Ukraine’s Economic Prospects and Priorities for Reform

Martin Raiser, Economic AdvisorWorld Bank

The Macro-Context: Strengths and Risks Strong fundamentals (public

debt 14% of GDP, low fiscal and current account deficits)

Regionally competitive – exchange rate and wages

Improved transparency in corporate sector

WTO accession and EU FTA anchors for reform

Increasing investor interest (FDI up > 5% of GDP)

Huge, under-served domestic market: finance, housing, consumer durables, retail etc.

Rising inflation Growing external

imbalances Credit boom may hide

underlying credit risks Limited degree of export

diversification and vulnerability to terms of trade shock (gas ↑; metals ↓)

Laggard in structural reform and un-tested financial regulatory framework

Political instability and short election cycles ~ populist spending promises

A Risk Fairly Priced?

Gradual re-pricing since May ’07

Reflects shift in perceptions of political risks after dissolution of parliament

Now broadly in line with other BB- sovereigns0

100

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800

2004

M1

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M3

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M5

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M7

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M9

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M11

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M3

2005

M5

2005

M7

2005

M9

2005

M11

2006

M1

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M3

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M5

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M7

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M9

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M11

2007

M1

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M5

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M7

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M9

Philippines Turkey

Ukraine Uruguay

Why Did Macro Performance Hold Up So Well So Far? Underutilized capacity: what goes down must come

up (to some extent) Luck: strong metal price growth offsets gas price

shock; EURO and Ruble strength against the US $ keep real effective exchange rate in check

Clever budgeting: indexation of social payments and wages to CPI, but budget revenues grow in line with GDP deflator – aggregate fiscal impact more restrained than appears from the approved budget

But this benign constellation cannot continue forever => signs of strain and imbalances emerging

Real effective exchange rate remains under control for now

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1997

M01

1997

M06

1997

M11

1998

M04

1998

M09

1999

M02

1999

M07

1999

M12

2000

M05

2000

M10

2001

M03

2001

M08

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M01

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M06

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M11

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M04

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M09

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M02

2004

M07

2004

M12

2005

M05

2005

M10

2006

M03

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M08

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M01

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M06

Real Effective Exchange Rate

GDP still driven by steel prices

0%

2%

4%

6%

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12%

14%

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-20%

0%

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100%

GDP y/y

EU steel y/y

Indexation rules help the budget

-5

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2002 2003 2004 2005 2006 2007F

GDP deflator, % change

CPI, % change eop

But rising imbalances, driven by private sector

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Current Account Balance, % GDP

Fiscal balance, % GDP

The “price” of a quasi-peg

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2002 2003 2004 2005 2006 2007F

GDP deflator, % change

Monetary base, % change

Medium-term Economic Prospects in the Era of Globalization Two World Views:

“De-coupling” and European Convergence => Ukraine inevitably will catch-up and fast because emerging markets are no longer considered risky

The Four-Speed World => only fast reformers in emerging markets benefit long-term from globalization

Ukraine can benefit regardless of which view is right – but only if it reforms

The European Convergence Path

Ukraine can finance 4-6% GDP current account deficit

Ukraine’s dollar wages (US$250 av) roughly in balance with relative GDP level

Medium-term trend is for moderate real exchange rate appreciation – around 1.75% US$ wage growth for every 1% GDP growth

Note: all competitors appreciating at similar if not faster pace!

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Log per capita GDP (Index, EU25=0)

UKR 2000

UKR 2005

UKR 2004

Reform Challenges

Avoid fiscal populism – at this stage in the cycle Ukraine should aim for fiscal surpluses

Improve the Investment Climate and Governance

Improve the quality of public services (health and education)

Increase public investment in infrastructure Reform the legal and judicial system to

protect property and contract rights

Investment climate & Governance: diagnostics Ranked 139th of

175 in Doing Business

Ranked 73th of 131 in WEF Competitiveness

Lagging lower middle income av. in rule of law and ctrl of corruption

Ukraine, % rank

0102030405060708090

2006 2007 2006 2007 2005 2006

Doing Business Competitiveness Index Control of Corruption

Public sector reform and social inclusion: diagnostics Public wage bill ~ 10% of

GDP (incl in kind) – EU 8.8%, CIS 5%

SOE employment 12.5% - EU8 4%, CIS 9%

Public investment 2% of GDP – EU 5%, Asia 8-10%

Little improvement in service quality despite high spending

Poverty is declining but people do not feel their lives have improved

Figure 1: Standard poverty rate in Ukraine: 2000-2005

(In percentage points; using the standard poverty line)

0%

5%

10%

15%

20%

25%

30%

35%

2000 2001 2002 2003 2004 2005

Source: World Bank, computed from the Ukraine Living Conditions Survey

Headc

ount R

ate

Economic reform: the politicians’ dilemma Not much choice when it comes to economic model

All three major parties supported basic market-oriented policy platform during elections

WTO and EU integration are strong anchors Not much hope for immediate quick wins

Strong recent growth record may suggest reforms are not needed

Institutional reforms take longer to bear fruit Not much public support for the long-haul of

structural reforms Redistribution through re-privatization and tighter tax

enforcement sounds attractive but track record suggests that it may not work

Reforms and Performance During Transition

A

B The growth impact of reform

Ukraine may still be at point “A”

Growth path 2

Growth path 1

Inco

me

leve

l

t

The Expectations of the Population EBRD/World Bank “Life in Transition Survey”

42% market economy preferable, 33% planned economy preferable

Only 15% economic situation better than 1989 (CIS 30%, EU8 26%)

80% think state should guarantee employment and low prices (CIS 80%, EU8 65%)

38% dissatisfied with health services (CIS 32%, EU8 25%) Close to 50% completely distrust political institutions (CIS

25%, EU 30%) People expect state to take social responsibility but

have little trust that it will

Economic reform strategy

Focus attention on a few selected issues Use interests of large domestic capital to build

reform coalition -> access to finance & markets requires improved governance and business climate

Focus on public service delivery to build support for economic reform in the population

Try to avoid politicizing reform – remember: there are no alternative economic models

Prioritizing Reforms: World Bank proposals Quick Wins:

Enact a new Law on State Procurement (opposition to reform is small; losses to the budget are huge)

Pass the Joint Stock Company law (key signal to investors) Adopt a realistic 2008 budget (avoid macro-overheating

and adjust people’s expectations while going is good) Opportunities:

Use FTA negotiations to push deregulation agenda EURO 2012 as an opportunity to renew government

infrastructure investment Strengthen financial market regulators while markets are

benign (don’t wait until they are tested by investors)

Prioritizing Reforms: Long Term Economic and Social Reform Challenges Reduce tax burden and reform tax administration =>

new tax code, but existing drafts need more work! Push ahead with pension reform Reform financing of social services as a key to

improve quality Continue raising energy tariffs to full cost recovery

levels Re-launch privatization – competitively and

transparently Reform the land market – start with auctioning urban

real estate competitively Reform public administration and the judiciary

What it all adds up to: WB Base Case (Oct 07) ToT weakening in 2008-2010 – lower growth and

larger external deficits As revenue growth declines, fiscal policy will tighten

to prevent widening deficits Ukraine retains access to international capital

markets and investment-led growth continues (at somewhat lower rates)

Reforms will continue at gradual, sometimes inconsistent pace – faster growth in 09-10 if reforms accelerate

Quarterly updates on: www.worldbank.org.ua

WB Base Case