Ukraine – 2015:From economic crisis to

sustainable growth

Analytical center «New social and economic policy»

Iryna Akimova

May 2015

The roots of crisis and its implications

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External and internal shocks• political instability caused by a revolutionary removal of the previous government, formation of

transitional government institutions, early election of the President and the parliament;• annexation of the Crimea by the Russian Federation and war (anti - terror operation) in Donbass, which

resulted in the loss of 20% of Ukraine’s industrial potential; 30% of the territory of the Donetsk and Lugansk regions is not controlled by the Ukrainian government;

• the loss of traditional markets in Customs Union, especially in Russia+ deteriorating situation in the main export markets in the second half of 2014.

Main reason of the crisis: • Unreformed economy + low pace of modernization in 2014-15---- increase in vulnerability to external

and internal shocksConsequences:• rapid decline in GDP in 2014 (6.8%) and industrial production (10.1%), increased state budget deficit

(10.3% of GDP) and public debt (72.6% of GDP), frozen external financial markets and ↑ risks of sovereign default;

• deep devaluation of the hryvnia (UAH lost almost 2/3 of its value vs USD), and galloping inflation (60.9%, y-o-y in April 2015);

• crisis in the banking sector = flight of deposits (31.2% currency and 13.7% in local currency, 2014) + the share of insolvent banks grew fast (in 2014 every 4th bank was derived from the market);

• 194 thousand of legal entities (15.2%) ceased to exist in the I quarter of 2015;• social crisis: unemployment rose from 7.2 to 9.3%, real wages fell by 6.5% y-o-y, pensions were frozen at

the level of 2013; more than 1.1 million of IDPs in need of assistance.

Weak growth perspectives and an expanding gap with EU in terms of GDP/ per capita

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Weak growth perspectives. In 2015 , GDP is expected to drop by 5.5% (official forecast), - 9% (NBU estimates), - 9,7% (JP Morgan); slow recovery is envisaged in the mid-run: + 0.5-2% (official, NBU – growth up to 3% in 2016, and + 0.8-3.5% - in 2017), which is still lower than the Ukraine’s level of potential growth (4%).

The gap in economic and social development between Ukraine and the EU countries has increased:• In 2015, GDP in relative prices may return to the level of late 2004 – early 2005- a decade has been “lost” for

economic development of the country; • In 2014, Ukraine's GDP per capita in USD amounted to 9% of ЕU-28 average and 18% of ЕU-13 average (new

members of EU since 2003); • in 2005-2014, GDP per capita in Ukraine as % of the corresponding indicator in the other country went down from

23 to 21.4% of Poland, from 24 to 18.6 % of Lithuania ,and from 39 % to 30% of Romania ;• In 2015, GDP per capita will contract to nearly 2000$ assuming an average annual exchange rate of 21.7 UAH /USD

(compared 3900$ in 2013). According to the WEF methodology, Ukraine will enter the club of poorest countries (with GDP/ per capita of ≤ 2000$) whose pace of development is driven by natural resources and unskilled labor.

• In 2015, GDP per capita based on PPP, (8240 $. In 2014 г., IMF) is expected will to be less than 1/3 of ЕU-13 average and 1/4 of ЕU-28 average → reaching the target of 16000$ per capita (PPP adjusted) by 2020 -one of major QPI in Strategy “Ukraine - 2020”- seems to be unrealistic.

The quality of public administration hasn’t improved in 2014-2015

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Though new ruling political parties….. were able to form a pro-governmental constitutional majority, start a successful cooperation with international partners (receiving external financial support that

decreased the risks of sovereign default, signing the Association Agreement with EU) launch several reforms (revitalizing public finance and banking system, the energy sector,

continuing deregulation and the setting a new framework in fighting corruption)…

……….quality of public policy did not improve significantly:• Social populism was substituted by “reforms” populism. Number of plans of reforms has increased

sharply. But implementations disciple remained low, dynamics of reforms did not correspond to the dynamics of ongoing economic crisis and the level of external threats. E. g., , only 13 tasks (or 30%) were implemented out of 44 tasks set in the Actions plan for implementation of the Association agreement and due by 1 April 2015;

• The impact of oligarchs on national economy and politics remained high. Redistribution of property has started, economic monopolization remained;

• Social mistrust to the state authorities and economic institutions has increased. E.g., according to the study by Rasumkov Center (March 2015), more than 77% of respondents distrust NBU. International partners do not trust political promises and firmly link provision of financial support to the progress in reforms ;

• Negative expectations of business and population has strengthen driven by inconsistency of actions (e. g., foreign exchange restrictions and refinancing policies of NBU) , continuous conflicts inside the coalition + poor communication policies.

IMF program doesn’t guarantee a success due to a lack of trust to the government

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IMF currently stands as the main source of external funding for Ukraine, laying grounds for cooperation with other IFO’s. IMF program has become the main external anchor of reforms. IMF program sets the tasks of stabilization policy. However, it can not guarantee the success of reforms. Moreover, , if the level of trust between the central authorities, population and business remains low, implementation of IMF program might cause a further economic cooling down or even an increase in social tension

Government’s stabilization policy looses its support among business and civil society due to:• the dominance of fiscal targets ;• the active use of rigid administrative methods;• the attempts to shift all the costs of painful reforms on population and business without offering a

"compensation package" - improved quality of social services, reduction in corruption and shadow economy;

• the attacks on freedom of speech and cases of political persecution of the opponents that are used to reduce public criticism of the lack of reforms.

Main weaknesses of the governmental social and economic policy in 2014-May 2015

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Macroeconomic stabilization: Soft monetary policy →dominance of fiscal goals over fight against inflation reduction (NBU is pressed to finance about

40% of the budget revenues) ; allowing 4 rounds of landslide depreciation of Hryvnia , the absence of a consistent exchange rate policy ; Late reaction on outflow of deposits, flaws in banking regulation and resolution of problem banks from the market

(95% of insolvent banks were liquidated) ; High budget deficit combined with weak results in ‘de-shadowing’ the economy;

Business Climate: Corruption remained high (142 place among 175 countries, Transparency International) Regulatory burden on business remained high (even after deregulation – 24 regulatory bodies with 680 control

functions, 33 types of licensed activities) Fiscal and administrative pressure on business gave gone up (doubled rent rates impede the increase of domestic

natural gas extraction, introduction of special VAT-accounts and non-disputable withdrawal of tax liabilities); Corporate raiding became more frequent;

Real Sector of the Economy: Late reaction to the supply shocks in the markets for natural gas, coal and electricity in 2014; No credible support of Ukrainian exporters that faced political barriers in the Russian market (exports to Russian

Federation dropped by USD 5,9 billion, and to EU increased just by USD 0,3 billion) Social Sector:

A sharp fall in living standards («frozen» social minimums, ↓ of financial aid for the 2nd and 3rd newborn child, new taxes on pensions of employed pensioners) without launching mechanisms to prevent the extreme poverty;

A sharp raise in public utility tariffs without an installation of meters and any improvement in the quality of services; ↓ financing in social sector without taking measures to ↑ efficiency of their using; An abolishment of some useful projects of the predecessors - reimbursement for the select drugs, incentives for GPs

Recommendations: macroeconomic stabilization-strengthen the cooperation

between NBU and the Cabinet of Ministers

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Implement and communicate a predictable FX policy: Develop an anti-crisis plan for the case of a new round of steep devaluation, including switching to a more predictable

FX policy under currency corridor or other managed FX arrangements; Ensure a tight control over banking refinancing; Ease gradually foreign exchange restrictions; Develop the tools for FX risks insurance; In the medium term: switch to a floating exchange rate as economic situation returns to the equilibrium, liberalizing

currency regulation and reducing the level of dollarization. Carry anti-inflationary policy based on an increased independence of the NBU: In 2015,continue a tight monetary policy with the positive real interest rates and efficient and transparent refinancing; Increase the political, financial and operational independence of the NBU by adopting necessary legislation; In the medium term: switch to the inflation targeting; Improve sustainability of the banking sector: Speed up the restructuring/closure of “zombie banks”, and capitalize solvent banks gradually; Use flexible schemes for recapitalization, restructuring and transferring of problematic banks to investors in order to

minimize the losses for the state/ bank customers; Improve the effectiveness of banking supervision, set constraints on the transactions with the related parties; Strengthen the protection of creditors' rights; In the medium term: attract long-term resources to restore the lending activity; Reduce the debt burden on the economy and ensure a flexible approach to fiscal consolidation: Restructure the external debt of Ukraine taking into account parameters set by the agreement with IMF; develop

domestic debt markets, including a possibility for issuing bonds in local currency by IFOs; In the medium term: in case of a deeper economic recession in 2015 extend (by 1-2 years) the plan of fiscal

consolidation in order to stimulate aggregate demand in the economy.

Recommendations : deregulation & combatting corruption

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In the short term:• Strengthen the fight against corruption – launch NAB and National agency for prevention of corruption, start

the assessment of revenues and expenditures of civil servants and their families, enhance the transparency of public procurement (min exceptions from general rules, reducing time of the procedures, revealing info on real owners standing behind the bidders , and switching to E-procurement);

• Fight against raider-schemes, including strengthening an appropriate criminal prosecution ;• Harmonize the standards of technical regulation with the EU requirements ;• Continue deregulation and de-monopolization – cut the number of licenses from 33 to 12-15, the number of

licensing procedures – by 1/3; promote local "regulatory guillotine"; increase the independence and efficiency of Anti- Monopoly Committee ;

• Ease the tax burden for business : cancel special VAT - accounts, ensure full VAT reimbursement (including covering the accumulated debts); improve practices of voluntary advance payments on CIT;

• Reduce the level of state intrusion into business activities : an interruption of business operations during the checks should be allowed only after the court decision; the size of financial sanctions should be set in accordance with damage implied ; the decisions of KMU on having unplanned checks of business entities during the moratorium should become public;

• Continue the administrative reform and improve quality of administrative services: revise the number/ functions of central executive bodies, de-politicize civil service, expand the network and enrich the list of administrative services offered by the centers for providing administrative services /

In the medium term: Switch to e- format in provision of all the permits; Tax reform – simplify tax administration and reporting procedures, minimize exemptions from the general tax

rules; set the investment-attractive tax rates , incl. rate of social contribution ; Harmonize the state checking system with the European standards; Adopt a new legislative framework on provision of state support to enterprises, incl. SME

Recommendations :support real sector of the economy and increase energy

security

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Increase national energy security: Increase energy supply by boosting domestic production:

o Reduce rent rates on extraction of natural gas to the level as of 2013; o Increase the purchasing price of natural gas from state owned producers to the level consistent with full

import parity Cut energy demand by increasing energy efficiency

o By 2017 , ensure commercial metering of gas consumption by all households and business entities;o Increase financial support of the energy efficiency projects from all sources (budget, IFO, soft external credits);

By October 2015, switch from cost-plus to incentive- based tariff policy in order to provide incentives for costs reduction and transparent tariff setting

In the medium-run: increase the level of energy efficiency and promote competition in energy markets (incl unbundling of Naftogaz into separate production, transportation and storage companies; switch to the bilateral contracts model in energy market)

Support of the real sector: Promote export by establishing the export credit agency to provide credits and state guarantees on credits to

exporters, ensure export credits against economic and political risks ;Use mixed financing to support agency's activities Support the exporters in obtaining the certificates of conformity and product labelling to ease their

entering EU market ; Attract additional international investment&credit resources (USD 30-40 bn of FDI and soft credits) for

restoring the economic potential of the country ,including:o gradual restoration of the destroyed social&transport infrastructure in Donbass, o increase energy efficiency and develop renewable energy; o Increase the share of goods with high value added in Ukrainian exports;

In the medium-run: use smart industrial policy to support poles/cluster of growth

Recommendations: combat crisis in social sector

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Strengthen the support to internally displaced persons Simplify registration of IDPs + switch to the common interagency registrar of IDPs; Use PPP mechanisms to provide social housing for IDPs on the regional level ;

Introduce one-for-all approach for providing pensions from pay-as-you-go pension system; Ensure effective work of the new social support system ( incl.utility subsidies )

In the medium-run: Optimize the system of social benefits, eliminating profession-based benefits; Monetize social benefits gradually taking into account existing budget constraints.

Fight against unemployment in the short run: Offer paid public works to restore the infrastructure of Donbass and provide social services for IDPs; Promote SMEs, up-date retraining programs of the State Employment Service according to the forecasted structural

changes in labour market; Develop new financing mechanisms in healthcare + broaden financial autonomy of healthcare units

Extend the Law “On pilot regions” to allow regional testing of the new financial mechanisms; Change the Budget Code to pool the financing of specialized healthcare on the regional level ; Provide operational and financial autonomy of the on the basis of service contacts between local authorities and

healthcare unitsIn the medium-run:

Define the ‘State-guaranteed healthcare package’ that is financed from the state budget; Develop and implement DRG-based financing for hospitals; Restore the pilot project on reimbursement of the select drugs and widen the reimbursement list;

Improve public procurement of drugs+ foster competition in the pharmaceutical market Develop drug supply based on the direct long-term contracts with the producers, including foreign ones; Simplify regulatory framework in the market for drugs.

Recommendations:restore the trust to the government

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Demonstrate “quick wins” in reforms (priorities – fighting corruption, public procurement, licensing system);

Abandon the idea of mass nationalization and re-privatization and continue privatization process ensuring transparency and equal treatment of all potential participants;

Try to separate politics from business instead of fighting against large business: Adopt the Law “On financing of political parties”, the Law “On mandatory disclosure of the ultimate owners of

mass media” and the Law ‘On lobbying”, Ensure independence of AMC from the Government; Focus state support policy on SMEs to promote growing middle class ;

Transparent personnel policy and division of authority: Support the Constitution Commission to develop a proposal on the division of responsibilities between the

legislative, executive, and judicial branches of power in order to minimize overlaps and maximize the efficiency of implementation mechanisms;

Change the Law «On Lustration» in line with the recommendations of Venetian Commission

Provide guarantees for democracy and freedom of speech: Stop any attempts of restricting the freedom of speech – either by creating artificial control/ regulatory obstacles

for mass media, or by starting politically-motivated criminal proceedings against political opponents / citizens with an alternative point of view

Re-loading Ukraine’s economy: strategic points

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Ordinary set of stabilization policies, even supported by IMF, is not enough to close the economic gap between Ukraine and EU. A public dialogue is needed to find consensus on several strategic questions:

What model of economic development to choose: state capitalism, liberal market economy, smart industrial /economic policy?

What is Ukrainian path of European integration? In the short-term – launching fully -fledged DCFTA regime with EU after 2015 . In the mid-term – open discussion with the European partners on Ukraine perspectives after implementation of AA (possibility of applying for membership in the EU after 2020-25).

How to change the Constitution in order to ensure country’s prosperity? What kind of decentralization do we want? What would be the efficient way of division of power between legislative, executive and judicial branches? What kind of state-guaranteed social package can we afford?

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