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The World Bank Group in Ukraine, 2012–20

Chapter 3 | Crisis Response and Macroeconomic Resilience

Highlights

After the 2014–15 economic and financial crises, the World Bank Group joined an international coalition to help stabilize the Ukrainian economy.

The Bank Group was an important contributor to restoring the health and stability of the banking system and enhancing the capacity of core financial sector institutions. The International Finance Corporation contributed to improving corporate governance and risk management in the financial sector.

Efforts to reform the banking sector’s regulatory framework focused on legislative changes supported through prior actions in development policy loans. The majority of these changes became bogged down in the legislative process for a prolonged period by vested interests in the Rada. Although most legislation has subsequently passed, implementation remains weak in the face of an unreformed judiciary.

The Bank Group made an important contribution to fiscal consolidation through its support for pension reform and the reform of utility subsidies and health services. This support helped the government bring household energy prices to market levels without social unrest.

Ukraine went through several economic crises during the evaluation period, and the Bank Group was a key partner in helping to manage them while supporting efforts to build greater economic resilience. This section assesses the relevance and effectiveness of the Bank Group’s engagement to restore macroeconomic stability, enhance resilience, and reduce macroeconomic and financial sector vulnerabilities.

Enhancing Macroeconomic Resilience

Fiscal and financial sector vulnerabilities were critical constraints to development in Ukraine. They became most visible during the global financial crisis of 2008–09, but a lack of political will and opposition from vested interests resulted in major policy reforms being delayed until the 2014–15 macroeconomic and financial crisis. In 2014, the exchange rate depreciated by 47 percent, inflation accelerated to 24 percent, the fiscal deficit exceeded 10 percent of GDP, and public debt (including guarantees) spiked from 36 (in 2011) to 70 percent of GDP (World Bank 2019c). Energy tariffs, household utility subsidies, pensions, and health and social protection systems were major fiscal burdens. By 2014, subsidies for underpriced gas combined with other losses of Naftogaz (the state-owned gas monopoly) accounted for 7 percent of GDP and for about 3.3 percent of GDP in direct budget subsidies.

Throughout the evaluation period, the Bank Group maintained a good understanding of Ukraine’s macroeconomic, fiscal, and financial sector vulnerabilities and provided relevant financial and technical support. World Bank support ($2.2 billion) was large relative to International Bank for Reconstruction and Development borrowing limits, but modest compared with the resources provided by the IMF ($17.5 billion) and the EU (€11 billion) through parallel arrangements. Budget support operations (DPLs) beginning in 2014 sought to incentivize the policy reforms needed to regain macroeconomic and financial sector stability and strengthen institutions for economic management. A significant body of World Bank ASA underpinned the identification and design of reforms supported by the DPLs.

By 2017–18, macroeconomic stability had been reestablished, with the World Bank supporting many of the underlying reforms, including improving fiscal consolidation; reforming energy tariffs to reduce subsidies and the quasi-fiscal deficit; strengthening the social safety net to cushion the impact of higher energy prices on poor people; and stabilizing the banking sector. The overall fiscal deficit declined to just over 2 percent of GDP in both 2017, down from 10 percent of GDP in 2014. Public and publicly guaranteed debt declined from 85 percent of GDP in 2014 to 61 percent in 2018 and further to 50 percent by the end of 2019.

The World Bank made an important contribution to fiscal consolidation through its support for pension reform and reform of utility subsidies and health services. This support (through policy dialogue, technical analysis, DPL prior actions, and targeted ASA and technical assistance) helped the government bring household energy prices to market levels without social unrest. Spending on the subsidy declined from a peak of 2.1 percent of GDP in 2017 to 1.4 percent in 2019. Scaling down the subsidy contributed to an overall reduction in social spending from 4.4 percent of GDP in 2017 to 3.0 percent in 2019. The government, with World Bank support, slowly consolidated the existing categorical benefit programs and expanded the means-tested guaranteed minimum income program.

The primary reform promoted by the World Bank in social protection was a dramatic expansion of the household utility subsidy (HUS) in 2014–15 to protect the population and maintain support for energy reform. The rapid expansion of the HUS (from fewer than 5 percent of households in 2014 to 55 percent by mid-2015) was underpinned by World Bank analytical and simulation work on the distributional effects of increased energy prices, mitigation measures, and the distributional incidence of subsidies. DPLs in 2014 and 2015 contained prior actions related to reforming Ukraine’s inefficient and inequitable gas and heating subsidies while protecting poor people. These actions were also based on World Bank analytical work showing that if the energy sector moved rapidly to full cost recovery, household subsidies would need to be quickly increased in conjunction with major simplification of the benefits application process. Bank Group support in these areas facilitated a peaceful, rapid alignment of energy tariffs, taking advantage of earlier investments in benefits processing and administrative capacity.

However, the expanded HUS was not fiscally sustainable, costing 1.8 percent of GDP at its peak in 2016. The second DPL took a longer-term perspective, requiring measures to shrink and apply a means test to the HUS benefit and, in parallel, to gradually replace the universal child benefit with the income-based guaranteed minimum income. The IMF relied heavily on World Bank expertise when implementing the 2014–15 energy price reform, and there was close coordination with the IMF when designing policy lending on pensions and social protection. Importantly, within the World Bank, easy access to the Energy Sector Management Assistance Program facility (see chapter 4) enabled cross-sectoral work, including with energy and social protection sector specialists.

The World Bank’s support for pensions and social protection focused on efficiency, fiscal sustainability, and equity. It involved extensive analytical work and policy dialogue, as well as pension-related prior actions in two DPLs. The pension system was a major fiscal burden due to rapid population aging, labor emigration, and incentives to hide income from taxation. The social protection system was complex and expensive, and the bulk of its spending did not reach poor people. The $750 million FY18 policy-based guarantee contained prior actions to enhance the adequacy and sustainability of old-age pension benefits and included the enactment (in 2017) of the pension reform law aimed at improving the program’s fiscal sustainability, adequacy of the benefits, and incentives to contribute. The underlying reforms imposed stricter eligibility requirements, phased out early retirement schemes, adopted clear indexation rules, and introduced a flexible retirement age corridor that effectively increased the retirement age. Pension expenditures were reduced from about 18 percent of GDP in 2010 to less than 11 percent in 2016 and stayed relatively stable through 2019. The FY20 $350 million First Economic Recovery DPL (World Bank 2020c) included a prior action on pension indexation intended to boost the purchasing power of benefits and improve their predictability and sustainability.

Ukraine’s response to the COVID-19 crisis has demonstrated improved economic management and a more resilient economy. Although overall macroeconomic vulnerabilities increased during 2020, driven by both the direct impact of the pandemic (including a 4.4 percent decline in GDP) and strong pressures from vested interests to ease fiscal and monetary policies, to date, the deterioration in macroeconomic indicators and financial sector stability has been manageable.

Reducing Financial Sector Vulnerabilities

Ukraine’s financial sector was highly vulnerable in the wake of the global financial crisis of 2008–09. Compounding weak sector governance, the recession and depreciation caused a major banking crisis in the country leading to deposit outflows, rising number of NPLs, and many bank failures. The share of NPLs reached 55 percent of total loans in 2017, up from 17 percent in 2012, among the highest in the world at the time (World Bank 2021).

The relevance and ambition of the Bank Group–supported program in the financial sector grew during the period under review. Under the CPS FY12–16, the Bank Group’s objectives were quite modest (World Bank 2012b). Reflecting the fact that authorities had shown little interest in fundamental reforms of the financial sector, the strategy included only one subobjective (out of 20)—on the stability of the financial system—to be pursued by strengthening banking sector regulation and supervision. Despite the lack of appetite for reform, the World Bank—through policy dialogue, analytical work, and technical assistance—continued to advocate for reforms, accumulated sector knowledge, and built relationships with technical counterparts in the government. This proved to be a sound strategy, given that, with no active IMF program in Ukraine at that time and relatively modest IMF engagement in the financial sector, the World Bank was well positioned to quickly respond with support when the opportunity presented itself.

After 2014, support for financial sector reform became a top priority for the Bank Group. The primary instrument used by the World Bank to advance reforms was the financial sector DPL series (two $500 million loans approved in 2014 and 2015). The financial sector DPL series supported reforms to (i) improve the legal and institutional framework to strengthen the resiliency of the banking system, (ii) improve the solvency of the banking system through bank recapitalization, and (iii) strengthen the financial, operational, and regulatory capacity of the Deposit Guarantee Fund (DGF) for the resolution of insolvent banks. The program was boosted by a well-funded technical assistance program. In addition, the 2018 policy-based guarantee contained prior actions to improve the governance of state-owned commercial banks and facilitate the resolution of NPLs.

The World Bank played a prominent role in supporting the stabilization and cleanup of the banking sector in 2014–16, and since 2017, has focused on reforms in state-owned commercial banks to address the NPL overhang. Initially World Bank technical assistance focused on building capacity in the DGF (established with direct support from the World Bank in 2010), which, as a new institution, had not been captured by vested interests (box 3.1). The DGF led efforts to close failed banks and enable asset recovery. The DGF’s financial capacity to reimburse insured depositors in failed banks was strengthened, and longer-term funding arrangements were established. These steps helped prevent financial panic and large-scale withdrawal of bank deposits, although some challenges remained for the DGF to achieve financial sustainability.1 In December 2016, on the advice of the IMF and World Bank, the largest private bank in the country (PrivatBank) was declared insolvent and was nationalized. This was an unpopular but necessary decision to advance the cleanup of the banking system—PrivatBank alone was responsible for 43 percent of total NPLs (National Bank of Ukraine 2019, 39). By 2018, 97 banks had been closed (more than half of the total number of operational banks in 2014). In the latter half of the evaluation period, the World Bank contributed to the effort to restore the credibility and independence of the National Bank of Ukraine through technical assistance (box 3.1).2

With Bank Group support, the banking sector regulatory framework was upgraded, aligned with the EU regulations, and made consistent with the Basel III principles. As of the end of July 2018, all banks met the minimum regulatory capital of 7 percent of risk-weighted assets. The banks’ core equity capital ratio increased from 8.3 percent in late 2015 to 11.2 percent by the end of July 2018 and to 13.5 percent at the end of 2019. Related party exposures substantially declined, whereas liquidity ratios improved (World Bank 2021).

IFC helped identify and address vulnerabilities in risk management and corporate governance. IFC helped establish a market for distressed assets and improved risk management in the financial sector through its Financial Market Crisis Response advisory services project, benefiting six banks. These efforts targeted institutional gaps in asset markets, which held back the cleanup of bank balance sheets, and contributed to the strengthening of corporate and risk management in the banking sector. IFC interventions were complementary to World Bank efforts and included pre-privatization investment, investment in privatized state-owned enterprises, stronger corporate governance, and short-term trade and agribusiness financing.

Box 3.1. World Bank Group Support for Enhancing the Capacity of the National Bank of Ukraine and the Deposit Guarantee Fund

The World Bank Group’s advisory support to the National Bank of Ukraine and the Deposit Guarantee Fund (as part of programmatic financial sector technical assistance) covered bank supervision, bank resolution, and deposit insurance. The Bank Group helped deliver two Bank Quality Asset Reviews in 2015–16 that assessed the scale of the banking crisis and identified steps to clean up the system. Just-in-time advice included assistance to the National Bank of Ukraine to develop recapitalization plans and to commence the disclosure of the banks’ ultimate beneficiary owners.

The Bank Group was also a major source of technical assistance for the Deposit Guarantee Fund with a focus on strengthening its institutional capacity to carry out effective bank resolution and liquidation, as well as securing sufficient funding. This support helped advance reforms at a time when National Bank of Ukraine was perceived to be captured by vested interests and therefore unable to fulfill its mandate. The World Bank helped the authorities modernize key financial sector laws and advised them on preparing the new Insolvency Code, a critical component for improving the nonperforming loan resolution framework. The International Finance Corporation provided vital inputs to the design of the financial sector development policy loan series. The substance of the sector reform program and associated analytics were presented in several Bank Group reports, including policy notes (fiscal year 2015) and the sources of growth study (fiscal year 2019).

Source: Independent Evaluation Group.

Despite these achievements, Ukraine’s banking sector remains vulnerable. The pace of reform slowed considerably after 2016 as the risk of the banking sector’s collapse diminished. Passage of key pieces of World Bank–supported legislation was impeded by vested interests in the Rada. It was not until after the 2019 election that legislation was passed, although implementation challenges remained. Indeed, several past decisions on bank closures have been challenged in courts, drawing into question the real impact of changes to the legislative and regulatory frameworks. In addition, although the share of NPLs declined gradually in 2019–20, it remained high at 41 percent, with state-owned commercial banks accounting for 73 percent of the total. Largely due to the burden of NPLs and weak de facto protection of creditor rights, commercial bank lending to the private sector has remained depressed and annual credit growth has been negative in real terms since 2015, failing to meet the CPF target of 10 percent. The absence of meaningful judicial reform continues to undermine efforts to reduce the large stock of NPLs burdening the banking sector.

Public support for financial sector reform was weak throughout much of the review period. Reasons for the large number of bank closures were poorly understood by the public, who came to associate this aspect of the financial sector reform agenda with external players such as the World Bank and IMF. Although dissemination and outreach were evident in several aspects of the GAC agenda, this was not the case with respect to financial sector reform. As stressed in IEG’s evaluation of Bank Group support for addressing country-level fiscal and financial sector vulnerabilities (World Bank 2021), with a relatively low level of financial literacy among the general public in Ukraine, a concerted effort was needed to foster a better understanding of the importance of banking sector reform and the costs of not reforming.

  1. Facing sizable repayments to depositors in 2015–17, the Deposit Guarantee Fund borrowed long term from the government and the National Bank of Ukraine. The specific repayment arrangements for these loans remain unclear.
  2. In 2019, the National Bank of Ukraine won the Global Central Banking Transparency award from Central Banking magazine.