Economic risks of the introduction of the martial law in Ukraine

In the time of Ukraine’s independence, the martial law has never been introduced, therefore it is difficult to estimate its economic consequences. Not surprisingly, the introduction of the martial law in Ukraine has caused mass discussions both among the public and in expert circles. As of today, it can be noted that some of the risks have been overestimated – in particular, the risks of cooperation with the IMF and the sharp drop in hryvnia exchange rates. However, the situation may change in case of an escalation of the conflict. The underrated risk is the situation in the budget sector. In case of introduction of the martial law, the budget loses its significance in favor of rapid procedures and fewer parties are involved in the decision-making process.

 

Cooperation with international organizations. One of the main concerns was the threat that Ukraine may not receeve the long-awaited tranche from the IMF. Such a statement was actively circulated in media and social networks. The IMF Resident Representative Office reported that the Fund has an experience of cooperation with the countries where the state of war was declared. It is not the first time when the probability of introducing the martial law in Ukraine has been discussed. In autumn of 2014, the then IMF Resident Representative in Ukraine Jerome Vacher said that the IMF has no formal legal prohibitions that prevent from continuing cooperation in such conditions. As an international practice shows, the IMF lent to Croatia, where the war lasted from 1991 to 1995. In addition, the possible tranche of the IMF within the standby program should be aimed exclusively at replenishing gold and foreign exchange reserves. Therefore, direct financing of military expenditures at the expense of the tranche, which may be a direct obstacle to its allocation, will not happen.

Much larger obstacle to receive the tranche was the problems with the fulfillment of the conditions of the IMF. Ukraine still managed to adopt a timely budget for 2019. As a result, the IMF Board of Directors plans to consider a new program of cooperation with Ukraine at its meeting after December 10, 2018.

Hryvnia exchange rate It was expected that the hryvnia exchange rate could be negatively affected by panic among the population and in the business environment. Actually, the hryvnia rate has fallen, but not for a long time. The NBU’s deliberate actions managed to stop panic in the market in a few days. Therefore, these developments largely depend on the actions of the NBU and state authorities. An important aspect is to conduct competent communication with the market and the population, and announce a plan of action that will help avoid panic.

The NBU can use gold and foreign exchange reserves to stabilize the situation, but their significant decline (moreover, it may further affect the international ratings of Ukraine). In November 2018, Ukraine’s gold and foreign currency reserves increased by USD 975 million and reached USD 17.7 billion.

The situation in the banking sector. The Head of the National Bank of Ukraine Yakiv Smoliy promptly stated that in case the martial law is introduced, the work of the banking system in Ukraine will not be violated. However, panic in society can cause mass withdrawal of deposits, which may cause a crisis in the banking sector. Therefore, in case of a full-scale conflict, the NBU will have to impose restrictions on outflow of capital abroad in order to prevent panic.

External borrowing. In 2019, Ukraine will have to pay over USD 5 billion to repay and service external debt. One of the sources of covering the expected costs is external borrowing. In 2018, Ukraine has quite successfully attracted funds on foreign markets through the sale of Eurobonds. Given the introduction of the martial law, attracting funds on foreign markets through the mechanism of Eurobonds will be more problematic.

Foreign investments. There is a threat that an inflow of foreign direct investment in 2019 may be suspended. The situation in Ukraine will scare off international investors and they will be forced to freeze or suspend the implementation of investment projects in areas where the martial law is introduced. In case of escalation of the conflict, an outflow of investment can be rather expected.

Export-import operations. The introduction of the martial law may negatively effect on the external economic situation. The formal introduction of the martial law can lead to suspension of contracts or worsening conditions for Ukrainian exporters and importers. First of all, it concerns the respective regions. This can have a negative effect on the inflow of currency to Ukraine, which will become an additional factor of pressure on the hryvnia.

Strengthening migration trends. It is possible that this situation will affect citizens’ decision on migration to other countries. In this case, there will be an outflow of labor, which may negatively effect on both the rates of economic growth and the amount of deductions to the budget and the Pension Fund.

Management of the state budget at manual mode. Ukrainian fiscal legislation provides for a number of direct actions which are applied in case the martial law is introduced:

The reserve fund is increasing and unlimited in volumes. At present, the Reserve Fund cannot exceed 1% of the general fund expenditures of the relevant budget. In addition, the volume of the Reserve Fund will be determined by the Cabinet of Ministers in agreement with the Supreme Commander-in-Chief of the Armed Forces of Ukraine. Social priorities are inferior to the military. Now wages, debt servicing, social payments are primarily financed, and even if the budget is not enough, teachers receive salaries, and people receive subsidies. With the introduction of the martial law, the priority of expenditures may be different. Even more, the Cabinet of Ministers in consultation with the Commander-in-Chief may change the size of state social standards and guarantees.

Taxes can change frequently and unexpectedly. At present, changes in legislation which reduce revenues or increase costs were taken no later than July 25, 2017 and will be implemented not earlier than the start of the planned budget period.

The significance of the budget law offset frequent and unplanned changes. The influence of the Verkhovna Rada on the budget is decreasing, and the possibilities of manual control and centralization are increasing. In particular:

  • Budget text and its indicators may not change over the years;
  • In case of overfulfillment/deficiency of the budget by more than 15%, the government should make changes to the budget. In case of the martial law, this norm is not required.
  • The funds between the regions are redistributed, taking into account military priorities. Now the redistribution of the state budget expenditures to centralized measures between administrative-territorial units is carried out by the decision of the Cabinet of Ministers, agreed with the Budget Committee.

Introduction of military administrations will lead to greater centralization. Military administrations will approve rayon and oblast budgets, approve reports on their implementation, distribute dotation and subventions; may set new tax rates and introduce incentives to pay local taxes and fees.

Legislation also contains other rules which may have an indirect effect on the budget. In particular, this concerns the risks of:

Reduction of sources to pump up the budget. Military solutions will be directed not to support the economy, but defense.

Growth of the expenditure pattern of the budget. In addition to a possible increase in defense expenditures, the expenditure pattern of the budget may have an upward effect:

  • Compensation for damage incurred during the introduction of the martial law;
  • Funding of additional functions. Military administrations may need to ensure law enforcement, which have additional powers of the security forces. This also applies to the organization of evacuation of the population, providing, if necessary, with water, medicines, food, strengthening the control of documentary evidence of persons etc.