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Ukraine-2008 Article IV Consultation: Preliminary Conclusions
of the IMF Mission to Ukraine
International Monetary Fund (IMF)
Kyiv, Ukraine, Monday, March 31, 2008

KYIV - The IMF report below describes the preliminary findings of IMF
staff at the conclusion of certain missions (official staff visits, in most
cases to member countries).

Missions are undertaken as part of regular (usually annual) consultations
under Article IV of the IMF's Articles of Agreement, in the context of a
request to use IMF resources (borrow from the IMF), as part of discussions
of staff monitored programs, and as part of other staff reviews of economic


The Ukrainian economy has grown strongly since 2000, supported by a robust international environment, stabilizing macroeconomic policies, including the de facto currency peg to the dollar and low fiscal deficits, as well assignificant structural reforms.

By many measures, Ukraine has also become better insulated against shocks.
Reserves have increased substantially and now cover 170 percent of
short-term debt or four months of imports.

The underlying fiscal position is strong: government debt is only about 10
percent of GDP, and the deficit, if maintained at the present level, would
ensure fiscal sustainability under a wide range of scenarios.

The financial sector as a whole appears to be well capitalized and
profitable, and has been strengthened by the increasing importance of
foreign banks. WTO accession and the negotiations for an EU trade agreement should spur structural reform efforts.

However, over the last three years expansionary fiscal and incomes policies,
rising terms of trade, surging capital inflows, and a credit boom and have
led to very strong domestic demand growth and a deteriorating current
account position.

Surging demand, along with rising food and gas prices, has raised inflation
to unacceptably high levels. Moreover, inflation may be increasingly
entrenched in expectations and wage setting, partly reflecting the legal
mechanisms determining the official subsistence level and minimum wage.

Amidst turmoil in global financial markets and volatility in world commodity
prices, the Ukrainian economy also faces significant external and financial

. On the external side, the real exchange rate is still broadly consistent
with fundamentals, but overvaluation could result if inflation persists and
the current account deficit continues to widen. Also, the terms of trade may
deteriorate as Ukrainian gas prices move to world levels and because steel
prices might soften as world economic growth slows.

. On the financial side, global turbulence has heightened external financing
risks, including for rising short-term debt rollover, as interest rate
spreads have widened (more than in many other emerging markets) and
euro-bond issues have dried up.

Very high domestic lending growth, including in foreign exchange to unhedged
borrowers, points to increased credit risks, and a number of smaller banks
seem to be weak. The potential reversal of high asset valuations, notably in
some urban real estate markets, poses further risks.

Against this backdrop, the mission expects growth to slow modestly toward
a more sustainable rate in 2008, and further in 2009, as weaker world growth
reduces export demand, terms-of-trade gains moderate, and ongoing
difficulties in international financial markets tighten financing conditions
and reduce the pace of credit expansion.

Still high domestic demand growth and rising gas prices will contribute to
a further widening of the current account deficit, financed by continued
inward direct investment. However, as the economy slows and food prices
begin to stabilize, inflation should fall gradually, reaching 17 percent
(December on December) by the end of 2008.

We would emphasize the large uncertainties of this projection. For example,
a fiscal expansion or greater steel price increases would raise growth, but
also inflation. Intensified global financial market turbulence that spilled
over into Ukraine could cut growth substantially.

Given still buoyant steel prices and domestic credit expansion, we assess
the risks in 2008 as somewhat on the upside for both inflation and growth.


The mission strongly supports fundamental structural reforms, which will be
essential to ensure higher output and living standards over the medium term.
However, these reforms will take time to raise aggregate supply.

Therefore, high inflation, rising vulnerabilities, and global financial
turbulence call for near-term measures to strengthen fiscal, monetary, and
financial policies.

In this connection, the mission welcomes calls in the authorities' recent
anti-inflation program for greater fiscal prudence and better use of the
exchange rate band.

Our policy recommendations focus on current macroeconomic policy needs
and, if implemented, would contribute to stabilizing the external position
andreducing inflation, which could fall to single digits by end-2009.


For this year, the burden of controlling demand and inflation must fall on
fiscal policy, because limits to exchange rate flexibility preclude
sufficiently effective monetary policy action. A general government deficit
reduction of 1½ percent of GDP in 2008, bringing it to near balance, would
ease pressures significantly.

Holding nominal spending to the level specified in the December budget and
saving all revenue overruns, including in social funds, would largely
achieve this deficit objective; excess privatization receipts should also be

Further cuts, if needed, should be implemented by restraining subsidies and
social transfers, because these feed directly into demand and inflationary

Other fiscal measures will be needed to ensure a sustained reduction in
inflationary pressure. Minimum wage, public sector wage, and social spending
growth should be held to rates consistent with single-digit inflation; the
current increases of 20-40 percent feed inflationary pressures and undermine
anti-inflationary policies. Restitution of lost savings should be spread
over a number of years or offset by spending cuts elsewhere.

Tax cuts, which are desirable as part of an overall reduction in the size of
government, should be fully offset with spending cuts or base broadening
(for instance, via improved tax administration, especially of the VAT; by
contrast, abolishing the VAT would risk increasing evasion and move
Ukraine away from European norms).

Given the large uncertainties regarding the prospects for output growth and
inflation, the authorities should stand ready to adjust the fiscal stance as
needed. If growth does not slow as we anticipate, inflation pressures would
be stronger and a still tighter fiscal stance would be needed.

Conversely, the sustainable medium-term fiscal position provides room to
ease the fiscal stance if downside risks materialize and inflation clearly

The fiscal framework also needs strengthening. Further improving
macro-fiscal analysis would clarify the macroeconomic impact of fiscal
policy, and integrating it into the budget process would help to prevent the
procyclical stance that has characterized fiscal policy in recent years.

A multi-year fiscal framework, including spending ceilings, would facilitate
monetary-fiscal coordination and help to guide budgets toward medium-term
fiscal goals (for example, gradually reducing the size of government, or
implementing pension reform). Broader fiscal coverage and closer monitoring
of public enterprises would identify and contain fiscal risks.

Reducing the use of administered prices would improve the fiscal position
and economic efficiency. In particular, gas price increases should be passed
through fully to final users, with vulnerable groups protected by better
targeted social programs.
Monetary policy

The mission welcomes recent NBU policies to tighten monetary conditions,
including by stepping up sterilization and broadening reserve requirements.
Until inflationary pressures ease, the NBU should continue such efforts to
the extent feasible. As this will be costly, the government should accept
profit transfers from the NBU that deviate from budget targets.

However, at some point short-term capital inflows and strains on financial
institutions will limit the scope for further tightening in the current
policy framework.

The de facto exchange rate peg is no longer adequate to contain inflation,
encourages dollarization, and prevents the nominal exchange rate from
cushioning activity against external shocks.

Therefore, as anticipated in the 2008 monetary guidelines, the current
monetary framework should be replaced by, first, a more flexible exchange
rate and, ultimately, by inflation targeting.

This transition, which we recommend begin now, will require a joint and
coordinated effort between the government and the NBU:

. Public and decisive government support for the proposed new monetary
policy regime is fundamental, since otherwise it will lack crucial political
credibility. A key part of this support is legislative and de facto
guarantees of central-bank independence to carry out monetary policy

In preparation for inflation targeting and to develop key asset markets for
monetary policy operation the government should abolish the tax on foreign
exchange transactions, convert its outstanding liabilities to the NBU into
tradable securities by mid-year, and issue more public debt in hryvnia.
Also, the extensive use of administered pricing should be scaled back to
provide monetary policy maximum leverage over inflation.

. The NBU, with government support, should as a first step establish and
fully use an exchange rate band that allows more scope for active monetary
policy. The 2009 monetary policy guidelines should indicate that the band
will be progressively widened as circumstances permit and policy needs
require, without specifying bands or timing in advance.

The NBU should continue its welcome efforts to strengthen its analytical
capacity and integrate macroeconomic analysis into its policy decisions.

Communication with the public and the markets needs to be improved,
including through publication of inflation reports and regular, transparent
announcements of policy intentions and actions.


In view of actual and possible strains, we urge the NBU to continue to
intensify its supervision of banks. Key measures are consolidated
supervision, increased transparency of bank ownership (the recent
publication by the NBU of bank ownership is welcome in this regard),
encouragement to banks to enhance their risk management capabilities,
strong guidance regarding stress testing, and intensified on-site
Bank secrecy provisions should be brought into line with Basel II standards.

Prudential measures might include, in addition to the recent welcome
increase in minimum statutory capital, greater risk weights for assets that
pose higher credit risk (notably unhedged foreign currency denominated
lending) and stronger prudential requirements for banks with deteriorating
liquidity positions. Finally, nonbank supervisors should be strengthened,
which would also foster the development of insurance and capital markets.

The mission supports the authorities' intention to implement a sequenced
liberalization of capital controls, including through a new foreign exchange
law. Safeguards should be retained, but used only in clearly specified and
exceptional circumstances.

The mission recommends greater attention be paid to bank resolution and
crisis management. On the former, problem banks need to be identified
earlier and bank exit options expanded to include rapid resolution
mechanisms, notably by increasing incentives of owners of weak banks to
agree to mergers.

On the latter, contingency planning should be further developed and refined,
to ensure an effective response in the event of unforeseen turbulence.


Ukrainian statistics have improved significantly, but heightened risks
underscore the need to improve data on foreign trade, notably trade prices,
and on external assets, liabilities, and investment flows.

The mission thanks the authorities for fruitful and useful discussions, and
looks forward to a continuation of close and constructive policy dialogue.

LINK: http://www.imf.org/external/np/ms/2008/033108.htm