Ukraine’s Reform Crossroads

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This blog is based on an ECFR study trip to Kyiv and Minsk on 30 March–2 April 2015. The ECFR delegation met President Petro Poroshenko, Maidan activists who are now members of the Ukrainian Parliament (the Rada), think tanks, ministers, and representatives of the Crimean Tatars and civil society.

Ukraine has not crossed its Rubicon. The most important and urgent decisions for its future, both internal and external, are still ahead, and the next few months will be decisive. The big challenges will be how to keep Ukraine together (as friction develops in various spheres: between the president and prime minister, between various factions in Ukrainian politics, and within civil society itself) and how to maintain European unity (something not taken for granted in Kyiv).

Towards freezing the conflict in the East

The main security risk at present is the fragility of the Minsk agreement – and both sides are preparing for the battle of narratives if it should break down. The situation around Mariupol is still tense. According to the Organisation for Security and Cooperation in Europe (OSCE), after the second meeting of the Normandy format in February, ceasefire violations were still taking place and several people were killed. The OSCE mission cannot verify that heavy weapons have been withdrawn, since it has access to only 4km of the 400km border.

There is a growing consensus that a frozen conflict has gone from being a nightmare scenario to the best possible outcome, both for Kyiv and for the EU. A frozen conflict would insulate and pacify the East and would open more space for much-needed reforms. However, this is not the preferred scenario of Russia and the separatists in the Donbas. Moscow does not want to foot the bill for Ukraine’s most energy-inefficient and under-reformed region. And for the leaders of the “Donetsk People’s Republic” and the “Lugansk People’s Republic”, freezing the conflict would mean losing their current leverage in Moscow and their ability to meddle in Ukraine’s plans. Freezing the conflict would also involve a massive humanitarian crisis, which should be factored into the EU’s thinking.

Decentralisation is another key aspect of the crisis in Ukraine. Russia’s push for the federalisation of Ukraine has clearly dropped off Kyiv’s agenda. Instead, the formula is decentralisation to empower local government (what President Poroshenko has called the Polish model). This policy will take the pressure off implementing the Minsk II agreement, but it risks creating a degree of dysfunctionality. Only a strong and well-functioning public administration and a clear, constitutionally-defined balance of power can provide a proper framework for decentralisation.

In order to implement the Minsk agreement, President Poroshenko said he was ready to hold referendums on decentralisation and on the status of Russian as the country’s second official language. He is confident of winning both and maintaining the newly-gained unity of the Ukrainian political nation. In any case, even if the people were to reject the use of Russian as an official language, it would not stop people from using Russian in public – and it is essential that this point is communicated publicly, because the contrary position is an important element of Moscow’s information war against Kyiv.

The Inevitable Reforms

IMF conditionality provides a good basis for reform and can be used by reformers in government to communicate to the public difficult measures. Many of its reformers understand that their public careers may be short-lived and may come at a high personal cost. Both domestic and foreign political adversaries may misuse social tensions to discredit the pro-European path.

The real battle for the future of Ukraine will be not on the military frontline; it will be the struggle to push through economic reforms. The prospects for success here look extremely bleak. High defence payments ($5-10 million/day), low tax revenues, extremely low energy efficiency, high debt servicing expenses, social payments, and housing for over 850,000 internally displaced persons are a major strain on the Ukrainian budget. The plans to cut budget spending and restructure debt will help, but the government needs to borrow another $40 billion to avoid a default. Bilateral loans from EU member states have been few and far between (examples include €500 million from Germany and €100 million from Poland). The recent EU-Ukraine summit and the related donors’ conference, on April 27th and 28th, did not change this pattern: EU leaders failed to come up with fresh money. Tis is disappointing as EU member states should make every effort to step up direct bilateral financial assistance to Ukraine in the short term. Such assistance would make a real difference now, later the stabilisation of Ukraine will be costlier and more difficult.

On the energy front, new gas tariffs have just been introduced, but their effects will not be felt before next winter. Meanwhile, energy efficiency programmes, direct means-based compensation for gas bills for the poorest third of the population, and lending instruments will be prepared.

The security situation has dimmed the prospects for oil and gas production in Ukraine. Offshore blocks between Crimea and Odessa are now off-limits to Kyiv. But Ukraine feels somewhat more confident about its gas relationship with Russia. This is due to the fact that negotiations over volume and price are being conducted in a much more transparent way now that the EU is directly involved as a third party. In addition, reverse flow capacity from the EU is enabling Ukraine to further diversify supply and reduce its overall dependence on Russia. Finally, Russia demonstrated flexibility on price during negotiations over gas supplies in the summer. Moscow seems to recognise that Russia will need both the Ukrainian gas market and Ukrainian gas transit in the years to come, given the apparent shelving of the South Stream project.

Despite the role that Ukraine can and must play in European energy security, it does not feature in Brussels’s plans for an Energy Union. Enlarging the scope of the Energy Union to include Ukraine will help create the proper regulatory framework in a region that is crucial for Europe’s energy security. 

De-oligarchisation is the keyword in Kyiv these days. The recent dismissal of Ihor Kolomoisky from his position as governor of the Dnipropetrovsk region represents an important step in the right direction: it signals the leadership’s seriousness in their attempts to diminish the role of oligarchs and eliminate them from power. The Ukrainian leadership’s stance will be crucial in accomplishing this task.

Ukrainian officials say that the only realistic prospect for growth will come from the “de-shadowisation”, or legalisation, of big parts of the Ukrainian economy. According to recent estimates, around 60 percent of businesses in Ukraine pay no tax. Rectifying this will be an important step in restoring the rule of law and reassuring foreign investors, who have thus far been reluctant to move into the Ukrainian market.

The reforms have not so far caused the government to become hugely unpopular, partly because much of the pain has yet to kick in. But, very soon, the gap between the public’s expectations and the reality will make itself felt. Things are likely to get worse before they get better. Handling the expectations gap will require strong leadership on the part of the Ukrainian government as well as visible assistance by the EU.

 

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