IMF Urges Reform

Economic News

22 Jul 2010
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The International Monetary Fund's (IMF) June 12 report on Ukraine highlighted inflation as a major area of concern, while forecasting steady growth and urging the country to step up reforms.

The report noted Ukraine's significant growth rate with real Gross Domestic Product (GDP) advancing by 7.6% in 2007, around the same level of increase it has averaged since 2000. This is similar to the rate experienced by other former Soviet countries. This growth occurred despite political uncertainties and powerful supply shocks, including the doubling of imported natural gas costs from 2005, and a poor harvest last year.

These shocks, combined with rapidly increasing demand, have contributed to soaring inflation. This figure, which the IMF expects to be 23.2% by the end of 2008, hit 30% in April this year.

At that level, it is scarcely surprising that inflation is a hot topic in Ukraine at the moment, influencing political, economic and social issues and raising heated debate between different parts of government affecting issues ranging from relations with the EU to the country's export policy.

The escalating prices are being driven by several factors. Global inflationary pressures, which are being felt by many emerging markets, include rising fuel and food prices caused in part by political instability, growing demand and shifting consumption patterns. These factors have been exacerbated in Ukraine by strained relations with Russia, from which Ukraine imports much of its hydrocarbon needs.

Nevertheless, many emerging markets are experiencing rapid-demand growth, partly driven by credit expansion and capital inflows. Both are indentified by the IMF as key causes of inflation in Ukraine. Foreign direct investment (FDI), which has topped 5% of GDP three years running and is expected to reach 6.8% in 2008, has helped Ukraine grow and is seen as a sign of confidence in the country, yet at the same time contributing to the country's inflation woes.

The IMF report made it clear that Ukraine's governments have contributed to inflation by following a procyclical fiscal policy. Understandably keen to share the benefits of growth and build up the country's infrastructure - and to appear more generous than other parties given Ukraine's finely balanced political situation - successive administrations have spent above the level of growth. Nominal spending has increased by more than 30% annually over the past five years, as public sector wages, welfare spending and post-Soviet restitution transfers (reparations given to people who lost their savings in state banks during the hyperinflation of the 1990s) have risen.

It is therefore understandable that the IMF directors urged Ukraine to tighten the fiscal stance considerably. The report noted the government's indication that it will do so, and suggests how: "Growth in social transfers will need to be reined in and increases in minimum wages and public sector wages scaled back".

"In addition, further restitutions of depreciated Soviet-era bank deposits should be spread over a number of years," it added. The report also suggested Ukraine's planned shift to a floating exchange rate and an inflation-targeting regime will be key to ensuring effective monetary policy and controlling inflation.

According to the fund's report, the growth of credit has also left the banking system exposed to risk. House prices are high relative to incomes, as a result of increasing mortgage default risk, and lending to unhedged borrowers has risen alarmingly.

Nonetheless, the IMF argues that the risks to Ukraine of the global credit crunch are receding. Most major banks operating in the country have been relatively unscathed, not having invested heavily in collateralised debt obligations (CDOs) and other subprime-backed products. The flip side is that Ukraine may not experience the easing of credit growth that is expected by some analysts to help cool inflationary pressures in other fast-growing markets.

The IMF forecasts a slowdown in economic growth to 5.6% this year and 4.2% in 2009. These rates are still very respectable when seen in the context of a global economic cooling, with Europe in particular expected to grow more slowly over the next two years. However, the fund warned that an expected drop in the price of steel could impact Ukraine's economy, reducing a key source of income and thereby increasing the trade deficit.

The IMF's main recommendation is for Ukraine to step up its programme of pro-business reforms, encouraging business formation and open markets. Encouraging competition could help boost productivity and ease inflationary pressures on supply. The introduction of a floating currency and supply-side reforms could get Ukraine out of its current inflationary spiral while keeping growth strong and sustainable.

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