Ukraine's economic recovery should have been expected

It was not even re-privatization per se, but the real threat of having a massive re-privatization, fueled by the disagreements within the Orange team that scared away many investors

Remember the anecdotal incident that happened in May of 2006, when the president of the EBRD, Jean Lemier, publicly accepted a bet from Yuriy Yekhanurov (at that time the Ukrainian prime minister) that Ukraine's economy would grow at a much faster rate than EBRD economists had forecasted? The stake was quite peculiar: if Yekhanurov were to lose then he would have to praise the professionalism of the EBRD economists during his lectures in economics at his university. On the other hand, if Yekhanurov were to win, then according to the bet, the EBRD must increase its investments into Ukraine by 100 million euros for each 0.1 percent above the EBRD forecasted growth rate for Ukraine. The timing of the bet is coming to an end, and someone must get prepared to lose. Who do you think that will be? Well, at the beginning of 2006, the EBRD believed that Ukraine would grow only at 1.2 percent (in terms of real GDP) and later updated its forecast, but only to 2 percent. Already at this point, it should have been clear that the EBRD was highly underestimating Ukraine's capability to return to high economic growth this year. For example, if we compare August 2006 to August 2005, the Ukrainian economy grew at a rate of 5.7 percent (according to the State Statistics Committee), and by our estimates it is expected to attain an annual growth rate of about 8 percent (plus or minus about 1 percent, depending on the international market conditions for metals and energy products). This means that the EBRD had better prepare enough cash - about 5 to 7 billion euros - to invest into the Ukrainian economy, while Yuriy Yekhanurov ought to probably get a medal of honor from the Ukrainian people.

Was it hard to see that Ukraine would return to a decent growth rate at that time? I think Yuriy Yekhanurov must have known what he was doing when suggesting the bet. By looking a little bit back into history, one should note that before the hectic year of 2005 and since 2000, Ukraine was growing at an average rate of about 8 percent. What is also important to consider is that it was a recovery-driven growth, and Ukraine was just at the beginning of the recovery path - from a deep, decade-long economic crisis that brought Ukrainian official real GDP in 1999 down to about 40 percent compared to that of 1990.  So, even after an extraordinary growth of 12.1 percent in 2004, Ukraine's real GDP was still under 65 percent compared to that of 1990. So, under 'normal' circumstances (which assumes gradual implementation of important reforms to liberalize the market), the recovery process should have continued for at least five more years with an average growth of about seven to nine percent. The problem was that in 2005, Ukraine did not have  'normal' circumstances, but rather a post-revolutionary mess that Yekhanurov managed to clean up by the end of that year. Indeed, one of the main reasons for the unexpected underperformance in 2005 (2.6 percent relative growth) was the 'shakeout of property rights.'  It was not even  re-privatization per se, but the real threat of having a massive re-privatization, fueled by the disagreements within the Orange team that scared away many investors. Ironically, the investment climate was spoilt for both the losers and the winners of the Orange Revolution: many investors were just busy fighting to secure or take over the existing assets of others, instead of starting new business projects. Or they were just waiting for things to calm down. Another important reason for the sudden underperformance was frequent government intervention into markets, which scared many investors even more. By the way, it seems that among Western economists, it was only Anders Aslund who openly and widely criticized the Orange team for these problems, being the first to predict the resulting problems of 2005, while the majority of Western economists had great expectations.

The property-rights shakeout was finally pacified in September of 2005, and this is perhaps the main contribution of Yuriy Yekhanurov  as prime minister. The other main contribution of Yekhanurov was further liberalization of the economy. Although not many formal reforms happened,  his government substantially reduced interventions into private businesses and markets. These two contributions were critical in helping to revive private investment and to make Ukraine substantially more attractive for foreign investors.  In 2005 and 2006, most of the foreign investors were banks and financial companies, but these are just the 'first birds' that arrive to later accommodate the entrance of others.

What about the prospects for 2007 and further on? Well, under normal conditions, the economy must continue its recovery. The exact rate of future economic growth in Ukraine will certainly depend on many factors, and so it is extremely hard to predict and very easy to make a mistake in the forecast. In fact, most of the official forecasts of Ukraine's economic growth, made by various renowned institutions, both foreign and domestic, both for 2005 and 2006, failed because of this difficulty.  What is certainly clear, however, is that the growth rates for the following years will strongly depend on the success of the country's reforms (mainly tax, administrative and land reforms) as well as world market prices for its main exports (steel, machinery, chemicals) and for the main imports (oil and gas). In particular, if the government manages to substantially  reduce the tax burden (specifically, to reduce corporate taxes and VAT) then the economy should boom with a high rate of about 8 percent for the coming three to four years.

    Noteworthy is the fact that, according to the estimates of various international scholars and the World Bank, the shadow economy in Ukraine is huge: about 50 percent relative to the official GDP, and much of it is due to the excessive tax burden. So, in principle, even higher economic growth is possible, 10 to 15 percent -that is if the new government successfully implements the necessary economic reforms to improve economic conditions for both local and foreign investors, and encourage existing businesses currently operating in the shadow to go legit.

Finally, if we are to go back to that bet, the huge investment from the EBRD into Ukraine should help boost the long-term growth of the Ukrainian economy. The impact of this investment should be especially large if it is directed into strategic sectors like high-tech production and services, as well as production and provision of transportation  and public services. Last but not least, there is also a hope that the EBRD would hire some Ukrainian economists (e.g., Yekhanurov) to help with forecasting of economic growth and development in Ukraine.

Valentin Zelenyuk has a Ph.D in economics; is a senior economist at the Kyiv Economics Institute (KEI),  and a  professor of EERC (Kyiv-Mohyla Academy). The views expressed in this article are his own and not those of the above institutions.

Oct 26 2006