Ukraine’s Economic Prospects and Priorities for Reform

1. Ukraine’s Economic Prospects and Priorities for Reform Martin Raiser, Economic Advisor World Bank

2. Strong fundamentals (public debt 14% of GDP, low fiscal and current account deficits) Regionally competitive – exchange rate and wages Improved transparency in corporate sector WTO accession and EU FTA anchors for reform Increasing investor interest (FDI up > 5% of GDP) Huge, under-served domestic market: finance, housing, consumer durables, retail etc. Rising inflation Growing external imbalances Credit boom may hide underlying credit risks Limited degree of export diversification and vulnerability to terms of trade shock (gas ↑; metals ↓) Laggard in structural reform and un-tested financial regulatory framework Political instability and short election cycles ~ populist spending promises The Macro-Context: Strengths and Risks

3. Gradual re-pricing since May ’07 Reflects shift in perceptions of political risks after dissolution of parliament Now broadly in line with other BB- sovereigns A Risk Fairly Priced?

4. Why Did Macro Performance Hold Up So Well So Far? • Underutilized capacity: what goes down must come up (to some extent) • Luck: strong metal price growth offsets gas price shock; EURO and Ruble strength against the US $ keep real effective exchange rate in check • Clever budgeting: indexation of social payments and wages to CPI, but budget revenues grow in line with GDP deflator – aggregate fiscal impact more restrained than appears from the approved budget • But this benign constellation cannot continue forever => signs of strain and imbalances emerging

5. Real effective exchange rate remains under control for now

6. GDP still driven by steel prices

7. Indexation rules help the budget

8. But rising imbalances, driven by private sector

9. The “price” of a quasi-peg

10. Medium-term Economic Prospects in the Era of Globalization • Two World Views: • “De-coupling” and European Convergence => Ukraine inevitably will catch-up and fast because emerging markets are no longer considered risky • The Four-Speed World => only fast reformers in emerging markets benefit long-term from globalization • Ukraine can benefit regardless of which view is right – but only if it reforms

11. Ukraine can finance 4-6% GDP current account deficit Ukraine’s dollar wages (US$250 av) roughly in balance with relative GDP level Medium-term trend is for moderate real exchange rate appreciation – around 1.75% US$ wage growth for every 1% GDP growth Note: all competitors appreciating at similar if not faster pace! The European Convergence Path

12. Reform Challenges • Avoid fiscal populism – at this stage in the cycle Ukraine should aim for fiscal surpluses • Improve the Investment Climate and Governance • Improve the quality of public services (health and education) • Increase public investment in infrastructure • Reform the legal and judicial system to protect property and contract rights

13. Ranked 139th of 175 in Doing Business Ranked 73th of 131 in WEF Competitiveness Lagging lower middle income av. in rule of law and ctrl of corruption Investment climate & Governance: diagnostics

14. Public sector reform and social inclusion: diagnostics • Public wage bill ~ 10% of GDP (incl in kind) – EU 8.8%, CIS 5% • SOE employment 12.5% - EU8 4%, CIS 9% • Public investment 2% of GDP – EU 5%, Asia 8-10% • Little improvement in service quality despite high spending • Poverty is declining but people do not feel their lives have improved

15. Economic reform: the politicians’ dilemma • Not much choice when it comes to economic model • All three major parties supported basic market-oriented policy platform during elections • WTO and EU integration are strong anchors • Not much hope for immediate quick wins • Strong recent growth record may suggest reforms are not needed • Institutional reforms take longer to bear fruit • Not much public support for the long-haul of structural reforms • Redistribution through re-privatization and tighter tax enforcement sounds attractive but track record suggests that it may not work

16. Reforms and Performance During Transition Ukraine may still be at point “A” Growth path 2 Income level Growth path 1 B The growth impact of reform A t

17. The Expectations of the Population • EBRD/World Bank “Life in Transition Survey” • 42% market economy preferable, 33% planned economy preferable • Only 15% economic situation better than 1989 (CIS 30%, EU8 26%) • 80% think state should guarantee employment and low prices (CIS 80%, EU8 65%) • 38% dissatisfied with health services (CIS 32%, EU8 25%) • Close to 50% completely distrust political institutions (CIS 25%, EU 30%) • People expect state to take social responsibility but have little trust that it will

18. Economic reform strategy • Focus attention on a few selected issues • Use interests of large domestic capital to build reform coalition -> access to finance & markets requires improved governance and business climate • Focus on public service delivery to build support for economic reform in the population • Try to avoid politicizing reform – remember: there are no alternative economic models

19. Prioritizing Reforms: World Bank proposals • Quick Wins: • Enact a new Law on State Procurement (opposition to reform is small; losses to the budget are huge) • Pass the Joint Stock Company law (key signal to investors) • Adopt a realistic 2008 budget (avoid macro-overheating and adjust people’s expectations while going is good) • Opportunities: • Use FTA negotiations to push deregulation agenda • EURO 2012 as an opportunity to renew government infrastructure investment • Strengthen financial market regulators while markets are benign (don’t wait until they are tested by investors)

20. Prioritizing Reforms: Long Term Economic and Social Reform Challenges • Reduce tax burden and reform tax administration => new tax code, but existing drafts need more work! • Push ahead with pension reform • Reform financing of social services as a key to improve quality • Continue raising energy tariffs to full cost recovery levels • Re-launch privatization – competitively and transparently • Reform the land market – start with auctioning urban real estate competitively • Reform public administration and the judiciary

21. What it all adds up to: WB Base Case (Oct 07) • ToT weakening in 2008-2010 – lower growth and larger external deficits • As revenue growth declines, fiscal policy will tighten to prevent widening deficits • Ukraine retains access to international capital markets and investment-led growth continues (at somewhat lower rates) • Reforms will continue at gradual, sometimes inconsistent pace – faster growth in 09-10 if reforms accelerate • Quarterly updates on: www.worldbank.org.ua

22. WB Base Case