Ukraine: The Basket Case
Op-ed in Foreign Policy. Reposted with permission.
© Foreign Policy
Recently, a big investment bank invited me to give a talk about the Ukrainian economy. I was happily surprised to find 300 interested fund managers in the hall, showing that Ukraine is a current focus of hedge-fund managers. The present Ukrainian intrigue is thick, involving the International Monetary Fund (IMF), the European Union (EU), and, of course, Russia. The United States, by contrast, is strangely absent from this drama.
For years, the Ukrainian government has pursued a disastrous economic policy, rendering a serious financial crisis possible or even likely. The outlook for Ukraine's economy looks even worse now that Ukraine's leaders have put the brakes on a planned agreement to deepen cooperation with the European Union. The last-minute decision by Ukraine's president, Viktor Yanukovych, to cancel the signing of an Association Agreement with Brussels is being widely attributed—not least by Yanukovych and EU officials themselves—to pressure from Russia, which has been threatening Ukraine with draconian sanctions if the country does sign the EU agreement. This drama deserves wide attention.
Like most former Soviet states, Ukraine is subject to predatory rule. Its masters have two predominant objectives: to maintain power and enrich themselves. In February 2010, Viktor Yanukovych won free and reasonably fair presidential elections with a narrow margin over then-Prime Minister Yulia Tymoshenko. He represented the Russian-speaking electorate in eastern and southern Ukraine, while Tymoshenko found most of her support in the Ukrainian-speaking west and center of the country. This balance between West and East has kept Ukraine more open and pluralist than Russia.
Most of all Yanukovych represents the interests of a limited number of big businessmen in Donetsk, his eastern home region and its metallurgical industry. President Yanukovych started off with full control of parliament, government, and the courts. His first government represented nine big business groups, but he quickly reduced their number to three. Instead, friends of his son Oleksandr have come to dominate the government since December 2012. These young businessmen from Donetsk hold all key economic posts in the government, including first deputy prime minister for economic affairs, finance minister, and chairman of the central bank.
With full control over courts and law enforcement, Yanukovych utilizes them at will, not least for jailing opposition leaders. In August 2011, the law enforcement authorities arrested Yulia Tymoshenko, his main opponent in the 2010 presidential election. She was subsequently sentenced to seven years in prison for abuse of power in a blatantly flawed court proceeding.
Yanukovych started his presidency by adopting an ambitious structural reform program in June 2010. It was in line with an independent presidential reform program commission [pdf] that I co-chaired. One month later, the president concluded a stand-by agreement with the IMF of $15 billion for two and a half years. Within a month, his government complied with the sensible prior actions required by the IMF, and Ukraine received the first two tranches of this loan of a total of $3 billion.
Yet by November 2010 reform had already ground to a halt. The turning point was the adoption of Ukraine's first tax code, which taxed more than a million small businessmen out of existence. After protesting vehemently for a month, many of those affected closed shop. The tax code was all the more beneficial to large businessmen, because it facilitated transfer pricing, enabling them to transfer their profits to trade companies in Cyprus without paying any tax. As a consequence, the tax code also devastated the Ukrainian stock exchange, which has fallen starkly during Yanukovych's years in power and almost disappeared because of ever worse corporate governance.
Yanukovych's economic policies have stayed off track. In February 2011, an IMF mission agreed to three key conditions for the government, but the government has not fulfilled them as yet. Sensibly, the IMF continues to insist upon them.
The most important IMF condition requires the government to hike domestic gas prices. The Ukrainian state oil and gas company Naftogaz imports natural gas from Russia for over $400 per 1,000 cubic meters, but the government insists on purchasing natural gas produced in Ukraine for only $53 per 1,000 cubic meters, keeping domestic gas production artificially low while subsidizing purchases of Russian gas. Naftogaz sells gas to consumers and utilities at similarly low prices, but the purchased and sold quantities do not add up. Somebody is buying gas at the low regulated price and selling it at the higher market-oriented price, making fortunes on this arbitrage. We do not know who benefits, but Yanukovych has adamantly opposed raising these prices. These price disparities cost Naftogaz losses of 2 percent of GDP each year, which are ultimately financed by the state budget, that is, the taxpayers.
The second IMF condition is to reduce the budget deficit. Instead, Yanukovych has let it expand due to a variety of populist social expenditures. Competitive public procurement has basically ended. Large public contracts are distributed among cronies, and the kickbacks or overpricing reported by the independent media that still exist is often 50 percent of the contract. Yet no legal measures are undertaken against the senior officials who indulge in this large-scale embezzlement. This year, the budget deficit is likely to reach at least 6 percent of GDP, and the public debt is set to exceed 40 percent of GDP, which might be more than Ukraine can bear. The Ukrainian government could ignore IMF demands because it could borrow on the international eurobond market at ten-year yields of 7.5–9.5 percent, but now these yields have risen to 12 to 13 percent, depriving the Ukrainian government of access to the international capital market.
The third IMF condition is that Ukraine introduces a more flexible exchange rate, which is a code word for depreciation. The exchange rate of the Ukrainian hryvnia is pegged at too high a level. As a consequence, last year Ukraine's current account deficit was 8.2 percent of GDP, and it is likely to be about the same this year. In September 2011, Ukraine's international reserves peaked at $38 billion. Since then, they have steadily shrunk to the present level of $20.6 billion, corresponding to only 2.6 months of imports, and they are set to contract further. The general market expectation is a depreciation of the hryvnia, which is reflected in the low and falling ratings of outstanding Ukrainian loans.
Rather than following its commitments to the IMF, the Ukrainian government has imposed strict currency regulations to make it exceedingly difficult to take money out of the country. It has also pursued very high interest rates. Last year, posters with the picture of Gerard Depardieu promised 19.5 percent interest on one-year time deposits in a Ukrainian savings bank. The high interest rates have kept inflation at zero, but they have also killed investment and thus liquidated economic growth. Output has fallen for the last five quarters. The expected contraction for 2013 is now 1 percent, but it might become 1.5 percent.
It is difficult to imagine a worse economic policy. A visit by the IMF Mission in October 2013 yielded a concluding press release that shocked those accustomed to the Fund's usual diplomatic bromides. The statement said that the Fund continues to insist on a more flexible exchange rate, "ambitious fiscal consolidation," and reform of the markedly inefficient energy sector. The only positive note in the statement involved some minor improvements in the business environment, such as simplified procedures for construction registration of real estate ownership rights. "Much remains to be done, however," the communiqué pointedly noted.
Yet all relevant top officials from the prime minister down met with the IMF mission, showing that the Ukrainian government is anxious to keep the Fund fully informed and the doors to the IMF open, so that they can call for support on short notice. When needed, the IMF can provide Ukraine with emergency financing within a month, but then the government has to fulfill all the IMF top conditions in advance.
Instead of taking IMF demands at face value, the present Ukrainian government treats the IMF as a public relations issue. The young Ukrainian economics ministers go to Washington as often as they can get an appointment with top IMF officials. They hire ever more expensive lobbyists and seem surprised that they do not receive IMF funding in return.
Why would any government pursue such a harmful and mindless economic policy? The simple answer is that it benefits the ruling "family" and its closest friends. Previously unknown individuals, who are presumed to be connected with people at the top, have taken over a large number of private companies at low prices. The worse the economic situation is, the cheaper Ukrainian companies become for these selected buyers. A few businessmen close to the president have enjoyed the benefit of being invited as the single bidder permitted at "auctions" to buy state corporations at minimal prices.
For six years, Ukraine has pursued negotiations with the European Union about a very substantial Association Agreement, which also includes a deep and comprehensive free trade agreement. It was supposed to be signed at the EU Eastern partnership summit in Vilnius on November 28–29. But on November 21, the Ukrainian government announced that it has decided to stop the preparations for signing the agreement.
Considering the national interest, Yanukovych had every reason to sign the Association Agreement. A solid majority of Ukrainians is pro-European, and the president's advisors acknowledge that it will be hard for him to be reelected in March 2015 without signing the agreement. Moreover, all the leading businessmen are eyeing the vast European market for their future expansion, although Russia and the European Union each take about one quarter of Ukraine's exports at present. They also want to defend their properties from the president's predators.
The free trade agreement would have abolished all customs tariffs between the European Union and Ukraine as well as promoting regulatory convergence in competition policy, state aid, and energy policy. It would have a great positive impact on the Ukrainian economy. The economists Veronika Movchan and Ricardo Giucci have estimated that it would add 12 percent to Ukraine's GDP in the long term, and Oleksandr Shepotylo has assessed that it would expand Ukraine's exports by 46 percent in the long term.
The Association Agreement also offers a far-reaching reform plan for the Ukrainian state. The European Union has committed itself to considerable technical assistance. Sixty state agencies in various EU countries have committed themselves to reform their Ukrainian counterparts. This could amount to a cleansing of Ukraine's pervasive corruption and the state-building that Ukraine itself so far has failed to accomplish. The EU state agencies already have a successful record from the previous enlargements of the Union.
But for the moment these incentives seem to have been overridden by Yanukovych's fear of Russia's President Vladimir Putin, whose government openly threatened Ukraine with a variety of economic and political sanctions if Kiev were to follow up on its promise to seek closer relations with Brussels.
For a long time the Kremlin did not pay much attention to Ukraine's dealings with Europe, presumably thinking that the European Union could not possibly accept Yanukovych's shenanigans. In the middle of the summer, however, Moscow woke up. It started a trade war with Ukraine, blocking exports to the Russian market of steel pipes, chocolate, and various agricultural goods—all of which, it happened, were products controlled by pro-European Ukrainian businessmen. In August, Russia blocked most Ukrainian exports for 10 days by complicating customs procedures at the border. Ukraine's large exports of railway cars have also been impeded. Russia eased up temporarily but threatened to impose new trade barriers (designed to drive Ukraine into default) and to cut gas deliveries, as it did in 2006 and 2009.
Both Russia and Ukraine are members of the World Trade Organization (WTO) (Ukraine since 2008 and Russia since August 2012), but neither country complies with its WTO commitments. Ukraine has launched complaints against Russia in the WTO, but WTO procedures are too slow to be useful, and Ukraine is in desperate straits. The European Union proposed a more effective remedy: immediate additional market access as compensation for Russian trade sanctions.
Ukraine has traditionally tried to straddle the divide between the West and Russia. The Russian trade war of August suggested that this tactic had been exhausted. Yanukovych reacted swiftly but contradictorily, first turning to Europe and then to Russia.
EU representatives have long demanded that Yanukovych carry out 11 major legal and political reforms, but the president just stonewalled them. At the end of August, Yanukovych changed tune. He accepted all the EU conditions lock, stock, and barrel, and jump-started a legislative process to have them all adopted before Vilnius. They include constitutional amendments on the judicial system and the constitutional court, laws on all arms of law enforcement, a new electoral law, and renewed elections where parliamentarians had wrongly been deprived of their seats. A score of laws went through the parliament, the last being the new electoral law.
Yet two bills that did not pass were precisely the ones that mattered the most: On November 21 the Ukrainian parliament, the Rada, voted down a proposed law that would have allowed Tymoshenko to seek medical treatment in the West, thus flouting the European Union's key demand. Nor did the parliament adopt a vital judicial law aimed at transforming the prosecutor's office. Without it, all the planned reforms of law enforcement become toothless. Shortly thereafter the Ukrainian cabinet confirmed that it would stop its preparations for signing the European Association Agreement and instead negotiate deals on trade, gas, and transportation with Russia.
This turn of events had been preceded by two trips by Yanukovych to see Putin in Russia. On November 20, Ukraine's Prime Minister Mykola Azarov met Russia's Prime Minister Dmitry Medvedev in St. Petersburg, and they seem to have settled the deal. The official communiqué stated that they discussed mutual cooperation on "access to pipeline transportation, free trade in services, and the gradual restriction of export taxes." The general understanding is that Russia is about to offer a substantial package of financing of some $10 billion a year in the form of lower gas prices and credits from Russian state banks. Putin's advisor Sergey Glazyev mentioned such an arrangement at a conference in Yalta in September. (Azarov has dismissed these assumptions as nonsense.) All this leaves the impression that Yanukovych tried to bargain with the European Union, which refused, while Putin was ready to put money on the table.
Putin has all along made clear that his aim is to compel Ukraine to join his Customs Union with Belarus and Kazakhstan. Yanukovych, for his part, has firmly opposed accession, which would reduce both his power and economic growth in his country. No formal agreement between Russia and Ukraine has been made public. It is doubtful whether Putin will accept $10 billion a year of financing for Ukraine just for it not signing the European Association Agreement. Russia pays approximately as much a year to bankroll Belarus and keep it in the Customs Union. There has been no public talk about Russia stopping South Stream, the gas pipeline that is supposed to eliminate Russian gas transit through Ukraine.
It is also possible that Yanukovych did not want the Association Agreement, but he wanted to look as if he was trying. Now he can keep Tymoshenko in prison and deprive other opposition leaders of the right to stand in the presidential elections scheduled for March 2015, and, without any new law on prosecution, he maintains control over law enforcement and courts. The large-scale transfer of financial assets and companies to his "family" can continue. But given the circumstances surrounding Ukraine's sudden rejection of the agreement, Yanukovych is not in a position to credibly blame Tymoshenko for the problems. Instead, he has cited pressure from Russia, while Azarov has blamed the IMF for its impermissible demands.
Yanukovych is walking on eggshells. Ukraine's economic situation is precarious. The risk for a run by ordinary Ukrainians both on banks and the Ukrainian currency is evident, though Ukraine has been on the brink for so long that no panic is apparent. The rating agencies mercilessly downgrade Ukraine ever lower, and corporate defaults are all too common. Ukraine is in desperate need of an IMF agreement, but Yanukovych has recently firmly rejected any (necessary) increase in domestic gas prices, and it should depreciate the hryvnia in any case.
On Sunday, November 24, more than 100,000 Ukrainians took to the streets in Kiev, and protests erupted throughout Ukraine. Demonstrators draped themselves in the European flag and blue-and-yellow ribbons. Opposition leaders took the stage at the European Square in Kiev, eerily reminiscent of the Orange Revolution. A serious political challenge has been added to the economic risks.
The European Union, and the United States, has regretted Ukraine's decision to stop its preparations for signing the Association Agreement, but the European Union has emphasized that its door remains open. Yanukovych is welcome to sign at the planned EU-Ukraine summit in the spring. The game is not over. Russian financing remains uncertain and hardly sufficient. This does not look good for anybody.