As requested by BMC Software, Inc., this report discusses the business risk environment in Ukraine, focused on the country’s political stability, economy (including regulatory environment), labor environment, and security environment as it relates to the software, non-manufacturing sector where possible. STRATFOR has also provided a forecast of whether any major shifts in the country’s current conditions can be expected within the next three-year period.
INTRODUCTION TO UKRAINE
Outside of Russia, Ukraine is the most important and strategic former Soviet state. Physically Ukraine is the largest country in Europe, lying east of the European Union. Ukraine borders seven countries and caps the north of the Black Sea. Ukraine has historically been Slavic, even as it was integrated and divided into various empires throughout the centuries. Divided between 78 percent Ukrainian and 17 percent Russian, nearly a third of Ukraine’s population considers Russian as their first language, though nearly all Ukrainians speak Russian as their second.
Since the 19th century, Ukraine has been part of the Russian Empire, then the Soviet Union before gaining independence in 1991. Because of this it is nearly impossible to talk about Ukraine without discussing Russia. Ukraine is the cornerstone to Russia’s defense and survival as any sort of power. The former Soviet state hosts the largest Russian community in the world outside of Russia--approximately 15 million, which reside in a zone geographically identical and continuous to Russia itself. Ukraine has traditionally been the Russian and Soviet’s breadbasket, and is tightly integrated to Russia’s industrial heartland. It is the location of nearly all of Russia’s infrastructure links not only to Europe, but also to the Caucasus, making it critical for both trade and internal coherence. The most important piece of this infrastructure is that Ukraine transits 80 percent of Russia’s natural gas headed for Europe. Russia also houses its strategic Black Sea Naval Fleet in Ukraine, not Russia.
Ukraine gives Russia the ability to project political, military and economic power into Eastern Europe, the Caucasus and the Black Sea. Ukrainian territory also pushes deep into Russia’s sphere, with only a mere 300 miles from Ukraine to either Volgograd or Moscow. To put it simply, without Ukraine, Russia would have fewer ways to become a regional power and would have trouble maintaining stability within itself. Moreover, so many in Ukraine consider their ties to Russia as not only protection, but inevitable.
POLITICAL STABILITY
This deep connection to Russia is why Ukraine’s pro-Western 2004 Orange Revolution was a nightmare for Russia and half of Ukrainians. The change in government in Kiev during the revolution brought a president, Victor Yushchenko, who was hostile to Russian interests and with him a slew of possibilities that would harm Russia, including Ukraine’s integration into the European Union or even NATO. The Orange Revolution also deepened the divide within the country. Ukraine’s population is divided between those that look east towards Russia and those that look west to the EU. The divide nearly runs perfectly down the Dnieper River, meaning half of Kiev and the eastern and southern parts of Ukraine are highly pro-Russian with the rest pro-Western. Such a divide can be clearly seen in political allegiances with the pro-Western parties that came into power during the Orange Revolution being voted in from pretty much only the western regions of the country.
However, the Orange Revolution’s wave did not materialize into the pro-Western country Europe and the United States hoped for. The deepening divide exacerbated already present political divisions. Those pro-Western forces under Yushchenko and former Prime Minister Yulia Timoshenko struggled to hold onto power while being completely ineffective in actually implementing any Western reforms. In short, the Orange Revolution led only to chaos. After 2004, Russia did not attempt a full counter to the Orangists. Instead Moscow was content to merely meddle in and destabilize Ukraine further in order to ensure it never fully fell into the West’s orbit.
The rolling back of the Orange tide began in 2007 when Victor Yanukovich’s pro-Russian Party of Regions won back parliament and began to pick away at Yushchenko and Timoshenko’s popularity. Helping Yanukovich was internal squabbles between Yushchenko’s Our Ukraine and Timoshenko’s eponymous bloc. Moreover, the Ukrainian people began to grow tired of a chaotic government. The only real stability the country knew was under Moscow’s wing, leading to the inevitable change in government in 2010 that brought pro-Russian Yanukovich into the presidency while also holding a coalition with majority in parliament.
Under Yanukovich, the political theater has calmed by Ukrainian standards. One of the largest stabilizing factors in recent politics has been Russia. Having Moscow’s meddling end with a pro-Russian government has allowed the upheaval of the previous five years to settle. But this does not mean that all the chaos is over as Ukrainian politics are inherently dramatic and unstable. Orange leader, former President Yushchenko, has nearly dropped out of the public eye altogether, while his partner Timoshenko is still attempting to be an opposition figure against Yanukovich, though her popularity has been in heavy decline since the elections. Since Timoshenko is a political survivor, however, she could come back to be a real force in the future. Though Ukrainian politics are so chaotic that they are notoriously hard to judge.
Another possible destabilizing factor is whether Yanukovich’s coalition breaks between his party, a handful of independents, the Communist Party and the Litvin Bloc. After the 2010 elections, Yanukovich gave nearly all his cabinet positions to his own party with only a few doled out to Litvin Bloc. Thus far the coalition partners (including those without cabinet positions) have not contested Yanukovich’s domination of the government but egos are a driving factor in Ukrainian politics and thus a break in Yanukovich’s block cannot be ruled out at any point.
Typically, with each turnover in the government and coalitions, the laws and reforms passed by the former ruling group are either undone or ignored. This has seriously retarded any restructuring or improvement in almost any sector or institution in the country.
ECONOMIC OVERVIEW
Ukraine’s economy is volatile at best, leaving little hope for the country to pull itself out of any difficulty. One problem is that each region in Ukraine is highly dependent on a specific industry for money so when that industry fails, the entire region tends to fail. Furthermore, most of Ukraine’s lucrative business is based in the eastern half of the country, which typically gives that half (and Russia) a bit more political and economic power. Although Ukraine mainly depends on its metallurgical industry, it also gains much revenue from grain, military exports and energy transit. However, each of these sectors is suffering from deep problems that could not be easily fixed even if the country had the proper tools.
Ukraine did not start to pull out of its post-Soviet economic slump until around 2000 when the country began to see results of rebuilding and modernizing its core sectories—industry and agriculture. But the 2008 global economic crisis hit Ukraine hard, shrinking its economy by 15 percent in 2009. A major component of this was steel demand falling 43 percent in 2009. In the crisis, inflation soared to 16.4%, and Ukraine’s currency, the hryvnia, dropped by 38 percent against the dollar. Ukrainian banks faced depositor flight during the crisis due to instability and lack of confidence, forcing the government to nationalize more than a dozen banks.
The IMF planned on loaning $16.43 billion to Ukraine, though only 2.2 billion has been released as the rest of the world, especially other European countries, were begging for funds as well. The IMF funds that were released showed little effect as they became entangled in the volatile political situation at the time with every faction fighting (and stealing) funds. Russia also stepped up to help Ukraine, issuing a $5 billion loan, which was also tussled over.
With the new and more stable government coming into office in 2010, Ukraine’s economy has seen some recovery. Inflation has started to fall to around 7 percent, growth for 2011 is projected at 4.5 percent and private consumption and investment is starting to pick back up—mainly due to the plans for the 2012 Euro football tournament (more below). Ukraine’s economic activity is expected to surpass its pre-crisis peak by 2013.
Regarding the IT and software industry specifically, this sector’s growth currently ranks fourth in Central and Eastern European countries. The IT sector was nearly exempt to the earthquakes of the global financial and domestic political crises in the country as it is still isolated from the bulk of Ukraine’s economy. Ukraine’s IT industry remained stable and even grew during each year from 2004 to today—and is expected to continue growing in the future.
Infrastructure
Ukraine’s transport infrastructure used to be on the low end of Western standards and the minimal maintenance after the fall of the Soviet Union led to nearly holistic degradation. Today, the transport infrastructure (roads, rails, seaports, and airports) are still in desperate need of modernization. One reason transportation infrastructure has not been a priority is a cultural divide in the country to where most people stay to their region. Due to this, Ukraine has uncommonly high transport costs. However, this could all be shifting, as infrastructure in terms of transport, buildings and commerce is recently a top priority for Kiev as the Union of European Football Associations (UEFA) Euro football 2012 games approach.
Telecommunications is much stronger sector in Ukraine than other types of infrastructure, though this is dependent on the region. Nearly all regional capitals have modern digital infrastructure and analog and digital cellular services are available in many areas. However, in rural areas, telephone services are outdated, inadequate and low-density, and large demand for main line telephone service remains unsatisfied.
Overall, falling behind in infrastructure has become the norm in Ukraine, mainly because Kiev runs the large strategic firms and organizations needed to invest in modernization, while the government still expects foreign groups to come in and fund such projects. This goes back to the disarray both in the government and in regards to understanding what is needed to move the country forward.
BUSINESS AND REGULATORY ENVIRONMENT
After the fall of the Soviet Union, Ukraine’s transition to a market economy has been the most challenging of all of the major transition economies. According to the World Bank, Ukraine is the second worst former Soviet and Eastern European state to do business in, only being beat by Uzbekistan. State institutions are weak, markets are small and volatile, and the culture has not easily adapted to change. The transition has been halting, incomplete and dogged by corruption at every turn. It still has not implemented the basic steps (transparency, shareholder management, financial accountability, rule of law and others) that the Central European states had moved beyond by 1995. The chaotic government that was in place from 2004-2010 only set the process back further. Unsurprisingly, ownership structures are sketchy, competition is weak, transparency is rare and conflicts of interest are chronic.
Unlike other former Soviet states, businesses and industry can be run outside of the capital, which traditionally is the financial center for any incoming investment and capital. Ukraine has economic hotspots in Kiev, Donetsk, Dnipropetrovsk, Zaporizhia, Sevastopol and Luhansk.
Out of all Eastern European and former Soviet states, restrictions on foreign equity ownership are the most severely restricted in Ukraine. Restrictions are on foreign ownership in many industrial and service sectors – particularly metals, agriculture, media and communication. Some of the newer sectors like IT are less restricted though it does not mean they are fully cleared. The World Trade Organization has pressured Ukraine, which became a member in 2008, to lift such restrictions in the future though such movement has been slow to get going on the government side. Most foreign operations in Ukraine also require full outside financing as the vast majority of Ukraine’s banks are attached to either the state or the country’s oligarchic networks and consider bank lending to be an exotic income source.
There are many reforms underway, however, which have allowed the international view of doing business in Ukraine to be more optimistic in the future. In just the past year, the view of Ukraine has leapt exponentially since a more stable government and overall political situation has come into play. Underneath President Yanukovich, a bulk reform package has been put in place to overcome these hardships, though most businesses have yet to see any major tangible progress. Small headway has been made with reductions in the minimum capital required, ease in obtaining construction permits, creating electronic tax filing, and streamlining some national and local regulations. The planned reforms will take years to be fully implemented and even longer to start to become regular practice, if they’ll be implemented at all.
Meanwhile, still struggling with overcoming the chaos since the Orange Revolution, the government has yet to consider judicial and legal reforms. Ukrainians also have a reputation for changing the rules of the game quickly and frequently but foreigners find it extremely difficult to change even minor details in most legal documentation. Complying with all laws is often impossible because many of the regulations contradict. There are old Soviet laws, newer Ukrainian laws, regional laws and contradictory regulations from various bureaus and agencies. This opens the way for bureaucratic demands (e.g., corruption). All this has eroded Ukraine’s competitiveness for foreign investment.