## Ukraine—Stand-By Arrangement—Review Under the Emergency Financing Mechanism (Section 1)

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### Summary / Overview
- Arrangement: two-year Stand-By Arrangement (SBA) for Ukraine under the Emergency Financing Mechanism (EFM), approved on November 5, 2008, in the amount of SDR 11 billion ($16.4 billion, 802 percent of Ukraine’s quota).
- First purchase: SDR 3 billion ($4.5 billion) made following the Board meeting.
- Report completion date: December 11, 2008.
- Main judgement: Policies are being implemented broadly in line with program understandings, although risks to the program remain high given political tensions, the fragile state of the banking system, the sharp contraction of the economy, and rapid currency depreciation.
- Key near-term action: Policies will be assessed carefully at the time of the first review under the arrangement (late January 2009) to ensure program objectives remain within reach.

### Staff and Consultations
- Staff team: Ms. Pazarbasioglu (head); Messrs. Hofman and Moulin (EUR), Mr. Arslanalp (FAD), Mr. Duenwald (SPR), and Mr. Laeven (RES).
- Additional support: concurrent MCM mission led by Mr. Olafsson and Mr. Horvath (resident representative); a safeguards assessment mission by FIN; LEG/MCM mission on exchange controls (to finalize by December 19, 2008); cooperation with World Bank staff on structural issues.
- Meetings (December 1–9, 2008) with: President Yushchenko; Prime Minister Tymoshenko; Minister of Finance Pynzenyk; NBU Governor Stelmakh; First Deputy Chief of Staff Mr. Shlapak; senior officials; ambassadors; members of Parliament; private banking and business communities; senior representatives of the main opposition party.

### Recent Developments and Outlook
- Output and growth:
  - October real GDP growth: –2 percent (year-on-year), down from above 5 percent in September.
  - 2008 expected real GDP growth: likely in the 4–5 percent range, instead of 6 percent as assumed in the program.
  - Risks: increased likelihood of a deeper-than-expected recession in 2009.
- Inflation and exchange:
  - CPI inflation: eased from 24.6 to 22.3 percent year-on-year between September and November.
  - Cumulative nominal depreciation of the hryvnia in effective terms since end-September: 30 percent.
  - Core inflation and wage growth: declined slightly.
- Trade and terms-of-trade:
  - Pronounced turnaround in trade in October: both export and import growth fell markedly.
  - Current account deficit: continued to widen, preliminary November figures suggest an inversion of tendency.
  - Outlook: imported energy prices likely to be lower than expected in 2009; recent modest rebound in steel prices could produce upside surprise to Ukraine’s terms-of-trade.
- Capital flows and market access:
  - Net FDI and medium- and long-term borrowing: indications of decline relative to year-ago levels, but remained positive in October.
  - Several big companies and subsidiaries of foreign banks rolled over debt through direct borrowing from parent banks and related offshore entities.
- Financial market indicators and sentiment:
  - Sovereign CDS and bond spreads: rose again after a late-October drop and remain at elevated levels.
  - Exchange rate: weakened considerably.
  - Market sentiment deterioration since approval of the program attributed to political developments and concerns about private sector defaults due to refinancing difficulties.

### Exchange Rate, Reserves, and Banking Conditions
- Exchange rate and reserves:
  - NBU foreign exchange sales since beginning of November: about $3.5 billion.
  - Net international reserves (measured at program exchange rates) as of December 5: $29.9 billion.
  - Program end-December floor for net international reserves: $26.7 billion.
  - Policy: for a brief period since approval of the arrangement on November 5, authorities essentially re-pegged the exchange rate, causing sizeable reserve losses; subsequently allowed the currency to float and introduced regular foreign exchange intervention auctions.
- Hryvnia behavior:
  - Large-scale interventions kept the exchange rate around Hrv 5.8 per dollar up to mid-November; since then a more flexible exchange rate policy allowed depreciation.
- Interbank rates and liquidity:
  - Interbank overnight rates: peaked at about 50 percent at end-November, declined to the 25–30 percent range in early December.
  - NBU liquidity support provided since early October: about Hrv 40 billion, partly through a “financial rehabilitation” facility to banks with shortfalls in regulatory capital.
  - Base money: Hrv 174 billion as of December 5 compared to the end-year target of Hrv 190 billion.
- Deposits and credit:
  - Local currency deposits: loss of 14 percent between end-September and end-November.
  - Foreign currency deposits: also declined, but since mid-November households’ foreign currency deposits returned attracted by high interest rates.
  - Credit growth: came to a halt in November (taking into account revaluation effects), with sharp contractions in mortgage and consumer lending.
- Nonperforming loans and vulnerabilities:
  - Banks report that a 50 percent depreciation of the hryvnia against the dollar would increase the debt service-to-income ratio from 60 percent to nearly 100 percent for about 20 percent of borrowers.
  - Foreign currency deposits share in total deposits (households): about 50 percent.
  - Underreporting of income: about one third.
  - Banks approaching minimum regulatory capitalization: 10 percent.
  - Sector impact: foreign currency household loans and loans to corporates in metal, energy, and construction sectors taking the brunt of losses.

### Policy Implementation — Monetary and Exchange Rate Policy
- Exchange rate policy measures:
  - After an initial re-peg, authorities introduced a flexible exchange rate policy in line with the program and introduced regular FX intervention auctions to increase transparency and improve price discovery.
  - Foreign exchange tax: to be abolished in 2009 as agreed under the program to improve FX market operation.
  - Mission advice: keep intervention amounts low given large reserve losses and potential external payments (such as Naftogaz debt); convey clear public commitment to a flexible exchange rate regime.
- Monetary tightening (early December measures):
  - Refinance rate: increased from 16 to 20 percent.
  - Interest rate paid on bank deposits at the central bank: raised from 7 to 10 percent.
  - Refinance credit: provision restricted to overnight and two week maturities; collateral requirements tightened; bank shares eliminated from list of acceptable collateral.
  - Vault cash: excluded from calculation of bank reserves.
  - Staff recommendation: keep base money under the end-year target and consider further tightening should pressure on the hryvnia continue.

### Policy Implementation — Financial Sector Policy
- Bank recapitalization diagnostic:
  - NBU resolution on November 21 specified guidelines for diagnostic study.
  - Audit firms selected and started work in systemically important banks; plan to provide audit reports to the NBU by December 15, 2008 to observe related conditionality (MEFP ¶13).
  - A more comprehensive analysis covering a larger portion of banks’ credit portfolios to be made available by January 5, 2009.
  - During diagnostics: authorities will agree with bank management on restructuring plans if financial conditions deteriorate.
  - Mission recommendation: NBU should intensify discussions with foreign banks and home supervisors to assess parent bank funding to Ukrainian subsidiaries and develop contingency plans.
- Prominvest Bank resolution:
  - Prominvest Bank was sold to private investors in November (prior action); strategic investors failed to inject required additional capital and the bank was nationalized on December 9, 2008.
  - Authorities will seek potential capital participation by the EBRD and/or other IFIs.
  - Mission view: a final resolution with IFI participation would increase transparency and facilitate faster resolution of problem banks.

### Policy Implementation — Fiscal Policy
- End-year fiscal target and measures:
  - Target: general government deficit below 1 percent of GDP.
  - Budget position: in balance at end-November.
  - Cabinet measures (November): resolution to contain seasonal end-year spending surge; strengthens Treasury control over expenditures by line ministries and local governments; requires public enterprises to submit surplus revenues to the budget by end-year; freezes non-priority spending on goods and services.
  - Risks to target: sharp contraction of output and tax arrears from Naftogaz affecting revenue performance.
  - Authorities’ stance: confident about meeting end-December fiscal performance criterion.
- 2009 budget preparations and guidance:
  - Authorities reiterated commitment to a balanced budget next year and started technical preparations for the draft 2009 budget.
  - Staff advice: construct the budget on conservative growth and revenue assumptions; international experience suggests weak tax collection during crisis periods.
  - Mission proposals: additional expenditure-saving measures to balance the budget (including subsidies to loss-making companies), while advising against a sharp contraction in capital spending and encouraging sufficient appropriations for well-targeted social programs.
  - Budget adoption: will take place once parliament resumes operations; timing remains uncertain.
  - Cabinet resolution: ensure effective budget execution in first three months of 2009 based on expenditure targets of the 2008 budget.
  - Fiscal stance: to be reevaluated at the time of the first review in light of macroeconomic and financing developments.
- Financing:
  - Financing remains limited to official sources.

### Financing, Privatization, and Official Financing (Section 2)
- Market access and privatization:
  - Ukraine remains shut out from international capital markets, and domestic borrowing is constrained by limited liquidity in the banking sector.
  - The Cabinet has approved an expanded list of enterprises slated for privatization in 2009; prospects may be limited given adverse global financial conditions.
- Official financing prospects:
  - World Bank expected to approve a $500 million loan for budget support by end-December.
  - World Bank negotiations underway for financing of two large projects for roads and railways (noted: $500 million of project financing has been approved and another $1.1 billion is under preparation).
  - EBRD has approved a EUR 1.1 billion envelope for Ukraine financial sector projects, equity, debt, trade finance and SME finance for 2009.

### Import Restrictions and Private Sector Foreign-Currency Debt
- Import restrictions:
  - Staff opposed proposed import restrictions.
  - A draft legislative amendment to allow temporary import surcharges in event of balance of payments difficulties has been cleared by a parliamentary committee and registered in parliament.
  - Staff stressed such measures would be inconsistent with a continuous performance criterion under the program and that balance of payments difficulties are best addressed through macroeconomic and exchange rate policies in the program.
- Private foreign-currency debt resolution:
  - Mission urged authorities to make progress on resolution of private sector debt denominated in foreign currency.
  - Mission discussed implications of different scenarios regarding risks of extensive private sector default based on macroeconomic and banks’ portfolio data.
  - Recommendation: authorities work jointly with banks to develop a voluntary framework for restructuring household debt.

### Staff Appraisal — Policy Implementation and Economic Outlook
- Policy implementation:
  - Largely in line with the program, except for some initial slippage in exchange rate policy.
  - Authorities have introduced a flexible exchange rate regime, tightened monetary policy, and taken measures to contain the 2008 government deficit.
  - Progress made on the diagnosis phase of the bank recapitalization program.
- Economic outlook:
  - The outlook has deteriorated: the large negative terms-of-trade shock and capital and deposits outflow-driven credit contraction have had a considerable impact on the real sector.
  - Real GDP growth in 2008 is likely to fall short of the program projection and risks of a deeper recession in 2009 have increased.

### Exchange Rate and Monetary Policy Recommendations
- Continue implementation of the flexible exchange rate regime to:
  - Cushion the economy against further deterioration of the terms-of-trade.
  - Prevent pent-up demand for foreign currency.
  - Potentially stimulate capital inflows.
- Authorities should continue regular foreign exchange auctions, with intervention amounts grounded in appropriate reserves targets.
- Monetary tightening measures noted and recommended:
  - Recent increases in the refinance rate and tightening of prudential limits on foreign currency lending should improve attractiveness of hryvnia holdings.
  - Restriction of refinance credit at maturities of less than two weeks and elimination of bank shares from acceptable collateral are positive steps.
  - Further tightening of monetary policy, should pressures on the hryvnia continue, is an essential part of the program.

### Banking Sector Policies and Bank Resolution
- Adhere closely to banking policies specified under the program:
  - Closely monitor liquidity positions of banks and intensify supervision of banks increasingly relying on central bank liquidity support.
  - Prompt action necessary to resolve banks that may be facing difficulties.
  - For Prominvest bank: authorities should promptly engage on potential capital participation by the EBRD and/or other IFIs to restructure the bank in a transparent manner.
- Diagnostic and deliverables:
  - Authorities should deliver the diagnostic reports for systemic banks on December 15, 2008.
  - Staff welcomes commitment to provide further analysis of banks’ loan portfolios by January 5, 2008.

### Fiscal Policy Guidance
- Prudent fiscal policy critical given difficult financing conditions and revenue risks:
  - For 2008, authorities should keep the government deficit below 1 percent of GDP.
  - For 2009, they should target a balanced budget in line with the program.
  - Fiscal plans should be based on conservative assumptions, supported by credible expenditure-saving measures, avoid overly large cuts in capital expenditure, and expand well-targeted social programs.
- Plans to impose import restrictions should be abandoned as inconsistent with a continuous performance criterion under the SBA.

### Private Debt Restructuring Strategy
- Urgent need for a voluntary resolution strategy for corporate and household debt problems.
- Working group composed of banks, NBU, and MoF should rapidly design and implement a voluntary framework for restructuring private sector debts, including proposals to facilitate out-of-court settlements.

### Implementation Risks and Coordination
- Program implementation risks require close coordination among the authorities and with the Fund.
- Bank resolution is a key element nearing implementation phase and will involve decisions affecting vested interests and public finances.
- Requires extraordinary coordination among authorities, consistent backing by key political leaders, and better communication to markets.

### Key Statistics (selected from Table 1)
- Nominal GDP (billions of hryvnias): 345 (2004), 441 (2005), 544 (2006), 713 (2007), 993 (2008), 1,112 (2009 Proj. 1/)
- Real GDP (percent change): 12.1 (2004), 2.7 (2005), 7.3 (2006), 7.6 (2007), 6.0 (2008), -3.0 (2009 Proj. 1/)
- Contributions to real GDP:
  - Domestic demand: 9.1 (2004), 13.2 (2005), 13.1 (2006), 16.1 (2007), 14.4 (2008), -14.3 (2009 Proj. 1/)
  - Net exports: 3.0 (2004), -10.5 (2005), -5.8 (2006), -8.5 (2007), -8.3 (2008), 11.3 (2009 Proj. 1/)
- Unemployment rate (ILO): 8.6 (2004), 7.2 (2005), 6.8 (2006), 6.4 (2007), 6.0 (2008), 9.5 (2009 Proj. 1/)
- Consumer prices (period average): 9.0 (2004), 13.5 (2005), 9.1 (2006), 12.8 (2007), 25.6 (2008), 21.0 (2009 Proj. 1/)
- Consumer prices (end of period): 12.3 (2004), 10.3 (2005), 11.6 (2006), 16.6 (2007), 25.5 (2008), 17.0 (2009 Proj. 1/)
- Nominal monthly wages (average): 27.5 (2004), 36.7 (2005), 29.2 (2006), 29.7 (2007), 37.1 (2008), 10.5 (2009 Proj. 1/)
- Real monthly wages (average): 16.9 (2004), 20.4 (2005), 18.4 (2006), 15.0 (2007), 9.1 (2008), -8.7 (2009 Proj. 1/)
- Cash balance excluding banks recap (percent of GDP): -4.4 (2004), -2.3 (2005), -1.4 (2006), -2.0 (2007), -1.0 (2008), 0.0 (2009 Proj. 1/)
- Augmented balance, including effects of banks recap. (percent of GDP): -4.4 (2004), -2.3 (2005), -1.4 (2006), -2.0 (2007), -2.0 (2008), -4.5 (2009 Proj. 1/)
- Privatization proceeds (percent of GDP): 3.1 (2004), 5.0 (2005), 0.4 (2006), 0.6 (2007), 0.2 (2008), 0.1 (2009 Proj. 1/)
- Net domestic financing (percent of GDP): -0.1 (2004), -3.3 (2005), -0.4 (2006), 0.3 (2007), 1.8 (2008), 4.4 (2009 Proj. 1/)
- Net external financing (percent of GDP): 1.4 (2004), 0.6 (2005), 1.3 (2006), 1.0 (2007), 0.0 (2008), 0.0 (2009 Proj. 1/)
- Public debt (percent of GDP): 25.5 (2004), 18.7 (2005), 15.7 (2006), 13.0 (2007), 10.6 (2008), 17.4 (2009 Proj. 1/)
  - Of which: external debt (foreign currency denominated) (percent of GDP): 19.2 (2004), 14.1 (2005), 12.5 (2006), 10.2 (2007), 7.4 (2008), 10.0 (2009 Proj. 1/)
- Base money (end of period, percent change): 34.1 (2004), 53.9 (2005), 17.5 (2006), 46.0 (2007), 33.0 (2008), 10.9 (2009 Proj. 1/)
- Broad money (end of period, percent change): 31.9 (2004), 54.4 (2005), 34.5 (2006), 51.7 (2007), 37.2 (2008), 9.4 (2009 Proj. 1/)
- Credit to nongovernment (end of period, percent change): 30.2 (2004), 61.8 (2005), 70.6 (2006), 74.0 (2007), 40.9 (2008), -9.8 (2009 Proj. 1/)
- Current account balance (percent of GDP): 10.6 (2004), 2.9 (2005), -1.5 (2006), -3.7 (2007), -6.2 (2008), -2.0 (2009 Proj. 1/)
- Foreign direct investment (percent of GDP): 2.6 (2004), 8.7 (2005), 5.3 (2006), 6.5 (2007), 6.2 (2008), 6.8 (2009 Proj. 1/)
- Gross reserves (end of period, billions of U.S. dollars): 9.5 (2004), 19.4 (2005), 22.3 (2006), 32.5 (2007), 31.4 (2008), 30.7 (2009 Proj. 1/)
  - In months of next year's imports: 2.6 (2004), 4.4 (2005), 3.7 (2006), 4.0 (2007), 5.1 (2008), 4.5 (2009 Proj. 1/)
- Debt service (percent of exports of goods and services): 5.3 (2004), 4.9 (2005), 5.1 (2006), 3.9 (2007), 2.8 (2008), 4.2 (2009 Proj. 1/)
- Goods exports (annual volume change, percent): 18.2 (2004), -8.5 (2005), 2.7 (2006), 3.2 (2007), 0.3 (2008), 0.8 (2009 Proj. 1/)
- Goods imports (annual volume change, percent): 13.8 (2004), 13.0 (2005), 12.5 (2006), 20.3 (2007), 16.0 (2008), -19.7 (2009 Proj. 1/)
- Goods exports (percent of GDP): 51.5 (2004), 40.7 (2005), 36.1 (2006), 35.2 (2007), 35.3 (2008), 39.9 (2009 Proj. 1/)
- Goods imports (percent of GDP): 45.8 (2004), 42.0 (2005), 40.9 (2006), 42.7 (2007), 44.8 (2008), 46.4 (2009 Proj. 1/)
- Share of metals in merchandise exports (percent): 39.0 (2004), 40.1 (2005), 42.2 (2006), 41.7 (2007), 44.5 (2008), 30.3 (2009 Proj. 1/)
- Net imports of energy (billions of U.S. dollars): 6.0 (2004), 6.1 (2005), 8.1 (2006), 11.5 (2007), 17.2 (2008), 16.0 (2009 Proj. 1/)
- Goods terms of trade (percent change): 9.6 (2004), 6.2 (2005), -0.2 (2006), 9.0 (2007), 7.8 (2008), -14.5 (2009 Proj. 1/)
- Goods and services terms of trade (percent change): 7.8 (2004), 4.9 (2005), 1.5 (2006), 7.4 (2007), 8.9 (2008), -10.5 (2009 Proj. 1/)
- Exchange rate regime: de facto peg (2004–2007), managed float (from 2008 with policies assumed)
- Hryvnia per U.S. dollar, end of period: 5.3 (2004), 5.0 (2005), 5.0 (2006), 5.0 (2007)
- Per capita GDP: US$ 3,035 (2007)
- Poverty (percent of population): 8.0 (2006; World Bank estimate)
- Life expectancy at birth: 68.3 years (2007)
- Infant mortality (per 1,000): 11.0 (2007)
- Gross primary enrollment (percent net): 90.2 (2007)

*International Monetary Fund staff report, December 11, 2008.*

### Section 1

### Ukraine—Stand-By Arrangement—Review Under the Emergency Financing Mechanism (Section 1)

### Summary / Overview
- Arrangement: two-year Stand-By Arrangement (SBA) for Ukraine under the Emergency Financing Mechanism (EFM), approved on November 5, 2008, in the amount of SDR 11 billion ($16.4 billion, 802 percent of Ukraine’s quota).
- First purchase: SDR 3 billion ($4.5 billion) made following the Board meeting.
- Report completion date: December 11, 2008.
- Main judgement: Policies are being implemented broadly in line with program understandings, although risks to the program remain high given political tensions, the fragile state of the banking system, the sharp contraction of the economy, and rapid currency depreciation.
- Key near-term action: Policies will be assessed carefully at the time of the first review under the arrangement (late January 2009) to ensure program objectives remain within reach.

### Staff and Consultations
- Staff team: Ms. Pazarbasioglu (head); Messrs. Hofman and Moulin (EUR), Mr. Arslanalp (FAD), Mr. Duenwald (SPR), and Mr. Laeven (RES).
- Additional support: concurrent MCM mission led by Mr. Olafsson and Mr. Horvath (resident representative); a safeguards assessment mission by FIN; LEG/MCM mission on exchange controls (to finalize by December 19, 2008); cooperation with World Bank staff on structural issues.
- Meetings (December 1–9, 2008) with: President Yushchenko; Prime Minister Tymoshenko; Minister of Finance Pynzenyk; NBU Governor Stelmakh; First Deputy Chief of Staff Mr. Shlapak; senior officials; ambassadors; members of Parliament; private banking and business communities; senior representatives of the main opposition party.

### Recent Developments and Outlook
- Output and growth:
  - October real GDP growth: –2 percent (year-on-year), down from above 5 percent in September.
  - 2008 expected real GDP growth: likely in the 4–5 percent range, instead of 6 percent as assumed in the program.
  - Risks: increased likelihood of a deeper-than-expected recession in 2009.
- Inflation:
  - CPI inflation: eased from 24.6 to 22.3 percent year-on-year between September and November.
  - Cumulative nominal depreciation of the hryvnia in effective terms since end-September: 30 percent.
  - Core inflation and wage growth: declined slightly.
- Trade and terms-of-trade:
  - Pronounced turnaround in trade in October: both export and import growth fell markedly.
  - Current account deficit: continued to widen, preliminary November figures suggest an inversion of tendency.
  - Outlook: imported energy prices likely to be lower than expected in 2009; recent modest rebound in steel prices could produce upside surprise to Ukraine’s terms-of-trade.
- Capital flows and market access:
  - Net FDI and medium- and long-term borrowing: indications of decline relative to year-ago levels, but remained positive in October.
  - Several big companies and subsidiaries of foreign banks rolled over debt through direct borrowing from parent banks and related offshore entities.
- Financial market indicators:
  - Sovereign CDS and bond spreads: rose again after a late-October drop and remain at elevated levels.
  - Exchange rate: weakened considerably.
  - Market sentiment deterioration since approval of the program attributed to political developments and concerns about private sector defaults due to refinancing difficulties.

### Exchange Rate, Reserves, and Banking Conditions
- Exchange rate and reserves:
  - NBU foreign exchange sales since beginning of November: about $3.5 billion.
  - Net international reserves (measured at program exchange rates) as of December 5: $29.9 billion.
  - Program end-December floor for net international reserves: $26.7 billion.
  - Policy: for a brief period since approval of the arrangement on November 5, authorities essentially re-pegged the exchange rate, causing sizeable reserve losses; subsequently allowed the currency to float and introduced regular foreign exchange intervention auctions.
- Hryvnia behavior:
  - Large-scale interventions kept the exchange rate around Hrv 5.8 per dollar up to mid-November; since then a more flexible exchange rate policy allowed depreciation.
- Interbank rates and liquidity:
  - Interbank overnight rates: peaked at about 50 percent at end-November, declined to the 25–30 percent range in early December.
  - NBU liquidity support provided since early October: about Hrv 40 billion, partly through a “financial rehabilitation” facility to banks with shortfalls in regulatory capital.
  - Base money: Hrv 174 billion as of December 5 compared to the end-year target of Hrv 190 billion.
- Deposits and credit:
  - Local currency deposits: loss of 14 percent between end-September and end-November.
  - Foreign currency deposits: also declined, but since mid-November households’ foreign currency deposits returned attracted by high interest rates.
  - Credit growth: came to a halt in November (taking into account revaluation effects), with sharp contractions in mortgage and consumer lending.
- Nonperforming loans and vulnerabilities:
  - Significant share of borrowers affected: banks report that a 50 percent depreciation of the hryvnia against the dollar would increase the debt service-to-income ratio from 60 percent to nearly 100 percent for about 20 percent of borrowers.
  - Foreign currency deposits share in total deposits (households): about 50 percent.
  - Underreporting of income: about one third.
  - Banks approaching minimum regulatory capitalization: 10 percent.
  - Sector impact: foreign currency household loans and loans to corporates in metal, energy, and construction sectors taking the brunt of losses.

### Policy Implementation — Monetary and Exchange Rate Policy
- Exchange rate policy:
  - After an initial re-peg, authorities introduced a flexible exchange rate policy in line with the program and introduced regular FX intervention auctions to increase transparency and improve price discovery.
  - Foreign exchange tax: to be abolished in 2009 as agreed under the program to improve FX market operation.
  - Mission advice: keep intervention amounts low given large reserve losses and potential external payments (such as Naftogaz debt); convey clear public commitment to a flexible exchange rate regime.
- Monetary tightening (early December measures):
  - Refinance rate: increased from 16 to 20 percent.
  - Interest rate paid on bank deposits at the central bank: raised from 7 to 10 percent.
  - Refinance credit: provision restricted to overnight and two week maturities; collateral requirements tightened; bank shares eliminated from list of acceptable collateral.
  - Vault cash: excluded from calculation of bank reserves.
  - Staff recommendation: keep base money under the end-year target and consider further tightening should pressure on the hryvnia continue.

### Policy Implementation — Financial Sector Policy
- Bank recapitalization diagnostic:
  - NBU resolution on November 21 specified guidelines for diagnostic study.
  - Audit firms selected and started work in systemically important banks; plan to provide audit reports to the NBU by December 15, 2008 to observe related conditionality (MEFP ¶13).
  - A more comprehensive analysis covering a larger portion of banks’ credit portfolios to be made available by January 5, 2009.
  - During diagnostics: authorities will agree with bank management on restructuring plans if financial conditions deteriorate.
  - Mission recommendation: NBU should intensify discussions with foreign banks and home supervisors to assess parent bank funding to Ukrainian subsidiaries and develop contingency plans.
- Prominvest Bank resolution:
  - Prominvest Bank was sold to private investors in November (prior action); strategic investors failed to inject required additional capital and the bank was nationalized on December 9, 2008.
  - Authorities will seek potential capital participation by the EBRD and/or other IFIs.
  - Mission view: a final resolution with IFI participation would increase transparency and facilitate faster resolution of problem banks.

### Policy Implementation — Fiscal Policy
- End-year fiscal target:
  - Target: general government deficit below 1 percent of GDP.
  - Budget position: in balance at end-November.
  - Cabinet measures (November): resolution to contain seasonal end-year spending surge; strengthens Treasury control over expenditures by line ministries and local governments; requires public enterprises to submit surplus revenues to the budget by end-year; freezes non-priority spending on goods and services.
  - Risks to target: sharp contraction of output and tax arrears from Naftogaz affecting revenue performance.
  - Authorities’ stance: confident about meeting end-December fiscal performance criterion.
- 2009 budget preparations:
  - Authorities reiterated commitment to a balanced budget next year and started technical preparations for the draft 2009 budget.
  - Staff advice: construct the budget on conservative growth and revenue assumptions; international experience suggests weak tax collection during crisis periods.
  - Mission proposals: additional expenditure-saving measures to balance the budget (including subsidies to loss-making companies), while advising against a sharp contraction in capital spending and encouraging sufficient appropriations for well-targeted social programs.
  - Budget adoption: will take place once parliament resumes operations; timing remains uncertain.
  - Cabinet resolution: ensure effective budget execution in first three months of 2009 based on expenditure targets of the 2008 budget.
  - Fiscal stance: to be reevaluated at the time of the first review in light of macroeconomic and financing developments.
- Financing:
  - Financing remains limited to official sources.

*International Monetary Fund staff report, December 11, 2008.*

### Section 2

### _cr0917 - Section 2

### Financing, Privatization, and Official Financing
- Ukraine remains shut out from international capital markets, and domestic borrowing is constrained by limited liquidity in the banking sector.
- The Cabinet has approved an expanded list of enterprises slated for privatization in 2009; prospects may be limited given adverse global financial conditions.
- Official financing prospects described:
  - World Bank expected to approve a $500 million loan for budget support by end-December.
  - World Bank negotiations underway for financing of two large projects for roads and railways (noted: $500 million of project financing has been approved and another $1.1 billion is under preparation).
  - EBRD has approved a EUR 1.1 billion envelope for Ukraine financial sector projects, equity, debt, trade finance and SME finance for 2009.

### Import Restrictions and Private Sector Foreign-Currency Debt
- Staff opposed proposed import restrictions:
  - A draft legislative amendment to allow temporary import surcharges in event of balance of payments difficulties has been cleared by a parliamentary committee and registered in parliament.
  - Staff stressed such measures would be inconsistent with a continuous performance criterion under the program and that balance of payments difficulties are best addressed through macroeconomic and exchange rate policies in the program.
- Debt resolution:
  - Mission urged authorities to make progress on resolution of private sector debt denominated in foreign currency.
  - Mission discussed implications of different scenarios regarding risks of extensive private sector default based on macroeconomic and banks’ portfolio data.
  - Recommendation: authorities work jointly with banks to develop a voluntary framework for restructuring household debt.

### Staff Appraisal — Policy Implementation and Economic Outlook
- Policy implementation:
  - Largely in line with the program, except for some initial slippage in exchange rate policy.
  - Authorities have introduced a flexible exchange rate regime, tightened monetary policy, and taken measures to contain the 2008 government deficit.
  - Progress made on the diagnosis phase of the bank recapitalization program.
- Economic outlook:
  - The outlook has deteriorated: the large negative terms-of-trade shock and capital and deposits outflow-driven credit contraction have had a considerable impact on the real sector.
  - Real GDP growth in 2008 is likely to fall short of the program projection and risks of a deeper recession in 2009 have increased.

### Exchange Rate and Monetary Policy Recommendations
- Continue implementation of the flexible exchange rate regime to:
  - Cushion the economy against further deterioration of the terms-of-trade.
  - Prevent pent-up demand for foreign currency.
  - Potentially stimulate capital inflows.
- Authorities should continue regular foreign exchange auctions, with intervention amounts grounded in appropriate reserves targets.
- Monetary tightening measures noted and recommended:
  - Recent increases in the refinance rate and tightening of prudential limits on foreign currency lending should improve attractiveness of hryvnia holdings.
  - Restriction of refinance credit at maturities of less than two weeks and elimination of bank shares from acceptable collateral are positive steps.
  - Further tightening of monetary policy, should pressures on the hryvnia continue, is an essential part of the program.

### Banking Sector Policies and Bank Resolution
- Authorities should adhere closely to banking policies specified under the program:
  - Closely monitor liquidity positions of banks and intensify supervision of banks increasingly relying on central bank liquidity support.
  - Prompt action necessary to resolve banks that may be facing difficulties.
  - For Prominvest bank: authorities should promptly engage on potential capital participation by the EBRD and/or other IFIs to restructure the bank in a transparent manner.
  - Diagnostic and analysis deliverables:
    - Authorities should deliver the diagnostic reports for systemic banks on December 15, 2008.
    - Staff welcomes commitment to provide further analysis of banks’ loan portfolios by January 5, 2008.

### Fiscal Policy Guidance
- Prudent fiscal policy critical given difficult financing conditions and revenue risks:
  - For 2008, authorities should keep the government deficit below 1 percent of GDP.
  - For 2009, they should target a balanced budget in line with the program.
  - Fiscal plans should be based on conservative assumptions, supported by credible expenditure-saving measures, avoid overly large cuts in capital expenditure, and expand well-targeted social programs.
- Plans to impose import restrictions should be abandoned as inconsistent with a continuous performance criterion under the SBA.

### Private Debt Restructuring Strategy
- A strategy for voluntary resolution of corporate and household debt problems is urgently needed.
- The working group composed of banks, NBU, and MoF should rapidly design and implement a voluntary framework for restructuring private sector debts, including proposals to facilitate out-of-court settlements.

### Implementation Risks and Coordination
- Program implementation risks require close coordination among the authorities and with the Fund.
- Bank resolution is a key element nearing implementation phase and will involve decisions affecting vested interests and public finances.
- Requires extraordinary coordination among authorities, consistent backing by key political leaders, and better communication to markets.

### Key Statistics (selected from Table 1)
- Nominal GDP (billions of hryvnias): 345 (2004), 441 (2005), 544 (2006), 713 (2007), 993 (2008), 1,112 (2009 Proj. 1/)
- Real GDP (percent change): 12.1 (2004), 2.7 (2005), 7.3 (2006), 7.6 (2007), 6.0 (2008), -3.0 (2009 Proj. 1/)
- Contributions to real GDP:
  - Domestic demand: 9.1 (2004), 13.2 (2005), 13.1 (2006), 16.1 (2007), 14.4 (2008), -14.3 (2009 Proj. 1/)
  - Net exports: 3.0 (2004), -10.5 (2005), -5.8 (2006), -8.5 (2007), -8.3 (2008), 11.3 (2009 Proj. 1/)
- Unemployment rate (ILO): 8.6 (2004), 7.2 (2005), 6.8 (2006), 6.4 (2007), 6.0 (2008), 9.5 (2009 Proj. 1/)
- Consumer prices (period average): 9.0 (2004), 13.5 (2005), 9.1 (2006), 12.8 (2007), 25.6 (2008), 21.0 (2009 Proj. 1/)
- Consumer prices (end of period): 12.3 (2004), 10.3 (2005), 11.6 (2006), 16.6 (2007), 25.5 (2008), 17.0 (2009 Proj. 1/)
- Nominal monthly wages (average): 27.5 (2004), 36.7 (2005), 29.2 (2006), 29.7 (2007), 37.1 (2008), 10.5 (2009 Proj. 1/)
- Real monthly wages (average): 16.9 (2004), 20.4 (2005), 18.4 (2006), 15.0 (2007), 9.1 (2008), -8.7 (2009 Proj. 1/)
- Cash balance excluding banks recap (percent of GDP): -4.4 (2004), -2.3 (2005), -1.4 (2006), -2.0 (2007), -1.0 (2008), 0.0 (2009 Proj. 1/)
- Augmented balance, including effects of banks recap. (percent of GDP): -4.4 (2004), -2.3 (2005), -1.4 (2006), -2.0 (2007), -2.0 (2008), -4.5 (2009 Proj. 1/)
- Privatization proceeds (percent of GDP): 3.1 (2004), 5.0 (2005), 0.4 (2006), 0.6 (2007), 0.2 (2008), 0.1 (2009 Proj. 1/)
- Net domestic financing (percent of GDP): -0.1 (2004), -3.3 (2005), -0.4 (2006), 0.3 (2007), 1.8 (2008), 4.4 (2009 Proj. 1/)
- Net external financing (percent of GDP): 1.4 (2004), 0.6 (2005), 1.3 (2006), 1.0 (2007), 0.0 (2008), 0.0 (2009 Proj. 1/)
- Public debt (percent of GDP): 25.5 (2004), 18.7 (2005), 15.7 (2006), 13.0 (2007), 10.6 (2008), 17.4 (2009 Proj. 1/)
  - Of which: external debt (foreign currency denominated) (percent of GDP): 19.2 (2004), 14.1 (2005), 12.5 (2006), 10.2 (2007), 7.4 (2008), 10.0 (2009 Proj. 1/)
- Base money (end of period, percent change): 34.1 (2004), 53.9 (2005), 17.5 (2006), 46.0 (2007), 33.0 (2008), 10.9 (2009 Proj. 1/)
- Broad money (end of period, percent change): 31.9 (2004), 54.4 (2005), 34.5 (2006), 51.7 (2007), 37.2 (2008), 9.4 (2009 Proj. 1/)
- Credit to nongovernment (end of period, percent change): 30.2 (2004), 61.8 (2005), 70.6 (2006), 74.0 (2007), 40.9 (2008), -9.8 (2009 Proj. 1/)
- Current account balance (percent of GDP): 10.6 (2004), 2.9 (2005), -1.5 (2006), -3.7 (2007), -6.2 (2008), -2.0 (2009 Proj. 1/)
- Foreign direct investment (percent of GDP): 2.6 (2004), 8.7 (2005), 5.3 (2006), 6.5 (2007), 6.2 (2008), 6.8 (2009 Proj. 1/)
- Gross reserves (end of period, billions of U.S. dollars): 9.5 (2004), 19.4 (2005), 22.3 (2006), 32.5 (2007), 31.4 (2008), 30.7 (2009 Proj. 1/)
  - In months of next year's imports: 2.6 (2004), 4.4 (2005), 3.7 (2006), 4.0 (2007), 5.1 (2008), 4.5 (2009 Proj. 1/)
- Debt service (percent of exports of goods and services): 5.3 (2004), 4.9 (2005), 5.1 (2006), 3.9 (2007), 2.8 (2008), 4.2 (2009 Proj. 1/)
- Goods exports (annual volume change, percent): 18.2 (2004), -8.5 (2005), 2.7 (2006), 3.2 (2007), 0.3 (2008), 0.8 (2009 Proj. 1/)
- Goods imports (annual volume change, percent): 13.8 (2004), 13.0 (2005), 12.5 (2006), 20.3 (2007), 16.0 (2008), -19.7 (2009 Proj. 1/)
- Goods exports (percent of GDP): 51.5 (2004), 40.7 (2005), 36.1 (2006), 35.2 (2007), 35.3 (2008), 39.9 (2009 Proj. 1/)
- Goods imports (percent of GDP): 45.8 (2004), 42.0 (2005), 40.9 (2006), 42.7 (2007), 44.8 (2008), 46.4 (2009 Proj. 1/)
- Share of metals in merchandise exports (percent): 39.0 (2004), 40.1 (2005), 42.2 (2006), 41.7 (2007), 44.5 (2008), 30.3 (2009 Proj. 1/)
- Net imports of energy (billions of U.S. dollars): 6.0 (2004), 6.1 (2005), 8.1 (2006), 11.5 (2007), 17.2 (2008), 16.0 (2009 Proj. 1/)
- Goods terms of trade (percent change): 9.6 (2004), 6.2 (2005), -0.2 (2006), 9.0 (2007), 7.8 (2008), -14.5 (2009 Proj. 1/)
- Goods and services terms of trade (percent change): 7.8 (2004), 4.9 (2005), 1.5 (2006), 7.4 (2007), 8.9 (2008), -10.5 (2009 Proj. 1/)
- Exchange rate regime: de facto peg (2004–2007), managed float (from 2008 with policies assumed)
- Hryvnia per U.S. dollar, end of period: 5.3 (2004), 5.0 (2005), 5.0 (2006), 5.0 (2007)
- Per capita GDP: US$ 3,035 (2007)
- Poverty (percent of population): 8.0 (2006; World Bank estimate)
- Life expectancy at birth: 68.3 years (2007)
- Infant mortality (per 1,000): 11.0 (2007)
- Gross primary enrollment (percent net): 90.2 (2007)

*Sources: Ukrainian authorities; and staff estimates and projections.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0917.pdf_