Ukraine Reform Monitor: February 2016

The Ukraine Reform Monitor provides independent, rigorous assessments of the extent and quality of reforms in Ukraine. The Carnegie Endowment has assembled an independent team of Ukraine-based scholars to analyze reforms in four key areas. This fourth memo covers the period from December 2015 to mid-February 2016. The monitor is supported in part by a grant from the Open Society Foundations.

In early 2016, the administration of Ukrainian President Petro Poroshenko suffered a series of major setbacks that threatened a new political crisis in Ukraine. The government failed to secure the necessary support in the parliament for a decentralization reform. This in turn raised new doubts about the feasibility of the Minsk process aimed at settling the conflict in eastern Ukraine and the prospects for peace there.

The country was rocked by several scandals involving corruption allegations against Poroshenko’s team and charges that the president was turning a blind eye to corruption. The government adopted the 2016 budget necessary for the IMF to deliver the next tranche of its financial assistance, but the aid was delayed pending resolution of the corruption scandals. The cabinet of Prime Minister Arseniy Yatsenyuk survived a parliamentary vote of no confidence on February 16, but two ruling coalition partners (Batkivshchyna or Fatherland and Samopomich or Self-Reliance) officially left the coalition. The trade portion of the EU-Ukraine Association Agreement, delayed at Russia’s insistence, entered into force on January 1.

Political and Judicial Reform

Constitutional Reforms

• The Constitutional Court of Ukraine completed its review of and approved a package of judicial reforms, including amendments to the constitution designed to strengthen judicial independence.
   
• The government’s package of decentralization reforms failed to gain the necessary 300 votes in the parliament to become law. The main obstacle was a controversial set of provisions for the special status of the separatist-held territories in eastern Ukraine, required under the Minsk accords. As a compromise, the parliament changed its procedural rules to allow more time to debate the package in 2016. This change gave the government more time to build support for the provisions, avoided what would have been an embarrassing failure by the administration to live up to its commitments under the terms of the Minsk accords, and—at least temporarily—kept the governing coalition together and averted early elections.

Civil Service Reform

• The parliament approved a long-postponed law on the civil service. The law introduces a distinction between political appointments and civil service posts, requires that civil service posts be filled through open competition, prohibits political lobbying for senior civil service appointments, introduces term limits for political appointees, and makes civil service processes and salaries transparent to the public. The process of implementing this reform, however, will no doubt be lengthy and encounter many obstacles from the entrenched government bureaucracy.

Corruption

• The economy minister, Aivaras Abromavičius, resigned on February 3 citing government corruption and the Poroshenko administration’s lack of commitment to fight it. His resignation triggered a major domestic political crisis, raised the possibility of the ruling coalition’s collapse, prompted protests from the country’s key donors, and resulted in a delay of the next tranche of IMF assistance.
   
• Abromavičius’s resignation was followed on February 15 by that of the deputy prosecutor general, Vitaliy Kasko, also in protest of the government’s lack of action against corruption as well as attempts to sideline him by Prosecutor General Viktor Shokin, who has been widely criticized for turning a blind eye to corruption.
   
• On February 16, the day the government presented its annual report to the parliament, Poroshenko called on Yatsenyuk and Shokin to resign. While media reports claimed Shokin had resigned, at the time of writing there was no confirmation of this by the Prosecutor General’s Office as he was on vacation at the time. The Yatsenyuk cabinet survived a parliamentary vote of no confidence, a result that was largely seen as an effort to avoid early elections and accelerate the next tranche of IMF assistance.
   
• A new anticorruption movement led by Mikheil Saakashvili, governor of Odessa and a former Georgian president, was launched in December 2015. Having embraced “purification” of the political system as its slogan, the movement already has the support of several prominent political figures and civic activists from around Ukraine.

Economic Policy

EU Trade Agreement

• On January 1, 2016, an agreement establishing an EU-Ukraine Deep and Comprehensive Free Trade Area entered into force. Russia retaliated with sanctions on Ukrainian exports. Ukraine responded by imposing trade sanctions on Russian goods. These moves were largely symbolic and had no significant impact on trade between the two countries, which had already declined dramatically with total Russian-Ukrainian trade turnover falling from $50.6 billion in 2011 to $12.5 billion in the first ten months of 2015.

Budget

• On December 25, 2015, the parliament approved the state budget for 2016. The budget projects a deficit of 3.7 percent of GDP, in line with IMF requirements. This budget’s most important change is a cut in the social security tax—the so-called single social contribution—to a flat rate of 22 percent of income. This contribution is the main source of revenue for the state pension fund, which is already chronically underfunded and whose deficit will now increase.

Relations With the IMF

• Citing the slow pace of reforms and allegations of corruption, the IMF postponed the delivery of the third (September 2015) and fourth (December 2015) tranches of the Extended Fund Facility program. The IMF decided to delay the installments after Abromavičius’s resignation and charges against the Poroshenko administration. The charges were echoed by Western governments and renewed pressure on the Poroshenko administration to be more active in fighting corruption. A cabinet reshuffle is also expected as a result.
   
• In December 2015, Ukraine defaulted on its $3 billion debt owed to Russia. New IMF rules adopted in November prevented this default from disrupting the IMF program. Russian Finance Minister Anton Siluanov announced that Russia would sue Ukraine in the London Court of International Arbitration but left the door open to negotiations.

Currency Pressures

• The hryvnia came under more pressure due to falling export prices. The interbank exchange rate was down from 22.9 hryvnia to the U.S. dollar in late October 2015 to 24.7 hryvnia to the dollar in mid-January 2016; black market rates reached 27.5 hryvnia. In response, the central bank introduced de facto rationing on the official foreign exchange market. The falling currency will make it harder for the central bank to meet its inflation target.

Reform of Naftogaz

• The cabinet approved the reform of corporate governance of the state-owned energy giant Naftogaz. The reform is required for Ukraine to receive loans from the European Bank of Reconstruction and Development (EBRD) and the European Investment Bank (EIB) to support the modernization of the Urengoy–Pomary–Uzhhorod gas pipeline. The reform is expected to reduce Naftogaz’s deficit and align the company’s corporate governance with the principles of the Organization for Economic Cooperation and Development (OECD).

National Security

The Occupied Territories

• The situation in Ukraine’s eastern Donbas region remained tense. The Organization for Security and Cooperation in Europe (OSCE) and Ukrainian government sources reported daily explosions and small-arms and heavy-machine-gun fire during this period. The ceasefire between Ukrainian forces and Russian-backed separatists was frequently violated along the ceasefire line, more frequently from the separatists’ than from the Kyiv-controlled side.
   
• Russia and the West took new diplomatic steps to encourage the implementation of the Minsk accords. Moscow named Russian Security Council member and former Duma speaker Boris Gryzlov as its new representative to the Trilateral Contact Group, which brings together Russia, Ukraine, and the OSCE. The appointment of political heavyweight Gryzlov was widely interpreted as a positive sign. U.S. Assistant Secretary of State for European and Eurasian Affairs Victoria Nuland met Kremlin aide Vyacheslav Surkov in Kaliningrad, Russia, to discuss the implementation of the Minsk accords. The meeting fueled further speculation about an imminent breakthrough. However, none of these moves has produced tangible results so far.
   
• The government imposed a ban on trade with Crimea, which took effect on January 17. Crimea continues to suffer from electricity blackouts caused in part by explosions that resulted in a cutoff of electricity from Ukraine. The explosions had reportedly been carried out by Crimean Tatar activists supported by Ukrainian nationalist organizations. Although the damaged power lines were repaired, Crimea is still experiencing outages because the contract for the peninsula’s energy supply expired at the end of December 2015 and has not been renewed. The Ukrainian authorities—under pressure from the Crimean Tatars—insist that Crimea be defined in the contract as a “temporarily occupied territory,” a demand to which Russia will not agree.

Defense

• The Ministry of Defense’s budget for 2016 increased by 16 percent compared with 2015. At $2.2 billion, the budget amounts to 2.5 percent of Ukraine’s GDP. Budgetary expenditures allocated to armaments and military equipment will be four times higher in 2016 than in 2014.
   
• The government signed contracts with Ukrainian aircraft manufacturer Antonov to build 60 cargo airplanes for the military. Antonov, one of the two largest aircraft manufacturers in the former Soviet Union, is looking for alternatives to Russian spare parts for Ukrainian planes to decrease its reliance on Russia, described as a military adversary in Ukraine’s military doctrine adopted in September 2015.

National Police

• The national police opened its first recruitment center in Kyiv, which will coordinate the hiring of new personnel and recertification of former militia officers. The police plans to open ten more centers in Ukraine’s regions by summer 2016.
   
• The new patrol police, created earlier in 2015 and already deployed in Kyiv and elsewhere, began operating in two more cities, Mykolaiv and Dnipropetrovsk.

Prosecutor General

• The prosecutor general appointed 154 new heads of local prosecutors’ offices through a new and nominally open process; no outside candidates were appointed.
   
• A new General Inspectorate for Internal Investigations was established to fight corruption in the Prosecutor General’s Office.

Decentralization

• Amendments to the Tax Code had a positive albeit small impact on local governments. The ceiling on the local property tax was raised slightly, the local vehicle tax was changed to target expensive cars, and the local business tax was simplified. These changes are likely to result in a modest increase in local revenues.
   
• A new law, approved in November and signed by the president in December, transferred the right to register legal entities and property from central to local governments. This will enable local governments to expand their tax bases and collect administrative fees.

Overall Assessment

The past several months have demonstrated that Ukraine’s challenges are increasingly domestic rather than external. The ceasefire in eastern Ukraine is largely holding despite frequent violations thanks to pressure from external actors. Although the unsettled conflict continues to exact a heavy toll on the country’s economy, politics, and social fabric, some of the biggest challenges facing Ukraine have been its long-standing, systemic failures—a corrupt government and a political system dominated by big business.

The Poroshenko administration’s perceived lack of commitment or ability to take decisive action against both corruption and the role of big business emerged as a major impediment to Ukraine’s further progress at home and relations with major partners abroad. A statement on February 3 by ten ambassadors to Ukraine, including those of the United States, the United Kingdom, and Canada, was a sign that Ukraine’s partners are disappointed with its progress. The statement was prompted by Abromavičius’s resignation and echoed his frustration with the government.

The IMF’s postponement of its next tranche of assistance was a blow both to Ukraine’s reformers and to its finances, as well as a reminder of past failed IMF programs. In another serious development reflecting Europe’s frustration with Ukraine’s slow progress, Danish officials warned that in the event of Kyiv’s failure to implement its portion of the Minsk accords, the EU would not maintain the sanctions it imposed on Russia following Moscow’s March 2014 annexation of Crimea.

Although Prime Minister Yatsenyuk and his cabinet have survived a no-confidence vote, Ukraine appears to be heading for more turbulence in 2016. Failure to adopt constitutional changes required of Kyiv by the Minsk accords runs the risk of handing a political victory to Russia, making it possible for Moscow to shift the blame for the conflict onto Ukraine.

At the same time, by pushing for these constitutional changes, the Poroshenko administration risks becoming vulnerable to attacks from the nationalist wing of the political spectrum and seeing its parliamentary coalition collapse, leading to an early parliamentary election. Because two partners have left the coalition, the government does not have a parliamentary majority. It also suffers from strains caused by allegations of corruption and political and personal rivalries. These tensions may result in a new parliamentary election, a cabinet reshuffle, or simply more political maneuvering. Any of these outcomes would be an unwelcome distraction at a time when a strong coalition is essential for the government’s ability to function and proceed with reforms necessary to restore the confidence of the Ukrainian population and the international community.