The Future of Ukraine

Bordering Moldova, Romania, Hungary, Slovakia, and Poland to the west, and Russia and Belarus to the East, Ukraine should be well placed to benefit from the trade opportunities in both directions. Although the 47 million population of modern (post WWII) Ukraine is overwhelmingly ethnically Ukrainian (about 78%) followed by 17% Russian (concentrated in the industrial eastern and southern areas), Ukraine’s educated citizens are almost universally bilingual in Ukrainian and Russian. Ukraine’s western half naturally leans toward Europe while its eastern half leans toward Russia. The country’s presidency has shifted between favoring one then the other. The tensions between the two are real but can easily be exaggerated.

Many of us wonder why President Putin seems to want yet another unproductive, loss-making territory added to Russia’s care, something it increasingly cannot afford. As with Transnistria, the inefficient, loss-making, industrial, secessionist, eastern part of Moldova (now largely a gangster haven), the eastern part of Ukraine is saddled with former Soviet, industrial, white elephants, which sooner or later must be dismantled. Why is Putin flirting with isolation from the world community with ultimately devastating economic costs to Russia to take over more industrial dinosaurs? Why, in short, is Russia giving up joining the “civilized” world it seemed to once aspire to?  The only tangible benefit for Putin seems to be great popularity at home. Having almost totally snuffed out significant political opposition and a free press in Russia, and then convinced the vast majority of Russians that he is defending Russia from its many enemies, his moves against Ukraine have sent his popularity soaring at home.( “Putin wins in Russia only by escalating his war rhetoric” Washington Post /2014/03/14/ )

Just as President Victor Yanukovych’s brutal repression of the Ukrainian protesters following his switch from signing the Association and Free Trade Agreements with the EU to signing a trade and financing agreement with Russia backfired, resulting in his removal from office by an overwhelming vote of the Ukrainian Parliament, Putin’s thuggish maneuvers against Ukraine seem to have backfired as well. By all accounts (except those broadcast by Russian media) almost all Ukrainians, ethnically Russian as well as Ukrainian, are uniting in their opposition to a Russian take over. Just because many Ukrainians in the eastern parts of the country are native Russians doesn’t mean they want to be annexed by Russia. It reminds me of the large number of Mexicans now living in southern California. No one would imagine that they would vote in a referendum to become part of Mexico (again). “Putin’s interference is strengthening Ukraine” Washington Post /2014/03/13/, “Russia supporters in eastern Ukraine pose challenges to pro western government” Washington Post/2014/03/14/.

I found it interesting that the Ukrainian Minister of Economy, Pavlo Sheremeta, switched from English to Russian during the “Emergency Economic Summit For Ukraine” in which I participated in Kyiv on March 12, for the benefit of the two Russian panelists to whom he was speaking. The Russians, Andrei Illarionov, former Economic Advisor to President Putin, and Kakha Bendukidze, fomer Minister of Economy of Georgia, both speak English as flawlessly as does Minister Sheremeta. The real point was to show affinity with Russia and Russian Ukrainians, while criticizing President Putin’s bullying.

Ukraine has much to do to clean up its government and to liberate the entrepreneurial energies of its economy. But such reform efforts could be interrupted if Putin moves Russian troops into Ukraine beyond the Crimea. It is certainly desirable to dissuade them from doing so if possible. The question for the U.S. and Europe is what measures should they be willing to take against Russia for violating Ukraine’s sovereign territory. The West’s objective should be to deter further Russian aggression if possible or to diminish its ability to continue to misbehave in the future if it persists in violating or threatening to violate the sovereignty of its neighbors.

Putin’s justification for its invasion of the Crimea and potentially more of Ukraine, the need to protect ethnically Russian citizens of Ukraine, is reminiscent of Hitler’s take over of the Sudetenland (the largely German-speaking western areas of Czechoslovakia). “Putin-the mask comes off but will anybody care” American Interest 2014/03/15/3.  Particularly egregious is Russia’s disregard of its commitments made on December 5, 1994 in Budapest, Hungary Budapest Memorandum on Security Assurances (also signed by the U.K. and the U.S.). In exchange for Ukraine’s giving up its nuclear weapons stockpile (then the third largest in the world) Russia and the U.S. provided assurances against the use of force against the territorial integrity or political independence of Ukraine.

Henry Kissinger has set out reasonable terms of an agreement with Russia (on the assumption that Putin is pursuing genuine Russian interests in the area) but offered no suggestions for how to encourage Russia to accept them. “To settle the Ukraine crisis start at the end” Washington Post /2014/03/05/.  The West’s strategy should be explicit and transparent and should escalate with continued Russian aggression. It should begin with measures that will command the most attention in Russia at the least cost and risk to the West. We should not make threats that we are not willing to carry out. No Obama red lines that are later ignored.

President Obama has already ordered the freezing of U.S. assets and a ban on travel into the United States of those involved in threatening the sovereignty and territorial integrity of Ukraine. No individuals have been named yet. It is a tool that can easily be expanded to a larger number of people if and when Russian intrusion expands. These measures are aimed at those in Russia with the greatest influence with Putin and would diminish the joys of their ill-gotten wealth (extravagant vacations in London, etc.). But unless the EU joins the U.S. in applying such sanctions, they will obviously be far less effective.

If Putin is unwilling to reverse course or at least stop advancing even in the face of targeted sanctions, the West’s strategy should be to reduce or limit Russia’s financial capacity to reestablish its former empire. Putin’s hold on power rests on the wealth he has directed to his friends, and wage and pension promises to the general public. About one half of Russia’s federal budget financing comes from its exports of oil and gas. The price of oil needed for Russian fiscal balance is in the neighborhood of $120 per barrel. This so-called breakeven price increases with expenditures by the Russian government and with the cost of producing its oil and gas. Brent crude is currently trading for around $108 per barrel. Russian exports and government revenue have become overly dependent on oil and gas and its supply of cheap oil is running out. It has not kept up with the investment in newer technologies and while its output can be sustained for some time its cost of production is rising.  Acquiring the Crimea or eastern Ukraine would add to Russia’s budgetary costs.  “Crimea as consolation prize-Russia faces some big costs over Ukrainian region” Washington Post /2014/03/15/

Europe is more cautious than the U.S. about trade sections in part because of its heavy reliance on Russian gas delivered though pipelines running through Ukraine and large investments by some of its companies in Russia. One of the interesting and beneficial things about increasing trade interdependence is that it cuts both ways and thus tempers the behavior of all sides. Russia is reluctant to shut off its gas sales to Europe as it did in 2006 and 2009 because it needs the money. Europe is less dependent on Russian gas than it was then and could replace it all together if it got over its aversion to the use of fracking technology. The U.S. should be doing everything possible to bring oil prices down in any event. Obama’s long delay in approving the Keystone Pipeline project to deliver Canadian oil to and through the U.S. is more than embarrassing. And all U.S. restrictions on shipping natural gas to Europe or elsewhere should be removed. In addition, oil supplies globally are expected to improve as the embargo on Iranian oil is lifted and production in Iraq, Libya, and South Sudan increases. Liberalization in Mexico promise increases in its oil production. Russia can’t afford to expand its empire of inefficient industries.

If we went all out, Russians and Russian companies could be locked out of the use of the U.S. dollar, a tool that has brought increasing pain to Iran. It is an effective tool because of the dominance of the dollar and dollar financial instruments in international commerce.  But like Russia’s shutting its gas pipelines to Europe, every use of such tools reduces its future effectiveness as those affected take measures to reduce their dependence on the products involved (Russian oil, or the U.S. dollar and financial system).

If in the hopes of preventing a Russian attack, the United States threatens to respond militarily in any way, it had better be prepared to do so. But should it? Clearly the American defense umbrella over our NATO allies should not be questioned and deploying additional aircraft and military capacity to Europe (especially the Baltic members) makes sense. Ukraine is not a member of NATO and I agree with Henry Kissinger that they should not be. If Russia grows up and behaves like a responsible adult we should not unnecessarily provoke insecurity on its part.

But if Russia, despite all, invades mainland Ukraine, should we militarily assist Ukraine and if so in what ways? Or should we prepare for a new cold war of containment, isolation and the eventual economic collapse of the new Russian empire? This, as they say, is above my pay grade. However, an invasion of Ukraine would be quite different from the invasions of Iraq and Afghanistan because we wouldn’t be the invaders. It would be different from the situations in Syria, or Libya because we would not be joining one group or another in a civil war.

The new interim government in Ukraine is promising but unproven. The distraction from the reforms needed that would result from a Russian invasion of Ukraine would be a tragedy for Ukraine as well as Russia. Excessive external aid (financial and/or military) from the West would likely prolong Ukraine’s history of corruption and deepen ethnic tensions. The external financial assistance now planned would largely address external debt service and would allow a more gradual reduction in government spending than would be required by a debt default. This would allow Ukraine itself to strengthen its governance and economy, but would not guarantee such a result. The West can encourage the adoptions of helpful reforms but cannot impose them on an unwilling or unready Ukraine. Russia is in a position to destroy or undermine these efforts, if that is Russia’s role in history that Putin wants.

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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One Response to The Future of Ukraine

  1. Mark Winkle says:

    Warren, It’s been a while since I had time to read your blog. I found it interesting considering the fact that I have been advising the US, NATO, Ukraine, and the EU since November of 2013. And yes, Ukraine will be much better off with the European Union than with Russia’s economic union. I think the stand off in Crimea will continue for the next few months. More sword rattling by NATO, etc. The 13- 1 UN Security Council vote against Russia was a sign to Mr. Putin that naked aggression is folly without UN backing. Russia will bear the brunt of economic sanctions for some time to come. The screws will be tightened a little at a time. Ukraine will join NATO in the next month or so and will be under NATO protection.

    This will provide security. The upgrading of Ukraine’s manufacturing sector and markets will continue to improve. The US, Australia, and the EU will pick up any loss of trade with Russia.

    Nice to read your thoughts again.

    Sincerely,
    Mark Winkle
    Winkle Institute for Worldwide Economic Stability

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