The fighting in eastern Ukraine has pushed the country deeper into an economic tailspin, and the strife-torn nation will need billions of dollars of new assistance this year, economists say.
Less than three months after approving a $17 billion loan package for Ukraine, the International Monetary Fund has revised its forecasts, predicting a sharper economic downturn, lower tax revenue, a spike in military expenditures and new costs to repair bridges and other infrastructure damaged by fighting.
“Ukraine will now need more financing,” said Anders Aslund, a senior fellow at the Institute for International Economics and a former adviser to Russia and Poland. He said the country would need at least an additional $3 billion; other experts said it could require as much as $5 billion more in aid.
On Friday, in a report overshadowed by news about the downed Malaysian airliner and fighting in Gaza, the IMF issued its first review of Ukraine’s reform program and said that the government had met all but one of the “benchmarks” for additional IMF aid, “a notable achievement.”
But the IMF added that because of the conflict in eastern Ukraine, it now expects the country’s economy to shrink 6.5 percent instead of 5 percent and the government’s fiscal deficit to reach 10.1 percent of gross domestic product, up from 8.5 percent forecast in April.
Tax revenue has taken a hit because many residents in the cities seized by separatists have not been paying taxes. Fighting and Russia’s closed border have also reduced output in local plants. Before fighting broke out, the
rebel-held regions accounted for about one-sixth of Ukraine’s economy and 27 percent of exports, economists say.
“Production has stopped at many industries in that area, and these are highly industrialized areas, like Cleveland or Pittsburgh,” Aslund said.
Senior international finance advisers, who asked for anonymity to protect relationships, said that 30 to 40 percent of people in the three main rebel-held cities are not paying taxes. Thanks to tax payments in western Ukraine, which ran ahead of IMF forecasts, the loss of revenue to the central government has been more modest overall but is still serious.
The state natural gas company, Naftogaz, has also had trouble collecting debts in the eastern regions under rebel control.
At the same time, Ukrainian government expenditures in eastern regions remain high because pension payments are still being made. Stopping those payments would alienate people in the east, analysts said.
Higher military expenditures are also a drain on the budget. Lubomir Mitov, chief economist for central and eastern Europe at the Institute of International Finance, said the Ukrainian finance minister has requested an extra $1 billion for military spending, although the IMF said the government offset that with spendingcuts in other areas. Replacing destroyed tanks and planes that were shot down will add more costs later.
Aslund said he expects the United States to provide some non-
lethal military assistance, but any large amount of aid will require congressional approval.
The economic crisis in Ukraine comes on top of two decades of bad policy, corruption and decline. In 1990, when the Soviet Union collapsed, Poland and Ukraine had about the same GDP per capita; by 2013, Poland’s GDP per capita was 31 / 2 times greater. “This shows the cost of doing nothing” about reform, said Mitov.
One reason is Ukraine’s banks, which have a legacy of poor lending policies. Even before conflict broke out in Ukraine, non-
performing loans made up about 40 percent of the assets of Ukraine’s banks, Mitov said.
Ukraine’s bickering rival oligarchs could pump money into some of the banks, but Mitov said that wasn’t likely. “Ukraine’s banks were in bad shape before all this chaos started,” Mitov said. “Ukraine has been hiding from this for a long time.”
The European Bank for Reconstruction and Development told the Reuters news agency in June that it would build up its stakes in Ukrainian banks to prevent collapse of the system.
Another legacy has been the artificially inflated exchange rate, which made Ukraine less attractive for foreign investment, its exports less competitive and imports more appealing. As a result, the country’s account deficit mounted and its foreign exchange reserves dwindled.
Since the IMF agreement, the government has let the value of the local currency, the hryvnia, tumble about 30 percent.
But adjusting the exchange rate may be essential, though painful. Eliminating subsidies for oil and gas — both priced in dollars — will mean even steeper price increases in the local currency. Mitov said that eliminating gas subsidies would now mean a sixfold increase in local currency, compared with a fourfold increase at the old exchange rate.
Moreover, because of the conflict, foreign currency reserves have dwindled as businesses take capital out of the country and investors hold back.
The IMF said capital outflows over the past three months were “higher than expected.” It now says the fall in Ukraine’s foreign exchange reserves by mid-2015 will be $3.4 billion greater than earlier forecasts.
A financial adviser who recently visited the Ukraine said that reserves had tumbled below the level needed to pay for three months worth of imports.
The IMF, satisfied with the government’s efforts, has pumped about $3 billion into Ukraine, and an additional $1.4 billion draw will be made soon. The IMF has more than $12 billion left.
Before the crisis began this year, Ukraine’s foreign debt was not a dire problem, running about 40 percent of GDP. But mounting debts and a shrinking economy will push that over 60 percent, economists say. The IMF said the external-debt-to-GDP ratio will peak seven percentage points higher than it expected in April.
That would trigger a clause in a $3 billion eurobond held by Russia that would allow the nation to demand immediate repayment. That would, however, push Ukraine into default, and economists doubt that Russia would take such a self-destructive step. The bonds come due this year.
Despite the litany of gloomy news, the IMF praised the Ukrainian government for its anti-
corruption measures, currency adjustment, wage and pension increases limited to the inflation level, and spending controls.
But the IMF has told U.S., Russian and European leaders that Ukraine’s economy could get worse if the conflict doesn’t come to an end. “The program hinges crucially on the assumption that the conflict will begin to subside in the coming months,” the fund said last Friday, adding that “a significant prolongation of the crisis would seriously strain” Ukraine’s ability to reform “without a substantial increase in external support on adequate terms.”