Counteroffensive budget. Rada approves extra $14.5 billion for defense — where will it come from?

This week, the Verkhovna Rada adopted amendments to the state budget as a whole — defense spending is increased by more than half a trillion hryvnias. The law will come into force after being signed by the President.

Last week, Prime Minister Denys Shmyhal had already announced a 20% increase in public spending. The Cabinet of Ministers desperately needs additional funds for defense, primarily for the military. There is no doubt that this legal act will go through all the bureaucratic procedures at full throttle.

Given that Ukraine's GDP has shrunk by 30%, it will be difficult, but not impossible, to find additional UAH 537 billion ($14.5 billion) for the army. LIGA.net studied how the government is going to solve this problem, and what will be the consequences for the economy and taxpayers.

Funds for six months of war

According to the calculations of MP Roksolana Pidlasa, the head of the Verkhovna Rada Budget Committee, UAH 518.2 billion ($14.1 billion) will be allocated to the security and defense sector. This is mainly an increase in the total amount of salaries for the personnel of the Armed Forces (UAH 366.5 billion or $10 billion), the National Guard (UAH 49.9 billion or $1.4 billion), the State Border Guard Service (UAH 25.5 billion or $0.7 billion), the Security Service (UAH 9.3 billion or $0.25 billion) and the Defense Intelligence of Ukraine (UAH 4.6 billion or $0.13 billion).

An additional UAH 19 billion ($0.52 billion) will be spent to replenish the State Budget Reserve Fund, which is used for unforeseen and urgent measures. Pidlasa points out that this year the reserve fund was used to build fortifications. The same fund is also used to make payments to the families of fallen soldiers.

A significant increase in the cost of paying the military does not mean that their salaries will increase. So what is the reason for revising the state budget, why didn't the government budget for the planned expenditures earlier? There are two main reasons.

First, the number of military personnel continues to increase. In particular, eight new brigades are planned to be formed as part of the Offensive Guard project. In addition, it is impossible to predict the development of events at the front, to make a comprehensive estimate of the construction of the necessary engineering structures, logistics costs, etc.

Second, and most importantly, defense and security spending for the entire year of 2023 is planned to be about the same as what was spent in the last six months of last year.

For the Ukrainian economy, UAH 537 billion ($14.6 billion) is an astronomical amount of money (almost half of all state budget revenues). After the changes to the state budget come into effect, the picture will be as follows. Annual state budget revenues will amount to UAH 1.3 trillion ($35.4 billion), and annual expenditures will exceed UAH 3 trillion ($81.7 billion). The difference will be compensated mainly by international financial assistance and domestic government bonds.

This is the economic reality of the hot phase of the war. Last year, support from foreign taxpayers ranged from $3-5 billion per month. This year, according to Oleksandr Parashchiy, head of research at Concorde Capital, "it makes sense for the government to aim for $50 billion in foreign aid". But the problem is that this support is not guaranteed (currently, the confirmed funding stands at about $28 billion).

IMF assistance

Roksolana Pidlasa, commenting on the draft law, generally outlined a map of the "treasure island" where the government will look for additional UAH 537 billion ($14.5 billion).

The lion's share of the additional costs will be covered by "external and internal borrowing" – UAH 419.3 billion ($11.3 billion). This will automatically increase the state budget deficit to UAH 1.7 trillion (about $40 billion). As already noted, confirmed funding from the allies so far amounts to only $28 billion.

Recently, another round of negotiations on a new IMF economic program for Ukraine came to an end. The program will provide $15 billion in support over four years. According to the IMF Resident Representative in Ukraine Vahram Stepanyan, "very significant progress" was made during the negotiations.

A barrier to providing assistance could have been the IMF's rules that do not allow non-emergency loans to countries facing "great uncertainty" as a result of war or natural disasters. However, this obstacle has been overcome.

The Fund has announced changes to its Financing Assurances Policy. The updated rules will pave the way for loans that allow official bilateral creditors and donors to provide advance guarantees of debt repayment and cancellation. However, it is too early to say what kind of IMF financing will be provided this year.

Quest on the treasure island

So far, the government considers domestic borrowing rather than external borrowing to be the main source of funds. According to the explanatory note to the government's draft law, external debt obligations will amount to UAH 180.6 billion ($4.9 bilion), and domestic debt obligations will amount to UAH 271.3 billion ($7.3 billion).

CASE Ukraine's Executive Director Dmytro Boyarchuk told LIGA.net that it will be difficult to raise UAH 271.3 billion ($7.3 billion) on the domestic market using classic mechanisms. But much depends on the interpretation of the concept of "domestic borrowing".

One of the connotations of the phrase "domestic borrowing" is the scheme of issuing the national currency. Can the NBU buy back domestic government bonds using a printing press? To put it as simply as possible: in the absence of sufficient foreign support and other "normal" sources, the regulator has the ability to print the required amount.

Dmytro Boyarchuk notes that expert forecasts are now lower than even the central bank's forecasts: 16% versus 18%. The expert recalls that representatives of the Ministry of Finance and the NBU declare their desire not to ramp up the issue of hryvnia.

Ukraine today is highly dependent on external support, says the executive director of CASE Ukraine. The fall in exports due to the war has led to a trade deficit. But at the same time, international aid is covering this deficit, thanks to large injections of foreign currency.

The expert does not rule out that the set of sources declared in the explanations to the bill is a kind of plan A. It is possible that the Cabinet of Ministers also has plans B and C. "It is quite possible that there are already certain agreements with international partners that have not yet been made public," the expert concludes.

The next source is taxes. The Verkhovna Rada Committee on Budgetary Affairs hopes that tax revenues will increase by UAH 60.7 billion ($1.6 billion) compared to last year. The increase in payments to the military alone will lead to an increase in personal income tax revenues of UAH 36.5 billion ($0.99 billion).

There will also be an increase in dividends (income) accrued on shares of companies with state ownership in their authorized capital.

At the end of January, the Cabinet of Ministers registered draft law No. 8401, which terminates the preferential tax mode. In particular, the 2% rate for the third group of single tax payers will be scrapped. The moratorium on inspections will end. VAT revenues should also increase to UAH 5.2 billion ($141 million). The preferences will expire on July 1, 2023.

In addition, the Budget Committee expects an increase in profits of state-owned banks (UAH 19 billion or $514 million), plans to save on public debt servicing (UAH 50.3 billion or $1.36 billion), and takes into account the partial curtailment of state guarantee programs (about UAH 7 billion or $189 million).

The government also has a fiscal weapon named Getmantsev. Danil Getmantsev, chairman of the Parliamentary Finance Committee, has high hopes for exposing tax and customs schemes. Today, the temporary investigative commission of the Verkhovna Rada is working on several large cases.

These are cases related to the banking sector, procurement from Naftogaz, black grain exports, gambling, ammonia sales, etc. "We cannot yet estimate the losses from these schemes, but they are in the billions. We do not deal with anything less than billions," says Danil Getmantsev.

Back to reality

It is still difficult to talk about specific negative consequences for the economy. We are looking at risks rather than consequences: inflation, gradual tightening of the tax authorities, and administrative interference by the regulator in the activities of banks.

All the experts we interviewed are unanimous: the macroeconomic situation is difficult, but not catastrophic. Last year, the Ukrainian economy withstood a huge crash test with dignity. It will pass the current tests this year as well. Banks are working, farmers are exporting their products despite numerous difficulties, and large cities continue to live their lives. This will continue to be the case in the future.

Last summer, CASE Ukraine banking expert and former head of the NBU's Macroprudential Policy Department Yevhen Dubohryz compared the Ukrainian banking system to the Armed Forces: "We not only survived, but we are winning: the electronic payment system is working, liquidity is growing, and there is an increase in household funds." The picture is similar in other areas.

There have been no dramatic changes since then. Today, when asked whether the increase in budget expenditures by UAH 537 billion ($14.5 billion) will not be a devastating blow to the economy, Yevhen Dubohryz answers:

In other words, it is getting rid of illusions. For example, that the war is about to end, that tax holidays will last forever, that international aid is unlimited.

By and large, getting rid of illusions is a good thing. The fewer of them there are, the more adequate and effective the decisions of both officials and taxpayers will be. The fewer illusions, the closer the victory.