Article by: Oleh Havrylyshyn, Mariya Sydorovych, Liubomyr Shavaliuk
The new Ukrainian government that will be formed as a result of the parliamentary elections will face the threat of two crises.
The first — financial meltdown that has high probability of happening soon.
The second — low or negative economic growth for the medium term.
These two crises exacerbate the existential threat that Ukraine is experiencing due to Russia’s occupation of Crimea and Russian attempts to destabilize the situation in the Donbas. Needless to say, the end of the military conflict should become a priority for the new government. However, it will not be enough to solve the critical economic problems.
Indeed, Russia’s military invasion is the primary cause of the current economic crisis, but there is also an inverse relationship: the weakness of the economy and the general uncertainty have made Ukraine vulnerable to Russian intervention. These related problems are complex and therefore difficult to overcome. However, there is one radical and effective public policy tool that will help address both problems rapidly . We are referring to a significant reduction in public spending coupled with substantial reduction of government influence on the economy.
Ukraine’s budgetary deficit has become unmanageable due to the damage caused to the country by external aggression and the subsequent deterioration in the economy. According to the latest IMF report, the actual deficit in 2014 will be around 5.8% of GDP. Other experts tend to believe it will be higher still.
It will be much higher if extra-budgetary expenditures are taken into account. The financial deficit of Naftogaz Ukraine for 2014 alone is estimated at 4.3% of GDP, and this altogether is more than 10% of GDP.
Such a large deficit cannot be closed by tax revenues, which are shrinking already. Neither can it be done through non-inflationary financing, since the risk premiums and yields on Ukraine’s sovereign bonds have risen sharply. Continued regular borrowing abroad is unrealistic, since the current level of interest rates on short-term loans has reached 20%, which places Ukraine in the same high risk category as Venezuela.
According to the current IMF baseline, by 2015 the ratio of government debt to GDP, which was a moderate 40% at the beginning of 2014, will grow to at least 70%. However, this forecast is already no longer relevant. Given the current existential threat to Ukraine, it would be much more appropriate to assume that events will unfold according to the fund’s worst-case scenarios. According to these scenarios, the government debt will approach 100% of GDP and may even exceed this level in the event of prolonged conflict.
Historically, in the case of such large budgetary deficits and debt growth rates, the vicious circle of degradation always shows its ugly face. This forced domestic deficit financing is enabled by the printing of money by the National Bank, inflation, further devaluation of the national currency, lower GDP growth rates, lower government revenues, and higher deficits.
Haven’t we seen anything like this before? Of course, this would be a repetition of the situation in Ukraine during the first years of independence. Haven’t we learned the lessons of that time? Perhaps not, since today we can see the first signs that the country is falling into a vicious circle. The hryvnia has depreciated by half, inflation exceeds an initial 9-percent benchmark and is close to 20%, and various institutions are now forecasting a 6-8% reduction of GDP.
The new government will have only one realistic way to avoid the financial crisis — it must dramatically reduce budget expenditures. Any return to the populist arguments of the ’90s will only lead to a vicious circle. The cuts in expenditures inevitably will occur the same way as then, and in the worst possible way.
Budget revenues will not be enough to pay for the empty promises of the politicians. Is there anyone in Ukraine who still believes that in the ’90s a similar government policy alleviated social ills? Obviously it only exacerbated them. Poland, the Baltic States, and other countries of Central Europe eventually experienced less social disruption than Ukraine because they had taken drastic measure to reduce the state budgets and to liberalize their economies.
Let us look at the crisis of economic growth. Although the most recent decline is the result of armed conflict, the slow pace of long term economic growth is due to significant delays in reforms and the huge government interference in the economy.
It is precisely for that reason that the income level of the Ukrainian population is only a third of the earnings of the residents of Poland and other countries in the region, even though all had been at the same stage of development when Ukraine became independent.
With the current state of public spending representing 53% of GDP, Ukraine stands out among similar countries in the role the government plays in the economy. A number of wealthy countries in Western Europe have similar degrees of state intervention in the economy but they also have significantly higher levels of development.
The countries of Central Europe and the Baltics that are comparable to Ukraine in economic indicators have government spending in the vicinity of 35% of GDP. They have also shown the highest rates of economic growth in Europe, and their populations are receiving better social benefits at a lower share of the GDP than Ukrainians.
Large budget expenditures lead to lower economic growth for several reasons. Subsidies to enterprises reduce the motivation to improve efficiency. By maintaining energy waste at the old Soviet levels, they make Ukraine chronically dependent on Russian handouts, creating a fertile ground for corruption.
A huge army of bureaucrats, necessary to ensure the various government activities, has enough incentives to implement and maintain complex regulatory procedures, licensing, and numerous inspections. All this has resulted in an environment in Ukraine that is among the least attractive in the world for business and which is accompanied by one of the highest levels of corruption.
The sharp budget cuts mean a significant reduction in the number of officials who live off bribes. This in itself will automatically reduce the number of opponents of critically needed deregulation. It will also remove some of the pressure on business and will stimulate economic growth through new production, investments, and market entry by new entrepreneurs.
To avoid a financial crisis Ukraine must drastically cut budget expenditures. This is not only a question of the financial situation but of the survival of the country. During the first 100 days the government must set a goal to cut government spending for the year by at least 10% of GDP and to continue to cut expenditures until they reach the levels of neighboring countries with similar levels of development — 35% of GDP.
By reducing budget expenditures and the scale of damaging government interference in the economy Ukraine could kill two birds with one stone: avoid financial crisis and set a foundation for economic growth. We can prove that this “stone” can even kill a few more birds.
First, it deprives the country of opportunities for corruption and rent-seeking. Such opportunities will become less numerous — if there is no regulation, there is no bribe. Secondly, rapid and radical actions by the new government will increase its credibility. People are demanding more action. Activists, businesspeople, international donors, investors, all say in unison: “Why has so little been done since February?”
It is true that critics and populists will argue that radical measures will lead to social upheaval. This is probably even less true today than when Kravchuk, Kuchma and Yushchenko talked about it for the past twenty years. In Ukraine few believe that the delay in reforms helped mitigate the social consequences of the economic decline in the ’90s. Poor government, personal interests of the political leaders and their populism only worsened the situation.
The reduction of budget expenditures can begin with the following steps. In the current situation, it is unrealistic and undesirable to increase any government spending except for defense. Instead, the government should concentrate on cutting large and unnecessary expenditures, something that can be done quickly.
First of all, we are talking about energy subsidies, which in 2014 will represent 7.5% of GDP, according to IMF projections. These subsidies have absolutely no justification especially since they are so sizable that they weaken Ukraine in every way. Ukraine is more dependent on Russia, extracts less gas, and consumes too much of it.
The Ukrainian government should remove all these subsidies as soon as possible and thereby standardize the price of gas for all consumers while simultaneously giving the poorest segment of the population full compensation for the price differences in the form of targeted cash assistance.
Public procurement represents the second category of expenditures that need to be reviewed. After the energy sector, they served as the main source of enrichment for the Yanukovych regime. They represent 8% of GDP, so at least half of this amount could be saved if, as is generally assumed, the kickback under Yanukovych stood at 50%.
Additional reductions should be realized in the extremely high costs of the pension fund, which constitute 17% of GDP. Although in the short term these options are limited by the partial pension reform of 2010, a significant portion of fund expenses still go to pay the high pensions of the former nomenklatura.
Excessive bureaucracy and regulation present other opportunities for savings. If everything is done wisely, then the cuts will affect only those areas where corruption is likely. For example, a significant number of the regulatory agencies need to be closed down and their inspectors fired.
Many elements of government expenditures include subsidies that supposedly help the poor. However, they are not effective since they are also given to people with high incomes. Such subsidies have the effect of a regressive taxation policy.
This list of actions is not exhaustive, but it will allow for the budget spending to be cut by at least 10% of GDP in a year. Only the corrupt will suffer.
At the same time, these actions will allow us to reduce the tax burden, especially the so-called social taxes, and thereby stimulate economic growth. In addition, these steps will significantly improve the security of Ukraine. We sincerely hope the government will act accordingly.
Oleh Havrylyshyn, former deputy director of the Department of Post-Soviet Countries at the IMF, economic adviser to the government of Ukraine.
Maria Sydorovych, head of Fixed Income at the KINTO asset management company, specialist in macroeconomics.
Liubomyr Shavaliuk, economist, regular contributor to The Ukrainian Week