Public Information Notice No. 01/5

Public Information Notice: IMF Concludes Article IV Consultation with Ukraine

January 19, 2001

On December 19, 2000, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ukraine.¹

Background

The economic situation in 2000 has been encouraging. Following the gradual stabilization of the economy in 1999 in the aftermath of the Russia crisis, real GDP growth in 2000 turned positive for the first time since independence, and was expected under the program to reach some 4 percent for the year as a whole. The improved growth performance stemmed in large part from the positive response to the real effective exchange rate depreciation of the hryvnia in 1999; better-than-expected growth in Russia, as well as a recovery in other export markets, notably of metals; and increased gas imports from Russia in the 1999/2000 winter season, despite continued non-payment problems, which enabled a strong industrial rebound. Ukraine's external position improved significantly in 1999, and the external current account surplus was expected to increase further to almost 5 percent of GDP in 2000, reflecting the strong export growth in volume terms and a modest increase in non-energy imports. Large debt-service payments fell due in 2000, but debt service pressures were moderated by the rescheduling in April 2000 of official debt to private creditors.

The nominal exchange rate remained broadly stable in 2000, after having depreciated by 34 percent in U.S. dollar terms in 1999. The National Bank of Ukraine (NBU) purchased significant amounts of foreign exchange in the interbank market in 2000, which allowed gross international reserves to remain mostly above a level equivalent to 3 weeks of imports, while significant payments were made to the Fund. However, annual inflation was expected to increase to 27 percent in 2000, up from 19 percent in 1999, partly reflecting the unsterilized intervention by the NBU and increases in administered prices. As a result, the competitiveness gains achieved in 1999 were eroded somewhat as the real effective exchange rate appreciated by about 7½ percent during the first nine months of 2000.

Following a mixed record in 1999, the fiscal position improved markedly through September 2000. The overall cash deficit of the general government is projected at about 1½ percent of GDP in 2000, against an outcome of almost 2½ percent in 1999, as revenues performed better than foreseen and expenditures were kept in check. Except for some limited netting operations in the first quarter of 2000, the government has refrained from accepting noncash payments. Arrears in the social sectors were reduced by 1.1 percent of GDP, with pension fund arrears eliminated by end-September. Some payments arrears, however, were accumulated in the energy and utility sectors.

Monetary policy in 1999 was marked by the government's heavy reliance on NBU financing, while during the first nine months of 2000, the growth of monetary aggregates was dominated by the unsterilized foreign exchange intervention by the NBU. Broad money grew by 40 percent for 1999 as a whole, with a build-up in liquidity in the banking system toward the end of the year. During the first nine months of 2000, base and broad money increased by 24 percent and 31 percent, respectively. The NBU bought more than $1 billion in the foreign exchange market in this period, reflecting the strengthened balance of payments situation. These large purchases matched significant private sector inflows in 2000 to finance purchases of state enterprises and the monetization of the economy.

Some progress has been made on structural reforms. In the area of public enterprise reform, a new privatization law was passed in early 2000 and a law was recently adopted permitting the sale of a minority share in the telecommunications company Ukrtelecom. However, no single large enterprise has yet been sold through open and transparent bidding procedures. In the energy sector, payments discipline was strengthened in 2000, and progressively higher cash collection ratios for gas and electricity through September were achieved. Communal tariffs for public utilities were eventually raised in most areas of the country. The law establishing the 30 percent export tax on oil seeds was vetoed, but subsequently approved at a lower rate of 23 percent. During the course of 1999 and early 2000, significant progress was made in the area of public administration reform.

Executive Board Assessment

Executive Directors welcomed the recent improvements in economic policy implementation, and endorsed Ukraine's overall economic strategy based on a sound budget, tight monetary policy, and supportive structural reforms. However, they underscored that sustained efforts to implement the program are necessary. Directors urged the authorities to pursue firmly their economic strategy, which would support the expansion currently underway and better enable Ukraine to face the substantial challenges ahead in making a successful transition to a market-based economy.

Directors were encouraged by the recent economic performance, noting that real GDP growth in 2000 is expected to be positive for the first time since independence and approach 5 percent. The improved performance stems largely from the positive response to the real effective exchange rate depreciation of the hryvnia in 1999, as well as a recovery in export markets. Ukraine's external position also strengthened in 2000, allowing a significant repayment of external debt and a slowdown in the buildup of external arrears.

Directors noted that the nominal exchange rate has remained broadly stable in 2000, but that annual inflation was higher than projected, meaning that the substantial competitiveness gains achieved in 1999 have been somewhat eroded. They urged the National Bank of Ukraine not to target any particular level of the exchange rate and to be prepared to accept greater exchange rate flexibility in both directions. Directors agreed that it was important to keep monetary aggregates under control to lower the inflation rate. Regarding the financial sector, they welcomed the recent parliamentary approval of the new Law on Banks and Banking Activity, and urged the authorities to continue taking steps to strengthen the financial system. Directors urged speedy action to resolve the uncertainties and minimize the fiscal costs of restructuring the financial sector.

Directors commended the authorities for the fiscal performance in 2000, as revenue performed better than foreseen and expenditures were kept in check, and noted that the projected deficit was lower than in 1999. They also welcomed the structural improvements to the budget, in particular the reduction in noncash operations, the elimination of several distortive taxes, and the removal of most discretionary tax exemptions, but regretted the accumulation of payment arrears in the energy and utility sectors. Looking to 2001, Directors considered that the budget recently approved by parliament is consistent with the requirements of macroeconomic stability, and provides an indication of the authorities' commitment to economic reform. They stressed that spending in 2001 should take into account the expected timing of available financing, and that privatization receipts in excess of expected amounts should be used for debt reduction operations. However, several Directors were concerned about the financing of the budget purely from privatization receipts and the associated quarterly pattern of the budget deficit. Directors were disappointed that a number of funds had again been excluded from the 2001 budget, and called for their reintegration. They underlined that any cuts in tax rates should be preceded by measures to broaden the tax base to ensure revenue neutrality. Directors also welcomed the efforts underway to strengthen the effectiveness of the social safety net. They underlined the need to prepare for budgetary consolidation over the medium term.

Directors were encouraged by some actions taken in the structural area in 2000 following sluggish progress in 1999. The passage of a privatization law that fosters transparent procedures, strengthened payments discipline in the energy sector, and the increase in communal tariffs to cost-recovery levels over most of the country as well as the introduction of significant reforms in the agricultural sector, are all positive developments. However, several Directors expressed concern at the slow pace of privatization, noting in particular that no large enterprise has yet been sold through open and transparent bidding procedures. Moreover, a number of new free economic zones have been established, which introduce further distortions in the tax system, while an export tax has been imposed on oilseeds. They stressed that it is essential that the authorities move ahead more rapidly on their structural reform agenda, given the need to reduce the role of the state in the economy and bolster private sector confidence and investment to ensure that growth becomes sustained. The privatization of public enterprises should be accelerated and carried out in a fair and transparent manner so as to maintain public support. To this end, Directors welcomed the planned ex-post reviews of privatization operations. They urged the authorities to ensure that the targets for cash collection ratios in the energy sector are met. The authorities should also push ahead in other areas, including efforts to reduce the cost of doing business, agricultural reforms, improving governance, further streamlining the public administration, as well as reducing the export tax on oilseeds.

Directors welcomed the sharp turnaround in Ukraine's trade balance in 1999-2000, but noted that the external current account surplus is likely to narrow in 2001, reflecting the expected return of export growth to a more moderate pace and the full-year impact of higher energy imports. They also welcomed the restructuring earlier this year of official debt to private creditors, and supported the authorities' request for a rescheduling of debt to official creditors given the tight external cash flow and fiscal situation. In view of the potentially disruptive nature of large commercial arrears, the authorities' efforts to encourage Naftogaz to regularize its relations with suppliers are especially important.

Directors noted the progress made in the area of statistics, and welcomed the authorities' intention to subscribe to the Special Data Dissemination Standard by the end of 2001. They urged the authorities to continue their efforts to strengthen statistical systems, notably in the areas of national accounts and public finance.