Country Report Ukraine
Ukraine’s economy shrank considerably last year, due to a conflict in eastern Ukraine and economic mismanagement in the past years. The country’s outlook is highly uncertain and depends on external assistance and on how the conflict evolves.
Strengths (+) and weaknesses (-)
(+) Strong agricultural and industrial sector
Ukraine has high agricultural potential due to its fertile soil and geographical location.
(-) Weak government finances
Government finances are in bad shape, as fiscal policy is weak and the budget balance continuously records deficits. In addition, government debt increased to a critical level of around 70% of GDP in 2014.
(-) Weak external position
The external position is structurally weak, as Ukraine continuously posts current account deficits, while their level of FX-reserves is at a very low level.
(-) Embedded corruption
Corruption within the government and business elite is widespread and pervasive. In 2014 Transparency International ranked Ukraine 142nd out of 175 countries, according to its Corruption Perception Index.
1. Armed conflict with Russia and political changes
The conflict between Russia and Ukraine that started at the end of February 2014 was the outburst of existing political tensions in the region and economic problems in Ukraine. Ukraine’s budget balance had consistently been in deficit and on top of that, the country’s level of foreign reserves had been low and declining. Instead of dealing with these problems head-on by implementing fundamental reforms, former President Yanukovych started to look for external assistance, both in the West and in Russia. In December 2013, Yanukovych finally chose to sign a financing agreement with Russia that should have solved Ukraine’s short-term financing needs. However, the deal led to considerable anti-government protests and in February 2014 president Yanukovych fled the country. Since then Ukraine has shifted its focus from Russia to the West. This is reflected by the fact that both the previous parliament and the new parliament, which was elected on 26 October 2014, have been supportive towards the pro-western stands of the government. Interim-president Oleksandr Turchynov signed a deal with the IMF in April, while current President Petro Poroshenko, who was elected on 25 May 2014, signed an Association Agreement with European Union that was ratified in September 2014.
The appointment of Oleksandr Turchynov as interim-president and the pro-European stance of the government triggered pro-Russian demonstrations in Crimea. After a referendum in March, Crimea was incorporated into Russia. In the months thereafter a conflict erupted in the east of Ukraine, as pro-Russian separatists started to fight for independence. It seems plausible that Russia intermeddles in the conflict, as it wants to prevent Ukraine from tightening its ties with the west in the form of closer cooperation with the EU and/or NATO. Since Ukraine is not likely to change its pro-Western course, as that would be political suicide for the government, and Russia is not likely to allow Ukraine to build a relationship with the EU and/or NATO, a solution for the conflict will be very difficult to find. This is also illustrated by the fact that the Minsk Protocol (a cease-fire agreement) signed in September 2014 did not hold. In the meantime, more than 5,000 people have been killed by the conflict and the real figure may be considerable higher according to the UN. In addition, between 659.000 and 921.000 people are internally displaced according to the Ukrainian government, while more than 300.000 people have asked for international protection in other countries.
2. The economy has contracted heavily
The east of Ukraine accounts for a large share of industrial output and is also important for Ukraine’s export revenue. Due to the conflict, production in the region has fallen considerably, which has a negative impact on Ukraine’s economic performance (figure 1). The current estimates for 2014 point at an economic contraction of 8.2%. The slowdown of production has also led to a decline in tax revenues, while government spending has increased as a result of the conflict. This has led to deterioration of Ukraine’s fiscal balance. Ukraine public debt level as percentage of GDP has also risen sharply. After having a fixed exchange rate policy, the National Bank of Ukraine had no choice but to float the Hryvnia freely in February 2014, as it was running out of foreign exchange reserves (figure 2). In the months thereafter, the Hryvnia depreciated considerably, which has made foreign currency denominated public debt more expensive to service.
3. Debt pressure and funding need
Back in April 2014 the International Monetary Fund agreed to provide Ukraine a USD 17bn bailout package. Dependent on the IMF loan was an additional USD 15bn package from other entities, including the World Bank, EU, US and Japan. The IMF loan is conditional upon the implementation of several austerity measures and structural reforms in Ukraine that include phasing out natural-gas subsidies, reducing corruption and addressing long-standing imbalances in public finances. Until now USD 8.3 billion of the package has been transferred to Ukraine. However, due to a stronger than anticipated deterioration of the economic situation, Prime Minister Arseny Yatseniu announced recently that an additional USD 15bn in financial aid is needed in 2015 to avoid a default. The European Union and the United States are both discussing an extra USD 2bn each in loan guarantees. Russia on the other hand might demand early repayment of a USD 3bn loan to Ukraine. Moscow has the right to do so, as Kiev has breached a loan condition that requires that Ukraine’s public debt should not exceed 60% of GDP. Whether the IMF will provide Ukraine with an additional help package is unclear.
Before its independence in 1991, Ukraine was the second-most important economic component of the former Soviet Union after Russia, producing about four times the output of the next-ranking republic. Its fertile black soil generated more than one-fourth of total Soviet agricultural output, and its farms provided substantial quantities of meat, milk, grain, and vegetables to other republics. Currently, Ukraine remains one of the top ten wheat exporters in the world. Ukraine also has a strong industrial base, which is mainly located in the east of the country. The highly cyclical steel industry is very important for Ukraine, since steel and other non-precious metals are Ukraine’s largest export product. Since the industrial sector is heavily dependent on imported gas, fuel and energy are Ukraine’s largest import product. The industrial sector has been suffering significantly from the conflict in east Ukraine that started in March 2014. Pro-Russian separatists are fighting for independence. Next to a strong and negative impact on the economy the human impact is also considerable. At the end of January 2015, more than 5,000 people had been killed by the conflict, while between 659.000 and 921.000 people had been internally displaced and more than 300.000 people had asked for international protection in other countries. Structural reforms are needed to improve the economy including fighting embedded corruption, developing capital markets, improving the legislative and institutional framework. Finally, Ukraine has various oligarchical political and business elites that are in fierce competition for the country’s leadership, which from time to time results in political turmoil.