On the Track of the Fleeing Capital

27 February 2015, 12:00

2014 was extremely hard for Ukraine. The overt war, the actual loss of territories and the long history of misgovernment had a negative impact on the economy. Its scale is largely unprecedented, making the government face challenging tasks that require outstanding skills in crisis management. One of the persistent problems of Ukrainian economy last year was capital flight. It had a number of reasons and a number of channels, but its only overall result was panic on the currency market, hryvnia depreciation, and falling living standards.

Foreign investment

Of course, the exact amount of the capital exported from the country is unknown even to the eagle-sighted intelligence officers. However, very tentatively, the volume of capital outflow (or shortage) can be estimated by comparing certain economic indicators against the same figures for the previous years.

The key indicator associated with the long term capital inflow and the economic development of the country is foreign direct investment (FDI). Last year, Ukraine received direct investment in the amount of USD 413mn net (see Capital Drought). This is 9.9 times less than in 2013, and 17.4 times less than in the relatively active 2012. That is, FDI influx fell significantly already in 2013, as the world realized the essence of the Yanukovych regime and the prospects for Ukraine under his rule. But last year saw a really dramatic decline in FDI.

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According to the NBU, direct investment from Ukraine to other countries in January through September 2014 amounted to USD 108 million, which is 42% less than in 2013. This means that investments abroad made by businesses registered in Ukraine were not a channel of massive capital outflow. Instead, it happened through direct investment in Ukrainian economy (or, in this case, rather divestment from it) from overseas. For instance, during the first three quarters, USD 133mn of FDI were received, while for the same period of 2013, the inflow of investment in Ukraine amounted to almost USD 3.3bn. This means that after the power shift, the capital flow not only decreased, but also changed direction, resulting in the loss of billions of proceeds in foreign currency.

The structure of direct investment explains the nature of this phenomenon. According to the State Statistics Service, in early October 2014, FDI in Ukraine (cumulative invested capital from the beginning of investment) totaled USD 48.5bn, which is 17% less than at the end of 2013. The biggest investor countries were Cyprus with USD 15.1bn (-21%), Germany with USD 5.8bn (-8%), the Netherlands with USD 5.2bn (-6%), and Russia with USD 3.0bn (-31%). It turns out that the investors most afraid of the war were Russians, who previously invested in Ukraine either directly from Russia or indirectly via Cyprus, and Ukrainian oligarchs, for whom Cyprus is the most traditional offshore territory (followed by the British Virgin Islands, with FDI of USD 2.5bn coming from there. That one fell 20%).

Through the investors' panic and their efforts to protect their capital from the worst-case scenarios (this applies mostly to the adherers of the Yanukovych regime), FDI amounts had been negative through May 2014, rebounding to the level of 2013, a crisis year, in December only. In this way, Ukraine underreceived the total of USD 6.0-6.5bn in 2014 (compared to the relatively successful 2011 and 2012). This money still exists somewhere as it (its value) was most probably created by the economy and did not disappear, but was deposited somewhere abroad. The question is whether it will ever return to Ukraine.

Portfolio investments have also become a channel of capital flight from Ukraine, even though insignificant in volume. In 2014, the country lost USD 395mn through this channel, compared to inflows amounting to USD 1.2bn recorded in 2013. It should be noted that transactions with fictitious (junk) bonds may also serve as an instrument for disinvestment. It is usually used for transactions with millions or tens of millions, and not billions of dollars. However, given the current balance of payments, not more than USD 0.8-1.0bn could have been channeled out of Ukraine last year using this method. Compared to the overall capital flight, this amount is not too large.

External debt

The largest volume of foreign exchange earnings arrears recorded last year was due to debt (medium- and long-term loans and bonds). The outflow of capital in this case occurred via two channels: through banks and nonfinancial (mostly production) corporations. In the first case, everything is more or less clear: it takes financial institution years to pay back foreign loans taken before the crisis of 2008-2009. 2014 was no exception, although the outstanding bank debt to non-residents today is not too large. However, in the last year, financial institutions reduced the rate of raising debt 2.8 times. This is not surprising, since foreign investors who know the current situation in the banking sector, even from hearsay, are not excited about lending to Ukrainian depository corporations. Therefore, the outflow of capital using this channel is totally consistent with the market situation.

However, not everything is clear with the real sector debts. Last year, Ukraine spent almost USD 4.2bn net to repay them, although previously this budget item generated revenue: USD 1.3bn in 2013 and USD 4.7bn in 2011-2012 (see Capital Drought). The rate of borrowing in 2014 decreased 5.6 times compared to 2013, which could be explained, as in the case with banks, by the fact that foreigners are not willing to lend to a country involved in a war. But, as we said above, foreign borrowings of financial institutions decreased only 2.8 times (the difference in absolute terms is even more impressive: -USD 2.9bn for banks against -USD 11.0bn for nonfinancial corporations), while it was the banking sector that had the most problems in 2014. Besides, the volume of external debt repayment by real sector companies last year fell by almost 1.5 times, although the total volume of external debt as of the beginning of 2014, naturally, increased compared to the previous years, that is, there were no reasons for such decrease.

Given the above, it seems that the statistics of foreign borrowings and foreign debt repayment by nonfinancial corporations are also affected by the cash flows of Ukrainian oligarchs. Many years ago, the Ukrainian new rich often used external debts to funnel capital out of the country to offshore territories under the guise of high interest rates on such loans. Today, they might register the financing of their production assets as loans to management companies registered offshore in order to avoid the risks of the Ukrainian banking sector or to hold their equity in the foreign jurisdiction in case of disputes (through the incapacity of the national judicial system that could not deal with, say, forcible takeovers of businesses often practiced under Yanukovych). One way or another, the refusal of the oligarchs to continue investing funds in financing Ukrainian assets apparently significantly limited the amount of foreign exchange earnings on loans and bonds obtained by the real sector. As a result, last year Ukraine received USD 8.10bn less proceeds, most of which would have gone to the national economy, if not for the war.

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Other items

A notable component of the capital flight was the outflow of foreign exchange cash from the banking system. Last year, its volume amounted to USD 2.6bn, which is 4% less than in 2013. A lot of myths are associated with this item. One of them is that the population buys up currency to keep it under mattresses. If so, where did Yanukovych find USD 32bn (according to other sources, USD 2-5bn) in cash that he allegedly took to Russia, and what is the source of financing for the large-scale illegal trafficking that flourished under the regime and has largely survived to this day? This is a rhetorical question. It would be probably right to say that a portion of the foreign exchange cash that was withdrawn from the Ukrainian banks through currency exchange offices was neatly packed into cases and shipped abroad.

The same goes for the outflow of deposits from the banking system. The Prime Minister once said that Ukrainians withdraw money from their bank accounts and put them into cashboxes in anticipation of financial institutions’ bankruptcy. This is partly true. But, of course, a portion of these funds was also taken out of the country in cash, since after the power shift, according to The Ukrainian Week's sources, overt transfer of funds abroad through banks has become much more complicated, primarily because of the measures taken by the US authorities and their counterparty banks. Since the total of foreign currency deposits withdrawn last year from Ukrainian financial institutions, according to the National Bank of Ukraine, amounted to USD 11.4bn in dollar terms, it is very likely that at least a third or a half of this amount can no longer be found in Ukraine. It may well be that these funds have migrated abroad along with their owners. Taking into account that under normal economic conditions, Ukrainian banking system received an additional USD 5bn in the form of deposits from individuals and businesses annually, the financial sector in 2014 received over USD 16bn less in deposits. God only knows, which share of this amount was taken out of the country.

Another popular channel of capital flight are fictitious transactions related to the import of certain goods or services. The scheme is quite simple: a fake importer pays in foreign currency under a contract that is either not executed (then the amount stays on the importer's balance as accounts receivable), or executed only on paper (which is very common in the case of import of services, such as consulting). The scale of capital outflow via this channel is hard to estimate accurately, but we will give a try. In 2014, total imports of goods and services in Ukraine amounted to USD 74.1bn, which is 27% less than in 2013. At the same time, hryvnia depreciated over the year by 134%, and the average dollar exchange rate grew by 52% compared to 2013. During the last crisis of 2009, imports of goods and services fell by 44%, while the average annual dollar exchange rate grew by 53%. It turns out that at that time, imports fell faster than now. There may be two reasons for this. Firstly, at that time a special duty was imposed on most commodity items at the rate of 12%, which probably restricted imports. Secondly, this year the statistics showed an increase in imports of some goods due to the elimination of illegal trafficking schemes coordinated by the Yanukovych regime. Nevertheless, there are rumors that many schemes continue to operate successfully, and the figures show that the legalization of illegal trafficking had no significant impact on the balance of payments.

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So how can we explain those 17 percentage points representing the difference between the imports drop in 2014 compared to 2009, given that the average annual hryvnia depreciation is almost the same? It is obvious that the lion's share of this difference can be attributed to the fictitious imports used to funnel money abroad. This hypothesis is indirectly confirmed by the fact that when the Head of the National Bank Valeria Hontareva tried in late August to introduce administrative barriers to such transactions by signing the respective NBU order, she had to rescind it under the pressure from above already in two months. Here we are talking about an amount of about USD 17bn. Even if only a half of this sum was generated through fake import operations, this is a huge loss to Ukraine in the current situation.

In more developed countries, central banks strictly monitor transactions related to the channeling of funds abroad and try to prevent them. Even Russia's balance of payments statistics have "suspicious transactions" item for the contracts of purchase and sale of goods, securities etc. aimed at withdrawing funds from the country. The volume of such transactions amounts to 1–2% of GDP. If we draw an analogy with the Russian Federation, the invisible share of capital flight from Ukraine could be estimated at USD  3–4bn. However, given the current economic and political situation, which has dramatically reshaped the balance of payments compared to the last year, the actual amount is probably much higher.


Using the above calculations, it is safe to say that last year the Ukrainian economy lost over USD 40bn in foreign exchange earnings compared to normal years. Basing on a rough estimate, about USD 20-25bn out of this amount accounted for the capital channeled out of Ukraine during 2014. This sum is probably higher than what the oligarchs funneled out of the country annually using transfer pricing (USD 5-20bn per year, according to different estimates), but obviously much lower than the amount which was allegedly stolen by the Yanukovych regime (USD 70-100bn). But it is quite comparable to the changes in the financial account balance, which in 2013 amounted to USD 18.6bn, and in 2014 to minus USD 8.4bn. This drastic metamorphosis became the cornerstone of the dramatic hryvnia depreciation and the impoverishment of the population.

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One way or another, this money in Ukraine would come in handy in the current situation, especially given the fact that we are talking about an extended cooperation program with the IMF, envisaging tens of billions of dollars of additional credit that the country's economy badly needs. Since no one in the new government is trying to prevent the outflow of capital from Ukraine, except for minor and short-lived exceptions, the conclusion would be as follows: the Revolution of Dignity has transformed the system of values ​​of just about anyone, except for the authorities. For them, the money stays at the top of Maslow's pyramid, remaining the sacred cow that cannot be touched, even when the country is bulging at the seams. As before, they are quite tolerant of the activities of the oligarchs and the like, who can easily take their money out of the country, directly contributing to the hryvnia depreciation and the increased poverty of Ukrainians. 

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