Your wallet or your life: Ukraine is faced with a hard choice between military necessity and economic recovery

RU

The economy pushes off rock bottom

The first few months of the full-scale war came as a massive shock for Ukrainians, causing the unemployment rate to soar to almost 30% and nearly half of Ukrainian businesses to close down or reduce operations significantly, as the exchange value of the hryvnia plummeted. The national bank initially fixed the hryvnia to dollar rate at 29.25 hryvnias but had to devalue it to 36.57 in July 2022.

By the end of the first year of the war, Ukraine’s GDP had shrunk by 29.1%, hitting a record low in the history of independence. The inflation rate peaked at 26.6%.

In 2023, the situation took a turn for the better. The GDP grew by almost 5%, though this achievement largely owes to the low base effect. The inflation rate slowed to 5% — much to the surprise of analysts and authorities, who had offered grimmer forecasts. The price growth was tempered by large crop yields, lower energy carrier prices, a rigid monetary policy of the National Bank of Ukraine, and a freeze in utilities tariffs.

Although the National Bank of Ukraine let go of the hryvnia exchange rate peg, the currency did not sink all that low. It is currently fluctuating at around 38.28 hryvnias per $1.

Ukrainians’ salaries are on the rise too. At the end of Q3 2023, the average monthly income bordered on 18,000 hryvnias, according to Gosstat — the current equivalent of $490. To compare, Ukraine's average monthly income in 2021 was $525.

However, a tangible share of the national labor market is still in the shadow economy. Many citizens pose as self-employed to cut their tax obligations. Therefore, the official salary statistics ought not to be taken as representing the full story of economic life in Ukraine — either before February 24, 2022, or after.

Drones saving exports

One of Ukraine's main economic victories in 2023 can be credited to its armed forces — to be more precise, to the agencies in charge of seaborne drones. The grain deal that was in place in the Black Sea from July 2022 to July 2023, when Moscow unilaterally withdrew from the arrangement, had allowed Ukraine to maintain its agricultural exports almost at their prewar level of 6 million tonnes a month. The deal’s termination halved exports almost immediately.

However, Ukraine's regular sea drone attacks and occasional strikes with long-range Western missiles pushed back Russia's Black Sea Navy, securing safe passage for commercial vessels — even if they still had to be wary of Russian mines. In December 2023 and January 2024, Ukrainian agricultural exports bounced back to 6 million tonnes.

The war has propelled agricultural products to the top of Ukraine's list of exports. Previously, they ranked on par with metals, but Ukraine's leading metalworks enterprises, Azovstal and Ilyich Iron and Steel Works in Russian-occupied Mariupol, were razed to the ground by Russian forces.

In 2021 Ukraine supplied 19.6 million tonnes of ferrous materials for the world market. In 2023, these exports shrunk to 4.76 million tonnes.

Conditional support

One of the main challenges for the Ukrainian economy is the rapid growth of public spending. In the second year of the war, this figure was nearly double what it had been in peacetime when measured in U.S. dollars and had approximately tripled in hryvnia terms. Defense spending has surged most significantly — it is now 16 times higher than it was before the start of the full-scale war. Plans for 2024 are more modest, but the government still anticipates a further increase of 722 billion hryvnias (~$19 billion).

Since the start of the full-scale invasion, the Ukrainian budget has been receiving foreign funding.

Foreign assistance falls under three main categories: military, humanitarian, and financial. The latter is the only kind that goes directly to the budget. It has reached $74 billion over two years of the war, covering over one-third (38.3%) of Ukraine's public spending.

The main donors are the European Union and the United States, which have provided $27.5 billion and $23 billion, respectively. Importantly, American assistance is more beneficial because it comes in grants that do not demand repayment. The EU offers loans, albeit with very favorable terms.

The third source of financing is the International Monetary Fund ($7.2 billion). However, the IMF's contribution goes beyond just multibillion-dollar loans. After a prolonged negotiation, the IMF signed a four-year Extended Fund Facility for Ukraine – an unprecedented decision for a nation at war. The program aims to raise another $115 billion in financial aid from Western countries, and that’s in addition to direct funding already pledged from the IMF ($15.6 billion). However, the fund's assistance comes with a number of conditions designed to bolster macroeconomic stability and encourage Ukraine’s self-sustainability in the long term. Ukraine’s partners, including the U.S., Canada, Japan, and the EU, also benefit from the arrangement. If such a credible entity as the IMF approves financial aid to Ukraine, they can forgo analytical work, and other donors will be more willing to follow suit.

Importantly, Ukraine is not allowed to use this financial aid for military needs. As surprising as it may sound, two years into Russia’s full-scale invasion of Ukraine, the West formally refuses to finance the war. Therefore, Ukraine can cover its military expenses only with revenue from taxes, tariffs, duties, domestic loans (such as military bonds), state enterprise dividends, and so on.

Meanwhile, foreign aid covers pensions, social benefits, public sector payrolls, and other civilian needs. When Ukraine runs out of its partners’ money, the government resorts to domestic loans, and in 2022, it also issued an additional 440 billion hryvnias (which caused a surge in the inflation rate and a drop in the hryvnia exchange rate).

In 2023, the budget was split between military and civilian expenses fifty-fifty.

As for military assistance to Ukraine, its volumes are even higher. Last September, then Defense Minister Oleksiy Reznikov assessed the aggregate value of military supplies, including equipment, weapons, and ammunition, to have reached $100 billion.

Corruption ab ovo

In wartime, foreign financial assistance cannot be embezzled because the money is strictly controlled and allocated for specific purposes: pensions, public sector payrolls, and social benefits — in other words, it is dispersed in fixed amounts transferred directly to recipients’ bank accounts. There is simply no opportunity to misuse these tranches of funds. However, although certain progress has been made, the corruption that was endemic in pre-war Ukraine is not gone for good.

As before the full-scale invasion, its main hotbeds are state enterprises and public procurement — by municipal authorities in particular. Journalists, social activists, and opposition politicians regularly expose tenders with inflated prices.

The highlight of their findings was the Defense Ministry's procurement of mind-bogglingly expensive eggs — 17 hryvnias apiece ($0.45), while retail prices in supermarkets were approximately 7 hryvnias. Shady deals like this one were cited as having contributed to the resignation of Defense Minister Reznikov in September 2023.

“Over the past four months alone, we have uncovered previous violations in the amount of over 10 billion hryvnias [~$263 million],” said new Defense Minister Rustem Umerov in January 2024. One such violation was a corrupt scheme involving the purchase of $39.4 million worth of munitions for the Armed Forces of Ukraine.

Instances of embezzlement have been exposed in road maintenance, the coal and grain trade, and the energy market.

However, the problem goes beyond inflated expenses and bribes to include corrupt courts of law. The inadequate protection of property rights in Ukraine is a major red flag for potential investors. The court reform continues even amid the war, but the overall credibility level of the national judiciary remains low. In May 2023, the National Anti-Corruption Bureau arrested Vsevolod Kniaziev, the head of Ukraine's Supreme Court, on the charges that he had received a bribe of $2.7 million. The investigation is ongoing.

To increase Ukraine's appeal to investors, its government has to amp up the fight against corruption, according to Penny Pritzker, United States Special Representative for Ukraine’s Economic Recovery.

Mobilization threatened by underfunding

Now that Ukraine has entered the third year of the full-scale war, covering its military budget promises to become even more challenging. As President Volodymyr Zelensky announced on Dec. 19, 2023, the Armed Forces of Ukraine plan to mobilize another 400,000-500,000 troops, which will require billions of dollars.

Half of Ukraine's defense spending is compensation for currently serving personnel. A serviceman's monthly salary varies from a base pay of 20,000 up to 100,000 hryvnias ($522–2,612) for those qualifying for combat duty bonuses.

In 2023, military payrolls amounted to 944 billion hryvnias ($25.8 billion) out of overall defense outlays of 2.1 trillion hryvnias ($55.2 billion).

According to the latest estimates by the budget committee of the Ukrainian parliament, the additional mobilization will cost 322 billion hryvnias ($8.4 billion). Apart from that, the military command has requested another 400 billion hryvnias ($10.5 billion) for equipment procurement and maintenance. The government is yet to figure out how to cover the additional defense costs.

The list of available options includes tax increases, the issuance of ever more domestic loans, redirecting local taxes to the central budget, or simply expanding the supply of hryvnias by having the National Bank buy bonds from the Ministry of Finance (the only realistic way of obtaining hundreds of billions of hryvnias on short notice). However, firing up the money-printing press threatens to boost the inflation rate and devalue the national currency — something the Ukrainian government is keen to avoid.

Officials in Kyiv have developed a framework designed to set out clear rules of exemption from mobilization on the one hand while balancing the budget on the other. The Office of the President suggests exempting all high-income employees who pay at least 6,000-7,000 hryvnias in taxes monthly ($160 and more).

Meanwhile, the parliament suggests setting a fixed payment for employers who want to keep their specialists in civilian life: 20,000 hryvnias ($525) a month per employee. The final decision has yet to be made, and the future of the initiatives remains unclear. Both options are actively criticized, mostly due to the risk of making military service the burden of the country’s poorest citizens.

Human resources gap growing

The business community is anxious to see clear mobilization rules. Overall, the labor market has entered into a paradoxical state: while some sectors are plagued with an acute shortage of workers, others have become overpopulated.

After peaking at 30% immediately after the start of the full-scale invasion, Ukraine's unemployment rate has already sunk below 20%. Businesses bemoan the lack of engineers, mechanics, industrial workers, service personnel, and so on. By contrast, creative workers and IT specialists struggle to find employment. The war has taken a particularly heavy toll on the domestic IT industry: previously booming, today this field sometimes has 40-50 candidates competing for a single opening.

Ukrainian IT professionals used to work for foreign companies, but the war, especially last winter’s power outages, has decimated their client base. In the spirit of minimizing risks, many international companies avoid hiring the residents of a country fighting for its survival.

As for workforce shortages, they are caused by both mobilization and emigration. Around 6 million Ukrainians have left their country because of the war, and another 3.7 million have become internally displaced. Even though two-thirds of the emigrants have expressed the desire to return, the longer the war lasts, the more of them will build a new life abroad and stay there for good.

Unless the government comes up with an effective policy to bring back the nation's workforce, Ukraine risks running into a shortage of 3.1-4.5 million employees before 2032, according to a study by the Economic Strategy Center:

“In the upcoming decade, cumulative economic losses may reach $113 billion. Coupled with the low birth rate, these losses will be impossible to mitigate through natural population growth.”

Businesses vs. law enforcement

Ukraine’s commercial health has also been threatened by an open conflict between law enforcement agencies and the business community. More and more entrepreneurs have complained of fabricated criminal cases, searches, and arrests.

The arrest at the border of well-known Concorde Capital investment banker Ihor Mazepa and his subsequent criminal prosecution have made Ukrainian businessmen uneasy. The entrepreneurial association Manifest 42 threatened to halt its manufacturing enterprises for an hour in protest. In response, the government promised to set up a special Presidential Entrepreneurs’ Council to facilitate legislative change and protect the business community. Ukraine has had several such bodies, but none of them proved effective.

Meanwhile, the key item of today’s agenda is the overhaul of law enforcement agencies. Primarily, this concerns the Economic Security Bureau of Ukraine, which was conceived as a single law enforcement body investigating economic crime. However, the Office of the President and MPs cannot agree on an approach to the new bureau. The parliament has suggested electing the head of the bureau through an open vote, in which international experts would have the decisive voice, and an immediate reevaluation of all current employees has also been proposed. The Office of the President advocates less radical changes and hopes to retain control over the bureau. One of the project sponsors is Oleh Tatarov, deputy of the head of the Office of the President Andriy Yermak and de-facto chief of Ukraine’s law enforcement bodies.

Third-year risks

The main threat to Ukraine, of course, is the ongoing hostilities. Despite Ukrainians’ efforts to adapt to their “new reality,” life in wartime is costly: huge public expenses, disrupted production, demographic problems, and the resulting unavailability of direct foreign investment.

Another existential risk comes as the direct result of delays in foreign aid. The U.S. Congress has been stalling the approval of both military and financial aid to Ukraine for months, and the amount in question, $60 billion, is irreplaceable for Kyiv.

On the plus side, now that February is over, we can say that another serious risk has somewhat lost its relevance: the strikes on Ukraine’s energy infrastructure. Last winter, power outages undermined the nation's business activity, and many Ukrainians entered this past winter with serious apprehension about what might await them. This time around, however, the country managed to pull through without large-scale blackouts.

Despite that bit of good news, export routes remain fraught with obstacles, even if the opening of the shipping corridor across the Black Sea has been a massive help. The latest problem struck out of the blue — from Poland, where local farmers are blocking roads in protest, demanding a ban on Ukrainian grain imports. Tensions are rising higher by the day. Polish protesters have already pried open a truck and a railway car, spilling grain onto the ground. Passenger vehicles are being stopped as well, and Polish law enforcement agencies have yet to intervene. The situation is spiraling out of control, according to Ukraine's Infrastructure Minister Oleksandr Kubrakov.

Yet from the multitude of troubles and challenges, the issue of mobilization remains the most pressing and painful. Within weeks, the Ukrainian parliament is expected to pass a law detailing new military conscription rules. However, it is still unclear how Ukraine plans to equip and compensate the new soldiers while making up for the damage to the labor market.

The Ukrainian government appears to have arrived at a point where unpopular measures have become imperative. On the one hand, the Armed Forces of Ukraine need reinforcement, even at the cost of punishing draft dodgers. On the other, the authorities have to finally figure out how to cover additional military costs. A tax increase will be met with resentment, but printing more money will devalue the national currency and drive up prices. Such are the dilemmas faced by Ukraine in the third year of the war.