Ukraine update
(Business New Europe – bne.eu – Tim Ash, Standard Bank – July 24, 2014) What is now clear on the ground is that Ukraine is at war, and with significant casualties suffered now by both sides on a daily basis – tens of lives lost almost daily now.
The conflict is also causing very significant disruption and costs to the Ukrainian economy, given that it is being inflicted on a major economic region of Ukraine – the Donbas, which contributes anywhere from 11-18% of Ukraine’s overall GDP, and perhaps as much as 27% of industrial output, and significant interlinkages back to the Ukrainian economy. Herein, major Ukrainian cities, including Donetsk and Luhansk are suffering significant destruction, with economic activity badly impacted. Their populations are fleeing and production facilities are halting production. Transport links through and across Ukraine are being disrupted, as reflected in the difficulties in transporting the bodies of those lost on the Malaysian Airlines plane from the crash site to Kharkiv and then on and out of the country. Broader transport and trade across the economy must now be suffering a sizeable disruption. Railway and road bridges are being sabotaged, and air routes disrupted.
The IMF recently revised down its real GDP forecast for 2014 down to a 6.5% YOY contraction, but is still forecasting recovery in 2015. This seems optimistic. Even in a best case scenario we would have assumed that the conflict in Donbas might cost the economy 2-3% of GDP this year – the IMF already assumed a 5% real GDP contraction. Prime minister Yatseniuk has also spoken of a near total loss of trade with Russia – which could perhaps suggest another 2-3% loss to real GDP. That could all begin to suggest a sharper real GDP contraction, perhaps in the order of 8-9% of GDP, or worse.
Such a real GDP contraction, and disruption to the payments system, is also likely to see fiscal revenues suffer, while budget spending on emergency relief, reconstruction and defence will surely have bolstered the budget deficit – again PM Yatseniuk has suggested that spending on the conflict might reach around USD1bn. The IMF hence has spoken about the budget deficit rising to reach 10% of GDP this year, which again might prove to be something of a best case, as forecasting Ukraine’s macro framework for this year is very much a finger in the air exercise at present.
All the above suggests higher budget financing costs, more debt issuance and greater Western financing. The latter is still generally assumed by the market, I.e whatever the costs, Ukraine is too important for the West to be allowed to fail, and it will be financed. However, a point will be reached where the debt burden reaches a point where PSI comes back into focus – it now seems inevitable that the public sector debt/GDP ratio will extend beyond the 60% mark this year and beyond. And the question might be asked as to what would be failure. Would a move to PSI be failure at this point in time and given the broader challenges facing Ukraine?
In terms of prospects for an early end to the conflict, things do not appear that encouraging.
On the ground the Ukrainian military appear to have momentum on their side, after the capture of Slovyansk and surrounding towns. The Ukrainian population seem to be rallying behind the cause, and with the West focused back on the conflict, the assumption/hope is that Western pressure will prevent separatists from further resorting to the use of air defence assets to restrict the Ukrainian military’s air superiority, which still seems to be the decisive factor – that said note the news of the loss of two further Ukrainian airforce jets today presumably to SAMs. The government in Kyiv nevertheless appears in no mood to negotiate at this stage, but seems eager to finally clear its land of the threat from what it views as foreign terrorists.
Russia has appeared more willing to partake in peace talks in recent days, albeit the suspicion in Kyiv still is that Moscow is not genuine, and would merely be looking to take momentum away from the on-going Ukrainian military offensive.
Indeed, even after the tragic loss of the Malaysian Airlines flight, this failed to encourage a new wave of peace negotiations between the two sides, and military action has continued. Any negotiations have thus far centred on facilitating the return of bodies from the crash site and access for crash investigators, and seemingly not over a broader ceasefire or broader peace negotiations to being a lasting solution to the crisis.
Numerous problems still exist in respect to facilitating meaningful negotiations towards a peace deal. Critical though remains the chasm that exists between the objectives of the two sides. Moscow – whom we view as ultimately having sway over the separatists – wants to stall Ukraine’s Western orientation, black balling future EU and NATO membership, while also wanting to ensure the failure of the pro-Western Maydan administration in Kyiv. The government of Kyiv sets high store in its right to determine its own path, East or West, and is now firmly set on a Western course. Ukraine has never harboured aspirations for NATO membership, but any such assurances are simply not believed in Moscow and it now seems that any such future assurances, even Treaty based, would not be believed by Russia. Ukraine’s EU orientation is simply seen as equal to and inevitably leading to Ukrainian membership of NATO. Somewhat perversely Russia’s hard line stance is changing public opinion in Ukraine more decisively now in favour of NATO membership.
So where is the room for compromise?
Simply put, we cannot see it, or it is very hard to see.
The solution might ultimately lie on the field of battle, with one of the two sides delivering a decisive victory.
At present this seems more likely to be Ukraine, given the military victories noted above, and the failure of the separatists to really rally strong support behind their cause in Ukraine itself – significant manpower for the separatists appears to being “imported” from Russia.
However, things can easily change on the ground, and much depends on Russia’s ability and willingness to further escalate, through either significant re supply of separatists or even a more direct and formal military intervention.
The problem for Russia still is that allowing the Ukrainian military to “win” on the ground would represent a major and arguably catastrophic defeat on its current number one strategic priority – to prevent Ukraine’s Western (re)orientation. In victory Ukraine would likely be staunchly suspicious of Russia, likely to re-arm against the threat of future Russian aggression, and be even more staunchly pro-Western. With a fresh wind for Ukrainian nationalism and feeling of statehood, the Maydan administration would stand a good chance of succeeding in transforming and modernising the Ukrainian economy, which represents a further threat to Russia’s regional hegemony, or the perception in Russia of that. The Ukrainian nation is hence more likely to rally behind a reform agenda, as a means to stand up to perceived Russian aggression. Ukraine is also likely to benefit therein by a generous programme of Western financial support and investment.
In exchange for such a defeat, Russia will be left with the “annexed” Crimea, which was already de-facto controlled anyway by Moscow via the BSF agreement. But Western sanctions will likely ensure that Crimea will remain a large drag on an already weak Russian economy – arguably in a similar fashion to how Turkey has been left to fund the self-declared Republic of Northern Cyprus. It is difficult to imagine that the “return” of Crimea will in any meaningful way provide sufficient return for the loss of Ukraine and also the likely deadweight of Western sanctions on Russia. Note therein that Western sanctions have been slow to be rolled out, but are likely to be as slow to be withdrawn, as that is the experience of sanctions levied on other nations, including on the former Soviet Union and Russia in the past.
The probability hence is that Moscow likely feels unable to accept and tolerate defeat in Ukraine, and especially after such expectations have been built in the Russian media that a line has been, and has to be drawn against Russian expansionism and perceived fascism in Ukraine. After the above, Moscow has boxed itself into something of a corner where none if the options now appear particularly palatable.
Moscow does not though appear ready to throw in the towel just yet, and there is scant evidence thus far of compromise. Indeed, it might just looks to further military options, or raises the stakes in other areas – Russia has proved adept at evolving its tactics as this crisis has gone on, playing for time, re-positioning, and lobbying/spinning its case for advantage.