RECENT ECONOMIC DEVELOPMENTS
World Bank, Kyiv, Ukraine, December, 2008
The global financial crisis has exposed Ukraine’s inherent macroeconomic vulnerabilities, leading to a sizable exchange rate adjustment and to the current economic downturn.
The short-term macroeconomic stabilization will require a significant tightening of aggregate demand ending several years of high growth in real incomes.
External debt refinancing and market confidence are at the core of the stabilization process, underscoring the need for greater consistency in policy implementation and reinvigorated structural reform efforts.
The global financial crisis has exposed Ukraine’s inherent macroeconomic risks, requiring a sharp adjustment of the economy. While sovereign and corporate spreads were already increasing for Ukraine since the first half of 2008 in the context of high inflation and a widening current account deficit, the international financial crisis brought existing refinancing risks and risks associated with the banking sector to the fore. Moreover, the slowing global economy led to a sharp fall in the demand for and the price of steel, Ukraine’s main export. Thus, the terms of trade have abruptly worsened and the access to external financing has dramatically deteriorated
The government initiated important macroeconomic adjustment measures, but consistent implementation is essential to avoid a further erosion of market confidence. In November 5, 2008 the IMF’s board approved a Stand-By-Arrangement for US$16.4 billion supporting a program of domestic and external adjustment as well as financial sector rehabilitation. The authorities initiated the shift towards a flexible exchange rate policy, started measures to stabilize the financial sector, and continued with conservative budget execution through the last quarter of 2008. However, initial slippages in handling the new exchange rate policy and current pressures for a relaxation of budget discipline underscore the need for a consistent and credible policy response moving forward.
The Ukrainian economy entered into recession in Q4. Real GDP dynamics have shifted from a peak of 11% y/y growth in August to a 14% drop in November, with annual growth decelerating to 3.6% over 11 months. The contraction has been led by manufacturing and construction. The leakage of UAH deposits from the banking system amounted to 14% over October-November, but slowed down more recently. Consumer price inflation decelerated to 22.3% y/y in November.
Ukraine is heading for a recession during 2009 in the face of a credit crunch, terms of trade deterioration, and the slowdown in export demand. Short-term macroeconomic stabilization will require a significant tightening of aggregate demand and a shift in the composition of aggregate demand towards net exports. The stock of public debt is currently low at 10 percent of GDP, and is projected to remain sustainable throughout and after the adjustment, even after adding the potential costs of bank recapitalization. Successful adjustment hinges critically on the willingness of external creditors to refinance banking and corporate sector debts. This will require close attention to consistent policy implementation and communication to the public to ensure market confidence as well as efforts to accelerate structural reforms.
The basic macroeconomic parameters in our forecast are broadly consistent with those of the IMF program. Balance of payments pressures will lead the economy to adjust the composition of growth through 2009. As a result, the current account deficit is expected to improve from over 6 percent of GDP in 2008 to 1-2 percent of GDP in 2009-11. To achieve this adjustment, an over 20 percent real import contraction will be needed in 2009 in order to counter the 7 percent forecast terms of trade deterioration. Real wages and employment are forecast to decline in 2009 to restore price competitiveness of Ukrainian exports in the wake of declining export prices and to support the adjustment in aggregate demand. With this current account adjustment and with the support of the IMF Stand-By, the external financing gap would be closed under our baseline assumptions. Declining commodity prices, tightening liquidity and the forecast decline in domestic demand will contribute to disinflation. However, offsetting this, the exchange rate correction and the adjustment of energy and utilities tariffs will make disinflation a more prolonged process. We assume that the government will maintain a balanced budget in 2009 (not accounting for bank recapitalization costs) and have a small deficit thereafter.
The economic downturn has just started and further downside risks are rooted in the size of the external shocks and inadequate policy responses. Above-expected terms of trade deterioration and a sharper decline in export demand may put additional pressure on the real sector. Banking sector vulnerabilities may be further exacerbated by an overshooting exchange rate and external debt refinancing difficulties as corporate balance sheets weaken further and households’ incomes come under strain from rising debt service costs. Prudent fiscal, monetary, and financial policies (many of them anchored in the program supported by the IMF), accompanied with renewed efforts to deepen structural reforms, can help Ukraine to stabilize and move the economy towards recovery in 2010. Conversely, a disorderly response with poor implementation of these policies may trigger an even shaper downturn and delay the recovery.