Ukraine, Russia deal is a bandage not a remedy

(Business New Europe – bne.eu – Lilit Gevorgyan, IHS Global – December 18, 2013) Any form of aid is probably going to be a bandage on Ukraine’s economic troubles rather than a serious remedy. These troubles are a result of a toxic combination of domestic macroeconomic policy failures and unfavorable external demand for Ukrainian undiversified exports, which are heavily dependent on steel. There are painful decisions to be taken, which are essential for the overall health of Ukrainian economy. Key among these is abandoning very generous domestic gas subsidies that will help to rein in the budget deficit and stabilize the state-run energy monopoly Naftogaz Ukrainyi. Meanwhile weakening artificially strong exchange rate could make Ukrainian exports more attractive and in turn helping the country to start generating the much needed foreign currency reserves and controlling that widening trade deficit.

But after securing a lifeline from Russia Yanukovych’s priority now is to regain control over the economic situation, defuse the opposition movement and prepare for this second term presidential bid. He does not have enough political capital or indeed willingness to introduce those necessary but painful macroeconomic measures. And while the Russian aid helps in the short-term to stabilize the economy but it will also push the reforms into the backburner.

Russian aid will have a positive short- term impact, dissipating market concerns over Ukraine’s creditworthiness and in time bringing down Kiev’s borrowing costs on capital markets. Also, unlike IMF or EU loans, the new Russian credit line comes with no macroeconomic policy pre-conditions. This would give the Ukrainian government some freedom of maneuvering without taking unpopular austerity measures which can further undermine president Yanukovych’s already declining popularity. More specifically, this means that the president can avoid significant devaluation of the currency and sharp increase in domestic gas prices. Both measures, if implemented can take a toll on Ukrainian households’ pockets, and damage the president’s faltering ratings.

Gas price discount, even if temporary, will take off the pressure on the government to cut back its social spending. It is really important for the president Yanukovych to maintain public spending ahead of the presidential vote. The price cut will also ease the pressure on foreign exchange reserves in the short- term.

Moscow is unlikely to extend that much needed condition free credit line in full, but perhaps in the region of up to USD5 billion may be made available immediately. This is slightly more than the USD4 billion worth Eurobonds that Ukraine was planning to place in early 2014. However, the Ukrainian Finance Ministry will probably refrain from any bond placement in the coming months considering that the country’s access to capital markets has become very costly as Kiev’s central squares remains fielded with large number of opposition protestors.

Teaser for Customs Union

So far Ukraine has made no commitment to joining the Customs Union. But it could well be that the mechanisms for further economic integration agreed upon at the Moscow meeting are all but in name laying the roadmap to the membership to the Customs bloc. It seems that Ukraine has got a teaser for the Customs Union with the temporary gas price cut. The price cut is most likely to be scrapped if Ukraine chooses not to join the Customs Union. Effectively the discount that Ukraine has received is around 33%, nearly as much a Armenia received after it made its own U-turn on the EU integration. In case of Armenia, discount was due to wavering the export duty as it is not applicable to the Customs Union members.

Russia is unlikely to simply become benevolent rescuer of Ukraine. Kiev has proven to be an unreliable partner for Moscow in recent months, as it kept oscillating between Brussels and Moscow and trying to clinch the best commercial deal. While the details of the deal are not disclosed yet, Russia is likely to aim for tangible gains, such as ownership of lucrative Ukrainian assets, preferably at competitive prices and bigger role in Ukraine’s energy sector, especially in the gas transiting network, although this might be an arduous and complicated business given the popular opposition to the idea. Commercially, Russia would have more clout over Ukrainian economy and businesses, although eased trade terms will benefit both countries.

Helping to avert economic but not political crisis

The Ukrainian opposition is going to scrutinize the gas price discount and bond-buying deal, but most likely reaction of the protestors is likely to be a deep mistrust of anything that President Yanukovych agrees to. At the same time, as EU remains divided and unclear on its strategy on the Association deal with Ukraine, no serious progress is expected between the European bloc and Ukraine. Yanukovych is likely to focus on ensuring that the Russian aid flows without problems and that the opposition movement loses steam. The freedom of expression is not likely to be curtailed overnight but perhaps more stricter rules will be implemented and the police will show less tolerance to violations of regulations on street demonstrations, especially if it involves invasion or occupation of administrative buildings.

With the Russian financial backing for Yanukovych’s government, the pro- and anti- EU divide has just become even more pronounced and is likely to dominate the presidential race in 2014. Securing Russian aid brings stability to Yanukovych’s government. But he challenge now will be to try to protect Ukraine’s economic interests, including those of the big businesses that might be weary of rising Russian influence. After all, Yanukovych and his big business supporters themselves have been unsure about accepting in full Russia’s terms of integration fearing this is may not benefit their commercial interests. Meanwhile, EU with its comprehensive free trade deal that covers goods and services sectors, still remains an attractive option that if not achieved now, will not be completely taken off the table in the coming years.

Bailing out Ukraine is most certainly yet another victory for Putin in his competition with EU, which emerged as divided and indecisive in pursuing its association plans with Ukraine. However, Ukraine’s tactics of bargaining between the EU and Russia has not been completely abandoned and may be employed again. This is because large number of Ukrainian voters as well as influential businesspeople feel that it is only due to Ukraine’s short term financial troubles Russia has gained a tactical victory and that in the long- term Ukraine will benefit from its economic convergence with EU while also maintaining good relations with Russia.