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Elliott Morss | October 25, 2014

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Ukraine and the IMF: The Economic Impact of Proposed Reforms

Ukraine and the IMF:  The Economic Impact of Proposed Reforms
© Elliott R. Morss, Ph.D.

Under pressure from the US and EU countries, The IMF has just thrown Ukraine a bailout “lifeline”. But there are strings attached. In what follows, I intersperse quotes from Nikolay Gueorguiev, the IMF Ukrainian Mission Chief for Ukraine, following negotiations for the bailout with my comments.

Gueorguiev: Ukraine’s macroeconomic imbalances became unsustainable over the past year. The (until recently) pegged and overvalued exchange rate drove the current account deficit to over 9 percent of GDP, and a lack of competitiveness led to the stagnation of exports and GDP. With significant external payments and limited access to international debt markets, international reserves fell to a critically low level of two months of import in early 2014. The 2013 fiscal deficit was 4½ percent of GDP, and the government accumulated sizeable expenditure arrears. The 2013 deficit of the state-owned gas company Naftogaz reached nearly 2 percent of GDP, driven by the sharp increase in sales at below-cost prices. Without policy action, the combined budget/Naftogaz deficit would widen to over 10 percent of GDP in 2014.

Elliott: This is chilling. Aside from the country running out of international reserves, the Naftogaz deficit of 2% of GDP reflects subsidies that make energy cheaper for citizens. And now that Russia has annexed Crimea, it will longer offer Ukraine a price break on energy. It follows that the higher Russian energy price Naftogaz will have to pay will increase its deficit further.

Gueorguiev: Fiscal policy will secure priority spending during the coming months and implement deeper fiscal adjustment over the medium-term. The initial stabilization in 2014 will be achieved through a mix of revenue and expenditure measures. For 2015-16, the program envisions a gradual expenditure-led fiscal adjustment—proceeding at a pace commensurate with the speed of economic recovery and protecting the vulnerable—aiming to reduce the fiscal deficit to around 2½ percent of GDP by 2016.

Elliott: In earlier postings, I have noted how the IMF pulled away from the Greek austerity program promoted by Germany. Why? Because it saw what impact lower government deficits were having on unemployment – it soared to 27.5%! In place of austerity, the Fund is pressuring the EU to forgive more Greek debt, now standing at an unsustainable 177% of GDP.

So how about Ukraine? What does the IMF by “a mix of revenue and expenditure measures? It means lower expenditures and higher taxes. Lower expenditures will lead to a reduction in aggregate demand; higher taxes will reduce purchasing power and this will also reduce aggregate demand.

Gueorguiev said:The 2013 fiscal deficit was 4½ percent of GDP, and the government accumulated sizeable expenditure arrears.” Put the arrears together with the stated deficit, and FocusEconomics estimates that Ukraine’s fiscal deficit now exceeds 5%. Cutting the deficit in half over the next two years is an “austerity” program. And as a result, unemployment in Ukraine will rise. FocusEconomics estimates the unemployment rate in Ukraine is a modest 8%. Implementation of the IMF agreement will cause it to rise. This will mean serious problems for a new government trying to curry favor from its citizens.   

Gueorguiev: Energy sector reforms will focus on reducing this sector’s fiscal drag, while attracting new investment and enhancing efficiency. A key step is the commitment to step by step energy reform to move retail gas and heating tariffs to full cost recovery, along with early action towards that goal.

Elliott: Reducing “fiscal drag” will mean much higher energy prices. Higher energy prices will have the same effect as higher taxes: it will absorb more disposable income and result in more unemployment.

Gueorguiev: Reforms to strengthen governance, enhance transparency, and improve the business climate will be central elements of the program. Policy measures in these areas will include adoption of a new procurement law to close loopholes allowing evasion of a competitive procedure; measures to facilitate VAT refunds to businesses; and an independent quarterly audit of the Naftogaz accounts. Moreover, the IMF will prepare a comprehensive diagnostic study that will cover the anti-corruption and governance framework, the design and implementation of laws and regulations, the effectiveness of the judiciary, and tax administration.

Elliott: Perhaps overly ambitious? We will see. I predict the IMF program will cause riots in the streets and political chaos. One has to wonder why the West is so eager to strengthen ties with this corrupt and broken country on Russia’s border. Western imperialism?

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