Explanatory Memorandum to COM(2022)37 - Providing 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(2022)37 - Providing macro-financial assistance to Ukraine. |
|---|---|
| source | COM(2022)37  |
| date | 01-02-2022 |
1. CONTEXT OF THE PROPOSAL
• Reasons for and objectives of the proposal
Ukraine has been developing a strong partnership with the European Union since 2014, going beyond mere bilateral cooperation to evolve towards gradual political association and economic integration. The EU-Ukraine Association Agreement, which entered into force on 1 September 2017 and includes a Deep and Comprehensive Free Trade Area, is the main tool for bringing Ukraine and the EU closer together. In addition to promoting deeper political ties, stronger economic links and the respect for common values, the Agreement has provided a solid framework for pursuing an ambitious reform agenda, focused on the fight against corruption, an independent judicial system, the rule of law, and a better business climate. The EU has shown continuous support for these reforms, which are crucial for attracting investments, boosting productivity and lifting the standards of living in the medium term. Among other support instruments, the EU has supported Ukraine through five consecutive Macro-Financial Assistance (MFA) operations that totalled EUR 5 billion of loans in the period 2014-2021.
However, notwithstanding the strategic long-term political orientation and commitment to implementing reforms, Ukraine continues to face significant challenges. Since the outbreak of the COVID-19 pandemic, more than 3.8 million contaminations resulted in almost 100,000 deaths. The return to economic growth in 2021 was slow, driven primarily by the retail and construction sectors, and the outlook is surrounded by considerable risks. Inflation accelerated and reached 10% at the end of 2021. The growing geopolitical tensions at its border with Russia have had considerable knock-on effects on confidence, in particular of foreign investors. The national currency has lost 9% of its value relative to the USD since mid-November 2021, despite interventions by the National Bank of Ukraine for about USD 1.6 billion during the same period, thereby drawing down the stock of official reserves by 5.5%.
In this context, the yields on the Ukrainian government Eurobonds increased to prohibitive levels in mid-January 2022. Private financing of the underlying balance-of-payments gap of Ukraine is thus no longer available at sustainable terms. Based on the latest projections by the International Monetary Fund in their first programme review, concluded on 8 November and approved on 22 November 2021, the lack of access to capital markets would imply a widening of the country’s funding gap by the equivalent of, at least, USD 2.5 billion in 2022. Moreover, the escalating geopolitical tensions are having a detrimental effect on Ukraine's already precarious economic and financial stability. Persistent security threats have already triggered a substantial outflow of capital. The negative impact on future investment, where Ukraine has been lagging behind regional peers already, further reduces the country’s resilience to both economic and political shocks. Furthermore, the multiple threats that Ukraine currently is facing put a lot of pressure on state institutions to protect its citizens, which generates significant additional risks to the overall stability of the country and the broader society.
Against the backdrop of the loss of access to international capital markets due to the heightened geopolitical uncertainty and its impact on the economic situation in Ukraine, the Commission is submitting to the European Parliament and the Council a proposal to provide a new MFA of EUR 1.2 billion in the form of loans to foster stability in Ukraine.
The planned emergency MFA, put forward to provide swift support in a situation of acute crisis and to strengthen the resilience of the country, will have a duration of 12 months and include two disbursements. The release of the first tranche, subject to the political precondition and a satisfactory implementation of the IMF programme, would occur swiftly after the approval of this proposal, upon entry into force of the Memorandum of Understanding (MoU) on specific structural policy measures, agreed between the European Commission on behalf of the EU and Ukraine. The disbursement of the second tranche would be linked to the continuous satisfactory implementation of both an IMF programme and the policy measures agreed in the MoU. The MoU underpinning this emergency macro-financial assistance operation is likely to focus on a limited number of feasible, short-term policy actions in the most urgent priority areas, such as strengthening economic resilience and stability, governance and rule of law, and energy. A subsequent, longer-term MFA could look beyond the immediate crisis and focus on a broader set of reform priorities. The implementation of the proposed operation is expected to go hand-in-hand with the support under budgetary operations financed by the Neighbourhood, Development and International Cooperation Instrument (NDICI). The announced additional allocation of EUR 120 million in NDICI grants will be important to further strengthen Ukraine’s state-building and resilience efforts. Moreover, the EU will work closely with Ukraine to follow up on their request for a subsequent, regular MFA operation when the situation stabilises.
As further elaborated in the Commission Staff Working Document accompanying this proposal, the Commission considers, based also on the assessment of the political situation made by the European External Action Service, that the political and economic pre-conditions for the proposed MFA operation are satisfied.
• General context
The risks from the current geopolitical tensions and the security concerns at the border with Russia have been rising steadily since mid-November. They have weighed heavily on investors’ confidence, as evidenced by a steady outflow of capital and drain on official foreign reserves. The weakening of the hryvna, despite continued interventions by the National Bank of Ukraine in support of the domestic currency, and the de facto loss of access to capital markets for the government increase the risks to the macroeconomic outlook of Ukraine significantly. Following a less severe-than-expected recession of 4% only in 2020, the Gross Domestic Product contracted by 2.2% year-on-year in the first quarter of 2021. The second quarter rebound by 5.7% year-on-year is disappointing, given the size of the earlier contraction, and was followed by a deceleration of growth to 2.7% in the third quarter. The weaknesses in growth are driven by both the on-going difficult pandemic situation (with the number of COVID-19 cases rising and a relatively low vaccination rate of 33% by late January 2022), the impact on confidence from escalating tensions, and by constraining structural factors, including a chronically low investment rate. Among the significant structural obstacles to investment, the still wide-spread corruption and the unfinished governance reform of the dense network of state-owned enterprises remain priorities for future policy efforts.
Taking into account the growing money supply and the accelerating inflation, the National Bank of Ukraine (NBU) increased its key policy rate by 400 basis points to 10% between June 2021 and January 2022. After significant disinflation in the first half of 2020, inflation had started accelerating again in November 2020. The average increase in consumer goods’ prices reached 11% in September 2021, before moderating to 10% in December. The acceleration in producer goods’ price inflation is still ongoing, the rate having amounted to a spectacular 62.2% in December 2021. While the NBU considers that the peak in inflation has been reached, further monetary tightening is to be expected in the course of 2022, especially to rein inflation in to the 4% to 6% target. In the current context of a gradual global tightening of financing conditions, and as an emerging market, Ukraine is also exposed to additional fragility stemming from a re-assessment of global risks.
On the back of return to growth and higher tax revenues, the 2021 public deficit is estimated at 3.1% of Gross Domestic Product, which is 200 basis points lower than the initially planned deficit. Public revenues rose by 24% in 2021, which is 2.8 percentage points higher than planned, while spending increased by 11%, which is 1.5 percentage points below the target. In light of these results, public finances performed well last year. The 2022 budgetary deficit is currently planned at 3.5% of Gross Domestic Product, but the actual turnout is very uncertain, can prove dramatically worse, and will notably depend on how the international geopolitical context evolves.
Following the resumption of economic growth, the significant 2020 current-account surplus, reflecting demand compression, turned into a deficit in 2021. After a surplus of USD 5.3 billion in 2020, the current account registered a deficit of USD 830 million, or 0.5% of Gross Domestic Product, in the period January-August 2021. Over the same period, exports and imports of goods rose by respectively 36% and 30% year-on-year, resulting in a merchandise trade deficit of USD 3 billion. The services balance, where exports and imports increased by respectively 12% and 21%, showed a surplus of USD 2.3 billion. Primary income turned into a significant deficit of USD 3 billion, as opposed to a surplus of USD 3.2 billion in January-August 2020, despite remittances surging by 18% to USD 8.9 billion. The stock of foreign direct investment also recovered significantly in the first half of 2021, notably due to the reinvestment of earnings.
The stock of official foreign exchange reserves proved stable throughout the pandemic in 2020 and even reached an all-time high of USD 31.6 billion in August 2021, including the additional allocation of Special Drawing Rights by the IMF for the equivalent of USD 2.73 billion. Despite a minor decline in September 2021, reserves continued to grow and remained close to USD 31 billion in December of last year, which is still 6% higher than a year earlier. However, following the recent change in investors’ confidence and the ensuring central bank’s interventions in the foreign exchange market for more than USD 700 million in the start of 2022, official reserves are expected to have declined.
• Consistency with existing policy provisions in the policy area
Decision No 701/2020/EU on providing previous macro-financial assistance to Ukraine (as part of the MFA package to the enlargement and neighbourhood countries in the context of the COVID-19 pandemic) in the amount of EUR 1.2 billion in loans was adopted by the European Parliament and the Council on 25 May 2020. The assistance was fully disbursed during 2020-2021.
• Consistency with other Union policies
The proposed MFA is in line with the objectives of the European Neighbourhood Policy. It contributes to support the European Union’s objectives of economic stability and development in Ukraine and, more broadly, resilience in the Eastern European neighbourhood. By supporting the authorities’ efforts to establish a stable macroeconomic framework and implement ambitious structural reforms, the proposed operation enhances the added value of the overall EU involvement in Ukraine and improves the effectiveness of other forms of EU financial assistance to the country, including budget support operations and grants available through external financial instruments under the current multiannual financial framework for 2021-2027. The proposed emergency MFA is part of an EU package containing also a grant element, through the additional deployment of EUR 120 million under the “Neighbourhood, Development and International Cooperation Instrument – Global Europe” (NDICI-Global Europe), and is an integral part of overall international support for Ukraine. MFA will continue to complement the assistance provided by other multilateral and bilateral donors.
These efforts should be seen against the important economic ties Ukraine has established with the EU. On 1 September 2017, the EU-Ukraine Association Agreement came into force. The provisions concerning the Deep and Comprehensive Free Trade Area had been provisionally applied since 1 January 2016, when the EU and Ukraine started to mutually open their markets for goods and services. The EU is Ukraine's first trading partner, accounting for 38.1% (in value terms) of Ukraine's total external trade turnover in 2020. EU countries account persistently for one third of the Ukrainian exports of goods and services. Imports from EU countries have been growing even more and reached 43.3% of all imports in 2020.
2. LEGAL BASIS, SUBSIDIARITY AND PROPORTIONALITY
• Legal basis
The legal basis for this proposal is Article 212 TFEU.
• Subsidiarity (for non-exclusive competence)
The subsidiarity principle is respected as the objectives of restoring macro-financial stability in the short-term in Ukraine cannot be sufficiently achieved by the Member States alone and can 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
The proposal complies with the proportionality principle: it confines itself to the minimum required in order to achieve the objectives of strengthening macro-financial stability in the short-term 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 current Stand-by Arrangement, the amount of the proposed new MFA corresponds to close to half of the estimated residual financing gap for 2022, whilst noting that this gap was calculated prior to the recent deterioration of the crisis. This proportion is consistent with standard practices on burden-sharing for MFA operations (for a country with an Association Agreement, the upper limit would be 60% according to the ECOFIN Council conclusions of 8 October 2002), taking into account the assistance pledged to Ukraine by other bilateral and multilateral donors.
• Choice of the instrument
Project finance or technical assistance would not be suitable or sufficient to address the macroeconomic objectives. The key value added of the MFA in comparison to other EU instruments would be to alleviate the external financial constraints 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 policy framework, MFA can increase the effectiveness of the actions financed in Ukraine under other, more narrowly-focused EU financial instruments.
3. RESULTS OF EX-POST EVALUATIONS, STAKEHOLDER CONSULTATIONS AND IMPACT ASSESSMENTS
• Stakeholder consultations
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 IMF and the World Bank, which already have sizeable financing programmes. The Commission has also been in regular contact with the Ukrainian authorities.
• Collection and use of expertise
In line with the requirements of the Financial Regulation, in the context of the COVID-19 MFA package, the Commission services have carried out an Operational Assessment (OA) of the financial and administrative circuits of Ukraine in order to ascertain that the procedures in place for the management of programme assistance, including MFA, provide adequate guarantees. This Operational Assessment drew on the findings of the 2018 OA, which could be considered broadly up to date, and the thorough analysis of the 2019 Public Expenditure and Financial Accountability Performance Assessment report. The assessment concludes that the financial circuits and procedures in Ukraine are found to be based and work on sound principles and are therefore deemed appropriate for the purposes of Macro-Financial Assistance. Developments in this area will continue to be closely monitored also through the regular progress reports on PFM reforms produced by the EU Delegation in Kyiv.
• Impact assessment
The EU’s macro-financial assistance is an exceptional emergency instrument aimed at addressing severe balance-of-payment difficulties in third countries. Therefore, this MFA proposal is exempted from the requirement to carry out an Impact Assessment in accordance with the Commission's Better Regulation Guidelines (SWD(2015) 111 final) as there is a political imperative to move ahead quickly in a situation requiring a rapid response.
More generally, the Commission's MFA proposals build on lessons learned from ex-post evaluations carried out on past operations in the EU's neighbourhood. The new MFA, and the economic adjustment and reform programme attached to it, will help alleviate the short-term financing needs of Ukraine. The attached policy measures aimed at strengthening the medium-term balance of payments position and fiscal sustainability will raise resilience and contribute to a more sustainable growth model, thus complementing the current IMF programme. The policy conditions should build upon the achievements of the five MFA programmes since 2015, including the latest COVID-19 emergency MFA assistance. Possible areas of conditionality could, in principle, include reforms to strengthen the fight against corruption, the independence of the judicial system, the governance of state-owned enterprises and the energy sector.
• Fundamental rights
Countries that are covered by the ENP are eligible for MFA. A pre-condition for granting MFA is that the eligible country respects effective democratic mechanisms, including a multi-party parliamentary system and the rule of law, and guarantees respect for human rights.
The renewed reform-commitment and strong political will by the Ukrainian authorities, in particular as evidenced by the successful completion of the structural policy conditionality attached to the last and fifth COVID-19 MFA programme to Ukraine, in key areas including the judiciary, good governance, the rule of law and the fight against corruption, is a clear positive sign. The authorities are committed to pursue these reforms in a transparent manner and in line with EU standards. To that end, the political pre-condition for an MFA operation is considered to be satisfied.
4. BUDGETARY IMPLICATIONS
The proposed EUR 1.2 billion MFA operation for Ukraine is foreseen to be disbursed in two equal tranches to be released within 12 months. These funds will be borrowed in the capital market and onlend to Ukraine. The loan will be backed by the External Action Guarantee. The required provisioning (at a rate of 9% of the amount of the loan) is provided under the Neighbourhood, Development and International Cooperation Instrument (NDICI), for a total amount of EUR 108 million (budget line 14 02 01 70 “NDICI – Provisioning of the Common Provisioning Fund”).
5. OTHER ELEMENTS
• Implementation plans and monitoring, evaluation and reporting arrangements
The European Union shall make the MFA available to Ukraine for a total amount of EUR 1.2 billion, provided in the form of medium- to long-term loans. This assistance will contribute to covering the residual financing needs of Ukraine in 2022. The assistance is planned to be disbursed in two equal instalments. The release of the first tranche would occur swiftly after the approval of this proposal and the entry into force of the corresponding MoU. The disbursement of the second tranche is conditional upon the successful and timely implementation of structural policy measures, to which the Ukrainian authorities would commit.
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. Moreover, as is normally the case with MFA, the disbursements would inter alia be conditional on the continuous successful implementation of an IMF programme, as well as progress on the implementation of the EU-Ukraine Association Agreement and the Deep and Comprehensive Free Trade Area. The Commission will work closely with the authorities to monitor progress on the policy actions and the pre-conditions, as specified above.