UKRAINE: RECOVERY IMMINENT, PACE UNCERTAIN

April 6, 2010

The most important economic news to come from Ukraine in years has been the orderly political transition after the presidential election last winter, indicating a high level of cultural integration. Contrary to the dogma of Marx and his disciples, the true societal hierarchy is culture-politics-economics. Culture is the “basis,” economics is the “superstructure,” and politics is the essential link between them. Culture enables natural resource and energy-starved Japan, Finland, Denmark or Switzerland to be mega-rich. Culture has doomed the Muslim world to immobile penury, temporary oil-induced distortions notwithstanding.

Two fundamentally irreconcilable visions of what Ukraine is (or should be) were on offer last January. In a less integrated society, the resulting tension could have led to separatism, civil war even – the northwest vs. the rest – or at least to a protracted period of instability. This did not happen. This encouraging, and to many minds surprising, fact indicates that Ukraine should be capable of completing the less demanding task of reforming its economy, increasing its wealth, and becoming an attractive destination for foreign investors. Cultural coherence and political stability are not in themselves sufficient for that task, but they are its necessary precondition that had been lacking under the Orange administration.

Last year was annus horribilis for Ukraine, marked by the credit crunch abroad and recession at home. The hryvnia lost almost half of its value against the U.S. dollar as steel and chemical exports declined. Both former premier Yulia Tymoshenko and former president Viktor Yushchenko had spent lavishly, knowing full well that if Viktor Yanukovich won the resulting mess would be his to resolve.

A gradual recovery is finally under way, with industrial production showing positive results in the first two months of this year. The upturn starts from a low level, however, following the 15 percent slide in 2009. Domestic demand is impeded by fiscal tightening. The still-rising unemployment, static incomes, and low capacity utilization will likely hamper consumption and investments. The growth will be a modest 3.5 percent this year, rising – at best – to 5 percent in 2011. Such rates are well below Ukraine’s 7.5 percent average for 2000-2007, but they can be sustained if the new team in Kiev fulfills two necessary tasks.

1. RESTRUCTURING ENERGY NETWORKS AND POLICIES – Ukraine’s geographic position as the natural transit route from the oil and gas fields of Russia, the Caucasus, and Central Asia to Central and Western Europe is a valuable asset. The previous administration unnecessarily turned that asset into a liability and a source of periodic friction with Moscow and the EU. It failed to grasp that being a transit route for a strategic commodity is not tantamount to having the commodity itself – especially if alternative transit routes are potentially available. The issue has always been political rather than economic. The solution may be found in a plus-sum-game model of shared responsibility and shared profits.

Yanukovich’s suggestion is to find a permanent solution to the gas issue by forming a multinational pipeline consortium in which Ukraine’s Naftogaz – currently the sole importer of Russian gas – would be joined by Moscow’s giant Gazprom and an unnamed European partner. The idea is radical but not unprecedented: Gazprom has had similar agreements with Armenia and Belarus for years, which gives the Russian company an implied (but so far unexercised) veto power over key decisions in return for deep discounts to the host country. The same arrangement with Ukraine was initially proposed in 2000, but shelved after Yushchenko’s team, deeply antagonistic to Moscow, came to power in 2004. While Ukraine has had to pay over three hundred U.S. dollars for a thousand cubic meters of Russian gas recently, the price for Belarus was just over one-half of that amount ($168 per 1,000 cu.m.). A joint venture agreement could save Ukraine close to four billion dollars a year, which in Eastern Europe is still real money.

Meeting Ukraine’s premier Mykola Azarov on March 26, Prime Minister Vladimir Putin indicated that Russia was positive about the idea of creating the gas consortium. A firm long-term agreement with Ukraine and a stake in its transit system might prompt Russia to cancel the South Stream pipeline – specifically designed to bypass a hostile, Orange-ruled Ukraine – as unnecessary. This would be bad news for Serbs and Greeks, and its cancellation would give a boost to the rival Nabucco project, favored by Washington. Wider geopolitical considerations of Ukraine’s energy decisions are not Kiev’s concern, however, and Moscow might still prefer to keep South Stream on track to hedge its commercial and political bets. In any case, appropriate action by the Rada will be needed to make the arrangement legal, but that does not present a problem in the new political equation. The arrangement would ease Ukraine’s transition to less heavily subsidized energy in a country where all people – rich and poor alike – pay under one-third of the real cost of heat and electricity.

2. REDUCING PUBLIC EXPENDITURE – This task is inseparable from energy restructuring. Right now Ukraine is subsidizing imported Russian gas by almost 3 percent of GDP a year, which cannot and should not continue. An austerity program was initially agreed in November 2008, but it was violated by former President Yushchenko a year later when he signed an extravagant wages and pensions bill in a bid to foster popularity in the run-up to the election. The IMF responded last November by suspending its $16.4 bn. bailout program. It may reinstate payments within weeks it if the Rada belatedly passes the 2010 budget based on a deficit no greater than 6 percent of the GDP including Naftogaz subsidies. Resumption of IMF lending would enable Ukraine to obtain soft loans from the European Bank for Reconstruction and Development (EBRD) and the World Bank. It is also regarded by the European Union as a key precondition for further reforms.

It is ironic that the “pro-Western reformist” Yushchenko was regarded as discredited by the international financial institutions, while the new president – sometimes described in the Western media as a neo-Soviet nostalgist – is determined to satisfy the IMF’s key demand and pass a “realistic” 2010 budget. “Everything has to be done so that the budget goes through a constructive debate in parliament and receives approval,” Yanukovich’s aide Iryna Akimova declared March 26: “If in April this task is completed, then the question of supportive cooperation could be looked at by the IMF within a month.”

If the tasks of reforming energy policy and introducing fiscal discipline is tackled with courage and determination, other pressing issues would be far easier to resolve. Yes, decisive action is needed to combat corruption and reform the judiciary, but the problem is neither unique to Ukraine nor potentially fatal to its reformist endeavors. Indeed, the business climate should be improved by abolishing bloated instruments of administrative control that breed corruption and waste, but the political will and practical measures to do so are already in place. The central bank should be made more independent, inflation predictable, and exchange rates floating – but all those tasks are of a different order of magnitude to the twin challenge of energy policy and public spending.

OPPOSITION IN DISARRAY

The prospects for Ukraine’s economic recovery are enhanced by the fact that President Yanukovich and his team face no serious political opposition at the moment. Yulia Tymoshenko was dismissed from the prime ministerial post on March 3 and she has been unable to secure the formal title of the leader of the opposition. She announced just before her dismissal her goal of bringing together “all true democratic national-patriotic forces,” but her coalition in the Rada has disintegrated and she enjoys limited credibility in the nationalist camp. Her BYT bloc is strong by itself but so far unable to attract support from the majority of Our Ukraine –People’s Self-Defense (NUNS) deputies, the third largest Rada grouping.

Former president Yushchenko, whose spoiling tactics may have helped cost Tymoshenko the presidency, will not help her either. Ihor Popov, Yushchenko’s close ally, says the opposition would remain divided because it consists of “parties and personalities that have been in a state of war between each other for years.” Tymoshenko is paying the price of her miscalculation dating back to last fall. She could have started to build bridges with future opposition partners long before her expected defeat, but this did not happen: “The lack of strategic planning several months ago now slows the consolidation of the opposition.” But Yushchenko is a spent force anyway. His devastating performance in the first round of the presidential contest in January – 5.5% - set a world record for the worst electoral result by a sitting head of state.

That consolidation of Ukraine’s opposition cannot be effected on the basis of Orange demagoguery of six years ago. The new reality was summed up by Vladimir Putin after the meeting with Azerov on March 25:

We appreciate very much that the new Ukrainian prime minister has chosen Moscow as the location of his first official foreign trip. We see this as a confirmation of our Ukrainian partners’ determination to strengthen relations with Russia, achieve real, positive change in bilateral relations and overcome the artificial burdens of the recent past, which have prevented us from fully realizing the vast potential of our bilateral partnership. This approach certainly serves the fundamental interests of our peoples.

The “Old Europe” is on board; the litmus test was the complete lack of interest in Berlin, Paris, Rome, or Madrid for Yulia Tymoshenko’s feeble claims of foul play following the second round of presidential elections last February. Washington did not appear unduly concerned about Ukraine’s decision to pass a law that will prevent the country from joining NATO. Even Georgia says it expects excellent relations with the new team in Kiev. It may take months or even years for the Ukrainian opposition to come to terms with the new realities at home and abroad. This gives the new government a comfortable window of opportunity to apply painful but necessary economic measures with near-impunity.

CONCLUSION

The main result of the collapse of the Orange forces is that Ukraine is fast becoming a normal country. Foreign bankers and investors are taking note. European institutions are also taking note, no less approvingly. Having discarded the divisive Orange legacy Ukraine can finally focus on finding pragmatic solutions to the real problems of economic reform and recovery. Given the instability of the wider global economy, no one should doubt the challenges Ukraine faces. But its prospects of success in this endeavor are better now than at any time since independence.