UKRAINE SYSTEMATIC COUNTRY DIAGNOSTIC...in a serious economic crisis in Ukraine in 2014‐2015. The...

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ReportNo.114826‐UA

UKRAINE

SYSTEMATICCOUNTRYDIAGNOSTIC

TOWARDSUSTAINABLERECOVERYANDSHAREDPROSPERITY

April28,2017

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TableofContents

ExecutiveSummary................................................................................................................................................................3

I. Introduction.............................................................................................................................................................12

II. GrowthandSustainability:PatternsandSources....................................................................................14

III. PovertyandSharedProsperity:PatternsandTrends............................................................................21

IV. Framework:PathwaysandConstraints.......................................................................................................35

V. Cross‐CuttingPathway:BetterGovernanceandAnticorruptionInstitutions..............................44

VI. Pathway1:MacroeconomicStability............................................................................................................52

VII. Pathway2:PrivateSectorProductivity........................................................................................................63

VIII. Pathway3:Effectiveservicesandtargetedassistance..........................................................................80

Acknowledgements..............................................................................................................................................................92

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ExecutiveSummary1. Ukrainehasexperiencedacutepolitical,security,andeconomicchallengesduringthelastthreeyears.Followingthe“Maidan”uprisingthatledtotheoustingofthepreviousPresidentinNovember2013,thelastthreeyearshavewitnessedseveralmomentousevents:developmentsinCrimea and Sevastopol inMarch2014which led to theUNGeneralAssembly resolution68/262affirmingtheterritorial integrityofUkraine; theoutbreakofconflict in theDonetskandLuhanskregionsineasternUkraine;andPresidential,Parliamentaryandlocalelectionsin2014‐2015.TheGovernmentthattookofficeinDecember2014hadamandateforreformsinthefaceofformidablechallenges, including: containing conflict and restoring peace; ensuringmacroeconomic stability;tackling a major banking crisis; reducing the fiscal deficit in the midst of a recession withouttriggering social unrest or backlash against reforms; and reducing deep‐seated corruptionwhilecontendingwithpowerfulvestedintereststhatcontinuetoopposereforms.AfterSeptember2015,thepaceof reformmoderateddue to increasingpoliticaluncertainty and the influenceof vestedinterests.InApril2016,anewgovernmenttookofficeandissuedaprogramandactionplancoveringawiderangingreformagendainMay2016.Anupdatedmediumtermactionplanfor2017‐2020wasadoptedinApril2017. Figure1 Figure2

2. SevereshockscombinedwithahistoryofslowprogressonstructuralreformstoresultinaseriouseconomiccrisisinUkrainein2014‐2015.TheeconomywashitbyunprecedenteddoubleshocksfromtheconflictineasternUkraineandaconsiderablyweakerexternalenvironment,includinglowerglobalcommodityprices. Theconflictcausedsignificantcontractionof industrialproductionandrevenuesintheDonetskandLuhanskregions,ledtowidespreaddisruptioninsupplyanddistributionchains,andunderminedconfidenceintheoveralleconomy.Inaddition,thedropinglobalcommoditypricesresultedinaseriousdeteriorationofUkraine’stermsoftradeandrecessionamongitstradingpartners.Asaresultofthesefactors,realGDPcontractedsharplyby6.6percentin2014andbyafurther9.8percentin2015.Furthermore,structuralbottlenecksandaccumulatingimbalances preceding the crisis necessitated a considerable fiscal and external adjustment inresponsetotheshocks,whichfurthercompresseddomesticdemand.Thecurrencydepreciatedby

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‐10

‐5

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2010 2011 2012 2013 2014 2015 2016

GDP Growth (%);Fiscal Bal incl Naftgz, CAB (% of GDP)

GDP growth (annual %) Fiscal Def incl Naftgz (% GDP)

Current Acct Bal (% of GDP)

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47percentin2014andafurther33percentin2015,whiletheconsolidatedfiscaldeficit,includingNaftogaz,reached10.1percentofGDPin2014andpublicandguaranteeddebtspikedto79percentof GDP in 2015. The deep recession and depreciation caused deposit outflows, rising levels ofnonperforming loans, and large numbers of bank failures, further reducing confidence in theeconomy.3. Poverty increased significantly since 2015,with access to services and livelihoodsparticularly impacted in conflict affected areas. The deep recession, depreciation, andcompression of public current expenditures contributed to significant contraction of disposableincomesinUkraine,withbothlaborandnon‐laborincomescontractingin2015inrealterms.Asaresult,theestimatedpovertyrate(under$5/dayin2005PPP)increasedfrom3.3percentin2014to5.8percentin2015,whileestimatedmoderatepoverty(Bank’snationalmethodologyforUkraine)increased from 15.2 percent in 2014 to 22.2 percent in 2015. Poor households,which spend asignificantshareoftheirbudgetonheatingandutilities,werealsoaffectedbythedramaticincreasein energy prices in 2015. The rapid expansion of the newmeans‐tested housing utility subsidyprogram(withupto5millionhouseholdscoveredatend‐2015)helpedtomitigatetheimpactonpoverty.Labormarketconditionsdeteriorated,withnominalwagegrowthlagginginflation,andrealwagesdownonaverageby20percentin2015.Unemploymentincreasedfrom7.8percentin2013to9.5percentin2015.Joblessness,accesstoservices,socialtensions,andlivelihoodsmorebroadlywereparticularly impactedinconflictaffectedareas. Furthermore,withabout1.7millionpeopleestimatedtohavebeeninternallydisplaced,thesesocialandhumanitarianimpactsarefeltbybothdisplacedandhostcommunities.

4. The“Maidan”uprisingof2013‐14generateddemandforchangeinUkraine,andtheauthoritiesundertookdecisivereformsin2014‐2015tostabilizeandreformtheeconomy.Key reforms implemented included: (i) moving to a flexible exchange rate to stabilize externalimbalances;(ii)undertakingconsiderablefiscalconsolidationbycompressingexpenditures,avertingcontingentliabilitiesfromthefinancialsector,andreformingenergytariffstoreduceakeyquasi‐fiscaldeficit,whilestrengtheningsocialassistancetocushiontheimpactonthepoor;(iii)stabilizingthebankingsectorbyputtinginplaceaframeworktoresolveandrecapitalizebanksandstrengthensupervision; (iv) streamlining the business environment; and (v) taking initial steps to enhanceaccountabilityinthepublicsectorbyestablishinganti‐corruptionagencies.

5. Ukrainetodayisatacrossroads:theeconomyhasstabilizedbuteconomicprospectsremainweak,andaddressinglongstandingstructuralbottlenecksonmultiplefrontswillbecriticaltoadvancedevelopmentprospectsanddelivertangiblebenefitsforthepopulation.Asa result of the reforms since 2014, the economy has stabilized and large imbalances have beenreduced at least for the short term. Real GDP grew by 2.3 percent in 2016, while the generalgovernmentdeficit,includingNaftogaz,wasdownto2.1percentofGDPin2015and2.3percentin2016. However,poverty isupsignificantlyand livelihoodshavebeendisrupted fromtheseriousshocks to the economy and the resulting economic crisis. Furthermore, prospects for economicrecovery remain weak in light of the weak global economic environment, continuing conflict ineastern Ukraine, and the deep structural bottlenecks and governance challenges that have

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constrainedsustainablegrowthandsharedprosperityforthelastdecadeandhalf.Addressingmanyofthoselongstandingstructuralbottlenecksandgovernancechallengeswillbecentraltosupportingsustainedeconomicrecoveryandsharedprosperitygoingforward.6. Evenprior to thecurrentcrisis,macroeconomic imbalancesandweakproductivitygrowthderivingfromdeepstructuralbottlenecksandgovernancechallengesledtomorethanadecadeofunsustainablegrowthenabledbyfavorableexternalconditions.Growthaveraged7percentannuallyduring2000‐2007,drivenmostlybyfavorableexternalconditionsandreboundfromthesharppost‐transitioncontraction.Ukraine’stermsoftrade(TOT)improvedby50percentbetween2001and2008,includinghighersteelpricesontheexportsideandbeneficialpricingofnaturalgasontheimportside.Capitalinflowssurgedafter2005whilecreditgrowthboomed,fueledby external borrowing of commercial banks. These favorable external conditions enabled anexpansionaryfiscalpolicywithaccumulatingstructuraldeficitsincludingrisingpensionspending,Naftogaz and other subsidies, and a growing publicwage bill. Public capital expendituresweresqueezed,whilelimitedstructuralreformswereundertaken,withtheresultthatproductivitygrowthslowedand the sophisticationofUkraine’sexportbasketexperienced limited improvement. Theeconomy stagnated during 2008‐2013, with growth averaging ‐0.7 percent annually during thisperiod. Furthermore, imbalances accumulated from2005,with the current account shifting intodeficitfrom2006andaveraging‐5.7percentofGDPduring2008‐2013comparedtoa+3.7percentduring2000‐2007.ThefiscaldeficitincludingNaftogazaveraged5.5percentofGDPduring2011‐2013.

7. Povertydeclinedbetween2000and2013,but less so since2008,whilehouseholdincomeshave reliedheavily onpensions and social transfers, raising concerns about thesustainabilityofpovertygains. The share of the population under themoderate poverty linedeclinedfrom79percentin2002to15percentin2014,whiletheshareofthepopulationunder$5PPPdeclined from46percent in2002 to3.3percent in2014. While theoverallpaceofpovertyreductionsince2002wasstrong,itslowedsince2008duetotheoverallstagnationintheeconomy.Furthermore,householdincomeshavereliedheavilyonpensionsandsocialtransfers.Outofincomegrowth of 4.5 percent per year during 2009‐2014 for the bottom 40 percent of the population,pensionsandsocialassistanceaccountedforalargeportion(2percentperyear),whilelaborincomeaccountedfor2percentperyear.Thisraisesconcernsaboutsustainabilityofthegainsinreducingpoverty,particularlybecauseofthelargecostofpensions(11percentofGDPin2016).Furthermore,thebottom40percenthavelowerlabormarketoutcomesandlevelsofeducationalattainmentandaccesstoutilities,whichhaveanimpactontheirqualityoflifeandabilitytogenerateincomes.8. Ineffectiveservicesandweakly targetedassistancehavecontributed to inadequateemploymentoutcomes,therelianceontransfers,andtheunsustainablepatternofpovertyreduction.UkrainespendsalargeshareofGDPonsocialservicesandassistance,althoughthisdoesnot translate into high quality service delivery. Access to services has improved over time in anumberofareas,althoughoutcomes,deliverymechanisms,andtargetingremainineffective.Infantmortality has decreased from 17 per thousand live births in 1990 to 8 in 2014, while under‐5mortalityandmaternalmortalityhavealsoimprovedoverthesameperiod.However,lifeexpectancy

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has not changed much over the last 20 years and the hospital sector remains oversized andinefficient. With70percentofspendingoneducation,health,andsocialservicespassingthroughsubnationalgovernments,improvingdeliverymechanismsatthesubnationallevelcanhelpenhancetheeffectivenessofservices.Finally,inlightoftheimpactoftheconflict,providingtargetedsocialassistanceandservicestoconflictaffectedpopulationscanhelpmitigatetheimpact.9. Corruptionandstatecapturehavebeenentrenched inUkraineandareadominantimpedimentonthepathtosustainedrecoveryandsharedprosperity.CorruptionpermeatesallwalksofpubliclifeinUkraine.Onmanyaggregatemeasuresofcorruption,UkrainescoresclosertothepooresteconomiesthantotheEUwhichitaspirestojoin.Ukrainewasinthe15thpercentileworldwideintheWGI(WorldGovernanceIndicators)ControlofCorruptionindicatorin2014,wellbelowPoland andRomania (71st and 53rd percentile, respectively), aswell as averages for lowmiddleincomecountries(37thpercentile),theECAregion(64rdpercentile),andsub‐SaharanAfrica(30thpercentile).Withsuchextraordinarylevelsofcorruptionandstatecapture,powerfulvestedinterestsacrossawiderangeofsectorsseriouslyimpedeUkraine’spathtowardsustainedrecoveryandsharedprosperity.Forexample,widespreadtaxevasionandrelatedpartylendingunderminemacroeconomicstability,ahighlyconcentratedandanticompetitiveproductionstructure inhibitsproductivity and job creation, and weaknesses in the management of public resources impedesdeliveryofeffectiveservicesandtargetedassistancetothepopulation.10. Ukrainehasstruggledwithcorruptionandstatecapturesinceitsindependenceandthevestedinterestshaveestablisheddeeproots.Privatizedstateassetswereconcentratedinafewhands in theearly transitionyears. State‐regulatedcommodityprices,underpriced leasesoflargetractsofagriculturalland,andbudgetsubsidieshavealsohelpedstrengthenthehandofvestedinterests. Asaresult,asmallnumberofoligarchshavedominated largesectorsof theUkrainianeconomy, extracting rents, and influencing public institutions, including through directrepresentation in political parties and the Parliament. The symbioses linking oligarchs withpoliticiansandstateofficialsstandinthewayofreformstoleveltheplayingfieldandeliminaterents.Vestedinterestshavefinancedpoliticalpartiesandexpensiveelectioncampaigns,whilecivilsocietyhasbeentooweaktocountersuchdeep‐seated influence,althoughsomesuccessesareemergingrecently,forexample,withNGOwatchdogsadvocatingforaneffectivelaunchoftheelectronicassetdeclarationsystem.11. ConflictandshocksisanotherimportantconstraintimpedingUkraine’spathtowardsustainedrecoveryandsharedprosperity.Asdiscussed,theconflicthashadawidespreadimpacton economicactivity andprospects inUkraine.Disruptions in industry, transport, and small andmediumenterpriseactivityledtowidespreadjoblossesandoverallconfidenceintheeconomywasseriouslyundermined.Theconflictalsohadaconsiderablehumancost,withvulnerablegroupsinconflictareas,especiallypensioners,women,childrenandpeoplewithdisabilitiesmostatrisk,andlargenumbers of internally displacedpersons (IDPs). Continuing insecuritymeans thatUkrainemustgotheextrasteptobolsterconfidenceinitseconomy.Managingthehumancostoftheconflictwillalsorequireprovidingtargetedservicesandsupportingemploymentgenerationamongconflictaffectedpopulationsandhostcommunities.Inadditiontotheconflict,Ukrainewashitbyverylarge

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externalshocks,includingthesharpfallinglobalcommoditypricesandrecessionanddepreciationinexportmarkets.Giventheweakexternaloutlook,Ukrainewillneedtogotheextramiletomanagemacroeconomicimbalancesandsupportconfidenceinitseconomy.12. DemographyandgeographyarealsoattherootofUkraine’sdevelopmentchallenges.Ukraine’sworkingagepopulationhasbeendecliningwhiletheelderlypopulationhasbeenrisingduetohighmortality,lowbirthrates,andout‐migration.Theworkingagepopulationhasfallenfromaround34millionin2000to32millionin2013andisprojectedtokeepondecliningtoreach25millionby2050,whiletheelderlypopulationisprojectedtorise.ThesedemographicfactorshavesignificantimplicationsforUkraine’sdevelopmentchallenges,includingalargerroleforproductivityand capital accumulation in driving growth, and initiating a nationwide dialogue on the socialcontractforsustainableoldagepensionssupport.Ukrainealsohasauniquegeography,witharichendowmentofagriculturalandothernaturalresources,andadjacenttotheEUtothewest,RussiatotheEast,andtheBlackSeatothesouth.Thelargeadjacentmarketscanbetappedfordevelopingamorediversifiedexportbase.Ontheotherhand,therichendowmentofnaturalresourcesleadstosignificantchallengesrelatingtocorruptionandrentseeking.

PathwaysandPriorityInterventions

13. Basedonthe foregoinganalysisofdevelopmentchallenges,thisSystematicCountryDiagnostic (SCD) identifies a set ofpathways andpriorities toward achieving sustainablerecoveryandsharedprosperityinUkraine.Thechallengesdescribedabovepointtowardfourkeypathways:safeguardingmacroeconomicstability,boostingprivatesectorproductivity,andprovidingmoreeffectiveservices,whilebuildinginstitutionsofbettergovernanceandanticorruption.Whilethemeasurestakentodatehavebeenimportantinstabilizingtheeconomy,thelargebacklogofreformsandstructuralbottlenecks,coupledwiththeweakeconomicoutlook,considerablevulnerabilities,

Figure3.ConstraintsandPathways toSustainedRecoveryandSharedProsperity

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andhigherpovertymeanthatadvancing furtherreformsonmultiple frontswillbecritical toputUkraineonapathtowardsustainedrecoveryandsharedprosperity. First, inlightofthedifficultexternal environment, persisting vulnerabilities, and history of large imbalances, safeguardingmacroeconomicstabilitywillbecriticaltomovefromstabilizationtosustainedrecovery.Thiswillrequirereformstoconsolidatethestructuralfiscaldeficitandstrengthenthefinancialsector,whilemaintainingaflexibleexchangerate.Second,inlightofthehistoryofweakproductivitygrowthandlabormarketoutcomes,Ukrainewillneedtoimproveprivatesectorproductivity.Thiswillrequireinvestingininfrastructure,creatingalevelplayingfieldintheprivatesector,reforminglandmarkets,andtakingadvantageoftradeopportunities.Third,inordertoreduceexpenditurepressures,ensurethatthebenefitsofrecoveryarebroadlyshared,andgeneratetangibleimprovementsinthequalityof life of the population, Ukraine will need to providemore effective services and targetedassistance to thepopulation. Thiswill require reforming health care financing, optimizing theschool network, enhancing skills of the workforce, and improving targeting of social assistance.Finally,inlightofthehighdegreeofcorruptionandstatecapture,buildinginstitutionsofbettergovernanceandanticorruptionwillbecriticaltothesuccessofreformsacrosstheboard.14. ProgresstowardtheWorldBank’stwingoals inUkrainegoingforwardwilldependcriticallyonthepathwaystosustainedrecoveryandsharedprosperitypresentedinthisSCD.OneofthecriticalimpedimentstoprogresstowardthetwingoalsgoingforwardisthatUkrainehasnot yet established the environment for sustained economic growth. Thehistory of volatile andunsustainablegrowthfueledbylargemacroeconomicimbalances,coupledwithapatternofweakproductivitygrowth,hasmeantthatprogresstowardthetwingoalsinthepasthashadtorelyonincreasinglyunsustainablesocialprotection.Goingforward,inordertogeneratesustainedprogresstowardthetwingoals,anewmodelofpovertyreductionandsharedprosperitybasedonsustainedeconomicrecoverycoupledwithmoreeffectiveserviceswillbecritical.Sustainedeconomicrecoverywill require breaking the underlying drivers of large macroeconomic imbalances and weakproductivitygrowth.Furthermore,moreeffectiveserviceswillensurethatthepoorersegmentsofthepopulationcanalsobenefitfromlabormarketopportunities,whileensuringthatthebenefitsofgrowtharebroadlysharedinasustainablemanner.15. Thefirstpathwayissafeguardingmacroeconomicstabilitybyaddressingthelargestsourcesof fiscaland financial sectorvulnerability. Ukraine hasmade important progress in2014‐16 inmanaging fiscal and financial sector imbalances in the face of unprecedented shocks.Going forward, the focus will need to be on the deeper structural roots of the vulnerabilities.Considerablefiscaladjustmenthasbeenimplementedin2014‐16throughtightcontrolsonnominalspendingcoupledwithinflation,aswellasenergytariffincreases.Goingforward,thelargestmediumtermfiscalvulnerabilitiescomefromanarrowtaxbase,weaktaxadministration,andanineffectivepension system. Reforming the tax system will require broadening the tax base by removingexemptionsand loopholes, improving international taxationarrangements,andstrengthening taxadministration. The pension system in Ukraine not only represents a major fiscal vulnerability(expenditures of 11 percent of GDP in 2016), but also provides elderly benefits that are far tooinadequate (the average old age pension is only about $2 a day). Reform options includerestructuringthebenefitpackagetostrengthensustainability,adequacy,andtransparency,aswell

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asparametricmeasurestoaddresscategoricalbenefits,earlyretirement,andprovideincentivestoretirelater.Inthefinancialsector,deep‐rootedrelatedpartylendingandweaknessesinsupervisionhave combinedwith the economicdownturn to result in largenumbersof bank closures and anincrease in non‐performing loans. Going forward, reforms will need to focus on continuing toimplementtheframeworkputinplacetoresolveandrecapitalizebanksandstrengthensupervision,but also put in place measures to support a resumption of lending by strengthening corporategovernanceofstateownedbanksandfacilitatingworkoutofNPLs.16. The second pathway is boosting private sector productivity by strengtheninginfrastructureinvestment,creatingalevelplayingfieldintheprivatesector,reforminglandmarkets,andtappingtradeopportunities.Ukrainehasmadeimportantprogressinstreamliningitsbusinessenvironmentinrecentyears,withitsDoingBusinessrankingimprovingfrom140thin2013to80thin2017. However,deeperstructuralbottlenecksremainthathave, foranextendedperiod,underminedtheemergenceofamoreproductiveprivatesectorandamoresophisticatedexport structure. These bottlenecks include weak infrastructure, a highly concentrated andanticompetitivemarketstructure,andweaklandmanagement.Addressingthesebottlenecksisallthe more important under the current environment in which the conflict and weak externalconditionscontinuetoundercutinvestorconfidence.Improvinginfrastructurewillrequirecreatingfiscal space for public investment and strengthening public investment management, whileimprovinggovernanceandtransparencyintheimportantenergyandtransportsectors.Creatingalevel playing field for the private sector will require further deregulation, more effectiveimplementationofcompetitionlegislation,andimprovingcorporategovernanceofineffectivestateownedenterprises.Perhapsmostcriticalfortheprivatesectoristoreformlandmarkets.Weaklandgovernance seriously undermines investment and productivity in the high‐potential agriculturesector, as well as other sectors. Reforming land markets will require improving state landmanagementthroughanewlegalframework,whilegraduallyopeningsalesforprivateagriculturallandensuringtransparencyandequalaccess.17. The thirdpathway isprovidingmore effective services and targeted assistancebyoptimizingthefinancingandimprovingthequalityofhealthandeducation,furtherimprovingtargeting of social assistance, and providing effective support to conflict affected people.DespitespendingalargeshareofGDPonsocialservicesandassistance,thequalityandeffectivenessofhealthandeducationservicesisweak,whilesocialassistanceisweaklytargeted.Providingmoreeffectiveservicesandtargetedassistancecan,therefore,notonlyreduceexpenditurepressures,butalsohelpimproveemploymentoutcomesandresultintangibleimprovementsinthequalityoflifeforthepopulation.Themostimportantprioritiesareintheareasofhealth,socialassistance,andtargetedsupporttoconflictaffectedpeople.Inhealth,akeypriorityistoreformthehealthfinancingmodelfromafocusonhospitalcareandinput‐basednormstowardapaymentsystemwheremoneyfollowsthepatient.Insocialassistance,keyprioritiesincludeimprovingthetargetingofthehousingand utilities subsidy (HUS) program which has provided temporary relief from energy tariffincreases,butalsocontinuing tomove fromcategorical to targetedbenefits for theoverall socialassistancepackage.InlightofthecontinuingconflictandlargenumbersofIDPs,providingtargetedsupport to conflict affected people is a high priority. Thiswill require providing effective skills,

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training,andenterprisesupportinaffectedareasandextendingsystematicassistancetovulnerablehouseholds.18. Thefourthandcross‐cuttingpathwayisbuildinginstitutionsofbettergovernanceandanticorruption.Theseincludeinstitutionsofpublicfinancialmanagement(PFM),anticorruption,justice,publicadministration,andcitizens’engagement.StrengtheningPFMinstitutionswouldhelpimprove efficiency, accountability, and transparency in the use of public resources, including forservicedelivery,publicinvestment,andstate‐ownedenterprises.Thiswouldhelpreducefiscalrisksand contribute to more effective infrastructure and service delivery. Building effectiveanticorruptionandjusticeinstitutionswouldcontributetooveralltransparency,accountabilityandfairness in the interface between citizens, businesses, and the state, while providing the toolsnecessarytobattlegrandcorruption,statecapture,andtheinfluenceofvestedinterestsinordertore‐establishpublictrustinthepublicsector. Improvingpublicadministrationbybuildingamoreprofessionalandmotivatedcivilserviceandmoreefficientinstitutionswillhelpreduceincentivesforcorruptionwhileimprovingdeliveryofpublicservices.Finally,enhancingcitizens’engagementeffortsinadvancingkeystructuralreformsandmonitoringtheeffectivenessofservicedeliverywillbeimportantinharnessingandchannelingtheenergyandenthusiasmforchangeinUkrainesincetheMaidanuprising.19. Infact,atwo‐prongedstrategyisimportantinaddressingUkraine’sgovernanceandcorruptionchallenges. Thefirstprongofthestrategyinvolvesbuildingtheinstitutionsofbettergovernanceandanticorruptionthatwouldhaveacross‐cuttingimpactinsupportingprogressalongtheotherpathwaystosustainedrecoveryandsharedprosperity.Thesecondprongofthestrategyinvolves advancing reforms across the three other pathways ofmacroeconomic stability, privatesector productivity, and service delivery to disempower vested interests. Reforms in taxadministrationandthefinancialsectorcanhelpnotonlycontainmacroeconomic imbalances,butalso disempower powerful underlying vested interests by cutting tax evasion and reining inopportunities for related party lending. Similarly, streamlining business regulations, increasingcompetition,andreforming landmarketswouldnotonlyhelp level theplaying fieldandsupportproductivitygrowth,butalsoundercutrentsforpowerfulvestedinterests.Furthermore,effectivedecentralizationcannotonlyhelpdelivermoreeffectiveservicesundertherightcircumstances,butcan also undercut a centralized system of influence and rebuild public support for governmentinstitutions.ThismeansthatanimportantprongofabettergovernanceandanticorruptionstrategyforUkraineinvolvespushingprogressonreformsacrosstheboardthatunderminevestedinterests.20. Thefollowingtableprovidesasummaryofthepathwaysandpriority interventionsidentifiedbythisSCD.Fourpathwaysandsixteenprioritiesarelisted.Whilethisisnarroweddownfromawideruniverseofpossiblepathwaysandpriorities,sixteenprioritiesisstillalargenumberandnotallofthemareequallycriticalinhelpingUkrainegeneratesustainedrecoveryandsharedprosperity.Norcanallofthembeexpectedtobeimplementedoverthesametimehorizon.Eachoftheprioritiesare,therefore,assignedacriticalityratingof“critical”,“high”,or“medium”andatimehorizonof“immediate”,“short”,or“medium”overwhichprogressisneededandcanbeexpected.

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SummaryofPathwaysandPriorities

Priorities Criticality TimehorizonPublicfinancialmanagement:ImplementupdatedPFMStrategy,includingmediumtermbudgeting,streamliningperformancebasedbudgeting,andintroducingfiscalriskassessmentframework.

High Short,Medium

AnticorruptionandJusticeInstitutions:Effectivelyimplementnewanti‐corruptionlaws;strengthenpublictrustinjusticesystembyimprovingenforcementandHRreform.

Critical Short,Medium

Publicadministrationreform:Improvepolicyanddecision‐making;streamlinepersonnelwhileimprovinghumanresourcemanagement;undertakemerit‐basedappointmentsandoptimizesalaries.


CitizensEngagement:Buildonsuccessfulpost‐Maidanmobilizationbypromotingmoresystematicplanning,management,andcommunicationsbasedoninformationandevidence‐basedanalysis.

Critical Immediate,Short

Priorities Criticality TimehorizonTaxReform:Broadentaxbasebyremovingexemptionsandloopholes;improveinternationaltaxationtreaties;andstrengthentaxadministration

High Immediate,Short

PensionReform:Restructurebenefitpackagetobetterlinkcontributionstobenefits;parametricreformstoaddresscategoricalbenefits,earlyretirement,andprovideincentivestoretirelater

CriticalImmediate,Short,

Medium

StrengthenFinancialSector:Implementframeworktorecapitalizeandresolvebanksandstrengthensupervision;restorecreditgrowthbyputtinginplaceeffectiveNPLresolutionframework;andimprovegovernanceofstateownedbanks

Critical,High Immediate,Short

Priorities Criticality TimehorizonStrengthenPIMandExpandInfrastructure: High Short

•CreatefiscalspaceforpublicinvestmentandstrengthenPIMsystems High Medium•Energysector–improvegovernanceandtransparency,reducelosses,andreducehighenergyintensity

Critical/High Medium

•Transportsector–promoteefficientmultimodaltransportsystemtounleashingUkraine’stradepotential

Medium Medium

CreateLevelPlayingFieldinPrivateSector: High Short

•Deregulation–furtherstreamlinebusinessregulatoryenvironment High Short/Medium

•CompetitionPolicy–enhancecapacityofAMCtoimplementlegislationandstreamlinestateaidforenterprisestoreducedistortionofcompetition

High Medium

•SOEReform–triageofSOEs;strengthenaccountingandfinancialreporting;andimprovecorporategovernance

High Short

LandReform:Increaseefficiencyofstatelandmanagementthroughnewlegalframework;opensalesmarketforprivateagriculturallandensuringtransparencyandequalaccess;andclearstatusofunclaimedproperty.

Critical Short/Medium

TradeFacilitation:Strengthenandharmonizequalityandstandardsarrangementstotappotentialofinternationaltradeagreements

Medium Short

Priorities Criticality TimehorizonHealthReform:Revisehealthfinancingmodelfrominput‐basednormstowardpaymentsystemswhere“moneyfollows”thepatient

High Short

Education:Implement“hubschools”programtooptimizeschoolnetworkwhileprioritizinginvestmentsinquality‐enhancinginputs

Medium Short

Subnationaldeliverymechanisms:Improvenorm‐basedfinancingforservices,increasefinancialautonomy,andclarifyrolesandresponsibilities

Medium Short

SocialAssistance:Continueshiftfromcategoricaltotargetedbenefitsandimprovetargetingofthehousingutilitysubsidy(HUS)program


Targetedsupporttoconflictaffectedpeople:skills,training,andMSMEinaffectedareasandhostcommunitiesandextendsystematicassistancetovulnerablehouseholds


Pathway3:EffectiveServicesandTargetedAssistance

CrossCuttingPathway:BetterGovernanceandAnticorruptionInstitutions

Pathway1:MacroeconomicStability

Pathway2:PrivateSectorProductivity

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I. Introduction1. Ukrainehastremendouspotentialthathasnotyetbeenreached.Ukraineisendowedwith intelligent, energetic, and entrepreneurial people; extraordinary fertile land; considerablenaturalresources;andageographiclocationatthecrossroadsofEuropeandAsia.Thereisnoreasonwhy Ukraine, under the right conditions, should not be among the league of prosperous andsuccessful nations. The circumstances today, however, are of course, still far from that ultimatetarget.Ukraine’sGDPperpersonin2015was$2,115,whilethecorrespondingfigurewas$12,500for Poland, around $9,000 for Turkey and Romania, and $9,800 for Malaysia, and $13,000 forArgentina.TheflipsideofthecurrentcircumstancesisthatifUkraineisabletoputinplacetherightconditions,itwillexperienceaperiodofstrongeconomicgrowthasitcatchesupandconvergestothelevelsofincomeofmoreprosperousnations.

2. Two important factors explainwhy Ukraine today finds itself considerably belowpotential: (i)ahistoryofdeep structuralbottlenecksand governance challenges;and (ii)seriousshocksfrompolitical,security,andeconomicchallengesduringthelastthreeyears.Thehistoryof structural bottlenecks and governance challengeshas led to largemacroeconomicimbalances,weakproductivity growth, and ineffective social services inUkraine for an extendedperiod.Thishasinturnledtoapatternofunsustainableeconomicgrowthandpovertyreduction.Growthaveragedonly2percentperyearinUkraineduring2000‐2015,comparedto3.6percentinPoland, 4.2 percent in Turkey, and 5.1 percent in Malaysia. Second, Ukraine has been hit byunprecedented shocks on two fronts in 2014‐2015: the conflict in eastern Ukraine and thedeteriorationintheglobaleconomicenvironment,includingsharplylowercommodityprices.Theimpactofthedualshockshasbeenverysignificant.RealGDPcontractedby6.6percentin2014andby a further 9.8 percent in 2015. The currency depreciated sharply in 2014‐2015 and theconsolidatedfiscaldeficit,includingNaftogaz,reached10.1percentofGDPin2014.Alargenumberofbankshavefailedandthelevelofnonperformingloansincreased.3. TheeconomiccrisishasbeenanopportunityforchangeinUkraine.Formuchofthelast15years,Ukrainefacedveryfavorableexternalconditions.CapitalflowedfreelyintoUkraineandotheremergingmarkets,whilecommoditypricesboomed. Asaresult,Ukrainewasabletogrow

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withoutstructuralreformsorsignificantimprovementsinefficiency.Allthisledtoanunsustainablepattern of growth. The economic crisis since 2013 has forced change and Ukraine has takenadvantageoftheopportunity.Considerablereformshavebeenimplementedinthelastthreeyearstostabilizetheeconomyinthefaceofshocks,reducelargeimbalances,andcushiontheimpactoftheshocks on the population. Key reforms adopted include moving to a flexible exchange rate;undertaking significant fiscal consolidation; reformingenergy tariffs andstrengthening the socialsafetynettocushiontheimpactonthepoor; stabilizingthebankingsectorbyputtinginplacetheframeworktoresolveandrecapitalizebanks,andstrengthensupervision;streamliningthebusinessenvironment; making public procurement more transparent and improving public investmentmanagement;andputtinginplacekeyinstrumentsofanticorruption.

4. Muchmoreneedstobedonetomovefromeconomicstabilizationtodurablerecoveryandsharedprosperityforthepopulation.Strongandsustainedrecoveryhavenotyettakenholdandpovertyhasincreasedsignificantlyinlightoftheeconomiccrisis.Ukraineneedstonowaddressthe deeper structural bottlenecks and governance challenges on multiple fronts that haveconstrained sustainable development for the last 15 years. This will help translate economicstabilizationintolastingeconomicgrowthandtangibleimprovementsforthepopulation.Itwillalsocontributetothepoliticalandsocialsustainabilityofthereformprogram.Acrosstheboard,makingprogressonthereformswillrequireintensifyinganti‐corruptionandgovernanceeffortstoreducetheinfluenceofvestedinterests.Withoutnewreformmomentum,economicprospectswillremainveryweak,largemacroeconomicimbalancescouldre‐emerge,andthepopulationwillcontinuetohurtfromtheimpactoftheeconomicdownturn.Withnewreformmomentumtobolsterinvestorconfidenceandproductivityanddelivermoreeffectiveservicestothepopulation,economicgrowthcouldpickupto4percentormoreinthemediumtermandthepopulationwouldexperiencetangibleimprovementsovertime.Withevengreaterreformmomentum,Ukrainewouldbeabletogeneratetheconditionsforrapideconomicgrowthandconvergencetotheincomelevelsofthecommunityofprosperous,sociallyequitable,andsuccessfulnationswhereitbelongs.5. ThisSystematicCountryDiagnostic(SCD)forUkraineisintendedasanevidencebaseddiagnosticoftheconstraintsandprioritiestoreducepovertyandpromotesharedprosperityinasustainableway.TheSCDisintendedasanevidence‐basedandintegrativeanalyticalreport,combininganalysisofgrowth,inclusion,andsustainability.TheSCDisnotintendedtobelimitedtoexpectedareasofWorldBankGroup(WBG)engagement,butisinsteadintendedtoassesswhatthecountryitselfshoulddotoadvanceitsgrowth,povertyreduction,andsharedprosperityobjectivesinasustainableway.6. ThisSCD is structuredas follows. The next section covers the analysis of growth andsustainability.Thethirdsectioncoverstheanalysisofpovertyandsharedprosperity.ThefourthsectionusestheanalysisfromthepriortwosectionstolayouttheframeworkfortheSCD,includingtheconstraintsandpathwaystosustainablerecoveryandsharedprosperityforUkraine.Thefifth,sixth,seventh,andeighthsectionselaborateonthepathwaystoachievingsustainablerecoveryandsharedprosperityinUkraine.

14

II. GrowthandSustainability:PatternsandSources

KeyTakeaways Afterareboundandboomduring2000‐07,growthstagnatedonaverageduring2008‐13and

collapsedin2014‐15.

Theunsustainablegrowthpathandoverallstagnationingrowthsince2008resultedfromlargemacroeconomicimbalancesandinstabilityassociatedwithstructuralbottlenecksandaweakpolicystance.

WeakproductivitygrowthhasalsocontributedtotheunsustainablegrowthpathandoverallstagnationinUkraine’sgrowthperformancesince2008.

Limitedprogress indiversifyingandenhancingthesophisticationofUkraine’sexportandproductionbasehascontributedtoweakproductivitygrowth.

1. GrowthinUkraineoverthelastfifteenyearshasbeencharacterizedbythreephases:reboundandboomduring2000‐2007;stagnationduring2008‐2013;andcrisisandcollapseduring2014‐2015.FollowingthebreakupoftheformerSovietUnion,Ukraineexperiencedoneofthesharpestandmostprotractedoutputcontractionsamongtransitioneconomies. By1999,realGDPcollapsedtoamere38percentofits1989level.From2000,positiveexternalconditions,alongwithsomeinitialstabilizationandreformefforts,contributedtoreboundandgrowthfromhighlydepressedlevels.Growthaveraged7percentperyearduring2000‐2007.Ukraine’stermsoftrade(TOT)improvedby50percentbetween2001and2008,includinghighersteelpricesontheexportsideandbeneficialpricingofnaturalgasonthe importside. Asexternalconditionsdeterioratedfollowingtheglobalfinancialcrisisof2008‐2009,theeconomycontractedsharplyin2009andthenmostlystagnatedthrough2013.Between2008and2013,growthaveraged‐0.7percentperyear.Finally,asUkrainewashitbythedoubleshocksoftheconflictandlowerglobalcommoditypricesin2014‐2015, the economy contracted sharply by 8.7 percent per year during 2014‐2015. Theeconomystabilizedandgrewby2.3percentin2016. Figure4 Figure5

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15

Table1.StructureofAggregateDemand(%ofGDP)

2. Unsustainablemacroeconomicpoliciesandlimitedstructuralreformscontributedtoanunsustainablegrowthpathsince2004.Capitalinflowssurgedafter2005whilecreditgrowthboomed,fueledbyexternalborrowingofcommercialbanks.Giventhepositiveexternalconditionsfuelingtheboom,limitedstructuralreformstookplace.Ukraine’sexportsactuallydeclinedfrom61percentofGDPin2004to45percentin2007,pointingtoanerosionofcompetitivenessoftradables.Theauthoritiescontinuedtopursueunsustainablemacroeconomicpoliciesduringthisperiod,sothatthecurrentaccountdeficitgrewto9.2percentofGDPin2013.Grossnationalsavingsdeclinedsteadilyafter2004,whilegrossinvestmentactually increased,suggestingthatgrowthsince2004wasassociatedwithacreditfueledconsumptionboomandinvestmentinnontradablessectors.3. Anunsustainablefiscalstancefueledlargeimbalancesandmacroeconomicinstabilityevenbefore thecurrenteconomiccrisis. Between2005and2009,while general governmentrevenuesaveragedaround41percentofGDP,generalgovernmentexpendituresincreasedfrom43percentofGDPin2005to47percentin2009andfurtherto49percentin2010. Asaresult,theconsolidatedgeneralgovernmentdeficit,includingNaftogaz,increasedfrom1.8percentofGDPin2005to9percentofGDPin2009.Thegrowthofexpenditureswasfueledbycurrentspending,whichincreased from 39 percent of GDP in 2005 to 46 percent in 2010. The large fiscal imbalancescombinedwitharigidexchangerateregimecompoundedthecreditfueledconsumptionboom,sothatwhenexternalconditionsdeteriorated,theeconomycontractedsharplyby14.8percentin2009.

Table2.KeyEconomicIndicators

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

HH Consumption 54.4 57.0 57.1 56.4 53.3 57.9 59.6 60.6 64.0 64.5 62.9 66.8 68.3 72.7 71.4Govt Consumption 20.9 19.6 18.4 19.0 18.1 18.6 18.4 18.3 17.0 20.1 20.3 17.4 18.6 18.4 18.6Gross Investment 19.6 21.8 20.1 22.0 21.1 22.6 24.8 26.7 27.9 17.1 19.6 22.4 21.7 18.1 14.1Net Exports 5.0 1.6 4.4 2.6 7.5 0.8 -2.8 -5.5 -8.0 -1.7 -2.8 -6.6 -8.7 -9.3 -4.1

SHARE OF GDP (%)

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017P 2018P 2019P

NominalGDP,UAHbillion 721 948 913 1,083 1,300 1,405 1,465 1,587 1,980 2,383 2,735 3,085 3,450GDPpercapita,US$ 3,090 3,916 2,560 2,992 3,784 4,080 4,216 3,119 2,122 2,174 2,277 2,464 2,736UnemploymentRate 6.4 6.4 8.8 8.1 7.9 7.5 7.3 9.3 9.1 8.8 9.2 8.8 8.5

RealGDP,%change 7.9 2.1 ‐14.8 4.1 5.5 0.2 0.0 ‐6.6 ‐9.8 2.3 2.0 3.5 4.0GrossDomesticInvestment,%GDP 26.7 27.9 17.1 19.6 22.4 21.7 17.9 14.1 15.3 18.5 18.6 19.2 18.6CPI,%changeeop 16.6 22.3 12.3 9.1 4.6 ‐0.2 0.5 24.9 43.3 12.4 10.2 7.0 6.0

CurrentAccountBalance,%GDP ‐3.7 ‐7.1 ‐1.5 ‐2.2 ‐6.3 ‐8.2 ‐9.2 ‐3.5 ‐0.2 ‐3.8 ‐4.1 ‐3.0 ‐3.3ExportsofG&S,%GDP 43.0 45.8 44.4 48.1 51.3 49.3 45.2 49.1 52.9 49.2 49.5 50.0 48.5ImportsofG&S,%GDP 48.7 53.8 46.1 51.0 57.5 57.4 53.8 52.5 54.7 55.4 54.7 54.1 52.7Externaldebt,%GDP 58.6 83.6 90.8 85.0 77.6 76.6 78.6 97.6 131.5 129.6 131.6 125.4 107.5InternationalReserves,US$billion 32.5 31.5 26.5 34.6 31.8 24.5 20.4 7.5 13.3 15.5 21.8 29.5 29.8Inmonthsofnextyear’simports 4.0 7.0 4.6 4.4 3.7 2.9 3.3 1.9 3.2 3.4 4.6 5.8 5.4

Budgetrevenues,%GDP 40.0 42.3 40.4 43.9 42.9 44.5 43.6 40.3 42.1 38.4 38.8 38.9 39.0Taxrevenues,%GDP 36.7 37.8 37.2 39.3 38.4 38.9 37.9 35.8 35.5 33.1 34.3 34.8 34.8

Budgetexpenditures,%GDP 42.1 45.4 46.8 49.2 45.7 48.9 48.4 44.8 43.2 40.6 41.9 41.5 41.4Currentexpenditures,%GDP 36.9 40.1 44.7 46.4 42.3 45.7 46.2 44.3 41.0 37.4 38.6 37.8 37.5Capitalexpenditures,%GDP 5.2 5.3 2.1 2.8 3.0 2.9 2.0 1.3 2.2 3.1 2.8 2.9 3.1

Fiscalbalance,%GDP ‐2.1 ‐3.1 ‐6.4 ‐5.3 ‐2.8 ‐4.4 ‐4.8 ‐4.5 ‐1.2 ‐2.2 ‐3.1 ‐2.6 ‐2.4Consolidateddeficit,inclNagtogaz,% ‐2.1 ‐3.1 ‐8.9 ‐6.3 ‐4.4 ‐5.5 ‐6.7 ‐10.1 ‐2.1 ‐2.3 ‐3.1 ‐2.6 ‐2.4PublicandGuaranteedDebt,%GDP 12.4 20.0 35.4 40.5 36.3 36.6 40.6 70.3 79.4 81.2 88.8 83.5 75.9

Source:UkrainianAuthorities,WBprojections

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4. After a spurt of productivity growth in part associated with improved capacityutilizationduring2000‐07,productivityhasstagnatedinUkraine. During2000‐2007,outoftotalgrowthof7.2percentperyear,totalfactorproductivity(TFP)growthaccountedfor6.3percent,whilecapitalaccumulationaccountedfor1.1percentandthelaborforceactuallycontractedslightly,pullinggrowthbackby0.26percent.WhileTFPgrowthof6.3percentperyearlooksimpressiveatfacevalue,roughestimatessuggestthatagoodpartofthisproductivityspurtwasduetothereboundincapacityutilizationfollowingthesharppost‐transitioncontractionwhenrealGDPin1999reached38percentof its1989value. Of course, the rebound incapacityutilizationafter2000was itselfsupportedby initial reformsdirectedatmacroeconomicstabilizationandvery favorableexternalconditionswithUkraine’stermsoftradeimprovingsignificantly. However,Ukrainedidnotmakesignificantprogressintappingexportmarketsfornewproductsandinnewdestinationsormovingup the export quality ladder, all of which would have laid the foundation for more durableproductivity growth. As a result, when external conditions deteriorated from 2008 onward,productivitygrowthstagnated. Infact,during2008‐2013,TFPgrowthactuallyaveragednegative1.52percentperyear,contributingtooverallcontractionofGDPby0.7peryear.Furthermore,asUkrainewashitbythedualshocksoftheconflictandthesharpdeclineinglobalcommoditypricesduring2014‐15,TFPplummetedfurtherby8.3percentperyear.Whilesomeofthisisundoubtedlya result of lower capacity utilization, the overall story is one of limited reforms and progress ingeneratingproductivitygrowthwhichhascontributedtoapatternofunsustainablegrowthoverthelastfifteenyears.Infact,in2015,totalfactorproductivitywasonly27percentaboveits1999level,whichlargelyexplainswhyrealGDPin2015wasonly42percentaboveits1999level. Figure6 Figure7

5. Agriculturehasservedasasteadydriverofgrowth,whileindustryandservicesdrovethe strong rebound and growth of 2000‐2007, they also stagnated during 2008‐13 andcontractedsharplyduring2014‐15.Ukrainehasanabundantendowmentoffertileagriculturallandandisamajorproducerandexporterofwheat,corn,barley,andsunfloweroil.Thishasresultedinasteadycontributionofagriculturetogrowthoveranextendedperiodoftime.Ontheotherhand,agricultureremainsarelativelysmallpartoftheeconomy,accountingfor14percentofGDPin1999anddroppingto7.5percentin2007beforeincreasingagainto12.5percentin2015.Industryand

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services,whichaccount for thebulkof theeconomy,playedamajorpart indrivingreboundandgrowthduring2000‐2007,butalsoplayedamajorpartindrivingstagnationduring2008‐13andcollapsein2014‐15.During2000‐2007,outoftotalgrowthof7.4percent,industryaccountedfor3.4percent andservicesaccounted for3.5percent,while the contributionof agriculturewas0.6percent.AsUkraineemergedfromthedepthsofthepost‐crisistransitionstartingin2000,itslargeindustrial base rebounded supported by improving global commodity prices, while the servicessectorexpandedasthenewmarketeconomytookhold.Theexpansionofservicesfollowing2004was also driven by the unsustainable credit fueled consumption and investment boom as banksborrowedexternallytoexpandtheirportfolioinUkraine.Since2007,however,thestoryofindustryandserviceshaslargelybeenoneofstagnationandcollapse.During2008‐13,industrycontractedby1.3percentperyear,whileservicescontractedby2.1percentperyear.During2014‐15,industrycontractedby14.1percentperyear,whileservicescontractedby7.1percentperyear.Incontrast,agriculturegrewsteadilyby6.6percentperyearduring2008‐13andcontractedonlyslightlyduringtheeconomiccollapseof2014‐15. Figure8 Figure9

Table3.SectoralStructureandSourcesofGrowth

6. Ukrainehasnot succeeded ingeneratingsustainedgrowth inexportsover the lastdecade. In fact, exports have fluctuated considerably in line with the volatility in the globalcommodityprices.Primarygoodscomprisedover80percentoftotalexportsonaverageoverthelast 10 years. With export dynamics depending heavily on commodity prices, exports grewsignificantlyduring2005‐2008,but subsequently collapsedbyover40percentduring the globalcrisesin2009.Exportsrecoveredagainduring2010‐2012,buthavedeclinedagainsince2013duetolowerglobalcommoditypricesanddisruptedtraderelationswiththeRussianFederation.Infact,

1999 2007 2013 2015 2000‐2007 2008‐2013 2014‐2015 2000‐2007 2008‐2013 2014‐2015

Agriculture 14.3 7.5 10.2 12.5 3.56 6.62 ‐0.97 0.55 0.31 ‐0.10

Industry 38.5 36.7 26.2 24.4 8.05 ‐1.30 ‐14.05 3.35 ‐0.30 ‐3.70

Services 47.2 55.8 63.6 63.1 6.92 ‐2.11 ‐7.13 3.53 ‐0.73 ‐4.56

TotalGDP 100.0 100.0 100.0 100.0 7.43 ‐0.72 ‐8.36 7.43 ‐0.72 ‐8.36

SECTORALSHAREOFGDP(%) SECTORGROWTHRATE(%) SECTORCONTRIBUTIONTOGROWTH(%)

18

lookingatexportdestinations,theRussianFederationwasUkraine’smajortradingpartnerthrough2013,withRussiaandotherCISmarketsaccountingfor35percentofUkraine’sexportsin2013.Ontheotherhand,theshareofexportsgoingtotheEU‐28countrieswasrelativelystableat26percentin2013,comparedto23percentin1996.FollowingtheconflictineasternUkraineanddisruptedeconomic relationswithRussia,exports toRussiahavedeclined to12percentof totalexports in2015,whilethesharegoingtotheEU‐28countriesgrewto30percentin2015.

Figure10:UkraineExports(typesofgoods,$mn) Figure11:Geographicalstructureofexports

Source: NBU, WB estimates Source: NBU, WB estimates Figure12:ExportStructure(%ofTotal) Figure13:ExportSophisticationIndex

7. Ukrainehasmadelimitedprogressindiversifyingitsexportbaseandenhancingthesophisticationofitsexports. Ukraine’sexportstructurehasremainedlargelyunchangedwithapredominantshareofresources.Theconsolidatedshareofmetals,mineralsandcropsamounted45percentin2014,whichisonly9percentagepointslowerthanin1996. Theshareofengineering

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productshas remainedunchanged. In2000, the level of sophistication ofUkraine’s exportswasalmostthesameasthatofPoland,LithuaniaandBulgaria.However,overthelast5years,Ukraine’sexportsophisticationhasdeclinedbelowthelevelof2000,whilethatofpeercountrieshasimprovedsignificantly.GrossRegionalProductpercapita(UAH,2014) RegionalExports(%ofGRP,2014)

8. ThedistributionofoutputandexportsacrossoblastsalsosuggeststhatUkrainehasnotyetmade sufficientprogress inmovingbeyond commodityexportsand leveraging itsothercomparativeadvantages.TheoblastswiththehighestlevelsofoutputpercapitaandexportsarethosewhereUkraine’scommoditybasedexportsareconcentrated.Theoblastswiththehighestlevelsofoutputpercapitain2014includeKyiv,Dnipro,Zaporizhia,Kharkiv,Poltava,andOdessa,while the oblasts with the highest export shares in 2014 include Dnipro, Zaporizhia, Donetsk,Luhansk, and Mykolayiv. On the other hand, those oblasts that are home to Ukraine’s othercomparativeadvantages(agricultureandgreaterproximitytothelargeEUmarket)generallyhavelowerlevelsofoutputpercapitaandexportshares.Thispointstowardasignificantopportunitytocreate the enabling conditions for the private sector in Ukraine to tap its other comparativeadvantagesbyleveragingtheagriculturesectorandbyintegratingintoEuropeanproductionchains,particularlyatatimewhentraditionalcomparativeadvantagesincommoditieshasbeenaffectedbyshocks..9. Going forward, theprospects forgeneratingsustainedmoderategrowth inUkrainewillrequirecombininganincreaseinbothproductivitygrowthandinvestmentfromrecenttrends.TheburdenoninvestmentandproductivitygrowthareparticularlyhighinUkrainegiventhat its labor force is projected to continue to decline gently going forward due to demographicfactors. Thelabor force isprojectedtodeclinebyabout0.1percentperyearduringthenexttenyears.AnumberofscenariosofinvestmentandTFPgrowthratesrequiredtogenerategivenGDPgrowthratesduring2017‐2021areshownintable3below.Inordertogenerateagrowthrateof5percent per year during 2017‐2021,with investment at 20 percent ofGDP, the TFP growth ratenecessaryisastaggering4.5percentperyear.SuchaTFPgrowthrateisveryhighbyinternationalstandardsforasustainedperiodoftime,andalsoconsiderablyhigherthanUkraine’saverageTFPgrowthrateof1.2percentduringthelast15years. If investmentrisesto30percentofGDP,thenecessaryTFPgrowthrateisstillaformidable3.4percent.InordertogenerateamoremodestGDP

20

growthof3percentduring2017‐2021,withinvestmentat25percentofGDP,TFPgrowthwillhavetoaverageabout2percentperyear.ThesescenariosdemonstratethatUkraineneedstoincreaseinvestmentandproductivitygrowthfromrecenttrendsinordertogeneratereasonableeconomicgrowthratesgoingforward.

Table4:Ukraine:GrowthScenariosfor2017‐2021

Source:WorldBankstaffestimates.

10. Generatingthenecessaryincreaseininvestmentandproductivitywillrequirebothamoresustainablemacroeconomicstanceanddeepstructuralreforms.Grossnationalsavingshasaveraged12.5percentofGDPduringthelastfiveyears(2011‐2015).Thiswasduetobothlowprivatesavings(13.5percentofGDP)andnegativepublicsavings(‐1.0percentofGDP)duringthisperiod. So,inordertoincreaseinvestmentto25percentofGDP(fromtheaverageof18percentduringthelastfiveyears),Ukrainewillneedtoincreasebothprivateandpublicsavings.Increasingpublicsavingswillrequiresignificantconsolidationofcurrentexpendituresgoingforward.Whileprivate savings is difficult to influence through policy, sound macro‐financial policies, pensionreform, and improvements in financial intermediation canhelp. Beyond the increase innationalsavings, Ukraine will also require higher levels of foreign direct investment. Both this and thenecessaryincreaseinproductivitywillrequiredeepstructuralreformstoimproveinfrastructure,leveltheplayingfieldfortheprivatesector,andtakeadvantageofinternationaltradeopportunities.

Growth Investment (%GDP) TFP Growth5.0% 20% 4.5%

5.0% 25% 4.0%

5.0% 30% 3.4%

5.0% 35% 3.1%

3.0% 20% 2.5%

3.0% 25% 2.1%

3.0% 30% 1.9%

3.0% 35% 1.6%

2.0% 21% 1.2%

Actual Growth (for Comparison): 2001-2015

21

III. PovertyandSharedProsperity:PatternsandTrends

KeyTakeaways Poverty has declined significantly in Ukraine since 2000, although the pace of poverty

reductionslowedduring2008‐13,beforepovertyincreasedsignificantlyin2014‐15.

Household incomes have relied on large pension and social assistance spending, raisingconcernsaboutthesustainabilityofpovertyreduction.

Withhigher education levels, households enjoy thedoublebenefit of higher employmentratesandhigher returns, though for theB40s theseeducationpremiaappear tobemorerestrainedthanfortherestofthepopulation.Thissuggeststhatbettereducation–combinedwithmeasurestoraiseoverallproductivityintheeconomyandespeciallyinthesectorstheB40tendtobeemployedin–couldbeanimportantdriverofamoresustainablemodelofpovertyreduction.

11. Betweentheturnofthecenturyand2013,Ukraineexperiencedasignificantreductioninpoverty,thoughthepacehasslowedsincetheglobalfinancialcrisisof2008‐09.Since2002,the earliest date forwhich comparable estimates are available, the countrywitnessed significantpovertyreduction,inbothurbanandruralareas.AccordingtotherecentlydevelopedWorldBanknational methodology for Ukraine, “moderate poverty” declined from 79 percent in 2002 to 38percentin2007.Inruralareas,thedeclinewasfrom85percentin2002to50percentin2007,whileinurbanareas,moderatepovertydeclinedfrom76percentin2002to33percentin2007.Theglobalfinancial crisis brought a trend reversal in 2009, especially in urban areas. Subsequent years,however, saw a resumption of poverty reductionwithmoderate poverty declining further to 14percentin2013.Thebreakoutofconflictandeconomiccrisisledtoareversaloftrend,withpovertyupsignificantlysince2014‐15. Figure14 Figure15

12. PovertytrendsbasedontheECAwideregionalpovertyline($5aday,2005PPP)areconsistentwith trends for the “moderatepoverty”measure. The twopovertymeasuresuse

22

differentconsumptionaggregatesbutneverthelessyieldsimilartrends.Theshareofthepopulationbelow the $5PPPpoverty linedecreased from46percent in2002 to8 percent in2008and3.2percentin2013.Beyondmoderatepovertyandthe$5PPPperdayline,othermeasuresofextremepovertybasedonthenationalfoodpovertylineorthe$2.5PPPperdaylinesuggestthatextremepovertyislargelynotpresentinUkraine.Theextremepovertyratebasedonthefoodlinedeclinedfrom26percentin2002to0.4percentin2014,whilethepovertyratebasedon$2.5PPPperdaydeclinedfrom6.5percentin2002to0.1percentin2013.

MeasuringpovertyinUkraineThisSCDusesmultiplelinestolookatpovertytrendsgiventhecomplementaryinsightstheyprovide.Giventhelackofareliablenationalindicator,therobustnessoftrendstodifferentmethodologiesiscomfortingontheestimates’abilitytocapturewelfaredynamicsinthecountry.TheofficialpovertymethodologytomeasureextremepovertyisbasedonameasureofincomepercapitaandadoptstheofficialSubsistenceMinimum(SM)asapovertyline.ThisisproblematicastheSMisapolicyvariableratherthanatechnicalone–whilebasedonabasketintendedtocoversubsistenceneeds,itisreviewedandapprovedbytheCabinetofMinistersbasedonpolicyconsiderationsasitactsasananchorforanumberofbenefits,aswellaspensionsandtheminimumwage.TrendsanalysisbasedontheSMcanthereforeprovemisleadingasitisbasedonavaryingyardstick.ToobviatethemethodologicalshortfallsoftheofficialmethodologytheWorldBankintroducedin2016anewpovertyline,basedonanewconsumptionaggregateandthecostofbasicneedsmethodology.Thisisthelineadoptedhere topresent “moderatepoverty” estimates, though themethodologyprovides also an extremepovertylinecoveringonlythefoodcomponentofthemoderatepovertyline.AsthislineisnotpartoftheofficialsetofpovertylinesandisnotyetfamiliartoUkrainianaudiences,theSCDalsoreportsestimatesbasedonthewell‐establishedECAPOVmethodology(the5USDadayand2.5USDaday,2005PPPlines).Thislineismostlyintendedforinternationalcomparisons,thoughthemethodologysuffersfromaspecialshortcominginthecaseof Ukraine, in that there is a perception among audiences familiarwith Ukraine that the 2005 PPPmightoverestimatehouseholdwelfarewhencomparedtoothercountriesintheregion.ForcomparisonpurposeswhenlookingatdifferentestimatesitisworthconsideringthattheWBmoderatepovertylineissetin2014pricesat1045hryvniapermonth.Thisisequivalentto8.5USDadayin2005PPP,andissomewhatlowerthantheofficialpovertyline(SM)for2014,whichwassetat1176hryvniapermonth.NotehoweverthatityieldsapovertyincidenceestimatewhichismuchhigherthantheECAPOVmethodology(15.2ratherthan3.3percent)duetodifferencesintheconsumptionaggregateadopted;andtwiceashighastheofficialpovertyestimatewhichisbasedonanincomeratherthanaconsumptionaggregate.

13. The long termdecline inpovertywasaccompaniedbya sizeable increaseof thoselivingineconomicsecurity,thoughsince2008theranksofthoselivinginnearpovertyhaveswollensignificantly.Lookingmorebroadlyatthedistribution,Ukrainehasadoptedasatargetforits 2020 Strategy increasing the number of people living in economic security, i.e. with lowvulnerabilityoffallingintopoverty(definedashavingmorethan15USDadayinPPP).Thisgrouphasgrownsignificantlybetween2003and2008.Theglobalfinancialcrisisreversedthistrend–andthenagain thecurrentcrisis is reversing thegainsmadebetween2011and2013. An importantelementthatemergesfromFigure15isthegrowingnumberofpeoplewhooverthedecadehavebeenabletoescapepoverty,butnottotheextentofbeingconsideredeconomicallysecure.

23

14. Poverty is estimated to have increased significantly in 2015. The deep recession,depreciation, and compression of public current expenditures have resulted in significantcontractionofdisposable incomesinUkraine. Asaresult,moderatepovertyisestimatedtohaveincreasedfrom14.1percentin2013to22.2percentin2015,whilethepovertyrate(under$5/dayin2005PPP)isestimatedtohaveincreasedfrom3.2percentin2013to5.8percentin2015.Labormarketconditionshavedeteriorated,withnominalwagegrowthlagging inflation,andrealwagesdownonaverageby13percent(year‐over‐year)inDecember2015.Unemploymentincreasedfrom8percentin2013to9.5percentinthesecondhalfof2015.

Table5.PovertyRates(basedondifferentpovertylines,%ofpopulation)

15. Despite significant poverty reduction over time, geographical gaps in povertyincidenceremainsignificant.Therural‐urbangapinmoderatepovertyhashoveredaround7‐8percentagepointsinrecentyears.In2014,povertyincidenceinruralareaswas20.1,whileinurbanareasitwas12.7. Overall,asignificantshareofthepoorliveinruralareasandkeydemographicgroups, such as pensioners, are evenmore concentrated in rural areas. Poverty incidence alsoappearstovarysignificantlyacrossregions(possiblybyasmuchasafactorof8betweenKyivandotherpartsofthecountry,thoughformostregionsthedifferenceinincidenceismorecontained).Despitetherelevanceoftheseregionaldisparitiestocurrentpolicydebates,suchcomparisonsneedtobeconsideredpurely indicative,due toquestionsaboutwhetherdataat theregional level aresufficientlyrepresentativeandbecausedataavailabilitylimitstheextenttowhicharegionalpriceindexcancapturefullydifferencesinpurchasingpoweracrossregions.16. The conflict has had significant impacts on poverty and the well‐being of largepopulationsineasternUkraine,althoughtheregionaldatahasitslimitations.Over4millionUkrainiansintheeastofthecountryhavebeenaffected.DonetskhasoneofthehighestpopulationsoftheB40inabsoluteterms.Italsohadthehighestnumber(1.4million)ofpensionersbeforetheoutbreakofconflictinearly2014,whilethenumberwas730,000inLuhanskregion.Theconflictand

ExtremePoverty $5PPP $2.5PPPTotal Rural Urban (foodpovline) (ECAregional)

2002 78.8 85.3 75.5 25.9 46.4 6.52003 73.3 82.3 68.7 18.7 36.8 3.52004 63.5 72.5 59.0 14.2 28.5 2.92005 50.0 59.5 45.3 8.6 18.5 1.22006 43.7 53.6 38.9 6.0 14.7 0.72007 38.3 50.0 32.5 3.3 11.5 0.52008 26.4 36.8 21.3 2.4 8.1 0.12009 29.2 37.9 25.1 2.1 9.1 0.32010 24.1 29.5 21.5 1.4 6.0 0.12011 20.8 25.1 18.7 1.1 5.3 0.12012 18.2 24.8 15.1 0.6 3.9 0.12013 14.1 19.4 11.6 0.4 3.2 0.12014 15.2 20.1 12.7 0.4 3.3 0.0

2015(est) 22.2 5.8 0.1

ModeratePoverty

(percentofpopulation) (percentofpopulation)

24

itsimpactsonlivelihoodsandsocialandeconomicopportunitieshaspushedsuchhouseholdsfurtherintopovertyandcreatedadditionalpressuresonUkraine’salreadyoverstretchedsocialprotectionsystems. Insecurity has also interrupted service delivery and infrastructure. Vulnerability isparticularlyacuteforforciblydisplacedhouseholdslivinginareaswithsignificantconflict‐relateddamageandthe800,000personslivinginareasclosetothe“lineofcontact”betweengovernmentandnon‐governmentcontrolledareas.Forthesecommunities,damagetohomesandbusinessesandinterruptions inpublic services (fromelectricity andwater tohealth andeducation), livelihoods,travelroutesandsupplychains,compoundedbythepsychosocialstressesoflivinginaconflictzone,andthedangersandconstraintsresultingfromlandminesandexplosiveremnantsofwar,allresultinastateofhighvulnerability.Opportunitiesforemploymentinminingandheavyindustryintheeasthasalsobeenimpactedconsiderably.Asaresult,IDPsfromtheheavyindustrializedareasoftheeasternUkraineoften faceamismatchbetween their skillsetsand theeconomicopportunities incommunitieswheretheysettle.17. Labormarkettrendsandparticularlyrealwagegrowthplayedanimportantroleindrivingthepovertydeclineobservedupto2013.Indeed,theboomperiodof2000‐2007sawanincreaseinthenumberofemployedandoftheemploymentrate,witharelativestablelaborforceparticipationrate.Thisperiodwasalsocharacterizedbyveryhighrealwagegrowth(onaverageabove15percent annually)whichmore than tripled realwagesduring theperiodof2000‐2007(Figure16).After2008theeconomiccrisiscoincidedwithadeclineintheworkingagepopulationdue to long term demographic trends. After a significant fall in 2009 as a reaction for the deeprecessiontheemploymentrategrewmoderatelyuntil2013,despiteadeclineintheabsolutenumberofemployedovertheperiod.Despitethecrisis,becauseofthetighteningofthelabormarket,averagerealwagegrowthinUkrainefortheperiod2008‐2013wasrelativelyhighatthelevelof6.4percent.

Figure16:Labormarkettrends2000‐2015 Figure17:Realwagesandrealwagegrowth2000‐2015

18. Thecrisisin2014‐2015sawlabormarketadjustthroughtheriseofunemploymentanda realwagecorrection. During the crisis of 2014‐2015both employment and labor forceparticipationratesandabsolutenumberssharplydeclinedwhiletheunemploymentjumpedtoover

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14

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2000200120022003200420052006200720082009201020112012201320142015

LFP employment uneployement(rightaxis)

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25

9percentlevels.Onthebackgroundofhighinflationwagesdeclinedinrealtermsbyonequarterovertwoyearperiodandreturnedtothelevelsof2008.

Figure18:IncomeGrowthofB40vsTotalPop Figure19:GrowthIncidenceCurve,2008‐13

Source:Bankstaffestimatesusinghouseholdbudgetsurveys19. IncomegrowthoftheB40populationinUkraineexceededthatofthetotalpopulationduring 2008‐13, although questions about data quality remain. A comparison of sharedprosperityindicatorsacrosstheECAregionindicatesthatUkraineperformedfavorablyrelativetoother countries in the region, includingmanyEUmember states. Thedata indicates thatduring2008‐13,incomegrowthofthebottom40percentofthepopulationinUkraineexceededthatofthetotalpopulation.Thisassessment,however,needstobetemperedbyaconsiderationofsomeoftheweaknessesthatcharacterizethedata,particularlythelikelyunderestimationofthetopincomesinthedistribution.Whilecommontotheregion,thisproblemislikelytoresultinarosierpictureoftherelativegrowthperformanceofthebottom40percent.Thebeliefthatthesurveymightbemissingalargepartofthehigherendoftheincomedistributioniswell‐establishedamonglocalresearchersand supported by the fact that estimates of private consumption in the survey are less than 60percentofestimatesfromnationalaccounts. Furthermore,theavailabledataonprofessionalandhighskilledwages fromhumanresource firmsshowthat theyaresignificantlyhigher thanthosecapturedbythesurvey.Finally,whiletheperceptionisthattheupperendoftheincomedistributionin Ukraine is extremelywell‐off, the evidence from the household survey points to very limitedinequality(aGiniofabout24percentin2013).

ComparisonofHBSandNationalAccountsConsumptionGrowthThe significantdecline inpoverty incidence, particularlyduring the2008‐13periodof stagnantgrowth,raisesquestionsabouttheunderlyingdrivers.Theanalysisinthischaptersuggeststhattwofactorscouldberesponsibleforthis.Thefirstistheconsiderabledependenceofincomegrowthonpensionsandsocialassistance,whichwill be discussed in the next section. The second is that consumption growth in thehouseholdsurveyhasexceededthatinnationalaccounts,asshownbythefiguresinthisbox.

‐2%

0%

2%

4%

6%

8%

10%

Serbia (2007‐2010)

Arm

enia (2008‐2013)

Macedonia, FYR (2003‐2008)

Albania (2008‐2012)

Hungary (2006‐2011)

Latvia (2006‐2011)

Lithuania (2006‐2011)

Estonia (2006‐2011)

Bulgaria (2007‐2011)

Slovenia (2006‐2011)

Czech Republic (2006‐2011)

Montenegro (2006‐2011)

Georgia (2008‐2013)

Croatia (2004‐2009)

Romania (2006‐2011)

Ukraine (2008‐2013)

Turkey (2007‐2012)

Moldova (2008‐2013)

Poland (2006‐2011)

Kyrgyz Republic (2006‐2011)

Russian Federation (2007‐2012)

Tajikistan (2004‐2009)

Kazakhstan (2006‐2010)

Slovak Republic (2006‐2011)

Belarus (2006‐2011)

Bottom 40% Total Population

23

45

67

0 20 40 60 80 100Percentiles

Median spline Growth rate in mean

26

Acomparisonofconsumptiongrowthinthehouseholdsurveyandinnationalaccountsturnsupanumberofinterestingfindings.ThefirstisthatconsumptiongrowthinthehouseholdsurveyoverallandparticularlyfortheB40populationexceededconsumptiongrowthinnationalaccounts.Thisislikelybecausenationalaccounts do not fully take account for the large unobserved economy. The second is that consumptiongrowth exceeds growth of GDP per capita, in part because transfers and social assistance, alongwith acompressionofsavings,enabledhouseholdsto increaseconsumption faster thantheir incomes. Bothofthesefindingscanpartlyexplainwhypovertywasdecliningduringaperiodofstagnantgrowthin2008‐13.Furtheranalysisonthisissuewouldbeusefulgoingforward.

RelianceonPensionsandTransfers20. Overall,asignificantportionofhouseholdincomeinUkraineandparticularlyforthepoorcomesfrompensionsandtransfers,raisingconcernsaboutthesustainabilityofpovertyreduction.Thefigurebelowprovidesasnapshotoftheincomestreamsofhouseholdsinthebottom40percentofthepopulation(B40)andinthetop20percent(T60)in2013.ThefigurealsoshowshowthisdiffersacrossruralandurbanareasfortheB40.Overall,theB40derivelessoftheirincomefromlaborandemploymentandmorefrompensions,socialassistanceandothertransfers.ThistypeofincomeprofileisverycommoninEasternEuropeandCentralAsia,wheretheB40relyonpublictransfersmorethaninotherregionsoftheworld.DisaggregatingtheincomeprofileoftheB40byurban and rural shows that the biggest differences across areas are in the extent towhich theydependonlaborincome(drivenbywageincome)andagriculturalincomes.Thisdifferencemattersas,whilebothlaborincomeandagriculturalincomeareproducedbylabor(theB40inruralUkraineareunlikelytobeenjoyingrentsfromland),agriculturalincomeismorelikelytovarywithexogenousshocks,suchaschangesincommoditypricesorweathershocks.21. Socialassistanceaccountedfor6percentoftheincomeoftheB40,withlittledifferencebetweenurbanandruralareas. It isnoticeable,however,thatalsotheT60in2013received3percentoftheirincomefromsocialassistance.Detailedanalysisofthesystemfor2012showsindeedthatasmanyas49percentofthoselivinginthetopdecilewerebeingreachedbysomeformofsocialassistance.Inadditiontoavarietyof“privileges”whichwereuntargeted,themajorsocialassistanceprogramswasthechildbirthgrant(thatwouldgiveincreasingamountsofmoneyforchildrenofhigher order). Other programs included subsidies for energy consumption, and a small targeted

27

guaranteedminimumincomeprogram.Aslowerincomegroupshavemorechildren,thechildbirthgranthadanelementof“self‐targeting”andcouldamounttoasmuchas38percentoftheresourcesofthoseinthebottomdecilethatwouldreceiveit.Forthetopdecilethesameindicatorofgenerositywouldamountto4percent,whichisnottrivialconsideringthatthoseweremeanttobetherichestgroups in the population. Reforms undertaken since 2014 have addressed some elements ofregressivityinthesystem,withreformsoftheHousingandUtilitySubsidies,andintroducingafixedamount per child in the birth grant, resulting in an increase on the first child and decreases onsubsequentchildren.However,considerablechallengesremaininachievingamoretargetedpackageofsocialassistancegoingforward.

Figure20:IncomesourcesoftheB40andtheT60forurbanandruralpopulation

Note:Othertransfers=otherpublictransfers+privatetransfers;Otherincome=Proceedsfromsalesofpersonalandhouseholdeffects+Proceedsfromsalesoftherealestate+otherproceeds+incomefromproperties.

22. Concernsaboutsustainabilityofpovertyreductionarealsoreflectedinabreakdownof sources of household income growth,with pensions and transfers again a prominentsource.During2009‐2014,outofanannualB40householdincomegrowthof4.5percent,pensionsandsocialassistanceaccountedfor2percent,whilelaborincomeaccountedfor2percent.Infact,thesepatternsarealsoreflected,althoughtoasomewhatlesserextent,intheearlierboomperiod.During2002‐2007,outofannualB40householdincomegrowthof17.6percent,pensionsandsocialassistanceaccountedfor8percent,whilelaborincomeaccountedfor9.3percent.Between2008and2013,bothsocialassistanceandpensionsgrew inweight in thebudgetof thosewhoreceived it,particularlyforthoseintheB40(socialassistancefrom8to13percent).Thisreflectedtheimpactoftwodifferentfactors.First,socialassistanceisanchoredtotheSubsistenceMinimumIncome(SMI)whichgrewsignificantlymorethantheCPIoverthisperiod(itwassubsequentlyfrozenin2013andadjusted, albeit rathermarginallywhen compared to inflation, in2016). In addition, someof theprograms changed,with the birth grant in particular increasing over the period. In the case ofpensions,changestotheSMIappeartobethemaindrivingforcebehindtheobservedincrease.Theparametric reforms introduced in 2011 are unlikely to already have had an impact on incomes,

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

b40 t60

2013

other income Other transfers Social Assistance

Pensions Agricultural income Labor income

Source: UkrStat, World Bank staff estimation

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

rural urban

2013 b40

other income Other transfers Social Assistance

Pensions Agricultural income Labor income

Source: UkrStat, World Bank staff estimation

28

thoughinthelongrunelementsofthereform–suchasincreasingthepensionableage–willresultinincreasesinthepensionincomerecipientswillget.

Figure21:GrowthofHHIncomeSources,B40versusT60,2009‐2014and2002‐2007

Note:WBownestimatesfor2008‐2013basedonUkrStatdata.

28. Whiletheheavyrelianceofhouseholdincomesonsocialbenefitsisaseriousconcernforsustainabilityofpovertyreduction,more targetedprogramshaveplayedan importantrolesince2014incushioningtheimpactofthelargeshocks. Inthewakeofthelargeenergyprice and income shocks, targeted social assistance programs have played an important role incushioningtheimpactonthevulnerablepopulation.Themeans‐testedhousingandutilitiessubsidy(HUS) program has been expanded significantly, with coverage increasing from 1 to 5 millionhouseholdsbyend‐2015. Furthermore,theauthoritieshavetakeninitialstepstowardcontainingnon‐targetedsocialassistanceprograms.WhiletheHUShasprovedaneffectivecrisisresponsetool,goingforward,ashouseholdsadjusttoanewpriceenvironmentandcomplementarymeasures(e.g.improvingenergyefficiency)arerolledout,theHUSprogramwillneedfurtherreformtoenhancetargetingandfiscalaffordability.23. Improvededucationprovidesan importantrouteoutofrelianceonsocialbenefits,withhighereducationlevelsleadingtoahighershareoflaborincomeandlowerrelianceonsocialbenefits. For households in theT60 groupwhoseheadhas tertiary education this sharereached67percent,whileforB40itis10percentagepointslower.Similargapsinthelaborsharecharacterize households whose heads have other educational levels. These differences in laborsharesasa functionofeducationdependon theeffectsofeducationonbothwagesand levelsofemployment.Onthewageside,thepremiumfortertiaryeducationcomparingtocompletesecondary(orevenincompletetertiary)is18percentfortheB40and30percentfortheT60.FortheB40thispremiumismuchhigherinruralareas,whileforT60itisofthesamesizeinurbanandrurallocations.ItisalsohigherfortheT60forbothgenders.Alsoontheemploymentsideshighereducationhashighpayoffs.Onaverage tertiaryeducatedpeople inT60have employment ratehigher than80percent(higheremploymentratesarerecordedformeninurbanareas),thatis10‐15percentage

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1.3

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-0.2

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-1.0 0.0 1.0 2.0 3.0 4.0 5.0

labor income

agricultural income

pensions

social assistance

other private income

other income

Total

2009-2014

b40 t60

9.3

1.4

6.4

1.5

3.3

0.1

17.6

10.8

0.6

4.9

0.6

2.7

0.0

16.5

0.0 5.0 10.0 15.0 20.0

labor income

agricultural income

pensions

social assistance

other private income

other income

Total

2002-2007

b40 t60

29

pointsmorethanforsecondaryeducation.IntheB40groupthegapbetweenlevelsofeducationisasbigasintheT60,butthelevelsthemselvesarelower–67percentonaverage.

Table6.Shareoflaborincomebyeducationlevels

Note:WBownestimatesfor2008‐2013basedonUkrStatdata.

24. Whileeducationoffersapremiumthroughbothhigherwagesandhigheremploymentlevels,theB40appearlessabletocapitalizeonthesebenefits.Educationleadstohighersharesof labour incomedue toboth its employmentandwageeffects: forhouseholds in theT60groupwhoseheadhastertiaryeducationthelabourincomesharereached67percent,whileforB40itwas10percentagepointslower.Similargapsinthelaborsharecharacterizehouseholdswhoseheadshaveothereducationallevels.Onthewageside,thepremiumfortertiaryeducationcomparingtocompletesecondary(orevenincompletetertiary)is18percentfortheB40and30percentfortheT60.FortheB40thispremiumismuchhigherinruralareas,whileforT60itisofthesamesizeinurbanandrurallocations.ItisalsohigherfortheT60forbothgenders. Alsoontheemploymentsideshighereducationhashighpayoffs,butlesssoontheB40.OnaveragetertiaryeducatedpeopleinT60haveemploymentratehigherthan80percent(higheremploymentratesarerecordedformeninurbanareas),thatis10‐15percentagepointsmorethanforsecondaryeducation.IntheB40groupthegapbetweenlevelsofeducationisasbigasintheT60,butthelevelsthemselvesarelower–67percentonaverage.

ProfileoftheBottom40andPoor25. Overall,thebottom40percentofthepopulationfeelsmoredeprivedandexpectsmorestate support. Overall, when asked where they would classify themselves, 80 percent of therespondentsfromthisgroupconsiderthemselvespoorratherthanmiddleclass.Incontrast,only56percentoftherestofthepopulationconsiderthemselvespoor.Interestingly,thisisagroupwherepeople feel more entitled to state support and less able to look after themselves: over 1/3 ofrespondentsfeelthatthestatehasthemainorfullresponsibilitytoensurethewelfareofitscitizen,againstaboutonequarterintherestofthepopulation.

2008 2013 2008 2013 2008 2013 2008 2013 2008 2013 2008 2013tertiary 55.2% 56.1% 68.4% 66.9% 40.6% 49.0% 51.4% 53.5% 59.0% 57.5% 70.5% 69.2%full secondary 48.3% 46.6% 62.3% 56.5% 39.3% 41.1% 45.9% 43.7% 54.7% 50.1% 68.0% 62.4%incomplete secondary and below 38.6% 42.6% 49.1% 49.8% 31.0% 32.5% 28.5% 31.5% 47.8% 52.2% 61.9% 61.7%

2008 2013 2008 2013 2008 2013 2008 2013 2008 2013 2008 2013tertiary 55.2% 56.1% 68.4% 66.9% 58.8% 59.3% 69.1% 67.8% 52.7% 54.1% 67.9% 66.2%full secondary 48.3% 46.6% 62.3% 56.5% 51.4% 50.6% 65.4% 59.2% 45.9% 43.3% 59.4% 54.0%incomplete secondary and below 38.6% 42.6% 49.1% 49.8% 44.8% 48.2% 53.2% 54.1% 34.0% 38.2% 45.7% 46.6%

t60

total

b40 t60

female

b40 t60 b40 t60 b40 t60

b40 t60 b40

total rural urban

male

30

Figure22:EducationandLaborMarketOutcomesforB40andT60,shareofpopulation

26. Thebottom40percentliveinhouseholdswithhigherdependencyratios.Householdsinthebottom40percentaremorelikelytoliveinfamilieswithchildren–indeed55percentofT60liveinhouseholdsofadultsonlyascomparedto33percentfortheB40.Incontrast,theincidenceofhouseholdsofpensionersonlyissimilaracrossthetwogroups.Thishastwoimportantimplications:oneisthat,asaresultofthisdemographicstructure,childrenrepresentalmostonequarteroftheB40(asopposedto15percentfortheT60);theotheristhattheyoung‐dependencyratiofortheB40is54percentagainst30percentfortheT60.Inotherwords,anyB40adulthasmanymorechildrentosupportthanisthecasefortheT60.WhilethisisanempiricalregularityacrosstheworldandnotexclusivetoUkraine,itneverthelesssuggeststhatappropriateservicesmaybeneededtofacilitatelabormarketparticipationforwomeninthebottom40percent.27. TheB40have lesseducationandweaker labormarketoutcomes than their richercounterparts.Only28percent of the adults in this grouphave some formof tertiary education,against47percentoftheT60. ThebulkoftheB40hascompletedsecondaryeducation.ItseemslikelythatloweducationcompoundstheimpactsofrurallocationinreducingtheopportunitiesforB40householdstoaccessjobs,andespeciallygoodjobs.TheB40’semploymentrate(for15‐64agegroupforbothgenders)isonly48percent,against65fortheT60.Theyarealsomorelikelytobeinactive(36percentvs28),andespeciallyunemployed(16percentofthisgroupsisunemployedversus7percentfortheT60).Asfarasjobqualityisconcerned,theHBSprovidesscantinformationaboutit.Self‐employedworkerswithnoemployeesmightbeaproxyforalowqualitysegmentof

22%13% 17% 10%

57%

44%

55%

43%

21%

44%28%

47%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

b40 t60 b40 t60

2008 2013

Primary Secondary Tertiary (incl. incomplete)

53%69%

23%

9%

24% 21%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

b40 t60

male: employed male: unemployed male: inactive

Source: WB staff calculations based on HLCS by UkrStat

43%

61%

11%

4%

46%35%

0%

20%

40%

60%

80%

100%

b40 t60

female: employed female: unemployed female: inactive

Source: WB staff calculations based on HLCS by UkrStat

31

themarket.TheshareofpeoplewiththistypeofjobsishigherfortheB40inruralareas,whileinurbanareas therearemoreself‐employedwithemployees. These indicators,however,arequitevolatile(in2008thesituationwasdifferent).28. The educationprofile of theB40 and their concentration in sectors such as trade,manufacturing,andagriculturehelpsexplaintheirlowwagepremia,suggestingthatraisingproductivity economy‐wide and particularly in these sectors would support sharedprosperityandpovertyreduction.TheB40aremostlikelytobeworkingintrade(21percent),manufacturing (12 percent), and agriculture (10 percent). Furthermore, the construction andtransportsectorseachemployedabout8percentoftheB40.Thesesectorsgenerallyemployworkerswithlowerlevelsofeducation.Inaddition,withtheexceptionoftransportation,thesesectorsappeartoprovidejobswhichtendtopaylessthanaveragewages.Publicsectorservices(education,healthand public administration and defense), which generally employ workers with higher levels ofeducation, provided employment to almost one quarter of the B40 (11 percent in education, 8percentinhealth,and5percentinpublicadministrationanddefense).Ofthesepublicsectorjobs,only those in public administration and defense appear to pay higher than average wages. InadditiontothevariationacrosssectorsinB40employment,itisalsolikelythattheB40areemployedin less education‐intensive and lower paying jobs within sectors. Over time, the share of B40employment has risen in agriculture and trade, but declined in manufacturing and publicadministrationanddefense. Thesepatternscouldberelatedtoemploymentandgrowthpatternsacrosssectorsinlightoftheseriousshockstotheeconomysince2014.Manufacturing,whichhasbeenseriouslyaffectedbytheconflictandsawadeclineinoutputaswellasoverallemployment,alsosawadecreaseintheshareofB40workers.Ontheotherhand,theshareofB40inthetransport,trade,andagricultureincreasedsignificantly,suggestingashiftofB40workersintothesesectorsbetween2009and2014.

Figure23:EmploymentbySectorsofB40,percent Figure24:EmploymentGrowthofB40percent

Source:Bankstaffestimatesusinghouseholdbudgetsurveys

0

5

10

15

20

25

2009 2010 2014

0.7

0.8

0.9

1

1.1

B40employmentgrowthbysectors,2010‐2014

TotalB40employmentgrowth,2010‐2014

32

29. Peopleinhigherquintilesarebettereducated,andasitistypicallythecase,theyaremorelikelytoreportseriouscardiovascularhealthissues,althoughdataonabroaderrangeofhealthindicatorsinnotcapturedinthehouseholdsurvey.Theshareofthepopulationwithtertiaryeducationishigherforricherquintiles(table7).Thispatternappliesforbothgendersthoughwomenaremorelikelytohavetertiaryeducationthanmen.Asfarashealthindicatorsareconcerned,peopleathigherincomelevelstendtoreportmoreproblemswiththeirhealth,forexamplechroniccardiovasculardiseases (table 8). This is generally attributed to some “reverse causation”wherebetteraccesstodiagnosticsandmedicalservicesingeneralmakesthemmoreawareoftheirhealthstatus. Similarpatterns apply to gender,withwomenwhoare typically found tobemorehealthconsciousmore likely toreportcardiovasculardisease(note thatmortalitydatasuggest that thisshouldnotbethecase).Thehouseholdsurveydoesnotcoverquestionsofaccess,soitisnotpossibletotesttheimportanceofaccesstoservicesindrivingthesefindings.

Table7.LevelofEducationbyQuintilesin2014,PercentofPopulationabove21

Note:Bankstaffestimatesusinghouseholdbudgetsurveys.

Table8.ShareofPopulationReportedChronicDiseasesbyQuintilesin2014,Percent


30. ThecharacteristicsofthepooraresimilartothoseoftheB40.LiketheB40,poorpeoplearemorelikelytoliveinruralareasandsmalltowns.Theyalsotendtoliveinbiggerhouseholdswithmorechildrenandhigheryoungdependencyrates(table9).Theoldagedependencyratioisalsosomewhathigherforthepoorthanforthenon‐poor.AswiththeB40,thepoorhavelesseducation–theshareofpeoplewithtertiaryeducationismorethanhalfamongthepoorthatamongthenon‐poor.Thepooralsohaveworselabormarketoutcomesthantherestofthepopulation,withloweremploymentand labor forceparticipationrates.Theyarealsomore likelytobeemployedin lessproductivesectorswithlowerlevelsofincomes.31. Regional variation inhuman capital compounds differences by income groups. Inaddition to the differences in education levels and household characteristics highlighted above,regionaldifferencesalsoplayasignificantrole.Thosearehardtocapturewiththeexistinghouseholdsurvey as even before the conflict, coverage by administrative regionwas uneven. Estimates ofregionalvariationbasedonfourmacro‐regionsare,therefore,morereliablefromastatisticalpointof view, but also a lower bound for the real variation given the higher level of aggregation thanadministrativeboundariesweadopt.Bothpoorandnon‐poorpeopleinWesternandCentralregionsonaveragehavelowerlevelsofeducationandarelesslikelytobeinemploymentthanintherestof

1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5thTertiary (copmplte or incomplete) 31.9 42.9 44.5 52.2 62.2 28.2 37.2 37.1 46.6 56.7 34.7 47.7 51.0 57.2 67.2 Complete general secondary 57.1 45.6 44.5 38.2 30.8 63.6 53.7 54.8 46.0 37.8 52.1 38.8 35.6 31.3 24.5 Incomplete general secondary or below 11.0 11.5 10.9 9.6 7.0 8.2 9.1 8.2 7.4 5.5 13.1 13.6 13.3 11.5 8.3

Total population Male Female

1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5thHypertension (high blood pressure) 6.6 10.4 12.6 13.3 14.4 3.9 5.7 6.7 8.5 9.8 8.9 14.8 17.8 17.8 18.8 Cardiovascular diseases 4.4 6.9 7.8 8.6 9.6 2.9 4.7 5.8 7.0 8.3 5.6 8.9 9.5 10.2 10.7

Total population Male Female

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thecountry,whileSouthernandEasternhavehigherlevelsofbothindicators.ThemoreindustrialSouthernandEasternregionsaremoreurbanized.Theirpopulationsarecharacterizedbysmallerfamilies with less children and lower young age dependency rates. These variations in socialindicatorsacrossregionsapplytoboththebottom40percentofthepopulation(depictedinthemapsbelow)aswellasfortherestofthepopulation.

Table9.SocialindicatorsforBottom40%ofPopulationbyRegions,percent

Youngagedependencyratio Shareofpeoplewithcompletetertiaryeducation

Shareofemployedinworkingagepopulation


32. Significantdifferencesemergealsoinaccesstoutilitiesandothercommunalservices,especiallyintheruralareas.Whilemostofhouseholdsinurbanareasdohaveaccesstowaterandsewerage(theshareisabove90percentforallquintiles),thisisnotthecaseforruralones(table10).Accesstothistypeofservicesishigherforhouseholdswithhigherincomes.Inruralareasonly45percentofthepoorestquintilehaveaccesstowaterandsanitation,against66‐67percentforthetopquintile. In urban areas the rich aremore likely than the poor to have access to district heating(thoughtheshareofpoorerhouseholdsconnectedtodistrictheatingisover40percent)–inruralareas access to individual heating is better for richer rural households than for poor. The samepattern of richer households more likely to have access than poorer ones applies also to otherutilities,(centralgas,bathorshower,hometelephone).

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Table10.AccesstoUtilitiesbyQuintilesforUrbanandRuralPopulationin2014,Percent


33. Whiletherichenjoybetteraccesstoutilitieseverywhere,thegapsbetweenricherandpoorerhouseholdsvarysignificantlybyregion,andrural/urbanareaswithinregion.Accessto main utilities (water and heating) is different across the four macro‐regions. While richerhouseholdtendtohavebetteraccesstocentralheatingandwatersupplyeverywhere(table11),thegapbetweenrichandpoorvariesacrossregion,beingparticularlymarkedforaccesstowaterinruralpartsoftheEastregion,andoftheWest.InruralareasoftheCentralregioneventherichhavelessaccess than poorer households in other regions. Eastern regions had the biggest gap in accessbetweenurbanandruralareasin2014,thoughtheconflictislikelytohavechangedsignificantlythispicture.Table11.AccesstoUtilitiesbyQuintilesforUrbanandRuralPopulationin2014,Percent


1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5thDistrict heating 24.3 29.1 34.1 40.1 48.5 41.2 49.4 54.6 61.5 66.3 0.1 0.4 0.2 0.6 1.3 Individual heating system 50.9 50.8 47.9 44.7 40.3 44.5 41.0 38.5 32.4 28.5 60.0 64.7 63.6 67.4 71.4 Water mains 72.1 78.2 79.8 83.8 89.7 91.2 91.5 94.7 95.4 98.0 44.9 59.4 55.1 62.3 67.6 Waste water disposal system 71.5 77.4 79.5 83.6 89.2 90.4 90.8 94.4 95.3 97.8 44.6 58.4 54.8 61.9 66.5 Hot water supply 25.1 37.6 40.5 41.9 53.4 37.7 47.1 54.9 58.7 65.9 7.3 24.2 16.7 10.7 20.3 Gas-fired water heater 16.9 16.0 17.9 19.2 14.7 21.4 18.6 18.3 17.6 14.1 10.6 12.2 17.3 22.2 16.2 Centralised gas supply 76.2 82.4 80.4 82.7 81.7 85.0 90.1 87.9 87.6 85.9 63.7 71.4 68.0 73.6 70.4 Bottled gas 14.4 9.7 12.9 10.3 9.2 6.4 3.6 6.0 3.4 3.0 25.7 18.4 24.1 23.1 25.7 Bathtub or shower 66.4 72.9 75.7 80.0 86.4 85.3 87.0 91.3 93.6 95.4 39.4 53.0 49.9 54.6 62.6 Home telephone 35.2 40.1 39.6 48.7 56.9 46.7 54.1 48.5 59.9 64.2 18.8 20.1 24.9 28.2 37.7

Total population Urban population Rural population

1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5th 1st 2nd 3rd 4th 5thRegion 1 (West):District heating 15.2 17.5 12.9 18.6 13.7 33.1 38.1 30.4 40.9 23.4

Individual heating system 46.1 53.0 54.1 51.1 64.4 44.9 39.7 51.0 48.9 58.7 47.2 64.2 56.4 52.9 70.3

Water mains 67.0 75.8 74.7 77.0 89.6 91.4 86.4 94.5 97.7 98.5 46.2 66.8 60.1 61.1 80.1

Region 2 (Center):District heating 28.9 33.3 43.9 48.4 61.5 44.5 56.0 63.3 69.1 81.9


Water mains 69.1 72.0 80.3 80.3 86.8 86.4 90.6 94.2 93.8 98.5 36.9 44.7 49.1 48.5 51.7

Region 3 (South):District heating 29.4 42.2 45.2 49.9 52.0 44.3 59.2 63.8 68.6 65.9


Water mains 84.8 87.0 81.9 91.2 93.4 95.6 97.1 95.4 96.8 98.8 63.2 63.5 49.7 76.5 73.2

Region 4 (East):District heating 33.6 34.8 43.1 42.2 59.6 46.0 42.6 52.1 54.1 68.6


Water mains 71.3 88.4 89.0 92.6 90.5 94.1 94.9 95.3 94.3 94.5 13.0 59.4 58.6 86.5 63.6

Total population Urban population Rural population

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IV. Framework:PathwaysandConstraints34. The analysis in the twoprior chapters shows thatUkraine faceskey challenges inachieving sustainable recovery and shared prosperity:macroeconomic imbalances,weakproductivitygrowth,and inadequate servicedelivery.Largemacroeconomic imbalances andinstability, includinglargefiscalandcurrentaccountdeficitsandaninsolventbankingsector,notonlystifleconfidenceunderthecurrentcrisis,butalsocontributedtoanunsustainablegrowthpathin the pre‐crisis period. Weak productivity and inadequate progress in diversifying exportscontributedtoeconomicstagnationafterthe initialspurtofreboundandgrowthduring2000‐07fueledbyexternalconditions.Weaklabormarketoutcomesalsogeneratedanexcessiverelianceonunsustainablepensionsandsocialassistanceinimprovingincomesofthebottom40percentofthe

Figure25:UkraineSCDFramework

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population. Inadequate and inefficient service delivery has constrained labormarket outcomes,particularly for the bottom 40 percent of the population, while contributing to macroeconomicimbalances,andsqueezingresourcesforpublicinvestment.Inadditiontothechallengesdescribedabove, Ukraine also faces the fundamental challenge of extraordinary levels of corruption andpowerfulvestedintereststhatseriouslyimpededevelopmentprogressacrosstheboard.Thiswillbedescribedinmoredetailbelow.ThechallengesdescribedpointtowardfourkeypathwaystowardsustainedrecoveryandsharedprosperityinUkraine:safeguardingmacroeconomicstability,boostingprivatesectorproductivity,andprovidingmoreeffectiveservices,whilebuildinginstitutionsofbettergovernanceandanticorruption.35. The rest of this chapter is organized as follows. The next section describes theprioritizationmethodologythatisusedinthisSCD. Thespecificpriorityinterventionstoaddresswithinthepathways,whilesummarizedintheframeworkgraphicabove,willbediscussedfurtherinthe subsequent chaptersoneachof the fourpathways. This chapteralsodescribes three “initialconditions”orrootconstraintsfacingUkraine:conflictandshocks;demographyandgeography;andcorruption and state capture. These constraints are important factors in gaining a betterunderstandingofthetypesofinterventionsnecessarytomakeprogressalongeachofthepathwaysidentifiedinthisSCD.

PrioritizationMethod36. TheprioritizationmethodutilizedinthisSCDinvolvesathreestepprocess.Thesethreesteps include: (i) identifying the broad pathways to address Ukraine’s overarching developmentchallenges;(ii)identifyingpriorityinterventionstoaddressthemorespecificchallengeswithineachof thepathways;and(iii)assessing thecriticality for twingoalsand timehorizon foreachof thepriorityinterventions.

37. The firststep involves identifying thepathways thataddressUkraine’soverarchingdevelopmentchallenges.Aspartofthisfirststep,thediagnosticsofgrowth,sustainability,poverty,and shared prosperity have contributed to identifying the pathways ofmacroeconomic stability,private sector productivity, and more effective service delivery. Furthermore, the subsequentanalysisofsomeoftheinitialconditionsandconstraintsaffectingprogressalongthethreepathwaysshowsthatbettergovernanceandanticorruptioninstitutionsisacross‐cuttingpathwayimportantinachievingUkraine’sdevelopmentobjectivesacrosstheboard.Inparticular,theanalysiswillshowthataddressingthegovernancechallengewillrequireatwo‐prongedstrategythatincludesbuildingbetter governance and anticorruption institutions and advancing reforms along the three otherpathwaysthatdisempowervestedinterests.Inthissense,thecross‐cuttingpathwayisnotsomuchafilterforprioritiesandinterventionswithintheotherthreepathways,butratherafoundationtofacilitateprogressacrossthethreepathways.38. Thesecondstepinprioritizationinvolvesidentifyingpriorityinterventionstoaddressthespecificchallengeswithineachofthepathways.ThissecondstepreliesontheanalysesoftheSCDaswellasextensivedeliberationsandconsultationsacrossmultiplesectoralteamsengaged

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inUkraine.First,theanalysesofgrowth,sustainability,andpovertygoesbeyondtheidentificationof pathways and also informs the selection of priorities and interventionswithin the pathways.Second, the analyses in the subsequent chapters on the cross‐cutting and three other pathwaysfurther informs the selection of priorities and interventions. Third, extensive deliberations andconsultationshavetakenplaceacrossthesectoralteamsinthecontextof:preparingthepolicynotesdeliveredtothenewgovernmentofinJune2016;theextensiveinputspreparedandconsultationsundertakenfortheSCDacrossdifferentsectoralteams;theworkbythedifferentsectoralteamsintheir respective engagements on development prospects and priorities in Ukraine; subsequentprioritizationdiscussionsheldacrossthefullcountryteaminOctober2016;externalconsultationsheld with the government, private sector, civil society, and development partners in October‐December2016.

39. The third step involves assessing the criticality and time horizon for the priorityinterventions. The first two steps result in four pathways and fifteen priorities. While this isnarroweddownfromawideruniverseofpossiblepathwaysandpriorities,fifteenprioritiesisstillalargenumber.NotallofthemwillbeequallycriticalinhelpingUkrainegeneratesustainedrecoveryandsharedprosperity.Furthermore,notallof themcanbeexpectedtobe implementedoverthesametimehorizon.Therefore,theanalysesinthesubsequentchaptersonthecrosscuttingandthreeotherpathwaysassignsacriticalityratingof“critical”,“high”,or“medium”foreachofthepriorityinterventions.Forexample,pensionreformisassessedascriticalsinceisrepresentsafundamentalsourceoffiscalandmacroeconomicvulnerability.Inaddition,theassessmentofthestateofaffairs,challenges, and prospects for progress within each priority area is used to determine the timehorizon(“immediate”,“short”,or“medium”)overwhichprogressisneededandcanbeexpected.Forexample,whilepublicadministrationreform is critical forbettergovernance,progresscannotbeexpectedimmediately,butratheroverthemediumterm.40. It is important tonote that significantcomplementaritiesexistacross thedifferentpathwaysandpriorities.Inotherwords,theprioritieswithinthepathwaysdonotcontributetoaddressing mutually exclusive challenges. For example, improving the effectiveness of servicedelivery can help consolidate Ukraine’s large current expenditures and thus contribute tomacroeconomic stability. Similarly, improving financial sector stability not only contributes tomacroeconomicstability,butalso facilitatesgrowthofcredit to theprivatesector,whichenablesproductivityandjobcreation.Finally,buildinginstitutionsofbettergovernanceandanticorruptioncontributetoprogressacrossthethreeotherpathways.

Constraints41. Therestofthischapterdiscussesthreeimportantconstraintsthataffectdevelopmentprogress inUkraine:conflictand shocks,demographyandgeography,andcorruptionandstatecapture.First,thedoubleshocksfromtheconflictandlowerglobalcommoditypricesin2014‐15triggeredmacroeconomicinstability,depressedeconomicactivity,employmentandlivelihoods,anddisrupteddeliveryofservices.Thisaddedtoahistoryofvolatileexternalconditionswiththecommodityboomandfreecapitalflowsof2000‐07followedbytheglobalfinancialcrisisof2008‐09.

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Second, the demographic pattern of a decliningworking agepopulation puts a larger burdenonproductivity and capital accumulation in driving growth and leads to larger social insuranceobligationsthatneedtobesupportedbyfewerworkers.Inaddition,Ukraine’sgeographywitharichendowmentofnaturalresourcescaninhibitexportdiversificationandprovideareadyhabitatforcorruptionandrentseeking,althoughitslocationadjacenttolargemarketsrepresentsasignificantopportunitytodevelopingitsexportbase. Third,state‐captureandcorruptionareattheheartofmanyofthestructuralbottlenecksfacingUkraine, includingfiscal liabilitiesfortheenergysector,insolventbanks, inadequateprotectionofpropertyrights,anticompetitivebusinesspractices,andinefficient delivery of services. Combatting state capture and corruptionwill, therefore, requirereformsacrossanumberofareastodisempowervestedinterests,aswellaseffortstostrengtheninstitutionsspecificallydedicatedtoPFM,anticorruptionandjustice,andpublicadministration.

ConflictandExternalShocks42. The conflict has had awidespread impact on economic activity and prospects inUkraine, so that extra effortwill be needed to bolster confidence in the economy. TheimplicationsforeconomicactivityinUkraine’seasternindustrialheartlandweredrastic.Beforetheconflict,theDonetskandLuhanskregionsaccountedforalmostone‐quarterofUkraine’sindustrialactivityandanequalshareofitsexports.Inaddition,disruptionsinindustry,transportandsmallandmediumenterpriseactivityledtowidespreadjoblossesandoverallconfidenceintheeconomyhasbeenseriouslyundermined.ContinuinginsecuritymeansthatUkrainemustgotheextrasteptobolsterconfidenceinitseconomy.43. Theconflicthasalsohadaconsiderablehumancost,andwillrequiretargetedservicesandopportunitiesforaffectedpopulations.WiththeDonetskregionhometoalargepopulationofthebottom40percent,andwithlargenumbersofpensionersinDonetsk(1.4millionbeforetheconflict) and Luhansk (730,000 before the conflict), the human cost on populations in conflictaffectedareashasbeensevere.Vulnerablegroupsinconflictareas,especiallypensioners,women,childrenandpeoplewithdisabilitiesaremostatrisk,especiallyasaresultofalackofaccesstoqualityhousing,waterandelectricityandhealthcare.Whilethewellbeingofvulnerablegroupsinconflictareasisaconcern,thefootprintoftheconflictextendsmuchmorewidely.AccordingtoUNestimates,the conflict has resulted in 9,800 deaths through January 2017. Furthermore, large scaledisplacement means that social and humanitarian costs are felt by both displaced and hostcommunities—service delivery deficits, overburdened social welfare services, joblessness,increasingsocialtensions,anddeterioratingdebtandcreditrelations.Itisestimatedthatasaresultoftheconflict,about2.5millionpeoplehavebeendisplacedbothinternally(1.7million)andoutsideUkraine(1million).Thisrepresentsapproximately5percentofUkraine’spopulation.Managingthehuman cost of the conflict will require providing targeted services and supporting employmentgenerationamongconflictaffectedpopulationsandhostcommunities.

DevelopmentImpactoftheConflictConflictineasternUkrainehashadasevereimpactonthelivesandlivelihoodopportunitiesofmillionsofUkrainians. Sincetheoutbreakoffightingin2014,about9.800peoplehavebeenkilled,

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over2.7milliondisplaced(about5percentofUkraine’spopulation)andover4millionpeopleintheeasternDonbasregionhavebeendirectlyaffected. As theconflictspills into its thirdyear, therearemounting development challenges alongside humanitarian concerns, including pressures on theeconomy,lackofinvestment,joblessness,servicedeliverydeficits,andsocialtensions.

EconomicImpacts SocialImpact DisruptionofeconomicactivityinUkraine’seasternindustrial base (one quarter pre‐crisis industrialproduction)andsignificantdeclineinexports

Crisisofinvestorconfidence:Uncertaintyrelatedtotheconflictunderminesinvestorconfidence

Widespread job loss. Net employment inDonetskand Luhansk down by 40 and 70 percent,respectively(about800,000jobs)byend2014.

Fiscalpressures–RevenuesfromDonbasdown40percentin2014andmilitaryexpendituresupto5percentofGDPin2015.

Acuteimpactsforover4millionpeoplelivinginconflict‐affectedareas/800,000livingclosetothe‘lineofcontact’

Insecurity has interrupted service delivery,infrastructure,urbandevelopment

Over 1.7 million IDPs: socio‐economicpressuresondisplacedandhostcommunities

Over 200,000 veterans integrating back intocommunities

Theconflict,alongwiththesharpdeclineincommodityprices,hashadaconsiderableimpactonUkraine’seconomyand itsdevelopmentprospects. TheDonbas regionwas an importantpart ofUkraine’s industrialbase.Theconflicthascausedsignificantcontractionofproductionandrevenues,disrupted supply chains and trade, and undermined investor confidence. The conflict has also putsignificant burden on the national budget. However, industry in easternUkrainewas outdated andobsoletepriortotheoutbreakoffightingandrecoveryeffortscouldoffertheopportunitytobuildbackbetter—tomodernizeindustry,pushnewtechnologies,andpursueefficientenergysources.Thedirectimpactsoftheconflictarefacedbyeasternpopulationsbutalsobyinternallydisplacedpersons,formercombatants,andhostcommunitiesacrossUkraine.MorethanhalfofIDPshavestayedinDonetskandLuhanskregionsneartheconflictzone,butIDPshavealsosettledthroughoutthecountryinsearchofopportunity.Theoveralleconomicsituationandtheincreasinglyprotractednatureof the challenge means IDPs are becoming increasingly vulnerable. As the conflict continues,development impacts are felt by both displaced and host communities—service delivery deficits,overburdenedsocialwelfareservicesandhousingmarkets,joblessness,andsocialtensions.

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44. In addition to the conflict,Ukrainehasbeenhitby large external shocks, anotherreasonwhyextraeffortwillbeneededtobolsterconfidence. Globalcommoditypriceshavedeclinedsharplysince2014.ThishasnotonlyimpactedUkraine’sexportsofcommoditiesglobally,butithasalsomeantthatmanyofUkraine’sresourcerichexportmarketshavebeenhitbyrecessionand have experienced sharp depreciation in their currencies. Given the weak external outlook,Ukrainewill need to go the extramile to restoremacroeconomic balances and confidence in itseconomy. Theweakoutlook forcommoditymarketsalsopresentsanopportunity forUkrainetodevelop a more diversified export base. In fact, Ukraine’s reliance on commodity markets hascontributedtoitsvolatileandunsustainablegrowthpathinthepre‐crisisperiod.

DemographyandGeography45. Ukraine’sworkingagepopulationhasbeendecliningwhiletheelderlypopulationhasbeen rising due to highmortality, low birth rates, and considerable out‐migration. Theworkingagepopulationfellfromaround34millionin2000to32millionin2013andisprojectedtokeepondecliningtoreach25millionby2050. Ukrainerankssecond in theworld togetherwithBulgariaandGeorgiaandafterMoldovaintermsofthepaceofaging.Theshareofelderlypopulationisprojectedtorisesignificantly. Thisdemographyshifthassignificant implications forsustainedrecoveryandsharedprosperity.

Figure26:UkrainePopulationAgeDistribution

46. Lowfertilityandhighmortalityratesresultinlowlifeexpectancyatbirth(71yearsin2013) that lag EU and the OECD averages bymore than 10 years. The main losses in lifeexpectancyaredue toexcessmortality fromnon‐communicablediseases (NCD)among themale,especiallytheruralpopulation.Lowlifeexpectancytodayistheresultofasteeplossatthebeginningofthe1990scommontootherformerSovietcountriescausedmostlybystress‐relatedheartattacks,alcoholismandaccidents,andslowimprovementssubsequentlybutonlyafter2011whenUkrainereachedpre‐transitionlifeexpectancylevels.TherecentconflictintheEastandtheeconomiccrisisthatfollowedcouldjeopardizethepositivetrendinlifeexpectancyofthelastfewyears.Thedecline

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inworkingagepopulationandtheincreaseintheelderlypopulationmeansthathealthcareserviceswillneedtobeimprovedsignificantlynotonlyfortheelderly,butalsofortheworkingagepopulationthroughascalingupofpreventiveandprimarycare.47. In addition to the human costs of low life expectancy, the decline in fertility andmarkedexcessmortalityamongworkingagemenhavesignificanteconomicconsequences.IfUkrainehadexperiencedthesamemortalityreductionsasFrancesince1950,itslaborforcewouldbe19percentlargerthanitistoday.Thisimpliesalossofproductivepotential,ontopofthehumancosts of the lives lost. This loss ofworking‐agepopulation to high adultmortality rates has thepotentialofraisingtheeconomicdependencyratiostolevelsthatareunsustainable.Inadditiontothe loss of productive population, the decline in the working age population raises significantquestionsaboutthesustainabilityofsocialinsurancesystems.48. Thedecliningworking‐agepopulationmeansthatsubstantialgrowthinproductivityisneededtogeneratehigherpercapitaincomes.Thischallengingrequirementputsapremiumontherangeoffactorsnecessarytoimproveproductivity,includingbetterinfrastructure,entryormoreproductivefirmsandexitoflessproductivefirmsandproductivityimprovementswithinfirms,tapping international tradeopportunities,andeffective functioningof the labormarket. The freemovement of labor across firms, sectors, and geographical areas is an important component ofproductivitygrowth.EvidencesuggeststhatthedegreeofinternalmigrationinUkraineislessthanin other ECA countries, andwithin‐countrymigration appears to be taking place towards lowerproductivityandlowerwageareas.

49. Ukrainehasauniquegeography,witharichendowmentofnaturalresourceswhichareassetsbuthavealsoencouragedrentseekingandstymiedreformsanddiversification.Ukraineisendowedwithconsiderablenaturalresources,including:richdepositsofvariousmetalores(morethan5percentoftheworldreservesofironore),one‐quarteroftheworld’sblacksoil(over60.4mnha),theworld’slargestnumberofmineralrockdeposits;nativesulfur,potashsalt,inadditionconsiderablefuelandenergyreservesthathavebeendiscovered.Thenaturalresourcesleadto significant economic potential for development of such industries as agriculture and foodprocessing,metallurgy, chemicals, aswell as the production of ceramic articles and constructionmaterials.Atthesametime,therichendowmentofnaturalresourcescoupledwiththecommodityboomof2000‐2007discourageddiversificationandencouragedrentseekingandcorruption.Theinfluenceofvestedinterestshasalsobeenaseriousobstacleforstructuralreforms.

50. Ukraine’sgeographyalsoputsitatthecenterofmajormarketsandleadstosignificantpotentialtodevelopexports.Ukraine’sgeographiclocationisatthecenterofEasternEurope,atthecrossroadsofmajortransportationroutesfromEuropetoAsiaandfromtheScandinavianstatestotheMediterraneanregion.Thispresentsaveryfavorableenvironmenttodevelopinternationaltrade.UkraineisadjacenttotheEUtothewest,RussiatotheEast,andtheBlackSeatothesouth.UkrainemayalsobenefitfromtherecentsigningofDCFTAagreementwiththeEU,whichcaneaseaccesstothelargeandcompetitiveEUmarket.

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CorruptionandStateCapture151. Corruptionandstatecaptureareentrenched inUkraineandadominantconstraintimpedingreformsandprogresstowardsustainedrecoveryandsharedprosperity.CorruptionpermeatesallwalksofpubliclifeinUkraine.Onmanyaggregatemeasuresofcorruption,UkrainescoresclosertothelowestincomecountriesthantotheEUwhichitaspirestojoin.Ukrainewasinthe 15th percentileworldwide in theWGI (World Governance Indicators) Control of Corruptionindicatorin2014,wellbelowPolandandRomania(71stand53rdpercentile,respectively),aswellasaveragesforlowmiddleincomecountries(37thpercentile),theECAregion(64rdpercentile),andsub‐SaharanAfrica(30thpercentile).Withsuchextraordinarylevelsofcorruptionandstatecapture,powerfulvestedinterestsacrosstheboardseriouslyimpedeUkraine’spathwaystowardsustainedrecovery and shared prosperity. Widespread tax evasion and related party lending underminemacroeconomicstability,ahighlyconcentratedandanticompetitiveproductionstructure inhibitsproductivity and job creation, and weaknesses in the management of public resources impedesefficientandeffectivedeliveryofpublicservicestothepopulation.52. Ukrainehasstruggledwithcorruptionandstatecapturesinceitsindependencemorethan two decades ago. Privatized state assets were concentrated in a few hands in the earlytransitionyears.Inaddition,commoditieswereoftenboughtatstate‐regulatedpricesandsoldatfullmarketprices,whileunderpricedleasesoflargetractsofagriculturalland,budgetsubsidies,andlow‐interestbankloansweremadeavailabletofavoredpersons.Allthishasbeenmadepossiblebypartialand incompletemarketreforms. Asaresult,anumberofoligarchshavedominated largesectors of the Ukrainian economy (energy, metallurgy, mining, chemicals and more recentlyagriculture), extracting rents, and influencing public institutions, including through directrepresentation in political parties and the Parliament. The symbiosis linking oligarchs withpoliticians and state officials stands in theway of reforms that could level the playing field andeliminaterents.Vestedinterestshavefinancedpoliticalpartiesandexpensiveelectioncampaigns,and influenced decisions of officials in state‐owned enterprises, courts and presidentialadministrations2inordertocreateandmaintainanon‐levelplayingfieldtotheirbenefit.Civilsocietyhasbeentooweaktocountertheseinfluences,renderingpoliticiansandstateofficialsaccountablemoretothefewthantothemanywhovotedforthem.53. SystematicevidencepointstoahighdegreeofcorruptionfacingUkraine.AccordingtoTransparencyInternational’s2015CorruptionPerceptionIndex(CPI),Ukraineranks130thoutof167countries;onlyTajikistan,UzbekistanandTurkmenistanintheECAregionperformedworse.TheGlobal CorruptionBarometer2013 shows that 95 per cent of Ukraine’s citizens believe thatcorruption levelshadeitherworsenedor stayed the sameover theprevious twoyears,with thejudiciaryandthepolicebeingperceivedasthesectorsmostaffectedbycorruption.Anticorruption

1 Statecaptureisdefinedastheactionsofindividuals,groups,orfirmsbothinthepublicandprivatesectorstoinfluencetheformationoflaws,regulations,decrees,andothergovernmentpoliciestotheirownadvantageasa result of the illicit and non‐transparent provision of private benefits to public officials (Hellman andKaufmann,2001).2SeeAslund(2009)andAslund(2015)

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institutionsinUkrainehavebeenineffective,withfinancialdeclarationsofhighlevelofficialsandcivilservantshardtoverifyandlackingaccountabilityforcontainingfalseinformation.Untilveryrecently,conflictof interestwasnotadequately legislated. Work isnowunderwaytoestablishapreventive anticorruption agency, broaden and publicize income and asset declarations, andimplementconflictofinterestprovisions.Atthesametime,rightsizingthepublicsectorcouldcreatethefiscalspacetoalignremunerationwiththemarketandhelpincreasetheattractivenessofthecivilserviceandbringinqualifiedstaff.Figure27.CorruptionPerceptionsIndex,2015 Figure28.GovernmentEffectiveness

Sources:TICorruptionPerceptionsIndexandWorldGovernanceIndicators54. Poorgovernance,includingabrokensocialcontractbetweencitizensandthestate,isamajorstructuralimpedimenttoeffectiveprovisionofpublicservices.Ukrainescoresbelowmost comparator countries in terms of government effectiveness, as reflected in the WorldGovernance Indicators. The government has an outsized role in the economy (with generalgovernment spending 43 percent of GDP in 2015), but government effectiveness is poor. Anineffective public sector undermines health and education service‐delivery, public investment ininfrastructure, and protection of property rights for the private sector. Furthermore, the weakindependence and low quality of the judiciary has a direct bearing on prospects for improvinggovernance across the board. Unless government effectiveness is strengthened and impunityremovedfromthestate,Ukrainewillfacedifficultyinmakingprogressalongitspathwaystowardsustainablerecoveryandsharedprosperity.

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V. Cross‐CuttingPathway:BetterGovernanceandAnticorruptionInstitutions55. A two‐pronged strategy is important in addressing Ukraine’s governance andcorruptionchallenges. The firstprongof the strategy involvesbuilding the institutionsofbettergovernanceandanticorruptionthatwouldhaveacross‐cuttingimpactinsupportingprogressalongthe pathways to sustained recovery and shared prosperity. These include institutions of publicfinancialmanagement(PFM),anticorruption,justice,andpublicadministration.StrengtheningPFMinstitutionswould help improve efficiency, accountability, and transparency in the use of publicresources, including for service delivery, public investment, and state‐owned enterprises. Thiswouldhelpreducefiscalrisksandcontributetomoreeffectiveinfrastructureandservicedelivery.Building anticorruption and justice institutions would contribute to overall transparency andaccountability in the interfacebetween the citizen,businesses, and the state,whilebattling statecapture,administrativecorruption,andtheinfluenceofvestedinterestsacrosstheboard.Improvingpublicadministrationbybuildingamoreprofessionalandmotivatedcivilserviceandstrengtheningstrategic planning and coordination will help reduce incentives for corruption while improvingdeliveryofpublicservices.56. The second prong of the strategy involves advancing reforms across the threepathways of macroeconomic stability, productivity, and service delivery to disempowervestedinterests.Reformsintaxadministrationandthefinancialsectorcanhelpnotonlycontainmacroeconomicimbalances,butalsodisempowerpowerfulunderlyingvestedinterestsbycuttingtaxevasionandreininginopportunitiesforrelatedpartylending.Similarly,streamliningbusinessregulations, increasing competition, and reforming land markets would not only help level theplayingfieldandsupportproductivitygrowth,butalsoundercutrentsforpowerfulvestedinterests.Furthermore,effectivedecentralizationcannotonlyhelpdelivermoreeffectiveservicesundertherightcircumstances,butcanalsoundercutacentralizedsystemofinfluenceAllthismeansthatanimportantprongofabettergovernanceandanticorruptionstrategyistopushprogressonreformsacrosstheboardthatunderminevestedinterests.57. The analysis in this chapter suggests that building better governance andanticorruption institutions are critical forUkraine, although improved outcomesmay berealizedinthemediumterm. Buildingbetteranticorruption, justice,andpublicadministrationinstitutions are critically important for Ukraine and would have far reaching ramifications forprogress along each of the other development pathways. At the same time, building suchfundamentalinstitutionstakestimeandactualimprovementsmayberealizedinthemediumterm.Nonetheless,itisimportanttocontinuetopushforspecificimplementationstepsinareaswheretheprocesshasbeeninitiated,suchaseffectiveimplementationofanticorruptionlaws. Andinotherareas that are at a more incipient stage, such as justice and public administration reform, it isimportanttolaunchtheprocess.Whilethesecriticallyimportantreformprocessesareunderway,immediate and systematic efforts to enhance citizens’ engagement will be critical in facilitatingprogress.Thefollowingtablesummarizesthepriorityinterventionsforbuildingbettergovernanceandanticorruptioninstitutionsidentifiedthroughtheanalysisinthischapter.

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PublicFinancialManagement58. Strengthening PFM institutions is a key component of improving governance inUkraine by improving efficiency, accountability, and transparency in the use of publicresources.Inthefaceofsubstantialfiscalpressuresinrecentyears,fiscalmanagementinUkrainehasbeendominatedbyshort‐termconsolidationneeds,whilelongterminstitutionalimprovementshavebeensidelined. Inrecentyears,progresshasbeenmadeinbudgettransparency,revampingintergovernmental transfers, and changes to procurement to allow for implementation of e‐procurementandreducednumberofexemptionsfromcompetitivetenders.However,progresshasbeenslowinsuchimportantareasasthepolicyalignmentofbudgeting,multiyearfiscalplanningandbudgeting,expenditureconsolidationand fiscal riskmanagement,and internal control. ThePFMsysteminUkrainethushampersefficientservicedelivery.Thebudgetprocessdoesnothaveastrongpolicyorstrategicfocusandamedium‐termfiscalstrategytoguidethebudgetprocessislacking.Performanceinformationisincludedinprogrambudgetsbuttendstofocusonoutputsratherthanoutcomesandresults.Weaklinksbetweensectorplansandbudgetallocationsandweaknessesinpublic investmentmanagementbothatselectionandimplementationstagesarenotconducivetoefficienttargetingofresourcestostrategicpolicypriorities.59. Ukraine’s PFM system is control oriented and rigid. The control environment isburdensomeandobligesthoseresponsibleforthedeliveryofpublicservicestofocustheireffortsoncompliance rather than improving performance and the effectiveness of service delivery. Cashrationingpracticeshavehelpedcurtailthedeficitduringthefiscalcrisis,butwilladdfurtherrigiditybudgetsystemoncethefiscalsituationnormalizes.Ongoingefforts to improve internalauditandexternal audit and focus on performance auditing are only likely to have an impact on theperformanceorientationofthePFMsystemoverthelonger‐term.

60. A key step in strengthening PFM institutions going forward is to continueimplementation of PFM reforms that enable efficient service delivery and ensure fiscaldiscipline.ThereformprocessisshapedbytherecentadoptedPFMReformStrategyasalong‐termvisionforreform,alongwithanextendedactionplanfortheperiod2017‐2020.Keyreformelementsinclude:moving forwardwith implementation ofmedium term budgeting including establishing

Priorities Criticality TimehorizonPublicfinancialmanagement:ImplementupdatedPFMStrategy,includingmediumtermbudgeting,streamliningperformancebasedbudgeting,andintroducingfiscalriskassessmentframework.

High Short,Medium

AnticorruptionandJusticeInstitutions:Effectivelyimplementnewanti‐corruptionlaws;strengthenpublictrustinjusticesystembyimprovingenforcementandHRreform.


Publicadministrationreform:Improvepolicyanddecision‐making;streamlinepersonnelwhileimprovinghumanresourcemanagement;undertakemerit‐basedappointmentsandoptimizesalaries.


CitizensEngagement:Buildonsuccessfulpost‐Maidanmobilizationbypromotingmoresystematicplanning,management,andcommunicationsbasedoninformationandevidence‐basedanalysis.


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multi‐yearceilingsforlineministriesandagencies;streamliningperformancebasedbudgetingbyreducingthenumberofprogramsandlinkingresultswiththedecisionsmakingprocessatboththeparliament and executive levels; fully institutionalizing and introducing a fiscal risk assessmentframework. The governance arrangements to implement thePFMStrategywould be essential tosuccessofthereformprocess.Highlevelleadership’supfrontcommitmenttoclearandmeasurableresults,andmonitoringimplementationofthePFMreformactionsisrequired.Ukrainehasmadeconsiderableprocessinbringingbudgetlegislationtogoodinternationalpracticeinmanyareas.Thechallengegoing forward is toensure transformationofpractices.Practicechangeswouldrequirebuilding institutional and human capacity across all government agencies. Development andimplementationofaPFMICTStrategywillenableacomprehensiveandcostefficientICTsupporttoallthereforms.

AnticorruptionandJusticeInstitutions61. Effective implementation of new anti‐corruption laws aimed at battling grandcorruptionandstatecaptureiscrucialinimprovinggovernanceinUkraine.In2014,anumberofanti‐corruptionlawswereadopted,institutionalizingsomeoftheanti‐corruptioninitiativesaimedatbattlingcorruptionandstatecapture.Mostnotably,apackageofanti‐corruptionlawswaspassedinOctober2014,whichestablishtheAnti‐CorruptionBureauwithinvestigativefunctionsandtheSpecializedAnti‐CorruptionProsecutor’sOffice(SACPO)toprosecutehigh‐levelcorruptioncrimes.Another law creates a corruption prevention body, National Agency for Corruption Prevention(NACP), whose responsibilities include verification of asset declarations of public officials andimplementingconflictofinterestprovisions.BoththeBureauandNACParestillinearlydaysoftheiroperations. Another newly adopted law regulates the provision of information onultimate/beneficial ownership, closing some of the loopholes for not declaring assets that areformallyregisteredtootherindividualsorentities.AnimportantlawwasadoptedinOctober2015,introducingcomprehensiverulesonfinancingofpoliticalpartiesandassigningsupervisorypowersoverpoliticalfinancingtotheNACP.In2015,UkrainealsoadoptedlawsthatestablishanAgencyforTracing,RecoveringandManagingCriminalProceedsandtheStateBureauofInvestigationsthatwilldealwithcorruptionatthemiddleandlowerlevelsofgovernment.ThesuccessoftheBureau,SACPOandNACP,aswellasothernewagencies,hingesontheirfinancing,staffingandfullcooperationfromothergovernmentbodies.62. While the passage of these laws is an important step, to strengthen Ukraine’scommitment to fight corruption, the government will need to publicly endorse a set ofambitiousyetachievableanti‐corruptiongoals.Suchgoalsshouldfocusonensuringthesuccessofthenewanti‐corruptioninstitutionsbyprovidingpoliticalandfinancialsupportandworkingtoensurethecooperationandcollaborationofothergovernmentbodies.TheBureauandtheNACPwillfocus both on investigating and prosecuting existing corruption as well as on preventing it byaddressing conflicts of interest, illegal financing of political parties and ensuring the filing andpublicationofaccurateassetdeclarations. Ifdonewell, theseeffortscouldmarkedly increase theaccountabilityofpublicofficialsandtransparencyabouttheirassets–aworthyanti‐corruptiongoal

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initself.TheGovernmentshouldfocusonselectedachievableactivitiesinordertobuildsuccessonestepatatime.63. Thejusticesystemispoorlytrustedandineffective.Publictrustinthecourtshasbeenaslowas9percent (December2014survey,Democratic InitiativeFund). Inaddition, internationalcomparisonsshowUkraineperformingwellbehindanumberofregionalcomparatorsintermsofthe effectivenessof its rule of law. The sourcesofUkraine’sweak justice sector governance arecomplex,andhaveresultedinlimitedreformstorestrainarbitrarystateactionsandforlegalredress.Ukraine’s justice sector shares governance challengeswithmany transition countries, suggestingthathistoricallegaciescouldplayanimportantrole,suchastheemergenceofoligarchswhohavesponsoredpolitical parties andoften exercise strong influence over government institutions andofficialsacrossallthreebranchesofstate.Inaddition,someunfinishedjusticereformshaveseverelyimpactedthestate’sabilitytocollectrevenues.ThesignificanceofthechallengeisillustratedbythehighcostofenforcingcontractsinUkraine(46percentofthetotalcostoftheclaim(comparedtotheECAaverageof26.2percentaccordingtoDB2016)andtheimpactofnon‐enforcementofcivilclaims(Ukraine’srecoveryrateisestimatedtobe3centsonthedollarcomparedto,forexample,27centsfortheUS).3Civilsociety,whilestrong,hasnotyetbecomeaforcetoconsistentlyinfluencepolicy‐makerstoactinthepublicinterest.Socialcollectiveactionisoftenhamperedbythejuxtapositionofunrealistically high expectations of what the state should deliver on justice reform, against lowconfidenceinitsabilitytodoso.

Ukraine:ConstitutionalAmendmentstoStrengthenJusticeandAnti‐CorruptionReformsTheVerkhovnaRada(parliament)inmid‐2016adoptedseveralconstitutionalamendmentsandanewlaw (“On the Court System and the Status of Judges”),which together aim to strengthen judicialindependenceandstreamlinethefunctioningofthejusticesystem.Somelegalexpertshaveopinedthatif implemented properly, they could reduce corruption and enhance judges’ accountability and systemefficiency.Thesevenkeychangescomprise:a) AbolitionofexistingHighCourts(reducingthenumberofcourttiersfromfourtothree),changesto

Supreme Court functions and composition, and establishment of twonewHigh Courts. The threeexistingHighCourts4(abovethecourtsofappealandbelowtheSupremeCourt)willbeabolishedandtheSupremeCourtwillconsistoffourcourtsofcassation(criminal,civil,commercialandadministrative)andagrandchamber.ThiswilleliminateUkraine’ssystemofthreeparallelindependentspecializedhighcourtsandaimstoreduce–overtime‐forum‐shopping,inconsistencies,unpredictabilityandcorruption.AHighSpecializedCourtonIntellectualPropertyandaHighSpecializedCourtonAnti‐Corruptionwillbesetup;theirplaceinthejudicialsystemremainsunclear.

b) Actions to improve judicial independence, competenceand ethics: Judges will be appointed by thePresidentofUkraineuponnominationbytheSupremeCouncilofJustice,anewstatebodytobeestablishedto replace the current High Council of Justice. The competence to appoint and to remove judgeswastransferredtotheSupremeCouncilofJusticefromtheParliamentofUkraine.Theprobationperiodoffiveyears will be revoked for newly appointed judges, and significantly increased base salaries will be

3Asaresultofhighrecoverycostsandlowrecoveryratesondebtcollection,privatecompaniesinUkraineareincreasingly turning to private debt collection companies (including some foreign firms) to address debtcollection.ThishasbecomeagrowingbutcompletelyunregulatedindustryinUkraine.4HighCourtofCivilandCriminalCases,HighCommercialCourtandHighAdministrativeCourt

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provided. Sitting judges will be tested on professional expertise and ethics. Failure to demonstratecompliance,orrefusaltoparticipateinthereview,willconstitutegroundsfordismissal.

c) Strongeranti‐corruptionprovisionsforjudges:Eachjudgewillhavetosubmittwoadditionalannualdeclarations,onetodiscloseonfamilyrelationsandtheotheradeclarationofintegrity,tobemadepubliclyavailable.Judgeshavetoconfirmthelegalityofthesourceoftheirassets,withfailuretojustifysourcesoffundsandotherassetsbeingtreatedasgroundsfordismissal.Judges’blanketimmunityfromprosecutionwillbelifted;immunityfromcriminalliabilitywillonlybelimitedtofunctionalimmunity5.

d) Changestotheprosecutorialfunction.Theamendmentsabolishthewidegeneralsupervisoryauthorityofthegeneralprosecutor’sofficeandlimititsfunctionsto(a)pre‐trialinvestigations,(b)supportingpublicprosecutionincourtsand(c)representingthestate’sinterestincourts.

e) Representationalmonopoly of advocates. The Constitutional amendments also propose to regulaterepresentation of litigants before courts: from January 1, 2017 only licensed advocates can representclientsincassationmatters;fromJanuary1,2018inappealmattersandfromJanuary1,2019incourtsoffirst instance. (Currently, any duly authorized individual can represent any person in court except incriminalproceedings).

f) GreateraccesstotheConstitutionalCourthasbeenprovidedtoall individualsandcompanieswherethereareclaimsthatafinalcourtdecisioncontradictstheConstitution.AcomplaintmaybefiledonlyafterallotherremedieshavebeenexhaustedinregularUkrainiancourts.Thisamendmentcouldsignificantlyimproveaccessto justice,obviating(inmanycases)theneedforremediesfrominternationaltribunals(e.g.theEuropeanCourtofHumanRights).

64. JusticereformisanimportantcomponentofstrengtheninggovernanceinUkraineandfacilitatingitsaspirationsofjoiningtheEuropeanUnion.Inordertoaccomplishthis,itwillbeimportanttosystematicallyimplementtheintegratedjusticereformstrategy,wherecredibleresultswilldependonhowUkraine’sauthoritiesaddressanumberofkeychallengesinthejusticesystem.First, pervasive corruption and state capture in the courts and prosecution has resulted inpersistentlylowpublictrustandcredibility.Second,slowandnon‐transparentenforcementofcivilcases has locked up scarce capital, impeded the business climate and adversely impacted theeconomyincludingthebankingsector6.Enforcementreportedlycommencesonlessthan10percentofcivildecisions,withthousandsofcivildecisions–whosenumber,monetaryvalueandpendencyarenotyetaccuratelyassessed‐remainunenforced,denyingjusticetofirmsandindividuals.Third,ensuring access to justice for vulnerable groups and businesseswill be important in supportingbroad‐basedemploymentgenerationandinclusivegrowth.Fourth,reversingtheeffectsofdecadesofunder‐performanceandover‐staffing,compoundedbystructuralandinstitutionaldysfunctionsandconflict‐wroughtinfrastructurelossanddamage.Finally,improvingtheenforcementofjudicialdecisionscouldenableUkrainetocollectconsiderablesumsfromprivateentitieswho,foryears,haveowedmoneytothestate.7

5 Judgeswillbeprotected from liabilityonly in respectof judicialactionsandcanbeprosecuted forotheroffences.6 The banking system faces significant constraints associated with shortcomings in court decisions andenforcementrelatedtononperformingloans,transfer/saleofassets,foreclosingofcollateral,andotherissues.7AccordingtotheMinistryofJusticedata,morethan400billionhryvnias(equivalentto$16billion)are‘lockedup’ in unenforced civil claims pending with public bailiffs in the Kyiv headquarters unit of the StateEnforcementService(SES)DepartmentundertheMinistryofJustice.AccordingtoWorldBankstaffestimates,at leastaquarterofthisamountrepresentsdebtsowedtothestatebyprivatesectordebtors,andanotherquarterrepresentsdebtsowedbyprivatesectordebtorstoUkraine’scash‐strappedSOEsincludingNaftogaz.

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PublicAdministrationReform

65. Improving public sector performance requires professional, motivated and well‐managedpersonnel.PublicadministrationinUkrainesuffersfromloweffectiveness,aningrainedcultureofcorruptionandlackofaserviceculture,allofwhichtranslatestoonly8percentofthepopulationexpressingtrustinthegovernmentaccordingtothe2015Galluppoll.Thepublicsectorin Ukraine employs a very large number of people, while the level of salaries is low anduncompetitive, reducingattractiveness,weakening retentionof staffwithhigh‐level competencesandskills,andleadingtoincentivesforcorruption.Thepublicwagebillamountedto9.4percentofGDP in 2015, while public sector employment in 2013 was over 1 million employees in publicadministrationandnationaldefense,andanadditional1.7millionineducationand1.2millioninhealthcare.Over1millionemployees,almostquarterofthetotalpublicemployment,workedinaverylargeSOEsectorrepresentedby1,833activeentities. Thesedatapointtowardsystem‐wideinefficienciesandpoorservicedelivery.AccordingtotheGalluppollbarelyhalfofthepopulationaresatisfiedwitheducationalservices,whileonly22percentaresatisfiedwithUkraine’shealthservices.66. The challenge facing the Government is to improve transparency in policy andadministrativedecision‐making,appointpublicservantsbasedonmeritandincreasesalarieswhilestreamliningstatepersonnelandimprovinghumanresourcemanagement.Todothateffectively, itwill be important tohave access to accurate andup‐to‐datepersonnel information,including a central personnel database,which currently does not exist. In addition, opening thepolicy dialogue to increased citizen engagement and monitoring of the performance of publicinstitutions should help to improve the effectiveness of Ukraine’s public administration. TheGovernmenttookfirststepsinthisdirectlybypublishingquarterlyreportsofitsactivitiesonline.The quarterly report for the second quarter of 2016, includes information on the Government’srecentinitiativesanddecisions,includingtheinitialimplementationofthecivilservicelaw,processofinstitutionalstreamliningofcentralexecutivebodies,introductionofe‐licensingforconstructionpermits,creationofBusinessOmbudsmanOfficeandenhancingtransparencyinpublicprocurement.67. TheGovernmentofUkrainehas identifieda transparentpublicadministrationandprofessionalcivilserviceasoneofpriorities.InJune2016,theGovernmentapprovedaPublicAdministrationReform(PAR)Strategy.Thestrategyaimsatimprovingeffectiveness,efficiencyandtransparency of the public administration in line with the Principles of Public Administrationdeveloped by SIGMA. The PAR Strategy seeks to: (i) overhaul the system of policymaking andstrategicplanningtomakeittransparent,accountableandresults‐oriented;(ii)significantlyimprovetheperformanceandaccountabilityofthecivilservice;(iii)betteralignorganizationalstructureofthepublicadministrationwiththekeygovernmentfunctionsandstrategicgoals;(iv)improvethequality,accessandefficiencyofgovernmentservices;and(v)achieveeffectiveness,efficiencyandtransparency in the management of public resources through enhancing the public financialmanagement system. To implement the goals of Public Administration Reform Strategy, theGovernment,particularlythePublicAdministrationReformunitoftheSecretariatoftheCabinetof

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Ministerswillneedtoassumealeadershiproletocoordinate,monitorandsupportreforms,andholdresponsibleinstitutionsaccountable.

Citizens’Engagement68. DuringtheEuromaidanprotestsof2013,civilsocietyemergedasacentralvehicleforchange inUkraine. The pivotal role played by civil society organizations (CSOs) and ordinaryUkrainiancitizensinpushingforchange,heightenedcivicactivismandfundamentallyalteredthewayUkrainiansengagedinthegovernanceofthecountry.TheMaidanandtheperiodafter–whichincluded theMaidan‐appointed interim government – illustrated the real and potential role of amaturingcivilsociety,betterorganizedandastrongerforceonkeyissues.Thestrengthenedsocialcapital also illustrated how young professionals could be empowered to stimulate change anddemandforchange.Thesetransformationsareonlypartiallyreflectedindemand‐sidegovernanceindicators.Ukrainereachedasub‐ratingof3(partlyfree)onthe2016FreedomHousescale(1=mostfreeand7=leastfree)onkeycivilrightsindicators,upfrom4undertheYanukovychregime,butstillpressuredbythestruggleinconflict‐areas. DisaggregatedindicatorsshowthatwhilethevoiceofUkrainiancitizenshasimproved,thecountryisyettoseeamarkedimprovementinaccountability.

69. Civil society engagement to more systematically promote the design andimplementationofthereformagendaisessential.Whilecivilsocietyhasplayedacentralroleinpushing forchange inUkrainesince theMaidan,harnessing itsenergyandenthusiasmtoengagemore systematically and effectively on the reform agenda going forwardwill be important. Civilsocietyisnowcomposedofamyriadofformalandinformal,activeandinactive,andmostlyvoluntaryCSOs.Despiteitssuccesses,civilsocietyorganizationslackplanningandmanagementskills,areyettodevelopprofessionalcommunicationsskillswithitsmembersandthepress,andtochannelhighlevelsofmotivationintocoordinatedsystemsnecessaryforeffectivecoexistence.Moreoverforumsfordialogueoverreformsare immature,andplatforms forcoordinationwithgovernmentare farfromeffective(e.g. theciviccouncils).Akeyrole forcivil societyorganizationswillbehelping tochangethemindsetofcitizensfromthatofpassivebeneficiaries–alegacyfromtheSovietera–toactive users of services. To optimize its potential, civil societywill need to organize itself to: (i)maintain and focus the successful mobilization of 2013‐14; (ii) ensure the engagement ofprofessionalsandthemedia;(iii)actastransparentlyaspossible,ensuringanintegrityfarbeyondthe state; (iv) optimize the channels and openings made available by the shift of civil societyrepresentatives into parliament; (v) mobilize the youth and professionals to contribute to thedialogue;and(iv)translatingthetechnicalaspectsofthereformprocessintomeaningful,tangiblediscoursethatcitizenunderstand.70. Improving the performance of state institutions and functions will require thecontinuedengagementofUkrainiancitizens,andanactiveand informedcivil society. ThemomentumandtransformationalcapacitydemonstratedbycivilsocietyinUkrainenowneedstobesustainedandharnessedbyallactorstosupportmediumandlongtermreform.Thisreformagendais complex and far reaching, but there ismuch benefit to be gained from direct and immediateengagement with citizens and CSOs: more targeted allocation of local resources, improved

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accountability and responsiveness of service providers, greater ownership of reforms andsustainabilityofinvestments,aswellastheemergenceofamoreopenandresponsivegovernmentin which citizens have voice and agency. This engagement will require vast improvement intransparencyandaccesstoinformation,theplatformsforaveragecitizenstoparticipateatthelocalandnationallevelsaswellaseffortstotailorapproachestosuitthesignificantregionalvariation.OpportunitiesforeasternpopulationstoengagethenationalGovernmentandincreasedavenuesfordialogue and outreach will also combat growing east‐west divides, and contribute to overallconfidenceinthereformprocess.71. Enhancingcitizens’engagementon thequalityandeffectivenessofservicedeliverywillrequireaccess toreliableand timely information,aswellas theopportunity tobetterunderstandanduse information. Citizens andusers of services need to know their rights andresponsibilities,nationaltargetsandstandards,thebudgetsavailable,andaboutperformance–howthe services they receive comparewith others. Data from2014 (DIF) suggests that 9 percent ofUkrainiansare fully satisfied that governmentwas informing themabout itswork,39percentofcitizensreportthattheinformationprovideddoesnotcorrespondtoreality.Yetthereisexperienceofsuccessfulpocketsofaction,eveninthemostproblematicreforms.Governmenteffortstoraiseawarenessfortheneedforhigherenergytariffsandtheenergyefficiencymeasuresthatcanhelphouseholdscopewithhigherpricesradicallyimprovedthewayinformationonanissuecriticaltolivelihoodswasimparted.Itinvolvedpublicopinionresearch,aredesignofaTV‐basedawarenesscampaignandthedevelopmentofunderstandingofjournalistsandotherintermediaries.Asaresultoftheseefforts,in8months,enrollmentinthesubsidyprogramincreasedfrom1.25millionto5.5million households, energy consumptiondropped significantly in 2015 and the new governmentappearstobecommittedtocontinuingthereforms.

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VI. Pathway1:MacroeconomicStability72. Safeguardingmacroeconomic stability isacriticalpathway to sustainable recoveryandsharedprosperity. Thecrisisof2014‐15exacerbated large fiscal andexternal imbalances,alongwith a fragile banking sector. Such largemacroeconomic imbalances seriously undermineinvestorconfidence.Furthermore,theanalysisofgrowthinthepre‐crisisperiodshowedthatsuchimbalancescontributed toavolatileandunsustainablegrowthpath in thepre‐crisisperiod,withgrowthessentiallystagnatingonaverageduring2008‐13.Inlightofthetremendousvulnerabilitiesfacingtheeconomy,reducingmacroeconomicimbalancesandsafeguardingmacroeconomicstabilitywillbecriticaltoputUkraineonapathtowardsustainablerecovery.73. Addressinganumberofstructuralprioritiesintheareasoffiscalandfinancialsectorstabilizationwillbe important. In fact, many of the drivers ofmacroeconomic imbalances inUkrainearestructuralinnature.Someofthegreatestfiscalvulnerabilities,forexample,comefromanarrow taxbaseandweak tax administration, andan ineffectivepensions system. Asa result,reducingstructuralfiscalimbalanceswillrequireafocusontaxreformtobroadenthetaxbaseandstrengthentaxadministration;andpensionreformtoreducethelargepensionfunddeficit. Untilrecently, the gas sector has also been the source of a large structural deficit, so going forward,monitoringthedriversoftheNaftogazdeficitwillbeimportant.Inthefinancialsector,deep‐rootedrelatedpartylendingandweaknessesinsupervisionhavecombinedwiththeeconomicdownturntoresult in large numbers of bank closures and an increase in non‐performing loans (NPLs).Strengtheningthefinancialsectorwillrequireimplementingtheframeworkputinplacetoresolveand recapitalize banks and strengthen supervision, but alsoput inplacemeasures to strengthencorporategovernanceof stateownedbanksand facilitateworkoutofNPLs. The following tablesummarizesthepriorityinterventionsforsafeguardingfiscalandfinancialsectorstabilityidentifiedthroughtheanalysisinthischapter.

FiscalConsolidation74. Large fiscal deficits with structural roots are a major source of macroeconomicvulnerabilityforUkraine.Ukrainehasbeenrunningfiscaldeficitoverthelast20years.Thefiscalposition deteriorated considerably since 2009when budget revenues declined as a result of themacroeconomicslowdown,whileexpenditurecontinuedtogrowduetoincreaseinsocialspendingrelated to the political cycle. In addition, the structural deficit of Naftogaz grew rapidly as the

Priorities Criticality TimehorizonTaxReform:Broadentaxbasebyremovingexemptionsandloopholes;improveinternationaltaxationtreaties;andstrengthentaxadministration


PensionReform:Restructurebenefitpackagetobetterlinkcontributionstobenefits;parametricreformstoaddresscategoricalbenefits,earlyretirement,andprovideincentivestoretirelater

CriticalImmediate,Short,

Medium

StrengthenFinancialSector:Implementframeworktorecapitalizeandresolvebanksandstrengthensupervision;restorecreditgrowthbyputtinginplaceeffectiveNPLresolutionframework;andimprovegovernanceofstateownedbanks

Critical,High Immediate,Short

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authoritiesrefusedtoadjustgastariffsinlinewiththeincreaseinimportgasprices.Conflictintheeastandthe2014‐2015economiccrisesexacerbatedfiscalproblemsfurtherduetorevenuelosesand increased security spending. In addition, thequasi‐fiscal deficit ofNaftogazwideneddue toincreased import gas value inHryvnia terms following devaluation and lower sales to industrialconsumersbecauseofweakeconomicactivity.Despitesome fiscal tighteningand increase ingastariffs, the consolidated fiscal deficit including Naftogaz reached 10.1 percent of GDP in 2014.Bankingsectorcapitalizationadded1.7percentofGDPtothesefiscalfinancingneeds.Whilefiscaltighteningmeasures(nominalexpenditurerestraintcoupledwithhighinflation)andanincreaseingastariffshelpedtosignificantlyreducetheconsolidatedfiscaldeficitin2015and2016,thefiscaloutlookremainschallenging.

Figure29.Fiscalandquasi‐fiscalbalances(percentofGDP)

Figure30.PublicandGuaranteedDebt(PPG)andInterestPayments(percentofGDP)

Source:WorldBankstaffestimates Source:MinistryofFinance,WorldBankstaffestimates

75. Publicdebt isveryhigh inUkraineandrepresentsamajorsourceofvulnerability.Publicdebtbecameunsustainableandwasrestructured.Currencydepreciation,accumulatedfiscalimbalances, large quasi‐fiscal losses of Naftogaz, and bank recapitalization needs led to a rapidexpansionofpublicandpubliclyguaranteeddebt,whichexceeded70percentofGDPin2014(vs40percent of GDP in 2013). Debt servicing became unaffordable, requiring Ukraine to negotiate arestructuringofitsexternalpublicdebtwithprivatecreditorsinNovember2015.Asaresult,publicandpublicly‐guaranteeddebt stabilizedat86percentofGDPatend‐2016,although this remainslargeandamajorsourceofvulnerabilityforUkrainegoingforward.76. In the faceofcrisisduring2014‐2015,anambitious fiscaladjustmentprogramhasbeen implemented to reduce the general government deficit. Tight controls on nominalspendingacrosstheboard,coupledwithinflation,aswellasenergytariffincreases,helpedtoreducethegeneralgovernmentdeficit,includingNaftogaz,to2percentofGDPin2015and1.2percentin2016.Atthesametime,manyoftheexpenditurecontrolsimplementedduringthelastthreeyearshave been done in crisis mode (including the wage bill in social sectors, including health and

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education,andsocialprotection)andarenotsustainableoverthemediumterm.Furthermore,therevenue measures that have contributed to the adjustment have been temporary, rather thandurable.

77. Despite the recent consolidation, the fiscal outlook remains challenging, and asystematic fiscal consolidation effort linked to durable improvements in expenditureefficiencywillbeneeded.Thefiscalframeworkactuallyprojectsanincreaseintheconsolidatedfiscaldeficitto3.2percentofGDPin2017(becauseofmediumtermfiscalpressures,alongwiththerecent cut in the social security contribution rate and the increase in theminimumwage). Theconsolidateddeficitisprojectedtodeclinetoabout2percentby2020ifstructuralreformstomanagethemediumtermfiscalpressuresmoveforward.Meetingthisdeficittargetwillprovechallengingbecause of the weak growth outlook and the challenging nature of the necessary reforms. Asystematicfiscalconsolidationstrategybasedondurableimprovedintaxrevenuesandincreasedefficiencyofexpenditureswillbeparticularlyimportanttoreducepublicdebt.78. Ukraineissubjecttoconsiderablefiscalrisksarisingfromawiderangeofquasi‐fiscalliabilities.Thelargestquasi‐fiscalliabilitiesarisefromsubsidiestotheenergysector,subsidiestoother state owned enterprises (SOEs), and financing for bank recapitalization and the depositguaranteefund(DGF).In2015,whiletheNaftogazdeficithadbeenreducedto0.9percenttoGDP,subsidies to all other SOEs amounted to roughly 2 percent of GDP, while financing for bankrecapitalizationandtheDGFamountedto2.4percentofGDP.ThefinancesofSOEs,includingbudgetsubsidies,arenottransparentandtheirfiscalrisks,aswellastheefficiencyoftheirinvestments,arenotunderconsistentgovernmentsupervision.Forexample,theNaftogazdeficitisnotdisclosedinitsfinancialreports,whichonlyincludelossincurredbythecompany.BeyondthesequasifiscalrisksassociatedwithSOEsandthefinancialsector,PensionFundexpenditures(aboutathirdofgeneralgovernmentexpendituresin2015)usetheirownchartsofaccount,withtheirreportsneitherlinkedtopublicfinancereportingnorsubjecttoParliamentscrutiny.Onthewhole,quasi‐fiscalrisksareconsiderableandnotadequatelymanaged.ImprovingtransparencyandpredictabilityofquasifiscalliabilitiesiscriticaltoreducingfiscalvulnerabilitiesinUkraine.

Taxreform

79. Tax reform is an important part of addressing fiscal vulnerabilities andcomplementary challengesgoing forward. Despite recent reforms, the current system is stillcomplex,inequitable,anderodedbyexemptions.Thelargenumberofexemptionsandloopholesforspecial interests results in anarrow tax base and ahigh effective taxburdenon the law‐abidingcitizensandcompanies.Second,thetaxadministrationislarge,inefficientandwidelyperceivedtobe corrupt. Third, international taxation and related profit shifting and tax base erosion areparticularly weak areas for Ukraine. All three of these problems undermine Ukraine’scompetitiveness and a level playing field for firms, encourage widespread informal economicactivities,andstuntthecountry’sgrowthprospects.

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80. Thecutinthepayrolltaxratein2016underminesmediumtermfiscalstabilityandraisestheurgencyofbroadertaxreform. SinceJanuary2016, thesocialsecuritycontribution(SSC)ratewascutfrom40percentto22percentthroughamendmentstotheTaxCodeapprovedbyParliament. Overall, themotivation to reform the Tax Code waswell placed, as the tax regimeunderminedthecountry’scompetitivenessandcreatedstrongincentivestounder‐reportwagesandemployment.ThecutintheSSCratebroughtthetotaltaxonlaborincomeinUkrainedownfrom56percentto38percent,whichisinlinewiththeaverageforEuropeancountries.ThereductionofSSCratewasalsoaimedatshrinking the informaleconomyand improvingcompliance.However, thenecessarycomplementarymeasurestostrengthentaxadministrationhavenotyetbeenaddressed.Asaresult,theestimatedshorttermrevenuelosseswereabout4percentofGDP.Thisraisestheurgencyofreformstobroadenthetaxbase,strengthentaxadministration,andrationalizecurrentexpenditures.

Table7:TaxExpendituresfromVATexemptions(percentofGDP) 2011 2012 2013 2014Agriculture 1.29 1.01 1.01 1.21Printing 0.06 0.07 0.06 0.04Pharmaceutical 0.2 0.22 0.21 0.07

Source:StateStatisticsCommittee,TaxAdministration

Figure31:Firmsexpectedtopaybribes totaxofficials,percent,2013

Figure32:TaxpayersperStaff:UkrainevsComparators

Source:WorldBankEnterpriseSurvey. Source:IOTA

81. Ukraine’staxbasehasbeenerodedbyexemptions,tailor‐madewaivers,andloopholesthathaveenabledspecialintereststoengageintaxavoidanceandtaxevasion.Inparticular,Ukraineispronetoconsiderableprofitshiftingandtaxbaseerosionarisingfromitsinternationaltaxation arrangements. The Cyprus treaty is notable in this regard as Cyprusmaintains a verypreferentialstatusevenafterthe2012renegotiationofthetreaty,accountingforover30percentofFDIintoUkraineand90percentoutofUkraine.Removaloftheseexemptions,tailor‐madewaiversandlucrativeloopholeswouldnotonlybroadenthetaxbaseandincreaserevenuecollection,itwillalsohelppromotealevel‐playingfieldfortheprivatesector.ThisshouldbeatoppriorityforanytaxreforminUkraine.Inaddition,VAThasbeensubjecttoseveralexemptions,withmajoronesbeingagriculture, publishing and pharmaceuticals. At present, the exemption for agriculture—which

50

62 2.5

0

10.8

22.3

0.2 62 73

262 285351

472 481

882

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previouslyenabledagricultureproducerstokeepVATforreinvestingintheirfixedassets—hasbeenremoved. Furthermore, printing services in the publishing sector are exempt from VAT.PharmaceuticalproductsandmedicalequipmentwerenotsubjecttoVATbefore2014andthenareduced rate of 7 percentwas imposed. As a result, in 2013, actual VAT collectionwas only 44percentofpotentialVATcollections‐theVATrevenuesthatwouldbegeneratedifthestatutoryratewereappliedtoalltaxpayers.82. Second,taxadministrationislarge,inefficient,andwidelyperceivedtobecorrupt.InUkraine,over54,000staffworkinthetaxadministrationagencies–thatisonetaxadministrationofficialforevery74taxpayers,comparedto882inSweden,481inPoland,351inSlovakia,262inGermany,and146inBulgaria.WhileSFSstaffwasreducedto41,178fulltimeequivalentsin2016,inefficienttaxadministrationcontinuestoresultinahighcostofcompliance.InUkraine,firmsspend350hoursayearfiling,preparingandpayingtaxes.Thiscompareswithanaverageof247hoursforCentralAsiaandEasternEurope,andanevenloweraverageof173hoursforEUandEFTAcountries.Therevenueslostfromcompliancegaparesizeable,withtheestimatedVATcompliancegapfor2014atover5percentofGDP.Taxadministrationreformshouldthereforebepartandparcelofanytaxreformproposal inUkraine.Taxadministration inUkraine isalsoassociatedwithperceivedhighlevelsofcorruption.AccordingtothelatestBusinessEnterpriseSurvey,2013releasedinMay2014,15percentfirmsstatedthatbriberyisfrequentindealingwithtaxes,over50percentstatedtheywere expected to give gifts in meetings with tax inspectors, while only 19 percent consideredcorruptiontonotbenotaproblem.Inaddition,limiteduseofriskmanagementintaxadministrationresultsinpoorcollectioneffort.ThebulkoftheStateFiscalService(SFS)auditcoverageisachievedthroughunplannedaudits,whicharetriggeredbycriteriawithinthelaw.Plannedaudits,forwhichcompaniesareselectedbasedonriskprofiling,yieldmuchbetterresults.The2015datashowsthatplannedauditonaverageyielded7timesbetterresultsthanunplanned.

Pensions

83. The pensions system in Ukraine represents a major fiscal vulnerability. Pensionexpendituresamountedto13.4percentofGDPor31percentoftotalpublicexpendituresin2015.While this is down from 17 percent of GDP in 2013, the deficit of the pension system remainssignificant.Payrolltaxesamountedto9.6percentofGDPin2015,andfiscaltransferstothepensionssystemconstituted3.8percentofGDP.Followingthecutinthesocialcontributionrate,payrolltaxesdeclined to5.8percent ofGDP in2016, and fiscal transfers to thepension fund increased to6.5percent of GDP. This represents a major fiscal burden for Ukraine, undermines macroeconomicstability,andcrowdsoutresourcesforpublicinvestmentandothercriticalexpenditures.Asaresultof large current expenditure obligations, public investment has been chronically low inUkraine,averagingonly2.3percentofGDP,whichunderminesgrowthprospects.84. Fiscalvulnerabilities frompensionshavebeenexacerbatedbytherecentcut in thesocialcontributionrate,whichraisestheurgencyofpensionreform.Tostimulateparticipationintheformalpensionsystem,thesocialcontribution(SSC)ratewasreducedfrom40to22percenteffective 2016. The authorities anticipated that cutting the SSC rate would shrink the informaleconomyandimprovecompliance.However,theshort‐termrevenuelosseswereabout4percentof

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GDP,whichhascreatedalargerlongtermdeficitinthepensionsystemandraisedtheurgencyofpensionreform,alongwithmeasurestobroadenthetaxbaseandstrengthentaxadministration.

Figure33.FiscalburdenfromPensionFund(%GDP)

Figure34.Taxrevenue(%ofGDP)

Source: IMF WEO, World bank estimates Source: IMF WEO, World Bank estimates

85. Demographicpressuresgoingforwardareconsiderable.Thecountrynowhasaround12.3 million pension beneficiaries and about 14 million contributors. Demographic projectionsindicate that going forward, the cohorts entering retirementwill be considerably larger than theyoungcohortsenteringthe labormarket.Asaresult,systemdependencywould increase, furtherburdeningthesystem.Estimatesindicatethatin20‐25years,theratioofcontributorstopensionerswillfalltotwothirds.86. The fiscal burden is amplified by a host of categorical benefits and theminimumsubsistencetop‐up,whichalsoundermine incentivestocontribute.Thestructureofpensionexpendituresareheavilyinfluencedbythecostsofvariouscategoricalbenefits,privileges,andtheminimum subsistence top‐up, which jointly constitute over one‐third of the total pensionexpenditures. This translates into a heavy fiscal burden and creates non‐transparent subsidiesbetweendifferentprogramsadministeredbythePensionFund,leadingtoerosionofincentivestoparticipateinthepensionsystem.

87. Thesystemisonapathofconvertingfromanearnings‐relatedbenefittoade‐factoflatbenefit program, undermining incentives to contribute. The government tops any pensionbenefit up to the subsistence minimum level, irrespective of the degree of the individual’sparticipation in the system.Thisundermines the fundamentalpremiseof a contributorypensionprogram,whichistograntbenefitsproportionaltopastwagesandlengthofservice.Furthermore,benefitindexationremainscomplexandad‐hoc,eatingupconsiderablevalueofindividualbenefitsovertimeandproducingabenefitstructurethatisnon‐transparentandunmanageable.

88. Theadequacyofpensionbenefitsisunderminedbythecurrentpolicyofindexingonlytheminimum pension amount at or below inflation. Indexation to inflation or below wasintendedtocontainpensionexpenditurepressures,butthelargeproportionofbeneficiariesunder

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thesubsistenceminimumimpliesthatcostshavenotbeenreducedmuch.Furthermore,undersuchscenario,thereplacementratesforexistingbenefitswillfalltoaround20percentoftheaveragewageinthelongrun.Thiswillinturnexertpressuresonthepoliticalsystemtoaddresssocialinequities.

89. Initiatives to reform pensions have been ad hoc to date. In 2015, the authoritiesintroducedsomesavingmeasuresbycuttingbenefitsofworkingretireesandbyunifyingprovisionsfor eligibility and pension benefit calculations for various categories. The indexation of pensionbenefitswasalsotemporarilysuspended.Adraftpensionbillalsoproposedamandatorydefinedcontributioncomponent,whichcouldslightlyimproveindividualbenefitsbutonlyintheverylongrun,giventhetimeneededtoaccumulatesavings.Thefundamentalchallengesofthecurrentpensionprogram,however,remainedunaddressed.

90. Acomprehensive strategyandvision, supportedbyassessmentsof fiscalcostsandadequacyofresultingbenefits,areneededaspartofconsideringreformoptions.Anumberofreform options are available to both improve financial sustainability of the pension system andenhanceitsadequacyandtransparency.Parametricoptionsforimprovingfinancialsustainabilityofpensionsinclude:(i)Graduallyincreasingtheretirementageforbothmenandwomenorcreatingaretirementagecorridorbetweenalowerandregularlevelofbenefits;(ii)Increasingtheminimumservicerequiredfornormalretirement;(iii)Increasingtheeligibilityageforsocialpensionfrom63to65years,whichwillinitiallyaffectasmallnumberofcitizensbutwillproduceconsiderablesavingsovertimeastheshareofindividualsineligiblefortheoldagepensionwillsteadilyincreaseoverthenextdecade;(iv)Includingallcategoricalandcompensatorypayments,andtheearningsofworkingpensioners,inthecalculationofthesubsistencetop‐up;and(v)Adoptingamoratoriumonreducingstatutoryretirementageanyspecialcategoriesorprofessions,unlessproperlyfunded.

91. Beyondtheparametricreformsunderconsideration,restructuringthecurrentbenefitpackage can help improve both sustainability and adequacy, as well as enhancingtransparencyof thepensionssystem. A key option in this regardwould be to restructure thecurrentbenefitpackageintoeithertwoseparateelements,includingabasicincomecomponentthatis universal and flat for all retiring individuals, funded from the general budget, as a new socialcontractbetweenthestateandcitizens;andanearnings‐relatedinsurancecomponentfundedfromcontribution revenues. Anotherkeyelementwouldbe to introduceclearandequitable rules forindexationofindividualpensionbenefits.Itisimportanttoinstituterulesthatpreservethebenefitvalueandthataresimpletounderstandandfiscallyaffordable.Indexationformulacouldbesomecombinationofpriceinflationandthewagegrowth,whichisconsistentwithboththehistorictrendin Ukraine and international precedents. The indexation should be clearly defined for basic,insurance,andpovertycomponents.Finally,whenconditionsarerightforaDefinedContributioncomponent,itcouldbeintroducedasasupplementarymechanism.Itcouldoperateonavoluntarybasisfundedbyemployeecontributionsandwouldhelpfundearlyretirementand/orhigherfuturebenefits.However,importantpreparatoryworkwouldberequired,sothisshouldcomponentshouldnotberushed.

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FinancialSectorStrengthening

92. The financial sector has been under severe stress since 2014, as a result of theeconomic shocks and long standing structural bottlenecks, which has amplifiedmacroeconomic instability. Bank liquidity and asset quality were hit hard by the precipitousdepreciationoftheHryvnya(by65percentsincethestartof2014),thelargecontractioninGDP(16percentovertwoyears),andthesecuritycrisis.Thisstresswasmagnifiedbyaccumulatedrisksfromdeep‐rootedstructuralproblemspersistingforover20years,includingwidespreadrelatedlending,substantial banking supervision weaknesses, inefficiencies in financial markets, and anunderdeveloped financial infrastructure. All this triggered an outflow of deposits and decline incapital adequacyof banks.The stress in the financial sectorhas in turn reinforced the economicdownturnandmacroeconomicvulnerabilities.Reformstosafeguardfinancialsectorstability93. Theauthoritieshaverespondedproactivelytoputinplaceaframeworktoresolveandrecapitalizebanksandstrengthensupervision,whichishelpingtostabilizeconfidence.Theauthorities’bankingsectorreformprogramisfocusedonthreeareas:(i)strengtheningthefinancialandoperationalcapacityoftheDepositGuaranteeFund(DGF);(ii)ensuringthatthelargestbanksareadequatelycapitalized;and(iii)improvingregulationandsupervisionofthebankingsystem.Asaresult,anunprecedentedcleanupofweakandnontransparentbankshasbeenunderway.Atotalof 85 banks (including several large andmedium‐sized banks) out of 180 banks were declaredinsolventandsentforresolutiontotheDGF.

Table8.KeycharacteristicsofthebankingsectorMarch2016 End2015 End2014 End2013

BankingsectorassetstoGDP(%) ‐ 64.08 85.19 88.18Bankingsectorassets(UAHmillion) 1,288 1,220 1,316 1,278o/wdomesticprivatebanks(%) 35.6 36.2 48.4 56.2o/wdomesticpublicbanks(%) 30.1 28.1 21.8 18.2o/wforeignbanks(%) 34.3 35.7 29.8 25.6Top5banksassetconcentrationratio(%) 56 55 43 40Numberofbanks 109 117 163 180o/wdomesticprivatebanks 78 86 131 150o/wdomesticpublicbanks 6 6 8 8o/wforeignbanks 25 25 24 22Source:NBUwebsite

94. Bank restructuring and recapitalization plans have been adopted following assetqualityreviews.Theauthoritieshaveconductedassetqualityandrelatedpartyexposurereviewsin 2014 and 2015which revealed significant capital shortfall in the largest banks that cover 85percentofthebankingsystem.Followingthediagnostic,theNationalBankofUkraine(NBU)adoptedrecapitalizationandrestructuringplansforaffectedbanks,withthreeyearplansadoptedtobringcapital requirements and the level of related party exposures in line with NBU’s prudential

60

regulations.Inmostinstanceswhereownerswereunabletobringinthenecessarycapital,bankswereresolved.Whilemonitoringtheimplementationofadoptedrecapitalizationandrestructuringplans,NBUintendstocompletetheAQRandrelatedpartyexposurereviewfortherestofthebankingsystemin2017aswell. InDecember2016, theCabinetofMinistersapprovedadecisiononstateparticipation intherecapitalizationofPrivatBank, the largestandsystemicbankinUkraine,withtransferoffullownershiptothestate.Thisbecamenecessaryafterthefailureoftheformerownersto implementrecapitalizationplans,andisanimportantpartoftheauthorities’broaderpolicytosafeguard financial sectorstability.Going forward,professionalmanagementandan independentsupervisoryboardtoeffectivelyrestructuretheBankwillbeimportant.95. TheNBUhasundertakensignificantstepstoimproveregulationandsupervisionofthebanking sector, though further important reforms are underway. The measures adoptedincludeimprovingtheprocessforidentifyingproblembanks;bolsteringtheoperationalcapacityofthe banking supervision and licensing; enhancing supervisory and regulatory requirements forsystemic banks; and creating the Financial Stability Council to improve coordination amongregulators,ensureearlyidentification,andminimizerisks.Akeyfocushasbeentomakeprogressinaddressing high levels of related‐party lending in the system. To this end, the banking law andassociated regulationshavebeen amended to broaden thedefinitionof bank relatedparties andincreasedaccountabilityforviolations,includingcriminalchargesincaseswhereabankwasbroughttoinsolvencybyunlawfulactionsofbankmanagersandowners.Theseactionsareexpectedtocreatealevelplayingfieldforbankswithagoodgovernanceandtransparentownershipstructure,whichdo real lending to theeconomy.Albeit significantprogresswasachieved so far, further essentialreformsarerequirestobringbankregulatoryandsupervisoryframeworkinlinewithBaselCorePrinciplesandEUdirectives.96. Reformstostabilizethefinancialsectorhelpmitigatevulnerabilityofthepoortothecrisisandcansupporteconomicrecovery.Globalexperiencehasshownthatfinancialcrisesleadtoanincreaseinpoverty.InUkraine,strengtheningtheDepositGuaranteeFund’sinstitutionalandfinancial capacity to ensure continuouspayout of insureddeposits serves as a safeguard againsthigherpovertyfromlossofvitalsavingsbythevulnerablepopulation,withcloseto30percentofinsureddepositstransferredtotheDGF.Reformstorecapitalizeandcleanthesystemofnon‐viablebankscanalsosupporteconomicrecoverybyforcingbankownerstobringcapitalbacktothesystem.97. Theauthoritieswillneedtofurtherenhancethebankresolutionframework,completerestructuring of the banking system, and continue to strengthen supervision. It will beimportanttoinvestintheinstitutionalcapacitiesofDGFandeffectivelyutilizenewbankresolutionpowersinlinewithgoodinternationalstandards.SignificantprogresswasmadebytransformingDGFintoabankresolutionagencyin2012andstreamliningdepositspayoutandresolutionfunctionsin2014‐15togiveDGFmorelegalpowers,enhanceresolutiontools,andexpeditetimeofpayoutstoinsureddepositors.However,additionalworkisneededtofurtherstrengthenDGFasaninstitutionand bring the bank resolution and deposit insurance framework in linewith good internationalpracticeandEUDirectives.

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FacilitatingcreditgrowththroughNPLresolution,corporategovernancereformsandenhancedaccesstofinance98. Inadditiontocontinuingtosafeguardfinancialsectorstability,reformstofacilitatearesumption of credit growthwill be important. While the banking sector has pretty muchstabilized,creditgrowthhasnotresumed.Furthermore,thecostofcapitalremainselevated.Asthebankingsectorcontinuestode‐leverageandthegovernmentattractsagreatershareoflocalcurrencysavingstocoverfiscalneeds,theprivatesectorcontinuestosufferfromlimitedaccesstofinance.HouseholdsandSMEshaverestrictiveaccesstocredit.Restoringtheabilityofthebankingsectortoresumecreditgrowthwillhelpsupporteconomicrecovery.Thiswillrequirereformstoreducenon‐performingloansandimprovegovernancespecificallyofstateownedbanks.99. AneffectiveNPL resolution frameworkwillbe important. The crisis has resulted inhighernon‐performingloans(NPLs).OfficiallyreportedNPLsincreased15percentagepointsover2014‐2015to31percentatend‐September20168,thissharecouldcontinuetoincrease(duetothetimeneededfordeterioratingassetqualitytobefullyreflectedinbalancesheets).Furthermore,thereallevelofNPLs(usingabroaderdefinition)maybehigher.SincehigherNPLsleadbankstobecomemoreconservativeinlending,aneffectiveNPLresolutionframeworkisneededtofacilitateNPLworkout,sale,andtransfer,includingamulticreditoroutofcourtdebtrestructuringfacility.Thisisalsocrucial for DGF where the failure of 85 banks has resulted in a significant volume of assetaccumulationtobesoldorworked‐outintheprocessofbankliquidation.TheinstitutionalcapacityoftheDGFtoworkwiththeseassetshasbeensignificantlyenhancedin2015andneedstoleadtoincreasedassetrecoveriesviaoperationalizingtheConsolidatedOfficeforassetmanagementandsales.100. Governanceofstateownedbanksneedsprofoundreform. State‐ownedbanks (SOBs)represent25percentofdeposits. TheAQRhas revealed significantweakness in thegovernancestructure of the core SOBs and highlighted a need for comprehensive reform. Currently theauthorities possess significant influence over decision making in those banks which historicallyresulted in poor credit quality and significant costs for the government. The authorities shouldintroduce independent governance structures and enhance the risk management practices topreventuseofthesebankstofundpoliticalinterestsusingthesavingsofthepopulation.Currentlythesecondandthirdlargestbanksinthecountryarestateownedandimprovingtheirgovernanceand business‐models making them self‐sustainable is essential for possible privatization in thefuture, while the state’s exit from other non‐core banks would give a clear message that thegovernmentiscommittedtoenhancingcompetitioninthemarket.

101. Postcrisisgrowthandaccesstofinanceorienteddevelopmentalpoliciesareneeded.Afterthestabilizationofthebankingsystemfollowingthe2014‐2015crisis,Ukrainianauthorities,besides implementingpoliciesaimedat general improvementof financial setorpolicies,will alsohavetoturntheirattentiontopoliciesstimulatinglong‐termdevelopmentalcreditgrowthandaccess

8System‐averageIFRSbasedNPLsratio,asestimatedbytheratingagencies,stoodatabout44percentinend‐2015

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to finance, especially for SMEs and exporters, who are now adjusting to the fundamentalreorientation of terms of trade for Ukraine from Eastern to EU markets driven by EU‐UkraineAssociationAgreement.Enhancingthediversificationofthefinancialsectorandimprovingfinancialinfrastructure102. Developingnon‐bank financial institutions (NBFIs)willhelpdiversify the financialsectorandenhanceaccesstofinanceinthecountry.CurrentlytheNBFIsectorisunderdevelopedwithapoorregulatoryframeworkandanunjustifiedlargenumberofweakinstitutionsoperatingindifferent markets. The unification of supervisory functions in the country is a vital first step toenhancethequalityofsectoralsupervision,mitigatethepossibleregulatoryarbitrageandclean‐upthesystemfromnon‐viableinstitutions.ThiswouldcreatealevelplayingfieldforhealthyNBFIsandfurtherfostercompetitionandaccesstoalternativefinancialinstrumentsinthemarket.

103. DevelopingeffectivefinancialmarketinfrastructureinUkrainecanhelp.Althoughtheprivatecreditreportingmarketiswelldeveloped,itisnotwellregulatedandisquitefragmentedintermsofinformationcoverage.Improvedsupervisionandaccesstootherdebtinformationsourcescouldeffectivelyimprovethecreditreportingframeworkandthusimprovecreditdecisionmakingby the banks. The development of the payment systems infrastructure and secured transactionframework are other strategic aspects of financial infrastructure for the authorities to consider.Capital and money markets development in the country will depend on quality financialinfrastructureaswell.

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VII. Pathway2:PrivateSectorProductivity104. WeakprivatesectorproductivitygrowthhasbeenattheheartoftheunsustainablemodelofgrowthandpovertyreductioninUkraine.Productivitygrowthhasaveragedapaltry1.2 percent per year over the last fifteen years. Even in the pre‐crisis period, after a spurt inproductivity during 2000‐07, productivity essentially stagnated during 2008‐13, leading tostagnationineconomicgrowth.Thesharpeconomicdownturnof2014‐2015hasexacerbatedthesetrends by undercutting private sector confidence. Thus, in order to achieve sustained economicrecoveryandgrowth,itwillbeimportanttounlockproductivityandconfidenceoftheprivatesector.Thiswillrequireconditionstosupportmoredynamicentryofmoreproductivefirmsandexitoflessproductivefirms,aswellasproductivityimprovementswithinfirms.Itwillalsorequirediversifyingintonewproductsandmarkets forUkraine’sexports. Thismeansthatexistingsubsectorswithinmanufacturing,servicesandagriculturemustmodernizeandraiseproductivity‐levels.Inaddition,newsubsectorswithhigherproductivitylevelswouldneedtobeaddedtoeachsector.Laborwillneedtoincreasinglymovefromlowerproductivityjobstohigherproductivityones.105. Improvingproductivityisallthemoreimportantinanenvironmentwithadecliningworking age population and also helps support improved employment outcomes. Raisingincomes in Ukraine will require higher productivity growth to offset the fall in labor‐force.Furthermore, improvedemploymentoutcomesarealso important increatingamoresustainablemodel of poverty reduction. Unemployment stands at about 9.5 percent though hiddenunemployment is larger given that informal workers comprise a significant portion of totalemployment.Manyoftheemployedarethusinlow‐productivityandlow‐wagejobs.Measurestoimproveprivatesectorproductivitycanhelp improveemploymentoutcomesbymovingworkersfromlowerproductivitytohighproductivityjobs.

106. Ukrainewouldneedtogenerateashiftinitsexportandproductionstructureintonewproductsandmarkets.Productivitygrowthhasoftenbeenassociatedwithanexpansionofexportsinto higher‐value skill‐intensive goods and services. While three‐fifths of Ukraine’s currentmerchandiseexportscompriseofminerals,metalsandagriculture,agreatershareofexportsgoingforward can consist of highly differentiated, higher‐value, and higher‐productivity metal andagriculturalproducts.Thesamecanbetrueofcurrentmachineryandserviceexports.Whilerapidlyexpanding and shifting the compositionof exports canbe challenging, it hasbeendonebyothercountriesintheregion.OpenaccesstothemarketsofEuropeanUnion(EU)countriesisagreatstartbut a lotmorewillhave tobedonebehind theborder athome tomakedomesticmarketsmorecompetitiveandincreaseexportcompetitiveness.

107. Boosting private sector productivity will require strengthening infrastructureinvestment,creatingalevelplayingfieldintheprivatesector,reforminglandmarkets,andtappingtradeopportunities. Ukrainehasmadeimportantprogressinstreamliningitsbusinessenvironmentinrecentyears,withitsDoingBusinessrankingimprovingfrom140thin2013to84thin 2016. However, deeper structural bottlenecks remain that have, for an extended period,undermined theemergenceof amoreproductiveprivatesectorandamoresophisticatedexport

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structure.Thesebottlenecksincludeweakinfrastructure,ahighlyconcentratedandanticompetitivemarketstructure,andweaklandmanagement.Improvinginfrastructurewillrequirecreatingfiscalspace for public investment and strengthening public investmentmanagement, while improvinggovernanceandtransparencyintheimportantenergyandtransportsectors.Creatingalevelplayingfield for the private sector will require further deregulation, more effective implementation ofcompetitionlegislation,andimprovingcorporategovernanceofineffectivestateownedenterprises.Perhaps most critical for the private sector is to reform land markets. Weak land governanceseriouslyunderminesinvestmentandproductivityinthehigh‐potentialagriculturesector,aswellasothersectors.Reforminglandmarketswillrequireimprovingstatelandmanagementthroughanewlegalframework,whilegraduallyopeningsalesforprivateagriculturallandensuringtransparencyandequalaccess. The followingtablesummarizes thepriority interventions forboostingprivatesectorproductivityidentifiedthroughtheanalysisinthischapter.

PublicInvestmentManagement&Infrastructure108. Supporting productivity, job creation, and exports will require improved publicinvestmentandinfrastructuretoreducecostsandequipfirmstoproducemorecompetitively.Withlevelsofprivateandpublicinvestmenthoveringataround16percentand2percentofGDPrespectivelyduring2009‐14,thenecessaryexpansionofinvestmentisdaunting9.Privateinvestmentdependsontheincentivesthatinvestors–bothdomesticandforeign–faceinthecountry.Improvedincentives depend onmacroeconomic stability, a competitive and level playing field including afavorablebusinessandregulatoryenvironment,andgoodqualityinfrastructureservices.Ukraineis

9Strongandenduringgrowthrequireshighlevelsofinvestment.AccordingtotheGrowthCommissionreport;countrieswithstronggrowthofproductivityandGDPhadaveragetotalinvestmentratesof25percentwithpublicinvestmentininfrastructureof5‐7percentofGDP.

Priorities Criticality TimehorizonStrengthenPIMandExpandInfrastructure: High Short

•CreatefiscalspaceforpublicinvestmentandstrengthenPIMsystems Critical/ Medium•Energysector–improvegovernanceandtransparency,reducelosses,andreducehighenergyintensity

High Medium

•Transportsector–promoteefficientmultimodaltransportsystemtounleashingUkraine’stradepotential

Medium

CreateLevelPlayingFieldinPrivateSector: High Short

•Deregulation–furtherstreamlinebusinessregulatoryenvironment High Short/Medium

•CompetitionPolicy–enhancecapacityofAMCtoimplementlegislationandstreamlinestateaidforenterprisestoreducedistortionofcompetition

High Medium

•SOEReform–triageofSOEs;strengthenaccountingandfinancialreporting;andimprovecorporategovernance

High Short

LandReform:Increaseefficiencyofstatelandmanagementthroughnewlegalframework;opensalesmarketforprivateagriculturallandensuringtransparencyandequalaccess;andclearstatusofunclaimedproperty.

Critical Short/Medium

TradeFacilitation:Strengthenandharmonizequalityandstandardsarrangementstotappotentialofinternationaltradeagreements

Medium Short

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startingfromalowbaseonallthesecountsandthechallengeisnotonlytoimproveonthecurrentsituation,butalsotoimprovesufficientlytobecompetitiveintheregion.

Figure35.PrivateInvestment(percentofGDP,2010‐2015)

Figure36.PublicandPrivateInvestment,(percentofGDP)

Source:IMFWEO,WorldBankstaffestimates. Source:IMFWEO,WorldBankstaffestimates.

Figure37.Gen.governmentexpenditures,

(percentofGDP,2010‐2015)Figure38.Publiccapitalexpenditure

(percentofGDP,2010‐2015)

Source: IMF WEO, World Bank staff estimates. Source: IMF WEO, World Bank staff estimates.109. Improving infrastructure in Ukraine will require creating fiscal space for capitalexpendituresandalsoimprovingpublicinvestmentmanagement(PIM).WhileoverallpublicspendinginUkraineishigherthancomparatorcountries,publiccapitalexpendituresareamongthelowestofcomparatorcountries.ThisisbecausepublicspendinginUkraineisskewedtowardcurrentexpenditures, including social transfers, subsidies, and the wage bill, all of which crowd outgovernment investment. In fact, during 2010‐2015, public investment in Ukraine averaged 2.4percentofGDP,comparedto4.2percentinTurkey,4.6percentinPoland,and8.6percentinVietnam.

12.5

14.8

18.4

14.4

16.2

11.3

16.6

14.9

16.8 16.3 16.517.5

0

5

10

15

20

25

30

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Private investment Public investment

47.043.1

36.8 36.8 35.7 35.1

28.8 27.431.0

34.2 35.2

43.2

2.43.2

4.24.6

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Social expenditures have absorbed a large and growing share of public resources in Ukraine.Spendingonsocialbenefitsincluding,mostimportantly,pensions,expandedfromanalreadyhigh19.6percentofGDPin2007to23.4percentin2013.Thisincreasewasdrivenbothbyincreasingbenefits(manyofwhichareindexedtowages)andlargernumberofbeneficiarieswhichisrisingduetodemographicdevelopments.Since2014,theauthoritiesreducedsocialsecurityexpendituresbytemporarilyfreezingpensionbenefitsinnominaltermsandbyreducingsomepensionsforspecialcategories.However,thefiscalspacewasabsorbedbyinterestpayments.Thus,capitalexpendituresdroppedto1.3percentofGDPin2014andincreasedonlymodestlyin2015to2.4percentofGDP.110. Ukraine needs to make further progress in strengthening its public investmentmanagement (PIM) systems. The 2012 Public Investment Management Assessment (PIMA)considered public investment management as one of the weakest aspects of Public FinanceManagement(PFM)inUkraineandanareawhichisvulnerabletocorruptionbecauseofahighlevelofdiscretionatvariousstagesofthePIMcycle.Asaresultof inefficienciesofthePIMsystemandgovernanceissues,thecostofconstructioninUkraineis22percenthigherthanintheEU,despitelowerlaborcosts.TheseproblemsaremagnifiedbyvastinvestmentneedsofUkraineestimatedat$100billionover thenext10years. Despite some improvements implemented in2015, thePIMsystemisstillfragmentedandnotconduciveforefficienttargetingofresourcestostrategicpolicypriorities. The latestversionof theBudgetCoderequiredselectionofpublic investmentprojectsbasedoncost‐benefitanalysisandclearlyestablishedcriteria.However,thenewrulesdonotincludeSOEs’investmentprojects,projectsimplementedbystateguarantees,orthoseimplementedbytheFundforRegionalDevelopmentortheStateRoadFund. Assuch,thereformshaveaffectedalowshareoftotalcapitalspendingin2015.111. Enhancinginfrastructure,especiallyintransportandenergy,isanimportantpriorityforraisingprivatesectorproductivity.Increasedpublicinvestmentandinstitutionalreformsintheseimportantinfrastructureareaswillbekeytoimprovingefficiencyandqualityofinfrastructureservices. As discussed, the crowding out of infrastructure investment by current spending is alongstandingissueinUkraine.However,theongoingfiscalconsolidationpresentsanopportunitytocreatethefiscalspacenecessaryforhigherpublicinvestment.EnergySector

112. EnergysupplyreliabilityandsecurityisasourceofmajorvulnerabilityinUkrainethatalsounderminesproductivitygrowthandjobcreation.Possibledisruptionsofelectricity,gas,and/orheatsupplycanhaveseriousrepercussionsforproductivityandoutput,particularlygiventhehighenergyintensityofUkraine’seconomy.Inaddition,universalaccesstoelectricityandgascoupledwiththecoldclimatemeansthatthereliabilityandsecurityofsupplyareanessentialneedforthepopulation,andparticularlythepoorwhocannotaffordalternatives.113. Despiteimprovement,Ukrainecontinuestobereliantongasimports,whicharenotwelldiversified.In2015,Ukraine’sgasconsumptionwas34billioncubicmeters,ofwhichabout20billioncubicmeterswasproduceddomesticallyandtherestwasimported.Diversificationofgasimports improved in 2015 with European gas supplies accounting for about 63 percent of gas

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imports.AccordingtotheInternationalEnergyAgency,Ukrainecanachieveself‐sufficiencyinthenextdecadebyutilizingitsconventionalandnon‐conventionalgasreservesandrealizingitsenergyefficiencypotential.However,thiswillrequireimprovingtheinvestmentclimateandthelicensingregimeandinvestinginsupplyanddemandsideenergyefficiency.114. The energy sector suffers from low efficiency and lack of investments; underlyingthesechallengesarepoorsectorgovernanceandlackoftransparency.Thegassectorislargelystateownedanddominatedbytheverticallyintegratedoilandgascompany,Naftogaz,whichhasoperations in exploration and production of crude oil and natural gas; processing and supply tocustomers,andtransitofRussiangasviaUkrainetoEuropeanmarkets.TheorganizationalstructureofNaftogaziscomplex;ninesubsidiariesandaffiliatescarryoutday‐to‐dayoperationsbutgeneraloperationalandfinancialdecisionsaswellasthefunctionsofassetmanagementareentrustedtotheholding company. The ownership of the regional gas distribution and supply companies isconcentrated and the lack of transparency hinders competition and operational efficiencyimprovementinthegasdistributionandsupply.LossesinthegasnetworkareestimatedtobenearlytwiceashighasinWesternEuropeandgasflowsandbalancesaredifficulttotraceduetoincompletemeteringandreportingandinadequatesystemofchecksandbalances.115. Anambitiousreformprogramintheenergysectorisunderwaywithlargelypositiveoutcomes,and it isessential tocontinue thereformmomentumgoing forward.The reformagendaincludes:(i)bringinghouseholdgasanddistrictheatingpricestoimportparitypricelevelsby 201710; (ii) mitigating the impact of price increases on vulnerable households with socialassistance;(iii)supportingNaftogazrestructuringtoreducelossesandimproveitsgovernance;and(iv)promotingeffortstoenhanceenergyefficiencyandraiseinvestmentanddomesticproduction.Immediateactionsshouldbetakentowardstrengtheningsectorgovernanceandaccountabilityandimprovementofitsfinancialviability.116. TheunbundlingofgastransmissionoperationsfromNaftogazisapriorityreformstep.To facilitate Government’s informed decision making about the unbundling model, a study ofunbundlingoptionscompliantwiththeEU’s3rdEnergyPackagewascommissionedunderthejointEC ‐WorldBankFacility.Basedonamulti‐criteriaassessmentand theoverarchingobjectivesofachieving an efficient and fully competitivemarket in Ukraine, the study recommended that theimmediate restructuring step shouldbe separationof transmission, storage and systemoperatorfunctions from the production and supply functions of Naftogaz. Consistent with therecommendationsofthisstudy,inJuly2016theGovernmentapprovedownershipunbundlingmodelfor transmission and storage operations through establishment of two new entities. Theimplementationoftheunbundlingplanwillneedtobeginwithoutadditionaldelay,betransparent,accompaniedbyreformoftheregulatoryframework,andtakeadvantageofthetransitionperiodtofosterimprovementsintransmissionandstorageoperations.

10TheGovernment is estimated tohaveaccomplished this a year earlier in2016, takingadvantageof lowimportprices.

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Figure39.Energyintensitylevelofprimaryenergyin2012(MJ/$2011PPP)11

117. Ukraine’senergyintensityisveryhigh(seefigure),whichwillrequirebothefficiencyinvestmentsandsustainingpricingreforms.EnergyintensityinUkraineisamongthehighestofcomparatorcountries.Thepotentialforenergyefficiencyimprovementissignificantinpowerandheatsupply,inindustryandinresidentialbuildings.Forexample,comprehensivethermalretrofitofbuildingsconstructedduringtheSovieteracouldpotentiallyreduceheatloadbyupto50percentormore,whichwouldmakeasignificantcontributiontoreducingdemandfornaturalgas.Ontheotherhand,whilesustainedincreasesintariffstocostrecoverylevelswouldhelptomoderatedemand,complementary investments in energy efficiency are also needed to contain total energyexpenditures,improveresilienceofthepopulation,andlimitfiscalliabilities.

Figure40.Quasi‐fiscaldeficitsinEnergySector(%ofGDP)12

118. Quasifiscaldeficitsoftheenergysectorhavebeenlargeinrecentyearsbutreducedsignificantly in2015‐16,andsustainingpricingreformswillbecritical inmaintaining thisprogress. Until recently, energy pricing policies have generated substantial quasi‐fiscal deficits,

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encouragedexcessiveuse,discouragedinvestments,andcreatedopportunitiesforcorruptionandrentseeking.In2013,residentialtariffsforgas,electricity,andheatwere18,19and64percentofcost, with delayed adjustment to world prices. To deal with this, the authorities increased gas,electricityandheatingtariffsconsiderablyduring2014‐2016.Asaresult,theNaftogazdeficithasbeenreducedfrom5.5percentofGDPin2014to0.9percentin2015andaprojected0.3percentin2016. Tomitigate the impacton thevulnerablepopulation, up to5millionhouseholds receivedbenefitsfromthenewHousingandUtilitiesSubsidyProgramatend‐2015.Theprogramimprovessignificantlytheresilienceofthepoorpopulationtofurtherfluctuationsinenergyprices.

Figure41:Electricitytransmissionanddistributionlosses(%)13

119. Electricitysupplyunreliabilityisamajorvulnerabilityundermininggrowthinprivatesectorproductivity.Thesecurityandsupplyreliabilityofelectricityisexacerbatedbythewearandtear of its infrastructure and shortages of peaking power capacity. The electricity sector needssignificant investments to modernize the generation capacity, to remove bottlenecks in thetransmissioncapacity,andtoreducelossesindistributionsystem.Despitereductionintransmissionanddistributionlosses,theyremainhighcomparedtoEU‐28countries.Powersupplyreliabilityisfurtherjeopardizedbylowpeakingcapacity14.Theunreliabilityofsupplyisalsoreflectedin2016DBratingsongettingelectricitywhereUkraineisratedas137thglobally.Itisdifficultforproducersandexporters to be competitivewith otherswhen it has to pay high cost of supply disruptions andshortagesthatothersdonotface.120. Lack of cost recovery and resulting poor financial viability undermine Ukraine’senergy security. Ukraine needs to attract financing to upgrade and expand aging generatingcapacitiestomeetthedemandforelectricity/heatandtostartimplementingmeasurestointegratethe power system of Ukraine into the EuropeanNetwork of Transmission SystemOperators forElectricity (ENTSO‐E). Investments in the sector and energy efficiency have been hampered bybelow‐cost recovery pricing and extensive cross‐subsidies between sub‐sectors and different

13Source:WorldBankSCDdatabase,GTF14Witha25GWavailablepowergenerationcapacity,thecapacitymarginfor2015isestimatedat‐6%againsttherecommendedminimumof15%.

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consumercategories.The2015decisionoftheNationalEnergyandUtilitiesRegulatoryCommission(NEURC)tograduallybringelectricitytariffstocostrecoverylevelforthepopulationby2017whileeliminatingcross‐subsidies,isanimportantstep,whichshouldbeconsistentlyenforced.121. Power market reforms aimed at increased sector transparency, unbundling andliberalizationhavebeen slow andwithout a clear roadmap for their timelyplanning andimplementation. Power market reforms are part of Ukraine’s commitments as part of itsmembershiptotheEuropeanEnergyCommunity.Animportantstepforestablishingnewelectricitymarketrules,mechanismsandadequatemarketmonitoringistheadoptionofthenewElectricityMarketLaw#4493andtheEnergyRegulatorLaw.Inaddition,theGovernmentwillneedaroadmapthatwilloutlinethedetailedimplementationstepsformarketreforms,includinginitiationofDayAhead,Intraday,BalancingandAncillaryServicesmarkets,unbundlingneededtoalignwithEU3rdEnergyPackage,increasingcompetition,andstimulatingefficiencyimprovements.122. Theconflicthadmixedimpactsontheenergysecurityandsupplyreliability.Theon‐goingconflicthas reducedaccess todomesticenergysources: coal isamajorsourceofdomesticenergy, but the government currentlyhasno access to60percent of coalmines andhas startedimportingcoal.Atthesametime,theconflictfostereddiversificationofsourcesofgassupply;thusin2014,shareofnon‐RussianimportsreachedonethirdoftheimportednaturalgasinUkrainewhilein2015thisshareincreasedto63percent.

Transport123. High quality transport is a prerequisite to unleashing private sector productivity.Ukraine’sgeographyandstructureofoutputgeneratesfivetimesthetransportvolumeperunitofGDPcomparedtotheEU‐15countriesimplyingthattransportcostsmakeupaproportionatelylargepartofthefinalpriceofmanygoods.Tobesuccessfulintappingtradeopportunities,greaterregionalconnectivityandimprovementstotransitcorridorswillbeneeded.124. An efficientmultimodal transport system is critical to unleashing Ukraine’s tradepotential,includingitscentralroleintheglobalfoodsupplychain.Thisincludesrealizingthefullpotentialof theassociationagreementwith theEU, theDeepandComprehensiveFreeTradeAgreement, and removing constraints from the development of the domestic agricultural andmanufacturingindustry.ThecurrenttransportstrategyforUkraineseeksabalanceddevelopmentofdifferenttransportmodes,withrailtransportretainingitsroleasthedominantmodeforheavybulkgoodsandtheroadnetworkbeingdevelopedtoservehigher‐valuegoodsandtosupportbetterconnectionwithUkraine’sneighbors. Increasingly,emphasis isalsobeinggiventothewaterwayssectorasameansofrelievingsomeof theharvest‐timebottlenecksontherailwaysbutalsoasameansofgettingbulkcargoesofftheroadstoreducecongestionandroaddeterioration.125. Ukraine isranked80th froma totalof160countries in theWorldBank’sLogisticsPerformanceIndex2016(LPI).Withtherankinggoingdownoverthelastfiveyears,UkrainelagsthebestperformersintheregionandallEUmemberstates.Accordingtothe2016LPI,Ukrainestill

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requiressubstantialreformstoimprovecustomsperformance,infrastructure,competencyoflogisticoperators,internationalshipments,andthecapacitytotrackandtraceshipments.Thelogisticscostsfor moving grain, the Ukrainian key export commodity, from farms to the Black Sea ports areapproximately40percenthigher thancosts forcomparableservices inFranceandGermany,andabout30percenthigherthancostsintheUnitedStates.Inadditiontotheoveralllogisticsframework,there is also aneed for sub‐sectoral reform,particularly in the rail and road sectors, to increaseefficiencyandensurethatthesekeysectorsareoperatingonasustainablefinancialbasis.TheBankisprovidingadviceinall theseareaswithtrustfundedactivitiesinlogistics,railwaysreform,androadreform.

126. Given the strong private sector focus of the logistics industry and the need forgovernment to facilitate theproductiveareasof theeconomy, there isastrong interest indevelopingthelogisticsindustry.TheBankhasundertakenanalyticalworkonAgro‐Logisticsandis working with other development partners on developing a more comprehensive and greenlogisticsactionplanforthecountry.Someoftheareasbeinglookedatinclude:(i)reviewingtariffpoliciesintherailwaysandportssectors;(ii)supportingwithprioritizationofroadcorridorsandaddressingoverloadedtrucksonroadnetwork;(iii)assessingtheoptionfortherailwaystoexpandintotheprovisionoflogisticsservicesthroughaddingvaluetoline‐haulservicesandattractingmulti‐modaltraffictorailways;and(iv)developingthewaterwaystoalleviatepeaktimepressureonrailandroads. Investinginportlogistics,developingtransparentmethodologiesforraisingfeesattheport, and facilitating cross‐border trade logistics by introducing automatic customs proceduresystemswillbecrucialtosupportcompetitivenessofUkrainianBlackSeaports.127. Roads:currentfinancialandinstitutionalarrangementsintheroadsectorinUkrainehavenot delivered results and the shortage of maintenance funding, combined with a large share ofoverweight trucks, has resulted in premature deterioration of the network. Ukraine has a roadnetworkofabout169,600km,ofwhich49,200kmarenationalroadsand120,400kmareregionalandlocalroads.Itisnowestimated,thatroughly51percentofthenationalnetworkdoesnotmeetnational road roughness requirements and39percentdoesnotmeet the strength requirements.Withtrafficgrowth,standardtwolaneroadshavebegunfacingcapacitybottlenecks,compoundingtheroadsafetyissueresultingfromtheoverallpoorconditionofthenetwork.Ultimatelyaveragetrafficspeedsareaffected,withaveragespeedsrangingbetweenone‐halfandone‐thirdofUkraine’swesternEuropeanneighbors.

128. AroadmapforroadsectordevelopmentinUkrainefor2015–2017waspublishedbytheMinistryofInfrastructureinJune2015.Thestrategicobjectivesoftheroadmapareasarethreefold:(a)theprotectionofroadsfromearlydeterioration,(b)thereformofUkravtodorandtheirdependentconstructionandmaintenancecompanies;and(c)asustainablefinancialstructureandcollectionofnewrevenues.The firstprioritywillbedealtwith through improvedweightcontrol(particularlyfromoverloadedgraintrucks),theimplementationofaroadassetmanagementsystemandtherollingoutofamodernsystemofmaintenance.Thesecondpriorityareawillleadtoamoredynamicmarket,withprivate sector involvement in thedesignandmaintenanceof roads. Itwillincluderestructuringofthejointstockcompaniesthatcurrentlymaintainthenetworkandtransfer

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ofassetsfromUkravtodortotheoblaststateadministrationsandthedivestitureofnon‐keyassetsofUkravtodor,includingthedesigninstitutes.Thethirdpriorityareaaimstosecureexistingrevenuesfromfuelleviesandsoontotheroadsectorandtoraisenewrevenuesthroughtheintroductionofatrucktollingscheme.129. Theroadssector,particularlymaintenance,isunderfinanced.Althoughtherehasbeenacontinuousincreaseintherevenuesfromexcisedutiesonfuels,expendituresonroadmaintenancehave been falling since 2011 and debt servicing has almost tripled since 2012. The shortfall inresourceswillaffectsustainabilityofthenetwork,withthecurrentleveloffundingformaintenanceof the network at about half theminimum level. Addressing these shortageswill require higherchargesonroadusersincludingthroughincreasingthefuellevy,increasingvehicleregistrationfeesandbystartingtotoll(orusevignette)themainhighwaysinthecountry.Intheshortterm,itisalsoimportant that the authorities enforce axle load controls and introduce systematicmonitoringofexistingmaintenanceexpenditures.

Figure42:RoadSafety(Fatalitiesperyearper100,000population)

130. Roadsafetyisaproblemwhichrequiresmoreattentionandcommitmenttodelivercontinuous improvement.Duringtheperiod from2004‐2014, fatalities fromroadaccidents fellfrom7,000deathsperyearin2004tojustunder4,500deathsin2014.Overthelastfewyearsthereductioninroadtrafficfatalitieshasstagnatedwithfatalityratesoverfourtimesthosefoundinthebetter‐performingEuropeancountries..Roadtrafficinjurywasestimatedbythe2013GlobalBurdenofDiseasestudytobethemaincauseofdeathforUkrainiansAged15‐24andthesecondmaincauseofdeathforUkrainiansAged5‐14.Whileimprovedsafetyconditionsandsomenewinfrastructurehave helped stabilize the number of road traffic fatalities and injuries, these activities are notsufficienttodeliverimprovementstotheleveloftheEuropeancontextandtohalfroaddeathsby2020.Ukraine’sroadsafetyinstitutionalcapacity,managementpracticesandstandardsneedtobesignificantlyimprovedtosustainablyreduceroaddeathtoll.Seriousimprovementsinroadsafetyarethereforeamongthepriorityobjectivesforroadtransportsystemdevelopment.131. Railways: Railways carry over 70 percent of non‐pipeline freight traffic (measured inton/km) and around 38 percent of public long‐distance passenger traffic (measured bypassenger/km).Anefficientrailnetworkisthereforeessentialfor:(i)efficientandenvironmentally

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sustainable transportation of Ukraine’s natural resources andmetallurgical products; (ii) transittraffic;and(iii)connectingmanyofUkraine’s largecities located200‐600kmfromKyiv.Ukrainerankswell (25th out of 104 countries) in the Global Competitiveness Index on the quality of itsrailroadinfrastructure.However,shrinkingprofits,over‐agedassets(70percentoftherollingstockwaspurchasedinthe1980sandneedsurgentreplacement)andlackoftimelyrenewal,rehabilitationand upgrading of assets will ultimately lead to the deterioration in the quality of service andadverselyaffectthesafetyoftherailwaynetwork.

132. Thekeysectorchallenge,andmajorrisk,isthelackofsustainablefinancingforrailwayinvestmentandoperations.Thisriskisfurtherexacerbatedbytheuncertaintyregardingthetrafficfrom/toRussiaandtheneedforreconstructionofrailwayinfrastructuredestroyedintheeastofthecountry.TheGovernmentofUkrainehasembarkedonamajorreform,manyyearsinthemaking,tomodernizeUkrzaliznytsia(UZ)andenhanceitsorganizational,operationalandfinancialefficiency.AlawadoptedbyParliament in2013enabled creationof a joint stock company forpublic railwaytransport.UZhaspotential tobe financiallysustainablegiven itsstrongtrafficbaseanditsdenserailwaynetworkwitha total lengthof trackofabout22,000km, the14th largestnetwork in theworld.UZ’sfreighttransporttaskisabout260billiontonkm.This,togetherwithabout450millionpassengertripsperyear,makestheUkrainianrailwaysthe6thmostdenselyoperatedrailwayintheworld(measuredintonkmpluspassengerkmperroutekm).

133. Urbantransport:Goodurbanmobility (passengerand freight) isparticularlyrelevant toincreaseproductivitywhileimprovingthequalityoflifeofthecitizens.Thisisparticularlyrelevantin an environment likeUkrainewhich has one of the highest urbanization rates in Europe,witharound69%ofthetotalpopulationlivinginurbanareas.However,duetothelackofinvestmentsinpublic transport infrastructureandrollingstocksovertherecentyears, theirconditionhasmuchdeteriorated.Theserviceintegrationamongpublictransportmodesisgenerallyweak;inparticular,theservicesoperatedbyprivateoperatorsareentirelyseparatefrom,andoftencompetewith,thoseoperatedbymunicipalcompanies.Moreover,theurbanmobilityplanshavenotfullyrespondedtothespatialexpansionofthecities,growingmotorizationandchangingmobilitypatterns.Underthesecircumstances,urbanareasexperienceincreasingtrafficcongestion,andconsequently,deteriorationoftheairquality,increaseintraveltimeandcosts,andincreaseinroadtrafficcrashesandcasualties.

PrivateSector:CreatingaLevelPlayingField134. Ukraine’shighlyconcentratedandanticompetitiveproductionstructure,alongwiththe absence of a level playing field in the private sector, are serious impediments toproductivityandjobcreation.The2014WBGreporton“OpportunitiesandChallengesforPrivateSectorDevelopment”foundthatUkraine’stepidprivatesectorgrowthisreflectedin:(i)thestagnantstructureofthecountry’sindustryandexports,whereoldindustriessuchassteel,machine‐buildingandchemicalscontinuetodominateandoperateatlowlevelsofproductivity;(ii)thelowinflowofhighvalue‐addedFDI,especially inexport‐orientedmanufacturing;and(iii) therelatively limitedroleofSMEsintheprivatesector,withlargerfirmsandbusinessgroupsdominating.Allthesefactors

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suggest that the market‐driven and competitive process of entrepreneurship, innovation, andproductivitygrowthdoesnotfunctionproperlyinUkraine.135. Creatingamorecompetitiveandlevelplayingfieldintheprivatesectorwillrequirestreamliningtheregulatoryenvironment,strengtheningcompetitionpolicy,andreformingstate owned enterprises. Complicated regulatory barriers hinder market contestability, fuelcorruption opportunities, and ultimately lead to an environment where only a small number ofpoliticallyconnectedfirmsareabletofunctionatlowlevelsofproductivity.Despiterecentprogressinstreamliningtheregulatoryenvironmentinselectedareas,Ukrainelagscomparatorcountriesbyaconsiderabledistance.Second,withmanysectorsexhibitinghighconcentrationoffirmsandlowratesoffirmentryandexit,weakimplementationofcompetitionpolicydoesnothelpaddresstheproblem. The Anti‐Monopoly Committee (AMC), the competition watchdog, is supported by arelatively strong legal framework, while themain challenge is weak implementation of the law.Third,thelargeandinefficientstate‐ownedenterprise(SOE)sectorisoftenabletooperateatlowlevelsofproductivityandtransparencywithpreferentialaccesstoresources,markets,andinfluence,thus crowding out entry and growth of more productive firms. Generating a more competitiveprivatesectorinUkrainewill,therefore,requirecomprehensivereformofSOEs,includingimprovingtransparency,governance,andacceleratingpreparationsfortransparentprivatization.

Deregulation:streamliningtheregulatoryenvironment

Figure43.DoingBusinessRankingUkraineandComparators,2017

Figure44.DoingBusinessRankingRegulatoryDimensions,Ukraine,2017

Source:WorldBankGroup Source:WorldBankGroup

136. Ukrainehas takensteps to improve itsregulatoryenvironment,butstill lagsothercountries in the region by a considerabledistance. Improving the business environment iscritical not only for encouraging private investment but also for moving investment to moreproductiveandmoreprofitablesubsectors. The2017DoingBusiness(DB)ReportranksUkraine80thglobally,whichmakesit22ndintheregion.Ukraine’srankinghasimprovedsignificantlyfrom140th in 2013, 112th in 2014, and 96th in 2015, indicating steady progress over time. However,Ukraine’s ranking lags those of the new EU member states that rank among the top 20‐50.

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Furthermore,whileUkrainehasimproveditsrankinginsomeareas(20thingettingcreditand20thinstartingabusinessin2017)inrecentyears,itrankspoorlyinseveralotherimportantareas(150thinResolvingInsolvency,140thinGettingConstructionPermits,130thinGettingElectricity,and115thinTradingacrossBorders).Also,itisimportanttonotethattheDoingBusinessrankingsrepresentonlyasmallpartofalargerinvestmentclimate.Ukraineis79thintheGlobalCompetitivenessIndex2015‐2016, down from being 73rd just three years earlier. The European Business AssociationInvestmentAttractivenessIndexshowslittleimprovementinthebusinessenvironmentfrom2011to2015.FindingsfromIFCsurveysconsistentlyshowthatUkrainianfirmsdescribetheframeworkofpermits,licenses,certifications,andinspectionsasburdensome.137. Reform efforts to streamline the regulatory environment so far have not beensystematicandcomprehensive.Instead,reformshavebeensporadicandhavehadalimitedeffecton businesses. This has resulted in continuing dissatisfaction of businesses with the regulatoryenvironment. For example, the business start‐up process has been streamlined, but voluntarybusinessexitremainshighlydifficult,andcompletingmostlynon‐reformedlicensingrequirementsformanytypesoflicensesisstilltime‐consuming.Businessinspectionsandpermittingprocedurescontinuetobeviewedbybusinessesascumbersome,especiallybySMEs.Despitereductioninthenumber of permits during recent years, a large number of permits and licenses have not beeneliminated or streamlined, but simply renamed in order to bypass relevant laws. Poorimplementation of the 2007 Law on Inspections is aggravated by an excessive number ofinspectorateswithamandatetovisitbusinessesinUkraineandinternationalbestpracticeonrisk‐basedinspectionsisnotfollowed.Regulatorypolicyisalsoplaguedbylowtransparencyandweakimpact assessment. Thequality of theRegulatory ImpactAssessment (RIA),withamain goal toassesstheeconomiceffectsofproposedlegislationandensurethatthebenefitsofapolicyactionarelikelytobegreaterthanthecosts,isgenerallypooranddoesnotmeettherequirementsoftheRIAMethodology.Asaresult,manyregulatoryactsarenotbusiness‐friendly.138. Goingforward,Ukrainewillneedtotakeanumberofsystematicstepstostreamlineitsregulatoryenvironment. These include: implementing reforms in the areasof constructionpermits,resolvinginsolvencyandtradingacrossborders,asmeasuredbyDoingBusiness;bringingtheRegulatory ImpactAssessment(RIA) in linewith internationalpracticeandtheMethodology,including the SMETest; improving regulations governing business inspections and canceling themoratoriumimposedonsuchinspections;makinganinventoryandrevisionof‘hidden’permitsandpermittingproceduresoutsidethescopeoftheLawontheLicensingofCommercialActivityandtheLawontheListofPermits;andincreasingtheuseofdeclarationsinsteadofpermitsorlicensesandimprovingtheprocedureofsubmissionofsuchdeclarationstostateauthorities.

CompetitionPolicy

139. EnterpriseownershipinUkraineremainsconcentratedinafewlargebusinessgroups.While other transition economies have shifted toward more diversified industries and dynamicmarkets,theconcentrationofownershipofUkraine’skeyresourcesinafewlargebusinessgroupshas prevented dynamism and diversification from taking hold, amissed opportunity for growth.Promotingcompetitionisnoteasyinthisenvironment,butafairandbalancedenforcementofanti‐

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monopoly rules, enforcing disclosure of ultimate owners, identifying and limiting related‐partylendingtoprudentialnormscanallhelp.140. The Anti‐Monopoly Committee (AMC) is supported by a relatively strong legalframework,whilethemainchallengeisweakimplementationofthelaw.TheAntimonopolyCommittee generally has adequate legal powers but needs to reinforce its independence, and itscapacitytoapplyanti‐monopolyrulesinafairandbalancedway.Itshouldalsohavetheobligationtodiscloseultimateownersofbusinesses.Enforcementisalsoaproblem,withlessthan10percentoffinesimposedbytheAMCactuallypaid.TheCommitteeisover‐burdenedwithcasesthatdonotpose risk to competition, and the Committee is empowered to excessively intervene in ordinarymarketactivity.Goingforward,itwillbeimportanttofullyharmonizeUkrainianlegislationwiththatof the European Union and international good practice as well as implementing the NationalCompetition Program 2014‐2020, including enhancing capacity of AMC to carry out itsresponsibilities and providing adequate resources to ensure that the AMC can maintain highstandards of performance and accomplish its mission. Moreover, enhanced competition wouldrequire better‐trained judges adjudicating competition cases, including a checks and balancesapproach in reviewing the imposed fines, truly competitive public procurement andnondistortionary state aid, and stronger awareness and involvement of the civil society. ThelegislationonstateaidhasbeenadoptedbutitsenactmentisplannedforAugust2017.Asaresult,thereisnothecontrolofstatesupportforsectorsandcompaniesthatrisksdistortingcompetition.StateOwnedEnterprise(SOE)Reform141. SOEshave a large share in theUkrainian economy, contributing approximately20percentofGDP,butaregrosslyinefficient.In2015,Ukrainehadabout3,500SOEs,ofwhichonlyhalfwereoperating.SOEshaveastrongpresenceinseveralsub‐sectors,includingenergy,transport,agriculture,andmachine‐building.Thegovernmentowns25percentoftotalfarmlandandprovidesproduct‐specificsubsidies inagriculture, includingareapayments forhorticulture,viticultureandhops;aswellassubstantialsupportforpoultryandsugarproduction.SOEsarethelargestemployerinUkraine:about1millionpeople,roughly5percentoftheworkforce.TheSOEsectorreportedanaggregatelossofUAH115billionin2014,about7percentoftheGDP.Outofthelargest100SOEs,only57wereprofitablein2014andnetprofitmarginswere,onaverage,verylow.Furthermore,these entities are non‐transparent, poorly supervised and governed, and plagued by corruption,whichunderminespublictrustinbothSOEsandthelargerpublicsector.Withreportedprofitsandlosseslikelydistortedduetovestedinterestsofofficialsandspecificbusinessgroups,agoodfirststep is to introduce transparent and competitive recruitment of top management of the mostimportant SOEs and to insist on international corporate governance principles. The SOE sectorrequiresurgentreformsastheseenterprisesdistorttheeconomyandlimitgrowthopportunitiesforthe private sector. Trading enterprises and alcohol production are important examples, amongothers.142. Improving transparency and accountability in SOEs and the private sector isimportant.Ukraineneedstostrengthenitscorporatefinancialreportingstandardsandpractices,

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aswellastransparencyandpublicavailabilityofreliablefinancialinformation.ThisisimportanttoimprovepublictrustinfinancialreportsofSOEsandprivatecompanies,butwillrequireimprovingregulation and building capacity to comply. Although national accounting standards wereapproximated to the International Financial Reporting Standards (IFRS) in 2000, and directapplicationofIFRSbycertaincategoriesofbusinesseswasintroducedsince2012,mostentitiesinUkraine continueusing outdated accounting standards to report their financial statements. ThisleadstoincompletefinancialreportingbySOEsandprivateenterprises.Auditregulationsalsoneedreform:UkraineadoptedtheInternationalStandardsonAuditing(ISA)in2003,buteffectivenessofthe regulatory system proved to be inefficient. The EU Association Agreement requiresapproximatingfinancialreporting,accountingandauditlawstothoseoftheEU.143. ImprovinggovernanceofSOEsisimportanttoprovideastrongercommercialfocustoSOE operations. At themoment, there is no oversight body in charge of managing the state’scommercial assets. SOEs are managed by various individual line ministries or agencies, incooperationwithprivateshareholders,incasesofjointownership.Asaresult,SOEsaregovernedbya complicated and heterogeneous set of management practices, with no clear delineation ofresponsibilitiesbetweenSOEmanagement, relevantstateagenciesand,whereapplicable,privateshareholders.Suchasituationunderminesaccountability.144. Restructuring,privatization,andinsomecases,liquidation,ofSOEsonacase‐by‐casebasis will be needed. Cumbersome and outdated procedures greatly impede the efficientprivatization, restructuring or liquidation of SOEs. An assessment of the current framework isplanned,followingwhichthelegalandregulatoryframeworkforprivatizationwouldbeupdatedandsimplified,followedbyaPrivatizationActionPlan.

LandReform145. Weak land governance seriously undermines investment and productivity inagricultureandothersectorsinUkraine.ThefullrealizationofUkraine’sagriculturalpotential,especiallyinwaysthatincludesmallandmediumscaleproducers,ispossibleonlyiflandtenureissecureforthelongtermandlandrightsaretransferable.AsUkraineisamajorglobalexporterofagriculturalproducts,thequalityoflandgovernanceinUkrainealsohasimplicationsforglobalfoodsecurity.About71percentofUkrainianterritory(42.7mha)isclassifiedasagriculturalland.Stateland comprises 25 percent of Ukraine’s agricultural land base. There are about 23m privatelandownersandusers(ofwhich90percentarenaturalpersons)andabout5musersofstateland(10.5mha).About21.5mhaofagriculturallandiscultivatedbyabout45,000commercialproducers(ofwhichabout36,000arebelow200ha).Thus,thequalityoflandgovernanceaffectsthewellbeingofasignificantportionofcountry’spopulationandefficiencyofseveralindustriesthatuselandasafactorofproductionorareverticallyintegratedwithsuchindustries.146. Results of amonitoring survey point toward a number of considerable challengesassociatedwithlandgovernance. Theresultsshowthatthelevelofregistrationofstatelandissignificantlylowerthanthatofprivateland(24vs71percent),whichisasourceofnon‐transparent

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practicesandconsiderablelossesofstaterevenues.Second,therentalpriceforagriculturallandisone of the lowest in Europe and CIS countries, reducing thewellbeing of rural land owners andproviding for inefficient use of land resources. Third, the sales market for land (outside ofMoratoriumforagriculturalland)isextremelythinprimarilyduetolackoffinancialinstrumentsanddifficultieswithusingpropertyandrentalrightsasacollateral.Theprimarytypeoftransactionsforagricultural land is rent (about 4.7 rental agreements with average duration of 7.6 years) withsubstantial informal rentalmarket reinforcedby recent legal initiatives to increase theminimumdurationofrentalcontractsto7years.Fourth,thenumberoftaxpayersforlandtax(about7.3mln)issubstantiallylowerthanthenumberofprivatelandownersandlandusers.

147. In order to address the challenges associatedwith land governance, a number ofinitiatives will be important. These include (i) improving institutional arrangements andtransparencyoflandgovernanceincludingestablishmentofpermanentlandgovernancemonitoringsystembased on administrative records of LandCadaster andother government authorities; (ii)increasing efficiency of state landmanagement through a new legal framework and transparentprocedure to clearly demarcate the state land and transfer it out of state ownership by eitherauctioningortransferringtocommunalownership(preferablyatrayonlevel)basedonclearcriteria;(iii)clearinglegalstatus,formallyregisteringandestablishingaclearmanagementarrangementoverunclaimedpropertyandunclaimedprivatizationshares,landofformercollectivefarms(windbreak,foreststrips,farmyards,fieldroads),(iv)openingupofthesalesmarketforprivateagriculturalland,possiblyinadecentralizedwayand(iv)testing,monitoring,evaluatingandimprovingefficiencyoflandreform.

TradeFacilitation

148. Ukraineneedsabalancedtradepolicytoincreaseexportsophisticationandlinkingdomesticwithglobalvalue chains. Itwill be important to promotemore sophisticated exportproductswithhighervalueaddition inthecountry(fromgrainstomeatanddairy, fromwoodtofurniture, from steel tomachinery). Market opening and targeted investment promotionwill beimportanttoreachthisgoal.However,itshouldbenotedthatexportsophisticationandcommodityexports are not necessarily mutually exclusive. Many developed countries, including France,GermanyandtheUSAaresuccessfulnetexportersofcommoditiesandhightechproductsatthesametime. Due to limited domestic commoditymarketswith shrinking population future growthwillmainlybegeneratedbyexportgrowth.Everytonofcommodityproducedwillleadtoalmostonetonmoreexport.However,tradelogisticsareunder‐developedandlogisticscostsaremuchhigherinUkrainetocopewithfutureexportgrowth.ForexampleportlogisticscostsatUkrainianBlackSeaportsareabout20$pertonofgrainand7.5$inFranceandGermany.Investmentsininfrastructureand logistics(ports,railcars,rivertransport,storage, just‐intimesupplysystems)combinedwithregulatoryreformsareimportantmeanstofacilitatetradeandtomakespecificindustriesstrongerandcompetitive.ForUkrainetoovercomeitscrisis,itneedstointegratewithEuropeandtheworld.149. Tradefacilitation,standardsandcompetitiveness.ThetradeagreementwiththeEUisdeep(it’sabouttariffsandstandards)andcomprehensive(itcoversalmosteverything).EUmarketsarehighlycompetitiveandUkrainefeelsthischallengealready.Ukraineneedsstrongcommitments

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toadaptitstradeproceduresandstandardstofacilitatetradeacrossbordersforitsownindustriestointegrateintoglobalmarketsandvaluechains.Also,theWTOTradeFacilitationAgreementwithitsfocusonremovingnon‐tariffbarrierstotradewouldbeanimportantreformanchor.Keyreformmeasures would focus on the operating environment for traders, simplifying border clearanceprocedures, improving the National Quality Infrastructure (investing in metrology, adaptingconformity assessment to trade partners, internationalize private and public safety andsustainabilitystandards,promotemutualrecognitionofaccreditationbodies)andmodernizationoflogisticsinfrastructureandtradeservices.

150. Ukrainehasconsiderablepotentialacrossthebroadagribusinesssector.Thispotentialis capableofhelping to address global food security challengesover time.The sectorhas shownremarkable resilienceandcompetitiveness in timesdecliningglobalcommoditypricesandcrisis,increasingitsexportsharetoabout40percentoftotalexports.However,itspotentialhasbeenonlypartly realized as specific challenges in the sector include raising farming efficiency and yields,improvingfarmers’accesstofinancing,developingstorage,transportanddistributioninfrastructure,modernizing food processing and agricultural processing especially in industries with stronglinkages to other sub‐sectors across the whole economic value chain, and supporting thedevelopmentoflocalcompanieswithhighpotentialwhichhavebeenamongthosethehardesthitbythecrisis.Uncertaintyabout the futureof the landownership limits investmentandyields in thesectorassignificantsharesofagriculturallandremainunderutilized.

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VIII. Pathway3:Effectiveservicesandtargetedassistance151. Effective servicedelivery is importantnotonly toenhance skillsand labormarketoutcomes,butalsotoensurethatthebenefitsofgrowtharebroadlysharedinasustainableway.SocialsectorexpendituresarehighinUkraine:5.8percentofGDPoneducationand4.5percentonhealth. However, thepopulation, including the bottom40percent, hasnot beenwell served.Healthoutcomesarepoorrelativetocomparatorsandthoughgeneraleducationoutcomes(e.g.yearsofschooling,completionofsecondary/tertiaryeducation)arebetter,firmsinUkrainefindthatskillsforhighly‐skilledand/ormiddle‐skilled jobsare inshortsupply.Similarly,whileexpendituresonsocial protection (pensions and other social assistance–17 percent and 4 percent of GDPrespectively)areoneofthehighestintheregion,socialassistanceisnotwelltargeted.Thebulkofpayments for social assistance go to those outside the bottom 40 percent andmany vulnerablegroupsarenotadequatelyprotectedviasocialcareservices.Infacttobecomemoreeffective,socialcare services in Ukraine need to address problematic funding and accountability arrangements.Finally, thereareconcernsthatsocialexpenditures inUkraineareunsustainably large,squeezingresourcesforpublicinvestmentandraisingrisksofmacroeconomicimbalances. AllthissuggeststhatservicedeliveryinUkraineneedstofocusongreaterefficiencyandeffectiveness,whilesocialassistancewillrequireimprovedtargeting.

Figure45:Compositionofgeneralgovernmentexpenditure,Ukrainevspeers,2013

Figure46:HumanDevelopmentIndex Rank2014(lowerrankmeanshigherdevelopment)

Source:IMFGFSfor2013 Source: UNDP,2014152. GeneralgovernmentspendinginUkraineisconsiderablyhigherthanthatofcountriesatsimilarlevelsofincome.Ukraine’sgeneralgovernmentbudgetrevenue,includingsocialsecuritycontributions,amountsto41percentofGDPonaverageforthelasttenyears,whichisnotablyhigherthantheaveragesforECAandlower‐middleincomecountriesof33and31percent,respectively.UkrainealsospendsmorethancountriesatsimilarlevelsofincomeandcountriesintheECAregion.

0 10 20 30 40 50

Georgia

Albania

Lithuania

Romania

Czech Repablic

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Moldova

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Health Education Social protection Other GG expenditures

Ukraine

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Romania

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At over 45 percent of GDP on average for the last ten years, Ukraine’s general governmentexpendituresareabout10percentagepointshigher than theECAregionalaverageandabout15percentagepointsabovetheaverageforlower‐middleincomecountries.153. Thehighlevelofexpendituredoesnottranslateintohigherqualityofpublicservicedelivery.Despitefallingstudentnumbers,expendituresoneducationincreasedfrom5.9percentofGDP in 2007 to 7.2 percent in 2013 before declining back to 5.8 percent in 2015. Health careexpendituresalsoincreased,albeitfromarelativelylow3.7percentofGDPin2007to4.2percentofGDPin2013.Wageincreasespushedupspendingonthepublicsectorwagebillfrom10.1percentofGDP in2007 to about11.5percent in2013. Interest paymentshave also pickedup reaching2.5percentofGDPin2013drivenbygreaterdebtissuancesduringthecrisisperiod.Ontheotherhand,capitalspendingcontractedmostsharplyoverthesameperiod,downfrom5.4percentofGDPin2007to2percentofGDPin2013.154. Moreeffectiveservicesandtargetedassistancewillrequireoptimizingthefinancingand improving the quality of health and education, further improving targeting of socialassistance,andprovidingeffectivesupport toconflictaffectedpeople. Themost importantprioritiesareintheareasofhealth,socialassistance,andtargetedsupporttoconflictaffectedpeople.Inhealth,akeypriorityistoreformthehealthfinancingmodelfromafocusonhospitalcareandinput‐basednormstowardapaymentsystemwheremoneyfollowsthepatient.Insocialassistance,keypriorities includeimprovingthetargetingof thehousingandutilitiessubsidy(HUS)programwhichhasprovidedtemporaryrelieffromenergytariffincreases,butalsocontinuingtomovefromcategoricaltotargetedbenefitsfortheoverallsocialassistancepackage.InlightofthecontinuingconflictandlargenumbersofIDPs,providingtargetedsupporttoconflictaffectedpeopleisahighpriority.Thiswillrequireprovidingeffectiveskills,training,andenterprisesupportinaffectedareasandextendingsystematicassistancetovulnerablehouseholds.Thefollowingtablesummarizesthepriority interventions for providing more effective services and targeted assistance identifiedthroughtheanalysisinthischapter.

Priorities Criticality TimehorizonHealthReform:Revisehealthfinancingmodelfrominput‐basednormstowardpaymentsystemswhere“moneyfollows”thepatient

High Short

Education:Implement“hubschools”programtooptimizeschoolnetworkwhileprioritizinginvestmentsinquality‐enhancinginputs

Medium Short

Subnationaldeliverymechanisms:Improvenorm‐basedfinancingforservices,increasefinancialautonomy,andclarifyrolesandresponsibilities

Medium Short

SocialAssistance:Continueshiftfromcategoricaltotargetedbenefitsandimprovingtargetingofthehousingutilitysubsidy(HUS)program


Targetedsupporttoconflictaffectedpeople:skills,training,andMSMEinaffectedareasandhostcommunitiesandextendsystematicassistancetovulnerablehouseholds


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MoreEfficientHealthServices

155. Provisionofbetterandmorecomprehensivehealthcareisapriority.Ukraineisfacingaserioushealthsituationandneedstotakeurgent,appropriateanddeepreformactionstoimproveitshealthservicesandtoreversetheprogressivedeteriorationofitscitizen’shealth.Theoverarchinggoalofthesereformsshouldbetocreateahealthsystemthatisresponsivetoclients,transparent,effectiveandequitableinpreventingandcontrollingnon‐communicablediseases(NCDs)byscalinguppreventiveandprimarycare.

Figure47.Distributionofresourcesbytypeofservices/activities(%oftotal),2014

156. Mostresourcesarespentonin‐patientandspecializedoutpatientcareandaround10percentonprimaryandpreventivecare.Ofallprematuredeaths(atunder75yearsofage)in2004,17percentcouldhavebeenavoidedwithadequatepreventionofmajorriskfactors(smoking,alcohol,dietandroadtrafficaccidents).Also80percentofdeathsamongworking‐agemalesand30percent of deaths amongworking‐age femaleswere from illnesses that could have been treatedadequatelyattheprimarycarelevel.157. TheGovernmentspendsabout12percentoftotalpublicexpenditureonhealth,whichiscomparabletoothercountriesintheregion. Mostgovernmenthealthfinancingcomesfromgeneral taxation, and it is allocated according to inputs andmainly to cover recurrent costs (96percentoftotalcosts).In2013,directfundingtohealthfacilitieswasmainlyspenttocoversalariesofpersonnel(e.g.84percentoftotalbudgetspentonpersonnelinout‐patientsclinicsand74percentingeneralhospitalsin2013,BOOSTdata).Ukrainehasanoversizedhealthcareinfrastructurewithabout40percentmorebedspercapitathantheWHOEuropeanRegionaverage.Thisinfrastructureconsumesmostof theavailable funding,oftenprovidingonlyverybasic inpatientandoutpatientservices.In2014,morethanahalfofpublicspendingonhealthwasallocatedforin‐patientfacilitiesandlessthanatenthonprimaryhealthcarediseaseprevention.

11.5

0.0

0.6

1.8

1.8

9.4

12.1

62.7

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Other activity in the health protection system

Medical products and equipment

Research and development in the health…

Sanatoria and resorts

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Primary health care

Out‐patients’ clinics, ambulance departments, …

Patient care institutions

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158. Outofpocketpaymentsarehigh,whichisabarriertoaccessforallandparticularlyfor the ruraland thepoorpopulation. High levels of out of pocket payments (OOPs) create abarrier to access health services for the poor and the bottom 40 percent and can generatecatastrophicexpensesforthoseseekingurgentcare,orthoseaffectedbychronicdiseasesrequiringmedicines.Privatehouseholds’expenditure,mainlypatients’outofpockets(OOPs)atthepointofservicedelivery,amountedto43.6percentoftotalhealthexpenditureor3.3percentofGDPin2012,andhavegrown furthersince.De jure,allmedicalservicesshouldbeprovided freeofcharge forpatients,butinpracticepatientspayfortreatment.Anticipationofhighexpendituresassociatedwithuseofhealthcareservicesputsanotherbarriertotimelyandregularaccesstomedicalservice.159. Ukraine is losing itshumancapitaldue to ineffectiveandpoorlyperforminghealthsystem,somethingitcanillaffordwithadecliningworking‐agepopulation15.Lifeexpectancyatbirth(LEB)islow(71yearsin2013);itlagsmorethan10yearsbehindEUandOECD.ThelowLEBismainlyexplainedbyexcessmortalityduetonon‐communicablediseases(NCD)amongmaleandruralpopulation.Takentogether,evidenceshowsthatUkraineisfacingahealthcrisisandneedstoundertake urgent, appropriate, and deep reforms to reverse the progressive deterioration of itscitizens’ health and in their trust of the system. Better governance would be a key lever forimplementationoftheneededchanges.160. ThemainreasonofprematuredeathsanddisabilitiesisahighburdenofNCDs,anditsignificantlycontributestoavoidableproductivityloses.NCD‐relatedmorbidityandmortalityisveryhighinUkraine:theage‐standardizedmortalityratefromNCDsin2012accountedfor749casesper 100,000population,while in neighboringPoland itwas 494 cases, and533 in Slovakia. TheexistinghealthcaresystemisnotshapedtoeffectivelycontrolepidemicofNCDsinthecountry.Thecurrent health service delivery is not oriented towards prevention, early detection and effectivemanagement of NCDs; it stays mainly unchanged since country’s independency and focused atcontrolofinfectiousdiseasesandprovisionofcurativemedicineinsteadofhealthpromotion.Highlevelsofconsumptionofalcohol(13.9litersofpurealcoholperpersonperyear)andtobacco(21%prevalence as of 2014 ), unhealthy diets and low physical activity are among key risk factorsexplaininghighburdenofNCDs.

161. Strong leadership and the stewardship function at the central level are neededparticularlyinthenewdecentralizedenvironment.Atpresent,81.5percentoftotalgovernmentexpenditureonhealth is channeled through localgovernments,and18.5percent throughcentralinstitutions, including theMinistryofHealth. In thenewdecentralizedenvironment,MoHshoulddeveloptheroleofplanner,coordinator,andevaluatorofhealthservices’standardsandresults,withlocalauthoritiesatregional,city,district,andcommunitylevelsassumingtheroleofimplementingactors.Instead,theministerialorders,oftenoutdated,continuetoimposeextremelydetailedinput‐based“norms”(onpersonnel,infrastructure,etc.)onallindividualfacilities,andhasfocusedmainlyonprocuring(veryinefficiently)inputssuchasdrugsforthenationalprograms.Thelocalauthorities

15Bloometal(2004)findthatincreaseoflifeexpectancyby1yearraisesthesteadystateGDPpercapitabyabout4percent.

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arehaving limited flexibility foreffective systemmanagementandactwithout clearmandates intermsofservicestandardsandresults.SkilledLaborForce

162. With firms complainingabout the shortageof skilled labor,Ukraine’s trainingandeducationinstitutionsneedtobecomemoreresponsive.Whilethecountryperformsatthetopend in terms of educational outcomes like average years of schooling and tertiary educationattainment,thereisincreasingevidencethatskillsthatemployersneedaredeficient.Accordingtoafirmsurveyin2015,mostfirmsinfourkeysectorsofeconomy(i.e.agribusinessfoodprocessors,Agri‐businessgrowers,ICT,andrenewableenergy)reportthattheeducationsystemdoesnottrainstudentstogettheskillsthatemployersneed.About70percentofthefirmssurveyedreportedthatgraduatesofthegeneraleducationsystemandtechnicalvocationaleducationandtraining(TVET)systemdonothavepracticalskillsorup‐to‐dateknowledge.Closetofourfirmsoutoftenreportthattheiremployees’skillgapspreventthemfromachievingbusinessobjectives.ThisistrueforroughlyhalfthefirmsinthefoodprocessingandICTsectors(Figure48)

Figure48.Shareoffirmsreportingasignificantskillgap,%

Source:DelCarpioandothersforthcoming163. Theskillsmostdemandedbyemployers includeamixoftechnical,socio‐emotionalandadvancedcognitiveskills. The firmsurvey shows that advanced cognitive skills that allowworkers to analyze and solve problems,manage their time, gain new knowledge and learn newmethods,andcommunicateeffectively,arehighlydemandedinUkraine.Employersnotonlylookforworkerswhothinkwellbutalsoforthosewhodemonstratesocio‐emotionalskillsthathelpmanageone’semotionsandbehaviors(likeself‐management,resilience,ethics),goalsettingandwillingnesstolearn(achievementmotivation),andtheabilitytoworkwithothers(teamwork).Thetechnicalskills sought are typically occupation or job‐specific, like sales skills, knowledge ofmarkets andproducts,andadvancedcomputingskills.164. Formal education institutions are themost fertile ground to build skills, but thecurrent system lacks flexibility,quality standards,and relevance for today’s labormarketneeds.Sixoutoftenfirmsfromfourkeysectorsreportaskillsgap.Ukraine’seighth‐gradestudents

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scoredwellinthe2011internationalassessmentconductedaspartoftheTrendsinInternationalMathematicsandScienceStudy(TIMSS),rankinginthesamegroupashigh‐incomecountrieslikeItaly,Norway,orSweden.However,beyondcredentialsandstudents’basicacademicskills,therearequestions about the relevance of the workers’ education, particularly those graduating fromvocationaleducationinstitutions.Overtheyears,thesupplyofuniversitygraduateshasincreasedbeyondactualdemand, although therearequestionsabout thequalityof instruction.Curriculumformation is mostly a top‐down process with limited private sector involvement. This lack ofinteractionbetweenemployers and the formaleducation systemexacerbates skillmismatches.Alargesegmentofthelaborforceistrainedforprofessionsthatarenolongerindemand,creatingasurplusofunneededskills.Whilefirmsalsoseektopartnerwitheducationinstitutionstoprovideinputstotheircurricula,lessthanaquarterofallfirmssurveyedactuallyhaveregularcontactwitheducationortraininginstitutions.Figure49:Publicexpenditureoneducation,

2010‐2015,percentGDPFigure50:Pupil‐TeacherRatioinsecondary

education,Ukrainevscomparators,2010‐2015

Source:FindMyFriendsusingtheEdStatsDatabase Source:FindMyFriendsusingtheEdStatsDatabase

165. Bymostmetrics,Ukraine’spublicexpenditureoneducationhasbeenhighinrecentyears.However,therecenteconomicturmoiltookitstollonthelevelofpublicfundingforeducation.Between2013and2015,budgetfinancingofthesectorshrankfrom7.2percentofGDPto5.8percent(from21percentto17percentoftotalgovernmentexpenditures).Followingthesharpdevaluationofthehryvnia,publiceducationspendingdeclinedby35percentinrealtermsovertwoyears.ThisdeclinebroughtUkraineclosertointernationalbenchmarksintermsoftheshareofnationalwealthdevotedtothefinancingofeducation.UkraineisnowonparwithsuchcountriesasSlovenia,Israel,France,andtheUKandclosertotheOECDandEUaveragesof5.3percentofGDP.166. However, the efficiencyofpublic spending in education remainsquestionable. Thepublicbudgetfinancesthemaintenanceofanoversizedschoolnetwork.Thenumberofteachersandschools has remained nearly the same despite a severe decline in student population (by fortypercentoverthelasttwodecades).Efficiencyindicators,includingtheaverageschoolsizeandthestudent‐teacherratio,havebeenfallingsharply—theratioof8.5studentsperteacherisamongthe

6.5 6.35.8

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lowest in the world. Large allocations to non‐personnel recurrent costs and non‐means testedscholarshipsaffectalllevelsoftheeducationsystem—frompreschoolthroughuniversity.

Figure51:UkrainePublicExpenditureonEducation(%ofGDPand%ofTotalGovernmentExpenditure,2007‐2015)

Source:UkrainePFR2016.

167. In2016,theGovernmenthasbeguntoaddresssomeoftheseconcerns.Thelaunchingof the “hubschools”program isaimedatbeginning the longoverdueoptimizationof thegeneralsecondary school network in linewith the declining student population. Further reallocations ofpublic resources should prioritize investments in quality‐enhancing inputs to improve educationqualityandmakethesectoradaptabletoneweconomicneeds.Targetingscarcepublicfundstowardtheir most optimal uses—such as capital investment and ensuring equitable access to learningmaterialsandwell‐qualified teachers forall students—shouldbe thepriority.Meanwhileshiftingawayfromsubsidizingnon‐qualityenhancingexpenditures—suchasunnecessarilysmallclasssizesorgenerousscholarshipsfornon‐needystudents—cancreatefiscalspaceformorepressingbudgetneeds.168. Atthesametime,concernsregardingdecliningaccesstoqualityeducationforthepoorandthebottom40percentshouldbetakenseriously.Thequalityofbasiceducationisbecominghighly differentiated for different groups within Ukrainian society. Unequal access to qualityeducationcreatesbarriersforsocialmobilityandnegativelyaffectshigherlevelsofeducation.Thereareanecdoticcasesprovidingevidenceofdramaticdifferencesinpublicfinancingamongeliteandnon‐elite schools and preschool organizations. More than half the parents disagreed with thestatementthatsecondaryeducationgiveequalaccesstoeverybodyforfree,inarecentpoll.Thereisalsopublicperceptionofunequalaccesstothebesthighereducationinstitutions.Thisissuehasnotbeenanobjectofanyin‐depthstudiessofarbutmayrequirefurtherinvestigationinthefuture.

19.6% 19.7%

21.7% 21.1% 20.7% 20.6% 20.9%19.1%

16.8%

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25%

2007 2008 2009 2010 2011 2012 2013 2014 2015

% of Total Government Expenditures % of GDP

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SubnationalDeliveryMechanismsandMunicipalUtilities169. In fiscal terms, Ukraine is highly decentralized, although administrativedecentralization is lagging considerably. Subnational expenditures account for 31 percent ofconsolidatedgovernmentspending.ThisplacesUkraineinthecompanyofsuchcountriesasAustria,Poland,andItaly,andranks itconsiderablymoredecentralizedthanRomaniaandBulgaria.Mostsubnationalspendingoccursatthesecond(raionandcity‐of‐oblast‐subordination)tier.Together,second‐tier subnational governments accounted for 65 percent of total subnational spending in2015. Top‐tier subnational governments (Kyiv and the oblasts) accounted for 27 percent ofsubnational spending. Third‐tier subnational governments accounted for the remaining sevenpercent.170. The vastmajority of subnational spending is devoted to the social sectors,whilespendingoneconomicinfrastructure,suchasroads,accountsforonlysevenpercentoftotalexpenditure.LocalgovernmentsinUkrainebearthefullcostofrunningschools,hospitalsandsocialwelfare facilities (including the wage cost associated with the provision of these services). Inaddition,socialassistance‐relatedcashbenefits,whichareusuallyfullyadministratedbyrelevantcentralgovernmentbodiesinothercountries,arepassedthroughthebudgetsoflocalgovernmentsinUkraineaswell.In2015,78percentoftotalsubnationalspendingisdevotedtoeducation,healthand social protection. Spending on ‘housing’ including subsidies to cover the arrears of utilitycompanies,accountsforanothersixpercent.Capitalexpenditureatthelocallevelislowforalowermiddleincomecountry.Despitenotableprogresstoincreasecapitalexpenditures,whichwerescaledupfromalowof0.9percentofGDPin2014to1.6percentofGDPin2015,thelevelisyetverylowgiventhetransitionstatusofthecountryanditsgrowingneedsforinvestmentsinjections.171. Ukraine’sintergovernmentalfiscalrelationsprovideanadequatelevelequalization,butfallsshortofpromotingefficientservicedelivery:

Theinter‐budgetarytransfersystemisrigidandbasedonanofficialregisterednumberof

citizensandoutdatedinput‐based“norms”dis‐incentivizingrationalizationofeducationandhealthcarenetworks.Itnotonlyunderminesefficientserviceprovisionbutrecentlybecamea bottleneck for timely and effective financial support of conflict‐affected territory andpeople.

Revenuesharingarrangementsarenotaligningresourceswithservices‐corporateincometax,forexample,isnotasuitablesourceofrevenueforsubnationalgovernments;andlimitedtaxbase forpropertytax(i.e.,highsquareareathresholdsandexclusionof industrialandcommercialproperty)willlimittheyieldofthepropertytax.

Ongoingamalgamationofvillagesandsettlementsmayfallshortofexpectationsofimprovedservicedeliveryandlocalaccountability.Thekeydecentralizationgoals,suchasdeterminingtheterritorialandadministrativeorganizationofdifferent tiersofgovernment tosupportsubsidiarity,localaccountabilityandsoundfiscalmanagementatthesubnationallevelwouldbedifficulttoreachwithinexistingdesignofthevoluntaryamalgamationofcommunities.

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172. Access tomunicipal utilities ismore constrained for theB40population,with thesector suffering from decades of underinvestment, poormaintenance, and low quality ofservicedelivery.Estimatesbasedonthehouseholdsurveyindicatethatin2013,only27percentoftheB40populationhadaccesstodistrictheating,comparedto43percentof theT60population.Similarly,23percentoftheB40populationhadaccesstohotwatercomparedto38percentoftheT60.Theneedtoinvestinenhancingtheefficiency,access,andqualityofdistrictheating,water,andsanitationisconsiderable.Furthermore,lowtarifflevelsareamajorlimitationtothesustainabilityoftheseutilities.173. Protracted underinvestment in district heating sector has led to physical andeconomicinefficiencyandhighheatlossesinproduction,transmissionanddistribution.Onthedemandside,buildingenergyefficiencyinUkraineisestimatedtobeabout2‐2.5timesworsethan in Western Europe. However, until recently, consumers have had very little incentive toconserveheatduetolowtariffsandthelowlevelofheatconsumptionmetering.Asaresult,about30percentofallheatis lostduringenduse. In2012,thegovernmentapprovedamasterplantoimproveenergyefficiency in theDHsectorbasedona largescale investmentprogram inenergyefficiencymeasuresandreformsofthesocialsafetynettoprotectvulnerableconsumers.However,implementationofthisactionplanhasbeenslow.ReformsinDHsectorcontinuedwithmovingtheregulatoryresponsibilitiesforthesectortothenewlyestablishedregulator.However,goingforward,thisnewregulatorrequirescapacitybuilding,especiallyintheareaofincentive‐basedregulationforutilities.

174. The need for rehabilitation is exacerbated by high overall energy consumption inwaterproductionandwastewatertreatment.ItisestimatedthatenergyintensityinUkraineisone of the highest in the region. Improving service delivery through the rehabilitation ofinfrastructure and the promotion of energy‐efficiency solutions offers the possibility of drivingutilitiestowardfinancialsustainabilitywhileprovidingimprovedservices.Inaddition,institutionalcapacitybuildingforwaterandsanitationutilitiesisalsocritical.SocialAssistance175. Ukrainespendsaconsiderableamountonsocialassistance,althoughmuchofitisnotwelltargeted. Socialassistancespendingincreasedsignificantlybetween2009and2012,chieflydue to increases inchildand family relatedbenefits.Althoughspendinghasdeclinedsince2012,Ukraineremainsoneofthehighestspendersonsocialassistanceintheregion.Yet,thebulkofthespendingdoesnotreachthepoor.Accordingtoprioranalysis,onlyathirdofalltransfersreachedthepoor.Spendingisdominatedbythechild‐birthbenefitandvariouscategoricalbenefits,whilethemeans‐testedlow‐incomefamilybenefitaccountsforasmallportion.Priorto2014,expendituresalsoincludedalargeportiononuniversalenergysubsidies.

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Figure52:Coveragerateforvariouscountries,2012andforUkraine,2014

Figure53:Shareoftotalbeneficiariesbydecilesandshareoftotaltransfersbydecilesofexpenditure

Sources: WB staff based on BOOST, Sources: WB staff based on BOOSTNote: (Direct and indirect beneficiaries, 2014 HBS)

176. Despitethehighratesofwelfarespending,Ukrainerankslowinprovidingprotectionthroughsocialassistance. The rate of coverage forpoor inUkraine is among the lowest in theregion,whilewelfarespendingissizeable.Inotherwords,thecost‐effectivenessandequityresultingfromsocialassistanceisnotcommensuratewiththeamountofresourcesspent.Ukraineonlycoversaroundhalf of thepoorestquintile through social assistance, lower thanmostother countries inEurope.177. Despite on‐going fiscally expansive efforts to support the population such as theenlarged Housing and Utilities Subsidy (HUS) program, overall support to vulnerablehouseholds suffers from both low coverage and low adequacy. Ukraine inherited a welfaresystemdominatedbycategoricalbenefits.Manyoftheseprogramsareaimedforgroupsthatarenotpooronaverage.Asaresult,despitehighratesofspendingUkrainerankslowinprovidingprotectionthroughsocialassistance ‐Ukraineonlycoversaroundhalfof thepoorestquintile throughsocialassistance,lowerthanmostothercountriesinEurope.Thegenerosityoftargetedsocialassistanceisalsolow;onaveragesocialprogramsamountsonlytoabout17percentofexpendituresofthepoorestquintile.During2014‐15,theGovernmentofUkraineimplementedarangeofmeasurestoreformsocialassistanceprogramswiththebroaderaimofcontainingspendingandtoreallocateresourcestoincreasetheshareoftransferstargetingthepoor.Atthesametime,overallsupporttolow‐incomehouseholdsstillisnotadequate.178. Since2014,theauthoritieshaveimplementedanumberofmeasurestoreformsocialassistanceprograms.Thesemeasuresaimtoputinplacefiscallyaffordablesafety‐netsprogramsandmitigatetheimpactofthecrisisonthepoorthroughtargetedassistance.Thereformsshouldhaveincreasedtheshareoftargetedassistancereachinglow‐incomehouseholdsandhelpedcontain

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socialassistancespending.However,theeconomiccrisisandtherapidescalationofenergytariffsareerodingthesesavingsastheneedforsocialassistancehasincreased.

179. Despite the efforts, challenges remain that suggest a number of areas for furtherattentiongoingforward.First,onthecompositionofspending,thechildbirthgrantremainsapoorpolicychoicewithattendanthighcostandlowsocialreturn.Second,whileoverallsocialassistancereachesa large shareof thepopulation (with55percentof thepopulationbenefitingdirectlyorindirectlyfromatleastoneformofsocialassistance),adequacyofsupportmeasuredbygenerosityof payments is generally low. Third, the system is in need of administrative modernization, toimproveaccessibility,administrativeefficiencyandtargeting.

180. TheHUSprogramhasservedan important functionofmitigating the impactof theenergytariffincreasesonthepopulation,buttheprogramneedstobebettertargetedgoingforward,includingpossibleconsolidationwiththeGMIprograminthelongerterm.WhiletheHUSprogramismeans‐tested,thebenefitisreceivedbyaroundsixmillionhouseholds,makingitapoorlytargeted.Inthemediumterm,akeypriorityistoimprovetargetingoftheprogramandinthelongerterm,itshouldalsobeconsideredforconsolidationwiththeGMIprogram.WhileUkrainehasanumberoftargetedprograms,thesehavetheirowneligibilityrulesandtargetingmethodologieswhicharenotachievingtheneededtargetingaccuracy.Therefore,itisrecommendedthatacommontargeting approach be adopted that takes advantage of economies of scale made possible by acommonplatform.Theunified approachwould enable betterquality information,more effectivecross‐checks,verification,datasourcing,analytics,anddatasharingprotocolsbetweenagencies.Inthe short term, the HUS should continue to be given priority for improving the ManagementInformation System (MIS), streamlined procedures, and improving human resources throughtrainingandappropriateremuneration.MoretransparentfinancialmanagementoftheHUSisalsoimportanttoreplaceanopaquesystemofinter‐institutionalsettlementsthatresultsinwaste,fraudanderrors.Targetedsupporttoconflict‐affected

181. Targetedsupporttoconflictaffectedpeopleisanurgentpriority.Thedirectimpactsoftheconflictare facedby thepopulation inconflictaffectedareas,butalsoby internallydisplacedpersons,returningcombatants,andhostcommunitiesacrossUkraine.Astheconflictentersitsthirdyear,whilethereisstillanurgentneedforhumanitarianassistance,conflict‐affectedcommunities,displaced Ukrainians, and the communities that host them also face considerable broaderdevelopment challenges, including employment, education, health, and psychological and socialstress. Preexisting social inequalities and regional divides are often exacerbated and there areconsiderablestrainsonservicedeliverysystemsandalreadydepressedlabormarkets.182. There isanurgentneed foranationalvisionanddevelopmentstrategy,developedwith conflictaffected citizens, in response to the socio‐economic impactsof the conflict—targeting both eastern populations and conflict‐affected communities across Ukraine (includingIDPs, former combatants, and host communities). The 2015 Recovery and PeacebuildingAssessmentforeasternUkraine(jointlypreparedbytheWorldBank,UnitedNations,andEuropean

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UnionattherequestofGovernment)andtheUkraineStateTargetProgramforPeacebuildingandRecoveryoftheEasternRegions(plannedforreleaseinlate2016)andledbyMOT,provideprioritiesforactioninthisregard.Targetareasinclude:

Restoring critical infrastructure and key social services in such fields as education, health care, social protection, public buildings and housing, energy, transport, water supply and removal, and environmental protection. In areas hosting IDPs, this would also include reducing the burdens on overstretched service delivery systems;

Promoting economic recovery by considering viable options for economic revitalization in eastern Ukraine implementing local economic planning, creating new jobs, skill training and building human capital, providing support to micro-, small and medium-size business, expanding access to financial services;

Strengthening social resilience, peacebuilding and community security by restoring citizen

confidence; providing legal assistance and ensuring access to justice; monitoring the situation in communities in terms of vulnerability, risks and social bonds; providing psychological and social support to the conflict-affected populations.

183. Acrossall targetareas,modified localdeliverymechanismsandstrengthened localgovernancewillberequired,includinginnovativemechanismsfordeliveringservicesandsupportinhigh‐riskandinsecuresettings.Engagingconflict‐affectedcitizensisacriticalstartingpointforthedevelopment of appropriate locally‐relevant responses. Government outreach and support toeasternregionswillhelpbuildconfidenceandtrustandtopromotelonger‐termstability,integrationanddevelopmentprogress.

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AcknowledgementsThisSystematicCountryDiagnostic(SCD)forUkrainewaspreparedthroughaconsultativeprocessinvolving the Government of Ukraine, development partners, civil society, and private sectorrepresentativesheldbetweenAprilandDecember2016.SpecialthanksareduetotheMinistryofFinance,MinistryofEconomicDevelopmentandTrade,andkeylineministriesfortheircontributionsto initial discussions on the evidence base and findings and subsequent consultations on thepathwaysandprioritiesidentifiedinthedraftreport.TheSCDwaspreparedbyateamoftechnicalandpolicyexpertsnominatedbyPracticeManagersacrosstheGlobalPractices,IFC,andMIGA.ThetableofSCDteammembersandfocalpointsandtheirrespectivepracticemanagersisbelow.TheworkoftheSCDwassteeredbyaninformaladvisoryGroup comprising the Country Director (Satu Kahkonen and previously Qimiao Fan), GallinaVincelette/Ivailo Izvorski (MFMPracticeManager),CarolinaSanchez(PovertyPracticeManager),RufatAlimardanov(IFCCountryManager),KartickKumar(IFCStrategyOfficer),AlejandroCedeno(CPC),FengZhao(HDProgramLeader),LudmillaButenko(SDProgramLeader),FarukKhan(LeadEconomistandEFIProgramLeader,co‐TTL),andCaterinaLaderchi(SeniorPovertyEconomist,co‐TTL).Thanksaredueforcommentsandsuggestionsreceivedatvariousstagesoftheanalysisfromthepeerreviewers(GallinaVincelette,LarsSondergaard,andSebastianEckardt),practicegroups,andotherswithintheWorldBankGroup.ThisreportwaspreparedundertheoverallguidanceofCyrilMuller (Regional Vice President, ECA), Satu Kahkonen (Country Director), and Tomasz Telma(Director,IFC).

UKRAINESCDTEAM

GlobalPractice FocalPoints/TeamMembers PracticeManager

CountryDirector:SatuKahkonenCMU:AlejandroCedeno,KlavdiyaMaksymenko

Macroeconomics&FiscalMgmt.

FarukKhan(co‐TTL),AnastasiaGolovach

IvailoIzvorski/GallinaVincelette

PovertyCaterinaRuggeriLaderchi(co‐TTL),MikhailMatytsin

CarolinaSanchez

Finance&Markets VaheVardanyan,YevhenHrebeniuk AuroraFerrari

GovernanceOleksiiBalabushko,IrynaShcherbyna,IrinaShmeliova,NataliaManuilova,DavidBernstein,AmitMukherjee

AdrianFozzard,HibaTahboub,SoukeynaKane

Trade&Competitiveness HeinzStrubenhoff;EugeniuOsmochescu LisaKaestner

EducationIgorKheyfets(EducationPER)andXimenaDelCarpio(SkillsReport)

CristianAedo

Health,Nutrition&Population FengZhao

EnisBaris

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SocialProtectionandLabor

KaterinaPetrina,NithinUmapathi,YuliyaSmolyar,OleksiySluchynskyy

AndrewMason

Agriculture PeterGoodman MarianneGrosclaude(Acting)

Energy&ExtractivesAniBalabanyan,DmytroGlazkov,ElinaHokkanen

RanjitLamech

Environment&NaturalResources AlexeiSlenzak KulsumAhmed

Social,Urban,Rural&Resilience(SURR)

LudmillaButenko(UrbanandDRM),HollyBenner(Social)

DavidSislen(UrbanandDRM),NinaBhatt(Social)

Transport&ICT SimonEllis JuanGavira

Water WilfriedHundertmark StevenN.Schonberger

IFC KartickKumar,ElenaVoloshina RufatAlimardanov

MIGAFranciscusJohannesLinden,PaulBarbour

DanBiller

UKRAINE SYSTEMATIC COUNTRY DIAGNOSTIC...in a serious economic crisis in Ukraine in 2014‐2015. The...

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