Lessons from the Ukrainian Transition: Reform Driving Forces in a Captured State Reform Driving Forces in a Captured State CASE-Ukraine Center for Social and Economic Research Delhi, January 2004

Reforms in Ukraine ( ) : A process, not an action Reactive, not proactive Occurred in the historically “captured” state Never openly supported by the majority of population Very painful Slow, inconsistent, incomplete But nevertheless resulted in the impressive growth and relative macroeconomic stability A success story ???? CASE Ukraine

Economic policies defined within the elites “Public choice”: the “ mandated ” reforms, based on the political support of a resulting political force In Ukraine: The major reforms were undertaken irrelevant to the position of a broad public No program of reforms has ever got a public mandate The only positive example we may provide is the simplified taxation for small and micro business A majority of broad public was always against privatization of the large enterprises The monetary stabilization was started without any mandate and continued despite the political defeat of its initiators. The paternalism towards the enterprises was contracted despite the growing public sentiment in its support CASE Ukraine

The reforms in Ukraine: rarely proactive “Passive”“Reactive” Just accepting the new rules of the game that have already become dominant in the grassroots Rarely took placePrice liberalization Imposed by an authoritarian government “Proactive” maximize the political gains minimize the political loses Privatization and reduction of paternalism Mandated In Ukraine: Public alienated from the state

CASE Ukraine Why the inefficient institutions persist? Nobody knows how to make the things better Vested interests of the rent seekers The efficient institutions already exists in other countries t h e r e n t s e e k i n g i s t o s o m e e x t e n t p r i m a r y t o o t h e r i m p e d i m e n t s b e c a u s e i t p r o v i d e s a n i n c e n t i v e f o r m a r k e t p l a y e r s t o s u p p o r t, c r e a t e o r m a g n i f y t h e m a r k e t d i s t o r t i o n s a n d i m p e r f e c t n e s s

CASE Ukraine a dead end? Sonin: Who needs the bad [formal] institutions ? Efficient allocation of resources Market imperfections Rent seeking opportunities creates supports

CASE Ukraine A rent source player The reforms under rent seeking Tornell: The rent is an exhaustible common resource Competition destroys it because of the problem of commons

CASE Ukraine monopoly rents at the product and factor markets player Different sources of rents Distorting and inhibiting the factor allocation Competition should be protected and encouraged

CASE Ukraine State budget Natural endowment player Different sources of rents The “good” ones, vitally needed for a society Competition should be restricted It is safer to even prohibit it at all if there is no way to discriminate between sources of rents

CASE Ukraine Rent source player Back to the rent maximization – 1:

CASE Ukraine The rational and transparent formal institutions provides with the opportunity of distinguishing between the rent sources if such distinction may be rationally justified May still serve to prohibit the market competition Requires the corresponding informal institutions Limit the property rights but do not affect their clearness, symmetry and distribution Can be a basis for an efficient market economy

CASE Ukraine Rent source player Back to the rent maximization – 2: Authoritarian arbiter

An arbiter: CASE Ukraine Has an incentive to extract the rent (share the players’ rents) If he does so, he becomes “captured” with the vested interests Asymmetry: The players may motivate their arbiter with a “carrot”, but not threaten to him  irresponsibility players are clients of an arbiter But still preserves some freedom of choice (in a sense of Grossman-Helpman-Dixit model) He is interested in using his discretionary power for weakening the players’ residual property rights of control Being endowed with authority to resolve the problem of commons in the vital sectors is interested to use it for enforcing any kind of cartel, therefore restricting the economic freedom

He is constrained with the threat of PUBLIC UNREST that may occur if a vital rent source would get exhausted is not interested in the market reforms as long as they reduce the sources of rents and enhance the economic freedom An arbiter: and particularly those, strengthening the residual property rights of the players BUT: His ability to control the players is limited by the same factors, primarily non-transparency, that facilitate rent seeking Even a hierarchical structure with the players and arbiter at each level cannot secure the rents from exhausting The reforms are get imposed on the players mostly when a crisis comes

CASE Ukraine Vague and asymmetric property rights Paternalism Clientelism Soft budget constrains (SBC) “Party rule”: never formally legitimized Elitism The post-Soviet institutional legacy Discretion Formal institutions Selective implementation

CASE Ukraine State property Budget director bureaucrat USSR: Under the command economy Communist Party

CASE Ukraine State property Budget director bureaucrat Soon after Unconstrained paternalism towards enterprises (not the population!) The first-wave “intermediate winners”

CASE Ukraine rents for the directors at the expense of the population and deadweight loses Paternalism is dangerous Credit emission The government commits to “support a domestic producer” “support of the effective demand” Tolerating arrears ProtectionismDirect subsidies monetary emission Soft crediting monopolismForced crediting Fiscal deficit Tolerating barter Price growth out of control

CASE Ukraine Consolidated budget’s expenditure structure Source: Ministry of finance, own estimates

CASE Ukraine Remedy suggested: privatization Oligarchs: wanted title property rights to secure their rent The first program was developed already in 1992 T h e g o v e r n m e n t d e c i s i o n - m a k i n g w a s c o n t r o l l e d b y d i r e c t o r s a n d b u r e a u c r a t s a l r e a d y “ c a p t u r e d ” t h e r i g h t s o f c o n t r o l a n d n o t i n t e r e s t e d i n g a i n i n g o f t h e t i t l e p r o p e r t y r i g h t s BUT: “Under Kuchma your factory will stay in business!” The director supported by communists became the President in 1994: Kuchma became an “arbiter” of the oligarchs and conducted the mass privatization ( )

CASE Ukraine “captured” by the directors and bureaucrats Still controlled by the directors and bureaucrats by the means of SBC Property rights Time The title property rights The residual rights of control Privatization: just a half-way

CASE Ukraine Tax arrears (UAH billions) Source: the World Bank, 2003

CASE Ukraine Tax privileges (% of budget revenues) Source: Ministry of finance, own estimates

CASE Ukraine Oligarchs: interested in the title property rights as a means of control the rents brought by paternalism The next step: reducing paternalism “virtual economy” + irresponsible borrowing Crisis of 1998 and expected default in 2000 Series of reforms subversive for oligarchs and directors but VERY POPULAR

CASE Ukraine Evolution of the informal property rights

CASE Ukraine Per capita GDP (1990=1) The “unpopular reforms” appeared to begot the most popular Ukrainian politician

CASE Ukraine The clientism is alive Business Environment In Ukraine, International Finance Corporation, 2003 About 40% of enterprises respond that the personal changes in some government authorities could significantly affect their business (IER, 2002)

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