Severe shocks, combined with a backlog of structural reforms, resulted in a serious economic crisis in 2014-2015. The economy has been hit by unprecedented double shocks from the conflict in the east of Ukraine and a considerably weaker external environment, including lower global commodity prices.
Real GDP contracted by 6.8 percent in 2014 and by a further 10 percent in 2015. The currency depreciated sharply in 2014-15, while the consolidated fiscal deficit, including Naftogaz, reached 10.1 percent of GDP in 2014 and public and guaranteed debt spiked to 82 percent of GDP in 2015. The banking sector experienced deposit outflows, rising levels of nonperforming loans, and large numbers of bank failures.
Decisive reforms have helped to stabilize the economy, reduce large imbalances, and cushion the impact of the shocks on the population. Key reforms adopted with the support of the international community included: moving to a flexible exchange rate; undertaking significant fiscal consolidation; reforming energy tariffs and strengthening the social safety net system; stabilizing the banking sector by putting in place the framework to resolve and recapitalize banks and strengthen supervision; streamlining the business environment; making public procurement more transparent; putting in place external verification of financial disclosures.
As a result of the reforms, the economy has begun to stabilize, with real GDP contracting by only 1.4 percent y/y in the fourth quarter of 2015, compared to 16 percent y/y in the first half of 2015. Furthermore, large imbalances have been reduced, with the general government deficit, including Naftogaz, reduced to 2 percent of GDP in 2015. The banking system is being cleaned up as 75 weak or nontransparent institutions have been sent for resolution.
Economic prospects remain weak and the fiscal outlook remains challenging, raising the urgency of reforms to unlock growth and manage medium term imbalances. The global economic environment remains weak, the conflict in the East continues despite de-escalation, and a large backlog of reforms remains. As a result, a very gradual economic recovery is expected, with growth of 1-2 percent in 2016 and 2-3 percent in 2017.
This raises the urgency of reforms to unlock growth and productivity through more effective public investment and a more competitive market structure. Furthermore, meeting the fiscal deficit target of 3 percent of GDP in 2016 will prove challenging, particularly in light of the payroll tax rate cut from 40 to 22 percent in 2016.
Estimates suggest that short term revenue losses could amount to 3 percent of GDP. This raises the urgency of addressing the medium term structural fiscal pressures, including broadening the tax base, strengthening tax administration, and rationalizing current expenditures (including pensions and the large public sector footprint).
Poverty is estimated to have increased in 2015, raising the urgency more effective service delivery to improve labor market outcomes and promote shared prosperity. Disposable incomes have contracted significantly from the deep recession, with real wages down by 13 percent y/y in December 2015.
The poverty rate (under US$5/day in 2005 PPP) is estimated to have increased from 3.3 percent in 2014 to 5.8 percent in 2015, while moderate poverty (WB national methodology for Ukraine) is estimated to have increased from 15.2 percent in 2014 to 22.2 percent in 2015.
Going forward, fiscal consolidation will require restraint on growth of public-sector wages, pensions, and other social programs, which will affect household purchasing power across the income distribution. More effective service delivery can not only reduce expenditure pressures, but also improve labor market outcomes, while improving targeting of social transfers can also help better support incomes of the poor and bottom 40 percent.
Ukraine will need to simultaneously advance reforms on multiple fronts to achieve sustainable recovery and shared prosperity going forward. As the economy has begun to stabilize and large imbalances have been reduced at least for the short term, Ukraine now needs to also address the deeper structural bottlenecks and governance challenges that have constrained sustainable development for the last decade and half.
First, safeguarding macroeconomic stability by addressing the largest sources of macroeconomic risk in the medium term is important. This is important in light of the difficult external environment and persisting vulnerabilities, and will require implementing tax and pension reform, continuing reforms in the financial sector, and strengthening public financial management.
Second, Ukraine will need to unlock productivity, support growth, and create jobs. This will require investing in infrastructure by improving public investment management; reforming and investing in the important energy, transport, and agriculture sectors; dismantling the oligarchical production structure, enhancing competition, improving the business climate, and tapping the EU market; more effective land management; and building the critical anticorruption and justice institutions.
Third, Ukraine will need to provide more targeted and effective services to the population. This will not only reduce expenditure pressures, but also result in tangible improvements in the quality of life for the population, improve labor market outcomes, ensure that the benefits of recovery are broadly shared by more effectively supporting the incomes of the poor and bottom 40 percent. This will require reforming health care financing; optimizing the school network and enhancing skills of the workforce; effective decentralization of service delivery; and improved targeting of social assistance.
Last Updated: Jun 02, 2016