Economic growth with equity : which strategy for Ukraine?

W_O_WORLD BANK DISCUSSION PAPER NO. 408 Work in progress WDP408 for public discussion October 1999 Economic Growth with Equity Which Strategy for Ukraine? John Hansen Diana Cook  Recent World Bank Discussion Papers No. 339 Pu.blic and Private Roles in Health: Theory and Financing Patterns. Philip Musgrove No. 340 Developing the Nonfarmn Sector in Bangladeshi: Lessons from Other Asian Countries. Shahid Yusuf and Praveen Kumar No. 341 Beyond Privatizationi: The Second Wave of Telecommunications Reforms in Mexico. Bjbrn Wellenius and Gregory Staple No. 342 Ecoiionomic Integration and Trade Liberalizationz in Souitherni Africa: Is There a Rolefor South Africa? Merle Holden No. 343 Financing Private Infrastructuire inl Developing Countries. David Ferreira and Karman Khatami No. 344 Transport and the l'illage: Findingsfrom Africani Village-Level Travel and Transport Suirveys and Related Studies. 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Csaba Csaki and Zvi Lerman (Continued on1 the inside back cover)  World Bank Discussion Paper No. 408 EconorrLic Growth with Equity: Which Strategy for Ukraine? John Hansen (the World Bank) Diana Cook (the International Centre for Policy Studies)  Copyright C) 1999 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in Ukraine First printing October 1999 Discussion papers present results of country analysis that are circulated to encourage discussion and comment within the development community. The typescript of this paper has not therefore been pre- pared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to mem- bers of its Board of Executive Directors or the countries they represent. The World Bank does riot guar- antee the accuracy of the data included in this publication and accepts no responsibility for any conse- quence of their use. The material in this publication is copyrighted. The World Bank encourages dissemination of its work and will normally grant permission promptly. Permission to photocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational classroom use, is granted by the World Bank, provided that the appropriate fee is paid directly to Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, U.S.A., telephone 978-750-8400, fax 978-750-4470. Please contact the Copyright Clearance Center before photocopying items. For permission to reprint individual articles or chapters, please fax your request with complete informa- tion to the Republication Department, Copyright Clearance Center, fax 978-750-4470. All other queries on rights and licenses should be addressed to the World Bank at the address above or faxed to 202-522-2422. ISBN: 0-8213-4400-5 ISSN: 0259-21OX Library of Congress Cataloging-in-Publication Data has been applied for.  CONTENTS ACKNOWLEDGMENTS .......................................... V ABSTRACT ..................... VI 1. THE NEED FOR AN ECONOMIC STRATEGY .......................................... 1 DEALING WITH DEPRESSION .......................................... I ECONOMIC POLICY WITHOUT VISION .......................................... 2 2. ECONOMIC GROWTH WITH EQUITY ..........................................., 5 ECON OMIC GROWITH .......................................... 5 EQUITY NOT EQUALITY .......................................... 7 3. CHOOSING TH[E RIGHT ROAD .......................................... 8 4. RETURNING TO THE PAST - A NON-OPTION .......................................... 10 INHERENT INEFFICIENCY .......................................... 10 ENERGY PRICES .......................................... 12 INTER-REPUBLICAN SUBSIDIES .......................................... 12 GLOBALISATION .......................................... 12 UKRAINE CAN NOT Go BACK .......................................... 13 5. THE PRESERV7ATION STRATEGY .......................................... 14 THE STRATEGY .......................................... 14 EVALUATING THE PRESERVATION STRATEGY .......................................... 15 Fiscal Position ........................................... 15 Inflation ......................16 Current Account Deficit ........................................... 17 Economic Gr,wth ........................................... 19 Employment ........................................... 21 Equity ......................,22 SUMMARY ..................... 23 6. PROTE CTION ST1 RATEGY4 .......................................... 2 THE STRATEEGY .......................................... 24 PROTECTION FRoM EXTERNAL COMPETITION .......................................... 25 PROTECTION FROM INTERNAL COMPETITION .......................................... 26 EVALUATING THIE PROTECTION STRATEGY .......................................... 28 Fiscal Position ........................................... 28 Inflation ......................30 CurrentAccount ........................................... 30 Economic Growth ........................................... 31 Employment ........................................... 33 Distribution of Income ........................................... 33 SUMMARY ..................... 34 7. COMPETITIVENESS STRATEGY .......................................... 35 THE STRATEGY .......................................... 35 EVALUATION O]F THE COMPETITIVENESS STRATEGY ........................................... 36 Fiscal Position ........................................... 36 Inflation ......................37 Current Account ........................................... 38 Economic Growthz ........................................... 39 Employmenit ........................................... 43 111  Distribution of Income ........ ............................................................... 43 SUMMARY ..................................................................... 44 8. THE TRANSITION TO A COMPETITIVE ECONOMY ..................................................................... 45 ARGUMENTS AGAINST PROTECTION ..................................................................... 46 TRANSITION AND COMPARATIVE ADVANTAGE AS DYNAMIC PROCESSES ............................................................ 47 WHEN IS PROTECTION JUSTIFIED - AND WHEN IS IT NOT? .......................................... ........................... 48 Do MARKET FAILURES JUSTIFY PROTECTION? ..................................................................... 52 Institutioinalfailures ....................................................................... 53 Information failures ............................... ........................................ 54 Policy failures ....... ................................................................ 55 Externalities ....................................................................... 56 How CAN THE DANGERS OF PROTECTIONISM BE MINIMIZED9? ..................................................................... 58 SUMMARY ..................................................................... 59 9. FACING THE CHALLENGE ..................................................................... 60 TEXT FIGURES FIGURE I CUMULATIVE ECONOMIC DECLINE FOR FSU: 1989-96 ......................................................................1 FIGURE 2 CONSOLIDATED BUDGET BALANCE, % GDP ..................................................................... 3 FIGuRE 3 UKRAINE: T-BILLS ......................................................................4 FIGURE 4 ANNUAL INFLATION AND PER CAPITA GROWTH RATES, 1960-92 ...........................................................6 FIGURE 5 INVESTMENT AND RATES OF RETURN IN SOVIET INDUSTRY ................................................................... 11 FIGURE 6 UKRAINE: REAL EXCHANGE RATE INDEX AND CPI ..................................................................... 17 FIGURE 7 CUMULATIVE FDI-INFLOWS 1989-97 PER CAPITA IN USD .................................................................... 19 FIGURE 8 NOMINAL AND REAL EXCHANGE RATE INDEXES, 1992Q3=100 ............................................................ 39 FIGURE 9 FDI AND REFORMS ..................................................................... 41 FIGURE 10 PROTECTION MAY BE JUSTIFIED IF FUTURE PROFITS OUTWEIGH SHORT-TERM LOSSES .. 49 TEXT TABLES TABLE I IMPORT DUTIES FOR TOP TEN PRODUCT GROUPS, % ..................................................................... 26 TEXT BOXES Box 1 BELARUS: A SUCCESS STORY FOR THE PRESERVATION STRATEGY? ........................................................... 20 Box 2 PROTECTING THE AUTOMOBILE INDUSTRY ..................................................................... 27 Box 3 INTERNATIONAL EXPERIENCE WITH PROTECTIONISM ..................................................................... 32 Box 4 T H E POLISH THERAPY ..................................................................... 42 iv  ACKNOWLEDGMENTS The inspiration fox this paper came from conversations with the many talented Ukrainian counterparts with whom the authors worked during the participatory Country Economic Memorandum (CEM) Project, a participatory economic study co-lead by John Hansen (Economic Advisor, World Bank Of- fice in Ukraine), Thor Shumylo (Deputy Minister of Economy of Ulkraine) and Vira Nanivska (Director of Internationial Center for Policy Studies). The participatory process in Ukraine benefited from the guidance of a CEM Advisory Board composed of Mr. Vasyl Rohovy, Minister of Economy and Chair of the CEM Advisory Board, Prof. Anatoliy Halchinskiy, Advi,sor on Macroeconomy to the President of Ukraine, and the three co-leaders of the CEM process. Most of the preparatory and review work was done betweeri June 1998 and June 1999. Special thanks are due to Hafez Ghanem (Sector Leader, World Bank) for his encouraging us to de- velop our original notes into a formal paper. The authors also greatly appreciate the comments of Wil- liam Easterly, Marek Dabrowski, Alex Sundakov, and the many others who participated in the formal review of this and other documents produced by the participatcory CEM process. The views expressed here do not necessarily reflect those of the reviewers or of the organizations for which the authors work. T'he authors remain solely responsible for any errors that may remain in this paper. v  ABSTRACT Putting Ukraine back on the path to prosperity requires that policy makers stop letting economic crises dictate the policy agenda. Short-term problems need to be dealt with in the context of a longer-term strategic view focused on improving the living standards of Ukrainian people. What strategy should Ukraine follow? This report identifies and evaluates three sharply different alternatives, all of which are under active consideration today as Ukraine considers what to do after ten years of halting reforms and economic decline. These options for the future include (a) the Preservation Strategy, (b) the Pro- tection Strategy, and (c) the Competition Strategy. The preservation strategy, which is particularly popular among older people nostalgic for their way of life during the days of the Soviet, recognizes that it is neither possible nor desirable to return to the past, but seeks to preserve as much as possible of the state-dominated economic and social welfare systems of the Soviet era. The role of government would change little under this alternative. Neigh- boring Belarus is a good example of a country that has followed this strategy. The protection strategy, which is particularly popular among both private and public sector industrial- ists, invokes the infant industry argument as a basis for throwing up trade barriers, providing subsi- dies, and extending tax privileges so that Ukraine's industrial enterprises - particularly those that are heavily energy dependent and technologically out-of-date - can survive without having to face pres- sures from internationally competitive enterprises. The protection strategy, which has been popular in many countries, was followed with particular vigor by the Latin American countries in the 1960s and 1970s, for example. The conmpetition strategy enjoys support particularly among the modern Ukrainians who know that their country, with its highly developed industrial structure, has always been very outward-oriented and trade-dependent. They want to see Ukraine become a prosperous European country based on the same market principles that have brought wealth and prosperity to the European Union, East Asia, and many other parts of the world. Each strategy is evaluated in terms of its probable impact on fiscal balances, inflation, the current ac- count deficit, economic growth, employment, and equity. The report recognizes that, in the real world, all countries including Ukraine will adopt some blend of these three stylized models. But based on the analysis of the probable consequences of these models for the Ukrainian people, this note concludes that strategic economic policies for Ukraine should be based as fully as possible on the competitive- ness model. Although implementing it will involve some difficult transitional problems, it is the only vision for the future that holds promise of sustainably higher levels of income for all Ukrainians. vi  The Need for an Economic Strategy 1 1. THE NEED FOR AN ECONCOMIC STRATEGY Ukraine's economy has been slipping backwards for nearly a decade, resulting in a significant fall in the living standards of the Ukrainian peoplie. Putting Ukraine back on the path to pros- perity will require policy makers to stop letting economic crises dictate the policy agenda. Short-term problems need to lie dealt with in the context of a longer-term strategy. DEALING WITH1 DEPRESSION Ukraine is a country of great potential, blessed with well-educated peo- Ukraine is a country ple, abundant nataral resources and a tradition of hard work in industry of great potential. and agriculture. Its geographical location in the heart of Europe leaves it But it has endured in a good position to benefit from world trade. At independence, Ukraine one of the world's was widely considered to have excellent prospects. worst depressions in modern history. The Instead Ukraine has endured one of the world's worst depressions in impact of declines in modern history. That depression has lasted for nearly 10 years and hzs GDP on the people of reduced gross domestic product (GDP) by over 60%. Even among the Ukraiine has been countries of the former Soviet Union. Ukraine stands out as having one of acute. the deepest and longest periods of economic decline (Figure 1). Figure I Cutmulative Economic Decline for FSU: 1989-96 -10 _ L -20 -30H -40 L -50 -60 -70 ,,, N a N Na N-aMN D n 3 Source: World Development Indicators  2 Chapter I Although the economy seemed to have stabilized by mid-1998, the crises of Asia and Russia now threaten this hard-won stability. With limited signs of real growth for the economy as a whole, the hard-won stability now looks more like stagnation. The impact of declines in GDP on the people of Ukraine has been acute. They must now live on less than half the income they enjoyed a few short years ago. At least 30%, and perhaps up to 75%, of families now live below the poverty line, up sharply from the time of independence.' Their savings accounts were wiped out by the hyperinflation of 1992-93. Sick- ness from preventable causes is rising, death rates are climbing, life ex- pectancy is falling, and the population is shrinking. Although the collapse in industrial production has somewhat reduced environmental pollution, the levels still far exceed the standards of countries not suffering frcm the environmental neglect of the Soviet past. In addition, the people of Ukraine still must deal with the aftermath of the Chemobyl disaster. ECONOMIC POLICY WITHOUT VISION Ukraine has become Why has Ukraine not been able to take advantage of its great potential? bogged down in The problem is that Ukraine has become bogged down in "fire-fighting" "fire-fighting" and and has lost sight of its overall objectives. While the President and Gov- has lost sight of its ernment have articulated a general medium term direction for economic overall objectives. As policy, policy implementation bears little resemblance to that visionl. As a a result, Ukraine has result, Ukraine has stumbled from one crisis to another. The recent eco- stumbled.from one nomic history of Ukraine illustrates this problem. crisis to another. The initial years after independence were characterized by large budget deficits as the Government vainly sought to support declining enterprises and industries (Figure 2). These deficits were financed largely by bor- rowing from the central bank and the resulting hyperinflation contributed to the uncertainty facing potential investors. In the middle of 1994, recognizing the costs of inflation, the Government began to rely less on the National Bank to finance its deficits and the majority of the deficit was financed through borrowing. It also made a major effort to reduce the budget deficit, which fell to just over 49'c by 1996. Inflation dropped from the hyperinflationary levels of 1992 and 1993 to a modest 10% in 1997. The nominal exchange rate, which had devalued by over 400 times between the third quarter of 1992 and De- cember 1994, has been more or less stable since mid-1995. However, the Government was so overwhelmed by the need to stabilize the economy, it seemed unable to step back and address the underlying problems. A more fundamental problem was that Ukraine's ability to l See: "Ukraine: Restoring Growth with Equity" - Country Economic Mlemo- randum.  The Need for an Economic Strategy 3 produce goods and services had fallen since the collapse of the Soviet economy. The weakness in the economic outlook reflects a fall in pro- ductive capacity, and a continuing decline in GDP during 1998 was matched by a resurgence in inflation. The combination of falling GDI' and rising prices suggests that Ukrainian enterprises are not able to pro- duce the goods and services that Ukrainians and foreigners wait to buy. Figure 2 Consolidated Budget Balance, % GDP 2 -2 -4 L -6 -8 Maastricht Limit -10 -12 Source: Ministry of Finance of Ukraine There are a number of explanations for this fall in Ukraine', productive capacity. With the collapse of the Soviet Union, increases in energy prices raised the cost of doing business especially in the highly energy intensive Ukrainian economy. The move to world prices worsened Ukraine's terms of trade with Russia, its main supplier of raw materia]s. Perhaps most important[y, the economy had been caughl between a planned and a market economy without a clear economic system for allo- cating resources. This has been reflected in the continued growth of incli- rect subsidies, such as tax exemptions, the shadow economy and arrears. As a result, financial stability did not bring economic grDwth. These problems continued to undermine economic activity, despite the govern- ment's fiscal reforms, putting renewed upward pressure on spending and shrinking the government's tax base. The deficit shot up to almost 7% of GDP in 1997. I'he combination of tight monetary policy and growing fiscal deficits lead Ukrain-e into a classic debt trap. With inflation running at about 10%, real interest rates were exceeding 60% by late 1998 (Figu- re 3). As a result, the 1998 crisis in Russia caught Ukraine in a vulnerable position.  4 Chapter I Figure 3 Ukraine: T-Bills so - - - F l 2 000 60, I 10000 Real Retumn 8 000 S 20 (left scale) <- 00 1 /\/ 2 _ _ _ _ _ _ _ 6000 -4 000 W / ~~~~~T-Bill Stock_400 -40 (right scale)____; 0 Ql Q3 Ql Q3 Ql Q3 QI Q3 1995 1996 1997 1998 Source: Bank staff estimates Ukraine's recent experience highlights the dangers of not addressing eco- nomic problems in the context of a wider economic strategy. Expenditure cuts to reduce the deficit were not sustainable without policies to change the role of government in the economy, to reduce structural inefficien- cies, to move shadow activity into the formal economy and to improve the productive capacity of Ukraine. Therefore, this report seeks to iden- tify a strategy for putting Ukraine back on the road to economic prcsper- ity. It begins by clarifying the objectives of economic policy (chapter 2), then evaluates altemative strategies for achieving those objectives (chapters 3-7) and, based on this analysis, develops a recommendecL strat- egy (chapter 9).  The Need for an Economic Strategy 5 2. ECONOM][C GROWTH WITH EQUITrY Before developing a strategy for economic and social policy, Ukraine needs a clear idea of what it wants to achieve. 211terna- tive strategies need to be evaluated in terms of their success at getting Ukraine where it wants to be. What does Ukraine want to achieve? The ultimate objective of public policy is to raise the living standards of the Ukrainian people. Policy makers are con- cerned with the overall economic welfare of Ukrainians and in how that welfare is dlistributed amongst the population. ECONOMIC GROWTH It is important to keep in mind when designing economic policy that liv- Living standards are ing standards are our ultimate objective. Therefore, the subsequent chap- ultimate objective of ters evaluate alternative economic strategies in terms of the impact on economic policy. The Ukrainian living stanclards, both in the immediate and more distance fui- level of real GDP is a ture. Sometimes policy makers will face trade-offs between maintaining good gauge of eco- economic activity in the short term and setting the backgrolnd for sus- nomic prosperity. tainable economic growthi. While short term consequences are important, Public deficits, infla- they should not be the sole drivers of economic policy. tion, ,he current ac- count balance, and The level of real GD)P is a good gauge of economic prosperity, arid employment are im- growth in real G]DP is a good gauge of economic progress. In particular, portant measures of for policy makers concerned about living standards, GDP per person is an the sustainability of important measure of economic well being. It tells us about the quantity economic growth. of goods and services avaLilable for the typical person in the economy. While policy makers are ultimately concerned about living standards, they often worry about other economic variables like the public deficit, inflation, the current account balance, and employment. These indicatcrs are important measures of the sustainability of economic grcwth and irn- provements in living standards. In particular: * International experience has indicated that very high le,vels of infla- tion are generally harmful to economic growth. In particular, high levels of inflation can discourage savings and investment. Sorne countries manage to attain quite respectable rates of grDwth despite inflation. In fact, up to about 25% per year, there is little correlation between inflation and economic growth (Figure 4). I[owever, be- yond this level growth generally drops off quickly. * A large current account deficit means that a country is spending more than it is earning. I'he gap between the two is financed by foreign lending and investing. But we can not continue to spend more than we earn forever. As the current account deficit gets bigger, foreign  6 Chapter 2 lenders and investors become increasingly nervous about the ability of a country to repay them and about the stability of the exchange rate. They impose high interest rates to compensate them for this risk. In the extreme case, investors may actually flee the country, pushing the value of the domestic currency down and interest rates up. High interest rates stifle economic growth by discouraging consumption and investment. Over time, exports recover and imports ease, bring- ing the current account back into balance. Figure 4 Annual Inflation and Per Capita Growth Rates, 1960-92 31 _ 2 1- X1 [- OII -2 -3 -4 -5 -6 -7 Soiirce: Easterly and Fisher, 1994 Persistent fiscal deficits can also be a constraint to economic activity. By reducing national savings, budget deficits translate into inc-reases in real interest rates and falls in investment. Reduced investment leads over time to a smaller stock of capital, reducing the abili-ty of the economy to produce goods and services. In addition, the build up of debt must eventually be repaid implying an increase in future tax rates or a cut in future government spending. Either way, inheriting a large government debt lower is the living standards of f-utture generations. * Access to employment or paid work is an important determinant of the welfare of Ukrainian people. In addition, people are an important resource. If a growing number are not utilized, this is a significant constraint on Ukraine's ability to grow. We are not interested in these variables for their own sake but because of their impact on economic activity or standards of living. Predicting the consequences of alternative economic strategies for these variables can help assess whether the strategy can deliver sustainable economic growth.  The Need for an Economic Strategy 7 EQUITY NoT EQIJALITY Of course policy makers are not only concerned about the size of the pie Policy makers are not but also about how that pie is distributed. In this case, we are likely to be only concerned about concerned about the level of employment, or unemployment, for its ow]1 the size of the pie but sake. Employment provides a link between economic growth and equity also about how that objectives. Improved employment opportunities is one of the key ways pie is distributed. Our that the benefits of economic growth are delivered to the average definition of equity Ukrainian person. If our economic strategy delivers robust economic implies the existence growth but high levels of unemployment, large numbers of Ukrainians of a safety net to en- would not be sharing in the economic success. sure that the incomes of the poorest Evaluating the ec[uity of a strategy is more difficult than evaluating its Ukrainians do not impact on economic growth. Equity relates to the fairness of the distribu- fall below a mini- tion of well-being among the members of society. But defining fairness mum level. involves normative judgmnents that go beyond the realm of eccnomics and enters into the realm of political philosophy. Therefore, it is important for policy makers to think carefully about what their equity objectives are. We suggest that equity is not the same thing as equality. Some increase in income inequality is completely normal, even desirable, as countries move from the artificial equality of the soviet sys- tem to a system where income inequalities provide incentives for people to get more education, work harder, and take on more responsibility. It is equitable for people ito be rewarded for working hard, for investing in education or for taking, entrepreneurial risks. While equity may not mean equality of outcomes, this report assumes that it does mean equality of opportunity; for example in access to educa- tion. We also suggest that the state has a role to play in protecting the most vulnerable in society. Our definition of equity implies the existence of a safety net to ensure that the incomes of the poorest Ukrainians do not fall below a minimum level.  8 Chapter 3 3. CHOOSING THE RIGHT ROAD Given the objective of raising living standards, what strategy should Ukrainefollow? We identify three different alternatives for Ukraine: the preservation strategy, the protectionist strategy or the competitiveness strategy. Thefollowing chap- Ukraine stands at a crossroads. Past policies have produced apparent eco- ters examine the nomic stability but no growth. Sharply different roads are under d.iscus- probable conse- sion today for Ukraine's future. What direction should Ukraine head to quences of three ba- seek a prosperous future? sic strategic options for Ukraine: (1) the Ukraine faces a number of options. Indeed, the possible combinations of preservation strategy, policy strategies from which Ukraine could chose are endless. To iacili- (2) the protectionist tate the discussion of alternative strategic choices, the following chapters strategy, (3) the com- examine the probable consequences of three basic strategic optiorns for petitiveness strategy. Ukraine: - THE PRESERVATION STRATEGY. Should Ukraine pursue growth by preserving as much as possible of the status quo to avoid social problems? This would involve maintaining a major role for the gov- ernment in production while moving only cautiously towards private enterprise. * THE PROTECTIONIST STRATEGY. Should Ukraine seek growth by protecting its domestic farms and factories from excessive coiripeti- tion? This would involve implementing protective measures designed to stimulate domestic production within a relatively closed, self- sufficient market economy. * THE COMPETITIVENESS STRATEGY. Or should Ukraine pursue growth by creating an open market economy and encouraging com- petition. This would involve removing barriers to competiticn and limiting the Govemment's role to facilitation rather than ownership and participation in production. Each of these policy directions has worked for at least some time in vari- ous countries. There is no absolutely "right" or "wrong" answer to these questions. Each path could conceivably produce improved living stan- dards in Ukraine someday, at least for a while. The strategy that Uraine ultimately chooses will almost certainly, as in every other country, be a blend of these strategies. However, one of these strategies is likely to dominate. In choosing what strategy should dominate, it is vitally i.npor- tant to understand the probable consequences of each strategy for future living standards in Ukraine.  Choosing the Right Road 9 The following discussion draws on economic theory, international expe- rience and Ukraine's own experience since independence in trying to pre- dict the probable consequences of following the preservation, protection, and competitiveness strategies. Each strategy is evaluated in terms of the following criteria: * The fiscal deficit and, more broadly, the role of government in the economy. * Inflation * The current account deficit. * Improvement: in overall living standards or economic growth. * Employment. * Distribution of income. However, before we turn to this evaluation, we need to discuss briefly an option not mentioned above. This is an option that many people in Ukraine today consider very attractive: returning to the past.  10 Chapter 4 4. RETURNING TO THE PAST A NON-OPTION Returning to a command economy is not a realistic option for Ukraine. The economic and politicalfactors that led to the down- fall of communism have not disappeared. In addition, Ukraine no longer enjoys the implicit subsidies that helped support central- ized decision making under the Soviet Union. Each of the three strategies listed in chapter 3 recognizes that some form of market economy must be developed to replace the old command econ- omy. Even in Belarus, where the authorities are pursuing a very cautious pace of reform, almost everyone, including the President, recognizes that the country will have to depend on some form of market-based economic organization. There are at least four reasons why a return to the past is not a viable option: * Inherent inefficiency. * The rise in energy prices. - The end of inter-republican subsidies. * Globalisation. INHERENT INEFFICIENCY The old command- The old command-and-control system was inherently inefficient and col- and-control system lapsed of its own internal weaknesses, as the economy became more so- was inherently ineffi- phisticated. In the fairly simple, largely agrarian society that existed in cient and collapsed of the early years of the Union of Soviet Socialist Republics, a relatively its own internal small group of centralized bureaucrats could m-ake basic decisions with- weaknesses. The sys- out great inefficiency. tem was supported by the immense natural However, as the economies of the FSU became increasingly complex, resources of conti- centralized decision-makers lacked the information they need to make nental Russia. In good decisions about production and distribution. The decisions to be contrast, the Soviet made regarding investment priorities, sources of materials, production system grossly under- methods, labor management, and marketing became increasingly specific utilized the region's to individual, specialized lines of production. These information prob- most valuable re- lems led Soviet authorities to direct an ever-higher share of national. in- source: its people. come into investment that, in the end, added almost nothing to output (Figure 5). The Soviet system survived as long as it did partly because a lot of good people tried very hard to make the system work. Even more importantly,  Returning to the F'ast --a Non-Option 11 the system was suppoirted by the immense natural resources of continen- tal Russia. A price of this survival was massive and perhaps irreparable environmental damage, as wealth was stripped from mines, oil and gas fields, forests, waterways, and agricultural land in order to support the failing Soviet system. Figure 5 In vestment and Rates of Return in Soviet Industry 35 Investmert 30 shale of GDP 25 20 15 10 \ Return on investment 5 0 - 1950 1954 1958 1962 1966 1970 1974 1978 1982 Source: World Bank, World Development Report, 1996 In contrast, the Soviet system grossly under-utilized the region's most valuable resource: its people. By centralizing decision making, the system "dis-empowered" the talented, well-educated people of these republics. People working daily in farms and factories were in the best position to make production decisions. They knew what really needed to be done to improve productivity, but were not allowed to put the fruits of their knowledge and tnderstandinig to full effect. Nor were they given the in- centive to press for improvements. And it was the state, as owner of vir- tually all product:ive assets, that reaped the benefits. The result was an increasing impoverishment of the people who, towards the end of the regime, were forced to stand in long lines even for the ne- cessities of life and who were paid in money for which tfiere were no goods. (It is ironic to note that today, in the virtualised economies, the opposite problem has developed. People are paid in goods for which there is no money.) W'hile many people had large savings accounts, the money was almost worthless as the economy could not produce or import enough goods to meet the demand represented by that money. In an economy without controlled prices, the money printed to pay work- ers under the Soviet system would have caused inflation. The rising prices would have balanced the supply of money with the physical supply  12 Chapter 4 of goods. That was not allowed to happen until the break-up of the FSU. When price controls were removed, inflation surged, destroying the value of household's savings. ENERGY PRICES The sharp increase in The sharp increase in energy prices also prevents a return to the past. Un- energy prices also der the Soviet system Ukraine had access to artificially cheap enaergy prevents a return to supplies. For example, hydrocarbon energy supplies, such as oil and( gas, the past. The energy were priced for domestic production at about one-tenth of the prevailing intensive Soviet sys- world prices. Energy was also grossly under-priced in terms of the envi- tem can not survive ronmental damage it created during extraction, transport and use, The using energy costed damage was most notable - or to be more precise, devastating - in the atfull value. case of the Chernobyl disaster. Residual liabilities of this era are still found throughout the region, including in Ukraine in terms of dangerous nuclear plants, many which are still operating, and tons of nuclear waste. The energy intensive Soviet system can not survive using energy costed at full value. As Ukraine is not energy self-sufficient and must irmport fuel at world prices, it has to follow a strategy that forces the efficient use of energy. INTER-REPUBLICAN SUBSIDIES Ukraine can no A return to the past is also impossible because Ukraine can no longer de- longer depend on the pend on the massive inter-republican subsidies that once helped disguise massive inter- the inefficiencies of the Soviet system. The most important of these sub- republican subsidies sidies has already been noted - Ukraine's access to energy at prices far that once helped dis- below world market levels. But Ukraine also depended on other subsidies guise the inefficien- that were indirectly financed by the vast natural resource wealth of Rus- cies of the Soviet sia. The best example is probably the large and very sophisticated defense system. industry that the Soviet Union developed on Ukrainian soil. The tanks, aeroplanes, and rockets that Ukraine produced were paid for by the So- viet military machine which in turn was fed by a government that ex- ploited a vast base of natural resources. This implicit subsidy of mi!Litary, which once accounted for around one third of total Ukrainian industrial output, has come to an end. Ukraine can no longer rely on guaranteed Russian markets and must develop new markets for its products. GLOBALISATION The globalisation of the world is a fourth reason why Ukraine can never go back to a Soviet system. With instant world-wide communications, rebuilding an Iron Curtain that keeps average people more or less igno- rant of life in the rest of the world would be virtually impossible today. In fact, modern communications were instrumental in bringing down the former Soviet Union. Attempts to impose soviet-style controls, including the limitation of consumer choice, would quickly meet with widespread opposition today.  Returning to the Plast-- a Non-Option 13 For Ukraine to cut itself off from participation in global economic mar- Pre-industrial, self- kets would be an economic disaster. Ukraine has always depended heav- sufficient agrarian ily on international trade, Even during Soviet days, total trade turnover economies can shut (imports plus exports) was equal to 50% to 60% of GDP, a. figure that themnslves offfrom today stands at 9D% to 100%. This increase reflects the incr2ased open- international trade. ness to global markets and the fundamental realignment of the exchang;e But Ukraine with its rates used to value trade relative to GDP. sophisticated indus- Pre-industrial, self-suf'ficient agrarian economies can shut themselves off tries nieeds a global from international trade. ]3ut this is impossible for a country like Ukraine market to maintain with sophisticated industries such as aeroplanes, rockets, tanks, iron arid economic scales of steel, and chemicals. Ukraine needs a global market to maintain economic proditctioe in these scales of production in these highly technical and competitive products. highly technical aird competitive products. UKRAINE CAN NOT Go BACK These reasons highlight that it is impossible to recreate an economy in Ukraine based on centralized controls and administrative fiat. The old centrally controlled soviet system proved incapable of dealing efficientLy with the complexities of a modern industrial economy. It alsD proved in- compatible with the existence of the basic democratic freedoms and re- sponsibilities that are so important to people everywhere in the world, including the people of Ukraine. Some form of market economy where resources are allocated and production decisions are made by individuals on the basis of prices, rather than by bureaucrats on the basis of state plans, is the only solid foundation for a modern Ukraine. Therefore, Ukraine can not ao back. But in which direction should it go forward?  14 Chapter 5 5. THE PRESERVATION STRATEGY "Belarus is an example of how to preserve the best of what was previ- ously present (in the Soviet Union) - something that positively influenced its economic development". - 0. Tkachenko, 28 January 1999. The preservation strategy involves a slow movement towards a market economy with the greatest possible maintenance of the status quo. Under this strategy, Government maintains existing structures of ownership and control and seeks to preserve the so- cial benefits of the Soviet regime. Advantages: The maintenance of subsidies to agricultural and industrial enter- prises avoids the sharp initial drop in production and employment that would result from their removal. Maintaining the status quo also reduces social stress and political tensions. Disadvantages: Long term growth prospects are damaged by the continued support of inefficient production and the cost offinancing high government spending. This results in high interest rates, scarcity of working and investment capital, banking system instability, external pay- ments problems, enterprise losses, mounting arrears in wage and social payments, rising unemployment, and inevitably, falling liv- ing standards. THE STRATEGY The preservation The preservation strategy is based on the premise that the Government strategy is based on can preserve the social benefits of the Soviet regime while still moving the premise that the towards a market-based economy. To avoid enterprise closures and lay- Government can pre- offs, Government provides extensive support to enterprises so that they serve the social bene- can continue working and providing employment despite low sales and fits of the Soviet re- losses. Also, to avoid conflicts with groups such as the managers and gime while still mov- workers of state enterprises and collective farms, and with governrnent ing towards a mar- officials, the government should seek to preserve the existing structures ket-based economy. of ownership and control. This strategy is being pursued with particular vigor today in this region by the authorities in Belarus. Similar strategies have also been followed in the past through out the world, most notably in the totalitarian states of Africa and Latin America.  The Preservatiorn Strategy 15 However, the strategy has not been limited to countries with totalitarian governments. Essentially similar policies have been followed in the past by more populist but still centrally-controlled governmlents such as those in Nayerie's Tanzania, Allende's Chile, Garcia's Peru, and Peron's Argentina. EVALUATI;NG TIlE PRESERVATION STRATEGY In this section the impact of the preservation strategy is predicted and evaluated in terms of the criteria we identified in section 2 and 3. Al- though no one can be certain what the future consequences of any spe- cific strategy will be, evaluating the recent experience of Ulraine gives a good idea of the probable consequences of the preservation strategy, for many of the policies that Ukraine has followed since independence fit comfortably within the preservation strategy. At the same time, it would be wrong to describe Ukraine's overall policies to date as "status quo preservation". In areas such as privatization of small and medium enterprises, introduction of its own naticnal currency, establishment of a more modern system of taxation, and development of the governance structures of an independent nation, Ukrairne has clearly been leaving the past behind. But in other areas Ukraine has tended to preserve the status quo. These include the structure of agriculture, the ownership of large enterprises, the development of a modern framework of laws and institutions, and foreign trade policies. Fiscal Position A preservation strategy implies no significant revision of governiment A preservation strat- spending or of the role of government in Ukraine. The government would egy implies no sig- maintain current employment levels in the public sector and spending in nificant revision of social areas, such as health and education. It would also continue to play government spending a large role in subsidizing enterprises through direct paymnents and tax or of the role of gov- concessions. To preserve the current size of government relative to GDP, ernment in Ukraine. the government will either have to run large deficits or increase tax rat s. To preserve the cur- rent size of govern- Any effort to close the budget deficit by increasing tax revenues would ment relative to GDP, fall heavily on the production of goods and services. Taxation on pro- the government will duction in Ukraine is estimated to have accounted for about 73% of total eithcer have to run tax revenues in 1998. The tax burden on legal enterprises is exacerbated large deficits or in- as about half of all economic activity in Ukraine hides in the shadow crease tax rates. economy where it is not taxed. Of the other half of enterprises, about half are not profitable. Thus, in terms of corporate profit tax, the burden falls on about one quarter of all economic activity. Increases in taxes would further erode the profitability of potentially viable enterprises, reducing their ability to invest and grow. This would drive more enterprises into the shadow economy. If instead the Government finances the current level of expenditure through deficits, the consequence will be a continued high cost of capital  16 Chapter 5 for private enterprises. It is largely because of high budget deficits that investment capital in Ukraine is both scarce and extraordinarily expen- sive. This can be very costly for economic growth, particularly in the longer term. Investment is an important source of future growth and pro- ductivity through its contribution to the nation's capital stock. If the Government continues to run high budget deficits, it will be forced to borrow at an increasingly high cost, until it can no longer afford to pay its debt servicing obligations. At that point, the Government woul(d be forced to restructure its debts, effectively cutting it off from further bor- rowing abroad. Meanwhile, the severe scarcity of capital in the domestic market would make further borrowing there extremely difficult, forcing the government to default on its payment obligations and to accumullate arrears. These risks are obviously not theoretical. In fact, such problems are already quite visible in Ukraine today. Inflation As borrowing be- There is another way that the government could finance its deficits. It comes increasingly could borrow from the central bank by printing money. Under the preser- difficult and costly, vation scenario, it is likely that the government would come under in- the government creasing pressure to do just that. As borrowing becomes increasingly dif- would again resort to ficult and costly, the government would again resort to printing money as printing money as it it did in the early 1990s. did in the early 1990S. The borrowing may be small at first, taking the form of residual central bank purchases of t-bills that did not sell in the t-bill auctions, something that has been happening with great regularity since the crisis of late 1998. Borrowing from the central bank would gradually become more visible and important relative to the bank's total assets, making it difficult for the Government to remain in compliance with IMF ceilings on net domestic assets. The sale of foreign exchange would offset part of the monetary emission, but once reserves fall to dangerously low levels, IMF con)ndi- tions would be breached. This would prompt the World Bank to cut off its lending, making the situation even more acute. With no access to do- mestic or foreign borrowing, and with public sector employees and pen- sioners clamouring to be paid, the Government would have any chcice but to begin large-scale monetary emission, thus triggering another round of hyperinflation. If domestic inflation exceeds the pace of inflation in trading partner countries, Ukraine will come under pressure to further devalue its ex- change rate. During the hyperinflation of 1993-94, Ukraine devalued sharply. This was not enough to offset inflation, during 1993 the real rate appreciated sharply. In 1994, however, the real rate began to stabilize and even depreciated, reversing part of the earlier real appreciation (Figure 6). Allowing the nominal exchange rate to depreciate in the face of rapid domestic inflation preserved Ukraine's competitive position, but aggra- vated an already unstable price environment, making investment cleci-  The Preservation Strategy 17 sions very risky. Clearly less inflation would have been highly desirable, allowing the nominal and real exchange rates both to remain mnore stable. If Ukraine tries :o keep a "stable"' exchange rate as a "nominal anchor" to stabilize the economy, the results are likely to be disastrous unless the country pursues equally tight fiscal policy. If fiscal policy remains loose and the exchange rate remains relatively fixed, inflation will make Ukraine's goods increasingly uncompetitive in foreign markets. Figure 6 Ukraine: Real Exchange Rate Index and CPI 1 000 000~ - - 1000 100 000- 10 0001. - 100 [001 C-PI (1992 Q3=100) - 10 l - - Real Exchange Rate Index (1992 Q3=100) 10 es '>: r o- o- c~ '0 '. a- a- 00 00 CY ~ C'Y CY > CY a CY 0C C0 CY CY CY CY Source: National Bank of Ukraine Indeed, if Ukraine does want to maintain a steady exchange rate, the best approach is to maintain firm fiscal and monetary policy. If a country has limited deficit-financing requirements, the pressure to expand monetary emission will be modest, inflation will be low, and the exchange rate will naturally tend to be stable in the absence of strong exogenous shocks, such as a major change in oil prices. Current Account Deficit If a preservation strategy involves policy makers attempting to keep the exchange rate stable in the face of high rates of inflation, the current ac- count implications are not rosy. Ukraine is already experiencing current account problems. HIowever, these can not all be attributed to the preser- vation strategy. In fact, Ukraine's earliest external payments problems were the result of developments over which it had almost no control: * The loss of traditional markets that came with the break-up of the former Soviet Union.  18 Chapter 5 The sharply higher energy prices that resulted from Russia's decision to begin exporting its abundant energy resources at international prices. If a preservation However, the loss of traditional markets and the oil price shock were strategy involves common to all republics of the former Soviet Union. Many adjusted more policy makers at- quickly and more successfully than Ukraine. For example, the ]Baltic tempting to keep the States quickly compensated for the higher energy costs and the loss of exchange rate in the traditional markets by improving production efficiency and developing face of high rates of new markets. inflation, the current account implications In contrast, Ukraine has failed to adjust successfully to the loss of tradi- are not rosy. As the tional markets and to develop new products and markets. As a result, the strategy leads to merchandise trade balance has deteriorated from a surplus of nearly IJSD growing government 2 billion in 1991 to a merchandise trade deficit of over USD 4 billion in deficits, the current 1996 and 1997. A somewhat smaller deficit was realized for 1998, but account deficit will this is more the result of the sharp decline in imports resulting from. the also become wider. problems in Asia and Russia than success in stimulating exports. Mer- chandise exports, in fact, are expected to decline significantly compared to 1997. While we can discuss the current account deficit as the difference be- tween imports and exports, it is also important to remember that the clefi- cit represents the difference between national savings and investment. The only way to invest more than domestic savings is to access the sav- ings of the rest of the world. This has been the case in Ukraine during the past several years. While investment has been weak, domestic savings have been even weaker. Budget deficits have been a significant driver of the weak national savings. The negative saving of government has sig- nificantly reduced national savings and contributed to the widening cur- rent account deficit. Government foreign borrowing also puts upward pressure on the ex- change rate. This exacerbates the current account problems by making Ukrainian goods and services less competitive relative to foreign goods. High government debt makes foreign investors increasingly nervous about investing in Ukraine. This helps explain the extraordinarily low level of foreign direct investment in Ukraine compared to other countries in the region (Figure 7). As the preservation strategy almost inevitably leads to growing govern- ment deficits, the current account deficit will also become wider. If a na- tion is using foreign capital to build its productive capacity, the resulting current account deficit is of less concern because the investments will generate a return to repay foreign lenders and investors. However, if Ukraine borrows to finance consumption, it will ultimately have to reduice future living standards to repay this debt.  The Preservation Strategy 19 Figure 7 Cumulative EDI-inflows 1989-97 per capita in USD 1800 1600 1400 1200 1000 800 600 400 200 E C a ts CC aC C) - Source: NationcNl Bank o (Ukraine Economic Growth Employing elements of the preservation strategy helped the Ukrainian people avoid slharp reductions in living standards in the early years of independence. The subsidies to agriculture and industry maintained pro- duction, and thus the incomes of workers, despite the severe shocks caused by the break-up of the former Soviet Union. However, our evaluation suggests that this maintenance cf living stan- Perhaps the most dards was accomplished at the cost of future economic growth. As dis- harmful element of cussed above, the large government sector will continue to inhibit eco- the preservation nomic growth rno matter how it is financed. But perhaps the most harmful strategy for economic element of the preservation strategy for economic growth is the lack of growth is the lack of hard budget constraints. This has removed the incentive for producers to hard budget con- look for ways to raise productivity and minimize costs. It has also re- straints. This has re- duced the movement of resources to those enteiprises that could use them moved the incentive most effectively (Box 1). for producers to look for ways to raise pro- Hard budget constraints mean that all institutions, including government, ductivity and mini- enterprises and households, have to pay for what they consume. Further- mize costs. It has also more, they can not consume more than they can earn or borrow on a sus- reduced the move- tainable basis. Hard budget constraints force individuals, en:terprises, and ment of resources to governments to make hard decisions about priorities, thus maximizing the those enterprises that efficiency of resource use and economic growth. In the production sector, could use them most the arrears that have built up because enterprises are unable to pay their eff,ectively. workers, suppliers, bank loans, and taxes is clear evidence that the enter- prises are not living within their means.  20 Chapter 5 If individual, enterprises, and government bodies do not live within their means and pay for what they use, prices become irrelevant. If an enter- prise does not pay its electricity bill, a price of $40 per thousand kWh is simply an illusion. The real price is zero. If the real price is zero, the en- terprise will make no effort to reduce its energy consumption. If the worker does not get paid, the wage is not UAH 100 per month. The real wage is zero. At that price, the enterprise will preserve existing staffing levels, thereby avoiding the uncomfortable process of laying off workers, a process that would encourage them to look for more productive employment. Box I Belarus: a Success Story for the Preservation Strategy? Proponents of the preservation strategy often point to Belarus as evidence of the success of taking the transition frorn the command to market economy slowly. Economic growth reached 11% in 1997, and despite a serious slump in trade with Russia towards the end of the year, growth in Belarus in 1998 was still about 10%. But it's hard to reconcile these figures with the fate of the average Belarusian. A survey b-y the scientific research institute of the Ministry of Economy shows that people's expectations have become steadily worse over the last two years. In the fourth quarter of 1996, 46% of people expected the material status of their family to get worse over the next six months. By late 1998, during this so- called miracle of 10% growth, the share had increased to 78%. By early 1998 even Prescdent Lukashenko demanded to know from his Cabinet why living standards were getting worse despite the economic growth. In short, economic growth does not appear to be translating into improved living standards for the Belarusian people. Why not? Unfortunately, this success is not real. Official GDP appears high because of a system of barter and non-payment, where the prices are artificially high. Belarusian enterprises, using materials that they have taken on credit from abroad and using National Bank loans, are manufacturing products whose real prices are lower than the cost of the factors of production used to make them, then they are shipping a major share of the resulting output back to Russia on a barter basis to pay for the materials, leaving little if any real net gain for the peolple. Large volumes of food products are also exported both as part of barter agreements to pay for imported energy and materials and in response to price controls in the domestic market. GDP has been further overstated by enterprises taking advantage of the National Bank attemy't to restrain exchange rate fluctuations. The spread between the official and market rates for the Belarusian rouble was small in 1996 but jumped up to 10% in 1997. The spread means that enterprises can increase their profits by getting an intermediary to buy their products for Belarusian roubles, sell them in a foreign currency and convert the money back into Belarusian roubles. To legalise this process in their accounts at the official rate, enterprises overstate their quantitalive output. Its no coincidence that economic growth in Belarus began in April 1996 after the spread between official and market exchange rates began to increase. The gains in official GDP may therefore be as much an illusion as an accurate reflection of the economic circumstances of the Belarus people. Actual living standards continue to erode as the flight of food from Belarus to Russia through barter and smuggling leave the shelves bare for important products like cheese, butter, meat and eggs.  The Preservation Strategy 21 Without the threat of bankruptcy, enterprises have no incentive to volun- tarily undertake the measures needed to become more efficient. The threat of losing ones job as a manager or ones assets as an owner fosters changes that bring efficiency and expenditure discipline. These changes may include selling off unused assets, finding new equity partners, vol- untarily restructuring and privatizing, investing in new equipment and technology to irnprove production efficiency and product quality, or for seeking out new markets. The problems are exacerbated by a crumbling banking sector. The bank- ing sector in Ukraine is already weak because most of the banks are either small start-up-banks with no previous experience and little capital, or they are large banks left over from the Soviet era that are struggling to restructure themselves and operate in a market economy. Thtey are weak- ened further when they are forced to lend money to the Government and to public enterprises at artificially low interest rates, Their profitability is further hit by the high reserve requirements that the central bank intro- duces to reduce domestic liquidity and prop up the exchange rate. Faced with low profitability, the hard-pressed commercial banks extend increasingly risky loans to failing enterprises at high interest rates to compensate. When enterprises fail to repay their loans on time, the banks face a serious liquidity crunch. Under such conditions, providing liquidity support to avert a crisis would be inadvisable without restructuring. This would involve the merger or closure of under-capitalized banks or their acquisition by olher investors, including foreign banks. However, this approach would not be consistent with the preservation strategy. As a result, the liquidity problems become a solvency crisis. More banks, their meagre assets eroded by bad loans, would close their doors. When the banking crisis becomes unavoidable, it will be quite destructive. By disrupting the flow of payments, the cIisis makes it impossible for otherwise good banks and creditors to make payments, thereby triggering widespread loan defaults. The economic decline would inevitably become worse after such a crisis, and restoring growth would become an even longer and more painful process. The strategy has the Employment advantage of main- The preservation strategy has the advantage of maintainilng official em- taiing official em- ployment levels in the short term. It avoids the laying off of large num- ployment levels in the bers of public sector ernployees and maintains employment opportunities short term. But, by within businesses thtat would be bankrupt if subsidies were withdrawn. keeping them em- ployed in unproduc- However, official employment levels would be deceptive. The growth of tive industries, the wage arrears suaggests that many enterprises are unable to pay their em- Government is pre- ployees. Under these circumstances, employment does not convey many venting workers from benefits to the worker, If even subsidized enterprises are unable to pay mllving to those areas their employees, the workers must not be making a significant contribu- where they would add tion to the value of goods and services produced in Ukraine. By keeping value.  22 Chapter 5 them employed in unproductive industries, the Government is preventing workers from moving to those areas where they would add value. If the preservation strategy is harmful to economic growth, over the longer term it will limit the opportunities for new job creation. Achieving economic growth is the best way to generate new employment opportu- nities. In addition, if the strategy resulted in an overvalued exchange rate, it could also have harmful effects on employment. It creates a bias against employment. When imported capital equipment is made artificially cheap through an artificial exchange rate, producers will tend to substitute im- ported equipment for domestic workers or domestically produced equip- ment. An overvalued exchange rate also makes imported consumer goods artificially inexpensive, leading consumers to prefer imported goods over those which are domestically produced. This reduces the profits of do- mestic producers and thus their ability to pay taxes, to repay bank loans, to use domestic materials as inputs and to hire new workers. Equity The preservation On the positive side, the preservation strategy clearly has two advantages strategy protects en- in terms of equity. These help explain why Ukraine has tended to follow terprises rather than this strategy during the past seven years. First, most people like stability people. Providing and dislike change. Unless the current situation becomes intolerable, hu- subsidies and tax ex- mans instinctively prefer the status quo. Second, change almost always emptions to ineffi- brings a degree of civil and political unrest because it upsets the estab- cient enterprises lished order and the associated vested interests. By pursuing a strategy of benefits only those very gradual change, Ukraine has protected vested interests and mini- who own and man- mized political and civil unrest. age the enterprise. However, by protecting vested interests, the preservation strategy tends to underscore existing income inequalities in society. It generally favors a limited group of powerful individuals with a vested interest in the status quo. To preserve social peace, the government does not "rock the boat." There is evidence of growing inequality of the income distribution in Ukraine. There are some particularly vulnerable groups in society. The most vulnerable group in Ukraine today is families with more than three children - especially if the family is headed by a single parent (usually a woman). This group is about twice as likely to be poor as the average household. Pensioners are commonly regarded as being the most li:kely group to fall below the poverty line. Therefore, the preservation strategy protects enterprises, rather than pro- tecting people. Money that could be spent on protecting the most vulner- able in society is instead directed towards those that have political clout. Providing subsidies and tax exemptions to inefficient enterprises benefits only those who own and manage the enterprise. It does not benefit those workers who are not paid despite continuing employment and work. It does not benefit consumers who can not buy the goods and services that they want to as resources are channeled into unproductive enterprises. It  The Preservation Strategy 23 does not benefit the owners and employees of productive enlerprises who are forced to pay high taxes to finance their unproductive cotnterparts. SUMMARY The preservation strategy avoids some of the social costs involved in moving from a centrally planned to a market based economy. However, the strategy does not appear to be sustainable and only postpones the costs associated with the inevitable transition to a mark.et economy. Overall, preser- ation will ultimately fail to promote the (Govemment's objectives of economic growth and equity. Is there a better way? The following chapters explore two fundamentally different strategies for bringing about the economic changes needed to restore, preserve, and enhance the living standards of the people of Ukraine.  24 Chapter 6 6. PROTECTION STRATEGY External and internalforces interested in the uncontrolled import of certain products have actively blocked state regulations that could protect Ukrainian producers... The economic crisis can be overcome, but only by an economy founded on domestic production. " Ukrainian League of Consumers and Producers. The protectionist strategy involves shielding selected domestic industries from competition with external and other domestic producers. Protectionfrom external sources can take manyforms including tariff and non-tariff barriers. Privileged domestic en- terprises may be protectedfrom domestic competition by fiscal, quasi-fiscal and regulatory instruments. Advantages The protection strategy often stimulates investment, including from foreign investors who want to "get behind the tariff wall. " Old factories take on new life; new factories are built, and jobs are created. Tariffs and import duties can also generate revenue for the Government. Disadvantages A protectionist strategy make factors such as access to decision- makers and to special privileges more important to the financial success of an enterprise than production efficiency and effective In the most conser- marketing. As a result, protectionism tends to lead to economic in- vative form, protec- efficiencies, making goods and services more expensive for con- tion is limited to sumers. These inefficiencies ultimately undermine economic competition from se- growth. lected imported prod- ucts for a limited pe- THE STRATEGY riod of time. At the other extreme it may Protectionist strategies come in many different varieties. In the most con- involve measures that servative form, protection is limited to competition from selected im- virtually eliminate ported products for a limited period of time. At the other extreme protec- external competitors. tion may involve prohibitive tariffs, quantitative restrictions, import bans, On the domestic side, and quality certification procedures that virtually eliminate external com- protection can be of- petitors. On the domestic side, protection can be offered through subsi- fered through subsi- dies, privileges, and preferential state procurement for selected domestic dies, privileges, and producers, often public sector enterprises, which have trouble compel:ing preferential state with other domestic producers. procuremenltfor se- lected domestic pro- This chapter will not explore the many variants of the protection strategy, ducers. but will focus on the key instruments and tactics of protection that have been used or are being considered in Ukraine. It then examines their im-  Protection Strategy 25 plications for the government's fiscal accounts, inflation, the current ac- count, economic growth employment and income distribution. PROTECTION FROM EXTERNAL COMPETITION The main approaches that Ukraine uses to protect domestic producers from external competition are: * TARIFF BARRIERS. Specific and ad valorem duties are the most The main approaches common instrumnents for protection against imports. In Ukraine, the that Ukraine uses to weighted average duty is about 11% and about 5%7o under the protect domestic pro- "favorable scherne".! The highest duties (up to 60%) iapply to agri- ducers from external cultural products. Seasonal tariffs may be imposed on these products, competition are: (1) and these can roughly double the normal tariff rate, yielding maxi- tarijffbarriers, (2) mum rates of up to 100% on vegetables, for example (Table 1). export subsidies, (3) non-tariff barriers * EXPORT SUlBSIDIES can be used to protect domestic enterprises hav- and subsidies, (4) ing trouble competing with foreign competition in external markets. implicit barriers and Direct export subsidies appear to be very restricted in Ukraine. subsidies. * NON-TARIIF BARRIERS AND SUBSIDIES. These instruments are in- creasingly being used in favor of Ukrainian producers. Explicit quantitative restrictions on imports are still limited in lJkraine - ap- plying only to skins, live animals and meat, and they a^e intended to protect Ukrainian farmers whose productivity has fallen significantly behind world standards. However, there is considerable potential for immediate, widespread and ad-hoc application of quantitative restric- tions. A Cabinet decision of June 26, 1996, allows impcirt limits to be imposed whenever it is deemed necessary "to prevent or remove seri- ous damage to national enterprises." The decision, which provides only loose guidelines for what qualifies as "serious damage", allows the restrictions to be put into place for up to eight years. * IMPLICIT BARRIERS AND SUBSIDIES are perhaps more prevalent. Much of the trade in agricultural products, for example, is still con- trolled through state-owned or state-controlled, co-operatively owned agricultural enterprises. These enterprises have the pDwer to favor domestic producers. As in many countries, quality ceitification pro- cedures have the potential to be used to restrict competition from im- ported goods. Recent well-known cases in Ukraine include delayed or non-certification of television sets, car parts, detergents, and toothpaste from internationally known producers. * SUBSIDIES, which can be used to protect domestic producers both from foreign and domestic competition, will be discussed in the fol- lowing section. Michael Michaely. 1998. Ukraine: Foreign Trade and Commercial Policies. World Bank, processed., p. 8.  26 Chapter 6 Table 1 Import duties for top ten product groups, % ......................................... ................ ....... ............... ................................................................................. Product Mln Favorable rate Full rate $ min avg max min avg max ............... ......................-.................- - - .............. . ........ .. ........... .............. .............. .................... ...................................................................................... Petroleum products 7,807 0 1 2 0 5 10 Non-electrical machinery 1,961 0 4 30 1 12 40 Transport except railway 639 0 9 20 20 21 40 Electrical machinery 634 0 6 25 2 15 40 Pharmaceutical products 424 10 10 10 20 20 20 Plastic goods 367 0 3 10 2 9 [0 Rubber 358 1 5 5 5 10 20 Paper, carton 327 0 7 25 2 11 40 Other chemical products 264 0 3 10 5 9 1.0 Optical, photo, med equip 231 0 6 10 1 14 20 .......I.........................................I...................................................... ................ .............. ............. ........... ........ ........... ....... ........... ............. ............ ...... Notes: This table covers 76 percent of all products by value in 1997 Source: Ministry of Finance of Ukraine and Bank staff estimate PROTECTION FROM INTERNAL COMPETITION Protection from more Although popular attention tends to be focused on the issue of protection efficient domestic from foreign competition, protection from more efficient domestic riro- producers is also ducers is also common in Ukraine. Protection for less-efficient producers common in Ukraine. comes through fiscal, quasi-fiscal and non-fiscal measures. Protection for less- efficient producers , FISCAL PROTECTION. Ukraine has made significant reductions in comesithrough fiscal, the use of fiscal measures to protect selected enterprises. In 1994 quasi-fiscal and non- "Support to the National Economy" accounted for 13% of GDP, of which a major share went to support loss-making agricultural enler- prises. By 1998 this had dropped to 2% of GDP. Similarly the use of directed credits from the budget to enterprises has declined sharply. In 1992 these amounted to 13% of GDP, but had fallen to zero by 1996. On the revenue side, the government provides substantial amounts of support worth an estimated UAH 1.7 billion in the form of preferential or zero tax rates and by failing to take enterprises into bankruptcy court for the non-payment of taxes. In some cases, such as the elimination of value added taxes on meat and milk products in the agriculture sector, entire sub-sectors are given preferential tax treatment. In other cases, individual enterprises are given special tax and subsidy treatment. This is commonly done because the enter- prise is in an area of "strategic importance" such as high technology, or because the government wants to avoid large-scale reductions in the number of workers employed. Such preferential protection has been given, for example, to the AvtoZaz-Daewoo plant in Zaporiz- hia both on the basis that the motor vehicle industry is a priority sector and to protect the 20,000 jobs in the plant (Box 2).  Protection Strategy 27 Box 2 Protecting the Automobile Industry The Daewoo-AutoZAZ joint venture is the largest single foreign direct investment in the Ukrainian economy. To attract this investment the Ukrainian Government made a number of concessions designed to support the development of the "infanlt Ukrainian automobile industry". These concessions are available to any enterprise that is willing to invest at least $150 million in the automobile industry. They include: * A zero VAT and excise rate on the imports of manufactur ing equipmnent, construc-tion materials and car assembly components. e Exemption from land tax. * Exemption of reinvested profits from the enterprise's tax liability. a Exemption cf cars assembled in Ukraine from VAT and excise duties.