Ukrainian Crisis Enters New And Dangerous Phase

BMI View: The Ukrainian crisis entered a new and dangerous phase over the weekend, after the Ukrainian government vowed to unleash a large-scale anti-terrorist operation against armed pro-Russian separatists in the eastern oblasts of the country. Russia's alleged support of separatists is pushing the country towards civil war: a strategy designed to coerce the Ukrainian government into accepting a federalised country rather than face an economic and political meltdown. While the Ukrainian government is unwilling to discuss the possibility of a federalised state granting significant autonomy to the eastern and southern oblasts, the situation is deteriorating so rapidly that this may eventually become the least unattractive option.

The situation in eastern Ukraine has deteriorated significantly after pro-Russian demonstrators in Dontesk, Kharkov, and Lugansk seized government buildings and announced their intention to hold referendums on self-determination. The Ukrainian government responded with a threat to use lethal force against the armed protestors if they had not surrendered their positions by April 14, using military as well as law enforcement agencies to crush the separatists, although we note that security services have been conspicuously absent during recent seizures of government buildings, suggesting local powers may be at work. In particular, it seems probable that the situation could not have developed without the support of local oligarchs, which may suggest they are interested in gaining some form of autonomy in the region in order to guarantee the safety of their assets.

While the central government in Kiev has until this point resisted open discussions of force again separatist movements for fear of provoking a military invasion by Russia on the pretext of defending ethnic Russians living in Ukraine, their announcement is intended to send a clear signal to Russia that it will not tolerate a repeat of the Crimea scenario. Nonetheless, recent events have shown just how weak the control of central government is over local power organs in the eastern and southern oblasts. If the government tackles the situation with force, then it would open itself up to two major risks. The first risk is that by crushing separatist movements with force, it could generate more anti-Kiev sentiment; leading to greater support for what at present is widely believed to be a Russian-sponsored movement of no more than a few thousand people lacking widespread public support.

On The Brink Of Economic Collapse
Ukraine - UAH/USD Exchange Rate

BMI View: The Ukrainian crisis entered a new and dangerous phase over the weekend, after the Ukrainian government vowed to unleash a large-scale anti-terrorist operation against armed pro-Russian separatists in the eastern oblasts of the country. Russia's alleged support of separatists is pushing the country towards civil war: a strategy designed to coerce the Ukrainian government into accepting a federalised country rather than face an economic and political meltdown. While the Ukrainian government is unwilling to discuss the possibility of a federalised state granting significant autonomy to the eastern and southern oblasts, the situation is deteriorating so rapidly that this may eventually become the least unattractive option.

The situation in eastern Ukraine has deteriorated significantly after pro-Russian demonstrators in Dontesk, Kharkov, and Lugansk seized government buildings and announced their intention to hold referendums on self-determination. The Ukrainian government responded with a threat to use lethal force against the armed protestors if they had not surrendered their positions by April 14, using military as well as law enforcement agencies to crush the separatists, although we note that security services have been conspicuously absent during recent seizures of government buildings, suggesting local powers may be at work. In particular, it seems probable that the situation could not have developed without the support of local oligarchs, which may suggest they are interested in gaining some form of autonomy in the region in order to guarantee the safety of their assets.

While the central government in Kiev has until this point resisted open discussions of force again separatist movements for fear of provoking a military invasion by Russia on the pretext of defending ethnic Russians living in Ukraine, their announcement is intended to send a clear signal to Russia that it will not tolerate a repeat of the Crimea scenario. Nonetheless, recent events have shown just how weak the control of central government is over local power organs in the eastern and southern oblasts. If the government tackles the situation with force, then it would open itself up to two major risks. The first risk is that by crushing separatist movements with force, it could generate more anti-Kiev sentiment; leading to greater support for what at present is widely believed to be a Russian-sponsored movement of no more than a few thousand people lacking widespread public support.

On The Brink Of Economic Collapse
Ukraine - UAH/USD Exchange Rate

The second major risk is that it could ultimately open up the eastern and southern Ukrainian regions to an invasion by Russia. This is not our core view as we do not think Russia holds any particular interest in annexing these regions of Ukraine and the economic and political costs involved would be huge. Ukraine is of far more strategic value to Russia as a relatively friendly non-NATO member buffer state. It seems probable that the Kremlin's strategy is therefore to keep pressure on the government to federalise the country, creating significant autonomy for the eastern and southern oblasts. This would allow Russia to use these regions as pressure points to coerce Ukraine for the foreseeable future, while avoiding the long-term economic and political fallout that a military invasion would create.

Ukraine's government is unlikely to want to discuss federalisation at this stage, for the aforementioned reasons. However, the situation is deteriorating at such a rapid pace that it is increasingly hard to see a more orderly resolution for the crisis. Despite criticism from the EU, Russia appears unwilling to wind down its attempts to destabilise Ukraine, both economically (through gas prices and trade blockades) and politically through support of separatist movements. These are pushing Ukraine to the brink of economic collapse. Russia and Ukraine's economic ties are sufficiently strong that even EU/IMF financing will be insufficient to prevent Russia from driving Ukraine to economic ruin if it desires. It is therefore difficult to envision a scenario where Ukraine is able to divorce its future from Russia's interests, and hence why the possibility of a federal Ukraine seems increasingly likely.

Prospect Of Federalised Ukraine Growing

Furthermore, as we previously noted, the West appears to have substantially underestimated the political challenges involved in pushing through a major reform package as a condition of financing. The imposition of austerity itself has the potential to become a destabilising force as pensions are cut and gas prices for households hiked sharply. While these economic reforms are clearly necessary to keep Ukraine on a sustainable trajectory, an unwillingness to delay their implementation could act as a catalyst for further secessionist movements across the country. The recent collapse in the hryvnia to UAH13.00/USD will stoke inflation and damage the country's credit profile if it remains at this level. We have recently downgraded our 2014 real GDP growth forecast to -4.4%, from -1.8% previously on the back of substantially reduced household purchasing power due to higher heating costs and a weaker hryvnia, as well as sharp contractions in government spending and investment.

Going forward, the situation will remain extremely volatile as we fully expect Russia will continue its destabilisation efforts, and there is a growing risk of violence breaking out between the government and separatist movements. While the government in Kiev appears unwilling to discuss any discussion of federalisation at present, the risk of a protracted civil conflict breaking out may soon become salient enough to warrant some concessions on this front.

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Sector: Country Risk
Geography: Ukraine, Russia
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