Ms. Anne O. Krueger
Acting Managing Director
International Monetary Fund
Washington, D.C. 20431


Dear Ms. Krueger,

The attached Memorandum of Economic and Financial Policies (MEFP) describes the policies that the Government of Ukraine and the National Bank of Ukraine (NBU) intend to implement in 2004. These policies are aimed at ensuring continued macroeconomic stability and supporting sustainable economic growth. In this context we view as central to our economic program the maintenance of prudent fiscal and monetary policies, as well as the implementation of our structural reform agenda. In support of these policies, we are requesting a 12-month stand-by arrangement in an amount equivalent to SDR 411.6 million (30 percent of quota). Ukraine's balance of payments position has improved substantially since 1999 and we do not intend to effect any purchases under the arrangement.

We believe that the policies set forth in the attached MEFP are adequate to achieve the objectives of our economic program, but we will take any further measures that may become appropriate for this purpose. We will consult with the Fund on the adoption of these measures, and in advance of revisions to the policies contained in the MEFP, in accordance with the Fund's policies on such consultations. We will provide the Fund with information it requests for monitoring progress in program implementation. After the arrangement expires, and while Ukraine has outstanding financial obligations to the Fund, we will consult with the Fund on Ukraine's economic and financial policies at the initiative of the Government of Ukraine or at the request of the Managing Director, in line with the Fund's policies on such consultations.

The program will be evaluated on the basis of quarterly quantitative performance criteria, as well as structural performance criteria and benchmarks. These are summarized in Tables 1 and 2 of the MEFP and the attached Technical Memorandum of Understanding (TMU). We will also conduct with the Fund one review of economic developments under the program in September 2004. The review will focus on fiscal developments, in particular the implementation of tax reforms, and the monetary program, as well as on measures to strengthen the banking system, develop the domestic securities market, and monitor quasi-fiscal deficits in the energy sector. Quantitative performance criteria have been specified for end-March 2004 and end-June 2004, and will be specified for end-September 2004 and end-December 2004 at the time of the review.

Sincerely yours,

Memorandum of Economic and Financial Policies

I. Background

1. Following a decade of output contraction and an economic crisis in 1998-99, Ukraine's economy has entered a phase of recovery and stabilization. Real GDP grew on average by almost 7 percent per year during 2000-2003, inflation fell to single digits, and the exchange rate remained stable. International trade with countries outside the CIS has grown rapidly, the current account surplus has increased substantially, and the NBU's gross international reserves position has strengthened markedly. Access to international capital markets has recently been restored. These achievements have been supported by prudent fiscal and monetary policies. The consolidated budget has maintained a primary surplus during 2000-2003 and Ukraine has reduced its debts to the IMF, allowing for a substantial reduction in public debt. Monetary policy has accommodated a rapid increase in money demand.

2. Recent trends have continued to be mostly positive. Real GDP growth increased to an estimated 8½ percent in 2003, despite the poor grain harvest, on account of strong growth in industry, construction, transportation, and trade. Consumer price inflation picked up as a result of poor weather conditions in agriculture, but remained in single digits. Money, credit, and deposits continued to grow rapidly in 2003, reflecting strong domestic confidence. The central bank's international reserves increased substantially, reaching about 3 months of imports. In contrast to previous years, the 2003 budget was based on realistic parameters and was fully implemented. Public debt ratios continued to decline. The government issued US$1 billion in new 10-year Eurobonds at relatively low interest rates, reflecting renewed confidence by international investors.

3. There has also been progress on structural reforms in recent years. Noncash transactions in the economy have fallen drastically, reflecting the ban on noncash offsets with the budget and increased cash collections in the energy sector. Budgetary wage arrears have been sharply reduced, while pension arrears have been fully eliminated. The treasury system has been reformed, including through the introduction of a treasury single account. Intergovernmental fiscal relations were reformed and a modern budget code was adopted in 2001. A broad reform of the pension system has recently been approved by parliament. Improved tax, customs and pension administration procedures have boosted revenues substantially. Recently approved tax reforms have reduced rates, while broadening the tax base. Financial sector reforms have contributed to an increase in public confidence in the banking sector, as evidenced by the rapid growth in banking deposits. Productivity in agriculture has increased, reflecting ongoing land reforms and the privatization and dismantling of collective and state-owned enterprises. There has also been progress in privatizing the power sector. Judicial reform has been initiated and the legal framework has been strengthened by the adoption of a new criminal code, customs code, and civil code, as well as the law on mortgages and recent amendments to anti-money laundering legislation.

4. Notwithstanding these positive developments, the economy remains vulnerable to economic shocks, and the recent pace of structural reform would need to be maintained to ensure sustainable growth over the long run. While an improved macroeconomic outlook contributed to a rebound in investment in 2003, remaining distortions in the tax regime and an unstable legal environment have kept domestic and foreign direct investment below its potential. The financial sector and the securities market remain underdeveloped and interest rates remain high, partly reflecting credit risk. The energy sector remains in financial difficulties, despite the improved payments discipline by energy consumers. Problems remain regarding governance and transparency, especially in the gas sector. Despite rapid wage growth, living standards of large parts of the population remain low. While poverty and unemployment have declined, the social safety net is not fully effective.

5. Our broader economic program is set out in the "Program of Activities of the Cabinet of Ministers," which was approved by parliament in 2003. The policies described below, for which we are seeking support under an IMF stand-by arrangement, are central elements of our program.

II. Program Objectives

6. Our economic program is aimed at moving towards a well-functioning market economy with an effective social safety net, based on EU standards of the rule of law and public institutions. The program is intended to promote economic growth and employment, in order to raise the living standards of the population and help lay the foundations for membership in the WTO and eventually the European Union.

7. Our program is designed to support strong economic growth and maintain stability. Apart from sound fiscal and monetary policies, this will require continued progress on structural reforms, described in Section III C, to improve the conditions for domestic and foreign direct investment. Tax reforms, including the normalization of the VAT refund process and the elimination of tax preferences, will allow a reduction in the tax burden on enterprises and individuals, which should help to support investment and economic growth. Expenditures will be rationalized, including through pension and social safety net reforms. The financial sector will be strengthened to support well-functioning credit and securities markets, with a particular focus to reduce credit risk in the banking sector. In order to improve the investment climate and reduce the shadow economy, the rule of law will be strengthened and economic policy will become more transparent and less discretionary.

8. The macroeconomic program for 2004 and beyond aims to keep inflation in the low-to-mid single digits, underpinned by prudent fiscal and monetary policies. The current account surplus is expected to unwind gradually as investment and import demand pick up, while foreign direct investment should continue along the positive trend seen in 2003. We intend to maintain a level of gross international reserves equivalent to about 3 months of imports, which should ensure adequate coverage of near-term external debt service by the government and the central bank. The program aims to bolster debt sustainability by implementing the 2004 budget and preparing a 2005 budget consistent with a further significant reduction in the government debt-to-GDP ratio.

III. Policies for 2004

A. Fiscal Policy

9. Our fiscal policies are designed to encourage economic growth and ensure debt sustainability. The 2004 budget law implies a consolidated budget deficit of 1¾ percent of GDP on a cash basis, according to IMF methodology, partly reflecting debt issued to clear VAT refund arrears and local government deficits. As in the previous three years, we intend to sustain a primary surplus (excluding the financing of VAT refund arrears clearance) and achieve a further reduction in the government debt-to-GDP ratio. Quarterly ceilings on the cash deficit of the consolidated budget are shown in Table 2.

10. Revenues are projected to increase broadly in line with GDP. The reductions in corporate and personal income tax rates, effective January 2004, will be largely offset by curtailing tax preferences and other base-broadening measures, including the taxation of interest income and replacement of occupation-based tax privileges with budgetary payments. The VAT base has also been broadened, with the suspension of many sectoral tax preferences during 2004. Other revenue measures include the reinstatement of customs fees, an export duty on natural gas, and a fee on car sales. Quarterly indicative targets for nonearmarked cash revenues of the state budget are shown in Table 2.

11. We are committed to resolve the problem of VAT refund arrears. We intend to remain current on VAT refunds, by addressing fraud through an improved risk-based system of verification of claims and by holding the tax administration fully accountable for refunding all valid claims, including through interest payments on refund arrears and subordinating revenue targets to the legal refund process. In 2003, we reduced the stock of refund arrears by more than a third, as a prior action under the program, and we intend to eliminate the entire outstanding stock during the program period, financed through a voluntary one-time securitization, based on the issuance of liquid domestic government bonds on market terms. Quarterly ceilings for the stock of VAT refund arrears are shown in Table 2.

12. The expenditure-to-GDP ratio is projected to increase somewhat in 2004, largely reflecting higher interest payments. To slow the growth in the wage bill, we postponed a minimum wage increase scheduled for July 2003 to December 2003, a prior action under the program. To gain better control over wages, we have reduced employment of state executive bodies and introduced amendments to the Budget Code establishing that minimum wage increases should be determined by annual budget laws. We will ensure the zero-financial balance of each social insurance fund, including through a prudent implementation of the pension reform.

B. Monetary and Exchange Rate Policy

13. The NBU will ensure that monetary policy is in line with inflation in the low-to-mid single digits and does not cause excessive credit growth. If inflation pressures emerge (other than adjustments to administered prices and temporary and fully reversible supply shocks), we stand ready to tighten monetary policy, including through the issuance of CDs and, if necessary, by scaling down the pace of intervention in the foreign exchange market. We will also ensure that the refinancing rate remains positive in real terms.

14. We intend to allow a flexible exchange rate policy to absorb external shocks, as well as in case inflation pressures rise, credit growth is excessive, or there are risks to the international reserves target. In general, foreign exchange interventions by the NBU will be aimed at avoiding excessive short-term fluctuations in the exchange rate, while building up international reserves broadly in line with the growth of imports.

15. The monetary program for 2004 targets a decline in monetary growth, reflecting a smaller decrease in money velocity. As in 2003, reserve money growth is projected to be driven primarily by an increase in net international reserves. Quarterly floors on net international reserves and ceilings on net domestic assets are set out in Table 2.

16. Structural reforms in the banking sector and in the enterprise sector, described further below, should help reduce interest rates and lengthen loan maturities. The NBU will ensure that liquidity support provided to banks is based primarily on short-term refinancing, and interest rates reflect market conditions. We have eliminated the NBU's long-term refinancing facility, implementing ahead of time a step that was envisaged as a structural benchmark under the program. We will take steps to develop the domestic securities market, with a view to enhancing the NBU's ability to conduct open market operations and to facilitate risk management in the financial sector through the diversification of assets. In particular, as a structural benchmark under the program by end-June 2004, we will enhance the marketability of restructured treasury bills held by the NBU, and further develop and implement government debt management guidelines, with a view to establishing a yield curve.

C. Structural Reform

17. The main objective of our structural reform program is to improve the investment climate and lay the foundations for long-term growth. Tax reform is a central element of our program, with the aim to reduce the tax burden, make the tax system less discretionary, provide equal rights to taxpayers, and reduce the size of the shadow economy. On January 1, 2004, the corporate income tax rate was reduced from 30 percent to 25 percent, and a 13 percent flat tax on personal income was introduced. We have also broadened the tax base, including through a significant reduction in corporate and personal income tax exemptions. In addition, as a prior action under the program, several sectoral VAT exemptions and zero-ratings, including for housing construction, have been suspended, and the list for VAT-exempt pharmaceuticals has been narrowed. The current VAT preferences for agriculture will expire at the end of 2004. As a structural performance criterion under the program, we will by mid-August 2004 permanently eliminate sectoral exemptions from the VAT law, reducing the total fiscal cost of remaining VAT preferences (excluding agriculture) to at most Hrv 3.2 billion, and, as structural benchmark, we will reduce the overall cost of VAT preferences effective in 2005 (including agriculture) to at most Hrv 2.9 billion, based on 2003 estimates in the 2004 tax expenditure budget. We will ensure that no new tax preferences are introduced, and we have imposed a moratorium on introducing new or expanding existing free and priority economic zones in 2004. We will also rationalize the simplified fixed tax for individual entrepreneurs.

18. We are making the remaining tax preferences more transparent by improving the quality of the cost estimates of tax expenditures included in the budget documents. We will continue to refrain from using offsets and other noncash forms of payments to the budget. We will strengthen the accountability of the state tax and customs administration, and improve their collection and audit functions. We will not permit any write-offs of current tax liabilities or overdue obligations.

19. Another reform priority is to rationalize public expenditures and reduce financial deficits of public enterprises. We are establishing a monitoring system for all social privileges and have assigned these expenditure responsibilities to the central and local budgets. In addition, to help improve the targeting of benefits, we will establish a unified state register of individuals eligible for social privileges. We will continue to prepare a more comprehensive social safety net reform that would introduce a new system of targeted cash benefits. We will implement the first phase of pension reform, approved by parliament last year, ensuring the financial sustainability of the pay-as-you-go component, including by discouraging early retirement, establishing formula-based benefits, and rationalizing privileged pension regimes. We will press ahead with reforms in the agricultural and coal sectors, with a view to transforming the financial support to these sectors, as we seek accession to the WTO. Future public sector wage increases will be linked to the rationalization of employment, in the context of broader administrative reforms.

20. In order to strengthen budget implementation and controls, we have extended the coverage of the treasury system to local budgets, a step that had been envisaged as a structural benchmark under the program, but has already been completed. In addition, we will improve the management of domestic and external state debt and guarantees, including by tightening rules for subnational borrowing. We intend to establish a full-fledged system of commitments recording and ex-ante control.

21. In the banking sector, our primary goal will be to enhance prudent lending practices and reduce bad loan portfolios. A reduction in credit risk would help lower interest rates and encourage long-term lending. This will require steps to strengthen creditor rights, including through the laws on secured interest and mortgages, as well as the recently approved commercial code. It will also require judicial reform and improved financial disclosure of the enterprise sector. In order to strengthen the banking sector, the NBU will continue to improve banking supervision and intensify the enforcement of prudential regulations. In this context, we are moving towards risk-based banking supervision. As a prior action under the program, we have adopted an increase in the required minimum capital adequacy ratio from 8 to initially 10 percent, effective from March 1, 2004. We will strengthen related-party lending legislation and regulations by August 15, 2004 (structural performance criterion) by (a) requiring identification of ultimate bank owners; (b) eliminating exceptions that permit more favorable terms than market terms for related-party lending; (c) prohibiting concerned parties' involvement in the credit analysis; and (d) requiring regular disclosure of related-party lending in the banks' annual reports. In the interim, we will also amend NBU resolutions to limit related-party lending at favorable terms by April 30, 2004 (structural performance criterion). We will continue the process of strengthening the financial position of the Savings Bank, in line with agreements with the World Bank.

22. We will consult with the World Bank and EBRD on developing a prudent system for development lending. We have amended Ukraine's anti-money laundering legislation based on FATF recommendations and will now make progress on implementation, with a view to be taken off the list of noncompliant countries.

23. In the energy sector, we aim to raise transparency and reduce financial deficits. As a structural benchmark under the program, we will develop a monitoring system to assess the financial position and quasi-fiscal operations in the electricity, gas, and coal sectors, and report the results in the context of the budgetary submission for 2005. We aim to continue to improve cash collection ratios in the electricity and gas sectors and adjust tariffs towards short-term cost-recovery levels. We will further develop the energy debt restructuring plan, in consultation with the World Bank, EBRD, EU Commission, USAID and others, in order to set the conditions for the future privatization of the oblenergos. To enhance transparency in the gas sector, we will ensure the regular publication of annual financial reports by Naftogaz and other large public enterprises, implement a financial recovery plan for Naftogaz, and improve the quality and coverage of audits, in line with terms of references to be agreed with the World Bank. We will also implement procedures to measure and finance implicit subsidies in communal services, including heating and water supply. We will continue the restructuring of the coal sector, including through the liquidation of coal mines without prospects for financial recovery.

24. We will submit a new 3-year privatization program for approval by parliament this year, as well as legislation that substantially reduces the list of enterprises excluded from privatization. We intend to ensure that all sales of state assets are made under open and competitive conditions. We will also implement a unified land and real estate registration process.

25. In all of the above reforms, an overriding principle will be to strengthen governance, by making public institutions more transparent, reducing corruption, making economic policy more predictable and rules-based, and limiting discretionary government intervention. To strengthen the rule of law, we will implement a comprehensive reform of the judicial system. We will liberalize the trade regime, in line with our aim to join the WTO in 2004, and streamline foreign exchange regulations with the objective to integrate Ukraine further into the world economy. We will remain current on all external obligations. We will continue to improve the quality and availability of official data, including on GDP and short-term external debt. Under a new IMF arrangement, the NBU will undertake a full safeguards assessment.

IV. Program Monitoring

26. Performance under the program supported by the precautionary stand-by arrangement will be evaluated on the basis of quantitative performance criteria and indicative targets shown in Table 2 and on the basis of structural performance criteria and benchmarks shown in Table 1. Definitions and reporting requirements are specified in the attached Technical Memorandum of Understanding.

27. Other structural reforms are monitored under the World Bank's Programmatic Adjustment Loan (PAL) program, including steps to improve the targeting of social assistance; strengthen the social and financial viability of the pension system; enhance the accountability of the state tax administration; strengthen the financial position of the Savings Bank; improve the quality and coverage of Naftogaz audits; implement an energy debt restructuring plan and privatize the remaining state-owned oblenergos; improve the transparency of the privatization process; improve the legal system to strengthen creditor and shareholder rights; establish a unified registration for land and real estate ownership; and prepare for WTO membership.

Ukraine—Technical Memorandum of Understanding

March 11, 2004

1. This memorandum sets out the understandings between the Ukrainian authorities and IMF staff regarding reporting requirements and definitions of quantitative targets and structural measures for the economic program supported under the standby arrangement, as described in the authorities' Letter of Intent dated March 11, 2004 and the attached Memorandum of Economic and Financial Policies (MEFP).

2. Quantitative performance criteria and indicative targets are shown in Table 2 of the MEFP, defined as cumulative changes from end-December 2003. The definitions of these quantitative targets and the adjustment mechanisms are described in Section I below. Program exchange rates are based on actual exchange rates and cross-rates as of end-December 2003, shown in Section II below. Prior actions, structural performance criteria, and structural benchmarks are listed in Table 1 of the MEFP, with corresponding definitions in Section III below. Reporting requirements are specified in Section IV below.

I. Quantitative Targets

A. Net international reserves of the National Bank of Ukraine

Definition

3. Net international reserves (NIR) of the National Bank of Ukraine (NBU) are defined as the difference between usable gross international reserve assets and reserve-related liabilities to nonresidents, evaluated at program exchange rates (Section II). Usable gross international reserve assets comprise all reserve assets of the NBU (Table A, item 1), to the extent that they are readily available for intervention in the foreign exchange market and held in first-rank international banks or as securities issued by G-7 countries. Excluded from usable reserves, inter alia, are:

• any assets denominated in foreign currencies held at, or which are claims on, domestic institutions (i.e., institutions headquartered domestically, but located either domestically or abroad, or institutions headquartered abroad, but located domestically). Excluded are, inter alia, all foreign currency claims of the NBU on domestic banks, and 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, held by the NBU;
  
  
• any assets that correspond to claims of commercial banks in foreign currency on the NBU and any reserves assets that are: (i) encumbered; or (ii) pledged as collateral (in so far as not already included in foreign liabilities, or excluded from reserve assets); or (iii) frozen;
  
  
• any reserve assets that are not readily available for intervention in the foreign exchange market, inter alia, because of lack of quality or lack of liquidity that limits marketability at the book price.

4. For the purpose of this program, reserve-related liabilities are liabilities with an original maturity of one year or less and comprise:

• all short-term liabilities of the NBU vis-à-vis non-residents with an original maturity of one year or less;
  
  
• the stock of IMF credit outstanding;
  
  
• the nominal value of all derivative positions¹ of the NBU and government, implying the sale of foreign currency or other reserve assets against domestic currency.

Adjustment mechanism

5. The floor on the NIR of the NBU is subject to an automatic adjuster, based on cumulative deviations of non-project foreign financing (for monitoring purposes defined narrowly as major projected disbursements with significant uncertainty about timing, specifically the sum of: (i) World Bank disbursements under the PAL, (ii) EU disbursements under macrofinancial assistance, and (iii) new Eurobond issues by the Government of Ukraine) from program projections (specified in Table 2 of the MEFP). Specifically, if the cumulative proceeds from non-project foreign financing (in US$ evaluated at actual exchange rates):

a) exceed program projections, the NIR floor will be increased by 100 percent of the additional financing;

b) fall short of program projections, the NIR floor will be reduced by 100 percent of the shortfall, but the amount of the downward adjustment cannot exceed US$500 million.

B. Monetary base of the NBU (base money)

Definition

6. The NBU's monetary base comprises domestic currency outside banks and banks' reserves, including cash in vault of commercial banks,⁵ and funds of customers at the NBU. Currency outside banks is defined as: Currency—banknotes and coins—(NBU accounts 3000 (net)+3001 (net)-3007A-3009A-1001A-1004A-1007A-1008A-1009A) minus cash in vault at deposit money banks (DMBs) (DMB accounts 1001A:1005A and 1007A). Banks' reserves are 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 3230, 3232, 3233, 3234, 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 (NBU liability account 3238).

Adjustment mechanism

7. The target on the NBU's monetary base is not subject to an automatic adjuster.

C. Net domestic assets (NDA) of the NBU

Definition

8. The net domestic assets of the NBU are defined as the difference between the monetary base and the NIR of the NBU, with the NIR as defined above and expressed in hryvnia, evaluated at program exchange rates.

Adjustment mechanism

9. The ceiling on the NDA of the NBU is subject to an automatic adjuster for the amounts by which cumulative non-project foreign financing (for monitoring purposes defined narrowly as major projected disbursements with significant uncertainty about timing, specifically the sum of: (i) World Bank disbursements under the PAL, (ii) EU disbursements under macrofinancial assistance, and (iii) new Eurobond issues by the Government of Ukraine) deviates from program projections (specified in Table 2 of the MEFP). If the cumulative proceeds from foreign financing (in US$ evaluated at actual exchange rates):

a) exceed program projections, the NDA ceiling will be reduced by 100 percent of the additional financing, evaluated at the program hryvnia/US$ exchange rate;

b) fall short of the program projections, the NDA ceiling will be increased by 100 percent of the shortfall in financing, evaluated at the program hryvnia/US$ exchange rate, but the amount of the upward adjustment cannot exceed the hryvnia equivalent of US$200 million, evaluated at the program exchange rate.

D. Cash deficit of the general government

Definition

10. The general government comprises the central government, all local governments, and all extrabudgetary funds, including the Pension, Employment, Social Insurance for Temporary Disability, State Material Reserve, Leasing, Occupational Accident and Sickness Insurance, and State Property funds. The consolidated budget of the general government comprises: (i) the state budget; (ii) all local government budgets; and (iii), if not already included in (i), the budgets of the extrabudgetary funds listed above, as well as any other extrabudgetary funds included in the monetary statistics compiled by the NBU. The cash deficit of the general government is measured from below the line as:

• total net treasury bill sales as measured by the information kept in the NBU registry of treasury bill sales (net treasury bill sales are defined as the cumulative total funds realized from the sales of treasury bills at the primary auction less the cumulative total redemption of principal on treasury bills); plus
  
• other net domestic banking system credit to government as measured by the monetary statistics provided by the NBU (this consists of all non-treasury-bill financing in either domestic or foreign currency extended to the government by banks less the change in all government deposits in the banking system); plus



• total receipts from privatization received by the SPF and local governments; plus



• the difference between disbursements and amortization on any bond issued by the government or the NBU to nonresidents for purposes of financing the deficit of the general government; plus



• the difference between disbursements of official foreign credits to the general government (including project loans on-lent to public enterprises) and the amortization of official foreign credits by the general government (including of on-lent project loans, and excluding offset-based amortization with Russia); plus



• the net change in government deposits in nonresident banks, or other nonresident institutions; plus



• net proceeds from any promissory note or other financial instruments issued by the general government.

Adjustment mechanism

12. The ceiling on the cash deficit of the general government is subject to an automatic adjuster, based on deviations of external project financing (defined as disbursements from bilateral and multilateral creditors to the state budget for specific project expenditure) from program projections (shown in Table 2 of the MEFP). Specifically, if the cumulative proceeds from external project financing (in hryvnia evaluated at actual exchange rates):

a) exceed program projections, the ceiling on the consolidated general government deficit will be adjusted upward by 100 percent of the excess in external project financing;

b) fall short of program projections, the ceiling on the consolidated general government deficit will be adjusted downward by 100 percent of the shortfall in external project financing.

E. Non-earmarked central government cash revenue

Definition

13. Non-earmarked central government cash revenue comprises all taxes, fees, and charges levied by the central government that are collected in cash and are not earmarked by law for specific expenditure programs. Not included in the definition of revenue are any proceeds from loans or other banking system credits, the issuance of securities, or privatization receipts.

Adjustment mechanism

14. The target on non-earmarked central government cash revenue is not subject to an automatic adjuster.

F. Stock of budgetary arrears on wages, pensions, and social benefits

Definition

15. Budgetary arrears on wages, pensions, and social benefits comprise all arrears of the consolidated budget on wages, pensions (including on Chernobyl pensions), and social benefits owed by the Pension Fund, the central, or local governments (including Chernobyl benefits). Budgetary arrears are defined as payments not made thirty days after they are due. Wages are defined to comprise all forms of remuneration for work performed, including, but not limited to, payments in cash and in-kind for standard and overtime work. Pension obligations of the Pension Fund comprise all pension benefits and other obligations of the Pension Fund.

Adjustment mechanism

16. The ceiling on budgetary arrears on wages, pensions, and social benefits is not subject to an automatic adjuster.

G. Stock of VAT refund arrears

Definition

17. The stock of VAT refund arrears is defined as the stock of requests for VAT refunds outstanding for more than the legal carry-forward period net of refund claims lawfully denied, in line with the VAT law.

Adjustment mechanism

18. The ceiling on the stock of VAT refund arrears is not subject to an automatic adjuster.

H. Non-accumulation of external arrears by the government and the NBU

Definition

19. External arrears comprise all payment arrears to official and nonofficial creditors on debt guaranteed or contracted by the Government of Ukraine and the NBU, and those to private creditors that did not participate in the 2000 bond exchange or its subsequent reopening. The criterion for non-accumulation of external arrears applies on a continuous basis.

Adjustment mechanism

20. The criterion for non-accumulation of external arrears is not subject to an automatic adjuster.

I. Contracting or guaranteeing external debt⁶

Definition

21. The ceilings on contracting or guaranteeing external debt apply to the contracting or guaranteeing by the central government or the NBU of new external debt with an original maturity of more than one year In addition, during the program period, the central government shall not contract or guarantee debt of an original maturity of up to and including one year, other than for normal import financing. Excluded from the limits is the use of IMF resources; but other balance of payments support—including loans from official creditors and foreign banks, and bond issues—is included within these limits. The amount of debt contracted or guaranteed will be valued at the relevant currencies of denomination and converted into dollars using the NBU's official exchange rates prevailing at the time the debt is contracted. The maturity of debt instruments with put options shall be taken to be the period from the issuance to the earliest date the option can be exercised.

J. Cash collection ratios for electricity and gas

Definition

22. The cash collection ratio for electricity is defined as total cash payments (including direct bank transfers, but excluding in-kind payments, offsets, and payments in a form of promissory notes, bonds, stocks) to the state enterprise "Energorynok" divided by total billings for electricity supplied. The cash collection ratio for gas is defined as total cash payments to Naftogaz divided by total billings for gas supplied. Both payments and billings for electricity and gas include transportation and delivery fees.

Adjustment mechanism

23. The targets for cash collection ratios for electricity and gas are not subject to automatic adjusters.

II. Exchange rates

24. The program exchange rates are the official exchange rates determined by the NBU as of December 31, 2003, in particular Hrv 5.3315 per U.S. dollar and Hrv 6.662242 per Euro. The SDR is valued at 1.48597 U.S. dollars. Official gold holdings are valued at US$417.25 per ounce, which was the London gold price on December 31, 2003. The program exchange rate between the hryvnia and the U.S. dollar is an accounting exchange rate used for the sole purpose of converting foreign currency denominated assets and liabilities into hryvnias. According to IMF standard practice, the program exchange rate is kept fixed over the program period. Therefore, the program exchange rate differs from the actual exchange rate set in the foreign exchange market. Furthermore, setting a program exchange rate for the purpose of computing monetary aggregates does not imply that there is any target exchange rate for policy purposes.

III. Prior Actions and Structural Measures

Prior Action A1: Suspension of VAT exemptions and zero-ratings extended to newly-built housing construction, aircraft production, and shipbuilding.

25. The measure involves the adoption of a budget law for 2004 that suspends VAT exemptions and zero-ratings for newly-built housing constructions, aircraft production, and shipbuilding.

Prior Action A5: Enactment of a 2004 budget law that provides for the clearance of the entire stock of VAT refund arrears, on market terms; is based on budgetary parameters in line with the specifications in Section III of the TMU; and provides a tax expenditure budget for information.

26. The measure requires that the 2004 budget law explicitly identifies the resources and mechanisms to clear at least Hrv 1.8 billion in VAT refund arrears. If the stock of arrears is securitized, it should be on a voluntary basis, and the underlying provisions and legislation should specify that the securities are domestic government bonds, tradable on the secondary market, with a maturity no longer than 5 years and a interest rate no lower than 120 percent of the NBU discount rate. If the arrears are cleared through cash payments, the budget law should explicitly identify these payments and their financing.

27. The measure also requires that the draft 2004 budget law is based on a central government deficit, excluding external project financing, that does not exceed Hrv 3.5 billion, using IMF methodology (i.e. privatization proceeds treated as financing, Black Sea Fleet offset excluded from amortization, and clearance of VAT refund arrears treated as negative revenue). The financing of the central government deficit should reflect privatization receipts of at most Hrv 2.5 billion, and net external non-project financing (excluding the Black Sea Fleet offset from amortization) of at most Hrv 0.5 billion. The planned reduction in the stock of arrears on wages, pensions, and social benefits should be at least Hrv 0.3 billion.

28. The measure also requires that the government submit a tax expenditure budget to parliament alongside the 2004 draft budget law for information. Tax expenditures are defined as special tax provisions that deviate from a tax structure corresponding to internationally accepted good practice, produce a revenue loss, and are in this sense equivalent to direct government expenditures. Tax expenditures can take the form of exempt, or partially exempt, bases, taxpayers, economic sectors, geographical spaces, or a combination of these options (e.g., simplified tax regimes); tax holidays; special tax credits; or preferential rates of tax. Another type of tax expenditure is the write-off of past due debts or the deferral of tax liabilities.

Structural Measure B1: Enactment of changes to the VAT law that eliminate sectoral VAT preferences, effective no later than January 2005, reducing the total fiscal cost of remaining VAT preferences (excluding agriculture) to at most Hrv 3.2 billion, based on the 2003 estimates in the 2004 tax expenditure budget.

29. The measure requires the elimination of VAT preferences (such as exemptions and zero-ratings) from the VAT law, such that the total fiscal cost of the remaining VAT preferences in the VAT law (excluding those extended to agriculture) does not exceed Hrv 3.2 billion, as measured by the estimates for 2003 provided in the tax expenditure budget submitted to parliament in September 2003, corrected for the VAT exemption for imports of goods for the publishing industry (Table B attached to the TMU). The total estimated cost for 2003 was Hrv 4.1 billion excluding agriculture.

Structural Measure B2: Submission to parliament by the NBU and enactment of amendments to the Law on Banks and Banking, and revisions of NBU resolutions, to strengthen the provisions on related-party lending, in particular by (a) requiring identification of ultimate bank owners; (b) eliminating exceptions that permit more favorable terms than market terms for related-party lending; (c) prohibiting concerned parties' involvement in the credit analysis; and (d) requiring regular disclosure of related-party lending in the banks' annual reports.

30. Tightening of related-party lending legislation and rules includes (a) a clause in the Law on Banks and Banking requiring banks to identify the ultimate owners—physical persons—of the banks, and to communicate their identity to the supervisor; (b) eliminating the clause in the Law on Banks and Banking allowing an exception for related-party lending linked to the bank's net profit (Article 52, paragraph 4); and, in the interim, amending NBU resolutions by April 30, 2004, so that lending to related parties on favorable terms must be fully matched by set-aside capital, which would be deducted from capital available to meet any other capital requirement, and be granted only on the basis of a decision by the supervisory board, with the explicit consent of the management board; (c) adopting an NBU resolution requiring banks to introduce procedures preventing any person benefiting from the loan from being part of the credit analysis for the loan or for the credit decision itself; (d) adopting an NBU resolution requiring the description of all lending to and from related parties in separate disclosures in banks' annual reports.

Structural Measure B3: Steps to develop the domestic securities market, including by (a) enhancing the marketability of restructured treasury bills held by the NBU and (b) further developing and implementing debt management guidelines that promote the development of the government securities market.

31. The measure requires the adoption of a change in the interest formula for all restructured treasury bills held by the NBU, such that the nominal interest rate remains positive at all times and the inflation indexation is based on past inflation, not on projections. The measure also requires that the Ministry of Finance and the NBU, in consultation with banks, develop further and implement guidelines for managing the primary government debt market. The guidelines will include steps to enhance the availability of securities with maturities of one year or more, contributing to the establishment of a yield curve.

Structural Measure B4: Adoption of a monitoring system of quasi-fiscal operations in the electricity, gas, and coal sectors, and including the analysis for information purposes in the context of the budgetary submission for 2005.

32. The monitoring system, developed by the government in consultation with IMF staff, provides annual estimates of the aggregated financial position of companies in the electricity, gas and coal sectors, including detailed information in the agreed format on (a) overdue payables, broken down by creditor, (b) net borrowing, (c) budgetary subsidies, (d) actual tariff levels and the degree to which they cover costs, (e) total and cash collection rates, (f) overdue receivables, broken down by debtor, (g) technological losses. In addition, the information should include cash flow statements from the major state-owned energy companies, including Naftogaz and Energoatom. The information should be used to estimate quasi-fiscal deficits in the three sectors, based on an agreed methodology. A summary of findings for the years 2001-2003 and for the first half of 2004 will be included for information in the documents accompanying the draft budget law for 2005.

Structural Measure B5: Reducing the total fiscal cost of the remaining VAT preferences (including agriculture) effective in 2005 to at most Hrv 2.9 billion, based on the 2003 estimates in the 2004 tax expenditure budget.

33. The measure requires that VAT preferences effective in 2005 (including those extended to agriculture) under the VAT law and other relevant laws amount to a total fiscal cost of at most Hrv 2.9 billion, as measured by the estimates for 2003 provided in the tax expenditure budget submitted to parliament in September 2003, corrected for the VAT exemption for imports of goods for the publishing industry (Table B attached below). The total estimated cost for 2003 was Hrv 5.0 billion including agriculture.

IV. Reporting Requirements

A. National Bank of Ukraine

34. The NBU will continue to provide to the IMF on a monthly basis, no later than the 25th day of the following month, an aggregate balance sheet for the NBU and a consolidated balance sheet for the deposit money banks, in the format envisaged by forms 10R and 20R, respectively. All foreign assets and liabilities of the NBU will be included in the NBU balance sheet, valued at the official exchange rate prevailing on the day for which the balance sheet is compiled. All NBU claims on and liabilities to the IMF will be included in the NBU monthly balance sheet at the $/SDR exchange rate of the IMF's Finance Department at the last day of each month. All derivative transactions, and transactions involving encumbering reserves will be separately reported.

35. The NBU will provide to the IMF on a monthly basis, no later than the 25^th of the following month, the full breakdown of NBU accounts included in net international reserves (defined in Table A above), at both actual and program exchange rates.

36. The NBU will continue to provide to the IMF the daily report on the primary treasury bill market, reports on each treasury bill auction, and the monthly report on treasury bills.

37. The NBU will provide the IMF, no later than the 25^th of each month, with data on the total financing (including refinancing) issued by the NBU to commercial banks, broken down by original maturity of the financing.

38. Every 10 days, the NBU will continue to provide the IMF with the operational monetary survey of the NBU, including any additional information that is needed for the IMF staff to monitor monetary policy and developments in the banking sector.

39. The NBU will continue to provide to the IMF on a daily basis the daily operational balance sheet of the NBU and commercial banks in the standard format, including detailed information on banking sector credit to the general government.

40. The NBU will continue to provide to the IMF on a daily basis the standard daily data sheet on currency operations and weekly reports on NIR and gross foreign assets and liabilities evaluated at both actual and program exchange rates. The NBU will continue to provide daily information on exchange market transactions, including exchange rates.

41. The NBU will provide to the IMF reports N 381.25; 381.26 with information on reserve requirements and reports on CD operations when performed.

42. The NBU will continue to provide on a monthly basis, no later than 25 days after the end of the month, banking system monitoring indicators in an agreed format.

43. The NBU will provide to the IMF consolidated banking sector data and aggregated data (without specifying the names of the banks) for the 10 largest banks on a quarterly basis, no later than 30 days after the end of the quarter: (i) balance sheet; (ii) loan classification (standard, watch, sub-standard, doubtful, loss); (iii) provisions for all assets (required and actual) (iv) foreign currency denominated lending and deposits; (v) capital adequacy ratios for normative and regulatory capital (Tier II and I), normatives H2 and H3; weighted averages based on banks' total assets; (vi) liquidity normatives H5 and H6; weighted averages based on banks' total assets. In addition, the NBU will provide profit and loss statement for the same aggregated groups on an annual basis, no later than 60 days after the calendar year.

44. The NBU will continue to provide quarterly balance of payments data in electronic format.

45. The NBU will provide data on credit to nongovernment units that is guaranteed by the NBU on a monthly basis no later than 25 days after the end of the month.

46. The NBU will inform IMF staff if the Treasury does not pay interest or principal on treasury bills due to the NBU, deposit money banks, or non-bank entities and individuals. In such case, the NBU will provide information on outstanding interest and principal payments.

47. The NBU will inform IMF staff of any changes to reserve requirements for deposit money banks. The NBU will communicate in writing to the IMF staff any changes in accounting conventions and valuation principles incorporated into the balance sheet data and will notify the staff before introducing any change to the Charts of Accounts of the NBU and the Commercial Banks, as well as changes in the reporting forms.

B. Ministry of Finance

48. The Treasury will continue to provide to the IMF on a weekly basis its report on daily operational budget execution indicators, on a 10-day basis data on revenue of the state, local government, and consolidated budget revenues, and on a 10-day basis data on cash nonearmarked state revenue.

49. The Treasury will continue to provide to the IMF in electronic form monthly treasury reports on revenue and expenditure figures of the consolidated, state and local government, no later than 25 days after the end of the month. These reports will provide expenditure data by programs and key spending units, as well as based on standard functional and economic classifications. The Treasury will report monthly data on on-budget and off-budget, cash and non-cash, netting operations.

50. The Ministry of Finance will continue to provide monthly reports 1.P0 on actual tax revenue and 1.P6 on tax arrears, no later than 25 days after the end of each month.

51. The Ministry of Finance will continue to report the final fiscal accounts at the end of each fiscal year, no later than April of the following year. These reports will provide expenditure data by programs and key spending units, as well as based on standard functional and economic classifications.

52. The Ministry of Finance will report any revisions to monthly and annual fiscal reports as well as any amendments to the state budget and local government budgets within a month after their approval.

53. The Ministry of Finance will report to the IMF on a monthly basis, no later than 25 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 (state, local, and extrabudgetary funds), including net t-bill issuance, issuance of other government debt instruments, and change in government deposits.

54. The Ministry of Finance will provide data on the stock of all budgetary arrears on a monthly basis, 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. The Treasury will report monthly data on accounts payable for state and local budgets (economic and functional classification).

55. The Ministry of Finance will provide monthly information, no later than 25 days after the end of each month, on the amounts and terms of all external debt contracted or guaranteed by the general government.

56. The Ministry of Finance will provide to the IMF in electronic form on a monthly basis, no later than 25 days after the end of the month, (a) data on the outstanding stock of domestic and external debt of the state and local budgets (including general and special funds), (b) the standard files planned and actual external debt disbursement, amortization, and interest payments (including general and special funds), broken down in detail by creditor categories as agreed with Fund staff, and (c) the report on external debt amortization and interest payments by days and currencies. The Ministry of Finance will also report the accumulation of any budgetary arrears on external and domestic debt service.

57. The Ministry of Finance and the NBU will provide data on external and domestic credit to nongovernment units that is guaranteed by the government or the NBU on a monthly basis, no later than 25 days after the end of the month.

58. The Ministry of Finance will provide data on the approved budgets and quarterly operational data (monthly for the Pension Fund only) on the revenue, expenditures, and arrears, and balance sheets of the Pension Fund, Social Insurance Fund, Employment Fund, Occupational Accident and Sickness Insurance Fund, and any other extrabudgetary funds managed at the state level. Any within-year amendments to the budgets of these funds will be reported within a month after their approval. The Ministry of Finance will also report the annual financial statement including the final fiscal accounts of those funds at the end of each fiscal years, no later than April of the following year.

59. The Ministry of Finance will report semi-annual data on the number of employees of budgetary institutions financed from the central and local budgets, starting from January 2002. After any public sector wage increase, the Ministry of Finance will provide an estimate of its costs for the current and subsequent fiscal years, for the state and local government budgets.

C. State Tax Administration

60. The State Tax Administration (STA) will provide monthly data, no later than 25 days after the end of the month, on tax arrears, inclusive of interest and penalties outstanding, in the following format:

	Beginning Stock				Netting out during month	Deferrals during month	Write- -offs (arrears written off during month)	Collections of outstanding debt at beginning of month	NewArrears (tax liabilities becoming overdue during month)	Ending Stock
	Total	Principal	Interest	Penalties
Tax arrears

61. The STA will provide monthly data, no later than 25 days after the end of the month, on the stock and flow of tax arrears in the energy industry, in total and separately for the electricity, gas and coal sectors; the list (identifying taxpayers) of the 10 largest accumulated stocks of tax liabilities at the end of the month, and the list (identifying taxpayers) of the 10 largest additions to the stock of arrears during that month (flow). These lists should be prepared separately for the electricity, gas and coal sectors.

62. The STA will provide on a quarterly basis, no later than 25 days after the end of the quarter, aggregate data on tax arrears in the above format for the 50 largest tax debtor enterprises, and their cumulative monthly tax payments since the beginning of the year.

63. The STA will continue to provide on a quarterly basis, no later than 2 months after the end of the quarter, a listing of all tax exemptions granted, specifying the beneficiary, the exemption provided, the duration, and the estimated subsequent revenue loss for the current fiscal year.

64. The STA will continue to provide monthly information, no later than 25 days after the end of the month, on VAT refunds in the following format: (i) beginning stock of refund requests; (ii) refund requests paid in cash; (iii) netted out against obligations of the taxpayer; (iv) denied requests; (v) new refund requests; (vi) end-of-period stock; and (vii) stock of end-of-period requests that are overdue in accordance with the VAT law (currently, refunds are overdue after 1 month for exporters and 3 months for other VAT taxpayers). It is understood that while monthly data could be operational, quarterly figures will be subject to verification and will be final.

D. Ministry of Economy and Ministry of Fuel and Energy

65. The Ministry of Economy and European Integration will provide quarterly information on actual levels of communal service tariffs in all regions for major services (heating, water supply, sewage and rent). In addition, the Ministry of Economy and European Integration, the State Housing Policy Committee, and the National Energy Regulatory Commission, will provide the methodology underlying the tariff calculations for full cost recovery, including electricity and gas.

66. For each month, no later than the 25^th of the following month, the government (based on information by the Ministry of Fuel and Energy, the Ministry of Economy and European Integration, STA, MoF, NERC, and Naftogaz) will provide IMF staff with information in electronic form (in an agreed format) on financial indicators in the gas, electricity and coal sectors, including sales, tariffs, arrears, payments to the budget, subsidies, and debt.

E. State Statistics Committee

67. The state Statistics Committee and Naftogaz will provide to the IMF, on a monthly basis, no later than 45 days after the end of the month, data on prices, volumes, and payments for imported and exported oil and natural gas by country of origin and destination.