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http://www.foreignpolicy.com Ukraine Can't Afford the IMF's Shock Therapy Economic austerity ruined post-Soviet countries in the 1990s. Why are the same policies being forced on Ukraine today? The war in eastern Ukraine continues to rage on, despite efforts by separatist and national forces to reach a cease-fire. But even if the warring sides reach a long-term truce, the government in Kiev is simultaneously fighting another, perhaps equally important battle: the economy. Unfortunately, President Petro Poroshenko is shooting himself in the foot. Ukraine's government is in the middle of implementing a set of stringent economic reforms agreed to in April with the International Monetary Fund (IMF) in exchange for a $17 billion bailout. Although Kiev has been commended by the IMF for a "bold economic program," the loan's terms, combined with Ukraine's political and economic crisis, are a recipe for disaster. We have seen this story before. During the 1990s, when I worked at the U.S. Agency for International Development (USAID) in the office charged with managing economic reform projects in the former Soviet Union, I observed that the type of austerity now being required of Ukraine was the standard prescription for countries in economic crisis. The leading Washington financial institutions, such as the IMF, World Bank, and U.S. Treasury Department, were passing out this one-size-fits-all solution. And it almost never worked. Russia was the classic case. In the midst of the political shock caused by the breakup of the Soviet Union, neoliberal reformers supported by the West instituted a policy of so-called "shock therapy" involving an end to price controls and large cuts in government spending and subsidies. The result was a plunge in Russia's GDP and inflation rates averaging 20 percent per month. As the poverty rate climbed to a full 55 percent of the population, there was a widespread political backlash against austerity led by Russian Vice President Alexander Rutskoy, who termed the reforms "genocide" and led a failed attempt to overthrow President Boris Yeltsin in 1993. Ukraine's current political crisis, of course, differs from Russia's during the 1990s. But Kiev's decision to implement similarly painful austerity measures during its own political turmoil is doomed to fail in the same way, leading to even more instability and crisis in a country that has had more than its share of both over the past year. This does not mean that Ukraine can forever neglect efforts to undertake reforms. The country has been racked by corruption and poor governance since it became independent in 1991. As a result, Ukraine has endured the worst economic performance of any country in the former Soviet Union. Reforms that reduce corruption and cut government spending and subsidies are necessary if Ukraine is ever going to come close to reaching its economic potential. However, with a collapsing economy and an ongoing war, Kiev needs a semblance of stability far more than shock therapy. Ukraine is currently in economic free-fall. After estimating that the economy would shrink 5 percent in 2014, the IMF now predicts a 6.5 percent drop in the country's GDP, while some analysts think it could be as high as 10 percent. While the IMF's loan is designed to support Ukraine's budget and allow Kiev to pay its external debts as they come due, the fund now says that Ukraine's central government will have a substantially higher deficit then originally predicted due to a spike in military expenditures combined with reduced tax collection as its taxable base shrinks along with the broader economy. The IMF now acknowledges that Ukraine could need a further $19 billion in emergency support over the next 16 months. Despite the economic crisis, the IMF's loan requires Kiev to enact a series of policy changes, all of which will accelerate the collapse of the economy and decrease the purchasing power of ordinary Ukrainians. The IMF demands that Ukraine make immediate cutbacks to reduce the fiscal deficit. To meet this requirement, Kiev has already enacted a series of laws raising excise and property taxes, reduced social income support expenditures for retirees and public employees, frozen Ukraine's minimum wage, and cut public-sector wages. Another target is the energy sector. Ukraine is required to increase natural gas and heating tariffs for consumers by 56 percent and 40 percent in 2014, respectively, and by 20 to 40 percent annually from 2015 to 2017. At the same time, as gas prices increase sharply, gas subsidies to end users will be completely ended over the next two years. With Russia ceasing gas supplies to Ukraine since June as a result of a payment dispute, Ukrainian consumers may face further price increases unless Kiev is able to obtain gas from other sources. Finally, the National Bank of Ukraine has already implemented a floating exchange rate for its national currency, the hryvnia, ending its fixed peg to the dollar. Because the value of the hryvnia has depreciated over 40 percent against the dollar this year, both businesses and consumers are having increasing difficulty servicing their dollar-denominated loans. The country's entire banking system is at risk of wholesale default. This overall combination of increased taxes and energy costs, decreased wages and social expenditures, and growing inflation is more akin to a Kevorkian prescription for Ukraine's economy then a recipe for a return to economic growth. Given that a USAID-funded opinion survey released in April found that a majority of Ukrainians already oppose higher energy tariffs and prices, the political consequences of austerity could be explosive. The West could help Ukraine through this economic crisis. As a recent Bloomberg editorial noted, "In Ukraine, the IMF will in essence be trying an economic solution to a geopolitical problem." Indeed, Kiev's decision to implement austerity in the middle of a bitter civil war is foolhardy for both financial and political reasons: Wars cost money -- lots of it -- and unsurprisingly, Poroshenko has already announced $3 billion in additional defense spending for this year. Given that the second tranche of the IMF's loan is $1.4 billion, the ongoing costs of the war make it extremely unlikely that Ukraine will be able to meet the IMF's fiscal and financial targets. But the political problems with shock therapy for Ukraine are even greater. The austerity program will further alienate the very citizens of Donbass, the restive eastern region currently hosting the worst fighting. If the country will ever be put back together, the people of the east must feel that Kiev takes their concerns into account. Unfortunately, by implementing austerity when industrial output has as of July declined by 29 percent year-on-year in Donetsk and a whopping 56 percent in Luhansk, the government in Kiev provides just the opposite message to the east. The Donbass is heavily industrialized, but the IMF's mandate that Kiev slash the large energy subsidies provided to its numerous energy-inefficient Soviet-era factories and mines in the Donbass means that the region's economy is now facing a double whammy from both war and the cutback in financial support. This in turn could raise unemployment in the Donbass, which is not exactly a recipe for promoting reconciliation. Beyond the need to prioritize political stability over austerity, any economic reform program in Ukraine should include debt relief. This means that Ukraine's foreign creditors should be made to take haircuts on their loans to Kiev. There is a recent precedent for this approach in Cyprus, where the holdings of large depositors and bondholders were converted to equity in the country's largest bank, the Bank of Cyprus. Investors already understand that a Ukrainian debt restructuring is now a question of "when, not if," and Ukraine's Ministry of Finance and the National Bank of Ukraine should negotiate a comprehensive debt-restructuring program directly with foreign creditors. Despite sometimes-lengthy delays in negotiations, a 2012 IMF study found that investors in emerging markets generally come to terms with debtors. This offers Kiev ample precedent to use in negotiations with its foreign creditors, making a debt restructuring the most logical course for Ukraine to follow. As with any restructuring of liabilities, the terms of the loan or bond determine how losses are allocated. Absent this "bail-in" of foreign creditors, Ukraine will simply be taking on more debt that it lacks the capacity to service, risking a long-term compound debt spiral for the country and practically guaranteeing a wholesale default down the road -- and continuing political instability. Finally, the West should provide Ukraine with aid that doesn't come with the IMF's harsh conditions. Through a combination of grants and low-interest loans subsidized by the United States and the European Union that could be rolled over as necessary, Western governments directly -- rather than the IMF -- could assist Ukraine with a recovery program that focuses first and foremost on jump-starting the country's economy rather than one that further squeezes it. The road ahead for Ukraine will not be easy. The country faces a violent civil war, political distrust, and a collapsing economy. It needs all the help it can get right now, not the IMF's painful medicine.
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