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Country Commercial Guides for FY 2000: Ukraine Report prepared by U.S. Embassy Kiev, Released July 1999 Note*

Chapter II: Economic Trends and Outlook

A. Major Trends and Outlook

Ukraine was deeply integrated into the former Soviet economy, particularly in the agricultural and defense industries. Ukraine's future economic development will be directly tied to its efforts to build its own industries and to forge ahead with economic reform - areas where the country has historically had little experience.

Upon achieving independence, many analysts agreed that Ukraine had the best medium-term prospects for development of any of the former Soviet republics, including Russia. Ukraine's vast agricultural resources, port and shipbuilding facilities, machinery sector, transportation network, and skilled workforce created a favorable investment picture. Ukrainian authorities, however, were unwilling to undertake serious economic reform. In 1993, for example, annual inflation ran 10,000%, privatization was at a standstill, real wages plummeted, and economic output continued its steep decline.

After assuming office in July 1994, the Kuchma government announced the pursuit of a more serious program of economic reform, though pursuit of reforms has been uneven. Reforms led to a Systematic Transformation Facility (STF) with the International Monetary Fund (IMF) in 1994, to IMF Standby Agreements which functioned during parts of 1995-1997 and early 1998, and to a three-year IMF Extended Fund Facility (EFF) in September 1998. Ukraine has also received disbursements under major World Bank sectoral loans in areas such as financial sector development, privatization, agriculture, and energy.

The country's persistent decline in industrial output since independence has slowed in recent years. After a decline of 10% in 1996 (heavily influenced by a poor agricultural harvest), GDP began to grow in mid-1997 and fell only 3.2% for the year. It increased during the first half of 1998, but the August Russian financial crisis had a strong impact in Ukraine and led to a renewed fall in economic activity. GDP fell 1.7% in 1998 and is projected to suffer another small drop in 1999. However, GDP and industrial production figures do not include the output of goods and services from the vast informal "shadow economy," which by some estimates accounts for as much as half of actual GDP.

The greatest economic achievement of the Kuchma government has been to bring inflation down progressively from the hyperinflation of 1993 to 10% in 1997. Inflation was even lower during the first half of 1998, but prices rose sharply in late 1998 after the steep drop in the Russian ruble led to a significant (though more modest) depreciation of the Ukrainian hryvnia. Total inflation for 1998 was 20%; a similar figure is projected for 1999. In early August 1999 the exchange rate was about 4.5 hryvnia per U.S. dollar.

B. Principal Growth Sectors

Literally all sectors, considered good for investment now or in the future, face the same business environment that is complicated by overregulation, burdensome tax structures, unevenness in application of laws, and a wanting concept of sanctity of law. Microeconomic growth will remain tied to overall structural changes such as tax reform, deregulation, privatization, budget austerity, and greater openness to trade. Nevertheless, even a slowly improving economic situation can serve to strengthen Ukrainian purchasing power, and Ukrainians will eagerly consume depending on their amounts of disposable income. Imported durable consumer goods such as shoes, clothing, and electrical household goods will likely witness continued demand in the future, although their market share has been threatened by the higher relative cost of imported goods following the late-1998 depreciation of the hryvnia. Demand continues as well for imported non-durable goods like foodstuff, candies, and other grocery items.

Agribusiness and food processing and packaging sectors have potential to become areas of significant growth. Previously concluded transactions that resulted in the export of over $300 million of combines to Ukraine by John Deere and Case Corporation are excellent examples of the potential for rapid growth in the agricultural sector. However, this potential growth is very much dependent on the government's commitment to a real privatization policy in agriculture and rapid implementation of that policy. Agricultural reform has stalled in recent years, and many producers remain heavily indebted to the government for past deliveries of agricultural inputs.

The energy sector can also provide a high level of potential investment. Opportunities in the electrical power area can be significant if and when restructuring and privatization take hold. The passage of Production Sharing Agreement (PSA) legislation in July 1999 has improved prospects for significant foreign investment in oil, gas, and coal production.

In the high-tech area, telecommunications, computers, and computer software are other important growth sectors. As Ukraine attempts to merge onto the international information "superhighway," Ukrainian enterprises will require complete solutions to their information processing needs.

A mini-construction boom of "dachas" and apartment renovations, characteristic of an emerging economy, will create demand for quality building products, hand-held construction equipment, finishing materials, etc. U.S. companies can position themselves for this potential surge in demand by identifying qualified distributors in Ukraine or establishing an on-the-ground market presence.

C. Government Role in the Economy

Current public spending levels are high by international standards for countries of Ukraine's level of development. The budget currently finances the provision of numerous goods and services that could be financed by the private sector, including explicit and implicit agricultural subsidies, support for government-controlled industrial enterprises, housing and communal services, and transport and telecommunications subsidies. Public spending is estimated at 22% of GDP in 1999. Under the terms of its IMF EFF program, Ukraine has had success in reducing the budge deficit and imposing more effective control on government expenditures, but arrears in salary and pension payments remains a serious problem.

Privatization in Ukraine has proceeded unevenly thus far, with relatively rapid results in small-scale privatization and a slower pace for large-scale privatization. While the reasons for delays are complex, factors include: an underdeveloped legislative base without clear, easily-understood procedures for selling state property; the absence of political will to overcome strong resistance from local authorities and enterprise directors; parliamentary resistance and a lack of clear incentives in the complicated privatization scheme. Privatization, for Ukrainian citizens as well as foreign investors, will remain a key variable that will shape Ukraine's success or failure in implementing market reforms.

Significant progress was made in 1995-96 in building a nationwide infrastructure for the larger privatization effort. A USAID-financed effort, along with the State Property Fund of Ukraine and accounting/consulting firm Price Waterhouse, established privatization auction centers in every oblast and a national auction center in Kyiv. The distribution of privatization certificates to all of Ukraine's citizens continued, with some 85% of Ukrainians having claimed their certificates as of year-end 1996.

During 1997, privatization picked up from the previous year. Initially, privatization in Ukraine was given a big boost by a solid pro-privatization speech by President Kuchma in January 1996 and a series of measures to remove roadblocks and accelerate the rate of privatization. The State Property Fund (SPF), Ukraine's landlord of all state-owned assets, announced that Ukraine privatized approximately 9,000 medium- and large-scale enterprises into joint stock companies during 1997. Overall, in the three years since the beginning of Ukraine's mass privatization program in January 1995, a total of 45,000 small businesses were privatized and 7,850 larger enterprises sold at least 70% of their shares.

In most cases government divestiture was based on buy-outs, referential sales, and the free transfer of shares to managers and workers' collectives of the given enterprise. Foreign participation in the privatization process has been limited. Foreigners may not participate directly in the mass privatization program, although they may purchase shares of enterprises following their privatization. Some medium-scale enterprises are sold at auction or through tender, and there have been one or two notable sales to foreign investors. The government designated some 250 large-scale enterprises that were to be sold directly to strategic investors, including foreigners, starting in 1997, though this process has moved slowly. Potential candidates for privatization are particularly attractive in the energy and telecommunications sectors, but actual energy privatization has been disappointing while parliamentary opposition has blocked major telecommunications privatization.

D. Balance of Payments Situation

Ukraine's foreign reserves tended to recover in the mid-1990s. However, persistent budget deficits and difficulties in obtaining foreign financing led to a decline in foreign exchange reserves during 1998. Reserves have recovered somewhat in 1999 thanks to disbursements by the IMF and World Bank and purchases of foreign exchange by the central bank (the National Bank of Ukraine). The maintenance of reserve levels may become difficult again in 2000, because the country will face around $3.2 billion in external debt service obligations.

E. Infrastructure

A large part of Ukraine's national infrastructure dates back to the post-World War II period. Economic decline, investment cutbacks, and insufficient rates for services have led to the deterioration of this infrastructure. The tenuous state of Ukraine's telecommunications, energy systems, transportation, and road/highway infrastructure will require upwards of $40 billion in investment over several decades. As part of international efforts to assist Ukraine in its transformation to a market economy, the World Bank, the European Bank for Reconstruction and Development, and other institutions have several infrastructure projects underway. Special emphasis will be given to energy conversion, projects that promote private sector initiative in infrastructure development and improvement, and projects that promote improved nuclear safety.