UKRAINE RISK ASSESSMENTS
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Tensions Running High as Voters Head for the Polls
The political crisis that erupted earlier this year continues with no end in sight, despite a shaky cease-fire agreement concluded with separatist rebels in the eastern Donetsk and Luhansk oblasts in early September. Ukraine held a special presidential election in May to replace Viktor Yanukovych, who fled to Russia in February, following deadly clashes between pro-western opponents of closer relations with Russia and government security forces, and an early legislative poll scheduled for late October looks to produce a Parliament dominated by allies of the country’s new leader, President Petro Poroshenko. However, simmering tensions between Ukraine and Russia, which annexed Crimea in March and is backing the separatist revolt in eastern Ukraine, and the more general polarization of the country along east-west lines are contributing to a significantly elevated risk of political instability that is further heightened by a sharp economic downturn and the danger of shortages of gas over the winter months.
President Poroshenko agreed to a cease-fire on September 5, following a rout of Ukrainian forces at Ilovaisk that officials in Kiev attributed to the Russian military’s direct support for the rebels. The Russian government has consistently denied any role in the conflict, despite significant evidence to the contrary, including satellite imagery, first-hand accounts, and captured Russian troops and weapons. The US and the EU have responded to Russia’s violation of Ukrainian sovereignty by imposing sanctions on Russia, and Moscow has countered with punitive measures of its own, contributing to a diplomatic standoff reminiscent of the Cold War era.
The government held talks with leaders of the eastern rebel groups in Minsk that resulted in a formal truce, along with Kiev’s promise to pass legislation granting autonomy to Donetsk and Luhansk in return for the separatists’ agreement to refrain from seizing any more territory than they currently control. Although the pact brought at least a temporary end to large-scale military operations, regular exchanges of fire have continued without interruption, with each side accusing the other of violating the cease-fire.
Even more troubling, a fresh Russian aid convoy crossed the border and made its way to separatist lines after the signing of the truce. Moscow’s actions belie the Putin government’s stated desire to restore stability to the region and have reinforced suspicions in Kiev that the rebels are using the breathing room created by the cease-fire to prepare—with help from Russia—for another round of heavy fighting.
For the moment, the Ukrainian government is hoping that the truce holds long enough to ensure that elections take place under relatively stable conditions. However, Russia has made no secret of its aims, namely, a weakened Ukraine that is firmly in its sphere of influence, and as long as the government in Kiev poses an obstacle to securing that objective, there is every reason to assume that Moscow will continue to do what it can to sow instability inside Ukraine.
Investment Profile/External Conflict
EU Integration Put on the Slow Track
For its part, the current government has affirmed its intention to pursue closer integration with the EU. In September, the Parliament finally ratified a long-delayed association agreement with the EU. It was former President Yushchenko’s last-minute decision to shelve the agreement—under pressure from Moscow—that triggered the upheaval that led to his political downfall.
Prime Minister Arseniy Yatseniuk revived the process in March 2014, and a final agreement as signed in June. The pact was ratified simultaneously by both the Ukrainian and European parliaments on September 16.
The association agreement reduces barriers to trade between Ukraine and the EU, while also obligating Ukraine to meet the western bloc’s regulatory standards, and establishes a framework for closer political ties that would create a basis for Ukraine’s future formal accession to membership in the EU. However, under a deal reached in negotiations with Russia, full implementation of the trade component of the association agreement—the so-called Deep and Comprehensive Free Trade Agreement (DCFTA)—will be delayed until December 31, 2015.
The concession on the DCFTA is clearly a victory for Russia, which had threatened to immediately hike tariffs and impose other restrictions on bilateral trade with Ukraine if the trade agreement went into effect on November 1, when the rest of the association agreement comes into force. However, it remains to be seen what the long-term impact of that concession will be.
Assuming the good faith implementation of the trilateral deal, Ukrainian exports will continue to enjoy preferential access to the broader EU market, as it has under an existing arrangement, and can be assured that it will not be hit with any further restrictions on its trade with members of the Russian-led Commonwealth of Independent States (CIS). At the same time, Ukraine will not have to worry about the competitiveness issues and loss of income that would result from the near-term reduction of tariffs on EU imports.
Russia argued that implementation of the DCFTA would leave it no choice but to raise barriers to imports from Ukraine to protect its own market from a flood of EU goods entering Russia via Ukraine. But the main reason Moscow sought the delay was to buy time to reverse Ukraine’s shift toward the west, either by creating conditions within Ukraine that undermine support for integration among Ukrainians and the EU member states alike, or, at the very least, persuading the EU to make changes to the association agreement that leave open the possibility of Ukraine’s movement back into the Russian orbit sometime down the road.
Government Stability Far from Assured
Against that backdrop, Ukraine’s pro-western political forces will face an extremely daunting task in the aftermath of the upcoming elections. At a minimum, they will need to form a stable government that is capable of convincing the EU members that it is in their interest to keep battling Russia in defense of Ukraine’s sovereignty. At the same time, the next government will need to persuade the Ukrainian public that integration with the west is worth the pain that Russia is prepared to inflict to convince them otherwise.
Recent polls indicate that pro-western parties will win a comfortable majority of seats in the Parliament. The Petro Poroshenko Bloc, headed by the president’s Solidarity Party, leads all contenders with 26.9% support. Its nearest competitor, the nationalist Radical Party, is polling just 6.2%, and former Prime Minister Yuliya Tymoshenko’s All-Ukrainian Union “Fatherland” (Batkivshchyna) is close behind with 5.5%.
Both Prime Minister Yatseniuk’s People’s Front and Civil Position, a party headed by former Defense Minister Anatoly Hrytsenko that has formed an anti-corruption coalition with the Democratic Alliance, are also expected to achieve the minimum vote share required to qualify for seats. However, roughly one-third of voters remain undecided, which means that any number of other parties might manage to claim seats, including the far-right Svoboda and the Opposition Bloc, a new party established by former members of Yanukovych’s Party of Regions (PR).
In terms of the pro-western or pro-Russian leanings of the various parties that are in the hunt, it would seem that political forces that support integration with the EU will dominate the next Parliament. However, differences over how best to deal with Russian aggression and the rebel uprising in the east represent a significant political fault line that could impede the formation of a stable government.
President Poroshenko favors a negotiated resolution on both fronts, a strategy reflected in his agreement to delay implementation of the DCFTA and the deal to grant greater autonomy to the restive eastern oblasts. However, several other parties favor a much more aggressive posture, with both Batkivshchyna and the Radical Party having adopted a particularly bellicose stance. The persistence of deadly clashes in the east creates the risk of an erosion of support for Poroshenko’s peace plan that could benefit the so-called “war parties,” and also boost support for fringe nationalist parties.
One of the key weaknesses of the president’s peace plan is that it is not at all clear how autonomy would work in practice. Measures approved by the Parliament under the terms of the cease-fire agreement grant temporary self-rule to Donestsk and Luhansk for a period of three years (during which time a permanent arrangement will be hammered out), which entails local control over economic development, the right to establish a local police force, the use of Russian as an official language, and the independent organization of local elections.
Despite those concessions, the leaders of the self-proclaimed People’s Republic of Lugansk, while accepting the terms, have stated that their ultimate goal is secession from Ukraine and annexation by Russia. Critics of the plan argue that autonomy for the eastern oblasts will amount to de facto annexation of the Donbass region, with a large section of Ukraine’s industrial heartland establishing closer economic and political ties with Russia while the rest of the country moves toward integration with the EU. At the very least, eastern autonomy will provide Moscow with an ongoing base from which to meddle in Ukraine’s internal affairs.
A more worrisome possibility is that a new government in Kiev could force Poroshenko to renege on the autonomy agreement, which Russia has signaled it would treat as a justification for military action to defend the interests of the pro-Russian region. Even if Moscow stopped short of that step, it is likely that backtracking by Kiev would provoke punitive measures by Moscow aimed at tightening the noose on the Ukrainian economy.
Chaotic Economic Conditions
Poroshenko is trying to remain optimistic while preparing for the worst. Violent demonstrations by masked protestors outside the Parliament forced the body to adjourn early on its last day of business before the elections, but not before lawmakers approved the appointment of a new defense minister and a package of anti-corruption measures, both of which are seen as essential to securing the increased military and financial aid from the international community that Ukraine will need to meet the coming challenges. The president made a plea for aid to bolster the country’s military capability during a visit to the US in September, but he returned home empty handed, after US officials signaled that they are not yet prepared to take that step.
The conflict in the Donbass region has forced the shutdown of steel and mining operations, resulting in a sharp contraction in industrial output, which fell by more than 20% (year-on-year) at the height of the fighting in August. Even if the cease-fire holds, the situation is unlikely to improve quickly, as significant damage to infrastructure will pose an obstacle to restarting production.
At the same time, a plummeting currency, rising unemployment, and the prospect of shortages of both gas and coal are reinforcing a general sense of gloom among the Ukrainian population that has dealt a hammer-blow to confidence. In September, the IMF issued a revised economic forecast that predicted a contraction of 6.5% in 2014 and meager growth of just 1% in 2015. The World Bank is even more pessimistic, forecasting a real decline of 8% this year, and forecasting another (albeit much smaller) contraction in 2015.
The hryvnia has depreciated by nearly 40% since the beginning of the year, and the depletion of foreign reserves has pushed bond yields sharply higher, reflecting growing expectations that Ukraine will be forced to restructure its debt. The IMF approved a $17 billion standby agreement in late April, but Prime Minister Yatseniuk has confirmed in late September that the government will need additional support and will also seek a relaxation of the conditions attached to the loans, citing the war-related strains that were not anticipated when the agreement was negotiated back in March.
The IMF has signaled its readiness to be flexible, but a multilateral backstop may not be sufficient if Russia refuses to ease the pressure on Ukraine. Of special concern in that regard is a $3 billion Ukrainian bond held by Russia that was part of a $15 billion loan program that Moscow offered to the Yanukovych administration in return for its abandonment of the association agreement with the EU. Under the terms of the loan, Ukraine is obligated to make immediate payment in full if the general government debt rises above 60% of GDP.
The Finance Ministry has stated that it will determine whether the year-end debt burden exceeds the threshold, based on the final economic data for 2014, which is scheduled to be released at the end of March 2015. However, Russia contends that it can demand repayment as soon as the 60% of GDP ceiling is breached, and officials in Moscow claim that a combination of falling GDP and currency depreciation makes it almost certain that this has already occurred.
A default is simply not an option, as non-payment on the bond held by Russia would leave Ukraine liable to make immediately repayment on all of its Eurobonds. If Russia forces the issue, Ukraine would either have to tap its already depleted foreign reserves or use IMF loans. However, Russia might delay taking action, using the leverage afforded by the $3 billion bond to complicate Ukraine’s efforts to carry out a broader restructuring of its debt.
With that in mind, President Poroshenko will need to proceed cautiously when he meets with President Putin in Milan in a few days. Among the topics to be discussed is the price that Ukraine receives for the use of its network to deliver Russian gas supplies to European markets. However, the state gas company, Naftogaz, has filed a complaint in Stockholm seeking a revision of the terms of a 2009 deal with Russia’s Gazprom, a move that is unlikely to make Russia inclined to be flexible.
Poroshenko will also be seeking a resolution of a dispute that led to the cessation of Russian gas sales directly to Ukraine in June. Gazprom halted sales to Ukraine over the latter’s refusal to make payments for gas that it contracted from the Russian supplier but did not use. Russia has assured that it will continue to supply gas to its customers elsewhere in Europe, but has warned that it will cut off EU countries that sell gas sourced from Russia back to Ukraine, a threat that prompted Slovakia, Czech Republic, and Hungary, among others, to cease the practice.
Leaders in the EU are well aware of the danger that winter gas shortages would create a strong temptation for Ukraine to divert gas supplies intended for western markets for its own use, a move that could jeopardize the EU’s access to gas. As such, the EU has a strong incentive to resolve the dispute between Russia and Ukraine, but it is not clear what Moscow will demand for its cooperation. The upcoming election could yield some very unpleasant surprises for Poroshenko if, upon his return home, he is perceived to have made excessive concessions or if voters conclude that Ukraine has been hung out to dry by the EU.