2 – Ukraine’s fiscal arithmetic
BSSB.BE http://www.bruegel.org 30.06.2015
Ukraine is struggling with both external aggression and the dramatically poor shape of its economy. The pace of political and institutional change has so far been too slow to prevent the deepening of the fiscal and balance-of-payments crises, while business confidence continues to be undermined.
ALTERNATIVE ADJUSTMENT STEPS
Being reluctant to make a far-going systemic adjustments to energy subsidies and the pension system, Ukrainian authorities had to look for other ways to increase revenues and cut expenditure as part of the new programme. The adjustment package includes combination of both types of measure.
Some, such as elimination of subsidies to the coal industry, reduction of employment in the budgetary sphere and public administration or broadening the property tax base are steps in the right direction. Other proposals look more controversial.
In particular, there are plans to reintroduce a progressive scale of personal income tax (as compared to the flat rate in recent years) and a temporary import duty surcharge. The latter would be an additional import barrier (on top of almost three-fold devaluation of hryvnia) for an economy that is strongly dependent on imports, both in the consumption and production sectors.
Together with postponing the implementation of the deep and comprehensive free trade agreement (DCFTA) with the EU until 2016, this will slow down the restructuring of the Ukrainian economy and the reorientation of its foreign trade.
It also violates at least the spirit of the DCFTA and Autonomous Trade Preferences granted to Ukraine by the EU for the transitory period up to the end of 2015.
THE FINANCING GAP, DEBT RESTRUCTURING AND LONG-TERM DEBT SUSTAINABILITY
Ukraine’s relatively slow pace of fiscal and macroeconomic adjustment creates large borrowing requirements. The IMF (2015, p.12) estimates a financing gap of $40 billion in 2015-18, with more than half ($21.4 billion) falling due in 2015. This might again be (like the 2014 SBA) an overly optimistic estimate.
The first source of risk relates to the expected GDP dynamics. In January-April 2015, Ukrainian GDP declined by 17.6 percent compared to JanuaryApril 2014 (Ustenko et al, 2015). The steepest decline was recorded in construction (-34.2 percent) and industry (-21.5 percent). As result, in the course of the EFF First Review completed in May 2015, the IMF increased the expected GDP contraction in 2015 from -5.5 percent (as assumed in the original version of the EFF) to -9 percent.
The 2 percent GDP growth projected for 2016 remains under question. There are other risks, especially of a geopolitical and security character: continuation of the war in Donbass and its possible spread to other territories.
However, even the currently estimated financial gap of $40 billion might not be fully financeable. The IMF, World Bank, European Union and other multilateral and bilateral donors have pledged only $24.7 billion. The remaining $15.3 billion should come from the so-called debt operation, ie the restructuring of public external debt in the form of Eurobonds held by foreign creditors.
Even if the debt agreement is signed soon, it will close Ukraine’s access to private markets for years. It might also discourage FDI and other forms of private capital inflows that are so badly needed to restructure and modernise the Ukrainian economy.
Furthermore, when one looks at the EFF medium-term fiscal projection, the question arises of how Ukraine will be able to finance the continued fiscal deficit of more than 2 percent of GDP and refinance its public debt exceeding 80 percent of GDP after expiration of the EFF at the end of 2018.
It is worth remembering that Ukraine faced problems before (1998-99, 2008-09, 2014) with private market access when it had much lower public debt-to-GDP ratios.
The EFF programme only partly addresses the structural and institutional reforms that are so important for the modernisation and consolidation of the Ukrainian state and the return of the Ukrainian economy to a sustainable growth path.
This reflects generally slow and sometimes contradictory changes in this area. Since the collapse of the Yanukovych regime in early 2014, the new authorities have made some progress in areas such as business deregulation (streamlining registration procedures, limiting numbers of permits and inspections), simplification of the tax system (elimination of various distorting taxes of marginal importance), strengthening corporate governance (especially in relation to state-owned enterprises), transparency (broader access to public information), public procurement and amendments to anti-money laundering laws.
Nevertheless, this is still too little (and often too slow) progress to ensure sufficient changes in the Ukrainian economy and governance structures. In several important spheres, the major reform agenda is still lagging far behind. This includes, for example, the reform of the judiciary and lawenforcement agencies, local and regional government, fighting corruption, bank restructuring, comprehensive business deregulation, civil service reform, tax and customs administration and tax collection procedures and privatisation of state-owned enterprises.
INTERNAL POLITICS AND THE POLITICAL ECONOMY
There is no problem of lack of pro-reform political mandate, but there is a question of effective reform leadership. This also involves the question of policy coordination between the president and prime minister (in the context of an unclear demarcation of their responsibilities), between the government and the Rada (parliament), and within the government coalition.
Numerous incidents of spontaneous legislative initiatives in parliament, including the example of a law aimed at restructuring foreign-currencydenominated loans at very favourable exchange rate (for debtors), which would ruin the banking system and state budget8, point to serious problems in this area.
Obviously, the conflict with Russia distracts attention, political energy and resources from the domestic reform agenda. However, it also helps to consolidate and mobilise society around the president and government, and can justify politically unpopular decisions. Time is working against the new Ukrainian authorities.
Slow progress on reform will delay economic recovery and will weaken the Ukrainian state. It will make the period of pain and sacrifices longer with no visible gains.
This might lead to popular disappointment and a weakening of the pro-reform mandate. It will not help in confronting the external threats.
THE ROLE OF THE INTERNATIONAL COMMUNITY
The international community, including the EU, should encourage and facilitate fast and consistent reform in Ukraine through sufficient and welltailored assistance, which should address Ukraine’s most important needs but also involve ambitious and demanding conditionality and fargoing technical assistance.
The latter should focus, among other things, on facilitating smooth implementation of the EU-Ukraine Association Agreement (AA) and DCFTA, which is a difficult tas for the Ukrainian side given the numerous institutional weaknesses that the country suffers from. If done rapidly and successfully, implementation of the AA/DCFTA can help in institutional and regulator convergence with the EU’s acquis in several important areas and sectors, and provide an important external anchor for the domestic reform process (see Gligorov and Landesmann, 2015).
To avoid the build-up of an excessive and unsustainable debt burden, part of the foreign aid package should be in the form of grants instead of loans. This concerns, for example, some infrastructure projects (especially those that can increase transport and transit facilities between Ukraine and the EU) or projects to strengthen Ukraine’s defence capacities against external aggression.
Looking ahead, Ukraine and two other Eastern Partnership countries (Georgia and Moldova), which already signed AAs/DCFTAs with the EU, would benefit from ambitious roadmaps setting out closer cooperation in various areas, and stepbystep integration with the EU based on welldefined institutional conditionality.
Author: Marek Dabrowski
*This is the second part of the article. More information You will find in the first part.