Ukraine’s Decisive Moment

Budget debates are often dry affairs, but not so in Kiev. By the end of this month, the Ukrainian parliament (Verkhovna Rada) must decide on a budget that will have profound effects on the future course of the government. The Ministry of Finance has proposed a budget that sets most tax rates at 20 percent, while closing loopholes and holding the deficit to an estimated 3.7 percent of GDP.  The International Monetary Fund (IMF) has endorsed the plan, and the passage of the bill, or something close to it, is essential to completing the IMF review and keeping the government’s adjustment program on track.

An alternative plan, which is supported by the opposition and, disappointingly, by elements of President Poroshenko’s own party, involves a massive tax cut that would reduce rates to a flat rate of 10 percent, causing the deficit to soar to over 10 percent of GDP. A continued IMF role would be ruled out. Following a deep recession from which Ukraine is just starting to recover, populist fiscal policy promising quick fixes understandably is attractive, and opponents of the government may well believe that the government can do it alone without foreign financing (and, importantly, without the rule of law reforms that form the core of the government’s IMF-backed program). But it would be a tremendous mistake.

It’s important to remember how much has been achieved by this government on the economic front. Against the backdrop of war and a historic political transition, the economic team has carried forward a difficult and ambitious adjustment program. After a fall of GDP of around 20 percent, the economy has stabilized, fiscal deficits have been slashed to levels consistent with available domestic and external financing, and a deep restructuring of the banking sector has been launched. Perhaps more importantly, significant structural reforms have been enacted including hikes in energy prices and a comprehensive rewriting of the legal framework underpinning the economy.

Recently, a broad debt restructuring was completed that provides over $15 billion in cash flow relief over the next three years, as well as a modest reduction in principal. Russia refused to participate and restructure a $3 billion bond due in December, but later this week the IMF Board will meet and agree to a policy change that will allow Ukraine’s IMF program to proceed even if the bond is not paid.

Unfortunately, the program has faltered in some important aspects. The move against corruption has stalled in recent months, raising serious concerns among Ukraine’s allies whether vested interests were reasserting themselves. Rule of law reforms are central to the IMF program and critical to any effort to break from the past decades of corruption and poor economic performance. But the implementation of these reforms (including paying adequate salaries) is costly. Further, without a sound macroeconomic framework, it will be increasingly hard to sustain popular support for this reform effort. A sound budget is a gateway test for any serious reform effort.

Vice President Biden is in Kiev and will speak to the Rada tomorrow. He is expected to deliver a tough measure on the need for Ukraine to jumpstart the reform process, particularly the anti-corruption agenda, and will also promise additional U.S. assistance. This message, which was foreshadowed and endorsed by my colleague Stephen Sestanovich, includes a strong case for an attack on corruption but there also needs to be a stepping up of financial support for the government to allow for a budget that can support the reform effort and enhance security.

A grand bargain is urgently needed. The Ukraine government needs to jumpstart the implementation of rule of law, judiciary and civil service  reforms and take on vested interests. President Poroshenko must come out and fully endorse the Ministry of Finance proposal (and his finance minister Natalie Jaresko), and then whip the votes needed to get it passed.  And Western governments must provide more bilateral assistance so that Ukrainians can have confidence that the program can succeed and restore growth. Ukraine should not go back.