Ukraine’s economic pressures

The next battle for Ukraine series

Russia’s aim is to create a dysfunctional Ukraine, and it will continue using economic means as much as military attacks.

With Ukraine’s economy on the brink of disaster, the International Monetary Fund agreed a $17.5 billion package for Ukraine in February. Some think this programme will save Ukraine’s troubled economy: the promise of an immediate injection of $5 billion caused a rebound for the Ukrainian currency. Having just days before faced a near collapse, falling to 40 hryvnia to the dollar, it rose back up to 22 hryvnia to the dollar. The Ukrainian parliament passed a dramatic reform package on 2 March. Total funding for the programme may amount to $40 billion, including $7.5 billion leveraged from other sources, and supplementary funding is possible.

However, others point out that the IMF deal provides only $6 billion in new money. Further, it was already out of date on arrival, because GDP fell more than expected in 2014, by 6.9 percent rather than the 5 percent forecast. As of March, the IMF was predicting a further fall of 5.5 percent for GDP in 2015.

Most of the damage to Ukraine’s economy has been done by the war in the east. Ukraine has taken some measures to blunt the impact of “traditional” forms of Russian pressure, but it cannot isolate itself from the effects of war. Russia’s aim remains to create a dysfunctional Ukraine, by whatever means it can – and the economic avenue is just as promising as the military route, although the two are likely to proceed in tandem.

Points of Russian pressure

The war has already inflicted huge damage. It is currently costing Ukraine between $5 million and $10 million a day, and the number of internally displaced persons is set to top 1 million. Local estimates are that 5 to 6 percent out of the 6.9 percent lost from GDP in 2014 (that is, 70-80 percent of the drop) was due to the direct effect of the war in the Donbas. Russia has its own economic troubles, but it could easily do the same or worse to Ukraine in 2015 – especially if it starts to look like Ukraine might get its reform process on track.

The war is currently costing Ukraine between $5 million and $10 million a day.

According to the “black book” issued by the Ukrainian authorities in February 2015, the war has cost Ukraine “20 percent of its economic potential, including its forecast revenues and foreign exchange earnings”, and brought about a fall in budget revenue in 2014 of 23 billion hryvnia – a large part of the overall fiscal deficit, which at 78 billion hryvnia was considerably greater than expected. Industrial production in Donetsk fell by 31.5 percent and in Luhansk by 42 percent, contributing to a 10.7 percent fall in industrial production in Ukraine as a whole. The conflict caused a net outflow of foreign investment of $6.5 billion.

Asset grabs

The separatist “republics” have consistently targeted key economic assets and they will continue to do so. Neither their mini-regions nor Crimea are economically self-sufficient. “Project Novorossiya” would require the seizure of key power plants and water supplies in Zaporizhzhia and Kherson. In the short term, it is perhaps more likely that the rebels will attempt to seize the gas hubs to the north of Luhansk (Novopskov) and northwest of Donetsk (Shebelynka).

Kyiv has long worried about an attack on Mariupol, the key import-export port hub for the Donbas, which is still in government hands, although its situation is precarious. However, there is a theory that Ukrainian oligarch Rinat Akhmetov wants to keep the port “free”, because he wants to channel his export from his residual businesses in the rebel “republics” from a legitimate Ukrainian port (and stay sanction-free), and had encouraged the rebels to back off; and because rival Ukrainian oligarchs control the other Black Sea ports (even after his removal as Dnipropetrovsk governor, the influential oligarch Ihor Kolomoisky holds onto Odesa for now).

Disruption of supply

Where the rebels have not seized assets for themselves, they have done deliberate damage to the Ukrainian economy. Rail links and gas lines have been cut, as have the traditional “coal-coke-metal” and “coal-electricity” production chains. By the end of 2014, the rebels had taken over six out of 14 thermal power plants in the Donbas and 88 local mines, leaving only 37 mines for Ukraine. Shell’s shale gas exploration project in east Ukraine is on hold. The February fighting cut even more supply lines, and any new offensive would do the same.

Sending gas to the rebel “republics”

Gas supplies are allegedly already being diverted to the rebel “republics”, through the previously unused Prokhorovka and Platove gas metering stations on the Russian border. Just as Moldova does for Transnistria, Kyiv will have to pay for this gas. Russia thought that it would be able to cut off gas supply to east Ukraine during the 2009 crisis, and was shocked when Kyiv managed to organise “reverse supply” from the main storage area in western Ukraine. Now, it wants as much of the Russian-speaking east as possible to be directly dependent on Russian supply.

Trade wars

Traditional methods of economic pressure have had a lesser impact. The trade war that Russia began in August 2013 and restarted in 2014 has already reduced Ukrainian exports to Russia by half. But, as of the end of 2014, Russia’s share of Ukrainian exports was still 19 percent and its share of imports was 25 percent. Further cuts would damage the interests of Russian oligarchs and their joint schemes with their Ukrainian counterparts, which have so far been protected.

Ukraine’s energy supply

Russia has less leverage than it used to in pipeline gas supply. Ukraine’s new energy team, Minister of Energy Volodymyr Demchyshyn and Naftohaz of Ukraine chair Andriy Kobolev, have worked hard to reduce Ukraine’s traditional dependence on Russia, which now supplies Ukraine with less than a third of its gas. The recession, together with alternative supply schemes, has reduced demand. Slovakia’s supply system has had a technical upgrade. Central Europe as a whole is better able to buy from elsewhere and less fearful of Gazprom’s ability to block “re-export”, since the European Commission announced in February that measures against Gazprom were likely “within weeks”. In January 2015, “reverse flow” supply from Central Europe to Ukraine actually exceeded supply from Russia, with an average price saving of 4 percent. On 1 April Demchyshyn even said that Ukraine could temporarily stop all purchases from Russia.

The threat to the Ukrainian market (which has in recent years been one of Gazprom’s three largest, alongside Germany and Turkey) as well as to transit markets west of Ukraine has caused Russia to accept a series of quarterly deals, overseen by the European Union. The cancellation of the South Stream pipeline project also encourages Russia to be moderate in the short term, as does Russia’s possible longer-term aim of attaching the EU to supplies via Turkey. On 1 April Russian gas supply to Ukraine was extended until 30 June, and the price was set low at $248 per 1,000m3, as compared to $378 a year ago – although Russia has kept the deals short-term.

Ukraine’s nuclear power stations have enough nuclear fuel to last until the autumn at least. Ukraine’s contract with Westinghouse allows the US firm to pick up the slack if Russia cuts supply.

Russia’s $3 billion time bomb

Russia has a more powerful weapon in the form of Ukraine’s upcoming obligation to repay a $3 billion loan from Russia, which is due in December 2015. This is the first tranche of the infamous loan obtained by Viktor Yanukovych at the height of the Euromaidan protests in December 2013. The bond was written under English law, and the infamous “60 percent clause”, under which Russia can call for default if Ukraine’s debt exceeds 60 percent of GDP, has already been activated. The IMF programme is supposed to reduce Ukraine’s debt down from 86 percent of GDP, though one forecast suggests debt will rise to 94 percent.

Foreign bondholders are negotiating with Ukraine, hoping to avoid a summer “haircut”. But Russia is not participating, which casts a shadow over the talks. Negotiations could drag on until a nasty dénouement in December. This could in turn threaten Ukraine’s IMF deal, given the IMF’s rules about not lending to states that miss payments.

Independent weaknesses

A bond haircut?

A debt deal is necessary in any case, since Ukrainian companies are facing $15 billion in re-financing needs in 2015. Metinvest, owned by Rinat Akhmetov, defaulted on a $113 million debt in April.Ukraine wants to save $15.3 billion in public sector financing under the IMF deal, concentrating on debt issued before March 2014, that is, just after Yanukovych fled to Russia (total Eurobond debt is $18 billion). If this does not happen, money from international financial institutions will disproportionately go towards servicing interest payments. A fudge, in the form of a “reprofiling” of debt (prolonging maturity and cutting payments), is still possible – but protracted negotiations are reducing Ukraine’s freedom of manoeuvre.

The hryvnia and the banks

Ukraine’s foreign exchange reserves were as low as $5.6 billion on 1 March. The IMF agreed to pay $5 billion upfront, but interest rates are still at 30 percent. As of 1 April, reserves were up to $9.97 billion, indicating that some of the initial allocation had already been used. The hryvnia was then at 23.2 to the dollar. The authorities claim that they have stabilised the three biggest banks. But the reason that Privatbank, owned by Ihor Kolomoisky, was given a 800 million hryvnia loan on 30 March was that it was “too big to fail”. It holds 26 percent of all deposits, giving Kolomoisky considerable blackmail power. The financial system as a whole is still extremely vulnerable, and the potential for both capital and deposit flight is high.

Fiscal retrenchment and public opinion

IMF benchmarks require $15 billion in budget savings over the next five years. Public opinion differs sharply from the government on reform priorities. Opinion polls show that the number one public concern is the renewal of the public sector, especially the heath sector, not defence or even corruption. In the autumn, domestic energy bills are set for a steep increase, which will be felt across the board – although Ukraine has taken the right steps in preparing a compensation fund for the poorest households.

Russia is calculating that opinion in Ukraine will swing in its direction as economic costs mount.

Russia is calculating that the “new patriotism” in Ukraine is only skin-deep, and that opinion will swing back in its direction as the economic costs mount. One polltaken at the end of 2014 showed that 33.5 percent of Ukrainians were prepared to make sacrifices for “up to a year” in the name of reform, and 10.3 percent were ready to do so for “as long as is necessary”. That actually represented an increase in the number of people ready to make sacrifices – but it still meant that less than half of the population was prepared to tighten their belts.


Oligarchs’ wars

Russia could also try to exploit the struggles between Ukraine’s warring oligarchs. Kolomoisky was dramatically removed as governor of Dnipropetrovsk region in March. The reason was his use of armed men to try to keep control of Ukraine’s main oil company, Ukrnafta, but even so, the company is still in his hands, and is in fact paying him retrospective dividends. “Raiding” (forcible takeover of rival companies) is still common, fuelled by coded talk of “re-privatisations”. Rinat Akhmetov’s company, DTEK, is threatening to disrupt national power supplies to maintain its position and its subsidies.

Ukraine’s response

Ukraine was slow to form a new government after the October elections, and that government has been slow to act. But a flurry of measures has followed the second Minsk Agreement in February 2015. These measures partly resulted from the fact that the agreement provided Kyiv with some breathing space to act – but the new measures were also taken because Kyiv sees itself as being isolated by a bad agreement.

The package passed on 2 March did much that the IMF had been demanding. Most significant was sharp but stepped increases in household energy prices to target two of Ukraine’s biggest problems: firstly, the gap between household and industry prices had been Ukraine’s biggest source of arbitrage corruption, and secondly, the national gas company, Naftohaz of Ukraine, had represented a massive subsidy drain, amounting to a staggering 7 percent of GDP. Some of the savings were used to set up a compensation fund for poor households. The March measures also promised big cuts to bureaucracy and pensions, a start to deregulation, and cuts to unproductive subsidies and benefits.

On 9 April parliament followed up with a law to unbundle Naftohaz and deal with one of the main sources of oligarchic corruption. A new Anti-Corruption Bureau is being staffed, but, given the mixed record of such bodies in the former Soviet space, the introduction of new Procurator General Viktor Shokin on 11 February has had a more short-term effect. He immediately broke the taboo against arresting oligarchs with his first victim, former Party of Regions stalwart Oleksandr Yefremov, although Yefremov was soon freed on bail of 3.6 million hryvnia (about $135,000). Charges have been laid against troublesome regional elites in both Kharkiv and Dnipropetrovsk, and, as mentioned, Ihor Kolomoisky was dramatically removed as governor of Dnipropetrovsk in March.

Can Europe help?

Ukraine still has much to do, but it is finally looking serious about reform. The most significant EU measure to date is the loan of at least $800 million that it has offered to allow Ukraine to pay for Russian gas and build up reserves before next winter – although this move obviously also comes out of self-interest, given Europe’s desire to avoid future cut-offs in transit supply. In view of the fact that Kyiv has finally taken steps to reform its energy sector, the EU should do more to integrate Ukraine into the common space of the EU and Energy Charter Treaty. It could revive the proposal made in the 2005 Memorandum on Cooperation in the Energy Sphere to set up gas metering stations on the Ukraine-Russia border.

Ukraine still has much to do, but it is finally looking serious about reform.

Reverse supply from Central Europe has been facilitated and can be expanded further. Anything that the EU does to tame Gazprom is of indirect help to Ukraine. This is particularly the case with the European Commission’s anti-monopoly case against the Russian gas giant.

The decision to delay the implementation of the Association Agreement, due to take effect in September 2014, brought no concessions from Russia; it only fed the Kremlin’s appetite to cause the whole agreement to be renegotiated. No discussions on renegotiation should take place. It is open to EU member states to ratify the agreement before the delayed December 2015 implementation date.

Political pressure on Ukraine, on the other hand, has brought dividends. The EU has pushed back against the myth that reform is impossible during times of war. Private warnings have helped Ukraine at last to take some first steps towards curtailing the oligarchs’ power.

The biggest question remains the size of the financial package that will be provided to help Ukraine get back on track. International financial institutions can be encouraged to commit more, but direct EU assistance has to date mostly been confined to existing programmes and bilateral loans: for example, €500 million from Germany and €100 million from Poland. The size of the economic challenge is clear, though it is dwarfed by the sums consumed by Greece. Some have baulked at the politics involved, fearing that increased commitment might raise the political and military stakes. They also fear that the money would be wasted, since Ukraine has done only half the job of reform. But, likewise, the EU has so far only done half the job of support.

Read more on: Wider Europe,EaP,Ukraine,Ukraine Crisis

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