The Carnegie Endowment publishes the Ukraine Reform Monitor to provide independent, fact-based, rigorous assessments of the scope and quality of reforms in Ukraine. The Carnegie Endowment works with a team of independent Ukraine-based scholars. The seventh memo covers the period from April to October 2017. The monitor is supported in part by grants from the Center for East European and International Studies (Zentrum für Osteuropa- und internationale Studien, ZOiS) and the Open Society Foundations.

Executive Summary

The hallmark of Ukrainian political life over the last six months has been President Petro Poroshenko’s efforts to consolidate power, as he looks ahead to the presidential and parliamentary elections of 2019. However, he faces challenges to his authority, in the parliament and, most visibly, from former Georgian president Mikheil Saakashvili and his supporters.

The first signs of preelection political maneuvering have already affected the reform process. Reforms with the necessary political “clearance”—such as the judiciary, decentralization, and pension reform—have moved forward in the Ukrainian parliament, or Rada. However, the overall pace of reforms remained slow and delays in the Rada put a pause on the recently launched healthcare reforms. Tensions between Ukraine and the West are mounting, mostly due to the Ukrainian leadership’s reluctance to tackle corruption.

The conflict in Ukraine’s eastern Donbas region has also continued to have a negative impact on the whole country and the reform process. The January rail blockade of Donbas, and appropriation of businesses there, depressed economic growth. The threat from Russia, and the upcoming 2019 Ukrainian elections, gives Kyiv arguments against strict Western conditionality and has helped ensure material and rhetorical support from the United States. The successful placement of $3 billion Eurobonds in international markets also buys Kyiv time.

The European Union (EU) has expressed impatience about the need to implement reforms, despite granting visa-free travel to Ukrainians in June and the full application of the EU-Ukraine Association Agreement on September 1.

Political Developments: A September Storm

During the summer, Poroshenko sought to strengthen his own power base. Tensions between Poroshenko’s bloc and its only parliamentary ally, the Popular Front, emerged as politicians prioritized positioning ahead of the 2019 elections. Some media outlets associated with the opposition and civil society actors complained of government harassment, while anticorruption activists said that new legislation was designed to stop their scrutiny of officials. Critics also complain that the Security Service of Ukraine (SBU) is too powerful and unaccountable. It has been accused of corrupt practices, such as smuggling goods across the Donbas blockade line and extorting businesses.

With less than two years before the country votes on whether to reelect him, Poroshenko’s approval rating has declined to only 17 percent, with 75 percent of Ukrainians disapproving of his performance. However, the opposition is not strong either and, according to a June opinion poll, over 80 percent of the population believes Ukraine to be in “chaos.”

In late July, Poroshenko moved to marginalize former Georgian president and Odessa governor Mikheil Saakashvili, once a political ally but now a vocal critic of his administration’s failure to tackle corruption. Saakashvili was stripped of Ukrainian citizenship for allegedly providing incorrect information on his citizenship application. However, this maneuver apparently backfired, giving new impetus to the opposition. Saakashvili’s forcible entry into Ukraine on September 10 energized the opposition and left many with the impression that both the president and his rivals were flouting the law to pursue their political agendas to the detriment of Ukraine’s international legitimacy.

The main beneficiary of this drama is likely to be former prime minister Yulia Tymoshenko, who leads the polls with around 13.5 percent support (followed closely by Poroshenko). Her populist agenda emphasizing the need for social welfare, combined with Saakashvili’s anticorruption message, puts Poroshenko on the defensive and opens the door for other antiestablishment candidates.

This political dynamic is likely to persuade the authorities to disregard Western advice by watering down austerity measures and postponing controversial steps, such as land reform. The president is not promoting reforms as visibly as before, and the National Reform Council, which reports to him and was formerly the driver of reforms, has also stepped back to focus on public relations and communication more than the reform process itself. Instead, the day-to-day management and responsibility for reforms has shifted to the Cabinet of Ministers, led by Prime Minister Volodymyr Groysman. He is instrumental to moving decentralization forward and has prioritized public administration reform, which has attracted generous EU aid.

Overall, Western actors and civic groups remained the main advocates of reform in Ukraine. Progress was reported in areas where the West has pushed hard and technical assistance has been used to good effect, such as with public administration reform, decentralization, or the introduction of a new system of food inspections that will further harmonize Ukraine with EU standards.

After resisiting for several months, President Poroshenko conceded to demands to create a special anticorruption court on October 4. However, the Rada—with the support of the Petro Poroshenko Bloc, Popular Front, and offshoots of the Party of Regions—passed changes to a judicial reform bill on October 3 that would limit the term of pretrial investigations of serious criminal cases to six months. If Poroshenko signs the bill as approved by parliament, investigations into unsolved crimes committed during the Euromaidan protests may be terminated. It would also deliver a serious blow to corruption investigations, which typically take more than one year to complete.

The EU has been delivering a double message, welcoming developments that deepen its relationship with Kyiv while also striking a more critical tone. The final approval of the EU’s visa-free regime with Ukraine on June 11 was declared a success. In the first month, over 95,000 Ukrainians traveled to the EU visa free. The EU-Ukraine Association Agreement, another achievement for Brussels and Kyiv, came into full force on September 1, after which EU officials sharpened their talking points. EU Ambassador to Ukraine Hugues Mingarelli was outspoken in his criticism of the Rada for blocking reforms, and EU Commission President Jean-Claude Juncker told Poroshenko “to increase the fight against corruption.”

Ukraine’s western EU neighbors have also reacted with anger to a new education law signed by the president on September 26. The law specifies Ukrainian as the language of instruction in schools starting in the the fifth grade. Many provisions of the law are vague but its main target is evidently the Russian language, which is the sole native language of about 15 percent of Ukrainians. Bulgaria, Hungary, Moldova, and Romania have all objected that this restricts the rights of their ethnic kin in Ukraine to receive an education in their native languages. In response, the Romanian president canceled a planned trip to Kyiv and the Hungarian foreign minister said that his country “will block all steps within the European Union that would represent a step forward in Ukraine’s European integration process.”

The Bleeding East

The conflict in eastern Ukraine has continued to exert a human, financial, and political toll on the country as a whole. In the first seven months of the year, 59 civilians were killed and 280 were injured in the conflict zone. Although the majority of ceasefire violations came from the Russian-backed separatists, the increasingly confident and resilient Ukrainian army has also been testing the front line of the conflict zone.

Residents of eastern Ukraine continue to bear the brunt of the conflict. More than 6 million crossings of the line of contact in the conflict zone have been documented since the start of 2017 (compared to 8.5 million total in 2016) due to a new procedure for social payments introduced by the Ukrainian government. The UN Refugee Agency (UNHCR) estimated that 560,000 people living in non-government-controlled areas—400,000 of them this year—had lost access to their Ukrainian state pensions due to bureaucratic impediments.

The conflict also had broader effects, causing low economic growth and diverting attention away from discussions about the lack of security sector reform. Investigations into corruption and suicides in the army—500 in three years—paint a bleak picture of life in the armed forces. Reform has also been held back by the president and People’s Front volunteers’ difficulties collaborating over army supervision and military procurement.

The only legitimate economic beneficiary of the conflict has been the domestic defense industry. Ukraine’s state-owned military conglomerate Ukroboronprom reported a 100 percent fulfillment of state defense orders and a 25 percent increase in exports in 2016. The Corsar, a domestically produced, next-generation anti-tank guided missile system, was brought into service at a relatively low cost.

In July, pro-Russian separatists in eastern Ukraine declared the formation of a new state named Malorossiya, or Little Russia. The declaration was disavowed by the Kremlin but further destabilized the region. The separatists seized control of 53 Ukrainian companies, while a blockade by nationalist groups on the Ukrainian-controlled side and the government’s temporary freeze of rail and road cargo links may shave 0.6 and 0.7 percent respectively off Ukraine’s GDP. In April, Kyiv cut electricity to Luhansk after it accumulated $431 million in unpaid debt (together with Donetsk).

As the conflict continued, Poroshenko and the government pursued several measures that were well received by much of the Ukrainian establishment but were criticized in Russia and parts of Ukraine with high usage of the Russian language. In April, the president issued an order imposing sanctions on a new set of Russian companies and individuals, including Crimean enterprises reregistered in Russia and officials responsible for prosecuting Ukrainian citizens on political grounds in Russia. Controversially, the measures targeted popular Russian websites, including the biggest Russian social media network, VKontakte, and the Yandex search engine.

The conflict with Russia was Kyiv’s main agenda item with Washington, although it has been hard to escape the impression that the administration of U.S. President Donald Trump has effectively downgraded the importance of Ukraine in its overall foreign policy. The U.S. Congress has tried to alleviate the drift and disarray in the executive branch, including via near-unanimous passage in July of new anti-Russian sanctions. Despite unusually long delays in making senior-level appointments, the Trump administration named former ambassador to NATO Kurt Volker as special envoy for the conflict in Ukraine. Secretary of State Rex Tillerson visited Ukraine in July and Defense Secretary James Mattis visited Kyiv to take part in Independence Day celebrations in August. The White House is also reportedly reviewing the provision of lethal aid, but public comments by National Security Adviser H. R. McMaster suggest a major shift in U.S. policy is probably not in the offing.

Lagging Economic Reforms

The news on the economy and economic reforms has been mixed. On the one hand, Ukraine’s economy continued to grow, even if only at the sluggish pace of 2 percent a year. The rail blockade of non-government-controlled territories as well as unfavorable weather conditions affecting crop yields were blamed for these lower-than-anticipated figures. The credit rating agency Moody’s raised Ukraine’s rating at the end of August, citing progress on structural reforms that, “if sustained, could lead to further improvements in Ukraine’s public and external debt sustainability.” In a further positive development, Ukraine returned to the international credit markets in September, having raised $3 billion in Eurobonds. The success of the Eurobond issuance is likely to stoke expectations that Ukraine can rely more on global capital markets and less on support from international financial institutions (IFIs) that use conditionality to coax progress on painful reforms.

On the other hand, the pace of economic reforms has been slow. On a recent visit to Kyiv, the deputy head of the IMF, David Lipton, warned that Ukraine risks backsliding on its reforms and singled out the lack of progress in the fight against corruption as a critical shortcoming. The IMF’s most recent tranche of $1 billion was disbursed in April after multiple delays, and the next tranche, which was due in the summer, has not yet been approved. Doubts about the Ukrainian government’s ability to sustain the program abound. At the same time, the Ukrainian Central Bank has remained without a leader since Valeria Hontareva stepped down in April.

The IMF as well as the World Bank have expressed concerns about the pension reform legislation that was approved in the Rada after more than 1,000 amendments were registered. The reform has been criticized by populist politicians and encountered strong legislative opposition, but was ultimately accepted by key political factions as a major requirement to unlock the next IMF tranche. It is yet to be seen whether the legislation will satisfy the IMF’s conditions. Populist posturing and preelection tensions in the fragile government coalitions, combined with the newfound ability to borrow in international credit markets, raise further concerns about the government’s commitment to reforms and fiscal discipline in the run-up to 2019.

In keeping with the overall mixed economic picture, the government’s progress on privatization has been patchy at best. There have been widespread allegations of corrupt practices by the well-connected that have stalled progress. Many potentially valuable assets that need to be privatized are in the energy sector and must be restructured before they can be sold off. Efforts to do so have encountered strong opposition from powerful interests that have long profited from corrupt practices in that sector.

Two cases illustrated the persistence of old business practices. Restructuring of the state-owned gas monopoly Naftogaz was jeopardized when two additional independent foreign members of its supervisory board resigned, blaming the government for failing to deliver corporate governance reform. The board members clashed with the government over Kyiv’s reluctance to hold to commitments (such as another gas price hike for the population), resistance within the company against unbundling, and broader allegations that “increasing political meddling had become the norm.”

In a second case, the budget airline Ryanair abandoned plans to expand its operations to Ukraine, blaming local vested interests. It was reported that the Ukrainian government had intervened on behalf of a group of powerful oligarchs who own Ukrainian International Airlines (UIA) and who did not want to face competition from a foreign rival.

Controversy also surrounded the way in which the former owners of Ukraine’s PrivatBank—billionaires Igor Kolomoisky, who also owns UIA, and Gennady Bogolyubov—missed the deadline at the end of June to restructure a massive related-party lending portfolio. Although the General Prosecutor’s Office opened a criminal case against them, the bank may need an additional $1.5 billion injection to stay afloat.

Overhaul of the Judiciary

Judicial reform has progressed, although it has also raised controversy. An unprecedented open competition was held to fill vacancies on the Supreme Court. The competition was fierce: out of more than 1,400 applicants who submitted their names for consideration, only 120 made it past the final selection panel and were approved as judges. In another first, civil society representatives were allowed to present evidence in the selection process and contest any candidate in the Public Integrity Council. However, the council raised concerns that one-quarter of the new judges have violated human rights, made politically motivated rulings, or cannot explain the sources of their income. The U.S. embassy tweeted, “A number of strong Supreme Court nominations, but integrity concerns of many nominees remain.”

Some progress was made in reforming the Constitutional Court. New legislation adopted in August introduced competitive selection of Constitutional Court judges and made it possible for individuals and companies to challenge the constitutionality of laws. However, the legislation was also criticized because of provisions that leave the court vulnerable to political pressure from the presidency and the Rada.

Business and Banking

Several positive steps have been taken to reduce administrative burdens on industry, and they should also help the all-important fight against corruption. New legislation is expected to reduce red tape in the construction industry.

In an important step toward greater transparency, the government has agreed to share data on the beneficial owners of Ukrainian legal entities with the new Global Beneficial Ownership Register, which was established in 2016 by worldwide anticorruption NGOs such as Transparency International and Global Witness.

In addition, several new laws are intended to harmonize Ukrainian business practice with EU regulations that protect the rights of minority shareholders, simplify procedures for bank restructuring, and provide small and medium-sized banks with new tools for consolidation.

Targeting Energy Efficiency

In June, three long-anticipated laws intended to improve efficiency in the energy sector were passed and an Energy Efficiency Fund was established. The legislation aims to reduce gas consumption in Ukraine by 25 percent in fifteen years. It authorizes the installation of meters in all buildings connected to external heat networks and the certification of buildings for energy efficiency. Residential buildings consume more than half of Ukraine’s gas, and around 60 percent of the energy consumed gets lost, which amounts to an annual loss of nearly $3 billion. The EU confirmed its support for this reform by pledging to contribute 100 million euros. Estimates of the overall cost of household efficiency measures are as high as $57 billion.

Healthcare: Two Steps Forward, One Step Back?

Ambitious plans for a complete overhaul of Ukraine’s healthcare system have continued to make progress but face opposition in the Rada. Ukraine’s parliament passed the initial healthcare reform bill in April. However, vital accompanying legislation to set up Ukraine’s national health service and establish new payment methods for healthcare has yet to be approved. The draft law creating the financing model for the new health system was passed in a first reading in June, but its further progress was slowed down by more than 800 further proposals and amendments submitted in parliament. This testifies to how many parliamentarians are opposed to changing from a system of state subsidies to one that gives more autonomy to healthcare facilities. Voting on this bill has been postponed until the fall. Similarly, a draft law making changes to the Budget Code—which defines, among other things, how spending responsibilities are divided between central and local government tiers—also passed in a first reading in June but failed to collect enough votes for a second reading. Further debate on it was also postponed.

At the same time, healthcare decentralization is making progress. Fifteen of Ukraine’s twenty-four regions, or oblasts, as well as the city of Kyiv have already approved the formation of new hospital districts, which will be a basis for providing secondary care.

Decentralization: Reaching the Point of No Return?

Decentralization reform, designed to greatly increase the responsibility and spending power of new local administrations, has continued apace. The first local elections are due to be held in the newly formed self-governing districts on October 29. By the end of August, 413 new communities had been formed by uniting towns and villages with one another. A further 203 are waiting for the first local elections to be held this fall to complete their amalgamation. By the end of 2017, over 600 communities will have completed their amalgamation out of the originally planned 1,500. The Ministry of Regional Development hopes that these communities will cover over 50 percent of Ukraine’s rural territory and constitute a symbolic point of no return.

According to the Ukrainian central government, the financial benefits of the reform are already evident. The government announced that it has provided 1.5 billion Ukranian hryvnia (UAH), or about $58 million, to amalgamated communities for infrastructure development; 3.5 billion UAH (about $136 million) for the State Regional Development Fund; and 4 billion UAH (about $155 million) for the Socio-Economic Development Fund. So far in 2017, the State Regional Development Fund has supported 767 projects worth 3.4 billion UAH (about $132 million), including repairs in schools, hospitals, and social care and sports infrastructure. However, the government has complained that the new infrastructure funding is not yet fully spent, as more than 14 billion UAH (about $543 million) remained in bank deposit accounts as of August 2017.

Decentralization reform remains an incomplete process as long as the Rada fails to pass the constitutional amendments needed to underpin it. This is due to the parliament’s reluctance to approve a special status for Donbas, which is also part of the administrative restructuring package. In that sense, a reform which is broadly welcomed is also being held hostage to the conflict in the east and Ukraine’s ongoing domestic political battles.