TRANSITION REPORT 2014 Innovation in Transition

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Highlights

  • Ukraine has been living through enormous turbulence since the end of 2013. Social unrest, which started in Kiev at the end of 2013, led to an overturn of the Yanukovych government. New presidential elections took place at the end of May. In 2014, relations between Russia and Ukraine became complicated, with a new gas supply dispute, the events in Crimea and an escalation in fighting in Ukraine’s Donbas region.
  • The new government committed itself to broad structural reforms to rebalance the economy, in the context of unprecedented security challenges. Ukraine signed an Association Agreement (AA), including a Deep and Comprehensive Free Trade Area (DCFTA), with the European Union (EU), secured a new International Monetary Fund (IMF) programme and initiated structural changes in the energy and banking sectors. Many other challenges in the public finance, financial and real sectors lie ahead.
  • Macroeconomic adjustment has been sharp. The hryvnia depreciated by around 40 per cent after the National Bank of Ukraine (NBU) was forced to abandon the currency peg in February 2014. The economic contraction has been profound, aggravated by severe damage to industrial capacity and infrastructure in the east, and significant disruptions in trade with Russia.

Key priorities for 2015

  • The government should pursue market-friendly policies to correct fiscal and external imbalances, bearing in mind the exceptional challenges stemming from the intensification of the Ukraine crisis. To enhance buffers against external shocks, a sound economic policy framework should be maintained with assistance from international financial institutions.
  • Major reforms are needed to provide incentives for foreign and domestic investment. Reforming the country’s institutional environment, securing a level playing field in the private sector, rooting out corruption, and improving corporate governance and transparency remain key priorities. Commercial courts should be depoliticised and made accountable for their decisions. Strengthening non-state institutions that would advocate fair treatment of businesses could serve as an interim measure.
  • Steps should be taken to reduce the deficit of oil and gas monopoly, Naftogaz, and to bolster its finances. This could then be followed by its unbundling and corporatisation. Gas prices for households and heating utilities should be gradually increased and cross-subsidies eliminated.

UKRAINE HAS BEEN LIVING THROUGH ENORMOUS TURBULENCE SINCE THE END OF 2013

THE NEW GOVERNMENT COMMITTED ITSELF TO BROAD STRUCTURAL REFORMS TO REBALANCE THE ECONOMY

MACROECONOMIC ADJUSTMENT HAS BEEN SHARP

2014 sector transition indicators
Corporate Energy Infrastructure FI

Source: EBRD. 
Note: FI – Financial institution; ICT – Information and communication technology; Water – Water and wastewater; IAOFS – Insurance and other financial services; PE – Private equity.


Main macroeconomic indicators %

  2010 2011 2012 2013 2014
          proj.
GDP growth 4.1 5.2 0.3 0.0 -9.0
Inflation (average) 9.4 8.0 0.6 -0.3 11.5
Government balance/GDP -9.5 -4.3 -6.6 -6.7 -10.1
Current account balance/GDP -2.2 -6.3 -8.1 -9.2 -2.5
Net FDI/GDP 4.2 4.3 3.8 1.8 0.1
External debt/GDP 86.0 77.2 76.5 78.6 n.a.
Gross reserves/GDP 24.5 18.6 12.9 10.6 n.a.
Credit to private sector/GDP 62.4 56.5 53.6 59.1 n.a.

Note:  Overall government balance includes Naftogaz and other debt-creating flows.

Macroeconomic performance

The economy is going through a painful macroeconomic adjustment aggravated by the war. The acute political crisis, which started towards the end of 2013, took place at a time when Ukraine’s economy was facing significant challenges. The economy had been in recession since mid-2012; the inconsistent policies of the previous government had led to large external and fiscal imbalances; the deteriorating regulatory and “doing business” environments and pervasive corruption depressed investor activity and led to foreign investors fleeing the country; and the banking sector had accumulated large exposures to lending related to politically exposed persons and was vulnerable to outflows. As the crisis unfolded and pressure on international reserves increased, the NBU abandoned the currency peg in early February 2014, allowing the hryvnia to depreciate by around 40 per cent between February and September 2014, fuelling inflation, affecting domestic demand and weakening public and private sector balance sheets. Banks suffered large retail deposit outflows of nearly 25 per cent (adjusted for currency depreciation) in the first nine months of 2014 and curbed lending. In addition, 26 small and medium-sized banks were declared insolvent as of mid-October. To prevent the fiscal deficit running out of control, the government embarked on a fiscal austerity programme and hiked energy tariffs for households and industry. At the same time, the events in Crimea and the severe destruction of industrial capacities and infrastructure in Ukraine’s east triggered economic losses. Exports to Russia, the country’s largest trade partner, fell by 25 per cent in the first eight months of 2014.

In April 2014 Ukraine secured a 24-month Stand-By Arrangement (SBA) with the IMF. The programme (approximately US$ 17.1 billion) aims to stabilise and rebalance the economy, namely by: (i) maintaining a flexible exchange rate and adopting inflation targeting by mid-2015; (ii) stabilising the financial system; (iii) reducing the structural fiscal deficit through a mix of revenue enhancements and expenditure cuts, and meeting near-term fiscal obligations; (iv) modernising and restructuring the energy sector, including reducing quasi-fiscal losses of Naftogaz by 2018; and (v) implementing comprehensive structural reforms to help reduce economic imbalances, tackle corruption and improve the business climate. The SBA with the IMF unlocked other multilateral and bilateral assistance to Ukraine. The World Bank has already approved and disbursed two development policy loans (for budget and financial sector support) amounting to US$ 1.25 billion, and the European Union pledged two Macro-Financial Assistance packages of €1.61 billion, out of which €0.6 billion has been disbursed. In May 2014 the Ukrainian government issued a US$ 1 billion bond with a US guarantee.

The economic outlook is highly uncertain. GDP is currently forecast to contract by 9 per cent in 2014 and by 3 per cent in 2015. Domestic demand is likely to remain weak due to the efforts at fiscal consolidation, deteriorated real incomes and banking sector deleveraging. The situation in the east of Ukraine remains the biggest source of uncertainty. There are significant downside risks to the outlook stemming from protracted and intensified fighting and from a further breakdown of trade linkages with Russia. On the upside, stabilisation in the east of the country may pave the way for industrial and infrastructural rehabilitation and for a general recovery in confidence. Exports may get a boost from trade liberalisation with the European Union and from the hryvnia depreciation. Prospects for recovery in the medium to long term will hinge on the government’s ability to implement structural reforms and attract foreign direct investment.


Major structural reform developments

Faced with such economic challenges, the new government and the President initiated important structural reforms. Under the IMF programme, the authorities are pursuing ambitious reforms, including energy sector reforms, banking sector restructuring, improvements to the business environment, fiscal adjustments and tax administration. The government adopted a more transparent public procurement law, closed some large tax evasion schemes and imposed a moratorium on inspections of businesses by controlling agencies (except by fiscal authorities) until the end of 2014. To ensure more coordinated reforms, in May 2014 the EBRD signed with the government a Memorandum of Understanding for the Ukrainian Anti-Corruption Initiative, which envisages a Business Ombudsman Institution to foster fair treatment of businesses. In addition, the National Reforms Council (chaired by the President) was formed in July 2014 and in October 2014 parliament passed the law on the creation of an Anti-Corruption Bureau, which will have broad investigative powers in line with best practices. The reform agenda, however, is daunting and many of its elements (anti-corruption, law enforcement, judicial system and public administration reforms) are still either unaddressed or addressed only partially.

In June 2014 Ukraine completed the signing of the AA/DCFTA with the European Union. The deal is seen as an important milestone for Ukraine and could serve as an external anchor for institutional and systemic reforms. The agreement envisages a mutual opening of markets for goods and services, lower tariff and non-tariff barriers, and the gradual approximation of Ukrainian norms and regulations to EU standards. In July and August 2014, Russia introduced bans on imports of Ukrainian cheese, milk and milk products, juices, soya, sunflower, selected spirits and other foodstuffs, and contemplated imposing the most-favoured-nation tariff on other goods. In September 2014 the European Union and Ukraine agreed to delay the application of the DCFTA until the end of 2015, with unilateral extension by the European Union of autonomous trade preferences for Ukraine for the same period. This could reduce risks of further trade measures from Russia and may benefit Ukraine’s domestic producers and the budget. On the other hand, this may lead to the postponement of necessary reforms.

Energy sector restructuring started in three main areas: subsidies, Naftogaz unbundling and gas supply diversification. First, in May 2014, the government increased household gas tariffs. Then in July 2014 heating tariffs were also raised, addressing one element of subsidisation in the sector. The plan is to have gradual tariff increases to cost-recovery levels by 2018. In parallel, the government began preparing the support programme for poorer households to mitigate the effects of the tariff increases. Second, the government indicated its intent to unbundle the state energy monopoly Naftogaz and to sell off approximately 25 per cent of the company through an IPO. In August 2014 parliament adopted a law that provides for full separation of the gas transit system (pipelines and underground storage facilities) as well as for the separation of Ukrtransgaz from Naftogaz, allowing Western partnerships to begin operating these assets. A Naftogaz unbundling could offer significant benefits, such as attracting foreign investments in the modernisation of the gas transit system and providing better oversight. Lastly, faced with an unresolved gas dispute with Gazprom and suspension of its gas supply since mid-June 2014, Ukraine signed a reverse flow deal with the Slovak Republic in late April 2014. The agreement cleared the way for the supply of up to 10 billion cubic metres of gas per year through a new interconnector. The reverse flow started in September 2014. On 30 October, with the EU’s support, Ukraine and Russia agreed to a US$ 4.6 billion gas deal. The agreement aims to address energy debt issues and to provide an interim solution that will secure gas supply to Ukraine and Europe through the winter.

The financial sector is being transformed. In early February 2014 the NBU abandoned a long-standing peg and floated the hryvnia. Under the IMF programme, the NBU committed to a gradual shift towards an inflation-targeting regime and started to develop its necessary elements. Inflation targeting may serve as an anchor for transformations in the NBU’s monetary policy framework. At the same time, faced with renewed currency pressures in August and September of 2014, the NBU substantially tightened foreign exchange restrictions. The NBU also seeks to improve banking sector supervision. The bank resolution framework under the Deposit Guarantee Fund (DGF) is being strengthened and the DGF is being recapitalised. Asset quality reviews and stress tests conducted under the IMF programme showed that 9 out of 15 top banks are in need of recapitalisation for a total of UAH 56 billion (approximately US$ 4.3 billion). Several banks have announced capital increases. The NBU also started to improve its own institutional capacity by initiating important organisational, functional and personnel restructuring.

The government abolished a number of business permits and signalled further deregulation. In April 2014 the new government cut the number of business-related permits for different industries from 143 to 60. In July 2014 a draft law, which passed the first reading in parliament, envisaged a 30 per cent decrease in mandatory business licences and the introduction of an electronic system for obtaining a licence. In August 2014 the Ministry of Economic Development and Trade unveiled a detailed deregulation road map, which consists of around 800 steps to reduce bureaucracy. The government sought to improve value added tax (VAT) refund procedures and transparency, and issued around UAH 7 billion of VAT bonds to compensate for previously accumulated VAT refund arrears. The government has also proposed a draft plan to simplify the tax system by reducing the number of taxes from 22 to 9 and by limiting the scope for tax avoidance.