Ukraine’s economy still stuck in vicious rent-seeking trap
By Anders Aslund, Kyiv Post, Kyiv, Ukraine
Wash, D.C., Mon, April 2, 2018
Even though Ukraine’s Black Sea ports are one of the country’s main gates of trade, businesspeople complain about their outdated infrastructure, non-transparent regulations and red tape. The ports are informally considered to be controlled by a "racket" that includes the Customs Service, the Ministry of Interior, and the Ministry of Transportation and Infrastructure.
Photo by Kostyantyn Chernichkin
Ukraine is the second poorest country in Europe, after Moldova. Its backwardness is starkly illustrated by gross domestic product per capita.
In 2017, according to the International Monetary Fund, Germany’s was $44,000, Poland’s $13,400, Romania’s $10,400, but Ukraine’s just $2,500.
In 1989, Poland and Ukraine were at a similar economic level.
These numbers do not reflect purchasing power, and Ukraine has a much larger unofficial economy than the other countries. The difference is that Poland and the rest of the European Union have open and competitive markets with real property rights. In Ukraine, businesspeople thrive on rents in monopolistic sectors.
In their monumental work “Why Nations Fail,” professors Daron Acemoglu and James Robinson explain why countries do not easily move from one trajectory of development to another. Either they are in a virtuous circle of inclusive economic and political institutions, or they are caught in a vicious circle of extractive institutions.
Ukraine is still stuck in such a vicious circle. Acemoglu and Robinson conclude: “Attempting to engineer prosperity without confronting the root cause of the problems — extractive institutions and the politics that keep them in place — is unlikely to bear fruit.”
Ukraine has carried out many economic reforms, but they need to be completed if the country is to break out of its vicious circle of rent-seeking. Today, the main emphasis should be on reforming the judiciary, law enforcement, the state and political institutions, whereas this article highlights the major sources of monopolistic rents that remain.
How the rich make money in Ukraine
The key question is not who makes how much money, but how the rich and powerful make money. The expenses for the nation are far greater than the comparatively small rents they extract. Ukraine needs to break up the feudal system, where the lords extract rent from the land and safeguard their rents through their control of the courts.
The most closed sectors are energy and transportation, while the most open are high technology, small-scale services and retail trade. In the 1990s, all the big Ukrainian fortunes were made on commodity trading, mainly on gas but also steel. The preconditions were state control of prices at different levels for the same commodity, and export controls.
By and large, these price disparities are gone, even if a gap has developed between household and industrial prices for gas. A remaining problem in the energy sector is the poor payment discipline of some key actors. A major complaint of Naftogaz is that most regional gas distributors (oblgazes) that are monopolies do not pay for the gas they sell. Most are controlled by billionaire oligarch Dmytro Firtash, fighting U.S. corruption charges from exile in Austria.
In the electricity sector, all tariffs are regulated, but since people do not trust the energy regulator’s independence, all tariffs are subject to dispute, both for the generation of different kinds of electricity and for their transportation and distribution.
Ukraine has adopted a law on gas markets, and the development of a law on electricity markets is under way. Both have been designed in line with the EU third energy package, with the support of the European Energy Community, of which Ukraine is a member. This needs to be completed to finally eliminate distrust in the Ukrainian energy market.
Stifling oil, gas production
Oil and gas production is controlled by the state and a few big Ukrainian businessmen. The tax burden has been reduced to a reasonable level, but so many permits are required that new independent businessmen cannot enter the market. If Ukraine allowed normal market conditions in gas production, the country could become self-sufficient in gas within five years, but that has been true for over 20 years. It can and should be done.
Currently, businessmen complain in particular about problems in the Black Sea ports, from Odesa, through Kherson and Mykolaiv up to Zaporizhzhya. They are considered to be controlled by a racket, including the Customs Service, the Ministry of Interior, and the Ministry of Transportation and Infrastructure. Today, this probably causes greater costs to business in Ukraine than the energy sector. It is mainly a matter of law enforcement reform, but privatization of the ports to different owners would help develop sound competition between these ports.
Sordid arms trade
A particularly sordid kind of business is arms procurement, which is controlled by a handful of people, representing two competing political groups. No-bid procurement should not be allowed in any large-scale business, and arms procurement is big business. This is a matter of national security. The state-owned Ukroboronprom, with 120 companies and 80,000 employees, does not appear to have any right to exist. It should be broken up. Its healthy enterprises will survive and thrive, leaving many dying enterprises to close.
Kolomoisky’s air monopoly
Today, Ukraine is an attractive tourist destination that does not require visas for Europeans. Lviv should compete with Prague and Krakow. The western Ukrainian city of 728,000 people, located 540 kilometers west of Kyiv, is attractive while offering far lower prices. But one thing is missing: airline connections.
For years, the airlines controlled by billionaire oligarch Ihor Kolomoisky have successfully fought against the entrance of low-cost airlines such as Ryanair and Wizz Air through eminent contacts in the relevant state agencies. Finally, a breakthrough appears to be coming about, thanks to Ukraine’s greater transparency, making it possible to identify the culprits. Freer travel would stimulate the Ukrainian economy in so many ways with more tourist income, more personal contacts and cheaper travel for Ukrainians.
Start land market
The oldest source of rents is agricultural land, and that is also the case in Ukraine. About 30 percent of the land is held by vast agroholdings, many of which are too large to manage. Many big farmers have convinced small landholders that they are better off leasing their land to them for a pittance rather than selling it for a far higher price. This form of rent-seeking is best ended by allowing private sales of agricultural land, which has been delayed every year since 2000. The government needs to make sure that people who sell their land are not cheated and that they are convinced that they will be justly treated.
A traditional way of making money has been to “sit” on a state company and tap it for money, partly through transfer pricing on both inputs and outputs, and partly through privileged procurement of investment goods. This has been characteristic of all the big state companies that actually made profits.
About 30 percent of Ukraine’s land is held by vast agroholdings, of which many are too large to manage. Economist Anders Aslund says that this form of rent-seeking is best ended by allowing private sales of agricultural land. (Kostyantyn Chernichkin)
The Naftogaz management has heroically cleaned up their company and the government has established an independent supervisory board. Other big state companies that have to stay state-owned for security reasons should follow their example, while the vast majority of Ukraine’s 3,500 state companies should be auctioned off as soon as possible. They do more harm than good in state hands, and most of them have little or no value.
Most of the banking sector has been cleaned up, but two big problems remain. One is the Russian state banks, although they might just close down. The other is the state banking sector that has swollen to 56 percent of total banking assets. Their non-performing loans are large, and the government should not spend too much money on them but privatize them as soon as possible.
Rise of the gray cardinals
Most people criticize the Ukrainian system as oligarchic, but the main usurpers of rents are no longer the old oligarchs, who have all lost a lot of money since 2013. The recent winners are the gray cardinals who sit in parliament, from where they control state companies, which they tap for money. With this money, they finance their party colleagues and enrich themselves. Politics is their business, and several of them have never owned or run companies.
The oligarchs were bred under the government of acting Prime Minister Yukhim Zviahilskiy in 1993–94. The early oligarchs were Hrihoriy Surkis, Viktor Medvedchuk and Ihor Bakai, all gas traders, and the metal trader Zviahilskiy. They all dwindled after 2000 when Ukraine’s big businessmen focused on production of raw materials rather than trade.
Today, the commodity boom is long passed. The raw material oligarchs have lost much of their wealth and standing. Their strength was government relations and raw materials extraction rather than innovative production. Some may survive; others have already faded away. The best cure against oligarchy is open markets and a strong, independent court system, which would reduce the importance of government relations for maintaining property rights. Fortunately, Ukraine’s policymakers are well aware of the key problems and impressive attempts at reform are apparent on all the main fronts. This will be a big battle. Let us hope they succeed!
Anders Åslund is a senior fellow at the Atlantic Council in Washington and author of the book “Ukraine: What Went Wrong and How to Fix It.”
USUBC NOTE: Anders Aslund serves as a Senior Advisor to U.S.-Ukraine Business Council (USUBC), Wash, D.C. www.USUBC.org