Ukraine Politics


Ukraine: Peace talks resume against backdrop of escalating violence and economic crisis

May 11, 2015

Ukrainian government officials and pro-Russia separatist rebels, along with officials from Russia and the Organization for Security and Cooperation in Europe (OSCE), met for the first time on 6 May since the signing of the Minsk II peace agreement in an effort to salvage the deal. Fighting has ramped up in recent weeks, thus threatening the shaky progress that has been made toward a lasting resolution to the conflict. While Minsk II was able to reduce fighting initially, progress toward implementing the terms of the peace accord has been at a standstill of late. In the recent negotiations, the Ukrainian government officials and separatist rebels agreed to establish a number of expert groups to evaluate the security and political measures contained in Minsk II as well as to decide how to proceed in implementing them. This includes holding democratic elections in the rebel-held territories and granting the regions greater autonomy.

Meanwhile, the International Monetary Fund (IMF) returned to Ukraine on 12 May to begin the first review of the USD 17.5 billion bailout that was approved on 11 March. The review, which will take approximately two to three weeks to complete, will evaluate Ukraine’s progress in implementing the reforms and fiscal objectives laid out in the bailout package, which are necessary to release the next tranche of financing. The IMF extended a small life-line to the cash-strapped country on 11 March, releasing a desperately-needed USD 5.0 billion, however, the funds do little to shore up Ukraine’s finances. Critical to the disbursement of the next tranche of funds is a successful debt restructuring with private lenders, but discussions have barely made any progress so far. Ukraine’s Ministry of Finance is pushing for principal haircuts on sovereign bonds, which has been the stumbling block in negotiations with investors. Complicating matters further, Russia is the second-largest holder of Ukrainian debt and Moscow has refused to participate in joint restructuring talks.

On top of the difficult debt negotiations, Ukraine’s government is tasked with trying to halt the economy’s downward spiral. The military conflict is centered in Ukraine’s industrial heartland, which represents over 15% of the country’s GDP. The conflict has resulted in large amounts of capital flight and pushed Ukraine into an economic crisis characterized by skyrocketing inflation and double-digit contractions in industrial production. To make matters worse, Russia’s economy is expected to nosedive this year and demand from the Eurozone is anticipated to remain lackluster—providing Ukraine with unfavorable external conditions for growth.

On the domestic side, prospects are also bleak. Ukrainian households have been hard-hit by the crisis. Taking into account the fact that the economic meltdown is expected to continue and the dramatic depreciation of the hryvnia, the FocusEconomics Consensus Forecast panel projects that per capita GDP will fall to USD 1,900 in 2015, which is drastically down from the USD 4,195 tallied just two years prior. While the IMF’s ambitious reform plan is designed to correct the economy’s momentum, in the near term, it will dampen private consumption further. Specifically, a large reduction in the state energy subsidy and hefty reductions in state employment and benefits will hurt Ukraine’s already-struggling households. The dire state of the economy could, in an extreme scenario, erode support from the government and increases the risk of greater political turmoil. Ivan Tchakarov, Head of Russia/CIS Economics at Citi adds:

“[R]isks center on the government’s likely inability to meet its fiscal targets and the probability that the significant pain inflicted on the general population will lead to unrest. The assumptions laid out in the adopted 2015 budget underscore the daunting challenges faced by the government. Even if the fiscal envelope appears robust (planned budget deficit at just 4.0% of GDP), the assumption of a 40% increase in revenues (following a mere 4% increase in 2014) suggest that revenues will likely undershoot, leading to a much higher fiscal deficit. In addition, the already struggling general population will need to endure a sevenfold increase in domestic gas prices over the next two years against the backdrop of meagre increases in nominal incomes and planned drastic cuts in civil services.”

Going forward, Ukraine’s economy is unlikely to turn around without a lasting resolution to the military conflict. While the recent negotiations are a step in the right direction, a large amount of uncertainty remains regarding if or when lasting peace will come to fruition. Against this backdrop, FocusEconomics panelists have downgraded Ukraine’s 2015 economic outlook for the eleventh month in a row. Panelists now expect GDP to contract 6.2% in 2015, which is down 0.4 percentage points from last month’s forecast. For 2016, panelists expect the economy to rebound to a 1.8% expansion

Author: Angela Bouzanis, Senior Economist

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