On September 8, President Viktor Yushchenko made an undoubtedly difficult decision, dismissing two key members of the glorious Orange Revolution. That dramatic decision exposed dissimilar views on economic policy and completely different approaches to public administration within Yushchenko’s team. It was also a political statement that tried to liberate the new team from two evils at one stroke: corruption and economic populism.
The evil of corruption is well known to Ukrainians. The country started the post-revolution period with a heavy burden: according to the best known international comparative corruption index, that of Transparency International, in 2004 Ukraine was in 122nd place among 146 nations. The Orange Revolution was primarily a revolt of the Ukrainian nation against an ethical morass, expressing itself in corruption, a distorted and biased mass media, and falsified elections, among other things. Only a few benefited from the fruits of rapid economic growth through 2004. Although privatization was inevitable, and was accelerated during Viktor Yushchenko’s time as prime minister in 2000, there was a downside: privatization occurred in a way that benefited just a few well-positioned people, who became multimillionaires almost overnight. The underlying assumption was that, while it produces extreme inequalities, only an economy based on private enterprise could put Ukraine on the path to long-term prosperity and help it to catch up with the world’s wealthy nations.
An undervalued national currency enabled Ukraine to boost external trade performance and replenish foreign currency reserves, thanks to emerged comparative competitive advantages and increased demand for traditional low value-added Ukrainian export items such as ores, metals and other semis. And indeed Ukraine started to grow: since 1999 per capita GDP grew to US$ 1,370 from US$ 639.
This year, the situation has worsened, due to downturns on the external markets and overall increases in prices for inputs (most importantly — for energy).
After impressive 12.1% growth, 12.3% inflation and 3.4% of GDP fiscal deficit in 2004, this year inflationary pressures have mounted to 6.7% while real growth has slowed down to 2.8% from January to August. Although fiscal balance remains under control so far, vague privatization prospects and accumulated VAT refund arrears impose contingent expenditure liabilities that would bring the consolidated fiscal balance out of the planned 2.1% this year. Although the fiscal position had improved considerably by 2004 in comparison with the late 1990s, political considerations related to the presidential election in late 2004 brought significant fiscal loosening. The election efforts of the 2004 government resulted in inflated salaries, unfunded pension payments of up to 16% of GDP, and thus a very rapid deterioration of the budget at the end of 2004.
The macroeconomic situation inherited from the outgoing government in January 2005 was very difficult. Unfortunately, economic policy pursued this year has so far not resolved this; on the contrary, social spending further ballooned. Moreover, the non- productive budgetary spending which does not contribute to future prosperity has increased. One feels the need for increased social support: but without a sound economic foundation, this can only be a short-lived irresponsible bonanza for which the neediest will pay the price over time.
It is clear that, without foreign investment, it will be next to impossible to correct current development problems. The government’s investment policy has been influenced by several factors. First, Ukraine is in a pre-election mood, since parliamentary elections are scheduled for March 2006. This has reduced the opportunity to undertake serious structural reforms and has resulted in an outburst of economic populism incoherent with sound investment policy. Second, additional social benefit payouts accepted by the government contributed to a further growth of budget expenditures in 2005. Consequently, economic policy has been dominated by a fiscal focus. Third, the post-revolution government inherited the diseases of its predecessors, and mostly worked to ‘put out fires.’ Moreover, widely diverse interests in the government made consensus on economic policy difficult. It was very difficult for that government to withstand the temptation to follow the demands of a marginal electorate and special interests, and to develop a long-term strategy and apply appropriate tools for that purposes.
Another, no less important reason for the dramatic economic slowdown was the de-privatization sloganry which took place over so many months. As we argued in our Blue Ribbon Commission Report in January 2005, any revisions of earlier privatization deals should have been well defined and limited to a manageable amount of cases. Most of all, the process should have been swift. The consequence of any lengthy process that causes uncertainty among investors is radically reduced investment (including foreign investment) and capital flight. In fact, the government did not take advantage of an unrepeatable golden opportunity: the international goodwill and expectations around Ukraine were such that one could have realistically targeted an FDI boom of US$ 10 billion a year — comparable to what has been achieved in neighbouring countries of similar size and potential, such as Poland. Ukraine has retained its attractiveness to investors, but now attracting investment will be much more difficult than it would have been with prudent economic policies. This is not speculation: it was the boom in FDI that led to long-term sustained economic growth and contributed to rapid corporate restructuring and an honest business climate in Hungary, Poland and the Baltic states. It also contributed to rapid corporate restructuring, to a healthier, more honest business climate — in sum, to the nation’s rapid creation of wealth. Nothing is preventing Ukraine from not following those countries’ spectacular success, but Ukraine attracted only US$ 605 million in the first half of this year.
So, privatization efforts did not significantly correct past transactions, but contributed to a dramatic deterioration of the investment climate — the worst of both worlds. Besides, tax legislation remained unreformed and arbitrary, and did not address the long-term, structural problems of the tax system. The government, furthermore, was trying to interfere with and hold down market prices, further giving the impression of a lack of respect for transparency or for the very basic interest of entrepreneurs to work in a reliable regulatory environment.
In sum, while until 2004 Ukraine had very good economic years in a bad political and social environment, the post revolutionary situation was the reverse: a much better political and social environment appeared, but the economic foundation for long term social policy was badly mismanaged. Change came when time is very short for correction, but Mr Yekhanurov’s government is capable of beginning positive changes even in the short timeframe before March 2006.
It is in Ukraine’s vital national interest to integrate much deeper into the world economy. The most urgent issues are WTO membership and restoring investors’ confidence. Regarding the WTO, the only chance to achieve a decision of the trade organization in 2005 is if necessary legislation is adopted in the first half of October. This should be an issue of national consensus for legislators, and the president has every right to demand from members of parliament that the issue of WTO-related legislation should be above politics and narrow particular interests.
Concerning investor confidence, legislation necessary to create clarity in re-privatization issues has to be urgently adopted. Reinforcing investor confidence requires a very clear privatization amnesty for almost all previous transactions. This needs to be coupled with a renewed energetic and credible effort towards further privatization — with open, honest international tenders. The anticipated new tender for Kryvorizhstal should become a model for the privatization deals of the current government and should send the message around the world that rule of law is finally in Ukraine.
During the last three months of the Tymoshenko government, serious efforts were made to simplify the regulatory environment for businesses, and the Yekhanurov government must finish this urgent task. Passage of the draft law on simplification of enterprise registration procedures and implementation of ‘one-window’ policies remain urgent and achievable tasks. This again will send the right signals — this time, very importantly, to small domestic investors as well. It is also important that the government very energetically advertise its policy shift on the local level, where reports of harassment of small entrepreneurs are widespread.
Finally, the government has to return to macroeconomic prudence. The 2004 presidential elections created a dangerous and misguided belief that elections can be won by throwing public money to certain electoral groups. The long-term effects of such policies are higher inflation and thus larger social inequalities, and greater poverty of those who cannot effectively fend off inflation. The Yekhanurov government needs to show great social responsibility and present a budget based on realistic revenue estimates.
In the coming five months, one can expect the government to take these actions. When in 2004 the Blue Ribbon Commission worked on its recommendations, we assumed good and reformist governance over the course of the whole year. If the Prime Minister concentrates on the above tasks, he will create a foundation for government policy after the parliamentary elections that can target deeper structural issues and the long-term prosperity of Ukrainian society: financial sector legislation, social sector reform that is more protective of the poorest people and, first and foremost, a transparent and decentralized government. Sceptics would say that even the above package of corrective measures is too much to expect this close to the parliamentary elections. The experience of the new democracies in Central Europe teaches us a different lesson: the more reform-minded a government is, the more likely it is that it will be re-elected — a prominent example of this is the case of the Dzurinda government in Slovakia. Not just unfunded populism, but also responsible and transparent government, can gain the respect of the Ukrainian people, who expressed their desire for decent and ethical governance during those cold but wonderful days last winter. Is this not the legacy of the Maidan? There is no reason why Ukraine, with its talented and educated population, should not be as prosperous as its Western neighbours, the Poles, Slovaks and Hungarians.
