Foreign investors wary as Ukraine plumps for closer Russia ties

By bne IntelliNews December 18, 2013

Harriet Salem in Kyiv -

Ukraine's president may have managed to secure a deal from Russia to halt his country plunging into crisis, but observers warn the expected upsurge in political instability will have investors looking for an exit.

After turning his back on the EU in November by failing to sign an association and free trade pact, Ukrainian President Viktor Yanukovych boarded a plane to Moscow to hammer out the details of a controversial backroom deal with his Russian counterpart Vladimir Putin. The result was announced on December 17: Russia will buy $15bn worth of Ukrainian government bonds and slash the price of its natural gas exports from $400 per 1,000 cubic metres to $268.5.

The markets welcomed the news, as the inflow of money will probably ensure that Ukraine's tottering economy avoids a full-blown crisis, which has been looking increasingly likely for several months now. Economic experts say Ukraine desperately needs $10bn to avoid bankruptcy in the next few months. Ukraine's bond prices jumped following the announcement of the deal, with the yield on Ukraine's bond maturing in April 2023 falling by more than 100 basis points to around 8.6%, its lowest level since June. The cost of ensuring Ukrainian debt against a default also dropped sharply, with five-year credit default swaps down 214 basis points to 829, Bloomberg cited data from CMA.

But for longer-term investors, the news of a deal with Russia has been greeted with less enthusiasm. "It is simply a disaster," an insider at one of Kyiv's top legal firms tells bne. "As soon as the news broke that the European Association Agreement had fallen through the phone was ringing all day. Investors are very edgy about the political situation here. Contracts that were ready to go are being put on ice for the foreseeable future."

Large anti-government demonstrations are now entering their fourth week in Kyiv, with hundreds of thousands of people cramming the central square in Kyiv, Maidan Nezalezhnosti (Independence Square), to protest against the decision to turn away from closer ties to Europe. Smaller pro-EU rallies have also been held in several of the country's other western cities.

The concern amongst investors is that Ukraine's business environment will become even more difficult to operate in as the country becomes locked into a political and economic allegiance with Russia - a place well known for its obstructive attitude towards would-be investors. "The situation in Ukraine is already prohibitive for outsiders to do business here," Oleh Shamshur a consultant and former Ukrainian ambassador to the US, tells bne.

Complex bureaucratic procedures and culture of bribery and nepotism make Ukraine already a challenging place for enterprises to establish and prosper. This year the country ranked a joint 144th place on Transparency International's Corruption Perceptions Index - tying with the Central African Republic, Iran and Nigeria. Several western banks, such as UniCredit Group and Raiffeisen Bank International, have been reassessing their presence in the Ukrainian market.

"There was a lot of hopes attached to the possibility of the Association Agreement being signed," Shamshur says. "These have now been dashed, undoubtedly fears of increased pressure from Russia are going to result in a rapid decline of foreign direct investment and business withdrawing from their operations here."

"If Yanukovych is able to triumph with this backroom dealing, then this is the green light for the 'Putinisation' of Ukraine - the situation will get much, much worse," Shamshur warns.

Reform or bust

Yankovych's government will undoubtedly enjoy an immediate financial easing as a result of the deal. But Ian Bond, director of foreign policy at the Centre for European Reform (CER), warns that in the long run the agreement will leave Ukraine lagging behind in terms of modernisation and evermore vulnerable to the whims of a capricious Russia. "Instead of diversifying Ukraine's gas supplies and increasing its energy efficiency, this agreement is likely to ensure that Ukraine continues to be tied to Russia, subject to the threat of gas supplies being turned off for political or economic reasons," says Bond.

There is no long-term future in a relationship with Moscow, he warns, explaining that Ukraine will have to eventually reform, regardless of the sweeteners that Russia has given Yanukovych for his decision not to move closer to the EU.

Bond points out that Ukraine has a lot of industrial and agricultural potential, and cites Poland as an example of how the tough medicine of the EU and International Monetary Fund (IMF) can pay off in the long run. "Ukraine's future in a protectionist Russian-dominated trading block looks unpromising. Borrowing money to invest in modernisation makes sense; taking out loans to enable Ukraine to avoid modernising does not," he says.

Speaking at the press conference in Moscow on December 17, Putin looked relaxed as he lounged in his chair. "[Ukraine] is without doubt, and in the fullest sense of the word, our strategic partner and ally," he told the media. In stark contrast, his Ukrainian counterpart, who reportedly unsuccessfully requested that the joint press conference not be held, sat bolt upright in his chair and uncomfortably stated that the deal represented a "strategic decision" and that he hoped the "traditional" issue of gas prices would be resolved.

Yanukovych did not make any formal commitments regarding Ukraine's stance on joining the Russia-led Customs Union, which also includes Belarus and Kazakhstan. But insiders say it is just a matter of time. "This deal is not a symbol of Russia's love for Ukraine. Nothing is free and these gifts have a price, and that will be related to the Customs Union when the time is right, most likely after the 2015 presidential elections. That has already been decided behind closed doors. The deal is done," says a Kyiv-based financial consultant who declined to be named.

The Ukrainian president's tense demeanour is telling of just how precarious his position is. Whilst the EU has left the door open for Ukraine to resume negotiations, after the twists and turns of the last few weeks officials in Brussels are likely to tread carefully in the future. "No one will take at face value statements from Yanukovych or Azarov that they support European integration anymore," CER's Bond tells bne.

And Yanukovych is now boxed in, because double-crossing Russia now would much riskier than what he did to the EU. "Putin is not a man you renege on without having some very big problems. Yanukovych is in bed with Moscow now, and there he must stay, they can make any demands they want of him," says the Kyiv financial insider.

Meanwhile, the political crisis at home looks set to deepen, and with no resolution in sight a protracted one. Protesters on Kyiv's Maidan are hunkering down for winter. "We will stay here as long as we need, in all the snow and ice, because this is about the future of Ukraine," says Dimitry Pavlychko, who has braved the freezing temperatures camping out since the demonstrations began. "There is no other option, because as long as it is with Russia, Ukraine has no future."

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