War and Economic Reforms in Ukraine

October 07, 2014

Are economic reforms possible during times of war? This question is too narrow for Ukraine. The better question is whether reforms, in general, are possible in Ukraine. Our 22-year history, including the 6-month history of our “new” government, proves that Ukraine and reforms are simply incompatible. Why? The answer seems simple: the Ukrainian “elite” makes only populist decisions and clearly, under this guise, steals. Until today the population stood against corruption, but never against populism. Real economic reforms are not compatible with either populism or corruption. Their result is always increased salaries, income and profit of those who productively, creatively, innovatively, diligently and honestly work, while decreasing the amount and income of corrupt bureaucrats, social parasites, shadow business and those who work very little at an unproductive rate.

Perhaps this is paradoxical, but for me it is the indisputable truth: the war began namely in Ukraine because there were no reforms and Ukraine became the poorest and, therefore, weakest country in Europe. The Lumpenization of Eastern Ukraine from one side, and the militarization of Russia from the other side, became the grounds for the unleashing of a war by Putin against Ukraine. In nature, the predator always chooses to attack the weakest animal or, in our case, country, which is an unreformed Ukraine. Would even such an unpredictable president such as Putin have ventured to invade a 45-million strong country where everything is in order in the economy and the army, where fairness rules the day, where salaries and pensions grow, and where corruption is eradicated and, therefore, there are vast amounts of foreign investments and interests? I think that even Putin would act toward such country with respect. Here is an even more paradoxical thought: only decisive and radical reforms can stop the war in Ukraine. Neither pacifism and conformism, nor amicable plans and negotiations (although beneficial in the right format) can stop the war in Ukraine – only reforms can.

The fact of the matter is that Vladimir Putin is intent on destroying Ukraine not only by military means, but also by economic, political and informational means. His economists, by the way, with the assistance of the Academy of Sciences of Ukraine, have worked out both an optimal and realistic scenario for the development of the Ukrainian economy in 2014-2015. The essence of these evaluations is to prove to the West that it cannot nourish (provide lifeline credit to) Ukraine. They forecast that according to the realistic scenario, already in 2015 there will be a deficit of the payment balance of Ukraine of almost 100 billion dollars. This will mean default. As it happens, the IMF and the EU believe that 18-20 billion dollars over this and next year are sufficient for Ukraine to recover from the crisis. Indeed, these funds would actually be sufficient, but only on the condition that reforms are instituted. Importantly, Putin will apply all of his efforts to implement his plan to bankrupt Ukraine. This plan involves destroying Ukrainian factories and their infrastructure, banning imports of key Ukrainian goods to Russia, and blocking economic reforms with the aid of the army of FSB (Federal Security Service of the Russian Federation) agents in Ukraine.

Putin’s plan is aimed at Ukraine’s default in 2015, which will create various problems, including those associated with association with the EU. Moreover, Ukraine’s bankruptcy will prove that it cannot exist in Western Civilization. Rather, Ukraine’s place is within the Muscovite-Orthodox Civilization under the Putin’s patronage. The Ukrainian people have made a mistake. In another article, “The War of Civilizations”, I made a calculation of how much time remains before Russia goes bankrupt. I concluded that it would occur within approximately two and a half years if the sanctions do not change and Putin’s policy does not change. In other words, under this scenario, Russia’s default will occur in the beginning of 2017. Putin can avoid this and achieve victory over the West in the following order of events: he, together with the Ukrainian Muscovite-Orthodox elite, economically destroys Ukraine in 2015 (achievement of an exchange rate of 15/20 UAH to the USD, decrease of GDP by 7-8%, decrease of Ukrainians’ income by 10-15% and a deficit of the payment balance of 40-50 billion dollars). In 2016, Putin will suspend military actions and the most severe methods of influence on Ukraine and the EU. The US and EU sanctions are cancelled. Russia avoids default and Putin achieves his goals.

Why am I confident that Putin will act in just this way? Because he simply does not have any other game, and his new Ukrainian friends are already embroiled in this game. Is the exchange rate of 15 UAH to 1 USD not a part of this game? If one looks at the financial system in Russia, then it seems that it is still sufficiently stable: the gold currency reserves of the central bank are at 15% of GDP and the aggregate reserves of sovereign funds are at 9.1% of GDP. At the same time, the expenses on the army are at 3.2% of GDP and the expenses on national security are at 3.1% of GDP.

However, the Russian economy has gone into a recession, prices of oil and gas are falling and the budget runs at a deficit of nearly 1% of GDP. The economic advisors of the Russian government openly enough advised the President to refrain from militarization of the economy and populist decisions to increase social expenses in the 2015 budget. Nevertheless, Vladimir Putin decided on an increase of military expenses and populism to the tune of 1.5 trillion rubles in 2015, which will lead to a budget deficit of 2% of GDP. This means that the Russian people will support Vladimir Putin next year, but in 2016 he will already not have the possibility for populism. Thus, next year is a decisive year for both Ukraine and Vladimir Putin. Ukraine will either reform or go bankrupt economically as well as civilly.

It turns out that the government in 2014-2015 will belong to the team of Poroshenko and Yatseniuk. I will say frankly that with the team of “reformers” that we see now, there cannot even be thoughts about any reforms. This team needs to firstly get rid of the Fifth Column and reinforce themselves with specialists. Secondly, the President and the Prime Minister should be granted immunity from criminal investigations for a period of five years after they step down and guaranteed protection of their declared property rights. Corresponding law must be passed for this purpose.

What should the team of reformers do over the next half year? It should begin with a radical decrease of the GDP, which should be redistributed through the state budget and social insurance funds (no more than 33%). This step will significantly increase the working capital of businesses and the income of citizens which will create an additional demand for GDP growth and ensure the potential growth of the corresponding financial resources.

The second step of budget policy reforms should be the redistribution of income in favor of the young generation – those who create national wealth. The third step should be the redistribution of income in favor of local budgets from 43% to 60% in 2015. These steps will allow a significant decrease of taxes at the expense of decreasing budget expenses across the board, except expenses on defense and culture. Moreover, they should terminate monetary financing by the National Bank of Ukraine, which will have a positive impact on the exchange rate of the hryvnia. A catastrophe is unavoidable without such reforms of the budget and pension system.

Significantly, the above-mentioned steps will create only a precondition for economic growth. Growth itself is possible when the mechanisms of a market economy, and primarily the credit and investment markets, work. Today, it is not governments but the central banks that play the primary role in the creation of conditions for economic growth. Therefore, the principal function of the National Bank of Ukraine today should become the support of this growth under conditions of financial and price stability. Specifically, the National Bank of Ukraine, with the support of the government, must ensure an annual growth of credit provision on the level of 15-25% at normal rates for businesses and individuals (inflation plus 4-6%). A normal inflation rate for 2015 is 5%. This means that next year a trend toward revaluation of the hryvnia should dominate. Is the National Bank of Ukraine capable now to undertake such monetary policy? Obviously not. Its management staff must be significantly updated.

The success of reforms will depend on whether they move Ukrainian society toward a society where justice rules, rather than the social populism to which the Ukrainian “elite” are accustomed. After two “Maidans” Ukrainians innately sense social dishonesty. I am confident, for example, that Ukrainians support pension reform, including an increase of the pension age, provided that there is fair differentiation – an increase of the minimum pension amount at the expense of limiting the maximum pension payouts. Reasonable pension reforms should also create stimulation for lengthy and rigorous labor activity and the legal receipt of income. In addition, reforms should initiate the accumulation of financial resources for long-term investments into the economy of Ukraine.

Last, but not least, war only complicates economic reforms, but it does not completely block them. The war has brought the exchange rate of the hryvnia to 10 and the National Bank of Ukraine, with the “economic experts” of the government, has brought it to 15 UAH to 1 USD. The war is responsible for the decrease of GDP by 3-4%, while the absence of reforms will lead to a decrease of GDP in 2014 by 7-8%. The war blocks domestic, private investments and credit, but the National Bank of Ukraine and the government have not created conditions for domestic credit and investment. In fact, primitive, administrative methods of regulating the currency market are responsible for the flight and deficit of currency in Ukraine.

The Poroshenko – Yatseniuk team does not have the moral right and time to delay with reforms. Therefore, let’s initiate reforms with the passing of a law on their political immunity.

 

Of Counsel, Frishberg & Partners

Professor Alexander Savchenko

 

 

News

Frishberg & Partners 2012