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Recommendations for immediate policy actions to address financial crisis in Ukraine

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Oct. 26, 2014, 12:16 a.m. |

A girl walks past booths at a polling station in Kiev on October 25, 2014, on the eve of the country's parliamentary elections. Ukrainian leaders made final appeals to voters ahead of snap parliamentary elections on October 26 that are intended to give impetus to democratic reforms, but are overshadowed by deepening conflict with Russia and pro-Russian rebels. AFP PHOTO/ VASILY MAXIMOV
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Ukraine’s fiscal deficit has become explosive due to the uncertainties created by the external aggression and the resulting weak economic performance. 

For 2014, the IMF assesses the actual size of the deficit at 10.1 percent of gross domestic product.

However, the deficit might even become larger, perhaps approaching 15 percetn of GDP if off-budget items are included as the International Monetary Fund estimates the financial deficit of Naftogaz alone this year at 7.6 percent of GDP. 

Such a deficit magnitude cannot possibly be closed by raising already-falling tax revenues. Neither can it be closed by non-inflationary financing given the sharp increase in the risk-premium for sovereign debt which is skyrocketing from 40 percent of GDP in 2013 to 68 percent of GDP according to the current base case IMF projection. In more pessimistic scenarios it is even higher, possibly exceeding 100% in the worst-case.

Under a favorable scenario about an early resolution of the conflict in the east,  the IMF currently considers the financial position to be  sustainable. 

However, under the current existential threats to Ukraine, that scenario may not materialize and the present budgetary position will not be financially sustainable.  For the sake of national security, Ukraine must cut its public expenditures sharply. This is no longer a matter of finances, but an issue of national survival. Ukraine’s aim should be to cut public expenditures by 10 percent of GDP within one year if total default and monetary chaos is to be avoided.

At 53 percent of GDP in public expenditures expected by the IMF in 2014, Ukraine’s public expenditures are far too high. That leaves only one alternative to closing the gap; namely extensive budget-cutting. If nothing is done to plan such cuts, they will happen anyway brutally by sequester as eventual lack of revenues to cover expenditures will lead to “forced-closing” in the form of freezing and random cuts.  Across-the-board cuts are the worst possible outcome. 

Hence we recommended that a strategy of budget-cutting focusing on the least desired public expenditures be developed immediately. Such cuts would also facilitate badly-needed structural reforms, notably energy reforms and subsidy elimination.

Ukraine has no realistic choice but to focus on extensive expenditure cuts. 

It is also consistent with Ukraine’s medium-term strategy of reducing the size of government to stimulate economic growth. 

With its current budget expenditure share of GDP of 53 perent of GDP, Ukraine stands out among comparable countries as having an extremely high government share in the economy. While several countries in Western Europe have similar shares they have a far higher level of economic development. 

 The best comparable countries appear to be the Baltic countries that have public expenditures of 34-38 percent of GDP. The best standard for Ukraine appears to be Lithuania that has public expenditures of 34 percent of GDP, the highest economic growth in Europe and yet has far better social benefits than Ukraine.

In the current situation, it is both unrealistic and undesirable to raise public expenditures outside of the most pressing military spending.

Instead, the government needs to focus on cutting big and inappropriate public expenditures that can be cut fast. 

A number of big items stand out.

The first is energy subsidies that will probably amount to 10 percent of GDP in 2014 according to the latest IMF calculations.

This is totally unjustified as such high subsidies make Ukraine weaker in all regards – more dependent on Russian gas, producing less gas itself, and consuming more gas. Instead the Ukrainian government should eliminate these subsidies as soon as possible by normalizing Ukrainian energy prices while giving the poorest half of the population full cash compensation.

The second big cut should be directed to the old Nomenklatura. Many of their privileges are hidden in the uniquely high public pension expenditures of no less than 18 percent of GDP. Special pensions alone amount to 4 percent of GDP.

The third category of spending that should be checked is public procurement that was the prime boondoggle of the Yanukovych government after energy. With a total public procurement of 10 percent of GDP, half of this amount could be saved if the standard kickback under Yanukovych was 50 percent as is widely reported.

Another area of opportunity for cuts is related to superfluous regulation and bureaucracy. If wisely done, the cuts will fall most heavily on areas where corruption opportunities abound. For example, a substantial percentage of superfluous inspection agencies should be abolished and their cadres laid off.

Finally, many expenditure items comprise subsidies allegedly intended to help low-income population, but are highly inefficient because they are also being provided to those with high incomes. Indeed such subsidies are well-known to have the effect of regressive as opposed to progressive budget policy.

In this way, Ukraine can in one year cut public expenditures of at least one-tenth of GDP without anybody but vested interests suffering. At the same time, one of the benefits would be that the tax-burden-including social taxes – can be reduced considerably with a consequent stimulus to economic activity. The unified social contribution should be cut to 25 percent to encourage the emergence of private business in the official economy.

Reductions of this magnitude will mean positive results in terms of higher economic welfare of the Ukrainian nation, better state finances, greater equity, and higher economic growth.

Authors:

Daron Acemoglu, Professor of Economics, Massachusetts Institute of Technology, Boston, USA;

Anders Aslund, Senior Research Associate, Peterson Institute, Washington, USA;

Kakha Bendukidze, Chairman, Free University, Tbilisi, Georgia;

Oleh Havrylyshyn, Adjunct Professor, George Washington University, Washington, USA;

Basil Kalymon, Professor Emeritus, Ivey Business School, Western University, London, Canada

 

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