Proposal for a COUNCIL DECISION providing supplementary macro-financial assistance to Ukraine

(presented by the Commission)

EXPLANATORY MEMORANDUM

Background

In October 1998, the Council approved a third macro-financial loan for Ukraine in the amount of up to EUR150 million. The first tranche of this loan, amounting to EUR58 million, was disbursed in July 1999. The disbursement of the remaining funds, however, has been delayed reflecting temporary interruptions of the IMF's extended arrangement (EFF) and delays in the confirmation by the authorities of their agreement on the policy measures for the second tranche.

In July 2001, following the reactivation of the EFF in December 2000, Ukraine reached agreement with its Paris Club creditors on the re-scheduling of approximately US$ 580 million due on loans contracted before 31 December 1998. As a result of this agreement, Ukraine's debt service due to Paris Club creditors in 2001 and 2002 will be reduced to about a third, which should help in strengthening the country's balance of payments position. The normalisation of Ukraine's relations with the Paris Club could also pave the way for an eventual return of the country to the international capital markets.

Ukraine's macroeconomic situation has recently improved. Growth has resumed, the fiscal and current account positions have strengthened and inflation, following a temporary acceleration provoked by the sharp depreciation suffered by the hryvnia in late 1999, has been on a downward trend. However, despite a healthier current account, the balance of payments remains vulnerable, reflecting a weak capital account characterised by low foreign direct investment (FDI), weak access to the international capital markets and a complicated short-term debt profile that led Ukraine in early 2000 to default on its debts to the Paris Club and reschedule its bond debts to private creditors.

Following some initial uncertainty, the new Ukrainian government formed in May 2001 confirmed that it would continue implementing the economic stabilisation and reform programme agreed between the previous government and the international financial institutions. This and the implementation of a number of prior actions led the IMF to complete in September 2001 the 5th and 6th reviews of the EFF, allowing Ukraine to draw immediately about US$375 million from the IMF.

In these circumstances, and following the consultation of the Economic and Financial Committee, the Commission is now proposing to the Council to adopt a Decision providing further macro-financial assistance to Ukraine. This new assistance would take the form of a new loan of up to EUR110 million (including the EUR92 million that remain undisbursed from the 1998 Decision, which would no longer be disbursed under that operation) and a 15-year maturity.

Recent Macroeconomic Developments

After expanding by 6 percent in 2000, the first positive yearly rate since independence, Ukraine's real GDP grew by 10.5 percent in January-July of 2001 (on a year-on-year basis). The acceleration of growth seen this year is partly explained by a spectacular recovery of agricultural production, which increased by 26.5 percent in January-July supported by good weather conditions. On the demand side, growth is being explained by both exports (which are benefiting from relatively strong Russian demand) and domestic demand. For 2001, the government is forecasting GDP growth of 7¼ percent.

Despite the strengthening of economic activity, inflation has been on a downward trend, and is expected to finish 2001 at an annual rate of around 12 percent (compared to 25.8 percent in December 2000). [1] The decline in inflation reflects a combination of factors, including the nominal stability of the hrvynia since March 2000, a prudent fiscal policy, moderate world oil prices and the impact of a good harvest on food prices.

[1] Year-on-year inflation accelerated sharply between November 1999 (18.3 percent) and July 2000 (31.5 percent) reflecting the sharp depreciation suffered by the hryvnia around the Presidential elections of late 1999, the increase experienced by oil prices during that period and the adjustment of administered prices.

In this context, the central bank has cut interest rates several times since the start of 2001. There are some concerns, however, about the sustainability of these positive inflation trends, given the high rates of monetary growth observed (M3, for example, expanded by 15.2 percent in the first seven months of 2001). Although the rapid growth of monetary aggregates seems to largely reflect a remonetisation process, as citizens regain confidence in the domestic currency and banking system, there are some fears that monetary policy may be becoming too lax and might be further eased ahead of the parliamentary elections of March 2002.

The deficit of the consolidated government (on a cash basis and excluding privatisation revenues) declined from 2.4 percent of GDP in 1999 to 1.5 percent of GDP in 2000. The 2001 budget implied a deficit of about 3 percent of GDP once privatisation revenues (5,9 billion hryvnias) were shown as a financing item. Owing to delays in the execution of the privatisation programme, however, privatisation receipts in 2001 are expected to be much lower than budgeted, amounting to only 3.5 billion hryvnias (about 1.7 percent of GDP). To compensate for this, the government has agreed with the IMF to reduce to 1.7 percent of GDP the target for the deficit. This will be achieved through expenditure cuts (mainly capital spending) and higher than budgeted tax revenues (on account of strong economic activity). A new Budget Code introducing more transparent and efficient budget procedures and regularising inter-governmental financial relations was enacted in July 2001. In September 2001, the government submitted to parliament a budget proposal that implies the maintenance of the deficit at 1.7 percent of GDP, as recommended by the IMF, but the parliament has rejected it in first reading.

Supported by the depreciation of the hryvnia in 1999 and stronger demand in Ukraine's main trading partners, exports grew strongly in 2000. Although import growth also accelerated reflecting the recovery of domestic demand, the surplus in the current account widened to 4.7 percent of GDP in 2000. In 2001, however, the surplus is narrowing due to the combination of strong domestic demand, the global slowdown and an appreciating real exchange rate.

Despite the surplus in the current account, the balance of payments remains vulnerable. The capital account has weakened since mid-1998. Access to the international capital markets was lost in the wake of the Russian crisis of 1998 and Ukraine experienced significant capital outflows around the time of the 1999 Presidential elections. At the same time, Ukraine's debt service obligations increased markedly in 1999-2001, partly reflecting the excessive borrowing at relatively short maturities incurred by the country in 1997-98. Meanwhile, FDI inflows have continued to be disappointing, partly reflecting a complex and investor-unfriendly regulatory framework and investors' concerns about political instability. In this context, official foreign exchange reserves, have remained rather low (about US$2.07 billion, or 5.5 weeks of imports, in mid-September 2001). [2]

[2] Reserves have shown, however, an upward trend since the second quarter of 2000.

All this led Ukraine to stop servicing its debts to the Paris Club in January 2000. That same month, Moody's downgraded Ukraine to a default grade rating (from B3 to Caa1) and, in April 2000, Ukraine had to reschedule some its foreign debts to the private sector. Some US$2.6 billion in foreign debt to the private sector, mostly eurobonds but also part of Ukraine's debt to the Russian gas company Gazprom, were swapped into 7-year bonds denominated in euros or dollars. Then, in July 2001, the Paris Club agreed to reschedule Ukraine's debts, as noted.

The Paris Club Rescheduling

The debt restructuring agreed by the Paris Club in July 2001 consolidates approximately US$580 million due on loans contracted by Ukraine before 31 December 1998. This amount consists of principal arrears and maturities due from 19 December 2000 through 3 September 2002. These amounts are now to be repaid over 12 years, with a 3-year grace period, in 18 equal successive semi-annual payments. In addition, the Paris Club has granted deferrals on the interest payments, which effectively means that much of the interest payments burden for 2001 has been shifted to 2002.

The rescheduling agreement is expected to reduce Ukraine's debt service due to Paris Club creditors during 2001 and 2002 from an initial amount of US$805 million to US$286 million, which consists mainly of payments of interest and payments of principal falling due in 2002 after the end of the consolidation period. This should make a significant contribution to strengthening Ukraine's balance of payments position (the reduction in debt service in 2001-02 is equivalent to about 1.4 percent of projected 2001 GDP). The normalisation of Ukraine's relations with the Paris Club could also pave the way for an eventual return of the country to the international capital markets.

Main Features of the Proposed New Loan Facility

In this context, the Commission is proposing the adoption of a Council Decision providing further macro-financial assistance to Ukraine, in the form of a loan of up to EUR110 million. The proposed amount would include the undisbursed funds from the 1998 loan operation (EUR92 million), which would no longer be disbursed as part of the 1998 Council Decision. Given the need to lengthen the average maturity of Ukraine's debt and smooth the shorter-term debt profile, the Commission is proposing a loan of a maximum maturity of 15 years, compared to the 10 years maximum maturity of the previous loan. The grace period of the loan would be extended to 10 years from the 7 years on the 1998 loan. By disbursing the remaining funds from the 1998 loan facility under the proposed new Decision, the maturity and grace period at which those funds will be lent will effectively be lengthened.

The proposed new assistance would be disbursed in at least two tranches. The disbursement of each tranche would depend on:

- a satisfactory track record of Ukraine in the implementation of the adjustment and reform programme agreed with the IMF in the context of the EFF and/or any successor arrangement with the IMF;

- progress with respect to a number of structural reform measures to be agreed between the Commission and the Ukrainian authorities.

The adoption of this new assistance would require an additional provisioning of the Guarantee Fund for some EUR1.62 million (corresponding to the proposed increase by some EUR18 million of the loan amount relative to what remained available under the 1998 loan facility).

2002/0018 (CNS)

Proposal for a COUNCIL DECISION providing supplementary macro-financial assistance to Ukraine

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community, and in particular Article 308 thereof,

Having regard to the proposal from the Commission [3],

[3] OJ C , , p. .

Having regard to the opinion of the European Parliament [4],

[4] OJ C , , p. .

Whereas:

(1) The Commission has consulted the Economic and Financial Committee before submitting its proposal;

(2) Ukraine is undertaking fundamental political and economic reforms and is making substantial efforts to implement a market economy model;

(3) Ukraine and the European Communities and their Member States have concluded a Partnership and Cooperation Agreement which will help the development of a full cooperation relationship;

(4) The Chernobyl nuclear power plant was closed down in December 2000, in line with what was agreed by the Ukrainian authorities, the Group of Seven countries and the European Union in a Memorandum of Understanding signed on 21 December 1995;

(5) The International Monetary Fund (IMF) approved in September 1998 an "Extended Fund Facility"(EFF) for Ukraine ) of approximately US$ 2,3 billion, later augmented to approximately US$ 2.6 billion, in support of an economic programme for the period July 1998 to June 2001; in December 2000, the IMF extended the duration of this financial arrangement through August 2002; the World Bank since 1998 has provided substantial support for Ukraine's reform efforts, including through the approval in September 1998 of a US$300 million Financial Sector Adjustment Loan (FSAL); the World Bank is expected to continue providing substantial financial assistance to Ukraine in the coming years, including through the approval of a number of adjustment loans;

(6) the Members of the Paris Club agreed in July 2001 on a rescheduling of Ukraine's debts;

(7) By Decisions 94/940/EC ( [5]), 95/442/EC ( [6]) and 98/592/EC ( [7]) the Council approved macro-financial assistance for Ukraine of up to a total amount of EUR 435 million to support previous macroeconomic programmes;

[5] OJ L 366, 31.12.1994, p. 32.

[6] OJ L 258, 28.10.1995, p. 63.

[7] OJ L 284, 22.10.1998, p. 45.

(8) The circumstances that justified the provision of macro-financial assistance to Ukraine pursuant to Decision 98/592/EC have changed and this decision, including any undisbursed amounts of assistance, should now be replaced;

(9) However, additional official support from the Community is required in the context of the present programme to support the balance of payments, consolidate the reserve position and facilitate the necessary structural adjustment of the country;

(10) The Community loan should be managed by the Commission;

(11) The Treaty does not provide, for the adoption of this Decision, powers other than those of Article 308;

HAS DECIDED AS FOLLOWS:

Article 1

1. The Community shall make available to Ukraine a long-term loan facility of a maximum principal amount of EUR 110 million with a maximum maturity of 15 years, with a view to ensuring a sustainable balance-of-payments situation, strengthening the country's reserve position and comforting the implementation of the necessary structural reforms.

2. To this end, the Commission is empowered to borrow, on behalf of the European Community, the necessary resources that will be placed at the disposal of Ukraine in the form of a loan.

3. This loan will be managed by the Commission in close consultation with the Economic and Financial Committee and in a manner consistent with any agreement reached between the IMF and Ukraine.

Article 2

1. The Commission is empowered to agree with the Ukrainian authorities, after consulting the Economic and Financial Committee, the economic policy conditions attached to the loan. These conditions shall be consistent with the agreements referred to in Article 1(3).

2. The Commission shall verify at regular intervals, in collaboration with the Economic and Financial Committee and in close coordination with the IMF, that the economic policy in Ukraine is in accordance with the objectives of this loan and that its conditions are being fulfilled.

Article 3

1. The loan shall be made available to Ukraine in at least two instalments. Subject to Article 2, the first instalment is to be released on the basis of a satisfactory track record of Ukraine's macroeconomic programme agreed with the IMF in the context of the present EFF or of a successor upper credit tranche arrangement.

2. Subject to Article 2, the later instalment(s) shall be released on the basis of a satisfactory continuation of the arrangements referred to in paragraph 1 and not before a period of three months has elapsed after the release of the previous instalment.

3. The funds shall be paid to the National Bank of Ukraine.

Article 4

1. The borrowing and lending operations referred to in Article 1 shall be carried out using the same value date and must not involve the Community in the transformation of maturities, in any exchange or interest rate risk, or in any other commercial risk.

2. The Commission shall take the necessary steps, if Ukraine so requests, to ensure that an early repayment clause is included in the loan terms and conditions and that it may be exercised.

3. At the request of Ukraine, and where circumstances permit an improvement in the interest rate on the loans, the Commission may refinance all or part of its initial borrowings or restructure the corresponding financial conditions. Refinancing or restructuring operations shall be carried out in accordance with the conditions set out in paragraph 1 and shall not have the effect of extending the average maturity of the borrowing concerned or increasing the amount, expressed at the current exchange rate, of capital outstanding at the date of the refinancing or restructuring.

4. All related costs incurred by the Community in concluding and carrying out the operation under this Decision shall be borne by Ukraine.

5. The Economic and Financial Committee shall be kept informed of developments in the operations referred to in paragraphs 2 and 3 at least once a year.

Article 5

At least once a year the Commission shall address to the European Parliament and to the Council a report, which will include an evaluation of the implementation of this Decision.

Article 6

Council Decision 98/592/EC is hereby repealed.

Done at Brussels,

For the Council

The President

FINANCIAL STATEMENT

1. Title of operation

Supplementary macro-financial assistance to Ukraine.

2. Budget headings involved

Heading B0-230 ("Reserve for loans and loan guarantees in favour of third countries").

Heading B0-213, reflecting the European Community guarantee for borrowing programmes contracted by the Community to provide financial assistance for the New Independent States and Mongolia.

3. Legal basis

Article 308 of the Treaty.

4. Description and justification for the action

a) Description of the action

Provision of a Community loan (to be financed by Community borrowing in the international capital markets), in the amount of up to EUR 110 million to Ukraine with a view to supporting Ukraine's adjustment and reform efforts.

b) Justification for the action

The viability of Ukraine's external position depends considerably on external financial assistance from official sources.

5. Classification of the expenditure

Obligatory.

6. Nature of the expenditure

Heading B0-230: transfer to the Guarantee Fund (BO-240) according to Council Regulation 2728/94 to cover the risks related to guarantees covering loans granted to third countries.

Potential activation of budget guarantee for the Community borrowing aimed at funding the loan to Ukraine.

7. Financial impact

a) Method of calculation

Heading B0-230: calculation according to Council Regulation 2728/94.

Heading B0-213: a token entry is proposed because it is expected that the budget guarantee will not be called and, in any case, the amount and timing of any call on this budget line cannot be calculated in advance.

b) Effect of the action on intervention credits

Only in the case of an effective call on the guarantee.

c) Financing of the intervention expenditure

The Decision will require a transfer from the Reserve for the Guarantee Fund (B0-230) to the Guarantee Fund (B0-240). Out of the EUR 110 million, EUR 92 million have already been provisioned. The transfer will amount to EUR 1.62 million, corresponding to the EUR 18 million still to be provisioned on the basis of a 100 percent Community Guarantee and a provisioning rate of 9 percent. Because of its small impact on the reserve, this proposal is compatible with the priority use of the Reserve.

In case of call on the budget guarantee:

- Recourse to the Guarantee Fund established by Council Regulation (EC, EURATOM) n° 2728 of 31 October 1994.

- In case the Guarantee Fund did not contain sufficient resources, additional payments would be called up from the budget by transfer:

- of any margin remaining in the Reserve for guarantees;

- of any late payments to the budget for which the budget guarantee has been activated (under article 27(3) of the Financial Regulation);

- of any margin available under the ceiling of category 4 of the financial perspectives or redeployment therein.

- In order to fulfil its obligations, the Commission can provisionally ensure the debt service with funds from its treasury. In that case, Article 12 of the Council Regulation (EEC, Euratom) n° 1552/89 of 29.5.1989 will apply.

8. Fraud prevention measures

The funds will be paid directly to the Central Bank of the beneficiary country only after verification by the Commission Services, in consultation of the Economic and Financial Committee and in liaison with the IMF and World Bank Services, that the macroeconomic policies implemented in Ukraine are satisfactory and that the specific conditions attached to this assistance are fulfilled.

9. Elements of cost-effectiveness analysis

a) Grounds for the operation and specific objectives

By supporting Ukraine's macroeconomic reform efforts and complementing financing by the International Community provided to this country by the international financial institutions, this assistance would ease the country's external financing constraints, would improve its growth prospects and would underpin its transition towards a market economy.

b) Monitoring and evaluation

This assistance is of macroeconomic nature and its monitoring and evaluation is undertaken in the framework of the IMF-supported adjustment and reform programme that Ukraine is implementing.

The Commission services will monitor the action on the basis of a genuine system of macroeconomic and structural policy indicators to be agreed with the authorities of the beneficiary country. They will also remain in close contact with the IMF and World Bank services and will benefit from their assessment of the recipient country's stabilisation and reform achievements.

An annual report to the European Parliament and to the Council is foreseen in the proposed Council decision, which will include an evaluation of the implementation of this operation.

10. Administrative expenditure

This action is exceptional in nature and will not involve an increase in the number of Commission staff.