Commentary Type

Ukraine: Coalition Agreement and Looming Financial Crisis

Daron Acemoglu (Massachusetts Institute of Technology), Anders Åslund (PIIE), Oleh Havrylyshyn (International Monetary Fund) and Basil Kalymon (Ivey Business School, Western University, London, Canada)

Op-ed in the Kyiv Post


The coalition agreement signed on November 21 by the five participating political parties is an essential step toward the creation of a new government for Ukraine that could undertake the reforms that are so critically needed.

Most importantly, the coalition agreement commits the signatories to measures for the elimination of corruption and the establishment of the rule of law. The coalition agreement includes a number of important reforms, including that of the military and security systems, the courts, and the decentralization of public administration. Also welcome are changes included with regard to constitutional reform and the electoral system. Further, the coalition agreement recognizes the need to make changes in the social support and health systems.

The coalition agreement signed on November 21 is an essential step toward the creation of a new government for Ukraine that could undertake the reforms that are so critically needed.

With regard to economic reforms, the coalition agreement does outline a number of measures that are both necessary and important. These include the reduction of the number of regulatory agencies, the simplification of the tax system, the reduction in the social tax, the reduction in bureaucracy, and the simplification of business procedures. However, the coalition agreement totally fails to recognize the looming financial crisis and is highly flawed or totally inadequate in a number of critical areas.

At the present time, Ukraine is forecasted to have a budgetary deficit (including gas subsidies) of over 10 percent of GDP in 2014, requiring annual borrowing of around 200 billion hryvnia. This deficit is being financed by emissions by the central bank, increasing the supply of hryvnia.

At the same time, the total national debt to GDP will likely exceed 70 percent by year end, up from 40 percent at the start of the year.

Foreign reserves have fallen to approximately $12 billion at the present time, with major payments forecasted to essentially deplete this reserve by the end of the year. The value of the hryvnia has fallen by around 50 percent over the past year to an official level of approximately 15 to the dollar and trades even lower on the black market.

Inflation has risen above 20 percent. The central bank has imposed drastic restrictive measures on the purchase and trading of foreign currency, resulting in a seizing up of markets. The banking system is widely insolvent as a result of nonperforming loans and has required massive infusions of funding from the central bank. Ukraine is at risk of a financial meltdown that could result in a further massive currency devaluation and hyperinflationary conditions.

While the war imposed by Russia in the Donbas is a significant factor in the financial crisis, much of the damage is attributable to the policies of the government of Ukraine. The general decline in economic activity in the Donbas and loss of trade with Russia has lowered the overall level of economic activity. The continued fighting in the Donbas has closed down a significant portion of domestic coal production, requiring the importation of coal and impacting foreign reserves. The partial shutdown of steel production in the Donbas has resulted in a loss of exports with the resulting reduction of foreign currency inflows. However, military expenditures (which need further increases) constitute only 1.5 percent of GDP at the present time. At the same time, the subsidies provided to hold gas prices at unreasonably low levels in the domestic retail market impose a cost of around 7.5 percent of GDP.

In the current context of insignificant reforms, further credits from international sources are highly uncertain. The $17 billion credit that the International Monetary Fund (IMF) agreement provides is conditional on substantial reforms with regard to corruption and governance. It comes only with specific targets for budget deficits, bank reform, and overall debt levels.

At the present time, only $4.2 billion of the total credit has been advanced, and future funds, which were to be advanced before year end, are still under review. Given the key criteria of financial sustainability, a requirement for IMF extension of credit, it is becoming increasingly questionable as to whether Ukraine can qualify for further funding. While public discussion of an increase in IMF funding by a further $19 billion has occurred, this new credit is not available at present and will not be offered in the absence of deep and comprehensive reforms. Similarly, credits offered by other sources such as the European Union, the United States, the World Bank, the European Bank for Reconstruction and Development, or others will not be forthcoming in any substantial amount under present conditions. Hopes of a Marshall Plan cannot possibly be realized without tangible commitment to reform.

The only way for Ukraine to avert a financial meltdown is to adopt deep and comprehensive reforms starting with a drastic reduction of government expenditures by 25 percent to reduce the massive deficit. This can be achieved by the following measures: gas price liberalization, transparency in government purchases, reform of pension expenditures, elimination of industrial subsidies, and effective restructuring of the banking sector.

The elimination of the gas subsidy can save up to 7.5 percent of GDP and at the same time eliminate a major source of corruption and reduce the dependency of the country on Russian gas supplies. With the adoption of market prices and the complete restructuring of Naftogaz, as has been proposed, the industry could be moved from being a major burden on the economy to contributing to its independence and sovereignty. Conservation and diversification of energy sources would be encouraged and alternative sources of supply would be developed. Measures to shelter the most vulnerable in society can be put in place by social assistance payments.

Government procurement reform by making the process transparent and eliminate corruption is estimated to present possible savings of around 2 to 5 percent of GDP. Such reforms would again not only reduce the burden of government deficits but also serve to reduce corruption. Proper bidding procedures would enhance the effectiveness of government expenditures, not the least of which would be to boost the effectiveness of spending on the military, which is also subject to many corruptive schemes.

Pension reform is important, as the current system imposes exorbitant costs amounting to 17 percent of GDP. While it is recognized that basic pensions are inadequate and impose a hardship on the poor, there are many pension provisions that provide excessive payments to the privileged. Elimination of Nomenklatura and other special benefits can result in savings of up to 4 percent of GDP. These targeted reductions can provide more budgetary flexibility.

There are a number of industrial subsidies that are costly to the budget and, in reality, are simply a method of public funding for special oligarchic interests. These exist in the coal industry and in the form of privileged access to electricity and other state services. A potential saving of around 2 percent is possible. Again, while imposing costs, these subsidies serve only to fuel the corrupt influence of oligarchic enterprises.

Finally, the banking sector restructuring must be altered to reduce the burden being imposed on the state budget. While it is recognized that the banking system requires liquidity support from the central bank, it is clear that current refinancing is occurring without proper controls. Many banks that are not solvent should not be supported. Furthermore, the refinancing of systematically important banks must be done with instruments that impose real costs on the current shareholders and maximize the value of the interventions to the government.

In conclusion, any government that fails to respond to the challenge imposed by the financial crisis currently afflicting Ukraine will seriously undermine the viability of the country and its ability to withstand Russian aggression. As the economy degenerates, the prospects of the government to rule the country will greatly diminish, and a new Maidan, oft mentioned by activists, will be inevitable.

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