Report No. 30928-UA Ukraine Building Foundations for Sustainable Growth A Country Economic Memorandum December 27, 2004 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank ACKNOWLEDGEMENT This volume of the Ukraine C E M was prepared by Task Manager John Litwack under the supervision of Sector Manager Deborah Wetzel, and draws from investigative work carried out bynine Ukrainian CEMworking groups andthe CEM WorldBank team during2003 and early 2004. Inputsfor this volume were also providedby Ukraine CEM team members: Mark Davis, Lev Freinkman, Larisa Leshchenko, Ruslan Piontkivksy, Svetlana Budagovskaya, Oleksiy Balabushko, Denis Gaiovy, and Oleh Khalayim. The work within Ukraine was led by Larisa Leshchenko and her assistant, Oleksiy Balabushko. Editorial and technical assistance was provided by Virginia Sapinoso, Irina Partola, Helena Makarenko, Usha Rani Khanna, and Judy Wiltshire. The preparation of this CEM profited at every stage from close cooperationwith the Ukrainian government, the Ukrainian National Bank, the Administration o f the President, and regional (oblast), district (raion) and municipal state administrations in Lviv, Chernovtsy, Mykolayiv, Boguslav (Kyiv oblast), and Kozeletsk (Chemigiv oblast). This CEM also benefited from productive relationships with the Institute for Economic Research and Policy Consulting (IER), the International Center for Social and Economic Research (CASE), the Center for Economic Development, and the International Center for Policy Studies (ICPS), the Ukrainian Center for Social Reforms (UCSR), and Institute for the Development o f the Stock Market. The C E M Oversight Committee consisted o f John Litwack (World Bank), Larisa Leshchenko (World Bank), Lev Freinkman (World Bank), Mark Davis (World Bank), Katerina Petrina (World Bank), Lyudmila Musina (Ministry o f the Economy and European Integration), Sergei Romaniuk (Ministry o f the Economy and European Integration), Ella Libanova (Administration o f the President), Anatoly Galchinskii (Economic Advisor to the President), Anatolyi Maksiuta (Economic Advisor to the President), Volodomir Granovsky(Ministry o f the Economy and European Integration), Olexander Shlapak (the National Bank), Igor Shumilo (the National Bank), Vira Nanivska (ICPS), Alexander Paskhaver (Center for Economic Development). C E M working groups and their leaders consisted of: (i)Foreign Trade and Economic Growth (Ruslan Piontkivsky); (ii) Pension Reform (Katerina Petrina); (iii) Poverty and Economic Growth (Ella Libanova); (iv) Financial Industrial Groups and Ukrainian Economic Development (Alexander Paskhaver); (v) Financial Industrial Groups and Corporate Governance (Dmitriyi Leonov); (vi) Interbudgetary Relations and Regional Policy (Larisa Leshchenko); (vii) Enterprise and commercial bank restructuring and performance (CASE), and (viii) Competition Policy (Oleksandr Kiliievych). Individual papers produced within these working groups comprise the second volume o f this CEM, which canbe found onthe web at: http://wbln0018.worldbank.org/eca/ecspeExt.nsf/ExtECADocbyUnid/9EEl347599313DF185 256D5E0057D4FD?Opendocument. Three seminars were held inKyiv for the discussion of C E M work inprogress. A first seminar on October 2, 2003 involved the participation of the C E M Oversight Committee and working groups. Preliminary draft papers o f the working groups and the general conclusions o f this volume were presented at a second seminar on November 19- 20, co-organized with the ICPS, which included the additional participation of the Ukrainiangovernment and World Bank staff, The first draft of this volume was discussed at a seminar with the Ukrainian government on July 1, 2004. Feedback from these seminars has been critical to the content of the final drafts of this volume and the papers of the CEMworking groups. Peer reviewers for this CEM are Anders Aslund (Carnegie Foundation), Vladimir Kreacic (World Bank) andBrianPinto (World Bank). *. 11 Table of Contents EXECUTIVE SUMMARY ....................................................................................... vi1 CHAPTER 1 THE TURNAROUND TO ECONOMICGROWTHAND POVERTY . REDUCTION ................................................................................................. 1 A. Introductory Comments ....................................................................................... 1 B. The UkrainianEconomy on the Eve of the 1998 Crisis ........................................ 1 C. The Turning Point ................................................................................................ 3 D. Growth andPoverty Reduction: The Responseofthe UkrainianEconomy to the New Conditions ................................................................................................ 6 E. The Intemal Sources of Growth ......................................................................... 15 F. Concluding Comments: Growth andInstitutional ChangeinUkraine .................37 CHAPTER2 OBSTACLESTO SUSTAINABLEGROWTH . ................................. 39 A. Introductory Comments ..................................................................................... B. Exports: ExchangeRateAppreciation. Volatility. andMarket Access ................39 40 C. Investment Risks ............................................................................................... 44 E. Problems inthe Climate for Business andInvestment ........................................ 52 CHAPTER3.BUILDING STRATEGICVISION INECONOMIC POLICY AND REF0RM ............................................................................................ 64 A. Introductory Comments ..................................................................................... 64 B. MeetingFutureChallenges inStabilization andBank Regulation ...................... 67 C. Upholding Commitments to Fair and Stable Rulesand Regulations ...................70 D. Promoting Fair Competition andPrivate Sector Development ............................ 76 E. Creating a Public Sector that Supports Growth andPoverty Reduction ..............82 F. The Determined Pursuit of RapidIntegrationwith the EUandWorld Economy ....................................................................................................................... 87 G. Conclusion ........................................................................................................ 88 ANNEX: THE UKRAINIANBALANCEOF PAYMENTSAND FOREIGN TRADE .......................................................................................................... 89 BIBLIOGRAPHY ....................................................................................................... 94 ... 111 INDEXOFFIGURES Figure 1.1: RealEffective ExchangeRates..................................................................... 3 Figure 1.2: Average $ PricesReceivedby UkrainianExporters................................. 4 Figure 1.3: Macroeconomic Financial Adjustment: .................................................. 5 Figure 1.4: Gross Reserves ofthe National Bank ofUkraine ................................ 5 Figure 1.5: Economic Growth: 19997.2003 ......................................................... 6 Figure 1.6: $ Value Index of GoodsExports ..................................................... 7 Figure 1.7: GrowthinIndustry..................................................................... 8 Figure 1.8: Growth inFixedCapital Investment................................................. 8 Figure 1.9: Unemployment andUnderemployment............................................. 9 Figure 1.10: Real Growth inOutput. Incomes. Expenditures. and Consumption.............................................................................. 10 Figure 1.11: Real Average MonthlyWages andPensions.................................... 12 Figure 1.12: Poverty Headcount andReal Pensions ........................................... 15 Figure 1:13: UrbanPoverty HeadcountandRealMonthly Wages: ............................ 15 Figure 1.14: NBUNet Claims on Government and Commercial Banks ...................-18 Figure 1.15: Annual InflationRates.............................................................. 19 Figure 1.16: Monetization: 1999, 2002, and2003............................................ 20 Figure 1.17: PayableArrears andBarter........................................................ 23 Figure 1.18: CashCollections inthe Energy Sector ........................................... 23 Figure 1.19: Tax andBudgetaryArrears ........................................................ 24 Figure 1.20: State Budgetary Subsidiesto the Coal Sector.................................. 26 Figure 1.21: Employment inSmall Businesses andFirmso f Individual Entrepreneurs ............................................................................. 30 Figure 1.22: Deregulation: Share of Firms inthe IFC Surveys Reporting the Following Regulatory Barriers as Major or Significant Obstaclesto Business..................................................................... 31 Figure 1.23: Fixed Capital Investment: Sources o fFinance.................................. 33 Figure 1.24: NumberofNewly Commercialized IndustrialProducts....................... 36 Figure 1.25: RestructuringMeasuresbefore 2000 and from 2000-02 ........................ 36 Figure 2.1: Export Prices, Wages, andUnit Costs inMetallurgy............................. 43 Figure 2.2: SelectedIndicators fromMetallurgy............................................. 44 Figure 2:3: Index o f Fixed Capital Investment.................................................. 46 iv Figure2.4: Shares of Fixed Capital InvestmentinGDP inSelected Transition Economies ................................................................ 47 Figure 2.5: Cumulative per Capita FDIinSelected Transition Economies., ...............47 Figure 2.6: GDP andElectricity Production..................................................... 48 Figure 2.7: Selected Commercial Bank Indicators............................................. 50 Figure 2.8: Real (CPI-Deflated) Average Annualized Interest Rates on Commercial Loans and Deposits................................................... 52 Figure 2.9: Ukraine: Short- and Long-Term (over 1year) Commercial Credit...................................................................................................... 53 Figure 2.10: Russia: Short- and Long-Term (over 1year) Commercial Credit..................................................................................................... 53 Figure 2.11: Regulatory Problems for Business., .............................................. 55 Figure 2.12: Regulatory Problems for Business: Has the ProblemBeen GettingBetter or Worse inRecent Years......................................... 56 Figure 2.13: Barriers to Business., ............................................................... 57 Figure 2.14: Importance of Informal Relationswith State Authorities for Success inBusiness., ................................................................ 57 Figure 2.15: Influence of Large Conglomerates on Recently EnactedLaws and Regulations that have a Substantial Impact on your Business................58 Figure 2.16: Transparency International2003 Corruption Ratings .......................... 59 Figure2.17: Influenceof Regional or LocalAdministrations onRecently EnactedLaws and Regulations that have a Substantial Impact on your Business..........60 Figure 2.18: Perceptions o f Local Government................................................ 60 Figure 2.19: The Composition of Local Revenues: 1999 and 2002 ........................ 62 Figure A.1: Ukraine's MainIndustrial Exports.................................................. 94 INDEXOF TABLES Table 1.1: Poverty Headcount Measures......................................................... 11 Table 1.2: The Geographic Distribution of Poverty.......................................... 13 Table 1.3: Inequality by Geographic Region................................................... 13 Table 1.4: The General Government Budget.................................................... 21 V Table 1.5: Tax Expenditures....................................................................... 27 Table 1.6: The ownership structure o f Ukrainian firms........................................ 34 Table A 1:The Balance of Payments of Ukraine . ................................................ 92 Table A.2: The Structure of Ukrainian GoodsExports......................................... 93 Table A.3: The Structure of Ukrainian Goods Imports......................................... 95 vi EXECUTIVESUMMARY Favorable economic Conditions inUkraine have never been so favorable for the conditions offer a window of realization o f policies and reforms that are crucial to the opportunity for the country's future development. Most economic trends and Ukrainian government short-term prospects in Ukraine remain highly positive. After a decade o f economic decline and crisis, the Ukrainian economy has exhibited strong growth and unprecedented macroeconomic stability since 2000. By the end o f 2003, official GDP stood 30 percent higher than in 1997.Duringthe sameperiod, industrial output grewby an estimated 56 percent and fixed capital investment doubled. Unemployment has fallen, household incomes increased significantly, and progress inpoverty reduction is visible. Inflationhas beenunder control since mid-2000, while credit markets have expanded at a remarkable pace. Competition and restructuring have increased, and institutions o f outside corporate governance have emerged. These conditions provide the government with an important window o f opportunity to pursue policies and reforms that can ensure the continuation o f strong growth andpovertyreductionover the mediumandlonger term. Externalfactors served as a Following the financial turmoil of 1998, three primary catalystfor the economic external factors served as a catalyst for the recent turnaround.. . economic turnaround: a strong depreciation o f the Ukrainian m a , a strengthening o f key export prices on world markets, and much tighter extemal financial constraints on the country. In this context, Ukraine experienced a major macroeconomic adjustment under which the current account moved from deficit to surplus, former large state budget deficits were eliminated, the exchange rate stabilized, and inflation fell well into single digits. Export-oriented and import-substituting industries began to show signs o f growth almost immediately in 1999. Since 2000, economic recovery and growth has become broad based throughout the economy, although industry continues to play a leading role. Progress in poverty reductionhas come from higher realwages, higher pensions, lower unemployment, and a recovery in social spending. ...butpolicies and reforms These three external factors created preconditions have alsoplayed a critical favorable to growth. Yet they can not fully explain the role. recent positive trends. All three o f these conditions were vii no less favorable in the mid-l990s, yet economic decline continued. The fact that Ukraine responded so strongly in exploiting extemal changes reflects fundamental changes in incentives at the micro-level in Ukrainian firms and organizations. A number o f important changes in economic policy andreforms have strengthened incentives and the expectations o f the population. These include a responsible and effective macroeconomic policy, numerous measures since 2000 to enhance payment and financial discipline, major reform in agriculture, key changes intax rules, deregulation, and reductions in(fiscal and quasi-fiscal) subsidies to loss-making firms. These measures, together with related institutional changes, re- enforced the positive incentive effects from favorable extemal conditions, encouraged the deshadowization o f underground activities, and boosted efficiency in the economy as a whole. Nevertheless, thepositive The current trends in growth and poverty reduction will trends will weaken without nevertheless weaken considerably in the medium term vision at the top level of without vision and determination at the top level o f the government. Ukrainian government. Despite genuine progress in economic transition and institutional development, the rapid pace o f growth is still supported by extemal factors that are either temporary or inherently unpredictable. This includes a still exceptionally weak national currency, strong world prices for Ukrainian exports, substantial intemal excess capacity, and extremely rapid growth in money demand and credit. As these conditions weaken, the challenges to economic policy will become greater, and the continuation o f the strong favorable trends will be possible only through improvements inthe overall climate inUkraine for business, investment, and fair competition. Despite progress in some areas, the investment climate in Ukraine remains difficult, with significant weaknesses in key market institutions, high regulatory instability, and serious problems o f low transparency, unfair competition, andregulatory capture. An "insider economy" Indeed, a good share o f the recent economic growth in threatens to become Ukraine has been concentrated inlarge financial-industrial aprimary obstacle to groups (FIGs) with the power to circumvent formal Ukraine'sfuture institutions through ownership ties, relations with development.. . government administrations, and direct influence over the courts and other regulatory bodies. FIGshave made some positive contributions to the Ukrainian economy, andhave played a leading role inthe development o f institutions o f ... V l l l corporate govemance and financial intermediation. Nevertheless, the "insider economy" model now threatens to become a primary obstacle to the continued development o f Ukraine. By its very nature, the insider economy hinders fair competition, encourages low transparency and corruption, discourages foreign investment, restricts the adaptability o f the economy to changing market conditions, limits the realization o f genuine comparative advantage, andcomplicates processes associated with access to foreign markets and world economic integration. ...and also weakens the link The insider economy also weakens the link between between economic growth economic growth and welfare benefits for the larger and welfare benefisfor the population. While the recovery in wages, pensions, and larger population. social services following the crisis o f the late 1990s has so far supported poverty reduction, the concentration o f wealth in a handfil o f privileged groups may generate increasing problems from a polarization in income distribution. Limited opportunities for entrepreneurship and fair competitionare also, inandofthemselves, serious constraints on the welfare o f the greater population. The complicated investment climate o f the insider economy continues to encourage the offshore flight of substantial Ukrainiancapital. Many developmentsin The recent development o f the Ukrainian economy Ukraine haveparalleled parallels that in the neighboring Russian Federation to a those in the Russian striking degree. Inboth countries, a strong economic Federation.. . decline in the 1990s culminated in financial turmoil in 1998. This was followed by a major exchange rate and macroeconomic adjustment, greater financial discipline, and subsequent rapid recovery and monetization. Inboth countries, much o f the recent economic growth has been concentrated in large and expanding financial industrial groups inthe context o f a difficult andcomplicated overall climate for business and investment. Both countries showed signs o f an economic slowdown in 2001-02, but received a subsequent boost from a strengthening o f key export prices on world markets. Both countries will face formidable challenges in maintaining the strong positive economic momentum in the absence o f the current exceptional circumstances. ...but Ukraine can nowforge Yet Ukraine now finds itself in a potentially much more ahead on an independent advantageous position than Russia and most other CIS i x acceleratedpath of countries for forging ahead on its own independent development accelerated path of development and integration with Europe andworld markets. Ukraine's advantages include its geographical position, bordering on (from mid-2004) the EuropeanUnionandcontaining a large part o fthe most fertile agricultural land in the world. This stands in contrast to Russia, where difficult geographical factors and political errors o f the Soviet andearlier times concentrated too many settlements and industrial firms in excessively cold areas and expanded agriculture to marginal (inefficient) lands. Second, as emphasized in a number o f studies, the he1energy wealth of neighboring Russia may be as much o f a curse as a blessing for economic development. Ukraine does not suffer from the same sort o f "Dutch Disease," where large exports o f natural resources place continual upward pressure on the national currency to the detriment o f the competitiveness o f manufacturing industries. Due in part to substantially lower levels of implicit energy subsidies to producers, Ukraine is in a much more favorable negotiating position for WTO membership, the pursuit o f EU economic integration, and for securing better market access for exports. Ukraine's comparative advantage o f a relatively cheap and highly skilled labor force may actually become greater following EU enlargement, which promises to increase labor costs in neighboring new member states. Deep integration with the EUandlower labor costs offer a potentially powerful combination for propelling Ukraine toward convergence to EU standards and eventual membership at arapidpace. Thegovernment program of The government program o f European Choice seeks to European Choice seeks to exploit this major opportunity for pushing ahead. exploit this major European Choice declares an explicit underlying goal o f opportunity... rapid integration with, and convergence to, the European Union, leading to eventual EUmembership. Inthe last few years, the Ukrainian government has been actively pursuing the European Choice agenda on many fronts. Thousands o f individual laws, regulations, and standards have been changed, or are scheduled to be changed, in accordance with WTO accession and EU requirements. Ukraine has adopted a set o f Millennium Development Goals for elevating key social indicators inthe direction o f EU levels. his includes ambitious goals for poverty reduction, expanding access to quality health and education, reducing infant mortality, preventingthe spread o f HIV/AIDS, achieving environmental sustainability, and X addressing gender inequality in the labor market, Most recently, the government unveiled a comprehensive Strategy for the Economic and Social Development o f Ukraine from 2004-15. This strategy re-enforces European integration as the overriding objective o f economic policy, while placing strong priorities on a continuation o f rapid economic growth, developing high- tech industries, and improvingsocial policy. ...which will require a broad The realization o fthe European Choice agendawill require visionfor the transformation a consistent application o f a broad vision for the of the Ukrainian ecortomy.. . transformation o f Ukraine. Sustaining inclusive economic growth and achieving deeper integration with the EU necessitate, first and foremost, a clear and stable legal and regulatory framework that is consistent with fair competition, a favorable investment climate, and more equal opportunities for Ukrainian citizens. Ukraine must realize a transformation from a largely closed and insider economy, based on informal relations, special privileges, and a handful o f dominant politicized business groups, to an economy based on rule of law, transparency, and commitment to a level playing field for business and investment ,,.as wellasadetermination This successful transformation will require combining and aprogressive coalition. determination at the top level o f government with support o f a strong progressive coalition in the business community and civil society. Such a coalition would have been exceedingly difficult to form in the past, as both government officials and powerfkl businesses typically had little interest in giving up their exceptional discretionary power and special advantages in the economic sphere. But the Ukrainian political and economic landscape has now matured to the point where such a coalition can be nurhued. An increasing number o f business groups and firms in Ukraine would prefer a situation in which neither they nor their rivals need to waste resources on lobbying for special extra-legal relations or influence, under which neither they nor their rivals are able to operate under special exemptions or privileges, under which both they and their rivals are protected from unfair business practices, under which foreign trading partners and investors do not always suspecthidden subsidies andinsider agendas. xi Potentialpowerful Potential powerful champions o f reform are emerging. champions of reform are Growing competition and other favorable changes in the emerging... Ukrainian business environment have supported efforts by many financial-industrial groups (FIGs) andfirms to work more within the law and, in a number o f cases, improve their standards o f openness andtransparency. Many FIGs and other organizations indicate increasing ambitions to boost their international reputations with the goal o f tapping international capital markets and securing better market access. Under these conditions, a strong strategic vision on the part o fthe Ukrainian government to facilitate this process will be welcomed by a significant part o f the Ukrainian business community. Business associations o f smaller firms are also becoming increasingly active in voicing their demands for a more levelplaying field. ...yet combating the insider On the other hand, recent surveys raise concerns over a economy will not be easy. possible recent deterioration o f the Ukrainian business environment with respect to measures o f capture, unfair competition, and the activities o f state officials. Historical evidence suggests that aspects o f the insider economy may be self-perpetuating in the absence o f a strong counter-initiative led by the government. Some recent studies highlight the point that the "crony economy" can become a vicious circle, whereby organizations that have the most influence over government and the courts accumulate more wealth and power, and thereby become increasingly capable o f blocking investment in the development o f formal institutions that would limit their power. This can be a particular problem in countries with a weak middle class. The growing relative wealth and power o f some Ukrainian FIGs may be a concern in this respect. The fact that the government has not yet succeeded in passing into law key progressive draft legislation on corporate governance and disclosures i s indicative o f a continued reluctance in some parts o f the business community and government apparatus to move in the direction o f openness and legality. Combating the insider economy will not be easy. xii Thegovernment can be a Ukraine currently stands at an important crossroads. critical influence on the Vision and determination at the top level o f government future path of development. can be critical at this time for influencing the path o f the country's hture development, and for determining the speed o f growth, improvements in social welfare, and integration with the world economy. As stated in the President' address on European Choice, "the next decade will become critical in the settlement o f these matters; otherwise Ukraine may be held at the sideline o f global processes." Ukrainian f m s and other organizations will bechoosing their fbture strategiesbasedon expectations of the direction and pace with which the country is moving. Expectations o f fewer opportunities for rent seeking and inevitable rapid integration with world markets will naturally support heightened concem over intemational reputations and competitiveness, leading to greater openness and the development o f corporate culture consistent with the realization o f European Choice. Expectations that Ukraine will remain largely an insider economy based on under-the-table relationships will perpetuate a reluctance o f Ukrainian FIGSand f m s to open their books or adopt high standards o f corporate behavior. In this light, it will be essential to build a consensus o f positive expectations among a critical mass of Ukrainian stakeholders. As long as businesses groups suspect that their competitors are obtaining special advantages from state officials, the courts, or regulatory agencies, they will be inclined to protect their interests through the same means. Thegovernment will need to In this context, the most effective strategy for the signal its resolve to realize government will be to signal its resolve to realize the European Choice on several desired transformation o f the Ukrainian economy on different fronts. several different fronts simultaneously, thereby maximizing the probability o f reaching a necessary consensus among a critical mass o f stakeholders. At the same time, the government needs to adopt measures to reform itself andincrease the interest o f state officials at all levels o f govemment inpromoting a favorable investment climate and alleviating poverty. The insider economy i s a two-way street o f business-government relations. Key general directions for economic policy are: k Meeting future challenges in stabilization and bank regulation. Maintaining macroeconomic stability will be critical for sustaining growth. X l l l ... P Upholding commitments to fair and stable rules and regulations. The government needs to develop a reputation for upholding medium and longer-term commitments to stable regulations and programs that send clear signals to the business community andthe population. P Promoting fair competition and private sector development. Measures are needed to combat continuing high uncertainty, the absence o f a level playing field, low transparency, and selectivity inthe enforcement o fregulations. P Creating a public sector that supports growth and poverty reduction. Completing reforms in interbudgetary relations and public administration, along with an active battle with corruption, can improve the behavior and efficiency o f state officials and administrations. Reforms inpublic expenditures can boost the effectiveness o f social programs targeted at the poor. > The determined pursuit of rapid integration with the EU and world economy. The government should leave as little doubt as possible about its determination to realize EuropeanChoice. Meetingfuture challenges in stabilization and bank regulation Macroeconomic stabilization is one o f the most important factors behind the recent positive trends inthe Ukrainian economy. While the government and the National Bank have demonstrated considerable skill in stabilizing the economy since 1999, this C E M argues that Ukraine will continue to face challenges inthis area. These challenges can be met effectively by building on areas o f progress in recent years, developing more sophisticated tools o f monetary policy and bank regulation, and managing possible individual commercial bank failures in a quick and effective manner. This includes maintaining an independent National Bank with a concentrated focus on stabilization and bank regulation. Important areas for attention are: B Broadening the tax base and improving tax administration. Fromthe point of view o f macroeconomic stability, the government will need to ensure that the tax base expands sufficiently with economic growth. Ukraine has made important strides toward improving the tax system. Yet indirect taxation (VAT and excises) continues to be a particular area o f weakness. Chronic problems with tax and VAT refund arrears remain. B Introducingjlexibility into exchangeratepolicy. Stabilizationpolicyin2000- 03 has profited from a virtual balance between purchases by authorities o f foreign reserves from balance o f payment inflows and growth in internal money demand. As money velocity stabilizes, however, the maintenance o f such a balance in the future is highly uncertain, and balance o f payment inflows should lead to increasing inflationary pressures at a stable nominal exchange rate. Some nominal exchange rate flexibility will alleviate such pressures, as well as give an advantageous signal to financial markets that the NBUis not committedto defendinga fixed rateindefinitely. xiv B Improving commercial bank monitoring and regulation. The National Bank still possesses limited abilities to monitor and regulate commercial banks. This particularly concerns banks whose finances are connected incomplicated ways with FIGS.The NationalBank has beenworking to improve its capacity to monitor commercial banks and bringprudential standards up to Base1Core Principles. B Avoiding any increase in household deposit insurance at this time, maintaining highly restrictive refinance policies, and managing possible individual bankfailures in a quick and effective manner. Evidence suggests that a combination o f low capitalization and increasing competition has led a number o f Ukrainian banks to adopt excessively risky investment strategies, It is therefore important that the NBUsends out a strong and clear signal to the effect that these banks are operating at their own risk, and manages problem banks in a manner that avoids systemic risk. Creating a self-sustaining and eficient pension system. The launching o f a major pension reform was a major accomplishment in 2003. Simulations conducted for this CEM indicate that the sustainability and rationality o f the pension system can be better ensured through an increase in the retirement age, particularly for women, reconsidering existing privileged pension benefits, and committing credibly to a more specific and rational indexation scheme for the mediumand longer term. B Continuing progress toward the reduction of quasi-fiscal subsidies. This C E M notes major progress in reducing high former off-budget subsidies that took the form o f non-payments, soft commercial loans, non-equivalent barter transactions, cheap energy, and tax arrears. The government should maintain this positive momentum, enforcing payment discipline, rational energy pricing, and shifting the administration o f remaining subsidies to the state budget. Upholding commitments tofair and stable rules and regulations Giventhe highlevel o f political and economic instability inthe 1 9 9 0 ~economic policy ~ in Ukraine focused understandably on short-term problems and issues. Government administrations continually adjusted laws, regulations, and other conditions on a discretionary basis in the context o f crisis management. Despite the increased macroeconomic stability and other positive trends o f recent years, an excessively myopic policy orientation has largely survived through inertia. The relatively favorable conditions o f recent years offer a vital opportunity for improving economic policy and combating the insider economy by shifting focus toward the implementation o f commitments to longer-term objectives consistent with the realization o f European Choice. The costs to the Ukrainian economy from excessive myopia and discretion in economic policy and regulation are high. The current large number o f important regulatory decisions at the day-to-day discretion o f state officials is itself a key component o f the xv insider economy, and re-enforces continued perceptions in the business community o f necessary bilateral relationships with government and regulatory bodies. A dominant focus on helping various sectors, regions, and organizations with day-to-day needs encourages wasting resources on continual lobbying activities and the shifting of economic responsibility for private losses to the government. A sound business and regulatory environment requires stability. Recent survey evidence confirms that instability inrules and regulations remain a central problem for Ukrainian businesses and investors. Finally, weak confidence inthe durability of basic laws and regulations feeds into political uncertainty on the future overall direction o f change in the country. Here, the government must seize the initiative to signal its determination to establish a regulatory environment in Ukraine that i s highly conducive to investment, growth, and convergence to EUstandards. Important individual components o f this initiative include: B Avoidingsuddenpolicy reversals or administrative interventions into markets. Agriculture and oil processing represent two important negative examples from 2003 in this area. The enormous costs from such actions on the expectations o f potential future investors are even more serious than the direct costs o f temporary market distortions. The government should take a longer- term view and earn a reputation for upholding basic regulatory stability. It is particularly important to avoid "hold ups," whereby regulatory conditions are changed inan adverse manner after private investment has already been sunk. % Maintaining greater stability in taxation and other regulations. The tax reform o f 2004 makes important progress toward reducing rates and broadening the tax base. Yet the business environment continues to suffer fkom a perception that tax rates and rules are highly unstable. While the development o f an effective tax system in Ukraine will certainly require further adjustments, most particularly measures to equalize tax conditions and phase out the remaining plethora o f special exemptions and privileges (see below), the government should be aware that excessive sharp adjustments in tax rates and rules have serious costs to business, the process o f "deshadowization," and state revenues. In the aftermath o f the major tax reform, the government will have the opportunity to boost confidence in the business community through maintaining much greater stability in tax rates and rules. As is the case with taxation, a favorable business and investment climate in Ukraine requires the codification and stability o f regulations concerning licenses, inspections, customs regulations, permits, price caps (in case o f regulated monopoly), and other areas. Inmany cases, commitment to fair and stable regulatory rules may require the creation o f regulatory bodies with a substantial degree o f independence from day-to-day government decisions. B Strengthening budgetaypolicies by shiftingemphasistoexplicit medium-term priorities and targets. Budgetary management inUkraine i s a prime example o f an excessively myopic policy focus rooted in inertia from past years. The budgetary process currently gives exceedingly little attention to issues beyond the scope o f a single budgetary year. In addition, many categories o f the annual budget itself derive from inertia o f previous years, essentially xvi replicating past allocations without a comprehensive assessment o f existing programs from the point o f view o f rationality, efficiency, and the achievement of specific goals. In addition to improving the overall effectiveness of fiscal policy, a shift in emphasis to a Medium-Tenn Budgetary Framework can provide a context for addressing a number o f complicated issues critical to Ukraine's development and the European Choice agenda in a rational, effective, and politically palatable manner. This includes the managed transition from non-cash social benefits to targeted cash-based social assistance, strict timetables for phasing out various budgetary subsidies, the concentration o f fiscal resources in core areas, including public investment, and ensuring that the annual budgetary process i s consistent with maintaining needed medium-termregulatory stability. b Enforcing stable, effective, and transparent rules for the regulation of the energy sector and natural monopolies. Ukraine stands to profit from a longer- term approach to price and other regulations inthis area through commitment to stable, rational, and transparent rules. Within such a framework, it will be possible to increase economic efficiency, improve incentives for reducing production costs, ensure the future viability o f the energy sector, and make energy and other infrastructural industries more attractive to domestic and foreign investors. This should involve explicit and clear methodologies for linkingutility prices to cost information ina manner that leaves little room for discretionary interference by the government. Either price cap or rate-of- return regulations should remain stable over a medium-term horizon, optimally including an explicit commitment to a sharing rule for additional profits from cost reduction between producers and consumers. The stability of regulatory rules can be better ensured through their explicit codification into laws or licenses. Increasing tariffs to cost-recovery levels, including the recovery o f long-run (investment) costs, will be vital to ensuring the viability of the energy sector, encouraging the rational and efficient use o f energy resources, and attracting needed private investment. The burden o f higher average energy tariffs for producers can be alleviated through a reduction o f (currently high) cross subsidies from producers to consumers. Ukraine is already making good progress toward the difficult task o f building an effective system to compensate vulnerable households for higher energy prices. The realization o f these goals clearly requires longer-term vision and coordination. b Improvingsubsidypoliciesandincentivesin thecoalsector. Economiclosses and state subsidies in the coal sector continue to represent one o f the most politically and socially complicated problems in Ukraine. High economic losses in coal mines are rooted in a combination o f economic, regulatory, and political economy issues. Given the availability of budgetary subsidies, business groups around the coal and metallurgy complex currently operate under an incentive to concentrate losses inthe mining sector through transfer pricing or other means. This i s one reason why coal prices are currently depressed below rational levels, and more mines operate at a loss than would be the case under more rational conditions. Minimum prices should be xvii regulated at levels that would ensure the profitability o f viable mines, but not exceed the opportunity cost o f imported coal. The design o f subsidy policies toward the coal industry should focus on hardening budget constraints by breaking the dependency between support levels and current or recent economic losses. A strong political effort will be needed to uphold a longer- term commitment to a declining schedule for coal subsidies over time. This will end incentives to concentrate lossesincoal andreveal the genuine state of affairs inthe industry. Promotingfair competition andprivate sector development A growing private sector and greater competitionhave been central to the positive trends inUkraine. By2002, the shareofthe non-state sector inindustrial output hadreached an estimated 80 percent. Small businesses and entrepreneurs increasedtheir official share o f employment from 13 percent o f the work force in 1997 to an estimated 22 percent by 2002.' Recent agricultural reforms are finally paving the way for the development o f a thriving private sector in the countryside. Surveys o f Ukrainian businesses confirm perceptions o f increasing competition and competitive pressures. Nevertheless, the business environment continues to suffer from high uncertainty, unequal economic conditions and selectivity inthe application of laws and regulations. This state o f affairs i s a mirror reflection o f the insider economy itself, and its eradication will require the type o f comprehensive approach outlined here. Part of this approach should involve measures specifically aimed at promoting fair competition, which includes making regulations more uniform throughout the economy, improving the effectiveness o f competition policy, reforming the judiciary, enforcing minimal standards o f corporate governance, and completing privatization under enhanced transparency and fairness. In many o f these areas, the government can build on substantial progress that has already been made in recent years. The completion of agricultural reform, together with the creation o f efficient land markets, will represent a major stride forward for Ukraine in realizing its economic potential. B Thecontinuedphasing out of most tax exemptionsand benefits allocated on a sectoral, regional, or individual basis. The Ukrainian government has made steady progress in reducing numerous tax exemptions and benefits, although there i s room for much more progress. This includes special tax and customs treatment in so-called special economic zones and "territories o f priority development," which cover roughly 10 percent o f the territory o f Ukraine. A recent government study concludes that these zones have been largely ineffective in their objective o f attracting foreign and other investment. Ironically, special economic zones and other types o f exceptional benefits can have just the opposite o f their intended effect by re-enforcing expectations among investors that the regulatory climate in Ukraine i s complicated, unequal, and subject to change at any given moment. ' ~~ Although it is not clear how much this increase reflects greater incentives for many citizens to register as individual entrepreneurs. xviii Fb Expanding the scope and leverage of competition authorities. Competition policy received a major boost from the adoption o f legislation in 2002 that i s widely viewed as satisfying intemational best practice, and the Anti- Monopoly Committee (AMC) has been gradually expanding its activities in monitoring firms with dominant shares o f markets and ensuring the consistency o f government legislation at the subnational level with fair competition. Nevertheless, there exists much room for increasing the effectiveness o f the AMC's activities in combating the insider economy and promoting a more level playing field inUkraine. The role o f the A M C should be expanded to monitoring acts at the level o f the central government, and for bringingpossible violations o f fair competition emanating at this level to the attention o f the government, Parliament, the judiciary, and the public. The A M C should be empowered with the ability to levy immediate significant fines or other punishments on government administrations and organizations that do not comply with its decisions except in cases when the courts do not uphold these decisions. Methodologies and accounting standards need to be developed for the more effective identification and monitoring o f financial- industrial groups. Fb The continued strengthening of thejudiciary. The Ukrainian court system i s still perceived in the country as being very weak. This complicates the solution o f problems in selective law enforcement, contract fulfillment, and corruption. Measures to strengthen the judiciary, including better training, pay, and monitoring o fjudges, should continue to receive the highest priority. % Re-invigorating the privatization process. Following the transfer o f the majority o f state assets to private hands, the privatization process has become understandably slower and more complicated in recent years. Nevertheless, several areas still require attention. The state currently retains minority shares ina large number ofprivatized enterprises. This has become a focal point for so-called "spontaneous privatization" and problems in corporate govemance. The Ukrainian government would be wise to sell the remainingstate minority shares as soon as possible, preferably through auctions with minimal restrictions. Second, the government should continue its efforts to adopt an explicit strategy for the privatization of remaining state assets for which there is no compelling reason to retain state ownership. Third, privatization sales continue to lack transparency in the basic rules for participation and the evaluation o fbids. Fb Continuing agricultural reform and the development of land markets. The genuine decollectivization o f agriculture was one o f the most important reforms of recent years. Given the magnitude o f this reform, the current period has been characterized by a rather high degree o f disorganization in many regions. The continued clarification and defense o f property rights, together with the development o f agricultural land markets, promise to give a major boost to the organization and efficiency o f the rural economy. The ability to use land as collateral would support a healthy expansion o f commercial credit to agriculture, including loans to smaller farmers. xix Agricultural reform also raises some key social issues, inparticular the need to develop effective policies to address shrinking agricultural employment and (often) insufficient local government resources to compensate for declines in social support that formerly came from large (collective) farms. % Improving the management and conditions of operation for state-owned enterprises. The government role inenterprises that remain instate hands has often beentoo passive and tolerant o f abuses by management. One example i s the large oil and gas conglomerate, Naftegaz. The government would be wise to use its ownership o fNaAegaz to require enhanced oversight, more open and detailed financial audits, comprehensive (unbundled) accounting o f gas production, transmission, storage, and distribution, and the divestiture o f un- related assets. In addition, a number o f state-owned enterprises continue to operate under weaker financial discipline and softer budget constraints than their private counterparts. Ironically, this can actually place these firms at a disadvantage, as fears o f nonpayment compromise their credibility inmarket transactions. Allowing state-owned firms with soft budget constraints to interact in markets also invites the theft o f state resources through various schemes. Inthe interest o f fair competition and the protection o f state assets, efforts should be made to place most state-owned enterprises under the same market and payment discipline as their private counterparts. This includes an active role for the state as a dominant shareholder inmonitoring managers and replacing ineffective management. B Enforcing basic standards of corporate governance and disclosures. Developing standards o f corporate governance in Ukraine consistent with convergence to EUstandards will be an important challenge inthe battle with the insider economy and realization o f European Choice. Even to the degree that the government succeeds in passing progressive legislation into law in this area, business groups will manage to exploit loopholes in these regulations unless they are themselves interested in projecting a favorable image in markets. As emphasized above, the willingness o f Ukrainian business groups to develop higher standards o f corporate governance and disclosures will depend on their overall expectations o f the direction that the country is moving in, and thus on the entire policy and reform agenda o f the government. This reform agenda should nevertheless give highpriority to the adoption o f requisite laws and regulations in Ukraine pertaining to corporate governance, as well as to encouraging firms to meet even higher voluntary standards that exceed legal requirements as a means o f gaining advantages in interactions on world markets. % Developing effective institutions of insolvency and bankruptcy. This is another area in which Ukraine has made important recent progress, but more progress will be needed in streamlining excessively costly and time consuming procedures associated with filing bankruptcies and completing liquidations. The future development o f credit markets can profit enormously from better protection o f creditor rights, particularly the ability o f creditors to seize collateral quickly in the event o f default on secured loans. The xx insolvency o f firms remaining in state ownership i s another issue that has yet to be solved. Creating apublic sector that supportsgrowth andpoverty reduction Realizing the European Choice agenda and overcoming the insider economy will require the government to reform itself into a more efficient administration under which state officials have a strong interest in promoting a favorable climate for investment and fair competition. Recent survey evidence confirms the continued presence o f serious problems and distortions in the incentives and activities o f state officials and administrations, particularly at subnational levels o f government. As long as these distortions remain, they will create obstacles to the transformation o f Ukraine into an economy based on rule o f law and fair competition. Consequently, the reform o f government itself should represent a critical pillar o f Ukraine's European Choice strategy. Despite the recent positive trends, a substantial burden o f economic transition continues to be shouldered by poorer segments o f the population, particularly in rural areas. In particular, basic services in health and education appear to have deteriorated for that segment o f the population that cannot afford growing formal or informal payments for quality services. The Ukrainian government has correctly prioritized the creation o f a more effective social safety net, together with a restructuring o f expenditures and programs inhealth and education. This C E M highlights a number o f important recent reforms and policies that have succeeded in imposing greater financial discipline on government finance, as well as delineating a clearer division o f responsibility between different levels o f government. Important strides have been made in re-monetizing state budgets, reducing arrears, expanding the state treasury, improving state procurement practices, codifying basic budgetary procedures in a new Budget Code, and making interbudgetary transfers more rational, stable, and transparent. Building on this progress in an effective manner will require a dual approach o f both "carrot and stick." On the one hand, heightened audit, discipline and control will be necessary in many areas, including efforts to ensure that central legislation i s properly implemented in the regions. On the other hand, heightened discipline and central control will be far from sufficient for success. As long as regional and local officials retain a weak interest in improving the economic situation in their territories, they will succeed inexploiting informational advantages to circumvent central control to the detriment o f Ukrainian economic development. Consequently, government officials in responsible positions should earn decent salaries, perceive a strong link between local economic growth and budgetary opportunities, and have at least some budgetary autonomy within well-defined bounds. Genuine responsibility for budgetary management cannot be imposed without the delegation o f decision-making authority. Critical directions o f reform include: B Thecreation of limited budgetary autonomy, along with responsibility, within well-defined bounds at local levels of government. Local governments should be able to adjust their own taxes and expenditures on the margin and compete xxi with each other for the attraction o f business and investment. This is particularly important at the municipal level in urban areas. Most Ukrainian municipal budgets currently do have some autonomy on the expenditure side, but tax autonomy remains an important outstanding question. Existing proposals include the creation o f a local property tax and/or the delegation o f control over part o f the income tax to the subnational level. % The continued clariJication of a rational division of autonomy, competency, and responsibility between different levels of government. The recent Budget Code i s a major step forward in this area. Yet confusion still exists in some areas. A contribution to the second volume o f this C E M suggests shifting to a clearer and more mutually exclusive functional division o f expenditure assignments to prevent problems due to overlapping functions. % The restructuring of social expenditures and assistance. Currently, local budgets inrural andpoorer areas often lack the capacity to provide acceptable levels o f social assistance to the poorer segments o f the population. The breakup o f the larger (collective) farms has also, in many cases, removed a former source o f social benefits. For this reason, the Ukrainian government might consider the possibility o f centralizing financial responsibility for a larger share o f social assistance to either the oblast or central government level. This would facilitate addressing regional inequalities and poverty in a comprehensive and rational manner. The restructuring o f government expenditures in the social sphere as part of a medium-term budgetary framework discussed above would increase the share o f resources received by genuinely needy families. % Weakening the dependency of interbudgetary transfers on recent budgetary performance. The introduction o f a transfer formula and elimination o f (soft) interbudgetary loans represented major accomplishments in placing transfer policies on a sounder foundation and increasing incentives for improving budgetary performance at lower levels o f government. Nevertheless, the budgetary formula still depends strongly on the performance o f recent years, thereby punishing improved budgetary performance with lower transfers in subsequent years. Second, the recent reintroduction o f interbudgetary loans could potentially set the clock back for Ukraine inthis area. Finally, Ukraine needs to explore options for consolidating the thousands o f smaller municipalities in a manner that would allow the extension of a formula-based transfer system to budgets at this level o f government. % Enforcing hard budget constraints for subnational government administrations. Along with the delegation o f limited budgetary autonomy, the central government should commit explicitly not to bail out local governments that default on their debt or payment obligations. % Enforcing the implementation of central legislation and regulations in the regions. Surveys cite poor or selective enforcement o f central legislation in the regions as a particular problem in Ukraine, and this situation may have actually deteriorated since 2000. Part o f this problem may concern the dual xxii subordination of subnational administrations in Ukraine to both the government and the President. A joint coordinated effort will be needed to ensure that central legislation and regulations are better enforced in the regions. B Reforming public administration. The incentives and effectiveness of state officials can be improved through changes in the public administration system. In particular, the base salaries o f public officials making important budgetary and financial decisions should be increased, along with more effective monitoring and a crackdown on corruption. The current system o f pay for higher level civil servants lacks transparency and gives excessive weight to various pay increments andbonuses relative to base salaries. This i s incontrast to the practice inEUcountries. Ukraine will also needto adjust a number o f other practices in the civil service inthe direction o f EUstandards, and has already launched an initiative inthis area. B Improving external and internalJinancial audit and control. The realization o f European Choice will require efforts to implement EUstandards inintemal and external financial auditing and control. This is an important general direction for increasing the effectiveness and transparency o f government finance. Outstanding issues include better clarification and stability in the rules governing financial responsibilities o f ministries and auditing bodies, expanding extemal audit to include budgetary revenues and the management o f state property, and focusing more attention on the evaluation o f the effectiveness o fpublic expenditures. The determinedpursuit of rapid integration with the EU and world economy A central pillar of European Choice concems measures to open the Ukrainian economy, achieve deeper integration with world markets, and secure improved market access for Ukrainian exporters. In addition to the direct gains from trade and market access, the determined pursuit o f this direction can play a decisive role inthe overall transformation of the Ukrainian economy, inducing FIGS and other organizations to change their strategies toward boosting intemational reputation and achieving competitiveness on world markets. The value o f this transformation serves to justify sometimes sizeable short-run costs o f adjusting standards and regulations in areas such as intellectual property rights and product quality. The strong orientation o f the Ukrainian economy toward the politically sensitive areas o f metals, food, and agriculture also underlines the importance for future economic growth o f improving trade relations and achieving free trade agreements with the EU and neighboring countries. It is thus important that the government continues to give strong and unambiguous signals in this area. Priorities should include: B Joining the WTO as quickly as possible. This is a prerequisite for the achievement o f deeper integration with the EU and world economy. It will also help Ukraine receive fairer treatment in anti-dumping and other issues xxiii that potentially restrict access to foreign markets. WTO membership will represent an important milestone inthe realization o f European Choice. % Negotiatingfree trade zones with the EUand other tradingpartners. Ukraine continues to suffer from restricted market access, which could become an increasing constraint on economic growth. Inthe context o f European Choice and the overall goal o f forging an independent path toward integration with the West, the development o f a free trade zone with the EU should be a first priority. Yet trade with Russia and the CIS will continue to be o f primary importance to Ukraine as well. Trade barriers with Russia have been particularly costly inrecent years. Therefore, it is also to Ukraine's advantage to work toward improving trade relations with Russia and the CIS, although in a manner that does not contradict the European Choice imperative. % Continuing theprocess of bringing overall laws and standards in line with EU requirements. Here i s another area where the government can give unambiguous signals to the country o f the direction o f change. This will nevertheless be a long process, and strategic issues o f sequencing are important. For example, it i s not at all clear that Ukraine would profit at the present time from rushing to adopt EUstandards for the labor market. Infact, EU enlargement should boost the competitiveness of Ukraine by increasing relative labor costs inneighboring countries. The World Bank has orientedits new Country Assistance Strategy and lending operations to support the realization o f European Choice. The series o f programmatic adjustment loans (PAL) is providing assistance to the govemment for making progress in a number o f the areas cited above pertaining to financial discipline, public sector efficiency and accountability, regulatory framework, property rights, and the management of social and environmental risks. Specific PAL activities are in place to support the reform agenda and create an institutional framework consistent with EUstandards. The 2004 elections provide a golden opportunity for Ukraine to solidify its vision for the future development o f the country, and think ahead to the implementation o f an action plan that corresponds to a comprehensive longer-term agenda for the realization o f European Choice. The skill and effectiveness that the government has demonstrated in economic policy since 1999 offers strong hopes that it will cope well with the new formidable challenges o f coming years. xxiv CHAPTER 1. THE TURNAROUND TO ECONOMIC GROWTHAND POVERTY REDUCTION A. INTRODUCTORY COMMENTS 1.1 Rapid economic growth, poverty reduction, and institutional development have finally begun to narrow the still substantial gap between Ukraine and the European Union, thus supporting the country's aspirations for convergence to the EU by basic economic, welfare, and regulatory indicators. What are the prospects that the Ukrainian economy will continue to expand and evolve in a manner consistent with the realization o f this goal? This chapter begins an examination o f this question through an identification o f the sources o f the recent positive trends in Ukraine since the late 1990s. Subsequent chapters will examine obstacles to the future growth and development o f Ukraine, together with policy implications. 1.2 Several recent studies seek to identify sources o f growth inUkraine. Berengaut, et al. (2002) argue that growth has been driven primarily by external factors, namely currency depreciation and lower wage costs in the context o f macroeconomic stabilization and excess economic capacity. By contrast, Aslund (2002) emphasizes institutional factors and economic policies associated with the government o f Prime Minister Yushchenko in 2000: the greater enforcement o f payment discipline, a crackdown on corrupt practices in the energy sector, and improvements in government administration. Babanin, et al. (2002) and CASE (2002) take more mixed views that stress a combination o f external, policy, and institutional factors. 1.3 A consideration o f the evidence in this chapter suggests that the recent economic growth derives from a complex interaction between external factors, changes in economic policy, reforms, and institutional development. While external factors provided a context for growth, the fact that Ukraine has so successfully exploited the new market opportunities reflects deep internal changes in the country that are related to economic policy and institutional change. The government has succeeded in generating much more positive expectations among the population and businesses community in a number o f areas, most particularly in stabilization, financial discipline, and the allocation o f state resources. In addition, structural reforms in agriculture and some other areas appear to be having a measurable effect on economic performance. Yet factors o f a temporary and unpredictable nature also continue to play an important role inthe Ukrainian growth story. B. THEUKRAINIANECONOMY ONTHE EVEOFTHE 1998CRISIS 1.4 Prior to recent positive developments, Ukraine experienced a decade o f severe political and economic instability and decline. This was partly due to difficult initial conditions o f economic transition and the burden o f an inherited energy-intensive and defense-oriented industrial infrastructure that was largely isolated from international markets. But Ukraine also suffered during the 1990s from missed opportunities in economic policy and reform. In the context o f social and political upheaval, vested interests surrounding struggling Ukrainian industries and farms lobbied for state subsidies, protection from international markets, the preservation o f collective farms, and insider privatization schemes. Substantial rents were made from channeling a large part o f these state resources underground. At a time o f falling output and tax revenue, the strain from maintaining such policies manifested itself in extreme macroeconomic instability, including a bout o f outright hyperinflation in 1993. According to official data, GDP had fallen to only 40 percent of its 1990 level by 1998. Although this figure likely overestimates the actual fall in output, a severe economic decline and increased hardship for a large share o f the population during the 1990s were unmistakable.2 1.5 Many studies have noted adverse conditions in Ukraine for business and investment in the 1990s relative to most other transition countrie~.~ High and unpredictable inflation, corruption, repeated sudden administrative interventions into markets, harassment of new private businesses, and continual discretionary adjustments in tax and other regulations implied exceedingly high costs and risks for Ukrainian firms. At the same time, well- connected organizations had ample opportunities for rent seeking. Substantial inflows inthe form o f short-term capital and (unpaid) Russian energyY4together with internal rents from the gas pipeline, were dissipated throughout the economy in the form o f subsidies to organizations that at least put up a faqade o f low liquidity and current economic losses. When the National Bank curtailed inflationary monetary and credit expansion in the mid- 1 9 9 0 ~various schemes involving non-payments, debt offsets or (non-equivalent) barter ~ became a primary means by which Ukrainian firms received subsidies on an individual basis. Local administrations also operated under quite adverse incentives, and were active players in this process. The Ukrainian history o f demonetization, high deficits, and speculative capital inflows, followed by the financial crash in 1998, closely paralleled similar trends in the Russian Federation, about which much has been written (Gaddy andIckes (1998), OECD (2000), Pinto, et al. (2000)). 1.6 The nature of subsidizationthrough the "virtual economy" had a destructive effect on incentives and economic performance that went far beyond the direct social cost o f the subsidies themselves. To receive support, firms typically needed to operate as illiquid or unprofitable in the formal economy. This supported a strong incentive for Ukrainian enterprises (as well as local administrations) to keep cash revenues underground while milkingthe official illiquid status o f their enterprises for cheap energy and other subsidies. Such incentives were strongly re-enforced by the introduction of draconian tax collection measures (Kartoteka-2) that blocked the official bank accounts o f tax delinquent enterprises and confiscated all receipts. Firms leamed to avoid these accounts through schemes that hid The official estimate most likely overstates the GDP decline inUkraine for two primary reasons. First, price indices most likely exaggerate the relative value of many Soviet era products that were producedfrom inertia in the early years of transition before being phased out. Second, the relative size of the informal economy likely expanded during this period, Several studies suggest that the actual sue o f the informal sector inUkraine was closer to 50 percent o f official GDP, as opposed to approximately 25 percent used in official estimates. Nevertheless, increased hardship for much o f the population during the 1990s is reflected in various demographic statistics. For example, between 1989 and 1997, average life expectancy declined from 66 and 75 years for males and females to 62 and 73 years, respectively (Derzhkomstat data). This trend has fortunately beenreversed inthe context o f the current growth. See for example Kaufmann (1997) and Babanin, et al. (2002). Ukrainianaccumulated debts to Russia reached over US$3 billionby 1999. 2 their actual receipts from the tax administration and the government. Corrupt relations between business, government, and the courts protected firms from bankruptcy or reductions in supplies due to non-payments. As was the case in Russia, the "virtual economy" represented a sort o f bad equilibriumunder which huge resources and effort were wasted on rent seeking. C. THETURNINGPOINT 1.7 The financial instability of 1998 shattered this equilibrium by cutting o f f the substantial extemal inflows that had been financing the virtual economy, namely the accumulation of trade arrears to Russia, direct foreign borrowing, and very active foreign participation on the domestic T-Bill market. This set inmotion forces for the transformation to a new economic model. Three primary factors served as a catalyst for economic growth in the aftermath ofthe financial crisis: P Exchange rates. The strong depreciation of the hryvnia relative to the dollar and EURO increased significantly the profitability o f both exports to the non-CIS region and domestic sales in import-substitution industries. The subsequent rapid real appreciation of the Russian ruble supported a recovery of exports to Russia in 2000 and boosted the competitiveness o f Ukrainian exporters inmetals and chemicals that compete with Russianfirms on thirdmarkets. (Figure 1.1) Figure 1.1: Real Effective Exchange Rates (CPI-based) (1996=100) 160.0 3 I 140.0 120.0 100.0 80.0 60.0 Source: Derzhkomstat, World Bank. > World market prices. The revival o f the world economy in 2000 brought a major strengthening o f metals and other key export prices for Ukraine. This bolstered 3 Ukrainian exports and export profits, which fed into investment and domestic demand. (Figure 1.2) I Figure 1.2: Average $ prices mceivedby UkrainianExporters (1996=100) 130 / 120 / 1 , I 8o 1996 ' 1997 1998 1999 2000 2001 2002 2003 (proj) ~~ Source: Derzhkomstat, World Bank calculations. > Externalfinancial constraints on government and business. The reversal of capital inflows and the debt crunch cut o f f the external sources that had been financing budgetary and quasi-fiscal deficits. The turnaround inforeign portfolio investment in Ukraine in 1998 relative to 1997 amounted to a net loss o f US$2.6 billion. In addition, in the midst o f the crisis and mounting Ukrainian trade debts, the Russian Federation demanded payment for gas and began reducing energy supplies to Ukraine.' Following default on its domestic debt obligations and tense relations with foreign creditors, the govemment could no longer finance deficits through borrowing. 1.8 These events precipitated a major macroeconomic financial adjustment. A sharp contraction o f imports, combinedwith subsequent export growth, brought the current account from deficit to surplus, while tighter financial constraints and political resolve by the government eliminated the large budget deficit. Figure 1.3 summarizes this macroeconomic adjustment, which was o f prime importance for the recent economic revival and expansion in the country. During2000-03, the government succeeded instabilizing the exchange rate and domestic prices, while accumulating substantial foreign reserves from net balance of payments (current account) inflows (Figure 1.4). By March 2004, gross foreign reserves had reached the equivalent of over four months o f merchandise imports. In2000, a lump sum payment of US274 million was made to Russia as part of an agreement to defuse the situation. 4 Figure 1.3: Macroconomic FinancialAdjustment: 1997-2002 - (share of GDP (left scale) unless otherwise noted) 10.0 8.0 6.0 Net portfolio investment inflows 4.0 mcurrentaccountbalance 2.0 0.0 0consolidatedgov.budget -2.0 balance -4.0 +Average UHV/dollar U exchange rate (right scale) -6.0 -8.0 w Source: Derzhkomstat, NBU,MoF, World Bank Calculations. Figure 1.4: Gross Reservesof the National 9000 Bank of Ukraine I 4.5 4 scale) 3.5 -+- months of 3 merchandise imports 2.5 4000 2 3000 1.5 I 2000 1000 n ~ 1997' 1998' 1999' 2000' 2001' 2002'i 2003' 20&larcW) Source: Derzhkomstat, NBU. 5 D. GROWTH AND POVERTYREDUCTION: THERESPONSEOFTHE UKRAINIAN ECONOMY THENEWCONDITIONS TO Economic Growth 1.9 The strong depreciation of the hryvnia relative to the dollar and Euro gave an immediate boost to the profitability of Ukrainian export and import substitution-oriented industries. The collapse of domestic financial markets also had a very limited impact on Ukrainian firms due to their low average dependence on outside finance during this time. Industry already exhibited positive (4 percent) growth in 1999 at a time when sharp declines were still registered in agriculture (-7 percent), construction (-8 percent), and financial services (-9 percent). This growth was led primarily by the large export-oriented steel industry and the import substituting food industry. While growth in Ukraine has subsequently become rather broadly based throughout the economy, industry has continued to play the leading role. As shown inFigure 1.5, aggregate industrial output in2003 was 65 percent higher than its pre-crisis (1997) level, while GDP soared by an estimated 30 percent during the same period. Agriculture also recovered notably since 2000 untilbadweather in 2003 interruptedthis positive dynamic. Figure 1.5: Economic Growth: 1997-2003 140 120 100 80 - -0--services output index 1997 1998 1999 2000 2001 2002 2003 1 Source: Derzhkomstat, World Bank calculations. 1.10 Exports have responded in a generally rational manner to changes in exchange rates and extemal demand (prices). This point is elaborated in more detail in the Annex to this volume and inthe contribution to the second volume o f the C E M by Pindyuk and Piotkivsky (2004). As indicated in Figure 1.3 above, during the financial turmoil o f 1998-99, the hrynvia depreciated sharply in real terms against OECD currencies, yet actually appreciated against the Russian ruble. The initial expansion of exports was therefore directed at non-CIS markets. The subsequent rapid real appreciation of the Russian ruble and restoration of Russian extemal demand led to an export boom to that country in 2000. But Ukraine- 6 Russian trade relations have become somewhat strained since that time, and have suffered from changes in tax rules, quotas, and anti-dumping acts. Consistent with these developments, a primary general trend through 2003 has been a re-orientation in Ukrainian trade away from the CIS and inthe direction o f Europe and Asia, particularly exports (Figure 1.6). In2003, the share of CIS countries inthe value o fUkrainian goods exports (26 percent) was only roughly halfof its pre-1998 level. While the dollar value o f exports outside the CIS expanded by an estimated 33 percent between duringthe two-year period o f 2001 and 2002, exports to the CIS actually contracted by 3 percent. Improvements in trade relations since 2003 can be associated with a more recent resumption inexport growth to Russia. A similar, iflessdramatictrendhasbeenvisibleonthesideofimports. WhiletheCIScontinuesto account for over half of the value o f Ukrainian imports, the majority o f this represents gas and oil from Russian and Turkmenistan. The share o f non-energy imports from CIS countries fell to a low o f 28 percent in2002. Figure 1.6: $ Value Index of Goods Exports (1996=100) '80.0 '60.0 '40.0 '20.0 '00.0 80.0 60.0 40.0 1996 1997 1998 1999 2000 2001 2002 2003 Source: NBU. 1.11 As important as export growth has been for Ukraine, domestic demand became the primaryengineo f (industrial) growth since 2001. This is clearly visible inFigure 1.7, which employs a quantity index for industrial exports. The average annual growth o f industrial exports in quantity terms during 2001-03 was 5 percent, only half the pace o f growth o f aggregate industrial production. Ofparticular note among industries oriented to the domestic market are food and machine building, which together now account for an estimated 40 percent o f all manufactured industrial output in Ukraine. Both food and machine-building registered levels o f production in 2003 that were respectively 75 and 95 percent higher than pre-crisis (1996) levels. The domestic food industry has virtually taken over a market formerly dominated by imports, and is now responsible for an estimated 94 percent o f food sales inthe country. 7 Figure 1.7: GrowthinIndustry 220 , 80 , 1996 1997 1998 1999 2000 2001 2002 2003 I Source: Derzhkomstat, World Bank calculations. 1.12 Higher output in machine-building i s indicative of strong growth in fixed capital investment. At the end of 2003, aggregate fixed capital investment stoodroughly 80 percent higher than in 1999 (Figure 1.8). Growth in investment has been particularly rapid in industry, especially food processing. Figure 1.8: Growth inFixed CapitalInvestment (1995=100) 160 0 0 other (incl. realestate: 22.5% in 120.01- w agriculture (4%) I Industry(41%) I995 1996 1997 1998 1999 2000 2001 2002 2003H1 ~ Source: Derzhkomstat. 8 Growth and PovertyReduction 1.13 The balance of evidence suggests that the recent economic growth inUkraine has had a substantial impact on welfare and poverty reduction. This progress has come from declines in unemployment, real increases in wages and pension levels, and a recovery in social spending since the crisis of the late 1990s. Trends have been much more favorable in urban than inrural areas, however. The majority o f new opportunities from economic growth have beenconcentrated inthe cities, rural employment has declined, and many local budgets inthe countryside have struggled with the task o f compensating for a decline insocial benefits that were formerly provided through large (collective) farms. Nevertheless, rural poverty rates appear to have declined significantly in2002 along with a strong increase inreal pensions. 1.14 The estimated rate o f unemployment inthe Ukrainian economy by the ILO definition has declined steadily from a high o f 12 percent o f the active population in 1999 to an estimated 9 percent in 2003. This figure underestimates the actual increase in employment, as hidden unemployment in the form o f forced part-time regimes or "administrative leaves" has declined even more rapidly (Figure 1.9). It i s notable that these positive trends on the labor market occurred in the context of much more rapid labor turnover in the economy, as illustrated indetail inthe contribution to this CEMby CASE(2004). Figure 1.9: UnemploymentandUnderemployment 25 % of workforce experiening forced "admnstrativeleave" 0%ofworkforceexperiencin - ... - " forced part time regime ... ..Unerrpioymnt A rate (iL0 definition) ... + 1999 2000 2001 2002 2003 (Q2) Source: Derzhkomstat. 1.15 While economic growth has had a significant positive impact on the welfare o f the population and poverty reduction, the absolute magnitude o f this impact is difficult to assess. Both macroeconomic and household budget data suffer from a number o f weaknesses and inconsistencies. As indicated above, macroeconomic figures most likely exaggerate the actual pace o f growth in output and incomes due to an ongoing process of "deshadowization," whereby a larger share o f actual economic activity and income in the country i s being registered in official statistics. On the other hand, expenditures as recorded 9 in the household budget survey most likely underestimate welfare increases for several reasons6 1.16 Ukrainians have consistently reported higher expenditures than incomes in the household budget survey. As the category o f "expenditures" includes a measure of net changes in savings, these two measures should in principle be equal. In fact, the methodology o f the survey i s specifically designed to measure the same magnitude from the income and expenditure points o f view. This difference i s sometimes interpreted as being due to an underreporting o f income on the part of households, as would be consistent with the presence o f a large shadow economy in Ukraine and (perhaps) the unwillingness o f households to list informal income in the survey. This difference between reported incomes and expenditures has also been decreasing over time since 1999, which would be consistent with an ongoing process o f deshadowization. Due to a rapidly narrowing gap between reported incomes and expenditures in the household budget survey, the calculation o f real growth in incomes and expenditures in recent years on the basis o f these numbers yields quite different dynamics. As shown inFigure 1,lO below, reported real incomes have grown much faster than GDP or domestic consumption, whereas the opposite is true for expenditures. Figure 1.10: RealGrowthinOutput, Incomes, Expenditures,and Consumption (1999=100) 150 140 -m-domsticconsumption 130 -e- realexpenditures inde 120 110 100 90 80 1999 2000 2001 2002 Source: Derzhkomstat, UCSR (2004). The small size of the fee paid to participants leads many relatively wealthy households not to accept the offer for participation. The measurement o f savings is treated in an unreliable manner in the survey. After the decumulation o f savings during the crisis, many households may be replenishing these savings, as witnessed by the strong growth in commercial bank deposits. Finally, price and inflation dynamics in rural areas go unrecorded in official statistics, but are most likely quite different than in many urban areas. This particularly concerns poorer households in rural districts that produce or trade for food products in a manner that, for the most part, bypassescash purchases and sales. 10 1.17 As the expenditure series from a household budget survey i s generally thought to be more reliable for the measurement of welfare and poverty, the remaining part of this discussion will focus primarily on this data. As illustrated in Figure 1.10 above, other than the major exception of the year 2001, the real expenditures series i s generally consistent with macroeconomic data. While GDP grew substantially in 2000, this was due largely to an increase innet exports. Domestic consumption and wages increased only marginally in2000 and reported real expenditures were flat. In2002, consumption inthe national accounts data increased by an estimated 16 percent, while reported real expenditures increased by 8 percent. This would be consistent with an interpretation of official estimated growth in consumption as a combination of real growth and continued deshadowization. The year 2001 appears quite mysterious however, as GDP, retail trade, and consumption all soared by more than 9 percent while aggregate reportedreal expenditures remained flat. This mystery carries over to measures o f poverty that are calculated on the basis of this expenditure data (Table l,l), examinedinmoredetailinthecontributiontothisCEMbytheUkrainianCenter and for Social Reform (UCSR (2004)). Table 1.1: PovertyHeadcountMeasures 1999 2000 2001 2002 Poverty Headcount (75%)* 27.8 28.7 29.7 23.8 Poverty Headcount (60%) ** 14.4 15.9 16.4 11.7 Less than 2100 calories a day 32.6 25.6 25.9 23.2 Less than $4.3 (PPP adjusted) 14 11.9 11 6.9 * % below absolute poverty line constructed at 75% of median expenditures in 1999 ** %below absolute poverty line constructed at 60% o'fmedian expenditures in 1999 source: UCSR (2004) 1.18 The headcount measures in Table 1.1 are based on two absolute poverty lines, one drawn at 75 percent of median expenditures in 1999 and the other at 60 percent.' The trends inbothof these series resemble those ofaggregate reportedexpenditures. After no apparent progress in poverty reduction in 2000 and 2001, a measurable reduction in the poverty ' The Ukrainian government has adopted an official definition o f poverty that differs from the definitions employed in this chapter. The official definition is a relative poverty measure that indicates the proportion on households with expenditures (income) below 25 percent o f the median level. By this measure, the poverty headcount has fallen only very marginally during 1999-2003 from 27.8 percent of the population to 26.6 percent. Yet this reflects the fact that median income itself is increasing. As the purpose inthis section is to understand recent developments in poverty reduction from the point o f view o f changes in real income or consumption o f the poor over time, an absolute definition o f poverty is employed. Absolute poverty and severe poverty lines were drawn at 75 and 60 percent o f the median expenditures in 1999, respectively. These poverty lines were then held fixed inreal terms over time. 11 headcount occurred in 2002. For comparative purposes, two other poverty measures calculated by UCSR (2004) are also given in Table 1.1: estimates o f the share o f the population that consumes less than 2100 calories a day and the share o f the population that spends (consumes) less than $4.3 a day corrected for purchasingpower parity. Both o f these measures support the view that there has been substantial progress in poverty reduction, and also suggest that this progress might have been a bit more continuous than the measures based on the household expenditure data. Given the dependence o f many poorer households on wage and pension income, it i s natural to link poverty data to the dynamics o f average wages and pensions. Figure 1.11 shows the evolution o f average monthly wages and pensions in 1999 prices.8 The wage series resembles very much the trends inFigure 1.10 on consumption, while the pension series appears to mirror the trends inaggregate expenditures and poverty. As will be argued below, this holds the key to unraveling at least part o f the mysteryo f reported expenditures andthe poverty measures derived fromthe data. Figure 1.11:Real Average Monthly Wages andPensions (inUHV 1999, CPIdeflated) 300 250 200 1999 2000 2001 2002 i Source: Derzhkomstat, MoF, World Bank calculations. 1.19 The household expenditure data also suggest an apparent strong redistribution o f poverty from urban to rural areas. As illustrated inTable 1.2below, estimated poverty levels in larger cities parallel closely the dynamics of consumption and real wages in the macroeconomic data. While the poverty headcount in larger cities remained virtually unchanged in 2000, it declined notably in both 2001 and 2002. Small cities and rural settlements show a very different dynamic, however. Taken at face value, these data would suggest a rather sharp increase inrural poverty from 1999 to 2001, followed by a decline in 2002. * The averagepension series inofficial statistics was adjusted for the repayment of pension arrears in2000. 12 Table 1.2: The Geographic Distributionof Poverty (Headcounts based on absolute poverty line drawn at 75% of median expenditures in 1995 1999 2000 2001 2002 All Ukraine 27.8 28.7 29.7 23.8 large cities headcount (with Kyiv) 26.6 27.3 23.9 17 large cities (without Kyiv) 29 29.7 26.6 18.6 small cities 27.7 27.8 30.9 25.2 all cities 27.1 27.5 27 20.5 rural settlements 29.2 31.3 35.2 30.3 Isource: UCSR (2004) 1.20 What could explain these rather gloomy rural poverty numbers at a time o f strong economic growth in Ukraine, including a significant revival o f agriculture during 2000-02? A first hypothesis might be a greater polarization in the distribution o f income in the countryside. Privatization and decollectivization in the countryside has often favored the more industrious or larger businesses as opposed to the rural poor. Indeed, employment positions for rural residents appear to have declined in recent years, with a good portion of surplus labor being absorbed by the household s e ~ t o r As . ~ shown in Table 1.3, however, there is no evidence in the household expenditure data o f any such increase in the polarization o f income distribution, either for the country as a whole or for different geographical regions inparticular. Thus, the increase inurbanexpenditures relative to rural in the household expenditure data is an aggregate phenomenon. Urban dwellers appear to have become richer on average relative to rural dwellers throughout the entire distribution o f income. Table 1.3: Inequality by Geographic Region (Gini coefficients calculated from household expenditure data) 1999 2000 2001 2002 All Ukraine 28.5 29.3 30.3 29.3 large cities 29.1 30.1 31.3 30.4 small cities 28.7 29.5 29.3 29.2 rural settlements 27.4 27.6 28.8 28.1 source: UCSR (2004) 1.21 To the degree that the measures in Tables 1.2 and 1.3 are to be believed, they would together suggest that real aggregate wealth declined considerably in the countryside during 2000-01. For the year 2000, this would be conceivable, as agricultural incomes depend greatly on the previous year's harvest. Agricultural output declined in 1999 by an estimated 7 percent, while the share of agriculture in GDP fell from 14.8 percent in 1998 to 13.6 percent. Yet the implied huge decline in wealth in the countryside in 2001 i s plainly OECD andWorld Bank(2003), pp. 6. 13 inconsistent with strong growth inthe rural economy in2000-01,and an increase inthe share o f agriculture inGDP back to 14.5 percent for bothyears. 1.22 To understand this rural poverty puzzle, it is useful to consider a few facts about the Ukrainian countryside. It contains perhaps the richest agricultural land o f any country inthe world. Almost all families living inrural areas have their own plots o f land o f adequate size to feed themselves even inyears o f poor weather. Second, as emphasized inthe contribution o f UCSR (2004), the economy for the rural poor is largely demonetized. They consume from their own holdings and trade surplus directly for other products. This part of rural consumption raises statistical complications in accounting for the effects o f inflation on rural household budget expenditures. Second, there i s at least anecdotal evidence that inflation may have been lower in rural than urban areas in recent years." Thus, deflating the expenditures o f the rural poor by rather high average (urban) consumer price inflation in 2000 and 2001 (28 percent and 12 percent, respectively) might present a deceiving picture o f apparent growing poverty. 1.23 Inaddition, the rural population inUkraine has a very highproportion of pensioners (38 percent o f the population). Many households with pensioners are concentrated around the poverty line. Given the high share o f in-kindincome in rural areas and smaller cities, pensions represent perhaps the major source o f money income for poorer households. It therefore makes sense that changes in real pensions would have a particularly strong effect on estimated poverty rates. Even taking into account the repayment of past arrears, real pensions did not increase until 2002. As shown in Figure 1.12 below, there i s a very close correspondence (-.97 correlation) between average monthly pensions and the poverty headcount rate. The same very strong relationship can be seen between average real wages andthe urbanpoverty headcount (Figure 1.13). Figure 1.12: PovertyHeadcount andRealPensions: 1999-2002 30 c 28- U c t 26- r" 80P24- 22 20 I ~ 50.0 55.0 60.0 65.0 70.0 75.0 80.0 85.0 real average monthly pensions (1999 UHV) Source: Derzhkomstat, MoF, UCSR (2004), World Bank calculations. lo Unfortunately, no official separate statistical series exist for rural and urban prices. A forthcoming Bank study may shed some additional light on this question through the derivation of implicit price series from the household budget survey. 14 Figure 1.13: UrbanpovertyHeadcountandReal Monthly Wages: 1999-2002 27 c 25 3 2 23 0g021 P : s 19 17 150.0 170.0 190.0 210.0 230.0 250.0 270.0 real wages (1999 UW) Source: Derzhkomstat, MoF, UCSR (2004), World Bank calculations. 1.24 Inconclusionto this section, the balance of evidence suggests that poverty reduction in Ukraine during the period of 2001-02 has been substantial. This progress is visible in poverty headcount measures from expenditure data inurban areas, and on the basis of calorie or $-PPP estimates o f severe poverty. While expenditure data from rural areas does not confirm any progress in poverty reduction until 2002, this i s most likely due to a high concentration o f pensioners inrural areas and an overestimation o f the effects o f inflation on the implicit incomes o f the rural poor. Income inequality does not appear to have increased, either for the country as a whole, or inurban and rural areas inparticular. Incomes appear to be growing faster inurbanareas, as is consistent with the industry-led growth. E. THEINTERNALSOURCESOFGROWTH 1.25 The earlier discussion inthis chapter and the contribution o f Pindyukand Piontkivsky (2004) to the second volume o f this CEM conclude that the Ukrainian economy responded quite rationally to movements in exchange rates and relative prices. The recovery was also facilitated by the existence o f substantial excess capacity left from the previous decade o f economic decline. Yet, given the history o f the previous decade, the fact itself that Ukraine responded so strongly to changes in market signals suggests that important internal changes in the country have also contributed to growth. The real exchange rate and export prices were no less favorable inthe mid-1990s at a time when balance o fpayment inflows were also quite modest compared to the levels reached in the latter half o f the decade. Yet economic decline continued. What has been so different about the period o f 2000-04? 15 1.26 Some studies view Ukrainian growth as largely a consequence o f the strong economic expansion and high export profits in the neighboring Russian Federation. Certainly, a growing Russian economy represents a key difference in the surrounding economic environment from the 1990s. Many parallels can be drawn between recent economic developments in Russia and Ukraine. Russia remains Ukraine's single most important trading partner, and Russian investmenthas also played an important role in some sectors o f the Ukrainian economy, most notably oil processing. Yet the role o f Russia in explaining Ukrainian growth should not be exaggerated. Despite a partial recovery in 2000 and 2003, Ukrainian-Russian trade volume has remained lower than levels obtained prior to the 1998 crisis, Official figures on FDIfrom Russia are quite low (US$377.6 millioncumulative as of 1/1/04), although a significant amount o f investment coming from a number o f other countries is most likely o f Russian origin. But even aggregate volumes o f FDI to Ukraine have remained modest in recent years, and have played only a very secondary role in the recent growth. Thus, Russian economic growth and profits cannot explain a very large part of the growth inUkraine. Mucho f the growth has come from internal factors. 1.27 Despite the many disappointments of the 1990s, Ukraine did receive some dividends from a decade o f gradual adjustment to a market economy. Although riddled with controversies and scandals, mass privatization was one crucial accomplishment. From negligible levels, the share o f the non-state sector in industrial output already reached 41 percent by 1995, and an estimated 80 percent in 2002. A good share o f remaining assets in the hands of the state i s in infrastructure and energy. Private ownership created the foundation for key changes in management and corporate governance that are documented below. Although the privatization process has slowed in recent years, the immediate post- crisis period also witnessed a few key privatization sales that have had an impact on subsequent economic performance. This includes the sale o f most o f the oil processing industry to Russian investors, which led to significant investment, restructuring, and the emergence of a new major export industryinUkraine 1.28 Nevertheless, the step from formal privatization to active secondary markets and expanding outsider control was far from automatic. Infact, evidence suggests that the initial impact o f privatization on the performance o f Ukrainian firms may have been minimal. De facto control typically remained with the same insiders, and many so-called "private" enterprises continued to access various forms o f state subsidies. A 1996 empirical study of Ukrainian enterprises by Estrin and Rosevear (1999) found no evidence o f improved enterprise performance from privatization. Another 1996 study by Pryor and Blackman (1998) documented the entrenchment of control by so-called "red directors" in Ukrainian industry. Thus, while formal privatization was a prerequisite for the more recent changes, it was far from sufficient. Other factors have been important. The discussion below devotes attention to key internal sources o f growth related to policies and reforms (stabilization, financial discipline, subsidies, reform in agriculture, changes in tax rules, de-regulation) and institutional development (commercial banking, competition, corporate govemance, restructuring, and financial-industrial groups). 16 Policies, Reforms, and Economic Growth 1.29 A close examination of the Ukrainian economy leads to the unavoidable conclusion that, together with the three extemal factors discussed above, key policies and reforms have played a central role inthe recent economic growth. They have affected growthprimarily at the micro-level through changes in the expectations, incentives and the orientation o f businesses. Accomplishments in stabilization policy and the imposition o f greater financial discipline on many different fronts appear to have been particularly important inthis regard. In addition, structural reforms and policy changes in agriculture, the budgetary sphere, subsidies, tax rules, and deregulation have most likely had an important impact on the economic growth. While subsequent changes in government led to initial uncertainty and speculation o f a possible reversal o f the reform momentum o f 2000, there has so far been no real effort to turn back the clock in these areas, thus re-enforcing expectations that recent changes are of a more durable nature. Stabilization and monetization: the role of macroeconomicpolicy 1.30 A positive current account, higher cash liquidity from export sales, and tight extemal financial constraints facilitated the macroeconomic stabilization o f the Ukrainian economy. Yet world experience demonstrates that stabilization is far from automatic even under such circumstances. The Ukrainian govemment deserves credit for a number o f effective decisions in macroeconomic policy and foreign economic relations that stabilized expectations and the economy. The importance of stabilization for recovery and growth in transition economies has been strongly confirmed innumerous empirical studies.' 1.31 Perhaps most importantly, the Ukrainian govemment and the National Bank did not resort to major credit expansion as a means o f financing deficits or propping up struggling banks. The National Bank (NBU) did build up net claims on the government in 1998-99 through purchases o f T-bills on the secondary market. But the government and NBU refrained from direct National Bank finance o f budget deficits, virtually limiting deficits to privatization receipts. Despite significant financial distress in the banking sector, the NBU didnot expand refinance, and finally sent an important signal in2001 by allowing the failure o f the large Bank Ukraina, which had accounted for 10 percent o f all banking assets in the country. As illustrated in Figure 1.14, National Bank claims on the government contracted from 15 percent to 8 percent of GDP between 1999 and 2002, while outstanding refinance credit remained quite modest. ''These ~ numerous studies are summarizedwell inHavrylyshyn(2001). 17 Figure 1.14: NBUnet claimsongovernment and commercialbanks(as a shareof GDP) 16.0 14.0 net claims on commerical 12.0 10.0 8.0 6.0 4.0 2.0 0.0 1998 1999 2000 2001 2002 I Source: NBU, Derzhkomstat, World Bankcalculations. 1.32 The strong commitment to stabilization exhibited by the government and the National Bank was sufficiently credible to obtain several major foreign debt restructuring agreements in 1999-2000, thus restoring the solvency of the country. This included a restructuring agreement for T-bills, a debt swap with Russia associated with the Black Sea Fleet, Eurobond restructuring, and a Paris Clu6 agreement. After official foreign debt reached an estimated 40 percent o f GDP during the crisis o f 1998-99, this figure fell to 24 percent by the end of 2002. Ukraine's outstanding external foreign debt may fall to less than 15 percent o f GDP by 2007. Ukraine's sovereign debt received an average Bratingby leadingratingagencies in November 2003.12 Domestic official debt has also remained quite low since 1998. 1.33 During 2000-03, the National Bank maintained a stable nominal exchange rate against the U S dollar. Under these circumstances, the current account inflows and growth in demand for the hryvnia allowed for the rapidaccumulation o f official foreign reserves noted above. The simple and stable monetary policy and exchange rate anchor stabilized expectations very quickly. Even considering the extent o f the current economic expansion and previous demonetization, the pace o f money demand growth inUkraine has beenrather remarkable. Largely unsterilized purchases o f foreign exchange by Ukrainian authorities since 2000 supported average annual growth in money supply (M2) o f 44 percent during 1999-2003. Thus, while growth in GDP during this 4-year period is estimated at 33 percent, the expansion in money supply amounted to 331 percent. Yet money demand growth was sufficient to prevent this huge monetary expansion from generating inflationary pressures. On the contrary, (CPI) annual inflation fell well into single digits since 2000, and even became negative in2002 (Figure 1.15) l2FitchandMoody's upgradedtheir ratings toB+and B1, respectively, while S&P maintainedthe rating ofB. 18 Figure 1.15: Annual inflationrates (CPImontWmonthofpreviousyear) Source: Derzhkomstat. 1.34 The pace of monetization (M2/GDP) o f the Ukrainian economy has well exceeded that in any other transition economy inthe region, increasing from 11percent in 1996 all the way to 36 percent in 2003. Figure 1.16 places Ukraine in the context o f other transition economies in Eastern Europe and the former Soviet Union by this measure for 1999, 2002, and (for the case of Ukraine) 2003. In 1999, Ukraine's level o f monetization (17 percent) was close to the average inthe CIS region, and considerably lower than inEasternEurope or the Baltics. By 2002, Ukraine joined Moldova as an outlier inthe CIS region, with a level o f monetization well surpassing other CIS countries. In2003, Ukraine was already approaching levels of monetization corresponding to the more developed Eastern European countries. Of course, if official statistics underestimate GDP in Ukraine more than in most transition countries due to the large informal sector, official numbers on the relative level o f monetization would be somewhat inflated. Nevertheless, even under an alternative assumption that the shadow economy is equivalent to 50 percent o f GDP as opposed to the official estimate o f roughly 25 percent, monetization would have increased from 10 to 32 percent, which i s still a remarkable transformation. Figure 1.16: Monetization: 1999,2002, and 2003 (M2/GDP) Source: 2003 EBRD Transition Report, NBU, IMF, World Bank calculations. 19 1.35 Along with responsible monetary policy, major improvements in the management o f the state budget and government finance have contributed enormously to the stabilization process. In the absence of direct NEW finance and domestic borrowing, the general government deficit was reduced essentially to the size o f privatization revenues and external support in 2000 and 2001, and the budget actually moved into surplus in 2002 (Table 1.4). This can be contrasted with a general government deficit inthe range o f 7 percent o f GDP in 1997 before the crisis. As discussed below, the government also reduced substantially off- budgetary quasi-fiscal deficits during the same period. Table 1.4 indicates a major compression o f general government expenditures following the crisis from 47 percent o f GDP in 1997 to 36 percent in2000. This compression was fairly broad-based, and included the reduction o f a number o f subsidies to various sectors o fthe economy. Aggregate general government expenditures outside o f the social sphere have not exhibited an upward trend as a share o f GDP since 1999-2000. Table 1.4The General Government Budget (As A Share of GDP) 1997 1998 1999 2000 2001 2002 2003 Revenues 40.5 36.4 32.7 35.1 35.5 38.2 38.9 of which tax 32.9 29.0 27.4 27.7 30.9 31.0 payrolltaxes 11.8 11.6 9.7 9.0 9.7 10.8 10.4 taxes on profits and income 8.7 9.0 8.3 8.3 8.4 9.0 10.2 taxes on goods and setvices 10.2 9.0 8.3 7.2 6.7 8.1 7.1 non-tax revenue 2.1 2.0 6.1 7.0 6.5 6.9 Expenditures 47.3 38.8 35.0 35.8 36.3 37.7 39.2 of which social 21.2 18.6 10.7 21.6 26.0 25.5 health 4.2 3.5 2.9 2.9 3.1 3.3 3.7 education 5.3 4.4 3.6 4.2 4.7 5.4 5.7 other 17.6 16.4 17.1 14.7 11.7 13.7 Balance -6.9 -2.4 -2.3 -0.7 -0.8 0.5 -0.3 Financing 6.9 2.4 2.3 0.7 0.8 -0.5 0.3 domestic 6.6 0.9 I.5 0.1 0.0 0.4 external 0.3 1.2 0.2 -0.1 0.2 -0.4 prviatization revenues 0.0 0.3 0.6 0.7 0.6 -0.5 Source: MoF, Bank calculations. 1.36 The recovery in government revenue since the late 1990s is difficult to assess, as much of this growth has come from non-tax revenues, consisting primarily o f various administrative fees and charges that were formerly not a part of the explicit government budget. Direct taxes on income and profits as a share o f GDP show a measurable upward trend in recent years. The increase in personal income tax revenue through 2003 may be related to fact that this tax has become the primary source o f revenue for regional and local budgets, and interest in its collection has therefore increased at the local level. On the other hand, Ukraine continues to struggle with indirect taxation on goods and services, including the VAT. Revenue from these taxes has not kept pace with GDP growth. Direct taxes on incomes and profits, including payroll taxes, accounted for a full two thirds o f general government tax revenues in 2003, which implies a very high tax burden on personal income (labor) relative to consumption inUkraine as compared with most other countries. 20 Payment discipline and the hardening of budget constraints 1.37 A sharp increase in payment discipline and a hardening o f budget constraints are perhaps the most notable institutional changes inthe Ukrainian economy since the late 1990s. As discussed above, prior to the financial crisis o f 1998, the Ukrainian economy hadbecome largely demonetized. Close to half o f all industrial transactions in 1997 were conducted in barter, and budgetary operations at the central and regional levels relied heavily on various forms of offsets or bills o f exchange. This situation has changed dramatically. While the tightening o f external financial constraints and the injection of liquidity to the export sector certainly gave a strong boost to the monetization process, a strong policy initiative of the Ukrainian govemment since 2000 appears to be the most important source of the positive changes in this area. The Ukrainian government of 2000 gave the highest priority to establishing financial discipline and accountability inthe budgetary sphere, the energy sector, and incontractual relations ingeneral. This included: > The creation and enforcement of cash only rulefor state budgetay operationsfrom 2000. > The elimination of pension andpublic sector arrears, and the vast reduction of most other budgetary arrears. > I n the energy sector: (a) taking explicit control of the accounts of the electricity distribution companies (oblenergos) to ensurepayment to the electricity market and producers; (b) demanding cashpayment and authorizing the reduction or elimination of energy supplies to non-paying customers in a wide variety of circumstances: (c) increasing incentives in oblenergos and gas companiesfor collecting cashpayments, including linking price regulations to payment collections in privatized distribution companies; and (d) removing ineffective managers in gas and electricityfirms.l3 > Since 2001, a Budget Code raises overall standardsfor budgetformation, execution, and thefinancial accountability of government administrations and Parliament. This includes important measures to harden interbudgetay transfers. > A signijkant expansion of the state treasuy to cover all extra-budgetayfunds other than the Pension Fund, and the consolidation of a number of extra-budgetay funds into the explicit state budget. 1.38 Inthis context, barter fell steadily from over 40 percent of industrial transactions in 1998 to negligible levels in2003, and payable arrears inthe economy declined from 90 to 50 percent of GDP during the same period (Figure 1.17). Non-payments and barter had been particularly concentrated in gas and electricity. Cash receipts in the gas and electricity markets increased from less than 20 percent in 1999 to over 80 percent in2002 (Figure 1.18). This reflects significant declines in quasi-fiscal subsidies and a highly advantageous unraveling of the "virtual economy." However, serious payment problems remain in the energy sector. Figure 1.18 actually gives a somewhat exaggerated impression o f progress as l3 Leonov (2004) examines the frequency o f managerial turnover during 2000-03 in a "top profit" group o f 12 enterprises. 7 of these 12 enterprises are energy firms (Naftogaz, Energoatom, and 6 oblenergos). H e found managerialtumover in 10 o f these 12 f m s during this period. 21 listed receipts relative to current deliveries include the re-payment o f past accumulated debts by more profitable enterprises. Thus, the share o f actual payment for current deliveries is not quite as high. Figure 1.17: Payablearrears and barter 90 - 80 Y + 30 --+payable arrears (as O> \ 20 -- of GDP) IO --+Yo share of barter in 0 -- industrialsales m I I I Source: Ministry of the Economy, MoF, World Bank calculations. Figure 1.18: Cashcollectionsinthe energy sector 100 (as a YOof billings) 90 80 70 60 50 40 30 20 10 0 1999 2000 2001 2002 Source: Ministry of Energy. 1.39 The initiative to eliminate pension and other budgetary arrears can be associated with a decline o f such arrears from an estimated 4.5 percent of GDP in 1999 to 0.5 percent in 2003. Solving the problem o f tax arrears has proven more difficult, however. The decline in tax arrears through 2001 shown inFigure 1.19 was due inlarge part to a tax amnesty granted for tax debts incurred before 1999. Indeed, while the stock o f tax arrears as a share o f GDP was halved during 2001 from 6 to 3 percent, the estimated flow o f new tax arrears actually 22 increased from 8 to 8.7 per~ent.'~ The stock o f tax arrears began to increase again in 2002, although preliminary data indicates that the government succeeded in preventing further growth inthe stock o f arrears during 2003. Figure 1.19: Tax and budgetary arrears (as a share of GDP) 1999 2000 2001 2002 Source: Ministry o f the Economy, MoF, World Bank calculations. 1.40 The progress in establishing financial discipline and transparency in the sphere o f interbudgetary relations has also been important. Prior to 2000, Ukrainian local administrations had little incentive to improve their own explicit budgetary position.' Sharing rules for tax revenues between budgets and interbudgetary transfers exhibited very high instability, and were adjusted on a continual basis in a manner that extracted surplus resources from regions that increased revenues or economized on expenditures. In addition, local administrations that ran budgetary arrears in the social sphere commonly received bailouts from the central government in the form o f soft interbudgetary loans that would never have to be repaid ("Improving Inter-Governmental.. ." (2004)). 1.41 A new Budget Code and other measures eliminated interbudgetary loans altogether and adopted a formula-based approach to the determination o f transfers. An additional subvention fund was also set up to finance directly (through the treasury) some centrally- mandated social benefits in the regions. The most important combined effect o f these measures was to narrow enormously the scope for discretionary bailouts o f local administrations. These changes, together with commitments to longer-term norms for tax sharing rules, also created at least a minimal degree o f predictability o f future financial flows inthe regions and localities, thereby allowing for the developmentof financial planning. For the first time, a number o f local administrations came to understand the links between their own budgetary capacity and local tax revenues. As noted above, a greater interest o f local governments in income tax receipts most likely contributed to better collection rates for this tax. The CEM team met with several local administrations in2003 to discuss perceptions o f l4O'Connell(2002), pp. 16. A detailed summary of the Ukrainian system of interbudgetary relations prior to the recent reforms i s containedinWorld Bank (2003b) and O'Connell and Wetzel(2003). 23 recent changes at the local level.16 Despite many remaining problems highlighted in subsequent chapters, local officials gave an overwhelmingly positive overall evaluation o f the reforms, and indicated strong improvements intheir own financial planning. Changes in the size of state subsidies and the nature of their allocation 1.42 Changes in the size, type, and allocation o f various subsidies available to economic organizations since the late 1990s have most likely had a strong positive impact on incentives in the Ukrainian economy. Two types of changes deserve emphasis.. First, the levels of aggregate producer subsidies to various sectors and regions have declined. This followed the tightening of extemal financial constraints and more responsible economic policy. Second, the allocation o f subsidies has changed in a manner that no longer favors to the same degree firms that show low current liquidity or highlosses. 1.43 Budgetary subsidies sustained significant cuts in the post-crisis fiscal adjustment. Between 1998 and 2001, real budgetary outlays on industry, construction, housing, and special funds declined by an estimated 40 percent, 50 percent, 85 percent, and 45 percent, respectively. As indicated above, these expenditures have, for the most part, remained at much lower levels. The coal sector has traditionally been the primary recipient of direct state subsidies in the form o f budgetary outlays, and this remains the case today. Yet the size o f budgetary subsidies to the coal sector has declined since the financial crisis. Coal subsidies amounted to over 2 percent o f GDP in 1997, and jumped to almost 3 percent in 1998. By contrast, direct budgetary outlays to the coal sector have declined to under 1percent of GDP in recent years (Figure 1.20). Planned coal subsidies have also been cut during budget sequestration. Outlays to the coal sector were only 80 percent o f planned levels in2002, and 96 percent in2001. 1.44 Since the introduction o f a program in 2000 for subsidizing interest rates on commercial loans, subsidies to agriculture have become an explicit item in the state budget, Such subsidies grew to an estimated 0.6 percent o f GDP in 2002. However, this program replaced a policy o f off-budget "commodity credit'' to large (collective) farms, under which the payable arrears o f these farms increased from an estimated 8 to 13 percent of GDP between 1994 and 1998. Debts to the government represented rough1 half of this sum, which was continually written off or restructured during 1997-99.` This i s to be distinguished from current loans that are allocated by banks at their own risk on a commercial basis with (so far) a high repayment rate. Thus, on balance, agricultural subsidies have declined significantly, and less profitable farms are no longer favored in the same manner. 1.45 Tax expenditures (selective reductions in tax rates and obligations) have been a significant source o f implicit state subsidies in the Ukrainian economy. The largest exemptions pertain to the VAT, the enterprise profit tax, and the land tax. Exemptions have l6 These discussions were held with oblast, raion, and municipal representatives in the cities of Lviv, Chernovtsy, Mykolayiv and in the raions of XXX (Lviv oblast), XXX (Chernivtsi oblast), Boguslav (Kyiv oblast), and Kozeletsk (Chernigiv oblast). "OECDandWorldBank(2003), pp.37-38. 24 Figure 1.20: State budgetary subsidiesto the coal sector (as a share of GDP) 3.50 3.00 2.50 - 2.00 - 1 1.50 -f \\ 0.00 0.50 ~ 1996 1997 1998 1999 2000 2001 2002 (planned) 2003 I Source: MoF, State Treasury, Derzhkomstat, WorldBank calculations. particularly favored producers in metallurgy, coal, agriculture, shipbuilding and pharmaceuticals. The so-called "experiment" in metallurgy from 1999-2002 represents perhaps the most conspicuous example o f subsidization through tax exemptions in recent years. Under this experiment, metals firms were granted a 50-70 percent reduction in the profit tax, complete exemption from the Road Fund tax, and other benefits. In addition to sectorally-based tax subsidies, 11 free economic zones and 9 so-called areas o f priority development operate on 10 percent o f the territory of Ukraine, receiving various special tax and customs privileges. Given constraints on the ability o f the government to increase explicit budgetary outlays in the immediate post-crisis period, tax expenditures became an easier political means for granting subsidies on a selective basis. Partly for this reason, estimated tax expenditures remained significant in Ukraine in 2003 at roughly 4 percent of GDP. Nevertheless, as shown inTable 1.5, there is a visible positive dynamic inthis area as well. Unfortunately, methodological differences between the series prior to 2000 (estimated bythe Ministry o fFinance) and 2000-03 (estimated byWorld Bank experts) prevent an exact comparison of these two series. 1.46 Quasi-fiscal subsidies in the Ukrainian economy have been realized primarily in the budgetary, gas, electricity, and utilities sectors. In the budgetary sphere, they take the primary form o f tax arrears and, prior to 2001, various forms o f (non-equivalent) offsets. In energy and utilities, they have derived from price subsidies, non-payments, and various types of (non-equivalent) non-cash payments. A share o f subsidies to households is financed through cross subsidization at the expense of higher prices charged to enterprises. Yet there remains a significant net flow o f resources from the energy sector to manufacturing and other areas o f the economy that i s financed through a combination o f pipeline rents, the decapitalization o f energy infrastructure, and state budgets (through tax arrears o f energy companies). 25 Table 1.5: Tax Expenditures (As a share of GDP) 1998 1999 2000 2001 2002 2003 Total tax expenditures Ministryof Financeestimate 5.7 6.0 4.4 4.0 World Bank estimate 5.0 5.1 4.1 of which enterprise profittax Ministryof Financeestimate 0.8 1.0 1.6 1.2 World Bank estimate 1.6 1.2 0.5 VAT Ministryof Financeestimate 3.7 4.0 2.1 2.2 World Bank estimate 2.4 2.7 2.5 LandTax Ministryof Financeestimate 0.9 0.8 0.5 0.5 World Bank estimate 0.5 0.6 0.5 Personal IncomeTax Ministryof Financeestimate World Bank estimate 0.3 0.3 0.3 Other Ministryof Financeestimate 0.3 0.2 0.2 0.1 World Bank estimate 0.2 0.4 0.31 Source: MoF, World Bank calculations. 1.47 Recent World Bank estimates on the size o f net subsidies transferred from the gas sector to the economy through repressed (below cost) prices and non-payments suggest a figure close to 2.5 percent o f GDP. Electricity and other utility prices are also below long- run marginal costs, and insufficient to reverse the deterioration in infrastructure that will eventually become unsustainable. World Bank estimates suggest that, net of indirect gas subsidies received by thermal power stations, electricity subsidies to the economy would account for about another 1percent o f GDP. 1.48 Yet these quasi-fiscal subsidies are o f a different order o fmagnitude today than inthe late 1990s, as evidenced by the substantial increases in cash payments in the energy sector illustrated above. Notably, this rise in cash payments has come at a time when gas and electricity tariffs have actually increased inreal terms. Duringthe three-year period o f 2000- 02, average prices in gas, electricity, heating, and water increased by an estimated 44.5 percent, as opposed to CPI inflation o f 32.7 percent and PPI inflation o f 28.8 percent..18 Recent World Bank estimates suggest that aggregate net energy (gas, electricity, coal) subsidies to the economy in 1999 amounted to over 10 percent o f GDP, in contrast to approximately 4.5 percent today.l9 l8 That can be contrasted to the case o f Russia, where declines in energy subsidies through non-payments and non-cash payments during the same period were offset by increases inprice subsidies (see OECD (2002)). Using a different methodology, a recent IMF estimate also indicates a contraction o f the quasi-fiscal deficit in the energy sector from 5.2 to 3.4 percent of GDP from 2000-02 (IMF (2003b). T h i s estimate combines budgetary subsidies to the coal sector with non-payments inelectricity and tax arrears from the gas sector. This 26 1.49 Together with absolute declines in subsidy levels, changes in the allocation o f remaining subsidies may have been as least as important for improving economic incentives. As implied by the above discussion, there has been a strong qualitative shift in the make-up o f remaining subsidies away from non-payments, barter, direct budgetary outlays, and soft loans, and toward tax exemptions and price subsidies. This has served to reallocate a significant share o f state support from discretionary bailouts o f (officially) loss-making or illiquid firms to benefits received in greater part by producers who are expanding their production and profitability. Reform in agriculture 1S O Structural reform in agriculture represents another major accomplishment o f recent years. Both inherited problems from the Soviet period and former delays in reform have preventedUkraine from exploiting its obvious strong comparative advantage in agriculture. Agricultural output in 1999 stood at less than 50 percent o f its 1990 level, while its share in GDP fell from 18.6 to 13.6 percent.20 2000-02 represented a turningpoint, with agricultural output growing by an estimated 22.5 percent over this three-year period. Exceptionally poor weather prevented a continuation o f this trend in 2003. While favorable weather played a role in the agricultural growth o f 2000-02, there i s evidence that recent reform initiatives in decollectivization, agricultural credits, and liberalization have also been important. This question is not without controversy, however. The current period o f decollectivization suffers from a high degree o f disorganization and uncertainty about the ownership and user rights o f much farm land and (especially) collectively owned machines and equipment. In fact, CASE (2002) concluded that the growth inagriculture in2000 and 2001 was most likely due to factors unrelated to the recent reforms. 1.51 Although the process o f decollectivization began in the early 1990s, the government has only recently taken measures to spur the actual breakup o f the collective farms infavor o f private farming. In fact, the period 1996-99 witnessed an increase in administrative interference in the development o f agricultural markets to the overall detriment o f private business activity inthe sector.*' The year 2000 represented a milestone from several points of view, A presidential decree o f December 1999 finally provided the real foundation for the dissolution collective farms as legal entities, the distribution o f land to new private owners, and the creation o f rental markets. A new Land Code, passed in October 2001, provides a legal foundation for the ownership and transfer o f agricultural land. The dissolution o f the collective farms was accompanied by the writing o f f o f a large debt overhang that had essentially prevented profitable lending to the sector on a commercial basis. The system o f government support for agriculture also changed fundamentally in 2000. Instead o f the previous administratively directed soft loans to loss-making farms, the government program ~~ estimate does not account for a substantial portion o f gas subsidies that are financed through pipelinerents or a deterioration of infrastructure. 2o During this time (the 199Os),the share o f household production relative to that o f agricultural firms (mostly the remnants of Soviet collective farms) increased from 27 to 59 percent o f all agricultural output. This included a more active involvement o f the government in providing inputs and credits to agriculture, restrictions on private trading and movements o f grain, and other measures that placed private grain traders and input suppliers in a disadvantageous position. Private sector input supply to agriculture declined by an estimated 80percent in 1995-96. (OECD and World Bank (2003), pp 61). 27 became based on interest rate subsidies for commercial banks that make agricultural loans at their own risk. Credit to agriculture has expanded at a very fast rate under this program, and reported rates of repayment of these loans exceeded 90 percent in 2000 and 2001.22 An additional positive impetus to agriculture in the form o f demand and investment has come fromthe rapidgrowth o ftheUkrainian food industry since 1999. 1.52 Despite the current high level o f disorganization in the countryside in the context o f major agricultural reform, a recently completed comprehensive report by the OECD and World Bank (2003) provides some important evidence o f a positive impact from reform on recent economic performance inagriculture. This includes notable declines inaverage costs, growth in productivity, and greater allocative efficiency. The latter i s reflected in a strong convergence in profit margins for different agricultural commodities. Significant re- planting ledto an approximately equal yield of US$50 per hectare for all major crops (grain, sunflower, and sugar beets) by 2002. Changes in tax rules 1.53 Although the tax reform implemented inJanuary 2004 i s too recent for an assessment inthis CEM, at least two previousmeasures inthe tax sphere may have played an important role in supporting deshadowization and the recent economic As discussed above, the system o f Kurtoteka IIthat blocked the official accounts for tax delinquent organizations created a huge disincentive to operate inthe formal economy through official accounts. This systemwas abolished in2001. Second, the introduction of a simplified tax regime for small businesses and entrepreneurs in2000 appears to have had a positive effect on small business development. A recent survey of the Intemational Financial Corporation (IFC (2003)) suggests those small businesses and entrepreneurs working under this regime experienced measurable improvements in their relations with tax authorities and complained much less than other firms about taxation in general. The rapid growth in the share o f employment in the small business and entrepreneurial sector since 1997 reflects primarily a huge increase in the number of individual entrepreneurs who have registered for the simplified tax (Figure 1.21). It i s difficult to assess the degree to which this increase is due to greater numbers of active individual entrepreneurs, as opposed to a larger share of existing entrepreneurs and Ukrainian citizens registering as taxpayers.24 (Registration with tax authorities i s the only source o f official information on the number o f individual entrepreneurs.) Ineither case, the result i s positive for the Ukrainian economy. The simplified tax for small firms has also created some problems in encouraging entrepreneurs and local administration to keep firms small and below the threshold o f the tax. This threshold will evidently need to be reduced over time. 22OECDand World Bank (2003), pp. 51. 23A comprehensive discussion and evaluation of Ukraine's tax system as of 2002-03 can be found in World Bank (2003d). 24Infact, anumber of registeredentrepreneurs have their actualprimary employment inlarger firms. Underthe new tax regime, Ukrainian citizens sometimes find it advantageous to register as individual entrepreneurs for carrying out specific transactions such as the rental o f an apartment. Thus, the interpretation of the numbers in Figure 1.20is difficult. 28 Figure1.21: Employmentinsmallbusinesses andfirms of individualentrepreneurs (as a share of the working population) 25 0 20 0 15 0 10 0 5 0 0 0 1997 1998 1999 2001 2002 lource: Derzhkomstat. Deregulation 1.54 A number o f comparative studies o f transition economies in the 1990s highlighted relatively high costs o f doing business in Ukraine due to so-called "administrative barriers." Since the late 1 9 9 0 ~Ukraine has carried out a special initiative aimed at alleviating or ~ removing some o f these barriers. This includes decrees and laws for simplifyingprocesses o f registration, licensing, product certification, permits, and customs clearance, while protecting firms from excessive inspections and harassment by state authorities. A State Committee on Regulatory Policy and Entrepreneurship (SCRPE) assumed the task of evaluating existing and newly proposed regulatory acts of the central and local governments, and o f proposing the amendment or elimination o f acts that place a needless administrative burden on entrepreneurs. During the period 1998-2002, the SCRPE recommended changing or eliminating 160 legal acts o f executive power under the pretense that they restrained the development of entrepreneurship. 70 percent o f these cases resulted in elimination or amendments o f these acts.25 1.55 Several recent surveys addressed the degree to which deregulation efforts may have changed perceptions o f the business environment. The results o f these surveys are somewhat mixed, but the balance o fevidence suggests significant progress inan overall reduction inthe so-called administrative costs of doing business inUkraine. The strongest results come from a World Bank Cost of Doing Business (CODB) survey carried out in 2002 (Palianytsia (2002)). This survey questioned 1600 businesses from all 24 regional centers o f Ukraine on the specific costs intime andresources spent on registration, permits, licenses, certification, and customs procedures, including various informal payments. The most striking responses concern the reported amount o f time spent dealing with various state officials. In 1999, Ukrainian firms inthis survey reportedto have devoted, on average, 32 percent of their time to this activity, a very high amount relative to other transition economies where similar surveys have been carried out. In2002, this figure declined to 15 percent, which is close to SCRPE(2003). 29 the norm for the CIS or Balkan region. Overall reported costs inthe CODB Survey (CODB) also declined from an estimated US$3,222 in 1999 to US$2,248 in2002.26 1.56 While this decline inthe "time tax" reported in the CODB Survey would be quite an achievement inonly 3 years, two other recent reports raise some questions aboutthe figure o f 32 percent for 1999. The survey of the International Financial Corporation (IFC) o f over 2000 Ukrainian firms (60 percent SMEs) in all regional centers also shows a decline in the time tax, although only from 16 percent in2000 and 2001 to 14 percent in2002. 27Together with the CODB study, this would imply a huge decline in the time tax in 2000 alone. However, another survey o f 300 manufacturing firms carried out by the IER (Institute for Economic Research and Policy Consulting) in February 2003 would su est almost no change inthe time tax between 1999 (13.5 percent) and 2002 (13.2 percent)!' Nevertheless, even if the decline in the time tax has been more marginal, other results o f the recent IFC survey still support the conclusion o f some progress in deregulation. As shown in Figure 1.22 below, complaints about procedures for registration, customs, permits, licensing, and certification have fallen steadily over the period 2000-02. Although this has not the case for state inspections, these same businesses nevertheless report the average number o f days undergoing inspections duringa year to have fallen from 27 in2000, to 23 in2001,and to 17 in2002.~' Figure 1.22: Deregulation:Share of firms inthe IFCSurveys Reportingthe FollowingRegulatoryBarriers as Major or SignificantObstacles to Business Source: IFC (2003). InstitutionalChange andGrowth 1.57 Inthe context ofthe major extemal andpolicy changes described above, Ukraine has experienced a period o f rapid institutional change. For the most part, evolving institutions have interacted with economic growth in a positive manner that makes the sustainability of the current positive trends more likely. On the other hand, as argued in the following 26Palianytsia (2003), pp. 8-9. 27IFC (2003). 28IER(2003), pp.2. 29IFC (2003). 30 chapter, a few o f these trends give some cause for concern, and pose difficult policy questions for the future. Notable areas o f rapid institutional development in Ukraine since 1999 include commercial banking, corporate governance, restructuring, competition, and the expansion o f financial-industrial groups. Developments in each o f these areas are discussed briefly below. Commercial banking 1.58 Rising from negligible levels in the latter 199Os, commercial banking and the expansion o f commercial credit now appear to be playing a measurable role in supporting Ukrainian economic growth. Commercial banks have expanded their assets, deposits, and (especially) credit at a pace that far exceeds growth inthe economy as a whole. Commercial loans have grown at a particularly rapid rate. The volume o f commercial credit in GDP increased from an estimated 6.7 percent o f GDP in 1996 to an estimated 25.7 percent in 2003. By this indicator, Ukraine i s now approaching a number of the more advanced Eastern European transition countries. The following chapter examines the commercial banking sector further, and raises some concerns about the rapidity of this credit growth, given existing low levels of capitalization inthe Ukrainian banking sector. It is notable, however, that this credit expansion has been based on commercially attracted resources, as opposed to liberal refinance policies o f the National Bank. As indicated inFigure 1.14above, net claims of the NEW on commercial banks have remained low, and actually declined from an estimated 1.7 percent o f GDP in 1997 to 1percent in2003. 1.59 Together with bank lending, borrowing on the corporate bond market has also been expandingvery quickly inrecent years. The combination of growing commercial credit and other corporate borrowing has fundamentally altered the financing o f fixed capital investment in Ukraine. From negligible levels, domestic outside sources now account for close to 20 percent o f the financing o f fixed capital investment in Ukraine (Figure 1.23). Thus, financial marketshave begunto play a significant role insupporting economic growth. Figure 1.23: Fixed Capital Investment: Sources of Finance 100 90 80 70 60 50 40 30 20 10 1 0 1997 1998 1999 2000 2001 2002 2003 HI Source: Derzhkomstat, Ministryof the Economy, World Bank calculations. 31 Corporategovernance 1.60 The development of an active market for corporate control i s one o f the most important recent institutional changes in Ukraine. This market has served to strengthen the incentives o f enterprise managers and facilitate the removal o f ineffective management. At the outset o f economic transition, Ukraine inherited a stock o f enterprise directors who sometimes possessed high technical competence, but often lacked the initiative or skill for effective large-scale restructuring or market competition. Insider privatization, combined with weak bankruptcy institutions and secondary markets, initially entrenched the power of these "red directors" (Pryor and Blackman (1998). The absence o f outside supervision or fear o f removal for poor performance weakened incentives for restructuring relative to asset strippingandrent seeking. 1.61 A market for corporate control began to emerge inthe latter 1 9 9 0 andhas developed ~ ~ at an accelerated rate since 1999. This i s visible in a 2002 survey o f 151 corporatized enterprises in Kyiv, Lviv, Kharkiv, and Sumy, with more than 50 employees conducted by the Institute for Economic Research and Policy Consulting (IER) (Akimova (2004)). These firms were asked about their shareholding structure in 2002 and 1999. Table 1.6 summarizes these results. The first two columns indicate the average shareholding by different groups in all enterprises in 1999 and 2002, while the last two indicate the share o f all firms with dominant shareholding (greater than 50 percent) by any one group. Table 1.6: The ownership structure of Ukrainianfirms: 1999versus 2002 I Average shareholding %with greaterthan 50% 1999 2002 1999 2002 The state 8.6 8.6 6 6 insiders (workers +managers) 57.6 49.8 53.0 47.7 of which workers 40.1 30.7 27.8 19.9 of which managers 17.5 19.1 6 14.6 Outsiders (Ukrainian and foreign) 33.6 41.1 33.2 43.8 of which Ukrainian companies 21 25.7 21.2 27.8 of which Ukrainian individuals 11.5 13.8 8.6 11.9 of which foreigners 1.14 1.6 0.7 1.4 Neither insiders, outsiders, nor state - 7.9 2.5 Source IER Survey data from 151 enterprises in 2002 (See Akimova (2004)). 1.62 As indicated in Table 1.6, outside shareholders, almost entirely in the form o f Ukrainian companies and individuals, had already acquired control o f 33 percent of the enterprises in the sample as o f 1999. By 2002, this share increased to 44 percent, with most of the new takeovers coming from Ukrainian firms (business groups). Furthermore, managers have succeeded in concentrating controlling blocks in a good share of the 48 percent that has remained inthe hands o f insiders (employees). Managers own 15 percent o f the enterprises inthe sample, as opposed to 6 percent in 1999. The share o f enterprises with dispersed ownership, corresponding to either over 50 percent in the hands o f workers or no 32 single groups with over 50 percent, declined from 36 percent to 22 percent inthis three-year period. The share of foreign ownership inthe sample has remainedrather insignificant. 1.63 In a paper prepared for this CEM, Akimova (2004) relates an increasing rate of managerial tumover to the ownership structure and financial performance of firms inthis and another sample. In a similar sample o f firms from the year 2001, 38 percent reported a turnover intop management following privatization, with 70 percent o f those changes taking place between 1998 and 2000. In2003, 33 percent o f firms inthe sample used for Table 1.6 above reported a turnover inmanagement during the period 2000-02. This is consistent with other scattered evidence on managerialturnover inUkraine inrecent years. For example, the contribution to this C E M o f Leonov (2004) examined a sample o f firms in food processing and light industry, and found that 30 percent o f all firms had experienced a turnover of top management since 2000. 1.64 Ina probit estimation, Akimova findsthat higher shareholding byoutside (Ukrainian) owners significantly increases the probability o f managerial turnover. Indeed, the firms in the survey indicated directly that new management commonly comes from outside o f the firm. Inaddition, managerialturnover dependsnegatively on profitability and positively on the size o f payment arrears. This suggests that a good share o f managerial turnover in Ukraine i s most likely motivated by economic considerations, as opposed to being just a political process whereby business groups have been taking over the most profitable enterprises andplacing their own cadres intop managerialpositions. Although future studies based on larger and more geographically representative samples will be needed to clarify these questions further, these results are good news from the point o f view o f managerial incentives and human capital. Competition 1.65 As emphasized inthe next chapter, Ukraine continues to experience serious problems in the area of fair competition. Nevertheless, evidence suggests that the degree o f competition inmany sectors of the Ukrainian economy has increased substantially inrecent years. In the sample o f firms that was used for Table 1.6 above (of the IER), 82 percent o f all firms claimed in 2002 that they faced "strong competitive pressures" from other Ukrainian firms.30 38 percent o f these firms cited competitive pressures as an impediment to growth in 2002 as opposed to only 13 percent in 1999. In the 2003 survey by the International Financial Corporation (IFC) o f over 2014 firms (60 percent SMEs) in 23 Ukrainian oblast centers, 85 percent o f all firms questioned claimed to have at least 4 main competitors (IFC (2003)). Similar results were found in the World Bank Business Environment and Enterprise Performance Survey (BEEPS) from 2002 that was conducted in almost all transition countries o f Eastern Europe and the former Soviet Union. 83 percent o f all surveyed Ukrainian firms inBEEPS reported 4 or more competitors intheir product lines. By this measure, Ukraine appears similar to Eastern Europe and Russia, and ahead o f most other CIS countries. ~ 30 Only 20 percent indicated such pressures coming from foreign firms. 33 1.66 Survey evidence examined in Chapter 2 confirms that perceptions o f Ukrainian firms on problems of unfair competition appear to have actually worsened in recent years. While this is certainly a negative result for the Ukrainian business environment, it is worth noting that part of the growing concern among Ukrainian firms about unfair competition may be related to the (positive) fact that competitive pressures in the country are increasing in general. A final important dimension o f growing competition in the Ukrainian economy concerns competition among large business groups, as discussed below. Restructuring 1.67 The combination of higher profits, competition, investment, and managerial turnover since 1999 appears to be associated with the acceleration in the process of enterprise restructuring. In a contribution to this CEM, CASE (2004) notes several notable trends in this regard. After falling during the period 1992-96, the number o f new products commercialized inUkraine has shown dramatic growth inrecent years (Figure 1.24). CASE (2004) also notes some interesting evidence regarding the quality o f investments. While only 60 percent o f fixed capital investment was classified by industrial enterprises as being designated for "restructuring" in 1999, this share increased to almost 80 percent by 2001. Less investment is sunk in notorious "unfinished construction" projects. Furthermore, in contrast to the past, investment appears to have become more positively correlated with profitability among enterprises, which i s consistent with the hardening o f budget constraints and the expansion o f more profitable activities. Figure1.24: Number of NewlyCommercializedIndustrialProducts 25000 20000 15000 10000 5000 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: CASE (2004). 1.68 This CEM also conducted a specific survey in2003 throughthe Institute of Economic Research, which asked their sample o f 221 firms cited above about the extent o f restructuring activities taken by their companies in 2002 as compared with 1999. Although many of these enterprises indicated a significant degree o f restructuring activities already in 1999, the 34 results presented in Figure 1.25 below suggest a higher frequency o f almost all areas o f restructuring and innovation in2000-02. Figure 1.25: RestructuringMeasures Before 2000 and From2000- 2002 (YOof firms respondingthat such measureswere taken) 70 1 60 50 40 30 20 10 A I Source: FromCEM survey conducted by IER. Financial industrial groups 1.69 The expansion o f activities o f financial industrial groups (FIGs) represents an important part of the recent institutional development o f the Ukrainian economy. A primary goal of this C E M has beento achieve a better understanding o f Ukrainian FIGs, their role in the recent economic growth, and the challenges they pose for present and future economic policy. The contributions o f Leonov (2004) and Verkhovodina, et al. (2004) to this C E M examine these questions in some detail. This section provides a brief overview o f conclusions on the contributions of FIGs to the recent growth and institutional change in Ukraine, while subsequent chapters address relatedproblems and policy challenges. 1.70 Ukrainian FIGS have been increasing in number, size and scope inrecent years. On the one hand, a number o f groups that came into existence relatively early in economic transition have grown from essentially regional-based entities, dependent on state (oblast) administrations, to larger and more independent organizations with diverse national portfolios and strong lobbies within the central government. On the other hand, given the continued weakness o f many formal economic institutions inUkraine, most notably the court system, vertical integration remains a primary means o f ensuring contract enforcement, protecting business interests relative to competitors, and achieving good relations with various state organs. Survey evidence confirms that such relations continue to be important for successful business inmany areas (see Chapter 2). Such motivations have given rise to a plethora o f new smaller FIGs in recent years. While most o f the newer FIGs remain politically weak relative to the larger dominant groups, a few o f the newer groups have expanded rather fast. 35 1.71 The larger FIGs are particularly dominant in the industries o f metallurgy, energy, machine-building, and chemicals, and they are currently rapidly expanding their activities in food and agriculture. The large gas and transportation complexes have been organized into large government-owned financial-industrial groups whose holdings also include enterprises o f related upstream and downstream firms. Both Verkhovodina, et al. (2004) and Leonov (2004) contain outlines of the holdings and ownership o f the larger Ukrainian groups to the degree to which this information can be ascertained from various official and unofficial sources. Relative to their Russian counterparts, Ukrainian FIGs appear to have a somewhat simpler ownership structure, with a larger concentration o f shares in the hands o f a small number o f interests. Nevertheless, Ukrainian FIGs do not usually present themselves as groups, either formally or legally, and the scope o f their interests, including offshore affiliates, is still a matter o f much speculation. Leonov (2004) was able to associate more than half o f the value o f Ukrainian exports in 2001 and 2002 from the 100 top exporting companies with specific large (private) FIGs. The actual figure i s likely to be substantially larger, maybe as high as 80 percent. For example, almost all o f the major exporters in metallurgy and oil processing are affiliated with large FIGS, and those two branches alone account for roughly 50 percent o f the value of exports. 1.72 FIGs have played an important role in a number o f the institutional changes emphasized above. This includes the rapid expansion o f commercial credit, particularly investment loans. While prudential regulations now limit related lending, banks have been able to bypass these regulations by crediting firms that are not explicit affiliates, but still transact with affiliates. Despite the rapid expansion o f commercial lending in Ukraine, the recent IFC survey o f over 2000 enterprises (60 percent SMEs) in 23 regional centers found that only 17 percent o f these enterprises had taken a commercial loan during 2002. This suggests that credit i s quite concentrated in larger firms with direct or indirect FIG affiliations. As suggested by the above discussion o f corporate governance, Ukrainian companies (business groups) have been the most active players on the market for corporate control and the acquisition o f new enterprises. FIGs have also been responsible for introducing and expanding a qualitatively new model o f outside corporate governance that creates an important role for a supervisory board between shareholders and management. 1.73 The expansion o f Ukrainian FIGs and their relations with government raise a number of difficult questions and challenges for future economic policy in Ukraine. Problems in monopoly power, predatory behavior, and unfair competition are prominent among those problems. Yet, ironically, FIGs may have actually played an important role in creating a more competitive environment inthe Ukrainian economy since the mid-1990s. Government administrations at both the national and subnational levels continued to play the dominant role inthe economy for most o f the 1990s. Even following mass privatization, the influence of the State remained ubiquitous, and a number of the first and most important FIGS were formed at the initiative o f government. More recent years have witnessed a transformation o f a handful o f FIGs into groups with interests in many different regions and sectors of the economy. This has had the effect o f both increasing their independence from subnational governments, and o f placing them in direct competition with one another in a number of markets. This is evidenced in part by an increasing number o f appeals to regulatory authorities and court cases that involve conflicts between competing FIGs. President Kuchma appears to have adopted a strategy that deliberately preserves a balance o f power 36 between different FIG interest groups within the presidential administration and central government. 1.74 What are the relationships between Ukrainian FIGs, the Ukrainian economy, and the large business groups o f the Russian Federation? From the information gathered by Verkhovodia, et al. and Leonov, the presence and influence o f Russian FIGs within Ukraine i s perhaps lower than might be expected, given the cultural, historical, linguistic, and institutional ties between the two countries. On this question, however, two important points deserve emphasis. First, given the political tensions surrounding Russian capital inUkraine, it may oftenbe advantageous for Russian investors to investinUkraine through Ukrainianor other foreign counterparts. The purchase several years ago o f regional electricity distribution networks (Oblenergos) by Russian investors through Slovak companies i s a case in point. Second, Russian investors (business groups) do indeedplay an important role insome sectors o f the Ukrainian economy, and this role may be increasing. Russian groups have purchased almost all o f Ukraine's oil processing facilities, made large investments in this sector, and rapidly transformed refined oil into one o f the major export commodities of Ukraine. Russian groups also have increased their involvement inmetals, telecommunications, and the food industry, although it remains unclear to the degree that political tensions, as well as overall common discrimination against foreign investors in Ukraine, will continue to limit this role. 1.75 Leonov examines the question o f the degree o f openness and transparency o f Ukrainian FIGs, and concludes that this level remains quite low ingeneral. This includes the timely disclosure o f reliable information on charters, financial balances, audits, changes in management, and other activities. Nevertheless, Leonov and Verkhovodia, et al. both document a trend within a subset o f Ukrainian FIGs toward more openness, a greater willingness to conform to official laws and regulations, and, in some cases, concern about developing a favorable international reputation. A leader in this regard i s the large metal conglomerate, Interpipe, which has recently subjected its complete structure to an international audit. It appears that many Ukrainian FIGs currently stand at a crossroads in terms o f business strategy. One option i s to "come clean," open the books, and adopt high standards o f corporate governance andbehavior, with the goal o f becoming more accepted on world markets and attracting foreign capital. At the same time, many owners and managers o f FIGs continue to profit from special relations with the government, unfair competition, or opportunities to channel state resources to affiliated interests. Under these circumstances, FIGs may have a strong incentive to keep a large share o f their activities concealed and sacrifice the potential benefits o f international acceptance and foreign capital. As discussed in Chapter 3, one of the central policy questions for Ukraine in coming years is how to influence this fundamental strategic choice within Ukrainian FIGs. F. CONCLUDING COMMENTS: GROWTH AND INSTITUTIONAL CHANGE INUKRAINE. 1.76 To summarize, a particular interaction between external factors, internal policy changes, and reforms has altered fundamentally the opportunities, constraints, and incentives of Ukrainian firms and entrepreneurs. Under new conditions and incentives, the activities o f Ukrainian firms and financial organizations have, in turn, induced further institutional changes. This includes the development o f an active market for corporate control, 37 restructuring, greater competition, and genuine market-based financial intermediation. Economic policies have playeda central role inthe recent growth. While extemal factors set the context for and motivated many o f the intemal changes, they by no means made inevitable many o f the key government policy directions described above. 1.77 Ukraine experienced the same sort o f bad "virtual economy" equilibrium as the Russian Federation in the late 1990s. But one component o f this equilibrium could not be sustained, namely the strong extemal inflows. The reversal of short-term capital flows in 1998, tougher conditions for imported Russian gas, and the consequential financial crisis brought harder budget constraints and dramatic changes in the terms o f trade favoring exporters and import-substituting industries. Yet an unstable macroeconomic environment, uncertainty about economic policy, and low domestic demand delayed somewhat the adjustment o f the economy to the new conditions. Industrial output began to recover in 1999, and strong growth in exports led the first year o f GDP growth in 2000, during a time whenconsumption, wages, and domestic demand remained rather depressed. 1.78 During2000, the govemment sent a particularly strong signal that it would not revert back to past practices. On the contrary, there was no financial accommodation from the National Bank and the government worked actively to put the final nail in the coffin of the "virtual economy" by curtailing subsidies, eliminating non-cash instruments in budgetary operations, consolidating the state budget, cracking down on the energy sector and associated non-payments, changing tax rules, targeting administrative barriers to business, and pushing through far reaching reforms in agriculture and interbudgetary relations. Although several subsequent changes ingovernment ledto speculation o f possible reversals o f the new course, this has by and large not beenthe case. 1.79 When domestic demand began its strong expansion in 2001, the Ukrainian economy had changed significantly. Incentives to restructure and operate in the official economy relative to rent-seeking and lobbying for subsidies became much stronger for a large number of Ukrainian firms. An expansion in profit-seeking activities o f Ukrainian business groups can be associated with the acceleration in corporate takeovers, together with shifts in the structure o f ownership, managerial incentives, and investments in restructuring. Money demand and the financial sector also began their rapid recovery and growth in this period. Since 2001, growth in the Ukrainian economy has been driven primarily by domestic demand. This growth can be associated with substantial welfare benefits for the population and progress in poverty reduction. Yet, as summarized in the following chapter, the challenges ahead for Ukraine remain formidable. 38 CHAPTER 2. OBSTACLESTO SUSTAINABLE GROWTH A. INTRODUCTORY COMMENTS 2.1 The previous chapter focused primarily on positive recent developments in the Ukrainian economy and the identification o f their sources. This is with good reason, as Ukraine has made remarkable progress ineconomic transition since the completion o f the previous Country Economic Memorandum in 1999. Along with stabilization, economic growth, and increased welfare o f the population, many o f the institutional foundations o f a market economy are developing and maturing. Ukraine has genuinely entered a new stage o f economic transition. 2.2 Nevertheless, sustaining the strong positive momentum will not be easy. A number o f the sources of growth examined in the previous chapter are either o f a temporary or uncertain nature. This includes a weak hryvnia, strong prices for Ukraine's main exports, exceptionally rapid growth inmoney demand and credit, excess capacity in many Ukrainian enterprises, and significant energy and utilities subsidies. The inevitable weakening o f some or all o f these factors in the near or medium term implies that economic growth will depend increasingly on the evolution o f Ukraine toward a more dynamic, efficient, and competitive economy with high rates o f fixed capital investment and the capacity to adjust quickly to changing market conditions. This hinges first and foremost on continued improvements inthe overall climate for business, investment, and fair competition. Despite some improvements, the business environment in Ukraine remains highlyproblematic. Substantial reserves for growth remain tied up insectors and enterprises with relatively low profitability and competitiveness. Less restricted access to foreign markets will also become increasingly important for the continued expansion o f exports. As the relatively tight extemal and intemal financial constraints on state budgets ease with the growth o f the economy, the government and the National Bank will also be challenged to maintain responsible macroeconomic policy in the face o f strong political lobbies. 2.3 As indicated in Chapter 1, the economic growth in Ukraine so far appears consistent with benefits for poorer segments o f the population. This reflects substantial increases in real wages and pensions, lower unemployment, and the recovery o f social spending following the 1998 crisis. On the other hand, the future linkbetween economic growth and poverty reduction could very well weaken in the context of a growing concentration o f wealth in large financial industrial groups, unfair competition, difficulties for small firms, and a business climate that still encourages the flight o f capital offshore. Deteriorating infrastructure in energy and utilities i s also a cause for concem for the welfare o f the population, as are problems inaccess to quality services in health and education for poorer segments o f the population. The recent revival in operations for many large industrial firms also brings to the forefront environment issues that are important for the sustainability o f growth. 2.4 While the current momentum in the Ukrainian economy could perpetuate growth inthe near andmediumterm evenwithout majorpolicy andreform initiatives, this inertia 39 alone would imply a gradual slowdown, leaving Ukraine well behind most other transition and medium income countries inwelfare, development and integrationwith the world economy. Such a slowdown, together with declines in profitability and liquidity, was already visible in 2001-02 before the fortunate movements in export prices and further realdepreciationo fthe hryvniawithrespect to the Euro andruble inlate2002 and 2003. This chapter will examine some o f the most important areas o f vulnerability for the future development o f the Ukrainian economy, while the following chapter turns to the policy implications o f these conclusions. Separate sections examine risks associated with the exchange rate (exports), investment, the financial sector, and problems in the business environment. B. EXPORTS: EXCHANGE APPRECIATION, VOLATILITY, AND MARKET RATE ACCESS 2.5 Exports play a central role in the Ukrainian economy, generating revenues equivalent to over 50 percent o f GDP. As examined in Chapter 1, industrial exports led the beginning o f the rapid growth in2000, and have also played a key role instimulating domestic demand and supporting investment growth, But exporters have profited from exceptionally good conditions during 2000-04 that are unlikely to be sustained. The primary risks include a likely real appreciation o f the hryvnia, uncertainty surrounding export prices, and the continued concentration o f over 40 percent o f exports in metals, where a large share o f firms already operate on the margin or in the red. Chapter 1 and PindyukandPiontkivsky (2004) inVolume 2 o fthis CEM emphasize the degree to which a weak hryvnia and strong world prices have played in the recent export growth, and suggest a strong sensitivityo f some major export groups to these variables. 2.6 In spite of sizeable current account and balance of payments surpluses, the hryvnia has not appreciated significantly inrecent years, and remains well below its pre- crisis level inreal terms against the Euro, dollar, and the Russian ruble.3' Inthe two-year period from mid-2000 to mid-2003, the hryvnia actually depreciated in real terms (CPI based) by 10 percent against the Euro and 18 percent against the Russian ruble, while appreciating by 11percent against the US dollar. The question o f why the hryvnia has not appreciated in real terms inthe presence o f strong balance o f payment inflows i s the other side o f the mystery as to why very rapid (over 40 percent annual) increases in money supply from unsterilized foreign exchange purchases by the NBUhave not been inflationary since 2000. As emphasized inChapter 1, this has been an exceptional period o f money demand growth in Ukraine that i s virtually without parallel in other transition economies. 2.7 The exceptional growth in money demand in Ukraine reflects both a low initial level and a sudden burst o f new confidence inthe hryvnia along with stabilization. Inthe future, (real) money demand growth should be expected to converge toward the growth rate o f the economy. Under these conditions, continued balance o f payments surpluses willputthe hryvniaunder strongpressure for real appreciation, either innominal terms or 31 As indicated inChapter 2, the real value of the hryvnia inmid-2003 continued to stand at 63, 58, and 18 percent weaker (by CPI-based REER)relative to the EURO, dollar, and the Russianruble, respectively. 40 through more rapid inflation at the fixed exchange rate. This i s a natural phenomenon under the current circumstances in Ukraine and, under the right policy mix, could actually boost consumption, investment, and GDP growth. The standard growth story in Eastern Europe has involved stronger exchange rates, with current account deficits financed by inflows o f direct foreign investment. But given the prominent role playedin Ukrainian growth by exporters, some o f whose viability may be quite sensitive to exchange rate movements and unpredictable swings inworld prices, growth inUkraine's traditional export sectors may slow down considerably. Even at a relatively weak real exchange rate, there were already signs o f this sort of slowdown in2001 and 2002. The potential high vulnerability o f exports to an extemal shock i s still another source o f concern. 2.8 Accounting for over 40 percent o f all Ukrainian goods exports, metallurgy i s a primary source o f vulnerability. Figure 2.1 plots measures o f relative input and output prices faced by Ukrainian exporters inmetallurgy. The upper curve i s the average UAH export price received by Ukrainian metals exporters. This curve i s affected by both exchange rate andworld price movements. The lower curve shows (official) average unit UAH costs for metals producers. Given rather low PPI inflation in recent years, this curve has not increased at nearly the same pace as the export price, thereby generating a much larger profit margin for Ukrainian metals exporters since 1999. One the other hand, average wages, as represented by the middle curve in Figure 2.1, are one component o f costs that has been growing quite rapidly. Rising wage rates are also the primary factor behind the increasing trend in average costs. The book value o f unit average costs most likely underestimates actual costs in the metals sector, as most depreciation allowances have not been adjusted since the rapid inflation in 1998-2000. Quite likely, actual unit costs for metals exporters are somewhere between the wage cost and unit cost curves inFigure 2.1. 50 -. 41 2.9 Assuming that actual unit costs are somewhere between book value unit costs and wage costs represented inFigure2.1,2000 emerges as a particular banner year for metals exporters. The depreciation o f the hryvnia was followed by sharp increases in average metals prices at a time when domestic costs were still quite low. 2001 saw a deterioration, as costs increased and metals prices dipped a bit. The new VAT rules and trade barriers also limited metals exports to the Russian Federation at this time. This deterioration carried into 2002, as metals prices did not increase until the latter part o f that year. Finally, a 24 percent average strengthening o f metals prices inthe first half o f 2003 again improved the situation, and prices became even stronger in 2004. These trends are directly reflected in official indicators o f performance of metallurgy during these years, as given inFigure2.2. Figure 2.2: Selected Indicators from Metallurgy 1 -10 2000 2001 2w 2003 HI -20 ingrowth in output (%) share of profitable enterprises growth in fixed capital investment H profitability1 Source: Derzhkomstat, Ministry of the Economy, World Bank calculations. 2.10 Even during the highly favorable economic conditions in 2000, 37 percent of Ukrainian metal firms nevertheless reported losses for the year. This reflects what appears to be a very high variance in profitability within the metals sector, with many lagging enterprises relying on outmoded open-hearth furnace steel p r o d ~ c t i o n .As ~ ~ a whole, the industry responded strongly to the opportunities presented by price movements in 2000, increasing output by an estimated 20 percent and fixed capital investment by 45 percent. The official measure o f profitability for metals in 2000 was 32T h i s is the conclusion reached in IER (2002), pp. 15, para. 4. Open-hearth furnace production continues to account for almost 50 percent of Ukrainiansteel output. 42 9.8 percent. In2001, however, all three o f these indicators fell significantly. In2002, the number o f metal firms reporting losses soared to almost 50 percent, while output increased by only 4 percent and investment growth tumed negative. Profitability also fell. In 2003, growth, investment, and profitability all picked up again, although the share o f official loss-making firms remainedhigh. 2.11 Pindyuk and Piontkivsky (2004) offer econometric evidence consistent with the above story, concluding that metals appear quite sensitive to price and exchange rate movements. They estimate that a 1percent increase inthe export price of metals can be associated with roughly 0.4 percent growth in the quantity o f metals exports, while a 1 percent real depreciation o f the hryvnia yields 0.6 percent growth. This presents risks to the Ukrainian economy from at least two points o f view. First, given the high share o f metals in Ukrainian exports, it implies that a price or exchange rate shock could have a strong impact on the economy. But questions concerning the medium or long-term competitiveness o f a large part o f the Ukrainian metals industry are even more serious. In addition to a weak exchange rate, metallurgy has profited from cheap energy resources. Energy accounts for 30 percent o f costs in metallurgy, while coal prices for metals producers remain depressed and payment arrears o f metal firms for gas have been ~ubstantial.~~Metal firms have also been among the primary recipients o f special tax and price benefits. In 1999-2002, the "experiment" inmining and metallurgy allowed for the postponement o f tax payments by 36 months, a 50-70 percent reduction inthe profit tax, and other privileges. These special benefits were revoked in2003, but special protection continued in the form o f high export duties on scrap metal. Metal firms have also received special electricity price subsidies at various points in time. Neither the weak hryvnia nor energy subsidies appear sustainable over the medium and longer term. Real wage rates also continue their rapid accent. Thus, it appears likely that a share o f the metals industry will require restructuring and substantial downsizing. This includes firms that may even be profitable under current conditions. Much the same argument can probably be made for the traditional export industryo f chemicals, which still accounts for another 8 percent o f Ukrainian goods exports. A primary structural, political and social hurdle for Ukraine will be facilitating the transfer o f labor and other resources from low and negative value added areas o f these traditional industries to more profitable areas o f the economy. 2.12 Domestic industries should also face some additional competitive pressure from imports as the hryvnia strengthens, wages increase further, and selected tariffs and non- tariff barriers are lowered or removed in accordance with WTO requirements and trade arrangements with the European Union. Pindyk and Piontkivsky (2004) highlight a high elasticity o f imports with respect to the real exchange rate, Nevertheless, a number o f Ukrainian industries would benefit greatly from a more open economy and better access to foreign markets. This i s certainly the case for agriculture andthe food industry. 33 A recent World Bank study concludes that average coal prices inUkraine are at least 15 percent, and possibly as much as 40 percent below the appropriate domestic value. (World Bank (2003a). As of January 2003, metallurgy accounted for an estimated 45 percent of all payable arrears to the gas sector, an amount equal to UAH 141.8 million (World Bank (2003f)), pp. 14, Table 10. 43 2.13 Metals, chemicals, agriculture and food are, unfortunately, particularly sensitive areas in foreign economic relations. Within Ukraine, these industries could become highly constrainedby domestic demand, which cannot continueto grow at the same pace. Indeed, Ukraine appears to suffer significantly from problems inforeign market access in these areas. As discussed inthe previous chapter, tense trade relations with Russia can be associated with very slow export growth to the CIS region after 2000. Such barriers have also undoubtedly limitedexports o f some goods to the EU, the US, Canada, and a number o f other countries. From 1999-2002, Ukraine was hit by 24 separate anti-dumping measures from WTO member countries, mostly originatin in the US, the EU, and Canada, which have affectedprimarily metals and chemicals4 The actual magnitude o f the distortions in Ukrainian trade patterns due to restricted market access is somewhat difficult to assess. On the basis o f a gravity model analysis, Aslund and Warner (2003) argue that the share o f Ukrainian exports to the EU should rationally be almost triple its current level o f 20 percent (excluding recent accession countries). On the other hand, another gravity model analysis in a recent World Bank report (World Bank (2003e), which attempts to account for alternative gravity pulls from other regions, suggests that overall Ukrainian trade volume with the EU is largely in line with model predictions. Regardless o f the conclusion drawn on this specific question, there seems little doubt that Ukrainian exports continue to suffer from problems o f market access. Unless Ukraine can improve foreign trade relations, these problems could become an increasing constraint on the economic expansion. c. INVESTMENTRISKS 2.14 The fact that growth in fixed capital investment has even exceeded GDP growth in recent years is one of the most encouraging signs for Ukrainian economic development. Nevertheless, the current pickup ininvestment began from very low levels (Figure 2.3). Figure2.3: Indexof FixedCapitalInvestment (1990=100) 120.0 I t'-----"- 60.0 i I 40'0 20.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 ' " """"" Source: Derzhkomstat. ~ 34IMF (2003b), pp. 50-51. 44 2.15 In the national accounts, fixed capital investment in Ukraine now accounts for close to 20 percent o f GDP. Almost a quarter o f this investment is in real estate. The figure o f 20 percent i s similar to many other transition economies in the region (Figure 2.4), yet lower than in most o f the more advanced transition countries that have succeeded in attracting high levels o f direct foreign investment. Among the more advanced countries, Poland i s currently an outlier with fixed capital investment at only 19 percent o f GDP in2002. Yet investment inPoland amounted to over 24 percent o f GDP from 1997-2000. As indicated in Figures 2.4 and 2.5, there i s a strong correlation (.75) between transition countries with high investment/GDP ratios and countries that have attracted relatively high foreign direct investment. Leshchenko (2004) finds a similar relationship among different Ukrainian regions. 2.4: Shares ofFixed Capital Investment in GDP inSelected Transition Economies Source: 2003 EBRD TransitionReport. Figure 2.5: Cumulative per Capita FDI in Selected Transition Economies (1998-2002) Source: 2003 EBRD Transition Report. 45 2.16 Although investment levels in Ukraine appear adequate to support economic growth in general, it i s not clear ifthey will be sufficient to support a sustained period o f rapid growth over the medium term. Strong growth since 2000 has undoubtedly reflected low marginal costs for expanding production in many areas due to excess capacity after the free fall in output of the 1990s. Under these conditions, growth in domestic demand has had much more o f an impact on output than prices. Yet marginal costs are increasing as capacity constraints become more binding, which makes fixed capital investment, along with a more efficient allocation o f existing resources, increasingly important as a determinant o f future growth potential. 2.17 On this question, the energy and utilities sectors deserve special attention. Throughout the transition period, these sectors have consistently provided implicit subsidies to the population and producers through low tariffs and non-payments. Part o f these subsidies has been passed on to government either through tax arrears o f energy companies or direct budgetary subsidies. Yet another part has been financed through postponing investments and allowing the gradual deterioration o f infrastructure. This was a feasible strategy during the period that output and energy demand were declining, and thereby leaving considerable excess capacity in energy. By expert assessments, substantial excess capacity has still not been exhausted in electricity. Yet, as energy ~ demand continues to increase and infrastructure deteriorates, a day of reckoning will be unavoidable. (Figure 2.6). 70.0 65.0 60.0 A * A v 55.0 v v v 50.0 45.0 40.0 30.0 / , , , I , 1 , I 1995 1996 1997 1998 1999 2000 2001 2002 2003 +electricity production index+GDP index W j ) I Source: Derzhkomstat, World Bank calculations. 2.18 A recent World Bank study indicates that deterioration o f infrastructure in the natural gas industryhas already reached a point o f concern, particularly as Ukraine needs to maintain its credibility as a reliable pipeline transportation route for Russia.35 World Bank estimates place needed rehabilitation investment inthe transmission system alone at 35World Bank (20030. 46 US$300-400 million over the next several years, and most likely a similar sum will be needed for the rehabilitation o f distribution. Furthermore, Ukraine can profit greatly from the expansion o f its gas transmission capacity and exploitation o f its own sizeable gas reserves, but this would require substantial investments o f probably up to US$6 billion.36 2.19 In addition to robbing the energy sector of needed investment resources, low energy prices and continuingproblems inpayment discipline encourage wastefulness and distort the production input mix toward energy-intensive technologies. The solution to these problems requires higher average tariffs for gas, electricity, coal, and water, . together with the enforcement o f payment discipline, Under these conditions, Ukraine could also attract major foreign investment to meet overhead financing needs in energy. While these measures are necessary to ensure the viability o f the energy sector, economic efficiency, and the sustainability o f growth, they may have a temporary negative effect on some o f the current areas o f growth inthe Ukrainian economy that rely on cheap energy. They also require social assistanceto protect poorer households from the effects o fhigher energy and utilities tariffs. Thus, this i s another area where needed structural adjustment still stands betweenUkraine's current situation and a sustainable long-term growth path. D. RISKSINTHE FINANCIALANDBANKING SECTORS 2.20 As summarized inChapter 1, developments inthe financial andbankingsectors in Ukraine since 1999 have been quite dramatic. Ukraine was distinguished from most transition countries in the second half o f the 1990s by particularly low levels o f monetization and commercial credit to the non-financial sector. By 2003, this was no longer the case. By both o f these measures, Ukraine has now become a leader among CIS countries. But the rapidity o f these developments is in itself a signal that their stability may be questionable. Financial and banking crises have been quite common in emerging market and transition countries. The good news from this experience i s that, if problems in the financial sector are managed correctly by the govemment and National Bank, the overall impact on the economy from instability in the banking sector can be quite limited(Berglof and Bolton (2003)). This was already the case for Ukraine during the financial crisis o f 1998. But given the increased importance o f the financial sector in the Ukrainian economy today and the growing role that financial markets are playing in financing not only working capital but investment (see Chapter l), impact o f the instability in the banking sector would certainly be o f a greater magnitude in Ukraine today than duringthe late 1990s. 2.21 Although Ukraine has made strides inthe stabilization o f expectations on inflation and the exchange rate, memories of instability in the not so distant past imply that these expectations could still be volatile. The National Bank's awareness o f this fact i s one reason why it has kept the nominal exchange rate stable against the U S dollar for such an extended period o f time. Given that growth inmoney demand cannot continue for long at the current pace, maintainingstable expectations may require a somewhat more complex 36Ditto, pp. 5,24. 47 monetary policy in the future, as discussed in Chapter 3. A destabilization o f expectations on inflation or the exchange rate remains an important, although avoidable, risk. 2.22 The development o f the banking sector in Ukraine has been a complicated process. The instability o f the 1990s culminated in the bankruptcy o f Bank Ukraina in 2001, which had accounted for 10 percent o f all bank assets. The number o f registered commercial banks in Ukraine has declined from 230 in 1995 to 180 in 2003. In recent years, while increases in bank assets, deposits, and (particularly) commercial loans have been extremely rapid, aggregate bank capital has remainedvirtually unchanged as a share o f GDP (Figure 2.7) Figure 2.7: Selected Commercial Bank Indicators (as a share of GDP) 35.0 30 0 25 0 20 0 15 0 10 0 5 0 0 0 Assets Commercial loans Household deposits Capital 02000 12001 CI 2002 12003 Source: NBU, Derzhkomstat, World Bank calculations. 2.23 This increase in attracted resources and commercial loans relative to capital is at the heart o f recent worries about the future health o f the banking sector in Ukraine. While this i s indeed highlighted as a major concern below, it is important to keep inmind five facts about the current situation with regard to risks inthe banking sector. These can be summarized as: > The recent expansion of loans and deposits has occurred on a commercial basis and, for the most part, does not reflect an injection of resources from the government or the National Bank. Use of the refinance facility has been highly limited and outstanding claims of the NBU on commercial banks remain at very low levels. P Many of the poorly-capitalized Ukrainian banks do not work with household deposits or have access to NBU refinance. Their solvency is typically tied to the 48 client enterprises that they service. In this case, the risks of failure are entirely internalized by the banks and their aflliates. P Household deposit insurance remains modest at UAH 1200-2000per depositor, most likely implying a manageablefiscal burdenfrom individual bankfailures. P Volumes on the inter-bank loan market are quite modest, implying a high degree of financial independence of commercial banks from one another. Thus, the failure of individual banks need not pose a systemic risk. P With the exception of one large problematic bank that is undergoing rehabilitation, most Ukrainian banks appear solvent at thepresent time. 2.24 The above conditions implythat the National Bank has the opportunity to manage possible individual bank failures, including those o f larger banks, in a manner that does not threaten the banking sector as a whole, let alone other sectors of the economy. Central to this task, o f course, i s maintaining the stability o f the expectations of depositors. 2.25 What are the current risks to individual banks? Although recent data would indicate a high degree of solvency, the ability o f many banks to withstand an external shock or economic downturn might be questioned. Furthermore, even in the event that the overall macroeconomic picture remains positive, it appears likely that a number o f banks will still begin to experience problems. The main concern is the degree to which low capitalization and increasing competition are inducing banks to adopt excessively riskyinvestment strategies and excessively costly strategies for attracting resources. An effect o f increasing competition in the banking sector is visible in rapidly-declining interest rate spreads between loans and deposits (Figure 2.8). Competition for deposits has kept average interest rates in 2003 at almost the same level as 2002 at a time when average real interest rates on loans have fallen with inflationary expectations from over 20 percent in 2002 to under 15 percent in 2003. These spreads are still high by international standards at 7.5 percent. However, for various reasons, operating costs of Ukrainian banks are also quite high. Inaddition, highreal interest rates onboth loans and deposits are a source o f concern, as they imply both high contingent risks for loan portfolios and highfuture liabilities. While the official NBUnumber on the share o f bad loans inoutstanding commercial credit has fallen significantly inrecent years, reaching a mere 2.7 percent in2003, a recent IMF assessment that employs international definitions estimates the share of classified loans (substandard, doubtful, and hopeless) to be as high as 22.37 37IMF(2003a). 49 Figure 2.8: Real(CPI-deflated) Average AnnualizedInterestRates on commercialLoans andDeposits 45.0 40.0 +loans +I+deposits--cspread 35.0 30.0 25.0 20.0 15.0 10.0 5.0 I I Source: NBU, Derzhkomstat, World Bank calculations. 2.26 The recent expansion in commercial credit in Ukraine has been particularly concentrated in long-term loans o f over one-year duration. While the growing contribution o f commercial banks to investment resources has certainly had positive benefits for the Ukrainian economy, this is perhaps the most worrisome indicator from the point o f view o f assessing the riskness o f current commercial bank strategies in Ukraine. Long-term loans in a country like Ukraine are considerably more risky than short-term loans. For this reason, long-term lending usually remains modest for commercial banks operating at their own risk in transition or developing countries with high macroeconomic uncertainty, low financial transparency in business, and weak institutions for upholding creditor rights. A large share o f new commercial loans in Ukraine, and o f long-term loans in particular, i s denominated in foreign currency (see below). This implies an additional high exchange rate risk, as many firms would not be able to pay back such loans after the devaluation. 2.27 On this point, it is instructive to compare Ukraine with the Russian Federation. The Russian Federation also experienced a banking crisis in 1998, and has subsequently witnessed an expansion o f commercial credit along with economic growth that parallels that inUkraine. While bank credit inUkraine expanded from 9 to 25.7 percent o f GDP between 1999 and 2003, commercial credit inRussia also increased significantly from 12 to 22 percent duringthe same period. Inaddition to the difference inthe overall pace of growth, Figures 2.9 and 2.10 reveal important qualitative differences between the nature of credit expansion in Russian and that in Ukraine. In Russia, this expansion has been primarily short-term credit denominated in rubles for the financing o f working capital, while the Ukrainian expansion since 2000 has been concentrated in long-term loans, a full half ofwhich are denominatedinforeign currency. This growth inUkraine became particularly rapidin2002-03. 50 Figure 2.9: Ukraine: Short- and Long-Term (over 1 year) Commercial Credit (as a share of GDP) 30.0 25.0 20.0 15.0 10.0 5.0 0.0 I 1 1999 2000 2001 2002 2003 e short-termHW short-termforeign o long-termHW mlongtermforeign Source: NBU, Derzhkomstat, World Bank calculations. Figure 2.10: Russia: Short- and Long-Term (over 1 year) Commercial Credit (as a share o fGDP) 15.0 1999 2000 2001 2002 2003 ashorttermruble 0 shorttermforeign 0 long-termrublemlong-term foreign Source: Central Bank of Russia, Goskomstat Russia, World Bank calculations. 2.28 Thus, evidence suggests that many Ukrainian commercial banks are adopting very risky investment strategies. This not only creates significant contingent risks in the event of an external price shock, exchange rate shock, or slowdown o f the domestic economy. Even if the overall positive macroeconomic trends in the economy continue, the sustainability o f the current credit expansion, particularly for long-term loans, appears 51 improbable, andthe likelihood that a number o fbanks will experience financial distress i s high, This situation creates strong challenges for the National Bank in banking regulation; although the presence o f the positive factors listed above imply that the situation should nevertheless be manageable for the NBU. Inany case, the current rapid growth incommercial investment credit inUkraine appears unlikely to be sustained. E. PROBLEMSINTHECLIMATEFORBUSINESS AND INVESTMENT 2.29 The discussion inthis chapter so far suggests that some o f the current sources o f economic growth inUkraine will likely not be sustained. This includes the expansion o f traditional energy-intensive export sectors, the rapid increase o f domestic demand under conditions o f excess capacity, and the very rapid expansion o f commercial credit. Inthis context, future economic growth in Ukraine will depend increasingly on investment, restructuring, emerging or expanding new private firms, and a corresponding re- allocation o f labor, capital, and resources to more efficient and higher value-added activities. The economic system must also develop the flexibility to adapt quickly to rapidly changing market conditions. InUkraine, progress inthese areas will depend, first and foremost, on improvingthe overall climate in the country for business, investment, and fair competition. A number of recent surveys indicate that, despite the recent positive trends, the business environment in Ukraine remains quite problematic. Although some recent progress has been made in reducing the administrative costs o f doing business, the larger problems o f unfair competition and regulatory capture may have become even more serious. The same is true ingeneral for problems inthe business environment due to activities o fregional and local government administrations. Regulatory Instability, Unfair Competition, and Capture 2.30 The previous chapter presented evidence o f at least some progress in the alleviation o f so-called administrative barriers to business related to costs in time and resources for registration, licensing, permits, certification, customs, and state inspections. These costs appear to have declined to levels comparable to most other transition countries in the region, as i s supported by the 2002 cross country World Bank Business Environment and Enterprise Performance Survey (BEEPS). Further efforts in "deregulation" will hopefully sustain the momentum that Ukraine has established inthis area. 2.31 Nevertheless, there are other categories o f problems with the business environment for which the situation remains particularly difficult inUkraine. Along with the expansion o f the activities o f large financial industrial groups, some o f these problems may be becoming even more serious with time. While Ukraine may have progressed in the battle with petty corruption, the larger and more complicated issues o f regulatory capture, collusion betweenbusiness and government, and unfair competition remain large thorns inthe side of the business climate. The continued perception o f a very highdegree of instability in laws and regulations remains another serious problem. A few recent surveys attempt to measure perceptions of these larger problems, as well as place Ukraine incomparative perspective with other transition countries o fthe region. 52 2.32 In addition to conducting the larger survey discussed in Chapter 1, the World Bank CODB study (Palianystia (2003)) called together in 2002 a focus group o f 17 representative small and medium-sized businesses in areas such as food, construction, manufacturing, and trade, with the goal o f identifying the most important current problems in Ukraine's business environment. Although this sample i s very small, the results o f this discussion are nevertheless quite enlightening for interpreting the larger surveys that are examined below. As a first exercise, members o f the focus group were asked to rank various regulatory problems in terms o f detrimental effects on their business activities. As illustrated inFigure 2.11, the focus group ranked larger issues of selective (politically motivated) law enforcement, the use o f state power in unfair competition, a weak court system, and the instability o f regulations as being more severe problems than the standard cost o f doing business issues o f the time tax and informal payments. Complicatedor contradictory rules and regulations were also considered to be a relatively minor problem. Figure2.11: RegulatoryProblemsfor Business (on a 1-10 scale with l=non-problematic and lO=severe problem) Use of state power in unfair competiti Selectivelaw enforcement wth political motiv Regulatorycosts too highand unpredict Zourts cannotprotectfrom unfair practices of the s Ruleschangetoo quic Regulationssubject to discretionof offic Necessityof makinginformal payme Too muchtime spent on public offici Rules too complicat Overlappingand contradictory rules andregulat 0 1 2 3 4 5 6 7 8 9 1 0 Source: 2002 World Bank Cost o f Doing Business Focus Group of 17 representative companies and managers. 2.33 The opinions o f this focus group on changes in the severity o f these problems over time are also informative (Figure 2.12). Consistent with the positive results on deregulation reported in Chapter 2, the focus group perceived an improvement in the situation with regard to time wasted on interactions with state officials and petty corruption. Problems with the court system and the instability o f regulations are perceived to be largely the same as inthe past. Yet, the focus group actually perceived a deterioration with regardto the larger issues o f grand corruption such as the use of state power inunfair competition andthe selective enforcement o f laws and regulations. 53 Figure2.12: RegulatoryProblem for Business:Has the ProblemBeenGettingBetter or vane inRecentYean? (-5=much worse and I=much better) Source: 2002WorldBankCost ofDoingBusinessFocusGroupof 17representativecompaniesandmanagen. 2.34 The IFC survey of over 2000 Ukrainian firms (IFC (2003)) asked a series of questions related to the problems emphasizedby the focus group. Inboth 2001 and 2002, managerswere askedto identify regulatory problems that present a significant obstacle to their business. As shown inFigure 2.13, the largest number of responses inboth years (70 percent) complains of taxation. While Ukraine does suffer from a number of problemsintaxation, this result might be givena positive interpretation. Firms inalmost any country would list taxation as a primary obstacle. Yet taxation i s followed closely by problems in the instability of legislation and unfair competition. The categories of corruption, political instability, and the regulatory environment also receive a number of citations. Figure 2.13: Baniem to Business ("/a offirms that cited factor as a Significantobstacle) -___ 0 2001 70 60 50 40 30 20 10 0 taxation Unstable Anti- Folical 'Corruption Regulatory hterference of hterference of iegislation conpetitive instability environmnt local central practices authorities authorities Source: 2003 IFC Survey of over 2,014 firms in23 oblast centers (60 small firms). 54 2.35 Consistent with the perceptions of the focus group, a larger share o f IFC survey respondents cited these larger problems as significant obstacles in 2002 than in 2001, particularly anticompetitive practices, corruption, and the interference o f regional or central authorities. Conceming this latter problem, a recent survey conducted by the Institute for Economic Research and Policy Consulting (IER) o f 300 manufacturing firms (Akimova and Kuziakiv (2003)) confirmed perceptions o f the continued importance o f good informal relations with state officials for successful business inmany areas (Figure 2.14). The responses also indicate that the perceived degree o f importance o f these relationships did not decline from 1999-2002. Still another question in this IER survey asked firms about the degree to which changes in government officials have had an impact on the operation o f the firm. 45 percent answered affirmatively in 2002, as opposed to 40 percent in 1999. Figure 2.14: Importance ofInformalRelationswith State Authorities for Success inBusibness (YOoffirms who cite such relationsas important) 1 60.0 I - 50.0 40.0 30.0 20.0 10.0 0.0 tax city oblast police central authorities (municipal) government authorities Source: Akimova and Kuziakiv (2003). 2.36 The BEEPs Survey places a particularly strong emphasis on the question o f so- called "state capture," which measures the ability o f various conglomerates, organizations, or interest groups in the country to use informal power to influence the drafting, adoption, andenforcement o f various laws or regulations that affect the business climate. The first BEEPs survey o f 1999 compiled a "capture index" for transition countries in Eastem Europe and the CIS based on the degree to which Ukrainian firms complained o f obstacles to business owing to various informal payments or favors that affect the policy and regulatory process in this manner. Among all o f these countries, only Azerbaijan and Moldova had a higher capture index than Ukraine.38 The BEEPs survey o f 2002 asked a similar, though not identical, question on the influence informal payments are thought to have on the policy and regulatory process. According to this index, Ukraine scored close to the average among other transition countries. 38 Hellman, Jones, Kaufmann, and Shankerman, M. (2000) present the BEEPS results for 1999 on the subject of state capture. 55 2.37 Yet informal payments are only the tip o f the iceberg o f regulatory capture and relations between business and government inUkraine. First, influence flows both ways between government and business, and the capture o f business by government may be as common as the other direction o f causality. Second, the process o f regulatory capture in Ukraine often takes a much more subtle form than outright payments or favors for regulatory decisions. For example, Ukrainian FIGShave direct or indirect representation inkey government andregulatorybodies. Long-term mutually-beneficialrelationships of various sorts can also be as important as explicit payments in regulatory capture. Another question in the 2002 BEEPs Survey asks more generally about problems due to the influence o f large conglomerates over policy andregulation. Figure 2.15 verifies that, bythis measure, Ukraine remains an outlier among other transition countries. Figure 2.15: Influence of Large Conglomeratesonon recentlyenactedlaws and regulationsthat have a substantialimpactonyour business. (shares offirms indicating a "major" or "decisive" impact) 50.00% m Decisive influence ~ 40.00% 30.00% 20.00% 10.00% 0.00% Source: World Bank Business Environment and Enterprise Performance Survey (BEEPs) (2002). 2.38 It is notable that a number o f more advanced transition countries score poorly with respect to the measure in Figure 2.15. This most likely reflects the fact that some less developed transition countries do not yet have business groups that are powerful enough to capture the State. While Poland and the Slovak Republic score almost as high as Ukraine with respect to the perceived influence o f large conglomerates, they still score lower with respect to more comprehensive measures o f corruption. In the most recent comprehensive corruption index o f Transparency International, Ukraine still received a relatively low rating(Figure 2.16). 56 Figure 2.16: TranparencyInternational2003 CorruptionRatings (out of 10 possible with 0 the most corrupt) Source: Transparency International. SubnationalGovernmentAdministrations andthe BusinessClimate 2.39 The survey results examined above reveal growing complaints on interference by local government officials, and o f a remaining widespread perceived need for good informal relations with regional or local administrations for successful business. Although regional and local government administrations have limitedformal authority or budgetary autonomy in Ukraine, they continue to possess substantial informal authority on their territories. The sources o f leverage over economic organizations are numerous, and include control over communal services and utilities, the selective enforcement o f laws and regulations, including payment discipline, influence over the courts, and discretion over tax conditions, includingtax deferrals. The 2002 World Bank Business Environment and Enterprise Performance Survey (BEEPS) confirm this strong informal authority o f regional and local administrations inUkraine. Despite the fact that Ukraine i s a unitary state, Ukrainian businesses perceive the de facto influence o f local administrations on how various central laws and regulations are drafted, interpreted and enforced on their territories to be quite strong relative to most other transition countries in the region (Figure2.17). 2.40 The IFC survey asked some specific questions about the activities o f local (regional and municipal) officials. The results presented in Figure 2.18 for the years 2000 and 2002 give little cause for optimism. Overall perceptions o f local government by firms in the IFC survey remain quite negative, and have actually deteriorated over time. Less than 20 percent o f respondents in both years agreed with the statement that local government creates equal opportunities for firms on their territories, while the age of firms that agree with a precise and accurate implementation o f state laws and regulations by local governments fell from 40 percent in2000 to 27 percent in2002. 57 Figure 2.17: Influenceof Regionalor Local Adminstrations on recentlyenactedlaw and regulationsthat have a substantial impacton your business.(shares of firms indicatinga "major" or "decisive" impact) 45 , ' 40 35 30 25 20 15 10 5 0 Source: World Bank BusinessEnvironment and EnterprisePerformance Survey (BEEPS) (2002). Figure 2.18: Perceptions ofLocal Government (YOoffirms that agree with given statement) 40 35 30 25 20 15 10 5 0 Local gov. does not Local gov. precisely Business Localgov creates impede business and accuately environment in my equalopportunities development implements laws and city promotes for entrepreneurs regulationsof central investmentgrowth government Source: IFC(2003). 2.41 What are the causes o f the particular problems for the business environment created by regional and local government administrations? Chapter 1 summarized the sources o f adverse incentives for local officials in Ukraine prior to the major reform o f 2000-02.39 The two primary sets o f problems were: (a) exceedingly low explicit budgetary autonomy that essentially absolved local officials from genuine budgetary 39For a detailed analysis o f some of these problems inUkraine, see O'Connell andWetzel(2003). 58 responsibility and encouraged them to realize their own defacto fiscal policies through various off-budgetary means; and (b) an expectation o f soft adjustments in transfers and bailouts of social arrears that seriously weakened the perceived benefits from improving budgetary Performance at the local level, and further re-enforced incentives to keep de facto fiscal policies underground. Together with low official civil servant salaries, the consequential informal nature o f local finance encouraged corruption and rent seeking relative to the promotion o f a healthy overall climate for business and fair competition. It also provided the motivation for collusive relationships between local administrations and large enterprises in their territories with the capacity for the direct provision o f public goods. 2.42 Chapter 1 also highlightedthe recent reform in interbudgetary relations which is an important step forward toward solving problem (b) through a formula-based transfer system and the elimination o f soft interbudgetary loans. It should be noted, however, that the existing transfer formula still places local administrations who improve their budgetary performance at a disadvantage in future transfer allocations. The formula also currently covers only regions (oblasts), districts (raions), and larger cities. In addition, the expectations and orientations o f local government administrations might respond to this reform only with a delay, as trust inthe stability o f regulatory conditions i s still quite difficult to establish inUkraine today. 2.43 If at least some recent progress has been made toward solving problem (b), problem (a) remains a major outstanding issue. As indicated in Figure 2.19, explicit budgetary autonomy on the revenue side of local budgets remains exceedingly low, and the interbudgetaryreform has done little to change this situation. 2.44 Inconsolidated regionalbudgets, the share ofrevenues from local (own) taxes has actually declined from an already small 3 percent in 1999 to under 2 percent in2002. For large and small cities, these declines were from 5 to 3 percent and 12 to 8 percent, respectively. The fall in the share o f revenues from own taxes may have been partly offset by increases in non-tax receipts, which stood at over 7 percent o f consolidated local revenues in 2002. In that year, 94 percent o f these non-tax revenues consisted of various administrative fees, charges, and fines. Much o f the growth in these non-tax receipts, however, reflects the fact that many o f them have only recently been incorporated into the explicit budget. It i s quite notable that these administrative non-tax receipts now comprise a more significant share o f revenue at all levels o f local government than revenues from own explicit taxes. Transfers in 2002 also comprised a significantly larger share o f local revenues than in2001, although this i s due inpart to the introduction of the new subvention fund for financing a share o f centrally-mandated expenditures inthe regions. 2.45 Thus, the central problem of exceedingly little budgetary autonomy at lower levels o f government has not yet been addressed inthe interbudgetary reform agenda. A lack of formal means to manage the revenue side of the budget, particularly at the municipal level, bears a direct relationship to continued distortions in incentives and the existence o f "shadow budgets" at local levels o f government. In a survey conducted for this CEMthroughthe Institute for Economic Research andPolicy Consulting (IEA), over 59 30 percent o f Ukrainian enterprises indicated their regular participation in off-budgetary programs associated with direct (non-tax) contributions or the direct provision o f public goods and services to the region. Furthermore, these surveys indicate no perceived change in the frequency and burden of this participationbetween 2000 and 2003. These activities are in addition to a typical high remaining burden o f social assets on the balances o f enterprises inherited from the Soviet period. Figure 2.19: The Composition of Local Revenues: 1999 and 2002 100 60 60 40 20 0 C -e Central tax sharing ed Other centraliydeteminedtaxes transfers own taxes non-tax reLenue Source: Basedon MoF data and World Bank calculations (2004). The "Insider Economy" andEconomicGrowth 2.46 A continued strong positive dynamic in the Ukrainian economy depends on the creation o f a business climate that is favorable enough to ensure sustained competitiveness on world markets, and i s transparent enough to support integration with world markets and greater market access. As emphasized inthe previous chapters, while the business environment has improved in some areas, a large share of these improvements have been concentrated in larger business groups that can circumvent weaknesses in formal institutions through ownership ties, relations with government, and direct influence over the courts and other law enforcement/regulatory organizations. In this manner, these business groups have developed informal institutionsto function inthe very difficult business climate highlighted by the survey evidence above. FIGShave made a number of positive contributions to the Ukrainian economy, and have played a leading role in the development of institutions o f corporate governance and financial intermediation. Nevertheless, this closed "insider" model o f economic development now threatens to become one of the greatest obstacles to continued sustainable growth and the successful integration of Ukraine with the EU and world economy. While other transition countries in the region also suffer from symptoms o f an "insider economy" 60 which functions on the basis o f informal relations, special privileges, and a handful of dominant politicized business groups, Ukraine appears to be a particularly extreme example. By its very nature, the insider economy model: > Hindersfair competition. Fair competition, including the relatively easy entry o f new firms into markets, represents a primary component o f an efficient and internationally competitive economy. As indicated above, unfair competition is currently a primary obstacle to business in Ukraine. Furthermore, this problem may have even become more serious inrecent years. P Encourages low transparency and corruption. Under the insider economy model, a large number o f economic agreements o f various shades o f legality occur "under the table." Many businesses that might prefer to work honestly according to the law and establish favorable intemational reputations can be discouraged from doing so due to pressures from competitors that gain advantages through special collusive relationships. As long as these under-the-table arrangements remain important, large Ukrainian businesses will be understandably reluctant to open their books. This helps explain why Ukrainian FIGSremain quite closed by international standards, and often appear reluctant to seek the investment or participation o f foreigners. In addition, collusive relationships between state officials and business, especially given the low explicit salaries for civil servants, naturally create a strong temptation for corruption and rent seeking. > Discourages foreign investment. The insider economy inherently puts "outsiders" at a strong disadvantage. These disadvantages find direct reflection in comparatively low levels o f foreign direct investment inUkraine. StrongFDIinflows could potentially become a major source o f growth, welfare improvements for the country, and integrationwith the world economy. > Restricts the realization of true comparative advantage and the adaptability of the economy to changing market conditions. While collusive relations between various segments o f the business community and government may generate high profits in "good times," market conditions are subject to rapid change. Special support and preferential treatment for certain businesses and industries can perpetuate their dominance even when considerations o f efficiency and comparative advantage would necessitate a reallocation o f resources to other areas o f the economy. , Similarly, an anti-competitive environment in a profitable industry i s often detrimental to its expansion through higher production and the entry o f new firms. Vested interests incertain sectors continue to create related obstacles inthe Ukrainian economy beyond the unavoidable social costs o f adjustment. For example, there are serious structural questions for Ukraine's future economic viability associated with parts of the metallurgy-coal complex that need to be depoliticized to the greatest degree possible. > Slowsprocesses associated with integration with the world economy and access to foreign markets. As long as the conditions under which Ukrainian enterprises operate lack transparency, foreign businesses and governments will always find justifications for administrative decisions that protect their interests and markets from 61 Ukrainian competition. This includes tariff and non-tariff barriers to foreign trade, anti-dumping acts, and complications in the realization o f Ukraine's aspirations for WTO entry, free trade agreements, and eventual accession to the EU. 2.47 To what degree would spontaneous (market) forces already at work inUkraine be sufficient to realize the fundamental transformation from insider economy to competitive market economy based on transparency, rule o f law, and fair competition? After all, the recent evolution of the Ukrainian economy has been consistent with the strengthening o f competition, efforts by business groups to work more within the law and, in some cases, attempts at increasing openness and transparency in the corporate sphere On the other hand, the perceived deterioration o f the business environment with respect to measures o f capture, unfair competition, and the activities o f state officials summarized in Chapter 3 suggest that other compensating negative processes might be at work. Historical evidence suggests that aspects o f the insider economy may be self-perpetuating in the absence o f a vision at the top level o f government, and a supporting alliance within the business community and civil society. Hellmann and Kaufmann (2002) highlight the point that the "crony economy" can become a vicious circle, whereby organizations that have the most influence over government and the courts accumulate more wealth and power, and thereby become increasingly capable o f blocking investment in the development o f formal institutions that would limit their power. Glaeser, Scheinkman, and Shleifer (2002) give a similar argument with historical perspective on how market institutions can be subverted by the wealthy and powerful in a developing country with a polarized income distribution and weak middle class. The growing relative wealth and power of Ukrainian FIGSmay be a concern inthis respect. 2.48 Thus, there is no guarantee that the current conditions in Ukraine would be consistent with a natural spontaneous evolution to an economic system based on rule o f law and fair competition. Ukraine currently stands at a major crossroads in its institutional development. On the one hand, greater competition between various Ukrainian business interests and the many advantages that go with favorable international reputations are pushing toward more openness, transparency, and legality. On the other hand, the relative wealth and power o f a handful o f Ukrainian FIGS has increased during the recent economic upturn, and that wealth and power might be used to secure even greater insider advantages over potential competitors, as well as to slow the development o f institutions that could threaten to limit this power. Inthis context, the orientation and initiatives o f the top level o f government can be critical at this point intime, not only in influencing the path o f institutional development itself, but also the speed at which this vital transformation inUkraine can occur. 2.49 In conclusion to this chapter, some of the factors supporting rapid growth in Ukraine still appear to be o f a temporary or unpredictable nature. Important sources o f vulnerability include a concentration o f exports in metals, where price sensitivity is high and longer-term competitiveness is unclear, high risks in the banking sector, substantial needs in fixed capital investment, restricted access to foreign markets, and remaining problems in the business climate owing primarily to unfair competition, regulatory capture, and regulatory instability. To sustain the current strong momentum in economic growth and welfare improvements, Ukraine will need to improve the business and 62 investment climate, enhancing the rule o f law relative to the "insider economy," and forwarding the agenda o f integration with world markets. The following chapter addressesthese issues. 63 CHAPTER 3. BUILDINGSTRATEGIC VISION IN ECONOMIC POLICYAND REFORM A. INTRODUCTORY COMMENTS 3.1 The preceding two chapters conclude that the recent performance o f the Ukrainian economy has been quite impressive and encouraging, but that the future challenges remain formidable. In the absence of vision and determination at the top level of government, the current strong positive trends should weaken progressively along with some o f the exceptional factors that have contributed to economic growth inrecent years. On the other hand, the unprecedented degree of economic stability in Ukraine today offers a major window o f opportunity for the pursuit o f policies and reforms that can ensure the sustainability o f growth and future prosperity o fthe country. 3.2 The adopted economic strategy of European Choice addresses many o f the outstanding problems emphasized in the previous chapter. This includes strengthening legal and regulatory institutions, improving standards o f corporate governance, reducing subsidies, continuing reform in agriculture, negotiating free trade agreements, and bringingnumerous standards into harmony with WTO and EUrequirements. European Choice makes the adoption and convergence to EU standards a primary anchor for economic reform. Thousands o f individual laws, regulations, and standards have been changed, or are scheduled to be changed, in accordance with WTO accession and EU requirements. Ukraine has also established a set o f Millennium Development Goals for elevating key social indicators in the direction o f EU levels. This includes ambitious goals for poverty reduction, expanding access to quality health and education, reducing infant mortality, preventing the spread o f HIV/AIDS, achieving environmental sustainability, and addressing gender inequality inthe labor market. The next task will be a more precise formulation o f policy and reform directions that are consistent with these underlying goals, including the prioritizing and sequencing o f specific measures to make most effective use o f the Ukrainian political process. Major elections make 2004 a particularly advantageous year for the articulation andrealization o f a more precise vision for the medium and longer-term development o f the country. 3.3 European Choice offers a potentially powerful framework for placing Ukraine on a course toward sustained rapid growth, competitiveness on world markets, and the convergence to EU standards in output, welfare and regulation. The realization o f this agenda will require a consistent application o f a broad vision for the transformation o f the country. Sustaining inclusive economic growth and achieving deeper integration with the EUnecessitate, first and foremost, a clear and stable legal and regulatory framework that i s consistent with fair competition, a favorable investment climate, and more equal opportunities for Ukrainian citizens. Inlight o f the conclusions o f the previous chapter: 64 The realization of European Choice requires transforming Ukraine from a predominantly "insider economy"based on informal relations, specialprivileges, and a handful of dominant `>politicized" business groups to an economy based on rule of law, transparency, and commitment to a levelplayingfield for fair competition. 3.4 The realization of this transformation will require combining determination at the top level o f government with support of a strong progressive coalition in the business community and civil society. Such a coalition would have been exceedingly difficult to form inthe past, as both government officials andpowerful businesses typically had little interest in giving up their exceptional discretionary power and special advantages in the economic sphere. But the Ukrainian political and economic landscape has now matured to the point where such a coalition can be nurtured. An increasing number o f business groups and firms inUkraine would prefer a situation inwhich neither they nor their rivals need to waste resources on lobbying for special extra-legal relations or influence, under which neither they nor their rivals are able to operate under special exemptions or privileges, under which both they and their rivals are protected from unfair business practices, under which foreign trading partners and investors do not always suspect hiddensubsidies andinsider agendas. 3.5 As described in the previous chapter, growing competition and other favorable changes in the Ukrainian business environment have already supported efforts by many financial industrial groups to work more within the law and, in a number o f cases, improve their standards o f openness and transparency. Many FIGS and other organizations indicate increasing ambitions to boost their international reputations with the goal o f tapping international capital markets and securing better market access. Under these conditions, a strong strategic vision on the part o f the Ukrainian government to facilitate this process would be welcomed by a significant portion o f the Ukrainian business community. On the other hand, a handful o f financial industrial groups have been accumulating wealth and power that could potentially be used to subvert market institutions even more effectively. In this regard, the worsening perceptions in the business community concerning unfair competition, regulatory capture, and corruption are a cause for concern. Resistance to reform should be expected inparticular from some government officials who receive personal benefits from their discretion over the regulatory environment, and from certain business interests that may currently lack the foundation or determination to compete successfully on a level playing field or in world markets. 3.6 Ukraine currently stands at an important crossroads. Vision and determination at the top level of government can be critical at this time for influencing the path o f the country's future development, including the pace o f growth, improvements in social welfare, and integration with the world economy. As stated inthe President' address on EuropeanChoice, "the next decade will become critical inthe settlement o f these matters; otherwise Ukraine may be held at the sideline o f global processes." Ukrainian firms and other organizations will be choosing their future strategies based on expectations of the direction and pace with which the country is moving. Clear prospects for integration with world markets andexpectations o f fewer opportunities for rent seeking will naturally support heightened concern over international reputations and competitiveness, leading to 65 greater openness and the development o f corporate culture consistent with the realization o f European Choice. Expectations that Ukraine will remain largely an insider economy based on under-the-table relationships will perpetuate the reluctance o f Ukrainian FIGS and firms to open their books or adopt highstandards o f corporate behavior. Inthis light, it will be essential to builda consensus o fpositive expectations among a critical mass o f Ukrainian stakeholders. As long as businesses groups suspect that their competitors are obtaining special advantages from state officials, the courts, or regulatory agencies, then they will be inclined to protect their interests through the same means. 3.7 Inthis context, the most effective strategy for the government will be to signalits resolve to realize the desired transformation on several different fronts simultaneously, thereby maximizing the probability o f reaching this necessary consensus among a critical mass o f stakeholders. At the same time, the government needs to adopt measures to reform itself and increase the interest o f state officials at all levels of government in promoting a favorable investment climate and alleviating poverty. The insider economy is a two-way street o f business-government relations. Key general directions for economic policy are: 9 Meeting future challenges in stabilization and bank regulation. Maintaining macroeconomic stability is critical for sustaining growth. 9 Upholding commitments to fair and stable rules and regulations. The govemment needs to develop a reputation for upholding medium and longer-term commitments to stable regulations and programs that send clear signals to the business community andthe population. k Promoting fair competition and private sector development. Measures are needed to combat continuing high uncertainty, the absence o f a level playing field, low transparency, and selectivity inthe enforcement o f regulations. 9 Creating a public sector that supports growth and poverty reduction. Completing reforms in interbudgetary relations and public administration, along with an active battle with corruption, can improve the behavior and efficiency o f state officials and administrations. Reforms inpublic expenditures can boost the effectiveness o f social programs targeted at the poor. 9 The determinedpursuit of rapid integration with the EU and world economy. The government should leave as little doubt as possible about its determination to realize EuropeanChoice. 3.8 The remainder o f this chapter will focus on key policy and reform goals that correspond to each o f these themes. 66 B. MEETING FUTURE CHALLENGES INSTABILIZATIONAND BANKREGULATION 3.9 Macroeconomic stabilization i s one o f the most important factors behind the recent positive trends inthe Ukrainian economy. While the government and the National Bank have demonstrated considerable skill in stabilizing the economy since 1999, Ukraine will continue to face challenges in this area. These challenges can be met effectively by building on areas o f progress in recent years, developing more sophisticated tools o f monetary policy and bank regulation, and managing possible individual commercial bank failures ina quick and effective manner. Fiscal Sustainability 3.10 Progress inthe budgetary sphere should be continued. From the point o f view o f macroeconomic stability, the government will need to ensure that the tax base expands sufficiently with economic growth. Recent years show positive trends inthe collection of direct taxes on income and profits, but indirect taxation (VAT and excises) remains a primary area of weakness. The burden of direct (labor) taxation in Ukraine is already quite high relative to most other countries in the region, and the growing imbalance between direct and indirect taxation should be addressed through broadening the tax base and improving tax administration. For the VAT, broadening the tax base will require the reduction o f still substantial exemptions andmeasures to dealwith the chronic problems o f tax and refund arrears. Maintaining the momentum inreducing quasi-fiscal deficits will also be important, most notably the enforcement o f payment discipline, rational energy and utilities pricing, and shifting the administration o f remaining subsidies to the state budget. 3.11 Given the aging o f the population in Ukraine and the unsustainability o f the current pay-as-you-go pension system, pension reform represents a key issue for the longer term. Fortunately, the Ukrainian government has made good recent progress in this area, and the approval o f a comprehensive pensionreformplan in2003 represents a key accomplishment in economic reform. This pension reform introduces a multi-pillar system and a role for private pension funds. It potentially restores sustainability to the pension system, and enhances incentives for contributions by linking pension levels with lifetime income. The report prepared for this C E M by Anusic and Petrina (2004) gives a positive overall evaluation o f this reform, although it notes that some important outstanding issues will require attention. Simulations indicate that the sustainability and rationality of the pension system can be better ensured through an increase in the retirement age, particularly for women, reconsidering existing privileged pension benefits, scaling downplans for the initialpension adjustment, and committing to a more spec+ indexation scheme (See Anusic and Petrina (2004) for details). Pension contribution rates are already quite high in Ukraine. The appropriate prudential regulation o f the new public and private pension funds raises another set o f complicated issues. Given the existence o f explicit or implicit social insurance and still developing regulatory capacity, pension funds should most likely be restricted to very safe investments such as government bonds and foreign assets, particularly at the initial stages of their operation. 67 Monetary Policy 3.12 Future effective monetary policy will depend on maintaining the independence o f the National Bank from the government, and on the continued exclusive focus o f the NBUon stabilization and effective bank regulation. In2003, the new leadership of the NBU signaled a change in strategy toward using the refinance facility for supporting particular priority sectors or investment projects inthe economy. A special targeted long- term refinance facility was set up for this purpose, and loans from this facility totaled 600 million UAHas o f September 2003. Fortunately, the National Bank has vowed to close this special long-term facility in2004. 3.13 Sstabilization policy in 2000-03 has profited from a virtual balance between purchases by authorities o f foreign reserves from balance o f payment inflows and growth in intemal money demand. The exceptional growth in money demand represents the restoration o f confidence following the crisis o f 1998 and previous demonetization. This has allowed for a non-inflationary monetary expansion that well exceeds growth in GDP. However, as money velocity stabilizes, the maintenance o f such a balance inthe future is highly uncertain, and balance of payment inflows should lead to increasing inflationary pressures at the stable exchange rate. Such pressures for the real appreciation o f the hryvnia are natural under the circumstances, and the effects on welfare, consumption, and investment from a stronger hryvnia may actually be positive. At present, the balance o f payments surplus indicates that Ukraine is producing more than it is consuming or investing, and effectively saving the difference through the accumulation o f foreign assets. 3.14 Thought should be given to the appropriate future exchange rate policy under these circumstances. The implicit fixed exchange rate has been effective in stabilizing expectations in the aftermath of the instability o f 1998-99. Given the fact that expectations could still be destabilized relatively quickly, the National Bank has been hesitant to move away fiom a stable nominal exchange rate. Yet there are important reasons why the National Bank may want to consider introducing more flexibility into exchange rate policy. In the event that a strong balance of payments surplus is maintained, a managed gradual nominal appreciation could help contain inflationary pressures. Second, Ukrainian authorities may want to avoid generating widespread expectations that they are committed to maintaining a fixed rate indefinitely. Followinga possible balance of payments shock, such a commitment could lose credibility quickly. The recent experience with currency crises in many countries suggests the sensibility o f introducing some flexibility in exchange rate policy during "good times," as opposed to waiting for "bad times" under which such a move could be perceived as a sign o f weakness and only further destabilize expectations. As trade with Europe expands and the EURO becomes increasingly important to Ukraine, policies aimed at stabilizing the exchange rate should also give more explicit attention to the EURO relative to the U S dollar. 3.15 The overall potency o f monetary policy could be enhanced through developing more effective instrumentsfor the regulation of liquidity, especially considering the high uncertainty about future money demand. Inparticular, the restoration o f an active market 68 in treasury bills would be very beneficial for this purpose, as long as this market remained modest and was usedresponsibly. Inaddition to the benefits from diversifying its debt position, this is one reason why the Ministry of Finance might consider expanding domestic relative toforeign borrowing. A larger supply o f T-bills would also give commercial banks a relatively low risk interest-bearing asset for balancing the considerable risks intheir current investment portfolios. The Regulationof CommercialBanks 3.16 The regulation of commercial banks poses considerable future challenges. The National Bank i s currently taking measures to improve bank monitoring, and i s also tightening minimum capital and other prudential requirements. The World Bank and IMF prepared a Financial Sector Assessment in 2002 that offers detailed recommendations for improving commercial bank supervision and upgrading basic prudential regulations in line with Basel Core Principles. In2003-04, the NBUworked in particular toward encouraging and enabling banks to boost their capital, while also putting into place a system o f early warning indicators for identifying problems in commercial banks. While the efforts o f the NBUinthis area should pay good dividends for the development o f effective bank regulation, many prudential norms will nevertheless remain inherently difficult to measure and enforce in the current Ukrainian context. This particularly concerns banks whose finances are linked incomplicatedways with larger financial-industrial groups. Nevertheless, Chapter 1 noted a number of fortunate circumstances surrounding the recent expansion o f the banking sector, namely highly restrictive refinance policies, very limited deposit insurance, the small size o f the inter-bank loan market, and the current apparent solvency o f the vast majority o f operating banks. The combination o f these factors implies that the National Bank should have the means to prevent systemic risk or prohibitively high fiscal costs from possible individualbank failures. 3.17 The National Bank will nevertheless need to be consistent and firm in this area. Evidence suggests that a combination o f low capitalization and increasing competition are inducing many Ukrainian banks to adopt excessively risky business strategies. Inthis context, it i s critical that banks are led to understand that they themselves must shoulder the risks o f their operations, and that future insolvency will result in bankruptcy and liquidation as opposed to a bailout. An expectation o f accommodation o f the National Bank will distort incentives inthe direction o f encouraging even more riskybehavior, and increase the probability of systemic risk. From this point o f view, it would be a mistake for the government to expand deposit insurance at this point in time. Access to NBU refinancing should also remain highly restricted. Growth indeposits has beenquite rapid and adequate in the absence of such expanded insurance. In fact, as some struggling banks may begin to raise interest rates on household deposits in a desperate attempt to boost liquidity, the government might do well to signal to the population that depositors should not be entirely complacent about the choice o f bank for holding accounts. Depositor confidence is not a positive phenomenon inthe event that it is false confidence. Inaddition, theNational Bank should consider restrictingstate deposit insurance or even the right to work with household deposits to commercial banks that meet particularly strong prudential requirements with respect to minimum capital, capital adequacy, and 69 other measures. As long as banks are operating with their own funds at their own risk, weak capitalization or violations o f prudential requirements present much less social risk or costs. Thus, the key to success inthe regulation of commercial banks inthe short and medium term will depend on forcing banks to intemalize their own risks to the greatest degree possible, and managing individualbank failures in a clear and quick manner that avoids systemic risk and the destabilization o f the population's expectations. This will be a difficult, yet feasible task for the Ukrainian government and the National Bank. 3.18 The healthy development o f the banking sector and financial intermediation will also depend on measures to boost the rights o f creditors in the event of default on commercial loans. A particularly important goal is the creation of conditions under which banks can seize collateral quickly in the event of default on secured loans. This i s still often far from the case inUkraine, and this fact hinders the development o f financial markets and increases the risks of commercial lending. Both lenders and borrowers stand to profit from measures in this area. Problems in creditor rights, including the case o f secured loans, received detailed attention in the recent IMF and World Bank Financial Sector Assessment. Hopefully, the recent adoption o f a new law on the Security o f Creditors' Claims will have a positive impact on alleviating these problems. c. UPHOLDING COMMITMENTS TO FAIRAND STABLERULES AND REGULATIONS Tax and Other Basic Regulations 3.19 Given the high level o f political and economic instability in the 1 9 9 0 ~economic ~ policy in Ukraine focused understandably on short-term problems and issues. Government administrations continually adjusted laws, regulations, and other conditions on a discretionary basis in the context o f crisis management. Despite enhanced macroeconomic stability and other positive trends o f recent years, an excessively myopic policy orientation has largely survived through inertia. The relatively favorable conditions o f recent years offer a vital opportunity for improving economic policy and combating the insider economy by shifting focus toward the implementation o f commitments to longer-term objectives consistent with the realization o f European Choice. 3.20 The costs to the Ukrainian economy from excessive myopia and discretion in economic policy and regulation are high. The current large number o f important regulatory decisions at the day-to-day discretion o f state officials i s itself a key component of the insider economy, and re-enforces continued perceptions inthe business community o f necessary bilateral relationships with government and regulatory bodies. A dominant focus on helping various sectors, regions, and organizations with day-to-day needs encourages the wasting o f resources on continual lobbying activities and the shifting o f economic responsibility for private losses to the govemment. A sound business and regulatory environment requires stability. Recent survey evidence confirms that instability inrules and regulations remain a central problem for Ukrainian businesses and investors. Finally, weak confidence in the durability o f basic laws and regulations feeds into political uncertainty on the future overall direction o f change in the country. Here, the government must seize the initiative to signal its determination to establish a 70 regulatory environment in Ukraine that is highly conducive to investment, growth, and convergence to EUstandards. 3.21 Ukraine would profit greatly from a particular effort to avoid sudden policy reversals or administrative interventions into markets. The business environment in the country continues to suffer from adverse expectations that the regulatory environment can change suddenly in an adverse manner at the discretion of govemment officials. 2003 witnessed two major negative examples in this regard. The recent decision to change customs procedures for oil exporters as an explicit method for forcing foreign investors to sell oil to the domestic market at lower prices sent very adverse signals to the business community. Similarly, the sudden introduction o f administrative restrictions in agriculture in 2003 also cast a cloud over the investment climate in that sector. Foreign investment in oil refinement, which included considerable overhead costs for modernizing facilities, represents a major success story in FDI, and a significant factor behind the recent growth in Ukrainian exports. The enormous costs o f such actions on the expectations o f potential future investors are even more serious than the direct costs of temporary market distortions. In particular, the Ukrainian government must fight expectations of future "hold ups," whereby regulations or tax rules are changed to siphon off additional profits from investors after capital has already been sunk (initial costs already incurred). This goal cannot be accomplished in a policy environment that only takes a myopic perspective. The government should take a longer-term view and earn a reputation for upholding basic regulatory stability. 3.22 Ukrainian firms continue to perceive rapidly changing tax rules to be a particular source o f regulatory instability. This remains a serious obstacle to a favorable investment climate, the deshadowization o f the economy, and the improvement o f tax collection. Whilethe development o f an effective tax system inUkraine will certainly require further adjustments, most particularly measures to broaden the tax base, reduce the relative burden o f direct taxation, and equalize tax conditions throughout the economy, the government should be aware that excessive sharp adjustments in tax rates and rules have serious costs to both business and state revenues. In the aftermath o f the major tax reform of 2004, the central government will have an opportunity to concentrate on maintaining a greater degree of stability in major tax rules. Greater perceived stability intax conditions alone can have a major positive impact on the business and investment climate inthe country. 3.23 This problem of instability intax rules is a particular concem for small businesses and entrepreneurs. The current threshold o f the simplified tax regime i s somewhat problematic in that it creates incentives for businesses and local govemments to keep firms small. Inflation has progressively made the current (nominal) threshold even more significant in real terms. Nevertheless, to the degree that narrowing this threshold requires increasing the tax burden on small businesses, this gap might be bridged only gradually with a goal o f preserving a maximum degree o f stability, perhaps even with a pre-announced schedule over time. Recent proposals and debates within the government concerning a possible sharp increase in the simplified tax had a negative impact on expectations, and recent progress in the "deshadowization" o f the small business sector could potentially be reversed. 71 3.24 Stability and transparency are also important conditions for other regulations affecting business. As i s the case with taxation, a favorable business and investment climate in Ukraine requires the codijkation and stability of regulations concerning licenses, inspections, customs regulations, permits, price caps (in case of regulated monopoly), and other areas. In many cases, commitment to fair and stable regulatory rules may require the creation o f regulatory bodies with a substantial degree o f independence from day-to-day government decisions. The particularly important case o f regulation inthe energy sector i s highlighted below. BudgetaryManagement 3.25 Budgetary management inUkraine i s a prime example o f an excessively myopic policy focus rooted in inertia from past years. The budgetary process currently gives exceedingly little attention to issues beyond the scope o f a single budgetary year. In addition, many,categories o f the annual budget itself derive from inertia o f previous years, essentially replicating past allocations without a comprehensive assessment o f existing programs from the point o f view o f rationality, efficiency, and the achievement of specific goals. 3.26 The continued proliferation o f various targeted government programs in Ukraine i s a clear indication o f this latter problem. At the end o f 2003, more than 150 targeted state programs were effective in Ukraine, most o f which were outdated in design and completely de-linked from the budgetary process itself. Programs are typically developed in a declarative format; program sponsors insist on incorporating into documents very broad principles pertaining to government support, but fall short o f committing specific volumes o f public financing. Such programs usually have limited implications for actual decisions on the allocation o f public funds. Moreover, most existing targeted programs suffer from unclear overall objectives, a lack o f efficient monitoring mechanisms, and inadequate consultations with potential beneficiaries. 3.27 Fiscal policy can be strengthened considerably though the adoption of a set of explicit and realistic medium-term priorities and targets. Such priorities should be identified through open public debates and an in-depth analysis o f current trends, and subsequently finalized by a political decision at a high level o f government. These medium-termpriorities andguidelines should thencomprise an obligatory framework for the preparation o f annual budgets. Once established, they should be reviewed and updated annually as part o f the regular budget process. Current areas in Ukraine that would profit from a clearer articulation and adoption o f specific strategic priorities and targets are: > medium-termparameters for the resource envelop: desirable level of tax burden, debt sustainability path, expenditure breakdown by level of government, etc.; > a restructuring of expenditures in the social sectors to increase their efficiency and make them more equalizing; > aplanned transitionfrom non-cash social benefits to targeted social assistance; 72 9 strict timetablesfor phasing out various budgetary subsidies and otherforms of government support; 9 an explicit link betweentheongoingpublic administration reform, interbudgetary reform, and changes in the structure of expenditures; 9 the concentration of existing fiscal resources in core areas, including public investments; and 9 Ensuring that the annual budgetary process upholds needed medium-term regulatory stability. 3.28 The Ukrainian Budget Code introduced a requirement (Article 38) for the preparation o f three-year macroeconomic and fiscal projections. These projections have beendeveloped every year since 2000, and are attached by the government to the annual draft Budget Law that i s submitted to Parliament. This practice represents an important pre-requisite for improving fiscal management and shifting to a longer-term policy orientation. However, at present, the three-year projections have significant limitations in their format, status, and timing within the budget calendar. They are only descriptive by nature, and are intended to inform policymakers engaged in policy corrections and re- allocations. Best practice in fiscal management would accompany these projections by a normative medium-term fiscal plan that explicitly embodies government decisions and priorities, The projections also fail to provide sector ministries with a normative basis for their annual budgetary preparation. In particular, they do not specify ministerial expenditure ceilings and, therefore, do not communicate annual limits for budgetary requests. The projections are also not comprehensive, as they do not cover the whole set of public expenditures, for example the PensionFund. 3.29 A recent World Bank report on the budgetary process in Ukraine (World Bank (2002~))provides detailed recommendations for strengthening the strategic focus in the budgetary process. These recommendations retain their validity. Specifically, this World Bank report propose^:^' 9 expanding the role of the Ministry of Finance in fiscal forecasting, budget formulation and coordination; 9 developing aformal three-year rolling expenditureframework (MTEF)aspart of the annual budget cycle, and linking the annual Budget Resolution with MTEF objectives and targets; 9 introducing a system of budget ceilings for sectoral ministries (i.e., sectoral resource envelops)for a three-year period, which would improve predictability at the sectoral level; 9 expanding the authority of sectoral ministries in the preparation of sectoral budgets (within established ceilings) and making ministries more accountablefor the results of thesepolicies; and 40See also World Bank (1997), PublicExpenditure Management Handbook, Washington. DC. 73 P preparing three-year sectoral expenditure programs that contain agreed underlying objectives, monitoring indicators, and a set of costed-out sectoral programs. 3.30 Inlate 2000, with the support of international technical advisers, the Ministry of Finance already made an attempt to incorporate several o f the above recommendations in a draft government resolution on the reform o f the budgetary process. However, the draft was never finalized. A section on the MTEF might also be added to the Budget Code. This section would clarify the objectives, timing, roles, and responsibilities for the preparation, approval and implementation o f the MTEF. Second, the budget calendar should be revised to include the stages related to the annual MTEF update, and to give sectoral ministries more time to prepare their submissions under the sectoral ceilings for negotiations with the Ministryo f Finance. The Regulation of the Energy Sector 3.31 The regulation o f the energy sector and natural monopolies also stands to profit from a longer-term approach that commits to stable, rational, and transparent rules. Within such a framework, it will be possible to increase economic efficiency, improve incentives inenergy firms, ensure the future viability o f the energy sector as a whole, and make energy more attractive to domestic and foreign investors. This includes programs andmeasures to: > keep regulation transparent, fair, and virtually independent of day-to-day >> government decision-making; make regulation consistent with incentivesfor cost reduction in energyfirms; increase average energy and utilities tariffs to rational (cost recovey) levels, while simultaneously reducing cross subsidies and providing direct (budgetary) > compensation topoorer households; and enforce more rational pricing in the coal sector, and reduce budgetay subsidies to this sector over time according to a strictpre-agreed schedule. 3.32 The first two sets o f measures require credible commitment to an effective, fair, and stable regulatory framework, which can build on important strides that Ukraine has already made. This should involve explicit and clear methodologies for linking utility prices to cost information in a manner that leaves little room for discretionary interference by the government. Either price cap or rate-of-retum regulations should remain stable over a medium-term horizon, optimally including an explicit commitment to a sharing rule for additional profits from cost reduction between producers and consumers. Different countries employ different approaches to supporting credible commitment in dynamic regulation. Obligatory legal procedures can be designed that would make changingregulations within a given (stable) reviewperiod difficult or costly. The hands o f regulators and the government can be bound though explicit laws (the Chilean experience) or protection clauses inlicenses (the UK experience). Spiller (1994) argues that the Chilean-type approach can be more effective in a country like Ukraine with a relatively weak court system. 74 3.33 Increasing utilities tariffs to cost-recovery levels, including the recovery o f long- run (investment) costs, will be vital for ensuring the viability o f the energy sector, encouraging the rational and efficient use o f energy resources, and attracting needed private investment. As discussed in the previous chapter, the existence o f high excess capacity in much o f the energy sector has allowed for an extended period o f low investment. Consequently, little attention has been given to this component o f costs in price regulations. But this strategy i s not sustainable over time, and infrastructure in the gas sector is already becoming strained. As the Russian Federation considers long-term strategies for European pipelines, it i s also to Ukraine's advantage to make a convincing case for its longer-term viability as an efficient transporter o f Russian gas. Even disregarding most investment costs, over sixty percent o f all enterprises inwater, gas, and electricity distribution in Ukraine currently operate at a loss. The burden o f higher average energy tariffs for producers can be alleviated through a reduction o f (currently high) cross subsidies from producers to consumers. A simultaneous medium-term program should also be in place to target potentially vulnerable households with direct compensation for higher energy prices. Thus, the realization o f these goals clearly requires longer-term vision and coordination. These measures might also be coordinated with benchmarks to improve the governance and operation o f the gas monopoly, Naftegaz, and other energy firms, as outlined below. 3.34 Economic losses and state subsidies inthe coal sector continue to represent one o f the most politically and socially complicated questions inUkraine. Higheconomic losses incoalmines are rootedina combinationof economic, regulatory, andpolitical economy issues. Unfortunately, some mines are clearly not economically viable, and will need to be shut down through comprehensive plans that address temporary social distress and environmental concerns in their respective regions. A number o f other loss-making mines would most likely be viable under more rational economic conditions, Given the availability o f budgetary subsidies, business groups around the coal and metallurgy complex currently operate under an incentive to concentrate losses in the mining sector through transfer pricing or other means. This is one reason why coal prices are currently depressed below rational levels.41 A primary task o f the government will be to put an end to this political economy game. Minimumprices should be regulated at levels that would ensure the profitability of viable mines, although not exceed the opportunity cost of imported coal. The design of subsidy policies toward the coal industry shouldfocus on breaking the dependency between support levels and current or recent economic losses. A strong political effort will be needed to uphold a longer-tenn commitment to a declining schedule for coal subsidies over time. This will end incentives in firms to concentrate losses incoal and reveal the genuine state o f affairs inthe industry. Ukraine can profit well from studying the very successful Russian experience, where a tough policy stance by the government to decrease coal subsidies supported incentives for substantial restructuring and a strong economic revival o f the sector.42 3.35 This approach for reducing and rationalizing coal subsidies reflects a more general strategic issue for subsidy reduction and the hardening o f budget constraints in a 41This i s analyzed in detail in "Ukraine: the Major Problems.. .(2003)." 42See Artemiev and Haney (2002). 75 manner that is politically palatable and minimizes temporary social hardship. While many approaches are possible, one basic point deserves emphasis: the presence o f subsidies does not negate hard budget constraints and their associated advantageous incentives. Hard budget constraints can be established by breaking the dependence of subsidies on recent or current economic losses. Although the presence o f uncertainty necessitates at least some flexibility inthis regard, incentives inUkraine can be improved through an effort to weaken this dependency. In some cases, as in the example o f coal discussed above, it may be beneficial to eliminate the dependency altogether through a medium or long-term commitment to a rigid declining scale for the determination o f subsidy levels over time. Such an approach can also help the political palatability of subsidy reduction policies and the minimization o f adverse social consequences. A pre- announced agreement for gradual subsidy reduction signals clearly the intentions o f the government, thereby giving organizations a clear planning horizon for adjusting to new conditions. This approach also minimizes political fallout that could surround sudden shifts inpolicy, takes the politically difficult task o f determining subsidylevels out o f the day-to-day discretion o f government officials, and allows for effective coordination with additional medium and long-term budgetary assistance for alleviating temporary social hardship. D. PROMOTINGFAIRCOMPETITIONANDPRIVATESECTORDEVELOPMENT 3.36 A growing private sector and greater competition have been central to the recent positive developments in Ukraine. Nevertheless, the survey evidence presented in the previous chapter confirms that the business environment still suffers from high uncertainty, unequal economic conditions and selectivity in the application o f laws and regulations. In a murky and weak regulatory climate, firms and business groups are reluctant to open their books, disclose their various activities, adopt higher standards o f corporate governance, or actively attract foreign investment. The allocation o f resources becomes distorted away from that consistent with genuine competitiveness and higher value added. Such an environment also naturally fosters corruption. A transition from an economy based on special privileges to one o f rule o f law i s central to the realization o f European Choice and the achievement o f sustainable inclusive economic growth. 3.37 The lack o f a level playing field for business inUkraine is a mirror reflection o f the insider economy itself, and its eradication will require the type o f comprehensive approach outlined in this chapter. An important part o f this strategy should be aimed specifically at promoting fair competition, including measures to make regulations more uniform throughout the economy, improve the effectiveness o f competition policy, reform the judiciary, enforce minimal standards o f corporate governance, and re- invigorate the privatization process under enhanced transparency and fairness. In many of these areas, the government can buildon substantial progress that it has already made inrecent years. Among other benefits, these measures canhelp unleashthe true potential of the small business sector for creating employment opportunities, facilitating the transfer o f resources from loss-making to high value added activities, and adjusting to rapidly-changing market conditions. The importance o f de novo private firms and entrepreneurs for success in economic transition has been confirmed in a number o f 76 empirical studies.43 The completion o f agricultural reform, together with the creation o f efficient land markets, will also represent a major stride forward for Ukraine inrealizing its economic potential. Creating More Uniform Regulatory Conditions 3.38 Chapter 2 indicates that Ukraine has made some good recent progress inreducing the number and size o f tax exemptions and privileges. Yet the continual aggressive phasing out of tax exemptions andprivileges should remain a central goal. This includes special tax and customs treatment in so-called special economic zones and "territories o f priority development," which cover roughly 10 percent o f the territory o f Ukraine. A recent government study concludes that these zones have been largely ineffective intheir objective o f attracting foreign and other investment, and that the exploitation o f the benefits from these zones has been concentrated in relatively more developed areas, particularly inthe Donetsk region.44 Ironically, special economic zones can havejust the opposite o f their intended effect by re-enforcing expectations among investors that the regulatory climate inUkraine i s complicated, unequal, and subject to change at any given moment. Transfer pricing and other schemes can also exploit special economic zones for arbitrage. The consistent pursuit o f more equal tax conditions is consistent with the creation of a single "special economic zone" inthe entire country that i s highly conducive to business and investment. The recent moratorium imposed by the government on creating new special economic zones or granting new benefits to enterprises operating in existing zones i s a step ina positive direction. 3.39 The chronic problem o f VAT refundarrears, which places an unnecessary burden on exporters and continues to compromise the credibility o f government finance, should be solved as soon as possible. This has been a common problem in other transition economies as well. While distinguishing between legitimate and fraudulent VAT claims may present serious difficulties in the current Ukrainian context, the government could boost its credibility by opening its books in this area and inviting international experts to participate directly in the creation of an effective mechanism to address this problem. 3.40 Selectivity in the application and enforcement o f laws and regulations is quite a complicated, although no less serious problem in the perception o f Ukrainian businesses. Several areas o f economic policy and reform concern this area. One vital direction o f reform i s the continued strengthening of thejudiciary as a trusted institution for enforcing the law, This goal can be achieved only with time, along with the improved training, pay, and monitoring o fjudges. Other important questions in selectivity relate to the sphere o f competition policy and local government discussed below. As emphasized below, laws and regulations should also be enforced for state-owned enterprises in the same manner as for their private counterparts. 43 See, for example, Jackson, Klich, and Poznanska, K. (1998), Blanchard (1997), andWorld Bank (2002). 44" O c o 6 n ~ ~ oIIpaBOBOI`OpeXHMY..." c ~ i (2003) and "Pe3YnbTaTbI @yHKUHOHHpOBaHHX..." (2003). 77 Expandingthe Scope and Leverageof CompetitionAuthorities 3.4 1 The activities o f competition authorities, the Anti-Monopoly Committee, (AMC) are central to defending equal economic conditions and battling problems o f unfair competition and collusion. Ukraine adopted basic competition legislation in2002 that i s widely viewed as satisfying intemational best practice. The key task is to make this legislation more effective in the Ukrainian context. The A M C has been gradually expanding its activities inmonitoring firms with dominant shares o fmarkets and ensuring the consistency o f government legislation at the subnational level with fair competition. Nevertheless, as discussed in more detail in the contribution to this C E M o f Kiliievich (2004), a number o f factors currently restrict the effectiveness o f the activities o f the Antimonopoly Committee. 3.42 Considering its task to monitor the legislation and activities o f government bodies for possible violations o f fair competition, the A M C currently operates with too little independence from the central government and Parliament. A more independent AMC should be responsible for also monitoring possible violations at the level of the central government, andfor bringing suchpotential violations to the attention of government, the public, Parliament, and thejudiciary. 3.43 The A M C has inadequate authority to induce local state administrations to comply with its decisions regarding the repealing or cessation o f anti-competitive acts. Currently, the enforcement of such A M C decisions must comply with a lengthy and costly court process. Furthermore, regardless o f the court decision, local administrations are not subject to fines or other punishments for the time during which they refused to comply. Thus, local administrations have little incentive to comply, and even decisions that are upheld by the courts can be counteracted by the subsequent adoption o f a sequence o f new acts that can be contested in the same way. Thus, the AMC should be empowered with the ability to levy immediate signijicantfines or other punishments on government administrations and organizations that do not comply with its decisions excepting cases when the courts do not uphold these decisions. 3.44 The nature of the insider economy limits the ability o f the A M C to monitor and evaluate potential predatory, anti-competitive, or collusive behavior. The AMC, like other govemment bodies, would profit from a better understanding and consideration o f the relationships between different firms and organizations within the same financial- industrial group. In addition, given the current widespread conduct o f de facto fiscal policies at the local level of government through underground "shadow budgets,'' the legal foundation for monitoring and controlling these activities by competition authorities is quite weak. The effectiveness of competition policy in Ukraine thus depends on the overall transformation from an insider economy to rule o f law. 78 Reinvigoratingthe PrivatizationProcess 3.45 Following the transfer of the majority of state assets to private hands, the privatization process has become understandably slower and more complicated inrecent years. Nevertheless, a few areas still require attention. Numerous controversies continue to surround the residual state shares inmany privatized enterprises. Verkhovodina, et al. (2004) and Leonov (2004) summarize a number o f related scandals that typically involve "spontaneous privatization." Through various schemes, business groups succeed either in diluting the State's shareholding, or in decapitalizing privately managed but partially state-owned firms through transfer pricing, asset sales, or deliberate debt accumulation. Paskhaver (2003) links the recent wave o f spontaneous privatization to a slower period of explicit privatization since 2001. Inaddition to this problem, the State typically does not have the capacity to provide an effective and independent representation on boards o f directors as a minority shareholder o f these firms.45 Therefore, as has been recommended by numerous specialists and organizations, the Ukrainian government would be wise to sell the remaining packets of state minority shares as soon as possible, preferably through auctions with minimal restrictions. Second, the government should continue its efforts to adopt an explicit strategy for the privatization of remaining state assets for which there is no compelling reason to retain state ownership. This would not only provide a strong impetus to the privatization process itself, but would serve as an additional signal to the business community o f the government's general commitment to private sector development. ContinuingAgriculturalReformandthe Developmentof LandMarkets 3.46 The genuine decollectivization o f agriculture was one o f the most important reforms o f recent years. Given the magnitude o f the reform, the current period is characterized by a rather high degree o f disorganization in many regions. The govemment can help overcome this difficult transitional phase in agriculture by signaling in unambiguous terms its intentions to complete the process of creating and defending rural property rights and the development of private agricultural markets. The development of agricultural land markets will give a major boost to the organization and efficiency o f the rural economy. The ability to use land as collateral would support a healthy expansion o f commercial credit to agriculture, including to smaller farmers. Agricultural reform also raises some key social issues, in particular the need to develop effective social policies to address problems due to shrinking agricultural employment and (often) insufficient local government resources to compensatefor declines in social support thatformerly camefrom large (collective)farms. Improvingthe ManagementandOperationof State-OwnedEnterprises 3.47 The government's role inenterprises that remain in state hands has often been too passive and tolerant o f abuses by management. One example is the large oil and gas conglomerate, Naftegaz. The government would be wise to use its ownership of Naftegaz to require enhanced oversight, more open and detailed financial audits, 45 See Leonov andZhuk (2002) for an analysis ofthis and relatedquestions. 79 comprehensive (unbundled) accounting o f gas production, transmission, storage, and distribution, and the divestiture o f un-related assets. Until such time as detailed and audited unbundled accountingreveals the complete picture inthe gas sector, the effective regulation o f Naftegaz will be extremely difficult. Inaddition, a number of state-owned enterprises continue to operate under weaker financial discipline and softer budget constraints than their private counterparts. Ironically, this can actually place these firms at a disadvantage, as fears o f non-payment compromise their credibility in market transactions. Allowing state-owned firms with soft budget constraints to interact in markets also invites the theft o f state resources through various schemes. Inthe interest o f fair competition andthe protection o f state assets, efforts shouldbe made to place most state-owned enterprises under the same market and payment discipline as their private counterparts. This includes an active role for the state as a dominant shareholder in monitoring managers and replacing ineffective management. Enforcing Basic Standards of Corporate Governance and Disclosures 3.48 Developing standards o f corporate governance in Ukraine consistent with convergence to EUstandards will be an important challenge inthe battle with the insider economy and realization of European Choice. Even to the degree that the government succeeds in passing progressive legislation in this area, business groups will manage to exploit loopholes inthese regulations unless they are themselves interested inprojecting a favorable image inmarkets. As emphasized above, the willingness o fUkrainian business groups to develop higher standards o f corporate governance and disclosures will depend on their overall expectations o f the direction inwhich the country i s moving, and thus the entire policy and reform agenda o f the government. This reform agenda should nevertheless give high priority to the adoption o f requisite laws and regulations in Ukraine pertainingto corporate governance, as well as to encouraging firms to meet even higher voluntary standards that exceed legal requirements as a means o f gaining advantages in interactions on world markets. The adoption by the State Securities Commission in 2003 o f a set o f national principles o f corporate governance represents a positive step inthis direction. 3.49 A recent World Bank analysis (World Bank (2003~)makes a number o f recommendations on basic legislation for joint stock companies and securities markets, including corporate structure (open versus closed companies), ownership verification, disclosures o f shareholders, financial reporting, legal documents, voting rights, and licensing o f security market transactions. An important step toward the fulfillment of these goals will be a progressive Law on Joint Stock Companies. The government has worked on drafting such a law in 2002-03, but no new law has yet been passed through Parliament. Leonov (2004) also emphasizes problems owing to the strong influence o f large financial-industrial groups over regulatory bodies such as the Securities Commission and State Property Fund. For this reason, to increase the costs o f collusion and capture, activities related to corporate governance and securities shouldprobably be 80 monitored closely by at least one other authoritative state body such as the Antimonopoly ~ o m m i t t e e . ~ ~ 3.50 Attention should be given to voluntary as well as obligatory standards o f corporate governance and behavior. As Ukrainian businesses and FIGs become more interested in adopting voluntary guidelines that go beyond existing legal requirements, they might be encouraged if such standards were made a prerequisite for access to some privatization auctions, listings on the stock market, participation in other state programs, or (for commercial banks) NEW refinance. The successful sale by the government of the large Dzherzhinskii steelworks in Dnepopetrovsk in late 2003 under the requirement o f "clean money" may be a positive first example inthis regard. 3.5 1 The better explicit identijkation of connections between various firms and financial organizations through cross-ownership and other ties is a difficult, yet important task for the effective regulation o f corporate governance, competition policy, and the monitoring of commercial banks. The informal nature of most Ukrainian FIGS, together with a common lack o f disclosure o f information on their structures, complicates their effective regulation. The Ukrainian government should consider options for revising the Law on Financial IndustrialGroups in such a manner as to induce existing Ukrainian FIGs to disclose their various ties and networks. Leonov (2004) contains some proposals along these lines. StrengtheningInstitutionsof InsolvencyandBankruptcy 3.52 The further hardening o f budget constraints, together with the development o f strong financial markets and corporate govemance, depend on effective institutions inthe area of insolvency and bankruptcy. For a country like Ukraine, there exist )difficult tradeoffs in conditions surrounding bankruptcy. On the one hand, a quick and easy bankruptcy trigger is useful for enforcing payment discipline and preventing the decapitalization o f insolvent firms before an effective regime o f external control i s established, or bankruptcy declared. On the other hand, an excessively quick and easy trigger can leadto abuses o f the bankruptcy law for corrupt takeovers o f valuable firms at the expense o f some groups o f shareholders and creditors. Evidence suggests that this has indeed been a problem in Ukraine, and recent adjustments to the bankruptcy law attempt to address this problem, partly by increasing the threshold (trigger) level o f claims necessary to file bankruptcy. 3.53 The recent Financial Sector Assessment o f the World Bank and IMF confirmed that the new Bankruptcy Law has strengthened creditor rights, especially with regard to the active participation o f creditors inthe liquidation and reorganization processes. This can be associated with a higher share o f bankruptcy cases initiated by commercial creditors as opposed to State tax a~thorities.~~ But a number o f important problems remain. A World Bank Legal Diagnostic o f 2003 emphasizes that procedures associated 46 Laffont (1999) presents a case on how multiple supervision can reduce the likelihood of collusion and capture inmany circumstances. 47Before 1999, virtually 90 percent o f all cases were filedby the State Tax Authority. 81 withfiling bankruptcies and completing liquidations remain excessively costly and time consuming. (World Bank (2003~)). The same is often true for the ability o f creditors to seize collateral in the event o f secured loans, as already stressed above. The insolvency of firms remaining instate ownership i s another issue that has yet to be solved. E. CREATINGA PUBLICSECTORTHAT SUPPORTSGROWTH AND POVERTY REDUCTION 3.54 Realizing the European Choice Agenda and overcoming the insider economy will require the government to reform itself into an efficient administration under which state officials have a strong interest in promoting a favorable climate for investment and fair competition. Recent survey evidence confirms the continued presence o f serious problems and distortions in the incentives and activities o f state officials and administrations, particularly at subnational levels o f government. As long as these distortions remain, they will create obstacles to the transformation o f Ukraine into an economy based on rule o f law and fair competition. Consequently, the reform o f government itself should represent a critical pillar o f Ukraine's European Choice strategy. 3.55 Despite the recent positive trends, a substantial burden o f economic transition continues to be shouldered by poorer segments o f the population, particularly in rural areas. Inparticular, basic services inhealth and education appear to have deteriorated for that segment o f the population that cannot afford growing formal or informal payments for quality services. The Ukrainian government has correctly prioritized the creation o f a more effective social safety net, together with a restructuring o f expenditures and programs in health and education. The government will need to work on providing the financial means and efficient organization for addressing problems o f social distress and the delivery o f basic public services Completing the Reform of Interbudgetary Relations and Local Government Finance 3.56 Interbudgetary relations remain a key concern for the future development o f Ukraine. Much recent theoretical and applied literature emphasizes the important role o f proper incentives at the subnational level o f government for economic growth and de~elopment.~~The survey evidence examined in the previous chapter confirms that incentives at local levels o f government in Ukraine remain weak. Businesses perceive the activities o f local administrations to be largely detrimental to the business climate and typically in violation o f fair competition. Furthermore, despite recent reforms, this problem may actually be worsening over time. Business surveys also confirm that the de facto power o f local administrations is still substantial, and that good informal relations with local authorities are oftenperceived as necessary for successful business. 48 See, for example, Weingast (1995), Monitola, Qian, and Weingast (1995), Lavrov, Litwack, and Sutherland (2001). 82 3.57 The previous chapters discussed the sources o f incentive problems at lower levels o f government, and concluded that the reforms o f 2000-02 represented an important step in the right direction. In particular, the new formula-based transfer system and the abolishment of (soft) interbudgetary lending decreased the scope for discretionary bailouts o f subnational administrations and promoted greater financial responsibility and planning. Yet this reform remains incomplete and leaves the essential incentive problems at local levels of government unsolved. Important underlying goals o f reform are: P The continued clarijkation of a rational division of autonomy, competency, and responsibility between different levels of government; P The creation of conditions under which local governments will have strong incentives topromote an environment conducive to business, investment, andfair competition in their territories; and P The maintenance of macroeconomic financial control at the top level of government. 3.58 The Budget Code of 2001 did much to clarify a division o f autonomy, competency, and responsibility between different levels o f government. Nevertheless, some complicated issues remain to be resolved. The paper prepared for this CEM on interbudgetary relations (("Improving Inter-Governmental.. ." (2004)) identifies a number o f these issues. One important proposal in this paper calls for a clearer functional division of responsibility between different levels of government. This would end the current practice o f dividingresponsibility for each functional budgetary category between different levels o f government, and shift to the assignment o f entire functional categories to a single budgetary level. For example, there currently exist hospitals o f municipal, district (raion), and oblast subordination. Inaddition to complicating the co-ordination o f a single comprehensive and rational health care program for the region, this creates incentives for local governments to "free ride" on other administrations by under- financing their share o f the medical care infrastructure. ("Improving Inter- Governmental..." (2004)) proposes to solve this problem by shifting all responsibility for medical care to the oblast level. 3.59 In addition to a clear division of responsibility and competencies between different levels of government, a system o f interbudgetary relations that supports favorable incentives at lower levels of government should be consistent with a number o f principles. Perhaps most important are: (9 The delegation of at least some budgetary autonomy along with financial responsibility. Local governments should be able to adjust their own taxes and expenditures on the margin and compete with each other for the attraction of business and investment. (ii) A strong dependence of local budgetary revenues at the margin on local (tax) revenues and growth of the local economy. 83 (iii) An interbudgetary transfer system that operates by formula, as opposed to the discretion of policymakers, and does not accommodate recent changes in local revenue or expenditureswith compensatingadjustments in transfers. (iv) An explicit commitment by the central government not to insure or bail out subnational administrations that default on their obligations. (v) The enforcement of free movement of goods andfactors between regions, i,e., the prevention of regional barriers to trade and investment. 3.60 These five principles are interrelated and, to a large degree, require simultaneous implementation. In fact, movement in only one direction can lead to adverse results. Many examples from recent history, particularly in Latin America, highlight the dangers of delegating autonomy to lower levels o f government in circumstances when interbudgetary transfers are "soft" and the central government cannot commit not to bail out regions infinancial trouble.49 3.61 The current system o f interbudgetary relations in Ukraine satisfies condition (ii) to some degree by making local budgets dependent on income tax, land tax, and other local revenues. This is particularly the case for larger cities, where the average share o f tax and own revenues (as opposed to transfers) inlocal budgetary expenditures i s close to 80 percent. In fact, a greater interest o f local administrations in local tax revenues may have contributed to recently improved rates o f income tax collection. On the other hand, as discussed in Chapter 2 and the contribution to this C E M o f Leshchenko (2004), the average dependency o f local budgetson transfers has actually increased inrecent years. 3.62 While the introduction of a formula-based transfer system and the elimination o f soft interbudgetary loans represent major steps toward the establishment o f condition (iii), oftheseareasstillrequireattention. Thetransferformula stillmakesthesizeof both current transfers strongly dependent on recent past budgetary performance, thereby weakening incentives for increasing official revenues or economizing on expenditures. Thereintroduction of (medium-term) interbudgetary loans in the 2004 budget in violation of the Budget Code is also an issue of major concern that could potentially set the clock backfor Ukrainein this area. 3.63 The development of budgetary autonomy at lower levels o f government (condition (i)) i s a major outstanding issue. The expenditure side o f the budget appears to be o f relatively less concern. Local budgets, particularly those o f large cities, have already received a significant degree o f autonomy for the adjustment o f allocations within broadly defined categories. The new subvention facility has also eased the burden on local administrations from centrally-mandated expenditures. On the other hand, there currently exists little incentive for local administrations to economize on expenditures financed through these subventions by checking the satisfaction o f eligibility ~~ 49 Onthis topic, see Prud'homme,R.(1995) andRodden, J., Eskeland,G.S., andLitvak, J.(2003). 84 requirements or other means, as this would only lead to a perceived decrease in future subventions. 3.64 On the revenue side, as highlighted in Chapter 3, local administrations still have exceedingly little means o f affecting their own (official) budgets, as the vast majority of local receipts consist o f shared revenues from central taxes, other tax rates set by the central government, and transfers. Untilsuch time as local governments can control their own explicit tax revenues and policies within reasonable bounds, it will be exceedingly difficult to delegate genuine financial responsibility to the lower level, and local governments will continue to conduct their own implicit fiscal policies through informal "shadow budgets" that typically foster corruption and adversely affect the business environment. Various options exist for the expansion o f tax autonomy at lower levels o f government within well-defined bounds. There is much variety in the specific types of local budgetary autonomy that exist in different countries o f the world, and optimal arrangements may very well depend on country specific factors.50 World Bank (2003b) and ("Improving Inter-Governmental, .." (2004))propose the creation of a local property tax and local control over part of the income tax. These are issues that deserve the serious attention of the Ukrainiangovernment. 3.65 The development o f budgetary autonomy at local levels o f government within well-defined bounds can hopefully boost incentives for responsible budgetary management, support a strong link between budgetary revenues and the development o f the local economy, and increase the competition between regions for business and investment. This latter objective should be supported by a strong effort of the central government and Anti-Monopoly authorities to ensure the compliance of regional and local administrations with national legislation, including the prevention o f possible regional protectionism in the form o f barriers to the movement o f factors and goods. Competitive tenders for state investment projects, if designed correctly, could also play a potential positive role inthis area (see Leshchenko (2004)). The recent experience o f the Russian Federation with a special transfer facility that rewards specific progress in key reforms at the regional level also deserves consideration for the case o f Ukraine. 3.66 ("Improving Inter-Governmental..." (2004)) raises another fundamental question for the next stage o f reform in interbudgetary relations. So far, the formula has only covered transfers from the central government to oblasts, raions, and larger municipalities. Smaller cities, towns, and rural settlements continue to receive transfers from the raion level as in the past. ("Improving Inter-Governmental ..."(2004)) notes potential gains from expanding the formula-based transfer approach to these additional local administrations, but correctly notes that these local units are currently too numerous and diverse a group for this purpose. Thus, the general expansion o f a central formula- based transfer system to the lowest level o f government would likely require mergers or reorganization o f many existing municipalities. ("Improving Inter-Governmental..." (2004)) contains some interesting initial thoughts and recommendations on this difficult question, which deserves muchmore attention and investigation inthe near future. 50 Some of theseissues are covered well inBird(1999). 85 The ReorganizationandRestructuringof Social Expenditures,Assistance, and Services 3.67 Currently, local budgets in rural and poorer areas often lack the capacity to provide acceptable levels o f social assistance to the poorer segments o f the population. In many cases, the recent decollectivization of agriculture has also decreased or eliminated social expenditures formerly taken within larger farms. For this reason, the Ukrainian government might consider the possibility o f centralizing financial responsibility for a larger share of social assistance to either the oblast or central government level. This would facilitate addressing regional inequalities in poverty and basic service provision in a comprehensive and rational manner. The restructuring o f government expenditures in the social sphere as part o f a medium-term budgetary framework discussed above could increase the share o f resources received by genuinely needy families.. ReformingPublicAdministration 3.68 The incentives and effectiveness o f government officials can also be improved through changes in the public administration system. Inparticular, the base salaries of public officials making important budgetary andfinancial decisions should be increased, along with more effective monitoring and a crackdown on corruption. The current system of pay for higher level civil sewants lacks transparency and gives excessive weight to variouspay increments and bonuses relative to base salaries. This presents an important barrier to the development o f an impartial and ethical civil service. This i s different than in EU countries. Ukraine will also need to adjust a number o f other practices inthe civil service inthe direction of EUstandards, and has already launchedan initiative inthis area. ImprovingExternalandInternalFinancialAudit andControl 3.69 Ukraine has done much in the previous decade to create a functioning system o f both internal and extemal audit and control of government finance. The most important accomplishments include the development o f a state treasury system and the powerful internal State Audit and Inspection Service. The realization of European Choice will nevertheless require additional efforts to implementEUstandards ininternal and extemal financial auditing and control. This direction of reform also promises good dividends for the overall effectiveness and transparency of government finance. Outstanding issues include better clarijkation and stability in the rules governing financial responsibilities of ministries and auditing bodies, expanding external audit to include budgetary revenues and the management of state property, andfocusing more attention on the evaluation of the effectiveness of public expenditures. In this light, the government approved a Strategy in July 2003 for further development o f the system o f financial accountability and control. 86 F. THEDETERMINEDPURSUITOFRAPIDINTEGRATIONWITHTHEEUANDWORLD ECONOMY 3.70 The Ukrainian government was wise to make EUintegrationa central pillar o f the reform agenda. In addition to the direct gains from trade and market access, the determined pursuit of this agenda can play a decisive role inthe overall transformation of the Ukrainian economy, inducing FIGSand other organizations to change their strategies toward boosting intemational reputations and achieving competitiveness on world markets. The value o f this transformation serves to justify sometimes sizeable short-run costs of adjusting standards and regulations in areas such as intellectual property rights and product quality. The strong orientation o f the Ukrainian economy toward the politically sensitive areas of metals, food, and agriculture also underlines the importance for future economic growth o f improving trade relations and achieving free trade agreements with the EU and neighboring countries. It is thus important that the government continues to give strong and unambiguous signals inthis area. 3.71 Joining the WTO will be the next step for achieving deeper integration with the EU and world economy. It will also help Ukraine receive fairer treatment in anti- dumping and other issues that potentially restrict access to foreign markets. The vital importance o f WTO membership has been emphasized quite appropriately ina number o f studies.51 Ukraine has already made some strong efforts in this direction. By July 1, 2004, the government had negotiated 24 bilateral protocols on market access needed for entry to the WTO. As of the beginning o f 2004, however, a number o f issues still remained to be resolved in areas such as intellectual property rights, and pockets o f political resistance persist inUkraine to the specific prerequisites for WTO accession. It will be important for the government to continue to signal in a strong and unambiguous manner its determination to join the WTO as quickly as possible. Along with WTO accession, Ukraine i s also actively pursuinga free trade agreement with the EUunder the umbrella o f an Agreement on Partnership and Cooperation o f 1998 and the EU "Wider Europe-Neighborhood" initiative for the region. This would be highly advantageous for the future development o f the country. Discussions with the EUhave also focused on a broader agenda that could make Ukraine eligible over time for the EU's "four freedoms" o f capital, goods, services, and labor. 3.72 European Choice and the overall goal o f forging an independent path o f rapid development elevate free trade and other agreements on economic integration with the EUto the status o f first priority. Yet trade with Russiaandthe CIS will continue to be o f primaryimportance to Ukraine as well, and the CEM particularly highlights the costs o f trade barriers with Russia. Therefore, it is to Ukraine's advantage to work toward improving trade relations with Russia and the CIS, although in a manner that does not contradict the European Choice imperative. As stressed by the President inhis European Choice address, freer trade with Russia and the CIS does not contradict the focus on greater integration with the EU. There are gains from trade that all countries can profit from. On the other hand, the creation o f a customs or currency union, as has been proposed by Russia, would pose obvious barriers to WTO accession and economic 5 1See, for example, AHT ConsultingGroup(2002) andAslund (2003). 87 integration with the EU. A number o f specific policy complications owing to simultaneous trade liberalization with non-CIS and CIS countries may also need to be addressed on an individual basis. But the overall active pursuit o f free trade with boththe non-CIS and CIS would seem to represent the most constructive approach for Ukraine at this point intime. 3.73 The government can give another strong signal to the country on the direction o f change through an aggressive continuation of the process of bringing overall laws and standards in line with EU requirements. This will nevertheless be a long process, and strategic issues o f sequencing are important. For example, it is not at all clear that Ukraine would profit at the present time from rushing into the adoption o f EU standards for the labor market. In fact, EU enlargement should boost the competitiveness o f Ukraine by increasingrelative labor costs inneighboring countries. G. CONCLUSION 3.74 Ukraine currently stands at a crossroads where govemment initiative can be critical for determining the path o f future development, the potential for the economy to continue to grow at a rapid pace into the medium and longer term, and the speed o f integration into the world economy. The overall skill and effectiveness that the government has demonstrated in economic policy since 1999 offers hope that it will cope well with the new formidable challenge o f coming years. The Ukrainian government should seize the opportunity presented by the favorable current trends to create a foundation for the future successful development o f the country. 88 ANNEX: THE UKRAINIANBALANCE OF PAYMENTS AND FOREIGNTRADE 1. Foreign trade and the balance o f payments play a central role in the Ukrainian economy. The contribution o f Pindyuk and Piontkivsky (2004) to this C E M examines the relationship between foreign trade and the recent growth in Ukraine in some detail. This Annex provides some supplemental information on general trends inthe balance o f payments and Ukrainian foreign trade. 2. A sharp contraction of imports in 1998-99 and a subsequent expansion of exports altered significantly the balance of payments picture inUkraine (Table A.1). In 1997, a current account deficit o f US$1.3 billion was offset by strong short-term portfolio capital inflows (US$ 1.6 billion), primarily to the government bond market. The post-crisis balance o f payments picture has been the reverse. A growing current account surplus has supported a weak capital account. Preliminary data from 2003 indicate the beginning o f a possible modest trend in the other direction. In 2003, the current account weakened somewhat due to very rapid import growth, while the capital account became a bit stronger. 3. While the initial major current account adjustment came from the elimination o f the goods trade deficit, the strengthening o f the current account since 2000 has been due primarily to other factors, most notably rapidgrowth incurrent transfer inflows. Most o f this increase appears to be coming from remittances by Ukrainians living abroad. Net inflows o f transfers reached an estimated record US$2.2 billion in 2003. The service balance has also strengthened, partly on the basis o f higher revenues from pipeline transportation (US$1.75-2 billion inannual foreign revenues in2000-02). . 4. Figures from 2003 suggest that capital outflows from Ukraine may have finally started to decline, although the capital account remains weak ingeneral. Current account inflows o f US$8.7 billion over the period from January 2000 to December 2003 can be associated with a build-upo f US$5.1 billion in gross foreign reserves, indicating that net capital outflows amounted to US$3.6 billion. Roughly US$1 billion o f these net outflows represent repayments to the IMF. Remaining outflows enter the balance o f payments as negative "errors and omissions," as well as in negative portfolio and other investment. Through 2002, high and increasing net portfolio investment outflows were categorized primarily as net purchases o f Ukrainian securities from foreign organizations. This has been a common device of Ukrainian firms for transferring funds and assets to affiliates registered abroad. New regulations have limited these opportunities in 2003, although deterioration inthe "other investment" balance suggests that some o f these outflows may have continued through other means. Nevertheless, a decline in indirect investment outflows, along with a doubling in net direct foreign investment, strengthened the capital account in 2003, and supported a rapid build-up in foreign reserves. Accounting for errors and omissions, net capital inflows remainednegative, however. 89 Table A.1: The Balance of Payments of Ukraine USDmillion ,alanceof payments items 1997 1998 1999 2000 2001 2002 2003 'URRENTACCOUNT ~ ~ 9 3 2 1 2 3 7 ~ 3 1 2891 - 7 3 ;OODSAND SERVICES(balance) -1536 -1207 1095 1331 613 1857 1288 EXPORTSOF GOODSAND SERVICES 20355 17621 16332 I9278 21086 23351 28953 IMPORTS OF GOODSAND SERVICES -21891 -18828 -15237 -I7947 -20473 -21494 -2 7665 :OODS (balance) -4205 -2584 -482 535 198 710 -269 EXPORTSOF GOODS 15418 13699 12463 15478 17091 18669 23739 IMPORTS OF GOODS -19623 -16283 -12945 -14943 -16893 -17959 -24008 ERVICES(balance) 2669 1377 1577 796 415 1147 1557 EXPORTS OFSERVICES 4937 3922 3869 3800 3995 4682 5214 of whichpipeline transportation 1893 1868 I750 I703 I934 IMPORTS OFSERVICES -2268 -2545 -2292 -3004 -3580 -3535 -3657 INCOME(balance) -644 -871 -869 -942 -667 -606 -581 CURRENTTRANSFERS(balance) 845 782 706 848 1456 1922 2184 :APITALAND FINANCIALACCOUNT - - - 1413 -993 -163 - - -1050 -516 -188 247 :APITALACCOUNT 0 -3 -10 -8 3 15 -17 'INANCIALACCOUNT 1413 -990 -153 -508 -191 -1065 264 DIRECT INVESTMENT 581 747 489 594 769 698 1411 PORTFOLIOINVESTMENT 1603 -1031 -86 -201 -866 -I716 -922 OTHERINVESTMENT -771 -706 -556 -901 - - - - -785 -810 -954 -150 - - -94 -47 -225 IET ERRORSAND OMISSIONS -231 -885 -953 - IALANCE -707 -3099 -185 571 983 1238 2185 'INANCING 707 3099 185 -571 -983 -1238 -2185 LESERVEASSETS - - - -383 1324 -283 -398 -1606 -1045 - - -2045 Jse of IMFcredits (net) 285 275 78 -604 -79 -191 -215 drawings 285 381 635 245 375 0 0 repayments 0 -106 -557 -849 -454 -191 -215 'otal exceptional financing 805 1500 390 431 702 -2 75 ~ Jotes: ,Excluding the value of the goods handedover to the RussianFederationfor payment of debt obligations: in 1999, to the amount ofUSD726 million accordingto the Black Sea FleetAgreement; in2000, to the amount of USD274 million for paymentof debtsofthe NJSCNaftogazto the OJSC Gazprom, ,In2000, excludingmutualoffsetofpaymentswith the RussianFederationinpaymentfor thepublic externaldebt fUkraineaccordingto the agreementbetweenthegovemmentsofUkraineandthe RussianFederationas of28 May 997. r'ationalBank of Ukraine 5. Table A.2 presents the structural breakdown of the dollar value of Ukrainian exports of goods to the CIS and non-CIS regions through 2002. By the end of 2002, the value of Ukrainian goods exports was roughly 25 percent higher than its pre-crisis value in 1996, and 50 percent higher than in 1999. Of the 25 percent growth inthe value of exports since 1996, the decomposition into prices and quantities reveals that roughly 60 percent of this increase came from higher quantities and 40 percent from price increases. 90 Table A.2: The Structure of Ukrainian Goods Exports I Growth I 1996 1997 1998 1999 2000 2001 2002 2003' HI 200211996 index otal, US$ million 14400.8 14231.9 12637.4 10332.7 14572.6 16264.7 17957.1 10309.7 124.7 'otal I00 100 I00 100 100 100 I00 100 Agriculturaland food products 21.2 12.7 10.9 12.2 9.5 11.2 13.3 11.8 78.4 to non-CIS 5.8 4.0 5.8 8.0 to CIS 6.4 5.5 5.4 5.3 Mineral products 8.6 9.0 9.2 10.1 9.6 10.8 12.5 16.9 160.4 to non-CIS 9.0 8.7 9.6 11.3 to CIS 1.1 0.9 1.2 1.2 Chemicals 11.6 10.6 10.1 9.3 10.6 9.1 7.8 8.4 83.4 to non-CIS 5.4 6.0 5.5 5.1 to CIS 3.9 4.6 3.6 2.7 Wood and Pulp&Paper 0.4 0.4 0.8 1.3 1.5 I.4 1.6 1.8 522.1 to non-CIS 0.8 0.9 0.7 0.9 to CIS 0.5 0.6 0.7 0.7 Textile and Apparel 2.7 3.2 4.0 3.9 3.7 3.8 3.6 3.2 171.0 to non-CIS to CIS Metallurgy 33.1 41.5 42.2 42.2 44.4 41.3 39.7 37.4 149.6 to non-CIS 34.7 34.3 32.7 33.9 to CIS 7.5 10.0 8.6 5.8 Machineryand Equipment 14.2 13.4 13.6 11.4 12.3 13.9 13.6 12.9 119.9 to non-CIS 4.8 4.6 5.8 5.9 to CIS 6.7 7.7 8.1 7.8 Other 8.3 9.3 9.2 9.5 8.5 8.5 7.8 7.6 118.4 to non-CIS 6. Metals, particularly steel, continue to occupy a central place in Ukrainian trade, and currently account for close to 40 percent o f the value o f all exports. This share has been falling steadily in recent years, however. Table A.2 indicates that this declining trend owes much to a sharp decline in metals exports to the CIS region (Russia) since 2001. The very rapid growth o f mineral products represents the most notable new positive trend inUkrainian exports. Mineral products reached 17 percent o f the value o f goods exports in the first half o f 2003. This increase consists almost entirely o f processed oil, and followed the sale o f most o f this industry to Russian investors and considerable restructuring. Light industry and, particularly, wood and paper have also been increasing exports at a rapid pace, although they still account for a small share o f the total. Exports o f machinery and equipment have also begun to expand significantly in recent years. The traditional export sector o f chemicals has been the most sluggish in exploiting the recent favorable trends. In 2002, the dollar value of exports in that industrywas still 17 percent below pre-crisis levels. Figure A.1illustrates the dynamics o f Ukraine's main export commodity groups in quantity terms from 1996 to 2003 (projections). 91 Figure AI:Ukraine's Main Industrial Exports(quantity indecies:Q196=100) 320 270 -Mineral products 220 -Chemicals - Ferrousmetallurgy 170 120 70 20 7. As shown in Figure A.1, while steel was a leader in growth among Ukraine's main export industries from 1996-2000, the subsequent periodhas been quite different. Additional growth in the value o f metal exports has come almost entirely from higher prices, while quantities have been relatively flat. Mineral products (refined oil) have led the quantity surge in exports in recent years. While the weakness o f machinery and equipment inFigureA.1 may appear a bit surprising, this is most likely due to limitations inthe 4-digit Harmonized System quantity index derived from that particular industry.52 Therefore, the quantity index for exports o f machinery and equipment is likely to be a much poorer estimate o f trends inthat sector relative to the more homogeneous products insteel, refined oil, andchemicals. 8. Ukrainian imports have recently recovered to pre-crisis (1996) levels, although their structure has changed significantly (Table A.3). Over 40 percent o f imports continue to be dominated by energy coming from the CIS (Russia and Turkmenistan). But the composition o f these imports is now quite different. Despite economic growth, the value o f natural gas imports has fallen by over 40 percent since the pre-crisis years. Onthe other hand, oil has come to occupy a substantially larger share o f imports inrecent years (20 percent), which can be associated with the rise o f the oil processing industry in Ukraine. Russian investors now import large amounts o f crude oil into Ukraine for refinement and export to the non-CIS region. Nevertheless, on balance, mineral products as a whole now account for a smaller share o f imports than before the crisis. ~~ 52This indexmeasuresbroad categories of machinery and equipment intons, and a good part of the higher prices received for exported tons of machines i s most likely due to quality improvements or fundamentally new products. 92 Table A.3: The Structure of UkrainianGoods imports Growth index 1996 1997 1998 1999 2000 2001 2002 2003'Hl 2002/1996 otal, US$ million 17603.4 17128.0 14675.6 10385.4 13956.0 15775.1 16976.8 9865.1 96.4 otal 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 -ood and Agriculture 8.2 5.2 7.2 7.2 6.5 7.1 6.6 7.3 76.9 from non-CIS 6.1 5.2 5.3 5.2 from CIS 1.I 1.3 1.8 1.4 Mineralproducts 49.9 47.6 43.1 48.3 46.9 42.6 41.5 ' 40.6 80.3 of which gas 35.7 32.1 26.7 29.6 26.1 21.8 21.4 17.4 57.7 Oil and oil products 9.8 12.1 14.0 13.6 16.6 19.1 19.8 19.1 194.8 from non-CIS 3.5 3.6 2.6 2.6 from CIS 44.7 43.3 40.0 38.9 Chemicals 5.8 7.3 6.8 6.6 6.4 7.1 8.1 7.9 134.0 from non-CIS 4.6 4.6 5.3 6.3 from CIS 2.0 1.8 1.9 1.8 Wood and pulp&paper 2.9 2.9 3.2 3.4 3.1 3.9 4.5 3.9 149.8 from non-CIS 2.1 2.0 2.4 3.2 from CIS 1.3 1.2 1.5 1.3 Textile and apparel 2.8 2.9 3.7 3.9 4.0 4.1 4.0 3.8 135.7 from non-CIS from CIS Metals 4.5 3.9 4.3 3.4 4.9 5.2 4.8 5.1 102.4 from non-CIS 1.7 2.4 2.4 2.1 from CIS 1.8 2.4 2.8 2.6 Machinery and Equipment 16.9 20.2 21.6 17.1 17.5 19.8 20.8 22.0 118.3 from non-CIS 11.1 11.1 13.1 15.0 from CIS 6.0 6.4 6.7 5.8 Other 8.9 10.1 10.2 10.1 10.7 10.1 9.8 9.4 106.1 9. 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