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Ukraine Reforms Watch Update (March 17, 2015)

Over the past month and a half, the Ukrainian authorities made significant efforts towards implementing a set of key reforms, which resulted in a successful decision of the IMF board on approval of the USD 17.5 bn loan package. The most important initiatives were observed in the banking sector, judicial system and public sector. However, we note that some of the initiatives and policies were clearly intended to   “fight fires” and were not reforms in a general sense. We find that much work remains to be done. Nevertheless, we believe that the package of laws approved by the Parliament will form a solid base for further reforms.

Tax reform 32%
Decentralization reform 30%
Judicial sector reform 27%
Economic policy reform   23%
Public sector reform 15%
Energy sector reform 18%
Anti-corruption reform 15%
Agricultural sector reform 10%
Law enforcement reform 4%
Financial sector reform 7%
Overall score 18%

Economic policy reform

The progress in economic policy reforms was the most visible compared to all other initiatives of the Ukrainian government. The Ukrainian Parliament approved two bills on deregulation. The first bill decreased the time limit on getting administrative services, cancelled some permitting procedures and transferred certain functions related to approvals and permits to the local level. The second bill decreased the number of business activities that require a license to 29 from 57. Ukraine’s Minister of Economic Development and Trade Aivaras Abromavicius estimated the economic impact of deregulation at UAH 60-90 bn of savings over the period of five years. 

We also note the increased activity of the Ministry of Economy directed towards renewing the top-level staff of the Ministry. Thus, Alexander Borovik, a graduate of the Harvard Law School and the Head of Akamai Technologies’ EMEA legal arm, formerly lead attorney at Microsoft, has recently accepted the position of the Deputy Minister of Economy in Ukraine. Mr Borovick will supervise the work of five departments: Economic Strategy, Investment Climate, Deregulation of Business, International Donor Programs and the Digital Economy.

 The Ukrainian Parliament also passed the bill on investors’ rights protection in  the first reading. The bill introduces the practice of derivative suits and accountability of the company’s management for their actions that result in a loss to the company, as well as a legal procedure to recognize certain transactions as invalid and the return of profits earned as a result of such transaction. Additionally, the bill creates conditions for the transition of quasi-public companies to the private form (through squeeze-out of minority investors).

Energy sector reforms

The Ukrainian government made significant efforts towards reducing the deficit of Naftogaz and improving transparency of the company. Naftogaz, Ukraine’s state-owned gas company, engaged Ryder Scott Company to conduct an independent evaluation of the company’s hydrocarbon reserves. We view the development as refreshingly transparent and a step in the direction of forming a plan to develop domestic energy resources. 

As precondition for the subsequently received IMF support package, the National Commission for State Energy and Public Utilities Regulation (NERC) raised gas prices for households to UAH 3,600 per 1,000 cubic meters (mcm) of gas, an increase of nearly 300%. This price will be effective for the first 200 cubic meters per month. Volumes over and above this threshold will cost UAH 7,188/mcm. 

Authorities also allocated UAH 25 billion for subsidies to lower-income households to cope with the increases. We estimate that an increase in prices should decrease the gas consumption by households and reduce the deficit of the state-owned “Naftogas of Ukraine”. However, we expect that some poor families will not be able to receive subsidies due to bureaucratic processes, and thus there could be an increase in the non-payment rate of households.

We note that Ukraine must still negotiate a short-to-long term gas supply agreement with Russia. Russian import prices currently stand at USD 329 per mcm. It seems likely to us – and we venture, the most observers as well – that over time, import prices will migrate towards what Russia charges Western Europe. Gazprom charges a prices linked to the price of oil (with a lag), and is currently around USD 270-300 per 1,000 cubic meters. 

Anti-corruption reform

While the progress with the Anti-Corruption Bureau remains slow, recent legal actions suggest corruption will be investigated more seriously than before. The creation of the Anti-Corruption Bureau (ACB) should be finished in April, while previously it was stated that it will start working in February. The Selecting Committee short-listed four candidates for the position of the Head of ACB:  Viktor Chumak, Artem Sytnyk, Yakiv Varychev and Mykola Siryi, which all have a legal background.

After the removal of Vitaliy Yarema from the position of the Head of the Attorney General’s Office, and the appointment of  Victor Shokin, there was a significant progress in some high-profile cases. Arrest warrants were issued for the three Yanykovich-era judges (Oksana Tsarevich, Sergiy Vovk and Victor Kitsyuk), which were known for their participation in controversial political cases against Yuliya Timoshenko (the former Prime Minister of Ukraine) and Yuriy Lutsenko (the former Minister of Internal Affairs). Mr Shokin also commented that the Attorney General’s Office is preparing more than 100 applications to the Ukrainian Parliament to allow the detention and arrest of judges. However, we note that the aforementioned cases still need to be proved in court, which will be a better indicator of the competence of the new Attorney General.

We previously noted that Mykola Huta, the former CEO of bankrupt agriculture concern Mriya, was put on Interpol’s wanted list. It’s significant, in our opinion, that creditors have since taken control of Mriya’s assets. The restructuring is far from complete. However, we believe that creditors have already achieved a degree of success in advancing their legal claims that would have been nearly unthinkable a year ago. 

There is also some improvement in the public procurement system: low-value items are now purchased through an online auction system, while the Ministry of Economy and Trade appointed Alexander Starodubtsev, the creator of the system, to direct the State Procurement Department. The Ukrainian government plans to eventually do all public procurement through electronic systems, which should eliminate the majority of corrupt schemes associated with procurement.

Agricultural sector reform

Government acknowledges IMF’s demand that agriculture be taxed at normal rates, but no concrete action yet taken. Ukraine’s VAT tax is currently 20%. Agriculture concerns, however, benefit from a beneficial regime, under which they pay… no VAT, essentially. The IMF wants to improve the tax base by bringing the agriculture sector fully under the general VAT regime in 2016. We believe the government will be challenged to do so. There is a popular opposition as there are many small holders who benefit from the current regime. In addition, Ukraine has a “big ag” lobby, that also wields considerable influence. There may also be sound economic reasons not to change the current regime, in our view. Agriculture is one of the few sectors in Ukraine that has performed and continues to perform well. It may be prudent not to put it at risk. 

Another important initiative was the approval of a minimum lease term for agricultural land of 7 years (compared to 2 years before). We believe that this will help improve the investment attractiveness of the sector. 

Public sector reform

We noted significant progress in public sector reform, specifically in the transparency of public data and in the HR department. The Ukrainian parliament passed a bill that envisages public access to data on the use of public funds by the recipients, including public enterprises, local and state authorities, as well as state social insurance funds. The Ukrainian government also allowed public access to the databases of property rights and geological licenses. 

The National Bank of Ukraine, the Ministry of Economy and the Ministry of Finance have started the process of changing the top-level management, appointing professionals with western education and experience in the real sector. Furthermore, Ukraine’s Minister of Economy Aivaras Abromavichus promised to gradually reduce the Ministry’s staff by 50%, while overall the Ukrainian government has pledged to reduce the staff by 20%.

Financial sector reform

The most significant initiative in the financial sector was the adoption of the bill on the increased responsibility of managers and final beneficiaries of banks. The new law is intended to fight related party lending by banks and introduces criminal responsibility for actions that lead to the bankruptcy/liquidation of a bank. We believe that it will help stabilize the Ukrainian banking system and reduce related party lending. Thus, we have included the corresponding initiative into our scoreboards.

However, we also note that the law gives extended rights to the NBU to arbitrarily identify the beneficiaries of banks, and contains provisions that could allow the Deposit Guarantee Fund to expropriate other assets of bank owners to compensate for the losses of banks, which will reduce the investor attractiveness of the banking sector of Ukraine.

Recent actions of the NBU reduced speculation on the interbank market and return the exchange rate to 22-25 from the lows of 35-40 observed a month ago, which helped the Ukrainian government to receive the new loan package of the IMF. 

However, the methods used by the regulator were detrimental to the economic growth. The NBU raised the base lending rate to 30%, which effectively stopped all lending by banks, and new restrictions on the purchase of foreign currency for importers artificially excluded some importers from the interbank market. We hope that the NBU will cancel the restrictions in 1-2 months as the exchange rate seems to have stabilized and the international reserves of Ukraine got a sizable boost from the IMF.

Judicial system reform

The reform of the judicial system is hindered by political processes, but is generally going at an acceptable pace. The Ukrainian parliament passed the presidential bill on the judicial reform in the second reading and in whole. The bill increased responsibilities of judges and introduced a more competitive procedure for hiring and training judges, but leaves the right to appoint judges (based on the proposition from the High Justice Council), liquidate and reorganize courts to the President. The bill also envisions the initial evaluation of the qualification of judges (High Court judges—in 6-month term, judges of appellate court—in 2-year term) and monitoring of the lifestyle of judges.  We have included this initiative into our scoreboards, as it could lead to an improvement of the overall professional level of judges and simultaneously could help clean the system from unqualified judges. However, we have decreased the overall score due to the fact that some initiatives like declaration of income of judges and electronic registration of court proceedings were not included in the law.

Decentralization reform

There were no significant developments in the decentralization reform. Ukrainian government officials noted that the local authorities will have UAH 26 bn of additional funding as a result of the new legislation passed in December of  2014. It is unclear whether this is true, as some of additional taxes directed to the local level (10% of corporate income tax) are counterbalanced by the decrease in the share of personal income tax that is left for municipalities (75% vs. 100% before).

Tax system reform

We did not notice any major improvements in the tax system over the past two months. The government’s initiatives in the oil & gas sector taxation, however, have the potential to hurt domestic gas production. The Ukrainian Parliament voted for a 15% decrease in pensions for working pensioners and cancelled special pensions to MPs, judges and attorneys to cut down the expenses of the State Pension Fund, which was coordinated with the IMF. 

Additionally, the Parliament approved an increase in royalty rates on gas production to 70% from 20% for state-owned companies with the intention to use these funds as subsidies for poor families that cannot afford to pay high gas tariffs. However, the unintended effect of this initiative could be a sizable decrease in the natural gas production of Ukrgazvydobuvannya (100% owned by the state), the largest producer in Ukraine, as a result of the absence of funds to finance the investments in drilling and exploration. On the positive side, Ukraine’s Finance Minister Natalie Jaresko recently stated that the government intends to review the royalty rates for independent producers, which currently stand at 55% for gas wells with depth of less than 5,000 meters.