New Funding Deal Gives Kiev Added Incentive to Enact Reforms

Op-ed in Financial Times

February 15, 2015

There has been little good economic news to come out of Ukraine over the past year. The war in the east of the country brings ever greater losses, undermining the stability of the country as a whole and fuelling tensions between Russia and the West. The economic fallout has been dramatic. Last year output fell by 7 to 7.5 percent, of which 5 percent was caused by the war. The national currency, the hryvnia, has fallen by two-thirds in a year. The country was, until very recently, on the verge of financial meltdown.

The unveiling on Thursday of a new agreement between Ukraine and the International Monetary Fund (IMF) came as a relief. Christine Lagarde, IMF managing director, announced that Ukraine would receive a four-year credit program of $40 billion, of which the fund would provide $17.5 billion. The European Union has committed only $2.5 billion and the United States $2 billion. The World Bank and other international financial institutions can add a couple of billions of dollars. The rest of the funding is tenuous. The Ukrainian government hopes to get relief from its bondholders amounting to $14 billion.

Overall, the program appears underfunded. The European Union and the United States will need to come up with more funding in due course.

Overall, the program appears underfunded. The European Union and the United States will need to come up with more funding in due course. That said, we should not overlook the importance of the fact that an agreement was reached so Ukraine can receive some financial assistance. On February 1, Ukraine's international reserves had fallen to a paltry $6.4 billion, only one month of imports, causing the exchange rate to plummet further. The aim is now to raise reserves to $17 billion, corresponding to three months of imports, by the end of the year.

The plunging exchange rate has brought down many banks. Last year, the National Bank of Ukraine put 32 out of the country's 180 banks under administration. More are likely to go under this year. Fortunately, the central bank has declared that only eight are systemically important. Even so, substantial bank recapitalization will be needed.

Ms. Lagarde praised the program agreed with the Ukrainian government as "ambitious" and "tough." But she added that "it is not without risk." The obvious big risk is the war. Coincidentally, just before Ms. Lagarde made her announcement, the warring parties signed a new ceasefire agreement in Minsk, the Belarusian capital. Whether that will halt the conflict remains uncertain. What is known is that neither side has any immediate plan to scale back their military capabilities. The Kiev government, for example, intends to increase defense spending from 1.6 percent of GDP last year to 5.2 percent this year.

Arseniy Yatsenyuk, Ukraine's prime minister, insists that the reform program is aimed at re-establishing growth. The measures outlined are many and significant. The budget deficit is supposed to decline to 4 percent of GDP—compared with 11 percent last year—but that is presumably excluding bank recapitalization, which could boost the real budget deficit to 8 percent of GDP.

The most important reform will be the gradual elimination of the subsidies for gas, electricity, and heating. These have fuelled corruption, and their elimination will stimulate energy savings and promote domestic energy production. The IMF claims that most of the price adjustments from the elimination of the subsidies will take place early on, which will help in cleaning up the corrupt gas market. Even so, Ukraine and the IMF only aim to eliminate all subsidies by April 2017. Sensibly, the government and the Fund have agreed on substantial social support for the poor to mitigate the effects of increased energy prices.

Apart from reduced energy subsidies, the biggest budget savings are supposed to come from Ukraine's very large pension expenditure. At last, generous "special pensions" to the former elite are meant to be abolished. The overall pension bill will be reduced through a freezing of pension payouts until December—this will hit the poor hard, as annual inflation is currently 25 percent. It would be better to raise the very low retirement age of 55 for women and 60 for men.

The structural reforms look impressive and many are under way. On Thursday, the Ukrainian parliament adopted a law on deregulation of businesses, abolishing all kinds of cumbersome red tape. Another measure now being pursued is the improvement of corporate governance at the large state-owned companies, including the state oil and gas company Naftogaz.

Other legislation on the agenda includes anticorruption and judiciary reforms. Several anticorruption laws were adopted last October, but little has been implemented as yet. State administration reform is much discussed, and many government agencies have been slimmed down, but a modern administration needs to be introduced. Reforms to render education and health care more efficient are also proceeding.

To receive the IMF funding, the Ukrainian parliament will need to act on all the Fund's preconditions to disbursement. Fortunately, the government appears to have a sufficient majority to do what is required.