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30 December, 2010  ▪  Vitalii Melnychuk

Battle Unready

In 2011 the Government of Ukraine will expand the command economy model to the micro level – which could have catastrophic consequences
In the management of public finances, the State Budget is the key component. In 2010, the Government of Ukraine added some original elements that are intended to balance any gaps that emerge. According to official projections, the Pension Fund will have an astronomical deficit of UAH 29.6bn. But the Government and Verkhovna Ra­­da found a simple and effective solution to this problem: they allowed the State Treasury to lend money to the Fund at a zero interest rate whenever it had a current account shortfall. That this approach is only possible in a command economy is obvious, but officials are convinced that they solved the touchiest social issue and paid out UAH 13.7mn in pensions to the country’s elderly in time. 

Switching to manual mode

An entire series of items in the 2010 State Budget allowed the Government to hand-manage and adjust amounts without the approval of the Verkhovna Rada. The Government could also use unscheduled internal and external borrowings to cover urgent expenditures and projects. This kind of power is the dream of every Premier and Finance Minister in every country—though it is only possible in a command economy. It is an approach that lets the Government meet the main budget liabilities under any circumstances, regardless of how much revenue flows into state coffers. Moreover, the IMF may lend Ukraine US $15.2bn as part of its cooperation with the Government.

This model for managing external borrowings will be used in 2011, too. How effective spen­­ding will be is another question. The fact is that this mechanism alone not just balances out public finances automatically, but establishes the conditions for keeping the hryvnia stable. The NBU brags about having enough currency reserves to avoid hryv­­nia devaluation. Meanwhile, no one seems to notice that, in recent months, the amount of foreign currency coming to Ukraine from exported goods and services has been lower than the amount spent on imports. In short, exchange risks are there, although they don’t seem to be. 

In fact, there are many examples of this kind of crude balancing act with the country’s finances, such as the tax administration’s efforts to pump money out of the real sector, so that the State can later pump in into other sectors. This kind of shape-shifting looks like a brilliant macroeconomic concept for a crisis situation, since it allows the Government to meet all the conditions set out by the IMF, which suits the Fund just fine. 

So, it looks like the Government is ready for the economic challenges of 2011. Public finances are under tight control and Budget commitments have all been met. The question is: does this model match the situation on the domestic market and how does it affect the financial and real sectors or households? As they say, everything’s stable at a cemetery, too… 

What’s wrong with this picture?

Trying to apply command approaches to real economic processes is a huge mistake, and one that could lead to enormous social problems. Not in 2011, though. Until Euro 2012 is over, everything will be “hunky-dory,” since neither Ukrainians, nor Europeans, nor the international community—football is a sacred thing!—want to see the situation deteriorate, which would raise questions about the choice of country as a co-host for the final games. But what will come next? Ukraine will have to pay off its debts—its current external debt already exceeds US $104.5bn—and this is where serious trouble is likely to surface.

The dynamic of Ukraine’s GDP is unusually dependent on external markets no less than on the ability of the Government to keep the hryvnia stable. One way out of the situation would be to come up with measures to expand the country’s very narrow domestic market. Nothing like this is evident so far—rather the opposite seems to be happening, suggesting that the Government wants to expand the command model to the micro level. It’s understandable why, of course: the mentality of those in the executive does not allow otherwise. The story with the Tax Code demonstrated that the Government does not really understand the need to establish conditions for the domestic market to develop properly as the key to real stability. If any calamities strike global markets in 2011, their kind of regulation will not help.  
To stimulate the economy and develop infrastructure, the State needs resources, but not by shaking down the real sector—expanding the powers of tax inspectors enormously and allowing them to drop in on businesses anytime they want. Nor will it help to draw the payrolls of companies that already pay taxes and contributions on a general basis out of the shadows. Paradoxical as it may seem, but it was the grey economy that helped the country survive 2008-2010 without too much pain. Any pressure on this buffer in an unreformed transition economy is a mistake that could lead to social tension. 

In 2011, the Government should focus on looking for internal reserves in entirely different areas: not rush to cancel profit tax for those large corporations that move their dividends offshore, to the tune of at least UAH 10bn every year. Clean up the totally corrupt public procurement system. This is a huge resource and getting it under control would allow the Government to support more than one industry. Most likely, the Government will ignore such advice, as usual. As the saying goes, they won’t believe in wonder until they hear thunder.
Budget Realities

Author: Vilen Veremko

Before the New Year, the Verkhovna Rada passed the Cabinet’s version of the 2011 State Budget on emergency basis. This document not only reflects the new Tax Code but also not-yet passed new norms in pension legislation, including a higher retirement age. Passing the State Budget quickly guarantees the Government US $1.5bn from the IMF to cover the deficit—and Premier Mykola Azarov was ready to dance with joy.

Revenues are expected to reach UAH 281.46bn in 2011, which is UAH 28.71bn more than in 2010, while expenditures are going to be UAH 321.93bn or UAH 16.24bn more. As in 2010, the Government has secured itself the right to borrow and disburse additional credits without planning or approval. Thus, the risk that Budget commitments will not be met is minimal. A typical feature of the 2011 State Budget is increased funding for all enforcement agencies: the Interior Ministry gets almost UAH 2bn more, or up to UAH 13.6bn, while the Prosecutor’s Office now gets UAH 2.2bn, not UAH 1.2bn as before.

Article 8

Sets the limit of sovereign debt at UAH 375.643bn as of December 31, 2011. 

The State continues to live in debt, which could grow an additional UAH 60bn in 2011. But even this can be considered nominal, since other provisions in the law allow the Government to draw on external and internal borrowings above this limit. The Cabinet of Ministers will also be able to increase or decrease the amount of loans at its discretion without the consent of the Verkhovna Rada. 

Article 9

Allows the Government to underwrite UAH 15bn in loans in 2011.

The Government is supposed to underwrite loans to the National Agency for Preparing and Holding Euro 2012, to the State Road Service, to Energoatom to build the 3rd and the 4th blocks of Khmelnytsk Atomic Energy Station (AES), to build a bridge across the Dnipro at Zaporizhzhia, and so on. Returning to the practice of providing state guarantees at the Cabinet level is likely to facilitate corruption.

Article 28

Requires the Mandatory State Unemployment Insurance Fund to allocate at least UAH 360mn to create jobs for residents in coal mining regions.

This has been continued in the 2011 State Budget from the 2010 Budget largely unchanged. No statistics have been provided as to how effectively these funds are being used.

Article 31

Allows the Cabinet to issue domestic government bonds that can then be exchanged for additional shares emitted by NAK Naftogaz Ukrainy.

Since NAK Naftogaz Ukrainy has no financial plan for 2011 yet, it is unclear what volume of bonds is going to be purchased for Budget funds. The fact that this item is in the Budget means that the Naftogaz is not ready to meet its liabilities without outside support. 

Article 32

Allows the Cabinet of Ministers to issue domestic government bonds worth UAH 5bn in order to lend to the Agricultural Fund. 

Typically, these bonds have not taken included in the sovereign debt limit, although they in fact increase the deficit. Issuing bonds, their possible conversion into hryvnia, and lending to the Agricultural Fund all leave space for financial abuse.  

Article 33

Allows the State to purchase bank shares, provide financial assistance to banks and privatize them, based on a decision and procedure established by the Cabinet. The sources of funding include:

Government bonds or funds from other government borrowings.

This item sets up the conditions for the reorganization of the banking market expected once minimum statutory capital requirement is increased from UAH 75mn to UAH 500mn.

VII. CLOSING PROVISIONS

Requires the Cabinet to propose raising social standards, based on the State Budget performance review for Q1’11.

The Government’s talk of raising social standards will most likely remain just that. State revenues are unlikely to grow in Q1, whether due to tax, pension or administrative reforms.




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