Public Information Notice No. 05/7

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Ukraine

January 24, 2005

On October 25, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ukraine.¹

Background

Six years after the 1998 financial crisis, Ukraine continues to recover strongly. In 2003 real GDP grew by 9.4 percent, despite a poor harvest and reached 13.5 percent through July 2004. Growth in 2003-04 has been prompted by favorable external demand, a competitive cost structure, and dynamic domestic demand. Export growth has averaged 25 percent (year-on-year) since end-2002, yielding a sizeable current account surplus and foreign reserve accumulation. Despite the strong growth, unemployment remains high at about 9 percent, according to International Labor Organization's definitions.

Inflation has been moderate, but strong upward pressures are emerging. From a low of -0.6 percent in December 2002, the 12-month Consumer Price Index (CPI) rate reached 8.2 percent in December 2003 and increased to 10.7 percent in September 2004. Producer Price Index (PPI) inflation was 23.2 percent in September 2004 reflecting mostly higher world prices for energy and metals. Even excluding these items, core PPI inflation exceeded 10 percent. Wages continue to grow strongly. In June 2004, the average nominal monthly wage for the entire economy was 26.3 percent above its level the previous year.

Fiscal policy remained prudent through mid-2004. The consolidated government cash deficit was 0.7 percent of GDP in 2003. Through end-June 2004, it amounted to 0.2 percent of (annual) GDP versus an end-June adjusted program ceiling of 0.9 percent. However, the outturn reflects an accumulation of VAT refund arrears; had the programmed reduction occurred, the deficit would have been one percent of GDP. Indeed, general problems with VAT administration contributed to an overall drop in the revenue/GDP ratio, and led the president to replace senior management in the State Tax Administration in June. In the run-up to the presidential elections, the government approved an increase in the minimum monthly pension from Hrv 130 ($25) to Hrv 284.6 ($54), effective retroactively, September 1, 2004. This increase—which follows two earlier sizeable increases in the year—boosts the monthly pension bill by 36 percent for the remaining four months of the year, raising government expenditure by about 1¼ and three percent of GDP in 2004 and 2005, respectively. As a result, the draft 2005 budget, which was submitted to parliament in mid-September and targeted a consolidated budget deficit of 1.8 percent of GDP, is now obsolete. Provisional data show that this year fiscal deficit has increased to 1½ percent of GDP as of end-September.

In the context of a de facto peg to the dollar, strong money growth has until very recently been consistent with single-digit inflation, amid continued remonetization and a modest monetary policy tightening. In the first part of 2004, a large build-up of government deposits helped moderate base-money growth, despite the National Bank of Ukraine's (NBU) pronounced interventions in the foreign exchange market that led to strong NIR accumulation. Starting in May, the NBU has tightened monetary policy, including by issuing Certificates of Deposit (CDs) (although in low volumes) and raising reserve requirements. The discount rate was raised again by 50 basis points to eight percent in early October.

Competitiveness remains strong. In the 12 months to June 2004, the real effective exchange rate depreciated by four percent, reflecting mainly Ukraine's low inflation vis-à-vis Russia, and the strengthening euro. Average wages remain less than half Russia's wages.

Despite the NBU's ongoing steps to strengthen prudential regulation and banking supervision, credit expansion and credit quality remain a concern. The credit-to-GDP ratio stands at 29.5 percent compared to 12.4 percent in 2000. While credit expansion has decelerated since early 2004, loans have increased to about two-thirds of bank assets. Nonperforming loans classified by past due criteria are estimated at eight percent of total loans.

There has been progress in the structural reform agenda, but tax administration should improve. Income taxes have been cut and the tax base broadened by eliminating some exemptions, the pension system reformed, and collection ratios in the energy sector have improved. However, several actions under program conditionality—concerning related-party lending, tax preferences and exemptions, and VAT refund arrears—have not been completed.

Executive Board Assessment

Directors noted that the impressive macroeconomic developments over the last few years—fast growth, declining inflation and strong external position—owed much to the prudent macroeconomic and structural reform policies followed until recently. They expressed concern, however, about the fiscal expansion underway in the context of an already rapidly growing economy, and stressed the need to return to a more prudent fiscal stance. Moreover, structural policies needed to be stepped up to raise sustainable growth over the medium term. In this context, Directors regretted that the review of the Stand-By Arrangement could not be completed as scheduled.

Directors welcomed several positive features of Ukraine's recent macroeconomic performance. Growth has been booming, the external current account surplus has reached record levels, market confidence has improved, and, accordingly, official international reserves have increased considerably. However, Directors noted that capacity bottlenecks were now emerging, strong foreign exchange inflows continued to fuel domestic liquidity, and fiscal discipline was increasingly being undermined, pushing inflation up to double digits. They stressed that the overheating pressures and the fact that current activity was largely supported by the external sector, while banks' portfolios had expanded significantly, were reminders that the economy remained vulnerable to shocks.

In this context, Directors felt that the loosening of fiscal policy in 2004 increased the risks of overheating. They noted that, although the surge in the deficit this year was largely financed through higher-than-expected privatization proceeds, the significant increases in recurrent government spending, particularly pensions, compromised the 2005 budget and placed public finances on a less firm footing. Moreover, they emphasized that resources from the sale of public assets would be better used to retire existing debt so as to build room against future contingencies and for the sizable medium-term public spending needs, including in infrastructure.

Directors, noting that fiscal discipline had served Ukraine well in the past, urged the authorities to take prompt corrective measures to restore a sound fiscal outlook and to avoid a sizable slippage with respect to the original fiscal target for 2004—a consolidated budget deficit of 1¾ percent of GDP. A large correction was also needed to achieve the consolidated budget deficit envisaged in the draft 2005 budget of 1¾ percent of GDP.

Directors encouraged expenditure prioritization through further development of a medium-term budget framework, but cautioned against hasty tax rate reductions before the tax base was broadened and tax administration strengthened. While welcoming the recent sharp reduction in VAT refund arrears, Directors remained cautious on whether the good performance will be sustained, and saw significant scope for further improving VAT administration.

Directors noted that the real exchange rate would be subject to appreciation pressures in the medium term, and, given the choice between inflation and nominal appreciation in realizing this appreciation, they considered a move toward a more flexible exchange rate regime more beneficial to Ukraine. In this respect, Directors felt that the de facto peg to the U.S. dollar was now exacerbating the challenge for the NBU to achieve its inflation objective. It also contributed to a distorted saving-investment position and provided an implicit exchange rate guarantee, with attendant risks for the financial stability of the private sector as a whole. Many Directors referred to the vulnerability of the banking system, observed the need for appropriate sequencing, and suggested that the pace of movement toward flexibility should be left to the judgment of the authorities.

While welcoming the NBU's increasing efforts to drain liquidity, Directors noted that monetary conditions remained too loose to ensure attainment of the original inflation objective in 2004 and beyond. In the face of additional government spending, mounting inflationary pressures and absent greater exchange rate flexibility, Directors felt that the NBU should tighten monetary policy further to achieve its objective of bringing inflation back to single digits.

Directors commended the NBU on the continued progress in strengthening prudential banking regulation and supervision. The various actions taken to improve the monitoring of credit growth and of the adequacy of banks' capital and risk management practices were welcome. However, they regretted that the draft amendments to the Banking Act, which would allow identification of bank owners and tighten related-party lending, had not yet been adopted by parliament. While stressing the need to continue addressing the banking sector's vulnerabilities, Directors encouraged the authorities to raise the minimum capital adequacy ratio to 12 percent, to contain risk from foreign currency loans, and to adopt tighter accounting and reporting standards for corporations. They welcomed the inclusion of collective action clauses in Ukraine's 2004 Eurobond issues.

Directors agreed that sustaining high medium-term growth required a better investment climate. In this context, Directors noted that governance problems remained widespread, ranging from tax collection and public procurement to law enforcement and divestment of public assets. They regretted that, while privatization had recently accelerated, procedures remained nontransparent. Directors welcomed the recent fall in the energy sector quasi-fiscal deficit. They also advised prompt passage of important legislation, such as the energy debt restructuring law and the joint-stock company law; a reduction in the burden of licensing and inspection regimes; and a strengthening of the judiciary and of contract enforcement.

Directors noted that, while broadly adequate for surveillance, statistical data could be improved, particularly with regard to the national accounts and the balance of payments.