ED - In the last week popular protests have rallied against Ukraine’s powerful Interior Minister Arsen Avakov. One of the longest serving ministers in the Zelenskiy administration, he has ties to oligarch Ihor Kolomoisky and worked for the Poroshenko administration, but he is widely seen as building his own powerbase and operating independently. Now he has nailed his flag to Zelenskiy mast, who has come to rely on him to run the police and security services as the president is now clearly shoring up his hold on power. Calls are growing for his dismissal, but at least 150 deputies have to subscribe to a motion in the Rada to discuss his dismissal and that is unlikely to happen. Below is a note from Robert Homans, an American investor and political commentator.

 

Arsen Avakov has been Ukraine’s Interior Minister for six and half years, under three Presidents including Interim President Turchynov, who served for three and half months, between the time of Yanukovich’s departure and Poroshenko’s election as President.

As Interior Minister, Avakov controls the National Police, regional and city police departments, the National Guard, the Border Guard, and the State Migration Service. For Americans, imagine if the Attorney General of the United States controls the FBI, which he/she already controls, plus local police departments, the state national guards, and immigration & customs enforcement, and one can begin to imagine the power that Avakov has at his disposal. This amount of power, residing in one person for as long as it has, over six years, makes Avakov, along with the agencies he controls as Interior Minister, a “State Within a State.”

Along with the Presidential Administration, and Avakov’s Interior Ministry, I would argue that there are 3 other “States Within States” in Ukraine, where each operates with relative autonomy:

• The State Fiscal Service, consisting of tax and customs, through which flows much of Ukraine’s national income;
• The General Prosecutor who controls the judicial system;
• The big industrial combines, some of it State-owned that, together, control over 50% of Ukraine’s GDP, led by Ukraine’s State-owned gas company, Naftogaz, and others.

The five States Within States operate relatively independently of the country itself, with almost complete authority over their respective purviews, and with independent sources of financial support, much of it through collecting of rents, otherwise called graft.

Recently, there have been increasing calls for Avakov’s removal. There was an assault and rape of a woman by police, done inside a police station, in a city south of Kyiv. Just last week, in the town of Brovary just northeast of Kyiv, there was a shootout between two rival criminal gangs, over control of the marshutka service (minibuses that form a key part of Ukraine’s system of public transport. This has led people to ask, “in the six and half years Avakov has been Interior Minister, what has he done to reform the agencies under his control?” The answer is “not much” But does it really matter?

Even if Avakov leaves or is forced out will the underlying system, consisting of the States Within States as I’ve described, really change? Unless forced to do so, Avakov’s successor will likely be unwilling to give up the control that Avakov enjoys today. In addition, many of the efforts to weaken foundations of one, or more, of the States Within States, have foundered. Reformist Heads of Customs, Civil Service, General Prosecutor Service and the Health Minister have all been removed. All of these agencies were substantial sources of graft, which these reformers were trying to eliminate.

There are some encouraging signs:

• UkrBoronProm – The State-owned defense manufacturer may, under the leadership of Aivaras Abromavičius, is bringing in strong management, accounting system, and may in the process of breaking up the company. Abromavičius strongly supported Zelenskyy during his Presidential Campaign, and may be relatively immune from removal.
• Privatizations - UkrBoronProm may lead to increased privatization of the big State-owned industries. Even today, several State-owned industries operate under the supervision of international advisory boards, improving their corporate governance and transparency that has, in themselves, been a major source of graft.
• ProZorro - Now that Privat Bank is safely in the hands of the National Bank of Ukraine and will unlikely be returned to Kolomoisky, ProZorro, Ukraine’s on-line public procurement system, becomes a red line for Ukraine’s Western financial backers. Any decision by the Government to weaken ProZorro, will in turn weaken the support Ukraine has from its Western supporters.
• Banking System - The banking system, thanks largely to NBU, seems to be strong and getting stronger. Hopefully, they will become a source of financing for Ukraine’s private businesses, but only if there are stronger creditor and property rights.
• Decentralization - The new system of local governments, where cities and consolidated villages, called “hromadas,” have attained more significance and budgetary power, now retaining 100% of local property tax revenue and 60% of income tax revenue. Among other things, increased control of funds at the local level should allow voters to demand more accountability from their elected leaders, mayors and members of city councils. The first local elections under this new system will take place this coming October. In addition to demanding accountability from mayors and local councils, voters may well demand more accountability from the Presidential Administration, Cabinet of Ministers and Parliament in Kyiv.

Breaking up the power of the States within States can be done. The question is whether or not there is the will to do so.

 

Business Opportunities & Risks 

• Opportunity - I read somewhere that Ukraine can possibly become a place where companies intent of moving facilities out of China, with some of the some of the advantages China now possesses, including an educated workforce, attractive wages and cheap land costs. European companies have already developed a significant supply chain in Ukraine, including in auto parts, some machinery and electronics.
• Risk – Ukraine has not succeeded in attracting much foreign direct investment. Currently, one of the largest sectors attracting foreign investment is renewable energy, wind, solar and biomass, attracted to Ukraine’s “green tariffs,” where the major beneficiaries include oligarchs who control the generation and distribution of electricity. If Ukraine is going to attract investments by companies moving their operations out of China, Ukraine will have to improve property rights and the integrity of its judicial system.

 

• Opportunity – In spite of Economy Minister’s Petrashko’s statements to the contrary, Ukraine’s banking system is becoming more profitable, as shown in this report from the Kyiv Post. Much of the profitability is from consumer loans extended at high rates. The National Bank of Ukraine has reduced its discount rate to 8%, which will hopefully result in increased business lending. However, for this to happen Ukraine will have to improve its creditor and property rights, without which banks won’t lend to businesses. Based on the interviews that I’ve read or seen, I don’t believe Minister Petrashko has a strong understanding of the significance of property rights, as they relate to extensions of business credit. However, some people whose opinions I value, speak highly of Petrashko. We’ll see.
• Risk - According to this report from the European Business Association, private Ukrainian companies have taken a major hit from Covid-19. One unfortunate result may be Ukraine’s economy becoming more concentrated, on business combines controlled by oligarchs and state-owned industries. I’m concerned about the level of Government support that independent businesses can expect, given the current leadership at the Ministry of Economy.

 

• Opportunity – The IMF is about to release the proceeds of a $5bn Standby Loan to Ukraine. This will also result in the release of additional funds, from both the EU and the US, and improved access to international capital markets.
• Risk – Ukraine is facing the prospect of rolling over approximately $17bn of maturing sovereign debt in 2021 and the balance of 2020, plus the prospect of paying off maturing GDP warrants, attached to the sovereign debt that was re-negotiated in 2015, that are triggered based on Ukraine’s GDP growth.

 

• Opportunity – China has now become Ukraine’s largest trading partner, with $1.93bn of imports in the first quarter of 2019, consisting primarily of machinery, plastics and vehicles. Exports primarily consist of agricultural commodities.
• Risk – Balance of trade is largely in China’s favor.