In the near future, it is necessary to switch part of the national economy to a military track.
Until the end of hostilities, the Ukrainian state will need serious external support to continue the fight against the aggressor and maintain sovereignty. But it is also obvious that, taking into account existing problems and risks, it is critically necessary to maximize the internal resources of the Ukrainian state.
A military economy is primarily an economy of government incentives and government demand. After all, market incentives are suppressed by security risks and no amount of profit will pay for lost lives or a production complex destroyed by a missile.
Therefore, the primary role in the military economy belongs to state policy. But while there should be no over-reliance on market forces and the private sector to remove bottlenecks in the war economy, it is necessary to involve them in the process.
To effectively involve the private sector in the military economy, the state must present a clear economic doctrine, including three blocks: access to markets, access to labor resources, and access to financing.
Access to sales markets should include the unimpeded functioning of logistics routes and product distribution channels (including international ones), the creation of duty-free trading conditions in the markets of partner countries, the adoption of clear plans for government procurement (including State Reserve operations), and the improvement of practices in the field of public procurement.
Access to labor resources should include government assistance in finding qualified workers (including among foreign migrants and Ukrainian refugees), programs for booking workers, attracting the unemployed to work, training and retraining of personnel, in particular manufacturing specialties.
Access to financing should include the resumption of the banking sector as an institution of financial intermediation, the expansion of programs of credit, guarantee and grant support from the state, the attraction of international assistance for the restoration and development of business, and the use of tax instruments to stimulate investment.
What did Ukraine do to transition the economy to a war footing?
Ensuring adequate funding for the Armed Forces of Ukraine. If in 2015–2021 the expenditures of the consolidated budget of Ukraine on the defense sector amounted to 2.5–3.0% of GDP, then in 2022 they increased to 23.9% of GDP, and in 2023 they are planned at 28.4% of GDP .
Attracting unprecedented volumes of military and economic assistance from external allies. During the period from February 2022 to August 2023, the allied states announced the provision of military, financial and humanitarian assistance in the amount of 237.9 billion euros (data from the Kiel Institute), of which 95 billion was military assistance (or the equivalent of 86% and 33 % of Ukraine's GDP for two years).
Revival of military production in Ukraine. According to the government, in 2023 the capacity of the domestic defense-industrial complex (DIC) increased four times compared to 2022, and in 2024 it will increase another six times. However, production volumes are still very far from the needs of the Ukrainian Armed Forces. The domestic defense industry is faced with problems such as the destruction of some 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 defense industry enterprises to restore damaged equipment, and the need to adapt equipment to the production of NATO weapons systems.
Targeted measures of government support for business. To support economic activity during the war and preserve jobs, the government introduced a number of government programs: grants for starting your own small business, loan programs “Affordable Loans 5-7-9” and government portfolio guarantees. In particular, during martial law, 41,607 preferential loans worth UAH 164 billion were issued under the “5–7–9” program.
The reduction in the tax burden in the first months of the war contributed to the preservation of many jobs, in particular in the field of small and medium-sized businesses. The range of subjects of the simplified taxation system was expanded, and preferential taxation of critical imports was introduced - fuel and military goods.
What hasn't been done
Unfortunately, during 21 months of a full-scale war, the military economy did 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 unused capacity and have been waiting for state orders for months. According to the Ministry of Defense, there are enough funds to contract and pay for only half of the products that domestic defense industry enterprises could potentially produce.
At the same time, gigantic volumes of free liquidity have accumulated in the banking system (more than UAH 700 billion), banks store over $10 billion in accounts in foreign banks, and about $117 billion are in non-bank circulation. These funds are almost not involved in the productive economic turnover of the country . These are examples of irrational use of existing resources and artificial restrictions on internal sources of raising funds for the budget. At the same time, 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 almost never lend to businesses outside of government programs. The total volume of business loans provided by banks is about 7% of GDP , which is the lowest in the world among emerging market countries. The high cost of bank loans (due to both credit risks and high discount rates) does not allow enterprises to use credit resources to renew and expand both civil and military production.
What should Ukraine do next?
The key task of the military economy is the most efficient mobilization of material, financial and human resources to produce the goods and services necessary to support the Armed Forces, as well as the proper functioning of civilian industries to support human life.
At the same time, it is important to include market elements in solving the problems of the military economy, which will allow achieving goals relatively quickly and with acceptable losses. The symbiosis of the state and the private sector in strengthening the domestic defense industry looks like the optimal solution today. But such a symbiosis does not deny the fact of the increasing role of the state in managing and controlling the use of different types of resources and should be based on the use of a set of economic and managerial levers, the dominant one being the state defense order.
- A multiple increase in the state defense order to cover manufacturers of state and private forms of ownership and the introduction of state targeted programs with a focus on the needs of the Armed Forces of Ukraine.
Loading defense industry enterprises with government orders would make it possible, to some extent, to satisfy the needs of the Armed Forces of Ukraine in equipment and weapons at the expense of internal resources. In addition, this would contribute to the revival of the national economy, the development of new businesses, and the generation of new income and tax revenues to the budget. It is important to place government orders at domestic facilities as much as possible.
Promising industry areas for placing defense orders: armored vehicles; precision weapons and ammunition; artillery, anti-tank and anti-ship weapons; aircraft manufacturing and aircraft repair; drones; radar; special instrument making. All these components should involve the creation of new types of weapons and military equipment of NATO standards.
- Implementation of large-scale government investments in the creation of new military production facilities.
The start of a full-scale war signaled a serious shortage or complete absence of production capacity for such types of weapons as air defense, missile defense, combat aviation, artillery, anti-tank and anti-ship weapons, missile technology and man-portable missile systems, production of cartridges and ammunition (including for NATO calibers ).
The challenge is also the creation of a material and technical base for servicing 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 industry enterprises should be integrated into Western chains for the creation of military products with high added value.
One of the forms of public investment is the development 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 production and activities within the national defense industry.
In terms of historical precedent, the US Federal Government during World War II annually invested in physical assets (mostly new plants and factories) the equivalent of $350 billion in today's dollars, or about 25% of GDP. At the same time, 97% of government investment spending was directed to the defense sector. The main source of financing such expenses were loans from American banks, emissions from the Federal Reserve, and savings from households and businesses. For comparison, capital expenditures of the Ukrainian government in 2023–2024 will amount to only 1.5–2.5% of GDP.
- Use of government incentives/state support funds for manufacturers of military products of all forms of ownership.
Large government orders and investments must be combined with a system of incentives and government support methods. That is, the state will, on the one hand, rely on the action of market mechanisms, and on the other, ensure that these mechanisms are adjusted in the direction it desires in order to allocate more resources to military production.
The inclusion of a large number of private producers in the circle of subjects of the national defense industry will make it possible to achieve set goals at lower costs compared to the situation of a production monopoly or oligopoly of large state-owned companies.
The need for government incentives is also due to the fact that during war the barriers to any private investment are extremely high due to security risks. There is usually no market profitability that would motivate a business to invest in a production that is at risk of being destroyed by war.
The system of government incentives should be aimed at re-equipping and expanding the production base of defense industry enterprises, using additional capacities created from scratch or through the conversion of civilian production into military production, and creating joint ventures with NATO countries. Some military production in Ukraine could take the form of a public-private partnership.
In the United States during World War II, private shipyards built warships, automobile manufacturers built bombers, and companies that had specialized in toys before the war made handgun parts.
- Restoration of the institution of financial intermediation, development of the financial sector.
Financing the needs of the defense industry requires the maximum attraction of national savings.
A significant portion of the economy's potentially productive savings is concentrated in the banking system. But their effective redistribution for development purposes and structural restructuring of the country’s economy is almost never happening.
Thus, the level of lending to the economy is constantly decreasing, despite large-scale government support programs. The government bond market does not provide enough hryvnia loans, since the government does not have the ability to increase the cost of loans, and banks have no incentive to buy government bonds if they can buy high-yielding NBU certificates of deposit. Almost the entire net increase in hryvnia government bonds in 2023 was formed by the purchase by banks of special benchmark government bonds at the expense of required reserves.
The use of credit and borrowing resources of the banking system could significantly both accelerate the development of the defense industry and improve business activity in the economy as a whole. To do this, it is necessary: to reduce the key interest rate to a level comparable to current inflation, to limit the investment of banks’ funds in NBU certificates of deposit, to introduce instruments for targeted preferential refinancing of banks implementing priority credit and investment projects (like the TLTRO of the European Central Bank), to postpone the implementation (resumption) of more strict requirements for financial regulation of banks' lending activities, in particular requirements for the reliability of the borrower and the quality of collateral.
The use of limited emission financing of the National Bank (through the issuance of targeted government bonds by the government) can also be considered as a potential source for the implementation of important public investment projects and a tool for unblocking the market for domestic government borrowings. A limited repurchase of government bonds by the National Bank on the primary/secondary market, in combination with a reduction in the interest rate, will revive the government bond market.
The emission channel in the Ukrainian media space was unjustifiably discredited. From world practice, there are numerous examples of the use of limited emission financing during war without significant negative consequences for the economy (USA 1941–1945, Israel 1967–1970, even Ukraine 2022 in this list). In the macroeconomic plane, there is not much difference between the credit resource of banks and the emission resource of the central bank. Both channels generate an additional flow of funds. In specific circumstances (for example, in conditions of a significant decline in demand and/or the availability of external financing), this flow does not generate excessive imbalances if carried out in limited quantities.
Measures to attract private investors to the development of a modern defense industry in Ukraine:
- creating legal instruments for the use of public-private partnerships and joint ventures in the field of national security and defense;
- expansion of the Law of Ukraine “On Industrial Parks” to support the development of military production;
- extending the insurance system against military-political risks in Ukraine to foreign direct investments and joint ventures in the defense industry sector;
- issuance of state guarantees and compensation of credit interest rates on loans raised for the production of weapons and technical equipment for the Armed Forces of Ukraine;
- provision of benefits on corporate income tax and land tax for new enterprises in the defense industry, which will be valid for 2–5 years from the date of opening of such enterprises;
- providing tax subsidies to defense industry enterprises for the amount of investment expenses and tax preferences for investment imports;
- restoration and development of logistics and infrastructure for the production activities of defense industry enterprises.
Important tasks for the near future also include:
- the launch of a state system of investment insurance against war risks , which will include funding provided by international donors ;
- assistance to businesses in solving problems of product sales , access to markets and transportation of manufactured products;
- investment in education and human capital with a focus on mitigating demographic problems and restoring Ukraine’s labor potential.
