Improving Ukraine’s Investment Climate

Improving Ukraine’s Investment Climate Dr. Edilberto Segura SigmaBleyzer, The Bleyzer Foundation January 2008 v2

Economic Performance • Between 2001 and 2006, few countries showed the following combination of economic achievements: • High average rate of economic growth • Low fiscal deficits • Moderate inflation rates of about 10-12% pa • Good external fundamentals (with large surpluses in the current account) • Fairly stable foreign exchange rate • High international reserves in excess of three months of imports • Very low ratio of external public debt to GDP • However, 2007 already showed some signals of economic, disequilibrium both external (with a 3.0% CA deficit) and internal (with inflation at 16.6%). Source: State Statistics Committee of Ukraine, National Bank of Ukraine, Ministry of Finance of Ukraine, The Bleyzer Foundation

Past economic growth was supported by increases in private consumption (which grew in 2004-2007 by around 16%), fixed investments (surging on average by around 17% in 2004-2007) and export growth in 2004, 2007. The increases in private consumption were associated with major increases in pension payments and public wages approved by the government, as well as continuing credit boom (surging in 2004-2007 by almost 60% p.a.). Exports benefited from high metal and chemical prices and reasonable external conditions for other commodities (i.e., machinery and transport equipment). Unfortunately, consumption and export as a sources of growth are unlikely to be maintained in the future: Consumption increases are already been reflected in high inflation. Export prices for metals are unlikely to increase in the future. Therefore, over the medium term the country will not be able to rely on increased private consumption and exports as the main engines of growth. In order to achieve strong and sustainable economic growth in the long-run the country will require new investments and technology. This will require major improvements in the investment climate. Medium Term Outlook

Break-through to knowledge based economy • To ensure sustainability of the economic growth, Ukraine’s top priorities for 2008-2009 should include comprehensive efforts to improve country’s investment climate, stimulate investments in knowledge and innovations, other structural changes in order to boost productivity growth; • Based on extensive theoretical and empirical research, there is a broad recognition among economists and policy-makers of the positive impact of human capital, R&D, technological progress and innovation on productivity and economic growth; • In order to advance towards the knowledge-based economy, Ukraine needs to invest in high technology sectors and promote knowledge diffusion across economy. Investments in the knowledge-based economy must be channelled into: (i) highly-skilled human capital (ii) capacity and quality of education systems (education spending and life-long learning), (iii) purchase of new capital equipment that spread innovative technologies and managerial know-how.

Ukraine in Global Competitiveness Index 2007-2008 Source: World Competitiveness Report 2007-2008 According to the latest World Competitiveness Report, weak technological readiness of Ukraine continues to exact a visible toll on country’s competitive position. Hence, encouraging foreign investments into the high technology sectors is key to maintain and advance country’s global competitive advantages.

Improving the Country’s Business Environment: The government’s program should include measures in the following areas: • Public and Corporate Governance • Macroeconomic Stability • Stable and Predictable Legal Environment • Liberalization and Deregulation of Business Activities • Removal of International Capital & Foreign Trade Restrictions • Facilitation of Business Financing by the Financial Sector • Reduce Corruption • Country image • Political risks

Future Reform Agenda for Ukraine 1. Implement a fundamental public administration reform: The weaknesses of Ukraine’s public administration – including cumbersome decision-making, bureaucracy, unclear and overlapping responsibilities -- are major constraints in the implementation of economic reforms. The country can design policies, but fails in implementation. Without public administration reform, it is likely that needed economic reforms will be implemented very slowly or will be reversed quickly. A reform of public administration should include the following: • clearly define the Objectives/Role of the Government limiting it to “public” goods and support - not substitution – of the private sector; • Undertake a comprehensive “audit” of all government programs, with a view to transfer some of them to local governments, sub-contract others to the private sector and eliminate unnecessary/overlapping activities. • develop the concept of well-defined “Programs and Projects” for all government activities (this will help to improve administrative efficiency, deal with corruption and also bring equilibrium to the fiscal budget) • Improve the efficiency in retained “core” government activities and local governments, increasing public transparency and access to government information. • Carry out a civil service reform introducing effective "Incentives" and "Control“ Systems

….Future Reform Agenda for Ukraine 2. Improve macroeconomic Stability by strengthening fiscal policies (improving tax administration, reforming the pension system, decentralizing financing), monetary policies (developing techniques for inflation targeting –open market operations, forecasting models) and foreign exchange rate policies (abandoning the exchange rate anchor) 3. Improve the legal environment by: • Improving the practice of “public” consideration of any legislative act to be adopted, including their correspondence with existing legislation. • Ensure the independence of the Judiciary by further improvement of the financing of courts. • Improve court administration and enforcement procedures. • Deal expeditiously with issues of illegal corporate raidering. 4. Accelerate further quick deregulation and liberalization of business activities (permits, licenses).

….Future Reform Agenda for Ukraine 5. Develop sound Corporate Governance practices by enacting key pending legislation (e.g., the Joint Stock Companies law), abolishing the Commercial Code while amending the Civil Code, developing corporate governance codes, and accelerating the adjustment of Ukrainian accounting standards to international accounting standards. 6. Liberalize trade, join the WTO, sign free trade agreements with the EU, CIS, and other countries, and simplify trade clearance procedures. 7. Strengthen the Financial Sector, particularly by enforcing banking regulations and supervision. 8. Implement a prevention program to deal with Corruption 9. Improve the country’s image by strengthening an Investment Promotion Agency and implement specific activities for large investors (identify major projects, carry out targeted promotional campaigns, identify niches/sectors) and for small/medium firms (access to bank credit, better information on laws, etc).

Highly educated labor force (almost 60% university enrolment) Low wages Border on the EU, with increasing trade potential Large domestic market (large population with growing purchasing power) Great agricultural potential Industrial and high-tech potential Likely prolonged period of significant economic growth Inefficiently run companies provide significant opportunity for value creation through improved operations, marketing, finance, customer and quality focus – bottom line growth Growing interest in the country by multinationals and other investors Ukraine is the only post-Soviet country (in addition to the Baltic states) that is rated by Freedom House as a free country But there is strong competition to attract FDIs and Ukraine has a below average investment climate, as shown in the following country ratings of investment climates. Ukraine is an Attractive Country for Investment

1. Public and Corporate Governance CORPORATE GOVERNANCE • Accelerate the adoption of the Joint Stock Company Law • Speed up the adjustment of Ukrainian accounting standards to international accounting standards. • Remove inconsistencies between the Civil and the Commercial Codes by eliminating the Commercial Code and passing some of its provisions to the Civil Code. • Develop corporate governance codes. PUBLIC GOVERNANCE • Redefine the Government's Role towards Supporting Private Sector Activities • Undertake a comprehensive “audit” of all government programs, with a view to transfer some of them to local governments, sub-contract others and eliminate unnecessary/overlapping activities. • Improve efficiency in retained “core” government activities and local governments, increasing public transparency and access to government information. • Carry out civil service reform introducing effective "Incentives" and "Control“ systems

2. Macroeconomic Stability • Pursue sustainable fiscal budget policies, including improvements in tax administration and expenditure controls, reform of the pension system, and decentralization of financing/execution of some government activities. • Pave the way for adopting monetary policy based on inflation targeting. • Strike a reasonable balance between social, political and economic dimensions of policy decisions.

3. Stability and Predictability of the Legal Environment • Improve the practice of thorough consideration of any legislative act to be adopted, including their correspondence with existing legislation. • Ensure the independence of the Judiciary by further improvement of the financing of courts. • Improve court administration and enforcement procedures. • Drastically enhance enforcement of rights and contracts.

4. Liberalization and Deregulation of Business Activities • Secure effective implementation of the second phase of the quick deregulation strategy. • Increase stability of existing regulations by avoiding frequent changes in legislation concerning business activity. • Improve coordination between central and local government bodies on regulatory policy issues by avoiding conflict of interests between different levels of executive power and making clear distinctions in the area of their responsibilities.

5. Liberalization of Foreign Trade & Capital • Ensure entry into the WTO as soon as possible. • Promote signing free trade agreements with the EU, CIS and other countries. • Continue streamlining customs procedures and formalities to ensure prompt consideration and to avoid opportunities for rent seeking behavior. • Soften export restrictions and eliminate import nontariff restrictions. • Ease the system of certification and standardization to acknowledge international standards.

6. Financial Sector Development • Better enforce banking regulations and supervision • Ensure equal "playing conditions" for domestic and foreign banks. • Provide mechanisms to deal with risky unsecured debts issued by commercial banks • Encourage stock market transactions to be made on the organized market. • Stimulate development of nonbanking financial sector by introducing a framework law on nonbanking financial institutions.

7. Corruption Level • Implement a corruption prevention program, including public administration reform to improve transparency of decision making process and procurement procedures. • Reduce the ambiguity and discretion of government regulations and raise accountability of the public servants for their decisions by introduction of e-governance resources. • Strengthen the capacities of the internal audit and make it fully accountable for public. • Accelerate the creation of independent anticorruption agency.

8. Country Image • Strengthening an Investment Promotion Agency and implement specific activities for large investors (identify major projects, carry out targeted promotional campaigns, identify niches/sectors) and for small firms (access to bank credit, better information on laws, etc). • Resolve outstanding investment disputes with foreign investors; ensure fair treatment of foreign investors in courts. • Engage the country's embassies and other missions to disseminate up to date information on Ukraine and its business opportunities.

9. Political Risks • Take measures to eliminate power abuses at different levels of government. • Accelerate Public Administration Reform. • Ensure predictability and public consensus on political reforms in the country. • Ensure political stability by developing a long – term strategy on establishing the effective balance of powers and sustainable civil society. • Achieve balanced distribution of gains from economic and structural reforms. Avoid disproportionate allocation of economic and social hardships to selected groups of population.

Overall Investment Drivers – Country Ratings

The Role of Techno Parks • Poorly designed Industrial and Technology Parks have failed in many countries, including the Free Economic Zones of Ukraine. • The weaknesses in Ukraine included: • Patchy legal framework, with contradictory regulations, which frequently resulted in tax evasion and abuses of tax and customs privileges. • Ad hoc incentives and tax privileges led to distortions and rent-seeking behavior. • Week infrastructure and technology support. • Lack of seed capital for start-up companies. • Poor management and administration of the parks, with overlapping responsibilities and many cases of corruption. • As a result, these initiatives were abandoned in Ukraine. • Nevertheless, required improvements in Ukraine’s overall country’s investment climate will take time, even if pursued energetically. • International experience shows that prudent administration of Industrial and Techno Parks helps to trigger country-wide liberalization of business environment and promote technological development. • Therefore, in the meantime, the government could use well-designed Industrial and Technology Parks as pilots to accelerate investments and technology innovation.

High Potential For Knowledge Economy in Ukraine Ukraine: Selected Technology Indicators * percentage of surveyed countries performing worse than Ukraine • Despite obvious technological bottlenecks, Ukraine possesses key resources that, under adequate management, can trigger successful development of technology and innovations: • Highly educated and low cost labor force; • High enrollment rates in universities and exceptionally strong educational and research potential in engineering, cybernetics, programming and mathematics; • Established tradition of scientific and applied industrial research; • Developed network of research and educational facilities.

Policies to Develop Technology Parks in Ukraine • By Law, the government established 16 Technology Parks in various Oblasts. • But not all are operative, and most face weaknesses that undermine their growth, including poor infrastructure, poor property rights and lack of investments and financing. • To seriously developed Technology Parks, the Government should: • Cooperate with the private sector to develop a national vision and strategy on science and technology. • Entrust the management of these parks to a partnership between private companies and the government • Develop “stable” regulations and tax treatments. • Limit Government support to the needed initial infrastructure. • Strengthen and simplify customs procedures • Encourage knowledge transfers through industrial clusters • Facilitate start ups of innovation companies • Heavily invest into the human capital • Liberalize the telecommunications industry

Improving Ukraine’s Investment Climate