## _cr0750

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### Executive summary — background and recent developments
- Real GDP growth likely to rebound to 6 percent in 2006, helped by high steel export prices and strong domestic demand.
- Household credit expanded by well over 100 percent (2005–06 period).
- CPI inflation likely to exceed 12 percent in 2006; national savings likely to have dropped by some 8 percent of GDP.
- Ukraine experienced a 65 percent hike in the price of imported natural gas in early-2006; another agreed hike of some 35 percent for 2007.
- Terms-of-trade gains from high steel prices during 2003–05 (cumulative improvement about 20 percent) halted in 2006 as import prices rose.
- Current account moved from a surplus of 10½ percent of GDP in 2004 to a likely deficit of 1 percent of GDP in 2006.
- Foreign-exchange reserves have more than doubled since end-2004 to about 4½ months of imports (end-2006 gross reserves 21,122 millions of U.S. dollars reported).

### Outlook and scenarios
- Baseline projection for 2007:
  - Real GDP growth likely to slow to 4½ percent in 2007.
  - Current-account deficit likely to increase to 4 percent of GDP in 2007.
  - Inflation likely to drop to about 8 percent in 2007 (authorities’ intention not to pass through energy-price increases to consumers).
- Alternative scenarios:
  - Benign external environment: growth could exceed 7 percent with higher steel prices and FDI, but inflation control could be difficult under a de facto peg.
  - Adverse external outlook: under a peg, external sustainability problems could emerge.

### Key macroeconomic vulnerabilities and risks
- Exchange-rate regime: monetary policy anchored by a de facto peg (NBU allowed interbank exchange rate to fluctuate within Hrv/US$5.00-5.06), raising risks under external volatility.
- External risks: further hikes in import prices for gas and potential declines in steel export prices could materially worsen terms of trade and external balances.
- Financial sector risks:
  - Long-standing credit boom: real credit growth of about 40 percent annually since 2001; credit-to-GDP ratio reached 44.8 (Sep-06).
  - Overall corporate sector debt—two thirds in foreign currency—now exceeds 50 percent of GDP.
  - Substantial indirect foreign-currency risk because most borrowers are unhedged; rising foreign-currency liquidity risk from short-term foreign funding.
  - Declining capital-adequacy ratios: regulatory capital to risk-weighted assets fell to 13.9 percent (Sep-06); capital to total assets 11.2 percent (Sep-06).
- Fiscal risks:
  - Authorities intend a fiscal deficit target of about 2½ percent of GDP over the medium term, but planned 2007 policies expand subsidies and tax preferences, raising concern.
  - Contingent liabilities remain high at some 30 percent of GDP (lost-savings and implicit state-enterprise liabilities).
- Structural constraints: insecure property rights, corruption, restrictive regulation; underdeveloped financial markets.

### Policy recommendations — macroeconomic and monetary framework
- Core staff recommendation: accelerate the transition to a more flexible exchange rate to improve inflation control and insulate the economy from adverse external shocks.
- Recommended policy package (to be implemented together):
  - Full pass-through of higher energy import prices to producers and consumers (staff recommended; authorities’ policies allowed pass-through to industry but zero pass-through to consumers).
  - Shift to a monetary framework based on a more flexible exchange-rate regime (allow exchange rate to move within Hrv/US$4.95-5.25 corridor and gradually widen over time).
  - Restrain second-round inflation effects through an appropriately tight monetary stance (staff viewed NBU’s envisaged broad money growth of 28-33 percent for 2007 as too loose).
- Operational steps urged:
  - NBU introduce a short-term policy rate, prepare for inflation targeting, and be granted a clearer mandate to pursue price stability.
  - Government support financial-market development, including eliminating the foreign-exchange transaction tax and issuing benchmark securities.

### Fiscal policy — assessment and 2007 concerns
- Strengths:
  - Achieved low fiscal-deficit targets; explicit public debt reduced to about 16.8 percent of GDP in 2006 (public sector gross debt series: 2004: 25.5; 2005: 19.4; 2006: 16.8).
  - Authorities intend to target a fiscal deficit of about 2½ percent of GDP.
- Concerns:
  - Adopted 2007 budget projected nominal recurrent spending to rise by some 15 percent, leaving recurrent spending ratio well above 40 percent of GDP.
  - Achieving 2007 fiscal target just below 3 percent of GDP could be challenging; staff estimated some 1¼ percent of GDP of measures might be needed under their baseline.
  - Quasi-fiscal cost of freezing consumer energy prices in 2007 could be about ½ percent of GDP.
- Public finances (selected exact figures):
  - Revenue (Hrv millions): 2004: 120,944; 2005: 175,236; 2006 (Budget/Proj.): 212,931 / 217,518; 2007 (authorities): 241,830; 2007 (staff): 250,124.
  - Expenditure (Hrv millions): 2004: 136,148; 2005: 185,266; 2006 (Budget/Proj.): 229,040 / 229,622; 2007 (authorities): 258,492; 2007 (staff): 267,609.
  - Overall balance (cash basis; percent of GDP): 2004: -4.4 percent; 2005: -2.4 percent; 2006 (Budget/Proj.): -3.1 percent / -2.4 percent; 2007 (authorities): -2.9 percent; 2007 (staff projected): -2.5 percent.
  - Nominal GDP (Hrv millions): 345,113 (2004), 424,741 (2005), 512,300 / 505,409 (2006), 594,100 (2007 authorities and staff).

### Banking-sector safeguards and recommended measures
- Immediate vulnerabilities:
  - High credit concentration; heavy reliance on collateral that may be overvalued and hard to repossess.
  - Sensitivity analysis (foreign-currency-induced credit risk): a 20 percent depreciation assumed to increase nonperforming loans by 30 percent and require additional provisions of 15 percent of foreign-currency loans; such a shock would push the banking sector’s capital-to-asset ratio from 12 to 6.5 percent (13 of the largest 15 banks would fall below that level). A 5 percent depreciation would leave the capital-to-asset ratio close to 10 percent.
- Measures already taken by NBU:
  - Enhanced risk-management plans; tightened regulations; raised minimum-capital requirements; differentiated reserve ratios by currency; higher provisioning for unhedged FX borrowers; legal changes to improve transparency.
- Further recommended measures:
  - Short term: public information campaigns on exchange-rate risks; NBU guidelines on FX risk management and mortgage lending; set upper limits on debt service-to-income and loan-to-value ratios; enforce stricter collateral valuation.
  - Medium term: move toward risk-based supervision with bank-specific capital requirements; raise minimum capital-adequacy ratio from 10 to 12 percent (staff recommendation).
  - Legal/safety-net: amend NBU Law to allow suspension of early deposit withdrawals in times of crisis.
- Staff view: increases in provisions and in minimum capital-adequacy ratio are the first line of defense; administrative curbs on FX lending need careful monitoring to prevent regulatory arbitrage.

### Structural reforms and medium-term growth strategy
- Core objective: raise lagging living standards and close gap with more advanced transition peers.
- Binding constraints: insecure property rights, corruption, weak corporate governance, judicial weaknesses, restrictive regulations, and underdeveloped financial markets.
- Recommended reform priorities:
  - WTO accession and complementary behind-the-border reforms.
  - Adopt Joint Stock Company Law and Limited Liability Company Law; adopt International Accounting Standards for large corporates.
  - Lift the moratorium on agricultural land resale; remove restrictions on non-agricultural land ownership.
  - Reform the court system and re-launch transparent privatization.
  - Reform pensions: broaden social contribution base, raise retirement ages, tighten eligibility, and build a funded second-pillar system.
- Staff cautions:
  - Avoid new sectoral subsidies and selective tax relief that distort resource allocation.
  - If reinstating FEZ preferences, apply best-practice limits and fraud-containment measures.

### Data, surveillance, and IMF relations
- Data quality: official statistics broadly adequate for surveillance but important shortcomings remain (quarterly price indices for exports/imports unsuitable; need better data on trade prices, state-owned enterprises, and sectoral financial flows and stocks).
- IMF relations and financial arrangements:
  - Membership: Joined 09/03/1992; Article VIII.
  - Quota: SDR 1,372.00.
  - Extended arrangements outstanding: 594.78 SDR million (43.35 percent of quota).
  - Projected payments to Fund (SDR million, selected): Principal 2006: 42.90; 2007: 278.98; 2008: 215.62; 2009: 57.28.

### Selected exact indicators and projections (preserved)
- GDP growth: 6 percent in 2006 (likely); 4½ percent projected for 2007.
- CPI inflation: likely to exceed 12 percent in 2006; projected about 8 percent in 2007 under authorities’ intention not to pass through; staff recommended policies project 10.6 (end of period) for 2007 in one table and period-average Staff Recommended Policies: 13.6 (see tables).
- Current-account balance (percent of GDP): 2004: 10.5; 2005: 3.1; 2006: -1.0; 2007 (Proj.): -3.9 (authorities’ medium-term table); external memorandum series show further deterioration to -8.5 by 2011 under authorities’ projections.
- Natural gas price changes: 65 percent hike in early-2006; another agreed hike of some 35 percent for 2007.
- National savings: likely to have dropped by some 8 percent of GDP.
- Household credit growth: well over 100 percent (2005–06 period).
- Foreign-exchange reserves (gross): 2006 (30-Nov-06): 21,122 (millions of U.S. dollars); projections: 2007: 23,494; 2008: 22,903; 2009: 20,334; 2010: 16,954; 2011: 14,316.
- Public sector gross debt (percent of GDP): 2006: 16.8; 2007 (authorities): 15.5; staff recommended 2007: 14.6.
- External debt (percent of GDP, baseline DSA): 2006: 48.3; 2007: 49.4; 2011: 55.6.
- Gross external financing need (US$ billions and percent of GDP): 2006: US$15.3 (15.3 percent); 2007: US$20.5 (18.4 percent); 2011: US$33.8 (20.9 percent).
- Financial-sector indicators (selected, exact series where reported):
  - Credit growth (y-o-y): 63.5 (Sep-06); 62.9 (Jun-06); 62.8 (Mar-06); 61.5 (Dec-05).
  - Loans in foreign currency to total loans: 45.0 (Sep-06).
  - Regulatory capital to risk-weighted assets: 13.9 percent (Sep-06).
  - Capital to total assets: 11.2 percent (Sep-06).
  - NPLs to total loans (broad): 17.9 percent (Sep-06).
  - Return on equity (after tax): 14.0 (Sep-06).

### Executive Board and post-report updates (selected)
- Preliminary below-the-line data for 2006: general government cash deficit may have reached only 11⁄4 percent of GDP (compared with 23⁄4 percent projected in staff report).
- End-year CPI inflation contained at 11.6 percent, undershooting staff forecast of 12.5 percent.
- End-2006 gross reserves reached 21.1 (billions of U.S. dollars) in the Selected Economic and Social Indicators table.
- Executive Directors recommended gradual move toward greater exchange rate flexibility, preparatory steps toward inflation targeting, fiscal restraint (general government deficit close to 2½ percent of GDP), and urgent pension reform.

*Executive Summary and selected excerpts, IMF staff report (cr0750).*

### Executive Summary ......................................................................................................

### Executive Summary

### Background and recent developments
- GDP growth is likely to rebound to 6 percent in 2006, helped by high steel export prices and strong domestic demand.
- Domestic demand has been underpinned by rapid income growth and reinforced by a credit boom; household credit expanded by well over 100 percent.
- With domestic price pressures significant and rising prices for energy imports, CPI inflation will likely exceed 12 percent in 2006.
- National savings are likely to have dropped by some 8 percent of GDP due to a fiscal-policy-driven consumption boom and rapidly expanding household credit.
- Ukraine experienced a 65 percent hike in the price of imported natural gas in early-2006; another price hike of some 35 percent has been agreed for 2007.
- Terms-of-trade gains from high steel prices during 2003–05 (cumulative improvement about 20 percent) came to an abrupt halt in 2006 as import prices rose.
- The current account shifted from a surplus of 10½ percent of GDP in 2004 to a likely deficit of 1 percent of GDP in 2006.
- Capital inflows, notably FDI, have picked up; foreign-exchange reserves have more than doubled since end-2004 to about 4½ months of imports and are projected to exceed the level of short-term external debt at end-2006.
- Ukraine remains one of the most inefficient users of energy and is a heavy net energy importer; energy trade deficits are among the highest in transition economies.

### Outlook and scenarios
- Baseline projection for 2007:
  - Real GDP growth likely to slow to 4½ percent in 2007.
  - Current-account deficit likely to increase further to 4 percent of GDP in 2007 as import prices for natural gas continue to edge up.
  - Inflation likely to drop to about 8 percent in 2007, given the authorities’ intention not to continue pass-through of energy-price increases to consumers.
- Alternative scenarios:
  - Benign external environment: even higher steel prices and FDI could produce growth in excess of 7 percent; however, inflation could prove hard to control under a de facto peg.
  - Adverse external outlook: under a peg, external sustainability problems could emerge.

### Key macroeconomic vulnerabilities and risks
- Exchange-rate regime: monetary policy has been anchored by a de facto peg; this raises risks given external volatility.
- External risks: further hikes in import prices for gas and potential declines in steel export prices could materially worsen the terms of trade and external balances.
- Financial sector: long-standing credit boom, increasing foreign-currency lending to unhedged borrowers, and heavy external private-sector borrowing have raised banking-sector vulnerabilities.
- Fiscal risks: while the authorities intend to target a fiscal deficit of about 2½ percent of GDP over the medium term, planned policies for 2007 include an expansion in subsidies and tax preferences that raise concern.
- Structural constraints: binding constraints on long-term growth include insecure property rights, corruption, and restrictive regulation; financial markets remain underdeveloped.

### Policy discussions and staff recommendations
- Monetary framework:
  - Authorities’ stance: a very gradual transition to a more flexible exchange rate regime, reflecting a sanguine external view and concerns about abandoning the de facto peg.
  - Staff recommendation: accelerate the transition to a more flexible exchange rate to deliver better inflation control and insulate the economy against adverse external developments.
- Financial-sector policies:
  - Shared diagnosis: credit boom and heavy external borrowing have raised vulnerabilities, particularly from foreign-exchange lending to unhedged borrowers.
  - Staff recommendations: strengthen the regulatory framework and implement a temporary increase in the capital-adequacy ratio.
- Fiscal policy:
  - Authorities’ plan: target a fiscal deficit of about 2½ percent of GDP while reducing both recurrent spending and taxes over the medium term.
  - Staff assessment: the framework is appropriate from a debt sustainability and policy-mix perspective, but specific 2007 policies (tilt toward expanding subsidies and tax preferences) raise concerns.
  - Past performance: in 2005, the authorities met the recommended cash deficit target of 2½ percent of GDP; in 2006 they targeted a higher deficit than recommended (3¼ versus 2¼ percent of GDP) but may undershoot the original target.
- Structural reforms to accelerate growth:
  - Authorities’ emphasis: spurring investment spending to boost growth.
  - Staff view: while higher investment is important, the binding bottlenecks are insecure property rights, corruption, and a regulatory jungle—deficiencies also reflected in underdeveloped financial markets.
  - Progress and implementation: implementation of IMF advice has been slow or uneven, particularly on structural issues; political polarization and preference for gradualism have constrained reforms.

### Selected exact statistics and indicators (as reported)
- GDP growth: 6 percent in 2006 (likely); 4½ percent projected for 2007.
- CPI inflation: likely to exceed 12 percent in 2006; projected about 8 percent in 2007.
- Current-account balance: surplus of 10½ percent of GDP in 2004; likely deficit of 1 percent of GDP in 2006; projected deficit of 4 percent of GDP in 2007.
- Natural gas price changes: 65 percent hike in early-2006; another agreed hike of some 35 percent for 2007.
- National savings: likely to have dropped by some 8 percent of GDP.
- Household credit growth: well over 100 percent (2005–06 period).
- Foreign-exchange reserves: more than doubled since end-2004 to about 4½ months of imports.
- Fiscal targets and outcomes: 2005 cash deficit met at 2½ percent of GDP; 2006 target set at 3¼ percent of GDP (authorities) versus staff recommendation of 2¼ percent of GDP; medium-term target intended at about 2½ percent of GDP.

*Executive Summary, IMF staff report (cr0750).*

### 7.      The hryvnia’s real undervaluation has narrowed considerably. Staff work

### 7.      The hryvnia’s real undervaluation has narrowed considerably. Staff work

### Real exchange rate and external competitiveness
- Staff re-assessment using the IMF’s macroeconomic-balance approach points to a much reduced gap between Ukraine’s actual and estimated equilibrium current account.
- The analysis suggests a real effective exchange rate undervaluation of between 3 and 15 percent.
- Alternative approaches based on purchasing-power-parity and dollar-wage comparisons across countries are broadly consistent with the 3 to 15 percent assessment.
- These approaches also indicate that Ukraine’s real effective exchange rate should be expected to appreciate substantially over the longer term as its per capita income catches up with more advanced economies.
- Figure indicators noted:
  - Real effective exchange rates (1995=100) series shown for CPI-based, PPI-based, Unit labor cost-based, GDP deflator-based (1995–2006).
  - The gap between actual and equilibrium current-account balance narrowed sharply by 2005–2006 (Actual current-account balance and Equilibrium current-account balance 1/ shown in percent of GDP, 1995–2006 Proj.).

### Fiscal policy: achievements and emerging pressures
- The authorities have hit low fiscal deficit targets and explicit public debt has plunged.
  - General government cash deficit target of 2½ percent of GDP in 2005 was easily met.
  - Through November 2006, authorities seemed on track to undershoot the 3 percent of GDP annual deficit target.
  - Explicit public debt reduced to about 17 percent of GDP, down from over 60 percent in 1999.
- Contingent liabilities remain high at some 30 percent of GDP, largely reflecting the so-called lost-savings deposits and implicit contingent liabilities of state enterprises.
- Redistributionist shift in fiscal policy in 2005:
  - Average public wages and pensions were raised by over 50 percent (against an inflation target of just under 10 percent).
  - Pension spending commitments rose from 12 percent of GDP in 2004 to about 17 percent in 2005.
  - To finance recurrent-spending increases while reducing the fiscal deficit, the government:
    - Curtailed capital spending by some 1¾ percent of GDP.
    - Raised tax collections by some 6 percent of GDP (especially through canceling tax breaks for the free economic zones (FEZs) and administrative improvements).
  - The 2006 budget largely preserved these policy thrusts.
- Figure indicators noted:
  - Recurrent spending and revenue as percent of GDP for 2004, 2005, 2006 Proj.
  - Pension spending-to-GDP ratio (2004, 2005) highlighted as likely the world’s highest.
  - Public debt and contingent liabilities time series (1999–2006 Proj.).

### Lost-savings contingent liability (Box 2)
- Lost-savings deposits recognized as a government liability in 1996 amounted then to about 160 percent of GDP.
- Law requires a minimum annual repayment of about 0.1 percent of GDP; because the liability was neither indexed nor paid interest, it shrank to some 24 percent of GDP.
- Several repayment proposals could significantly increase fiscal cost if implemented.
- Table of Net Present Value of Lost Savings Repayment Proposals (in percent of GDP) shown with entries:
  - Status quo: Net Present Value 0.9; Maximum Annual Payment 0.1; Completion Date 2250
  - Parliament (2002): Net Present Value 23.0; Maximum Annual Payment 2.9; Completion Date 2014
  - Parliament (2005): Net Present Value 15.3; Maximum Annual Payment 1.4; Completion Date 2015
  - President (2005): Net Present Value 3.7 or 5.5; Maximum Annual Payment 0.2; Completion Date 2043 or 2028
- Calculation assumptions: real GDP growth of 5 percent, nominal GDP growth of 11 percent, and a nominal interest rate of 12 percent.

### Monetary framework and exchange-rate regime
- The monetary framework has remained anchored by a de facto peg.
- The NBU allowed the interbank exchange rate to fluctuate within a narrow band of Hrv/US$5.00-5.06; the exchange-rate regime remained a de facto peg.
- Base money growth has been mostly driven by foreign-exchange interventions and changes in the government’s deposits at the NBU.
- During most of 2006, NBU monetary reactions implied an automatic tightening of its stance, only partly offset by lower reserve requirements and a cut in NBU interest rates.
- More recently, monetary conditions loosened, reflecting a pickup in foreign-reserve accumulation and drawdown of government deposits.
- Real short-term interest rates have remained highly negative throughout the period.
- Figure indicators noted:
  - NBU exchange market interventions (US$ millions), interbank and official Hrv/US$ exchange rates, cumulative contributions to base money growth (Billions of hryvnias), base money and broad money percent change (y-o-y), banks' excess reserves (percent of deposits), real overnight interbank money market rate (Percent; monthly average).

### Banking sector risks and credit boom
- Long-lasting credit boom increased balance-sheet vulnerabilities of banks and borrowers.
  - Real credit growth of about 40 percent annually since 2001.
  - Ukraine’s domestic credit boom among the fastest in transition economies.
- Corporates and banks have continued to borrow heavily abroad.
  - Overall corporate sector debt—two thirds of which is in foreign currency—now exceeds 50 percent of GDP.
- Household sector debt, mostly in foreign currency, surged over the past 18 months (from a low level).
- Resulting risks:
  - Substantial indirect foreign-currency risk for banks because most borrowers are unhedged.
  - Rising foreign-currency liquidity risk due to increased reliance on short-term foreign funding.
  - Declining capital-adequacy ratios and other financial soundness indicators suggest the sector remains vulnerable to downside risks.
- Figure indicators noted:
  - Credit growth (Percent change; y-o-y), household loans to total loans (Percent), household loans in foreign currency (2005; Percent of total household loans), corporate debt (Percent of GDP, 2005), banks' net foreign assets (Percent of bank capital), share of foreign banks (Percent of total bank capital).

### Financial market development
- Financial markets remain heavily underdeveloped.
  - Equity-market capitalization relatively high but daily turnover miniscule and prices move in lockstep.
  - Government-securities market illiquid and shallow; between August 2005 and October 2006 no significant primary issuances took place.
  - Foreign-exchange market size and liquidity constrained by the de facto peg and a sizeable tax on non-cash foreign-exchange transactions.
- Figure indicators noted:
  - Trading activity at the PFTS (Annual turnover Percent of GDP; Daily turnover Millions of US$), stock of government securities (Percent of GDP), annual turnover on foreign-exchange markets (Percent of GDP), equity market capitalization (Percent of GDP).

### Macroeconomic outlook, scenarios, and policy implications
- External environment characterized by high uncertainty:
  - Natural gas prices expected to rise further toward Western European levels over the medium term, adversely affecting growth, inflation, and the current account.
  - Steel export prices surrounded by large margins of uncertainty; some expect increases, others expect declines.
  - Uncertainty about capital flows and FDI responses to shocks and policies.
- Authorities’ view (more favorable):
  - Expected sharply higher export prices for steel, falling non-energy import prices, and strong capital inflows.
  - Planned reversal of budgetary policies that cut national savings: restrain public wages and transfers to reduce consumption growth.
  - Intended to raise public-sector investment, particularly in the energy sector.
  - Expected FDI inflows to be buoyant and growth robust in the 6–7 percent range.
  - Expected CPI inflation to be brought down and kept in single digits via a stable nominal exchange rate, management of supplies, and administered price restraint.
- Staff analysis and risks:
  - Under staff’s external baseline, CPI inflation could drop to just over 8 percent in 2007, since authorities do not intend to pass through higher energy prices to consumers.
  - Over the medium term, negative external shocks combined with a pegged nominal exchange rate could lead to currency overvaluation, rising current-account deficits, falling international reserves, and an environment unfavorable to buoyant capital inflows and strong growth.
  - Risks to external-debt sustainability: gross external debt would rise with increasing current-account deficits and could reach uncomfortably high levels under adverse shocks.
  - Public debt sustainability would be maintained under baseline, but large-scale realization of contingent liabilities could ratchet it up considerably.
  - Under a benign external outlook and the authorities’ likely policies—including a maintained peg—the currency would likely remain undervalued; past monetary-policy behavior under the peg suggests authorities might not sterilize large foreign-exchange interventions, so monetary expansion could lead to medium-term inflationary pressure regardless of administrative price restraints.

*IMF staff report (excerpts).*

### 18.      More robust policies would therefore be needed to forestall medium-term

### _cr0750 - 18.      More robust policies would therefore be needed to forestall medium-term

### Macro policy package and projected outcomes
- Staff view: authorities’ fiscal framework and incomes-policy intentions are broadly appropriate but need complementing policies on energy-price pass-through, exchange-rate flexibility, and monetary tightness.
- Recommended policy package (to be implemented together):
  - Full pass-through of higher energy import prices to producers and consumers.
  - Shift to a monetary framework based on a more flexible exchange-rate regime.
  - Restrain second-round inflation effects of higher energy prices through an appropriately tight monetary stance.
- Projected macro outcomes under recommended policies and baseline external outlook:
  - Current-account deficits could be contained at some 5 percent of GDP.
  - Temporary increase in CPI inflation pushing inflation to 10½ percent by end-2007 (owing to continued energy-price pass-through to consumers).
  - Recommended policies would help contain second-round impacts and lower inflation to about 5 percent in the medium term.
  - Growth could moderate to 4½ percent in 2007, and return to some 5½ percent in the medium term.
- Benign external outlook effects under recommended policies:
  - Near-term adverse effects from the energy-price shock (higher inflation and lower growth).
  - Strong FDI would lift medium-term growth and exports.
  - A more flexible exchange rate would allow the NBU to counteract the inflationary impact of balance-of-payments inflows.

### Monetary framework: exchange-rate flexibility and monetary stance
- Central recommendation: a more flexible exchange-rate regime should be the centerpiece of a more robust policy framework.
- Rationale:
  - Ukraine is vulnerable to large terms-of-trade fluctuations and shifts in capital flows.
  - Maintaining a peg would likely impose large burdens on fiscal and incomes policies and hamper low and stable inflation.
- Authorities’ position:
  - NBU agreed in principle with benefits of greater flexibility but saw risks: undermining trust in the currency, distributional conflicts, adverse balance-sheet effects, and limited effectiveness of monetary policy due to underdeveloped financial markets.
  - Preparations toward inflation targeting to continue; no significant nominal exchange-rate fluctuations foreseen for the next few years (authorities’ view).
- Staff recommendation on timing and path:
  - Allow the exchange rate to move within the Hrv/US$4.95-5.25 corridor announced in the NBU’s 2007 Monetary Policy Guidelines for 2007.
  - Gradually widen the exchange-rate corridor over time.
- Complementary operational steps urged for swifter action:
  - NBU should introduce a short-term policy rate for monetary operations and proceed with technical preparations for inflation targeting.
  - Government should provide the NBU with a clearer mandate to pursue price stability as its primary objective (sign a joint Memorandum of Understanding; amend the NBU Law ultimately).
  - Government should more actively support financial-market development, including eliminating the foreign-exchange transaction tax and relying more on domestic borrowing and issuing benchmark securities (authorities cited fiscal-cost considerations and shallow domestic markets as reasons to phase out the tax gradually).
- Views on monetary proactiveness and liquidity:
  - Government’s inflation objective: 7½ percent for end-2007, implying an estimated disinflation of 4½ percentage points relative to end-2006.
  - Agreement that if energy price hikes are passed through to consumers, first-round effects should be accommodated.
  - NBU envisaged broad money growth in the range of 28-33 percent for 2007.
  - Staff viewed current monetary conditions as too loose (noting substantial excess liquidity and highly negative short-term interest rates) and argued for tighter liquidity to slow broad money growth significantly below the NBU’s envisaged range.

### Banking-sector vulnerabilities and recommended safeguards
- Key risks:
  - Rising macroeconomic imbalances causing large capital outflows could produce an overshooting exchange rate and severely impact borrowers’ repayment ability.
  - Stress tests suggest cushions in some banks might be insufficient under such shocks.
  - High credit concentration and heavy reliance on collateral (which may be overvalued and hard to repossess) could accentuate shocks.
  - Rating agencies rate many banks far-below investment grade.
- Measures already taken by the NBU:
  - Enhanced risk-management plans; tightened banking regulations.
  - Strengthened quality standards for bank capital; raised minimum-capital requirements.
  - Differentiated required reserve ratios by currency.
  - Introduced higher provisioning ratios for unhedged borrowers in foreign exchange.
  - Legal changes requiring transformation of banks into open joint-stock companies to improve transparency.
- Further recommended measures:
  - Short term:
    - Raise public awareness of exchange-rate risks via information campaigns.
    - Issue NBU guidelines on foreign-exchange risk management and mortgage lending.
    - Set upper limits on debt service-to-income and loan-to-value ratios for mortgage loans.
    - Enforce stricter collateral valuation rules.
  - Medium term:
    - Move toward more risk-based supervision with bank-specific capital requirements better matched to bank-specific risks.
    - Raise the minimum capital-adequacy ratio from 10 to a more prudent 12 percent (staff recommendation).
  - Legal/safety-net measure:
    - Adopt amendments to the NBU Law allowing authorities to suspend early deposit withdrawals in times of crisis to address heightened liquidity risks.
- Sensitivity analysis (foreign-currency-induced credit risk):
  - Assumptions: a 20 percent depreciation of the hryvnia would increase nonperforming loans by 30 percent, requiring additional provisions of 15 percent of foreign-currency loans.
  - Effects:
    - Such a shock would push the banking sector’s capital-to-asset ratio from a current 12 to 6.5 percent (13 of the largest 15 banks would fall below that level).
    - A 5 percent depreciation would leave the capital-to-asset ratio close to 10 percent.
  - Chart indicators: additional capital needs measured as percent of GDP; capital injection needed to maintain 10 percent CAR.

### Fiscal framework: strengths, risks, and 2007 budget concerns
- Strengths of authorities’ fiscal framework:
  - Intent to target a fiscal deficit of about 2½ percent of GDP over the medium term.
  - Achieving that target would stabilize explicit public debt at 10–15 percent of GDP.
  - Authorities intend to reduce recurrent spending and taxes over the medium term; incomes policy restraint (public wage bill increase in 2007 limited to 6½ percent) could assist monetary transition and competitiveness.
- Risks and weaknesses:
  - If the exchange-rate peg remains and adverse external conditions materialize, the fiscal-deficit target could prove too loose for maintaining external and internal balance.
  - State-enterprise sector management needs considerable improvement: loosely monitored, a significant drain on the budget, and a source of quasi-fiscal activity; rising energy-import prices could worsen state-enterprise balance sheets.
- Specific issues with 2007 fiscal plans adopted by parliament:
  - Achieving the 2007 fiscal target of just below 3 percent of GDP could be challenging; under staff’s baseline, revenues would be lower, and some 1¼ percent of GDP of measures might be needed to compensate.
  - Measures, if needed, should focus on reductions in recurrent spending: the adopted 2007 budget projected nominal recurrent spending to rise by some 15 percent, leaving the recurrent spending ratio well above 40 percent of GDP (at odds with the fiscal framework intentions).
  - The intention to pass through higher energy-import prices to producers but not to consumers in 2007 could have a quasi-fiscal cost of about ½ percent of GDP (even accounting for availability of cheaper domestically-produced gas).
    - Authorities’ rationale: freeze on pass-through to consumers warranted due to large 2006 price hikes, concerns about payment discipline, and additional fiscal cost as more lower-income households become eligible for cost subsidies.
    - Mitigating factors: large recent real wage and pension increases and an existing differentiated tariff scheme to protect small users.
    - Staff recommendation: give more independence to the energy regulator to set prices in line with cost to dilute political imperatives.

### Structural reforms and medium-term growth strategy
- Core objective: raise lagging living standards and close the gap with more advanced transition peers.
- Diagnosis:
  - Ukraine’s relatively low per capita income reflects highly inefficient use of available real and human resources.
  - Demographics: UN projects Ukraine’s population to shrink by almost half by 2050, and the old-age dependency ratio to more than double — adding urgency to structural reform.
- Authorities’ stated strategy:
  - Use savings from tight incomes and transfer policies to fund higher sectoral subsidies, significantly higher public investment, and tax relief.
  - Initial tax relief to be selective (restored tax breaks in FEZs), medium-term reductions in corporate and VAT rates.
  - Expected effects: ratchet up investment- and savings-GDP ratios, consistent with large future current-account surpluses.
- Staff cautions and reform priorities:
  - Avoid new sectoral subsidies and selective tax relief that inhibit resource flows to productive uses and raise fiscal-revenue risks.
  - If FEZ tax preferences are used, subject zones to best international practices with limited indirect tax relief and fraud-containment measures.
  - Sustainably reduce recurrent expenditures by:
    - Curtailing the high public-wage bill.
    - Tackling large pension-fund imbalances through a reform plan focusing on broadening the social contribution base, raising retirement ages, tightening pension eligibility, and building a funded second-pillar system (which could also boost financial-market development).

*Source: IMF staff report text (selected extracts).*

### 34.      Improving the investment climate would also be indispensable for unlocking

### 34.      Improving the investment climate would also be indispensable for unlocking

### Investment climate and institutional constraints
- Ukraine exhibits a large efficiency gap in using available resources explained by weak market-supporting institutions, proxied by variables capturing security of property rights, corruption, and regulatory quality.
- The World Bank’s Doing Business survey continues to rank Ukraine’s investment climate near the bottom among transition economies.
- Weak corporate governance and uncertain minority-shareholder rights have crippled stock markets; lagging financial-market development is a symptom of weak market-supporting institutions.
- Staff view private investors’ difficulties to appropriate returns on investments as a binding bottleneck on Ukraine’s growth.

### Structural reform progress and retrograde steps
- Notable progress since 2005:
  - Eliminated tax preferences, including in Free Economic Zones.
  - Reviewed over 9,000 business regulations and repealed and amended nearly 5,000.
  - Conducted a fully transparent re-privatization auction of a large steel mill (Kryvorizhstal).
- Key outstanding reforms (selected):
  - Abolish anachronistic Economic Code and improve the market-oriented Civil Code.
  - Adopt Joint Stock Company Law and Limited Liability Company Law.
  - Adopt International Accounting Standards for large corporates.
  - Lift the moratorium for the resale of agricultural land; remove current restrictions in Land Code on non-agricultural land ownership.
  - Implement reform of the court system to ensure independence and impartiality.
  - Re-launch transparent privatization program.
- Recent retrograde measures staff recommended reversing:
  - Introduction of restrictions on grain export.
  - Renewed withholding of VAT refunds; staff recalled long-standing Fund advice to address VAT-related fraud via fundamental tax-administration reform rather than ad-hoc measures.

### International integration, WTO accession, and capital-account approach
- Authorities aim to leverage international integration to raise growth; necessary legal steps for WTO accession likely to be in place by year-end.
- WTO accession would open the way for deeper integration, including free trade with the EU.
- Staff welcomed ambitious WTO accession commitments but stressed that complementary behind-the-border reforms are crucial to reap growth benefits from trade liberalization.
- Authorities remain cautious on capital-account liberalization; staff view this as appropriate given banking-sector stability concerns and the unsettled monetary framework.
- Short-term planned liberalization measure: extend the repatriation requirement for export proceeds from 90 to 180 days.

### Staff appraisal: macroeconomic stance, risks, and vulnerabilities
- Recent macro developments and strengths:
  - Growth returned to near trend; CPI inflation moderated through most of 2006.
  - Current account is close to balance after several years of large surpluses.
  - Foreign-exchange reserves at a comfortable level; the hryvnia’s previously large margin of undervaluation has narrowed considerably.
  - Authorities achieved fiscal-deficit targets; explicit public debt has fallen to low levels.
- Short-term and external risks:
  - Surging prices for energy amount to a negative productivity shock.
  - Authorities passed through energy-import price hikes in 2006 despite short-run inflationary impact.
  - Prices for imported natural gas seem set to continue to approach Western European levels.
  - Uncertainties related to prospects for steel prices and capital flows.
- Longer-standing challenges:
  - Lagging in adopting market-friendly institutions limits potential income given available human and real resources.
  - Present monetary framework, anchored by a de facto peg, likely to face increasing difficulties in maintaining internal and external balance given Ukraine’s volatile macroeconomic environment.
  - Financial dollarization remains high; long-lasting credit boom and heavy external borrowing by banks and corporates have created balance-sheet mismatches and increased banking-sector stability concerns.

### Policy package and recommendations
- Short- and medium-term policy mix recommended:
  - Allow continued pass-through of higher energy prices to consumers.
  - Introduce a more flexible exchange rate.
  - Tighten income policies and restrain monetary and fiscal policies to maintain external and internal balance regardless of external shocks.
  - Strengthen the banking sector’s ability to cope with adverse shocks.
  - Accelerate structural reforms and reverse the recent shift to a consumption-oriented budget structure to boost underlying growth.
- Fiscal policy guidance:
  - Authorities’ intention to target a general government deficit close to 2½ percent of GDP and to reverse the recent surge in recurrent spending over the medium term fits policy requirements.
  - The adopted 2007 budget represented a lost opportunity to contain recurrent spending and appears based on overly optimistic macro assumptions.
  - Undertakings to hike sectoral subsidies and to reopen, partially, tax breaks in free economic zones are inappropriate and risk a slippery slope.
  - Authorities should continue allowing full pass-through of energy prices in 2007 and beyond to raise energy efficiency and avoid quasi-fiscal deficits in the energy sector.
  - Social groups vulnerable to energy price increases should be protected using targeted support.
- Exchange rate and monetary policy:
  - A more flexible exchange rate would better facilitate external price adjustment and help control inflation.
  - Withdrawing the de facto exchange rate guarantee would help stem financial dollarization and provide scope for developing hedging markets.
  - Preparatory steps by the NBU toward introducing inflation targeting are welcome; authorities should accelerate the transition beyond the presently envisaged very gradual pace.
  - Government should support the transition by eliminating the foreign-exchange transactions tax and pursuing a deficit-financing strategy more focused on developing domestic securities markets.
- Banking-sector measures:
  - Rising balance-sheet vulnerabilities, particularly from foreign-exchange lending, call for more proactive regulation and supervision.
  - NBU’s recent steps to improve regulatory and supervisory safeguards are welcome.
  - Over the medium term, better match bank-specific capital requirements and risk management with bank-specific risks.
  - Recommend increasing the minimum capital-adequacy ratio from 10 to 12 percent as an additional safeguard until risk-management practices improve.
  - Envisaged update of the FSAP in 2007 would provide an opportunity to extend and deepen diagnosis of financial sector vulnerabilities.
- Structural reform priorities reiterated:
  - WTO accession.
  - Adopt legislation to strengthen investor rights and remove legal inconsistencies between laws.
  - Reactivate a transparent and fair privatization process.
  - Reform the energy sector to boost efficiency and transparency.
  - Reverse retrograde steps such as restrictions on grain exports.

### Data and surveillance
- Official statistics are broadly adequate for surveillance, but better data are needed to gauge external and financial vulnerabilities.
- Important to compile and disseminate better-quality data on trade prices, the state-owned enterprise sector, and sectoral financial flows and stocks.

### Selected key figures and projections (as reported)
- Authorities’ intended general government deficit target: close to 2½ percent of GDP.
- Recommended fiscal-deficit target (staff): 2.5 percent.
- Adopted 2007 budget criticized as inconsistent with containing recurrent spending.
- Consumer prices (period average) reported for 2006: 9.1; for 2007 (Proj. Authorities' Policies): 12.9; Staff Recommended Policies: 13.6.
- Consumer prices (end of period) reported for 2006: 12.5; for 2007 (Proj. Authorities' Policies): 8.2; Staff Recommended Policies: 10.6.
- Public debt (percent of GDP) reported for 2006: 16.8; 2007 (Proj.): 16.2; 2007 (Author./Recommended Policies columns shown in table).
- Exchange rate regime (2007): de facto peg (with staff recommendation to increase flexibility).
- Current account balance (percent of GDP, memorandum in Table 3): 2006: -1.0; 2007 (Proj.): -3.9; 2008 (Proj.): -6.6; 2009 (Proj.): -8.4; 2010 (Proj.): -9.0; 2011 (Proj.): -8.5.
- Gross international reserves (end of period, Table 3): 2006: 21,122 (millions of U.S. dollars); 2007 (Proj.): 23,494; 2008 (Proj.): 22,903; 2009 (Proj.): 20,334; 2010 (Proj.): 16,954; 2011 (Proj.): 14,316.
- Net minimum capital-adequacy ratio recommended increase: from 10 to 12 percent.

*Source: IMF staff report excerpts (sections 34–46, tables and projections).*

### 2.9 percent of GDP in 2007 and 2.5 percent thereafter; and (iv) annual real wage growth of 5 percent.

### _cr0750 - 2.9 percent of GDP in 2007 and 2.5 percent thereafter; and (iv) annual real wage growth of 5 percent.

### Authorities' macroeconomic framework and assumptions
- Exchange-rate policy: a fixed exchange rate through 2009, followed by a gradually widening exchange rate corridor.
- Energy price pass-through assumptions:
  - Full pass-through of rising energy import prices to industry, but zero pass-through to consumers (authorities' policies).
  - Under recommended/staff policies, assumes full pass-through of energy import prices.
- Fiscal and wage assumptions (authorities' policies):
  - General government fiscal deficit of 2.9 percent of GDP in 2007 and 2.5 percent thereafter.
  - Annual real wage growth of 5 percent.
- Alternative recommended policy assumptions (staff recommended):
  - General government deficit of 2.5 percent of GDP through the medium term.
  - A more flexible exchange rate.
  - Minimum wage growth in line with the CPI excluding energy.

### Public finances: 2004–07 (selected levels and ratios)
- Revenue (Hrv millions):
  - 2004: 120,944
  - 2005: 175,236
  - 2006 (Budget/Proj.): 212,931 / 217,518
  - 2007 (Authorities' Recommended Policies): 241,830; Staff Recommended Policies: 250,124; Alternative values: 244,266 / 245,966
- Tax revenue (Hrv millions) and breakdown (selected items):
  - 2004: 100,821
  - 2005: 150,301
  - 2006 (Budget/Proj.): 181,805 / 190,122
  - 2007 (Authorities' Recommended): 217,257; Staff Recommended: 223,186
  - Personal income tax (2007 authorities): 28,789; enterprise profit tax (2007 authorities): 25,033; payroll tax (2007 authorities): 59,616; VAT (2007 authorities): 55,161.
- Expenditure (Hrv millions):
  - 2004: 136,148
  - 2005: 185,266
  - 2006 (Budget/Proj.): 229,040 / 229,622
  - 2007 (Authorities' Recommended): 258,492; Staff Recommended: 267,609
- Overall balance (cash basis; percent of GDP):
  - 2004: -4.4 percent
  - 2005: -2.4 percent
  - 2006 (Budget/Proj.): -3.1 percent / -2.4 percent
  - 2007 (Authorities' Recommended, cash basis): -2.8 percent (without measures); overall balance (cash basis) -2.9 percent (authorities) and projected -2.5 percent (staff).
- Overall balance (commitment basis; percent of GDP):
  - 2004: -4.1 percent
  - 2005: -1.9 percent
  - 2006 (Budget/Proj.): -3.0 percent / -2.7 percent
  - 2007 (authorities): -2.7 percent; staff recommended: -2.4 percent.
- Financing (percent of GDP):
  - 2004: 4.3 percent
  - 2005: 2.4 percent
  - 2006 (Budget/Proj.): 3.1 percent / 2.4 percent
  - 2007 (authorities): 2.8 percent; staff recommended: 2.9 percent.
- Memorandum: Nominal GDP (Hrv millions) reported as: 345,113 (2004), 424,741 (2005), 512,300 / 505,409 (2006), 594,100 (2007 authorities and staff), with additional figures 565,387 / 573,708 listed.

### Medium-term public debt and fiscal projections (authorities' policies and staff recommended)
- Public sector gross debt (percent of GDP; end of period, authorities' policies Table 8):
  - 2004: 25.5
  - 2005: 19.4
  - 2006: 16.8
  - 2007: 15.5
  - 2008: 14.5
  - 2009: 14.0
  - 2010: 14.2
  - 2011: 14.3
- Public sector gross debt (percent of GDP; staff recommended Table 9):
  - 2007: 14.6
  - 2008: 13.4
  - 2009: 13.4
  - 2010: 13.2
  - 2011: 13.2
- Public sector net debt (percent of GDP; selected):
  - 2006 (Sep-06): 11.6 (from vulnerability indicators Table 4).
- Debt-stabilizing primary balance (percent of GDP, DSA): -1.7 (debt-stabilizing primary balance reported in Appendix I).

### Monetary accounts and monetary developments (selected)
- Broad money (end-period levels; monetary survey, in millions of hryvnias):
  - 2003: 95,043
  - 2004: 125,801
  - 2005: 194,071
  - 2006 (Dec, proj.): 259,471 (authorities' policies), 338,609 (recommended policies), 316,763 (alternate).
- Currency in circulation (millions):
  - 2003: 33,119
  - 2004: 42,345
  - 2005: 60,231
  - 2006 (Dec projection): 76,881; alternative projections: 98,942 / 92,558.
- Net international reserves (NIR; US$ billion; monetary survey):
  - 2003: 4.4
  - 2004: 6.9
  - 2005: 9.5
  - 2006 (Nov-06): 21.1 (Table 4 lists GIR 21.1 US$ billion; NIR 20.2 US$ billion as of 30-Nov-06 in Table 6).
- Velocity and money multipliers (memoranda):
  - Velocity of broad money (based on nominal GDP over last four quarters): 2.8 (2003), 2.7 (2004), 2.1 (2005), 2.2 (2006 Dec authorities), 2.0 / 1.67 / 1.8 in various projections.
  - Money multiplier: 2.37 (2003), 2.34 (2004), 2.34 (2005), 2.59 (Mar 2006), 2.67 (Jun 2006), 2.77 (Sep 2006), 2.64 / 2.94 / 2.88 in projections.

### Financial sector soundness (banking sector indicators, 2002–06)
- Number of banks:
  - Dec-02: 157; Dec-03: 158; Dec-04: 160; Dec-05: 165; Sep-06: 166.
  - Private banks: 155 (Dec-02) through 164 (Sep-06).
  - Foreign banks (number): 20 (Dec-02) increasing to 32 (Sep-06); 100% foreign-owned banks: 7 (Dec-02) to 11 (Sep-06).
- Concentration:
  - Share of assets of largest 10 banks: 54.1 percent (Dec-02), 53.7 (Dec-03), 53.1 (Dec-04), 53.8 (Dec-05), 53.2 (Mar-06), 53.0 (Jun-06), 53.4 (Sep-06).
- Capital adequacy:
  - Regulatory capital to risk-weighted assets: 18.0 percent (Dec-02), 15.2 (Dec-03), 16.8 (Dec-04), 15.0 (Dec-05), 14.9 (Mar-06), 14.3 (Jun-06), 13.9 (Sep-06).
  - Capital to total assets: 14.7 percent (Dec-02), 12.3 (Dec-03), 13.1 (Dec-04), 11.5 (Dec-05), 11.5 (Mar-06), 11.2 (Jun-06), 11.2 (Sep-06).
- Asset quality and credit:
  - Credit growth (year-over-year): 47.3 percent (Dec-02), 60.8 (Dec-03), 31.2 (Dec-04), 61.5 (Dec-05), 62.8 (Mar-06), 62.9 (Jun-06), 63.5 (Sep-06).
  - Credit-to-GDP ratio: 19.4 (Dec-02), 26.6 (Dec-03), 27.1 (Dec-04), 35.6 (Dec-05), 37.3 (Mar-06), 39.8 (Jun-06), 44.8 (Sep-06).
  - NPLs to total loans (broad definition): 21.9 percent (Dec-02), 28.3 (Dec-03), 30.0 (Dec-04), 19.6 (Dec-05), 18.3 (Mar-06), 19.1 (Jun-06), 17.9 (Sep-06).
  - Specific provisions to NPLs: 37.0 percent (Dec-02), 22.3 (Dec-03), 21.1 (Dec-04), 25.0 (Dec-05), 25.9 (Mar-06), 23.7 (Jun-06), 24.6 (Sep-06).
- Foreign exchange exposure:
  - Loans in foreign currency to total loans: 39.5 percent (Dec-02), 39.3 (Dec-03), 39.2 (Dec-04), 40.5 (Dec-05), 41.5 (Mar-06), 43.2 (Jun-06), 45.0 (Sep-06).
  - Deposits in foreign currency to total deposits: 32.2 percent (Dec-02), 33.5 (Dec-03), 36.5 (Dec-04), 34.2 (Dec-05), 37.6 (Mar-06), 39.2 (Jun-06), 39.5 (Sep-06).
  - Foreign currency loans to foreign currency deposits: 139.8 (Dec-02), 134.7 (Dec-03), 120.5 (Dec-04), 133.8 (Dec-05), 134.0 (Mar-06), 138.1 (Jun-06), 149.3 (Sep-06).
- Profitability:
  - Return on assets (after tax, end-of-period): 1.2 percent (Dec-02), 1.0 (Dec-03), 1.1 (Dec-04), 1.3 (Dec-05), 1.4 (Mar-06), 1.6 (Jun-06), 1.7 (Sep-06).
  - Return on equity (after tax): 8.0 percent (Dec-02) rising to 14.0 (Sep-06).

### Medium-term macroeconomic framework (2004–11) — Authorities' policies (Table 8, key projections)
- Real GDP growth (percent change):
  - 2004: 12.1
  - 2005: 2.6
  - 2006: 6.0
  - 2007: 4.3
  - 2008: 4.8
  - 2009: 4.7
  - 2010: 5.0
  - 2011: 5.3
  - Cumulative change 2007–11: 26.5 (shown in table header as Cumulative Change 2007-11).
- Consumer prices (end of period; percent change):
  - 2004: 12.3
  - 2005: 10.3
  - 2006: 12.5
  - 2007 (authorities): 8.2; 2007 (staff recommended Table 9): 10.6
  - 2008–2011 (authorities): 7.3, 6.7, 6.5, 6.5 (respectively).
- Wages:
  - Minimum wage (hryvnias per month; end of period): 2004: 237.0; 2005: 332.0; 2006: 400.0; 2007 (authorities): 450.0.
  - Nominal monthly wages (average): 2004: 27.7; 2005: 36.5; 2006: 23.3; 2007 (authorities): 14.8; other projections vary (note: values taken directly as presented).
  - Real monthly wages (average): 2004: 17.1; 2005: 20.3; 2006: 13.0; 2007 (authorities): 1.7; cumulative change 2007–11: 20.5.
- External sector (percent of GDP):
  - Current account balance:
    - 2004: 10.5
    - 2005: 3.1
    - 2006: -1.0 (Proj. in Table 4)
    - Authorities' medium-term (Table 8): 2007: -3.9; 2008: -6.6; 2009: -8.4; 2010: -9.0; 2011: -8.5.
  - Gross official reserves (end of period, US$ billions; authorities' policies Table 8):
    - 2004: 9.5
    - 2005: 19.4
    - 2006: 21.1
    - 2007: 23.5
    - 2008: 22.9
    - 2009: 20.3
    - 2010: 17.0
    - 2011: 14.3
  - Gross investment and gross national savings (percent of GDP) series are provided with values (e.g., Gross investment ~ 19.2–23.4 across 2004–11; Gross national savings 29.7 in 2004 down to 14.4 in 2009 and then 15.0 in 2011 under authorities).

### Debt sustainability analysis — public and external debt (Appendix I & external DSA)
- Public sector gross debt (baseline DSA, percent of GDP):
  - 2001: 39.4
  - 2002: 35.7
  - 2003: 30.6
  - 2004: 25.5
  - 2005: 19.4
  - 2006: 16.8
  - 2007: 15.5
  - 2008: 14.5
  - 2009: 14.0
  - 2010: 14.2
  - 2011: 14.3
- Identified debt-creating flows (public; percent of GDP, sum of 4+7+12):
  - 2001: -8.0
  - 2002: -4.6
  - 2003: -5.7
  - 2004: -5.6
  - 2005: -8.4
  - 2006: -0.8
  - 2007: -0.9
  - 2008: -0.6
  - 2009: -0.2
  - 2010: 0.1
  - 2011: -0.1
- Gross financing need (public sector; percent of GDP):
  - 2004: 6.8
  - 2005: 5.7
  - 2006: 4.4
  - 2007: 4.6
  - 2008: 3.7
  - 2009: 4.1
  - 2010: 3.7
  - 2011: 4.1
- External debt (baseline DSA, external debt percent of GDP):
  - 2001: 55.5
  - 2002: 52.1
  - 2003: 47.6
  - 2004: 47.3
  - 2005: 46.6
  - 2006: 48.3
  - 2007: 49.4
  - 2008: 50.3
  - 2009: 51.3
  - 2010: 53.8
  - 2011: 55.6
- Gross external financing need (in US$ billions and percent of GDP; Appendix I):
  - 2001: US$7.2 (18.9 percent of GDP)
  - 2002: US$6.0 (14.2 percent)
  - 2003: US$7.3 (14.6 percent)
  - 2004: US$4.0 (6.2 percent)
  - 2005: US$9.5 (11.5 percent)
  - 2006: US$15.3 (15.3 percent)
  - 2007: US$20.5 (18.4 percent)
  - 2008: US$25.0 (20.1 percent)
  - 2009: US$29.6 (21.4 percent)
  - 2010: US$32.1 (21.5 percent)
  - 2011: US$33.8 (20.9 percent)
- External debt-to-exports ratio (percent):
  - 2001: 100.1
  - 2002: 94.5
  - 2003: 82.4
  - 2004: 74.4
  - 2005: 87.1
  - 2006: 95.2
  - 2007: 101.6
  - 2008: 108.8
  - 2009: 116.3
  - 2010: 123.3
  - 2011: 129.1

### Financial sector reform, inflation targeting, and institutional reforms
- Progress toward inflation targeting (Table 10: Moving to Inflation Targeting: Progress Report):
  - Preconditions and achievements listed include drafting a Memorandum of Understanding (MoU) to set out NBU-government roles; submitted draft amendments to the NBU Law to increase independence; allowed the hryvnia/U.S. dollar rate to fluctuate in a 1 percent band; developed a small macroeconomic model; compiled an inflation report; published business surveys; issued a monetary-policy report; liberalized the foreign-exchange market in August 2005.
  - Further steps needed include: agreeing with government on the MoU; adopting further amendments to the NBU Act to provide a clear mandate to achieve price stability and allow greater NBU independence; drawing up an operational transition plan for exchange-rate role changes; gradually allow greater exchange-rate flexibility; identify a key policy rate and assess introducing an interest rate corridor; phase out the long-term refinancing facility; improve macroeconomic modeling; develop core inflation indicators; modernize the NBU website; conduct press conferences and issue press releases on inflation targeting; issue an Inflation Report; abolish the foreign-exchange turnover tax; develop benchmark government securities; simplify procedures for working in the foreign-exchange market; further tighten banking supervision, regulation, and legislation.
- Banking-sector stability and supervision:
  - Developed a strategy for medium-term banking sector development and supervision; gradual implementation of more risk-based supervision; continued efforts to improve prudential regulation.

### External sector and vulnerability indicators (selected)
- Exchange rate (end of period, NC/US$): 2002: 5.3; 2003: 5.3; 2004: 5.3; 2005: 5.1; 2006 (30-Nov-06): 5.1.
- Current account balance (percent of GDP; select years):
  - 2002: 7.5
  - 2003: 5.8
  - 2004: 10.5
  - 2005: 3.1
  - 2006: -1.0 (Proj. in Table 4)
- Net FDI inflows (percent of GDP):
  - 2002: 1.6
  - 2003: 2.8
  - 2004: 2.7
  - 2005: 9.0
  - 2006 (Proj.): 3.8
- Exports (percentage change of US$ value, GNFS):
  - 2002: 10.7
  - 2003: 24.0
  - 2004: 42.6
  - 2005: 7.5
  - 2006 (Proj.): 14.5
- Gross international reserves (GIR; US$ billion):
  - 2003: 4.4
  - 2004: 6.9
  - 2005: 9.5
  - 2006: 21.1 (30-Nov-06)
- GIR in percent of short-term debt at remaining maturity:
  - 2003: 42.6
  - 2004: 61.6
  - 2005: 71.5
  - 2006 (Sep-06): 116.6? (Table 4 shows 116.6 for 2005/2006—preserve as printed: GIR in percent of ST debt at RM 42.6, 61.6, 71.5, 116.6, 98.8—latest observation Sep-06.)
- Total gross external debt (percent of GDP):
  - 2002: 52.1
  - 2003: 47.6
  - 2004: 46.5
  - 2005: 44.3
  - 2006 (Sep-06): 45.1
- Public sector gross debt (PSGD, percent of GDP; Sep-06): 15.7 (Table 4).
  - Of which exposed to rollover risk (percent of total PSGD): 14.2 (Sep-06).
  - Exposed to exchange rate risk (percent of total PSGD): 75.8 (Sep-06).
  - Exposed to interest rate risk (percent of total PSGD): 18.5 (Sep-06).

### IMF relations, arrangements, and technical assistance (selected)
- Membership: Joined 09/03/1992; Article VIII.
- Quota: SDR 1,372.00.
- Outstanding purchases and loans: Extended arrangements 594.78 SDR million (43.35 percent of quota).
- Financial arrangements history (selected approvals and amounts approved):
  - Stand-by approved 03/29/04 — Amount approved SDR 411.6 (amount drawn 0.00).
  - EFF approved 09/04/98 — Amount approved SDR 1,919.95 (amount drawn 1,193.00).
  - Stand-by approved 08/25/97 — Amount approved SDR 398.92 (amount drawn 181.33).
- Projected payments to Fund (expectations basis; SDR million):
  - Principal: 2006: 42.90; 2007: 278.98; 2008: 215.62; 2009: 57.28.
  - Charges/Interest (2006–09): 25.49; 10.94; 1.68 (years unspecified in table excerpt).
- Safeguards assessment (NBU): completed July 14, 2004; most recommendations implemented; outstanding issues include (i) full adoption of IFRS, and (ii) detailed review of NBU Law and other legislation to strengthen NBU independence.
- Exchange arrangements history: Hryvnia introduced Sept 24, 1996 at conversion Krb 100,000 to Hrv 1; band and subsequent developments; as of Nov 30, 2006 official hryvnia/U.S. dollar rate stood at 5.05.
- Technical assistance missions (2001–06) covered tax administration, monetary policy, inflation targeting, banking supervision, debt management, statistics, and other topics (detailed list of missions and dates provided in Appendix II).
- IMF resident representation and advisors (as of Nov 30, 2006): Senior Resident Representative Mr. Franks (September 2004-present); Resident Representative Mr. Lissovolik (July 2001–January 2004); Advisors on inflation targeting, macro-fiscal policy, banking supervision, treasury, statistics listed with names and assignment periods.

### Data quality, statistical issues, and dissemination
- General assessment:
  - Economic and financial data broadly adequate for surveillance but with important shortcomings.
  - Statistical deficiencies remain for national accounts and balance of payments, including absence of proper quarterly price indices for exports and imports.
  - Compilation of accurate data on external assets by sector is weak due to non-classification of many items.
- Real sector statistics:
  - 1993 System of National Accounts used; significant improvements in quarterly GDP compilation; seasonally adjusted quarterly GDP compiled but disseminated to only a few users.
  - Quarterly price indices for exports and imports not yet suitable for analytical purposes.
  - Need to improve methodology covering the informal economy.
- Government finance statistics:
  - Ministry of Finance publishes monthly data within 25 days; economic classification consistent with GFSM 1986 and functional classification since 2002 largely consistent with GFSM 2001.
  - Reporting on arrears and timely reporting on special social funds (which represent almost half of general government spending) need improvement.
  - GFS under GFSM 2001 reported through 2005.
- Monetary and financial statistics:
  - Authorities implemented Standardized Report Forms (SRF) for reporting monetary data to STA; data from December 2001 converted to SRF framework and published.
  - Use of SDDS flexibility options for timeliness of analytical accounts noted.
- External sector statistics:
  - Balance of payments compiled in broad conformity with BPM5 and reported quarterly.
  - Expanded enterprise arrears survey; pilot travelers survey planned to improve shuttle trade, travel and compensation of employees estimates.
  - Progress in disseminating international reserves data (monthly reserve template since mid-2002) and external debt data since September 2004.
- Data ROSC and SDDS:
  - Data ROSC prepared in 2002 and published August 19, 2003; Ukraine subscribed to SDDS on January 10, 2003.

*Sources: Ukrainian authorities; National Bank of Ukraine; Ministry of Finance; IMF staff estimates, projections, and appendices in the provided IMF staff report content.*

### 1.      Since the issuance of the staff report, more information about 2006 developments has

### _cr0750 - 1.      Since the issuance of the staff report, more information about 2006 developments has

### Recent updates and fiscal outturns
- Preliminary below-the-line data for 2006 indicate that the general government cash deficit may have reached only 11⁄4 percent of GDP, compared with 23⁄4 percent of GDP projected in the staff report.
- If confirmed by final data, this overperformance likely reflects a combination of stronger-than-projected cash revenue growth and underexecution of spending; information about end-December VAT refund arrears is not yet available.
- Despite the budget overperformance, the government borrowed an additional US$600 million externally in December, contributing to international reserves exceeding the staff report’s projection by US$1.1 billion.
- The government and President agreed to revisit adopted 2007 budget wage and pension increases; proposed changes would increase average minimum wage growth in 2007 from 15 to 17 percent and, based on staff estimates, could add 1⁄2 percent of GDP to recurrent spending.
- The President initially vetoed the original 2007 budget law in late-December and signed an almost unchanged version subject to consideration of these additional wage and pension increases in April 2007.

### Inflation, prices, and energy pass-through
- End-year CPI inflation was contained at 11.6 percent, undershooting the staff forecast of 12.5 percent; the undershoot reflects legal delays in implementing envisaged large utility price increases in Kyiv in December.
- Inflation moderated through most of 2006 but climbed back into double digits late in the year, boosted by energy-price pass-through.
- Directors commended the authorities for passing through recent energy import price hikes to domestic users and urged continuing pass-through in 2007 and beyond to avoid rising quasi-fiscal deficits and to provide incentives to improve energy efficiency.

### Monetary policy, exchange rate, and reserves
- The exchange rate regime has remained a de facto peg; the NBU allowed the interbank exchange rate to fluctuate within a narrow band of Hrv/US$5.00-5.06.
- Base money growth has been mostly driven by foreign-exchange interventions and changes in government deposits at the NBU.
- More recently monetary conditions loosened, reflecting a pickup in foreign reserve accumulation and drawdown of government deposits.
- Foreign exchange reserves have more than doubled to about 41⁄2 months of imports and are projected to exceed the level of short-term external debt at end-2006.
- End-2006 gross reserves reached 21.1 (billions of U.S. dollars) in the Selected Economic and Social Indicators table.

### Credit boom, banking sector vulnerabilities, and regulatory responses
- Real credit growth has averaged about 40 percent since 2001.
- The corporate sector’s debt (two thirds of which is denominated in foreign currency) now exceeds 50 percent of GDP.
- Household sector debt, mostly in foreign exchange, surged over the past 18 months.
- The boom has created substantial credit risk, particularly indirect foreign-currency risk, and raised banks’ foreign exchange liquidity risk due to reliance on foreign funding with short maturities.
- Financial soundness indicators show declining capital-adequacy ratios, suggesting sector-wide vulnerability.
- In late-December, the NBU discussed administrative options with commercial banks to curb rapidly rising foreign-currency-denominated domestic bank lending, particularly to consumers. Proposals could set limits depending on borrower type and loan maturity and are still being developed.
- Staff continues to view increases in provisions and in the minimum capital-adequacy ratio as the first line of defense against rising indirect credit risk; administrative curbs on lending would need careful monitoring to prevent shifts into less well-regulated markets and instruments.
- Executive Directors noted consideration should be given to increasing the capital-adequacy ratio from 10 to 12 percent.

### Structural, fiscal, and policy assessments by the Executive Board
- Executive Directors noted Ukraine’s resilience in the face of higher energy prices and political uncertainties, and that the economy had become better balanced externally.
- Directors cautioned that rising energy import prices rekindled short-term macroeconomic tensions and that uncertainties about future steel export prices and capital flows loom large.
- Three longer-standing challenges highlighted:
  - Structural reforms still lag considerably.
  - The present monetary framework could face increasing difficulties in achieving internal and external balance given volatile fundamentals.
  - Sustained credit boom and heavy private-sector external borrowing have created balance-sheet vulnerabilities.
- Directors recommended a gradual move toward greater exchange rate flexibility to facilitate external adjustment, improve inflation control, stem financial dollarization, and incentivize hedging markets; the pace should be managed carefully.
- Preparatory steps toward inflation targeting by the NBU were welcomed; Directors encouraged moving forward with the transition.
- Measures to support increased exchange rate flexibility recommended:
  - Develop the foreign-exchange market, including by eliminating the foreign-exchange transactions tax.
  - Develop domestic securities markets and adopt a government financing strategy relying more on domestic debt issuance.
  - Maintain an appropriately restrained incomes policy to reduce pressure for large nominal exchange rate movements.
- Directors viewed the authorities’ fiscal framework as broadly appropriate, supporting a general government deficit target close to 21⁄2 percent of GDP to keep explicit debt low given significant contingent liabilities.
- Directors urged restraint on recurrent spending in the 2007 budget and warned against increases in sectoral subsidies and reopening tax breaks in free economic zones.
- Pension reform was highlighted as imperative to open significant fiscal space and address large public pension fund imbalances.
- Directors welcomed legislation toward WTO accession and urged reversing recent retrograde actions against exporters, particularly restrictions on grain exports.
- Data improvements were recommended in trade prices, the state-owned enterprise sector, and sectoral financial flows and stocks.

### Key statistics from "Ukraine: Selected Economic and Social Indicators, 2003-07" (selected entries preserved exactly)
- Nominal GDP (billions of hryvnias): 267.3 345.1 424.7 505.4 565.4 573.7
- Real GDP (percent change): 9.6 12.1 2.6 6.0 4.3 4.5
- Consumer prices (period average): 5.2 9.0 13.5 9.1 12.9 13.6
- Consumer prices (end of period): 8.2 12.3 10.3 12.5 8.2 10.6
- Cash balance (percent of GDP): -0.9 -4.4 -2.4 -2.4 -4.1 -2.5
- Revenue (percent of GDP): 35.9 35.0 41.3 43.0 43.2 42.9
- Expenditure (cash basis, percent of GDP): 36.8 39.5 43.6 45.4 47.3 45.3
- Public debt (percent of GDP): 30.6 25.5 19.4 16.8 16.2 14.6
- Current account balance (percent of GDP): 5.8 10.5 3.1 -1.0 -3.9 -3.1
- Foreign direct investment (percent of GDP): 2.8 2.7 9.0 3.8 4.9 4.9
- Gross reserves (end of period, billions of U.S. dollars): 6.9 9.5 19.4 21.1 23.5 24.1
- In months of next year's imports of goods and services: 2.4 2.7 4.4 4.2 4.2 4.3
- Exchange rate regime: de facto peg de facto peg managed float
- Hryvnia per U.S. dollar, end of period: 5.33 5.31 5.05 5.05

*IMF Executive Board Concludes 2006 Article IV Consultation with Ukraine; Public Information Notice (PIN) No. 07/5; January 22, 2007.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0750.pdf_