Report No. 55895-UA Ukraine Country Economic Memorandum Strategic Choices to Accelerate and Sustain Growth August 31, 2010 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENT UNITS (as of August 31, 2010) Currency Unit =UAH US1$=7.9 UAH GOVERNMENT FISCAL YEAR January 1 ­ December 31 ACRONYMS AND ABREVIATIONS BEEPS Business Environment and MTEF Medium Term Expenditure Enterprise Performance Survey Framework CHP Combined Heat and Power NACE Statistical Classification of Economic CIS Commonwealth of Independent Activities in the European Community States NBU National Bank of Ukraine CIT Corporate Income Tax NPL Non-Performing Loans CPI Consumer Price Index OECD Organization for Economic Co-operation CP Cost to Price Ratio and Development DB Doing Business PAYG Pay-As-You-Go DGF Deposits Guarantee Fund PCI Pulverized Coal Injection EBRD European Bank for Reconstruction PF Pension Fund and Development PFM Public Financial Management ECA Europe and Central Asia PFR Public Finance Review EPT Enterprise Profit Tax PIT Personal Income Tax ER Exchange Rate QFD Quasi-Fiscal Deficit EU European Union R&D Research and Development FDI Foreign Direct Investment SOE State-Owned Enterprise FEZ Free Economic Zone SPS Sanitary and Phyto-Sanitary FIAS Foreign Investment Advisory SSC State Statistics Committee Service STA State Tax Administration FOB Free on Board STS Simplified Tax System GCR Global Competitiveness Report TPP Thermal Power Plant GDP Gross Domestic Product VAT Value Added Tax HII Herfindahl-Hirshman Index TFP Total Factor Productivity IFI International Financial Institution TIMMS Trends in International Mathematics and IPR Intellectual Property Rights Science Study ISO International Organization for TOT Terms of Trade Standardization WDR World Development Report LITS Life in Transition Survey WITS World Integrated Trade Solutions (database) LPI Logistics Performance Index WTO World Trade Organization MNC Multinational Corporation MOE Ministry of Economy MOES Ministry of Education and Science MOF Ministry of Finance MOH Ministry of Health MOLSP Ministry of Labor and Social Policy Vice President: Philippe Le Houerou Country Director: Martin Raiser Sector Director: Luca Barbone Sector Manager: Benu Bidani Team Leader: Pablo Saavedra TABLE OF CONTENTS EXECUTIVE SUMMARY ......................................................................................................................................... i 1. THE STRATEGIC CHOICES: UKRAINE ON THE CUSP OF CHANGE OR STALLED AT A CROSSROAD? ...................................................................................................................................................1 2. GETTING UKRAINE'S GROWTH STORY RIGHT ....................................................................................6 A. MACROECONOMIC POLICIES: BOOM AND BUST ................................................................................................... 6 B. GROWTH ACCOUNTING ............................................................................................................................................ 18 C. GROWTH DIAGNOSTICS: A BIRD'S EYE VIEW ...................................................................................................... 19 3. DIGGING DEEP: A CLOSER LOOK AT THE REAL SECTOR ..............................................................28 A. MANUFACTURING ..................................................................................................................................................... 28 B. AGRICULTURE ............................................................................................................................................................ 33 C. SERVICE SECTOR ........................................................................................................................................................ 35 D. THE ENERGY SECTOR ................................................................................................................................................ 39 E. PATTERNS AND COMMON CONSTRAINTS ACROSS SECTORS .......................................................................... 41 4. DIGGING DEEPER: UKRAINE'S MICRO UNDERPINNINGS OF GROWTH .....................................42 A. FIRM DYNAMICS AND PRODUCTIVITY ................................................................................................................. 42 B. COMPETITION ............................................................................................................................................................. 46 C. EXPORT SOPHISTICATION AND DIVERSIFICATION ............................................................................................ 49 D. TECHNOLOGY ABSORPTION, INNOVATION, AND SKILLS ................................................................................ 55 E. TRADE LOGISTICS AND FACILITATION................................................................................................................. 60 5. ACCELERATING GROWTH ........................................................................................................................63 A. STARTING FISCAL REFORM TO CREATE SPACE FOR PUBLIC INVESTMENTS AND TO ATTRACT PRIVATE INVESTMENT ............................................................................................................................................................... 63 B. ENABLING A HEALTHY CHURNING IN THE ECONOMY: BREAKING DOWN ENTRY AND EXIT BARRIERS ........................................................................................................................................................................................ 66 C. FIXING THE FINANCIAL SECTOR ............................................................................................................................ 66 6. SUSTAINING GROWTH ................................................................................................................................68 A. DEEPENING INVESTMENT CLIMATE REFORMS................................................................................................... 68 B. DEEPENING FISCAL REFORMS ................................................................................................................................ 70 C. TACKLING PUBLIC SECTOR REFORM .................................................................................................................... 72 ANNEXES: ANNEX 2.1: Poverty Impact of the Crisis and Selected Reform Measure ..........................................................80 ANNEX 2.2: Growth Diagnostics Framework - Hausmann, Rodrik and Velasco (2005) ...................................83 ANNEX 3.1: Growth Accounting and Returns on Capital in the Real Sector ....................................................84 ANNEX 3.2: An Overview of the Steel Sector ........................................................................................................93 ANNEX 3.3: Non-Bank Financial Sector................................................................................................................95 ANNEX 4.1: Firm Productivity Analysis and Competition ..................................................................................96 ANNEX 4.2: Export Concentration ......................................................................................................................103 ANNEX 4.3: Export Sophistication and Structural Transformation.................................................................104 ACKNOWLEDGEMENTS This report was prepared by a team comprising Ruslan Piontkivsky, Gallina Vincelette, Oleksiy Balabushko, Maria Koreniako, Svetlana Budagovskaya, Friederike Koehler-Geib, Olasupo Olusi, Ashley Taylor, Gary Stuggins, Yadviga Semikolenova, Aurora Ferrari, Marius Vismantas, Sanjar Ibragimov, Natasha Kapil, Martin Raiser (former co-TTL and contributor) and Pablo Saavedra (Team Leader) The report benefited from background papers and studies undertaken by Bailey Klinger (Harvard Development Institute), Eric Bartelsman (University of Amsterdam), Umut Kilinc, (Tinbergen Institute), the Bureau for Economic Studies and Technology (BEST), the Institute for Economic Research and Policy Consulting, Hanna Vakhitova and Tom Coupe (Kyiv School of Economics). Iouri Loutsenko, Tetyana Komashko, and Judy Wiltshire provided document production, translation and organizational support. The peer reviewers were Kathie Krumm and Mona Haddad. Martin Raiser advised the team and provided detailed comments on intermediate outputs of the report. The team benefited from the guidance and advice of Luca Barbone, Benu Bidani, Asad Alam, and Indermit Gill. This report also benefited from comments from World Bank colleagues made in internal presentations and informal discussions, including comments received at several review stages. The team is grateful to the Ukrainian authorities for their collaboration and input throughout the discussions while preparing and finalizing this report. We are particularly grateful to the State Statistics Committee of Ukraine and the Ministry of Economy. EXECUTIVE SUMMARY 1. Much has been achieved in Ukraine in national consolidation, the establishment of the basic institutions of democracy and a market economy. But almost 20 years after gaining independence, the economy has yet to regain the income level it had in Soviet times. Looking back at the first two decades of transition, the overwhelming sense is of a country performing well below its potential. Ukraine has vast opportunities to benefit from the next phase of globalization given its enviable geographic location, abundant natural resources, and educated labor force. Yet, as this report argues, the country will require deep fiscal and structural reforms to realize its full potential. The decisions that Ukraine's leaders take now and over the next three years could make the difference between a low-growth, muddle-through scenario and a scenario of rapid modernization, turning Ukraine into a powerhouse in Eastern Europe. 2. Political power has been strongly contested in Ukraine, as reflected in frequent elections and government turnover between 2005 and 2009. In this context, politicians have found it difficult to resist populist policies that give voters short-term fiscal hand- outs such as pensions and subsidies, leading to massive spending hikes between 2005 and 2008. At the same time, with the buoyant economy pre 2008 and the lack of a strong reform anchor through an EU membership perspective, Ukraine's leaders faced little real pressure to engage in difficult structural reforms to strengthen the economy. But the economic crisis that led GDP to crash by 15 percent in 2009 and the weak global recovery highlight that Ukraine's past growth model is unsustainable moving forward. 3. This report undertakes a comprehensive assessment of Ukraine's growth experience over the past decade. It shows how vulnerabilities were allowed to accumulate during the economic boom. And how growth, averaging 7 percent annually between 2000 and 2008, was achieved without tackling Ukraine's well known weaknesses in the investment climate and public sector governance. The report also traces the emergence of large structural fiscal deficits and fiscal pressures since 2004, as buoyant revenues and terms of trade gains masked an increasingly unsustainable fiscal position. It shows how international excess liquidity allowed Ukraine to attract vast capital flows, intermediated through the banking system, while financial sector regulation remained inadequate. And it analyzes how a poor investment climate, low competitive pressures, limited innovation and slow structural transformation of the economy are all interlinked and perpetuate Ukraine's dependence on a few commodity based exports. 4. Consequently, the report argues, the route to sustained recovery in Ukraine lies in deepening key reforms. The report carries out an in-depth diagnostic of Ukraine's growth drivers at the macro, sector and firm-level and derives key constraints to sustained growth i from this analysis. The recommendations point to three main challenges that deserve priority attention if Ukraine is to re-launch its economy on a sustained growth path. First, Ukraine has to tackle its fiscal crisis to restore macroeconomic credibility and create fiscal space for investments needed to support private sector growth. Second, Ukraine needs to improve its investment climate and fix the financial system to attract private sector investment. Third, Ukraine needs to tackle the problems with public sector governance through deep public sector, judicial and administrative reforms. Since this is a large agenda, the analysis identifies short and medium term priorities. The report also argues that the key reforms highlighted above are closely interlinked and that cosmetic and halfway measures will not do. Growth Without Much Reform (2001-2008)? 5. Ukraine was an average growth performer in a fast growing region, with GDP growth averaging 7 percent annually between 2000 and 2008. Growth helped to significantly reduce poverty, despite the recent setback as a result of the downturn. The poverty headcount index fell steadily from 47 percent in 2002 to just 12.3 percent in 2007 (using a poverty line of USD 5 in purchasing power parity). The reduction in poverty was driven mainly by fast real wage growth, including large annual public sector wage increases; rising social transfers also helped since 2004. The economic downturn is estimated to have increased the poverty headcount index to around 16 percent in 2009, close to the 2006 level. 6. While some positive reforms were undertaken during this period, growth was driven mainly by external and (to some extent) temporary factors. Ukraine's recovery started from a low base, as GDP had fallen to below half of its pre-transition level by 1999. The depth of the transition shock in the 1990s was more prominent in Ukraine than in most of the other former Soviet Republics (in Europe). The low base implied a greater upside for growth once the recovery finally got off the ground in 2000. The following macroeconomic factors underpinned Ukraine's growth between 2000 and 2008: Early realignment of the exchange rate. The Russian financial crisis of 1998-9 led to a realignment of the real exchange rate, which gave an important push to export growth. Initial reforms and stabilization efforts. Initial fiscal and financial stabilization efforts, including prudent fiscal balances (up to 2003), a move away from barter transactions, and privatization of loss-making SOEs, among other reforms, helped to spark growth in the early 2000s (Box 1 highlights a number of positive reforms taken between 2000 and 2008). Unprecedented positive terms of trade (TOT) developments. The economy benefited from large positive TOT developments at levels that were higher than in most other countries. Cumulatively, TOT improved by 50 percent between 2001 and 2008, before falling by 11 percent in 2009. Between 2001 and 2009, advanced economies as well as Central European countries faced on average neutral TOT changes. Emerging and developing economies saw external price conditions improve by around 15 percent, whilst the relative external prices for Ukraine improved by 34 percent. On the export side, steel products drove a significant portion of the gains in relative prices. On the import side, the pricing of natural gas imports was highly beneficial for Ukraine's TOT, until 2009. The implied ii subsidy due to underpriced natural gas imports averaged 7.6 percent of GDP during 2000- 2008. Idle industrial capacity: Throughout the initial recovery period, and until 2006, the significant idle industrial capacity left by the output drop of the 1990s helped to increase production without significant investments. Ukraine's total factor productivity (TFP) looks impressive during this period, but is significantly reduced once figures are adjusted for capacity utilization (see Chapter 2B). A surge of capital inflows in the second half of the 2000s. While capital inflows started to increase early in the decade, after 2005 they ballooned on the back of highly liquid international capital markets, expectations of improved property rights protection (even though laws and institutions did not change materially), and the prospects offered by a large domestic market. Private external debt increased from USD12.5 billion in 2003 to USD86.1 billion at its peak in the third quarter of 2008. The rapid accumulation of private external debt translated into expansionary monetary policies under the de facto pegged exchange rate regime up to 2008, placing significant pressures on inflation. Credit growth to the economy fueled by commercial banks' external borrowing. The banking sector, the major beneficiary of cheap external borrowing, funneled credit to corporates and consumers at unprecedented growth rates. The loan portfolio grew from 9 percent of GDP in 2000 to 78 percent by 2008 (it doubled as percent of GDP just between 2005 and 2008), yet deposits lagged, reaching only 37 percent of GDP by 2008. Growing consumption was further pumped by aggressive consumer lending whilst the soaring mortgage portfolio helped to inflate a real estate bubble. Box 1: Highly Positive Reforms/Actions Taken by Ukraine between 2000 and 2008 WTO accession (and all reforms embedded in this process) Reduction of non-payment and barter transactions, especially in budget-related transactions and the energy sector New Joint Stock Company law that brings corporate governance closer to OECD standards Agricultural land titling Allowing entry of foreign banks Adoption of the Budget Code, establishment of the budget classification system and introduction of equalization formula into inter-governmental fiscal relations Establishment of the Treasury system, including Treasury Single Account that services the budgets of all levels of government Creation of internal audit function and improvement of available fiscal information Reduction of tax expenditures, including dismantling Free Economic Zones (FEZ) loopholes Introduction of flat rate for personal income tax The implementation of the Trends in International Mathematics and Science Study (TIMMS) and independent evaluation/examination in schools. 7. These macroeconomic factors also enabled an expansionary fiscal policy with growing structural fiscal deficits that were masked by the boom since 2004. Pension expenditures hit a record high of close to 18 percent of GDP in 2009, one of the highest in the world, up from 9.2 percent of GDP in 2003. The public wage bill also grew by several points of GDP. On the other hand, fixed capital investments shrank. The cash fiscal iii deficits during 2001-2008 averaged 1.9 percent GDP but in 2009, the general government cash fiscal deficit was 8.8 percent of GDP.1 While the headline cash deficits between 2001 and 2008 looked moderate, the underlying structural imbalances were much larger (see Chapter 2 Figure 2.11 that shows the actual cash balance, a cyclically adjusted balance2, and a corrected structural balance for terms of trade dynamics). The highly pro- cyclical fiscal policy exacerbated the boom and left little room to maneuver when negative shocks occurred. 8. All these developments led to a drastic change in the growth composition of the economy. While exports drove growth up to 2004, between 2005 and 2008 growth shifted to being consumption-led. Fiscal expansion and rapid commercial bank lending fueled rising domestic demand. Foreign savings intermediated through the banking system fueled household purchases of consumer durables (mainly imports) and housing. This placed additional pressure on the current account, which moved into deficit in 2006 after several years of surplus. Moreover, wage growth outstripped productivity growth for several years in a row prior to the crisis. Are the 2001-2008 main drivers of growth likely to persist in the same order of magnitude over the medium term? 9. Most likely not. First, international capital markets have become more risk averse and more selective within the portfolio of emerging economies. In this context, banks that deleveraged significantly in 20093 are likely to shore up their balance sheets in 2010 and only expand credit in 2011, and not at the pre-crisis growth rates. Second, TOT changes are likely to be positive in 2010 with commodity price recovery, but may remain close to zero for the three years thereafter. The real exchange rate is not far from equilibrium, so competitiveness advantages from further devaluation are limited. Fiscal expansion is not possible or advisable in the context of existing fiscal pressures and the required consolidation of public finances. Finally, idle capacity will soon return close to the pre-crisis levels, implying that output expansion will need investments at a time when financing is likely to be scarcer than before the crisis. 10. Moreover, the analysis of economic developments over the last decade shows that Ukraine has built up a number of fiscal and banking sector vulnerabilities, and thus faces serious challenges, as discussed below. On the fiscal side: Ever increasing public infrastructure needs (including repairs to existing deteriorated infrastructure) were estimated by the World Bank's Public Finance Review (PFR) (2006) to require USD100 billion between 2006 and 2015. Given the type of basic 1 This includes Naftogaz's cash deficit but not the costs of bank recapitalization, which amounted to 2.3 percent of GDP. The cost of bank recapitalization was agreed as part of a below-the-line adjuster under the IMF's SBA. 2 Cyclically-adjusted fiscal balance indicators estimate the fiscal balance if output were at its potential level. For this exercise quarterly real GDP series were de-trended using the Hodrick-Prescott filter. 3 External debt roll-over rate for commercial banks was 76 percent in 2009. iv infrastructure needed, this would imply at least tripling the current level of public infrastructure spending of 2 percent of GDP (average 2000-8). Despite more than doubling import gas prices in foreign currency, a significant depreciation of the UAH, and double-digit inflation over the last three years, utility tariffs have been adjusted only marginally since 2006. Domestic household utility tariffs (mainly for gas and heating) are well below cost recovery. In the absence of a program of tariff increases, Naftogaz and utility enterprises may risk bankruptcy whilst infrastructure deteriorates, causing more inefficiencies and further fiscal pressures. Ukraine's demographic trends and the already large population of pensioners (more than 14 million) present significant sustainability challenges. The unreformed pension system and Ukraine's aging population threatens short-term fiscal viability (with growing deficits that are becoming un-financeable) and long-term sustainability (by 2020 there will be almost one pensioner for each contributor in the system, and the ratio will worsen sharply after that). Yet many pensioners receive a small pension in nominal terms. Reforms are needed to protect current and future pensioners and ensure reasonable pension payouts that are more in line with contributions. The rapidly aging profile will also place pressures on service delivery (see World Bank PFR II), burdening the public health care system, particularly in the area of long-term care. These trends also affect the education system that has shrinking cohorts of students. In education, quality needs to be improved to build up the skills demanded by the economy, but without spending additional resources. This will require a shift away from the Soviet-era input norms to pure student financing through the existing intergovernmental financing systems, which can only be done through staffing and network rationalization. The process of staffing and network rationalization is at the core of the reforms in both the health care and education systems. Given the already high average tax burden and high marginal rates on direct taxes, fiscal space cannot be achieved by increasing tax rates or with tax administration procedures that deter self-compliance. This is particularly true while VAT tax exemptions and international double taxation treaties and loopholes continue to erode the tax base, and VAT refund arrears hinder exporters in a moment when the economy needs them the most. On the contrary, it is important to create a more stable and less onerous tax system that has a broader base and attracts investors. With large fiscal deficits (and quasi-fiscal deficits), public and publicly guaranteed debt will continue to grow. Without corrective measures this could impact the costs of external financing to the whole economy over the medium term as capital markets become more selective. All of the above needs to be tackled whilst gradually reducing the footprint of the government in the economy, to crowd in the private sector. On the banking sector side: The banking sector is undercapitalized and vulnerable to even minor shocks and to further increases of unrecognized NPLs. v Transparency needs to be improved to regain trust. The system continues to be plagued with lack of information on individual bank operations and results (the disclosure of which is common practice internationally). Lack of transparency in relation to ultimate bank ownership reduces trust and hampers effective supervision. Lack of trust, coupled with the consumption boom, has also been driving domestic savings down. Ukraine's savings level as a share of GDP has declined steadily since 2004. The interference of vested interests slows the rehabilitation process and reduces the value of time-sensitive assets in problem banks. More broadly, the existing representation of commercial banks in the supervisory council of the regulator hinders governance. Regulation remains weak, despite progress made in 2009. The banking sector needs consolidation to intermediate domestic savings more efficiently. In its current composition, with more than 175 banks (many of them small banks with significant connected lending operations), and without stronger prudential regulation including counter-cyclical provisioning practices, the system will be less resilient to future shocks. 11. Economic recovery and sustained growth will have to come from higher productivity, and this in turn will require Ukraine to embrace fiscal and structural reforms that were delayed during the preceding boom years. 12. Ukraine's reform agenda is broad and stretches across almost all sectors of the economy. To better prioritize reforms, this report examines the constraints to growth from different perspectives and using different methodologies. The aim is to distill those obstacles and constraints common across sectors and thus likely to bring the biggest growth gains if lifted. As a first step, a growth diagnostic was undertaken to identify the key constraints to growth and how these have evolved over time (see Chapter 2B). The key findings are the following: Ukraine's limited and deteriorated infrastructure is unable to support private sector growth. Public infrastructure needs are large and essential to support growth. Low levels of public infrastructure spending are at the core of the problem. But there is no fiscal space to increase public investments. Macroeconomic imbalances and concerns, particularly regarding fiscal policy, have kept capital inflows away. Marginal rates on direct taxes are high. Although the average tax burden is not significantly higher than in other European countries, it is high compared to countries with the same level of income and other emerging economies. Compliance costs are also high for taxpayers (including frequent and burdensome inspections). While access to finance was not an issue prior to the crisis, it has come to the fore in the context of sharp deleveraging in the banking sector. Ukraine has low returns to education, which could imply that labor constraints are not binding on growth, but the data may be problematic due to wage compression and underreporting of income. Other evidence suggests that a shortage of technical skills is a growing obstacle to firm growth, especially for more dynamic businesses. vi There are significant deficiencies in real estate (including land), contractual, and intellectual property rights. Regulatory and other barriers to entry are high. Entry and operation costs are particularly burdensome for growing export sectors. Governance and corruption concerns are a key issue discouraging FDI. 13. Second, an evaluation of selected sub-sectors in the manufacturing, services, and agriculture sectors was undertaken analyzing sectoral productivity performance and investment efficiency. This was complemented with detailed case studies on specific sub- sectors, including in-depth interviews with firms. The objective of this analysis was to identify key sectoral constraints to growth (see Chapter 3). The evaluation showed the following main constraints by sector: Short-term issues: Lack of financing (for both working capital and investments): all sectors VAT refund arrears: agriculture, food processing, steel, machine building, exporters Structural issues: High tax rates and burdensome tax administration inspections: all sectors. Inadequate transport and energy infrastructure: metallurgy, machine building, agriculture, food processing, and energy. High transport tariffs and weak reliability: metallurgy and agricultural production. Inadequate export logistics infrastructure: agriculture, food processing, wholesale and retail trade. Land policy issues: agriculture, food processing, wholesale and retail trade. Institutional and regulatory framework that imposes high entry and exit barriers and high operational costs, and consequently limited competition: all sectors (except banking) Intellectual property rights: machine building, sophisticated (light) manufacturing of durable goods. Inadequate technical skills: steel and machine building. 14. Third, to obtain a better sense of key micro underpinnings of growth in the economy, in-depth analyses were performed using data from the annual census of firms, industry trade data, and other sources of micro data. This allowed for the analysis of factors such as dynamics of firm entry and exit, productivity growth, competition, export diversification and sophistication, and technology absorption (see Chapter 4). The findings point to the following: Barriers to entry and exit hamper the economy's ability to allocate resources efficiently and thus drag down productivity growth. Entry and exit rates of firms are low compared to other countries. Barriers to entry and exit related to the regulatory and legislative framework may explain poor firm dynamism. The moderate reforms undertaken have not done enough to stimulate firm dynamism. In the service sector, entrants are on average more productive than incumbents, which suggests high entry vii barriers. The average firm that exits the market (across sectors) does so with an extremely low productivity level. While it is normal that firms exit with lower productivity levels than the average incumbent, in the case of Ukraine this gap is extremely large, indicating weak market selection incentives that allow firms to survive at low levels of productivity for a long time. Indicators proxying concentration and competitive pressures suggest low levels of competition in Ukraine's economy. Competition in the manufacturing sector seems to have increased only marginally since 2001, while heavy industry competition has been stagnant or declining. High mark-ups prevalent in the business/service sector indicate a lack of competition. This is consistent with evidence of high entry barriers and high margins in the wholesale and large retail and transport sectors gathered from case studies. The analysis shows that facilitating entry and exit to improve competition could generate significant productivity gains. Export concentration is high compared internationally, and a large share of exports (metals and chemicals) remains exposed to price volatility. Ukraine had favorable export sophistication relative to its income level in 2000, but progress has been slow since then. Key competitors have left Ukraine behind with faster progress in sophistication. The basket of products exported to CIS countries is more sophisticated than that exported to non-CIS countries, but heavy industries like machine building are losing market share to other competitors in Russia (its largest market), which in turn places further pressure to improve product sophistication. The number of newly exported products seems to be in line with other comparator countries, but with lower success rates over time. Technology absorption is particularly critical to increase productivity and sophistication in a "within-the-frontier" country such as Ukraine. But technology absorption seems low. A weak intellectual property rights regime, weak rule of law, and an unlevel playing field deters foreign investors from engaging in joint ventures with local investors in technology-intensive sectors, particularly manufacturing. Licensing of technology and off-the-shelf technology purchasing are underexploited. Moreover, adherence to globally-recognized standards is low. More than two-thirds of existing (Soviet-era) standards are not harmonized with the EU--a market where Ukraine has large upside potential. Infrastructure and metrology equipment issues are part of the problem in improving standards. But more important are the reforms needed around the harmonization of standards and the control bodies with redundant mandates and a culture of rent-seeking. Ukraine's historically renowned innovation system is under-performing and slowly fading out due to a weak alignment of property rights and economic incentives, weak linkages with the private sector, and an aging cadre of scientists. Labor skills are becoming an important obstacle for firm growth, particularly for fast- growing firms. This problem is more acute for technical positions in the manufacturing sector (mainly heavy manufacturing). There seems to be mismatch between the skills provided by the education system and labor demand. One-third of respondents in the Ukrainian Labor Market Survey claim that they are performing a viii job that either requires a different field of education or/and a different level of education. Ukraine ranks poorly on logistics and trade facilitation infrastructure and other behind-the-border issues. The top problems are outdated or insufficient infrastructure, expensive and non-transparent freight tariffs in the transport sector, burdensome cross border procedures, and inadequate warehousing space and storage facilities (including cold storage). 15. The sector and micro analyses undertaken show that Ukraine seems to be trapped in a self-perpetuating low equilibrium of high entry barriers, low competition, limited incentives for technology adoption, low export diversification and sophistication, and high vulnerability to commodity prices. This vicious circle hampers the structural transformation of the country's economy while key comparator countries move ahead, and cripples the aspiration of achieving higher per capita income levels and living standards for Ukraine's citizens. 16. These problems are compounded by patronage and capture in many of the interactions of the public sector with businesses and citizens. The public sector is large-- the general government alone spends roughly 47 percent of GDP. Ukraine scores low on public sector governance, despite some improvements. Regulatory bodies, inspection and control agencies, government procurement, line ministries, and state-owned enterprises (SOEs) are heavily intertwined with the activities and the non-tax costs incurred by the private sector. Significant uncertainties about contract enforcement and fairness in the rule of law hold back foreign direct investment (FDI) needed to modernize the economy. Reforming the public sector requires reducing its size and breaking the power of entrenched interests, to provide better public services to citizens and foster genuine competition. Investment climate and fiscal reforms will not be effective without undertaking at the same time deep public sector and administration reforms. 17. The diagnostic of the economy undertaken in this Report points to 3 key reform areas needed to accelerate growth in the short term: fiscal stabilization, business entry (and exit), and banking sector rehabilitation. 18. Over the medium term, reform also needs to focus on three areas: deeper fiscal and investment climate reforms complemented by public sector governance reform. In short, the objective is to turn Ukraine into an economy where the footprint of the state is smaller and more even-handed, and where the private sector thrives and invests as a result of the pressures of competition rather than the perks of state connections. In the short term 19. The objectives of fiscal reforms in the short term and their linkages to accelerating growth are to: (i) secure stability through a prudent fiscal stance to attract investors back to the country; (ii) adequately pay VAT refund arrears to support the export sector; and (iii) lay the foundations to generate fiscal space for public investments ix that would support employment and growth. On the expenditure side this can be done by initiating structural pension reform and increasing energy tariffs. This process should be mindful of adequately funding well-targeted social assistance programs to protect the poor from the downturn and future reforms by reallocating funds from poorly-targeted programs. On the revenue side, reforms can expand the tax base by eliminating tax exemptions and curtailing loopholes in the enterprise profit tax (EPT), such as double taxation international treaties. Measures on the revenue side also bring about a more balanced adjustment between citizens and firms. These measures constitute the first step in a process of saving and reallocating fiscal resources toward more productive and growth-enabling uses. Table 5.1 contains a detailed account of specific measures that the government could take to fulfill these objectives. 20. The objectives of business entry/exit reforms in the short term and their linkages to accelerating growth are to: (i) enable a healthy reallocation of resources in the economy from declining sectors and firms to more resilient sectors and new firms, which would help to generate employment and growth; and (ii) remove key obstacles to business entry and exit to attract FDI and encourage domestic investors with resources to start new ventures. In the short term, credible reforms need to be taken to generate enough momentum in licensing, permits, standards, and certification. Bold measures on business entry will not only help employment but also help to build confidence in the economy and credibility in the reform process. Table 5.2 contains the proposed short-term measures. 21. The objective of banking sector rehabilitation is to secure stability, enable intermediation, and prepare the sector for future shocks. Access to finance through the banking sector is not likely to be a constraint to growth over the medium term, but in the short term, the economy cannot afford another year of drastic deleveraging. Rehabilitating the sector is essential to secure stability and recovery. Reforms require a renewed effort to tackle the legacies of the past and strengthen regulation and transparency to regain trust. While progress has been achieved over the last year (e.g., setting up the process of recapitalization, providing the regulator with resolution tools), significant pressures and threats face the system today: unrecognized NPLs may rise, there is still a large number of weak small banks that cannot intermediate effectively the declining amount of national savings, and supervision and regulation is not ready to prevent another crisis. Recapitalizing the system whilst increasing its transparency is essential to the rehabilitation process. Beyond that, regulation and supervision reforms should help to make the financial sector more resilient to shocks whilst being a reliable source of financing for a growing domestic economy. But the authorities should move quickly as the window of opportunity for reforms in the sector is closing. Table 5.3 contains specific measures that the government could take to fulfill these objectives. 22. These three reform challenges are inter-related. Without fiscal reform, macroeconomic stability and a sustained recovery will not be possible and investors will remain risk averse toward Ukraine. Without private investment (through new entry) to fuel the recovery, fiscal consolidation will be more difficult, and banks will struggle to find viable lending opportunities in the real sector. Without a stable and properly capitalized banking sector and regained trust among depositors, banks will not have the x resources and the strength to support private businesses. Because of these inter-linkages, all three reform areas must be tackled simultaneously, and with strong up front measures. In the medium term 23. To sustain growth, deeper investment climate, fiscal, and public sector reforms will be needed. With capital markets likely to remain more selective and risk averse than in the past, Ukraine's growth will have to rely on significant productivity gains. These gains can result from a more dynamic entry and exit of firms in the economy, more competition, and greater sophistication and diversification of Ukraine's export basket. At the same time, this requires dealing with the large backlog of public infrastructure investments and improving efficiency of public services (to foster a highly skilled labor force) to support productivity and export growth. This will require deeper fiscal reforms and the continuation of the fiscal reallocation process described above. Finally, to achieve sustained growth, the public sector will need to be streamlined and reformed, eliminating red tape, securing property rights, and strengthening the rule of law. 24. The objectives of deep investment climate reforms and their linkages to sustained growth are to: (i) lift barriers to entry and exit to improve competition and productivity growth; (ii) increase and sustain FDI to foster technology adoption, modernization and productivity growth; and (iii) foster product diversification and sophistication to enable Ukraine's exports to become more resilient to shocks and sustainably support stronger growth. Reliance on foreign savings to finance explosive domestic consumption will not be an option in the current conditions of tight credit. But deep policy improvements to strengthen the institutional framework for business and continuing the process of modernization in key sectors of the economy will help to accelerate and sustain productivity growth over the medium term. Table 6.1 describes specific measures that the government could take to fulfill these objectives. 25. The objectives of deeper fiscal reforms and their linkages to sustained growth are to: (i) create fiscal space for public investments so infrastructure can sustainably support private sector growth; (ii) gradually reduce the footprint of the public sector in the economy to crowd in the private sector; (iii) improve efficiency and quality of service delivery for Ukraine's citizens; and (iv) secure the sustainability of public finances and social insurance. Table 6.2 contains specific measures that the government could take to achieve these objectives. 26. The objectives of public sector reforms and their linkages to sustained growth are to: (i) improve citizen and investor confidence in the country's rule of law and economy; (ii) sustainably attract FDI that can help modernize the economy as opposed to just short-term inflows in search of high rents; and (iii) reduce red tape, abuse and corruption in regulatory and control agencies that hamper private sector investment and growth. Tackling public sector and institutional reforms is necessary to improve governance and gain the trust of investors and citizens. Red tape, burdensome regulation, allegations of corruption and abuse, insecure property rights, a perception of weak rule of law, poor governance of SOEs and limited accountability are core problems hampering xi Ukraine's prospects as a place to make long-term investments. Tackling these problems will require radical reforms in the way the government interacts with business and with citizens: a change in role from a controller to an enabler of markets and welfare. Table 6.3 contains specific measures that the government could take to fulfill these objectives. 27. Public sector reforms are closely linked with investment climate and fiscal reforms. Public sector reforms will require a public administration reform program that rationalizes redundant state control agencies and redundant roles within the government itself, which should be done in parallel to investment climate and regulatory reforms. Tackling the problem of oversized public sector employment should be done in parallel to fiscal reforms in social services, such as the optimization reforms in health and education. These reforms would require drastic improvements in transparency, governance, and incentives for SOEs, in parallel with fiscal and public financial management reforms. Significant reforms are also required in the judicial system to level the playing field. Sustained increases in FDI over the medium term from countries that can help to push Ukraine's export diversification and sophistication will depend heavily on these reforms. Public sector reforms are complex. Sustained and high level political leadership will be needed to carry them through. xii 1. THE STRATEGIC CHOICES: UKRAINE ON THE CUSP OF CHANGE OR STALLED AT A CROSSROAD? 1.1 The balance of power in the world economy is shifting in favor of emerging markets. The global economic and financial crisis of 2007-2009 has reinforced this trend. Against this context, Ukraine has huge opportunities to benefit from the next phase of globalization given its excellent location, abundant natural resources, and skilled and low-wage labor force. Ukraine could be on the cusp of change and become a powerhouse in Eastern Europe. Yet, as this report shows, the country will require deep structural reforms to realize its full potential. And it will require strategic thinking and leadership to avoid the "short-termism" of the politics that has characterized Ukraine over the last five years. The decisions that leaders in business and politics take moving forward could make the difference between muddling through at the periphery of old Europe and sustained modernization in the global economy. The boom and bust cycle and its economic drivers 1.2 During 2001-2008 Ukraine grew by 7 percent on average. Yet, in 2009 GDP crashed by 15 percent and in US dollar terms Ukraine is back today where it was at the end of 2005. Why did the country experience such a deep decline after many years of fast growth? The answer lies in a combination of factors explored in this report. 1.3 Ukraine's growth was fuelled by extremely favorable external circumstances. Ukraine's terms of trade over the period show a striking resemblance with those of oil producing countries. These terms of trade gains, driven by the sustained boom in the prices of steel, but also of chemicals and in 2007-2008 agricultural commodities, allowed real incomes to outstrip productivity growth. When the global economy tanked, commodity prices collapsed and Ukraine's terms of trade gains went into reverse, while demand for exports was also sharply curtailed. Export revenues declined by some 45 percent in 2009. 1.4 The country belatedly joined the "convergence" belt of finance in Eastern Europe. As a frontier market, Ukraine benefited from huge inflows of FDI and bank lending, much of it invested in non-tradable sectors and justified by the expectation of inevitable income convergence with the rest of Europe, as had happened before in the EU's new member states. This further fuelled consumption, even as Ukraine's current account balance shifted from a large surplus of 11 percent of GDP in 2004 to a deficit of 7 percent in 2008. Ukraine's financial market regulation failed to keep up with this growth. Bank supervision was inadequate and credit risk practices in commercial banks were weak. The sudden stop of external financing exposed underlying credit, leverage, and maturity and foreign exchange risks. 1.5 Ukraine's domestic market suffers from a lack of competition and hence a lack of pressure for innovation. With favorable external conditions and low levels of domestic entry, there were few incentives during the boom for cost control and product and process innovation. As an "inside-the-frontier" country Ukraine also has been failing in the process of technology absorption, a key stepping stone toward innovation. Instead, Ukrainian businesses invested much of their energy into assets acquisition, building large corporate empires with little strategic focus. Competitive barriers are in many instances due to government regulation and enforcement 1 of legislation. Incumbents and public officials colluded in making it difficult for outsiders to break in, sharing the resulting rents. But the lack of competition is a key reason for the low level of productivity in Ukraine's economy and hence represents a major barrier for growth going forward. 1.6 The conclusion for Ukraine's growth prospects over the coming decade is clear. To catch-up, Ukraine needs to increase its rate of productivity growth. The old model of consumption based growth fuelled by external finance is over. Ukraine's financial system will continue to deleverage for some time to come and, when lending resumes, it will be available only to companies with strong sales prospects based on international competitiveness. Commodity markets are slowly recovering, yet, even in its traditional stronghold of steel production, Ukraine will face cost pressures as other emerging markets have expanded capacity and as Ukraine's cheap energy advantage has disappeared. 1.7 The depth of the bust may lead one to conclude that Ukraine's pre-crisis growth model was inherently unsustainable. At the same time, it is important to recognize that Ukraine, as the rest of Europe, has faced a massive external shock. The uniformity with which the region was hit suggests there were limits to what policy could have done to prevent the full extent of the crisis (World Bank's Turmoil at Twenty report, 2009). Yet, this report argues that policy will be decisive in determining the shape of the recovery and the future path of growth. The political economy of the boom-bust 1.8 Ukraine benefits from considerable political competition in a democratic system. Political power has been strongly contested in recent years. Yet politicians have found it difficult to resist populist policies that give voters short-term fiscal hand-outs such as pensions and subsidies to maximize gains in frequent elections. Politicians face little real pressure for accountability and improved governance or to engage in structural reforms to strengthen the economy, as long as populist policies are maintained. The result is a political low-expectations equilibrium that leaves vested interests unchecked and scuppers many good reform proposals because of their assumed unpopularity. Prior to the crisis, this also drove spending hikes and growing structural fiscal deficits that were masked by rapid growth. 1.9 External factors have failed to help Ukraine break out of this low expectations equilibrium. The lack of EU membership prospects has left the country without a strong reform anchor, one that contributed to deepening institutional and structural reforms in Eastern Europe. Compared to other countries in the Commonwealth of Independent States, Ukraine is not unusual for having struggled with deepening reforms. The legacy of weak governance in public institutions is hard to overcome even with determined political leadership. Moreover, it should be remembered that the country despite all the instability delivered remarkable improvements in living standards between 2005 and 2008. Why reform if things are getting better? As late as September 2008, many Ukrainian commentators were soothing nervous investors by declaring the Ukrainian economy and its financial markets immune to political instability. 2 The end of populism and the inevitable fiscal adjustment 1.10 The crisis has changed all this. It has emptied fiscal coffers and the scope for hand-outs to placate voters has disappeared. The consolidated fiscal deficit (including Naftogaz) reached 8.7 percent of GDP in 2009 and public debt increased from 10 percent of GDP pre-crisis to 35 percent in 2009. Without major fiscal adjustment, public finances are not sustainable. The required fiscal adjustment will not be possible without reducing public transfers, implicitly by reduced energy and utility subsidies and explicitly by reforming a bloated pension system. These adjustments will hurt the median voter and leaders from all political parties have been reluctant to embrace them. Yet, fiscal adjustment is at the core of any strategy to get Ukraine out of crisis. It matters because it directly influences investor confidence and the cost of capital, and thus has a bearing on the speed and sustainability of recovery in the private sector. From the perspective of average Ukrainian households, the failure to adjust fiscally could have much higher costs in terms of declining real incomes as a result of macroeconomic instability and foregone employment prospects than an orderly correction of excessive public consumption spending. The adjustment need not hurt the poor and vulnerable if social transfer targeting is improved and the scope for fiscal savings by cutting inefficient subsidies and closing tax loopholes is fully utilized. 1.11 The crisis is also an opportunity to renew the social contract between the citizens and the state. Ukrainians are unhappy with the quality of public services (LITS 2007). Years of underinvestment have left public infrastructure in disrepair. Ukraine spends less than 2 percent of GDP on public sector investment, around one-fourth the level of dynamic emerging market economies in Asia, as stated in the Ukraine Public Finance Review I 2006 (PFR I). Health and safety risks are considerable from leaking gas pipes, dilapidated district heating systems, and intercity roads interspersed with potholes and poor signaling. Health and demographic indicators are poor even by the standards of middle-income countries. And while Ukrainian students still turn out reasonable results in mathematics and sciences, skills gaps have been emerging for both high end financial and legal professionals and technically skilled workers. Refocusing government efforts, fiscal and political, on improving the quality of public services could help rebuild trust in the state and create support for necessary cut-backs in current spending. Ukraine's medium term strategic choices: reorient public finances, improve the investment climate, and overcome capture through public sector reform 1.12 Almost 20 years after gaining independence, Ukraine has yet to regain the income level it had in Soviet times. Much has been achieved in national consolidation, the establishment of the basic institutions of democracy and a market economy. Yet, the overwhelming sense looking back at the first two decades of transition, is that of a country remaining well below its potential. Whether the next decades will close this gap and turn Ukraine into the European power house that it could be, depends on how its political leaders address three key challenges. 1.13 Reorienting public finances: Will Ukraine's leaders find the courage to offer a new social contract to their citizens? Will they embrace better governance, more responsible fiscal management, and investments into public infrastructure and services or will they stick to the populism of the boom-bust? Ukraine has an opportunity over the coming 2-3 years to rebalance public finances and set the stage for more efficient, accountable, and socially responsible 3 government. There is huge scope for efficiency gains that would improve service quality whilst targeting assistance to the most vulnerable. If combined with tax policy and administration reforms that close loopholes, increase fairness and reduce the scope for discretion, tax morale could be significantly boosted creating the basis for a medium-term reduction in the tax burden on capital and labor, thereby encouraging investment and employment growth. This would also create the fiscal space required for greater investment in badly needed public infrastructure. These investments will not be cost effective, however, unless Ukraine adopts and implements modern public procurement legislation and further improves public finance management. 1.14 Improving Investment Climate: Will Ukraine's leaders strive for global competitiveness? In 2010, Ukraine's international economic policy stands at a crossroads. To realize its potential Ukraine will need to facilitate entry of new businesses by lifting the burden of existing red tape. It will need to attract FDI that brings new technology and know-how through clear, stable, and enforceable rules. It will have to embrace competitive pressures, modernization of its industry, and eventually innovation. Moreover, it will need to move fast in global trade integration, particularly tapping new markets for its products. Only then can Ukraine diversify the economy, improve export sophistication and achieve the structural transformation that would move it up the income ladder. However, it is not clear that powerful domestic vested interests in the business sector will allow reforms that would enhance entry and competition. Negotiations with the EU over a deep and comprehensive free trade area have progressed more slowly than originally hoped for, while the promise of EU market access is muted by the prospects of low growth in Europe. 1.15 Cosmetic changes will not do. The litmus test of the authorities' commitment in this regard will be to embark on a fundamental deregulation effort. Businesses in Ukraine face a bewildering array of rules and regulations, permits, licensing, standards, certification requirements, and legal impediments to private contracts and their enforcement. Many of these serve no public purpose but are rather designed to allow an army of inspectors find fault, collect fines or bribes and feed the large bureaucracy. The regulatory tax on incumbents is not insignificant, but they are compensated by high margins due to the absence of competition. With the crisis, the burden of this tax has increased and with it business support for reforms on deregulation. This is an opportunity for Ukraine's leaders that should not be missed. 1.16 The country also needs to establish transparent and independent financial market regulation. Access to finance through the banking sector was not a constraint to growth in the pre-crisis period, but it is critical to spark the recovery. The authorities took measures as the crisis un-folded in 2009, which helped to safeguard the core of the system. But the financial sector remains weak. Going forward Ukraine needs to establish rules-based, arms-length and transparent regulation of its banks and the entire financial sector. Bank ownership and disclosure of financial information needs to be transparent. Financial market reforms can only be implemented by independent central bankers and regulators free from any conflict of interest. Other emerging markets made this choice during the last financial crisis at the end of the last decade. They have emerged from the crisis of 2007-2009 stronger and with their credibility boosted. Ukraine needs to choose whether it wants to build resilience for the next shock or muddle through until the next crash. 4 1.17 Overcoming capture through public sector reform: Will Ukraine's leaders have the courage to break the power of vested interests entrenched throughout the state, to provide better public services to its citizens and foster genuine competition in its private sector? To move on this, a paradigm shift is needed: from the red tape controlling state that meddles non- transparently to extract rents from firms and citizens, to a public sector that is a true market enabler and a basic services provider. This will require a drastic change in the way the public sector and all its agencies interact with firms and with citizens. 1.18 Overcoming state capture will require deep institutional reforms, including most crucially: (i) the reform of the judiciary and the entire legal system, (ii) public administration reform; (iii) reforms of oversight bodies; and (iv) enhanced institutional transparency and accountability. International experience suggests that these deeper institutional reforms are complex and politically difficult. They will require leadership and quick early wins to be sustained, not least because an external anchor such as EU accession is currently absent. However, the benefits would be large: private domestic and foreign investors would respond positively to signals of improved governance and the resulting technological modernization will open new jobs and business opportunities. Politicians with the courage to see this through could be greatly rewarded. 1.19 The choices facing Ukraine's leaders are thus far-reaching. Ukraine's development since independence in 1991 has been characterized by extended periods of muddling through with occasional bursts forward, most notably after the last regional crisis in 2000-2001. A decade on, Ukraine once again faces the opportunity to make a decisive step forward. It is up to Ukraine's leaders to grasp it. 1.20 This report undertakes a deep diagnostic of the economy aimed at evaluating the factors that underpinned growth in the last decade and constraints to economic recovery and sustained growth moving forward. To do so it examines the economy from different angles and through different methodologies. First, it undertakes a broad macroeconomic analysis of the recent sources of growth (Chapter 2 section A). Second, analyzes productivity and investment performance at the aggregate level (Chapter 2 section B). Third, it undertakes a growth diagnostics, looking for constraints to economic returns (chapter 2 section C). Fourth, it examines key sub-sectors of the real economy (Chapter 3). Fifth, it digs deeper to evaluate the microeconomic underpinnings of growth using firm, trade, and other micro data (Chapter 4). Finally, it distills the common strands and constraints to growth that emerge from the analyses and suggests a prioritized and sequenced reform strategy to help the country reach its full growth potential (Chapters 4 and 6). 5 2. GETTING UKRAINE'S GROWTH STORY RIGHT 2.1 This chapter evaluates the macroeconomic drivers of growth in Ukraine in recent years and analyzes the potential binding constraints to a sustained economic recovery. It first focuses on the internal and external macroeconomic developments that underpinned the growth episode of 2001-2008, the downturn of 2009, and the significance of macroeconomic policies for growth going forward. Then it carries out a growth accounting analysis at the aggregate level, and lastly it provides an overall growth diagnostic to identify binding constraints to growth. A. MACROECONOMIC POLICIES: BOOM AND BUST 2.2 Ukraine was an average growth performer in a fast growing region between 2000 and 2008. Since the economy bottomed out in 1999 following the Russian crisis, real GDP growth averaged 7 percent between 2000 and 2008, just above the Europe and Central Asia (ECA) region4 average of 6.4 percent, but below the group of countries in the Commonwealth of Independent States (CIS) that averaged 7.5 percent (Figure 2.1a).5 Growth performance appears less impressive, however, taking into account the low base following the deep and protracted economic contraction of Ukraine in the 1990s (Figure 2.1b). Ukraine grew with the region, but did not converge toward the income level of new EU countries. Figure 2.1a: Average Growth Rates in ECA Figure 2.1b: Output Trajectories in the Countries (2000-8), in Percent Transition (Selected Countries) 1991=100 18 250 16 14 Average Growth Rates 20002008 12 200 10 8 6 150 Ukraine 4 Russia 2 100 Belarus 0 Poland Kazakhstan Uzbekistan Hungary Russia Turkmenistan Estonia Romania Moldova Albania Croatia Azerbaijan Tajikistan Poland Latvia Bulgaria Lithuania ECA Region Armenia Slovenia CIS Kyrgyz Republic Czech Republic Georgia Turkey CE and Baltics FYR Macedonia Ukraine Slovak Republic Belarus B and H 50 ECA 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: World Bank, IMF, Bank staff calculations. 2.3 Growth helped to significantly reduce poverty despite the setback in the context of the downturn. The headcount index fell steadily from 47 percent in 2002 to just 12.3 percent in 2007 using a poverty line of USD5 in purchasing power parity (Figure 2.2b). The reduction in poverty was driven mainly by fast real wage growth in the economy, including large annual 4 The ECA region includes the following countries: Albania, Armenia, Azerbaijan, Belarus, Bosnia & Herzegovina, Bulgaria, Croatia, Czech Republic, Estonia, Georgia, Hungary, Kosovo, Kyrgyz Republic, Latvia, Lithuania, FYR Macedonia, Moldova, Montenegro, Poland, Romania, Russian Federation, Serbia, Slovak Republic, Slovenia, Tajikistan, Turkey, Turkmenistan, Ukraine, and Uzbekistan. 5 The CIS include most of the former Soviet Union republics, except for the Baltic countries. 6 public sector wage increases. Rising social transfers also helped since 2004. The economic downturn is estimated to have increased the poverty headcount index to above 16 percent in 2009, about the 2006 level. The transmission channels of the crisis to the population were multiple. They included adjustments in the labor market, movements in real wages, and increased household debt service costs due to the exchange rate adjustment. The wage and labor effects account for around 80 percent of the overall effect of the crisis, although the increased debt service (due to the exchange rate) effect is also significant at 12 percent (Annex 2.1 contains a detailed analysis). Ukraine maintains a sizable system of social payments and transfers, including the non-contributory transfers and safety nets system that has provided some relief. But social safety net targeting can be improved to better cushion shocks and the impacts of reforms for the poorer and vulnerable households. Figure 2.2a: Per Capital Gross National Income Figure 2.2b: GDP and Poverty Dynamics and Population Growth Dynamics (1992-2009) (1992-2009) 3500 0.4 GNI per capita, Atlas method [LHS] 0.2 GDP and poverty 3000 Population growth, percent [RHS] 120 50 Poverty Rate $5.0 dollar a Real GDP, index: 1992=100 0 2500 100 40 0.2 2000 80 30 0.4 60 1500 0.6 20 day 40 1000 10 0.8 20 500 1 0 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 0 1.2 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Real GDP, index: 1992=100 $5 a day poverty Source: State Statistics Committee, Household Budget Surveys, Bank staff calculations. 2.4 While some positive reforms took hold between 2000 and 2008, growth during that period was primarily driven by external and (to some extent) temporary factors. Ukraine's recovery started from a low base, as GDP had fallen to below half of its pre-transition level by 1999. The Russian financial crisis of 1998 (with significant repercussions on Ukraine) led to a realignment of the real exchange rate which, together with initial fiscal and financial stabilization and reform efforts, kick-started growth in the early 2000s. After 2003 the country benefited from steady terms of trade gains in the context of growing export demand (See Table 2.1) (and importantly a booming large neighbor, Russia) that supported the tradable sector. Throughout this period, particularly until 2006, the significant idle industrial capacity allowed output increases without significant investments. While capital inflows and FDI started to increase early in the decade, it was after 2005 that they ballooned on the back of highly liquid international capital markets, expectations of improved governance and protection of property rights after the so-called "Orange Revolution" (even though laws and institutions did not change materially), and the prospects offered by a large domestic market. A significant portion of the external inflows was funneled to the banking sector, increasing lending to the economy at record rates, including consumer lending. 7 Table 2.1: Key Macroeconomic Indicators 2000-09 2001 2002 2003 2004 2005 2006 2007 2008 2009 Real GDP (change in percent) 9.2 5.2 9.6 12.1 2.7 7.3 7.9 2.3 -15.1 Real Industrial Production (change in percent) 14.2 7.0 15.8 12.5 3.1 6.2 10.2 -3.1 -21.9 CPI, a.o.p. (change in percent) 12.0 0.8 5.2 9.0 13.5 9.1 12.8 25.2 15.9 CPI, e.o.p. (change in percent) 6.1 -0.6 8.2 12.3 10.3 11.6 16.6 22.3 12.3 Exchange Rate, UAH/USD, a.o.p. 5.4 5.3 5.3 5.3 5.1 5.1 5.1 5.3 8.1* Current Account Balance (percent of GDP) 3.7 7.5 5.8 10.6 2.9 -1.5 -3.7 -7.1 -1.6 Foreign Exchange Reserves (USD billions) 3.1 4.4 6.9 9.7 19.4 22.4 32.5 31.5 26.5 Net FDI (USD billions) 0.8 0.7 1.4 1.7 7.5 5.7 9.2 9.9 4.7 Fiscal Balance (percent of GDP) -1.6 0.5 -0.9 -4.4 -2.3 -1.4 -2.0 -3.2 8.7 PPG Debt (percent of GDP) 38.6 36.5 29.0 24.7 17.7 14.8 12.4 20.1 34.7 Memo: Nominal GDP (in billions of USD) 38.0 42.4 50.1 64.9 86.2 107.8 142.7 180.2 113.5 GNI per capita (USD, Atlas method) 720 780 970 1260 1520 1960 2560 3140 2810 * market exchange rate Sources: SSC; NBU; IMF; Bank staff calculations. 2.5 The composition of growth changed significantly over the last decade. Two periods can be clearly distinguished. Between 2000 and 2004, real export was the major contributor to growth. Between 2005 and 2008 growth shifted from export-led to consumption-led, as export contributions became negative and the share of private consumption doubled (Figures 2.3a). Fiscal expansion and rapid commercial bank lending fueled rising domestic demand. Expansionary fiscal and income policies led to rising public and private sector wages and transfers to the population (mainly pensions). Foreign savings intermediated through the banking system fueled household purchases of consumer durables and housing. This placed additional pressure on the external current account and price stability. Moreover, with wage growth outstripping productivity growth for several years in a row, concerns over sustainability and pressures on Ukraine's growth model were increasing before the crisis (Figure 2.3b).6 Figure 2.3a: Growth Composition, by Expenditure Figure 2.3b: Real Wage Growth vs. Real 2000-09 GDP Per Capita Growth to Proxy Labor Productivity (1996-2009) 80% 300 60% Real wage, index import 250 40% Real GDP per capita, index export 200 20% 150 0% fixed investment 20% 100 public consumption 40% 50 private 60% consumption 0 80% 20002004 20052008 2009 Source: State Statistics Committee, Bank staff calculations. 2.6 As the crisis unfolded Ukraine's economy contracted by 15 percent in 2009, exposing its underlying macroeconomic and structural vulnerabilities. These included: (i) a 6 See World Bank's Development Policy Loan II Program Document (2007); Public Finance Review I (2006). 8 weak maturity structure of the fast growing private sector external debt; (ii) banking sector vulnerabilities associated with the rapid loan growth supported by predominantly external funding and weak regulatory and supervision controls; (iii) volatile terms of trade and lack of diversification in external demand (mainly related to the steel and heavy industry sectors on the export side and the gas sector on the import side), (iv) expansionary fiscal policies in the context of problematic expenditure and revenue structures; (v) weak competition and ability to diversify and generate higher value added products; and (vi) a burdensome regulatory environment and large government footprint hampering private sector development. Growth Without Much Reform? 2.7 In order to better understand the boom period between 2000 and mid 2008, as well as the deep bust of the 2009, this report examines the underlying external and domestic macroeconomic factors underlying these dynamics. Terms of Trade 2.8 Ukraine's economy benefited from positive terms of trade developments more than most other countries. Terms of trade (TOT) changes were positive every year between 2002 and 2008, the improvements averaged 6 percent annually. The TOT were extraordinarily high during 2005-2008, averaging 9 percent (Figure 2.4a). Cumulatively, between 2001 and 2008, TOT improved by 50 percent, before dipping by 11 percent in 2009. Ukraine appears to have benefited more from positive TOT developments than most countries. Between 2001 and 2009 advanced economies as well as Central European countries faced on average neutral TOT changes. Emerging and developing economies saw their external price conditions improve by around 15 percent, while the relative external prices for Ukraine rose by 34 percent (Figure 2.4b). Understanding the factors underlying these unprecedented relative prices is important in evaluating growth prospects moving forward. Figure 2.4a: Terms of Trade 2001-09, % Change Figure 2.4b: Terms of Trade Dynamics 2001-09, Cumulative 15 1.6 Ukraine TOT change, y/y 10 1.5 1.4 5 Emerging 1.3 and Developing 0 1.2 Economies Central and 5 1.1 Eastern 1 Europe 10 0.9 Advanced Economies 15 0.8 2001 2002 2003 2004 2005 2006 2007 2008 2009 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: State Statistics Committee, Comtrade, Bank staff calculations. 2.9 Two major factors underpinned fast-growing export prices. First, Ukraine exported relatively more goods with rapidly increasing global prices. Second, Ukraine benefited from reducing the unit-value gaps of its exports compared to leading exporters from advanced 9 countries (Figure 2.5a). Global merchandise export prices for all goods increased 33 percent between 2001 and 2006. Export prices for the core basket of Ukraine's exports7 produced by leading technologically advanced global exporters8 (e.g., "frontier" countries) increased by 91 percent. But Ukraine's actual export prices for the same basket went up by 125 percent over 2001-2006, accounting for over 30 p.p. (or one-quarter) of the total faster price growth. The reduction of unit-value gaps could be explained by the combination of: (i) reduced transfer pricing practices in export operations by Ukrainian enterprises; and (ii) improved marketing, delivery or other related product improvements. 2.10 Closing the remaining unit-value gaps with the `frontier' countries will be increasingly difficult for Ukraine. In 2006, Ukraine's export prices were still about 30 percent lower than those of the United States, the EU, and Japan (frontier producers), about 10 percent lower than those of Brazil, Russia and Turkey, and about 15 percent higher than those of China (Figure 2.5b). However, moving up the price ladder correlates with the level of economic development and the level of export sophistication (see Chapter 4). The higher the GDP of a country, the higher the price of its exports relative to other producers (Figure 2.5c). Ukraine is not an outlier anymore in terms of this correlation and hence going forward, TOT gains due to unit value increases will have to be earned through investments and technological upgrading, where Ukraine has lagged. Figure 2.5a: Export Unit Value Figure 2.5b: Unit Value Figure 2.5c: Correlation Growth Gaps of Ukraine's Export Between Unit Value Gaps and Basket GDP 140 30% 30% Export unit value growth 20% 120 20% (cumulative 200106) 10% 10% ch 100 0% ua -10% 0% 80 -20% br ru po -10% 60 -30% tu ko -40% -20% 40 ja -50% -30% 20 -60% eu / ge us -40% Turkey Japan Russia Brazil United States Switzerland Poland China European Union Ukraine Korea, Rep. 0 -50% World (all goods) Frontier producers Ukraine (Ukraine's core sw (Ukraine's core export exports bundle) -60% bundle) 0 10000 20000 30000 40000 50000 Source: State Statistics Committee, Comtrade, Bank staff calculations. 2.11 On the import side, the pricing of natural gas imports has been highly beneficial for Ukraine's TOT, until 2009. Since the breakup of the Soviet Union, the price of gas imports for Ukraine was set annually together with the transit fee collected by Ukraine for Russian gas transported to Europe. De facto, there was a barter transaction of gas-for-transit that covered 7 The forty-four largest value 6-digit lines (COMTRADE, HS1996 classification) accounted for 53 percent of Ukraine's export in 2006. It included all the lines with exports over USD200 million, and largest positions of groups 84-87. 8 These include United States, European Union, Japan and Switzerland. 10 part of the demand, while the remaining volumes were imported at a fixed price. Between 2000 and 2005, the weighted price was around USD60 per thousand cubic meters (tcm). Since 2006, Russia de-coupled pricing of gas imports from the gas transit fee and paid the latter in cash, but the principle of annual price determination remained in place through 2008, with annually renegotiated price increases. In January 2009, this was substituted by a formula-based pricing linked to lagged dynamics of oil prices, with a 20 percent discount applied in 2009. The dynamics of actual price of Ukraine's natural gas imports and a hypothetical formula-based price calculated backward using the historical oil-price dynamics shows that Ukraine has been paying on average USD116/tcm less in 2000-2008 than had a formula-based pricing been in place (Figure 2.6a). To put Ukraine's formula into a regional perspective of natural gas prices, Figure 2.6b presents the unit values of gas imports in selected European countries in 2008. This confirms that gas prices without the discount in Ukraine correspond roughly to prices in Austria, Hungary and the Czech Republic while prices in Germany and the Baltics are lower. Figure 2.6a: Recalculation of Import Gas Prices Figure 2.6b: Average Prices Paid in Selected Based on the Current Formula (and discount) vs Countries Actual Prices Paid 500 500 450 price of natural gas in 2008, USD/mcm 450 formulabased price with 20% discount 400 400 350 full formulabased price 350 (without 20% discount) 300 300 actual price 250 200 250 USD 150 200 100 150 50 100 0 Austria Moldova Germany Hungary Slovakia Ukraine Romania Belarus Lithuania formula (Ukr) Latvia Czech Rep 50 0 Source: State Statistics Committee, World Bank, Comtrade, Bank staff calculations. 2.12 The implied subsidy owed to the underpriced natural gas imports averaged 7.6 percent of GDP during 2000-2008. The formula, agreed in January 2009, gives a natural benchmark for the calculation of the subsidy Ukraine has been benefiting from during the last decade. Figures 2.7a and 2.7b present the annual estimation of the gas subsidy in USD terms and in percentage of GDP using both the full formula, applicable since 2010, and the formula with a 20 percent discount applied in 2009. When Ukraine's economy bottomed in 1997-1999, Ukraine was actually paying higher prices than the market, so the subsidy was negative. As the economy recovered after 2001, the annual subsidy averaged USD6 billion according to the full formula9, and USD 3.8 billion according to the formula with a discount. The transfer to market gas pricing in 2009 exacerbated the economic decline. Following the sharp downward adjustment of oil prices, gas prices in Europe declined in 2009 compared to 2008 (the formula indicates 26 percent decline y/y), whereas in Ukraine imported gas price increased by 22 percent y/y. The relative 9 The full formula-based subsidy could be considered as a ceiling for the subsidy, since it reflects the pricing in the countries that tend to pay highest price for gas. For instance, using Germany's import prices would result in lower estimated subsidy. 11 cost advantage for Ukraine during the period 2001-2008 was sharply reversed, and this event coincided with other negative macroeconomic external developments. Figure 2.7a: Import Gas Subsidy 1997-2009 Figure 2.7b: Import Gas Subsidy 1997-2009 (in USD) (as % of GDP) 14000 12% Value of subsidy (with 20% discount), USD mln 12000 10% 10000 Value of subsidy (with full formulabased price), 8% USD mln 8000 6% 6000 4% 4000 2% 2000 0% 0 2% Subsidy (with 20% discount), % GDP 2000 4% Subsidy (with full formulabased price), % GDP 4000 6% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: State Statistics Committee, World Bank, Bank staff calculations. Capital Inflows 2.13 A surge of capital inflows in the second half of the 2000s boosted domestic demand (Figure 2.8a). Private external debt increased from USD12.5 billion in 2003 to USD86.1 billion at its peak in the third quarter of 2008. This trend was dominated by commercial bank borrowing, with banking sector external debt soaring from USD1.7 billion to USD44 billion during the period. Corporate debt also increased substantially at a pace of 5 percent of GDP per annum. On the other hand, and on the back of favorable external conditions and revenue buoyancy, general government debt was declining (up to mid-2008). As a result, external debt accumulation exceeded inflows of generally more stable FDI, which averaged 5 percent of GDP per annum, and portfolio investments (Figure 2.8b). Figure 2.8a: Changes in External Debt by Figure 2.8b: External Inflows Sectors, 2004-09 20% 0.3 15% 0.25 Debt 0.2 10% 0.15 5% Portfolio 0.1 investment 0% Other sectors 0.05 FDI 5% Banks Monetary Authorities General Government 0 10% 2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009 0.05 Source: State Statistics Committee, World Bank, Bank staff calculations. 12 2.14 The reversal of private capital inflows resulting from the crisis was partly compensated with public debt accumulation, mostly from official financing. In the fourth quarter of 2008, banking sector inflows sharply changed direction. Over a quarter of this sector debt was repaid by the end-2009--in 2009 alone, Ukrainian banks repaid debt equivalent to over 7 percent of GDP. Early engagement with the IMF in late 2008 secured sizable balance of payments and budget support, accompanied by other sources of official financing (including from the World Bank) that helped to compensate the reduction of private debt. Due to the substantial depreciation of the real exchange rate and the economic downturn, external debt increased to over 90 percent of GDP by the end of 2009. Monetary and Exchange Rate Policies 2.15 Monetary policy, dominated until 2008 by a de-facto pegged exchange rate regime, led to unstable inflationary dynamics. Before the last quarter of 2008 monetary policy was dominated by the de-facto peg exchange rate regime. Abundant global liquidity and rapid accumulation of private external debt translated into expansionary monetary policy. Over 70 percent of base money creation prior to the crisis was due to the accumulation of foreign currency reserves by the National Bank (Figures 2.9a, b, c). As a result, consumer inflation has been unstable, subject to international price shocks and changes in global monetary conditions. The CPI posted deflation in 2002, reverted to a double-digit price growth by 2003, and peaked at over 30 percent y/y in May 2008 in the wake of global food price inflation and ample global liquidity. Money growth exceeded 40 percent annually in most years, and private sector credit expanded by over 60 percent in 2006-2008. The crisis changed the monetary policy stance, and the loss of foreign exchange reserves in defense of the currency has been compensated by the active refinancing of the banking system and by credit to the government. Figure 2.9a:Money Supply Figure 2.9b: Composition of Figure 2.9c: Real and Nominal Growth and Inflation the Monetary Base Exchange Rate 90 80% 140 4 Claims on private sector M3 CPI Other claims, REER 80 4.5 60% net UAH/USD 70 130 % GROWTH YoY 5 60 40% Claims on other 120 5.5 50 sectors 6 40 20% 110 Net claims on 6.5 30 0% Government 100 7 20 20% Claims on 7.5 10 90 depository 8 0 40% corporations 80 8.5 10 NFA M1 2000 M6 2000 M4 2001 M9 2001 M2 2002 M7 2002 M5 2003 M3 2004 M8 2004 M1 2005 M6 2005 M4 2006 M9 2006 M2 2007 M7 2007 M5 2008 M3 2009 M8 2009 M11 2000 M12 2002 M10 2003 M11 2005 M12 2007 M10 2008 60% 2000m6 2001m4 2001m9 2002m2 2002m7 2003m5 2004m3 2004m8 2005m1 2005m6 2006m4 2006m9 2007m2 2007m7 2008m5 2009m3 2009m8 2010m1 2000m1 2000m11 2002m12 2003m10 2005m11 2007m12 2008m10 20002008Q3 2008Q42009 Source: State Statistics Committee, National Bank of Ukraine, Bank staff calculations. 13 Financial Sector 2.16 Fueled by external borrowing, Ukraine's banking sector assets grew at record levels between 2005 and 2008, accumulating risks along the way. The loan portfolio grew from 9 percent of GDP in 2000 to 77 percent of GDP in 2008, yet deposits reached only 37 percent of GDP by that year (Figure 2.10). Growing consumption was further fueled by aggressive consumer lending whilst the soaring mortgage portfolio helped to inflate a real estate bubble. Regulation and supervision were unable to catch up with lax credit policies and connected lending in this fast-growing sector. By the end of 2008, banks' external borrowing stood at 40 percent the loan portfolio, with a weak maturity structure. The deposit base was (and remains) predominantly short-term, with one-third in sight deposits and almost two-thirds with a maturity of less than one year. Nearly 58 percent of the loan portfolio in 2008 was denominated in foreign currencies (primarily in US dollars). Figure 2.10: Loan to Deposit Ratio in Ukraine Banking Sector, 2004-10 Loans to deposits 240% 220% 200% 180% 160% 140% 120% 100% 80% 2004m1 2004m5 2004m9 2005m1 2005m5 2005m9 2006m1 2006m5 2006m9 2007m1 2007m5 2007m9 2008m1 2008m5 2008m9 2009m1 2009m5 2009m9 2010m1 Source: National Bank of Ukraine; Bank staff calculations. 2.17 The devaluation and the sharp export and demand contraction triggered a rise in non-performing loans (NPLs) and a crisis of confidence among depositors. The drop in export demand hammered the corporate sector and devaluation of the UAH hit un-hedged borrowers, particularly in consumer lending. Foreign banks were affected more by depreciation, as the structure of their portfolio was more vulnerable to consumer lending (mostly mortgages denominated in USD) and corporate lending. The crisis also eroded the deposit base. Between the third quarter of 2008 and the first quarter of 2009, the banking sector lost nearly 25 percent of deposits. A bank rehabilitation strategy, elaborated with IFI support, helped stabilize the situation. Systemic banks underwent stress tests and were asked to put in place recapitalization plans. Three domestic banks were nationalized and recapitalized by the state, two more were intervened (one of them, Nadra, is still not resolved), and several small banks were liquidated. However, NPLs were still rising in the first half of 2010 and without additional capital injections, consolidation of the fragmented banking sector with over 175 banks, and improved transparency and governance, the sector looks set for further deleveraging. Fiscal Policy 2.18 The economic boom masked growing structural deficits since 2004. Cash fiscal deficits during 2001-2008 averaged 1.9 percent GDP, but in 2009 the general government fiscal deficit on cash basis was 8.7 percent of GDP (including Naftogaz but not including the costs of 14 bank recapitalization).10 While the headline deficits during 2001 and 2008 looked moderate, the underlying structural imbalances were much larger. Figure 2.11 shows the actual cash balance, a cyclically adjusted balance11, and a corrected structural balance (that aside from being cyclically adjusted is corrected for terms of trade dynamics).12 The results of Figure 2.11 show a highly pro-cyclical fiscal policy in Ukraine. As a result, policies exacerbated the boom and left little room for maneuver to respond when the shocks occurred. Figure 2.11: Cash vis a vis Structural Balances, 2001-10 2 0 2 As % of GDP 4 6 8 Fiscal balance Structural fiscal balance (output gap) 10 Structural fiscal balance (output gap and TOT) 12 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Ministry of Finance, National Bank of Ukraine, Bank staff calculations. 2.19 The structure of public expenditures worsened. Between 2003 and 2009, public expenditures increased by over 10 percentage points (p.p.) of GDP (almost one-third) to 47.2 p.p. of GDP (Figure 2.12a). The fiscal expansion was driven by increases in public consumption (4.8 p.p.) and transfers (6.5 p.p.), as successive governments hiked public sector wages and pensions. Pensions expenditures hit a record high close to 18 percent of GDP, one of the highest in the world (Figure 2.12b) following a steady increase from 9.2 percent of GDP in 2003. Public sector wages reached 11.6 percent of GDP in 2009, driven by sharp increases and lack of reforms in social services such as education and health.13 On the other hand, capital expenditures declined by over 2 p.p. Capital investments in infrastructure averaged just 2 percent of GDP over the last decade, generating a significant backlog of needed public infrastructure (see section C in this chapter). 10 This includes Naftogaz but not the costs of bank recapitalization, which amounted to 2.3 percent of GDP. The bank recapitalization cost was agreed to be a below-the-line adjuster under the IMF's SBA. 11 Cyclically-adjusted fiscal balance indicators estimate the fiscal balance if output were at its potential level. For this exercise quarterly real GDP series were de-trended using the Hodrick-Prescott filter. 12 The terms of trade effect was calculated using deviations of the gas import price from the formula-based price on the import side; and on the deviations of the steel export price from constant real steel price in the European market. 13 These sectors are overstaffed and highly inefficient in the supply side (see the World Bank's PFR II 2008). The budget spends 6.3 percent of GDP on education and 3.7 percent of GDP on health. 15 Figure 2.12a: Expenditure Structure 2003 vs. 2009 Figure 2.12b: Pension Expenditures as % of GDP, Cross-Country Comparison 1/ 60 18 Fiscal Structure as % of GDP other 16 50 14 capital 12 40 transfers 10 investment 8 30 6 subsidies 4 20 transfers 2 10 0 consumption 0 2003 2009 1/ Data for Ukraine for 2009; all other countries 2008. Source: State Statistics Committee, Ministry of Finance, World Bank, Bank staff calculations. 2.20 The tax structure improved between 2003 and 2009 and a number of positive reforms took place, but the marginal rates on direct taxes, the average tax burden, and tax compliance costs remain high. Over the past few years Ukraine has made progress in tax policy and administration. In particular, it curtailed a significant number of tax exemptions and loopholes in 2005 (although many remain), ended the practice of issuing tax amnesties, streamlined the system for the corporate income tax (CIT), reformed personal income tax (PIT), improved revenue mobilization in the VAT, and increased excise taxes. Notwithstanding the progress, much remains to be done. The tax structure remains biased toward direct taxes, which tax labor and capital heavily with high marginal rates (Figure 2.13a and Table 2.2). Fiscal revenues reached 41 percent of GDP in 2009, out of which tax revenue accounted for more than 35 percent of GDP. This level of tax burden is close to the average for new EU member states but well above that of other emerging economies and economies at similar per capita income elsewhere. Moreover, Ukraine continues to rank poorly in international comparisons and domestic surveys due to high compliance costs, including the burden of tax inspections.14 Figure 2.13a: Tax Burden Across Countries (2008) Table 2.2: Tax Rates on Payroll Taxes (Social Insurance Contributions), Cross- Country Comparison 50 Payroll Taxes (Social Insurance Contributions) 45 Country Employer's share Employee's share Total 40 Belarus 39.6 1.0 40.6 35 Croatia 17.2 20.0 37.2 30 25 Georgia 20.0 0.0 20.0 20 Kazakhstan 17.0 10.0 27.0 15 Latvia 24.1 9.0 33.1 10 Lithuania 31.2 3.0 34.2 5 Moldova 28.0 5.0 33.0 0 Poland 20.4 25.4 45.8 Germany Hungary Ireland Greece Italy Japan New Zealand Poland Iceland Portugal Korea Slovenia Turkey OECD average Belgium Slovak Republic Canada Spain Czech Republic Belarus Finland Ukraine Switzerland United Kingdom United States Mexico France Russian Fed. 26.0 0.0 26.0 Serbia 17.9 17.9 35.8 Turkey 21.5 15.0 36.5 Ukraine 38.0 3.5 41.5 Source: State Statistics Committee, Ministry of Finance, World Bank, Bank staff calculations. 14 FIAS Tax Survey 2009 and Doing Businesses Indicators (2010). 16 2.21 Substantial fiscal pressures and challenges threaten stability and medium-term growth. The postponement of needed reforms over the last decade coupled with the external and domestic impact of the international economic crisis has brought fiscal pressures to the fore: Public infrastructure needs are large and essential to support growth. The World Bank's PFR I (2006) estimated core infrastructure investment needs at USD100 billion between 2006 and 2015. Given the type of basic infrastructure needed and the current investment conditions in the country, the lion's share of those needs would have to be met by the public sector. This would imply at least tripling the average level of public infrastructure spending done over the last years. Ukraine's demographic trends and the already large population of pensioners (more than 14 million) present significant sustainability challenges. The unreformed pension system and Ukraine's aging population threatens short-term fiscal viability (with growing deficits that are becoming un-financeable) and long- term sustainability (by 2020 there will be almost one pensioner for each contributor in the system, and the ratio will worsen sharply after that). Yet many pensioners receive a small pension in nominal terms. Reforms are needed to protect current and future pensioners and to ensure reasonable pension payouts that are more in line with contributions. The rapidly aging profile will also place pressures on service delivery (see World Bank PFR II), burdening the public health care system, particularly in the area of long-term care. These trends also affect the education system that has shrinking cohorts of students. Here quality needs to be improved to build up the skills demanded by the economy, but without spending additional resources. This will require a shift away from the Soviet-era input norms to pure student financing through the existing intergovernmental financing systems, which can only be done through staffing and network rationalization. The process of staffing and network rationalization is at the core of the reforms in both the health care and education systems. Marginal rates on direct taxes and the average tax burden need to be reduced. It is important to create a more stable and less onerous tax system (in policy and administration) that has a broadened base and attracts investors. The public and publicly guaranteed debt level is growing and needs to be stabilized and reduced over time. The current weak fiscal position and the lack of up-front action to rein in the deficit will significantly increase debt. Without corrective measures this may raise the costs of external financing as capital markets become more selective. There is thus a significant risk of crowding out private investments by raising the cost of finance both domestically and externally. All of the above needs to be tackled in the context of prudent deficit targets whilst gradually reducing the footprint of government in the economy to crowd in the private sector. A program of creating and reallocating fiscal space under all those constraints is urgently needed. 17 What Can be Expected Ahead? 2.22 The 2001-2008 growth drivers are not likely to be present in the same order of magnitude over the medium term. First, international capital markets have become more risk averse and more selective within the portfolio of emerging economies. Banks that deleveraged significantly in 200915 are likely to shore up their balance sheets in 2010 and only expand credit in 2011, and not at the pre-crisis growth rates. Second, terms of trade gains are likely to be positive in 2010 with commodity price recovery, but may remain close to zero for the three years thereafter. The real exchange rate is not far from equilibrium, so competitiveness through exchange rate adjustments is limited. Fiscal expansion is not possible or advisable in the context of existing fiscal pressures and the required fiscal consolidation lying ahead. Finally, capacity utilization will soon return close to pre-crisis levels, not allowing output growth without the corresponding investments that have become harder to finance. 2.23 This implies that Ukraine's growth will have to rely more on significant productivity gains driven by structural reforms (including fiscal reforms), whilst preserving macroeconomic stability. In the context of a country with a daunting range of reform needs, the question is where to start. The next section and subsequent chapters, through different perspectives, aim at examining key constraints to growth and the best policy options to address them. B. GROWTH ACCOUNTING 2.24 This section focuses on assessing the role of different factors of production--capital, labor, and technological progress or productivity--to explain the dynamics of growth. It looks at the production function of the economy at the aggregate level, analyzing productivity performance and investment efficiency. This is a useful and illustrative way to examine growth and its components. 2.25 Productivity growth explained over 40 percent of growth over the period of 2003- 2008. Figure 2.14a shows the annual growth decomposition, while Figure 2.14b represents the same information as contributions to growth in p.p. of GDP. Total factor productivity (TFP) accounted for more than half of GDP growth in the boom years of 2003-2004 and in 2006, it was close to zero in 2005, and became negative in 2008 as the economic crisis unfolded. Capital stock growth on average explained 55 percent of GDP growth whilst labor force growth was negligible.16 The high explanatory power of the capital stock is backed by high investment demand and growing inflows of FDI. An important element of the analysis and the understanding of the productivity dynamics is the distinction between the effective and idle capital stock. With the capital stock adjusted for actual capacity utilization, the contribution of changes in effective capital becomes larger and the role of TFP growth smaller. 15 External debt roll-over rate for commercial banks was 76 percent in 2009. 16 Given the high capital intensity of the Ukrainian economy, this analysis uses a share of capital of 40 percent and the labor of 60 percent in the growth accounting exercise and in the estimation of the return on capital. 18 Figure 2.14a: Growth Decomposition, Percent Figure 2.14b: Real Growth Rate Decomposition, Percentage Points 100% 0.15 80% 60% 0.1 40% 0.05 20% 0% 0 20% 40% 0.05 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008 Real value added growth rate due to capital % real value added growth due to capital % real value added growth due to capital adjusted for capacity utilization Real value added growth rate due to capital adjusted for capacity utilization % real value added growth due to labor Real value added growth rate due to labor % real value added growth due to TFP Real value added growth rate due to TFP Source: State Statistics Committee, Bank Staff calculations. 2.26 The relative importance of productivity growth and capital stock growth changed dramatically between the periods of 2003-2004 and 2005-2008. Prior to 2005, productivity growth explained most of GDP growth--57 percent--while after 2005 the capital stock dominated with 62 percent average contribution. Within the capital stock contribution, the share explained by rising capacity utilization shrank during the latter period, as the economy began to exhaust its idle capacity. The observed dynamics from the growth accounting exercise are consistent with the pattern of Ukraine's external competitiveness, which was high during the earlier period and then declined relatively, with growth driven increasingly by domestic consumption. C. GROWTH DIAGNOSTICS: A BIRD'S EYE VIEW 2.27 Summary indicators of reform progress, such as those produced by the EBRD, suggest that by 2009 Ukraine had achieved a level of reform progress not dissimilar to the new EU members in the second half of the 1990s. But it also suggests that Ukraine failed to close the gap in terms of structural reform with countries such as Bulgaria, Romania and other new EU members. Other cross-country rankings, including the World Economic Forum Global Competitiveness Index, similarly suggest that Ukraine lags many of its peers in Eastern Europe, as well as the more advanced middle-income countries. While a number of reforms have been achieved over the last 10 years (Box 2.1), the pending reform agenda in Ukraine is vast and thus a sense of priority is urgently needed. 19 Box 2.1: Highly Positive Reforms/Actions Taken by Ukraine Between 2000 and 2008 WTO accession (and all reforms embedded in this process) Reduction of non-payments and barter transactions, especially in budget-related transactions and the energy sector New Joint Stock Company law adoption that brings corporate governance closer to OECD standards Agricultural land titling Allowing entry of foreign banks Adoption of the Budget Code, establishment of the budget classification system and introduction of equalization formula into inter-governmental fiscal relations Establishment of the Treasury system, including Treasury Single Account that services the budgets of all levels of government Creation of internal audit function and improvement of available fiscal information Reduction of tax expenditures, including dismantling FEZ loopholes Introduction of flat rate for personal income tax TIMMS implementation and independent evaluation/examination in schools 2.28 This section attempts to narrow down key reform priorities by analyzing the potential medium-term constraints to growth prior to the crisis, how these evolved during the crisis, and implications for the path ahead. To have an initial bird's eye view of the key issues constraining potential economic growth, we use the Hausmann, Rodrik, and Velasco (2005) framework (see Annex 2.2). This framework helps to break the growth process down into its main constituent parts. It tests the severity of constraints to growth by looking at market information such as rates of return and price of inputs. The basic intuition is if a particular factor represents a binding constraint on growth the price for its removal should be high, as reflected in shadow prices for factor inputs, as well as other quantitative and qualitative data. Policy makers are then able to develop targeted and sequenced measures to tackle these constraints. This is particularly helpful in a country like Ukraine where the scope of the reform agenda is very broad. Was (and is) High-cost Finance a Problem for Ukraine's Growth? 2.29 When costs of finance are high, investments (and their returns) may not be realized even if they have potentially high social returns and/or if returns are easily appropriable. The evaluation of finance costs shows that prior to the crisis foreign and domestic savings were available at reasonable rates to the private sector in Ukraine, and thus financing was not a binding constraint to growth. However, following the crisis, and with credit to the economy halted, access to capital has become a key short-term constraint to accelerate growth. Whether this constraint is overcome is critically linked to reforms in the banking and financial sector and to macroeconomic management, as discussed elsewhere in this report. 2.30 The spreads for Ukraine prior to 2007 were not too different from the average for emerging markets. Between 2004 and 2007 the cost of finance was not a key problem and Ukraine was able to tap external savings to complement reasonably high domestic savings. But slippages in economic management (as discussed earlier) linked to political instability and a deteriorating external environment pushed spreads to record heights in early 2008 and through 20 2009 (Figure 2.15a). This, coupled with the process of shoring up balance sheets in financial institutions worldwide, practically closed external borrowing for the country--private external debt roll-over rates were 82 percent in 2009. While spreads have come down from the heights of the crisis, medium-term borrowing costs could be affected if appropriate macroeconomic and structural policies are not implemented and sustained. 2.31 Domestic financing, intermediation costs, and access to capital were not major constraints to growth prior to the crisis. Ukraine's level of domestic savings is not low compared to other emerging economies (Figure 2.15b). The costs of intermediation have gradually come down with the development of the banking sector, and while administrative costs seem to be relatively higher than in comparable countries, this did not seem to be an important constraint in the context of the credit boom (Figure 2.15c). Nevertheless, domestic savings have been coming down steadily since 2004 in tandem with the switch to a consumption-based growth model, a trend that accelerated in the crisis. Ukraine will need to rely on increasing domestic resource mobilization to re-launch credit growth post crisis and thus reestablishing trust in the financial system is a key short-term constraint to growth. Figure 2.15a:Spreads of Figure 2.15b: Savings as % of GDP, Figure 2.15c: Emerging Countries and Cross-Country Comparison Intermediation Costs Ukraine Trends In Spreads (2002-2010 daily) Savings (as % of GDP) for Selected Countries 30 4000 Lending Rate minus Deposit Rate in Ukraine Soverign Bond Banking (period averages) 3500 35 25 Spreads 3000 EMBI Global 30 Ukraine 20 2500 2000 25 Peru % Ukraine 15 bsp 1500 20 Poland 1000 10 Mexico Brazil 15 500 5 South Czech 0 10 Africa Republic 12/13/2002 10/28/2005 12/26/2007 8/5/2002 4/25/2003 9/3/2003 1/14/2004 5/24/2004 9/30/2004 2/10/2005 6/21/2005 3/13/2006 7/19/2006 11/27/2006 4/9/2007 8/15/2007 5/6/2008 9/12/2008 1/23/2009 6/3/2009 10/9/2009 2/22/2010 0 5 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Bloomberg, State Statistics Committee, National Bank of Ukraine, WDI, Bank staff calculations. Are Low Social Returns a Constraint for Growth? 2.32 Even when capital is available cheaply, the lack of complementary factors such as human capital, public goods (particularly infrastructure), and location may affect private sector returns and thus growth. The evaluation of these issues in Ukraine shows that geography is definitely an advantage rather than a constraint. On the other hand, the limited and deteriorating infrastructure is unable to support the private sector (particularly exporters) and is potentially a binding constraint to accelerate and sustain growth. The analysis is less conclusive with regards tohuman capital and skills when looking at shadow prices (i.e., returns on education), but there is evidence of an increasing problem of lack of technical skills required by fast-growing firms. 21 Is Poor Geography an Issue for Ukraine? 2.33 Ukraine has an enviable strategic location. It is the natural east-west corridor between Europe and Eurasia (through Russia). It has ports in the Black Sea that connect Turkey, the Caucasus countries and the Middle East with northern Europe. It borders four European Union countries, and thus has a direct connection with one of largest economic markets in the world. Geographic obstacles are thus not a binding constraint on growth. Is Human Capital a Constraint? 2.34 Ukraine has low returns to education, indicating that there is no shortfall of human capital. While more schooling is associated with less unemployment (e.g., unemployment rates for those with only high school education was higher than for those with university degrees), Ukraine's returns to education are nonetheless low. The latest measure of the annual rate of return to an additional year of education done for this report was just 5.2 percent. This is low compared to other transition countries or any emerging economy (Figure 2.16), and the same indicator for 2003 was also low, suggesting that no significant improvements have taken place. Most transition countries showed low returns to education in the early years of the transition period but increased sharply thereafter, except for Ukraine (Reilly and Newell 1999; Flabbi, Paternostro and Tiongson 2007). In the mid-1980s, the returns to schooling were lower in Russia than in Ukraine, and schooling levels were the same. By the mid-1990s, returns to schooling in Russia increased significantly to surpass the stagnant returns in Ukraine (Gorodnichenko and Sabirianova Peter 2005). This would seem to indicate that the there is no market premium for education in the country, suggesting that human capital should not be a constraint to growth. Figure 2.16: Returns to Education--Cross-Country Comparisons 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1991 1997 1998 1999/2000 2002 2007 Czech Hungary Poland Russia Ukraine1 Ukraine2 Ukraine3 Source: Ukraine1: ISSP 2008, Ukraine 2 G&P 2005 (comparable to Ukraine1), Ukraine3: ULMS 2003 and 2007 from Table 2, all other countries: ISSP 2007. 2.35 However, the data behind the calculation of this shadow price may be biased. There is significant wage compression in Ukraine's economy. One of the main drivers for wage compression is the underreporting of wage income, which in turn is encouraged by high marginal rates on payroll taxes.17 This may be driving the low estimated returns. Another way to check if 17 The large shadow economy in Ukraine consists mainly of firms and individuals that, while having some sort of official registration, under-report a significant share of their income and wages. 22 human capital may be a binding constraint for economic activity is to ask enterprises directly about their demand for skills. The Business Environment and Enterprise Performance Survey (BEEPS) reveals that a large percentage of firms report a lack of adequately educated personnel as a key constraint to further expansion of sales. The percentage of firms with this response in Ukraine is much higher than the average for the region (see Chapter 4, section D). Moreover, firms that are growing faster more often point to this issue as a key constraint to growth than those that do not. In summary, there are some indications of a labor supply and demand mismatch that may be related to education. Thus, adequate skill provision through an education system that is responsive to labor demand, as opposed to pure level of schooling, maybe a critical factor in sustaining growth in the long term (see Ukraine's Public Finance Report 2008). Is Poor Infrastructure a Binding Constraint? 2.36 Ukraine has spent little compared to other emerging economies in public fixed capital investments over the last 10 years. Emerging economies, particularly those that had growth episodes lasting more than 10 years, have been spending at least 7 percent of GDP annually on capital investments (Growth Commission Report 2008). Ukraine has been spending an average of 2 percent of GDP over the last 10 years in fixed capital expenditures (Figure 2.17a). Public expenditures in this category further collapsed in the crisis to around 1 percent of GDP. The infrastructure needs in Ukraine are significant, as highlighted by the World Bank's PFR I for Ukraine (2006) (Figure 2.17b) Figure 2.17a: Public Fixed Investments and Figure 2.17b: Infrastructure Needs 2006-2015 Gross Fixed Capital Formation, Average 2000- 2009. 8.0% 35% Annual Average Public Investment Needs in Basic Infrastructure Public (fixed as % of GDP (2006-2015) 7.0% 30% Capital) 7 6.0% Invetsments 25% 6 5.0% 20% 5 4.0% Gross Fixed 15% Capital 4 Average 3.0% formation as % last of GDP (Average 3 10% decade 2.0% 200008 and 200009 for 2 1.0% 5% Ukraine) 1 0.0% 0% Lower Middle New EU OECD Average Ukraine 0 Income Members (EU Lower Middle Income Upper Middle Income Ukraine 8) Average Source: Growth Commision paper and WB Ukraine PFR I Source: State Statistics Committee, Bank staff calculations. 2.37 Ukraine's limited and deteriorated infrastructure seems unable to support private sector growth. Key areas such as transport, logistics and energy are the most affected by under- investment. But under-provision of infrastructure can be seen across the board, including in water, heating and other urban and social services (Figure 2.18a). Weaknesses in transport and logistics infrastructure may become increasing constraints to Ukraine's international competitiveness. The country's relative performance in this dimension has been sharply declining since 2007 (World Bank Logistics Performance Index, 2007 and 2010). Firm-level 23 data from the BEEPS confirms problems due to weak infrastructure (Figure 2.18b). Existing infrastructure is deteriorating rapidly and is clearly inadequate to help support recovery and growth over the medium term. Infrastructure seems to be a short and medium-term binding constraint to growth in Ukraine, to which this report returns in subsequent chapters. Figure 2.18a: Road Network Density, Cross- Figure 2.18b: Transport Infrastructure as a Major Country Comparison. Constraint for Firm Growth km/1000 sq Km Road Network Density Road network density (km/1000 Percentage of Firms reporting Transportation as sq Km), 2006 a major/severe constraint 1.6 ECA Average 1.4 30 1.2 25 1 20 0.8 15 0.6 10 5 0.4 0 0.2 0 France Poland OECD Upper ECA Turkey Ukraine Middle ECA Source: Fiscal Policy and Growth in ECA (2007); BEEPS (2009); Bank staff calculations. Is Low Appropriability a Constraint for Growth? 2.38 Even when financing is available and social returns are high, a lack of appropriability of returns due to government policies and weak institutions may discourage investment and dampen growth. The evaluation finds that problems of appropriability are a key constraint to growth. Appropriability problems arise mainly from poor governance and corruption in the interactions of the public sector with private agents (including through the outdated regulatory system), deficiencies in property rights, macroeconomic instability, and high marginal tax rates. They have resulted in high entry and exit barriers and low levels of competition. All this has been compounded by the lack of confidence in macroeconomic management, particularly on the fiscal side. Prior to the crisis, and in the context of fast growth, high profits and low competition, many of these issues were accounted as a large "extra tax" at entry and throughout operation. Under current conditions, and beyond in the post crisis period with more limited profit opportunities, they are even more biding constraints to growth than before. Are there government failures? 2.39 A mixed implementation of the macro stabilization program in 2009 and early 2010, intertwined with political instability, have kept capital inflows away. As discussed in Section A of this chapter, prior to the crisis the ever-increasing fiscal transfers, income policies, loose monetary policies (in the context of a fixed ER), and weak regulation and supervision of the banking sector led to the overheating of the economy. These worrying developments in the context of the early signs of a potential international crisis in early 2008 led to a sudden stop in capital inflows. Outflows of capital and leakages of deposits from the banking sectors followed later that year and into 2009. While macroeconomic policies were not a constraint on growth 24 prior to the crisis, they failed to build resilience against external shocks and more appropriate fiscal, monetary and financial sector policies will be critical in aiding the recovery. 2.40 Contractual and property rights became more secure after 2005, but concerns over weaknesses in governance and the rule of law continue to loom large. FDI and overall capital inflows increased marginally but steadily between 2000 and 2004 as memories of hostile takeovers, prominent during the late 1990s and early 2000s, were still fresh. A sense of greater security of property rights and improved governance after the so-called "Orange Revolution" helped the surge of FDI to Ukraine after 2005. Cumulative FDI tripled between 2004 and 2007. Net capital inflows accounted for 10.8 percent of GDP on average in 2005-2008. Foreign investors felt more secure about their investments in the country, even though the legislation and the enforcement of the laws around property rights did not materially change. The worldwide visibility of the Orange Revolution also gave Ukraine significant prominence as an untapped market with large potential given its location in Europe and its sizeable domestic market. WTO accession, achieved in 2007, and the approval of a modern joint stock company law in 2008 provided some additional security to investors. However, to sustain FDI inflows in a more risk- discerning international environment, Ukraine will need further improvements in the legislative and regulatory framework, and above all more consistency in implementation. 2.41 Significant deficiencies remain in land and real estate, contractual, and intellectual property rights. An efficient unified registration system of land and real estate does not exist and the land registration process is plagued by concerns over governance. A moratorium on agricultural land sales has been in effect since 2001 and has deterred greater investment in one of Ukraine's most promising export sectors.18 Intellectual property rights face a number of unresolved issues such as geographical indications, registration of medical products, copyright obligations and deterrent sanctions. More broadly, the harmonization of the patent system for process and products is still on-going. Even when the legal framework is adequate, enforcement of legal rights through the courts is highly uncertain and the framework governing out-of-court settlement is underdeveloped. While there are several shortcomings in the area of property rights, by itself this issue was not a constraint to the growth experienced prior to the crisis, although the ban on agricultural sales had a significant effect on investments in the agriculture sector. In the new post-crisis context, with more risk aversion in capital markets, these problems may represent a much larger obstacle. These issues are further explored in Chapter 4. 2.42 Despite improvements in some policy aspects over the last decade, marginal rates on direct taxes are high. Fiscal revenues reached 41 percent of GDP in 2009, with tax revenue alone totaling 35 percent of GDP. This level of tax burden is close to the average for new EU member states but well above comparator countries (see section A of this chapter). A large portion of the tax revenues (more than 50 percent) still comes from direct taxes, which tax labor and capital at high marginal rates. But the shadow economy is large, between 47-52 percent of GDP (World Bank 2008; and Schneider et al. 2010). The shadow economy is mainly comprised by underreporting of income (including wage income and profits) to avoid the high marginal rates on direct taxes (see PFR I 2006 for more information), which are a more critical constraint than the average tax burden. 18 This measure was meant to be temporary but it has been renewed every year since. 25 2.43 Barriers to business entry, operation and exit are high. Ukraine ranks 134th out of 183 countries on the ease of starting a new business (Doing Business Survey), one of the worst in the region and among the worst compared to other emerging economies. Businesses have to comply with long list of permits, a protracted process of licensing, unnecessary mandatory certifications and other hurdles imposed by the outdated regulatory system. This may ingrain the existing low levels of product and market competition (Table 2.3). To close a business, shareholders have to go through a long, cumbersome, and costly process of liquidation before they can dispose of the remaining assets to start a different economic activity. It takes almost three years to close a business in Ukraine (Doing Business). Table 2.3: Cross Country Competition Rankings (2009) Intensity of Effectiveness of Domestic local Extent of market anti-monopoly competition competition dominance policy Germany 14 1 1 3 Korea 52 39 65 31 China 46 13 26 50 Poland 68 33 47 51 Brazil 120 52 35 36 Bulgaria 91 66 67 99 Romania 66 69 39 66 Russian Federation 105 106 92 107 Ukraine 122 111 91 111 Source: Global Competitiveness Report. 2.44 Entry and operation costs are particularly burdensome for growing sectors. For example, the food processing and light manufacturing sectors have heavy regulation imposed on them despite their high export growth potential. Lengthy and costly license and permit processes hinder entry and product diversification (see Chapter 3). The existing myriad inspection agencies in Ukraine generate significant losses of man-hours, costs, and distraction in their interactions with firms. Technical standards, sanitary and phyto-sanitary (SPS) and food safety regulations are outdated and not aligned with the EU, which increases costs and damages Ukraine's export potential. These issues are discussed in more detail in subsequent chapters. 2.45 Governance and corruption concerns are a key issue in Ukraine. Governance shortcomings are found in many interactions between individuals and firms with the public sector, including state-owned enterprises. Businesses complain about the absence of rule of law, excessive and unjustified hassles from regulatory and inspection authorities and an overall unlevel playing field fostered by weak governance in institutions (Ukraine Enterprise Surveys-- several years). Are Information and Coordination Externalities an Issue? 2.46 In addition to weak appropriability, coordination or information failures may also lead to sub-optimal investment in potentially attractive sectors. This may be revealed in different ways, for example as a lack of investment opportunities, low levels of diversification, or low levels of product sophistication in the export basket. The problems may be related to technology absorption, innovation, or other sector-specific constraints to growth. The analysis indicates that Ukraine is underperforming in export diversification and sophistication, and has been unable to improve the flow of technology to its economy. Chapter 4 offers a more detail discussion on these issues and how sector-specific binding constraints may be affecting these outcomes. 26 2.47 Limited export diversification has made Ukraine highly vulnerable to price shocks. More than 40 percent of exports are in the metallurgy industry, which has volatile prices in international markets. The world's real estate and construction bubble of this decade drove prices for Ukrainian steel well above historical averages, but they then collapsed in the third quarter of 2008. The stark decline of prices and demand for steel products led to a plunge in export revenues and contributed to bringing the real economy to its knees. While prices may recover over the next years this recovery is likely to be gradual, leaving Ukraine's economy without large TOT gains over the medium term. 2.48 Product diversification is low and export sophistication has improved less rapidly than in Ukraine's competitors. Export concentration data for Ukraine compared to other emerging economies point to a problem of diversification. The level of technology embedded in Ukrainian products seems to be relatively low compared to relevant international competitors (Figure 2.19a) (a deeper analysis of export sophistication can be found in Chapter 4). This may be driven by the lack of competition in Ukraine, which in turn is engrained by barriers to entry and other regulatory and governance factors that limit new domestic investments and FDI (Figure 2.19b). Despite an improved perception of security after 2005, joint ventures between Ukrainian and foreign partners remain at very low levels, hampering technology transfer. This type of partnerships is critical for knowledge transfer to emerging economies inside the technological frontier, such as Ukraine. Most FDI is channeled through 100 percent acquisition of existing companies. Figure 2.19a: Higher Technology Exports in Total Exports Figure 2.19b: Per Capita FDI 2000-8 Average Share of high tech products in total exports 300 250 200 Percentage of total exports 150 USD 100 50 0 Ukraine Russia Belarus Poland Romania ECA Source: World Bank ­PRED; ECA regional tables, Bank staff calculations 27 3. DIGGING DEEP: A CLOSER LOOK AT THE REAL SECTOR 3.1 This chapter looks at the sectoral level of the economy, analyzing productivity performance and investment efficiency. The results of the sectoral analysis are complemented with findings of case studies on key sub-sectors of Ukraine's real sector. By pairing quantitative and qualitative analyses, the chapter aims to distill patterns and identify key sectoral constraints to growth. A. MANUFACTURING 3.2 Total factor productivity (TFP) was the main driver of manufacturing growth over the last nine years, but it has been declining since 2004. Value added in manufacturing has been highly volatile, and this is mirrored by the pattern of changes in the capital stock adjusted for utilization rates. TFP and labor inputs have remained more constant, but TFP has been on a declining trend since 2003 (Figure 3.1a). The poor performance of manufacturing output in 2005 resulted predominantly from terms of trade effects, although political uncertainty also affected performance in the first quarter of 2005. The biggest contributor to value added among manufacturing sub-sectors in 2008 was the metallurgy industry, followed by food and agricultural processing and machine-building sector. 3.3 The rates of return on capital in manufacturing are high. Between 2002 and 2007, the average rate of return on capital was around 18 percent (Figure 3.1b), which is high by international standards. Manufacturing received significant FDI inflows throughout the period, although figures may be inflated owing to "thin capitalization schemes" that are pervasive in Ukraine.19 Relative to other sectors, FDI inflows to manufacturing became less important over time, mainly due to the rapid growth in inflows to the financial sector. Manufacturing sub-sectors particularly successful in attracting FDI were food processing, basic and fabricated metal products and machine building. Figure 3.1a: Growth Accounting-Manufacturing Figure 3.1b: Returns on Capital Manufacturing: Manufacturing: Real value added growth explained by factors of Average sectoral RoRK adjusted for capacity production utilization and sectoral FDI share in total 0.2 0.18 economy value added % real value added growth % changes in production factors 0.15 0.16 25% 7.0% 0.14 0.1 6.0% 0.12 20% 5.0% 0.05 0.1 15% 4.0% 0 0.08 10% 3.0% 0.06 2.0% 0.05 0.04 5% 1.0% 0.1 0.02 0% 0.0% 0.15 0 2002 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 changes in capital stock changes in labor force Average RoRK (left axis) FDI/VA Ukraine(right axis) productivity growth real value added growth Source: World Bank-PRED; Global Competitiveness Report, Bank staff calculations. 19 Thin capitalization is a scheme by which equity is shown in the books of a firm as debt owed to related companies, commonly located in tax havens or other lower corporate income tax rate jurisdictions with which Ukraine has a double taxation treaty (e.g., Cyprus). 28 3.4 The manufacturing sector's capacity to modernize has been uneven across and within sub-sectors. Two sub-sectors have undergone significant modernization of production: food processing and fabricated metal products. They have done so through FDI and borrowing. The former has been more predominant in the food processing industry and the latter in the metallurgy sector. The other two key sub-sectors in the manufacturing sector, chemicals and machine building, have been able to attract only modest investments and FDI. 3.5 Access to credit for the sector has become tight. Medium-sized enterprises are particularly affected, as they do not have access to foreign credit markets. Credit for working capital has tightened significantly, hampering flexibility in production and inventory. Long-term credit for new capital investments has been practically paralyzed, threatening the continuation of the sectoral modernization in the short run. 3.6 The rest of this section focuses on selected traditional and less traditional sub-sectors that are key to the industry and help to reveal key structural issues and specific sectoral constraints to growth. Metallurgy Sector 3.7 The metallurgy sub-sector was the fastest growing segment of manufacturing between 2002 and 2007, but much of the growth was price-driven (Figure 3.2). In the first half of the decade, idle capacity utilization was also an important growth driver. But worldwide steel production grew at the same pace as Ukrainian production, with Ukraine failing to gain substantial market shares. The unit price gains in steel were unprecedented for Ukrainian producers. While price growth favored Ukraine significantly, it also represented a significant vulnerability, as prices for steel products are notoriously volatile. Moreover, Ukraine's basket of metal products is mostly in the lower end of value added production of iron and steel (i.e., for construction and piping), which historically experience more price volatility. Before the crisis the sector represented roughly 10 percent of the output of the economy. In wake of the economic crisis, prices collapsed by over 40 percent (by late 2008). Capacity utilization in the sector reached close to 100 percent in 2007, up from around 66 percent in 2001, and is estimated to be around 90 percent by the end of 2010. Figure 3.2: Growth in Quantity and Price of Steel Exports 5 4.5 Steel exports volume, index 4 3.5 Steel exports unit value 3 (current USD), index 2.5 2 1.5 1 0.5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Comtrade; Bank staff calculations 29 3.8 Production increases and competitiveness depend heavily on investments (including in energy-saving technologies) and vertical integration. Several firms took advantage of the liquid credit market to leverage financing for plant modernization. Capital investments in the sector picked up in 2006 and 2007 with growth rates of 12 percent and 30 percent, respectively. Investment was mainly directed to the acquisition of new technologies, including pulverized coal injection (PCI) technology,20 replacing open-hearth furnaces to make operations more energy flexible and energy efficient. But many other firms also took profits from the boom times and did not invest significantly in modernization. Despite being less leveraged, the latter group may not be able to sustain profitability in the context of more subdued price and demand growth and potentially higher energy prices over the medium term.21 Steelmakers across the board do not have sufficient idle capacity to increase output in the next two to three years without immediate additional investments. Vertical integration through acquisitions to take advantage of key raw inputs is paying off for those groups that were able to acquire extraction assets such as iron ore and coking coal mines (see Annex 3.2 for details). Cheap and reliable access to those inputs is essential to maintain a low cost operation in the sector.22 3.9 Lack of skilled labor is reported by the industry as an emerging constraint. The survey of metallurgical companies commissioned for this report indicates that more than 25 percent of firms see the lack of labor skills as a major impediment, particularly for technical jobs. Managers in the industry suggest that while candidates have enough years of schooling, they do not have the technical skills required in the industry, particularly technical staff from vocational education and engineers from higher education. They point out that this problem has increased in importance over the last five years. Lack of skills seems to have driven wages up in the industry prior to the crisis for technical positions--the average wage in the sector is 30 percent higher than the average for the economy. But the sector also reflects the broader economy over the last eight years, with real wage growth outpacing labor productivity. 3.10 Transport infrastructure and policy have become serious obstacles for export competitiveness in the sector. The metallurgy sector suffers from limited transport infrastructure and logistics facilitation both in the import of inputs (e.g., iron ore and coking coal) and the export of final products. Due to deteriorated rolling stock and congested railroad infrastructure, the undersupply of wagons for metallurgical products is acute. In 2007, this caused contract infringements and a loss of trust among major customers. The existing complex/non-transparent tariff setting for railroad freight further distorts the playing field. The railways agency and the government continue to cross-subsidize passenger transportation with freight tariffs, which increases costs for the sector. The share of transport expenses in the cost of production is close to 8 percent in Ukraine, compared for example to 1.8-2.2 percent in Germany. Even though Ukraine has an extensive seaport network, ports are not suitable for handling cost-efficient supersized vessels due to insufficient depth and lack of support 20 Mittal Steel's acquisition of Kryvorizhstal in October 2005 helped to re-invigorate the modernization process in the sector. 21 Natural gas represents 7-15 percent of input costs in a steel mill, depending on the level of plant technology. Natural gas tariffs for industry increased by 220 percent in USD terms between 2005 and 2010 as they converge to market prices. 22 While Ukraine has significant reserves of natural resource inputs to the sector, it has failed to generate sufficient investments to exploit them productively. In some cases the quality of inputs, such as coking coal, is in short supply and thus the sector has to import more than one-third of this input (mainly from Russia). 30 infrastructure.23 Most of the cargo ports specialized in handling bulk cargo are close to their full carrying capacity,24 and it will be costly and difficult to expand them without a proper privatization process to bring fresh investments. Machine Building 3.11 The dislocation in production chains and low regional demand led to a sharp decline of the machine-building sector during the early years of the transition, but the sector recovered by 2008. Before the transition, machine building constituted 30 percent of total industrial output in Ukraine. The collapse of the Soviet Union led to a significant disruption of production chains in the sector, with some parts of the product made in Ukraine and others in Russia, Belarus and other Soviet republics. The economic situation and demand for Ukrainian products in other former Soviet republics, the core market destinations, worsened through the 1990s. By 2000, output in the machine-building sector constituted a third of the pre-transition level. The most affected were mining machinery, automotive, agricultural machinery, and aircraft and defense. Product lines such as railway rolling stock and equipment led the recovery in the early 2000s--in some areas with six-fold increases in sales between 2000 and 2007--as CIS countries renewed and expanded their capital stocks. Overall, the sector remains dependent on linkages with other CIS producers, with 40-60 percent of parts imported from other CIS countries. In some cases dispute over property and intellectual rights of products and processes continue to date. 3.12 Ownership changed but the industry was not modernized. Roughly 40 percent of the enterprises were state-owned in 1995, producing about 40 percent of sectoral output, while currently only 3 percent of the enterprises are state-owned, representing around 12 percent of output. FDI played no role in the ownership change, as most companies were privatized to domestic investors. Only a small portion of fixed assets (plant, machinery, and equipment) in the machine-building sector has been modernized. The wear and depreciation levels are the highest in the manufacturing sector, with roughly 60 percent of the machinery and equipment still dating from the Soviet era.25 The products themselves have changed only marginally, and most still show low levels of sophistication and thus have not been able to penetrate higher-end markets (see Chapter 4 for comprehensive discussion on export sophistication). 3.13 The sector is in need of new investment and technology. Without investment in new machinery and equipment, without significant FDI and partnerships with foreign firms to enable technological transfer, and without domestic policies and incentives to jump start innovation, the sector may have challenging times ahead. While the number of SOEs in the sector is reduced, they are large in size and are positioned in sectors that were highly sophisticated and have up- market potential (e.g., power turbines and aircraft). But investments in these sectors are constrained by the dividend policy of the government that does not allow for sufficient and 23 Pivdenny and Illichivsk are the only deep-water seaports that can receive Panamax vessels (50-65 thousand tons of dead-weight). 24 Ukrainian seaports handled 123.7 million tons of freight in 2007, close to the maximum capacity of about 130 million tons. 25 With an average age of the equipment between 25-30 years, according to State Statistics Committee data. 31 properly planned investment.26 The sector was (and through some SOEs remains) connected to the R&D laboratories of the Soviet era. Most of these laboratories maintain a cadre of well- trained scientists, but are unfunded, have lost ground technologically, and need young scientists to revitalize research. Within the companies themselves, well-trained engineers and specialists are an aging cohort (most are between 40 and 60 years old). In-depth interviews of companies in the sector also suggest a significant brain drain of the younger technical staff to neighboring countries in the EU. The laboratories lack the institutional and incentives framework to partner with the private sector in joint R&D activities (see discussion in Chapter 4). 3.14 Shorter-term issues also hamper the development of the sector. Exporters face significant pressures on working capital due to the lack of timely VAT refunds. This is particularly difficult given the low levels of profitability of some sub-sectors. Working capital is critical for the normal operation of the sector, as it has longer turnarounds between production, delivery and payment due to the complexity of products. Food Processing 3.15 The food processing industry is among the fastest growing sectors of the economy and has been highly resilient to the crisis. In the last decade the food processing industry represented between 7-8 percent of value added and around 8 percent of exports. This sector also proved to be highly resilient to the output drop of 2009. The leading exporter is the sunflower oil sub-sector. The highest pace of output growth over the last years was experienced by sub-sectors such as preserved vegetables, canned fruits and beverages. Fruit juices alone represented roughly 50 percent of food processing exports in 2009. Box 3.2: A Snapshot of the Food Processing Sector The food processing industry comprises a number of sub-sectors, including the flavouring industry, meat and dairy processing, flour and cereals, and feed mills. The flavouring sector, the largest one, comprises several specialised products, including sugar, fat and oil, baking, wine, spirits, alcoholic beverage, beer and non-alcoholic beverages, confectionery, pasta, fruits and vegetables, salt, tobacco, tea, and food concentrates. The leading products in volumes of sales are juices from vegetables and fruits and tomato sauces and other canned vegetables. The industry has been penetrated by large multinationals. The sector went through significant shifts in ownership from public to private. Moreover, the food industry has been transformed from a fragmented market, with mostly unbranded product lines, to a developed market featuring a wide range of both local and international brands with production plants in Ukraine. Ownership changes resulted in the consolidation of the sector. Part of this process was driven by vertical integration--upstream to agriculture production and downstream to processing and distribution. Yet this industry is still characterised by a large number of medium enterprises and is highly attractive for green field foreign investments. Some companies with foreign ownership have introduced the practice of benchmark farming in order to spread basic standards of efficiency and quality among Ukrainian farmers. 26 Dividend policy is changed on ad hoc basis each year by the budget. The dividend take for the government mandated by the annual budget is driven mainly by fiscal needs almost regardless of investment needs and planning of SOEs. 32 3.16 The level of investments in the sector outpaced that of other sectors in the manufacturing industry. FDI to the food industry over the last seven years made up around 25 percent of total manufacturing FDI. However, its share of FDI inflows has been declining over the last two years. Food processing industries invested significantly in new technology throughout the production chain, including in canning, bottling and packaging. 3.17 The current regulatory framework deters entry, increases operational costs, limits competition, and harms export diversification and growth. State policy and regulation in the agro-food sector is outdated, fragmented, complex, burdensome, and plagued by governance shortcomings. Over the years, the government developed specific regulations for sugar, bakery, oilseeds, alcoholic beverages, dairy products, and baby food, among others. Different sub- sectors often face very different regulations. In some cases, the same factory producing items across sub-sectors faces a myriad of complex and overlapping regulatory requirements. The legislation and regulation of product standards, including sanitary and phyto-sanitary standards (SPS), are outdated and do not correspond to standards in the European Union and other high- end markets. Most state laboratories lack modern equipment, failing to satisfy international standards, thus making certificates expensive or impossible to obtain domestically.27 As a result, the majority of enterprises in the food sector export predominately to former CIS countries. Lengthy and costly license and permit processes are necessary even for existing firms that want to expand product variety. For example a fruit juice company will have to go through the full process of licensing and permitting just to add a line of pear juice in addition to an existing apple juice line. Food processing plants are inspected by multiple agencies, generating high costs in man-hours. 3.18 Taxation, public infrastructure, logistics and trade facilitation, and financing issues also hamper the development of the sector. For exporting companies, VAT refund arrears choke working capital and their ability to fulfill export orders (e.g., due to the large volumes, comestible oils exporters are severely harmed). Moreover, high rates on the existing export tax on sunflower seeds and certification of oil harms larger exporters.28 Exporters also face significant behind-the-border costs due to poor logistics and expensive transport. Storage facilities including cold storage are limited, geographically concentrated, expensive, and are insufficient to support the growth of the sector. Railways freight tariffs are expensive for grain exporters due to preferential treatment of heavy industry. Financing has tightened significantly for the sector, except for the larger players who have access to external financing. B. AGRICULTURE 3.19 The agriculture sector (including fishing and forestry), a critical pillar of Ukraine's economy, shows low and declining productivity levels (Figure 3.2 a). The sector's value added share in the economy declined from 16 to 11 percent, although this has been a common trend among transition economies, particularly as the service sector develops. 27 Less than 2 percent of the laboratories are accredited according to ISO 17025 (IFC 2008) 28 Export duties for sunflower seed, flaxseed and linseed were decreased from 17 to 14 percent in 2008 and are subject to a 1 percentage point decrease each year until reaching 10 percent. 33 3.20 The sector shows high returns on capital, signaling high potential for growth. Agriculture shows an average annual return of over 25 percent (Figure 3.3b). One explanatory factor seems to be the depletion and scrapping of the capital stock in the early transition period. This trend was augmented by the lack of investment and further depreciation over the last decade.29 In turn, real value added declined only marginally, pushing returns up. An additional source of overestimation is the non-captured income accruing to labor. With a high share of subsistence and household farming in the sector, changes in labor are likely to have been imputed to changes in capital. Figure3.3a: Growth Accounting--Agriculture Figure 3.3b: Returns on Capital Agriculture, Fishing and Forestry: Agriculture, Fishing and Forestry: Real value added growth explained by factors of Average sectoral RoRK adjusted for capacity production utilization and sectoral FDI share in total 0.3 0.2 0.25 economy value added % re al value adde d grow th 0.15 40% 0.5% % change s in production factors 0.2 35% 0.1 0.4% 0.15 30% 0.1 0.05 25% 0.3% 0.05 0 20% 0 15% 0.2% 0.05 0.05 10% 0.1 0.1% 0.1 5% 0.15 0.15 0% 0.0% 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 changes in capital stock changes in labor force Average RoRK (left axis) FDI/VA Ukraine(right axis) productivity growth real value added growth Source: World Bank-PRED; Global Competitiveness Report, Bank staff calculations. 3.21 The agriculture sector has attracted modest FDI inflows and its modernization has been limited. FDI inflows have been limited and unable to offset the sharp trend of disinvestment in the sector. FDI inflows amounted to an average of 4 percent of sector value added per year and only 0.4 percent of overall value added during 2003-2007. Sectors that are linked downstream to the food processing sector, particularly to firms with FDI, have purchased new equipment and adopted new processes to unify quality. 3.22 The limited modernization and diminished competitiveness of the sector is also caused by an unfavorable institutional and policy setup. A unified registry for land and real estate has not been implemented, and thus property rights in land are poorly protected. The moratorium on agricultural land sales in effect since 2001 has favored large and politically connected business groups that have consolidated productive land through lease agreements. Land investors have been able to impose lease rates well below comparable rates in other countries in the region as land owners do not have the alternative to sell, cannot pledge land to raise capital and farm it themselves, or are often too old and frail to operate their farms. At the same time, without acquiring full ownership rights incentives for long-term investments are limited and land yields have remained low. An unpredictable policy framework hampers the 29 For example, in 2005, the capital stock adjusted for capacity utilization dropped by 10 percent, causing an increase in the return on capital of 18 percent from the previous year to 29 percent in 2005. 34 sector. Ad-hoc government interference in agricultural markets has reduced the transparency and efficiency of price formation, increased uncertainty and risk, and favored rent seeking. These factors have discouraged private investments and lead to inefficient public and private resource allocations. Persistent problems with export VAT refunds arrears have added significant pressure on the working capital of exporters in the sector. 3.23 Outdated and burdensome standards and sanitation requirements for exports prevent producers from reaching new markets and expanding production. Ukraine has inadequate systems to test and document food product quality and safety. The food safety control system is complicated and characterized by fragmented supervisory agencies, overlapping jurisdictions, and significant red tape and corruption. Many controls and standards applied in Ukraine are inconsistent with WTO provisions and EU directives, limiting export destinations. 3.24 Lack of public investments hampers growth prospects in the sector. A poorly maintained road network, costly and sometimes unreliable railway freight services, lack of logistic centers with storage facilities have caused waste of production in years of record harvest (e.g., 2008) and will likely limit growth moving forward. As stated in the World Bank (2008) policy note on the sector, marketing chains are characterized by physical losses due to poor harvesting and storage technology, and inefficient infrastructure and logistics between the farm gate and export positions. The result is costly: if farmers in Ukraine had received roughly the same share of free on board (FOB) grain prices as their counterparts in Germany, the 2006 harvest of roughly 35 million tons would have resulted in an additional USD1 billion of farm revenue, or almost 1 percent of GDP. Moreover, inefficient and poorly targeted input and production subsidies, including the special VAT system in agriculture, crowd out needed public investments and support for technological upgrade in the sector (PFR I 2006). 3.25 The sector faces significant credit constraints in the wake of the financial crisis. Commercial bank credit for the sector, readily available prior to the crisis, has tightened, leading to the use of other mechanisms to meet basic financing and production requirements. Fertilizer companies (also hard hit by the crisis), seed companies and other related firms are providing some direct credit to the agriculture sector for the 2009 harvest. Yet a large portion of the financing needs has not been met. C. SERVICE SECTOR 3.26 The service sector has expanded its value added share in the economy from 50.8 percent in 2002 to 62.4 percent in 2009. As in other transition countries, the sector has been very dynamic over the last decade. Wholesale and Retail Trade 3.27 In tandem with the consumption boom, wholesale and retail trade has grown steadily since 2005 with high rates of return on capital. The average annual growth rate was over 10 percent, supported by an average annual labor force growth rate of 6 percent. Changes in capital stock, labor force, and productivity growth each explained around one-third of sectoral 35 growth (Figure 3.4a). This pattern is different compared to other sectors in Ukraine's economy, where the labor factor was marginal. Between 2002 and 2007, the average annual return on capital stood at 18 percent (Figure 3.4b), mainly due to the rapid expansion of value added after 2004. Consistent with the high return on capital, sectoral FDI is around 20 percent of total FDI since the mid-2000s. The preferred FDI vehicle has been green field investment, with 100 percent foreign ownership. Very limited joint ventures and shared ownerships (foreign-domestic) exist in this sector. Figure 3.4a: Growth Accounting--Wholesale Figure 3.4b: Returns on Capital and Retail Trade Wholesale and Retail Trade: Wholesale and Retail Trade: Real value added growth explained by factors of Average sectoral RoRK adjusted for capacity production utilization and sectoral FDI share in total % changes in production factors economy value added % real value added growth 0.2 0.25 0.15 0.2 25% 3.0% 0.1 0.15 20% 2.5% 0.05 0.1 2.0% 0 0.05 15% 1.5% 0.05 0 10% 0.1 0.05 1.0% 0.15 0.1 5% 0.5% 2002 2003 2004 2005 2006 2007 0% 0.0% changes in capital stock changes in labor force 2002 2003 2004 2005 2006 2007 productivity growth real value added growth Average RoRK (left axis) FDI/VA Ukraine(right axis) Source: Fiscal Policy and Growth in ECA (2007); BEEPS (2009); Bank staff calculations. 3.28 Entry barriers are high and competition remains limited. Institutional barriers that limit entry include a cumbersome system of licenses and permits for entry and operation. It is difficult to find adequate land for purchasing/renting, as well as obtaining construction permits. All these processes for setting up a business are prone to rent-seeking activities of regulatory agencies and local governments. Consequently, competition is limited. For example, on the retail side, the leading grocery and large consumer products retailers comprise five to seven market players. Consolidation in the past years allowed large brands to consolidate their market presence and capture quasi-monopoly rents. 3.29 In the wake of the crisis, survival in the sector largely depends on the adjustment of cost structure. In the context of low domestic demand, dominant market players may have space for lower profit margins, but smaller market participants may have to exit the market. In addition, easy access to consumer credits prior to October 2008 is no longer available. The end result may well be even less competition, unless entry barriers are lifted and operational costs reduced through deregulation. Transport and Communications 3.30 The transport and communication sub-sector accounts for 15 percent of total real value added, with only marginal growth in its share over the last five years. Within the sector, transport accounts for more than three-quarters of real value added while 36 communication--including Internet, mobile and fix line telecommunication--accounts for the rest. While TFP growth explained most growth in the sector until 2005, capital stock growth has become the most important driver of growth thereafter (see Annex 3.1). Large investments made by telecommunications companies (particularly in the mobile segment) into the development of the network tower infrastructure post-2005 are the most plausible explanation. Strong growth in gross investment has positively contributed to the large increase in the capital stock, driving the rate of return on capital down. 3.31 FDI inflows in the telecommunications sector increased in nominal terms, but not at the pace of other sectors. FDI inflows into the transport and communication sector have been directed towards open segments, namely Internet and mobile telecommunications services, cargo road transportation and air transportation. The government continues to play a dominant role in the sector, and liberalizing the closed segments of the sector is an important agenda for future reforms. 3.32 Competition is strong is some segments (e.g., mobile), but weak in others (e.g., Internet and fixed line). The mobile communications market exhibits dynamic competition with strong penetration and steady reductions in price. By the end of 2008, the number of mobile subscribers reached 55 million (20 percent more than the population of the country), although the real level of penetration was about 70 percent.30 In contrast, the fixed line market is dominated by the state-owned Ukrtelecom, which is affected by inefficiencies in service delivery. Administrative barriers remain pervasive in the sector with a double licensing system for telecommunication operators in contrast to common practice in the European Union. Moreover, Internet providers must obtain three licenses from the regulators to operate. 3.33 There is significant underinvestment in the transport sector, in which the state has a large footprint. The state railways monopoly represents the primary mode of transportation. Railways infrastructure, freight, and passenger operations remain strongly integrated and cross- subsidized. The roads system, which encompasses four key pan-European corridors, is insufficient to support trade growth--Ukraine's road network density is roughly one-third of the Eastern Europe and Central Asia region average, and well below other emerging economies. Moreover, the fragile road network is deteriorating rapidly because of under-spending in maintenance. Countries with similar road networks spend at least twice as much as Ukraine on maintenance. The railway system faces a deteriorating infrastructure and rolling stock. Cross- subsidies from industrial users to passengers increase the cost of freight and reduce export competitiveness in some sectors such as steel. The on-going preparations for the 2012 Euro Cup have once more highlighted the poor airport infrastructure. Limited trade logistics and weak strategic planning across transport modes hamper exports and prevents Ukraine from developing into a transit hub (see Chapter 4 for more details). 3.34 Lack of reforms hampers private sector development. In the railways sector, vertical unbundling to separate freight and passenger transportation into different companies and to 30 The market for mobile and Internet services was opened for private domestic and foreign investment and has displayed impressive growth rates of 125 percent year-on-year in the mobile and 130 percent year-on-year growth in the Internet market segment (data from NCRC). 37 facilitate competition is still a pending task. The railway's management structure and practices are not aligned with market incentives. Moreover, this sector is subject to strong government intervention regarding price setting. Similar to the utilities sector, railway industrial customers cross-subsidize individual customers. Costs in Ukrainian ports are higher than in comparable countries and operations are less reliable (see the World Bank's Trade and Transit Facilitation Study 2010). Banking Sector 3.35 The Ukrainian banking sector dominates the financial sector, concentrating nearly 95 percent of total financial sector assets, or 96 percent of GDP. As of March 2010, 175 banks operated in Ukraine. Foreign-owned banks have gradually increased their share of assets as well as capital (Table 3.1). The share of the non-banking financial sector was less than 10 percent of GDP in 2008 and further shrank in 2009, owing to bankruptcies and closure of numerous insurance and leasing companies (see Annex 3.3 for details). The concentration of the banking system remains relatively low, with the top 10 banks (excluding Ukrprombank, which is now in liquidation) holding 58 percent of loans, and 57 percent of deposits as of March 2010. Table 3.1: Key Banking Sector Indicators Indicators 2002 2003 2004 2005 2006 2007 2008 2009 1Q10 Number of operating banks, incl: 157 157 160 165 170 175 184 182 175 - with foreign capital 20 19 19 23 35 47 53 51 51 - with 100% foreign ownership 7 7 7 9 13 17 17 18 18 Share of foreign banks in capital, % 13.7 11.3 9.6 19.5 27.6 35 36.7 35.8 34.2 Assets as % of GDP 28.3 37.5 38.9 48.4 62.5 84.5 97.7 96.2 N/A Assets growth, % 34.3 56.9 34 59.2 59.1 76.2 54.5 -4.9 -0.6 Deposits to GDP % 17 22 23 30 34 44.9 37.6 35.8 N/A Loans as % of GDP 20.7 23.4 25.4 32.2 45.1 60.6 78.1 78.4 N/A Loans to deposits ratio, % 106.8 111.2 107.5 106.3 134.1 156 207.6 214.5 206.1 Capital adequacy ratio 18 15.1 16.8 15 14.2 13.9 14 18.1 20.8 Profit/Loss, UAH bln 0.7 0.8 1.3 2.2 4.1 6.6 7.3 -38.5 -4.4 Return on assets 1.3 1 1.1 1.3 1.6 1.5 1 -4.4 -2.1 Return on equity 8 7.6 8.4 10.4 13.5 12.7 8.5 -32.5 -14.8 Net interest margin 6 5.8 4.9 4.9 5.3 5 5.3 6.2 5.6 Source: National Bank of Ukraine. 3.36 Lending growth in the banking sector was too fast, excessively leveraged (through foreign borrowing), and the quality of prudential regulation and supervision was unable to catch up. The growth rate of the sector reached 76 percent year-on-year at its peak in 2007. Assets to GDP are now comparable to higher-income Eastern European countries due to the explosive growth between 2005 and 2008 as loans to GDP tripled (Table 3.1). With the aim of gaining market share, and helped by cheap borrowing from abroad, banks grew their portfolios at an unprecedented rate. This growth was coupled with lax credit analysis and in the context of an institutional framework limited by poor disclosure of ultimate controllers and essential participants, poor enforcement of fit and proper criteria, and low paid capital requirements. Moreover, going into the crisis it became clear that the regulatory framework was inadequate to deal with a bank resolution, although this was partly addressed in the 2009 bank rehabilitation 38 process.31 In addition, the regulatory forbearance in enforcing existing prudential requirements led to violations of prudential indicators, including large exposures, related-party lending, liquidity and foreign exchange exposures. Finally, the system remains fragmented, populated by a large number of small banks, many of them with significant problems of connected lending. This situation is perpetuated by unfriendly regulations for bank mergers and an absence of incentives for banking sector consolidation. Table 3.2: Banking Assets to GDP, Cross-Country Comparison As s ets /GDP, % Country 2008 2009 Czech Republic 112.58 116.43 Lithuania 92.42 110.92 Bulgaria 104.24 106.96 Ukraine 97.68 96.24 Poland 91.95 91.19 Romania 66.03 74.64 Source: World Bank; National Bank of Ukraine; Bank staff calculations. 3.37 Poor liquidity and risk management practices, excessive credit and foreign exchange exposures, and related-party lending were the main causes for the failure of most problem banks during the crisis. Since the start of the crisis, the National Bank of Ukraine (NBU) introduced temporary administration in 24 problem banks, accompanied by a formal legal moratorium on repayment of liabilities (including a freeze of household deposits) and mandating temporary administrators to develop resolution programs. As of April 30, 2010, three problem banks had been sold to new private investors, three banks have been recapitalized by the state, and eighteen banks have been put into liquidation. Five more banks remain in temporary administration, awaiting NBU decision on their resolution. D. THE ENERGY SECTOR 3.38 Ukraine is among the most energy-intensive economies in the world, but significant sources of savings are available. Primary energy supply in Ukraine is dominated by fossil fuels: natural gas (41 percent), coal (30 percent) and oil (10 percent). About 70 percent of the total natural gas consumed is imported from Russia. Ukraine's energy intensity exceeds that of Germany by a factor of 3.6 (0.47 kg of oil equivalent in Ukraine vs. 0.13 kg in Germany). While Ukraine's energy efficiency has improved, it remains at a level similar to Poland in the early 1990s. Roughly 41 percent of all Ukrainian steel is still produced using open-hearth furnaces, which have been replaced in nearly every country in the world.32 Blast furnaces or electric arc furnace technology would reduce energy consumption more than four-fold. The heating needs in buildings in Ukraine are also expected to be a considerable source of energy savings as buildings energy efficiency is estimated to be about five times worse than in Western Europe. Demand- side issues are exacerbated by supply-side energy losses, with pipeline losses nearly double that 31 Before 2009 the options for bank resolutions were limited to: (i) liquidation of a bank with payoff of insured individual depositors through the DGF; (ii) recapitalization of a bank by the government for systemically important banks; and (iii) a transfer of selected assets and liabilities of a failed bank to an acquiring bank with no financial assistance from the government. The legislation adopted in July 2009 (Law 1617) provided the possibility of purchase and assumption transactions (P&A), voluntary mergers, and bridge banks. 32 Except for Russia, which is in the process of replacing its technology. 39 of Western European and boilers about 20 percent lower than new boilers. To a varying degree, all three sub-sectors are still subject to strong government intervention. 3.39 Gas and heating prices are heavily subsidized, creating large fiscal and quasi-fiscal deficits. The quasi-fiscal deficit (QFD) associated with gas prices in Ukraine was 2.8 percent of GDP in 2009.33 The gas price to industry is set lower but close to the estimated cost of imports, whilst gas prices to households and utility companies are less than a third of that cost,34 which creates a two-tier pricing system. This situation also deters the development of the domestic gas sector. Local gas production could increase by an estimated 50 percent if prices were set at competitive levels. As a result of inefficient energy pricing, district heating companies are virtually bankrupt and in 2009 paid only 55 percent of their gas bill, generating severe financial losses for Naftogaz. The problem is exacerbated by the lack of metering, which hinders energy saving incentives. Furthermore, the tariff setting is done at the local level, in a context where local governments have no incentives to set adequate tariff levels. While coal prices have been rising since 2003, they are still below production costs for steam coal used for power production.35 3.40 As a consequence of pricing policies there are severe inefficiencies and underinvestment. Bank staff estimates key investments needs at around USD3 billion per year36 over the next decade.37 Most district heating systems have not been modernized since the Soviet era and lack metering and controls, particularly at the customer end. Upstream investments in the gas sector are limited as private participation has been discouraged even though there is a large potential and rising import costs. The gas transportation system has not been modernized, despite large declared technical losses.38 Incentives for private participation in the power sector are weak due to low tariffs and weak regulation. A lack of funds for maintenance and investments negatively affect the efficiency of power facilities, which are deteriorating at an increasing pace. This is particularly pronounced in thermal power companies (TPPs).39 The coal sector remains un-restructured, plagued with inefficient SOEs, low quality 33 This estimate is based on the weighted average cost of cheap (well below import price) domestically-produced gas and imports from Russia. It also does not account for full potential capital costs. 34 The government has set gas price to households to cover short-run marginal costs of domestic production, which is roughly 15 percent of the full marginal cost of supply. 35 In the first eight months of 2009 the average price of coal produced by the state-owned mines was UAH444 (about USD55) per ton, while the production cost averaged UAH707 (about USD88) per ton. As a result of steam coal under-pricing, the cost of electricity production from coal-fired power plants (about 40 percent of total electricity produced) is relatively cheap: 4.6 cents/kWh vis a vis 6 cent/kWh if enterprises had to pay full cost of coal. 36 The gas sector needs about USD2 billion per year over the next five years to modernize compressors, replace aging pipelines and gas storage assets as well as upgrade its instrumentation and controls. District heating networks, boilers, CHP plants and TPP rehabilitation also requires at least USD1.5 billion per year. The coal sector needs investment of about USD1.8 billion per to address mine safety and to expand supply to meet growing needs. The power sector (including hydropower rehabilitation, power networks, nuclear and renewable sectors) investment requirements exceed USD2.6 billion per year to modernize existing assets and to replace the aging capital stock. 37 The 2005-2030 government's Energy Strategy estimates the total investment requirements on the supply side of the energy sector at more than UAH 1 trillion (USD200 billion). 38 Naftogaz' gas compressor plants have an efficiency of about 25 percent, well below that of replacement compressors which operate at 36-40 percent efficiency levels. 39 Much of equipment is operating well beyond its normal life-time. 40 steam coal (which represents roughly 80 percent of the coal production), and an ill-advised system of centralized state purchases and distribution. Infrastructure in the sector is crumbling and subsidies of 0.6 percent of GDP annually have failed to bring any improvement. A large portion of the sector is effectively a social program. E. PATTERNS AND COMMON CONSTRAINTS ACROSS SECTORS 3.41 Changes in capital stock and in productivity explain most of the economic growth in 2002-2007 in most sectors. This is consistent with the fact that the Ukrainian economy is highly capital intensive and undergoing a period of market liberalization. As expected, sectors with higher productivity growth grew faster in Ukraine than sectors where productivity growth was lower. Most sub-sectors show high returns on capital, which is consistent with limited competition within sub-sectors (see Chapter 4 and Annex 3.1). There is also a high correlation between higher returns on capital and FDI (see Annex 3.1). This exemplifies the potential to attract more FDI to Ukraine, should the government adopt policies to lower investment risks by improving the investment climate and the governance environment. 3.42 Some of the key sector-specific constraints to growth are as follows: Short-term issues: Lack of financing for both working capital and investments: all sectors. VAT refund arrears: agriculture, food processing, steel, machine building, exporters. Prior to the crisis, both issues were not the primary concerns to businesses. They are temporary, related to the weak fiscal position and the vulnerabilities of the banking sector. 3.43 More structurally, growth, exports, and FDI in the real sector are most affected by the following factors: Inadequate transport and energy infrastructure: steel (metals), machine building, agriculture, food processing, and energy. High transport tariffs and low reliability: steel (metals) and agricultural produce. Inadequate export logistics infrastructure: agriculture, food processing, wholesale and retail trade. Land policy issues: agriculture, food processing, wholesale and retail trade. High tax rates and burdensome tax administration inspections: all sectors. An institutional and regulatory framework that imposes high entry barriers, high operational costs, high exit barriers, and consequently limits competition, new products in the market and export potential: all sectors except banking. Intellectual property rights: machine building, sophisticated (light) manufacturing of durable goods. Inadequate technical skills: steel and machine building. 41 4. DIGGING DEEPER: UKRAINE'S MICRO UNDERPINNINGS OF GROWTH 4.1 This chapter looks at the micro underpinnings of growth in the economy. It is divided into five sections. First, using census firm data it focuses on dynamics of firm entry and exit in relation to firm characteristics and productivity growth. Second, using the same firm-level data, it evaluates competition dynamics in the economy and across sectors. Third, it analyzes the structural transformation and export sophistication of the economy over the last decade and prospects moving forward. Fourth, it looks at technology transfer, innovation and labor skills issues. Lastly, it summarizes key findings from an export logistics and transport assessment. A. FIRM DYNAMICS AND PRODUCTIVITY40 4.2 In order to analyze firm dynamics and the creative destruction process that supports productivity growth, this section focuses on three issues. First, it looks at firm demographics in relation to entry and exit dynamics and TFP. Analyzing the size distribution of firms in Ukraine is important for several reasons. International evidence suggests that small and medium sized firms are key engines of growth (Bartelsman et al. 2005). When the regulatory burden is high in an industry, firms tend to be larger to benefit from economies of scale in dealing with bureaucratic obstacles, or to operate informally to escape from rent seeking regulators. Thus, a low share of small firms can be a signal of excessive regulation, especially in emerging economies like Ukraine. Second, it uses productivity decomposition to compare productivity dynamics across sectors, assessing the effective allocation of factors of production across firms. Lastly, it looks at entry and exit in the context of productivity growth. The firm data comes from the firm census dataset provided by the State Statistics Committee. The dataset consist of 559,943 firms that operated at least one year during 2001-2007. While the dataset covers most sectors in the NACE coding system, this report mainly covers the performance of the manufacturing and services sectors.41 4.3 The main findings are: (i) average firm size in Ukraine tends to be larger than in other economies; (ii) there are low levels of firm entry and exit; (iii) the entry and exit of firms generates few productivity gains through improved allocation of resources; and consequently (iv) there are low levels of allocative efficiency. All are signs of weak firm dynamics and significant barriers to entry and exit that hamper a healthy churning in the economy and thus reduce productivity growth. 4.4 The share of employment of small-sized firms in Ukraine is smaller than that in other emerging economies, and has been decreasing.42 The share of small firms in total employment is even smaller in the manufacturing sector. More than 73 percent of employment is concentrated in firms with at least 150 workers, and only 14 percent of employment is in firms 40 This section draws on the background paper prepared for this report by Eric Bartelsman 41 While the census dataset counts all registered firms, the national accounts data may be adjusted to include output and production of informal firms, thus leading to slightly different growth rates (see Annex 4.1 for details). 42 In the analysis firms are divided into five size groups: (i) less than 20 employees; (ii) 20 to 49 employees; (iii) 50 to 149 employees; (iv) 150 to 399 employees; and (v) more than 399 employees. 42 with less than 50 employees. The share of small firms to large firms is low in Ukraine compared to other emerging and transition economies (see Figure 4.1 and Annex 4.1). Moreover, the share of small firms in employment decreased between 2001 and 2007. 4.5 Another factor explaining the low share of small firms is the lack of exit of inefficient large firms, often SOEs. Scarce factors of production may be bound up in these firms and thus unavailable to more efficient smaller producers, thereby hampering entry and growth of new firms. Not all large firms are inefficient of course. Thus, it is important to analyze the patterns of entry and exit of firms taking into account their productivity levels at entry and exit to understand whether the process of natural selection amongst producers leads to efficiency gains overall. Figure 4.1: Share of Small-Sized Firms in Total Employment, Cross-Country Comparison 30 Share of SmallSized Firms on Employment (%) (less than 20 employees) 25 20 % 15 10 5 0 Ukraine Romania Latvia OECD average Hungary Latin America Source: Ukraine Firm Census data; Bartelsman et al. (2005). 4.6 The entry rate of new firms has been low compared to other countries (see Annex 4.1). While the economy experienced a moderate increase in entry rates in the first half of the decade, firm entry slowed again after 2004 (Table 4.1). The low rate of firm entry and the relatively short episode of higher firm entry rates earlier in the transition may be an indication of remaining regulatory obstacles to entry, and contrasts with the experience of other transition economies (Earle and Brown 2007). Exit rates of firms have been persistently low (Table 4.1). The long survival of low productivity firms is a typical problem for economies that are in the early stage of transition from central planning to free market structures (OECD, 2007). Incumbents, often SOEs established prior to the transition, faced limited incentives to restructure and political reluctance to let them exit for fear of the social consequences of large-scale redundancies. While many SOEs were eventually privatized or closed in other transition economies, in Ukraine their share in GDP and in several sub-sectors of production remains large (see World Bank 2010).43 Moreover, governance structures in these companies create only very limited incentives for productivity improvements. While the boom years ensured their survival at relatively limited fiscal costs, most are not fit for the post-crisis world of increased competition and tighter budget constraints. 43 While accurate data is hard to find, the share of SOE output in GDP is estimated to be close to 20 percent. This share is dominated by the large state natural monopolies in the energy and transport sectors, but there is also a sizable amount of firms in the machine-building industry. 43 4.7 Thus, a healthy churning is not taking place in the economy. Entry rates were somewhat higher than exit rates early in the decade (2001-2004), but since 2005 the rate of entry decreased below the low rate of exit (Table 4.1). Table 4.1: Entry and Exit Rates by Sector (percent of employment and number of firms) Manufacturing Business Services Entry (%) #e mp #firm #e mp #firm 2002 3.6 11.9 5.9 15.4 2003 2.6 9.5 4.2 12.2 2004 1.7 6.8 3 10.1 2005 1.1 6.3 2.5 9.3 2006 1.1 6.4 2.4 9.6 2007 0.8 5.9 2.6 9.5 Exit (%) #e mp #firm #e mp #firm 2002 2 4.8 3 7 2003 1.6 4.8 3 6.7 2004 1.7 4.7 2 6.2 2005 0.9 4.1 1.7 5.3 2006 1.2 4.4 2.3 5.5 2007 1.2 4.5 2.4 6.1 Source: Ukraine Firm Census data; Bartelsman et al. (2010) prepared for this report. 4.8 Barriers to entry and exit related to the regulatory and legislative framework may explain the lack of churning. The analysis shows that the modest regulatory reforms undertaken in Ukraine between 2001 and 2007 have not done enough to stimulate firm dynamism. These results are consistent with other assessments that show that the costs of entry, operation and exit in Ukraine are high. Ukraine ranks 134th among 183 countries on the ease of starting a new business (Doing Business survey), one of the worst in the region and among emerging economies. At the same time, to close a business shareholders have to go through a long, cumbersome, and costly process of liquidation before they can dispose of assets, which hinders the reallocation of resources.44 These difficulties appear to reflect a combination of defects in bankruptcy procedures and the tendency of the tax authorities to view any form of exit as an attempt to avoid tax liability. 4.9 The average firm that exits the market does so with an abnormally low productivity level. While it is quite normal that exiting firms have a lower level of productivity than the average incumbent, in the case of Ukraine that gap is extremely large. This could indicate weak market selection incentives that allow firms to survive at low levels of productivity for a long time before they finally exit the market. At the sectoral level this is particularly acute in industries such as transport equipment, fabricated metals and chemicals (Figure 4.2). 4.10 In the service sector, entrants are on average more productive than incumbents, which suggest high entry barriers. In the case of hotels, entrants show similar productivities to incumbents. Entrants in the transport and communications sectors as well as in wholesale and retail trade show higher productivity than incumbents. This is consistent with the analysis shown in Chapter 3. These sectors have high entry barriers due to large sunk costs or burdensome and 44 It takes almost three years to close a business in Ukraine. The closure of a business typically costs 42 percent of the value of assets, compared to an average of 14 percent for other transition countries and 7 percent for OECD members in 2007. Furthermore, the exit process leaves an average rate of recovery for creditors of just 8.7 percent (Doing Business in Ukraine, 2008). 44 costly regulatory entry procedures, and they also show high margins due to low competition (see Chapters 3 and Chapter 4 b). Table 4.2: Ratio of the Average Productivity of Entrants and Exiters to Incumbents TFP Labor Prod. Firm Size entry exit entry exit entry Exit MANUFACTURING 0 . 94 0.69 0. 78 0. 77 0. 2 6 0.3 Manufacture of food products, beverages and tobacco 0.82 0.67 0.87 1.15 0.35 0.38 Manufacture of textiles and textile products 0.64 0.53 0.58 0.56 0.21 0.33 Manufacture of leather and leather products 0.63 0.57 0.39 0.44 0.47 0.49 Manufacture of wood and wood products 1.14 0.61 0.69 0.47 0.43 0.42 Manufacture of pulp, paper and paper products 0.84 0.56 0.85 0.42 0.37 0.41 Manufacture of chemicals, chemical products 0.92 0.72 0.56 0.46 0.48 0.22 Manufacture of rubber and plastic products 1.03 0.78 0.96 0.59 0.32 0.43 Manufacture of other non-metallic mineral products 1.1 0.92 0.78 0.69 0.26 0.53 Manufacture of basic metals and fabricated metal products 0.94 0.71 0.34 0.24 0.16 0.12 Manufacture of machinery and equipment n.e.c. 0.88 0.61 0.95 0.54 0.19 0.27 Manufacture of electrical and optical equipment 0.92 0.53 1.55 0.43 0.16 0.25 Manufacture of transport equipment 1.06 0.6 0.47 0.48 0.14 0.24 Manufacturing n.e.c. 1.24 1.47 1.47 1.62 0.62 0.39 SERVICES 1 . 57 1.12 1. 33 1. 52 0. 2 8 0. 39 Wholesale and retail trade 1.42 0.97 1.25 1.04 0.5 0.6 Hotels and restaurants 1.14 0.8 0.84 0.77 0.81 0.88 T ransport, storage and communication 2.04 1.75 1.12 3.29 0.12 0.17 Financial intermediation 1.25 0.7 1.01 0.99 0.26 0.33 Renting and business activities 1.57 1.06 1.27 0.99 0.44 0.72 Source: Ukraine Firm Census data; Bartelsman et al. (2010) prepared for this report. Productivity and Reallocation of Factors of Production 4.11 Ukraine's efficiency in the reallocation of labor rose during 2001-2003, but no efficiency gains occurred thereafter. This report uses the Olley and Pakes (1996) methodology to examine allocative efficiency (see Annex 4.1).45 The rise in labor allocation efficiency between 2001 and 2003 is mainly driven by efficiency gains in the manufacturing sector. Between 2004 and 2007, there are no significant efficiency gains from the reallocation of labor. During this period entry and exit rates are also stable and low, indicating a possible correlation between firm turnover and allocative efficiency. The allocative efficiency of the overall economy is lower if productivity is measured as TFP rather than labor productivity, driven by low allocative efficiency in the service sector (Figure 4.2a and 4.2b).46 Moreover, the increasing share of this sector in the economy's value added implies a decreasing efficiency trend overall. 4.12 The analysis shows that facilitating entry and exit could generate significant productivity gains. Allocative efficiency typically improves as countries move along the transition path. ECA countries started with a much lower efficiency in allocating resources. 45 Olley and Pakes (1996) decompose aggregate productivity into two parts, where the first component is the un- weighted average of the firm level productivity and the second is the so called Olley-Pakes cross term, that is the covariance between firm size and productivity represented by: C s i i C n i C i s i s i i i Where i and si represent the firm level productivity and firm's size share (e.g. input shares). 46 The capital input introduced in this figure for the efficiency analysis required excluding the periods before 2004. 45 Early in the transition, resources went to lower productivity firms, but allocation improved over time with the exit of low productivity firms and new entrants that achieved higher levels of productivity over time.47 In Ukraine the barriers to entry and exit are delaying this process. Figure 4.2a: Labor Productivity and Labor Figure 4.2b: TFP and Input Share ( kt lt ) Share 1 0.4 0.8 0.3 0.6 0.2 0.4 0.2 0.1 0 0 2001 2002 2003 2004 2005 2006 2007 2004 2005 2006 2007 0 1 1 Business Sector Services Total Economy Manufacturing Source: Ukraine Firm Census data; Bartelsman et al. (2010) prepared for this report. B. COMPETITION48 4.13 Empirical evidence for ECA and OECD countries shows that firm productivity growth is associated with high product and market competition (World Bank 2008; OECD 2006). Competition has significant effects on economic performance by affecting economic actors' incentives, driving innovative activities and selecting more efficient firms over less efficient ones over time. New entrants tend to spur productivity growth, particularly in fast growing and higher technology sectors. The literature in this field also shows that firms have little incentive to innovate if they are not stimulated by competition, particularly if they are far from the world's technological frontier for any given product or process. But the costs of weak competition rise as the economy gets closer to the technological frontier (Aghion et al 2005; 2006). 4.14 This section evaluates the levels of competition in the economy and across major sub- sectors using Ukraine's firm census data. Measuring competition is valuable in testing the dynamism and functionality of the creative destruction mechanism of an economy, which spurs productivity growth. The section evaluates these issues using three different indicators that proxy competition levels: (i) the Herfindahl-Hirshman Index (HHI) is a proxy of industry concentration (more concentration means less players in a sector, which reduces competitive pressures); (ii) the cost-to-price ratio (CP) is a measure of mark-up power (countries and sectors of the economy with larger mark-ups in prices tend to have less competition); and (iii) the Boone index is a proxy of competitive pressure by measuring differences in profits between the most and least productive firms (more productive firms should tend to have larger profits than less productive ones in a competitive sector). The methodology for each of these measures and a more detailed explanation can be found in Annex 4.1. It is important to mention that lower values of HHI correspond to higher level of competition, while the CP and Boone indices are positively 47 See World Bank 2008 "Unleashing Prosperity: Productivity Growth in Eastern Union and the Former Soviet Union". 48 This section draws on the background paper prepared for this report by Eric Bartelsman 46 correlated with competition. Moreover, while HHI covers the whole sample period (2001-2007), we could calculate CP only for 2004-2007 due to the lack of the data on material and capital inputs before 2004. 4.15 HHI results suggest low levels of competition in Ukraine. The level of concentration measured by this index is low compared to the same measure for other countries (Figure 4.3). But it is important to disaggregate this trend further for the major sectors of the economy. Figure 4.3: HHI in Selected Countries HHI (manufacturing) 0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 Ukraine Hungary Romania Russia Source: Ukraine Firm Census data 2007; World Bank (2008) based on Earle and Browne (2007). 4.16 Competition in the manufacturing sector has worsened since 2001. The HHI shows increasing concentration between 2002 and 2004, improvement in 2005 and 2006, and a marginal upward trend in 2007 (Figure 4.4a). These trends are difficult to explain in the absence of significant changes in legislation in those years. However, as discussed earlier in the report, increased entry owing to improved perception of the business climate and the commitment to reforms (e.g., during 2005) may explain these marginal improvements. The CP index confirms this trend, indicating a marginal improvement in 2005 and then larger mark-ups thereafter (Figures 4.4b and 4.4c). The Boone index shows a deterioration in competition throughout the period. Figure 4.4a:HHI- Figure 4.4b:CP Figure 4.4c: Boone Index Manufacturing 0.042 0.85 0.4 0.3 0.039 0.83 0.2 0.036 0.81 0.1 0.033 0.79 0 2001 2003 2005 2007 2004 2005 2006 2007 2004 2005 2006 2007 Source: Ukraine Firm Census data; Bartelsman et al. (2010) prepared for this report. 47 4.17 The Boone index shows a mixed picture among manufacturing sub-sectors. Most sub-sectors were almost stagnant regarding competition between 2004 and 2007, although the levels between sub-sectors diverge significantly. For example, the pulp and paper industry shows higher competition, but the metal sector has extremely low levels (perhaps not surprisingly given high fixed costs), as do machinery and transport equipment (see Annex 4.1). 4.18 Competition in the services sector has not improved. Figure 4.5a and b show the trends in this sector for all firms, and Figure 4.5c and d take out SOEs from the data. In the latter, the HHI levels of concentration increase significantly given the large state monopolies in the transport and telecom sector. Overall, the CP index shows high mark-ups, which do not differ much in levels between the samples with and without SOEs, indicating no significant differences in their levels of rents. This may be explained by the reduced number of competitors in sectors such as wholesale and large retail, and even the private sector portion of the transport sector. Moreover, from the case studies we know that these sub-sectors have high entry barriers (see Chapter 3). The Boone index shows a slight improvement in competition in 2005, which is subsequently reversed49 (see Annex 4.1). Figure 4.5a:HHI-Services Figure 4.5b:CP 0.06 0.9 0.04 0.88 0.02 0.86 0 0.84 2001 2003 2005 2007 2004 2005 2006 2007 Figure 4.5c:HHI-Services (without SOE) Figure 4.5d:CP (without SOE) 0.01 0.89 0.008 0.88 0.006 0.87 0.004 0.86 2001 2003 2005 2007 Source: Ukraine Firm Census data; Bartelsman et al. (2010) prepared for this report. 4.19 The firm-level analysis suggests low levels of entry and exit, which fosters the existing low levels of competition across sectors. As discussed earlier, competition has 49 The blip in 2005 may be explained by low profitability in 2005. 48 significant effects on productivity growth, and these effects will be amplified as the sophistication of products and processes approach their technological frontier. Most sub-sectors in Ukraine are inside the world's technological frontier, yet in some cases (including selected sectors of the machine-building industry and even food processing) the country has the potential to approach the frontier swiftly as long as it is able to absorb technology and later innovate (see section D of this chapter). Improving competition by reducing entry barriers and high operation costs will be a key policy to sustain productivity growth in Ukraine going forward. C. EXPORT SOPHISTICATION AND DIVERSIFICATION 4.20 Ukraine's economy has substantial natural comparative advantages but it is characterized by a narrow export structure, low labor productivity relative to its emerging market competitors and fragile export growth. Despite natural resource wealth, a strategic geographic location and a legacy of scientific excellence and high levels of human capital, Ukraine's export structure is still dominated by low value-added goods. 4.21 Ukraine's export structure and export destinations have changed only marginally over the last decade. The metallurgy sector continues to dominate exports with more than 40 percent of the total (Figure 4.6a). During 2009 this changed to some extent due to the collapse of demand and prices in this sector, although this is already being reversed in 2010. One change worth noting is the growing role of the agri-food sector in the export basket, and also its resilience in the context of the crisis during 2009. Export destinations have changed slightly, with a larger share of exports to Asian countries (Figure 4.6b). Figure 4.6a:Export Basket Composition 2001 -2008 2001 2008 agrofood agrofood 17.1 11.2 mineral products 15.1 16.2 mineral products 10.8 chemical products chemical products 9.5 10.5 10.5 9.1 metals metals 7.5 machinery and machinery and equipment equipment 41.3 other 41.2 other Source: State Statistics Committee, Comtrade, Bank staff calculations. 49 Figure 4.6b: Ukraine's Export Destination 2001-2009 35 30 2000 2009 25 20 15 10 5 0 EU Russia CIS (except Asia Other Russia) countries Source: State Statistics Committee, Comtrade, Bank staff calculations. 4.22 Export concentration is high and trade values remain exposed to volatile prices of metals and chemicals. Ukraine has a high level of export concentration compared to other countries (Figure 4.7a), and other measures of export concentration also highlight this problem (see Annex 4.1).GDP dynamics show a striking correlation with steel prices (Figure 4.7b). While there is not enough time series data to look into the direction of causality, the vulnerability to external price and demand shocks is nonetheless acute in an open and weakly diversified economy such as that of Ukraine. Figure 4.7a: Export Concentration Figure 4.7b: Steel Prices and GDP 5 largest products as a share of total exports 25% 100% 20% 80% 15% 60% 10% 40% Percentage of total exports 5% 20% 0% 0% -5% -20% -10% -40% Ukraine's real GDP y/y change [LHS] -15% -60% -20% EU steel price y/y change [RHS] -80% -25% -100% 2002q1 2002q2 2002q3 2002q4 2003q1 2003q2 2003q3 2003q4 2004q1 2004q2 2004q3 2004q4 2005q1 2005q2 2005q3 2005q4 2006q1 2006q2 2006q3 2006q4 2007q1 2007q2 2007q3 2007q4 2008q1 2008q2 2008q3 2008q4 2009q1 2009q2 2009q3 2009q4 Source: State Statistics Committee, Comtrade, Bank staff calculations. 50 4.23 Ukraine had a favorable position in terms of export sophistication in relation to its income level in 2000, but progress has been slow since. The level of export sophistication is not just a picture of the advantage of a country over others at some point on time. As Hausmann, Hwang and Rodrik (2007) argue, the sophistication of a country's export basket may be a significant determinant of subsequent growth. Ukraine's position was well above the average of its income level in export sophistication as of 2000 (Figure 4.8a). This was not uncommon for Eastern European countries following the transition. However, that advantage had been eroded by 2008 (Figure 4.8b). Furthermore, while Ukraine had some progress between 2001 and 2008, other key comparator countries made much more progress in the sophistication of their export baskets, leaving Ukraine behind in relative terms (Figure 4.8c). See Annex 4.2 for detailed/individual representations of product space and export sophistication for Ukraine and key comparator countries. Figure 4.8a:Export Basket Sophistication 2000 Figure 4.8b:Export Basket Sophistication 2008 20 25 CZE Ukraine 20 15 CHN RUS POL Ukraine CHN POL CZE E X P Y (P P P , '0 0 0 ) E X P Y (P P P , '0 0 0 ) BLR ROMLVA UKR ZAF LTU BRA ROM LTU COL ZAFBLR LVA 15 UKR 10 BRA CHL RUS MDA COL MDA CHL 10 5 5 0 6 7 8 9 10 11 6 7 8 9 10 11 GDP per capita (PPP, log) GDP per capita (PPP, log) Source: State Statistics Committee, Comtrade, Bank staff calculations. Figure 4.8c: Ukraine's Dynamics of Export Sophistication 19000 18000 BLR 17000 CHN EXPY (PPP, US$) 16000 LTU 15000 POL 14000 13000 ROM 12000 RUS 11000 UKR 10000 ZAF 2001 2002 2003 2004 2005 2006 2007 2008 Source: State Statistics Committee, Comtrade, Bank staff calculations. 51 Box 4.1: Key Concepts on Export Sophistication and Structural Transformation Structural transformation is the process of changing the structure (set of capabilities) of production and export mix (change in the "product space") of an economy, thus enhancing export opportunities. Export sophistication of a single product exported is denominated as PRODY. Export sophistication of the whole export baskets is denominated as EXPY. PRODY is the sophistication of every product in relation to the GDP per capita of the typical country that exports that good. Goods exported by poor countries usually have a low sophistication (or PRODY), and those typically exported by rich countries have a high PRODY. Thus, PRODY is the revealed comparative advantage (RCA)-weighted GDP per capita of each country that exports the good: xval / Xc i ,c ,t xval i ,c ,t / X c PRODY i ,t Yc c j where xvali,c,t equals exports of good i by country c in year t, Xc equals total exports by country c, and Yc equals GDP per capita of country c. EXPY is the weighted average of the PRODYs of its export basket, where the weights are the export share of each good in the country's export basket. EXPY is simply the PRODY of each good (i) that the country c exports, weighted by that good's share in the country's export basket (Xc). xval c , i , t EXPY c ,t X PRODY i ,t i c ,t Proximity formalizes the intuitive idea that the ability of a country to produce a product depends on its ability to produce other products, particularly those that require similar inputs. Density is the distance of good i from country c's export basket at time t. Density varies from 0 to 1, with higher values indicating that the country has a comparative advantage in many nearby products, and therefore should be more likely to export that good in the future. The charts in this study use the inverse density to better highlight differences across countries. Thus lower values indicate better export opportunities. i , k ,t x c , k ,t density k i ,c ,t i , k ,t k Open Forest is the connectedness/proximity of the current export basket to other new and valuable opportunities for structural transformation. A higher value indicates that the current export basket is a part of the product space that is well connected to other new and valuable opportunities for structural transformation. Open forest is calculated as follows: i , j ,t x c , j , t x c , i , t PRODY open _ forest c ,t 1 j ,t i i , j ,t i j Sources: Hausmann, Hwang and Rodrik (2007); Hausmann and Klinger (2006, 2007); Hidalgo, C., B. Klinger, A. Barabasi and R. Hausmann (2007). 52 4.24 Ukraine's connectedness of production and export capabilities is less advantageous than that of its competitors. In standard trade theory, moving to new export products (structural transformation) is a passive consequence of changing comparative advantage based on factor accumulation. However, structural transformation may be more complicated than this for many reasons. Several factors may create market failures, such as industry-specific learning- by-doing (Arrow 1962, Bardhan 1970), industry and information externalities (Hausmann and Rodrik 2003), technological spillovers between industries (Jaffe, Trajtemberg and Henderson 1993), or sector-specific obstacles to exporting. Hausmann and Klinger (2006 and 2007) and Hidalgo et al. (2007) investigate the determinants of the evolution of a country's export sophistication, and find that these barriers are less binding when moving to "nearby" products. This is based on the idea that every product involves highly specific inputs such as knowledge, physical assets, intermediate inputs, labor training requirements, infrastructure needs, property rights, regulatory requirements or other public goods. Thus, it is critical that the core product/export capabilities of a country are close to each other, as that facilitates structural transformation. Ukraine ranks relatively well internationally in this aspect, although it has been falling behind key competitors (Figure 4.9a and b). Figure 4.9a: Open Forest 2000 Figure 4.9b: Open Forest 2008 5 CHN Ukraine POL CZE 4 Ukraine O p e n F o re s t (M ) ROMLVA LTU 3 UKR ZAF BRA COL BLR 2 MDA CHL RUS 1 0 6 7 8 9 10 11 GDP per capita (PPP, log) Source: State Statistics Committee, Comtrade. 4.25 The basket of products exported to CIS countries is more sophisticated than that exported to non-CIS countries. It is common for countries to have a more sophisticated basket of products exported to traditional trade partners. Normally, these exports help as a stepping stone to increase sophistication and later reach less traditional and perhaps more contested up- markets. Yet it would also be common that sophistication levels would tend to converge over time. That seems not to be happening in the case of Ukrainian exports (Figure 4.10a). This result is mainly driven by exports of machine building to CIS countries that have not been upgraded enough to be exported to other markets. More worryingly, perhaps, the machine- 53 building sector has been losing market share even in the Russian market (Figure 4.10b). This makes the technological/sophistication upgrade of products in this sector even more urgent. Figure 4.10a: Sophistication of Export Baskets to Figure 4.10b: Russian Imports in Machinery CIS and Non-CIS Countries Products Source: State Statistics Committee, Comtrade. 4.26 The number of newly exported products seems to be in line with other comparator countries, but with lower success rates over time. Ukraine is not an under-performer in terms of the frequency of new product lines entering its export basket--it had 134 new product lines enter its export basket between 1996 and 2006 (Figure 4.11a).50 This is roughly equivalent to the number of discoveries in Thailand and greater than Brazil, but lower than Hungary, Poland, and Romania, as well as global leaders such as India and Indonesia. But success rates51 are low (Figure 4.11b), which may reflect the pervasive role of behind-the-border barriers to export. Section E of this chapter looks at this issue in detail. 50 Here a new export or "discovery" is defined as an exported product that in the previous years was non-existent or of an exported value of less than USD100,000, and then increased for at least two years in a row to above USD1million in exported value. 51 Rates of success are defined when a new export or "discovery" is successfully exported with revenues above USD1 million for another two years, that is, four years in a row since first reaching USD1 million in exports. 54 Figure 4.11a: New Exported Products - Figure 4.11b: Rates of Success in New Exports An International Comparison New Exported products (#) 0.90 Success Rates 80 0.80 0.70 60 0.60 40 0.50 20 0.40 0.30 0 0.20 19961997 19981999 19992000 20002001 20012002 20022003 0.10 BRA CHN COL POL 0.00 ROM RUS UKR BRA CHN COL ROM RUS UKR Source: State Statistics Committee, Comtrade. 4.27 Nonetheless, the potential for structural transformation in Ukraine is significant. With structural reforms addressing key constraints faced by the private and export sector, Ukraine can easily recover a higher level of export sophistication and progress in its structural transformation. Annex 4.3 contains two lists of products that are close to Ukraine's existing technical capabilities and could increase export value added in the short and medium term. These are not meant to be lists of "winners" to be promoted with subsidies and tax exemptions. Ukraine's track record with sector-specific subsidies is poor, which strongly argues against any such attempts. However, the analysis may help prioritize lifting constraints to growth and investment to the extent that these differ across sectors. At the end of Chapter 3 we highlighted sector specific constraints for broader sub-sectors of the real economy, which could be further refined based on this list of products with high export potential. This analysis also help to look at constraints that may be a common denominator across sectors (e.g., public goods that could be better provided by the government such as transport infrastructure or adequate regulation), and thus identify "horizontal" policy interventions that are good for all. This report attempts to capture those common denominators across chapters. D. TECHNOLOGY ABSORPTION, INNOVATION, AND SKILLS52 4.28 Sustainable growth is driven by the continuous accumulation not only of factors of production but also of knowledge and technology. These elements are embodied in new components, machinery and processes that raise productivity. Empirical evidence suggests that increases in productivity needed to sustain growth require technological progress, defined broadly as "the adoption and creation of knowledge relevant for production" according to Aghion and Howitt (1998). Successful knowledge-based economies typically enjoy long-term export diversification, rising productivity and growth due to high absorption of already existing technology and/or the generation of new technological innovation by domestic firms and research institutions, facilitated among others by a skilled labor force and a strong science base. 52 This section benefited from several background papers including those prepared by Natasha Kapil (on technology adoption and innovation), Hanna Vakhitova and Tom Coupe (education returns and labor skills) 55 4.29 At lower income levels, technological progress comes first from imitation, wherein firms adapt/absorb technology created elsewhere in the world to their products and processes. But with progress, as countries approach the technological frontier, the scope for imitation diminishes and competition becomes more binding (Aghion et al 2005). Ukraine is at the first stage for most of its product and export baskets. Thus, technology absorption is more critical in the short and medium term, whilst innovation will be essential in the long run. But both technology absorption and innovation require an adequate environment in both the public and private sectors to succeed. Firms clearly have the central role in absorbing and generating new technologies and in recruiting and training workers with high skills. The government's role is to ensure an enabling environment curbing public sector rent-seeking with a less intrusive regulatory environment for business and to provide high quality public goods (i.e. infrastructure and education services) as well as adequate incentives and institutions. 4.30 Technology absorption is particularly critical to increase productivity and sophistication in a non-core innovator country such as Ukraine.53 Most firms in middle- income countries (typically non-core innovator countries) do not invent and use the most advanced technologies and processes; they are not at the technological frontier. Thus, they have substantial scope to increase productivity by absorbing existing modern technologies.54 Knowledge and technology absorption is the transfer, adaptation and use of existing advanced technologies, methods and skills into local production processes that result in the introduction of improved goods and services domestically and higher exports. Technology absorption varies substantially by firm size in Ukraine, with small and medium firms far less likely to acquire new technology or to acquire ISO certification. 4.31 Technology absorption seems low in Ukraine. Firms absorb technology through several vehicles, including FDI, joint ventures with foreign partners, technology licensing, or simply by buying imported off-the-shelf technology. But Ukraine ranks low in these categories compared to other emerging economies. FDI increased significantly after 2005,55 but it is still lower than key comparator emerging economies. Low FDI not only reduces the country's potential for technology absorption and export diversification, but it also limits competitive pressures on domestic producers to improve products and services. Firm surveys suggest that joint ventures, particularly between Ukrainian and foreign partners, are rare. The number of joint ventures registered and payments for licensing are low (Table 4.3). Even the share of capital goods imports in GDP, which is a proxy of capital modernization, is relatively low (Figure 4.12). Qualitative evidence suggests that technology transfer from foreign-owned companies currently 53 The 2001-02 Global Competitiveness Report considers "core innovators" as economies whose capacity to innovate largely drives their growth, and "non-core innovators" as economies that depend more on absorption of foreign technologies. Core innovators are defined as countries whose firms and research organizations have registered at least 15 US patents per million of population, and by this standard Ukraine is a non-core innovator economy. 54 It is important to emphasize that most firms even in the most developed or core innovator countries devote their resources to absorbing existing knowledge/technology, and only a few invest in generating new knowledge and technologies with commercial application. More than half of productivity growth in OECD countries (except in the United States prior to 2000) is estimated to have come from imported technologies, and the proportion is higher for smaller economies. See J. Eaton and S. Kortum (1999). 55 In 2005, Ukraine attracted abnormally high FDI revenues of USD7.1 billion due to two very large transactions-- the re-privatization of Kryvorizhstal and the sale of the second largest private bank (Aval) to Raiffeisenbank group (Austria). 56 operating in Ukraine is also low: the Global Competitiveness Report 2009-2010 ranked Ukraine 116 of 133 countries for FDI and technology transfer. Table 4.3: Vehicles for Technology Figure 4.12: Capital Goods Imports in GDP Absorption, Cross-Country Comparison Percentage of Firms with Royalty & License Fee Payments perInternationally 25.0 Capital goods imports as % of GDP Population, 2008recognized (USD) Quality 20.0 Certification ISO Capital goods imports as % of GDP (except for transport Brazil 14.05 n/a 15.0 equipment) Russia 32.37 0.088 10.0 Poland 46.43 0.044 Czech Rep. 69.69 0.134 5.0 Bulgaria 12.48 0.136 0.0 Romania 16.08 0.129 Bulgaria Brazil Czech Hungary Poland Romania Russian Ukraine Hungary 199.96 0.090 Republic Fed. Ukraine 16.3 0.025 Source: World Bank Knowledge Economy Database, World Development Indicators; Bank staff calculations. 4.32 During the transition years the country made significant improvements in intellectual property rights (IPR), but much remains to be done to attract FDI and improve technology transfer. FDI can be a channel for modern technology diffusion and improved productivity to a local economy in two ways. Companies owned by foreign investors are more likely to adopt modern technology and in many countries joint ventures between local firms and foreign partners tend to display higher levels of knowledge transfer.56 Furthermore, international experience suggests that there are vertical spillovers within an industry (or closely related industries) as multinational corporations have the incentive to transfer knowledge to local suppliers upstream. This is in fact happening to some extent in the food processing sector (see Chapter 3). In most countries, the level of technology transfer tends to depend on the strength of the IPR regime and human skills But FDI and technology transfer by foreign investors seems constrained by a weak IPR regime. In firm interviews, foreign investors with operations in Ukraine expressed concerns about IPR and piracy. They highlighted that these concerns prevented them from using more advanced equipment and processes and/or partnering with local investors. Fears of copyright infringement due to specific gaps in the law or its enforcement were the key concerns. This is particularly the case in light manufacturing and the more technologically advanced machine component sector. 4.33 Licensing of technology--the contractual transfer of technology between firms-- could be further exploited in Ukraine. Licensing occurs within firms, among joint ventures, or between unrelated firms and is often a complement to FDI as a substantial share of global payments and receipts for intellectual property (royalties). Strengthening patent protection can shift international technology diffusion from technology importation and FDI towards licensing, and can raise knowledge inflows. Aside from improving the property rights regime, further 56 "Global Integration and Technology Transfer," World Bank 2004. Studies in transition economies have found that foreign-owned enterprises are twice as likely to have Internet access (see Clarke, 2001). 57 research should examine other constraints to licensing, including weak demand due local firms' lack of information or other factors. Box 4.2: Is the establishment of Special Economic Zones (SEZs) or of similar schemes a solution? The short answer at this stage is probably not, for several reasons. First, past experience in Ukraine with the free economic zones shows that the ultimate, albeit non-intended, result was a massive scheme of tax avoidance and evasion that came at a very high cost to the budget (more than 3 percent of GDP annually). Local investors appropriated most of the benefits through tax liability minimization, while the inflow of genuine FDI, particularly in export-related or R&D-intensive sectors, was almost non-existent. Second, these schemes are difficult to manage properly and require strong governance and institutions around them, which are still weak in Ukraine. Third, proponents of this scheme tend to mix the benefits of clustering economic agents in one place with the benefits that could be spill over in lagging or remote regions (that is, mixing up geography of economic production and the geography of welfare--see World Bank WDR 2009). Firms tend to cluster to take advantage of abundant skills, access to trade logistics, infrastructure, high levels of services and so on, which is why they tend to cluster around densely-populated and well-established urban areas. Fourth, international experience with special economic zones is mixed and suggests the following: (i) they are not a first-best solution; (ii) they tend to have limited applicability and impact; (iii) they work best when they are appropriately set up, managed, and WTO compliant; (iv) they work best in countries with developed infrastructure, financial markets, and strong institutions where downward linkages can be developed to domestic economic activity; (v) they are distortionary trade instruments which introduce discretion into the policy environment, and as such are vulnerable to abuse; and (vi) they tend to stick in the system--once privileges are provided, lobby groups help to maintain and expand them. Fifth, one special aspect of special economic zones that is often overlooked is that they act as a safety valve for attracting investment when the overall business climate is poor, and as such they reduce pressure on the government to improve the business climate for all investors. Typically, the investment attracted through them is small as a share of GDP, and can draw attention away from improving the investment climate throughout the country, which is critical in Ukraine. 4.34 Ukraine ranks low in adhering to globally-recognized standards, which maybe hindering technology absorption and innovation. These standards tend to be correlated to the absorption of technology in products and process and tend to increase firm productivity. The most prevalent voluntary international standards are ISO 9001 certificates. Ukraine fairs worse than most other comparator countries in this area (Table 4.3 above).57 But there several highly relevant sets of standards that help to improve competitiveness. The standardization regime in Ukraine currently fails to meet EU standards, which could bring the country the quickest gains, as most Soviet-era product standards and certifications are outdated (less than a third of the hundreds of standards are harmonized with international standards). They are burdensome, costly, and mandatory, deterring investments in technology and innovation and thus product diversification and sophistication. Infrastructure and metrology equipment issues (known collectively as the MSTQ system) are part of the problem. But perhaps more important are the reforms needed in the policy and institutional setting around standards. This setting encompasses control bodies without a clear purpose that feed on fines and hassling businesses. They need to be rationalized or eliminated altogether. 57 It has the second lowest proportion of ISO certified firms as well as the second lowest number of ISO certified firms as a proportion of manufacturing and services value-added, where ISO certificates are deemed most relevant. 58 4.35 Ukraine's renowned innovation system is under-performing and slowly fading out. Although innovation is more of a medium and long-term issue, it deserves attention as reforms and results tend to take time in this area. Ukraine has a strong and successful legacy of science and technology. Despite the transition disruption, it still has a system of R&D with institutes and laboratories and ranks relatively high (though with worsening trends on measures such as the quality its science education). Moreover, it is still endowed with human and financial capital. Yet Ukraine's innovation system compares very poorly with other emerging economies on innovation outputs. According to the Global Competitiveness Report 2009, Ukraine's innovation ranking was 73, far below EU emerging economies that compete with Ukraine such as Poland, the Czech Republic or other emerging economies such as Brazil and Turkey. This is confirmed by looking at the level of technology embodied in Ukraine's exports (see Figure 2.20a in Chapter 2). Moreover, system budgets are shrinking and the cadre of scientists is ageing fast. 4.36 A critical cause of the low level of commercial innovation is the lack of connection with the private sector and adequate incentives in the system. Researchers often refrain from collaborating with the domestic private sector due to lack of trust. They do not feel secure about the protection of their intellectual rights and the rents arising from them. The poor investment climate and weak IPR protection make it less worthwhile to invest in risky R&D or to collaborate with state owned R&D institutions. Data from the State Statistical Committee shows that the share of firms engaged in innovative activities fell from 18 percent in 2000 to less than 10 percent in 2008. Due to the lack of connection between private business and government centers, innovation outputs (mainly basic research) are not pushed to further stages of applied research and product development. The economic incentives are not aligned, competition for funding is not prevalent, and the mistrust spurred by the weak property rights system and its enforcement hampers an efficient innovation system. Education and Skills 4.37 Emerging evidence suggests that a higher stock of skilled human capital enhances the technological and knowledge transfer benefits of FDI and trade liberalization (Isaksson, 2002). On the other hand, countries with weak or eroding technical skills are less likely to absorb them. Engineers and scientists are required at the very least to facilitate diffusion and absorption of existing technologies as well to adapt existing technologies, aside from creating new ones. In developed economies, the availability of skilled workers has created incentives for firms to develop new more skill-intensive and productive technologies (Acemoglu 2001). By contrast, in many developing countries labor skills have forced firms to purchase used machinery - so-called vintage capital - due to inadequate skills of the labor force owing to unresponsive education systems, particularly in technical and vocational education. 4.38 Labor skills in technical areas seem to be an important obstacle for firm growth. According to firm-level data from BEEPS, the share of Ukrainian firms that believe this is a major issue for firm growth is higher than the regional average and that of key emerging economies in Eastern Europe (Figure 4.13a). Moreover, the problem seems to be more acute in firms that are growing, which could represent a significant drag for overall productivity growth (Figure 4.13b). This is more acute in the manufacturing sector, precisely where technical skills are more needed. This suggests that either: (i) there is a relatively large share of skilled labor 59 with skills ill-suited to current labor demand; (ii) there are insufficient or inadequate training opportunities for workers to learn skills in demand; and/or (iii) the education system, especially the vocational and higher education, is not providing the right skills to students. The apparent mismatch is supported by results from the Ukraine's Labor Market Survey (2007), in which more than one-third of respondents state that they are performing a job that either requires a different level of education or a different field of education. One way or another, the apparent mismatch between supply and demand of labor will need to be tackled by more responsive vocational and higher education systems. The current incentives embedded in the financing mechanisms for vocational and higher education institutions (with funding attached to the institutions rather than the students, among other problems) runs counter the aim of responsiveness (see World Bank's PFR II). Figure 4.13a: Percent of Firms Where Skills are a Figure 4.13b: Firms for Which Skills are a Major Constraint on Growth Very Important Constraint Percentage of Firms reporting Labour Skills as a major/severe Skills Intensity. obstacle 100% 60 90% 50 80% Very important 70% 40 60% 30 50% Moderately 20 40% important 10 30% 0 20% No issue 10% 0% Expanding Firms NonExpanding Firms Source: State Statistics Committee, Comtrade. E. TRADE LOGISTICS AND FACILITATION58 4.39 Ukraine's exports rely heavily on its transport infrastructure and are affected by transports costs. Owing to the heavy reliance on metals, chemicals and agriculture in the export basket, this requires almost 6 ton-km of freight transport for each USD of GDP, compared to an average of 0.3 ton-km per USD of GDP in the EU25 countries.59 Thus, logistics costs of trade are high. The estimated "Total Logistics Costs of Trade" are around 15 percent of total trade value in 2008, which is also high compared with other emerging economies. With improved and streamlined border operations and avoidance of unofficial payments, indirect logistics costs could be reduced by USD5 billion and direct logistics costs by USD1 billion. 4.40 The World Bank's cross-country Logistics Performance Index (LPI) ranks Ukraine poorly. In the latest survey (2010), Ukraine ranked 102 out of 155 countries. For comparison, 58 This section draws heavily on key findings of the recent World Bank's Trade and Transit Facilitation Study (2010) for Ukraine. 59 See http://www.eea.europa.eu/publications/eea_report_2006_3; transport intensity in the Baltic States was on average 5 ton-km per one USD of GDP. 60 Poland ranked 30, Romania 50, and Russia 94. The ranks are based on assessments made by freight forwarding/logistics professionals outside Ukraine in eight areas of performance: infrastructure for logistics, efficiency of customs clearance process, quality of transport and information technology, ease and affordability of international shipments, competence of the local logistics industry, ability to track and trace international shipments, timeliness of shipments in reaching destination and domestic logistics costs (Figure 4.14). Ukraine was actually placed at 73th in the last round of this survey in 2007. Considering that no significant changes have been observed in Ukraine over this time and the score in absolute value is almost unchanged, this means that most countries moved forward with investments and reform, leaving Ukraine behind. Figure 4.14: Trade Logistics Performance by Category: Ukraine compared internationally (2009) Overall Logistics Performance Index Customs Infrastructure Logistics Competence Source: World Bank LPI (2010) 4.41 Rail transport has relatively high freight tariffs and uneven reliability. Railways carry over 80 percent of Ukraine's freight traffic. The largest portion of rail traffic passes through only half of the existing network, causing significant congestion. Over the last decade the system has been severely under-investing in maintenance and development, satisfying only around 25-30 percent of needs. As a result, operational costs of fuel and repair have increased. Additionally, freight tariffs subsidize passenger tariffs, which places additional pressure on the export sector. Moreover, due to the lack of adjustment in passenger tariffs, the overall financial position of the rail company is weak, which in turn compromises needed investments. 4.42 The existing limited and deteriorated road infrastructure can no longer support private sector growth. The road network of Ukraine covers 169,400 kilometers, or 281 61 kilometers per 1000 sq km, one of the lowest road network densities in Europe. Only 280 kilometers of road comply with EU TEN standards.60 During recent years the vehicle fleet and the traffic volume in highways have increased significantly. The most strategic export corridors are in poor condition and working at peak capacity due to steadily increasing commercial traffic. The average funding for maintenance over the last five years for the national roads network was around 0.5 percent of GDP, while expenditures on road maintenance in most countries are about three times this level. All these problems, together with the poor regulatory framework for the commercial transport sector, increase cargo costs. 4.43 Ukraine's port system generates high costs to exporters and less than reliable service. Ukraine has 18 main seaports along the Black Sea and Azov Sea as well as number of river ports on the Dnieper and Danube. Most ports deal with bulk transportation, and only three have significant container operations. Some key ports have substantial capital requirements related to container berth and handling capacity increases (see World Bank's transport and transit facilitation study). 4.44 Strategic planning between ports, railway, roads, and customs/border agencies is disjointed. Investment, development, and capacity planning follows silo-style planning and decision-making, with separate and non-harmonized strategies. Consequently, the potential of Ukraine's strategic geographic location as a transport and logistics center remains almost untapped. 4.45 Ukraine lacks an adequate level of warehousing space, storage, and other logistics facilities. Firms operating in Ukraine or with transit through Ukraine have invested to be able to service themselves, as third party logistics services are underdeveloped. International experience shows that lack of business services such as logistics and facilitation generates significant productivity losses (World Bank 2005). Warehousing demand is much higher than the supply of existing stock and land plots available to build new facilities, particularly in key urban centers. The shortfall is more acute in temperature-controlled warehousing, which hampers the handling of products that require an uninterrupted cold chain from processing to the storage (e.g., Ukraine's food processing sector). Problems with land policy and construction permits are partly to blame for these shortcomings. 4.46 The heavy traffic on Ukraine's western borders exceeds the existing capacity of border facilities. Delays originated by lack of capacity generate significant costs and are likely to deter trade growth. The so-called "single window" for border processes has not worked effectively so far, as it operates differently from the international standards established by UN- CEFACT. It merely consists of an office at border stations where most agencies are located in one place, yet the procedure is such that all the paper work is still scrutinized by each agency. There is significant room to reduce red tape in the current system by placing more responsibilities on the Customs administration. Moreover, a paradigm change is needed regarding control, replacing the aim of scanning 100 percent of cargo with an adequate risk- based examination system. 60 Close to 63 percent of the network was built according to obsolete engineering standards. In 2008, over 500 bridges fail to meet adequate safety standards. 62 5. ACCELERATING GROWTH 5.1 The comprehensive diagnostic of Ukraine's growth prospects undertaken in chapters 2 through 4 underlines the breadth and depth of the country's reform needs. The task seems daunting. Yet, the approach of this report - examining the economy from different perspectives and then distilling the key obstacles to growth - also lends itself to developing a prioritized and sequenced reform program. This chapter presents the urgent short-run objectives of key reform areas needed to accelerate growth, and provides a set of detailed measures to achieve that aim. The next chapter examines the medium-term (beyond 12 months) reform agenda to sustain high rates of growth over time. 5.2 Underlying the following discussion and recommendations is a vision of a Ukraine where the footprint of the state is both smaller and more even-handed, and where private investment and business thrive due to the stimulus of competition rather than on the back of connections with the state and political patronage. 5.3 To secure stabilization and accelerate growth, fiscal, banking and business entry reforms are urgently needed. Public finances must be stabilized by reducing the deficit to restore confidence and encourage capital inflows to return. Urgent fiscal measures and reforms are also needed to create fiscal space for infrastructure investments that would support the weak real sector, spur employment and enable the recovery. Banking sector measures are needed to rehabilitate the fragile system and enable it to start intermediating resources to the economy. And key obstacles to business entry need to be lifted credibly to attract investment and reduce unemployment. 5.4 These three reform challenges are inter-related. Without fiscal reform, macroeconomic stability and a sustained recovery will not be possible and investors will remain risk averse toward Ukraine. Without private investment through the entry of new businesses to fuel the recovery, fiscal consolidation will be more difficult, and banks will struggle to find viable lending opportunities. Without a stable and properly capitalized banking sector and regained trust among depositors, banks will not have the resources and the strength to support private businesses. Because of these inter-linkages, all three reform areas must be tackled simultaneously with enough strength and credibility to create momentum in the short term. A. STARTING FISCAL REFORM TO CREATE SPACE FOR PUBLIC INVESTMENTS AND TO ATTRACT PRIVATE INVESTMENT 5.5 The current fiscal model has proven unsustainable and fiscal reform has become the most urgent priority. In the context of constrained external financing, delayed spending adjustment, growing public debt, and significant infrastructure investment needs, Ukraine's fiscal model is unsustainable. In the short term, the lack of corrective fiscal action exacerbates macro risks because of its impact on market confidence. Moreover, the lack of fiscal space for public investment hampers the recovery and opportunities for job creation. In the medium term, lack of fiscal reform could compromise debt sustainability, keep borrowing costs high, and leave little fiscal space for the backlog of public investments needed to support private sector growth, particularly for exports. The unreformed pension system and Ukraine's aging population 63 threatens short term fiscal viability (with growing deficits that are becoming un-financeable) and long term sustainability (by 2020 there will be almost one pensioner for each contributor in the system and this ratio will worsen sharply after that). Yet many pensioners receive a small pension in nominal terms. Reforms are needed to protect current and future pensioners and improve the prospects of having pension payouts that are more in line with contributions. Despite more than doubling import gas prices in foreign currency, a significant depreciation of the UAH, and double-digit inflation over the last three years, utility tariffs have been adjusted only marginally since 2006. Domestic household utility tariffs (mainly for gas and heating) are well below cost recovery. In the absence of a program of tariff increases, Naftogaz and utility enterprises may risk bankruptcy whilst infrastructure deteriorates, causing further inefficiencies and fiscal pressures. At the same time, VAT tax exemptions and international double taxation treaties and loopholes continue to erode the potential for revenue mobilization, which requires high marginal rates to maintain the average tax burden as percent of GDP. Moreover, the backlog of VAT refund arrears is hindering exporters at a time when the country's economy needs them the most to support the recovery. 5.6 The objectives of fiscal reforms in the short term and their linkages to accelerating growth are to: (i) secure stability through a prudent fiscal stance to attract investors back to the country; (ii) solve the problem of VAT refund arrears to support the export sector; and (iii) generate fiscal space for public investments that would support employment and growth. On the expenditure side this can be done by initiating structural pension reform and increasing energy tariffs. This process should be mindful of properly funding well-targeted social assistance programs to protect the poor by reallocating funds from badly targeted programs. On the revenue side, this can be done by eliminating tax exemptions and curtailing loopholes on the enterprise profits tax such as double taxation international treaties, to expand the tax base. Measures on the revenue side also bring about a more balanced adjustment between citizens and firms. 5.7 The strategy described above is basically a re-orientation of fiscal resources to face the current pressures and enable the economy to recover. The specific measures discussed below need to be taken during the first 6-12 months of recovery and growth (Table 5.1). They are designed to help reorient the budget toward growth by solving short-term imbalances and setting a path to gradually restore sustainability. All these measures are designed in parallel to improvements in safety net targeting to protect poor households. Other medium term and structural measures are presented in the next chapter. 64 Table 5.1: Short Term Fiscal Measures and Reforms Public Investments - Increase infrastructure investments by 1% of GDP in 2010 and 2012 (focus on the transport and energy). Pensions Reform - Cap pension payments for working pensioners. - Marginally reduce the accrual rate for all pensioners and/or go back the accrual rate of 1% for new pensioners. - Postpone paying special pensions until the statutory retirement age. - Freeze the special and privileged pension benefits transferred from the budget (overall size and top-ups). - Eliminate the 1% increase of pension benefit for service above 20/25 years for women/men. - Gradually increase retirement age for women from 55 to 60, with an increase of six months per year. - Start converging special/privileged pension levels to regular pension formula. - Gradually increase the averaging period for pensionable wages for some categories of special pension benefit recipients. - Lengthen the years of service required for minimum pension from 20/25 to 30/35 for new pensioners. - Introduce a stable inflation indexation rule. Utility Tariffs and Targeting Social Assistance to the Most Vulnerable Households - Increase the threshold in the program for the extreme poor from the current level to 50% of the subsistence minimum (increasing the funding for this well-targeted program). - Increase the threshold in the housing and utility subsidies program (HUS) to 30%. - Introduce an eligibility threshold for housing and utility privileges at two or three subsistence minimums. - Increase gas tariffs for households, heating enterprises (the tariffs of these two consumers should converge) and budget institutions. - Change the thresholds of gas tariff differentiation for households to better target the subsidy in the short term. - Increase gas tariffs for industry. - Increase heating tariffs for household. - Increase electricity tariffs for residential and non-residential consumers during 2010-12. - Centralize heating tariff-setting mechanism. - Open a special purpose account for centralized gas payment collections from heating enterprises. Tax Policy and Administration Reform - Implement a program to deal with VAT refund arrears that does not create market inefficiencies and does not punish VAT creditors with implicit discounts. All 2010 refunds should be paid in cash. - Eliminate VAT privilege for agriculture. - Eliminate VAT exemptions for medicines, publishing houses and printed materials. - Eliminate the excise exemption on bio components of fuel. - Eliminate the preferential tax treaty with Cyprus on the EPT. PFM Reform - Implement legislation on public procurement in line with good international practice and harmonized with EU directives. - Strengthen the government regulatory framework for project evaluation and selection. 65 B. ENABLING A HEALTHY CHURNING IN THE ECONOMY: BREAKING DOWN ENTRY AND EXIT BARRIERS 5.8 The costs of entry and operation in Ukraine are high and there are barriers to exit as well. Ukraine ranks 134th out of 183 countries on the ease of starting a new business (Doing Business survey), one of the worst in the region and among the worst of emerging economies. Businesses have to comply with a long list of permits, a protracted process of licensing, unnecessary mandatory standards and certifications and other hurdles imposed by the outdated Soviet-era regulatory system. They also have to follow a similarly arduous process to open new product lines within an operating firm. Entry and operation costs are particularly burdensome for promising growing sectors that have export potential and have been more resilient to the crisis, such food processing and new light manufacturing. Closing a business also requires a long, cumbersome and costly process to dispose of assets and start a different economic activity, which hinders efficient reallocation. Prior to the crisis, and in the context of high profits and low competition, many of the issues raised above were simply considered an unavoidable "extra tax". Under current conditions and in the post-crisis environment, with lower profits and slower growth, these weaknesses will keep new businesses and FDI away, harming growth and employment recovery. 5.9 The objectives of business entry and exit reforms in the short term and their linkages to accelerating growth are to: (i) enable a healthy reallocation of resources in the economy from declining sectors and firms to more resilient sectors and new firms, which would help to generate employment and growth; and (ii) remove key obstacles to business entry and exit to attract FDI and encourage domestic investors with resources to start new ventures. In the short term, credible reforms need to be taken to generate enough momentum in licensing, permits, standards, and certification. Initial entry of business will not only help employment but also help to build confidence in the economy and policy makers. Table 5.2 contains the proposed short-term measures Table 5.2: Business Entry and Exit Reforms Business Entry Reforms - Reduce the groups of activities subject to licensing by at least 30%. - Eliminate outdated technical regulations and start adopting EU regulations (a meaningful "guillotine" approach is needed to start momentum in this reform area). - Eliminate mandatory certification for goods and services that do not require it in line with EU and international practice. Business Exit Reforms - Legislate and implement a streamlined and swift legal framework for bankruptcy/insolvency. C. FIXING THE FINANCIAL SECTOR 5.10 The banking sector contributed to overheating the economy, was at the center of the macroeconomic pressures as the crisis unfolded, and is essential to the recovery. Mounting vulnerabilities in the banking sector, generated by lax credit analysis in the context of fast credit growth fueled by external borrowing, were accentuated by the crisis. During the years prior to 66 the downturn, regulation and supervision were unable to catch up with the growth of the sector, and thus currency and maturity risks increased, coupled with severe under-provisioning for potential problem loans. Access to finance through the banking sector is not likely to be a constraint to growth over the medium term. But in the short term, the economy cannot afford another year of drastic deleveraging, and thus rehabilitating the sector is essential to secure stability and recovery. This requires a renewed effort to tackle the legacies of the past and strengthen regulation and transparency to regain trust. 5.11 This is the time to reform the banking sector to avoid a protracted downturn due to the lack of intermediation, and to prepare the sector for future shocks. While progress has been achieved over the last year (e.g., setting up the process of recapitalization, providing the regulator with resolution tools), significant pressures and threats face the system today: unrecognized NPLs may rise, a large number of small banks cannot intermediate effectively the declining amount of national savings, and supervision and regulation is not ready to prevent another crisis. Recapitalizing the system whilst increasing its transparency is central to the rehabilitation process. Beyond that, regulation and supervision reforms should help to make the financial sector more resilient to shocks whilst being a reliable source of financing for a growing domestic economy. But the window of opportunity for reforms in the sector is closing. Table 5.2: Banking Sector Measures and Reforms Regulation and Supervision - Enact amendments to the legislative framework to facilitate NPLs restructuring. - Enact amendments to the legislative framework to facilitate bank mergers and reorganization. - Enact a legislative framework (through the banking law and the law on financial services) to enforce the disclosure of ultimate ownership of banks and non-bank financial institutions. The new legislation should significantly enhance the definition of beneficiary ownership (with a threshold of 5%) and include related legal entities, family and other associated persons at all levels. - Ensure that capitalization plans in all banks are fulfilled. - Legislate and enforce consolidated supervision of financial conglomerates. - Enact the legislative and regulatory framework to introduce the updated Basel regulatory framework. - Increase capital requirements to open a bank and strengthen the standards and enforcement of "fit and proper" criteria. - Revise capital requirement and provisioning rules to assure solvency and to avoid excessively pro- cyclical banking lending. Banks Resolution and Restructuring of State-Owned Banks - Further improve the set of resolution tools available to the NBU. - Complete due diligence in all banks recapitalized with public funding and improve corporate governance arrangements. - Transfer of bank resolution powers to DGF. - Divest nationalized banks that are commercially viable and can be sold at a fair value. Transparency and Governance - Enact legislation to make individual bank data transparent and publicly available in line with predominant international practice. - Avoid conflict of interest in the appointment of members of the council of the NBU. 67 6. SUSTAINING GROWTH 6.1 Ukraine is geographically and economically well placed to be an economic powerhouse in Eastern Europe. However, achieving this objective will depend on sustaining the economic reform effort beyond the end of the recovery from the current crisis. Productivity growth will need to drive income improvements, and the reform program laid out in this chapter is designed to achieve that goal. 6.2 To sustain growth, deeper investment climate, fiscal, and public sector reforms will be needed. With capital markets likely to remain more selective and risk averse than in the past, Ukraine's growth will have to rely on significant productivity gains. These gains will only be driven by a more dynamic entry and exit of firms in the economy, more competition, and more sophistication and diversification in Ukraine's export basket. At the same time, significant public investment and improved public services will be required to support productivity and export growth, which in turn requires deeper fiscal reforms. Lastly, to achieve sustained growth, the public sector will need to be streamlined and reformed, enforcing the rule of law and eliminating red tape that drags FDI, businesses and citizens. A. DEEPENING INVESTMENT CLIMATE REFORMS 6.3 Ukraine seems to be trapped in a self-perpetuating low equilibrium of high entry barriers, low competition, limited incentives for technology adoption, low export diversification and sophistication, high vulnerability to commodity prices, and incumbent fears of reduced rents that encourage them to support entry barriers (Figure 5.1) Figure 5.1: A Vicious Circle of Investment Climate, Competition, and Structural Transformation 6.4 Businesses face a bewildering array of rules and regulations, cumbersome processes to obtain permits and licenses, outdated standards and certification requirements, and weak legislation on property rights. Entry barriers are coupled with high costs of operation through 68 heavy-handed inspections from numerous unreformed control agencies, high tax compliance costs, and high costs for transport and logistics facilitation. While the Competition Law is broadly aligned with international practices, its application has remained in some instances subject to political pressures. These factors, in tandem with others, have limited competition across sectors. Limited competition has also slowed the drive for technology adoption and modernization. The country failed to upgrade technologically during the last decade and has remained stuck in an extensive, commodity-driven growth path that has amplified volatility and limited productivity growth. Key competitors have moved ahead with export diversification and sophistication, leaving Ukraine behind. This vicious circle is hampering the structural transformation of the country's economy and crippling the aspiration of reaching higher levels of per capita income and living standards for Ukraine's citizens. 6.5 The objectives of deep investment climate reforms and their linkages to sustained growth are to: (i) lift all barriers to entry and exit to improve competition and ultimately productivity growth; (ii) increase and sustain FDI to foster technology adoption, modernization and productivity; and (iii) promote product diversification and sophistication to enable Ukraine's economy to become more resilient to shocks and be sustainably driven by export-led growth. In short, reliance on foreign savings to finance explosive domestic consumption will not be an option in the current conditions of tight credit. But deep policy improvements to strengthen the institutional framework for business and competition will help to break the self-perpetuating low equilibrium above-described and accelerate and sustain growth over the medium term. 6.6 Thus, beyond the initial bold measures to lift obstacles on entry and exit recommended to spark economic recovery discussed in Chapter 5, deeper reforms on the business regulatory and control are needed to sustain high growth in the medium and long term. Table 6.1 contains some specific measures that should be considered. Table 6.1: Investment Climate Measures and Reforms Regulatory Reform - Reduce to a minimum the categories subject to licensing in line with international practice. - Fully implement risk-based supervision across all inspection bodies. Encourage Export Diversification, Sophistication, and Growth - Adopt EU harmonized standards across the board. - Reform sanitary and phyto sanitary requirements and introduce modern food safety regulation. - Lift sector-specific constraints for products/sub-sectors with export potential. - Improve the intellectual property rights legal framework and its enforcement in the courts. - Better protect the rights of foreign investors, particularly in joint partnerships to enable technology transfer. - Support marketing and investment (green box) subsidies rather than input and production subsidies in agriculture. - Re-align incentives of R&D funding, for example through grant scheme competitions. - Improve the incentives for collaboration between state R&D institutions and the private sector. Encourage Domestic Investments and FDI - Lift the ban on agricultural land sales. - Implement a unified registry of land and real estate. - Replace the legislation on concessions and other legislation with a single law/framework regulating public-private partnerships (PPP) based on UNCITRAL and OECD principles, which also accounts 69 prudently for fiscal risks. - Re-launch privatization through transparent, competitive auctions to attract FDI and achieve much- needed technological modernization of strategic industrial and energy sectors. - Increase prices for upstream domestic gas supply to stimulate private investment and increased production. Competition - Unify state aid legislation and strengthen political independence of the anti-monopoly committee. - Negotiate the elimination of exemptions in the Ukraine-Russia and other bilateral CIS FTAs. Transport and Behind-the-Border Issues - Separate economic-financial functions and state management activities between railways and government. - Phase out cross-subsidies from freight to passenger rail, which burdens exports. - Invest in transport infrastructure under a comprehensive multi-modal transport policy umbrella to ensure the most efficient use of investments. - Promote investments in logistics facilities through more flexible land and construction permits policies to enable cost savings and facilitate exports and transit. - Streamline border­crossing operations and customs clearance procedure and combat unofficial payments at border crossings. B. DEEPENING FISCAL REFORMS 6.7 The objectives of deeper fiscal reforms and their linkages to sustained growth are to: (i) create fiscal space for public investments, so infrastructure can sustainably support private sector growth (particularly for exports); (ii) gradually reduce the footprint of the public sector in the economy to crowd in the private sector; (iii) improve efficiency and quality of service delivery for Ukraine's citizens; and (iv) secure the sustainability of public finances and social insurance. 6.8 Overall, reforms should aim for a more efficient, smaller government. On the expenditure side this would imply a reallocation of resources from consumption and transfers to productive spending on infrastructure. Subsidies to economic sectors, pensions, utility tariffs, and targeted social assistance reforms are at the core of the fiscal reforms needed. This would also imply reallocating resources within social services (such as education and health) by which quality-enhancing expenditures are increased through savings achieved by a more efficient use of inputs, in the context of the same or a slightly reduced fiscal envelope. On the revenue side, the broad medium-term objective should be to lower the average tax burden through lower marginal rates on direct taxes, particularly on payroll taxes (i.e., social insurance contributions). This should also be accompanied by significant reforms to the Simplified Tax System, which erodes the base of all regular taxes, and measures to improve tax compliance. The reform should be strong enough to sustain significant reallocations to increased public infrastructure spending (particularly in the transport and energy sectors). By the third year of reforms the country should be spending around 4 to 5 percent of GDP in public infrastructure and keep that level over the next 10 years. 6.9 Table 6.2 below provides some of the key measures that should be taken to achieve the broad objectives described above. The World Bank's Public Finance Review I and II (2006 and 70 2008) have a more detailed account and discussion of potential fiscal reforms on every relevant fiscal aspect. Table 6.2: Fiscal Measures and Reforms Public Investments - Increase infrastructure spending by 1% of GDP annually until reaching the level of 4-5% of GDP per annum. - Fully align all capital spending to a country-wide strategy of development. - Improve financial incentives of SOEs to encourage investments in modernization (e.g., dividend policy). Pensions Reform - Continue increasing retirement age for women from 55 to 60, with an increase of six months per year. - Gradually increase the averaging period for pensionable wages for some categories of special pensions. - Lengthen years of service required for minimum pension from 20/25 to 30/35 for new pensioners. - Introduce a stable inflation indexation rule. Utility Tariffs and Targeting of Social Assistance to the most Vulnerable Households - Continue gradual increases of at least 25% per year, as required, on gas tariff increase for households until reaching import parity cost recovery (including investment). - Adjust industry gas tariff to reflect import parity cost recovery (including investment). - Continue gradual increases of at least 25% per year, as required, on heating tariffs until reaching cost recovery (gas cost + investment). - Establish an automatic indexation formula that adjusts tariffs to import prices of gas (including investment). - Invest in energy-saving technology at heating enterprises and in housing, and increase metering. Tax Policy and Administration - Gradually reduce the EPT rate as soon as it is fiscally prudent and manageable. - Reform the EPT in the insurance sector to stop avoidance and evasion schemes. - Reform the simplified tax system (STS) to allow only truly small businesses (including realigning the STS threshold to the VAT). - Continue developing a framework of taxation of the non-bank financial sector. - Improve taxation of extractive industries (including the gas sector) to attract private investments. - Over time, reduce social insurance marginal rates gradually to reduce tax burden on direct taxation, in tandem with the tax base expansion of other taxes to make the process fiscally manageable. - Re-establish a statutory limit after which a VAT refund is considered overdue (maximum 60 days). - Stop or tightly control voluntary registration below the VAT threshold. - Unify the several contributions rates to social funds into single rate. - Introduce a strengthened and centralized large tax payers unit. - Reduce transfer pricing activities and thin capitalization schemes by legislating controls on these practices in industrial-financial groups (following OECD guidelines). - Harmonize regular financial reporting and tax accounting. - Establish a proper framework for asset revaluation. 71 - Legislate and implement indirect methods of auditing for high-income individuals (setting a threshold). - Reduce the number of payments in communal, land, vehicle, and environmental taxes. Education and Health Expenditure Efficiency Reform - Revise, reformulate or eliminate norms dictated by the Ministry of Education and Ministry of Health for budget formation at the facility level. - Allow local governments more discretion on school and health facilities optimization, promoting synergies and eliminating duplication across different facilities. - Develop and implement hospital optimization at the oblast level. - Allow the natural process of attrition to help with the rationalization process by not hiring working pensioners and minimizing new hiring in the education sector. - Improve the responsiveness of vocational training institutions to the need for technical skills in the real sector. - Experiment on a pilot basis with a voucher system for "budget-financed" students in higher education, whereby the students would take funding with them to an institution of their choice to stimulate competition among universities and improve market relevance. - Provide adequate incentives for shifting a larger proportion of doctors into primary care and for integrating the family medicine model more strongly into Ukraine's health system. - Change the payment system for hospital to case-based payment, and for primary care centers to capitation-based payment. PFM reform - Anchor fiscal reforms into the medium-term budget framework. - Implement an integrated system of PFM to better control public finances. - Improve financial management of SOEs. - Implement legislation embedding improvements in planning, evaluation, and selection for multi-year public investments. C. TACKLING PUBLIC SECTOR REFORM 6.10 The objectives of public sector reforms and their linkages to sustained growth are to: (i) improve citizen and investor confidence in the country's rule of law and its economy; (ii) sustainably attract FDI that can help modernize the economy as opposed to just short-term inflows in search of high rents; and (iii) reduce red tape, abuse and corruption in regulatory and control agencies that hamper private sector investment and growth. Meaningfully tackling public sector reform is necessary to improve governance, trust in government, and investor and citizen confidence. Ukraine scores extremely low on public sector governance, despite some improvements made in recent years. Red tape, burdensome regulation, allegations of corruption and abuse, insecure property rights, capture, a perception of weak rule of law, weak governance of SOEs and limited accountability are core problems hampering Ukraine's prospects as a place to make long-term investments. Tackling these problems will require radical reforms in the ways the government interacts with business and citizens: a change in role from a controller to an enabler of markets and welfare. 6.11 Public sector reforms are closely inter-linked with investment climate and fiscal reforms. Public sector reforms will require a public administration reform program that rationalizes redundant state control agencies and redundant roles within the government, which 72 should be done in parallel with investment climate and regulatory reforms. Oversized public sector employment should be addressed in parallel with fiscal reforms to increase spending autonomy and accountability at the local level in social services, such as health and education. Improvements in transparency, governance, and incentives in SOEs are necessary in parallel with fiscal and public financial management reforms. Lastly, significant reforms are needed in the judicial system to level the playing field. Sustained increases in FDI over the medium term from countries that can help to push Ukraine's export diversification and sophistication will depend heavily on these reforms, which require the highest political commitment and leadership. 6.12 Some of the key measures and reforms that should be considered are presented below. Table 6.3: Public Sector Measures and Reforms - Reform and/or eliminate unnecessary regulatory and inspection bodies in line with international practice and reforms in standards and product certification. - Implement the unification of social insurance funds under a single body as a first step to later merge with other revenue authorities. - Reform non-civil service public sector employment and payment in tandem with the optimization process in the health and education sectors. - Reform civil service, starting with streamlining the cabinet of ministers and line ministries, following a functional review. - Strengthen inter-governmental fiscal relations (see specific recommendation in PFR II). - Introduce and implement administrative decentralization. The key objectives should be to provide core functions and administrative responsibilities to a level of local government that has adequate size and capacity to manage them. 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Chief Economist's regional Working Paper Series (part of the Europe and Central Asia Knowledge Economy Study Part III (ECKE II), Washington DC. 77 78 ANNEXES 79 ANNEX 2.1: Poverty Impact of the Crisis and Selected Reform Measure Figure A2.1.1: The Impact of the Crisis on Poverty and Vulnerability in Ukraine (In percent of the population and million people) Projected $5 dollar a day Poverty Rates Projected $5 dollar a day Poverty 18.0 16.8 (Million people) $5 dollar a day poverty and vulnerability rates 15.5 8.0 7.5 16.0 6.9 $5 dollar a day poverty and vulnerability 7.0 14.0 12.9 12.3 5.8 6.0 5.5 12.0 8.9 5.0 10.0 4.1 8.0 4.0 7.9 3.0 6.0 3.5 6.1 2.7 4.0 2.0 4.9 2.2 3.9 1.0 1.7 2.0 0.0 0.0 2007 2008 2009 2010 2011 2007 2008 2009 2010 2011 Pre crisis projections Current projections Pre crisis projections Current projections Source: Ukraine's HBS; Bank staff calculations. Figure A.1.1.2: Poverty Impact Decomposition: Income and Labor Effect and Increased Household Debt Service Costs due to the Exchange Rate Adjustment Effect Unemployment Effect, 9% ER on Debt Repayment Effect, 12% Income-wage Effect, 79% Source: Ukraine's HBS; Bank staff calculations. 80 Figure A2.1.3: Projected Poverty Risk in Ukraine, 2009 Source: Ukraine's HBS, Bank staff calculations. Figure A.2.1.4: Projected Poverty Loss in Millions of People and Percentages in 2009 (left chart) Distribution of the Population by Poverty Status and Population Groups (right chart) Distribution of poverty loss by age and LF status Distribution of the population Other 100% 12% 10% 7% 458 90% 7% student 6% 10% 6% 264 80% 18% 22% Other 6% 70% 16% Children, student 60% 12% 10% 7% 1,001 retired 50% retired 24% 843 40% 26% 32% unemployed 39% 18% employee, 30% selfemployed 1,359 20% employee 33% 10% 27% 24% 16% Children unemployed, 0% 387, self Poor before Become poor Total 9% employed, crisis because of population 54, the crisis 1% Source: Ukraine's HBS; World Bank calculations 81 Figure 3.2.5a and b: Decomposition of the Increase in Debt Repayments of Households due to the Exchange Rate Depreciation Effect, by Quintile Figure A3.2.5a: Increase in the Ratio of Figure A3.2.5b: Debt Repayments Relative Household Debt Repayments to Expenditure 2003 to Consumption by Quintile to 2007 by Quintile 200 18 187.4 180 16 160 Increase by Quintiles 14 Quintile 1 (low) 140 Average Increase 120 12 Quintile 2 100 10 Quintile 3 80 66.0 Quintile 4 53.1 63.4 8 60 Quintile 5 (high) 44.7 40 6 20 8.4 4 0 Quintile 1 (low) Quintile 3 Quintile 5 (high) 2003 2004 2005 2006 2007 Source: Bank staff estimates using HBS. Source: Bank staff estimates using HBS. 82 ANNEX 2.2: Growth Diagnostics Framework--Hausmann, Rodrik and Velasco (2005) 83 ANNEX 3.1: Growth Accounting and Returns on Capital in the Real Sector The analysis also shows that that sectors with higher productivity growth have grown faster than less productive ones (Figure A3.1.1a). This pattern is not so surprising, considering that productivity increases allow for a more efficient use of existing factors of production, in turn bringing higher returns to those sectors. Similarly, the relationship between returns on capital and FDI in Ukraine displays regularity. For most sectors, return on capital and FDI moved in the same direction (Figure A3.1.1b). Not surprisingly, investors seem to be allocating resources in the sectors with the highest returns, except notably for the agriculture sector which shows high returns on capital but modest FDI (Figure A3.1.1 b and d). Another interesting pattern is the tendency of the Ukrainian sectors to converge. Convergence implies that sectors that started out with the lowest returns have shown the highest increases later in time, while sectors with high initial return on capital have only exhibited modest increases of return on capital or decreases (Figure 3.1.1c). Figure A3.1.1a: GDP and TFP Growth Figure A3.1.1b: Returns on Capital and FDI 0.3 Average RoRK adjusted for capacity utilization and FDI share in total economy value added 15% 24% 0.2 14% 22% GDP growth 13% 20% 0.1 12% 18% 11% 16% 0 10% 14% 9% 12% 0.2 0 0.2 0.4 0.1 8% 10% 2002 2003 2004 2005 2006 2007 0.2productivity growth Average RoRK (l eft axi s) FDI/VA Ukrai ne(right axis) Figure A3.1.1c: Sectoral TFP and Growth Figure A3.1.1d: Average Rates of Return on Capital 2002-07 0.3 0.14 0.25 Education 0.12 Change in RORK, 2001- 0.2 Agriculture, Forestry, 0.1 and Fishing 0.15 0.08 Health and Social 0.1 Work Wholesale Manuf acturing 2007 0.05 0.06 Mining and Quarring and Construction Retail Trade 0 0.04 (C) Mining and Quarrying (D) Manufacturing (E) Electricity, Gas and Water (O) Other Types of Economic Total Economy (G) Wholesale and Retail Trade, (I) Transport and (A, B) Agriculture, Fishing and (F) Construction Communications 0.02 Transport and Activity Communication 0 Forestry Supply etc 0 0.05 0.1 0.15 Electricity, Gas -0.02 and Water Supply -0.04 RORK in 2001 Source: SSC, Bank staff calculations. 84 Figures A3.1.2: Growth Accounting by Sector (with fixed capital (0.4) and labor (0.6) shares, dynamic adjustment for capacity utilization). Real value added growth explained by Growth accounting, Agriculture factors of production, Agriculture 100% 0.3 0.2 80% % real value added growth % changes in production factors 0.15 60% 0.2 percent real value added 0.1 growth rate explained by 0.1 0.05 40% TFP 0 0 20% percent real value added 0.05 growth rate explained by 0.1 0% 0.1 labor force 0.2 0.15 20% percent real value added 2003 2004 2005 2006 2007 40% growth rate explained by capital stock 60% changes in capital stock changes in labor force 2003 2004 2005 2006 2007 productivity growth real value added growth Real value added growth explained by Growth accounting, Mining and factors of production, Mining and Quarrying Quarring 0.2 Quarrying Quarring 0.1 100% % real value added growth % changes in production factors 0.15 80% 0.08 0.1 60% percent real value added 0.06 growth rate explained by 0.05 40% TFP 0 0.04 20% percent real value added 0.05 growth rate explained by 0% 0.02 labor force 0.1 20% 0.15 0 percent real value added 40% growth rate explained by 2003 2004 2005 2006 2007 60% capital stock changes in capital stock changes in labor force 2003 2004 2005 2006 2007 productivity growth real value added growth Real value added growth explained by Growth accounting, Manufacturing factors of production, Manufacturing 100% 0.2 0.18 % real value added growth % changes in production factors 0.16 80% 0.15 0.14 60% 0.1 percent real value added 0.12 0.05 growth rate explained by 0.1 40% TFP 0 0.08 0.06 20% percent real value added 0.05 growth rate explained by 0.04 0% 0.1 0.02 labor force 0.15 0 20% percent real value added 2003 2004 2005 2006 2007 growth rate explained by 40% capital stock 60% changes in capital stock changes in labor force 2003 2004 2005 2006 2007 productivity growth real value added growth Real value added growth explained by Growth accounting, Electricity, Gas factors of production, Electricity, Gas and Water Supply 0.15 and Water Supply 0.06 100% % real value added growth % changes in production factors 80% 0.1 0.04 60% percent real value added 0.05 0.02 growth rate explained by 0 0 40% TFP 0.05 0.02 20% percent real value added 0.1 0.04 0% growth rate explained by labor force 0.15 0.06 20% 0.2 0.08 percent real value added 40% growth rate explained by 2003 2004 2005 2006 2007 60% capital stock changes in capital stock changes in labor force 2003 2004 2005 2006 2007 productivity growth real value added growth 85 Real value added growth explained by Growth accounting, Construction factors of production, Construction 100% 0.3 0.3 80% % real value added growth % changes in production factors 0.25 0.25 0.2 0.2 60% percent real value added 0.15 0.15 growth rate explained by 0.1 0.1 40% TFP 0.05 0.05 0 0 20% percent real value added 0.05 0.05 growth rate explained by 0.1 0.1 0% labor force 0.15 0.15 0.2 0.2 20% percent real value added growth rate explained by 2003 2004 2005 2006 2007 40% capital stock 60% changes in capital stock changes in labor force 2003 2004 2005 2006 2007 productivity growth real value added growth Real value added growth explained by Growth accounting, Wholesale and factors of production, Wholesale and Retail Trade Retail Trade 100% 0.2 0.25 80% % real value added growth % changes in production factors 0.15 0.2 percent real value added 0.1 0.15 60% growth rate explained by 0.05 0.1 TFP 40% 0 0.05 percent real value added 0.05 0 20% 0.1 0.05 growth rate explained by 0.15 0.1 0% labor force 2002 2003 2004 2005 2006 2007 percent real value added 20% growth rate explained by 40% capital stock changes in capital stock changes in labor force 2002 2003 2004 2005 2006 2007 productivity growth real value added growth Real value added growth explained by Growth accounting, Transport and factors of production, Transport and Communication 0.2 Communication 0.12 100% % real value added growth % changes in production factors 0.15 0.1 80% 0.1 percent real value added 0.08 60% growth rate explained by 0.05 0.06 TFP 40% 0 0.04 percent real value added 0.05 20% growth rate explained by 0.1 0.02 labor force 0% 0.15 0 percent real value added 20% 2002 2003 2004 2005 2006 2007 growth rate explained by 40% capital stock changes in capital stock changes in labor force 2002 2003 2004 2005 2006 2007 productivity growth real value added growth Real value added growth explained by Growth accounting, Other Economic factors of production, Other Economic Activity 0.4 Activity 0.25 100% % real value added growth % changes in production factors 80% 0.3 0.2 percent real value added 60% growth rate explained by 0.2 0.15 TFP 40% 0.1 0.1 percent real value added 20% growth rate explained by 0 0.05 labor force 0% 0.1 0 percent real value added 20% growth rate explained by 2002 2003 2004 2005 2006 2007 40% capital stock changes in capital stock changes in labor force 2002 2003 2004 2005 2006 2007 productivity growth real value added growth 86 Figure A.3.1.3: Returns on Capital (RoRKs) by Economic Sector (including sub-sectors of manufacturing) RoRK RoRK adjusted for capacity utilization total economy total economy 0.16 0.18 0.14 0.16 0.12 0.14 0.1 0.12 0.08 0.1 0.08 0.06 0.06 0.04 0.04 0.02 0.02 0 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Capital Share (dynamic) Capital Share (dynamic) Average RoRK (over dynamic shares, rule of thumb and B&G) Average RoRK (over dynamic shares, rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Agriculture, Fishing and Forestry Agriculture, Fishing and Forestry 0.3 0.45 0.25 0.4 0.35 0.2 0.3 0.15 0.25 0.2 0.1 0.15 0.05 0.1 0 0.05 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Mining and Quarrying Mining and Quarrying 0.25 0.18 0.16 0.2 0.14 0.15 0.12 0.1 0.1 0.08 0.06 0.05 0.04 0.02 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Manufacturing Manufacturing 0.18 0.25 0.16 0.14 0.2 0.12 0.15 0.1 0.08 0.1 0.06 0.04 0.05 0.02 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) 87 RoRK RoRK adjusted for capacity utilization Electricity, Gas and Water Supply Electricity, Gas and Water Supply 0.18 0.09 0.16 0.08 0.14 0.07 0.12 0.06 0.1 0.05 0.08 0.04 0.06 0.03 0.04 0.02 0.02 0.01 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Construction Construction 0.2 0.45 0.18 0.4 0.16 0.35 0.14 0.12 0.3 0.1 0.25 0.08 0.2 0.06 0.15 0.04 0.1 0.02 0.05 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Wholesale and Retail Trade, etc Wholesale and Retail Trade, etc 0.25 0.7 0.6 0.2 0.5 0.15 0.4 0.1 0.3 0.2 0.05 0.1 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Transport and Communications Transport and Communications 0.12 0.12 0.1 0.1 0.08 0.08 0.06 0.06 0.04 0.04 0.02 0.02 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) 88 RoRK RoRK adjusted for capacity utilization Other Types of Economic Activity Other Types of Economic Activity 0.12 0.12 0.1 0.1 0.08 0.08 0.06 0.06 0.04 0.04 0.02 0.02 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Food and Agricultural Processing Food and Agricultural Processing 0.25 0.35 0.3 0.2 0.25 0.15 0.2 0.1 0.15 0.1 0.05 0.05 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Textile and apparel Textile and apparel 0.45 0.6 0.4 0.5 0.35 0.3 0.4 0.25 0.3 0.2 0.15 0.2 0.1 0.1 0.05 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Leather and footwear Leather and footwear 0.9 1.2 0.8 1 0.7 0.6 0.8 0.5 0.6 0.4 0.3 0.4 0.2 0.2 0.1 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) 89 RoRK RoRK adjusted for capacity utilization Wood and paper Wood and paper 0.25 0.35 0.3 0.2 0.25 0.15 0.2 0.1 0.15 0.1 0.05 0.05 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Cox and Oil Refining Cox and Oil Refining 0.25 0.35 0.3 0.2 0.25 0.15 0.2 0.1 0.15 0.1 0.05 0.05 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Chemical and petrochemical Chemical and petrochemical 0.09 0.14 0.08 0.12 0.07 0.1 0.06 0.05 0.08 0.04 0.06 0.03 0.04 0.02 0.01 0.02 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Rubber and plastic goods Rubber and plastic goods 0.3 0.5 0.45 0.25 0.4 0.2 0.35 0.3 0.15 0.25 0.2 0.1 0.15 0.05 0.1 0.05 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) 90 RoRK RoRK adjusted for capacity utilization Other NonMetal Mineral Products Other NonMetal Mineral Products 0.18 0.25 0.16 0.14 0.2 0.12 0.1 0.15 0.08 0.1 0.06 0.04 0.05 0.02 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Iron and Steel Iron and Steel 0.25 0.3 0.2 0.25 0.2 0.15 0.15 0.1 0.1 0.05 0.05 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) RoRK RoRK adjusted for capacity utilization Machine Building Machine Building 0.14 0.25 0.12 0.2 0.1 0.15 0.08 0.06 0.1 0.04 0.05 0.02 0 0 2001 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Rule of thumb Rule of thumb Capital Share (B&G Region Dummies) Capital Share (B&G Region Dummies) Average RoRK (over rule of thumb and B&G) Average RoRK (over rule of thumb and B&G) 91 Figure A.3.1.4: Value Added by Sector Value Added by Sector (2002) (A,B) Agriculture, Fishing and Forestry (C) Mining and Quarrying 16% 16% 3% 4% (D) Manufacturing 5% (E) Electricity, Gas and Water Supply (F) Construction 14% 20% (G) Wholesale and Retail Trade, etc (I) Transport and Communications 12% 6% 4% (M) Education (N) Health and Social Work (O) Other Types of Economic Activity Source: SSC, Bank staff calculations. Figure A.3.1.5: Value Added within Manufacturing, by Sector Value Added by Subsector of Manufacturing (2002) Value Added by Subsector of Manufacturing (2007) (DA) Food and Agricultural Processing (DA) Food and Agricultural Processing 24% 25% 21% 22% (DB) Textile and apparel (DB) Textile and apparel (DC) Leather and footwear (DC) Leather and footwear 3% 4% (DD, DE) Wood and paper 1% (DD, DE) Wood and paper 1% (DF) Cox and Oil Refining 5% (DF) Cox and Oil Refining 6% (DG) Chemical and petrochemical 3% (DG) Chemical and petrochemical 23% 30% 4% 5% (DH) Rubber and plastic goods (DH) Rubber and plastic goods 3% 6% 7% 5% 2% (DI) Other NonMetal Mineral Products (DI) Other NonMetal Mineral Products (DJ) Iron and Steel (DJ) Iron and Steel (DK) Machine Building (DK) Machine Building Source: SSC, Bank staff calculations. 92 ANNEX 3.2: An Overview of the Steel Sector The Ukrainian mining-metallurgy complex consists of metal mining, coke production, steelmaking and rolling industries (Figure A3.2.1). Over the years the most successful companies have been able to integrate vertically and have taken advantage of resource inputs present in the country (around 20 percent of world reserves of iron ore, 30 billion tons of ironstone, 30 percent of world reserves of manganese, and coking coal reserves--although the country imports more than one-third of coking coal needs). The sector's main outputs are rolled steel, other semi-ferrous and steel rods and bars, pig and cast iron, pipes and hollow profiles, and scrap metal. These products are on the lower value added end of the industry. The main markets are in the Middle East (mainly for construction), Europe (in many case sold to other markets by European affiliated companies) and CIS countries (Figure A3.2.2). The main competitors for this sector are in China and Turkey. Figure A.3.2.1: Ukrainian Mining-Metallurgy Complex Coal sector Coking coal Coking Coke industry Fireproofs Agglomerate Fireproofs Fireproofs Blast-furnace Slab Cast iron Steelmaking Rolling Rolled metal production Fireproof industry Agglomerate industry Burnt dolomite Blanks Pellets Burnt dolomite Limestone Extraction and Dolomite Limestone enrichment of flux stuff Agglomeration Sheet industry products Extraction and enrichment of Concentrate, Concentrate agglomerate Ferroalloys Pipes manganese Ferroalloys Pipe industry stuff production Concentrate, Extraction and sintering ore Scrap metal Store up of enrichment of iron-and-steel iron-ore stuff scrap 93 Figure 3.2.2: Selected Indicators of the Steel Sector Geographical import structure, Merchandise export structure, bn US$ bn US$ Ferroalloy s CIS $1,0 6 $0,8 4 $0,6 $0,4 Pipes 2 Semis $0,2 0 $0,0 Asia EU Rods/bars Rolled f lat 2006 2007 2006 2007 Skill constraint as an obstacle for enterprise Capacity utilization in development metallurgy 30 100 25 90 20 % 80 15 70 10 60 5 50 01 1 02 1 03 1 04 1 05 1 06 1 07 1 0 20Q 20Q 20Q 20Q 20Q 20Q 20Q 01 2 01 3 02 2 02 3 02 4 03 1 03 2 06 3 06 4 07 1 20 Q 20 Q 20 Q 20 Q 20 Q 20 Q 20 Q 20 Q 20 Q 20 Q 94 ANNEX 3.3: Non-Bank Financial Sector Development of the non-bank financial system has lagged behind the banking sector, despite the growing interest of foreign investors in Ukrainian insurance and non-bank finance companies (e.g., leasing). The share of the non-bank financial sector was less than 10 percent of GDP in 2008 and shrank further in 2009, owing to bankruptcies and closure of numerous credit unions, insurance and leasing companies and reduction of overall demand for the financial services (Table A3.3.1). Table A3.3.1 Performance of the Non-Bank Financial Sector, 2008-2009 Insurance Credit companies Financial companies companies Legal entities of Life Insurance Credit unions NS Other credit Pawnshops investment Real estate companies public law Insurance Factoring NBFI institutions Non-life TOTAL TOTAL TOTAL Leasing PFs funds Number of institutions 2008 469 72 397 878 829 20 29 110 193 32 47 315 362 2009 450 72 378 816 755 32 29 109 208 43 64 373 313 Assets, bln UAH 2008 41.9 n/a n/a 12.6 6.1 3.2 3.3 0.6 n/a 28.5 1.4 0.5 8.0 2009 42.0 n/a n/a 11.8 4.2 3.1 4.5 0.9 n/a 27.2 1.6 0.6 7.8 Source: State Commission for Regulation of Financial Services Market (NBFIR). 95 ANNEX 4.1: Firm Productivity Analysis and Competition Figures A4.1.1: Firm Size Distribution Shares of Firm Size Groups (%) Non- Total Agricultural Manufacturing Business Economy Business Sector Services Sector Size Group #firm #emp #firm #emp #firm #emp #firm #emp 400 1.03 44.50 0.56 44.82 2.80 57.77 0.33 37.07 150, <400 2.70 16.87 1.22 10.91 4.72 15.87 0.93 10.96 50, <150 6.73 15.60 4.34 13.75 9.42 11.62 3.54 14.76 20, <50 12.48 10.83 10.91 13.14 17.64 8.10 9.28 14.77 >0, <20 77.06 12.20 82.97 17.37 65.41 6.64 85.92 22.45 #firm represents the ratio of the number of firms in a group to the total number of firms. #emp represents the shares weighted by employment. Shares of Firm Size Groups (%) (Private Sector) Non- Total Agricultural Manufacturing Business Economy Business Sector Services Sector Size Group #firm #emp #firm #emp #firm #emp #firm #emp 400 0.79 35.41 0.32 27.91 2.66 56.18 0.19 15.95 150, <400 2.42 18.67 0.93 12.18 4.54 16.24 0.73 12.56 50, <150 6.16 17.78 3.59 16.53 9.22 11.99 2.96 18.07 20, <50 11.87 12.79 10.07 17.65 17.79 8.62 8.61 20.06 >0, <20 78.75 15.35 85.08 25.72 65.79 6.96 87.51 33.36 #firm represents the ratio of the number of firms in a group to the total number of firms. #emp represents the shares weighted by employment. 96 Average Shares of the Firms with Less than 20 Employees Number of Firms (%) Employment (%) Non- Non- Total Manufacturing Business Total Manufacturing Business Agricultural Agricultural Economy Sector Services Economy Sector Services Business Sector Business Sector Industrial Countries Denmark 91.3 89.5 76.6 92.3 32.7 31.1 17.6 35.0 France 82.1 82.3 77.9 82.0 15.9 16.0 19.9 13.6 Italy 93.8 93.6 88.6 96.0 35.9 39.6 31.3 36.4 Netherlands 96.3 96.5 88.3 97.1 31.8 36.8 18.3 32.9 Finland 93.6 92.7 85.4 95.3 29.5 32.7 13.5 39.1 Portugal 89.2 88.9 75.3 93.8 32.2 31.4 18.9 42.9 USA 88.0 88.0 72.6 88.7 18.4 19.3 6.7 19.9 Latin America Mexico 90.1 90.0 82.8 92.2 23.2 24.5 13.9 28.5 Argentina 90.0 89.4 82.1 91.1 27.7 27.7 21.3 27.7 Transition Economies Ukraine 77.1 83.0 65.4 85.9 12.2 17.4 6.6 22.5 (Pr. Sector) 78.8 85.1 65.8 87.5 15.4 25.7 7.0 33.4 Slovenia 87.7 88.0 71.6 93.1 13.4 13.5 5.1 26.0 Hungary 84.4 85.5 71.1 90.8 16.0 16.4 8.8 23.6 Estonia 80.6 81.3 64.6 87.1 22.8 22.6 11.5 34.2 Latvia 87.7 87.7 87.8 87.6 24.7 24.8 26.9 24.2 Romania 90.9 91.5 77.1 95.6 12.9 12.8 4.2 31.6 Statistics for other countries are taken from Bartelsman et al. 2005. The shares in the countries except Ukraine are averaged over the periods covering the years during 1990's and the early 2000's which are different in each country. Figure A4.1.2: Entry and Exit Rates Overall Economy and Private Sector Only Table: Entry and Exit Rates in Broad Sectors Table: Entry and Exit Rates in Broad Sectors (Private Sector) Manufacturing Business Services Manufacturing Business Services Entry (%) Entry (%) #emp #firm #emp #firm #emp #firm #emp #firm 2002 3.6 11.9 5.9 15.4 2002 2.9 12.2 6.6 15.7 2003 2.6 9.5 4.2 12.2 2003 2.6 9.7 5.2 12.4 2004 1.7 6.8 3.0 10.1 2004 1.7 6.9 4.0 10.3 2005 1.1 6.3 2.5 9.3 2005 1.1 6.5 3.5 9.5 2006 1.1 6.4 2.4 9.6 2006 1.0 6.6 3.4 9.8 2007 0.8 5.9 2.6 9.5 2007 0.9 6.1 3.7 9.8 Exit (%) Exit (%) #emp #firm #emp #firm #emp #firm #emp #firm 2002 2.0 4.8 3.0 7.0 2002 1.3 4.9 2.7 7.0 2003 1.6 4.8 3.0 6.7 2003 1.1 4.8 2.6 6.6 2004 1.7 4.7 2.0 6.2 2004 1.5 4.7 2.6 6.2 2005 0.9 4.1 1.7 5.3 2005 0.9 4.2 2.2 5.3 2006 1.2 4.4 2.3 5.5 2006 1.2 4.0 2.6 5.4 2007 1.2 4.5 2.4 6.1 2007 1.2 4.5 2.7 6.1 97 Figure A4.1.3: Employment Weighted Entry and Exit Rates by Size Group (%) (All Manufacturing Sector) Small Firms (<20) Large Firms (400) 10 2.4 7.5 1.8 5 1.2 2.5 0.6 0 0 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Entry Rate Exit Rate Figure A4.1.4: Employment Wgt. Entry and Exit Rates by Size Group (%) (Private Manufacturing Sector) Small Firms (<20) Large Firms (400) 12 1 9 0.75 6 0.5 3 0.25 0 0 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 Entry Rate Exit Rate 98 Figure A.4.1.5: Entry and Exit Rates by Sub-sector Industry Exit Rate(%) Entry Rate (%) emp count emp count Agriculture, hunting and forestry 3.58 5.40 2.22 5.22 Fishing 1.37 2.69 1.83 6.88 Mining and quarrying of energy producing materials 11.43 10.08 9.38 8.54 Mining and quarrying, except of energy producing materials 1.51 2.54 1.28 7.95 Manufacture of food products, beverages and tobacco 1.93 4.40 1.71 5.04 Manufacture of textiles and textile products 1.24 2.85 1.83 5.77 Manufacture of leather and leather products 1.62 3.29 3.10 6.05 Manufacture of wood and wood products 1.59 3.12 3.40 6.18 Manufacture of pulp, paper and paper products; publishing and printing 1.40 3.19 2.92 6.87 Manufacture of coke, refined petroleum products and nuclear fuel 0.96 2.41 0.38 7.51 Manufacture of chemicals, chemical products and man-made fibers 1.00 3.09 1.81 6.19 Manufacture of rubber and plastic products 1.08 2.39 2.60 8.28 Manufacture of other non-metallic mineral products 2.03 3.19 2.05 6.73 Manufacture of basic metals and fabricated metal products 0.53 2.65 0.98 7.34 Manufacture of machinery and equipment n.e.c. 1.45 3.12 1.68 5.84 Manufacture of electrical and optical equipment 1.16 2.50 1.36 6.09 Manufacture of transport equipment 1.10 2.79 1.50 6.04 Manufacturing n.e.c. 1.78 3.48 2.78 7.22 Electricity, gas and water supply 0.79 2.86 1.13 9.15 Construction 2.22 3.34 4.08 9.61 Wholesale and retail trade; repair of motor v., motorcycles, per. and 2.34 4.32 4.16 8.49 Hotels and restaurants 2.15 3.07 3.75 5.49 Transport, storage and communication 0.90 3.13 1.18 8.59 Financial intermediation 1.06 3.66 4.14 12.61 Real estate, renting and business activities 2.63 2.90 4.82 8.85 Public administration and defense; compulsory social security 16.12 11.21 0.33 2.13 Education 8.23 6.41 2.62 5.73 Health and social work 2.20 2.19 5.00 7.62 Other community, social and personal service activities 2.89 3.41 3.84 6.59 Olley-Pakes Productivity Decomposition Olley and Pakes (1996) decompose aggregate productivity into two parts, the first component being the un-weighted average of the firm level productivity and the second the so-called Olley- Pakes cross term--the covariance between firm size and productivity. si i ni i si s iC iC iC In the above formula, i and si represent the firm level productivity and firm's size share (e.g. input shares). Therefore, we calculate the cross term at the end of the right-hand side of the equation by taking the difference between the weighted and un-weighted average of productivities. By doing so, we obtain an empirical measure of how efficiently the factors of production are distributed among the production units, so that when more factors are employed in more productive firms, the covariance is positive and high.61 Firms' labor shares are used as the measure of firm size in the covariance term of labor productivity, and the joint share of the capital and labor kti lti kti lti is considered in computing the covariance term with total i factor productivity. 61 For a more rigorous support of the link between efficient allocation and the OP cross-term, see Bartelsman et al. (2009). 99 Figure A.4.1.6: Average OP Cross Term in the Sub-Sectors of Business Service Activities 0.3 0 0.3 0.6 Wholesale and retail trade; repair of motor vehicles, motorcycles and personal and household goods Hotels and restaurants Transport, storage and communication Financial intermediation Renting and business activities TFP Labor p. Competition Indices Hirshman-Herfindal Index (HHI) The first index that we consider, HHI, defines the intensity of competition with the number of firms in a market and the degree of the homogeneity of their market shares. Therefore, HHI measures competition in industry j by the following formula: 2 pi xi n HHI j n pjxj i 1 j 1 where xi is the amount of the output of firm i and pi is the firms' price level. HHI is also referred as the concentration index, especially when the input shares of the production units are used in the place of revenue shares, so that the resulting value reflects the degree concentration of the inputs in the given industry. Cost-to-Price Ratio (CP) The second index in our analysis is the CP as an empirical measure of price-cost margin. CP represents the idea that a high degree of competition creates a pressure on the firms so that the share of the profits in the total revenue is reduced. One can calculate the CP at the firm or industry level, where the firm level formula can be simply written as follows: p x c x cpit 1 it it it it pit xit In the above formula, the subscript i is the firm identification, t is the time index and xi is the amount of output so that pi xi stands for the revenue and ci xi is the nominal cost of production. However, while the labor and material expenditures are usually available, it is often difficult to 100 find the user cost of the capital input in the firm level datasets. Since we do not observe the real capital stock directly, the calculation of the CP is further complicated. Nevertheless, we use the following formula where the revenue variable represents total firm sales net of taxes: revenue materials payroll depreciation uex * capital cpit 1 revenue it In the firm's CP identity, all variables except capital are in nominal terms, and u ex is the ex-post user cost of capital defined by the following identity: uex [ rt t (1 t )]Pt K K In the above equation, rt is the opportunity cost of capital, for which we used interbank overnight interest rate. t K is the (annual) inflation rate of capital goods' prices, that is the annual change in the capital input deflator given in the previous part. is the depreciation rate, assumed to be .05. Lastly, Pt is the price of capital goods. The derivation of the user cost of capital equation is explained in the appendix part. There are alternative ways of calculating industry level CP such as averaging (arithmetic mean) over the firm level CPs or taking the ratio of the industry-sum of costs to total sales. However, following Boone (b2008), we use the average of firm level CPs weighted by firms' market shares, so that the CP index is also sensitive to the asymmetric effects of competition on firms in the industry. Therefore, the arithmetic mean would fail if a highly profitable firm expands its market share without changing cost to revenue ratios of firms, and the total sum ratio would be irrespective of whatever happens in the industry holding the total cost to sales ratio constant. The Boone Index The Boone index (2008) measures the elasticity of relative profits to the relative efficiency in an industry. If we rank firms in a market according to their cost-efficiency levels, the profit ratio of an efficient firm to the inefficient would be higher when the competition is more intense--that is, the inefficient firms suffer more when the level of competition is higher. Assuming firm j is less efficient then firm i, the relationship between the cost efficiency measures is simply c j ci while j i . Therefore, if the competition is more intensive at time t+1 than it is at time t, then one should expect the inequality i i to hold. From an j t 1 j t industry-wide perspective, assuming that firm j is the least efficient firm in the industry, one would expect the inequality hold for every firm i in that industry. The elasticity of profits to cost-efficiency can be measured by estimating the following equation where and c represent the benchmark firm (firm j in the above discussion) but it should not necessarily be the least efficient firm for reasons we discuss below. c ln it i t ln it c t t 101 So we can rewrite the above equation as follows: ln it t i t lncit Where t ln t t ln ct . Thus, our competition measure is simply the slope coefficient . Ideally we need a benchmark (which is firm j in the above discussion) that can be the least efficient firm of the industry, but the choice of the benchmark only affects the intercept, not the slope coefficient. Thus, if the regression line becomes steeper, in other words, is larger in absolute value, the relative profits method concludes that competition is intensified. Therefore, the Boone index is estimated by regressing firms' profits on marginal costs for each year separately. Following Boone et al. (2007), we used total costs to total revenues ratio as the cost efficiency measure. For the dependent variable, we calculate the total firm's profit by deducting material expenses including cost of energy and service costs and payroll from total revenues. The Boone index differs from the other traditional methods of measuring competition, since it accounts for the presence of frictions in an industry. For instance, in case of higher entry barriers, more intense competition may force some less efficient firms to either shrink or exit the market. In that case, the operating firms would gain higher market power and a larger share from the total available rents. If this is the case, concentration based measures and CP may indicate a lower intensity of competition, while Boone index can capture the increase in the intensity of competition because efficient firms would be better off over the less efficient ones that leads the relative profits ratio to be higher. 102 ANNEX 4.2: Export Concentration Figure A4.2.1a: Percentage of Export Figure A4.2.1b: Export Concentration--HHI (4 Concentration (10 largest exported products) digit) Source: WB PREM ED tools; Bank staff calculations. 103 ANNEX 4.3: Export Sophistication and Structural Transformation In order to analyze how a country's pattern of specialization is changing compared to the rest of the world, we also present the revealed comparative advantage (RCA) index for each commodity group. We use the Balassa (1986) definition, where xval is the export value of sector i in country c in year t: xvalc ,i ,t xval c ,i ,t RCAc ,i ,t i xval c ,i ,t xval c c ,i ,t i c This is the ratio of the percentage of the sector in a country's export basket to the percentage of that sector's total share in world exports, or alternatively, the percentage of the country's market share in that sector to the country's overall market share in exports. So, if a particular country is increasing its specialization in a particular sector compared to the rest of the world, it's RCA index will rise. When this ratio is above 1, this means that this sector is more important in the country's export basket than in the world export basket as a whole, or alternatively, the country has a greater market share in this sector than it does in overall world exports. For this reason, when the index is above 1 the country is said to have comparative advantage in that sector. We present the data in two coding formats: SITC and HS (Figures A4.3.1a and b). The advantage of SITC over HS is that it is widely available before 2000, and therefore allows for a longer-term analysis. Figure A4.3.1a: Revealed Comparative Advantage Figure A4.3.1b: Revealed Comparative of Ukraine Exports by Leamer Category, Advantage of Ukraine Exports by Leamer (Calculated using SITC) Category, (Calculated using HS) Source: UN COMTRADE using SITCr2 4-digit and using HS 4-digit. 104 Figure A4.3.2: Ukraine's Top Contributors to Export Sophistication, 2008 Exports World Trade Contribution HS Code Product Name Leamer Group (US M) (US B) Prody to EXPY 7208 Hotrolled products, iron/steel, width>600mm, not cla Capital Intensive 5381 78 15563 1251 7216 Angles, shapes and sections of iron or nonalloy stee Capital Intensive 877 24 40174 526 7214 Iron/steel bar, only forged hotrolled drawn, extrude Capital Intensive 1886 30 15310 431 7304 Tube or hollow profile, seamless iron/steel not cast Capital Intensive 1420 42 17406 369 7213 Hot rolled bar, rod of iron/steel, in irregular coils Capital Intensive 1130 14 15283 258 7225 Flatrolled alloy steel nes, width >600mm Capital Intensive 598 27 25479 227 2814 Ammonia, anhydrous or in aqueous solution Chemical 680 7 19946 203 8703 Motor vehicles for transport of persons (except buses Machinery 602 621 22495 202 8504 Electric transformers,static converters and rectifier Machinery 682 67 17956 183 8607 Parts of railway, tramway locomotives, rollingstock Machinery 583 11 19526 170 8411 Turbojets, turbopropellers/other gas turbine engine Machinery 404 88 27748 167 2701 Coal, briquettes, ovoids etc, made from coal Raw Materials 554 93 18951 157 7209 Flatrolled iron/steel, >600mm, not clad, plated, etc Capital Intensive 581 21 16800 146 7228 Bar, rod, angle etc nes, hollow steel drill bars Capital Intensive 419 19 23026 144 1806 Chocolate and other foods containing cocoa Tropical Agriculture 489 19 15309 112 406 Cheese and curd Animal Products 403 26 18492 111 7306 Tube, pipe of iron or steel, except seamless > 406.4m Capital Intensive 491 26 15051 110 4811 Paper, board, etc coated, impregnated, coloured, nes Forest Products 195 17 37521 109 8525 Radio and TV transmitters, television cameras Machinery 305 156 21468 98 8414 Air, vacuum pumps, compressors, ventilating fans, etc Machinery 299 57 21369 96 Figure A4.3.3: Visual Representation of Ukraine's Product Space Source: UN COMTRADE. 105 Figure A4.3.4: Sophistication and Proximity of the Product Space: Several Countries Ukraine 2001 Ukraine 2008 UKR UKR -20-15-10 -5 0 5 10 15 20 PR OD Y-EXPY ('000) PR OD Y-EXPY ('000) -20-15-10 -5 0 5 10 15 20 1 1.5 2 2.5 3 3.5 4 1 1.5 2 2.5 3 3.5 4 Density (inverse) Density (inverse) Petroleum Raw Materials Petroleum Raw Materials Forest Tropical Ag Forest Tropical Ag Animal Prods Cereals Animal Prods Cereals L Intensive K Intensive L Intensive K Intensive Machinery Chemicals Machinery Chemicals Poland 2008 Czech Republic 20008 POL CZE -2 0 -1 5 -1 0 -5 0 5 1 0 1 5 2 0 -20 -15 -10 -5 0 5 10 15 20 PR OD Y-EXPY ('000) P R O D Y -E X P Y ('0 00 ) 1 1.5 2 2.5 3 3.5 4 1 1.5 2 2.5 3 3.5 4 Density (inverse) Density (inverse) Petroleum Raw Materials Petroleum Raw Materials Forest Tropical Ag Forest Tropical Ag Animal Prods Cereals Animal Prods Cereals L Intensive K Intensive L Intensive K Intensive Machinery Chemicals Machinery Chemicals Brazil 2008 Russia BRA RUS PR OD Y-EXPY ('000) P R O D Y -E X P Y ('0 00 ) -20-15-10 -5 0 5 10 15 20 -2 0-1 5-1 0 -5 0 5 1 0 1 5 2 0 1 1.5 2 2.5 3 3.5 4 1 1.5 2 2.5 3 3.5 4 Density (inverse) Density (inverse) Petroleum Raw Materials Petroleum Raw Materials Forest Tropical Ag Forest Tropical Ag Animal Prods Cereals Animal Prods Cereals L Intensive K Intensive L Intensive K Intensive Machinery Chemicals Machinery Chemicals 106 Romania 2008 China 2008 ROM CHN 20 -20-15-10 -5 0 5 10 15 20 Strategic Value ('000) PRODY-EXPY ('000) 5 10 0 15 1 1.5 2 2.5 3 3.5 4 1 1.5 2 2.5 3 3.5 4 Density (inverse) Density (inverse) Petroleum Raw Materials Petroleum Raw Materials Forest Tropical Ag Forest Tropical Ag Animal Prods Cereals Animal Prods Cereals L Intensive K Intensive L Intensive K Intensive Machinery Chemicals Machinery Chemicals South Africa 2008 Belarus 2008 ZAF BLR 10 15 20 25 20 Strategic Value ('000) Strategic Value ('000) 5 10 15 5 0 0 1 1.5 2 2.5 3 3.5 4 1.5 2 2.5 Density (inverse) Density (inverse) Petroleum Raw Materials Petroleum Raw Materials Forest Tropical Ag Forest Tropical Ag Animal Prods Cereals Animal Prods Cereals L Intensive K Intensive L Intensive K Intensive Machinery Chemicals Machinery Chemicals Source: Calculations made using Comtrade. 107 Figure A4.3.5: Opportunities Near to (or within) Existing Capability Set Leamer Group HS Code Product Name PRODY Density Capital Intensive 7309 Reservoirs, tanks, vats, etc, iron or steel cap >300l 16551 0.225 Capital Intensive 7311 Containers for compressed, liquefied gas, iron, steel 15317 0.219 Capital Intensive 7321 Stoves, ranges/barbecues,etc, nonelectric, iron/stee 16555 0.214 Capital Intensive 7313 Wire for fencing, including barbed wire 14878 0.210 Capital Intensive 7322 Radiators, nonelectric heaters (with fan), iron/stee 20552 0.207 Machinery 8411 Turbojets, turbopropellers/other gas turbine engine 27748 0.23 Machinery 8802 Aircraft, including cargo 13518 0.23 Machinery 8716 Trailers and nonmechanically propelled vehicle nes 22995 0.222 Machinery 8702 Publictransport type passenger motor vehicles 12978 0.219 Machinery 8418 Refrigerators, freezers and heat pumps nes 18219 0.217 Machinery 8707 Bodies (including cabs), for motor vehicles 20602 0.206 Machinery 8906 Warships, lifeboats, hospital ships, vessels nes 18663 0.206 Machinery 8902 Fishing vessels and factory ships 12411 0.205 Machinery 8503 Parts for electric motors and generators 23748 0.198 Chemical 3306 Oral and dental hygiene preparations 11383 0.216 Chemical 3307 Shaving and toilet preparations nes, cosmetics 21622 0.209 Chemical 3209 Polymer based paints, varnishes in aqueous medium 15143 0.206 Chemical 3921 Plastic plate, sheet, film, foil, strip, cellular, ne 22489 0.206 Raw Materials 7605 Aluminium wire 19229 0.220 Forest Products 4409 Wood continuously shaped along any edges 10936 0.239 Forest Products 4421 Articles of wood, nes 15093 0.228 Forest Products 9406 Prefabricated buildings 18082 0.228 Forest Products 4413 Densified wood, in blocks, plates, strips or profile 8665 0.226 Forest Products 4805 Uncoated paper and paperboard nes 19243 0.224 Forest Products 4808 Paper, board corrugated creped embossed perforated 16302 0.221 Forest Products 4412 Plywood, veneered panels and similar laminated wood 11921 0.217 Tropical Agriculture 2007 Jams, jellies, marmalades, fruit, nut pastes, purees 7358 0.225 Animal Products 401 Milk and cream, neither concentrated nor sweetened 21664 0.228 Animal Products 405 Butter and other fats and oils derived from milk 22288 0.220 Animal Products 403 Buttermilk, cream, yogurt etc 21584 0.216 Animal Products 105 Live poultry, domestic fowls, ducks, geese, etc. 14097 0.214 Labor Intensive 9404 Mattress supports, mattresses, bedding 14041 0.229 Labor Intensive 3925 Plastic articles for use in construction nes 17705 0.227 Labor Intensive 3923 Containers, bobbins and packages, of plastics 14221 0.220 Figure A4.3.6: Strategic Value Opportunities Manufacture of furniture and fixtures, except primarily of metal Manufacture of wearing apparel, except footwear Iron and steel basic industries Machinery and equipment except electrical not elsewhere classified Manufacture of motor vehicles Manufacture of pulp, paper and paperboard Manufacture of dairy products Sawmille, planing and other wood mills Manufacture of plastic products not elsewhere classified Manufacture of structural metal products Manufacture of fabricated metal products except machinery and equipement not elsewhere classified Canning, preserving and processing of fish, crustacea and similar foods Nonferrous metal basic industries 108