Recent Economic Developments
The economy recovered modestly by 2.3% in 2016, with a bumper agriculture harvest leading to stronger growth of 4.8% in the fourth quarter. Decisive reforms in the face of unprecedented shocks in 2014 and 2015 helped to stabilize confidence. As a result, real GDP grew modestly by 2.3% in 2016 after contracting by a cumulative 16% in the previous two years. Signs of stronger growth of 4.8% year-on-year (y-o-y) emerged in the fourth quarter of 2016.
The recovery was supported by an abundant harvest, with agriculture growing by 6% in 2016 overall and 18.4% (y-o-y) in the fourth quarter. Other sectors experienced a pickup from low levels in 2016, with growth of 3.6% in manufacturing, 16.3% in construction, 4% in domestic trade, and 3% in transport. Fixed investment rebounded strongly by 20% from a low base, including manufacturing equipment and imported capital goods, pointing toward strengthened investor confidence.
However, the overall pace of recovery remains modest, as significant weaknesses remain in some parts of the services sector, including education, health, and financial services. Stronger recovery has also been held back by weak external demand and the continuing conflict in the eastern part of the country. Although a number of important reforms have advanced in recent months, a further acceleration in reforms is needed to boost investor confidence and bolster economic recovery.
After a significant increase in 2015, poverty is estimated to have moderated slightly in 2016. Disposable incomes contracted significantly in 2015 from the deep recession and high inflation. Moderate poverty (applying the World Bank’s national methodology for Ukraine) increased from 15% in 2014 to 22% in 2015, while the poverty rate (under US$5/day in 2005 purchasing power parity, or PPP) increased from 3.3% in 2014 to 5.8% in 2015.
In 2016, real household incomes are estimated to have benefited from stabilization in consumer prices and the modest resumption of economic growth. Inflation slowed to 12.4% in 2016 from 43.3% at end-2015 due to exchange rate stabilization and prudent monetary policy, while real wages increased 11.6% (y-o-y) in December 2016. However, labor market conditions remained weak, with unemployment at 9.9% in the first three quarters of 2016.
The fiscal deficit increased in 2016 due to lower social security contributions (SSCs), but the increase in the deficit was less than projected due to expenditure restraint and the stronger performance of other tax revenues. The fiscal deficit (excluding Naftogaz) was 2.2% of GDP in 2016, up from 1.2% in 2015 but lower than previously projected. Total government revenues declined by 11% in real terms in 2016, in large part due to the cut in the SSC rate.
SSC revenues declined from 9.6% of GDP in 2015 to 5.5% in 2016—smaller than total pension spending of 10.8% of GDP. The resulting pension fund deficit of 5% of GDP has become a major fiscal vulnerability. On the other hand, other key tax revenues performed better than planned due to the pickup in economic activity in 2016. Revenues from value-added tax (VAT), personal income tax (PIT), and corporate income tax (CIT) increased by 7.6, 13.1, and 25.7%, respectively, in real terms. The authorities also implemented expenditure restraint measures in 2016. Pensions spending declined 21.8% in real terms due to continued limited indexation (and advance payment of January 2016 pensions in December 2015), while spending on goods and services declined by 9%.
Capital expenditures increased due to greater resources at the local level through decentralization, while social assistance spending increased due to a further increase in coverage of the housing and utilities subsidies (HUS) program. The Naftogaz deficit was reduced to zero in 2016 from 1% in 2015. Public and guaranteed debt increased to 81% of GDP due to the recapitalization of PrivatBank in December 2016.
The current account deficit widened to 3.8% of GDP in 2016 due to an increase in imports of intermediate and investment goods. Despite a significant reduction of imports of gas and other minerals, the merchandise trade deficit doubled in 2016 due to the increase in intermediate and investment goods imports. Higher foreign direct investment (FDI) inflows—mainly related to bank recapitalization—were sufficient to cover the current account deficit in 2016. International reserves grew to US$15.5 billion—equal to 3.4 months of imports.
The outlook for economic growth remains modest due to significant external and internal headwinds, but renewed reform momentum could support higher growth going forward. Significant obstacles remain to accelerating reforms in a complex political environment.
In addition, the conflict in the east of Ukraine has escalated since end-January 2017. The coal and trade blockade on the uncontrolled areas in Donbas is expected to negatively impact two key sectors: steel production and electricity generation.
On the positive side, there are encouraging signs of progress in a number of important reform areas, and the recovery should also benefit from improving terms of trade.
Growth is projected at 2% in 2017 and 3.5% in 2018. This projection assumes no resolution in the trade blockade before the end of the year, with reduced exports of steel, disruptions in electricity generation, and the diversification of coal supplies and higher exports of iron ore over time.
Growth of 4% or more in the medium term will require accelerating the implementation of politically difficult reforms to address longstanding structural challenges. Reforms to boost private sector competitiveness, together with the real depreciation of recent years, should help support exports, while reforms to create fiscal space can unlock public investment and improvements in the banking sector can permit a gradual resumption of lending.
The outlook is subject to risks, including an escalation of the conflict, further deterioration in the external environment, and difficulty in advancing reforms in a complex political environment.