How the Ukrainian crisis might
look like in five years? We look at performance and identify most-probable growth
trajectories for the EU, Russia and the Ukraine, analyze drivers, the internal
logic of change and the influence of global trends when good or bad political
decision-making by the involved parties disappears.
Problem description
The current situation around Ukraine is a mess. The seizure of Crimea
was the first time since World War II that a nation in Europe had engaged in
territorial conquest. Ukraine’s democratic and market orientation is challenged
by loss of territory and struggles to gain control over separatist area. Russia
counteracts a perceived threat of Western influence, democracy, rule of law, and
NATO enlargement. The possibility emerged of a permanent zone of conflict in eastern
Ukraine (King). The West, acting
in the best attention in offering support, is involved in a geopolitical
struggle. It imposed limited sanctions on Russia with the fear that the new cold war with the West could
warm up considerably.
Despite the context of growing global confrontation between political powers,
the situation took all parties by surprise. The entire existing fabric of
international relations is under scrutiny, not last because of the impact on
confidence and valuations, and just general uncertainty (Posner). Differences in worldviews and
economic trends have transformed into an open conflict, where the West and
Russia are testing each other. The default lines serve the whole political
spectrum: the values of an open society and traditional values in the interpretation
of a petrol state; between demonization of Russia as a policy or an alibi for
an absence of it (Kissinger); between Western universalism and national
identity; between post-Cold War triumphalism and the lack of resources or
mandate to police the World; between the Western support for democratic change
in Ukraine and the lack of an EU membership perspective, to name a few.
It is an asymmetric situation. On the one hand, GDP of the US and EU is
respectively 9 and 10 times bigger than of Russia. Russia’s total foreign debt
is almost twice its international currency reserve, creating vulnerabilities. Russia’s
dependency on the export pipelines, demographic decline, widespread corruption,
incompetent administrations, regional disparities, as well as coming obsolesce
of its nuclear material dwarf the challenges faced by the US and Europe. There
is no real military threat to NATO members. During a meeting of the
International Monetary Fund in Washington the question was asked: “Do we really
want to destroy Russia that fast.” (Aslund 2014).
On the other
hand, one should be aware of the perils of Russia’s retaliation. The West needs Russia’s
cooperation for strategic and geopolitical problem solving in Iran, Syria and
Afghanistan, to ensure EU’s uninterrupted gas supply (Granville), from fighting terrorism to arms control to
climate change. Russia has many levers to influence the future of Ukraine and
is capable of exploiting Ukraine’s challenges and political fragmentation by
different means and ways. Additionally, if Ukraine’s West integration is a
policy goal, cooperation with Russia lowers the restructuring cost or might
even not possible without it.
How to makes sense of the current situation? What are the long-term
consequences that Ukraine became the de facto linchpin of Europe’s geopolitical
equilibrium? In order to gain a more differentiated understanding, one might
wish to look five years ahead where the influence of current good and bad political
decision-making disappears while economic and political megatrends prevail.
EU
The worst may be over, but the EU is still in the midst of an
outstanding historic experiment about a new balance of national states and
supranational institutions. As often in major innovative undertakings, preliminary
results are disappointing. The EU GDP is below its 2007 figure. Unemployment
remains at a staggering 11.6 %. In Germany, the EU’s economic powerhouse, real
wages are mostly stagnating during the last 15 years. Deflation in the Southern
periphery worsens the structural adaptation process, the ongoing large-scale
austerity challenges democracy and political stability. The Euro-zone member
Greece has lost 25 per cent of its GDP without the perspective of recovering it
in the near future, which is unprecedented for a developed Western country. The
EU lacks shale gas and oil discoveries, which helped the US economy to achieve
“escape velocity” from the Great recession. Comparisons are always risky, but the
shadow of the global financial crisis from 2008 as well as the finding of the
new institutional equilibrium shares patterns with the transformation process
of Eastern Europe and former Soviet Union countries after the fall of the
Berlin wall from a planned economy to a market-oriented economy that consumed growth
for 10 years or more.
The ongoing internal restructuring process influences the possibilities
to project power to EU’s neighbourhood.
EU is divided on long-term issues by competing readings of current
events and trends. Lacking political will and economic resources, bureaucratic
dilatoriness and subordination of the strategic element to domestic politics
does not help to speak consistently with one voice. The EU enlargement process
in the Balkans came to a still stand in 2013 and is under threat. The EU Mediterranean
trade and cooperation agreements show disappointing results. To the East, the
EU did not offer EU membership, a proven, but demanding instrument for enlarging
the Western sphere of influence. The EU – Ukraine Association Agreement, signed
on 27 June 2014, is a low-cost, low-impact replacement.
However, when all other options have been tried out, the learning curve
of nations and elites will encounter a turning point for a sustainable
political compromise that might include, for example, the use of Eurobonds as one
of the many minefields in the current political negotiation process. If history
is a guide, it is most probably that the EU will re-enter a growth trajectory in
the next five years. The new equilibrium might not reflect the optimism of the
Lisbon Agenda from the year 2000 to become the most competitive region through
a knowledge-based economy. But it might be sufficient for a stronger commitment
to common defence, energy policy and contingency planning. More resources and
political attention will be available for large-scale initiatives in order to shape
EU’s periphery.
Russia
Russia had the best era in its history full of drama and turmoil, a Golden
age of prosperity and stability. Growth rates from 1998 – 2008 were 7 per cent.
Measured in constant (2009) roubles, data indicate that the economy-wide
average wage tripled from about 6,700 roubles per month in 2000 to over 19,000
in 2008 (Rosstat). Because of the appreciation of the rouble, real income per capita
in current US dollars increased tenfold. GDP per capita narrowed to the upper
half of the OECD. Total GDP set off from a dismal 271 billion USD in 1998 to 2
trillion USD in 2012 (IMF). The benefits of growth trickled down to all parts
of Russian society. This performance shaped self-confidence of the population
and legitimacy of the elites.
A more detailed narrative tells a controversial story about these
impressive figures. Ian Morris calls it the “paradox of development, “ and Mark
Elvin the “high-level equilibrium trap”: When a country thinks it is in a
golden age, it stops focusing on progress.
Russia is still within a century-long wave-like development pattern of oscillation
between external-induced shock therapy and inward turning, leaving a legacy of
ambivalence towards modernity. The beginnings of the particular eras are
personalized with their rulers: Peter and Catharina the Great, Alexander II of
Russia and Lenin. The socialist revolution was nurtured from the gap between
West’s advancement and Russia’s limited industrialization within a huge
territory. A trade-off between the need of market and civil-society
institutions versus economic growth allowed super power status, an arms race
and an ideological confrontation with the rest of the world. After 70 years,
the modernization impulse was exhausted and the Soviet Union has imploded
beyond repair.
Jelzin started in 1991 a new cycle with a trial-and-error phase of
ambitious market-oriented and democratic reforms. The objective was to set up
the missing institutions and capacities, necessary to modernize the country and
compete in global markets. The societal cost of these demanding institutional
innovations were high: loss of national identify, demographic collapse, hardships
of economic restructuring and social misery. The Russian default of 1998
demonstrated the extent to which the entire social edifice was overstretched by
the challenges of modernity.
Putin’s reign of 1999 started as a turning point towards consolidation
within this cycle. Unfortunately,
relief came also by a parallel global commodity boom. Due to the outstanding
cost-benefit profile, incentives favoured the integration of the inherited
resource-intensive economy into world markets. As a pathway to a dual economy,
any activity other than exporting commodities was not profitable or perceived
as not profitable. Russia developed some high-value activities outside the
country. London- named Londongrad by the oligarchs’ -became a centre for
serving Russia’s needs in IPOs, business dispute settling and financial
engineering with the value of transactions reaching 100 billion USD a year. It is
estimated that the oil and gas rent reached about 30 per cent of Russia’s GDP.
Many companies took debts abroad, larger than their market capitalization.
The governing elite, increasingly
consisting of former KGB and military with their particular worldviews,
exploited the results of the fortuitous set of circumstances and vindicated
blind eyes to corruption and increasing dependency on hydrocarbon extractions. Russia’s
economic modernization was limited to islands consisting of export pipelines,
retail and consumption, and stayed ossified und inefficient, with disappointing
investments in human capital and a deteriorating physical infrastructure.
With the fast-economy growing fast, incentives for following on Jelzin’s
risky and demanding path of structural, institutional and social reforms were
lost. After “low hanging fruit” of basic economic reform and prudent
macroeconomic policies were picked up, the reform process slowed down in the
face of popular indifference, bureaucratic inertia, and political resistance
and manoeuvring. Missing institutional constrains similar
to those in Australia or Norway, the Dutch disease and the resource curse
worked their way. After 2000 structural reforms stopped by and large. While
becoming richer, the country missed the chance to exploit windfalls to move up
the global value chain.
Growth slowed down before the financial crisis of 2008 as an indication
that Russia’s business model exhausted itself again. (When this happened in the
1970-ies, the Soviet Union started to export commodities, delaying change for
many years.) The leadership did what it could to encourage change without
addressing the underlying systemic problems of the post-Soviet state-let style
of development. The list of failed initiatives to generate momentum from Russia’s
newly-won soft and hard power is frustratingly long: the German-Russian
partnership for modernization in 2008, the use of state-owned Gasprom as an
instrument of foreign policy, the new-built town of Skolkovo as the Russian
respond to the Silicon Valley, the Eurasian Union as a challenger to European Union
for global influence (Beauchamp), the
Collective Security Treaty Organization as a counterweight to NATO, an attempt
to copy the US government that made huge investments in the development of
nanotechnology in the 1990s (Block and Keller, 2011), a state program to enter
the global aviation market, and other unsuccessful attempts to approach the
technological frontier besides defence and aerospace. Billions were spent, but the
declared results not achieved.
Sadly, as a downside of a “managed democracy”, Russia does not have an institutional
landscape as in advanced Western democracies for a smooth replacement of the
governing elite. The protests in December 2012 by urban middle-class dweller were
brought under control, but proved the possibility of a regime change from the
bottom. In order to strengthen legitimacy, Russia’s “securocratic” regime moved
to the right and switched public attention beyond economic growth. In a kind of
delayed reaction to the collapse of the Soviet Union in 1991 and skilfully
exploiting the fragile national identity after the traumatic loss of superpower
status, Putin promoted the vision of neo-Soviet authoritarian empire. From now
on, the regime relied increasingly on nationalism, positioned Russia as a moral
superior defender of conservative values and, recently, started a populist
media campaign against Ukraine’s Euromaidan.
In the wake of Crimea’s annexation, President Putin gained approval
ratings of up to 86 per cent (Bowen). At the same time, the economic results of
Putin’s statecraft went into the negative: “Putin’s seizure of Crimea has weakened the
Russian economy, led to China getting a bargain gas deal, revived NATO, spurred
Europe to start ending its addiction to Russian gas and begun a debate across
Europe about increasing defence spending”(Friedman).
Russia follows its own logic of historic development. As many times before,
the country is on the eve of a new development cycle. The current national political
equilibrium in support of Putin’s time in power is not stable at all. We are on
the eve of the end of Putin’s era. A window of opportunities will open, where the
cooperation with the West for identifying new opportunities will be
appreciated. The success and deepness of these upcoming reforms will define
Russia’s development trajectory for a decade and more. Latest in five years,
Russia will be a very different country.
Ukraine
While Poland and Russia started the transition process with almost a
similar GDP per capita as the Ukraine, they are now 2 and 3 times richer. Before
the crisis, the outlook of leading experts was positive. “Ukraine is a
competitive authoritarian regime, more pluralistic than those of Russia,
Kazakhstan or Belarus” (Ishenko) and Ukraine is “an oligarchy about to break
down into a democracy” (Aslund 2007:279). Why is the Ukraine now then near the
bottom of transition country league tables, has the most energy inefficient
economy, is riddled with unprecedented corruption and state failure?
A reason might be the consistently bad political decisions over the
last two decades (Ash). For supply-siders, the underlying rational is the
failure to push through reforms. Others maintain that Ukraine is located in the
no-mans land between two economic regions and fails to capitalize on size. Lacking
valuable natural resources, business opportunities and favourable
bio-geography, Ukraine might just have bad luck. We investigate in more detail the
influence of two factors, state building and the emergence of an adequate
growth model, which might have contributed to the current state of affairs.
The challenge of state and nation building: The economist Alfred Marshall remarked in 1919: “The
state is the most precious of human possessions and no care can be too great to
be spent on enabling it to do its work in the best way.” As the rule of
the thumb, it counts for 50 per cent of difference in GDP per head (Diamond).
Ukraine has been independent for only 23 years with some historic roots before
the 14th century. Furthermore, the Ukrainian territory is
heterogeneous. The west of the Ukraine is largely Catholic, speaks Ukrainian, was
part of the Habsburg monarchy and has had a century-long strong orientation towards
the West. Economically it is dominated by agriculture with low productivity and
high unemployment. The East is largely Russian Orthodox. As an industrial
heartland of the former Soviet Union, it has outdated technology, depends on
subsidizes, but still has above average value creation and export activities. Its
foreign orientation is mainly towards Russia, following historic, cultural, mental
and economic links.
Periodic turmoil and deep-seated fragmentation of the society might be
an indicator that the elites are challenged by the Westphalian sovereignty,
granted in 1991, and some elements of formal or juridical sovereignty are still
significant (Jackson). Considering the conflict-ridden European history in the Middle
Ages and the civil wars in the Balkan in the 1990-ies, Ukraine might be still
perceived as a country on its way from a sum of regions to a nation. The
implications are higher transaction costs and lower social capital. In a classic case of negative externalities, the
localized costs of suboptimal behaviour - the ones one might expect to be
internalized - fall well short of the overall national costs, contributing to
elite capture and corruption. Consequently, spill over effects of tensions
and loss of confidence contribute to lower outcomes, and higher risks of change
for the years to come.
Indeed, we are beginning to understand nation building, including the
identification of triggers that results in entering a sustainable modernization
path. During the last decade, the international community has invested
trillions of USD in Iraq and Afghanistan, that is comparable with the total of
official development assistance since World War II and exceeds many time the
GDP of the beneficiary countries. The focus was often on democratic skills and
institution, civic participation, and good governance. The US alone invested
US$ 5 billion (2,8 per cent of annual GDP) in Ukraine (Neuland). Of course, these are important wealth-enhancing
arrangements, but their perception as a precondition for economic growth is a
recent phenomenon. Historically, democratization often followed growth. In the
US during its revolution, in Germany after World War II and in South Korea
during the 1980-ies, the political consensus turned in favour of democratic and
inclusive institutions because of economic incentives, not vice versa. Contrary
to common economic textbooks, China’s successful reforms were the results of a bottom-up
process of intensive institutional trial and error on local and regional levels
(Rodrik 2007: 92). The Singaporean consensus, for example, promotes public
housing, academic meritocracy, elite governance and primacy of growth as one of
many alternatives to the Washington consensus that stills dominate
international institutions. Little is understood about what is correlation and
what is causation.
Identifying a sustainable growth trajectory. Every country has
a growth model that embeds the national economy in competitive global markets
and positions it in the global value creation pyramid. For more than 100 years the
US is at the top as the “indispensable” start-up nation, creating an asymmetric
equilibrium with the rest of the world (Acemoglu). With high costs, it defines by
and large the global technological frontier and innovates value chains,
corporate business models and institutions that diffuse to the rest of the
world, either immediately, or throughout many decades. Germany found a
lucrative global niche in the middle-technology segment by combining high-tech technologies
with traditional metal. Competitive medium-sized companies, the Hidden
Champions of the Mittelstand, lead the manufacture sector. China captured on technological
breakthroughs in transport and communication, a massive capital inflow of $ 1
trillion in foreign direct investment since 1992 and unimpeded access to
Western consumer markets. Its labour-intensive and export-led model redefined
global division of labour and made it the manufacturer of the world. On a lower
scale, India became the office of the world. The new EU accession states prospered
due to their integration into a single market as a provider of qualified, low-cost
labour in exchange to subsidies, direct investment, know-how and a stable institutional
landscape.
Identification of an appropriate growth model for the Ukraine faces a
most complicated mix of challenges and opportunities. As a complexity analysis
shows (Escobaria 2014), Ukraine exports machines and equipment to Russia and
low-value agriculture products (soybeans, honey) and commodities (metal and
steel) to the West. This is an unfavourable situation because - all other
things being equal - the amount of structural change and investment is higher
than in other countries.
Thus, an increase in Ukraine’s export of agricultural products requires
investments investment and capacities for providing the regulatory, legal and
other frameworks. On the one hand, Ukraine’s natural conditions are above
average as the territory is mostly covered by fertile black dirt, has a
favourable climate and demand occurs from the nearby world’s largest economic
region. But in a classical hen and egg problem, the critical point is a long
way away from providing the required state capacities, the necessary smart
public investment in market creation and, eventually, a business environment
that is enabling, stable, predictable, free of corruption and attractive for
national and foreign capital.
There is no demand on Western markets for Ukraine’s machines and
equipment. Foreign (Western) investment might be hampered by the close link of
the sector with Russia’s defence industry.
Ukraine’s Eastern industrial heartland, particularly the Donbass basin
with its old-fashioned energy-intensive coal and steel industry, needs
investment, new management and, particularly, energy-saving technology. The
experience of the US and EU in restructuring heavy industry and mining clusters
does not give cause for optimism. Wallonia, the first industrialized part of
continental Europe, is underperforming and might be forced into independence by
the richer parts of Belgium. Some towns in Germany’s Rhine basin are in worse
shape than socialist-ridden Eastern Germany. The US rust belt is still the
synonym for economic decline, population loss and decay. In all these cases,
drivers of growth switched and costs of restructuring exceeded new value
creation. Consequently and with mixed success, the focus moved on managing the
transition to knowledge-intensive activities, outsourcing, downsizing,
“factoryless” manufacturing and deindustrialization. As a result, not the West,
but investment-led and environmental-intensive China counts today nearly for half
the world’s steel and other low-value commodities. For Ukraine, the search is out for an appropriate niche in
the global market place that stops the relative fall in its economic dynamic.
The EU – Ukraine Association Agreement has offered a long-term
development perspective, but is not a short-term game changer. Ukraine might be
in a situation like Greece that lucks a sizable export potential and trade
competitiveness. It is therefore no surprise that austerity and structural
reforms add to a painfully slow process of harnessing the advantages from a
single market. A similar example provides Mexico. It achieved on average growth
rates of less than 2 per cent per capita after signing the North American Free
Trade Agreement (NAFTA) in 1994, which is low by emerging-economy standards.
Mario Draghi, the ECB’s president, raised the following concerns in regard to
EU’s Southern periphery: “Each economy has to stand on its own feet. It has to
be productive and competitive enough to benefit from the opportunities afforded
by the Single Market” (Draghi). Eventually, the EU will find a mechanism for dealing
with its periphery, an advantage that Ukraine does not have.
Summarizing the situation, Ukraine will need time to recover from the
current shocks. It is faced with a dilemma of multiple crisis and the needs of
demanding structural reforms. Significant risks remain for institutional
overstretch and instability. Some indices of state failure do not disappear.
The country has to balance the inherent trade-off between short-term costs and
long-term benefits.
On a geopolitical and strategic level, the options of the West to frame
these efforts might be reduced to two options. One policy is the focus on stability
and macroeconomic stimulus (Gros, Summer,
Gorodnichenko). The decline of GDP of more than 7 per cent for this year
should be offset by financial and technical assistance of the broader
international community. One might remember that the containment doctrine
during Cold War included strategic support to frontline states like South Korea
and Taiwan that triggered high growth rates. History does not repeat, political
and technological circumstances are very different today. Ukraine competes with
other geopolitical problems for resources and political attention, such as the
aftermath of Arab spring, the emergence of the ISIS-state, a violent Bosnia,
the Middle East conflict, and more. Nevertheless, the amount and conditions of investment
test the political commitment of the West to support democratic change in
Ukraine.
The other option, which is currently implemented, is support in
exchange to a reform package with focus on structural reforms, fiscal
stabilization and spending cuts. Ukraine will receive amounts up to $ 27
billion (15 per cent of annual GDP) over the next two years that covers
reported financial needs of the government (Erlanger).
The IMF program intends to float the Ukraine currency, remove energy
subsidises, raise taxes and freeze minimum wages. At least in the short-term,
this will contribute to a substantial economic contraction and political instability.
In our best guess, in five years a realistic scenario for Ukraine is a recovery
from the current crisis, a durable cooperation with Russia and the emergence of
the outlines fora sustainable growth model with a higher value proposition.
Recommendation and Conclusion
Based on these considerations we reach some conclusion:
1. De-escalate. Russia overplays its
cards, but has the advantage of an asymmetric player. Low-scale confrontation
prolongs Putin’s political life cycle; hard sanctions will hurt not only the
Russian economy. The leitmotif should be the art of muddling through in order
to achieve normalcy. Compromises are needed in the best traditions of
realpolitik.
2. Prepare for a window of opportunity in Russia. The implosion
of the Soviet Union took the West by surprise and there was no experience in of
moving from a planned economy to a market economy. Today the situation differs.
It would be a mistake to take current events by face value and assume historic linearity.
3. Stabilize the Ukrainian state. The political stalemate
between the West and Russia is a contributing factor to the disorder in
Ukraine. Russia cannot offer a long-term growth perspective; the West still copes
with the aftermath of the global recession and looks inwards. Ukraine needs stability,
time and resources for a trial-and-error process that encourages nation
building and the identification of a suitable growth model.
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