SUMMARY:
·
Analysts
have been behind the curve on the Ukraine/Russia crisis, typically neglecting
to consider worse case scenarios, which have tended to result. Now might be the
time to think through the consequences of less market-friendly outcomes.
·
The
military status quo on the ground appears unsustainable. The Ukrainian military
is making significant gains, and is eager to secure victory by the time of
parliamentary elections in October.
·
Russia
has to make some difficult choices, whether to accept ‘‘defeat’’ in Ukraine,
and back off, taking a less confrontational approach, or double up and move to
a more formalised intervention to stem the advance of the Ukrainian military.
·
We
attach a relatively high probability to an attempt by Russia to muster support
for intervention by a Russian-led peacekeeping force. We think the West will
block such attempts at the United Nations Security Council but, depending on
developments on the ground, Russia might still intervene more directly, using
regular troops ‘‘branded’’ as peacekeepers. We think that such a strategy would
risk a direct conflict between Russian and Ukrainian troops, which would
represent a further and significant escalation of the current conflict. We
think any such conflict would though be of a relatively short duration, albeit
intensive and damaging, but with the risk that Donbas, alongside Crimea,
becomes a ‘‘frozen conflict’’ and a source of long term friction between the
West/Ukraine and Russia.
·
We
see almost no chance of NATO becoming involved in a direct military conflict
with Russia, but the West could move to arm Ukraine, in response to Russia’s
direct intervention in Ukraine, and NATO is also likely to boost military
assets available to the Baltics and Poland.
·
The
West is likely to implement a further sanctions iteration on Russia, in
response to further and more formalized Russian intervention in Ukraine. These
sanctions will be slow to roll off, without agreement on a longer-term solution
over the issues of the future of Crimea, the Donbas and also Ukraine. Sanctions
will have a lasting and negative impact on relations between the West and
Russia, and more directly on investment in/out of Russia and more broadly on
Russia’s outlook for growth, development and also market perceptions.
Introduction
The crisis
in Ukraine has been nothing if not unpredictable throughout. Indeed, time and
time again the crisis has lurched to yet another worst case, or ‘‘Black Swan,” scenario.
To recap, no one expected the Maydan protests, few predicted the ousting of
former President Viktor Yanukovych, and similarly there seemed total
incomprehension beforehand that Russia would annex Crimea as it did in April,
questioning Ukraine’s territorial integrity and driving through the Budapest
Memorandum of 1994 (a lynchpin of regional security and global nuclear
non-proliferation) nor that Ukrainr could see a major conflict on its territory
— Ukrainians as recently as April were indignant to me at least at the
prospect of Ukrainians fighting Ukrainians, or even Russians; I should add
herein that most Ukrainians still do not see the current conflict as a civil war,
but rather a war of liberation against foreign intervention and aggression by
Russia. And again, few people predicted Western sanctions on Russia, or that Russia
would not back down, but would remain on a course heading towards conflict and confrontation
with Ukraine and the West.
In
understanding this abject failure to call this crisis I would highlight that
the bulk of analysts tend to be either Russian or Ukrainian specialists, and
there are few that cover and understand both credits, and how they interact,
that well. I am also of the view that Moscow invariably misunderstands, and
perhaps does not want to understand, Ukraine, viewing the country very much
through a Russian prism — the latter related to Moscow’s failure to totally
accept the concept of Ukraine as an independent state, some 23 years after the
collapse of the former Soviet Union. Of note also, with the Western focus on
the battle against global terrorism, post-911, few Western government’s devoted
that much ‘‘resource’’ to former-Soviet Union geopolitics — there are only a
handful of experienced post-Soviet specialists in the UK Foreign and
Commonwealth Office as far as I am aware, and I sense a similar level of
resource at the US State Department.
So should
we begin to think about possible future worst-case scenarios now — they are no
longer really Black Swan events, but quite possible outcomes? Prudence suggests
that we should. In the specific case of the current crisis in Ukraine, the
conflict shows little sign of abating, indeed, in the short term the conflict
looks set to intensify, as Ukrainian forces move in to finally try and clear
separatists from their strong-holds in and around Donetsk and Luhansk. The
imperative therein from the Ukrainian side to move quickly is multiple and
compelling:
• The
Ukrainian military currently has momentum on its side, and wants to retain the
initiative while it can, and perhaps before parliamentary elections likely by
October, and before winter sets in;
• The
longer the crisis goes on, the higher the humanitarian costs, and also the
larger cost to the Ukrainian economy which is already struggling from the
impact of the conflict and disruptions to trade ties, Russian sanctions and
disruptions to energy supplies. Continued conflict in the Donbas — which
accounts for 13-18 percent of gross domestic product — will make broader
macro stabilization that much more difficult.
•
Similarly, while the conflict continues the very latent threat of a more
formalized Russian intervention remains, with the threat then that this becomes
a frozen conflict, which would then play to Russia’s longer term strategic
objectives in Ukraine (No NATO, No European Union and no successful
Maydan-style administration). The authorities in Kyiv simply do not want to
give Moscow any further leverage to negotiate over the longer term future of
Ukraine.
With the
Ukrainian military likely on the offensive, and poised to clear the Donbas of
separatists, the risk then is that Russia would suffer a significant defeat in
respect to its policy towards Ukraine, and indeed the near abroad. Therein we
would highlight: No one has read the Ukraine crisis well, reflecting a lack of
deep understanding of the region. But time to plan for worst case scenarios. The
clock is counting for the Ukrainian military
While ‘defeat’ looms for Russia
• It would
likely face a much less Russo-centric Ukraine, with the recent crisis having re-invigorated
support for Ukrainian statehood, and this likely reflected in the election of
Petro Poroshenko as president in May, and the expectation that statehood
parties win a landslide victory in early parliamentary elections expected now
for October. Ukraine is likely to be much more Western-focused, likely set to
re-arm, to counter the perceived threat from Russia. This new Ukraine would perhaps
present a very significant latent threat to Russia’s security — at least when
viewed from Moscow.
• With
Ukraine set on a European orientation, Russia’s hopes of forging a CIS Customs/Eurasian
Union will lay in tatters — these entities amount to little without Ukraine’s
43 million people.
• An
economically successful Maydan administration would represent a clear challenge
to Putin’s ‘‘power vertical’’ and ‘‘sovereign democracy’’ concepts, as the
underlying values of the Maydan — free markets, rule of law, and justice,
could well play well in Russia, to Russians, and hence be transportable across
its border, threatening the durability of the Putin regime at home.
• Having
re-invigorated Russian nationalism at home, and having sold the ongoing conflict
as a battle against fascism, it seems difficult to see how Putin can now accept
defeat — or the failure to adequately support the separatist cause — the
annexation of Crimea is unlikely to provide a sufficient enough and
long-lasting feel-good factor. It is thus unclear whether Putin would be
willing to accept the defeat of the separatists in the Donbas — in whom Russia
still appears to have invested significant political capital, and military
support, not to ignore the large number of Russian nationals reported to be
fighting in the Donbas, and in fact in the top leadership roles of the
insurgency. The risk therein still is that Russia is further dragged into the
current conflict, escalating its role in support of the separatist cause.
Against the
above backdrop we have tried to think through the most likely scenarios now
lying ahead in terms of further Russian involvement in the conflict, and the
likely Western response:
What are the various scenarios?
First,
accept ‘‘defeat’’ in Ukraine, and step back, allowing the separatists to filter
back across the Russian border, and then fall back to a position where Russia moves
the focus to an economic war with
Ukraine, e.g. by imposing trade restrictions — rather similar to the scenario
which played out in 2005/06 after the Orange Revolution. Presumably then Moscow
would seek to ‘‘calm’’ the anti-Ukrainian rhetoric in the Russian press and
focus on the great merits of the reclamation of Crimea. I would perhaps attach
a 25% probability now to this scenario. Russia’s decision to step back therein
would be driven by the threat of further Western sanctions, plus also the military
calculation on the ground that any such formal military intervention could be
high risk, and likely subject to failure — e.g. in an Afghanistan-style war
of attrition.
A second
scenario would be a continued and ever increasing military support for separatists
but still implemented via ‘‘informal’’ support, with the hope of eventually
stopping the Ukrainian military in its tracks, and ensuing a ‘‘frozen
conflict’’ style scenario in the Donbas, where the West and Kyiv are forced to
negotiate and offer concessions to Moscow. This scenario also probably rests on
the military calculation on the ground, and whether the Ukrainian military have
the appetite and means to engage in the likely tough battles to retake the
large cities of Donetsk and Luhansk. This scenario would be for Russia to try
and drag out the conflict on the ground as long as possible. I would perhaps
attach a 25% probability to this ‘‘attritional’’ scenario.
Third, the
Russian military could simply opt for a full scale, formal military incursion
into the Donbas — unlikely extending beyond that. The calculation therein is
whether territory could be taken, and held and at what military/economic cost,
and the likely sanctions implications. I would perhaps attach a 5% probability
still to this scenario at this stage — the low probability therein is gleaned
from the fact that if Russia had this as a prime game plan, it would have
already probably done so already, e.g. around the time of the annexation of
Crimea, when it had a more decisive military advantage.
Fourth, and
perhaps now the most likely scenario, is that Russia tries to intervene in the
Donbas under the guise of a peacekeeping role, and again with the aim of
halting the advance of the Ukrainian military. Russia might push for a formal
UN mandate for such an operation, under the cover of providing much needed
‘‘humanitarian’’ assistance. However, we think the US and the West would veto
any such attempt in the UN Security Council arguing that the Ukrainian military
is correct in its current efforts to root out ‘‘terrorism’’ in the Donbas.
Under this scenario, and where the Ukrainian military continue to make
advances, regular Russian troops could still roll across the border with
Russian ‘‘blue’’ helmets, without a formal UN mandate. In effect they would aim
to halt any further advance of the Ukrainian military, perhaps limiting their
own advance to territory only currently held by separatists.
An
important question then would be if the Ukrainian military would resist any
such actions — we think they would, and hence this scenario could well
produce a high intensity conflict but perhaps of a relatively short duration.
We would think that Russian troops would likely be able to establish a
sufficient bridge-head in the Donbas, to ensure a ‘‘frozen conflict’’ scenario
which could run as long as similar situations in northern Cyprus,
Nagorno-Karabakh, Trans-Dniestr, or indeed South Ossetia/Abhazia.
Invariably
these types of conflict are acutely difficult to resolve. We would now perhaps assign
a 35% probability to this scenario — unless of course the West responds by
racking up the odds, for example, with the threat of yet more sanctions, and
sooner rather than later.
Fifth —
any other scenarios, 10%, as anything is possible in this current crisis. And
how is the West likely to react? A critical question for both markets and
likely in Moscow’s mind in terms of its own future actions in Ukraine will be
how the West will react to a more direct Russian intervention in Ukraine.
As a
starting point I think it is fair to say that there is a very low probability
of any direct NATO involvement in the current conflict, e.g. to extend a
security guarantee to Ukraine. There is simply no appetite across NATO members
to step in to militarily defend Ukraine — this much was evident after the
annexation of Crimea, as both the UK and US were guarantors of Ukraine’s
territorial integrity as per the Budapest Memorandum. Indeed, if NATO was going
to intervene, it was back in April. However, we would expect that NATO would
feel obliged to react to perceived Russian aggression, and to shore up
confidence of NATO members, particularly the Baltics and Poland. Thus NATO is
likely to agree to arm Ukraine, and would likely boost defence capability close
to Russia’s borders, in existing EU member states. The West will also likely
feel obliged to move towards a further sanctions iteration.
More
Russian individuals and corporates are likely to be subjected to sanctions, and
the scope of sectoral sanctions will likely be broadened and deepened. However,
we still think that the West will stop short of moving to Iran-style sanctions.
Perhaps it will be important to note that after a more formal intervention by
Russia in Ukraine the West is likely to be eager first to stop military
activities, which will presumably be ongoing, and then try and push more formal
peace negotiations. Some Western countries will thus likely then argue for a
step back, compromise and negotiation, before moving much more aggressively
towards sanctions. An argument will probably be waged that Western sanctions
had failed to stop Russian
expansionism, and that another tack is to raise the stakes again now
required — albeit there is much evidence to suggest that existing sanctions
rolled out have already changed Russian decision functions, and slowed both the
pace and scope of its intervention in Ukraine.
Concluding remarks
In summary,
we would argue that the existing situation on the ground in Ukraine, and the
Donbas in particular, is not sustainable. This crisis looks set to further
develop, with the risk that advances on the ground by the Ukrainian military
provoke a more formal reaction from Russia. This risks a further round of
Western sanctions, which could further drive Russian asset prices lower in one
further blow-out, before all sides look perhaps for something of a time-out and
attempts at a negotiated settlement. It has to be noted though that the crisis
is still filled with many uncertainties, and further Russian intervention could
still have very uncertain outcomes.
Timothy Ash
is an analyst of emerging markets for Standard Bank in London.
