## 1. Ukraine: Stand-By Arrangement

## Source details

**Canonical URL:** [1. Ukraine: Stand-By Arrangement](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12315.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12315.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12315.pdf.json)

---

### Context
- Real GDP contracted by 15 percent in 2009 and subsequently stabilized and resumed growth.
- Inflation fell to single digits during the recovery period.
- Combined general government and Naftogaz (NG) fiscal deficit was halved to 4.3 percent of GDP by 2011.
- Policy measures supporting consolidation included pension reform and gas price increases (in mid-2010), and a cyclical rebound in revenues.
- Banking system was stabilized and recapitalized; several banking and crisis resolution laws and reforms were completed.
- Sovereign regained access to international markets and foreign exchange reserves were rebuilt.
- Ukraine’s per-capita income is about $3,600, or 10 percent of the EU27 level.

### Stand-By Arrangement (SBA) details and status
- Program: 29-month, SDR 10.0 billion (US$15.4 billion, 729 percent of quota), approved July 28, 2010 (EBS/10/146).
- Reviews and purchases:
  - First review completed December 2010 (EBS/10/232).
  - Two purchases totaling SDR 2.25 billion have been made, of which US$2 billion was for budget support.
- Program expiration: December 2012.
- Implementation issues and status:
  - Second review under the SBA on hold since March 2011 due to program performance falling short of expectations.
  - Positive actions: pension reform legislation enacted in October 2011; progress strengthening the banking sector.
  - Key obstacles/delays: authorities backtracked on commitment to raise gas and heating tariffs in 2011; incomplete or delayed reforms in the VAT refund system, social assistance programs, corporate insolvency law, fx regulations, resolution of intervened banks, and framework for addressing NPLs.
  - Fiscal: combined deficit with NG of 4.3 percent of GDP exceeded the 3.5 percent program target due to NG’s overruns.
  - Exchange rate policy: reluctance to allow greater exchange rate flexibility undermined ability to boost reserve buffers in line with program objectives.
- Official sector support: World Bank and European Commission budget support remain suspended.
- Authorities are considering necessary actions to resume program relations.

### Key policy implications (high level)
- Immediate steps in fiscal consolidation and reforms in the energy and banking sectors are needed to reduce vulnerabilities and strengthen confidence and market access.
- Contingency planning for potential shocks should continue.
- Deeper structural reforms are needed to rebuild buffers and strengthen institutions to realize Ukraine’s substantial growth potential.

*Source: IMF — 2012 Article IV Report, "Ukraine: Stand-By Arrangement" (content unit provided).*

### Banking sector health, reforms, and vulnerabilities
- Capital and provisioning:
  - Capital adequacy ratios are above the statutory minimum after two rounds of capital injections in 2009–10.
  - Bank profitability is near zero as banks continue provisioning against bad loans.
  - Nonperforming loans are around 15 percent of total loans (39 percent under broad definition of NPLs).
- Credit and balance-sheet indicators:
  - Credit growth to the economy was only 6 percent in March, y-o-y.
  - Credit as a percent of GDP has fallen from 79 percent in 2008 to 59 percent.
  - Banking system overall fx short position about US$8 billion.
  - Banks have fx (mostly in US$) loans to unhedged borrowers.
  - BIS figures show a 26 percent drop in foreign bank exposure to Ukraine during 2011.
  - Loan-to-deposit ratio has fallen to 160 percent, from a 2009 peak of 230 percent.
  - External support for the banking system is shrinking.
- Legal and supervisory reforms completed (past 18 months):
  - Ultimate Controllers law (transparency).
  - Consolidated Supervision law (banking supervision).
  - New provisioning regulations.
  - Migration to IFRS.
  - Deposit Guarantee Fund law (resolution framework).
  - Implementing regulations for these laws are being finalized.
- Bank resolution and privatization:
  - Nadra Bank (intervened in 2009) was privatized and recapitalized during 2011 with private funds.
  - Resolution of the remaining state-intervened banks continues.
- Staff recommendations and supervisory priorities:
  - Review contingency plans; strengthen monitoring; create a dedicated financial stability unit.
  - Close supervision with ‘early warning system’ tracking; enhanced monitoring of banks with weaker indicators and well-developed action plans including additional capital injection and reductions of related party lending if necessary.
  - Encourage consolidation of the sector to address governance and supervision problems from a large number of smaller banks.
  - Quick resolution of remaining state-intervened banks, including completion of the transformation of one bank into a bad bank to absorb NPLs.

### Liquidity support and crisis-era legacy measures
- NBU stabilization loans outstanding total about UAH60 billion (granted in 2008-9).
- Resolution 109 pushed banks’ economic net open position about US$8 billion short.
- Staff urged gradual unwinding of Resolution 109 through staged liberalization of LLPs on fx loans and careful sequencing (pilot involving a few banks), and modest issuance of fx-linked bonds by the government.
- Banks face potential systemic liquidity gap from UAH60 billion in NBU stabilization loans, hryvnia liquidity needs to unwind Resolution 109, and loss of term financing through deleveraging.
- NBU could address liquidity gaps through refinancing, repo, and other liquidity management tools, but should reaffirm bank solvency before extending or providing new liquidity.

### Outlook: growth, inflation, external financing, and reserves (baseline and medium-term)
- Short-term baseline projections and needs:
  - Real GDP growth expected to slow to 3 percent this year.
  - Inflation expected to rise to 7.4 percent y-o-y.
  - Current account deficit expected to rise to 6.4 percent of GDP.
  - Gross external financing needs high, including US$21 billion in maturing bonds and MLT loans, and repayments to the Fund.
  - Gross reserves projected to drop to around US$24 billion (40 percent of short-term debt) by year-end.
  - Public financing needs significant; authorities will likely rely heavily on domestic financing.
- Medium-term baseline scenario:
  - Real GDP growth would recover to around 3.5 percent next year.
  - Current account deficit would moderate slightly to around 5.5 percent of GDP.
  - Inflation would gradually fall to about 5 percent.
  - Gross reserves would drop to very low levels in 2013–14 (27 percent of short-term debt).
  - External and public debt would settle at around 65 and 35 percent of GDP, respectively.
  - Some standard debt shocks suggest potentially unsustainable trajectories, particularly with respect to growth shocks.
- Risks:
  - Downside risks include worsening euro area turbulence or global growth slowdown.
  - Vulnerabilities: low reserve cover, large external and fiscal financing needs, heavy dependence on commodity export prices, and crisis-weary public.
  - Loss of market access or significant global slowdown could trigger currency overshooting, high interest rates, financial sector disruptions, recession, and higher unemployment.

### Fiscal policy, energy sector, and public finances
- Authorities’ fiscal targets and staff concerns:
  - Authorities reiterated commitment to limit the general government deficit to 1.8 percent of GDP in 2012 and the NG deficit to 0.7 percent of GDP.
  - Staff warned that, absent measures, the deficit likely to approach 3.3 percent of GDP in 2012 and projected combined general government and NG deficit could rise to 5.3 percent of GDP (against a 2.5 percent target).
- Staff-recommended fiscal measures to meet the 1.8 percent of GDP target:
  - Immediate adoption of fiscal measures, including:
    - Increase tax rate for higher income earners (from 17 to 20 percent for the second tax bracket).
    - Eliminate tax exemptions (mainly VAT exemptions).
    - Remove special tax treatment with offshore tax havens.
    - Cuts in current spending.
  - If contingency measures preferred, be prepared to adopt them quickly.
  - Staff cautioned against use of restrictive trade policy measures (tariffs) to generate revenue.
- Energy sector pricing and NG finances:
  - Prices received by NG from households and utilities are on average less than one-quarter of the cost to import the gas.
  - Staff view: raise household gas and heating tariffs to increase the gas price received by NG.
  - Staff estimate initial modest revenue gains of 0.2 percent of GDP this year from tariff increases, with larger gains over time.
  - Staff advocated energy efficiency improvements and better-targeted social assistance to support the poorest.
  - Authorities rejected near-term household tariff increases; focus on payment discipline, improving heating meter coverage and household energy saving infrastructure supported by subsidized loans to households, then gradually increase end-user energy prices.
  - Staff recommended significant and upfront increases (in context of SBA negotiations): 30 percent and 58 percent in the price received by NG for household gas and from heating utilities (with full pass-through to end-user tariffs), followed by semi-annual increases (20 percent) for each.
- Medium-term public finance reform priorities urged by staff:
  - Well-targeted social spending to cushion fiscal consolidation impacts.
  - Public administration reform in health and education sectors.
  - Fiscal framework improvements: monitoring, disclosing and controlling fiscal risks; develop a medium-term fiscal framework.
  - Improved revenue administration to reduce tax avoidance and shrink the shadow economy.
  - Prioritized public investment included in the budget; limit off-budget guarantees.

### Monetary and exchange rate policy guidance
- Monetary policy orientation:
  - Monetary policy should focus on achieving price stability, consistent with the NBU’s mandate.
  - Gradually increasing exchange rate flexibility would better adapt to fundamentals, preserve competitiveness, provide a buffer to external shocks, push private sector to assess fx risk, and help raise reserves.
  - Increased exchange rate flexibility should be supported by fiscal, monetary, and wage policies consistent with maintenance of price stability.
  - Staff advised continuation of agreed foreign exchange market liberalization plan, including establishing a framework to develop the forward exchange market.
- Authorities’ views:
  - De jure policy: “transition to a free floating exchange rate”; no predetermined path for the exchange rate.
  - Accepted case for more day-to-day flexibility but concerned about exchange rate volatility given balance sheet mismatches and public confidence in the hryvnia.
  - Agreed interest rates need a leading role but wish to proceed carefully and gradually.
  - Noted import coverage remained above 3 months and expected fx inflows to increase as confidence improves.
- Unwinding crisis-era measures:
  - Unwinding Resolution 109 and repayment of stabilization loans, combined with external deleveraging, could put pressure on liquidity and the exchange rate.
  - Staff urged NBU to gradually unwind Resolution 109 through staged liberalization of LLPs on fx loans in a manner that treats all banks equally.
  - Staff recommended careful sequencing (pilot involving a few banks) and modest issuance of fx-linked bonds by the government should begin soon.
  - NBU should reaffirm bank solvency before extending or providing new liquidity and avoid undermining development of private longer-term capital funding.

### Debt sustainability, stress tests, and scenarios (public and external)
- Public sector debt baseline (percent of GDP): 12.3; 20.5; 35.4; 40.5; 36.0; 34.7; 35.1; 35.2; 35.5; 35.5; 35.6 (series 2007–17 baseline and projections).
- External debt baseline (percent of GDP): 56.0; 56.4; 88.2; 86.0; 76.4; 69.8; 67.1; 65.9; 65.5; 65.3; 65.0 (series 2007–17 baseline and projections).
- Gross external financing need (billions of U.S. dollars): 53.2; 67.1; 57.4; 48.9; 69.9; 72.0; 71.3; 74.3; 78.4; 83.1; 85.6 (series 2007–17).
- Stress tests considered (public and external):
  - Interest rate shock (permanent one-half standard deviation).
  - Growth shock.
  - Primary balance shock and No Policy Change scenario (constant primary balance).
  - Combined shock (permanent 1/4 standard deviation shocks to real interest rate, growth rate, and primary balance).
  - Real depreciation and contingent liabilities shock (one-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occurring in 2009).
- Some standard debt shocks suggest potentially unsustainable trajectories, particularly with respect to growth shocks.

### Energy sector: Naftogaz (NG) economic costs and reform priorities
- Structure and flows:
  - Domestic natural gas production down to 16 bcm per annum from 20 bcm in past years.
  - Ukraine imports about two thirds of its annually consumed gas from Russia.
  - NG manages transit of about 100–110 bcm of Russian gas to western and central Europe.
- NG financials (billions of Ukrainian hryvnia):
  - Revenue: 2009 = 78.4; 2010 = 121.8; 2011 = 114.4
  - Gas sales: 2009 = 60.7; 2010 = 73.6; 2011 = 86.9
  - Gas transit fees: 2009 = 13.1; 2010 = 29.0; 2011 = 25.5
  - Expenditure: 2009 = 101.1; 2010 = 140.0; 2011 = 134.8
  - Gas imports: 2009 = 41.8; 2010 = 80.0; 2011 = 73.8
  - Cash balance: 2009 = -22.6; 2010 = -18.2; 2011 = -20.4
  - Underlying balance (percent of GDP): 2009 = -2.2; 2010 = -2.0; 2011 = -1.6
  - Quasi-fiscal activities (Total percent of GDP): 2009 = 4.7; 2010 = 5.2; 2011 = 5.0
  - Per unit of gas sold (UAH/tcm): 2009 = 1035; 2010 = 1201; 2011 = 1480
- Aggregate impacts:
  - In 2011, NG’s economic cost was almost 5 percent of GDP.
  - NG suffered deficits of 1.7 and 1.5 percent of GDP in 2010 and 2011.
- Policy recommendations and reforms:
  - Raise household gas and heating tariffs towards cost recovery; combine with energy efficiency improvements and targeted social assistance.
  - Regulatory and structural reforms: centralized independent regulator assuming oversight for tariff-setting; protocol for accession to Energy Community Treaty (ECT); 2012 law permitting unbundling of Naftogaz entities (privatization remains prohibited); pilot projects with EBRD and EIB; efforts to join EITI.

### Structural reforms, competitiveness, and medium-term growth
- Underlying weaknesses: business climate, high entry barriers, weak competition, poor infrastructure, and low export diversification.
- Key reform areas highlighted:
  - Agriculture: explore land reform and a unified registry of land and real estate.
  - Investment and integration: ease barriers to business entry, operation, and exit; faster integration with the EU.
  - Transparency and governance: reduce scope for discretionary administrative decisions; plan to set up a one-stop investment bureau.
- Staff warned of medium-term growth risks: risk of a low growth equilibrium due to an aging population and financing constraints; productivity improvements are essential; implementation of the President’s Economic Reform Program is critical.

### Statistical, TA, and capacity-building activities
- Ongoing technical assistance (selected items):
  - PEFA — Ongoing — June 2012.
  - Capital Budgeting TA — Ongoing TA through December 2012.
  - Gas sector reform TA — Ongoing 2012-2014.
  - TA provision to NBU, government, and DGF on selected bank supervision issues, problem bank resolution and DGF capacity building — Ongoing TA through June 2013.
  - TA provision to MoF on medium-term framework and budgeting, tax administration modernization — Ongoing TA through early 2013.
- Relations with EBRD:
  - As of end-April 2012, EBRD’s portfolio in Ukraine reached €4.4 billion.
  - EBRD investments in 2011: agribusiness €190 million (12 projects), manufacturing €228 million (9 transactions), infrastructure and energy (private sector) €143 million, and a €200 million sovereign loan for modernization of hydro power stations.
- Data and dissemination issues:
  - Data provision broadly adequate but shortcomings in national accounts, government finance statistics, and external sector statistics.
  - Participant in the SDDS since January 10, 2003.

### Executive Board assessment and priorities (summary of Directors’ guidance)
- Directors welcomed progress since the 2008–09 crisis: rebound in growth, decline in inflation, and decline in the general government deficit.
- Persistent vulnerabilities: low reserve cover, large external and fiscal funding needs, and difficult external environment.
- Priority policy directions:
  - Fiscal consolidation and identification of contingency measures to meet 2012 deficit targets.
  - Comprehensive energy sector reform: gradually increase gas and heating tariffs, enhance payment compliance, increase investment in domestic energy production, improve energy efficiency, and better-target subsidies to protect the poorest.
  - Monetary policy to focus more on price stability; tighten further if balance of payments or inflationary pressures intensify.
  - Gradually increase exchange rate flexibility supported by measures to reduce balance sheet mismatches and by consistent fiscal, monetary, and wage policies.
  - Continue banking-sector reforms to address high NPLs, low profitability, and currency mismatches; proceed with unwinding crisis-era policies.
  - Continue implementation of structural reforms to boost competitiveness, governance, and privatization.

*Source: IMF staff and Ukrainian authorities (2012 Article IV Report, excerpts from _cr12315).*

### 1. Ukraine: Stand-By Arrangement _________________________________________________________________ 5

### 1. Ukraine: Stand-By Arrangement

### Context
- Following the 2008/9 crisis, Ukraine experienced stabilization and resumed growth after a real GDP contraction of 15 percent in 2009.
- Inflation fell to single digits during the recovery period.
- The combined general government and Naftogaz (NG) fiscal deficit was halved to 4.3 percent of GDP by 2011, supported by policy measures including pension reform and gas price increases (in mid-2010), and a cyclical rebound in revenues.
- The banking system was stabilized and recapitalized; several banking and crisis resolution laws and reforms were completed.
- The sovereign regained access to international markets and foreign exchange reserves were rebuilt, strengthening resilience to external and macro-financial shocks.
- Ukraine’s per-capita income is about $3,600, or 10 percent of the EU27 level.

### Box 1 — Stand-By Arrangement (SBA) details and status
- Program: 29-month, SDR 10.0 billion (US$15.4 billion, 729 percent of quota), approved July 28, 2010 (EBS/10/146).
- Reviews and purchases:
  - First review completed December 2010 (EBS/10/232).
  - Two purchases totaling SDR 2.25 billion have been made, of which US$2 billion was for budget support.
- Program expiration: December 2012.
- Program implementation issues:
  - Second review under the SBA on hold since March 2011 due to program performance falling short of expectations.
  - Positive: pension reform legislation enacted in October 2011; progress strengthening the banking sector.
  - Key obstacles/delays: authorities backtracked on commitment to raise gas and heating tariffs in 2011; incomplete or delayed reforms in the VAT refund system, social assistance programs, corporate insolvency law, fx regulations, resolution of intervened banks, and framework for addressing NPLs.
  - Fiscal: combined deficit with NG of 4.3 percent of GDP exceeded the 3.5 percent program target due to NG’s overruns.
  - Exchange rate policy: reluctance to allow greater exchange rate flexibility undermined ability to boost reserve buffers in line with program objectives.
- Official sector support: World Bank and European Commission budget support remain suspended.
- Authorities are considering necessary actions to resume program relations.

### Key policy implications highlighted
- Immediate steps in fiscal consolidation and reforms in the energy and banking sectors are needed to reduce vulnerabilities and strengthen confidence and market access.
- Contingency planning for potential shocks should continue.
- Deeper structural reforms are needed to rebuild buffers and strengthen institutions to realize Ukraine’s substantial growth potential.

### _Italic attribution line_
*Source: IMF — 2012 Article IV Report, "Ukraine: Stand-By Arrangement" (content unit provided).*

### 10.      Progress has been made on banking sector reforms, but bank balance sheets remain

### 10.      Progress has been made on banking sector reforms, but bank balance sheets remain weak, and private credit growth is subdued.

### Banking sector health and recent reforms
- Findings:
  - Capital adequacy ratios are above the statutory minimum, supported by two rounds of capital injections in 2009–10.
  - Bank profitability is near zero as banks continue provisioning against bad loans.
  - Nonperforming loans are around 15 percent of total loans (39 percent under broad definition of NPLs).
  - Credit growth to the economy was only 6 percent in March, y-o-y.
  - Credit as a percent of GDP has fallen from 79 percent in 2008 to 59 percent.
  - The banking system has an overall fx short position of about US$8 billion.
  - Banks have fx (mostly in US$) loans to unhedged borrowers.
  - BIS figures show a 26 percent drop in foreign bank exposure to Ukraine during 2011.
  - Loan-to-deposit ratio has fallen to 160 percent, from a 2009 peak of 230 percent.
  - External support for the banking system is shrinking.
- Completed laws and reforms (past 18 months):
  - Ultimate Controllers law (transparency).
  - Consolidated Supervision law (banking supervision).
  - New provisioning regulations.
  - Migration to IFRS.
  - Deposit Guarantee Fund law (resolution framework).
  - Implementing regulations for these laws are being finalized.
- Bank resolution and privatization:
  - Nadra Bank (intervened in 2009) was privatized and recapitalized during 2011 with private funds.
  - Resolution of the remaining state-intervened banks continues.

### Outlook for growth, inflation, external financing, and reserves
- Baseline macro projections and near-term needs:
  - Real GDP growth expected to slow to 3 percent this year.
  - Inflation expected to rise to 7.4 percent y-o-y.
  - Current account deficit expected to rise to 6.4 percent of GDP.
  - Gross external financing needs are high, including US$21 billion in maturing bonds and MLT loans, and repayments to the Fund.
  - Gross reserves are projected to drop to around US$24 billion (40 percent of short-term debt) by year-end.
  - Public financing needs are significant; authorities will likely rely heavily on domestic financing.
- Medium-term baseline scenario:
  - Real GDP growth would recover to around 3.5 percent next year.
  - Current account deficit would moderate slightly to around 5.5 percent of GDP.
  - Inflation would gradually fall to about 5 percent.
  - Gross reserves would drop to very low levels in 2013–14 (27 percent of short-term debt).
  - External and public debt would settle at around 65 and 35 percent of GDP, respectively.
  - Some standard debt shocks suggest potentially unsustainable trajectories, particularly with respect to growth shocks.
- Risks:
  - Risks to the outlook are tilted to the downside, including worsening euro area turbulence or global growth slowdown.
  - Ukraine’s vulnerabilities: low reserve cover, large external and fiscal financing needs, heavy dependence on commodity export prices, and crisis-weary public.
  - Loss of market access for a protracted period and significant global slowdown could trigger currency overshooting, high interest rates, financial sector disruptions, recession, and higher unemployment.

### Fiscal policy, energy sector, and public finances
- Authorities’ fiscal targets and staff concerns:
  - Authorities reiterated commitment to limit the general government deficit to 1.8 percent of GDP in 2012 and the NG deficit to 0.7 percent of GDP.
  - Staff warned that, absent measures, the deficit is likely to approach 3.3 percent of GDP in 2012 and projected combined general government and NG deficit could rise to 5.3 percent of GDP (against a 2.5 percent target).
- Staff-recommended fiscal measures to meet the 1.8 percent of GDP target:
  - Immediate adoption of fiscal measures, including:
    - Increasing the tax rate for higher income earners (from 17 to 20 percent for the second tax bracket).
    - Eliminating tax exemptions (mainly VAT exemptions).
    - Removing special tax treatment with offshore tax havens.
    - Cuts in current spending.
  - If contingency measures are preferred, be prepared to adopt them quickly.
  - Staff cautioned against the use of restrictive trade policy measures (tariffs) to generate revenue.
- Energy sector strategy and pricing:
  - Staff view: Raise household gas and heating tariffs to increase the gas price received by NG (prices currently, on average, less than one-quarter of the cost to import the gas).
  - Staff estimate initial modest revenue gains of 0.2 percent of GDP this year from tariff increases, with larger gains over time.
  - Staff advocated energy efficiency improvements and better-targeted social assistance to support the poorest.
  - Authorities’ stance: Reject near-term household tariff increases; focus on payment discipline, improving heating meter coverage and household energy saving infrastructure supported by subsidized loans to households, then gradually increase end-user energy prices.
  - Staff argued for significant and upfront increases (in the context of SBA negotiations): 30 percent and 58 percent in the price received by NG for household gas and from heating utilities (with full pass-through to end-user tariffs), followed by semi-annual increases (20 percent) for each.
- Medium-term public finance reform priorities urged by staff:
  - Well-targeted social spending to cushion fiscal consolidation impacts.
  - Public administration reform in health and education sectors.
  - Fiscal framework improvements: monitoring, disclosing and controlling fiscal risks; develop a medium-term fiscal framework.
  - Improved revenue administration to reduce tax avoidance and shrink the shadow economy.
  - Prioritized public investment included in the budget; limit off-budget guarantees.

### Monetary and exchange rate policy, and unwinding crisis-era measures
- Monetary policy orientation:
  - Monetary policy should focus on achieving price stability, consistent with the NBU’s mandate.
  - Gradually increasing exchange rate flexibility would: better adapt to fundamentals, preserve competitiveness, provide a buffer to external shocks, push the private sector to assess fx risk, and help raise reserves.
  - Increased exchange rate flexibility should be supported by fiscal, monetary, and wage policies consistent with maintenance of price stability.
  - Staff advised continuation of the agreed foreign exchange market liberalization plan, including establishing a framework to develop the forward exchange market.
- Authorities’ views:
  - De jure policy: “transition to a free floating exchange rate”; no predetermined path for the exchange rate.
  - Accepted case for more day-to-day flexibility but concerned about exchange rate volatility given balance sheet mismatches and public confidence in the hryvnia.
  - Agreed interest rates need a leading role but wish to proceed carefully and gradually.
  - Noted import coverage remained above 3 months and expected fx inflows to increase as confidence improves.
- Unwinding crisis-era policies (key challenges and staff recommendations):
  - Unwinding Resolution 109 and repayment of stabilization loans, combined with external deleveraging, could put pressure on liquidity and the exchange rate.
  - Staff urged the NBU to gradually unwind Resolution 109 through staged liberalization of LLPs on fx loans (gradually returning them into banks’ statutory calculation of net open position) in a manner that treats all banks equally.
  - Staff recommended careful sequencing (following an NBU pilot involving a few banks) and modest issuance of fx-linked bonds by the government should begin soon, given bank vulnerability to exchange rate depreciation.
  - Banks face potential systemic liquidity gap from UAH60 billion in NBU stabilization loans, hryvnia liquidity needs to unwind Resolution 109, and loss of term financing through deleveraging.
  - The NBU could address liquidity gaps through refinancing, repo, and other liquidity management tools.
  - The NBU should reaffirm bank solvency before extending or providing new liquidity and should avoid undermining development of private longer term capital funding.

*Source: IMF staff and Ukrainian authorities (2012 Article IV Report).*

### 28.      Authorities’ views. The NBU noted it is preparing modifications of liquidity support

### _cr12315 - 28.      Authorities’ views. The NBU noted it is preparing modifications of liquidity support

### Liquidity support, NBU measures, and crisis-era legacies
- The NBU noted it is preparing modifications of liquidity support mechanisms to address the withdrawal of term financing, and to address any systemic liquidity gaps.
- Agreement that policies to unwind these crisis era legacies should be consistent with broader monetary policy objectives (with any support provided only to solvent banks), and that issuance of fx-linked bonds should be limited.
- Resolution 109 has pushed banks’ economic net open position about US$8 billion short.
- Banks have outstanding stabilization loans totaling about UAH60bn (granted by the NBU in 2008-9 in response to deposit runs and an external funding freeze).

### Reducing financial sector vulnerabilities and contingency planning
- Global and domestic risks call for contingency planning and close supervision to ensure an effective response in the event of any renewed pressure on the banking system.
- Staff recommendations:
  - Review contingency plans.
  - Strengthen monitoring.
  - Create a dedicated financial stability unit.
  - Close supervision to ensure compliance with prudential norms, including more reliance on ‘early warning system’ tracking of financial soundness.
  - Enhanced monitoring of banks with weaker indicators, with well-developed action plans including, if necessary, additional capital injection and reductions of related party lending.
  - Encourage consolidation of the sector to address governance and supervision problems from a large number of smaller banks (with reportedly significant connected lending in many cases).
  - Quick resolution of remaining state-intervened banks, including completion of the transformation of one bank into a bad bank to absorb NPLs from state-owned banks and state-intervened banks.
  - Further steps to strengthen state-owned banks consistent with due diligence findings.

- Authorities’ views:
  - Agreed on the importance of contingency plans.
  - Noted ongoing upgrades of supervisory framework, bank resolution and emergency liquidity assistance frameworks, and strengthened communication channels.
  - Indicated they are maintaining appropriate monitoring and supervision of all banks, and are proceeding with plans for enhanced financial stability functions inside the NBU.
  - Proceeding with plans to resolve the three remaining state-intervened banks, which include completing the creation of a bad bank to manage their NPLs.

### Nonperforming loans (NPLs), insolvency, and asset resolution
- Staff stressed the importance of removing regulatory and tax obstacles to recognizing, restructuring, writing off, and selling (to third parties) bad loans.
- Corporate insolvency legislation, approved by Rada in January 2012, needs to be amended to facilitate out-of-court restructuring.
- A strategy to develop the personal insolvency framework is also needed.
- Complementary steps needed to strengthen judicial decisions and collateral enforcement to free up resources for new lending.
- Authorities’ views:
  - Agreed that further steps to facilitate NPL reduction are important.
  - Noted discussions with banks and the government over possible additional tax and legal amendments.
  - Intend to incorporate changes to the insolvency law later this year.
  - Have no plans at this time to reform the personal insolvency framework.

### NBU governance, audit, and safeguards
- Progress noted in strengthening some aspects of the NBU’s safeguards framework.
- The external audit of the NBU’s 2011 financial statements was conducted by Ernst & Young (EY) and completed in a timely manner.
- EY issued an unqualified audit opinion, a progress from the previous qualified opinions from PWC.
- The NBU Council has met and approved the audited financial statements as required under the law.
- Staff is awaiting EY’s 2011 report concerning internal controls and other issues identified by the audit; this report is currently being finalized and should be available for review in mid-2012.

### Structural reforms to boost competitiveness and growth
- Generating sustained improvements in living standards requires further structural reforms to boost competitiveness and growth, while limiting external imbalances.
- Underlying weaknesses to address include the business climate, high entry barriers, weak competition, poor infrastructure, and low export diversification.
- Authorities should press forward with reforms envisaged in the President’s Economic Reform Plan; goals include deeper global integration, more deregulation, stronger governance, and further privatization.
- Key reform areas highlighted:
  - Agriculture: exploring measures including land reform, and a unified registry of land and real estate.
  - Investment and integration: easing barriers to business entry, operation, and exit; faster integration with the EU.
  - Transparency and governance: reduce scope for discretionary administrative decisions; plan to set up a one-stop investment bureau.

### Capacity to repay the Fund and fiscal/monetary policy appraisal
- Authorities have made commitments at the highest level to repay the Fund.
- Ukraine has repurchases of SDR 1.9 million and SDR3.7 million over the remainder of 2012 and 2013, respectively.
- All Fund repayments are fully reflected under the current baseline (which also shows a drop in gross reserves through 2014).

- Staff appraisal—key points and risks:
  - Progress: lower general government deficit in 2011; NBU brought down inflation; pension reform passed in 2011; simplification of tax and customs codes.
  - Policy slippages: new spending in the supplementary budget is certain; projected higher revenue less certain; failure to increase gas tariffs; NBU reluctance to let the exchange rate move.
  - Risks: high current account deficit projected to increase; financing risks for budget and balance of payments; debt fallen from post-crisis peak but remains high; reserve cover very low in relation to debt service; spreads have risen; deterioration in perceived creditworthiness reflects doubts about policy credibility.
  - Short-term priorities: ensure fiscal policy provides strong support for domestic and external stability; meet general government deficit target of 1.8 percent of GDP, but authorities depend heavily on better revenue collection and have not specified contingency measures.
  - Monetary and exchange rate policy: staff recommends gradual increases in exchange rate flexibility supported by fiscal, monetary, and wage policies consistent with maintenance of price stability; staff does not recommend approval of Ukraine’s two multiple currency practices (MCPs) and encourage elimination as soon as feasible.
  - Banking sector: high levels of NPLs; many banks rely on NBU liquidity support and face external deleveraging pressures; balance sheets exposed to currency movements; the crisis-era resolution on foreign exchange positions should be unwound as soon as possible; some use of fx-linked bonds could help but authorities should avoid exposing the government balance sheet to greatly increased foreign exchange risks; unwind the crisis era resolution supplying emergency liquidity while avoiding excessive liquidity creation and providing any new liquidity support only to solvent banks.
  - Energy sector: comprehensive reform needed; low household prices for gas and heating cause high consumption and heavy losses for NG; price increases are essential alongside increased investment, improved energy efficiency, and targeted subsidies to the poorest households.
  - Medium-term growth risks: risk of a low growth equilibrium due to an aging population and financing constraints; productivity improvements are essential; implementation of the President's Economic Reform Program is critical.

- Proposed next step:
  - It is proposed that the next Article IV Consultation with Ukraine be held on a 12-month cycle.

*International Monetary Fund — 2012 Article IV Consultation, Ukraine (excerpt).*

### Box 2. Ukraine: 2008 Article IV Consultation: Key Recommendations and Actions Taken

### Box 2. Ukraine: 2008 Article IV Consultation: Key Recommendations and Actions Taken

### Overview
- Soon after the conclusion of the 2008 Article IV consultation Ukraine was engulfed by the global financial crisis and entered into a program relationship with the Fund.
- As circumstances drastically changed, several recommendations became less or no longer relevant, in particular those related to short-term macroeconomic management.
- Staff policy advice was adjusted accordingly as reflected in program documents.
- Structural reforms remained largely valid and progress has been mixed.

### Fiscal recommendations
- Fiscal restraint (deficit at or below 2 percent of GDP); strengthen fiscal framework (broaden fiscal coverage; adopt medium-term fiscal framework).

Progress:
- In 2009 (when GDP fell 15 percent), the Fund adjusted its fiscal stance advice and encouraged greater protection of the poorest.
- The general government deficit widened to 6¼ percent of GDP, and narrowed to 2¾ percent of GDP by 2011.
- Some progress has been achieved in strengthening the fiscal framework. A medium-term budget was adopted this year as required by a new budget code.
- However, off-budget expenditures have continued (including significant guarantees).

### Monetary/exchange rate recommendations
- Shift to a flexible exchange rate regime, and ultimately to inflation targeting anchor.

Progress:
- During the global financial crisis the authorities devalued the hryvnia.
- An opportunity was missed to adopt a more flexible exchange rate regime and the hryvnia was eventually re-pegged.
- The NBU has continued technical preparations for adopting inflation targeting, including by strengthening its forecasting and modeling capabilities.

### Financial sector recommendations
- Strengthen banking sector risk management and oversight, including consolidated supervision, transparency of ownership, and intensified supervision.

Progress:
- The banking system nearly collapsed in 2009. Since then, banks have been recapitalized twice (and others liquidated or nationalized).
- As confidence returned the banking system regained deposits.
- The legal framework has been strengthened. However, implementation of some of these measures is still pending.

### Structural reform recommendations
- Energy sector reform; tax system reform (VAT administration, broader base; rate reductions); financial sector development.

Progress:
- Domestic gas prices for the industry and budgetary institutions are in line with import prices and adjusted regularly.
- Domestic prices for households and heating companies have been increased on two occasions but the increases have not offset the depreciation of the hryvnia and higher import prices.
- VAT administration has remained problematic with refund arrears recurrently accumulating.

*Source: Box 2. Ukraine: 2008 Article IV Consultation: Key Recommendations and Actions Taken (extracted from the provided IMF content).*

### 1.54 for 2012.

### _cr12315 - 1.54 for 2012.

### Monetary accounts and monetary aggregates (2010–13)
- Net foreign assets (Monetary survey, Millions of Ukrainian hryvnias): 62,043; 73,231; 95,971; 75,070; 36,641; 60,968; 64,960; 66,447; 67,424; 36,625; 37,237 (series across quarters shown in table).
- Net domestic assets (Monetary survey): 535,828; 548,150; 556,429; 587,206; 624,413; 624,547; 626,342; 646,508; 663,366; 688,686; 791,549.
- Broad money: 597,872; 621,380; 652,400; 662,276; 661,054; 685,515; 691,302; 712,955; 730,790; 725,311; 828,786.
- Currency in circulation: 182,990; 179,528; 187,702; 189,909; 204,091; 192,665; 187,913; 197,390; 202,337; 205,427; 212,868.
- Total deposits: 413,851; 439,202; 461,288; 468,934; 453,536; 489,136; 500,234; 511,839; 524,665; 515,955; 611,428.
- Money market instruments: 1,031; 2,650; 3,410; 3,433; 3,427; 3,714; 3,156; 3,726; 3,788; 3,929; 4,490.
- Base money (NBU): 225,692; 223,517; 228,144; 234,351; 253,006; 239,885; 233,128; 243,655; 249,236; 249,484; 267,524.
- Banks' reserves (NBU): 42,702; 43,989; 40,442; 44,442; 48,915; 47,220; 45,216; 46,265; 46,900; 44,057; 54,655.

### Banking sector structure, soundness, and liquidity (2007–12)
- Number of banks: 175.0; 184.0; 182.0; 176.0; 176.0; 178.0; 177.0; 176.0; 176.0 (series).
- Private banks: 173.0; 182.0; 180.0; 174.0; 174.0; 176.0; 175.0; 174.0; 174.0.
- Foreign-owned banks' share in statutory capital: 35.0; 36.7; 35.8; 40.6; 41.6; 38.9; 41.6; 41.9; 41.8.
- Concentration (share of assets of largest 10 banks): 49.7; 52.0; 52.8; 53.9; 54.1; 54.2; 53.7; 52.8; 51.8.
- Regulatory capital to risk-weighted assets: 13.9; 14.0; 18.1; 20.8; 20.0; 19.2; 18.9; 18.9; 17.9.
- Capital to total assets: 11.6; 12.9; 13.1; 14.6; 13.9; 14.5; 14.8; 14.8; 14.6.
- Credit growth (year-over-year percent change): 74.1; 72.1; -2.3; 1.1; 6.9; 9.9; 10.2; 9.5; 6.3 (series).
- Credit to GDP ratio: 59.4; 77.7; 78.9; 67.3; 66.4; 65.0; 63.3; 60.6; 59.5.
- NPLs to total loans (NBU definition): 3.0; 3.9; 13.7; 15.3; 15.5; 15.4; 15.3; 14.7; 14.9.
- NPLs to total loans (broad definition): 13.2; 16.4; 37.6; 40.3; 39.8; 40.3; 38.2; 37.7; 39.1.
- Specific provisions (percent of NPLs, NBU definition): 7.0; 13.2; 46.5; 66.1; 68.3; 70.1; 69.3; 68.3; 66.8.
- Loans in foreign currency to total loans: 49.8; 58.9; 51.2; 46.5; 46.1; 44.8; 42.4; 40.6; 40.3.
- Deposits in foreign currency to total deposits: 32.1; 44.0; 47.2; 42.1; 41.6; 41.6; 42.9; 42.6; 42.3.
- Foreign currency loans to foreign currency deposits: 237.2; 275.5; 239.2; 194.8; 189.3; 180.7; 168.6; 155.7; 152.1.
- Liquid assets to total assets: 10.3; 8.2; 9.6; 10.1; 10.4; 10.0; 9.6; 10.5; (ellipsis indicates series continues).
- Return on assets (after tax; end-of-period): 1.5; 1.0; -4.4; -1.5; -0.1; -0.2; -0.8; -0.8; 0.7.
- Return on equity (after tax; end-of-period): 12.7; 8.5; -32.5; -10.2; -0.6; -1.5; -5.3; -5.3; 4.4.
- Net interest margin to total assets: 5.0; 5.3; 6.2; 5.8; 5.8; 5.4; 5.4; 5.3; 4.7.

### Monetary and liquidity indicators (memorandum)
- Base money (year-on-year percent change entries listed): 15.8; 13.7; 3.9; 8.1; 13.5; 6.3; 4.3; 6.8; 6.4; 4.0; 7.2.
- Broad money (year-on-year percent change entries listed): 22.7; 25.7; 22.3; 16.4; 15.1; 14.7; 11.3; 9.3; 10.3; 5.8; 14.3.
- Credit to the economy (year-on-year percent change entries): 1.1; 6.9; 9.9; 10.2; 7.5; 9.5; 6.3; 3.1; 1.6; 1.9; 5.8.
- Velocity of broad money: 1.8; 1.8; 1.8; 1.9; 1.9; 1.9; 1.9; (ellipsis); 2.0; 2.0.
- Money multiplier: 2.6; 2.8; 2.9; 2.8; 2.6; 2.9; 3.0; 2.9; 2.9; 2.9; 3.1.

### Public sector debt sustainability (2007–17 baseline and projections)
- Baseline: public sector debt (percent of GDP): 12.3; 20.5; 35.4; 40.5; 36.0; 34.7; 35.1; 35.2; 35.5; 35.5; 35.6.
- Of which: foreign-currency denominated (percent of GDP): 9.7; 15.5; 23.8; 26.1; 22.7; 18.0; 14.7; 11.2; 10.1; 8.8; 8.1.
- Change in public sector debt (percent of GDP): -2.5; 8.2; 14.8; 5.1; -4.5; -1.3; 0.4; 0.1; 0.3; 0.0; 0.1.
- Identified debt-creating flows (4+7+12): -2.2; 4.5; 15.3; 3.5; -2.6; -0.9; -1.2; 0.3; -0.3; 0.0; -0.1.
- Primary deficit (percent of GDP): 1.5; 2.6; 5.1; 4.1; 1.0; 1.3; 1.0; 0.8; 0.4; 0.4; 0.1.
- Revenue and grants (percent of GDP): 41.8; 44.3; 42.3; 43.3; 42.4; 42.4; 40.7; 40.1; 39.5; 39.0; 38.5.
- Primary (noninterest) expenditure (percent of GDP): 43.3; 46.9; 47.4; 47.4; 43.4; 43.7; 41.6; 40.9; 39.9; 39.4; 38.6.
- Automatic debt dynamics (percent of GDP): -3.1; 1.6; 2.6; -4.0; -4.9; -1.4; -0.7; -0.2; 0.0; -0.1; 0.2.
- Contribution from interest rate/growth differential (percent of GDP): -3.1; -2.4; 1.9; -3.9; -5.0; -1.4; -0.7; -0.2; 0.0; -0.1; 0.2.
- Public sector debt-to-revenue ratio (percent): 29.4; 46.4; 83.6; 93.7; 84.9; 81.8; 86.3; 87.8; 89.8; 90.9; 92.3.
- Gross financing need (percent of GDP): 2.8; 3.8; 11.5; 10.0; 7.5; 9.7; 12.2; 14.7; 20.8; 14.4; 15.6.
- Gross financing need (billions of U.S. dollars): 4.0; 6.8; 13.4; 13.6; 12.4; 17.9; 24.3; 31.2; 46.9; 34.6; 39.8.
- Scenario with key variables at their historical averages (percent of GDP): 34.7; 31.5; 28.5; 26.0; 24.0; 22.2; -3.2 (series indicates scenario path).
- Scenario with no policy change (constant primary balance) in 2011: (series begins) 34.7; 31.7; 32.2; 32.1; 32.6; 33.1; -0.1 (scenario notation present).

Key macro-fiscal assumptions underlying baseline:
- Real GDP growth (percent): 7.3; 3.4; -14.4; 4.1; 5.2; 3.0; 3.5; 3.5; 3.5; 3.5; 3.5.
- Average nominal interest rate on public debt (percent): 4.6; 5.5; 5.5; 5.4; 6.5; 7.6; 9.7; 9.6; 9.8; 9.5; 10.2.
- Inflation rate (GDP deflator, percent): 23.5; 27.2; 12.5; 13.8; 15.7; 8.6; 8.2; 6.4; 6.2; 6.2; 5.9.
- Growth of real primary spending (deflated by GDP deflator, percent): 13.2; 15.4; -23.5; 5.3; -2.2; -2.5; -1.8; 0.1; 0.8; 2.2; 1.3.

### External debt sustainability (2007–17 baseline and projections)
- Baseline: external debt (percent of GDP): 56.0; 56.4; 88.2; 86.0; 76.4; 69.8; 67.1; 65.9; 65.5; 65.3; 65.0.
- Change in external debt (percent of GDP): 5.4; 0.4; 31.8; -2.2; -9.6; -6.6; -2.7; -1.3; -0.4; -0.2; -0.2.
- Identified external debt-creating flows (4+8+9): -19.2; -9.3; 29.1; -17.6; -3.4; -1.2; -0.5; -1.4; -1.1; -1.2; -2.4.
- Current account deficit, excluding interest payments (percent of GDP): 0.7; 3.2; -4.5; -2.7; -0.2; 1.7; 3.7; 2.9; 2.5; 1.9; 1.3.
- Deficit in balance of goods and services (percent of GDP): 5.7; 8.0; 1.7; 2.9; 5.4; 6.6; 7.7; 7.4; 6.8; 6.3; 5.8.
- Net non-debt creating capital inflows (negative; percent of GDP): -10.5; -4.8; -2.6; -7.4; -5.2; -5.5; -5.8; -6.4; -5.7; -5.2; -5.7.
- Automatic debt dynamics (percent of GDP): -9.4; -7.8; 36.3; -7.5; 2.0; 2.6; 1.5; 2.1; 2.1; 2.1; 2.1.
- Contribution from nominal interest rate (percent of GDP): 3.0; 3.9; 6.0; 4.9; 5.6; 4.7; 3.8; 4.3; 4.3; 4.2; 4.2.
- External debt-to-exports ratio (percent): 124.9; 118.7; 190.6; 169.4; 142.1; 135.9; 134.3; 131.3; 129.3; 127.4; 125.0.
- Gross external financing need (billions of U.S. dollars): 53.2; 67.1; 57.4; 48.9; 69.9; 72.0; 71.3; 74.3; 78.4; 83.1; 85.6.
- Gross external financing need (percent of GDP): 37.2; 37.2; 49.0; 35.8; 42.3; 39.1; 35.9; 35.1; 34.8; 34.5; 33.4.
- Scenario with key variables at their historical averages (percent of GDP): 76.4; 60.3; 45.8; 33.7; 23.1; 13.5; 5.2; -6.0 (scenario path shown).

Key macro assumptions underlying external baseline:
- Real GDP growth (percent): 7.9; 2.3; -14.8; 4.1; 5.2; 3.0; 3.5; 3.5; 3.5; 3.5; 3.5.
- GDP deflator in U.S. dollars (change in percent): 22.8; 23.4; -23.6; 11.8; 15.2; 8.3; 4.0; 2.9; 3.0; 3.1; 2.9.
- Nominal external interest rate (percent): 7.9; 8.7; 6.9; 6.5; 7.9; 6.9; 5.9; 6.9; 6.9; 6.9; 6.9.
- Growth of exports (U.S. dollar terms, percent): 27.4; 33.8; -36.6; 27.7; 28.3; 6.6; 4.8; 6.9; 7.7; 8.0; 8.2.
- Growth of imports (U.S. dollar terms, percent): 35.4; 38.5; -43.8; 30.3; 33.5; 9.3; 7.2; 6.2; 6.5; 6.9; 7.1.
- Current account balance, excluding interest payments (percent of GDP): -0.7; -3.2; 4.5; 2.7; 0.2; -1.7; -3.7; -2.9; -2.5; -1.9; -1.3.
- Net non-debt creating capital inflows (percent of GDP): 10.5; 4.8; 2.6; 7.4; 5.2; 5.5; 5.8; 6.4; 5.7; 5.2; 5.7.

### Real sector, inflation, and external developments (2007–12 highlights)
- Real GDP growth indicators and charts show growth momentum lost in the second quarter and slowdown in export-oriented activity; domestic demand recovery supported by real retail trade turnover and construction.
- Unemployment: ILO unemployment rate (NSA, percent) remains high (chart series).
- Real wage growth: strong year-on-year real wage growth supports domestic demand (chart series).
- CPI headline inflation has dropped to low single digits in 2012 (chart annotation).
- Core inflation measures remain higher than headline inflation (broad core and narrow core series).
- Inflation expectations and nominal wages: inflationary expectations are elevated relative to headline inflation (chart series).
- External: balance of payments shows overall weakness; current account deficit has widened (charts).
- Financial account: FDI and portfolio inflows have helped offset large FX cash outflows (chart note).
- International reserves: NBU intervened as needed; gross reserves and daily FX interventions charted.
- External spreads: EMBIG: Ukraine and EMBIG: emerging Europe show spreads rising again; 5-year CDS increased (chart series).
- Exchange rates: NBU interventions helped hold exchange rate steady against dollar (chart series).

### Debt and rollover dynamics, financial sector indicators (2000–12 highlights)
- External debt has risen (chart series in billions of U.S. dollars).
- EMBI Global spreads and rollover rates: bank deleveraging accompanied by shortening maturities; corporate sector rollovers have remained strong (charts).
- Households have reduced debt and FX exposures: household loans in domestic currency and FX charted.
- Public debt increased rapidly and its currency structure has worsened (public debt by domestic currency and FX charted).
- Monetary aggregates growth slowed; financial intermediation weakening: base money and broad money charts.
- Deposit dollarization remains high; credit growth is flat (charts).
- NPLs remain high; NBU refinancing loans are unwinding slowly (charts of NPLs and NBU claims on banks).

### Debt sustainability stress tests and scenarios (public and external)
- Public debt bound tests (Figure 8): baseline public debt level and responses to individual shocks shown; examples of shock scenarios include:
  - Interest rate shock (permanent one-half standard deviation).
  - Growth shock.
  - Primary balance shock and No Policy Change scenario (constant primary balance).
  - Combined shock (permanent 1/4 standard deviation shocks to real interest rate, growth rate, and primary balance).
  - Real depreciation and contingent liabilities shock (one-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occurring in 2009).
- External debt bound tests (Figure 9): baseline external debt level and responses to shocks shown; examples include:
  - Interest rate shock.
  - Growth shock.
  - Noninterest current account shock (percent of GDP).
  - Combined shock (permanent 1/4 standard deviation shocks to real interest rate, growth rate, and current account balance).
  - Real depreciation shock (one-time real depreciation of 30 percent in 2010).

*Sources: National Bank of Ukraine; State Statistics Committee of Ukraine; Ministry of Finance; World Bank; Transparency International; Haver; International Centre for Policy Studies; Bloomberg; IMF staff estimates and calculations.*

### Annex I. Ukraine: Exchange Rate, External Sustainability, and Competitiveness

### Annex I. Ukraine: Exchange Rate, External Sustainability, and Competitiveness

### Exchange rate assessment and REER valuation
- Historical context:
  - Between 2004 and 2008, Ukraine’s real effective exchange rate (REER) appreciated by over 40 percent.
  - Inflation at times exceeded that of main trading partners by 20–30 percent in that period.
  - In 2009, a nominal exchange rate devaluation compressed imports and boosted competitiveness.
- Staff assessment (CGER-type methodologies; Vitek (2012) panel):
  - Comparison across three approaches (percent deviation from equilibrium REER):
    - Sep-11 / Apr-12
    - Macroeconomic balance 2/: 8.5 / 13.0
    - External sustainability 3/: 5.5 / 8.2
    - Equilibrium real exchange rate: -9.3 / -9.2
  - Interpretation:
    - Two approaches yield overvaluation estimates in the range of 8 and 13 percent.
    - Macroeconomic balance method implies an REER depreciation of 13 percent to close the gap between the underlying current account balance (CAB) and an estimated equilibrium CAB.
    - External sustainability method implies an REER adjustment of 8.3 percent would be needed to close the gap between the underlying CAB and the balance that would stabilize Ukraine’s NFA position at around -28 percent of GDP.
    - The equilibrium real exchange rate method indicates the REER is undervalued by 9.2 percent relative to its medium-term equilibrium, driven mainly by non-structural and volatile variables (terms of trade, relative productivity, relative government consumption, initial NFA).

### Competitiveness, wages, and policy buffers
- Wage and productivity dynamics:
  - Ukraine’s low nominal wages are consistent with low total labor productivity.
  - Productivity growth has been somewhat slower than in other European countries, partly due to poor quality of capital stock and limited technological advancement.
  - Wage pressures, if unabated, will erode competitiveness.
- Business environment and export performance:
  - Poor performance in cross-country rankings of business environment indicators undermines competitiveness and inward FDI.
  - Ukraine’s penetration in global export markets has been well below that of other countries in the region.
- External vulnerability and reserves:
  - Gross reserves fell to around $31 billion in January 2012—from a peak of $38 billion in May 2011—and are expected to fall to $24 billion (40 percent of short-term debt) by end-2012.
  - Drivers of reserve decline: Fund repurchases, low bank rollovers, additional household fx withdrawals, and constrained sovereign market access.
  - Ukraine scores poorly in cross-country comparisons of reserve adequacy per the new metric; particularly poor coverage of short-term debt.

*Italicized source attribution: IMF staff analysis from Annex I of the 2012 Article IV Report for Ukraine.*

### Annex II. Energy Sector: Economic Costs and Policy Reform

### I. Background and sector structure
- Naftogaz (NG) structure and roles:
  - State-owned holding with subsidiaries for exploration and production; import, storage, transit, and distribution.
  - Exploration and production: natural gas production currently down to 16 from 20 bcm per annum in past years. Appropriate investment levels would permit tapping about 1.1 trillion cubic meters of proven gas reserves.
  - Importing gas from Russia: Ukraine imports about two thirds of its annually consumed gas from Russia. A contract signed in early 2010 links the price of gas to a nine-month backward looking moving average of oil prices, and offers a 30-percent discount over the price implied by the contract’s formula.
  - Transiting gas to Europe: NG manages pipelines and storage that transit about 100–110 bcm of Russian gas to western and central Europe; NG receives a transit fee based on volume transported, gas import prices, and distance.
  - Domestic distribution: NG supplies gas to (i) industries—one third of the domestic market; (ii) households—another third of the market; (iii) budgetary institutions; and (iv) utility companies (including district heating).
- Pricing and tariff context:
  - Gas prices paid by households and district heating companies are far below rising import prices, creating losses for NG—together on average about one quarter of import prices.
  - Years of gas import subsidies from Russia were terminated in 2006 when import prices were raised close to European levels. Domestic prices for industrial users have been adjusted to import parity while household and utility prices remain regulated.
  - District heating companies receive subsidies from the government in addition to paying below import prices for gas.

### II. Economic costs and quasi-fiscal activities
- Definition and sources of quasi-fiscal activities:
  - Quasi-fiscal activities are operations by NG that directly affect the company’s financial position and would not prevail without government intervention.
  - Main contributors:
    - Below cost-recovery of domestic gas and heating prices: implicit subsidies to households and district heating companies; heating tariffs below cost of producing heat.
    - Under-priced domestically produced gas: NG subsidiaries and some private producers sell domestically produced gas at about one-seventh of import prices (or potential re-export prices).
    - Poor payment enforcement: gas payment compliance is less than 90 percent.
    - Output losses: underinvestment and weak oversight cause significant output losses.
- Magnitude of costs and financials (Naftogaz balances and quasi-fiscal activities; billions of Ukrainian hryvnia unless otherwise indicated):
  - Revenue: 2009 = 78.4; 2010 = 121.8; 2011 = 114.4
  - Gas sales: 2009 = 60.7; 2010 = 73.6; 2011 = 86.9
  - Gas transit fees: 2009 = 13.1; 2010 = 29.0; 2011 = 25.5
  - Other revenue: 2009 = 4.6; 2010 = 19.1; 2011 = 2.1
  - Expenditure: 2009 = 101.1; 2010 = 140.0; 2011 = 134.8
  - Gas imports: 2009 = 41.8; 2010 = 80.0; 2011 = 73.8
  - Domestic gas (expenditure): 2009 = 4.3; 2010 = 4.8; 2011 = 6.1
  - Other expenditure: 2009 = 55.0; 2010 = 37.2; 2011 = 54.9
  - Cash balance: 2009 = -22.6; 2010 = -18.2; 2011 = -20.4
  - Underlying balance (excludes RosUkrEnergo operations; assumes import levels consistent with no change in stocks): underlying balance percent of GDP: 2009 = -2.2; 2010 = -2.0; 2011 = -1.6
  - Quasi-fiscal activities (Total percent of GDP): 2009 = 4.7; 2010 = 5.2; 2011 = 5.0
  - Per unit of gas sold (UAH/tcm): 2009 = 1035; 2010 = 1201; 2011 = 1480
- Aggregate impacts:
  - In 2011, NG’s economic cost was almost 5 percent of GDP.
  - In recent years, gas transit revenues have not fully offset quasi-fiscal costs.
  - NG suffered deficits of 1.7 and 1.5 percent of GDP in 2010 and 2011, undermining financial viability.
- Adverse implications of below-cost pricing:
  - Reliance on government support (direct cash transfers, recapitalization bonds, tax offsets, government guarantees that enabled restructuring of external liabilities in 2009).
  - Underinvestment in capital-intensive activities (exploration, production, transport, distribution).
  - High energy consumption.
  - Arbitrage across industries (industries paying import prices; households paying below-import prices).

### III. Policy reforms and institutional measures
- Tariff adjustment history and stance:
  - At the outset of a Fund-supported program, prices received by NG from households and utilities were increased by 50 percent in July 2010, with pass-through to end-user heating prices in January 2011.
  - NG’s finances have since deteriorated substantially due to rising gas import prices and postponement of further domestic gas price hikes.
  - The President’s Economic Reform Committee reform program recognizes the challenges; authorities advocate a very gradual pace of adjustment.
- Regulatory and structural reforms:
  - A new centralized and independent regulator is gradually assuming responsibility for overseeing tariff-setting. During transition:
    - The National Energy Regulatory Commission sets gas tariffs.
    - The National Commission for Utility Regulation sets household heating tariffs.
  - Broader modernization reforms:
    - Protocol for Ukraine’s accession to the Energy Community Treaty (ECT) was signed in fall 2011, following adoption of the gas sector law in summer 2011 (including provisions for restructuring NG).
    - In 2012, a law permitting unbundling of Naftogaz entities was enacted (privatization remains prohibited).
    - Pilot projects for modernization of the gas transit and distribution system are being pursued with EBRD and EIB assistance.
    - Efforts are underway to join the EITI.

*Italicized source attribution: IMF staff analysis from Annex II of the 2012 Article IV Report for Ukraine.*

### Annex III. Financial Sector Developments and Challenges

### Annex III. Financial Sector Developments and Challenges

### Emergence of the crisis and macro-financial context
- Credit growth peaked in 2005–07 at an average of 70 percent per annum.
- Loan-to-GDP ratio surged to nearly 80 percent of GDP by end-2008.
- Pre-crisis vulnerabilities: rapid household and corporate debt growth, weak banks’ risk management and lending standards, weak supervisory oversight, real estate prices surging well past levels in comparable-income countries, pervasive foreign-currency lending creating currency mismatches, and loan-to-deposit ratios approaching 230 percent.
- Late 2008 banking crisis dynamics:
  - Depositor base fell by 20 percent.
  - Hryvnia abandoned by depositors, triggering a currency crisis.
  - Bank lending froze: -2 percent nominal credit growth in 2009.
  - NPLs rose rapidly and bank profitability plummeted as banks increased capital buffers and provisioned against loan losses.
- Two rounds of recapitalization raised capital adequacy ratios to about 18 percent—well above the statutory minimum of 10 percent.

### Crisis response (measures taken in 2008/9)
- Emergency liquidity support:
  - NBU stabilization loans peaked at about UAH 85 billion (about 8 percent of GDP).
- Deposit guarantees and reimbursements:
  - Deposit guarantees expanded to cover nearly all household deposits.
  - Deposit Insurance Fund reimbursements about UAH 4 billion (0.3 percent of GDP).
  - Limits imposed on early withdrawal of time deposits.
- Crisis management and resolution institutional changes:
  - Crisis Management Unit created within the NBU.
  - Recapitalization Board established to decide government participation for systemic banks.
  - Legal framework amended to facilitate prompt and cost-effective bank resolution.
  - Of 184 banks operating before the crisis, 28 had temporary administrators and 20 went into liquidation.
- Recapitalization details:
  - Diagnostic tests in 2009 and 2010 identified 61 private banks with capital shortfalls totaling about UAH 30 billion (2.8 percent of GDP).
  - Government provided about UAH 40 billion (4.0 percent of GDP) in additional recapitalization funds.
- Regulatory measures:
  - NBU “Resolution 109” revised fx net open position calculation by removing loan loss provisions against fx loans from the statutory calculation, prompting banks to sell fx and leaving the banking system about US$8 billion short (economic perspective).
  - Ban on fx lending to unhedged borrowers.

### Key near-term challenges
- Overall context: Ukraine’s financial soundness indicators and credit growth remain comparatively weak; real credit growth has been negative.
- Four specific near-term challenges:
  1. Deleveraging
     - Foreign banking presence ~40 percent of banking system is foreign owned; about 22 percent by euro area banks.
     - External debt of banks fell 35 percent between end-2008 to end-2011 to US$25 billion.
     - Banks’ balance sheets continue to grow at a slower pace than nominal GDP; banks relying relatively more on local deposits to reduce high loan-to-deposit ratios.
     - Overall nominal credit growth is in single digits; fx-denominated loans continue to fall (ban on fx loans to unhedged borrowers), contributing to an overall drop in retail loans.
     - Deleveraging is expected to continue and foreign financing to Ukraine’s banking system is expected to continue to fall.
     - NBU interest in participating in Vienna 2.0 to mitigate deleveraging pressures and improve cross-border coordination.
  2. High nonperforming loans (NPLs)
     - By end-April 2012, NPLs (doubtful and loss items) stabilized at around 15 percent of total loans (or around 40 percent if including “substandard” loans).
     - NPLs concentrated among enterprises; household mortgages also contributed.
     - Banks’ high NPLs weigh on balance sheets and profitability; some analysts note current levels of loan loss provisions (LLPs) may be insufficient.
     - Tax relief and write-off measures: write-offs totaled UAH 33 billion (about 4 percent of loans) during the past 16 months.
     - New regulation aligns asset classification and provisioning closer to international best practices, but further tax, legal, and regulatory measures are needed.
     - Recommended additional steps: independent assessments where banks report high restructured loans; strengthen creditors’ rights; tax measures to facilitate write-offs (clarify tax consequences of writing off fully provisioned loans, establish fair value of NPL sales for tax purposes, tax treatment of accrued but unpaid (suspended) interest on overdue loans, VAT on resale of repossessed collateral).
  3. Currency mismatches
     - Resolution 109 (early 2009) instructed banks to exclude fx LLPs from net open fx position calculation, compelling banks to sell fx and creating a system-wide short economic position estimated at about US$8 billion (about 6 percent of system assets).
     - Exposure to exchange rate movements threatens capital adequacy via devaluation losses and possible increases in NPLs and provisioning.
     - NBU pilot program for unwinding Resolution 109 includes parallel sale of government fx-indexed bonds.
     - Stress tests suggest system capital buffers could absorb a modest exchange rate depreciation, though some individual banks may require additional capital.
  4. Unwinding longer-term liquidity support (stabilization loans)
     - Stock of stabilization loans fell from a peak of about UAH 85 billion to around UAH 60 billion.
     - These loans are scheduled to be paid down in roughly equally distributed amounts over the next four years; some may be only partially recoverable (e.g., to state-intervened banks).
     - Repayments, together with liquidity needs from unwinding Resolution 109 and deleveraging, present liquidity management challenges for banks and the NBU.
     - NBU likely to provide liquidity support to banks determined to be solvent during policy unwinding and as term external funding is withdrawn.
     - Authorities reviewing refinancing window to extend maturities towards 365 days and considering smoothing of stabilization loan payments under strengthened collateral conditions.

### Assessment of banks’ financial soundness and FSI index
- Staff compiled a financial soundness indicators (FSI) index using 2011 bank-by-bank NBU data.
- Findings: large majority of banks currently have adequate indicators, but some banks need close monitoring and assessment.
- Usefulness: indicators with thresholds could trigger supervisory actions and serve as ‘early warning indicators’.
- Technical note on FSI Index:
  - Six vulnerability indicators normalized and aggregated with differential weights.
  - Definitions:
    - Liquidity support (LS) = Refinancing loan as percent of deposits.
    - Capital adequacy ratio (CAR) = Capital/risk weighted assets.
    - NPLs net of provisions/total loans (NPL) = (Broad NPLs - provisions)/(total loans).
    - Liquidity (LIQ) = (Liquid assets)/deposits.
    - Return on assets (ROA) = Net profit (loss)/(total assets).
    - Fx Risk (FX) = Net fx exposure/capital where net fx exposure = gross fx assets – gross fx liabilities.
  - Aggregation: FSI Index = 0.15*LS + 0.20*CAR + 0.20*NPL + 0.10*LIQ + 0.28*ROA + 0.07*FX.
  - Individual FSIs were statistically normalized (expressed in standard deviations, averages equal to zero) before aggregation; results robust to equal weights and different normalization techniques.

### Spillovers and external risks
- Trade channel
  - Ukraine exports about 50 percent of GDP ($75bn).
  - High concentration of commodity exports: chemicals, agriculture, metals, minerals, and timber account for about (60%) of all goods exports.
  - EU and Russia dominate bilateral trade links.
  - During 2008/9 crisis deterioration in terms of trade and drops in trading partners’ demand led to significant reduction in export volumes and values; imports fell faster, producing a positive net export contribution to GDP.
- Financial spillover channels and openness
  - Financial openness above peer average with EU and Russia as important sources of financing, much exposure in corporate and household sectors.
  - Banking exposure:
    - About 25 percent of assets are controlled by euro area (EA) banks.
    - Russian banks own another 11 percent of system assets.
    - External bank debt dropped about 35 percent between end-2008 and end-2011, down to about 15 percent of GDP.
    - BIS data support significant reductions in foreign claims on Ukraine.
    - Loan-to-deposit ratios remain high among EA subsidiaries in Ukraine, providing incentive to deleverage.
    - Total bank-related FDI in 2009–10 was in the range of US$4.5 billion.
- Foreign presence and FDI
  - Ukraine has received around 4 percent of GDP in FDI annually in recent years (US$6 billion in 2010).
  - Stock of FDI about US$52 billion.
  - About 70 percent of inward FDI is sourced from the EA; 31 percent of overall FDI is from Cyprus (much reportedly round-trip investment).
  - Ukraine could see reduced FDI if external conditions worsen.
- Remittances
  - Ukraine receives about USD6 billion annually in remittances: 41 percent from the EU (32 percent from the EA), 27 percent from Russia, and 12 percent from the U.S.
  - Annual flows have been fairly steady (between US$4 and 7 billion).
- Other capital flows and investor behavior
  - Shocks could lead to capital outflows, lower rollovers for corporates and sovereigns, and declines in trade finance.
  - Households’ confidence in the banking sector is skittish; inflation, market turbulence, depreciation risk, or neighboring-country shocks can quickly lead to fx savings withdrawals as seen in 2008–09 and in the second half of 2011.
  - Foreign investors own less than 5 percent of local government paper in Ukraine (less than US$0.6 billion).
- Asset valuations and exposures
  - Ukrainian banks’ foreign assets: about 45 percent of bank foreign assets ($3.5 billion, or 3 percent of total assets of the Ukrainian banking sector) are held in the EA, roughly equally split between dollars and euros.
  - Ukrainian direct portfolio investment in the EA is negligible.
- Financing risks and market sensitivity
  - High gross external financing requirements and high investor risk perceptions make Ukraine vulnerable to shifts in market confidence and risk aversion.
  - Cross-country GEFR-to-reserves data indicate Ukraine is well above EM medians.
  - Correlation between Ukraine’s EMBI spreads and the VIX is about 0.75.
- VAR analysis on spillovers
  - Strong co-movement between real GDPs of the EA and Ukraine (and Russia and Ukraine) in response to a shock to EA real GDP.
  - A one-percent shock to EA real GDP brings a significant impact on Ukraine, peaking after 4 quarters.
  - A shock to Russian GDP also has a significant impact on Ukraine (interpreted as part of the EA effect transmitted through Russia).
  - If Russia were supported by higher oil prices, it could act as a brake against some spillovers from an EA shock.
- Policy implications for external shocks
  - Conventional first-round defenses may have limited effectiveness if regional peers react similarly (e.g., depreciation and interest rate defense).
  - Additional measures that may be needed depending on circumstances: capital controls, deposit freezes, and stronger cross-country collaboration (e.g., Vienna 2) to achieve initial stability.

*IMF Staff: Annex III. Financial Sector Developments and Challenges (from _cr12315)._

### 1. The euro area sovereign

### 1. The euro area sovereign

### Crisis intensifies and global growth conditions slow down
- Commodity prices are depressed, leading to further worsening of current account and balance of payments pressure.
- Slow down or evaporation of external financing.
- Ukraine exports about 50 percent of GDP, with bilateral trade links dominated by EU and Russia. Commodity exports (chemical, agriculture, metals, minerals and timber ) account for about 60 percent of exports).
- In 2009, Ukraine suffered a 40 percent decline in nominal goods exports and a 15 percent drop in real GDP.
- Euro area and Russian banks own about 24 and 11 percent, respectively, of Ukraine’s financial system and gross external financing requirements are large (about 40 percent of GDP).
- The sovereign has limited access to financial markets and spreads are high and composition is shifting towards shorter maturities. Higher funding cost would exacerbate external financing tensions, and lead to exchange rate pressures.

### Fiscal consolidation goes off track and structural reforms stall
- Changes in political leadership or policy complacency may weaken the implementation of fiscal cuts.
- Proposed energy sector reform may stall further.
- Higher-than-expected fiscal multipliers could lead to a sharper downturn, making it more difficult to meet consolidation targets.
- EA sudden loss of investor confidence could push up yields or dampen financing.
- Insufficient energy and social reform may keep growth low for a protracted period, undermine fiscal consolidation.

### Banks’ and corporates’ asset quality deteriorates / funding pressures arise
- Global liquidity shortage, contaminate bank and corporate balance sheets by slowing down rollovers, exacerbating currency mismatches, or trigger foreign cash withdrawal. Possible shortages of collateral could elevate funding pressures. NPLs could ncrease due to recession, especially from the SOE sector. This would weaken banks’ capital base and corporate balance sheets.
- The banking system is increasingly exposed to the sovereign (which has limited market funding options), including through the purchase of fx-linked bonds. Further policy slippages risks deposits and fx cash withdrawal, crowding out private credit, depressing activity and creating more NPLs. Higher interest rates and shorter rollovers would exacerbate the crunch and hurt growth further.
- Bank recapitalization needs may be difficult to source from market and may trigger contingent liabilities from possible government guarantees of bank debt.

### Oil / Energy price surge
- Geopolitical instability could trigger an oil/gas price shock.
- Higher oil/gas prices would increase import bills adding to balance of payment pressures and resulting inflationary pressures could undermine confidence in domestic currency and would erode purchasing powers.

### Annex V. Household Utilities: Social Assistance Reform — findings and fiscal scope
- Social assistance programs for household utilities are poorly targeted. Of the total utilities’ social assistance budget (0.3 percent of GDP), about 30 percent is distributed to wealthy households while the poorest households receive less than 8 percent.
- In 2010, the average transfer value per capita to the wealthiest quintile of households (UAH 1,200) was UAH 500 higher than for the poorest quintile.
- Targeting preferential categories of citizens and significant use of benefits over subsidies has skewed the system towards the wealthy.
  - Gas benefits are received by 20 percent of households, predominantly going to wealthier households.
  - Gas subsidies based on household income levels cover only 5 percent of households but even there governance challenges have resulted in high income earners receiving higher average per capita transfers than those with lower income.
- About 85 percent of individuals below the poverty line do not receive any transfers for household utilities.
- Cost-benefit analysis suggests that only 5–12 cents on the dollar spent in social assistance programs for household utilities go toward reducing the poverty gap (hryvnia equivalent needed to bring all poor to just above the poverty line).
- Transitioning to a well-targeted social assistance system will be essential as end-user gas and heating tariffs rise.
- If efficiently distributed, the current financial envelope (defined as a fraction of GDP) is sufficient to fully subsidize all households with a utility bill-to-income ratio above 10 percent, even once domestic tariffs reach market prices (assuming gradual increases over a decade).

### Costs of Social Assistance Programs for Household Utilities (IMF staff estimates)
- Current transfer schemes: 2.7 billion Ukrainian hryvnia; 0.3 Percent of GDP
- Of which: to households with utility/income ratio above 10 percent: 0.7 billion Ukrainian hryvnia; 0.06 Percent of GDP
- Targeted subsidy to households with utility/income ratio above 10 percent:
  - Under current prices: 3.1 billion Ukrainian hryvnia; 0.28 Percent of GDP
  - Under market prices 1/: 6.6 billion Ukrainian hryvnia; 0.34 Percent of GDP
  - 1/ Assumes market prices are phased in over 10 year period.

*Source: 2012 ARTICLE IV REPORT UKRAINE — INTERNATIONAL MONETARY FUND*

### Annex VI. Ukraine: Evidence on Monetary Policy Transmission Mechanism

### Annex VI. Ukraine: Evidence on Monetary Policy Transmission Mechanism

### Exchange rate regime, NBU interventions, and monetary aggregates
- Since mid-1990s a stable exchange rate has been de facto a key policy objective; the NBU introduced a band around the U.S. dollar in mid-1996 and has, except for short-lived forced floats (notably 1998–2000 and 2008–09), kept the hryvnia broadly stable against the U.S. dollar.
- The exchange rate regime has taken clear precedence over monetary policy targets, with the NBU’s foreign exchange interventions largely driving dynamics of monetary aggregates and complicating achievement of officially announced inflation objectives.
- Liquidity management operations only partially sterilized massive liquidity injections from FX interventions and were often guided by concerns over the strength of the NBU’s own balance sheet and fears of speculative capital inflows.
- Result: the NBU frequently prioritized steering the exchange rate within the targeted band while other policy targets were rarely met; the NBU has repeatedly failed to deliver on officially announced inflation objectives.

### Interest rate channel, liquidity conditions, and credit
- Empirical evidence indicates banks’ lending rates are sensitive to overall liquidity conditions in the banking system, directly affecting households’ and corporates’ spending decisions.
- The response coefficient of lending interest rates to movements in overnight interbank rates:
  - Was significant in 2000–02 and since mid-2007 to the present (within the sample).
  - Took larger values in periods when banks’ excess liquidity stood low and was tightly managed (including in the context of 2008 and 2010 SBA programs).
- With sticky prices, changes in nominal lending rates determined real cost of credit and thus affected credit growth and domestic demand.
  - Local currency credit growth peaked at about 80 percent (year-over-year) in early 2008, coinciding with historically high liquidity and highly negative real lending rates.
- The pass-through of changes in real lending rates to credit growth broke down in 2003–07 and 2010–12:
  - 2003–07: likely driven by proliferation of foreign currency lending (average annual credit growth of foreign currency credits to households and corporate was 160 percent and 36 percent, respectively).
  - 2010–12: likely associated with the legal ban on foreign currency lending to unhedged borrowers, which squeezed those borrowers into local currency credits notwithstanding rising real interest rates.

### Sterilization, policy rates, and liquidity management
- Sterilization operations often failed to offset intervention-driven liquidity and were influenced by concerns over the NBU balance sheet and speculative inflows.
- The NBU has been reluctant to aggressively adjust its menu of policy rates for open market operations and standing facilities, limiting its ability to influence interbank liquidity and aggregate demand via policy rates.
- Structural disincentives in the money market:
  - The money market is highly segmented and ineffective at redistributing liquidity across banks.
  - An overly wide spread (over 500 bps) between deposit and lending facilities of the NBU—aggravated by less-than-automatic access to standing facilities—encourages banks to be conservative with reserves and undermines development of a functioning interbank market.
  - As a result, the NBU often simultaneously lends to and absorbs from the banking system and the interbank rate has been very volatile, undermining transmission of monetary policy signals to other markets and retail lending rates.

### Empirical link from FX interventions to base money and inflation
- Vector autoregression evidence (monthly data 2000–11):
  - A one-standard deviation innovation in NBU foreign currency interventions is estimated at about 4½ percent of base money.
  - Such an innovation significantly increases growth in base money and, with a lag of about six/eight months, adds about ½ percent to core inflation.
  - Impulse response functions show NBU purchases of FX in the interbank market raise base money growth and drive up inflation after a roughly 6-month lag (responses reported with ± 2 S.E.).

### Real exchange rate, trade balance, and vulnerabilities
- Large inflation differentials vis-à-vis main trading partners pushed Ukraine’s real effective exchange rate away from levels consistent with fundamentals:
  - Between 2004 and 2008, the real effective exchange rate appreciated by over 40 percent as at times inflation exceeded that in main trading partners by 20–30 percent.
  - Resulting appreciation fueled domestic demand and pushed the trade balance into deficit despite high international demand for traditional exports.
- Mounting exchange rate misalignment increased vulnerability to external shocks and made eventual nominal exchange rate correction virtually inevitable.

### Dollarization, external liabilities, and balance-sheet effects
- The quasi fixed exchange rate regime contributed to financial dollarization and over-leveraging:
  - FX-denominated credit to corporates increased from 7 percent of GDP in 2000 to 23 percent of GDP in 2008.
  - FX-denominated credit to households increased from 0.1 percent of GDP in 2000 to 22 percent of GDP in 2008.
- External liabilities at the beginning of the 2008 crisis:
  - Corporates’ external liabilities amounted to 24 percent of GDP.
  - Banks’ external liabilities amounted to 23 percent of GDP.
- Consequence: realignment of the nominal exchange rate produced severe balance-sheet effects for borrowers and financial institutions.

### Policy recommendations and institutional priorities
- Allow greater exchange rate flexibility:
  - To implement its strengthened mandate of safeguarding price stability, the NBU needs to allow greater exchange rate flexibility and reduce frequent interventions in the interbank FX market and heavy-handed administrative measures (e.g., mandatory ID requirement with any purchase of cash foreign exchange).
  - Pace of liberalization should be carefully gauged against conditions in the foreign currency market to avoid undermining confidence in the hryvnia and to safeguard private sector balance sheets.
- Enhance liquidity management framework:
  - Improve the functioning of the money market to redistribute liquidity across the banking system.
  - Make more reliable standing facilities available, with access guided by price and availability of suitable collateral.
  - Bring the overnight rate closer to the middle of a narrower policy rate corridor and be more aggressive in managing liquidity fluctuations.
- Strengthen credibility and transparency of monetary policy:
  - Safeguard NBU independence, improve predictability of policy actions through greater transparency and stronger communication.
  - As the NBU’s ability to deliver on inflation objectives becomes established, private sector wage and price expectations should become more forward-looking, improving monetary policy effectiveness and reducing the need for large policy swings.

*Source: Annex VI. Ukraine: Evidence on Monetary Policy Transmission Mechanism (2012 Article IV Report).*

### 1. Bank Fiscal, Structural and Governance TA  Ongoing TA through June 2013

### _cr12315 - 1. Bank Fiscal, Structural and Governance TA  Ongoing TA through June 2013

### Ongoing Technical Assistance and Projects
- PEFA — Ongoing — June 2012
- Capital Budgeting TA — Ongoing TA through December 2012
- Investment Loans in Tax Administration, IT modernization, PFM, and Statistics Office — Ongoing
- Gas sector reform TA — Ongoing 2012-2014
- District heating sector analytical work (completed) and energy efficiency project — Ongoing; Project delivery in 2013
- Social Assistance Project and TA, preparation of a second-generation Social Assistance Project — Ongoing
- PFRL 2 — Ongoing (in the form of TA); Board discussion postponed, date TBD
- TA provision to NBU, government, and DGF on: selected bank supervision issues, problem bank resolution and DGF capacity building, restructuring and privatizing banks recapitalized by the state, new financial sector consumer protection framework; planned TA on selected NBFI and capital market development issues — Ongoing TA through June 2013
- TA provision on SOE restructuring and governance — Planned TA through June 2013
- IMF Article IV Consultation — May, 2012; Board discussion expected June 2012
- Second and subsequent reviews under SBA — TBD; Board discussion TBD
- TA provision to NBU and government: on bank restructuring, local currency market development and de-dollarization, monetary policy, FX market liberalization, financial stability, corporate insolvency, addressing NPLs — Ongoing TA through early 2013
- TA provision to MoF: on medium-term framework and budgeting, tax administration modernization — Ongoing TA through early 2013

### Relations with the EBRD — Key facts and activities
- Ukraine joined the EBRD in 1992; as of end-April 2012, EBRD’s portfolio in Ukraine reached €4.4 billion, most of it in the private sector.
- The Bank’s exposure in Ukraine is the second largest after Russia, accounting for 1/8th of the Bank’s overall portfolio.
- Financial sector and industry account for 3/4th of the total operating assets in Ukraine.
- EBRD contributions include funding projects with transition impact, technical cooperation, and policy dialogue with the government.

Selected crisis response and investment activity:
- During 2008–09 crisis, in 2009 the EBRD invested €1.1 billion in Ukraine (record level for the country); almost two-thirds of the total was invested in the banking sector.
- In 2009: investments of over €250 million in the corporate sector; €220 million in infrastructure and energy; over €600 million in the form of equity and subordinated capital in 2009.
- Bank’s country strategy for 2011–14 approved April 2011; focus on energy efficiency and energy security, agricultural and industrial potential, infrastructure, and addressing legacy of financial sector crisis.
- In 2011 the Bank invested over €1 billion:
  - Agribusiness: twelve projects totaling €190 million
  - Manufacturing: nine transactions totaling €228 million
  - Infrastructure and energy (private sector): €143 million, and a €200 million sovereign loan for modernization of hydro power stations operated by Ukrhydroenergo
- Financial sector: equity stakes in two banks and support to cross-border trade
- Policy engagement: agribusiness modernization, SOE restructuring (including Ukrainian Railways, Ukrenergo, NAK Naftogaz), local currency capital market development
- Business Advisory Services (BAS) Programme rolled out in May 2010 in Ukraine
- Support for local private sector clients (Obolon, Astarta, Centravis) and financing of international investors (Lafarge, Bosch, Louis Dreyfus)
- Engagement in energy sector: financing and equity in Galnaftogas; energy efficiency credit lines; support for implementation of March 2009 EU-Ukraine memorandum of understanding; plans to modernize trans-European energy networks, invest in modern and energy efficient generation, transportation and distribution, diversify supply sources, and support energy sector liberalization and private sector involvement
- Nuclear safety: work to improve safety at existing NPPs, safe decommissioning of Chernobyl NPP, and creation of a safe confinement for Unit 4
- Infrastructure projects: municipal transport in Kiev and regional centers, Odessa sea port development, pan-European road network modernization, first investment in media and telecommunications for Volia cable operator

### Statistical issues — Assessment and data dissemination
- General: Data provision has some shortcomings, but is broadly adequate for surveillance; notable shortcomings in national accounts, government finance statistics (GFS), and external sector statistics.
- National Accounts:
  - Broadly in line with the 1993 SNA.
  - STA multitopic TA mission April 2010 flagged financial account and sector balance sheets and estimates of financial intermediation services indirectly measured as areas to be developed.
  - QNA improvements implemented in 2009–10; GDP volumes rebased using 2007 as reference period.
  - Seasonally adjusted data are not disseminated on a quarterly basis.
  - Government regulations on revisions policy restrain State Statistics Committee’s ability to improve data accuracy.
  - Since 2011, beneficiary of STA TA project on Capacity Building for Sustainable Compilation of Real Sector Statistics in Eastern Europe (two/three missions per year on national accounts and price statistics, plus training).
- Price statistics:
  - CPI weights updated annually; geometric means used at first level of aggregation beginning January 2010.
  - Scientific sampling of outlets introduced beginning January 2011, results published within six days of month end.
  - Geographical coverage limited to urban areas; CPI excludes owner occupied housing price changes.
  - Efforts underway to develop imports and exports price indices.
- Government finance statistics:
  - Compilers cognizant of GFSM 2001 methodology.
  - Lack of strong legal framework and incomplete statistical coverage are significant shortcomings.
  - Full adoption of GFSM 2001 depends on strengthening primary data sources, government accounting reform (under IPSAS), and completion of World Bank GFS component.
  - Lack of clarity on stock of VAT refund claims prevents full fiscal assessment.
- Monetary statistics:
  - Authorities use Standardized Report Forms (SRF) for reporting monetary data to STA and EUR.
  - Data from December 2001 converted to SRF and published in IFS since September 2006; available online.
- Balance of payments:
  - Compilation relies on International Transactions Reporting System, customs database, and enterprise surveys.
  - Improvements needed: enterprise surveys and intensive use of available sources for financial services, travel, compensation of employees, remittances, reinvested earnings; better c.i.f./f.o.b. conversion methodology for goods; reconcile direct investment data between surveys and ITRS; determine sources of large FX cash held outside banking system classified under currency and deposits.
  - 2012 STA TA recommended improvements on external debt compilation on a remaining maturity basis and direct investment coverage and equity valuation.

### Data standards, reporting, and selected indicators
- Participant in the SDDS since January 10, 2003.
- Data ROSC published on August 19, 2003.
- IFS page published since July 1996. Monetary statistics published since September 2006 using SRF framework.
- Authorities report quarterly Financial Soundness Indicators; observations beginning in 2005.
- International investment position compiled and reported since 2002.

Selected dates and reporting frequencies from the Table of Common Indicators Required for Surveillance (May 30, 2012):
- Exchange Rates — Date of latest observation: 5/29/2012; Date received: 5/30/2012; Frequency of data: D; Frequency of reporting: D; Frequency of publication: D
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities — Date of latest observation: 5/24/2012; Date received: 5/30/2012; Frequency of data: W; Frequency of reporting: W; Frequency of publication: M
- Reserve/Base Money — 5/29/2012; 5/30/2012; D; D; M; Data quality—Methodological soundness: O, LO, O, O; Data quality—Accuracy and reliability: O, O, O, O, NA
- Broad Money — 5/29/2012; 5/30/2012; D; D; M
- Central Bank Balance Sheet — 4/2012; 5/15/2012; M; M; M
- Consolidated Balance Sheet of the Banking System — 4/2012; 5/15/2012; M; M; M
- Interest Rates — 5/29/2012; 5/30/2012; D; D; M
- Consumer Price Index — 4/2012; 5/10/2012; M; M; M; Data quality—Methodological soundness: O, LO, O, O; Data quality—Accuracy and reliability: O, O, LO, O, O
- Revenue, Expenditure, Balance and Composition of Financing — General Government — 4/30/2012; 5/25/2012; M; M; M; Data quality—Methodological soundness: O, LO, LO, O; Data quality—Accuracy and reliability: O, O, O, O, NA
- Revenue, Expenditure, Balance and Composition of Financing — Central Government — 4/30/2012; 5/25/2012; M; M; M
- Stocks of Central Government and Central Government-Guaranteed Debt — 4/30/2012; 5/25/2012; M; M; M
- External Current Account Balance — 4/2012; 5/25/2012; M; M; M; Data quality—Methodological soundness: O, LO, LO, O; Data quality—Accuracy and reliability: LO, O, O, O, LO
- Exports and Imports of Goods and Services — 4/2012; 5/25/2012; M; M; M
- GDP/GNP — Q1 2012; May 2012; Q; Q; Q; Data quality—Methodological soundness: O, LO, O, O; Data quality—Accuracy and reliability: O, LO, O, O, LO
- Gross External Debt — Q4 2011; 3/21/2012; Q; Q; Q

### IMF Public Information Notice — Key macro projections and risks (PIN No. 12/72, July 6, 2012)
- Executive Board concluded the 2012 Article IV consultation with Ukraine on June 29, 2012.
- Economic outlook and projections:
  - Economic growth is projected at 3 percent this year.
  - Inflation is projected to rise to 7.4 percent during the year.
  - Current account deficit is expected to widen to 6.5 percent of GDP.
- Fiscal and debt developments:
  - Following a 3.1 percent of GDP government deficit improvement in 2011, the fiscal position is under pressure in 2012.
  - Public debt fell from 41 to 36 percent in 2011.
  - Staff projects the general government deficit at 3¼ percent of GDP for the year, compared to a target (text cuts off).
- Risks:
  - Elevated risks in an uncertain global environment.
  - Potential shocks: significant contraction in global demand, commodity price shocks, or deleveraging by European banks — all posing risks to external stability given Ukraine’s high external financing requirements.

*Source: _cr12315 - 1. Bank Fiscal, Structural and Governance TA  Ongoing TA through June 2013 (PDF).*

### 1.8 percent. The state-owned gas company’s deficit is projected to reach 2 percent of GDP this

### _cr12315 - 1.8 percent. The state-owned gas company’s deficit is projected to reach 2 percent of GDP this

### Fiscal outlook and public finances
- The state-owned gas company’s deficit is projected to reach 2 percent of GDP this year, adding to the weight of the general government deficit on public finances.
- General government balance (percent of GDP):
  - 2009: -6.3
  - 2010: -5.8
  - 2011: -2.7
  - 2012 (Proj.): -3.3
- Overall balance (including Naftogaz operational deficit) (percent of GDP):
  - 2009: -8.7
  - 2010: -7.4
  - 2011: -4.2
  - 2012 (Proj.): -5.3
- Cyclically-adjusted general government balance:
  - 2009: -2.6
  - 2010: -3.1
  - 2011: -2.3
  - 2012 (Proj.): -3.3
- Structural general government balance:
  - 2009: -2.6
  - 2010: -3.1
  - 2011: -2.3
  - 2012 (Proj.): -3.8
- Public debt (end of period):
  - 2009: 35.4
  - 2010: 40.5
  - 2011: 36.0
  - 2012 (Proj.): 34.7

### Executive Board assessment and policy priorities
- Directors welcomed progress since the 2008–09 crisis: rebound in growth, decline in inflation, and decline in the general government deficit.
- Persistent vulnerabilities noted: low reserve cover, large external and fiscal funding needs, and the difficult external environment.
- Priority policy directions recommended by Directors:
  - Fiscal consolidation remains a priority; meet the 2012 deficit target and identify contingency measures for possible shortfalls.
  - Over the medium term: strengthen public revenue, reform the public sector, and reorient spending towards growth-enhancing priorities.
  - Comprehensive energy sector reform to reduce budget strain and gain energy independence.
  - Gradually increase gas and heating tariffs and enhance payment compliance.
  - Increase investment in domestic energy production, improve energy efficiency, and better-target subsidies to protect the poorest.
  - Monetary policy to focus more on price stability; tighten further if balance of payments or inflationary pressures intensify.
  - Gradually increase exchange rate flexibility to mitigate external shocks, strengthen reserves, and preserve competitiveness.
  - Support increased exchange rate flexibility with measures to reduce balance sheet mismatches in the financial sector and fiscal, monetary, and wage policies consistent with price stability.
  - Continue banking-sector reforms to address high non-performing loans, low profitability, and currency mismatches.
  - Press ahead with unwinding crisis-era policies and implement comprehensive structural reforms, including stronger governance and further privatization.

### Monetary policy and exchange rate
- Current stance: tight monetary stance to address external risks and contain inflation.
- Impact: combined with deleveraging by banks, this has constrained credit growth.
- Liquidity tightening plus prudential and administrative measures have contributed to exchange rate stability.
- Interbank overnight rate (annual average, percent):
  - 2009: 12.6
  - 2010: 3.4
  - 2011: 7.1
  - 2012 (Proj.): 2.3
- Directors' guidance: tighter monetary stance warranted if balance of payments or inflationary pressures intensify; gradually increase exchange rate flexibility.

### Banking sector and financial stability
- Reforms have advanced although balance sheets remain weak.
- Banking system appears well capitalized, but:
  - Profitability is near zero.
  - Nonperforming loans remain high.
  - Banks’ balance sheets remain exposed to currency movements.
- Directors welcomed plans to reduce banking system exposure to foreign exchange risks, including through limited sales to banks of foreign currency linked bonds issued by the government.
- Encouraged actions: address non-performing loans, improve profitability, reduce currency mismatches, and continue unwinding crisis-era policies.

### Structural reforms and business environment
- Measures have been taken to deregulate the economy and to simplify the tax and customs codes.
- Directors welcomed progress under the President’s Economic Reform Plan to promote growth, improve the business climate, and attract investment.
- Implementation needs: comprehensive structural reforms, stronger governance, and further privatization to achieve objectives.

### Selected economic and social indicators, 2009–12 (key figures)
- Nominal GDP (billions of Ukrainian hryvnias):
  - 2009: 913
  - 2010: 1,083
  - 2011: 1,317
  - 2012 (Proj.): 1,473
- Real GDP (percent change):
  - 2009: -14.8
  - 2010: 4.1
  - 2011: 5.2
  - 2012 (Proj.): 3.0
- Contributions to real GDP (percent):
  - Domestic demand:
    - 2009: -26.4
    - 2010: 7.3
    - 2011: 11.5
    - 2012 (Proj.): 4.1
  - Consumption:
    - 2009: -10.2
    - 2010: 5.6
    - 2011: 9.2
    - 2012 (Proj.): 4.9
  - Investment:
    - 2009: -16.2
    - 2010: 1.7
    - 2011: 2.3
    - 2012 (Proj.): -0.8
  - Net exports:
    - 2009: 11.6
    - 2010: -3.1
    - 2011: -6.4
    - 2012 (Proj.): -1.1
- Unemployment rate (ILO definition; percent):
  - 2009: 8.8
  - 2010: 8.1
  - 2011: 7.9
  - 2012 (Proj.): 7.8
- Consumer prices (period average):
  - 2009: 15.9
  - 2010: 9.4
  - 2011: 8.0
  - 2012 (Proj.): 3.8
- Consumer prices (end of period):
  - 2009: 12.3
  - 2010: 9.1
  - 2011: 4.6
  - 2012 (Proj.): 7.4
- Core inflation (period average) 1/:
  - 2009: 19.4
  - 2010: 8.6
  - 2011: 7.7
  - 2012 (Proj.): 5.2
- Core inflation (end of period) 1/:
  - 2009: 14.9
  - 2010: 7.9
  - 2011: 6.9
  - 2012 (Proj.): 5.3
- Nominal monthly wages (average):
  - 2009: 5.5
  - 2010: 17.7
  - 2011: 17.5
  - 2012 (Proj.): 13.8
- Real monthly wages (average):
  - 2009: -8.9
  - 2010: 7.6
  - 2011: 8.8
  - 2012 (Proj.): 9.6
- Money and credit (end of period, percent change):
  - Base money:
    - 2009: 4.4
    - 2010: 15.8
    - 2011: 6.3
    - 2012 (Proj.): 4.0
  - Broad money:
    - 2009: -5.5
    - 2010: 22.7
    - 2011: 14.7
    - 2012 (Proj.): 5.8
  - Credit to nongovernment:
    - 2009: -2.2
    - 2010: 1.1
    - 2011: 9.5
    - 2012 (Proj.): 1.9
- Balance of payments (percent of GDP):
  - Current account balance:
    - 2009: -1.5
    - 2010: -2.2
    - 2011: -5.5
    - 2012 (Proj.): -6.4
  - Foreign direct investment:
    - 2009: 4.0
    - 2010: 4.2
    - 2011: 4.2
    - 2012 (Proj.): 4.6
- Gross reserves (end of period, billions of U.S. dollars) 7/:
  - 2009: 26.5
  - 2010: 34.6
  - 2011: 31.8
  - 2012 (Proj.): 24.4
- Months of next year's imports of goods and services:
  - 2009: 4.3
  - 2010: 4.2
  - 2011: 3.6
  - 2012 (Proj.): 2.6
- Percent of short-term debt (remaining maturity):
  - 2009: 67.4
  - 2010: 71.5
  - 2011: 55.2
  - 2012 (Proj.): 39.6
- Net reserves (end of period, billions of U.S. dollars):
  - 2009: 15.5
  - 2010: 20.3
  - 2011: 17.6
  - 2012 (Proj.): 13.6
- External debt (percent of GDP):
  - 2009: 88.2
  - 2010: 86.0
  - 2011: 76.4
  - 2012 (Proj.): 69.8
- Goods exports (annual volume change in percent):
  - 2009: -24.2
  - 2010: 9.3
  - 2011: 7.1
  - 2012 (Proj.): 4.4
- Goods imports (annual volume change in percent):
  - 2009: -41.6
  - 2010: 18.1
  - 2011: 20.3
  - 2012 (Proj.): 7.3
- Goods terms of trade (percent change):
  - 2009: -13.8
  - 2010: 0.3
  - 2011: 7.6
  - 2012 (Proj.): -1.3
- Exchange rate:
  - Hryvnia per U.S. dollar, end-of-period 6/:
    - 2009: 8.0
    - 2010: 8.0
    - 2011: 8.0
    - 2012 (Proj.): 8.0
  - Hryvnia per U.S. dollar, period average 6/:
    - 2009: 7.8
    - 2010: 7.9
    - 2011: 8.0
    - 2012 (Proj.): 8.0
- Real effective rate (CPI, percent change) 8/:
  - 2009: -17.6
  - 2010: 6.0
  - 2011: 0.1
  - 2012 (Proj.): 2.6
- Memorandum items:
  - Nominal GDP (billions of U.S. dollars):
    - 2009: 117.2
    - 2010: 136.4
    - 2011: 165.2
    - 2012 (Proj.): ...
  - Per capita GDP (2011): $3,624 (WEO)
  - Percent of population below poverty line (2006): 8.0
  - Quota (2011): SDR 1,372 million (2,166 million U.S. dollars)

*IMF staff report excerpt and Executive Board assessment.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12315.pdf_