Public Information Notice No. 03/73

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Ukraine

June 13, 2003

On May 14, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ukraine.¹

Background

Real GDP grew by over 4½ percent in 2002, marking the third year of Ukraine's economic expansion following the 1998/99 financial crisis. As in 2001, growth was supported by robust consumer spending, reflecting large wage increases, but also by an increase in net external demand. Consumer price inflation fell to near zero in 2002, reflecting primarily the good harvests in 2001/02 and the resulting sharp drop in food prices. Low inflation was also supported by a tightening of fiscal policy and delays in increasing administered prices, as well as by continued exchange rate stability and rapid remonetization. Inflation has, however, picked up in late 2002 and early 2003.

The current account surplus increased significantly in 2002. The trade balance was boosted by a sharp increase in exports of grain and oil products. Recently imposed anti-dumping measures by some trading partners led to a reorientation of metals exports to markets in Asia. Current transfers were boosted by workers remittances and World War II compensation payments, while private sector portfolio outflows increased. In late 2002, the government augmented its 2007 Eurobond series by about US$350 million on a net basis, but due to large amortization payments, public external debt continued to decline. Gross international reserves increased to 2¼ months of imports of goods and services by end-2002.

National Bank of Ukraine (NBU) interventions kept the hryvnia constant against the U.S. dollar. Following the sharp exchange rate adjustment in the wake of the 1998/99 financial crisis, the real effective exchange rate has remained broadly stable. The strong improvement in Ukraine's trade and services balance suggests that competitiveness remains adequate, as reflected in Ukraine's comparatively low wage level.

Monetary aggregates continued to grow rapidly in 2002, fuelled by large unsterilized net foreign exchange purchases by the NBU. In response to falling inflation in 2002, the NBU reduced the refinancing rate and lowered reserve requirements. Strong growth in money demand, evidenced by the large balance of payments surplus, reflected growing public confidence and the continued remonetization of the economy. The monetary expansion contributed to the continuation of very rapid loan growth in the banking sector. Recent Financial Sector Assessment Program (FSAP) missions found that this has weakened banking sector capitalization and contributed to increased credit risk. Interest rates decreased, but lending rates and spreads still remained high. The share of nonperforming loans remains also relatively high. There was no significant change in dollarization in 2002.

The consolidated budget turned from a cash deficit of 1½ percent of GDP in 2001 to a surplus of ½ percent of GDP in 2002. Revenues increased sharply, partly due to high wage growth and improvements in tax administration. However, the stock of Value Added Tax (VAT) refund arrears increased further, reaching 1¼ percent of GDP at end-2002. A significant shortfall in privatization receipts and large wage and pension increases led to significant cuts in non-wage central government spending. Tax arrears increased, mainly reflecting noncompliance in the energy sector and the inability to collect installments for tax arrears restructured under the 2001 tax amnesty. The single treasury account was fully implemented and some tax privileges were eliminated. Unfunded social mandates were reinstated at the beginning of 2002, although eligibility criteria were recently tightened, targeting improved, and administration strengthened.

Progress on other structural reforms was mixed in 2002. Ongoing land reforms continued to support growth in the agricultural sector. However, the broader privatization process slowed down, partly reflecting the lack of any large sales to strategic investors. The restructuring of energy debts and the privatization of the remaining state-owned electricity distributors were delayed. Cash collections reportedly increased to about 85-90 percent for gas and electricity, but the energy sector accumulated significant tax arrears in 2002. The staff estimates that the quasi-fiscal deficit in the energy sector was about 2½ percent of GDP, as reflected in the increase in arrears to suppliers and the tax authorities. In addition, the coal sector receives budgetary subsidies of about 1 percent of GDP annually. The stock of debts and arrears of state-owned energy companies amounted to an estimated 12 percent of GDP.

Executive Board Assessment

Executive Directors noted Ukraine's strong macroeconomic performance in 2002, marked by robust GDP growth, low inflation, improved external position, and a rapid decline in public debt. Directors commended the authorities for their prudent demand management policies, including tight fiscal policy, but regretted that the authorities did not seize the opportunity to accelerate structural reforms. Going forward, they urged the authorities to maintain sound macroeconomic policies and to revive and accelerate structural reforms.

Directors considered that Ukraine's near-term outlook remains favorable, with economic growth in 2003 expected to remain solid and the balance of payments position strong. Nevertheless, the economy remains vulnerable to a number of risks. Directors noted the incipient inflationary risks, reflecting the recent high monetary growth, the large increases in the minimum wage and the wage bill, and the likely reversal of several temporary factors that kept inflation low in 2002. In addition, a delayed global recovery or macroeconomic policy slippages could undermine economic performance and weaken the banking sector. Directors noted that the remonetization of the economy has contributed to recent performance, and prudent debt policies have strengthened Ukraine's financial position. However, domestic confidence must be sustained to support the current stance of monetary and exchange rate policy. Overall, Directors considered that strong policies will therefore remain essential to protect the economy from any potential shocks and guarantee medium-term sustainability.

Directors stressed that an acceleration of structural reform will be necessary to improve the investment climate, create an enabling environment for the private sector, and increase productivity to achieve sustained economic growth and reduce poverty over the long term. They noted recent progress in land reform and small and medium-scale enterprise development and privatization. Among the priority areas requiring clear definition and further action are reforms of the tax system and the social safety net, a strengthening of the financial sector, reform of the energy sector, and improvements in transparency and governance—not only in the public sector but also in the private sector where there is a particular need for sound corporate governance.

Directors considered that the proposed fiscal stance for 2003 is appropriate. They nevertheless expressed concern about several fiscal issues that should be resolved as soon as possible. These include the continued accumulation of VAT refund arrears, which is jeopardizing tax compliance, exports, and the overall perception of the rule of law if it is not reversed. They were also concerned about the large increase in government spending, which could rise further in 2004 on the basis of the new minimum wage law. They considered that tax reform remains a high priority, but were concerned by the implications for the fiscal stance of rate-reducing reforms, which could constrain the scope for reforming the social sector. Directors suggested that further increases in public sector wages should be limited as much as possible, carefully phased, and linked to employment rationalization, with the aim of maintaining a low fiscal deficit in 2004.

Directors urged that, as part of the planned tax reforms, rate reductions should be linked with a broadening of the tax base and elimination of tax exemptions. They welcomed recent changes to the profit tax as a step in the right direction. Directors urged the authorities to work with parliament on further reforms, including the elimination of tax preferences under the VAT. In addition, they stressed the importance of providing a stable tax environment, which will need to involve greater accountability of the tax authorities and the rapid elimination of the stock of VAT refund arrears.

Directors endorsed the primary focus of monetary policy on keeping inflation low, and commended the authorities for reducing inflation in 2002. Going forward, they urged the authorities to monitor price trends closely, and to be ready to tighten monetary policy if needed to keep inflation low. They supported greater central bank independence. Directors agreed with the view that the hryvnia remains competitive. They urged the authorities to move towards greater exchange rate flexibility to absorb shifts in either direction in money demand and the balance of payments. They supported the authorities' intention to move toward a more explicit inflation targeting regime over the longer term, with the further development of financial markets and a more predictable monetary transmission mechanism.

Directors urged the authorities to implement the main recommendations of the recent FSAP missions to strengthen the banking system. High real interest rates and the still large share of nonperforming loans are indications that credit risk remains pervasive and calls into question the sustainability of the recent rapid growth in bank credit. Directors endorsed the importance of proceeding with the strengthening of the financial position of a major bank without further delay. Directors expressed concern about the NBU's new long-term lending facility, which may distort the credit market, limit the flexibility of monetary policy, and raise governance issues. They urged the NBU to focus its efforts on more fundamental banking issues, including improving banking supervision, raising capital ratios, and moving to close banks that do not meet prudential requirements. Directors welcomed recent steps to bring Ukraine's anti-money laundering legislation in line with Financial Action Task Force recommendations, and urged the authorities to move swiftly to its full implementation.

Directors stressed the importance of enhancing transparency, strengthening governance, and creating a level playing field for all economic agents. They welcomed the authorities' intention to accelerate the privatization process and urged that it be transparent and competitive.

Directors cautioned that large quasi-fiscal deficits and debts in the energy sector, manifested in the continued accumulation of tax and supplier arrears, constitute significant risks to fiscal policy and call for ensuring hard budget constraints. Addressing these problems will require greater transparency and accountability, especially with respect to the state-owned gas monopoly, Naftogaz.

Directors supported the authorities' goal of joining the World Trade Organization next year. They considered that the resulting progressive trade liberalization should help to strengthen Ukraine's economy and underpin its further integration into the world economy.

Directors welcomed the recent improvements in economic statistics, and Ukraine's subscription to the Special Data Dissemination Standard—the first among the countries of the Commonwealth of Independent States.

Directors commended the constructive dialogue between the Fund and the authorities aimed at reaching agreement in the near future on a program under a precautionary arrangement with the Fund. A strengthening of structural reforms, with broad ownership, and policies to preserve macroeconomic stability will be an essential part of such a program.

Directors encouraged the authorities to continue to include collective action clauses in their future sovereign debt issuances.