Glimmer of hope for peace in eastern Ukraine

(Business New Europe – bne.eu – RBS, Tim Ash, head of research – June 25, 2014) We assess positively the news that separatist leaders in eastern Ukraine have joined the ceasefire announced by Ukrainian President Poroshenko last week. We also observe growing signs that Russia is not interested in further escalation of fighting in eastern Ukraine, and is taking action to avoid further Western sancti…

We assess positively the news that separatist leaders in eastern Ukraine have joined the ceasefire announced by Ukrainian President Poroshenko last week. We also observe growing signs that Russia is not interested in further escalation of fighting in eastern Ukraine, and is taking action to avoid further Western sanctions. The strengthening hope for a peaceful resolution of the Ukraine crisis is positive for Russian assets across the board. It also creates a favourable backdrop for the IMF visit to Kiev and the signing of the Association Agreement between Ukraine and EU, expected by the end of this week.

• On Monday evening, multilateral talks in Donetsk unexpectedly produced a positive result. Leaders of self-proclaimed Donetsk and Luhansk republics agreed to a three-day ceasefire, until the morning of 27 June, and announced that during this period, consultations on the settlement of the conflict will be held in Donetsk.
• Today Russian President Putin asked the upper chamber of parliament to rescind the decree of 1 March that approved the use of the Russian army in the Ukrainian territory. The Senate will likely approve it tomorrow.
• Putin’s announcement comes ahead of his visit to Vienna. Today Gazprom and Austrian OMV announced that they have signed documents related to the construction of the South Stream gas pipeline across Austrian territory.
• We believe that these developments pave the way to eventually achieving peace in Donbass. What we find most encouraging is that the Kiev authorities are for the first time negotiating with pro-Russian separatists (albeit via intermediaries), as until now they had refused to talk to them.
• Some caution is still recommended as it is not clear whether the ceasefire is going to fully hold in eastern Ukraine, as rebel forces consist of several militias whose actions are poorly coordinated.

Ukraine needs a respite in fighting ahead of EU summit Last week, the markets reacted enthusiastically to the announcement by Ukrainian President Poroshenko that he had drafted a peace plan for eastern Ukraine, including a unilateral ceasefire (see Ukraine | Peace in Donbass would support UAH (19 June). On Friday, Poroshenko went on to declare a week-long ceasefire ending on Friday 27 June. However, the ceasefire remained unilateral during last weekend: Ukrainian forces reported that the rebels continued firing at Ukrainian military columns and checkpoints.

Meanwhile, diplomatic activity with participation of EU leaders intensified ahead of the signing of economic chapters of the Association Agreement between the EU and Ukraine, expected to be signed at the EC meeting on 27 June. Yesterday Poroshenko informed EC President Herman van Rompuy that the EC, Ukraine and Russia could conduct trilateral expert consultations on settlement in eastern Ukraine by that date (Interfax).

It is crucial that the ceasefire is observed by all parties involved in fighting Yesterday’s negotiations in Donetsk were multilateral, and for the first time since the conflict began in eastern Ukraine in April, they included the leaders of self-proclaimed Donetsk and Luhansk republics. They were also attended by Russian Ambassador Zurabov, OSCE Representative Heidi Tagliavini, Ukrainian ex-President Leonid Kuchma and Ukrainian politicians including Viktor Medvedchuk, leader of the Ukrainian Choice movement. Following the meeting, the rebel leaders announced a three-day ceasefire during which parties could “begin consultations on negotiations on peaceful settlement of the conflict (Kommersant)”.

While yesterday’s developments provide hope for the beginning of a process of demilitarisation in eastern Ukraine, the path to peace may be rocky. First of all, there are a few militias operating in the region, headed by different commanders who will not necessarily cooperate with the rebel leaders who announced the 3-day ceasefire. They may conduct military operations in the coming days, making peace negotiations more difficult. For example, today Interfax reported that a railway bridge has been blown up in the eastern region of Zaporizhye bordering Donetsk region. No one has claimed responsibility, however, such incidents strengthen the position of Ukrainian hardliners who are against negotiations with the rebels and in favour of more aggressive military action against them.

Russia may be looking for a graceful exit from Ukraine crisis Today President Putin requested the Senate (the upper chamber of the Russian parliament) to rescind the decree approved by it on 1 March, at the onset of the Crimea crisis, allowing the use of the Russian army in the Ukrainian territory (Bloomberg). We have little doubt that the Senate, which is to vote on this issue tomorrow, will support it.

This appears as a strong signal to the West that Russia is willing to cooperate.

Meanwhile, Russia seems to be investing a lot of diplomatic effort into avoiding further sanctions. In our previous reports we have noted that although the sanctions imposed so far have done little direct damage, they have soured the mood among investors and had other indirect adverse consequences for Russian businesses. FT reports Putin discussing a political solution to the eastern Ukraine crisis with President Poroshenko, Chancellor Merkel and President Hollande in recent days. Last night he also discussed this matter with President Obama. In the preceding weeks, the EC sought to exert more pressure on Russia ahead of the EC meeting on 27 June, reiterating its call on Russia to stop the flow of weapons and militants across the border with eastern Ukraine.

It is our impression that the Russian side is looking for ways to gracefully exit the Russia-Ukraine crisis. As we have mentioned before, the Crimea annexation in March has led to a rise in President Putin’s approval rating from 65% in early 2014 to 83% in May. However, opinion polls have also shown that the Russian public would not favour direct military involvement in eastern Ukraine. If the fighting in eastern Ukraine were allowed to escalate further, the Ukrainian army, which has surrounded the rebel forces in the town of Slavyansk, would probably move on to storming the rebel positions there, which would likely lead to a rise in civilian casualties. We have also been particularly worried about the risk of a sharp rise in civilian deaths if the military action spread to the densely populated cities of Donetsk and Luhansk. This could cause a swing in the Russian public opinion towards the need for Russia to intervene and protect primarily Russian-speaking civilian population of the rebel regions. In this case, Putin and the Russian government would find themselves in a difficult situation, with a looming risk of “biting” sanctions, both direct and indirect. In particular, in such a scenario a sovereign downgrade to n “junk” status, which would prompt an intensification of investor flight from Russian assets, would become very likely.

At this stage, we cannot completely exclude the risk of the crisis in eastern Ukraine escalating again if the peace talks fail. In this case, the US and the EU would intensify the pressure on Russia to seal its border with eastern Ukraine. We think Russia may to some extent co-operate, and increase pressure on rebel leaders to negotiate with the Ukrainian authorities. Given Russia’s more active diplomatic involvement and cooperation with the new Ukrainian President, the risk of further sanctions, especially those covering whole sectors of the Russian economy, should fade.

Positive reaction by Ukraine and Russia markets is justified The news of the rebels supporting the ceasefire prompted a strong positive reaction in the markets, which was reinforced by the news of Putin’s request to the Senate. For the first time in many weeks, we feel that the market’s optimism is fully justified. We believe that the news is positive for all classes of Russian assets, given the falling risk of any kind of new sanctions. For Ukraine, the news creates a favourable backdrop to the IMF mission visit to Kiev which begins today.

The Z-spreads on Russian and Ukrainian Eurobonds have already tightened to the levels observed before the crisis in the relations between the two countries began in earnest in February this year. Still, the sharp reduction in the geopolitical crisis in the region could add fuel to investors’ appetite for Russian Eurobonds. Despite the weakening of economic activity in Russia this year, the government has stuck to prudent fiscal policies, and is planning to finish the fiscal year with a budget surplus.

The recent rise in the oil price on the back of the ISIS insurgency in Iraq is an additional factor positive for Russian sovereign debt.

The reduction in geopolitical risks and the uptick in the oil price are also positive for the rouble and the Russian local government debt (OFZs). The crisis led to a significant undervaluation of the rouble, mainly prompted by massive FX purchases by local individuals and companies. At the same time, the fundamentals remained solid, with the current account posting a large surplus in 1Q and trade surplus improving further in the current quarter.

Russian 5-15yr OFZs currently offer very juicy yields, of 8.6-8.8%. Real yields are also positive, and could increase in the coming months as inflation is likely to peak at 7.7- 7.8% YoY in June, and then gradually descend towards 7% YoY in 3Q. The geopolitical crisis in the region caused a sharp drop in non-resident demand for OFZ in the primary market, and offloading of OFZ holdings. However, according to CBR, already in May foreign investors accounted for 49% of OFZ purchases in the primary market, vs. just 17% in April. Despite that, we still think that rate cuts are unlikely until the end of the year, the reduction in geopolitical risks reduces the likelihood of sharp RUB weakening, and should also soften the hawkish bias in the CBR’s rhetoric.

In these conditions, we see further potential for RUB strengthening in a short term. We would not be surprised to see RUB firming further towards the level of about 38.5-39 vs. the bi-currency basket in the coming days (vs. 39.3 currently). However, once the influence of the positive geopolitical developments abates, we expect it to weaken again due to the seasonally high demand for FX in 3Q (supported by a surge in tourism and dividend payments). Excessive RUB strengthening would also be seen as undesirable by the Russian authorities (see Russia | CBR edges closer to RUB float, 17June).

As for the Ukrainian Eurobonds, we will be awaiting for further signs of stabilisation of the security situation in the east of the country before we re-assess our “underweight” recommendation on Ukrainian sovereign debt. We do not expect sovereign default or debt restructuring in Ukraine in the coming months, given the massive political and financial support from the West and US in particular. However, we remain concerned about the country’s medium-term creditworthiness given the importance of Donbass for its economy (see Ukraine | Peace in Donbass would support UAH, 19 June).