Recent Economic Developments
Economic growth remains modest due to the unfinished structural reform agenda and headwinds from the conflict in eastern Ukraine. Real GDP grew by 2.4% year-on-year (y-o-y) in the first half of 2017, following growth of 2.3% in 2016. Although the resumption of growth is a positive development, it represents a weak recovery since it follows a cumulative 16% contraction in 2014 and 2015. Even key sectors exhibiting relative strength, such as manufacturing, trade services, and transport, continued to grow at a modest pace—3.7, 3.5, and 4.4%, respectively—in the first half of 2017, which is insufficient to drive stronger growth in the overall economy.
The mining and utility sectors contracted by 6.6 and 5.5%, respectively, due to the trade blockade against uncontrolled areas of the Donbas region, which affected coal, steel, and electricity production. On the other hand, construction and fixed investment continued to exhibit strong growth in the first half of 2017—at 26 and 22%, respectively—pointing to strengthening investor confidence in some areas, although both remain down sharply from pre-crisis levels. Merchandise exports grew by 23% in the first half of 2017.
Fiscal expenditures and revenues grew strongly in the first half of 2017, with the supplementary budget adding to expenditure pressures for the rest of the year. In the first half of 2017, both expenditures and revenues exhibited strong growth. Expenditures were up by 13.5% in real terms due to the increase in the minimum wage (and resulting higher wages for teachers, doctors, and civil servants), as well as higher spending on social programs. Revenues also grew strongly by 22.8% in real terms in the first half of 2017, driven by higher revenues across the board, including personal, corporate, and value added tax, as well as social security contributions and non-tax revenues. As a result, the fiscal balance in the first half of 2017 amounted to a surplus of 0.9% of full-year GDP.
However, the supplementary budget adopted in July 2017 adds to expenditure pressures for the rest of the year, including higher spending on the military, social programs, and capital investment, leading to a fiscal deficit in 2017 that may exceed the target of 3% of GDP. At the same time, the public debt level continued to grow, reaching 85% of GDP as of July 2017 due to the high cost of bank recapitalization.
The growth projection for 2017 remains modest at 2%, but progress on the ambitious package of reforms under consideration could accelerate growth to 4% or more going forward. The growth outlook is affected by two key factors. First, Ukraine faces continued headwinds from the conflict in the Donbas region as evidenced by the coal and trade blockade with the uncontrolled areas. Second, the authorities have been working on an ambitious package of reforms to address structural bottlenecks and advance growth prospects. The next few months are a critical window of opportunity within which to lock in these important reforms.
Establishing a transparent market for land transactions would enable Ukraine to tap its vast potential for agricultural exports. Strengthening the governance of state-owned banks and introducing measures to streamline the resolution of nonperforming loans (NPLs) would enable a gradual resumption of lending to the private sector.
Deeper anti-corruption reforms, further improvements to the business environment, and progress on privatization would strengthen investor confidence and attract foreign investment. Locking in these reforms in the next few months could raise growth to 4% or more in the next two years, an outlook subject to serious risks, however, related to progress on reforms in a complex political environment and a possible escalation of the conflict or deterioration in the external environment.