## _cr14106 — Executive Summary and Selected Excerpts (Ukraine Stand-By Arrangement, April 2014) ## Source details **Canonical URL:** [_cr14106 — Executive Summary and Selected Excerpts (Ukraine Stand-By Arrangement, April 2014)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14106.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14106.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14106.pdf.json) --- ### Program overview and modalities - Request: a 24-month Stand-By Arrangement of SDR 10.976 billion (800 percent of quota, about US$17.1 billion) involving exceptional access. - Disbursement phasing: - Initial purchase: SDR 2.058 billion on approval; SDR 1.290 billion allocated to budget support. - Second and third purchases: SDR 914.67 million each (contingent on end-May and end-July 2014 reviews). - Fourth purchase: SDR 914.66 million (contingent on end-September 2014 review). - Fifth–eighth purchases: SDR 1.372 billion each (quarterly reviews starting end-December 2014). - Last tranche: SDR 686 million (contingent on eighth review, end-December 2015 targets). - Exceptional access: staff evaluates Ukraine meets all four exceptional access criteria under Fund policy. ### Macroeconomic context and near-term outlook - Crisis drivers and recent developments: - Second major economic crisis in six years: overvalued exchange rate, sizable budget deficit, energy-sector losses. - NBU floated the hryvnia in February 2014; by early April the exchange rate depreciated by over 35 percent from end-2013, hovering around UAH 11–11.5/US$1. - International reserves: dropped to US$15½ billion by late February 2014 (about two months of imports); NBU international reserves reported as US$15.1 billion at end-March 2014. - Real GDP and inflation projections: - Real GDP: contract by 5 percent in 2014; rebound by 2 percent in 2015; medium-term growth of 4–4½ percent. - Inflation: 2014–15 elevated due to depreciation and energy tariff hikes; medium-term inflation expected to fall within authorities’ target. - External sector and reserves: - Current account deficit expected to fall to 4½ percent of GDP in 2014. - Program aims to rebuild reserves to 3.9 months of import coverage by end-2016. - Selected baseline projection values (time series in source): - Nominal GDP (billions UAH): 1,302; 1,411; 1,455; 1,506; 1,736; 1,950; 2,169; 2,414; 2,687 - Real GDP (percent change): 5.2; 0.3; 0.0; -5.0; 2.0; 4.0; 4.0; 4.5; 4.5 - Current account balance (percent of GDP): -6.3; -8.1; -9.2; -4.4; -4.3; -3.9; -4.0; -3.8; -3.7 - Gross reserves (end-period, US$ billions): 31.8; 24.5; 20.4; 19.2; 26.7; 32.3; 34.9; 37.9; 39.3 ### Financial sector stress and bank-sector program actions - System stress indicators and recent developments: - Banking system lost about 12½ percent of deposits in the two months to end-March. - Capital adequacy ratio (CAR): 14.8 percent at end-March (down 3.5 percentage points from end-2013). - NPL ratio: 13.3 percent (end-March 2014); about 80 percent covered by specific provisions; under best-practice inclusion of substandard loans NPLs ≈ 23 percent. - Four banks (~3 percent of system deposits) disclosed capital shortfalls and were moved under temporary administration. - Adjusted for exchange rate movements, credit to economy grew by 3 percent in real terms in March y-o-y. - NBU emergency measures: - Floated exchange rate; adjusted monetary policy to accommodate emergency financing. - Accelerated profit transfers to the budget; back-stopped T-bond placements. - New liquidity facilities: special facility at penalty rate limited to deposit outflows; ELA lending at a high penalty rate against nonstandard collateral at 65–75 percent haircut. - Late-February restriction: limited households’ FX deposit withdrawals to equivalent of UAH 15,000 per day unless converted to hryvnia. - Bank diagnostics, capital and recapitalization framework: - Largest 35 banks (≈82 percent of assets) to be subjected to independent asset diagnostics and business viability studies (prior action launched). - Diagnostic completion deadlines: - 15 largest banks: end-July 2014 (structural benchmark). - Next 20 banks: end-September 2014. - Tier 1 capital (“T1”) metric targets: - Main scenario: T1 target 7 percent within overall capital requirement of 10 percent. - Adverse scenario: 4.5 percent T1. - Recapitalization deadlines: - 15 largest banks: end-December 2014. - Next 20 banks: end-February 2015. - Public support if private recapitalization fails: authorization sought in supplementary budget for funds ≈ 1 percent of GDP (structural benchmark by end-May 2014), to be used under strict criteria agreed with IMF and WB. ### Monetary policy, exchange-rate regime, and inflation-targeting transition - Exchange-rate regime: - Float of the hryvnia preserved; official exchange rate defined as weighted average of same-day interbank transaction rates. - Staff analysis: exchange rate in UAH 10–13/US$1 range consistent with fundamentals; UAH 10–11/US$1 manageable; UAH 12–13/US$1 would impose stronger balance-sheet hits. - Program exchange rate for accounting: UAH 10.9546/US$1 (set by NBU as of March 31, 2014); program keeps program exchange rates fixed for computing aggregates (no policy target implied). - Inflation targeting: - NBU to prepare timetable by end-June 2014; aim to formally switch to inflation targeting by mid-2015. - Inflation target: 3–5 percent over the medium term. - Initial framework: money-based framework with strict NDA and NIR targets; transition to inflation targeting during program. - Monetary operational stance: - Money supply path set consistent with inflation objectives for 2014; monetary policy to tighten in 2014:H2 and bring inflation down in 2015. - Effective policy interest rates expected to stay positive in real terms throughout the program. ### Fiscal policy, Naftogaz losses, and program fiscal targets - Fiscal deterioration and program targets: - Combined general government-Naftogaz deficit 2013: 6¾ percent of GDP. - Without adjustment combined deficit in 2014 would have exceeded 12 percent of GDP (8½ percent for the budget alone). - Program targets: - General government headline budget deficit 2014: 5¼ percent of GDP. - Naftogaz deficit 2014: 3¼ percent of GDP. - Combined general government and Naftogaz deficit 2014: 8½ percent of GDP. - Structural fiscal adjustment: 2 percent of GDP over 2014–16 (3 percent including Naftogaz). - Quantified 2014 fiscal measures (yields, percent of GDP): - Expenditure measures total: 2.0 percent of GDP (breakdown: wage/hiring freeze 0.5; cancel discretionary pension/wage hikes 0.2; non-pension social funds savings 0.3; rationalization of social assistance 0.2; capital expenditure prioritization 0.5; subsidies rationalization 0.1; procurement and other savings 0.2). - Revenue measures total: 1.3 percent of GDP (elimination of zero VAT for grain/crops export 0.3; increase mineral resources fees 0.1; excises/land price indexation 0.3; reduction of VAT exemptions on medical products 0.1; elimination of tax frauds 0.4). - VAT refund arrears handling: - Issue up to UAH 16.7 billion in one-time marketable VAT bonds to settle VAT refund arrears through end-2013. - Indicative target on VAT refund arrears: end-December 2014 ceiling UAH 0 (with intermediate ceilings at end-May UAH 5 billion, end-July UAH 5 billion, end-September UAH 2.5 billion). - Naftogaz financing and targets: - Naftogaz operational deficit projected at 3¼ percent of GDP in 2014; actual financing need could reach 4.1 percent of GDP in 2014 (including arrears and Eurobond maturing Sep 2014). - Government recapitalizations in 2014:Q1 of UAH 11 billion; supplementary budget allocated UAH 22 billion. - Naftogaz deficit reduction path: 3¼ percent of GDP in 2014 → 1.9 percent of GDP in 2015 → eliminated by 2018. - Tariff increases: gas +56 percent in 2014 (effective May 1); heating +40 percent in 2014 (effective July 1); further scheduled increases: +40 percent in 2015, +20 percent in 2016 and +20 percent in 2017. ### Energy sector reforms and social protection measures - Energy subsidy context and impacts: - Overall energy subsidies (on- and off-budget) ≈ 7½ percent of GDP in 2012. - Retail gas and heating tariffs are 11–25 percent of levels in other regional gas-importing countries. - Naftogaz arrears to Gazprom by end-March 2014: about US$2.2 billion (1½ percent of GDP). - Gas import price developments: Gazprom raised import price to US$385.5/tcm in April 2014; later sought US$485/tcm; Ukrainian authorities planning arbitration. - Household impact and protection: - Gas and heating spending currently account for 3–7 percent of household budgets; 40–56 percent tariff increases would raise share to 5–11 percent. - Nearly 30 percent of population to be shielded; most vulnerable 25–30 percent fully offset. - Coverage expansion: from about 810,000 to 4.5 million households next fall via existing and new schemes (new scheme effective July 1 with World Bank assistance; envelope UAH 3 billion). - Operational and governance reforms for Naftogaz: - Quarterly audits of Naftogaz operations; tender launched and auditor to be in place within 60 days. - Structural benchmark: legislation to create distribution accounts for utility payments by end-June 2014; increase building-level heating meter coverage from 36 to 45 percent by end-2014; move to consumption-based billing. ### External financing, Fund role, and capacity to repay - Gross external financing requirements over program: projected about US$27 billion (driven by current account deficits, private external obligations, need to rebuild reserves). - Official financing commitments projected to exceed US$6 billion in 2014 and US$5 billion in 2015 from World Bank, European Commission, EBRD and others; private inflows expected to increase from 2016. - Fund financing intended to fill remaining gap and catalyze official and private support. - Peak Fund credit outstanding under arrangement expected to be about 10.5 percent of GDP (62.4 percent of gross reserves) by end of arrangement in 2016. - Debt-service to the Fund projected to peak at 7.3 percent of exports of goods and services in 2019. - Staff view: capacity to repay adequate under strong program implementation; sizable downside risks could undermine capacity to repay. ### Debt sustainability and stress tests (Annex I & II highlights) - Public debt baseline: - Public debt projected to peak at 63½ percent of GDP in 2015 and decline to about 45 percent of GDP by 2019 (baseline). - Gross financing needs peak in 2014 at 17.5 percent of GDP (above 15 percent high-risk benchmark), averaging about 13 percent of GDP medium-term. - External debt baseline: - Gross external debt was 78.6 percent of GDP end-2013; projected to peak at 99.5 percent of GDP in 2014; decline to 81.5 percent of GDP by 2019 under program. - External debt-to-exports ratio projected to remain elevated, 167 percent by 2019. - Stress-test outcomes (selected): - Growth shock scenario: debt-to-GDP reaches 86 percent in 2016 (large growth shock); combined macro-fiscal shock: debt could reach 112 percent of GDP in 2016. - Contingent liability (bank guarantees) shock: debt peaks at 83 percent of GDP in 2016. - Real exchange rate shock: debt near 75 percent of GDP in 2015 in one configuration. - DSA implications: full implementation of program measures, fiscal adjustment, and energy reforms critical to entrench sustainability; gross financing needs in near term are a key vulnerability. ### Program conditionality, monitoring, and safeguards - Monitoring cadence: - Two initial bi-monthly reviews (end-May and end-July 2014 test dates), then quarterly reviews thereafter. - Quantitative performance criteria include floors on net international reserves (NIR) and ceilings on net domestic assets (NDA), cash deficit of general government, cash deficit of general government and Naftogaz, and ceiling on publicly guaranteed debt. - Indicative targets include ceilings on monetary base and VAT refund arrears. - Selected prior actions (implemented or required): - NBU regulation specifying official exchange rate calculation (weighted average of same-day interbank transactions). - NBU instructed largest 35 banks to launch diagnostic studies (prior action). - Repeal of NBU Resolution 109 and timetable to unwind banks’ net open FX positions (prior action). - Supplementary budget and package of revenue/expenditure measures yielding at least UAH 45 billion (prior action). - Parliament passed new public procurement law and kept VAT at 20 percent (prior actions). - NERC/NURC decisions to raise gas tariffs by 56 percent (May 1) and heating by 40 percent (July 1) (prior actions). - Technical Memorandum of Understanding (TMU) provisions: - Definitions and adjusters for NIR and NDA targets, program exchange rates (UAH 10.9546/US$1), adjusters for external disbursements, Naftogaz foreign-exchange purchases, NBU purchases of T-bonds for Naftogaz recapitalization, and NBU loans to DGF. - Ceiling on cash deficit of general government and Naftogaz with automatic adjusters for external project financing, NBU purchases of government bonds for DGF or bank recapitalization (limit UAH 15 billion), and VAT-bond usage (limit UAH 16.7 billion in 2014). - Safeguards: - Update safeguards assessment of NBU initiated; independent audit committee of the NBU Council established (prior action); special audit of reserves to be reported by May 1. ### Key program risks and mitigation - Principal downside risks: - Geopolitical: disruption of trade with Russia (Russia ≈ one-quarter of Ukrainian exports, ≈10 percent of GDP) and energy pricing/supply shocks (baseline gas price US$386/tcm; Gazprom sought US$485/tcm). - Financial: larger-than-expected banking sector capital needs (stress tests suggest recapitalization up to 5 percent of GDP under severe depreciation scenario). - Growth and fiscal: deeper/longer recession, sharper REER depreciation, higher military spending, or loss of control over eastern regions require program recalibration. - Mitigation and upside: - Program consists of strong prior actions, high-frequency reviews, and a mix of stabilization and structural measures; international financing commitments aim to cover financing gap and rebuild reserves. - Upside scenarios include faster export diversification, higher commodity prices, stronger FDI pickup, and increased reverse-flow gas availability from EU suppliers. - Staff emphasizes decisive program implementation, protection of the vulnerable, and transparency to maintain political and public support. *Italic: International Monetary Fund staff report content as provided in the source document.* ### EXECUTIVE SUMMARY ### _cr14106 - EXECUTIVE SUMMARY ### Stand-By Arrangement and Program Modalities - Request for a 24-month Stand-By Arrangement of SDR 10.976 billion (800 percent of quota, about US$17.1 billion) involving exceptional access. - Initial purchase of SDR 2.058 billion will become available on approval, with SDR 1.290 billion being allocated to budget support. - Second and third purchases tied to bi-monthly reviews and performance criteria; remainder subject to quarterly reviews. - Proposed arrangement described in Box 6 (attachment in the full report). ### Program Objectives and Policy Priorities - Key objectives: restore macroeconomic stability, strengthen economic governance and transparency, and lay the foundation for robust and balanced economic growth. - Immediate measures to secure stability combined with deeper reforms to: - achieve and sustain external sustainability, - ensure financial stability, - restore sound public finances, - rationalize the energy sector, - improve the business environment. - Authorities have adopted a number of key measures as prior actions to underscore commitment. - Successful and timely implementation is expected to unlock sizable official financing already committed to Ukraine and catalyze private inflows. ### Political Context, Discussions, and Assurances - Mission discussions held in Kyiv during March 4–26, 2014 with: Acting President Turchinov, Prime Minister Yatseniuk, Governor of the National Bank of Ukraine Kubiv, Minister of Finance Shlapak, Minister of Economy Sheremeta, Minister of Energy Prodan, Minister of Labor and Social Policies Denissova, other senior officials, ambassadors, trade unions, banking and business community, presidential candidates, the Maidan Council, and other politicians. - Staff met three leading presidential candidates and representatives of several key political parties and civil society organizations; they expressed agreement with key program objectives and policies. - Ukrainian authorities authorized the Fund to publish the staff report and the LOI/MEFP. - Approved by Poul M. Thomsen and Mark Flanagan (April 22, 2014). ### Context: Crisis Overview - Ukraine experiencing its second major economic crisis in six years, driven by an overvalued exchange rate, substantial budget deficit, and sizable losses in the energy sector. - In February 2014 the NBU allowed the exchange rate to float after mounting pressures on the hryvnia and reserves; this eased reserve pressures but: - large depreciation, - heightened uncertainties and geopolitical risks, - weakened bank and corporate balance sheets, - triggered bank deposit withdrawals, and - fueled capital flight. - Economic activity is contracting; international debt markets are closed. - Fiscal situation challenging as government revenues have fallen due to political uncertainty and weak economic performance. - Political tensions persisted in some regions after the change in government, including secessionist movement in Crimea and tensions in the East. ### Build Up of Imbalances and Vulnerabilities Before the Crisis - Policy mix in 2012–13: effectively pegged exchange rate, loose fiscal policy, and sizable losses in state-owned gas company Naftogaz ultimately covered by the budget (and monetized by the NBU, which holds about 60 percent of domestic government debt). - Resultant problems: overvalued exchange rate, large twin deficits, rising indebtedness, recurrent external financing difficulties, and depletion of international reserves. - Monetary responses to devaluation pressures included tightened monetary policy and heavy FX market interventions; devaluation expectations rose from late 2011. - Real hryvnia interest rates moved into double digits in 2013 despite zero consumer price inflation. - Hryvnia deposits increased by 50 percent during 2012–13; banks used inflows mainly to buy government securities and repay loans to the NBU; credit to the economy expanded only by 14 percent over two years. - Economy in recession since mid-2012; late-2013 bumper harvest temporarily boosted GDP. - General government deficit widened to 4¾ percent of GDP by 2013 due to large pension and wage increases and generous energy subsidies. - Naftogaz operating deficit reached 1.9 percent of GDP in 2013 and accumulated gas payment arrears to Gazprom. ### Loss of Market Access and External Pressures - Ukraine placed two Eurobond issues in early 2013 raising US$2.25 billion at yields of about 7½ percent; after program discussions stalled in May 2013, international debt markets effectively closed. - Current account deficit was on course to 9.2 percent of GDP; reserves declined to critically low levels; sovereign yields rose to double digits and CDS spreads widened sharply. - Rating agencies downgraded Ukraine to pre-default levels by end-2013. - Private external debt roll-over rates remained high due to inter-company lending. ### Short-lived Russian Assistance - In mid-December 2013 agreements with Russia provided assurances of US$15 billion in two-year loans and a gas price discount of about 30 percent. - First tranche of US$3 billion arrived in late 2013 and the gas price was reduced in 2014:Q1. - With no fundamental policy change and continued defense of the de facto peg, reserves were quickly depleted. - Following government resignation in January, Russia put its financial assistance on hold and in April Gazprom raised demanded import price (see Box 1). ### Recent Developments: Exchange Rate, Reserves, and Volatility - By late February 2014 international reserves dropped to US$15½ billion, covering about two months of imports and equivalent to 28 percent of the remaining external debt service in 2014. - NBU abandoned the de facto exchange rate peg and switched to a flexible exchange rate regime. - By early April the exchange rate had depreciated by over 35 percent from its end-2013 level, hovering around UAH 11–11.5/US$1. ### Box 1 — Ukraine’s Dire Energy Finances (Key Points) - Overall energy subsidies (on- and off-budget) amounted to 7½ percent of GDP in 2012, with relatively well-off households capturing a larger share of benefits. - Ukraine’s energy use per unit of GDP is 10 times above the OECD average. - Extremely low retail gas and heating prices contributed to large Naftogaz cash deficits and inability to pay for imported gas. - By end-March 2014, Naftogaz had built up arrears of about US$2.2 billion (1½ percent of GDP) to Gazprom and significantly depleted stored gas reserves. - Government frequently recapitalizes Naftogaz by issuing bonds, placing a large burden on the budget; lack of funds deters maintenance and investment, generating large technical losses. - Gas transit fees are currently very low because of pre-payment by Gazprom in 2012–13. - In April 2014 Gazprom cancelled the December 2013 discount, raising the gas import price to US$385.5 per thousand cubic meters (tcm), a level envisaged in the program framework. - Gazprom later announced cancellation of another US$100 discount, and began asking Naftogaz to pay as much as US$485/tcm from April 2014; the Ukrainian authorities dispute this price and plan to appeal to arbitration. ### Fiscal Developments and Near-Term Financing Pressures - The 2014 budget approved in January contained increases in wages and social spending that were unaffordable and based on highly unrealistic revenue assumptions. - Tax revenues down 8½ percent y-o-y in January–February due to deterioration in compliance amid political turmoil. - The revenue gap was partly filled with profit transfers from the central bank; the Single Treasury Account experienced intermittent payment difficulties. - Local market financing has become limited to a handful of banks, including state-owned financial institutions. *International Monetary Fund. Executive Summary, Staff Report on Ukraine Stand-By Arrangement, April 22, 2014.* ### 13. The financial sector is under significant stress. The banking system lost about ### _cr14106 - 13. The financial sector is under significant stress. The banking system lost about ### Financial sector stress and banking system indicators - The banking system lost about 12½ percent of deposits in the two months to end-March. - Reduced bank liquidity made several banks vulnerable and dependent on emergency liquidity support from the NBU. - Many banks have imposed ATM withdrawal limits due to liquidity shortages. - Exchange rate depreciation and economic contraction exposed banks with negative open foreign exchange positions and put loan portfolios at risk. - System indicators: - Capital adequacy ratio (CAR) dropped to 14.8 percent at end-March, 3.5 percentage points less than at end-2013. - NPL ratio inched up to 13.3 percent. - In March, four banks accounting for about 3 percent of the system deposits disclosed capital shortfalls and were moved under temporary administration by the Deposit Guarantee Fund (DGF) after owners refused to provide extra capital. - The 22 largest banks (accounting for over 70 percent of the system deposits) reported meeting the minimum of 10 percent CAR as of mid-March. - Adjusted for exchange rate movements, credit to the economy still grew by 3 percent in real terms in March relative to a year ago. ### NBU extraordinary measures and liquidity facilities - NBU measures taken in crisis circumstances: - Floated the exchange rate. - Adjusted monetary policy to accommodate emergency financing to the budget and the banking system. - Accelerated profit transfers to the budget and back-stopped government T-bond placements by purchasing similar bonds from the secondary market. - Introduced new facilities allowing banks to pledge as collateral government debt securities and loans to companies at a sizable discount. - Specific NBU facilities: - A special facility at a penalty rate, with access limited to the size of deposit outflows. - An emergency liquidity assistance (ELA) facility that lends at a high penalty rate against nonstandard collateral (corporate and household loans) at a 65–75 percent haircut. - Foreign exchange deposit withdrawal restriction: - In late February, the NBU limited households’ FX deposit withdrawals from banks to an equivalent of UAH 15,000 per day—but allowed households to withdraw all deposited amount if converted into hryvnia. ### Near-term economic developments and indicators - Macro and sectoral developments: - Economy is in recession. - Industrial production: continues to contract, -5 percent y-o-y in Q1, driven by declining manufacturing, particularly export-oriented industries. - Retail trade: grew 7.7 percent up in real terms in Q1 y-o-y. - Wage growth: still positive but decelerating, 3.6 percent in February y-o-y (real terms). - Consumer price inflation: 3.4 percent y-o-y in March, only moderately picking up from low levels. - January-February trade: - Exports of goods contracted by 9½ percent y-o-y, driven by drops in chemicals and machinery and equipment exports and intermittent customs restrictions imposed by Russia. - Imports of goods declined by 16 percent y-o-y, reflecting mainly a drop in gas and machinery imports. ### Crimea economic exposure - Crimea’s share and economic exposure (included in Ukraine data): - Accounts for 3.7 percent of Ukraine’s GDP. - Its 2.3 million residents represent some 5 percent of the country’s population. - Banking sector exposure in the region: 2.3 percent of deposits and 1.9 percent of issued loans. - One state-owned domestic gas extraction company in Crimea accounts for 14 percent of Naftogaz output, with output broadly equal to the region’s gas consumption. - Fiscal effect likely essentially neutral, as Crimea is a slight net recipient of fiscal transfers from the central government. ### Program objectives, strategy, and risks - Main program aims: - Restore macroeconomic stability. - Strengthen economic governance and transparency. - Lay foundation for robust and balanced economic growth by restoring competitiveness while maintaining financial stability, and resolving balance of payments needs via external financing. - Deep-reaching structural reforms to reduce imbalances, improve governance and the business climate. - Program design considerations: - Attention to pace of adjustment, protection of the most vulnerable, and flexibility via adjustors to performance criteria. - Focus on capacity building to address legacy of ad hoc policy design and implementation. - Key program policy pillars (summarized): - Maintain a flexible exchange rate and focus monetary policy on domestic price stability; adopt initially a money-based framework with strict NDA and NIR targets; introduce inflation targeting during the program. - Stabilize the financial system: maintain confidence in banks and develop a plan for strengthening balance sheets and financial infrastructure. - Meet near-term fiscal obligations and gradually reduce the structural fiscal deficit; stabilize budget revenues and embark on expenditure-led medium-term fiscal adjustment with equitable burden distribution. - Modernize and restructure the energy sector; begin staged increases in end-user energy prices while enhancing the social safety net; pursue structural and governance reforms in Naftogaz and the energy sector. - Implement comprehensive structural reforms to reduce imbalances, reduce corruption, improve the business climate, and achieve high and sustainable growth. - Program risk environment: - Unprecedented risks including political risks around presidential elections, vested interest resistance to governance reforms, and significant geopolitical risks from developments in the East and relations with Russia that could severely disrupt trade and investment confidence. - If central government control over the East is lost, the program would need redesign. ### Macroeconomic framework and projections - Growth and inflation projections: - Real GDP: contract by 5 percent in 2014, modestly rebound by 2 percent in 2015, and grow by 4–4½ percent in the medium term. - 2014 drivers: weak banking sector constraining credit, subdued confidence, restricted wage growth, fiscal tightening → significant contraction in domestic demand; net exports’ positive contribution stems from sharp import contraction and less pronounced export drop. - 2015: moderate investment- and export-driven recovery after stabilization. - Inflation: 2014–15 inflation will remain elevated driven by hryvnia depreciation and energy tariff hikes; demand contraction in 2014 and slow rebound in 2015 should cap price increases; price growth expected to fall within authorities’ inflation target range in the medium term. - Current account and reserves: - Current account deficit expected to fall to 4½ percent of GDP in 2014. - Exchange rate adjustment and subdued demand drive sharp reduction in current account deficit in 2014; decline of net interest bill due to low-interest official financing and smaller private sector debt burden reduces deficit further over medium term. - Official financing, augmented by private inflows over time, will cover external financing needs in 2014 and create preconditions for replenishing NBU international reserves from 2015 onwards. - Outlook subject to significant downside risks related to deterioration in economic relations with Russia, potentially deeper/longer recession, further REER depreciation, and larger financial sector hit requiring recalibration of program macroeconomic framework and policies. ### Monetary and exchange rate policy stance and assessments - Exchange rate regime and recommendations: - Float of the hryvnia is an important breakthrough to be preserved. - Maintaining a flexible exchange rate will restore competitiveness, protect reserves, and act as a shock absorber. - Authorities specified that the official exchange rate is calculated as the weighted average of same-day interbank transaction rates, institutionalizing the flexible exchange rate regime. - Staff analysis suggests an exchange rate in the UAH 10–13/US$1 range is consistent with fundamentals over the medium term. - If the hryvnia trades within the UAH 10–11/US$1 range, the impact would be manageable for banks, firms, and households. - Balance sheets would take a stronger hit if exchange rate settled in the UAH 12–13/US$1 range. - NIR floor targets back commitment to a flexible exchange rate and support gradual rebuilding of reserves to adequate levels by end of the program. - FX market restrictions: - Authorities agreed to identify and assess existing foreign exchange restrictions by end-May 2014 and to formulate and begin implementing a plan for their removal by end-July. - Agreed not to impose any new restrictions affecting foreign exchange operations, nor intensify existing restrictions. - Staff recommended a condition-based approach to unwinding FX market controls to safeguard macro-financial stability and limit negative effects of existing controls. - Monetary policy framework: - NBU will focus on achieving domestic price stability through targeting monetary aggregates in early stages. - The program sets a money supply path consistent with inflation objectives for 2014, achieved by controlling credit to government and commercial banks while providing sufficient liquidity to solvent but illiquid banks. - Monetary policy stance will tighten in 2014:H2, bringing inflation down in 2015 after an initial increase in 2014 driven by exchange rate pass-through and energy tariff adjustments. - Effective policy interest rates expected to stay positive in real terms throughout the program. ### Box 2 — Balance sheet impact of currency depreciation (stress test findings) - Stress test caveat: results indicative given questions about data quality; more comprehensive analysis planned in program reviews. - At a sustained exchange rate around UAH10.5/US$1: - Recapitalization needs of the largest 22 banks would amount to about 1½ percent of GDP or 9½ percent of the system’s regulatory capital, emanating from asset quality deterioration and large FX open positions. - Corporate balance sheets would on average lose about 2 percent of their end-2012 equity. - Corporate debt service would increase by the equivalent of 4 percent of their liquid assets as of December 2013. - Households as a group would be net winners from exchange rate depreciation because their FX assets significantly exceed FX liabilities (FX loan to deposit ratio for households was about 0.4 at end-2013), although disposable income will be affected by increased burden of servicing foreign currency denominated loans. - At an exchange rate around UAH12.5/US$1 (a 50 percent depreciation from end-December): - Would require a total capital injection of up to 5 percent of GDP in the largest 22 banks (conservative estimate). - By comparison, the 2008–09 crisis saw a bank recapitalization of 4 percent of GDP for the same group. - Bank recapitalization modalities discussed in Section D (in source). ### Box 3 — Exchange rate and reserve adequacy assessment (key metrics) - REER assessment: - Macroeconomic balance method: negligible gap; REER would need to depreciate by about 2.6 percent to close 0.7 percentage point gap. - External sustainability method: indicates a 1 percentage point negative gap implying slight undervaluation; REER would need to appreciate by about 3.6 percent. - Reduced-form equilibrium REER method: points to a larger undervaluation of over 14 percent. - Combined interpretation: at UAH 10.5–11/US$1, the hryvnia is in close alignment with fundamentals; new external shocks could push estimates toward UAH 12–13/US$1. - Reserve adequacy and program targets: - As of end-March 2014, NBU international reserves dropped to US$15.1 billion, covering only two months of Ukraine’s imports of goods and services. - Program aims to build reserves up to 3.9 months of import coverage by end-2016, above the standard sufficiency threshold of three months. - Current level of reserves covers about 28 percent of short-term debt by remaining maturity basis; projected to reach 59 percent at end-2016. - Reserves amounted to less than 50 percent of the IMF composite metric; official reserves would exceed 100 percent of this metric by end-2016. *Italic: IMF staff report content as provided in the source document.* ### 26. By mid-2015, the authorities will aim to adopt inflation targeting as Ukraine’s new ### 26. By mid-2015, the authorities will aim to adopt inflation targeting as Ukraine’s new ### Monetary policy: adoption of inflation targeting - The NBU plans to complete preparations and formally switch to inflation targeting by mid-2015 (MEFP ¶10). - With IMF technical assistance, the NBU will prepare by end-June 2014 a clear timetable for completing remaining preparations. - Transition facilitators: planned fiscal consolidation and steps to strengthen NBU independence, accountability and policy communications (MEFP ¶11). - Inflation target under the new anchor: 3–5 percent inflation over the medium-term. ### Financial sector policy — objectives and priority areas - Program aim: rebuild public confidence and strengthen financial stability via five priority areas: - (i) monitoring and supporting bank liquidity; - (ii) assessing banks’ financial resilience; - (iii) restructuring and recapitalizing banks in need; - (iv) reviewing and upgrading the regulatory and supervisory framework; - (v) removing impediments and upgrading banks’ capacity to resolve NPLs. ### Monitoring and supporting bank liquidity - Near-term actions: - NBU to continue providing liquidity to solvent banks in need. - Allow averaging of minimum obligatory reserve requirements over the monthly maintenance period. - Require the largest banks to share weekly cash flow projections based on best estimates of loan repayments and deposit withdrawals. - NBU will ensure liquidity policy is implemented in a transparent and expeditious manner (MEFP ¶14). ### Assessing bank resilience — diagnostics, capital standards, recapitalization - Diagnostics and scope: - The largest 35 banks, accounting for about 82 percent of the system’s assets, will be subjected to independent asset diagnostics and business viability studies. - NBU instructed participant banks to launch diagnostic studies (prior action). - Diagnostic studies completion deadlines: - 15 largest banks: end-July 2014 (structural benchmark). - 20 next largest banks: end-September 2014. - Capital requirements and scenarios: - Main Tier 1 capital (“T1”) metric target: 7 percent (defined as paid-up capital, disclosed reserves, share premiums, additional contributions of shareholders, and general risk provisioning fund) within an overall capital requirement of 10 percent—under the main program scenario. - Adverse macroeconomic scenarios: 4.5 percent T1 (agreed with Fund staff). - Recapitalization process and timelines: - Private shareholders are first line of defense; capital-deficient banks required to submit recapitalization and restructuring plans. - Deadlines for compliance: - 15 largest banks: end-December 2014. - 20 next largest banks: end-February 2015. - Private owners asked to make up capital shortfalls through cash injections. - Public support if private recapitalization fails: - Authorities agreed to seek authorization in a supplementary budget for funds amounting to about 1 percent of GDP to support banks (structural benchmark by end-May 2014). - These funds to be injected on basis of strict criteria to be agreed with IMF and WB staff. - Governance of public funds and resolution capacity: - Appoint a high level committee by end-March 2014 (MEFP ¶15). - Management of potential state ownership to be handled by a specialized unit at the Ministry of Finance by end-September 2014 (structural benchmark). - Deposit Guarantee Fund (DGF) will continue as resolution agency; steps to ensure adequate resources, staffing, and training. - NBU to appoint a Steering Committee to oversee the diagnostic process with IMF and World Bank staff involvement. ### Upgrading regulatory and supervisory framework - Prior action: NBU repealed Resolution 109 (which forced banks to maintain a large negative open foreign exchange position). - FX position provisions: - NBU will allow banks to gradually add provisions in foreign exchange in the calculation of their foreign currency position over a period of 20 months, ending in December 2015. - Rationale: gradual approach reduces likelihood of sharp exchange rate spikes. - Accounting and supervision improvements: - With IMF TA, NBU will compare Ukraine’s IFRS implementing practices against international best practice; if material enhancements needed, NBU will issue corrective guidelines by end-November 2014. - NBU will invite IMF and WB staff to assess compliance with Basel Core Principles for Effective Supervision and prepare an action plan over the following 12–24 months. - Credit information and register: - NBU to establish a centralized credit risk register and share information with all market participants. - Legal framework revision deadline: end-August 2014. - Aim to become operational no later than August 2015. ### Facilitating banks’ capacity to resolve NPLs - NPL levels and provisioning: - As of end-March 2014, banks’ NPLs are 13.3 percent by the NBU definition and are about 80 percent covered by specific provisions. - If substandard loans were included in NPLs (in line with best practices), NPLs would rise to about 23 percent. - Risks to capital: - Recession is expected to push NPLs higher. - Bank diagnostics may uncover additional loan provisioning needs, notably for banks with FX loans to non-exporters. - Strengthening debt workout framework: - NBU will assess banks’ preparedness to deal with troubled borrowers by end-September 2014. - Authorities will request Fund TA on strengthening legal framework for NPL resolution, including out-of-court restructuring and in-court processes. - Program authorities to complete a review of the existing legal framework by end-October 2014. - As part of diagnostic studies, auditing firms to assess quality of bank debt restructuring policies and procedures; report due by end-October 2014. ### Fiscal policy — deterioration, objectives, and measures - Fiscal deterioration and targets: - Combined general government-Naftogaz deficit in 2013: 6¾ percent of GDP. - Without adjustment, combined deficit in 2014 would have exceeded 12 percent of GDP (8½ percent for the budget alone). - Program targets a moderate structural fiscal adjustment of 2 percent of GDP from 2013 levels over 2014–16, or 3 percent including Naftogaz. - For 2014: - Headline budget deficit target: 5¼ percent of GDP. - Naftogaz deficit target: 3¼ percent of GDP. - Combined general government and Naftogaz deficit: 8½ percent of GDP (widening by 1¾ percent of GDP relative to 2013). - Structural fiscal cut for 2014: 1 percent of GDP (part of the medium-term path). - Immediate revenue and expenditure measures: - Strengthen revenue collection to break tax evasion schemes; noted improvement in March but additional efforts needed. - Priority spending: timely payments of wages, pensions, and debt service. - Unpaid bills: UAH 6.4 billion (0.4 percent of GDP) at end-March, down from UAH 9.9 billion at end-January. - Expenditure restraint and pension/wage measures: - Cancel discretionary wage increases planned for July and October 2014; maintain hiring freeze to reduce employment via attrition and staff optimization. Existing inflation indexation of wages remains. - Cancel discretionary increase in pensions and pension-linked benefits planned for July and October 2014; suspend indexation of pensions with part of the average economy-wide wage growth. Inflation indexation of pensions remains intact. - Governance and fiscal risk limits: - Prior action: Parliament adopted a new public procurement law to strengthen governance and reduce exemptions. - New loan guarantees issued by the central government will not exceed UAH 25 billion in 2014 (quantitative performance criterion). - Revenue-side measures and tax policy: - Break two major fraudulent tax evasion schemes (fake fuel exports and illegal alcohol production); reorganize state tax and customs services. - Prior action: Parliament reversed the introduced VAT rate reduction in 2015 and kept the rate at 20 percent. - Extended until October 1, 2014 the recently expired VAT exemption regime for grain exporters, pending a VAT reform in agriculture planned for late 2014. - Apply a single higher excise tax rate for diesel fuel; hike excises for other products. - Apply a reduced 7 percent VAT rate to supplies of pharmaceutical and medical products (currently exempt). - Addressing VAT refund arrears: - Securitize accumulated VAT refund arrears by end-2013 (MEFP ¶21) via a one-time bond issuance of up to UAH 16.7 billion (1.1 percent of GDP); bonds fully marketable at market interest rates. - Commitment to provide VAT refunds on time going forward, increase transparency, widen automatic VAT refund systems, and prohibit CIT advance payments in exchange for VAT refunds (MEFP ¶27). - Naftogaz financing: - Naftogaz operational deficit projected at 3¼ percent of GDP in 2014. - Taking into account accumulated arrears and the US$1.6 billion Eurobond maturing in September 2014, Naftogaz’s actual financing needs could reach 4.1 percent of GDP in 2014. - Government recapitalized Naftogaz by UAH 11 billion in 2014:Q1; another UAH 22 billion allocated in the supplementary budget. - Naftogaz to develop a plan based on cost rationalization and improved revenue collection; further budget backing possible. ### Fiscal adjustment measures (2014) — quantified yields (percent of GDP) - Expenditure measures (total 2.0 percent of GDP): - Wage and hiring freeze in the public sector: 0.5 - Cancel discretionary hikes and wage indexation of pensions: 0.2 - Savings in non-pension social funds: 0.3 - Rationalization of social assistance: 0.2 - Prioritization of capital expenditures: 0.5 - Rationalization of subsidies to enterprises: 0.1 - Public procurement and other savings: 0.2 - Revenue measures (total 1.3 percent of GDP): - Elimination of zero VAT rate for grain and crops export: 0.3 - Increase of mineral resources fees: 0.1 - Increase in excises, and indexation of land prices: 0.3 - Reduction of VAT exemptions on medical products: 0.1 - Elimination of tax frauds: 0.4 ### Energy sector reforms and Naftogaz - Naftogaz fiscal pressures and causes: - Naftogaz deficit would have doubled in 2014 without adjustment due to exchange rate depreciation and need to replenish depleted gas storage. - Retail gas and heating tariffs are only 11–25 percent of the levels in other gas-importing countries in the region and significantly below levels in Russia. - Low and differentiated tariffs create governance problems, stimulate overconsumption, and contribute to Ukraine being one of the most energy-intensive countries in Europe. - Policy direction: - Naftogaz to pursue cost rationalization, improved revenue collection, and may require further financial backing from the budget to remain current on obligations and clear arrears. *Source: UKRAINE — INTERNATIONAL MONETARY FUND (excerpt).* ### 41. The authorities’ program aims to gradually eliminate Naftogaz losses by 2018 by ### _cr14106 - 41. The authorities’ program aims to gradually eliminate Naftogaz losses by 2018 by ### Naftogaz deficit reduction targets and strategy - Objective: contain Naftogaz’s deficit to 3¼ percent of GDP in 2014 and clear its arrears. - Subsequent targets: reduce Naftogaz’s deficit to 1.9 percent of GDP in 2015 and eliminate it completely by 2018. - Core measures: - Staged tariff hikes over 2014–17. - Reducing Naftogaz’s costs through restructuring and strengthened payment discipline. - Increases in retail gas and heating tariffs: 56 and 40 percent in 2014, respectively, and 20–40 percent in 2015–17. - Enhanced social assistance from the budget to cover the most vulnerable. ### Household impact and social protection - Current share: gas and heating spending account for 3–7 percent of household budgets. - Impact of increases: Increasing gas and heating prices by 40–56 percent would raise this share to 5–11 percent. - Distributional protection: - Nearly 30 percent of the population will be shielded from the increase. - Tariff increase fully offset for the most vulnerable 25–30 percent of the population. - Expansion of coverage: from about 810,000 today on average to 4.5 million next fall. - Existing housing utility subsidy scheme to expand to cover about 1 million households (payments in excess of 10/15 percent of the income of eligible households). - New scheme from July 1 (with World Bank assistance) to cover additional 3.5 million households; benefit equal to the difference between pre-and post-increase gas and heating bills. - Cabinet decision to introduce the new scheme was a prior action. - Targeting concerns: - Majority of social assistance is captured by higher-income households who consume the largest share of gas and heat. - Example: the top quintile gets subsidy benefits that are, as a rule, double those of the bottom quintile. - For a fraction of the cost of existing utility subsidies, the government could fund additional social assistance programs that would substantially reduce poverty. ### Box 4 — Energy Sector Reforms (main reform objectives and prior actions) - Public communications: - Government will run an extensive campaign to inform the population why tariff hikes are necessary and lay out the approach to increased social assistance. - Tariff policy and prior actions: - NERC and NURC will adopt decisions to raise retail gas tariffs by 56 percent on average from May 1, and retail heating tariffs by 40 percent on average from July 1 (prior actions). - Government announced schedule: end-user gas and heating tariff increases of 40 percent in 2015 and 20 percent in 2016 and 2017, respectively. - Parliament passed legislation to vest the communal services regulator with exclusive authority to set heating tariffs. - Gas prices to industrial and budget consumers adjusted in early April taking into account new gas import prices and exchange rate movements. - Protecting the vulnerable: - Existing Housing and Utility Subsidy program remains and will fully shield current beneficiaries and cover new entrants. - New social assistance scheme to compensate for average utility bill increase for families earning incomes below subsistence levels. - Total coverage: 4.5 million families—about 27 percent of the total—will receive government support. - Strengthen payment discipline (structural benchmark for end-June, 2014): - Pass legislation to create distribution accounts into which all utility payments are made, and from which payments to Naftogaz are automatically drafted. - Raise building-level heating meter coverage from 36 to 45 percent by end-2014. - Move to consumption-based utility bills rather than current use of norms. - Improve energy efficiency: - Continue efforts with the World Bank on building efficiency, consumption-based billing, utilities’ production/transmission/distribution efficiency, and public sector (public buildings). - Transparency and audits: - Conduct quarterly audits of Naftogaz operations; a tender launched and an auditor will be in place within 60 days. - Restructuring: - Authorities will start to identify strategic priorities, including restructuring, for Naftogaz, relying also on advice from the World Bank. ### Governance, transparency, and anticorruption measures - Overall objective: address weak governance, transparency, and difficult business climate to achieve greater efficiency, higher growth, and trust in government. - Commitments: - Address governance issues in state-owned companies. - Strengthen transparency of public procurement procedures. - Build capacity for anti-money laundering (AML) activities and anti-corruption actions. - Seek recovery of stolen assets. - Enhance effectiveness of the judiciary and tax administration (MEFP ¶25). - Diagnostic study (structural benchmark): - Authorities requested a comprehensive diagnostic study to be completed in close consultation with IMF staff prior to the first program review; it will cover the anti-corruption framework, design and implementation of key laws and regulations affecting the business climate, effectiveness of the judiciary, and tax administration (MEFP ¶26). - The diagnostic study will: - (i) assess current governance arrangements and frameworks, identifying areas for strengthening and reform; - (ii) judge the relative importance of issues flowing from the diagnostic findings; - (iii) propose specific remedial measures and time frames for implementation. - Specific anticorruption and AML actions (MEFP ¶27): - Strengthen AML framework and revise relevant laws in line with international standards. - Banks required to conduct enhanced due diligence on business relationships with domestic politically exposed persons. - NBU to properly assess fit and proper requirements, including checking the source of wealth/funds of owners of qualifying holdings of banks. - Work with the World Bank and other international partners under the Stolen Asset Recovery (“STAR”) Initiative to develop a strategy and action plan for pursuing and recovering assets stolen by corrupt former officials. - Develop measures to simplify the regulatory environment and reduce compliance costs for business to improve the business climate. ### Risks to the program — macroeconomic and geopolitical - Disruption of non-energy trade with Russia: - Russia accounts for about a quarter of Ukrainian exports (equivalent to about 10 percent of GDP). - A significant reduction in non-energy bilateral trade could cause a highly disruptive negative economic shock. - Disruption of energy trade or pricing with Russia: - Baseline gas price: US$386/tcm. - Gazprom sought price: US$485/tcm. - Staff estimate: an increase to US$485/tcm would raise Ukraine’s current account deficit by an additional US$1½–2 billion a year (1 percent of GDP) and Naftogaz’s deficit by about ½ percent of GDP assuming full pass-through to industrial and budget users. - Planned expansion of reverse-flow gas imports from European countries at prices below US$400/tcm could mitigate effects. - Review scheduled to be completed by end-September will take stock of progress in reaching agreement between the parties, including implications for the program’s objectives, key policies, and adequacy of financing. - Geopolitical risks relating to Crimea: - Authorities do not have effective control with respect to Crimea for purposes of implementing economic policies in that territory. - While this might lead to Ukraine being deprived of significant energy assets in the medium term, the small economic size of Crimea and other available information (¶16) suggests such lack of control would not impair the authorities’ ability to meet program targets and objectives. - Staff will take stock of future developments that might affect the need and feasibility of presenting Ukraine’s data with or without Crimea. - Broader geopolitical risks and unrest in Eastern Ukraine: - Eastern Ukraine is highly industrialized; impact depends on duration and intensity of unrest. - In 2013 the provinces of Donetsk, Luhansk, and Kharkiv accounted for about 21½ percent of GDP and 30 percent of Ukraine’s total industrial production; about 28 percent of Ukraine’s exports of goods and 11 percent of imports; net contribution to the central budget amounted to 1.3 percent of GDP. - Conflict could weaken budget revenue, damage investment prospects, widen the budget deficit, necessitate corrective measures or higher donor financing, and deteriorate the trade balance. - Financial sector risks: - Diagnostic studies could identify more severe bank weaknesses than expected. - Deposit withdrawals and loan portfolio deterioration could accelerate, producing a deeper negative impact on the banking system. - Potential bank recapitalization costs could be as much as 5 percent of GDP or more (Box 2). - NBU may be called on to provide additional liquidity injections. - Other risks: - Sharp increases in military spending could make it difficult to adhere to the program fiscal envelope. - Political and economic uncertainty could linger, negatively affecting investment and potentially driving activity underground. - Unreported governance issues may disrupt program implementation. ### Upside scenarios and mitigation strategy - Upside potential: - Quick rebound and diversification of exports, higher international steel or grain prices, or faster recovery in investor sentiment. - Stronger global growth improving the current account outlook and boosting growth. - Decisive program implementation could lead to stronger and faster FDI pick-up and earlier reopening of international capital markets. - Stepped up efforts by EU countries to increase reverse flows of gas to Ukraine could alleviate gas import burden. - Faster-than-envisaged export growth to international markets and rapid investment and technology transfer could shift export structure toward higher value-added products. - Strategy for mitigating program risks and uncertainties: - Program balances strong upfront adjustment with measures to sustain public support, including improvements in governance and enhanced social safety nets. - Authorities implemented twelve prior actions in areas critical for program success; program reviews will be conditional on other macro-critical prior actions. - Two high-frequency bi-monthly reviews will start; first review sets end-May as a test date for close monitoring. - Staff engagement with leading presidential candidates, political parties, and civil society organizations reduced political risks from presidential elections in May/June 2014. - Program benefits from broad international support and financing commitments from the EU, the U.S., Japan, Canada, China, the World Bank, the EBRD, and the EIB, suggesting scope for increased donor support over the program period. *Source: Ukrainian authorities; WB and IMF staff estimates; www.energy.eu; www.euroheat.org.* ### 50. The authorities request a 24-month SBA in an amount equivalent to ### The authorities request a 24-month SBA in an amount equivalent to SDR 10.976 billion, or 800 percent of quota (about US$17.1 billion) ### Financing needs and rationale - Access requested: SDR 10.976 billion, or 800 percent of quota (about US$17.1 billion). - Gross external financing requirements projected at about US$27 billion over the course of the program, driven by: - still substantial current account deficits; - large external debt obligations of the private sector; - the need to replenish reserves. - Ukraine has lost access to international capital markets; rollover rates for corporate and bank obligations are projected to drop considerably in 2014. - Official financing from World Bank, the European Commission, the EBRD and other sources is projected to exceed US$6 billion in 2014 and US$5 billion in 2015. - Private inflows are expected to increase from 2016. - Program includes adjustors to cope with risks of delayed official support. ### Role of the Fund and use of Fund financing - The Fund’s financing is intended to fill financing needs and unlock official and private support to cover the remaining financing gap. - Without Fund and other official financing, debt service and critical import payments could have completely depleted the remaining official reserves by end-2014, potentially forcing Ukraine to default on external obligations. - The committed official financing, together with Fund support, is expected to help bring Ukraine’s GIR to comfortable levels (over 100 percent of the composite reserve metric by end-2016). - Ample public financing needs and limited market access justify an allocation of Fund financing for the budget in 2014. - Authorities requested that the domestic currency counterpart of Fund purchases be used to finance the budget deficit in the amount of SDR 1.290 billion (equivalent to about US$2 billion, 1.4 percent of GDP) from the first purchase. - Statement of consistency with Fund policy framework: - (i) Ukraine needs financial support under the proposed SBA to address its current account deficit and pressures on the capital account, as well as to build up reserves; - (ii) Ukraine has committed to implement policies that will assist in resolving its balance of payments problems and ensure repayment of Fund resources; - (iii) the program envisages that an amount equivalent to foreign exchange purchases from the Fund will be used to meet a balance of payments deficit or to strengthen reserves. ### Phasing of disbursements (Box 6 phasing summary) - Length: 24 months. - Initial disbursement: SDR 2.058 billion upon Board approval. - Domestic currency counterpart of SDR 1.290 billion (about US$2 billion) to be used to finance the government’s budget deficit. - Second and third tranches: SDR 914.67 million each (contingent on completion of reviews based on end-May and end-July 2014 test dates). - Fourth tranche: SDR 914.66 million (contingent on completion of review based on end-September 2014 test date). - Fifth, sixth, seventh, and eighth tranches: SDR 1.372 billion each (contingent on quarterly reviews based on targets starting from end-December 2014). - Last tranche (contingent on completion of the eighth review for end-December 2015 targets): SDR 686 million. ### Exceptional access criteria — staff evaluation (Criterion-by-criterion) - Staff evaluates that Ukraine meets all four exceptional access criteria: - Criterion 1: Exceptional balance of payments pressures on current and capital accounts leading to needs beyond normal limits. Current account deficit expected to shrink but remain elevated; official reserves have fallen to dangerously low levels; risks from geopolitical tensions. - Criterion 2: Rigorous and systemic analysis indicates a high probability that public debt is sustainable in the medium term, conditional on full implementation of envisaged fiscal adjustment. DSA notes vulnerabilities: - Projected average level of gross financing needs is close to the standard high-risk benchmark of 15 percent. - Debt could exceed the 70 percent DSA high-risk benchmark if growth disappoints, the exchange rate depreciates considerably, or higher than projected contingent liabilities materialize. - Debt structure indicates significant exposure to exchange rate movements and external market sentiment. - Shift in composition of external financing towards official sources alleviates some risks; after initial shocks the debt trajectory remains non-explosive. - Criterion 3: Prospects of regaining access to private capital markets within the timeframe when Fund resources are outstanding: - Loss of market access linked largely to domestic vulnerabilities and policies, with geopolitical events also relevant. - Policy mix under the program addresses imbalances and is expected to stabilize the economy and revive growth medium-term, improving prospects of regaining market access. - 2013 issuance of two sovereign Eurobonds and several private debt issues on expectations of a Fund-supported program suggest markets will reopen once macroeconomic stabilization is achieved; program assumes conservative market financing in 2014–15. - Criterion 4: Program provides a reasonably strong prospect of success: - New authorities have implemented a strong set of prior actions, including fiscal and energy tariff adjustments. - NBU has floated the exchange rate and begun regulatory and supervisory reforms. - Government preparing ambitious structural reform plans to improve transparency and fight corruption. - Prior actions are more comprehensive than in previous programs and have launched core macroeconomic adjustment components. - IMF advice appears to have more traction; institutional and technical capacity strengthened by technical support from the Fund and other partners. - Political support from leading presidential candidates and parliamentary representatives for key objectives; geopolitical developments may unite parliament and help overcome resistance to reform. ### Capacity to repay the Fund - With strong program implementation, Ukraine’s capacity to repay the Fund will remain adequate provided important risks are contained. - By end of the arrangement in 2016, outstanding credit to the Fund is expected to peak at about 10.5 percent of GDP, or 62.4 percent of gross reserves. - In 2014–15, Ukraine is expected to complete repayments of obligations to the Fund that originated from previous SBAs. - Debt service to the Fund as a ratio of exports of goods and services would peak at 7.3 percent in 2019, including liabilities of the NBU and the central government to the Fund. - Ukraine’s capacity to repay depends on its ability to: - correct its current account; - unlock official and multilateral financing; - regain market access; - strengthen budget and Naftogaz finances. - Risks to capacity to repay include deterioration from geopolitical developments and incomplete implementation of the program’s macroeconomic adjustment and growth-supporting policies. - Ukraine remains current on all payments to the Fund and reaffirmed commitment to continue servicing IMF obligations as a matter of priority. ### Program monitoring, conditionality, and prior actions - Monitoring frequency: - Initially bi-monthly, then quarterly reviews. - Initial disbursement: SDR 2.058 billion upon program approval. - First review set for July 25, 2014 (based on end-May 2014 targets). - Second review proposed for September 25, 2014 (based on end-July 2014 targets). - Third review proposed for December 15, 2014 (based on end-September 2014 targets). - Thereafter quarterly reviews subject to quantitative performance criteria and structural benchmarks. - Prior actions (selected): - NBU to adopt regulation specifying that the official exchange rate is calculated as a weighted average of rates on the same day’s interbank transactions. - NBU to instruct the largest 35 banks to launch diagnostic studies based on end-December 2013 data and terms of reference developed by the NBU. - NBU to repeal Resolution 109 and announce a timetable, agreed with IMF staff, for gradually unwinding banks’ net open foreign exchange positions, beginning May 1, 2014 and concluding in 20 months. - Government to approve a package of revenue and expenditure measures yielding at least UAH 45 billion and implement them by passing a supplementary budget. - Parliament to pass a new public procurement law strengthening governance and reducing exemptions from regular competitive procedures. - Parliament to reverse the VAT rate reduction in 2015 and keep the rate at 20 percent. - Parliament to pass an extension until October 1, 2014 in the recently expired VAT exemption regime for grain exporters. - NERC to adopt and publish a decision to raise end-user gas tariffs for households by 56 percent, effective May 1, 2014; NURC to adopt heating tariff increases for households by 40 percent on average, effective July 1, 2014. - Decision and schedule for tariff increases through 2017 to be publicly announced: (i) in 2015, raise end-user gas and heating tariffs by 40 percent on average, effective May 1; (ii) thereafter, raise these tariffs by 20 percent on average in each of 2016 and 2017, effective May 1. - Parliament to pass legislation vesting NURC with exclusive authority to set heating tariffs. - Government to approve a decision to introduce a new social assistance scheme to compensate increases in gas and heating tariffs for the most vulnerable. - NBU Council to establish an independent audit committee with a well-defined mandate for oversight of financial reporting, audit processes and internal controls at the NBU. - Quantitative and continuous performance criteria (selected): - Floor on net international reserves; - Ceiling on net domestic assets; - Ceiling on the cash deficit of the general government; - Ceiling on cash deficit of the general government and Naftogaz; - Ceiling on publicly guaranteed debt; - Non-accumulation of external debt payments arrears by the general government. - Indicative quantitative targets (selected): - Ceiling on monetary base; - Ceiling on VAT refund arrears. - Structural benchmarks (selected): - Complete diagnostic studies and review of business plans for the 15 largest banks. - If existing fit and proper shareholders are unwilling or incapable of recapitalizing a weak bank in full, public funds could be used under strict criteria to bring it back into solvency; Government and NBU to agree with IMF staff on these criteria. - Government to prepare to manage financial sector shareholdings; a specialized unit to be set up at the Finance Ministry. - Prepare a proposal for reform of VAT in agriculture to bring the regime closer to the general VAT regime. - Naftogaz to launch a tender by April 3 to conduct audits of Naftogaz operations, led by an external auditor; auditor to be in place within 60 days of the tender; results to be shared with the IMF within 30 days of each period, initially monthly beginning with data for end-May 2014, and then quarterly for end-September data forward. - Parliament to pass legislation to make distribution accounts fully operational and mandatory for utility payments to strengthen payment discipline for the heating sector. - Comprehensive diagnostic study, to be completed prior to the first review, covering the anti-corruption framework, implementation of key laws and regulations affecting the business climate, effectiveness of the judiciary, and tax administration. ### Safeguards and governance - An update safeguards assessment of the NBU has been initiated and is expected to be completed by the first review of the proposed arrangement; previous assessment completed in February 2011. - Remaining recommendations include legal and institutional changes to strengthen the NBU’s financial and operational independence and governance practices. - Prior action: independent audit committee of the NBU Council established on April 4 with a mandate to oversee financial reporting, external and internal audit processes, and internal controls. - NBU has appointed its external audit firm to conduct a special audit of foreign exchange and gold holdings as of February 28, 2014 and report findings to the NBU by May 1 to provide assurances concerning the existence and availability of international reserves. ### Staff appraisal and risks - Program success depends critically on sustained reform drive by the authorities. - Program aims to stabilize the economy after a deep crisis and address long-standing structural weaknesses and macroeconomic imbalances. - A comprehensive turnaround of previous unsustainable policies is needed for Ukraine to re-emerge as dynamic and competitive and catch up with European neighbors. - New government and parliamentary majority demonstrated commitment via strong prior actions; strong political and public backing will be needed for program success and to ensure a decisive break with the past. *International Monetary Fund — Selected excerpts from the staff report on Ukraine’s proposed Stand-By Arrangement (24-month SBA, SDR 10.976 billion).* ### 59. Strengthening the NBU’s independence and upgrading its monetary policy toolkit is ### 59. Strengthening the NBU’s independence and upgrading its monetary policy toolkit is ### Monetary policy and NBU independence - For most of 15 years, Ukraine relied on stabilized exchange rate arrangements as the nominal policy anchor, resulting in periods of stability intertwined with acute balance of payments crises. - To keep prices stable over the medium term without re-pegging the exchange rate, NBU needs to: - regain control over monetary aggregates in 2014:H2, and - switch to an inflation targeting framework in 2015. - The existing NBU law and additional legal changes envisaged under the program are designed to protect NBU independence and bolster its mandate to focus squarely on domestic price stability as its main policy objective. ### Banking sector reforms and safeguards - Diagnostic studies of the largest banks have been launched to clarify financial health and quality of data reporting. - Based on diagnostic results, the largest banks will need to: - address revealed shortcomings expeditiously, - contribute additional capital, and - upgrade reporting standards. - Expected outcomes: assure depositors and clients of bank soundness, help reverse deposit outflows, and establish the basis for robust credit recovery from 2015 on. ### Fiscal adjustment - The program involves moderate front-loading and a gradual transition to a sustainable deficit level. - The program envisages a structural fiscal balance improvement of 2 percent of GDP over three years, with half of it achieved in the first year. - The adjustment path balances reducing fiscal imbalances and keeping public debt sustainable against social and political costs. - Given very large public expenditure, the medium-term focus should be on expenditure rationalization, including control over wages and public procurement, facilitated by the new procurement law. ### Energy sector reforms and social mitigation - Energy sector reforms will gradually bring Naftogaz finances back to health and must be accompanied by mitigating measures to protect the poorest. - Tariff increases are from extremely low existing gas and heating tariffs relative to even poorer neighboring countries and relative to an energy exporting country like Russia. - The actual impact on the population will be manageable given the low share of gas and heating in the budget of most households. - It is critically important to implement, on schedule, the proposed new program to alleviate the impact of energy price hikes on Ukraine’s most vulnerable. - Existing and envisaged utility subsidy and compensation schemes will protect nearly 30 percent of the most vulnerable Ukrainians from the impact of the tariff increases. - Given large Naftogaz losses and distance to cost recovery, authorities need to persevere with significant household energy price adjustments over several years. - Objectives of price adjustments: reduce quasi-fiscal losses and budget subsidies, increase energy efficiency, promote domestic production, and alleviate governance problems in the energy sector. ### Governance, transparency, and business climate - Directly tackling weak governance, transparency, and business climate is critical to achieve higher growth and restore trust in government. - Weak governance and resistance from entrenched vested interests derailed two previous SBA-supported programs. - Corruption Perception Index compiled by Transparency International ranks Ukraine the most corrupt country in Europe. - Perceived corruption of government and judiciary and opaque operations of state-owned enterprises reduce investment attractiveness and prevent unlocking full growth potential. - Governance reform is generally a long process involving deep institutional and cultural change and requires a comprehensive approach with strong leadership and ownership from top to bottom. ### Financing, safeguards, and risks - The program is fully financed ex-ante, but hard work will be needed to unlock all available funding. - Unprecedented strong official support, bilateral and multilateral, generates sufficient financing commitments to cover the balance of payments and fiscal needs in the next two years. - This support enabled a relatively smooth fiscal adjustment path under the program, limiting strains on the economy and population, particularly the most vulnerable groups. - Authorities need to collaborate closely with international partners and implement reforms as planned to ensure timely delivery of committed assistance. - Program safeguards include: - a comprehensive set of prior actions to advance critical reforms, - high frequency of program reviews (with the first two on bi-monthly basis), and - massive financial backing by the international community to help mitigate new shocks. - The program envisages a gradual adjustment path supported by an increase in enhanced social assistance to the most vulnerable to cushion impact and secure public support. - Considerable residual risks remain: - A long-lasting disruption of relations with Russia that depresses exports, investment, and growth, or - A loss of economic control over the East that reduces budget revenue, - Either scenario would require significant recalibration of the program and additional financing, including from Ukraine’s bilateral partners. *IMF staff report excerpt.* ### 67. Decisive implementation of program policies provides the best chance for Ukraine to ### _cr14106 - 67. Decisive implementation of program policies provides the best chance for Ukraine to ### Program rationale and staff assessment - Decisive implementation of program policies provides the best chance for Ukraine to stabilize the economy, resolve the imbalances, and lay the basis for fast and sustainable growth. - Staff believes that the reform-based program adjustment path supported by international community will offer Ukraine best chance for sustained growth and prosperity. - The program is expected to pave the way for Ukraine to restore external sustainability, reassert sovereignty, and graduate from Fund support by the end of the arrangement. - On the basis of the authorities’ recent actions and forward-looking commitments, staff supports the authorities’ request for a Stand-By Arrangement. ### Macroeconomic projections and key real economy indicators (selected) - Nominal GDP (billions of Ukrainian hryvnias): 1,302; 1,411; 1,455; 1,506; 1,736; 1,950; 2,169; 2,414; 2,687 - Real GDP (percent change): 5.2; 0.3; 0.0; -5.0; 2.0; 4.0; 4.0; 4.5; 4.5 - Contributions to Real GDP (percent): - Domestic demand: 1.2; 6.5; 5.6; 0.9; -8.2; 2.0; 4.6; 4.8; 5.3; 5.3 - Private consumption: 10.0; 7.8; 5.6; -3.7; 0.8; 2.5; 2.5; 2.8; 2.8 - Public consumption: -0.6; 0.4; -0.5; -0.5; -0.3; -0.2; 0.3; 0.3; 0.3 - Investment: 3.2; -2.6; -4.2; -4.0; 1.5; 2.4; 2.0; 2.2; 2.2 - Net exports: -7.4; -5.3; -1.0; 3.2; 0.0; -0.6; -0.8; -0.8; -0.8 - GDP deflator (percent change): 14.3; 8.1; 3.1; 9.0; 13.0; 8.0; 7.0; 6.5; 6.5 - Output gap (percent of potential GDP): 0.9; 0.2; -1.0; -3.2; -2.3; -1.0; -0.5; 0.0; 0.0 - Unemployment rate (ILO definition; percent): 7.9; 7.5; 7.2; 8.5; 8.0; 7.5; 7.0; 6.5; 6.5 - Consumer prices (period average): 8.0; 0.6; -0.3; 8.3; 12.9; 6.3; 5.8; 5.0; 4.8 - Consumer prices (end of period): 4.6; -0.2; 0.5; 16.2; 7.4; 6.3; 5.4; 5.0; 4.6 - Nominal monthly wages (average): 17.5; 14.9; 8.0; 4.7; 14.0; 9.5; 9.1; 8.7; 8.5 - Real monthly wages (average): 8.8; 14.2; 8.3; -3.3; 1.0; 3.0; 3.1; 3.5; 3.5 ### Public finance projections (selected; percent of GDP and billions of hryvnias) - General government balance (percent of GDP): -2.8; -4.3; -4.8; -5.2; -4.2; -3.1; -2.9; -2.5; -2.4 - Overall balance (including Naftogaz operational deficit, percent of GDP): -4.3; -6.6; -6.7; -8.5; -6.1; -4.4; -3.1; -2.5; -2.4 - Structural general government balance (percent of GDP): -3.2; -4.4; -4.6; -3.6; -3.1; -2.6; -2.6; -2.5; -2.4 - Public debt (end of period, percent of GDP): 36.8; 37.4; 40.9; 56.5; 62.1; 61.2; 57.9; 51.9; 45.3 - Table 2 (billions of Ukrainian hryvnias, selected rows): - Revenue: 558.2; 627.3; 634.9; 651.3; 677.3; 781.2; 875.0; 969.3; 1,070.2; 1,178.2 - Tax revenue: 499.8; 547.8; 551.2; 575.9; 601.9; 692.5; 775.5; 858.5; 946.9; 1,041.0 - Nontax revenue: 58.4; 79.5; 83.7; 75.4; 75.4; 88.6; 99.5; 110.8; 123.3; 137.2 - Expenditure: 594.1; 687.9; 704.9; 778.8; 755.3; 854.4; 934.9; 1,031.8; 1,130.6; 1,241.8 - Overall balance (billions): -35.9; -60.5; -70.1; -127.5; -78.0; -73.2; -59.8; -62.5; -60.3; -63.7 - Naftogaz balance (billions): -20.4; -32.2; -27.5; -55.4; -50.4; -32.7; -25.3; -4.1; 0.0; 0.0 - General government and Naftogaz balance (billions): -56.3; -92.7; -97.6; -182.9; -128.4; -105.9; -85.1; -66.6; -60.4; -63.7 - Memorandum public sector debt (billions of hryvnias): 479.4; 527.3; 595.6; 850.7; 1,078.3; 1,193.8; 1,257.0; 1,253.9; 1,217.0 ### External sector, reserves, and financing - Current account balance (percent of GDP): -6.3; -8.1; -9.2; -4.4; -4.3; -3.9; -4.0; -3.8; -3.7 - Gross reserves (end of period, billions of U.S. dollars): 31.8; 24.5; 20.4; 19.2; 26.7; 32.3; 34.9; 37.9; 39.3 - Months of next year's imports of goods and services: 3.7; 2.9; 2.8; 2.6; 3.4; 3.9; 4.0; 4.0; 3.9 - Percent of short-term debt (remaining maturity): 55.4; 38.1; 30.3; 33.9; 53.6; 58.5; 60.5; 67.7; 96.3 - Percent of the IMF composite measure (float): 78.3; 57.0; 47.3; 62.3; 91.9; 114.6; 118.5; 127.3; 131.0 - External debt (percent of GDP): 77.2; 76.5; 78.6; 99.5; 99.3; 95.4; 91.0; 87.1; 81.5 - Table 3 (balance of payments, billions of U.S. dollars; selected): - Current account balance (billions): -10.2; -14.3; -16.3; -6.3; -6.4; -6.4; -7.1; -7.4; -7.9 - Goods exports (f.o.b., billions): 69.4; 70.2; 65.0; 62.5; 65.8; 68.9; 73.1; 78.3; 84.2 - Imports, f.o.b. (billions): -85.7; -89.7; -84.6; -72.9; -75.9; -80.2; -85.4; -91.3; -98.0 - Capital and financial account balance (billions): 6.6; 8.4; 15.8; -4.9; 1.4; 7.6; 8.0; 12.9; 13.7 - Overall balance (billions): -3.4; -5.3; -0.8; -11.2; -5.0; 1.2; 0.9; 5.5; 5.8 - Official financing (billions): 0.3; 1.5; 2.3; 6.3; 5.4; 3.3; 2.8; 2.9; 2.9 ### Gross external financing requirements and sources (Table 4, selected, U.S. dollars, billions) - Total financing requirements: 71.1; 85.5; 73.7; 63.0; 58.0; 55.0; 57.6; 56.2; 58.1 - Current account deficit (component): 10.2; 14.3; 16.3; 6.3; 6.4; 6.4; 7.1; 7.4; 7.9 - Trade credit (component): 13.9; 17.6; 21.2; 24.9; 22.1; 21.0; 21.2; 22.3; 23.4 - Total financing sources: 67.4; 79.7; 73.0; 51.8; 53.1; 56.2; 58.6; 61.7; 63.9 - Increase in gross reserves (negative indicates drawdown): -3.1; -7.2; -4.1; -1.2; 7.5; 5.6; 2.6; 3.0; 1.4 - IMF net use of resources (row noted): 0.0; -3.4; -5.6; 3.7; 7.1; 1.1; -1.2; -5.4; -7.3 - Total financing needs (net): 0.3; -1.9; -3.3; 10.0; 12.5; 4.4; 1.7; -2.5; -4.4 ### Financial sector and monetary outlook (selected) - Base money (end of period, percent change): 6.3; 6.4; 20.3; 21.5; 14.8; 14.2; 13.7; 13.5; 13.3 - Broad money (end of period, percent change): 14.7; 12.8; 17.6; 11.8; 17.6; 14.6; 14.0; 13.8; 13.6 - Credit to nongovernment (end of period, percent change): 9.5; 2.2; 11.8; 8.7; 11.7; 10.8; 11.0; 11.8; (table shows 11.8) - Monetary velocity (ratio): 1.9; 1.8; 1.6; 1.5; 1.5; 1.4; 1.4; 1.4; 1.3 - Banking sector indicators (Table 6, selected, percent unless otherwise specified): - Number of banks (2014): 176 - Regulatory capital to risk-weighted assets: 18.1; 20.8; 19.8; 18.1; 18.2; 18.0; 17.9; 18.3; 14.8 - NPLs to total loans (NBU definition): 13.1; 14.9; 14.3; 16.5; 15.9; 15.2; 14.0; 12.9; 13.3 - Loans in foreign currency to total loans: 51.2; 46.5; 40.6; 36.9; 37.2; 36.7; 35.7; 34.1; 41.7 - Deposits in foreign currency to total deposits: 47.2; 42.1; 42.6; 43.8; 41.7; 39.9; 39.1; 36.9; 43.5 ### IMF credit and program financing (Table 7 and narrative) - Stock of existing and prospective Fund credit (Millions of SDRs, end of period): 7,016; 3,359; 5,771; 10,290; 10,976; 10,233; 6,803; 2,144 - Percent of quota (end of period): 511; 245; 421; 750; 800; 746; 496; 156 - Percent of GDP (end of period): 6.1; 2.9; 6.3; 10.7; 10.5; 9.2; 5.6; 1.6 - Obligations to the Fund from existing and prospective drawings (Millions of SDRs): 2,434; 3,788; 1,670; 1,132; 255; 1,023; 3,694; 4,762 ### Principal policy recommendations and expected outcomes - Implement the reform-based program decisively to stabilize the economy and resolve macroeconomic imbalances. - Secure and coordinate international community support to restore external sustainability and rebuild reserves. - Strengthen public finance consolidation to achieve the projected improvements in general government and structural balances (see projections above). - Undertake financial sector measures, including adequate liquidity support and bank recapitalization where necessary, to address deposit outflows, high NPLs, and FX imbalances in the banking sector. - Proceed with the Stand-By Arrangement request supported by staff based on the authorities’ actions and commitments. *International Monetary Fund staff summary (extracted from the provided program scenario tables and narrative).* ### Annex I. Public Debt Sustainability Analysis ### Annex I. Public Debt Sustainability Analysis ### Key findings and baseline projection - Public debt is assessed to be sustainable with high probability despite its rapid increase. - Under the baseline scenario: - Public debt is projected to peak at 63½ percent of GDP in 2015 (below the 70 percent of GDP high-risk threshold). - Debt is projected to decline thereafter, reaching 45 percent of GDP by 2019. - Gross financing needs are forecast to peak in 2014 at 17.5 percent of GDP and will average 13 percent of GDP over the medium term. - The baseline path is subject to considerable risks from lower growth, real exchange rate, and contingent liabilities shocks. - Full implementation of the SBA-supported program—fiscal adjustment and energy-sector reforms together with stabilization and structural reforms—would entrench public debt sustainability in the medium term. ### Macroeconomic and fiscal assumptions underpinning the DSA - Scenario: program (baseline) scenario assumptions. - Real GDP growth: - 2014: -5 percent - Medium term: rising gradually to 4.5 percent - Inflation (GDP deflator): - 2014 average: 9 percent - Peak in 2015: 13 percent - General government fiscal deficit: - 2014: 5¼ percent of GDP - Declines to 3.1 percent over the program years - Reaches 2½ percent by 2019 - Historic and projected public financing for Naftogaz is added to general government debt. - The DSA tool assessing realism of growth, primary balance, and inflation assumptions does not reveal systematic forecast errors. ### Definition and coverage of public debt in this DSA - Public debt includes: - (i) Central government debt as reported by the authorities (includes domestic debt held by the NBU: 10¼ percent of GDP at end-2013). - (ii) Government guarantees on loans extended to state enterprises (including Naftogaz). - (iii) Debt of local governments. - (iv) National Bank of Ukraine’s (NBU’s) liabilities to the IMF. - All past government guarantees (whether called or not) as well as projected issuances of guarantees are reflected in public debt numbers. Existing guarantees are amortized as they expire according to the authorities’ schedule. Projected issuances of guarantees are assumed to have a five-year maturity. ### Baseline debt path and indicators - Public debt trajectory highlights: - End-2014: debt will reach 57½ percent of GDP (a jump of over 16 percentage points). - Peak: 63½ percent of GDP in 2015. - 2019: 45 percent of GDP. - Gross financing needs: - 2014: 17½ percent of GDP (above the high-risk indicative threshold of 15 percent). - Decline steadily over the program period and drop below the high-risk threshold by 2016. - Excluding financing needs generated by debt held by the NBU, gross financing needs would peak at 15 percent of GDP in 2014. - Debt profile vulnerabilities captured by: - EMBIG spreads (noted as elevated in figures). - Economy-wide external financing requirements. - Debt held by non-residents. - Alleviating factor: significant shift in composition of external financing in favor of official sources. ### Stress tests and shock scenarios (summary of outcomes) - Under several individual shocks debt-to-GDP remains below the 70 percent benchmark: - Unchanged primary balance shock. - Historical scenario where key variables remain at their 10-year historical average. - Other one-time shocks to the primary balance and the real interest rate lead to moderate increases but remain below 70 percent. - Shocks that push debt above 70 percent of GDP: - Growth shock: - Entails a cumulative growth decline of nearly 9 percent in 2015–16 on top of projected 2014 decline of 5 percent. - Debt-to-GDP reaches 86 percent in 2016. - Combined macro-fiscal shock: - Aggregation of shocks to real growth, interest rate, primary balance, and exchange rate (avoiding double-counting). - Debt reaches 112 percent of GDP in 2016 (largest effect). - Contingent liabilities shock (implicit guarantees to the banking sector; includes associated growth shock, primary balance deterioration, higher interest rates, lower inflation): - Debt peaks at 83 percent of GDP in 2016. - Real exchange rate shock (deterioration in inflation, interest rates, primary balance): - Debt reaches nearly 75 percent of GDP in 2015. - Heat map risk assessment: - Debt level (top row): low or medium risk under baseline and certain shocks (debt remains below 70 percent). - Gross financing needs (middle row): high risk (red) because the 15 percent threshold is breached in 2014–15 under the baseline. - Debt profile (bottom row): some risks high due to EMBIG spreads, external financing needs, and non-resident holdings; partially alleviated by shift toward official external financing. ### Composition of public debt, drivers, and debt dynamics - Components and dynamics highlighted in the DSA: - Identified debt-creating flows include primary deficit, real GDP growth effects, real interest rate effects, exchange rate depreciation, net privatization proceeds (negative), and contingent liabilities. - Selected figures from DSA projections (as of April 21, 2014): - Nominal gross public debt (percent of GDP): 2012: 25.8; 2013: 37.4; 2014: 40.9; 2015: 57.5; 2016: 63.6; 2017: 62.3; 2018: 58.6; 2019: 52.1; projection listed also as 45.4 in another table for 2019. - Of which: guarantees (percent of GDP): 2012: 5.9; 2013: 8.2; 2014: 7.2; 2015: 9.3; 2016: 13.3; 2017: 12.3; 2018: 10.1; 2019: 6.1; 2019 alternative value: 1.4. - Public gross financing needs (percent of GDP): 2012: 5.5; 2013: 9.3; 2014: 9.9; 2014 (alternate/high): 17.5; 2015: 16.3; 2016: 12.0; 2017: 12.6; 2018: 11.4; 2019: 9.9. - Effective interest rate (percent): 2012: 6.1; 2013: 7.4; 2014: 8.7; 2015: 10.1; 2016: 11.3; 2017: 11.1; 2018: 10.4; 2019: 10.2. - Real GDP growth (percent): 2012: 4.1; 2013: 0.3; 2014: 0.0 (alternate table shows -5.0 for 2014 in baseline); projections list medium-term 4.0–4.5 percent. - Inflation (GDP deflator, percent): 2012: 17.2; 2013: 8.1; 2014: 3.1 (alternate shows 9.0 in baseline); 2015: 13.0; 2016: 8.0; 2017: 7.0; 2018: 6.5; 2019: 6.5. - Contribution to change in gross public sector debt (selected cumulative changes, percent of GDP): - Change in gross public sector debt: 2014: 0.6; 2015: 3.6; 2016: 16.6; 2017: 6.1; 2018: -1.3; 2019: -3.7; subsequent years show further declines. - Primary deficit contribution (percent of GDP): 2012: 2.2; 2013: 2.4; 2014: 2.4; 2015: 1.8; projected improvements thereafter. - Automatic debt dynamics (percent of GDP): 2012: -3.6; 2013: -0.3; 2014: 3.0; 2015: 2.6; negative contributions thereafter in parts of the projection. - Other identified debt-creating flows include contingent liabilities (e.g., 2015: 5.1; cumulative effects shown in table). - Composition by maturity and currency: - Charts indicate shares by short-term vs. medium and long-term maturity and by local vs. foreign currency denominations; projections show shifts over 2013–2019. ### Alternative scenarios and additional stress tests - Alternative scenarios modeled: - Historical scenario: key variables remain at 10-year historical averages. - Constant Primary Balance scenario: primary balance held constant at -1.8 percent of GDP across projection years. - Stress-test scenario summaries (underlying assumptions shown for each): - Primary Balance Shock: alters primary balance path (examples in table). - Real GDP Growth Shock: e.g., 2015–2016 growth path changed to -5.2 and -3.2 in stress test. - Real Interest Rate Shock: raises effective interest rates in projection years (examples in table). - Real Exchange Rate Shock: increases inflation to 30.5 in 2015 in one configuration and alters effective interest rates. - Combined Macro-Fiscal Shock: raises interest rates and worsens primary balance; produces largest debt impact. - Contingent Liability Shock: models bank-related implicit guarantees and associated fiscal, growth, and interest-rate effects. - Resulting outcomes: - Gross nominal public debt and public gross financing needs are materially higher under adverse shocks, with some scenarios producing debt peaks well above 70 percent of GDP and large financing-need pressures measured as percent of GDP and percent of revenue. ### Policy implications and vulnerability mitigation - Key risks to address: - Large near-term gross financing needs (17½ percent of GDP in 2014 under baseline) create rollover and financing risks. - Exposure to growth, contingent liability, and exchange rate shocks that can push debt above 70 percent of GDP. - Debt-profile vulnerabilities related to market perception, external financing requirements, and non-resident holdings. - Recommended program focus (as implied by DSA findings): - Full implementation of SBA-supported program measures. - Fiscal adjustment to reduce primary deficits and financing needs. - Reforms in the energy sector to eliminate quasi-fiscal losses (notably those related to Naftogaz). - Structural reforms and stabilization policies that support return to growth and improve debt dynamics. *Source: IMF staff, Annex I. Public Debt Sustainability Analysis.* ### Annex II. External Debt Sustainability Analysis ### Annex II. External Debt Sustainability Analysis ### Baseline external debt trajectory and key findings - Gross external debt stood at 78.6 percent of GDP at end 2013 and is expected to rise to almost 100 percent of GDP in 2014. - The compounding effects of the recent hryvnia devaluation and expected GDP decline of about 5 percent will materially boost gross external debt to a peak of 99.5 percent of GDP in 2014. - Under successful implementation of a Fund arrangement, external debt is projected to follow a slowly falling trajectory to 81.5 percent of GDP by 2019. - The ratio of external debt to exports will remain elevated, falling to 167 percent at 2019. - Change in external debt (percent of GDP) by year (2011–2019): -8.8, -0.7, 2.1, 20.8, -0.2, -3.8, -4.4, -4.0, -5.5. - Baseline: external debt (percent of GDP) by year (2011–2019): 77.2, 76.5, 78.6, 99.5, 99.3, 95.4, 91.0, 87.1, 81.5. - External debt-to-exports ratio (percent) by year (2011–2019): 142.1, 150.0, 164.2, 174.0, 176.6, 179.3, 176.6, 173.7, 167.0. ### Downside growth shock scenario and impacts - A permanent ½ standard deviation shock to growth implies: - GDP contraction of around 8.6 percent in 2014 (about 3.6 percentage points below the baseline). - Subsequent contraction of 1.6 percent in 2015 and less than 1 percent GDP growth annually thereafter. - Debt dynamics under this shock: - Debt-to-GDP ratio peaks at 107.3 percent of GDP at 2015. - Debt-to-GDP is around 104 percent of GDP at 2019 (22.5 percentage points above the baseline). - External debt-to-exports would reach around 213 percent at 2019 (46 percentage points above the baseline). ### Identified external debt-creating flows (percent of GDP) - Identified external debt-creating flows (2011–2019): -13.2, -4.6, 1.7, 7.0, 1.5, -3.2, -2.8, -4.9, -4.7. - Current account deficit, excluding interest payments (2011–2019): 0.6, 2.4, 3.1, -3.2, -3.3, -3.6, -3.6, -3.5, -3.4. - Deficit in balance of goods and services (2011–2019): 6.2, 8.1, 8.7, 3.5, 3.2, 4.0, 4.4, 4.6, 4.7. - Exports (percent of GDP, 2011–2019): 54.4, 51.0, 47.9, 57.1, 56.2, 53.2, 51.5, 50.1, 48.8. - Imports (percent of GDP, 2011–2019): 60.6, 59.1, 56.6, 60.7, 59.4, 57.2, 55.9, 54.7, 53.5. - Net non-debt creating capital inflows (negative) 1/ (2011–2019): -5.2, -7.0, -6.7, -2.3, -0.9, -3.5, -3.2, -5.0, -4.9. ### Automatic debt dynamics and residuals (percent of GDP) - Automatic debt dynamics (2011–2019): -8.5, 0.0, 5.3, 12.6, 5.6, 3.9, 4.0, 3.6, 3.5. - Contribution from nominal interest rate (2011–2019): 5.7, 5.7, 6.1, 7.7, 7.5, 7.5, 7.5, 7.4, 7.1. - Contribution from real GDP growth (2011–2019): -3.7, -0.2, 0.0, 4.9, -1.9, -3.6, -3.5, -3.8, -3.6. - Contribution from price and exchange rate changes 3/ (2011–2019): -10.5, -5.6, -0.8, ... (table continuation not provided in source excerpt). - Residual, including change in gross foreign assets (2-3) (2011–2019): 4.4, 3.9, -0.4, 13.8, -1.7, -0.6, -1.6, 0.9, -0.8. ### Gross external financing needs - Gross external financing need (billions of U.S. dollars) by year (2011–2019): 70.8, 85.4, 73.5, 63.0, 58.0, 55.0, 57.6, 56.2, 58.1. - Gross external financing need as percent of GDP (2011–2019): 43.3, 48.4, 41.3, 44.3, 38.6, 33.5, 32.5, 29.1, 27.6. - Scenario with key variables at their historical averages (external debt percent of GDP for 2011–2018): 78.6, 63.9, 52.1, 42.5, 32.2, 23.9, 15.1 (table truncated). ### Key macroeconomic assumptions underlying the baseline - Real GDP growth (percent) by year (2011–2019): 5.2, 0.3, 0.0, -5.0, 2.0, 4.0, 4.0, 4.5, 4.5. - GDP deflator in U.S. dollars (change in percent) by year (2011–2019): 13.9, 7.7, 1.0, -16.0, 3.5, 5.0, 4.1, 4.2, 4.3. - Nominal external interest rate (percent) by year (2011–2019): 7.9, 8.0, 8.0, 7.8, 8.0, 8.3, 8.5, 8.8, 8.9. - Growth of exports (U.S. dollar terms, percent) by year (2011–2019): 28.3, 1.3, -5.2, -4.7, 3.9, 3.4, 4.8, 5.8, 6.3. - Growth of imports (U.S. dollar terms, percent) by year (2011–2019): 35.2, 5.4, -3.4, -14.4, 3.4, 5.2, 5.8, 6.4, 6.7. - Current account balance, excluding interest payments (percent of GDP) by year (2011–2019): -0.6, -2.4, -3.1, 3.2, 3.3, 3.6, 3.6, 3.5, 3.4. - Net non-debt creating capital inflows (percent of GDP) by year (2011–2019): 5.2, 7.0, 6.7, 2.3, 0.9, 3.5, 3.2, 5.0, 4.9. ### Stress tests and alternative scenarios - Bound tests follow standard IMF stress test structure; individual shocks are permanent one-half standard deviation shocks. - Interest rate shock, growth shock, current account (noninterest) shock, combined shock, and a one-time 30 percent real depreciation shock (2010) are presented in the program’s stress testing framework. - Representative scenario outcomes shown in charts (figures in source) indicate: - Interest rate shock: projected external debt outcomes illustrated relative to baseline. - Growth shock: projected external debt outcomes illustrated relative to baseline. - CA shock: projected external debt outcomes illustrated relative to baseline. - Combined shock and real depreciation shock: projected external debt outcomes illustrated relative to baseline. - Historical and baseline average indicators reported in the charts (numeric averages shown in source figures). ### Policy implications reflected in the program (selected) - Successful implementation of a Fund arrangement is critical to restoring growth, confidence, and competitiveness, which underpin the projected decline in external debt ratios. - Downside growth risks materially worsen debt dynamics; maintaining program policies and securing external financing are essential to contain risks. - Rebuilding international reserves, fiscal consolidation, and structural reforms to boost exports and growth are central to achieving external debt sustainability. *Source: Annex II. External Debt Sustainability Analysis (excerpts) from the attached IMF program documents.* ### 10. Within 12 months of program approval, the NBU will have completed necessary ### _cr14106 - 10. Within 12 months of program approval, the NBU will have completed necessary ### Monetary policy: Adoption of inflation targeting (IT) - Within 12 months of program approval, the NBU will have completed necessary technical preparations and will adopt inflation targeting (IT) as its new monetary policy anchor. - Actions to achieve IT: - Set a clear timeline (by end-June 2014) for completing remaining preparations, including measures to strengthen the NBU’s forecasting capacity, independence, communications, and operational framework of monetary policy. - Reform decision-making to separate the policy-setting function (to be vested in the NBU Board and, eventually, in the Monetary Policy Committee (MPC)) from the function of conducting open market operations. Once the MPC is reactivated, vest in it the authority to set policy interest rates consistent with inflation objectives. - Provide the NBU full authority to develop and use its own projections for inflation and other macroeconomic variables for monetary policy purposes; the NBU will be free to set its own inflation target and will no longer be obliged to accommodate inflation projections developed by the Ministry of Economy and approved by the Government. - Publish (with an appropriate lag) minutes of the NBU Board monetary policy meetings and strengthen the NBU’s communications strategy. - Refine monetary policy instruments to align interest rates on active and passive operations with the official policy rate. As IT approaches, the NBU will increasingly rely on adjusting its policy rate to support domestic price stability and anticipates maintaining positive real interest rates. ### Institutional strengthening, governance, transparency, accountability of the NBU - Measures to strengthen independence and governance and pave the way for IT: - Establish an audit committee of the NBU Council (see paragraph 28). - Enact legal amendments abolishing the superiority of the Budget Law over the NBU Law, and discontinue advance profit transfers from the NBU to the budget during the fiscal year. ### Program monitoring targets - The program will be monitored through targets on net international reserves and monetary aggregates. - Intend to meet NDA ceilings and NIR floors (quantitative performance criteria), with base money as an indicative target. ### Financial sector policies: Overview and objectives - Commitment to strengthen financial stability to support economic growth. - Current priorities: (i) properly monitoring and supporting bank liquidity; (ii) assessing financial resilience in banks; (iii) restructuring and recapitalizing institutions in need; (iv) upgrading regulatory and supervisory framework; (v) enhancing banks’ capacity to resolve NPLs. ### Monitoring and supporting bank liquidity - Continue to provide adequate liquidity in a transparent and expeditious manner. - Actions taken and planned: - In February 2014 eased reserve requirements and accepted performing loans as collateral for emergency liquidity support (after a prudent discount). - Continue daily monitoring of liquidity; ease reserve requirements further and allow banks to average required reserves over the monthly maintenance period (paragraph 9). - Require, beginning end-March 2014, the largest 35 institutions to provide the NBU with their cash flow forecast for the following week. - NBU stands ready to take appropriate measures to maintain sufficient liquidity in all banks. ### Assessing financial resilience and recapitalization strategy - Diagnostic studies and business-plan reviews: - Require independent diagnostic studies of current asset valuation and banks’ business plans through 2016 to verify solvency and viability. - On April 14, 2014, the NBU instructed the largest 35 banks to launch diagnostic studies on the basis of end-December 2013 data and terms of reference developed by the NBU (prior action). - Diagnostic studies will assess capital adequacy to meet a Tier 1 capital (“T1”) target of 7 percent within an overall capital requirement of 10 percent and 4.5 percent under the baseline and adverse macroeconomic scenarios agreed with the IMF, respectively. - Banks must submit business plans to maintain capital requirements through 2016. Terms of reference, agreed with IMF and World Bank staff and based on the manual of the 2014 ECB Asset Quality Review, to be delivered to auditors by end-April 2014; selected auditor should not have conducted the regular annual audit of the bank during the past three years. - Deadlines: - For the 15 largest banks: diagnostic studies and business-plan review completed by end-July 2014 (structural benchmark). - For the 20 next largest banks: diagnostic studies and business-plan review completed by end-September 2014. - Where adequate capitalization and viable business plan exist, no further steps required; otherwise banks with deficiencies must submit recapitalization and restructuring plans: - Plans submitted for NBU approval by end-September 2014 for the 15 largest banks and end-November 2014 for the 20 next largest banks. - NBU to appoint a Steering Committee to oversee diagnostic process for each of the 35 banks; IMF and World Bank staff involved. - Assessment of remaining smaller institutions to be completed by the second quarter of 2015 using banks’ annual audits and factoring in any IFRS revisions from the IFRS assessment. - Capitalization requirements and deadlines: - Banks must be compliant with the T1 capital targets of 7 percent under the baseline scenario and 4.5 percent under the adverse scenario through 2016. - Deadlines for compliance: end-December 2014 for the 15 largest banks and end-February 2015 for the 20 next largest banks. - Private owners asked to make up shortfalls under the base and adverse scenarios through cash injection. - Back-up recapitalization/restructuring funds and procedures: - If fit and proper shareholders are unwilling or incapable of recapitalizing a weak bank, public funds could be used according to strict criteria. Government and NBU to reach agreement with IMF staff on these criteria by May 31, 2014 (structural benchmark). Criteria to ensure losses are passed to shareholders before public funds, appointment of a monitoring trustee, and voluntary suspension of voting rights of shares pending documentation of ultimate ownership; necessary legislative changes to be made. - Government will seek authorization in a supplementary budget as needed to provide financial support to banks, subject to procedures agreed with Fund staff. - Set up a high level committee by end-March 2014 to ensure proper governance in use of public funds for recapitalizations/restructuring; committee comprised of the Minister of Finance, the Governor of the NBU, and the head of the Deposit Guarantee Fund (DGF). Committee to appoint a spokesperson for recapitalization communications. - Specialized unit at the Finance Ministry to manage financial sector shareholdings to be set up by end-September 2014 (structural benchmark); mandate to maximize value of State holdings and interact on an arm’s length basis; ensure fit and proper board members and managers; sign relationship framework between Finance Ministry and State-shareholding banks. - Resolution policy: - Use resolution mechanisms when a bank is not supported by shareholders or deemed unviable: preference order—mergers, purchase and assumption (P&A), bridge banks, full bank recapitalization by the State, or liquidation. - DGF to continue role as resolution agency; ensure adequate staffing, training, and reserves by end-July 2014. - Enhance coordination between NBU, Finance Ministry, and DGF; revise memorandum of understanding and publish revised version on individual websites by end-May 2014 (after consultation with IMF and World Bank staff). - Early intervention and resolution procedures: - Monitor banks closely; send inspection teams as needed. - If a bank’s capital declines below regulatory minimum, require shareholders to submit action plan to recapitalize and impose restrictions per law. - If capital below one-third of minimum legally required level, owners required to bring bank immediately back into solvency or institution put under temporary administration (removal of managers and suspension of shareholders’ meeting, supervisory board, and board of directors powers). - Commit to subject all banks under resolution to an official DGF investigation to identify wrongdoing or bad banking practices and prosecute those responsible. ### Upgrading regulatory and supervisory framework - Actions to boost confidence: - Ensure conservative implementation of IFRS accounting and disclosure on related parties, loan provisioning, collateral valuation, and income recognition on NPLs. - Upon completion of diagnostic studies, with IMF technical assistance, complete assessment of whether accounting practices of a sample of large and medium-sized banks are comparable to international banks by end-October 2014. - If material room to enhance IFRS implementation, prepare guidelines to correct practices by end-November 2014 for use in preparing banks’ 2014 financial statements (after consultation with IMF and World Bank staff). - Align foreign exchange rules to international best practices; unwind Resolution 109. On April 4, 2014 the NBU repealed Resolution 109 and announced timetable, agreed with IMF staff, for gradually unwinding banks’ net open FX positions beginning May 1, 2014 and concluding in 20 months (prior action). - Request from IMF and World Bank a stand-alone assessment of compliance with Core Principles for Effective Bank Supervision (CPEBS) by end-December 2015. - Set up a central credit register at the NBU: - Revise legal framework for the credit register by end-August 2014 in consultation with IMF and WB staff, with aim to become operational no later than August 2015. ### Facilitating banks’ capacity to resolve NPLs - Two fronts: - Assess banks’ policies and procedures for loan workouts: - As part of diagnostic studies, auditors to assess quality of debt restructuring policies and procedures, including write-off and transfer of NPLs. Auditors’ reports to be completed by end-September 2014. - Identify legal impediments for effective out-of-court debt resolution: - With IMF technical assistance, review current legal framework for NPL resolution and identify legal, regulatory, and tax obstacles by end-October 2014. ### Fiscal policy: Immediate measures and medium-term strategy - Immediate emphasis: maintain timely priority spending amid large macroeconomic and political uncertainties and revenue erosion; unpaid bills of (0.4 percent of GDP as of end-March). - Strengthening weekly cash management and expenditure prioritization; tools include: - Near-term revenue administration measures: (i) breaking tax evasion schemes; (ii) halting imports through entries other than official checkpoints; (iii) strengthening control over sales of alcohol; (iv) enforcing collection of large debts; (v) tightening verification of compliance with recurrent tax obligations (VAT) through automation; (vi) conducting tax audits and expeditiously collecting assessed amounts; (vii) enhancing efforts to collect utility payments to improve Naftogaz finances. - Expenditure prioritization to meet debt service, wage, and pension obligations; identify other spending pressure points. - Tapping financing from the banking sector where possible. - Target and prior actions: - Targeting a structural fiscal adjustment of 1.0 of GDP this year. - Government approved package of revenue and expenditure measures yielding at least UAH 45 billion and implemented them by passing a supplementary budget on March 27, 2014 (prior action). - Expenditure measures (yields in UAH mln): - Maintain minimum wage and first category tariff grade wage at their January 1, 2014 level during 12 months of 2014 and reduce employment by attrition. 7,300 - Maintain minimum subsistence level entering calculation of pensions and various pension-linked benefits at their January 1, 2014 level during 12 months of 2014 and suspend wage indexation of pensions. 2,900 - Rationalization of expenditures in non-pension social funds and transfer of savings to the pension fund. 4,100 - Rationalization of social assistance spending 2,300 - Prioritization and rationalization of capital expenditures 7,700 - Prioritization and rationalization of subsidies to enterprises 2,100 - Enhancing efficiency of public procurement and reduction of other expenditures 3,200 - Additional debt service costs associated with exchange rate depreciation and called guarantees -3,700 - Total expenditure measures 25,900 - Revenue measures (yields in UAH mln where specified): - Suspend application of zero VAT rate to export operations with grain and industrial crops during April 1–September 30, 2014. 4,000 - Increase fees on the usage of mineral resources and broaden the base. 1,600 - Increase in excise tax rates and expansion of tax bases 4,600 - Introduce a reduced 7 percent VAT rate on pharmaceutical and medical products 2,200 - Improvement of tax administration through elimination of tax frauds discovered in fuel imports and production of alcoholic beverages. 6,700 - Total revenue measures 19,100 - Additional fiscal actions and details: - Cancelled planned increases in minimum wage and first category tariff grade wage; keep minimum wage at UAH 1,218 and first category tariff grade wage at UAH 852 until end-2014. - Cancelled planned increases in minimum subsistence level entering pension calculations and suspended wage indexation of pensions previously planned for March 1, 2014. - Hiring freeze for general government; exceptions for critical positions limited to no more than 1/5 of newly opening vacancies and need approval by line ministries. - In cooperation with the World Bank, re-prioritize social assistance benefits toward a means-tested framework. - On April 10, 2014 Parliament passed a new public procurement law to strengthen governance and reduce exemptions from regular competitive procedures (prior action). - Reduce administrative and non-priority expenditure of non-pension social funds and subsidies to SOEs. - Limit new central government loan guarantees to no more than UAH 25 billion in 2014 (quantitative performance criterion); focus guarantees on high priority projects to unlock complementary external financing. - On March 27, 2014 Parliament kept the VAT rate at 20 percent (prior action) and introduced VAT taxation of pharmaceutical products at 7 percent. - Prepare proposal for reform of VAT in agriculture by end-September 2014 (structural benchmark) with view to bringing regime closer to general VAT regime; consider reduction in VAT exemptions in agriculture in 2015. - On March 27, Parliament extended VAT exemption regime for grain exporters until October 1, 2014 (prior action). - Revised legislation to increase excise tax rate for alcohol and tobacco by 25 percent, for beer by 42.5 percent, and for diesel fuel (€98 and €128 per ton) instead of previous differentiated rates (€46, 68, 75 and 98 per ton); conduct price indexation of selected other products and series subject to excise taxation and duties, expressed as absolute values. - Revenue collection efforts have broken two major fraudulent tax evasion schemes and ongoing reorganization of state tax and customs services expected to yield additional revenues. ### Medium-term fiscal consolidation and targets - Over the medium-term, emphasize expenditure-led gradual fiscal consolidation to build confidence and reduce imbalances; consider public administration review and better utilization of performance-based expenditure framework. IMF mission expected in late April to assess options and embed key reforms at first review. - Target a cumulative structural fiscal adjustment of 2 percent of GDP through 2016 and a gradually slowing pace of adjustment through 2019 to place public debt on a declining path. - Fiscal path implication: - Target combined deficits of the general government and Naftogaz consistent with 8.5 percent of GDP in 2014, *Source: _cr14106 - 10. Within 12 months of program approval, the NBU will have completed necessary* ### 6.1 percent of GDP in 2015, and 4.4 percent of GDP in 2016. For the general government, we will ### _cr14106 - 6.1 percent of GDP in 2015, and 4.4 percent of GDP in 2016. For the general government, we will ### Fiscal targets and trajectory - Target deficits consistent with 5.2 percent of GDP in 2014. - Target deficits consistent with 4.2 percent of GDP in 2015. - Target deficits consistent with 4.4 percent of GDP in 2016. - Projected or referenced values: 6.1 percent of GDP in 2015, and 4.4 percent of GDP in 2016. ### Scope and coverage - The targets are specified "For the general government." *Source: _cr14106 - 6.1 percent of GDP in 2015, and 4.4 percent of GDP in 2016. For the general government, we will* ### 3.1 percent of GDP in 2016. Intra-year targets consistent with these annual targets will be set as ### _cr14106 - 3.1 percent of GDP in 2016. Intra-year targets consistent with these annual targets will be set as ### Fiscal measures and VAT refund arrears - Issue up to UAH 16.7 billion in government bonds this year to address build-up of VAT refund arrears. - Conditions and safeguards for the VAT-bond operation: - (i) make every effort to first identify ways to pay these refund arrears in cash; - (ii) this will be a one-off operation; - (iii) all arrears to be cleared with the bonds will first be properly verified; - (iv) the bonds will be used only to pay VAT refund arrears accumulated through end-2013; - (v) the bonds will be fully marketable and issued at market interest rates. - Commitment to undertake reforms to the VAT refund process (see ¶26). ### Energy sector policy and Naftogaz finances - Two operational elements of energy strategy: - (i) strengthen sector finances by narrowing the gap between tariffs and cost-recovery levels; - (ii) provide better targeted subsidies to protect the poorest from higher tariffs. - Objectives and expected outcomes: - Reduce large quasi-fiscal losses and budget subsidies; rein in the current account deficit; provide incentives for energy efficiency; promote domestic production and investment; alleviate governance problems from tariff differentials. - Energy subsidy context: - Overall energy subsidies in Ukraine, on- and off-budget, are estimated to have been 7½ percent of GDP in 2012. - Naftogaz deficit targets and timeline: - Contain Naftogaz deficit to 3.3 percent of GDP in 2014. - Reduce Naftogaz’s deficit to 1.9 percent of GDP in 2015. - Aim to eliminate Naftogaz deficit by 2018. - Financing gap and government support: - Naftogaz’s financing gap in 2014 is UAH 62 billion, of which the government has already provided UAH 11 billion. - Government supplementary budget will include UAH 22 billion in ‘recapitalization’ bonds to help fill the gap. - Remaining gap of UAH 51 billion requires further support and a Naftogaz plan based on cost rationalization, improved revenue collection, and additional budget backing to repay large arrears to Gazprom. - Tariff adjustment commitments (prior actions and schedule): - By April 10, 2014: NERC to adopt and publish decision to raise end-user gas tariffs for households by 56 percent, effective May 1, 2014. - By April 18, 2014: NURC to adopt decisions to raise heating tariffs for households by 40 percent on average, effective July 1, 2014 (prior actions). - Legislation so that future tariff increases become effective within 40 days of announcement; full-cost retail gas and heating tariffs to be reflected on bills. - Publicly announced decision and schedule for tariff increases through 2017 (prior action): - 2015: raise end-user gas and heating tariffs by 40 percent on average, effective May 1. - 2016 and 2017: raise tariffs by 20 percent on average each year, effective May 1, until Naftogaz losses eliminated by 2018. - April 10, 2014: Parliament passed legislation vesting NURC with exclusive authority to set heating tariffs (prior action). - Communications and implementation: - A well-coordinated campaign to inform population on necessity of tariff hikes and on increased social assistance. - By April 7, 2014 gas prices to industrial and budget consumers adjusted in line with actual gas import costs. - Tender launched April 3 for external auditor to conduct Naftogaz audits; auditor to be in place within 60 days of tender. Audit results to be shared with IMF within 30 days of each period, initially monthly beginning with end-May 2014 data, then quarterly for end-September data forward (structural benchmark). - By end-June 2014 (structural benchmark): Parliament to pass legislation to make distribution accounts fully operational and mandatory for utility payments to strengthen payment discipline for heating sector. - Raise building-level heating meter coverage from 36 to 45 percent by end-2014 together with heat controls at IHS; move to consumption-based utility bills from norms. - Longer-term reforms: - Diversify gas supply sources and reform Naftogaz in accordance with Ukraine’s Energy Community membership; work with World Bank on strategic priorities including restructuring. - In cooperation with World Bank, improve energy efficiency of heating sector across residential, utilities, and public sector. ### Protecting vulnerable households and social assistance - Priority to protect poorest from gas and heating tariff increases by improving targeting of social assistance programs in consultation with IMF and World Bank experts. - Existing Housing and Utility Subsidy program (covers utility bills above 10/15 percent of enrolled households’ income) will fully shield enrolled households and cover new entrants who fall on hard times. - New social assistance scheme: - Government approved decision on April 5, 2014 to introduce a new social assistance scheme (prior action). - By April 10, government to share with IMF and World Bank staff a draft proposal specifying eligibility, envelope, benefits, mode of delivery, and administrative process. - Envelope of UAH 3 billion. - Scheme to become effective July 1, 2014. ### Governance, transparency, and business climate reforms - Recognition that weak governance and transparency are major drags on growth; problems span anti-corruption, law design/implementation, judiciary effectiveness, AML-CFT, tax administration, procurement, and energy sector. - Diagnostic study: - Request for comprehensive diagnostic study to be completed in close consultation with IMF staff by July 15 that will cover anti-corruption, design/implementation of key laws/regulations impacting business climate, judiciary effectiveness, and tax administration (structural benchmark). - Study will: (i) assess current governance arrangements and identify areas for reform; (ii) judge relative importance of issues; (iii) propose remedial measures and time frames. - Commitment to full support and follow-up on recommendations. - Near-term measures to address specific governance and AML/CFT issues (¶26): - a. Establish by end-September 2014 specific criteria and procedures at the NBU to assess fit and proper requirement in compliance with AML/CFT standards, including checking source of wealth/funds of owners of qualifying holdings of banks. - b. Strengthen AML framework: relevant laws to be revised in line with international standards by end-September 2014 (in consultation with IMF staff) to ensure: - (i) banks required to conduct enhanced due diligence on business relationships with domestic politically exposed persons; - (ii) laundering of proceeds of tax crimes is criminalized; - (iii) financial secrecy laws do not inhibit AML implementation. - Once legal framework is in place, regulations and policies to be implemented. - c. Follow-up on request to World Bank within Stolen Asset Recovery (“STAR”) Initiative to develop strategy and action plan for pursuing and recovering stolen assets; reach out to international partners as appropriate. - d. Prepare, in consultation with IMF and other partners, a strategy by end-June 2014 for strengthening tax compliance of high income earners and those with foreign assets. - e. Address VAT refund delays and weak transparency via measures to be implemented by end-June 2014: - (i) implement automatic VAT refund system to low-risk taxpayers without pre-payment inspection or audit of refund claims (by end-June 2014); - (ii) resume publishing amounts of VAT claims, outstanding refunds, settlements (including amounts released automatically), and arrears (by-end June); - (iii) explore upgrading IT system to manage refunds; - (iv) revamp VAT refund criteria related to taxpayer’s wage level to address underreporting of wages; - (v) ensure all large taxpayers administered by Large Taxpayer Inspectorates (LTIs) are by default included in automated system; - (vi) consistent with Tax Code, prohibit practice of requesting CIT advance payments in exchange for VAT refunds—the State Tax Service to issue instructions to confirm this by end-June 2014. ### Safeguards for National Bank of Ukraine (NBU) - Update safeguards assessment of NBU by first review of Stand-By Arrangement. - NBU external auditors authorized to provide information and hold discussions directly with IMF staff. - Special audit of international reserves being conducted; report to be finalized by May 1. - Commitment to receive safeguards mission and provide requested information without delay, including correspondent banks and foreign reserves placements. - Steps to strengthen NBU governance, control, and internal audit functions: - April 4: NBU Council appointed an independent audit committee with two external members and a well-defined mandate to oversee financial reporting, audit processes and internal controls (prior action). - Review of NBU legal framework to provide financial autonomy of central bank and implement independence requirements for NBU Council members by end-September 2014. - Prepare a report by end-2014 on status and steps taken to implement recommendations of external audit as to quality standards. - Select external audit firm by end-September 2014 to carry out external audit of NBU financial statement. ### Program monitoring, performance criteria, and phasing - Program implementation monitored through prior actions, reviews (bi-monthly then quarterly), quantitative performance criteria and indicative targets, and structural benchmarks. - First bi-monthly review set for July 2014 based on end-May 2014 quantitative targets. - Quantitative targets for reviews to include: - ceiling on cash deficit of general government; - ceiling on combined deficits of general government and Naftogaz; - ceiling on publicly guaranteed debt; - floor on cumulative change in NIR; - ceiling on cumulative change in NBU’s NDA; - non-accumulation of external debt payments arrears by general government. - Table 2 (Access and Phasing) highlights schedule of purchases under the Stand-By Arrangement: - April 30, 2014: 2,058.00 Millions of SDRs (150.00 percent of quota) — Board approval of arrangement. - July 25, 2014: 914.67 Millions of SDRs (66.67 percent of quota) — First review and end-May 2014 performance criteria. - September 25, 2014: 914.67 Millions of SDRs (66.67 percent of quota) — Second review and end-July 2014 performance criteria. - December 15, 2014: 914.66 Millions of SDRs (66.67 percent of quota) — Third review and end-September 2014 performance criteria. - March 15, 2015: 1,372.00 Millions of SDRs (100.00 percent of quota) — Fourth review and end-December 2014 performance criteria. - June 15, 2015: 1,372.00 Millions of SDRs (100.00 percent of quota) — Fifth review and end-March 2015 performance criteria. - September 15, 2015: 1,372.00 Millions of SDRs (100.00 percent of quota) — Sixth review and end-June 2015 performance criteria. - December 15, 2015: 1,372.00 Millions of SDRs (100.00 percent of quota) — Seventh review and end-September 2015 performance criteria. - March 15, 2016: 686.00 Millions of SDRs (50.00 percent of quota) — Eighth review and end-December 2015 performance criteria. - Total: 10,976 Millions of SDRs (800.0 percent of quota). - Note: Of which SDR 1,290 (about US$2 billion) for budget support. - Selected program quantitative targets and indicative targets (Table 3 excerpts, end-of-period unless otherwise indicated): - Ceiling on the cash deficit of the general government (end periods shown): March 2014: 18,000; May 2014: 31,000; July 2014: 47,500; September 2014: 59,000; December 2014: 78,000. - Ceiling on the cash deficit of the general government and Naftogaz: March 2014: 28,200; May 2014: 44,700; July 2014: 69,200; September 2014: 94,800; December 2014: 128,500. - Floor on cumulative change in net international reserves (in millions of U.S. dollars): March 2014 (stock): 11,100; May: -1,273; July: 1,096; September: 266; December: -687. - Ceiling on cumulative change in net domestic assets of the NBU: March 2014 (stock): 7,465; May: 36,383; July: 21,292; September: 29,685; December: 51,527. - Ceiling on publicly guaranteed debt: March/May/July/September/December: 25,000. - Continuous performance criterion: Non-accumulation of new external debt payments arrears by the general government: 0 (March/May/July/September/December). - Indicative target - Ceiling on cumulative change in base money: March: 29,061; May: 22,438; July: 33,303; September: 32,593; December: 44,003. - Indicative target - Ceiling on net accumulation of VAT refund arrears (cumulative flows from January 1, 2014; March are stocks as of end-March): March: 21,700; May: 0.0; July: 0.0; September: -2,500; December: -5,000. - Memorandum items include Naftogaz foreign exchange purchases from NBU for repaying gas payment arrears and Eurobond maturing in September 2014 (millions of U.S. dollars): March: 813; May: 2,160; July: 2,160; September: 3,830; December: 4,830. - NBU purchases of T-bonds issued by Government for Naftogaz recapitalization: March: 11,100; May: 23,662; July: 23,662; September: 41,956; December: 52,911. - Ceiling on bonds issued to pay VAT refund arrears (VAT bonds): March/May/July/September/December: 16,700. - Program exchange rate, Hryvnia per U.S. dollar: 10.9546 for March/May/July/September/December (program exchange rate specified in TMU). - Note in Table 3: MoF will issue UAH 16.7 bln in VAT bonds to settle VAT refund arrears accumulated through December 31, 2013. ### Technical Memorandum of Understanding (TMU) and reporting - TMU dated April 22, 2014 describes definitions of variables subject to quantitative targets, methods for assessing program performance, and information requirements for monitoring targets. - All exchange rates used to evaluate reserve levels and monetary aggregates are the official exchange rate of the Ukrainian hryvnia to the U.S. dollar (further definitions and reporting requirements specified in TMU). *Source: IMF staff and Ukrainian authorities as presented in the memorandum and Technical Memorandum of Understanding.* ### 10.9546 set by the NBU as of March 31, 2014, and (ii) reference exchange rates of foreign currencies ### _cr14106 - 10.9546 set by the NBU as of March 31, 2014, and (ii) reference exchange rates of foreign currencies ### Exchange rates, valuing assumptions, and program exchange rate - Program exchange rate of UAH 10.9546 per dollar (set by the NBU as of March 31, 2014). - Reference exchange rates of foreign currencies reported by the European Central Bank (ECB) as of March 28, 2014, used by the NBU to set official exchange rates: - Swiss Franc: 0.8857 per dollar - Euro: 1.3759 dollars - Pound Sterling: 1.6633 dollars - Australian dollar: 0.9243 U.S. dollars - Japanese yen: 102.41 per dollar - Accounting exchange rate for the SDR: 0.647773 per dollar. - Official gold holdings valued at 1,295.75 dollars per fine ounce. - Program exchange rates are kept fixed over the program period and are used to compute monetary aggregates; this does not imply an exchange-rate target for policy purposes. ### GDP compilation - Gross domestic product (GDP) for the program is compiled as per the System of National Accounts 1993 (SNA’93). - The State Statistics Service plans to change to the System of National Accounts 2008 and discontinue the SNA’93 series at some point in 2014. Any modifications to GDP compilation used for program purposes will be agreed with the Fund before implementation. ### Quantitative performance criteria — Net International Reserves (NIR) - Definition: - NIR of the NBU = dollar value of the difference between usable gross international reserve assets and reserve-related liabilities to nonresidents, evaluated at program exchange rates. - Usable gross international reserves comprise readily available claims on nonresidents in convertible foreign currencies (consistent with BPM5 and SDDS, Table A, item 1). - Exclusions from usable reserves include, inter alia: - assets denominated in foreign currencies held at or claims on domestic institutions (including foreign-headquartered institutions located domestically); - all foreign currency claims of the NBU on domestic banks; - NBU deposits held at the Interbank Foreign Currency Exchange Market and domestic banks for trading purposes; - any precious metals or metal deposits other than monetary gold and gold deposits held by the NBU; - any assets corresponding to claims of commercial banks in foreign currency on the NBU and any reserve assets that are: (i) encumbered; or (ii) pledged as collateral (insofar as not already included in foreign liabilities, or excluded from reserve assets); or (iii) frozen; - any reserve assets not readily available for intervention in the foreign exchange market due to lack of quality or liquidity. - Reserve-related liabilities (for program purpose) comprise: - all short-term liabilities of the NBU vis-à-vis nonresidents with original maturity of one year or less; - the stock of IMF credit outstanding; - the nominal value of all derivative positions (including swaps, options, forwards, and futures) of the NBU and general government, implying the sale of foreign currency or other reserve assets against domestic currency (notional value of commitments, not market value); - all foreign exchange liabilities of the NBU to resident entities (e.g., claims in foreign exchange of domestic banks, NBU credits in foreign exchange from domestic market) excluding foreign exchange liabilities to the general government or related to deposit guarantees. - Components of NIR correspond to NBU balance sheet and memorandum accounts (definitions correspond to accounts in existence on March 31, 2014). - Adjustment mechanism for NIR targets: - End-May and end-July 2014 test dates: NIR targets adjusted upward (downward) by the full amount of cumulative excess (shortfall) in program disbursements relative to baseline (Table B). - End-September and end-December 2014 test dates: NIR targets adjusted upward (downward) by the full amount (75 percent) of the cumulative excess (shortfall) in program disbursements relative to baseline (Table B). - Program disbursements defined as external disbursements from official multilateral creditors (World Bank, European Commission, European Investment Bank, and European Bank for Reconstruction and Development), official bilateral creditors (net), and external bond placements usable for financing central government budget. - NIR targets adjusted upward by the full amount of the cumulative shortfall in Naftogaz purchases of foreign exchange from NBU for repaying gas supply arrears to Gazprom and Eurobond maturing in September 2014 relative to baseline (Table C). - Table B. Eurobond Placements and Disbursements from IFIs and Official Sources: Projections for NIR/NDA Adjustment (Cumulative flows from end-March 2014, millions of US dollars at program exchange rate) - End-May 2014: Eurobond placement 0; World Bank 175; EU 160; EBRD 273; EIB 341; Others (Canada, Japan) 200; Total 1,150 - End-July 2014: Eurobond placement 1,000; World Bank 1,350; EU 867; EBRD 546; EIB 683; Others 300; Total 4,746 - End-September 2014: Eurobond placement 1,000; World Bank 1,350; EU 1,907; EBRD 546; EIB 683; Others 300; Total 5,786 - End-December 2014: Eurobond placement 1,000; World Bank 1,850; EU 1,907; EBRD 546; EIB 683; Others 300; Total 6,286 - Table C. Naftogaz Purchases of Foreign Exchange from NBU: Projections for NIR/NDA Adjustment (Cumulative flows from end-March 2014) - Naftogaz purchases of foreign exchange from NBU for repaying gas supply arrears to Gazprom and Eurobond issue maturing in September 2014 (millions of U.S. dollars): - End-May 2014: 2,160 - End-July 2014: 2,160 - End-September 2014: 3,830 - End-December 2014: 4,830 - NBU purchases of T-bonds issued by Government for Naftogaz recapitalization (millions of hryvnia, at program exchange rates): - End-May 2014: 23,662 - End-July 2014: 23,662 - End-September 2014: 41,956 - End-December 2014: 52,911 ### Net Domestic Assets (NDA) — Ceiling on cumulative change (Performance Criterion) - Definition: - NDA of the NBU = monetary base (defined below) minus NIR of Ukraine (valued at program exchange rate UAH 10.9546 per dollar and expressed in hryvnia) for computing the NDA target. - Adjustment mechanism for NDA targets: - End-May and end-July 2014: NDA targets adjusted downward (upward) by the full amount of cumulative excess (shortfall) in program disbursements relative to baseline (Table B), evaluated at the program exchange rate. - End-September and end-December 2014: NDA targets adjusted downward (upward) by the full amount (75 percent) of the cumulative excess (shortfall) in program disbursements relative to baseline (Table B), evaluated at the program exchange rate. - NDA targets adjusted downward by the full amount of the cumulative shortfall in NBU purchases of T-bonds issued by Government for Naftogaz recapitalization for purposes of repaying gas supply arrears to Gazprom and Eurobond maturing in September 2014 relative to baseline, evaluated at program exchange rate (Table C). - NDA targets adjusted upward by the full amount of the cumulative excess in total amount of NBU loans to the Deposit Guarantee Fund (DGF) as well as total amount of NBU purchases of government bonds issued for DGF financing, and NBU purchases of government bonds issued (up to a limit of UAH 15 billion) for bank recapitalization, relative to baseline (Table D). - Table D. NBU Loans to DGF and Purchases of Government Bonds Issued for DGF Financing or Banks Recapitalization: Projections for NDA/Monetary Base Adjustment (Cumulative flows from end-March 2014, millions of hryvnia, at program exchange rates when applicable) - End-May 2014: NBU purchase of Government bonds issued for DGF financing 0.0; NBU purchase of Government bonds issued for banks recapitalization 0.0; NBU loans to DGF 0.0; Total 0.0 - End-July 2014: 0.0; 0.0; 0.0; Total 0.0 - End-September 2014: 0.0; 0.0; 0.0; Total 0.0 - End-December 2014: 0.0; 15,000; 0.0; Total 15,000 ### Monetary base (base money) — Ceiling on cumulative change (Indicative Target) - Definition: - Monetary base comprises domestic currency outside banks and banks' reserves, including cash in vault of commercial banks, and funds of customers at the NBU. - Currency outside banks defined via NBU and DMB account specifications (NBU accounts 3000 (net)+3001 (net)-3007A-3009A-1001A-1004A-1007A-1008A-1009A minus cash in vault at deposit money banks (DMB accounts 1001A:1005A, and 1007A)). - Banks' reserves defined as cash in vault at deposit money banks (DMB accounts 1001A:1005A, and 1007A) plus DMB correspondent account deposits at the NBU in hryvnia (NBU liabilities accounts 3200, 3203, 3204, and 3206) plus funds of customers at the NBU in hryvnia (NBU liabilities accounts of groups 323, 3250, 4731, 4732, 4735, 4736, 4738, 4739, and 4750), plus accrued interest on time deposits of DMBs in national currency (NBU accounts 3208L), plus accrued interest on client’s current accounts in national currency. - Adjustment mechanism: - Monetary base targets will be adjusted upward by the full amount of the cumulative excess in total amount of NBU loans to the DGF as well as total amount of NBU purchases of government bonds issued for DGF financing or banks recapitalization (up to a limit of UAH 15 billion for recapitalization), relative to baseline (Table D), evaluated at program exchange rate if provided in foreign exchange. ### Ceiling on Cash Deficit of the General Government (Performance Criterion) - Definition: - General government comprises: the central (state) government (including the Road Fund (UkrAvtoDor)), all local governments, and all extra budgetary funds, including the Pension, Unemployment Insurance, Temporary Disability Insurance, Occupational Injury and Disease Insurance Funds. - Budget of the general government comprises: (i) the state budget; (ii) all local government budgets; and (iii) the budgets of extra budgetary funds listed above, if not already included in (i). - The government will inform IMF staff of creation or reclassification of any new funds, programs, or entities immediately. - Cash deficit of the general government measured by net financing flows including: - total net treasury bill sales (in hryvnias and foreign currency) as measured by NBU registry of treasury bill sales (net treasury bill sales = cumulative funds realized from primary auction sales of treasury bills and Government securities issued for recapitalization of banks and SOEs less cumulative total redemption of principal on treasury bills), excluding bonds issued to recapitalize Naftogaz and other SOEs and banks; - other net domestic banking system credit to general government as measured by NBU monetary statistics (all non-treasury-bill financing in domestic or foreign currency extended to general government by banks less change in all government deposits in banking system) and any other financing extended by entities not reflected in NBU monetary statistics; - total receipts from privatization received by the State Property Fund and local governments (including change in stock of refundable participation deposits); - difference between disbursements and amortization on any bond issued by general government or the NBU to nonresidents for financing the deficit of the general government; - difference between disbursements of foreign credits to the general government (including project loans on-lent to public enterprises) and amortization of foreign credits by the general government (including on-lent project loans); - net sales of SDR allocation in the SDR department; - net change in general government deposits in nonresident banks or other nonresident institutions; - net proceeds from any promissory note or other financial instruments issued by the general government. - For measuring the deficit, all flows to/from the budget in foreign currency will be accounted in hryvnias at the official exchange rate established as of the transaction date. - Adjustment mechanisms for the cash deficit ceiling: - Automatic adjuster based on deviations of external project financing (disbursements from bilateral and multilateral creditors to consolidated general government for specific project expenditure) from program projections (Table E): - If cumulative proceeds from external project financing (in hryvnia evaluated at actual exchange rates) exceed program projections, the ceiling on the consolidated general government deficit will be adjusted upward by 100 percent of the excess. - If cumulative proceeds fall short of program projections, the ceiling on the consolidated general government deficit will be adjusted downward by 100 percent of the shortfall. - Table E. External Financing of General Government Projects—Adjustment (Cumulative flows from January 1, 2014, In millions of hryvnia — technical assumption for the adjuster purpose) - End-May 2014: 2,800 - End-July 2014: 5,000 - End-September 2014: 15,500 - End-December 2014: 31,400 - Ceilings at end-May, end-July, end-September, and end-December 2014 are subject to automatic adjuster corresponding to full amount of NBU purchases of government bonds issued for DGF financing (excluding subsequent interest payments). - Ceilings also subject to automatic adjuster corresponding to amount of NBU purchases of government bonds issued for banks recapitalization, up to cumulative maximum of UAH 15 billion in 2014. Test date ceilings for 2015 will be adjusted upward by any amount of the UAH 15 billion bank recapitalization ceiling not used in 2014. - Ceiling subject to automatic adjuster on stock of budgetary arrears on social payments (arrears comprise consolidated budget arrears on wages, pensions, and social benefits owed by Pension Fund and central or local governments; arrears defined as payments not made thirty days after due date). - Ceilings at end-May, end-July, end-September, and end-December 2014 subject to automatic upward adjustment for full amount of bonds used to pay VAT refund arrears (VAT bonds) accumulated before January 1, 2014, limited to no more than UAH 16.7 billion cumulatively during 2014. No such bonds will be issued in 2015 or later. - Ceiling at other 2014 test dates will be automatically adjusted downward by VAT refund arrears accumulated in excess of ceilings defined in Section E from January 1, 2014. ### Ceiling on VAT Refund Arrears (Indicative Target) - Ceiling on net accumulation of VAT refund arrears: - UAH 5 billion at end-May 2014 - UAH 5 billion at end-July 2014 - UAH 2.5 billion at end-September 2014 - UAH 0 billion at end-December 2014 - Definition of VAT refund arrears: - Claims not settled (through cash refund, netting against taxpayer obligations, payment with a government bond (VAT bond), or an official decision to reject the claim) within 74 days after VAT refund claim submission to the State Tax Service (STS) in 2014 (time period allows for verification and payment processing). - Stock of VAT refund arrears as of December 31, 2013: (statement ends mid-sentence in source; numeric value not provided in supplied excerpt). *International Monetary Fund — technical memorandum excerpt (content from the cited program documentation).* ### 16.7 billion and UAH 21.7 billion as of March 31, 2014. ### _cr14106 - 16.7 billion and UAH 21.7 billion as of March 31, 2014. ### F. Ceiling on Cash Deficit of the General Government and Naftogaz (Performance Criterion) - Definition - 13. The cash deficit of the General Government and Naftogaz is the cash deficit of the General Government as defined above plus the cash deficit of Naftogaz. - 14. Naftogaz is defined as the national joint stock company “Naftogaz of Ukraine.” The cash deficit of Naftogaz is measured from below the line as: - net domestic banking system credit to the company (this consists of all financing in either domestic or foreign currency extended to the company by banks less the change in company deposits in the banking system); - the difference between disbursements of private foreign loans to Naftogaz (including private placements) and the amortization of private foreign loans (including private placements); - the difference between disbursements of official foreign credits to Naftogaz (including project loans) and the amortization of official foreign credits (including project loans); - the disbursements of trade credits from Gazprom to import gas; - the difference between disbursements and amortization on any bonds issued by Naftogaz; - the net change in deposits of Naftogaz in nonresident banks, or other nonresident institutions; - net proceeds from any promissory note or other financial instruments issued by Naftogaz; - net receipts from sale of financial assets (including recapitalization or other form of treasury securities issued to Naftogaz, irrespective of their issuance date); - any other forms of financing of the company not identified above. - 15. For the purposes of measuring the deficit of Naftogaz, all flows in foreign currency will be accounted in hryvnias at the official exchange rate established as of the date of the transaction. - Adjustment mechanism - The ceiling on the cash deficit of the general government and Naftogaz will be adjusted upward by the amount of financing by multilateral institutions and official bilateral creditors disbursed to Naftogaz for investment projects. - The ceiling on the cash deficit of the general government and Naftogaz will be adjusted downward by the net transfers made by Gazprom (advance transit fee). These transfers are measured on a cumulative basis from the beginning of each calendar year. - The ceiling on the cash deficit of the general government and Naftogaz will be adjusted downward by the amount of arrears to Gazprom for gas imports the day after their payment is due (7th day of the subsequent month of imports). ### G. Ceiling on Non-Accumulation of New External Debt Payments Arrears by the General Government (Continuous Performance Criterion) - Definition - 16. For the purposes of the program, an external debt payment arrear will be defined as a payment by the general government, which has not been made within seven days after falling due (including grace period, if any). The performance criterion will apply on a continuous basis throughout the program period. ### H. Ceiling on Publicly Guaranteed Debt (Performance Criterion) - Definition - 17. The ceiling on publicly guaranteed debt will apply to the amount of guarantees issued in 2014 by the central (state) government. The official exchange rate will apply to all non-UAH denominated debt. New state guarantees in 2014 will amount to no more than UAH 25 billion. ### I. Other Continuous Performance Criteria - 18. During the period of the Stand-By Arrangement, Ukraine will not: - (i) impose or intensify restrictions on the making of payments and transfers for current international transactions; - (ii) introduce or modify multiple currency practices; - (iii) conclude bilateral payments agreements that are inconsistent with Article VIII; - (iv) impose or intensify import restrictions for balance of payments reasons. ### II. Official Exchange Rate - Determination of the official exchange rate - 19. The NBU will, on a daily basis, set the official rate calculated as a weighted average of rates on the same day’s interbank market transactions. NBU will make public its official exchange rate by no later than 16:00 of the day for which it is set. ### III. Reporting Requirements - A. National Bank of Ukraine (NBU) — main reporting obligations and frequencies - 20. Monthly: aggregate balance sheet for the NBU and a consolidated balance sheet for the deposit money banks, no later than the 25th day of the following month. - 21. Weekly: with daily data the stock of net and gross international reserves, at both actual and program exchange rates; weekly and monthly full breakdown of NBU accounts included in net international reserves, no later than the 25th of the following month. - 22. Daily: information on official foreign exchange interventions and results of any foreign exchange auctions. - 23. Daily: information on balances held in analytical accounts 2900 “Accounts payable per transactions for the foreign exchange, banking and precious metals purchase and sale on behalf of banks’ clients”, created according to the NBU Resolution 49. - 24. The NBU will continue to provide on its web site the daily holdings of treasury bills at primary market prices, at current exchange rates; daily holdings broken down by type of holders; information on t-bills sales from the beginning of the year at the official rate as of the date of placement; t-bills in circulation by principal debt outstanding at the official exchange rate as of the date of placement (OP-2); reports on each treasury bill auction; and provide to the IMF the monthly report on treasury bills, in the format agreed with the IMF staff. - 25. Daily: information on transactions (volumes and yields) on the secondary market treasury bills (including over the counter transactions). - 26. Daily: information on the banks’ claims on the loans provided and liabilities in the format agreed with the IMF staff. - 27. Monthly: general information on the NBU financing (as well as the refinancing) of the banks of Ukraine, and on operations of mopping up (absorption) of the liquidity from the banking system (including through the CDs issuance) in the format agreed with the IMF staff. - 28. Quarterly: report on the banking sector financial stability indicators in the format agreed with the IMF staff, no later than 30 days after the expiration of the reporting quarter. - 29. Every 10 days: operational monetary survey of the NBU, including any additional information needed to monitor monetary policy and developments in the banking sector. - 30. Monthly: net domestic assets data based on the monthly balance sheets within three weeks following the end of the month. - 31. Daily: operational balance sheets of the NBU and commercial banks according to standard reporting forms, including detailed information on loans of the banking sector provided to the general government, breakdown by central (state) government and local budgets, national and foreign currency, by loan and by security, and information on balances of Government funds held at the NBU (including Single Treasury Account account 3240 A and State Treasury account 3513 A). - 32. Monthly: projections for external payments falling due in the next twelve months. Quarterly: actual settlement of external obligations (principal and interest) for public and private sectors, within 80 days following the end of the quarter. - 33. Quarterly: stock of short- and long-term external debt (including arrears) for both public and private sectors. - 34. Daily: aggregated data on main currency flows, including government foreign receipts and payments by currencies and currency breakdown of interbank market operations; continue daily information on exchange market transactions including the exchange rate. - 35. Reports N 381.25; 381.26 with information on reserve requirements. - 36. Two weekly: daily data on the total financing (including refinancing) issued by the NBU to commercial banks, broken down by instrument type, original maturity, interest rate, and transactions to absorb liquidity. - 37. Two weekly: data for the entire banking sector and bank-by-bank for Group I and Group II banks on total assets and liabilities; weighted averages based on banks’ total assets; capital adequacy ratios for normative and regulatory capital (Tier I and Tier II); deposits (maturity, currency, and type of depositor); loans (local currency, foreign exchange, public and private sector, classified as standard, watch, substandard, doubtful); provisions for all loans; foreign exchange net open position; banks holding of government and private debt instrument; mandatory reserve requirement and access holding at the NBU. - 38. Same day: inform the IMF of any regulatory and supervisory measures against banks violating NBU regulations, including lower capital adequacy, liquidity ration, large exposures, connected lending. - 39. Monthly: banking system monitoring indicators in agreed format, no later than 25 days after the end of the month (includes nonperforming loans: substandard, doubtful, and loss criterion). - 40. Quarterly: detailed quarterly balance of payments data in electronic format within 80 days after the end of the quarter. - 41. Monthly: data on credit to nongovernment units that are guaranteed by the NBU, no later than 25 days after the end of the month. - 42. Notify IMF staff if the Treasury does not pay interest or principal on treasury bills due to the NBU, deposit money banks, or nonbank entities and individuals; provide information on outstanding interest and principal payments. - 43. Inform IMF staff of any changes to reserve requirements for deposit money banks. - 44. Communicate electronically to IMF staff any changes in accounting and valuation principles applicable to balance-sheet data and notify staff before introducing changes to Charts of Accounts and reporting forms of both the NBU and the commercial banks. - 45. NBU Internal Audit Department: provide an assurance report to the Fund, no later than six weeks after each test date, confirming: (i) monetary data are in accordance with program definitions and verified and reconciled to accounting records; and (ii) no changes to chart of accounts or valuation methods that would impact data reporting. - 46. Provide Fund with a copy of the annual management letter from the external auditor within six weeks of completion of each audit; this remains in effect for the duration of the arrangement and while credit remains outstanding. - B. Ministry of Finance — main reporting obligations and frequencies - 47. Monthly: consolidated balances (end-month) of other non-general government entities, including SOEs, holding accounts at the Treasury, no later than 25 days after the end of the month. - 48. Treasury to provide: daily operational budget execution indicators; daily inflow of borrowed funds (by currency of issuance) to the state budget and expenditures related to debt service; weekly balances of Treasury cash flow (outturn and forecast), including government foreign exchange deposits; 10-day basis data on revenue of the state, local government, and consolidated budgets; monthly data on funds deposited with the Single Treasury Account; stock of public entities in account #3712 within the Single Treasury Account; inflow to the State budget from placing Treasury or any other liabilities to households in foreign and domestic currency and their redemption. - 49. Treasury to provide in electronic form monthly and quarterly treasury reports, no later than 25 and 35 days after the end of the period respectively; final fiscal accounts at the end of each fiscal year, no later than March of the following year; reports to include expenditure data by programs and key spending units and standard functional and economic classifications; quarterly reports to contain standard information on budget expenses to cover called government guarantees. - 50. Monthly: report on the public wage bill in line with the template agreed with IMF staff; monthly reports on borrowing (disbursements, interests and amortization) of UrkAvtoDor in agreed format; monthly report, no later than 15 days after the end of the month, the cash deficit of the general government with details on budget execution data for privatization receipts of the state and local governments; disbursements of external credits (including budget support and project loans for on-lending) to the consolidated budget and amortization of external debt by the consolidated budget; net domestic borrowing of the general government, including net t-bill issuance, issuance of other government debt instruments, and change in government deposits; monthly information on municipal borrowing and amortization of debt in format agreed with IMF staff. - 51. (Repeat) Monthly: the Ministry of Finance will report to the IMF, no later than 15 days after the end of the month, the cash deficit of the general government with specified details (see 50). - 52. Monthly: data on the stock of all budgetary arrears, no more than 25 days after the end of the month, including separate line items for wages, pensions, social benefits, energy, communal services, and all other arrears on goods and services. Treasury will report monthly data on accounts payable for state and local budgets (economic and functional classification). - 53. Monthly: information on the amounts and terms of all external debt contracted or guaranteed by the central government, no later than 25 days after the end of each month. - 54. Monthly (electronic): (a) data on the outstanding stock of domestic and external debt of the state and local budgets (including general and special funds); (b) standard files planned and actual external debt disbursement, amortization, and interest payments (including general and special funds), broken down by creditor categories as agreed with Fund staff; (c) report on external debt amortization and interest payments by days and currencies. Report accumulation of any budgetary arrears on external and domestic debt service. - 55. Monthly: debt (domestic and external) amortization schedules updated on a weekly basis. - 56. Monthly: data on external and domestic credit to key budgetary spending units and nongovernment units (including Naftogaz, State Mortgage Institution, Deposit Guarantee Fund and Agrarian Fund) that is guaranteed by the government (sovereign guarantees extended by executive resolutions and actually effectuated; total amount of outstanding guarantees and list of recipients), no later than 25 days after the end of the month. - 57. Quarterly: approved budgets and quarterly operational data (daily for the Pension Fund only) on revenue, expenditures, arrears, and balance sheets of the Pension Fund, Social Insurance Fund, Employment Fund, Occupational Accident and Sickness Insurance Fund, and other extra budgetary funds managed at the state level, no later than 50 days after the end of each quarter (each month in case of the Pension Fund). Within-year amendments to these funds’ budgets to be reported within a week after approval. Annual financial statement including final fiscal accounts of those funds at the end of each fiscal year, no later than April of the following year. - 58. Semi-annual: data on the number of employees of budgetary institutions financed from the central (state) and local budgets, starting from January 2010. After any public sector wage increase, provide estimate of its costs for the current and two subsequent fiscal years, for the state and local government budgets. - 59. Monthly: no later than 15 days after the end of each month, monthly data on the budgetary costs associated with the recapitalization of banks and SOEs, including the upfront impact on the cash deficit of the general government and costs associated with payment of interests. - 60. Monthly: data on their expenditure plans (ROSPIS) for state budget. - 61. State Tax Service (STS) and, where applicable, State Customs Service (SCS) will provide monthly data, no later than 25 days after the end of the month, on tax arrears, inclusive of deferred payments, interest and penalties outstanding, in the specified tabular format (columns listed in source). - 62. Quarterly: STS will provide, no later than two months after the end of the quarter, a listing of all tax exemptions granted, specifying beneficiary, exemption provided, duration, and estimated subsequent revenue loss for the current fiscal year. - 63. Monthly: STS to provide information, no later than 25 days after the end of the month, on VAT refunds in the specified format including stock of VAT refund arrears according to paragraph 11 definition (unsettled VAT refund claims submitted to the STS more than 74 days before the end-of-period). - 64. Monthly: STS will continue to provide reports 1.P0 on actual tax revenue and 1.P6 on tax arrears, no later than 25 days after the end of each month. - 65. STA will provide monthly data on revenue plans (ROSPIS) for state and local budgets. - C. Ministry of Economy, Ministry of Energy and Coal Industry, Ministry of Housing and Municipal Economy, NURC and NERC - 66. Ministry of Economy will provide quarterly information on actual levels of communal service tariffs in all regions for major services (heating, water supply, sewage and rent) and their level of cost recovery. Ministry of Economy, Ministry of Housing and Municipal Economy, and National Energy Regulatory Commission will provide the methodology underlying tariff calculations for full cost recovery, including heating and gas. - 67. Monthly, no later than the 25th of the following month: the government (based on information from Ministry of Energy and Coal Industry, Ministry of Economy, STS/SCS, MoF, NERC, and Naftogaz) will provide IMF staff with electronic information (agreed format “Ukraine: The Financial Position of Gas Sector”) on financial indicators in the gas and heating sectors, including prices and volumes of domestically produced (by production entity) and imported (by sources of imports) gas, sales, tariffs, arrears, payments to the budget, subsidies, and debt. Naftogaz will provide updated information on the Company’s financial liabilities, with a schedule of loan-by-loan interest and principal payments. - 68. Monthly, no later than the 25th of the following month: Ministry of Energy and Coal Industry (based on information by Naftogaz) will provide IMF staff electronic information in an agreed format on the cash flows and deficit of the company, as defined above. This report will break down total cash outlays for gas imports from Gazprom by month in a separate mutually agreed table. This report is subject to auditing by a reputable external auditor, first monthly then quarterly, as set out in the MEFP. - 69. Monthly, no later than the 25th of the following month: Ministry of Energy and Coal Industry (based on information by Naftogaz) will provide IMF staff electronic information (agreed format and verified by a reputable external auditor) on domestic gas used by Naftogaz for sales to households, heating utilities, budget institutions, and industries, including gas produced by SC “Ukrgasvydobuvannya,” SJSC “Chornomornaftogas,” and OJSC “Ukrnafta”. - 70. Weekly, no later than the Thursday of the following week: Ministry of Energy and Coal Industry (based on information by Naftogaz) will provide IMF staff electronic information in agreed format on the cash flow transactions of the company for the previous week. - 71. Quarterly, no later than the 25th of the following month: Ministry of Housing and Municipal Economy will provide information on the quantity of heating energy meters installed at a building-level measured also as a ratio to the applicable buildings. - 72. Monthly, no later than the 25th of the following month: Ministry of Energy and Coal Industry (based on information by Naftogaz) will provide IMF staff electronic information on the amount of Naftogaz arrears to domestic suppliers including Naftogaz subsidiaries, Ukrtransgas, Ukrgas vydobuvannya, Ukrnafta, Chornomornaftogas 90 days after they are due. - D. State Statistics Service - 73. Monthly, no later than 45 days after the end of the month: State Statistics Service and Naftogaz will provide data on prices, volumes, and payments (payments data provided by Naftogaz) for imported and exported oil and natural gas by country of origin and destination. - 74. In case of any revisions of gross domestic product the State Statistics Service will provide to the IMF revised quarterly data on gross domestic product (nominal, real, deflator) and their components (economic activities, expenditure, income), no later than 10 days after any revisions have been made. *Source: _cr14106 - 16.7 billion and UAH 21.7 billion as of March 31, 2014.* ### INTRODUCTION __________________________________________________________________________ 2 ### _cr14106 - INTRODUCTION __________________________________________________________________________ 2 ### INTRODUCTION - Assessment scope: risks to the Fund from the proposed Stand-By Arrangement (SBA) for Ukraine and effects on the Fund's liquidity under the policy on exceptional access. - Request: a 24-month SBA with access of SDR 10.976 billion (800 percent of quota). - Phasing and front-loading: - SDR 2.058 billion (150 percent of quota) available upon approval (April 2014). - Three equal disbursements of SDR 914.7 million each (July, September, December 2014). - Four quarterly purchases of SDR 1.372 billion (100 percent of quota) each (March, June, September, December 2015). - Final purchase of SDR 686.0 million (50 percent of quota) scheduled for mid-March 2016 following completion of the eighth review. - Total: SDR 10,976.0 (800.0 percent of quota). ### BACKGROUND - IMF relationship and past performance: - Ukraine member since September 1992. - GRA credit outstanding to Ukraine currently SDR 2.58 billion (187.9 percent of quota). - Past program performance characterized as poor; 2005 ex-post assessment highlighted lack of political consensus for market-friendly reforms as main cause of repeated program failures. - 2008 two-year SBA: drew SDR 7 billion of approved SDR 11 billion (802 percent of quota); program cancelled in mid-2010. - July 2010 SBA: approved SDR 10 billion (729 percent of quota); two purchases totaling SDR 2.25 billion made before program expired in December 2012. - Ukraine has met payment obligations to the Fund in a timely fashion. - External debt structure and trends (selected figures): - Total external debt: 78 percent of GDP in 2013; projected to increase to 99 percent in 2014. - About three quarters of the 2014 total external debt is owed by the private sector; most of the debt is long term. - Public sector external debt-to-GDP projected to rise to 27½ percent in 2014, 11 percentage points above end-2013. - External debt service: - External debt service-to-exports of goods and services peaked at 61 percent in 2009; reached 49½ percent in 2013. - Projected to rise to 52 percent in 2014. - Ukraine’s 2014 total external debt service projected at 31¾ percent of GDP; less than a quarter borne by the public sector. - Without comprehensive corrective policies and official financing, capacity to meet debt obligations would be stressed. - Public debt and financing needs: - Public debt-to-GDP about 40 percent over 2010–2013. - Public gross financing needs projected to rise sharply in 2014 due to widening fiscal deficit and rise in quasi-fiscal losses in the energy sector. - Total public debt projected to reach 57 percent of GDP by end-2014 (17 percentage points of GDP above median public debt of recent exceptional access cases). - Risk mitigant: substantial share of public debt held by the National Bank of Ukraine. ### THE NEW STAND–BY ARRANGEMENT—RISKS AND IMPACT ON FUND’S FINANCES A. Risks to the Fund - Access and exposure: - Proposed access would exceed both annual and cumulative access limits and be high on several indicators. - If all purchases made as scheduled, Ukraine’s outstanding use of GRA resources would rise from about 188 percent of quota at end-March 2014 to peak at nearly 800 percent of quota in March 2016. - Peak credit outstanding relative to quota would equal Jordan’s and align with the median of recent exceptional access cases; below Greece, Ireland, Portugal, Romania, Latvia, and Iceland. - Debt service burdens: - If all purchases made as scheduled, total external debt service projected to peak at 31¾ percent of GDP in 2014. - External debt service as a share of exports of goods and services would peak at 55½ percent in 2014 (median peak in recent exceptional access cases is 36½ percent). - Under program assumptions, by 2019 total external debt service would fall to 13.1 percent of GDP and 26.9 percent of exports of goods and services. - Debt service to the Fund would peak at about SDR 4.76 billion in 2019. - This peak would be equivalent to 3.5 percent of GDP, 19 percent of gross international reserves, and 7.3 percent of projected exports of goods and services. - Fund exposure metrics: - Fund’s peak exposure in terms of GDP, gross international reserves, and total external debt would be in the medium to high range compared to recent exceptional access cases. - Peak Fund exposure in terms of gross international reserves would be 60.2 percent—about 15 percentage points and 9 percentage points higher than the median of recent exceptional access cases and Ukraine’s 2010 SBA respectively. - Peak debt service to the Fund in terms of exports or total external debt service would be in the medium to high range compared to recent exceptional access cases. - Role among creditors and concentration risk: - Since 2008, by credit outstanding, the Fund has been the top official creditor to Ukraine’s government, with an average share of 57 percent during 2008–13. - At end-2013, the Fund’s share of outstanding credit in total official lending to Ukraine stood at 42 percent; would have trended to zero by end-2015 absent the proposed arrangement. - During 2014–16, Fund financing under the proposed arrangement would represent 44 percent of total financing to Ukraine from all official creditors. - The Fund would remain the single highest official creditor to Ukraine’s public sector; high Fund exposure underscores the need for substantial non-Fund external finance during the program and beyond to mitigate risks, especially when repayments to the Fund increase in 2018–19. B. Impact on the Fund’s Liquidity Position and Risk Exposure - (Section heading present; substantive analysis and quantified impacts continue beyond the provided excerpt.) *Prepared by the Finance and Strategy, Policy, and Review Departments; Approved by Andrew Tweedie and Mark Flanagan; April 26, 2014.* ### 8. The proposed arrangement would have a modest impact on the Fund’s liquidity but ### 8. The proposed arrangement would have a modest impact on the Fund’s liquidity but ### Impact on Fund liquidity and credit concentration - The proposed arrangement would reduce Fund liquidity by about 4 percent. - Commitments under the proposed arrangement would reduce the one-year forward commitment capacity (FCC) from SDR 274.9 billion as of April 9, 2014 to SDR 263.9 billion. - Ukraine is among the top five users of Fund resources and, after the first purchase is made, will move from the fifth to the fourth position, ahead of Romania. - Ukraine’s share of total GRA credit outstanding would increase by 2 percentage points to 5.2 percent. - The share of the top five users of Fund resources of total outstanding credit would increase only marginally since Ukraine is already part of this group of borrowers. ### Impact on precautionary balances and burden-sharing capacity - The GRA commitment to Ukraine amounts to 83 percent of the Fund’s current level of precautionary balances. - Assuming that all purchases will be made as scheduled: - Fund exposure to Ukraine as a share of the current level of precautionary balances will rise from 32 percent after the first purchase is made to 77 percent in 2015 and will peak at 83 percent in 2016. - At SDR 60.7 million, charges on Ukraine’s GRA arrangement excluding the portion of the charges already paid in the first quarter of 2014 would represent nearly five times the current residual burden sharing capacity of the Fund in 2014. - Assuming all purchases will be made as scheduled, these charges will increase during the program period and peak at SDR 278 million in 2017, almost 22 times the Fund’s current residual burden sharing capacity. ### Table 5 — Key GRA finance figures (as of 4/9/2014) - Current one-year Forward Commitment Capacity (FCC): 274,897.4 (Millions of SDRs) - Impact on FCC on approval: 10,976.0 - Fund GRA credit outstanding to Ukraine: 4,214.3 - Fund GRA credit outstanding to Ukraine, in percent of current precautionary balances: 31.9 - Fund GRA credit outstanding to Ukraine, in percent of total GRA credit outstanding: 5.2 - Fund GRA credit outstanding to top five borrowers: 70,158.3 - Top five borrowers, in percent of total GRA credit outstanding: 86.8 - Top five borrowers, in percent of total GRA credit outstanding including Ukraine's first purchase: 86.6 - Ukraine's annual GRA charges in percent of Fund's residual burden sharing capacity for 2014: 476.0 - Fund's precautionary balances (FY 2014) (Memorandum item): 13,218 - Fund's residual burden-sharing capacity (Memorandum item): 12.8 ### Assessment: program objectives and required policy actions - The proposed program aims to support near-term stabilization policies and deeper reforms over the medium term to reduce macroeconomic imbalances and promote sustainable growth. - Ukraine’s ability to achieve the program’s objectives critically hinges on overcoming resistance to sustained implementation of overdue structural reforms and on a coherent macroeconomic policy mix. - Reliance on two bimonthly reviews in the early months of the program will help ensure very close monitoring of developments in the run-up to the elections and immediately after. - Key actions whose sustained discipline is critical: - Maintain a flexible exchange rate to restore competitiveness, and to facilitate macroeconomic adjustments to shocks and safeguard foreign exchange reserves - Stabilize the financial system, maintain confidence in the banking sector, and upgrade the financial sector’s regulatory framework to reduce macrofinancial vulnerabilities - Reduce the government’s financing needs by stepping up revenue collection efforts and embarking on an expenditure-led medium-term fiscal adjustment path - Reform the energy sector through a comprehensive plan aimed at eliminating quasi-fiscal losses and attracting private investment to the sector - Implement legal and regulatory reforms aimed at improving the business climate to promote private investment and strong sustainable growth ### Financial risks, downside scenarios, and potential debt outcomes - Financial risks associated with the proposed arrangement for Ukraine are exceptionally high. - By 2015, Fund credit outstanding to Ukraine as a share of Ukraine’s public external debt would reach 34 percent and trend down afterward. - Debt service to the Fund is expected to peak at high levels in 2019 and account for 19 percent of gross international reserves and 35 percent of exports of goods and services. - Peak Fund exposure and debt ratios under the proposed arrangement generally exceed the median of corresponding peak levels of recent exceptional cases. - Downside risks and uncertainties that exacerbate financial risks include: - Higher imported gas prices, with pressures for increases already in evidence - A worsening of tensions with Russia that significantly disrupt Russia-Ukraine trade, including in natural gas, and financial flows - Political commitment and public support to comprehensive reforms could falter once initial adjustments are accomplished; presidential elections scheduled for May 25, with a likely run-off on June 15, could create political pressures resulting in incomplete program implementation - Deterioration in the political and security situation stemming from separatist tensions in the Eastern part of the country or an intensification in the conflict with Russia - Further weaknesses in banks’ balance sheets that could erode depositor confidence, encourage capital flight, and trigger financial instability - If downside growth shocks materialize as discussed in the staff report: - By 2016, the public debt-to-GDP ratio would be 24 percentage points higher than in the baseline. - External debt would be about 8 percentage points higher than in the baseline in 2015, reaching 107 percent of GDP. - These risks could adversely affect Ukraine’s capacity to repay the Fund; strict adherence to the program is essential to sustain donor assistance and access to private finance and to mitigate risks to the Fund. ### Statement by the Staff Representative (April 29, 2014) — new information since the staff report - The two remaining prior actions have been completed and verified: - Staff has verified that the substance of the procurement law passed by Parliament earlier meets the requirements of the prior action. - On April 23 the communal services regulator adopted the last set of decisions that increase retail heating tariffs by 40 percent on average from July 1, 2014. - Financial markets have stabilized in recent days despite continuing tensions in the East: - As of April 24, total bank deposits have flattened at a level 13 percent below that at end-2013, with household deposit withdrawals sharply moderating and corporate deposits rising. - Supply has exceeded demand on the cash foreign exchange market used by the population, contributing to the stabilization of the exchange rate around UAH 11.4–11.8/US1. - In the East, deposit dynamics is broadly in line with nation-wide trends, while demand for foreign currency remains more elevated. - As of April 22, tax revenue in the Eastern provinces remains in line with national trends as well. *Source: IMF staff report excerpt (Section 8 and accompanying assessment and staff statement).* ### 4. Leading politicians have re-confirmed in public statements their support for the ### _cr14106 - 4. Leading politicians have re-confirmed in public statements their support for the ### Political support and public statements - Mr. Poroshenko, a presidential candidate, stated his support for the reform agenda embedded in the program as well as its key objectives and policies in an open letter to the Executive Board. - Mr. Klitschko, leader of the parliamentary represented party UDAR, issued a press statement supporting the program. ### IMF approval and financial terms - The Executive Board approved a two-year Stand-By Arrangement (SBA) for Ukraine amounting to SDR 10.976 billion (about US$17.01 billion, 800 percent of quota), approved under the Fund's exceptional access policy. - Immediate disbursement enabled by approval: - SDR 2.058 billion (about US$3.19 billion) immediate disbursement. - SDR 1.29 billion (about US$2 billion) allocated to budget support. - Disbursement sequencing: - Second and third disbursements based on bi-monthly reviews and performance criteria. - Remainder of program period subject to standard quarterly reviews and performance criteria. ### Managing Director's summary of program focus - Program objectives: - Restore macroeconomic stability. - Strengthen economic governance and transparency. - Launch sound and sustainable economic growth while protecting the most vulnerable. - Key policy pillars emphasized: - Maintain a flexible exchange rate to restore competitiveness. - Stabilize the financial system. - Gradually reduce the unaffordable fiscal deficit. - Eliminate losses in the energy sector while enhancing social safety nets. - Decisively break with problematic past governance practices. - Monetary policy: - Authorities committed to maintaining a flexible exchange rate regime and focusing monetary policy on domestic price stability. - With Fund technical assistance, plan to adopt inflation targeting by mid-2015. - Financial sector: - Launch diagnostic studies of the largest banks. - Strengthen balance sheets and financial regulation and supervision. - Fiscal policy: - Target a structural fiscal adjustment of 2 percent of GDP over the program horizon. - Aim to keep the minimum wage and public wage growth in line with productivity. - Energy sector: - Plan to eliminate large quasi-fiscal losses of Naftogaz by 2018. - Embarked on meaningful, broad-based, and sustained gas and heating increases over several years, starting from May 2014. - Enhance social assistance to protect the most vulnerable from energy price adjustments. - Importance of early agreement on repayment of accumulated arrears and gas price dispute with Gazprom. - Governance and structural reforms: - Enacted a new public procurement law. - Address governance issues in state-owned companies and seek recovery of stolen assets. - Build capacity for enforcement of anti-money laundering and anti-corruption legislation, and enhance effectiveness of the judiciary and tax administration. ### Recent economic developments and vulnerabilities - Structural and historical vulnerabilities: - Pegged and overvalued exchange rate led to deterioration of competitiveness and slower export growth. - Current account deficit over 9 percent of GDP in 2013. - Public debt rose to 41 percent of GDP. - External debt at 79 percent of GDP. - International reserves fell to a critically low level of around two months of imports. - Policy change: - National Bank of Ukraine allowed the exchange rate to float in February (first important break with past policies). - Macroeconomic indicators and sectoral performance (selected) - Economic activity contracting; international debt markets closed. - Early presidential elections scheduled for May 25, 2014. - Industrial production decreased by 5 percent as a whole in the first quarter of 2014. - Export-oriented metallurgical production declined by 10.7 percent in 1Q2014. - Machinery declined by 17.9 percent in 1Q2014. - Chemical declined by 5.3 percent in 1Q2014. - Retail trade grew by 7.7 percent in the first quarter of 2014 compared with 11.9 percent in 1Q2013. - Construction declined by 6.4 percent in 1Q2014. - Agricultural production grew by 6 percent in 1Q2014. - Inflation and price developments - After more than two years of low inflation, y-o-y inflation rose to 3.4% in March 2014. - Core inflation accelerated to 2.1 percent. - Non-core inflation accelerated to 4.5 percent. - Non processed food prices up by 4.6 percent y-o-y. - Administratively regulated prices rose by 3.8 percent. - Fuel prices increased by 12.9 percent. - External sector and reserves - Current account deficit exceeded 9 percent of GDP in 2013. - In Jan–Feb 2014, current account deficit was USD 326 mln. compared with USD 1.6 bln. in the same period in 2013. - Imports squeezed by 15.9 percent y-o-y; energy imports fell 27.5 percent y-o-y; machinery imports fell 26.1 percent y-o-y. - Merchandise exports decreased by 9.5 percent y-o-y. - Financial account experienced strong capital outflow: deficit of USD 3.7 bln. in January and February 2014. - International reserves fell to USD 15.1 billion as of April 1, covering 1.7 months of imports of goods and services. - Fiscal developments - In the first two months of 2014 the consolidated budget deficit almost doubled compared with the same period in the previous year. - Tax revenues dropped by 17,9 percent y-o-y. - Corporate income tax was down by 61.5 percent y-o-y. - Gross VAT declined (text cut off in source). ### Program projections and medium-term outlook - Short-term forecast: - Real GDP expected to contract by about 5 percent in 2014. - Inflation expected to reach 16 percent at end-2014. - Current account deficit should fall to about 4½ percent of GDP. - Gross international reserves expected to stabilize at around 2½ months of import coverage, replenished by international assistance. - Public sector debt expected to rise to 57 percent of GDP. - External debt expected to rise to just below 100 percent of GDP. - Medium-term forecast: - Real GDP growth expected to rebound to 2 percent in 2015, rising to 4-4½ percent in the medium term. - Unemployment rate expected to decline from 8½ percent in 2014 to 7½ percent by 2016. - Exports projected to grow by over 6 percent a year in 2015–16. - By end-2016, inflation expected to fall to about 6 percent. - NBU expected to build international reserves to cover nearly 4 months of imports by end-2016. - Fiscal medium-term target: - Further gradual expenditure-based fiscal adjustment for 2015–16 aiming to reduce the fiscal deficit to about 3 percent of GDP by 2016. - Energy sector target: - Objective to bring Naftogaz’s deficit to zero by 2018 through revenue increases, cost reductions, tariff increases starting May 2014, and strengthened governance. ### Risks and conditions for success - Risks highlighted: - Further escalation of tensions with Russia and unrest in the east pose a substantial risk to the economic outlook. - High program risks given political and economic uncertainty. - Conditions for program success: - Steady and rigorous implementation of policy measures. - Maintaining broad public support. - Early agreement on gas arrears and price dispute to prevent energy trade disruptions. - Implementation of structural reforms to reduce corruption, improve business climate, and strengthen governance. *IMF Press Release No. 14/189; Statement by Ms. Christine Lagarde; Annex and Statement by Oleksandr Petryk (April 30, 2014).* ### 19.5 percent y- o-y, excise duties by 4.0 percent y-o-y and customs duties by 25 percent. ### _cr14106 - 19.5 percent y- o-y, excise duties by 4.0 percent y-o-y and customs duties by 25 percent. ### Prior action implementation - Despite complex circumstances the authorities implemented all prior actions in a very short period. ### Monetary policy and financial system - Monetary policy will focus more explicitly on domestic price stability rather than be based, as before, on the exchange rate anchor. - Since March the NBU has moved to a flexible exchange rate and does not use foreign currency interventions as its main monetary policy instrument. - The NBU adopted a regulation specifying that the official exchange rate is calculated as a weighted average of rates on the same day’s interbank transactions (prior action). - The newly elected NBU Council appointed an independent audit committee with a clear mandate to provide close oversight of the audit processes, a system of internal controls, and financial reporting at the NBU (prior action). - The monetary authorities repealed Resolution 109 which forced banks to keep a large open negative foreign exchange position and announced a specific timetable for gradually unwinding this position (prior action). - The NBU instructed the 35 largest banks to launch a diagnostic exercise on terms of reference developed by the NBU (prior action). - Within one year of the program’s start the NBU will introduce inflation targeting. - In mid-June 2013 the NBU started the placement of overnight deposit certificates. - A model-based system of macroeconomic analysis and forecasting has been developed and established by the NBU. - The NBU is reactivating the Monetary Policy Committee (MPC) which will set the policy interest rate, consistent with inflation objectives. - The NBU will have the right to set policy objectives and use its own projections for inflation and other macroeconomic variables in the process of monetary policy decision making. - The NBU will improve transparency and accountability through enhanced communication with the public. - Envisaged publications include minutes of the MPC (with appropriate lags), an inflation report, and strengthening of other communications channels. - Anticipated benefits of the inflation targeting framework: - provide price stability in the medium term, - eliminate external imbalances, - anchor inflation expectations, - facilitate the gradual rebuilding of foreign reserves. - The authorities will enhance the independence of the NBU as a modern central bank, enforced by non fiscal dominance, instrumental independence, forward-looking monetary policy based on the NBU’s own macroeconomic forecasting and prevention by law of any political interference. - Financial stability is the second key pillar of the monetary authorities’ long-term strategy. - A financial stability unit was established in the NBU and started to work successfully in accordance with international experts’ assessments. - A modeling toolkit has been developed for banking system stress testing purposes. - Recent years have seen progress in strengthening the financial sector, notwithstanding some losses and liquidity pressures in recent months. ### Financial sector reforms - Core focuses: - restructuring and recapitalizing banking and non banking financial institutions, - adopting legislation based on international standards, - upgrading the supervisory and regulatory framework, - restructuring of NPLs in the banking system. - Expected outcomes: - boost confidence, - promote credit growth to support economic activity, - improve banking system effectiveness and soundness. ### Fiscal policy - Fiscal policy will concentrate on meeting fiscal benchmarks of the program and implementing deeper and comprehensive fiscal reforms over the medium term. - Recently approved amendments to the state budget law and accompanying revenue-boosting measures should prevent the fiscal deficit from widening further in the coming months. - Stabilization in 2014 will be implemented through a mix of revenue and expenditure measures but with the accent on the expenditure side (prior action). - Main expenditure measures: - keep the level of wages unchanged until the end of the year, - prioritize and rationalize capital expenditures and subsidies to enterprises, - enhance the efficiency of public procurement. - Parliament introduced a new public procurement law to strengthen governance and checks and balances, including reducing exemptions (prior action). - the government will substantially reduce the growth of pension expenditure by cancelling the discretionary increase in pensions planned for July and October 2014. - Main revenue measures: - get additional tax income from agricultural producers, - improve the tax administration, - increase excise tax rates by widening of the tax base, and strengthening of tax collection. - Parliament passed a law to reverse the already introduced VAT rate reduction in 2015 and keep the rate at 20 percent (prior action). - The state budget will benefit from a hike in excise and mineral extraction tax rates. - The government is stepping up revenue collection efforts through measures to break tax evasion schemes and to widen the tax base by reducing the number of exemptions. ### Structural reforms - Energy sector reforms will focus on step by step reduction of fiscal subsidies and increasing efficiency. - Mechanism: gradual but persistent increases in retail gas prices and heating tariffs, accompanied by enhanced social assistance measures to mitigate the impact on low-income households. - The government approved a decision to introduce a new social assistance scheme (prior action). - The gas price regulator NERC adopted and officially published a decision on increasing end–user gas prices for households by 56 percent starting on May 1, 2014. - The utility regulator NURC adopted a decision to raise the heating tariffs for households by 40 percent on average as per July 1, 2014 (prior action). - Parliament approved legislation to vest in NURC the authority to set heating tariffs across the country (prior action). - The government announced the decision and scheme for tariff increases through 2017, including increases for gas and heating tariffs by 40 percent on average in 2015, and by 20 percent subsequently in 2016 and 2017 until “Naftogaz” state gas company will have zero deficit (prior action). - Parliament will pass legislation that will strengthen payment discipline for the heating sector. - Governance, transparency and business climate: - plan to strengthen the AML framework, - build capacity to more effectively conduct anti-corruption actions, - enhance the effectiveness of the judiciary and tax administrations. - The authorities intend to sign by end-May 2014 a memorandum of understanding between the government, IFIs, and the business sector in the context of the anticorruption initiative led by the EBRD. ### Key statistics and recent fiscal/ revenue developments - General government revenues dropped by an estimated 7.4 percent y-o-y. - General government spending declined by an estimated 3.0 percent y-o-y. - Revenue composition changes noted at the start: - 19.5 percent y- o-y, - excise duties by 4.0 percent y-o-y, - customs duties by 25 percent. ### Final remarks - Ukraine faces an extremely difficult path ahead through an extended period of consolidation and repair. - An adjustment program provides a chance for the authorities and the people of Ukraine to rebuild the economy and consolidate society. - With financial support and expertise of the Fund and Ukraine’s other international partners, the authorities reiterate their commitment towards the necessary reforms. - The new Stand-By Arrangement will help maintain reform momentum and provide additional security against unforeseen shocks. - The progress made so far and to be reached in the near future will set the stage for strong and sustainable economic developments while maintaining external and internal stability. *Source: IMF document _cr14106* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14106.pdf_