The Ukrainian Economy: A Slow Recovery and Much More to Be Done

In recent months, the long-awaited good news on the Ukrainian economy started coming. Although the economic crisis had begun two years before the outbreak of the Revolution of Dignity, the war with Russia and the loss of a large part of the industrial Donbas along with the access to the Russian market (traditionally crucial for Ukrainian exports) led to a breakdown of the economy. GDP fell by 6.6% in 2014 and by 9.9% in 2015, while industrial production dropped by 10.1% and 13.4% respectively. Exports, always the lifeblood of the Ukrainian economy, dived by 13.5% in 2014 and 30% in 2015. These declines produced a dramatic reduction of budget revenues, increased unemployment, and led to great impoverishment of the Ukrainian society. In the face of such a serious crisis, an obvious expectation was that the authorities would manage to stabilize the economic situation.

Signs of improvement in the macroeconomic situation have been visible since the second half of 2015, but only in the first quarter of 2016 they translated into GDP growth, by 0.1% compared to the same period of the previous year. In subsequent quarters, this index began to rise: to 1.4% in the second quarter and to 2% in the third quarter. The aggregate for 2016 will probably be in the region of 1.5%. Domestic investment also started to rise after many months of decline, by almost 10% in the first half of 2016. The return of the Ukrainian economy to the growth path is very good news, especially given the persistently adverse external conditions, i.e. the ongoing war in Donbas and restrictions on exports to Russia.

The renewal of economic growth has become possible thanks to macroeconomic stability. First, the dive of the hryvna exchange rate has been stopped and inflation lowered to 10% from several times this figure in 2015 (the highest rate, 61%, was recorded in April 2015). Second, a reform of the banking system was started, with the aim of removing quasi-banking institutions from it. As a result, 80 out of 177 banks disappeared from the market. The largest operation was the nationalization— in December 2016—of PrivatBank, controlling a quarter of Ukrainian banking assets. This set off the “healing” of the banking system and led to the growth of customer trust, reflected in the increase of bank deposits by 14% in just over a year. Third, foreign exchange reserves of the National Bank of Ukraine started to be rebuilt: from the critical level of $5.6 billion they grew to $15.3 billion by November 2016. They are still lower than before the Euromaidan Revolution (18.8 billion in November 2013) and significantly lower than in the first period of Victor Janukovych’s rule (30 billion in mid-2012). Fourth, public finance deficit was successfully reduced, from more than 10% in 2015 to 2% in 2016. Reining in budget expenditure is all the more remarkable in the face of the increased cost of maintaining the army, surpassing 5% of the GDP. At the same time, it would not be possible without removing subsidies on gas and electricity prices for private consumers and the public sector, previously absorbing as much as 7-8% of the GDP. Reform of the gas market, without which the repair of public finances would have failed, was also successful. Another success is that such a significant growth of energy prices has not led to social tensions (this was achieved also thanks to the introduction of a subsidy system for private households).

The stabilization of the economic situation would not have been possible without the support of international financial institutions and Western partners. From 2014 to 2016, Ukraine received almost $17 billion in the form of various types of loans and loan guarantees. The key creditor is the International Monetary Fund, which loaned Ukraine a total of $12.1 billion under its aid program, 5.1 billion of which was spent on repayment of older Ukrainian debts to this institution. The importance of Ukrainian cooperation with the IMF goes far beyond loans, as the Fund has been able to enforce key reforms on the Ukrainian authorities (including the energy sector reform, the bank reform, and the fight against corruption). Without the IMF pressure would many changes certainly be much more difficult and lengthy.

Despite these successes and a 2.5% growth forecasted for Ukraine in 2017, it would be definitely premature to say that the Ukrainian economy has entered a path of permanent growth. Although it does seem that the hardest part is already behind it, achieving rapid GDP growth will not be possible without further structural reforms. And it is important for the future of Ukraine if the annual growth rate is 2-3% or 5-6%. Recent months have confirmed a significant slowdown in reforms. This is among the reasons why in 2016 Kyiv received only one tranche of aid from the IMF ($1 billion). Stabilization of the financial situation meant a decreased significance of the Fund for Ukraine, hence the reduced readiness of the authorities in Kiev to introduce further structural reforms. The payment of the next tranche ($1.3 billion) is significantly delayed and successive reforms required by the IMF are lagging behind. It particularly concerns a more robust fight against corruption (including the extension of the powers of the National Anticorruption Bureau), the reform of pensions, and the privatization of state-owned enterprises. Out of eight key points of the IMF program for 2016, Ukraine implemented only one (launching a website for financial declarations of politicians and officials; it was also an EU requirement for the liberalization of the Visa regime).

There is an evident growth of resistance on the part of some government leaders and the bureaucracy uninterested in systemic reforms. This also means a delay in the implementation of changes already adopted by the parliament and in the preparation of new reforms (e.g. of the energy sector). The reason is that the planned reforms hit at the interests of oligarchic groups, which remain important players in Ukrainian politics and economy. The relationships between the government and the big business show that politicians have to reckon with the interests of the oligarchs controlling important sectors of the economy. This is clearly reflected, for example, in tariff preferences for DTEK, the largest Ukrainian power company controlled by Rinat Akhmetov, or in the nationalization of the PrivatBank, carried out in a way benefiting Ihor Kolomoisky, and leaving in his hands the control over Ukrnafta, Ukraine’s largest oil company (the government holds 51% of its shares).

It may be expected that the IMF will keep up its pressure on Kyiv to continue the process of reforms. Maintaining cooperation with the Fund is important for the reconstruction of Ukrainian credibility among investors and on the capital markets. Although the financial situation no longer requires successive IMF loans and Kyiv could start selling Eurobonds, the interest rate would be about 9% per year, which is still a very high rate. It is worth remembering that in the next three years the budget will be burdened with the necessity of repaying as much as $14 billion of foreign debt (which amounts to 14% of the Ukrainian GDP), and the repayments will systematically grow: from 2.6 billion in 2017 to 3.9 billion in 2018 and as much as 7.5 billion in 2019.

If Ukraine is to achieve a consistently high GDP growth rate, the following steps must be taken:

— A successful fight against corruption, which still remains the fundamental problem of Ukraine, the most corrupt country in Europe. Establishing anticorruption institutions is an important change, but there are evident attempts at restraining their effectiveness on the part of some government representatives to whom they pose a threat;

— a continued reform of the corrupt justice system and providing better protection of private property, as well as removing the limitations on trading in farming land;

— improving the business environment for small and medium-sized companies, including a tax reform and further liberalization and deregulation.

Without real improvements in these three areas it is difficult to expect that Ukraine may successfully attract foreign investors. The aggregate value of direct foreign investments in Ukraine fell from $58 billion in late 2013 to $45 billion. This situation is well illustrated by photographs from the November International Economic Forum in Kyiv, where you can see that at least two thirds of the seats were empty. Although Ukrainian labor costs are among the lowest in Europe (the average salary is currently around €150 per month), it is not sufficient to guarantee an influx of foreign investors. No less important is providing independent economic courts, securing property rights, and reducing corruption.

Another problem is the so-called corporate raiding, that is illegal takeovers of property with the aid of bribed judges and notaries. Ukrainian authorities take measures to attract foreign investment (for example, National Investment Council was established in August 2016), but they have not produced the expected results so far. Even Ukrainian businessmen are afraid to make larger investments, and billions of dollars of domestic capital which escaped abroad after the Euromaidan Revolution have still not returned to Ukraine. And yet the authorities estimate that if the Ukrainian economy is to develop more rapidly, $8-14 billion of annual investment are required until 2030. On the one hand, the ongoing war keeps discouraging potential investors, and on the other hand more robust measures aimed at improving the business environment are needed. Although in the Doing Business 2017 ranking Ukraine went up from 87 to 80 in the world, recording an improvement in 5 out of 11 categories studied (in six categories it fared worse than before), it is still a bad result. In the most recent World Economic Forum’s Global Competitiveness Index rating Ukraine went down from 79 to 85. Lack of improvement in the business environment is exacerbated by repeated delays in the planned privatization process. Ambitious aims assuming $700 billion of revenue from privatization in 2016 remain unfulfilled (the sale of state-owned assets brought around $40 billion).

Another condition for entering the path of rapid growth by the Ukrainian economy is rebuilding exports, traditionally one on the engines of GDP growth. Data for the period from January to October 2016 show that Ukrainian exports keep falling—by 8% compared to the same period in 2015. The cumulative value of exports was just $29.1 billion. In the same period imports amounted to $31.2 billion (down by 0.1%). This means that Ukrainian producers have still not recovered from the shock of losing the Russian market, which previously was getting one third of exports. In the first 10 months of 2016, exports to Russia fell by 28% and were worth just $2.9 billion, that is, less than 10% of the entire Ukrainian export. This is an effect of politically motivated tariff barriers and sanctions introduced by Russia. As a result, the exports of Ukrainian goods to Russia decreased by 75% since 2013. The loss of the Russian market has so far been only marginally compensated by an increase in exports to the EU. The share of EU countries in Ukrainian foreign sales increased from 31.8% in 2013 to 35.7% in 2016. This is facilitated by the implementation of the DCFTA, although we have to wait a few years for the full effect of this agreement to become visible.

Ukrainian economy is in the process of structural remodeling. If Ukraine uses the opportunities provided by the agreement with the EU, the authorities continue the process of reforms, and the conflict with Russia does not escalate, we may optimistically assume that Ukrainian economy will have a good chance of achieving a stable growth. Given the currently still difficult economic situation of Ukraine, it should be stated that the future of this country largely depends on the realization of this scenario.