Recent Economic Developments
Although the economic impact from the COVID-19 outbreak appears to be less severe than initially anticipated—GDP declined by an estimated 4.5 percent in 2020 compared to a 6.5 percent decline in the first half of the year—the pandemic has exacted a heavy toll in terms of health and mortality and has undermined the government’s commitment to undertake critical reforms. Recent anti-corruption reforms have also suffered setbacks due to adverse court rulings in late 2020.
Economic activity recovered in the first half of 2020, supported by a number of measures to mitigate the impact of COVID-19. The full-scale lockdown was replaced by an adaptive quarantine in June 2020 that enabled many services to return to normal functioning. Domestic demand was boosted by over 10 percent (year-on-year [y-o-y]) real wage growth due to an increase in the minimum wage and a gradual recovery in economic activity. On the supply side, retail and wholesale trade grew 7.9 percent y-o-y in 2020 and made a significant positive contribution to GDP growth. The financial sector has weathered the downturn with its capital adequacy still strong. At the same time, agriculture output fell almost 12 percent due to drought and a poor harvest.
On the external side, lower energy and higher iron and grain commodity prices resulted in the most favorable terms of trade for Ukraine in the past decade. Combined with import compression, this resulted in a current account surplus of 4.4 percent in 2020. Remittances were relatively resilient, down only 5.3 percent y-o-y in 2020, while private capital inflows also recovered in the second half of the year. International reserves reached US$29.1 billion at end-December, equal to 4.7 months of next year’s imports.
Following the smaller-than-expected economic decline, fiscal revenue also performed better than anticipated. On the expenditure side, COVID-19-related outlays were less than budgeted, and a portion of the pandemic special fund was redirected to capital expenditures and to a public sector wage and pension increase. The fiscal deficit amounted to 6.2 percent of GDP compared to the initial plan of 7.6 percent.
After two years of tight monetary policy, the National Bank of Ukraine (NBU) gradually cut its key policy rate to 6 percent in June 2020, a level it has since maintained However, a more accommodative fiscal policy stance resulted in an increase in inflation expectations from 6.7 percent in August to 8 percent at year-end. The inflation rate grew from 2.5 percent on average in the first three quarters of 2020 to 6.1 percent in January 2021, which is slightly above the NBU’s target of 5+/-1 percent. This triggered a key rate increase to 6.5 percent in March 2021.
Although the COVID-19 relief measures were welcome, attention once again needs to turn to structural reforms that are required to raise medium-term growth prospects. Slower reform momentum has undermined investor confidence and delayed financing from international financial institutions; as a result, significant public financing needs in 2020 have been met mostly by domestic borrowing that amounted to 10.5 percent of GDP (gross). The composition of external financing has shifted toward more expensive commercial borrowings and Eurobonds comprising 4.3 percent of GDP in total.
The poverty effects of COVID-19 are expected to be relatively muted, with the poverty rate, based on US$5.5 a day, projected to have increased by only 0.5 percentage points to 3 percent in 2020, as increases in pensions and wages helped to partially offset the decline in employment.
Ukraine’s economic recovery in 2021 is expected to be mild, given the high uncertainty associated with the vaccine rollout and the direction of economic policies to address investment bottlenecks and to safeguard macroeconomic sustainability. The GDP growth projection of 3.8 percent is underpinned by positive base effects in agriculture and the processing industry and assumes that further temporary lockdowns are possible in the first half of 2021 due to delays in vaccinations.
The 2021 budget targets a 5.4 percent deficit. Together with 10.5 percent of GDP debt amortization and 1.3 percent of GDP in arrears to the private sector, this will increase total fiscal financing needs to 17.2 percent of GDP (compared 15 percent of GDP in 2020). The increase in minimum wages will push the public wage bill to over 11 percent of GDP and create additional pressures on current account imbalances and inflation. Prudent fiscal policy is needed to address inflationary pressures in the medium term.
The poverty rate, based on the US$5.5 a day threshold, is expected to decrease to 2.5 percent in 2021, similar to the level in 2019. Accelerating the reform momentum is key to achieving faster economic growth and poverty reduction in 2022 and 2023.