Transition from Planning: Case of Ukraine

1. Lecture 11TRANSITION FROM PLANNING: A CASE OF UKRAINESergiy Pivnenko, Department of Economics, SFU

2. Introduction to Theory of Transition Transition - Definition: “The process from socialism to capitalism in former socialist economies” - Gerard Roland • A move from central planning to market economy • Large-scale institutional change • A complex economic and social change which affects - Laws, rules and norms according to which agents interact contract law, bankruptcy law, property law, competition law, securities law and intellectual property law - Organizations: economic, political etc. - Change from communist party regime to representative democracy (Is democracy a necessary condition for market reforms?)

3. Central planning: economy as a big firm • fixed prices, quantity and quality (absence of markets) • production and exchange governed by central administration (ministries) • centralized distribution of resources • setting output targets Distortions: • oversized heavy industry and small service sector • coordination failure  shortages or excess supply • poor incentives  low quality products, no cost minimization (soft budget constraints)

4. Transition Reforms Basic steps: • Stabilization – to create macroeconomic environment for markets functioning - fiscal: balanced budget (cut subsidies, sell and restructure bankrupt enterprises) - monetary: low inflation and stable currency create conditions for the price system to provide correct signals to consumers and producers • Liberalization – to end the excess demand and create working price system - deregulation, end of price controls - demonopolization, ease of entry for new firms and businesses - creating a convertible currency followed by opening of domestic economy to foreign trade • Mass privatization – to correct incentives - a transfer of ownership of state assets to the private sector • Creation of social safety net – to alleviate the negative effects of enterprise restructuring • introduction of unemployment compensation system • effective utilization of government expenditures for social needs — on pensions, family assistance, and health

5. The debate over gradualism vs. “shock therapy” Examples: Shock Therapy: Poland, Czech Republic Gradualism: Russia and Ukraine - “shock without therapy”, China Argument against shock therapy: Institutional transformation is rather evolutionary process: - Cannot privatize overnight - Cannot build financial system overnight However, fast stabilization makes possible efficient structural reforms High social cost of shock therapy (will it be lower under gradualism?) Political argument for shock therapy: Jeffrey Sachs: ”Fragile governments facing a deep economic crisis are best able to carry out strong measures at the beginning of their tenure”

6. Economic Transformation: a case of Ukraine Population: 47,732,079 (July 2004 est.) Territory: 603,700 sq km (slightly greater than France) Location: Eastern Europe Life expectancy at birth: male: 61.35 years, female: 72.27 years (2004 est.) GDP per capita: at purchasing power parity - $5,400 (2003 est.) Ukraine remains the only country in the world that voluntarily got rid of its entire nuclear arsenal During 1994-1996 all nuclear warheads and their carriers were partly destroyed, partly transferred to Russia in exchange for the nuclear plants fuel.

7. A Lost DecadeUkraine's transition in 1990's: half-hearted reforms=no reforms • Total decline of about 53 percent of GDP from 1989 to 1998 (negative value added, disorganization) • The underground economy amounted to 49 percent of GDP in 1995 (tax evasion) • Privatization of land has been persistently blocked by the left wing of the parliament • Rudimentary stock market, shareholders’ rights not protected • Pervasive corruption (Ukraine ranked 69 out of 85 countries in 1998 Corruption Perception Index) • Lack of liberalization (Ukraine ranked 122 out of 123 countries in 1995 Index of Economic Freedom) • Disorganized financial system (amount of barter transactions was estimated about 50% of GDP in 1996)

8. Partial success • After a period of hyperinflation in 1991-94 macroeconomic stability was achieved (government stopped uncontrolled monetary emission, balanced budget) • In 1996 a new Ukrainian currency (hryvna) with fixed exchange rate was introduced. • Independence of Central Bank (!). Despite of the pressures from the Government Central Bank maintained stability of Ukrainian currency • Privatization (though slow and inefficient) was on the way: sale to insiders/outsiders, IPOs, small scale privatization

9. Why gradualism? - Lost momentum! Immediately after collapse of communist rule (1991) the leadership of newly independent Ukraine was preoccupied with nation building which was widely perceived as separate from market economic reform. The devastating financial crisis (10,155% inflation in 1993) ruined social consensus thus making “shock therapy” politically impossible.

10. What went wrong? A rent-seeking model of Ukrainian economy (Anders Aslund): Four sectors: 1. The government: opposes any deregulation that would reduce its monopoly power and thus its revenues from bribes. 2. Rent-seeking businessmen: focus on elementary monopoly rents, lobbying for regulations that guarantee them. They favor all kinds of regulations, which apply to others but not to themselves. 3. The parliament: largely lives for bribes, in particular the center that represents the party of power, which essentially supports the government. Thus, the parliament is largely interested in as messy a legislation as possible. 4. The Ukrainian households suffer from corruption and a dysfunctional economy. They have to work in the underground economy in order to sustain minimal living standards. Many blame reform, as Ukraine has officially been pursuing reform for years.

11. A rent-seeking model (continued) Anders Aslund: “Thus, we have found an iron triangle of government, businessmen and parliament who all favor a maximum of regulation and state interference to maximize rent-seeking and corruption, while the population is of little consequence and partly co-opted and compromised. The problem is that this model of self-reinforcing rent-seeking looks far too stable and it is close to an equilibrium.”

12. A rent-seeking model (concluded) A Vicious Circle: “Piecemeal reforms have bred extraordinary corruption and rent-seeking. A small group of very rich people has arisen, and they have bought political power with their wealth. They are using their fortunes to maintain their fortunes by bribing politicians, bureaucrats and parliamentarians to introduce new regulations that generate more rents.” “… Ukraine appeared stuck in a severe under-reform trap.” Anders Aslund, 1999

13. Ukraine’s return to growth in 2000 Fastest growing industries: food processing and packaging, energy generation and transit, telecommunication and information technology, construction • 6% growth in 2000 (13% growth in industrial output, 9% - in agriculture) • 9 % GDP growth in 2001 (18% - in industrial output, 27% - in agriculture) • 4.1% GDP growth in 2002; • 6% GDP growth in 2003; • In 2004 GDP is set to expand by an amazing 10% to 12% (mainly export driven growth, due to the high metals prices at world markets) Reform leaders: • prime-minister Victor Yuschenko (former governor of Central Bank) • vice-prime-minister Yulia Tymoshenko (formerly one of the biggest gas traders)

14. What has worked well: • substantial progress in establishing fiscal discipline • refusal of the central and local governments to settle tax obligations in anything other than cash, • the increase in cash payments for gas and electricity by final consumers from levels around 10 % of payments due in 1999 to levels around 70 % in 2001 • sources of energy rents (these rents amounted to 13% of GDP, - import at subsidized prices and re-export at world prices) were removed in - gas imports - electricity generating industry - oil imports • large scale privatization intensified competition for rents • lower and simplified taxes pulled entrepreneurs out of the shadow economy • foreign trade liberalization created a competitive pressure that forced large enterprises to restructure

15. Ukraine’s transition reform today • February 2001: president Kuchma dismissed Tymoshenko and in April 2001 the pro-president parties and communists voted Yuschenko out of power. • 2001-2004: reforms slowed down. Despite of the growing GDP living standards have not improved (30% of the population remain below poverty line). Pervasive corruption and lack of economic restructuring threaten the sustainability of growth. • January 2005: Victor Yuschenko inaugurated as a new President of Ukraine. • February 2005: Yulia Timoshenko appointed by the President and unanimously approved by the Parliament as a Prime-Minister of Ukraine, announced The Government's Action Program: • dismantling “corruption vertical”, create new judicial system; • creation of reliable and transparent business environment; • modernization of the power industry, reliance on renewable energy sources and energy-saving technologies; • reducing government intervention, fostering small and midsized privately-run businesses; • “taxes must be comprehensible, stable and low” • core principle: “the State serves the people, not the other way about”