Mission Concluding Statement 

Preliminary Conclusions of the Mission
Kyiv, October 24, 2006

1. Ukraine's has gone through another turbulent year, but macroeconomic outcomes for 2006 are poised to be better than expected. Notwithstanding wide fluctuations in international steel prices, soaring energy import prices, and political uncertainties, real GDP growth is likely to rebound to about 6 percent. A sustained consumption boom, unleashed by fiscal policy and reinforced by loose credit conditions, has contributed to better-than-expected growth. However, these factors, combined with rising energy prices, are also projected to push CPI inflation to over 10 percent by end-year. Strong domestic demand, real exchange rate appreciation, and weaker terms of trade are likely to turn the current account into a small deficit. At the same time, stronger capital inflows, reflecting a modest improvement in external perceptions of Ukraine's still difficult investment climate, should allow a small accumulation of foreign-exchange reserves.

2. In several respects, the economy now appears better balanced, but new challenges have surfaced:

• Foreign-exchange reserves have risen to a comfortable level, and the hryvnia's previously large margin of fundamental undervaluation has narrowed considerably. However, further permanent hikes in gas import prices are in the pipeline, and steel export prices are expected to soften somewhat from their historically high levels. The consequent decline in the terms of trade will put substantial downward pressure on the current account and generate a strong headwind for the economy.

• Growth has returned to near trend, and CPI inflation has fallen into single digits. However, rising energy prices amount to a negative shock that will depress growth and drive up inflation. The adverse growth impact is magnified by Ukraine's highly energy-inefficient production structure, while existing strong domestic demand will amplify the inflation challenge.

• Fiscal deficits and explicit public debt have been kept low. However, the heavily consumption-oriented 2005 and 2006 budgets and their required high levels of taxes do not seem sustainable, as highlighted by the large financial imbalance in the public pension fund. Largely driven by fiscal policy, the national savings rate has continued to contract sharply, constraining the economy's potential to invest.

• The authorities have continued to strengthen the framework for containing financial stability risks. However, an unabated domestic credit boom, a surge in external borrowing by banks and corporates, and domestic foreign-currency borrowing by those who lack foreign-currency assets or incomes have all combined to create mismatches on both banks' and borrowers' balance sheets. This has raised the banking sector's credit, liquidity, and maturity risks.

3. The mission's recommended policies should allow the authorities to handle these considerable challenges with little near-term macroeconomic difficulties. Under a more flexible exchange rate regime, tight incomes policies, and restrained monetary and fiscal policies, current-account deficits could be contained at some 5 percent of GDP, broadly in line with the economy's savings constraints and investment needs. Moreover, Ukraine's sharply increased needs for gross external financing should prove manageable. There would be some temporary increase in CPI inflation owing to energy-price pass-through, pushing inflation in the mission's baseline to 10½ percent by end-2007. But the recommended policies would help contain second-round impacts, and lower inflation to about 5 percent in the medium term. In this environment, growth could moderate to about 4½ percent in 2007, but return to some 5½ percent in the medium term.

4. The government's forecast assumes a much more favorable external environment, but the mission also sees possible internal inconsistencies in the government's baseline macroeconomic outlook. If, as the government projects, the trade balance shifts indeed back into surplus, and net capital inflows materialize, a large balance-of-payment surplus would result. This would add to the NBU's foreign-exchange reserves and, given the assumption of a maintained exchange-rate peg, create an new source of inflationary pressure. While reversing the policy of charging domestic consumers more market-oriented prices for energy would temporarily help restrain this inflationary impulse, it would have negative medium-term growth and inflation implications.

5. The mission's recommended policy framework would also remain appropriate under a more favorable external environment. In particular, the ability to appreciate under a more flexible exchange rate would allow the NBU to counteract the inflationary impact of balance-of-payments inflows; the fiscal and incomes policy recommendations would help to address likely continued excessive consumption growth; and the structural recommendations would allow the economy to use its human and real resources better. Before turning to specific policies, however, it is useful to emphasize that the mission's advice should be seen as a package: not implementing some proposed policies would put an increased burden on other policy areas.

Monetary and Exchange Rate Policy

6. The NBU's intention to shift to a more flexible exchange rate is an apt response to Ukraine's changing economic challenges. With Ukraine's economy vulnerable to terms-of-trade fluctuations and increasingly open to capital flows, the NBU's ability to deliver low and stable inflation would be hamstrung by a de facto peg. Would it be feasible to simply use fiscal and incomes policies to maintain internal and external balance under a peg? The answer is likely to be no in Ukraine's case since required policy adjustments would be large in the face of adverse external shocks, and, in the mission's view, fiscal and income policies would be difficult to restrain to the required extent. A more flexible exchange rate would also address another key policy concern. By withdrawing its de facto exchange rate guarantee, the NBU would raise the longer-term attractiveness of the hryvnia over foreign currencies, thereby removing one of the key driving forces behind financial dollarization.

7. In 2007, the NBU should continue to move toward inflation targeting, but its efforts need strong backing from the government. As two key steps, the NBU should allow the exchange rate to move within the full announced Hrv/US$4.95-5.25 corridor and introduce a short-term policy rate for monetary operations. But the government also has to play its part, foremost by enhancing the NBU's independence and providing it with a clear mandate to pursue price stability as its primary objective, as agreed under the Ukraine-EU Action Plan. In that respect, signing the joint Memorandum of Understanding between the NBU and the government could send a useful signal to the public that the government explicitly backs a shift to inflation targeting.

8. The NBU's monetary stance during 2006-07 should aim at keeping inflation excluding energy prices in single digits. While monetary policy should accommodate the direct effect of energy-price shocks on CPI inflation, it should also contain second-round effects on prices. To achieve this inflation objective, the NBU should tighten liquidity conditions in the banking system. In particular, the NBU should more actively use its liquidity-absorbing instruments in case foreign-exchange market interventions or deposit financing of budget deficits lead to further loosening of liquidity conditions.

Fiscal Policy

9. The government's envisaged medium-term fiscal framework seems broadly appropriate. A fiscal deficit target for the general government of about 2½ percent of GDP would stabilize the explicit public debt at some 15 percent of GDP. This in turn would provide a cushion to cover contingent fiscal liabilities should they materialize—for instance, loan guarantees to state enterprises and the so-called lost-savings held in the former Soviet savings bank. Moreover, planned reductions in recurrent spending over the medium term would free up room for tax cuts and public investment, and contain domestic demand and current account pressures.

10. Achieving the fiscal targets in the 2007 draft budget may, however, prove quite challenging. The authorities seem on track toward meeting the 2006 fiscal deficit target. However, the draft budget for 2007 reflects the government's optimistic nominal GDP growth assumption; under our baseline forecast, some 2 percent of GDP of measures would be needed to achieve the draft budget deficit target.

11. Moreover, off-budget fiscal risks need to be included in the government's fiscal plans. A policy of incomplete energy price pass-through could require heavy off-budget borrowing, and further constrain investment in the already heavily undercapitalized energy sector, particularly investments needed to improve energy efficiency. While protection of vulnerable social groups is a legitimate concern, it could be better accommodated through explicit budget subsidies or differentiated utility tariff schemes.

12. There are also several issues that the government should consider when finalizing its spending and revenue plans:

• Plans to contain public wages and social transfers in 2007 are appropriate after the massive recent increases. The mission encourages the government to continue achieving wage restraint through contained lower minimum wage increases over the medium term, thus also encouraging lower wage growth in the wider economy. For social transfers, restraint should go hand-in-hand with more targeted social assistance.

• Proposed higher sectoral subsidies will inhibit Ukraine's envisaged transition to a "postindustrial" economy, and should be reconsidered. The mission recommends that there be no further delays in implementing the new agricultural VAT regime, and that energy-sector subsidies be reduced, including by raising coal prices in line with increases in other energy prices.

• Re-opening tax preferences for the Free Economic Zones should be avoided. A level playing field for business is in Ukraine's best interest, and a simple tax system will minimize revenue risks for the government.If this advice can not be heeded, Free Economic Zones should be subject to best international practice, in particular be clearly export oriented, physically delineated, and only receive indirect tax breaks.

• Re-emerging governance problems with VAT refunds need to be resolved. The mission agrees that containing VAT refund fraud is a serious problem. However, this should be addressed via fundamental administrative reforms, and not by reverting back to a discretionary refund regime.

• To better articulate its plans, the government needs to improve its budget planning framework. More focus on medium-term budgeting would assist with re-orienting the structure of spending and designing sustainable tax cuts. At the same time, the government should avoid setting up new funds, like the proposed stabilization fund, which would introduce new budget uncertainties.

13. The envisaged fiscal deficit financing strategy is biased toward foreign financing. There should be more focus on issuing domestic debt to help develop financial markets, inter alia to support the transition to an inflation-targeting regime and reduce dollarization.

Financial Sector Policies

14. The NBU has already taken several measures to address stability risks in the banking sector. It has tightened quality standards for bank capital, raised minimum capital requirements, differentiated reserve requirements, and introduced higher provisioning for unhedged borrowers in foreign exchange. Plans to raise provisioning requirements further and apply higher capital-adequacy risk weights for loans in foreign exchange would be welcome additional steps.

15. However, rising balance-sheet vulnerabilities, particularly from foreign-exchange lending, call for further actions. Given the plans to shift to more exchange-rate flexibility, the public awareness about exchange-rate risks of foreign-currency lending needs to be raised. Banks' risk management practices should also be strengthened, including by issuing NBU guidelines on foreign-exchange risk management and mortgage lending, setting upper limits on debt service-to-income and loan-to-value ratios, and enforcing strict collateral valuation rules. Over the medium term, the authorities should continue moving toward more risk-based supervision, where bank-specific capital requirements are better matched with bank-specific risks. In the meantime, however, the NBU should raise the minimum capital-adequacy ratio from 10 to 12 percent. Finally, adopting long-delayed legal initiatives requiring the identification of real bank owners and allowing the authorities to suspend early deposit withdrawals in times of crisis would also improve banking-sector stability.

16. Underdeveloped financial markets remain a bottleneck for moving to inflation targeting and managing balance-sheet risks. Deeper and more liquid securities and foreign-exchange markets would allow better hedging of unwanted balance-sheet exposures and would strengthen the monetary transmission mechanism via interest rates. Priority steps should include developing domestic government debt benchmark issues, eliminating the tax on non-cash foreign exchange transactions, and improving investor protection through tighter information requirements for bond issues and strengthening of minority shareholder and, more generally, creditor rights.

Policies to Improve the Investment Climate

17. A difficult investment climate is the main binding constraint on Ukraine's catch-up growth. Ukraine uses its human and real resources very poorly, and its vast efficiency gap is largely explained by its growth-unfriendly investment climate. In fact, the World Bank's Doing Business survey continues to rank Ukraine's investment climate near the bottom among transition economies. The country also continues to fare poorly in Transparency International's ratings of corruption. Ukraine's bleak longer-term demographic outlook adds further urgency to accelerating structural reforms. If the investment climate remains difficult, Ukraine's more prosperous neighbors, which themselves will have to face the challenge of rapidly aging populations, could become irresistible magnets for Ukrainian labor. This would have adverse implications for Ukraine's sustainable growth and pension finances.

18. While the new government has declared its intention to promote transparency, fight corruption, and build a functioning market economy, there have been regrettable retrograde steps in recent months. The introduction of grain export quotas, renewed problems with timely VAT refunds, and back-stepping on the commitment to full price pass-through in the energy sector are negative signals that should be reversed if the country is to persuade investors that its business climate is on the mend.

19. The upcoming years without new elections provide a wide window of opportunity to press ahead with long-delayed reforms. The following are the most crucial measures:

• Complete the necessary steps for WTO accession immediately. Cross-country experience shows that ambitious WTO accession commitments are later rewarded with significant growth benefits. Moreover, WTO accession would open the way for deeper economic integration, including free trade, with the EU.

• Adopt key legislation to improve the investment climate. The approval of the Joint Stock Company Law, abolishing the anachronistic Economic Code while improving the market-oriented Civil Code, and allowing for the resale of agricultural land are essential.

• Reactivate the privatization process. The ambitious privatization targets in the 2007 draft budget and the medium-term fiscal plan are unlikely to be achieved unless major state-owned firms are sold in a transparent manner.

• Reform the energy sector. Energy consumption and production should be based on transparent rules and market prices so as to encourage greater investment in energy efficiency and higher domestic production.

Statistics

20. Ukraine's statistics have been improving, but the State Statistics Committee and the NBU must address new challenges. Given Ukraine's external and domestic financial vulnerabilities, it is especially important to compile better-quality data on the terms of trade, the sectoral flows of savings, investment, and financing, and sectoral balance sheets.

The mission would like to thank the authorities for organizing these discussions, and we look forward to a continued close and constructive dialogue in the future.