March 16, 1999

Dear Mr. Camdessus:

In the period since the approval of the extended arrangement, the government and the National Bank of Ukraine have continued to implement the program supported by the Fund, despite difficulties stemming from the financial crisis in Russia and continuing volatility in international capital markets. The economic position remains fragile but we have broadly managed to maintain stability. Nevertheless, in a number of areas the structural reforms and financial policies have deviated from our program. In addition, a number of restrictions were introduced to relieve pressures on the foreign exchange market.

The attached Supplemental Memorandum of Economic Policies (MEP) describes the steps we are taking to bring our economic program for 1999 back on track and supplements our letters (and MEPs) to you of August 14, September 4, October 17, and October 27, 1998. The present MEP includes an extensive list of measures, including prior actions, on the basis of which we request completion of the first program review under the extended arrangement approved by the Executive Board on September 4, 1998. In addition, we would like to request waivers for the nonobservance of performance criteria, as specified in the attached Supplemental Memorandum, and a rephasing of purchases under the arrangement. We believe that the policies detailed in the attached MEP are adequate to achieve the objectives of our economic reform program, but we remain prepared to take additional measures as necessary for this purpose. The second review under the program, now scheduled to be completed by mid-May 1999, will focus on the implementation of the program, and will be conducted jointly with a financing assurances review.

Sincerely,

1. Macroeconomic performance in 1998, and especially since the approval of the extended arrangement, was influenced by the financial crisis in Russia. This factor restrained the development of the real economy, resulting in an estimated 1.7 percent decline in real GDP. The external position remained highly vulnerable, and, in the face of strong pressures on the exchange rate and depreciation of the rate, the National Bank of Ukraine (NBU) introduced a number of administrative measures to reduce the demand for foreign exchange and limit capital flight. At the same time, a voluntary restructuring of debt obligations falling due to private creditors, both residents and nonresidents, was successfully negotiated. However, this restructuring contributed to a sharp shift in market sentiment and the effective cessation of demand for treasury bills by commercial banks. Consequently, the NBU became the sole purchaser of new bills, which, coupled with the liquidity injections stemming from the redemptions of outstanding treasury bills, placed severe constraints on the ability of the NBU to pursue a tight monetary policy.

2. Despite the problems experienced in the treasury bill market, monetary and fiscal policies during the second half of 1998 were generally appropriate, although there was some loosening during December. The budget deficit for 1998 is estimated at Hrv 2.8 billion on a cash basis (2.7 percent of GDP), which is slightly below the program target and considerably less than the deficit of 5.6 percent of GDP in 1997. Since the beginning of the program, cash non-earmarked revenues of the central government have increased substantially compared to the same period in 1997. On the expenditure side, operations of the treasury have been strengthened and almost all remaining agencies at the level of the central government were brought under treasury control, including, as of January 1, 1999, the remaining structures of the Ministry of Defense. However, contrary to the program, domestic budgetary arrears on wages, pensions and benefits that were outstanding for more than 1 month are estimated to have increased by about Hrv 300 million. Consequently the performance criterion on the stock of budgetary arrears on wages, pensions and benefits, was not observed at the end of December for which we request a waiver. The heavy reliance of government on financing from the NBU also led to nonobservance of the end-December performance criterion on the net domestic assets of the NBU, for which we also request a waiver. Finally, we request a waiver for nonobservance of the performance criterion on net international reserves for end-December, which was not observed due to the difficult external environment. At the same time, notwithstanding the absence of external financing since the beginning of November, all external debt service obligations were met on time.

3. Recent developments are likely to continue to influence macroeconomic performance in 1999. We now expect that real GDP will continue to decline and, taking into account the effect of increases in communal tariffs scheduled for the next few months, the consumer price index is targeted to increase by no more than 19 percent. Consistent with this objective, the monetary program foresees broad money growth of about 10 percent during the year. The external position is expected to remain difficult. In light of the large debt service obligations falling due in 1999, and given the limited availability of external financing, net international reserves of the NBU are projected to decline by no more than $100 million, although gross usable reserves are targeted to increase modestly.

4. A strengthening of the fiscal stance is the cornerstone of the economic program for 1999. While the approved 1999 budget envisages a deficit of nearly Hrv 2 billion, or 1.5 percent of GDP (IMF definition), in light of the difficult macroeconomic situation, we have determined that a more ambitious fiscal adjustment is required and are taking steps to contain the deficit to no more than Hrv 1.34 billion, or 1 percent of GDP, significantly lower than the 1998 outcome. This revised target includes a reduction in the stock of budgetary arrears on wages, pensions and benefits of Hrv 2.15 billion. Revised monthly limits on the level of expenditure commitments for the state budgetary units consistent with the revised fiscal targets for 1999 will be issued by March 24 by the Cabinet of Ministers.

5. On the revenue side, the approved budget eliminated the Chernobyl tax, reducing the payroll tax by another 5 percentage points, and eliminated VAT exemptions for critical imports. A recent parliamentary decision to revert the VAT calculations to a cash basis has been vetoed by the President and this veto was sustained. A parliamentary decision to reduce oil excises was also vetoed. The accrual method has been in effect since October 1, 1998. The State Tax Administration (STA) has also prepared a more aggressive plan to pursue enterprises with large tax arrears and will accelerate the sale of seized assets from such tax debtors. Finally ,we will also take measures (including the introduction of a special fee on real estate transactions and on mobile phones) to increase revenues of the Pension Fund, without which it will not be possible to reduce pension arrears. Indexation of pensions will be strictly limited.

6. We realize that a number of important structural fiscal measures that had been envisaged have not been implemented, mainly due to insufficient support in parliament. In particular, coal and imported gas continue to be zero-rated under the VAT, earmarked taxes for the Road Fund and the Innovation Fund as well as the Social Insurance tax have not been reduced, and amendments to the personal income tax law have not yet been approved. We will continue to work with parliament on these measures to help ensure that they will be implemented in the budget for the year 2000, if not before. By then, we also intend to propose to parliament to eliminate the stamp duty that was introduced in the 1999 budget. A special two-year moratorium on the payment of taxes by the agriculture sector, including an explicit VAT exemption, was granted in December. While it is not possible to remove these exemptions, at this time, no new tax exemptions or privileges-including for special economic zones-will be granted during 1999. A number of additional measures have been identified to remove distortions from the tax system: (I) the taxation of unrealized capital gains on statutory capital of banks with foreign capital has been eliminated; (ii) certificates of deposit issued by commercial banks will not be considered as gross earnings under the enterprise profit tax; (iii) the parliamentary decision on the avoidance of double taxation has been enacted; and (iv) the state duty on transactions in the secondary market for securities will be repealed.

7. Fiscal operations continue to be constrained by the use of various noncash means for settling tax obligations. We have attempted to limit the use of such instruments but it has not been possible to completely eliminate this practice. We are keenly aware of the need to collect more revenues in cash, both to improve the transparency of the budget and reduce the difficulties that we have encountered in meeting certain expenditure obligations. To this end, we propose that quarterly targets on the collection of unearmarked cash revenues by the central government be included as a performance criterion under the program, which will target a significant increase in 1999.

8. On the expenditure side, the approved budget reduces noninterest expenditures on a commitment basis by about 6 percent of GDP relative to 1998 and further reductions will be necessary due to expected revenue and financing shortfalls. The expenditure reductions are to be achieved by cutting non-priority expenditures. A further sizeable reduction in budgetary employees will be achieved during 1999, after a reduction of nearly 300,000 in 1998. Over time, further expenditure savings without a reduction in the quality of services are likely to be possible following the implementation of the public administration reform program.

9. Delays in obtaining a ruling by the Constitutional Court prevented the increase in tariffs for communal services in 1998. In light of the depreciation of the hryvnia since the start of the EFF program, substantial increases in the tariff rates relative to their levels in 1998 will be necessary to achieve full cost recovery. Following the decision of the Constitutional Court, tariffs for gas and electricity (services regulated by the central government) will be increased by 25 and 20 percent, effective April 1, 1999 (a structural performance criterion). In addition, the central government has instructed local governments to bring tariffs for heating, water supply, sewage, rent, and public transportation to full cost recovery levels no later than April 30, 1999, in line with the understandings reached with the Fund staff. We understand that the observance of these targets will be prior action for the Fund staff's recommendation to complete the second program review under the extended arrangement. In addition, should the recent increases for electricity and gas prove insufficient, these tariffs will be increased to full cost recovery levels not later than June 30, 1999.

10. Expenditure control will be enhanced through a strengthening of the treasury system. We intend to accelerate the implementation of this project, and to bring all extrabudgetary accounts under its control. A full listing of these extrabudgetary accounts has been provided to the Fund staff. In addition, a presidential decree and Cabinet of Ministers resolution have been issued that prevent the opening of new accounts and require freezing of the balances on such accounts if the monthly reporting requirements are not adhered to. An explicit timetable for the transfer of all extrabudgetary accounts to the treasury has been approved by the Cabinet of Ministers and all agencies concerned informed of this decision. The extrabudgetary accounts of the Ministry of Health have been transferred to the treasury. The extrabudgetary accounts of the STA will be transferred to the treasury by end-March 1999 (while keeping the STA properly funded), while treasury control of the extrabudgetary accounts of the State Customs Service will be a structural benchmark for end-June 1999. All other extrabudgetary accounts will be brought under the treasury by end-September 1999. We will also seek immediate parliamentary approval of the World Bank's treasury project loan.

11. The monetary policy pursued by the NBU, together with the system of controls on the foreign exchange market introduced in late 1998, was instrumental in minimizing the pressures on the hryvnia. However, the system of controls has become increasingly distortive and by early January a significant excess demand for foreign exchange had accumulated. As a first step, in a move to a more flexible exchange system, a new band for the exchange rate of Hrv 3.4 to 4.6 per U.S. dollar was announced on February 9, following a significant tightening of the monetary stance, as explained below, and the rate has already adjusted. At the same time, a number of restrictions were removed (see below), and following the stabilization of the rate within this new band, the interbank market will be reopened starting March 19. The NBU continues to monitor developments in the foreign exchange market closely and is prepared to tighten its monetary policy further to support the exchange rate. The NBU will refrain from intervening in the market to control the rate.

12. The NBU has taken strong measures to tighten liquidity in the banking system substantially, especially in view of the scheduled opening of the interbank market. Beginning February 5, the NBU started to auction its own certificates of deposit. Reserve requirements were raised to 17 percent and the definition of required reserve balances was tightened to exclude cash in vault. Liquidity in the banking system has also been reduced as a result of the recent restructuring of treasury bills held by commercial banks that would fall due in February. Treasury bills will henceforth be redeemed as scheduled.

13. Together with Fund staff and representatives of other creditor and donor organizations, we are in the process of working out a bank restructuring program, based on the results of the diagnostic studies that were completed with the assistance of these parties in late 1998. The broad outline of the strategy is given in the Presidential Decree of January 23 "On Comprehensive Measures to Improve the Banking System of Ukraine in 1999-2000" To strengthen our implementation capacity, we have recently reorganized the banking supervision department, and the new large bank unit will be fully staffed by end-February. By end-March we will reach agreements with the seven large banks on required reform measures and on a timebound action plan to bring them back to the normal capital adequacy level, or withdraw their license if this is not feasible. Prudential requirements and their implementation, in particular those related to loan loss provisioning will be strengthened in line with the need demonstrated by the diagnostics studies. These, and other measures will be contained in a comprehensive action plan that will be prepared by end-March 1999. Finally, to strengthen our implementation capacity, we will attempt to secure passage of the second reading of the Law on the NBU by end-March, and adoption of the law by end-June. A draft law on commercial banks and the banking system will be submitted to parliament shortly thereafter. An agreement has also been signed between the NBU and the Ministry of Finance on the treatment of treasury bills held by the NBU.

14. The NBU has continued to improve the liquidity of its international reserves, and the transparency of its operations in this area. Apart from a small number of transactions for which there are contractual constraints, all of the transactions that had earlier tied up a portion of our international reserves have been unwound. The international reserves of the NBU at end-October were reviewed by an international firm and a copy of their report has been provided to the Fund staff. A contract has been issued for a full audit of the international reserves of the NBU at end-1998.

15. As noted, administrative procedures for screening and allocating foreign exchange were introduced during the third quarter of 1998 in response to concerns over possible contagion from the financial crisis in Russia. After careful review with the Fund staff, four exchange restrictions were identified that are inconsistent with Article VIII of the Fund's Articles of Agreement. These are: (i) a restriction on the availability of foreign exchange to meet debt service payments on foreign borrowing exceeding a designated interest rate; (ii) limitations on the extension of certain trade credits in hryvnia and foreign exchange; (iii) a restriction on the repatriation of interest by certain nonresident investors, and (iv) a restriction on the making of advance import payments. In conjunction with our move to a more flexible exchange system we have now removed the first two restrictions identified above. The third restriction arose from the creation of special blocked hryvnia accounts for nonresident holders of treasury bills that chose not to participate in a debt restructuring operation. The balances in the special blocked accounts have been largely drawn down. We will continue to work with these creditors to help ensure that the remaining balances can be used in a manner satisfactory to all parties concerned and intend to eliminate this restriction and the one on advance payments by end-June. Remaining requirements regarding the provision of supporting documentation are used exclusively for purposes of verification. In light of the extraordinary circumstances facing Ukraine, we request waivers for the nonobservance of the performance criterion on the introduction of exchange restrictions, and the approval of the remaining exchange restrictions subject to Fund jurisdiction through end-June 1999.

16. We have made significant progress in a number of structural reform areas, including privatization and deregulation and demonopolization, although in some other areas progress has lagged. Efforts are underway on a number of important initiatives. In this context, administrative reform remains an important priority on the government's agenda. A comprehensive reform program in this area has been developed with the assistance of the World Bank. A number of important measures have already been implemented. In particular, a presidential decree on the system of central bodies of Ukrainian executive authorities has been issued that formally establishes the framework for public administration reform and the liquidation or merger of ministries, committees, and agencies, and raises to 38 the number of committees that are subordinated to the relevant ministries. This decree gives greater authority to ministers in the area of appointing and dismissing of heads of committees under their jurisdiction. This decree is a first step and further, more comprehensive measures in this area will be taken by end-July 1999 in cooperation with the Fund and World Bank staff. A Cabinet of Ministers decision has been taken that implements the restructuring program for the Ministry of Finance. The latter decision specifies the transfer of all tax policy functions from the STA to the Ministry, merges the two debt departments, centralizes all macroeconomic functions in one department, and centralizes the authority on all the work done by various sectoral departments of the Ministry under the First Deputy Minister for budgetary issues. STA will cease to have responsibility in the tax policy area and will reassign the remaining staff currently carrying out this function to other responsibilities. We intend to review the new structure of the Ministry of Finance in consultation with the World Bank and IMF staff by no later than end-1999. Finally, action plans, in line with World Bank recommendations, for the reform of the Ministries of Agriculture, Labor, and the Environment, were approved by the Cabinet of Ministers. Some more work will be needed to finalize a plan for the restructuring of the Ministry of Economy. Completion of a plan, in line with recommendations of the World Bank, and its implementation will be condition for completion of the second program review. Action plans for the Ministries of Health and Education will be finalized no later than end-June.

17. The privatization program has progressed largely as contemplated in the program. Case by case procedures for the privatization of large enterprises have been initiated and a substantial block of shares in 24 large enterprises have been offered for sale using new, revised tender procedures. Both the end-December targets established for sales of shares in enterprises and the target for the sales of units under "Bread of Ukraine" will be achieved, with only a small delay by mid-March. To enhance the effectiveness of the privatization of Bread of Ukraine, the focus of the privatization program for 1999 will shift to the sale of 100 percent of shares, rather than the 70 percent shares offered previously. To this end, share allocation plans have been approved for the sale of 100 percent of shares in no less than 100 grain silos. Of this number, at least 10 large attractive grain silos will be sold by end-March, which will assessed as part of the second program review.

18. We realize that reform of the agriculture sector is essential to provide a strengthened basis for future economic growth. While there has been some progress in developing a market based structure in this sector, the momentum of reform has so far been slow. To remove key constraints in this sector, we now have: (i) prepared a resolution that introduces amendments to documents to authenticate land titles in cases of joint ownership of land; (ii) identified a list of 170 collective farms with large outstanding debts. These farms have been informed that they have one month to resolve their debts or bankruptcy procedures will be initiated; (iii) adopted changes to the by-laws of Bread of Ukraine that eliminate its role as a government agent dealing with issues of provision of agricultural inputs and debt collection; and (iv) taken measures to improve the operations of the state leasing fund. All receipts of this fund are now channeled through the treasury and by end-March is will be established as a legal entity separate from the Ministry of Agriculture. Furthermore, to improve financial discipline in the agricultural sector efforts will be made to collect overdue budgetary loans. By mid-March, the STA will take charge of debt collection.

19. There has been some progress in the development of the gas sector but a market for gas has not yet emerged. The regulatory framework to support liberalization of gas prices is now in place and five gas auctions were organized in 1998. However, these auctions were not successful and only a very small amount of gas was sold. In order to promote the development of a more meaningful auction mechanism, we have issued a Cabinet of Ministers resolution that requires budgetary organizations-including local governments and heating companies-to procure natural gas only at the auction, where all payments are made in cash. The minimum price will be unified for all consumers and set between $27.50 and $30 per 1000 cubic meters for the auction scheduled for March. If interest in the auctions remains low we will consult with the Fund on additional measures to take, including on the need to have a minimum price. In the circumstances , we understand that understandings with the Fund staff on a strategy would be necessary for the staff `s recommendation for completion of the second program review. We are committed to sell at least 500 million cubic meters of gas by March 4. We are continuing to investigate mechanisms for making the gas auction more effective and plan to offer a minimum of 20 billion cubic meters of natural gas for sale via the auctions during 1999. Moreover, to improve transparency, a tender will be opened by mid-March for an audit of the production costs and the accounts of Naftogas Ukrainy in 1998 by an internationally reputable company, the terms of reference for which were drawn up in coordination with the World Bank and USAID.

20. The balance of payments position remains vulnerable due to the bunching of debt service obligations in the next two years and the relatively low level of international reserves. However, the recent depreciation of the hryvnia and the liberalization of the foreign exchange market coupled with the implementation of a strong budget and appropriately tight monetary policy and an acceleration of structural reforms should facilitate a strengthening of the current account and boost foreign investment. The government is, however, well aware of the vulnerability of the external position in the near term and will continue to monitor the position closely. We remain committed to meeting our obligations in a timely manner.

21. The government is committed to the maintenance of a liberal trade regime. Tariff rates have been reduced in line with program commitments and the reduction in the number of commodity positions subject to mixed specific/ad valorem tariffs, a structural performance criterion, was achieved on schedule. Protectionist pressures in response to the regional crisis have been successfully resisted. However, the elimination of the export duty on animal skins and hides has not yet been approved by the parliament, but this measure will be done before end-April.

22. The prior actions for the first review are summarized in Annex Table 1. Monthly performance criteria have been established for the period March-August on: (i) the deficit of the consolidated budget; (ii) the stock of budgetary arrears on wages, pensions, and benefits; (iii) net domestic assets of the NBU; (iv) net international reserves of the NBU; (In addition, quantitative performance criteria have been set for the contracting or guaranteeing of nonconcessional external loans, with sub-ceilings on maturities of up to three years and on credit lines. There are also continuous performance criteria on, inter alia, the nonaccumulation of external arrears by the government and the NBU, and the accumulation of short term debt. In addition, we propose quarterly performance criteria on unearmarked cash revenues of the central government. Finally, there will be a structural performance criterion on increasing gas and electricity tariffs by April 1, 1999. The performance criteria, indicative targets, and the adjusters, as well as structural benchmarks under the program are set out in Annex Tables 2 and 3, and the technical memorandum.

23. The second review under the program based on end-April 1999 performance is scheduled to be completed by May 14, 1999. It will focus on the implementation of monetary and fiscal policy; the implementation of the public administration reforms; progress with the development of the gas market; and the formulation of a strategy for the reform of the banking system. The second program review will also review financing assurances.