: high excess liquidity in the banking system and all interest rates, including banks’ lending rates, are now negative in real terms. - Monetary aggregates expanded more slowly than in 2004, amid sharply decelerating money demand as inflation rose into double digits. ### Exchange rate flexibility and FX market measures - First steps toward greater exchange rate flexibility included relaxation of foreign exchange control measures: export surrender requirements and removal of the requirement that non-residents predeposit the full amount of their T-bill auction bids. - In August the NBU: lifted the ban requiring banks to operate only on one side (buy/sell) of the FX market within the same day; allowed forward operations. - These impediments were complemented by a "1.5 percent" foreign exchange transaction tax (the draft 2006 budget proposes to halve this tax). - The NBU introduced a restriction on purchases by non-residents of government securities with original maturities of less than one year (likely non-binding). - The NBU introduced a "20 percent" reserve requirement on foreign currency loans with maturity up to "180 days" from non-residents. - On "April 20", the NBU allowed the hryvnia to appreciate by almost "3 percent" and has since occasionally withdrawn from the market. ### Real exchange rate, inflation, and competitiveness - High domestic inflation has markedly appreciated the real exchange rate: since "August 2004" domestic inflation surge plus modest nominal re-valuation against the U.S. dollar appreciated the real exchange rate by "about 11 percent". - U.S. dollar wages in manufacturing have increased by "almost 40 percent". - The current account surplus declined considerably during H1 2005. - Updated indicators (PPP-based measures, staff estimates of the real equilibrium exchange rate, international wage comparisons) suggest Ukraine’s real exchange rate remains below its equilibrium level, though quantitative estimates vary considerably. - Wages remain about half the level prevailing in Russia. ### Structural policies and investment climate - Lack of clear and market-friendly structural policies has dampened the investment climate and weighed on supply-side performance. - Continued debate on reconsidering past privatizations has increased property-rights uncertainty and prompted a wait-and-see stance by domestic and foreign investors. - Heavy-handed interventions to contain price pressures in fuel, meat, and sugar markets contributed to perceived policy drift. - Progress on some areas (notably WTO accession) occurred, but lack of political consensus hindered long-delayed structural measures, including adoption of a joint stock company law. ### Financial sector developments and vulnerabilities - The banking system weathered last year’s political shocks well, but the near-crisis exposed prudential and supervisory shortcomings: legislative framework limiting ability to prevent panic withdrawals of time- and savings deposits; indirect exchange-rate risk from FX lending to unhedged borrowers; inadequate liquidity management in many banks; lack of administrative preparedness by the NBU for a full-blown crisis. - Structural weaknesses persist; largest vulnerability is the potential impact of disappointing macroeconomic performance on borrower repayment ability given sharp loan portfolio increases. - Credit growth in August remained high at "42 percent". - Banks are refocusing on household-sector loans: household share of total loans rose from "5 percent" at end-2001 to "19 percent" by end-August 2005. - Mortgage lending is financing a booming housing market; U.S. dollar housing prices in Kyiv rose (Figure 6). - Remaining concerns in some banks: capitalization, risk management, related-party lending, widening maturity mismatches, and still-high (albeit declining) non-performing loans ratio. - Low profitability, partially owing to tax avoidance, restricts banks’ ability to replenish capital internally. - Increased foreign bank entry is expected to raise competition, risk management standards, and efficiency (example: Raiffeisen announced agreement to buy Aval in August 2005). ### Staff views, projections, and policy recommendations - Staff viewed reaching the 2005 general government deficit target of "2½ percent of GDP" as important for supporting the disinflation effort, but emphasized that the budget composition was a key driver behind inflationary pressures. - Preliminary data through August hint at buoyant income- and VAT collections, suggesting with maintained spending discipline the deficit target would be missed by only a small margin, up to "½ percent of GDP". - The mission recommended targeting a general government deficit of "2¼ percent of GDP" in 2006, underpinned by a freeze of real recurrent spending to restrain nominal growth in social spending and public wages. - Under the recommended stance, staff projected the general government debt ratio would fall by "over 4 percent" to "18½ percent of GDP". - The authorities’ draft 2006 budget targets a general government deficit equivalent to "2½ percent of GDP" and projects a real growth rebound in 2006 "1½ percentage points higher" than staff’s baseline; staff’s preliminary estimates indicate the deficit could approach "3¼ percent of GDP" on a more realistic macro framework and conservative revenue estimates. - To reach the staff’s recommended deficit target under an adjustment scenario would require measures of up to "1½ percent of GDP"; a fiscal package could include: - Expenditure cuts, including subsidies, net lending, and goods and services. - Aligning the minimum wage increase to inflation (lower minimum wage increase). - Further reduction of tax expenditures. - Specific options for fiscal measures in 2006 (In Hrv million; In percent of GDP; "Sum of fiscal measures (1+2+3) 7,804 1.6"): - 1. Expenditure cuts: "3,580 0.7" - Align public wage increase to inflation "674 0.1" - Reduce subsidies and net lending "1,316 0.4" - Reduce state payroll by "2 percent" and cuts on goods and services "1,490 0.2" - 2. Tax preferences: "3,024 0.6" - VAT exemptions and zero ratings on transport and cars "516 0.1" - VAT, elimination of special agriculture regimes "1,968 0.4" - Excise "540 0.1" - 3. Pension fund: "1,200 0.2" - Lower net spending due to smaller minimum wage increase "1,200 0.2" - The staff urged eliminating the provision that allows spending of excess privatization receipts without previous parliamentary approval to reduce the risk of discretionary fiscal loosening in 2006. *IMF staff report (content unit _cr05415).* ### 21. The authorities aim at resolving the VAT refund arrears problem, but some ### _cr05415 - 21. The authorities aim at resolving the VAT refund arrears problem, but some ### VAT refunds, audits, and fraud detection - Authorities abandoned a recently-introduced risk-oriented audit scheme because of its heavy information requirements. - Authorities intend to legalize the practice of denying refunds to any claimant who sources from a chain where VAT was not paid. - Positive actions: strengthening reporting systems to identify fraud at an earlier stage. - Mission recommendation: reconsider risk-based audits, but based on a simpler approach. - Political timing: the next parliament elected in March 2006 could revisit the 2006 budget. ### Medium-term fiscal policy: self-financing reforms and public–private partnerships - Staff view: many needed reforms could be implemented over time in a self-financing manner. - Examples of self-financing measures: - Raising low civil servant wages could be addressed by cutting excessive employment over time. - Tax-rate cuts could be offset by broadening the tax base (including through reform of the simplified taxation regimes and improvement in tax administration). - Additional social spending on health and education could be financed by better targeting of benefits. - Public–private partnerships (PPPs) noted as an option to bridge resource gaps, but staff strongly cautioned against reliance on PPPs until capacity to monitor and assess related risks is built up. ### Pension system concerns and reform priorities - Recent pension hikes have effectively dismantled the multi-pillar system envisaged by the 2003 reform. - Ukraine’s pension system described as one of the most expensive in the world; massive budget transfers are needed to cover contribution shortfalls. - Each contributor to the pension fund is effectively supporting one pensioner, implying higher labor taxation is not a feasible solution. - Demographic outlook points to a need for early action. - Mission suggested reform focus: - Better targeting the minimum pension subsidy. - Lifting retirement ages. - Pruning privileged pension regimes. - Strengthening transparency regarding the cost of the privileged pension regimes to build support for reform. - Political constraint: authorities saw little scope for discussing such reforms prior to parliamentary elections. ### Monetary and exchange rate policy: diagnosis and recommended transition - Differing interpretations of inflation roots: - Staff view: present monetary framework unlikely to anchor inflation around a low and stable rate; higher net international reserves under the de facto peg have translated directly into higher monetary aggregates. - NBU view: sharp increases in social spending and public wages, and some supply side shocks, were main drivers; monetary policy’s contribution was relatively minor. - Staff recommendation: tighten monetary stance to bring inflation back to single digits; NBU should more actively absorb excess liquidity and limit monetary growth to a rate consistent with an end-2006 inflation goal of about 9 percent. - At mission time: - Staff judged the NBU’s envisaged base money growth target of 38-43 percent for end-2005 as too expansionary to achieve a recommended end-2006 inflation target of about 7 percent. - Staff recommended base money growth slowdown during remainder of 2005 to about 32 percent and a significant deceleration in 2006 to about 22 percent. - Staff warned that, because monetary conditions were not tightened in the interim, money growth and inflation during the remainder of 2005 are now likely to exceed staff’s earlier recommendations. - NBU position: - Stressed policy uncertainties but argued planned 2006 monetary stance is adequate to reduce inflation to single-digits. - Called for tighter fiscal policy and accelerated structural reforms to increase aggregate supply. - Envisaged in 2006 Monetary Policy Guidelines: lower bounds of targeted corridors for base and broad money growth broadly in line with staff recommendations. - NBU’s inflation objective for end-2006: 8.5-9.5 percent. - Emphasized Guidelines are preliminary and may be adjusted in response to fiscal developments and Cabinet macroeconomic forecasts. - Exchange rate policy: - Staff argued a more flexible exchange rate would allow lower and more stable inflation, act as a shock-absorber, stem speculative capital inflows, and discipline unwarranted private-sector risk-taking. - Mission recommended moving gradually to a managed float, and ultimately to inflation targeting; urged swift preparations for the new regime. - If sufficient progress is made in 2006, NBU could introduce implicit inflation targeting in 2007, using the 2006 Monetary Policy Guidelines to communicate characteristics of the new regime. - NBU favored a gradual approach not bound by a specific timeframe, expressing concern that more exchange-rate flexibility would eliminate a key anchor of stability and negatively impact competitiveness. - NBU plan: to revitalize a long-term lending facility for banks; staff opposed, citing prior elimination of a similar facility (2003–04) because it interfered with monetary policy, exposed NBU to credit risk, and distorted market intermediation. ### Box 2: Preparing Inflation Targeting — technical assistance and recommended actions - Main recommendations to develop prerequisites for more exchange rate flexibility and eventual inflation targeting: - Develop foreign exchange markets: - Allow banks to conduct forward operations and to trade in both directions within the same day. - Eliminate the current limited trading session. - Reconsider the 1.5 percent tax on foreign exchange operations. - Make the NBU reference exchange rate more transparent. - Note: Most recommendations were implemented in August 2005. - Improve banks’ risk-management capabilities: - Allow use of hedging instruments. - Encourage banks to extend foreign currency loans to borrowers with foreign exchange income and appropriate hedges. - Conduct survey on banks’ direct and indirect foreign exchange rate exposures and closely monitor banks’ ability to manage these exposures. - Strengthen monetary policy operations: - Communicate more clearly the NBU’s main policy rate. - Engage in more active liquidity management through open market operations. - Securitize the NBU loan to the government for use in open market operations. - Improve coordination between monetary and fiscal policy. - Promote development of interbank and government securities markets to provide benchmark interest rates. - Dealing with volatile capital inflows: - Reduce incentives for short-term inflows, including by increasing exchange rate flexibility and maintaining a consistent monetary-exchange rate-fiscal policy mix. - Carefully sequence capital control liberalization, including by liberalizing some controls on capital outflows. - Avoid new capital controls. - Better monitor and analyze the nature of capital flows. ### Near-term outlook, growth, inflation, and external accounts - Growth developments and projections: - January–August 2005 preliminary data suggest GDP growth declined to about 3 percent (relative to same period last year). - Growth in 2005 projected to slow to 4 percent. - Staff expect a modest recovery in investor confidence after the March 2006 elections, likely offset by deterioration in Ukraine’s external environment. - Terms of trade assumed to drop by about 6 percent in 2006. - Expected 2006 growth rate of about 5½ percent, underpinned largely by continued strong consumer demand. - Inflation outlook: - Present policies unlikely to bring 2006 inflation back into single digits. - Current budget envisages further social payments in final quarter of 2005, adding upward pressure. - Sharply increased gasoline prices in 2005 raised transport and business costs. - Staff project CPI inflation firmly in double digits in 2005, with an end-year outcome of around 14 percent. - Baseline scenario assumes increases in utility prices and tariffs will be delayed until after March 2006 elections, complicating disinflation in 2006. - On the basis of authorities’ announced intentions (continued monetary accommodation and no fiscal tightening), staff project inflation will likely remain in double digits in 2006. - Current account and savings: - Significant downward shift in savings; Ukraine’s current account surplus projected to shrink rapidly in near term. - Fiscal policy over 2004-05 has reallocated resources from high-savings corporate sector to low-savings household sector; imports surged as buoyant household demand increased import volumes. - Adjustment scenario to bring 2006 inflation below 10 percent (staff outline): - General government deficit of 2¼ percent of GDP. - A real freeze on recurrent spending. - Significant slowdown in rate of money growth in 2006. - NBU move to a more flexible exchange rate. - Under this scenario, staff projected inflation could be reduced to 9 percent in 2006, with little impact on growth (combined impact of tighter policy and possible nominal appreciation was unlikely to exceed half a percentage point). ### Policy coordination and communication - Observation: policies over the past year were not well coordinated — procyclical fiscal spending fuelling inflation, insufficient monetary resistance, and structural policies undermining supply side and growth momentum. - Recommendation: implement macroeconomic policies in a more coordinated fashion and improve communication to avoid public confusion about policy objectives and responsibilities. - NBU noted efforts underway to reach a formal coordination agreement among key policy makers. ### Institutional reforms and medium-term growth framework - Core problem: low production efficiency rooted in market-unfriendly institutions (weak security of property rights, degree of corruption, competence of civil servants, regulatory quality). - Cross-country data: Ukraine uses physical and human resources poorly even compared with other transition economies. - Institutional reform progress: - Reform of market-enhancing institutions appears to have essentially stalled since 1998. - Ukraine ranked 122 out of 146 countries in 2004 on Transparency International’s corruption perception index. - Strength of market-friendly institutions lags behind more successful transition countries. - Authorities’ reform agenda and achievements: - Institutional reforms placed at top of policy agenda; anchoring reform within a program of closer integration with the European Union and global markets emphasized. - Notable achievements: adoption of legislation to simplify the permit system; mutual offset and restructuring of energy sector debts; considerable reduction of import tariffs on food products, appliances, and some industrial equipment; establishment of a telecommunications regulatory agency. - Noteworthy plans: presidential decree on eliminating corruption and reforming customs administration and procedures; Cabinet concept for comprehensive reform of internal financial control and auditing; pending legislation on reviewing past privatizations. - Previous government announced about 3000 targeted cuts in red tape and regulations and initial steps to establish a new agency to assist foreign investors. *Source: IMF staff report content provided in the supplied PDF excerpt.* ### 41. The staff’s medium-term baseline scenario assumes a sustained structural ### _cr05415 - 41. The staff’s medium-term baseline scenario assumes a sustained structural ### Medium-term baseline and higher-growth scenarios - Baseline assumes a sustained structural reform effort, but allows for delays or slippages. - Under a moderately successful reform effort: - Trend growth rate of about 5 percent. - Under full implementation of the authorities’ reform agenda (higher-growth scenario): - Productivity increases could be consistent with a medium-term growth rate as high as 8-9 percent. - This higher-growth scenario is based on the assumption that the authorities implement their ambitious reform agenda in full: i.e. the scenario assumes that, over the next decade, Ukraine will have successfully met all the requirements for EU membership. A precise policy roadmap is difficult to outline at this stage, and will likely evolve over time. - Fiscal implications under higher growth: - If the debt-GDP ratio is kept constant at about 16 percent of GDP over the medium term, higher growth could free up budgetary resources of about 2 percent of GDP annually for additional fiscal reforms. - Inflation and monetary regime assumptions: - Baseline assumes move to inflation targeting and bringing average inflation down into single digits in 2007. - Higher-growth scenario assumes a similar monetary policy regime, plus front-loaded policy adjustments in 2006 consistent with a lower inflation path in 2006-08. - These paths would place Ukraine within range of a feasible longer-term inflation target (4-5 percent) by 2009. ### Public debt sustainability and contingent liabilities - Public debt described as low and sustainable, conditional on containing risks from the savings lost during the 1990s hyperinflation. - Sensitivity analysis highlights two principal threats: - A collapse in medium-term growth. - Recognition of lost savings as public debt. - Recognition of lost savings: - Lost savings could be up to 30 percent of GDP. - Recognition as debt could more than double the current level of public debt. - Political proposals in 2005: - Parliament and president proposed repaying this debt over extended periods and without awarding interest. - Staff view on settlements: - Any settlement must be sustainable and final, and carefully designed considering financing, macroeconomic, and budget impacts. - Certain means of settlement, for instance mutual debt cancellation (utilized in 2005), should not be considered due to adverse incentive effects. ### External position, current account, and external risks/opportunities - Baseline assumes continuing healthy export growth but a return to an external deficit: - Current account forecast to switch to moderate deficits by the end of the projection period. - Deficits expected to be financed by capital inflows, especially foreign direct investment and private long-term borrowing. - Gross international reserves should remain at adequate levels for import coverage and relative to short-term debt. - Key factors underpinning medium-term switch in current account: - An increase in investment. - More rapid productivity growth relative to Ukraine’s main trading partners. - Real appreciation (mainly through nominal exchange rate flexibility rather than high inflation). - External risks (current account): - Much sharper-than-projected reduction in world metal prices. - Slowdown in metal export markets. - Rapid convergence of Ukraine’s energy import prices, particularly natural gas, to world levels. - These could cause a much sharper deterioration of the current account and adverse impact on growth. - External vulnerabilities and opportunities: - Ukraine’s relatively high external debt is significant by transition-country standards; without substantial FDI inflows, running large and sustained current account deficits could be difficult. - Opportunities: deep institutional reforms could result in FDI and other long-term inflows higher than envisaged in the baseline. - Risks of more volatile short-term capital flows with liberalization. ### Financial sector issues and vulnerabilities - Banking system risks to monitor closely: - Large exposure to credit risk, especially under a deteriorating macro outlook. - Opaque ownership structures. - Concerns about capitalization. - Real estate exposure: - Increasing exposure through mortgage and construction lending or collateral could be a major vulnerability if real-estate prices reverse. - Housing prices have quadrupled over the past 3½ years. - Regulatory and supervisory actions and gaps: - National Bank of Ukraine (NBU) measures: - Plans to tighten asset revaluations. - Increased the minimum core capital adequacy ratio from 4 percent to 5 percent. - Reduced the ceiling on related-party lending. - Plans to strengthen banks’ reporting requirements on mortgage lending. - Reduced limits on open foreign exchange positions and tightened loan-loss provisioning requirements. - Mission recommendation: - Increase minimum capital adequacy ratio from 10 percent to 12 percent would serve as a further safeguard until risk-management practices and capital quality improve. - Remaining weaknesses: - NBU supervisory practices described as rigidly procedural rather than risk-based. - Need to implement MFD recommendations on strengthening the process of bank resolution. - Liquidity and FX risk: - Proper foreign-exchange risk management crucial with more exchange rate flexibility. - Liquidity risk remains a concern given political uncertainties; NBU submitted draft amendments to limit early withdrawal of deposits. ### Trade policy progress - 2005 trade policy objectives set by government: - Acceding to the WTO. - Receiving market economy status from the EU. - Legislative and policy actions: - Parliament adopted key bills to ensure WTO-conformity, including on intellectual property rights. - Significant tariff cuts enacted. - Legislation to lower the 17 percent export tax on sunflower seeds by 1 percentage point per year upon WTO accession. - Outstanding issues: - Several WTO bills, particularly on agricultural issues, faced strong parliamentary opposition. - Need to complete bilateral negotiations with several countries, including the United States. - Issues raised in EU market-economy status process included bankruptcy laws, price controls, and the re-surgence of VAT refund arrears. ### Statistics and data integrity - National accounts 2004: - No compelling reasons to doubt broad integrity of the 2004 national accounts data. - Some senior government officials suggested export and GDP statistics for 2004 might have been significantly overstated due to fraudulent VAT refund claims; investigations pending. - Statistical Office found no strong reasons to adjust national accounts data before 2005. - Staff’s preliminary analysis: export data broadly consistent with direction-of-trade statistics, import growth of trading partners, and dollar-price trends of main exports. ### Relations with the Fund and program ownership - EPA assessment of Ukraine’s transition experience: - Attributes disappointing transition mainly to lack of political consensus on building market-friendly institutions. - Noted gradual macro stabilization but slow structural reform pace; improved performance during 2000-04 supported by favorable external environment and fiscal discipline. - Institutional indicators have improved little since 1998; tackling institutional reforms prioritized. - EPA conclusions on program engagement: - Better program ownership, rooted in stronger political consensus, would be key to success of future program-based engagement. - Fund-supported programs were effective in supporting macroeconomic stability but less effective in accelerating market-friendly institutional reforms. - Transfer of macroeconomic knowledge via sustained dialogue was a crucial benefit of long-term Fund engagement. - Success of a future program depends critically on program ownership and anchoring reforms externally (e.g., Ukraine-EU Action Plan); prior actions should demonstrate sufficient political and social consensus. - Authorities’ views: - Felt EPA overemphasized lagging institutions and underplayed Fund shortcomings. - Highlighted progress in fiscal and monetary institutions since 1998 with Fund support. - Sought EPA focus on fiscal, monetary, and financial sector issues and on alternative policy options tailored to Ukraine’s conditions. - Did not express a view on desirability of near-term IMF-supported program engagement. ### Staff appraisal and policy recommendations - Overall assessment: - Ukraine faces considerable challenges but has significant untapped potential. - Highly open, undiversified export structure and terms-of-trade gains create external risks. - Coherent policies, restored macroeconomic stability, and sustained structural reforms could allow catchup growth to resume. - Recent macro performance and concerns: - GDP growth slowed sharply and inflation surged into double digits. - Fiscal policy became procyclical during the 2004 presidential run-up; supplementary 2005 budget raised public pensions and wages and increased tax burden, adding inflationary pressure. - Monetary policy largely focused on defending the peg to the U.S. dollar and accommodated excess demand. - Limited progress on structural policies; debates on past privatizations raised property-rights concerns. - Monetary policy recommendations: - Tighter monetary conditions needed to contain inflation. - NBU should actively reduce excess liquidity by constraining money growth to rates consistent with single-digit inflation. - This will likely require significant deceleration in money growth in 2006 given current liquidity overhang. - The lower bound of NBU’s envisaged monetary growth corridors for 2006, combined with appropriate macro policies, would be broadly in line with bringing inflation below 10 percent by end-2006. - Exchange rate and monetary framework: - Introduce more exchange rate flexibility and move toward an inflation targeting framework to better achieve low and stable inflation. - The peg stabilized inflation historically but now fails to provide a firm nominal anchor. - Maintaining the peg would continue to result in reserve accumulation given remaining real undervaluation and could be inconsistent with substantial needed capital inflows for investment. *Source: IMF country report content unit _cr05415 - 41.* ### 56. Tentative steps toward a more flexible exchange rate regime are welcome, but ### Tentative steps toward a more flexible exchange rate regime are welcome, but ### Exchange rate regime and NBU operations - Tentative shift to a more flexible exchange rate is welcomed but must be communicated more consistently by the NBU. - Ukraine could proceed gradually from a position of relative strength, but the modalities of the new regime must be explained transparently to avoid market confusion. - The NBU should build on recent efforts, including significant deregulation of the exchange rate market, and continue to strengthen its operational framework and the development of financial markets. - The NBU’s tentative plans to expand its tools and support bank intermediation by a long-term credit facility should be re-considered. - The NBU should see its main role in providing liquidity, rather than longer-term credit, to the banking system. ### Fiscal policy and disinflation - For 2005, authorities should seek to achieve the budget deficit target of 2½ percent of GDP, while clearing all legitimate VAT refund arrears. - For 2006, the draft budget submitted to parliament in mid-September targets a general government deficit of 2½ percent of GDP but appears to be based on unrealistic macroeconomic assumptions and contains policies that might be revisited. - Staff recommends maintaining a tight fiscal stance in 2006, including by targeting a general government deficit of 2¼ percent of GDP and freezing re-current expenditures in real terms. - If new initiatives in the draft budget are upheld, they should be financed through spending cuts or measures to broaden the tax base. ### Policy coordination - There is a strong case for improving policy coordination between the government and the NBU. - International experience shows that assigning clear objectives and roles to policy makers is key for ensuring macroeconomic stability and sustained growth. - Staff welcomes a recent NBU initiative to reach a more formal understanding on policy coordination between the NBU and the government. ### Pensions and fiscal space - Restoring a viable public pension fund would open significant room for higher public investment and lower taxes in the medium-term. - Recent pension hikes have put the pension fund in a precarious financial position, requiring large budget transfers to cover contribution shortfalls and constraining the room for reducing the high tax burden on labor. - Authorities’ focus should be on better targeting the minimum pension subsidy, lifting retirement ages, and pruning privileged pension regimes. ### Structural reforms, privatization, and investment climate - Sustained growth will have to come from the new administration’s vision of sweeping structural reforms. - Even accounting for the growth rates of 2000-2004, Ukraine’s performance has lagged significantly behind that of most other transition economies, reflecting a failure to build market-enhancing institutions. - The Ukraine-EU Action Plan commits the authorities to a wide range of actions, anchoring the institutional reform drive within closer integration with the EU and global markets. - A rapid resolution of the debate on past privatizations is needed; the recent presidential memorandum guaranteeing property rights and government efforts to identify state enterprises to be privatized and to comply with privatization legislation are welcome. - A credible legislative proposal is needed that outlines the full scope of possible challenges to past privatizations to eliminate investor uncertainty and strengthen prospects for successful new privatizations. - Authorities should give priority to improving the investment climate by eliminating excessive, opaque, and discretionary regulations; targeting some 3,000 unhelpful regulations for elimination is a welcome first step. ### Trade policy - The ambitious trade-policy agenda is highly welcome. - Trade will be key to improving overall productivity, creating new and better-paid jobs, and helping improve corporate transparency. - Liberalization achieved so far this year is an important step, but early implementation of the pending measures needed for WTO membership should remain a priority. ### Domestic capital markets - Development of domestic capital markets is important and consistent with earlier Fund and World Bank recommendations. - Authorities should focus on establishing benchmark issues for government securities, setting up a coherent debt management strategy, and swiftly adopting a Joint Stock Company Law. - More developed capital markets will facilitate the shift to inflation targeting by strengthening the transmission mechanism. ### Financial sector supervision and stability - The supervisory framework should be strengthened further. - Positive regulatory changes include: foreign-currency loan-loss provisioning; open foreign currency positions; limits for related-party lending; and the definition of capital. - It is essential to approve long-delayed amendments to the Banking Act, which would require identification of bank owners. - Revisions to the Civil Code and the Banking Act to limit early withdrawal of deposits should be a priority to safeguard against a future liquidity crisis. - Authorities should move from highly-procedural supervision methods to a more risk-based framework and strengthen their bank resolution process. - Improving the quality of capital is key; until this is achieved and structural weaknesses of the banking system have been overcome, the authorities should consider raising the minimum capital adequacy ratio to 12 percent. ### Statistics and data quality - There has been tangible progress on statistics, which are broadly adequate for surveillance, but shortcomings remain. - The recent controversy about the integrity of the 2004 export and GDP statistics should be resolved speedily, based on impartial assessments. - Further improvements should focus on reconciling stock data on sectoral financial assets and liabilities with flow data, particularly on the external side. - The quality of labor market data, particularly on wages and employment, could be improved. *IMF staff assessment as presented in the source document.* ### 66. It is recommended that the next Article IV consultation take place on the standard ### It is recommended that the next Article IV consultation take place on the standard 12-month cycle. ### Real economy: growth, prices, labor, wages - Real GDP (percent change): 2001: 9.2; 2002: 5.2; 2003: 9.6; 2004: 12.1; 2005: 4.0; 2006 Prel.: 5.5; 2006 Baseline scenario: 5.0. - Nominal GDP (in billions of hryvnias): 2001: 204.2; 2002: 225.8; 2003: 267.3; 2004: 345.9; 2005 Prel.: 415.5; 2006 Baseline: 499.8; 2006 Adjustment scenario: 486.5. - Unemployment rate (ILO definition; percent): 2001: 11.8; 2002: 10.1; 2003: 9.1; 2004: 6.1. - Consumer prices, period average: 2001: 12.0; 2002: 0.8; 2003: 5.2; 2004: 9.0; 2005: 14.2; 2006 Prel.: 14.4; 2006 Baseline: 12.1. - Consumer prices, end of period: 2001: 6.1; 2002: -0.6; 2003: 8.2; 2004: 12.3; 2005: 14.0; 2006 Prel.: 13.0; 2006 Baseline: 9.0. - Average monthly wages, annual average: 2001: 34.9; 2002: 20.7; 2003: 23.0; 2004: 27.7. ### Public finance: cash balances, revenue, expenditure, debt - Cash balance (in percent of GDP): 2001: -1.6; 2002: 0.5; 2003: -0.9; 2004: -4.4; 2005 Prel.: -2.9; 2006 Prel.: -3.2; 2006 Baseline: -2.3. - Revenue (percent of GDP): 2001: 33.5; 2002: 36.0; 2003: 35.9; 2004: 35.0; 2005 Prel.: 39.7; 2006 Prel.: 38.4; 2006 Baseline: 38.4. - Expenditure (cash basis, percent of GDP): 2001: 35.1; 2002: 35.5; 2003: 36.8; 2004: 39.4; 2005 Prel.: 42.7; 2006 Prel.: 41.5; 2006 Baseline: 40.7. - Primary balance (cash basis, percent of GDP): 2001: 0.4; 2002: 1.8; 2003: 0.1; 2004: -3.5; 2005 Prel.: -2.1; 2006 Prel.: -2.1; 2006 Baseline: -1.2. - Commitments balance (percent of GDP): 2001: -1.5; 2002: 0.2; 2003: -0.1; 2004: -3.6; 2005 Prel.: -2.8; 2006 Prel.: -3.1; 2006 Baseline: -2.2. - Privatization proceeds (percent of GDP): 2001: 1.3; 2002: 0.5; 2003: 1.1; 2004: 3.1; 2005 Prel.: 0.8; 2006 Prel.: 1.8; 2006 Baseline: 1.8. - Net domestic financing (percent of GDP): 2001: -0.1; 2002: -0.3; 2003: -1.2; 2004: -0.1; 2005 Prel.: 1.4; 2006 Prel.: 0.8; 2006 Baseline: -0.1. - Net external financing (percent of GDP): 2001: 0.4; 2002: -0.7; 2003: 1.0; 2004: 1.5; 2005 Prel.: 0.7; 2006 Prel.: 0.5; 2006 Baseline: 0.6. - Public debt and arrears (percent of GDP): 2001: 38.6; 2002: 35.7; 2003: 27.7; 2004: 25.1; 2005 Prel.: 22.8; 2006 Prel.: 19.9; 2006 Baseline: 18.5. - o.w. external debt (percent of GDP): 2001: 26.6; 2002: 24.0; 2003: 21.6; 2004: 19.2; 2005 Prel.: 15.6; 2006 Prel.: 12.5; 2006 Baseline: 12.3. ### Money and credit: growth and monetary aggregates - Base money (end of period, percent change): 2001: 37.4; 2002: 33.6; 2003: 30.1; 2004: 34.1; 2005: 42.1; 2006 Prel.: 24.5; 2006 Baseline: 21.8. - Broad money (end of period, percent change): 2001: 41.9; 2002: 41.8; 2003: 46.5; 2004: 32.3; 2005: 41.0; 2006 Prel.: 27.9; 2006 Baseline: 25.1. - Credit to nongovernment (end of period, percent change): 2001: 40.5; 2002: 47.3; 2003: 63.4; 2004: 31.2; 2005: 29.5; 2006 Prel.: 33.9; 2006 Baseline: 30.3. - Velocity (annual GDP / end-period broad money): 2001: 4.46; 2002: 3.48; 2003: 2.78; 2004: 2.75; 2005: 2.34; 2006 Prel.: 2.20; 2006 Baseline: 2.19. ### External sector and balance of payments - Current account balance (in percent of GDP): 2001: 3.7; 2002: 7.5; 2003: 5.8; 2004: 10.5; 2005 Prel.: 6.0; 2006 Prel.: 1.2; 2006 Baseline: 1.1. - Foreign direct investment (percent of GDP): 2001: 2.0; 2002: 1.7; 2003: 2.8; 2004: 2.7; 2005 Prel.: 1.6; 2006 Prel.: 2.4; 2006 Baseline: 2.6. - Gross reserves (end of period, in billions of U.S. dollars): 2001: 3.1; 2002: 4.4; 2003: 6.9; 2004: 9.5; 2005 Prel.: 16.0; 2006 Prel.: 18.2; 2006 Baseline: 18.8. - In months of next year's imports of goods and services: 2001: 1.7; 2002: 1.9; 2003: 2.4; 2004: 2.7; 2005 Prel.: 3.9; 2006 Prel.: 4.1; 2006 Baseline: 4.1. - Debt service (in percent of exports of goods and services): 2001: 6.7; 2002: 5.4; 2003: 6.2; 2004: 4.8; 2005 Prel.: 4.8; 2006 Prel.: 5.1; 2006 Baseline: 5.1. - Merchandise exports (annual volume change in percent): 2001: 7.0; 2002: 7.1; 2003: 14.1; 2004: 16.5; 2005 Prel.: 3.2; 2006 Prel.: 6.9; 2006 Baseline: 6.4. - Merchandise imports (annual volume change in percent): 2001: 12.8; 2002: 5.9; 2003: 30.4; 2004: 15.7; 2005 Prel.: 13.8; 2006 Prel.: 10.9; 2006 Baseline: 10.3. - Merchandise exports (percent of GDP): 2001: 45.0; 2002: 44.0; 2003: 47.4; 2004: 51.4; 2005 Prel.: 46.8; 2006 Prel.: 40.7; 2006 Baseline: 38.9. - Merchandise imports (percent of GDP): 2001: 44.4; 2002: 42.4; 2003: 47.9; 2004: 46.3; 2005 Prel.: 45.4; 2006 Prel.: 43.3; 2006 Baseline: 42.2. - Net imports of energy (in billions of U.S. dollars): 2001: 5.0; 2002: 4.9; 2003: 5.1; 2004: 6.6. ### Savings and investment (percent of GDP) - Foreign savings: 2001: -3.7; 2002: -7.5; 2003: -5.8; 2004: -10.5; 2005 Prel.: -6.0; 2006 Prel.: -1.2; 2006 Baseline: -1.1. - Gross national savings: 2001: 25.5; 2002: 27.7; 2003: 27.8; 2004: 29.9; 2005 Prel.: 25.4; 2006 Prel.: 21.9; 2006 Baseline: 22.2. - Nongovernment: 2001: 24.0; 2002: 24.2; 2003: 24.2; 2004: 28.0; 2005 Prel.: 24.7; 2006 Prel.: 21.4; 2006 Baseline: 20.8. - Government: 2001: 1.5; 2002: 3.5; 2003: 3.6; 2004: 1.9; 2005 Prel.: 0.7; 2006 Prel.: 0.5; 2006 Baseline: 1.3. - Gross investment: 2001: 21.8; 2002: 20.2; 2003: 22.0; 2004: 19.4; 2005 Prel.: 19.4; 2006 Prel.: 20.7; 2006 Baseline: 21.1. ### Exchange rate and regime - Exchange rate regime: de facto peg to U.S. dollar (2006 note). - Hryvnia per U.S. dollar, end of period: 2001: 5.3; 2002: 5.3; 2003: 5.3; 2004: 5.3. - Hryvnia per U.S. dollar, period average: 2001: 5.4; 2002: 5.3; 2003: 5.3; 2004: 5.3. - Real effective rate (percent change, period averages; (+) represents real appreciation): 2001: 6.0; 2002: -4.1; 2003: -6.3; 2004: -0.9. ### Social indicators and development - Per capita GDP: US$ 1,311 (2004). - Poverty (percent of population): 31.7 (2001; national headcount index). - Life expectancy at birth: 68.2 years (2002). - Infant mortality (per 1,000): 16.0 (2002). - Child malnutrition (percent of children under 5): 3.0 (2001). - Income/consumption distribution (Gini index): 29.0 (1999). - Gross primary enrollment (percent of school-age group): 90.5 (2001). ### Medium-term balance of payments (select annual levels, Table 2) - Current account balance (in millions of U.S. dollars): 2001: 1,402; 2002: 3,173; 2003: 2,891; 2004: 6,804; 2005: 4,837; 2006 Prel.: 1,186; 2007: -941; 2008: -2,707; 2009: -3,385; 2010: -4,278. - Merchandise exports (US$ millions): 2001: 17,091; 2002: 18,669; 2003: 23,739; 2004: 33,432; 2005: 37,933; 2006: 40,237. - Merchandise imports (US$ millions): 2001: -16,893; 2002: -17,959; 2003: -24,008; 2004: -29,691; 2005: -36,839; 2006: -42,839. - Gross official reserves (end of period, US$ millions): 2001: 3,089; 2002: 4,417; 2003: 6,937; 2004: 9,525; 2005: 15,962; 2006 Prel./Proj.: 18,216; 2007: 19,332; 2008: 20,117; 2009: 21,502; 2010: 22,897. - Overall balance (US$ millions): 2001: 1,293; 2002: 1,238; 2003: 2,260; 2004: 2,539; 2005: 6,750; 2006 Prel.: 2,684; 2007: 1,530; 2008: 1,106; 2009: 1,470; 2010: 1,395. ### General government finances (Table 3, select items, in millions of hryvnias and percent of GDP) - Nominal GDP (Hrv millions): 2003: 267,344; 2004: 345,943; 2005: 415,547; 2006 Staff assessment: 436,000; 2006 Baseline: 499,778; 2006 Adjustment scenario: 499,778; 2006 Staff assessment/Adjustment scenario later columns show 486,502 and 512,300. - Revenue (2003–2005, Hrv millions): 2003 Gov't: 96,000; 2004 Gov't: 120,940; 2005 Staff assessment: 165,152; 2005 Baseline: 100,806; 2006 Baseline: 106,191; 2006 Adjustment scenario: 191,734; 2006 Staff assessment columns show various. - Tax revenue (Hrv millions, selected): 2003: 81,720; 2004: 100,821; 2005 Staff assessment: 140,928; 2005 Baseline: 80,086; 2006 Baseline: 84,566; 2006 Adjustment scenario: 168,334. - Overall cash balance (without measures, percent of GDP): 2003: -0.9; 2004: -4.4; 2005: -2.9; 2006 Staff assessment: -3.2; 2006 Baseline: -2.6; 2006 Adjustment scenario: -3.9. - Primary balance (in percent of GDP, memorandum): 2003: 0.1; 2004: -3.5; 2005: -2.1; 2006 Baseline: -2.1; 2006 Adjustment scenario: -1.2. ### Monetary sector and monetary accounts (Table 4, selected) - Monetary survey, broad money (Hrv millions): Dec-2001: 45,755; Dec-2002: 64,870; Dec-2003: 95,043; Dec-2004: 101,151; Dec-2005: 113,961; Dec-2006 Baseline proj.: 130,277; Dec-2006 Adjustment scenario: 125,705. - Monetary survey, net foreign assets (Hrv millions): Dec-2001: 6,875; Dec-2002: 13,942; Dec-2003: 25,511; Dec-2004 (Dec): 30,607; Dec-2005: 40,016. - Accounts of the NBU, net international reserves (in millions of U.S. dollars): Dec-2001: 6,242; Dec-2002: 13,551; Dec-2003: 27,204; Dec-2004: 32,819; Dec-2005: 42,374; Dec-2006 proj.: 55,743 (note: projections and reporting conventions described in source). - Base money (Hrv millions): Dec-2001: 23,055; Dec-2002: 30,808; Dec-2003: 40,089; Dec-2004: 41,438; Dec-2005: 47,222. ### Financial soundness indicators (banking sector, Table 5, select) - Number of banks: Dec-00: 153; Dec-01: 152; Dec-02: 157; Dec-03: 158; Dec-04: 160; Mar-05: 161; Jun-05: 162. - Regulatory capital to risk-weighted assets: Dec-00: 15.5; Dec-01: 20.7; Dec-02: 18.0; Dec-03: 15.2; Dec-04: 16.8; Mar-05: 17.1; Jun-05: 15.2. - NPLs to total loans (NPLs are substandard, doubtful, loss): Dec-00: 29.6; Dec-01: 24.6; Dec-02: 21.9; Dec-03: 28.3; Dec-04: 30.0; Mar-05: 25.3; Jun-05: 23.1. - Return on assets (after tax; end-of-period): Dec-00: -0.1; Dec-01: 1.2; Dec-02: 1.2; Dec-03: 1.0; Dec-04: 1.1; Mar-05: 1.5; Jun-05: 1.2. - Loans in foreign currency to total loans: Dec-00: 41.4; Dec-01: 41.3; Dec-02: 39.5; Dec-03: 39.3; Dec-04: 39.2; Mar-05: 39.1; Jun-05: 38.4. - Customer deposits to total (non-interbank) loans: Dec-00: 59.1; Dec-01: 87.6; Dec-02: 87.6; Dec-03: 87.1; Dec-04: 89.2; Mar-05: 95.3; Jun-05: 91.2. ### Medium-term macroeconomic framework and scenarios (Table 6, select projections) - Real GDP growth (baseline scenario): 2006: 5.5; 2007: 5.0; 2008: 5.0; 2009: 5.0; 2010: 5.0. - Consumer prices (period average, baseline): 2006 Prel.: 14.4; 2006 Baseline proj.: 10.7; 2007: 7.0; 2008: 4.0; 2009: 4.0; 2010: 4.0. - Consolidated budget revenue and grants (percent of GDP, baseline): 2005: 38.4; 2006 Baseline: 38.6; 2007: 38.4; 2008: 38.3. - Cash balance (percent of GDP, baseline): 2005: -3.2; 2006 Baseline: -4.0; 2007: -4.4; 2008: -4.6; 2009: -4.5; 2010: -2.3 (staff table shows several scenario variants). ### Selected vulnerability and debt sustainability indicators (Tables 7–9, select) - EMBI secondary market spread (bps, end of period): 2001: 974; 2002: 469; 2003: 1275; 2004: 264; 2005: 172 (21-Sep-05 observation). - Short-term ST external debt (percent of total external debt): 2001: 39.0; 2002: 40.4; 2003: 36.3; 2004: 29.2; 2005: 28.1 (June). - Total public external debt (percent of GDP): 2001: 26.3; 2002: 24.0; 2003: 21.6; 2004: 19.3; 2005: 14.5 (June). - Baseline public sector debt (percent of GDP): 2000: 45.5; 2001: 38.6; 2002: 35.7; 2003: 27.7; 2004: 25.1; 2005: 22.8; 2006: 19.9; projected 2010: 21.0. - Debt-stabilizing primary balance (percent of GDP): -2.2 (Table 8 line). - Baseline external debt (percent of GDP): 2000: 63.6; 2001: 55.5; 2002: 52.1; 2003: 47.5; 2004: 46.1; 2005: 43.5; projected 2006: 38.3. ### Structural and policy actions (Ukraine–EU Action Plan, Table 10; selected actions) - Legal framework and governance: Adopt Joint Stock Company Law; improve competence and independence of auditors; implement competition and bankruptcy legislation; adopt legislation for Land Code implementation; reform the court system; enhance transparency and accountability in public administration. - Fiscal reforms: Reinforce fiscal sustainability including measures on pension system; implement strategic plan for State Tax Administration; adopt Customs Code in line with WTO and EU; solve VAT refund backlog; improve transparency of public finance management; approximate EU public procurement legislation. - Energy sector: Adopt law to allow operation of National Electricity Regulatory Commission; develop gas sector restructuring plan; implement coal mine restructuring plan; ensure convergence of energy price developments with EU markets. - Financial sector: Strengthen independence of NBU by aligning NBU law with EU standards; comply with IMF’s FSAP of November 2003; develop domestic securities market. ### Millennium Development Goals (select indicators, Table 11) - Immunization, measles (percent of children ages 12-23 months): 1990: 88.7; 1994: 95.5; 1997: 97.8; 2000: 98.8; 2003: 99.0; 2004: 99.2. - Infant mortality rate (per 1,000 live births): 1990: 12.8; 1994: 14.5; 1997: 14.0; 2000: 11.9; 2003: 9.6; 2004: 9.5. - Net primary enrollment ratio (percent of relevant age group): 2000: 75.5; 2003: 78.3. ### IMF relations, reserves, and Article IV consultation timing (Appendix I highlights) - Ukraine is on the standard 12-month consultation cycle. - Membership: Joined 09/03/1992; Article VIII. - IMF quota (SDR million): 1,372.00. - Fund financial arrangements (select): Extended arrangements outstanding: SDR 914.70 (66.67 percent of quota). - Exchange arrangements history: Hryvnia introduced September 1996; de facto conventional pegged arrangement classification with notable interventions; on August 30, 2005 the hryvnia stood at HRV 5.05 per U.S. dollar. *Sources: Ukrainian authorities; and Fund staff estimates and projections (IMF staff report and supporting tables in the 2005 Article IV Consultation supplementary information).* ### 1. This supplement provides information on developments since the staff report was ### This supplement provides information on developments since the staff report was issued. ### Developments and overall assessment - The re-sale of the Kryvorizhstal steel combine points to an improvement in the investment climate and is consistent with the staff’s assumption that investment activity would pick up to support growth in 2006. - Uncertainties regarding the use of the windfall proceeds from the Kryvorizhstal re-sale strengthen the staff appraisal’s concern that fiscal policy may turn out insufficiently tight to support disinflation in 2006. ### Recent macroeconomic indicators and short-term projections - Real GDP growth over January-September 2005 has declined to about 3 percent (over the same period last year). - Annual CPI inflation: - September 2005: 13.9 percent. - October 2005: 12.4 percent. - End-year CPI inflation is now likely to reach 12 percent (staff report projection was 14 percent). - Near-term inflation outlook: assuming full execution of fiscal spending plans and continued rapid growth of household incomes and spending, inflation is likely to remain in double-digits through early-2006. - Monetary aggregates (September 2005): - Annual base money growth: 27 percent. - Annual broad money growth: 31 percent. - Credit expansion: 44 percent, financed increasingly through borrowing from abroad. - Overnight interbank rates: trending upward to 4½-6½ percent in September and October 2005; most interest rates remain negative in real terms. - External sector: - Third-quarter 2005 current account was weaker than previously envisaged. - Staff forecast for the full-year 2005 current account surplus revised down to 4.8 percent of GDP (from 6 percent of GDP). - The weakening current account is likely to be more than offset by the impact of the Kryvorizhstal re-sale on the capital account. - Gross official reserve accumulation for 2005 could be higher than previously envisaged. ### Budget implementation and financing - Cash revenue through September 2005 remained buoyant, including for VAT and profit tax collections. - VAT refund arrears: - Reduced to ½ percent of GDP at end-September 2005 (from ¾ percent of GDP at end-June 2005). - October 2005 sovereign bond issuance: - Ten-year EUR 600 million eurobond issued yielding 4.95 percent, consistent with a spread of 155 basis points above the German benchmark bond. - Supplementary 2005 budget (parliament approved): - Incorporates unbudgeted pension spending amounting to some ¾ percent of GDP (anticipated in staff projections). - Incorporates spending of ¼ percent of GDP to re-capitalize two state banks. - Underexecution of spending noted in recent data, which, if maintained, could broadly compensate for the additional spending measures. - General government deficit target for 2005 (2½ percent of GDP) could still be within reach, or be exceeded by only a small margin. ### Kryvorizhstal re-auction: outcome and fiscal impact - Auction result: - Mittal Steel acquired about 93 percent equity stake for $4.8 billion (5¾ percent of GDP). - This was six times the price paid at last year’s privatization auction. - Payments and net proceeds: - After repaying Kryvorizhstal’s previous owners $0.8 billion, net revenue to the budget from the sale will amount to about Hrv 20 billion (or 5 percent of GDP). - Net proceeds significantly exceed budgeted privatization revenue for 2005 (1¾ percent of GDP). - Government and Mittal Steel agreed that payments will be completed before end-2005. ### Options for using privatization windfall and macroeconomic implications - Staff estimate of financing needs and net windfall: - 1½ percent of GDP of the proceeds needed to cover remaining gross financing needs of the state budget in 2005 (assuming no additional borrowing during the rest of the year). - Net windfall remaining: 3½ percent of GDP. - Government officials’ stated preferences: - Restrict use of additional financial resources to operations that broadly preserve government net worth: repaying debt and investing in public infrastructure. - Political pressures: - With parliamentary elections in March 2006, some politicians advocate increasing recurrent spending, including social transfers and subsidies for agriculture and mining. - Macroeconomic consequences: - Additional recurrent spending would add to inflationary pressures and call for an offsetting monetary policy response. - Even without a change in fiscal stance, shifting the budget’s financing structure (e.g., from domestic debt to the use of privatization receipts) could impact liquidity conditions and require a compensatory monetary policy response. ### 2006 budget process outlook - Parliament initially rejected the government’s draft budget during the first reading and proposed: - Increasing revenue projections by removing proposed tax cuts. - Raising spending. - Increasing the deficit ceiling by about 1 percent of GDP. - The privatization windfall added pressure to raise spending and the deficit ceiling. - Government later noted there is no good reason to increase the deficit and stressed the need to reduce the tax burden. - On November 1 (repeated first reading), parliament approved a revised government budget proposal that kept the deficit ceiling unchanged; parliamentary pressures to raise spending and the deficit are likely to remain strong. ### Structural reforms and institutional developments - Cabinet of Ministers approved a new draft law on strengthening minority shareholder rights (three previous drafts rejected by parliament). - Government considering eliminating the Economic Code in parts that contradict the Civil Code. - Parliament adopted two more bills required for WTO accession. - The EU Commission confirmed it will grant market economy status to Ukraine at the beginning of December. - Transparency International corruption perception index: - Ukraine ranked 107th out of 158 countries in 2005, compared with 122nd out of 146 in 2004. ### Staff appraisal and policy recommendations - The transparent re-auction of Kryvorizhstal is welcome, but proceeds should be used wisely. - Key recommendations: - Avoid using additional financial resources in ways that could complicate macroeconomic management, particularly by increasing inflation pressures through higher recurrent spending (e.g., social transfers or subsidies). - Allocate the windfall proceeds primarily for debt redemptions that do not aggravate the domestic liquidity overhang. - To a limited extent, allocate for well-targeted spending on public infrastructure programs. - Monetary policymakers should be vigilant and ready to counteract any relaxation of monetary conditions entailed by the use of the privatization proceeds. - Intended outcomes of recommended strategy: - Avoid fuelling significant inflationary pressures. - Broadly preserve the government’s net worth. - Build room against future contingencies and for medium-term fiscal needs. ### Selected numeric highlights from Table 1 (Ukraine: Selected Economic and Social Indicators, 2001–06) - Real GDP (percent change): 2001: 9.2; 2002: 5.2; 2003: 9.6; 2004: 12.1; 2005 Prel.: 4.0; 2006 Proj. baseline: 5.5; adjustment scenario: 5.0. - Nominal GDP (in billions of hryvnias): 2001: 204.2; 2002: 225.8; 2003: 267.3; 2004: 344.8; 2005 Prel.: 415.5; 2006 Proj. baseline: 499.8; adjustment scenario: 486.5. - Consumer prices, period average: 2001: 12.0; 2002: 0.8; 2003: 5.2; 2004: 9.0; 2005 Prel.: 13.7; 2006 Proj. baseline: 12.9; adjustment scenario: 10.5. - Consumer prices, end of period: 2001: 6.1; 2002: -0.6; 2003: 8.2; 2004: 12.3; 2005 Prel.: 12.0; 2006 Proj. baseline: 13.0; adjustment scenario: 9.0. - Cash balance (percent of GDP): 2001: -1.6; 2002: 0.5; 2003: -0.9; 2004: -4.4; 2005 Prel.: -2.9; 2006 Proj. baseline: -3.2; adjustment scenario: -2.3. - Privatization proceeds (percent of GDP): 2001: 1.3; 2002: 0.5; 2003: 1.1; 2004: 3.1; 2005 Prel.: 5.3; 2006 Proj. baseline: 1.8; adjustment scenario: 1.8. - Current account balance (percent of GDP): 2001: 3.7; 2002: 7.5; 2003: 5.8; 2004: 10.5; 2005 Prel.: 4.8; 2006 Proj. baseline: 1.0; adjustment scenario: 0.9. - Gross reserves (end of period, in billions of U.S. dollars): 2001: 3.1; 2002: 4.4; 2003: 6.9; 2004: 9.5; 2005 Prel.: 18.9; 2006 Proj. baseline: 21.4; adjustment scenario: 21.6. - Share of metals in merchandise exports (percent): 2004: 39.1. - Net imports of energy (in billions of U.S. dollars): 2001: 5.0; 2002: 4.9; 2003: 5.1; 2004: 6.6. - Foreign savings (percent of GDP): 2001: -3.7; 2002: -7.5; 2003: -5.8; 2004: -10.5; 2005 Prel.: -4.8; 2006 Proj. baseline: -1.0; adjustment scenario: -0.9. - Gross national savings (percent of GDP): 2001: 25.5; 2002: 27.7; 2003: 27.8; 2004: 29.9; 2005 Prel.: 25.6; 2006 Proj. baseline: 22.1; adjustment scenario: 22.1. - Gross investment (percent of GDP): 2001: 21.8; 2002: 20.2; 2003: 22.0; 2004: 19.4; 2005 Prel.: 20.8; 2006 Proj. baseline: 21.1; adjustment scenario: 21.2. - Base money (end of period, percent change): 2001: 37.4; 2002: 33.6; 2003: 30.1; 2004: 34.1; 2005 Prel.: 42.1; 2006 Proj. baseline: 24.5; adjustment scenario: 21.8. - Broad money (end of period, percent change): 2001: 41.9; 2002: 41.8; 2003: 46.5; 2004: 32.3; 2005 Prel.: 41.0; 2006 Proj. baseline: 27.9; adjustment scenario: 25.1. *Prepared by IMF staff (supplement to the staff report).* ### 9. Disagreements on Exchange Rate Policy ............................................................................30 ### 9. Disagreements on Exchange Rate Policy ............................................................................30 ### Executive Summary - Over the last 13 years, while drawing heavily on Fund policy advice and financial support, Ukraine’s transition experience has been disappointing. - Key reasons for lackluster performance: - Prevalence of rent seeking and the absence of strong private-sector lobbies favoring reform. - Lack of political consensus on the scope and pace of economic reforms. - A public administration with a generally thin economic knowledge base and weak capacity to prepare and implement policy decisions. - Consequences: - Ukraine became stuck in an under-reform trap with constrained growth dynamics, an expanding shadow economy, and a pervasive non-payment culture. - The 1998 financial crisis was a turning point; growth rebounded strongly during 2000-04, triggered mainly by a massive real devaluation combined with limited, but focused, structural reform efforts. - Export-led growth rebound and maintained fiscal discipline put Ukraine on a high-savings path, resulting in large and growing external surpluses and relatively low levels of public and external debt. - Backlog of market-friendly institutions remained largely unaddressed; inflation started to trend up in early-2003, and the growth-boosting effects of a fundamentally undervalued exchange rate and excess capacities seem to be fading. - Fund role and lessons: - Fund-supported programs were effective in supporting macroeconomic stability but did not succeed in accelerating the buildup of market-friendly institutions. - Program designs, at least until 1999, were too wide-ranging in the structural area and difficult to monitor. - The Fund contributed to knowledge transfer through continuous policy dialogue and technical assistance. - Lessons for future engagement: - Program ownership is key and needs to be tested. - Political and administrative constraints argue for streamlined conditionality. - Programs should focus on Fund core areas: strengthening and maintaining macroeconomic and financial stability. - A future program could provide a coherent macroeconomic framework and insurance given Ukraine’s openness and vulnerability to shocks, but should include sufficient conditionality in critical structural areas anchored within the Ukraine-EU Action Plan and coordinated with the World Bank. - It would be desirable to first test political consensus by making a prior action implementation of a few key, long-delayed reforms (examples given: strengthening transparency in the banking sector or improving corporate governance). ### Introduction - The Ex Post Assessment (EPA) focuses on three main issues: - Accounting for Ukraine’s macroeconomic record: why the weak growth performance in the 1990s and the rebound starting in 2000. - Accounting for the Fund’s role in Ukraine’s difficult transition and why Fund-supported programs often did not achieve their objectives. - Drawing lessons for future Fund involvement. - The EPA draws on IMF documents since Ukraine became a Fund member in September 1992, studies by academics and World Bank and Fund staff, and interviews with Fund and Bank staff and present and former government officials of Ukraine. - Report structure: - Section II recounts Ukraine’s macroeconomic record and key features of IMF-supported programs. - Section III attempts to account for the macroeconomic record. - Section IV looks at the role of the IMF and why it stayed engaged in program mode. - Section V reflects on lessons for future Fund engagement in Ukraine. ### What Happened? — Three Phases of Development and Fund Engagement - Phase descriptions: - 1992-94: Incoherent policies, rampant inflation, and collapsing output. The Fund acted mainly as an educator and provider of technical assistance. - 1995-99: Fitful drive toward macroeconomic stabilization amidst continued output declines; structural reforms lagged. Phase ended with the 1998 financial crisis. The Fund played a high-profile role through consecutive Fund-supported programs and technical assistance. - 2000-04: Strong rebound in growth with strengthened financial fundamentals. Improved fiscal discipline and a massive relative price shift in favor of corporate profitability transformed Ukraine into a “savings overhang” economy with little need for IFI financing. Progress on market-friendly institutions remained slow due to lack of political consensus. Fund and authorities maintained intensive policy dialogue and attempted to rekindle a formal program relationship. ### Macroeconomic Record — Snapshots and Key Statistics - Output and income: - Output slid cumulatively by 55 percent over eight consecutive years, followed by a cumulative output gain of 50 percent during 2000-04. - In 2004, official gross national income per capita amounted to $6,250. - Comparative per capita incomes (PPP): Poland $12,640; Russia $9,620; Moldova $1,930. - Efficiency and social indicators: - Ukraine’s production efficiency in 2000 is one of the lowest among transition economies (output per worker relative to global best practice frontier). - Male life expectancy dropped dramatically since 1991. - Population has shrunk by 4 million since independence. - Inflation: - Monthly CPI inflation rates exceeded 50 percent in 1993 and again in late-1994. - Monetary control over inflation was broadly established by late-1996. - Inflation veered toward deflation in 2002 and surged back into double-digits since 2004. - Savings, investment, and external balance: - After 1998, fiscal policy from 2000 onward adopted and broadly maintained a tight stance, shifting toward higher public savings. - Private savings increased, driven by improved corporate profitability following a sharp real devaluation and favorable terms of trade shifts. - Level of investment (percent of GDP) remained fairly steady, producing large external current account surpluses. - Debt and financial indicators: - The WEO classifies Ukraine as a net creditor country based on cumulated current account balances since 1992. - Official data indicate private external debt of 29 percent of GDP. - Public external indebtedness in 2004 was low (19 percent of GDP). - Interest rate spreads narrowed from more than 2,000 basis points in 2001 to about 175 basis points in August 2005. - Financial sector: - Loan portfolio of Ukrainian banks contracted to 9 percent of GDP by 1998, then surged on average by 3 percentage points per year thereafter. - Measures introduced in 1998 to stabilize the foreign exchange market (export surrender requirements and prohibition of forward transactions) were only lifted in 2005. - Revival of a rudimentary market for government securities took several years. ### IMF Program Record — Objectives, Instruments, and Outcomes - Fund-supported arrangements and timeline: - Systemic Transformation Facility (STF): October 1994-April 1995. - Three Stand-By Arrangements (SBA): April 1995-April 1996; May 1996-February 1997; August 1997-August 1998. - Extended Fund Facility (EFF): September 1998-September 2002. - One-year precautionary SBA that expired in March 2005. - Financial exposure and disbursements: - Most recent Fund disbursement occurred in 2001. - Fund exposure vis-à-vis Ukraine peaked at about 200 percent of quota at end-November 1998. - Fund exposure declined to 67 percent of quota as of end-July 2005. - Program performance: - Fund programs were effective in supporting macroeconomic stability but less successful in accelerating market-oriented institutional reform. - Program designs prior to 1999 were too wide-ranging in structural conditionality and difficult to monitor. - Despite limited program success, the Fund played a continuous role in policy dialogue and technical assistance, aiding the development of home-grown analytical and policy capacities. *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05415.pdf* ### Introduction of ### Introduction of hryvnia ### Program compliance and Fund-supported programs - Ukraine’s program compliance was generally weak. - Four Fund-supported programs covered the next seven years almost continuously. - Only three out of 13 reviews were completed on time and without waivers (Table 3). - Measured by the number of reviews, programs were off-track for more than 85 percent of the time, or, if programs with delayed reviews are considered as still on track, 45 percent. - Ukraine drew 68 percent of the approved amounts (excluding the recent precautionary SBA). - The early programs focused on: (i) limiting central bank financing of the fiscal deficit; (ii) eliminating directed lending to so-called priority sectors; and (iii) preparing the ground for structural reforms. - Lack of policy resolve during mid-1995 delayed stabilization, depleted the NBU’s international reserves, and pushed the first SBA off track. - Financial stability was restored under the second SBA, with most quantitative performance criteria observed. - Inflation was brought down to 25 percent by early-1997. - The fiscal deficit was reduced to 3.2 percent of GDP in 1996 (from 4.9 percent in 1995), but the authorities achieved the fiscal reduction mainly by running arrears. - Subsequent SBAs established ceilings on arrears as new conditionality; when fiscal adjustment continued to lag, the new program went promptly off-track. ### Transition from short- to medium-term programs and structural reform agenda - A comprehensive medium-term reform agenda to be supported by an EFF arrangement was discussed in 1997 but lacked political support prior to the March 1998 parliamentary elections; a one-year SBA was approved in August 1997 focusing on structural reforms. - When political deadlock resolved after elections, discussions for an EFF arrangement succeeded; the EFF was adjusted to reflect short-term stabilization needs following the Russian financial crisis. - Structural measures under the EFF covered: privatization; public, tax and customs administration; treasury operations; pension system; public employment; energy and agricultural sectors; external trade; and the banking sector. - The Ukraine program placed much more weight on structural reforms in non-Fund core areas, particularly privatization (Table 4). ### EFF arrangement outcomes and program derailment - Stabilization policies under the EFF were broadly appropriate, but the program was derailed by lagging structural reforms. - After initial stabilization following the Russian financial crisis and relatively quick progress in restructuring government debt, EFF reviews halted after twelve months. - A major misreporting incident further strained relations with the Fund; the Fund briefly disengaged and reengaged in December 2000 with a streamlined structural approach. - When program performance remained poor, the Fund interrupted the arrangement; only one delayed review was completed before the program expired in September 2002. - Major sticking points: accumulation of VAT-refund arrears; failure to reduce tax exemptions and export taxes; slow pace of banking sector reforms; delays in privatization; and poor transparency. ### Box 1 — Misreporting International Reserves (summary) - During IMF Stand-By Arrangements in 1996-98, Ukraine consistently misreported its levels of foreign reserve assets. - Misreporting arose from counting as reserves items that did not meet program performance criteria definitions, including “round-tripping operations” (NBU deposits in foreign banks on-lent to domestic banks which then re-deposited them in foreign banks), leading to double-counting of NBU reserve assets. - Subsequent NBU-commissioned audits found no evidence of misappropriation of Ukraine’s reserves. - The Fund’s Executive Board concluded in September 2000 that, as a result of misreporting reserve assets, Ukraine had breached its obligations under the Articles of Agreement. - The Board also observed that on the Fund’s side a willingness to work under rushed and disorganized circumstances and a climate of forbearance had played a role in allowing misreporting to persist. - The incident cooled Fund–authorities relations; the EFF was off-track from September 1999 to December 2000, partly due to slow reform progress and reduced willingness by the Fund and international community to accept waivers and modifications given lack of commitment and ownership. ### Public debt restructuring (Box 2 summary) - Ukraine faced serious cash-flow problems after the financial crisis and initially used selective debt restructuring with private creditors between 1998 and early 2000. - Initial restructuring efforts included: voluntary exchange of short-term T-bills for long-term bonds with domestic banks (August 1998); exchange of T-bills for non-resident investors for a Eurobond; and restructuring of a fiduciary loan by Chase Manhattan. - Negotiations with ING Barings for debt maturing in June 1999 stalled; the Board in end-June 1999 insisted on an agreement with private creditors on terms comparable to recent agreements. - A comprehensive exchange later succeeded with a 99 percent participation rate, swapping four Eurobonds and three Gazprom bonds maturing in 2000-01 for four Eurobonds maturing in 2007. - Between 2000 and 2002, Ukraine restructured external debt with Paris Club creditors and other bilateral creditors, most importantly Turkmenistan. - The total debt restructuring operation covered US$2.5 billion of external debt and US$0.3billion of domestic debt, representing about 9 percent of GDP. - Debt restructuring, rapid economic growth, and fiscal discipline combined to bring public debt down from 67 percent of GDP in 1999 to 25 percent of GDP in 2004. ### Recent precautionary SBA and outcomes - The recent precautionary SBA sought first to establish a track record but failed to meet most key objectives. - Structural reforms had advanced in a few areas, including: introduction of a new budget code; public administration and pension reform; reforms in the banking sector; and trade liberalization. - Five prior actions were met, including: various measures to reduce VAT refund arrears; a delay in a minimum wage increase; and an increase in banks’ minimum capital adequacy ratio. - The program went quickly off-track, mainly due to a massive loosening of fiscal policy in the run-up to the presidential election, renewed buildup of VAT refund arrears, and little follow-up on structural reforms; none of the structural performance criteria were observed. ### IMF–World Bank cooperation - The World Bank engaged relatively late in Ukraine through project and program lending, initially focused on enterprise, coal, agricultural, and financial sectors. - Implementation of the World Bank’s 1996-99 Country Assistance Strategy (CAS) was disappointing: disbursement ratios were significantly lower than in other CIS countries; many prepared projects did not materialize; and the Bank’s resource cost in supervising projects and programs were 50 percent higher than the regional average (World Bank, 2000a). - In 2000 the World Bank approved a new CAS shifting from separate sector adjustment operations to addressing institutional and governance issues that cut across sectors. - Achievements in World Bank supported areas included: better financial discipline; budget system and treasury reform; stepwise tax reform; passage of laws for secured interest and mortgage finance; establishment of regulatory agencies for non-bank financial institutions and telecom; financial sector reform; and legislative basis for pension reform. - Many objectives were not achieved and Bank disbursements, particularly for project lending, fell far short of the envisaged envelope. - The Fund and Bank generally coordinated; overlapping conditionality was used for key reforms (e.g., audit of the state energy company; selling gas through cash auctions; audits of largest banks; resolving or rehabilitating problem banks). - Different timing of engagements complicated program relationships; when Bank disbursements stalled in 1998 the Fund stepped up efforts to promote structural reforms and drew on World Bank expertise. - A shift back toward World Bank responsibilities occurred in 2000 with its new CAS; the Fund streamlined conditionality around the same time. - In 2003 and 2005 the World Bank supported Ukraine financially through a PAL and a Development Policy Loan respectively, while the Fund had no formal program relationship. The Fund’s assessment letters were a factor in World Bank design and loan amount decisions. ### Accounting for the macroeconomic record — Trauma years (1992–99) - Ukraine’s initial conditions were unfavorable despite potential tailwinds (well-educated population; excellent conditions for agriculture; favorable geographic position; international community support). - Two Soviet legacies were major impediments: - External shocks caused an initial output collapse due to loss of supply links to traditional trading partners and a sharp terms of trade deterioration; Ukraine was dependent on heavy, energy-intensive industries, including a large military goods sector. - Weak knowledge base for managing transition from plan to market; needed to build state institutions almost from scratch; capacity for planning and implementing policies was weak. - The length and severity of Ukraine’s economic downturn during the 1990s was unexpectedly large: the WEO projected real GDP to remain roughly stable between 1994 and 1999, but growth fell short year after year, resulting in a record cumulative forecast error of more than 40 percent during 1994–99 (Table 5, Figure 8). - Monetary policy gradually succeeded in reducing inflation as control over money growth improved; repeated bursts of hyperinflation undermined confidence in state institutions. - By 1995 the National Bank of Ukraine (NBU) had a broad political mandate and tools to control money growth, though fiscal policy relied heavily on NBU deficit financing in the run-up to the 1998 financial crisis (Figure 9). - The introduction of the hryvnia in 1996 and its use as an exchange rate anchor contributed to stabilization. - Fiscal discipline took longer to establish; modern budgetary institutions and practices (treasury, budget code) emerged only slowly. - Fiscal discipline, as measured by deficit outcomes, seemed broadly maintained (Figure 10), but repeated GDP growth shortfalls, a culture of tax and spending arrears, high quasi-fiscal deficits, and sales of high-yield short-term T-bills to non-residents created vulnerability. - When the 1998 financial crisis hit and Ukraine was temporarily unable to roll over short-term external debt, the shock proved to be a liquidity crunch rather than a solvency problem. ### Institutions, growth, and macroeconomic stability — Three lessons (Box 3) - Distinction between two types of institutions: - Market-stabilizing institutions: monetary, fiscal, prudential and supervisory arrangements. With Fund support, Ukraine made gradual but consistent progress on these, particularly after the 1998 crisis. - Market-enhancing institutions: secure property rights, enforceable contracts, regulatory quality; these are harder to build and in Ukraine formal laws and regulation are sometimes unclear or inconsistent (e.g., Economic and Civil Codes). - Three cross-country lessons relevant to Ukraine: - Strength of market-enhancing institutions is strongly positively correlated with income levels and productive efficiency in the longer term; Ukraine’s growth experience since 1992 is consistent with this lesson. - Growth accelerations can occur without broad-based strengthening of market-enhancing institutions; Ukraine’s strong growth rebound during 2000-04 fits this but such rebounds tend to peter out without broader institutional reforms. - Progress on market-stabilizing institutions not complemented by progress on market-enhancing institutions is unlikely to ensure durable macroeconomic stability; medium-term stability needs to be anchored by broader institution building. - Indicators in Kaufmann and others (2005) are used to measure strength of market-enhancing institutions. ### Additional indicators and figures referenced - Inflation was brought down to 25 percent by early-1997. - Fiscal deficit: 3.2 percent of GDP in 1996 (from 4.9 percent in 1995). - Total debt restructuring operation covered US$2.5 billion of external debt and US$0.3billion of domestic debt, representing about 9 percent of GDP. - Public debt fell from 67 percent of GDP in 1999 to 25 percent of GDP in 2004. - Cumulative forecast error of more than 40 percent during 1994–99. - World Bank supervision resource cost was 50 percent higher than the regional average. - Figures referenced: Figure 8 (Forecast Errors for Real GDP Growth), Figure 9 (Inflation and Base Money Growth), Figure 10 (Fiscal Targets and Outcome), Figure 11 (Efficiency and Institutions, 2000), Figure 12 (Shadow Economy). *International Monetary Fund staff report excerpt: Introduction of hryvnia.* ### 26. Mass privatization resulted in dispersed ownership and may have contributed to ### _cr05415 - 26. Mass privatization resulted in dispersed ownership and may have contributed to ### Mass privatization and ownership structure - Privatization during 1992–98 primarily transferred ownership to large numbers of individuals or to holdings of broadly-held financial intermediaries. - Legal environment did not much support minority shareholders; dispersed ownership structures led to pilfering of enterprise assets by insiders, which may have undermined economic activity. - Allowing widespread strategic foreign ownership was not preferred by authorities and would have been difficult given the adverse investment climate. ### Economic consequences and the vicious circle of inefficiencies - Activities migrated into the shadow economy—estimated to make up more than half of official GDP in1997 (Figure 12). - To maintain fiscal revenues, the government levied a high tax burden on the formal economy, driving more activities underground. - Insufficient fiscal revenues led the government to finance through arrears: - Wage, pension, and other payment arrears amounted to 3 percent of GDP in 1996, surging to 6 percent in 1999. - A non-payment culture became ingrained with the government leading by example. - Lingering doubts about currency solidity and lack of trust in poorly supervised financial institutions led to demonetization and sharply restricted bank loans to newly privatized enterprises. ### Four interlocking reasons why institution-building reforms did not take off - No strong private sector lobbies for institution-building emerged; the post-independence elite focused on consolidating power rather than economic reform, enabling looting of state enterprises and creation of powerful insider groups bent on state capture. - The political system was fractured: - Little institutional clarity on roles of the executive, legislative, and judicial branches. - Policy making hampered by slow buildup of legal foundations and a rapid succession of governments. - Parliament decisions dominated by vested interests; up to one half of members had no or only loose party affiliation. - Policy making remained within a Soviet-style managerial framework: - Government decision making focused on micro crises (e.g., clearing wage arrears, closing specific coal mines), leaving little energy for strategic law- and regulation-building needed for a market economy. - Incentives rewarded officials for resolving micro crises over pursuing strategic institutional reforms. - A version of the natural resource curse: - Dominance of heavy industries, coal, steel, large energy and agricultural sectors provided habitat for corruption and rent-seeking. - A small set of people benefited from asset-stripping and insider deals, undermining perceived legitimacy of ownership and incentivizing investment in political capital. ### Retooling policy-making (Box 4): key institutional improvements identified - Establish a government agenda that focuses on strategic priorities; control the agenda via properly constituted meetings with pre-announced and transparent agendas. - Prepare policy papers to inform policy meetings on options and risks rather than relying solely on draft legislation acts. - Build requisite policy analysis skills via a medium-term program to develop and upgrade analytical and strategic skills of ministry staff. ### Energy sector governance and reform (Box 5): from rent- to profit-seeking - Ukraine was highly energy-dependent in 1991; per dollar of output energy use surpassed other transition economies. - Energy sector became fulcrum of industrial and social policies, leading to massive redistribution of rents and arrears accumulation. - A largest operation involved a $3.3 billion gas settlement with Russia and Turkmenistan in March 2005. - Energy traders and enterprises engaged in intransparent barter strategies that worsened governance and created powerful elites. - Quasi-fiscal activities in energy declined after 1999-2000 reforms: - Cash collection ratio for electricity increased from a 15 percent in 1999 to 50 percent by end-2000 and over 90 percent by end-2004. - Economy remained highly energy-intensive and governance in energy markets remained weak; gas prices from Russia and Turkmenistan were still sold far below market rates, posing a key test once they adjust to international levels. ### Accounting for the growth turnaround: 2000–04 - GDP during 2000-04 increased cumulatively by some 50 percent; one-year-ahead WEO forecasts had projected about 19 percent, leaving a cumulative forecast error of 31 percent. - Main factors behind the rebound: - Rising demand met idle capacities; late-1990s had large unused capacity. - Massive relative price shifts turned the enterprise sector profitable: - Sharp devaluation and fall in real wages after the financial crisis raised competitiveness. - Real devaluation combined with consolidation of previously dispersed ownership encouraged growth-enhancing managerial behavior. - Sharp terms of trade gains added momentum from rising global prices for exports of steel, other metals, and chemicals. - Limited but well-focused structural reforms: - Successful insistence on cash payments for energy. - Withdrawal of the state from providing agricultural inputs. - Reduction in social arrears by the government led by then-Prime Minister Yushchenko. - Financial and fiscal constraints also disciplined deficits: - Access to external and domestic financing was severely constrained during 2000-02. - Quasi-fiscal deficits, particularly in energy, started to decline sharply in 2001. - Fiscal institution-building advanced: an interim treasury account became operational by 1998; a modern Budget Code was introduced in 2001. - Inflation dynamics: - Inflation declined sharply after 2000 despite robust nominal money growth; however, after deflation in 2002, inflation rose again in early-2003 due to rapid growth, large terms of trade gains, supply-side disturbances in rigid food markets, and hikes in public wages and pensions in 2004 and 2005. - Monetary policy framework devoted to defending the peg to the U.S. dollar left medium-term inflation outcomes seemingly unanchored. - Waning drivers of growth by 2005: - Capacity bottlenecks emerged as investment remained relatively subdued. - Recent surge in inflation and some nominal appreciation partly corrected real undervaluation of the hryvnia. - Prices for major exports that climbed since 2001 had started to reverse. - Institutional weaknesses persisted: - World Bank indicators point to no significant improvements in governance since 1998 (Figure 15). - In 2004, Ukraine ranked 122 out of 146 countries in the Transparency International corruption index. - Business climate remained difficult during 1998-2004, reflected in miniscule cumulative FDI flows to Ukraine; among transition economies, only the Kyrgyz Republic, Turkmenistan, and Uzbekistan fared worse in FDI per capita terms (Figure 16). ### The role of the IMF and program effectiveness - IMF-supported programs were instrumental in supporting gradual macroeconomic stability but had limited traction as commitment devices for authorities and did not permanently accelerate institution-building. - The Russian financial crisis and its fallout “resolved” Ukraine’s growth problem in a second-best and likely temporary manner. - The IMF contributed by: - Transferring knowledge about macroeconomic policy making through continuous policy dialogue. - Facilitating coordination and communication of the authorities’ policy agenda. - Helping to block or mitigate errant policy initiatives. - Policy developments and Fund advice in Ukraine often shadowed trends in Russia; structural condition patterns in Ukraine mirrored Russia. ### Political, administrative, and social obstacles to program implementation - Lack of political consensus to pursue market-friendly reforms was the main cause of repeated program failures; reform visions were not anchored in broad political consensus and parliament often blocked initiatives. - Weak administrative capacities hampered implementation; Ukraine took longer than other CIS countries to raise administrative quality and decision-making capacities. - Unfunded social promises undercut policy making and commitments: - Social protection programs proved fiscally unsustainable; when funding was insufficient, adjustments took the form of arrears or were ignored. - Tension between legislated social promises and fiscal reality added to population mistrust and incentivized procyclical or strategic fiscal uses. ### Ukraine’s social mandate overhang (Box 7) - A surprise pension hike in September 2004 raised monthly pensions to the subsistence minimum level of Hrv 284; staff estimates suggested the annualized budget cost was about 3½ percent of GDP. - Together with a further increase in the subsistence level later in 2004, pension spending rose by 5 percent of GDP to an estimated 14 percent of GDP in 2005. - The 2004 pension hike derailed the shift to a multi-pillar pension system foreseen by 2003 legislation. - Other constitutional social mandates (free education, healthcare, public housing) are partially fulfilled or ignored; estimated costs of fulfilling all social mandates could amount to about 10 percent of GDP. - A proposal to recognize inflation-era savings losses as public debt could create additional official government debt up to about 30 percent of GDP. *Source: IMF staff report content provided in the supplied PDF excerpt.* ### 40. At least until 1999, the authorities’ perception of the Fund’s willingness to be ### _cr05415 - 40. At least until 1999, the authorities’ perception of the Fund’s willingness to be ### Fund engagement, program continuity, and incentives - Nearly uninterrupted program coverage during 1994-99, a large number of missions, and delivery of copious technical assistance signaled the Fund’s strong interest in supporting Ukraine. - Fund management was generally closely involved in program negotiations and reviews; the aim of tipping the balance toward reformers was the main driving force behind continued Fund involvement. - Major shareholder pressure existed but was considered by interviewees to have played a much less prominent role than in the case of Russia. - At the time of the 1998 financial crisis, the Fund was also concerned about regional contagion given Ukraine’s size and trade links. - Consequence: Failure to implement agreed program commitments may have seemed to the authorities to carry little practical consequences for delaying program approvals and disbursements; almost uninterrupted access to Fund (and other IFIs) financial support may well have delayed reform efforts before 1999. ### Structural conditionality: early shortcomings and later excesses - Early programs: - Did not include conditionality on arrears buildup or the establishment of more effective fiscal institutions. - Placed much emphasis on numerical targets for privatization and speed of mass privatization rather than modus and quality. - Focused on reforms already on the government’s agenda while not tackling authorities’ creative ways of evading fiscal discipline. - Later programs: - The EFF-supported program introduced a large policy matrix with the objective of providing a step-by-step action plan; the matrix included 88 measures (and 150 sub-measures). - The 88-measure matrix proved unwieldy, taxing staff’s and authorities’ limited capacities to monitor implementation. - The matrix included many measures in non-core Fund areas, including the energy sector and privatization. - None of the measures were performance criteria under the original program; four of the measures later became structural performance criteria. - Staff introduced a large number of prior actions for completing reviews, an approach viewed by authorities as an arbitrary shifting of goalposts. - Streamlining and outcomes: - At the second review the structural policy matrix of the EFF arrangement was reduced from 88 to 36 measures. - The recent precautionary SBA-supported arrangement shifted to a highly parsimonious approach on structural conditionality, including only five structural measures (in addition to five prior actions), all clearly located in Fund-core areas. - Political and administrative effects: - The detailed policy matrix was welcomed technically and politically but did not necessarily strengthen program ownership; politically it could be used to deflect criticism to the Fund when implementation faced opposition or administrative bungling. ### High-profile conditionality case: sunflower seed export tax (Box 8) - Context: - Ukraine is one of the world’s largest producer and exporter of sunflower seeds. - In August 1999, in a clear breach of the EFF–supported program undertaking to refrain from introducing any new restrictions on exports, Ukraine imposed a 23 percent export tax on sunflower seeds. - Fund position: - Fund staff strongly argued for eliminating the export tax, viewing it as emblematic of powerful groups bending rules to their advantage and imposing a significant deadweight cost. - It was difficult to make a compelling case that reducing the tax was critical for achieving key program objectives; aspects such as evasion remained unclear. - Developments: - In December 2000, an EFF review was completed without the tax having been eliminated; a structural benchmark to reduce the tax to 10 percent was agreed. - In June 2001, the tax was reduced to only 17 percent, but the sunflower seed issue was quietly dropped from the agenda. - In July 2005, to fulfill a precondition for WTO accession, parliament adopted legislation to lower the tax by 1 percentage point per year upon WTO membership. ### Policy advice, mistakes, and contested judgments - Criticisms cited by authorities and interviewees: - The Fund’s insistence in 1997-98 on letting T-bill rates be market-determined and avoiding restrictions on purchases by non-residents was felt to have contributed to the severity of the 1998 financial crisis. - Examples of ill-advised or politically overestimated measures included: - Increase in housing and rental tariffs in 1995 (a structural benchmark of the 1995 SBA), which led to large arrears buildup. - Increase in the alcohol excise tax in 1998 (a prior action of the EFF arrangement), which caused sharp increases in smuggling. - The Fund’s underestimation of the rapid remonetization after the 1998 financial crisis and repeated calls for more exchange rate flexibility were singled out; a call for tighter monetary policy in 2001 coincided with Ukraine being on the brink of deflation. - Exchange rate policy (Box 9) — contested area: - The NBU steered the hryvnia within a band against the U.S. dollar from June 1996 but shifted the band upward three times during the financial crisis. - The hryvnia floated briefly between May 1999 and February 2000 but remained de facto fixed until April 2005 when the NBU allowed it to appreciate by 5 percent. - The Fund frequently called for more exchange rate flexibility; controversy surrounded timing of the initial introduction of the exchange rate band (authorities intended 1995; Fund insisted on mid-June 1996). - During the financial crisis, the Fund agreed to defend the exchange rate including through administrative controls—later judged a mistake as the NBU lost substantial amounts of reserves and ultimately had to float the currency. - After the crisis, the Fund favored a more flexible regime but accepted the authorities’ de facto peg; the de facto peg generally served Ukraine well by disciplining fiscal policy and serving as an external anchor despite risks (rapid reserve accumulation posing inflation risk and lack of incentives to hedge foreign-currency bank lending). ### Other impacts of Fund-supported programs and involvement - Positive roles despite mixed record: - Transferring knowledge: - Continuous policy dialogue and technical assistance helped establish broader understanding of market economy requirements and macroeconomic policy interactions. - Fund support helped set up key policy-making institutions such as the central bank and supported buildup/strengthening of banking supervisory function. - In 2003 Ukraine became the first CIS country to subscribe to the Fund’s Special Data Dissemination Standard (SDDS). - By 1998 the World Bank had disbursed $1.8 billion to Ukraine (90 percent adjustment loans), but with little to show for it, in particular in the energy sector. - The Financial Sector Assessment Program (FSAP) findings were used to formulate one prior action and conditionality under the precautionary SBA. - Coordinating policies: - Fund-supported programs introduced the need for consistent macroeconomic frameworks and facilitated communication among different policy makers, including the NBU and the Ministry of Finance. - Advising on policy initiatives: - The Fund screened potentially detrimental policy proposals (e.g., new tax exemptions and amnesties) and helped shield particular policy areas (e.g., helped fend off government pressure on the NBU to provide cheap refinancing loans to banks for on-lending to the agricultural sector by making elimination of this practice a precondition to complete precautionary SBA discussions). - Caveats: - The link between program conditionality and technical assistance may have impaired the effectiveness of technical assistance by blurring technical and policy decisions. ### Lessons and assessment - Overall outcomes: - Ukraine’s transition to a market economy has—so far—not worked out as well as expected; the sustained rebound in output that began in 2000 owes much to exceptional and temporary conditions. - Ukraine’s income levels remain relatively low, reflecting an economy highly inefficient in using available resources. - Institutional progress during 1998-2004 shows little fundamental improvement despite some margins of structural reform and rapid re-monetization. - Role of Fund-supported programs: - Broadly successful in supporting macroeconomic stabilization—high inflation and excessive fiscal deficits were gradually but successfully reigned in from the mid-1990s. - Did not succeed in accelerating reform of market-enhancing institutions; lack of a reform-oriented political consensus within Ukraine is judged the main cause. - Until 1999, the Fund’s perceived eagerness to stay in a continuous program relationship and program designs characterized by perhaps excessive structural activism were unhelpful but not decisive in delaying reforms. - Current reform orientation: - President Yushchenko has placed reforms at the top of the government’s agenda, pledging to tackle corruption and rent-seeking and to anchor reform within closer integration with the EU and global markets. - Main payoff from Fund involvement: - Successful knowledge transfer through close and continuous policy dialogue and wide-ranging technical assistance provided authorities with tools for macroeconomic analysis and policy making. *Source: Excerpt from IMF staff report content provided in the supplied document.* ### 54. What role could an IMF-supported program in the near-term play? Under ### 54. What role could an IMF-supported program in the near-term play? Under ### Near-term role and rationale - Under plausible baseline projections, Ukraine has no immediate external financing need. - Potential benefits of a Fund-supported program: - Help anchor and coordinate the authorities’ reform agenda, particularly by reestablishing a coherent macroeconomic framework that aims at bringing inflation back into the single-digits. - Provide insurance against external shocks given Ukraine’s exposure to: - a sharp decline in metal prices and export demand, - uncertainty about foreign direct investment and short-term capital flows, - a potential convergence of energy import prices to world levels. - Address vulnerabilities in the banking sector that has taken on large credit and indirect foreign exchange risks during the rapid growth years and remains vulnerable to a slowdown of the economy. ### Conditions for more successful Fund program engagement (checklist) - Is there sufficient political support behind a program? - Strong program ownership and political support would be the key preconditions. - Past underestimation of political constraints led to program failures. - President Yushchenko’s vision of the need for sweeping institutional reform is encouraging. - So far, the present parliament has been reluctant to adopt proposed reform legislation. - The upcoming March 2006 parliamentary election should clarify the extent of political support for a strong structural reform agenda. - The Ukraine-EU Action plan could be viewed as a blueprint, serving the authorities as a compass for where they want to go during the program period and beyond. - Are the policy-making capacities to implement a program in place? - The present authorities’ decision-making process seems to exhibit many of the tendencies noted by earlier observers as inhibiting government effectiveness. - There may still be too much focus on addressing micro crises (reflected in recent heavy-handed interventions in fuel, meat, and sugar markets) at the cost of focusing the government’s energies on achieving strategic goals (such as WTO accession). - Is the program sufficiently focused on addressing the key obstacles to sustained growth? - Main issues to be addressed in a Fund-supported program would seem to comprise: - (i) as regards monetary and exchange rate policy, tightening loose monetary conditions and re-orienting the monetary framework toward achieving low and stable inflation, including through a shift to a more flexible exchange rate regime; - (ii) as regards fiscal policy, maintaining a tight fiscal stance, restoring a viable public pension fund, systemic tax reform, and strengthening the transparency of fiscal and quasi-fiscal operations; - (iii) as regards the financial sector, strengthening the resilience of the banking sector and developing domestic capital markets; and - (iv) improving the investment climate through stronger governance and institutions. - Measures would need to be kept streamlined and focused on critical institutional bottlenecks. - Building more market-friendly institutions remains the key to relaunching sustained catch-up growth; closing the institutional gap should therefore play a key role in a Fund-supported program. - In marked contrast to earlier programs, such a structural reform agenda could be anchored externally in the Ukraine-EU Action Plan. ### Suggested form of Fund engagement and sequencing - Given no immediate external financing needs, the program would likely be a low-access, precautionary arrangement. - To address medium-term challenges, a Fund-supported program would have to consider a duration that exceeds one year. - Designing a credible exit strategy will be difficult given Ukraine’s circumstances and uncertain prospects for closer EU integration. - Before re-engaging in a program, and to address potential concerns about ownership given the past record, the Fund could ask first for a demonstrated track record of good macro policies and prior implementation of key structural reform measures that demonstrate the authorities command the political consensus needed to see a program through. - Potential candidates for such prior actions could be long-delayed measures to strengthen transparency in the financial sector (such as making ownership structures more transparent) or to improve corporate governance (such as adopting a market-friendly joint-stock company law). *Source: _cr05415 - 54. What role could an IMF-supported program in the near-term play? Under* ### 57. What would be the benefits of a Fund-supported program over Fund ### 57. What would be the benefits of a Fund-supported program over Fund surveillance and technical assistance for Ukraine? ### Role and potential benefits of a Fund-supported program - A program could serve the authorities as an additional external anchor, both in terms of jumpstarting structural reforms, including through prior actions, and staying the course during the program period. - The Fund played a similar role in Bulgaria’s and Romania’s EU accession process, but these experiences also suggest that the Fund’s leverage was closely linked to the status and progress in EU membership negotiations. - Whether an additional anchor has merit for improving policy making in Ukraine will ultimately be the authorities’ decision. ### Conditions for success - The success of a future program will clearly rest on the authorities’ willingness and ability to implement agreed policies. ### Alternative: continued engagement through surveillance and technical assistance - As an alternative, the Fund could remain engaged through a close policy dialogue and technical assistance. - This option would allow the Fund to continue to provide valuable support through transferring knowledge and advising on policies. *International Monetary Fund staff text.* ### 648.2 million (65 percent of quota) in first 12 months and SDR 498.6 million (50 ### _cr05415 - 648.2 million (65 percent of quota) in first 12 months and SDR 498.6 million (50 ### Program financing and disbursement schedule - Initial availability: SDR 648.2 million (65 percent of quota) in first 12 months and SDR 498.6 million (50 percent of quota) in second and third years. - Within first year disbursements: - SDR 190 million available mid-September. - SDR 55.55 million available after October 20, 1998, November 20, 1998, and December 20, 1998. - SDR 41.66 million due after January 20, 1999, February 20, 1999, March 20, 1999, April 20, 1999, May 20, 1999, June 20, 1999, and August 20, 1999. - New phasing (post-March 1999): SDR 111.1 million available after March 10, 1999 and SDR 48.6 million available after 20th of each month from April through September. - Augmentation (May 27, 1999): extended arrangement augmented by 20 percent of quota or SDR 274.4 million. - Cumulative drawings noted: SDR 712.5 million (after seventh purchase); cumulative purchases SDR 1,193 million (by September 20, 2001). - Specific purchases recorded: - First purchase: SDR 190 million (made September 1998). - Second purchase: SDR 55.5 million (October 1998). - Fourth purchase: SDR 134.7 million (after May 27, 1999 Board approval). - Fifth purchase: SDR 86.1 million (after June 20, 1999). - Seventh purchase: SDR 134.7 million (September 7, 1999). - Purchase at extension/rephasing (December 19, 2000): SDR 191 million. - Purchases after Fifth and Sixth reviews (September 20, 2001): SDR 290.8 million. ### Prior actions, structural reforms, and policy areas covered - Thirty prior actions covering reforms in: fiscal structural, tax, subsidies, pensions, bank supervision, domestic treasury bill market, land reform, privatization, public administration, trade liberalization, electricity tariff deregulation. - Structural performance criteria and benchmarks (selected examples): - Structural PCs added later: increase in communal tariffs (two PCs), reduction in commodities subject to mixed specific/ad valorem import tariffs, adoption of formula-based transfers to local governments. - Structural PC (March 1999): tariffs on gas and electricity to be raised by 25/20 percent, respectively, by April 1, 1999; local government tariffs to achieve full cost recovery for communal services by May 1, 1999. (Both met, except cost recovery in Kyiv.) - Structural PC added (May 27, 1999): full cost recovery of heating, water, sewer, rent, and transport services in Kyiv. - Three prior actions for the October 2000–December 2001 program: approval of budget, submission to parliament of privatization list, passage of banking law. - Seven structural benchmarks for October 2000–December 2001 program: reduce export tax on oil seeds; publish information on privatization; progress on Naftogaz audit; medium-term strategy for Bank Ukraina; review Free Economic Zones and Special Investment Regimes; publish NBU's audited statements; initiate bankruptcy procedures on 5 of 50 largest tax debtors. - Quantitative structural benchmarks (2, quarterly): collection rate for household gas payments; cumulative reduction in the number of budgetary employees. - Structural benchmarks (11) earlier: tax administration, privatization, pension reform, deregulation, central bank reform, reorganization of ministry of finance. - Later program additions: new PC relating to netting operations on consolidated government obligations and two quantitative structural benchmarks on cash collection ratios for gas and electricity. ### Performance criteria, indicative targets, and monitoring - Performance criteria and monitoring: - Monthly monitoring of PCs and monthly purchases during August-December 1998, with quarterly reviews. - Four monthly PCs: ceiling on consolidated fiscal deficit; ceiling on budgetary arrears of wages, pensions, and benefits; ceiling on NDA of NBU; floor on NIR of NBU. - Continuous PC on nonaccumulation of external official arrears. - Quarterly PC: ceiling on nonconcessional public debt (five separate categories: up to 1 year; 1-3 years, with sublimit on credit lines; and more than 1 year, with sublimit on credit lines). - Four structural PCs (added later): communal tariffs increases, reduction of mixed-tariff commodities, formula-based transfers to local governments. - Indicative targets: - Three monthly indicative targets from August to December: base money; floor on unearmarked state cash revenue; ceiling on NBU gross purchases of t-bills from the primary market. - Quarterly indicative targets later introduced: base money growth; nonearmarked cash revenue; cash collection ratio for electricity; cash collection ratio by Naftogaz. - Quantitative performance criteria (for the 12-month precautionary SBA approved March 29, 2004): - Six PCs: (a) ceilings on cash deficit of central government; (b) ceiling on stock of budgetary arrears; (c) ceiling on stock of VAT refund arrears; (d) ceilings of NDA of NBU; (e) floors on NIR of NBU; and (f) ceiling on external debt contracted or guaranteed by the government. - Continuous PC on non-accumulation of external arrears. - Structural PCs (2): eliminate VAT exemptions; and enact amendments to banking law and NBU regulations to tighten related-party lending. - Structural benchmarks (3): develop domestic securities market; adopt monitoring system for quasi-fiscal operations; reduce fiscal cost of remaining VAT preferences. ### Reviews, waivers, missed conditions, and program rephasing - October 1998: Financing assurances review and request for waivers and modification of performance criteria. Waivers approved for nonobservance of 3 PCs: end-September PCs on NIR and NDA of the NBU and continuous PC on the introduction of exchange measures subject to Fund jurisdiction; modification of program targets for end-October on NIR and NDA of the NBU. - First review delayed (could not be completed in December) due to cash revenue shortfalls, uncertain 1999 fiscal prospects, and delayed structural reforms. March 1999: first review and waivers approved; rephasing of purchases approved. - Fourth purchase delayed (April 1999) because of nonobservance of end-March PCs on budgetary arrears for pensions/wages/benefits and on accumulation of external arrears; waiver and modification approved May 27, 1999. - Sixth purchase delayed in July due to non-observance of end-June PC on state cash revenue. - Third review and waivers approved September 7, 1999; modification of multiple PCs for August and end-September. - Eighth purchase could not be made (based on September PCs) due to missed end-September structural PC on communal tariffs and five end-December quantitative PCs (consolidated deficit, nonearmarked state cash revenue, stock of budgetary arrears, NDA of NBU, and continuous PC on nonaccumulation of external payment arrears). - December 19, 2000: completed fourth review and waiver of missed September 1999 structural PC and December 1999 quantitative PCs, and extension (to September 2002) and rephasing of extended arrangement. Purchase of SDR 191 million. - Review delays and eventual expiry: - September 20, 2001: Fifth and Sixth reviews completed; purchases of SDR 290.8 million; new PC added for formula-based transfers to local governments in context of 2002 budget; cumulative purchases SDR 1,193 million. - September 3, 2002: extended arrangement expires without completion of seventh or subsequent reviews, due to non-implementation of prior actions, including steps to reduce VAT arrears and eliminate tax exemptions. - 12 months precautionary SBA (approved March 29, 2004): SDR 411.6 million (30 percent of quota) with quarterly disbursements and one review (scheduled for completion by September 2004). Review not completed due to disagreement on 2004 fiscal stance and 2005 fiscal prospects, non-compliance with structural PCs and structural benchmark, and issue of exchange rage flexibility. All end-March and end-June quantitative PCs met except ceiling on VAT refund arrears. ### Summary of program compliance (detailed counts) - Total PCs: 70 met, 19 not met, 89 total. - Monthly quantitative PCs: 33 met, 15 not met, 48 total. - Quarterly PCs: 33 met, 3 not met, 36 total. - Continuous PCs: 1 met, 1 not met, 2 total. - Structural PCs: 2 met, 2 not met, 4 total. - Quarterly quantitative benchmarks: 8 met, 18 unmet, 26 total. - Structural benchmarks: 17 done, 5 partly done, 6 not done, 28 total. - For the March 29, 2004 precautionary SBA: - 10 out of 12 quantitative PCs met. - Two structural PCs: both missed. - One structural benchmark (by time of review): missed. - One of four quarterly indicative targets missed (on base money). ### Public Information Notice — macroeconomic background (Article IV consultation, November 9, 2005) - Growth: - After four years of strong activity, annual growth slowed from about 12 percent in 2004 to 3 percent for January-September 2005. - Export growth fell from 41 percent in 2004 (in nominal terms) to about 9 percent over the first half of 2005. - Import growth changed from 24 percent to 23 percent over the same comparison. - Inflation and prices: - 12-month CPI: -0.6 percent in 2002; 12.3 percent by end-2004; peaked at 14.9 percent in August 2005; declined to 12.4 percent in October 2005. - Producer Price Index (PPI): peaked at about 25 percent toward the end of 2004; fell to 12.9 in October 2005. - Recent surge in inflation concentrated in select food-related items; wage and pension increases contributed to consumer demand. - Wages: - July 2005 average nominal monthly wage was 38 percent above its level the previous year, representing an increase of about 20 percent in real terms. - Spending provisions helped raise average public pensions and wages by over 50 percent (against an inflation target of just under 10 percent). - Fiscal policy and budget outcomes: - Supplementary 2005 budget targeted a general government deficit of 2½ percent of GDP; realized 4½ percent of GDP in 2004; original 2005 budget implicit deficit 6-7 percent of GDP. - Unbudgeted pension spending pressures amounted to some ¾ percent of GDP. - Stock of VAT refund arrears amounted to ½ percent of annual GDP at end-September 2005. - Re-auction of Kryvorizhstal generated net privatization revenues of $4 billion (5 percent of GDP), exceeding overall budgeted privatization revenue for 2005 (1¾ percent of GDP). - Cash revenue through September 2005 described as buoyant; underexecution of central government spending noted. - Monetary and exchange rate conditions: - Monetary conditions remained loose; NBU continued to purchase foreign exchange rather than allow the exchange rate to appreciate. - 5 percent nominal appreciation of the hryvnia against the U.S. dollar during the first four months of 2005. - Sterilization efforts limited; government absorbed liquidity by issuing new T-bills to buy back higher-yield restructured securities held by the NBU and by building up deposits via tight fiscal stance. - Excess liquidity in banking system; most interest rates negative in real terms. - Monetary aggregates expanded more slowly in 2005 compared to 2004, against decelerating money demand. - Real effective exchange rate: real exchange rate appreciated markedly, with the real effective rate rising by about 12 percent during the 12 months to end-July (2005). *Public Information Notice (PIN) No. 05/156 — IMF Executive Board Concludes 2005 Article IV Consultation with Ukraine (November 11, 2005).* ### 2005. However, all indicators, including cross-country wage data, suggest that price ### _cr05415 - 2005. However, all indicators, including cross-country wage data, suggest that price ### Exchange rate policy and foreign exchange market reforms - NBU relaxed a number of foreign exchange restrictions, including Ukraine’s export surrender requirements and the provision that non-residents predeposit the full amount of their auction T-bill bids. - In August, the NBU allowed banks to operate on both sides (buy/sell) of the foreign exchange market within the same day, and also allowed forward operations. - A 1.5 percent foreign exchange transaction tax exists; the draft 2006 budget envisages to halve it. - New NBU measures: a restriction (likely non-binding) on purchases by non-residents of government securities with original maturities of less than one year, and a 20 percent reserve requirement on foreign currency loans with a maturity of up to 180 days from non-residents. - Directors broadly agreed that a gradual shift to increased exchange rate flexibility and inflation targeting would increase the NBU’s ability to achieve low and stable inflation; they welcomed recent steps toward a more flexible exchange rate regime. - Directors urged the NBU to communicate its policies and intentions more consistently and to ensure preconditions and technical capacity for a successful policy shift; they encouraged further deregulation of the foreign exchange market and strengthening of the operational framework. ### Banking system, credit growth, and financial sector resilience - The banking system weathered last year’s political turmoil well. - Credit growth remained high at 44 percent in September 2005, after some deceleration in late 2004 and early 2005. - Banks are refocusing lending toward household-sector loans: share in total loans increased from 5 percent at end-2001 to 20 percent by end-September 2005, including mortgage lending to the buoyant housing market. - Non-performing loans ratio is declining, but remains high. - Directors cautioned against the NBU establishing a long-term credit facility; the NBU’s main role should be to provide liquidity rather than long-term credit. - Directors encouraged authorities to strengthen further the supervisory framework and commended NBU tightening of regulations, including those pertaining to: - foreign-currency loan-loss provisioning, - open foreign currency positions, - limits for related-party lending, - definition of bank capital. - Directors regretted the delay in amending the Banking Act and encouraged short-term measures to shore up the banking system until new legislation is approved—including raising the minimum capital adequacy ratio to 12 percent. - They also encouraged switching from highly procedural supervision to a more risk-based framework and strengthening the bank resolution process. ### Monetary policy and liquidity - Directors stressed that tighter monetary conditions are needed to help contain inflation, while acknowledging limitations of interest rate policy given the absence of a developed monetary transmission mechanism. - They urged the NBU to reduce further excess liquidity in the banking sector through a deceleration in money growth. - Velocity (annual GDP divided by end of period broad money) figures in the Selected Economic Indicators underline monetary dynamics: 4.46 (2001), 3.48 (2002), 2.78 (2003), 2.75 (2004), 2.34 (2005), 2.20 (2006 Proj.). ### Fiscal policy, budget, and public finances - Directors welcomed the authorities’ expressed commitment to fiscal discipline and progress in implementing a sound fiscal policy in 2005, noting prudent budget implementation and that authorities seem broadly on track toward achieving their 2005 general government deficit target. - Relaxation in the fiscal stance during the run-up to the 2004 presidential elections, together with large increases in public pensions and wages in the supplementary 2005 budget, contributed significantly to recent inflationary pressures. - Target: reduced 2005 fiscal deficit of 2½ percent of GDP (noted as targeted). - Directors recommended that the general government deficit not exceed 2¼ percent of GDP in 2006, underpinned by a freeze on recurrent expenditure in real terms and realistic macroeconomic assumptions. - Directors called on the government to allocate the Kryvorizhstal privatization windfall primarily to debt redemptions that do not add to domestic liquidity and to resist pressures to re-open tax loopholes closed in the 2005 budget. - Directors encouraged clearing all legitimate VAT refund arrears. - Directors considered reestablishment of a viable public pension fund a key medium-term priority; noted massive pension hikes have put the pension fund in a precarious financial position, requiring large budget transfers to cover contribution shortfalls. - Pension-related recommendations: improve targeting of the minimum pension subsidy, raise effective retirement ages, prune privileged pension regimes. ### Structural reforms, privatization, and governance - Directors welcomed the authorities’ vision of sweeping structural reforms and urged an aggressive campaign to educate the public on benefits of these reforms. - Emphasized importance of reforms to strengthen public administration, fight corruption, and establish a stable and predictable business environment. - Welcomed the Ukraine-EU Action Plan as an anchor for reforms and closer integration with the EU and global markets. - Encouraged rapid resolution of debate on past privatizations; noted recent presidential memorandum guaranteeing property rights, efforts to identify state enterprises to be privatized, commitment to comply with privatization legislation, and the transparent re-auction of Kryvorizhstal as important steps. - Noted a credible legislative proposal outlining the full scope of possible challenges to past privatizations may still be needed to address lingering investor concerns. ### Trade policy and WTO accession - Directors welcomed the government’s ambitious trade-policy agenda and considered early implementation of remaining measures needed for WTO membership should remain a priority. ### Capital markets, debt management, and statistics - Development of domestic capital markets seen as key to strengthen monetary policy transmission and improve risk management and financial intermediation. - Recommendations: establish benchmarks for government securities, set up a coherent debt management strategy, and swiftly adopt a Joint Stock Company Law. - Directors welcomed progress in improving statistics but noted shortcomings remain: - Stock data on sectoral financial assets and liabilities need reconciliation with flow data, especially on the external side. - Quality of labor market data, particularly on wages and employment, could be improved. ### Fund engagement and program lessons - Directors welcomed the candid Ex Post Assessment (EPA) of Ukraine’s longer-term program engagement with the Fund. - EPA findings: Fund–supported programs were quite effective in supporting macroeconomic stability and policy dialogue influenced important policy decisions and transferred knowledge to Ukrainian policy makers. - Directors noted Fund-supported programs did not succeed in accelerating reform of more market-friendly institutions; stronger program ownership rooted in stronger political consensus would be key for future program success. ### Selected Economic Indicators (exact figures from source) - Nominal GDP (billions of hryvnia): 204.2 (2001), 225.8 (2002), 267.3 (2003), 344.8 (2004), 415.5 (2005), 499.8 (2006 Proj.). - Real GDP growth: 9.2 (2001), 5.2 (2002), 9.6 (2003), 12.1 (2004), 4.0 (2005), 5.5 (2006 Proj.). - Consumer price index (period average): 12.0 (2001), 0.8 (2002), 5.2 (2003), 9.0 (2004), 13.7 (2005), 12.9 (2006 Proj.). - Consumer price index (end of period): 6.1 (2001), -0.6 (2002), 8.2 (2003), 12.3 (2004), 12.0 (2005), 13.0 (2006 Proj.). - Consolidated government budget balance, cash basis: -1.6 (2001), 0.5 (2002), -0.9 (2003), -4.4 (2004), -2.9 (2005), -3.2 (2006 Proj.). - Primary balance: 0.4 (2001), 1.8 (2002), 0.1 (2003), -3.5 (2004), -2.1 (2005), -2.1 (2006 Proj.). - Revenue (percent of GDP): 33.5 (2001), 36.0 (2002), 35.9 (2003), 35.0 (2004), 39.7 (2005), 38.4 (2006 Proj.). - Expenditure (percent of GDP): 35.1 (2001), 35.5 (2002), 36.8 (2003), 39.4 (2004), 42.7 (2005), 41.5 (2006 Proj.). - Public debt and arrears (in percent of GDP): 38.6 (2001), 35.7 (2002), 27.7 (2003), 25.1 (2004), 21.1 (2005), 18.5 (2006 Proj.). - Base money (percent change): 37.4 (2001), 33.6 (2002), 30.1 (2003), 34.1 (2004), 42.1 (2005), 24.5 (2006 Proj.). - Broad money (percent change): 41.9 (2001), 41.8 (2002), 46.5 (2003), 32.3 (2004), 41.0 (2005), 27.9 (2006 Proj.). - Credit to nongovernment (percent change): 40.5 (2001), 47.3 (2002), 63.4 (2003), 31.2 (2004), 49.5 (2005), 28.6 (2006 Proj.). - Current account balance (in percent of GDP): 3.7 (2001), 7.5 (2002), 5.8 (2003), 10.5 (2004), 4.8 (2005), 1.0 (2006 Proj.). - External public debt (in percent of GDP): 26.6 (2001), 24.0 (2002), 21.6 (2003), 19.3 (2004), 15.6 (2005), 12.5 (2006 Proj.). - Debt service (in percent of exports of goods and services): 6.7 (2001), 5.4 (2002), 6.2 (2003), 4.8 (2004), 4.9 (2005), 5.1 (2006 Proj.). - Terms of trade (annual change in percent): 1.3 (2001), 1.6 (2002), 8.6 (2003), 16.4 (2004), -1.4 (2005), -5.5 (2006 Proj.). - Gross reserves (end of period, in months of next year’s imports of goods and services): 1.7 (2001), 1.9 (2002), 2.4 (2003), 2.7 (2004), 4.7 (2005), 4.8 (2006 Proj.). *Sources: Ukrainian authorities; and IMF staff estimates and projections.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05415.pdf_