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29 September, 2011  ▪  Volodymyr Lanovyi

Capital Challenges

If technology collapses, Ukraine’s economy is doomed to crisis after crisis

The economic surge expected by Ukrainians may become a reality only if the country's means of production are upgraded. This will require extensive and efficient investments. Unlike other weakly-developed countries, Ukraine has a fairly good system of personnel training, but human skills will not be of much use without cutting-edge technology: labor will be unproductive as the majority of hard-working people are already seeking and finding employment abroad. A more absurd national economy is hard to imagine.

40-YEAR CRISIS                  

The means of production we have today took shape partially before the October revolution and then — the bigger part — throughout the 70 years of Soviet socialism. Among other things, German equipment and technology played a role in the process after the Second World War. Many enterprises have capital assets that have not been upgraded for decades since they were first put into operation.

Though the crisis of 2008 lingers in everyone's memory, Ukraine’s national economy was actually hit by a long-term crisis 40 years ago. As long as it remains in its current overall state of technological collapse, the economy cannot avoid mid-term dis-balance in capital and short-term crises on commodity markets. Thus, the challenge is to replace prevalent outdated technology of the industrial era with modern hi-tech equipment — from automated production lines to innovative infrastructure, service and management. To achieve this, intense investments need to be made in fixed capital and infrastructure.

INVESTMENT DROUGHT

A total of UAH 233 billion of investments a year, including from foreign sources, is Ukraine’s record so far. When the country reached this point in 2008, the figure amounted to 24.6% of GDP. Early into the global financial crisis, investments shrank to UAH 151.8 billion a year (16.6% of GDP). In 2010, the situation was even more alarming: UAH 130 billion (11.4%). Furthermore, Ukraine ranks last among European countries in terms of per capita GDP. This means that not only do we have low production volume, but we also invest just a fraction of it. In comparison, EU members are required to invest at least 30% of their national GDP. Considering that their per capita GDP is, on average, 10 times higher than Ukraine’s, they invest 30 times more than we do per capita. Add to this the fact that their economies are not as technologically outdated as Ukraine’s and the difference is easy to see.

Chinaprovides another point of comparison. The Middle Kingdom was similar to Ukraine in terms of production facilities and technology 10-15 years ago, but now it invests 40-46% of its GDP a year.

Consequently, it is safe to say that Ukraine is investing a miserable fraction of its national wealth. Is it enough to upgrade industry? Compare investment volumes with the value of the country’s capital assets: 6.0% in 2008, 3.9% in 2009 and a mere 3.1% in 2010. With this rate of investment, it will take 20-30 years to simply replace existing capital assets of all types, to say nothing of expanding or modernizing them. In this context, the government’s plans to make Ukraine more attractive to investors, which it says will take USD 1 trillion, look like mockery. Where will the money come from?

FROM SOURCES TO SOURCES

More than anything else, return on capital determines investment volumes. Technological backwardness and the production of competitive commodities are incompatible, so Ukrainian enterprises are unable to maximize returns and profits. Moreover, the existing system of commerce hampers modernization – many find it easier to act as parasites using corrupt officials as cover.

In general, the owners of financial resources are not interested in investing in the national economy. This is true of both oligarchs and other Ukrainian citizens: their active investments do not exceed 1% of their total income which is equal to nearly 90% of the country’s GDP. At the same time, we need to understand that individual incomes will be capitalized only in conditions of financial and monetary stability when investments do not lose value due to price increases and currency depreciation. Moreover, sluggish investments are explained by the political and legal problems businesses face – they operate in a hostile environment fighting red tape and corporate raiders and lack a fair judicial system.

DAMAGING RESOURCES

The quality of the investment mechanism is determined by the ability to channel capital flows into sectors that yield the highest returns. An average ratio of increment in profit to investments in Ukraine was 0.315 hryvnias in 2007 (before the crisis), -0.545 in 2008 (due to lower profits) and 0.446 in 2010. Prior to the crisis, the highest ratio was in the financial sector (2.62), real estate (0.652), agriculture (0.514) and trade (0.365). The banking system weathered the financial storm without significant damages. In 2008-2009, it stopped crediting the real sector and received ample opportunities to cash in on government bonds and currency speculations. Not surprisingly, the above ratio almost tripled in this sector, reaching 6.6 in 2010. Other leading sectors that year were industry (0.632) and commerce and repairs (0.375).

How were investments distributed across sectors? In 2007, the biggest chunks of the investment pie went to industry (34.1%), real estate (20.9%) and transport and communications (16.8%). The most profitable sectors attracted a minimum of monetary injections – 2.2% for the banking sector and 5.3% for agriculture. However, investors showed fairly strong interest in real estate (20.9%). With the onset of the global financial crisis the leaders kept their positions: industry (over 37%), real estate (21.9%) and transport and communications (16.9%). Of this trio, only industry posted above-average increments in profit. The financial and banking sector and commerce were near the rear with 1.5% and 1.2%, respectively.

Thus we see that investment flows have not followed the principle of profitability. They are also inert in that they are used to expand fixed capital in outdated sectors (industry, transport and communications) that yield low returns. Barriers preventing cash flows between sectors (for example, to the financial sector, utilities, telecommunications, etc.) remain strong and business penetrability low. The banking sector is a case in point: not everyone wishing to enter it can obtain a license from the authorities; there is no need to invest money (income is generated at other people’s expense); there is virtually no free flow of capital in the real Ukrainian economy (particularly, through open sales of shares issued by financial institutions). The same holds true for other attractive industries.

An excessive part of financial capital is concentrated in low-profit sectors, and this conservatism in financial redistribution strongly pulls down the overall ratio of increment in profit to investments. Therefore, with a given volume of investments, profits turn out to be relatively lower. The lower the profits from redistribution, the less money is available for investment in the next business cycle. The process repeats with the coefficient constantly decreasing.

CAUSE OF INEFFICIENCY

The primary cause for inefficient distribution of financial investments is the non-market origin of most of them. Non-market sources (enterprises' and organizations' own funds, as well as the state and local budgets) accounted for two-thirds of all capital flow in 2007. In-house funds are typically used to replace worn-out pieces of fixed capital, but this accomplished nothing in terms of upgrading technology and modernizing entire sectors.

Investments made from the national budget are scattered across nearly all sectors (from social infrastructure to coal mines to banks). However, efficiency is not to be expected here by definition, because as they pick projects to be financed, officials are not guided by profitability. In the past several years, budget investments have been shamelessly wasted: paying off the debts of bankrupt banks, meeting Naftogaz’s commitments without seeking parliamentary approval, and so on. At the same time, the lion’s share of market investments (bank loans, individual savings, money from private funds, etc.) is channeled not so much into industry as into mediating sectors. A lack of market-generated capital is caused primarily by the nascent stage of the monetary, credit and stock markets.

DOWN THE DRAIN

A distinctive feature of the so-called innovation-investment model promoted by the new administration is maximum concentration of financial capital in the hands of the central government to build large infrastructure objects. To this end, the state drains investment sources to the limit:

– the national banking system transferred 82% of all new receipts (UAH 66.7 billion for 2010) to the budget in order to finance its deficit and compensate for the losses incurred by government-run enterprises;

– foreign financial capital is spent largely on government bonds: Ukraine has borrowed UAH 68.5 billion abroad and on the domestic market and attracted loans to directly finance the budget in 2010;

– a number of businesses were forced to pay taxes in advance;

– the government fails to meet its commitments to businesses (VAT refunds, subsidies, etc.) in full and on time.

The list may be continued, but the bottom line is that the government concentrated around UAH 150-155 billion in its hands in 2010. The resulting losses for the real economy are hard to calculate. And government financing of large infrastructure objects is no compensation here. We need to understand that this sum is not the result of colossal budget receipts. On the contrary, the government put it together by taking out unprecedented loans while having a budget deficit. But why would someone invest borrowed money into something as unprofitable as typical infrastructure (bridges, highways, railways, crossings, airfields, traffic intersections, tunnels, etc.)? This is like draining water into sand. Intensive construction works are advised in a highly profitable economy, rather than in one operating at a loss, and the money should come from real savings, not hopeless debts. But even in these conditions, infrastructure should not come before profitable industrial sectors on the list of investment priorities.

Furthermore, the state should not take resources earmarked for profitable product manufacturing away from the private sector and invest them in infrastructure. Even if it does so, there has to be public discussion of proposed projects and in some cases plebiscites. Officials must inform citizens via the mass media, make models (showing the proposed object in its future neighborhood) and put them on display in public places. Even if the infrastructure must be expanded, it should be done using the best, cutting-edge technology – these objects will be used for 50-100 years and should not be a source of shame. Good examples to follow here are Japan, China and the UAE, which post the world’s highest growth rates and build only the best roads, canals, bays and islands and, in general, any infrastructure objects. One of Abu Dhabi’s suburbs, Khalifa, will turn into the world’s largest industrial zone (417 square kilometers) complete with petrochemical, biotech, pharmaceutical, electronics, food processing, logistics and other enterprises. Interestingly, the local authorities are building ports, roads and other communications for the zone on a budget of a mere USD 7.2 billion. Compare this with Ukraine: the Darnytsia bridge (rumored to be the world’s most expensive bridge) will cost UAH 9.5 billion alone.

DIZZINESS OR SUCCESSES?

Ukraine’s three leading metallurgical companies (Metinvest Holding, Interpipe and Ferrexpo) plan to invest a total of USD 8 billion to upgrade their production facilities in the next five years. In mid-September, Prime Minister Mykola Azarov voiced a conclusion that came as a surprise to many: implementing the Tax Code will allegedly give businesses an additional investment resource (as much as UAH 47 billion) in 2012. These success reports are nothing new. The problem is that it is hard to reconcile them with reality.

FOREIGN EXPERIENCE

The practice of overcoming economic crises

In this day and age, human communities are able to overcome economic crises and downfalls on their own. We have seen this take place in various countries in Europe, America and Asia. Solutions to economic crises are usually linked to structural and production modernization of the existing national capital. Especially encouraging is the experience of Japan and China – the world leaders which, at different times after the long-time rule of anti-market regimes, were able to take their economies to a high level. In order to put this mechanism in operation, they had to replace the former command-hierarchical models of economic management with market models based on private property, business freedom and competitiveness. Their governments have been consistent in pursuing an accumulative macroeconomic policy and promoted the growth of capital investments. Competition in the private sector was one of the engines of transformation in which old facilities were taken out of use and fixed assets were upgraded. Despite the deep depression their economies endured (Japan in the 1940s and 1950s and China in the 1960s and 1970s), the two economic systems began to generate alternative technologies, industries and sectors which eventually secured extraordinary growth rates for them. New resources and those removed from old industries were put to use precisely in these sectors. These “Oriental miracles” took place before our eyes – the economic systems of Japan and China were modernized and restructured.

CONCLUSIONS AND PROPOSALS

The government must see economic realities rather than simply care about its image. Resources needed for economic development should not be exhausted for the sake of sating someone’s financial appetite, while private initiatives need to be supported rather than stifled (as is the case with the new tax legislation). We need to grasp the complexity and scale of the reorganization and recapitalization that Ukraine’s economy needs. At the very least, this process will include the following components:

– a resolute transition to a free, competitive, market model;

– creating new market investment and innovation mechanisms geared toward maximum profitability and involving citizens as important investors;

– launching an accumulative macroeconomic model and progressive public multivector system of government investments;

– facilitating a better business climate (legal, customs and taxation systems, micro-investment programs, etc.); and

– removing economic “black holes” that devour national capital.

These minimal institutional changes may be a prerequisite for upgrading existing production facilities, which will be possible if the yearly flow of investment rises to UAH 350-400 billion within two to three years. Modernization itself will take at least a decade, assuming favorable conditions on the world markets.


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