Medium-term political outlook in Ukraine

The international situation of Ukraine in 2013

Early March 2013

Ukraine finds itself in a tug of war between the countries of the liberal-democratic West and Russia. The geo-political choices made by Ukrainian leaders in 2013 will set the broad course of the country’s political development over the medium term.

The main attraction of closer association with Russia is the prospect of cheaper Russian gas, on which swathes of Ukrainian heavy industry and most Ukrainian households depend. However, this would be offered only in return for joining the Russian-dominated customs union or ceding control of at least some of Ukraine’s gas pipeline network, which connects Russian suppliers with lucrative energy markets in Western Europe. These are both outcomes that most Ukrainian political leaders would resist.

Against this, the pull of closer integration with Western structures is twofold. The first is the prospect of finally ratifying an EU association agreement at the EU’s Eastern Partnership summit in Vilnius, Lithuania, in November 2013, and the “deep and comprehensive” free-trade agreement (FTA) that goes with it. Following the 16th EU-Ukraine summit in Brussels at the end of February, José Manuel Barroso, the president of the European Commission, stressed that a boost to trade, investment and economic modernisation were among the benefits that Ukraine could expect from such a development. In addition, greater integration into the EU’s energy system could shore up Ukraine's energy security. For many of the politically well-connected business groups that dominate Ukrainian politics, this could offer considerable opportunities to expand their business empires by offering privileged access to the single market—the world’s largest in terms of GDP. In addition, in 2013 the government faces sizeable debt repayments, as well as clear signs of mounting domestic financial strains. A second attraction of the West is, therefore, the prospect of a large loan from the IMF. Another visit by the Fund to Ukraine for negotiations on this issue got under way in late March. The agreement of a loan with the IMF would provide the funds needed to address the country’s financial problems directly, while boosting market confidence about the direction of economic policy, and helping to steer the economy away from a full-blown financial crisis. However, from the point of view of Ukraine’s leaders, clinching an association agreement will depend upon addressing EU concerns about the politicisation of the judiciary and the imprisonment of opposition political leaders during Mr Yanukovych’s presidency. If this means having to free Ms Tymoshenko, the most prominent opposition politician, the governing group will be wary of a conflict with their overriding goal of winning re-election for Mr Yanukovych in 2015. In respect to a borrowing deal with the IMF, the Ukrainian administration will be afraid that the economic reforms demanded in return for a loan—especially increasing gas tariffs to the population and easing the fixed exchange rate—will damage the living standards of key political constituencies (thereby further undermining its political support), and exacerbate the strains on public finances and on the banking system. These fears will have been stoked by the recent mass protests against high energy bills that swept Bulgaria in late February, leading to the resignation of the Bulgarian government.

Scenarios for Ukraine’s political development

In this context, a number of political scenarios are possible. The Economist Intelligence Unit’s main scenario is that Ukraine makes a tentative move towards greater integration with the West. However, recent political events have made a second scenario—maintenance of the status quo between Western and Eastern political blocs—an increasing possibility. This nevertheless comes with a high risk of financial destabilisation. It is possible that a financial crisis of this kind could be averted by a turn back towards Russia (the third scenario), but it could easily merge into our fourth scenario, by triggering another outbreak of mass social unrest at home. At the moment, we consider the third and fourth scenarios as less likely than either of the first two.

Main scenario: “Unconditional” Western integration, but with certain conditions

Caught between an urgent desire for external funds to avert an economic crisis and the goal of securing the presidency in 2015, the ruling group around Mr Yanukovych and his PoR tries to pursue a creative middle course.

In negotiations with the IMF, the government underscores the dangers of a "Bulgarian scenario"—that is, of politically destabilising popular protests against increases in fuel prices. As a result, the government achieves compromise deals on key reforms—an agreement to limit the impact on the general population of domestic gas price rises, and to devalue the hryvnya only partly. A deal on programme lending is signed in mid-April. Ahead of the EU’s May deadline for “tangible” evidence of movement on the association agenda, this contributes to the sense that Ukraine is making progress on the necessary economic reforms. The government tries to meet most of the EU’s economic and trade requirements. To address the issue of “selective justice”, some of the less prominent opposition figures are released, perhaps including Mr Lutsenko, a former interior minister in Ms Tymoshenko’s government. Promises are made that the case against Ms Tymoshenko will be reviewed with all possible haste—but that, in view of the seriousness of the charge (she is a suspect in the murder of a business rival in 1996), no country in the world could be expected to dismiss such charges out of hand. The authorities hope that the release of the first few tranches of the IMF loan is enough to get them past the immediate threat of an economic crisis. They bank on achieving sufficient progress in most economic and financial areas to convince the EU to compromise, on the assumption that the EU is eager to demonstrate a definite success story at its Eastern Partnership summit in Lithuania in November, and that it sees Ukraine as too valuable a prize to lose to Russia.

Ukraine signs its EU association agreement in November. However, the case of Ms Tymoshenko is dragged out for as long as possible, perhaps right up until the 2015 presidential election. Meanwhile, the short-term negative economic impact of raising gas tariffs and loosening the hryvnya peg—on consumer spending and bank lending, for example—erodes government support still further. The positive impact of the same measures—in terms of boosting exports and hence economic growth, and taming the signs of macroeconomic destabilisation—occur too late and too weakly to boost the government’s electoral prospects in time for the 2015 presidential vote. The government pulls out all the stops to hold on to the presidency, employing (for example) a mix of administrative resources and intimidation at the local level; heavy propaganda campaigns on the national TV stations owned by pro-government oligarchs; threats of “investigation” by the tax authorities against the business holdings of non-compliant business leaders; large-scale spending sprees on wages and public relations (PR) campaigns; creation of “clone” candidates (either with the same or similar names as opposition candidates, or with a similar policy offering) in order to split and confuse the opposition vote. Some creative new scams are implemented, as yet not invented.

The conduct of the election and its outcome—the re-election of Mr Yanukovych as president—are condemned by international observers as a backward step in democracy. Ukrainian leaders say that they are ready to make amends by moving unconditionally towards democratic norms and against corruption. At the same time—not wishing in practice to be held to their democratic promises—it is made clear that Ukraine remains interested in joining Russian economic structures.

Second scenario: Neither Brussels nor Moscow, but political stagnation and an economic crisis

It proves simply beyond the capacity or inclination of the groups that compose the Yanukovych regime to fulfil the political demands of the IMF and the EU. The regime stays put between political blocs and attempts to “muddle through”. It decides to content itself with plundering the domestic economy, as per usual. However, this has some very serious economic consequences.

Following a high-profile meeting with Mr Yanukovych in Brussels at the end of February, EU leaders called for “tangible progress” from Ukraine in three areas by early May, if the Ukrainian government hopes to proceed with ratification of its EU association agreement this year. The three areas specified are a clarification of electoral rules; implementation of the judicial and economic reforms required for association; and movement on “selective justice”, which alludes to the use of the courts to sideline opposition political leaders. For many observers, the absence of any progress on these criteria since previous high level meetings with the EU in May 2012 or December 2012 strongly favours a “staying put” scenario. Recent supporting evidence for this would include the flawed conduct of the 2012 parliamentary election, as well as the launch in January of a fresh investigation—this time as a suspect in a murder case—against Ms Tymoshenko. The latest move against the jailed former prime minister seems designed to prevent her from running against Mr Yanukovych in the 2015 presidential election, should forthcoming rulings by the European Court of Human Rights make it difficult to keep her locked up on the current charges.

However, in the current difficult economic situation, attempting to keep things as they are—with Ukraine positioned advantageously between rival political blocs, playing them off against one another—is unlikely to be cost-free. From the perspective of the current administration, it could even be more dangerous than the first scenario, because it implies greater risk of a loss of economic control and, perhaps, a more rapid and extensive loss of political support. This is the scenario of a full-blown financial crisis, which could pan out as outlined below.

Ukraine is unable to agree a programme loan with the IMF, but announces that it can go it alone, as it did in 2011-12. However, following an inconclusive election in Italy in late February and the threat in March to expropriate Cypriot bank deposits as part of the country's EU bail-out, this happens just as uncertainty over the fate of the Euro area intensifies again on international financial markets, causing investor sentiment to sour towards emerging markets. Together with clear indications of serious strains in Ukraine’s finances—economic recession, wide budget and current-account deficits, low official reserves, and low levels of foreign direct investment (FDI)—the government’s access to international capital markets is affected. This takes the form of a considerable constriction in access to borrowing and at a higher cost. Concerns grow that the government might be unable to borrow sufficient funds cheaply enough to meet its short-term debt repayment schedule, estimated at around US$9bn for 2013 as a whole. The prospect of a sovereign debt default looms.

Fear that the government might increase taxes to address its poor financial position encourages capital flight. This is the link with a second aspect of the emerging financial crisis, as capital flight greatly increases downward pressure on the hryvnya. However, the fixed exchange rate to the US dollar is maintained by the authorities for fear of increasing the debt burden on public and private holders of foreign loans, in this way exacerbating recession and aggravating the deterioration in public finances. Further unorthodox administrative measures are brought in to try to restrict demand for hard currency and, perhaps, to restrict imports, encouraging the development of a black market and concerns abroad of protectionism. Despite these measures, the deficit on the current account, already at its highest level in the post-Soviet era, continues to deteriorate, increasing downward pressure on the currency and stoking expectations of a devaluation. Official reserves fall to an unsustainable level. In these circumstances, the conduct of an orderly devaluation or depreciation becomes much more tricky, but either this or a disorderly fall in the currency nevertheless ensues. This weighs heavily on banks’ foreign-currency balance sheets, possibly threatening a banking crisis.

Politically, the multiple financial crises damage Ukraine’s already poor prospects for economic growth and therefore also the government’s electoral support. Following the high cost to exports and private investment of maintaining the fixed exchange rate, the spectre of a debt crisis dampens private investment still further. The fixed exchange rate has already hit livelihoods in the government’s heartland in eastern Ukraine. The rapid boost to inflation from soaring import prices undermines them still further. An invigorated anti-government popular mood boosts the public support and optimism of the opposition. Key business leaders who have been alienated from the regime step in with finances, media campaigns and political networks to back a credible candidate of the unified opposition in the 2015 election. The chances of Mr Yanukovych being re-elected, even with the enormous state and financial resources that he has at his disposal, become ever slimmer. It is possible that an intensification of political conflict along these lines is faced down by the regime using a mix of political and security measures—more or less as in the first scenario, but with more force. The stark choice of a decisive move back towards democracy or towards outright authoritarianism again presents itself.

Other scenarios

Other possibilities are that the situation is resolved before it gets out of hand by resorting to closer ties to Russia in return for economic relief (the third scenario), or that it escalates from a political into a social crisis, of large-scale popular unrest, which tests the oligarchic political system (the fourth scenario). At the moment, however, a return to the Russian fold does not seem likely, because Ukrainian oligarchs do not want to see Russian businesses with strong political backing enter the Ukrainian market as their competitors. Neither do they want to see what happened to their Russian counterparts under the current Russian president, Vladimir Putin—a re-subordination of the oligarchs to the state, as symbolised by the incarceration of the head of the giant Yukos oil firm, Mikhail Khodorkovsky, in 2005—happen to them. Also, an outbreak of spontaneous nationwide anti-government protests, in the manner of those that swept Bulgaria in late February, does not seem to be on the cards. This is because, with the broad failure of the Orange Revolution of 2005-10 still a recent memory, the population will probably be wary of backing a similar movement again so soon. In addition, the organised opposition is weak. The networks and resources that it would need to channel and promote such an episode of unrest have been systematically chipped away under the Yanukovych administration.