The Ukrainian economy has suffered an accumulation of external and domestic shocks: the pandemic (vaccination rates are still low), the ongoing geopolitical risk, and domestic political tensions. Adding to these factors, inflation has accelerated over the past year. However, the Covid-19 crisis has been much better absorbed than was the case for the crises of 2008 and 2014. The current account balance has recovered and foreign currency reserves have increased, thanks in particular to higher commodity prices (cereals and metals). International support (mainly from the IMF and European Union) provided the required complement, allowing fiscal support to the economy. However, the country remains exposed to a sudden stop of capital flows. As a result, Ukraine still remains dependent on financing from international financial institutions.
BRAKES ON THE RECOVERY
Ukrainian economic growth was disappointing throughout 2021, with an unexpected recession in the first half followed by a relatively modest recovery. However, the country has come through the Covid-19 episode without a financial crisis, in contrast to 2008 and 2014. One notable difference lies in the increase in prices for commodity exports (which fell in 2008 and 2014); this made a substantial contribution to improving the current account, despite the drop in agricultural production seen in 2020 and the first half of 2021. Alongside the support of international financial institutions (mainly the IMF and EU), this helped protect foreign currency reserves, stabilise the exchange rate and, ultimately, ensure the country’s solvency.
ForecastsHowever, the private capital inflows have dried up. The fickleness of this flowsaffects the financing of growth and continues to limit its potential.
The local economic situation has been difficult. Manufacturing production has not returned to its pre-Covid level and was still 6% below it in November 2021. The acceleration in inflation (with energy prices rising, particularly as the result of higher taxes) since the end of 2020 has hit household spending. Fortunately, production and exports of agricultural products probably bounced back in the second half of 2021, thanks to a good cereal harvest.
The health risk remains substantial, following several waves of infection, of which the most recent (in the autumn of 2021) was also the biggest both in the number of cases (25,000 per day at the peak) and of deaths (700 per day at the peak). Vaccination levels remain low, with only one-third of the population covered, which has resulted in severe restrictions being maintained.
Lastly, political risk remains significant and takes two forms: the difficulty in implementing reforms, notably to the judiciary (which is a condition of international aid), and the conflict with Russia (tensions in March 2021 and again since the end of the year). The continuation of these risks has resulted in the freezing of investment, despite a law introduced in early 2021 designed to encourage foreign investment.
SUPPORT FROM ECONOMIC POLICY IS CONSTRAINED
Initially, the policy mix helped support the Ukrainian economy. International financing supported this by funding the budget directly rather than payment being made to the central bank as in a traditional programme. A stable exchange rate and low inflation at the time the pandemic hit allowed the central bank to cut its policy rate. The shock of the pandemic was therefore cushioned and the recession in 2020 was fairly modest.
However, fiscal support remained more modest than in other emerging economies, with a primary government deficit (i.e. before interest costs) of 3.1% of GDP in 2020 and 1.2% of GDP in 2021 (compared to an average for emerging economies of 7.5% and 4.7% respectively). This gap can be explained by Ukraine’s more limited leeway. The country had a payment default in 2014 and debt service costs increased to 3.3% of GDP in 2021.
In particular, monetary support proved temporary. The acceleration in inflation (from 2.6% in October 2020 to 6.1% three months later and 10.9% a year later) led the central bank to act at the beginning of 2021 (more than 6 months before those in other emerging economies did so). Overall, the policy rate was increased by 300 basis points, to 9%, by the end of 2021. Ukraine’s exposure to inflationary risk is structural; monthly inflation figures have been above 10% half of the time since 2014. Imperfections in the transmission channels of monetary policy reduce the level of control the central bank has over these trends.
Moreover, international support has run up against persistent deficiencies in governance. The World Bank’s government effectiveness indicator is amongst the lowest amongst emerging economies. This suggests that government reforms do not always feed through into facts on the ground (notably due to problems of implementation and rule of law).
The judicial reform that the government introduced was intended precisely to reduce the risk that funds invested or loaned (whether by banks or by international funders) are not misused. The high level of non-performing loans (30.1% of loans by volume at the end of 2021) demonstrates the extent of this risk.
However, internal political conflict, notably between the country’s president and the constitutional court, have disrupted the adoption of these reforms. These are the symptoms of the existence of special interest groups that are delaying necessary structural changes.
The many limits on the support that economic policy could provide explain why the recovery in activity in 2021 was disappointing.
