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Graft, red tape, addiction to cheap gas kept Ukraine from fulfilling post-Soviet potential

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The battle in Kyiv is, in large part, a fight for the country's economic future — for better jobs and prosperity.

Ukraine's protesters want to pry their country away from Russian influence and move closer to the European Union. A look at neighbouring Poland, which did just that, suggests why.

The two countries emerged from the collapse of the Soviet Union two decades ago in roughly similar economic shape. But Poland joined the EU and focused on reforms and investment — and by one measure is now three times richer than Ukraine.

Ukraine, on the other hand, sank in a post-Soviet swamp of corruption, bad government and short-sighted reliance on cheap gas from Russia.

Per capita economic output is only around $7,300, even adjusted for the lower cost of living there, compared to $22,200 in Poland and around $51,700 in the United States. Ukraine ranks 137th worldwide, behind El Salvador, Namibia, and Guyana.

Protests broke out in November after President Viktor Yanukovych backed out of signing an agreement with the EU that would have brought the economy closer in line with European standards. After violent protests resulted in scores of deaths, the government and the opposition signed an agreement on Friday. But it is unclear whether it will succeed in providing a stable government that can heal the rifts and improve the economy.

It didn't have to be this way, experts say. Ukraine has a large potential consumer market, with 46 million people, an educated workforce, and a rich potential export market next door in the EU. It has a significant industrial base and good natural resources, in particular rich farmland.

How did things go so wrong? Here are the main reasons.

OLD INDUSTRY: Ukraine did little to move away from Soviet-era industries producing commodities such as steel, metals and chemicals. Former communist state companies, often privatized to politically connected figures, relied on cheap gas from Russia and growing demand from the world economy for their raw materials.

That helped Ukraine's economy grow rapidly from 2000 to 2008, but reduced pressure to modernize.

When the world economy fell into a crisis in 2008, demand for Ukraine's raw materials plunged. Then in 2009, Russia significantly raised the price of its gas supplies, further pulling the rug from underneath the country's export industries.

Pekka Sutela, an economist at Finland's Lappeenranta University of Technology who has extensively studied post-Soviet economies, calls the gas-based export boom "the Ukrainian curse."

"The economy was able to grow without making the necessary changes," he said.

GAS FOLLIES: Ukraine's state gas company, Naftogaz, charges customers only about 20 per cent of what it pays for imported Russian gas. That means the government spends about 7.5 per cent of the entire economy's output each year on a massive home heating subsidy aimed at keeping voters happy. That results in large budget deficits that the government must borrow to cover.

The International Monetary Fund tried to help Ukraine through its post-crisis troubles, with loan packages in 2008 and 2010. Each time, the IMF turned off the money tap after Ukraine refused to follow policy requirements including raising gas prices or cutting back sufficiently on generous government salaries and pensions.

CORRUPTION: A recent World Bank study of the economy cited "pervasive" corruption as a major factor holding back the economy. At street level, businesses are subjected to arbitrary treatment by officials and demands for bribes. Higher up, there is widespread public skepticism over the fortunes amassed by the connected, known as oligarchs. In particular, attention has focused on the career of Yanukovych's son Oleksandr, a dentist who according to Forbes Ukraine has amassed a $510 million fortune through various business enterprises.

Ukraine ranked 144 out of 175 countries in the 2013 corruption perception index compiled by Transparency International, an anti-corruption group, behind Papua New Guinea, Nigeria, and Iran.

RED TAPE: Business advocates say owners sometimes prefer paying bribes to obeying regulations and taxes that are so complicated and burdensome that they would be out of business if they complied. The country's complex business tax laws require 390 hours a year to comply with and take 54.9 per cent of profits. That put Ukraine 164th out of 189 countries in ease of paying taxes in a World Bank survey.

BROKEN FINANCES: Ukraine's finances now are in such bad shape that it will have trouble paying its debts this year without outside help. With continuing deficits, it faces borrowing needs of between $7 billion and $10 billion this year. Its poor prospects mean it's unlikely to be able to borrow more on bond markets.

On top of that, the central bank has been spending its dwindling foreign currency reserves, which were down to $17.8 billion at the end of January, to prop up the exchange rate of the hryvnia currency. One reason it is doing so is likely that many businesses and consumers owe money in dollars — a sharp drop in the hryvnia could trigger widespread bankruptcies.

Unfortunately, keeping the currency artificially strong hurts exports.

Russia had promised $15 billion in credit — an inducement to abandon closer ties with the EU and join a Russian-sponsored trade group. Even that money, however, seems to be on hold due to uncertainty about the fate of the Yanukovych government. Ratings agency Standard & Poors said Friday Ukraine would likely default without a significant improvement in the political crisis.

Sutela said that even Russian help would only be a stopgap and couldn't paper over the need for fundamental change.

"Next autumn, they will go cap in hand and beg the Russians for money again," he said.

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