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Feb 18, 2015 | 10:03 GMT

Ukraine's Economy Needs Russia

Ukrainian's Economy Needs Russia
(JOHN MACDOUGALL/AFP/Getty Images)
Summary

Despite Russia's annexation of Crimea and fighting in Ukraine's east, Ukraine and Russia remain economically intertwined. Kiev has lobbied Western governments to impose sanctions on Russian companies and advocated reducing dependence on Russia natural gas imports. However, Ukraine's banking and energy sectors are tied to Russia, giving the Kremlin several options with which to influence Kiev.

Russia and Ukraine have substantial trade ties in addition to closely integrated industrial sectors. Before the crisis began, Russia provided 6.8 percent of foreign direct investment in Ukraine, though the real figure may be higher. Formally, 33.4 percent of FDI to Ukraine in 2013 came from Cyprus, raising the possibility that Russian investment has passed through Cypriot banks and corporations. In 2014, with the onset of the crisis, the share of both Russian and Cypriot FDI flows to Ukraine decreased to 5.9 percent and 29.9 percent, respectively. At the same time, German FDI flows to Ukraine increased to 12.5 percent from only 10.9 percent a year earlier.

Moreover, Russian firms such as Rosneft and Lukoil were active in Ukraine before hostilities broke out. Fighting in the east and pressure from the new, pro-Western authorities, however, has led some Russian firms to cut back on their operations. In July 2014, Lukoil sold one of its subsidiaries, Lukoil-Ukraine CFI, which controlled 240 filling stations in Ukraine, to Austrian company AMIC Energy Management.

Ukraine's banking sector is still closely connected to Russia without these investments. Ukraine's fifth-largest bank in terms of total assets is Prominvestbank, a subsidiary of Russia's Vnesheconombank. Moreover, subsidiaries of Russia's Sberbank, Alfa-Bank and VTB Bank constitute Ukraine's eighth-, ninth-, and 10th-largest banks, respectively. Together these Ukrainian subsidiaries hold over $6 billion in assets. Because the Russian state owns Vnesheconombank and is a majority shareholder in Sberbank and VTB, the Kremlin indirectly controls a significant portion of Ukraine's banking sector. According to Ukraine's Finance Ministry, in the beginning of 2015, Ukraine's total direct and guaranteed debt to the Russian state and Russian banks totaled over $4 billion, the equivalent of about 12 percent of the country's external debt.

However, Russia's own banking sector has experienced difficulties over the past month. Some banks, including VTB, are even seeking state aid, motivating the Kremlin to avoid using its banks to destabilize Ukraine's banking sector. Still, Russia's strong presence does give the Kremlin another opportunity to influence the country's financial markets and pressure Kiev.

In addition to banking, Ukraine's energy sector is also closely tied to Russia. VS Energy International, a Russian firm, owns stakes in eight of Ukraine's 27 regional energy supplier companies, including power distributors in the Odessa and Kiev regions. Electricity shortages resulting from the loss of some of Ukraine's coal resources have led the country to begin importing electricity from Russia as well to fill the projected 10 percent shortfall. Indeed, in late December, Ukrainian energy company Ukrinterenergo signed a one-year contract to purchase up to 1,500 megawatts from Russia (Ukraine currently uses the total 26,000 megawatts it generates). With Russian firms controlling about 30 percent of Ukraine's regional power distribution companies and beginning to export electricity to the country, the Kremlin is positioned to continue playing a role in Ukraine's energy sector.

Kiev knows how dependent it is and has made moving away from relying on Russian natural gas a top priority. Ukraine is buying natural gas reverse flows from Slovakia and has purchased supplies from Poland and Hungary in the past. Also, Ukrainian Prime Minister Arseniy Yatsenyuk announced Feb. 14 that his country would borrow $1 billion in order to build up new natural gas and oil reserves.

But Ukraine will have to continue relying on Russia because Slovakia, Poland and Hungary are unable to provide sufficient natural gas supplies to meet demand during winter. Furthermore, the temporary deal between Ukraine's Naftogaz and Russia's Gazprom is set to expire at the end of March. Kiev will have to come to at least another temporary agreement with Gazprom before the summer months when Ukraine must begin filling up its storage facilities in preparation for winter.

On the surface, it appears the crisis has lessened Ukraine's economic and financial ties to Russia. The truth, however, is that Russia is still a significant player in the country's banking and energy sectors. In addition, it is maintaining its long-standing trade and industry ties. Moscow will continue using the subsidiaries of Russian firms, as well as Russian exporters, to apply pressure to Kiev and maintain influence within Ukraine's struggling economy. Nevertheless, Russia's own economic vulnerabilities to the West persist and will impact how the Kremlin wields its leverage over Ukraine.

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