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IMF Executive Board Concludes 2008 Article IV Consultation with Ukraine

International Monetary Fund (IMF)
Public Information Notice (PIN) No. 08/68
Washington, D.C., Thursday, June 12, 2008

WASHINGTON, D.C. - On June 2, 2008, the Executive Board of the
International Monetary Fund (IMF) concluded the Article IV consultation
with Ukraine. (1)


Growth remained strong in 2007. Real GDP growth reached 7.6 percent,
on par with the average since 2000, and in line with other CIS countries.

Production and investment have been resilient despite an uncertain political
climate and supply-side shocks (a doubling of imported natural gas prices
since 2005 and a poor 2007 agricultural harvest).

Rapid domestic demand growth pushed the economy beyond its capacity
in 2007-08, leading to accelerating inflation. The demand expansion, fed by
fiscal and incomes policies and a capital-inflow driven surge in money and
credit growth, in combination with rising food and energy prices, gradually
lifted CPI inflation to over 30 percent by end-April 2008.

Core inflation has also risen, nominal wage growth is very high, and
inflation expectations have drifted up.

The current account deficit continued to deteriorate in 2007, due to very
strong domestic demand growth, but it remains broadly consistent with
fundamentals. The deterioration has occurred despite terms of trade gains,
which may reverse as gas prices rise and if steel prices revert toward their
historical trend.

If domestic demand and inflation are not contained, a further erosion of
cost competitiveness would move the hryvnia toward real overvaluation.

Capital inflows, including foreign direct investment (FDI), remain strong,
but private external debt and debt rollover have risen sharply. The economy
has become more sensitive to balance-sheet risks and deteriorating global
liquidity conditions.

However, some external debt may be held by Ukrainians (i.e. misrecorded) and
some offset by unrecorded foreign exchange assets in Ukraine. International
reserves remain at comfortable levels.

Banks' credit risks have increased, reflecting very high lending growth,
including in foreign exchange to unhedged borrowers. Surging liabilities to
non-residents, although in part reflecting the presence of foreign banks,
point to growing liquidity risks. And, with house prices high relative to
incomes, credit risks on mortgages have grown.

The effects on Ukraine of international financial market turbulence have
begun to recede. Reflecting Ukraine's vulnerabilities, external spreads rose
sharply beginning in mid-2007 and euro-bond issuance dried up.

However, eurobond spreads have been falling since late-March 2008, while
access of banks and corporates to longer term external financing has
resumed, facilitating rollover of debt maturities.

The fiscal stance has been procyclical. Nominal spending has risen by over
30 percent a year since 2003, reflecting rapidly rising public-sector wages
and social transfers and, in early 2008, partial restitution of Soviet-era
deposits that had been wiped out by hyperinflation in the early 1990s.

General government deficits have been kept moderate, as spending growth has
been paid for by inflationary revenue windfalls. This has allowed the public
debt to decline to just over 10 percent of GDP.

Monetary conditions have tightened somewhat of late. The National Bank of
Ukraine (NBU) stepped up sterilization and imposed new reserve requirements
on banks' foreign borrowing beginning in late 2007, instituted new
prudential measures in early 2008, and since March 2008 has allowed the
exchange rate to appreciate outside the previous de facto Hrv/$ 5.00-5.06

Excess banking system liquidity has fallen considerably, interest rates have
risen sharply, notably on the interbank market, and lending in foreign
currency has slowed significantly. Nevertheless, real interest rates remain
negative and overall credit growth is still very high-76 percent
year-on-year in March.

Progress has been made on the structural reform agenda, but much remains
to be done. WTO accession was a significant achievement, but compared to
other transition economies Ukraine lags in energy efficiency, internal price
liberalization and has notable weaknesses in its business environment,
especially in the area of tax administration. Development of the
high-potential agricultural sector remains constrained by the lack of a
market for agricultural land.



Executive Directors commended Ukraine's continued strong economic growth
and increased overall resilience to shocks. They noted that reserves have
increased substantially, the fiscal position is sustainable, the financial
sector appears well capitalized and profitable, and foreign direct
investment is strong.

These developments would support Ukraine's considerable long-term growth
potential, the realization of which will require the steady pursuit of sound
macroeconomic policies and growth-enhancing structural reforms.


Directors also expressed concern that some macroeconomic vulnerabilities
have increased. Significantly higher inflation and a wider external current
account deficit reflect volatility in world commodity prices, but mainly
strong domestic demand growth.

Directors cautioned that rapid domestic lending growth, including in foreign
exchange to unhedged borrowers, and high house prices have increased
credit risks. They welcomed the authorities' efforts to mitigate liquidity
arising from growing external borrowing and debt rollover needs in the
context of the global financial market turbulence.


Directors noted uncertainties regarding growth prospects, but agreed that
further tightening of policies will be required to buttress macroeconomic
stability. In this context, they welcomed the authorities' intention to
tighten fiscal policy, which will be critical for restraining domestic
demand and reducing inflationary pressures. They encouraged the
authorities to aim for a near-balanced budget-or tighter-in 2008.

At the same time, Directors considered that, should growth slow
significantly and inflationary pressures ease, a larger fiscal deficit could
be accommodated if financing is available.

Directors also saw merit in taking steps to strengthen the fiscal framework
more generally to improve fiscal policy formulation and assessment, in
particular by broadening fiscal coverage, and adopting a medium-term
fiscal framework.

To achieve the desired fiscal tightening, Directors suggested that growth in
social transfers will need to be reined in, and increases in minimum wages
and public sector wages scaled back. In addition, further restitutions of
depreciated Soviet-era bank deposits should be spread over a number of
years. To shore up revenues, administration of the value added tax should
be strengthened, and the tax itself preserved.

Tax cuts, while desirable as part of an overall reduction in the size of
government, should be fully offset with spending cuts or tax base
broadening. Gas prices should be fully passed through to final consumers,
with vulnerable groups protected by better-targeted social programs.


Directors underscored the importance of a tight monetary stance to fight
inflation. Directors generally considered that a shift to a more flexible
exchange rate would enhance the effectiveness of monetary policy, and
welcomed the 2008 monetary guidelines, which call for a gradual transition
to a flexible exchange rate and ultimately to inflation targeting.

They were encouraged by the authorities' recent actions to allow greater
exchange rate flexibility, and encouraged the authorities to communicate
clearly and consistently to the markets and the public about the move.

Directors generally felt that if recent flexibility were allowed to continue
in the context of a wider official trading band, it would help underscore
the two-way risk to domestic borrowing in foreign currency. A few Directors
were not persuaded of the desirability of exchange rate flexibility leading
to inflation targeting.

Directors stressed the importance of developing foreign exchange and money
markets, in particular noting a weak interest rate channel of monetary
policy transmission. While some Directors noted the uncertainties
surrounding the assessment of the current level of the real exchange rate,
Directors generally agreed that the real exchange rate appears to be broadly
consistent with fundamentals.

Directors stressed that decisive government support for a new inflation
targeting regime will be fundamental, particularly in the form of a clear
inflation-targeting mandate and operational independence for the monetary

It would also be important for the government to abolish the tax on foreign
exchange transactions, securitize its debt to the National Bank of Ukraine,
issue more public debt in domestic currency, and further liberalize domestic
prices to provide monetary policy maximum leverage over inflation.

Directors welcomed the authorities' progress in implementing the Financial
Sector Assessment Program recommendations, noting that financial indicators
have improved further.


However, they noted that Ukraine's financial sector vulnerabilities remain.
In this context, they supported recent measures to identify bank owners,
raise minimum capital requirements, improve risk management practices,
and curb banks' foreign borrowing.

They encouraged efforts to fully develop consolidated supervision, improve
banks' stress testing and risk management capabilities, intensify on-site
examinations, and impose stronger prudential requirements on banks with
deteriorating liquidity positions.

Directors suggested that productivity-enhancing structural reforms should
play a significant role in boosting growth and restraining inflation over
the medium term.

In particular, they looked forward to the positive impact of Ukraine's WTO
accession on enhancing market competition and economic efficiency. They
encouraged the authorities to push forward in improving the business
environment and the legal framework.
(1) Under Article IV of the IMF's Articles of Agreement, the IMF holds
bilateral discussions with members, usually every year. A staff team visits
the country, collects economic and financial information, and discusses
with officials the country's economic developments and policies.

On return to headquarters, the staff prepares a report, which forms the
basis for discussion by the Executive Board. At the conclusion of the
discussion, the Managing Director, as Chairman of the Board, summarizes
the views of Executive Directors, and this summary is transmitted to the
country's authorities.
(A) Subheadings were inserted editorially by USUBC.
INDICATORS, 2003-2009 (Six Statistical Charts)
Real economy
Public finance
Money and credit
Balance of payments
Exchange rate
Social indicators
LINK:  To see the six charts with the Report click on the following link: