Smart Privatization Can Save Ukraine

Smart Privatization Can Save Ukraine

Ukraine’s 2014 Euromaidan revolution toppled a corrupt regime and promised Ukrainians radical change that would bring the country’s governance in line with European standards. But nearly two years later, reforms appear to have stalled. Ukraine’s parliament has passed only 59 out of 150 reform laws promoted by an alliance of leading civil society organizations amid allegations that the nation’s politicians are merely tinkering with a fundamentally corrupt system. The Democratic Initiatives Foundation has just released a poll indicating growing popular anger at the slow pace of change: Nearly 50 percent of Ukrainians believe nothing has been accomplished at all, while 25 percent feel only one-tenth of the needed reforms have been made. The country’s leaders, clearly feeling the heat, are starting to trade accusations about who’s most at fault. To head off populist unrest that could threaten Ukraine’s fragile democratic transition, Kiev needs to move forward with aggressive reforms — and quick.

One step the government could immediately undertake to promote cleaner governance is to privatize the approximately 1,800 state-owned enterprises it still controls, including many of the largest firms in the country, mostly in the energy and infrastructure sectors. Many of these state companies are holdovers from the Soviet economy, which was entirely state-run (and woefully inefficient). If successfully implemented, privatization could play a critical role in jump-starting Ukraine’s war against corruption, as well as spurring on other sorely needed political and economic reforms. After initially planning to launch mass privatization in 2015, the government recently postponed the process until 2016. Ukraine should do everything in its power to meet this schedule — without further delays.

The single greatest benefit of privatization is that it would assist Ukraine’s desperate battle to free its governing institutions from the baleful influence of corrupt oligarchs. Prime Minister Arseniy Yatsenyuk has noted that “state companies have essentially fallen into the private hands of one political group or another.” Anders Aslund of the Atlantic Council agrees, arguing that the majority of Ukraine’s state-owned enterprises “have a shadow proprietor who taps them on money through opaque procurement or transfer-pricing schemes.”

Ukrainian oligarch Ihor Kolomoisky’s relationship with state-owned oil company Ukrnafta aptly demonstrates this phenomenon. Kolomoisky owns 43 percent of Ukrnafta and has controlled the company behind the scenes since the early 2000s. He has been accused by critics in the Ukrainian press and private sector of forcing the company to sell oil at below market prices to a bank under his control. This bank, in turn, sold the oil to Ukraine’s only refinery, which — you guessed it — is also owned by Kolomoisky. The oligarch is therefore reaping windfall profits on oil that belongs to the state.

Natural gas subsidies — which are meant to benefit the poor — are another example of how Ukraine’s state companies have enriched oligarchs and corrupt officials. According to Aslund, until recently, Ukraine’s government-subsidized household prices for gas were only 12 percent of its actual market price. With such a huge discrepancy, shadowy intermediaries run by corrupt oligarchs could bribe the right people necessary to buy this cheap subsidized gas from Naftogaz, the state-owned natural gas company, and then sell it to industrial consumers for a big markup.

Ukraine’s current International Monetary Fund loan commits it to phasing out natural gas subsidies, and on April 1 the government began to do so, thereby increasing the price the country’s households pay. But while global gas prices have dropped, Ukraine’s household gas prices are still only about 75 percent of the real market price. Ukraine has been through nine previous IMF agreements requiring natural gas price increases, but one oligarch or another has always found a way to induce the government to halt the price hikes. Unless this cycle ends, argues Aslund, “somebody else will pick up this business.” This is how removing valuable enterprises from state control can finally break the corrupt links between oligarchs, government officials, and state companies like Naftogaz.

The privatization experience of Estonia, another former Soviet republic, shows how privatization could diminish graft in Ukraine. Neil A. Abrams, a political risk consultant who’s writing a book on Ukrainian corruption, argues that, in Estonia, eliminating subsidies to all firms ended the privileged position of so-called “political capitalists” and helps explain Estonia’s clean governance today. Corruption is more deeply entrenched in Ukraine than it ever was in Estonia, but that only makes aggressive action like mass privatization all the more necessary.

While cleaner governance is the most critical advantage of privatization, there are economic benefits as well. Even the best-run state-owned enterprises are susceptible to political interference and are frequently run as vehicles for patronage, not as profit-seeking firms. Even Ukraine’s Ministry of Economy admits this, noting that Ukraine’s state enterprises posted aggregate total losses of almost six billion dollars in 2014. Privatized firms, by contrast, are guided by market forces, operate more efficiently, and focus on maximizing profit. A study comparing privatized companies to state-owned enterprises found that privatization resulted in increased output, profits, and investments, and that these beneficial outcomes grew as more time since privatization passed. In short, privatizing Ukraine’s failing state-run firms could turn them into productive economic engines which would help boost its desperately sagging economy — and pay the government taxes on their profits, to boot.

Privatization would also provide a more direct boon to Ukraine’s budget by eliminating expensive subsidies, thereby promoting macro-economic reform. To survive, the country’ state-owned enterprises suck up government subsidies like a black hole to the tune of at least 10 percent of GDP in 2014 alone. State enterprises have also accumulated liabilities of over 12 percent of GDP. These liabilities represent a huge fiscal risk to Ukraine, as future budgets would be consumed by paying down these debts. With Ukraine’s public debt to GDP ratio expected hit an unsustainable 94 percent by the end of the year, the sooner Ukraine finishes privatization, the sooner it can begin reducing its debt load. Ending the explosive growth of public debt will not solve all of Ukraine’s problems, but it would buy Kiev time to make further progress on its reform agenda.

It’s crucial to note that what Ukraine needs is successful privatization. If the process is carried out as corruptly as everything else in Ukraine, it could only make things worse. Russia’s failed attempt to sell state companies fairly in its own 1990s privatization process demonstrates how high the stakes are. After the Yeltsin government sold many of its largest state enterprises for pennies on the dollar to oligarchs such as Boris Berezovsky and Vladimir Potanin in the corrupt “loans for shares” scheme, the entire reform process was discredited. Today, Russians still associate privatization and economic liberalization with poverty and chaos, preferring Putin’s authoritarian system of state capitalism, where the largest enterprises in the country are state-owned. Given Ukraine’s volatile politics, a corrupt privatization process could not only discredit the entire reform agenda — it could topple the government.

To ensure that privatization helps Ukraine’s reforms rather than discrediting them, the private sector and civil society must be involved from the start. For the sake of transparency, all state companies but the 100 largest should be sold at open electronic auctions, with the bidding and results publicly available for anybody to see. Transparency International Ukraine, an anti-corruption watchdog, recently helped create just such an e-auction system for public procurement called ProZorro. This system — or something similar to it — should be used to privatize the country’s smaller enterprises. Even a one-dollar winning bid should be accepted, since the ultimate objective is to get these companies off the government’s balance sheet.

The 100 largest state enterprises — which account for 82 percent of assets and 80 percent of sales of Ukraine’s total state-owned enterprise sector — are more complex, and a simple e-auction will not be sufficient. Many are money-losing, but possess valuable assets and could be profitable in the right hands. To make the privatization corruption-free, it should consist of two distinct steps. First, the government should select international investment banks to function as lead managers for each of these large enterprises. These banks would be responsible for preparing financial statements and bidding rules for each state enterprise, marketing it both domestically and internationally, and selecting the winning bidder.

Second, a committee of experts from one of Ukraine’s leading civil society organizations, such as Transparency International Ukraine, would be required to certify that the sales process was free of corruption. No final contract could be signed until this occurs. These steps would require the Ukrainian government to surrender some of its control over the process, and that would rankle — but it’s the whole point. The corrupt Ukrainian state has been by far the greatest impediment to the country’s success, and government officials simply cannot be trusted to run a graft-free privatization without oversight.

Changing Ukraine will continue to be a struggle, one thing’s for sure: Done properly, privatization could be the game-changer that jumpstarts the political and economic reforms the country desperately needs.

In the photo, a worker grasps a hand wheel on a valve at the Dashava natural gas facility on September 18, 2014 in Dashava, Ukraine. The Dashava facility is operated by Ukrtransgaz, a subsidiary of Naftogaz of Ukraine.

Photo credit: Sean Gallup/Getty Images