reflections

Dec 30, 2014 | 23:25 GMT

6 mins read

Ukraine's Economic Woes Create Problems in Kiev

(Stratfor)
It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

Ukrainians received gloomy economic news Dec. 30 when the governor of the National Bank of Ukraine announced that the country's real gross domestic product declined by 7.5 percent in 2014. Moreover, National Bank Gov. Valeriya Gontareva noted that despite earlier predictions of inflation of 13 to 14 percent in 2015, Ukraine could see inflation as high as 17 to 18 percent next year. Gontareva's announcement came a day after Ukraine's parliament approved a new budget based on an inflation estimate of 13 percent and a GDP contraction of 4.3 percent in 2015. Ukrainian lawmakers indicated that the budget will be revised in February after talks with international institutions, but Gontareva's forecast confirms that Ukrainian consumers and the Ukrainian state will struggle financially in the coming year.

As the country's economy continues contracting and the Ukrainian government seeks additional financial support from the international community, Russia maintains a host of economic levers that it has begun to apply selectively to further constrain Ukraine's struggling economy. While Ukraine's economic challenges do not threaten the stability of the government at this time, the governing coalition's success will depend partly on its ability to access international financial assistance and effectively restore economic stability.

The loss of control over Donbas and Crimea, increased military spending, and high energy costs have contributed to Ukraine's ongoing economic problems. Ukraine's currency has steadily depreciated, and the country has lost a significant portion of its international reserves, which shrank from $17 billion in January to $9.9 billion in November — enough for about two months of imports. Ukraine is thus heavily dependent on financial assistance from the international community and is vying for $10 billion to $15 billion in aid, in addition to its earlier $17 billion International Monetary Fund package, through early 2016.

Attempts to Gain International Assistance

Beyond the IMF, Ukraine has also looked to the European Union for financial assistance. On Dec. 17, European Commission President Jean-Claude Juncker said that while he expects Ukraine to request an additional $2 billion in aid from the commission, the commission cannot afford to provide that much assistance without additional contributions from member states.

For countries like Germany, Ukraine's economic problems pose a challenge. European governments have pledged to support the government in Kiev politically and are working to mediate between Ukraine, Russia and the Russia-backed rebels. These governments therefore do not wish to see instability erupt in Ukraine as a result of a persistent economic crisis or deep austerity measures. On the other hand, faced with the European Union's own economic problems, as well as its domestic challenges, these governments likely will not commit vast sums to Ukraine's financial stability. Therefore, Ukraine probably will have to depend on the IMF for the bulk of its assistance. With an IMF mission expected to visit Kiev in early January, the government has begun introducing a wide array of austerity measures to qualify for much-needed assistance.

Ukraine's 2015 budget prioritizes defense spending and funding for the country's struggling energy firm, Naftogaz. Ukraine is slated to spend more than $5.7 billion on defense, and $2.03 billion will be allocated to Naftogaz. At the same time, the new budget imposes significant cuts — estimated at $1 billion — for social spending and education. Over the next two years, about 100,000 teachers may lose their jobs as a result of these cuts. Moreover, household energy prices are expected to rise this year. Although Ukraine's government approved measures to lower tax burdens for small and medium-sized businesses and decrease the social security tax rate, it has instituted protectionist measures in the form of new import duties, which are expected to contribute about $1 billion in revenue. As a result, this coming year Ukrainians will face large-scale job cuts in the public sector, more expensive imports and higher utility prices. 

Russia's Economic Power in Ukraine

For Russia, Ukraine's economic challenges are an opportunity to use the Kremlin's economic tools against the government in Kiev. Despite Russia's own ongoing economic troubles — which ultimately could affect decision-making in Moscow regarding Ukraine's economy — the Kremlin can apply selective economic pressure in Ukraine. In the past, Russia has used its energy exports to Ukraine — particularly natural gas — to pressure the Ukrainian government. Having lost access to many of its coal supplies in Donbas, Ukraine is experiencing a coal and electricity shortage. The Kremlin demonstrated its ability to use coal as a lever when it cut off Russian coal exports to Ukraine in late November. This move led to negotiations between the two sides that resulted not only in the resumption of coal shipments, but also a new deal Dec. 27 for Russia to export 500,000 tons of coal per month, in addition to new electricity supplies, to Ukraine. By cutting off coal supplies in November, Russia demonstrated its ability to inflict economic pain on Ukraine, and the subsequent negotiations showed Moscow's ability, despite the ongoing conflict, to reinforce Ukraine's economic dependence on Russia.

Russia can also use remittances to impact Ukraine's economy. In 2014, Ukrainians could work inside Russia with relative ease. However, in late December the head of Russia's Federal Migration Service, Konstantin Romodanovskiy, announced that a different system of work permits for Ukrainian citizens wishing to work in Russia will take effect starting Jan. 1, along with other new requirements for workers from states that are not members of the Eurasian Economic Union. His statement came two weeks after Russian Prime Minister Dmitri Medvedev warned that Ukraine would lose $11 billion to $13 billion should Russia choose to ban Ukrainian citizens from working in Russia. Such a ban would not only significantly decrease remittances flowing from Russia to Ukraine, but it would also increase unemployment levels inside Ukraine at a time when the country's economy is contracting and government austerity measures are leading to layoffs. While Russia has not taken formal steps to completely prevent Ukrainians from working in Russia, the Federal Migration Service's bureaucratic changes and Medvedev's public warning are designed as a reminder to Kiev of Moscow's power.

Domestically, Ukraine's Western-leaning coalition government currently enjoys popular support. Some protests regarding austerity measures have erupted in the days ahead of the passage of the new budget, with attendance usually ranging in the hundreds. However, the majority of Ukrainians recognize that without these austerity measures, Ukraine will be unable to afford its growing defense expenditures and would fail to qualify for international financial assistance. Nevertheless, the government may struggle to sustain support for its austerity measures in the long term, depending on the severity of the economic and social consequences. The government's long-term success will hinge on its ability to effectively negotiate with the Kremlin, access significant international funding and ultimately restore financial stability and economic growth. 

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