Ukraine's obstacle-laden path to progress

Following years of uncertainty and war with separatist rebels supported by neighbouring Russia, Ukraine’s economy looked poised for some degree of recovery in 2017, but renewed tensions in its east could dash expectations.

The vast country, located between the EU and Russia, covers an area of about 603,500 square kilometres and is home to about 42.5 million people. Tensions with separatists, which started in 2014, saw Ukraine’s Crimean peninsula being annexed by Russia in March 2014. Meanwhile, separatists in eastern Ukraine's Donetsk and Luhansk regions proclaimed themselves as leaders of people's republics in May 2014, meaning some 7% of Ukraine's landmass is either in disputed territories or in the conflict zone.

The fighting has hurt the Ukrainian economy, which contracted by 6.6% in 2014 and 9.9% in 2015, but was expected to return to a fragile 1.8% growth in 2016, according to data from the central bank, the National Bank of Ukraine (NBU). And while the International Monetary Fund’s (IMF's) forecast of a 2.5% increase in GDP in 2017 is welcome, it would still leave GDP at constant prices behind even 2014’s Hrv1066bn ($39.4bn), at Hrv1000bn (see graph 1).

“What Ukraine has shown in the last three quarters is that it has reached economic stability,” says Șevki Acuner, director for Ukraine at the European Bank for Reconstruction and Development (EBRD). “Now it has to capture significant growth – 4% to 6% annually; 1% or 2% growth is not enough if you are looking at how much the economy has contracted in the previous two years.”

Blocking progress

And new uncertainty for Ukraine’s economic outlook comes from a rail blockade of the main routes between the country’s eastern and western territories.

First, western veterans blocked shipments of coal – vital to all parts of the country – from the separatist eastern region to the west, in an attempt to stop the government trading with it. Then, after separatists seized control of coal and steel businesses in the eastern region, president Petro Poroshenko imposed a freeze on rail and road cargo links in March 2017.

These developments could significantly harm Ukraine’s recovery, according to the NBU, which believes its 2017 GDP forecast of 2.8% could fall to 1.9% if the blockade continues until the end of the year. Furthermore, if the government does not diversify its coal supplies, the country could face power shortages since it is highly reliant on energy created in its coal power plants – many of which were designed to exclusively consume the rare variety of coal found in the eastern Donbass region. 

Economic recovery

The disruption comes just as expectations for the Ukrainian economy had finally turned positive and its GDP had grown by 4.7% in the fourth quarter of 2016. It was an improvement that experts such as Daniel Bilak, a director at investment promotion agency UkraineInvest and chief investment adviser to prime minister Volodymyr Groysman, call “impressive”, given the country’s difficulties in recent years. “We now have macroeconomic stabilisation, currency stabilisation and positive economic growth that shows reforms are kicking in on the macro level,” says Mr Bilak.

The improvements do not stop there. Following the abandonment of the Ukraine hryvnia’s peg to the US dollar in early 2014, a flotation of the hryvnia and several devaluations, the currency has stabilised – if at a new level of about Hrv27 to the dollar, compared with the Hrv8-to-the-dollar artificial exchange rate that was in place for about four years.

Besides floating the hryvnia, the NBU also decided to change monetary policy measures to inflation targeting – an often criticised step due to Ukraine’s fluctuating inflation history (see consumer price index inflation table) – but also this has borne fruit with 2015’s 48.7% inflation falling to about 15% in 2016. The medium-term target from 2019 is 5% inflation plus/minus 1 percentage point.

Yet it is not just locals and international financial institutions such as the IMF who are keeping a watchful eye on the country’s economic health, but also its creditors – especially since Ukraine’s 2015 $18bn debt restructuring and near default.

And with the transfers from the IMF due to end in 2019, credit rating agency Standard & Poor’s is asking how robust Ukraine's economy will be at that point, and whether the government will get market funding by 2019 to reduce the higher scheduled public debt payments for the year. (Payments are due to rise from $2.63bn in 2017 to $3.91bn in 2018 and $7.52bn in 2019, according to data from Dragon Capital.)

Frank Gill, primary credit analyst for Ukraine at S&P, believes “further escalation of the conflict will weigh on Ukraine’s growth prospects and, indirectly, on its solvency”. He says that at 73% of GDP, general government debt remains “high, and sensitive to exchange rate movements” – given that more than two-thirds of the debt is denominated in foreign currency.

The IMF programme helped Ukraine’s foreign currency reserves to reach $15.5bn at the end of 2016 and the NBU aims to reach $21.3bn by the end of 2017 (see interview with NBU governor Valeria Gontareva on page 73). However, at year-end 2016, the reserves only covered about 37% of expected short-term external debt maturing in 2017, according to Mr Gill.

He adds that in the past, the Ukraine economy has been supported by high iron ore prices, which as recently as 2014, made up some 30% of exports – representing about 15% of GDP and signalling the need to diversify the economy.

Reforms delivered…

The need for diversification and the implementation of structural reform in Ukraine is clear. Across the economy, experts agree that NBU reforms to monetary policy, and the clean-up of the banking and financial sector, have so far been the most striking and successful (see banking sector feature on page 70).

“During the past three years, the country has been moving in the right direction,” says Ivan Mikloš, former Slovak finance minister and chief economic adviser to Ukraine’s prime minister. “For the first time, things are really changing,” he adds.

Apart from the banking sector reforms, Mr Mikloš highlights achievements in macrostabilisation, the deregulation of energy tariffs and the reform of state-owned energy firm Naftogaz – which used to cost the government 7% to 8% of GDP and is now turning a profit – as well as anti-corruption measures.

The fight against corruption is a concern not just of the local business community but also of international financial institutions, which highlight a reduction in graft as an important step in attracting FDI (see story on page 76). As part of the country’s anti-corruption initiative – launched in May 2014 by the government together with the EBRD, the Organisation for Economic Co-operation and Development and business associations – at the end of 2014, Algirdas Šemeta, former minister of finance in Lithuania and European Commissioner tackling fraud, was appointed to the newly created post of Ukraine's business ombudsman.

“The business ombudsman is now the only anti-corruption institution that is solving the problems of the business community,” says the EBRD’s Mr Acuner. “In the two years it has been operating, it has received more than 1400 cases, about 1000 have been taken on and 800 or so have been resolved in a satisfactory way.”

Businesses have benefited directly from the ombudsman, he adds, noting it has proved a very useful institution for pushing things in “the right direction”, which is one reason why the EBRD will be renewing its funding in Ukraine for the next two years. 

…but more are needed

But despite the successes of the business ombudsman, the institution can only recommend, not enforce solutions. So if there is no will from the establishment and enforcement agencies, there might well not be a way to help.

Meanwhile, experts agree that Ukraine needs other reforms. “The most burning issue is the reform of the court system and of the law enforcement agencies,” says Elena Voloshina, acting regional manager for Ukraine and Belarus at the World Bank’s International Finance Corporation (IFC). “The government acknowledges that these are the areas that it needs to focus on but we would like to see faster movement. The challenge is delivering deeper, faster and more profound reforms.”

Though some alterations are being introduced with 2016’s judicial reform package, the implementation is expected to take a few years. According to Mr Mikloš, the reform process is starting with the highest appeals courts, while the implementation of further changes is also occurring from the top to the bottom of the system.

Aside from the judiciary, there still are plenty of issues left to address, however, such as pension and land reform – both prerequisites to the disbursement of Ukraine’s next tranche of IMF funding, expected later in 2017. Equally important are reforms to the healthcare system, as well as intellectual property and creditor rights – the latter being eagerly awaited by the banking sector.

Yet as with Ukraine’s widely publicised collapsed plans to privatise the country’s largest fertiliser company, Odessa Port Plant, in 2016, vested interests can sometimes undermine change. Odessa Port’s privatisation process suffered from a valuation deemed far too high by international financial institutions such as the EBRD and the IFC, while the asset also had some underlying problems, all of which caused the sale to fail.

“It was a big frustration that none of the privatisations occurred in 2016,” says Olexiy Soshenko, a partner at law firm Redcliffe Partners. “This could have fuelled the economy. The government now needs to make some serious changes to its privatisation approach, and present investors with a clean asset to invest in.” 

Political difficulties

Ukraine’s political process in itself is complex. Its presidential-parliamentary system of government sees both the president and government hold executive powers, while legislative powers are exercised in the national parliament, Verkhovna Rada. Parliament is fragmented, with 422 seats split between eight different factions as well as 47 unaligned members of parliament. Another 28 seats are currently vacant, largely related to the conflict in the east.

Thanks to a particularity of the constitution (and despite the 28 vacant seats), the governing coalition of Mr Poroshenko’s Solidarity Bloc party and People’s Front, led by Mr Groysman, still requires 226 votes to reach a majority in parliament, leaving it five seats short. To change the requirement from needing 226 votes to pass a bill to a simple majority of non-vacant seats would require a two-thirds majority vote, making it unlikely for such a reform to find enough support.

The government is also facing a potential impeachment challenge in April or May, when the opposition will have the option to give the government a no-confidence vote when it reports on the achievements of the past year in office. Experts expect a lot of criticism but not a no-confidence vote. That would leave the next scheduled elections in March and October 2019, when both the president and parliament will be elected.

“As informal campaigning usually starts a year before an election in Ukraine, this might cause a further delay to meaningful reforms,” says Viktor Luhovyk, research editor at Dragon Capital. “The government will clearly be less willing to go ahead with sensitive issues such as pension reform, which would mean raising the pension age, as this is something the population is vehemently opposed to.”

But for Ukraine, everything hinges on the delivery of thorough reforms, not only for the functioning of society and services but also to attract FDI – as was the case in Slovakia in the late 1990s, according to Mr Mikloš.

“Ukraine has a lot of unused potential,” he says. “It has hard-working labour and strong industrial capacities but it needs a reorientation, and that cannot come without modernisation and investment. But FDI will only come if reform is continuing.”