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  • 31.01.2018

    Ukraine in 2017: Macroeconomic review

    * This article was first published in the full version of the Monthly Economic Monitor Ukraine 1 (207) of January 2018. It had been available for subscribers only.

    Year_review_2017_eng

     

    2017 was a year of hopes that had a mixed record in coming true. In international relations, there were a number of successes including visa-free regime for short-term travels of Ukrainians to the EU, the introduction of free trade area with Canada and the full implementation of Association Agreement between Ukraine and the EU. Ukraine was able to return to the international capital markets for the first time since 2013. The Parliament finally approved the healthcare reform law, which means that the reform of primary healthcare starts in 2018. The approval of the Education Law became controversial. It means important changes in the status of education establishments and modernization of education curriculum, but its provision on the language of teaching was heavily criticised by Hungary and Poland. Approved pension reform only partially reflected the obligation of the country in the framework of the IMF program as higher requirements of working record were complemented by higher than previously expected increases in pensions. At the same time, the Government failed to approve the land market reform. Instead, the Parliament extended the moratorium on agricultural land sales for another year. The privatization law and the law on credit registry were not approved. The automatic inspection of e-declarations was not also introduced. The Anti-corruption court was not created The Government also did not increase gas tariffs for the population as it was previously planned. As a result, Ukraine did not receive scheduled for 2017 two tranches of IMF loan and the final tranche under the MFA III.

    Economic recovery was lower than previously expected: real GDP is estimated to grow at about 2.2% in 2017. Low growth is partially explained by the blocked of trade with the occupied part of Donbas. Inflation was significantly higher than the NBU target due to a rapid increase in minimum wage and growth of commodity prices.

     

    Politics

    •          The anti-corruption policy was among the most debated issues over entire 2017. The anti-corruption institutions continued working with the different levels of success. The National Anti-Corruption Bureau (NABU) indicted several high-ranking officials, including the Head of State Fiscal Service, in the corruption. Several members of the Parliament were stripped of their parliamentary immunity, which opens the possibility to open court trials against them. At the same time, the National Agency on Corruption Prevention (NAPS) has delayed the inspection of e-declarations; the selection of e-declarations for inspection was based on manual approach and not on risk profiling.
    •          During the year, several Ukrainian anti-corruption activists were attacked and charged with crimes. Additionally, a newly introduced legislation required anti-corruption activists to declare their personal assets starting from 2018, while a number of NGOs and commercial firms reported being searched by law enforcement bodies.
    •          Ukraine made progress in reforming healthcare, public administration, secondary education, justice and pension systems, and public media. The healthcare reform was started by adopting the laws that reorganize health care facilities from budget entities into state-owned and municipal non-profit enterprises and allowing patients to choose their primary care doctor. Justice system reform in 2017 included steps on introducing more transparency into the selection of judges, launching a new Supreme Court, and reorganization of the first instance courts. Ukraine also continued the transformation of state-controlled TV and radio broadcasting companies into politically independent public broadcasters by launching the new Ukrainian public broadcaster National Public TV and Radio Company of Ukraine (NPTRCU).
    •          Ukraine received the USD 1 bn disbursement of the loan from the International Monetary Fund under the Extended Fund Facility (EFF) program and EUR 0.6 bn from the EU in the framework of the MFA III. At the same time, the two planned disbursements of the IMF loan to Ukraine and the final tranche of the MFA III were missed in 2017. The country did not implement a number of significant reforms including elimination of the moratorium on the sales of agricultural land, the establishment of the Anti-Corruption court, and the introduction of the automatic inspection of e-declarations of government officials.
    •          Citizens of Ukraine holding biometric passports received the right for short-term visa-free travel to the EU following the respective approval of the EU Council. The official dialogue between Ukraine and the EU on visa liberalization began in 2008. In 2010, the EU provided a visa liberalization plan for Ukraine that included a list of measures to be implemented, including the introduction of biometric passports, the establishment of anti-corruption agencies, and the launch of electronic assets disclosure system for public officials. However, the EU reserves the right to cancel the visa-free travel for Ukraine if the country does not meet the necessary conditions, in particular, fails to ensure the independence, effectiveness, and sustainability of the anti-corruption institutions. 
    •          Since March 2017, the trade with the uncontrolled eastern parts of the country was stopped as a result of the shipments blocking campaign that was carried out by politicians and activists in protest against trading with Russia-led separatists. As the eastern parts of Ukraine supplied the major share of coal to the rest of the country, Ukraine experienced power shortages and had to import coal, while supply chains were disrupted for metallurgical factories in the country that relied on the eastern coal, coke, and ferrous metals.
    •          The Canada-Ukraine Free Trade Agreement (CUFTA) came into force on August 1, 2017. The Association Agreement between Ukraine and the EU fully entered into force on September 1, 2017.
    •          The military conflict with combined Russian-separatist forces in the eastern Ukraine continued in 2017. The most serious escalations of the conflict took place in winter in the town of Avdiivka where the shelling by combined Russian-separatist forces damaged infrastructure and left local residents without water, heating, and electricity in the freezing weather as well as in summer when combined Russian-separatist forces repeatedly broke the temporary ceasefires. With a purpose to counteract Russian disinformation, Ukraine blocked several Russian websites and social media platforms. In 2017, 203 service members of the Ukrainian Armed Forces were killed in the war and 1126 service members were wounded.
    •          In the biggest prisoner exchange since the beginning of the war, Ukraine in December exchanged 237 imprisoned fighters of illegal armed groups for 74 hostages captured by combined Russian-separatist forces. Earlier in 2017, two members of the Mejlis of the Crimean Tatar people were released from politically motivated imprisonment by Russian occupational authorities in the Autonomous Republic of Crimea, while many more Ukrainian citizens remain captive in the Crimea, in the eastern Ukraine, and in Russia.

     

    Real sector

    •          Real GDP in the first three quarters of 2017 increased by 2.3% yoy due to stronger domestic demand. Gross fixed capital accumulation surged by 19.5% yoy as companies continued to invest in new machinery and equipment and infrastructure after years of underinvestment. At the same time, higher minimum wage and tighter labour market helped spur income growth and domestic demand. However higher domestic demand drove 7.3% yoy growth of imports. Real exports increased by 1.8% yoy as diversification of exports and improved external demand offset the effects of blocked trade with occupied part of Donbas.
    •          Most sectors improved their performance during the year. Industrial output was almost unchanged in eleven months of 2017 (0.1% yoy decline reported). Growing domestic demand spurred the growth of manufacturing output by 3.9% yoy. This offset decline in extractive industry output by 6.0% yoy and electricity production by 5.7% yoy due to blocked trade with occupied part of Donbas. Rising domestic demand also fuelled growth in retail sales and freight volumes. Growing infrastructure investment and commercial property development helped construction to increase by 22.5% yoy in January-November.

     

    Energy

    •          The Stockholm Arbitrage Court adopted a final decision in the Naftogaz-Gazprom gas supply case. The court cancelled the “take or pay” clause of the gas contract for 2012-2017, thus, saving the Naftogaz USD 56 bn. It also decreased the required amount of gas purchase to 5 bcm per year from 52 bcm in 2018-2019 and obliged Gazprom to decrease the contracted gas price to market levels. However, the Naftogaz still has to pay the Gazprom USD 2 bn for the gas consumed in 2014.
    •          The law “On the Electricity Market of Ukraine” was adopted in May 2017. It introduced a new energy market model in accordance with the Third Energy Package, including the unbundling of transmission and distribution system operator requirements. The Energorynok, the national operator of the wholesale electricity market in Ukraine, later that year created a branch ‘Market Operator’ for selling the electricity on the “day ahead” and 24-hour electricity markets according to the new energy market model. In addition, the state enterprise Ukrenergo, the national operator of the electricity network, was transformed into a private joint stock company with a 100% public ownership.
    •          In June 2017, several important laws were adopted, including the law on general rules for commercial metering of utility services, on the Energy Efficiency Fund, and on the energy performance of buildings. The requirementon energy efficiency certification for several key b building categories, including new buildings, is expected to launch a fundamentally new market for the thermal and energy modernization of the buildings in Ukraine. Newly launched Energy Efficiency Fund will partially compensate costs improved energy efficiency of the buildings. The Fund’s activities are to be financed at the expense of central budget and international donors’ contributions. The State Budget Law for 2018 allocates UAH 1.2 bn for the Fund’s financing, which is unlikely to be sufficient for the effective Fund’s activity.
    •          In June, the Government refused the plans to increase gas tariffs for population requiring that the Naftogaz should provide the gas to households at the same price as before. This returns price distortions on the Ukrainian gas markets and might result in further deterioration of gas infrastructure and overconsumption of gas by the population.
    •          Ukrainian electricity system operator Ukrenergo signed an agreement on the unification of the electrical system of Ukraine and Moldova with the electricity system of continental Europe ENTSO-E. Synchronization with ENTSO-E requires not only resolving complex technical issues but also introducing different principles of selling electricity (when any consumer in Ukraine can buy electricity from any European producer and Ukrainian producers can export electricity to any consumer in Europe).

     

    Transport

    •          In 2017, the Cabinet of Ministers extended the temporary mechanism for financing the construction of highways in Ukraine. Half of the over-executed customs revenues (mostly VAT on imports) are earmarked for highway construction in the respective region. This plan was continued for 2018.
    •          High fees in Ukrainian seaports have long been an obstacle to the development of sea industry in Ukraine. The Cabinet of Ministers decided to increase the ports’ competitiveness by decreasing seaport (ship, channel, lighthouse, sanitary, anchor, private and administrative) fees by 20% starting 2018.
    •          In October 2017, the Ukrzalisnytsia finished construction of Beskydsky railway tunnel, which goes through Carpathian mountains from Beskyd to Skotarske stations. The new tunnel will allow up to 100 pairs of trains per day at the speed of 60-70 km/h (up from 47 pairs of trains at the speed of 15-40 km/h of the old tunnel). The Ukrzaliznytsya expects to make the new tunnel operational by June 2018 after it finishes constructing the railway in the tunnel and laying the electricity cables. The tunnel will increase Ukraine’s attractiveness as a transit country.

     

    Agriculture

    •          Between January and November, the agricultural production declined by 2.8% yoy due to a decrease in crop production at 3.8% yoy.
    •          The Government in 2017 set a priority to support farming and development of agricultural cooperation. It introduced the position of Deputy Minister of agricultural policy on the issues of the support of farming and adopted Concept on the development of farms and agricultural cooperatives for 2018-2020.
    •          One of the main Eurointegration laws "On the safety and hygiene of animal feed" was adopted. It approximates the animal feed production to the European food safety requirements.
    •          The EU adopted additional tariff quotas for duty-free importation of a number of Ukrainian agricultural products (cereals, honey, processed tomatoes, grape and apple juices). Quotas for honey and grape juice are filled almost immediately.
    •          The system of state support for agricultural producers showed limited effectiveness in 2017. Large poultry producers received the lion's share of subsidies.

     

    External Sector

    •          During 11 months of 2017, current account deficit remained at USD 3.0 bn (as close to 2016 figure). Larger merchandise trade deficit and investment income payments were offset by higher remittance inflows and trade in services surplus.
    •          Exports of goods increased by 20% yoy including 33% yoy increase in exports to the EU. This reflected higher commodity prices and likely effects of free trade with EU. Between January and November imports of goods increased by 22% yoy as mineral imports jumped by 51% yoy from a low base. Investment demand explained the continued fast growth in machine building imports that increased by over 81% from 2015 low. Imports of other items increased by 15% yoy buoyed by consumer demand.
    •          Financial account surplus reached USD 5.5 bn in January-November (as compared to USD 4.7 bn during the same period of 2016). Public sector inflows increased to USD 2.1 bn as Ukraine issued Eurobonds whiles nonfinancial FDI inflows increased to USD 1.5 bn but remained very low.

     

    Fiscal policy

    •          The fiscal year 2017 repeated traditional problems of fiscal policy in the country. During the year, central fiscal budget and local budgets were in surplus, which turned into deficit at the end of the year. The central fiscal deficit is estimated to reach near UAH 45 bn. Financing of capital expenditures at the end of the year again resulted in low effectiveness and efficiency, which urge the Government to shift to the Medium-Term Expenditure Framework (MTEF) from traditional one-year budgeting. The Government has promised to implement the MTEF starting the Budget 2019.
    •          Privatisation plans were again not realised in 2017. Overall, privatization receipts at UAH 3.4 bn accounted for only about 20% of annual target. The attempts to privatise the Odessa Portside Plant failed.
    •          In April, the automatic VAT refund was introduced on the basis of the electronic registry, which is available online. According to the State Fiscal Service, between April and October VAT refund arrears were almost eliminated. This contributes substantially to the improvement of the business climate. At the same time, the implementation of the blocking of the VAT invoices registration since July 2017 was controversial, what resulted in its termination since the beginning of 2018.
    •          In December, the Parliament approved the State Budget Law for 2018 and the amendments to the Budget Code and the Tax Code. The Budget-2018 is based on realistic macroeconomic assumptions but contains risks related to revenues and deficit financing. Amendments to the Budget Code primarily are explained by the necessity to implement healthcare reform and other changes in legislation. Tax amendments loosened fiscal stance through as the tax base was narrowed by the provision of some tax privileges on VAT payment (e.g. option paying VAT on imports of a number of investment goods in 24 monthly installments; zero VAT rate for imports of electro cars).

     

    Social policy

    •          Nominal disposable income increased in 2017 primarily due to higher wage income. Other income components increased slower. The growth of real disposable income was slow because of accelerated inflation.
    •          The pension reform was approved in autumn 2017. The retirement age was not increased. However, required the insurance record to receive an old-age pension will gradually increase. The minimum old-age pension was also raised. The Government also approved the roadmap to introduce the compulsory accumulative pillar of the pension system.
    •          The coverage of households with housing and utility subsidies increased in 2017. In November 2017, 6.6 m households received subsidies, which comprise 44.3% of all households. The central fiscal financing of subsidies was increased several times during the year.

     

    Labour market

    •          The average wage in November 2017 reached UAH 7479 and was by 38.3% higher than in November 2016. It increased by 21.4% yoy in real terms. Wage growth was explained by a surge in the minimum wage in 2017 (from UAH 1600 to UAH 3200) and improved financial situation of companies.
    •          Unemployment rate (ILO methodology) in the first nine months of 2017 increased by 0.2 p.p. to 9.4% of the economically active population in the age of 15-70 years old. This is partially explained by demographic changes.
    •          The Government increased the minimum wage from UAH 3200 to UAH 3723 since January 2018. The further increase of minimum wage to UAH 4200 during 2018 is promised by the Government.

     

    Deregulation

    •          To lower administrative pressure on business and promote competition, Ukraine cancelled the government regulation of prices of a number of goods and services, in particular on food products that are considered socially significant.
    •          In 2017, Ukraine adopted a Law aimed to protect businesses from unjustified and illegal searches by law enforcement agencies. The Law allows searches only with the presence of lawyers, requires the law enforcers carrying out searches to video record their actions, and prohibits seizing original documents and hardware.
    •          The obligatory use of stamps on documents for businesses was eliminated, which contributes to the ease of doing business.

     

    Inflation, monetary policy, and exchange rate

    •          Inflation remained high in 2017 and reached 14.4% on average in 2016 from 13.9% in 2015. This reflected a surge in food prices, gradual recovery in consumer demand and higher labour costs. Food prices increased by 13% while housing and utility costs surged by 27%.
    •          The NBU changed policy rate from 14% p.a. to 14.5% p.a. over the year. The NBU reduced the policy rate twice in spring but reverted the changes by the end of the year due to growing inflation pressure. Still, bank interest rates continued falling in 2017. The indicative retail rate for 12-month hryvnia deposits reduced to under 14% p.a. from 18% p.a.
    •          Interbank exchange rate weakened slightly from UAH 27 per USD in the beginning of 2017 to UAH 28 per USD Hryvnia exchange rate followed a seasonal pattern where it appreciated in the spring and weakened in the end of the year. Higher consumer and investment demand for imported goods increased pressure on the exchange rate in last quarter of 2017. International reserves reached USD 18.8 bn by the end of 2017 due to public sector foreign currency borrowing and net purchases of foreign currency on the interbank market.

     

    State debt

    •          State debt grew by 7.5% in the US dollar equivalent (to USD 76.3 bn) or by 6.9% in hryvnia equivalent (to UAH 2 062 bn) in eleven months of 2017. External fiscal sustainability risks remained high as FX debt accounts for 69.7%.
    •          Between January and November, domestic debt increased by 6.8% in hryvnia equivalent primarily due to the further recapitalization of the state banks. Total capital injection for PrivatBank, Oshchadbank, and Ukreximbank reached UAH 70.7 bn in 2017.
    •          In October, the Government and the NBU completed reprofiling of state domestic debt, which were in the portfolio of the NBU. The state domestic bonds at UAH 220 bn (out of UAH 361 bn) were exchanged by long-term bonds (with maturities in 2025-2047) with either indexed for inflation yields (about UAH 145 bn) or fixed yield.
    •          In 2017, Ukraine returned to the international capital markets for the first time since 2013. It placed 15-years Eurobonds of USD 3 bn at 7,375% p.a., USD 1.6 bn from which were directed for the buyback purchase of sovereign Eurobonds with maturity in 2019-2020. Ukraine also received USD 1.0 bn in one tranche from the IMF under the EFF and EUR 600 m from the EU under the MFA III. Overall, external debt grew by 7.6% in USD-equivalent in eleven months of 2017.
    • The Ministry of Finance approved the Medium-term State Debt Management Strategy for 2017-2019. The target of direct state debt in relation to GDP was set at 66%, 62%, and 58%, respectively for 2017-2019. The average debt maturity is planned to increase to 7 years in 2017-2018 and 6 years in 2019.
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