Erosion of Capital Signals Economic Degradation

29 October 2012, 16:00

In this edition of The Ukrainian Week, former head of the State Property Fund Volodymyr Lanovy launches a series of articles on the chronic maladies facing Ukraine’s economy, their causes and possible solutions. The next article in this series will address “local excesses” in the national taxation system.

It is a known fact that enterprises are rarely modernized in centrally planned economies. Their future is of little interest to bureaucrats who are the informal owners of socialist property. Production facilities built according to state plans eventually begin to operate at a loss, but this does not lead to any changes: their status is simply changed to “unprofitable reserve” and they begin to receive government subsidies. Thus, coal mines, electric power stations, food-processing plants, brickworks, mineral fertilizer plants and many others were unprofitable in the Soviet Union.

Unfortunately, the privatization of state-owned enterprises that has been carried out in Ukraine after its departure from planned socialism failed to alter the situation. Modernization is lacking and industrial enterprises are falling apart, while unused infrastructure rusts. Half of Ukraine’s production facilities are unprofitable. They do not pay taxes or make contributions to the pension fund. Machine-building plants and textile factories employ 10-20 per cent of their maximum staff capacity at best, and the situation is no better in other sectors. Given these indices, the managers of such enterprises (privatized, rented or state-owned) are not actually playing a management role—they are unable to increase their staff, introduce new products or improve energy efficiency.

The situation in the coal mining industry is critical. Most facilities are directly subsidized by the government and are not simply unprofitable. They do not amortize the cost of mine maintenance and technical upgrades. Money for these purposes comes out of the budget. Even then, nobody knows when it will arrive, whether it will suffice or whether it will be embezzled or diverted along the way—there are no guarantees. But the mines’ own expenses are lower. This atavism was barbaric even for the socialist epoch. It is as if coal mines were public libraries or schools that cannot exist without government financing, rather than production facilities that are supposed to be cost-efficient. The results are not surprising: the equipment is terribly worn down; coal that is extracted at extreme depths where workers can remain for no longer than two hours and which costs thousands or sometimes hundreds of lives every year is recognized as “cheap.” The nation now spends almost UAH 20 billion in subsidies and direct compensation of losses to maintain this wretched industry.

A very dubious, non-transparent modelof industrial capital renewal is also being used in most other branches of the energy complex. Companies here do not amortize their capital, hoping for budget subsidies. However, special extra-budget industry funds are set up to meet the needs of electric power stations and energy network enterprises. These funds are financed by consumers when they pay specially marked-up electricity tariffs which are controlled by energy officials rather than companies. This additional money is supposed to be spent to make capital investments in the development of power stations, maintenance, waste recycling, dismantling of old power-generating units, etc. This is another vestige of the soviet model that the Ukrainian energy clan has been able to perpetuate under all subsequent governments and presidents. Because these funds are not part of the budget, they are outside civic and parliamentary control and are therefore often misused or used inefficiently. It is difficult to obtain data on these extra-budgetary funds, as bureaucrats carefully mask their suspicious financial transactions. They are suspicious namely because they contradict Ukraine’s taxation and budget norms and pricing laws, “flexible” as they are. But the many years it has taken to complete the construction of power-generating units at the Khmelnytsky and Rivne nuclear power plants and the luxury cars used by EnerhoAtom chiefs are revealing facts that speak louder than words. These markups are not part of tariffs, and do not benefit the enterprises themselves. Nor do these payments have the status of taxes, because they have the opposite function. The conclusion is that, under the cover of the government, a mechanism is operating to extract money from society for the needs of energy bureaucrats. It is unrealistic to hope now that this industry is going to obtain real and sufficient capital. Meanwhile, nearly half of the country’s nuclear and thermal energy units have already reached the end of their lifespan. Moreover, their performance characteristics fall short of modern standards.

Ukrainian industrial capital, which is not being restored or modernized, is eroding. This points to both physical and moral backwardness and, in essence, the economic degradation of Ukraine’s enterprises. From the viewpoint of financial resource use, unprofitable and cost-inefficient companies shackle the economy: they extract from society pure profit in order to pay for losses, debts and wear and tear on their equipment. This profit would otherwise be spent to increase capital and generate jobs in other industries, particularly innovative and more efficient ones. Thus, Ukraine's economy would be growing at a much faster pace. So it turns out that by subsidizing unprofitable or parasitic companies at the expense of the national budget, Ukraine is becoming a planned economy that operates at a loss.

Why can't socialist-era enterprises be put on their feet when meanwhile there have been so many small companies founded or drastically overhauled in independent Ukraine? (in food processing, commerce, telecommunications, finance, etc.)

First, “soviet” plants cannot meet new market demands with the products they manufacture. Their production capacity is relatively excessive. They can only work to full capacity if they start producing innovative and high-quality goods. But so far these tasks are not on the agenda set by the owners and managers of many enterprises inherited from the USSR.

Second, they rely on grossly outdated technology. Hence, the operational structure has also become outdated: multiple specialty shops selling a single product are no longer needed. Procurement and auxiliary departments are also superfluous because materials and services can be purchased more cheaply from specialized companies on the market. Plants have to become more compact and shed their large plots of land, facilities and supply lines. This would lower energy and fuel consumption to a fraction of their current levels. Large administrative and support staffs will also become unnecessary.

Third, economically safe “vacation resort” conditions inherited from the socialist epoch led to a situation in which industries held on to their rusty equipment and decrepit facilities. The principle of unconditional material responsibility for performance does not, in essence, apply to them. It seems that nothing has changed and the government is responsible for their lack of cost efficiency and profitability.

Fourth, the need to implement new technologies, reform organizational and spatial structures, and learn to produce new products demands a complete overhaul of old facilities in terms of their profile, financial status (authorized capital, account balance, debts, financial assets, etc.), management, infrastructure and owners. Both officials and CEOs, whose interests lie elsewhere, are actively counteracting this process.

These phantoms of the past are defended and perpetuated in various ways. The infrastructure and energy sectors have seen the arrival of state-owned associations (holdings, corporations, concerns, etc.) that use the facilities of formerly independent enterprises and have monopolized the market. They dictate prices, guaranteeing profitability while taking possession of the finances owned by the enterprises themselves. If it is difficult to raise prices and tariffs (for example, when the government has committed to not doing so), they use a different tactic. Years of debt owed to suppliers by utility companies are periodically “written off.” This hurts the budget because money is subsequently withdrawn for several years to compensate for the losses incurred by suppliers. The last write-off, in autumn 2011, amounted to UAH 26 billion. If such compensation is impossible, as is the case with Naftogaz, which accrues external debt to Russia’s Gazprom, the government simply transfers budget money to increase the authorized capital of the company in question or refinance its debts.

In other words, companies can operate at a loss, waste energy and run production into the ground without facing any consequences. Socialist-era enterprises and newly founded quasi-corporations owe their physical and moral degeneration to the public administration system that has defended irresponsible bureaucrats and ignored real companies and their employees. And it has repeatedly taken money from taxpayers to fill holes in places where profits should be reaped.

Thus, there are some specific answers to the question: How can “soviet” plants be brought back to life?

1.      It should become a rule that there must be no permanently unprofitable plants, factories and companies. Such companies, if they are government or communal property, should be urgently reorganized on the government’s initiative. Possible ways to do so include pre-bankruptcy reorganization that involves switching to new products, cooperation with private (including international) companies, restructuring production complexes, technological upgrades, etc. In many cases, reorganization should be tackled after companies have been partly or fully privatized.

Bankruptcy proceedings of privately owned companies on submissions from creditors (employees, banks, suppliers, etc.) should be completed fairly quickly so that assets do not lose value or become embezzled.Creditors here should not include tax inspections, which do not belong to this category by definition, and only impede progress in paying private debts with assets. In this context, if tax debts arise, property mortgages (seizures) should be eliminated. Another barrier on the way to applying the bankruptcy mechanism is the lack of independence and qualification among the judiciary. The tax service and its desires are above the law and judicial competence. This issue is painfully familiar to Ukraine and, considering the nature of the current government, stands little chance of being resolved. But if no solution is found, the economy will continue to rot.

2.      A top-priority task is to de-monopolize state-owned industrial holdings, concerns and corporations (in particular through vertical and horizontal disintegration) and to turn their individual units into stand-alone enterprises. This will make it possible to single out unprofitable units and reorganize or privatize them. In the next stage, enterprises that have not begun to turn a profit should be subjected to bankruptcy proceedings.

3.      We should finally end the vicious cycle of planning to finance unprofitable companies and perpetuate socialist pricing. In this situation, prices cover production costs and secure profits regardless of whether consumers like and accept specific products. Here is a recent example: the Ministry of Infrastructure has announced another increase in train ticket prices. The state-owned Ukrzaliznytsia (Ukrainian Railway) will always be a profitable company, even though the quality of its services continues to deteriorate as passengers are offered increasingly worse and worn-down carriages and the danger of accidents is becoming more and more real. Subsidies and loans are again earmarked in the national budget for Naftogaz, heating companies, the coal mining sector, aircraft construction companies, agricultural producers and other uncompetitive enterprises. We need to get rid of this practice that kills both the budget and the economy in general. Prices should be formulated on market foundations; they should not automatically rise together with production costs. Economic profit should arise only when performance is increased, equipment is upgraded, costs are cut and product quality is enhanced. If a company is unable to deliver any of these and becomes unprofitable, it has to go through reorganization or bankruptcy proceedings. Only in this case can we hope to have modernized enterprises and communications, ride in comfortable train carriages and enjoy clean water in our apartments at an affordable price.

4.      A special real estate tax should be introduced that would make it burdensome for manufacturers and commercial companies to use excessively large facilities and plots of land. The tax should be paid by company owners – legal and physical persons. But small houses, land parcels and facilities should be exempt. The tax needs to be moderately progressive – from around zero to five per cent of the object’s value – and levied once a year. State and municipal property should not be exempt. Those who manage this property now are doing a terrible job, but suffer no consequences because of government protectionism. Incidentally, this kind of protectionism normally comes at a price, even though officials state on the record that they are protecting the flagships of the economy.

5.      The conditions for accumulating finances for the modernization of outdated enterprises should be put in place. Companies’ own amortization funds must become the primary source of such finances. Payments to these funds should be mandatory. Plants that have been shut down or discontinued operation should not be exempt from amortization payments, because otherwise soviet-era industrial wrecks will be able to stay afloat. Moreover, enterprises should be allowed to raise average amortization rates for active capital by 2-2.5 times or even more for high-tech plants. The value of capital being amortized needs to increase with the growth of average prices of equipment, vehicles, construction and engineering works, rather than that of consumer goods and services, as is now stated in the Tax Code. (It further sets a 10-percent inflation threshold, i.e., if the inflation rate is below 10 per cent, no indexation takes place.) Otherwise, only part of the capital value will be renewed. This is what is happening now, because investment goods and prices grow two to three times faster than the annual inflation rate.

With more money going to amortization accounts, profits will decrease, and hence companies will have to pay less in taxes. On the national scale, billions of hryvnias will be made available and accumulated by companies that are more capital-intensive. This approach is superior to the method of stimulating economic investments introduced by the new Tax Code. It exempts only reinvested profit from taxation and permits accumulating investment capital only in profitable companies, which normally do not need to be modernized.

The USA opted for increased amortization rates during the Reaganomics period (1980-1988). This was a major factor that enabled American industry to introduce new, flexible, robotic modular technology in the 1980s and the 1990s.

6.      Not only macroeconomic stimuli are needed. Companies themselves must make efforts to upgrade equipment. The biggest incentive to do so will be the growth of market competition and the elimination of monopolistic abuse and corrupt/political rent. Furthermore, a real financial mechanism for technological modernization is needed. It would have to include a number of elements: independent credit institutions without government protectionism or a monetary regulator, elimination of targeted, emission-based crediting of banks, their mandatory commitment to pay off loans, investment of deposit resources in economic development projects, and accessible market loan rates.

7.      The structure of capital should change dynamically. Understandably, its current distribution is hopelessly inadequate in terms of meeting the needs of Ukrainian society. This is true not only of soviet-era plants and factories. Most importantly, Ukraine needs to define its new investment priorities in order to create favorable conditions for new sectors and industries. IT sectors should have a special place in the economy. IT products and services are in high demand on both external and internal markets, while Ukraine has qualified personnel, a functional electrical engineering industry, and connections for collaboration that could be used to expand this sector. At the same time, the distribution of investments should follow consumption needs as defined by market demand (i.e., through commerce and financial services) rather than by bureaucrats.

8.      In order to safeguard capital against erosion, Ukraine also needs to drop administrative and fiscal constraints and barriers when capital structures change their form from natural to financial (through sale, reconstruction, bankruptcy, shutting down or property structure reorganization) and when financial investments turn into production assets (through construction, mergers, incorporation, technological upgrades, conversion, modernization, etc.). These operations now pose high risks to capital owners and hamper structural change due to excessively tight regulations.

9.      Ukraine’s economy needsto pursue a steadfast transition to largely private forms of ownership of production and financial assets and secured entrepreneurial freedom. This is not on the Party of Regions’ agenda because it favors an oligarchic model that makes no provisions for the growth of small and medium business. But sooner or later, the country will have to shed the burdensome old capital that is pulling its ship to the bottom. Otherwise, it will not be able to stay afloat.

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