IMF to the Rescue

Economic News

22 Jul 2010
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The IMF has approved a rescue package for Ukraine designed to "help the government strengthen confidence and restore economic stability," as the country's economy has been seriously hit by the global financial crisis, specifically by the credit crunch and falling commodity prices.

On November 5, the IMF's executive board approved a $16.4bn loan to Ukraine, with much of the package going toward "pre-emptive" recapitalisation of banks. The move followed the October 13 announcement that the National Bank of Ukraine (NBU) was instituting a series of measures designed to shore up the banking system, extending deposit guarantees and limiting withdrawal rights, having already extended $1.1bn of emergency funding to troubled institutions.

The central bank has also been intervening in the money markets in an attempt to protect the country's currency, the hryvnia, which fell to a low of 7.1250 to the dollar on October 29, recording its largest single-day fall in ten years.

Despite the NBU's best efforts, as October wore on it became increasingly apparent that Ukraine would require external help to prevent its economy from sinking into a deeper crisis. Negotiations with the IMF and Ukrainian authorities began mid-month and by October 26, a rescue package had been agreed upon.

The international financial crisis has hit Ukraine swiftly, after several years of robust growth (the economy grew by 7.6% last year, according to the IMF). While the speed of the deterioration from boom to bail-out may have been unexpected, the fact that Ukraine is suffering more than other emerging market peers is not entirely unexpected. The change in the global economic climate has exposed some long-term weaknesses in the country's economy.

As the IMF stated, until as recently as this summer, "Ukraine was riding on the coattails of a global economy that had an insatiable demand for steel", which makes up 40% of the country's exports and has brought in annual revenues of $17bn.

The government passed on many of the gains through "generous incomes policies", which, coupled with capital inflows (including from foreign direct investment), fuelled a dangerous expansion in consumption. Inflation topped 30% in the year to April 2008, and the IMF estimates that wages have been increased by 30-40%, while the import bill has risen at an annual rate of 50-60%.

With the onset of the global financial crisis, external sources of capital for the country's banks and companies have frozen, with many lenders comparatively more wary of Ukraine than other emerging markets due to the uncertain political situation, which has been characterised by bitter quarrels between President Viktor Yushchenko and Prime Minister Yulia Tymoshenko. Furthermore, the price of steel has dropped dramatically, by two-thirds by some measures, suddenly undermining another source of foreign currency as well as the government's budgetary position. Wage and import growth have become dangerously unsustainable.

"The Ukrainian economy, especially the banking system, is experiencing considerable stress," the IMF statement said. "Falling prices for Ukraine's major export, steel, have led to a substantial deterioration in Ukraine's current account outlook. This terms-of-trade shock, along with existing vulnerabilities - high inflation, relatively low foreign exchange reserves compared with short-term external debt, significant exposure of banks to foreign funding, balance sheet mismatches, and a weak underlying fiscal position - interacted with the drying up of liquidity caused by the international financial crisis and led to a significant slowdown in capital inflows."

Hence the hasty deal with the IMF. The conditions are less tight than previous rescue packages for Ukraine and other emerging market countries, reflecting the IMF's view of the seriousness of the situation, as well as its possible reluctance to become embroiled in the details of policy making.

Nonetheless, the package comes as part of a two-year "standby agreement," which will require Ukraine to tighten monetary policy and encourage more "prudent" fiscal behaviour. Furthermore, there should be a shift towards a more flexible exchange rate policy - for several years, the NBU has kept the hyrvnia within a rate band around the dollar, and its recent moves to allow a more liberal floatation seem likely to be formalised. The IMF states that a more flexible currency should act as "a shock absorber" for the economy.

These policies are likely to cause some short-term pain, as the Ukrainian government will not be able to build on its own stimulus package at a time of economic slowdown. Furthermore, subsidies are likely to be cut, and the public sector may be trimmed. To balance this, the IMF deal has provisioned that an additional 0.8% of GDP be set aside for social spending to protect the most vulnerable, while the government, with the IMF's blessing, has given notice that this could be increased.

Given the seriousness of the crisis and the need for a more responsible long-term fiscal and monetary policy, as well as structural reform, few are arguing against the deal. Indeed, it could be argued that the need for reform is so pressing that the IMF should have attached more strings to the bail-out.

Nonetheless, Murilo Portugal, deputy managing director for the IMF, has said that he has "confidence that the programme will succeed in stabilising economic and financial conditions".

"The road ahead is difficult," Ceyla Pazarbasioglu, mission chief for the IMF in Kiev, told the international press. "But Ukraine has enormous potential and should be able to reach it with consistent implementation of adequate policies."

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