The failed economy of Ukraine

The recent history of Ukraine is a clear example of how not to manage a country’s economy.


Enrique Jorge Roger Guiu
26 June 2014

The recent history of Ukraine is a clear example of how not to manage a country’s economy. Had the economic situation been different, we might not have seen the power game played out between the European Union and Russia, nor the people taking to the streets to demand a change of direction. There is nothing like economic health and financial autonomy if one wants to avoid depending on other countries for survival, and relying on bailouts from the IMF.

Image 1.jpg

Click graph to enlarge.

Outlining the links between politics and economics can help to better understand the current situation, despite its ever-changing nature. For this, we propose looking at three different moments in the recent economic past of Ukraine. First, to the Ukraine of the last decade, to identify the main errors in the economic policy that brought the country to the critical state it reached in autumn 2013, just before the Euromaidan. Second, to the Ukraine at the end of 2013, to review what the EU and Russia were offering to a government already in crisis. Finally, ending the journey in June 2014, where Ukraine’s future options are conditioned by the most immediate events in the eastern part of the country, and by the financial constraints imposed upon the newly elected government.

An artificial hryvnia

In most countries, the monetary policy that central banks implement is designed to keep inflation under control (inflation targeting). In Ukraine, on the other hand, it has been used –until recently, that is – to control the exchange rate of the local currency, the hryvnia. The Central Bank was aiming to maintain the over-valuation of the currency, with a fixed exchange rate of eight hryvnias per dollar. To achieve this, the Central Bank firstly set interest rates at very high levels, so that it could attract foreign capital, and keep it there, preventing it from flying away looking for higher profits; if capital flew out of the country, that would depreciate the currency. The Central Bank also used its foreign exchange reserves to buy hryvnias in the currency markets, and thus maintain an artificially high demand.

Image 2.jpg

Click graph to enlarge

But why did the Central Bank expend so much effort trying to maintain a strong hryvnia? When a currency’s value is strong, any payment abroad, for imports say, is relatively cheaper. A lower amount of local currency is needed to pay the same quantity in dollars or roubles. In the case of Ukraine, the country’s imports have been systematically higher than exports. The vast majority of Ukrainian imports relate to the purchase of Russian gas. Therefore, with a strong hryvnia, Ukraine needs to spend less on gas imports, which must be paid for in dollars or roubles. If, on the other hand, the hryvnia loses part of its value, the imports of gas become even more costly for a country that has been dragging along for years with an annual fiscal deficit of 6%, because the consumption of gas is highly subsidised at the expense of an ever-increasing public debt. Ukraine has also accumulated outstanding payments between $2 billion and $3 billion to Russia’s Gazprom. As if that were not enough, around half of the public debt is denominated in dollars; therefore, any payment of interest was easier to bear if the country had a strong hryvnia.


Such a situation can be only sustained if the Central Bank is constantly receiving dollars that can later be spent to defend the value of the local currency. But if the real economy does not perform well enough, the fundamentals that hold up the currency are eroded, and the holders of hryvnias start considering whether its value can be sustained in the long term. The crunch point comes when dollars do not flow into the country in the same quantity as they have been doing, either because exports are suffering (because the exchange rate is too high and industry is not competitive), economic growth is plummeting (because high interest rates slow down the economy), or investors do not invest in the country; Ukraine has been in recession since 2012 and a reduction of US and EU’s fiscal stimulus implies that less capital is available in the market). The situation then turns into a vicious circle, in which the efforts of the Central Bank are greater each time: an increasingly higher interest rate is needed to prevent capital flight, and an increasingly larger spending of dollars is needed to maintain demand for the local currency. In these cases, there is little or no alternative. If the hryvnia’s value were allowed to drop, the State would not be able to pay basic imports or service external debt. Thus, the Central Bank, the State and the whole economy end up in a blind alley; and this was Ukraine’s economic situation in November 2013.

Formidable Looking Euromaidan activists with shields, hardhats and face coverings.

Signing an agreement with Russia made perfect sense from Yanukovych's perspective, but led to the Euromaidan movement.

If the real economy does not perform well enough, the fundamentals that hold up the currency are eroded.

The result of the policy outlined above was a currency crisis. Kyiv’s foreign-exchange reserves were then at historical lows. Serious concerns appeared in the financial markets, concerned that the country only had reserves to cover imports for two months (the minimum recommended by the World Bank is three months). In fact, citizens stopped trusting the hryvnia’s value, and they started to exchange their hryvnias for dollars at exactly the same time as the Euromaidan protests were becoming significant. Reuters was perhaps being only slightly ironic when analysing the situation at that time: ‘While Egypt, in a similar financial situation, had wealthy and generous neighbours, such as Saudi Arabia or Kuwait, that pledged more than $12 billion in aid, no such benefactor has stepped forward for Ukraine.’ It was precisely the unsustainability of its economic model (further weakened by endemic corruption), the urgent need of additional funding, and the strategic appeal of such a vulnerable country situated between East and West, which started a race to see who could offer Ukraine the most economically and politically attractive lifeline.

Scylla and Charybdis

At the end of 2013, President Viktor Yanukovych had to choose between two possible solutions: on the one side, a treaty with the EU and the IMF; on the other, an agreement with Russia. Both had economic and political conditions. The reluctance of Yanukovych to sign the Deep and Comprehensive Free Trade Agreement with the EU, and the favouring, instead, of an understanding with Russia was the trigger for the protests known as Euromaidan. Both agreements included an immediate bailout of the failed economy. However, neither of them would have been beneficial.

Image 4.jpg

Click graph to enlarge.

The treaty with the EU and the IMF dangled the carrot of granting Ukraine preferential access to the European common market. In exchange, the EU asked Kyiv for reforms in the financial system, the judiciary, and its internal political system. The IMF was an intermediary, allocating resources both to heal Ukraine’s currency crisis, and ameliorate the anticipated shocks of opening up its trade. For its part, the IMF stipulated a programme of reforms, including two key demands that Ukraine has previously shied away from, for fear of social unrest: the removal of fossil-fuel subsidies and a free floating currency, which would imply an immediate devaluation of the hryvnia. In a country where economic policy has been traditionally articulated through three family clans (Kyiv, Donetsk and Dnipropetrovsk), these ‘political sacrifices’ were inconceivable.

The treaty proposed by the EU and the IMF will go down in history as a big mistake.

The treaty proposed by the EU and the IMF will go down in history as a big mistake. As we have seen above, Ukraine was a dysfunctional economy with an overvalued currency, burdened with an uncompetitive industry that could only survive thanks to favourable treatment from Russia, and an ever-increasing fiscal, commercial and energy deficit. An opening up of free trade with the far more competitive European common market was not feasible without structural reform. Neither would it have been beneficial for Ukrainian crop exports given the EU’s protectionist agricultural policy. In any case, the country would have defaulted. Because the EU would not accept Kyiv’s request for additional grants to soften the expected commercial shocks, Yanukovych’s decision to yield to Vladimir Putin’s proposal, and thus continue the system of crony capitalism, seems inevitable and quite foreseeable.

President Putin’s proposal was outwardly straightforward: the acquisition of $15 billion of Ukrainian Government bonds, as well as a reduction in the price of gas that Naftogaz (Ukraine’s public supplier) paid to Gazprom. It also included the incorporation of Ukraine into the Customs Union (at present, Russia, Belarus and Kazakhstan). Yanukovych signed the Russian deal on 17 December. In retrospect, this decision seems the most reasonable one if one thinks as Yanukovych probably did: a depressed industry surviving only because it is producing basic (and outdated) goods for Russia, with a few families in turn owning many of the most significant industrial conglomerates (meaning they will suffer the biggest shock from free trade with Europe); and a people’s consumption capacity (directly related to their political support) depending on the extent to which the country can keep its Russian energy subsidies. Yanukovych’s decision merely illustrated how much power in Ukraine was clustered in so few hands, and to what extent this hindered economic and social development. There was one problem with the Putin proposal: it led to Euromaidan.

There was one problem with the Putin proposal: it led to Euromaidan.

A chronic sickness

We finally move forward to the Ukraine of June 2014: President Yanukovych and Prime Minister Azarov have been replaced by Petro Poroshenko (elected) and Arseniy Yatsenyuk (interim). Euromaidan has gone quiet. Crimea is now a Russian region. The east of the country is in open revolt. Naftogaz now pays 80% more for gas. The Central Bank has had no option but to adopt a free floating regime for the hryvnia, and, as a consequence, it has already lost nearly 50% of its value since the start of the crisis; that is, the gas that was previously acquired with 100 hryvnia now costs around 250. To keep everything afloat, the IMF has granted a loan of $17 billion; and contributions are expected from the EU, the World Bank, Canada and Japan.

Image 5.jpg

Click graph to enlarge

The pendulum of power has been swinging back and forth, but inside the clock, the cogs are still basically the same.

The pendulum of power has been swinging back and forth, but inside the clock, the cogs are still basically the same: economic deterioration, industrial decline, and the debasement of resources, where rents are divvied up by the same old clans – all of the things that EuroMaidan was protesting about. They will be difficult to reverse in the short and medium term; productivity improvements, capital investment, labour reform, and technology upgrades always progress slower than exchange rates, financial flows and bailout programmes.

FocusEconomics Consensus Forecast for Eastern Europe expects private consumption to slump as a consequence of the IMF bailout package, especially due to the higher energy price burden on households. In particular, it estimates that the Ukrainian economy will shrink by 4.7%, affected by a drop in consumption of almost 6%, and in investment of nearly 12%. The likelihood that the recession continues into 2015 will depend on the actions taken by the recently elected government, and on the evolution of relations with Russia.

There are mixed signals as to whether Ukraine wants to stop being a chronically sick economy. A business-as-usual policy, as we have seen, only implies being permanently dependent on third parties that do not seek the best for the country. The fierce opposition in the streets to Yanukovych’s crony policy-making may have contributed to the creation of a new social context in which the neccesarily tough and costly structural reforms can be better accepted, and the burden perhaps willingly (or even grudgingly) assumed. The free trade and economic elements laid out in the EU treaty may have to wait: the new government should use the financial resources granted to it, to prioritise internal reforms rather than immediately open up the economy to free trade. But, above all, what needs to be addressed is not only a macroeconomic imbalance but also an unstable political equilibrium, in which the smallest movement in any direction – East or West – can destabilise the entire system.

Since Ukraine’s independence from the USSR, power has been swinging like a pendulum; a fragile equilibrium perpetuated by the same elite that has been repeatedly re-elected. One can imagine the European Union and Russia as two sides of the clock, below which the pendulum swings. As it swings, it hovers for just an instant on each of the two sides, yet if stopped at either side, the clock – and Ukraine – stops ticking.

Standfirst image: CC Andrew Butko

Image one: CC Mstyslav Chernov

Get oDR emails Occasional updates from our team covering the post-Soviet space Sign up here


We encourage anyone to comment, please consult the oD commenting guidelines if you have any questions.
Audio available Bookmark Check Language Close Comments Download Facebook Link Email Newsletter Newsletter Play Print Share Twitter Youtube Search Instagram WhatsApp yourData