This post was originally published on Diplomatist Online in July 2015.
As the conflict in Ukraine has worn on for the past 15 months, the Ukrainian economy has exhibited continuous decline to such a point that the next six months will determine the country’s economic survival.
Russia has No Desire of War with Ukraine: Putin
Speaking in Sochi in February of this year, Russian President Vladimir Putin dispelled claims of Russian warmongering by declaring that Russia had no desire to make war with its neighbours. Russian actions however have conveyed a different message. The last report of slain Russian activist Boris Nemtsov asserts that more than 220 Russian troops have been killed fighting in Ukraine and the Russian government has supplied up to $1 billion worth of support to the pro-Russian separatists. The report, which was based primarily on Nemtsov’s interviews with the families of the Russian casualties, finds that Russians who officially ‘quit’ the Russian Army were paid salaries as high as $1,774 per month for serving in Ukraine, and their families compensated with roughly $60,000 to not speak about their deaths.
Nemtsov’s report—brought to light after his death—was revealing. But the report by no means constitutes a revelation of the Russian military involvement in the separatist fighting in eastern Ukraine. Russian, Eurasian, and Serbian paramilitary volunteers have long been reported as fighting alongside the pro-Russian separatists; and modern Russian military hardware has been employed in the fighting.
American and British reports reveal that Russian artillery has been used from within Russia to shell Ukrainian government troops and positions. And, in the separatist region of Donetsk, Vladimir Antyufeyev, former Russian OMON special police officer and former Russian-backed separatist leader in Transnistria, was appointed the ‘deputy prime minister’. Regardless of official statements on military involvement, Russia has militarily and politically supported pro-Russian separatists through the provision of informal paramilitaries, experienced leaders, and military hardware, not dissimilar from the Serbian machinations in crumbling Yugoslavia during the 1990s.
Intense conflict in eastern Ukraine has had nothing but devastating effect upon the Ukrainian economy. Already with a national debt of more than $35 billion, it was the economically informed decision to turn towards Russia rather than the European Union in November 2013 that sparked the protests leading to Viktor Yanukovych’s downfall. Since the separatist conflict broke out following Crimean secession, the Ukrainian economy has exhibited fifteen consecutive months of decline while the national debt has more than doubled.
With such a severely contracted economy and continued fighting, Ukraine holds few prospects for economic recovery beyond external assistance. However, informed by their recent experiences in Greece, friendly stakeholders such as the European Union and International Monetary Fund (IMF) have proven wary of helping Ukraine without strict domestic reform.
By the end of 2014 economists were reporting that Ukraine’s economy as a whole had contracted by 8.2 percent while the national GDP had fallen by 7.5 percent. External debt reached $72.9 billion and internal debt $29 billion by the end of the year. Such decline has only worsened during the first half of 2015.
In April inflation had risen as high as 60 percent and the national currency, the Hryvnia, had devalued by more than 75 percent, the most in over a decade. Consequently the financial sector has suffered. Since the fighting began 40 banks have declared bankruptcy including the fourth largest lender, Delta Bank. The State Export-Import Bank of Ukraine (Ukrexim bank) and the State Savings Bank of Ukraine (Oschad bank), both holders of large Eurobonds, are at risk of probable default and have had their international credit rating continuously downgraded.
While the dire state of Ukrainian national debt is largely to blame for the marked contraction of the economy, decline in industrial production shares some of the blame. In May of 2014 the Ukrainian government lost de facto control over the country’s industrial heartland in the east. Both Donetsk and Luhansk, historically dominant industrial centers, declared themselves independent, the Donetsk People’s Republic and Luhansk People’s Republic respectively, and have since been the focus of intense fighting. Consequently, in the two regions that constitute over 15 percent of Ukraine’s national GDP, industrial output has drastically fallen.
In Luhansk output has fallen more than 90 percent in the past twelve months, while Donetsk has exhibited a 49 percent drop. This has contributed to an overall 21 percent decline in industrial output nationwide, while also denying the government a substantial tax base. Furthermore, the lengthy and intense violence focused in these regions has cost the government significantly in terms of human and financial capital. Without a successful peace settlement in this industrially-dominant region of the country it is difficult to expect the Ukrainian economy to begin a recovery under its own power.
Given the consistently worsening state over the past fifteen months and the continuation of hostilities indicating continued economic contraction, the only real prospect for economic salvage is external. Following Viktor Yanukovych’s ousting in 2014, interim president Oleksandr Turchynov signed an agreement with the IMF, and his elected successor Petro Poroshenko signed an Association Agreement with the EU. The EU quickly contributed $2 billion towards the payment of Ukraine’s $3.5 billion debt to Russian energy giant Gazprom. And, in March of this year, the IMF approved a $17.5 billion loan to Ukraine, the first $5 billion trance of which was paid that month.
However, still dealing with the effects of Greek default, dispersal of the remainder of the loan carries strict austerity conditions. Public employment must be reduced and the government is required to desist from extending energy subsidies, meaning that the price of gas for citizens will increase as much as seven-fold in the next months, while wages are expected to decrease. However the most problematic condition for dispersal of the second trance of the loan is the restructuring of $15.3 billion in sovereign debt to foreign investors.
Restructuring of debt is especially difficult given that it can not realistically be done unilaterally by the Ukrainian government, but must also have the endorsement of the holders of that debt. The omnipresent matter of gas debt to Russia is perhaps the easiest to address. As of November, the IMF had joined the EU in pledging funds for that expressed purpose. Gas debt has long been an issue, even under the Yanukovych government. After his ousting, Ukraine lost its discount from Gazprom, who cited debt and failure to make current payments.
This sparked stark remonstrations from the new Ukrainian government under Turchynov and the threat of a lawsuit against Gazprom. Under pressure from the EU, the Russian energy conglomerate has since granted Ukraine some leniency, restoring the previously offered discount rate on a prepaid basis. However, Gazprom has continued to quote figures as high as $25 billion that Ukraine owes to it and Gazprom bank.
Restructuring of sovereign debt, or externally issued national bonds in foreign currency, will prove far more difficult than relieving debt to Gazprom. Around $19 billion in sovereign debt is held by two groups of Western investors. One group—based in London and comprised of BTG Pactual Europe, Franklin Advisers, TCW Investment Management Company, and T. Rowe Price Associates—holds roughly $8.9 billion of Ukraine’s sovereign debt. And another group of five investors in the United States holds an additional $10 billion. Both groups have been supportive of Ukraine’s economic recovery efforts and efforts to satisfy the IMF conditions, however have spoken out against the restructuring of the sovereign debt they hold.
Far less supportive and agreeable to Ukrainian efforts to meet IMF conditionality has been the Russian government, which holds $3 billion of Ukraine’s sovereign debt in the form of a Eurobond. Purchased in late 2013, prior to Viktor Yanukovych’s fall from power, this bond comes due in December of this year.
This Moscow-held bond possesses a clause by which payment can be triggered should the issuer’s national debt reach 60 percent of its national GDP, a threshold which Ukraine has reached. However, Russian officials have indicated they will not invoke this clause and continue to repeat that they expect on-time payment in December, rather than early. But then again, even making that payment will be difficult. While it has been suggested that the Ukrainian government classify this as ‘odious debt’–money borrowed and misappropriated by a past regime–this argument has rarely been upheld in court and was not claimed even by the post-Apartheid government in South Africa or the post-Saddam Hussein government in Iraq.
On May 19, the Ukrainian Parliament passed a bill allowing the government the right to declare a moratorium, or stay of payment, on foreign-held debt. This is to apply to privately held debt, and is thus applicable to that debt held by the investment firms in the US and the UK. The Ukrainian government has furthermore classified the Moscow-held $3 billion Eurobond as a private investment and is accordingly subjected to a government moratorium.
Such an act has antagonised both the western investors and Moscow. Both have derided the unilateral debt restructuring. The Russian government regards this move as the first step in a Ukrainian technical default, by which further international borrowing would be prohibited.
Separatist conflict in eastern Ukraine following the Russian annexation of Crimea has sent the Ukrainian economy plummeting from an already deprived state. Consequently the fate of the economy has been taken from Ukrainian hands and is now dependent upon the patronage of the European Union and IMF, whose infamous austerity conditions have only further been informed by recent experiences in Greece.
In order to receive the aid of these benefactors, Ukraine must successfully address the issue of its immense sovereign debt, held, besides foreign investors, by the Russian government, which has demonstrated its support for subversive pro-Russian separatists. The coming months will tell if Ukraine is able to appease its debt-holders and meet IMF austerity conditions to begin a recovery. Or else the economic contraction will continue to ensure a default, plunging the war-ravaged country into further crisis.
Christopher M. Jackson earned a MA in European Union Studies from the European Union Center at the University of Illinois in spring 2015. Previously he earned a BA in history from Centre College in Kentucky. His research focuses primarily on conflict management, post-conflict normalisation, and international development.
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