SPECIAL REPORT—The political upheaval that erupted after President Viktor Yanukovych opted against signing an association agreement with the EU in November 2013 escalated sharply in February, and the situation is spiraling out of control, with serious negative implications for Ukraine’s already poor risk profile. Yanukovych has fled the country, taking refuge in Russia, while Moscow has declared the political takeover in Kiev by pro-western political elements to be illegal.
In turn, Russia has deployed its military forces in the Crimean peninsula, ostensibly to ensure the safety of the region’s sizeable ethnic Russian population from violence at the hands of what President Vladimir Putin has characterized as “extreme nationalists.”
In Kiev, Oleksandr Turchynov, the chairman of the Parliament, has assumed the presidency on an interim basis, while Arseniy Yatsenyuk, a leading figure in the All-Ukrainian Union “Fatherland,” the second largest parliamentary party after Yanukovych’s Party of Regions (PR), has been installed as prime minister. Their main immediate task will be preventing a further descent into chaos before an early presidential election is held on May 25, a straightforward challenge, but one which they might not be able to meet.
The political crisis unfolded against the backdrop of economic troubles that were exacerbated by a tug-of-war between the EU and Russia for Ukraine’s allegiance. A combination of heavy debt-repayment obligations and a swollen current account deficit threatened to deplete Ukraine’s foreign exchange reserves to a point where the central bank would no longer be able to sustain the peg of the hryvnia to the US dollar.
Moscow’s insistence that Ukraine owed Russia’s state-owned Gazprom $9.3 billion for gas that it contracted but did not use in 2012 and punitive restrictions imposed on imports from Ukraine — moves aimed at persuading Yanukovych to forego an agreement with the EU in favor of participation in Putin’s proposed Eurasian Union — only added to the difficulties.
Yanukovych’s government was in desperate need of a financial lifeline, as a forced abandonment of the currency peg would almost certainly trigger a rout of the hryvnia. However, the president was loath to accept the politically unpalatable conditions attached to a bailout package from the IMF.
On November 21, with Moscow sending clear signals that it intended to make Ukraine pay if it signed a deal with the EU, a threat lent significant weight by Russia’s control over the price Ukraine pays for its gas supplies, Yanukovych announced a suspension of negotiations for an association agreement pending a deeper analysis of the economic impact of a free-trade deal with the EU. The move prompted angry protests by advocates of closer integration with the west, and the political temperature rose significantly after Yanukovych reached a deal with Putin for $15 billion in financial support and a reduction in the price paid for gas imports from Russia.
The strong negative reaction to Yanukovych’s lurch in a pro-Russia direction was not surprising.
The strong negative reaction to Yanukovych’s lurch in a pro-Russia direction was not surprising. Ukraine has struggled to establish a unified national identity since it won independence in 1991, with the ethnic Russian (and Russian-speaking) population that is concentrated in the eastern part of the country maintaining a strong affinity with Russia, and the ethnic Ukrainians who are most dominant in the western oblasts generally (but far from universally) seeing in Russia a symbol of Ukraine’s troubled past and in the EU the promise of a brighter future.
Those incompatible perspectives came to the fore in the aftermath of a dispute 2004 presidential election that pitted the pro-Russia Yanukovych against the western-leaning Viktor Yushchenko, and animated the Orange Revolution, a popular movement that forced a do-over election that was won by Yushchenko. Although infighting among the orange parties enabled Yanukovych to make a comeback, even he seemed to concede the merits of closer relations with the EU, which only made his 11th hour retreat that much more disappointing.
That said, however understandable, and perhaps even predictable, the outraged response in the west, it was by no means foreordained that the protests triggered by Yanukovych’s reversal would prove to be his undoing. The permanent establishment of encampments of large numbers of anti-government protesters in Kiev’s Independence Square beginning in early December was reminiscent of the Orange Revolution.
Although clashes with police and the occupation of government buildings contributed to a persistent high level of tension, there were no episodes of deadly violence over the first two months of the standoff. And Yanukovych’s mid-February agreement to an amnesty for jailed protesters created some reason to hope that the crisis might be peacefully resolved.
Two factors, in particular, appear to have fueled the rapid escalation that culminated in Yanukovych’s forced flight into exile: the injection of a more militant tone into the main protest movement by a nationalist paramilitary group, Right Sector, and Russian pressure on the Ukrainian government to restore order in Kiev. According to various reports, Russia conditioned the release of a $2 billion tranche of its promised bailout package on Yanukovych’s agreement to adopt a more aggressive approach to ending the standoff.
The short and bloody climax of the months-long political battle commenced on February 18, shortly after the Russian funds were delivered. A march on the Parliament spearheaded by Right Sector quickly descended into rioting that featured the torching of the PR’s offices in the capital. A particularly intense clash marked by gunfire from both sides left 16 protesters and 10 police personnel dead.
In response, the government imposed a de facto state of emergency, and President Yanukovych demanded that opposition leaders order a cease-fire and direct their supporters to stop occupying buildings. No agreement was reached on a truce, and, on February 20, Minister of Internal Affairs Vitaliy Zakharchenko announced that he had authorized police to use deadly force.
Exactly who is responsible for the violence that erupted on February 20 remains a topic of debate. Government officials claimed that armed protesters began opening fire on police. Protest leaders contend that the police instigated the confrontation using plainclothes agents provocateurs who infiltrated the encampment. In any case, the result was a rapid rise of the death toll to nearly 80, with 1,000 more people reportedly sustaining injuries.
In the aftermath of the bloodbath, Yanukovych’s allies began deserting him at an alarming pace. The head of the Kiev City government and more than a dozen parliamentary lawmakers resigned from the PR, party leaders in Rivne and Zhytomyr dissolved the local party organizations, and numerous other PR lawmakers simply disappeared.
On February 21, Yanukovych announced that he had reached an agreement with leaders of the parliamentary opposition on a deal that provided for an early presidential election and authorized the Parliament to restore the constitution to its 2004 form, under which the Parliament wielded significant executive power. However, the protesters in Independence Square made clear that they would remain until Yanukovych was removed from power. Seeing the handwriting on the wall, Yanukovych fled the country as lawmakers initiated steps to impeach him.
Although it is unclear exactly how direct a role Russia played in the events that led to Yanukovych’s downfall, now that the president is out of power, Moscow is making no pretense of watching from the sidelines. Although there has not yet been any exchange of fire between Russian and Ukrainian military units, the violation of Ukrainian sovereignty in Crimea has provoked an international outcry — both the U.S. and the EU are taking steps to impose sanctions on Russia — and stoked fears of a potential miscalculation that could ignite a military conflict that nobody desires.
Putin has struck a defiant posture, declaring that Russia alone is acting within the bounds of international law, as the government in Kiev is not legally constituted, since Yanukovych never signed the bills restoring the 2004 constitution, and insisting that the international community has a duty to protect populations whose lives are put at risk by civil strife. But Russia is not limiting its role to that of peace-keeper.
The autonomous government in Crimea is preparing to hold a referendum on independence on March 16, an obvious first step toward the region’s annexation by Russia. Ethnic Russians account for roughly 55 percent to 60 percent of Crimea’s population, and while public sentiment on the matter of national affiliation with Russia is difficult to measure with any credibility under current conditions, the fact that the voting will take place under the shadow of a Russian military force pretty much assures an outcome in favor of independence from Ukraine.
It is probable that even Turchynov and Yatsenyuk are not sure at this point how the government in Kiev will respond in that event. At the very least, it will declare the referendum to be invalid, and assert the illegality of any move by Russia to annex territory. But what it might do beyond that is unclear.
A military response by Ukraine would hardly be a trivial problem for Putin.
A military response by Ukraine would hardly be a trivial problem for Putin. Although Ukraine does not possess anything close to a world-class fighting force, it would pose a bigger military challenge for Russia than was the case with Georgia in 2008. However, unelected leaders in Kiev would find it hard to seriously entertain a military showdown with Russia without at least a suggestion of military support from NATO, whose members thus far appear to be inclined to give sanctions an opportunity to encourage Putin to show some flexibility.
Moreover, Ukraine’s dependence on Russian gas supplies will force leaders in Kiev to think long and hard about taking steps that might provoke a total cessation of gas flows from Russia. Although the U.S. and Germany have offered assurances that they can fill the gap at least temporarily, shortages would be likely, and could fuel secessionist sentiment in eastern areas of the country.
On the other side, Russia has its own reasons for avoiding war. If Ukraine decides to defend its territorial integrity by force of arms, Russian cannot count on quickly cowing his opponent into submission as he did with Georgia in 2008. In addition, the stability of the Russian economy depends on the continued flow of gas exports. Although Moscow might be prepared to suffer the consequences of stopping gas flows as an exigency of war, Putin would undoubtedly prefer that matters not come to that.
Nevertheless, the risk of war is disconcertingly high. Nearly one-quarter of the Crimean population is ethnic Ukrainian, and a Tartar minority accounts for a further 12 percent, and neither of those groups is likely to support the region’s annexation by Russia, or to ascribe validity to a vote that authorizes a move in that direction. Organized resistance on their part would probably be met with reprisals that could create the same sort of moral argument for intervention that Putin is currently using to justify Russia’s intervention in Crimea.
Putin’s ultimate objective in all of this is a subject of debate. German Chancellor Angela Merkel’s comments about Putin’s demeanor — she described him as seemingly being in a fog during discussions with his European counterparts on how to defuse the situation — suggest that perhaps the Russian leader was caught off guard by how quickly Yanukovych’s position became untenable, and he has been more or less improvising ever since.
Be that as it may, now that the process of international escalation has begun, it is probably reasonable to assume that Putin is hoping to create conditions inside Ukraine that clear the way for the replacement of the pro-EU interim regime with a pro-Russia administration. It is possible that he is hoping to use Crimea as a bargaining chip in such a strategy, in which case the danger that he might push for de facto Russian control in other parts of eastern Ukraine to increase his leverage for pursuing that objective cannot be ruled out. Were it to come to that, the government in Kiev would have little choice but to act, and pressure would grow for NATO to lend its support.
All of this is pure speculation at this point. However, that Europe is facing its biggest diplomatic crisis since the break-up of the former Yugoslavia in the 1990s is indisputable. And given how much higher the stakes are in this case, not least owing to the direct involvement of the Russian military, so too are the risk implications.
All of which bodes ill for the restoration of stability in Kiev. Recognizing the urgent need to install a government with a popular mandate, the interim leadership is pushing to hold a presidential election on May 25. However, it is difficult to see how the election could have any chance of achieving national legitimacy if the sections of the country where opposition to the political forces organizing the vote is strongest have either declared independence from Ukraine (as Crimea seems poised to do), or cannot participate in the vote because of meddling by Russia, which has a clear interest in preventing the election.
The EU has matched Russia’s offer by pledging $15 billion in loans and grants to keep Ukraine’s economy afloat, but has conditioned delivery of the financial support on the conclusion of a deal with the IMF. Reflecting the urgency of the situation, Yatsenyuk appears to be prepared to strike a deal before an elected government is in place, if possible.
Given the certainty that the IMF’s demands will mean economic pain for Ukrainians, the inheritance of the conditions attached to a bailout as a fait accompli could provide a future elected government with some measure of political cover. However, for reasons already noted, there is a possibility that responsibility for fulfilling the terms of a loan agreement could fall to a government that has no claim to a mandate.
The harsh reality is that any government holding power in Kiev in the foreseeable future will need to act with a degree of political courage that Yanukovych could not muster, to his great misfortune. Inflicting pain will carry a risk of triggering spasms of protest — and a broader secessionist movement in the east — that could test the resolve of a government whose members just recently witnessed the power of an outraged citizenry. Assuming the government is pro-EU in orientation, the lack of an alternative source of funding should help to stiffen its resolve, but that is no guarantee of success.
The economy is limping along, weighed down by poor manufacturing output, declining exports, and weakened levels of investment. Real GDP growth was essentially flat in 2013, and even if a less-than-worst scenario is avoided, the near-term trajectory will be negative, with crisis-prevention policy making enforced by a looming threat of default.
The budget deficit is estimated at around 8 percent of GDP on its widest measure, and shrinking tax payments and curtailed state pensions underscore the need for immediate corrective action. The interim government requires around $5 billion of emergency relief just to keep the country running between now and the planned election in late May.
The conditions written into Russia’s bailout loans create a default trigger if state and state-guaranteed liabilities exceed 60 percent of GDP, an arrangement seemingly designed to discourage the government from considering any western-backed bailout. The public-sector debt burden reached 42 percent of GDP at the end of last year, and the extent to which it has risen since is uncertain owing to the possible involvement of some undeclared liabilities. Moreover, the size of the debt burden could be increased in the event of a currency shock.
The state’s total financing need of $25 billion for 2014 comprises some $9 billion of maturing sovereign bonds, up to $3 billion owed to the IMF (which will almost certainly be rolled over), and around $3 billion of disputed payment arrears to Gazprom. The current account deficit of some 8 percent of GDP will contribute to pressure on the currency, adding to the risks associated with a switch to a more flexible exchange-rate regime, as is likely to be required under an IMF deal.
On-the-ground reports suggest that with deposits shrinking, the commercial banks are short of hard currency and snowed under with a non-performing loan book fast-approaching half of all lending, with insufficient hedging signaling huge recapitalization needs. The central bank’s foreign currency reserves have plummeted to $12 billion in spite of capital controls, and by resorting to printing money to finance the deficit, the authorities risk an inflationary shock compounded by a larger devaluation of the hryvnia.
The currency adjustment made to stem the depletion of reserves will contribute to imported inflation, but without any competitiveness gains for an exports sector at risk from a Russian trade embargo and facing weak market demand, rising input prices, and punitive borrowing costs (inflation-adjusted borrowing rates are close to 15 percent).
Inflation will accelerate into double-digits on an annual basis as the effects of a downward shift in the currency and reductions in gas subsidies that will be required under an IMF deal make an impact. The adjustment process will be painful and the risk of further destabilizing reactions must be fully factored into all investment decisions.
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