Major Risks Surround The Vilnius Summit

BMI View: Ukraine appears to be giving the strongest indications yet that it is prepared to acquiesce to the IMF's demands in order to secure the necessary financing to see it through the likely Russian retaliation if Kiev signs the EU's Association Agreement at the end of November. Despite this, we see several major stumbling blocks and caution that even if this hasty deal goes ahead, it is unlikely to herald a turning point in Ukraine's political deterioration.

With Ukraine appearing increasingly likely to sign the Association Agreement with the EU at the end of November, both sides are now preparing for the probable backlash from Russia, which is likely to arrive in the form of an all out trade war between the two countries. In light of Ukraine's extremely precarious macroeconomic position, dwindling public finances and substantial quasi-fiscal liabilities related to state-owned Naftogaz, a trade war with Russia would likely push Ukraine into a full-blown economic crisis without external assistance.

Accordingly the EU and the IMF have stepped up emergency talks to coordinate on the possibility of providing financial support to Ukraine after it signs the Association Agreement. Ukraine still owes around XDR4.3bn from an XDR11bn Stand-By Arrangement loan authorised by the Fund in 2008 which was eventually frozen for non-compliance, mainly pertaining to Ukraine's failure to lift domestic gas subsidies. Unfortunately, not much has improved since 2008, and even the IMF's statement following its recent mission in October - which tend to be perennially diplomatic in their wording - was relatively critical of the state of affairs.

Time Is Running Out For A Solution
Ukraine - International Reserves, US$mn

BMI View: Ukraine appears to be giving the strongest indications yet that it is prepared to acquiesce to the IMF's demands in order to secure the necessary financing to see it through the likely Russian retaliation if Kiev signs the EU's Association Agreement at the end of November. Despite this, we see several major stumbling blocks and caution that even if this hasty deal goes ahead, it is unlikely to herald a turning point in Ukraine's political deterioration.

With Ukraine appearing increasingly likely to sign the Association Agreement with the EU at the end of November, both sides are now preparing for the probable backlash from Russia, which is likely to arrive in the form of an all out trade war between the two countries. In light of Ukraine's extremely precarious macroeconomic position, dwindling public finances and substantial quasi-fiscal liabilities related to state-owned Naftogaz, a trade war with Russia would likely push Ukraine into a full-blown economic crisis without external assistance.

Accordingly the EU and the IMF have stepped up emergency talks to coordinate on the possibility of providing financial support to Ukraine after it signs the Association Agreement. Ukraine still owes around XDR4.3bn from an XDR11bn Stand-By Arrangement loan authorised by the Fund in 2008 which was eventually frozen for non-compliance, mainly pertaining to Ukraine's failure to lift domestic gas subsidies. Unfortunately, not much has improved since 2008, and even the IMF's statement following its recent mission in October - which tend to be perennially diplomatic in their wording - was relatively critical of the state of affairs.

Highlighting the urgency behind the need to secure financing, President Viktor Yanukovych has allegedly announced that he is prepared to hike domestic gas prices by 60% - one of the main points of contention with the IMF - as well as liberalising the hryvnia's trading band, which might clear the way for an IMF deal. However, the issue of former Prime Minister Yulia Tymoshenko's incarceration remains unresolved, dangerously close to the date of the Vilnius Summit where the signing is expected to take place, representing another potential stumbling block for negotiations. Furthermore, Yanukovych has a poor track record of keeping promises, particularly those made to the IMF, and we remain sceptical towards such news flow.

Time Is Running Out For A Solution
Ukraine - International Reserves, US$mn

We believe Yanukovych now hopes that by agreeing to just enough to get the Association Agreement signed, the EU/IMF will be forced to bailout Ukraine to avoid an extremely embarrassing political defeat to Russia. However, this is a high risk strategy. Raising gas prices will be extremely unpopular domestically, as will IMF demands to liberalise the hryvnia's trading band, which would lead to a de facto devaluation of the currency. Having been burnt badly by Ukraine in the past, the IMF is unlikely to be as willing to throw vast sums of money towards Kiev without concrete assurances in place.

Trade War With Russia Could Prove Devastating
Ukraine - Export Destinations

However, without external financing, Ukraine would have little choice but to acquiesce to Russia. The benefits of trade integration with the EU would be completely outweighed by the devastating impact of a trade war with Russia, Ukraine's largest export partner. Indeed, even with fast-tracking it would take several years before many Ukrainian exports reach the required standards of the EU and most Ukrainian manufactured goods will struggle with competitiveness. In this time Ukraine would likely have slid into a balance of payments crisis and back towards Russia's sphere of influence, marking a major diplomatic defeat for the EU, which has been trying to cement its geopolitical influence in the region.

Still The Single Largest Trade Partner
Ukraine - Exports By Destination, US$mn

Even without a disruption of trade with Russia, Ukraine's economy is on an unsustainable path that will see international reserves eroded down to just US$19bn by the end of 2013 by our forecasts, which combined with the current account dynamics point towards a balance of payments crisis in the near-future, and a forced devaluation of the hryvnia. This places Yanukovych under substantial pressure to negotiate a deal with the EU/IMF that will allow funding to be released and Ukraine to avert disaster. Even so, we remain extremely sceptical that Yanukovych has any desire to implement the structural and institutional reforms that Brussels desires, as this would entail ending the system of patronage around which the political executive is built.

Overall, the outcome remains extremely uncertain, and even with EU/IMF intervention, the risk of economic collapse remains omnipresent. With no external financing currently in place and Russian retaliation looming, huge downside risks surround the Ukrainian economy. The haste surrounding negotiations with the EU and IMF points towards a deal motivated by political rather than a measured analysis of both short- and long-term economic and political benefits, which does not bode well for hopes that the signing of the Association Agreement will set Ukraine on the path towards prosperity.

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Sector: Country Risk
Geography: Ukraine
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