THE INSIDERS: Difficult choices lie ahead for Ukraine

By bne IntelliNews January 24, 2013

Tim Ash of Standard Bank -

Parliamentary elections in Ukraine in October have failed to produce much clarity in terms of the economic and political outlook for the country. The elections brought "victory" for the incumbent Regions of Ukraine party, yet despite changes to electoral rules which favoured the ruling party Regions saw both its share of the popular vote and its seat allocation in parliament fall. Regions has since been able to forge a ruling coalition with the support of the Communists, but with the strong showing of the opposition and the focus now on presidential elections due in 2015, support for the ruling coalition appears less than whole-hearted. Regions is not expected to enjoy a consistent majority but will likely rely on situational alliances, which suggests a somewhat fraught parliamentary term and an uneasy course on the economic policy reform front.

Even within the ruling party tensions appear to run deep between the various factions, driven by different and competing oligarchic groups and an increasingly powerful centre ranged around President Viktor Yanukovych and his so-called "family". Similar in many respects to the family circle that increasingly dominated the latter years of the Yeltsin era in Russia, the Yanukovych "family" is concentrating political and economic power and influence, and increasingly also control over the police and security services, plus the National Bank of Ukraine (NBU). This concentration of power around the "family" is itself creating fissures at the heart of Regions, which recently saw the departure of previously loyal and reformist ministers from the cabinet, including Serhiy Tyhipko and Valery Khoroshkovsky.

Political tensions have hardly been helped by the imprisonment of a number of leading opposition politicians, including the former prime minister, Yulia Tymoshenko, but also her former minister of interior, Yuri Lutsenko. The opposition and western governments have argued that the charges have been trumped up, and that the prosecutions represent the selective application of justice for political gain. They argue that the imprisonment of Tymoshenko et al, combined with changes in the electoral law, which ensured Regions took a majority in parliament with just 30% of the popular vote, suggest a significant step back in terms of basic democratic standards, and the hard fought gains from the Orange Revolution.

Economic fallout

The somewhat uncertain outlook for parliamentary politics, democracy and stability - parliament's work is frequently now marred by sit-ins and fisticuffs - plus coalition tensions and rivalries comes at an inopportune time, as Ukraine faces numerous challenges on the economic policy front.

The economy is stalling as global factors - weak demand for metals, which comprise 40% of exports - combine with specific domestic factors, including heightened risk perceptions around the elections, the concentration of power around the Yanukovych family, weak banks, an uncertain and often market unfriendly policy environment, to put the economy to the brink of recession. Full-year real GDP growth thus slowed to just above zero in 2012, and the economy is expected to contract in 2013. Weak growth, structural weaknesses, and pre-election pork barrelling boosted the budget deficit to around 5% of GDP in 2012, and fiscal revenues look set to take a further hit in 2013. Despite the weak growth backdrop, the current account deficit rose to reach the equivalent of 6.5-7.0% of GDP in 2012, and with a weight of external liabilities falling due, concern has mounted over the ability of the country to finance itself and also for the Ukrainian hryvnia to remain stable. The NBU has defended the hryvnia resolutely, keeping monetary policy tight, thereby squeezing domestic demand, while drawing down scarce forex reserves, which have fallen by around one-quarter over the past year. Risks are now of a large and disruptive currency correction, which could have a deeper and more systemic impact on the economy, particularly the banking sector.

While the regime's strategy in the run-up to parliamentary elections had perhaps been to buy time and hold the line, time is now running out and Ukraine is urgently in need of external assistance. Given geopolitical realities, the Yanukovych administration faces the choice of either turning to the International Monetary Fund (IMF) and the West for support, or eastwards to Russia. And yet neither option appears particularly palatable for a regime that seems intent on maintaining power and control this side of presidential elections.

In theory, Moscow could provide cheap energy and financing in abundance - but such support comes with strings attached. In the short term, Russia wants control of strategic assets in Ukraine, particularly pipelines and energy sector assets. Over the longer term, Moscow likely wants broader economic and political control over Ukraine, and one lever for this is perhaps its drive for Kyiv to join the Customs Union as a precursor to membership of the Eurasian Economic Union, which is developing between Russia, Belarus and Kazakhstan but is set to take in more members of the old Soviet Union. Years of broken promises and agreements, have, however, left little trust between the two states. Perhaps mindful of the dire economic situation that Ukraine currently finds itself in, Moscow appears in no mood to compromise on its wish list. In parallel, and perhaps at risk of overplaying its own hand, the Yanukovych administration seems in no particular rush to cut a deal with Moscow.

In part, the government's willingness to call Moscow's bluff may reflect its assumption that it can fall back on IMF financing. A track record of relatively soft IMF programmes, often with front-loaded disbursements and all too often weak conditionality, perhaps underpins this optimism. However, there is much to suggest that cutting a deal with the IMF will be much more difficult than in the past. First, across the region, and reflective of flush global market conditions, the IMF appears to be becoming much tougher with potential borrowers, exemplified by its recent tough stance towards agreeing new programmes with Hungary and Serbia. Second, the IMF is perhaps finally in recognition that this Ukrainian administration has delivered very little on the conditionality attached to the existing, off-track, programme. Third, key IMF demands for gas price hikes, greater exchange rate flexibility and fiscal consolidation will be difficult for an unpopular administration to deliver on given a fractious parliament and the presidential elections due in 2015. Fourth, key western IMF shareholders appear in no mood to plead on behalf of the Yanukovych administration while key opposition leaders remain in jail and when there is real concern over the deterioration in basic political standards in Ukraine.

In conclusion, the above suggests considerable challenges lie ahead for Ukraine, ranging for heightened domestic political risks, potential for strained foreign relations with Russia and the West, set again a backdrop of a significant deterioration in the economy. The Yanukovych administration will soon have to make difficult choices - either it agrees deeper integration with Russia, or greater economic reform and liberalisation, which would likely be part and parcel of an IMF deal. However, the price of the latter could yet be a firmer commitment to maintain and defend the democratic standards that were so craved by the population in the Orange Revolution. And yet the regime's declining popularity, and perhaps its Soviet-era instincts, makes it incline towards more rather than less control, and less political liberalisation. The regime's instinct is to play tactically for time, rather than to think long term and more strategically.

The problem is that both Russia and the West are beginning to understand how to read the regime in Kyiv, and its bluff may well be called by both sides.

Tim Ash is head of emerging market research at Standard Bank

THE INSIDERS: Difficult choices lie ahead for Ukraine

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