Explanatory Memorandum to COM(2014)182 - Macro-Financial Assistance to Ukraine - Main contents
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This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2014)182 - Macro-Financial Assistance to Ukraine. |
|---|---|
| source | COM(2014)182  |
| date | 19-03-2014 |
· Grounds for and objectives of the proposal
The Ukrainian economy has been in recession since the second half of 2012, with only one quarter of positive growth in the end of 2013, which was quickly reversed in the first two months of 2014 as a result of the deterioration of the political and security situation.
The Ukrainian government lost access to international financial markets during 2013 as confidence dropped in view of the widening fiscal and current account and in the absence of much needed reforms. The unwillingness of the authorities to commit to reforms also prevented them from concluding a financing agreement with the IMF.
As a result of large debt repayments in the fourth quarter of 2013 and beginning of 2014 and of the central bank's interventions to defend the currency peg against the dollar, reserves have dropped dramatically to USD 15.5 billion at the end of February, leaving Ukraine with a very weak and rapidly worsening balance-of-payments situation. The current political crisis has very damaging effects on Ukraine's already precarious economic and financial stability. The de facto interruption of Russia's assistance under its USD 15 billion package agreed last December, and the announced end to the reduced gas prices granted by Gazprom from April 2014 onwards, will deteriorate the situation even further. Under these circumstances Ukraine faces a serious risk of default in the near future.
At the same time, during the month of February and following mass protests on-going since end-November, the government resigned. A new government was approved by the Verkhovna Rada on 27 February and there was a reversal to the 2004 Constitution. Despite these changes, Ukraine has not been able to return to political stability since the sovereignty and territorial integrity of Ukraine has recently been violated by the Russian Federation.
The new government has publicly committed itself to begin implementing significant and comprehensive reforms before the 25 May presidential elections.. Although the political process at the moment is volatile, so far it shows clear signs of a commitment to economic reforms.
Against this background, the Ukrainian authorities are seeking financial assistance from the multilateral and bilateral creditors and donors to support a reform programme, currently under preparation, that would reduce economic vulnerabilities, boost international reserves and foster economic growth. The IMF sent a staff mission to Ukraine in the beginning of March, and is expected to play the key role in the preparation of this programme and mobilisation of international financial assistance to Ukraine. In the next weeks, the IMF and the Ukrainian authorities are expected to come to an agreement on an economic programme that will be supported by a financing arrangement.
It is expected that the external financing needs of Ukraine will exceed the funding likely to be provided by the IMF. In this context, the European Commission announced on 5 March 2014 a package of financial support to Ukraine, that was welcomed by the EU Heads of State or Government the day after. One of the elements of the package is a new Macro-Financial Assistance (MFA) programme in the amount of up to EUR 1 billion.
The European Commission submits to the Council a proposal to grant MFA to Ukraine amounting to a maximum of EUR 1 billion. The assistance would take the form of medium-term loans, with no grant component being envisaged given that Ukraine does not meet the eligibility criteria for the use of grants in MFA operations.
The proposed EU MFA is intended to help Ukraine cover part of its urgent external financing needs in the context of the stabilisation and reform programme currently under preparation, reducing in this way the economy’s short-term balance of payments and fiscal vulnerabilities. The proposed assistance would support the urgent fiscal consolidation and external stabilisation and encourage the implementation by the authorities of structural reforms aimed at improving the overall macroeconomic management, strenghtening economic governance and transparency and improving conditions for sutainable growth.
The proposed MFA is in line with the aims of the Eastern Partnership and the orientations of the new European Neighbourhood Policy (ENP). It would signal to the other countries in the region that the EU is ready to support countries embarking on political reforms, in moments of economic difficulties. In this context, the Commission considers that the political and economic pre-conditions for an MFA operation of the proposed amount and nature are satisfied.
· General context
After 5 quarters of consecutive decline, real GDP grew by 3.3% y/y in 4Q2013, leading to flat growth for the year 2013. The poor performance of the economy was due to a combination of a bad harvest, decline in steel exports and delayed domestic reforms. According to the IMF, it is believed that growth was negative in January and February. Due to the volatile situation forecasts for 2014 range from -5% to +3% depending on assumptions. Macroeconomic adjustments, including fiscal consolidation and exchange rate flexibility, will have contractionary effects, but on the other hand, the foreseen IMF arrangement would increase confidence that could lead to FDI inflows quite quickly. Still, Russia's policy towards Ukraine signifies a substantial downside risk to growth.
Inflation has been very low in the last few years, reaching 0.3% at end-2013; however, inflationary pressure has increased in 2014. CPI was 0.5% in January and 1.2% in February and the National Bank of Ukraine (NBU) expects it could reach 10% or more by end-2014, as a result of the depreciation of the hryvnia (UAH) and the expected increase in energy tariffs for households.
The fiscal deficit, including the operational deficit of the main Ukrainian energy sector operator Naftogaz, was estimated at 6.5%-7.5% of GDP in 2013, largely as a result of continued energy subsidies, which amount to 7% of GDP, but also as a result of the economic slowdown. Capital expenditure was cut by 40% in 2013, while VAT revenues dropped by 7%. The 2014 budget was passed by the Rada in early January, but was based on unrealistic assumptions of growth and inflation and is currently being revised by the Ministry of Finance in close cooperation with the IMF. Revenues in January-February 2014 amounted to 82% of what was planned in the budget, suggesting that expenses need to be cut by around UAH 80 billion, or 15-17% in 2014. In addition, the gas import price from Russia will be increased on 1 April to at least 400 USD per 1000 cubic meters, putting significant strain on the budget. However, the Minister of Finance has made assurances that gas tariffs for households and district heating companies will be increased before the 25 May elections, alleviating this pressure. An additional issue is arrears, both of VAT refunds to corporates and overdue subsidy payments to utility companies, amounting to UAH 12bn and UAH 8bn respectively.
There has been strong pressure on the local currency since the outbreak of the crisis. The NBU has allowed the hryvnia to depreciate significantly (by about 25%) in February. Part of this was a deliberate devaluation of the official exchange rate on 7 February from the 7.99 UAH/USD that had been kept since July 2012 to 8.708 UAH/USD. Later the depreciation of the currency sped up as a result of the NBU's inability to intervene due to very low foreign exchange reserves. In agreement with the IMF, the NBU is now pursuing a policy of non-intervention, except in cases of significant exchange rate movements. It is also maintaining a number of capital controls, but says it will refrain from introducing new ones. The hryvnia remains volatile, despite these measures. Further significant devaluation of the currency would risk deterioration of credit portfolios and capital of banks and would not necessarily rebalance the current account as much of exports are dependent on imported inputs. In addition, the Ukrainian economy is consumption-driven (75% of GDP) and devaluation with accompanying inflation would likely have a contractionary effect on GDP.
The current account deteriorated significantly in 2013 to an estimated deficit of 10% of GDP reflecting mostly decreased exports. The NBU expects a significant narrowing of the current account deficit in 2014 as a result of adjustments connected to the foreseen IMF arrangement, including fiscal consolidation. Yet, current account financing needs will remain substantial in the short run – at least USD 4 billion before the end of the second quarter of 2014. Net FDI is estimated to have dropped further from 5.0% of GDP in 2012 to 2.6% of GDP in 2013 and was near 0% in January 2014.
External debt was estimated at 76.7% of GDP at end-2013. Only about one-third of it is owed or guaranteed by the public authorities (including debt of the National Bank to the IMF). In addition to publicly guaranteed liabilities of some Ukraine's corporate borrowers, e.g. State guaranteed Eurobonds issued by Naftogaz, other external liabilities of Ukraine's corporates may have a systemic importance for the country. In particular, Naftogaz' debt (in arrears) for gas shipments from Russia's Gazprom has direct implications for the country's current account as Gazprom sets its price depending on Naftogaz' debt payment record.
Official reserves declined by 16% to USD 20.4 billion in the course of 2013, as a result of the large current account deficit, pressure on the hryvnia and significant debt repayments in 2013. This negative trend continued in January and February when reserves dropped a further 13% per month to USD 15.5 billion at end-February (2 months of import cover). This development clearly reflects an increased balance-of-payments vulnerability.
At 41% of GDP (end-2013), public debt is below the high-risk benchmark. At the same time, public debt servicing obligations, in particular on external debt or on foreign currency denominated domestic debt, weigh heavily on public finances and international reserves in the near future. Total debt service of the government and the NBU for the rest of 2014 amount to about USD 10 billion. Debt payments peak between June and September. In the period March-May debt service amounts to approximately USD 2 billion. In addition, the outstanding Naftogaz' debt to Gazprom amounts to another USD 2 billion. Debt payment obligations in 2015 are about USD 10 billion.
According to the NBU, there is sufficient liquidity in the banking sector, but no credits are extended to corporates since February. Deposit erosion amounted to some 2% in January and about 8% in February. Possible further currency devaluation would present problems for the banking sector and asset quality has the potential to fall quickly. The banking sector is in need of a thorough asset quality review. Beyond short-term risks, the banking sector in Ukraine presents some structural weaknesses that are likely to be a focus of a reform programme supported through the foreseen IMF arrangement. There are clear weaknesses in bank supervision and corporate governance in the banking sector and a lack of protection of creditor rights.
In addition to the need to restructure and strengthen the banking system, other key structural reform challenges include raising utility tariffs, currently a significant contributor to the fiscal deficit, while strengthening the social safety net; combatting corruption, not least in taxation and customs; strengthening private sector development; and improving the business environment to boost investment including FDI.
Based on the indications provided above, in 2014 and 2015 Ukraine will be facing significant external financing needs reflecting in particular a still substantial current account deficit, large external debt payment obligations and the need to re-build a minimum buffer of foreign exchange reserves. Also, private capital inflows, in the form of foreign direct investments or private credits, will remain extremely low. It is expected that preliminary projections of Ukraine's residual external financing needs will become available in the coming weeks, in view of the results of the on-going technical discussions the Ukrainian authorities are conducting with the IMF. But already now it is anticipated that a wider international support will be required to cover these needs and create conditions for a successful implementation of the reforms in Ukraine. The proposed EU MFA would contribute to cover part of the residual financing gap for the 2014-2015 period.
· Existing provisions in the area of the proposal
Council Decision of 12 July 2002 providing supplementary macro-financial assistance to Ukraine (2002/639/EC)[1]
Decision no 646/2010/EU of the European Parliamnt and of the Council of July 2010 providing macro-financial assistance to Ukraine[2]
· Consistency with the other policies and objectives of the Union
The EU is seeking an increasingly close relationship with Ukraine that goes beyond mere bilateral cooperation, encompassing gradual political association and economic integration. Ukraine is an important country both within the European Neighbourhood Policy and the Eastern Partnership. The EU signed a Partnership and Cooperation Agreement (PCA) with Ukraine in 1998 that outlines the framework of our cooperation in all key areas of reform and continues to be the legal basis of our relations. Relations were further enforced in November 2009 when the Cabinet of Ministers of Ukraine adopted the EU-Ukraine Association Agenda, which was updated in 2011 (endorsed by the EU-Ukraine Cooperation Council in June 2013), and aims to prepare for and facilitate the entry into force of the new Association Agreement, which was negotiated in 2007-2011, initialled in 2012 and is expected to be signed in the near future.
Economic ties with the EU are important. The EU is among Ukraine's most important commercial partner and accounts for about one third of its external trade. In 2012, the value of Ukrainian imports from the EU was EUR 23.8 billion while the value of its exports was EUR 14.6 billion. Ukraine also has a high dependence on the EU in terms of FDI and other financial flows. Within the framework of the Association Agreement, the EU finalised negotiations with Ukraine on establishing a Deep and Comprehensive Free Trade Area (DCFTA) in 2011 with the goal to allowing the full access of Ukraine to the EU’s single market. On 11 March 2014, the Commission adopted a proposal for an EU Council/Parliament Regulation temporarily removing customs duties on Ukrainian exports to the EU (COM 2014/166). The proposed measures, expected to be adopted by the co-legislators in the coming months, will be applied immediately and will be discontinued in November 2014, when the provisional application of the DCFTA will start.
The EU MFA would complement the total EUR 1.565 billion in grants mobilised under the European Neighbourhood Instrument, the Neighbourhood Investment Facility, the Instrument contributing to Stability and Peace and the EU budget line for the Common Foreign and Security Policy. By supporting the adoption by the Ukrainian authorities of an appropriate framework for short-term macroeconomic policy and structural reforms, the EU’s MFA would enhance the added value of the overall EU involvement increasing the effectiveness of the EU’s overall intervention including through other financial instruments.
Ukraine's immediate transition will be very difficult and the risk of political and economic collapse remains. At the same time, the new government has publicly committed to taking significant steps towards political and economic reforms, with the aim of tackling corruption and strengthening institutions and mechanisms, including the rule of law. The country is also envisaging an economic reform programme aimed at laying the ground for a sustainable growth model.
The proposed MFA is consistent with the EU's commitment to support Ukraine's immediate economic and political transition. Also, it is consistent with the principles: governing the use of the instrument of MFA, including its exceptional character, political preconditions, complementarity, conditionality and financial discipline. The current operation is taking place under very particular circumstances of extreme urgency.
The Commission will continue to monitor and assess during the life of the MFA operation satisfaction of these criteria, including the assessment, in close liaison with the European External Action Service, of the political preconditions.
Contents
· Consultation of interested parties
MFA is provided as an integral part of the international support to the economic stabilisation of Ukraine. In the preparation of this proposal for MFA, the Commission services have consulted with the International Monetary Fund, which is in the process of putting in place a sizeable financing programme, and other multilateral and bilateral creditors and donors. The Commission has also been in regular contact with the Ukrainian authorities.
· Collection and use of expertise
Due to the need for an urgent approval process, an Operational Assessment verifying the quality and reliability of Ukraine's public financial circuits and administrative procedures will only be carried out by the Commission, with the assistance of external experts, during the months of April and May 2014.
· Impact assessment
The MFA and the economic adjustment attached to it will help alleviate the risk of imminent default and economic collapse by addressing Ukraine's short-term external financing needs while supporting policy measures aimed at strengthening the balance-of-payments and fiscal positions and raising sustainable growth. It is planned that the conditionality attached to the programme will notably help improve the efficiency and transparency of public finance management; promote fiscal reforms to reduce utility subsidies and other expenditure; support existing efforts to strengthen the social safety net; strengthen the financial sector governance and supervision; strengthen anti-corruption measures that will increase revenue; and facilitate the adoption of measures to improve the regulatory framework for trade and investment.
· Summary of the proposed action
The European Union shall make available to Ukraine MFA for a total maximum amount of EUR 1 billion, provided in the form of a medium-term loan. The assistance will contribute to cover Ukraine's residual external financing needs in 2014.
The assistance will be provided in one or two instalments and will be conditional on an IMF arrangement being in place and on the implementation by Ukraine of specific structural reform measures that will be agreed by the Commission on behalf of the EU and Ukraine in a Memorandum of Understanding. The preparation of the Memorandum of Understanding will be made in coordination with the IMF and the World Bank. In view of the critical need for Ukraine to implement strong macroeconomic policies and ambitious reforms, it is not deemed appropriate to disburse the new programme without specific conditionality. In this context, the preferred option is to disburse the assistance in two tranches, with the first tranche being conditional to the IMF arrangement being in place, and the second tranche being also conditional to the implementation of the agreed conditions. There will be a delay of at least three months between the two tranches. The disbursement of the first instalment (possibly EUR 500 million) is expected to take place in June 2014, and the disbursement of the second instalment – in autumn of the current year. In case, however, it is decided by the Commission that in view of the extreme urgency of the financing needs the disbursement of the assistance should be made in one tranche, the Commission would still condition it to the completion of some critical prior actions.
In the preparation of the list of conditions or prior actions for the release of the assistance, the Commission will target structural reforms aimed at improving the overall macroeconomic management and the conditions for sustainable growth (e.g. targeting the transparency and efficiency of public finance management; fiscal reforms; governance and supervision of the financial sector; reforms to strengthen the social safety net; and reforms to improve the regulatory framework for trade and investment).
The assistance will be managed by the Commission. Specific provisions on the prevention of fraud and other irregularities, consistent with the Financial Regulation, are applicable.
The decision to disburse the full MFA in the form of loans is justified by Ukraine's level of development (as measured by its per-capita income) and debt indicators. It is also consistent with the treatment given to Ukraine by the World Bank and the IMF. Indeed, Ukraine is not eligible for concessional financing from either the IDA or the IMF.
· Legal basis
The legal basis for this proposal is Article 213 of the TFEU. Given that the beginning of the disbursement of the proposed assistance in the first half of 2014 would not be possible and would thus not address the urgent financial needs of Ukraine, if the decision was adopted by the Parliament and the Council in accordance with Article 212 TFEU under the ordinary legislative procedure, it is justified to use Article 213 TFEU providing for the adoption of the decision by the Council.
· Subsidiarity principle
The proposal does not fall under an exclusive competence of the EU. The subsidiarity principle applies to the extent that the objectives of restoring short-term macroeconomic stability in Ukraine cannot be sufficiently achieved by the Member States alone and can therefore be better achieved by the European Union. The main reasons are the budgetary constraints faced at the national level and the need for strong donor coordination in order to maximise the scale and effectivenes of the assistance.
· Proportionality principle
The proposal complies with the proportionality principle: it confines itself to the minimum required in order to achieve the objectives of short-term macroeconomic stability by alleviating the risk of a possible default and does not go beyond what is necessary for that purpose.
In view of the size of Ukraine's external financing needs in 2014 and 2015, the amount of the assistance will correspond to a relatively limited part of these needs. Given the assistance pledged to Ukraine by other bilateral and multilateral donors and creditors, it is deemed an appropriate level of burden-sharing for the EU.
· Complementarity
The proposed MFA would complement the assistance being envisaged by other multilateral and bilateral donors in the context of the IMF-sponsored economic programme. The EU MFA would also complement the EU grants and loans mobilised under the regular EU cooperation instruments (notably the European Neighbourhood Instrument) and extended by the European Investment Bank
· Choice of instruments
Project finance or technical assistance would not be suitable or sufficient to address these macroeconomic objectives. The key value added of the MFA in comparison to other EU instruments would be its rapid implementation to alleviate Ukraine's immediate external financial constraints, but also to help create a stable macroeconomic framework, including by promoting a sustainable balance of payments and budgetary situation, and an appropriate framework for structural reforms. By helping to put in place an appropriate overall framework for macroeconomic and structural policies, MFA can increase the effectiveness of the actions financed in Ukraine under other, more narrowly focused EU financial instruments.
The planned assistance would be provided in the form of a loan and should be financed through a borrowing operation that the Commission will conduct on behalf of the EU. The budgetary impact of the assistance will correspond to the provisioning, at a rate of 9%, of the amounts disbursed in the Guarantee Fund for External Actions of the EU, from budget line 01 03 06 ("Provisioning of the Guarantee Fund"). Assuming that the loan will be disbursed in 2014, and according to the rules governing the guarantee fund mechanism, the provisioning will take place in the 2016 budget.
· Review/revision/sunset clause
The proposal includes a sunset clause. The proposed MFA would be made available for one year, starting from the first day after the entry into force of the Memorandum of Understanding, with a possibility to extend it if necessary.