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Privatization: Ukraine

Sergei Blagov

Ukraine regained its independence in 1991 and three years later began to lay the foundation for macroeconomic stabilization and structural reforms. This included a strategy of gradual privatization. The government took measures to privatize the country’s industrial assets, yet the legacy of the Soviet past, such as bureaucratic inefficiency, a disproportionately developed military-industrial sector, and a weak rule of law, have hindered reform. Ukraine's privatization has also been affected by excessive government interference and over-regulation. As a result foreign investment has remained low, while inefficient energy and industrial sectors have been in crisis.

FISCAL PRIVATIZATION

Privatization in Ukraine is an all too familiar story, authorities blame low privatization revenues for the country’s deficit budget. On Jan. 5, 2003, President Leonid Kuchma signed into law the 2003 deficit budget. The budget adopted by parliament on Dec. 26, projects a revenue shortfall of some 2 billion hryvnas ($370 million). Ukraine's government has been strapped for cash after revenue from privatization of state assets failed to meet projections. In December 2002, Kuchma conceded that the actual deficit in 2002 was more than double then that forecasted-about 10 billion hryvna ($1.88 billion). It is possible to conclude that the Ukrainian leadership still views privatization primarily as a means to supplement the country’s state coffers, while issues of restructuring remain of secondary importance.

HISTORY

Ukraine, a former Soviet republic with a population of some 50 million, has been in an economic crisis since 1991. However, the country's vast agricultural and industrial potential, and the transportation networks it inherited from the former Soviet Union provide Ukraine the preconditions for economic growth.

Upon gaining its independence in 1991 Ukraine focused its attention on consolidating its nascent state and did not implement the kind of structural reforms that laid the way for rapid economic growth in some parts of Eastern Europe. Instead, it adopted for a "go slow" approach to economic reform that resulted in nine years of successive economic declines.

As the pace of reform accelerated, beginning in 2000, Ukraine has taken serious moves toward fiscal and monetary stability which have helped stimulate economic growth. After contracting every year since 1991, Ukraine's economy started growing in 2000, with real GNP growing by 5.8%, and industrial output, disposable income, and consumer spending all growing by double-digit figures.

In October 1994 Ukraine, with the parliament's backing, began to lay the foundations for macroeconomic stabilization and structural reforms. The government took action to liberalize domestic prices as well as the foreign exchange and trade regimes-legacies of the Soviet past. But, still reforms were hindered by bureaucratic inefficiency, endemic corruption, an antiquated industrial base, weakness in the rule of law, and overdevelopment of the military industrial sector.

Subsequently, foreign investment remains as low as $500 million, while the inefficient energy sector is in crisis, and the national currency (the hryvna) is still not fully convertible. The public sector generates most GDP, of which nearly 30% is consumed by the government, and efforts to privatize large state-owned enterprises has moved at a slow pace.

However, there has been progress on economic liberalization, including land reform. A 1999 presidential decree allowed farmers to leave collective farms while retaining their share of land, and a new Land Code is being considered that will allow the sale of private land and its use as collateral.

The previously leftist-dominated parliament opposed adopting the bill even thought, as analysts pointed out, the state was saddled with hundreds of failing enterprises. The privatization program includes the sale of nearly 1,000 non-strategic enterprises in the transport, machinery, chemical, agricultural and food industries. The list of companies in which stakes are to be privatized includes the Nikolayev factory, the AvtoKraz truck plant, Linos refinery, Oriana chemical factory, RivneAzot fertilizer company, nuclear turbine manufacturer Turboatom, regional power transportation grids and several telecommunication companies.

ATTEMPTS AT PRIVATIZATION

1. Privatization of the electricity market

Ukraine's power sector privatization has focused on the sale of stakes in the country's regional energy distribution companies. By mid-1996 Ukraine restructured its power sector into 34 competing companies-all wholly state-owned-and began operating a competitive wholesale electricity market. Ukraine has however been slow to privatize control of the resulting generation companies, thereby losing much of the potential created from its early restructuring work.

Ukraine sold stakes in the first seven firms in 1998, but these eventually came to be controlled by offshore companies (widely believed to be of Ukrainian origin). Investment in the companies has not been forthcoming. The World Bank, International Monetary Fund, and The European Bank for Reconstruction and Development made loans to Ukraine contingent on successful privatization of the country's electricity sector. Subsequently, the Ukrainian government decided to ban offshore firms from taking part in future privatizations. Ukrainian government wanted to sell its entire stake in seven electricity distribution companies, without keeping any shares in these energy units. Ukraine’s government sold 50% plus-one-share state-owned stakes in Kievoblenergo, Rovnooblenergo, Zhitomiroblenergo, 45% stakes in Nikolayevoblenergo and Sevastopoloblenergo, 40% of Khersonoblenergo, and a 26% stake in Kirovogradoblenergo.

In April 2001, Ukraine sold controlling stakes in six more power distribution companies. In the first round, US-based AES outbid Electricite de France to buy a 75% stake in Kyivoblenerho (the largest distributor up for sale) for $45.2 million. Slovakia’s Vychodoslovenske Energeticke (VEZ) outbid AES to purchase 75% of Zhytomyroblenerho for $34.5 million, while AES turned out to be the sole bidder at $23.2 million for a 75% share of Rivneoblenerho.

The April 2001 regional energy distribution companies privatizations was intended to kick-start a process that would lead to the privatization of all 27 of Ukraine's distributors, followed by privatization of the country's electricity generating companies. However, in late May 2001, Ukrainian President Leonid Kuchma ordered the government to temporarily suspend the privatization of Ukraine's electricity generating and distribution companies. A task force was formed in July 2001 to allow authorities to analyze the mistakes of the previous tenders and to restart tenders on a more competitive basis in 2002.

In December 2001, President Kuchma lifted the ban on the sale of electricity distribution companies. In February 2002, the State Property Fund released a list of 11 regional energy distribution companies that it planed to privatize this year. The sale will include 75% stakes in Vinnitsaoblenergo, Volynoblenergo, Zakarpatyeoblenergo and Dniproblenergo. In addition, the SPF will sell off 71% of Cherkassyoblenergo, 70% of Krimenergo and Khmelnitskoblenergo, 65% of Kharkivoblenergo and Donetskoblenergo, 60.25% of Zaporizhaioblenergo, and 51% of Ternopiloblenergo.

Despite these sales, the Ukrainian government understands that privatization of the regional energy distribution companies can not go forward with a major overhaul of debts sector-wide. Their total debt in Ukraine is $2 billion, while total energy sector debt currently stands at $10 billion. Hence these privatization deals could be thwarted by the debt problems.

2. Privatization of coal mines

The first wave of privatization of Ukraine's coal mines ended unsuccessfully in the mid-1990s, with the re-nationalizing of many mines. A second round of planned auctions for shares in Ukraine's coal mines, originally slated to begin in the fall of 2001, has been continually delayed. Ukraine's Fuel and Energy Ministry is currently operating 193 mines, at least one-third of which are involved in bankruptcy proceedings. With the slow pace of reforming Ukraine's coal sector, investor interest has been quiet. But the Ukrainian government is hoping to restart privatization in 2003.

3. Privatization of telecommunications

Two years ago, Ukraine’s parliament finally approved a draft law on privatizing telecom monopoly Ukrtelekom. The bill allows for the selling of at least a 25% stake in Ukrtelekom, but stipulates that the government must keep no less than 50% plus one share of the company.

The privatization of Ukraine’s key companies was blocked for years by the left wing members of parliament. But now the government expects to sell a 25% stake in Ukrtelekom for at least $548 million.

4. Privatization of Ukraine National Airlines

Ukraine’s other assets are also up for sale. The Ukraine State Property Fund (SPF) has been mulling over the idea of privatizing the country's major domestic carrier, AO Ukraine National Airlines (UNA). A controlling 51% stake in UNA is due to be tendered in an auction, while 23.78% of UNA will be offered on the Ukrainian exchange. The remaining 25.22% of UNA will be reserved for the company’s employees, including 5% to be acquired by UNA’s management.

PRIVATIZATION PLANS THWARTED

Ukrainian government has been keen to remain in control of key enterprises. The SPF has said that the government will keep control of 25% plus-one-share stakes in the key metal companies, Alchevsk Metal Plant and Alchevsk Coal-Tar Chemical Plant. The SPF will tender 25% stakes in these plants. According to earlier plans, 50% plus-one-share state-owned stakes in both plants had to be sold. The remaining stakes in both of these Lugansk region based plants are privately owned. Alchevsk Metal Plant and Alchevsk Coal-Tar Chemical Plant produce about 20% of the country’s total output.

1. Privatization hits a setback when payments fail and politics stall

The country’s privatization suffered a number of setbacks. Notably, in 2002 Ukraine’s SPF canceled the sale of a 25.22% stake in Turboatom, the nuclear turbine maker based in Kharkov. In 1999 the Fund sold a 25% stake in Turboatom but annulled the tender when the acquirer failed to pay.

Many privatization deals have so far been thwarted, partly by the nonpayment problems but also by political fights surrounding pervasive suspicions of the selling of strategic companies to foreigners (most notably Russian). Ukraine’s political elite has itself been divided on privatization strategy and has suspended sales several times.

According to the 1996 Foreign Investment law, foreign and domestic businesses receive equal treatment yet there were concerns over perceived discrimination against foreign companies. Moreover, foreign investment is restricted to less than 50 percent in some "strategic" sectors, including broadcasting where foreign participation is limited to 30 percent.

THE RUSSIAN CONNECTION

1. Russia’s hopes to acquire shares in Ukraine’s gas pipeline

Privatization in Ukraine's natural gas sector has been all but nonexistent, although there is now increased focus on the potential for privatizing the country's natural gas transit pipelines. Ukraine's natural gas transit system is in a state of disrepair and needs several billion dollars worth of investment. Ukraine's pipelines carry over 90% of Russia’s gas exports to Europe. Gazprom, the Russian pipeline monopoly, has expressed an interest in acquiring shares in Ukraine's pipelines to ensure that natural gas reaches its European customers. As payment for Ukraine's billion dollar natural gas debt, Gazprom has long sought to take a stake in all or part of Ukraine's state-owned gas pipeline system.

2. Ukraine’s debt to Russia

Prime Minister Mikhail Kasyanov has repeatedly called on Kiev to pay back some of its more than $1.5 billion debts to Russian enterprises by making use of Ukrainian state property. Moscow had given the Kiev government a list of state assets that Russia would be willing to accept in lieu of the money owed by Ukraine to Gazprom and other enterprises. There has been increased pressure from Gazprom as well as several other oil firms and the national power grid operator Unified Energy Systems for Ukraine to pay off its large debts to them.

Not unconnected to this is Shell's unsuccessful attempt to take over the Ukrainian gas pipeline system. Shell some two years ago first proposed acquiring a controlling stake in Ukraine's gas pipelines - offering $500 million and additional investments worth $1 billion. Since then, the attractiveness of the project has steadily declined due to falling transportation volumes, and Shell has lowered its bid.

Russia floated plans to swap debts for privatization shares several years ago. Ukraine had even considered issuing special privatization bonds in lieu of its staggering gas debts to Russia. In an unorthodox transaction, Kiev even transferred 11 strategic bombers to Russia under a deal to write off $285 million worth of gas debts. But the privatization process stalled because of the two countries' inability to agree on the terms of the scheme.

Ukraine, which consumes around 70 billion cubic meters of natural gas a year, annually imports 55 bcm from Russia. Nonetheless, Ukrainian President Leonid Kuchma has repeatedly said his impoverished country would never hand over shares in its top companies to Russia to pay off its multimillion dollar debt for gas supplies.

3. Russia, Germany and Ukraine’s consortium to guarantee gas supplies to Europe

Rather than privatize its transit pipeline system, in June 2002 Ukraine, along with Russia and Germany signed a trilateral agreement. The agreement would explore the creation of an international consortium to manage the Ukrainian natural gas pipelines in order to secure stable natural gas transit to Europe. The formation of the consortium rules out the possibility of unauthorized siphoning of natural gas by Ukraine, guaranteeing an uninterrupted natural gas supply to Europe. Germany reportedly pledged to invest $2.5 billion to upgrade the gas pipelines, as well as up to $15 billion for the development of Ukraine's transit system over the next ten years.

4. Russian oligarchs want to snap up Ukranian industries

Russia's oligarchs have a reported interest in acquisitions in Ukraine. Oleg Deripaska's Siberian Aluminum, Mikhail Fridman and Pyotr Aven's Alfa Group are just a few of the companies that have already made clear their intent to begin snapping up Ukrainian industrial companies when they go on sale.

Siberian Aluminum already has a controlling stake in Nikolayev Alumina, the country's largest alumina plant. Now Siberian is focusing its interests on the Azovstal steel smelter.

In June, 2000, Ukrainian anti-trust body approved an acquisition of a controlling stake in a local bank by Russian Alfa Bank and its two off-shore units, British Virgin Islands registered Alfa Capital Investments and Alfa Capital Holdings. Following the sale of Kievinvestbank’s 76% stake in the bank to Alfa Bank, the Ukrainian bank was re-christened Alfa Bank-Ukraine.

5. Russia joins Ukraine’s drive towards privatization

After several years of unsuccessfully offering stakes in Ukraine's oil refineries, the SPF has begun to achieve better results in the past few years. In March 1999, Russia’s top oil firm LUKoil paid $7.2 million for a 51.9% stake in Ukraine's Odessa refinery, the country's fourth largest in terms of refining volumes. Since its original purchase, LUKoil has increased its stake in the refinery to 94% by purchasing additional shares on the secondary market.

Russia's Tyumen Oil, through its subsidiary TNK-Ukraina, acquired 67.41% of the 320,000-bbl/d Lisichansk (LiNOS) refinery in July 2000, then upped its stake to 78% in October 2000. The company is carrying out an investment program to modernize the plant over the next five years and to boost its design capacity.

Apart from Russia, some other former Soviet states have joined Ukraine’s privatization drive. For instance, Kazakhstan’s state oil company, Kazakhoil (now Kazmunaigaz) purchased 60% of the Kherson oil refinery in November 2001. In May 2002, however, Kazmunaigaz announced plans to sell its stake in the Kherson refinery, owing to difficulties in meeting its commitments to ensure oil supplies to the refinery and to invest $250 million to modernize the plant. Russia's Rosneft has signed a preliminary agreement with Kazmunaigaz to purchase the 60% stake in the Kherson refinery.

PRIVATIZATION CHALLENGES

Recently President Leonid Kuchma has repeatedly pledged to push ahead aggressively with privatizations. Ukraine hoped to raise $3 billion in privatization revenues within 2000-2002. However, in September 2002 Kuchma lashed out at Alexander Bondar, head of the SPF, for what he perceived as a failure of Ukraine’s privatization plans. Ukrainian President claimed that since the beginning of 2002 privatization revenue amounted to just 3% of the anticipated amount. Kuchma stated that the privatization program for 2000-2002 was a failure, noting that the state coffers received roughly one third of the planned $3 billion.

In September 2002, Kuchma also ordered Bondar to outline a privatization blueprint for 2003-2008-designed to serve as an instrument of “strategic planning” in unloading the state-owned assets. Subsequently, on Dec.26 2002, Bondar announced that the sale of a controlling stake in the country’s oil monopoly, Ukrneft, would bring 2.1 billion, planned as privatization revenues in 2003. However, Bondar conceded that a “political will” was needed to meet projections.

In 2001, privatization revenues totaled 2.124 billion hryvnas ($400 million). Sales in the energy and telecommunication sectors failed. The State Property Fund expected to raise 5.9 billion hryvnas in 2001, but the program suffered a blow when President Leonid Kuchma ordered a freeze in energy sector sell-offs.

1. Privatization is hindered by higher taxes, corruption, and lack of transparency and economic reforms

Privatization in Ukraine has been limited by the lack of economic reforms and an unstable legal and tax environment. According to the U.S. Department of State’s estimate, “privatization in Ukraine has proceeded unevenly thus far, with relatively rapid results in small-scale privatization and a slower pace for large-scale privatization.” Privatization was stalled due to an underdeveloped legislative base without clear, easily understood procedures for selling state property; the absence of political will to overcome strong resistance from local authorities and enterprise directors. The overall business climate in Ukraine remains poor due to corruption, over-regulation, lack of transparency, high business taxes, and inconsistent application of local law. Not to mention that property is also weakly protected in Ukraine.

2. Legal battles against the Ukrainian State Property Fund

Positive examples of a rule of law are not numerous in Ukraine. One of the few foreign investors in Ukraine's oil sector, JKX Oil and Gas (UK), won a legal battle against the Ukrainian State Property Fund (SPF, the state agency tasked with overseeing privatization sales) to prevent the expropriation of its Ukrainian assets. After JKX's armed guards rebuked a hostile attempt to seize the offices of JKX's 49%-owned Ukrainian business Poltava Petroleum in March 2001, JKX appealed to the Supreme Arbitration Court, where the company triumphed. JKX's experience has soured the company on Ukraine's oil sector potential, as well as further dampened foreign interest in Ukraine's already dismal investment climate.

3. Nationalization

Moreover, there was a talk of nationalization. In June 2002, Valentyna Semeniuk, head of the ad hoc parliament commission for privatization submitted a bill on re-privatization of Ukraine’s property to the Verkhovna Rada. The bill defined the legal, economic and organizational principles of re-privatization and regulated the relations among the legal entities and individuals involved in re-privatization.

Ukraine was deeply integrated into the former Soviet economy, particularly in the agricultural and defense industries. Notably, Ukraine’s military-industrial complex of some 200 design bureaus and enterprises presupposed the existence of the Soviet empire. With that empires collapse, in many countries whole cities and industries no longer had reasons to be where they were-let alone do what they were doing. The only workable solution appeared to be fast privatization. However, the progress of privatization was extremely slow. The government still owned shares in some 6,000 companies.

THE MEDIA’S ROLE

In the meantime, Ukraine’s economy was receiving negative coverage in the media. This was mainly due to a lack of transparency and sluggish reforms. Yet, the homegrown media sources-no more than some 4,000 registered news publications-hardly made a difference. This wass true in large part because only 5 percent of the print media was privately owned. In Ukraine, a recent media monitoring of the European Institute for the Media (EIM) indicated that the country’s media outfits failed to live up to standards of impartiality and balance. Ukraine has no freedom-of-information law, restricting the ability of journalists to obtain accurate and reliable information on the privatization process.

Although the Constitution guarantees freedom of the press, this right is not enforced. There has been widespread violence and harassment against journalists who attempted to report on corruption and organized crime. According to the Freedom House’s recent survey, practically all Ukrainian publications survive on state subsidies or what are call "sponsors"-politicians and businessmen who use a news organization to further their political and economic agendas. In some cases, businessmen with suspected ties to organized crime have purchased news outlets. Therefore, coverage in Ukraine’s mass media is hardly able to ensure transparency of privatization.

LESSONS LEARNED

For years Ukrainian officials have been promoting investment opportunities, arguing that a strategically located country of 50 million people simply can not be ignored. However, most foreign investors largely ignore Ukraine. The flow of foreign investment into Ukraine has dwindled to a slow trickle. Since the beginning of the 1990s, Ukraine has experienced several high-profile corruption scandals. These factors helped promote an image of Ukraine as a deeply corrupt country. This image made a strong impression among the Ukrainian public. In an attempt to subvert this impression the Ukrainian government hired international public relations experts to conduct a nationwide campaign, including advertising and media relations, to educate Ukrainians on the government's mass privatization and post-privatization projects. The idea was to generate positive media coverage of the privatization program in both the national and international media. Despite all efforts, Ukraine is still getting a lot of negative media attention.

Regardless of the negative coverage, the real lesson to be learned is that investors shy away from Ukraine not because of the bad press but because of the market. Ukraine's image cannot change until Ukraine changes. And it remains to be seen whether Ukrainian officials will realize that privatization auctions of state property, critical for government receipts, need to be a lot more transparent, before outside money is invested.

CONCLUSION

Ukraine's inability to move beyond these inefficient policies has resulted in the continuation of excessive government interference and over-regulation. Scandals and corruption plague political life. Former Prime Minister Pavlo Lazarenko has been indicted for money laundering and corruption in the United States and Switzerland. Deputy Prime Minister Yulia Timoshenko was fired and indicted in Ukraine. President Leonid Kuchma himself was implicated in scandals involving the disappearance and death of investigative journalist Georgii Gongadze, as well as the discovery of hundreds of hours of recordings surreptitiously taped in his office. As President Kuchma’s government still faces seemingly endless political crisis, the country’s "go slow" approach to economic reforms and privatization is unlikely to change any time soon.

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