KYIV BLOG: Putin's Crimea gambit will crash Ukraine economy

By bne IntelliNews March 2, 2014

Ben Aris in Moscow -

Russia's Federation Council may have given President Vladimir Putin the authority to send troops into Crimea on February 28 and a war with Ukraine is on the cards, but Russia doesn't need to start shooting to bring its neighbour to its knees: the dramatic escalation of events should be enough to catalyse the growing economic crisis in Ukraine and force Kyiv into talks with Moscow. At least this could be the Kremlin's game plan, as commentators universally agree the annexation of the Crimea by Russia would result in an new Cold War and leave it a pariah in the international community.

Whatever the motives, Putin's Crimea gambit is astoundingly aggressive and has already caused a loud outcry even in the Russian press. But Putin is working the clock in his efforts to save his Eurasian Economic Union. The new government in Kyiv has clearly set its heart on signing the free trade and association deal with the EU that deposed president Viktor Yanukovych bilked the population out of in November, instead agreeing a series of murky deals with Moscow.

But the interim government in Kyiv would rather hold elections first, slated for May 25. The abrupt change of regime in February was of questionable legitimacy and nearly half of the population never supported the protests on the capital's Independence Square, known as Maidan. Before the government commits itself to such a major choice, it needs to win a clear mandate from the people. That gives Putin about three months to remind Ukraine of its deep and strategic ties with Russia.

Economic woes

The new government is under enormous pressure. The hryvna is collapsing, having lost 25% of its value since the start of the year; hard currency reserves have dwindled to $15bn, down by a quarter since January; and the finance ministry has a reported $400m on its accounts, barely enough to get to the end of the month. A team from the International Monetary Fund (IMF) is on the way, but the Fund said this week the earliest Kyiv can expect any cash is April. The EU has also doubled the amount it will lend Kyiv in the short term to $1.6bn, but there are bond redemptions due in the next two months that will eat that amount up in one bite. In short, the last thing the new government in Kyiv wants is to increase the chaos by starting a war with Russia.

It's a very ballsy move by Putin, but the stakes in this game are very high. Nominally, the US and other western countries, which signed the 1994 Budapest Memo that saw Ukraine rid itself of its Soviet nuclear missiles, guarantee Ukraine's borders. But no one is expecting the US to send in the marines to protect Crimea - or indeed do very much in practical terms at all.

Only four journalists turned up to hear what UN head Ban-Ki Moon had to say about Ukraine at a press conference on March 1. Later in the day, an "emergency" session of the Security Council also failed after the participants couldn't even agree on the format of the meeting - they didn't even start on discussing what to do about Russia's military moves. The EU foreign ministers were also scrambling to hold a second "emergency" meeting - but not for two days; apparently the situation is not so bad that the meeting couldn't wait until Monday, March 3. And despite Senator John McCain's hyperventilating, the US ambassador to the UN called for nothing stronger than monitors to be sent to the Crimea. If Putin judged he can act with ground troops in Crimea and not face any military response for the West, then he judged correctly.

It has not come to fighting yet. Despite the screaming headlines reporting Russia's "invasion" of Ukraine, Russia has been sending troops to its existing (and legitimate) military base in Crimea and has not crossed into mainland Ukraine yet. Reports are not clear and it could be that Russia has taken control of other assets like ports and airports, but this is not yet a war.

It is a serious escalation of tensions though, and the Kremlin is fighting this still-psychological war on more than one front: in parallel with the troop movements, Russia's Gazprom announced that sticking to the terms of the cash-and-discount deal struck with Yanukovych in December was "stupid": Ukraine was promised a $15bn bailout programme and gas prices that would be slashed in half. In many ways killing the December deal is the bigger threat to Ukraine than the 15,000 soldiers reportedly arriving in Crimea at the Russian naval base.

The first $3bn of the bailout money was paid in December in the form of Eurobonds that came with some pretty nasty strings attached to it, which included a 60% public sector debt/GDP ratio as a covenant. "This just further complicates the whole Ukraine story, and any bailout will need to take this documentation into account - it may cap the scale of any bailout programme, or force official creditors to deal with the issue of private sector bondholders as part of any deal," says Tim Ash of Standard Bank.

Ukraine's total debt is currently on the order of 42% of GDP, or $73bn as of December. But the new government has already said it needs as much as $35bn to see it through this year, which will breach the 60% cap. Moreover, if the devaluation of the hryvna continues - as seems likely given the coffers at the National Bank of Ukraine are bare - then this will also push the debt/GDP ratio up. Basically each hryvna you add to the exchange rate against the dollar adds another 2% to the debt to GDP ratio, estimates Standard Bank's Ash. The bottom line is that the IMF may not be able to lend Ukraine more than $10bn without breaking the 60% debt/GDP ratio.

"The West is currently trying to put together a very big ticket package of support for Ukraine - EP officials have spoken about €20bn. However, any such support will have to be carefully weighed now against this 60% GDP threshold which might be used by unfriendly third parties to force a sovereign debt event," says Ash.

Russia can also add to Ukraine's debt almost at whim. Gazprom said this week that Ukraine still owes several billion dollars from last year's unpaid bills, and Ukraine has also failed to pay any of its gas bills this year. But the most crushing change of all would be to re-impose the $400 per 1,000 cubic metre price for gas that was bleeding the country dry last year, that will cost Ukraine an extra $7bn a year, according to analyst estimates, until 2019 when the current gas deal expires.

If Ukraine doesn't cut a deal with Russia to deal with these problems, is the EU really prepared to pick up the tab? And if the IMF picks up the bill instead, then ultimately this will all go on the national account and it will be the people that will have to pay it back.

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