CASE Ukraine Investment environment in Ukraine Vladimir Dubrovskiy Prepared for the congress Investment in Ukraine. Challenges and opportunities Hotel Polonia Palace, Warsaw, 8th-9th November 2004

CASE Ukraine Formal and informal impediments to entrepreneurship and investments in Ukraine: the main peculiarities and the ways of coping with them The political-economic causes for persistence of the "bad institutions" in Ukraine: can we predict the changes, and promote the improvements? Evolution of the political-economic system: where Ukraine is going?

Peculiarities of investment climate Blat networks of interpersonal exchange with favors “Soft” rule of law The nachal’niks versus bureaucrats Making things done: Institutions: Vague property rights

CASE Ukraine The “pales of law” can be… …tight: so hard to keep within the law! …loose SOFT … and SOFT: no way to fully keep within the law! “Soft” rule of law but “ T h e r e i s o n l y a b l o c k o f c o n c r e t e t h a t r e a l l y m e a n s “ N O R O A D ”. T h e r e s t o f p r o h i b i t i o n s m e a n j u s t “ T O L L R O A D ” For your competitors too

CASE Ukraine personal vlast’ of NACHAL’NIKS “The severity of the Russian laws is alleviated only by discretion in their enforcement” “… just this disorder makes life in Russia possible” Everybody is a lawbreaker The law applies to all “ L a w s a r e w r i t t e n f o r t h e f o o l s ” “ W h o a r e t h e b o s s, w e o r t h e l a w ? ” Preconditions for extortion Authoritarian modernization: law contradicts to practices EXTORTION under enforcement of the law Because they are applied at the discretion of a nachal’nik Karamsin, 19th century Russian historian Gertzen, 19th century Russian social thinker “Soft” rule of law

Uncontrolled and mostly affiliated with business Strictly controlled and separated from business Possesses the political power to magnify ambiguity and non- transparency in legislation No decision-making power Clear separation of “powers” from branches of State Controls politicians rather than vice versa. Tries to control mass-media to avoid public scrutiny Operates under constant public scrutiny and political oversight Poorly-paid and dependent upon administrative rents (in money or barter) Relies upon discretionary discretionary power and vague and arbitrary informal rules Highly-paid professional public servants facilitating rational processes of control. Implements legislation in a strictly formal (impersonal) (impersonal) way Administrative power in Ukraine Bureaucracy (by Weber) Nachal’niks Nachal’niks: not the bureaucrats!

CASE Ukraine Blat networksReputation-based informal networks of interpersonal mutual exchange with “favors of access” (blat) Emerge to facilitate the illegal transactions of all kinds “One has to deserve a right to pay a bribe” No contract enforcement was officially available Normal economic activities were considered illegal Authoritarian modernization, especially under Communists : law contradicts to practices Ledeneva, 1998 Weak rule of law Litwak, 1991 (!) while

CASE Ukraine Right to use the object WITHIN THE LAW Vague property rights Under a “soft” rule of law Vague property rights Real value of an asset depends on the position of its owner within the informal networks of blat

CASE Ukraine Political economy The “vicious triangle” of legislation-corruption-discretion Rent seeking, overappropriation, and “arbiter-client” relations “State capture” by corrupt networks “Zero-sum perception” and the problem of legitimacy of entrepreneurship The Orange revolution and its immediate consequences Evolution of the rent-seeking society of Ukraine

FACILITATE CASE Ukraine Legislation (flawed, ambiguous, impracticable) Corruption Discretion ENHANCES INTEREST INTEREST Decreasing the demand for improvements ALLEVIATESALLEVIATES

In many cases players fail to establish the efficient institutions. CASE Ukraine Rent seeking vs. profit seeking Profit seeking Creation of the value voluntary apprised by competitive market Appropriation of already existing value, e.g. created by others A positive-sum game (“cooking a pie”) increases the public wealth A zero- or negative-sum game (“cutting a pie”) usually decreases the public wealth Rent seeking Players can establish certain efficient institutions, primarily, the property rights by a voluntary agreement A coercive force is required to arrange appropriation while preventing the overappropriation Rent seeking requires FORCED coordination and control that can only be arranged by AUTHORITARIAN POWER Sonin (2003), Hoff and Stiglitz (2002, 2004), Polishchuk and Savvateev (2002):

player client Rent source CASE Ukraine player player The “arbiter-clients” model Authoritaria n arbiter D i s t r i b u t e s t h e q u o t a s f o r r e n t a p p r o p r i a t i o n a aa a r b i t r a r i l y, a n d e n f o r c e s t h e m i n o r d e r t o r e s t r a i n t h e d e v a s t a t i n g c o m p e t i t i o n client … but instead extorts the rent himself, or trades it for loyalty Rent source Lobbyist “Oligarch” Nachal’nik... State budget Natural resources Public property... Weak property rights “ t h e t r a g e d y o f t h e c o m m o n s ”

CASE Ukraine An arbiter: CASE Ukraine Has an incentive to extract the rent (share the players’ rents) Looks as “captured” with vested interests Asymmetry: The players can motivate their arbiter with a “carrot”, but not threaten to him  irresponsibility players are clients of their arbiter In effect, “owns” a source of rent Interested in using his discretionary power for further weakening the clients’ residual rights of control Arbiters and clients form a hierarchy Crowds out and suppresses any other ways of preventing the overappropriation Rent-maximizing Power-maximizingtotalitarian authoritarian, plutocratic Arbiters: ≡ ≡

Any kind of market exchange is being perceived as a sort of «zero-sum game» Business incomes are not being distinguished by their origin Business and wealth of ANY kind is illegitimate Weak property rights “fairness” of business is unrewarded The rent seeking DOES dominate! A “zero-sum” perception Inherited to a traditional society CASE Ukraine Why do the people hate entrepreneurs?

Profit seeking (competitive) sector Rent seeking sector Monopoly rent CASE Ukraine player In Increase in the social wealth De Decrease in the social wealth Effects of authoritarian rule Paternalism (clietnelism) and corruption Firms earn their incomes mostly as rents depending primarily on the arbiter’s discretion client “A “zero-sum” perception

CASE Ukraine S i z e o f t h e r e n t - s e e k i n g s e c t o r i s d e t e r m i n e d b y t h e b a l a n c e b e t w e e n a m o u n t o f r e n t s a v a i l a b l e f o r a n a r b i t e r a n d h i s c o s t s o f c o n t r o l a n d c o o r d i n a t i o n o f t h e r e n t s e e k e r s The rent seeking is costly for a society It takes certain cost of an arbiter to coordinate and control the rent seekers The rent seeking contracts With exhausting of the available rents, and complicating of control and coordination Evolution:

Profit-seeking sector Rent-seeking sector Technology SOCIETAL NORMS CASE UkraineREVOLUTION? Rent-seeking sector Profit-seeking sector “Standard” approach applies Transition from a rent-seeking society: Evolution and REvolution? Politically responsible government

Depletion of the rent sources Market imbalances Financial instability Cheap energy and credit «intermediate winners» Sources of Rent Overappropriation of state budget and enterprises’ fixed assets “Overappropriation” of creditors’ trust Sources of Rent 1995 – 2000??? Subsidies and government contracts blat Close collaboration of business and officials based on blat

A t a c i t s o c i a l c o n t r a c t : “ W e ” d o n o t b o t h e r “ t h e m ”, “ t h e y ” d o n o t b o t h e r “ u s ” Business- administrative groups (BAG) captured state Whither “captured state”: a dead end? Business: a “Milk caw” or a “Rent pump” for officials Administrative power: Provides protection and patronage for business Property rights, rents Public Sources of rents Perceived totally corrupted Perceived totally rent- seeking PASSIVE PLAYER Perceived manipulated

Threat of populism and paternalism towards large groups of population CASE Ukraine Public is not passive anymore, it became a “principal” of the politicians BAGs and their arbiters are not the only players anymore Executive power officials have lesser impact on the legislature As a result of the revolution: Political market emerges Politicians appeal to the broad groups of population Public consciousness is still immature: while does not properly distinguish profits from rents supports redistributive activities (as “re-privatization”) supports “coordination and control” (e.g. price regulation)

The “captured” state starts working for the competitors Business- administrative groups Financial- industrial groups An “arbiter” for the large groups Revolution of the politicians Political capital POPULISM Political parties Destruction of the rent-seeking opportunities A “zero-sum” perception Demand for the UNIVERSAL rules of the game

CASE Ukraine People's attitude to the privatization of large-scale enterprises source: National Academy’s Institute of Sociology’s surveys (Panina, 2005)

CASE Ukraine Balance of attitudes to land privatization source: National Academy’s Institute of Sociology’s surveys (Panina, 2005)

CASE Ukraine SATISFACTION with own SOCIAL STATUS (score of maximum 5, right axis), and SELF-RELIANCE (percentage of respondents agreed that their life success depends on themselves, net of the percentage of respondents agreed that it is determined mostly by the external conditions – left axis). source: National Academy’s Institute of Sociology’s survey (Panina, 2005)

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