Review: The Year 2014 in Ukraine

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2014 was the most difficult year for Ukrainian economy in the 21st century. Ukraine faced economic crisis and military conflict in the East, while Russia annexed Crimea. Real GDP is estimated to decline by near 7% in 2014 due to a drop in domestic demand and weak external demand. High economic and political uncertainty resulted in low domestic and foreign investments. Private sector was not able to refinance its debts, which pushed financial account balance into deficit. The Government faced large liquidity gap as assistance from the IMF, the EU and other official donors was mostly used to repay previous debts including to Gazprom. As a result, fiscal expenditures were largely under-financed. At the same time, the authorities (during the year Ukraine received new President, new Government and new Parliament) were slow in implementing reforms in 2014. Still, the Association Agreement with the EU became partly effective in November 2014, defining Ukraine’s commitments on future reforms.

Politics

  • In 2014, pro-European forces came to power in Ukraine. In February, the President Viktor Yanukovych fled to Russia after a failed attempt to violently put down mass protests, known as Euromaidan. An opposition leader Oleksandr Turchynov was Acting President until the inauguration of Petro Poroshenko, a centrist politician who won the Presidential election in May. The Government changed twice: after the flight of Viktor Yanukovych and after the October parliamentary elections which were won by pro-European parties.

  • Ukraine embarked on the path towards European integration, putting aside its long standing policy of balancing between the EU and Russia. In June, Ukraine finally signed the long-awaited Association Agreement with the EU. A part of the Agreement became effective on November 1 (provisions on justice, freedom, and sector cooperation). In April, the EU also granted Ukraine autonomous trade preferences, which would be effective until 2016 when a free trade area between the EU and Ukraine is to be established.

  • Russia started an undeclared war against Ukraine. In March, Russia annexed Crimea, a peninsula with the population of 2.4 m in the south of Ukraine. In April, Russian-backed separatists began an insurgency in Donbas, an old industrial region in the East of Ukraine, which later turned into a large-scale war between Ukrainian and Russian troops. As a result, besides Crimea Ukraine lost control over an area in Donbas with a pre-war population of about 3.8 m. At least 4,700 people were killed, and a long-term military conflict on the territory of Ukraine is ongoing.

  • Ukraine resumed cooperation with the IMF. In April, the IMF approved a two-year Stand-By Arrangement (SBA) in the amount of SDR 11 bn (USD 15.8 bn at the current exchange rate) for Ukraine. The SBA is expected to support a comprehensive program of economic reforms. In May and September, Ukraine received two disbursements of the loan at SDR 3 bn (USD 4.7 bn).

Real sector

  • Real GDP is estimated to decline by near 7% in 2014. Real private final consumption dropped due to lower real disposable income. At the same time, financial constraints, terminated investment projects and fiscal gap caused sharp contraction of real gross fixed capital accumulation.

  • Agriculture again was the one of the few sectors with increased real gross value added. Industrial output dropped by 10.1% yoy in the eleven months of 2014 primarily due to destruction and closures of many companies in the occupied territory in the East of Ukraine and trade tensions with Russia.

Energy

  • In March, Russia cancelled the gas deal of December 2013 (promising gas price of USD 266 per 1000 cubic meters) and denounced the Kharkiv Agreement, which granted Ukraine a discount of USD 100 per tcm of gas. In October, after lengthy negotiations Ukraine signed provisional agreement with Russia on gas supplies from November 2014 till March 31, 2015.
  • Ukrainian Government continued efforts to diversify natural gas supplies. In 2014, reverse gas supplies were received through Poland, Hungary and Slovakia.

  • The National Commission for State Energy and Public Utilities Regulation raised the gas tariffs for all types of consumers during 2014 to reduce the deficit of the Naftogaz. In particular, tariffs for population were increased on average by 63% from May and for the heating companies by 40% from July. The electricity tariff for households was increased on average by 12% from July 2014. Starting July 1, the Government increased tariffs on heating and water supply to cost-covering levels and, simultaneously, cancelled compensations from the state budget to utility companies.

  • In November-December, Ukraine experienced severe power shortages due to lack of coal at thermal power stations, low water levels at hydro power stations and repairs at nuclear power plants. To cover the deficit Ukraine made coal purchases from the South Africa and Russia and signed deal on electricity imports from Russia.

Transport

  • Military operation on the East of Ukraine heavily damaged railway infrastructure and destroyed Donetsk international airport. According to Ukrzaliznytsya estimates, it will need UAH 700 m to restore 704 objects of railway infrastructure (696 objects were already restored).

  • In the end of December 2014, Ukraine stopped railway and bus communication with the Crimean peninsula. Air communication with Crimea was stopped in April after its annexation by Russia.

Agriculture

  • Favourable weather conditions resulted in record harvest of grains and pulses (more than 64 m t) even without Crimea and military conflict zone in the East of Ukraine.

  • Autonomous trade preferences granted by the EU to Ukraine and gradual harmonisation of legislation stimulated increase in agricultural and food to the EU by 16% yoy to USD 4.2 bn in the first ten months of 2014.

  • In April, the Parliament approved the Law that eliminated 113 of permits and procedures (including 14 related to the agricultural sector) in order to improve business climate.

  • In July, an important law on food and feed quality control was approved. It envisions implementation of the European model of food quality and safety system based on the HACCP (Hazard Analysis and Critical Control Points), establishment of a single government body on food safety, elimination of several permits and procedures not existing in the EU. In August, the Parliament approved the Law on identification and registration of animals, which is crucial for opening an access for Ukrainian meat produce to the EU market.

External Sector

  • Current account deficit in 2014 narrowed due to sharp hryvnia depreciation. At the same time, financial and capital account was in deficit as high political and economic uncertainty did not allow private sector to refinance its debts and resulted in low FDI inflows. As a result, balance of payments was in deficit, which was financed by IMF loans and international reserves.

  • Merchandise trade deficit narrowed as imports dropped more than exports. Merchandise exports declined due to military conflict in the East of Ukraine and trade tensions with Russia. Imports substitution and low consumption and investment demand resulted in sharp decline in non-energy imports. Lower industrial output and energy saving efforts resulted in decline in energy imports.

Fiscal policy

  • The Government faced high liquidity gap during the entire 2014 as international assistance (from the IMF, the EU, and several other official donors) was mostly used for debt service and repayments. Sharp deterioration of economy and accordingly massive shortfalls of revenues led the Government to push through two extensive budget sequesters and wide-reaching revenue side measures. In particular, the Government increased rates of rent payments and excise duties, introduced military surcharge to PIT collected to central budget, raised PIT rates from passive income, and re-introduced pension fund tax on currency exchange operations.

  • Fiscal revenues were under-executed in 2014 due to optimistic budget plan and higher than expected economic downturn. Central fiscal deficit increased but remained lower than planned due to absent privatisation receipts. As a result, the Government was forced to cut back further on discretionary spending. Capital expenditures were likely to be lower than 50% of annual target.

  • The Parliament hastily approved the State Budget Law for 2015 during the last days of December, which is based on amended provisions of the Tax and Budget Codes.

Privatisation

  • High political and economic uncertainty resulted in decent inflows from privatisation unrealistic. In eleven months of 2014, privatisation receipts reached UAH 60 m out of planned UAH 17 bn.

Social policy

  • Real disposable income declined in 2014 due to real decline of all income components.

  • The Pension Fund’s deficit remained high against the background of small increase in nominal gross wage bill.

  • The Government decided to cease all payments to occupied territories including wages, pensions and social payments to people that live there.

Labour market

  • Labour market developments were affected by the war with Russia and its economic consequences.

  • Average real wages declined by more than 10% in 2014 due to financial constraints of companies, fiscal consolidation measures and accelerated inflation.

  • Unemployment rate reached 9.5% of economically active population in age of 15-70 in the third quarter of 2014, which is the highest level for the last ten years. Underemployment also increased.

Inflation and exchange rate

  • Consumer inflation was 12.1% on average in 2014 but it reached 24.9% yoy in December. This reflected hrvynia depreciation from UAH 8 per USD on average in 2013 to UAH 12 per USD on average in 2014. The Government also allowed utility tariffs to increase by 11-69% adding 4% to CPI. At the same time, inflation was contained by minimal growth in wages and frozen social standards.
  • The NBU was forced to abandon exchange rate peg in February 2014 as the Government and private sector lost access to external funding. After brief episode of floating exchange rate the NBU started to apply harsh administrative measures to support exchange rate. NBU also increased interest rates on monetary policy operations but this was partly offset by refinancing of problem banks. Still the year ended with exchange rate of UAH 16 per USD and international reserves lower than half of that in the beginning of the year.

State debt

  • The state debt more than doubled in 2014 and reached near 70% of GDP due to hryvnia depreciation, new borrowings, and the recapitalisation of state-owned companies (primarily the Naftogaz and state banks). Besides, the Ministry of Finance issued special state domestic bonds to cover VAT refund arrears.
  • The support received from official international donors reached near USD 9 bn. In particular, the Government received USD 4.7 bn under two-year IMF SBA, EUR 1.36 bn within two EU macro-financial assistance loan programs and loans from the World Bank. The Ministry of Finance placed USD 1 bn of five-year Eurobonds, guaranteed by the US government. The rest was mainly provided by governments of Canada and Japan.

  • The NBU holdings of state domestic bonds increased by 11.3 p.p. to 69.5% of total state domestic bonds outstanding.

The Institute for Economic Research and Policy Consulting - Kiev