27th March 2014

Eastern promises: The IMF-Ukraine bailout

– while the current situation is very critical, it also provides a great opportunity for sweeping reform

by Ricardo Giucci and Georg Zachmann on 27th March 2014

The International Monetary Fund has announced a $14-18 billion rescue package for Ukraine. The country has considerable economic potential. It possesses the second-largest area of fertile soils in Europe after Russia, important natural gas resources, and has a significant industrial backbone, important transit routes and a well-educated population of 45 million. Nevertheless, Ukraine is in a dire economic situation. In 2013, its twin deficits – which have persisted for several years – reached a new record. The budget deficit increased to about 8 percent of GDP and the current account deficit reached almost 9 percent of GDP. Economic growth has been practically zero in the last two years. Access to foreign capital markets is closed. And the hryvnia devalued by about 20 percent in the first two months of this year.

But how did Ukraine get there? When Yanukovich became president in 2010, his administration envisaged a project of fiscal consolidation and structural reform. The budget deficit halved between 2009 and 2011 and a progressive tax-code reform was adopted. Access to financial markets allowed his administration to issue Eurobonds. But ahead of the 2012 parliamentary elections, the government moved from long-term economic stabilisation to short-term populism. Even before the elections, from 2010 to 2012, the administration shied away from the main steps needed to tackle macro-economic imbalances: adjusting domestic energy prices and allowing for more exchange rate flexibility. In an attempt to demonstrate strength and stability, the hryvnia was fixed at 8 hryvnia per dollar by a non-independent National Bank. As a consequence, the hryvnia appreciated strongly between 2011 and 2014 compared to other currencies in the region, for example by 10 percent compared to the Polish zloty or 20 percent compared to the Turkish lira. As a result of unfavourable agreements with Russia, gas import prices increased from about $250 per thousand cubic meters in 2010 to about $400 in 2013, but gas and heat tariffs for the population were not adjusted accordingly. This tariff deficit was ultimately financed from the state budget and amounted to about 6 percent of GDP per year.

The clearly unsustainable macro-economic policy of the Yanukovich administration implied first, that Ukraine was unable to issue fresh debt on the international financial market from May 2013. Cut off from financial markets, Ukraine tried to secure an IMF programme. But as the government was unwilling to tackle the exchange rate and energy price issues, the talks stalled. By that stage, in late 2013, Russia was the only creditor that proposed financing for Ukraine without requiring unpopular measures until the regular presidential elections in 2015. But the 30 percent gas price discount and the $15 billion credit offered by Russia would have only increased the adjustment need after the elections. Furthermore, the population was highly suspicious that there was a political price for this ‘gift’ that was supposed to assist Yanukovich’s re-election. Since then, of course, the deal with Russia has fallen apart and the macroeconomic crisis is acute again.

The National Bank of Ukraine has been forced to allow the hryvnia to devalue substantially and introduce capital controls. The banking sector is under severe stress. The devaluation, deposit withdrawals and an expected increase in non-performing loans have caused a blow to the balance sheets of several banks, which might have to be recapitalised. But worse is to come. The government has to service $9.7 billion in foreign-currency debt in 2014. If Russia returns from the preferential gas price of $268 granted in December last year to the more than $400 it demanded in 2013, it will imply a 2 percent of GDP hike in the current account deficit. If Russia imposes trade restrictions, the short-term impacts on Ukraine could be severe. Switching from the current free trade regime to most-favoured-nation tariffs would imply a loss of 1.7 percent of GDP. Non-tariff measures, as applied in August last year, could further deteriorate the situation.

However, it is not impossible for Ukraine to overcome its macroeconomic crisis. In the context of an IMF programme, the country could significantly reduce the twin deficits in the medium term, accompanied by the necessary funds to finance the deficits in the short term. Additional funds from the EU and the USA are certainly welcome. A key issue in this respect is the price of energy for the population, which in some cases covers only 16% of the import and distribution costs. A gradual but decisive increase in energy prices is a necessary condition for fiscal consolidation in the short term, but also for current account sustainability in the medium term. Such a move would also reduce dependence on Russia and decrease the widespread corruption in the energy sector. But stabilisation of the banking sector is also crucial, including liquidity support and recapitalisation for systemic banks. A strong push for institutional reform should also be initiated, including the strengthening of key institutions such as the National Bank and the energy regulator, in order to avoid the mistakes of the recent past. Finally, decisive structural reforms are needed to reinstall the rule of law, improve tax administration, reduce bureaucracy and fight corruption.

One might wonder if it is realistic to achieve these multiple tasks in the short- and medium terms. In fact, while the current situation is very critical, it also provides a great opportunity for sweeping reform. First, it became evident to large parts of the population that the “old ways” according to which the country has been managed no longer work. The country needs a new economic management approach. Second, members of the new government have put aside personal interests and decided to take over Fresponsibility, despite risking becoming unpopular. They are ready to change the country and create a better future for the Ukrainian people. Third, the EU and the USA are ready to support the country in this difficult situation, both in technical and financial terms. Seen from this angle, Ukraine might have a unique opportunity for decisive reform. The German Advisory Group in Ukraine, of which the two authors are members, just published its ‚Government Reform Agenda‘