How to Continue the Fast Pace of Economic Growth in Ukraine

Lorenzo FIGIUOLI  Bogdan LISSOVOLIK (Lorenzo FIGIUOLI, IMF Senior Resident Representative in Ukraine, Bogdan LISSOVOLIK, IMF economist) The advantages of a market economy are becoming more and more obvious in the context of several years of economic growth in Ukraine. At the same, there is serious concern about the slow pace of improvement in the living standards of many workers, pensioners, the rural population and other vulnerable groups. This concern has a strong impact on the political process; it will increase as the presidential election approaches and will not diminish after it. In this context, politicians will have to solve two major tasks: find ways (a) to maximize economic growth rates and (b) improve the living standards of the most vulnerable groups of the population. What is the best way to achieve this twofold goal? We do not have ready answers to these questions; however, we would like to share some of the recommendations provided by the science of economics and discuss how relevant they could be to Ukraine.

The growth dilemma

For the last several years, Ukraine’s economy has been characterized by fast economic growth rates, a small budget deficit, a low inflation rate and an improving balance of payment situation. Such a combination of factors can be defined as a “macroeconomic beneficial circle”. Ukraine’s economy is now the most dynamic one in the rapidly growing CIS region. For the last four years, its growth rates have exceeded 7% a year on average, and its real annual growth has also exceeded 7%. Inflation sustained a single-digit rate and the exchange rate of the hyrvnia remained stable, with exports keeping their competitive position. As a result, the positive balance of payment has lead to the accumulation of hard currency reserves, which, in its turn, has favored the monetisation of the economy. Due to these positive trends, the income of the population has grown significantly despite its extremely low initial level. There was an almost twofold increase in nominal salaries, both in hryvnia and dollar equivalents since 2000. Real salaries stabilized in 2000, grew by almost 20% per year in 2001-2002 and continued to grow in 2003. This growth was accompanied by significant progress in the repayment of salary and pension arrears. Currently there are two opposite points of view on the economic situation in Ukraine. On the one hand, dynamic economic growth, which has significantly increased in 2003 – 2004, prompts the optimists to believe in the “final recovery” of the Ukrainian economy. On the other hand, pessimists insist that progress was a very “modest one if compared to what it could be”, since other countries with economies in transition have much higher average indices of industrial output and standards of living, and Ukraine’s progress is not impressive against such a background. For example, per capita income in many countries in Central and Eastern Europe (CEE) exceeds the Ukrainian index by three to seven times. Such a lag, as well as uneven economic growth, raise doubts in the current policy and point to the need for a search for “a more radical improvement in the situation.” In our view, both these views are reasonable, yet pessimists have to admit that there are a number of special features. First, for the last several years Ukraine has approached these countries in some of the indices. Since 1999, its real GDP has grown by 32% whereas the GDPs of Hungary and Romania have increased by slightly more than 15% and that of Poland and the Czech Republic by only 10 -12 %. Apart from this, one should not forget that there was a significant difference between the levels of income in Ukraine and in other CEE countries at the early stages of transition. Second, pessimists should consider the scale of the shadow economy, which, according to expert assessment, is much larger than that in the CEE countries. This fact is indirectly confirmed by relatively high ratios of export to the GDP and tax volumes to the GDP: their continuing growth testifies to the fact that the estimate of the current GDP growth is unlikely to be understated. Moreover the growth rate in the number of small and medium enterprises has increased. These, according to the EBRD data, are more numerous in Ukraine than in the other CIS countries. Nevertheless, the “pessimistic” interpretation is very useful since it emphasizes the existing drawbacks and reservations concerning the Ukrainian economy. To approach its well-to-do neighbors and become ready for European integration, Ukraine must continue to ensure fast economic growth rates in the long-term.

“The Beneficial Circle”

What are the reasons for the current “beneficial circle”? In our opinion, economic growth is based on two groups of factors. First, economic policy has significantly improved since 1999 and paved the way for productivity growth (although it was belated) in response to the market incentives. In particular, the achievement and sustaining of macroeconomic and regulatory stability created a more predictable environment for production. The necessary prerequisites for development and an increase in enterprise efficiency within the system of market incentives and mechanisms have been created in all sectors of the economy. Second, the factors of production-labor and capital – were and remain (at least this is true about labor) very “cheap” and, therefore, competitive. A very low salary level is evidence of this, whereas at the beginning of the economic growth period five years ago there was also evidence of excess capacity. These “advantages”, however, could be the result of a deep fall in output volumes and “disorganization of production” during the previous decade. Such low costs, under other equal conditions, created an incentive for entrepreneurs and investors to use Ukraine’s production potential and thus contributed to the growth of export and GDP. For the last five years, production growth in Ukraine was fast enough to “make up” for the increase in labor and capital costs. Due to this, income and output growth did not create significant pressure on prices and the foreign trade balance, while the increase in tax revenues enabled the country to avoid an excessive budget deficit. However, numerous examples from developing countries and countries with an economy in transition testify that growth may unexpectedly stop due to macroeconomic problems, say, inflation growth or a decrease in hard currency reserves as a result of the overheating of the economy and external shocks. At some time, a slow down of production growth in Ukraine compared to salary and income growth may impede advanced economic growth, with decreased competitiveness having a negative impact on the economic growth rate, inflation and the balance of payments. Under such conditions, the country will, at best, fall out of the “beneficial circle” or at worst enter a “vicious circle” in its development, where one problem aggravates another. For how long can the favorable macroeconomic situation last in Ukraine? It is very difficult to answer this question, but there are a number of qualitative considerations that point to the decrease in the growth potential of the Ukrainian economy in the near future. First, we believe that the role of certain determinants, which ensured production and efficiency growth in the initial stage, will be reduced in the process of growth. This refers to the one-time effect of resumed use of the old production capacities, elimination of barter and other non-cash payments and the achievement of a certain macroeconomic stability. Second, the total amount and especially the structure of investments need to be improved. The inflow of investment has significantly increased recently and the total amount of about 20% of GDP in 2002 and 2003 does not seem small in comparison with other countries. (Although this is still a point of issue because of the need to consider the role of the shadow economy.) This investment must increase the amount and improve the quality of fixed assets (capital) in the economy, thus increasing its growth potential. Nevertheless, such an important component as direct foreign investment still remains at a low level. Direct foreign investment plays an important role since it generates technological and managerial knowledge acquisition. Moreover, there is a need for investment in infrastructure. In the absence of such investment, the production process will develop bottlenecks, which will impede further economic growth. All of these do not necessarily imply that Ukraine’s economy and production growth will slow down immediately. Economic growth may continue for some time at the cost of Ukrainian competitive production costs, along with the introduction of new production processes at the microeconomic level. Thus, low production costs may allow for the high economic growth rates of Ukraine, considering the increase in costs of its major eastern European competitors resulting from their joining the EU. Of course one can differ on the timing, but one must not take the retention of high economic growth rates for granted. Sooner or later, the Ukrainian economy will face either the recurring or structural slowdown of growth observed in all market economies. Regardless of the reason for the slowdown, a relevant macroeconomic and structural policy is needed to mitigate or prevent recession. First, the government and the National Bank of Ukraine must purse a reasonable taxation, budget and fiscal policy to preserve macroeconomic stability already achieved. The definition of “stability” may vary, but a serious budget deficit or high inflation rate will certainly undermine the basis of economic growth. A recent and rather unexpected example of this is the situation in the CEE countries (Poland and Hungary), where mitigation of taxation and budget policy recently has created many more economic problems than it has solved. In the short and mid-term, the Ukrainian government will have to define its standing on two key macroeconomic policy issues. First, concerning the transition to a more flexible exchange rate to avoid the risks related to maintaining a long-term fixed rate. It would be sensible to make a gradual introduction of inflation targets, as has been done in some of the CEE countries. Second, a very fast increase in the amount of bank loans, although it partly reflects the re-monetization processes of the last few years, may result in the accumulation of bad credit in case of a significant economic slowdown or negative shocks. To remove this threat, the following measures should be taken: (a) further toughening of standards of regulation and bank supervision; (b) an increase in capitalization of commercial banks; (c) improvement of the system of assessing the quality of commercial banks’ credit portfolio and their internal control. Last year’s reviving of the inflation rate is also worth of close attention because such processes can undermine competitiveness and, as a result, internal and external financial stability. Indeed, for the last several years the inflation rate has been within the small single-digit range in most of the developing countries and countries with economies in transition, including China and South Korea. These two countries were cited by some Ukrainian authors as examples of “successful inflationary stimulation of economic growth”, but their data on the rates of economic growth and inflation also testify to the fact that high economic growth rates can perfectly coexist with very low inflation. Obviously, the key to the “mystery of high economic growth rates” is something else, more complicated.

Long-term sustaining of growth

How can one ensure sustainable economic growth and an increase in labor productivity? Since the times of Adam Smith, scientists have been trying to develop and improve the principles of economic policy that would allow for maximization of economic efficiency in a market environment. The most important of them include the following: (a) transparency; (b) competition; (c) the rule of law that ensures basically the same approach to the regulation of the economy and unswerving observance of property rights. On practice, translation of these principles into effective decisions on economic policy turned out to be a very complicated task. Nevertheless, the countries which tried to adhere most closely to these principles have achieved the best results as far as long term economic growth is concerned. Furthermore, the principles of transparency, competition and the rule of law not only promote the private sector’s growth but also lay the foundation for the effective public sector – an essential condition for success in any market economy. These conclusions, as a rule, are confirmed by the latest empirical research into the basic reasons for economic growth in all countries of the world. Their authors agree that all things being equal, there is a positive correlation between economic growth on the one hand and the quality of education system, effective compliance with the rule of law, the development of the financial system and market institutions ensuring transparency, and certain quality indices of investment such as internal private and direct external investment on the other hand. At the same time, there is a negative correlation between economic growth and the variables that mirror “warps” in governmental policy (too large a share by the public sector in the economy, trade and currency restrictions, political instability). One must admit that due to methodological problems this analysis is not exhaustive, and a considerable part of economic growth in most countries still needs to be clarified. However, this research has proven that it is necessary to complete a thorough analysis of the conditions in each specific country. What does Ukraine’s economy look like in terms of these basic market principles stimulating economic growth? Despite the progress achieved for the several last years, it is generally admitted that transparency, honest competition and the rule of law are a serious problem for Ukraine. Excessively “interventionist” economic policy has stalled the development of key institutes both in private and public sectors. For example, Ukraine’s fast-growing financial-credit market could have been even more active if the corporate sector had been transparent and had had a clear property structure and generally accepted accounting standards. Where do these drawbacks take their roots? The legacy of centralized planning and inflationary policy of the early 1990’s have certainly played their role. However, this cannot justify the lack of transparency and the influence of excessive interest lobbying. Certain features of the lack of transparency, oligarchism and corruption are still clearly observed in certain sectors of Ukrainian capitalism, and do not comply with the “European choice” declared by Ukrainian government. Corruption is a heavy burden, worsening the quality of human capital since it undermines labor ethics and quality standards in education. It is true that Europe and the developed economies in general have examples of corruption and influential lobbies, but they do not play the determining role in the environment, which is generally based on compliance with certain rules and ensures equal conditions for all. It is the compliance with the rules and equal conditions that promote the development of new and existing businesses, whereas their lack stalls such development. What specific steps must be taken in the economic policy of Ukraine under such conditions? In our view, it is of paramount importance to reach an agreement on the principles and order of implementation of specific measures for the welfare of the majority of Ukrainians that would be unswervingly supported by all brunches of government. “The exact list” of such reforms is not so important. What is important is the commitment to the principles of transparency, competition and the rule of law during the decision-making and project implementation. At the same time, there is a number of specific areas where we believe this approach will be especially productive: - Clear distinction between public and private interests, especially in case of such industrial giants as Naftogas and Ukrtelecom, which must become transparent and accountable to the government and society in general. No private or political interest can be pursued in their management. The heads of such enterprises must be appointed and discharged in strict compliance with clear criteria and procedures. - Ensuring bigger corporate transparency at all levels, including the private sector (for example, by the adoption of the long-postponed law on joint-stock companies); - Adherence to the principle of sternness towards official and unofficial interference (or even signs of interference), as well as to selective lenience of tax and other regulatory bodes towards enterprises. This must be facilitated by tax reform aimed at abolishing unjustified tax benefits and privileges. In addition, to establish a clear vertical line of responsibility, it is advisable to subject the State Tax Administration, Customs and Treasury to the Finance Ministry. Such accountability, among the other things, will help to solve the problem of overdue VAT arrears which has a negative effect on tax discipline, and increase confidence in the state as a contract partner and as a body ensuring compliance with the rules. - Ensuring transparency in privatization. Auction results must mirror true competition rather than become a gift to a well-connected buyer. If the government is unable to organize a sale on a truly competitive basis within the rather limited framework of a privatization auction, it can hardly be trusted with more complicated regulatory functions. The major task of the State Property Fund should be the organization of transparent and competitive auctions. - Improvement of the judicial system and strengthening of its independence. Entrepreneurs often mention this issue as a major problem in the investment climate, without which Ukraine will not benefit from its rather good laws. - Ensuring support for research and educational institutions not only at the cost of their better financing but also by means of protecting their reputation and establishing and maintaining the standards of reward. This is essential for the long-term development of Ukraine’s economic growth potential, especially in the high-technology sector. These and other similar measures should intensify current significant yet incomplete progress in market reforms and lay the foundation for sustainable economic growth. It is obvious that most of the measures supplement each other: for example, termination of the “tax despotism” practice (actual or seeming) would be a good incentive for corporate openness. Moreover, many of the measures – especially those concerning the reduction of corruption, abolishment of still existing yet unjustified tax privileges, enhancement of the principles of strict compliance with contract terms, increase in corporate transparency and transparency of sales of state assets – would increase the inflow of market investment, enhance production efficiency and contribute to further production growth (and therefore the growth of standards of living). We believe that these obvious measures must be given priority over the recurrent attempts to assign primary importance to “industrial policy” because in the absence of transparency and fair competition, officials will select false priorities, which could be abused at the point of practical implementation. To implement the above measures it will occasionally be necessary to take unpopular decisions. The critical mass of state officials and politicians must act resolutely in the interests of the entire society and not depend on a lobby representing the interests of a limited circle of the “selected”. Considering the hierarchical structure of society inherited by Ukraine, success can be achieved only through a commitment to social priorities at the very highest level. Any attempts to solve deep structural problems by mitigating macroeconomic policy will be absolutely ineffective under such conditions. We are convinced that keeping high economic growth rates is the best way to fight poverty. Gradually increasing wealth diffusion, which accompanies the process of economic growth, becomes practically irreversible. Nevertheless, it is impossible to solve all of Ukraine’s problems by maximization of economic growth.

Income distribution

The issue of distribution of income has always raised controversy in any country. On the whole, some differentiation of income is necessary to ensure the effective functioning of a capitalist society, otherwise motivation for production operations will be very low. The degree of such differentiation may depend on special features or the culture of the country. In the industrially developed world, an egalitarian system of income distribution has traditionally existed in the countries of continental Europe, whereas greater inequality is more typical in Anglo-Saxon society (Great Britain, USA). The developing countries have a very diverse picture, combining the extreme examples of inequity of income especially in Latin America and tropical Africa and more equal income distribution in some but not all Asian countries. Nevertheless, inequality in most of the Asian countries is growing together with the development of markets and acceleration of the economic growth. However that may be, the overwhelming majority of economists agree that extreme forms of equality or inequality have a negative effect on economic development. Negative correlation between “extreme equality” and efficiency has been reflected in low quality of goods and services produced by the economies of former socialist states. Even the affluent states of Europe have difficulties with major state social programs due to a high tax burden necessary for their funding. This burden stalls economic development due to decreased effectiveness of incentives and has a negative effect on competitiveness and investment. The extreme forms of income inequality also affect economic development. They undermine the sense of fairness in society and lead to a huge distortion of inner demand towards luxuries, as a result of which domestic consumer demand is a weak incentive for the development of production. Is the concentration of incomes in Ukraine excessive, and to what extent is the policy of income redistribution necessary in this connection? A distinct opinion on this issue must be formed on the based of the social choice of Ukraine. It is obvious that according to public opinion the current distribution of incomes is extremely unequal. However, it is possible that inequality within the middle-income range should continue to grow in order to stimulate effectiveness, which by itself could reduce social inequality by reducing the difference between very rich and all the rest. Recent reform of individuals’ income tax, which introduced a unified tax rate at a very low level, stimulated an increase of efficiency in the distribution of resources and created an additional incentive for honest declaration of incomes. However, it can’t be ruled out that the price of greater effectiveness will be greater income inequality. All other conditions being equal, only the substantial effect of bringing the rich “out of the shade” could make up for the inequality, increased as a result of introduction of a single tax rate. Ukraine must evaluate to which extent such a situation agrees with social priorities. International experience, with regard to this, is rather controversial. On the one hand, it is quite possible that the effect of increased efficiency will be more valuable for society. As the practice of many rapidly developing countries of Asia has demonstrated, active economic growth will mitigate the tension caused by the growth of income inequality. On the other hand, some of the industrially developed states (especially the EU countries) retain significantly progressive income tax rates, partly sacrificing the effectives for “social justice”. However, the degree of progressiveness is being decreased in some of them. The incomes often happen to be unevenly distributed not so much because of the taxation rate as due to the lack of simple transparency and accountability. Such forms of maintaining inequality are most destructive for the economy: instead of stimulating useful economic activities they distort the incentives. Thus, many Ukrainian politicians and lawmakers declare their commitment to “the cause of social justice” but at the same time practical implementation of their declarations sometimes disagrees with their concern for unjust income distribution (taxation of luxurious restaurants and boutiques selling exclusive luxuries has a more lenient scale than the one applied to small businesses; numerous loopholes, enabling to apply tax privileges of medicines to non-medical goods, etc.). At the same time state enterprises with large tax arrears, which sponsor events, “competitions” or activities of questionable importance, draw away the resources that could be allocated for social needs. Limitation of such practices would become an important test for maturity of growing civil society in Ukraine. *** To ensure sustainability of high economic growth rates, macroeconomic stability and progress on structural reforms are needed. At the current stage, it is the last condition that poses the major problem requiring headway. The progress must concentrate on second-generation reforms (a fair, predictable and competent judicial system; transparent privatization; corporate management; accountability of state enterprises and governmental bodies). We are deeply convinced that Ukraine must solve these structural problems without any assistance. The positive effects of external assistance will be limited since it is obvious that it will require profound knowledge and understanding of institutional and political context, as well as issues and procedures, some of which are not within the competence of foreign states, donors and international organizations. Certainly, the solutions worked out by local specialists must be based on comprehensive information and competent economic analysis. Although at this stage Ukraine, as it seems to us, has all the grounds to expect continuation of high economic growth rates, delays and serious mistakes in solving the above issues may finally cost its economy and social climate too much.