Report No. 44984-UA Ukraine Competitive Agriculture or State Control Ukraine's Response to the Global Food Crisis May 2008 Europe and Central Asia Region Sustainable Development Unit Document of the World Bank Table of Contents Acronyms and Abbreviations ....................................................................................................... v Summary for policy makers ....................................................................................................... .. VII A. The globalfood crisis ........................................................................................................... 1 Agricultural commodity price developments ............................................................................................ 1 The impact ofrising commodity prices..................................................................................................... 3 Governmentresponsesworld-wide........................................................................................................... 4 B. The impactof a changingworld situation on Ukraine and local responseso far ........6 Foodprices. inflation. and poverty in Ukraine.......................................................................................... 6 The response of the Ukrainiangovernmentto increasingfood prices and inflation.................................. 8 Ukraine's agriculturalproductionand trade duringthe periodof increasingworld food prices..............I O Economic impact of world food price increase on Ukraine's consumers and producers within policy framework beforeApril 2008 .................................................................................................................. 11 Export revenues and investment incentives resulting from the decision (April 2008) to relax export restrictionsinthe grain sector .................................................................................................................. 15 C. When will Ukraine take its foot off the brake and why should it? ................................ 16 Impact of Ukrainianpolicies on the world until March2008.................................................................. 16 Ukraine's potentialfor increasingagriculturalproductionand trade....................................................... 16 Expectedeffects ofthe full removalof export restrictionsin the agriculture sector ............................... 17 D. BuildingUkraine's export.oriented. competitiveagriculture sector ............................ 20 An attempt to formulate a vision ............................................................................................................. 20 Current state programsto support the agriculture sector......................................................................... 20 Policy and institutionalframework.......................................................................................................... 21 Public investments................................................................................................................................... 22 E. Measuresto protectthe poor and vulnerable from food price increases ...................24 Briefassessment o f social assistance programs in Ukraine..................................................................... 24 National-levelresponse to rising food prices and preparedness.............................................................. 25 References .................................................................................................................................... 27 .111. ... Figures Figure 1: Real wheat prices (in 1995 US$/t. 1866-2008).................................................... 1 Figure 2: Daily wheat prices and price changes (MATIF wheat futures, nearby contract, March1998-April 2008) .................................................................................. 2 Figure 3: Exploitable yield gaps for wheat: actual versus obtainable yield ........................ 5 Figure 4: The CPI and its main componentsinUkraine (January 2001 - March2008).....7 Figure 5: Monthly exports of wheat and barley from Ukraine (million tons, January 2006 -March2008)..................................................................................................... 9 Figure 6: Prices and FOB-EXW spreads for feed wheat in Ukraine (US$/t. July 2004 January 2008).................................................................................................... . 12 Figure 7: Wheat. flour and breadprices before and after the introduction of export quotas .......................................................................................................................... 13 Figure 8: Wages in agriculture and the economy as a whole (January 2007 . 2008) ................................................................................................................. February 14 Figure 9: Simulation of gross marginsha o f wheat-producing farms in 2006. three scenarios............................................................................................................ 18 Tables Table 1: Food CPI Disaggregation in March2008.............................................................. 6 Table 2: History of cereals export restrictions in Ukraine since September 2006 (all amounts in 1000tons)......................................................................................... 8 Table 3: Production of major crops inUkraine. 2002-2008.............................................. 10 Table 4: Grain and wheat supply/demand balances in Ukraine (million tons. 2003/04 - 2007/08)............................................................................................................ 11 Table 5: Grainproduction potential inUkraine. alternative scenarios............................. -16 .iv. Acronyms andAbbreviations CMU Cabinet of Ministers of Ukraine CPI Consumer Price Index EBRD EuropeanBank for Reconstruction and Development ECA Europe and Central Asia EU EuropeanUnion F A 0 Food and Agriculture Organization FOB Free on Board FTA Free Trade Agreement GDP Gross Domestic Product HMT Hybrid Means Test IFPRI International Food Policy Research Institute IKAR Institutefor Agricultural Market Studies MAP MinistryofAgricultural Policy MTAIF Marche A Terme International de France NBU National Bank of Ukraine OECD Organization for Economic Cooperation and Development UAH Ukrainianhryvnia us UnitedStates USA UnitedStates ofAmerica USDA UnitedStates Departmentof Agriculture WTO World Trade Organization - v - - vi - Summary for policy makers World market prices for grains and oilseeds have risen dramatically over the last 24 months. Despite a recent drop, wheat prices are still about twice what they were two years ago. Given the underlying causes, this situation is likely to persist for the medium term (IFPRI and World Bank projections use a time horizon until 2015). Rising food prices are causing significant hardship worldwide and threatening to cast large numbers of people into poverty. However, the current situation is a major opportunity for Ukraine, a net grain exporter with a significant exploitable yield gap and one of the few countries in the world that are in a position to significantly increase net exports and make up for emerging deficits elsewhere. With appropriate policies and investments, Ukraine could significantly increase its grain harvest and gain global market share in an environment of rising global demand. Even relatively conservative estimates of growth in yields and acreage indicate that a regular harvest of over 40 milliontons would be possible. Seizing this opportunity would require a shift inpolicies and corresponding increasesinprivate andpublic investment. Government policies to date have failed to seize this opportunity. Indeed, Ukraine's main reaction to the global increase in food prices has been to introduce grain export restrictions. Together with the oilseed export tax and recent export quotas for sunflower seed oil, these restrictions are estimatedto have cost producers over US$ 2 billion in the 2007-08 marketing year to date. These are revenues for rural producers that could have been used to purchase improved inputs, upgrade the storage and handling infrastructure, and improve farming technologies and farm management skills. The Government's decision to increase grain export quotas in April 2008 is a step towards removing agricultural disincentives. The increaseof export quotas for wheat by 1 million tons and for barley by 0.5 million tons i s expected to generate some US$ 500 million in additional export revenues, equivalent to 0.3% of GDP. It also expected to provide critical relief to a tight global wheat market. However, as long as export restrictions remain inplace and the risk of their extension into next year remains, farmers will invest less than they could and international trade relations includingthe negotiation o f new agreements could be negatively affected. Rising food prices do create a difficult macroeconomic and social policy challenge. In some countries, rising food prices have caused political turbulence. Generally, the poor are more vulnerableto inflation and food price inflation inparticular, because they spend a larger proportion of their incomes on food, and are more dependent on wage incomes and transfers. However, because of large nominal increases in average wages and social transfers at the beginning of the year, the impact of rising food prices on poverty i s likely to have been muted in Ukraine. Without these increases, the poverty rate measured against an internationally comparable poverty line of US$ 2.15 a day would have risen from 3.1% to 17.6%. While the global increase in food prices has played a role, the underlying cause of inflation in Ukraine is that the economy is overheating. Domestic consumption has been - vii - growing at twice the rate of GDP growth in the past three years; the current account has widened by 15% of GDP since 2004; domestic credit i s growing at some 70% year on year; and nominal current spending o f the budget was up 68% in January 2008. The de facto peg of the Hryvnia against the US dollar has meant furthermore that increases in international commodity prices denominated in dollars have been transmitted directly into Hryvnia. In other emerging markets, appreciating currencies have buffered these increases. The Government should refrain from further upward spending adjustments in the 2008 budget and instead save additional revenues to cool the economy. The National Bank should introduce greater exchange rate flexibility and thus allow monetary policy to react to global price shocks. The world food crisis both poses challenges and presents opportunities for Ukraine. The solution to the challenges lies in appropriate macroeconomic policies and targeted social support, not ininterventions infood markets. Measures to protect the poor and vulnerable from food price increases need to be separated from agricultural market policy, so that Ukraine can seize the emerging opportunities: (i)Anappropriate agriculturalpolicy framework andpublic investmentprogramwould provide incentives for further and critical private investments needed to build Ukraine's export-oriented and competitive agriculture sector. Increased productivity in agriculture would also make Ukraine less vulnerable to low harvests. Ukraine's accession to the WTO and the beginning o f negotiations on a free trade agreement with the EU will provide key impetus to the requiredreforms, and the Ministry o f Agricultural Policy has taken several initial steps. Key reform and investment areas include: (a) trade policies (including refraining from export restrictions); (b) transport, storage (c) market information infrastructure and agricultural statistics; (d) institutional framework for land market; (e) access to finance and risk management instruments; (0 research and extension, and vocational training o f agricultural specialists and farm managers; (g) veterinary and food safety control system compliant with regulations intarget markets. (ii)Thenegative impact ofincreasing domestic foodpricesshould becushioned with targeted social assistance programs, complemented with tighter macroeconomic management to reduce overall inflation, ensuring that the gains from responding to this important economic opportunity for Ukraine are more equally shared. Ukraine already operates a number o f targeted social transfer systems that are quite efficient at identifying and supporting the most vulnerable. For instance, the "last resort" program for the very poor has a targeting efficiency o f 73% among the poorest fifth o f the population. Support to single mothers and to young (0-3 years) children i s also effective. These programs could be scaled up to support those most affected by rising food prices. This would be cheaper and more sustainable than the blanket increases in all social payments implementedin recent years. At the same time, numerous benefits that do not effectively target the poor, such as housing subsidies, could be scaled back. Ukraine i s in a position to make a significant contribution to the international effort to deal with the food crisis, while providing attractive investment and employment opportunities inthe agriculture sector (inrural areas) that are expected to yield significant income, trade and fiscal benefits. - viii - A. The global food crisis Agricultural commodity price developments 1. After a long decline in real terms, world market prices for grains and oilseeds have risen dramatically in recent months. Figure 1 illustrates the long-term trend for wheat and Figure 2 (next page) presents daily price data and its fluctuations for the recent past. These increases are the result of supply-side and demand-side shifts that have accumulatedover the last decade andthat have beenaccentuated inrecent years. Figure 1: Realwheat prices(in 1995 US$/t, 1866-2008) I000 World War I 900 I. 800 700 - 600 i % 500 2 ' 400 300 200 100 wrce: Antle, JM, and V.H.Smith, eds. (1999). The Economics of World Wheat Markets. Oxon, UK: CAB International; USDA; own calculations. Note: The 2008 price is an average ofprices in January through April. 2. On the supply side, rising energy prices have influenced world food prices by increasing costs of production (e.g. tractor fuel, fertilizer) and trade (e.g. transportation). Coupled with this, production has been lower than expected due to adverse weather conditions inthe last two years in several key production regions (such as Australia and Ukraine). those with large populations such as China and India - has led to increased demand 3. On the demand side, income growth in many emerging economies - especially for meat and dairy products. Since it takes significantly more than one kg of feed to produce one kg of meat or liter of milk, demand for grains and oilseeds has grown disproportionately. Demand for agricultural feed stocks for biohel production (vegetable - 1 - oils to produce biodiesel, and sugar and grains to produce bioethanol) has also surged in recent years. Figure 2: Daily wheat prices and price changes (MATIF wheat futures, nearby contract, March 1998 - April 2008) 450 I 200 -Wheat price - No.2 Hard, Kansas - 150 p t? c 350 U 88 h .-3 v) 0 .- 250 100 $ & P C 0 150 50 F al 6m 50 0 -50 I ' I -50 31.12.99 31.12.00 31.12.01 31.12.02 31.12.03 31.12.04 31.12.05 31.12.06 31.12.07 Source: World Bank DECPG. 4. Together, these supply and demand shifts have led to a situation in which world grain consumption has exceeded world grain production in seven of the last nine years. The resulting shortfalls have been compensated by a steady reduction in global cereal stocks, which at roughly 20% (equivalent to 10.4 weeks) o f global consumption are currently at their lowest level since the early 1970s'. Such reductions in stocks cannot continue indefinitely, and markets have responded to the increasing scarcity o f grain on world marketswith increasing prices. 5. Price volatility has also increased sharply. Low stocks make markets highly sensitive to new information about supply and demand. Sudden policy changes by governments (such as export restrictions in response to increased food prices, or new biofuel subsidies) and increasing climate variability and its impact on crop performance, as well as increased speculative interest in agricultural markets, have thus contributed to a significant increase inprice volatility (Figure 2 above). ' FAO, 2007. Food Outlook, November 2007. - 2 - 6. The observed increasein food prices is not a temporary henomenon,but likely to persist for the medium term. Food crop prices are expected to remain high in 2008 Y and 2009 and then beginto decline as supply and demand respondto highprices; however, they are likely to remain well above the 2004 levels through 2015 for most food crops. While other major organizations (IFPRI, FAO, OECD, USDA) that regularly monitor and project commodity prices broadly concur with these projections, long-term price forecasts are notoriously difficult to make. Besides the supply and demand side factors listed above, the future rate oftechnical change, climate change, and land and water degradation are key factors determiningthe prospects o f increased food production. The impactof risingcommodity prices 7. Rising agricultural commodity prices have fed into sharp food price increases and fueled overall inflation in recent months. Rising commodity prices do not necessarily translate into immediate and proportionate rises in domestic food prices, due to differences in macro-economic and exchange rate policies, as well as labor, energy and transportation costs. They nonetheless have fueled a sharp food price increase in recent months. In 2007, food price increases accounted for almost 70% o f 2007 aggregate inflation in emerging econ~mies.~ InEurope and Central Asia (ECA), food price inflation has been the main factor behindrising overall inflation, with aggregate inflation increasing from 6 percent in2006 to about 10 percent in2007, food inflation from 6.4 to 14.8 percent. 8. The impact of risingfood priceson developingcountries real incomes and terms of trade has varied. In many countries parallel increases in other commodity prices has offset the impact o f rising food prices on the terms o f trade. At the same time, growth in the world economy has remained healthy, driven in particular by emerging markets, and hence real income gains have often offset the impact o f higher food prices on household budgets. 9. The poor are generally more vulnerable to food price inflation. Poor households spend a higher share o f their incomes on food than better-off households, so food price inflation reduces their incomes proportionately more. Households also benefit or lose as a result o f higher prices depending on whether they are net producers or consumers o f staple foods and the extent to which their wages adjust to higher prices. But even when poor people are engaged in agricultural production, the rise in input costs and market imperfections have meant that they have not always benefited from higher output prices. Preliminary estimates o f the global impact o f recent food price rises suggest that u to 100 millionpeople indeveloping countries could fall into poverty inthe next 6 months. Y 2 See, for example, World Bank, 2008. Rising food prices: Policy options and World Bank response; httD://siteresources.worldbank.org/NEWS/Resources/risingfoodDrices backgroundnote apr08.pdf. Or: IFPRI, 2008: http://www.i~ri.orgithemes/foodprices/foodprices.asp IMF (2008): Impact of High Food and Fuel Prices on Developing Countries - FAQs. http://www.imf.ordexternal/ndexr/faa/ffDfaas.htm. Ivanic and Martin (2008):- Implications -of Higher Global Food Prices for Poverty in Low-Income Countries. The World Bank, Washington DC. - 3 - 10. As a result, risingfood prices have led to political unrest and violence. In many developing countries, rising food prices have led to protests and riots. Roughly 40 countries have been affected, and in the prominent case of Haiti, the Prime Minister was removed from office following food riots that left many dead and injured. Governmentresponsesworld-wide 11. Given the political sensitivity of food prices, many governments have reacted quickly to the global rise in food prices. Policy interventions can be divided into three broad categories: (i)Increasing food availability in households through direct (income) transfers in cash or kind. Measures ensuring household food security by strengthening targeted safety nets include targeted cash transfers to vulnerable groups, food-for-work programs, emergency food aid distribution, and school feeding programs; (ii)Reducing domestic food prices through short-run trade policy measures or administrative action, including the reduction of import tariffs and taxes, grain or bread subsidies, domestic price controls, state procurement and distribution, and export taxes or export restrictions; and (iii)Stimulating a domestic food production and marketing response, improving food supply in the long term, by enhancing agricultural production systems including research, extension, and information systems, and by strengthening post-harvest management, marketing infrastructure, and access to finance and risk management instruments. 12. Measures to increase household food availability support the poor without distorting domestic incentives to produce more food, and without reducing the incomes of poor food sellers. Hence, they address the symptoms of the food price crisis without impairing the mechanismsthat must function to solve this crisis inthe mediumand long run. However, measures in this category can be administratively costly and comparatively difficult to implement. 13. Measuresto reduce domestic pricesare sometimes easier to implement,but they have the decisive disadvantage that they reduce incentives for domestic production. Hence, they mask the symptoms of the food price crisis while hindering the cure. Furthermore, these measures also provide unnecessary benefits for the middle and upper classes. In recent months, many food exporting countries - including Ukraine - have resorted to export restrictions. Along with the domestic disadvantages listed above, such measures further increase the level and volatility of world market prices, adding to suffering amongthe truly needy worldwide. 14. In the long run, only a significant and sustained increase in food production can relax markets and ensure affordable food for all. According to FA0 (Food Outlook, Nov. 2007), an additional 1 billion tons of cereals will be needed by 2030. This can only be achieved ifthe right incentives frameworks through appropriate agricultural policies are establishedworldwide, and especially inhighpotential countries such as Ukraine. 15. Only very few countries are in a positionto significantly increasenet exports and make up for emerging deficits elsewhere. Increases in agricultural output can be achieved through the expansion of arable land-use or through intensification. F A 0 estimates that more than 80 percent of the projected expansion in arable area i s expected to - 4 - take place in sub-Saharan Africa and Latin America. While this expansion will bear its own environmental risks (esp. through the destruction o f rain forests), only 20 percent o f the overall increase incrop production will come from expansion anyway. The largest part, 80 percent, will have to come from intensification through higher yields per crop and more crops per year (multiple cropping, reduced fallow). Figure 3 shows for the example o f wheat that Ukraine i s a country with a significant exploitable yield gap. A recent EBRD/FAO report' identifies Kazakhstan, Russia and Ukraine as some o f the few countries where both an expansion o f arable land-use and considerable intensification could take place without serious environmental consequences. As net exporters o f grains and oilseeds these three countries could have a crucial impact on the world food situation, while realizing significant gains in terms o f export revenue, economic growth and rural development. Figure 3: Exploitable yield gaps for wheat: actual versus obtainable yield 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.o 0.0 Germany Ukraine USA Turkey Ethiopia Brazil Argentina Tanzania Source: FAO, 2002. Worldagriculture: towards2015 / 2030. Updated,pers. communicationwith FAO. EuropeanBank for Reconstructionand Development/ Food and AgricultureOrganization(2008): Fighting Food Inflation through SustainableInvestment.London. - 5 - B. The impact of a changingworld situation on Ukraine and local response so far Food prices,inflation, and povertyin Ukraine 16. Food prices have a significant share in average consumer expenditures in Ukraine and hence dominate CPI dynamics. Food (including beverages and alcohol) represents 58.4% o f the CPI basket and food price inflation reached 42.2% year-on-year in March 2008. This accounts for 93% o f the overall CPI inflation of 26.2% year-on-year. Ukraine's food price inflation and the share o f food inthe total CPI are higher than inmost middle income countries. 17. Ukraine effective dollar peg has meant that increases in commodity prices, fuelled by dollar weakness, have not been buffered by nominal appreciation as in many other emerging markets. Figure 4 (next page) shows how food price inflation accelerated since mid-2007, reflecting global trends, but also a poor harvest in Ukraine as can be seen from the large increase in fruit and vegetable prices (Table 1). At the same time, large gains in other commodity prices (inparticular metals) have been reflected in a similar increase inproducer price inflation and the GDP deflator. Table 1: Food CPI Disaggregationin March 2008 Share in the CPI Growth, % y/y Contribution, Contribution, food basket P.P. % Food 100.0 42.5 42.50 100.0 Bread and cereals 16.9 30.9 5.22 12.3 Meat 25.2 36.4 9.16 21.5 Fish 8.9 14.3 1.27 3.0 Milk 2.9 39.8 1.15 2.7 Cheese and curd 3.2 39.4 1.25 2.9 Eggs 2.0 62.9 1.28 3.0 Butter 2.4 39.8 0.95 2.2 Edible oil 3.6 115.7 4.12 9.7 Fruit 6.1 100.5 6.08 14.3 Vegetables 9.7 65.5 6.35 15.0 Sugar 4.4 20.7 0.91 2.1 Other 14.8 4.73 11.1 Source: State Statistic Committee and own calculations - 6 - Figure4: The CPI and its maincomponentsin Ukraine (January 2001-March 2008) 0Services -____ Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 Source: State Statistics Committee of Ukraine; own calculations. 18. However, the underlying reason for the rapid increase in inflation is that the Ukrainian economy has been overheating. Domestic consumption has been rising at an average rate of over 13% in 2005-07, muchhigher than GDP growth. The current account has deteriorated from a 10.6% of GDP surplus to a 4.2% of GDP deficit. Against this background, fiscal and monetary policies have been too loose. Nominal budget spending was up 68% in January 2008, private sector credit grew 72% in February, and nominal wage growth in the economy was 38.4% on average in March. Large capital inflows throughout 2007 led to heavy interventions by the NBU in the context of a de facto dollar peg driving money growth to 50% y-0-y. While net capital inflows have slowed since the start o f the year and the budget has run a cash surplus inthe first four months, inflationary expectations have risen and will require more concerted action to be brought back down. The National Bank of Ukraine (NBU) calculates a core price index net of food, energy and other administered prices, which shows an increase in core inflation from 2.5% in 2006- 2007 to 5.5% by March2008. 19. Because of fast risingreal incomes, the impact of food price inflationon poverty has been muted. Simulations using the 2006 household budget survey show that a 30% increase in food prices, uncompensatedby any income gains, would push the poverty rate (measured as incomes below $2.15 per day inPPP terms) from 3.1% to 8.6%. A 50% price increase would raise this to 17.6%. With the average wage rising approximately at the same rate as food prices, average poverty impact of food price inflation is expected to be negligible. However, given that a larger share of the rural population is below or close to the poverty line comparedto urban, and given that higher agricultural commodities prices - 7 - have not translated into higher agricultural wages (see below), the rural population i s more negatively affected by rising food prices. The responseof the Ukrainiangovernmentto increasingfood prices and inflation 20. The primary response of the Ukrainian Government to rising food prices has been to implement grain export quotas. Export quotas were first introduced in late September 2006 (Table 2). In spring and June of 2007, the quotas were abolished for corn and barley, respectively. But they were re-implemented in July when it became clear that the harvest would be low due to drought and high temperatures.The quota volumes set for the 2007/08 marketing year were so low as to effectively ban exports altogether (Figure 5, next page). In late April 2008, export quotas for wheat and barley were extended to July 2008, but also increased, from 0.2 to 1.2 million tons and from 0.4 to 0.9 million tons, respectively. Table2: Historyof cereals export restrictionsin Ukrainesince September 2006 (all amounts in 1000tons) 2007 Export quotas for wheat cancelled - 3 748 June 20, New Export quotas introduced for 2007 July 01 until 01Oct2007 3 3 3 3 844 September Export auotas extendeduntil 26: 2007 01Nov2O07 3 3 3 3 1179 October 3 1, Export quotas extendeduntil 2007 3 1Dec2007 3 3 3 3 1287 September New export quotas introduced, for 26,2007 01Jan2008 until 3 1Mar2008 200 400 600 3 1179 March 28, Export quotas extendeduntil 2008 30Apr2008; for maize abolished as of 01 Apr, only licensing until 01Ju12008 200 400 - 3 271 April 23, Export quotas for wheat and barley 2008 increased and extendeduntil 01Ju12008 1200 900 - 3 418 Total for 2007/2008 MY 1203 903 603 6 Source: Resolutions of the Cabinet of Ministers, Government of Ukraine. - 8 - Figure 5: Monthly exportsofwheat and barleyfrom Ukraine (milliontons, January 2006 -March 2008) 2500 W Wheat Barley Corn 2000 1500 8 L = I I 8 1 - 1 1 I I , 1 1 1 I - 21. Export quotas are administeredas follows.6 The Ministry o f Economy announces a call for applications for export quotas. Within 11 days of the announcement, traders must submit applications that include copies of export contracts that justify the requested volume, together with a state registration certificate and certification from the Ministry o f Agrarian Policy that the trader does have the grain in question. After all applications have been checked, a special commission distributes the available quota to the traders in proportion to the volumes that they have requested. This system creates powerful incentives for rent-seeking. 22. Local administrations are empowered to control flourhead margins in the bakery industry. A Cabinet resolution allows local administrations to set maximum margins for bakeries. Arrangements are oblast and city specific. In practice, 10% is the maximum margin, 5% i s commonly used, and there are cases inwhich marginsare smaller than 5%. If the fixed margin becomes unbearable for the bakeries in a region, they negotiate with local administrations. Inaddition, local administrations provide subsidiesto bakeries to ensure that they (i)can purchase cheaper graidflour early inthe season, and (ii) use these subsidies for 3 to 5 most commonly purchasedtypes o f bread. 6CMU Regulation#1179of 26.10.2007, with changes and amendmentsof 23.04.2008. - 9 - Ukraine's agricultural production and trade during the period of increasingworld food prices 23. Ukraine's yields and production of major grains has stagnated since the 2004/05 harvest, and fell sharply due to drought in 2007/08. Production o f oilseeds, especially rapeseed, has seen significant expansion, however primarily based on increased acreage rather than significant average yield increases. The forecast for 2008/09 i s currently positive, with wheat expected to rebound to the highest level o f production since 2002/03, and acreages and yields o f all crops expected to increase over the previous year (Table 3). Year I 02/03 I 03/04 I 04/05 I 05/06 1 06/07I 07/08I08/09" production(mil1. t) 3.50 4.59 3.40 5.05 5.75 4.86 5.31 Rapeseed acreage (ha) n.a. 54 106 202 405 945 1605 yields-(t/ha) n.a. 0.94 1.17 1.43 1.61 1.17 1,49 production(mill. t) Nu 51 124 289 652 1106 2391 Source: UkrAgroConsult. * 2008/09forecastas ofApril 20, 2008. 24. Export quotas have reduced export volumes and led to an increase in grain stocks in Ukraine to levels that are considerably higher than was the case in the past. With closing stocks o f 3.27 million tons o f wheat and 4.17 million tons o f grains total, Ukraine now stores 26.5 percent and 15.4 percent, respectively, of its annual demand (Table 4, next page), which i s broadly in line with the global average o f 20 percent of cereals stocks to use ratio. - 10- -Table 4: Grain and wheat supply/demandbalances inUkraine (million tons, 2003/04 2007/08) I Source: UkrAgroConsult Economicimpact of world food price increaseon Ukraine'sconsumers and producers within policy framework beforeApril 2008 Producers and exporters 25. As a result of the export quota system, farmers have sustained significant losses (foregone revenues). Before the introduction o f export quotas in September 2006, the spread between export prices and ex-warehouse prices for wheat in Ukraine averaged US$ 17.25 per ton. Since the introduction o f the quota, this spread increased to US$ 85.36 per ton on average. When exports were effectively eliminated in July 2007, the spread even rose to almost US$ 134 /t (Figure 6, next page). Given a wheat crop o f 13.7 million tons, the roughly US$ 116 /t o f excess spread in the 2007/08 marketing year alone represented almost US$ 1.6 billion foregone farm revenues7. For barley, the corresponding foregone farm revenueamounts to US$ 326 million for the same year. 26. Some of these losses appeared as rents for those traders who were able to secure export certificates. For wheat, multiplying the excess spread in each month since the quotas were implementedby the corresponding volume o f exports leads to an estimate o f US$ 48.0 million for wheat (US$ 47.3 million for barley) between September 2006 and March 2008. The remainder o f the producer losses largely accrues as benefits to the domestic feed and food processing sector, such as the poultry and flour industries, and to consumers. 7 Some of this effect must be attributed to legitimate increases in the spread that are due to energy price increases, and not export restrictions.However, energy prices only account for part of the exw-fob spread, andthey have not increasedat nearly the same rate as the spread. - 11 - Figure6: Prices and FOB-EXW spreads for feed wheat in Ukraine(USW,July 2004 -January 2008) $450 Consumers and workers 27. Almost simultaneouslywith the implementation of the export quota system, the margin between millingwheat prices and flour prices rose significantly (Figure 7, next page), from an average of US$ 60.1 per ton up to September 2006, to an average of US$ 90.3 per ton from October 2006 onwards. This suggests that the milling industry (which is regionally highly concentrated in Ukraine) took advantage o f the situation on wheat markets to expand its margins. The flour-bread margin fell at almost the same time, from US$ 137.3 per ton before to US$ 110.9 per ton after the implementation of the export quota system. Presumably, support from local administrations to bakers has compensated this reduction in margins to some extent. Since the milling-baking chain displays a high degree of vertical integration and concentration at the local level in Ukraine, price and margin determination is not transparent and often not competitive. Note that the Anti- Monopoly Commission has recently fined a number of enterprises in the flour-bread complex for setting bread prices too high, and for collusion. -12- Figure7: Wheat, flour and bread prices before and after the introduction of export quotas 600 500 400 h E e .-3 300 z 200 100 0 2005-Jan 2006-Jan 2007-Jan 2008-Jan Source: UkrAgroConsult, State Statistics Committee, own calculations. 28. A 17% tax on exports of sunflower seed has been significantly reducing farm revenues for many years. A rough estimate of this impact in the 2007/08 season alone indicates that farms have lost about US$660 million due to the export tax (based on a crop of 4.86 million tons, and a difference of US$137/t betweenthe average EXW price inthe season to date of US$ 670/t, and the price of US$807/t that would have prevailed without the tax, all other things being equal). Recently, quotas have been introduced on exports of sunflower seed oil. These quotas will have generated quota rents analogous to those for wheat and barley mentioned above.' 29. The grain and sunflower seed export restrictions have had some effect on restraining domestic consumer price growth. Note from Table 1that the share of cereals and bread in the food CPI i s 16.9%. Full transmission of the rough doubling of international grain prices into increases in domestic prices of wheat and bread would have added 6.1 percentage points to annual CPI inflation in 2007'. Another way of quantifying It is reportedthat two companieshave receivedover 50% of the allocatedquotas. This is based on the following calculations: Global wheat prices are up roughly 100% y-0-y. Domestic cereal and bread prices were up only 3 1% y-0-y. Hencethe additionalimpact o f a full pass through would be 70%. This multiplied by the share o f bread and cereals in the total CPI (8.8%) gives 6.1 percentage points additionalCPI inflation. -13 - the magnitude of this effect is to consider the revenue losses to producers due to export restrictions in 2007/08 (estimated at roughly US$ 1.8 billion for wheat and barley, net of quota rents, plus US$ 0.66 billion for sunflower seed) on a per capita basis. Assuming that these losses for producers are fully passed on as reduced food expenditure to consumers, the resulting savings amount to roughly US$ 52.30 per year and citizen of Ukraine. However, to the extent that the price controls reduce potential output, there are losses to the economy that provide no gains to consumers at all. As emphasized elsewhere in this note, the proper instrument to deal with inflation are tighter fiscal and monetary policies, and the appropriate reaction to the social costs of higher food prices are targeted social transfers. Both measures are clearly available to the Ukrainian authorities. 30. There is no indication that higher food prices have resulted in higher wage increases for agricultural workers. While agricultural wages have increases since early 2007 (Figure S), they have grown at almost exactly the same percentage rate as average wages in the economy as a whole. Hence, in absolute terms, the gap between average wages and agricultural wages has actually increased- a surprising development given the relative increasesinagricultural output prices and earnings. Figure 8: Wages in agriculture and the economy as a whole (January 2007 - February 2008) 2000 1800 +Total 4-Aariculture 1600 1400 C - 3 .-C i?.-1200 z.1000 5 v) 800 2Q) 0, 600 400 _ -- _ . -__- -__ ____ - 200 - -~ 0 Source: State Statistics Committee; own calculations. - 14- Export revenues and investmentincentivesresultingfrom the decision (April 2008) to relax export restrictions in the grain sector 3 1. Increased grain exports resulting from the relaxation of export restrictions will generate around US$ 500 million in additional export revenues by June 2008. As of April 23, 2008, export quotas have been increased by one million tons for wheat and 0.5 million tons for barley. Against the backdrop of an expectedrecordharvest, this increased export opportunity is likely to be taken, leadingto an additional US$ 150million in export revenues for barley and US$ 350 million for wheat at current prices. The total of US$500 million additional export revenues is equivalent to 0.3 percent of GDP and can contribute to reduce Ukraine's fast growing current account deficit. 32. The relaxation of export quotas should further lead to a significant increase in farm gate prices for grain in Ukraine and create incentives for private investments. The excess spread discussedabove would be expectedto disappear,providingfarmers with improved income opportunities and incentives for investments. In the medium-term, Ukraine couldprobablyproduceand export even larger grainvolumes (see next chapter). - 1 5 - C. When will Ukraine take itsfoot off the brake and why should it? Impact of Ukrainianpolicieson the world untilMarch 2008 33. By restricting exports of grains and oilseeds / vegetable oils, Ukraine has, along with countries such as Argentina, Kazakhstan and Russia, contributed to record world market price levels. As a result o f export restrictions in these countries, a number of other countries world-wide must adjust to a larger food shortage. In response to the proliferation o f such export restrictions in recent months, Japan announced in late April that it would ask the WTO to introduce new rules to prevent countries from restricting exports o f key staple products inthe future. 34. With world markets for these products tight, Ukraine does have a certain degree of influence on world market prices in the short run. However, Ukraine would be ill- advised to attempt to exercise this influence by purposely reducing exports in the long run in an effort to drive up world market prices and thus export revenues, either alone or in concert with some form o f 'grain cartel'. Ethical considerations aside, Ukraine's market power i s limited in the long run and the fundamental structure o f world grain markets differs considerably from that on, for example, oil markets. The exercise o f market power on world food marketshas never functioned sustainably inthe past. Table 5: Grain production potential in Ukraine, alternative scenarios Transitionperiod IKARforecast for 2016/17 Estimated maximum potential avg avg PA) IKAR Difference (%) Maximum Difference (%) 1992/ 2004/ forecast IKAR vs. potential max. pot. 94 06 present vs. 2004/06 Yield W a ) 2.96 2.64 -11 2.75 0.1 4 4.5 1.86 71 Area (mio. ha) 13 14 8 16 1.9 13 17 3 21 Product. (mio. t) 37 37 1 44 6.7 18 75 38 103 I I I ource: European Bank for Reconstruction and Development / Food and Agriculture Organization (2008, Fighting Food Infation through Sustainable Investment. London. Own corrections. Ukraine's potential for increasingagricultural production and trade 35. Both yields and agricultural areas in Ukraine could expand considerably if farmers were subject to appropriate incentives. On the occasion of a regional conference on "Fighting food inflation through sustainable investment" in London in March 2008, FA0 in collaboration with EBRD prepared an updated assessment of regional grain production and its potential. According to these analyses, average grain yields fell by 11% in the transition period, from 2.96 to 2.64 t/ha between 1992/94 and 2004/06. The IKAR forecast in Table 5 (above) calls for a relatively modest increase of 4% to 2.75 t/ha -16- by 2016, while the maximum potential projection based on yields in France corrected for the fact that Ukraine receives less precipitation suggests that a 71% increase to 4.5 tha i s possible. Combined with acreage expansions of 13% (IKAR forecast) and 21% (maximum potential projection), these yield increases would lead to an expansion in production of between 18 and 103%. Similar forecasts and projections could be generatedfor oilseeds. 36. While the IKAR forecasts in Table 5 appear relatively conservative, the maximum potentialprojections should not lead to a sense of complacency. Compared with almost two decades of talk about agricultural potential inUkraine, actualperformance has been disappointing, as other transformation economies with less natural advantages in agriculture have done much better. Whether or not existing potential is finally realized depends largely on policy decisions taken inUkraine. 37. Increased production would largely translate into increased export potential. Domestic demand in Ukraine will not significantly limit exports if production increases. First, the overall population of Ukraine is forecast to decline. On the other hand, regional per capita incomes will increase, and resulting increased meat consumption will boost demand for feed grains. However, this will likely be offset by improved feed conversion ratios. Overall, domestic demand will increase slowly relative to forecast growth in grain production. 38. The absorptive capacity of world markets is high, and will not limit Ukraine's ability to export. According to FAO's Food Outlook (Nov. 2007), Ukraine currently is the 8th largest exporter of wheat with 1.5 mio. tons behindUSA (31.5), Canada (14.5), EU (11.3), Argentina (9.0), Russia (11.2), Australia (9.9), Kazakhstan (8.6) and China (2.6), and is on rank 10 for overall cereals exports. FA0 projections that the world will need an additional 1 billion tons of grain by 2030 suggest that Ukraine will have no problems exporting the production increasesthat could occur inthe coming years. Expectedeffects of the full removalof export restrictionsin the agriculture sector 39. The full removal of export restrictions for agricultural would further increase farm-gate prices and thus create incentives for private investments, resulting in increased production and exports, as outlined for the recent relaxation of export restrictions above. Effects would be most felt inthe cereals and oilseeds sub-sectors where Ukraine has significant comparative advantages. Employment and overall rural development would also be positively affected. Input suppliers upstream of agriculture would benefit as well, as demand for machinery, seed, fertilizer etc. grows. In a competitive market, traders mainly earn money on volume, so they would benefit from a sustained expansion in Ukraine's exports. As increased production eliminated or greatly reduced the probability of net import situations such as prevailed in 2000 and 2003, both traders and processors would benefit from a dependable supply o f agricultural raw materials, and a more stable policy environment. - 17- Figure9: Simulationof gross marginshaofwheat-producingfarms in 2006, three scenarios. 0.8 I 1 I I I I I I I I - 0.6 - Gross Margins SimulationA 0.5 - Gross Margins SimulationB - GrossMargins- SimulationC Grossmargins,0 0 0 U M a Source: own calculations 40. Effects on cerealgross margins - as a measurementof these benefits- would be significant.Figure 9 presents simulation results for wheat that compare the distribution of gross marginsha across all large wheat-producing farms in 2006 with three scenarios. Simulation A adjusts the 2006 data to account for increasedfuel, fertilizer and seed prices, as well as increased output prices prevailing in January 2008. The distribution of gross margins is clearly shifted to the right, and calculations show that the aggregated gross margin" over all wheat farms increases from 1.7 billion UAH in 2006 to 4.2 billion UAH underthe prices prevailing inJanuary 2008. This indicates that on balance, grain producers have profited from recent input and output price increases. Simulation B is identical to simulation A except that output prices are permitted to increase further to the full value they would attain without the price-depressing impact of export restrictions. The distribution of gross margins shifts further to the right, and grows in aggregate to 6.8 billion UAH. Simulation C assumes that in addition to simulation B, the productivity of wheat farming inUkraine increases by 20%; in other words, farms are able to produce20% more wheat using a given amount of inputs.Again, the distribution of gross margins shifts, and the aggregate gross margin of wheat production in Ukraine increases to 8.8 billion UAH. Note that these simulations do not take into account production increases due to possible acreage expansion. loThe aggregate gross margincan be interpretedas an estimate of value added. - 1 8 - 41. The increase in farm gate prices will hurt consumers in the short run through higher food prices. However, it is important to realize that this effect is temporary. Grain export restrictions have contributed to stagnant performance inthe grain sector. As a result o f this under-performance, Ukraine remains highly vulnerable to poor harvests. In2000/01 and 2003/04, for example, poor harvests put Ukraine into a net import position for food grains, and domestic prices climbed significantly as a result. Luckily for Ukraine, world market prices were relatively low in those years. Imagine the political turmoil that would have resulted had Ukraine been forced by a poor harvest to import at current world market prices! The only sure way to avoid such a scenario in the future i s to lay the basis for an export-oriented agriculture sector that produces stable net food surpluses in the years and decades to come. Experts agree that Ukrainian grain production could be much more robust to adverse weather conditions such as those that prevailed in 2000 and 2003, if the necessary investments took place. Grain export restrictions may bring some measure o f short-term relief from highworld market prices for consumers, but they do so at the cost o f reduced investments in agricultural production and, hence, sustained and perilous vulnerability inthe long run. - 19- D. BuildingUkraine's export-oriented,competitiveagriculture sector An attempt to formulate a vision 42. Already within the medium term, Ukraine could have a thriving, export-oriented agriculture sector, producing high-quality food and feed for large domestic and foreign markets, ensuring food safety and compliance with demanding quality requirements, and providing attractive investment and employment opportunitiesin rural areas. Current state programs to support the agriculturesector 43. The Government of Ukraine has established a program for the 'Agroindustrial Complex and Development of Rural Areas' that, if implemented, would make a significant contribution to increased sectoral competitiveness and reduced ruralhrban disparities. This program - based on the three pillars (i)rural development, (ii) competitiveness o f agriculture, including quality and safety issues, and (iii)natural resource management and environmental sustainability - includes provisions for the improvement o f social and physical infrastructure in rural areas, for the development of key markets associated with agriculture (finance, land, insurance), for the adoption of international food safety and quality standards, for a transition to efficient mechanisms o f state support (decoupled payments), and for increased efficiency based on innovations and knowledge transfer. 44. The Ministry of Agricultural Policy (MAP) has prepared an advanced draft of a national program for rural development until 2015. Citing relevant laws such as the Law o f Ukraine "On basis principles o f national agrarian policy for the period until the year 2015", the Law o f Ukraine "On state support for the rural economy o f Ukraine", and the Law of Ukraine "On the priority o f the development of rural space and the agro- industrial sector inthe national economy", MAP has prepared a detailed draft o f a national program aiming at enhanced competitiveness on domestic and foreign markets, ensuring food securityfor the country, and thepreservation of rural way of life andpeasantry as the carrier of Ukrainian identi& culture, and spirituality. 45. The agricultural budget has been adjusted to reflect some of the priories and emphases in the government's program. Compared with 2007, the share o f non- distortive (green box") expendituresinthe adopted budget for 2008 increased from 47.2% " "Green Box" measures as defined underthe WTO Agreement on Agriculture are measures of domestic support to agriculture that have no, or at most minimal, trade-distorting effects or effects on production. Support needsto be providedthrough a publicly-fundedgovernment program (includinggovernment revenue foregone), not involving transfers from consumers, and the support in question must not provide price support to producers. Green box measures are exempt from reduction commitments and include (i) governmental services including research, extension advisory services, market information, pest control, inspection services, infrastructure; (ii) public stockholdingfor food security purposes; (iii)domestic food aid; (iv) direct payments to producers and decoupled income support; (v) government contribution to income insurance and income safety net programs; (vi) natural disaster relief including gov. contributions to crop - 20 - to 55.6%. Rural development expenditures have been significantly increased. The government has also significantly increased resources for land market development and the eventual lifting o f the moratorium o f land sales. Risk management i s addressed by increasing the allocation for insurance cost compensation, although the choice o f instrument may need to be revisited(see for example index-based weather risk insurance). Budget allocations for research and development, and education and training have increased by 40% and 52%, respectively, but it i s not yet evident that the increased budget would improve the quality o f education. Support to biofuels production, for which UAH 15 mio. were budgeted in 2007, has been cancelled in 2008, as have subsidies for fertilizer purchases. Overall, agricultural budget allocations under the M A P have increased to 91% o f total agricultural public expenditures, which makes the M A P the major authority responsible for agricultural policy and rural development. 46. Despitethese positive elements, the effectiveness of much of the public spending for agriculture remains low. The green box includes many elements such as funding for public stocks that can have a very distortive impact on markets. Many policies are not consistent with the stated goals o f improving efficiency and competitiveness. The fact that competitive products such as grains and oilseeds are taxed via export restrictions, for example, while uncompetitive products such as sugar receive significant support, reduces and distorts investment in agriculture. And many policies work at cross-purposes, with the taxing effect o f export restrictions, for example, neutralizing the impact o f budget spending designedto support grain and oilseeds production. 47. A broadly shared vision combinedwith an agreed, comprehensive and consistent sector development program, consolidating existing plans and programs and presentingmeasurable objectives with a timeline of concrete milestones appears to be still lacking but would be critical to increase efficiency and effectiveness of development initiatives inthe agriculture sector. Ukraine needs to finally arrive at a genuine sector-wide approach to agricultural development with a published, agreed, and coordinated agenda across areas o f ministerial responsibility and which establishes clear political accountability. The remainder o f this chapter outlines someI2 o f the key reform and investment areas in which significant progress i s necessary for the implementation of the vision o f an export-oriented, competitive agriculture sector inUkraine. Policy and institutionalframework 48. A transparent, predictable and market-oriented policy framework for the agriculture sector will both increase the effectiveness of public expenditure and reduceuncertainty and risk, and hence increase private investments.A key priority is to reduce ad-hoc interference in agricultural markets and eliminate the sudden and unpredictable steps to regulate quantities and prices that make investment in Ukrainian agriculture much less attractive for investors than it could be. insurance schemes; (vii) structural adjustment assistance through producer or resource retirement programs and investment aids; (viii) environmental programs; and (ix) regional assistance programs. l2This is not an exhaustive presentationof issues and options. - 2 1 - 49. Publicand privateinvestments are especially neededto improvethe efficiency of marketingsystems for agriculturalproducts.Evenif excess price spreads due to export restrictions were completely eliminated, farmers in Ukraine would still get less for their products than their counterparts in other countries because o f the high marketing costs. For example, if farmers in Ukraine had received roughly the same share o f fob grain prices as their counterparts in Germany, the 2006 harvest o f roughly 35 million tons would have resulted in an additional US$ 1 billion o f farm revenue, equivalent to about one-half of total government spendingin support o f agriculture inthat year.l3 50. Another policy priority is the completion of institutional arrangements for the registrationof property rights(includingland) and the removalof the moratoriumon land sales. Landpurchase and sale would not leadto rapid, dramatic changes, but it would set in motion a virtuous circle whereby the availability o f collateral increases investment and productivity in agriculture, which in turn leads to increased land values, which make yet more collateral available, etc. It would also, together with the enforcement of bankruptcy procedures in agriculture, increase the pressure on less efficient farmers to leave production and make the resources that they have been using poorly available to more efficient farmers. One o f the largest handicaps facing agriculture in Ukraine i s the persistence o f a very high proportion o f highly inefficient farms, many of which are subtracting rather than adding value as they produce14. 51. Compliance with internationalquality standards will be critical for Ukraine's further integrationinto the global economy. Ukraine has recently completed its lengthy negotiations on WTO accession, and has entered into negotiations with the EU on a free trade agreement (FTA). The extent to which Ukrainian agriculture benefits from WTO membership and an FTA with the EU hinges on its ability to comply with international quality standards. For example, Ukraine is currently only able to export most livestock products (meat, milk) to a small number o f mainly former Soviet countries. If agronomic practices and product quality do not comply with market requirements and internationally recognized guidelines and standards, the result will be lower quality food products for domestic consumers (food safety), delays in completion o f trade agreements, and an inability to access to high-quality-high-price foreign (and domestic) markets. Publicinvestments 52. Handling, storage and transportation infrastructure. Agricultural markets and supply chains continue to be characterized by significant post-harvest losses, high transaction costs, and intransparent price formation due to information asymmetries. This leaves producers with unnecessarily unfavorable deals and limited marketing options, causing low farm-gate prices and hence creating disincentives for private investment in agriculture. It also increases consumer prices. Public investmentespecially in infrastructure with public good characteristics (road and rail networks, waterways) can intensify l3Basedon an average fob price of 150$/tand a difference of 20% (= 30 $/t) betweenthe roughly 70% of the fob pricethat farmers in Germany receivecompared with roughly 50% inUkraine. 14World Bank, 2008. Ukraine-Agricultural Competitiveness. Draft PolicyNote. - 22 - competition by reducing regional market power, and therefore act as an important catalyst for private investmentin other links o f the supply chain. For example, incentives to expand on-farm storage capacity (which would make a major contribution by enabling farmers to avoid being forced to sell into post harvest glut markets) depend on dependable, low cost transport channels to more than one possible purchaser. 53. Ukrainian agriculture urgently needs centers of excellence in higher education and research to produce future innovations, agribusiness leaders, analysts and excellence in administration. As agriculture becomes increasingly sophisticated and competitiveness i s increasingly determined by transformations that take place post-harvest in a complex food web, the importance of purely production-based natural conditions is declining. Ukraine, however, currently combines its set o f high-potential agro-climatic conditions with insufficient amounts o f human capital. Lack o f information and expertise on farms coupled with significant information asymmetries have resultedin low and highly heterogeneous productivities, insufficient product qualities, and inequities along supply chains, with implications for farmer incomes individually, the competitiveness o f Ukrainian agricultural produce as a whole, and for consumers' food safety concerns. - 23 - E. Measuresto protect the poor andvulnerable from food price increases 54. Measures to protect the poor and vulnerable from food price increases need to be separatedfrom agriculturalmarket policy. Brief assessment of social assistanceprogramsin Ukraine 55. The Ukrainian governmentcan compensate poor consumers for the increasein food prices in a cost-effective manner, if it wishes to do so, through a means-tested compensation program which can be deployed quickly. The fraction o f the poorest populationto be compensated i s a political decision, and may be larger than the fraction o f the poor. 56. Ukraine spent about 18 % of its GDP on social security sector in 2007, out of which almost 2.5% of GDP was spent on social assistance, includingcash and in-kind transfers (known as privileges). Social pending in 2008 is expected to increase by a further two percent of GDP. While some social assistanceprograms, notably housing and utility allowances, are not as efficient as they could be becausethe distributiono f spending i s not focused on the poorest and most vulnerable groups, the country does have well performing programs. Specifically allowances for single mothers, child allowances for 0-3 years old and the guaranteed minimum income program are very good at identifying the poor. 57. Eligibility for the compensationcan be processed via the local department for labor and social protection, which already implements a number of well-targeted programs.Ukraine operates a number of income & asset tested programs, which are very good at identifying the poor: two types o f child allowances, and a program for extremely poor households. The last resort program for the extreme poor covers 3 to 4% o f the population, and channels 73% of the benefits to the poorest 20% o f the population. This program is excellent by regional or OECD standards. Two other child allowance programs are also good: 54% o f the allowances for lone mothers go to families at the bottom 20% o f the per capita income distribution, and 36% of the child allowances for 0-3 years old goes also there. These results are very good compared to other means-tested programs in Eastern Europe and Central Asia, or even OECD. 58. Targeted aid using the same procedures and legal framework as the last-resort program, and based on an income and asset test, should be implemented with a higher eligibility cut-off than the last-resortprogram, to include a larger fraction of the poorest population.The last-resort program covers only 3.5% o f the population. Low income pensioners, unemployed, and other poor families, would have access to this program, inaddition to the other social protection benefitsthey receive. 59. This solution is preferable to, for example, a grain subsidy or school feeding programs.Food subsidies for goods with positive income elasticity, such as wheat, maize or rice, are highly regressive, with the majority of the subsidy going to well-off consumers, who spent a small fraction o f their budget on these commodities and can afford to pay - 24 - more. School subsidies are not an effective way to handle the problem in Ukraine, because they will miss many of the poor. According to the 2006 Household Budget Survey data, families with children account for only 20% o f the total population, and only a subset o f these families have school-aged children. National-levelresponse to risingfood prices and preparedness 60. Over the medium term, the targeting outcomes of means-tested programs could be further improved by strengthening the verification of reported wages and other formal incomes combined with imputation of hard-to-verify incomes. This combination o f instruments i s called the hybrid means test (HMT) mechanism. A HMT mechanism selects beneficiaries o f social programs based on the total income o f the household, where the incomes earned in the formal sector are verified, and those from the informal sector are estimated based on a small set o f household characteristics correlated to the true income. This set of predictors of the actual welfare of households is derived from a representative household survey. They are easy to collect, hard to falsify and easy to verify. In addition verification o f formal income could be strengthen by applying,proxy means testing to create the risk profiling o f clients and by targeting verification to the fraudulent clients. 61. Given the relativelylarge amounts spent on social assistance in Ukraine and the existence of an effective and sophisticated system to target the poor, it would be most cost efficient to phase out some of the poor performing programs, such as housing subsidies, while focusing on existing well-designed programs and adapt them to cover the larger targeted group and compensate for food price increases. Combining income test with proxy means testing i s the best approach in Ukraine to ensure that the transfers reach the neediest. The government's best response to the challenges o f rising food prices would be the application o fthe HMTinstrumentto existing well-performing programs. 62. In addition to improved targeting of social transfers, appropriate macroeconomic policies have a critical role to play. By reducing overall inflation, fiscal and monetary policy contribute directly to limiting the impact o f exogenous price shocks on the poor, most o f whom are dependent on wage income or social transfers. By contrast, wealthier individuals benefit most from rising inflation, since it reduces their cost o f capital and inflates asset values. 63. In particular, the Government of Ukraine should refrain from further upward spending revisions in the 2008 budget.Current price trends are well above the forecasted levels in the 2008 budget. Some social payments, in particular minimum pensions, which are indexed against the official inflation forecast, are declining inreal terms. However, on the whole, the rise o f public wages and social transfers in the 2008 budget i s a sufficient cushion against higher inflation. The authorities should bolster the credibility o f their anti- inflation program by adopting a realistic inflation forecast but refraining from correspondingly increasing current spending in the budget. It would be preferable not to submit a revised budget at all which would runthe risk o f populist spending battles further undermining the fight against inflation. -25 - 64. The National Bank should pursue its intention to introduce greater exchange rate flexibility and continueits policyof tightening liquidity.The UAH/dollar exchange rate on the inter-bank market has recently strengthenedby around 2% against the official rate and the mid-point of the informal band. The NBU should widen the band and demonstrate its commitment to greater flexibility to the marketby allowing the official rate to move towards the market level. Moreover, the NBU should be encouragedto tighten the provision of liquidity and enforce tighter prudentialnorms on the banking sector. - 26 - References Antle, J.M. and V.H. Smith, eds. (1999). The Economicsof World Wheat Markets. Oxon, UK:CAB International;USDA. EuropeanBank for Reconstructionand Development/ Food and Agriculture Organization (2008). Fighting Food Inflation through Sustainable Investment. London. FAO, 2002. World agriculture:towards 2015 / 2030. FAO, 2007. FoodOutlook, November2007. IFPRI, 2008. http://www.ifpri.org/themes/foodprices/foodprices.asp, IMF (2008). Impact of High Food and Fuel Prices on Developing Countries - FAQs. http://www.imf.ornlexternal/np/exr/faq/ffpfaqs.htm. Ivanic. M and W. Martin, (2008). Implications of Higher Global Food Pricesfor Poverty in Low-Income Countries. The World Bank, WashingtonDC. UkrAgroConsult: 2008/09forecast as of April 20, 2008. World Bank, 2008. Rising food prices: Policy options and World Bank response; http://siteresources.worldbank.ora/NEWS/Resources/risingfoodpricesbackground note apr08.pdf. World Bank, 2008. Ukraine -Agricultural Competitiveness.ReportNo. 44843-UA Draft Policy Note. - 27 -