Explanatory Memorandum to COM(2015)5 - 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(2015)5 - Macro-financial assistance to Ukraine. |
|---|---|
| source | COM(2015)5  |
| date | 08-01-2015 |
· Grounds for and objectives of the proposal
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 cooperation in all key areas of reform and continues to be the legal basis of EU-Ukraine relations. Relations were further reinforced 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). On 21 March and 27 June 2014, the EU and Ukraine signed an Association Agreement, which will establish a deep political association and economic integration between the EU and Ukraine. It covers a wide range of areas such as justice, trade and sectorial cooperation including energy, transport and environment and sets out detailed commitments and timelines that are demanding for both parties.
The Ukrainian economy is experiencing a deep recession that is the result of long-standing macroeconomic imbalances and structural problems. The situation was aggravated by the eruption of an armed conflict in the East that had a heavy toll on the economy through sizable losses of productive capacity and reduced confidence. Following mass public protests, former President Viktor Yanukovych left power and a reform-minded government was appointed in Ukraine in February 2014. It embarked on an ambitious macroeconomic adjustment and structural reform programme that aimed to change the country’s unviable economic model and pave the way for long-term, sustainable growth. This programme was underpinned by a USD 17 billion financial assistance programme by the IMF and significant support from other international donors.
Following the political change in February 2014, Ukraine held free and democratic presidential and parliamentary elections (on 25 May and 26 October, respectively). Furthermore, important steps were taken by Ukrainian authorities in 2014 to fight corruption and strengthen the rule of law. In December 2014, the newly formed government presented an ambitious Action Plan outlining the reform agenda of the coalition government. It is envisaged to be followed up in early 2015 by a comprehensive National Reform Strategy setting out economic, political, judicial and administrative reform measures for 2015-17 that are necessary to ensure medium-term macroeconomic stability, as well as the implementation of the EU-Ukraine Association Agreement.
The reform efforts of the authorities have been seriously complicated, however, by the armed conflict in the East, growing trade restrictions from Russia, and the escalation of a natural gas dispute between the two countries. As a result, the economic recession in Ukraine has become more severe than initially expected by international donors. The crisis is expected to be a prolonged one, as Ukraine is heading for another year of a contraction in 2015. The loss of export proceeds due to the conflict in the East and the confidence crisis led to a sharp depreciation of the local currency and a depletion of international reserves. In the current situation, Ukraine does not have access to international debt markets and is not expected to regain it in the short term. A significant additional external financing gap has therefore emerged.
Against this background, additional official financial assistance is required to address Ukraine’s short-term balance of payments needs, including the replenishment of international reserves, and to support the reform programme of the authorities, in particular the restructuring of the energy and banking sectors. Last but not least, this support is required to shore up investor confidence, which is essential for bringing Ukraine’s economy eventually back to a sustainable growth path.
The Ukrainian authorities requested MFA from the EU of EUR 2 billion on 9 September 2014. The request for MFA was reiterated in a further letter on 15 December 2014. Taking into consideration these requests and the economic situation in Ukraine, in particular the emergence of significant additional external financing needs, the European Commission is submitting to the European Parliament and the Council a proposal to grant MFA to Ukraine of maximum EUR 1.8 billion in the form of medium-term loans.
The objective of the proposed MFA is to help Ukraine cover part of its residual additional external financing needs in 2015 and early 2016 in the context of the on-going IMF programme. These additional needs are estimated by the IMF at USD 15 billion. The EU’s assistance would also reduce the economy’s short-term balance of payments and fiscal vulnerabilities, while supporting the government’s adjustment and reform programmes through an appropriate package of accompanying policy measures to be agreed with the Ukrainian authorities in a Memorandum of Understanding (MoU).
In this context, the Commission considers that the political and economic pre-conditions for a MFA operation of the proposed amount and nature are satisfied.
· General context
Ukraine is experiencing a deep recession that is the result of long-standing economic and structural problems. The situation is aggravated by the armed conflict in the eastern part of the country that not only destroyed part of Ukraine’s productive capacity but also had significant confidence impact for households and businesses. In recent months, the implementation of much-needed stabilisation policies, aimed at reducing imbalances and safeguarding fiscal and external sustainability, have further weighed on short-term economic prospects. As a result, GDP is expected to contract by around 7% in real terms in 2014.
Despite the sharp economic contraction and the conservative central bank policies, inflationary pressures remain high, reflecting the currency weakening and an adjustment of administered prices (in particular of utility tariffs). CPI inflation accelerated to 21.8% year-on-year in November and is expected to pick up further in the near future as the effect of the currency depreciation fully kicks in. The hryvnia has lost close to 50% of its value against the USD since its floatation in February, well above initial expectations. The weakening was particularly strong in August and September, forcing the central bank to introduce a number of administrative measures and currency controls, in addition to undertaking some foreign exchange market interventions, which succeeded in bringing temporary stability to the exchange rate ahead of the October parliamentary elections. At the same time, these measures impacted negatively on business activity and led to a fast depletion of the already low international reserves. Following a slight relaxation of the administrative controls, the currency has depreciated strongly as from November.
Weak economic activity, coupled with higher interest outlays on foreign currency denominated debt in light of strong currency depreciation, as well as and sizable losses in tax collection capacity in the eastern parts of the country, led to widening of the budget deficit in 2014 despite a number of austerity measures introduced by the authorities[1]. According to recent forecasts of the Ministry of Finance, the government fiscal deficit will rise to 5.3% of GDP for 2014 as a whole.
A major additional drag on public finances in 2014 came from the ailing oil and gas company Naftogaz. This company traditionally runs sizable operational deficits due to the administrative cap on natural gas prices for households and municipal utility companies, which forces Naftogaz to sell at below-cost rates and general operational inefficiency. In 2014, the company’s activities were negatively affected by the strong depreciation of the hryvnia and the need for coverage of gas arrears to Russia (including ones accumulated in 2013). As a result, the state had to inject UAH 103bn into Naftogaz by November, an amount representing 6.8% of projected GDP. Thus, the overall fiscal deficit run by Ukraine in 2014, which includes the deficit of Naftogaz, is projected at nearly 12% of GDP, up from 6.7% in 2013 and compared to 8.5% forecast by the IMF in April 2014.
The widening budget deficit and the sharp depreciation of the local currency, coupled with a significant economic contraction, led to a sharp deterioration of Ukraine’s public debt metrics. At the end of October 2014, the general government public debt amounted to 63% of the projected GDP for the year, an increase of almost 23 percentage points from the year end-2013 debt of 40.2% of GDP.
On the external side, the depreciation of the hryvnia, coupled with weak domestic demand, has contributed to a significant adjustment of the current account. The deficit is expected to narrow to around 4% of the GDP in 2014 from 9.0% in 2013, although this is primarily due to strong import compression[2]. However, this was accompanied by sizeable private-sector financial outflows due to dwindling confidence in an environment of high geopolitical uncertainty. The official financing extended as from May 2014 was insufficient to offset the capital flight. Overall, Ukraine received around USD 9 billion in gross official financing in May-December, a large part of which was used to cover maturing debt (see IMF support and other donor assistance up to 2014).
In the context of a deepening economic recession and a confidence crisis, the sizable official financial assistance provided to Ukraine in 2014 was insufficient to stop the continuous drain on reserves. In the first eleven months of the year, reserves halved from their end-2013 level to only USD 10 billion. A further significant drop is expected in December as a result of payments for gas (including arrears to Russia). As a result, Ukraine’s gross international reserves are now expected to drop to USD 7 billion at the end of 2014, or around one month of projected 2015 imports of goods and services.
On 30 April 2014, the IMF approved a two-year Stand-By Arrangement (SBA) for Ukraine amounting to SDR 10.976 (USD 17 billion, or 800% of the country’s quota). The IMF’s financial assistance has been complemented by significant support from other official and bilateral assistance (EU, US, Japan, Canada). Other international financial institutions such as the World Bank, the EBRD and the EIB have also significantly scaled up their activity to support Ukraine’s economic transition.
However, in view of the deeper-than-expected economic recession and the strong capital outflows due to the confidence crises, Ukraine is facing significant additional external financing needs in 2015 and in early 2016. These needs arise mainly from the need to replenish the very low level of international reserves and sizable private capital outflows. These additional financing needs are estimated at USD 15 billion. The proposed MFA would cover 16.7% of the total additional financing gap.
· Existing provisions in the area of the proposal
MFA has been provided to Ukraine under three separate decisions:
· Council Decision of 12 July 2002 providing supplementary macro-financial assistance to Ukraine (2002/639/EC)
· Decision No 388 /2010/EU of the European Parliament and of the Council of 7 July 2010 providing macro-financial assistance to Ukraine
· Council Decision of 14 April 2014 providing macro-financial assistance to Ukraine (2014/215/EU)
· Consistency with the other policies and objectives of the Union
The proposed MFA is consistent with the EU’s commitment to support Ukraine’s immediate economic and political transition. 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 proposed MFA is in line with the objectives of the European Neighbourhood Policy (ENP). It contributes to support the European Union’s objectives of economic stability and economic development in Ukraine and, more broadly, in the eastern European neighbourhood. By helping the authorities’ efforts to establish a stable macroeconomic framework and implement an ambitious structural reform programme, the proposed assistance helps improve the effectiveness of other EU financial assistance to the country, including budgetary support operations The proposed MFA also complements the assistance provided by other multilateral and bilateral donors in the context of the IMF-sponsored economic programme.
The EU MFA would complement the total EUR 1.565 billion in grants that can be 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 over 2014-2020, whereby EUR 370 million have already been committed in 2014. 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 intervention including through other financial instruments, such as the State Building Contract and other budget support operations.
Ukraine has important economic ties to the EU. The EU is among Ukraine’s most important commercial partners and accounts for about one third of its external trade. In 2013, the value of Ukrainian imports from the EU was EUR 23.9 billion while the value of its exports was EUR 18.8 billion. Ukraine also has a high dependence on the EU in terms of FDI and other financial flows. On 27 June 2014, Ukraine and the EU agreed to the future establishment of a Deep and Comprehensive Free Trade Area (DCFTA). This will support a further increase in bilateral trade in goods and services and gradually bring Ukraine's trade-related rules and standards in line with those of the EU.
Ukraine’s transition is very difficult and the risk of 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, based on the rule of law. The country is also developing an economic reform programme aimed at laying the ground for a sustainable growth model. Progress in respect of these objectives and the reform programme will be of the utmost importance to underpin a successful transition.
Contents
· Consultation of interested parties
MFA is provided as an integral part of the international support for the economic stabilisation of Ukraine. In the preparation of this proposal for MFA, the Commission services have consulted with the International Monetary Fund and other international partners, which are putting in place sizeable financing programmes. The Commission has also been in regular contact with the Ukrainian authorities.
· Collection and use of expertise
An Operational Assessment verifying the quality and reliability of Ukraine's public financial circuits and administrative procedures was carried out by the Commission with the assistance of external experts, with the final report prepared in August 2014.
· Impact assessment
The MFA and the economic adjustment and reform programme attached to it will help alleviate Ukraine’s short-term financing needs while supporting policy measures aimed at strengthening medium-term balance of payments and fiscal sustainability and raising sustainable growth. It will notably support reform efforts in the following areas: public finance management and anti-corruption; tax administration; reforms in the energy sector, including strengthening the social safety net to ensure targeted cushioning of the ongoing withdrawal of retail energy price subsidies; financial sector reforms; and measures to improve the business environment.
· Summary of the proposed action
The European Union shall make MFA available to Ukraine for a total maximum amount of EUR 1.8 billion, provided in the form of medium term loans. The assistance will contribute to cover Ukraine’s residual external financing needs in 2015-16, as identified by the Commission based on the estimates of the IMF.
The assistance is planned to be disbursed in three loan instalments. The disbursement of the first instalment is expected to take place in the middle of 2015. The second instalment could be disbursed in the fourth quarter of 2015. The third and last instalment could be made available towards the end of the first quarter of 2016. 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 Commission and the Ukrainian authorities would agree on a Memorandum of Understanding setting out the structural reform measures associated with the proposed MFA operation, including aspects of timing and sequencing. These measures will support the authorities’ reform agenda, including relevant elements of the aforementioned forthcoming National Reform Strategy for 2015-17, and the implementation of the EU-Ukraine Association Agreement, as well as complementing the programmes agreed with the IMF, the World Bank and other multilateral and bilateral donors. As is normally the case with MFA, the disbursements would inter alia be conditional on satisfactory reviews under the IMF programme and the continued drawing by Ukraine on IMF funds.
The European Commission will seek consensus with the Ukrainian authorities on the expected National Reform Strategy, so as to facilitate smooth implementation also of the conditionality to be agreed in the Memorandum of Understanding for the proposed MFA operation. These policy conditions should address some of the fundamental weaknesses accumulated over the years by the Ukrainian economy. Possible areas of conditionality could in principle include: public finance management and anti-corruption; tax administration; reforms in the energy sector; financial sector reforms; and measures to improve the business environment.
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). It is also consistent with the treatment given to Ukraine by the World Bank and the IMF.
· Legal basis
The legal basis for this proposal is Article 212 of the TFEU.
· Subsidiarity principle
The subsidiarity principle is respected as 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 macro economic stability and does not go beyond what is necessary for that purpose.
As identified by the Commission based on the estimates of the IMF in the context of the stand-by arrangement, the amount of the assistance corresponds to around 16.7% of the estimated additional financing gap for the period 2015–Q1 2016. This significant commitment is justified by: the political importance of Ukraine for the stability in the European Neighbourhood; the political integration of the country with the EU as reflected by the Association Agreement between the two sides that provisionally entered into force on 1 November 2014; as well as the exceptionally challenging situation and correspondingly large financing needs that this EU neighbour is currently facing.
· Choice of instruments
Project finance or technical assistance would not be suitable or sufficient to addressmacroeconomic objectives. The key value added of the MFA in comparison to other EU instruments would be to alleviate the external financial constraint in a swift manner and 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 costs of the assistance will correspond to the provisioning, at a rate of 9%, of the amounts disbursed into the guarantee fund for external lending of the EU, from budget line 01 03 06 (“Provisioning of the Guarantee Fund”). Assuming that the first and second loan disbursements will be made in 2015 for a total amount of EUR 1,200 million and the third loan disbursement in 2016 for the amount of EUR 600 million, and according to the rules governing the guarantee fund mechanism, the provisioning will take place in the budgets for 2017 (for EUR 108 million) and 2018 (EUR 54 million). On the basis of the currently available information on the expected overall provisioning needs of the Guarantee Fund, this additional budgetary impact will be partly financed by a reallocation in the indicative financial programming for 2017 and 2018 from macro-financial assistance grants (budget line 01 03 02) and partly by using the unallocated margin for commitments under Heading 4 in the Multi-Annual Financial Framework. The indicative breakdown of this financing is as follows:
|| 2018
Additional expenditure:||
Provisioning of the Guarantee Fund as a result of the proposal (see the legislative financial statement)| 54
Sources of financing:||
Macro-financial assistance (grants) 01.0302 Margin under Heading -50 -| -40 -14
· Review/revision/sunset clause
The proposal includes a sunset clause. The proposed MFA would be made available for two and a half years, starting from the first day after the entry into force of the Memorandum of Understanding.