Ukraine: Reform Progress and the Way Forward

Olena Bilan, Chief Economist

85th East Jour Fixe of the OeNB

Sept. 12, 2019

2

Reform Progress in 2014-2018

3

Broad Picture• The assessment of reform progress

over 2014-2018 has been mixed. Some observers consider the progress to be more significant than over the previous 24 years of independence. Others say what has been done is not enough for a breakthrough

• The expert community praises:

• central bank transformation and banking system reforms

• business deregulation

• fiscal decentralization

• gas sector reforms

• changes in pension system and healthcare

• selected anti-corruption efforts

• The population has been largely dissatisfied, giving previous authorities credit only for decentralization and police reform

Index for Monitoring Reforms* (iMoRe)

0

50

100

150

200

250

300

Feb-1

5

May-1

5

Aug-1

5

Nov-1

5

Feb-1

6

May-1

6

Aug-1

6

Nov-1

6

Feb-1

7

May-1

7

Aug-1

7

Nov-1

7

Feb-1

8

May-1

8

Aug-1

8

Nov-1

8

Feb-1

9

May-1

9

Aug-1

9

Fight against CorruptionDecentralizationSocial Protection and Labor MarketBanking SectorBusiness RegulationEnergy Sector

The Most Reformed Areas: Expert Assessment** (points)

Note: *index assesses economic reform progress on the scale of -5.0 (regress) to +5.0 (progress) based on experts’ assessment of legislation; **calculated as cumulative iMoRe score of legislative acts affecting particular area. Source: VoxUkraine

May-1

5Ju

l-15

Sep-1

5N

ov-1

5Ja

n-1

6M

ar-

16

May-1

6Ju

l-16

Aug-1

6O

ct-1

6D

ec-

16

Feb-1

7Apr-

17

Jun-1

7Aug-1

7O

ct-1

7D

ec-

17

Feb-1

8Apr-

18

Jun-1

8Aug-1

8Sep-1

8N

ov-1

8Feb-1

9Apr-

19

Jun-1

9Aug-1

9

0

1

2

Trend

4

Banking System and NBU Transformation Number of Banks and Banking Sector Concentration

UAH:USD Exchange Rate

Sources: NBU, Dragon Capital

72%

78%

89% 90% 90% 91% 93%177

133 109

96 82 77 76

60

90

120

150

180

210

50%

60%

70%

80%

90%

100%

2013 2014 2015 2016 2017 2018 1H19

Top-20 banks market share (% of assets)

Number of operating banks

• The NBU became an independent institution with reform-minded management and efficient structure

• The Bank abandoned its de-facto exchange rate peg and has been shifting towards inflation targeting

• The NBU cleaned the banking sector of non-viable and money-laundering banks. The top bank, Privatbank (18% of assets), was nationalized smoothly despite risks

• The NBU enhanced requirements for bank UBO disclosure and related-party operations, mandated adequate capitalization and improved supervision, aligning it with EU bank legislation and Basel requirements

• The government recently appointed independent directors and state representatives to the Supervisory Boards at three state-owned banks

0

5

10

15

20

25

30

35

Apr-

13

Aug-1

3

Dec-

13

Apr-

14

Aug-1

4

Dec-

14

Apr-

15

Aug-1

5

Dec-

15

Apr-

16

Aug-1

6

Dec-

16

Apr-

17

Aug-1

7

Dec-

17

Apr-

18

Aug-1

8

Dec-

18

Apr-

19

Aug-1

9

Crisis

Flexible exchange rate management

De-facto peg

5

Business EnvironmentUkraine’s Doing Business Rank

Ukraine’s Progress in Doing Business Survey Components (points)

Source: World Bank

0

1

2

3

4

5

6

7

8

9

10

11

12

050100150200

Oct-13 Oct-18Doing Business

Starting a Business

Dealing with Construction Permits

Getting Electricity

Registering Property

Getting CreditProtecting Minority Investors

Paying TaxesTrading across Borders

Enforcing Contracts

Resolving Insolvency

112

96

83 8176

71

2014 2015 2016 2017 2018 2019

60

80

100

120

• Ukraine has advanced by 41 spots in the World Bank’s Doing Business survey in the past five years, ranking 71st

• Key improvements in business regulation include:

• number of licensed activities and permits down 40%

• payroll tax rate almost halved, from over 40% to 22%, since 2016, bringing tax burden to CEE average

• Online registry of VAT refund claims launched

• Over 14,000 Soviet-era safety standards and multiple sanitary norms abolished

6

Public Finance & Energy

Naftogaz Ukrainy Net Contribution to Budget ($bn)

Gas Price ($/tcm, net of VAT and transportation costs)

(10)

(8)

(6)

(4)

(2)

0

2

4

6

2014 2015 2016 2017 2018

Taxes Paid By Naftogaz

Indirect Gas Subsidies(Naftogaz Recap)

Direct Utility Subsidies toHouseholds

Net Contribution to StateBudget

Sources: Finance Ministry, Economic Ministry, Naftogaz Ukrainy, Dragon Capital

• Retail gas prices rose 11-fold in three years (2014-2016). State-owned gas monopoly Naftogaz Ukrainy enjoyed a financial turnaround, which enabled it to invest to expand gas extraction

• Ukraine stopped direct gas imports from Russia in favor of (reverse) supplies from the EU, thus reducing dependence on the adversarial eastern neighbor

• Tight budgetary constraints along with sharp increases in domestic gas tariffs (accompanied by direct subsidies to the poor) helped slash the broad fiscal deficit from 10% of GDP in 2014 to 2.0% in 2015, helping push public debt on a downward trend: debt-to-GDP slid by 20pp in to years to 60%.

• The government shifts to medium-term budget planning and is conducting spending reviews aiming to improve efficiency

0

50

100

150

200

250

300

350

400

450

Feb-1

4

Aug-1

4

Feb-1

5

Aug-1

5

Feb-1

6

Aug-1

6

Feb-1

7

Aug-1

7

Feb-1

8

Aug-1

8

Feb-1

9

Aug-1

9

Industry Households Imported gas

+27%

11-fold increase

7

Fight Against CorruptionStructure of Anti-Corruption Institutions

Corruption Perception Index (2018)

Sources: Transparency International, Dragon Capital

• New institutions to fight high-level corruption:

• National Anti-Corruption Bureau (NABU), Specialized Anti-Corruption Prosecutor’s Office (SAPO), Anti-Corruption Court (ACC)

• Electronic system of assets and income declarations for state officials (not very productive yet)

• Reducing corruption opportunities:

• Transparent and user-friendly electronic public procurement system ProZorro

• State registries made publicly available, ranging from beneficial ownership, court filings and car registrations

• Better corporate governance at selected SOEs

National Anti-Corruption Bureau (NABU)

Prevent, expose, stop, investigate corruption-

related offences committed by high-ranking officials

Key objectives

Specialized Anti-Corruption Prosecutor’s

Office (SAPO)

Support and oversee criminal investigations

launched by NABU

Anti-Corruption Court (ACC)

Try high-profile corruption cases investigated by NABU

0

20

40

60

80

100

120

140

160

180

Cost

a R

ica

Jord

an

Senegal

Bela

rus

Jam

aic

a

Tunis

ia

Ghana

Turk

ey

Arg

entina

Sri L

anka

Mongolia

Bahra

in

Egypt

El Salv

ador

Cote

d'Ivoire

Ecu

ador

Pakis

tan

Ukra

ine

Gabon

Lebanon

Kenya

Nig

eria

Ukra

ine (

2013)

Angola

+24 spotsin 5 years

8

What went wrong?

FDI in Ukraine (% of GDP)

Sources: UNCTAD, NBU, EBA, CES, Dragon Capital

Major obstacles to foreign investors

0 1 2 3 4 5 6 7 8 9 10

Widespread corruption

Lack of trust in judiciary

Markets monopolization & state capture by oligarchs

Military conflict with Russia

Oppressive law enforcement agencies

Unstable financial system and currency

Cumbersome and frequently changing legislation

2019

2018

2017

2016Most important

$0 $5,000 $10,000 $15,000 $20,000

UkraineBosnia & Herzeg.

AlbaniaRomania

SerbiaPoland

LithuaniaBulgariaCroatia

SloveniaMontenegro

LatviaHungary

Slovak Rep.Czech Rep.

Estonia

FDI stock per capita (end-2018)

(1%)

0%

1%

2%

3%

4%

5%

4Q

12

2Q

13

4Q

13

2Q

14

4Q

14

2Q

15

4Q

15

2Q

16

4Q

16

2Q

17

4Q

17

2Q

18

4Q

18

2Q

19

FDI to banking sector FDI to other sectors

• Reform progress over 2014-2018 was notable but not sufficient to change foreign investors’ perception

• Key obstacles to foreign investment –widespread corruption, lack of trust in judiciary and influence of oligarchs – were not sufficiently addressed

• As a result, FDI remained low and post-crisis economic recovery was sluggish

9

Reform Outlook

10

Post-Election Political Setup…

Composition of Parliament (number of seats)

0% 10% 20% 30% 40% 50% 60% 70% 80%

2019

2014*

2010

2004

1999

1994

Ukrainian Presidential Elections: Votes Cast in Runoff

ZelenskyPoroshenko

YanukovychTymoshenko

YushchenkoYanukovych

KuchmaSymonenko

KuchmaKravchuk

Servant of People

(Zelensky), 252

Opposition Platform

(Boyko), 43 European Solidarity

(Poroshenko), 27

Fatherland

(Tymoshenko), 24

For Future

(independent MPs), 22

Voice

(Vakarchuk), 17

Other, 38

Vacant, 26

Total = 450Note: *there was no runoff election as Poroshenko won more than 50% in first round. Source: Central Electoral Commission

• Volodymyr Zelensky won a record 72% of the vote in the presidential elections

• His political party, Servant of the People, secured an outright majority in parliament for the first time in Ukraine’s post-Soviet history

• First-time MPs represent 77% of the new Verkhovna Rada, the highest rate since Ukraine's first Rada elections of 1994. The average age of this Rada is 41 years

• The Rada swiftly approved 35-year-old Oleksiy Honcharuk as prime minister and voted in his reform-minded government, which became the youngest ever in Ukraine

TymoshenkoPoroshenko

11

…Conducive to Fulfilling Ambitious Reform Agenda…Fight against Corruption/Protection of Property Rights

• Lift the ban on farmland sales and launch farmland market from mid-2020

• Resume large-scale privatization of state assets

• Pass legislation on concessions and lease of state/communal property

• Pass new law on investment incentives and protection of foreign investment

Land, State Property and Investment

• Revive business deregulation

• Minimize state involvement in the economy, including by trimming authority of the State Security Service

• Create a new analytical financial investigations service

• Foster competition by undermining monopolies, particularly in the energy sector

• Introduce a tax amnesty and replace corporate tax with exit capital tax at a later stage

• Legalize gambling and amber mining

• Reduce the scope for informal employment and simplify procedures to hire and fire personnel

• Invigorate recently created anti-corruption institutions

• Restore punishment for illicit enrichment

• Downsize and overhaul the Prosecutor General’s Office

• Restart judicial reform

Business Environment & De-shadowing

12

…and Invigorating EconomyReal GDP Growth (% y-o-y)

Land Reform Impact on Growth (pp per annum)

• With this reform agenda, the new administration aims to propel Ukraine to the top-10 of the World Bank’s Doing Business ranking, attract foreign investment and speed up economic growth to 5-7% y-o-y

• These reform intentions correctly address Ukraine’s most pressing issues, including those viewed as key obstacles to foreign investment. Some initiatives, such as land reform and privatization, could be implemented quickly and bring visible results within the next several years

• In particular, land reform is viewed as transformational for Ukraine for its potential to attract sizable capital inflows and boost annual GDP growth by up to 4.0pp, according to some estimates, via higher private consumption and increased productivity

+1.25pp+0.50pp

+1.50pp+0.50pp

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Only smallfarmers

within 200haper head

Smallfarmers andlegal entities,

norestrictions

Improvedaccess to

financing forsmall farmers

Providingstate support

to smallfarmers

Foreigners,no

restrictions

50

60

70

80

90

100

110

120

130

140

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019E

2020F

2021F

2022F

2023F

2024F

(10%)

(8%)

(6%)

(4%)

(2%)

0%

2%

4%

6%

8%

Actual (% y-o-y, lhs)

Government Target (% y-o-y, lhs)

Level (2019E = 100, rhs)

Sources: SSS, Government, Kyiv School of Economics, Dragon Capital

13

Challenges/RisksWhat Should President Zelensky And His Team Prioritize? • Overcome vested interests and

resist pressure from oligarchs, particularly in areas such as de-monopolization of markets and reform of judiciary

• Resist temptation to monopolize political power, restrict freedoms and undermine independent institutions such as the central bank

• Balance the desire to preserve popularity and the need for painful reforms (gas price liberalization, low interest rates)

• Attract professionals to public service (especially middle and lower levels) to ensure proper reform implementation and policymaking

• Strike a balance between the approval speed and quality of introduced legislative and regulatory changes Source: Democratic Initiatives Foundation, Aug. 8-20 poll

13%

13%

18%

22%

31%

44%

72%

0% 20% 40% 60% 80%

Abolish lawmakers' immunity

Improve healthcare

Reduce oligarchs' politicalleverage

Prosecute corrupt officials

Cut utility tariffs

Improve living standards(wages, pensions)

Stop fighting in Donbas

% of respondents

14

Thank you!