As The Politicians Battle It Out Ukraine’s Economy Tunnels South In Search Of Australia

“In Ukraine, the evidence is still that policymakers do not quite understand the seriousness of the challenges they face,”. Timothy Ash, analyst at the Royal Bank of Scotland.

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

Make no mistake about it. What is taking place right now in Ukraine is extraordinarily serious. The IMF have recently agreed a support loan to the country, but the politicians themselves still can’t agree on whether or not they are actually going to abide by the conditions attached to it. Meantime, as we can all see on our TV screens, tensions with Russia continue to escalate, fuelled by the conflict-ridden negotiations over Ukraine’s gas debt.

And just to add to the nighmare, Ukrain’s economy made a dramatic entry into recession in Q4 2008. In fact, so severe has been the slowdown that nobody at this point can even muster enthusiasm for opening up one of those interminable discussions about whether or not what the country is going through really counts as a “technical recession” (in terms of two successive quarters of GDP contraction) or not, since the drop in national output has been enormous, and it it fairly obvious that isn’t about to come bouncing back up again. At least not for the next several quarters it isn’t, and – to give us an early glimpse of the terrain onto which we are now entering – the World Bank have just forecast a 4% contraction in GDP for 2009.

In a year when you would think little would surprise us the sharp change in real Ukraine GDP dynamics has been astonsihingly swift, with the growth rate moving from the 11% year on year expansion registered in August to the 14% year on year contraction reported in November (according to data put together by the World Bank). GDP for the whole January-November period is now down to 3.6% when compared with the equivalent months in 2007, and this is reall a sharp drop, since the average over the first nine months of the year was a growth rate of 6.9%. For his part the office of Ukraine President Viktor Yushchenko is suggesting that gross domestic product may contract at an annual rate of between 7 percent and 10 percent in the first quarter of next year, and by 5 percent over the whole year, according to Oleksandr Shlapak, deputy chief of staff to the president.

The contraction has been led by sharp falls in manufacturing and construction, while the financial system has been in serious trouble since late September, and the loss of UAH deposits from the banking system has amounted to 14% during October and November. But the real problems Ukraine is facing in confronting this most serious economic crisis, lieas in the political sphere, and the complete lack of the kind of political consensus which is so necessary to see through the measures which can it to an end.

Political Chaos Adds To The Problems

Ukraine’s government – which is laways a chaotic process at the best of times – is once more having a serious identity crisis about who it is and what it wants to do, with one of the exectutive’s two visible hydra’s heads (Prime Minister Yulia Timoshenko) seeking to respond by manipulating the currency downwards, by boosting social expenditure to an extent which will push next year’s budget deficit up to 2.96 percent of gross domestic product (from an agreed 1.4%) and well beyond the IMF pact level, and by attempting to resolve the trade deficit problem by imposing an administrative tax on imports. The other head of the hydra (President Viktor Yushchenko) is busy opposing all these moves on the grounds that they may jeopardize the second tranche of a $16.4 billion loan from the International Monetary Fund, and obviously, were this to be the case, the country would basically find itself bankrupt, and at the mercy of whatever sentiments the global financial markets wish to express when it comes to Ukraine.

Of course regular readers of this blog will not be surprised to find that this politically split personality crisis goes right into the heart of the central bank (see my Monetary Chaos Breaks Out At the Ukraine Central Bank post) and no one will be really that surprised to find that the two key characters in this round of the saga are (yet one more time, read the linked post, its all explained there) National Bank of Ukraine Governor (and board chairman) Volodymyr Stelmakh’s and Petro Poroshenko head of the central bank council.

Well things are really hotting up at the moment, with Viktor Yushchenko this week threatening to fire some central bank employees (presumeably those who were not implementing the decision to allow the Hryvnia to float), while Yulia Timoshenko was busy demanding the dismissal of National Bank Volodymyr Stelmakh himself – presumeably because he was trying to stop further currency intervention. In an official statement the central bank council responded by accusing Timoshenko of stirring up “chaos” and undermining the nation’s banking system, while Timoshenko, for her part has now taken the matter to the Ukrainian parliament (the Verkhovna Rada – where she may well carry a majority) which will now hold a full debate the role of the central bank next week. It seems not to matter too much here that the bank council is simply trying trying to implement a set of policies which were agreed to (or everyone thought they were agreed to) as part of the IMF loan agreement.

“A hryvnia level above 9 per dollar is unacceptable, it threatens the economy and banking system,” Petro Poroshenko, the head of the central bank council said. “The situation with the hryvnia rate demands urgent measures.”

Volodymyr Stelmakh, Central Bank Governor, the Yulia Tymoshenko Bloc is proposing his immediate arrest.

(Interfax-Ukraine) – Yulia Tymoshenko Bloc has proposed that, based on results of a report by an ad hoc parliamentary commission scrutinizing the National Bank of Ukraine’s activities, an address should be sent to the Prosecutor General’s Office and that National Bank Chairman Volodymyr Stelmakh should be arrested. “I think that, based on the report’s findings, there will surely be an address to the Prosecutor General’s Office of Ukraine and other law enforcement agencies, which, by the way, are already conducting inquiries,” Volodymyr Pylypenko of the Yulia Tymoshenko Bloc said in an interview with Interfax on Wednesday. “The best gift in this situation can only be an order on taking [National Bank of Ukraine Chairman Stelmakh] into custody for all wrongdoings the National Bank has committed in the past months,” Pylypenko said.

President Yushchenko did express the hope last Tuesday that Ukraine’s currency market might be moving rightside up, with the hryvnia trading at about 7.8-8.0 to the dollar and level of “stabilising” dollar purchases by the central bankdeclining, but Prime Minister Tymoshenko remained unconvinced that this was a desireable level, and demanded more concerted intervention to move the currency up to a much higher level – around the 6-6.5 to the $ mark. She gave Yushchenko a week-and-a-half apparently, since otherwise she stated the country would face increasing problems with inflation, and in the banking and other sectors. It is not clear (at least to me) why these problems (which are, and will continue to be, serious) should suddenly deteriorate within the time scale of ten days, but presumeably there was another, more political, message behind this choice of words.

Adding to the confusion, Ukraine’s parliament, has decided to impose an additional 13% temporary duty on all imported goods – and this despite the fact that Ukraine only recently entered the WTO. A total of 269 MPs from the ruling coalition and the Communist Party voted for the relevant law which amended existing Ukranian lefislation – with, it was said, the aim of improving the state of Ukraine’s balance of payments. “Duties have been increased on all imported goods, apart from a [so-called] ‘critical’ [list of goods],” the head of the parliament’s committee for tax and customs policies, Serhiy Teriokhin, is quoted as saying.

“I’m alarmed by the report of my legal department on parliament’s decision to impose an additional temporary duty on all imported goods. Parliament’s decision puts Ukraine’s presence in international programs in jeopardy,” President Yushchenko said at a press conference yesterday. “Similar decisions by Russia and Europe might be made against us in three days,”.

IMF Taking Large Political Risk

Last month, a point in time which now seems so distant it feels like eternity, Ukraine received approval for a two-year IMF loan intended to help support its banking system and cover the country’s widening current-account gap during what was always seen as being a difficult adjustment process. Under the terms of its agreement with the IMF, Ukraine is expected to have a balanced budget next year. If the Cabinet fails to meet the target, then the Fund may withhold the second tranche of the loan, according to press statements by Balazs Horvath, IMF representative in Kiev. Ukraine received the first installment of $4.5 billion last month, and is due to get the second tranche in February. Obviously the IMF is by now well accustomed to playing the part of the “bad boy” in this type of situation, but what if the country they are trying to deal with should simply “implode”, right in its face, I’m not sure even the hardened hand of the IMF are ready for this. So let’s just hope I’m exaggerating, and that it won’t happen (fingers tightly crossed everyone, please).

Discrepant GDP Forecasts

So Ukraine faces a crisis on three fronts, financial, economic and political. On the real economy side, the Ukraine cabinet currently expects growth in the country’s economy to slow to 0.4 percent next year, compared with a final rate which turn out to be somewhere between 1.8 percent and 2.5 percent this year. As I say the World Bank now expects a 4% contraction in GDP next year, and thus a 0.4% expansion in the budget is potentially a very serious problem indeed for the deficit, if the economy underperforms, as it surely will.

“The draft budget, prepared by the Cabinet, is not realistic,” Yushchenko said today in a statement on his Web site. “The 2009 budget is a tragedy; it is the most irresponsible document worked out by the government. Professionals should plan a realistic budget, not optimistic.”

The government plans to cover the budget deficit by selling bonds in domestic and foreign markets, and is to receive a $500 million loan from the World Bank to cover the budget deficit. Under the terms of the IMF agreement with the Inernational Monetary Fund Ukraine has pledged to keep its 2009 budget deficit under 1 percent of gross domestic product, below the 2 percent initially planned by the government. In October, the government reduced its planned 2008 budget revenue from the sale of state assets to 401 million hryvnia ($59.4 million) from 8.6 billion hryvnia, citing the unfavourability of the moment for selling.

Pressure On The Hryvnia

The Hyrvnia has been falling for a number of weeks, but the rate of decline has really accelerated in the last ten days, and we are really now talking about one of those famous currency crises. The national currency has fallen 50 percent against the dollar since June, and according to Michael Ganske, head of emerging markets in London for Commerzbank, it may well drop another 24 percent in the next few weeks given market sentiment and that the International Monetary Fund package effectively limits central bank intervention to halt the slide. The terms of the IMF $16.4 billion bailout package, agreed to last month, require Ukraine to move toward a flexible exchange rate and place a maximum limit of 4 percent for any reserves reduction during the remainder of 2008 (from the base of around $32.8 billion). Thus while the agreement does allow intervention to stem “disorderly” swings, it places a tight limit on what this means. And this now is just the problem, although before we jump to our guns, we should bear in mind that what is provoking the fall is not the IMF and the bailout, but confidence in the ability of the political system to implement a workable recovery plan. Trying to run a currency corridor, and accepting the inflation that went with it, is how we got here in the first place.

The only real remedy Ukraine’s central bank has at its disposal at this point is to raise its base refinancing rate, and this it duly did last week, taking it up from 18 percent to 22 percent in an attempt to arrest the hryvnia’s decline To give us some idea where we are at this point, at the start of 2008 the dollar bought 5.04 hryvnia, while right now it can purchase around 8.25 hryvnia.

The central bank is currently offering to sell dollars at 8.0 hryvnias and to buy them at 7.8788 on the interbank market. Yushchenko told a news conference last week that the central bank had bought $270 million on Monday and Tuesday, but had been required to sell only $30 million on Tuesday. He informed the assembled journalists, however, that complete stabilisation would need to wait until after the debts for Russian gas and other expenditures had been paid (you should be able to start to smell just how complicated all this is by this point, just who exactly is batting for who here?). “Until debts are paid for gas, and settling the debts of (the national road network) Ukravtodor, it would be madness to talk about steps aimed at a fundamental, professional stabilisation”. “Everything is earmarked”, he claimed, “$3 billion (for intervention from reserves), more than $2 billion set aside for gas arrears, $1 billion for repayment of a loan to Ukravtodorom, $200 million to (rocket maker) Yuzhmazh, leaves only an additional $400 million to defend the hryvnia.”

As a result of the $7.5 billion the Ukraine central bank spent supporting the hryvnia in October and November foreign reserves fell to $32.7 billion as of Nov. 30. At the same time the hryvnia has declined 21 percent against the dollar over the last month alone . Under the terms of the agreement with the IMF, the reserves should not fall below $31.4 billion by the end of this year, so we are talking about a very close call on this front too.

Equities Down And Credit Default Swaps Up

Ukraine’s stocks have also been falling, and the benchmark PFTS stock index is down 74 percent this year, the third-steepest decline among the 22 so-called frontier markets tracked by MSCI Barra. Mariupolsky Metallurgical Plant, Ukraine’s largest steel company by revenue, has fallen 92 percent on the Kiev stock market. On the other hand the extra yield investors demand to own Ukrainian government bonds instead of U.S. Treasuries has increased more than nine times this year to 25.86 percentage points, according to JPMorgan Chase’s EMBI+ indexes, which compares with an average three-fold increase in the main emerging-market index to 7.09 percentage points.

Loan Defaults Coming

And as the currency slides, so too does the ability of the average Ukrainian to pay his or her debts. Another Yushchenko aide, Roman Zhukovskyi, recently estimated that up to 60 percent of foreign-currency loans and mortgages could default given the extent of the decline. Ukraine, which has around $105 billion in corporate and state debt, has the fourth-highest credit risk worldwide, according to credit-default swap data. The cost of insuring Ukraine bonds against default is up more than thirteenfold this year, to an astonishing 31 percent of the amount of debt protected. This puts the country behind only Ecuador, which defaulted last week (59 percent), Argentina, which defaulted on $95 billion in bonds in 2001 (46 percent), and Venezuala ( 33) percent, according to the data from CMA Datavision.

Ukrainian companies need to repay as much as $4.1 billion this month while lenders refuse to refinance debt, according to Dmitry Gourov, an economist at UniCredit in Vienna (oh, no, not Unicredit again, see this post). Dollar denominated loans made up 53 percent of credit issued by Ukrainian banks as of 30 September, according to central bank data.

Thus, with just over half of all bank loans denominated in US dollars, they obviously become vastly more expensive for borrowers who are paid in the national currency.

Aggressive lending by banks that borrowed heavily from abroad has obviously contributed to Ukraine’s ballooning private sector external debt (currently estimated at $85 billion). Official figures indicate that only some 2.5 percent of loans are currently problematic, but this situation is obviously about to worsen considerably next year as the currency is down and the economy contracting.

Earlier this month, Finance Minister Victor Pynzenyk called on banks to refinance loans amid a weakening hryvnia and rising interest rates. Some banks in recent days said they would seek compromises with clients, rather than hike interest rates further. Pynzenyk’s proposal called on the NBU to amend its rules to allow borrowers either partially or in whole to pay back loans in the national currency at the exchange rate which was operative when the loan agreement was signed. The banks, in turn, would be allowed to lower their capital/asset ratios and write off their losses, thus paying lower taxes, which would also require amendments to the tax legislation. Obviously some such solution will need to be found for this problem. (There has already been some move in this direction in Hungary, another of the countries which is strongly affected by the forex loans problem).

Other measures under consideration at the present time include extending loan periods, and the temporary reductions in loan payment installments. If the hryvnia-dollar exchange rate further widens, mass loan defaults are inevitable, according to Yuriy Belinsky, head analyst at Astrum Investment Management. At the current Hr 8 to the $1 rate, “40 percent won’t be able to pay their loans,” Belinsky told Korrespondent, a Russian-language Ukraine newspaper.

And the situation is deteriorating fast, a quick visit to the foreclosure sections on the websites of banks like Finance and Credit Bank or Alfa will turn up plenty of property and cars already listed for sale or soon to be auctioned. But given the slump in the real estate market and falling house prices it isn’t clear that banks will find it any too easy unloading any property they do repossess. We are back to the “you owe them a little money and you have a problem, and you owe them a lot of money and they have a problem” situation. Last weekend, the NBU also recommended that banks lower interest rates on foreign-currency denominated loans, but the problem is going to be, as ever, who is actually going to fund these measures?

Industrial Output Plummets

Meantime in the world of the real economy things simply get worse and worse. Industrial production shrank by a record 28.6 percent in November as steel, machine building and oil refining slumped, after a 19.8 percent decline in October.

And as output falls, prices come tumbling behind. Steel production dropped 48.8 percent in November, while the price of the benckmark European hot rolled coil has fallen 47 percent since August and is now at around $425 a metric ton, according to data from U.K. industry publication Metal Bulletin.

World Bank Forecast

The World Bank have predicted a sharp recession for Ukraine in 2009, with GDP being expected to fall by some 4.0 percent. This compares with their July forecast of 4.5 percent growth. The Bank also cut back its forecast for 2008 growth to 2.3 percent from a previously forecast 6.0 percent. It raised its inflation forecast for this year to 22.8 percent from 21.5 percent previously predicted, up from 16.6 percent in 2007. It cut its forecast for inflation next year to 13.6 percent from 15.3 percent.

(please click on image for better viewing)

The Bank take the view that the Ukraine government – in agreeing to the terms of the IMF loan package – have initiated an important programme of macroeconomic adjustment measures, but (with a wary eye on what is actually going on in the Parliament) stress that consistent implementation is essential to avoid a further erosion of market confidence. In their latest report the Bank highlight the shift towards a flexible exchange rate policy, financial sector stabilisation measures , and a more conservative fiscal policy, but as we have seen, these are just the measures which seem to be being challenged by some of the political participants .

So What Does The Future Look Like?

Obviously Ukraine is heading into a major recession in 2009 fuelled by the nasty cocktail of a credit crunch, a terms of trade deterioration, and a consequent massive slowdown in both internal and export demand. Given the damage to competitiveness caused by two years of double digit inflation, macroeconomic stabilization will require a very large and significant correction, and this will mean a significant tightening of aggregate demand and a shift in its composition away from domestic consumption and towards net exports. The government debt stock is currently low at 10 percent of GDP, and will undoubtedly remain sustainable throughout and after the adjustment, even allowing for the potential costs of bank recapitalization. But the ability of the Ukraine administration to carry out the necessary adjustment hinges critically on the willingness of external creditors to refinance the banking and corporate sector debts, and this willingness in its turn depends on the perception those creditors have of the level of political coherence and stability the country has. And as we are seeing such perceptions must be reasonably near an all time low at the present time.

But even with the best political system in the world, the economic correction facing Ukraine is going to be large and the stresses enormous. The World Bank more or less spell this out in the paragraph I extract below. A 200% contraction in real imports (ie not due to cheaper energy prices or something) is massive, and we are talking about a basically balanced budget (ie very little fiscal stimulus) and monetary policy where interest rates are at the current giddy heights of 22%.

The basic macroeconomic parameters in our forecast are broadly consistent with those of the IMF program. Balance of payments pressures will lead the economy to adjust the composition of growth through 2009. As a result, the current account deficit is expected to improve from over 6 percent of GDP in 2008 to 1-2 percent of GDP in 2009-11. To achieve this adjustment, an over 20 percent real import contraction will be needed in 2009 in order to counter the 7 percent forecast terms of trade deterioration. Real wages and employment are forecast to decline in 2009 to restore price competitiveness of Ukrainian exports in the wake of declining export prices and to support the adjustment in aggregate demand. With this current account adjustment and with the support of the IMF Stand-By, the external financing gap would be closed under our baseline assumptions. Declining commodity prices, tightening liquidity and the forecast decline in domestic demand will contribute to disinflation. However, offsetting this, the exchange rate correction and the adjustment of energy and utilities tariffs will make disinflation a more prolonged process. We assume that the government will maintain a balanced budget in 2009 (not accounting for bank recapitalization costs) and have a small deficit thereafter.

So I think we need to be very clear at this point. The Ukraine position is very difficult, and everything is very delicate. The danger of total financial meltdown (which would be in this case in the private banking sector, not sovereign debt) is real and significant. The economic downturn has only just started and further downside risks are large and depend critically on the size of external shocks and the limitations imposed by inadequate policy responses.

Any further deterioration in the terms of trade (unlikely at this point given how far steel prices have already fallen, but these prices may stay lower for longer than many in the sector can sustain) or further decline in export demand would certainly put almost unsustainable pressure on the real sector. Banking sector vulnerabilities may be further exacerbated by further overshooting of the exchange rate and external debt refinancing difficulties as corporate balance sheets weaken further and household incomes come under strain from rising debt service costs.

Prudent fiscal, monetary, and financial policies (many of them anchored in the program supported by the IMF), accompanied with renewed efforts to deepen structural reforms, can help Ukraine to stabilize its situation and move the economy towards recovery. Conversely, a continuation of the current disorderly response and poor implementation of the agrred policies may easily trigger further financial chaos leading to an even shaper downturn and a postponement of any recovery off into the distant sunset.

But Beyond The Recovery, What About The Demography?

One of the reasons why I think the IMF and the World Bank are taking such a big risk with their credibility in Eastern Europe at the moment, is that I don’t think they are getting through to the heart of the problem. One way of thinking about this is to take Paul Krugman’s favourite Keynes quote – “we’ve got magneto trouble” – and ask ourselves whether all we have before us in the CEE countires right now are magneto problems, or whether, to continue with the metaphor, we may not have issues with the cylinder head gasket. And it gets worse, because the cylinder head gasket does seem to have blown (and it will keep blowing) because we have leakage problems in the sump, and the main oil pump isn’t working – and who knows, maybe the crankshaft even needs replacing. As they always tell you when you take the car into a garage for “fixing”, we won’t know till we take the thing apart. What do I mean?

Well take a look at the chart showing the relative size of annual births and deaths in Ukraine over the last twenty years.

I mean to the normal and untrained eye stands the problem stands out a mile, population dynamics went underwater in the Ukraine in the early 1990s, and they aren’t coming back to the surface again (not now, not in thirty years, not…… well maybe never is too much of a long time, but certainly not over a time horizon which is going to make any essential difference to anyone who is already alive today.)

And this is without taking any outward labour migration into account, so just think about the negative labour market dynamics that this implies, and already has implied. Can anyone really be surprised that Ukraine has been suffering from acute inflation as its number one problem?

To some extent it is worth stressing here that what really matters is the actual numbers of annual live births, rather than any more complex measure of fertility. In 1989 for example there were nearly 700,000 children born in Ukraine. By 1998 this number was near to 400,000 (ie there was a drop of 40% or so in a decade). In practical terms (and if we take 18 as an average age for labour market entry in a country like Ukraine) next year there are potentially 650,000 people to enter the labour force, but by 2016 this number will be only 400,000. So it isn’t simply a question of pushing the fertility rate up towards the replacement rate (a difficult, but not impossible task), we also need to think about what economists term the “base effect” here, that is that with each passing year and cohort you have less and less women in the childbearing ages, so even if those women replace themselves, the base of the pyramid is still much narrower than the top, and it is the people at the top who need caring for and financing.

And even if some of this loss can be offset at the workforce level by increasing labour force participation at the older ages, we would still be talking about a very sharp rise in the average age of the workforce. And productivity improvement alone cannot possibly hope to compensate for the kind of labour force contraction we should reasonably expect, at least not over such a short period of time it can’t. So this is just one more reason why, against all expectation, fertility really does matter.

While many continue to believe that falling populations don’t actually have any tangible impact on economic performance, it is very striking to notice that when it comes to ageing and declining populations we really lack ANY evidence to substantiate that claim in the affirmative. On the other hand we do have plenty of evidence from countries where the population is either falling or gathering negative momentum to suggest that these countries face some very special kinds of economic problems. The example of Eastern Europe is clear enough I would have thought, but people really do need to take a closer look at what has been happening in recent years in countries like Japan, Germany, Italy and Portugal. And if falling population does produce its own kind of economic problems, well then we should be expecting to see plenty of them in Ukraine, since as we can see in the chart below Ukraine’s population peaked in 1993, and has been in some sort of free-fall ever since.

Evidently there are a number of factors which lie behind this dramatic decline in the Ukrainian population, fertility is just one of these (with poor health and net emigration being the others). Ukraine fertility is currently in the 1.1 to 1.2 Tfr range, and, as we can see in the chart below, it actually dropped below the 2.1 replacement level back in the 1980s.

Another major influence on demographic dynamics is health, and one good measure of this is the level of life expectancy, which in the Ukraine case has shown a most preoccupying evolution, since it has been falling rather than rising. The chart below shows life expectancy at birth for both men and women, the male life expectancy is evidently significantly below the combined figure.

This life expectancy situation is, as well as being preoccupying, highly unusual (it is however paralleled to some extent in Russia itself, and some other CIS countries). Apart from the obvious, the deteriorating health outlook which this data reflect places considerable constraints on the ability of a society like Ukraine to increase labour force participation rates in the older age groups, and this is a big problem since this is normally though to be one of the princple ways of compensating for a shortage of people in the younger age groups.

So what about the future? Well, two issues are really starting to worry me at present, the first of these is the short term fertility shock Ukraine will undoubtedly receive on the back of the current crisis. If young people were already rather reluctant to have children, then then will now almost certainly be much more so, given the downward pressure on living standards we are about to see.

The second worry concerns the future of the country itself. A recent study carried out jointly by the Kiev based Democratic Initiatives Foundation and Nova Doba History and Social Sciences Teachers Association found that while more than 93 percent of the Ukrainian seventeen year olds they inteviewed considered themselves Ukraine citizens, only 45 percent said they planned to live and work only in Ukraine, citing Western Europe, Russia and the United States as possible future destinations. When 55% of your potential future labour force are thinking of working elsewhere you have a problem, and one which needs a solution. Simply putting a strip of band-aid over a festering wound won’t work, I’m afraid, however much the Ukrainian people may struggle and sacrifice. With or without Keynes, we’ve got more than magneto problems on our hands here.


A much fuller analysis of the problems presented by Ukraine’s long term population implosion (including the issue of out-migration patterns and trends) can be found in this post here.

This entry was posted in A Fistful Of Euros, Economics and demography by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

39 thoughts on “As The Politicians Battle It Out Ukraine’s Economy Tunnels South In Search Of Australia

  1. Pingback: The second Great Depression has arrived … - Paul Krugman Blog -

  2. why would a declining population trigger inflation? if i look at japan it’s the opposite. in fact why would fertility have any impact on inflation?
    inflation is a policy decision and it’s been rampant in eastern europe because the privatizations kickbacks are so sweet and how else to attract foreign capital than debase your currency and let foreign capital have the assets on the cheap? true, 5% of $10bln is less than 5% of 15bln, but hey, it’s divided among a small number of “entreprenuers”

  3. No problem could take so much paper to explain.Perhaps we are not getting to the bottom of the problem whatever it is.Why do we insist on seeing the world as different countries instead of brothers living in the same world?
    Since the capitalist system has failed us so miserably maybe we should give the socialist system (as in Sweden)another try.Are the bankers of the world going to tell us now how to handle money?That is insulting to the rest of the world.

  4. Hi Edward,
    Very interesting article fnd useful information about Ukraine. However, I don’t understand – why “Australia” in the title?

  5. Hello everyone,

    “However, I don’t understand – why “Australia” in the title?”

    This I think is a generationally specific joke. It refers to a film with Jane Fonda and Jack Lemon, which was about the Three Mile Island nuclear power station crisis. The idea was that if the core started to melt it would go straight through the earth’s core and come out in China.

    Australia just seems to be more “antipodeian” in the Ukraine case (although my geography may be way out here). Their is also possibly a rather unfortunate secondary reference to Chernobyl. The idea is thus melt-down, but without repeating and repeating the same expression. I think Krugman got the joke anyway :).

    OK, I will try and find the time for Andy’s more serious question (and your one yesterday Mike) late this afternoon. So just check back.



  6. Just found your website and I only want to say thank you very much for your informative article on Ukraine. Excellent website
    From Lviv, Ukraine

  7. Pingback: Global Voices Online » Ukraine: Political chaos and economic crisis

  8. Wow, what a detailed and amazing post. Thanks for writing it. You do a good job of explaining what is happening in Ukraine in a way that can actually be understood! 🙂

  9. Thank you Edward.
    Hope Paul got the joke 🙂
    BTW Jane Fonda was very popular in Russia and Ukraine at last 80s due to aerobic video

  10. Pingback: For Those of You Who Like Charts | afoe | A Fistful of Euros | European Opinion

  11. Hello again Andy,

    OK let’s get back to this:

    “why would a declining population trigger inflation? if i look at japan it’s the opposite. in fact why would fertility have any impact on inflation?”

    The think here is the basic difficulty with what is normally known as the neo classical theory of steady state growth. The basic idea is that any economy has some sort of near constant capacity that it can grow at, and policy is geared to trying to tune any given economy to its “trend rate”.

    The thing is the only economy I know that really conforms to that picture is the US one, and there may be good reasons which can be adduced to explain this.

    The normal pattern, as we saw in Japan in the fiftees, or Italy in the 60s, or China now, and India in the next decade I’ll wager, is that economies as they develop attain very high growth rates.

    There is a generaally accepted (among economists I mean) explanation for this, in that as fertility drops a higher and higher percentage of the population eneter the working age groups, and then a higher and higher percentage of these enter the most productive ages (normally thought to be 35 to 50), thus the normal development of an economy passes through a largely labour intensive growth stage, and then a drive for quality and productivity catch up stage.

    Then, normally, economies enter the so called “steady state” period where growth is in the 2 to 3% range. This is more or less normal growth.

    But as we are now seeing, the story doesn’t end there, since as societies age further then the so called trend growth falls and falls, Think of Japan’s “lost decade” or Germany between 1995 and 2005 when growth hovered around the 1% annual mark, or Italy, where the decade average growth has dropped from around 5% in the 1960s to the zero percent we now have. Evidently some of these economies can now begin to contract as population declines.

    Well, that is more or less the theoretical background.

    So why do we get inflation in the ex communist societies – since I think more than the CEE is involved here, we have Vietnam, and we will have China, I mean we were already seeing the first signs in China earlier this year with the surge in inflation before the global crash put a stop to everything.

    Basically, it is to do with the catch up growth process. The CEE economies have all been trying to grow, not at 2-3%, but at much higher levels, and this is where you hit the capacity problem and the inflation. The only country which didn’t quite get there in my book was Poland, and again they simply didn’t have time, before they were hit in September by the credit crunch. But all the rest had wages going up towards the roof (oh, I know the explanation is that they were poor, and that they needed to catch up in their living standards, and in this I agree, but as we are now seeing, you need productivity improvements to do this, and if you try and get there without those, then you simply get a boom-bust, which as we are seeing before our eyes is a real tragedy).

    So the demographica argument is that you need a labour intensive stage to have this rapid development, and you can’t have this labour intensive stage without “thick” cohorts at the base of the pyramid to enter and do the work.

    Basically, I had long been expecting something like this, but I was really shocked in mid 2007 to see just how dramatic the whole thing was in the Baltics. I open several blogs to follow events, and more or less we have seen what I was suggesting take place.

    I mean, I’m not saying that I was 100% right or anything, but just that I was scratching around in the right area, and you go back and look, just how many people in 2007 were saying that Esat Europe would end up at the centre of the global crisis. I was. Straight after the sub prime thing broke out.

    I also quickly had my finger on Spain, but that is another story.

    “if i look at japan it’s the opposite.”

    Well Japan now becomes quite important, since if I am right a lot of CEE countries will now follow the Japan (or German) road, and have very low inflation (or even outright deflation) since this is the bust side of the boom-bust. But then we need to think about consumption (demand side) and not production/labour supply (supply side) dynamics. Basically fertility regulates the median age of a society, and median age regulates borrowing and saving patterns. These societies have largely been huge borrowers (CA deficits) and now will become net savers (CA surpluses). I think there is no other way. Domestic demand is now done, and we are moving over to export driven economies. But this means structural demand insufficiency internally, and hence a downward pressure on prices.

    I know this is all hellishly complicated. It took me years to get to grips with it myself. It’s a bit like the theory that global warming can very easily lead to a new ice age, in both cases substantial non linear processes are involved.

    But why should fertility matyter to economics? Well as I say, it regulates long term labour supply, and it influences savings supply via the impact on median ages and the life cycle behavioural patterns. It’s as simple, or as difficult, as that.

  12. Sorry, I missed out one very important point:

    “So why do we get inflation in the ex communist societies”

    Basically because, due to the very special mix of economic and social development they had, they all passed through the first half of the demographic transition – moving over to lowest low fertility – before they got the modern economic growth regime part. So they have been trying to run on one leg, as it were.

    Thirty years of Chinese one child per family policy is a bit like climbing a tree, sitting on a branch, and then sawing the branch off.

  13. There’s an interesting compare and contrast with Latvia. Why did the Fund agree to a fixed exchange program for Latvia but flexible for Ukraine. Someone in favour of the Latvia approach could look at Ukraine and say: see what happens if you try flexible exchange rate with recession — the floor drops out of the exchange rate and you have neither monetary stability or growth. At least Latvia has one. I say this as Devil’s Advovate, not because I agree with it (necessaril).

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  15. Hi Edward,

    Thanks for the article. It is very informative on what is a very interesting developing situation. Do you think that the conditions imposed by the IMF, such as restricting the size of the budget deficit, are making the crisis worse?

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  17. Hello Peter,

    “Do you think that the conditions imposed by the IMF, such as restricting the size of the budget deficit, are making the crisis worse?”

    Well…. not really. I mean, there would be good grounds for greater flexibility (accumulated debt to GDP is only 12%) if the political system could be trusted to act responsibly. But that is just the tragedy, they can’t. Give these people and inch and they will take a mile, it seems to me. So money could just disappear in populist and demagogic spending – in this sense Ukraine is more like Argentina than Latvia is – without addressing the underlying problems which have produced the mess, which means in particular having an independent central bank able to apply serious monetary policy, and as we can see at the moment, one faction wants to put the Governor of the Bank in prison.

    My guess is that some people in the fund must have been tempted to simply walk away and leave them to it, but that would have been irresponsible, since the contagion risk is huge, and even the risk of the country breaking up is non negligable.

    I think the IMF have little to gain, and everything to lose here, so in this sense I stand side by side with them for trying to do the best they can under difficult circumstances.

    Even though, as you will see in the Latvian case, I am far from being unwilling to criticise the IMF when there are what I consider to be good grounds. Basically, if the IMF hadn’t moved in this country would have already fallen apart, it is as bad as that.

  18. Hi Edward

    Thanks for your response. The reason that I asked is that it seems that with the Ukraine heading deep into a recession, it would make sense for the country to have a fiscal deficit, even if this would not help public finances. Imposing a balanced budget would create significant risks of a much deeper recession.

    I agree that there are governance problems, but I don’t see that the IMF has any potential to address this issue, except perhaps with regards to the central bank. It will take an election to resolve the power struggle between Timoshenko and Yushenko.

    I notice from news reports that the parliament has passed Timoshenko’s budget, which will be in a deficit. It will be interesting to see what happens next. I don’t know how much pork there is in the budget — hopefully not as much as we usually get down here in Australia!

  19. “Thanks for your response. The reason that I asked is that it seems that with the Ukraine heading deep into a recession, it would make sense for the country to have a fiscal deficit,”

    Obviously I agree, and especially with interest rates at 22% to protect the currency. There is simply nothing to stimulate the economy.But we are where we are, and I think we both agree there isn’t much the IMF can do about the governance issue. Basically I think people are paying brinkmanship with the IMF, and then they just get into a horrible amount of moral hazard.

    From the Kiev Post:

    “Many deputies said figures in the proposed budget were unrealistic: 0.4 percent growth against a 5 percent contraction forecast by the Economy Ministry and 4 percent by the World Bank.”

    In other words a projected 3% deficit is going to be much higher, but even this wouldn’t matter if they had a programme which was going to do something to put the country’s economy on a better footing. But I think what we have here isn’t so much pork (although I imagine there is that) as bread and circuses.


    The head of parliament’s budget committee, Mykola Derkach, acknowledged that the budget was “very optimistic. But we must adopt the budget. It is a step in overcoming the crisis.” An aide to President Viktor Yushchenko, Oleksander Shlapak, said this week new talks with the IMF would now be needed. “I cannot say how they will end, but think that the chances of winning them over are 50-50,” he said.

    The danger here is that the IMF, instead of being proactive, simply gets pushed and pushed by the pressure of public opinion and the scale of the problem.

    Again, you could ask whether there isn’t brinksmanship going on with the gas crisis, and that they don’t simply want the IMF to lend the money to pay the debt. Very hard to say.

    But what I am saying is, give some of these people an inch and they will take a mile, not a yard.

  20. Hi,

    “There’s an interesting compare and contrast with Latvia. Why did the Fund agree to a fixed exchange program for Latvia but flexible for Ukraine.”

    I would say there were two reasons, an arm twist one (a lot of political pressure, Ukraine has few friends, and indeed some powerful enemies), and Latvia has the possibility of euro membership, in which case the currency would be effectively pegged anyway. The question is only – at which level are you going to peg it. Indeed with Latvia being so small, and her friends so big, I don’t think it would have been hard to steer the currency down to a new lower level and hold it there. In the Ukraine case this is much harder. First off the inflation was (even) bigger, and secondly, whatever the issues with the Latvian political and institutional system, it is way above the Ukraine one. I may disagree with the Governor of the Bank of Latvia (over the peg), but I think he has a legitimate point of view, and is a completely credible individual. Ukraine is simply “another country” in all of this.

    Basically, I do think the IMF are sometimes a bit “wooden”, they swallowed the “we need to raise wages” argument too easily for too long, IMHO (this is to say they let their hearts rule their heads, which is not the typical critique of the IMF I don’t think), and then once they finally got round to pushing for bugdet surpluses (which were needed during the boom), they have not been able to move quickly enough away from this idea in the face of the severity of the downturn. Generally the stock of debt is low in Eastern Europe, and this does give them some small room for manoeuvre, provided you get the institutional and structural side right to go with this.

  21. Two things:

    1) On the longer term, I think you need to extend your theory to assess that human labour has never been less valuable. Most modern economies have been balanced by a huge wave of underemployment. “Productivity” has massively outstripped the ability of our unequal world to develop demand. There are lots of people who need more material things, but not only don’t have the money to buy them, there’s no way in the current system that they will foresee-ably ever have that money.

    2) A problem across all of CEE has been that young ambitious people don’t just gravitate to “the big city,” they gravitate to “the big imperial centre.”

    There’s a split, according to culture, history and diplomacy. Those richest in social capital tend to head for the USA. Then it depends on family history and connections, some head out to Berlin or London, but a huge number have been sucked into Moscow and St Petersburg as well…

    You can’t help but wonder if some of these intermediate countries (Ukraine?) are destined long term (like much of East Germany?) to be either forest or farmland, with a few provincial cities dotted around.

  22. Hi Meh

    “There are lots of people who need more material things, but not only don’t have the money to buy them”

    Need, or want. I say this because I myself am not especially materialist, and don’t miss a lot of the things that many people tell me they “need”.

    On the other hand I value time, and autonomy. I’m certainly not an admirer, but Milton Friedman would have called this “personal tastes and preferences”, a realm which the non normative economist is forbidden to enter.

    To be clear, I am certainly not saying that in a poor country like Ukraine, there aren’t lots of people, especially old people and young children who lack primary necessities, and especially access to good quality basic health care. I also just wrote this morning about 700 migrants in the Spanish village of Ubeda, who are having to sleep in the municipal sports centre and eat at “Caritas” soup kitchens, since they have been displaced by the housing crisis.

    So there are certainly plenty of people in real “need” in this world, but I doubt that too many of these are young people in Western Europe between the ages of 20 and 35, and I think we might all do well to ask ourselves just how many of these material objects we really do need.

    Of course:

    ““Productivity” has massively outstripped the ability of our unequal world to develop demand.”

    If all people thought like I do, then there would be a problem. That being said, the argument you are advancing here is a variety of what is known as “underconsumptionism”, and was very much in vogue in the 1930s, which is just one more reason why I think we are about to revisit “depression economics”, since all the old arguments are simply going to come up again.

    I don’t ,incidentally, agree with “underconsumptionism”, since I think that falling prices do normally correct these kind of imbalances in the economic system – ie the value of supply contracts to meet available demand – but this is just another reason why I think that the tone of the next decade may be more deflationary than inflationary.

    “You can’t help but wonder if some of these intermediate countries (Ukraine?) are destined long term (like much of East Germany?) to be either forest or farmland, with a few provincial cities dotted around.”

    Yeah, and populated by increasing numbers of wolves.

  23. I disagree with you on demographic issues.

    While a falling population will undoubtedly result in falling GDP, it can result in increasing PER CAPITA GDP.

    The best example of this is, of course, the black death of 14th century.

    For the average European, the result was increased labor mobility and standard of living, though those at the top of the pyramid generally were worse off, which is why laws were (unsuccessfully, in Western Europe) passed in an attempt to restrict wages.

  24. Dr. Hugh:

    1. Great analysis on a very complicated situation, congratulations!

    2. You keep using “the Ukraine”, should we use “the France”? or “the Japan”?

    3. Underground economy is huge……will it mitigate economic collapse?

    4. Will the recovery of global industrial and soft commodities(agricultural) improve the economic situation?

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  27. I was in Ukraine in June working on over $500 Million of orders for Australia and China. Being Australian I had to get the visa renewed in Latvia to go again.

    But the Ukraine embassy in Riga decided that my sponsor was not good enough and I had to send my passport to the Ukraine embassy in Australia for renewal. Meanwhile my business partner managed to get deals via Russia.

    I would like to add that driving through Ukraine discourages investors as the Police are incredibly corrupt with false breathalysers and threats on drug tests.

    People are the resource that can save Ukraine economically and Ukrainian people are the cause as to why Ukraine struggles.

  28. Hi Mathew G,

    Don’t worry about disagreeing with me, lots of people do.

    “The best example of this is, of course, the black death of 14th century.”

    Well look, could we have a more recent example, we are in the middle of a major demographic transition where the age structure of lots of countries is going to change while their populations shrink. I don’t think we need go all thje way back to interpretations of what happend back then (when incidentally population rebound was homestatic – which is the flaw in the Livi Bacci argument, which as it happens you are using, though you may be unaware of it. Since he is a great demographer you are in good company, even if I disagree with the way both of you would use the black death episode).

    What I am saying (I think) is that in the BD case you have dramatic population decline in a high fertility enviroment, while what we have here is log term population ageing (I mean no population pyramid in any society has ever looked like our modern ones do, so I think people need to be very careful about arguing from “experience”).

    Basically if we look at 6 modern societies, and put them into two groups – Italy, Japan and Germany – on the one hand – the US, the UK and Framce on the other. What we find is that populations in the first group are now stagnating, while in the second group they are still growing relatively robustly. What this means is that the pyramids are inverting more slowly in the second case, and more moderate change is ALWAYS in my book better than the more drastic variety when it comes to processes like this.

    Now, when we come to compare GDP per capita between the two groups using Eurostat Purchasing Power Standards (for relative comparisons) we find that GDP PER CAPITA is growing much more strongly in those with a higher percentage of younger people (ie the UK, the US and France) rather then in the older group. I find it perfectly obvious that this should be the case, but many economists seem to have great difficulty coming to grips with all this.

    At the present time we can only speak of slower GDP PER Capita growth, but all of this is now only starting. Italy is the first large economy to have GDP skirting the GDP growth zero bound, and realistically we can see GDP shrinkage begining in all three between now and 2020. When GDP contraction turns into GDP per capita contraction I don’t know, there are lots of factors involved, but the theoretical possibility is there. We will only know when it does or doesn’t happen, which should be between 2020 and 2030 as far as I can see.

    I may be right, or I may be wrong, we’ll only really know when we get there. But are you happy to take the risk solely on the basis of what you know about the Black Death, since the risk is real, and if we let things degenerate to that point, then realistically for the societies involved there will be no turning back, since systematic melt down gets inbuilt.

  29. Hi al billon

    “2. You keep using “the Ukraine”, should we use “the France”? or “the Japan”?”

    Sorry, my mistakes, writing to fast or whatever.

    “3. Underground economy is huge……will it mitigate economic collapse?”

    Basically no, since for what matters here it doesn’t exist. You can’t bail out a banking system with taxes from the informal economy, since by definition the informal economy doesn’t pay them. Access to the informal economy may help people get through the hard times better, but that is a different issue.

    For the economy to be stable they need to incorporate the underground economy into the official one, but during a crisis like this the danger is that things move in the opposite direction.

    “4. Will the recovery of global industrial and soft commodities(agricultural) improve the economic situation?”

    Of course, especially after the devaluation of the currency. But when will this recovery come? This is the problem. Not quickly and probably not this year (2009). Maybe better to talk about this in January 2010, but there’s a long hard road for Ukraine between now and then.

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  32. Thanks for your insightful artical.

    It’s detail is impressive.

    Ukraine has been inflicted with political instability ever since its declared independence., It has also been involved in a struggle to adopt a European parliamentary style democracy, something that Yushchenko has been opposed to.

    The latest fall in the value of the hrivina does appear to be artificially controlled. The property market has boomed beyond sustainability and reach of the Ukrainian population and average income. A boom bust cycle is unavoidable. Ukraine has only recently been seduced by the accessible level of credit Unlike the 1998 bust it has not had to undergo major bank foreclosures. Banks in Ukraine are highly capital geared and in many cases hold more value in assets then in liquidity. If the loss of confidence and over inflation and devaluation of the hrivina creates a run on the banks some banks might take flight with assets and investments disappearing overnight. Ukraine does not have a strong regulatory enforcement system in place to deal with opportunistic lending practices or asset redemption. It is in effect a tinder box likely to ignite.

    What needs to be look at is the comaritive indicators for neighboring states and economies. Ukraine appears to be more worst off then it’s neighbors, which begs the question why? to what extent did the political instability and threat of another round of parliamentary elections fueled the current crisis. It is difficult to see how fresh parliamentary election would resolve, only exacerbate Ukraine’s political instability.

    Ukraine needs to rebuild its governing institutions and adopt European standards and system of governance

    Most of the problems associated with Political instability are due primarily to the office of the President, According to recent public opinon polls by Viktor Yushchenko maintains 4% of public support. If fresh election are seen as a possible pressure release value then early Presidential elections are the better option. better still would be for Ukraine to adopt a European style parliamentary system of governance bringing it in line with other European states.

    Ukraine has foundered under Viktor Yushchenko’s rule. Opportunity lost with effort and time wasted on trivial infighting between the Office of the President and the parliament.

    Yushenko has sought to dismiss two parliaments and hold three elections under his termof office.

    2007 saw Ukraine embroiled in conflict for nine months, in what was clearly an unconstitutional power grab by the President who further undermined Ukraine’s democratic development by illegally interfering in the independence of Ukraine judiciary.

    The President’s attempt to further undermine Ukraine political instability in 2008 has only exacerbated Ukraine’s problems and fueled the loss of confidence.

    The reformation of the governing coalition last month has added further concern as to the ineffectiveness of Yushchenko’s role as head of state.

    Yushchenko has failed Ukraine.

    Yushchenko is unlikely to win a second term of office should have resigned by now and handed over the role of head of state to someone else. The sooner Yushchenko is removed from office the sooner Ukraine hopefully, can begin to rebuild a democratic economy.

    Of course replacing Yushchenko will not resolve all of Ukraine’s problems BUT it would go a long way towards reuniting a county that has suffered the negative consequences of his polices of division and destableization.

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