The case for Ukraine

Pessimists believe that Ukraine is on the verge of default. Fortunately, such a calamity is unlikely, but Ukraine badly needs more international financial support to handle a tremendous external shock.

A year ago, Ukraine’s economy was in sound health after eight years of an average annual economic growth of 7.6 percent. Ukraine has maintained a minimal budget deficit, and its public debt was as small as 12 percent of GDP in 2007.

Ukraine’s mistake, however, was to keep its exchange rate pegged to the US dollar, which encouraged speculative short-term capital inflows, driving up inflation to 31 percent last May and the current account deficit to 6.7 percent of GDP last year.

These flaws were not major, but Ukraine became a prime victim of the freezing of international financial markets after the Lehman Brothers bankruptcy. Without credit, most construction just stopped. Steel is Ukraine’s main export product, accounting for over 40 percent of exports, and both prices and volume of sales plummeted by half.

The blow to the Ukrainian economy has been horrendous. In January, industrial production fell by no less than 34 percent over January 2008, and GDP is estimated to have plunged by 20 percent. Steel production, mining and construction have fallen by half.

In current dollars, Ukraine’s GDP is likely to plummet by 40 percent this year. Exports are likely to drop by half, and imports even more, reducing the current account deficit to an insignificant level. Millions of workers are being laid off, and the stock market has contracted by 90 percent.

No other country has been hit as hard as Ukraine, and it needs all the support it can get to mitigate the social shock. The Ukrainian government reacted swiftly, asking the International Monetary Fund for support last October. Within four weeks, Ukraine and the IMF had agreed on a large, strong two-year standby agreement with $16.4 billion of IMF credits.

The IMF had three key demands: A balanced budget, a floating exchange rate, and bank restructuring. Ukraine has delivered. It has done more on bank restructuring than most Western countries. After some hesitation, the National Bank of Ukraine let the exchange rate float. It has depreciated by about 50 percent and stabilized, endowing Ukraine with new cost competitiveness. The Ukrainian government has maintained the budget close to balance in spite of collapsing state revenues. Inflation has fallen to 22 percent.

The international financial institutions recognize Ukraine’s dilemma and the government’s heroic achievements. The World Bank, the European Bank for Reconstruction and Development, and the European Investment Bank have contributed some $3 billion in new funds.

Their support is sufficient to avert default. Ukraine still has $28 billion in reserves, which reassuringly corresponds to eight months of imports. The only reason for talk about default is the loud, public acrimony between President Viktor Yushchenko and Prime Minister Yuliya Tymoshenko, who accuse each other of treason and corruption.

But we should not complain about open democracy. Apart from the Baltic countries, Ukraine is the only bona fide democracy with free media in the former Soviet Union, and it is committed to Euro-Atlantic integration. Such a country needs support when in peril.

Amazingly, Ukraine has so far seen minimal social unrest, but unemployment is bound to skyrocket, especially in the East with its steelworks and mines. Naturally, the Ukrainian government is anxious to reinforce its social safety net and insists on a budget deficit of a moderate 3 percent of GDP.

The IMF understands the government’s predicament, but it cannot approve a budget deficit of more than 1 percent of GDP without additional financing. The finance gap in this year’s balance of payment amounts to $5 billion, quite a moderate amount.

Seventeen international banks have just given their vote of confidence in Ukraine’s economic policy, by making commitments to invest $2 billion of their own capital in their Ukrainian subsidiaries. Western governments should follow the example of their hard-tested banks.

The European Union has a vital interest in saving its banks that are heavily invested in Ukraine, and for the United States, Ukraine is of major geopolitical importance. The United States and the European Union should stand up and deliver. Ukraine has long been a loyal friend of the West. Now the time has come for the West to prove its friendship toward Ukraine.

NOTE: RealTime Economic Issues Watch: A website forum in which senior fellows of the Peterson Institute for International Economics discuss and debate their responses to global economic and financial developments as they occur each day and offer insights that others might overlook.

Global Financial Crisis: Views on the current crisis in global financial markets, their impact on the real economy and the public policy choices confronting the United States and other countries.

FOOTNOTE: Anders Aslund has served for several years as a Senior Advisor to the U.S.-Ukraine Business Council (USUBC), Washington, D.C., www.usubc.org.

By Anders Aslund, Senior Fellow

Peterson Institute for International Economics

RealTime Economic Issues Watch, Global Financial Crisis