Sunday, May 24, 2015

Ukraine’s Economy: War-Torn Reform

KIEV, Ukraine -- Even before the Russian invasion of the east of the country last year, the task of reforming Ukraine’s economy was daunting.

Its people are poorer than they were when the Soviet Union ended.

Corruption pervades Ukrainian life.

The traffic police demand bribes at random and newspapers carry advertisements for companies that will forge exam papers for you.

To this set of chronic problems, the war has added acute ones: the destruction of much of the country’s industrial base, spooked investors and a balance-of-payments crisis.

If Ukraine is to build a stable economy, it must fix the public finances, shake up the all-important gas sector and stamp down on corruption against the backdrop of an unresolved conflict.

Ukraine’s public debt is around 100% of GDP, much of it denominated in foreign currency.

Already unsustainable, its debt burden is on an upward path: in the first quarter of 2015, Ukrainian GDP fell by almost 18% year on year.

With nearly $6 billion of foreign debt falling due in the next year, but foreign-exchange reserves of around $10 billion, Ukraine has little room for manoeuvre.

Despite the central bank offering interest rates of 30%—the world’s highest—the hryvnia, Ukraine’s currency, is shaky.

If it falls, servicing foreign debt will become even trickier. 

The IMF, with which Ukraine agreed a bail-out deal in March, has been clear about what is needed to make the country’s debts sustainable.

It assumes that the government in Kiev will write off $15.3 billion of debt and interest by 2018, and that it will have reduced its public-debt-to-GDP ratio to about 70% of GDP by 2020.

The goal is to reduce debt repayments in any given year to no more than 10% of GDP.

To achieve this, Ukraine must cut a deal with the holders of its debt.

Negotiations are going badly.

The creditors are trying to get the government to agree only to maturity extensions.

Ukraine wants to reduce the total amount of debt it owes, as well as pushing back repayment dates.

It looks increasingly likely that Ukraine will fail to reach an agreement by June, which could delay the disbursement of a badly needed $2.5 billion loan from the IMF.

Even in the face of obstinate creditors, says the IMF, all is not lost.

It hopes that tax rises and spending cuts will help make Ukraine’s debt sustainable.

As much as half of the economy operates out of the reach of the taxman: tackling this would boost revenues.

Ukraine’s big shadow economy is partly down to its high payroll taxes (ie, those that are levied on workers).

Low “tax morale” plays a role, too.

People see little point in paying their share, since public services are poor and corruption pervasive.

VAT evasion is rampant.

The government is acting.

It has introduced an electronic VAT system, for instance, which will make evasion more difficult.

Payroll-tax breaks should also help to bring more firms out of the shadows.

The State Fiscal Service reported in April that it had received about 3,000 applications to take advantage of a tax amnesty—whereby people make an honest tax declaration in exchange for a waiver from penalties—though that boosted revenues by just $12m.

Some taxes have risen.

The maximum rate of personal-income tax has moved from 17% to 20%.

This seems to be paying off: overall tax revenues are rising.

The government is also making tough decisions on spending.

Anders Aslund of the Atlantic Council, a think-tank, says that the government has cut the cost of Ukraine’s pension system from 18% to 14% of GDP, mainly by changing the way that payouts rise and removing perks enjoyed by the old Soviet elite.

The biggest reform to pensions, raising the retirement age, has been kicked into the long grass.

Spending on education and health care has seen big drops, and a fifth of civil servants are being fired.

In the first quarter of this year, state spending in real terms was 17% lower than the year before, leading to a budget surplus.

The government can also save money by reforming the gas sector, the second of its big tasks.

It is a huge fiscal hole: in 2014 the state monopoly, Naftogaz, ran a deficit worth 5.7% of Ukraine’s GDP.

An opaque system of subsidies is to blame.

For years, it ensured that Ukrainian households received gas at one-fifth of its cost.

That boosted disposable incomes for many (though not for the very poorest, who are cut off altogether from the gas network), but it was also an avenue for graft.

Many grew rich by buying gas at the household rate, then selling it on at industrial prices.

The current government, in contrast to predecessors, is making a serious effort to shake things up.

On April 9th the parliament passed EU -inspired legislation to “unbundle” Naftogaz—splitting it up into separate production, transit, storage and supply firms.

Once implemented, consumers will be able to choose their gas supplier, a radical change.

To close Naftogaz’s deficit, the government is increasing the household price of gas fourfold.

Ukrainians will not really feel the pain until November, when they see the first bill of the winter.

To offset the hardship, the government and the IMF say that spending on social programmes will see “an increase of 30% compared to 2014”.

These figures are in nominal terms, however; with inflation running at 60%, social spending is probably falling in real (ie, inflation-adjusted) terms.

In other areas, reform is more sluggish.

The stations used by Naftogaz to measure imports are inside Russia, meaning that no one is sure how much gas really enters Ukraine.

Although the Ukrainian authorities insist that the flow is closely monitored, others fear there is huge scope for malpractice.

A senior EU official dealing with energy believes that each year up to €200m ($222m) worth of gas may go astray.

Ukraine’s foreign allies have repeatedly urged it to install meters on the border, so far to no avail. 

Graft is everywhere.

A list of the world’s most corrupt states, compiled by Transparency International, a pressure group, puts the country at 142nd—little better than the Central African Republic.

The government has made much progress in one hotbed of corruption, public procurement, by closing loopholes and making it more transparent.

But another flagship policy, an anti-corruption bureau, worries some.

A 190-country study by Alina Mungiu-Pippidi and colleagues at the Hertie School of Governance, in Germany, shows that dedicated anti-corruption institutions typically fail.

That is usually because the bureau itself ends up becoming a target for corruption and political influence.

Corruption also festers in Ukraine’s legal system.

The courts use a mixture of a modern Western civil code and a Soviet-inspired economic code.

This creates problems, says Daniel Bilak of CMS Cameron McKenna, a law firm, since civil law in general, and commercial law in particular, require certainty and predictability in their application.

Judges can choose which code to apply in business disputes, which makes the law confusing and opens the door to bribes.

Some reform has begun, however, including making land-registry records available online, and judges are being more closely scrutinised.

This government has the most ambitious economic programme in Ukraine’s short history.

But one area beyond its control is the situation in the east of the country.

Vladimir Putin, the Russian president, has the power to heighten the conflict there at any time, doing further damage to the economy.

That is not a comfortable position for any country to be in.

Source: The Economist

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