When the former president Viktor Yanukovych was ousted in February 2014, fleeing across the border into Russia, few could have predicted the economic and political chaos that was set to unfold in the Ukraine. The events are now well known, from Vladimir Putin’s decision to annex Crimea, to his insertion of rebels in the easterly provinces of Donetsk and Luhansk, creating the sort of frozen conflict already fomented by Russia’s president in Georgia and Moldova.
Ukraine responded to the provocation with surprising alacrity. A new president, the oligarch Petro Poroshenko, was elected and sworn in along with a combative new premier, Arseniy Yatsenyuk. The two quickly finessed a good cop-bad cop routine, with Poroshenko’s weary, crinkle-eyed diplomat playing off against Yatsenyuk’s terrier-like snarl.
Both made the right noises about shaking up an inflexible and endemically corrupt state and injecting much-needed reform. Indeed, notes Liza Ermolenko, emerging Europe economist at London-based Capital Economics, “This is probably the first time in Ukraine’s history that it is genuinely keen on pushing through tough reforms.”
Their drive and determination to open up their markets to greater private sector competition, not to mention the clear yearning to join an expanded European Union, made them easy allies for politicians from Washington to Berlin.
Yet no amount of political and economic goodwill can replace a shaken and broken economy. Rebel attacks in the east have been judiciously targeted and co-ordinated by Moscow. In the Donetsk region, key coal and steel producing facilities have been taken and shuttered by rebel forces, slashing the size of Ukraine’s working economy by between 10% and 15%, reckons Charles Robertson, global chief economist at investment house Renaissance Capital. Industrial output fell 10.7% on an annualised basis in 2014 according to the central statistics office, adding to a decline of 4.3% in 2013, with output down 17.9% year-on-year in December alone.
Power lines and plants have been destroyed and supply routes cut off or disrupted across the east of the country. One of the more extraordinary developments was the revelation that Ukraine, once a key coal supplier to the EU, would be forced to import 160,000 tonnes of coal from South Africa merely to heat its houses and fire its industrial furnaces. In its January 2015 regional outlook, the European Bank for Reconstruction and Development warned that the economy remained in a “precarious state”, hammered by dwindling reserves and shrinking bank balance sheets.
All of which has left politicians in an invidious position, facing the need to push through unpopular reforms even as the economy shrinks. Gross domestic product shrank by 6.8% in 2014 and by an alarming 14.8% in the final three months of the year. Capital Economics’ Ermolenko describes the economic situation as “dire” and tips data to show a similar contraction of around 15% in the first quarter of 2015, with the economy set to shrink by another 12% in 2015.
IMF bailout package
With Ukraine in meltdown mode and inflation rising beyond 30%, the International Monetary Fund in March approved a $17.5bn bailout package, handing over $5bn of emergency credit. The fund is part of a far larger measure: a $40bn international package that requires Ukraine to restructure some of the country’s debt burden, currently standing at around $23bn.
Both Poroshenko and Yatsenyuk have expressed publicly their desire to have a restructuring plan in place before the IMF arrives on May 29 to begin the first review of its Extended Fund Facility programme for the heavily indebted ex-Soviet country. Whether they can achieve their ambition is open to debate. Russia is “likely to try to” prevent Ukraine from restructuring its debt, Capital Economics warned in a March 11 research note. Yet Russia’s retaliatory moves are likely to fail, the advisory outfit adds, noting that Russia lacks “the bargaining power... to block a deal”. If Ukraine succeeds in restructuring its debt, the IMF is prepared to hand over a second tranche of $2.46bn.
In its March 11 note, Capital Economics outlined the scale of the challenge. Public debt has ballooned, in large part due to the collapse of the hryvnia, Ukraine’s currency, which has fallen by 75% against the US dollar since January 2014. Ukraine’s debt-to-GDP ratio, it said, now topped 95%, up from 40% at the start of 2013. It also warned that capital flight had drained Ukraine’s foreign exchange reserves, which fell to $5.6bn in March 2013. The country is facing the added humiliation of being removed from the MSCI Frontier Markets Index, following its decision in March to impose capital controls.
Modernising the government
If there is a silver lining here, it comes in the shape of the new, reform-minded government. President Poroshenko and premier Yatsenyuk rose to power in 2014 pledging to transform a rotten and corrupt oligarchy. Both recognised the importance of cutting out graft, broadening the tax base and convincing a weary populace to trust central and local government.
Step one involved shaking up sclerotic ministries and instilling modern forms of governance. This wasn’t easy. Ukraine was in dire straits when Poroshenko took charge. A country widely expected, when the Soviet Union collapsed, to grab independence with both hands and run with it had become rudderless and becalmed. A nation “well placed for prosperity”, Deutsche Bank declared in a famous 1990 report, was virtually bankrupt, dominated by ruthless oligarchs (a group to which the immensely wealthy Poroshenko belongs).
The energy sector was, and remains in, a “complete mess”, notes Capital Economics’ Ermolenko. Its monopolistic nature and embedded corruption made it a prime candidate for reform. Other ministries targeted by the new government include education and health. In a speech to parliament in late 2014, Yatsenyuk highlighted the scale of the challenge facing Ukraine, a country that spent 8% of gross domestic product on healthcare—and lost more than half of that to graft.
Aware that parts of the government were rotten to the core, Poroshenko & Co looked elsewhere for help. Expatriates and private sector workers with good credentials, along with a handful of reform-minded foreign experts, were rolled in to the government in an attempt to create a clean, vibrant and modern-minded economy.
In December Natalie Jaresko, a Ukrainian who spent time in the US State Department and who in 2006 co-founded Horizon Capital, a Kiev-based investment fund specialising in emerging European assets, was elevated to the position of finance minister. Volodymyr Demchyshyn, a former banker who spent time at ING and Ernst & Young, was tapped for the challenging position of energy minister while Aleksandr Kvitashvili was installed as health minister.
Turning to Georgia
The latter appointment is interesting. Kvitashvili was chosen in large part because of his former role, heading Georgia’s health ministry between 2009 and 2012. That allowed him to view Ukraine’s problems as an outsider and ensured that he entered office without enemies or links to vested interests. “Kvitashvili must implement radical reforms as he has no ties with the Ukrainian pharmaceutical mafia,” Yatsenyuk announced when presenting his new hire to Kiev’s parliament.
Indeed, look closely at Ukraine’s new government and you see a heavy scattering of Georgian names, from minor treasury officials up to full ministers. Ekaterine Zguladze quit Tbilisi for Kiev in December to take up the same post she held in the Georgian government: first deputy minister of internal affairs. Even Georgian ex-president Mikheil Saakashvili was considered for a prominent government posting, along with former justice minister Zurab Adeishvili.
There is good reason to choose Georgian officials. Rather like a sporting coach buying world class talent to win trophies, Ukraine is dipping into the Caucasus country’s deep pool of reformist talent. When Saakashvili became president in 2004, Georgia was one of the region’s most deeply corrupt states. A decade later, it was a nation transformed, impelled by a set of driven, even “radical” minded reformists, notes Charles Robertson, global chief economist at Renaissance Capital.
That zeal paid dividends. In the World Bank’s 2015 Doing Business report Georgia ranked 15th, sandwiched between Germany and Canada. The next ranked state in the region was Armenia, 30 rungs lower. Nor has the transition to a new government in 2013 under billionaire Bidzina Ivanishvili and president Giorgi Margvelashvili hurt the country’s prospects.
In its latest report, the World Bank singled the country out for special praise, pointing to a 2014 rule change that cut the maximum length of fixed term contracts to 30 months. A new broom in Ukraine saw the benefits of emulating that success. “Ukraine is focused on the same radical process of change,” says RenCap’s Robertson. “Kiev has to stamp its foot on the reform accelerator.”
So where now for a country that once promised so much yet has fallen so low? There is, notes Capital Economics’ Ermolenko, “an argument to be made that, if things calm down in the east and the government pushes through all the reforms it has promised to instil to the IMF and the EU, things will get better”. Others argue that some of the economy’s bright spots have been overlooked by the wider sense of gloom. Donetsk province is assumed to be a write-off, yet the rich seams of coal in its northerly reaches remain outside rebel control.
Others take a far more pessimistic tone. RenCap’s Robertson sees a Russia controlled frozen conflict remaining in place for the next 20 years or more, preventing Ukraine from settling into its new skin and becoming a fully paid-up member of an expanded Europe. Another Ukraine-focused analyst offers an even more downbeat assessment. “The outlook is bleak. It will take years to get out of this mess,” she says. “Even with the IMF package and other financial assistance, I have trouble seeing how the country is ever going to return to growth.”