Why is the Ukrainian economy in such a mess?

UKRAINE’s problems are not just political. In recent weeks, its economy has taken a hammer. Until mid-January, its currency, the hryvnia, was fixed at 8: 1 with the dollar; it is now trading at around 10: 1. The government recently issued short-term debt at interest rates of up to 15%; this year its bonds have hurt about as bad as Venezuela’s. Many analysts fear the country will default on its debt soon.

The economic turmoil reflects recent political instability. But Ukraine’s economic problems were long in the making. Questionable economic policies, loathing for reforms and endemic corruption have brought the country to its knees.

In the immediate post-Soviet era, Ukraine was a massively unproductive economy. Like most of the former Soviet republics, it suffered huge production cuts and soaring inflation. But Ukraine has been among the hardest hit. Hyperinflation in the early 1990s was the result of lack of access to financial markets and massive monetary expansion to finance public spending, in the face of sharply declining output. The Ukrainian population has been marked by the experience of hyperinflation. In response, in 1996, the Ukrainian central bank replaced the old currency, the karbovanets, with the hryvnia and pledged to keep it stable against the dollar. However, the currency continued to falter until the late 1990s, and particularly in the midst of the Russian ruble crisis of 1998.

Russia and Ukraine stabilized in the early 2000s. Capital fell, attracted in part by relatively high interest rates (the early 2000s, when the Fed lowered its main interest rate to 1% for a long time, was kind of a repeat for the post-crisis environment). As foreign liquidity flooded the money supply, the money supply grew rapidly: from 2001 to 2010, broad money grew at an annual rate of 35%. In 2006 and 2007, credit growth averaged 73%. Assets started to look extraordinarily bubbly, and high inflation hurt the competitiveness of Ukraine’s exports.

After the global crisis and as the euro crisis intensified, Ukraine suffered from a drought in capital flows (as well as much of central and eastern Europe) which exerted a strong downward pressure on the hryvnia. Currency protection has depleted central bank reserves, which have grown from a high of $ 40 billion in 2011 to around $ 12 billion today. Last month, the central bank admitted defeat and ditched the currency. The depreciation of the currency, while necessary, will be an economic headache for Ukraine in the short term. About half of its public debt is denominated in foreign currencies: as hrvynia depreciates, Ukraine’s debt burden increases. Debt financing has also become more difficult due to the “taper” of the Federal Reserve, which has upset many emerging markets by halting the previously constant flow of capital in their direction.

Ukraine has been reluctant to embark on reforms. For a while, it seemed like it wasn’t necessary: high commodity prices in the 2000s supported growth. Many Ukrainian exports went to Russia, a country which was also doing well thanks to high oil prices. But Ukraine has been hit hard by the financial crisis and falling steel prices. GDP fell 15% in 2009. This made it a prime candidate for economic rationalization. In 2010, the IMF agreed to lend Ukraine $ 15 billion, under certain conditions. A major objective of the reform was the soft energy subsidies from Ukraine. The national gas company, Naftogaz, only charges consumers a quarter of the cost of importing gas. Cheap gas discourages investment: Ukraine is one of the most energy-intensive economies in the world, and domestic production has fallen by two-thirds since the 1970s. The IMF ended up freezing the deal in 2011 after Kiev did not touch on the expensive subsidies.

In other areas, reform has been timid. The government reached its public deficit target of 2.8% of GDP in 2011. Yet this was achieved by skimping on capital spending while spending too much on wages and pensions: this is not the recipe sustainable economic growth. The gradual drop in the corporate tax rate has also weakened the state’s finances.

Corruption and bad governance are other major problems. Ukraine’s underground economy is one of the largest in the world, accounting for around 50% of GDP, according to an IMF study. Companies operating underground tend not to pay taxes, further depriving the government of funds. And last week, the new Ukrainian prime minister estimated that $ 37 billion had disappeared under the reign of Viktor Yanukovych.

At present, Ukraine is not too concerned about improving economic management. But big bills are looming: Ukraine must find around $ 25 billion this year to finance its large current account deficit and meet its foreign creditors. Foreign exchange reserves are only $ 12 billion. The flaw is certainly on the cards. When the crisis ends, tackling its economic backwardness must be a major objective.

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