Crisis: Likely To Stop With Crimea

BMI Vie w: Russia's decision to assume de facto control of Crimea over the weekend has substantially raised political risks in Ukraine. While our core view is that Russia will consolidate control in Crimea and end its actions, there are outside risks that eastern Ukrainian oblasts fall victim to ethnic disturbances, potentially leading to further Russian intervention.

Russia has moved quickly to shore up its military presence in Crimea, and over the weekend of March 1-2 effectively assumed de facto if not de jure control of the peninsula. Russia's actions have more or less been in line with our expectations - we stated last week that Russia would stop short of invading Ukraine, instead choosing to bolster its troop numbers in Crimea in response to local developments ( see February 27, 2014, 'Will Russia Invade?'). However, Ukraine's interim government and several Western leaders are characterising Russia's moves as aggression, thereby raising the stakes. In addition to pre-existing Russian troops already stationed at the Russian naval base in Sevastopol, some additional 6,000 troops have reportedly entered the region, easily overwhelming the light Ukrainian army presence in Crimea.

We do not expect to see any Western military intervention as a direct result of Russia's actions in Crimea, with NATO reliant on Russian transit to secure the return of its hardware from Afghanistan. Our core view at present is that any US and EU actions will be limited to diplomatic mediation efforts, with the possibility of targeted economic sanctions in the future. With no support forthcoming from Western powers, we expect the Ukrainian army will be unwilling to launch any offensive against Russian troops, which substantially outnumber the Ukrainian forces.

Crimea Situation Driving Up Default Risk
Ukraine - US$2014 Government Bond, % yield

BMI Vie w: Russia's decision to assume de facto control of Crimea over the weekend has substantially raised political risks in Ukraine. While our core view is that Russia will consolidate control in Crimea and end its actions, there are outside risks that eastern Ukrainian oblasts fall victim to ethnic disturbances, potentially leading to further Russian intervention.

Russia has moved quickly to shore up its military presence in Crimea, and over the weekend of March 1-2 effectively assumed de facto if not de jure control of the peninsula. Russia's actions have more or less been in line with our expectations - we stated last week that Russia would stop short of invading Ukraine, instead choosing to bolster its troop numbers in Crimea in response to local developments ( see February 27, 2014, 'Will Russia Invade?'). However, Ukraine's interim government and several Western leaders are characterising Russia's moves as aggression, thereby raising the stakes. In addition to pre-existing Russian troops already stationed at the Russian naval base in Sevastopol, some additional 6,000 troops have reportedly entered the region, easily overwhelming the light Ukrainian army presence in Crimea.

We do not expect to see any Western military intervention as a direct result of Russia's actions in Crimea, with NATO reliant on Russian transit to secure the return of its hardware from Afghanistan. Our core view at present is that any US and EU actions will be limited to diplomatic mediation efforts, with the possibility of targeted economic sanctions in the future. With no support forthcoming from Western powers, we expect the Ukrainian army will be unwilling to launch any offensive against Russian troops, which substantially outnumber the Ukrainian forces.

Crimea Situation Driving Up Default Risk
Ukraine - US$2014 Government Bond, % yield

Recent military developments in the Crimea will only serve to exacerbate the economic pressure facing Ukraine and the country remains in urgent need of external financing to stave off economic collapse over the coming weeks. Ukraine's 2014 eurobond maturing in June is currently yielding 45% on the secondary market, reflecting a high probability of the country defaulting on this redemption, and despite recent capital controls, the hryvnia remains under pressure, dropping to UAH11.65/US$ on February 3 with the National Bank of Ukraine limited in its capacity to intervene in the exchange rate due to lack of FX reserves.

Furthermore, we expect that Russia will continue to ratchet up economic pressure on Ukraine. Gazprom has already threatened to end gas discounts agreed last year to Ukraine, ostensibly due to unpaid gas debts, and we see a high risk of Russia making good on this threat in the next quarter ( see 'Gas Leverage A Possible Russian Tool', February 28 2014). Further tranches of the US$15bn in financing - of which only US$3bn has been disbursed so far - are unlikely to be released while the current interim government remains in place, and it is more likely that the Kremlin instead focuses its financial aid towards Crimea.

Precedents For Russia's Actions: Moldova And Georgia

Russia's actions in Crimea are by no means unprecedented. In 1992, in the immediate aftermath of the Soviet Union's collapse, Russian troops assisted the de facto separation of ethnic Russians and Ukrainians in the Transnistria region of eastern Moldova following a brief conflict. The move attracted little international attention at the time, because it was overshadowed by much more sweeping political and economic changes in Russia and Eastern Europe. Nonetheless, Transnistria continues to exist as a de facto independent state in Moldova, backed by Russia and retaining a Russian military presence.

The more recent precedent for Russia's actions in Ukraine was its brief invasion of Georgia in August 2008. This was prompted by Georgia's decision to recapture the breakaway regions of South Ossetia and Abkhazia, both of which achieved de facto separation in 1992-1993 with Russian assistance. The fact that many Ossetians and Abkhazians had taken up Russian citizenship gave Moscow the official justification of protecting its citizens in neighbouring countries, when it invaded Georgia. Georgia lost the conflict, resulting in South Ossetia and Abkhazia being recognised by Moscow as independent states. Both continue to host Russian troops. A similar fate appears to have been decided for Crimea.

Three Scenarios For The Near Term

1: Russia Consolidates Control Of Crimea, And Ends Its Actions (Core Scenario). Russia's focus on Crimea demonstrates its prioritisation of the peninsula in its decision making. Moscow's priority is guaranteeing the continued presence of its Black Sea Fleet at Sevastopol, and ensuring that the status of ethnic Russians (who form almost 60% of the region's population) is guaranteed. Russia already maintained approximately 15,000 troops in Crimea before the current crisis, and has apparently moved in at least 6,000 more soldiers, with possibly more on the way. By the end of the weekend of March 1-2, the Kremlin had apparently achieved complete control of Crimea.

With Western criticism of Russia mounting, the rouble currency and stock market falling sharply, and the spectre of economic sanctions looming, the Kremlin could soon decide that it can afford to halt its military actions and declare victory. Crimea currently plans to hold a referendum on its status on March 30, though it is not clear that the Russian majority would automatically vote in favour of secession or merger with Russia.

A key question is whether the Ukrainian government will attempt to retake Crimea by force. Most observers believe that the Ukrainian military is far weaker than its nominal strength would suggest, meaning that it would fare poorly. Nonetheless, miscalculation by the untested Ukrainian interim government is a possibility. This means that a clash between Ukrainian and Russian troops remains a risk, one that could escalate the crisis.

2: Ethnic Disturbances Increase In Eastern Ukraine, Leading To Further Russian Intervention (Modest Risk). Another extremely dangerous scenario would involve violence between ethnic Russians and Ukrainians in Eastern Ukraine, such as the city of Donetsk. These could be spontaneous or orchestrated by provocateurs in one or both sides. If this were to happen, Russia could conceivably use the opportunity to send troops to key cities in the region. However, such a move would more visibly resemble an invasion, and be treated as such by Ukraine and Western governments, thereby escalating the crisis dramatically.

If Russia were to move forces into Eastern Ukraine, it is unclear how much resistance the Ukrainian military could put up, but Ukrainian militias could carry out some form of insurgency, greatly complicating matters for Russia. Indeed, Russia's swift 'recapture' of the breakaway republic of Chechnya in December 1994 was followed by a decade-long insurgency that cost Russia dearly.

3: Ukraine's Interim Government Collapses Under Pressure, Leading To Wider War (Low Risk). A third scenario could see the Ukrainian government collapse under the political, geopolitical, and financial pressures faced by the country. A new presidential election is due on May 25, 2014, but given the swift pace of developments in recent weeks, that date seems very far in the future, and much could happen by that time. For now, the Ukrainian government consists of former opposition groups that were mainly united by their desire to oust former president Viktor Yanukovych. The groups are also united in their desire to see a unified Ukraine, but if the government collapses, there would be a dangerous power vacuum that could lead to violence.

Meanwhile, the defection over the weekend of Ukraine's new navy commander, Rear-Admiral Denis Berezovsky, to the Crimean rebel cause demonstrates that there may be fissures in the Ukrainian armed forces. The military high command has already seen several reshuffles in recent weeks. If Ukraine were to descend into civil war, this would give Russia a further pretext for intervention. NATO, too, could decide to send troops to Western Ukraine. The resulting conflict could resemble a lighter version of the Korean War (1950-1953), whereby the US and Russia supported opposing governments within a single nation (although Korea had already been divided at that point for five years).

Read the full article

This article is tagged to:
Sector: Country Risk
Geography: Ukraine, Russia
×

Enter your details to read the full article

By submitting this form you are acknowledging that you have read and understood our Privacy Policy.