How to Accelerate and Sustain Growth in Ukraine?

Ukraine's economy is slowly getting back on track to growth. But even as the country recovers from the beating it took in the global financial crisis, its economic foundation is fragile. Reforms are needed if Ukraine and its people are to get the most out of the global recovery in coming years.

A new World Bank report points the way forward by examining what drove growth before the financial crisis and why GDP declined so much in its wake. The Country Economic Memorandum "Strategic Choices to Accelerate and Sustain Growth in Ukraine" argues that growth between 2000 and mid 2008 was mainly driven by external factors, such as unprecedented trade gains and massive capital inflows. These are unlikely to support growth as much during the recovery. The report also pinpoints structural vulnerabilities that were ignored in boom times and that, unchanged, may hamper future growth.

"Economic recovery and sustained growth will have to come from higher productivity and this in turn will require Ukraine to embrace deep fiscal, structural, and public sector governance reforms that have been delayed during the last decade," says Pablo Saavedra, Senior Economist and Country Sector Coordinator for Ukraine, Belarus and Moldova and lead author of the report. "The objective should be to reduce the footprint of the state and let the private sector thrive and drive growth based on the pressures of market competition rather than political connections."

On this fiscal side, the report suggests that reforming the pension system is key. In 2010, pension expenditures reached 18 percent of GDP, among the highest in the world. In ten years there will be one pensioner for every contributor and this ratio will worsen sharply. Yet, today's pensions do not keep up with the rising cost of living due to inflation, partly driven by loose fiscal policies.

"Look, my pension was UAH 130 and I could buy 640 loaves of bread for UAH 132. Today my monthly pension is UAH 850, but I can buy just 230 loaves. Is it better or worse? I think it's much worse," says Volodymyr Mykytovych, a 75-year old pensioner near Kyiv.

Cutting pensions is not a solution. Increasing already high contribution rates would not either would further burden employees and employers, encouraging the shadow economy. Among the report's recommendations are a gradual retirement age increase for women, who now retire earlier than in any European country (at 55), but live as long.

The report also recommends cutting inefficient tax exemptions, reducing subsidies, and introducing other budget efficiencies. Savings could pay for improved public services and much needed infrastructure upgrades which could help sustain growth.

"The biggest issue in Ukraine are the roads. We have spoonable yogurt that after spending eight hours on the road from Kherson to Odessa becomes drinkable yogurt. So the infrastructure of the roads, especially in winter, really creates a huge problem for our business," says Dario Marchetti, General Manager of a Multinational Company in Ukraine.

Tariff reform is also a key to fiscal health and good service delivery.

On the structural side, the report argues that the economy needs to move away from its reliance on commodities export. It recommends how to lift barriers to entry and exit of businesses and improve the business climate and enforcement of fair competition rules. That will help to attract more foreign investment, bring new technology and give the economy a broader export base to withstand outside shocks.

"Today our exports are dominated by commodities with low added value like metallurgical and chemical products. Unfortunately, these commodities do not form the export profile of our country needs. Given the big concentration of revenues from exporting a limited range of goods, any crisis or changes create problems for us. The Ukrainian economy is one of the most energy inefficient compared with the Central and East European and other post-communist states," points out Igor Burakovsky, Director of the Institute for Economic Research and Policy Consulting.

Red tape needs to be cut to make it easier and cheaper for companies to do business in the country, and to create more, better jobs for Ukrainians. But it is also critical to level the playing field for all enterprises and citizens, based on market rules. The report argues that fiscal and investment climate reforms need to be coupled with public sector governance reforms that reduce red tape and corruption.

"For instance, once I delayed payment to the pension fund for one day, and it cost me UAH 27 000. At the same time, the government doesn't repay me VAT, and it couldn't care less about it. How can I pay salaries to my workers if I don't have current assets?" says Yaroslav, owner of a small business in Lviv.

Ukraine is at a crossroads. The decisions Ukraine's leaders take now and over the next three years could make the difference between a scenario of low-growth and muddling through and one of sustained growth with rapidly rising living standards. The recent Country Economic Memorandum is solidifying a platform for authorities to formulate reform plans, and helping key development partners to identify a common agenda to move the country on that path.