'Dysfunctional' economy is Yushchenko's first challenge

Posted in Europe | 31-Dec-04 | Author: Judy Dempsey| Source: International Herald Tribune

Opposition presidential candidate Viktor Yushchenko shows V-signs to his supporters after a massive rally in Kiev, Tuesday, Dec. 28, 2004.
BERLIN When the Ukrainian transportation minister Georgy Kyrpa was found dead in his sauna on Dec. 28, Kiev was quickly awash with rumors.

Some commentators in the Ukraine capital said Kyrpa committed suicide because, among other things, he had provided public transport for supporters of the outgoing prime minister, Viktor Yanukovich, the Russian-backed presidential candidate. He may have feared reprisals from the incoming government.

Others said Kyrpa may have known too much about big infrastructure contracts and the wheeling and dealing among the handful of oligarchs who control Ukraine's economy.

Whatever the reason, Kyrpa's death cast a shadow over the Dec. 26 presidential victory of the opposition leader Viktor Yushchenko. What is more, his death seemed to confirm what one economist described as the "dysfunctional" state of an economy mired in secrecy and corruption.

"In a way, you could describe the economy as dysfunctional," said Igor Burakovsky, director of the independent Institute for Economic Research and Policy Consulting.

Sandwiched between Russia to the east and the European Union to the west, Ukraine, analysts said, has yet to complete its transition from a communist, centrally controlled economy to a market-based one underpinned by transparency and the rule of law.

That shift, which Yushchenko has pledged to put on a fast track, will have far-reaching implications for structural reform - and for the oligarchs who have profited handsomely from the opaque nature of the Ukraine economy.

Yushchenko, a former prime minister and former head of Ukraine's National Bank, is no stranger to the workings of his country's economy.

"He is neither naïve nor has he illusions," said a European diplomat based in Kiev. "He knows exactly what has to be done if Ukraine is to modernize, attract foreign investment and join the World Trade Organization. He has his work cut out."

Julian Exeter, senior economist at the European Bank for Reconstruction and Development, said one of Yushchenko's priorities, at least from the macroeconomic side, is to rein in the budget deficit, which is now running at around 3.5 percent of gross domestic product. That may seem fairly modest by European standards, but with the inflation rate this year closing in on 12 percent, according to Ukraine central bank forecasts, Exeter said Yushchenko had little leeway to reduce the deficit any time soon.

Yushchenko will find himself under pressure on another front, as well: Big promises of public spending are not accounted for in the 2004 budget. As part of his bid to woo votes in the presidential campaign, Yanukovich raised the minimum monthly pension, which economists say could cost 1 billion hrynias, or around $190 million, a month.

Some of this cost could be met by higher contributions from wage earners, Exeter said. But the government may also have to cut other areas of public spending or seek to close tax loopholes and improve revenue collection from large enterprises.

While doubts abound about the government's ability to do that, Burakovsky said tightening up the revenue collection system needed to be a priority.

"There are all sorts of tax exemptions and companies using connections to try and stop paying value added taxation or finding ways not to pay taxes," he added. A recent report by the International Monetary Fund criticized "frequent tax amnesties" and tolerance of tax arrears, especially for energy companies.

Another issue facing Yushchenko is privatization. Although the outgoing government set up what was supposed to be an independent State Property Fund to oversee privatization, Ukrainian and European economists said privatizations lacked transparency.

The most frequently cited case is the recent sale of the steel division of the Krasnodonvuhillia mining conglomerate. It was bought by System Capital Management, a group based in the eastern city of Donetsk and controlled by Rinat Akhmetov, one of the most powerful businessmen in eastern Ukraine.

Two foreign investors bidding for the company topped the $750 million winning bid by Akhmetov, who supported Yanukovich's presidential campaign.

A report by the Institute for Economic Research and Policy Consulting said there was "discrimination" in the way the final tender was issued.

The European Bank for Reconstruction and Development has been much blunter in its assessment of Ukraine's business environment, including the privatization program. In its recent transition report on former communist countries, it said the business environment in Ukraine was dogged by "a cumbersome regulatory framework, unstable legislation, anticompetitive practices and widespread corruption" which together represented "serious barriers to doing business."

Yushchenko, however, seems unenthusiastic about reversing past privatizations for fear of deterring foreign investors.

"He may do a deal with Akhmetov, particularly since Akhmetov paid well below the marker value," said a Western economist based in Kiev who requested anonymity. "The thing is that Yushchenko will have to deal with the oligarchs. He has no choice. But the oligarchs will have to deal with him, too."

The oligarchs in eastern Ukraine have prospered over the past few years.

"One reason why growth, especially exports, has been so high is because China has been importing huge amounts of steel from Ukraine," Burakovsky said. Exports rose 15.2 percent compared with a year earlier in the second quarter of 2004, up from a 9.8 percent growth rate a year earlier.

The European Bank for Reconstruction and Development estimates that gross domestic product has grown by around 12 percent this year. But according to Derzhkomstat, Ukraine's statistics office, the economy could slow in 2005 - especially as China shows signs of slowing down its own growth, a move that could lead to a reduction of steel imports from Ukraine. "This cannot be excluded," said the Institute for Economic Policy Research.

Yet Ukrainian analysts are divided over the long-term goals of the oligarchs and their future relationship with Yushchenko. Few of them backed him during the presidential campaign, fearing he would be considerably less tolerant of their current privileges.

Olexandr Tkachenko, chairman of Ukraine's New Channel TV, said some of the oligarchs, who had resisted modernizing their companies, feared Ukraine's entry into the global economy, since they would have to be competitive and play by international accounting standards. Yet, he added, some businesses, such as the Industrial Union of Donbass, were already engaging with Western companies.

"The oligarchs will have to make a choice," said Tkachenko. "Do they want to be swallowed up by Russia or do they want to modernize and be competitive?"

"They will have to adopt international accounting standards if they need to go to the Western capital markets to raise funds to modernize."

That choice may come sooner rather than later if Yushchenko pushes hard to complete negotiations for Ukraine to join the World Trade Organization, and works to speed up Ukraine's transition to a market economy - a key requirement for improving ties with the European Union.

So far, Ukraine has signed 28 bilateral agreements as part of its efforts to join the WTO. But the most important bilateral trade deal, with the United States, has yet to be concluded.

The outstanding issue, from Washington's perspective, is Ukraine's foot-dragging over the protection of intellectual property rights.

"The WTO would be a big fillip to Ukraine," said Exeter. "That, and the strengthening of corporate governance, would really boost its capital markets and attract foreign investment."