18/7/2014: IMF Approves Ukrainian Funding... & Pushes the Country into Deeper Austerity

IMF Announced agreement with Ukraine on First Review under the Stand-By Arrangement. Comments in italics are mine.

Mr. Nikolay Gueorguiev, mission chief for Ukraine, made the following statement today in Kyiv: “The mission has reached understandings with the Ukrainian authorities on the policies necessary for the completion of the first review under the SBA… the authorities have committed to take a number of policy actions prior to the completion of the review. …The completion of the review would enable the disbursement of ...about US$1.4 billion. The mission found that policies have generally been implemented as planned and that all but one of the performance criteria for end-May have been met. All structural benchmarks for the first review have been met as well, although some of them with a delay. This is a notable achievement as the intensification of the conflict in the East means that the program has been implemented in an environment that is considerably more difficult than anticipated when it was launched."

It is worth noting that IMF generally does not lend to countries in a state of civil war or major insurgency. Presumably, when it does lend to such countries, the conditions for lending allow for the risk of acceleration of the conflict. It appears IMF is taken by the surprise by the continuation of the conflict and by amplification in both the Ukrainian Government offensive and the rebels' defensive stances:

“The conflict is putting increasing strain on the program [after just a MONTH of the programme existence?!] and a number of key elements of the macroeconomic framework have had to be revised: (i) economic prospects have deteriorated notably, and GDP is now expected to contract by 6.5 percent this year, compared to 5 percent when the program was adopted; (ii) a shortfall in revenue collections in the East, higher security spending, and lower-than-expected debt collection by Naftogaz will cause fiscal and quasi-fiscal deficits and financing needs to rise above the programmed path; and (iii) higher-than-expected capital outflows and monetization of fiscal deficits are causing pressures on net international reserves."

Ok, one can excuse IMF for missing the forecast, but points (ii) and (iii) risks were predictable and material even BEFORE the programme started. One has to wonder, did IMF extend funds under the assumptions that 

1. The conflict will somehow go away without major costs on the ground?
2. The Government will be able to engage in revenue collection in rebel-controlled areas?
3. Naftogaz will be able to do more successfully that which the Government is failing to do?
4. Capital outflows will be benign and monetization of fiscal deficits will not be aggressive to compensate for (1)-(3)?

Things get worse. “Notwithstanding the authorities' continued commitment to the program and good record of implementation so far, the authorities have decided to take a number of compensatory measures to limit the negative impact of the conflict in the short run, and ensure that key program objectives are achieved over the period of the two-year program".

This sounds actually fine, except when you start reading into what exactly the IMF prescribed for the authorities and what they did in the wake of this prescription:

• Point 1: "On fiscal policy, the authorities have decided to implement a package of revenue and expenditure measures, amounting to 1 percent of GDP in 2014, offsetting the effect of increased security spending by other expenditure cuts. They have also committed to limiting wage and pension increases to the level of inflation in 2015, continuing reform-based reduction in public sector employment, and exercising tight control over discretionary spending." Set aside the issue of 2015. Look at NOW. The country is in a civil war, it is facing into the prospect of medium-term rebuilding and peace-building. Government response: cut spending, increase allocation to defense. The latter is necessary, no doubt. But the former is simply inconsistent with the need to build peace and rebuild infrastructure and businesses and peoples' lives. De facto, IMF is pushing Ukraine into austerity just at the time as the country is going through a civil war! As a fiscal hawk, I have to ask if this is simply mad?
• Point 2: "In the energy sector, the authorities are taking additional actions to strengthen payment discipline and compliance, such as pursuing payments from collectible accounts and seizing assets if repayment is not forthcoming. They are also preparing to restructure Naftogaz with a view to improve the transparency of its operations and reduce costs." Should second take place before the first? Should Naftogaz be reformed to increase its legitimacy and democratic acceptance and only AFTER that should it pursue more aggressive collection? Remember, again, this is not a society with comfortable margins of income and security!
• Point 3: "The authorities are taking steps toward strengthening governance and improving the business climate. A recent diagnostic study has identified major areas for reforms. Based on the study’s recommendations the authorities plan to implement a wide range of anti-corruption measures, including establishment of an independent anti-corruption agency with broad investigative powers and adoption of legislative amendments to support the anti-corruption effort." This is an area where progress is necessary and vital. And it is good to see Ukrainian Government taking serious reps here, if only academic ones for now.

I will skip monetary policy points identified by the IMF - these are technical and, for now, theoretically supportive of the economy.

So two sets of 'compensatory' policies are de facto a road to disaster, one is the road toward potentially better future and one is technically supportive of the present. 

Still, the Fund is pleased: “On the strength of these compensatory measures and continued implementation of other policies agreed when the program was approved, staff is confident that the program can achieve its fundamental objectives of restoring internal and external macroeconomic equilibrium, generating sound and sustainable economic growth, and strengthening economic governance and transparency. In particular, while the combined fiscal and quasi fiscal deficits are projected to amount to 10.1 and 5.8 percent of GDP in 2014 and 2015, respectively—compared to previous targets of 8.5 and 6.1 percent—the structural adjustment is stronger by ½ percent of GDP over 2014-16 and the headline deficit will be below the originally programmed path by 2016. Similarly, gross reserves will be only some US$3.4 billion lower than programmed by end-2015. While external debt to GDP will peak 7 percentage points higher than programmed at end-2015, it will be on a steady downward slope by the end of the program, suggesting that external viability is not at risk." This is a bag full of estimates, assertions and forecasts. We know how these play out in reality even in countries not undergoing a civil war conflict.

But it gets better: “The program hinges crucially on the assumption that the conflict will begin to subside in the coming months." How many months? No idea. What happens in the post-conflict process? No idea. How much destruction will be brought about in resolving the conflict? No projections. Hope, hope and more IMF money… while Ukrainian people and State are doing all the heavy lifting.

I noted months ago that Ukraine will need a Marshall Plan, not an 'emergency liquidity support'. It still does - more than ever. This is not even being discussed.