Ukraine Approaches Bankruptcy

People line up to get money from a bank machine in the western Ukrainian city of Lviv on Feb. 20 as a result of the financial panic caused by the protests in Kiev. YURIY DYACHYSHYN/AFP/Getty Images

Summary


The violent protests that have rocked Ukraine since the beginning of the year seem to have settled down after the Yanukovich government's retreat, but the situation in the country is far from resolved. While the new and yet-to-be-determined government will have to grapple with problems such as Ukraine's fundamental east-west divide, the issue of immediate concern is much more mundane: The country is perilously close to insolvency.

Analysis
The political upheaval of the past three months has aggravated the inherent vulnerabilities of the Ukrainian economy and has strained the country's limited foreign currency reserves. In addition to a monthly natural gas import bill to Russia that amounts to roughly $1 billion, in January the National Bank of Ukraine disbursed $1.7 billion to stabilize the country's currency, which has dropped in value by 15 percent since January. Ukraine also has to provide another $1.1 billion in debt repayment the same month.



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Ultimately, Ukraine's foreign currency reserves dropped from $20.4 billion to $17.8 billion in January. Clearly this is an unsustainable situation, given that Ukraine has a minimum debt repayment schedule of $17 billion in 2014 and is effectively cut off from international markets -- it even had to cancel a planned $2 billion eurobond issue late last week. Moreover, Russia may choose to renege on the 33 percent discount on natural gas imports it gave Kiev late in 2013. These circumstances are feeding rumors across the country that the government will not be able to pay for its pensions and public servants' salaries. Ukraine will have to make its first large-scale payment to various creditors in June, when $1 billion of its debt matures, after which Kiev can no longer financially sustain itself.

Ukraine will depend wholly on international aid to help it pay its bills and avoid bankruptcy, at least in the short term. Today, as throughout Ukraine's history, two possibilities are on the table: a loan from Russia and a loan from the West. Of course, both come with strings attached.
Kiev's Predicament

Until the current political unrest, the International Monetary Fund and European Union made it clear that financial assistance would require Ukraine to sign an association agreement with the European Union and enact a slew of painful financial, fiscal and labor reforms to bring the country's post-Soviet economy up to Western standards. Most of these reforms would entail a medium-term sharp drop in the average Ukrainian's quality of life; for example, an uncontrolled currency would result in lower purchasing power, and a deregulated natural gas industry would increase prices for consumers. This is a dangerous proposition for any government in a country as politically polarized as Ukraine.

This logic -- not to mention Moscow's threat to halt cross-border trade -- is what drove former President Viktor Yanukovich to freeze negotiations with the Europeans and accept a 15 billion euro ($20.5 billion) aid package from Russia and its natural gas discount. The Russian loan, of which 3 billion euros has already been disbursed, was a political victory for Moscow, which saw itself as preventing Ukraine from ingratiating itself with the West. The choice to move away from the EU integration agreements is also what sparked the initial protests in Kiev that escalated into the widespread demonstrations that toppled the government.

Russia has since frozen any further delivery of economic aid to Ukraine as it waits to see what the new government will look like. Moscow has been clear that its financial support depends on the Ukrainian government maintaining a neutral stance toward Western institutions, particularly the European Union and NATO. With the enormous uncertainty surrounding the next government's inclinations, Russia is also withholding aid to ensure Kiev's continued cooperation with Moscow and prevent its outright opening to the West.

This leaves the new government in Kiev with a dilemma similar to the one that toppled Yanukovich. Whatever it chooses, the new government will face the same constraints as its predecessor. Ironically, the only card Kiev can play for the moment is to emphasize the destabilizing effects a default would have. The economic disruption caused by a default could reignite protests in Ukraine and shatter the fragile compromise brokered by Western powers -- an option the West would find unacceptable. In addition, a breakdown of Ukraine's economy would have strong repercussions in Russia and other former Soviet states that have been battling a lack of investor confidence since the beginning of the year. In fact, the ruble has already depreciated by nearly 8 percent this year, with a 0.5 percent drop Feb. 25 following Ukraine's credit downgrade by the rating agency Fitch.
Pressure Mounts to Prop Up Ukraine's Economy

Though it is not in Russia's or the West's interest to let Ukraine default, neither side is willing to capitulate. Without the option of military intervention, economic pressure is the only leverage Russia and the West have to shape the direction of the new government. In addition, a joint EU-International Monetary Fund bailout without strict economic reforms would be politically untenable in those European countries that have been battling an economic crisis themselves and have been subject to more than five years of stringent austerity.

Notably, it would take Western institutions longer to approve financial aid because they would have to coordinate among several countries. Russia, on the other hand, can quickly access its sovereign wealth funds.





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As international pressure increases on the West to fix the deal it engineered in Ukraine, the most plausible outcome is for the International Monetary Fund to inject just enough capital to sustain Ukraine's economy for the next few months, during which a concrete government plan would be formed, without triggering backlash among the Europeans for the conditions the emergency package lacked. Moscow could also issue a small tranche of aid while it takes stock of the new government and begins figuring out whom it can work with.

After this short-term crisis is averted, the jostling between Moscow and the West over Ukraine's long-term alignment will begin anew, with the political division of the country making it very difficult for Kiev to make any clear or permanent decision -- a situation that is not new in Ukraine.