Opinion, Berkeley Blogs

Wartime economy for Ukraine

By Yuriy Gorodnichenko

Garment industry switched to military uniforms

For over 230 days, Ukraine has been resisting Russian aggression. This war brings death and destruction at a scale not seen in Europe since WWII and the ripples of the war are felt everywhere—from the Ukrainian families who lost their loved ones to African countries that face the prospect of hunger. A long war rather than a blitzkrieg is progressively looking like a baseline scenario. In this case, victory depends not only on how brave and motivated armed forces are but also on who has a stronger economy, who can sustain waging a war effort at a high pace, and who can muster more resources. Can Ukraine win on this front?

Garment industry switched to military uniforms

I hope to show you that the answer is yes. To this end, let me summarize the current situation, make connections with the economic lessons from previous wars, and discuss the way forward for Ukraine and its allies.

The war destroyed many, many lives, families and homes. Millions of people fled the country and many more millions are internally displaced. More than 7% of housing stock is destroyed. As of August 2022, a large chunk of the country (this roughly corresponds to 25% of France’s territory) was under Russian occupation. The economy toll is enormous too. The best estimate for the current rate of unemployment is 35% and the GDP is projected to fall by 30%-50% in 2022.

But the economy shock is highly uneven. The economy of Eastern Ukraine is largely destroyed (some of the largest steel mills were in Mariupol), while Western Ukraine is more lightly damaged. For example, construction of new housing has been resumed on only 2% of sites in the Kharkiv region (Eastern Ukraine), while the corresponding share is 81% in the Lviv region (Western Ukraine).

There is also major differentiation across production sectors. For example, Russian missiles have destroyed all major oil refineries, but the IT sector remains strong (for instance, the number of vacancies is similar to pre-war levels). The Russian blockade of sea ports prevents Ukraine from exporting metals and agricultural products which has devastated export-oriented sectors – for example, metals production is expected to fall by 50% in 2022. Adding to the balance of payments drain, Ukrainian refugees in the EU and other countries withdrew approximately $2 billion in April 2022, which exceeds $1 billion per month in remittances to Ukraine.

Despite huge stress in the early days of the war (the financial stress index spiked to a level not seen since debt restructuring following the Russian invasion in 2014), banks and the payment system continued to function. There are other signs that the economy is gradually recovering after the shock. For example, after almost complete collapse in March 2022, the number of sold railroad tickets is “only” 20% below the pre-war level. The “grain deal” that allowed Ukraine to ship agricultural products from Odesa and other ports is a move in the right direction too, although the flow is too small. This resilience reflects not only the resourcefulness of the Ukrainians who adapt to the new life, but also the policy choices made by the government.

In response to the Russian invasion, the National Bank of Ukraine fixed the exchange rate at the pre-war level to forestall panic and keep inflation in check. To protect domestic credit and payments, the central bank introduced capital controls and eased macroprudential regulations. In pursuit of the same goal, the government raised the maximum insurance limit threefold and, for the duration of the war, insured all retail deposits. The government suspended some taxes or substituted existing taxes with alternative taxes (for example, smaller businesses were allowed to switch from VAT to a sales tax) and introduced holidays for various payments (e.g., mortgages, utility bills) to provide households and businesses with liquidity to sustain their operations. The government’s liquidity needs were met by the central bank, which directly transferred resources to the Ministry of Finance. In short, the general approach of this initial response was to use reserves to absorb the shock and to fix some prices to limit instability.

This policy mix, however, is not sustainable. With the destroyed economy and massive needs to pay for defence expenditures (Ukraine’s monthly spending on defence now is greater than its annual spending before the war), the fiscal deficit is very large, roughly $5 billion per month. Approximately one-third of government spending is covered by tax revenue, loans, and grants from international organisations. Ukraine’s allies cover another one-third, and the central bank prints money to cover the final third. With so much new money, inflation is already above 20% and it is projected to accelerate to 30% by the end of the year. Furthermore, the central bank has had to burn its foreign exchange reserves to defend the hryvnia, Ukraine’s currency. If there is no change in the current course, Ukraine will end up in an economic crisis, which it can’t afford while fighting the Russian aggression.

To support the war effort, Ukraine needs to radically improve its fiscal position. Although the ability of the government to fund a long war historically boils down to the capacity of the government to raise tax revenues and control spending, the Ukrainian circumstances are different and thus call for a different approach.

With limited resources and constant Russian strikes, the Ukrainian government faces tough trade-offs. For example, it must balance adverse effects on the economy (from broad fiscal consolidation) with negative effects on morale (from lower salaries for soldiers). Ukraine can mobilize more resources by borrowing more but debt sustainability is a serious concern. Ukraine can raise more tax revenue (introduce new taxes, make tax schedule more progressive, broaden the tax base, etc.) or cut government spending. While some form of fiscal consolidation is possible, everyone should appreciate that fiscal consolidations hurt the economy and fiscal deficits are driven by the needs of war and basic public services which makes them very hard to control. Printing money to pay for military expenditures can provide temporary relief for government finances but if taken to excess it stokes inflation and can undermine the economy in the medium-to-long run. With the prospect of a long war, the risks of the economy being ravaged by high inflation outweigh the benefits of printing money. Clearly, there is no easy solutions for Ukraine if it has to rely on internal resources.

But it is not only about how to keep the fiscal matters in good order. For example, with a rapidly changing economic environment and military needs, as well as the highly uneven impact of the war on economic activity, Ukraine needs a system to allocate resources quickly and cost-effectively. Historically, wartime governments had to play a critical role in the economy to mobilise resources to produce weapons and munitions, given market incompleteness and imperfections. However, Ukraine quickly learned that massive government interventions can be counterproductive: Ukraine’s attempt to regulate prices of gasoline during the early months of this war resulted in major shortages of fuel; now these prices are set by the market and there is no shortage.  Lacking the capacity to micromanage flows of goods and services to meet the needs of the defence and civilian sectors, the Ukrainian government tends to rely on market-based mechanisms which could take longer to deliver results, but these would be more cost-effective, an important consideration given limited resources. For example, the highly-competitive garment industry reoriented towards meeting demand for military uniforms and the government procures from the most cost-effective manufacturers thus freeing up budgets for other uses. In the same spirit, the government has relaxed many regulations (e.g., firms can fire workers relatively easily; workers who would like to quit do not need to give advance notice to their employers) to accelerate the reallocation of labour, capital, and materials in the economy.

The government is also leveraging its digital app (“Diia”, which means “action”) to make the aid more targeted, help allocating the resources, and mobilise savings to pay for the war. For example, citizens can now buy war bonds via the app. There is a discussion how the government can build on the success of Airbnb and use the app to match the internally displaced to vacant homes of those who fled the war thus giving shelter to the displaced and income to the homeowners. Again, an ingenious idea to squeeze maximum from limited resources.

The wartime experience of many countries—including Ukraine’s in 2014-2015—suggests that the government has to make a number of tough choices. The budget constraints are particularly painful and call for many sacrifices shared by every Ukrainian. The marathon of this war requires prudence and caution in public finances, a reasonably low rate of inflation, a resilient financial system, a careful management of external balances, and flexibility and efficiency in the allocation of scarce resources. The good news is that all of these elements are doable.

More importantly, Ukraine is not alone and Ukraine’s allies can provide much needed economic aid to close the gaps. Indeed, foreign aid can relax budget constraints and provide a short-term solution to internal and external economic imbalances. Since the start of the full-scale war, Ukraine has received external support on the order of $2.5-3.0 billion per month. This is a significant sum, but it is well below what is needed to cover the many costs of the war. The composition and delays in transferring aid to Ukraine exacerbate the situation. For example, the EU had proposed an urgent macro-financial assistance programme of €9 billion in May but has only managed to mobilise €1 billion by July, with the remaining €8 billion still locked in discussions. Furthermore, according to the Kiel Institute for the World Economy, the share of grants in the EU aid programme is only 1% (for comparison, the corresponding share for the US is 87%).

Ukraine’s financial need for 2023 is between $40 billion and $50 billion. While $50 billion sounds large, it represents only one tenth of one percent of the GDP of Ukraine’s allies, 4% of NATO’s annual budget, and 9% of the spending announced so far by European countries on supporting consumers with energy costs. Furthermore, the civilized world would face far higher security and economic costs and risks if Russia is successful. Thus, in contrast to the experience of countries during the World Wars or other major wars, Ukraine cannot and should not rely only on internal resources to support the war effort.

In summary, Ukraine can defeat the Russian aggression. But Ukraine’s victory is unnecessarily at risk from a disorganised economic approach. For example, there is a real risk that central bank financing of the deficit will drive a weaker currency and higher inflation, and disrupt the war effort.  This and similar scenarios are avoidable.  The allies have the resources to finance Ukraine, and they should step up. After all, they are getting extraordinary value for money, as Ukraine’s armed forces are proving remarkably effective in their use of resources to degrade Russian military capability, at comparatively low cost.

Economic and military aid to Ukraine is the best investment in peace!