Is the Honeymoon on Ukraine over?

Is Ukraine lost? Again? Is the social contract between state and citizens fundamentally flawed?

We are now well past the "honeymoon period" of the post-Maidan street protests that ultimately led to the rather fast departure of the then president Yanikovich, who fled to Russia in 2014. Has the halcyon beacon of the EU helped to reshape the rampant political and economic corruption?

A spate of ministerial resignations at the start of 2016, an economy in dire straits and with a huge external debt overhang, having lost up to a third of its economic base from the loss of territories and ongoing conflict with Russia and being supported by western-supported IFI packages including dollops of soft EU macro-financial assistance, having witnessed a false dawn with the so-called Orange revolution in 2004 and the Maidan of 2014, which way reform?

Before I answer these questions, I invite you to view this video of a recent Cabinet meeting - it is fairly X rated... and unlike anything many who have attended any Cabinet meeting anywhere will have experienced. And it gives a flavour of the difficulties of copy-pasting a reform agenda without genuine political will and huge conflicts of interest without a fundamental reform of the current political system.

Many will have recognised a certain Georgian, Mikheil Saakashvili,who was former president of Georgia and now part of an "A Team" of former Georgian bureaucrats, fluent in Russian, brought in to help support the reform effort and given Ukrainian citizenships jousting (with glasses of water) with the Minister of Interior responsible for the police and security services,  himself an "oligarch". Oh yes, the Minister of Finance is originally American and the Minister of Economy - one of the key "reformers" Lithuanian-Ukrainian.

Now back to the questions. 

My starting point is to look at the data. And the picture is mixed. The odd-but-thus-far working relationship between the Prime Minister and the president has led to macroeconomic stabilisation - supported by strong western support - and important steps to liberalise the economy and reduce red tape. Global Governance indicators (that basically hoover up all available country risk indicators published) do show that Government Effectiveness has risen as shown in the figure below.

But Rule of Law?

Not so good - in fact its even worse. And the picture is the same when looking at Regulatory quality or perceptions of corruption. 

Ukraine’s minister for economic development and trade, Aivaras Abromavicius, announced his resignation in early February, citing corruption levels in the state.

“Neither me, nor my team have any desire to serve as a cover-up for the covert corruption, or become puppets for those who, very much like the ‘old’ government, are trying to exercise control over the flow of public funds,” effectively saying what many have been complaining about, that there are too many bent officials trying to continue their corrupt ways - and of more significance, that things aren't really getting any better.

There is now a real political risk that the government will fall, possibly through a vote of no confidence. Polls have given it approval ratings of less than 10%. And there is scant evidence, despite a flurry of ad-hoc measures, that there is a clear roadmap of reform  - which is worryingly familiar territory given previous false dawns and stabilisation plans effectively written at the IMF.

Despite a huge groundswell of popular support in what remains of Ukraine for a pro-EU direction of travel, it is not an EU candidate country forced to go through hoops and checklists to comply with the EU body of law, the acquis.  

And the EU's efforts beyond financial help has led to little material effect thus far. The European Commission is great if there is a natural disaster that requires fast response or when there are longer-term structural adjustments through sector plans and the like as witnessed in the enlargements of 2004 onward for the former central and eastern European economies. Less so in dealing a country that is in need of a mix of quick-win reforms and deep reform, often painful for vested interests.

It is perhaps too early to assess if the social contract is broken. But walk past the parliament in Kiev, the Rada, and the side street and its car park are full of Bentleys, Rolls Royces and Porsches when the average salary is a few hundred dollars. 

The disconnect between the elite and the rest is the effect, but the fusion of political and economic control in the hands of this narrow elite that is an unfortunate legacy in most of the ex-Soviet space is THE core root cause. 

What then are the choices for the West? One for another day, but ultimately, the sad truth is that ultimately, political ownership for reform cannot be imposed. On the other hand, if there is a serious set of governance concerns and dysfunctional system that effectively limits democratic voice and accountability then a further Maidan cannot be ruled out. For the West, the EU and the US, we have to be more sanguine and realistic of expectations, but to have more targeted conditionality - political and economic. 

Impact of the Crimean Annexation and Sanctions on Russian Growth

Whatever the narrative or counter-narrative, the annexation of Crimea by Russia is in effect.  What does this auger for Russia’s economy?

Russia’s growth was already flat-lining before the Russian-Ukrainian “conflict” with concern over the greater reliance in 2014 on hydrocarbons than in 1991 AND the increasing likelihood of a narrowing current account on the Balance of Payments in the coming years.

Did the Putin team do its sums?

Cost of Transfer of Fiscal Responsibilities To Moscow

The incorporation of approximately 2 million Crimeans represents an administrative challenge that Russia will manage although the transfer of property rights will prove more taxing whilst an asset-grab of prized real-estate or businesses has already begun.

Crimea was reliant on transfers from Kiev of around 60% of its budget of approx. $0.5 bn. Add additional (and higher) centrally managed social payments (eg pensions higher than in Ukraine) that Moscow will now have to manage and the expected reduction of both cash-payments from migrants working outside Crimea and the likely collapse – at least this year – of tourism receipts means that the net back-of-the-envelope cost to the Russian budget is around $1.5-2bn per year.

Add additional Russian transfers that will be needed to keep the Crimean economy afloat – and the total bill will be $4-5bn, equivalent to less than 0.2% of GDP for the Russian Budget.  I’m sure the boys from MinFin will have provided something along these lines in their preparatory brief to Mr Putin.

Cost of Sanctions

This is the big unknown. The Russian economy is far more integrated with the rest of the world than is often appreciated.  Even excluding the gas flows that cater for 30% of European energy consumption there is a surfeit of international connections from industry to finance that affect corporates and banks.

The combination of US and EU sanctions was scoffed at by Putin and co initially. However the very inter-connectivity of Russia to the global nexus of markets is already having a marked effect – in particular following the measures announced by the US.  Global banks will be reticent to fall foul of the US’s regulatory net by touching anything associated with the Putin Inc. clan that have been shown the equivalent of soccer’s Yellow Cards.  With regulators purportedly checking bank exposures to Russia, and with recent experience of handling and containing potential contagion, the possibility of a tail-risk event such as a gradual Iran-style financial squeeze led by the US could seriously hurt Russia.

With rating agencies such already highlighting a “negative” for Russia and reports of credit lines being cut, the initial flight of hot funds may prove to be a more lasting factor than Putin’s strategists may have anticipated in their cost-benefit analysis of the Crimean blitzkrieg.

Interbank rates in Moscow have risen over a percent over the last 48 days and the US’s clever focus on Bank Rossiya and the resultant freeze on its quarter of a million credit card holders by Mastercard and Visa will have done more to hit home to the rich upper and middle classes the potential financial impact of even a modest lock-out from the international financial architecture.

Old hands in Russia from the 90s will be aware of the  risk of mini bank runs given memories of two previous Russian financial crises since the Soviet collapse in 91 but I see this less of a risk and the Central Bank will manage any liquidity crises given its oodles of reserves.

One hopes that diplomacy at least de-escalates the situation so that the threat, in particular, of harsher German-led EU economic sanctions dissipates. If not the next round of trade and financial sanctions on Russia – and its likely reaction against foreign investments in Russia by it – will unfortunately mean a greater hit on the Russian economy.

The Putin model relies on hydrocarbon revenue and the short-term risk of say the US releasing reserves on the global market will have less of an impact than imagined as supply is based on agreed forward prices.

However if such a move affects the forward curve and at the same time presages a very likely structural shift in EU energy demand for Russian gas through say a strategic “energy security pact” to import US gas and accelerate alternative LNG and from other supply sources in the Mediterranean, then this will have a harder medium-term hit on the Putin model and its economy.

Compensation for loss of State Owned Assets to Ukraine?

Murky waters and hardly mentioned so far… but assume that Ukraine,  with western assistance, is able to get safe passage out for its military personnel.

And that it seeks damages from Moscow for loss of key refineries and other assets. .. what then?

The “zero agreement” at the time of the Soviet Dissolution amicably done by the successor republics and Russia was for Russia to assume all external debt obligations but also to secure external assets – including Soviet embassies. As the takeover in Crimea is an annexation and essentially – despite Russian protestations – in violation of the Budapest Agreement it signed in 1994 that recognized Ukraine’s borders, it is highly probable that Ukraine could seek damages in almost any western country.

Summary:

1.       The nominal cost of running Crimea will be peanuts but the short term cost for Russia will reduce growth by  1/5% of GDP to around 0.5%-0.7 and lower than the 1.3% year-start forecast.

2.       Russians are feeling very proud of Mr Putin but domestic consumption will be lower as the financial squeeze from the sanctions hits home and the cost of capital rises and imported inflation rises on the back of a falling rouble.

3.       Trade will be affected – both due to the rise in country risk and delay or cancellation of cross-border projects – but also due to the significant impact on Ukrainian-Russian trade, even excluding the risk of putative economic sanctions from the EU. The Current Account could be wiped out.

4.       An escalation of tension will lead to a much higher hit on the Russian economy from the external squeeze – particularly through the financial links - but Putin's government will tap into the huge fiscal reserves to ensure growth remains at least round 0.5% of GDP.

5.       Mr Putin has in effect secured his re-election! In turn the Putin 2.0 economic model will last longer . The EU will accelerate to reduce reliance on Russian gas. Together these two factors will lower trend growth.

Ukraine, Key Political-economy Concerns and Stabilisation

There are several overarching questions and concerns that are exercising the international community, some of which include:

• How did it get to this stage with Ukraine and Russia now on the brink of war?
• What can be done to assuage Russian concerns and de-escalate the situation?
• What does it mean for the longer term for Russia’s neighbours from the Narva region in north-east Estonia through to the ‘stans in the east and even Moldova in the south-east where there are sizeable Russian populations (if not majorities as in NE Estonia)?
• And in turn for the EU that now houses several former members of the Comecon bloc and for its own energy security given the continued reliance on Russian gas and for financial centres such as London a reliable diet of Russian capital – legal or otherwise – as well as listings?
• Concurrently how can the EU utilise its very successful soft power refined during the Accession Process since the late 90s that has helped former planned economies to successfully transform into functioning, democratic, market economies?
• And the Economics: how does the putative conflict between the countries likely to affect the economies of these two countries – both over the short and medium term -  and what are the potential spillover effects onto neighbouring economies? 

As someone who has advised worked on both countries (inc. the Crimea) since the mid-90s I have my own views on these questions from first-hand experience and various writings.

In this blog entry I will focus only on the last question as it is perhaps the underlying and central cause of the current malaise. Although events over the last few months seemed to accelerate toward the end till the eventual exit of the now-former president Yanukovych, to many of us long-time Ukraine-watchers the situation had been steadily worsening with gross mismanagement of the economy and in effect a social mis-contract between the political-economic elite that are essentially the one-and-same to effectively asset-strip the state, allow rampant corruption and in effect created the disconnect and discontent that so fuelled the anger on the street.

Result: macroeconomic instability with the economy in recession since 2012 but which was buoyed previously due to demand for steel from Russia and globally, a large current account deficit, fiscal mismanagement and with FX reserves below 90-day cover.

In the last week has seen the Ukraininan currency, the Hryvna bombed and Ukrainian assets nosedived as investors rushed to the Exit doors.  The threat of bank runs has been temporarily halted through restrictions on withdrawals but the threat of meltdown remains a tail risk without external support. The necessary devaluation through an open float of the currency will push up imported inflation and further reduce real incomes and purchasing power.

Though Russia has too been hit it is sitting on a half trillion dollar reserve base inclusive of oil funds and will ride out the storm…one for another blog.

Ukraine will, however, need rapid stabilisation and to their credit the big guns in the form of the IMF and the EU are already making preparations for rapid-response loans and budget support using the experience from recent years in the Eurozone and elsewhere.

The key question beyond short term plugging of financing gaps will be whether Ukraine will be willing and able to undertake genuine reforms to ensure sustainability. This in turn will depend on how the Russo-Ukrainian spat plays out – the longer the duration, the more costly the impact and the reconstruction/redevelopment efforts.

It will also depend on political will and all the bonhomie rhetoric from some western capitals about the Ukrainian parliament being the people’s senate ignores the rather unsavoury truth  that it does unfortunately retain the reputation of being a Members Club for crooks. Whether this group in the Rada has the courage or willingness to sanction broad-based reforms remains to be seen, particularly difficult reforms to balance the fiscal books through necessary but potentially difficult political amendments to the energy deficit that has been soaking close to 8% of GDP in subsidies.  A fresh election may well be required to give the new government a genuine mandate.

The so-called Orange Revolution in 2004-05 was pyrrhic and a gross disappointment for those that saw it as a precursor of a fundamental redress of governance in Ukraine. Unfortunately, and despite significant good-will and dollops of western assistance thereafter there was little real appetite in Kiev to modify the status quo and despite some sterling efforts to kick-start reform at a regional levels.

Hopefully, the penny has dropped for many of these rent-seeking members of the elite that political stability and effective economic governance go hand-in-hand….and hopefully the sabre-rattling from Moscow will cease….and the hit on the RTS, the rouble and share prices in energy stocks in Russia may well catalyse this.