For decades, like a spoilt child, Ukraine has relied on unlimited and very cheap gas from Russia. As a result, says Kamen Zahariev, head of the EBRD's Ukraine office, “Ukraine was probably the least energy efficient country in the world”.

The economy, as a result, was literally spoilt. It relied and still relies on enormous steel and chemical enterprises that were bureaucratic, unwieldy, beholden to politicians, and built on the premise of cheap gas.

Those enterprises continue to dominate the Ukrainian economy, accounting for around 40% of GDP. And they are highly inefficient, still using Soviet-era technology, which there was no incentive to upgrade while gas remained so cheap. Ukrainian steel mills, for example, are among the last in the world to use open hearth furnaces, while the rest of the world is using oxygen converters. Ukrainian people were also extremely profligate in their use of gas. Housing utilities tariffs have not gone up for five years, and gas was cheaper here than it is in Russia.

That was the luxury of being part of the Soviet or post-Soviet space. The drawback was lack of control over one's own political destiny, a distorted and very politicized economy, and an inability to question the government or those businessmen connected to it. Cheap gas in exchange for civil and economic rights, was the bargain offered by the Kremlin.

Now, like a teenager who wants some space from his parents and has abruptly been cut off from his trust fund, Ukraine is facing up to the price of freedom.

The gas hikes are already taking their toll. Analysts predict Ukrainian GDP will lose around two points this year, because of lower profits from steel and chemical companies. A few chemical companies could be forced into bankruptcy. The government is also in the red, with a budget deficit of around $2 billion. This week, Naftogaz Ukraine, the state gas company, announced its making a loss of $500 million a year. It was downgraded by Fitch, causing a drop in Ukrainian bond prices. And as of May 1, ordinary Ukrainians are feeling it too - gas prices for housing utilities went up 25%, and could easily go up more this year.

But Ukrainians recognize there is no going back, and they are learning to accept the cold realities of an independent existence. In fact, higher gas prices are actually pushing profound restructuring in the economy, which could ultimately help Ukraine's emergence as a healthy democracy.

First of all, Ukrainian industry is becoming more energy efficient. Chemicals and steel factories are switching to local forms of energy, like coal or hydroelectricity. They are also finally investing in new technologies to make themselves more efficient. Municipalities, which are among the worst wasters of energy in the country, are also upgrading their technology, in areas like water treatment and heating. Foreign multilaterals are helping them - the EBRD has put around $100 million into various projects, and the World Bank is talking about setting up a $300 million fund for a similar purpose.

But the fact is that the steel and chemicals sectors are going to be less profitable in the future, particularly as China becomes a net steel exporter in the next few years. That's driving a shift in the economy towards SMEs. Nikolai Oudovichenko, deputy chairman of Ukreximbank, says: The future of Ukraine lies in more of the GDP being produced by SMEs. They are more flexible, less energy dependent, more sophisticated." Interesting SMEs are growing in printing, in automobile parts, in textiles, in recreation and tourism. The tourism sector in particular is growing - the number of tourists who visited Ukraine tripled last year, thanks to the government waiving the necessity of visas for visitors from the EU and US.

The retail sector is also booming, and is increasingly becoming the driver for economic growth. Foreign banks have bought around 30% of the sector in the last 18 months. Their presence means the sector's growth is not limited by capital adequacy issues, as is the case in the more closed and state-controlled banking sector in Russia. SMEs are also doing well here too, in areas like consumer finance, household goods and furniture.

Why is this good news for Ukrainian democracy? Because an economy that's built on SMEs is more likely to produce a thriving democracy than one dominated by huge state-dependent enterprises. SMEs are less dependent on political support, either from the Ukrainian government or the Russian government. That means they are more inclined to stand up to the state and act as a check on state power. It means economic power is more diversified, and less easy for bureaucrats to control. It means support for political parties is more diversified. It means less people work for the state, so less people vote to support heavily Statist or authoritarian governments.

The hike in gas prices is also producing a new mental attitude that can only be productive for Ukrainian democracy - the attitude that independence is worth paying for, even if it means tightening one's belt and adapting to new realities. That kind of Stoical willingness to make sacrifices for one's freedom is the essence of liberalism.

More expensive gas is thus forcing Ukraine to become more mature, to move beyond Soviet-era behaviour. Compare this to Russia, where the blessing of huge natural resources also curses the country to remain in a quasi-Soviet economy, in which huge and inefficient enterprises controlled by the presidential administration dominate the economy, and ordinary people likewise expect the state to support them through cheap gas and utilities. The number of bureaucrats is rising each year, because people still believe the only way to get ahead is to join the state and salute one's superior. Yes, economic growth is much higher in Russia than in Ukraine, but that growth was not really earned.

And the cost of that growth is you end up with a country where everything comes back to the Kremlin - the economy is dominated by it, the country's top managers are answerable to it, and each individual and family relies on it for cheap gas. The idea of standing up for oneself, of not having to bow and scrape to bureaucrats, is lost. Russia's great hydrocarbon resources mean it is much harder for the country to become a pluralist democracy. Ukraine's lack of hydrocarbons must just help it on its way.

Julian Evans, a British freelance journalist based in Moscow.

Kyiv

May 6, 2006

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