Monday, April 28, 2014

Ukraine - What Will the West Inherit?

Ukraine has a long history of economic difficulties.  The process of transition from communism to a democracy and from a centrally planned economy to a free market economy has been most difficult for Ukraine, even when compared to its former Soviet republic partners.  In a question and answer session with the world's media in early March, Vladimir Putin hinted at the difficulties facing Ukraine in this comment:

"In my opinion, this revolutionary situation has been brewing for a long time, since the first days of Ukraine’s independence.  The ordinary Ukrainian citizen, the ordinary guy suffered during the rule of Nicholas II, during the reign of Kuchma, and Yushchenko, and Yanukovych. Nothing or almost nothing has changed for the better. Corruption has reached dimensions that are unheard of here in Russia. Accumulation of wealth and social stratification – problems that are also acute in this country – are much worse in Ukraine, radically worse. Out there, they are beyond anything we can imagine. Generally, people wanted change, but one should not support illegal change." (my bold)

Let's look at a few examples of what is wrong with Ukraine's economy and the impact on the overall economic situation.

First, let's look at inflation:

Notice the extreme level of inflation at in the mid-1990s?  Here's a closeup showing what happened to inflation over the period between 1990 and 1997, just after the Soviet Union collapsed, compared to inflation in the United States over the same timeframe:

When the Soviet system collapsed, fixed prices on goods and services ended, energy subsidies ended and, as a result, economic output shrank.  In response, the government ran a massive budget deficit of 13 percent of GDP in 1994 alone which was covered by borrowing funds totalling 12 percent of GDP from Ukraine's central bank.  It is this borrowing that led to hyperinflation.  How bad was inflation during the early 1990s?  The price of a cheeseburger in December 1992 was 0.99 kupons.  This had risen 100 fold to 101.52 kupons one year later.  Hyperinflation decimated the savings of individual Ukrainians.  During September 1993, monthly inflation was 80 percent, rising to 66 percent in October and to 91 percent in December.  Here is a chart showing the quarterly changes in Ukraine's consumer price index and official exchange rate for the period between 1993 and 1996:

In response, in September 1996, Ukraine replaced its currency; 100,000 kupons became 1 hryvna, the currency that is still in use today.  The hryvna has hardly been a resounding success; by the end of 1998, the hryvna had depreciated by 75 percent when measured against the United States dollar.   It appears that Ukraine's struggle with inflation is not over yet, although with any good fortune, it will not rise to levels experienced in the early 1990s or in the mid-2000s as shown on this graph:

According to Ukraine's appointed Prime Minister Yatsenyuk, inflation in 2014 is expected to range between 12 to 14 percent, largely related to the decline in the value of the hryvna.

Second, let's look at what has happened to the value of Ukraine's currency since 2002:

Throughout the period between 2002 and late 2008, the conversion rate for the hryvna was quite steady, ranging between 4.4 and 5.3 to the United States dollar.  When the world's economy looked like it was going to implode in 2008, the value of the hryvna dropped sharply to around 8 to the U.S. dollar, a decline of 75 percent.

Now, here's a chart that shows what has happened to the hryvna over the past year:

Over the past year alone, Ukraine's currency has dropped to as low as 13 to the U.S. dollar, currently sitting just over 11 to the U.S. dollar, largely related to the ongoing unrest in the nation.  This is a loss of 38 percent of its value over a single year.  Obviously, this is going to have a very strong impact on the prices of imported goods and the country is likely to see prices rise by something in the neighbourhood of 30 percent annually just as it did when the currency fell in value in late 2008 as you observed on the charts above.

Lastly, here is a chart that shows what has happened to the yield on two year Ukrainian bonds since February 2011:

Currently, two year bonds are yielding 20 percent, up from 10.75 percent in May 2013.  You will notice that back in October 2012, Ukraine's 2 year bonds yielded a whopping 26 percent!

To close, let's look at how Ukraine's economy has fared since 1992 compared to its former Soviet peers:

In large part, as Vladimir Putin so aptly put it, Ukraine has an ongoing problem with corruption and, might I add, mismanagement.  During the first half of the 2000s, Ukraine relied on its exports to Russia, whose economy was relatively strong based on high oil prices, to stabilize its own economy.  When the financial crisis of 2008 erupted, Ukraine's economy was very hard hit and its GDP fell by 15 percent in 2009 alone.  As Putin noted, another big problem with corruption and the uneven accumulation of wealth is the size of Ukraine's shadow economy; as a percentage of GDP, it is the third largest in the former Soviet states as shown on this chart from the IMF:

By way of comparison, using the same methodology, Canada's shadow economy is about 11.7 percent of  GDP, compared to 10.5 percent for the United States and 13.1 for Great Britain.

Ukraine's new leadership has its work cut out for it.  The same could be said for any developed nation or non-governmental organization (i.e. IMF, World Bank etcetera) that is seriously considering throwing a monetary lifeline to the nation.  A two decade history of lurching from one economic crisis to the next seems to be the norm for Ukraine and it looks like it will be a hard cycle to break.


  1. Anyone thinking Ukraine can be easily fixed is far more optimistic then they should be. Add to their woes the fact that they are a pawn by outside forces leads me to believe this will not end well. Sovereign borders often come at a great price.

  2. The shadow economy is an absolute must as the tax system is so bad one cannot be honest and survive. It is impossible. Example: employees are paid minimum wage on the books because the pension tax is so high (20%) which is paid by the empoyer and the balance is paid under the table. Nothing seems to be deductible. VAT is paid on gross but never seems to be refunded as it is in Canada. There is even VAT on farm produce - milk grain, livestock etc. If you could PLEASE put your wonky hat on and research and explain Ukraine's tax system, I would be forever in your debt. Ukrainians can't explain it. I had a Brit consultant tell me 15 years ago that the Ukrainian tax system was designed by Moscow prior to Ukraine's independence. Moscow could see it coming and wanted to make sure that Ukraine was ungovernable so it would eventually be driven back into Moscow's sphere of influence.