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Will The Boom Last In Ukraine?


It's the fastest-growing economy in Europe, in the fifth year of a boom that has seen gross domestic product climb by over a third since 1999. This year, GDP is set to expand by an amazing 11% to 13%. Bank lending is growing by more than 50% a year, while the stock market is up 100% in the past 12 months. In the increasingly colorful and cosmopolitan capital, the rising prosperity is tangible: from the brand-new shopping complexes in the city center to the blocks of luxury apartment buildings under construction on the outskirts. "Now everyone is driving around in foreign cars and having new apartments built. In the last few years the city has come alive," says Slavic Petrenko, a taxi driver. Welcome to Europe's tiger economy: Ukraine.

Incredible but true. And the boom is continuing despite one of the wildest political scenes in the former Soviet bloc. Since gaining independence in 1991, the nation of 47 million has been beset by one scandal after another. President Leonid Kuchma has been cold-shouldered by the West ever since an aide released tapes in 2000 that seemed to implicate the President in the murder of an opposition journalist. Kuchma denied any involvement. Now, the controversial President is preparing to step down. Under the constitution, he can serve no more than two five-year terms. But the campaign to elect Kuchma's replacement on Oct. 31 is keeping the drama at a fever pitch. The Kuchma government is throwing its weight behind Viktor Yanukovych, currently prime minister. The leading opposition candidate, Viktor Yushchenko, is recovering from a sudden and mysterious illness, which his supporters claim was a deliberate poisoning, a charge denied by the authorities. Western governments are watching the race closely for fairness, and international organizations are sending 4,000 observers. "We are deeply disappointed that the campaign to date has fallen short of international standards," the U.S. State Dept. said in an Oct. 14 statement that criticized "the disruption of opposition rallies, muzzling of independent media, misuse of 'administrative resources,' and other serious violations." Russian President Vladimir V. Putin, meanwhile, openly backs Yanukovych, who supports closer relations with Russia. Opinion polls show the two candidates running neck-and-neck, and there may have to be a November runoff.

With Ukraine's economy booming, it's not only governments but also investors who have an interest in the poll. If Yushchenko, a strongly pro-Western politician who jump-started Ukraine's boom when he was Prime Minister from 1999 to 2001, pulls off a victory, Ukraine could see major reforms that will put the country on the international investor map like never before. But if the ruling elite rigs the election to ensure a Yanukovych win, as some foreign governments fear, Ukraine faces the risk of international isolation and serious political unrest. The Yanukovych team denies any misdoing. "I think that these allegations of violations are not true in most cases, and that many are exaggerations," Stepan Havrysh, coordinator of the Yanukovych Presidential campaign, told journalists on Oct. 21.

NICE WORK

So far, Ukraine's interminable political scandals have not derailed its remarkable growth. But what's behind it? A combination of good luck and good macroeconomic policy. The luck is that metals, particularly steel, make up 60% of Ukraine's exports. Global prices have been high recently, thanks largely to demand from China and other Asian markets. The sound macroeconomic policy has been followed by successive governments since a financial crisis in 1998. The country has a 9.7% current account surplus, public debt is a low 24% of GDP, and inflation is in single digits. The wide-ranging privatization of the 1990s is bearing fruit: Some two-thirds of GDP is produced by the private sector, the main engine of Ukraine's growth. True, much of that is owned by a small number of tycoons. But these oligarchs -- the same term used in Russia -- are investing serious money in sectors such as agriculture, telecom, and banking. "Yes, privatization was dirty, but it has shown its effectiveness," says Olexander Paskhaver, president of the Center for Economic Development in Kiev.

There's a risk that a big fall in metals prices might unhinge Ukraine's growth. But the risk is mitigated by the healthy macroeconomic picture and rapid growth in noncommodity sectors. Machine-building grew 34% year-on-year in the first half of 2004, and construction rose 31%.

The bigger question is whether Ukraine can achieve the political stability needed to keep investment flowing. Foreign investment would be particularly helpful by injecting useful competition into Ukraine's oligarch-dominated economy and integrating Ukraine with the huge export market to the West. But so far, foreign direct investment has been minimal. Since independence, Ukraine has managed to attract just $7 billion, compared with around $50 billion in Poland. Besides the political strife, potential investors are deterred by Ukraine's mind-boggling bureaucracy and the rampant corruption that goes with it. But those who have already put their money down say such problems are manageable. "It's a challenging environment. But at the end of the day we can do business here, we're satisfied with our investment, and we're looking to make further investments," says Garry Levesley, Ukrainian director for Arlington (Va.)-based power company AES Corp. AES invested $70 million in 2001 to acquire two Ukrainian electricity distribution companies and is investing $10 million to $15 million each year in upgrades.

What's really needed are big manufacturers. Last year automotive suppliers Leoni from Germany and Yazaki Corp. from Japan opened plants in western Ukraine, investing $50 million and $40 million, respectively. Singapore electronics giant Flextronics Corp. (FLEX) plans a $50 million auto-electronics plant in the region -- a vote of confidence from a world-class manufacturer. Flextronics and the others are drawn by a highly educated, cheap work force. Labor costs are below $160 a month per worker, including all taxes and social levies, vs. around $400 a month in Poland. And as wage costs in European Union accession countries spiral upward, nearby Ukraine looks ever more tempting. "EU enlargement has brought the borders of Europe to Ukraine, so from a strategic point of view, a logistical point of view, and a cost point of view, it makes much more sense right now to manufacture in Ukraine," says Jorge Intriago, partner of PricewaterhouseCoopers in Kiev.

Western investors in Ukraine prefer Yushchenko but say they could also live with Yanukovych, provided his election is aboveboard. "Whoever wins, the country will continue to move forward economically, reform, and normalize. The only question is the pace of improvement," says Levesley of AES.

A former governor of the Donetsk region in eastern Ukraine, Yanukovych is linked to that area's powerful coal and steel barons. His government has openly favored the interests of these oligarchs, who are allied with Kuchma. In May it privatized Kryvorozhstal, Ukraine's largest steel producer, awarding the company to a business group headed by Kuchma's son-in-law, Viktor Pinchuk, even though the winning bid of $800 million was far less than a $1.5 billion offer from U.S. Steel Corp. (X).

Still, the Yanukovych government has its share of economic achievements. It has slashed the top income-tax rate from 40% to a flat 13%, passed laws to facilitate land privatization, firmed up protection for intellectual-property rights, and pursued membership in the World Trade Organization, which is expected by 2006.

The one outcome that could scare investors is if authorities manipulate the count or resort to even more drastic measures to keep the opposition from power -- such as canceling the election. A rigged election could well prompt Yushchenko's numerous supporters to take to the streets, as voters did in the ex-Soviet republic of Georgia in November, 2003, with unpredictable, and possibly violent, results.

As polling day approaches, the situation is growing tense, with rumors of army units being deployed around the capital. Which is it to be? A Ukrainian civil war, or more of the Ukrainian economic miracle? That's a question voters in the 2004 U.S. presidential race have never had to worry about.

By Jason Bush, with Roman Olearchyk in Kiev


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