Socio-Economic Crisis in Ukraine: Why and What’s Next?

7 june 2014

Leonid Grigoriev is chief advisor to the head of the Analysis Center under the Government of the Russian Federation, Head of the World Economy Chair of the World Economy and International Affairs Department of the National Research University–Higher School of Economics.

Resume: Ukraine’s main chance of entering Europe not as a source of labor force, but as a moderately developed industrialized country will be to go ahead with exports to Russia and other countries where Ukrainian manufactures are in demand.

Ukraine’s socio-political and economic crisis did not emerge out of nowhere and it will not die down all by itself. It has lasted throughout the period of post-Soviet transformation, and there are no immediate reasons to hope it will end soon. Our observations made from the very outset of this process1 provide ample reasons to postulate that the original expectations of progress have failed to materialize. In 2007 we maintained that Ukraine had very good chances of taking a worthy place in Europe by virtue of the potential competitive edges of the Ukrainian economy, but that would require hard work, patience, time and a coherent policy. Over the past five to ten years, in particular, in the context of the current political crisis, that chance has been wasted and, regrettably, another one may offer itself only in the distant future.

Transformations in Central and Eastern Europe have brought about a result that was hardly expected at the beginning, and that result was drastic polarization of countries and regions by many economic, social, and political parameters. The success of transformation was mostly confined to the departure from the ideology of Communism and the establishment of new government institutions. The quality of formal and particularly informal institutions remains a problem and gets increasingly varied. This article leaves politics aside to put the focus on socio-economic issues.

The socio-economic transformations in question have been underway for quite a while – about 25 years in Central and Eastern Europe and only a couple of years less in the post-Soviet space. However, successes are few and can be observed in far from all countries. Even the relatively well-to-do states, where the GDP has been up and a free market economy and democratic institutions have gained strength, have experienced (with very rare exceptions) a decline in the complexity of production and the loss of human capital in terms of the quality of research personnel and jobs at home and from the standpoint of mammoth emigration rates. Naturally, for those observers whose prime concern was the struggle against the “Communist system” and a “Soviet threat” the result is quite satisfactory. It should be remembered, though, that the post-Soviet space witnessed the collapse of the old economy with the accompanying transitional crises, which caused a 30%-40% percent slump of the GDP over a period of about ten years. This undermined not only the old (uncompetitive) industries, but the entire lifestyle, science and generation-to-generation relationships and forced millions to abandon their home countries in search of jobs (for natural reasons far less skilled, although better paid than the previous ones at home). Naturally, for the population of these countries such transformations could not be utterly painless, but the scale and disproportions of the crisis, as well as its duration and the depth of the turmoil proved too strong for many countries and regions.

Now, let me share with you several considerations that are important to discussing the problems of Ukraine after a quarter of a century in transition.

The country’s stability on the new development track requires success in three inter-related areas: transformation of the system of property, creation of market economy institutions, and adaptation of the social structure and political system. Economic transformation on the basis of private property encompassed the lives of families and the reformatting of businesses and government finance. Liberalization and privatization were only part of the efforts to transform the integral social organism. But fundamental changes in the economy cannot proceed successfully without adequate changes to the social structure of society and political institutions. Alongside the creation of new formal institutions there should emerge a new social system of production and distribution of wealth among social strata and regions. As a matter of fact, over this brief time span the countries in question witnessed the formation of not only a new political class and elites (from the standpoint of political science), but also the upper financial stratum (the result from the standpoint of sociology), and also the national system of government and private control and governance (in political economy terms). From this moment on one should proceed not from the initial parameters of transition, but from the results of activities and adequacy of the national institutions and elites and the chances for development in the future under the given institutions and elites. Whatever respect one may feel for the Ukrainian reformers of different periods and levels, it has to be admitted that they have suffered a disastrous failure in providing citizens’ welfare in their large country during the lifetime of a whole generation.

OMENS OF A PENDING CRISIS

It is generally agreed that before the beginning of the socio-political crisis of late 2013 and early 2014 Ukraine had rather advanced components of a democratic system. However, the adoption of major decisions crucial to the country’s economic development was confined to unbridled corruption and oligarchs’ domination – in the sphere of the agrarian reform, the system of government procurement (where the level of corruption was sky-high) and the energy industry (where laying hands on a hefty chunk of gas revenues was universal obsession leaving no chance for a genuine gas industry reform).

In the eyes of the country’s citizens (and not indifferent on-lookers) a summary of the most important socio-economic parameters of life in Ukraine today may look like this.

Firstly, in 2013 the GDP of Ukraine, a country with a population of 45 million, remained at a level of two-thirds of what it was at the end of the Soviet period. In 2013 the GDP per capita expressed in PPS was approximately equivalent to the levels of 2007 and 1992. The lagging behind all other neighboring countries is more than obvious.

Secondly, the country has lost about 10% of the population. Ukraine’s demographic parameters looked bad (still worse than Russian), and emigration swallowed a very large share of the workforce from the country’s east and in particular from the west.

Thirdly, the generations born in the 1980s and 1990s grew up in a situation of several consecutive crises and incessant struggle for the survival of their families. The conflicting groups of citizens aged under 30 (mobilized by the rival factions and roaming the country with automatic rifles in hand) belong to the generations who by and large know nothing of what life in the Soviet Union was like and whose sole ideology is a blend of nationalism and disillusionment. They have never lived in an era of prolonged and steady growth. Partially unemployed or unable to get a permanent job in Russia or the European Union, they have never had a chance to make long-term career plans. For many of them the internal conflict has proved an escape from socio-psychological problems and a permanent occupation as well, as no sound alternatives were anywhere near in sight.

Fourthly, the recurrent political crises in Kiev over elections and other high profile events, corruption at the presidential administration level, the oligarchs’ domination in regions and invariable gubernatorial shakeups by the winner parties have produced confidence that the national elites care little about the prosperity of the country and its citizens, if at all. Thriving corruption (3,500 GDP current dollars per capita) in a country with high education and the population’s vast experience of employment abroad generated enormous and lasting disillusionment.

Lastly, over the past few years very little has been done in terms of developing material infrastructures, leveling the region’s development and creating conditions for using national competitive advantages for developing the country as a whole. The oscillations of the political pendulum usually entailed shifts from “friendly corruption” to “alien corruption” at the regional level, with strong oligarchic and clan factors heavily present.

By the 2012 GDP per capita index, the Ukrainian economy proved close to the level of 1992 (with the crisis being as deep as 60%), while the overall GDP reached only two-thirds of the 1989 level (Fig. 1.).

 

The World Bank believes that “recent economic growth in Ukraine was based on undiversified, but strong export growth, from sectors controlled by financial industrial groups which operated through informal relations and special privileges.”1 Naturally, apart from the international financial organizations this flat development (seen in the chart) was obvious to investors, oligarchs and government officials in Kiev, but the issue remained unaddressed. In the meantime, ordinary citizens, forced to seek jobs in neighboring countries, are perfectly aware that the politicians and oligarchs have ruined the chances for the country’s development.

The brief period of economic growth during Victor Yushchenko’s rule in 2006-2008 was largely the result of a rising oil rent in Russia, greater commodity export to Russia, low prices of gas and growing cash transfers home by Ukrainians earning money in Russia. But politically low prices of gas created some extra problems for the Ukrainian economy.2 Energy inefficiency took deeper root and the gas business-related members of the elite kept enriching themselves. The 2008-2009 crisis in Russia and Ukraine buried the hope for steady growth. The loss of gas privileges in this situation reflected President Yushchenko’s strained relations with the Russian establishment stemming from his active nationalist and anti-Russian rhetoric.

The gas crisis set very simple conditions for resolving the budget and debt problems: lower energy consumption in the economy, higher domestic gas prices (as the IMF required) and a stop to the drain of resources through corruption schemes. The first condition had to be met willy-nilly, in a natural way, while the rest proved easier said than done despite continued debate. Plans and fine declarations were many, but very little was done over these years for the sake of overhauling Naftogaz and the budget. Naturally, the hryvnia was on the descent (see Table 1) and the foreign debt on the rise to have reached 140 billion dollars by the end of 2013 (without “new” loans and promises), with the biggest payments due at the end of 2014. Of course, in the current political situation the IMF and other donors will agree to extend loans and grants to the Ukrainian government. This money will be enough for a certain while to pay for gas and the services of the army and police. But they will surely fail to clear up the tremendous pile of problems facing a country having a 45-million population. Fundamental economic growth is of the essence.

For now the Ukrainian economy is thrown back – in 2014 the GDP is expected to slump 7%, the accumulation rate has been down from 21% in 2011 to 16% in 2013, and in the spring of this year it must be in free fall condition. Hardly anyone will be eager to invest in a country that is close to civil war. Whatever the outcome of the political crisis, Ukraine in 2014 will have to start from scratch: from a 3,000-dollar GDP per capita index at the current rate of exchange.

WHO IS WORTH TRADING WITH?

The debate over whether Ukraine should join the Association with the EU essentially revolved around universal misunderstanding. The Ukrainian population by and large erroneously thought that it would be a step towards accession to the EU, or even full-fledged accession. Naturally, it was not so, and the EU will hardly be able to cope with the admission of Turkey and then Ukraine. Brussels would be happy to go ahead with its bureaucratic program for spreading acquis communautaire and with the EU’s further expansion without bearing any responsibility for the future of Ukrainians. The deal looked very lucrative for the EU – new rights without any special costs and even with slight gains in terms of mutual tariffs. Meanwhile, Ukraine’s deficit in trade with the EU in 2012 stood at nine billion dollars (see Tables 2 and 3).

Ukrainian oligarchs (apparently, including President Victor Yanukovych) up to the last minute had remained unaware of Russia’s inevitable resistance in protecting its interests and the harsh reality the Ukrainian industry would have to operate amid an adverse environment, comply with harsh European competition rules, ecological standards, the transparency of finance, anti-corruption rules and the need to adhere to the IMF’s macroeconomic programs in real life, and not on paper.

Judging by the fast political response from Brussels and its concessions on trade tariffs and consent to cancel the economic part of the Association Agreement for the sake of politics, the EU is prepared to take reasonable steps. But the price of the general misunderstanding and confusion has proved incredibly high in socio-economic terms (including casualties).

Ukraine’s main chance of entering Europe not as a source of labor force, but as a moderately developed industrialized country will be to go ahead with exports to Russia and other countries where Ukrainian manufactures are in demand. Table 2 indicates quite clearly that the structure of Ukrainian exports to the EU and Russia are in stark contrast to each other. More complex goods go to Russia, which pays for them (with a surplus for itself) with oil and gas, which is characteristic of Russia’s trade balance with most countries. However, as far as Ukraine is concerned, the process of paying bills is dramatic and politicized.

In case of problems on the Russian market, the eastern part of Ukraine – developed, educated, and manufacturing high value added goods – will be the hardest hit. There are still operational industrial plants, research and development facilities, and industrial phase infrastructures there, while the rural areas of central and western Ukraine are still in the pre-industrial phase and remain heavily dependent on cash transfers from Ukrainians employed outside the country. Naturally, an agricultural reform and modern agribusiness technologies and know-how would enable Ukraine to feed half of Europe, but this news will hardly make farmers in the Balkans, Spain, Poland, Italy and France very happy.

 


Ukraine was doomed to balancing between the EU and Russia on trading and economic issues (even without the gas factor). In that sense Brussels might be acting in concert with Russia, and not against it. Territorially Ukraine already is in Europe, while developing the economy at least to the level of its neighbors in the Balkans – EU members – is a serious problem and will require years of hard work. Industries in Ukraine’s east generate export goods and taxes, but its engineers, chemists, and steel workers are far more important. Should the industry grind to a halt, the country will get into another depression of de-industrialization without any compensations, without jobs. Then there will follow a structural crisis – for political reasons – and another tide of emigration. In the meantime, the mission of genuinely responsible politicians should be not fine words, but the welfare of those living today.

It is noteworthy that over the past five years cash transfers by Ukrainian guest workers employed elsewhere have accounted for a steady ten billion dollars, or 4% of the GDP (Fig. 2). Possibly, the flow of cash from Russia is slightly greater than from the EU. But it is important to remember that the export of workforce makes up for half of the trade deficit with these two partners, or probably more.

Given the current unemployment in the EU and the shortage of labor force in Russia, it will be natural to expect a gradual drift of the population to Russia, something Russian capital investment might compete with. But either option implies economic stability. In the new conditions any restrictions on trade and the flows of labor and capital, in particular those between Russia and Ukraine, would lead the latter ever farther away from the development guidelines the world has been following ever since the Great Recession.

REGIONS AND STABILITY

William Ross Ashby, a pioneer in cybernetics, the study of complex systems, postulated that stability in large systems is hard to maintain if large subsystems with many interconnections are unstable. If one takes that into account, the distinctions among Ukraine’s regions will prove far more significant than most onlookers tend to think. By some general parameters – the nature of infrastructure and the type of consumption –

that country is very close to Russia. But let us not forget the average values: in Ukraine capital investment equivalent to 20% of the GDP (3,000 dollars per capita) yields 600 dollars, while in Russia the very same 20% yields 3,000 dollars. Further there begins regional inequality and instability.

It should be noted that many of the country’s regions remain not very rich. There has been no sound policy for the economic leveling of regions. Old-time infrastructures inherited from the Soviet era suffered the most. For instance, in Crimea thermal power and water supply infrastructures have been completely worn out over the last quarter of a century. Crimea’s main competitive asset – its potential of a health resort – has failed to be put to use rationally. The same applies to the country’s other material assets and labor resources.

The country’s budget absorbed huge resources, which were then distributed depending on what particular clan was in power in Kiev (under Yushchenko the funds were flowing westwards, and under Yanukovych, to Donetsk and Luhansk in the form of coal subsidies). However, during the entire period of independence (particularly so under Yushchenko) the money was largely funneled into the western regions. Three regions – Dnepropetrovsk, Kharkov, and Poltava – are the main budget donors. In any other country with a historical balance of two large parts as to the number of voters, the more advanced and educated donor regions, exporters, would be in the commanding position. In Ukraine, for a greater period of its independence the elite attached priority to the western regions – less industrialized, but with a very clear “national” agenda, which caused changes to the role of Kiev.

The gross regional product in Kiev is thrice the nation’s average (see Fig. 3, Table 4).

The existing system gives Kiev tremendous advantages not only as a city or a tax collection center, but as a community of government officials running a centralized state. For a quarter of a century a natural process was underway of moving personnel (of course, those professing the national idea) from the West to the civil service jobs in the capital, which naturally changed the nature of the city. Kiev became the sole region with a growing population (Fig. 4).

As a matter of fact, Kiev is a European city with a European population eager to enter Europe. Small wonder, therefore, that a large share of Kiev’s residents took to the streets to demonstrate in support of their dream of entering the EU – in defiance of the realities.

Under the previous president, the Ukrainian capital did not quite recover from the 2008 crisis and remained in a flat economic condition for four years, which caused tensions. Corruption in the government was “alien” – eastern. Simultaneously, there was observed some economic growth in Donetsk, which was a clear departure from the previous model. That socio-economic factor was predicted back in 2009: “Amid the crisis in Ukraine one can expect an upsurge in the struggle for control of the administrative resource, the redistribution of transfers and new growth in Kiev’s strength.”

In fact, Ukraine today is faced not with just political division into unitarianists and federalists. Behind it one finds both the division of the bureaucratic rent in Kiev or the home region of the incumbent president, and the natural distrust on the part of poorer regions or regions whose position depends on the bureaucrats in Kiev and Kiev-appointed governors in accordance with the political yardsticks of the day.

It should be noted, though, that amid the new crisis and IMF programs austerity measures always hit public sector employees. Any attempt to enforce IMF rules and public spending cuts will harm the bureaucracy and civil servants in Kiev, precisely the way it happened in Greece. It is likewise important that any measure to put taxation in order will affect the capital. In practice, positive influence of reforms – as it is now clear on the basis of the experience of the 1990s – may be implemented only in the context of peace, interaction and some balance of the elites. A party or movement with a regional support base can achieve political domination (in particular, with reliance on external support). But rationally-minded elites should presumably acknowledge the country will have no chances to achieve prosperity as long as there remains an unsettled conflict, regional distrust and attempts to dictate one’s own agenda to the other half of the country with an iron hand.

As a matter of fact, the current conflict is the culmination of 25-year-long discord between the conflicting parties over many issues. It is to be hoped that the internal and external forces will have enough wisdom to step over the rules of the zero sum game to care not about geopolitical scores, but about the prosperity of people in this large country, who do not deserve the disastrous position they have found themselves in after 23 years of independence.

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