WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

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By Michael Landesmann

• Once the vehemence of the military conflict abates, Ukraine has the potential to follow the catch-up experiences of EU-CEE countries.
• However, this requires massive support and engagement by the EU and other Western partners.
• It also needs the institutional and political economy deficiencies that blighted the country in the past to be overcome.
• Much effort needs to be devoted to reversing outward migration, making the country attractive to foreign investors, rebuilding and modernising its infrastructure and managing the necessary reorganisation of the economy both regionally and structurally.

It is possible to be both up-beat and down-beat with regard to the possibility and potential for the economic reconstruction of Ukraine and the outlook for its economic development. In any case, the current military situation is such that it is impossible to predict either the length or the intensity of the war. And yet the outlook for Ukraine’s economy depends heavily on this.

On the upside: EU candidate status, catch-up potential and progress already made on restructuring

Let us start with the up-beat assessment: first of all, the war itself has wrought a change in perspective regarding the possibility of EU accession. It will not happen overnight, but Ukraine has now been officially recognised as a candidate country for EU membership. This means that economic reconstruction will take place in the context of preparing for EU accession – and that brings with it pre-accession support both in financial terms and in terms of technical assistance to gradually align Ukraine’s regulatory framework with the Acquis Communautaire, over and above its (at least partial) inclusion in such EU programmes as the European Green Deal and its greater involvement in the Trans-European Transport Network Programme (TEN-T). All this is likely to provide coherence to whatever plans are made for Ukraine’s economic reconstruction. It will also involve significant support in improving the institutional capacity to implement such plans. The focus on EU accession and convergence in institutional/legal terms should provide a basis for economic stabilisation and serve to focus the efforts of the main actors (internal and external) on this goal.

Secondly, the adaptation of Ukraine’s economic structures to the new geo-political reality began in the aftermath of the events of 2014/2015 – Russia’s annexation of Crimea and its intervention in the Donbas region – which led to substantial trade reorientation, as well as to the economic decline of what was once Ukraine’s industrial heartland. In that sense, the impact of the 2022/2023 war means a further speeding-up of the structural and regional realignment of Ukraine’s economy. It also implies a much weaker position for some of the traditional industrial sectors – specifically the iron and steel and metal products industries, which used to account for a major share of the country’s exports. On the other hand, the war has led to a much greater reliance on agriculture and the agro-food industry, which will likely have further scope to strengthen its position by moving into processing and higher-value-added segments. Furthermore, the IT industry has expanded greatly and is now a major contributor to export earnings: that sector (along with other service industries) opens up employment opportunities for highly skilled persons, and therefore has an important role to play in catering for that segment of the labour force and thereby preventing (or slowing) the brain drain. Even those who have emigrated seem to keep abreast of domestic activities in this industry, and thereby contribute to its international reach.

Thirdly, prior to the war Ukraine was plagued by very problematic governance structures (in particular, in the areas of rule of law and corruption), as well as by entrenched oligarchic power structures. There are ample grounds for anticipating positive developments in political and economic governance structures: the shock of the war has weakened the specifically oligarchic economic interests based in the east of the country, while the standing of the presidency has been strengthened by its successful leadership role since the outbreak of the war. Furthermore, there is going to be considerable involvement by international agencies (European Commission, international financial institutions, donor countries) in monitoring the use of the huge funds that are likely to flow into Ukraine to bolster its reconstruction after the war. It is difficult to make confident forecasts in this respect, but it is likely that both civil society and international donors will exert powerful pressure to improve the situation with regard to transparency, the rule of law and getting corruption under control. At least for some time to come, the spirit of mobilising the national effort to successfully move towards economic, political and social renewal is likely to prevail.

Fourthly, we have the track record of those CEE countries that moved towards EU accession and that, in income terms, can be held up as examples of successful international catch-up processes. There has also been improved institutional development (although there have been examples of backsliding in certain countries, most notably Hungary). Ukraine can be expected to follow these positive examples, since there is plenty to gain from intensified trade and production integration with the European economy, and from the role that international investors can play in modernising production facilities and access to markets. Given the legacies of the war (ruined infrastructure, population loss through emigration, risk of continued military conflict), it is likely that such a catch-up process will face major hurdles, especially in its initial phases. But – unlike earlier ‘transition countries’ – Ukraine enjoys an advantage, in that the institutional and systemic changes associated with transition have already largely taken place: after all, it is embarking on the accession process long after it moved away from a planned economy. The adoption of the Deep and Comprehensive Free Trade Areas (DCFTA) arrangement has further accelerated regulatory convergence with the EU. The pre-accession phase – if handled well – has the potential to foster reform, as it focuses society’s interests on achieving this goal.

On the downside: very high costs of reconstruction, demographic decline and questions over investment attractiveness

We now consider the other side of the coin, which leads us to a more sober assessment of the likelihood of a rapid and successful recovery (and restructuring) of the Ukrainian economy and polity.

The first – and probably the most important – factor that could retard economic recovery is the dramatic ‘demographic shock’ that Ukraine has experienced: it is estimated that there are about 6m internally displaced persons, and that about 7m people have emigrated, mainly women and children (December 2022 estimates). This comes on top of the demographic decline that was apparent even before the start of the current war: whereas Ukraine had a population of over 50m in the mid-1990s, that had fallen to about 42m by the start of the war; and taking the recent emigration into account, the figure now stands at about 35m. This decline is due to long-term low fertility (about 1.3 children per woman) and emigration – a response to the income gap with neighbouring EU-CEE countries (Poland, in particular) that has been widening since before the war. Furthermore, the post-2014 conflict has led to depopulation in those regions in and around which the fighting was bitterest. The age profile of the population has deteriorated badly, which will put the social security (pension and health) system under considerable pressure long into the future. Furthermore, as is common in most migration flows, the migrants tend to be young and highly skilled, and that is also likely to have a significant impact on the size and quality of the domestic labour force. Of course, there may be ‘return migration’ by a significant proportion of those who have left; but the longer the military conflict (and hence the deeper the integration of young families and children into their host societies), the less likely this will be. It is therefore of paramount importance to initiate effective policies to attract (particularly) the highly qualified back to the country, as well as to keep in close contact with the sizeable and growing diaspora.

Secondly, in view of the experiences of other catch-up economies, we consider the role of foreign investors to be very important in the task of restructuring and modernising Ukraine’s economy. However, there are several reasons why (at least in the medium term) it may be difficult to attract foreign investors: first, there is the ‘risk’ of continued military conflict, which will deter foreign investors. In this respect, we (in line with other policy analysts) strongly advocate internationally funded ‘risk insurance’ schemes to cover some of the risks that international investors and traders will encounter in Ukraine, even once the most intense phase of the conflict is over. Secondly, Ukraine will be embarking on its recovery with a ruined infrastructure, major damage to the housing stock and potentially a strong mismatch between regional labour needs and the availability of an adequately trained work force (Anastasia et al., 2022). Thirdly, there is the issue of those selfsame institutional factors that used to deter foreign investment (rule of law, corruption, market structures and political influence skewed towards oligarchs). It will take time to rectify these. And lastly, the regions most in need of economic reconstruction and modernisation will be (or will be close to) those very regions that have been worst affected by the military conflict, with the greatest destruction of infrastructure, the largest number of displaced persons and the biggest risk of continued conflict. Hence they will be the least attractive to international investors. Those regions will have to rely largely on public investment and public support for training and education, and will need to be the areas best covered by any ‘risk insurance’ schemes.

Thirdly, quite a few studies (Becker et al., 2022; Bogdan et al., 2022; Ganster et al., 2022; World Bank, 2022) have calculated that the sums needed for the economic reconstruction of Ukraine will be astronomical: estimates range from USD 450 billion to 1 trillion over about a 10-year period. It is far from clear at this stage where that money will come from, as the international community (US, EU, G7) is still mainly concerned with covering Ukraine’s most urgent budgetary needs and supporting its current essential social and administrative services, as well as its military requirements. However, major pieces of analysis have already discussed detailed sectoral plans, as well as priority areas for the economic restructuring of Ukraine (National Recovery Council, 2022; Gorodnichenko et al., 2022; Bogdan, 2023). Suggestions have also been made about the institutional set-up of such a reconstruction effort and about how to coordinate the multitude of donor countries and institutions. It is fair to say that we are still a long way from having any clear idea about where the money for the massive funding needs will come from, how the coordination problems will be resolved and how Ukrainian ‘ownership’ of the programmes will proceed, given the country’s institutional deficiencies, which could well persist after the war (there are however, already policy initiatives in this direction, as well as detailed sets of proposals; see for example, Eichengreen and Rashkovan, 2022).

Fourthly, there is a particular issue that various ‘transition countries’ have encountered: the macroeconomic imbalances that emerge in the process of economic restructuring and catch-up. The economic reconstruction of Ukraine will – for a considerable time – likely be accompanied by persistent trade deficits, as (initially) there will be very strong import demand: domestic production (and export) capacities have taken a hit and will need time to recover. On top of that, the considerable financial inflows in support of the reconstruction effort, together with the significant remittances from the sizeable Ukrainian diaspora, may exert upward pressure on the Ukrainian hryvnia exchange rate, which could prove detrimental to the country’s competitiveness and to the build-up of export capacities. We have seen this happen in various transition countries (particularly in the Balkans), which have experienced long-term balance-of-payments problems. It will be difficult to counter these pressures unless there is a special focus on assisting the tradable sector (such as targeted efforts to support integration into cross-border production networks, through regionally differentiated industrial policy measures, including infrastructure, training, foreign direct investment support, etc.), plus measures to avoid domestic real estate booms and to channel remittance flows (at least in part) towards investment and business start-ups.

Finally, the speed of – and indeed the very commitment to – Ukraine’s EU accession are far from settled. The example of the dreadfully protracted process of the Western Balkans’ EU integration (let alone Turkey’s!) should be a warning sign – also with respect to the political repercussions that long delays and EU dithering can have in candidate countries. The pre-accession phase can (as previous accessions have shown) be a successful period of institutional reform and economic catch-up – provided realistic milestones are set and consistency in conditionalities and timelines is maintained. It is also important – even in the pre-accession phase – for new schemes of rapid integration into major EU programmes (regional and industrial policy, educational exchange and research collaboration, trans-border infrastructure development, Green Deal) to be developed and offered, so that Ukraine (and indeed other candidate countries) can, from the point of view of integration into such schemes, already be considered a ‘quasi-EU member’ country, even while it still has candidate status.

 

References

Anastasia, G., T. Boeri, M. Kudlyak and O. Zholud (2022): The labour market in Ukraine: Rebuild better. In: Y. Gorodnichenko, I. Sologoub and B. Weder di Mauro (eds), Rebuilding Ukraine: Principles and policies. London: CEPR Press.

Becker, T., B. Eichengreen, Y. Gorodnichenko, S. Guriev, S. Johnson, T. Mylovanov, K. Rogoff and B. Weder di Mauro (2022): A Blueprint for the Reconstruction of Ukraine. CEPR Rapid Response Economics No. 1. London: CEPR Press.

Bogdan, T. (2023): Public expenditure policy for post-war reconstruction of Ukraine, The Vienna Institute for International Economic Studies (wiiw), Vienna (forthcoming).

Bogdan, T., M. Landesmann and R. Grieveson (2022): Evaluation of Ukraine’s National Recovery Draft Plan, wiiw Policy Note/Policy Report No. 61, The Vienna Institute for International Economic Studies (wiiw), Vienna.

Eichengreen, B. and V. Rashkovan (2022): How to organise aid. In: Y. Gorodnichenko, I. Sologoub and B. Weder di Mauro (eds), Rebuilding Ukraine: Principles and policies. London: CEPR Press.

Ganster, R., J. Kirkegaard, T. Kleine-Brockhoff and B. Stokes (2022): Designing Ukraine’s Recovery in the Spirit of the Marshall Plan: Principles, Architecture, Financing, Accountability: Recommendations for Donor Countries. Washington, DC/Berlin: German Marshall Fund.  

Gorodnichenko, Y., I. Sologoub and B. Weder di Mauro (eds) (2022): Rebuilding Ukraine: Principles and policies. London: CEPR Press.

National Recovery Council (2022): Ukraine’s National Recovery Plan (2022); https://uploads-ssl.webflow.com/621f88db25fbf24758792dd8/62c166751fcf41105380a733_NRC%20Ukraine%27s%20Recovery%20Plan%20blueprint_ENG.pdf

World Bank (2022): Ukraine: Rapid damage and needs assessment. Washington, DC: World Bank.