Transition to a War Economy. Four Major Steps Ukraine Should Take

Putting part of the national economy on a war footing is a key task for the foreseeable future.

Until the end of hostilities, the Ukrainian state will need significant external support to continue the fight against the aggressor and preserve its own sovereignty. However, it is also obvious that in view of the existing problems and risks the maximization of internal resources at the disposal of the Ukrainian state is of critical necessity.

The wartime economy is primarily an economy of state incentives and state demand. After all, market incentives are suppressed by security risks, and no amount of profit will compensate for the lives or the industrial complex destroyed by a missile.

Therefore, the primary role in the war economy belongs to state policy. But, despite the fact that it is not worth relying excessively on market forces and the private sector to eliminate the bottlenecks of the wartime economy, it is necessary to involve them in the process.

For the private sector to be effectively engaged in the military economy, the state must present a clear economic doctrine, which must include three blocks: access to markets, access to labor resources and access to finance.

Access to markets should provide for the smooth functioning of logistical routes and sales channels for goods (including international ones), the creation of duty-free trade conditions on the markets of partner countries, the adoption of clear plans for state orders (including operations of the State Reserve) and the improvement of practices in the field of public procurement.

Access to labor resources should include government assistance in finding skilled workers (including among foreign migrants and Ukrainian refugees), employee reservation programs, attracting the unemployed to work, training and retraining of personnel, particularly those majoring in production-related specialties.

Access to finance should include the normalization of the work of the banking sector as an institution of financial intermediation, the expansion of credit, guarantee and grant support programs of the state, the attraction of international aid for business recovery and development and the use of tax instruments to stimulate investments.

 

What Ukraine has done for the transition of the economy to a war footing

Ensuring appropriate funding of the Armed Forces. Whereas in 2015–2021 the expenditures of the consolidated budget of Ukraine on the defense sector amounted to 2.5–3.0% of GDP, in 2022 they increased to 23.9% of GDP, and in 2023 they are planned at the level of 28.4% of GDP.

Attracting unprecedented amounts of military and economic aid from external allies. For the period from February 2022 to August 2023, the allied states announced the provision of military, financial and humanitarian aid in the amount of €237.9 billion (data from the Kiel Institute), of which €95 billion is military aid (or the equivalent of 86% and 33 % of GDP of Ukraine for two years).

Revival of the military industry in Ukraine. According to the government, in 2023 the capacity of the domestic military-industrial complex quadrupled compared to 2022, and in 2024 it will increase by another six times. However, production volumes are still a far cry from the needs of the Armed Forces. The domestic defense industry is faced with such problems as the destruction of part of the enterprises and their production lines, the outflow of labor due to forced emigration and mobilization, the incomplete readiness of the production and repair base of the defense industry enterprises to restore damaged equipment and the need to adapt the equipment to the production of weapons of NATO systems.

Targeted measures of state support for businesses. To support economic activity during the war and preserve jobs, the government has introduced a number of state programs, namely grants for starting your own small business, the “Affordable Credits 5-7-9” credit programs and state portfolio guarantees. In particular, during martial law, 41,607 preferential loans have been issued in the amount of UAH 164 billion within the framework of the “5–7–9” program.

Reduction of the tax burden in the first months of the war has contributed to the preservation of many jobs, especially in the field of small and medium-sized enterprises. The range of beneficiaries of the simplified taxation system was expanded, and the preferential taxation of critical imports — fuel and military goods — was introduced.

 

What is yet to be done

Unfortunately, 21 months into a full-scale war, the wartime economy has not become a key area of the country's economic life.

Dozens of enterprises of Ukroboronprom, the Ministry of Defense and the State Space Agency have significant idle capacity and have been waiting for months for a state order. According to the Ministry of Defense, there are enough funds to contract and pay for only half of the products that can potentially be produced by domestic defense industry enterprises.

At the same time, the banking system has accumulated huge amounts of free liquidity (over UAH 700 billion), banks keep more than $10 billion in accounts in foreign banks, and $117 billion is in non-bank circulation. These funds are hardly involved in the country's productive economic turnover. These are examples of irrational use of available resources and artificial limitation of internal sources of attracting funds to the budget. On the other hand, the state's net borrowing from banks for 11 months of 2023 amounted to only UAH 133 billion, or $3.6 billion, and from individuals — UAH 17.9 billion, or $0.5 billion.

Commercial banks barely lend money to businesses outside of government programs. The total volume of business loans provided by banks is about 7% of GDP, which is the lowest rate in the world among countries with emerging markets. The high cost of bank loans (due to both credit risks and a high interest rate) prevents enterprises from using credit resources to restore and expand both civilian and military production.

 

What Ukraine should do next

The key task of the military economy is the most effective mobilization of material, financial and human resources for the production of goods and services necessary to support the Armed Forces, as well as the proper functioning of civilian industries to support people's lives.

At the same time, it is important to include market elements in addressing the tasks of the war economy, which allows achieving the set goals relatively quickly and with acceptable losses. The symbiosis of the state and the private sector in the strengthening of the domestic defense industry seems to be the optimal solution today. Such symbiosis, however, does not deny the fact of increasing the role of the state in the management and control over the use of various types of resources and should be based on the use of a complex of economic and management levers, with the state defense order playing the dominant role.

 

1. Multiplication of the state defense order with the coverage of manufacturers of state and private forms of ownership and the implementation of targeted state programs focusing on the needs of the Armed Forces of Ukraine.

Loading defense industry enterprises with state orders would make it possible to meet the needs of the Armed Forces of the Armed Forces in equipment and weapons at the expense of internal resources to a certain extent. In addition, it would contribute to the revitalization of the national economy, the development of new businesses, the generation of new revenues and tax revenues for the budget. It is important to place government orders as much as possible on capacities within the country.

Promising sectoral areas of defense order placement: armored vehicles; high-precision weapons and ammunition; artillery, anti-tank and anti-ship weapons; aircraft construction and aircraft repair; drones; radar; special instrument construction. All these components should provide for the creation of new types of NATO-style weapons and military equipment.

 

2. Implementation of large-scale state investments in the creation of new military production facilities.

The beginning of a full-scale war signaled a serious shortage or complete absence of production capacity for such types of weapons as air defense, anti-missile defense, combat aviation, artillery, anti-tank and anti-ship weapons, missile technology and portable missile complexes, cartridge and ammunition production (including NATO calibers ).

The challenge is also the creation of a material and technical base for the maintenance of Western equipment on the territory of Ukraine, as well as the development of joint production of weapons according to NATO standards (including missile, anti-missile and anti-artillery systems). In the future, Ukrainian defense and military enterprises should be integrated into Western chains of military production with high added value.

One of the forms of state investment is the initiation by the state of leasing programs for the creation/expansion of production capacities of the defense industry. The leasing program should provide for the purchase and lease to state enterprises of production equipment for priority industries and types of activities within the national defense industry.

As for historical precedents, during World War II, the US Federal Government invested the equivalent of $350 billion in physical assets (mainly new plants and factories) every year at current prices, or about 25% of GDP. At the same time, 97% of the government's investment expenditures were directed to the defense sector. The main source of financing such expenses were loans from American banks, money issuance by the Fed, savings of the population and businesses. For comparison: capital expenditures of the government of Ukraine in 2023–2024 will amount to only 1.5–2.5% of GDP.

3. Application of state incentives/means of state support for manufacturers of military products of all forms of ownership.

Large government orders and investments must be combined with a system of incentives and methods of state support. In other words, the state, on the one hand, will rely on the operation of market mechanisms, and will, on the other hand, ensure the adjustment of these mechanisms in the desired direction in order to direct more resources to military production.

The inclusion of a large number of private manufacturers in the circle of entities of the national defense industry will make it possible to achieve the set goals with lower costs compared to the situation of a production monopoly or oligopoly of large state-owned companies.

The need to apply state incentives is also related to the fact that during war the barriers to any private investment are extremely high due to security risks. Usually, there is no such market profitability that would make it interesting for businesses to invest in production that can be destroyed by war.

The system of state incentives should be aimed at re-equipment and expansion of the production base of defense industry enterprises, the use of additional capacities created from scratch or through the conversion of civilian production into military production and the establishment of joint ventures with NATO countries. Part of military production in Ukraine could take the form of a public-private partnership.

During World War II, in the United States, private shipyards produced warships, automobile manufacturers built bombers and companies that specialized in toys before the war made parts for small arms.

4. Restoration of the institute of financial intermediation, development of the financial sector.

Financing the needs of the defense industry requires maximizing the attraction of national savings.

A significant share of the economy's potentially productive savings is concentrated in the banking system. However, the peculiar policy of tight monetary conditions does not provide an opportunity to effectively redistribute them for the purposes of the development and structural rebuilding of the country's economy.

The level of lending to the economy is constantly decreasing, despite large-scale state support programs. The government bond market remains effectively blocked, as the government is unable to raise the cost of loans, and banks have no incentive to purchase domestic government loan bonds when they have the opportunity to buy high-yield NBU certificates of deposit. Almost the entire net growth of hryvnia-denominated domestic government loan bonds in 2023 was formed by the purchase by banks of special benchmark government bonds at the expense of obligatory reserves (this mechanism was introduced in January 2023).

The use of credit and loan resources of the banking system, as well as limited targeted emission financing by the NBU, could significantly accelerate the development of the defense industry and improve business activity in the economy in general. To do this, it is necessary to: reduce the key interest rate to a level that corresponds to the current inflation, limit the investment of banks' funds in NBU certificates of deposit, introduce targeted preferential refinancing instruments for banks that implement priority credit and investment projects (such as the targeted longer-term refinancing operations (TLTRO) of the European Central Bank), postpone the introduction (restoration) of stricter requirements of the financial regulation of banks' lending activities, in particular requirements regarding the borrower's reliability and the quality of collateral assets.

The use of limited emission financing of the National Bank (through the government's issuance of targeted domestic government loan bonds) can also be considered as a potential source of implementing important state investment projects and a tool for unblocking the domestic state lending market. Limited repurchase of domestic government loan bonds by the National Bank on the primary/secondary market in combination with a reduced interest rate will enable the launch of the government bond market.

The money creation channel has been unjustifiably compromised in the Ukrainian media space. It is wrong to associate money emission with pure evil. As world practice shows, there are unique examples of the use of limited emission financing during the war without significant repercussions for the economy (US in 1941–1945, Israel in 1967–1970, even Ukraine in 2022 is on this list). In the macroeconomic plane, there is no great difference between the credit resource of banks and the emission resource of the central bank. Both channels form an additional flow of funds. In specific circumstances (for example, in conditions of a significant drop in demand and/or the availability of external financing), this flow does not generate excessive imbalances if carried out in limited volumes.

 

Measures to attract private investors to the development of a modern defense industry in Ukraine:

• creation of legal instruments for the use of the public-private partnership and joint enterprises in the domain of national security and defense;
• extension of the Law of Ukraine "On Industrial Parks" to supporting the development of military industries;
• extension of the application of the insurance system against military and political risks in Ukraine to foreign direct investments and joint ventures in the defense industry sector;
• issuance of state guarantees and compensation of loan interest rates for loans taken for producing weapons and technical means for the Armed Forces of Ukraine;
• provision of benefits from corporate income tax and land tax for new enterprises in the field of defense industry, which will be effective during 2–5 years from the moment of their opening;
• provision of tax subsidies to defense industry enterprises in the amount of investment costs and tax preferences for investment imports;
• reconstruction and development of logistics and infrastructure for the production activities of defense industry enterprises.

 

Important tasks for the near future are also to:

• launch of the state system of insurance of investments against military risks, which will include funding provided by international donors;
• help businesses solve problems of sales, access to markets and transportation of manufactured products;
• invest in education and human capital with a focus on mitigating demographic problems and restoring Ukraine's labor potential.

Read this article in russian and Ukrainian.