Ukraine after 10 Years of Transition ExperiencesJohn Odling-Smee
Director, European II Department
International Monetary Fund
Lecture at the National University "Kyiv-Mohyla Academy"
Kyiv, 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.
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.
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.
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.
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.
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.
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:
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.
IMF EXTERNAL RELATIONS DEPARTMENT