Crisis: Cribsheet And Potential Scenarios

At time of writing, events on the ground appear to be deteriorating rapidly, with police opening fire on protestors, and the death toll likely to rise sharply by this evening. We expect today's events will push the EU and the US into the imposition of targeted sanctions, and outline a number of potential scenarios below.

Key Support Bases

Parliament Still Under President's Control: President Viktor Yanukovych's Party of Regions maintains dominance over Ukraine's parliament (Verkhovna Rada) and is able to pass legislation without support from opposition parties. In some instances, legislation proposed by Yanukovych has been enacted without being subjected to even minimal parliamentary procedures, such as the 'Black-Thursday' anti-demonstration laws passed in January. Despite recent events, very few defections have been experienced by the Party of Regions. The strong connections between politicians and oligarchs mean that the business elite are in reality more important players in the political scene than the politicians themselves. The reversal of the 2004 Constitutional amendments - which curbed presidential power - in 2010, reduced the powers of the parliament.

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At time of writing, events on the ground appear to be deteriorating rapidly, with police opening fire on protestors, and the death toll likely to rise sharply by this evening. We expect today's events will push the EU and the US into the imposition of targeted sanctions, and outline a number of potential scenarios below.

Key Support Bases

Parliament Still Under President's Control: President Viktor Yanukovych's Party of Regions maintains dominance over Ukraine's parliament (Verkhovna Rada) and is able to pass legislation without support from opposition parties. In some instances, legislation proposed by Yanukovych has been enacted without being subjected to even minimal parliamentary procedures, such as the 'Black-Thursday' anti-demonstration laws passed in January. Despite recent events, very few defections have been experienced by the Party of Regions. The strong connections between politicians and oligarchs mean that the business elite are in reality more important players in the political scene than the politicians themselves. The reversal of the 2004 Constitutional amendments - which curbed presidential power - in 2010, reduced the powers of the parliament.

Political Unrest Hammering Hryvnia
Ukraine - UAH/USD Exchange Rate

Oligarchs Remain Loyal - For Now: Yanukovych was initially highly dependent upon support from oligarchs from the Donetsk clan, including Rinat Akhmetov. However, he has reduced his dependence on domestic oligarchs over time, instead seeking to build up his own support base through trusted individuals known informally as 'the Family', including his son Oleksandr. Several Ukrainian oligarchs have investments in Western Europe (Akhmetov, Zhevago) while many others own property there. For this reason, we think a Belarusian scenario in which travel bans and financial sanctions (including asset freezes) were enacted would be very painful for the business elites. The US has already imposed visa sanctions on around 20 individuals, but the real question will be whether EU foreign ministers can agree this week on sanctions. The EU has been reluctant in the past for fear of pushing Ukraine towards Russia, but escalation of violence has intensified pressure on international leaders to act. We think some oligarchs perceive Yanukovych to be losing control of the situation, and targeted sanctions could prompt oligarchs to turn on Yanukovych. The business elite are largely motivated by self-interest, and do not identify strongly with the political parties. Therefore, it is not too much of a stretch to suggest that oligarchs would have no problem in finding common ground with a new government were the current political configuration to suddenly change.

Risk Of Armed Forces Deployed Domestically Remains Low: Yanukovych appears to maintain strong control of the police forces across the country, including the feared 'Berkut', the elite special units of the Ukrainian police force which have been deployed by the government against protestors. The government appears likely to continue using the Berkut as its primary means of controlling the protests, secretly increasing the size of the force from 5,000 to 30,000. The government also appears to have unofficially engaged 'titushki' - a widely used term for street thugs - as hired provocateurs. Common tactics used by titushki include infiltrating protests and instigating fights, or destroying private property while dressed as protestors. The government's ability to maintain control over the military, which until very recently was mainly comprised of conscripts is unclear, and reports that Yanukovych sacked the head of the armed forces Colonel General Volodymyr Zamana may suggest that the president lacks total loyalty from the army. However, a military coup remains unlikely in our opinion.

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Ukraine Not As Divided As Media Imagines: Much attention has been drawn to the linguistic divides across Ukraine, with the eastern oblasts of the country where the Party of Region's support is strongest consisting predominantly of Russian-speakers, while the western oblasts are populated predominantly with Ukrainian-speakers more likely to vote for opposition parties such as Fatherland, Freedom or UDAR. The concentration of civil disorder within the western oblasts has made the divide particularly salient, and recent reports that the city of Lviv in Western Ukraine has declared independence from Yanukovych has fuelled speculation that a civil war could ultimately cause Ukraine to split into two separate countries. We think such a scenario is unlikely - for reasons discussed in more detail below - largely because despite the ethno-linguistic divide, the population of Ukraine is reasonably homogenous. While it is true that civil disorder has been concentrated in western oblasts, there has been very little evidence of pro-government or pro-Russia protests, with the exception of a small demonstration in Kiev that was largely suspected to be organised by the government with paid protestors. The exception to this is Crimea, which is predominantly Russian-speaking and was a part of Russia until 1954.

Middle Classes, Small But Active: The Ukrainian middle class is relatively small and undeveloped compared to the US and Europe, with between 30% of the population defining themselves as middle class, compared to 60-65% in Europe and 85% in the US, although some sociologists suggest that less than 5% of the Ukrainian population enjoys a quality of life comparable to the average level of the European middle class. The average national salary is less than US$500 a month, while double digit interest rates restrain investment opportunities and innovation and endemic corruption stifles the development of small and medium enterprises. Unsurprisingly, the middle class remain staunchly opposed to Yanukovych and have been involved with the protests, if not on the front-lines then in auxiliary roles. They have also been effective in engaging with Western media outlets, which has helped to prompt international action in response to recent events.

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3 Potential Scenarios For Ukraine

1) Following The Belarusian Path

Unconfirmed reports that snipers have been shooting unarmed protestors marks a sharp intensification of violence if true and could indicate that the situation is likely to deteriorate further. There is a growing risk that Yanukovych decides to impose a state of emergency, including a media and telecommunications blackout that presages a more violent crackdown on protests. This would likely trigger a rapid imposition of targeted economic and political sanctions from both the US and the EU including travel bans and asset freezes.

Nevertheless, we question how effective these sanctions will prove at this stage. While undoubtedly painful for those targeted, they will end any possibility of Yanukovych entering negotiations with the EU and might ultimately push Ukraine closer to Russia's orbit. The EU and US will be unwilling to provide financial support without reforms in place. Despite the EU's sympathy with protestors, Russia has shown itself far more willing to pay the price for keeping Ukraine within its economic orbit. In this scenario, we expect Russia would continue to support Ukraine financially through eurobond purchases, allowing Yanukovych to stave of economic collapse while government forces crack down swiftly and violently on protestors.

Following an ensuing deterioration of relations with the West, Yanukovych would be left with little choice but to forge closer economic and political ties with Russia in order to avoid economic ruin. Eventually, Ukraine would likely be forced into a de facto surrender of its gas transmission system to Russia, marking a major restriction of national sovereignty.

2.) Oligarchs Turn On Yanukovych

On the other hand, there is a possibility that sanctions are effective. As noted above, several prominent Ukrainian oligarchs, including Rinat Akhmetov - one of Yanukovych's main financial backers - would find the imposition of sanctions, particularly the freezing of assets in the EU particularly painful. As the oligarch's political preferences are dictated by self-interest rather than ideology, this suggests that Yanukovych remains at risk of his support base turning on him as the international community ratchets up the pressure on Ukraine.

With the bulk of Ukraine's economic output in the hands of the oligarchs, their political influence in Ukraine is considerable and arguably greater than the politicians. This opens up the potential for the oligarchs to pressure Yanukovych into seeking a political compromise. Earlier there had been suggestions from opposition leaders that a return to the 2004 constitution limiting the president's powers and allowing parliament to appoint the prime minister might have been an acceptable compromise until new elections. However, the political situation has deteriorated to a point where we are skeptical that protestors will accept a government where Yanukovych remains in power in any form, suggesting that an ousting of Yanukovych would be necessary.

3.) Protracted Civil War & Breakup Of Ukraine

The worst case scenario would be a period of extended civil disorder, eventually spilling over into civil war and even a violent breakup of Ukraine. We stress that this is not our core scenario, however, with reports that demonstrators in Lviv have announced they wish to declare independence, and pro-Russian separatism growing in the Crimea, it remains an outside possibility. Under this scenario, violence between anti-government protestors and the authorities would remain intense, with the government eventually losing control of eastern oblasts. However, in contrast to Crimea, it remains extremely unclear as to what exactly the eastern oblasts would be declaring independence from. In Crimea's case, it might announce its intention to secede from Ukraine. Given the strategic importance of the Sevastopol's naval base to Russia and strong cultural links, we expect Moscow might find itself caught up in any developing crisis. Overall, we think that the likelihood of this scenario remains quite low, with the majority of Ukrainians sharing reasonably strong cultural and social bonds.

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Sector: Country Risk
Geography: Ukraine
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