Ukraine’s Choice: Corruption or Growth
Since regaining its independence in 1991, Ukraine has shown systematic economic underperformance. The main driver of this record of thirty years of disappointing growth is bad governance and more particularly corruption.
Comparisons of the Ukrainian economy since 1992 with neighboring Poland and Russia illustrate this problem. In 1992, the GDP per capita in Poland was 2,459 USD. By 2019, that figure had risen to $ 15,695. The corresponding figures for Ukraine are $ 1,418 in 1992 and $ 3,659 in 2019.
Even Russia’s growth record is significantly better than Ukraine’s, with a GDP per capita of $ 3,099 in 1992 and $ 11,585 in 2019. Considering the undeniable costs of the conflict with Russia since 2014 and of the damage caused by Covid-19 since 2020, Ukraine’s post-Soviet economic performance has clearly been unsatisfactory.
During his visit to Kiev in May 2021, US Secretary of State Antony Blinken repeatedly called corruption the main enemy of the Ukrainian economy. It is difficult to dispute this assessment. Corruption erodes the effectiveness of all government institutions and the state itself.
According to former Georgian President Mikheil Saakashvili, who currently heads Ukraine’s National Reform Council, Ukraine’s state budget loses more than $ 37 billion annually due to corruption. This figure is close to a quarter of Ukraine’s annual GDP of USD 153.8 billion in 2019.
Fixed investment as a percentage of GDP was 17.6% in 2018 and 18.0% in 2019. The global share was 23.6% of GDP in 2019, but the figure for many successful emerging markets was clearly higher. The number of India in 2019 was 27%, China 43%, Romania 24% and Hungary 27%. To realize its potential, Ukraine must generate and maintain a fixed investment share of GDP not less than 20 years.
A major impetus for capital formation, in the absence of a corresponding spontaneous increase in domestic savings, will have to be financed from the outside. However, without a dramatic improvement in the business climate, foreign investment, including FDI, will not be forthcoming. Domestic investment either. Indeed, foreign investors consider the dynamism of domestic capital investments as an indicator of whether or not they should consider investing in a country.
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Conventional wisdom in Ukraine is that foreign investors will welcome the recently unveiled campaign against the country’s oligarchs. This will only be the case if it is pursued fairly and transparently through long overdue systemic reforms and does not turn into an attack on a large, successful company.
Official estimates from the Ministry of Economic Development and Trade in 2020 put 31% of Ukraine’s economy in the shadows, outside of official fiscal and regulatory frameworks. This is three percent more than a year earlier and is probably a significant underestimate. The Kyiv International Sociological Institute estimated Ukraine’s underground economy at 47.2% of GDP in 2018.
A large underground economy means that the tax base is eroded. In this environment, regulation becomes completely “manual” and is at the discretion of officials rather than governed by rules. In other words, the underground economy is a haven for corruption.
To encourage further investment, private property rights must be secure and enforceable in a transparent manner. This applies in particular to real estate, including agricultural land.
More generally, successful entrepreneurs in Ukraine are frequently shaken by corrupt officials or vulnerable to corporate raids by politically connected parties. Gaps in the protection of private property rights are pervasive and urgently need to be addressed.
Regulation means discretion for public servants. This makes it a breeding ground for corruption. Clear and simple rules and maximum transparency in their application will minimize the scope of “manual” regulation and associated corruption. Regulation in the energy sector is no exception to this rule.
Many sectors of the Ukrainian economy are dominated by monopolies. The best solution here is to introduce effective competition. There are very few natural monopolies, i.e. industries in which high start-up costs and other infrastructure, significant economies of scale relative to the size of the market, and other unavoidable barriers to entry. the entry make only one supplier of a good or a service in an industry or location. Fully opening up the EU to competition is in many cases the best solution here, including for the energy sector. Where appropriate, unnatural monopolies can be dismantled or unbundled by the regulator.
Too many Ukrainian companies are state-owned. State ownership should be limited to companies that produce pure public goods or services. The list should include national defense and public order, but not Naftogaz, which should be privatized and turned into a regulated monopoly, with the hope and expectation that, if not broken, external competition , mainly from the EU, will quickly end its monopoly status.
The prices of all energy sources, including gas and electricity, should cover long-term marginal social costs, including the cost of capital. Without this, there will be no adequate investments, national or foreign. If a credible sustainable commitment to such a tariff structure can be made, adequate investments in the energy sector will be forthcoming and special arrangements such as feed-in tariffs will not be necessary.
Ukraine is still a long way from that. Neither gas nor electricity for households is priced according to their economic costs, let alone their marginal long-term social costs. Although new projects are still announced, the full potential of renewable energy in Ukraine cannot be realized if there is significant debt distress due to the government’s failure to meet its commitment to investors.
At the end of July 2020, the guaranteed buyer (a state monopoly) owed renewable energy producers UAH 25.4 billion. Despite all the efforts of companies and the expert community, as well as Ukraine’s international partners, the provisions of the MoU signed between RES producers and the state are not implemented and debts remain unpaid.
Without radical reforms, blackouts will become a feature of daily life in Ukraine in the years to come. The state will have to meet the inherited debt by assuming it in full and paying it back. Ukraine should adopt competitive and comprehensive pricing by fully integrating into EU energy markets.
All energy users, including households that consume gas and electricity, should pay its full marginal social cost in the long run. This is only acceptable if the tax transfer system can ensure that this energy pricing does not lead to financial hardship for households. A reform of the tax transfer system is therefore necessary. If a comprehensive tax transfer reform goes too far, the state could subsidize the energy bills of low-income households.
For Ukraine to realize its economic potential, a number of major reforms are needed. The fight against corruption at all levels is a common denominator. The underground economy must be decisively reduced. The tax transfer mechanism must be simplified and made more transparent. It must be able to support an energy pricing system that allows all users (including households) to be billed for the long-term social marginal cost of energy. Monopolies should be minimized by unbundling or competition from the EU. All remaining monopolies should be regulated in a transparent manner. Most state-owned enterprises should be privatized. Until corruption is tackled comprehensively, it will continue to impede economic growth in Ukraine.
Willem Buiter is Visiting Professor of International and Public Affairs at Columbia University.
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The opinions expressed in UkraineAlert are solely those of the authors and do not necessarily reflect the views of the Atlantic Council, its staff or its supporters.
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