Ukraine's rush into Europe: be careful what you wish for

By bne IntelliNews March 28, 2014

Ben Aris in Moscow -

The International Monetary Fund (IMF) announced March 27 it will lend Kyiv between $14bn and $18bn over two years as a rescue package. However, the money won't be enough to meet Ukraine needs, warn analysts, and comes with harsh conditions that will undermine the popularity of the parties and politicians in the interim government ahead of crucial presidential elections in May.

The IMF money will bring some welcome relief for an economy that is running on fumes. Interim Prime Minister Aseny Yatsenyuk told Rada deputies on the day of the announcement that Ukraine is "on the brink of economic and financial bankruptcy." The IMF noted that hard currency reserves had fallen to "critically low levels."

However, the bailout cash will only assuage the danger of a default. "Frankly, $15bn-odd from the IMF does not seem enough in my book, especially when reviewing those dreadful numbers from Naftogaz," says Tim Ash, head of research at Standard Bank, referring to the state energy company's expected UAH80bn ($5.3bn) deficit for the year, which is even after taking into account a planned 50% hike in household gas prices.

The first problem is the IMF money will be paid out over two years, or between $7bn and $8bn this year and next year. This will be supplemented by various other offers of help. The EU increased its contribution to $1.6bn. For all its diplomatic bluster, the US has only promised $1bn. Japan threw another $1.5bn into the hat recently. And there will be some odds and sods from the World Bank. Totting up all the international contributions gives a of $20bn paid out over two years, or $10bn a year, which won't be enough to meet the known expenditures for this year and next.

The government said on March 27 that its own estimates for the fiscal gap amounted to a total of UAH289bn, including UAH71.6bn for the national budget and another UAH34bn of overestimated revenue. "Taking into account quasi-fiscal liabilities, the fiscal deficit of the country exceeded UAH500bn ($50bn)," Yatsenyuk told the Ukrainian parliament on March 27, alleging that Yanukovych and his cronies had stolen a whopping $8bn from the treasury before fleeing the country. Billions more have gone missing from VAT scams, over-estimates of costs by regional authorities, the debt of the national gas company and profit tax rebates. In short, Ukraine's budget is shot to pieces.

Standard Bank estimates when you add in all the costs – the budget deficit, the gas bill, Naftogaz's debt – the total bill this year comes to just shy of $20bn – or twice what the international financial institutions have put on the table.

To this must be added the rising cost of gas. Russia's Gazprom has said that it will probably increase the price of gas it sells to Ukraine from the "special price" of $268 per 1,000 cubic metres (cm) it had negotiated in December with the previous pro-Russia Yanukovych regime, to the $400 per 1,000 cm the country used to pay. That increase alone will add another $7bn to Ukraine's annual gas bill. And Russian Prime Minister Dmitry Medvedev even suggested at the end of March the price could be raised as high as $500.

If $10bn is not enough to cover this year's costs, then it will be even less for next year: just the debt redemptions in 2015 are put at $11.6bn (of which $7.9bn is foreign currency debt), while the other costs remain the same. And going forward the country has debt redemptions of about $8bn every year through to 2018, while the current gas deal with Russia doesn't expire until 2019.

In the meantime, the economic outlook for the country is poor. The government estimates that GDP will contract by 3% this year and inflation will hit 12-14%. "If these [reform and spending cut] bills are not adopted, we anticipate default and we anticipate [economic growth] of minus 10% of GDP," Yatsenyuk said.

Having snatched Ukraine from Russia, the EU and US have in effect committed themselves to not just the current bailout, but also sending Ukraine the same amount every year for several years to come – something that will be politically very difficult to swallow.

In an emergency the IMF can tap it Exceptional Financing facility to get more money for Ukraine, but that money comes with very strict oversight and conditionality that Ash speculates could spark social unrest. "Pushing the embattled Yatsenyuk administration any further might take it over the edge and damage social and political stability still further," reckons Ash.

Let the people eat medivnyk

Of course, in the end it will be the Ukrainian people that will have to foot the bill, and they may come to regret their rush to join Europe, say some analysts.

The IMF said that after the economy is stabilised with the current two-year worth of loans: "For 2015-16, the program envisions a gradual expenditure-led fiscal adjustment – proceeding at a pace commensurate with the speed of economic recovery and protecting the vulnerable – aiming to reduce the fiscal deficit to around 2.5% of GDP by 2016."

What this means in plain English is that the Ukrainian government will be forced to impose the kind of austerity measures that have caused protests in several EU nations grappling with the same sort of economic problems that Ukraine faces. "The economic situation [in Ukraine] is desperate and the government has hardly any alternative except for shock therapy," says Alexander Paraschiy, an analyst with Kyiv-based Concorde Capital, referring to the bitter economic medicine Russia was forced to swallow in the early 1990s that lead to a collapse of living standards.

The first round of austerity measures has already been announced. The government said on the same day the IMF made its announcement that it will freeze the minimum wage and the living wage this year, and Yatsenyuk told the Rada that household gas prices will be raised by half.

It is going to be a painful process and despite the desperate state of the budget, the government is already baulking at imposing the full measure of austerity needed to make the numbers add up. "The government should have done as the government in Greece and Italy did – namely, to reduce the minimum wage and the living wage. But we realize that this size is so small that a reduction in such sizes in the current situation, no matter how strongly we want it, is unacceptable," the PM told the Rada on March 27. "But we officially state that minimum living standards… will not change in 2014. We will neither lower nor change them."

Likewise, the hike in the domestic gas price is only a half measure. The IMF has called for a quadrupling in the cost of gas to households to end the government's subsidies, but the government has announced that prices will increase by half and a third of households will receive special subsidies to cover the increases. "The total number of households that fall under our programme of social assistance grows from 1.4m households to 4m households. We will cover 30% of the Ukrainian population with social assistance programmes," Yatsenyuk told the Rada.

The middle class will also be hit as the government hunts for new revenues. A progressive income tax system will replace the current 15-17% income tax rates. The top income tax rate will rise to 25% for those earning more than UAH500,000 per year ($50,000), which will affect only around 300,000 people, but they make up 60% of the income tax revenues.

All talk, no action

So far the EU and US attempts to woo Ukraine away from Russia's longing embrace has been all tactics and no strategy. The western money being put on the table is not enough and will force the country to borrow heavily.

"In contrast with Russia’s influence, the West's ability to affect Ukraine’s success is highly limited. The idea of providing Ukraine with a big loan from the International Monetary Fund and other forms of external financial assistance will not help much and may even make things worse," economists Peter Boone and Simon Johnson write in a New York Times blog ( ). "Given the financial state of Ukraine, such money could easily be wasted before Ukraine turns again, as it eventually must, toward better relations with Russia."

The EU is also not in the ideal shape to take on the problem of Ukraine, where the political chaos that followed the Orange Revolution in 2004 has meant no reforms were made in the last ten years and the country's performance has been amongst the worst in the region. Already saddled with the burden of Eurozone countries like Greece, Cyprus, Portugal, and Spain, the last thing Brussels needs is another economy to prop up.

 In the long run, the EU is almost certainly a better choice for Ukrainians. Eurasia Group founder Ian Bremmer showed in his book "The J curve" that democracy produces more prosperity than authoritarian systems, but the J in the title means that life gets worse before it gets better – and not all political systems survive the bad times, as Yugoslavia's fate showed.

The irony of the situation is that the one country that is in the best position to reduce the pain and make this transition work is Russia. "Russia controls many of the levers for Ukraine’s success. It is Ukraine’s largest trading partner. Ukraine is heavily in debt to Russia and relies on Russia for most of its energy imports," Boone and Johnson write in their blog.

Part of the political problem that the new government in Kyiv faces is its efforts will be set against the experience of Crimeans who have now for Russian rule.

The deal Yanukovych struck with Russia in December put twice as much cash on the table with $15bn offered over one year (that presumably would be renewed with more bond issues in 2015). Also the "special price" for gas was equivalent to another $7bn subsidy. Together, this money would have significantly reduced the pressure on Kyiv and the need for austerity. And that is before the promised Russian investment into a variety of industrial sectors arrived.

The problem with that deal is it no doubt came with significant unknown political costs; no one knows what riders Yanukovych agreed to in his meetings with Putin. Also, the deal would've allowed Yanukovych and his cronies to continue their industrial-scale stealing while putting off any crucial reforms.

Yet that is unlikely to be at the forefront of the minds of many Ukrainians, who will instead be looking at their erstwhile compatriots in Crimea. On March 24, the first working day after Crimea joined the Russian Federation, pensions were doubled to bring them up to Russian levels, affecting 750,000 out of a population of 2m. At the same time those working for the state, another 450,000 people, saw their incomes increased by 2.5-times. Overnight three-quarters of the population have seen their incomes soar. And this is before Russia starts pouring in investment into the region and building new infrastructure. The contrast between Crimea and the rest of Ukraine (especially the neighbouring eastern regions that are largely pro-Russian) will only complicate Kyiv's job of selling a "stick to our guns for the long-term benefits" policy of austerity.

"Russia also has substantial ability to promote riots, political intrigues and general instability. In short, unless Ukraine can normalize relations with Russia, it has little hope for growth," conclude Boone and Johnson. 

Ukraine's rush into Europe: be careful what you wish for

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