| Abstract: |
Apart from threats to its national security and territorial integrity, Ukraine
faces serious economic challenges. These result from the slow pace of economic
and institutional reform in the previous two decades, the populist policies of
the Yanukovych era and the consequences of the conflict with Russia.The new
Ukrainian authorities have made pro-reform declarations, but these do not seem
to be supported sufficiently by concrete policy measures, especially in the
critical areas of fiscal, balance-of-payment and structural adjustment. Also,
the international financial aid package granted to Ukraine has not been
accompanied by sufficiently strong policy conditionality.Ukraine urgently
needs a complex programme of far-reaching economic and institutional reform,
which will include both short-term fiscal and macroeconomic adjustment
measures and medium- to long-term structural and institutional changes.Energy
subsidies and the low retirement age are the two critical policy areas that
require adjustment to avoid sovereign default and a balance-of-payments
crisis.
Introduction
Since the end of 2013 Ukraine has faced a series of
dramatic geopolitical, domestic political and economic challenges. First,
there was mass protest in Kyivâ??s central square against former president
Viktor Yanukovych after he declined to sign an association agreement with the
European Union. After collapse of Yanukovychâ??s regime, the internal
Ukrainian conflict became internationalised with the illegal annexation of
Crimea by Russia, and Russiaâ??s active role in a â??proxyâ?? war in the
Donetsk and Lukhansk regions.
For this reason, international attention is
concentrated on geopolitical threats and the violation of Ukraineâ??s
territorial integrity. The geopolitical and security challenges are also at
the top of the agenda for the new president and government of Ukraine. As
result, the economic situation and economic reform are less prioritised,
domestically and internationally. However, pressing economic questions must
also be addressed. The unsatisfactory results of previous reform rounds were
very much responsible for the recent political crisis and the fragility of the
Ukrainian state. Most importantly, successful economic and institutional
reforms are critical for attempts to consolidate both state and society and to
prevent any new authoritarian drift.
The new Ukrainian authorities have made
general pro-reform declarations, but these do not seem to be supported
sufficiently by concrete policy measures, especially in the critical areas of
fiscal, balance-of-payment and structural adjustment. The same must be said
about the international financial aid package granted to Ukraine in April and
May 2014, which has not been accompanied by sufficiently strong policy
conditionality.
History of half-hearted reform
The recent developments in
Ukraine are not the first time since independence in 1991 that the country has
found itself at a critical juncture. In 1991-92, under Leonid Kravchukâ??s
presidency and on a wave of independence enthusiasm, Ukraine had the chance to
build new democratic and market institutions as was done, for example, by the
Baltic countries. Unfortunately, all the political energy went to giving old
Soviet institutions â??newâ?? Ukrainian names. The macroeconomic and social
populism of that period led to hyperinflation at the end of 1993.
After
Leonid Kuchmaâ??s victory in the 1994 presidential election, some market
reforms were finally enacted: most prices were liberalised, the exchange rate
system was unified, subsidies and the fiscal deficit were reduced (but not
eliminated), the issuing of money was brought under control and, finally, a
new currency, the hryvna (UAH), was introduced in September 1996. This
half-hearted reform process was stalled by a coalition of emerging oligarchs
â?? the early winners from partial liberalisation and the macroeconomic
disequilibria of early the 1990s, and the beneficiaries of various rents
created by them â?? and old-style â??redâ?? directors in industry and
agriculture.
The next reform push came after the financial crisis of 1998-99
and Kuchmaâ??s re-election in 1999 alongside Prime Minister Viktor Yushchenko,
the former governor of the National Bank of Ukraine. There was some fiscal
adjustment, reform of the management of public finance and attempts were made
to restructure the loss-making and heavily corrupted energy sector. However,
the political life of Yushchenkoâ??s government was short (17 months) and it
was soon replaced by a government that was again dominated by â??redâ??
industrialists and oligarchs.
After the Orange Revolution at the end of 2004
and Yushchenkoâ??s election as the third president of Ukraine, there was a
political window of opportunity to start serious political, institutional and
economic reform. Unfortunately, this was prevented by a political split inside
the â??Orangeâ?? camp, in particular, the permanent political infighting
between Yushchenko and twice Prime Minister Yulia Tymoshenko (2005 and
2007-10). The only success of the period were entering the World Trade
Organisation (WTO) in 2008 and starting negotiations with the EU on the
association agreement.
The economic boom of 2000-07 did not create pressure
for serious reform either. The macroeconomic situation improved: after 10
years (1990-99) of steep output decline and thanks to reforms that were
partially completed at the beginning of the new millennium (especially
privatisation of the larger part of the manufacturing industry), a rapid
recovery started. This was also fuelled by the 2003-07 global boom (high
prices of metals and agriculture commodities, Ukraineâ??s main exports) and an
oil boom in Russia. The UAH exchange rate stabilised against the dollar,
inflation diminished for a while, and the fiscal deficit and public debt to
GDP ratio declined as result of rapid GDP growth. On the institutional front,
the economic system could be considered largely a market system, but heavily
distorted by pervasive corruption and nepotism, poor governance (which made
implementation of market-related legislation and definition of the rules of
the game a permanent problem) and state capture by oligarchic groups, similar
to most other post-Soviet countries.
The era of relative prosperity came to
the abrupt end with the global financial crisis in 2008. The era of relative
prosperity came to the abrupt end with the global financial crisis in 2008.
Ukraine was particularly heavily hit, recording in 2009 a decline in GDP of
14.8 percent (Table 1), one of the steepest falls of all emerging-market
economies. Despite a low public-debt-to-GDP level (12.3 percent of GDP in
2007), Ukraine was cut off from international markets because of a current
account deficit (-7.1 percent of GDP in 2008), external debt exceeding 50
percent of gross national income, external debt service costs equal to 20
percent of export proceeds, and expectations of devaluation. Between September
2008 and January 2009, the UAH depreciated by almost 60 percent, from 4.85 to
7.70 UAH to the dollar, and then further down to 8 UAH to the dollar in 2009
(see Figure 1). Ukrainian authorities had to ask for the International
Monetary Fund Stand-by Arrangement (SBA) in the second half of 2008.
Legacy of the Yanukovych era
After the victory of Viktor Yanukovych (who had
been prime minister in 2002-04 and 2006-07) in the February 2010 presidential
election, and the formation of the government of Mykola Azarov, a new reform
effort was declared. Legislation was adopted related, among other issues, to
social policy (a gradual increase in the retirement age of women from 55 to
60, lengthening the service period needed to obtain a minimum pension and, for
various privileged groups, limiting the maxi-mum pension to 10 times the
subsistence mini-mum), Ukraineâ??s WTO membership commitments, and preparing
the legal ground for the forthcoming EU-Ukraine association agreement
(including the Deep and Comprehensive Free Trade Agreement, DCFTA). However,
corruption and predatory pressure from the narrow oligarchic elite around the
president and his family led to a deterioration in the already poor business
climate and further declining confidence in state institutions. The
continuously deteriorating total investment rate, and the declining gross
national savings rate (see Table 1) illustrate well the macroeconomic
consequences of dysfunctional governance.
Governance failings and
authoritarian drift created fertile social ground for the wave of civil unrest
that erupted as the Euro-Maidan protest movement in November 2013, after it
became clear that the government would not sign the association agreement with
the EU (see the next section).
Another source of social disappointment was
the deteriorating economic situation. After the 2008-09 crisis, Ukraine failed
to return to its pre-crisis GDP level (Table 1). In 2010 and 2011, GDP grew by
4.1 and 5.2 percent, respectively (not enough to compensate for the 2009
output decline), followed by stagnation in 2012-13. Stagnation was a result of
weak external demand (a consequence of the European debt and financial
crisis), increasing domestic imbalances, a deteriorating business and
investment climate and increasing Russian import restrictions â?? Russia
wanted to discourage the government of Ukraine from signing the association
agreement with the EU.
The Azarov governmentâ??s populist policies, such as
keeping domestic energy prices low and generous wage1 and pension increases,
led to deteriorating fiscal and current account balances, a typical
manifestation of the twin deficits. These policies also effectively derailed
the two subsequent IMF SBAs (of 2008 and 2010), both backed by the EUâ??s
Macro-Financial Assistance (MFA). As result, from summer 2013, Ukraine started
to face the growing danger of the subsequent balance-of-payments crisis (the
two previous balance-of-payments crises happened in 1998-99 and 2008-09).
Relations with the EU
In 1990s and early 2000s, the EUâ??s relationships with
countries of the former Soviet Union other than the Baltic states were based
on the bilateral Partnership and Cooperation Agreements (PCA) which included,
in the economic sphere, the Most-Favoured Nation clause, and technical, legal
and institutional cooperation in such sectors as transportation, energy,
competition policy, and some legal approximation in the areas such as customs
law, corporate law, banking law, intellectual property rights, technical
standards and certification. Ukraine signed the PCA in June 1994 and the
agreement entered into force on 1 March 1998.
The next steps, after the start
of the European Neighbourhood Policy in May 2004 and the Orange Revolution in
Ukraine at the end of 2004, were the signing the of the EU-Ukraine Action Plan
and the granting of market economy status to Ukraine (both in 2005). The
action plan was updated and upgraded into the EU-Ukraine Association Agenda3
in 2009 and then, once again, updated in June 2013 with the focus on
implementation of the forthcoming association agreement4.
In March 2007, the
EU and Ukraine started negotiations on a new enhanced agreement to replace the
PCA. At the Paris EU-Ukraine Summit in September 2008, the negotiated
agreement was upgraded to the association agreement and included the DCFTA as
an integral part. The negotiation was concluded in December 2011, and the text
of the association agreement was initialled on 30 March 2012 and signed on 27
June 2014 after a series of dramatic political events in 2013 and first half
of 2014. These included the failure of Yanukovychâ??s administration to meet
the political preconditions for signing the association agreement stipulated
by the EU (related to fair elections, judicial reform and so-called selective
justice against opposition leaders5), the subsequent last-minute refusal to
sign the association agreement during the Third Eastern Partnership Summit in
Vilnius on 28-29 November 2013, the resulting Euro-Maidan mass protests in
Kyiv and regime change (November 2013 â?? February 2014), Russian annexation
of Crimea and war in eastern Ukraine (since March 2014).
The association
agreement, in particular, its DCFTA component, will offer Ukrainian companies
partial access to the European single market. At the same time, it might
stimulate regulatory and institutional reforms in trade and investment-related
spheres, and ease the business climate for domestic and foreign firms. It can
also help to bring the countryâ??s legal system, public administration and
infrastructure services closer to EU standards (the acquis), depending on the
political will and determination to reform on the Ukrainian side.
Economic
challenges posed by the current crisis
The combination of recent dramatic
political developments and the deteriorating economic situation has made the
current crisis particularly serious and severe. Ukraine faces an existential
threat to its independence and territorial integrity caused by Russiaâ??s
aggressive policy, and must also overcome the adverse consequences of its past
failures in economic and institutional reform to secure its survival and
rebuild domestic and international confidence.
As result of the violent
conflict in eastern Ukraine and the related political uncertainty, real GDP
will decline in 2014. According to the IMF estimate built into the SBA
assumptions, the decline could reach 5 percent; according to the European Bank
for Reconstruction and Development May 2014 forecast it could even reach 7
percent.
Decline in GDP and political turmoil, including war in the east,
have undermined seriously the revenue flow to Ukraineâ??s budget and have
created additional expenditure needs, especially in the area of national
defence and security, humanitarian assistance and infrastructure repair. The
same IMF estimates of April 2014 predicted an increase in the general
government deficit to 5.2 percent of GDP in 2014 from 4.8 percent in 2013,
despite the recommended fiscal adjustment. If the quasifiscal deficit of
Naftogaz (the state-owned monopoly in charge of natural gas imports and
distribution) is added, the combined deficit will increase from 6.7 percent of
GDP in 2013 to 8.5 percent of GDP in 2014. Generally, the IMF projections are
based on optimistic assumptions. They might underestimate the downside risks
in the national security sphere, potential further disruption to trade
relations with Russia and bank recapitalisation needs.
In the first half of
2014, the hryvna depreciated from 8 UAH to more than 11.5 UAH to the dollar,
i.e. more than 45 percent. In the face of a looming balance-of-payments
crisis, such an adjustment was both unavoidable and necessary to improve trade
and current account balances. However, it has also put an additional burden on
the balance sheets of unhedged banks, companies (including Naftogaz) and
households. The ratio of non-performing loans (NPL) to total loans in the
banking sector amounted to 23.5 percent at the end of 2013, i.e. before the
UAH depreciation.
Overcoming these negative tendencies requires not only
political stabilisation but also far-reaching fiscal adjustment and structural
and institutional reforms to help eliminate macroeconomic disequilibria and
unlock Ukraineâ??s long-term growth potential, as we detail in the next
section.
International aid package
The international community supported the
new Ukrainian authorities with a generous financial aid package. At the core
of this package is the 24-month $17.1 billion IMF SBA, i.e. 800 percent of
Ukraineâ??s quota in the Fund6, provided under so-called exceptional access7.
The first tranche, which was disbursed immediately after the SBAâ??s approval
(on 30 April 2014), amounted to about $3.2 billion, of which $2 billion could
be used as budget deficit financing.
In April 2014, the IMF SBA was backed by
an EU MFA loan of â?¬1 billion available in two instalments and the EUâ??s
grant of â?¬355 million (also in two instalments) under the State Building
Contract.
Recently, the World Bank approved two loans to Ukraine â?? the
District Heating Energy Efficiency Project of $382 million and the Social
Safety Nets Modernisation Project of $300 million. The US Government provided
loan guarantees amounting to $1 billion. Investment loans can be provided by
the European Bank for Reconstruction and Development and the European
Investment Bank.
Weak conditionality
Even the most generous international
aid package can provide only temporary respite to Ukraineâ??s balance of
payments. To ensure the sustaining effect, aid must be supplemented by a
domestic adjustment and reform package which aims at removing the roots of
domestic and external imbalances. This is why the conditionality attached to
financial aid should require reform of policies and institutions. However,
such conditions are not obvious in the content of the IMF SBA and EU
assistance.
The IMF SBA said the following reforms should be implemented:
Changes to the monetary policy regime, i.e. replacing the de-facto fixed but
adjustable peg of the UAH to the dollar by a flexible exchange rate and
inflation targeting, with the targeting of monetary aggregates as the
intermediate solution in 2014; Financial sector stability, i.e. in-depth
diagnosis of Ukrainian banks and their recapitalisation needs (if necessary),
and bringing banking regulations into line with best international practices;
Gradual reduction of the structural fiscal deficit; Modernisation and
restructuring of the energy sector, gradual adjustment of end-user energy
prices accompanied by development of the respective social safety net;
Structural and governance reforms, improving the business climate.
At first
glance, this looks like a comprehensive approach that aims to address key
challenges faced by the economy of Ukraine. However, detailed proposals raise
some doubts.
In fact, structural and governance reforms which are essential
for improving the business climate and investorsâ?? confidence have not been
detailed in the SBA at all. There are no structural bench-marks â?? they are
to be the subject of a separate diagnostic study.
The memoranda signed
between the Government of Ukraine and the European Commission on the occasion
of both the MFA and the State Building Contract are a bit more concrete in
this respect. They set out some detailed conditions on fighting corruption,
avoiding conflicts of interest for public servants, government transparency,
changes in public procurement legislation and practices, public access to
information, civil service reform, constitutional reform, election law and
financing for political parties. However, very important areas such as
deregulation of business activity, simplifying public administration
structures and procedures, reform of the judiciary and law enforcement
agencies and decentralisation (building genuine local and regional
self-government) are virtually absent.
As we have noted, exchange-rate
adjustment was crucial in avoiding a full-scale and uncontrolled currency
crisis earlier this year. Similarly, attempts to make the exchange rate more
flexible, together with the abandoning of existing restrictions on current
account convertibility, should be welcomed. However, moving to inflation
targeting in a one-year period does not look feasible, especially in a time of
political and security turmoil and continuous fiscal pressure on monetary
policy, and considering the limited legal and actual independence of the
National Bank of Ukraine.
In order to create room for more independent
monetary policy and an inflation-targeting regime, serious fiscal adjustment
is needed, but on this the IMF programme looks rather weak and unconvincing.
The fiscal adjustment target of 2 percent-age points of GDP annually plus
another 1 percentage point of GDP of quasi-fiscal adjustment by Naftogaz
cannot prevent further rapid increases in Ukraineâ??s fiscal deficit and
public debt. According to the SBA targets, the general government deficit will
stay at the level of 4.2 per-cent of GDP (without Naftogaz) and 6.1 percent of
GDP (including Naftogaz) in 2015. Furthermore, several risks have been
evidently underestimated in this projection, as we have noted.
As result of
lax fiscal policy, the public debt-to-GDP ratio will jump from 40.9 percent in
2013 to 56.5 percent in 2014 and further up to 62.1 percent in 2015. Then it
will reduce slowly to 51.9 percent in 2018, under the assumption that the
economy will grow by at least 4 percent annually from 2016. So far, the
government of Ukraine faced problems accessing private financial markets even
at a much lower level of public debt. Similar public-debt funding constraints
have been experienced by other post-Soviet and developing countries with
similar characteristics to Ukraine. In practical terms, this means that
despite the IMF programme, Ukraine will remain cut off from private debt
markets for several years, and will be totally dependent on official financial
aid.
Furthermore, without bolder fiscal adjustment there is no chance to
increase substantially the very low rate of gross national savings (6 percent
of GDP in 2013), because most private savings are absorbed by the public
sector borrowing requirements, or to improve the current account balance. In
turn, this will mean continuous balance-of-payments vulnerability and a
limited pool of resources to finance investment.
Some of the proposed fiscal
adjustment measures go in the right direction, such as abandoning the previous
populist decision to replace the 20 per-cent VAT rate with two much lower
rates. However, the fiscal effects of some one-off steps, for example,
fighting tax fraud, might be overestimated. Wage and hiring freezes in the
public sector might complicate the badly-needed reform of the civil service
and public services such as education and healthcare. The Ukrainian public
sector suffers from an excessive number of employees, who are poorly paid and
managed. In such a situation, targeting the public-sector wage bill would be a
better strategy to create both financial room and incentives for deep
restructuring of both public administration and major public-service sectors.
In two areas of fiscal adjustment, the SBA looks particularly disappointing:
elimination of energy subsidies and social welfare reform.
Energy subsidies
According to the IMF estimate8 post-tax energy subsidies in Ukraine amounted
to 7.6 percent of GDP in 2012. They are much higher than in other countries of
central and Eastern Europe and the former Soviet Union, apart from
Turkmenistan, Uzbekistan and Kyrgyzstan. Most subsidies have the quasi-fiscal
form (periodical recapitalisation of Naftogaz) and are aimed to support low
house-hold tariffs for natural gas and district-heating services (which use
natural gas as an input). The price paid by Ukrainian households for natural
gas covers only about 20 percent of the cost-recovery level, and is ten times
or more lower than the price paid by Lithuanian and Estonian households.
Low
domestic energy prices are not only responsible for high fiscal and
quasi-fiscal deficits and the deteriorating current account balance. They do
not help to reduce excessive energy consumption and increase energy
efficiency, which in Ukraine is among the lowest in the world and has hardly
improved since 1990 (Table 2).
Furthermore, low energy prices do not create
incentives to increase domestic energy production and invest in energy-saving
technologies. They do not allow the elimination of one of the most obvious
sources of corruption â?? trading in, and distribution of, subsidised energy
imports â?? and they prevent the reorientation of the energy sector towards a
competitive market environment. As long as Naftogaz is obliged to deliver gas
at price below the cost-recovery level, its reorganisation, de-concentration
and privatisation will not be possible.
Low energy prices are also
counterproductive for reducing Ukraineâ??s energy dependence on Russia. In
this context, the discussion on economic sanctions against Russia has limited
merit as long as the international community is ready to support financially
Ukraineâ??s overconsumption of Russian gas.
Unfortunately, despite a correct
diagnosis, the IMF SBA sets only a very gradual price adjustment schedule with
the aim of eliminating Naftogazâ??s deficit only by 2018. The first round of
tariff increases, for gas by 56 percent (from May 2014) and for district
heating by 40 percent (from July 2014) looks drastic, but only if one
disregards their very low initial level. In fact, the 2014 increase only
compensates for the effect of UAH depreciation earlier this year. The next
planned rounds of tariffs increases (by 40 percent in 2015 and by 20 percent
in 2016 and 2017) might bring them closer to the cost-recovery level, but only
if the UAH exchange rate and other cost components remain unchanged. And there
is no certainty that the tariffs will reach the cost-recovery level even in
2017.
Oversized and inefficient welfare state
The general government total
expenditure in Ukraine is close to the level of 50 percent of GDP, one of the
highest in Europe and among emerging-market economies. In 2014, it might even
exceed 50 percent of GDP. The biggest expenditure item is various social
benefits (23.1 percent in 2013), of which public pensions account for 17.2
percent of GDP, again one of the highest shares in Europe and the world. The
limited pension reform of 2011 (discussed previously) has stopped the growth
in pension expenditure, but is unable to ensure system sustainability over the
long term in the context of one of the least favourable demographic trends in
Europe.
The retirement age, both statutory and effective, remains low by
international standards and taking into consideration the rapid ageing of
Ukrainian society. Numerous group privileges and special pension schemes offer
opportunities for earlier retirement and generous benefits. As result, 13.6
million pensioners account for about one third of the Ukrainian population.
This implies dependency ratio of 1 or higher.
Both the public components of
benefits to better-off groups instead of lower-income groups. According to the
World Bankâ??s Atlas of Social Protection, only 13.4 percent of total
social-protection and labour-programme benefits went to the poorest 20 percent
of the Ukrainian population in 2006.
What should be done?
Our analysis
suggests there is an urgent necessity for the new Ukrainian authorities with
the help and support of international community to elaborate a complex
programme of far-going economic and institutional reforms. These should
include both short-term measures of fiscal and macro-economic adjustment (much
bolder than currently planned) and medium- to long-term structural and
institutional changes. These are closely interlinked. For example, without
removing energy subsidies, fiscal and balance-of-payments adjustment looks
unrealistic and deeper reform of the energy sector (especially Naftogaz)
cannot start, leaving serious distortions and sources of rents and corruption
intact. Public pensions are a similar case: without increase in both the
statutory and actual retirement age, the fiscal cost of the pension system
will further expand, and labour market distortions and widespread informal
employment will not be reduced.
Fiscal adjustment must play a central role in
short-term policies, i.e. in 2014-15 because of deep dis-equilibria and
sovereign insolvency risk. The concern that a too-radical fiscal adjustment
can hurt growth prospects through the demand channel might not be justified in
the Ukrainian economy in which eliminating distortions (for example, in the
energy sector) and uncertainties (related to macroeconomic imbalances), and
returning business confidence, can boost both investment and consumption.
Long-term growth will be impossible without increasing the national savings
rate, which requires, in first instance, the elimination of fiscal
imbalances.
Discussion on the speed of reform must take into account both
politics and economics. Obviously, fiscal adjustment which is crucial for
rebuilding macroeconomic equilibrium and business confidence, will include
politically unpopular measures, especially in relation to energy prices and
the pension system. There will be social costs and various special interests
will be threatened. How-ever, the unfavourable social consequences for the
poor can be mitigated by well-targeted social safety nets. In turn, overcoming
the resistance of special interest groups requires political mobilisation
around the reform programme.
A time of geopolitical confrontation with a
powerful neighbour might be considered to be an unlikely opportunity for
difficult economic and political reform. However, Ukraine does not have any
more time to waste. It must quickly rebuild confidence in its state
institutions and economy. Perhaps the current patriotic mobilisation of
Ukrainian society in the face of a threat to the countryâ??s independence and
after political change can create sufficient window of opportunity for
difficult reforms.
Past experience tends to illustrate that such a window of
opportunity is usually short-lived. Revolutionary mobilisation does not last
long. People who do not see visible positive changes become disappointed, and
enthusiasm is replaced by apathy and impatience. This opens door to populism
and authoritarianism as experienced by Ukraine itself after the failure of the
Orange revolution, or recently in Egypt. Easing social pain over longer period
does not necessarily make life easier compared to a more radical and upfront
reform package.
The resignation of Prime Minister Arseniy Yatsenyukâ??s
government on 24 July 2014 with the objective of facilitating early
parliamentary election in October 2014 might help build a stable pro-reform
majority. However, it also means a further delay in implementation of reforms,
and additional instability and uncertainty, which will accompany the
forthcoming election campaign in the environment of the unresolved conflict in
the east.
For international donors, the best strategy is to offer a
substantial aid package to Ukraine (which has partly happened) but with more
stringent conditions on reform compared to the current pack-age, and immediate
technical assistance. This means upgrading the existing aid package built
around the IMF SBA, EU and World Bank programmes to ensure faster
macroeconomic adjustment in short-term and deeper institutional and structural
reform in the medium-to long-term, backed by more international resources. |