Punishing Russia Isn’t Going to Fix Ukraine’s Economy

But a realistic aid package would help, says Brett House.

By: /
11 March, 2014
Brett House
By: Brett House

Deputy chief economist, Scotiabank

The United States and the European Union both announced aid packages for Ukraine last week. But with the new government in Kiev struggling to clean house after the corrupt rule of Viktor Yanukovych and face down a belligerent Russia, the aid packages are too small and will disburse too slowly to provide the immediate help it needs.

Ukraine’s current crisis is typically miscast as a political conflict between East and West – between pro-Russian Yanukovych and Europhile opposition leader Yulia Tymoshenko; between the country’s Russian-speaking eastern regions and its Ukrainian-speaking western half; and between Russia and its old Cold War adversaries. These political clashes are, however, byproducts of a much more profound, long-simmering Ukrainian economic crisis that has been decades in the making.

Since its independence in 1991, Ukraine hasn’t been economically viable. Though it is one of the world’s top cereal producers, its manufacturing infrastructure is tired and its steel industry is obsolete. It adds to these woes by rigging its currency at artificially high levels, making consumer imports cheap, but exports uncompetitive.


GRAPHIC: Charting economic growth in the post-Soviet economies.

The economy is also dangerously dependent on natural gas imports from Russia that power about 40% of Ukraine’s electricity production. The supply contracts for Russia’s natural gas provide a cover for massive corruption by Russian and Ukrainian interests, as Quartz’s Steve LeVine notes.

The problem is compounded by huge Ukrainian government subsidies: Kiev pays about 80% of the cost of Russian gas imports. In theory, it passes the remaining 20% on to consumers and businesses, but the government’s collection efforts are spotty.

As a result, the Ukrainian state has racked up debt equivalent to about 40% of GDP. That’s not massive compared with other troubled countries – Greece’s debt-to-GDP ratio exceeds 150% – but it’s more than Ukraine and most emerging markets can sustain.

Ukraine is living on borrowed time

Through the 1990s and early 2000s, foreign appetite for Ukrainian grain and steel kept the country afloat. But with the 2008 financial crisis, demand for Ukrainian exports crashed. Rather than adjusting their spending, successive Ukrainian governments flirted alternately with Russia and the West to paper over the country’s financial cracks.

With IMF support, the government set reform programs in motion in 2008 and 2010 to put the country on a sounder financial footing. But both IMF loans were suspended when Ukraine reneged on promised reforms. Accession talks with the European Union stalled. Kiev turned to Moscow for help, and replaced Western financing with $15 billion in support from Russia combined with $7 billion of natural gas discounts. All of that got pulled when Yanukovych fled office a few weeks ago.

Ukraine is now living on borrowed time. Around $20 billion in debt comes due over the next two years. That’s $20 billion the Ukrainian government can’t finance. Its other financing needs are murky: No-one trusts the Kiev authorities’ numbers. An IMF mission arrived in Kiev last week to set the facts straight, but it won’t report back to Washington for another week.

In any case, a crisis two decades in the making can’t be undone in the 18 to 36 months of a typical IMF-supported reform program. As for the American and European aid, it will also likely carry conditions the fledgling Ukrainian government can’t fulfill in the coming months. The government has already started slashing pensions and social spending to meet the West’s demands. Rather than shoring up the interim administration, this is a recipe for disaster ahead of May elections.

Kiev needs more money, and sooner

Ukraine needs more time to reform its economy and put it on a sustainable path. The West should make its offer of aid more realistic.

First, the U.S. and EU need to front-load their aid packages and make them richer. The American offer of $1 billion in loan guarantees would make only a dent in Ukraine’s financing needs. Europe’s $11 billion aid package would release only about $1.6 billion this year, and then only on agreement to widespread reforms and a deal with the IMF. To dispel any fear of a debt default and defer crippling spending cuts, the U.S. and Europe should offer Ukraine $20 billion over the next two years, of which $7 billion to $10 billion should be upfront in liquid non-project financing.

Second, the West needs to ensure that IMF money carries fewer strings and disburses faster than past loans. The Ukrainian government has requested $15 billion from the IMF, but this is likely to come in two parts: perhaps $1 billion under an emergency facility, with the rest over the next three years once Kiev has agreed to tough conditions.

Third, the West needs to open unilaterally and immediately its markets to Ukrainian goods by dropping tariff barriers.

Punishing Russia won’t achieve anything

Diplomatic isolation, asset freezes, and travel bans may be appropriate, but are unlikely to have much impact on Russia. Economic and financial sanctions that would actually bite aren’t credible. Russia does $100 billion in annual trade with Europe. One-third of European natural gas comes from Russia. The $3 billion in transit fees on that gas constitute Ukraine’s largest service export. And London’s banks house billions in oligarchs’ assets. Europe needs Russia and Vladimir Putin knows it.

Likewise, musings about the U.S. using its abundant shale gas or releases from its Strategic Petroleum Reserve (SPR) to drive down global energy prices and hurt Russia’s exports are fantasies. It will be years before the U.S. has the infrastructure needed to export its gas surplus. And SPR releases turn the screws on Russia only if OPEC, or at least the Saudis, check their production too.

Finally, helping Ukraine is diplomatically easier than sanctioning Russia. In contrast with the UN Security Council, where Russian and Chinese vetoes hamper action, the US and Europe have enough voting power on the IMF Executive Board to approve a large loan with few strings to Ukraine. They should use that power.

Solve Ukraine’s economic problems, and you stop Kiev’s oscillating tease between East and West. Help Ukraine’s emerging leaders make the country economically sustainable, and you make Ukraine a bridge between East and West rather than a flash point of tension. Henry Kissinger asks how the Ukraine crisis ends. The answer: When we start sending real money to Kiev.

This article originally appeared on Quartz.

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