ARCHIVES Danyliw Seminar 2014
The Challenge of Economic Reforms
The IMF and EU Challenge: Can Ukraine Afford Reforms?
In The Shock Doctrine: The Rise of Disaster Capitalism, Naomi Klein argues that the International Monetary Fund (IMF) and the US Treasury take advantage of countries undergoing massive crises to force radical neoliberal economic reforms. In the grip of a severe crisis, countries have no choice but to take the tough economic “medicine” that these organizations dole out. It is difficult not to see contemporary Ukraine in this context.
The international financial institutions clearly have Ukraine over a barrel. After many years in which Ukrainian officials deceived the IMF by promising tough economic reforms, such as cutting massive consumer energy subsidies or fighting corruption, or imposing the rule of law, and then absconding with the money and failing to do what it promised, Ukraine has lost the ability to play games. It desperately needs IMF funding and European Union (EU) support or it will fall into the hands of Russia. Ukraine is finally between a rock and a hard place.
Whereas Ukraine always felt it could ignore the international financial institutions and fall back on patterns of economic behavior that enabled its corrupt oligarchy to move forward unhindered, while paying off the poor with transfer payments and cheap gas, this post-Soviet economic formula has worn out. Now, rejecting the IMF means falling into the arms of Russia, which would provide bailout funds only in exchange for taking ownership of key assets, no longer the Sevastopol naval base, but the military industrial complex of the Donbas, the steel mills of Eastern Ukraine, and the pipeline network that unreliably delivers gas to the West. Not to mention the presidency, the government, and the security services of the state. This price has proven too great for even the most corrupt and venal president of Ukraine and its oligarchs to pay.
So, Ukraine is stuck with the IMF, which has provided some $18bn to Ukraine to enable it to survive its economic crisis with enough dollars to finance foreign trade, prevent the banking sector from collapsing, and allow the government to resolve the gas debt with Russia and purchase enough fuel for the winter, if Russia allows. This assistance, given in small “tranches” every few months, and the even greater funds that will be required in future years, is contingent on Ukraine enacting “necessary” reforms. The tough medicine is coming.
What are these reforms? Can Ukraine afford them?
Will they work?
In a sense, it is wrong to call them “reforms.” What the IMF and European Union, whose accession agreement with Ukraine is a key element of the upcoming changes, call for is a wholesale economic revolution. It is a mega makeover, a thorough transformation. Ukraine’s economy should be unrecognizable after.
While the IMF casts reform of Naftogaz’s subsidies as an issue of simple fiscal discipline, the real objective is much broader: to wean Ukraine off the gas subsidies that Russia and various Ukrainian middlemen have kept the country subjugated to their control. Ukraine’s need for gas subsidies has enabled Russia to control Ukrainian governments and government policy by offering to keep the gas flowing at a particular price – and a portion of gas revenues flowing to the right politicians – in exchange for compliance. Gas sector reforms – including the elimination of Naftogaz subsidies to consumers, IMF financing, and European Union help with negotiating a gas deal with Russia, are intended to set a predictable price for Ukrainian gas imports, make sure that Ukraine has the means to pay it, prevent Ukraine from siphoning off gas in an attempt to unilaterally reduce the price it pays for Russian gas, stop using gas middleman to illegally enrich political leaders, stop providing massive subsidies to gas consumers that cost approximately seven percent of GDP and encourage the country to enact the conservation and rationalization measures to reduce consumption. By doing so, Ukraine will become a more reliable conduit for the export of Russian gas to the European Union. The European Union will also work to enable energy diversification in Ukraine through a variety of means. At the same time, this wholesale reform of Ukraine’s energy policy will be painful. Russia is unlikely to agree to a gas deal anytime soon and Ukraine now anticipates a nearly 25% reduction in gas usage this winter.
In addition to sudden and massive changes in Ukraine’s energy policy and the Naftogaz budget, the IMF has already been forced to change the way it manages its currency. Prior to the IMF package in April 2014, the government sought to stabilize the hryvnia exchange rate at around eight to the dollar. The IMF insisted, however, that the hryvnia be allowed to float, which caused the currency to devalue by about 60 percent to around 14-16 to the dollar today, increasing the prices Ukrainians must pay for foreign products, including gas, and making domestic products cheaper to sell abroad. This rapid decline in the value of the currency forced consumers to cut consumption and increased price inflation to about 19 percent. It also set the stage for a future export boom by making Ukrainian products less expensive in foreign markets. It also made Ukrainian assets cheap for foreign investors, though capital has been fleeing the country so far, not returning. From a Naomi Klein perspective, which has been picked up by Russian propaganda and domestic critics, Ukraine has been forcibly impoverished, turned into a cheap workshop serving foreign markets. Sensitive to these criticisms, the IMF now believes that the hryvnia has declined too much and is supporting the imposition temporarily of capital controls to prevent it falling further. Currency declines also make foreign debt more expensive to service and economists are now worried that Ukraine will not be able to service its growing foreign obligations.
Speaking of Ukraine’s external obligations, Ukraine is scheduled to change its export and trade regime in January 2016, when the Deep and Comprehensive Free Trade Agreement with the EU comes into effect. The DCFTA does not amount to joining the EU customs union. In a way, it is more favorable. It enables Ukraine to enjoy free trade within the EU without imposing its external tariffs on outside trade. In contrast, Poland enjoys free trade within the EU, but imposes EU external tariffs on trade with others. Turkey’s free trade agreement with the EU does not allow as unfettered access to EU markets. Thus Ukraine should be in an enviable position after January 2016. Yet, at the same time the DCFTA complicates trade relations with Ukraine’s second largest trade partner, Russia. Ukraine cannot join both the DCFTA and the Eurasian Union, forcing a choice that has been at the heart of political turmoil in Ukraine. The reason is that the Eurasian Union (and eventually the EU after membership) requires that Ukraine impose a common external tariff. The DCFTA does not force Ukraine to choose, but the Eurasian Union does. And, once Ukraine enacts the DCFTA, it would enable EU goods to move into the Eurasian Union countries without external tariffs, unless new tariff barriers were erected, as Ukraine currently enjoys free trade with Russia. Therefore, Ukraine’s move towards Europe necessarily means moving away from Russia, if Russia wishes to maintain tariff barriers with the European Union. Another way of putting it is that EU integration for Ukraine forces Russia and other countries that trade with Ukraine to consider opening their markets to the EU. For Ukraine, the DCFTA is a great deal, except for the poison pill of complicating its relations with Russia. One can think of the DCFTA as a potential payoff to Ukraine for enacting difficult and costly reforms in many other areas.
Another set of reforms pushed by both the IMF and EU involve wholesale changes to Ukraine’s public administration. These are broad-based and aim to root out a culture of corruption, to make state institutions function more effectively, and to create a strong and competent civil service that is capable of making decisions and implementing them in an manner compatible with the rest of Europe. The Ukrainian state is to be thoroughly transformed. This will be a very tall order, but the EU and IMF are serious about rooting out worst practices of the past and giving Ukraine a functional state. This requires legislative, normative, and administrative changes to increase transparency and create European standards for state behavior. While it is true that no Central or East European state has achieved these goals perfectly, all have done better than Ukraine, so the hope is that, under EU tutelage, Ukraine can radically improve.
In addition to radically altering its energy strategy, its trade stance, its currency, and its state administration, Ukraine faces significant reforms to other economic sectors, such as banking and agriculture, that will align Ukrainian practices with those of the European Union. Banking sector reforms will seek to identify and address problem banks, those with weak balance sheets and uncertain future prospects, as well as those banks that have served as illegal conduits for money laundering and stashing corrupt rents abroad. The IMF and EU seek to keep foreign banks involved in the Ukrainian economy. Agricultural reforms seek to reorganize land management and unlock Ukraine’s enormous potential as an agricultural exporter.
In addition to a wide range of sectoral economic reforms, the international financial institutions are also supportive of Ukraine’s need to increase military spending to keep its industry intact. This is a departure for the international financial institutions, which normally seek to get countries to reduce defense spending. Yet, in the case of Ukraine, it is widely acknowledged that the country needs to spend money on defense in order preserve the integrity of the country and thus increase the probability it will repay its loans.
Can Ukraine afford these extensive reforms?
Ukraine is no longer in a position to ignore, derail, or prevent reforms recommended by the IMF and EU. But can Ukraine afford them without catastrophic effects and an economic collapse? Shock therapy reforms are known to hurt economic consumption before they improve it. A large part of that adjustment has already happened, as the hryvnia has fallen to very low levels. So, the population has suffered and will suffer for the foreseeable future. Ukraine’s economic salvation will come from exports of its raw industrial goods, such as steel, its agricultural produce, and its people. The incentives for Ukrainians to work abroad and send remittances home has increased with the decline of the national currency. Not only will households face challenges in balancing their budgets, but the state as well will face difficult tradeoffs in coming years, managing to pay for the war in the East, greatly increased demand for social transfer payments, and debt and gas payments that have suddenly increased in hryvnia terms. This is why Anders Aslund recently penned an article in Financial Times calling for a “Marshall Plan” for Ukraine. He insisted that Ukraine will not be able to service its debt payments if all the money it needs from the international financial institutions must be repaid with interest. Instead, the international financial institutions are likely to use this mountain of new debt as leverage to force Ukraine to enact reforms and forgive it in part as necessary, on the basis of periodic visits. Ukraine will be a ward of the Western countries and international financial institutions for the medium term, reliant on them to heat its houses, to manage its obligations, and to give it one day the means to stand on its own through export-led growth.
None of this would be possible without a Ukrainian government that supported “reforms” or rather the economic and state revolution about to be imposed on Ukraine from above. The elections of October 26 appear to have returned just such a government, determined to grasp the one final chance Ukraine has to transform itself in the manner that Poland did back in 1989. These elections again marginalized extremist voices and gave an enormous victory to the party of Poroshenko and the party of Yatseniuk, who are the most action-oriented pro-Western figures on the Ukrainian political landscape today. Ukraine will have its chance, its shock therapy, thanks to Vladimir Putin, who has convinced the average Ukrainian that the country has no choice but to turn to the West.