Ukraine - Country economic memorandum (Vol. 1 of 2) : Main report

Report No. 10029.UA Ukraine Country Economic Memorandum (In Two Volumes) Volume I June 2, 1993 Country Operations Division 2 Country Department IV Europe and Central Asia Region FOR OFFICIAL USE ONLY MICROFICHE COPY Report No.:10029-UA Type: (ECO) Title: COUNTRY ECONOMIC MEMORANDUM - Author: ROSENTHAL, FRANCIS Ext.:37257 Room:H2041 Dept.:EC4C2 2 VOLS Document of the World Bank This documient has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  URRENCY EOUIVALENTS Currency Unit: Karbovanets EXCHANGE RATE U.S.$ 1 = karbovantsi 715 (December 1, 1992) FISCAL YEAR January I - December 31 ABBR fVIATIONS CMEA Council for Mutual Economic Assistance EC European Community FSU Former Soviet Union GDP Gross Domestic Product GNP Gross National Product NBU National Bank of Ukraine NMP Net Material Product VAT Value Added Tax  FOR OFFICIAL USE ONLY UKRAINE COUNTRY ECONOMIC MEMORANDUM VOLUME 1 CONENTS Page No. Executive Summary ..............,,,,,, i 1. Introduction. 1 2. Recent Developments and Medium-Term Prospects ...................... 2 Recent Economic Developments ............................... 2 Medium-Term Prospects .................................... 5 3. The Prerequisites of Economic Growth .............................. 13 Macroeconomic Stabilization: The Establishment of Noninflationary Expectations ............................ 13 Fiscal Policy ...................................... 14 Incomes Policy ..................................... 18 Monetary Policy .................................... 18 Private Sector Development: Incentives and Signals .................. 19 Pricing and Distributiop ............................... 19 Taxation Policies ...... I .......................... 24 External Sector Policies ............................... 25 The Legal Framework: The Inner Workings of a Market Economy ....................................... 29 4. The Foundation of Economic Growth: Priorities in Privatization .............. 31 Land Reform and Fanm Privatization ............................ 31 Privatization of State Enterprises ............................... 35 5. The Mainstay of Economic Reform .......................... ... 42 The Financial System .......... ................... 42 Labor Market Policies ............ ................. 47 Social Expenditures ............................ 51 BIBLIOGRAPHY ................................................. 57 MAP This document has a restricted distribu.ion and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  List of Text Tables, Boxes and Figures Text Tables Table 2.1 Evolution of NMP in 1990 Constant Prices, 1989-92 .................. 2 Table 2.2 Output Collapse in Transition Economies, 1990-92 ................... 6 Table 2.3 Total and Intraregional Trade as Share of NMP, 1989 or 1990 ............ ............................... 6 Table 2.4 Trends in Macroeconomic Variables, 1991-2000 ..................... 9 Table 2.5 Indicative Financing Requirements, 1992-95 ....................... 10 Table 3.1 Size of the Government in Selected Middle Income Countries, 19?3 ......................................... 15 Table 5.1 Public Social Spending, 1989 and 1990s ......................... 52 A o es Box 3.1 The Practice of Incomes Policies .... 20 Box 3.2 Private Enterprises and Perceptions of Obstacles to Growth ....... .......... 26 Box 3.3 The Symmetry Between Export and Import Taxes .................... 27 Box 4.1 The Traditional Farm Enterprise in Ukraine ........................ 32 Box 4.2 Mass Privatization and Vouchers .............................. 39 Box 5.1 The Financial System of Ukraine .............................. 43 Box 5.2 Housing Privatization and Development of a Housing Market .... ......... 48 Figures Fig. 5.1 International Comparison of Employment by Economic Sector, Late 1980s .47 Fig. 5.2 Percentage of GDP Spent on Active and Passive Labor Market Policy in OECD Countries and Ukraine, 1992 .50 Fig. 5.3 International Comparison of GNP Devoted to Social Sector Spending .53 Thta~pot~sbase on onthatvistedlUev ba e~id H~I' 1- My ,199 nlacsnt sbn~~~~~~~a a* - t40 ,p8 w::Z~~~~~.( d *. i .. ig W., eiti secetariaassiane Mr. Abin and Msa. Le Gali were responsible for the p on ofth *irall repo;t.  UTKRAINE COUNTRY ECONOMIC MEMORANDUM VOLUME II CONhNTS ANNEXES Annex A: Privatizadon ............................. 1 Annex B: Private Sector Development . ............................. 7 Annex C: Financial Sector Development ................................. 21 Annex D: Industry ............................. 50 AnnexE: Agriculture ............................. 72 Annex F: Energy Sector ............................. 113 Annex G: Transport Sector ............................. 122 Annex H: Environmental Sector ........... .................. 147 STATISTICAL APPENDIX  EXECUTIVE SUMMARY I. Independent Ukraine has the potential to join the group of the world's rich societies. The country has a land mass that is the largest In Europe (with the exception of European Russia) and a population of 52 mililon that ranks fifth in Europe, only slightly less than that of France, Italy or the United Kingdom. It also has a highly educated labor force, fertile agricultural land, and significant coal deposits. Yet, economic performance is steadily deteriorating. The economy is caught in a "no man's land" where central planning Is foundering, but no market system is in place. 2. A key challenge now facing Ukraine is to secure the transition from a centrally planned to a market-oriented economy. Seventy years of Soviet control have left the country with a structure of production and trade that reflects the political economy objectives of central planners rather than the most efficient use of resources, and thus, with a poorer population. At its most basic level, the shift to a market economy will require a radical change in relative prices, and correspondingly, a major reallocation of resources. This transformation will not be painless, but it constitutes the very basis of future growth and improved living conditions for the people of Ukraine. 3. The process of defining the institutions and policies to make the transition to a market economy is underway. In this regard, the role of the Government will necessarily evolve. It will no longer be focussed on close involvement in productive activities, but instead on macroeconomic and structural policies supportive of efficiency and growth in these activities. At this stage, the Government must deal simultaneously with three overriding issues. First, it must provide a stable macroeconomic environment -- both to control inflation so that prices give meaningful signals for resource allocation and to mitigate the short term decline in production. Second, it needs to carry out systemic reforms including the transfer of ownership from the state to the private sector, for without these reforms, there will be no supply response and only fitful stabilization. Third, it will have to protect the poorest groups of society. This report analyzes the critical issues and options in each of these main areas, and lays out a reform agenda for Ukraine's transition to a private market economy. RECENT ECONOMIC DEVELOPMENTS 4. In recent years, economic and financial imbalances in Ukraine have become very serious, as evidenced by the chronic state of excess demand, the emergence of fiscal deficits, and growing pressures on the balance of payments. Output has fallen continuously since 1990; real net material product (NMP) registered declines of 3 percent and 11 percent, respectively, in 1990 and 1991, and is estimated to have contracted by another 16 percent in 1992. Despite its size, Ukraine depends heavily on trade in general and on trade with the former Soviet Union (FSU) in particular. Thus, the collapse in trade with the FSU has had an especially disruptive effect on the economy, leading to domestic shortages of many essential inputs (notably petroleum products) and consumption commodities. In addition, inflation has come out into the open, the result mainly of lax financial policies. The r,artial price liberalization in early 1992 should have been a one-shot adjustment to the hidden or repressed inflation built up In past years, and indeed, retail prices rose by 240 percent in January relative to December 1991. However, inflation continued unabated, reaching a monthly rate of about 30 percent by the end of 1992, and averaged almost 1,500 percent for the year as a whole. The persistent inflation has been fed by monetization of a widening fiscal deficit, a dramatic expansion in credit to eraerprises, and indiscriminate wage hikes in state-owned enterprises; higher import prices for energy have also been a contributing factor.  5. Macroeconomic policies have not been consistent with stabilization. An incomes policy based on mandatory wage indexation contributed to a 10-fold increase In nominal wages from the first quarter of 1991 to March 1992, compared with an 8-fold increase in retail prices during the same period (in response to such developments, a tighter incomes policy was Implemented during the first quarter of 1993). Following years of balanced budgets, the state budget of Ukraine swung into a defic:t equivalent to 14 percent of GDP in 1991 on account of higher outlays, notably on subsidies and the social safety net. The fiscal imbalance widened again in 1992 as the state budget deficit reached an estimated 18 percent of GDP. Taking into account quasi-fiscal payments, mostly to loss-making enterprises channeled through the banking system, government operations registered a deficit equivalent to approximately 33 percent of GDP. The loss of fiscal control has spilled over into the financial sector as credit to the Government has risen sharply. As noted above, there has also been a massive increase in credit to the enterprise sector, i.e., almost two-fold in 1991 and by a factor of 17 from end-1991 to end-1992. All In all, the monetary system has broadly accommodated the rise in prices. The excessively expansionary monetary and credit policies of the authorities have been facllitated by the introduction in January 1992 of the karbovanets or coupon. First brought into circulation in response to a shortage of ruble bank notes, the karbovanets became the official currency unit when Ukraine left the ruble zone in November 1992; the official exchange rate was initially set at 1.454 karbovantsi per ruble. 6. The performance and behavior of state enterprises too have been a key ingredient in the financial deterioration. Many state enterprises are in a precarious financial position themselves, which has led to lower government revenues from profits and greater pressures for subsidies. In addition, many of these enterprises now operate in a limbo where ownership rights are ambiguous. Uncertainty over the future has in all likelihood shortened the time horizon of workers and managers, inducing them to appropriate the assets of the enterprises. In particular, workers have been granted large wage increases, notwithstanding a severe drop in average labor productivity. AN AGENDA FOR ECONOMIC REFORM 7. In December 1992-January 1993, the Government issued in quick succession numerous decrees in such areas as taxation, pricing, and foreign trade in an effort to initiate the process of economic change. However, an integrated and comprehensive approach to reform - incorporating three major elements - is needed to address the problems of the Ukrainian economy. The first group of measures, to be implemented in the short-term, includes steps aimed at reaching macroeconomic stability as well as actions designed to encourage development of the private sector, namely correct price signals and incentives, and clear laws and regulations that guide economic agents in their decisions. Second, privatization, which could help secure for Ukraine the base of a market economy, would in all likelihood cover the short to the medium term. Third, such a reform package could not be implemented without two essential support mechanisms, i.e., a sound banking system and an adequate social safety net. The overhaul of the financial sector and social sector programs would undoubtedly be a lengthy process, but should be initiated promptly so as not to delay adjustment and structural change in other fields.  - iii - MACROECONOMIC STABILIZATION 8. The establishment of al non-inflationary setting for economic growth calls for rigorous demand management policies. Since the government deficit is a significant contributor to excess demand pressures, it will depend heavily on a reorientation of fiscal policy. 9. The 1992 revised budlget was based on the premise that the Government must be predominant in the economy, and in this capacity, receive a disproportionate share of available resources. In essence, a very high level of taxation was to be used to distribute an average level of benefits to the entire population through a myriad of social programs. Thus, the targeted shares of revenue and expenditure in the consolidated budget (the combined republican and regional budget plus the Pension Fund, the Social Insurance Fund, and the Employment Fund) -- 53 percent and 59 percent of GDP respectively - were among the highest in the world. As of 1993, the authorities need to set more realistic targets for revenue, and cut and restructure expenditute. An incomes policy that encompasses both incentives and penalties for enterprises to observe wage guidelines could bolster a restrictive fiscal policy. 10. Realism in p'blic finance means, among other things, recognizing the difficulties in mobilizing revenue during the transition. As mentioned previously, the fragile position of state enterprises could translate into lower transfers to the budget in the form of income taxes. More generally, the main sources of revenue can be expected to come under stress at the very time when the demands on available resources for payment of unemployment and welfare benefits are likely to increase. In 1992, the VAT yielded roughly 13 percent of GDP, and receipts from income and profits 11 percent of GDP, well below the albeit excessively ambitious targets of 23 percent and 18 percent of GDP. A number of measures can offset these forces, namely a broadening of the tax base, and limits on exemptions and tax holidays, as these apply to the value added tax, and the personal and corporate income tax; increases in the rates for selected excise taxes; and imposition of a relatively uniform customs duty on all imports from outside the FSU. In fact, the authorities have recently taken various steps along these lines. 11. Even with a stronger revenue performance, much of the needed improvement in the fiscal deficit would have to come from cuts in expenditure together with a change in its composition. Spending on social programs including subsidies and pensions, which was budgeted at 44 percent of GDP in 1992, could be reduced while providing a minimum level of income for the most vulnerable groups. Work is now underway in Ukraine to determine who should be targeted to receive benefits and to develop an appropriate mechanism to channel these benefits. The focus of the Government would include the needs of invalids, poor children, and pensioners with incomes less than 1.5 times the minimum wage. There is also a wide range of programs that should be reexamined with a view to identifying further savings. These are programs for which it may be inappropriate to involve the public sector or for which thorough feasibility studies have not been conducted. They encompass such areas as investments in the agro- industrial complex; reconstruction of enterprises inherited from the union; capital investments under "funding the national economy"; and benefits related to Chernobyl and the repatriation of groups from the FSU. Moreover, the banking system should not be forced to provide subsidized credit or make irrecoverable loans to finance operating losses of state-owned enterprises. The experience of 1992, when quasi-fiscal payments directed through the banks to producers in industry and agriculture reached about 15 percent of GDP, shows that such credits weaken the budgetary process, fuel inflation, and slow needed restructuring by creating expectations of future "bail-outs".  - iv - 12. Notwithstanding the crucial role of the public flnances, monetary policy would be called upon to play an active part in the stabilization effort, one that would become stronger as the flnancial system evolved. At the moment, a serious problem is the ilability of the National Bank of Ukraine (NJ3U) to conduct effective monetary policies. In this regard, it Is of considerable importance that the NBLJ be granted operational and financial independence. In addition, the NBU would have to make better use of the principal monetary instruments at its disposal - reserve requirements, and especially, the quantity of credit that it extends and the rate of interest charged on this credit (80 percent in 1992 compared with an annual average rate of inflation of almost 1,500 percent). First, in support of a tight fiscal policy, the NBU would have -1 limit strictly its financing of the government deficit, and through the establishment of ceilings on commercial bank lending, credit to the economy as well. Second, an active interest rate policy, i.e., one that allows for more frequent adjustments in interest rates, would be crucial to an efficient allocation of resources. Therefore, o. the basis of expected inflation, the NBU should increase its refinance rate to a level that is positive in real terms. This step would come after strict fiscal policies had been implemented; otherwise, the higher interest rate would simply translate into higher government indebtedness. Full liberalization of interest rates would come at a later stage once the portfolios of the state lending banks had been restructured and competition in the banking system established. THF, MECHANISMS OF A MARKET ECONOMY 13. A market economy rests in large part on mechanisms that work "behind the scenes" to allocate resources. These consist of appropriate price signals and incentives that influence economic agents, and a legal framework that establishes the "rules of the game". Pricing, Distribution, and Taxation 14. The policies of the Government in these areas have often run contrary to the direction of a market economy. Subsequent to the partial liberalization of prices on January 2, 1992, the authorities introduced extensive and sector specific controls in an attempt to contain larger than expected price increases. These types of controls are very difficult to administer, and as shown by the numbers on inflation cited above, were not effective in limiting overall price increases. Against this backdrop, the Government passed a decree in December 1992 that reduces the scope of administered prices, liberalizing virtually all food prices. However, it requires prior notification and government approval of price increases contemplated by state enterprises until a mechanism to regulate the prices of goods and services of monopolistic enterprises is put in place. Thus, the decree implicitly extends price regulation to a potentially large sector of the economy. 15. The way to bring down core inflation is not to maintain price controls, but to follow up on government plans to implement tight budget, credit, and wage policies; promote easy entry into and exit from economic activities; enact regulatory reform (including demonopolization, partly through divestiture or liquidation by large firms of many of their activities); and carry out rapid small-scale enterprise privatization (particularly of shops and transport services). The authorities would also be advised to support an open foreign trade regime and unimpeded trade between oblasts. Moreover, they should act quickly to open up government orders to competitive bidding and abolish state orders. Within this context, the Government must act swiftly to remove the price controls on tradable goods, and to  .V. adjust prices for nontradables (public utilities, urban transport, and rents) so as to attain full cost recovery over the next 2-3 years. In agriculture, it is vital that producer prices be allowed to respond to market forces, and that relative producer prices be consistent with price patterns on world markets. The question is then how to safeguard the living st-ndards of poor households. In this respect, it Is worth noting that the centralized system (i.e., fixed prices of basic goods in state shops and obligatory delivery) has not done a good job; It has been costly, poorly targeted, and inefficient -- good reason to restructure social expenditures as noted earlier. In the energy sector, given that Ukraine will have to pay higher prices for its imports, the Government should begin now to introduce a new set of policies, and raise the prices of traded energy goods so that they fully cover import, transport, and distrlbution costs; the adjustment applied to households could be more gradual. 16. Taxation also helps define the relationship between the Government and economic agents. It has a significant impact on investment decisions, directly because it affects profit levels and relative incentives, and indirectly because it signals the Government's attitude towards private enterprise. At present, businesses widely view the tax structure as punitive. Accordingly, efforts to Improve revenue performance within the framework of a stabilization package should hinge on an expanding tax base, rather than on high rates. External Sector Policies 17. Foreign trade, notably with the other republics of the FSU, has had an adverse effect on the Ukrainian economy in the past few years as various links broke down. By the same token, it could have a beneficial influence In the future as trade flows pick up. Thus, together with liberalized prices, appropriate incentives to trade, and mainly to export, are essential. Despite a move to greater openness, the trade regime adopted by decree of the Cabinet of Ministers in January 1993 maintains numerous restrictions on foreign trade. Twenty-six categories of exports are subject to quotas and licenses, with the export quotas to be allocated in part through an auction system. Export taxes are to be levied on a similar number of categories and an export surcharge of 5 percent on all goods except for those covered by intergovernmental agreements. Regarding imports, customs duties are to be applied as recommended by the World Bank and International Monetary Fund. In order to minimize distortions In trade pattenis and limit the demands on the customs administration, it is important that the tariff structure be kept relatively uniform and low (about 15 percent), and that only e..emptions in accordance with international conventions be accoided. As for interrepubli- trade, much of the flow takes place within bilateral agreements. 18. Concerted action is needed to eliminate the remaining obstacles to export growth and orient trade policy toward export promotion. The Government should move rapidly to eliminate the system of export taxes - which it can be shown are equivalent to import taxes - and of export licensing, and continue to improve the payments system. In an effort to shield domestic enterprises from severe shock as the domestic market is opened to foreign competition, a sensible policy during the transition would be to rely on an import tariff as described in paragraph 18. Finally, exchange arrangements could be a powerful tool in an export drive. In view of the constraints imposed by budgetary pressures, a central bank that for the time being lacks in independence, and a shortage of foreign reserves, Ukraine would be best served by adopting a system based on a unified foreign exchange market.  -vi - Legal Framework 19. The legal framework must be consistent with the workings of a market economy, i.e., it must establish rules that are simple, transparent and stable, and that foster competition. A legal framework that Is supportive of the private sector will indirectly contribute to greater flexibility in the economy and to an Increase In employment opportunities. 20. The most fundamental legislation required by the private sector relates to the protection and transferability of private property, the enforcement of contracts, and mechanisms for dispute resolution and administrative appeal. Much of this legislation is in place in Ukraine. Yet, alongside laws that promote the expansion of the private sector, there must be legislation on bankruptcy procedures to weed out inefficient and loss-making enterprises, mostly those in the state sector that will be unable to survive in a new and open environment. More generally, emphasis should be placed on enhancing the precision of the laws and promoting observance of market rules rather than administrative flat. 21. Laws that allow for the dismantling of monopolies and for free entry and exit, and that encourage the development of a real estate market are also of great significance. The Ciovernment recently formed an Antimonopoly Committee, which as a signal of its commitment to demonopolization, should quickly target a few important enterprises and break them down into smaller entities. The achievement of free entry requires the elimination of regulatory and legal harriers, namely those regarding "legalization" of business activlties, business registration, and regulation mechanisms. Since the lack of access to larnd, office space, and productive premises has become a hindrance to the establishment and expansion of prlvate businesses, the authorities should develop a land policy that allows land and buildings to be available to new enterprises. Given that widespread transfers of property with proper documentation may take considerable time to realize, the approach in the short-term should be to develop a transparent and standard approach to leasing. In parallel with the leasing and/or sale of real estate owned by the public sector, the sale of other assets by existing enterprises should be encouraged. This would release a large source of equipment for private enterpr1ses, particularly in view of the shortage of foreign exchange for imports. PRIVATIZATION AND ENTERPRISE REFORM 22. Privatization in Ukraine is a task of vast proportions. In the agricultural sector, there are 8,800 kolkhozes (collective farms) and approximately 2,600 sovkhozes (state farms). In the state enterprise sector, there are an estimated 60,000 small enterprises, more than 40,000 small to medium enterprises, and about 6,000 large enterprises. In determining the priorities in privatization, the authorities should consider privatizing first those sectors where (a) the potential for short-run growth is the greatest, (b) the gains arising from increased flexibility are maximized, and (c) the distortions arising from monopolistic structures are minimized. This approach would call for agricultural units and small- scale units in such sectors as trade, distribution, and transport to be privatized without delay. Agricultural Sector 23. In parallel with the adjustment of agricultural producer prices, reform of tie kolkhoz and sovkhoz system is needed so that producers are able to respond to a very different set of relative prices. It will not be sufficient to make limited changes to the koUdioz/sovkhoz system; the goal of land reform  vii - must be full private ownership in a market framework., Thus, the reform of land ownership should encompass land currently held by kolkhozes and sovkhozes as well as the small amount of unused agrlcultural land, and should start with an immediate titling of land to the kolkhoz/sovkhoz members. Under this approach, every individual would receive a plot of land free of charge or with a symbolic payment. fhis basic allotment would be determined according to local conditions and would be free from any restriction on use, including sale and rental. As part of the restructuring and privatization of the kolkhoz/sovklhoz, members should be free to decide on the futuro form of farming, and other assets as well as land should move to private ownership. The break up of large farms into more manageable units should be encouraged, while the creation of structures based on faceless ownership, such as closed type shareholding companies, should be avoided. Finally, the privatization of agricultural processing and marketing and of the farm supply network will be required in rder to support the emerging private agriculture. State Enterprise Sector 24. Privatization of the state enterprise sector is probably one of the most challenging and critical of the systemic reformis to be undertaken in Ukraine. In order to minimize the obstacles along the path of privatization, the authorities would be advised to tackle first the issues and programs that cover a shorter time horizon. This would involve establishing a general framework for privatization, i.e., setting up the required institutions and laws (much has already been done in this area), strengthening implementation capacity, and breaking down monopoisidc patterns of behavior; carrying out small-scale privatization; and undertaking the preparatory work for mass privatization. It is recognized that the process of mass privatization itself will likely span the n. 'ium-term. Accordingly, the authotities must clarify early on which enterprises are to remain in the public sector for some time, and reform corporate governance. 25. Small-Scale Enterprise Privatization. The decision has been made in Ukraine to proceed rapidly with small-scale enterprise privatization. The fastest way to privatize small enterprises, mainly engaged in wholesale and retail trade, construction, food, and trucking, would be to auction their assets, and in some cases, also lease their buildings. In order to advance along these lines, the authorities must take action promptly to amend a number of legal provisions, for as currently drafted, they could produce serious delays in small-scale enterprise privatization. These relate to the right of employees and citizens to use 'trivatization certificates' (vouchers) to buy small enterprises at auctions; the corporatization of small enterprises before sale; and the provision linking small-scale enterprise privatization to the introduction of the new currency, the hryvna. 26. Mass Privatization. At this stage, the authorities need to formulate a comprehensive and coherent program of mass privatization. The plan should satisfy four principal requirements in order to have a chance of success. First, it must incorporate an ambitious yet realistic pace of privatization. Second, the plan must be transparent and clear to society. Third, the plan must promote effective control over the management of privatized enterprises. And four, it must allow access to foreign capital and expertise. 27. The design of a mass privatization program, including the specific mechanism for distributing vouchers, should take into consideration the following points. In the first place, the scheme should give priority to administrative simplicity; other goals such as equity and revenue maximization are important but secondary. It should avoid mechanisms that involve detailed valuation or complex share  - viii - distribution to the public. Moreover, the distribution of vouchers cannot be drawn out over time. The program itself should be implemented in sequential tranches of firms in order to be able to tust the design and make any necessary adjustments in the light of experience. In addition, privatization should allow sales to controlling shareholders who will press for better management performance; widely dispersed ownership through non trading shares, employee shares, or sales to small shareholders does not provide the incentives to improve management. And finally, investment funds should be created to provide a means by which the number of voucher holders can be consolidated. These funds would allow for greater concentration of ownership which is vital to effective governance. 28. Corporate governance. Given the sheer number and weight of state enterprises, and the administrative constraints on the pace of privatization, it is .nevitable that a significant number of enterprises will remain in the public sector in the medium term. Many enterprises exist in a vacuum - no effective ownership rights, no hard budget constraint, and no bankruptcy procedures - and their operations are plagued by inefficiency and significant losses. With a view to putting an end to these patterns of behavior, the Government must take ste2s to establish clear ownership; impose a hard budget constraint; formulate a limited set of achievable, commercial goals for enterprises; provide sufficient autonomy to managers; and create mechanisms by which the representatives of the owner can monitor performance, reward success, and punish failure. 29. There is an overwhelming need to clarify the ownership and strengthen the governance of enterprises that will not be privatized in the short term. To this end, the authorities have proposed to cotporatize most medium and large-scale enterprises by July 1993. Such a step generally involves the transformation of state enterprises into joint stock companies (with the Government as sole shareholder) and the appointment of outside diretors. In an economy with a private sector still unable to shape the behavior of state-appointed directors, corporatization is unlikely to result in a widespread improvement in enterprise operations; however, it could provide a remedy for the worst cases of mismanagement and abuse. 30. Hardening of the budget constraint on enterprises will be indispensable for restructuring and reform. In simple terms, enterprises with access to unlimited budget subsidies or bank credit have no incentive to reform; they can continue to operate regardless of demand for their products or the profitability of their operations. This has certainly been the case in Ukraine. In 1992, payments channeled through the banking system to state enterprises, mostly loss-makers, totaled approximately krb 340 billion, or 9 percent of GDP, and support for agriculture reached krb 210 billion, or 5 percent of GDP. 31. Government subsidies need to be cut drastically and linked to performance under restructuring plans. There should be a realistic assessment of the financial needs of the enterprises during the transition and a phased reduction in transfers consistent with macroeconomic targets on the reduction of the budgetary deficit. All subsidies should be transparent and made through the budget, rather than through tax concessions, subsidized credit from the banking system, or the accumulation of inter- enterprise arrears. Furthermore, the Government should not guarantee loans to enterprises from the banking system. If these measures are not implemented in a coordinated manner, there is a serious risk that enterprise losses will accumulate and that the budgetary burden will be increasingly transferred to the banking system, with distressing consequences.  - a - TH FNANCIAL SYSTEM 32. As a major element in economic reform, the financial system in Ukraine must change from being an agent called upon to provide the credit necessary to facilitate implementation of decisions made by planners and administrators (as reflected in the physical plan) to being a system that mobilizes domestic resources and allocates them efficiently. 33. At present, the financial system is unable to perform these functions. In this regard, state-controlled lending banks have no deposit base since until recently the Savings Bank had a monopoly on deposit-taking from households. And as nominal interest rates have ranged from zero to 200 percent (end-1992) compared with an estimated average annual inflation rate of roughly 1,500 percent in 1992, it is extremely unattractive to hold financial assets. On account of public policy considerations, these state-owned banks still lend to state enterprises that are not creditworthy. As a result, the portfolios of the state lending banks are of poor quality. Limited supervision and prudential regulation have allowed small financiUl companies that go by the name of 'commercial bank", but that in fact are simply the financial arm of state enterprises, to proliferate. In brief, the system perpetuates the existence of fragile financial Institutions with concentrated loan portfolios and significant credit outstanding to unprofitable firms. It also discourages market-based credit decisions and limits the amount of credit available to the private sector. 34. Under these circumstances, reform of the financial sector should focus on ending the serious misallocation of resources through the four largest banks (including the Savings Bank), which account for more than 98 percent of total bank assets, and ensuring that adequate financing will be available to the private sector. In turn, this broad objective calls for steps to phase out directed credits, clean up the relationship between banks and state enterprises, promote bank competition, and improve supervision of the banking system. In addition, the NBU itself will have to be strengthened. 35. The restructuring of the Savings Bank is crucial to the more productive use of household deposits. As part of the effort to generate competition in the banking system, the monopoly of the Savings Bank on household deposits has been lifted. In keeping with this approach, the overhaul of the bank could involve the sale of branches to the commercial banks (including state banks once they themselves have been restructured) that will be required to meet stricter standards in a new banking system, and sound development of its lending capacity at the level of consumer loans (and later in the housing market). In the longer-run, it would be appropriate for the Government to divest itself from the Savings Bank and perhaps to privatize it as well. 36. The authorities also need to restructure the portfolios of the state lending banks, taking into account the effects of such a process on the budget, the banking system, and the privatization program. One approach is to transfer the bank losses to the Government or a special state agency, and proceed to recapitalize (through the issuance of government bonds), corporatize, and privatize the banks. Another approach is to share the responsibilities and financing of a restructuring program between the Government and the banking system. Whatever the strategy adopted, the restructuring of the bank portfolios would have to go hand in hand with the restructuring and privatization of state enterprises - after all, the behavior of these enterprises is at the origin of the problem. 37. As part of a financial reform program, the authorities might consider, in P. first step, establishing a 'core' banking sector whose privileges and responsibilities would distinguish it from other kinds of financial entities. Whether or not the Government adopts this approach, it is recommended that  -x the proliferation of inadequately regulated and supervised commercial banks be controlled by immediately curtailing the NBU's issuance of licenses for commercial banks. Moreover, alongside development of new prudential regulations, existing conamercial banks should be encouraged to consolidate through mergors or to close down. THE SOCIAL SECTORS 38. During the transition to a market economy, the social policies of the Government must address the problems of unemployment and poverty, and provide satisfactory health and education services. At the same time, they should not increase the burden on the public finances or create disincentives for a rapid reallocation of labor to new opportunities. In 1992, the cost of Ukraine's program of social protection was budgeted at 44 percent of GDP, and two thirds of spending by the state and oblast budgets and social funds. These shares are very high by international standards and exceed the resources of the Government. Thus, the state must cut back on its obligations, concentrating on reductions where they will do the least harm to the vulnerable groups. 39. Against this backdrop, a top priority of the Government in the short term should be to establish a benefits scheme that meets the basic needs of the unemployed and that can be sustained. The present system is best suited to cope with short-term cyclical unemployment: benefits are related to earnings, and the initial replacement rate is 100 percent (paid by enterprises for 100 days from the date of notification of layoff). Given the prospect of prolonged, structural unemployment in Ukraine, it will not be possible to maintain the current level of unemployment benefits. The Government would be advised to introduce now, when unemployment remains very low, a scheme of flat benefits that are independent of previous cash earnings. 40. More generally, as the system of unemployment benefits is restructured, the Government will have to strengthen the social safety net by adopting a program of social assistance benefits that targets minimum income support to the poorest segments of society. On this basis, policies to construct an adequate social safety net would include restriction of unemployment benefits to a flat rate (see above) or perhaps to two or three payment levels dependent on age and experience; a gradual increase in the retirement age; introduction of a unitary benefit for all pensioners as an emergency measure until the economy improves; elimination of untargeted food subsidies; a shift in curative health care costs to patients who can afford to pay; and efficiency gains in schools and their administration. 41. The shift of financial resources sand capital) to growing sectors of the economy will h2ve to be accompanied by a shift of labor to the same sectors. Hence, the Government needs to ease the structural constraints on labor mobility by strengthening employment services, and improving training and retraining programs. Labor mobility would also be increased by privatization of the housing stock and the development of a housing market, a restructuring of the education system towards the acquisition of general skills, and the inclusion of job search strategies in both secondary schooling and adult retraining.  - xi - MEDIUM-TERM PROSPECTS 42. On the assumption that a far-reaching reform program, as described in the sections above, is carried out as of the first half of 1993, Ukraine should be able to moderate the decline in economic activity in the next two years, and to set the stage for a resumption of growth thereafter. In order to enhance growth prospects and show tangible results from reform, the Government should first concentrate its efforts on those sectors with the greatest potential in the short to medium term. Given rigorous macroeconomic policies, agriculture and small-scale activities in retail trade, distribution, and transport could offer a relatively quick response to improved incentives on the supply side. With consumption and investment constrained by the need for fiscal and monetary discipline, exports would be best suited to stimulating the economy on the demand side. 43. Tentative projections suggest that real GDP would decrease by a total of 17 percent in 1993-95, compared with 24 percent in 1991-92; it would begin to increase as of 1996, and average a rate of growth of 4 percent per annum during 1997-2000. This scenario, while seemingly modest, calls for an unflinching commitment on the part of the Ukrainian authorities to macroeconomic stabilization and structural reform. The strict implementation of such a policy package is also necessary for Ukraine to secure full commercial creditworthiness. In view of the extraordinary combination of circumstances that prevails -- the country has only recently gained its independence, faces the challenge of having to transform its economy, and has no credit record -, progress toward this goal will take some time. In the interim, economic recovery will depend in part on financial and technical support from the international community. Assuming that the prices of energy imported from the FSU increase very quickly (with the price of oil reaching world levels in mid-1994 and that of gas more than 90 percent of the world price by 1995), and that Ukraine does not assume responsibility for debt service payments on its share (16.37 percent) of the external debt inherited from the FSU, external financing requirements could reach US$11.0 billion for the period 1993-95, or about US$3.7 billion annually. The cumulative current account deficit (excluding scheduled interest payments) would represent US$7.7 billion or 70 percent of total requirements.  CHAPTER ONE INTRODUCTION 1.1 Ukraine is the largest country in Europe, geographically, with the exception of the European part of Russia. It has a population of 52 million, only slightly less than that of France, Italy or the United Kingdom, and five cities of more than one million inhabitants. It also has a highly educated labor force, fertile agricultural land, and significant coal resources. Independent Ukraine has the potential to join the group of the world's rich societies. At this junction, Ukraine faces the immense challenge. of creating the institutions of a sovereign state while securing the transition from a centrally planned to a market-based economy. 1.2 Management of the transition to a market economy will be a complex task. Seventy years of Soviet control have left the country with a structure of production and trade that reflects the political economy objectives of central planners rather than the most efficient use of resources, and thus, with a poorer population. At its most basic level, the shift to a market-oriented economy will require a radical change in relative prices, and correspondingly, a major reallocation of resources. This transforation constitutes the very basis for future growth and improved living conditions for the people of Ukraine. 1.3 The role of the Government will necessarily evolve. It will no longer be focussed on close involvement in productive activities, but instead on macroe-xonomic and structural policies supportive of efficiency and growth in these activities. At this stage, the Government must deal simultaneously with three overriding issues. First, it must provide a stable macroeconomic environment -- both to control inflation so that prices give meaningful signals for resource allocation and to mitigate the short-term decline in production. Second, it needs to carry out systemic reforms including the transfer of ownership from the state to the private sector, for without these reforms, there will be no supply response and only fitful stabilization. Third, it will have to protect the poorest groups of society during the transition. 1.4 This report analyzes the critical issues and options in each of the above areas, and lays out a reform agenda for Ukraine's transition to a private market economy. The annexes provide descriptive information and detailed analyses of key questions and major sectors of the economy.  CHAPTER TWO RECENT DEVELOPMENTS AND MEDIUM-TERM PROSPECTS RECENT ECONOMIC DEVELOPMENTS 2.1 Output and Expenditure. Ukraine has gained its independence and initiated the transformation to a market economy at a time of rapidly deteriorating economic conditions. In particular, output remains on a downward path, real net material product (NMP) having fallen by 3 percent and 11 percent, respectively in 1990 and 1991, and by another 16 percent approximately in 1992 (Table 2.1). A number of macroeconomic forces have combined to hurt production in Ukraine, foremost among them the disruption in trade with the republics of the former Soviet Union (FSU). Its signiffcance reflects the large prior dependence of Ukraine -- despite its size - on interrepublic trade, mainly with Russia. In 1990-91, imports from the other republics of the FSU were equivalent to 38 percent of NMP, and exports to the republics, 33 percent of NMP.1 In the wake of the break up of the FSU, imports of raw materials and energy goods have been in increasingly short supply and industry, which accounts for 42 percent of NMP, has been especially hard hit. Moreover, export markets have collapsed. Roughly one third of exports came from the machine-building sector, with a large but unknown proportion destined for military purposes. The demand fbr military exports dropped in 1990-91, and virtually disappeared in 1992, a trend that alone could account for a fall of five to ten percent of NMP. Reflecting these various developments, value-added in the industrial sector dropped by 9 percent in 1991 and an estimated 10 percent in 1992. Agriculture, with a share of 30 percent in NMP, fell significantly in 1991 owing to the dual effects of input shortages and drought, and registered another poor performance in 1992. Table 2.1: EVOLUTION OF NMP IN 1990 CONSTANT PRICES, 1989-92 (Annual Percentage Change) NMP 4.0 -3.4 -11.3 -16 By Origin Industry 3.4 -0.9 -9.2 -10 Agriculture 7.0 -6.9 -13.4 ... Construction - - -7.0 ... Transport & communications -1.9 -12.5 D Trade and other 5.6 -3.3 -21.5 .. By Use Consumption 5.2 2.5 -6.7 Investment 9.9 -22.5 -29.9 ... NMP Deflator 2.2 12.2 101.1 I Exports and imports valued at world prices.  -3- 2.2 The brunt of adjustment on the expenditure side has been borne by investment (mainly fixed investment), which, according to official data, declined by a total of 46 percent during the period 1989-91 and remained weak in 1992. This phenomenon may be in part attributable to incentives of decentralized state enterprises to increase wage payments at the expense of maintenance or renewal of the capital stock, and in part to the increase in excess capacity. The drop in consumption, for a total of four percent in 1989-91, was more moderate. It was cushioned by important adjustments to household incomes, particularly in 1991 when average wages grew by about 119 percent, incomes from pensions increased by more than 160 percent, and receipts from the financial system rose by more than 200 percent owing to the revaluation of households' monetary savings in April of that year. Nonetheless, real household expenditures fell by around 10 percent, and forced savings - the consequence of worsening shortages and tight constraints placed on the use of the revalued portion of savings deposits - boosted the ratio of nominal saving to disposable income from 11 percent to 22 percent. 2.3 Innation. Inflation has come into the open in Ukraine, evidence mainly of lax financial and incomes policies. In 1991, retail prices rose by roughly 90 percent and wholesale prices by 125 percent as administered price adjustments came into effect. Following the partial price liberalization in early 1992, retail prices rose by 240 percent in January relative to December 1991. This increase essentially represented an adjustment of the price level to the hidden or repressed inflation built up in past years, and thus absorbed a large portion of the monetary overhang at the beginning of the year. However, inflation continued unabated, rising to a monthly rate of about 30 percent by the end of 1992, and is estimated to have averaged almost 1,500 percent for the year as a whole. The persistent inflation has been fed by monetization of a widening fiscal deficit, a dramatic expansion in domestic credit to enterprises, and indiscriminate wage hikes in state-owned enterprises; higher import prices for energy products have also been a contributing factor. 2.4 Incomes Policy. Incomes policy has been driven by efforts to cushion the impact on incomes of higher prices. In October 1991, Parliament passed a law requiring all enterprises, at a minimum, to raise wages according to an indexation formula. Under the formula adopted, wages up to twice the minimum wage were fully indexed and those between two and three times the minimum wage were indexed at 50 percent; wages above three times the minimum were not indexed.2 These adjustments were made in line with movements in a price index based on a minimum consumer basket that provides a standard of living well above subsistence.3 2.5 It appears that nominal wages doubled in the last quarter of 1991 and again in the first quarter of 1992. While retail prices increased roughly 8-fold from the last quarter of 1991 to March 1992, nominal wages increased 10-fold. As a result, the average real wage (using the retail price index as deflator) was 24 percent higher in March 1992 than during the first quarter of 1991. Preliminary figures suggest that on average real wages fell by about 10 percent in 1992. Nonetheless, in practice, wage increases have often exceeded those implied by mandatory indexation. This development pardy reflects the problem of 'corporate governance" (see paragraphs 4.26 to 4.30). Many state enterprises operate in a limbo where ownership rights are ambiguous. Uncertainty over the future has in all 2 The minimum wage itself was raised from krb 900 (coupons) to krb 2,300 per month effective November 1, 1992, and to krb 4,600 per month in December 1992. 3 In December 1992, the Govemment suspended the indexation of wages, and con January 1, 1993, adopted a tax-based wage policy.  -4- likelihood shortened the time horizon of workers and managers, inducing them to appropriate the assets of the enterprise. More specifically, workers and managers focus on redistributing resources to themselves to the detriment of government revenue from profits and the level of investment. 2.6 Fiscal Policy. Following years of balanced budgets, the state budget of Ukraine swung into a deficlt equivalent to about 14 percent of GDP in 1991.4 This deterioration was primarily the result of a significant expansion in spending. Indeed, total revenue retainad by the state budget rose to 32 percent of GDP compared with 27 percent of GDP in 1990 as transfers to the Union were phased out and new revenue measures (retention by the Government of part of the proceeds of the payroll tax destined to an extrabudgetary economic stabilization fund, and introduction of a 5 percent sales tax) offset the decline in receipts from the enterprise income tax. But the growth in expenditure was far more dramatic -- from 28 percent to 46 percent of GDP - reflecting considerably higher outlays on subsidies and the social safety net. In 1992, the state budget deficit rose to an estimated 18 percent of GDP. Once again, the poor fiscal outturn was in large part attributable to the lack of control over expenditures, which rose by 8 percentage points of GDP. In addition, massive expenditures, mostly transfers to loss-making producers in industry and agriculture, were channeled directly through the banking system. Taking into account these quasi-fiscal operations, the government deficit reached 33 percent of GDP.' 2.7 Monetary Policy. The loss of fiscal control spilled over into the financial sector. Thus, In 1991, credit to the Government increased markedly. Moreover, as elsewhere in the FSU, the Ukrainian authorities decided to relax credit to enterprises, and the stock of bank credit to the enterprise sector approximately doubled. Monetary growth accelerated sharply, with total monetary liabilities rising by 80 percent. In sum, the monetary system broadly accommodated the increase in prices. In 1992, the banking system itself became an arm of fiscal policy. Accordingly, domestic credit rose by a factor of 17 from end-1991 to end-1992. Problems in the interrepublic payments system and the agricultural sector contributed to the rapid credit growth. As a result of payments delays of up to two months between Ukraine and Russia, enterprises failed to receive payment for their output and could not afford to buy inputs, prompting the National Bank of Ukraine (NBU) to provide additional credit. Similarly, as the terms of trade of agriculture deteriorated following the partial price liberalization at the beginning of the year, strong pressures developed to finance the losses of the producers (see paragraphs 3.28 and 3.29). 2.8 The excessively expansionary monetary and credit policies of the authorities were facilitated by the introduction in January 1992 of the karbovanets or coupon. In view of the substantial increase in prices at the beginning of the year and constraints on the availability of rubles, there were not enough ruble bank notes to meet the normal needs of the economy, in particular the payment of wages. Hence, the karbovanets was used for cash payments. In November 1992, Ukraine withdrew from the ruble zone and the karbovanets became the official currency unit, replacing the ruble in both cash and non-cash transactions. Following a period of three days during which rubles could be exchanged for karbovanets at parity, the official exchange rate was initially set at 1.454 karbovantsi per ruble. 4 The state budget covers the republican and oblast budgets as well as those of Kiev and Sebastopol. The figures here on the state budget cannot be compared to those on the consolidated budget which also includes the Pension Fund, the Social Insurance Fund, and the Employment Fund (see paragraphs 3.6 to 3.9). 5 When the balance on the various social funds (see footnote 4) is included, the general government deficit in 1992 is estimated at about 30 percent of GDP.  -5- MEIUM-TERM PROSPECTS 2.9 In December 1992-January 1993, the Government issued in quick succession numerous decrees in such areas as taxation, pricing, and foreign trade in an effort to initiate the process of economic change. However, an integrated and comprehensive approach to reform Is needed to address the problems facing the Ukrainian economy. Its focus must be on: (a) macroeconomic adjustment, which is among the prerequisites for growth because it stabilizes expectations and inspires confidence about the economy in investors, both domestic and foreign; and (b) structural reforms, in particular the transformation of ownership patterns, which are the very foundation of growth, bringing about a competitive environment as well as the institutions and structures that encourage agents to respond to market forces. On the assumption that such a reform package for the economy Is carried out as of the first half of 1993, the paragraphs below outline a highly stylized path of adjustment and recovery in Ukraine. With rapidly changing conditions and few reliable data, the scenario is meant to be indicative; actual developments will be contingent on the design, timetable, and phasing of economic measures, and therefore on the determination and capacity of the authorities to implement them. External support will also be critical to the unfolding of the transition period. Output Trends 2.10 Initial Contraction in Output. If expe.ience in other Eastern European countries is any indicator, output in Ukraine is likely to continue falling beyond 1992. In some Eastern European countries, economic activity has continued to slide for up to two years after far-reaching programs have been adopted (Table 2.2). In Ukraine, output started to collapse prior to reforms, reflecting in part a situation that was "neither plan nor market" whereby state enterprises were not tightly controlled, but did not face appropriate incentives. Moreover, the restructuring of the economy, which will be necessary to hait the decline in production and lay the basis for future growth, is only just beginning.  -6. Table 2.2: OUTPUT COLLAPSE IN TRANSTON ECONOMiTES, 1990-92 Ukraine -3.0 -11.0 -15 Russia -3.6 -9.0 -18 to -22 Hungary -4.0 -8.0 -1 to -2 Poland -11.9 -7.0 Romania -8.4 -13.0 -10 Czechoslovakia -3.0 -15.9 -9 Bulgaria -10.0 -22.9 -4 Albania -10.0 -30.0 -10 Table 2.3: lOTAL AND NlTRAREGIONAL TRADE AS SHARE OF GNP, 1989 OR 1990' FSU Ukraine 29.0 23.8 82.1 Russia 18.3 11.1 60.6 CMEA Bulgaria 30.1 16.1 53.4 Czechoslovakia 23.0 10.9 47.2 Hungary 34.1 13.7 40.3 Poland 19.6 8.4 43.1 Romania 17.6 3.7 21.0 EC Belgium 74.2 44.5 60.0 Denmark 32.7 13.7 41.7 France 23.3 13.0 55.6 Germany 29.8 14.4 48.2 Italy 20.4 9.7 47.5 Netherlands 54.4 34.2 62.9 United Kingdom 26.0 10.7 41.2 1I Data on the FSU and the SC reter to 1990, and those on whe CMEA to 1989.  -7- 2.11 In the short-run, the contraction of trade with the FSU, which in 1M accounted for 80 percent of Ukraine's total foreign trade, will continue to have an adverse impact on the economy. As shown in Table 2.3, Ukraine depends more on intraregional trade than all former CMEA countries and most EC countries. Trade with the FSU is expected to pick up, if only because of close economic ties inherited from central planning, but may be constrained by difficulties in the payments system and in the economies of the individual republics. 2.12 The shift to world prices for interrepublic trade as well as external trade 6 will accelerate given the withdrawal of Ukraine from the ruble zone. This change is likely to result in a deterioration in the interrepublic trade terms of trade owing to higher import prices of oil and gas, and an improvement in the external trade terms of trade reflecting the fact that Ukraine paid above world prices for many imports under the former centralized system. Estimates for 1990 suggest that the overall terms of trade would have declined by roughly 12-19 percent had trade taken place at world prices, and that as a consequence, real GDP would have fallen by 2.6 percent.7 The use of world prices in interrepublic trade could also deal a major blow to certain sectors. Preliminary analysis of input-output data for 1987 indicates that about 16 percent of production in Ukraine had negative value added at world prices,, i.e., the cost of material inputs alone exceeded the value of output when both were valued at world prices. A stop to production in these sectors would actually raise national income, although NMP measured at the currently distorted domestic prices would fall. 2.13 Decreases in output, income, and employment result not from restructuring itself, but from market rigidities that impede the reallocation of labor and capital to more productive uses. From a strictly economic perspective, a large cutback in production in some sectors is not only inevitable, but desirabl!e, and the gains from a reallocation of resources could be substantial.9 Thus, priority must be given to reducing the obstacles to a smooth transfer of resources between sectors. 2.14 The Potential for Economic Growth. Although the public sector is called upon to contract in the move to a market economy, the Government will have a crucial role in fostering economic growth. The establishment of a legal framework that is fully supportive of private sector activities, price liberalization, and promotion of trade are all actions that the authorities are considering and that would enhance prospecs for growth. The Government could also take an active lead by pursuing early land reform in agriculture and privatization of small-scale businesses, two areas that offer considerable potential. 6 In this report, external trade refers to transactions with countries outside the FSU. 7 See Tarr (1992). 8 The revaluation at world prices is fraught with difficulties, and sectoral measures of world value added provide no indication of the potential for productivity improvements or long-run comparative advantage. See Industry Annex. 9 To illustrate this point, rough calculations indicate that if output were to decrease by 50 percent and 25 percent, respectively, in the sectors constituting the lowest and second lowest quintal of output ranked by efficiency (by social profit ratios), and output were to increase by 50 percent and 25 percent, respectively, in the two highest quintals, then at world prices, total output would rise by 17 percent and value added by 74 percent, while employment would grow by 7 percent. See Industry Annex.  -8- 2.15 On the supply side, agriculture and small-scale services (e.g., retail trade, transportation, and distribution) could make a significant contribution to the economic recovery during the transition period. Agriculture accounts for almost 30 percent of NMP and 20 percent of the labor force. A more prosperous agricultural sector could produce more food supplies that in turn would contribute to an Improvement in living standards and a dampening of inflationary pressures, especially in the urban areas; reduce imports and boost exports, thereby lessening the balance of payments pressures; and provide inputs for the food processing industry. Small-scale services and transport would be crucial to increasing employment opportunities and tightening the linkages between sectors. 2.16 An expansion of domestic demand is made difficult in the short-term by macroeconomic constraints. The weak fiscal position, the risk of continued high inflation, and external financing constraints preclude the option of expansionary financial policies, and instead mandate a policy of rigorous demand management. Fiscal discipline would tend to inhibit the growth of consumption in the public sector. Investment would be touched less because public investments have fallen to a very low level, and because new investment would be necessary to upgrade basic infrastructure. Household consumption would be constrained by the need to keep wages in check in order to limit the growth in unit labor costs and improve international competitiveness; furthermore, household savings would have to be mobilized to finance investment when it revived. Enterprise investment would be adversely affected by the stricter control of financial flows from the Government to enterprises and a tight credit policy, though it could later be bolstered by new opportunities in the expanding private sector. Under these conditions, exports would be the component of demand best suited to stimulating the economy without doing harm to macroeconomic stability. 2.17 The figures in Table 2.4 -- very tentative projections - highlight these trends and further indicate that the road to recovery will take some time. In this scenario, economic activity continues to fall through 1995, and picks up thereafter as real GDP growth (at market prices) reaches 2 percent in 1996 and an annual average of 4 percent in 1997-2000. Consumption, which stabilizes in 1995-96, increases modestly in the following four years, and investment begins to post substantial gains in 1995. The expansion in foreign trade (including interrepublic trade) gets underway in 1994-95 as discussed below. E xternal Trade Prospects 2.18 Exports. The above scenario, in which exports constitute one of the pockets of growth in the economy, is heavily dependent on the implementation of prudent macroeconomic policies and major restructuring in both the agricultural and industrial sectors. With large potential markets, especially in Russia, agriculture in particular could expand its export base. Given such possibilities, Ukraine must move quickly to an environment where appropriate incentives and private ownership encourage producers to adjust to foreign demand by responding with competitive products, both in terms of quality and price. Following another decline in 1993, real growth in exports is projected to resume in 1994, and as of 1995, to range from 3 percent to 5 percent per annum. 2.19 Imports. Throughout the economy, the recovery in growth and the associated increase in investment would call for a sustained increase in imports. In real terms, they are projected to bottom out in 1994 and increase thereafter at an average annual rate of 3 percent. Goods from abroad would be essential to complement limited domestic supplies. In the short run, imports would bolster consumption as domestic production decreased, and over the longer term, would provide investment goods to upgrade the capital stock.  -9- 2.20 Trade Balance. Ukraine enters the transition period with a sizable trade deficit vis a vis the FSU, In particular Russia on which it depends for Imports of petroleum products. Ukrainian enterprises have reportedly accumulated considerable payments arrears that are owed to their Russian counterparts (and vice versa); these arrears are difficult to estimate and will have to be settled within the framework of bllatersl negotiations. The projections here assume that the prices of energy imported from the PSU increase very quickly, with the price of oil reaching world levels in mid-1994 and that of gas more than 90 percent of the world prlce by 1995; prices of non-energy goods traded with the other republics increase at the pace of Russian inflation adjusted for exchange rate changes. In keeping with this scenario, Ukraine's interrepublic trade deficit rises dramatically in 1993. As the economy adjusts to the energy price shocks and the volume of exports expands, this deficit with the FSU declines gradually. As for trade with the rest of the world, the surplus first registered in 1992 widens on the strength of a pick-up in exports combined with moderate growth in imports. However, trade developments with the FSU predominate, and as a result, the overall trade account registers a large - but decreasing - deficit during 1993-95. Table 2.4: TRENDS IN MACROECONOMIC VARIABLES, 1991-2000 (in Percen of GDP) Consumption 92.9 93.3 121.9 101.9 97.6 89.1 Govenment 16.1 18.0 13.5 13.0 12.0 10.7 Private" 76.8 75.3 108.4 88.9 85.6 78.4 investment 9.0 9.0 9.0 8.8 9.3 10.8 Govemnment 2.7 2.7 2.7 3.0 3.0 3.3 Privatel"2 6.2 6.3 6.3 5.8 6.3 7.6 Resource Balance (deficit-) -1.9 -2.3 -30.9 -10.7 -6.8 0.1 (Real Orowh Ratesi a Percent) GDP At Market Pric -11.0 -14.7 -10.0 -6.9 -1.0 4.2 GDP At Factor Cost ... -13.8 -16.1 -9.0 -2.0 2.9 Consumption -5.0 -16.5 -11.9 -9.9 -2.2 2.6 Government -4.0 -4.6 -32.5 -10.3 -8.6 0.7 Private"l -5.0 -19.0 -6.8 -9.8 -1.0 2.9 Investmnent -57.0 -14.4 -10.0 -9.5 4.7 11.6 ExpoIs (ONPS) -28.0 -21.5 -11.9 2.6 3.3 5.4 Imports (GNPS) -28.0 -26.4 -18.1 -8.2 2.1 3.6 Includes tate enterprises. 1' Includes ohanges in inventory.  -10- External Finandng Needs 2.21 During the period 1993-95, Ukraine will have to mobilize substantial external resources, notwithstanding projections of a steady decline In the current account deficit (excluding scheduled interest payments). The financing requirements take into account theprojected shift in interrepublic energy prices to approximate world levels in 1994-95. They are also associated with the imports necessary to stem the ongoing decline of the Ukrainian economy, with a modest buildup in foreign exchange reserves (estimated at US$ 10 million at the beginning of 1992), and with the servicing of the external debt. While Russia and Ukraine have not reached agreement on the sharing of foreign assets and liabilities inherited from the PSU, it Is assumed for the purpose of this exercise that the two countries agree on the "zero option", i.e., Ukraine relinquishes its claims to a share of tho foreign assets as well as responsibility for debt service on a portion of the foreign liabilities.10 lTus, external financing requirements are tentatively projected at US$11.0 billion for the period 1993-95, or about US$3.7 billion annually (Table 2.5). The cumulative current account deficit (excluding interest payments) would represent US$7.7 billion or 70 percent of total requirements. Table 2.5: INDICATIVE FINANCING REQUIREMENTS, 1992-95 Financing Requirments 0.5 3.6 3.9 3.5 Current account deficit (-surplus)' 0.4 3.2 2.5 2.0 Interrepuolic 1.1 4.2 4.2 3.6 Extal -0.7 -1.0 -1.7 -1.7 Interest payments" -- . 0.5 0.8 Amortizatioe2 -