Ukraine: Recent Economic Challenges and Trends

UKRAINE: RECENT ECONOMIC CHALLENGES AND TRENDS

Background and recent developments Ukraine’s economic transition has presented many challenges. In the course of its brief post-independence history, the country endured hyperinflation,currency crises, a decade-long output contraction, and substantial social hardship, not least because the high inflation hurt the most vulnerable groups. However, the economy gradually stabilized, and the recovery that started in late 1999 has exceeded expectations.

This rebound has been mostly led by export expansion-initially driven by a significant real exchange rate depreciation and the resumption of growth in Russia-and largely based on filling idle capacities in the industrial sector. Growth has been supported by improved fiscal discipline, a sharp reduction in non-monetary transactions such as offsets and barter, and by progress in agriculture, and, to a more limited extent, the energy sector.

In 2002, macroeconomic performance stayed its positive course, despite considerable weakness in global economic conditions. GDP growth slowed somewhat but remained robust at over 4 percent, supported by domestic demand but also by a pick-up in exports toward the end of the year. Consumer price inflation continued to decline and was near zero in 2002, partly reflecting a drop in food prices.

The current account surplus surged to some 6 percent of GDP on account of net trade, service and transfer receipts, helping international reserves increase further to 2? months of imports by the end of the year. The foreign exchange inflows have allowed continued remonetization of the economy, with little inflationary pressure so far. The fiscal stance remained prudent in 2002, indeed it was tightened, as non-wage spending had to be curtailed well below budgeted levels following a large shortfall in privatization proceeds, resulting in a first-ever consolidated surplus of ? percent of GDP.

These macroeconomic gains have not yet been adequately supported by deeper structural reforms, the progress of which has remained uneven. On the positive side, Treasury management was strengthened and tax administration reforms continued. However, VAT refund arrears continued to increase, new tax preferences were granted, and privatization nearly stalled. The energy sector, notwithstanding growing cash collection rates, accounted for most of the sizable increase in tax arrears in 2002. There were some advances in financial sector restructuring, but the ongoing remonetization has also supported a credit boom by commercial banks, which may undermine capital adequacy and increase credit risk in the event of a significant slowdown in economic growth. The business environment has shown modest signs of improvement, but it still remains one of the worst in Europe and hence a significant drag on growth and investment.

ECONOMIC PROSPECTS

With prudent macroeconomic policies and no slowdown in structural reform, the near-term outlook should be favorable. Real GDP may grow by about 4 percent this year, in part thanks to continued demand for traditional Ukrainian products in world markets. Inflation should pick up slightly in 2003, reflecting the likely reversal of one-off factors-such as the very good harvests-that prevailed in 2002. The current account is expected to remain in large surplus, although some deterioration in the trade balance is possible. Gross international reserves will continue to increase.

The assessment of Ukraine’s external position, though favorable so far, is somewhat uncertain given the large disparity between the main competitiveness indicators. The CPI-based real effective exchange rate is near its ten-year average and about 25 percent below its peak in 1997. The relatively large current account surpluses also suggest that the exchange rate is not overvalued, although a more detailed analysis is needed in light of the very rapid wage growth in recent years. Near-term export prospects are, nonetheless, doubtful, especially for metals (about 40 percent of total exports), which face anti-dumping restrictions in several markets. Imports could rise more rapidly than projected if oil prices exceed current forecasts, although this effect will likely be mitigated by more rapid growth in Russia.

However, while the short-term outlook is favorable, there are significant vulnerabilities over the medium term quite apart from risks associated with higher oil prices.

Excerpt from a presentation by John Odling-Smee, Director of the European II Department Interntional Monetary Fund (IMF), Washington, D.C., presented at National University "Kyiv-Mohyla Academy" Kyiv, Ukraine, Monday, 21.02.2003