1 – Ukraine’s fiscal arithmetic
BSSB.BE http://www.bruegel.org 25.06.2015
Ukraine is struggling with both external aggression and the dramatically poor shape of its economy. The pace of political and institutional change has so far been too slow to prevent the deepening of the fiscal and balance-of-payments crises, while business confidence continues to be undermined.
- Unfortunately, the 2015 International Monetary Fund Extended Fund Facility programme repeats many weaknesses of the 2014 IMF Stand-by Arrangement: slow pace of fiscal adjustment especially in the two key areas of energy prices and pension entitlements, lack of a comprehensive structural and institutional reform vision, and insufficient external financing to close the expected balance-of-payments gap and allow Ukraine to return to debt sustainability in the long term.
- The reform process in Ukraine must be accelerated and better managed. A frontloaded fiscal adjustment is necessary to stabilise public finances and the balance-of-payments, and to bring inflation down. The international community, especially the European Union, should offer sufficient financial aid backed by strong conditionality, technical assistance and support to Ukraine’s independence and territorial integrity.
The main issues, as highlighted by Dabrowski (2014), were:
1 Apart from numerous structural and institutional weaknesses, deep macroeconomic fiscal and balance-of-payments) imbalances posed the main threat to the Ukrainian economy in spring 2014; they required an immediate and bold response.
2 Given the size of macroeconomic imbalances and the high probability of further adverse shocks (which indeed happened), there was no time for gradual adjustment. The insufficient adjustment package brought with it the risk of widening imbalances and a crisis of confidence – unfortunately, this scenario materialised.
3 The two areas that required immediate and major adjustments were natural gas subsidies and oversized public pension entitlements.
FROM WEAK PROGRAMME TO BALANCE-OFPAYMENTS CRISIS
The dramatic developments in the second half of 2014 painfully exposed the overly optimistic macroeconomic projections of the SBA. Ukraine’s GDP declined by 6.9 percent in 2014 instead of the forecast drop of 5.2 percent, as the conflict in Donbass escalated (see Havlik, 2014, for its consequences).
The slow pace of reform meant no real improvement in the business climate or business confidence in regions not affected directly by war2. On the other hand, the general government cash deficit in 2014 was smaller than projected: 4.6 percent of GDP instead of 5.2 percent of GDP, marking a small improvement in comparison with 2013 when it amounted to 4.8 percent of GDP.
Here, paradoxically, the conflict in Donbass provided some sort of relief: the earlier scheduled fiscal transfers to the region were suspended.
However, if the government of Ukraine manages to regain control over the conflict areas, it will have to pay arrears to pensioners. The 2014 fiscal picture looked much worse when one added in the quasi-fiscal deficit of Naftogaz. The consolidated deficit exploded from 6.7 percent of GDP in 2013 to 10.3 percent in 2014 (instead of the forecast 8.5 percent).
This clearly confirmed insufficient adjustment of administrative gas tariffs for households and heating utilities in 2014, which increasingly lagged behind the actual import prices (which Naftogaz had to pay to Gazprom and other gas suppliers).
The unfavourable fiscal developments, only partial improvement in the current account (from -9.2 percent of GDP in 2013 to -4.8 percent of GDP in 2014) and intensive capital outflows meant that the external financing envisaged in the 2014 SBA was insufficient to avoid a balance-of-payment crisis.
The National Bank of Ukraine’s (NBU) foreign exchange reserves started to decrease rapidly in Q4 2014, reaching the critically low level of $4.7 billion in February 2015 (Figure 1 on the next page).
As result, the hryvnia rapidly depreciated, despite various capital and current account control measures adopted by the NBU (Figure 2).
While market panics were partly triggered by the new escalation of the Donbass conflict in January and February 2015 (before the signing of the second Minsk ceasefire agreement on 12 February 2015) and by contagion effects from the currency crisis in Russia and other Commonwealth of Independent States countries (Dabrowski, 2015), it was Ukraine’s weak macroeconomic fundamentals that played the decisive role.
IS HISTORY REPEATING ITSELF? THE NEW RESCUE PROGRAMME AND ITS WEAKNESSES
To arrest market panics and avoid even deeper macroeconomic crisis, the international community has rushed a new rescue package for Ukraine.
As before, the IMF programme will play a central role. The four-year Extended Fund Facility (EFF) programme of $17.5 billion approved on 11 March 2015 replaces the 2014 SBA4. The overall amount of the EFF remains roughly the same as the 2014 SBA, but offers Ukraine longer maturity.
The amounts pledged by other multilateral and unilateral donors to supplement the EFF are a bit higher than a year ago.
The approval of the EFF, immediate disbursement of its first tranche of $5 billion (including $2.7 billion of budget support) and decisions of other donors to join the aid package have allowed a partial replenishing of the NBU’s foreign exchange reserves, calming the currency market and strengthening the hryvnia (see Figure 2).
Up to the end of 2015, the entire IMF disbursement should amount to $10 billion, assuming positive results from the debt-restructuring negotiation and subsequent reviews of programme implementation.
However, the question of whether the new programme is sufficient to arrest entirely the crisis and address its roots in a sustainable way remains open. As with the SBA, two major doubts are: (i) weak conditionality, which allows for the continuation of the strategy of gradual fiscal adjustment and slow structural and institutional reforms; (ii) the insufficient size of financial aid to close fiscal and balance-of-payments gaps, especially in a medium-to-long-term perspective.
Needless to say, these two issues are closely related: deeper upfront fiscal adjustment would enable faster reduction of public-sector borrowing requirements and make it easier to close the balance-of-payments gap.
FISCAL GRADUALISM AND GAS TARIFFS
According to the EFF programme (IMF 2015 Table 1, p. 47), in 2015 the general government deficit will amount to 4.2 percent of GDP, a modest decrease from its 2014 level (4.6 percent of GDP).
Gradual deficit reduction will continue in the subsequent years (Figure 3) – to 3.7 percent of GDP in 2016, 3.1 percent in 2017, 2.6 percent in 2018, 2.4 percent in 2019 and 2.2 percent of GDP in 2020.
Apart from the ‘official’ general government deficit, one should add the quasi-fiscal deficit of Naftogaz: 3.2 percent of GDP in 2015 (which gives 7.2 percent of GDP total) and 0.2 percent of GDP in 2016. After 2016, Naftogaz’s operational deficit should disappear.
Naftogaz’s losses will continue in 2015-16 because of the delay in the adjustment of household gas and heating tariffs to the cost-recovery level (this will happen only in 2017).
Nevertheless, because of the effects of abrupt hryvnia devaluation in 2014-15 (Figure 2), the tariffs increase on 1 April 2015 had to be steeper than the 2014 increase, by 284 percent and 67 percent, on average, respectively.
As before, gas tariffs remain differentiated depending on the volume of gas consumed: 3,600 UAH for 1 cubic metre in the winter period (October-April) if monthly consumption is below 200 cubic metres, and 7,188 UAH/cubic metre for monthly consumption above 200 cubic metres and in the summer period (May-September)5.
Author: Marek Dabrowski
*This is the first part of the article. More information You will find in the next part.