Introduction

            This paper analyzes the economic development prospects of two nations, Poland and Ukraine, that are currently trying to make the transition to modern market-based economic systems.  In tackling such an ambitious undertaking, this paper will focus on two essential and interrelated aspects of these nations' economic infrastructure: the structure of property rights and the commercial banking sector.  The first section discusses the importance of formal property rights for the formation of capital and the history of property rights in Poland and Ukraine.  This is followed by a description of the banking system within the command economy system and the initial steps that were taken in both countries to introduce a commercial banking sector.  Three critical areas need to be addressed to ensure a functioning banking system.  Each of these areas are discussed at length with regard to the initiatives undertaken, successes, and failures in Poland and Ukraine.  The conclusion focuses on the continued weakness of the commercial banking sectors in both countries but emphasizes the relative progress that has been made in Poland as compared to Ukraine.

            By virtually any measure, the economic performance of Poland has been far superior to that of Ukraine.  Table 1 shows the GDP growth rates in Poland and Ukraine while Table 2 gives inflation rates over the past decade.  The two countries have undergone very different paths since the move to market economies.  Poland's macroeconomic situation reflects the effects of the shock therapy that was implemented very early in the transition process.  Initially, it resulted in a serious contraction of the economy and very high inflation.  The policy eventually led to steady growth and declining inflation during the balance of the 1990s.  The transition period in Ukraine has been slow and painful.  Ukraine experienced significant declines in real output and income throughout the 1990s with positive economic growth only commencing in 2000.  This has been accompanied by extremely high inflation, reaching hyperinflation status in 1992 and 1993.  By 1997 Ukraine successfully reduced inflation to reasonable levels.

Ukraine and Poland are still considered to be transitional economies and have not yet reached high levels of income associated with highly developed countries, such as the United States.  By comparing GDP per capita, Table 3 indicates that Poland is on par with countries such as Mexico and Brazil in terms of income while Ukraine is closer to China.  While much will be made of the superior performance of Poland's economy, it should be remembered that both of these countries have considerable problems that must be addressed.  Both nations face many of the same problems.  It will be shown, however, that Poland has had much more success in addressing these issues than has Ukraine.

In his recent book The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, Hernando de Soto describes the problems of capital formation in developing countries and concludes that the underlying cause is the lack of formal property rights.  Though many individuals in developing countries own assets, the absence of formal property rights inhibits the ability to create capital from these assets, limiting potential economic growth.  A formal property rights system is necessary to unleash the economic potential of capital.  In the West, the desire to protect property ownership led to the formalization of property rights.  This was a long and difficult process with many conflicts and eventual resolutions.  It resulted in the hidden thousands of pieces of legislations, statutes, regulations, and institutions that govern the system (de Soto 2000, p. 48).  Without these "thousands of pieces", ownership is governed by no legally recognized set of rules and assets with economic potential are not described or organized.  In this case, the assets become "dead capital".   In the West, the primary source of capital for new businesses is a home mortgage.  Without a formal property rights system, the home is "dead capital".  The ability to use land as collateral assumes some degree of financial intermediation exists.  By examining the financial sector, with a focus on the commercial banking system, we can assess the progress (or lack thereof) in the creation of the "thousands of pieces" of institutional structures needed for creating a dynamic capitalist economy, one capable of creating capital from assets. 

Poland and Ukraine started with very similar banking systems before transition.  They both faced similar problems in moving to a commercial banking system based on financial intermediation and the efficient allocation of capital.  Their progress gives a clear picture of each nation's ability to create wealth.  While Poland had made considerable strides in this direction, Ukraine has lagged.  The institutional structures necessary for economic development currently are absent in Ukraine.  While Poland's progress to a healthy commercial banking sector has been stronger, considerable work remains.  However, this progress does indicate that underlying institutional and support structures are developing and hopefully, setting the stage for considerable economic growth in the future.  The future of Ukraine remains in doubt at this time, although there are some glimmers of hope.

Property Rights

            Poland and Ukraine have very different backgrounds when it comes to property rights.  Following World War II, Poland endured occupation by Nazi Germany and was controlled by the Soviet Union.   However, their property rights system remained in tact, except in Warsaw where all land was seized by the state.  Certain lands were seized (such as large estates) and redistributed to local peasants and land titles were granted to the new owners.  Despite title ownership, the use of property was no longer under the control of the owner (Strong, 1996).  Homes were registered and the state allocated living space to others based on the size of the house.  Owners were forced into becoming landlords or required to concentrate holdings into cooperatives.  Farmers had land titles but were placed into collective farms and production decisions were initiated by the state.  This disregard for private use of property and the dismantling of the institutional structure that had surrounded and protected private property rights continues to make Poland's transition to a market economy very difficult.  As de Soto hypothesizes, the past has left Poland with a void that ultimately has impeded capital formation.

            During the transition to a market based economy, Poland has begun to address issues relating to formal property rights, including privatizing state-owned enterprises and creating the legal and institutional framework necessary for a market system to operate.  This has been a difficult and slow process.  However, Poland does have an institutional memory and close ties to a system based on private property rights.  Unlike many other countries under Soviet control, Poland had more autonomy.  It was able to continue trade with the West, especially Western Europe, to bring in needed funds for operating the command economy.  Black markets were rampant and often tolerated.  Proximity to Western Europe encouraged entrepreneurs to smuggle goods into the country to satisfy consumer demands that were not being met by the industrial production focus of a command economy.  Poland certainly had some, albeit small, experience to draw on during the transition to a market economy (Strong, 1996).

            Ukraine, on the other hand, was part of Russia in 1919 when most agricultural land was seized through forced evacuations (Banaian, 1999).  After a brief period of German control during World War II, what is now Ukraine was again part of the Soviet Union.  In Ukraine, the communist government forbade any private ownership of land with the exception of small garden plots.  After the break up of the Soviet Union, the state began the process of reintroducing private property rights in Ukraine.  Between 1991 and 1995, state-owned land was transferred into collective enterprises that were owned by individual members, and land shares were introduced.  In 1993, the land share concept was created to move from collective ownership to private ownership of land.  A land share certificate was to be issued to 6.8 million members of the collectives, entitling the member with a share of land.  However, it took six years before issuing and of land titles occurred in any true sense.  By early 2002, only 2.4 million land share holders had received a title (35% of holders of land share certificates).  An additional 1.2 million titles were in various states of preparation (Korchakova, 2002).  Once these are processed, over 50% of land share certificate holders will have titles.

            While progress has been slow, a new land code took effect in January 2002 that is highly significant.  For the first time, legal entities, such as businesses, can own land; land was officially recognized as a commodity that can be purchased, sold or used as collateral.  Prior to 2002, individuals can own buildings but not the land under it.  It is hardly surprising that foreign direct investment in Ukraine has been virtually non-existent.  However, it is clearly understood in Ukraine that full implementation of the new Land Code will not be possible without the enactment of additional legislation and administrative actions at all levels (Wolfe, 2001).  While land titling has begun, there are still many restrictions on land in Ukraine.  Agricultural land holdings are limited to 100 hectares per person until January 2010; agricultural land can not be bought or sold until January 2005; no minority foreign ownership is possible for agricultural land; and only banks meeting Ukrainian government requirements (which require additional clarification) are allowed to use land as collateral.

            Ukraine obviously has made very slow progress in the move to private property.  And even Poland, where title ownership but not private use of land had existed, continues to face difficulties.  The issue of restitution has become a problem in Poland.  Since original owners of land and factories are still often alive (usually expatriates living in the United States or Israel), the question of who owns title to the land needs to be addressed.  Large estate owners whose land was confiscated may pursue restitution from current peasant owners who currently hold title to the land.   

The Commercial Banking Sector

            The commercial banking sectors in Poland and Ukraine emerged from the former communist system where there was a separation between the real flows and the monetary flows in the economy under central planning.  Financial payments were simply a by-product of the state-directed production allocations and were used by the government to allocate pensions and other spending programs financed by the state.  State-owned enterprises were required to keep accounts and clear business transactions at the branch of the monobank designated for their use.  As they were centrally administered, banks did not direct money flows or credit.  Lacking business skills, banks operated mainly as bureaucratic institutions.  The public perceived the banking sector simply as an arm of the state and part of the government bureaucracy.  The first task of reform was to create commercial banks out of the previous monobank system.                      

                        After the break up of the monobanks, Poland and Ukraine needed to address three critical areas.  First, a two-tiered system that divorces the central bank from making commercial credit decisions needs to be developed.  Second, the countries need to establish a clear legal and supervisory framework that regulates banking activities.  Third, each nation needs to find ways to deal with bad debts and ensure that banks are adequately capitalized (Dean, 1997/98).  In each of these respects, Poland was able to achieve some degree of progress while Ukraine is still lacking in all of these areas.  The splitting up of the monobank and creation of a central bank did not ensure a two-tiered system.  While this was essentially the case in Poland, it was not in Ukraine.

A Two-Tiered System

            Ukraine was in the midst a political power struggle between the President, Prime Minister and Parliament after its declaration of independence in 1991 until the passing of the Constitution in 1996.  During this period, the legislative framework for the government and governmental agencies was unclear, affecting the ability of the central banks to assert certain controls and undertake reforms.  The government and the central bank directed lending of the banks to specific key enterprises or sectors of the economy, causing a severe problem of non-performing loans that would need to be dealt with in the future.

            In Poland, the government and the NBP were motivated to privatize the regional banks in order to receive financial support from the Polish Bank Privatization Fund that was established by G7 donors and international financial institutions.  Privatization did proceed with two banks in 1993.  However, the privatization of the second bank (which was considerably larger than the first) resulted in a political backlash when share prices increased 13-fold on the first day of trading.  Many in the government opposed to privatization complained that the bank had been undersold, raising accusations of profiteering and ministerial negligence.  The finance minister was forced out of office and the reform process stalled under calls for increased consolidation of banks within the state sector before continuing further privatization effots(EIU, 1999).  Privatization did proceed in 1995 and 1996 with three more banks sold primarily through a mix of IPO and tender offers, but progress was again halted in 1996 when it was clear that the deadline for the external funds was not going to be met.  Again calls for consolidation arose with three of the state-owned banks merging into the Pekao group that by 1999 controlled a 20 percent share of total bank assets (Bonin, 1999).  This group was finally privatized in 1999.  The state-owned savings bank (PKO BP) and the group of rural cooperative banks have yet to be privatized and most commercial banking is still conducted by what were the nine regional banks.

            In both Poland and Ukraine, the government continued to influence the lending decisions of the commercial banks.  In the case of Ukraine, this interference was extreme with political entities controlling not only the banks but loans undertaken by the banks.  The government directly influenced banks by encouraging them to lend to enterprises they considered vital or that were politically connected by dangling the right to service government budget accounts, a big source of profit, and the right to handle subsidies to state-owned enterprises (Dean, 1997-98).  In Poland, there was still government interference with banks but on a much smaller scale.  Banks were not amassing considerable amounts of non-performing loans through negligent practices, but rather they inherited the debts when they were created.  Pressure to meet the European Unions (EU) conditions for entry, moved the government more steadily toward reform of the banking sector in every regard.

            Small private banks began springing up in both countries but with significant differences.  In Ukraine, a large number of small, undercapitalized banks emerged.  Loose regulations and extremely low capital equity requirements allowed for easy entry of new private banks. As early as 1991, there were 76 banks registered, peaking in 1995 at 230.  Since then, the number has dropped to 189 by 2001 (NBP, 2002) indicating a serious problem.  These banks are too small to operate efficiently and Ukraine still requires a large amount of consolidation to reform its banking sector.  Many of these banks were directly controlled or owned by the directors of the state-owned enterprises or newly privatized previously state-owned enterprises. Because ownership was established using assets of the enterprises as payments for equity, banks often lent to state-owned enterprises without any consideration of their ability to repay loans.  Lending to shareholders was considered to be good business.  As one private banker stated when queried about this practice "Why else would anyone set up a bank?"  (Sochan, 1998, p. 86)  As a consequence, bad debts accrued to their books, but these were well hidden and ignored.  It was not until the move to international accounting standards (IAS) in 1998 that the level of non-performing loans was known.

            In Poland, new private banks did emerge but to a much lesser extent.  In 1993, state-controlled banks accounted for 80.4% of total assets with private banks holding only a 13% share (of which 2.6% was foreign owned).  By 2001, the state-owned banks accounted for only 23.1% of total assets while private banks' holdings increased to 72.4% (of which 69.2% was majority foreign-owned).  Unlike Ukraine, Poland had significant investment of foreign equity in their private banks.  Foreign access to private banking in Poland was not always easy but the EU requirements pushed the government in this direction.  When foreign investors were encouraged, it was often to buy up troubled banks saddled with non-performing loans as a "cost to entry" into the Polish market.  The EU requires open access to financial markets and Poland is steadily making progress to gain entry into the EU.

A Clear Legal and Supervisory Framework

            Poland has made considerable progress towards the second criteria for a functioning financial sector while Ukraine has lagged far behind.  However, recent events have moved Ukraine forward in this area.  This aspect requires institutional restructuring of the banking system including changes to collateral and bankruptcy laws, regulations limiting bank credit risk, deposit insurance and bank supervision.  Poland's bank regulations have been significantly tightened during the transition period.  Minimum capital requirements are now at ECU 5 ml., which comply with the EU levels.  Capital adequacy regulations (CAR) were at 8% in 1993, and in 1999 were raised to 15% for the first year of a new bank, increasing to 12% thereafter.  Poland now ranks as one of the best in the region (EUI, 1999).  The 1998 European Bank for Reconstruction and Development (EBRD) index measures extensiveness and effectiveness of financial laws and regulations.  In this index, based on a top score of 4, Poland received 4 and 3 respectively and Ukraine ranked 2+ and 2 (EBRD, 1998).

             Inadequate supervision and regulation of the commercial banks in Ukraine contributed directly to the bad loan problem that commercial banks faced in the 1990s. Early in the transition, entry and capital requirements on new banks were very lax, leading to a massive increase in the number of banks (many of which will need to be liquidated).  Until 1993, the minimum capital requirements were approximately USD 500,000.  It was raised to a minimum of USD 500,000 for all banks by 1996.  Ukraine has not been successful at removing the weak and potentially insolvent banks that clog the system.  However, few of these banks actually conduct financial intermediation, and therefore, do not threaten the health of the entire commercial banking system.  In both nations, the industry is highly concentrated, with the vast majority of activity accounted for by a few large  banks. 

            Ukraine's new bankruptcy laws, based on U.S. laws, became effective January 1, 2000 and are considered to be a major improvement.  Under former law, it was virtually impossible for enterprises to restructure.  The new law allows viable enterprises to avoid liquidation, while making the rights of creditors clearer and improving the process of liquidation.  The communist faction in Parliament sponsored them as a potential way to restore employment in the industrial sector.  Between 1992 and 2000, the previous law had been used primarily to eliminate defunct enterprises from the state tax roles.  Massive liquidation of enterprises stripped of their assets was the norm.  It was imperative to be able to distinguish between enterprises that were "losses on paper" but still able to contribute to productive capabilities.  This law has been cited as one of the more effective bankruptcy laws in former Soviet Republics (Wolfe, 2002).  It is hoped that it will help revive an ailing industrial sector.

Resolution of Bad Debts

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