6:17 AM Monday, February 19, 2018
From the August Lull: Ukraine's Political and Economic Outlook
image/svg+xml Kyiv Lutsk Rivne Zhytomyr Lviv Ternopil Khmelnytskyi Uzhgorod Chernivtsi Vinnytsia Chernigiv Sumy Kharkiv Poltava Cherkasy Kirovohrad Lugansk Dnipropetrovsk Donetsk Zaporizhzhia Mykolaiv Odesa Kherson Simferopol Sevastopol Ivano- Frankivsk

To update my Ukraine view, I address this via a Q&A format:

How do you read domestic politics in Ukraine?

Answer: Messy – as usual. President Poroshenko seems to be positioning for elections – whether they are early or not that is a question. But in recent months he seems to have taken action to take out two political rivals – Andriy Sadoviy over the Lviv trash crisis, and Mikheil Saakashvili over the legality of his citizenship application – and I think by so doing sending a message to others that Ukrainian politics can get very dirty, and to play at the top table you have to be ruthless.

Poroshenko sees off one rival, Saakashvili (UNIAN/Oleg Smal)

Q? Who is your top pick for the next presidential elections?

Answer: Well Poroshenko has the benefits of incumbency, but is trailing Yulia Tymoshenko in the polls, only just. Both are only polling in the teens with high negative ratings. YT has proven over a long political career that you can never rule her out – like her or love her, she is a political/campaign machine. But Ukraine needs a new fresh face. In past presidential elections, candidates coming from the left field have a tendency to do well. Remember Serhiy Tyhipko in 2010, or even Leonid Kuchma back in 1994, albeit as a former Red Director, he was clearly part of the establishment.

Svyatoslav Vakarchuk, the pop star, is the dark horse to watch. Although he might be looking to keep his powder dry for the election after next. That said, his opportunity, and Ukraine’s need might only be now. Whether he has the stomach for the fight – and has a skeleton-free cupboard is the question. But having a cupboard full of skeletons has never particularly been a constraint to Ukrainian politicians doing well. Aligning enough oligarchic interests into your camp has been key, and ensuring backing of their media groups.

Q? What would you watch for at this stage?

Answer: We are in the summer lull, but political action will resume with full force in September. Watch for tensions between PM Groysman and President Poroshenko. I think Poroshenko sees Groysman as a potential rival – getting above his stature, perhaps. I don’t buy the line that Groysman does not have political ambitions. Russian-speaking Azarov was the only one who clearly did not, which is why Yanukovych kept him so long. And Ukraine has a long history of rivalry between presidents and their prime ministers. The problem is the constitution. Remember: Yushchenko and Tymoshenko (Poroshenko had a tortuous relationship with YT at that time as well), Poroshenko and Yatseniuk,

Returning to Groysman, he almost set himself to follow the Kamikaze Yatseniuk, by promising to resign if he failed to enact pension reform this year. He may have tied his own political noose if he fails to deliver. One reading of the pension reform bill was cleared before the Rada went into recess in July, but getting the next two signed off could still be challenging and risking the “chop” for Groysman. The only issue for Poroshenko, if he moves against Groysman is: who he would chose as a replacement and what deals would he have to cut, with which oligarchs, in and around the Rada, to get his man, or woman, in the seat? Keeping Groysman might still be a less risky option. But he will surely want to slap his PM down somewhat – perhaps letting him walk to the gallows, just before giving him a last gasp reprieve.

Prime Minister Volodymyr Groysman confers with Verkhovna Rada speaker Andrey Parubiy at a Rada session on July 14 (UNIAN/Vladislav Musienko)

In the context of political intrigue, it was interesting that last week allegations of nonpayment of taxes were made against Minister of Finance Alexander Danylyuk. This smacked of a political vendetta against Danylyuk who has emerged as the reform darling now of the IMF/international community – having earned his spurs fighting the good fight against the tax police, et al. He has emerged as the must-go-to person for the IFIS. This latter battle may well have come back to haunt him. But he has denied any wrong-doing.

Danylyuk’s situation come September should be closely watched. The forces of reaction have their eyes on his position. The agenda would be a pro-growth, anti-IMF agenda. The message will likely be that to win an election, the fiscal coffers need to be opened, taxes cuts, as per the Yuzhanina tax proposals back in late 2016, which were heavily criticized by the IMF. But the big oligarchic groups will argue that Ukraine just needs a low tax, pro-growth agenda, and all the anti-corruption stuff will be side-lined. That would be hugely disappointing. It would go right against the spirit of Euromaidan.

Q? What about the new NBU governor?

Answer: What new NBU governor would be the best response? It is quite remarkable, in the four months since Gontareva resigned, that Poroshenko has not yet named a successor. It is not as though the NBU is not an important/anchor institution. This role/institution is key. How the president can let the NBU drift – admittedly in the relatively safe hands of the acting governor – is beyond me. The charitable interpretation is that he is just biding his time until the leading reform candidate, Volodymyr Lavrenchuk, currently CEO of Aval Bank, is “available” – supposedly in September. But this not an internship, this is the NBU governorship position, so I don’t think it is particularly encouraging that the market is being left in limbo – at least Lavrenchuk should have been announced by Poroshenko as his preferred candidate. The fear and risk is that Lavrenchuk’s nomination could get lost amid broader politicking around early elections, or a cabinet reshuffle and some less-reform minded candidate might emerge. Cynics might argue that Poroshenko had no intention of appointing an independent minded person such as Lavrenchuk as governor, and he is just biding his time to see what options arise to use the NBU posting for leverage with others.

Q? What about the IMF program?

Answer: Autumn will be the battle ground. Let’s see how quickly pension reform is passed, and whether gas price hikes, which should have been announced July 1, are introduced before the October heating season begins. The longer this is delayed, we get into the 2018 budget debate (from September anyway). Towards December the whole land reform issues come back into focus. In any event it seems unlikely that we get a speedy sign off on the next IMF review. This could push out to 2018.

Part of the problem is that Ukraine does not currently need IMF cash. The single Treasury account had a UAH44.1bn surplus as of August 1, close to four times the year earlier level, with the budget posting a SURPLUS of UAH29bn for H1 2017, helped by NBU profit transfers and, yes Naftogas dividend transfers. This is a truly remarkable achievement, given this institution was running deficits of 3-4% of GDP only a few years back. This compares to a deficit of UAH35.1bn one year earlier and reflects 49% YOY revenue growth, offsetting the 22% YOY increase in spending.

But it is fair to say the budget is looking in a rude state of health – which is why I have a sneaking suspicion that Poroshenko might just go for early elections. He has cash to spend, he can sell a positive message of growth, macro stability, higher pensions, and elections would stall a bit longer difficult, IMF-related reforms on the structural side. Anti-corruption means taking the “get out of jail for free” cards from Ukraine’s elites, and land reform – also unpopular with rural elites, but not unpopular if explained to ordinary Ukrainians.

The danger is of a repeat of 2011-2013 for Ukraine. Strong budget/financing conditions allow the country to go off-piste on the IMF front, structural reforms lag, but eventually do come back to haunt Ukraine, as they did in 2013, and were a factor in the Euromaidan. Now, it is quite possible, even with the IMF program staying off track, that Ukraine comes back to the market, borrows cheaply (sub-7%) from the Eurobond market, giving the government more cash in the bank to fund an early election campaign. Yes history repeating itself. Whether Poroshenko wants to go down in history as Yanukovych Mark II is open to question. Poroshenko was a founding member of Yanukovych’s Regions of Ukraine Party.

Q?And how is the economy doing?

Answer: Ok. H1 real GDP growth is estimated at 2.5% by the ministry of economy, which is close to the NBU’s production index outcome of +2.7% YOY. This is solid, given the travails at the beginning of the year, over the blockade in the East. The base is low, which obviously helps. The strength of the agricultural sector remains enduring, and reflects its stellar competitiveness and great longer term prospects. This likely reflects why land using elites are doing so much to stall land reform: they love the status quo where land costs are low.

With real GDP growth resuming, the current account deficit has widened again, reaching $1.6bn or 3.4% of GDP for H1 2017, up from $946m or 2.4% of GDP in the year earlier period. But with broader confidence in place, this is easily financed, as reflected by the continued upward pressure on NBU reserves, which reached $18bn in June, despite relatively little in terms of IFI disbursements YTD.

Reserves are higher by $4bn YOY, and the highest level since December 2013, i.e. pre-Euromaidan. Reflective of this, the UAH remains under appreciation pressure, rallying 5% YTD, and hence around 13% in real terms, which likely will just put more pressure on the current account deficit, growth and competitiveness.

Despite the strength of the UAH, inflation remains a problem, rising steadily since the recent low of 6.9% in June 2016, to 15.6% this June. Low base effects, food price inflation on a slightly poorer harvest, and rising domestic demand are pushing prices higher – and pension hikes and possibly utility price hikes in the autumn should further keep inflation elevated. That has limited scope for the NBU to cut rate. It held its policy rate unchanged at 12.5% this week.

Net-net, rising inflation, real FX appreciation, just underlines why Ukraine needs to crack on with implementation of a radical/ambitious structural reform agenda. It still is benefitting from the low base, adjustment from 2014-2016, but this favorable base will soon evaporate again, leaving the economy exposed, perhaps 1-2 years down the line to another macro shock.

Net-net the macro looks okay for the time–being, and this stability is another reason why early elections might just be tempting for Poroshenko.

Q? What about the structural reform agenda, is progress being made?

Answer: We have seen strong progress in certain fields, including energy sector reform, banking reform, NBU reform, et al. Plans for pension reform are encouraging, albeit let’s see if the Rada bites the bullet in the autumn. The mood music is good around healthcare reform, but we are waiting to see delivery. As noted above, fiscal has outperformed – helped by the performance of the NBU and Naftogas, but also the impact of higher inflation and real GDP growth.

The government has unveiled plans for privatization. Not sure how much value is left in remaining assets, aside from land. Ten million hectares in state ownership, if sold, could be a cash cow for the Treasury.

But bigger question marks still hang over the anticorruption agenda, where progress is being made in creating institutions, but we are long overdue impact in terms of bringing corrupt individuals to account and changing behavior. In many respects it looks like the administration, and indeed system/political class, is just going through the motions of doing what it is being told to do by the IFIs, but without real commitment. The latter might reflect understanding of the logical conclusion to all may well be that large sections of Ukraine’s elites will eventually be brought to account, and potentially will go to jail.

I don’t think the current strategy will work. Reining in corruption is the key factor in boosting long term growth as it is key to improving the business environment. It has to work to ensure Ukraine’s successful transition from a twilight zone of elite capture to a functioning and effective market economy serving all the population. A truth and reconciliation process and windfall tax for wrong doing would be quicker/more effective. But I have been banging on there for several years with no effect.

What is the probability of a re-escalation of the conflict in Eastern Ukraine?

Answer: The sad reality is that there has already been an upsurge in fighting and with it casualties this year so far – with reported ceasefire violations running around twice the year earlier level, and at over 200,000 YTD. This has resulted in 59 civilian deaths, and over 330 injured. Ukrainian military casualties are running at close to 900 (DIA/WIA) YTD, also close to double the year earlier level. As is evidenced herein this is hardly a “frozen conflict” but very hot, especially if you are at the sharp end of “incoming.” That said, the conflict is still running at a much lower intensity than in the peak of military operations in mid-2014 and 2015, around the landmark battles of Illovaisk and Debeltseva. Both sides have to a certain extent learned how to adjust to the current (even high) level of conflict. The Ukrainian economyis moving on, and becoming more insulated against developments in the East.

But all the above said, it is fair to ask what the probability is of a return to the level of intensity seen in mid-2014 and 2015, in and around the run-up to the Minsk peace talks?

Certainly on the ground, this is relatively easily done, given both sides have tens of thousands of troops, and military equipment still in theater. And, both sides have been rotating and, if anything, increasing/improving capability. Against this backdrop it would not take much for one or both of the sides to move quickly to more offensive military action. But therein it would require a political decision.

It is now generally understood/accepted that large scale military action by LPR/DPR is only with agreement/approval of its backers in Moscow. And therein Moscow still seems unwilling to move just yet to a larger-scale intensification. I think this reflects understanding that intensification risks greater casualties – more likely now given that the Ukrainian military has undergone extensive re-equipment, and training assisted by NATO.

Large-scale casualties are not tolerable in the context of looming elections in Russia, where soldiers’ wives/mothers associations have assumed some prominence and political clout. In Moscow there is also a parallel battle to counter Western sanction risks – and manage relations with the US administration. The view seemed to be that the Trump White House was more amenable/understanding to Russian interests. There was an unwillingness in Moscow to appear to be overly aggressive/assertive in Ukraine for risks of undermining efforts by friends in the Trump administration looking to alleviate sanctions on Russia – albeit as noted, on the ground 2017 has seen an upsurge in violence.

This policy seems to have failed, with the US Congressional decision to codify sanctions, and hence some in Moscow might argue that there is little reason now for moderation over Ukraine. But again we come down to the line that re-escalation in Ukraine risks Russian casualties, which are unpopular at home.

But it is possible that Moscow could try another bout of tightly controlled/managed re-escalation at specific points along the line of contact – e.g. as occurred at Andriivka, and other economically strategic assets. Moscow though likely will also want to weigh how this plays on relations with Europe, the US, but also how it impacts on domestic politics in Ukraine. And on the latter point, Moscow likely might still want to give domestic politics time still to play out, in the hope that it still works to its interests – the hope in Moscow still seems to be that a government is formed in Kyiv more amenable to Russian interests, e.g. a coalition including former allies from the Party of Regions, now re-constituted as the Opposition Party, and a number of other groupings. Talk of early elections being called in Ukraine, perhaps for late 2017, or 2018 might again encourage Moscow to bide its time for a period yet.

But it is important that Putin’s strategic objectives in Ukraine have not changed: to bring Ukraine back under its strategic umbrella, and within its sphere of influence. This means the presence of a government in Kyiv which is deferential to Russian interests. It is hard at present to imagine any Ukrainian politician delivering on this agenda – at least given current opinion polls. But as long as Moscow thinks that such an outcome is possible, over its desired timeframe, it is more likely to hold back from a higher risk fuller scale military intervention.

Q? Where are we in terms of the US arming Ukraine with defensive military capability?

Answer: Kurt Volker, the new US representative to Ukrainian peace talks, indicated last month in a BBC interview that the issue is being evaluated in the US – and appeared to play down the risks that this could be viewed as an escalation by Russia. Reading between the lines, Volker himself appeared supportive of arming Ukraine. That said, most of the DC establishment, including the bulk of the Obama WH, with the exception of Obama and Susan Rice themselves, and a weight of Congress, and also now the Trump executive at least, were/are also supportive of arming Ukraine.

Trump, Tillerson and those around Bannon are still likely opposed – unwilling to upset Russia, and likely still wanting some kind of deal with Moscow. This still suggests no early decision in favor of arming Ukraine. That said, some in the US Administration might see some use in keeping this issue warm. The mere threat of the US arming Ukraine, might encourage a more conciliatory approach from Moscow towards Ukraine.

Much though now depends on whether after the codification of Russian sanctions by Congress, Putin has just given up on the Trump presidency, and looks to meet US pressure, with more pressure. We will have to await Putin’s return from his latest adventures/vacation in the Russian outdoors, which will no doubt be covered extensively in the Russian media.

Timothy Ash is Senior Sovereign Analyst for Blue Bay Asset Management in London

Slider photo: Before the August holidays, President Petro Poroshenko announced on Friday completion of the contest for a new Supreme Court. (UNIAN/Mikhail Markhiv)

Posted Aug. 3, 2017

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