December 5, 2000

Mr. Horst Köhler
The Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler

1. Since the completion of the third review under the Extended Arrangement in September 1999, the financial and economic situation in Ukraine has improved markedly. In particular, a recovery of economic activity in late 1999 has turned into a broadly based economic expansion in 2000; external debt to the private sector has been successfully rescheduled; the exchange rate has remained stable; and the international reserves position was strengthened. On the structural front, a number of important measures were taken, including the improvement of payments discipline in the energy sector; major reforms in the agricultural sector; the elimination of non-cash revenue offsets and significant reduction of discretionary tax exemptions; the lowering of the maximum import tariff rate from 30 percent to 25 percent; the drastic reduction of payments arrears on government wages and social benefits, and the virtual elimination of pension arrears; the increase of communal tariffs to cost-recovery levels practically all over Ukraine; a streamlining of the public administration; and the passage of a privatization law fostering transparent procedures.



2. Notwithstanding the improvements outlined above, further progress is required to consolidate Ukraine’s financial position and create a solid base for sustainable economic growth. The annual inflation rate exceeded our target and rose from 19 percent in 1999 to an expected 27 percent in 2000, reflecting increases in administered prices, notably communal tariffs, higher prices for energy imports and some staples, and the impact of purchases of foreign exchange by the National Bank of Ukraine (NBU). The consolidated budget deficit (cash basis) for 2000 is expected to be lower than foreseen owing to strong revenue performance coupled with shortfalls in foreign financing and privatization receipts. However, arrears on energy and other non-social payments remain a serious problem. Looking ahead we see the greatest need for further action with regard to reforming the banking sector, especially with regard to Bank Ukraina; ensuring the transparency of privatization operations; further improving payments discipline in the energy sector; rationalizing financial relations between the central and local governments; and further reducing distortions in the tax and foreign trade systems.



3. We are determined to consolidate the progress made by tightening fiscal and monetary policies, and by accelerating key structural reforms necessary to ensure sustained growth. In this regard, the following measures have already been implemented: (a) the 2001 government budget was approved by parliament in the second reading with a deficit of 3 percent of GDP; and (b) a privatization list for 2001 consistent with the budget has been submitted to parliament.



4. On the basis of these actions and our policy intentions set forth below, we request completion of the fourth review under the Extended Arrangement and, in order to permit the resumption of purchases, the granting of waivers for nonobservance of performance criteria. In view of the length of the period during which the arrangement was inoperative, we also request an extension of the arrangement and a rephasing of the remaining purchases under the arrangement.

THE MEDIUM-TERM STRATEGY

5. The main macroeconomic objectives under our medium-term strategy are to: (i) maintain real GDP growth at a rate of not less than 4–5 percent in 2001–05; (ii) reduce annual inflation from an expected 27 percent in 2000 to less than 10 percent by 2004; and (iii) gradually strengthen the gross official reserves position of the NBU. Fiscal policy will aim at strictly limiting the consolidated budget deficit to 3 percent of GDP in 2001 and reducing it to a more sustainable level from 2002 onwards, in order to increase government savings and bring about a much-needed reduction of the public debt-to-GDP ratio. Achieving this objective will allow monetary policy to focus on keeping inflation under control, and thus help ensure a stable exchange rate. Our growth strategy is based on promoting private sector activity and investment by accelerating privatization, eliminating excessive regulations and controls, reducing government intervention in economic activity, improving the equity of the tax structure, curbing corruption, and developing a judicial framework necessary for a market economy.

THE PROGRAM FOR 2001

6. Within the medium-term framework outlined above, we have elaborated a program for the period October 1, 2000–December 31, 2001, as detailed in the attached policy matrix (Table 3). The proposed quarterly quantitative performance criteria, indicative targets, and quantitative structural benchmarks for December 31, 2000 and March 31, 2001 are set out in Table 1. Prior actions and structural benchmarks are listed in Table 2. With a view to strengthening the role of cash transactions and market forces in our economy, we propose to include a new performance criterion related to netting operations on consolidated government obligations and two structural benchmarks on cash collection ratios for gas and electricity. We will review the program targets with the Fund in the context of the fifth EFF review, which is scheduled to be completed in the first quarter of 2001. A program review will be conducted in each subsequent quarter through the second quarter of 2002. We understand that, in each case, completion of the review will be a condition for the release of the corresponding purchase.

A. Fiscal Policy

7. The government has adopted an ambitious fiscal program that aims to further consolidate government finances, improve the tax structure and widen the tax base, better target public expenditures in line with priorities for structural reform, and improve the transparency of government operations. Building on good progress in 2000, the 2001 budget law prohibits netting and non-cash operations, and government loan guarantees (other than for loans from multilateral organizations). In addition, the coverage of the budget has been widened to encompass all privatization receipts (including those that are earmarked), all external project loans that are on-lent, and the State Property Fund (SPF), while the presentation and coverage of the special funds has been improved. At the same time, however, the Social Insurance, Employment, and Leasing Funds have been placed off-budget. Finally, transfers to municipalities will be in line with the principles of the formula-based reform that is underway.



8. The 2001 budget adopted by parliament in the second reading targets a fiscal deficit of not more than 3 percent of GDP. The budget also fully provides for the energy consumption of the government sector. Finally, any amount of privatization receipts in excess of Hrv 5.9 billion will be used for public debt reduction. Since the bulk of the privatization receipts—the main source of budgetary financing in 2001—are expected to materialize towards year-end, the monthly expenditure ceilings have been matched to the expected pattern of financing. In light of the inherent uncertainties, the government will retain until the end of 2001 sufficient flexibility in its expenditure allocations to avoid accumulating payments arrears in the event that privatization receipts turn out to be significantly less than currently envisaged.



9. The government will continue to take steps to rationalize the revenue structure and improve intergovernmental financial relations. A review of the existing Free Economic Zones and Special Investment Regimes will be completed by end-April 2001; the terms of reference for this review stress the need for a rationalization of tax exemptions, including through additional measures in the event that the total amount of net budgetary losses would jeopardize fiscal sustainability. To simplify and rationalize the tax system, a new tax code is being considered by parliament, for implementation in 2002. Furthermore, we have severely reduced the possibilities for tax deferrals or restructuring of tax arrears that arose after January 1, 2000, and we will resist any initiatives to widen tax exemptions or introduce tax amnesties. Financial relations between the central and local governments will be rationalized through the introduction of formula-based transfers. The remaining legislative steps will be adopted in time to introduce a full formula-based system with the 2002 budget.



10. In the area of tax administration, the State Tax Administration (STA) has begun to establish regional large taxpayer offices. In order to further improve collection enforcement from large taxpayers, the STA will extend the IMF-supported pilot project on collection enforcement to the large taxpayers offices in the entire country. Legislation to replace the Kartoteka II system with modern collection procedures has been submitted to parliament, and the government will initiate proceedings by June 2001 against 5 of the 50 largest tax debtors according to the Law on Recovery of the Debtor’s Solvency or Announcing Bankruptcy. Also, the government will continue to reduce the stock of VAT refund requests outstanding for more than three months.



11. The government will continue to give high priority to rationalizing government expenditures, and to ensuring that no new payments arrears on wages, pensions, and benefits emerge. To improve transparency and accountability, and reduce opportunities for corruption, the fiscal program aims to promote cash operations, and to scale back government activities outside the budget and quasi-fiscal operations. To strengthen expenditure controls, the number of key budgetary units has been reduced substantially and budgetary coverage has been extended to most extrabudgetary funds. In the 2001 budget, all social programs have been consolidated into a single, targeted social assistance program under the authority of the Ministry of Labor and Social Policy. In addition, we intend to strengthen the compulsory state pension insurance system by encouraging retirement at a later age, improving the link between contributions and benefits, and eliminating privileges. Finally, the fiscal reporting and cash management capabilities of the treasury are to be enhanced through the introduction of the single treasury account and electronic ledger system by end-2001, with technical assistance from the Fund.

B. Monetary and Exchange Rate Policies and Banking Sector Reform

12. For the remainder of 2000 and during 2001, monetary policy will remain cautious and be guided primarily by the net domestic assets (NDA) target for the NBU and the inflation objectives of the program. The NBU will continue to manage the exchange rate flexibly. Intervention in the foreign exchange market will be guided by the need to counteract exchange rate volatility and to safeguard the external reserves objectives of the program. The targets for base money and broad money growth are consistent with the inflation target, and allow for an increase of credit to the economy in real terms. With a view to improving the efficiency of the banking system and its contribution to economic growth, we intend to reduce reserve requirements for time deposits. The monetary program mentioned above takes these reductions into account. The government will refrain from influencing or directing credits extended by the banking system, including through reserve requirements which would be differentiated based on sectoral lending.



13. The financial relationship between the NBU and the Ministry of Finance was placed on a sound basis with the conclusion in September 2000 of an agreement to restructure the stock of Treasury bills held by the NBU and to ensure positive real interest rates thereon. The Ministry of Finance will continue to make all the payments to the NBU as envisaged under this agreement. Furthermore, the NBU profit transfers to the Ministry of Finance will be based only upon its audited financial statements of the previous year, and take place after approval of the NBU Council.



14. Reforms being undertaken in the financial sector aim at strengthening banking legislation and accelerating the restructuring of major problem banks. We will move this process forward on the basis of the new Law on Banks and Banking Activity that is expected to be approved by parliament by mid-December and allows the NBU to deal more effectively with problem banks. Concerning Bank Ukraina, a NBU resolution has been issued limiting the bank’s operations and preventing it from taking new deposits, and a provisional administration was installed in September. An outline of a joint medium-term strategy will be worked out with the World Bank by December 15, 2000, which will not require recourse to government financing. The provisional administration has begun implementing an action plan to cut operating losses, and, with a view to reducing systemic risks, to protect household deposits currently held at Bank Ukraina. The provisional administrator of Bank Ukraina will present, in consultation with the World Bank, by 15 December, 2000 a plan to eliminate the operating losses of the bank within a reasonable time frame.



15. The Savings Bank will renew its efforts to implement the recovery plan agreed with the NBU in 1999, with the objective of enhancing the quality of its portfolio and improving its capital adequacy. In this context, the NBU has stipulated strict limits on loans to the energy sector by the Savings Bank. The NBU will monitor closely the lending of Savings Bank to the energy sector, with a view to safeguarding the soundness of the bank, and reducing over time its exposure to the energy sector.

C. Privatization and Sectoral Reforms

16. To accelerate the privatization process, a transparent privatization law covering the period 2000–02 was approved by parliament. The law provides for the cash sale of majority shareholdings in a substantial number of strategic enterprises, and the use of financial advisors to assist the State Property Fund (SPF) in ensuring transparency of all aspects of privatization processes.



17. For 2001, the Cabinet of Ministers has submitted to parliament a list of strategic enterprises whose privatization will mark a further step in disengaging the state from commercial and industrial activities. In this context, all government-held shares in the capital of six energy distribution companies (oblenergos) have been put up for sale; these operations will be conducted with the assistance of financial advisors and are expected to be concluded in the first quarter of 2001. Tenders will be issued shortly for financial advisors to assist in the privatization of the remaining oblenergos in which the state holds a majority share. Some of these sales should also be concluded during 2001. In addition, a law was recently passed permitting the sale of a substantial minority stake in the telecommunications company Ukrtelecom. This operation is under preparation and is to be completed during the course of 2001. In order to meet the privatization objectives for 2001 and beyond, the government has submitted to parliament draft legislation that would revise the negative list, thereby permitting the sale of some 200 additional enterprises.



18. The government is committed to strengthening privatization procedures and increasing the transparency of privatization operations. This is being achieved in part through reducing the number and scope of investment conditions, publishing tenders in international mass media, and streamlining the prequalification process. Tenders for large enterprises will be conducted using open bidding procedures and, as a rule, financial advisors. Comprehensive information on privatizations in 2000 will be provided by the SPF to parliament by end-March 2001, and will be placed on the SPF web-site. In addition, the government, in consultation with the World Bank, will initiate the undertaking of ex-post reviews of privatization operations from 2000 onwards.



19. Communal tariffs in the city of Kyiv and almost all other regions in Ukraine have been increased in line with earlier understandings. We will take further steps to ensure that communal tariffs are at cost-recovery levels.



20. As part of our strategy to reduce the cost of doing business in Ukraine, we are taking a number of steps to improve the environment for investment and small businesses, reduce bureaucracy, and simplify further regulations and laws on business registration, licensing, and inspections. The Law on Licensing, which provides for a reduction in activities subject to licensing and a streamlining of procedures, has been approved by parliament. Separate draft laws on certification, standardization, and accreditation are expected to be approved by parliament during the first half of 2001, and will render Ukraine’s regulations on certification and standardization consistent with European Union norms. Finally, to simplify reporting requirements for small businesses, we have raised the VAT turnover-threshold to Hrv 61,200, and we intend to consolidate registration procedures for new businesses.



21. In the energy sector, the non-payment problem has adversely affected macroeconomic stability and growth. Payments discipline will be safeguarded by the following short-term measures: (i) raising cash collection ratios for gas and electricity, based on a schedule set out in Table 1; (ii) cutting off consumers that fall substantially short of these targets; and (iii) increasing transparency by completing the audit of the natural gas company Naftogaz by September 2001, and auditing on a monthly basis the transit account for the wholesale electricity market (WEM) and regional oblenergo settlement accounts. Our medium-term strategy for the energy sector relies on reducing the role of the state and introducing more competition into the sector. We are exploring ways to promote a market structure in the natural gas sector that provides for more transparent and reliable imports and transit.



22. We regard the development of a market-oriented agricultural sector as key to restoring output growth and balance of payments viability in Ukraine. Accordingly, we have undertaken a wide-ranging land reform, largely privatized the grain elevators, and substantially scaled back state involvement in input supply services. The government is working closely with parliament to pass the land code, title registration and mortgage laws, as well as the removal of the parliamentary ban on bankruptcy procedures for agricultural enterprises. In line with our reform strategy, the government will not play a direct role in the provision of inputs, and it will ensure that there is no interference by central and local administrations in the marketing of outputs.



23. We continue to attach high importance to further streamlining the public administration and have already taken a number of important actions, including the reduction in the number of ministries from 18 to 15. In addition, we have cut 40,000 budgetary positions in 2000 and plan further reductions in the number of budgetary positions in 2001, in line with the ongoing civil service reform efforts.

D. Balance of Payments and External Financing

24. A viable external position is one of the key elements of our medium-term strategy. We have pursued a comprehensive strategy of restructuring all sovereign debt to private and official bilateral creditors falling due in 2000 and 2001. All four outstanding Eurobonds/notes and the Gazprom bonds were restructured on April 14, 2000, with an acceptance rate of over 98 percent. In addition, letters have been sent to all bilateral official creditors, including Paris Club creditors, explaining Ukraine’s balance of payments difficulties and requesting a rescheduling on comparable terms. We have instructed Naftogaz to present a plan for regularizing its relations with its suppliers, and have recommended publication of monthly data on its operations and arrears.



25. We will accelerate our efforts to join the WTO. As a first step toward eliminating the tax on exports of sunflower seeds, we have submitted legislation to parliament that calls for reducing the tax rate from 23 percent to 10 percent. Legislative action is expected by end-2000. We are also currently reviewing the advisability of maintaining the export restrictions on livestock, skins and hides. We expect to eliminate these distortionary measures during the course of 2001. Finally, the government will refrain from introducing any new export restrictions during the period of the arrangement.



26. We have set quarterly ceilings on the amount of nonconcessional external loans contracted or guaranteed by the government and the NBU, which are detailed in Table 1. During the period of the program, neither the government nor the NBU will accumulate arrears on any external payment obligations (a continuous performance criterion under the program).

E. Statistical Issues

27. We will continue to strengthen our statistical database and compilation methods. Earlier this year, the new Law on State Statistics was passed, thereby clarifying the responsibilities and strengthening the autonomy of government statistical agencies. The State Statistics Committee will improve the quarterly national accounts. The Ministry of Finance will shortly issue an order to compile and disseminate government finance statistics in accordance with the IMF Government Finance Statistics manual. In addition, an inter-agency working group will be created to allocate responsibilities between the Ministry of Finance, the State Treasury of Ukraine, and the State Statistics Committee for the compilation and dissemination of government finance statistics. Regarding data on international reserves, the NBU will start compiling statements in line with the Special Data Dissemination Standard (SDDS) data template on reserves, which will be reported to the IMF.

F. Transparency and Governance

28. A major focus of our program is on improving transparency and governance, and reducing opportunities for rent seeking and corruption. We recognize that progress in this area is essential to encourage private activity and ensure an efficient use of public resources.



29. Audits are to be used to increase accountability of public enterprises and institutions in other areas, including Naftogaz, the State Material Reserves Company (SMR), the transit account of the wholesale electricity market, and the regional settlement accounts set-up by oblenergos for electricity payments collection. All budgetary operations will be audited by the National Board of Auditors. Additional measures include improving the system of budgetary accounting and reporting; incorporating all extrabudgetary funds and accounts in the budget; and the regular reporting to parliament on tax arrears. The NBU will include externally audited financial statements with the audit letter and all notes to these statements in the annual report submitted to parliament. These financial statements will be compiled in accordance with international accounting standards, including disclosures of fair value of assets and appropriate allowances for impairment of assets. Finally, we are in the process of compiling comprehensive data on credit extended to the private sector that was guaranteed by the government or the NBU during the period 1997–99, and will, once this exercise is completed, provide the Fund with the results.



30. Measures are also being taken to improve international reserve management practices at the NBU based on the audits and the recommendations of a technical assistance mission from the IMF’s Monetary and Exchange Affairs department. These include: (i) development of a revised statement of objectives for reserve management to be adopted by the Board of the NBU; (ii) creation of a risk management unit separated from the foreign exchange department to, among other things, develop the risk management framework for the foreign reserves function, and develop and begin operation of a monitoring system; and (iii) develop a risk-based internal audit function with an initial priority on foreign exchange activities of the head office. The NBU also intends to keep the proceeds of any future purchases that would be made under the Extended Arrangement in Ukraine’s SDR account held with the IMF.



31. As part of our plans to strengthen and enforce the judicial system and the legal environment for private investment, the new law on public procurement consistent with European Union directives is being implemented, and we will shortly present a law on joint-stock companies to parliament which will better protect minority-shareholders’ rights. In order to bring current practices against money laundering in line with international practices, the government intends to approach the OECD-based Financial Action Task Force.



32. We believe that the policies detailed above are adequate to achieve the objectives of the program, but we remain prepared to take any additional measures that may be necessary for this purpose.