WASHINGTON, DC – Ukraine has suddenly arrived at a democratic breakthrough. After former President Viktor Yanukovych incited major bloodshed, many of his MPs defected to the opposition, creating a large majority. In order to consolidate its authority, whatever new government emerges will need to act fast and resolutely – and receive considerable international support – to overhaul the country’s crisis-ridden economy.
Ukraine suffers from three large economic problems. First, its foreign payments are unsustainable. Its current-account deficit last year was an estimated 8.3% of GDP, and its foreign-currency reserves are quickly being depleted, covering just over two months of imports. Second, public finances are also unsustainable, with the budget deficit reaching almost 8% of GDP and government-bond yields skyrocketing. Third, the economy has been in recession for five quarters since mid-2012.
These problems reflect Yanukovych’s economic policy, which had one aim: enriching him, his family, and a few of his cronies. During the last four years, Ukraine has experienced unprecedented embezzlement by its rulers, with estimates putting the Yanukovych family’s wealth at $12 billion. Here, too, the new government will need international assistance if it is to recover at least some of this loot.
With Yanukovych out of the way, official extortion of Ukrainian business should end, enabling the economy to recover. In fact, Ukraine’s GDP actually grew by 3.3% in the last quarter of 2013, because his cronyism was stifled by the protests. Yet much can and must be done very quickly, because Ukraine is running out of money.
For starters, the new parliamentary majority needs to appoint a new government, so that a fresh economic-policy agenda can be launched. A new central bank governor also should be named, with the first order of business being to float the exchange rate. This would lead to a substantial devaluation of perhaps 10%, thereby ending the current run on the hryvnia, eliminating the current-account deficit, and enabling a reduction in Ukraine’s extremely high interest rates, which would stimulate investment.
As soon as a government has been appointed, the International Monetary Fund should send a mission to Ukraine. Within two weeks, the IMF mission could conclude a new financial stabilization program with the new administration. The IMF works fast and could make a first large disbursement in late March.
The IMF could lend Ukraine $10-12 billion for a one-year stabilization program, with the European Union using $3-5 billion from its balance-of-payments facility to co-finance an IMF standby program. These two sources alone could cover much of the $35 billion in external financing that Yuriy Kolobov, Ukraine’s acting finance minister, has said the country could need over the next two years. Moreover, IMF loans carry a lower interest rate and a longer maturity than the Russian loans on which the Yanukovych government relied (and which are unlikely to continue).
The conditions that the IMF places on its loans can help Ukraine undo Yanukovych’s venal policies. First and foremost, Ukraine will have to reduce its budget deficit sharply, which, given large tax revenues, should be accomplished through expenditure cuts and freezes. Large industrial subsidies – for example, to the coal industry – amount to nothing but giveaways to Yanukovych’s supporters and should be eliminated immediately. Likewise, gas prices should be liberalized to stop corrupt enrichment from regulatory arbitrage. Needy consumers, not wealthy producers, should receive assistance.
Similarly, the IMF will insist on the reintroduction of competitive tenders. Since 2010, orderly public procurement has ceased, with Yanukovych simply doling out state contracts to friends and acolytes at twice the market price. Naturally, sales of state enterprises to loyalists – typically at rock-bottom prices – must end as well.
Another source of corruption has been refunds of value-added tax for exporters, for which top tax officials charge a commission. Putting a stop to this would stimulate exports.
In addition, Ukraine should reintroduce the simplified tax code for small businesses that Yanukovych abolished. Two million small enterprises were wiped out by that change; many of them could be revived if tax procedures were no longer prohibitive.
Ukraine also needs to work with the EU. Within a week, the new government can fulfill the EU’s conditions for signing the long-concluded Association Agreement, and doing so should be on the agenda at the EU-Ukraine summit in March. Parliament has already scheduled new elections, and former Prime Minister Yuliya Tymoshenko has been released from prison. The only remaining EU condition – legislation reforming the prosecutor’s office – can be adopted quickly.
The EU-Ukraine Association Agreement will greatly benefit Ukraine. It amounts to a comprehensive reform program for the Ukrainian state apparatus, including its law-enforcement bodies. Sixty state agencies in various EU countries have already concluded agreements with their Ukrainian counterparts concerning the necessary reforms.
The agreement also contains a Deep and Comprehensive Free Trade Area, which will open the vast European market to Ukrainian exporters – and thus attract more foreign direct investment to Ukraine. This will also help to safeguard the country against possible Russian trade sanctions.
Here, diplomacy will play an important role as well. The United States and the EU need to persuade Russian President Vladimir Putin to reach an understanding with Ukraine’s new leaders, rather than follow through on his threat to impose sanctions. Peaceful co-existence, not mounting bilateral tension, is in both countries’ best interest.