What has gone wrong with reform in Ukraine?

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What has gone wrong with reform in Ukraine? There will be no IMF bailout without economic, political and social reform. So why do Ukrainian politicians drag their feet?



Andrii Ianitskyi
5 March 2015

By the end of 2014, Ukraine had lost seven per cent of its territory through secret, but increasingly open aggression from Russia. These regions – stretching from Luhansk to the Azov coast – formed the basis of Ukraine’s industrial base and contributed about 17% to its GDP according to the country’s National Bank.

As a result, Ukraine’s GDP shrank by 6.7% by the end of the 2014. At the start of 2014, these lost territories were still making payments to the central budget, which is why the contraction was not greater. Basic sectors such as agriculture, construction, industry, as well as wholesale and retail trading fell by 10%. But it’s not possible to blame all of this on Russia. Ukraine has shown poor economic indicators in recent years.

Unfavourable comparisons

In 1990, Poland, a country of 38 million, had a GDP smaller than Ukraine, with a population of 52 million. 23 years later, Poland’s GDP (measured in dollars) had grown more than 800% and its population has grown by almost 400,000. Ukraine’s economy has grown by only two-and-a-half times and its population has decreased by almost 6.5 million people – a genuine demographic crisis.

Leszek Balcerowicz, the Polish reformer responsible for his country’s success, is now working as a consultant to President Petro Poroshenko. At an open lecture in February 2015, Balcerowicz put forward his view of the existing structure in Ukraine: ‘oligarch capitalism’. The local oligarchs control whole sectors of the economy. They influence parliamentary deputies, judges and civil servants, and formulate public consensus through the media.'

Balcerowicz told journalists: ‘This is already Ukraine’s fourth attempt at reform. There won’t be a fifth.’

A cash flow crisis

In 2014, Ukraine received $9.5 billion from various sources ($4.6 billion from the IMF’s ‘Stand-by’ programme) – a huge amount of money for such a small economy. But this money is only to service the country’s existing foreign debts.

The internal deficit is being financed at the expense of the internal devaluation of the national currency, the hryvnia. The result is that the exchange rate of the currency against the dollar has fallen by almost 400%, from 8 to the dollar at the start of 2014, to almost 24 to the dollar. (On the black market, the figure is 27-28 hryvnia to the dollar.) The National Bank’s reserves have fallen from $20.4 billion to $6.4 billion in the same period.

‘This is already Ukraine’s fourth attempt at reform. There won’t be a fifth.’

The hrynia has lost 50-60% of its trade-weighted value in the past year, according to Oleksandr Valchyshen at the Ukrainian investing company ICU. This loss is not without precedent. In 1997, the Bulgarian Lev fell by 96% of its nominal estimated value. In Brazil, the currency fell by 84% in 1995. The hryvnia’s exchange rate may set a new record if politicians fail to act.

The average wage in Ukraine is currently about $148 a month; travelling abroad and purchasing expensive imported goods are impossible for the majority of the population.

If current trends continue (and there is little indication they won’t), consumer inflation is projected at 28.5% per year in January 2015. All social payments (to pensioners, the poor and families with multiple children) have been frozen for the second year in a row.

Breathing room

On 12 February 2015, the IMF and developed countries promised to give Ukraine $40 billion in credit over the next four years ($17.5 billion of which will come from the IMF). The question of the first tranche of this new Extended Fund Facility programme will be examined by the Fund’s board of directors on 11 March. The International Clearing Union expects that the first transfer will comprise at least $5 billion, and will be divided equally between the National Bank of Ukraine and the state budget.

All social payments have been frozen for the second year in a row.

At the same time, Ukraine will ask for an extension on its loans from its private creditors. The details of these negotiations have not yet been revealed. However, the negotiations will most likely result in a deferment on all payments for four years, reckons Yelena Belan, senior economist at the Ukrainian investment company Dragon Capital.

Lagarde -  Frederic Legrand - Shutterstock.jpg

Christine Lagarde and the IMF have demanded reforms in return for the bailout package. Image by Fredric Legrand Shutterstock (c)

Even factoring in the help of the IMF and concessions from creditors, Ukraine will have to wait three years for a return to growth. Ukraine’s GDP in 2015 will contract by 7.6% according to Valchyshen. The contraction will end in 2016, with weak growth of 2.5-3% starting only in 2017.

Corruption and reform

What has been achieved in the year since EuroMaidan? There is little cause for pride, but some changes have been effected all the same.

Last year, deputies passed anti-corruption laws, but these will take effect only in spring of 2015. There has been a purge of the authorities and a round of sackings has begun. But civil servants are fighting the round of sackings in the courts.

A new law on education has been introduced, which will bring the Ukrainian system closer to European standards.

The sale of confiscated criminal assets has become more transparent, and the level of corruption has been reduced in state purchases. Oleksiy Shalaysky, head of the anti-corruption project Nashi Hroshi (Ukrainian for ‘our money’), says that theft in state tenders has decreased. The difference between prices of state purchases and the market rate has decreased to 10-15% whereas before it was 30-40%. ‘Dozens of corruption schemes have disappeared,’ says Shalaysky, currently concentrating his attention on judges, customs officials and prosecutors.

The National Bank has begun to work more transparently, publishing detailed notices about the refinancing of commercial banks. A purge of the banking system has begun, focused on weak banks and fraudulent banks channelling money to the black market. In total, 40 banks have been shut down. If the national bank preferred to nationalise weak banks during the 2008-2009 crisis, now the preference is to close them. The nationalisation of one of the biggest banks, Delta, would require 22 billion hryvnia, but the payments on its clients guaranteed deposits requires 15 billion hryvnia. A loss, to be sure. But the economy saves seven billion hryvnia. The government has also cut billions in subsidies to the coal industry.

The government developed a new budget for 2015, in which the rights of regions are noticeably expanded. However, these rights have not yet been exercised in full measure because the necessary laws and by-laws have not yet come into force.

There have been smaller changes. The post of business ombudsman has been confirmed. The process of hiring foreigners simplified, and the tax and bookkeeping rules have been harmonised. Last week, Ukraine’s 3G frequencies were finally put out to tender. Up till this point, mobile internet was unpopular among Ukrainians due to slow connecting speeds – it’s impossible to even load a YouTube video.

The main breakthrough in the reforms came on 2 March 2015, when deputies gathered to pass the necessary laws required to conform with the IMF’s credit conditions at an extraordinary parliamentary session, including:

–  Cancelling pensions for several categories of working pensioners, decreasing pensions for remaining working pensioners by 15%
–  Increasing the rent payments on gas production from 20% to 70% for small deposits of up to 5 km in depth
–  Increasing the responsibility of bank owners in cases of bankruptcy
–  Changing the 2015 budget (taking into account devaluation and inflation) and adding money to the subsidies for the payment of     communal tariffs 

The decision to increase communal tariffs had already been taken by a special national commission. This right was given to the commission by deputies in December 2014.

But it can’t be said that these laws were adopted easily. The pension law was passed on the fifth attempt, and is a light version of a necessary reform.

The total budget deficit (including state companies) has reached 10% of GDP. To reduce it, the Ukrainian government needs to adopt more decisive measures than the ones currently in force. Why, then, have they acted so slowly and indecisively?

Oligarchs and populists

There are two main political players in Ukraine – President Petro Poroshenko and Prime Minister Arseny Yatsenyuk. These figures control the most powerful factions in Ukraine’s parliament and important representatives in the cabinet. Both have declared their intentions to implement reforms; and their parties are part of a coalition of five.

But the number of coalition partners renders this government weak and unstable, and in reality, Poroshenko and Yatsenyuk are constantly fighting amongst themselves for power. For example, Yatsenyuk managed to force the resignation of the head of the National Bank, Valeria Gontareva, who was considered to be close to Poroshenko. In response, Yury Lutsenko, the head of the Poroshenko Bloc, in parliament threatened to fire government ministers. Conflict between Yatsenyuk and Poroshenko or organised opposition to reform on the part of the oligarchs could break this brittle union. A possible split in the coalition is a new source of political instability.

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President Poroshenko and Prime Minister Yatsenyuk are constantly fighting for power. Image by Drop of Light via Shutterstock (c)

At the same time, Poroshenko and Yatsenyuk are far from the biggest populists in parliament. Other less popular politicians seek to improve their ratings by making promises, which cannot be delivered in the current economic climate. Among the most noted populists are Yulia Tymoshenko, Oleh Lyashko and his Radical Party, as well as Yury Boiko from Opposition Bloc, built from the remnants of the Party of Regions.

The number of coalition partners renders this government weak and unstable.

Oligarchs such as Dmytro Firtash, Ihor Kolomoisky, Rinat Akhmetov and Viktor Pinchuk are also playing their own game, and have representatives of their interests in parliament and the cabinet. They also control the most popular Ukrainian television channels and formulate public opinion.

Local elections are due to take place in Ukraine on 25 October 2015. But, in truth, no new law on local elections has been drafted. This has not stopped politicians from engaging in unofficial pre-electoral campaigns. Before elections, even local ones, politicians are loathe to slash budgets.

Disputing reforms in court

The court system is another weak link. Any reform or dismissal can be derailed in court. For example, the Dnipropetrovsk regional administrative court blocked the open competition for the top position at Ukrzaliznytsya, Ukraine’s rail network, as well as Borispil and Lviv airports in February 2015. The internet portal Hubs.com.ua writes that the case was brought to court by Kirill Zvonaryov, a former deputy general director at the airline Aerosvit, which went bankrupt in 2012. The company belonged to Ihor Kolomoiskyi, the governor of Dnipropetrovsk region, the same region where the case is being heard.

The head of the new Anti-Corruption Bureau – the main body which fights corruption in Ukraine – is expected to be appointed in April. But the non-governmental Centre for Combatting Corruption has warned that any decision regarding this appointment can be challenged in court.

Oligarchs are playing their own game.

Since 2011, judges are the only professional group in Ukraine to receive a pension ten times higher than the minimum wage, and have used the constitutional court to secure these favourable conditions for themselves. On 2 March 2015, lawmakers set limits on the pensions of judges, but this decision can still be appealed.

Unfortunately, Ukraine does not yet have a sufficiently trusted court system to rely on the decisions it makes. The press has so far paid little attention to judges and the work they do. The Prosecutor General’s Office is currently attempting to punish those judges who, under the previous Yanukovych government, sanctioned the arrest of former prime minister Yulia Tymoshenko, and former Interior Minister Yury Lutsenko on charges of embezzlement and abuse of office in 2010.

'Maidan 3'

Finally, external aggression also poses a significant risk to Ukraine’s reforms, whether in the form of renewed fighting in eastern Ukraine or street battles in Kyiv, possibly leading to a ‘Maidan 3’. Without encouragement from abroad, protests on social issues are unlikely to reach the heights of 2014. Equally, separatists in eastern Ukraine cannot open any new offensive without support from Russia.

In the case of military aggression, Ukraine risks losing control of Mariupol, a major port on the Azov coast. Mariupol houses several major industrial enterprises with significant export contracts. The sabotage of Ukrainian enterprises behind enemy lines is also a possible scenario, especially in the Kharkiv region, which borders Russia and which possesses military factories. Mass protests in Kyiv could be a cover for an armed revolution, or, at the very least, an attempt to destabilise the situation.

Assessing the likelihood of such events is not yet possible – they seem unimaginable. But just one year ago, it seemed unimaginable that 6,000 – mostly peaceful – people would die in a war in Ukraine, and that more than 1.3 million people would abandon their homes to seek refuge in other regions of the country or even abroad.

Standfirst image: Logotype of the IMF (International Monetary Fund) by Ssolbergj via Wikipedia. All rights reserved.

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