Resource curse: Why Ukraine became poor and how could we avoid it?

Author : Oleksiy Kushch

Source :

We do not have a financial mechanism to conduct an independent industrial policy, we do not have a sufficient fund to minimize external crises. Ukraine is like a tortoise that slowly moves along a dangerous part of the land and is devoid of protective shell
21:53, 28 November 2017

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Resource curse - this is the name of the state of countries that, hoping for rich subsoil or mono goods of high demand, lost the tone of the national economy and as a result found themselves broken. In due time, Ukraine was also called the "Eastern European tiger". Unfortunately, some leaders of our country, not content with this status, decided to play geopolitics. Cold shower, generously spilled on Ukraine, along with a state of invigorating freshness, brought unfavorable news: the raw curse in our economy operates like in no other country in the world. And not a single magician will be able to get rid of it, unless, of course, we do not want to do it ourselves.

A little background or start with the definitions. Question one: who is to blame?

The raw curse is characteristic of countries that specialize in the extraction of minerals, for example oil, the production of intermediate goods, for example agricultural, the release of monoproducts, for example, metal. If there are smart people in power in the country, then they should understand that: a) natural resources will end sooner or later; b) commodity prices are subject to cyclical fluctuations and sharply reduced during periods of world crises; c) the rate on the production of mono goods, based on local absolute competitive advantages, can bring welfare growth over the medium-term interval, but is doomed to failure in the long-term time horizon.

The Norwegian economist Erik Reinert in his book How Rich Countries Become Rich and Why the Poor Countries Remain Poor convincingly showed that the so-called vicious cycle of poverty or the ontological cycle of evil doom some countries with colossal starting opportunities for constant subsidence on the "poverty rings" on the bottom of the well of life. The main reason for this is the orientation toward mono-production with decreasing returns and the incorrect application of the theory of comparative advantages. This theory was formulated in the XIX century by the English economist David Ricardo and says that trade is beneficial not only in case of its basing on absolute advantages, but also on the use of relative ones. With regard to Ukraine, this trap of poverty looks like this: since we have favorable conditions for agriculture, then we have absolute advantages in this sector compared to other countries, so we will concentrate on the production of corn, grain and sunflower oil, that is, raw monotgoods with decreasing returns. But unlike goods with a high level of added value, the production of agricultural products cannot get the effect of scale. Thus, in the production of passenger cars, an increase in production volumes will lead to a reduction in costs, while in the agrarian sector and in the extraction of minerals, on the contrary: every additional ton of wheat or a new ton of mined ore requires new expenditure: fertile soils are depleted, stocks are depleted. In addition, our metallurgical complex for a long time has been developed with the help of absolute competitive advantages: cheap Russian gas, for which it was necessary to pay political concessions and subsidies from the state. As a result, we obtained an economy in which only those industries are developed that either had absolute advantages in the world market or were based on the production of agrarian mono- and raw materials with decreasing returns. Industries with increasing returns, which could be based on the use of relative advantages, for example, processing, production of consumer goods, engineering and so on, are not practically in developed state.

What can the imbalances in development like ours lead to? Until 1960, the Somali economy outstripped the qualitative parameters of South Korea. But the latter, thanks to the development of a creative and innovative economy (true, before that, an independent industrial policy was implemented), managed to break out of the vicious circle of absolute and relative advantages in the form of cheap labor and success in agriculture, while Somalia continues to search for them during such an exciting actions as "catching" of foreign tankers.

Ukraine should understand that the orientation towards cheap labor, which our president was so excited telling about in Indonesia, as well as reliance on raw materials, metal and agricultural products, is, in essence, a search for competitive advantages in our own backwardness.

In order to break out of this trajectory of poverty, the government should direct revenues received in the raw materials sectors with decreasing returns to the development of industries with increasing returns, for example, the profits of the agricultural sector should be directed to processing and the food industry, and the revenue from the sale of metal into the engineering sector.

Unfortunately, the influx of "easy" money into obese years (2000-2008), as well as the enormous level of corruption, completely deprived our country of resistance to external price shocks in world markets and twice brought Ukraine into the maelstrom of a systemic crisis: in 2008-2009 and 2014- 2015 years. By the way, the low quality of state administration and the high level of corruption are the constant companions of the "raw curse", since raw materials are so convenient in terms of withdrawing it from the working capital of the economy for feeding home-grown financial and industrial groups and corrupt clans. Without detracting the extent of the influence of war and the closure of the Customs Union markets on the state of our economy, we note that Ukraine is still, like a roller coaster, tied to the dynamics of prices in world commodity markets. In these conditions, our growth will be associated with an increase in raw materials price in the world, and the fall will be as rapid as the future collapse (and it will happen, because the world economic cycles have not been canceled yet). The role of the government under such a model of country governance is reduced to a simple redistribution of financial flows between 5-10 "families": a monkey can be successfully placed in the position of a minister, the result will be the same (or maybe better): the economy will still grow next year to put it to 2-3%.

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Reliance on raw materials has led to the fact that the Ukrainian hryvnia has been sick for many years with the "Dutch disease", which is also called the "Groningen effect". The discovery in 1959 of the Groningen gas field in the Netherlands led to a short-term replacement by gas revenues of the development of other, more labor-intensive sectors of the economy. As a result - stagnation, unemployment and the collapse of the national currency against the backdrop of a fall in world prices for hydrocarbons. For a long time, the exchange rate stability of the hryvnia was "bought" not by the efficiency of our economy and its investment attractiveness, but by the growth of export earnings from the sale of raw materials, metal and agricultural products.

How this illness affected the health of the Ukrainian economy can be seen as a result of the so-called Rybchinsky theorem implementation. As this theorem says, in the case of the emergence of an increasing factor of production, those branches of the economy will intensively develop, where this factor is predominant. In Ukraine in recent years such a factor was cheap natural gas, which was fostered by several large financial and industrial groups. At the moment, such factors are: reimbursement of value added tax to exporters; cheap rent for the use of agricultural land; state-regulated tariffs. In January-August this year, the sum of VAT refund to exporters amounted to about 77 billion UAH and by the end of the year will exceed UAH 100 billion. That is, in fact, the whole economy is working to collect additional 10% of the working capital in favor of the 10 largest financial and industrial groups. At the same time in Ukraine we see the lowest rent in Europe for the use of agricultural land: about 30-40 dollars per hectare of arable land.

As a result, following the "Rybchinsky theorem", only branches that are aimed at exporting raw materials can develop in Ukraine. It is these segments of the economy that take the main social resource and human capital. For production with a high level of added value, we have not enough resources. In this model, there is no place for industries that meet the needs of the domestic market, they simply cannot withstand competition for resources with "factorial" directions of development. There is no place in it for complicated engineering, not to mention innovative directions. The hryvnia rate in this model plays the role of a regulator of positive profitability of the largest financial-industrial groups: in the event of a fall in prices for their products in world markets, the hryvnia immediately devalues by the appropriate amount, sometimes artificially pushed to it by the NBU. Rent income of monopolists is a sacred thing, all state institutions "must" work for their "filling". It is not difficult to see that if the world economy is a self-increasing model, then the Ukrainian one is self-destructive. According to the research of Serhiy Korablin, for 25 years of independence our real GDP has decreased by 35%, and this is the worst indicator in the world. Between 1991 and 2014, gross product declined in only five countries: Ukraine (-35%), Moldova (-29%), Georgia (-15.4%), Zimbabwe (-2.3%), Central African Republic (-0,94%). And the world economy for the same period, on average, increased by 88%. Few countries can afford to fall at a time when the whole world is growing ...

Question Two: what to do?

Not all countries are subject to a commodity curse. For example, Norway managed to create a sovereign investment fund, which accumulated almost a trillion dollars as of autumn 2017. Even if Norway is running out of oil, the Norwegians will be able to take additional funds: the fund's resources are invested in shares of the largest international companies (over 60%), debt securities - investment grade bonds (over 30%) and real estate (from 2 to 5%). Currently, the proceeds from the use of the fund's assets are already 50% of the planned revenue part, and the profit from the sale of oil is the second 50%. Every Norwegian owes 200,000 dollars from accumulated in the fund.

Saudi Arabia forms a sovereign investment fund of $ 2 trillion dollars - but this is only the first level of diversification of the economy, tied to raw materials. At the second level we see the development of an efficient secondary sector of the economy (industrial production). The Saudis plan to purchase ready-made technologies and intellectual property rights in order to create an assembly of finished products already in their country. So, within the framework of this stage, they acquired design documentation in Ukraine, including the right to use intellectual property, and are planning to launch a new AN-132 aircraft production plant in the near future. Creation of an efficient and competitive tertiary sector of the economy in the form of services, corporate governance, medicine, education, science, information technology, biotechnology is the third level. For example, the construction of the city of the future Neom on the Red Sea coast. This should also include the development of alternative energy sources, solar and nuclear, the implementation of space and missile programs. In the implementation of the Neom project, Saudi Arabia plans to invest up to $ 500 billion. As a result, a city of futuristic predictions should appear, in which will work more robots than people, with an emphasis on innovative and digital technologies. In the fourth stage of diversification, the Saudis plan to create joint projects in other countries that will not only bring profit to them and provide different levels of security (food, information, military), but also actively integrate with the investment, industrial and innovation infrastructure in the kingdom itself. At the final, fifth stage, a transnational model for managing investment projects, an effective secondary sector of the economy and a tertiary innovative services sector should appear in Saudi Arabia, with which the modern segments of medicine, education and science will be integrated.

Thus, commodity incomes can be effectively used to create both an "airbag" and structural adjustment of the economy. The first option is suitable for small countries with a small population, for example Norway. The second is for economies, which need to work with tens of millions of local residents - for example, Saudi Arabia.

The largest commodity countries managed to form their sovereign investment funds: China - 1.7 trillion dollars (including the Hong Kong fund, the Chinese investment corporation and the management fund for foreign exchange markets), Norway - 1 trillion dollars, the UAE - 0.8 trillion dollars, Kuwait and Saudi Arabia ($ 0.5 trillion each).

The creation of the Reserve Fund and the National Welfare Fund in the Russian Federation allowed it to substantially amortize the impact of Western sanctions and low oil prices in 2014-2017. Although it is worth noting that the multi-layered architectonics of the financial security system, created by former Minister of Finance Kudrin, is at a minimum level: if at the end of 2013 the total resources of the two funds were $ 175 billion, then as of November 1 this year - slightly more than $ 86 billion .

From 2005 to the last year, Ukraine exported intermediate goods, that is, raw materials and semi-finished products, to the amount of more than 448 billion dollars. In case of applying to these products a minimum wide export duty of 5%, our country could form its own sovereign investment fund in the amount of 22.4 billion dollars. Note that this amount significantly exceeds the amount of credit funds that Ukraine received from international donors in 2014-2017 and is comparable to the parameters of the mythical "Marshall’s plan" for Ukraine, which so far remained in the web of subcortical connections of our officials.

Even in times of crisis, Ukraine could easily replenish its reserve bins by 1-1.5 billion dollars a year at the expense of broad export duties. It should be noted that we are talking about the introduction of wide export duties for the whole range of raw materials, including the products of mining and metallurgical and agrarian complexes. Exception here should be made only for export goods with a high level of added value. At the moment, we have only a lobbying system of export duties, for example, ferrous scrap.

Unfortunately, Ukraine is the only sufficiently large raw material economy of the world, which has not bothered to create its sovereign investment fund, formed at the expense of revenues derived from the export of raw materials, semi-finished products and raw agricultural products.

As a result, we do not have a financial mechanism for conducting an independent industrial policy, or leverages on the exchange rate support for the national currency, or a sufficient airbag to minimize external crisis phenomena. Ukraine is like a tortoise, which slowly moves along a dangerous part of the land and is devoid of protective shell.

Without the creation of a sovereign investment fund, our country will not be able to conduct an effective structural transformation of the national economy: foreign investments are always narrowly selfish and will be accumulated only in the "factorial" branches of our real sector, that is, in the simplest commodity cycles. The rhythm of structural reforms must be defined within the country, and not under external management from the outside. The key problem here is the system of political and business cohesion in Ukraine. Stop paying VAT refunds to exporters and impose a five percent duty on them in order to make a structural reorganization of the economy in favor of domestic consumption, the tertiary services sector, and small and medium-sized businesses - only unaffiliated politicians who know how to do it can cope with this. Just one action remains - to find such people.

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