How to end the Ukraine conflict
(Business New Europe – bne.eu – Ben Aris in Moscow – March 19, 2015)
March will be a tense month as Russia has decided to poke its finger in Nato’s eye again. Russia’s Armed Forces are holding for the first time Arctic military exercises, which kicked off on March 16 and will last through March 21.
The exercises are massive. The entire Northern Fleet has been put on alert, as well as units of the Western Military District and the Airborne Forces, which cover the territory right up to the border with the Baltics. A total of 38,000 personnel are in the field, together with 3,360 pieces of military hardware, 500 tanks, more than 55 battle ships and submarines, and 110 aircraft and helicopters. And if that wasn’t enough, Russian President Vladimir Putin said explicitly in a documentary to commemorate the annexation of the Crimea a year ago that he would have put Russia’s nuclear missiles on alert if the West had tried to stop him from taking over Eastern Europe’s favourite holiday resort.
The military exercises are clearly more sabre rattling by Russia and a warning to Nato, which has increased its military training on the other side of the border in recent months. It’s like two bullies in the playground trying to “shirt-front” each other, as Austrian prime minister Tony Abbott threatened to do to Putin during the Asia-Pacific Economic Cooperation (APEC) summit in November.
It is time to start to walk things back, as this is starting to get dangerous. To paraphrase Thucydides, the author of “The History of the Peloponnesian War” and father of realpolitik: “The longer a standoff lasts, the more things tend to depend on accidents”.
And it is still possible to walk things back from here, but the focus needs to change from principles and punishment to realism and compromise. Currently all the talk is about punishing Russia, lethal weapons and extending sanctions, when what needs to be discussed is how to deal with the substantive issues in this dispute: Ukraine’s potential Nato membership, what can be done to improve security arrangements in post-Cold War Europe, turning Ukraine’s collapsing economy around, and thrashing out a new pan-European trade regime that takes in both Russia’s and the EU’s interests.
Happily all the pieces needed are already on the table. A shaky ceasefire following the Minsk II talks seems to be holding, although The Economist correspondent Tim Judah on the ground in the Donbas says it is more like a “less-fire than a cease-fire”. A new International Monetary Fund (IMF) deal and the arrival of the first $5bn tranche at the start of March has stabilised Ukraine’s financial system and currency for the moment. And dealing with the Nato and trade issues is complicated but fairly clear cut. Still, actually cutting a deal in this toxic atmosphere will be very hard.
The government in Kyiv has now been put in an extremely uncomfortable position of trying to persuade its main private investors to take a substantial haircut – something they can refuse to do – while Russia has opted itself out of the same haircut on its $3bn bond that comes due in December. This is the time when the government should be spending ever joule of its energy on building a new economy, not having heated conversations with fund managers at Franklin Templeton about how much money it is going to lose.
Moreover, these are the very same people that Ukraine will have to turn to as soon as the first green shoots of growth appear. The IMF calls for $40bn of borrowing over the next four years, but says Ukraine needs to spend $45bn. Why did the IMF sign off on a plan that is short $5bn? Surely the international donors could have come up with the extra $5bn so the government can get to work undistracted.
The investors should not be worried by the overall level of debt. Ukraine’s debt/GDP ratio has soared from the mid-30s before the Maidan protests, to over 70% now, and is on course to end this year at whopping 100-130%. However, given the economy can be expected to as much as quadruple in size when it finally starts on its post-Soviet catchup growth – as Russia’s and many of the other former Soviet states have done since the 1990s – the current high level of debt is not an issue, as growth will shrink the ratio back to manageable levels in just a few years time.
Moreover, when international investors do agree to start lending again after the crisis, Ukraine will be made to pay back the money saved by the proposed “debt operations” many times over in higher borrowing costs.
When Russia defaulted on its debt in 1998 it was very careful not to actually default. It imposed a five-year moratorium on debt payment and locked their money up in special “S” accounts. As the economy recovered (GDP grew by 10% in 2000 during the bounce back) the Russian Ministry of Finance gradually relaxed the restrictions on recovering this debt. Investors lost money, but after a few years they were given their original stake back and also offered opportunities to make money on other investments.
There is also a political aspect to getting Ukraine back on its feet as fast as possible. The IMF riders on its programme have imposed a terrible cost on the people. Household gas prices are to rise by over 200% and pensions will be cut. Inflation is already on the cusp of tipping over into hyperinflation and the quality of life is already visibility deteriorating, while unemployment is rising. In short, Ukraine is having its 1998 Russia moment or perhaps even its 1993 Russia moment, which was far worse.
The pressure on the Ukrainian people will lead some to ask whether they should not have gone with Russia’s offer to join the Russia-led Eurasian Economic Union (EEU) after all? Of course this is not an issue now, but when elections come up in four years time there will clearly be a pro-Russia party that can play on the current economic nightmare. This is already happening in Georgia where a rising proportion of young people, still in the minority, have more sympathy for Russia and its EEU than last year. It would be ironic for Ukrainian President Petro Poroshenko to win the war only to lose the politics at the next elections, because he can’t deliver on his implicit promise of a better life under a more EU-oriented government. The IMF’s penny pinching in this light looks incredibly short sighted. And if Europe and the US are really serious about containing Russia on the Continent, then given a military solution is off the table, transforming Ukraine into a prosperous country is not only the only option available, but also a highly attractive one for the rest of Europe.
Nearly everyone says Ukraine cannot join Nato, except the Ukrainians, so why not take this off the table? An alternative would be for the West to sign a separate deal to guarantee Ukraine’s borders outside of Nato, by creating some sort of new “strategic and economic partnership” category. Indeed, Ukraine already exists in this category of countries that Europe wants to support and boost trade ties with, but will never be asked to join the EU. Ukraine would not be alone in this – countries like Turkey and Azerbaijan are also in the same category.
The danger is that the West will fail to honour this commitment if push comes to shoot, just as they failed to honour the Budapest Agreement, signed when Ukraine gave up its nuclear missiles in 1994. But that is a risk Ukraine will have to take and having an actual signed treaty is more protection than the embarrassment that Ukraine’s application to Nato and subsequent rejection will cause. Indeed, to go down this road is downright dangerous, because Russia is guaranteed to take a strong line to Ukraine’s Nato bid and could reignite the current conflict.
Drawing up a new pan-European security pact is an extension of the Nato problem and also its solution. Nato is a security pact from the Cold War, but the Russians have argued that it needs to be replaced with a new European security deal that defines everyone’s place and responsibilities to reflect the new realities on the Continent. The Kremlin has already drawn up detailed proposals, which it is willing to negotiate. But if a new security deal is agreed, the need for Ukraine to join Nato becomes superfluous, as Ukraine’s borders and independence will be guaranteed by the new deal without the need for Nato. Nato can act as the guarantor for the West, but membership would not be necessary.
EU trade deal
Merkel has already admitted that a trade regime between the EU and the EEU is possible and has proposed three-way talks between the EU, Ukraine and Russia. But these have yet to start.
The point here is that trade will restart as soon as peace returns. Ukraine and Russia are both large countries with large populations that need almost everything that the EU has to sell. Even if relations remain bad, some sort of trade deal will have to be worked out.
And a trade deal between Russia and Ukraine is imperative for Ukraine’s recovery. Trade between Ukraine and Russia fell by 30% in the last quarter of 2014, but Ukraine has no prospect of redirecting those goods to the EU. The chances that Volkswagen will buy Ukraine’s diesel engines, Siemens will order Ukraine’s locomotives, Hochtief will ship in Ukraine’s low quality raw steel for construction projects, or that the EU farmers will welcome a flood of cheap Ukrainian eggs and vegetable oil are next to zero. Trade relations between Ukraine and Russia have to be normalised or else some of the biggest and best known of Ukraine’s few productive industries will go bust.
Instead of flooding Ukraine with guns, the EU should flood it with consultants and technical assistant programmes. Equipping the Ukrainian government with a new IT system and putting the entire government online would be a practical measure to fight corruption and improve efficiency that would cost a fraction of equipping the ragged Ukraine army with smart rockets and modern tanks.
Kyiv has already taken a step towards outsourcing its government operation by hiring three foreign-born nationals to high office, including US-born Natalie Jaresko as finance minister. Why not go the whole hog and bring in the EBRD and IFC to run the economics ministry and privatisation agency amongst other things, like the Kazakhs are proposing to do? Desperate times call for desperate measures – and things in Ukraine are desperate.