Will the Ukrainian Economy Collapse in 2015?

On March 11, the Executive Board of the International Monetary Fund (IMF) approved an Extended Fund Facility for Ukraine. This is the tenth IMF program with Ukraine since 1994, none of which have been completed. The question is whether this one will be more successful than the others.

This program is much stronger than the 2-year standby arrangement concluded one year ago. It involves a much greater fiscal adjustment, which Ukraine badly needs, and comes on the heels of substantial reforms adopted by the Ukrainian parliament on March 2. The most important of these reforms are sharp energy price increases and reductions in pensions. The IMF program is supposed to last longer, for four years rather than two years, and offers more financing. The IMF itself will provide $17.5 billion, while it assesses the total financing at $40 billion. Both funding and reforms will be heavily frontloaded. Last year's program required too little fiscal adjustment, too few reforms, and too little funding. This time around Ukraine has a chance, but the risks are numerous.

The IMF decision came at the very last minute. During February 23–25, Ukraine experienced a financial meltdown. The market exchange rate collapsed from 20 hryvnia per dollar in late January to as little as 40 hryvnia per dollar. Ukraine experienced a run on shops, as people tried to buy while their money still had some value. Inflation has surged to 35 percent a year.

Curiously, this panic occurred after the Minsk-2 ceasefire agreement signed on February 12 and the IMF mission in Kiev had concluded the new agreement with the Ukrainian government. Neither of these agreements was sufficient to contain the panic, which subsided only after people realized that the parliament really would adopt the laws required by the IMF.

The reason for the panic was that Ukraine's reserves had fallen below the permissible limit to only $5.6 billion on March 1. With such small reserves, no currency stability was possible. The bare minimum is $10 billion, which has now been accomplished thanks to an initial IMF disbursement of $5 billion. Now, the exchange rate has almost doubled to 22 hryvnia per dollar and will hopefully stabilize at this level. The Ukrainian government and the IMF have calculated an exchange rate of 21.7 hryvnia per dollar.

The fundamental reason for failure of the last IMF program was that GDP fell by 6.9 percent rather than the 5 percent anticipated by the IMF. The dominant cause for the decline in output is the Russian military aggression in Donbas. The war reduced Ukraine's GDP by roughly 5 percent. Industrial production, construction, and retail trade fell by 40 to 50 percent in Donbas for the year as a whole. These figures do not include the destruction caused by the war, only the production that it hindered. As a consequence, Ukraine has become quite a poor country. Its GDP in current dollars is as low as $80 billion.

Can Ukraine survive? The level of poverty in Ukraine is striking, but so too is the young, competent group of professionals that have taken over the government, reminiscent of the Yegor Gaidar team that entered the Russian government in 1991. The war has also brought Ukrainians together with far stronger sentiments of national cohesion than previously. Ukraine has one of the most vibrant civil societies in the world with people volunteering for all kinds of functions but also protesting against corruption.

Yet the state administration remains pervasively corrupt and dysfunctional. It has new bosses, but they need to reform the whole state apparatus from the top down. The worst problems persist in law enforcement, particularly in the prosecutors' office and the courts that seem unable to prosecute and sentence even the most obvious criminals of the Yanukovich regime. The most important reform is energy, especially to raise prices to the market level, so that corrupt arbitrage between regulated energy prices finally can be eliminated. Much of this has already been done. Gas prices for households have increased almost four times without provoking any popular protests. Major deregulation is another vital endeavor underway.

The risks are many and great. Most notable are Russian warfare, the very poor state of the economy, too little reform, limited funding, and the specter of a popular uprising against poverty.

The greatest risk is the Russian military aggression. Nobody outside the Kremlin knows when or where Russian troops will intensify their attacks again. Ukraine's exports to Russia have fallen by half since 2013 because of severe trade sanctions. That alone is 12 percent of Ukraine's exports. In December 2013, Russia gave Ukraine a credit of $3 billion that is supposed to be paid back in December 2015 and will cause a major strain. Gazprom charges Ukraine far higher gas prices than it charges other countries so that Ukraine has minimized its gas imports from Russia. Ukraine used to be Gazprom's largest customer. Presumably, the Kremlin's intention is to destabilize Ukraine so that this democratic country fails.

The IMF expects Ukraine's GDP to contract by 5.5 percent this year after a decline of 6.9 percent last year. From 2016, the Fund anticipates a growth of approximately 4 percent a year. At present, year-over-year inflation runs at 35 percent, but the IMF anticipates that it will moderate to 25 percent by year end, the same as last year, and then fall to 10 percent in 2016. The consolidated budget deficit is supposed to be brought down from 10.3 percent of GDP in 2014 to 2.6 percent of GDP in 2018.

But this funding is only a minimum. The IMF hopes that Ukraine will reach reserves of $17 billion by the end of the year, and this year it intends to disburse about $5.5 billion more itself. The Ukrainian ministry of finance needs to mobilize a large number of more or less committed funding. The United States, the European Union, and the World Bank have each committed about $2 billion this year. Various bilateral donors are likely to provide an additional $1.5 billion. The European Investment Bank and the European Bank for Reconstruction and Development will also contribute substantial amounts, perhaps $2 billion this year. Somewhat unexpectedly, it appears that an old Chinese swap credit of $2.4 billion from China can be activated. This makes for a possible total credit disbursement of over $22 billion this year.

What attracts the most attention among bond investors is that the IMF expects a "debt operation" of no less than $15 billion from outstanding eurobonds of $18 billion. The Ukrainian government has appointed Lazard Freres to assist in negotiations with its bondholders, which are supposed to start very soon and be completed before the first review of the IMF program. The big question is whether these savings will be possible only by prolonging the maturity of the bonds by four years and by cutting the average coupon from 7.5 percent to something like 2 to 2.5 percent, or whether a nominal haircut is necessary, which would be much more difficult to accomplish. The common assumption is that the Russian claims that include $3 billion of eurobonds and about $2 billion of short-term bank loans will be left for last. Neither the Russian nor the Ukrainian side have spelled out their tactics.

There are also domestic risks, the greatest of which remains corruption. It is therefore vital that the Ukrainian government not relax but intensify its reform efforts. This government has only lasted 100 days, but there was substantial discussion about bringing in the old establishment in the government after the young professionals had organized reforms and IMF funding. Fortunately, the Poroshenko loyalist and parliamentary speaker Volodymyr Groisman denied such plans on March 10.

Ukraine has a new chance to reform and save itself, but the situation remains precarious.

Anders Åslund is a senior fellow at the Peterson Institute for International Economics and author of the forthcoming book Ukraine: What Went Wrong and How to Fix It.