Yesterday, 23:02 PM Today, it's clear to everyone except perhaps the IMF, the EU, and the US: the new government in Ukraine and reforms are incompatible. I can state it even more categorically: all Ukrainian governments and reforms have been incompatible.
Today, it is obvious to everyone except perhaps the IMF, the EU, and the US: the new government in Ukraine and reforms are incompatible.
I can state even more categorically: all Ukrainian governments and reforms have been incompatible (with the possible exception of Viktor Yushchenko's premiership, when Yulia Tymoshenko served as deputy prime minister). If these governments made any rational decisions, it was only under pressure from the IMF and the World Bank. But even this pressure was insufficient. As a result, while global GDP more than doubled from 1990 to 2013, in Ukraine it fell by 30%! Based on the results of the current year, there is reason to expect a decline of 40% compared to 1990.
Therefore, we must focus on Ukraine's global problems (mistakes) that are blocking economic development and reform. Let's start with Ukrainian society and its conscious core—the voters. Their main problem is that they still hope that presidents, ministers, and members of parliament run for power to improve people's lives. This is a mistake! They run for power solely to improve their own lives or the lives of their sponsors—this should become an axiom for the people not only of Ukraine but also of many other developing countries.
Almost two years have passed since the victory of the Maidan. So, the time has come for the current Prime Minister and the Governor of the National Bank of Ukraine (NBU) to account to the Ukrainian people and businesses for their achievements and failures. I won't analyze in detail or even list all the "achievements" of the government's economic bloc (the Ministry of Economy, the Ministry of Finance, and the NBU); they are obvious to everyone. I will simply note the following: in 2014, GDP fell by 6,8%, real incomes by 8,4%, the hryvnia exchange rate by 97%, and prices rose by 24,9%. Half of this decline last year can and should be attributed to Putin and Yanukovych. But in 2015, the expected GDP decline of 11%, real income by 25%, the hryvnia exchange rate by 52%, and price growth by 46% are solely the work of the government's economic bloc and the NBU.
Moreover, in my opinion, the NBU's contribution to the economic decline is approximately 70%, while the Cabinet of Ministers' contribution is 30%. The NBU's recent actions—extending currency restrictions for three months, and the government's implementation of "tax reform"—indicate an increase in administrative and tax pressure on the Ukrainian economy. While previously this pressure primarily affected exporters and importers (the decline in 2015 will be 30-40%), after the government's "tax reform," the pressure will spread to new categories of the Ukrainian economy—small and medium-sized businesses, agricultural producers, as well as enterprises engaged in innovation, technical re-equipment, reconstruction, and new construction. Thus, the government's mistakes are becoming increasingly threatening to Ukrainian society.
Government mistakes
I'll begin my analysis with the government. The main problem with the Cabinet is its composition, which was formed based on party-based and crony-based criteria. It contains virtually no professionals or idealists. Without them, reforms and the cleansing of government from corruption are impossible. The solution lies in changing the criteria for forming the government. Positions such as the ministers of foreign affairs, finance, and economy, as well as the governor of the National Bank, should be selected and dismissed by parliament using a special procedure: the Verkhovna Rada must hear at least three candidates for the position and conduct a preferential vote among them. Special requirements for these ministers should also be established: education, professional experience, publications, expert opinions, including those of foreign experts, etc.
In the budgetary sphere, the fundamental mistake of the Yatsenyuk government is that it has relied primarily on external government borrowing rather than on reducing public spending, which is where real economic reforms should begin. Arseniy Yatsenyuk even established criteria for the effectiveness and intensity of economic reforms: "If we are given loans, then reforms are happening!" In other words, the more government loans, the more reforms! This policy has already led to the level of external debt of the government and the National Bank of Ukraine reaching 100% of GDP in early 2016, while the average gross public debt of developing countries in 2015 will be less than 44% of GDP. Furthermore, emerging economies, especially dynamic ones (Poland, the Baltic states, and Turkey), redistribute far less funds through the state budget. Thus, government spending in Ukraine in 2015 will equal approximately 46-47% of GDP, which is 7-11 percentage points higher than in the aforementioned countries!
What does this mean in practice? In Ukraine, money is taken from those who earn it—entrepreneurs and workers—and given to those who merely consume it, as well as to state parasites. Too much budget money means too many parasites. This policy is turning the Ukrainian economy into a depressed one with no chance of dynamic development, since businesses and individuals lack the resources (money) for growth. The savings rate (domestic investment, which is the key resource for development) in Ukraine fell to 5-7% in 2015, compared to 18% in Poland and 15-20% in the vast majority of emerging economies. Incidentally, this indicator (the savings rate) in Ukraine reached 22% in 2007 and only began to decline after the global financial crisis.
What needs to be done in 2016 to correct this strategic error? First, reduce government spending by approximately 10% of GDP and bring it to 36-37% of GDP. This will make it possible to eliminate the public finance deficit (approximately 4% of GDP), and therefore eliminate new government borrowing, thereby reducing the debt burden on the budget and the threat of a new default! This will further reduce taxes by 6% of GDP. First and foremost, abolish the populist taxation of deposits and real estate. Such taxes kill investment and the construction industry—the main catalysts for GDP growth—and also lead to capital flight abroad (where the rich buy yachts, planes, apartments, and dachas) or under their mattresses (where the poor invest their money). I was shocked by the government's new proposal to tax not only residential but also commercial real estate starting in 2016—this will lead to mass bankruptcies of real businesses. Only a business "a la" Kurchenko will flourish, where the means of production are not workshops, warehouses, or buildings, but only a telephone and a bribe case (they are not subject to taxes)!
A separate issue is reducing the tax on wages! What can be proposed? A 10% tax on wages up to the minimum wage, and 20% on wages above the minimum wage. Pensions and other social benefits are paid from the state budget. Therefore, the pension and other social funds are being eliminated, along with the pension and all other social contributions, along with tens of thousands of bureaucrats. All social payments are being covered by the budget! If wages exceed ten minimum wages, the excess is taxed at 15%, and 5% is transferred to a personal pension savings account, creating a powerful private investment resource for the development of the Ukrainian economy. Such fundamental changes in taxation can truly be called a reform.
Why am I proposing taxing the minimum wage? Because half the country earns the minimum wage for tax optimization purposes. The Ministry of Finance's proposal to exempt the minimum wage from taxation stimulates the shadow economy and leads to budget losses (over 40 billion UAH)! Clearly, even to fill the budget, the minimum wage and pensions must be raised to 2000 UAH by early 2016.
The second mistake of the Cabinet of Ministers This concerns housing and utility tariffs, the minimum wage, pensions, and subsidies for poor families. The essence of government policy is to maximize housing and utility tariffs to a level that most Ukrainian families cannot afford, on the one hand, and to maximize the number of families who should receive budget subsidies (34 billion UAH in the 2016 budget) to pay companies (primarily Russian and Ukrainian oligarchs) for utilities (gas, heat, water, sewerage, and electricity), on the other. The government is enthusiastically pushing Ukrainians to accept targeted subsidies and pay the oligarchs! In 2015, Ukrainian and Russian oligarchs are expected to receive at least 10 billion UAH from the budget, and in 2016, twice that amount! That's what social policy is all about...
Why was this seemingly absurd approach chosen? After all, it doesn't incentivize conservation of extremely scarce resources—gas, electricity, water, heat—but rather helps oligarchs generate superprofits, at the expense of the budget (people and honest businesses, who pay the highest taxes in the world). The answer is obvious. These cynical, corrupt schemes must be combated.
What else needs to be done? First, implement a new tariff system for the housing and utilities sector. Its essence lies in the following: All resources we pay for have three components. Let me explain this using heat as an example. The first component is the portion we actually consume. The second is losses due to mismanagement and outdated heat production and delivery technologies. The third is heat theft by corrupt officials. Tariffs should indeed be sufficient, but they should only cover the costs of the first component, the one people actually consume, without any expenses on corruption, mismanagement, and the technological backwardness of the companies providing these services.
Only transparent and open competition will ensure lower tariffs in the housing and utilities system. Where monopolies cannot be eliminated, strict government regulation must be introduced. Clearly, tariff caps for gas, cleaning, electricity, water, heat, and sewerage must be established for the country as a whole, along with mechanisms for reducing them within regions. This means that dozens of companies (not just housing and utilities departments) should compete for the right to provide housing and utilities services in a given district, and the primary selection criterion should be the lowest tariff for services. For example, the state has set a maximum tariff for cleaning adjacent areas in Ukraine—3 hryvnias per square meter. The company offering the lowest tariff in a given district should win the right to provide such services, but in any case, it cannot exceed 3 hryvnias. This competition should be widespread across the country: in some places, the tariff will be 2 hryvnias per square meter, in others 2,5, but nowhere more than 2!
I am confident that a sound tariff policy and competition will ensure tariff reductions of 25–30%. But this is not enough to eliminate the shameful system of subsidies, which not only demeans human dignity but also encourages wastefulness and corruptly enriches oligarchs.
To this end, I repeat, I propose raising the minimum pension and wage to UAH 2000 as early as early 2016 (this will provide a more or less fair partial compensation for devaluation and inflation); even after a 10% tax, it will amount to UAH 1800 per month. Moreover, it is crucial to simultaneously eliminate all special pension systems. Retirement for everyone should be at 65. It is better to work more and live a long, prosperous life (as in the EU) than to work less and die early in poverty (as is currently the case in Ukraine). Moreover, the maximum pension should not exceed the minimum by more than five times (currently it is 20-30 times), and the maximum salary for civil servants should not exceed the minimum wage by more than ten times (for the heads of profitable state-owned enterprises, provide for the possibility of receiving bonuses limited to 10% of their net profits).
I admit that for a transitional period (but no more than two years), the Verkhovna Rada could adopt a special law to increase salaries for 20-30 civil servants. Currently, the leadership of the new police force and the new anti-corruption prosecutors receive such salaries. But if this practice becomes systemic, we will create a police state. Poor people and wealthy law enforcement officers... I call the system of salary dependence for ministers, deputies, and other officials a "matrix of socioeconomic justice." This socioeconomic matrix creates an incentive for officials to raise the minimum wage and pensions in Ukraine, provided, of course, that taxes remain unchanged and the system under which most taxes are measured by the number or percentage of the minimum wage is abolished! If the government and the NBU are unable to control inflation, taxes should be fixed in euros.
I guarantee GDP growth and real income growth of at least 10% per year if the following tax changes are added to my proposed salary tax reform. The corporate income tax rate should be 15%, the dividend tax rate 10%, and the VAT rate 20%. Small businesses (entrepreneurs or enterprises in any field) with revenues of less than €1 million have the right to pay 2% of their income instead of corporate income tax, and 3% of their income instead of VAT. They will be able to operate without accountants, but with 100% cash registers, starting in mid-2016. Excise taxes will be set at the level of average EU countries (incidentally, the government's proposals on excise rates are not controversial). The tax on the sale of foreign currency in cash, real estate, cars, as well as over-the-counter securities and property rights will be 2% of the selling price, instead of capital gains taxation. Other taxes are prohibited. The system must remain unchanged for ten years. Moreover, a ban on changing taxes for ten years should be included in the Constitution of Ukraine.
The third error The government's task lies in the realm of foreign economic policy. It's a place where there are continuous failures and colossal losses. I'll start with Ukrainian-Russian trade relations.
If we're talking about a rational foreign economic policy, then the Ministry of Economy should be the one formulating it. I have many questions for it. It's well known that Russia has blocked almost all of our exports for two years now. Why hasn't Ukraine imposed reciprocal measures? Most importantly, why does Ukraine continue to buy food and agricultural products from Russia? Between January and May of this year, $146,4 million worth of such goods were purchased! Why are we buying chemical products ($865,4 million), light industry ($21,6 million), and mechanical engineering products, including Ladas, Gazelles, and other junk ($323,7 million)? In other words, in the first five months of this year, in these items alone, we supported Russia by $1,4 billion and reduced our GDP by the same amount! This is called "economic policy, Ukrainian style," despite the fact that the minister is an expat. If we extrapolate our five-month imports from Russia (for the aforementioned items) over a year, the losses could reach $3,4 billion! Esteemed ministers, a simple ban on imports of goods from Russia that could be produced in Ukraine would boost the country's GDP by UAH 81 billion—approximately 4%—so these $3 billion don't need to be restructured…
Regarding Ukraine's sanctions against Russia, it can be said that they are purely declarative. Perhaps with the exception of the Crimean Tatars' initiative to cut off electricity supplies to Crimea, but this is not a government decision, which, on the contrary, has already resumed these supplies at dumping prices, even without a proper agreement. Frankly, the entire domestic government apparatus (from Ukreximbank to customs) is working to support imports and block domestic production and exports. One of the banal, yet powerful, incentives for this policy is the usual bribes paid by foreign (including, of course, Russian) lobbyists to Ukrainian officials...
But the most disastrous is the government's policy of suing Russia for the annexation of Crimea and the occupation of part of Donbas, along with all state property. I estimate Ukraine's one-time losses at approximately $20-25 billion, plus annual losses of $4-5 billion. More specifically, I estimate the NBU's losses at approximately $0,5 billion, and Naftogaz's at approximately $1.5 billion.
Oschadbank and Ukreximbank – approximately $0,5 billion. No lawsuit against Russia has been properly prepared, let alone filed. The position of the government, the NBU, and state-owned enterprises on this issue is passive, if not criminal! The management of these institutions is effectively supporting the aggressor to the tune of tens of billions of dollars! Moreover, the Ukrainian government is attempting to restructure Russia's $3 billion debt. Such activity regarding this debt surprises me. Only the firm stance of the IMF has slowed this process down.
What should the government do? Instruct all state-owned enterprises, ministries, and agencies to properly prepare and file financial claims against Russia for damages from the annexation of our territories, and this should be done with the participation of reputable Western law firms (I don't trust the competence and integrity of Ukrainian officials). Next, include funds or state assets confiscated from Russia for the annexation of our territories in the revenue items of the 2016 state budget (more realistically, the 2017-2018 budgets). Then, at the very least, Ukraine's $3 billion debt to the Russian Federation will be transformed from a liability into an asset of $3 billion in 2016 (incidentally, this is approximately 4% of GDP)! Therefore, these $3 billion don't need to be restructured...
Let me remind you that Yukos, which has already won $50 billion in international court judgments against Russia and could effectively become the owner of all Russian state assets in Ukraine, with the exception of diplomatic property, will be a competitor in the confiscation of Russian assets in Ukraine. Russia will certainly appeal to the court and could win in three to four years. But Ukraine, too, should win a significantly larger sum in three to four years. A mutual offset could be arranged in five years.
As already noted, responsibility for the dire economic situation in Ukraine lies not only with the government, but also with the NBU.
NBU
The National Bank's main problem is its inadequacy due to dependence, lack of experience, and incompetence. This is precisely what prevents the NBU from gaining control over the exchange rate, inflation, banking stability, and lending to individuals and businesses. The methods by which this regulator conducts monetary policy can be described as primitive: they harken back to a different era—the Soviet era. Responsibility for the decline in GDP, inflation, and devaluation of 2015 lies primarily with the NBU. Its first mistake was, and remains, the introduction of primitive, administrative, non-transparent, and anti-market methods of foreign exchange rate policy.
What's the most important thing for the NBU leadership to understand? Monetary policy should be based on control over at least one of its three elements: the exchange rate, inflation, or the rate of money supply growth (emission). If the NBU decides not to control the exchange rate (and this is correct), then it must control emission and/or inflation. Almost all developed countries control inflation. Central banks are responsible for price increases in their countries and try to keep it at approximately 2%. The NBU must immediately initiate an inflation targeting policy. Without such a policy, letting the exchange rate slide is irresponsible and unprofessional.
The NBU's leadership must understand that a floating exchange rate is an integral element of inflation-targeting monetary policy. Without this anchor of stability (inflation cap), monetary policy leads to the collapse of the currency and financial system, especially in the context of uncontrolled emission, which is currently happening in Ukraine! Initially, the floating exchange rate should be controlled for at least a year, and then free. The central bank's foreign exchange interventions should be non-periodic and explainable, meaning they should address one-off, ad hoc issues that arise in the foreign exchange market.
I would like to emphasize once again that, given the floating exchange rate policy, it is essential to bring inflation under control. Moreover, in the first stage (one year), I recommend introducing soft inflation targeting, which would correspond to a controlled, free-floating hryvnia exchange rate within an exchange rate corridor of 20 to 28 UAH/USD.
2016. Soft inflation targeting allows for both high inflation rates (but not exceeding 10%) and flexible targeting frameworks. For 2016, the NBU should set an inflation target of 7–10%. I would like to emphasize once again that, under inflation targeting, central banks do not completely lose their ability to influence the exchange rate. This influence can be both direct (through foreign exchange interventions) and indirect (through managing money market rates). In 2016, the optimal level for the NBU's lending and deposit operations should be 12% with a 2-percentage-point tolerance. In 2017, this level should be reduced to 5% with a 1-percentage-point tolerance. Rate reductions should be gradual as inflation declines and the exchange rate stabilizes.
It's essential to strengthen the NBU and the government's economic bloc with genuine, internationally recognized professionals. Central bankers and public finance officials must not only know what to do and how to do it, but also have a keen understanding of monetary and foreign exchange markets and macroeconomic proportions—a true art. You can't even learn to drive a car from a manual, let alone manage monetary and exchange rate mechanisms.
I am confident that even simply following the recommendations provided will guarantee a halt to the hryvnia's decline; moreover, the exchange rate will roll back to 20–22 UAH/USD, and GDP in 2016 will grow by 5–6% (even without changes to the tax system).
The NBU's second mistake is its failed policy of overseeing commercial banks, which has led to the bankruptcy of a large number of financial institutions. Moreover, at least half of the remaining banks are on the brink of insolvency—that is, they ostensibly exist, but in reality, they don't function as banks (failing to repay deposits on time, failing to provide loans, etc.).
It should be noted that the mass bankruptcies of Ukrainian banks are caused not only by poor (unprofessional) management of commercial banks and financial fraud (assisted by the courts), but also by the unprofessional monetary policy of the NBU and the economic policy of the government. It is also important to understand that the bankruptcy of even a small bank leads to losses for both Ukrainians and businesses, especially small and medium-sized entrepreneurs, who will not receive any compensation in the event of its liquidation. But while someone loses (the state, which pays compensation to depositors up to 200 UAH, as well as wealthier individuals and businesses when their deposits and account balances disappear), someone else gains. In finance, there is always a balance: debits and credits, assets and liabilities, losses and profits. Bank assets do not disappear during bankruptcy; they pass into the hands of bureaucrats and fraudsters, or, to put it bluntly, they are stolen. Incidentally, right now (2014–2015), the banking and financial sector has become the most corrupt—we're talking about 240 billion hryvnias that disappeared through bankruptcy, that is, stolen banking assets. Of this 240 billion, I'm sure we'll never see again at least 200 billion. This is more than the losses (thefts) at state-owned enterprises—140 billion hryvnias.
My proposals are very simple. Temporary administration teams for problem banks and their liquidators should be appointed not by the Deposit Guarantee Fund (bureaucratic officials), but by the problem bank's largest creditors, willing to recover the bank's problem assets and save their money, which bureaucrats and financial fraudsters are trying to steal! Therefore, every bank that has lost capital below the required level or has become insolvent should be given a new supervisory board composed of representatives of the defrauded individuals and businesses, as well as the state, proportionate to their deposit portfolio, balances, unpaid taxes, and state loans (including NBU refinancing loans and expenses for compensating household deposits). This supervisory board should form a team of bankers and lawyers who will either rescue the bank (with the goal of selling it later) or return the problem assets. Only such measures can stop the "bank collapse" and the theft of bank assets.
The NBU's third mistake is its complete disregard for, and even facilitating, the reduction in commercial bank lending to individuals and businesses, both in foreign currency (the decline reached 19,5% in the first ten months of 2015) and in hryvnia (-5%). Unfortunately, neither the government nor the NBU understands that without increased lending, our GDP will not grow.
How can we initiate a policy of credit expansion in a situation where the banking system is barely surviving, and neither individuals nor businesses have any internal resources? Today, there is only one source—foreign investment and borrowing—which must be converted into GDP growth. The government and the NBU should adopt a rule of channeling at least 30% of the foreign currency raised by the government from all donors, primarily the World Bank, into the interbank market. Adherence to this rule will increase the supply of dollars on the market, which will contribute to the strengthening of the hryvnia. Currently, the government and the NBU, like businesses, are bypassing the legal, organized foreign exchange market. They are essentially operating in the shadows.
Two-thirds of foreign exchange demand during a currency panic (which, for some reason, always follows any public statement from the NBU leadership) is driven by speculative sentiment, and only one-third by importers. I reached this conclusion after analyzing currency purchase orders during the 2008 crisis. I am confident that speculators still rule the roost... They must be weaned off the market through transparent regulatory measures, not by banning and slowing down legal import and investment transactions.
From 1993 to 1996, while serving as Executive Director at the EBRD, I initiated the first credit line of €300 million for small and medium-sized businesses in Ukraine. This was essentially the first currency to enter our market through the Ukrainian banking system for SMEs. Unfortunately, we've now effectively returned to the 90s. Therefore, the government's task is to open several such credit lines, under state guarantees, for the Ukrainian banking system, which is currently on the brink of collapse. This could begin with the $1 billion in loan guarantees promised by the United States. Therefore, my proposal to the Americans is not to give this money to the government, but rather, under its guarantee, channel it through the Ukrainian banking system to support small and medium-sized businesses, with a quota for problematic (essentially frontline) regions. This will increase the supply of foreign currency and help banks and businesses, especially small ones.
The six mistakes listed above by the government and the NBU are killing the Ukrainian economy more effectively than bullets…
"Fantastic" tips
Unfortunately, I don't believe in the implementation of a more global (and in Ukraine's context, almost fantastical) recommendation: the NBU announces an adequate monetary and exchange rate policy and will adhere to it. Similarly, the government presents to the public its doctrine of modern economic policy, with a specific plan for economic reforms and the names of Ukrainian implementers. Why don't I believe this? Because our political system is not European; in Ukraine, behind-the-scenes deals and shady corrupt dealings still dominate, rather than clear rules and transparent decisions. Moreover, the main problem with Ukraine's political system is the simultaneous existence of two branches of executive power, one centered around the president, the other around the prime minister. Thus, each of them devotes most of their energy not to combating economic problems or external enemies, but to internecine strife. And the parliament's structure isn't divided between the majority and the opposition, but between those who support the president and those who support the prime minister, with the exception of a few small groups around the oligarchs and 40-50 relatively honest new deputies. This even applies to ministers and government officials.
The solution is obvious: Ukrainians must decide in a referendum which alternative is most acceptable for the country. One is the European model, where the head of the executive branch and state is the prime minister, and the president is elected by parliament (in this capacity, the latter embodies the conscience of the nation, is its moral authority, and is prohibited from belonging to any party or being involved in business). The other is the American model, where the president is elected by the people and heads the government, and the position of prime minister does not exist at all.
If we move from strategic recommendations to tactical ones, then I would insist on a technical government of experienced professionals, and if the prime minister's resignation is impossible without the collapse of the coalition, I would advise the president and prime minister to appoint a technical government headed by a technical vice-premier for economic reforms, delegating to him (the government) the necessary powers with the consent of the Verkhovna Rada.
The problem is that economic reforms require dozens of extremely unpopular decisions in the first year of reform, namely: cutting the number of government officials not by half, but by three to four times, and above all, the presidential administration, the Verkhovna Rada (even the number of deputies should be reduced from 450 to 350), and the Cabinet of Ministers (savings of 20-30 billion UAH). But that's just the tip of the iceberg. The reforms also require cutting the number of students and state universities by approximately half (of course, we're talking about poorly run institutions); eliminating the administrative apparatus of numerous academies of sciences (savings of 10-15 billion UAH). Furthermore, closing a large number of poorly run schools and hospitals, especially in rural areas, merging villages and small towns in a three-to-one ratio across Ukraine, and so on (savings of 15-20 billion UAH).
As a result, within a year, GDP and personal incomes will grow by 10-12%, the hryvnia will strengthen, loans will be cheap, and investments will flow in. I believe this, but the president and prime minister clearly don't. So they don't want to take any risks, but the paradox is that it's precisely they who stand to gain by appointing a technical government with a technical deputy prime minister! If all goes well in a year, they'll reap the laurels of reform; if not, this government will be the scapegoat, but they'll still be in power for at least a few more years.
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