UBS -

Ukraine was thrown back into political turmoil when President Victor Yushchenko decreed on April 2 that parliament should be dissolved and new elections held on May 27. The Victor Yanukovich-led government coalition has called on the Constitutional Court to examine the legality of the presidential decree. The Constitutional Court will have a month to decide on the decision's legitimacy.

The decree, in our view, stands on questionable constitutional grounds. The given legal reason is the recent defection of some of the president's supporters in parliament to the government's side. However while we can see arguments that these defections might be unconstitutional, we find it difficult to see that this provides sufficient legal grounds to dissolve parliament.

Hence, the president's surprise move to dissolve parliament is in our view part of the ongoing political power manoeuvring between the government and the Orange Revolution's supporters, led by opposition leader Yulia Tymoshenko and the president. Yulia Tymoshenko had previously asked the president to dissolve parliament due to the fact that the Yanukovich-led government had essentially assumed power and seemed to have finally won the argument with the president. The final trigger was the realization by Yushchenko that the government might draw sufficient opposition MPs into the ruling coalition to gain a two-thirds majority, which would overrule any presidential veto, the last layer of power left to the "Orange" parties.

Given that the struggle is about power politics rather than narrowly upholding the Constitution, the resolution is not easy to predict. Much will depend on the Constitutional Court and whether it decides to even rule on the issue. In its current form, Ukraine's Constitutional Court is largely an untested institution and we believe there is a risk that it will try to avoid making any judgment. In this case, the political resolution will not only depend on Yushchenko and Yanukovich, but also on Tymoshenko. We think early presidential and parliamentary elections are the most likely outcome in the event that there is no judgment by the court.

We find it difficult to forecast the exact resolution of the crisis and therefore offer scenario approaches with assigned probabilities below. However, what we are quite sure about is that the resolution will be peaceful and that the risk often speculated on in the press of the country splitting up is remote.

We see four key scenarios:

-- The Constitutional Court rules that the dissolution of parliament was legal and early parliamentary elections are held in accordance with the presidential decree;

-- Decision of the Constitutional Court to stop the presidential decree and everything goes back to the status quo;

-- The Constitutional Court does not provide a final ruling and the opposition and government agree to hold both parliamentary and presidential elections; and,

-- Compromise between the President and the coalition; recall of the presidential act-status-quo resumes.

We view the first two scenarios (a clear ruling one way or the other) as the most likely outcomes and the last scenario (political compromise with no reference to the court) as the least likely to occur.

Early parliamentary elections

This scenario will prevent the president from losing power through the enforcement of the new laws (such as the Law on the President, etc), but will lead Ukraine to at least a half-year of political turmoil involving pre-elections, elections, counting the votes, claiming victory, certain parties contesting the results, formation of a coalition and finally a government. While the country would in our view emerge in-tact and with a new government, the extended period of uncertainty will come at a cost of some slowdown in growth. Under this scenario:

-- President Yushchenko will preserve his powers or even manage to expand them by stopping the amendments to the Constitution; The Party of Regions will stop short of trying to gain a 2/3 majority in parliament and the President would be able to influence legislation through his veto power.

-- Parliament will have two large antagonistic blocs-the Party of Regions and Bloc Yulia Tymoshenko (BYT)-and a small number of MPs from an additional 1-3 factions that managed to overcome the 3% barrier.

-- Government will depend on the coalition's configuration but could be either led by (1) Victor Yanukovich or (2) Yulia Tymoshenko.

-- Investment climate will be negatively affected by the uncertainty concerning who will win the election.

Decision of the Constitutional Court to stop the presidential act

This scenario will resume the pre-crisis divisions and will force the parties to find a compromise in the legal sphere. We see this as the best outcome for markets. The Constitutional Court might rule at the same time that the MPs are not allowed to switch sides, putting the President's worries at rest that the Party of Regions might win a 2/3 majority. Under this scenario:

-- President Yushchenko will be weakened further somehow but as long as the Party of Regions refrains from achieving a 2/3 majority, he keeps his veto powers.

-- Parliament remains in its current configuration until the next elections in 2011.

-- Government will continue to be led by Victor Yanukovich until the next elections in 2011 or until the next presidential race.

-- Investment climate will remain stable with some regulatory improvement.

The Constitutional Court does not make a decision

The Constitutional Court might not make a decision or the parties will not accept the Court's decision. In this case, the resolution depends on compromises between the three main actors, the two Victors and Tymoshenko. Yanukovich has suggested that he might accept early parliamentary elections under certain conditions; the most important being that there should be presidential elections as well. We find it quite possible that Tymoshenko will agree to this compromise and Yushchenko will be completely isolated and without any allies in parliament. Pressure on him to step aside could mount, especially if foreign mediators reinforce it.

-- The Presidential election would probably be fought between Yulia Tymoshenko and Victor Yanukovich. Judging from the polls it would be a close race, with Yulia Tymoshenko possibly having a slightly better chance.

-- Parliament would be split between Bloc Yulia Tymoshenko and the Party of Regions with a few small parties tilting the balance one way or the other.

-- Government would be built around either of the two factions. However, if both Victor Yanukovich and Yulia Tymochenko run for president, they rule themselves out as prime ministers and it is difficult to forecast who would take their place.

-- Investment climate will be hampered by an extended period of political uncertainty before the winners and losers are determined in the elections.

Compromise between the President and the coalition; recall of the presidential act

This scenario will lead back to the pre-crisis situation and force parties to such a compromise on an equal basis. We see this as a positive outcome.

-- The President will either remain with his current powers or enjoy partial increases due to the implementation of the new regulations.

-- Parliament remains in its current configuration until the next elections in 2011.

-- Government will continue to be led by Victor Yanukovich until the next elections in 2011 or until the next presidential race.

-- Investment climate will remain stable.

Economic implications

Given that we cannot see any significant risk of a violent resolution or a threat to the integrity of the country, the main downside for the economy arises from a potentially lengthy period of political uncertainty in the event that the crisis is unresolved by a Constitutional Court ruling. Still, unlike in Central Europe, property rights and the rules of the game are not well established and any political uncertainty has significant costs. Following the "Orange" Revolution, the country's growth rates collapsed from 12.1% in 2004 to 2.6% in 2005, as investment plans were put on hold and capital flight increased. Only when the Yanukovich government was in place was some kind of political stability resumed with strong growth resuming and with it large capital inflows and aggressive investment plans.

Thus, in the worst case scenarios that entail an extended period of political uncertainty, the economy is likely to slow significantly in our view and capital flight to resume. However, we do not think that this will have any effect on the exchange rate. It is true that unlike in 2005, Ukraine now has a current account deficit (1.7% in 2006 and rising) and has thus less ability to withstand capital outflows.

However, at the same time, the Central Bank's reserves have risen to a record $23bn from $9.4bn at the end of 2004, which should be enough of a buffer to compensate for negative capital and the current account for some time. This is why we believe that the current peg will be maintained and the cost will come mainly in terms of real economic activity.

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