Russian cash still key to stability in Ukraine

It would appear that a deal has been struck in Ukraine. We must hope that it holds. The plan is to hold early presidential elections, by December 2014, while immediately returning to the 2004 constitution, which bolsters the power of Parliament.

It remains to be seen if these concessions will placate those who’ve protested so angrily and forcefully against incumbent President Victor Yanukovich. While keeping our fingers crossed for calm in Kiev, we should also watch closely the reaction of the many millions of Ukrainians in the Russian-speaking South and East of the country, who voted for Yanukovich as their President back in 2010. That election, let us not forget, was judged by the internationally-respected and Western-backed Organization for Security and Co-operation in Europe to be “fair”, “truly competitive” and an “impressive display” of democracy.

More than 70 people were killed in the Ukrainian capital last week. A country of 46m, and roughly two and a half times bigger than France, Ukraine has just seen its most violent episode since the Second World War. These protest began relatively peacefully, back in November, when Yanukovich refused to sign a trade deal with the European Union. Again, many Ukrainians opposed this EU deal, not least because it demanded full market access for EU goods, without granting Ukraine reciprocal permission to export much of its agricultural produce to West European. In recent weeks, though, these protests have obviously spiraled well beyond questions of trading links, mutating into a fully blown battle across the deep an ancient cultural and ethnic fault-line that divides this sprawling country’s Russia-facing regions from its Ukrainian-speaking West and North.

History will no doubt judge Yanukovich harshly – and rightly so. The Ukrainian President has often acted in a thuggish and unjust manner. Reports of police marksmen taking aim at protesters through telescopic sights in recent days clearly raise very serious questions indeed – questions that must not be brushed under the carpet. At the time of writing, an uneasy calm hangs over “the Maidan” – the main square in central Kiev, the heart of the struggle. But the protestors could yet re-group – manning the barricades and taking to the international airwaves once more, in a bid to secure an immediate Yanukovich resignation.

It may seem callous amidst all this recent bloodshed to consider economic and financial issues. But consider them we must. For even if Ukraine’s fragile peace is maintained, the country is racing towards financial collapse regardless. Such a calamity could not only spark renewed hardship and yet more violence across Ukraine itself. There are growing fears this country could act as an economic tinderbox, causing a systemic meltdown in neighboring Russia, emerging markets more broadly, and possibly even the West.

For while these concessions from Yanukovich have hopefully pulled Ukraine back from the brink of further rioting, and even civil war, the country is still heading towards bankruptcy and sovereign default. One reason is that, even before these protests began, the Ukrainian economy was on its uppers.

During the Soviet-era, Ukraine built on its traditional agricultural base, with the central planners developing a sizeable state-led industrial sector that specialized in coal, steel and some of the USSR’s most complex engineering. The rapid privatization and consumer-led growth of the last two post-Soviet decades have since transformed the shape of the Ukrainian economy, with the service sector enjoying rapid growth, so that it now accounts for three-fifths of GDP, while employing 7 out of every 10 workers.

In principle, Ukraine has a lot going for it – not least supremely fertile arable land. Yet the agricultural sector, which should be world class, is currently just 10pc of national income, given slow modernization and insecure land ownership rights. Having said that, thee population is well-educated population, with huge mathematical and scientific acumen. The high-tech sector is particularly strong, with Ukraine ranking in the world’s top five in terms of the absolute number of IT specialists, ahead of many countries with much bigger populations.

Having expanded by a healthy 4.1pc in 2010, and 5.2pc the following year, Ukraine slumped to just 0.2pc growth in 2012, as the combination of a weak Eurozone and a sluggish Russian economy cast a pall over this nascent capitalist society. In 2013, the Ukrainian economy was even weaker, registering no growth at all.

So long before these protests started, Ukraine was in economic trouble. World prices for steel, its biggest export, have fallen by half since the Chinese economy began to slow in 2011. As a result, the dollar-pegged national currency, the hryvnia, became seriously overvalued. Successive governments, trying to curry favour with a restive electorate, have spent heavily, resulting in last year’s budget deficit coming in at a chunky 5pc of GDP. Ukraine has also consistently refused to cut back on massive energy subsidies, despite the constant demands of overseas creditors, not least the International Monetary Fund.

The result is that, for quite a few years now, Ukraine has been borrowing from private creditors at increasingly onerous interest rates. While the country’s total debt burden should be manageable at around 38pc of GDP, almost a quarter of the $40bn total must be repaid over the next 12-18 months.

Which brings us to the nub of the issue. Yanukovich is widely seen, and with some justification, as “Russia’s man”. But even if the protesters delight Western capitals by getting rid of him, Russia is still likely to be a big part of the solution to a restoration of financial stability in Kiev, in turn preventing Ukraine from upending any number of financial markets elsewhere.

Russia’s trump card is its massive $500bn war-chest of foreign exchange reserves – the world’s fourth-biggest haul. Before Christmas, Moscow agreed to earmark $15bn to buy newly-issued Ukrainian sovereign debt over the next two years, so allowing Kiev to roll-over its obligations. An initial $3bn slice was bought last month, bringing yields down to more manageable levels.

As the protests in Kiev have escalated, though, successive Russian bond purchases have been shelved. Moscow has also since begun to make noises that it may only buy further Ukrainian government paper if Kiev pays back the $2.8bn it apparently owes Moscow for subsidized imports of natural gas. “We will fulfill what we have promised to Ukraine,” said Russian Finance Minister Anton Siluanov ominously, while President Putin was meeting with Yanukovich during the Sochi Olympics. “But we would like the Ukrainian side to comply with its obligations too”.

The EU has talked about “putting a financial package on the table”. US Secretary of State John Kerry has told the world “a big carrot” is in the works. Little Western largesse has transpired. Moscow, meanwhile, has suspended the purchase of an additional $2bn Ukrainian Eurobond, placed last Monday. No-one is quite sure if the Russians will buy it or not. Meanwhile the financial future of Ukraine hangs in the balance. As does the future of Yanukovich.

On Friday, Standard & Poors downgraded Ukraine to CCC – just two notches above default. “We now believe it is likely Ukraine will default in the absence of significantly favorable changes in circumstances, which we do not anticipate,” the ratings agency commented.

Even if the political truce holds, Ukraine needs $15-$20bn of hard cash to avoid financial implosion – and Russia looks like the only realistic source of such funds. Tensions remain very high in the Maidan Square this weekend, across Kiev and Ukraine as a whole. Yet tensions are rising across the world too, as Western and Eastern leaders seemed determined, between them, to provoke a Cold-War style stand-off.

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