Ukraine’s economy has turned a corner
On the surface, little appears to have changed since Russian-sponsored separatists seized parts of eastern Ukraine three years ago. Fighting broke out intermittently, but the frontline remained effectively frozen and efforts to find a diplomatic solution stalled.
Yet that is far from the whole story. While the military aspects of the conflict have dominated the headlines, the real battle for Ukraine’s future has always been elsewhere.
It is based on the country’s ability to restore stability and prosperity even though its territorial integrity has been brutally compromised. On this measure, Ukraine is beginning to make real progress.
Russia’s intervention was primarily intended as a form of economic warfare. The goal was not to capture land but to weaken Ukraine and turn it into something akin to a failed state.
In this he at first succeeded. At war with its biggest trading partner and cut off from many of its most productive industrial assets to the east, Ukraine has been forced to the brink of economic collapse.
The hryvnia lost around 70% of its value against the dollar, inflation soared to 60% and the combined budget deficit (including the state budget and the national energy company, Naftogaz) soared to more than 10% of GDP. The economy contracted by 6.6% in 2014 and another 9.8% in 2015, a more severe downturn than that experienced by Greece.
Things look very different three years later. Macroeconomic stability has been restored and Ukraine appears to be on the road to recovery. A more stable exchange rate has helped bring inflation under control (it fell to 12.4% last year and to 6% according to projections next year).
Production is now rising for the first time since 2012, with growth of 2% last year expected to increase to 2.8% this year and over 3% in 2018. The resumption of growth and the decline in l Inflation have, in turn, led to difficult living conditions. standards to start recovering. Real wages increased by 11.6% in 2016.
The Ukrainian government has also paved the way for long-term fiscal sustainability through a combination of spending cuts and tax reform. A budget deficit of 2.2% last year was well below the 3.7% ceiling set by the IMF.
Although the deficit is expected to widen to 3.1% this year, the increase is largely due to payroll tax cuts needed to reduce labor costs and stimulate the economy.
An improved and simplified tax code, together with increased economic activity, increases the contributions of income tax and VAT to national revenue. Naftogaz is now in surplus.
The next big challenge is reforming an unsustainable pension system that accounts for more than a quarter of public spending and has been described by the World Bank as “a major fiscal vulnerability”.
A plan drawn up by Finance Minister Oleksandr Danyliuk is currently before the Rada and aims to bring costs into line with income by tightening eligibility, broadening the contribution base and raising the effective retirement age.
With the pension deficit currently exceeding 6% of GDP, changes are essential to achieve the government’s objective of reducing the overall budget deficit to 2% by 2020.
None of the progress made so far would have been possible without international financial support, mainly in the form of a $17.5 billion loan facility from the IMF.
The fact that Ukraine managed to release four tranches of this funding, totaling $8.38 billion, is an achievement in itself. The past failure of reforms meant that, until now, no Ukrainian government had managed to secure more than a single tranche of IMF financing.
The current administration deserves credit for enacting unpopular but necessary reforms that its predecessors eschewed, such as the removal of energy subsidies that fostered inefficiency and corruption.
He was also hailed for the speed with which he acted to avert a major financial threat by nationalizing PrivatBank, Ukraine’s biggest lender, after it went bankrupt in December.
The big test of these changes is how they affect investor sentiment and allow Ukraine to attract much-needed foreign capital. FDI flows, which came to a halt with the start of the war, have resumed, albeit timidly.
While much of this money is tied to the recapitalization of the banking system, there has also been significant new foreign investment in export-oriented production, particularly in western Ukraine.
The new free trade agreement with the EU, combined with the proximity to the European market, creates an opportunity for Ukraine to become an integral part of the continental supply chain, creating new centers of economic production to replace the lost capacity to the east.
Another milestone is expected this year when Ukraine is expected to return to the sovereign debt market with its first new bond issue since 2013.
At the time of Ukraine’s debt restructuring deal in 2015, the prospect seemed remote. But the IMF program has always envisaged that Ukraine would be ready to return to the market in 2017 and there are signs of investor appetite.
To achieve these results, Ukraine will need to maintain and deepen its reform efforts.
In addition to cleaning up the pension system, the next frontier is land reform where the government hopes that liberalization will bring higher investments and a new dynamism to the agricultural sector.
This week the government delayed bringing a reform bill to parliament where populist opposition politicians are trying to obstruct changes that are needed before the next tranche of IMF funding can be released. The moment of truth on this subject will come in the fall.
As always, further steps must be taken to root out corruption, which remains a greater impediment to Ukraine’s progress than any plan devised by the Kremlin.
Much good work has already been done, but perceptions of corruption remain stubbornly high. Changing this remains by far Ukraine’s most important challenge.
It is becoming increasingly clear that Russian President Vladimir Putin’s strategy to weaken Ukraine and raise the price of Western support has failed as the country continues to move towards the goal of economic self-sufficiency.
On the contrary, it is the dissident entities in eastern Ukraine that seem likely to become an exorbitant and unproductive burden on Moscow.
It is this dynamic, not the balance of military forces, that offers Ukraine the best hope of restoring its territorial integrity. Reform is, and always has been, its most powerful weapon.
David Clark is President of the Russia Foundation