In the first part of this series we discussed Greece and its ongoing negotiations with the European Union – particularly with Germany – and how the complicated history between these two countries makes it exceedingly difficult for the Greek people to accept the terms on offer from the EU. The financial media’s reporting on the Greek saga has become quite dramatic (at least in comparison to other financial dramas); it has become one of the more memorable economic conflicts in recent years.
This time we will turn our attention north, to a different kind of conflict. This one has also wrought economic devastation to a European country, but of a much higher intensity. It is the first civil war that the European continent has seen since the Balkan Wars of the 1990s, when the regional superpower of Yugoslavia was ultimately broken up amidst a series of separatist and independence movements. Today’s conflict will almost certainly result in a similar outcome for its host country.
I’m talking, of course, about Ukraine. Let’s take a closer look.
A Very Bad Year For Ukraine
The past eighteen months have been cataclysmic for Ukraine. Its current descent into anarchy began in November 2013 with the Euromaidan protests, when pro-Western protestors denounced then-president Viktor Yanukovych and demanded closer integration with Europe. The protests endured until February 2014, when clashes between police and protestors descended into urban warfare. Police snipers used live ammunition against protestors and at least 88 people were killed within 48 hours.
Ukrainian politics are famously ruthless. Fistfights routinely break out in their parliament (gratuitous examples provided here and here). This is also the country where a former president was poisoned and disfigured by dioxin — and ultimately implicated the godfather of his own children as the culprit. Perhaps it’s no coincidence that Vitaliy Klitschko, a 200-cm world heavyweight boxing champion who has never been knocked out, is now the mayor of Kiev.
However, even the murder of unarmed protestors proved too much for arch-stooge Yanukovych to withstand and he was forced to flee Kiev within days. A media sideshow ensued when the public discovered their president-in-exile’s opulent dacha outside of Kiev, built with some of the billions that he had siphoned out of the country’s coffers. The ensuing “Marie Antoinette on the Dnieper River” moment, coupled with the rapidly increasing list of his former associates who have lately been found dead, ensures that he will not emerge from his current and undisclosed location anytime soon.
In such a chaotic political climate, it is rather unsurprising that the leadership vacuum created by Yanukovych’s hasty exit ultimately led to civil war and a thinly-veiled Russian military invasion. The Ukrainian presidency (also known as “the world’s least desirable head of state position”) was ultimately claimed by oligarch Petr Poroshenko, the “chocolate king” of Ukraine. His Roshen Corporation is the world’s 18th-largest confectionery company, providing him with a net worth of approximately $1.5 billion. He managed to win elections in May 2014 with enough margin to avoid a run-off.
However, Poroshenko has not always enjoyed similar support from his foreign friends. Take US Assistant Secretary of State Victoria Nuland, for instance. Married to conservative foreign policy commentator Robert Kagan, Nuland is one-half of the perennial Washington neoconservative power couple. Her husband aggressively pushed for the Iraq War; she now aggressively lobbies for American military sales to Ukraine and other Eastern European countries. Tasked with managing US diplomatic relations in Europe, Nuland became famous after a phone conversation between her and the US Ambassador to Ukraine was leaked to the media. During that call, Nuland made several references to whom she thought should become the next prime minister of Ukraine after Yanukovych’s ouster. Her recommendation, Arseniy Yatseniuk (whom she referred to colloquially as “Yats”) became the PM on 27 February but was defeated by Poroshenko in elections. The call descended from creepy interventionist plot into a full-on diplomatic neutron bomb when she was quoted as saying “F*** the EU” in response to the continent’s leaders failing to join ranks with the US in enforcing sanctions against Ukrainian political leaders. Whether or not her interference played a role in the succession of “Yats”, the incident provided the Russian government with a golden opportunity to portray her as a villain, and to paint the pro-European Maidan protests as more of the usual American meddling.
All of this aside, it goes a bit beyond hypocritical when the Russians accuse the US of meddling in Ukraine’s affairs. In contrast to one diplomat’s ill-advised comments, Putin has spent the past twelve months taking the art of covert foreign intervention to a new level. When was the last time a foreign power sent armored columns of tanks and troop carriers into a neighboring country and denied that such an event was actually happening?
The Russian Angle
This week marks the one-year anniversary of Russia’s annexation of Crimea. Conveniently, Putin made the decision to send Russian troops into Sevastopol on the eve of the Olympic closing ceremonies in Sochi. Overall the past year has been quite peaceful if you live in Crimea. The same cannot be said of the eastern regions of Donetsk and Lugansk, where loss of confidence in Kiev’s government led to the establishment of separatist movements and new allegiances to Russia. Over 5,000 soldiers, partisans and civilians have died in the intense fighting that has taken place in those regions over the past year.
Western media has portrayed Russian incursions into eastern Ukraine as a “reign of terror” (a quote from none other than Victoria Nuland) where chaos abounds and no one is safe. One wonders how this can be true after reviewing poll counts from a March 2014 referendum where Crimeans voted on the issue of secession from Ukraine and annexation to Russia — 83% of the population cast a vote, and 96% of those voted in favor of annexation. A “reign of terror” might be under way against some hard-line ethnic Tatars who refuse to accept majority rule, but overall these facts appear to further undermine whatever shred of credibility Nuland and the US can still lay claim to on this topic. According to several polls, Crimeans overwhelmingly lost faith in the Yanukovych government and believed that the Maidan protests were orchestrated by the West. As shown below, nearly two-thirds of Crimean residents have Russian heritage and a collective decision was made to seek safety and security in their homeland.
The battlegrounds of Donetsk and Lugansk are far more difficult to explain. These are the eastern provinces where the vast majority of conflicts has taken place. Over the past several months we have been shown images of high-intensity conflict from Ukrainian villages like Debaltseve and Mariupol. Over 5,000 have died in these conflicts since the two provinces declared themselves to be independent sovereigns (the Donetsk and Lugansk People’s Republics, naturally) that swore allegiance to Russia, who have had the diplomatic sense to stop short of recognizing their independence. To date the only foreign “country” to recognize their status is South Ossetia, another former battleground on Russia’s border that has remained in a state of suspended animation since it left the Georgian sphere of influence in 2008 (and Russia’s most recent foreign incursion).
Why Is This Important?
Before we answer that question, let’s take a quick look at Ukraine’s economy:
Population: 44.2 million
Population growth rate in 2013: -0.6% (lowest in Europe)
GDP (2013 official): US$ 175B (purchasing power parity of US$ 377B)
GDP per capita: US$ 7,400 (2nd lowest in Europe)
GDP growth rate (2014): -7.5%
GDP growth rate (2015E): -4.5%
Trade deficit (2014): -6.9%
Ukraine’s currency, the hryvnia, is the worst-performing currency in the world with a 40% loss against the USD in 2014 and another 40% drop reported so far this year. A drop of this magnitude has been enough to spark hyperinflation in the country — as high as 272%, according to one economist. Two weeks ago Ukraine raised its benchmark interest rate by 10.5 points, up to 30%, in an effort to stop the bleeding. The increased lending rate makes it all but certain that business activity will come to a screeching halt.
An emergency $17.5B rescue package was negotiated with the IMF earlier this month. The country is no stranger to the IMF’s lending officers; they have accepted eight loans since 1991, and only completed one program successfully. Even with an IMF bailout, the economy is in terrible shape. Foreign currency reserves have dropped below $10 billion, which is less than the interest payments that must be paid to service the Kiev government’s existing debt.
The IMF’s economic bailout is not the only aid package being discussed in Western policy circles. Calls for increased military aid to the Ukrainian government are coming from the usual Washington suspects: US secretary of defense Ashton Carter (who lobbied to bomb Iran in 2009), Senator Lindsey Graham (together with John McCain, the neocon wing’s “Odd Couple”), and, of course, Victoria Nuland of the US State Department who has led the push for regime change in Kiev since the Maidan protests last year.
Unsurprisingly, this contingent of (chicken)hawks is encountering resistance from their EU partners, who are wary of a proxy war on the European continent. Everyone involved knows that, if push comes to shove, Putin is the only player who is willing to send troops to fight in Ukraine. There is not a single NATO signatory that is willing to do the same. This became apparent in 2008, when the Ukrainian government applied to join NATO and was rebuffed by both France and Germany, who cited concerns about “the balance of power between Europe and Russia.” Ukraine has always known that it cannot count on European assistance in the event of a conflict with Russia, and in fact a 2008 poll found that over 40% of Ukrainians expressed suspicion and distrust toward NATO.
Both Ukrainians and Russians are well aware of the enormous power that Russia holds over the European continent. Eastern Europe is almost completely dependent upon reliable imports of Russian natural gas, and even the Germans and French are loth to shake the bear’s cage too much. In addition to gas imports, Russia remains one of Germany’s and France’s most significant trading partners; Russia is a reliable buyer of heavy mining and engineering equipment, and US-led sanctions have undoubtedly been a thorn in the side of the export-driven German economy of late. The US, whose exports to Russia are essentially non-existent (less than 0.2% of GDP), is quite content to sit back and push its European partners into supporting economically painful sanctions programs. It’s therefore a bit disingenuous to accuse the Europeans in going wobbly on sanctions when their interests clearly compel them to be much less aggressive toward Russia. That is exactly what is now happening, as the head of US sanctions policy just visited Brussels last week amidst mounting European opposition to an extension of anti-Russian sanctions when the EU is next scheduled to debate an extension, in June of this year.
None of this is meant to imply support of, or admiration for, Russia’s covert military campaign in eastern Ukraine which has led to widespread mayhem and loss of life over the past several months. However the endgame in Ukraine appears inevitable at this point. Crimea has peacefully and quite happily run the Russian tricolor up the flagpole, and two provinces from the country’s industrial heartland have seceded from Kiev. Several other disputed enclaves sit astride the Russian border – South Ossetia, Nagorno-Karabakh, Transdniestria — but Donetsk and Lugansk sit uncomfortably close to the heart of Europe.
The Kiev-based Ukrainian government has no choice but to accept the fact that its country is, and will continue to be, substantially smaller than it was 18 months ago. Its tax base has been reduced substantially, and its banks are going to have to write their number of ‘non-performing loans’ (currently approaching rates of 20%) substantially upward as they realize that most will never be repaid.
There is a story that was never confirmed, but has been widely reported: at a summit in Bucharest in 2008, Putin spoke to US President George W. Bush and told him, “You have to understand, George. Ukraine is not even a country.” This statement summarizes Moscow’s long-held view toward Ukraine — that it is an artificial state created in the wake of the Soviet Union’s demise. Putin has been quoted as saying that the USSR’s collapse ranks as the “greatest geopolitical catastrophe of the 20th century.” With that in mind, why should we be surprised at Russia’s aggressive moves into eastern Ukraine?
I have been looking at the investment implications of the Ukrainian break-up. The obvious play is to search for deep-value opportunities on the Ukrainian stock exchange (also known as the UX), where 80% of the listings are heavy industrials and basic materials. The UX index seems to be finding a level, after a -35% selloff last year, and has rebounded slightly in 2015. Dragon Capital is a well-known equity broker that can work with foreign investors.
If you decide to take a punt on Ukrainian stocks, take comfort in knowing that you won’t fare as poorly as Rinat Akhmetov has this year. Akhmetov, a Ukrainian oligarch, has lost as much as $5.8bn in the conflict. His SCM Group owns coal mines, steel mills, and power generation operations in the Donbas region of eastern Ukraine. His steel mills in other regions are now forced to import coal from Russia and South Africa. Dozens of his employees have been killed or injured in the fighting. Over 70,000 of his employees are located in Donetsk and Luhansk, which are now rebel-controlled. SCM Group has stated that these companies are still under their control and operating under Ukrainian law. (Good luck with that.) Akhmetov is well-known for carefully straddling the Moscow-Kiev divide, an exceptionally difficult act to perform in the current environment.
Next time, in the final part of this series, we will take a trip east to Moscow where we shall further explore Russia’s expected actions along the growing European fault line. We will also take a look at other potential regional hot-spots, and how we might all be surprised at where the next battleground of the Second Cold War kicks off.
One final note, on an update to my recent article on Greece. I was entertained to see that the intrepid Ms. Nuland (as mentioned above) decided to pay a visit to Greek Prime Minister Alexis Tsipras in Athens this week. It seems that the US has been watching Tsipras’ ongoing difficulties with EU debt negotiations, and has heard about his pending 8 April trip to Moscow where he almost certainly intends to explore alternatives to further austerity as prescribed by Herr Schäuble of the German Finance Ministry. It appears that Washington and Moscow may soon be climbing over each other to provide “aid packages” to the Greeks.
The world continues to become more interesting every day. See you in two weeks!
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