LOL I AINT TELLING YOU M8

The economic turmoil reflects recent political instability. But Ukraines economic problems were
long in the making. Dodgy economic policy, distaste for reform and endemic corruption have
brought the country to its knees.
In the immediate post-Soviet era Ukraine was a massively unproductive economy. Like most former
Soviet republics it suffered huge output declines and soaring inflation. But Ukraine was among the
hardest hit of the lot. Hyperinflation in the early 1990s resulted from lack of access to financial
markets and massive monetary expansion to finance government spending, in the face of sharply
declining output. The Ukrainian population was scarred by the experience of hyperinflation. In
response, in 1996 the Ukrainian central bank replaced the old currency, the karbovanets, with the
hryvnia and pledged to keep it stable in relation to the dollar. The currency continued to wobble
through the late 1990s, however, and particularly amid the Russian rouble crisis of 1998.

Both Russia and Ukraine stabilised by the early 2000s. Capital flowed back, attracted in part by
relatively high interest rates (the early 2000s, when the Fed pushed its main interest rate down to
1% for an extended period, were a rehearsal of sorts for the post-crisis environment). As foreign
cash flooded in the money supply grew rapidly: from 2001 to 2010 broad money increased at an
annual rate of 35%. In 2006 and 2007 credit growth averaged 73%. Assets began to look
extraordinarily bubbly and high inflation damaged Ukraine's export competitiveness.
After the global crisis, and as the euro crisis intensified, Ukraine suffered from a drought in capital
flows (along with much of central and eastern Europe) which placed strong downward pressure on
the hryvnia. Protecting the currency drained the central banks reserves, which tumbled from a high
of $40 billion in 2011 to about $12 billion today. Last month the central bank admitted defeat and
let the currency go. Currency depreciation, while necessary, will be an economic headache for
Ukraine in the short term. About half of its public debt is in foreign currencies: as the hrvynia loses
value, Ukraines debt burden rises. Debt financing has also become more difficult as a result of the
Federal Reserve's "taper", which has wrong-footed many emerging markets by stanching the
previously steady flow of capital in their direction.
Ukraine has proven reluctant to engage in reform. For a while it felt as if it didn't need to: high
commodity prices during the 2000s supported growth. Many of Ukraine's exports went to Russia, a
country that was also doing well on the back of high oil prices. But Ukraine was badly hit by the
financial crisis and plummeting steel prices. GDP fell by 15% in 2009. That made it a prime

candidate for economic streamlining. In 2010 the IMF agreed to loan Ukraine $15 billionwith
conditions attached. A major target for reform were Ukraines cushy energy subsidies. The state gas
company, Naftogaz, only charges consumers a quarter of the cost of importing the gas. Cheap gas
discourages investment: Ukraine is one of the most energy-intensive economies in the world and
domestic production has slumped by two-thirds since the 1970s. The IMF ended up freezing the
deal in 2011 after Kiev failed to touch the costly subsidies.
In other areas reform has been half-hearted. The government did meet its public deficit target of
2.8% of GDP in 2011. Yet this was achieved by skimping on capital expenditures while
overspending on wages and pensions: hardly the recipe for sustainable economic growth.
Progressively lowering the rate of corporation tax has also weakened the states finances.
Corruption and poor governance are other major problems. The Ukrainian shadow economy is one
of the biggest in the worldat around 50% of GDP, according to IMF research. Businesses
operating underground tend not to pay taxes, further depriving the government of funds. And last
week Ukraines new prime minister estimated that $37 billion had gone missing during Viktor
Yanukovychs rule.
Right now Ukraine is not too worried about improving economic management. But big bills are
imminent: Ukraine needs to find about $25 billion this year to finance its large current-account
deficit and to meet foreign creditors. Foreign-exchange reserves are only $12 billion. Default is
certainly on the cards. When the crisis does end, addressing its economic backwardness must be a
major objective.

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In 199599, both Ukraine and Russia performed badly. In the decade of 198999, Ukraine's GDP
fell by no less than 61 percent compared with a similar 59 percent for Russia. Both countries were
woken up by the Russian financial crash of 1998. They were forced to balance their budgets by
cutting harmful enterprise subsidies, which prompted economic growth.
In the third period 200007, both Ukraine and Russia grew soundly, Ukraine by an average of 7.5
percent a year and Russia at 7 percent a year. The global financial crisis of 200809 called them
bluff over their overheating. Ukraine had thrived on a big financial bubble, which burst in
September 2008. It saw its GDP decline by 15 percent in 2009, while Russia's GDP plummeted by
7.8 percent.
Neither country carried out any serious reforms after the crash of 2008. Ukraine was bailed out by
the International Monetary Fund and Russia by its currency reserves. They grew at a similarly low
speed in 2010 and 2011, though Ukraine stagnated in 2012, while Russia continued growing
slightly.
From this perspective, the Ukrainian situation does not look that strange. It differs from Russia's
mainly because of three reasons. First and most importantly, Ukraine had no economic policy but
maintained the old Soviet system, while allowing hyperinflation from 1991 to 1994; Russia
attempted serious market reforms. Second, from 2000 onward world oil prices started rising,
boosting Russia's GDP at current exchange rates but not in terms of real economic growth. Third, in
201013, president Viktor Yanukovych pursued an incredibly predatory regime, concentrating all
power and wealth to his family. He failed to follow late Russian Finance Minister Aleksandr
Livshits's dictum: " [You need to share]!"
The National Bank of Ukraine forecasts that the country's economic output will plummet by 10
percent this year. Then the budget deficit will surge to 15 percent of GDP, and the public debt to
over 100 percent of GDP next year. The Ukrainian currency has already been devalued by 60
percent, driving inflation to 19 percent. A classical devaluation-inflation cycle is near and can lead

to a financial meltdown.
Three-quarters of this sharp decline in output is caused by the war in the eastern part of Donbas,
which used to deliver 10 percent of GDP and 16 percent of Ukraine's industrial production. After
artillery from the east blew up the power stations, the pumps in the coalmines have stopped, and the
mines have been flooded. As a consequence, Ukraine's total coal production fell by more than half
in August and September in comparison with those months in 2013. Steel production is down by
one-third. Agriculture, by contrast, is booming and the grain harvest may even top last year's
bumper harvest.
While Ukraine's economic situation is desperate, it is not hopeless. The first thing to do is to have
new presidential and parliamentary elections to get political leaders who want to save the country
rather than themselves and their families. That is what Ukraine has just done.
The next step is to throw out the old officials. In September Ukraine's parliament adopted a law on
lustration, which is now leading to the sacking of old top officials throughout the administration. It
needs to be accompanied by a constitutional reform leading to more decentralization and an
abolition of superfluous or even harmful state agencies and a far-reaching deregulation.
Then comes the hard step: to cut public expenditures from their current level of 53 percent of GDP
by one-tenth of GDP in 2015 to rein them in to a reasonable level. The excessive payroll tax must
be slashed and the flat personal income tax should be restored. The lawless tax police should be
abolished.
The main cut in public expenditures should be the elimination of the energy subsidies, which
currently amount to 10 percent of GDP. Domestic energy prices should finally be unified, while
social cash compensation should be given to the poorest half of the population. As a consequence,
Ukraine could cut its energy consumption by half and boost domestic energy production to become
self-sufficient in energy. The most important effect would be that the corrupt arbitrage between low
state-controlled gas prices and free market prices finally could come to an end.
Needless to say, Ukraine will need substantial international financial assistance to carry out these
major reforms. It is likely to come primarily from the International Monetary Fund and the
European Union.
Ukraine's financial crisis forces the country to change its ways for the better. Democracy has
already been established. The public budget deficit must be cut and the rest financed with
international support. The power of the old Soviet establishment and its endemic corruption should
be broken. Finally, Ukraine can pursue a deregulation that allows its economy to grow.
Figure 1 GDP growth in Russia and Ukraine, 1989-2013