Ukraine Has Escaped Financial Meltdown—But Challenges Lie Ahead

March 4, 2015 4:15 PM

 

The desperate financial crisis that Ukraine faced in February has been lifted temporarily by recent positive actions in Kiev. Ukraine is far from out of the woods, but it has bought time to undertake the reforms that its new government appears committed to carrying out. The most important recent development occurred in the late evening of March 2, when the Ukrainian parliament enacted the eight laws required by the International Monetary Fund (IMF) as the price for its assistance. On March 11, the IMF Executive Board can approve the 4-year Extended Fund Facility that it concluded with the Ukrainian government on February 12. This program is supposed to offer Ukraine $40 billion of credits, of which $17.5 billion is to come from the IMF itself. This may allow Ukraine to escape the doldrums of financial meltdown, where it has spent January and February.

Ukraine's crisis had been precipitated by several factors. In January, its exchange rate plummeted, its annualized inflation rose to 28.5 percent, and industrial production plunged by 21 percent. Crucially, Ukraine's reserves fell as low as $6.4 billion at the end of January. An important cause was that at the end of October, the European Union insisted that Ukraine pay $3.1 billion in disputed arrears to Gazprom in late 2014 so that Gazprom would not cut deliveries to EU countries. The European Union provided no financing for this action, however. With reserves equal to only one month's worth of imports, no currency stability is possible. The hryvnia plunged in late January, which led to panic buying in Ukrainian shops, peaking on February 23.

The conclusion of the IMF agreement last month was not sufficient to stop the panic. Three additional measures were needed. First, the government had to cut the budget deficit. Second, the IMF had to provide substantial financing. Third, the National Bank of Ukraine (NBU) needed to tighten monetary policy. Now the Ukrainian government and the NBU have done their part, and the IMF is likely to do its part as well. In addition, substantial structural reforms that are underway, such as deregulation and improved governance of state corporations, should facilitate a return to economic growth next year.

The most important law adopted by the parliament on March 2 was the budget amendments. The official state budget deficit is supposed to be limited to 4.1 percent of GDP, but the consolidated state budget deficit, which also includes recapitalization of banks and the state oil and gas company Naftogaz, is expected to be 8.8 percent of GDP, compared with 13.5 percent last year. A large majority of 273 deputies voted for this law, more than the 226 required for passage.

The next significant law was the increase in the energy prices. This law embodies a complex scheme with many different price increases to be imposed at various times for different customers. It calls for the hikes to be frontloaded and for all price subsidizies to be abolished by April 2017. The heavily-subsidized gas price for households is to rise by 280 percent in April. The average household electricity tariff is to increase 3.5 times in five semiannual steps over the course of two years. Similarly, heating subsidies are to be phased out. This law constitutes the most important measure ever enacted against corruption in Ukraine, because most big fortunes in the country have been made on buying gas at a low state-controlled price and sold at a high market price.

Politically, the most sensitive law adjusts Ukraine's expensive pensions, which cost 16 percent of GDP last year. The benefits of working pensioners have been reduced by 15 percent. A gradual increase of the retirement age for women from 57 to 60 has been reinstated. A longer period of work is required for obtaining a full pension, and the base for the calculation of pensions has been reduced. The savings from these limited changes will be significant. This law was so controversial that it went through with only 238 votes, and only on the fourth attempt.

Other laws amended various tax provisions, mainly by raising the royalties on state gas producers that benefit from higher gas prices and on iron ore producers. Another new law forces banks to reveal their beneficiary owners and to rein in the common practice of large lending to the actual owners.

In the wake of these decisions, the National Bank of Ukraine (NBU) tightened its monetary policy considerably. It raised its key interest rate from 19.5 percent a year to 30 percent a year, slightly above the inflation rate. It also hiked mandatory reserve requirements in hryvnia for commercial banks, a step designed to hinder excessive liquidity flowing into the foreign exchange market, and it extended its requirement that exporters exchange three quarters of their foreign exchange earning into hryvnia. The NBU continued its aggressive closure of banks, taking over three banks, included the fourth biggest, the long-troubled Ukrainian-owned Delta Bank.

The two key policymakers who designed the legislation and heralded it through parliament were Prime Minister Arseniy Yatsenyuk and Finance Minister Natalie Jaresko. President Petro Poroshenko's bloc in parliament cooperated smoothly, while the three smaller coalition partners offered populist resistance, especially with regard to the pension legislation.

Accordingly, the IMF is set to approve its program with Ukraine on March 11 and its first disbursement should go out the next day. An informed guess is that it will amount to $5 billion, but there has been speculation that the disbursement might be even larger, which would help Ukraine expand its reserves quickly and stabilize its currency. Yatsenyuk has stated that $3.5 billion of additional financing from other donors is ready to come as soon as the IMF approves its program with Ukraine.

As a result of these reforms, the hryvnia started rising sharply in the last week of February, recovering from 40 hryvnia per dollar on the black market to currently 26 hryvnia per dollar. Further rises are likely as IMF and related financing arrives. Three great risks remain as Ukraine seeks to make further progress. The most important is further Russian military aggression. A second risk is that the international financing turns out to be insufficient. Hopefully, a reprofiling of the outstanding foreign debt and a tentatively planned donor meeting in April will reduce that concern. Finally, the Ukrainian government needs to implement its bravely adopted legislation.

Anders Åslund is the author of the forthcoming book Ukraine: What Went Wrong and How to Fix It.