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How can Ukrainian SME grow into national and global champions?

Small and medium companies are the backbone of any national economy. An economy with a high share of strong SMEs enjoys several benefits, such as inclusive and sustainable growth and economic growth based on knowledge and innovation. SMEs are also more flexible and community-embedded.

In Germany, the development of a strong SME sector (known as the Mittelstand) leads to the appearance of ‘hidden champions’, which contribute to the economic success of the country.

In this paper, we study the key internal factors of resource management in Mittelstand companies and the policy measures that contributed to the success of the German SME sector, as well as the applicability of the German experience to the Ukrainian SME sector.

Our paper is based on desk research, previous research projects of the Institute of Economic Research (Kyiv), field visits to German SMEs and policymaking bodies, and in-depth interviews with Ukrainian and German policymakers and business.

As for Ukraine, there are general factors that need to be taken into consideration when developing strategic policy measures for SMEs, including low levels of trust and a relatively weak rule of law, and political and economic instability. These long-term circumstances have a strong impact on both public governance and business management.

To formulate policy recommendations for Ukrainian SME policy, we analysed the development of a business from being run by an individual entrepreneur to becoming an international champion.  First, we compared absolute and relative numbers of population and businesses for the latest available years for both countries. The relative rate of operating businesses to 1,000 population at a certain moment of time shows both the willingness and the ability to run a business or to be an entrepreneur. Then we analysed the reasons why more businesses succeed and/or grow in Germany than in Ukraine at each level.

While the structure of small and medium enterprises and individual entrepreneurs in Ukraine is similar to that of Germany, the Ukrainian SME sector lacks capabilities and productivity that might lead it to become successful at a national or international level. Particularly, Ukraine substantially lags behind in the number of small and medium companies that are successful in international markets. Therefore, after conducting a comparative analysis of the German and Ukrainian SME sector at each size and market level, we suggest policy measures to increase the share of businesses that are able and willing to develop to the upper level, up to becoming exporters.

Below we summarize our recommendations for policy interventions at each stage of business development.

For prospective and new entrepreneurs:

  • Development of a sustainable policy framework by the Ministry of Education and Science and the Ministry of Economic Development and Trade to revitalize the existing innovation and science parks at universities and create new ones.
  • Giving reformed university clusters the necessary level of autonomy and freedom to engage with possible stakeholders.
  • Funding the introduction of dedicated cluster management and part-time involvement of academics.
  • Funding advisory support for clusters.
  • Support for clusters based on the principles of co-funding, sustainability, objective-based performance, and realistic goals.
  • Boosting the ideas of innovative and competitive start-ups among students by encouraging businesses to intervene into the study process, especially in technical fields.
  • Implementing programs encouraging Ukrainian labour migrants and other vulnerable population groups to launch their own businesses.

For business entity creation:

  • Unification of the taxation system framework, simplifying the transition from being a micro- to a small enterprise, including the change of legal form.
  • Microgrants and microloans should be distributed by local authorities and Ukrainian banks in cooperation with international financial institutions in order to minimize the risk of inappropriate funding allocation.
  • Combining lending with consulting or mentoring programmes to mitigate the risks of not returning loans.
  • Innovation support centres for SMEs could be established in Ukrainian regions by the ministerial SME development office, in cooperation with the World Intellectual Property Organisation and local stakeholders and using the best practices of the German Mittelstand Agency 4.0. The focus should be on less economically developed regions or settlement types.

For growing to the national level and expanding the market:

  • Enhancing cooperation and networking possibilities for SMEs (business associations, work councils, technology parks, etc.) for exploring new business opportunities, giving them not only consultancy but also a co-determination power in the policymaking process.
  • Boosting digital infrastructure usage and providing better digital infrastructure outside of big cities.
  • Compensating for personnel scarcity and skills mismatches, e.g. introducing joint vocational training schemes with technical universities with the support of business associations.
  • Sharing information on best practices of business support mechanisms at local and regional levels in order to make better use of the powers and financial resources granted to local authorities as part of decentralisation.

For foreign market entry:

  • Encouraging a company to develop its own brand rather than become an outsourcing unit when entering external markets.
  • Encouraging expansion abroad via establishing subsidiaries while retaining headquarters, R&D, and production in Ukraine.
  • Further foreign currency liberalisation measures to ease export operations.
  • Securing the constant supply of labour force and managers with a migration background and foreign language skills by encouraging short-term educational and labour mobility.

Developing a competitive SME sector based on the Mittelstand role model could help Ukraine solve economic and social problems, such as monopolisation, unemployment, and the underdevelopment of certain regions. This would pave the way for more inclusive and sustainable economic growth in the country.

25 September 2019
Ukraine’s Budget Schedules Growth in 2020

First of all, what are your thoughts on this draft law?

I think that the draft law on state budget shows some figures, which, I would say, are related to a moderate increase of the budget revenues and expenditures. On the one hand, it isn’t an expansionary budget, on the other hand — it’s good because it will allow keeping macroeconomic stability, it will allow keeping low inflation and will reduce risks. Because, on the one hand, we can increase the budget to stimulate economic growth, but, on the other hand, whenever we increase the budget, it also raises the corruption risks. So, in my opinion, we should rather create opportunities for private investment growth, which will fuel the growth of GDP rather than trying to boost economic growth via increasing the budget. And in this case, moderate budget increase is good for the economy.

The Ministry of Finance expects GDP growth of 3.3%, but at the same time, Prime Minister Honcharuk was talking about 7%. Why, do think, the figures differ, were the ongoing reforms calculated in both forecasts?

Basically, there are approaches and goals of forecasting the GDP growth by the Ministry of Finance, for example, and by the Prime Minister or Minister of Economy. The Ministry of Finance should be more conservative, because it bases its forecast of tax revenues, for example, based on GDP growth. If it overestimates the GDP growth, and the actual growth will be lower than we have a risk of not enough taxes collected. So, in this case, for the purposes of budget planning, I would agree that a conservative estimate is ok. But, of course, for the purpose of economic planning, of government program planning we should set more ambitious goals, like 5% to 7%.

But what figure is more realistic, 3.3% or 5% to 7%?

I think that 3.3% is achievable by just doing nothing. The state doesn’t need to do anything specific, but we can achieve this goal. Why? Because we have the achieved macroeconomic stability, and we also have some new businesses coming, and we have some good signs in the economy for that. But again if you want to drastically increase the economic growth, we should think of some extraordinary measures, which, as I know, are being considered now by Ministry of Economy and Agriculture, as it is called now because they are really thinking in what ways they can boost the economic growth.

According to the 2020 draft budget, the deficit is estimated to be around 2% of GDP. How would you compare the deficit with the last year, I think it was around the same figure?

Yes, this is relatively the same. Besides, the Minister of Finance, Oksana Markarova, claimed that the overall or long term goal for the Ministry of Finance is to decrease the size of budget deficit relative to the budget size and relative to the GDP. So, basically, we don’t expect anything unusual, except for the fact that we hope that, finally, we will renew the cooperation with the International Monetary Fund, and we’ll get funds from this organization. Usually, these loans are cheaper than borrowing from private borrowers. And also, these loans usually open the door for other opportunities, like loans or grants from other international financial institutions, like EBRD, World Bank, etc. They are all watching the cooperation with the country and the status of cooperation of the country with the IMF, and if the cooperation continues, then we have higher chances and lower interest rates for other loans.

You said that the deficit is about the same as in the previous year, but at the same time, the draft budget allocates more money on healthcare. It’s about $400 million, more on defense, because this is the priority, of course, education, social policies that take 10% of the budget, pensions — $7 billion will be allocated, if adopted, for pension payments, and pensions might be increased by 8%, minimum wage might be also increased. So, we see that expenditures rise, the deficit stays the same. This forms the question: where is Ukraine planning to get this much income, or is Ukraine planning on increasing an international debt?

I think the main aspiration of the Ministry of Finance is as the economy grows, you will increase the tax revenues. Basically, how they can increase them there are two ways. For example, if the revenues of the certain company increase, then they will have higher taxes on these revenues. I mean, the tax rate is the same, because the revenues basically increase, then you have higher tax revenues from the companies. This is one scenario. But when actually the tax rates are not changed, but you to grow revenue, incomes, we will have higher tax revenues into the budget. The other scenario is also trying to decrease the shadow part of the economy. And in this respect Parliament is passing a new laws to avoiding these schemes, for example, using too much cash within the trade. So, basically there are plans to reform the retail trade to decrease the number of shadow operations. If there is a success, it will be also additional revenue from taxes.

Plus, as far as we heard from the media, from different experts, privatization reform and land reform could also benefit and provide lots of revenues to the state budget. And if I am not mistaken, according to the World Bank, the opening of the land market would benefit into $15 billion dollars annually. What do you think of that figure? And what do you think about the opening of the land market? Because as far as we see, Zelenskyi is a big supporter of this idea and he even ordered his government to prepare the legislation and submitted to the Verkhovna Rada, but there has been a lot of discussion on this reform, there has been a lot of controversy whether it should be restricted somehow or nor, because the main idea is that foreigners and wealthy people might get a total control over Ukrainian agricultural land and buy all — even though considered impossible — all the 43 thousand hectares of Ukrainian land. What are your thoughts on this reform and whether they should be restricted or not anyhow?

The idea of this reform is not about, at least, at current framework, not about increasing immediately budget revenues, because there is not plan to immediately sale all the ten million hectares that belong to state, because they would be rather transferred to local authorities. Ten million hectares belong to state now and about 28 million hectares belong to private people, who are not also able to sale this land. Basically, moratorium it covers both state-owned land and privately owned agricultural land. So, when the market starts, it covers both state-owned land and privately-held land. And for the state-owned land, at least, currently politicians say that there is no plan to sale it massively. Of course, some of the state-owned lands should be sold which is not used by the state, but the overall idea is that it would be transferred to local authorities. This is a part of the decentralization reform when local authorities would be given additional resources. But land reform would stimulate investments. Why it would stimulate investment? Because currently most of those farmers or companies who process the land usually lease the land, but now own the land. The idea is that, at least, at some cases when the state or private owners are ready to sell the land, they can sell the land to those companies and farmers. And when the farmer becomes an owner of the land, his business planning horizon increases substantially. For example, if you want to grow a garden, you need ten-fifteen years for that, but if you just lease the land you are not sure if you can lease this land in 5 or 10 years. If you can buy the land, then you are sure that you are the owner of this land in ten years, and then you can invest. So, the main idea behind the opening of the land reform, on the one hand, it allows those people who own the land to sale it, if you want. On the other hand, it allows the farmers of the agricultural producers to become owners, buying this land and then increase the business planning horizon, which will increase the probability for the investment. And these investments will have a further impact on economic growth or GDP growth.

Another interesting aspect to discuss. Andrii Radchenko, the chairman of the state-owned Agrarian Fund, told to Radio Free Liberty that Russia was using scare tactics to convince Ukrainians that rich foreigners would gobble up all their farmland that is what I’ve mentioned in the previous question. This is probably the main argument and the main fear spread by Zelenskyi’s opponents. Do you think this fear has enough ground to somehow impact and subsequently forecast some bad outcomes from the land reform?

I would start probably from setting the scenario. Of course, we really think about some limitations but rather we should think not about limitations but why we want these limitations. The reasons are that we want level playing field or equal opportunities for both smaller farmers and big agro holdings to buy the land. And in this case, the correct solution would be not to limit someone but to provide opportunities. For example, if we believe that smaller farmers do not have money to buy the land after the market opening is launched, then we should offer them some loans and indeed this program is already being discussed. What the Prime Minister has already mentioned and also other politicians that they will be at least 4.4 bln hryvnias in the budget for the next year which can be distributed as loans for the farmers, for small farmers to buy the land. And the interest rate can be, for example, 5 percent per annum in hryvnia which I would say quite low and affordable. So, in this case, we should rather not limit somebody but create equal opportunities and loans with the aim to create equal opportunities for small farmers. Another limitation is being considered as a limitation on concentration.  So, basically, we don’t want anyone to buy all the Ukrainian land. Despite the fact that it is impossible it’s really a huge amount of money which none of the oligarchs has and even foreigners cannot afford to do so. But, in any case, if we think that concentration is not good for the economy, we should set some limits and it is now being discussed, for example, to set a limit of 0.5 percent for the total land in Ukraine. But also to set some certain limits of ownership in one hands in for example oblast (regional) level or even raion (district) level. In this case, I think these limitations are possible and they can be justified. So, basically, returning to your question, on the one hand, we should not rather limit but create equal opportunities, on the other hand, for the concentration, yes, we can have limits and they are being discussed. And as for the foreigners, basically, at least now, we told that physical persons, foreigners would not be allowed to purchase Ukrainian land according to the new draft law. But again we should wait for this law to be published. Hopefully, it will be published in October and we can discuss it in more detail.

Every government has been launching this privatization reform and Ukraine was trying to sell some big state-owned enterprises and get some output from there but every government has been failing so far. Why do you think this year the new government can actually succeed?

At least I see a new Minister of Economy who doesn’t have any vested interest in State-Owned Enterprises, to my best knowledge, and then there is a proposal for Putin and new top-manager for State Property Fund which also seems to be an independent candidate. If we don’t have vested interest among politicians, then I think the privatization process can speed up because this opposition can be blocked and finally we can start not only small-scale but large-scale privatization as well.

Let’s see what will be the finalized version of the budget-2020 after November, 2 expectedly. 

23 September 2019
Principles of reforms in Ukraine: a vision of civil society

“Toronto principles” — is the vision document that describes key Ukraine reform priorities for 2019-2013 and that was developed by a group of civil society experts coordinated by the Reanimation Package of Reforms Coalition between December 2018 and June 2019 through a series of regional and national consultations in Ukraine. Additionally, over 100 sectoral experts provided their input. It consolidates the perspectives of over 90 Ukrainian reform-minded civil society organizations (CSOs) on their aspirations for the future of Ukraine. It is anticipated that this platform will enable continued CSO dialogue and joint collaboration on implementing democratic reforms in Ukraine.

The policy brief on economic development of the Toronto principles was prepared by Hlib Vyshlinsky, Executive Director of the Centre for Economic Strategy, member of the Coalition Board, the Reanimation Package of Reforms, co-authored with Dmitry Livch, head of the analytical department, project manager of EasyBusiness. Anna Derevyanko, Executive Director of the European Business Association (EBA), has been invited to peer review the economic development brief.

According to the document, the growth of investments is a key task and a mechanism for promoting Ukraine’s economic development. An important prerequisite here is to preserve macroeconomic stability, which is impossible without a responsible fiscal and politically independent monetary policy. Is expected that the following reforms could give a nudge to investment-based economic growth:

  • Open agricultural land market – the adoption of a law regulating the sale of agricultural land and thus lifting the moratorium.
  • Privatization of all large state-owned enterprises which are allowed to be sold in particular, state-owned banks, and a significant reduction of the list of state-owned enterprises which are prohibited for privatization. Independent supervisory boards should be established at all large state-owned enterprises. Parliament should adopt a new law on empowerment and increase the political independence of supervisory boards.
  • Simplification and optimization of customs procedures, establishment of the institute of the authorized economic operator. This will make Ukrainian companies more competitive in global value chains.
  • Reform of the fiscal service and establishment of financial intelligence service which will replace the tax police and numerous crime fighting units in law enforcement agencies. The goal is to create a tax and customs service that is friendly and transparent, as well as financial intelligence service that will apply analysis rather than force. Employees of these new services need to be employed after a complete integrity check. It is necessary to establish competitive salaries for them by introducing personal responsibility, and reduce their number through processes automation.
  • Liberalization of capital movement and regulation of foreign exchange transactions. New law on currency transactions was adopted in 2018, it gave the National Bank the freedom to regulate them by its decisions. This freedom should be used to make Ukraine more open to capital movements and trade in line with EU practice.

Implementation of these reforms will make Ukraine more attractive both for foreign and for domestic investments, and will also contribute to the growth of the economy by 5-7% annually over a long period of time. In addition, it will make the Ukrainian economy more resistant to crises. Together, these steps will help bring Ukraine’s welfare closer to the level of the new EU member states.

3 July 2019
Banking fragility rooted in justice failures

This paper investigates the links between the rule of law and sustainable economic growth, focusing on a specific aspect – namely how corruption and lack of the rule of law affect the functioning of the banking sector.

It draws on the experience of Ukraine amid the crises in the banking sector (which is most of the financial sector). The burst of a bubble in the banking sector after the 2008–09 crisis was never followed by a robust recovery, and the 2014–15 crisis1 deepened the problem. It highlighted serious dysfunctions in the justice system, with issues of corruption and political interference. Much of the banking system’s fragility and poor credit utilisation could be explained by a lack of the rule of law on different levels. When the losses materialised, flaws in the rule of law impeded a response and resulted in a massive burden falling on the state and on the economy at large.

At the same time, reforms to the rule of law and the financial sector are going along separate tracks – being implemented by different teams that contact each other randomly at best. If these efforts are combined, a strong synergistic effect might be achieved.

This paper recommends a cross-sectoral policy angle for EU–Ukraine cooperation towards financial and justice sector reforms. It suggests six steps that might be taken at the crossroads:

  1. launch a special forensic bureau for financial crime;
  2. create a database for insolvency and financial fraud cases to support court expertise;
  3. streamline insolvency law and regulations;
  4. empower the independent regulator;
  5. improve the know your client and anti-money laundering procedures of EU banks internally; and
  6. support reform of the state-owned banks.

This paper has been prepared as part of the ENGAGE II Fellowship Programme, with support by the Open Society Initiative for Europe (OSIFE). This publication has been written under the supervision of Cinzia Alcidi, Head of the Economic Policy Unit by Maria Repko who is Deputy Director at the Centre for Economic Strategy, Kiev.

12 June 2019