Ukraine’s economy shows signs of improvement, but considerable challenges remain. Limited exchange rate flexibility, a large budget deficit, and sizable quasi-fiscal losses in the energy sector have given rise to a large external current account deficit and a steady loss of foreign exchange reserves. The tight monetary policy and administrative measures in support of the exchange rate will likely continue to constrain investment and depress growth. And Ukraine’s significant external financing needs remain a key vulnerability.
The mission and the authorities consider that a set of comprehensive and credible reforms is needed to address vulnerabilities and revive growth. The mission recommends that the reform agenda include: (i) increased exchange rate flexibility combined with policies to strengthen the financial sector; (ii) ambitious fiscal consolidation; (iii) increases in domestic energy tariffs, and (iv) comprehensive structural reforms to improve the business climate and support growth.
A more flexible exchange rate would boost Ukraine’s export performance and economic growth, especially in the face of volatile export prices and partner country demand. It would also allow more room for independent monetary policy to keep inflation on target. In the medium term, inflation targeting is the appropriate monetary framework for Ukraine, and preparations for its introduction should be accelerated.
The authorities have steered the economy through domestic market tensions at the end of 2012, and confidence in the banking system has improved. A high average capital adequacy ratio provides a cushion against risks. Large negative foreign exchange positions have been reduced, but further progress is needed. The mission advised the use of independent bank audits to ascertain asset quality and the adequacy of loan classification, provisioning, and collateral.
The general government budget deficit is projected to rise to 5¾ percent in 2013, including up to 1¼ percent of GDP in recognized VAT refund and expenditure arrears to be covered by recently approved promissory notes. The mission welcomes the authorities’ aim to clear these arrears but recommends that this be done through conventional methods, as promissory notes risk undermining future fiscal performance.
An ambitious fiscal consolidation is needed to reduce the budget’s large financing needs and support external adjustment. Consolidation efforts should focus on the high level of budget expenditure—nearly 50 percent of GDP—through wage and employment restraint, subsidy cuts, and rationalization of spending on goods and services. Tax cuts should be postponed until the budget deficit is reduced to a sustainable level.
The large loss-making energy sector needs to be reformed. The low retail tariffs (covering only a small fraction of economic costs) generate quasi-fiscal losses, balance of payment weaknesses, underinvestment in domestic production, and governance problems. As a priority measure, we advise a significant upfront increase in gas and heating tariffs for households and adoption of a schedule for further increases until cost recovery is reached. To mitigate the effect of tariff adjustment on the less affluent, we recommend scaling up targeted social assistance programs that would cover up to 40 percent of the population.
Improving the business climate is imperative for high and sustainable growth. In the past year, Ukraine advanced 25 places—to rank 112 out of 189 countries—in the World Bank’s Doing Business 2014 report by making dealing with construction permits easier and simplifying registration of real estate ownership rights. Much remains to be done, however.
We recommend a focus on structural reforms that would address the most binding constraints to growth. This includes revamping the judicial system, simplifying or repealing burdensome government regulations, stepping up anti-corruption measures, and enforcing clear and consistent rules in tax administration. Decisive progress in these areas should raise productivity and investment, substantially lifting potential growth in the medium term.
The authorities are developing policy proposals to correct external imbalances and revitalize growth. Further technical consultations between the staff and the authorities will continue with a view to ensuring that policies are sufficiently ambitious to address Ukraine’s challenges. The mission emphasized the need for the authorities to make significant progress in all of the above policy areas.
