Progress is encouraging, but the pace of reforms underwhelms

The political will to make difficult decisions and enact reforms has returned to Ukraine on the back of the critical mass achieved through the EuroMaidan/Revolution of Dignity, as well as through cooperation with the IMF and other international partners. The Ukrainian government, NBU, parliament, and presidential administration have made significant changes in monetary policy, energy independence, and governance, and have made both large and small inroads in the fight against corruption. The pace of reforms has underwhelmed against some very high initial expectations, but the progress made in 1Q15 is without a doubt encouraging.

There can be no question that Ukraine has made progress in adopting and implementing reforms. The process has been far from perfect and the efforts have faced and will continue to face significant opposition (both in big business and in several change-averse pockets of society), but the reformist drive seems to have finally attained the critical mass needed to change Ukraine, one which never materialized with the Orange Revolution or in the decade since. In turn, the recognition of that critical mass by Ukraine's political elite has manifested itself in a resurgence of political will to make difficult decisions for the country's benefit.

By many measures, the pace of reforms has underwhelmed, even though the reforms are moving in the right direction. A local think tank, Vox Ukraine, compiles a bi-weekly index of reforms called IMoRe (Index of Monitoring Reforms). The index tracks 5 key areas – governance and anti-corruption, state finances, monetary policy and financial markets, external trade, and energy independence – and the reforms that have been implemented from late December 2014 until now.

The index has remained in positive territory throughout the 6 monitoring periods thus far. Thanks to the added impetus provided by the IMF funding package, the Index hit +2.2 on a +5.0/-5.0 scale in March, finally reaching the so-called "acceptable" range of reforms, defined as +2.0 to +3.0 on the index.

Based on the individual components within the index, the most impactful reforms have come in energy independence, governance, and anti-corruption, which are all real priority areas for the government.

Key Reforms

Below we identify the key reform initiatives that have been implemented in the 4 months since the new government came to power.

• Monetary Policy: Under National Bank Governor Hontaryeva and with guidance from the IMF, the banking regulator has freed the hryvnia to float and is implementing the institutional framework for inflation-targeting as a key tenet of monetary policy. A monetary policy committee was set up in December 2014, institutionalizing decision-making on interest rates and other monetary policy tools. Last week, the NBU released its first-ever flagship inflation report with detailed macroeconomic projections.

• Banking/Anti-Corruption: The NBU also adopted a new law on bank beneficiary owner disclosure. Banks can no longer hide beneficiaries by splitting ownership into stakes of less than 10%. With the same law, the NBU toughened regulation of related-party lending and has obliged banks to develop credible plans to reduce exposure to related parties. In the event a bank does not adhere to the new regulations the regulator can declare it insolvent.

• Governance/Anti-Corruption/State Finances: The long-awaited law on joint-stock companies, specifically the lowering of the quorum requirement for shareholder meetings to 50%+1 for companies in which the state is the majority owner, will boost transparency in cash flows to government coffers and help the state re-establish control over companies, notably UkrNafta.

• Governance/Anti-Corruption: The Ministry of Infrastructure now requires live online feeds of tenders involving state enterprises in the sector.

• Energy/Governance/State Finances: Under heavy pressure from the IMF, the national electricity regulator significantly increased gas and heating rates for households. Tariffs will rise 3.5x in 5 stages from April 1, 2015 to March 1, 2017. Under the plan, average gas tariffs will be hiked 3.9x and the minimum gas tariff rate will grow 3.3x to UAH 3,600/tcm. The hike in tariffs will help eliminate the state's subsidization of public gas rates and will have a material positive impact on state finances.

• Anti-Corruption: The Economy Ministry targeted corrupt schemes within its ministry and throughout the economy by eliminating licensing for 26 business activities and eliminating 16 regulatory restrictions. The Agriculture Ministry has also abolished 14 permits and 6 licenses to improve business activities in the sector.

• Anti-Corruption: The Cabinet of Ministers and Parliament have moved to eliminate monopolistic, go-between bodies that served little purpose but to fuel graft. One example was the UkrEkoResources state agency, a national waste management body, which the government has now shut down.

• Banking/Anti-Corruption: The banking sector is being cleaned up of insolvent banks. Over 50 lenders have been placed into receivership over the past 12 months and the NBU is determined to remove several other large, insolvent banks from the market by end-1H15.

• Banking/Anti-Corruption: A bill that enhances the independence of the central bank has been drafted and approved by the IMF, and it will be submitted to parliament soon. The IMF requires the law to be adopted by the end of April.

• Energy/Anti-Corruption: The government eliminated the 15% discount during auctions for crude oil sales, which improves transparency and levels the competitive market landscape for producers.

• Governance: The Interior Ministry is making progress on establishing a new road patrol service to replace the hated State Automotive Inspectorate, with newly trained officers due to appear in Kyiv in June.

• Governance/Anti-Corruption: The government has sought to tame Ukraine's bloated bureaucracy and rein in public spending by cutting staff at many ministries and departments. For example, the NBU is on its way to downsizing 1/4 of the employees at the central office and 50% at regional offices. The Economy Ministry has reportedly cut 30% of its staff already.

On the negative side, not enough has been done to tackle corruption in the judicial branch. The very public arrests of three judges from the Kyiv Pechersk Administrative Court involved in the politically motivated arrests of former Interior Minister Yuri Lutsenko and former PM Yulia Tymoshenko is an important signal, but it does nothing to eliminate the environment that breeds corruption in the courts. In addition, the Cabinet of Ministers has created the much-vaunted national anti-corruption agency, but the body's powers and limitations are unclear, and its effectiveness remains to be seen.

Significant reforms remain in the weeks, months, and years ahead, and we will continue to track progress through the 2Q and in the remainder of 2015.

Most recently, the NBU and other regulatory bodies and market participants revealed an overview of its Financial Market Reform Program, to start in 2015 and be completed in 2020. The central bank is moving forward quickly with the program – the document is currently open for public discussion and is slated to be formally presented to the National Council on Reforms on April 10. Below we provide an outline of the reform program.

Financial Market Reform Program (2015-2020)

The program has four priorities: macroeconomic stability, financial stability and financial market development, development of investment capabilities, and the protection of consumers' and investors' rights. The financial market reform is still in its infancy, but continued progress in broad reforms will bode well for the likelihood of success with these efforts as well.

Macroeconomic Stability

1. Monetary policy based on inflation-targeting and a flexible exchange rate regime

Financial Stability, Financial Market Development

1. Harmonizing legislation with EU standards

2. Modernizing the regulatory framework and system of oversight

3. Increasing transparency and the stability of financial markets

4. Ensuring the development of financial market instruments and infrastructure

5. Improvement of financial market taxation

6. Cleaning the financial system of problematic assets

Development of Investment Capabilities

1. Ensuring institutional independence for regulatory bodies

2. Improving the organizational effectiveness of regulatory bodies

3. Improving coordination between regulatory bodies and financial market participants

4. Stimulating the introduction of new IT technologies

Protection of Consumer and Investor Rights

1. Stimulating the development of financial literacy among consumers and investors

2. Increasing rights protection standards for consumers and investors

As mentioned, the pace of reforms has underperformed against elevated expectations. Those expectations were, in our view, unrealistic. Despite a real desire to change the system, those implementing real reforms are waging a war of attrition against well-entrenched corrupt elements. One of the most important sources of corruption remains the class of oligarchs that dominate business interests in Ukraine, and who – many would argue – have little real interest in reform or change; vast fortunes were built on graft and the future growth of profits depends to a degree on those advantageous positions.

The minority shareholder/quorum law and other efforts by the government have done their part to break a number of corrupt practices that benefited certain business groups, but the oligarchs remain an entrenched and powerful force. Especially because of their control over mass media they will remain a key cog in the Ukrainian political machine for a while still. How the game plays out with Igor Kolomoysky and others remains to be seen, but it's fair to say they have the ability to pose a threat to reform efforts.

Obviously, the other major factor that could derail all reform efforts and take the IMF program off-track is a re-escalation of the conflict in the east. Everyone seems to be awaiting a fresh offensive from Russia this spring or early summer. Unfortunately, the Ukrainian government has little control over such an important factor to the success of its reform agenda: peace.

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