Moreover, the 2006 parliamentary election and the planned transfer of greater powers to the legislature will bring significant distractions. Even after the election, the new pro-government majority in parliament will be unstable.
The Economist Intelligence Unit expects real GDP growth to decelerate to 4.3% in 2005, before recovering to 5% in 2006. Year-end inflation is forecast to slow to 9% by 2006.
The currency will remain broadly stable in nominal terms against the US dollar in 2005-2006, with only a slight appreciation expected. The current-account surplus reached a record high in 2004, but will decline in 2005-2006 as export growth decelerates.
President of Ukraine, Viktor Yushchenko, and Ukraine's Prime Minister, Yulia Timoshenko, are expected to continue to co-operate with one another during the rest of the 2005-06 forecast period. The risk of political instability and inefficacy will nevertheless remain high.
Ukraine's new leadership represents an uneasy coalition of heterogeneous political forces that frequently disagree over policy and the division of responsibilities. These differences will become harder to contain as the March 2006 parliamentary election approaches, and as the debate heats up over the implementation of constitutional changes that are scheduled to come into effect at the start of 2006.
Moreover, the pro-government majority that is expected in parliament after the election is unlikely to be cohesive or to work smoothly with the executive branch.
Ukraine's relationship with the West will be much better than it was during the tenure of Yushchenko's predecessor, Leonid Kuchma.
Despite the recent rejection of the EU's proposed constitutional treaty by French and Dutch voters--which has produced a backlash against enlargement--Ukraine will continue to priorities its relationship with the EU and push ahead with implementing the commitments contained in the EU-Ukraine Action Plan signed earlier in 2005.
However, there is now more of a risk that the plan will be a less effective policy anchor than had been expected before the French and Dutch referendums.
The election of Viktor Yushchenko as president in late 2004, and the appointment of a pro-reform cabinet, has given new impetus to the process of economic liberalization.
We continue to expect greater progress on crucial issues than in the past: privatization sales are likely to become more transparent; fiscal policy will be rationalized; energy sector reform will resume; and a more concerted effort will be made to bring businesses out of the shadow economy.
However, this forecast comes with a number of caveats. Many of these reforms are unlikely to begin in earnest until after the March 2006 parliamentary election; even then, they will suffer because of a lack of cohesion within the executive branch and within the expected pro-government majority in parliament.
Moreover, the government's performance to date shows that conflicting priorities and limited capacity to generate and implement effective policies will, on occasion, hamper reform. Policy initiatives continue to be badly prioritized and co-coordinated, while legislation is often poorly thought out. Sometimes, the government will put other goals ahead of its interest in economic liberalization.
With economic policy being tightened in a number of countries and high levels of debt weighing on consumers, companies and governments, the global economy is expected to continue to slow.
We forecast a deceleration in world GDP growth on purchasing power parity (PPP) basis, from an estimated 5.1% in 2004 to 4.3% in 2005 and 4.1% in 2006.
A fall in oil prices later in 2005 and in 2006, combined with real appreciation of the exchange rate of the RUR and slower growth of Russian oil output, will bring down real GDP growth in Russia, Ukraine's largest export market. The prospects for Ukraine's terms of trade are not particularly favorable.
Ukraine will benefit from a modest reduction in the cost of oil imports in 2006, but prices will still remain high, at over $50 per barrel. Moreover, prices for steel, which account for almost 40% of Ukraine's export earnings, have been falling since late 2004 and are expected to continue to do so until early next year.
Steel prices are forecast to be down by over 30% year on year in early 2006, before then recovering somewhat. Average steel prices for 2006 as a whole are likely to be 10% below 2005 prices.
Real GDP growth continues to decelerate rapidly. The economy expanded by just 2.4% year on year in July, and cumulatively by 3.7% year on year in January-July. The slowdown reflects less buoyant external conditions, particularly for the steel sector, as well as sluggish investment trends, attributable to political instability and concerns over the government's review of previous privatizations.
This review has been both controversial and protracted, and any improvement in investment in the second half of 2005 is expected to be modest. Real GDP growth for the year as a whole is now forecast at 4.3%.
Consumer price inflation stood at 14.8% year on year in July 2005. Inflation is expected to ease to below 12% by end-2005, but will still remain high owing to sharply rising incomes.
An increase in administered prices, which were generally kept down in 2004 because of the approach of the presidential election, will also add to inflation--although the government will still try to contain any price increases, in anticipation of the March 2006 parliamentary election.
The narrowing trade surplus and slight currency strengthening expected will nevertheless contain the pressure on prices by permitting a tighter monetary policy. Moreover, the government's fiscal policy in the second half of 2005 will be considerably more prudent than it was in the year-earlier period, when expenditure surged in advance of the presidential vote.
Nevertheless, the government is expected to post budgetary deficits in both 2005 and 2006. Combined with high oil prices and a rise in the gas price paid to Russia, as well as further large foreign-currency inflows expected as a result of the current-account surplus, inflation is only likely to fall to around 9% year on year at end-2006.
During the past three years the NBU had often intervened on the interbank market to keep the hrivna's exchange rate fixed against the US dollar. The central bank signaled a shift in policy in April 2005, when it allowed the hrivna to appreciate by 3%.
So far this has proved to be a one-off attempt by the NBU to mitigate risks inherent in the continued large-scale inflows of export earnings. We believe that the NBU will not permit significantly greater appreciation, and will continue to intervene to soak up excess foreign currency when necessary.
However, recent personnel changes at the NBU have increased the risks to this forecast, and stronger than expected currency appreciation is now a greater possibility than before. Although the economy is slowing, the opposite risk--of currency weakening--is still limited, in view of the strong current-account inflows and concerns over inflation.
With higher incomes and oil prices pushing up import expenditure, and the steel sector suffering from a less favorable external environment, Ukraine's current-account surplus is expected to fall to around 5.3% of GDP in 2005. Preliminary data already show the trade in goods surplus in January-June narrowing to just over $380 million, down by almost $2 milliard compared with the year-earlier period.
The current-account surplus is set to narrow further, to around 4.2% of GDP, in 2006. This will reflect lower annual average steel prices, and continued strong import growth linked to a further rise in incomes and a pick-up in investment. However, the current-account surplus in 2006 is now likely to be larger than previously forecast, as the outlook on the steel market appears set to improve.
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