Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Camdessus:

1.  As provided for in our EFF program, we have reviewed with the IMF staff developments under the extended arrangement approved by the Fund on September 4, 1998. Since the last review in March 1999, economic policies have been implemented largely as envisaged. Inflation amounted to just 5.9 percent during January–April while the exchange rate has stabilized at around Hrv 3.94 per U.S. dollar following the re-opening of the interbank market on March 19. Indeed, exchange rate stability has been achieved at a time of significant purchases of foreign exchange by the NBU. Output performance has, however, remained weak and preliminary data suggest that in the first quarter of 1999, real GDP may have been some 5 percent below the level of the previous year.

2.  Despite a significant improvement, fiscal performance has deviated slightly from the program objectives, though we believe that the measures described below will be sufficient to bring fiscal performance back on track. Significant progress has been made in structural reforms, including the raising of communal tariffs for heating, water supply, sewage, rent, and public transportation to full cost recovery levels, no later than May 20 and effective May 1, 1999, for all regions except for the city of Kyiv which will be done no later than end-June (a structural performance criterion under the program). In order to ensure continued progress in our structural reform program, additional measures, outlined below, have been identified, including a number that have been taken as prior actions for the current review (see attached Tables 1 and 2).

3.  During April, the NBU purchased some $180 million in the foreign exchange market, contributing to a large over-performance relative to the program target for net international reserves (NIR). In light of the very low level of reserves, in consultation with the Fund staff, the National Bank of Ukraine (NBU) determined that it was prudent to take the opportunity to accumulate reserves, which was achieved without putting pressure on the exchange rate. However, as a consequence, base money increased sharply in April, including an increase in currency in circulation of 9 percent. The NBU is closely monitoring the impact of these developments and stands ready to tighten domestic liquidity if necessary. In the meantime, we will continue to accumulate foreign exchange reserves beyond the levels envisaged under the program, to the extent possible. The end-April performance criterion on the net domestic assets (NDA) of the NBU was missed by a small margin, due to a reclassification of certain foreign exchange deposits. In light of the very small departure from the target, we request a waiver for the nonobservance of the performance criterion on the NDA of the NBU.

4.  The overall fiscal deficit of the government (on a cash basis) amounted to 1 percent of period GDP in the first quarter of 1999, compared with 6.8 percent in the same period of 1998. During the January-April period, the government has observed the targets established under the program for the overall deficit of the consolidated budget and unearmarked cash revenues, but there were shortfalls relative to the target for the stock of budgetary arrears on wages, pensions, and benefits. As specified in Table 1, we have taken a number of steps to strengthen the 1999 fiscal program performance and to bring the fiscal program back on track. In light of these measures, we request a waiver for nonobservance of the performance criterion on the stock of budgetary arrears on wages, pensions, and benefits at end-April.

5.  We remain concerned about the social impact of the prolonged existence of a large stock of arrears on social payments and, in order to permit a more rapid clearance of these arrears, we propose a modification of the annual target on the overall deficit of Hrv 0.3 billion (0.25 percent of annual GDP) with an equivalent modification to the end-year target for the stock of budgetary arrears on wages, pensions, and benefits. In addition, in order to provide a more comprehensive picture of fiscal performance, we request that the existing definition of the performance criterion on budgetary arrears be amended to incorporate all budgetary arrears on wages, pensions, and benefits rather than just those beyond 30 days.

6.  With the assistance of the staff of the IMF and the World Bank, formal restructuring programs including time-bound performance objectives have been developed for each of the seven large banks for which diagnostic studies were conducted. The seven banks will sign these agreements by May 20 as part of which detailed quantified plans for achieving capital adequacy will be developed no later than June 20, 1999. As elaborated in Tables 1 and 2, over the next few months the NBU will be taking a number of steps, consistent with the recommendations of the staff of the IMF and the World Bank, to strengthen existing prudential regulations and to enhance the capacity of the NBU to implement its supervisory responsibilities. In this context, the NBU has increased the number of staff positions of the large bank unit to 39 and will fill these positions with qualified staff during the next three months. Moreover, the NBU by end-August will assign on a full time basis a group of banking supervisors to establish a framework for comprehensive on-site examinations of all banks with total assets greater than Hrv 100 million. The high-level inter-ministerial committee that is already in place will begin to monitor the reform of the banking sector by end-June. This group will, among other issues, recommend the necessary allocation to be included in the year 2000 budget to clear the government's obligations to the banking system. In addition, the government will refrain from instructing banks to lend to specific entities or for specific purposes. The NBU will modify the deposit insurance scheme so that any of these seven large banks is expelled if it fails to comply materially with the above restructuring agreement. The NBU will continue in its efforts to secure the passage of the NBU Law by parliament. Furthermore, the NBU will submit the draft Law on Banks and Banking Activity, reviewed by the Fund and Bank staff, to the parliament by end-June 1999.

7.  Following a comprehensive review of the foreign exchange system, in consultation with the Fund staff, we have removed all but two foreign exchange restrictions. The two remaining restrictions-on the making of advance import payments exceeding fixed limits and on the convertibility of certain hryvnia balances held by non-residents-will be eliminated by June 30, 1999. Contrary to earlier expectations, the NBU will permit the Birzha to reopen for the settlement of foreign exchange transactions. Transactions take place via the electronic trading facilities located at the Birzha rather than via a formal auction and, we believe, this provides improved access to the foreign exchange market for the smaller banks. There are no restrictions on the participants or the types of transactions that can be conducted in either market. The NBU will closely monitor the operation of the foreign exchange markets in order to ensure that the reopening of the Birzha does not result in a multiple currency practice.

8.  We remain committed to maintaining a liberal trade and payments regime in order to stimulate exports and growth. However, in view of our difficult fiscal position, by May 20 we will impose a strictly temporary two percent import surcharge. The surcharge will apply uniformly to all imported goods, irrespective of country of origin, and will be eliminated by end-December 1999. The government does not intend to introduce any new restrictions on exports. Although it has not been possible to eliminate the export duty on skins and hides, the government will make every effort to secure the removal of this duty before the end of the year.

9.  The privatization program is proceeding as scheduled and we expect to meet the targets established for end-June. In addition, in cooperation with the World Bank staff, we have identified additional steps to expedite progress with larger scale privatization, to fully privatize (100 percent of shares) additional grain elevators, and to reduce substantially the licensing requirements on enterprises. In particular, we have identified 10 attractive strategic enterprises important for the state economy and security which should be privatized via commercial tenders or open cash tenders, including with the participation of advisors and in line with the recommendations of the World Bank. We have already fully privatized 26 large, attractive grain elevators and plan to privatize 50 elevators (cumulatively) by end-June and 65 elevators (cumulatively) by end-September.

10.  In the area of public administration reform, plans for restructuring the Ministry of Finance and Ministry of Economy have been developed with the assistance of the World Bank and other donor agencies. A seminar, with World Bank participation, will be held within the Ministry of Finance to explain the objectives and modalities of the reforms and further such seminars are intended. In addition, we have formulated a timetable for the reform of the Apparat of the Cabinet of Ministers. We will continue to work with the World Bank to develop further the reform strategy in this area.

11.  Despite some progress in reform of the energy sector, gas auctions have not been successful. However, 1 billion cubic meters of gas will be sold for cash at the auctions by May 20 and monthly targets for the remainder of 1999 have been established. In order to facilitate the operation of the auctions, as noted in Table 1, we have eliminated the minimum price for bids. A number of initiatives are also under way to enhance the transparency of operations in the energy sector, specifically via the publication of auction results and other transactions in the sector as well as through an audit of the production costs and accounts of Naftogas Ukrainy. We have also advanced reforms in the coal and electricity sectors and collection rates for electricity have improved recently following a decision to cut off non-paying consumers. We will continue to examine proposals for expanding the role of the private sector in the activities of the energy sector.

12.  Despite the more rapid than anticipated accumulation of official reserves, the bunching of debt service payments falling due in the next two years is of considerable concern to the government and the NBU. We have remained current on our payments to creditors, but we are exploring options with a group of external private creditors that hold a domestic debt instrument that falls due in June. We are confident that a cooperative solution to refinance or restructure this payment can be found and that, consequently, Ukraine will be able to meet the program's targets for official reserves. However, due to the uncertainty surrounding the outcome of these negotiations, we would request that the next purchase under the arrangement, based on observance of end-May performance criteria, also be made subject to a financing review. Regarding official creditors, a small arrear was incurred to Turkmenistan in early April, due to a disputed claim held by Ukraine on Turkmenistan which we are still attempting to resolve. However, this arrear was cleared in mid-April and we request a waiver for the nonobservance of the continuous performance criterion on the nonaccumulation of external arrears by the government and the NBU.

13.  The external environment facing Ukraine remains difficult. The economy continues to suffer from the impact of generally weak commodity prices for our major exports, particularly metals, while demand in the region remains depressed due to the continuing difficulties in Russia. More recently, the crisis in Kosovo has resulted in a disruption to shipping services on the Danube and forced the diversion of trade to alternative transportation corridors. While the export shortfall caused by these external shocks might make Ukraine eligible to request a purchase under the Compensatory and Contingency Financing Facility (CCFF), we believe that the Extended Fund Facility (EFF) provides terms and conditions that are more appropriate for Ukraine at this time. Accordingly, we request an augmentation of the existing arrangement under the EFF in the amount equivalent to SDR 274.4 million (20 percent of quota).

14.  We believe that the measures taken to bring the fiscal program back on track and to accelerate structural reforms are sufficient to achieve the objectives of the arrangement supported by the Fund and on this basis request the completion of the current review, the modification of performance criteria through August 31, 1999 and establishment of performance criteria for end-September, 1999. The third review under the program, based on end-July 1999 performance, is scheduled to be completed by August 20, 1999. It will focus on the implementation of the reform of the banking system, and progress with the development of the energy sector. A further program review will be completed by November 19, 1999.

Sincerely,

Administrative reform

Adopt a time-table for reform of the Apparat of the Cabinet of Ministers, in line with recommendations provided by the World Bank staff.

Adopt an action plan for restructuring the Ministry of Economy, in line with recommendations provided by the World Bank staff.

Approval by the Minister of Finance of a new structure for the Ministry of Finance, and an action plan for strengthening of the Ministry, in line with recommendations provided by the World Bank staff, by May 24, 1999.

Banking sector

Conclude rehabilitation plans for 7 large banks in line with findings of diagnostic studies, with quantified targets for eliminating capital deficiencies as recommended in the diagnostic reviews.

Upgrade prudential standards to eliminate deficiencies in loan loss provisioning as well as classification and provisioning of accounts receivable. Establish a time-table for addressing remaining prudential issues as discussed with the Fund staff.

Initiate on-site examinations using procedures in conformity with diagnostic analysis, for the Privatbank and Ukrsotsbank.

Adopt an NBU decree establishing the required level of staffing of the Large Bank Unit, as discussed with the Fund staff, and focus on the selection of adequate personnel.

Adopt a time-table for adjusting the on-site examination manual in line with procedures used for the diagnostic studies, to be completed by December 1999.

Require that all banks with total assets greater than Hrv 100 million undergo annual audits by audit firms with internationally accepted qualifications and using internationally accepted standards, adjust their accounts accordingly, and publish the audited financial statements in their annual reports.

Reduction of the government's outstanding liabilities (through a subset of guaranteed loans, as formulated in consultation with the Fund staff) to banks to no more than
Hrv 125 million.

Communal service tariffs

Bring tariffs for heating, water supply, sewage, rent, and public transportation to full cost recovery levels, except for the city of Kyiv where tariffs will be increased before end-June 1999.

Sell 1 billion cubic meters of gas through cash auctions (cumulatively since
January 1, 1999).

Remove the minimum price after the May 20 gas auction, for all subsequent gas auctions, announce this decision publicly, and announce the guidelines for participation in subsequent auctions.


As an interim step, allow 300 large enterprises referred to in the Cabinet of Ministers Resolution No. 594 of April 15, 1999, to purchase gas from suppliers/traders, provided that the price does not exceed the price from the latest gas auction.

Adopt monthly targets to reach a level of 20 billion cubic meters of gas sold through the auctions for cash through end-March, 2000.

Adoption by the Cabinet of Ministers of an updated financial recovery plan for the power sector for 1999.

Revise tax administration procedures to charge excises when goods leave the factories in a manner that would yield additional Hrv 50 million for the remainder of 1999.

Issue a new resolution that supercedes the Cabinet of Ministers Resolution No. 611 of April 19, 1999 that exempts accounts of educational institutions from being moved to the treasury, in a manner that would safeguard use of these accounts for educational purposes.

Transfer the extra budgetary accounts of the State Tax Administration to the treasury.

Implement increases in fees/charges for forestry, water resources, radio waves, and oil loading in a manner that would yield additional revenues of Hrv 100 million for the remainder of 1999.

Change STA's collection mechanism for 36 metalurgical companies that will make tax debts senior to all other debts in a manner that would yield additional revenues of Hrv 100 million for the remainder of 1999.

Implement a temporary, uniform, non-discriminatory, two percent import surcharge in a manner that would yield additional revenues of Hrv 300 million for the remainder of 1999.

Identify a list of 10 companies for case-by-case privatization, in line with recommendations provided by the World Bank staff.

Approval of new share allocation plans (that allow the SPF to sell at least
51 percent of shares in each enterprise) by the Cabinet of Ministers for 15 large attractive enterprises, in addition to the 44 enterprises for which share allocation plans were specified under Cabinet of Ministers Resolution Nos. 418 (March 18, 1999), and 553 (April 7, 1999).

In line with the recommendations provided by the World Bank staff, adopt a Presidential decree on licensing which would require: (i) the government to undertake a review of all existing license-like permits; (ii) the removal of those permits which contradict the Law on Entrepreneurship's provisions on licensing; and (iii) limit the power of government agencies to introduce new license-like permits.

In line with the recommendations provided by the World Bank staff, abolish those licenses introduced after the December 12, 1997, "Amendments to the Law on Entrepreneurship," which do not meet the principle that new licensing could only be justified by public health, environmental protection, and national security criteria that is established in this law.

Administrative reform

Finalize action plans for restructuring the Ministries of Health and Education, by end-June (benchmark).

Presidential approval and implementation of the new statute and functions of the Ministry of Finance, in line with the Fund staff recommendations, including completion of the transfer of tax policy functions from the State Tax Administration to the Ministry, consolidation of all sectoral policy departments under the budget department, and steps to develop tax policy and macroeconomic forecasting capacity, by June 15.

Develop a proposal for restructuring the Apparat of the Cabinet of Ministers in line with the "Concept on Administrative Reform," and with recommendations provided by the World Bank staff, by end-June, with full implementation by end-July.

Agriculture

Adopt a decision to corporatize the Bread of Ukraine, by end-June (benchmark).

Approve the decision to implement pilot projects on the use of land as collateral, by end-June.

Initiate bankruptcy proceedings for another 100 large insolvent collective farms by end-July.

Monitor the requirement that any government agency procure grain only through the commodity exchanges for cash and publish monthly information on this, by end-June.

Banking sector

Issue a Presidential edict for corporatization of the Savings Bank, by June 1.

The high-level committee between the National Bank of Ukraine and the Cabinet of Ministers that is already in place will begin to consider issues related to banking sector restructuring, by end-June.

Submit to parliament the Law on Banks and Banking Activity reviewed by the Fund and Bank staff, by end-June.

Elaborate quantitative targets for eliminating capital deficiencies as recommended in the diagnostic reviews, by June 20 (benchmark).

Assign, on a full time basis, a group of banking supervisors to establish a framework for comprehensive on-site examination of all banks with total assets greater than Hrv 100 million, by end-August.

Complete adjustment of the on-site examination manual in line with procedures used for the diagnostic studies, by end-December.


Complete on-site examinations for the seven large banks, by end-December.

Communal service tariffs

If necessary, raise tariffs for electricity and gas to full cost recovery levels, by end-June (benchmark).

Fiscal

Consolidate bank accounts into the Treasury Single Account (TSA) at the NBU (covering the central NBU account and accounts at NBU branches in oblasts), except for Treasury balances with commercial banks in locations remote from NBU branches, where balances should not exceed 24-hour payment needs, by end-June (benchmark).

Move the extrabudgetary accounts of the State Customs Service to the treasury, by end-June (benchmark).

Prepare the first monthly budget review document in line with recommendations by the Fund staff by June 30.

Finalize property revaluation for the land tax in a manner that would yield additional revenues of Hrv 100 million for the remainder of 1999.

Sell gas through the cash auctions consistent with the monthly targets under the program.

Audit the production costs and accounts of Naftogas Ukrainy, in consultation with Fund and Bank staff.

Publish auction results and other transactions, including monthly prices and quantities of gas sold to all consumers by Naftohas of Ukraine.

Repeal paragraphs 6, 9, and 12 of the Cabinet of Ministers Resolution No. 594 of April 15, 1999, that authorizes netting operations and requieres 300 large enterprises to purchase 50 to 100 percent of their gas needs solely from Naftogas Ukrainy, by end-June.

Complete the privatization of 400 enterprises under "Bread of Ukraine" (70 percent of shares) by end-June (benchmark), and 443 enterprises by end-September. Fully privatize (100 percent of shares) 50 grain elevators(cumulatively), by end-June. Fully privatize 65 grain elevators (cumulatively), by end-September.

Enact the legislation necessary for the corporatization of Ukrtelecom by end-May.

Initiate 10 enterprises for case-by-case privatization by end-June.

Annul all license-like permits which are introduced by the Cabinet of Ministers resolutions and Presidential decrees, by end-July. Submit proposals to parliament to introduce amendments to the laws requiring the removal of all license-like permits that contradict the Law on Entrepreneurship, by end-July.

Complete the first stage in the development of a depository system, clearance and settlement system and settlement payment system (with NBU participation) for all regulated trading systems, in line with recommendations provided by the World Bank staff, by end-June.

Trade and exchange system

Eliminate the exchange restriction on the repatriation of interest by nonresidents and the restriction on the making of advance import payments, by end-June (benchmark).

The government will make every effort to secure the removal of the export duty on hides and skins by end-December 1999.

Eliminate the import surcharge by end-December 1999.

Refrain from introducing any new restrictions on exports, throughout the period.