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28 February, 2018

“We have to build capitalism where those who do a lot receive a lot”

Deputy Chair of the National Bank of Ukraine Council and Honorary President of the Kyiv School of Economics on monetary policy, mid-term risks, fundamental problems in Ukraine’s economy, the role of confidence and the restoration of fairness in economic development

Interviewed by Lyubomyr Shavalyuk

The NBU has increased the interest rate for the third time in a row. How does this affect the economy?

— The NBU was following the rules like all regulators do. It increased the interest rate as a response to the growing inflation pressure and expectations. Initially, the inflation rate was expected to hit 8-10% but it has crossed that and is not going down. Something has to be done about it. What instruments do we have? We need to make money more expensive. That’s when it will be used less, so the prices won’t rise so fast. This is a very simple connection we see in practice. When the market has more money and the price of products doesn’t change, prices will be higher. And vice versa.

What is the NBU doing? It raises the interest rate to make sure that prices don’t grow so fast. This means that deposit interest rates are likely to grow with time. When deposits yielded 10% while inflation was 12-14%, some people may have preferred to buy more bread or a car rather than deposit their money. Now, it’s more convenient to deposit money. So, the amount of money in the economic system will shrink while the amount of money on bank deposits will increase. The NBU sterilizes that money by taking it from banks and paying a certain interest rate to them. That’s how the NBU accomplishes its goal of making money more expensive.

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We can discuss the point to which the interest rate should be raised. Experts are having heated debates about that: some say that it’s not working, while others say it is. I think this mechanism does work, even if not as ideally as it does in developed countries.That’s bad for the Cabinet of Ministers and some companies. When money gets more expensive, loans do too. The economy always works like that — what’s good for one person is bad for another. If I want to deposit my money, it’s good for me. If someone wants to get a loan, it’s bad for that person. There’s also macroeconomic balance: if we make money more expensive, this is not necessarily good for the economy, but it does help to push inflation down.

Why is the inflation rate going up?

— It’s an important question that is looked at from different perspectives. The Cabinet of Ministers and a number of experts believe that prices are growing for objective reasons, not as a result of the Government’s decision. These objective reasons may include growing prices for the goods we import in the world, the growing price of gas or oil, rising exports to the EU which pushes domestic prices up to the EU level, the increase of utility rates and many others. These factors cannot be controlled by the Government.

According to another perspective, whenever the Government raises pensions or salaries in the public sector beyond the level which the economy can afford, the problem emerges. On the one hand, higher salaries create proper incentives for civil servants and attract smart people to the public sector. On the other hand, we spend more than we can afford on the state level. 

Some experts believe that social spending is growing faster than the economy does, so the Government’s actions, such as the increase of pensions or minimum wages, provision of subsidies and listing handouts in the budget, drive expected inflation rates up.

Regardless of which perspective is accurate, the NBU responds to the situation by raising the interest rate. This will have a negative short-term effect on the economy and a positive mid-term effect on inflation.

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Which perspective do you stick to?

— I’ll be diplomatic: I’ve heard different estimates. For instance, the increase of minimum wages partly drove the economy into the shadow as people switched to Individual Entrepreneur status, and contributed to inflation pressure. The figures on the pension reform I have seen show a serious burden on the budget. Many programs funded by the state also have a negative impact. However, I also agree with the idea that objective factors exist which the Government cannot control.

In fact, the fundamental factor is the underdeveloped economy. This raises questions to the Cabinet of Ministers, the NBU, the Presidential Administration and politicians — have they done everything possible to make sure that the economy develops? It is safe to say that their actions have led to the current situation. They could have conducted reforms more effectively, focusing more on structural changes and on making the economy more competitive, and less on political squabbling with each other.

Why are reforms going so slow in Ukraine?

— Reforms benefit those who are ready for them. As a result of the changes, the winners are those with better education (better professors and universities, including internationally); those who adjust better, and those who have longer life expectancy — the fruit of transformations come in the future. It makes sense to build an infrastructure for the rest to enable people to change their qualifications. That’s what has not been done in Ukraine.

This shows the clash between the Government and the NBU that’s rooted in the fundamental conflict between inequality and economic growth. Any policy aimed at macroeconomic stabilization will benefit younger and better educated people. This will increase inequality.  One of the Government’s tasks is to decrease it. In order to ensure economic growth, we need to build capitalism where those who do a lot receive a lot. This will create an incentive to work a lot. Also, this will deepen inequality — those who have done something will have more compared to those who have not done anything. As long as society does not perceive this inequality as a fair norm, it will not support capitalism, economic growth and reforms that lead to it. 

This takes us to another question: is the inequality we have in Ukraine fair? No. In the 1990s, a handful of people became wealthy in an unfair manner. They did so by creating the environment for their own enrichment rather than by competing fairly. They monopolized markets, controlled companies, made profits on a distorted gas market, set up captive banks, took part in cheap privatization etc. This has led to fundamental inequality where several percent of people are extremely wealthy compared to the rest, but they have not made that money competitively. That’s why people in Ukraine don’t trust the rich — we see them as enemies, not heroes. Inequality is perceived as an unfair thing in society. This has a complex and far-reaching impact.

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Wealthy people are seen as loyal to those in power. Therefore, there is no confidence in the government, and there is a permanent demand for the restoration of fairness: for “bandits in jails”, deoligarchisation or simply an answer to the question of who killed people on the Maidan. Ukraine’s leadership is unable to meet that demand. It needs support and gets none from society because society does not trust it from day one. Unless society supports it, the government relies on those who do. And who is that? The wealthy people with resources and connections. At that point people say, “sure, we knew they were just like their predecessors and cannot be trusted”. The result is a vicious circle: we don’t trust the government, and the government is forced to rely on the people that are the reason why we don’t trust it. We’re stuck in it.

Someone has to restore fairness in a fundamental sense if we are ever to leave this point. It doesn’t take putting someone in jail, shooting someone or dragging someone to courts for 20 years. Constructive fairness lies in giving people an opportunity to earn money in an honest way, in creating conditions for that.

An increase of pensions or minimum wages is a local solution that does not really solve the problem. Even when pensions are raised, nobody says “What a nice Government we have!”. Instead, we hear, “These losers have given us something at least.” That’s not what nurtures confidence. It can only be gained through the restoration of fairness. 

How are the conditions created to help people earn money on their own?

— First of all, people should realize that expecting the Government to make things work well for everyone, to increase pensions and salaries, is a way to nowhere. Even if the Government does raise pensions, it will do so through the budget. Eventually, this will lead to higher taxes which is bad, or to higher prices. This means that we will still be paying for the increase. Macroeconomics does not allow governments to simply give people money from the state. If I’m given money and you are not, I will feel good. If all are given money and all go and buy milk with no new dairy plants built, the supply of milk will not increase. We will have to import it from Poland, it will get more expensive and hryvnia rate will collapse.

If only Ukrainians realized that they cannot expect anything from the state, they would slowly start looking for ways out. Some are really good at knitting, so they can turn it into a small business and sell things online. We don’t see this in Ukraine because nobody instructs people about ways to create a small business plan or get an individual entrepreneur status.

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What would it take to grow an Apple or Amazon in Ukraine?

— There is one simple recipe for creating an Apple. You should not be afraid to do business. When you found a new company, you will inevitably violate something because you have not done anything like this before, or because you are introducing innovation that is not yet regulated. Trading in bitcoins or coding blockchain are good examples. There is no regulation for this yet, so the SBU [Security Bureau of Ukraine] can come by and say that you are sponsoring the “Donetsk People’s Republic”. That’s where change has to take place. Law enforcement authorities should not put pressure on small and medium businesses that do innovations. Not paying all the due taxes is still better than being intimidated. How many people try to do something but are scared away? This gets into the news and makes others think, hey, I won’t even try. People have to read news about others coming up with ideas, transforming them into a legitimate business and selling it to the Silicone Valley through an IPO, not about the SBU coming to a company and withdrawing all of its servers⃰. People will not try to create anything here for as long as they read about the SBU in the news.

It’s like sports. When everyone reads about Dynamo and Shakhtar, everyone loves football and plays it. This leads to a selection of talents who grow into strong players. That’s how business should work too: everyone should try and do business while the system and markets will select the best ones. For now, nobody wants to do it because they will be attacked for merely starting to act as a businessman. It should be the other way around: violations should be forgiven even if they do take place at times.

Some do not expect any tranches of funding from the IMF up until the end of Ukraine’s program with it. What awaits Ukraine in a situation like that?

-- I think that Ukraine will then lack the money to pay its foreign debt. This will lead to high inflation and an economic crisis. Or the Government should borrow in foreign markets which will increase the debt burden for future generations. This is a no-win scenario.

We can meet the IMF’s conditions and get the next tranche. The first condition is the establishment of an Anti-Corruption Court. The second one is an increase in gas prices to meet the international market rate. It’s very important that gas price in Ukraine gets to the European scale. This is difficult for people, but this is also about our energy independence. Market prices will enable competition where nobody will tell us: I’m closing the gas tap for you in the coldest time of the year.

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The gas tariff situation is even more difficult. The Government has pledged to establish it based on a certain formula. It is now saying that the formula is unfair and inaccurate. Even if we assume that the Government is right, how do our western partners see this? If the Government has committed to that formula, it must have been incompetent, or it does not want to stick to its promises now. The Government is saying that it protects the rights of the population. Then why is this protection selective, and why is there no fight against corruption, shadow economy or cleaning up of the tax system? What is hurting people more – corruption or high utility rates?

If Ukraine was cleared of corruption, people could be making more money. Or taxes could be lowered – then people would have different salaries and could afford more expensive utility services.  Clearly, the PM office cannot overcome corruption overnight. It takes consistent work. Screws should be tightened to remove the benefits of shadow dealings. Part of this work is about putting the breakers of new rules in jail. But new rules have to be created too, and this cannot be done overnight. 

There is a lot of talk about labor migration from Ukraine. Can anything be done to minimize it?

— Why are people leaving? They have nothing to do in a country that’s not fair. So they will leave. If fairness is restored, people stop feeling second-rate and have something to do here, they will probably stay. It’s easier to create a startup in Ukraine than it is in Poland. You can try and build something here, become an owner of it. There, you will only be an employee. 

The fact that Ukrainians are leaving is not the end of the world. I lived abroad for 18 years, getting my degree there, writing analytical and academic articles, making a career, and seeing how people work and study there. Some of this may be helping me do some things better in Ukraine today. Those who have not returned are transferring money here and sometimes coming to develop business with local partners. So there is nothing bad about it.

This problem affects the macroeconomic and demographic dimensions. When people, especially the young ones leave, who will work and pay taxes to cover decent pensions? If we cannot keep Ukrainians in the country, we should open up to the countries where life is worse than it is here. We are a racist society that doesn’t like anyone but Ukrainians and white people. We refer to people of other races as beasts, banabaks, blacks and so on. I think that this is unacceptable, but that’s our reality. And that’s a huge shame: we are not open to other people and new ideas.

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What’s the sense of the fight against racism and for diversity overall? Diversity brings diversity of ideas. It makes it more likely that a good idea comes up; it means tolerance for new perspectives, fewer conflicts, more exchange of information, better networking, brainstorming, economy and life for all. While we spend our time squabbling over whether we should be on the right or on the left, people are setting up a new Google.

Therefore we can’t curb migration directly. We can’t set up a fence on the border. This is bad because emigration from Ukraine is at the point where it raises a fundamental question: who is Ukraine for? If Ukraine is for the Ukrainians who think that life here is bad, maybe it’s better for them to leave? Think of a child who will spend a lifetime working as a clerk for USD 300 per month, or can get lucky, go study abroad and make USD 50,000 per year? On a fundamental level, is it better to not let the person do that?   

Can Kyiv School of Economics contribute to solving the emigration problem?

— If we are given land or a campus – I mean private capital, not just state funding – we will easily create an incubator for small and medium business. We will do this on a nationwide systemic level because we know how to do this.

We use the resources we have available to create a program for ATO veterans, teaching them to make business plans for an own business. I think we will launch it in March. We have many other short-term entrepreneurship programs and an MBA, so we’re helping people set up their own business.


Dr. Tymofiy Mylovanov is Professor at University of Pittsburgh and Deputy Chair of the NBU Board. He is KSE Honorary President and a co-founder of VoxUkraine. Born in 1975 in Kyiv, Dr. Mylovanov graduated from the Kyiv Polytechnic Institute and Kyiv-Mohyla Academy. He received his Master degree in Economics from the Kyiv School of Economics in 1999. He earned his PhD in Economics from the University of Wisconsin Madison in 2004 and has taught at the University of Bonn, Penn State University, the University of Pennsylvania, and the University of Pittsburgh.

On the first days of February 2018, the SBU searched the premises of a Kyiv-based company and withdrew its cryptocurrency mining equipment. According to official allegations, the company was involved in a scheme of mining cryptocurrencies and funding the “LNR” and “DNR” quasi-republics in Eastern Ukraine. This was met with controversy in Ukraine’s business, IT and media community.

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