THE INSIDERS: Which way for Ukraine at Europe-Asia crossroads?

By bne IntelliNews February 20, 2013

Alexander Savchenko of the International Business Institute -

Even if the government of Ukraine cannot agree on a new deal with the International Monetary Fund (IMF), it will not save itself by throwing itself into Russia's embrace. More likely, it suffocate perish in Russia's arms from the lack of oxygen and hard economic realities.

Russia is the big Slavic brother and has got used to bullying in its dealings with the more junior members of the family, becoming rigid and brutal in its negotiations, imposing conditions that are tougher than those of the IMF, which the Ukrainian government is currently considering.

A new loan deal from the IMF is as indispensable as air for Ukraine today. External obligation payments by the state in 2013 will be about $9bn, and it's unlikely the government will be able to refinance its IMF debt (about $6bn this year alone) at low rates of around about 3% without a new IMF deal in place. And the country faces this debt at time when international hard currency reserves have been considerably depleted, the current account is negative and the population has lost faith in the national currency.

But meeting the IMF's conditions - a sharp, almost double, increase of natural gas tariffs for the population, and transition to a floating exchange rate under conditions of almost 50% dollarization of the official segment of economy and almost 100% dollarization of its shadow component - is not a simple task and could lead to a further deepening of the crisis.

Gas scams

But the main problem that Ukraine faces is not the IMF's demands: at the end of the day, if Ukraine has a well-defined path it can defend in the negotiations, a deal can be struck. The larger issue is in the quality of state management, which missed the chance to create regenerative growth in 2009-2011 and the gradual transition to a floating exchange rate, as well as a smooth increase of tariffs with a transparent mechanism of subsidies to the poor.

Instead, once again the necessary measures are only going to be implemented in a crisis and very few people in today's government are ready to take responsibility for them. Prime Minister Nikolay Azarov has diligently avoided engaging the IMF throughout the last two years. His official excuse was "full price tariffs are too expensive for Ukrainians." But this is only an excuse. The four-fold difference in retail and commercial gas tariffs has become a source of earnings for pro-government groups, which supervise gas distribution networks and regional gas distribution companies. The absence of a transparent system of accounting for gas consumption by the population creates the possibility for highly profitable scams with the blue fuel. This is the main barrier to reform of an energy sector that is non-transparent and riddled with corruption, out of which a lot of today's nouveaux riches have sprung.

With its cheap gas and unlimited credit resources, Russia looks like a very attractive economic partner that, as many representatives of the ruling elite assure, can replace the IMF. Russia's key requirement in any deal is for Ukraine to enter the Customs Union, which would cut the country off from a free trade zone (FTZ) deal with the EU. An FTZ with the EU could provide a powerful impetus to bring Ukraine out of the current crisis, by creating safe and predictable conditions for business and investment.

Unlike Europe, which continues to speak to Kyiv in the language of diplomacy in spite all the problems in Ukraine with selective justice and a poor investment climate, Russia prefers to operate from a position of strength. And it will only push harder if the two countries continue to diverge.

If Ukraine chooses the Eurasian vector, it will not define the long-term economic strategy of the country: after the next gas row or trade war where the elite always loses both money and face, inevitably Ukraine will return to closer mutual cooperation with the EU. The government understands this. Consequently, it is searching for a compromise with the IMF and it has a few resources it can fall back on.

Closing loopholes

First is the search for additional sources of income for the budget. The government (despite fierce internal conflicts between representatives of various power factions) shows a willingness to strengthen its controls over the oligarchical capital, which for many years was "a sacred cow" for the authorities as their key sponsor.

It is necessary to say that following the formation of the new government, President Victor Yanukovych has essentially expanded the influence of his closest circles (the Ukrainian media often calls his representatives "The Family") over economic policy. He appointed the ex-head of National Bank of Ukraine, Sergey Arbuzov, as the first deputy PM; Yury Kolobov as the finance minister; and Oleksandr Klymenko, minister of incomes and fees. This group has managed what none of his predecessors could - tightening control over the operations of the largest Ukrainian financial and industrial groups.

International experts estimate these groups have whisked some $100bn offshore in the last ten years. In a crisis, the profits of business fall and so the state budget becomes not only the main source of money (taking into account expenses of the pension fund, the level of state expenses in Ukraine comprises about 45% of official GDP), but also the sole resource for the country.

Having concentrated almost 100% control over the key budgetary processes, the president and his closest circles decide who and how many get access to these resources. But how this redistribution of wealth functions remains a secret hidden behind seven seals. International standards of transparency and accountability remain a dream for Ukrainian society.

But at the very end of last year a new law for tax "optimization" for both large and small businesses so capital transfers abroad using securities is now regulated. And another law halting the practice of transfer pricing is on the agenda. The purpose of this law is to limit the use of offshore intermediaries to prevent the real profit of the Ukrainian enterprises from leaving the country or escaping taxation.

The job of developing and implementing both laws has been given to the youngest minister in the government - the 31-year-old head of the new created Ministry of Incomes and Fees, Oleksandr Klymenko. Among his ministry initiatives is the introduction of the general declaration of incomes and control over final expenses of, first of all, politicians, officials and big businessmen. The ministry will also conduct full-scale audits of tax privileges that businessmen who are close to the authorities have gotten used to abusing.

If these measures can be successfully implemented, the first winner would be the Ukrainian state budget. However, they are bound to face fierce resistance not only at an adoption stage in parliament, but also in their implementation by the bureaucracy, whose interests and incomes are based on the non-transparency and inefficiency of the system.

Other IMF demands will be equally difficult to meet, but these difficult and unpopular reforms have been put off for decades and any losses from implementing them will be smaller than the loss of influence and business that would follow caving in to Russia's demands. Ukraine needs to make a deal with the IMF, and thereby move in a Western direction, simply because it is safer and more profitable to do so.

Alexander Savchenko is a former deputy finance minister of Ukraine (2009) and currently president of the International Business Institute.

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