IMF Program: Summary before the Review

Ukraine looks set to receive the next tranche of IMF funding after accomplishing most of about 100 reform measures stipulated by the IMF Memorandum signed in February 2015.  However, as long as the country relies on external pressure to generate the political will, comprehensive action on reforms will remain elusive.

On February 27, 2015, Ukraine signed a Memorandum of cooperation with the IMF that may soon be characterized as “money in exchange for reforms”. In their “First 100 days in the Office Report” government officials named the IMF agreement one of their main achievements. Indeed, without the IMF loan, Ukraine would not have been able to pay out its external liabilities and stabilize its exchange rate. More details about the IMF program can be found here, here and here.

The reforms envisaged by Memorandum can be summarized as follows:

• Monetary and banking policy: flexible exchange rate, transfer to inflation targeting, further “cleaning” of the banking system, establishing fair rules of the game and enforcing them;
• Fiscal policy: elimination of the Naftogaz deficit, raising tax compliance, and providing social safety net for vulnerable groups;
• Deregulation, judicial reform and the fight against corruption – the “three pillars” of a healthy economy. Ukraine’s Western partners often stress that the combatting corruption must be the foundation of reforms in Ukraine. No wonder that it received significant attention in the Memorandum.

As we can see, nothing is new here – these are the measures that have been discussed by experts and government officials for at least the last decade. Now they have to be implemented.

Importantly, the Memorandum contains not only the reforms outlined above, but, unlike the Ukrainian government program, also a very clear schedule for their implementation. The majority of reform activities will be carried out with technical assistance from the IMF, the World Bank and other international organizations.

The Memorandum also calls for the Government to conduct communication campaigns to inform the public about reform efforts – particularly regarding energy price increases. Unfortunately, this requirement is quite vague and, perhaps because of that the Government does not pay sufficient attention to the informational component of their work.

In May, the IMF mission arrived in Ukraine to assess the implementation of Ukraine’s key performance indicators. The decision on additional funding for Ukraine by the IMF’s Executive Board, which is due in early July, will hinge on the mission’s findings. Judging from the press release issued by the mission, there is a high probability that the Board will decide in Ukraine’s favor. Although some have been delayed, the majority of “structural benchmarks” – that is specific activities with clearly defined terms – were met. The reforms planned in the Memorandum, and their execution, are detailed below (note that we don’t know which measures were included into the Memorandum at the IMF’s request, and which of them were proposed by the Ukrainian government officials).

Note: areas marked in green denote measures that were implemented in time, orange – implemented partially or with a delay, red – measures for which the deadline has passed.

Reform of the monetary and exchange rate policy

Despite the formal announcement about the transfer to a flexible exchange rate policy and a number of periods of significant (over 10%) devaluation of the Hryvnia, the National Bank of Ukraine (the NBU) had actually been pursuing a fixed exchange rate until February 2015. This policy, coupled with the structure of Ukrainian exports, consisting primarily of raw materials, resulted in Ukraine’s over-sensitivity to the world economic crises with alternating periods of deceptive stability and outright panic (read more here). Now the NBU is targeting price stability because the majority of people earn and spend in Hryvnia. The following measures were included into the Memorandum:

 Banking system reform

There are several problems in the Ukrainian banking system. First, there is a large number of “pocket” banks in Ukraine and thus a high level of related party lending. Second, there is insufficient capital, which raises risks of bank insolvency in case of exchange rate fluctuations or deterioration of assets. Third there is high amount of non-performing loans, which often became non-performing back in 2008, after a sharp Hryvnia devaluation.

It’s no secret that almost every financial-industrial group had its own “pocket” bank not only for operational purposes, but also for preferential lending to companies belonging to this financial-industrial group – and the source of these loans were personal deposits, often attracted at above the market interest rates. When needed, one could empty this kind of bank in a few days by withdrawing the assets and shifting the cost of deposits redemption to the Deposit Guarantee Fund, i.e., to the other banks which contribute to the Fund and, in case of the insufficiency of such funding, to the taxpayers. Before the adoption of the relevant law on increasing the bankowner responsibility, dishonest owners were not held responsible for engaging in such schemes. Although there were legal restrictions to related party lending, they were easily bypassed via complicated structures of financial-industrial groups. The recently adopted law obliges enterprises, including banks, to disclose the information on the final beneficiaries, but it has not come into full force yet. To eliminate the above schemes and clean up the banking system, the following actions are planned:

 Fiscal policy

The main fiscal policy problems that Ukrainian governments have faced have been revenue-expenditure mismatch and spending inefficiency due to both corruption and “social state” inherited from the Soviet times. Until recently Ukraine had a “Russian-type” social contract, which implies that people let officials enrich themselves, and in return receive “crumbs from the table”, mainly in the form of low tariffs, an ineffective system of privileges and supposedly free healthcare system.

Under such a setup, the middle class representatives, and particularly entrepreneurs, had to pay for both the palaces of the ruling class, and the “guaranteed minimum” of others. Obviously, this model of social relations could not last for long. From now on both the government and households will have to engage in the long-term planning and economizing. For this purpose the following measures are envisaged:

Except the internal reforms, the Memorandum envisages restructuring of the state foreign debt as well as external liabilities of the state-owned enterprises. The government actively negotiates with investors, but for now only the restructuring of the state-owned Ukreximbank bonds has been agreed upon. To strengthen the government bargaining position, the law was adopted providing the government with the right to impose a moratorium on external debt payments.

Energy sector

Today Ukraine is one of the most energy inefficient countries in the world. For example, according to the World Bank data, Ukraine produces 2.8 times less GDP per unit of energy use than Poland, and 3.7 times less than Germany. This can be partially explained by the high share of the shadow economy in GDP. However, a more important reason for this is a complete mess in the energy sector, where a large part of energy resources are not accounted for, are lost during transportation, or simply wasted. As we don’t value things what we get cheaply, the majority of people do not realize the true price of the “cheap energy”. For example, in 2014 Naftogas financing exceeded the Defense Ministry budget by 3.5 times and the Health Ministry budget by 10 times. In 2013, subsidies for the coal mining industry were equal to the financing of all higher educational institutions.

The energy sector reform plan includes three components – market tariffs, with no hidden subsidies, strict accounting, and targeted support of the poor. The need to raise energy tariffs has been explained by the [broad] Government on numerous occasion – for example, see a recent interview of the Naftogas Head. Planned energy sector reforms are primarily concerned with the gas sector:

Business climate and fight against corruption

There is no doubt that corruption is the main problem in our country. Moreover, as repeatedly noted, corruption in Ukraine is not episodic, as in developed countries, but rather systemic. In current conditions an optimal strategy for a Ukrainian citizen without informal connections is to give a bribe and quickly get a service from the state, or avoid punishment. The alternative is not to give a bribe and be kicked from one office to another for months or, for example, pay a fine that exceeds the size of the bribe.

The high priority of fighting corruption was acknowledged in the previously mentioned government program, Strategy of reforms – 2020. It is also acknowledged in a more detailed strategic document that is currently under development.

It is clear that it is impossible to place a policeman next to every civil servant. That is why the most effective method of fighting corruption is reduction of state functions, aka deregulation. For this purpose such measures are planned:

 Judicial system

Apparently, there is no need to stipulate the importance of a properly working judicial system for the existence of a democratic state guided by the rule of law – for the laws that are not enforced are useless – as well as the court orders which are not executed. However, judicial reform is perhaps most difficult because formally it is not subordinate to the government. Nevertheless, some measures for the legal system reform have been included into the Memorandum:

Restructuring of state-owned enterprises (SOE)

Of Ukraine’s nearly 3,400 state-owned enterprises only a little over a half are operating and the majority of those are unprofitable. In 2014 the subsidies to state-owned enterprises (without Naftogas) amounted to 2,5% of GDP, and dividends from them were only to 0,2% of GDP (data from the Memorandum). Therefore, it makes sense to sell the underperforming companies, except for those important for the national security – at the least to reduce state subsidies to loss-making SOE. To remove this “deadweight” from the state budget the following measures are foreseen:

Conclusion

Ukraine implemented the majority of measures foreseen by the Memorandum. However, these reforms are only a necessary minimum that will “keep Ukraine afloat”. The “shock therapy” experience of other Eastern European countries suggests that to switch into a stable economic growth path, one should implement more rapid and sweeping reforms. It would not only improve the life of Ukrainians already in a year or two, but also attract a new wave of foreign investment. Current pace of reforms induces “weariness from Ukraine” syndrome abroad and “nothing has changed” position within the country.