Public Information Notice No. 02/52

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Ukraine

May 8, 2002

On April 24, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ukraine.¹

Background

The economic situation has continued to improve in 2001. Real GDP growth is estimated to have increased from almost 6 percent in 2000 to 9 percent in 2001, mainly on account of double-digit growth of industrial output and a good grain harvest, resulting from favorable weather conditions and a lessening of government controls in agriculture. The continued economic recovery in 2001 has been made possible by: (i) considerable idle capacity; (ii) improved competitiveness of the Ukrainian economy in the wake of the real exchange rate depreciation in 1998-99 and, through the first half of the year, further expansion of Ukraine's main export markets, in particular Russia; and (iii) the strengthening of domestic demand as a result of wage and pension increases granted in 2000-01; and (iv) the clearance of wage and pension arrears. Annual consumer price inflation declined sharply from almost 26 percent in 2000 to a rate of about 6 percent in 2001, significantly below target. This outcome reflected the downward impact of the good harvest on food prices, some delays in increasing administered prices, including for electricity, and the stable exchange rate.

Ukraine's external current account surplus narrowed from 4¾ percent of GDP in 2000 to 3½ percent in 2001, mainly because of strong import growth driven by the expansion of domestic demand. Export growth remained vigorous, but slowed in the course of the year. The competitiveness of the Ukrainian economy was preserved, as the real effective exchange rate has remained broadly stable since mid-2000. As a result of the debt-rescheduling agreement with Paris Club creditors concluded in July 2001, the debt-service burden was moderated. Ukraine has also started to benefit from transfers, including in the form of World War II compensation payments, and from increasing inflows of foreign direct investment, albeit from a comparatively low base.

The nominal exchange rate of the hryvnia remained stable in 2001. With the National Bank of Ukraine (NBU) continuing its extensive purchases of foreign exchange on the interbank market, Ukraine's official gross international reserves increased to $3.1 billion at end-December, equivalent to almost eight weeks of imports, and net international reserves turned positive, reaching $1.1 billion. Spreads for Ukrainian eurobonds are now at about 650 basis points, some 800 basis points below their levels in the first half of 2001.

Fiscal policy through end-September 2001 was broadly on track, although indicators of revenue were affected by the accumulation of arrears on VAT refunds, and privatization proceeds fell short of the budgeted amounts. While spending policies were kept under control, tax collection has been undermined by the broad tax amnesty granted in early 2001, and by the rapid accumulation of new tax arrears. The overall cash deficit of the general government is estimated at 1½ percent of GDP in 2001, compared to 1 1/3 percent in 2000. The reduction of social payments arrears by end-September exceeded the target for the year as a whole, and the stock of payments arrears on energy consumption and other utilities remained at 1 percent of GDP.

Monetary policy in 2001 was dominated by largely-unsterilized foreign exchange market intervention by the NBU, and monetary aggregates continued to expand rapidly. Base and broad money grew by 37 percent and 42 percent, respectively. The strong money growth accommodated a further increase in real money demand, in line with the economic growth, the continuing remonetization of the economy, and the return of confidence in the hryvnia. During the period January-October, the NBU bought some $2.1 billion in the foreign exchange market, reflecting the strong balance of payments situation. The commercial banks boosted their lending to the economy, although real interest rates remain high.

Some progress has been made on structural reforms. Despite the successful sale of six electricity distribution companies earlier in the year and satisfactory compliance with transparency criteria, the implementation of the 2001 privatization program met with delays. In the energy sector, payments discipline has continued to improve, as a result of adequate budget allocations for energy consumption and stricter implementation of cut-off policies, but the completion of the audit of Naftogaz was delayed. The overall health of the financial system has improved in 2001, but weaknesses remain with regard to a number of banks. A new Land Code was adopted, which allows for private ownership of land in the medium term.

Executive Board Assessment

Executive Directors commended the authorities for Ukraine's strong economic performance in 2001, marked by high growth, low inflation, and an improved external position. While acknowledging that temporary factors had facilitated the positive outcome, Directors commended the authorities' contribution in protecting the macroeconomic stabilization gains. They regretted, however, that the seventh and eighth reviews under the Extended Arrangement have not been completed, owing mainly to delays in reaching understandings on appropriate fiscal measures and the requisite parliamentary approval to close the fiscal gap and on the timing and pace of clearing the outstanding value-added tax (VAT) arrears.

Directors urged the authorities to continue adhering to a prudent macroeconomic policy stance and press ahead with comprehensive and well-implemented structural reforms in order to bring about the strong and sustained economic growth that Ukraine needs to raise living standards and alleviate poverty. Firm steps to close the fiscal gap and a clear resolution of the problems associated with the VAT will be crucial initial measures for keeping macroeconomic policy on course in 2002. The prospects for economic growth in 2002 remain good, although somewhat less favorable than earlier envisaged. The authorities should, however, remain alert to potential downside risks arising from weaker external demand.

Directors noted that although the authorities met most of their fiscal program targets for 2001, they accumulated arrears of VAT refunds and privatization proceeds fell short of projections. While expressing concern about the adverse impact of the tax amnesty passed in April 2001 and the continued granting of tax exemptions and privileges, Directors welcomed the introduction of several key structural reforms in the fiscal area, including the Budget Code and improvements in tax administration.

For 2002, Directors welcomed the adoption of a budget with a deficit of 1¾ percent of GDP, but expressed concern that corrective measures remain to be put in place to compensate for possible shortfalls in revenue and privatization receipts, as well as to cover unfunded social expenditure mandates. They called on the authorities to refrain from granting wage increases not incorporated in the budget. Directors expressed concern about the deteriorating revenue performance in recent years. They urged the authorities to broaden the tax base and reduce tax distortions and tax privileges, and called on them to ensure that any Tax Code adopted in 2002 addresses these concerns. Directors also stressed the urgency of repayment of VAT refund arrears in order to safeguard the integrity of the tax system. They added that more progress is needed in developing a single treasury account that will support other reforms at the treasury including spending controls.

Directors noted that high growth in combination with an expansion of the cash economy has allowed greater room for remonetization of the economy. They called on the authorities to monitor price developments closely, and to be prepared to tighten monetary policy as necessary if inflationary pressures emerge. Directors also encouraged the authorities to manage the exchange rate flexibly.

Directors urged the authorities to pay particular attention to the financial sector in light of the recent rapid credit growth, poor capitalization of many banks, and incomplete application of prudential regulations. In this context, they suggested that the authorities should enforce supervisory regulations, improve loan evaluation procedures, and formulate and implement reform plans for the two state-owned banks. Directors welcomed the authorities' plan to participate in the forthcoming Financial Sector Assessment Program (FSAP). They urged the authorities to move ahead rapidly and ambitiously on efforts to combat money laundering and the financing of terrorism.

Directors called on the authorities to press ahead vigorously with their structural policy agenda. Measures to improve the privatization climate and to level the playing field for all investors will be crucial to overcome weaknesses in the business environment and promote private investment, including foreign direct investment, which remains quite low in Ukraine. In the energy sector, measures to resolve the debts of the companies should be developed, and efforts are needed to strengthen payments discipline further in the electricity and gas sectors. Directors urged the authorities to speed up preparations for a comprehensive and independent third stage Naftogaz audit, in line with international standards, as a crucial step toward better governance in the energy sector. They also urged the authorities to implement the actions required for World Trade Organization accession. Directors regretted that Ukrainian exporters face significant trade barriers in certain foreign markets.

Directors commended the authorities' efforts to enhance Ukraine's macroeconomic statistics and welcomed their decision to proceed with subscription to the Special Data Dissemination Standard (SDDS) by July 2002.