Democracy as a weapon. How Political Reforms Helped Ukraine Prepare for War

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On the eve of the invasion of Ukraine, Vladimir Putin said in a major keynote address: “No sustainable statehood has emerged in Ukraine.” The Kremlin's perception of Ukraine as a “failed state,” was one of the reasons for the attempted blitzkrieg in February 2022, and then led to its failure. But Ukraine withstood the onslaught of a superior enemy not only because of its military efforts and the heroism of its military, but also because of the successful organization of the home front, which is impossible without an effective state. The Kremlin experts whose reports landed on Putin's desk simply ignored the fact that, since 2014, Ukraine has been reforming its government institutions, which, despite the resistance of corrupt elites, has led to serious qualitative changes.

Decentralization and a strong home front

One of the tenets of pre-war Kremlin propaganda was the belief that Ukrainian power was imitative, decorative, and that true power was in the hands of the American embassy and a bunch of oligarchs. At moment X (or, if you prefer, Z), as Putin's strategists imagined, the Americans and oligarchs will simply abandon Ukraine and flee, as they did in Afghanistan, and the “puppet government” will collapse in a couple of days. In addition to the great power arrogance, we see the inability to imagine any other kind of government system other than the Russian supercentralization, where all the threads of control go to the “center”. Even if Russian subversive groups had succeeded in killing or capturing Zelensky in the first days, the resistance would have continued due to the decentralized nature of the country's governance.

When decentralization began in Ukraine, many skeptics, including those inside the country, predicted that it would lead to disintegration or “federalization,” worsening governability. In practice, it was this reform that increased the sustainability of the state. Decentralization began under Poroshenko and continued under the Zelensky administration. It was aimed at expanding the powers of local government in terms of financial management and the implementation of regional development programs.

At the same time, administrative-territorial reform was also carried out, based on a new unit - the united territorial community, which brought local self-government services closer to local communities. After the amendments made to the Tax and Budget Codes in 2015, the territorial communities received the right to dispose of 100% of the unified tax and property tax revenues; earnings from administrative services and 60% of individual income tax revenues remain in the regions.

Under wartime conditions, local authorities, which had received more rights and resources, were able to supply the AFU and provide refugees with accommodation, as well as continue to work effectively in autonomous mode. In the regions under attack local self-government became yet another line of defense, and under occupation it became a hotbed of resistance.

A good example is Kherson, captured by the Russians, where the mayor Igor Kolykhayev remained in the city and continued to provide its vital functions, without cooperating with the occupants, and the Ukrainian flag hung over the city hall for a long time (in late June, Kolykhayev was kidnapped by Russian security forces, and power went to the puppet “administration”). Cases of treason among local government employees were sporadic, thanks to the elected heads of administrative units, accountable to territorial communities. Witnesses note that this “nuance” was poorly understood by the occupation authorities, who in Russia traditionally perceived mayors and heads of villages as autonomous appointees of the center.

People’s deputy Vitaly Bezgin, head of the parliamentary subcommittee on administrative and territorial reform, gives the following not quite obvious example of how administrative reform contributed to the defense of the country and complicated the invaders' plans: “They relied on old maps, old approaches to the way our government works. And they were totally unprepared for the fact that things actually functioned differently.”

Under martial law, the Ministry of Regional Policy, together with the relevant committee of the Verkhovna Rada and the Association of Ukrainian Cities, is developing wartime amendments to the administrative-territorial system related to security issues. All territories will be divided into four types: temporarily occupied, territories of combat operations, support territories that help the theater of combat operations, and territories of deep rear, to which refugees will be evacuated and production temporarily relocated. An example of such a territory is the Odessa region, which acts as the logistics center for the frontline Mykolaiv region, and the territories of the rear are the Zakarpattia and Chernivtsi regions on the western borders. In accordance with this division, the tax system will be adapted to the requirements of wartime: for example, the territories of the deep rear will be granted the right to administer local taxes.

Local administrations are now facing the problem of imbalance caused by the war. The outflow of population and relocation of businesses from the frontline regions have reduced the local tax base and require additional support from the national budget. Experts also point out that the creation of free economic zones to stimulate business in the rear areas must be balanced with the revenues received by local budgets.

Financial front

One important frontier of state stability is the financial system. In 2014, the Russian invasion of Crimea and Donbass provoked the collapse of the hryvnia, and inflation jumped by 40%. In 2022, despite larger threats, Ukraine's financial system held firm. From the first days the National Bank of Ukraine took a number of steps to overcome the inevitable panic among the population and preserve financial stability. As early as February 24, the NBU prepared wartime regulations for the banking system aimed at curbing the devaluation of the national currency. To curb the depreciation of the hryvnia the NBU fixed its exchange rate against the dollar. This limitation on the exchange rate was in force until May 2022. During the war the NBU abandoned its peacetime inflation targeting policy.

The National Bank's smooth operation was made possible by reforms in the financial sector carried out in 2014-2016. The former head of the strategy department of the National Bank of Ukraine Mikhail Vidyakin, who then headed the office of reforms of the banking system and the National Bank, said in a conversation with The Ιnsider that the foundations of the country’s financial system stability had been laid down in those years. “During those three years Ukraine moved from an oligarchic financial market to a transparent and civilized market that allowed the National Bank to adopt the best international practices of inflation targeting,” he said.

The banking system was improved in the course of the reform. The National Bank required Ukrainian banks to disclose ultimate beneficiaries, to ensure transparency of transactions with related parties, recapitalization based on stress testing results, as well as compliance with international rules of financial monitoring, so only stable and transparent institutions remained in the market. According to Vidyakin's estimates, about 70 of the 180 banks operating as of 2014 remained as a result of the “improvement.” The culmination was the nationalization of Privatbank, the country's largest bank controlled by oligarch Igor Kolomoisky.

But most importantly, the reformed National Bank managed to build a working system aimed at fulfilling the key functions of the central bank, independent of personalities or changes in governments. The management structure was streamlined and centralized, the decision-making system was reformed, the institutional and functional role of the central bank in the financial market was strengthened legislatively, and the NBU got rid of a number of non-core functions and assets, which had been rendering the work of the institution unwieldy.

According to Vidyakin, the key to the success of the reforms was the independence of the National Bank as an institution. Back in 2015, a number of laws were adopted, which strengthened the NBU's independence in formulating financial policy. This work continued under President Zelensky. Strengthening the independence of the country's main bank is one of the requirements of the IMF, which was lending to the Ukrainian economy.

The crisis in the real sector of the economy remains the main challenge for the financial system - the war has dealt a serious blow to business. In January-March 2022, Ukrainian banks received a negative financial result of 160 million hryvnias. The overall picture was spoiled by March, when the banks suffered the net loss of 10.07 billion hryvnias due to the war. In January-February, the net profit of the banking system had been 9.91 billion hryvnias.

Because of the shrinking tax base, the fiscal deficit is nearly $5 billion a month, about 30% of the monthly prewar GDP. Taxes fill about one third of the budget, and the rest is supplemented by the sale of military bonds by the National Bank and foreign aid.

Doubts and disagreements

Serious disagreements remain between the National Bank and the Ministry of Finance about the priorities of the wartime economy: the NBU aims to control inflation and prevent its growth, while the goal of the Ministry of Finance is to fill the budget by any means here and now. For example, one of the controversial points was the increase of the discount rate from 10% to 25% by the National Bank of Ukraine and the Cabinet of Ministers with the aim of curbing inflation and keeping hryvnia revenues and savings. This decision led to an increase in the yield of government bonds and demand for them on the part of private banks. At the same time, the Ministry of Finance believes that during the war government bonds should be a tool to support the state, rather than a way to earn interest; besides, the government believes that high inflation will allow for a sharp one-off increase in budget revenues.

Yuriy Gorodnichenko, a Ukrainian economist at UCLA, believes that Ukraine's dependence on external injections and National Bank interventions cannot ensure the stability of the war economy. “Cutting taxes at the beginning of the war with the expectation of providing liquidity to businesses and people was right. But in the [longer] term, with large military expenditures, cutting taxes completely would be wrong... It seems to me that in the end, in the realities of war, Ukraine will adopt another philosophy, whereby we need to focus on collections here and now, in order to pay for the war. Most likely, a progressive taxation scale will be introduced, rather than a flat one as it is now. There will be an increase in import tax, value added tax, etc.” The Ukrainian government is already on this path, with VAT for imported goods and import duties reinstated on July 1.

With no foreseeable outline of the end of the war in sight, plans to restore the Ukrainian economy are being actively developed. The best known is the Plan for Reconstruction of Ukraine, developed by a group of internationally renowned economists, including Ukrainians Yuri Gorodnichenko and Timofey Milovanov, Russian émigré Sergei Guriev and Kenneth Rogoff of Harvard (former IMF chief economist). It draws on the experience of the Marshall Plan for postwar Europe and will require 200 to 500 billion euros. The authors of the plan assume that the key to the rapid recovery of Ukraine should be its economic integration with the EU, which will help mobilize resources and finally free the Ukrainian economy from its dependence on Russia. But for this to happen, Ukraine will have to implement reforms to bring it closer to European standards in parallel with the reconstruction process, which will be a serious challenge for the country and its political elite.