Developments Since Independence Ukraine experienced a solid recovery since the 1998-99 financial crisis, with annual growth averaging above 7 percent between 2000 and 2007. The financial crisis of 1998 led to a realignment of the real exchange rate, which together with fiscal and financial stabilization efforts, initial structural reforms, a favorable external environment (particularly after 2003), and significant idle industrial capacity, helped to jump start the economy. The macro-policy framework, until November 2008, involved a de facto peg of the UAH to the USD with the burden of adjustment to external shocks falling on fiscal policy. Large terms of trade improvements and significant private sector capital inflows swelled fiscal revenues and spending, and fuelled a demand boom, which led to growing pressures on the current account and on price stability after 2005. By late 2007, the economy was showing increased signs of overheating, with pressures intensifying in the first half of 2008. The current account balance deteriorated from a surplus of 10.6 percent of GDP in 2004 to a deficit of 3.7 percent in 2007, despite substantial terms of trade improvements. Up to 2007, the widening of the current account deficit was financed by large foreign borrowings and FDI. In 2008, price pressures mounted driven by higher food and energy prices, but also by an inconsistent macroeconomic policy mix with loose fiscal and monetary policies. Real wage growth continued to outstrip productivity improvements and inflation rates rose to about 30 percent during the first half of 2008. The Government tried to contain fiscal and monetary pressures by restraining non-discretionary spending, over-executing revenues (helped by the de facto inflation tax), tightening provisioning on external borrowings, and allowing the appreciation of the UAH by 10 percent relative to the US dollar in May 2008. By the Fall of 2008, the global financial crisis exposed Ukraine’s inherent macroeconomic vulnerabilities and led to an economic crisis. While sovereign and corporate spreads were already increasing for Ukraine since the first half of 2008, the international financial crisis brought to the fore pre-existing refinancing risks (of large private sector debts accumulated in recent years) and risks associated with the banking sector. Moreover, the prospects of slowing global demand led to a sharp fall in the price of steel, Ukraine’s main export. The economy contracted by 8 percent during the last quarter of 2008, with industrial production dropping over 25 percent. The exchange rate has depreciated sharply (close to 40 percent to USD since September) to adjust to the terms of trade shock and the drying-up of foreign financing, closing the current account deficit. Ukraine’s progress in structural reform has been modest but continuous since 2000. Ukraine ranks slightly above the CIS countries average in terms of progress in structural reform as measured by the EBRD Transition Indicators. The indicators reveal particular weaknesses in the process of enterprise restructuring, governance, competition policy, non-bank financial sector performance, and infrastructure reform. They also suggest that Ukraine is not closing the gap with new EU member states very fast, which may compromise the country’s European integration aspirations and medium term growth prospects. A key impetus for reforms has come from Ukraine’s WTO accession process. On May 16, 2008 Ukraine became the 152nd member of the WTO after a 14 year process of negotiations and legislative changes to comply with WTO demands supported by successive governments across the party political spectrum. With WTO accession, Ukraine has fulfilled the conditions established by the EU to begin negotiations on a Free Trade Agreement. Additional pressures for structural adjustment will come from the continued rise in energy import prices and increased costs of external borrowing. Challenges Ahead The economic and financial crisis creates immediate challenges for macroeconomic, structural and social policies, The economy is expected to experience a deep recession in 2009, and a comprehensive package of measures is required to stabilize market expectations, mitigate the social impact of the crisis and lay the foundations for a return to sustainable economic growth. Key areas for reform include: - the implementation of sound macroeconomic management, including consolidating the transition to a flexible exchange rate regime and supportive monetary and fiscal policies;
- expenditure reallocations towards growth supporting investments in public infrastructure and improved targeting of social transfers to the poor;
- measures to restore confidence in the financial sector and lay the foundation for sector consolidation and improved supervision and regulation going forward; and
- structural reforms to facilitate the necessary adjustment and reallocation of economic activity by lowering entry barriers and improving the investment climate.
Over the medium-term, Ukraine needs to adopt a growth strategy that reflects the likely scarcity of risk capital and emphasizes productivity improvements (including energy efficiency) as the main source of growth. Public sector modernization and improved governance will be key ingredients of such a strategy to allow the tax burden to decline, and the state to deliver improved quality public services under tighter fiscal constraints. | 
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