Executive Directors noted that Ukraine made impressive economic gains during 2000-04, largely as a result of favorable external factors and prudent macroeconomic policies. However, the period since late 2004 has been a turbulent time for Ukraine, involving political uncertainties and major shifts of policy that adversely affected business confidence and investment. In tandem with less favorable external conditions—notably on the terms of trade—and slow progress on structural reforms, this turbulence led to a significant weakening in economic performance in 2005: growth slowed sharply, inflationaccelerated, and the current account surplus halved. Directors welcomed the tentative signs of stabilization of the macroeconomic situation in recent months, IMF report reads.

Directors stressed that a focused effort by the authorities to restore macroeconomic stability and implement structural reforms to complete the transition to a full-fledged market economy will be needed to unleash the economy's significant untapped potential. They considered that Ukraine's medium-term growth outlook is highly favorable, provided the right policies are put into place. Against this background, Directors welcomed the authorities' expressed commitment to fiscal discipline and their progress in implementing a sound fiscal policy in 2005, as well as their initial steps toward greater exchange rate flexibility, their commitment to market-strengthening structural reforms, and their efforts to resolve lingering uncertainty regarding property rights in Ukraine.

Directors observed that the relaxation in the fiscal stance during the run-up to the 2004 presidential elections, together with the large increases in public pensions and wages in the supplementary 2005 budget, contributed significantly to recent inflationary pressures. Directors commended the prudent budget implementation in 2005, noting that the authorities seem broadly on track toward achieving their 2005 general government deficit target, and encouraged the authorities to clear all legitimate VAT refund arrears.

Looking ahead, Directors underscored the need for a fiscal stance that supports disinflation. They urged the authorities to continue to resist strong pressures to raise spending, particularly on social transfers and subsidies, and the fiscal deficit in the run-up to elections in 2006. In line with this target, Directors called on the government to allocate the Kryvorizhstal privatization windfall primarily to debt redemptions that do not add to domestic liquidity, and to resist pressures to re-open the tax loopholes that were closed in the 2005 budget. Such a fiscal strategy would avoid fuelling inflationary pressures, and would increase the authorities' ability to address future contingencies as well as Ukraine's sizeable medium-term fiscal needs, including spending on public infrastructure.

Directors considered the reestablishment of a viable public pension fund to be a key medium-term priority. They noted that the recent massive pension hikes have put the pension fund in a precarious financial position, requiring large budget transfers to cover contribution shortfalls and constraining the authorities' scope for reducing the high tax burden on labor. Directors encouraged the authorities to improve the targeting of the minimum pension subsidy, raise effective retirement ages, and prune privileged pension regimes.

Directors stressed that tighter monetary conditions are needed to help contain inflation, while acknowledging both the limitations of interest rate policy given the absence of a developed monetary transmission mechanism and the need to pay attention to ongoing relative price adjustments. They urged the NBU to reduce further the excess liquidity in the banking sector through a deceleration in money growth. Directors cautioned against the NBU's tentative plans to support bank intermediation by establishing a long-term credit facility, since the NBU's main role should be to provide liquidity rather than long-term credit.

Directors broadly agreed that a gradual shift to increased exchange rate flexibility and inflation targeting would increase the NBU's ability to achieve low and stable inflation, particularly in the context of strong foreign investor interest and a competitive exchange rate. They therefore welcomed the NBU's recent steps toward a more flexible exchange rate regime. However, they stressed the need for the NBU to communicate its policies and intentions more consistently, and to ensure that the appropriate preconditions and technical capacity for a successful policy shift are in place. In this regard, they encouraged the NBU to build on its recent efforts to deregulate the foreign exchange market and further strengthen its operational framework, while developing financial markets. Directors noted Ukraine's low productivity relative to potential, and stressed that competitiveness is best enhanced through productivity-boosting reforms and prudent policies to lower inflation.

Directors welcomed the authorities' vision of sweeping structural reforms. Theyobserved that Ukraine's lagging growth performance since 1992 relative to that of most other transition economies—even accounting for the strong growth rates of 2000-2004—in large part reflects long-standing difficulties in reaching a political consensus to build the more market-friendly institutions that would allow Ukraine to use its resources more efficiently. They stressed, in particular, the importance of reforms to strengthen public administration, fight corruption, and establish a stable and predictable business environment. In this context, Directors welcomed the Ukraine-EU Action Plan, which commits Ukraine to a wide range of structural policy actions and anchors the authorities' reform drive within the process of closer integration with the EU and global markets. They urged the authorities to launch an aggressive campaign to educate the public on the benefits of these reforms.

Directors encouraged a rapid resolution of the debate on past privatizations. The recent presidential memorandum guaranteeing property rights, the government's efforts to clearly and quickly identify those state enterprises to be privatized, the official commitment to fully comply with privatization legislation, and the transparent re-auction of the Kryvorizhstal steel mill were all seen as important steps in the right direction. Directors noted, however, that a credible legislative proposal that outlines the full scope of possible challenges to past privatizations may still be needed to address lingering investor concerns.

Directors welcomed the government's ambitious trade-policy agenda. While the liberalization achieved so far this year constitutes important and tangible progress, Directors considered that early implementation of the remaining measures needed for WTO membership should remain a priority.

Directors viewed the development of domestic capital markets as key in strengthening the monetary policy transmission mechanism and improving risk management and financial intermediation. In line with Fund and World Bank recommendations, the authorities should establish benchmarks for government securities, set up a coherent debt management strategy, and swiftly adopt a Joint Stock Company Law.

Directors welcomed the candid Ex Post Assessment (EPA) of Ukraine's longer-term program engagement with the Fund. They welcomed the EPA's findings that Fund-supported programs were quite effective in supporting macroeconomic stability, and that the continuous policy dialogue between the Fund and the authorities influenced important policy decisions and resulted in a beneficial transfer of knowledge to Ukrainian policy makers. At the same time, Directors noted that Fund-supported programs did not succeed in accelerating the pace of reform of more market-friendly institutions, which ultimately explains Ukraine's relatively poor program compliance. In light of this, theyconcluded that stronger program ownership, rooted in stronger political consensus, would be key to maximize the chances of success of any future program.


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