Ukraine’s Economy Needs A New Lease On Life

One doesn’t need to be a military genius to understand Ukraine is in a tough spot in its war against Russia – writes Stephen J. Blank. A new Russian offensive against Kharkiv, the second largest city, over the last weekend, serves as a testament to the stubbornness of the Russian threats to turn the flanks of the Ukrainian frontline. The unnecessary six-month delay of aid and weapons from the West has enabled Russian advances.

At some point, the war will end. Whether or not Ukraine cedes land east of the Dnieper River or the two sides agree to an armistice that includes Crimea under Russian occupation  is unknowable.

What is known is that industrial capacity east of that river has been largely destroyed, and the Ukrainian economy will endure only on Western life support without drastic changes. The fact that much of Ukraine’s heavy industry is concentrated in the east of the country doesn’t help.

Prior to the latest invasion which began in the winter of 2022, Ukraine was already a leading borrower at the International Monetary Fund. The European Bank for Reconstruction and Development was also there, trying to reform the Ukrainian economy. Change did arrive – but too slowly. Reforms advanced both decentralization and liberalization (which continues even during wartime).

Political acrimony only worsened this economic malaise. Following a failure to squash a Moscow-concocted separatist movement in the Donbas, the full-scale invasion came, and a bad situation got worse.

In 2022, the World Bank, reported that Ukraine’s poverty level increased 10-fold. Simultaneously, its GDP per capita fell 17.1% that year. The fog of war obscures data from the last year, but it is assuredly far worse now.

Unsurprisingly, this devastation against society and business has created an opening for the criminal organizations in Ukraine, an element that the Ukrainian government already had difficulty containing.

Over the past three decades, Ukrainian organized crime corrupted Ukrainian politics and business, and was closely connected to Russian criminal networks. A Brookings report details how Ukraine’s criminal underworld, which was slowly being pushed out of politics prior to the Russian invasion, could side with the Russians if the situation allows.

For years, this criminal element also worked with some Ukrainian oligarchs. It might not be crime in the made-for-TV sense – murder and bank robberies, narcotics or human trafficking operations, but there is a black-market component to the Ukrainian economy, resurgent after a decade of slow decline. As Ukraine’s economy spirals into uncertainty, counterfeit and illicit trade is on rising.

The scale of this illicit trade is difficult to determine, but there is one standout product: cigarettes. In 2020, Ukraine surpassed China to become Europe’s largest source of illegal tobacco, and it remains so. For Ukraine, illicit tobacco trade results in revenue losses of as much as 20.5 billion hryvnia (around 480 million euros) in non-paid or underpaid taxes in 2022. Ukraine’s market for illicit tobacco has grown rapidly from about 2% of total tobacco consumption in 2017, to 22% in 2022, according to a 2022 report by market research agency Kantar. A 2018 following an agreement between Kyiv and Brussels to gradually increase taxes on cigarettes to align with European tax norms failed to stem the tide. The legal volume of cigarettes decreased by 46% from 2018-2022 while the share of illegal trade increased from 2% in 2017 to the record high level 25.7% in October 2023.

To maintain foreign credit, Ukraine had to reform its economy, and clean it up from tax evasion. The Economic Security Bureau of Ukraine was created in 2021 to do that. Their job was to investigate economic crimes, including the illicit tobacco trade.

Ukraine’s inability to resolve the illicit tobacco trade showcases the country’s stereotype as a geopolitically unstable frontier market, in constant need of financial help. It showcases an overall lack of institutional capability to really conduct the economic reforms and fight corruption, something the IMF and EBRD have been asking for over a decade. Such illicit trade may undermine the West’s willingness to stick it out with Ukraine.

This is a resolvable problem. Kyiv could encourage setting certain benchmarks and achievable goals in countering the illicit tobacco trade in Ukraine. After another increase of taxes it might bring in more than 30 billion hryvnia (around 700 million euros) of additional budget revenues this year and show that Ukraine is an economic asset. It could showcase political willpower and institutional capacity to self-finance, potentially ensuring a more sustainable long-term relationship with Europe. It’s just a good look for Ukraine if they can get this under control.

Since 2014, Western-focused Ukrainian leaders have discussed their desire to join the EU one day and leave Russia’s sphere of influence and economy. Ukraine’s integration into the EU internal market is at risk if Brussels sees it as a country that cannot even get its black market under control. 

Foreign actors are not impressed with Kyiv’s sluggish progress. “Considering the ongoing war, insufficient filling of the State Budget, and reduction of economic and military aid from international partners, the growth of the shadow sector of the economy, according to business representatives, is unacceptable,” the American Chamber of Commerce said in a statement following the Kantar report in 2023.

The European Business Association said it has “repeatedly emphasized the problem of the shadow economy in Ukraine, which goes far beyond the tobacco industry. However, despite high-profile cases in the media, the situation continues to deteriorate.”

The scale of illicit trade occurring in Ukraine suggests that organized crime groups are behind it. They have likely bribed police, customs and border patrol agents and other law enforcement officials to allow for the sale and export of these goods.

If Ukraine ever wants to become an EU Member, it has a long way to go. Corruption and an old-world, devil-may-care attitude are entrenched. Once this war is over, the clean-up crew will have a lot of work ahead. That work will include more than sifting through rubble and making sure the lights are on. It will mean trying to convince Ukraine’s political leadership to do what the IMF and EBRD have failed to do since 2014: change a culture of political corruption.

Stephen J. Blank, Ph.D., is Senior Fellow at FPRI’s Eurasia Program. He has published over 1500 articles and monographs on Soviet/Russian, Ukrainian U.S., Asian, and European military and foreign policies.

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