Ukraine is being lost in transition: should it stay, or should it go?

Ukraine is currently in a very awkward position of moving away from CIS (or rather Russia, Belarus, and Kazakhstan emerging trade bloc), but not getting closer to the EU. My new research paper shows that any integration strategy -- CIS oriented or EU oriented -- would be better than the current status of being lost in transition. Here is the graph that demonstrate actual vs predicted aggregate trade under the EU and CIS integration scenarios:

By distancing itself away from Moscow, Ukraine is losing its current trading partners in traditional goods that it exports. By not integrating with EU it is losing in two different ways: its old trading partners from new EU member-states (trade diversion effect) and is finding it more difficult to attract FDI, create competitive products in manufacturing sector, promote its production in the EU market (losing possibility for expansion of manufactured exports and probably agricultural products).
Here is the graph that shows the gains in exports of Ukraine in 4 large groups of products from chosing EU integration rather than CIS integration:

Gazprom faces high uncertanty

Gazprom position as the main gas supplier is weakening in the short run and is very uncertain in the long run:

Kyiv Post:  As it sits on nearly one-fifth of the world's natural gas, Gazprom is and will remain an indispensable player in the gas market, particularly in Europe. But the shock waves from the economic crisis have contributed to create a perfect storm large enough to rock even the largest boats.

EU double standards

An issue of visas is very important in Ukrainian-EU relationships. As another evidence of double standards, Kyiv Posts reports:

The Parliament: EU castigated over Ukraine visa issue 

"...At present, Europeans wishing to visit Ukraine do not need a visa and Kiev eventually wants reciprocal visa-free facilities for its citizens travelling to the EU.

Speaking at a breakfast briefing in Brussels on Thursday, Kostiantyn Yelisyeiev stressed, "We are not asking for the immediate introduction of a visa-free regime because we realise we have to take certain measures.

"But what we are saying is that the EU should be doing much more to help facilitate this."

He singled out four member states – Germany, Belgium, Austria and the Netherlands – for particular criticism, saying they were obstructing the start of "serious" negotiations on the issue."

The state of the macro: new developments

Paul Krugman in his article has criticized the current macroeconomists for throwing out everything interesting from macro models by assuming away bubbles, irrationality, "animal spirit".  A recent conference "What's wrong with current macroeconomics" addressed some of Krugman's concerns. A couple of articles on www.voxeu.org popularize some of the research in that direction:

• "heuristic" economic agents (Top down versus bottom up macroeconomics by Paul de Grauwe) that do not quite understand how the economy works but by optimizing their behavior trying various simple rules
• incorporating politics, institutions, and ideology in their models (The roles of ideology, institutions, politics and economic knowledge in forecasting macroeconomic developments: Illustrations from the recent crisis by Alex Cukierman)

Industrial output in Ukraine is up, but down

There is a typical good news, bad news story:

Industrial output in October, 2009 is 5% up relative to September, 2009 but...

...It is 6.2% down relative to October, 2009

The most troublesome figure is that  the industrial output in January-October, 2009 is 26.4% down relative to the same period of 2008.

Manufacturing industries were hit the most -- 31.2% decline relative to January-October, 2008. Among manufacturing industries, car industry is the clear loser with drop by 63.2%.

New GDP number

Ukrstat reports a preliminary GDP of Ukraine for the Q3 2009:

GDP in Q3 2009 is 84.1% of GDP in Q3 2008


Such an awkward and indirect  statement (why did not they give us a number?) can be explained by the fact that the Chief Ukrainian Statisticians  do not want to upset the prime-minister.

is EU not welcomed anymore?

Current presidential elections are marked with low interest of population in the idea of EU integration. Ukrainians are just giving up on that due to more important domestic problems caused by  economic crisis. However, the EU politicians, if they ever were interested in integration of Ukraine into EU, are also responsible by sending confusing, often discouraging signals. In contrast, Russians have a very clear idea on what they want from Ukraine.

Global trade imbalances are back

This is what worries me about US  trade deficit is growing again:

The illusion of improving global imbalances, voxEU.org, Richard Baldwin and  Daria Taglioni

...projections of improving imbalances are almost surely wrong. The rapid collapse of trade between the third quarter of 2008 and the first quarter of 2009 improved most balances of trade. It could not have done otherwise; if both imports and exports drop rapidly, the gap between them drops equally rapidly. In the same mechanistic manner, the recovery of trade flows – a recovery that seems to have started this summer – will almost surely return the US, Germany, China and others to their old paths.

Zero import duties for chemical industry

Tymoshenko proposes zero import duties on equipment, raw materials for chemical enterprises. It is an example of a new view on industrial policy that was rarely used in Ukraine before: 

She said this at a meeting dedicated to Ukraine's chemical industry in Severodonetsk, Luhansk region, on Saturday. "I believe we need a zero import duty on component parts and raw materials for domestic [chemical] industry," Tymoshenko said. At the same time, Ukraine needs to learn how to protect the domestic while importing foreign chemical products, she said.

Demand for construction jobs is on the rise

Kyiv Post reports that companies are actively searching for construction workers:

The number of construction jobs registered on the professional recruitment portal rabota.ua in October totaled 66.6% of the general number of vacancies in the sector of construction and architecture, while a total of 27.4% of registered jobseekers have applied for construction jobs. 

Trade Deficit in U.S. Increases by Most Since 1999

I really do not understand how can it be a good news in the long run. It means that we are back into the situation that lead to the crisis. If the shock of 2008 could not make the US trade more balanced then the future adjustments will be huge and consequences for all countries very unclear.

Food and energy prices in 1960-2005

Kym Anderson writes about agricultural policy: "... it is not only high-income countries that are resisting committing to further reform, as many developing countries also want to retain their capacity to raise trade restrictions when prices spike. More than that, developing countries are seeking a Special Safeguard Mechanism that would allow them to set tariffs even higher than their ceiling bindings should food prices collapse or imports surge. This would only add to the volatility of international markets for agricultural products, as each country’s actions spill over to other countries and related products."


There is an interesting figure that shows energy prices are unusually high and food prices are unusually low right now:

Europeans demand Ukraine to have a fair election

Europeans really think that Ukraine owes them something. In a new article Tony Barber portrays Ukraine as an unstable, corrupt country that constantly irritates its neighbors. He further says the following: "...the key moment in EU-Ukrainian relations would be its January 17 presidential election. Anything less than a free and fair election, and a mature acceptance of the result by winners and losers alike, would be catastrophic for Ukraine's image in EU eyes."
One might wonder, do Europeans have a moral superiority to say something like that? What has the EU done in the last 5 years to improve its relationships with and help to develop Ukraine? The answer is it has done nothing. There were some talks, conferences, empty promises: all kind of things that the EU bureaucrats are good at. But die the EU made any effort in make the EU open for the movements of people, goods, and capital between the EU and Ukraine. Did the visa issuance improved? No, it got worse. Can Ukrainian farmers access the EU market? No, they can not. Do we have a free trade agreement? No we do not.
Ukraine is in deep political and economic trouble and needs some help from the international community, but all we have got so far from EU are empty words from their side and ungrounded demands. Sorry guys, if you do nothing to help, you have no rights to teach us.

Second wave of the financial crisis for Ukraine?

After the parliament and the president acted based on political considerations, it is the economy that suffers:

Reuters: Fitch cut Ukraine's credit rating on Thursday and said a delay in IMF funding coupled with a huge budget gap would lead to more instability.

Both Yushchenko and Yanukovich act according to a slogan: bad for the country -- good for  us. It is a strategy that brought Lenin to power in 1917, but he was not the one that really benefited from that -- Russia was ruined and could not restore for long time.

Flu mask externality

Kyiv Posts reports:


Two men wearing medical masks and carrying guns of a rare designon the morning of Nov. 11 robbed an outlet in Donetsk of the Finance and Credit bank, ranking among Ukrainian largest commercial banks, and an outlet of Pravex bank, ranking among Ukrainian large commercial banks, in some 30 minutes.

Three reasons why central banks keep assets

Nick Rowe, a professor of economics at Carleton University in Ottawa, Canada, about the reasons why central banks have assets:

Why do central banks have assets?

If you look at the balance sheet of a central bank, you will see it has liabilities (mostly currency) and assets (normally mostly government bonds/bills). Why do central banks have assets? Do they need them?

The wrong answer is that central banks need assets to "back" the value of the currency, and that paper currency would be worthless otherwise. The right answer is: since the government gets all the profits from a central bank anyway, there's no point in giving the government the assets; that owning assets lets the bank reverse course and reduce the money supply if it ever needs to; and it stops the accountants freaking out.

Let's deal with the wrong answer first. According to the "backing" theory of the value of money, the value of a central bank's currency is equal to and determined by the value of the central bank's assets backing the currency. (This is different from the fiscal theory of the price level, which says that the value of currency plus bonds is equal to and determined by the present value of primary fiscal surpluses.)

The backing theory sounds good. How can intrinsically worthless paper money have value? Because it is backed by valuable assets. It's just like shares in a mutual fund, which have value equal to and determined by the value of the assets in the fund.

Here are three arguments against the backing theory of money:

1. The assets of central banks are normally nearly all nominal assets, denominated in the same currency as the liabilities. Suppose the price level were to double magically overnight, and the real value of currency halved. The real value of the bonds held by the central bank would also halve. So a magical doubling of the price level would not violate the equality between the value of the currency and the value of the assets backing it. The backing theory leaves the price level indeterminate. It could only pin down the price level if the assets were real assets. If (say) 10% of the bank's assets were real (gold reserves, plus the building), then a 1% loss of its real assets (the building burns down) would cause a 10% jump in the price level.

2. Suppose a mutual fund held bonds, but all the interest on the bonds (minus the administrative expenses of running the fund) were handed over to some third party, and not to the owners of shares in the mutual fund. Who would want to own shares in that mutual fund? The net present value of the dividends paid to the shareholders would be zero, so the shares would be worth zero too. But this is exactly what central banks do. Every year central banks earn profits from the interest on the bonds they own, minus administrative expenses, and hand the whole of that profit to the government, not to the holders of currency.

3. We don't need "backing" to explain why money has value. People want to hold a stock of money because money is a medium of exchange, and holding a stock of the medium of exchange makes shopping easier. This creates a (stock) demand for money. Provided the central bank restricts the supply of money, the intersection of demand and supply curves creates a positive equilibrium value of money (a finite price level). Now you could argue that if paper money were worthless it could not function as a medium of exchange, so you need to assume paper money has value in order to explain the value it has, so the demand and supply theory of the value of money begs the question.

There is some truth in this criticism of standard theories of the value of money. There are indeed two equilibria: the normal one, where paper money has value, and a weird one, where it is worthless. But Ludwig von Mises, for example, addressed this problem in 1912 with his Regression Theory of Money. Historically, money needed to be commodity money, or have commodity backing, in order to get started. But once it does get started, as a social institution, the demand for a medium of exchange supplements the industrial demand for the commodity, and the commodity backing can eventually be withdrawn as custom keeps us out of the weird equilibrium. (When Cambodia reintroduced paper money, after the fall of the Kymer Rouge, it could not create paper money ex nihilo, but initially made it convertible into rice, IIRC.)

A Ponzi scheme is a financial institution with liabilities and no assets backing those liabilities. Paper money can operate just like a Ponzi scheme, but with one important difference. Mr Ponzi promised his clients high rates of interest and/or capital gains. They would not have held his liabilities unless they believed him. The Bank of Canada promises zero interest, zero nominal capital gains, and a minus 2% real rate of interest on people who hold its paper money. Mr Ponzi could not deliver on his promise, even if he hadn't spent the assets. The Bank of Canada can deliver on its promise, even if it gave away all its assets, provided the (real) demand for its paper money does not fall over time more quickly than 2% per year. (If the real demand for money were falling at 2% per year, a constant nominal supply of money would yield 2% annual inflation).

The Bank of Canada does not need assets, because the long run growth in the (real) demand for its paper exceeds the real interest rate at which people are willing to hold its paper. If Mr Ponzi could have met the same test, he wouldn't have needed assets either. People are willing to hold paper money, even at very negative real rates of return (Zimbabwe), because doing so makes shopping easier.

The only reason that the value of a central bank's liabilities are roughly equal to the value of its assets is that whenever the difference between them (its net worth) gets too big, the bank hands its profits over to the government. If central banks choose to keep assets equal in value to their liabilities, and only hand over their annual profits to the government, then saying the value of their assets determines the value of their liabilities gets causality reversed. It is the value of their liabilities that determines the value of their assets.

So why do central banks hold any assets at all? Three reasons (funny how 3 is a magic number):

1. It makes no difference to the owners of the central bank (the government) whether the central bank keeps the bonds and hands the interest over to the government each year, or whether the central bank gives the bonds to the government. The government gets the interest either way; it just passes through another pair of hands. It's a wash.

2. Normally the real demand for paper money grows at about 3% per year (roughly the same as GDP growth rate), but sometimes it rises faster than this (like last year), and sometimes it falls (like next year?). If the demand for money falls, the central bank needs to reduce the supply of money to prevent inflation, and it reduces the supply of money by selling assets. If it had given away all its assets it wouldn't be able to do this.

3. Accountants like double-entry bookkeeping and balance sheets and stuff so they can keep track of things. They like to record assets on one side, and liabilities on the other side, to make sure that everything adds up, to check that everything's been properly recorded. So they like to list currency as a liability of central banks (even though it isn't, because there's no promise to redeem it, or pay interest on it), and assets on the other side. An accountant would freak out if he recorded currency as a liability and couldn't find an equivalent value of assets. He would say that the central bank is a Ponzi scheme. Which of course it is. And it's just not worth the hassle of trying to explain to accountants that some Ponzi schemes are sustainable, really.

Gold as fiat commodity

An interesting article by Willem Buiter about gold as a fiat money. In the center of the argument lies a proposition that gold has no intrinsic value but it is costly to produce and hard to change its stock, therefore, during the time when paper money supply is rapidly increasing, price of gold can increase very rapidly, but there is always a possibility that the price can go to zero as well.

Gold - a six thousand year-old bubble

Gold is unlike any other commodity.  It is costly to extract from the earth and to refine to a reasonable degree of purity.  It is costly to store.  It has no remaining uses as a producer good - equivalent or superior alternatives exist for all its industrial uses.  It may have some value as a consumer good - somewhat surprisingly people like to attach it to their earlobes or nostrils and to hang it around their necks.  I have always considered it a rather vulgar metal, made for the Saturday Night Fever crowd, all shiny and in-your-face, as opposed to the much classier silver, but de gustibus… .

The total stock of ‘above-ground’ gold is about 160,000 metric tonnes (a metric ton is 2,204 lbs. or 35,264 oz, for those of a non-decimal mind-set).  About 50 percent of this existing stock of above-ground gold is kept as a pure a store of value (for investment purposes), most likely somewhere below-ground, for security reasons. The other 50 percent exists as jewellery.  I would argue that most of this jewellery demand is simply small-scale store of value (investment) demand by households, rather than demand driven by aesthetic considerations or other intrinsic sources of joy associated with having gold hanging from your extremities.

From a social perspective, gold held by central banks as part of their foreign exchange reserves is a barbarous relic (Keynes used the expression to refer to the Gold Standard, but close enough is close enough).  The same holds for gold held idle in private vaults as a store of value.  The cost and waste involved in getting the gold out of the ground only to but it back under ground in secure vaults is considerable.  

How about creative destruction?

Apparently, crisis has little impact on Ukraine through the mechanism of creative distruction.
Between 1 October, 2008 and 1 October, 2009, number of registered enterprises and organizations has increased by 25 thousands: from 1,223 thousands to 1,248 thousands. The largest gains are observed in business services (10 thousand new enterprises and organizations). All sorts of services, retail, repair and maintenance, culture and sports also get an increase. At the same time, number of enterprises and organizations in agriculture and financial sectors declined by 900 and 411 respectively. Despite decline in financial sector, the decline came from closing down 764 branches of banks and not from bankruptcies of the banks.

In term of the legal status, number of labor unions and NGOs has increased by 6.7 thousands. The number of political parties has increased by 714 and now stands at 17204.

Budget deficit in 2009 can exceed 40 bln hryvna

Korrespondent reports that the budget revenue may fall 40 bln short of what has been planned. However, the real picture can not be known until the next year when the annual data becomes available. Traditionally, the budget revenue are much higher during  the last months of the year relative to the monthly average. Also, it is not clear how the government treat the IMF loan: surely, it has not been planned as a part of the government budget revenue but if the government include the borrowed money it can paint  rosier picture just before the presidential election.

According to the  law on state budget, the revenue of the budget are planned at 238 bln hryvna. The budget deficit is planned at 30 bln hryvna.

Money supply during crisis

At the peak of the crisis, in November of 2008, Ukrainians run for cash which rapidly increased currency to deposit  ratio (cr). The changing composition of broad money was responsible for drop in the money multiplier, m. At the same time, reserve-to-deposit ration remained relatively stable.

Interestingly, looking at broader definition of money (M2) which include foreign currency denominated checking deposits and all sorts of saving deposits shows much smoother picture:

My guess is that if we exclude dollar and euro denominated deposits, the second figure will be similar to the first figure. During the financial panic of Fall, 2008 people saw the local currency, hryvna, unstable and run to the banks to withdraw hryvnas and exchange them for dollars and euro.

Ukraine is the IMF's headache

 Mr Strauss-Kahn said “the big problem for me is Ukraine” when answering the question about Eastern Europe in his interview to FT.


Bloomberg reports: Ukraine has failed to comply with the loan’s terms, including raising natural gas prices for households and adopting laws needed to stabilize the financial system. At the same time, Ukraine’s parliament approved a law on Oct. 20 increasing social payments, including the minimum wage, in an effort to win voter support ahead of Jan. 17 general elections.