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.

Forks in the road

Economic prospects in the CIS in 2011

Main patterns of growth in 2010
A drop in real GDP of almost 6% in the east European transition economies in 2009 was the most severe of the regional recessions of that year. Beginning in the first quarter, however, most of east European economies saw a return to economic growth in 2010, which averaged about 3% for the year. In the main, the recoveries were export-led, with the lagged effects of large international stimulus packages, and in some cases substantial multilateral aid programmes, also playing a role. The pace of growth in domestic demand was generally much weaker, or in some cases remained negative. In particular, investment remained weak, depressed by low levels of business confidence linked to the uncertainty of the macroeconomic outlook, as well as to spare production capacity. In addition, household spending was weighed down by low levels of consumer confidence linked to poor employment prospects, high unemployment, falling or slowing wage growth, high levels of indebtedness, the paucity of credit as banks continued to repair their balance sheets, and a drop in workers' remittances.
Notably, the recoveries in the economies of the Commonwealth of Independent States (CIS) were generally stronger than for regional economies further west. The contrast was starkest between those economies that had been tipped into recession in 2008-09 by a fall in external demand and international commodity prices, and those that, before the crisis, had relied for rapid growth on domestic credit booms fuelled from external borrowing. Some of the bigger countries in the CIS, such as Russia and Ukraine, exemplify the first situation, whereas a number of countries in the Baltics and the south-eastern Balkans exemplify the second. [Some latest growth figures, highs, lows, averages, contrasted with rates before the crisis.] A second contrast with the countries of central-eastern Europe is that, whereas their prospects are bound up with those of the EU, where unfolding sovereign debt crises in peripheral countries have threatened the integrity of the common currency, the crucial relation for many CIS countries is with developments in Russia and Kazakhstan, the leading hydrocarbons-exporting economies within the organisation.
Finally, the political uprisings in the Arabian Peninsula and Arab North Africa may hold mixed economic and political prospects for the authoritarian hydrocarbons producers in the CIS, boosting state resources by pushing up hydrocarbons prices on world markets, while at the same time providing potentially replicable models for political confrontation with authoritarian state apparatuses.

The main, interlinked policy dilemmas
With the recovery having gained purchase, governments are now turning to a number of tough common policy dilemmas. The first weighs fiscal austerity against growth, because of the potential damage of withdrawing budgetary support before economic recovery has become self-sustaining. This concern is accentuated by the expectation of a downturn in global economic growth in 2011, as the boost from the big international stimulus packages fades. Thus, with fiscal and growth imperatives pulling in opposite directions, the benefits of running a loose monetary policy are likely to be cast in a favourable light, at least for a time longer. This is because maintaining liquidity could help to sustain economic activity, both directly, through its impact on domestic demand, and indirectly, by way of aiding the repair of bank balance sheets. This second effect could encourage a return to higher rates of credit growth, which plummeted during in the crisis and which are still well below the rates seen in the boom period. Without this, lower rates of economic growth will remain the norm for longer. However, for some governments, the return of inflationary pressures, both from rising international prices for commodities and food, and, further off, from individual economies as consumption demand begins to revive and spare capacity to dwindle, will create pressures in the opposite direction, pitching the desire to boost economic growth against the need to contain the pace of rise in the general price level. Another policy priority facing some governments across the region, and especially a few of the weaker economies in the CIS, will be the need to pursue policies to maintain external stability in the face of large external deficits and the build up of external debt.

Policy and performance in Russia and Kazakhstan
In both Russia and Kazakhstan, high and rising prices for hydrocarbons internationally, relative to 2009, will continue to sustain economic recovery in 2011. In Russia, the pick-up of consumer demand has been relatively unhindered by an overhang of private debt. In contrast, despite some progress in 2010, in Kazakhstan the inability of households and firms to pay pack loans—aggravated by the depreciation of the tenge that was induced by a sharp fall in inflows of foreign-exchange from the end of 2008 as a result of the global financial crisis—continues to place limits on the lending of the Kazakh banks, as they are forced to raise provisions against non-performing loans (NPLs). Thus, NPLs across the banking sector had risen to 26% in the first half of 2010, according to the IMF. Domestic credit growth in Kazakhstan dropped from a peak of almost 80% year on year in 2006, to just below 7% in both 2009 and 2010, according to the Fund. (In contrast, the peak rate of annual domestic credit growth in Russia was lower, at around 44% in 2007, and it dropped much less steeply, to around 22% in 2010.) This will restrict the speed of growth not only of the domestic economy, but also of its smaller Central Asian neighbours in particular. It should push policymakers in Kazakhstan to keep short-term policy interest rates low for the near future.
Of the two, Russia would thus appear to be in a better position economically to attempt to reduce the fiscal deficit in 2011. The possibly short-term boost to hydrocarbons export earnings as a result of a fresh round of political turmoil in the Middle East, which has stoked market fears over supply, should ease official plans to bring down the fiscal deficit, which reached the equivalent of almost 6% of GDP in 2009. Nonetheless, addressing the underlying problem of a structural non-oil fiscal deficit could remain, or even be discouraged by the same development.
Another important factor to keep an eye on for assessing regional economic prospects is the construction sectors in both countries, which continue to perform poorly, reflecting both excess capacity and a reluctance of the financial sector to lend. Construction is traditionally a large employer of migrant workers from other countries in the CIS and will thus feed into the prospects for a revival of private consumption and some kinds of investment in those states, through the link of remittance returns.

Fiscal consolidation in Central Asia

Fiscal consolidation is required not only as the payoff for any fiscal expansion undertaken during the economic crisis: following events in Greece in the first half of 2010, there is the additional incentive for governments to do so to try to convince international lenders of their fiscal rectitude. The kind of response possible will depend on the resources available. Broadly, just as hydrocarbons exports had allowed some countries to build up funds to draw on to cushion the full impact of the fall in external demand during the recession, so the recovery of oil prices and revenue will afford them greater room for manoeuvre for fiscal consolidation during the recovery. Kazakhstan and Azerbaijan both appear to be aiming for fiscal consolidation in 2011. In practice, in Kazakhstan this is planned to happen not only by means of a reduction of transfers from the NFRK, the sovereign oil wealth fund, but also through the imposition of an export duty and a progressive income tax. In Azerbaijan, overall deficit reduction is planned to go hand in hand with a rise in transfers from SOFAZ, its own oil windfall account, for social and infrastructural programmes, as well as part of the medium-term goal of industrial diversification. On the revenue side, non-oil fiscal consolidation will be hampered by an expected sharp slowdown in economic growth in 2011 linked to a fall in oil production volumes, which will put a dent in the growth of fiscal inflows. Hydrocarbons revenue may discourage necessary structural reforms in Turkmenistan and Uzbekistan.

Pulling the rug

More notes from May 2009

The possible impact of the global economic crisis on political instability in Central Asia and the Transaucasus
The level of trust in a range of political institutions across the counties of eastern Europe and the former Soviet Union was low even before the onset of the ongoing global financial and economic crisis, but it will make the situation worse.
In broad terms, the consequences of the crisis have been transmitted to the countries of Central Asia and the Transcaucasus through the impact of the financial meltdown and fall in hydrocarbon prices on the region's leading economies. For many former Soviet countries, the consequent fall in trade, remittances and investment inflows has already started to be felt, although not evenly, in terms of declining incomes and rising unemployment—two factors that tend to presage outbreaks of social and political unrest. However, economic stress on its own would not usually be enough to cause an outbreak of unrest. Rather, it is the interaction of economic stress with specific political and social factors already in place that is crucial.

Much in common
The states of Central Asia, the Transcaucasus and Russia share a number of these underlying factors associated with political upheaval. For instance, all of them, except Russia, have had a limited existence as independent states, all emerging as national entities only with the demise of the Soviet Union in 1991. In many, low levels of public trust hinder the effectiveness of political and governance systems, all of which are also mired by high levels of corruption. Finally, all of them, except Russia and Kazakhstan, are surrounded by countries that are also prone to the structural causes of unrest. This is the so called bad neighbourhood effect, which is one of the main causative factors behind political stability, according to the political science literature.

Most exposed
Those states most at risk because of pre-existing structural weaknesses—the Kyrgyz Republic, Tajikistan and Georgia—share a number of relevant traits in common. The Kyrgyz Republic and Tajikistan exhibit a high degree of ethic fragmentation; for example, conflicts between the ethnic Kyrgyz majority and the Uzbek minority, which is concentrated in the south of the country, have been a persistent source of political tension in the Kyrgyz Republic since independence. Tajikistan and Georgia have both experiences of at least two major episodes of political instability in the recent historical past. Tajikistan, for instance, suffered two bouts of all-out fighting in its five-year civil war of the 1990s, in which at least 50,000 people were killed (fuelled, among other things, by ethnic rivalries). For its part, not only has Georgia seen the outbreak of armed conflict as a part of it effort to bring its breakaway regions of South Ossetia and Abkhazia under control—most recently and disastrously in August 2008—but the existing political order has been overturned by force more than once. The first time was in the early 1990s, when the nationalist president, Zviad Gamsakurdia, was ousted in a coup. His successor, Eduard Shevardnadze, was kicked out in turn in a peaceful, large-scale social protest following a falsified election in the so-called Rose Revolution of November 2003. (Demonstrations in the Georgian capital, Tbilisi, ongoing since April 2009 against the authoritarian drift of the current president, Mikheil Saakashvilli, have suggested to may observers that a similar pattern may be about to be repeated.)
Another important factor, shared by the Kyrgyz Republic and Georgia, is that they are held to be regimes of an intermediate type. That is, they benefit from neither the public consent necessary for the working of a consolidated democracy, nor the combination of institutions and resources for repression necessary to maintain wholly authoritarian rule. Additionally, Georgia's susceptibility to the underlying causes of unrest is greatly heightened by the combination of its intermediate regime type and a fractional polity (mainly reflecting the inability of the central authorities to exercise political control over the country's breakaway regions, which make up 10-15% of Georgia's territory). On the other hand, Georgia's better economic starting point puts it in a healthier position to deal with the consequences of the economic crisis than either Central Asian country. The likely impact the regional economic downturn on unemployment rates in the Kyrgyz Republic and Tajikistan thus put them at highest potential exposure to political instability overall.

Look at the fine print
Finally, at the beginning of 2009, suffering electricity shortages and blackouts, facing factional fallouts within the ruling group, a unifying opposition and a looming economic downturn, the government of the Kyrgyz Republic began to look vulnerable to a financial crisis. However, a large aid package from Russia in February has since turned the situation around completely. This shows the importance of looking at detailed country case studies, in combination with quantitative comparative models, when assessing vulnerability to political unrest in specific cases.