The IMF will shortly go back to the drawing board with Ukraine. As it prepares to revise the economic programme on which the third tranche of its funding will be based, the IMF faces three interconnected problems:
- How to salvage the credibility of the programme;
- How to maximise pressure on the government and vested interests to deliver long-elusive structural reforms; and
- How to handle a sizeable financing gap that will characterise a credible set of macro projections.
The contours of the programme
Having approved a two-year $17 billion loan in April based on excessively sanguine assumptions about the macroeconomy, the IMF revised its projections modestly in August when it released the second of eight funding tranches. At the same time, it announced that it would roll over the October review of the programme and the related funding tranche into that scheduled for December. This was a sensible move insofar as elections are to occur in late October; it is also fortuitous as it gives the IMF breathing space to decide how to put together and fund a more realistic programme.
A snapshot of the August review assessing divergences of developments from the original programme helps define the magnitude of the task the IMF faces.1
The IMF continues to assert that Ukraine’s government is fully committed to deep-seated reform. Though there is no reason to doubt this on the basis of concrete actions, it is too early to tell whether an enduring determination to reform has taken hold. Early commitments have been met – an increase in energy tariffs (and some background work that is probably necessary for improving energy tariff collection), reductions in energy subsidies, strengthening of bank regulation, recapitalisation of banks, and governance reform. But most actions to date have been preparatory. Political commitment will only be clear when a broad swathe of changes are actually implemented.
Indeed, some aspects of the record leave room for doubt.
- First, the authorities backtracked on their commitment to let the exchange rate float, which had been seen as essential to maintaining their already-small cushion of foreign-exchange reserves.
- Second, parliament passed a bill in May that would have allowed much of the burden of foreign-exchange denomination of mortgages to be shifted from borrowers to banks’ balance sheets; the IMF subsequently insisted that this be reversed.
- And third, in a move that raises questions about the government’s commitment to central-bank independence, a large ‘advance transfer’ of central-bank profits (presumably arising from seignorage buttressed by exchange-rate gains on NBU foreign-exchange reserve assets) was made in order to meet programme targets for the general government deficit.2
These concrete actions – in contrast to the preparatory steps and promises characterising most other early parts of the reform agenda – are worrisome.
Macroeconomic developments are far less ambiguous: as of the end of August, the programme had veered significantly away from the scenario established four months earlier. This is not surprising given the severity of the situation and the optimism of the previous scenario. But it means that the gamble for redemption – a programme built on the hope that an unidentified piece of good luck would bolster Ukraine’s fortunes – looks increasingly desperate.
The review acknowledged that GDP growth, inflation, the general government accounts, the accounts of the publicly-owned oil and gas company (Naftogaz), and the bill for bank recapitalisation were all worse than expected at the outset of the programme (see Table). Reflecting the sharp dip in activity, the current account improved more than expected, but net financial inflows were lower and official intervention larger – so foreign-exchange reserves tanked. Revisions to the macro framework were inescapable, but insufficient. Indeed, a set of projections termed a hypothetical ‘adverse scenario’ looks substantially more plausible for 2014 than the programme scenario.
Table 1. Programme projections and revisions and 'adverse' scenario
There was even less of an effort to come to terms with the worsening outlook for 2015, when the programme scenario shows a bounce back for almost all variables even larger than in the original programme. Though projections for external and public debt ratios in 2015 were raised relative to the April programme, the debt sustainability analysis still shows debt stabilising, just at higher levels. The report is laden with qualifiers that the programme has substantial downside risks and that the programme scenario is predicated on the assumption that “fighting in the East will begin to subside in the coming months”. This leaves the impression that IMF staff and management find the programme scenario as skewed toward optimism as markets do.3
Constraints on programme revisions
The IMF faces specific and conventional constraints in redesigning the programme with Ukraine. The key specific constraint is that given the geopolitical dimensions of Ukraine’s situation, the option of not completing the review/releasing the third funding tranche would appear to be all but off the table. Contrast this with the seven lending arrangements that the IMF has had with Ukraine since 1995: in all but one, the IMF cut off its disbursement of funds when Ukraine failed to follow through with promised structural reforms and/or commitments to allow the exchange rate to float. In the current programme, the IMF's leverage will be vitiated by Ukraine's political circumstances.
More conventionally, the IMF must work within two other constraints.
- First, it must build its revised projections off the base of newly available data (most likely through September) for the main macroeconomic variables. Revisions to 2014 estimates and 2015 projections to reflect worse-than-expected developments in 2014 will therefore be impossible to avoid.
- Second, before disbursing its own funds, the IMF is formally obliged to ensure that provisions are in place to meet all government and external funding requirements during the 12 months after the review.
Four principles for redesigning the programme
Faced with these constraints, the IMF would be wise to stick to four principles, both to maximise chances for the programme to effectively put Ukraine on a viable path and to bolster its own institutional credibility.
First, the so-called programme scenario (the set of macroeconomic projections for the remainder of the programme period) should be constructed as a central scenario – one where risks on either side of the baseline are more or less equally distributed. This is the only way to salvage the credibility of the IMF as a crisis manager. Projections for GDP, inflation, government financing needs, the balance of payments, the debt sustainability analysis, and the recapitalisation requirements for banks need to be plausible for a scenario where – as is widely expected – Ukraine faces a frozen conflict.
Second, the IMF needs to agree with Ukraine a clear and mutually acceptable exchange-rate policy consistent with its macro and financial projections. The authorities’ April commitment to floating the exchange rate – with obvious implications for the sustainability of private and public exposure to foreign-denominated debt, and for the balance sheets of banks with direct and indirect foreign-exchange exposure – has been reluctant and halting. During departures from the commitment, the central bank has run down foreign-exchange reserves and increased future financing needs. Projections for 2015 must be consistent with an agreed exchange-rate policy to which the authorities actually adhere.
Third, the IMF needs to provide a hard assessment of progress with structural reforms. The programme is at the point where concrete actions – as opposed to studies and preparatory steps – are the only convincing indication of the government’s commitment and ability to implement reforms affecting deeply embedded inefficiency and corruption.
Fourth, the IMF needs to insist that the central scenario is adequately financed. Three financing options exist.
- The first – and the only one that should not be employed – is to increase access to IMF financing. The IMF has already provided financing above the normal quota limits and departed from its normal practice of avoiding lending in situations of acute conflict.
- The second is for other official creditors to raise the amount of their financing commitments to the programme. This is highly likely to be necessary.
- The third is to involve Ukraine’s bondholders in the financing burden. This option should also be part of a credible programme.
So far Ukraine has made over $2.5 billion in amortisation payments to private creditors since the programme began in April. During the next 15 months alone a further $3.8 billion comes due. It seems glaringly inconsistent for the Fund to propose that these large payments proceed despite the large (and probably understated) gap between actual financing needs and potential sources of funds. Earlier this year, an IMF staff paper discussed by the Executive Board made a serious and timely proposal for countries borrowing from the Fund but having less than certain prospects for debt sustainability.4 The proposal was to ask for bondholders to agree to an extension of maturities – either at the outset of the programme or at a point when serious doubts about debt sustainability are raised. The proposal was aimed at situations when time was needed to assess the capacity of the indebted country to repay and the possible need for a restructuring of debt. If there was ever a case tailor-made for this proposal, Ukraine would seem to be it.
IMF (2014a) “The Fund’s Lending Framework and Sovereign Debt – Preliminary Considerations”, June.
IMF (2014b) “Ukraine: Request for a Stand-By Arrangement” – Staff Report; Supplement; Staff Statement; Press Release; and Statement by the Executive Director for Ukraine; IMF Country Report 14/106; April.
IMF (2014c) “Ukraine: First Review under the Stand-by Arrangement”, IMF Country Report No. 14/263, September.
Stern, G (2014) “Ukraine’s Debt Sustainability: Greece déjà Vu?” Oxford Economics, September.
Talley, I (2014) “Ukrainian Elections May Ease Way toward Bailout Overhaul”, Real Time Economics blog, September 17.
1 IMF (2014b) and IMF (2014c).
2 NBU profit transfers are included in the government accounts as revenue.
3 For examples of market commentary see Stern (2014) and Talley (2014).
4 IMF (2014a).