Post-crisis roadmap for the Ukrainian economy

Recognizing the complexity of the situation in which Ukraine finds itself today, this report does not primarily focus on questions of security or geopolitics, but instead aims to contextualize sweeping global trends and highlight internal choices that decision-makers in Ukraine face with respect to the country’s long-term socio-economic development. The interplay between domestic and global developments, as outlined in this report, is central to the post-crisis roadmap for the Ukrainian economy. Looking through the lens of longterm scenarios intends to inform decisions that need to be taken today in order to put Ukraine on a track to sustainable economic growth.

As Europe’s sixth largest consumer market, Ukraine has many endowments which position it for economic success: strategic location, some of the world’s most fertile land, and a highly educated population. It also enjoys a long-established comparative advantage in the metals sector as well as in other manufacturing and technology industries. Neighbouring Russia as well as four EU countries, Ukraine also has direct access to the dynamic markets of the Middle East through the Black Sea. All this could make the country a key player in tomorrow’s global economy. Indeed, the next phase of globalization provides Ukraine with tremendous opportunities, as deep transformations in emerging markets and burgeoning middle classes in Asia and beyond will reshape global consumption and production patterns.

Yet, an assessment of economic indicators since independence shows a country performing well below its potential. The absence of long-term strategies, institutional weaknesses, entrenched political divisions and widespread corruption have made it difficult for successive governments to implement even well-intended reform efforts. As one civil society leader argued, “since Ukraine’s independence, consecutive governments displayed an utter lack of vision and focused exclusively on narrow, short-term interests, which made it impossible for the country to advance.”

After the difficult transition of the 1990s, the country experienced an economic boom in the early 2000s with average growth rates of up to 7%. But this growth was largely driven by particularly favorable external conditions that allowed Ukraine to reap quick wins in the metals and chemicals sectors on the back of the global commodities boom. Soaring steel prices and, for much of the period, cheap natural gas imports from Russia supported significant improvements in the country’s terms of trade, while highly liquid international capital markets simultaneously fuelled foreign direct investment (FDI) inflows into the country.

Notwithstanding this period of strong growth, the country’s weaknesses in terms of governance and business climate remained unaddressed. A business leader highlighted that “favorable external conditions could have been used to develop a strong institutional foundation.” Instead, “those in power focused on dividing the pie of the Ukrainian economy rather than growing it”. The absence of major structural reforms, deteriorating investment conditions, and low competitive pressures in the market created an extremely fragile economy which became heavily dependent on a few commodity-based exports for growth. Not only did this model limit the tremendous entrepreneurial potential of the country’s educated workforce, but it also constrained the country’s ability to adjust to and benefit from shifting dynamics in the world economy. The impact of the 2008 global economic crisis illustrated the vulnerability of this model: Ukraine’s GDP contracted by almost 15% in 2009 (versus a 3.7% average in OECD countries), and was followed by a slow recovery in the ensuing years. The drying up of cross-border capital flows as capital markets became more risk averse, persistently high corruption and poor public management further weakened the country’s unsustainable fiscal situation. Amid the current geopolitical crisis, Ukraine’s economy is extremely fragile and dependent on significant external support.

China has been the dominant factor behind Ukraine’s commodities-based growth story, consuming a disproportionate share of the world’s hard commodities. China’s share of global steel demand rose from 16.4% in 2015 to 47.5% in 2012, as its investment-driven economy soaked up global steel supplies. Commodity prices rose to record highs as producers struggled to meet this booming demand. While this period brought lavish profits to Ukraine’s metals sector, global steel production simultaneously caught up with these new demand levels, and Ukraine failed to gain significant new market shares.

China now produces well over half of the world’s steel, and even Ukraine’s traditional export markets in the Middle East are building up their own steel industries. This significantly increases competitive pressures on Ukraine’s metals sector, especially in the relatively lower value-added segment in which Ukrainian producers compete. At present, its basket of metal products falls into the low quality range of iron and steel, mostly used for construction and piping, given that the country’s private sector largely failed to use the boom years to upgrade Ukraine’s industry to higher levels of value creation. With domestic use for its steel products constrained by the low economic activity and dim growth prospects, Ukraine is almost entirely dependent on external demand, making it vulnerable in an increasingly competitive market. Pressure on Ukraine’s metals sector is accentuated by the fact that China’s demand for hard commodities is beginning to fade as the country transitions from investment to consumption-driven growth.

After reaching their historical peak in July 2008, average global steel prices more than halved within the 10 months following the global financial crisis and, despite a relatively quick recovery, metals markets remain highly volatile. With steelmaking capacity having outstripped consumption, overcapacity is prevalent not only in China, but also in all of Ukraine’s main export markets.

While demand for hard commodities could decline even further, the economic transition in China and other emerging market economies provides new opportunities for services and consumer goods exports. Whether or not Ukraine will be able to reposition itself in global markets and retool its economy in line with such transformations will be a defining factor in the country’s ability to ensure sustainable prosperity for generations to come. If Asia was once considered the world’s workshop, over the next 10 years it will also become its fastest-growing consumer market.8 Discretionary spending is already rising across all income levels, and if China’s rebalancing is successful, wealthier Chinese consumers are likely to fundamentally reshape global consumption patterns.

The growth of a new middle class will likely come with significant changes in dietary habits and trigger a boom for meat and grain producers. As home to the world’s most fertile soil and one of the few agricultural markets with significant potential for productivity gains and land-use increases, Ukraine could be set to gain significantly from this shifting global consumer landscape. An added opportunity for Ukraine rests in the major transformations currently being experienced by the global food and agribusiness industry where changes are occurring in product characteristics, technology use, company structures, and supply chains as well as processing cycles. As a leading executive in the agricultural sector points out, “Ukraine could position itself as a leader in this transforming global agri-food industry”. But, as he also argues, “in order to do so, the country needs to adopt a global outlook, unlock investments and develop strong links with new markets”. China’s recent negotiation of a long-term lease of 5% of Ukraine’s total landmass, or 9% of its arable farmland, to feed Chinese consumers is a case in point. It demonstrates the potential for Ukraine to become a key player in this market. But it also highlights the importance of leveraging this increasing demand to upgrade Ukraine’s agri-food industry and to move to the centre of global food supply chains. Otherwise, Ukraine’s agricultural sector may well become characterized by elements of the resource curse.

Opportunities stemming from this shifting global context are clear. Ukraine could indeed position itself at the centre of global consumer market value chains and emerge as a winner in the next phase of globalization. But this does not depend solely on the exploitation of the existing factors of production that Ukraine is so strongly endowed with. Knowledge, technology absorption and innovation are crucial to increase productivity and sophistication in the use of these assets, drawing on the country’s strong human capital. However, weak institutions and a poor investment climate are stifling Ukraine’s potential to excel in all segments of the economy. A senior business leader argued: “The political situation in the country used to motivate entrepreneurial inaction; it taught people to do nothing, to be in a defensive mode instead of trying something new, starting a business or expanding operations.” Another executive elaborated: “There was no feeling of safety among owners, which made them unable to commit to long-term investments.”