Source: EURLEX
Language: en
Format: md

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# 52013SC0211

**COMMISSION STAFF WORKING DOCUMENT Background analysis per beneficiary Accompanying the document REPORT FROM THE COMMISSION on the implementation of macro-financial assistance to third countries in 2012 /\* SWD/2013/0211 final \*/**

  

List of Abbreviations

CEFTA || Central European Free Trade Agreement

CPI || Consumer Price Index

DCFTA || Deep and Comprehensive Free Trade Area

EC || European Community

ECF || Extended Credit Facility

EFF || Extended Fund Facility

EU || European Union

EUR || Euro

FDI || Foreign Direct Investment

GDP || Gross Domestic Product

GSP || Generalised System of Preferences

IMF || International Monetary Fund

MFA || Macro-Financial Assistance

MoU || Memorandum of Understanding

SDR || Special Drawing Rights

USD || Dollar of the United States of America

VAT || Value Added Tax

WTO || World Trade Organisation

Table of Contents

Introduction............................................................................................................... 4

Background Analysis of Beneficiaries of
Macro-financial Assistance            5

1.       Bosnia and Herzegovina...................................................................... 5

1.1.        Executive summary................................................................................ 5

1.2.        Macroeconomic
performance................................................................ 5

1.3.        Structural reforms.................................................................................. 6

1.4.        Implementation of macro-financial
assistance.......................................... 7

2.       Armenia......................................................................................................... 9

2.1.        Executive summary................................................................................ 9

2.2.        Macroeconomic performance................................................................ 9

2.3.        Structural reforms................................................................................ 10

2.4.        Implementation of macro-financial
assistance........................................ 11

3.       Georgia........................................................................................................ 14

3.1.        Executive summary.............................................................................. 14

3.2.        Macroeconomic
performance.............................................................. 14

3.3.        Structural reforms................................................................................ 15

3.4.        Implementation of macro-financial
assistance........................................ 16

4.       Ukraine........................................................................................................ 18

4.1.        Executive summary.............................................................................. 18

4.2.        Macroeconomic performance.............................................................. 18

4.3.        Structural reforms................................................................................ 19

4.4.        Implementation of macro-financial
assistance........................................ 20

5.       The Kyrgyz Republic............................................................................. 23

5.1.        Executive summary.............................................................................. 23

5.2.        Macroeconomic performance.............................................................. 23

5.3.        Structural reforms................................................................................ 24

5.4.        Implementation of macro-financial
assistance........................................ 26

Annexes......................................................................................................................... 28

              Introduction

This working document is
published in parallel with the Report from the Commission to the Council and to
the European Parliament on the implementation of macro-financial assistance
(MFA) to third countries in 2012. It provides economic and financial
information regarding the situation of countries having benefitted from MFA in
2012, as well as more detailed information on the implementation of MFA
operations in those countries. Statistical data on the different macro-financial
assistance decisions adopted since 1990, by date and by regions, are included
in annexes. Total amounts of MFA commitments and payments over the period
2003-2012, by year and by region, are also provided.

              Background Analysis of Beneficiaries of
Macro-financial Assistance

1.       Bosnia and Herzegovina
1.1.    Executive summary

In 2012, the
economy of Bosnia and Herzegovina, negatively affected by the worsened external
environment, entered into recession, with an estimated real GDP contraction of
0.7%. The external imbalances have been growing again after slightly decreasing
in the earlier crisis period. The current account deficit reached an estimated
9.4% of GDP, as a result of falling exports of goods. Budget planning and
fiscal coordination have improved, but the composition of spending remains a
concern. Against the background of rising macroeconomic imbalances and growing
concerns about macroeconomic stability, the authorities agreed on a new
Stand-By Arrangement with the IMF of about EUR 400 million in September 2012.

The current EU MFA to Bosnia and Herzegovina (a loan facility of up to EUR 100 million, Council Decision
2009/891/EC of 30 November 2009) was initially set to expire in November 2012.
Until then, no disbursement under this assistance had been made, due to the
non-fulfilment of the specific conditions attached to it. However, given that
the authorities had reached an agreement with the IMF about a new
Stand-By-Arrangement and had taken steps towards improving public finance
sustainability, and in view of the difficult budget and balance of payments
situation of the country, the European Commission extended the availability
period of the MFA to Bosnia and Herzegovina by one additional year, until 7
November 2013. The disbursment of the first instalment under the MFA, in the
amount of EUR 50 million, took place in early-2013. The disbursement of the
second instalment could take place in the second half of 2013, under the
conditions that the IMF programme remains on track and that the specific policy
conditions laid down in the Memorandum of Understanding are met.

1.2.    Macroeconomic performance

After a mild recovery
from the initial effects of the global economic crisis, the economy entered
negative territory again in 2012, when real GDP shrank by an estimated 0.7%,
partly as of result of the severe winter conditions in early-2012 and the
drought in the summer. The economy had registered a growth rate of around 1% in
each of the previous two years. In 2012, tight lending conditions, stagnant
wages and the implementation of fiscal consolidation measures had negative
repercussions on domestic demand. At the same time, the worsened external
environment – due to the EU sovereign debt crisis – resulted in falling
exports, which had a negative impact on growth. Industrial production fell by
5.2% in 2012, compared with a 5.6% growth a year ealier. This was due to the
simultanenous underperformance of the mining sector (-4.9%) and the
manufacturing industry (-4.7%), while the output of the energy sector
contracted at an even higher rate (-7.1%). Alongside falling economic activity,
the level of employment dropped by 0.4% and the registered unemployment rate
reached 44.5% at the end of 2012, as a result of continued labour shedding in
the private sector, notably in construction.

After its strong
deterioration in 2011, the current account deficit continued to widen in 2012
albeit at a moderated pace, reaching an estimated 9.4% of GDP. This further
deterioration was mainly driven by a growing trade deficit (32.4% of GDP) and,
to a lesser extent, by a lower surplus of the services balance. The higher
trade deficit was only partially offset by increased surpluses in net factor
income (+8.1%) and the current transfer balance (+2.3%). Even though starting from
a very low basis, net FDI inflows soared by 70.6% in 2012 to an estimated 3.5%
of GDP – a level still insufficient to cover the current account deficit.
Official foreign exchange reserves rose slightly by 1.3%, covering around five
months of imports.

Consumer price inflation
has been rather volatile in the course of 2012. Following a downward trend in
the first half of the year leading to a 30-month low rate of 1.4% in July, it
rebounded to 2.3% in September-October, triggered by rising food prices. However,
the moderating transport and housing prices exerted some downward pressure on
the overall price level in the country, and annual inflation decelerated to
1.9% towards the end of the year. This brought the 12-month moving average
inflation rate down to 2.1%, compared to 3.7% in 2011. Overall, depressed
domestic demand contributed to low consumer price inflation. The monetary
policy of the Central Bank continued to be conducted under a currency board
arrangement, with the euro as the anchor currency, enjoying a high level of
confidence and credibility.

The fiscal position
mildly improved in the first three quarters of 2012, since the consolidated
budget posted a slightly higher surplus of 0.5% of GDP over the period,
compared to the same period in 2011. Consolidated revenue increased by 1.8%
year-on-year in January-September mainly because of higher grants and other
non-tax revenue (up by 15%), while collection of tax revenue and social
contributions rose only marginally. Consolidated expenditures expanded at a
slightly lower rate of 1.6%. The wage bill of the government and subsidies fell
by 0.7% and 6.4%, respectively, while social spending rose only marginally due
to the continued fiscal restriction. However, the composition of public
spending remains a concern: current expenditures represented a very high 98.5%
of total expenditures in the first three quarters of 2012, while capital
spending, even though increased by 27.6% from the prior year, remained
extremely low.

1.3.    Structural reforms

After gaining momentum
in 2009 and early 2010, the pace of structural reforms slowed down in 2011 and
2012, partly because of the lengthy government formation after the October 2010
general elections. Some reform measures were implemented in order to strengthen
public finance management, leading to improved budget planning and fiscal
coordination. The State and the Entities[1] adopted
their 2013 budgets before the expiration of the previous budget year. This was
a welcomed improvement compared with previous practices of late budget laws
endorsement and temporary fiscal arrangements, which weakened the reliability
of public finances and the planning and decision-making of economic agents. The
adoption of the Global Framework for Fiscal Policies 2013-2015 by the Fiscal
Council in June 2012, after the lack of a medium-term fiscal programme at
country level for a couple of years, was another welcome development. It inter
alia facilitated the timely preparation of the budgets. However, the quality of
public finances remained low with a high share of current expenditures, at the
expense of growth-enhancing capital expenditures.  High labour taxation
continued to hamper job creation and labour market participation.

Against the background
of rising fiscal and external imbalances and growing concerns for macroeconomic
stability, the authorities elaborated in mid-2012 an economic programme which
aimed, inter alia, at safeguarding fiscal sustainability through further fiscal
consolidation and structural fiscal reforms. The programme was supported by a
new Stand-By Arrangement with the IMF of about EUR 400 million, adopted by the
IMF Board in September 2012.

In the World Bank's 2013
Doing Business Report, Bosnia and Herzegovina ranks 126th in terms
of ease of doing business (125th in the previous year), out of 185
countries covered, lagging well behind its regional peers. Main obstacles are
dealing with construction permits, starting a business and enforcing contracts.
In the Global Competitiveness Report of the World Economic Forum, Bosnia and
Herzegovina ranks 88th (climbing 12 places in a year) among 144
countries. Access to financing, and political instability are indicated as the
most problematic factors for doing business in the country.

1.4.   Implementation of
macro-financial assistance

In November 2009, the EU
Council approved a MFA of up to EUR 100 million in the form of loans. The
assistance aims at alleviating the impact that the economic crisis had on Bosnia and Herzegovina's stressed budgetary and external position and at contributing to
fill the remainder of the external and budgetary financing gap identified in
the IMF programme. The European Commission agreed the economic policy
conditions with the Bosnian authorities in a Memorandum of Understanding (MoU)
that was signed in November 2010. The disbursement is conditional upon a
satisfactory track record in the implementation of the Stand-By Arrangement
with the IMF, as well as upon a positive evaluation by the European Commission
of progress made with respect to a number of structural reforms. The specific
policy conditions stressed public finance management issues, statistics and
budgetary procedures. The detailed financial terms of the assistance were
spelled out in a Loan Agreement which was signed in November 2010 and ratified
by the Bosnia and Herzegovina's Presidency in August 2011.

The availability of the
MFA was to expire on 7 November 2012. No disbursement had been made as key
conditions were not met. The IMF programme had turned de facto into a
non-disbursing one since October 2010 due to the political standstill.
Moreover, one of the two policy conditions attached to the disbursement of the
first MFA tranche - the approval of the Global Framework of Fiscal Policies by
the Fiscal Council of Bosnia and Herzegovina - was not fulfilled.

After duly consulting
the Economic and Financial Committee which raised no objection to the proposed
action, the European Commission adopted on 29 October 2012 a Decision
(2012/674/EU) to extend the availability period of the EU macro-financial
assistance to Bosnia and Herzegovina by one additional year, until 7 November
2013. This extension was motivated by the authorities' previous steps towards
improving public finance sustainability, the adoption of a new
Stand-By-Arrangement by the IMF Board on 26 September 2012, as well as the
difficult budget and balance of payments situation of the country.
Consequently, the MoU was extended until 7 November 2013 by an addendum signed
by the Bosnia and Herzegovina’s authorities and the European Commission on 21
November 2012.

Following the receipt of
a compliance report on the fulfilment of the structural reform criteria related
to the first instalment in November 2012 and of a request for funds in January
2013, the European Commission disbursed the first instalment of MFA in the
amount of EUR 50 million in February 2013.

Provided that the IMF
programme remains on track and that all policy conditions as laid down in the
MoU for the second tranche are fulfilled, the second disbursement of the EU MFA
could take place in the second half of 2013.

Summary Status of Economic Reform Bosnia and Herzegovina (BiH)

1. Price liberalisation Most prices are liberalised even though a number of administered prices remain, for example for utilities, including electricity and gas.

2. Trade liberalisation BiH started WTO accession negotiations in 1999. In July 2008, the Stabilisation and Association Agreement with the EU was signed and the Interim Agreement entered into force. BiH is part of the CEFTA agreement.

3. Exchange rate regime In 1997, the Central Bank of Bosnia and Herzegovina established a currency board with the Deutsche Mark as the anchor currency which has functioned smoothly since. With the introduction of the euro, the Bosnian Convertible Mark was pegged at 1.95583 to the euro, exchange rate which has remained unchanged since.

4. Foreign direct investment Net FDI reached a peak in 2007 (when the telecommunications company of Republika Srpska was privatised). A downward trend followed in the next couple of years (with the net FDI even becoming negative in the first half of 2010), and FDI slightly recovered in 2011 and 2012, reaching around 3.5% of GDP in 2012. FDI has been mainly related to privatisation transactions, as green-field investment is still hampered by a difficult business environment.

5. Monetary policy The Central Bank of Bosnia and Herzegovina is responsible for operating the currency board arrangement, which limits the scope of monetary policy basically to adjustments of minimum reserve requirements.

6. Public finances The quality of public finances in Bosnia and Herzegovina remains low. The ratio of general government expenditure to GDP continuously increased in recent years from 39% in 2005 to 46.3% in 2010, before slightly decreasing to 45.5% in 2011. Moreover, expenditure remained concentrated in current expenditure, in particular wages and social benefits, and was not shifted towards growth-enhancing areas. The fiscal balance of the general government was positive until 2007, but high fiscal deficits materialised in 2008 and 2009, while some fiscal consolidation was evident in the last couple of years. The bulk of public expenditures is spent at entity level, while the federal government accounts for about 9% of consolidated expenditures.

7. Privatisation and enterprise restructuring Progress in privatisation and enterprise restructuring has remained limited, especially in the Federation.

8. Financial sector reform The financial sector is dominated by banks. Overall, the sector remains sound and stable despite the continuing deterioration of loan portfolios' quality over the last couple of years.

2.       Armenia
2.1.    Executive summary

The Armenian economy
continued to strengthen in 2012. GDP growth rate reached 7.2% in 2012, a
further increase from the already solid growth rate of 4.7% registered in 2011.
The strengthening of growth in 2012 was mainly driven by an increase in private
consumption and exports. However, the inflow of investments continued to
weaken, due to the difficult global financial environment.

The current financial arrangement with the
International Monetary Fund (IMF) under the Extended Fund Facility and Extended
Credit Facility (EFF/ECF) was signed in 2010 and is expected to expire in
mid-2013. In December 2012, the Executive Board of the IMF successfully
completed its fifth review of Armenia’s economic performance under this
arrangement and concluded that the programme remains broadly on track.

In early 2012 the
Commission completed the implementation of the macro-financial assistance
programme approved back in 2009. The MFA to Armenia, consisting of a loan of
EUR 65 million and of a grant of EUR 35 million, was released in two
instalments: the first instalment in July 2011; the second instalment in
December 2011 (grant component) and in February 2012 (loan component). The MFA
conditions contributed to reforms in the areas of public debt, pensions, tax
systems and public finance management. In February 2013, the Armenian
authorities requested from the EU a new MFA. At the same time, the Armenian
authorities have requested from the IMF a new financing that would
replace the current EFF/ECF arrangement.

2.2.    Macroeconomic performance

After a large shock that
affected the Armenian economy in the global financial crisis in 2009, the economic
activity started its gradual recovery in 2010 and 2011. In 2012, the recovery
continued to strengthen, as the GDP growth rate reached 7.2%, accelerating from
4.7% in 2011.

The strengthening of
growth in 2012 was mainly driven by an increase in private consumption and
exports. Private consumption growth accelerated in 2012, reaching 10.2%,
compared to 2.4% in 2011. On the negative side, investments, both domestic and
foreign, continued to weaken, pointing at Armenia's slowing growth prospects.
Gross fixed capital formation decreased by 7.7% in 2012 after dropping by 4.7%
in 2011. FDI inflows contracted by 7%, after dropping by 8% in 2011.

At the sectoral level,
particularly strong growth was recorded in mining, financial services and
transportation services, each of these sectors registering in 2012 a growth
rate of 14.5%, 23.6% and 14.8%, respectively. Also, agriculture grew by 9.3%
thanks to favourable weather conditions, an important change over 2011.

After reaching a peak of
19.0% in 2010, the unemployment rate fell to 18.4% in 2011. Led by strong
economic activity in 2012, the reduction of the jobless rate continued in 2012,
falling to 17.3%. Youth unemployment remains, however, very high, reaching
almost 40% in 2011.

After inflation rates in
the range of 7-8% in 2010 and 2011, consumer price growth moderated steeply in
2012 (2.6%), mostly as a result of favourable food price dynamics on global
markets and a bumper harvest in the country. By May 2012, CPI inflation had
eased to 0.5% year-on-year, but it rebounded slightly thereafter, as a result
of the increase in world energy prices. Moderate inflationary pressures are
expected in the medium term. The Central Bank of Armenia has kept the policy
rate steady at 8% since September 2011.

The authorities
continued the fiscal consolidation, and the fiscal position improved further in
2012. Last year, the budget deficit is estimated to have declined to 2.1% of
GDP, from 2.8% in 2011 and 4.6% in 2010. The decreasing deficit reflects mainly
spending restraint, while the revenue performance remained weak. Tax revenues
increased by 0.6% of GDP supported by increases of the personal and corporate
income taxes as well as of the excise tax. However the tax-to-GDP ratio
remained low at 17.1%. At the same time, the public debt remains on an upward
path, reflecting on-going borrowing from international financial institutions.
It reached 44.3% of GDP at the end of 2012, up from 42.2% a year earlier.

The external situation
remains fragile. Despite significant adjustment since 2009, the current account
deficit is large. It decreased slightly to 10.7% of GDP in 2012 (10.9% in
2011), underlining a critical need to strengthen competitiveness. Remittances
continued to increase, though at a slower pace, due to the subdued growth in
Russia. In 2012 they grew by 7.7%, well below the 24.6% increase in 2011.
Exports, mostly driven by mining and agriculture, increased by 3.5% in 2012 (in
2011, export growth had reached 24.3%). The trade deficit remained high, 24.3%
of GDP. Further narrowing the current account deficit is crucial as the FDI
continued to weaken: it shrank by 7% in 2012 after contracting by 8% in 2011. Thus,
despite an improvement in the current account deficit, the bulk of the external
financing needs continued to be covered by the international community.

2.3.    Structural reforms

In 2012, the authorities
continued to implement structural reforms focused on business environment
improvements and deregulation, through changes in legislation and strengthening
the relevant administrative capacities. The fundamental laws on technical
regulation, standardization, accreditation and measurement were adopted in
February 2012. They are intended to support export diversification and
competitiveness, but would need to be supported by further measures. In
particular, in the competition area, the government intends to propose to
parliament shortly legal changes, including amendments to the competition act,
to step up enforcement efforts. In the area of tax administration, the authorities
continue to implement measures to simplify and streamline the reporting
process.

Deepening the financial
sector is a priority for the authorities, as a number of reforms have been
introduced lately. In the banking sector, greater provisioning and risk
weighting of foreign assets were introduced to limit further dollarization.
Pension reform that should result in a better mobilisation of domestic
financial resources is on track and scheduled to be introduced in 2014.

The country's
market-friendly reform efforts have been recently acknowledged by the World
Bank, which rated Armenia 32nd (out of 185 states) for the ease of
doing business. The country thus advanced 18 positions in the ranking due to
strong improvements in the electricity availability, investor protection and
tax payment areas.

In order to maintain
high growth rates in an unfavourable external environment, the authorities
should build on the sustained structural reform pace and pursue an even more
ambitious agenda to further improve the business environment and enhance
competitiveness. They should also focus on trade deepening. A positive step in
this direction was made in 2012, when Armenia launched negotiations on a Deep
and Comprehensive Free Trade Agreement (DCFTA) with the EU, which was the
starting point in the country's reform process especially in the areas of
sanitary and phyto-sanitary issues, technical barriers to trade and protection
of intellectual property rights.

Other important
challenges Armenia faces include promoting inclusive and sustainable growth,
diminishing poverty rates, decreasing corruption and diversifying the economic
activity while facing its geopolitical difficulties, being a landlocked country
with two closed borders out of four.

2.4.    Implementation of macro-financial
assistance

The
implementation of the macro-financial assistance programme approved back in
2009 and which consisted of a loan of EUR 65 million and of a grant of EUR 35
million was completed in February 2012, with the release of the loan part of
the second instalment.[2]

The conditionality
linked to this MFA programme included specific policy measures in the areas of
public debt management, pension system, public internal financial control,
external audit, public procurement, tax policy, tax administration, and customs
policy. The developments having taken place in 2012 and in early 2013 in the
policy areas targeted by the MFA programme are detailed below.

In the area of public internal financial control, the
implementation of the Government’s Public Finance Management (PFM) reform
strategy continued to progress. As of 2012, 52 government entities were
equipped with Internal Audit systems. Armenia adopted a tax policy strategy for
2013–15 and a tax administration strategy for 2012–14 focused on expanding the
scope of e-filing. A new compulsory income tax, merging social security
deductions and private insurance payments, entered into effect in January 2013.
Armenia also integrated the tax and customs information systems through new
software.

In February 2013, the
Commission received a request from the Armenian authorities for a new MFA
programme for 2013–14. In fact, the IMF estimated in the Article IV report
published in December 2012 that Armenia will be facing an important external
financing gap in this period. Since the current IMF arrangement under EFF/ECF signed in
2010 will be completed in June 2013, a possible new MFA programme will be
conditional on an agreement between the IMF and the Armenian authorities on a
new IMF programme, negotiations on which started in April 2013, together with
the final review of the 2010-13 EFF/ECF programme. In December 2012, the
Executive Board of the IMF successfully completed its fifth review of Armenia’s
economic performance under that programme. The decision enabled the authorities
to draw an additional SDR 33.5 million (about EUR 38.8 million), bringing total
disbursements under the arrangements to SDR 211.8 million (about EUR 245.3
million).

Summary Status of Economic Reform - Armenia

1. Price liberalisation Prices are largely free but there are oligopolistic conditions in many sectors of the economy.

2. Trade regime Armenia is a WTO member since 2003. The tariff structure is simple, all tariffs are bound. In 2009, Armenia qualified for the EU GSP+. In March 2012, the EU launched DCFTA negotiations with Armenia. Although sufficient progress has been achieved by Armenia in order to start DCFTA negotiations, trade and trade-related reforms should be continued, in particular the adoption and implementation of relevant horizontal or vertical legislation in the key regulatory areas of Technical Barriers to Trade (TBT), Sanitary and Phytosanitary Standards (SPS) and Intellectual Property Rights (IPR). Armenia has made progress in the application of the WTO compliant customs valuation methods, which was a condition in the MFA operation. Monitoring of effective application will be continued in this area.

3. Exchange rate regime After the March 2009 devaluation of the Armenian dram, the central bank announced the adoption of a free floating exchange rate regime. However, the exchange rate market is small and highly volatile, and the central bank often undertakes foreign exchange interventions to limit exchange rate volatility.

4. Foreign direct investment Overall, Armenia has a liberal trade and investment regime. The country's land-locked geographical position with two closed borders and the oligarchic structure of the private sector hampers growth potential and competitiveness, which however slightly improved in 2012. Investors' protection, payment of taxes, access to finance and corruption remain points of concern.

5. Monetary policy The Central Bank of Armenia follows an inflation targeting regime to conduct the monetary policy. The impact of monetary policy decisions on the economy is limited because the domestic money market is not sufficiently developed and the rate of dollarization of deposits is 63%.

6. Public Finances and Taxation Even though the public debt management has been strengthened (partly as an effect of MFA conditionality), there is room for improvement. The government has created a Central Harmonisation Unit that provides monitoring of financial management and control functions and internal audit. Efforts have also been made to strengthen tax and customs administration by simplifying the taxpayers' reporting system.

7. Privatisation and enterprise restructuring Armenia has made significant progress in privatisation and some progress in competition policy. According to the EBRD, the privatisation in the industry is complete, and enterprises face very few market distortions from government subsidies or formal trade barriers. The authorities continue to introduce various measures to eliminate excessive regulation (reduction of required licences, initiative of regulatory guillotine, which was launched in November 2011).

8. Financial Sector The banking sector in Armenia is relatively small (banking assets represent around 50% of GDP) but well capitalised and deposit-funded. It consists mainly of private banks. The authorities have enhanced the risk management and supervisory frameworks in the banking sector, including contingency planning. Prudential regulations on higher capital and provisioning requirements on foreign currency loans were issued. Future efforts should focus not only on enhancing financial stability but also on reducing obstacles to credit growth and financial intermediation.

3.       Georgia
3.1.    Executive summary

Despite the worsening
global environment, Georgia's economy expanded by an impressive 6.1% in 2012, a
slight moderation from the 7.2% GDP growth achieved in 2011. Economic activity
was strong for most of the year, save for the last quarter when growth
moderated markedly due to weakening external demand, but also the uncertainty
arising from the political transition following the October parliamentary
elections. The budget deficit is estimated at 3.0% of GDP in 2012 (an
improvement from the 3.5% initial target) due to one-off revenue gains and
prudent expenditure policies. At the same time, falling global food prices and
weak demand-side pressures led to a steep disinflation throughout the year -
consumer prices declined by 0.9% on average in 2012. This enabled the central
bank to continue its monetary easing cycle. Strong investment demand widened
the trade deficit and was therefore a key factor behind the high current
account deficit (at 11.4% in 2012). At the same time, net FDI declined by
one-third during the year. This was compensated by increased borrowing, which
ultimately led to an increase of the gross external debt of the country to
84.2% of GDP at the end of 2012.

Following a successful
implementation of an IMF arrangement in 2008-2011, the authorities agreed on a
follow-up programme to support the completion of the macroeconomic adjustment
programme, but also to insure against risks stemming from the unsettled global
environment. The agreement approved in April 2012 foresees potential support of
SDR 250 million (EUR 294 million). Until now, the programme has been precautionary,
since no funds have been withdrawn so far.

In January 2011, the
Commission adopted a decision for a MFA programme to Georgia for a total of EUR
46 million, to be provided equally in loans and grants. The proposal was part
of a pledge made by the European Commission at a donor conference in October
2008 for two possible MFA operations, amounting to EUR 46 million each. The
first MFA operation was successfully implemented in 2009-2010. As for the
second one, its approval has been delayed by disagreements between the two
co-legislators (European Parliament and Council) over the procedure to be used
for the adoption of the Memorandum of Understanding, which lays down the
economic policy measures to be undertaken by the country benefiting from the
MFA. While the two co-legislators agree with the substance of the proposal,
this procedural dispute has entailed thorough discussions, which should lead to
a decision in mid 2013.

3.2.    Macroeconomic performance[3]

Georgia's economy
demonstrated a remarkable recovery after the 2009 recession, recording a 6.5%
annual average growth in 2010-2012 that was underpinned by sound macroeconomic
policies and market-oriented reforms. Significant donor assistance pledged in
the aftermath of the 2008 conflict with Russia was also instrumental to that
end. In 2012, GDP growth slowed down to 6.1% from 7.2% a year earlier and
remained predominantly supported by strong investment activity. Household
demand has also favourably affected economic performance. Private consumption was
encouraged by an on-going wage increase coupled with a steep disinflation,
robust credit growth for most of the year, and a booming tourist sector.
Economic activity moderated significantly in the final quarter of 2012, with a
GDP growth of only 2.8%. This reflected a worsening global environment but also
the uncertainty arising from the change of power following the October
elections. Despite robust economic growth, the unemployment rate remains
elevated at 15.1% in 2011 (down from 16.3% a year earlier) due to a high
structural unemployment.

In marked contrast with
the high inflationary environment in the previous two years, there was an
impressive disinflationary trend in 2012 that was mainly due to lower
food prices worldwide. Demand-side pressures remained subdued as the booming
economy is still mainly the result of high investment activity. The CPI was in
the deflationary area for most of the year, with the average price decline
reaching 0.9% in 2012. In the absence of any inflationary pressures, the National
Bank of Georgia continued its easing cycle and reduced the key policy rate by
cumulative 150 basis points to 5.25% at the end of the year. Another 50 basis
points reduction followed in February 2013, which was necessitated by weaker
economic activity. However, the monetary policy transmission mechanism remains
constrained by the high dollarization ratio.

In the fiscal area, the
budget deficit came at a better-than-expected 3.0% of GDP in 2012 (initial
target of 3.5%) due to a combination of one-off revenues (namely a dividend by
the state railway company Georgian Railways) and restrained expenditures by the
new government in the final quarter of the year. The 2013 budget targets a
further tightening of the fiscal deficit to 2.8% of GDP, which, however, will
be accompanied by a reduced fiscal flexibility, as the share of capital
expenditures will be curtailed at the expense of growing recurrent spending for
rising pensions and social benefits.

Georgia's external
vulnerabilities remain prominent. The current account deficit amounted to 11.4%
of GDP in 2012, declining from 12.7% in 2011. The merchandise trade deficit
widened due to a strong investment demand and a weak export base, which were
only partially compensated by rising tourism proceeds and growing, although at
a slower pace, remittances. Net FDI declined by a third in the first three
quarters of 2012 to USD 603 million (3.8% of GDP). This resulted in growing
reliance on debt financing and the country's gross external debt rose to 84.2%
of GDP at the end of the year. After a significant rise in 2011, international
reserves were almost unchanged throughout 2012, reaching USD 2.9 billion at
end-year (or around 3.7 months of next year's imports). Elevated external risks
are somewhat mitigated by the on-going access to donor assistance as well as a
new programme concluded with the IMF in April 2012.

Following the completion
of an IMF arrangement that ran from end-2008 to mid-2011, the authorities
agreed with the IMF on a follow-up programme whose objectives are to guard
against risks stemming from the unsettled global enviroment and high external
debt payments as well as to support the successful completion of the adjustment
process following the 2008-2009 crisis. The IMF approved the new 24-month programme,
in the form of a Stand-By Arrangement and a concessional Stand-By Credit
Facility, in April 2012. Under the agreement, Georgia could borrow up to SDR
250 million (EUR 294 million) over the programme period, evenly distributed
between the two instruments. The authorities have decided to treat the
agreement as precautionary and have not withdrawn any funds for the time being.
The IMF carried out its first mission review in November and December 2012,
concluding that performance under the programme has been good.

3.3.    Structural reforms

Georgia, which has
succesfully developed several important structural reforms in the past few
years, continued on this path in 2012, although at a slower pace due to the
parliamentary elections and the following political transition. The country
climbed three positions in the World Bank's Doing Business index[4]. 2013
ranking to the 9th place (out of 185 countries). Georgia's
pro-business policy efforts, including numerous institutional and regulatory
reforms, made it the top performer globally since 2005 in terms of improving
the business enviroment, according to the World Bank. Reforms have covered
various areas such as fiscal sustainability, public finance management, public
procurement, taxation and customs regulations, among others. The central bank's
prudential instruments have been strenghtened, including through transition to
risk-based supervision. However, concerns about the independence of the
institution emerged following the October elections, although they have not
materialised for the time being. In order to encourage private investment, the
authorities set up in 2011 a public financial institution, the Partnership
Fund, which is expected to play an important role as part of the strategy of
the new government to encourage economic activity. A special fund will also be
established to support the development of the large agricultural sector in the
country. In 2012, Georgia steadily advanced in the talks on the establishment
of a Deep and Comprehensive Free Trade Area (DCFTA) with the EU. In line with
the policy of the new government, trade with Russia is likely to be revived,
opening new export possibilities. However, the very weak export base indicates
the need for more vigorous measures to support export-oriented sectors and to
benefit from the country's comparative advantage in terms of closer trade
integration with the EU and Russia. Progress is still
needed in complying with core ILO conventions, even though positive
developments have recently been registered in this respect.

3.4.    Implementation of
macro-financial assistance

The EU pledged up to EUR
500 million support for Georgia's economic recovery at a International Donor
Conference in Brussels in October 2008, in the aftermath of the military
conflict with Russia. The pledge included two potential MFA operations,
amounting to EUR 46 million each. The first part was successfully implemented
in 2009-2010. The Commission made in January 2011 a proposal for a second MFA
programme of EUR 46 million, to be provided evenly in grants and loans.
However, the adoption of this decision has been delayed by disagreements
between the two co-legislators (European Parliament and Council) over the
procedure to be used for the adoption of the Memorandum of Understanding, which
lays down the economic policy measures to be undertaken by the country
benefiting from the MFA. While the two co-legislators agree with the substance
of the proposal, this procedural dispute related to the entry into force of the
new "comitology" regulation in March 2011[5] has
entailed thorough discussions, which are foreseen to result in a decision in
mid 2013.

Summary Status of Economic Reform - Georgia

1. Price liberalisation Prices are largely free.

2. Trade regime Georgia has a liberal trade policy. Import tariffs have been abolished on around 85% of products. In September 2006, the number of tariff bands on imported goods was reduced from 16 to 3 (0%, 5% and 12%). The maximum tariff of 12% is applied to those agricultural products and building materials which compete with domestic goods. The average weighted tariff is estimated to be 1.5%. There are no quantitative restrictions on imports and exports. Since July 2005, under the EU Generalised System of Preferences (GSP), Georgia has been benefiting from the tariff preferences of the special incentive arrangement for sustainable development and good governance covering 7,200 items, the GSP+. In May 2010, the mandate for the negotiations of the Association Agreement between the EU and Georgia was approved. In the area of trade, the agreement foresees the establishment of a DCFTA, for which the negotiations started in February 2012. This will provide a framework for improving the trade environment in Georgia with the objective of strengthening the country's economic and trade profile, thereby boosting both trade and investment.

3. Exchange regime There is a floating exchange rate of the lari with limited official intervention by the National Bank of Georgia. There are no restrictions on current international transactions in conformity with Article VIII of the IMF’s Articles of Agreement.

4. Foreign direct investment Adequate overall legislation. Unlimited repatriation of capital and profits.

5. Monetary policy The major monetary policy objective of the National Bank of Georgia is to ensure price stability. Other objectives, pursued only if they do not contradict with the price stability goal, incude support to the financial system of the country and promotion of economic growth. The Bank is currently applying an inflation-targeting regime. The price gowth target set for 2012-14 is 6% and will be gradually reduced afterwards to 3%. The effectiveness of the monetary policy is significantly constrained by the high dollarization of the economy. The dollarization ratio of deposits to the non-bank sector amounted to 64 % at the end of 2012, increasing from 60% a year earlier.

6. Public finances and taxation The public finance management system is essentially sound and transparent, although further reforms are still needed in areas such as internal financial control and audit. New legislation foreseen to come into force in 2014 will limit the budget deficit to 3% of GDP, public debt to 60% of GDP and public spending to 30% of GDP.

7. Privatisation and enterprise restructuring The majority of state-owned enterprises has been privatised. Privatisation receipts are expected to have declined to 0.5% of GDP in 2012 from estimated 1.6% in 2011.

8. Financial Sector There were 19 banks at end-2012, including 14 foreign-controlled banks and 3 branches of non-resident banks. The share of foreign capital in the banks' paid-in capital was approximately 75% at end-2012. The share of non-performing loans increased by 0.7% year-on-year to 9.3% at end-2012. The capital adequacy ratio remained unchanged on the year at 17.0%. The net profit of the banking sector more than halved in 2012, resulting in a reduction of the return on assets to 1.0% (from 2.9% at end-2011) and the return of equity to 5.8% (17.3%). Both credit and deposits rose by approximately 13% year-on-year in 2012, after a 23% rise in 2011.

4.       Ukraine
4.1.    Executive summary

In 2012, real GDP growth
in Ukraine decelerated to a mere 0.2% compared to 5.2% in 2011, mainly as a
result of a deteriorating external environment, lower demand for Ukrainian
metal exports as well as low investment levels. Despite the slowdown in growth
and deflationary tendencies, the National Bank of Ukraine kept the monetary
policy very tight in an attempt to fend off devaluation pressures on the local
currency. External vulnerabilities were growing as the current account deficit
widened to 8.3% of GDP and currency reserves declined by almost one fourth in
2012.
The fiscal deficit widened to 5-6% of GDP in 2012, after 4.2% in 2011, mainly due
to fiscal loosening ahead of the parliamentary elections and the rising level
of energy subsidies

Ukraine's progress in
achieving important structural reforms and implementing the priorities of the
EU-Ukraine Association Agenda, foreseen to prepare and facilitate the
implementation of the Association Agreement with the EU,  remained uneven. Some
improvements took place in the energy sector and in the stabilisation of the
banking system. However, the government failed to increase retail energy
prices towards cost recovery levels and thus meet one of the IMF's conditions
for a resumption of disbursements under the Stand-By Arrangement, which expired
in December 2012. There has been no improvement of the operating environment
for businesses, which remains hampered by red tape, corruption, insufficient
rule of law and continued constraints in companies’ access to credit.

Against the backdrop of a persistent external
financing gap and in order to support the economic reform process in the
country, the EU adopted in July 2010 a decision providing up to EUR 500 million
of MFA to Ukraine. In combination with the EUR 110 million still available from
the MFA decision adopted in 2002, this implied a potential MFA package of up to
EUR 610 million.  The Memorandum of Understanding (MoU) laying down the policy
conditions for the disbursement of the assistance as well as the Loan Agreement
(LA) were signed and entered into force in March 2013. The MoU contains policy
measures in the key areas of public finance management, trade and taxation,
energy sector reform and the harmonisation of financial regulation.
Disbursements of MFA in 2013 are conditional on the approval of, and good
progress under, a new financing arrangement to eb agreed with the IMF and, for
the second and third tranches, on satisfactory progress in the implementation
of the structural policy conditions laid down in the MoU.

4.2.    Macroeconomic performance

Real GDP growth slowed
significantly in 2012 to 0.2%, after reaching 5.2% in 2011 and 4.2% in 2010. The
main factors explaining this slowdown were the more challenging global economic
environment, tight monetary policy, and the worsening domestic business
climate. The economy would presumably have entered recession if the government
had not sustained public investment in the run-up to the Euro 2012 football
championship and loosened fiscal policy before the October 2012 parliamentary
elections. Still, construction plummeted by 14% year-on-year, and industrial
production declined by 1.8%, according to preliminary statistics. Economic
activity is expected to recover only slightly in 2013 and 2014. The external
outlook and the slow progress in improving the business environment continue to
cloud growth prospects and make the 3.4% GDP growth forecast of the Ukrainian
government for 2013 appear overly optimistic.

Inflation was at its
lowest level for a decade as of year-end 2012, reaching -0.2% year-on-year, as
food prices declined, administrative tariffs were kept flat, and as the
National Bank of Ukraine (NBU) kept the refinancing rate high at 7.5%, with a
view to limiting downward pressure on the exchange rate. However, this trend
may be reversed in 2013, as a result, among other things, of a possible
increase in gas tariffs for households – the main pre-condition of the IMF for
a new stand-by arrangement. Price dynamics will also depend on whether the
NBU's focus will shift to inflation targeting in the medium term. Its current
focus on supporting the currency has resulted in a decline of the foreign
exchange reserves by about one fourth in 2012, to USD 24.5 billion, which would
cover 2.8 months of imports. While administrative measures and market
interventions to stabilize the hryvnya provided some short-term relief, the
currency peg is unsustainable in the medium term against the background of a
persistently large current account deficit and slowing growth. As a consequence
of the NBU's restrictive approach to the provision of refinancing to banks,
overnight inter-bank interest rates exceeded 45% in the third quarter of 2012,
resulting in prohibitively high interest rates on credits to households and
businesses. However, they later declined to about 25% at the end of 2012 as the
liquidity situation in the banking system improved somewhat.

While Ukraine successfully
reined in its budget deficit following the 2008-2009 crisis, recent trends have
been less positive, and the overall budget deficit reached an estimated 6% of
GDP in 2012 after 4.2% in 2011. Apart from fiscal loosening ahead of the 2012
parliamentary elections, an important factor contributing to the deficit is the
state-owned oil and gas company Naftogas, which sells natural gas to households
and utilities at prices which are significantly below cost-recovery levels.
Naftogas' deficit reached about 1.7% of GDP in 2012, and will continue to
remain at similarly high levels unless the government implements the gas price
increases recommended by the IMF. The public debt ratio has increased
significantly in recent years, to approximately 37% of GDP at the end of 2012
from only 12% of GDP in 2007. Although it remains at a relatively manageable
level, the debt ratio may further increase as a result of delays in the
adjustment of gas prices and the slowdown in economic activity.

The balance of payments
situation continued to deteriorate in 2012, with the current account deficit
widening to 8.4% of GDP from 6.2% a year earlier, as a result of higher energy
import prices and weak external demand for traditional Ukrainian exports,
mainly steel, and despite a pickup of agricultural exports. There are also
significant risks to the financial account if foreign banks continue to
deleverage and if the current trend of subdued FDI inflows, in the context of a
deteriorating business climate, persists. FDI fell to an estimated USD 6
billion in 2012, out of which USD 5 billion originated from Cyprus, compared to
USD 7 billion in 2011. Overall, Ukraine's vulnerability to external shocks,
such as a new oil price spike or a slump in steel prices, remains high.

4.3.    Structural reforms

Ukraine's achievements
in the implementation of structural reforms remained below expectations in
2012. Despite the ambitious Programme for Economic Reforms for 2010-2014 (PER),
which aims at unlocking Ukraine's long-term growth potential through structural
reforms in most sectors of the economy, the investment climate deteriorated
further. These challenges are reflected in Ukraine's low ratings, by regional
comparison, in a number of comparative studies, including the World Bank's
Doing Business Index (137th out of 185), the Transparency
International Corruption Perceptions Index (144th out of 176), the
Economic Freedom Index (Heritage Foundation, 161st out of 177) and
the Press Freedom Index (Reporters Without Borders, 126th out of
179).

Insufficient progress
has been achieved in the area of public finance management. Apart from the
insufficient remit and capacity of the Supreme Audit Institution (the
Accounting Chamber of Ukraine, see section below), a key concern remains the
public procurement system. While the public procurement law adopted in July
2010 was a step in the right direction, the public procurement system is not in
line with European standards and is weakened by an excessive number of
exceptions, e.g. for state-owned enterprises. More work also needs to be done
to create an effective system of public internal financial control and to
improve the budgeting system. As regards the fight against corruption, new
pieces of legislation were adopted in 2011. However, anti-corruption
legislation is still not in line with European and international standards, and
Ukraine continues to lack an independent anti-corruption body. Some progress
was made to deal with the substantial arrears on VAT refunds, including by
increasing the number of companies receiving automatic refunds and gradually
applying a risk-based refund system. However, the problem of significant
arrears in VAT refunds persists, and the targets for their elimination that
were part of the IMF programme have not been met.

Another important area
where significant work still has to be completed, even though some progress has
been registered recently, is the reform of the energy sector. The energy sector
as a whole is dominated by large state-owned operators, most notably oil and
gas monopolist Naftogas, entailing significant problems of governance and
transparency. In July 2010, Ukraine adopted a new gas law, which was followed
by its accession to the European Energy Community Treaty (ECT) in December
2010. Some progress has been made towards implementing key obligations under
the ECT, notably the implementation of EU Directive 55/2004, foreseeing the
unbundling of the production, transport and delivery of natural gas, although a
January 2012 deadline for unbundling was missed. A law allowing for the
unbundling to take place was adopted in April 2012, and progress was made in
the regulation of the gas market, in line with the new gas law. On the other
hand, progress in improving energy efficiency has been slow, mainly as a result
of the  high subsidies for gas consumption.

The banking sector is in
better shape than in 2008, when the economic downturn and simultaneous credit
crunch forced several banks out of business. Further progress has been made
with the recapitalisation and rehabilitation of the banks affected by the 2009
crisis. The average capital adequacy ratio has been relatively high at about 18
% over the last two years, and the deposit base resilient, albeit with some
evidence of switching from local currency to US dollars. One issue of concern
is the high percentage of non-performing loans, which were estimated at between
14% and 48% in 2012, depending on the methodology applied. Loan growth has been
negative and the market share of foreign banks decreased in 2012.

On the positive side,
the EU and Ukraine initialled the Association Agreement (AA) in March 2012,
which includes a Deep and Comprehensive Free Trade Area. The AA contains an
ambitious reform agenda, foreseeing the approximation to the EU acquis in a
number of areas.

4.4.    Implementation of macro-financial assistance

In reaction to the
deterioration of the economic and balance of payments situation, Ukraine
requested MFA from the EU in February 2009. In response, the European
Parliament and the Council adopted Decision 646/2010/EU on the provision of MFA
of up to EUR 500 million in July 2010. Together with the EUR 110 million loan
available from Council Decision 2002/639/EC, this translates into a total
amount of up to EUR 610 million.

Discussions on the
Memorandum of Understanding (MoU) laying down the economic policy measures to
be undertaken by Ukraine and the Loan Agreement (LA) were launched in July 2010
by a mission of Commission staff to Ukraine. Negotiations took longer than
expected and were concluded in late 2012, after the Ukrainian authorities
lifted their reservations on some key policy conditions. Both documents were
signed in March 2013. The payment of the first tranche (EUR 100 million) is
conditional on the IMF arrangement currently negotiated by Ukraine being in
place, and funds being drawn under this new IMF programme. The disbursement of
the second and third tranches, of EUR 260 million and 250 million respectively,
will also be subject to the fulfilment of the policy conditions laid down in
the MoU,  which fall into four thematic areas: public finance management (PFM);
trade and taxation; energy; and the harmonisation of financial sector
regulation with that of the EU.

Conditions related to
PFM play a key role in the proposed conditionality of this MFA operation. This
is in line with the provisions of Decision 646/2010/EU, which stipulate that
the conditions of this operation shall aim at “strengthening the efficiency,
transparency and accountability of the assistance, including in particular
public finance management systems in Ukraine” and that “specific measures [are]
to be implemented by Ukraine in relation to the prevention of, and the fight
against, fraud, corruption and other irregularities affecting the assistance”.
Within the broad area of PFM, the focus is on internal and external financial
control, the fight against corruption, as well as public procurement (an area
which has also an important trade dimension).

The PFM was a key
element
in the negotiations on the MoU. Apart from the framework for public procurement
(see above), a major point of discussions has been Ukraine's current
legislation on external audit, which should be brought in line with generally
accepted international practices and the Mexico Declaration of the
International Organisation of Supreme Audit Institutions (INTOSAI). In
particular, Ukraine's Accounting Chamber (ACU) has no right to audit government
revenue, nor local governments, extra-budgetary funds and state-owned
enterprises. Positively, the Ukrainian authorities agreed to remedy the
situation during the last round of negotiations in 2012. In January 2013,
President Yanukovich introduced a draft law to Parliament which would, if
adopted, allow the ACU to audit the revenue side of the budget.

The issue of the
substantial arrears accumulated on VAT refunds is closely related to PFM. The
MoU stipulates that these arrears, which hurt the affected exporters and
contribute to weaken the overall investment climate, should be eliminated,
while improvements in tax administration should prevent a recurrence of the
problem in the future. The MoU measures also commit the Ukrainian authorities
to clearing any arrears on VAT refunds either in cash or by netting them out
against obligations of the tax payers, thus avoiding the unorthodox clearance
through the issuance of VAT bonds, as was done in 2010.

As noted, the energy
sector reform has accelerated recently. The MoU refers to Ukraine's  commitment
to fully implement the EU Directive 2004/55, which foresees the unbundling of
the production, transport and delivery segments of gas sector. Although
progress has been uneven, the EU and the World Bank are in close contact with
the Ukrainian authorities regarding the reform of Naftogas, Ukraine's oil and
gas monopolist. Moreover, the MoU contains conditions related to the payment
discipline of utility consumers and the targetting of subsidies in the energy
sector.

Summary Status of Economic Reform - Ukraine

1. Price liberalisation Most prices are free, but regulated prices prevail for some utilities, notably gas, and in some other areas, including agricultural products and medicines (so called socially-sensitive goods).

2. Trade liberalisation Ukraine joined the WTO in May 2008. However, export duties and quotas for individual products remain in force, and often create an unlevel playing field and opportunities for rent-seeking, notably in the agricultural sector. Technical and administrative barriers to trade remain an obstacle for importers. Positively, negotiations on a deep and comprehensive free trade area with the EU were technically concluded in 2011.

3. Exchange rate regime The National Bank of Ukraine (NBU) sustains its de-facto peg of the hryvnya against the US dollar, maintaining an exchange rate close to UAH 8 per USD throughout 2012. The IMF has been requesting Ukrainian authorities to gradually introduce a floating exchange rate.

4. Foreign direct investment FDI-related flows are largely liberalised. Some sectors, however, remain closed to foreign ownership, i.e. the gas transmission system and agricultural land market.

5. Monetary policy The National Bank of Ukraine is responsible for controlling the domestic money supply. In order to stabilize the exchange rate, the NBU implemented a tight monetary policy throughout 2012.

6. Public finances General government expenditure made up an estimated 46% of GDP in 2012. Nearly three-quarters of Ukraine's government expenditure goes towards wages and social transfers. As domestic gas prices for households and utilities are kept at an artificially low level of about 20% of import prices, the finances of state oil-and gas monopolist Naftogas are in dire straits, leading to a higher fiscal deficit. Ukraine still needs to implement key reforms in the public finance management sector, including in the areas of public procurement, public internal financial control, external audit and VAT refunds, which are crucial elements of the MoU of the MFA programme.

7. Privatisation and enterprise restructuring State-owned companies, which are insufficiently controlled and not subject to external audit by the Supreme Audit Institution, continue to dominate certain sectors, in particular utilities. Some utility companies, mainly energy generating and distributing companies were privatised in 2012.

8. Financial sector reform At the end of 2012, 176 banks were operating in Ukraine, including 22 foreign-owned banks. Consolidation and recapitalisation of the banking sector remain key priorities for Ukraine. The amount of non-performing loans remains high.

5.       The Kyrgyz Republic
5.1.    Executive summary

In 2012, economic growth
of the Kyrgyz Republic was limited to 0.9%, significantly below earlier
forecasts, as production in the gold-mining sector sharply contracted because
of geological issues. Excluding the gold-mining sector, growth reached about
4.8% in 2012, driven by manufacturing, construction and services, gradually
recovering from the sharp slowdown in 2009 and 2010 caused by global recession
and internal political and ethnic conflicts. The
current account deficit widened to an estimated 9% of GDP in 2012,
reflecting a decline in gold exports and higher oil prices. Despite a tight monetary policy, inflation reached 7.5%
by the end of 2012 on account of rising international fuel and food prices. The
overall fiscal deficit declined to an estimated 5.3% of GDP (excluding energy
infrastructure projects), mostly due to a stronger revenue collection.

On 20 December 2011, the
Commission adopted a proposal for a Decision by the European Parliament and the
Council to provide MFA of up to EUR 30 million to the Kyrgyz Republic. The
assistance will support the macroeconomic adjustment programme agreed between
the Kyrgyz Republic and the IMF in June 2011, which is supported by a USD 106
million Extended Credit Facility (ECF). It will also support implementation of
a number of reform measures to be agreed between the EU and the Kyrgyz
Republic. However, the adoption of the decision on a MFA operation to the
Kyrgyz Republic has been delayed by disagreements between the two co-legislators
(European Parliament and Council) over the procedures to be used for its
implementation. It can be expected that the MFA will be adopted by the
co-legislators in 2013 and that a first disbursement could still take place in
that year.

The political events
experienced by the Kyrgyz Republic in 2010, and in particular the inter-ethnic
violence of June 2010, disrupted the Kyrgyz economy by affecting trade, tourism
flows and agricultural production. The EU's MFA will contribute to covering the
Kyrgyz Republic's external financing needs in 2013 and 2014, which are partly
due to the economic disruptions and the social and reconstruction expenditure
for alleviating the consequences of the 2010 events, while supporting reform
measures aimed at achieving a more sustainable balance of payments and
budgetary situation over the medium-term. While the Kyrgyz Republic is out of
the normal geographical scope of the EU's MFA instrument, the exceptional
circumstances, including EU political support to the Kyrgyz Republic’s incipient
parliamentary democracy, argue in favour of such an operation. The proposed MFA
would complement the funds pledged by the international community at the donors
conference organised in Bishkek in June 2010 in support of Kyrgyzstan's
democratisation, reconstruction and social assistance policies, to which the EU
was a major contributor.

Progress under the IMF's
ECF programme has been sustained so far: the Kyrgyz Republic, in the framework
of the third review of the programme conducted during the fall of 2012, was
meeting all end-June 2012 quantitative programme targets, and all but one
structural benchmarks.

5.2.    Macroeconomic performance

The popular
revolt in April 2010
and, more importantly, the escalation of the ethnic conflict in June
2010 had a strong negative impact on economic growth in the Kyrgyz Republic,
resulting in a 0.5% decline in real GDP in 2010. In
2011, real GDP expanded by 5.7%, supported by a more stable political
situation, and the recovery of the agricultural and mining sectors as well as
of remittances. In 2012, real GDP growth is foreseen to be limited to 0.9% , as
production in the gold-mining sector sharply contracted (-63% in the first nine
months of 2012) because of geological issues at the major Kumtor gold mine.
Excluding the gold-mining sector, growth reached an estimated 4.8% in 2012,
driven by manufacturing, construction and services. This trend is foreseen to
continue in 2013 and, coupled with a sharp increase in gold production, is
expected to result in a 7.5% real GDP growth in 2013.

Year-on-year
inflation has been very volatile over the last few years, spiking from 0% at the end of 2009 to 22.7% in June 2011 because of
a sharp increase in the global prices of food and fuel, then declining to 5.7%
at the end of 2011 thanks to an easing of global food prices and a tightening
of the monetary policy by the central bank (sales of
short-term notes in order to mop-up excess liquidity, an increased discount
rate and increased reserve requirements). In 2012, despite a still tight
monetary policy, inflation reached 7.5% as a result of economic growth
(excluding the gold-mining sector) and rising international food and fuel
prices.

In 2010, the fiscal
deficit reached
6.3% of GDP, reflecting the budgetary cost of the crisis-related measures and
the negative effect of weaker economic activity on tax revenues. In 2011, a stronger
revenue collection and delays in implementing post-conflict reconstruction projects
led to a slight decrease of the budget deficit to 4.8% of GDP. In 2012, the
deficit increased to about 5.3% of GDP, despite stronger revenue growth, due to
the impact of the government’s decision to increase pensions and wages for
teachers and health care employees from below the subsistence levels. The
Kyrgyz Republic's external public debt rose from about 41% of GDP at end-2008
to over 55% of GDP at end-2010, reflecting new loans by international financial
institutions and other donors. It has gradually been decreasing since, reaching
about 47% of GDP at year-end 2012, mostly thanks to debt forgiveness by some
creditors (most recently from Russia and Turkey).

In 2010 the current
account experienced a marked deterioration, moving from a temporary surplus of
0.7% of GDP in 2009 to a deficit of 6.4% of GDP, as the
conflict and ethnic violence led to a shutdown of the borders by the
neighbouring countries, which had a negative impact on agricultural exports and
services such as tourism and transit transportation. The current account
remained at a similar level in 2011, at 6.3% of GDP, as strong remittances and increased earnings from gold exports were more
than offset by increased domestic demand and imports for large energy and
mining projects. For 2012, the current account deficit is expected to widen
further to about 9% of GDP, reflecting higher oil prices and a decline in gold
exports. Overall, the current account position remains vulnerable to external
trade shocks, including an increase in prices of imported energy products.

Foreign
direct investment and other private capital inflows were negatively affected by
the 2009 global crisis but began to recover in 2010, despite the political
crisis. In
2012, the capital account is expected to show an
annual surplus of USD 330 million, reflecting sizeable external loans
for public investment projects and sustained FDI.

Official foreign
exchange reserves reached USD 1.97 billion (EUR 1.48 billion) by the end of
2012,
and the import coverage ratio by the foreign exchange reserves declined from
4.0 months at year-end 2010 to an estimated 3.7 months at year-end 2012.

5.3.    Structural reforms

Political
uncertainty arose from the breakup of the coalition government in August 2012.
However, the new government quickly took over the ongoing essential structural
reforms, continuing the Kyrgyz authorities' efforts to improve the business
climate, becoming one of the most advanced countries in Central Asia in terms
of economic reforms. The 2012 World Bank/IFC Doing
Business survey ranks the Kyrgyz Republic at 70th place out of 185 with regard
to the ease of doing business, while the regional average of Eastern Europe and
Central Asia stands at 74. Over the last couple of years, improvements were
made in easing business creation, obtaining credit for businesses, dealing with
construction permits, registering property and employing workers. However,
despite progress with reforms, the Kyrgyz Republic still faces serious
structural weaknesses. Cross border
trading,  taxes' collection and access to the reliable and affordable
electricity still remained very problematic areas. Further efforts are
also necessary to strenghten property rights and fight corruption.

The banking
system was severely affected by the crisis. The level of nonperforming
loans was almost 16% at the beginning of 2011, but has been gradually declining
to 9.0% by June 2012. In April 2010, seven banks were put under
temporary administration. Subsequently, two banks were released from temporary
administration, four were placed under conservatorship and the biggest one -
Asia Universal Bank - was nationalised and separated into a "bad
bank" and a "good bank" (called Zalkar Bank). The role of the state in the banking system should be
reduced, and there is a pressing need for the authorities to restore trust in
the banking system through successful and transparent privatization of major
banks. However, several attempts by Kyrgyz authorities to privatise the
Zalkar Bank have already failed, the 5th auction of the bank being
cancelled in January 2013 because of the lack of bidders. Should the sale of
the bank not materialize, its liquidation may be the only remaining option. The
banking crisis also revealed deficiencies in the bank resolution powers and a
lack of de facto independence of the central bank, including its exposure to
interference by the government and the courts. Consequently, banking
regulations are being upgraded to a Banking Code to strengthen the central
bank’s early intervention and resolution powers and to guarantee its
independence.The domestic financial sector remains underdeveloped, lending interest rates are high and a significant part of
loans and deposits are denominated in foreign currency.

The political events of
2010 hindered progress in public finance management (PFM) reforms, but this
situation has been reversed. One of the main weaknesses in PFM is the system of
external audit and this area requires longer term support in capacity building.
The Law on the Chamber of Accounts (supreme audit institution) is broadly
adequate but the capacities of this institution need to be developed. The World
Bank is providing technical assistance in this area. Public procurement is
another source of concern. While there has been tangible progress on internal
audit in some line ministries (notably in the Ministry of Health supported by
the World Bank’s Health and Social Protection project), there remains
significant room for improvement.

Kyrgyzstan is a member
of the WTO and is a very open economy, with a trade-to-GDP ratio of almost
140%. The bulk of its exports (41% in 2010, 32% in 2011) goes to Uzbekistan,
Russia and Kazakhstan. In October 2011, Kyrgyzstan applied for membership of a
trilateral customs union (CU) between Russia, Kazakstan and Belarus. The main
benefits Kyrgyzstan expects to obtain from entering this CU, apart from possible
foreign policy considerations, is to preserve the supply of oil and gas from
Russia and Kazakhstan at favourable prices and to
limit the risk of disruptions in trade flows with those important trading
partners. Entering the CU would entail a number of significant costs, however.
First, it could jeopardize the Kyrgyz relationship with the
WTO, since the CU has relatively high Common External Tariff (CET).
What is more, a high tariff would diminish Kyrgyzstan's ability to import and
re-export inexpensive Chinese goods, restricting the important
transit trade with China, which provides employment to thousands of people in
Kyrgyzstan.

5.4.    Implementation of macro-financial assistance

The sharp
drop of economic growth and the worsening of the external position in 2010,
which were caused by the above described external shocks and internal political
and ethnic conflicts, led to a sizable external financing gap. In an
international donor conference in July 2010, the EU pledged to support the
recovery after the end of the ethnic conflict. In June 2011, the IMF
agreed with the Kyrgyz authorities on a three-year programme, to be supported
by an ECF arrangement (about USD 106 million). The ECF established a framework
for medium-term economic policy and reforms with adequate conditionality and
monitoring by the IMF Executive Board. However, the
external position remained vulnerable and the existence of a
considerable residual external financing gap for 2011-2013 was confirmed by the IMF and the Commission.

The Kyrgyz government
requested EU MFA support in October 2010 asking for a grant in the order of EUR
30 million to cover part of the external financing gap. On 20 December 2011,
the Commission submitted to the European Parliament and to the Council a
proposal for a MFA to the Kyrgyz Republic on an exceptional basis, proposing
EUR 15 million in loans and EUR 15 million in grants.

In addition to the
economic justifications above, the exceptional MFA operation, i.e. outside the
normal geographical scope of MFA, was justified by the strength of the
pro-democratic political and economic reform momentum in the country and by its
position in a region of economic and political importance for the EU. By
supporting the adoption of an appropriate macroeconomic and structural reform
framework, MFA can both underpin economic and political stability and increase
the effectiveness of interventions through other EU support instruments.

In order to ensure that
the Kyrgyz public finance management system provides sufficient safeguards for
the provision of MFA, the EC undertook an Operational Assessment (OA) of the
Kyrgyz financial circuits and procedures in June 2012. The OA mission concluded
that, despite weaknesses in internal and external audit and the need for
further improvements in several other areas, the Public Finance Management
system in the Kyrgyz Republic was sufficiently solid to provide reasonable
assurance about the use of the MFA funds to be provided by the EC.

The disbursement of MFA
will be conditional on the satisfactory implementation of the economic
programme agreed with the IMF and of a series of policy measures to be agreed
between the Commission and the Kyrgyz authorities in a Memorandum of
Understanding (MoU). The MoU conditions are expected to focus on PFM reforms,
coherent with the PFM conditions attached to the budget support programme
provided under the Development Cooperation Instrument and drawing on the
recommendations of the OA, as well as measures in other key structural reform
areas, including the banking sector.

However, the adoption of
the EC decision on a MFA operation to Kyrgyzstan has been delayed by
disagreements between the two co-legislators (European Parliament and Council)
over the procedures to be used for its implementation. It can be expected that
the MFA will be adopted by the co-legislators in 2013 and that a first
disbursement could still take place in that year.

In terms of other
sources of financing the residual financing gap, the World Bank, the Asian
Development Bank and also the bilateral EU programme, the latter through sector
budget support, will provide funds which will help covering the external
financing needs of the Kyrgyz Republic in 2013.

Summary Status of Economic Reform - Kyrgyz Republic

1. Price liberalisation Most prices are liberalised while administered prices are maintained for some utilities.

2. Trade liberalisation The Kyrgyz Republic is a member of the WTO since 1998 and is a very open economy, with a trade-to-GDP ratio of almost 140%. The bulk of its non-gold exports goes to Kazakhstan and Russia – which are members of a trilateral customs union (CU), also including Belarus. In April 2011, the Kyrgyz Republic applied for membership of this CU. However, entering the CU may clash with some of the Kyrgyz Republic's WTO commitments, since the CU has currently partly higher tariffs than the ones bound by the Kyrgyz Republic in its WTO commitments.

3. Exchange rate regime The central bank operates a managed floating exchange rate regime, allowing the exchange rate to adjust in case of substantial pressures or shocks while aiming at maintaining a competitive exchange rate.

4. Foreign direct investment Foreign direct investment and other private capital inflows were negatively affected by the global recession, but began to recover in 2010. In the coming years, FDI is expected to increase steadily, partly reflecting foreign financed energy investment projects.

5. Monetary policy The main target of the activities of the central bank is to guarantee price stability, while in practice it has to balance this with its task of maintaining the purchasing power of the national currency.

6. Public finances The IMF programme assumes a considerable effort of fiscal consolidation for the remainder of the programme period, with the fiscal deficit targeted to decline gradually to 3.9% of GDP by 2014. In particular, tax collection is planned to be strengthened by removing some tax exemptions, strengthening customs administration, shifting from weight-based to price-based customs valuation and reforming excise taxation on tobacco and alcohol.

7. Privatisation and enterprise restructuring The political change in 2010 led to the reversal of some privatisation deals in the energy and telecommunication sectors, made under the previous regime, due to allegations of nepotism and corruption. In 2011, government initiated privatisation in telecommunication and banking sectors, but in the banking sector, progress has been very slow. In particular, several attempts by the Kyrgyz authorities to privatise the large Zalkar Bank have already failed, the 5th auction of the bank being cancelled in January 2013 because of the lack of bidders.

8. Financial sector reform The banking crisis in 2010 revealed deficiencies in the resolution powers and degree of de facto independence of the central bank, including its exposure to interference by the government and the courts. Consequently, banking regulations are being amended and upgraded to a Banking Code to strengthen the central bank’s early intervention and resolution powers.

              Annexes

Annex 2: MFA amounts authorised by year
over 2003-2012 (in EUR million)

Chart 2A: MFA amounts authorised by year
over 2003-2012 (in EUR million)

Chart 2B: MFA amounts authorised by regions
over 2003-2012

Annex 3: MFA
amounts disbursed by year over 2003-2012 (EUR million)

Chart
3A: MFA amounts disbursed by year over 2003-2012 (in EUR million)

Chart
3B: MFA amounts disbursed by regions over 2003-2012

[1]       Bosnia and Herzegovina is composed of two first-order
administrative divisions (entities) - the Federation of Bosnia and Herzegovina
and Republika Srpska, each having its own (entity) government, linked by a weak
federal government.

[2]       For a detailed account of the implementation of the programme,
please see Report on the implementation of MFA to third countries in 2011 and
the Commission Staff Working document accompanying the Report (COM(2012) 339
final and SWD(2012) 181 final, of 26 June 2012).

[3]              The territories of Abkhazia and South Ossetia are
excluded from the analysis due to lack of data.

[4]       The 2013 WB index covers ten topics related to the operation
of a local business: starting a business, dealing with construction permits,
getting electricity, registering a property, getting a credit, protecting
investors, paying taxes, trading across borders, and enforcing contracts

[5]       Regulation (EC) No 182/2011 of the European Parliament and of
the Council of 16 February 2011.

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