How real are the reforms in Ukraine?

By bne IntelliNews June 7, 2010

bne -

Ukrainian president Viktor Yanukovych passed a 100 days in office on Friday June 4 and surprised observers by announced a sweeping package of reforms.

How real are they? The Kyiv bourse soared after Yanukovych walked off with control over both presidency and the Rada following February's presidential election thanks to the promise of political stability after five years of chaos.

But the promise quickly went sour following rows with IMF over how to proceed resulted in the stand by programme being put on hold yet again.

"Despite Ukraine having adopted a more realistic macro forecast than that in the first version of its 2010 budget law, the IMF still thinks planned budget revenues are unrealistic. We believe the fund's concerns are justified," says Anastasiya Golovach, an analyst with Renaissance Capital in Kyiv.

The IMFhas suggested a further increase in the taxation base, including the cancellation of VAT subsidies for agricultural and pharmaceuticals producers. But it will also need further proof that Ukraine can raise its announced volume of budget revenues this year. Kyiv is trying to avoid implementing a very tight fiscal policy this year, in order to boost economic growth, says Golovach.

The talks continue and the IMF has promised to send a delegation to Kyiv this week. The delay was probably a part of game playing to underscore to Yanukovych that the fund is serious about forcing the government to stick to its promises.

Yanukovych responded well by announcing a five-year reform programme for his five-year term that, if carried out as billed, should send the economy rocketing.

"In a nutshell, it seems to the most comprehensive and all- encompassing action plan of all reform programs produced by Ukrainian leadership in recent history," Viktor Luhovyk of Dragon Capital said in a note on Friday. "We think conditions to achieve the ambitious targets set by the president have hardly ever been better with the current administration boasting a solid and growing majority in parliament and acting coherently on the executive level."

This is what everyone was hoping for: political stability is pointless unless you use it to push through all the reforms that have been ice for the last five years. The main points of the programme include:

• increase growth to 6-7%

• enact a new tax code

• sweeping deregulation and licensing reforms

• introduction of an accumulative pension scheme

• cut inflation

• complete the privatisation programme by 2015

• phase in a flexible exchange rate

• increase tariffs

• push harder to join the EU

Boosting growth should be easy. Currently half of Ukraine's GDP is in the shadow and simply encouraging companies to come into the light will add enormously to both growth and tax revenues.

Russia has successfully whitened its economy by using a combination of stick and carrot: simplifying the tax code and more recently cracking down on corruption; the shadow economy's share has fallen from about half of GDP to somewhere around a quarter to a fifth. Companies' motive for cleaning up their act is the fast growth itself: as the economy takes off there is more money to be made from investing and to do this companies need capital and have to borrow. The only way you can borrow is to have understandable and believable accounts, including paying your taxes.

Thus the introduction of a new tax code next year, promised by Yanukovych, is bound up with the growth goal and very encouraging. The president called the current code, "one of the most complicated and least transparent globally." Again given Russia's success with this sort of reform means that this reform should sail through and will hopefully be well structured.

"The strategic goals of tax reform are cutting the tax burden and increasing tax payments. The achievement of strategic goals of the reform would be realized through drawing up and adopting the Tax Code of Ukraine, on which we're working," Vice Premier Sergiy Tigipko said last week.

The fiscal reforms are also important but these are basic things that all CIS countries need to do. Things like pension reform and controlling inflation are on everyone's things to do list. The "sweeping deregulation and licensing reforms" is more of the same: simplifying the system and reducing the paperwork will reduce corruption and make it harder to hide income. The key with all these reforms is a commitment of political will to fight the fight. The same is true of the privatisation programme.

"This will require a new governmental privatization program and significant improvements in the privatization laws. These changes should resolutely counter corporate raiding and radically improve the efficiency of enterprise management in the public sector," Yanukovych said. "I will not let any outside influence on state decisions. The era of wild capitalism ended at the 2010 election."

The reforms to the exchange rate and increasing tariffs will come more slowly. Both are necessary but both come with a cost. Easing the onerous exchange rate rules open you up to hot money and so make you more vulnerable to sudden collapses. Increasing tariffs will not go down well with the population and it also fuels inflation - a major headache for Ukraine in recent years. But both have to be done.

The push towards the EU is going to be hardest. This is clearly at the top of Yanukovych foreign policy goals and Moscow was miffed after he chose to go to Brussels on his first foreign trip as president.

But the EU was already suffering from "expansion fatigue" before the crisis, and following the meltdown it has become very unlikely that the EU will be expanded again any time soon.

Yanukovych's recently love in with the Russians that has resulted in a string of deals is simply good sense as Russia remains Ukraine's biggest trade partner. Moreover, Russian investors are keen on Ukraine and investing far more than European companies.

The decision to move closer to Europe lies in Europe, not Kyiv. European leaders need to step up to the challenge - and will almost certainly fluff it. Indeed, Yanukovych's predecessor Viktor Yushchenko would not had such a hard time of it (basically he failed to make a difference) if the EU had genuinely extended a helpful hand of friendship rather than simply applauding the rise of democracy in Ukraine, but keeping the door tightly shut. Now the door is probably locked as well.

Consequently the need to placate Russia will remain an important part of Kyiv's foreign policy going forward. Yanukovych delivered here on Friday ending Yushchenko's dream of joining Nato. Moscow could swallow Ukraine's membership of the EU, but not its membership of Nato.

Promises, promises

Yanukovych is looking good and saying all the right things. And after five years of chaos the population is pleased with the progress if not the politician; a recent poll found that 46.9% would vote for Yanukovych again if presidential elections were held again, against the 9.7% Tymoshenko would win. The actually race was neck and neck with only 3% between the two leaders.

Still, words are one thing, action is another and there has been little seen on the ground so far, as far as reform is concerned. Indeed the IMF row shows that Yanukovych will struggle to build up some creditability in the short-term.

When Vladimir Putin became president of Russia he brought in a team of "St Petersburg liberals" such as German Gref, Anatoly Chubais and Arkardy Dvorkovich who formed policy and oversaw economic management. As the economy flourished this group became more powerful in that the statist Siloviki fraction began to believe in the reform programme, as everyone was getting richer.

Yanukovych, on the other hand, is busy breaking his ties to the oligarchs, but he is doing this by dumping one group to take on another.

The links between politics and business in Ukraine are far closer than in Russia. The Kremlin has explicitly abandoned the western ideal of a split between business and politics where the state supports business if business follows the state's lead.

However, the oligarchs are essentially treated as a class that is managed by Putin like a CEO: ZAO Kremlin. Even oligarchs that are not particularly popular with the Kremlin's elite, such as Viktor Vekselberg and Alexander Lebedev, are still given important jobs to do (and make money in the process).

The link between politics and business in Ukraine are far tighter and essentially clannish. Putin expelled the oligarchs from the corridors of power in spectacular fashion in 2001 with the campaigns against Vladimir Gusinsky and Boris Berezovsky, but the Rada remains stuffed with business interests.

According to bne sources Yanukovych has broken his ties with Ukraine's richest man Rinat Akhmetov, who is credited with backing Yanukovych's party in several of the previous elections. While Akhmetov, now an MP, had many allies in government, now he has almost none.

"Akhmetov is still rich and so is still a power in the Rada - he can count on the support of 50-60 deputies - his political power has been broken," says one Ukrainian investment banker, who didn't want to be named.

This break with the vested interests should be a good thing, but to make this break Yanukovych has been forced to swap one clan for another and it could go wrong.

Moreover, according to bankers on the ground the change of leadership has come with a cleaning of the house. Former Prime Minister Yulia Tymoshenko also had built up many supporters in the business world and the new regime is in the process of cleaning out these people. The businesses of Tymoshenko's allies are being checked and political risk for anyone found on the wrong side of the fence are high. In this sense the political risks of doing business in Ukraine are much higher than Russia as knowing who the company is aligned with is a key consideration.

Lastly the Russian influence in the economy has risen dramatically and emphasises the links between politics and business. In the last week a mystery appeared after steel mills Mariupol Ilyich and Zaporizhstal were both sold - but no one knew who the new owners were.

"It was the Russians. Moreover, we have heard that these deals were ordered by Putin personally; it was a political deal," says bne's source.

This is why the EU needs to step up to the plate. Struggling to get the economy moving and desperate to raise investment capital, Yanukovych can talk until he is blue in the face about EU relations but unless its comes up with cash and trade Yanukovych will turn to the only source of help on offer - Russia.

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