Ukraine Reform Monitor: April 2017

This month, the Carnegie Endowment relaunches the Ukraine Reform Monitor, which provides independent, fact-based, rigorous assessments of the scope and quality of reforms in Ukraine. The Carnegie Endowment continues to work with a team of independent Ukraine-based scholars. This sixth memo covers the period from April 2016 to March 2017. The monitor is supported in part by grants from the Center for East European and International Studies (Zentrum für Osteuropa- und internationale Studien, ZOiS) and the Open Society Foundations.

Executive Summary

In the past year, Ukraine’s reforms proceeded more slowly than previously against the background of consolidation of executive power under President Petro Poroshenko, resistance from oligarchs, and opposition in the parliament. Nonetheless, the government of Ukrainian Prime Minister Volodymyr Groysman, appointed in April 2016, managed to sustain the momentum of reform, despite having only a very slim parliamentary majority.

There was progress in reform of the court system and in the fight against corruption. The National Anti-Corruption Bureau of Ukraine (NABU) initiated the first prosecution of a major government official.

Territorial decentralization reform advanced with the voluntary amalgamation of small communities into larger viable districts. However, political decentralization stalled, while there was no consensus in the parliament on amending the constitution.

The government started an ambitious four-year health reform program that aims to extend coverage and improve the quality of care, with every citizen guaranteed a basic healthcare package.

These reforms took place against a background of economic stabilization. International investors were upbeat about Ukraine because the macroeconomic situation stabilized and the economy grew—by 4.7 percent in the fourth quarter of 2016 and by 2.2 percent over the year.

On April 3, 2017, the IMF released its latest tranche of financial aid worth about $1 billion, but only after two postponements and while urging the Ukrainian government to do more to tackle corruption and reform the pension system. The delays occurred first because of a holdup in the release of the electronic declarations of public officials’ incomes and then because of a blockade of Ukraine’s eastern Donbas region, initiated by war veterans’ organizations and later supported by the government.

The unresolved conflict in the east of the country still overshadows most other issues, and the main reason that Ukraine is in the headlines is the continuing fighting in Donbas and the conflict with Russia.

Political Reforms: Presidential Consolidation

With the appointment of his ally Volodymyr Groysman as prime minister in April 2016, Poroshenko made a big step toward consolidating executive power. The Rada was limited in its ability to control the government, as officially there was no ruling coalition in the parliament, making a no-confidence vote more difficult. Yuriy Lutsenko, another ally of the president, was appointed prosecutor general after lawmakers removed the requirement that the holder of the post must have a law degree, which Lutsenko does not.

The legitimacy of the Central Electoral Committee (CEC) came under question as the mandates of thirteen of the committee’s fifteen members expired. Yet they remained in office, and the CEC conducted ongoing local elections The CEC head, Mikhail Okhendovskiy, was under investigation for corruption but also remained in office.

New Opposition

• The strengthening of executive power triggered more radical forms of resistance. Nationalist groups organized a blockade of Donbas with the support of opposition actors including Andriy Sadovyi’s Samopomich (Self-Reliance) and former Ukrainian prime minister Yulia Tymoshenko’s Batkivshchyna (Fatherland) parties. After failed attempts to end the blockade, the government decided to enforce a temporary transportation blockade. As a consequence, on March 16, 2017, the largest nationalist and veterans’ movements—Svoboda (Freedom), Right Sector, and National Corps—formed a united network.

Anticorruption

• NABU and the National Agency for Prevention of Corruption (NAPC) started to set the rules for a new, more transparent political culture in Ukraine. But the public perception is that corruption is still very high.
• The NAPC’s supervision of the state’s financing of political parties and establishment of a new e-declaration system for assets had a major impact. The e-declaration system was launched on September 1, 2016, and by October 30, senior state officials had submitted over 100,000 declarations. The declarations of the 423 members of the Rada, totaling 12.6 billion hryvnia ($500 million), caused shock. Over 1 million officials must submit their declarations by April 2017.
• Resistance by some officials to anticorruption efforts remains high. The Rada passed amendments to the e-declaration law—with votes from the ruling coalition and the opposition on the initiative of ruling coalition member Tetiana Chornovol—to include declarations from anticorruption NGOs. That move led to some critical statements from civil-society organizations and to Western concerns that life will become difficult for smaller NGOs investigating official corruption.
• NABU, in cooperation with the Specialized Anti-Corruption Prosecutor’s Office (SAPO), had submitted over 50 cases to court by February 2017. Roman Nasirov, head of Ukraine’s Fiscal Service, was arrested following NABU charges. However, NABU’s institutional autonomy depends on political support from the West, and the bureau is under pressure from groups in the ruling elite.

The Judiciary: A Major Step Forward

On June 2, 2016, Ukraine’s parliament approved a package of constitutional amendments reforming the justice system and the law on the judiciary and the status of judges. The court system was simplified, becoming a three-tier setup consisting of local courts, appellate courts, and the supreme court instead of a four-tier model—a step that shortens the time required for resolving disputes.

The new rules are designed to strengthen the independence of judges from political and commercial influence. The authority to nominate and remove judges was transferred from the parliament to the Supreme Council of Justice, a new body created to ensure judicial self-governance. But the amendments increased the president’s influence over the judiciary for a transitional period, and the role of the president remains crucial: judges are now appointed by the president following their nomination by the Supreme Council of Justice. The reform reduced the authority of the Prosecutor General’s Office, while access to the Constitutional Court of Ukraine was significantly expanded to include all individuals and companies.

The Economy: Stabilization but a Slowdown of Reforms

Ukraine achieved solid growth, macroeconomic stabilization, and lower inflation rates, thanks to structural reforms, a gradual recovery from the economic shock of the loss of territories in the east, higher world prices for Ukrainian exports, and Western financial assistance. The pace of economic reforms decelerated, and one much-anticipated reform, the planned privatization of state-owned enterprises, did not take place.

Economic Recovery

• The Ukrainian economy began to recover in 2016 after two years that saw a significant drop in output. In the second quarter of 2016, GDP increased by 1.5 percent year on year, accelerating to 2.3 percent in the third quarter and 4.8 percent in the fourth quarter. Annual GDP growth for 2016 was 2.3 percent year on year, which was higher than forecasts due to a record-high crop harvest.

Solid Growth

• Major sectors of the economy—agriculture, construction, industry, trade, and transportation—all showed growth. Construction grew especially fast, at 17.5 percent year on year in 2016, partly due to a decentralization reform that allocated funds to improve infrastructure. Only merchandise exports fell by 4.6 percent year on year in U.S. dollars, chiefly due to a 25.6 percent fall in exports to Ukraine’s traditionally largest partner, Russia. Increased imports widened the deficit and put pressure on the currency.

Inflation Under Control

• The National Bank of Ukraine (NBU) managed to stick to its inflation target for the first time. Inflation as measured by growth in the consumer price index decelerated from 43.3 percent year on year in 2015 to just 12.4 percent in 2016 (the target for 2016 was 12 percent ±3 percentage points).

Banking Cleanup

• The NBU continued to clean up the banking system, liquidating a total of 87 banks that were unable to supply capital to cover their losses. In December 2016, the NBU decided to nationalize PrivatBank, the largest bank in terms of total assets and deposits, partly owned by Ihor Kolomoyskyi, one of Ukraine’s best-known oligarchs. The bank’s bailout package is estimated to cost 148 billion hryvnia ($5.6 billion), making it larger than the 2016 budget deficit of 70.1 billion ($2.7 billion). Most of the package consists of long-term government bonds, meaning that the bailout has not led to a significant spike in monetary aggregates.

Energy Sector

• The government increased tariffs for heating by 75–90 percent and made several steps toward creating a competitive gas market. In July 2016, the unbundling of the state gas monopoly Naftogaz began, in line with EU regulations on the separation of extraction, transportation, and distribution, but the process is very slow.

No Easy Reforms Left

• Economic reform slowed significantly because all relatively easy changes have been implemented and the reforms that remain are more difficult to execute. The implementation of the IMF program was delayed due to inadequate progress in institutional changes, such as the introduction of a market for agricultural land. Pension reform, identified as a priority by the IMF, was also delayed because of its unpopularity among voters. The privatization of state-owned enterprises failed when the flagship Odessa Portside Plant made two unsuccessful attempts to attract a private investor. The sale of assets is opposed by groups that stand to gain financially from deals with the managers of state enterprises.

• In 2016, real budget revenues constituted 91.9 percent of those in 2013. Declines were recorded across corporate profits tax (43 percent) and revenues of budgetary institutions (33 percent). Several sectors suffered from expenditure cuts: environmental protection (41.9 percent), healthcare (36.3 percent), education (36.2 percent), and state administration (30.6 percent).

• Public investments grew but were low in relative terms. They amounted to only 1.3 percent of GDP in 2014, 2.4 percent in 2015, and 3 percent in 2016.

Minimum Wage

• The government announced a doubling of the minimum wage to 3,200 hryvnia ($119) a month, starting in January 2017. The move aims to fight the widespread business tax-avoidance practice of paying employees the minimum wage officially and supplementing it with an informal envelope payment.

Economic Effects of the Donbas Blockade

• Following the blockade of the railroad connection with the occupied territories in eastern Ukraine, the Russian-backed so-called Donetsk People’s Republic announced the “nationalization” (a term it later changed to “external management without change of owner”) of all enterprises on the territory under its control. This move especially hurts the interests of Ukraine’s richest man, Rinat Akhmetov, who owns much of the industry in the region. The blockade could result in a $2 billion loss of exports. (In 2016, Ukraine’s export of merchandise was worth $36.5 billion.) The direct effect on the Ukrainian budget is expected to be small, as taxes from the occupied territories in 2016 were worth 2.8 billion hryvnia ($104 million) out of a total tax revenue of 651 billion hryvnia ($24 billion).

National Security: Effects of Increased Funding

Ukraine’s military achieved some tactical successes in the conflict in eastern Ukraine, but military reform was hampered by bureaucratic and political resistance.

Conflict Zone in Eastern Ukraine

• The situation in the east of Ukraine remained tense, with daily ceasefire violations, a continuous influx of military equipment into the separatist-controlled Donbas from Russia, and a rising death toll in the Ukrainian military. In 2016, there were 208 combat losses, 258 noncombat losses, and 1,176 persons wounded. The total military death toll since the beginning of the conflict reached 2,629.

Defense

• In 2016, Kyiv unveiled the long-awaited Strategic Defense Bulletin, which sets out a strategic plan for reform of the armed forces. The document was developed in coordination with experts and aims to follow international best practice. Defense reform enjoys broad public support in Ukraine. A survey showed that 59 percent of respondents support military reform, while 63 percent trust the army, an 18 percent increase on 2015.
• Defense spending in 2016 doubled compared with 2014, while the number of active duty soldiers increased by 40 percent and stood at 250,000 as of late 2016. New Special Operations Forces were established. Army personnel underwent an unprecedented level of training by Western militaries. Extra funds allowed for a new e-procurement system, research and development, and an increase in the production of military equipment.
• Reformers in the Ministry of Defense said there was still much to do to enact systemic change, in particular with regard to management. Critics said that vetting in the ministry had had limited impact, while basic training of soldiers remained outdated.

Prosecutor General’s Office

• Staff selected for local prosecutors’ offices included many outside candidates, and 74 percent of those newly appointed had no prior experience with the Prosecutor General’s Office. The percentage of cases investigated by the office and sent to court increased from 11 in 2015 to 12 in 2016, while the investigation of killings on Kyiv’s Independence Square, or Maidan, in 2014 remained sluggish at best. Public trust in the Prosecutor General’s Office remained very low, barely increasing from 8 to 11 percent.

National Police

• Following the departure of Khatia Dekanoidze, Serhiy Knyazev was appointed the new chief of the National Police of Ukraine (NPU) after an open selection process with the participation of civil-society representatives and international experts. The vetting process of the majority of police personnel was completed in 2016; 14 percent of all officers and 26 percent of senior management were dismissed. Many were reinstated to their posts by court decisions. Even though thousands of candidates entered the NPU through an advanced and fair recruitment system, the police force suffers from a shortage of personnel. On average, 20 percent of vacancies are open, a figure that reaches 40 percent in some regions.

Decentralization: Moving Ahead Despite Constitutional Deadlock

Political Decentralization

• Constitutional amendments necessary to implement political decentralization remained blocked in the Rada because they include provisions on the special status of Donbas, based on the unpopular Minsk agreements of 2014 and 2015. Unofficially, government representatives raised the possibility of decoupling most of the decentralization provisions in the amendments from those on the special status, as there is a strong consensus in the Rada on the need for decentralization reform.

Fiscal and Administrative Decentralization

• By the end of 2016, 366 new amalgamated communities had been formed out of smaller administrative districts and had elected their village heads and councils. In addition, 47 new communities will complete the amalgamation process after the local elections scheduled for April 2017. Thanks to fiscal decentralization, the 159 amalgamated communities that had been formed in 2015 increased their budget revenues by 49.5 percent.

• The Rada approved critical legislation allowing other settlements to join already established hromadas (communities) and the formation of hromadas across current administrative boundaries. The legislation defined the authority of mayors of amalgamated communities and of starostas, a new elected position for the enlarged communities.

• Decentralization had a positive effect in the education and healthcare sectors, where access to and quality of services improved and spending became more efficient. The government approved rules for establishing hospital districts, which were subsequently created by eleven out of 25 oblasts as well as the city of Kyiv.

• Decentralization reform received broad support from international donors. In 2016, the EU, Germany, Switzerland, the United States, and other bilateral donors launched major projects to help implement this reform.

Healthcare: A Landmark Reform

On November 30, 2016, the government started to implement a four-year reform program to fundamentally transform Ukraine’s healthcare funding. Key elements of the program aim to expand the coverage and improve the quality of healthcare.

Tax-Funded Healthcare for All Citizens, Residents, and Refugees

• Healthcare will be funded via general taxation. Every citizen and permanent resident, as well as refugees, will be guaranteed a basic healthcare benefit package. For specialized care, there will be a system of co-payments from patients at transparent, unified rates. Emergency care will be provided free of charge to citizens, residents, and visitors.

Single Healthcare Purchaser

• The healthcare budget is currently tax funded and allocated to local governments (oblasts, cities, rayons, and hromadas). After the reform, all healthcare funds will be pooled under a national purchaser, the National Health Service (NHS), which will report to the Cabinet of Ministers and purchase services directly from care providers, both public and private.

New Payment Methods

• Ukraine’s budget currently pays for healthcare based on the size of inputs (such as the number of patient beds and the area of hospital rooms) rather than outputs. After the reform, facilities will be paid for based on contracts linked to relevant output indicators: for primary health, the number of enrolled patients; for hospitals, the patient case mix. Outpatient medicines from a list of essential drugs will be covered via reimbursements to pharmacies.

Purchaser-Provider Split

• Most of Ukraine’s healthcare facilities are owned and funded by local administrations. This system represents a profound conflict of interest, because local administrations are purchasing services from their own providers. After the reform, local administrations will still own the facilities, but the NHS will purchase all current health services provided by these facilities. The Ministry of Health will simplify licensing requirements for private practices to ensure diversity and competition among providers.

Hospital Districts

• Ukraine’s obsolete network of hospitals will go through a stressful transition as many hospitals will close or be transformed into social-service providers. To minimize disruptions, the newly created hospital districts will be offered extra funding if they successfully negotiate which of their local hospitals need to survive.

E-Health

• The government will introduce a new system for processing clinical and financial data in the healthcare system to set and process payments, check for fraud and mistakes, and administer prescriptions of medicines that can be reimbursed.