by Anders Aslund, Peterson Institute for International Economics
Op-ed in the Moscow Times
April 22, 2009
© Moscow Times
A month ago, I wrote a column about Russia's return to sane economic policy, but Ukraine has undertaken an even more impressive turnaround. Few countries have been more misunderstood than Ukraine, which has been particularly hurt by the global financial crisis.
In the wake of the Lehman Brothers bankruptcy, international finance froze throughout the world. Ukraine suffered from an underlying problem, its high dependence on steel exports, whose prices and demand collapsed in fall 2008. In the first half of 2008, steel accounted for no less than 42 percent of Ukraine's exports. This year all of Ukraine's exports are likely to drop by almost 50 percent, but imports even more, so the current account deficit will become insignificant.
Ukraine's Central Bank made one serious policy mistake. It insisted on maintaining a fixed peg of the hryvna to the US dollar. Because of the apparent safety and obvious profitability, foreign banks transferred short-term, speculative funds to Ukraine, which expanded the domestic money supply as the exchange rate was fixed and boosted inflation similar to what happened in Russia but worse.
In 2007 Ukraine's money supply surged by 51 percent and inflation peaked at 31 percent in May 2008. The speculative currency inflow widened the current account deficit to 7 percent of gross domestic product in 2008. This was not tenable, although Ukraine's budget deficit was minimal and its public foreign debt was only 12 percent of GDP in 2007.
What ultimately scared foreign investors was Ukraine's open political feuding. International investors are a strange, antidemocratic lot who get worried by open arguments between politicians. They prefer strict authoritarian regimes like in China, Azerbaijan, and Kazakhstan.
By October 1 the Ukrainian economy had suddenly come to a halt. Steel production, mining, and construction plummeted by about 50 percent in no time. The largest harvest ever could not salvage the economy. Astoundingly, industrial production contracted by more than 30 percent in the first quarter of 2009 over the same time one year earlier, and GDP probably plunged by 20 percent in this period. In addition, the stock market dropped by 90 percent from its peak last year.
Fortunately, the Ukrainian government acknowledged its crisis in early October and asked for help from the International Monetary Fund (IMF). Within four weeks, Ukraine concluded a deal with the IMF: a large, strong, two-year standby agreement with $16.4 billion of credits.
The IMF program was standard with three key demands: a nearly balanced budget, a floating exchange rate, and bank restructuring. Ukraine has delivered. After some hesitation, the country's Central Bank let the exchange rate float. Although it depreciated by about 50 percent, it has since stabilized, giving Ukraine a new cost competitiveness.
Together with the international financial institutions, the Central Bank has examined all of Ukraine's banks and quantified their bad debt. Compared to the West, Ukraine's share of toxic debt is small.
Seventeen Western banks have committed themselves to recapitalizing their subsidiaries in Ukraine with $2 billion this year. In addition, it is estimated that two-thirds of the country's refinancing needs this year will be met. Most of this will be done by European banks. So far, not a single foreign bank has withdrawn from Ukraine. Their prospects are just too attractive. Similarly, the three big Russian banks, VEB, VTB, and Sberbank, have increased their activity in Ukraine despite the crisis.
The Ukrainian authorities have taken seven private, Ukrainian-owned banks under administration, and they have mobilized $2.6 billion for their recapitalization from the World Bank, the European Bank for Reconstruction and Development, and the European Investment Bank. All of them understand Ukraine's financial dilemma. The IMF assesses the total need for recapitalization at no more than $5 billion.
Yet the Ukrainian government had problems receiving its second tranche of the IMF loan because GDP, and thus state revenues, declined much more than expected. The IMF assessed that the budget deficit would be untenable at 6 percent of GDP, even leaving a possible public bank recapitalization of 4.5 percent of GDP aside.
The Ukrainian parliament agreed to increase excise taxes on alcohol, tobacco, and diesel, and the prime minister decreed further revenue measures to reduce the budget deficit by 2 percent of GDP. With substantial financing from various international financial institutions, the IMF mission considered that the shortfall was almost covered and recommended a second, enlarged tranche.
At the same time, the Ukrainian government has made a break with nontransparent gas-trading arrangements through the gas agreement with Russia on January 19 and the agreement on the gas transit system with the European Union on March 23. These two decisions might be among Ukraine's most fortuitous reforms. Fortunately, it joined the World Trade Organization in May last year, securing reasonable market access.
On April 1, the Ukrainian parliament voted by an overwhelming majority to hold the next presidential election on October 25, which will help the country to clarify the political situation. The fundamental political problem, however, lies in the confusing constitutional compromise of December 2004, which was one of the most significant results of the Orange Revolution. Now all the major parties demand a transition to a purely parliamentary system that would make it impossible for a president to block all decisions. They also call for open-party lists to make it impossible for wealthy businesspeople to purchase seats in parliament.
Ukraine has not faced the level of social unrest that other countries have experienced, despite the serious blows to its economy. During television talk shows, both the government and opposition speak their minds freely, and the people hear their arguments until they are satisfied, or bored.
Thanks to early and resolute anticrisis actions, international reserves remain reassuring at $25 billion, or eight months of imports. Industrial production increased in both February and March over the preceding month, suggesting that Ukraine might already have turned the corner (although GDP will probably still decrease by 8 to 10 percent this year). Even the bond and stock markets have soared in the last month.
Ukraine has shown exemplary crisis management thanks to a few Ukrainian top officials, notably Prime Minister Yulia Tymoshenko, and a good job by the international financial institutions.