Speech

Ukraine after 10 Years of Transition Experiences -- Speech by John Odling-Smee, Director, European II Department

February 5, 2001

At the outset, I would like to thank the organizers at the Kyiv-Mohyla Academy for the opportunity to speak today to a wide cross section of the Ukrainian community.

The completion of the first decade of what we now call the "transition process" has provided a useful perspective to look back over the efforts to establish market-oriented economies in this region, and to assess the results achieved thus far. In broad terms, the picture is impressive: virtually all the economies are growing (after initial output declines that averaged 40 percent), inflation is at low to moderate levels (generally less than 20 percent, and often in single digits), and the share of output generated by the private sector now averages over 50 percent of GDP. When one considers that at the same time as market reforms were implemented, many new nations had to be established and democratic institutions developed, these positive economic results are a testament to the extraordinary achievements that have been made by the people in the region in such a short period of time.

However, the record of economic achievement has been very uneven, with some countries having grown strongly for many years while others have lagged behind. These differences have been analyzed extensively, and the general conclusion is that they are partly explained by geography (especially proximity to the EU), partly by the initial industrial structure, but also in particular by the quality of the economic policies that have been followed. With regard to economic policies, four main themes have been the critical hallmarks of successful transition: (i) persistence in pursuing macroeconomic stabilization policies; (ii) structural reforms across a wide range of sectors, including the imposition of hard budget constraints; (iii) establishment of the legal and regulatory framework required for a market economy; and (iv) the provision of a well-functioning social safety net to cushion the inevitable social dislocation and thereby ensure sustained support for the transition process.

In this speech, I will outline in more detail the main lessons that have emerged from the transition economies in this region, note why strong actions in these areas have been so important to the transition process, and then turn to discuss recent experiences in Ukraine.

1. Sound macroeconomic environment

The importance of sound money as the basis for a strong market economy cannot be overestimated. Why is it so important to achieve a sound macroeconomic stabilization characterized by low inflation and fairly steady exchange rate, in the context of an open trade regime with free prices? The very premise of a market rather than a command economy is that policy makers can not know what consumers want and what producers should produce. Rather, in a market economy, it is the prices of different goods and services, and in particular their relative prices, that guide the demand for goods and services by consumers and supply from producers. But for this process to work efficiently, it is essential that the price system be protected from high and variable rates of inflation, that domestic prices reflect international prices, and that the price of a particular good or service is free to adjust to changing circumstances so that it provides the correct signal to consumers and producers. More generally, inflation creates uncertainty which discourages businesses from expanding their activities and investing for the future, and thereby prevents economic growth.

The actual experience over the last ten years has shown that macroeconomic stability is just as important for a transition economy as for any other economy. Transition countries that pursued tight monetary and fiscal policies, and followed internal monetary and fiscal policies consistent with their announced exchange rate regime, have been rewarded with low inflation levels. Moreover, low inflation was a precondition for the resumption of positive rates of economic growth after the initial output collapse of the early 1990s. These conclusions are very clear from the historical data and have been set out in many reports and papers.

2. Structural reform

But there is little point in ensuring macroeconomic stability if one does not then encourage producers to respond to it. "Transition" implies a process where production activities that are no longer profitable must exit from the scene and release their resources, while profitable activities should be allowed to enter freely, especially for new small and medium sized enterprises (SMEs) which can be a strong driving force for the resumption of economic growth. At the same time, transition governments need to change from being a direct provider of production, to being a facilitator, with a wide-ranging privatization of enterprises and a focus instead on providing the legal and regulatory framework for private economic activity. These processes imply the need to accept—and indeed to foster—rapid and deep structural reform, for there can certainly be no transition without it.

It is in this area that the actual record of the last decade has been mixed. Many countries in the region attempted to prop up industries for which demand was low and costs were high, using a variety of mechanisms including cash subsidies from the budget, tax privileges and non-cash tax settlement schemes, barter, provision of virtually free energy resources, directed bank financing, monopoly protection, and import restrictions. But these efforts produced the worst of all worlds: output levels from these old industries declined despite the soft budget constraints, while at the same time output from the new profitable activities did not respond—in part because the new activities faced ever higher tax and regulatory burdens put in place to help the old industries—all of which simply slowed the transition process.

The net result has been a downward spiral in economic output levels, at least as measured by recorded GDP since some profitable activities sought sanctuary from tax and other burdens in the shadow sector. Studies of the transition experience—by the Fund, the World Bank, the EBRD, and by many independent scholars—are quite clear in showing that countries that accepted the deepest structural reforms have indeed experienced the fastest rates of growth.

3. The role of government in the transition

The need for the State to provide an environment that encourages creation of new private sector activities is at the heart of the transition process. While the need for this is readily accepted by everyone, defining what it means in practice—and hence whether countries have achieved it—is inherently difficult given the many dimensions reflected in this role. In very broad terms, the role of government is to create systems that ensure freedom of exit and entry of business activities, promote transparency, clarity, and accountability of public decisions and activities, ensure minimal amounts but uniform and evenhanded enforcement of regulations, and to provide stable rules within which the private sector operates. The government should not interfere in the decisions of individual enterprises in sectors of the economy, or otherwise grant privileges or special treatment to private businesses.

Writing legislation that supports these principles has proven to be easier than ensuring that they are actually put into practice, and indeed implementation of reforms of the legal, tax, treasury, and banking institutions and systems has proven to be amongst the most difficult task in building market-based economies in this region. After ten years, the record suggests that some countries are stuck half-way along the transition process. They have achieved macroeconomic stability, may have liberalized prices, and may have privatized some state assets, but have not yet seen growth in the private sector. I believe a major reason for this is the rise of a new nomenklatura. Partial and halting reforms have allowed new (and sometimes old!) elites to gain control over productive assets, and they have then successfully used the State as a means to preserve their position by ensuring that they receive privileges. This process—the capture of the State by powerful vested interests—thrives on non-transparent payment activities, quasi-legal enforcement systems that work only against potential competitors rather than a legal system that treats everyone equally, monopoly rights, protection from import competition, and soft budget constraints. It also involves a close relationship between public officials and the managers and owners who form the nomenklatura. These opportunities are enhanced by the fluid nature of the transition process.

The most fruitful way to counteract the power of the new nomenklatura is through greater use of transparent procedures, better and properly paid civil servants and legal officials, deregulation where possible, and by the government itself tying its own hands through the adoption of international codes and standards of reporting and committing to a stable set of international rules, e.g., by joining the WTO or the EU. The importance of these types of efforts is increasingly recognized and the multilateral institutions are responding accordingly.

4. Social safety net

Finally, it is the responsibility of policy makers, and those who advise them, to recognize that not everyone gains equally from reform—and that some may even lose from it. It is therefore essential to have in place a coherent and affordable social safety net. On this aspect, the record of the past decade has been poor: transition countries in Central Europe and the CIS have shown a dramatic increase in poverty levels, both in an absolute and in a relative sense.

Poverty has increased for several reasons. First, the growth of poverty reflects in part the efforts noted earlier to preserve old industries that rely on dwindling subsidies and soft budgets while at the same time blocking the entry of the new kinds of private firms that have proven to be the engines of employment growth in the more successful countries. Second, it has turned out to be difficult for the population to adapt skills that were learnt under the old system to the needs of the new, which points to the importance of retraining. And third, poverty has grown as a result of a lack of attention and political will to ensure that government expenditures for social needs—on pensions, family assistance, and health—are utilized efficiently, with the consequence that these systems have been eroded. There can be little doubt that transition countries need to make a clear decision on their priorities in the social safety net, and then, whatever they decide, that they honor these stated commitments.

So, if these are the broad lessons from a retrospective examination of transition experiences during the last ten years, how do Ukraine's current policies measure up? I will not dwell on the policies of the past: we are all familiar with the destructiveness of Ukraine's hyperinflation period in the early 1990s, the subsequent struggle to achieve and preserve macroeconomic stability, and the slow pace of structural reform and development of well functioning institutions, all of which led to many years of negative growth. Instead, I will focus the rest of these remarks on the positive developments which led to the resumption of IMF financial support in the context of the EFF program, and then turn briefly to sketch the challenges for the future.

1. Ongoing macroeconomic stability

Ukraine has now had several years of reasonably tight monetary and fiscal policies leading to lower inflation levels, although the Russian crisis caused a period of somewhat higher inflation that continued even to last year. But because of slow progress with structural reform, Ukraine did not experience positive economic growth until last year. Nonetheless, this recent strong growth, together with the restructuring last year of external and internal Ministry of Finance debts which led to a better debt servicing profile, has provided a window of opportunity, and it is clearly important that this window is now well utilized.

2. Promoting use of cash transactions

Perhaps the most significant structural reform during 2000 has been the implementation of policies that have reduced the share of non-transparent, non-cash transactions in the economy. In this regard, there has been substantial progress in the budget sector with the 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 percent of payments due a year ago to levels around 50 percent now, and to the prepayment in cash for the use of agricultural inputs as the government has withdrawn from its wide-ranging interference in this sector.

These reforms have had a large number of positive impacts. First, they ensure that the price of energy influences consumer and producer behavior; they conserve energy as they have to pay cash for it which reduces the import bill. Second, along with the removal of tax exemptions, they harden budget constraints and hence speed the process of transition. Third, these policies force greater transparency which is an effective anti-corruption mechanism. And, fourth, the government's refusal to accept non-cash tax settlement mechanisms and the removal of tax exemptions provide more cash revenue to the budget, and this enabled the government to settle most of the budget's stock of social arrears during the year 2000.

3. Efforts to strengthen governance and transparency

In addition to policies that promote cash transactions, other reform efforts have strengthened important governance aspects. These include the passage of a budget with realistic tax revenue estimates which reduces discretion as to which expenditures are financed making the process more orderly and transparent, reform of public decision making processes and publication of government decisions, new laws that require privatization on a transparent basis and establishment of a Working Group to review such progress, the initiation of audit-work in Naftogaz and the electricity sector, better laws for the reporting of statistics, and ongoing efforts to strengthen the institutional economic structure, especially in the Ministry of Finance, State Tax Administration, Treasury, National Bank, and Statistics Committee.

Agenda for the future

As noted, the result of these policy actions is starting to pay off, with a broad based economic recovery now underway, although part of the renewed economic growth is undoubtedly due to stronger growth in the whole region. But to sustain these positive trends into the future it is critical that the types of policies that the government formulated and implemented last year are continued and indeed enhanced.

Public reform agendas never stand still—even in advanced countries—and this is all the more true in Ukraine. It is important especially to guard against complacency: while the current economic situation is favorable, especially the resumption of growth and the rise in liquidity within the economy, it will not be sustained if structural reforms are not accelerated. The truth is that many years have been lost and the reform agenda remains very long. Any further delays or backtracking will allow vested interests to continue to prevent the development of a truely competitive market economy, and that will threaten the prospects for sustained growth. In consequence, the agenda for the next 18 months or so should include the following aspects:

• Containing inflation, which will be a challenge for monetary and fiscal policies in an environment of significant foreign exchange inflows as the economy continues to remonetize;

• Further budget reforms, including adoption of a tax code that widens tax bases before reducing tax rates to ensure revenue neutrality, the avoidance of tax amnesties, exemptions, and privileges, a critical examination of the Free Economic Zones and Special Investment Regimes policy which by definition increases the tax burden on the regions and activities which are not singled out for special treatment, and reform of education, health, pension, and family assistance benefits and expenditures;

• The continuation of the improvement in payments discipline in the gas and electricity sectors; current cash payment ratios at around 50 percent, impressive as they are, still imply that half of the cost of energy is not paid for, or is settled through non-transparent mechanisms which provide fertile ground for corruption;

• There is a wide range of other structural reforms that need to be deepened, including completing in a transparent manner the privatization of large strategic enterprises, avoidance of any form of government interference in the agricultural sector so that this sector can contribute to its full potential, and further deregulation, especially for SMEs;

• And, finally, efforts to enhance governance through strengthening the accountability of public institutions, further public administration reform (a start on which has been made), and a commitment to adopt international codes and standards.

The IMF, our sister organization the World Bank, and other creditors and donors will continue to be actively engaged in the policy dialogue in these areas, provide technical assistance, and, where applicable, financial resources. We are confident that, if the government and the Rada implement their future reform agenda, building on the critical mass of reforms that have been undertaken during 2000, Ukraine will see a strong and sustainable high level of economic growth, a goal which everyone agrees is of the utmost importance.

Thank you.