By these developments Europe has come closest to a major land war for the first time since the fall of the Berlin Wall, with shades now of a return to the Cold War, and of Russia set against the West. Suffice to say that is a hugely dangerous scenario with potential global impact.
I think most people, including myself, expected a very significant Russian reaction to the fall of the Yanukovych regime in Ukraine, but I think the consensus was that this would primarily be in the field of the economy, with for example, the expectation for the pulling of the remainder of the USD15bn aid package for Ukraine, higher gas prices and disruptions to cross border trade. No one imagined a scenario involving direct Russia military intervention in Ukraine – which is what we are currently experiencing. Russia has crossed all the lines, the only question is how much further it is willing to go, and what the West can do to halt Russian expansionism?
Russia has explained its intervention in Crimea as defending the safety and security of ethnic Russians in Ukraine, following what it claims is the victory of radical/terrorist forces in the recent Maidan unrest in Kiev and elsewhere. There has, however, been little real evidence of inter-ethnic conflict in Ukraine though the last several months of street protests.
Moscow seems instead greatly irritated by the fall from power of its proxy, Viktor Yanukovych, and what it sees as the unacceptable move by the new Maidan administration in Kiev towards deeper Western orientation/integration. Moscow likely sees this as precluding Ukrainian membership in its own CIS Customs Union, and the Eurasian Union, which is now the centre piece of President Putin’s domestic and foreign policy agenda – there is clearly no meaningful CIS CU without participation of Ukraine and its 46 million people. Moscow perhaps also views Ukraine’s signing of the AA/DCFTA with the EU as the thin end of the wedge and a precursor to its eventual membership in NATO – even though successive Ukrainian governments have ruled out NATO membership, and opinion polls have shown majority opposition amongst Ukrainians for NATO membership. Clearly Moscow feels that signing the AA/DCFTA as an inevitable precursor to NATO membership would damage its security interests, and particularly the strategic position/importance of the Black Sea Fleet, located in Crimea.
I had assumed that Russian action after victory by the Maidan forces in Kiev would have focused on stalling/derailing the signing of the AA/DCFTA, I.e. buying time. However Moscow’s direct intervention in Crimea, and threat of broader intervention across Ukraine’s borders (laid open by the vote in the Russian State Duma now giving the government the legal basis to do this) perhaps suggests a much more aggressive strategy. Perhaps the assumption is now that Ukraine will not sign up to the CIS CU – Russia’s action in recent days have now made this incomprehensible – and the game plan is to redraw borders to include in a Greater Russia those parts of Ukraine significantly comprised of ethnic Russians. Perhaps the game plan now is to destabilise Ukraine to such an extent that these South and Eastern parts of Ukraine, follow the Crimea in asking for Russian military intervention, and in so doing Russia then annexes these regions alongside the Crimea.
If the above strategy is correct, this is a quite incredible, bold and an extremely high risk approach from Moscow.
In Ukraine the danger for Russia is that this just cements support for an independent Ukraine, rallying support behind the Maidan administration in Kiev and against Russia. But therein Putin perhaps is still confident that so much anarchy can be sown in Ukraine that inevitably regions in South and Eastern Ukraine will request Russian support and intervention. Over the weekend pro-Russian demonstrations were held in cities in Eastern Ukraine, attended by upwards if 10,000 people, and some of these were violent.
What can the West do?
Much has been made of the fact that Russia, the US and UK signed the Budapest Memorandum in 1994, which in exchange for securing agreement on the decommissioning of nuclear weapons present in Ukraine, guaranteed Ukraine’s territorial integrity. That said, it seems very unlikely that the West would be willing to risk all out war with Russia over Ukraine, given the the clear nuclear threats. As has been noted, the West did not intervene to counter Russian intervention in Georgia in 2008, and the annexation of South Ossetia and Abhazia. Moscow is probably making a similar assumption this time around – albeit it seems as though the West maybe willing to provide military assistance (arms, training, intelligence) to Ukraine, as it did with Georgia in 2008. Ukraine does have a much larger military than does Georgia, and perhaps would put up significant resistance to a Russian intervention. However, as evidenced by defections from the Ukrainian navy in Crimea over the weekend, the effectiveness of the Ukrainian military may be undermined by internal divisions and further defections. The danger though for Russia still is that it could be dragged in to a brutal and long running civil war in South and Eastern Ukraine, with an uncertain outcome, a large draw on the already weak Russian economy, and with potential to disrupt the Russian economy, e.g. disrupting trade/transport routes, and energy transit.
President Obama and State Secretary Kerry have both warned of repercussions for Russia’s action, and hinted of possible sanctions. Already Western governments are signalling that their participation in the G8 summit in Sochi in June is now under threat. We also think there is a real chance of economic and financial sanctions being imposed on Russia. These could involve asset freezes, and visa bans as have been threatened and then rolled out by the West with respect to the former Yanukovych regime in Ukraine.
Can Western action impact on Russia?
We think that the threat and imposition of sanctions by the West on Russia could be effective.
First, targeted sanctions rolled out on key regime members and oligarchs proved effective in finally forcing the Yanukovych regime in Ukraine to the negotiating table, and helped secure the signing of the January 21, 2014 agreement that eventually brought the demise of the Yanukovych regime.
Second, as with Ukraine, Russia’s political and business elites live, invest and educate their offspring in the West. I estimate that over the past 20 years at least USD1trillion in Russian elite assets has been deposited offshore, mostly in the Western banking sector. The identification and freezing of these assets could have a sobering impact on its elites. Similarly, elite sanctions, asset freezes and trade restrictions could make it very difficult for Russian banks and corporates to secure external financing/roll over debt liabilities. This comes at a time when the Russian economy is already suffering from low growth dynamics, and a crisis of confidence which is seeing consumption and investment dip, and capital flight accelerate. The rouble has been on a weakening trend for some months now, and elites/oligarchs would likely move to increase capital flight to try and defend their interests. True the, CBR has a weight of FX reserves – close to USD500bn – but as we saw in 2008/09 this could quickly drop precipitously, accentuating concerns and capital flight into a vicious process. Devaluation/corporate default/restructuring would quickly produce ratings downgrades, higher borrowing costs and lower long term growth prospects.
Russia could easily retaliate, e.g. by cutting energy deliveries to Europe. However, Europe is already worried by over dependency on Russia for energy security – not helped by supply disruptions via Ukraine after previous bouts of geopolitical tension between Russia and Ukraine – and has been diversifying away from Russia. Further disruptions to energy supplies from Europe would see accelerated efforts to diversify from Russia, e.g. to LNG, hurting Russia over the longer term. Would Russia risk further accelerating this process, and in turn make it even more dependent on markets in China? Perhaps not, but predicting the actions of President Putin is becoming increasingly difficult, and as the national mood on Russia itself becomes ever more jingoistic, egged on by the official media.
In the very near term we expect rating agencies to downgrade Russia’s ratings, as the fear will be for disruption to trade, FX weakness, capital flight, and a generally less market friendly policy impulse. This crisis will have already changed risk perceptions of Russia and the Putin administration in a very negative way.
How are developments in Crimea going to impact on Ukraine?
The latest setback in relations with Russia come at an already acutely difficult time for Ukraine, as its economy is already tottering on the brink. Real GDP growth was close to zero in 2013 – the economy was actually in recession for much of the year, only pulling out of recession in the final quarter due to a better harvest buoyed the important agricultural sector. The budget deficit is estimated to have amounted to 7-8% of GDP in 2013, and the current account deficit amounted to around 9% of GDP. A wide external financing requirement and efforts to hold to a rigid exchange rate regime saw FX reserves collapse to only USD15bn at present down from a peak of USD38bn in 2011, and providing less than 2 months of import cover. The MOF has reported having less than USD1m in its single treasury account, and will likely struggle to cover day to day cash demands – leaving it entirely reliant on NBU financing in turn creating risks of a spike in inflation. Amid heightened political and economic risks the banking sector has suffered significant deposit flight in recent weeks – at least 10%. This has likely weakened the capital base of many banks, and the sector now poses systemic risks. The UAH has suffered a marked depreciation, and the NBU has now stepped away from trying to defend the currency.
Assuming no decent into actual conflict, but more likely the imposition of trade restrictions and blockades from Moscow, alongside a halt in investment and dip in business and consumer confidence, there will likely be a very significant fall in real GDP this year – likely 5-10%. We assume further weakness in the UAH, and further pressure on the banking sector – efforts by the NBU to underpin the sector by providing additional liquidity injections will likely feed thru into further exchange rate weakness, without speedy provision of external support. Budget revenues will likely weaken, the budget deficit widen, and this will pressurise government debt ratios as will the likely need to recapitalise the banking sector.
A conflict scenario, with further Russian military intervention in South and Eastern Ukraine, the threat of civil war, and all out war with Russia, would accentuate all the problems noted above. Conflict economies can easily suffer 20-30% real GDP declines, depending on the length/severity of conflict.
The Ukrainian government has requested outside financial assistance, and an IMF mission is expected to visit Kiev over the next week. Hopes are for a 2-3 year programme, perhaps for more than USD15bn in financing, linked to the identification of a far reaching reform programme. The extent of threats now facing the Ukrainian economy may stall provision of IMF assistance – the fund are likely to want to see some normalisation of the security situation before rolling out a new programme. Ukraine may, however, now benefit from a range of bilateral and concessionary financing facilities from the West. However, it still seems unlikely that this will be much more than perhaps USD3-5bn. This may not be sufficient to cover budget and external financing pressures which may now surface.
The future of the AA/DCFTA must now be in some doubt. The EU will likely want to see some stabilisation in the domestic political situation before moving to sign this agreement, and will likely want to see the conclusion of the scheduled presidential elections due on May 25, 2014. There must though be some doubt now as to whether these elections can go ahead as scheduled, given the security situation on the ground.
In conclusion, there are now huge risks/pressures facing Ukraine and the Ukrainian economy. It is now acutely difficult to predict an outcome to current political and security risks facing Ukraine, or to predict likely economic outcomes. A stabilisation in the security situation is essential, and some normalisation in relations with Moscow – albeit at this stage this is very difficult to envision given the seismic changes which have taken place in recent weeks in Ukraine.
Timothy Ash is an analyst with the Standard Bank in London.
