EU makes fresh attempt to pull Ukraine back into its orbit

By bne IntelliNews February 26, 2013

bne -

Attempting to up the stakes in its face-off with Russia for the affections of Ukraine, the EU signed off on a preliminary deal for a €610m loan to Kyiv on February 25. The cash is complementary to a proposed International Monetary Fund (IMF) loan, and also comes attached with conditions on a range of issues designed to pull Ukraine back into the EU's orbit, but analysts suggest Brussels is overplaying its hand.

At the 16th Ukraine-EU summit, the EU also pledged to support Ukraine in the modernisation of its gas transit system and in its plans to diversify gas supplies. In addition, the sides confirmed their mutual commitment to signing an Association Agreement during November's Eastern Partnership Summit in Vilnius.

The memorandum of understanding on the loan lays out the allocation of four tranches over two years, with a repayment period of 15 years. The first tranche is conditional on Ukraine clinching a new stand-by loan deal from the IMF, and carefully targets Ukraine's balance of payments. Kyiv is struggling to hold off a devaluation of the hvyrna due in large part to its dwindling foreign currency reserves, with expensive Russian gas a major culprit for that fall.

The next tranches depend on the fulfillment of commitments outside the IMF's demands - which centre on raising gas tariffs - regarding public finances, trade, energy, and taxation and financial policy. However, Brussels also insists on political reforms and the release of high-profile opposition leaders from prison.

Playing both sides

News on that front the same day clearly illustrates Kyiv is ready to push on the issues it has with the West, although the smart money predicts that Ukraine wants to continue to try to play off Brussels and Moscow against one another.

The jailing of former prime minister Yulia Tymoshenko and others from the previous government disrupted talks on a free-trade agreement between the pair last year. President Viktor Yanukovych was reported to have promised his Polish and Slovak counterparts the same day as the summit that he would improve the detention conditions of Tymoshenko and to release the former interior minister Yuriy Lutsenko.

"Yanukovych is maneuvering," an unnamed Polish official told Gazeta Wyborcza. "Let's wait until he eventually fulfills any of the promises." The diplomat added that it looked like Yanukovych wanted to improve relations with the EU, if only to be in a better position when negotiating with Russia.

Unconfirmed reports in the Ukrainian media on February 26 said Yanukovych has now said he's willing to release Tymoshenko to the West for medical treatment, but only if she is forbidden to participate in Ukrainian politics.

If accurate, those reports indicate another about-face in Kyiv. Ahead of the EU summit, Yanukovych was busy trying to strengthen his position by playing up to Russian concerns. Last week, the president said that Ukraine may lease out its gas pipelines - a major route for Russian exports to Europe and long-coveted by the Kremlin - and later insisted, in contrast to recent hints, that he will definitely not lower gas tariffs. The high cost of Russian gas is Moscow's main point of leverage in this argument.

The EU's loan offer clearly looks to counter Ukraine's attempt to continue playing both sides by placing clear deadlines on its issues. In reality, Yanukovych has little inclination to head one way or the other, and most analysts suggest the real aim is to keep Russian oligarchs and EU regulators and investors away from Ukrainian assets whilst the president and the powerful business clans grab them.

Hence the long delay on a free trade deal with the EU and resistance to joining the Customs Union established last year by Russia, Belarus and Kazakhstan.

The aid from the EU and potential $15bn loan from the IMF also remains heavily contingent on Ukraine moving towards that agreement once more, with the target now to seal it by November, when the EU will hold a summit with the six countries from EU's Eastern Partnership. Herman Van Rompuy, president of the European Council, insisted at the latest summit that for that to happen, Kyiv has to take "determined actions" to meet the EU demands "by the latest by May this year".

Overplaying its hand

Yet Brussels' latest bid to raise the pressure on Kyiv appears weak, especially considering the relatively small sum of €610m that it's putting on the table. Yanukovych's key advantage is that the strategic importance of Ukraine means both the EU and Russia are unwilling to give up on it, leaving the pair in a straight race with the developing economic crisis in the country.

Zenon Zawada of Concorde Capital suggests that the demands from the EU are simply too large to fit into such a time frame. "The EU leaders proposed their 11 requirements with no flexibility," he writes in a note. "We don't expect his administration will fulfill them all in just two months, not only regarding Tymoshenko but on other issues, which are challenging as well. For instance, the EU wants Ukraine to adopt open-list elections. The Yanukovych administration is reluctant to commit to any form of elections, wanting to reserve the flexibility of switching voting systems. Moreover, the Yanukovych administration has already told EU officials it won't pursue reforms proposed for the state prosecutor's office,"

Meanwhile, Pavlo Shostak of Art Capital believes that Brussels is overplaying its hand. "It has been over two months since the European Council set out the said requirements in mid-December last year, but Ukraine seems to have done nothing to fulfill them," he points out. "It appears that Kyiv does not take Europe's demands seriously. The government seems to have gotten used to international isolation, which means it has no plans to adequately respond to gestures by the European Community, which signal willingness to make compromises."

The key to Kyiv's ability to hold out so long has been its ability to tap international debt markets thanks to the ongoing emerging market bond rally, albeit at high prices, despite the deteriorating economic indicators. Yet that access may well have a limited lifespan now, with both the US Federal Reserve and European Central Bank recently suggesting that they're ready to start winding in the huge volumes of liquidity injected into the global markets over the past year or so.

"The strategy seems still to be to play for time, hope markets continue to facilitate this by funding the sovereign, and hope that it can wear the EU and the Russians down over time," says Timothy Ash at Standard Bank. "Perhaps, Kyiv believes it can afford not to take Western concerns seriously and bet on Ukraine's strategic importance for EU."

Indeed, Shostak suggests that the offer of fresh support from Brussels may well be counter-productive for the EU's aims. "Ukraine's authorities will probably take further concessions from the EU as a sign of weakness at best; of the long-awaited surrender by Europe's institutions of their fidelity to principle, i.e. as a signal for further neglect of Europe's position while implementing the "family" model of the state. Some in Ukraine believe that Europe will overlook the massive violations of constitutional principles after a short period of indignation, simply because Ukraine is of strategic importance."

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