COMMISSION STAFF WORKING DOCUMENT Ex-ante evaluation statement on EU macro-financial assistance to the Republic of Ukraine Accompanying the document Proposal for a DECISION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL providing macro-financial assistance to Ukraine
Date: 2015-01-08
Institutions: European Commission
Subjects: Community loan, EU aid, Ukraine, economic aid, financial aid, macroeconomics, territorial dispute













EUR-Lex - 52015SC0001 - EN











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52015SC0001

COMMISSION STAFF WORKING DOCUMENT Ex-ante evaluation statement on EU macro-financial assistance to the Republic of Ukraine Accompanying the document Proposal for a DECISION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL providing macro-financial assistance to Ukraine /* SWD/2015/0001 final */









Ex-ante
evaluation statement on 
EU macro-financial assistance to the Republic
 of Ukraine
Table of Contents
1........... Problem analysis and needs assessment 3
1.1.        Introduction. 3
1.2.        Ukraine’s macro-economic situation. 4
1.3.        IMF and other donor support 7
1.4.        Ukraine’s external financing needs. 8
1.5.        Ukraine’s structural reform challenges. 9
2........... Objectives and related indicators of the macro-financial assistance. 12
2.1.        Objectives. 12
2.2.        Indicators. 12
3........... Delivery mechanisms and risk assessment 13
3.1.        Delivery mechanisms. 13
3.2.        Risk assessment 13
4........... Added value of EU involvement 14
5........... Characteristics of macro-financial assistance. 15
5.1.        Exceptional Character and Limited Timeframe. 15
5.2.        Political preconditions and EU-Ukraine relations. 15
5.3.        Complementarity. 16
5.4.        Conditionality. 17
5.5.        Financial Discipline. 17
6........... Planning of future monitoring and evaluation. 17
6.1.        Monitoring. 17
6.2.        Evaluation. 18
7........... Achieving cost-effectiveness. 18
1.           Problem analysis and needs
assessment
1.1.        Introduction
Following public
mass protests, former President Viktor Yanukovych left power and a reform-minded
government was appointed in Ukraine in February 2014. It embarked on an
ambitious macroeconomic adjustment and structural reform programme that aimed
to change the country’s unviable economic model and pave the way for long-term,
sustainable growth. The reform programme was underpinned by a USD 17 billion
financial assistance programme by the IMF and significant support from other
international donors. On its side, the EU committed to implementing two
macro-financial assistance (MFA) programmes of a combined amount of EUR 1.61
billion to alleviate the short-term financing pressures Ukraine was facing,
while supporting the reform programme of the authorities in the areas of public
finance management and anti-corruption, trade and taxation, energy and
financial sector restructuring. In addition to the MFA assistance, the EU put
in place a EUR 355 million programme in the form of grants for institution
building. 
Despite the
volatile political calendar in Ukraine, which included the holding of
presidential and parliamentary elections within less than six months from each
other, the authorities made significant progress with advancing their reform
programme. Monetary policy and fiscal consolidation steps were accompanied
by important structural reforms in the energy and banking sectors. In addition,
steps were taken to fight corruption by the introduction of an anti-corruption
legislative package and significant amendments to the public procurement
legislation. 
Following a stalling
of reform progress in the period around the parliamentary election in October
2014, the government that took office in December 2014 has committed itself to
further resolute reforms, both in the macroeconomic and structural areas.
Encouragingly, it has a strong parliamentary majority, which is required for
pushing such reforms through. In December 2014, the newly formed government
presented an ambitious Action Plan outlining the reform agenda of the coalition
government. It is envisaged to be followed up in early 2015 by a comprehensive
National Reform Strategy setting out structural reform measures for 2015-17
that are necessary to ensure the medium-term macroeconomic stability of Ukraine and the implementation of the EU-Ukraine Association Agreement. It is expected that
this document will cover areas including public finance management and the
transparency of the budgetary process; tax administration; management of
state-owned enterprises; reform of the judiciary, rule of law and
anti-corruption; public administration reform; reforms in the energy and
financial sectors; and measures to improve the business and investment
environment.
The reform
efforts of the authorities have been seriously complicated, however, due to the
eruption of an armed conflict in the East that took a heavy toll on the
domestic economy by destroying part of the country’s productive capacity and
leading to a confidence crisis. The situation was aggravated by growing trade
restriction from Russia, one of the key export markets for Ukraine, and the escalation of a natural gas dispute between the two countries. As a
result, the economic recession in Ukraine has become more severe than initially
expected by international donors. The crisis is expected to be prolonged, as Ukraine is heading for another year of a contraction in 2015. The loss of export proceeds
due to the conflict in the east and the confidence crisis led to a sharp
depreciation of the local currency and a depletion of international reserves.
In the current situation, Ukraine does not have access to international debt
markets and is not expected to regain it in the short term. A significant
additional external financing gap has therefore emerged.
Against this
background, additional official financial assistance is required to
address Ukraine’s short-term balance of payments needs, including the
replenishment of international reserves, and to support the reform programme of
the authorities, in particular the restructuring of the energy and banking
sectors. Last but not least, this support is required to shore up investor
confidence, which is essential for bringing Ukraine’s economy eventually back
to a sustainable growth path.
In this context,
the Ukrainian authorities requested Macro-Financial Assistance (MFA) from
the EU of EUR 2 billion on 9 September 2014. The request for MFA was
reiterated in a further letter of 15 December 2014. Taking into consideration
these requests, the economic situation in Ukraine and discussions among
Ukraine’s major donors about possible additional external financing, the
European Commission is submitting to the European Parliament and the Council a
proposal to grant Ukraine MFA of EUR 1.8 billion in the form of medium-term
loans to be disbursed in three instalments. The proposed MFA will help Ukraine cover part of its residual additional external financing needs in 2015 and early
2016 in the context of the on-going IMF programme. These additional needs are
estimated at USD 15 billion. The EU’s assistance will also reduce the economy’s
short-term balance of payments and fiscal vulnerabilities, while supporting the
government’s adjustment and reform programmes through an appropriate package of
accompanying policy measures to be agreed with the Ukrainian authorities in a
Memorandum of Understanding (MoU).
1.2.        Ukraine’s macro-economic situation
Ukraine is
experiencing a deep recession that is the result of long-standing economic and
structural problems. The situation is aggravated by the armed conflict in the
eastern part of the country that not only destroyed part of Ukraine’s productive capacity but also had significant confidence impact for households and
businesses. In recent months, the implementation of much-needed stabilisation
policies, aimed at reducing imbalances and safeguarding fiscal and external
sustainability, have further weighed on short-term economic prospects. As a
result, GDP is expected to contract by 7% in real terms in 2014.
The drop of the
real GDP in 2014 is the result of a significant decline in investment activity
and reduced household expenditure. Household consumption, which was still
expanding in the first quarter of 2014 as a result of the delayed impact from
the expansionary income policies implemented by former President Yanukovych,
started gradually contracting with the steep weakening of the hryvnia and the
negative spillover effects from the uncertain geopolitical situation. At the
same time, export performance, despite benefiting from the weaker currency and
the trade preference provided by the EU, was hurt by disruptions of the
production chain and growing trade tensions with Russia. On the supply side,
there was a broad-based decline in 2014, with the exception of agriculture,
which benefited from yet another strong harvest. The biggest slump was recorded
in industry and construction, which were the worst-performing sectors in 2013
as well. The ongoing weakening of industrial activity reflects primarily the
impact for the economy of the armed conflict in the East, the major industrial
hub of the country that accounted for nearly a quarter of industrial production
in 2013.
Looking ahead, Ukraine’s
economy seems to be heading for another year of recession in 2015 due to
depressed household consumption (reflecting low confidence, erosion of
purchasing power owing to currency depreciation and concomitant inflation, and
weak credit activity), tight fiscal and monetary policies (required to address
the on-going macroeconomic imbalances) and weak investment activity (due to the
unstable geopolitical situation). Export performance, although benefiting from
the depreciation of the hryvnia, is likely to be constrained by the on-going
trade tensions with Russia and the serious damage to industrial exports as a
result of the armed conflict in the East. In view of the above-mentioned
factors, the Ministry of Finance and the National Bank of Ukraine revealed in November 2014 their forecast for GDP contraction of 4.3-4.5% in 2015. 
The economic
outlook is clouded by downside risks reflecting a possible intensification
of armed activities in the East and uncertainty over natural gas deliveries by
Russia[1]
and over the extent of restrictive trade measures by Russia following the
signature of the Association Agreement (AA) and the Deep and Comprehensive Free
Trade Area (DCFTA) agreement with the EU in March and June.[2] An
additional risk could arise from an unfavourable judgement of the international
arbitration court in Stockholm on Russia’s claim for gas arrears by Ukraine.[3] The
sharp contraction of the Russian economy including as a result of the fall in
oil prices in the final months of 2014 and the economic sanctions by the EU and
the US against the country, as well as the still weak economic activity in the
EU pose additional challenges to the possible economic recovery of Ukraine in view
of the country’s strong exposure to these neighbours via trade and financial
channels.
Despite the
strong economic contraction and the conservative central bank policies, inflationary
pressures remain high, reflecting the currency weakening and an adjustment
of administered prices (in particular of utility tariffs). CPI inflation
accelerated to 21.8% year-on-year in November and is expected to pick up
further in the near future as the effect of the currency depreciation fully
kicks in. The hryvnia has lost close to 50% of its value against the USD since
its floatation in February, well above initial expectations. The weakening was
particularly strong in August and September, forcing the central bank to
introduce a number of administrative measures and currency controls, in
addition to undertaking some foreign exchange market interventions, which
succeeded in bringing temporary stability to the exchange rate ahead of the
October parliamentary elections. At the same time, these measures negatively
impacted business activity and led to a fast depletion of the already low
international reserves. Following a slight relaxation of the administrative
controls, the currency has depreciated strongly as from November.
Weak economic
activity, coupled with higher interest outlays on foreign currency denominated
debt in light of strong currency depreciation, as well as and sizable losses of
tax collection in the eastern parts of the country, led to widening of the
budget deficit in 2014 despite a number of austerity measures introduced by
the authorities.[4]
The fiscal deficit rose by 31% on the year in January-October to UAH 54
billion, or 3.5% of the projected GDP for the year. On the revenue side, a
sharp decline in corporate tax revenues was offset by tax increases, in particular
excise duties and fees for extraction of mineral resources. Furthermore, an
additional 1.5% tax on personal income was introduced as of September to
finance security spending. In the meantime, expenditure growth was driven by
higher interest outlays on foreign liabilities due to currency weakening and
increased transfers to local authorities for repayments of their arrears.
Security spending also rose sharply, by 60% year-on-year in January-October,
and thus contributed to the widening fiscal deficit. In order to rein in
expenditure, the authorities implemented significant cuts in other main
expenditure items such as public administration, education and healthcare.
According to recent forecasts of the Ministry of Finance, the government fiscal
deficit will rise to 5.3% of GDP for 2014 as a whole.
A major
additional drag on public finances in 2014 came from the ailing oil and gas
company Naftogaz. This company traditionally runs sizable operational
deficits due to the administrative cap on natural gas prices for households and
municipal utility companies, which forces Naftogaz to sell at below-cost rates,
and general operational inefficiency. In 2014, the company’s activities were
negatively affected by the strong depreciation of the hryvnia and the need to
cover gas arrears to Russia (including ones accumulated in 2013). As a result,
the state had to inject UAH 103bn into Naftogaz by November, an amount
representing 6.8% of projected GDP. Thus, the overall fiscal deficit run by
Ukraine in 2014, which includes the deficit of Naftogaz, is projected at nearly
12% of GDP, up from 6.7% in 2013 and compared to 8.5% forecast by the IMF
in April 2014. 
The widening
budget deficit and the sharp depreciation of the local currency, coupled with a
significant economic contraction, led to a sharp deterioration of Ukraine’s public debt metrics. The general government public debt increased by 62% (in
nominal local currency terms) in the first ten months of the year to UAH 945
billion (USD 73 billion) at the end of October. The figure corresponds to 63%
of the projected GDP for 2014 and represents an increase of almost 23
percentage points from the end-2013 debt of 40.2% of GDP. In view of the sharp
depreciation of the local currency in November and disbursements of EUR 760 million
in financial support loans under the EU MFA programme in November and December
2014, as well as capital injections in state-owned enterprises, Ukraine’s public debt is likely to near 70% of GDP at the end of 2014. A further increase
must be expected in 2015 on the back of continued economic contraction and
significant official external financing expected in the year, which comes
almost entirely in the forms of loans. The planned
recapitalisation of state-owned financial institutions will also contribute to
the increase of the public debt in 2015.
On the external
side, the depreciation of the hryvnia, coupled with weak domestic demand, has
contributed to a significant adjustment of the current account. The
deficit is expected to narrow to around 4% of the GDP in 2014 from 9.0% in
2013, although this is primarily due to strong import compression.[5]
However, this was accompanied by sizeable private-sector financial outflows
due to dwindling confidence in an environment of high geopolitical
uncertainty.[6]
The official financing extended as from May 2014 was insufficient to offset the
capital flight. Overall, Ukraine received around USD 9 billion in gross
official financing in May-December, a large part of which was used to cover
maturing debt (see IMF support and other donor assistance up to 2014). 
In the context
of a deepening economic recession and a confidence crisis, the substantial
official financial assistance provided to Ukraine in 2014 was insufficient to
stop the continuous drain on reserves. In the first eleven months of the
year, reserves halved from their end-2013 level to only USD 10 billion. A
further significant drop is expected in December as a result of payments for
gas (including arrears to Russia). As a result, Ukraine’s gross international
reserves are now expected to drop to USD 7 billion at the end of 2014, or
around one month of 2015 projected imports of goods and services.
1.3.        IMF
and other donor support
The government’s
ambitious economic adjustment and structural reform programme has been
supported by the IMF and other IFIs (namely the
World Bank and the EBRD), as well as the EU and other bilateral partners. On 30
April 2014, the Executive Board of the IMF approved a two-year Stand-By
Arrangement (SBA) for Ukraine amounting to SDR 10.976 (USD 17 billion, or 800%
of the country’s quota). 
The IMF
programme is focused on reforms in the following key areas: monetary and
exchange rate policies; financial sector; fiscal policies; energy sector; and
governance, transparency, and the business climate. In the area of
monetary policy, the focus is on ensuring price stability while maintaining a
flexible exchange rate regime. Financial sector reforms aim at maintaining
confidence in the system and strengthening financial regulation and supervision.
This is ensured by the implementation of diagnostic tests to assess the
strength of the major domestic lenders and their recapitalisation needs. The
main objective of the policy measures in the area of fiscal policy is the
gradual reduction of the budget deficit, in particular by streamlining public
expenditures.[7]
Fiscal sustainability should also be ensured by comprehensive reforms of the
energy sector, in particular restructuring Naftogaz and gradually raising
energy tariffs to cost-recovery levels. Finally, reforms to strengthen
governance and transparency in order to improve the business climate consist of
capacity building to reform public procurement and tax administration, measures
to strengthen anti-money laundering activities and to fight corruption. 
Along with the
approval of the SBA in April, the IMF made a first disbursement of USD 3.2
billion. On 29 August, the Board approved the first mission review and made
available almost USD 1.4 billion. The completion of the first review was
delayed (originally approval was planned for July) due to a longer-than-planned
review mission and the summer recess. Out of the USD 4.6 billion provided by
the IMF, USD 3 billion were directed to the budget. 
In order to
accommodate the delay in its programme schedule, and following a request by the
Ukrainian authorities, the Fund decided to re-phase the SBA. Thus, the second
and the third programme reviews, initially planned for end-August and
end-October 2014, were merged into one single programme review to be conducted
in November, with a view to combining the two subsequent tranches (USD 2.7bn in
total) in one single payment, in principle in December. However, in view of the
early parliamentary elections on 26 October, the IMF’s second review was
postponed to December and has since been extended to January, meaning that the
possible approval of the disbursement of the next tranche could be expected
in late January 2015 at the earliest. 
The IMF’s USD 17
billion financial support has been complemented by significant support from
other official and bilateral assistance (EU, US, Japan, Canada).
Other
international financial institutions such as the World Bank, the EBRD and the
EIB have also significantly scaled up their activity to support Ukraine’s economic transition.
The EU
provided EUR 1.6 billion (USD 2.1 billion) in emergency
support to Ukraine in 2014, becoming the biggest net contributor in the year.[8] The
majority of this financing, EUR 1.36 billion, was disbursed from the
Macro-Financial Assistance (MFA) facility in the form of long-term loans (with
maturity of 10 or 15 years) on very favourable terms. Another EUR 250 million
was provided in the form of grants for budget support under the State Building
Contract that aims to strengthen the institutions in Ukraine. 
The World
Bank provided USD 1.25 billion under two policy loans – a USD 750 million
Development Policy Loan (DPL) that focuses on implementing reforms in the
public sector, the business environment and the subsidy system and a USD 500
million Financial Sector DPL that aims at supporting the restructuring of the
banking sector. The World Bank is expected soon to approve a second DPL in the
amount of USD 500 million. The approval of the loan was initially expected by
the end of 2014 but was delayed due to the unforeseen parliamentary elections
and the slow formation of a new government. Finally, the World Bank has
committed to more than USD 1 billion in project financing, namely under three
projects that aim to improve energy efficiency, support infrastructure and
modernise the social safety net. However, being project-related, this financing
will likely take longer to be disbursed.
The US provided a bond guarantee to Ukraine, which enabled the authorities to raise USD 1
billion from external debt markets in May. Bilateral assistance, although of a
much smaller scale, was provided by Canada (USD 180 million) and Japan (USD 100 million).
Finally, as part
of the international support for the economic recovery of Ukraine, there was a substantial increase in project financing provided by the EBRD and
EIB. This increase relates mainly to commitments for projects, though the
growth of actual disbursements was limited due to the medium to long-term
nature of such financing as well as the relatively slow and not sufficiently
efficient administrative process, including parliamentary ratification, on the
Ukrainian side. Specifically, the EBRD and the EIB signed new projects of
approximately EUR 1 billion each in the course of 2014. This represents a
substantial increase from the traditional business volume of the two lenders to
the country. 
1.4.        Ukraine’s external financing needs
At the time of
the launch of its programme, the IMF estimated Ukraine’s gross external
financing needs at almost USD 27 billion over the course of the SBA (Q2
2014–Q1 2016). They were attributed to still substantial current account
deficits, large external debt obligations of both public and private sector and
the need to replenish reserves. The Fund’s committed net financing (i.e. taking
into account Ukraine’s repayments to the IMF of debts stemming from an earlier
IMF programme) over the course of the programme amounted to USD 11.9bn, or 44%
of the identified external financing needs. Other IFIs and bilaterals
contributed to filling the residual financing gap.[9] 
In August, with
the approval of its first programme review, the IMF stated that the programme
was adequately financed. It also identified a shortfall of USD
3.5 billion (USD 1.1 billion on 2014 and USD 2.5 billion in 2015) resulting
from revisions in projections for the speed of project implementation and
accompanying financing. However, the IMF expected at the time that USD 2
billion in bond issues would cover a large part of this gap, while official
donors would come up with an additional USD 0.9bn of support. At that time, the
IMF also presented a negative scenario for Ukraine’s economy that
envisaged a prolonged armed conflict in the East and an associated confidence
crisis. Under this scenario, Ukraine’s GDP was projected to contract by 7.3% in
2014 and another 4.2% in 2015, while the additional external financing needs
would reach USD 19 billion.
This negative
scenario has now largely materialised. In the absence
of a sustainable resolution to the conflict in the East, and in view of Russia’s obstructive trade policy,[10] Ukraine has witnessed a confidence crisis. This crisis has resulted in a higher capital
outflow[11] than
initially projected and a much sharper currency depreciation, which prompted
foreign exchange market interventions by the central bank despite a low level
of international reserves. Private investments plummeted from already low
levels, while the limited fiscal space of the government meant no state
response was possible to offset the negative trends in the real sector. In view
of the above-mentioned developments, Ukraine’s gross international reserves are
expected to drop to only USD 7 billion at the end of 2014 (from USD 20.6
billion a year earlier), which translates into one month of imports.
The urgent need
to rebuild reserves to viable levels that would instil enough credibility in
the local currency and thus in Ukraine’s ability to service its debt has
resulted in a significant increase of the external financing needs in the
short-term. According to preliminary estimates, these extra needs total USD
15 billion until Q1 2016 (see table below). Apart from the need to
replenish reserves, ongoing capital outflows reflecting weak confidence also
contribute to the additional financing gap. The current account adjustment,
while significant, is also now believed to be somewhat slower than initially
expected. This is primarily due to the strong reduction of export proceeds
following the loss of productive capacity in the East and the imposition of
trade barriers by Russia. These two factors counteract the positive impact for
exporters from the weaker currency and the trade preferences provided to Ukraine by the EU.
This estimated
USD 15 billion of additional financing needed by Q1 2016 comes on top of the
financing gap initially estimated by the IMF. The fresh financial assistance
needed to fill the additional financing gap would ensure primarily a
significant build-up of reserves, while indirectly also enabling continued
imports of essential goods, notably purchases of gas from Russia and EU Member States. This would act as a catalyst for the return of private inflows
and thus supporting the uninterrupted servicing by Ukraine of its international
liabilities. Indeed, in 2015, the sovereign will face another year of sizable foreign
exchange debt repayments of close to USD 10 billion. The biggest part of these
repayments falls into Q4 2015, when Ukraine has to redeem a USD 3 billion
Eurobond held by Russia. It should be noted that a possible rollover of this
bond could provide an important short-term relief to Ukraine’s balance of
payments.
The proposed MFA
programme of EUR 1.8 billion would cover around 15% of the estimated total
additional external financing needs faced by Ukraine in 2015–Q1 2016. This
proposal is exceptionally large not only in nominal terms (it would be the
largest-ever MFA operation by a wide margin) but also in terms of coverage.[12]
However, this exceptionally high coverage can be justified by: the political
importance of Ukraine for the stability in the European Neighbourhood; the
political integration of the country with the EU as reflected by the
Association Agreement between the two sides that provisionally entered into
force on 1 November 2014; as well as the exceptionally challenging
situation and correspondingly large financing needs that this EU neighbour is
currently facing.
1.5.        Ukraine’s structural reform challenges
Ukraine has
been lagging significantly behind its regional peers with the implementation of
structural reforms. Slow progress on this front was a major factor for the
absence of growth in 2012 and 2013. After  former President Yanukovych left
power, the newly appointed government announced a very ambitious and
comprehensive structural reform agenda. This programme was supported by the
IMF through its two-year SBA and other multilateral and bilateral partners. The
core of the structural reform agenda were the energy and banking sectors, areas
that have been important contributors for the accumulation of imbalances over
the preceding years and in particular for the overall weak fiscal position of
the state. The authorities also committed to undertake measures to address
long-standing problems to the business climate in the country such as
widespread corruption, a high regulatory burden and an inefficient public
administration. 
With the
macroeconomic crisis turning deeper than expected and the conflict in the East,
the authorities did not manage to push through their entire structural
reform agenda in 2014. The political calendar, which included presidential
elections in May and early parliamentary elections in October, also impacted
negatively on the progress with the policy reform programme. 
Despite these
impediments, important steps were made in addressing long-standing problems in
the areas of energy, banking sector restructuring, public finance management
and the fight against corruption. These reforms were underpinned
by the financial support programmes Ukraine entered with the IMF, the World
Bank and the EU. 
In the energy
sector, the authorities started to gradually increase gas tariffs with the
objective to bring prices closer to cost-recovery levels[13] and
thus gradually scale down the generous subsidies the state provides through the
state-owned company Naftogaz. The heavily subsidised gas prices for households
and municipal heating utilities not only result in a sizable fiscal drag for
the budget but also give a rise to numerous corruption practices.[14] Along
with the price adjustment, the authorities strengthened the social safety net
in order to cushion the most vulnerable households at least partially against
retail energy price increases. Notably, on 1 July 2014, a new targeted
social security scheme became operational. Important measures were also
introduced to improve collection rates of Naftogaz - special purpose
accounts were introduced in July 2014 for the centralised collection of gas
settlements from municipal utilities. These mandatory accounts will distribute
the proceeds from the gas settlements between the entities producing, transporting
and supplying the gas, which should ensure that Naftogaz automatically receives
its dues. In another step to improve collection of current and past bills, the
government decided in August 2014 to establish an interagency working group for
the collection of debts of natural gas consumers and the improvement of the
financial state of Naftogaz. Last but not least, the authorities had launched
the process of restructuring the state-owned gas conglomerate, in particular by
allowing for the unbundling of the company by the establishment of two separate
entities to deal with storage and transit of natural gas.
The banking
sector is undergoing a comprehensive restructuring whose main objective is
to streamline the system by eliminating unviable banks from the market and set
a stronger regulatory framework for banking activity. The reforms that were
implemented by the central bank in 2014 included, among others, steps to
clean-up the banking sector from insolvent, measures for recapitalisation of
the banking sector, strengthening of the operational and financial capacity of
the Deposit Guarantee Fund (DGF), and disclosure of the banks' ultimate
beneficial owners. As a result of these measures, the National Bank of Ukraine put more than 30 commercial banks into receivership in 2014 (out of 180 operational
at the end of 2013). It also carried out stress tests to identify the
recapitalisation needs of the 35 biggest lenders accounting for 82% of total
assets. Furthermore, bank resolution practices were improved with the technical
assistance provided by the IMF, the World Bank, the EBRD and the US Treasury.
In order to improve transparency in the sector, measures were launched to
introduce strict requirements of ultimate beneficial owners' disclosure for the
26 banks with the least transparent ownership structure. 
The ambitious
reform agenda in the energy and banking sectors has been important for an
improvement in Ukraine’s medium- to long-term prospects. However, the reforms
have so far failed to yield the hoped-for positive results in the short term,
given a much worse macroeconomic environment than initially expected. For
example, the sharp depreciation of the local currency more than offset the
impact from the increases of energy tariffs on Naftogaz’ operating deficit,
which widened further in 2014. Furthermore, collection rates were negatively
impacted by the weakening economic activity and the armed conflict in the
eastern parts, where Naftogaz retained its operations but could not collect its
receivables.[15]
The weakening of the currency also resulted in a rapid deterioration of the
banks’ credit portfolio. Moreover, banks were affected by the forced suspension
of their activities in the separatist-controlled areas and the inability to
collect their claims in these parts.
Reform drive was
more limited in the area of public finance management (PFM),
where the biggest achievement was the amendment to the procurement legislation
in April 2014, which led to a reduction of the procedures that are exempted
from competitive bidding and an extension of the definition of procuring
entities that allowed for a wider coverage of state-owned enterprises.
Furthermore, publication requirements regarding public procurements had been
substantially widened and improved, thus increasing transparency. 
Among the
challenges in the area of PFM that have yet to be tackled by the authorities
are low budget transparency, weak forecasting and budgetary planning, high tax
evasion and corruption in the area of tax administration. The country lacks a
public debt management strategy and has to strengthen significantly the
institutional and analytical framework for quasi-fiscal operations in order to
improve transparency and reduce corruption in state-owned enterprises. Even
though the institutional set-up for internal auditing is gradually being
strengthened, constraints are arising due to budgetary limitations. The
institute of external auditing remains underdeveloped due to the lack of a
proper legislative framework.[16]

In the area of tax
administration, partial progress was achieved in the settlement of VAT
refund claims as the share of automatic refunds increased considerably over the
course of 2014. However, accumulation of arrears continued, in part as a result
of the difficult fiscal situation, negatively impacting on the business
climate. Legislative changes that envisage the introduction of electronic VAT
accounts as of January 2015 have been strongly contested by businesses, which
is likely to lead to a postponement of their introduction. The government that
took office in early December 2014 pledged a major overhaul of the tax system
to improve the competitiveness of the economy. As a result, the number of taxes
will be reduced to 9 from 22 at present. However, details about the fiscal impact
of these cuts and the overall reform of the tax system have so far remained
insufficient.
The tax reform
is an important element of the government reform programme that was approved
by parliament on 11 December and is underpinned by the coalition agreement
among the ruling parties finalised in November. The programme also aims at
streamlining the state sector by significantly reducing public spending;
reducing the shadow economy; improving public finance management and
encouraging competition. If implemented, these measures could be expected to
lead to a significant improvement in the business environment in the country,
which at the current stage is not propitious for investment activity.[17] In a
context of high security concerns and domestic political volatility,
privatisation came to a halt in 2014.
2.           Objectives and related
indicators of the macro-financial assistance
2.1.        Objectives
The objectives
of the proposed MFA operation are to: 
·      Contribute to covering the external financing needs of Ukraine in the context of a significant deterioration of the country’s external accounts
brought about by the on-going political and economic transition, heightened
security risks, and the economic and political developments in the region. 
·      Alleviating Ukraine’s budgetary financing needs.
·      Support the fiscal consolidation effort and external stabilisation
in the context of the IMF programme.
·      Facilitate and encourage efforts of the authorities of Ukraine to implement measures identified under the EU-Ukraine Association Agreement, while
reinforcing the EU’s economic policy dialogue with the authorities.
·      Support structural reform efforts aimed at improving the overall
macroeconomic management, strenghening economic governance and transparency,
and improving conditions for sustainable growth.
2.2.        Indicators
The fulfilment
of the objectives of the assistance will be assessed by the Commission,
including in the context of the ex-post evaluation (see below), on the basis of
the following indicators: 
·      Progress with macroeconomic and financial stabilisation, notably by
assessing the degree of adherence to the IMF-supported programme. 
·      Progress with the implementation of structural reforms, notably the
specific policy actions identified as conditions for disbursement of the assistance,
which will be included in a Memorandum of Understanding to be negotiated
between the Commission and the Ukrainian authorities. Conditions will include
structural measures relevant for ensuring macroeconomic stability, e.g. in the
areas of public finance management and anti-corruption; tax administration;
reforms in the energy sector, including strengthening the social safety net to
ensure targeted cushioning of the ongoing withdrawal of retail energy price
subsidies; financial sector reforms; and measures to improve the business
environment.
3.           Delivery
mechanisms and risk assessment
3.1.        Delivery
mechanisms
The proposed new
MFA would amount to EUR 1.8 billion. Regarding the form of the assistance, the
Commission proposes to disburse the full amount in the form of medium-term
loans. This is based on the following considerations: 
Firstly, Ukraine is a middle-income country with a relatively high per capita income level. Ukraine’s per capita Gross National Income (GNI) of USD 3,960 in 2013[18] is
the third highest among the six countries of the Eastern Partnership, behind Azerbaijan and Belarus. For comparison,
Tunisia, a country for which the Parliament and the Council adopted an MFA
operation of up to EUR 300 million in loans in May 2014, had a GNI per capita
of USD 4,360 in 2013. An MFA loan of EUR 180 million to Jordan (with a GNI per capita of USD 4,380) was approved in December 2013. The proposal to
provide the full MFA in the form of loans is also consistent with the
treatment granted by the World Bank and the IMF to Ukraine.
MFA is an untied
and undesignated macroeconomic support instrument, which helps the beneficiary
country to meet its external financing needs, and may contribute to alleviating
budgetary financing needs. The funds would be paid to the National Bank of Ukraine. Subject to provisions to be agreed in the Memorandum of Understanding, including a
confirmation of residual budgetary financing needs, the funds may be
transferred to the Ministry of Finance of Ukraine as the final beneficiary. 
3.2.        Risk
assessment
There are
fiduciary, policy and political risks related to the proposed MFA operation. 
There is a risk
that the macro-financial assistance, which is not dedicated to specific
expenses, could be used in a fraudulent way. In general terms, this risk is
related to factors such as the quality of management systems in the central
bank and the Ministry of Finance and the appropriateness of internal and
external audit capabilities. 
To mitigate the
risks of fraudulent use several measures have been and will be taken. First,
the Commission services, with the support of duly mandated external experts,
carried out an Operational Assessment of the financial circuits and
administrative procedures at the Ministry of Finance and the National Bank of Ukraine in April 2014, in order to fulfil the requirements of the Financial Regulation
applicable to the General Budget of the European Communities. This review
covered areas such as budget preparation and execution, public internal
financial control, internal and external audit, public procurement, cash and
public debt management, as well as the independence of the central bank. It
determined that the framework for sound financial management of macro-financial
assistance is sufficiently effective in Ukraine for the EU to provide this
support. Also, the assistance will be paid to a dedicated account at the
National Bank of Ukraine. Second, the proposed legal basis for macro-financial
assistance to Ukraine includes a provision on fraud prevention measures. These
measures will be elaborated further in the Memorandum of Understanding and the
Loan Agreement, envisaging a set of provisions on inspection, fraud prevention,
audits, and recovery of funds in case of fraud or corruption. It is further
envisaged that a number of specific policy conditions will be attached to the
assistance, including in the area of public finance management, with a view to
strengthening efficiency, transparency and accountability. Finally, the
assistance will be liable to verification, control and auditing procedures
under the responsibility of the Commission, including OLAF, and the European
Court of Auditors.
Another key risk
to the operation stems from the economic and political uncertainty, notably due
to the unprovoked Russian violation of Ukrainian sovereignty and territorial
integrity. On the domestic front, the main risk is instability related to
difficulties in the political and economic reform process. The full
implementation of the stabilisation and reform measures supported by the
international community, including the proposed MFA operation, might be
undermined by social dissatisfaction potentially leading to unrest.
Finally,
there are risks stemming from a possible weakening of the European and global
economic environment.
Having made a
thorough assessment of the risks, the Commission services consider that there
are sufficiently strong grounds to proceed with the MFA to Ukraine. 
The Commission
services will maintain close contacts with the authorities during the implementation
of the macro-financial assistance in order to address quickly any concerns that
may arise.
4.           Added
value of EU involvement
The Community
financial support to Ukraine reflects the country’s strategic importance to the
EU in the context of the European Neighbourhood Policy. The instrument of
macro-financial assistance is a policy-based instrument directed to alleviate
short- and medium-term external financial needs. As a part of the overall
European Commission’s package of assistance for the economic transformation of
Ukraine, it will contribute to support the European Union’s objectives of
economic stability and economic development in Ukraine and, more broadly, in
the eastern European neighbourhood. 
By helping the
authorities’ efforts to establish a stable macroeconomic framework and
implement an ambitious structural reform programme, the proposed assistance
will help improve the effectiveness of other EU financial assistance to the
country, including budgetary support operations such as the State Building
Contract.
By helping the
country overcome the economic difficulties caused by the economic transition
and the deteriorating security situation in the eastern parts of the country
that had a strong negative impact on confidence, the proposed MFA will contribute
to promoting macroeconomic stability and political progress in the country. 
By complementing
the resources made available by the international financial institutions,
bilateral donors and other EU financial institutions, it will contribute to the
overall effectiveness of the package of financial support agreed by the
international donor community in the spring of 2014. 
In addition to
the financial impact of the MFA, the proposed programme will strengthen the
government’s reform commitment and further foster its aspiration towards closer
relations with the EU, as reflected by the recently signed Association
Agreement and Deep and Comprehensive Free Trade Area agreement. This result
will be achieved, inter alia, through appropriate conditionality for the
disbursement of the assistance. In a larger context, the programme will signal
to the other countries in the region that the EU is ready to support countries
like Ukraine, embarking on a clear path towards economic and political reforms,
in moments of economic difficulties.
5.           Characteristics
of macro-financial assistance
5.1.        Exceptional Character and Limited Timeframe 
The MFA proposal
will be exceptional, aiming to support the restoration of a sustainable
external finance situation of Ukraine. It will be linked to an IMF arrangement
(currently the SBA from April 2014) and, in principle, should not exceed the
timeframe of this arrangement. Against this background and given the expected
time of approval of the programme by the co-legislators, the assistance is
expected to be implemented in 2015–Q1
2016. The disbursement of the first tranche could take place in the middle of
2015 provided that the IMF programme remains on track and provided a swift
ratification of the MoU by the Ukrainian side. The second instalment,
conditional on a number of policy measures, could be disbursed in the fourth
quarter of 2015. The third and last instalment could be made available,
provided the policy measures are met, towards the end of the first quarter of
2016. While in the short term the country faces substantial balance of payments
financing needs, the macroeconomic and structural adjustment programme agreed
with the IMF and supported by the proposed MFA is expected to produce a gradual
strengthening of the balance of payments and fiscal positions. 
5.2.        Political preconditions and
EU-Ukraine relations 
As a country
covered by the European Neighbourhood Policy (ENP), Ukraine is eligible for
MFA. It is a pre-condition for granting MFA that the country respects effective
democratic mechanisms, including a multi-party parliamentary system and the
rule of law and guarantees respect for human rights. 
Following mass
public protests, former President Viktor Yanukovych left power in February 2014
and Ukraine held democratic presidential and parliamentary elections (on 25 May
and 26 October, respectively), which were largely in compliance with its
international commitments according to the OSCE ODIHR. The reinstatement of the
2004 has improved checks and balances among the branches of power. 
Since the spring
of 2014 Ukraine has shown engagement in improving the independence and the
functioning of its justice system by taking some of the long-awaited steps such
as the adoption of the law on the Prosecutor General’s Office, now awaiting
implementation. The reform of the security sector is also high on the agenda
and is supported by the EU Advisory Mission to Ukraine. Important legislative
amendments were adopted to combat corruption, proving Ukraine’s commitment to strengthen the rule of law. 
While the human
rights situation has deteriorated gravely in the territories under the control
of the separatists in Donbas and in the illegally annexed Crimea as per reports
of the Office of the High Commissioner for Human Rights of the United Nations,
human rights in the rest of Ukraine have largely been respected since spring
2014. In addition, a comprehensive legislative framework in the human rights
field is expected to be developed, with notably a human rights strategy listing
necessary legislative amendments to be submitted by the Cabinet of Ministers.
Investigations into the human rights abuses at Maidan and into the tragic
events in Odesa on 2 May are assisted by the Council of Europe’s Investigation
Advisory Panel.
EU-Ukraine
relations:
Since 1991, when Ukraine gained independence, the EU and Ukraine have developed an increasingly dynamic relationship. Ukraine is a priority partner
country within the European Neighbourhood Policy and the Eastern Partnership.
The ambitions of both the EU and Ukraine to enhance their relationship created
an opportunity to move beyond cooperation towards gradual economic integration
and deepening political association.
As a result, the
two sides signed an Association Agreement on 21 March 2014, which includes an
agreement for the establishment of a so-called Deep and Comprehensive Free
Trade Area (DCFTA), signed on 27 June 2014. After the 12 September trilateral
meeting on the Association Agreement, at the request of Ukraine, the European
Union agreed to delay the provisional application of the DCFTA until 31
December 2015. Provisional application of remaining relevant parts of the AA
started on 1 November following ratification by the Ukrainian Parliament and
the consent given by the European Parliament on 16 September 2014. 
In the meantime,
Ukrainian exporters can benefit from autonomous trade preferences that were
first granted by the EU in April 2014 until end-October 2014 and later extended
until the end of 2015. In view of these measures, and as a result of a decrease
in trade between Ukraine and the Russian Federation, the EU has become Ukraine’s major trade partner in 2014. On 15 December, the European Union and Ukraine held the first meeting of the Association Council, which launched the institutional
framework of enhanced cooperation. 
The EU is also
an important source of assistance to the reform process in Ukraine, including through the Support Group for Ukraine. On 11 March, the Commission adopted an
unprecedented support package to Ukraine worth EUR 11 billion for the next few
years. With the help of the newly created Support Group for Ukraine, the implementation of this support package is under way. As of 15 December, the
European Union has disbursed more than EUR 1.6 billion in loans and grants to
the state budget to support the financial, economic and political stabilisation
of the country. 
In sum, Ukraine is facing a dramatic situation with the illegal annexation of Crimea/Sevastopol and the
conflict in Eastern Ukraine due to the activities by illegal armed groups. In
the meantime, the internal political situation is stabilising and Ukraine has taken first steps in the reform process. Ukraine conducted largely free and
fair presidential and parliamentary elections, took steps to improve the rule
of law and largely respected human rights. Further improvements of the
situation are expected to happen in the following months in view of the
declared political engagement of Ukraine’s authorities in continuing the reform
process (Association Agreement, coalition agreement, Government Action Plan).
In this context, the political preconditions for macro-financial assistance may
be considered to be sufficiently fulfilled at this stage, while a continued
monitoring of the situation will have to take place. A more detailed assessment
of the compliance with this criterion, provided by the European External Action
Service (EEAS), is reproduced in the Annex of this Staff Working Document.
5.3.        Complementarity
The proposed MFA
would complement the assistance provided by other multilateral and bilateral
donors in the context of the IMF-sponsored economic programme. The EU’s MFA
would also complement other EU aid packages mobilised under the European
Neighbourhood Instrument, and in particular the policy measures envisaged under
the State Building Contract for Ukraine, which was signed in May 2014. By
supporting the adoption by the Ukrainian authorities of an appropriate
framework for macroeconomic policy and structural reforms, the EU’s MFA would
enhance the added value of the overall EU involvement, increasing the
effectiveness of the EU’s overall intervention including through other
financial instruments.
5.4.        Conditionality
As it
is normally the case with MFA, the disbursements would be conditional on
successful reviews under the IMF programme and the continued drawing by Ukraine on
IMF funds. In addition, the Commission and the Ukrainian authorities would
agree on a specific set of structural reform measures, to be defined in a
Memorandum of Understanding. These measures will support the authorities’
reform agenda and implementation of the EU-Ukraine Association Agreement, as
well as complementing the programmes agreed with the IMF, the World Bank and
other multilateral and bilateral donors.
The European
Commission will seek a broad consensus with the Ukrainian authorities, so as to
ensure a smooth implementation of the agreed conditionality. These policy
conditions should address some of the fundamental weaknesses accumulated over
the years by the Ukrainian economy. Possible areas of conditionality could in
principle include: public finance management and anti-corruption; tax
administration; reforms in the energy sector, including strengthening the
social safety net to ensure targeted cushioning of the ongoing withdrawal of
retail energy price subsidies; financial sector reforms; and measures to
improve the business environment.
5.5.        Financial
Discipline
The planned assistance would be provided in the form of a loan and
should be financed through a borrowing operation that the Commission will
conduct on behalf of the EU. The budgetary costs of the assistance will
correspond to the provisioning, at a rate of 9%, of the amounts disbursed in
the guarantee fund for external lending of the EU, from budget line 01 03 06
(“the provisioning of the Guarantee Fund”). Assuming that the first and second
loan disbursements will be made in 2015 for a total amount of EUR 1,200
million and the third loan disbursement in 2016 for the amount of EUR 600
million, and according to the rules governing the guarantee fund mechanism, the
provisioning will take place in the budgets for 2017 (for EUR 108 million) and
2018 (EUR 54 million). On the basis of the currently available
information on the expected overall provisioning needs of the Guarantee Fund, the 
additional budgetary impact will be partly financed by a reallocation in the
indicative financial programming for 2017 and 2018 from macro-financial assistance
grants (budget line 01 03 02) and partly by using the unallocated margin for
commitments under Heading 4 in the Multi-Annual Financial Framework.
To ascertain that the beneficiary has sound
financial management in place, in line with the requirements of the Financial
Regulation, the European Commission services undertook an Operational
Assessment (OA) of the reliability of the financial circuits and administrative
controls at the Ministry of Finance and the National Bank of Ukraine. This OA, prepared by a team of international experts, was finalised in August
2014.
6.           Planning of future monitoring and evaluation
This assistance
is of exceptional and macroeconomic nature and its monitoring and evaluation
will be undertaken in line with the standard Commission procedures. 
6.1.        Monitoring
Monitoring will
involve the review of reports and data provided by the authorities and by
review missions to Ukraine by Commission staff. To monitor the fulfilment of
the objectives of the programme throughout the implementation period of the
assistance, the Commission will use two types of indicators: 
·      Adherence to the IMF-supported programme, including compliance with
macroeconomic performance criteria and structural reform benchmarks identified
under the SBA, as reported by the IMF in the context of the regular review of
the programme. 
·      Progress in the implementation of structural policy indicators,
which are to be agreed with the Ukrainian authorities in a Memorandum of
Understanding. In this process, the Commission services will monitor key areas
of the public finance management system, including the ones identified in the
Operational Assessment from August 2014, so as to have the relevant information
on any changes in the control environment. Ahead of the disbursement of the
second and third instalments, the authorities will be asked to submit a compliance
statement in relation to the policy conditionalities. In addition, under the
Memorandum of Understanding monitoring system, the authorities will be required
to submit quarterly reports of certain economic and reform indicators. 
Although this
assistance is centrally managed, where appropriate, the EU Delegation in Ukraine will also be called to provide reporting. An annual report, as well as regular
information on developments in the management of the assistance, to the
European Parliament and to the Council are foreseen. 
6.2.        Evaluation
Ex-post
evaluations of macro-financial assistance operations are foreseen in the
Multi-Annual Evaluation Programme of the Commission’s Directorate-General for
Economic and Financial Affairs. An ex-post evaluation of the proposed
macro-financial assistance to Ukraine will be launched within a period of two
years after the completion of the operation. A provision for the ex-post
evaluation is included in the proposed Decision for the assistance, and will
also be included in the Memorandum of Understanding. Budget appropriations from
the macroeconomic assistance budget line will be used for this evaluation. 
7.           Achieving
cost-effectiveness
The proposed
assistance would entail a high degree of cost effectiveness for several reasons:

·      First, since the assistance would be leveraged by that provided by
the international financial institutions, with which, as noted, it would be
closely coordinated, its ultimate impact could be very significant compared to
its cost. Moreover, in negotiating specific policy conditions, the Commission
will be able to draw on the expertise of those institutions, including the
International Monetary Fund and the World Bank, and to influence their
conditionality as well in ways that will take into account the EU's views. 
·      Second, providing a coordinated macroeconomic support to Ukraine on behalf of the EU countries, the MFA would be more cost efficient than the
provision of a similar total amount of financial support by EU Member States
individually. 
·      Third, all of the assistance would be provided in the form of loans,
the budgetary impact of which is more limited.
·      In addition, the Commission will aim at achieving synergies with
other EU policies and instruments used to support the implementation by the beneficiary
of the relevant measures (notably in the area of public finance management). 
ANNEX
 EUROPEAN EXTERNAL ACTION SERVICE 
Brussels,
19 December 2014
Assessment of the Political Situation in Ukraine
Political
preconditions: Countries which are covered by the ENP
are eligible for MFA. A pre-condition for granting MFA should be that the
eligible country respects effective democratic mechanisms, including a
multi-party parliamentary system and the rule of law and guarantees respect for
human rights. 
Mass public
protests following which former President Viktor Yanukovych left power in
February 2014 led the Parliament to reinstate the 2004 Constitution, which
improved checks and balances among the branches of power. Further improvements
of the constitution should be developed in an inclusive manner to allow
decentralisation, judiciary reform and to clarify the balance of powers between
the President and the Government. Ukraine conducted successfully presidential
and parliamentary elections (on 25 May and 26 October, respectively), which
were largely in compliance with its international commitments according to the
OSCE ODIHR. The legislative framework was improved for the Presidential and
Parliamentary elections and Ukraine has proven its ability to develop a
multi-party democracy, while a comprehensive reform of the electoral
legislative framework is still pending. In parallel, the process of
decentralisation was launched with the presentation of the "Concept on
Local Self-Governance and Territorial Organisation of Power in Ukraine" in April 2014 and of a legislative package to the Parliament. So far, only
the law on cooperation of territorial communities received in June 2014 the
necessary support of the Parliament. 
Since the spring
of 2014 Ukraine has demonstrated engagement in improving the independence and
the functioning of its judiciary by taking some long-awaited steps, such as the
final adoption of the law on the Prosecutor General's Office in October 2014,
largely taking into account recommendations of the Venice Commission of the
Council of Europe. To eliminate the risk of selective justice, a law on
"The restoration of Trust in the Judiciary" was adopted by the
Parliament in April 2014, changing the undue administrative subordination of
judges to court presidents and making court presidents and judges independent
from the political authorities. Laws on the role of the High Council of
Justice, the judicial system and the status of judges are awaited as well as
constitutional amendments enabling the independence of judges. While the
implementation of the new Criminal Procedure Code continued to improve the
treatment of detainees and prisoners, the establishment of a State Bureau of
Investigations is still awaited. The reform of the civilian security sector is
also high on the political agenda and concrete proposals (strategy, amending
laws) are under consideration with the support of the EU Advisory Mission to Ukraine (a CSDP mission officially launched on 1 December 2014). Extraordinary
powers were given to law-enforcement bodies by the Parliament in connection
with the anti-terrorist operation in the East, including provisions regarding
the investigation of crimes committed in the area of the anti-terrorist
operation. The
fight against corruption also intensified, and two anti-corruption legislative
packages were adopted in May and October 2014 as well as a new law on public
procurement. As a consequence, the ranking of Ukraine in the Transparency
International Corruption Perception Index 2014 improved (142 compared to 175 in
2013). Progress is expected in 2015 with the implementation of these laws and
notably with the establishment of the National Agency for Preventing Corruption
and the National Anti-Corruption Bureau. Important steps were taken by Ukrainian
authorities in 2014 to strengthen the rule of law, which should be continued in
2015. 
The respect for
human rights and fundamental freedoms in the parts of Ukraine under the control of the Government has improved since February 2014 compared to 2013.
A comprehensive legislative framework in the human rights field is expected to
be developed. Investigations into the human rights abuses at Maidan and into
the tragic events in Odesa on 2 May are carried out with the support of the
Council of Europe's Investigation Advisory Panel. Freedom of
Assembly was well respected since the cancellation of the restrictive
legislation introduced mid-January 2014. Freedom of expression and media has
substantially improved since February 2014, notably with the adoption of the
law on Public Broadcasting aiming at transforming the state broadcasting
service into an independent public service. Amendments were made to the
anti-discrimination law in May 2014 and a ruling of the Highest Specialised
Court on Civil and Criminal Cases was issued in May confirming that sexual
orientation is implicitly considered in the existing legislation, and
discrimination on grounds of sexual orientation therefore prohibited. The
President vetoed the revocation of the 2012 language law. Since 2014, human
rights in Ukraine have largely been respected notably compared with 2013.
Further progress is still awaited, notably of Internally Displaced Persons. 
In 2014, Ukraine faced a dramatic situation with the illegal annexation of Crimea/Sebastopol by the Russian Federation and the conflict in Eastern Ukraine due to the activities of illegal armed
groups. Ukraine has been active in seeking a sustainable political solution to
the conflict on its territory with the support of the European Union. Rule of
law and respect for democracy and human rights in the illegally annexed Crimea
and the territories in Eastern Ukraine under the control of the separatists
have dramatically deteriorated as reported by the Office of the High Commission
for Human Rights of the United Nations. The Crimean Tatar Community is
particularly affected in the Crimean peninsula. In Eastern Ukraine, numerous
cases of intimidation, threat, "expropriation" of private property,
arbitrary detention, torture, forced disappearance and violence against the
civilian population, including by indiscriminate use of weapons are reported
notably by the Office of the High Commission for Human Rights of the United
Nations. 
EU-Ukraine
relations:
Since 1991, when Ukraine gained independence, the EU and Ukraine have developed an increasingly dynamic relationship. Ukraine is a priority partner
country within the European Neighbourhood Policy and the Eastern Partnership. The
ambitions of both the EU and Ukraine to enhance their relationship created an
opportunity to move beyond cooperation towards gradual economic integration and
deepening political association. 
As a result, the
two sides signed an Association Agreement on 21 March 2014, which includes an
agreement for the establishment of a so-called Deep and Comprehensive Free
Trade Area (DCFTA), signed on 27 June 2014. After the 12 September trilateral
meeting on the Association Agreement, at the request of Ukraine, the European
Union agreed to delay the provisional application of the DCFTA until 31
December 2015. Provisional application of remaining relevant parts of the AA
started on 1 November following ratification by the Ukrainian Parliament and
the consent given by the European Parliament on 16 September 2014. The
Association Agreement is currently under ratification by Member States. The
Association Agreement is currently under ratification by Member States. 
In the meantime,
Ukrainian exporters can benefit from autonomous trade preferences that were
first granted by the EU in April 2014 until end-October 2014 and later extended
until the end of 2015. In view of these measures, and as a result of a decrease
in trade between Ukraine and the Russian Federation, the EU has become Ukraine’s major trade partner in 2014 and is expected to further strengthen its position in
the future. To conclude an intense series of high level meetings in 2014, on 15
December, the European Union and Ukraine held the first meeting of the
Association Council, which launched the institutional framework of enhanced
cooperation.
The EU is also
an important source of assistance to the reform process in Ukraine, including through the Support Group for Ukraine. On 11 March, in response to the economic
and political crisis in Ukraine, the Commission adopted an unprecedented
support package to Ukraine worth EUR 11 billion for the next few years. The
implementation of this support package is under way. A Support Group for Ukraine was created to support the implementation of the support package and the reform process in Ukraine. The EU disbursed EUR 1.36 billion out of its EUR 1.61 billion macro-financial
assistance package to Ukraine, following the continued implementation of the
IMF Stand-By Agreement and policy conditions attached to the programmes by
Ukrainian Government. In 2014, the European Commission provided EUR 250 million
out of EUR 355 million in grants (State Building Contract) to support the
reform process in Ukraine. Subsequently, a programme of EUR 55 million aiming
at supporting regional development and decentralisation was signed in November.

The EU is
strongly committed to support the territorial integrity, sovereignty and
independence of Ukraine. The EU is engaged in diplomatic talks to facilitate
the finding of a sustainable political solution to the conflict and decided to
take restrictive measures against those responsible for the illegal annexation
of Crimea and Sevastopol and the destabilisation in Eastern Ukraine (and the
entities associated with them), as well as restrictive measures against the
Russian Federation. The European Union stands ready to review its sanctions
regime according to developments on the ground. 
In sum, Ukraine is facing a dramatic situation with the illegal annexation of Crimea/Sevastopol and the
conflict in Eastern Ukraine due to the activities by illegal armed groups. In
the meantime, the internal political situation is stabilising and Ukraine has taken first steps in the reform process. Ukraine conducted largely free and
fair presidential and parliamentary elections, took steps to improve the rule
of law and largely respected human rights. Further improvements of the
situation are expected to happen in the following months in view of the
declared political engagement of Ukraine's authorities in continuing the reform
process (Association Agreement, coalition agreement, Government Action Plan).
In this context, the political preconditions for macro-financial assistance may
be considered to be sufficiently fulfilled at this stage, while a continued
monitoring of the situation will have to take place.
[1]               A short-term gas deal, until March 2015, was reached
by Russia and Ukraine on 30 October. A longer-term solution has yet to be
negotiated.
[2]               Russia has introduced a number of barriers to Ukraine’s imports and pledged to abolish the preferential CIS FTA regime for the country if
the DCFTA enters into force. Due to the tense trade relations between the two
countries, Ukraine’s exports to Russia dropped to 19% of the total in Q1-Q3
2014 from 24% in 2013. 
[3]               Russia has demanded USD 4.5 billion from Ukraine for unsettled gas deliveries implemented until mid-2014. Ukraine contests the price
and evaluated its liabilities at USD 3.1 billion. As part of the October deal, Ukraine committed to clear USD 3.1 billion of gas arrears to Russia.
[4]               The authorities have twice revised the budget (in
March and in July) in an attempt to rein in the high fiscal deficit.
[5]               In January-October, imports of goods plummeted by
26.2% year-on-year, well outpacing the 10.8% decline of exports.
[6]               The net outflow from the financial account amounted
to USD 4.8 billion in January-October 2014. Withdrawals of bank deposits by
non-residents were the main factor behind the capital outflow. Both FDI and
portfolio investments also recorded outflows in the period, although of a
smaller size.
[7]               The aim of the Ukrainian authorities is to reduce the
fiscal deficit to 3% of GDP in 2016.
[8]               Even though the IMF was the principal provider of
financial assistance in gross terms, a large part of this support was directed
to repayment of loans previously extended by the Fund. These repayments
amounted to USD 3.7 billion in 2014, meaning that the net inflow was USD 0.9
billion in the year.
[9]               The bilateral contributions
include Ukraine's borrowing from international debt markets using official
bilateral guarantees (such as the US guarantee provided to Ukraine in May 2014);
while appearing as normal portfolio investment in the balance of payments, this
borrowing effectively contributes to satisfying the identified residual
financing need.
[10]             In 2014, Russia occasionally imposed bans on various
imports from Ukraine, claiming that Ukrainian products did not meet Russia’s technical and phyto-sanitary norms.
[11]             Capital outflows reached USD
4.4 billion in January-October 2014 compared to inflows of USD 14.7 billion in
the same period in the previous year. As a result, the balance of payments
recorded a deficit of USD 8.5 billion in the 10 months compared to a USD 1.1
billion surplus in the corresponding period a year earlier.
[12]             For comparison, recent MFA operations for ENP countries
have covered on average 6.6% of the total financing gap (unweighted average of
nine MFA decisions over the period 2009-2014).
[13]             In line with the IMF programme, the Ukrainian
authorities raised retail gas tariffs by 56% on average from 1 May 2014 and
increased retail heating tariffs by 40% from 1 July 2014. However, the impact
of these increases was eroded by the stronger-than-expected depreciation of the
local currency in 2014. Thus, a more ambitious price adjustment programme than
the one agreed with the IMF in the spring of 2014 may be needed in the future
to bring residential gas prices closer to their cost-levels and thus reduce the
deficit that Naftogaz is running. 
[14]             In 2009-2013, the operating deficit of Naftogaz
amounted to 1.7% annually on average. In 2014, it is estimated to have worsened
to more than 6% of GDP and thus becoming the main factor behind Ukraine’s double-digit
overall fiscal deficit in that year.
[15]             In order to address the dire financial situation at
Naftogaz, in November 2014 the government obliged almost 170 of the biggest
industrial consumers to purchase natural gas from the state-owned company. This,
de-facto monopolisation of the market was strongly criticised by the private
gas companies operating in Ukraine. Following their appeal, the Kyiv Administrative Court overturned the relevant government resolution. 
[16]             The activities of the Accounting Chamber of Ukraine
(ACU) are regulated by legislation introduced in 1996. In line with the
MFA-related programme policy agreed with the EU, the government submitted a
draft proposal to parliament in October 2014 that should have updated and
improved the framework for the ACU, including by extending its remit to cover
state-owned enterprises. However, this proposal was withdrawn from the
parliamentary agenda as the new parliament convened after the election.
[17]             According to the most recent global report of the World
Bank on the ease of doing business, Ukraine ranks 96th, well behind
its regional peers from the Eastern neighbourhood. Ukraine scores particularly
poorly in access to electricity (185th out of 189); trade across
borders (154th) and resolving insolvency (142nd).
[18]             World Bank’s Atlas 2011 figures. GNI per capita is the
gross national income, converted to US Dollars using the World Bank Atlas
method, divided by the mid-year population.