Resuscitating Ukraine’s Moribund Economy

20 May 2014, 20:00

The new government is a little more than 50 days in office – too short a period to assess its performance, especially considering the events in Crimea and Eastern Ukraine. But the important thing is that citizens look to the new Cabinet with hope for a better life, and this expectation has to be fulfilled. Fifty days is, however, enough time to be able to say that the new government is moving in the right direction despite having to overcome big hurdles and making multiple mistakes. These laudable efforts are the reason why Ukraine’s economy, which is not in the best of shapes now, is showing the first signs of growth. These are only the first harbingers of change, but they give reassurance that if Ukrainians keep the government on its toes, their hopes may come true this time around.

Real sector

The volume of industrial production in the first quarter of 2014 fell five% year-on-year. This negative indicator might seem to be merely a continuation of the last year’s trend when industry lost 4.3%. As a matter of fact, it is an expression of a number of trends that will persist in the future. March data is telling, because this is the first full month under the new government: the decline rate rose to 6.8% from 3.7% in February due to certain factors.

First, the Russian blockade of Ukrainian-made goods is gaining momentum, causing Ukraine’s industry to lose its positions in a number of areas. In January through February, Ukrainian exports to Russia dropped by 30%. This took place before power changed hands in Ukraine, but the scale of the drop-off is a reflection of Russia’s continuing policy to replace Ukrainian imports with Russian goods launched long before the revolutionary events in Ukraine. The foreign trade data for March and subsequent months, when made public, is likely to be even gloomier but can already be seen in the industry’s performance. For example, Ukrainian producers of freight wagons, most of which go to Russia, reported March figures that were just one-fifth of the production volume they had a year ago. They have experienced decline for many months due to the hostile Russian policy.

In March and April, the Kremlin greatly expanded the list of Ukrainian goods banned for import, which now included potatoes, dairy products, confectionery and so on. Facing a full-fledged trade war, our economy will take longer to bounce back, but there is a crucial positive aspect to the situation. By dealing with a fear of losing its biggest trade partner of the past, Ukraine has opened a way for rapid, unrestrained growth in the future. The economic situation now nearly completely depends on us, so after surviving a brief period of hardship, we will be able to embark on a trajectory of steady economic growth.

Second, industrial statistics reflect transformations that have taken place due to the replacement of the government. For example, coal production slightly rose in February (by 0.9% year-on-year) but fell 9.9% in March. On the one hand, this drop-off in a key industry may lead to higher unemployment in some of the most depressed regions in the country. On the other hand, the underlying cause may the discontinuation of shadow schemes in which charcoal was produced in large quantities in small illegal makeshift coalmines and “pits” and then sold for peanuts to coalmines and intermediaries who made millions on these transactions. This “business” provided jobs to many people, saving them from financial distress, but also wrecked or took numerous lives. The new government has to put an end to these kinds of schemes in the coalmining industry and elsewhere, which will postpose economic recovery and require offering alternative employment opportunities.

Third, the decline in some industries is of a purely seasonal nature or started long before power changed hands in Ukraine. For example, the metallurgical industry fell 11.1% in March and 10.7% over the first quarter of 2014, while it lost 5.3% over the previous year. This serious drop-off is caused by external factors, primarily the lower global demand for steel which has brought iron ore prices down by 18% since December 2013. The production of electrical energy, gas and water in March dropped by 8.3% only because the first spring month was much warmer in 2014 than last year. These kinds of factors will eventually have no effect on industrial output.

Construction and transport are two industries that offer hope. The construction industry posted a double-digit declinerate throughout 2013, dropped by 10% in January and February each but slowed down to 5% in March. Freight turnover in transportation companies fell 3.1% but the volume of goods carried rose by 2.6% in Q1 2014. These two sectors are growing faster than the rest of the economy and permit discerning economic growth where it is still hard to see. That the decline is slowing down and growth is seen in certain areas suggests that the economy may leave from the bottom earlier than the end of 2014, as predicted by the government.

Financial sector

The situation in the finance department is ambiguous. On the one hand, a month or two ago Ukraine was having a hard time finding resources to finance the huge budget deficitleft behind by the previous government. The situation was further aggravated by the panic over deposits and currency fluctuations, which undermined the banking system. On the other hand, the new government fairly promptly reacted to financial challenges and rushed to fill the gaps. The methods used were not always optimal, but what we have today is a stable financial system. A number of reforms that are now at an early stage will determine the parameters of macroeconomic balance in the future.

The Ukrainian Week has already reported the first steps taken by the new governor of the National Bank, including a fully flexible exchange rate, temporary administrations in problem banks and light constraints on refinancing. These measures have already yielded a number of results worthy of closer inspection.

The key change in the financial sector has been the devaluation of the national currency. Even though it dropped to around UAH 13 per USD 1 by mid-April, triggering some apocalyptic forecasts, it regained, with equal ease, some ground by going back up to UAH 11.5/USD and has every chance of advancing even more. Most important, these fluctuations took place against the backdrop of record-high balances on banks’ correspondent and transit accounts: UAH 29-34bn throughout nearly all of April as compared to UAH 25.3bn in the past year. In other words, financial institutions, which once were the chief currency speculators and now have excess liquidity, are not directing it to the currency market. And this is the first step towards restoring the crediting of the economy. In fact, the result came quickly. Loan interest rates spiked in February but went down in March (see Inflation up, interest rates down) and kept falling in April.

It is too early to say that the financial sector, primarily banks, is ready to pour money into the economy rather than milk it as was the case in the past years. The withdrawal of deposits is still continuing. Deposits in Ukrainian banks were at UAH 380bn and US $26.5bn by the end of March, having shed 10.1 and 14.0%, respectively, over the first quarter. This made banks reduce lending volumes. However, due to large-scale refinancing (the National Bank provided a total of UAH 24.2bn in refinancing for periods from one week to six months), this trend was essentially set off in March. By the end of April, the loan portfolio may grow. The devaluation of hryvnia, which brought the exchange rate closer to the market figure, also opened the door to Ukraine, particularly to its financial sectors, for foreign investors. They are so far waiting for a signal in the form of loans to the Ukrainian government from the IMF and other large international organizations and foreign governments, but as soon as they arrive, money will be poured into Ukraine’s banking sector at a higher rate, interest rates will go down even more and the economy will receive a reliable and relatively cheap resource for growth.

Ukraine’s state budget has also benefited from the hryvnia’s devaluation. Initially facing huge problems with filling it, the government reported having some UAH 88.7bn (up by 5.8% year-on-year) in receipts for the first quarter. However, even the spending cuts undertaken by the newly appointed Cabinet are not enough to reduce the budget deficit to a minimum. Therefore, the government has resorted to the tried and tested option – sale of internal government bonds to the National Bank. In less than two months, the NBU purchased more than UAH 10bn worth of bonds, while foreign entities spent an additional UAH 2bn. In 2013, the NBU bought bonds worth a total of UAH 42bn. This approach will be effective if used only as a temporary measure. As soon as foreign money enters Ukraine, there will be no need to continue with it and additional inflationary pressure will be avoided.

The only players who lost, rather than gained, from the hryvnia’s devaluation are, as is often the case in such situations, ordinary citizens. Initially, their income rose by 35-50% under Viktor Yanukovych with the economy staying almost flat, thus creating an illusion of a somewhat richer life. Now the economic system has restored justice as the income level remains unchanged, while the prices of imported products have skyrocketed. (For example, petrol is 44% more expensive than it was in early 2014.). The prices of domestic productsare steadily growing, too, and will soon compensate for the devaluation. People feel hurt, and Yanukovych, acting like a buffoon in Russia, has even found evidence to accuse the new government of unprofessionalism. But here is a strange thing. How could Ukrainians, whose nominal salaries and pensions grew, while the prices remained almost the same, rise and carry out a revolution? And what for? For the sake of a lower purchasing power of their own income which resulted from this? This is the crux of the matter – the nominally increasing income level was coupled with severe curtailment of personal freedoms and opportunities for growth. So ordinary Ukrainians essentially swapped rotting in prosperity for an opportunity to grow and actually have a life but suffer from hardships for a while. This step is worthy of respect; it offers hope and negates the drawbacks of revolutionary time.

Reassuring result

On balance, we have a fairly complicated but in no way hopeless situation. On the one hand, Russia’s actions and the need to destroy the old shadow schemes are aggravating the crisis in the real sector and pushing producers to seek new markets. On the other hand, Ukraine is drawing close to macroeconomic stabilization as it expects to receive significant financial and trade support from the developed countries and international organizations. Most of this money will go towards refinancing old debts and will simply buy time for the government. Sweeping economic reform will take a year or two to implement. If it succeeds, foreign capital will start flowing, because it is hard to put it to good use elsewhere in the world, considering record-high prices on the financial markets. In that case, the GDP drop-off may turn out to be much smaller than is currently projected by the government. If, however, the Ukrainian oligarchic monster of the past gets the upper hand and the reform is a debacle, the consequences will be ruinous for many years to come. As long as the government is taking the right steps and is ready for drastic changes and a shift away from the state’s paternalism, which has never been a fitting paradigm for Ukraine’s politico-economic system throughout the independence period, there is hope. For this hope to turn into achievements, all Ukrainians will have to work hard and relentlessly keep tabs on politicians.

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