EVALUATION OF THE IMPLICIT SUBSIDIES PROVIDED TO THE METALLURGY SECTOR IN UKRAINE

Abstract
Ukrainian metal industry represents a huge complex that employs about one tenth of all industrial labor force and contributes about 20% to the national gross domestic product.. At the same time, with assets heavily worn out (58% on average in 1998) and little capital investments, metallurgy constantly performed bellows the industry average. Nevertheless, metallurgy is the largest exporter in the economy – almost half of export revenues originate from this sector. At the same time domestic sales of metallurgy constitute only about 30%, making it vulnerable to changes in external demand.In the former times metallurgy was considered as a strategic industry with the majority of enterprises not allowed to undergo privatization. The situation has changed since then – some of enterprises have changed the owners. Nevertheless, metallurgy is still among the largest Ukrainian producers and its new owners are among the most powerful groups of influence at the domestic arena. The importance of metallurgy to the domestic economy allows them to continue obtaining different kinds of ‘support’ from the state. The efforts of metallurgical lobbying groups can be seen at the different branches of the state powers. Two laws – ‘On the metal scrap’ and ‘On the experiment in metallurgy sector’ became the most prominent example of their work within the Parliament.The main goal of this research was to evaluate the impact of the state support in metallurgy as well as to discuss the necessity and the successfulness of it.We found that the amount of implicit subsidization of metallurgy in the course of the experiment ranges from 0.7% to 1.5% GDP, constitutes about 5% of the revenues of consolidated budget or about 20% of budgetary expenditures on social protection in 2000.

Given the magnitude of these figures one should question the success of the experiment and doubtful positive developments in employment and repayment of arrears of the branch. We have not found the evidence that the experiment made metallurgy more attractive to foreign investors and, thus, question its ability to stimulate any investments and, correspondingly, the whole idea of it.

General description of a situation in the country before the experiment

At the beginning of the new millennium Ukraine enjoyed the continuation of economic growth started in the fourth quarter of 1999, the eighth year since the country gained its independence as Soviet Union collapsed. In addition to growth (6%) in 2000, the Ukrainian economy managed to stabilize inflation at moderate level (28.1%) and bring balance of the Current Account out of red. Significant progress was achieved in decreasing the budget deficit (0.7% of GDP).

The evidence of successful development made it easier for the new prime – minister (appointed at the eve of 2000) to prove his way of conducting structural economic reforms before the president, elected for his last period in November 1999. The main efforts towards reformation of the economy, however, were concentrated on combating corruption and malpractice of the oligarchs and naturally led to tensions in political circles.

Majority in the parliament (elected in 1998) consisted of the coalition of oligarchic and non-communist, non-oligarchic parties, was created to fight against communists, which were the largest single party to win elections. Opposition (communists), by definition, disliked the market – oriented reforms of the cabinet. Liberal rightists who colluded with centrists against communists, on the other hand, could hardly adopt any pro-market changes in the laws without giving concessions for the sufferings, which were made by these changes to the oligarchic businesses. Adoption of every significant law was possible only after long discussions on the concessions. This, unsurprisingly, almost blocked the legislative process and created high demand for the individuals capable to write and present laws with the hidden impact on the economy.

Cabinet proved to be smart when managed to adopt budget laws, which did not contain many opportunities for the oligarchs. Centrists sometimes managed to prove before the rightists the usefulness of the anti-competitive changes.

Problem
Between May and July 1999 a parliament of Ukraine adopted series of changes to the laws aimed at the creation of the favorite business environment for the metallurgical industry in Ukraine. The official titles of the laws were as following:

  1. Law on metal scrap
  2. Law on the establishment of economic experiment in the metallurgical industry

The first was created a barrier to the exports of metal scrap (one of the main inputs for the metalwork) by setting additional administrative rules to regulate collection, keeping and transportation of the scrap to abroad.

The need for this law was highly motivated via massive media campaign around the criminal nature of that-time scrap collectors, which had transferred the exports revenues not back to the Ukrainian economy, but rather to some bank accounts in secrecy jurisdictions. The press and TV presented many episodes where people were steeling covers of utility pipelines or wires from the electric energy suppliers to cut into pieces and sell to the collector as a scrap. A campaign resulted in the strong negative public opinion towards scrap collectors and the law ‘On metal scrap’ was seen as the only way to correct their ‘immoral’ activities.

The second law has established special privileges (called ‘the economic experiment in metallurgical industry’) to some enterprises in the industry for the period starting July 1, 1999 and ending January 1, 2002. The major part of these privileges touched upon tax issues.

To be eligible to participate in the experiment, the metallurgical enterprise had to satisfy two of three requirements: a) produce not less than 2% of the goods of metallurgical industry; b) have the assets worn out at least by half; c) export not less than 8% of the goods it produces.

Although the official purpose of the law, as stated in the preamble, which was to drive the metallurgical industry out of crisis, the alternative evaluations of its successfulness prevail in the country.

  • As early as July 2000, Parliament of Ukraine supported highly the experiment and by Decision #1892-III (July 13, 2000) recommended to the Government to increase the number of metallurgical enterprises – participants of the experiment, as well as to involve into it the enterprises of the other branches of Ukrainian economy.
  • Later, The State Tax Administration (STA) of Ukraine doubted the merits of the experiment stating (December 11, 2000) that, “the amount of tax obligations, which was ‘forgiven’ to these enterprises at July 1999 was about 800 mn. UAH (or above 0.6% of GDP in 1999) and, based on the latter developments, the positive impact of the experiment was close to zero.” At the same time, some regional (oblast’) STA departments at their web sites expressed their support to the experiment based on the results of the studies they have not disclosed.
  • Finally, in its recent speech (July 2002) to “The II Meetings of Metallurgists and Miners”, President of Ukraine stated that a country has not seen the predicted results from the experiment.

Presidential speech has brought up a variety of interpretations at the top of powers. Industrial lobbyists declared that the speech was in favor of the experiment (see for example, statements from a ministry of industrial policy), while others agreed with the President. From informal sources we found that some of the biggest metal works in Ukraine expressed their dissatisfaction with the experiment, presumably due to a number of trade barriers erected by countries – importers of Ukrainian metal. It was them, who initiated a series of trade negotiations aimed at providing Ukrainian metallurgy with a status of ‘market-oriented branch’. This status should make metallurgical enterprises less vulnerable to the anti-dumping cases, because respective accusations and measures would have to be taken against the particular enterprises and not the branch at a whole. No countrywide professional discussion on the merits of the experiment has been initiated so far.

Research framework and experience of other countries

The two laws above perceive one goal – provision of subsidies to the enterprises of metallurgical industry. Since the first law resulted in lower prices for the inputs for metal production, its impact should be seen as a hidden subsidy. Similarly, though the second law has not entitled the enterprises to receive any support from the budget, but rather allowed them to pay less to the budget, it resulted also in a hidden subsidy.

Economic theory as well as previous researches in this sphere has shown little support to the use of subsidies to promote the economic development of the countries. We will confine ourselves here to the main messages of the previous works:

  • Export subsidies are prohibited by the WTO;
  • The successful cases of export subsidies (Korea and Brazil) turned out to be ones in which governments exercised discretion and selectivity, while the most uniform and non-discretionary cases (Kenya and Bolivia) were clear failures’
  • The lessons from the successful countries above are not clear and their application in the other countries might lead to the different results;
  • If the government seeks to stimulate investments and the objective is magnitude, not qualitative composition, the greatest investments effect will come from measures that increase demand, rather than from measures that increase internal funds.

Box 1. The experiment and demand stimulation In the case of the experiment, Ukrainian authorities intended to do just the opposite to the Kuh findings. Naturally, they had no direct instruments to increase demand for metallurgical products, especially foreign demand. The experiment, however, has worsened the situation by creating the conditions under which foreign groups of interests were able to motivate a need to limit metal imports from Ukraine. This motivation came in the various forms, first of all is antidumping investigations, preliminary and final prohibitive duties for exports from Ukraine.

Metallurgy and the need of the experiment for this sector

Metallurgy – a branch destined to service all the industry of former Soviet Union – constitutes a serious pain to policy makers in Ukraine.

Figure 1 Industrial production (ip), capital investments (inv) and energy consumption (ec) by metallurgy and industry on average, 1995-2001, index 1995=100.

 

Source: State Statistical Committee (SSC) of Ukraine

Despite the ‘almost completed’ privatization – 14% of branch’s output was produced by state owned enterprises in 1999, compared to 45% in 1995 and 93% in 1992 – metallurgical industry in Ukraine should be considered as slow reformer. With assets heavily worn out (up to 60% in average in 1998) and little capital investments, the industry was naturally characterized by old technologies and the inability to reduce energy consumption following the contraction of output.

At the same time, it produces about one fifth of industrial output, employs one tenth of industry’s employees and returns constantly bellow industry’s average.

Similarly to former times, when this branch was externally orientated, currently, metallurgy is heavily dependent on external demand, earning around 70% of revenues from exports in 1998. Given the ‘importance’ of the branch to the national economy of Ukraine, most of the enterprises were (and some still are) considered as ‘strategic’ and enlisted in the respective governmental decree.

Since location of metallurgical enterprises is resource oriented, the overwhelming majority of them were established in four southeastern regions of the country – Donets’k, Dnipropetrovs’k, Zoporizhzhia and Lugans’k. This natural pattern gave rise to the effective consolidation of their interests and subsequent formation of powerful lobbying groups within the parliament and government of Ukraine.

Box 2. Tax privileges provided by the law on the experiment

According to the law, enterprises were allowed not to pay:

a) Half of the payments to State Innovation Fund [Payments to SIF constitute 1% of the goods produced minus VAT and Excise tax].

b) All payments ‘for the building, reconstructing and maintaining roads’ [Payments to this ‘road’ fund constitute between 0.4% and 1.2% of the goods produced, irrespectively of the profit made and are counted as costs].

c) Payments for environmental pollution, which constitute more than 0.15% of total costs.

d) More than 30% of Enterprise Profit Tax [Current EPT rate constitute 30% of profit]

e) Subtract from profit funds up to 9% [15% during 2002] of the value of assets acquired before 1993 and directed into renovation and modernization of these assets. [This applies only to Groups 1 and 3 of assets].

f) All fines for the delayed payments to the budget accrued before July 1, 1999.

g) Half of the fines on delayed payments to the budget accrued between July 1, 1999 and January 1, 2002.

Given the poor state of the branch as well as intensified lobbying activities (especially when the major part of the enterprises were privatized), the parliament of Ukraine during May – July 1999 adopted two laws mentioned above aimed to support the branch.

A law entitled the Government of Ukraine to develop a list of enterprises to participate in the experiment and government in October 1, 1999 produced a list of participants.

According to our estimates, about one half of all enterprises in the metallurgical branch of Ukrainian industry were enlisted.[4]

Revenues of these enterprises, however, were about ninety percent of all revenues in the branch; the same situation was with exports (see Figure 2).

Given the importance of external market to metallurgy and the condition of export orientation for the participation in the experiment, as well as the absence of reliable statistics on the profits of metallurgical enterprises, to estimate implicit subsidy provided to the sector we use data on its exports.

Figure 2 Revenues and exports of the participants of the experiment vs. other enterprises in the branch, 1998-1999, (current UAH billion).

Source: State Statistical Committee (SSC) of Ukraine

As it was already mentioned, at the beginning of the experiment revenues and exports of the participating enterprises concluded about ninety percent of all revenues and exports of the sector (recall Figure 2).

As can be seen from Figure 3 more than 80% of all exported ferrous metals and their products are produced within three oblasts (Dnipropetrovsk, Donetsk and Zaporizhia). Exports consist primarily of ‘raw’ metals with products at higher stages of manufacturing taking only 10% to 20%.

Figure 3. Regional and Product structure of exports, 1997-2001, %

Source: State Statistical Committee

Some issues on the legal side

Before going into economic analysis of the enterprise behavior during the experiment, we highlight several judicial pitfalls of the law on the experiment, which should have limited the potential success of this tool for state intervention already at the stage of its design.

A. According to Article 1 of the law, the aim of the experiment is to ‘create the conditions for the enterprises of metallurgy of Ukraine that are necessary to increase output and budgetary receipts [payments to the budgets – Y.K.] by providing them with tax incentives.

B. According to Article 5, paragraph 3.2 “the profit tax rate for the enterprises [which participate in the experiment – Y.K.] is set at 30% of the active rate, and the difference in the earnings that appeared as a result of tax rate change has to be used to increase floating assets”[5]

As it is implied in (A) above, the aim of the experiment is to increase budget revenues. According to (A) this has to be accomplished by increasing output. It is assumed that increase in output will lead to the increase of profit and the increase of enterprise profit tax (EPT) base will compensate the decrease of corporate profit tax rate from 30% to 9%. There are several issues related to increasing of EPT base to be discussed (see Box 3).

On the other hand, as it is mentioned in (B) above, a law on the experiment states that the money, which comes as a result of the tax differentials, should be used as ‘floating assets’, that is for paying suppliers of inputs (except for factors of production: labor, capital, etc.) This part of the law, if followed strictly, would prevent metallurgical enterprises from using the money they have not paid as taxes for the modernization of assets and technologies (capital investments), education of labor or marketing researches. They would be prohibited from using the funds for things which lead to the decrease of production costs and, thus, gaining stable competitive advantage.[6] This formulation would not preclude enterprises from taking advantage of increased ‘floating assets’ to obtain some of their inputs more cheaply.

Box 3. Increase of EPT base. Some ex-post considerations of ex-ante claims and facts

A. Assuming constant average costs of production, as long as these costs are lower than price of output, increasing output should generate higher profits and, subsequently, higher EPT revenues. In this case alone, one should expect to increase output at least 3.33 times to generate EPT revenues at the same level as before the experiment. Given that metallurgy in 1999 produced about half of what it was producing near its peak in 1985 – 1990 *, which roughly corresponds to high depreciation of production capacities (58% on average in 1999), one should have concluded already in 1999 that metallurgy would be in no way able to increase output more than 1.5 times due to the lack of potential. The reality appeared to be harsher and output of metallurgy increased in 2000 only by 20.5% compared to 1999.

B. The other potential source of revenue increase is increase of prices. In 1999 it was difficult to foresee any beneficial trend in domestic prices given low demand – result of the general economic downturn – even the most optimistic forecasts predicted not less than 3% of GDP decline. External market could have been another source of revenue increase.** Despite unfavorable price movements in 1997-1998 and decreased export revenues, Ukraine continued to increase volume of exports (an indication of how lucrative is the external market for metal producers or how badly they need to increase volume of output) and growing external demand was an indication of potential price increase in the future. The increased foreign prices for metallurgical products in 2000 (by 16% compared to 1999) along with increased volume of exports (by 14%) resulted in the increased revenues from exports (by 32%). This was clearly below the threshold increase of enterprise revenues necessary for the budgetary revenues remain at the same level if the EPT rate were not changed.

C. Economy of scale in production – alternatively to A above – is another channel of revenue increase when decrease of costs per unit is associated with the increase of output. *** The concept, however, assumes, that everything that has been produced can be sold. Thus, the decrease of average costs and a) subsequent increase of profitability and, as a result, b) additional increase of EPT base and, may be, even c) increase of capital investments, could be possible if and only if the branch would be able to sell more. We do not see, however, the way the experiment could improve the ability of enterprises to sell, except that it allowed them to offer lower prices to the consumers. Unfortunately for Ukrainian metal exporters, other (especially domestic) producers painfully reacted to this “price competition” and, as one could imagine, initiated some anti-dumping investigations to limit or prevent the access to some markets.

D. If, as some experts claim, the real goal of experiment was to decrease the EPT rate, the aim of experiment had to be stated as “to correct the distortions imposed by high tax rate”, but not as “to increase budgetary revenues”. ****

E. The other claim in favor of experiment is that budgetary arrears of the linked sectors are related to the high tax rate in the metallurgy. For example, energy companies could not be paying their taxes because metallurgy was not paying for energy. However, this is clearly a case of state support of the linked sectors via the support of metallurgy sector. Besides the fact that we do not see any reason for the support of the linked sectors, it would be less costly for the state to provide subsidies directly to their final recipients.

* According to SSC of Ukraine, that year Ukrainian metallurgy produced 44.9 mn. ton of pig iron, 52.6 mn. ton of steel (55 mn. ton in 1985), 6.5 mn. ton (6.7 mn. ton in 1985) of steel pipes.

** 37% of metallurgical output was exported in 1998 and 53% – in 1999.

*** This concept helps to explain why Ukrainian metallurgists could want to and did increase output despite the decrease of prices in 1997-1998.

**** Imagine the situation where the enterprises for which EPT at 30% rate is unaffordable are not paying at all and the others pay in full, so the average revenues is at the level as if all the enterprises were paying based on EPT of 9%.

To complete the discussion, one should consider the reasons for the lack of ‘floating assets’. Economists specializing in transition mention different causes of the problem. While this is not a subject of our research, without presenting supportive arguments, we agree with the opinion that lack of ‘floating assets’ in Ukraine stems primarily from soft budget constraints and, possibly, from the undeveloped financial market. One should conclude that state intervention in this case was not the first best, and, possibly, not even the second best choice.

Some issues related to the law of scrap metal

The ‘Law on scrap metal’ started to regulate the activity of collection and exports of scrap metal in May 1999. As can be seen from Figure 4, law on metal scrap had a limited success. Scrap exports increased by 40%on average in the last two quarters of 1999 compared to 1998, and by 10% on average in 2000 (compared to 1999).

Figure 4 Exports of scrap metal by Ukraine in 1997-2001, mn.ton.

Source: SSC of Ukraine.

That was probably the reason why the law has been substantially revised and augmented in November 2000. Currently we do not have enough information to comment on the importance of changes adopted in 2000. The main consumers of Ukrainian metal scrap remain Turkey (more than 55%), Italy (9%), Korea and Moldova (each about 8%). It is noteworthy that Cyprus was the second largest trader of Ukrainian scrap metal.[7] Latvia, Switzerland, Liechtenstein and Virgin Islands (British) are ranked as 5th and 7th  – 10th largest traders. The companies from above countries serviced above a third of Ukrainian metal scrap exports in 1997-2000, while Ukrainian exports to those countries was less than 1% of total metal scrap exports. It is not difficult to envisage that broad use of ‘off-shore’ intermediaries, presumably for profit concealing along with VAT refund to exporters, should have had a negative net impact on Ukrainian budget.

From the above one might conclude that the law on scrap metal has had an insignificant effect on the steel makers in Ukraine, as exports of scrap metal were not effectively prohibited. Moreover, given the budgetary losses on this type of export operation, one should claim that the law did not reach its goal – ‘effective regulation of the relations between agents [presumably collectors, exporters, domestic consumer and state] during their operations with strategically important and energy saving raw material for the domestic producer.

Foreign Direct Investments
We confine our analysis to the determination of the impact the experiment has made on foreign direct investments, employment and repayment of arrears. Examination of these areas along with estimates of the scope of implicit subsidization provided by the experiment, will allow us to draw conclusions on its costs and successfulness.7.1. Foreign Direct InvestmentsUnder the conditions of highly worn out production capacities, the final goal of the experiment – to increase production and tax receipts – could only be attained by investments and modernization of production.  As it was already mentioned, the law on the experiment contained some legal provisions that precluded the use of extra profit to finance investments. Since we do not have data to evaluate the level of investments made by other domestic parties, we will proceed with evaluation of foreign investments.

Figure 5. Dynamics of FDI in Ukraine by industry of destination in 1997-2001, USD millions

Source: SSC  of Ukraine

At the end of 2001 the metallurgical industry of Ukraine was only the eleventh largest recipient of FDI. Contrary to usual expectations (when foreign investors come to the country attracted by favorable conditions), only minor investments into metallurgy were made after the participants of the experiment were defined. Unlike in other industries of Ukrainian economy, growth of 2000 was not among the major factors to attract foreign investors to metallurgy. In our opinion, the experiment not only has provided weak stimulus to FDI into the sector, but also created a prohibitive barrier for those willing to invest into Ukrainian metallurgy. While supporting some enterprises, the state has further dampened the competition in metallurgy by putting the rest of the branch in the conditions even worse than before. Those who invested happen to be powerful enough to keep the risk under control.[8] Those who had no insider influence, decided to stay aside.

Support for this hypothesis comes from the fact that about 90% of FDI into the sector came from so-called ‘offshore’ zones and were financed, most probably, from the capital outsourced from Ukraine in the previous years. While appreciating the fact that any investments are better than no investments, we should stress here that importance of FDI for the country lies not only in the amount of capital invested, but also in the managerial skills, technological innovations, and business culture brought along with. Taking into account lack of competition in metallurgy and the origin of FDI, one should doubt the ‘quality’ of the above-mentioned inflows. Moreover, unequal local distribution of these investments should point to the regions where investors have special ties to the local authorities.

Considering the above nature of foreign investments attracted by the metallurgical sector of Ukraine three other reasons for low FDI inflows after 1999 are possible.  First, investments into these ‘less-competitive’ industries practically stopped after 1999 as a result of hard budget constraints imposed by the government of Yuschenko. Second, metallurgical sector remains totally controlled by domestic groups, which extract rent from it. It is possible to relate, at least theoretically, those who invested into metallurgy in 1998 and 1999 to those who lobbied for the experiment. In this case, the search for the benefits for the national economy becomes no longer a simple exercise. The third reason for the sudden drop of FDI in 2000 and 2001 lies in a decrease of world demand and, as a result, effective barriers to Ukrainian iron and steel exports built by USA and Russia made further investments into the sector inconceivable.

Figure 6. Geographical origin of the FDI into metallurgy, 1998-2001, stock, USD million.

Source: SSC of Ukraine

Figure 7. B. Geographical destination of the FDI into metallurgy, 1998-2001, stock, USD  million

Source: SSC of Ukraine

Whatever the true weights of the above reasons might be, the dynamics of FDI during the experiment serve as a clear indication of small potential value of metallurgy to both foreign and domestic investors. Therefore, the provision of additional tax exemptions to the sector should not be regarded as a measure that ensures upgrading and modernization of its production capacities. In this respect, the experiment clearly failed to fulfill its goal – increase investments into domestic metallurgy.

Employment
Ferrous metallurgy traditionally employed around one tenth of all industrial workers in Ukraine. Even in the pre-the experiment period, the balance of inflows/outflows in metallurgy was better than in industry on average.  During the experiment year of 2000 the situation improved significantly. Metallurgy managed to decrease amount of wasted working time more than industry on average (15% vs. 7% decrease of ‘administrative vacations’ and 25% vs. 15% for those working not on full time schedule). Based on that one might conclude that the experiment significantly boosted progress in labor related issues.Despite the fact that productivity in ferrous metallurgy remained about 82% higher than productivity in industry in 2000, this difference decreased by 10 percentage points over the period 1997 – 2000.

Source: SSC of Ukraine

As can be seen from Figure 9, both industry and the metallurgical sector were gaining their competitiveness from the workers during 1998 and 1999. During that period productivity was increasing faster than real wages. In the year of 2000, which roughly corresponds to a beginning of the experiment, the pattern for metallurgy has changed.[9] While we acknowledge the increase of real wage in the sector, one should look for the sources of such increase. One of them is in the implicit subsidies provided through the experiment.

Figure 9. Real wage and productivity in Industry and Ferrous metallurgy, % ch. over perdiod.

Source: SSC of Ukraine; own calculations.

Arrears
According to the law on the experiment, for the participating enterprises all fines on budgetary arrears were cancelled as on July 1, 1999. In addition, during the experiment these enterprises paid only half of fines on the budgetary arrears. On the other hand, in order not to be excluded from the experiment, enterprises were required to avoid budgetary and other arrears. Given the dominance of the participants in the sector, we believe that sectored data is a good approximation of the situation. Figure 10 shows that creditor arrears were slowly decreasing over time. This was mainly due to the reduction in arrears for goods and services (including repayment of bad arrears) and pre-payments (avans) arrears. Nevertheless, arrears for the goods and services consumed in the past remain a major part of creditor arrears.Figure 10. Arrear in metallurgy sector and their main components, 2000-2001, UAH billions.

Source: SSC of Ukraine. Note: graph on the left in averages over the year

Along with the reduction of creditor arrears, ferrous metallurgy was constantly accruing debtor arrears. Despite the fact that debtor arrears are usually regarded in a positive manner, one should be cautious when adopting this rule to the case of metallurgy. During 2000 – 2001 this sector managed to accrue about 2 UAH billion of debtor arrears, over half of which became bad debts.

Figure 11. Arrear in metallurgy sector: structural changes between 2/2000 and 9/2001, UAH billions

Source: SSC of Ukraine

While being at the beginning of 2000 a net debtor (with creditor arrears higher by 6.7 UAH billion than debtor arrears), metallurgy reduced its net indebtness over 2000 – 2001 by 2.9 UAH billion. Despite these positive developments metallurgy remains a net debtor with its current obligations higher by 2.2 UAH billion than its current claims (as of September 2001).

Given that differences between total obligations and claims is 3.8 UAH billion (as of September 2001), one should admit that with that the pace of the reforms in the sector (even if the reduction of indebtness was entirely due to the experiment), it will take another two years for the sector to cross the red line. This, naturally, requires an assumption that all the conditions, including foreign demand, remain as favorable as they were during the first years of the experiment.

Another unresolved problem with the experiment lies in the VAT refund due to Ukrainian exporters of iron and steel. As can be seen from Figure 11, metallurgy became a net creditor of the government with total amount to be paid to metal exporters from the budget reaching 600 UAH millions by the end of September 2001.

To conclude: the experiment has resulted in the decrease of net indebtness of metallurgy.  This reduction, however, was too small to get out of red. Rough estimates suggest that it would take another two years to reach the balance assuming continuation of favorable external conditions. Unfortunately, even if this took place, the amounts of VAT to be paid to the exporters would, most probably, be a serious problem for the budget.

Estimation of implicit subsidy provided through the experiment
The subsidy provided to Ukrainian metal producers cannot be measured directly, as it has neither ever been recorded, nor ever could be. Because of the implicit nature of the subsidy, we will have to use indirect methods of estimation. Roughly speaking, we have to estimate changes between the states of nature before and during the experiment. These states of nature are believed to be influenced by the factors, which in turn, are influenced by the behavior of agents involved into the experiment. The task is complicated by the fact that not only the factors influenced by the experiment caused the changes in the states of nature, but also other factors most of which can not be even measured properly. Therefore, we will have to make a set of assumptions, whose quality, among other things, will determine the precision of our estimates. To minimize error, we will use two different approaches to evaluation of the subsidy and then compare the results.The first approach was based on the derivation of the value of the subsidy from an econometric model of demand and supply for metallurgical products in USA. The details on the model specification as well as data are presented in Appendix  I.According to our estimates, the growth of export during the period of the experiment is equivalent to the one that could result from the subsidy of about 5% to 30% of metal export for the market of USA. If one can generalize on overall influence of the experiment taking into account a share of US market in total exports of Ukrainian ferrous metals (7.7%), a subsidy would be in the range of 1.3 to 7.8 UAH billion, with average amount of 4.6 UAH billion a year.[10]

This amounts to 0.7% to 1.5% GDP or about 2.5% to 5% of the revenues of consolidated budget or 10% to 20% of budgetary expenditures on social protection in 2000. Through the experiment the state subsidized from 3% to 6% of metallurgical output.

Our second approach is based on the analysis of arrears (see previous section). This approach utilizes an assumption that entire/some amount of the reduction in arrears was given to metallurgy as a subsidy from the state. The logic of arguments is simple – enterprises pay back the arrears not sooner than they earn ‘enough’ revenues for doing so. Similarly to the first approach, we assume that state subsidizes the whole amount of ‘extra’ output and, correspondingly, ‘extra’ revenues. Given that metallurgy reduced its total net indebtness by 1.4 UAH billion over 2000, we believe that it was the state that carried the burden of payments. This roughly corresponds to the scope of implicit subsidies obtained by econometric estimates.

Conclusions

The research has revealed several issues to keep in mind while evaluating budget projects like ‘the experiment in metallurgical sector of Ukraine’.

Theoretical considerations and prior experience
The successful cases of export subsidies (Korea and Brazil) turned out to be ones in which the governments exercised discretion and selectivity, while the most uniform and non-discretionary cases (Kenya and Bolivia) were clear failures. The lessons from the successful countries above are not clear and their application in the other countries might lead to the different results.

Moreover, the previous studies have shown that if the government seeks to stimulate investments the greatest effect will come from measures that increase demand, rather than from measures that increase internal funds.

Export subsidies are prohibited by the WTO and a country seeking a membership in this club cannot use them whatever the reason or expected result is.

Legal issues and implementation
The law on the experiment was poorly developed and contained provisions, which prevented metallurgical enterprises from using the money they have not paid as taxes for the modernization of assets and technologies (capital investments), education of labor, marketing researches, that is for gaining a stable competitive advantage. The law on scrap metal, on the other hand, has had an insignificant effect on the steel makers in Ukraine, as exports of scrap metal was not effectively prohibited.

Foreign Direct Investments
The dynamics of FDI during the experiment served as a clear indication of the small potential value of metallurgy to both foreign and domestic investors. Therefore, the provision of additional tax exemptions to the sector should not be regarded as a measure that ensures upgrading and modernization of its production capacities. In this respect, the experiment clearly failed to fulfill its goal – investments into domestic metallurgy sector.

Arrears
The experiment has resulted in the decrease of net indebtness of metallurgy.  This reduction, however, has not led the sector out of red. Rough estimates suggest that it will take another two years to reach the balance assuming continuation of favorable external conditions. Unfortunately, even if this took place, the amounts of VAT to be paid to the exporters would, most probably, be a serious problem to the budget.

Labor
Based on the analysis of employment we conclude that the experiment significantly boosted employment. The dynamics of productivity differentials between industry on average and metallurgy does not allow for making robust conclusion in favor of the experiment. While we acknowledge the increase of real wage in the sector, that might have taken place due to the influences other than the experiment-related factors.

Scope of Subsidization
Econometric analysis proved the evidence of hidden subsidy to the metal producers and exporters in Ukraine. Analysis has shown that the growth of export during the period of the experiment is equivalent to the one that could result from the subsidy of about 5% to 30% of metal export for the market of USA. We tend to downsize that corridor to 5%-10% due to our vision of the developments as well as the expert advice. Nevertheless, the scope of implicit subsidization of metallurgy in the course of the experiment amounted to 0.7% to 1.5% GDP or to about 5% of the revenues of consolidated budget or to 20% of budgetary expenditures on social protection in 2000.

General
The experiment has shown no or negligible positive impact in the most of analyzed spheres. It has little theoretical justification as well as poor implementation even at the stage of normative document. The experiment caused a number of anti-dumping claims and measures by trade partners important for Ukraine.

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