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  • 03.12.2013

    Fiscal consolidation in Ukraine: Why it is needed and how to do it

    (Code:PP_03_2013)

    The consolidation of public finances is a major topic in many countries around the globein the aftermath of the global financial crisis 2008/09. Rapidly increasing fiscal deficitsduring the crisis put significant upward pressure on the public debt stock, which resultedin public debt crises in some economies. Ukraine was also hit hard during the crisis, andsaw a widening of its fiscal balances, leading to a steep increase in its public debt level toalmost 43% of GDP at the end of 2013 (from 12% in 2007). In a wide definition (i.e.including the operational deficit of state-owned Naftogaz) the overall general governmentdeficit is expected to reach almost 8% of GDP this year, up from 4.3% in 2011.

    It is obvious that this situation is not sustainable, and the current financing difficulties ofthe government (e.g. no access to international capital markets, limited liquidity atdomestic capital markets, rating downgrades and negative outlooks by all three majorrating agencies) are proof of that. Thus, the authorities need to re-embark on a path offiscal consolidation in order to firmly anchor the sustainability of public debt. This is achallenging, but nevertheless manageable task, as the government has demonstratedduring the recent past: Over the years 2010-2011, the authorities achieved some initialsuccess in stabilizing public finances, as the deficit was significantly reduced.

    In terms of how to achieve fiscal consolidation, our recommendations can be broadlyseparated into four categories. First, we think that the authorities should aim for apositive primary balance of 0.7% of GDP, which would stabilize public debt at currentlevels. This is a value that should be achieved gradually over the next few years. Second,in terms of ensuring enough revenues, the foreseen reductions in EPT and VAT rates in2014 should not be enacted. A reduction in existing tax privileges (e.g. in agriculture)should be undertaken, while at the same time no new privileges should be introduced.

    Fair, stable and transparent rules of taxation would help to improve revenue collection inthe medium term. Third, on the expenditure side, there is also significant room forimprovement. A reduction in energy subsidies plays a key role here, as well as the topicof corporate subsidies. Regarding the latter, the adoption of the law on state aid, as wellas streamlining public procurement would ensure higher efficiency of spending and largerreturns from subsidies provided. With a view of the Presidential elections in 2015, a clearrestraint in terms of the public wage bill and social assistance payments is warranted,especially in the current period of price level stability. Finally, the financing of theremaining deficit should be conducted in a transparent manner, and with a clear viewtowards reducing borrowing risks (e.g. FX risks).Finally, it should be stressed that fiscal consolidation is only one cornerstone of a widerstrategy to stabilize Ukraine’s economy, which is running some of the highest twindeficits in the world. Reducing these imbalances requires a new policy mix, whichincludes also fundamental changes in the conduct of monetary and exchange rate policy.

    Allowing gradually more exchange rate flexibility would be another major component ofthis policy mix, which could help to decrease external deficits, and support sustainableeconomic growth.

    Attached file  (183.7 kb)
    Authors:  Betliy Oleksandra, Robert Kirchner
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