Ukraine: Now Comes the Hard Part

Petro Poroshenko’s convincing first-round victory in yesterday’s Ukrainian presidential elections, with 54 percent of the vote, is an important step toward political stability. But hard work lies ahead, as attention now returns to the even-more-daunting task of restoring economic stability.

Remember that the political crisis of the last six months began as an economic crisis and had its origins in decades of failed economic policies. Massive fuel subsidies going disproportionately to the wealthy, widespread corruption, and distorted markets all contributed to the rot. These policies were reflected in an overvalued exchange rate, large sustained budget deficits, a rising current account deficit, and a falling foreign exchange reserves. Former President Yanukovych’s decision to accept $12 billion from Russia and repudiate the EU association agreement in late 2013 was an effort to delay the inevitable economic crisis that Ukraine now confronts.

The IMF stepped in with a $17 billion reform package at the end of April designed to both provide emergency financing and begin the process of reform. Actions taken prior to IMF approval of its program included floating the exchange rate, an initial increase in energy prices, some other budget measures, and steps to address corruption. While necessary, the additional austerity implied by these measures represents a burden on an economy already in recession. So far, the government has sustained support for pro-Western policies despite the clear economic pain involved. Goodwill towards the new regime, and perhaps the unifying effect of the threat from Russia, have limited opposition to these measures outside of southeast Ukraine. But the new President will have to move quickly to address a number of economic challenges if yesterday’s political achievement is going to translate into a more enduring stability. These include:

1.  Reaching agreement with Russia on energy and debt.  Attention has focused on Russia’s threat to cut off gas deliveries on June 1, but equally important is the price that Ukraine pays. The IMF assumes agreement is reached with Russia on a price for gas in line with global prices at $385/mcm (thousand cubic meters).  It also assumes gas arrears and debt service are paid.  A slightly higher or lower price would be handled through an adjustment to IMF financing, but a significantly higher price for gas would outstrip Western financing and raise serious concerns about fiscal and debt sustainability.

2.  Accelerate the financial and trade flows from the West. The West has actually contributed little relative to headline promises so far, though Europe has accelerated trade benefits from the still-to-be–signed association agreement. The $17 billion pledged by the IMF is supposed to unlock a further $10 billion to $15 billion in funding from the World Bank, EU, and other individual countries, and accelerating those flows will be a critical task.

3.  “Sell” austerity at home. The new government will need to explain to the general public why deeper austerity is needed, and why the measures being taken are being done. The interim government, perhaps reflecting Russia’s threat, had maintained a low profile on economic as well as political grounds. That will need to change.

4.  Renegotiate the IMF program?  When the IMF team returns to Kiev at the end of June, it likely will find an economy far different from the rosy economic projections in the program. Anecdotally, the economy outside of southeast Ukraine looks to have weathered the crisis better than some feared, but there is no doubt that the recent turmoil has imposed material costs. The threat of Russian invasion may have receded, but the crisis is imposing continuing costs on economic activity and investment. Further, it is usually the case in cases like this that fiscal revenue falls, not just because of falling growth but also because of increased tax avoidance. The program is not asking for a lot of fiscal austerity—just two percent of GDP in measures (and the deficit actually widens in the short term with the decline in output). But activity is likely to be lower, and debt higher, than projected. The costs of the financial sector bailout are still not clear, and could be higher than the government is assuming. The new government will likely make the case that a more gradual fiscal adjustment, coupled with additional spending on social services, would be more sustainable. I have sympathy for that argument, though Ukraine’s past record of failed programs creates unsurprising skepticism. And who will pay, official creditors or creditors who may be asked to restructure their claims? The IMF is scheduled to disburse $1.4 billion as soon as July 25, and again at end September.

Success will require strong governance, and substantial support from the West.  It will not come cheap, and it will take time.  But some early success may be essential to sustaining public support over a difficult coming period.

This piece is cross-posted from Macro and Markets with permission.