KYIV BLOG: How the EU will lose Ukraine

By bne IntelliNews November 27, 2013

bne -

Ukraine was willing, but the EU has fluffed an attempt to bring the struggling country into the broader European fold by offering rhetoric and red tape when what it should have done is put cash on the table. The EU's failure to understand Ukraine's desperate need for cash has tied Ukrainian President Viktor Yanukovych's hands and forced him into doing a deal with Russia.

European leaders from the EU and several countries from the former Eastern Bloc will meet in the Lithuanian capital of Vilnius November 28 for a two-day summit. But all eyes will be on Yanukovych, who may sign an association and free trade agreement at the very last minute and snub Russia's offer to join its Customs Union trade club in the process. As the pro-Europe street protests in Kyiv go into their fourth day, Yanukovych is under intense pressure.

It all comes down to money. Yanukovych is probably sincere when he says he sees Ukraine future as an integral part of Europe, but because he is facing an imminent economic meltdown, he needs money - and he needs it right now.

Russia has been accused of "bullying" Ukraine into nixing its effort to sign off on the EU Association Agreement and Deep and Comprehensive Free Trade Agreement. Indeed, it has been playing hardball. But this emotive talk that reflects schoolyard values of what is "fair" is pure political rhetoric. We live in a grownup world and Russia is acting in its national interests, using what tools it has to get what it thinks it needs. Its Eurasia Economic Union, due to be created in 2015, makes no sense without Ukraine's participation.

For the West to claim that Russia is "bullying" Ukraine to achieve its ends is disingenuous, as what are the current sanctions on Iran if not bullying to get a reluctant Tehran to curb its nuclear ambitions. And that is not to mention the Persian coup organised by the US and the UK in 1953 to bring in a more western-friendly government. Or the more recent wars in Afghanistan, Iraq and Libya. The list of this sort of "bullying" by the West is very long indeed.

To better understand Russia's position, think of it as a company. Over the last decade relations with its main rival, the EU, have deteriorated dramatically. The Kremlin has made a few attempts to cooperate in joint ventures, like Russia's investment into the aerospace corporate EADS, the maker of the Airbus, or its bid to buy the carmaker Opel, which have all been rudely rebuffed. There is little goodwill left between Russia and the EU.

Ukraine can be thought of a supplier, lying between ZAO Kremlin and EU Inc (and Ukraine's exports are more-or-less evenly split between east and west). What would a company do if its rival tried to take over a key supplier - a move which would cause an increase in prices and decrease in supplies following the acquisition? It would get into a bidding war for the supplier. Ukraine has to decide what is more profitable: to become Ukraine GmbH or OAO Ukraina.

And that is just where Yanukovych finds himself. The trouble is bulk of the EU's offer is shiny new "values" and the promise of a brighter future, whereas Russia is offering cold, hard cash.

Do the math

Just do the do the math. Ukraine's hard currency reserves have been plummeting this year, from about $35bn in April to around $20bn now. This is below the three months' import cover economists say is needed to ensure the stability of the national currency. This means Ukraine should have already seen a sharp and extremely painful devaluation of at least 15% already, but the government has been propping up the currency. According to Standard Bank, the finance ministry has only one month's worth of cash on account to pay the state's ongoing running costs.

Things have become so bad that the central bank has reintroduced a mandatory surrender of hard currency rule, which almost every other transition country in the east abandoned in the 1990s. The country has effectively run out of cash and is now living on its credit cards.

On top of this dire economic position, Ukraine is facing a pretty heavy bond redemption schedule, with several billion in International Monetary Fund (IMF) loans due this year and another $7bn of bonds maturing next year, according to reports. Earlier this year, Kyiv tapped the Eurobond market for some useful cheap cash, but with the talk by the US Federal Reserve of "tapering" its asset buying programme, the yields on its bonds have already risen sharply, made worse by the international rating agencies starting to downgrade the country's outlook.

The EU has offered a paltry €1bn as a reward for signing off on the agreements. But set against the prospects of the high cost of EU integration, the inevitably higher prices for Russian gas, plus the reduced trade with Russia, the government poured scorn on the offer earlier this week.

"We were told that Ukraine could count on €1bn. €1bn is nothing. One can say that it is a pittance to a beggar," Ukrainian Prime Minister Mykola Azarov said during an interview on Russia's Channel 1 "Sunday time" programme.

Aware that it was losing the battle for Ukraine, the EU upped the offer with another $610m on November 25, but this laughably small amount would be burnt up in a month. Yanukovych confirmed he would go to Vilnius all the same, but sharply criticized the new offer and the fact that even this is conditional on agreeing a new stand-by loan deal with the IMF. "For three years in succession they have shown this candy in pretty wrapping to us... We don't have to be humiliated like this. We are a serious country, a European one," Yanukovych said. "When it corresponds to our interests, when we have agreed [with the EU] on normal conditions, [only] then can we consider signing."

Even this money would be released over a seven-year period. And Azarov also complained that bringing Ukraine's laws into line with the EU's demands under the terms of the Association Agreement would cost €160bn-170bn over 10 years. And this doesn't take into account the fact that high-quality, low-cost European goods would suddenly have unfettered access to Ukraine's market.

Meanwhile, cheap goods from Russia would rise in price, while the tariffs on its exports to the east would also rise steeply. Indeed, Moscow has in the last year been screwing about with administrative barriers to the export of things like railway cars, which has already hurt Kyiv in pocket. If Ukraine was a strong economy with access to credit, it might consider biting the bullet on all this for the obvious long-term benefits free trade with Europe brings. But there is no way the economy would survive this sort of extra pain in the short term without significant help.

The final straw has been the EU's decision to tie the agreement to the fate of one woman, jailed former prime minister Yulia Tymoshenko, which was a grave mistake. Clearly the EU is right when it accuses Kyiv of using "selective justice" and her release is central to the EU's "values" that are at the core of the offer to tie up with Europe. But Tymoshenko's case highlights the mismatch between the motives of both sides: the EU insists on these values, but Yanukovych has no interest in them and is focused on business (and his own political survival in the 2015 presidential elections).

The IMF's mooted $15bn stand-by loan programme would be enough to tide Ukraine over and allow it to sign the EU deals. However, the IMF won't link its decision on the loans to the signing of the Association Agreement and, after being repeatedly lied to by Kyiv in the previous programme (ironically negotiated under Tymoshenko's government), it has taken a hard line: it will not release any money until the government raises domestic gas tariffs and frees the currency exchange regime, among other things. In other words, the IMF money will be hard to get, will come with a big political cost and won't arrive for months at best.

On the other side of the fence Russia's offer could be generous and immediate. Firstly, it is holding a $7bn unpaid gas bill over Kyiv's head, which will have to be paid if Ukraine ties up with the EU. More generally, the price Ukraine pays for Russian gas will remain at about the current $411 per thousand cubic metres (cm) and somehow the EU will have to help Ukraine reduce this bill of at least finance it. But if Kyiv throws in its lot with Moscow, then the price would be slashed, maybe even to the $178 per 1,000 cm that Minsk pays as a member of the Customs Union. That would immediately free up a huge amount of tax revenue for other uses and take a lot of the financial pressure off the government at a stroke.

And there could be a bounty of other credits. The leading Russian banks Sberbank and VTB Bank both moved into Ukraine in a big way following the 2008 crisis and have extended a total of $30bn in loans to Ukraine's government and companies since, according to reports this week. As a member of the Customs Union, Ukraine would also be eligible for the Eurasian Develop Bank's crisis programme that has bailed Belarus out to the tune of $4bn over the last couple of years. Finally, the Kremlin has reportedly promised heavy investment and joint development programmes in several of Ukraine's key industrial sectors. All this cash and investment comes with no complicated talk about "values."

Indeed, it is a measure of how badly the EU understands Ukraine's position that it offered to water down its value-demands on November 25, as if Yanukovych cares. EU parliamentarians have removed Article 49 from the EU treaty on the table that allows any European country to apply for membership if it "respects the fundamental values of the EU," reports RFE/RL.

Yanukovych was on TV again on November 25 and said the financial terms offered by the EU are "humiliating" and that he would wait for a better offer before agreeing to anything. "As soon as we agree on normal conditions, then we will talk about signing," " Yanukovych was quoted as saying by RFE/RL.

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