July 13, 2015
Ukraine Must Put Reform Agenda in Overdrive While There's Still Time
By Anders Åslund
The economic situation is frightful with GDP falling by 17.6 percent in annualized terms in the first quarter and annual inflation reaching 61 percent in April. But much has gone right, more than Ukrainians usually notice.
What everyone recognizes is that Ukraine has a strong civil society. People are active both in discussions and in deeds. The state functions poorly, but volunteers help everywhere from the battlefields to hospital beds and schools. Civil activists expose corruption and its culprits every day, often forcing top officials out after prolonged struggles. Street protests are commonplace.
Soon after the democratic breakthrough in February 2014, Ukraine carried out presidential and parliamentary elections. Pro-European reformers won both elections, laying a political base for serious democratic and market economic reforms. Until the parliamentary elections on October 26, the old vested interests dominated the parliament blocking most reform legislation. These elections gave reform a political mandate.
On December 2, a new government was appointed. It is younger and more qualified than any previous Ukrainian government. Tellingly, in the last Yanukovych government only two ministers spoke English, while only two out of twenty ministers do not speak English in the current government. The typical new minister is a 38-year-old investment banker with a Western MBA. Many ministers are not corrupt and strongly committed to sensible reforms. Radical anti-corruption reforms are usually carried out by young, well-educated outsiders, who are free from the old system. Of Ukraine's twenty ministers, only five had been ministers before December 2014, and only the prime minister also under the old regime. Ukraine has got a credible reform team.
On December 9, the new government presented its reform program. It was the kind of program Ukraine needed, brief and focused on key reforms. It was criticized within the coalition because it did not contain all the measures of the 66-page-long coalition agreement, but that was its strength: It offered a clear focus.
The new government started with a Sisyphus task, to adopt a new budget for 2015 and to conclude a new loan agreement with the International Monetary Fund. A budget was hastily adopted on New Year's, but it had to be redone. The IMF arrived with an unprecedentedly large mission of twenty-five professionals that worked for one month with the new government. The result was an unexpectedly strong financial stabilization program, called an Extended Fund Facility, and supposed to last for four years. It was agreed to on February 12.
Ukraine and the IMF concluded a standby program in April 2014, but it was never more than a stopgap measure to keep Ukraine afloat until the reforms of the Euromaidan had worked through. It contained too little reform, fiscal adjustment, and international financing. The new IMF program is stronger in all these key regards.
One of the critical concerns is that Ukraine's economic situation is truly terrible. Last year, the IMF had anticipated a GDP fall of 5 percent, but it became 6.8 percent. The reason for the whole economic contraction is entirely Russian economic warfare against Ukraine. The occupied area of the Donbas is Ukraine's correspondence to Germany's old Ruhr Gebiet, a rustbelt of mines and steel mills accounting for 10 percent of Ukraine's GDP but only 3 percent of its territory. Now this production has fallen by half, as the Russians intentionally bomb infrastructure. Ukraine's coal production has roughly fallen by two-thirds and its steel production by one-third, though the numbers vary with the intensity of the warfare.
Less noticed is that Russia is also pursuing a trade war against Ukraine. Last year alone, Ukraine lost half of its exports to Russia, amounting to 12 percent of Ukraine's total exports in 2013, and this decline has been aggravated this year. Russia pursues all kinds of illicit trade sanctions against Ukraine. Ukraine's previously substantial agricultural exports to Russia have largely been eliminated through all kinds of phytosanitary regulations amounting to unfounded prohibitions. Steel exports have been blocked through personalized antidumping actions. In addition, Russian state enterprises have stopped purchases from Ukraine as a matter of policy. That Russia became a member of the World Trade Organization in 2012 has had no positive impact. Naturally the Ukrainian exports of armaments to Russia have declined.
A key aspect of Ukraine's economic crisis is that its international currency reserves have run low. From February 23 to 25, the country experienced a real financial meltdown. Temporarily, the exchange rate of the hryvnia collapsed from 20 hryvnia per dollar to 40 hryvnia. People rushed to shops to buy whatever they could. The National Bank of Ukraine (NBU) has sensibly adopted a floating exchange rate as recommended by the IMF and minimized interventions. But Ukraine's international reserves had declined to $5 billion, just over one month of imports, which was far too little.
The reason for the dwindling reserves has been a lack of international financial support. Last year, Ukraine's international debt obligations were far larger than the international credits it received. Even the IMF disbursed only $4.6 billion, while it received $3.6 billion in repayments, so its net credits to Ukraine were merely $1 billion. Incredibly, on October 30 the European Commission forced Ukraine to pay Gazprom $3.1 billion of disputed arrears without offering any additional support to Ukraine. This large payment brought Ukraine's reserves below the critical level. The EU purpose was entirely self-centered—to make sure that Gazprom continued to deliver gas to EU countries during the winter.
The new IMF program made all the difference. On its own, it was not sufficient to impress the market, but on March 2 the Ukrainian parliament adopted eight important laws as prior actions, which turned the market around. These laws involved energy prices, the budget, and taxation. The market saw this coming and on February 26 the currency recovered. On March 11, the IMF Executive Board adopted its program for Ukraine, and the next day a disbursement of $5 billion was made, doubling the Ukrainian currency reserves. The exchange rate has stabilized at 21-22 hryvnia per dollar as the IMF predicted, but currency regulations remain severe, impeding foreign trade.
The IMF program foresees $40 billion of international financing for Ukraine during four years, of which $10 billion shall be disbursed in the first year. The problem is that other financing is minimal. The EU is offering credits of about $2 billion, the United States $2 billion, Japan $1.6 billion, the World Bank $2 billion, China $2.4 billion, and Germany $800 million. Optimistically, this financing might amount to $12 billion, but virtually all of this is credits, some not very soon and some short-term.
Therefore the IMF has called for a restructuring of Ukraine's foreign Eurobonds of a total of $23 billion. The IMF hopes that Ukraine can save $15.3 billion by a combination of longer bond maturities, lower yields, and reduced face value of the bonds. This is a complicated negotiation and the outcome is by no means given. It is further complicated by Russia owning a Eurobond of $3 billion that it insists on getting back in full. Thus, Russia is adding a financial battlefield in its war against Ukraine. The international financing for Ukraine remains desperately short. Moreover, the IMF has just altered its forecast for Ukraine's GDP in 2015 from a decline of 5.5% to 9%.
Strangely, the EU has only offered some $5 billion of financing to Ukraine in 2014 and 2015, while it has committed forty times more to Greece, although Ukraine is in an existential crisis and the country's collapse under Russian aggression and financial strains would put also Europe in jeopardy. If Europe refuses to arm democratic Ukraine in its courageous defense against Russia's military aggression, it could at least provide serious financial assistance.
Ukraine's critical need is to double its reserves to some $20 billion. The best way of doing so would be that the European Central Bank offered a swap credit of some $10 billion to the NBU. This credit would function like the stabilization fund Poland received from the West in 1990. That funding should exist but never be touched because if Ukraine's other reserves fell below a certain level, the creditor (ECB) would be entitled to impose new policies that would strengthen the reserve situation. The money would stay in Frankfurt and never be used, but this backstop would calm the currency market so that Ukraine could ease its draconian currency regulations.
The implementation of Ukraine's reforms has been impressive. On April 1, Ukraine raised all energy prices to half the cost level. Gas tariffs for households quadrupled. Wasteful energy subsidies that amounted to 10 percent of GDP in 2014 are set to fall to 2 percent of GDP this year. At the same time, special pensions to privileged groups have been cut down and pensions are not supposed to be indexed until December, reducing the costs of pensions by about 4 percent of GDP. Thus, Ukraine is carrying out a fiscal adjustment of some 12 percent this year, though military expenditures are supposed to increase from 1.6 percent of GDP to 5.2 percent of GDP. In parallel, Ukraine has carried out substantial deregulation, abolished a dozen inspection agencies, prolonged and simplified agricultural leaseholds, and many more things. Real reform is under way.
Alas, the window of opportunity might be closing. I have an eerie feeling of Moscow in May 1992, when the reform program fell apart because of populist opposition. Such opposition is building against increases in energy tariffs and the awful economic situation. Politicians are mobilizing for scheduled local elections in October. The parliament will work in June, and that might be the last chance to adopt good reform legislation as the coalition is fracturing. Officially, the coalition consists of 302 deputies, while 226 votes are needed to adopt legislation. Most reform laws pass with about 270 votes. Out of 582 draft laws that the government has put to the parliament this year, only 44 percent have been adopted. Often laws are sidelined by procedural means because the coalition lacks cohesion.
The Fatherland Party of Yulia Tymoshenko with nineteen deputies votes persistently against the government and it belongs to the coalition in name only. The Radical Party of Oleh Lyashko with twenty mandates produces similar populist arguments but tends to vote with the government. Prime Minister Arseniy Yatsenyuk's People's Front with 82 deputies votes for government proposals as could be expected with good discipline. President Petro Poroshenko's bloc of 152 seats, on the contrary, is a diverse and undisciplined bunch. All too often it hinders votes on government proposals. Self-Reliance with 32 deputies is undisciplined and unpredictable but often tells the truth. Right now, it is vital for the prime minister and President to drive through as much reform legislation as they can before their window of opportunity closes.
An underlying problem is that the clarity of market principles is generally lacking in Ukraine. The debate usually deteriorates to what the government can do to help people, while the real question is how the burden of the state can be eased so that Ukraine can finally start developing. According to the World Bank, its GDP measured in purchasing power parities is one-fifth less than in 1990. In 2014, Ukraine's public expenditures were 53% of GDP, while most countries in the region have a level of 35% of GDP, which would make sense also for Ukraine. Ukraine's additional expenditures fell on energy subsidies of 10% of GDP and pension expenditures of 16% of GDP, approximately twice as much as in Europe.
One of the greatest shortcomings of the current government lies in its communication of the reforms, which requires great attention and resources. This task is complicated by several television channels still belonging to Yanukovych loyalists who indulge in skillful anti-government propaganda.
The final concern is that the power of the old vested interests has not been broken. The worst problem lies in law enforcement. Ukraine has 19,000 prosecutors and 10,000 judges. There are good reasons to believe that virtually all are corrupt. They should all be sacked through lustration as was so wisely done in eastern Germany after reunification. There, roughly one-third of the replaced prosecutors were young East Germans, one-third West Germans, and one-third retrained East German prosecutors. The number of Ukrainian judges and prosecutors should probably be halved. Ukraine adopted a law on lustration last fall, but only about 2,000 senior officials have been sacked. One obstacle is resistance of the old elite that appeals to the still corrupt courts and usually win. Another problem is the Council of Europe, which opposes and delays the vital lustration with all kinds of more or less irrelevant legal arguments. Without cleaning out the top rung of the judiciary, Ukraine's reforms cannot succeed.
Far more reforms have been accomplished in Ukraine than is generally understood both in Ukraine and the West, but the situation remains desperate. Ukraine needs more Western support, especially financial assistance. The economic situation is terrible. A GDP fall for the whole year of 8-9 percent now appears likely. The economic hardship bears on the brave population, and the danger of a serious backlash is imminent.
Anders Åslund is a senior fellow at the Atlantic Council and author of the new book "Ukraine: What Went Wrong and How to Fix It." This article was originally published in German by Internationale Politik.