2015 ESCTD Draft Report on Ukraine - NATO PA - 172 E… · Web viewAccording to conservative U.N estimates, 6,417 people had been killed in the fighting as of 15 May 2015 and nearly

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172 ESCTD 15 E rev. 1 finOriginal: English

NATO Parliamentary Assembly

ECONOMICS AND SECURITY COMMITTEE

THE STATE OF THE UKRAINIAN ECONOMY AND PROSPECTS FOR ITS

FUTURE DEVELOPMENT

REPORT

Richard BENYON (United Kingdom)Rapporteur,

Sub-Committee on Transition and Development

www.nato-pa.int 10 October 2015

172 ESCTD 15 E rev. 1 fin

TABLE OF CONTENTS

I. INTRODUCTION....................................................................................................................1

II. THE STATE OF THE UKRAINIAN ECONOMY AND DIRECT ECONOMIC CONSEQUENCES OF THE WAR..........................................................................................3

III. RELATIONS WITH THE EU...................................................................................................8

IV. INTERNATIONAL STRATEGIES FOR ASSISTING UKRAINE............................................11

V. THE ENERGY DIMENSIONS OF THE CRISIS....................................................................13

VI. CONCLUSIONS...................................................................................................................15

BIBLIOGRAPHY...................................................................................................................19

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I. INTRODUCTION

1. International tensions arising from Russia’s illegal annexation of Crimea and support for pro-Russian separatists in the Donbas represent perhaps the greatest diplomatic and security crisis in Europe since the end of the Cold War. Indeed, Russia’s overt intervention in Ukraine, illegal and illegitimate occupation of Crimea and steadfast effort to deny Ukraine its sovereign right to associate with the European Union represents a Russian repudiation of the very principles on which many believed the post-Cold War European order had been premised: respect for national sovereignty, the creation of a Europe whole, free and at peace, and an open trading system as a foundation for shared prosperity. Europe and North America had seen Russia and Ukraine both as partners and beneficiaries of this emerging order. It is now quite apparent that Russia has opted out of this particular logic and is now seeking to upend that system. Ukraine, however, has indicated that it wants to opt in, but it has paid a very high price, partly because of its divided nature but more importantly because Russia has challenged its right to associate freely with Europe.

2. It is essential to point out from the outset that Russia’s illegal annexation of Crimea and its military intervention in Eastern Ukraine represent a grotesque violation of international law. On 5 December 1994 Russia signed the Budapest Memorandum on Security Assurances related to Ukraine’s accession to the Treaty on the Non-Proliferation of Nuclear Weapons. The United States and the United Kingdom also signed that agreement while China and France provided individual assurances. The Memorandum merged a set of security assurances already existing under the UN Charter, the CSCE Final Act and the Non-Proliferation Treaty, but it did so in a Ukraine specific fashion. It also reasserted the territorial integrity and political independence of Ukraine, as well as of Belarus and Kazakhstan, in exchange for Ukraine’s decision to forego the world’s third largest nuclear weapons stockpile. Russia has unambiguously violated its obligations under this agreement by failing to respect Ukrainian sovereignty, by threatening and using force against Ukraine, and by applying economic pressure on Ukraine in order to shape its politics 3. According to conservative U.N estimates, 6,417 people had been killed in the fighting as of 15 May 2015 and nearly 16,000 had been injured. The Ukrainian Health Ministry reports that 42 Children have been killed and 109 wounded by mines and other explosive devices in the areas around Donetsk and Luhansk controlled by Russian armed groups. The UN is investigating human rights violations on both sides (Cumming-Bruce). NATO Secretary General Stoltenberg recently noted that Russia is continuing to provide Ukrainian insurgents with heavy weapons, artillery, training, and, importantly, its own military personnel, all of which are blatant violations of the Minsk Agreement signed this past February. Russia denies that it is providing aid or troops to support the pro-Russian separatists but there is strong evidence that it is doing precisely this and according to a recent study by the Royal United Services Institute may have 42,000 troops directly or indirectly involved in the conflict (Harres).

4. Ukraine is at the front line of what increasingly looks like a struggle between a Western or internationalist vision for the country’s future and a Eurasian outlook, in which Russia alone sets the agenda. The new government led by President Petro Poroshenko is clearly intent on breaking with the past and setting Ukraine on a path of reform and integration with the European Union. It has strong technocratic credentials and includes the former US citizen Natalie Jaresko as the Minister of Finance, Aivaras Abromavicius, a Lithuanian advocate of deep spending cuts, deregulation and privatization who now heads the Ministry of Economic Development and Trade and Alexander Kvitashvili, a former Georgian Minister of Health who is now playing the same role in Ukraine. The ministers in this new government are young, determined to break with the past and implement a reform agenda embedded in the Association Agreement between Ukraine and the European Union signed in March 2014. But they confront three major challenges: a war, a deep recession, and the need to establish the post-revolutionary government’s legitimacy (Jaresko).

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5. Russia’s leadership has expressly challenged the logic of European integration and its relevance to non-members including Ukraine, Moldova, and Georgia, the ongoing centrality of NATO to European security, the win-win nature of open trading relations, the relevance of democratic institutions and practices to former Soviet states and what the West judges to be the principles of good governance. Russian president Putin has incorrectly conflated EU and NATO membership and has also linked the consolidation of his own position in Russia to Russia’s international posture. He very openly asserts the right of Russia to exercise hegemony in its backyard and claims that Ukraine is rightfully part of the Russian orbit. For Putin, Ukraine has become the very fulcrum of the alternate universe he is seeking to construct. The war he has waged in Crimea and is now conducting in the Donbas is not simply about Ukraine’s future, it is very much about Europe’s.

6. The current Russian government seems to comprehend genuine economic and political reform in Ukraine as a threat. From President Putin’s perspective, a successful liberal democratic reform in Ukraine and a deeper association with the European Union would represent a repudiation of the illiberal crony capitalist order that he has constructed in Russia and which he hopes to internationalize in a Russian dominated Eurasian Union. For Putin, that union means little as long as Ukraine remains outside of it. The Eurasian Union, which few countries have shown any enthusiasm in joining, would essentially employ a regional trading system to entrench the political status quo not only in Russia but also among the states in its economic orbit.

7. Constructing a Russian dominated bloc in the East has been a long-term ambition of post-Soviet Russia. It has employed various schemes toward this end including the Commonwealth of Independent States (CIS), a number of Free Trade Areas (FTAs), the Single Economic Space (SES) and now the Eurasian Economic Union (EEU), which Russia defines as an alternative to the EU. None of these efforts have been effective, none have elicited great enthusiasm and none were able to contain the mutual suspicions and occasional trade wars that broke out among members. Russian and Ukrainian commercial relations, in particular, have been characterized by countless trade disputes, the most serious of which have involved gas pricing and Russian gas cut-offs, most notably in 2006 and 2009.

8. Vladimir Putin famously observed that the Soviet Union’s collapse “was the biggest geopolitical disaster of the century” (Aslund, 2013). Apparently, this was not an incidental slip of the tongue, and it is a lament that informs president Putin’s foreign policy. George Kennan once said of the Soviet Union that it could only tolerate vassals or enemies on its borders, and this notion seems to have taken on renewed life within the Kremlin. Russia’s leadership has very strong views on the relations bordering states establish with Europe, and this lies at the heart of the current crisis. President Putin has asserted that Ukraine need not look to the EU as Russia itself is offering to construct an Eurasian order based on the “universal principles of integration as an integral part of greater Europe united by common values of freedom, democracy and market laws” (Elder). This might have seemed a benign and even a welcome vision until Ukraine challenged it by turning to the European Union. The problem for Vladimir Putin is that Ukraine’s defiance has exposed the project for what it is: a veiled effort to establish a hegemonic position for itself, at least in that part of Eastern Europe which has not yet fully integrated into Euro-Atlantic structures.

9. While President Putin has sometimes employed the language of consensual and democratic integration, he has also frequently mocked the notion that Ukraine is a viable state or can have a real identity without Russian consent. The implication has been that, at best, Ukraine is a vassal state and at worst a natural part of Russia itself. That was certainly the case with Crimea, and the drama playing out in the Donbas suggests that this vision might also be animating his actions there and perhaps further afield.

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10. Ukrainian leaders of many stripes, however, have rejected Putin’s vision, and now Russia has taken extreme measures to demonstrate that Ukraine’s sovereignty and its capacity to adopt so-called Western political and economic norms are a fiction as are Western commitments to support Ukraine in this grand endeavor. It seems to think that a frozen conflict in Eastern Ukraine hammers home this point. The current Russian regime’s concerns are perhaps understandable, even when not viewed with sympathy. A successful liberal democratic transition in Ukraine might well suggest to many Russians that such a transition would also be possible in their country. In other words, were Ukraine finally to manage a successful reform and position itself to integrate more easily with the rest of Europe, it could become a signpost for Russia’s currently marginalized and threatened democratic reformers. This is clearly a major concern for the Kremlin. Meanwhile the West is far more focused on Ukraine’s right to choose than it is on the nature of the Russian regime. The problem with Russia today is far more about its international posture than its internal structures, however lamentably undemocratic they may have become. 11. This report thus begins with an acknowledgement of the extraordinarily high stakes that Ukraine, the West and Russia have in the outcome of this struggle. Ukraine’s future could well be determined at the negotiating table or, perhaps more ominously on the battlefield. But Ukraine’s government, its people and, to a certain extent, the international community have a responsibility, even in the midst of the current crisis, to lay the foundation for and begin the very difficult process of carrying out the democratic and market transition that successive Ukrainian governments have failed to implement over the past 20 years. This report will accordingly explore the economic dimensions of this particular set of immediate and long-term challenges while acknowledging at the outset that military factors could overshadow progress on the economic front.

II. THE STATE OF THE UKRAINIAN ECONOMY AND THE DIRECT ECONOMIC CONSEQUENCES OF THE WAR

12. Unlike many of the Eastern European countries that ultimately joined the European Union as well as NATO, for more than two decades Ukraine never undertook the hard reforms needed to complete a successful transition. What transpired in Ukraine can more adequately be described as the emergence and entrenchment of a kind of semi-Soviet style, semi-market based crony capitalism in which politically connected operators acquired control over the means of production and systematically rewarded their political friends for the favoritism they were shown. The State was weak, the legal system burdened by its Soviet predecessor, the market system was essentially rigged, public contracts were uncompetitive, bribery was rampant and the economy operated in a highly inefficient and costly manner. Market reform was more a rhetorical veneer than a reality.

13. The system undermined commercial competition and impeded the emergence of a vibrant sector of small and medium enterprises which are essential to nurturing and sustaining a genuine market system. Although very few people actually benefitted from these structures, Ukraine’s governing elite purchased a bare modicum of political support through ultimately very poor and unsustainable policies like costly fuel subsidies and a range of other practices that distorted prices, weakened competition and thwarted both domestic and international investment. Energy “markets” posed a particular daunting set of problems. Corrupt Ukrainian officials and their commercial cronies long profited by purchasing gas at subsidized rates and selling it on at market prices while reaping windfall profits at the country’s expense (Aslund, 2014). Such practices only encouraged unproductive uses of a very scarce strategic resource and left Ukraine increasingly vulnerable to Russian influence and pressure. Moreover, no post-Soviet government in Ukraine systematically addressed these fundamental problems, which only worsened over time. Indeed, the level of corruption achieved a dubious apotheosis during the presidency of Viktor Yanukovych, who is believed to have accrued as much as 12 billion USD for himself and his family (Aslund, 2014). Not surprisingly, Transparency International categorized Ukraine in 2014

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as one of the most corrupt countries in the world, 142nd place out of 175 ranked countries—slightly worse than Russia which ranked 136th.

14. Ukraine’s economy has long performed more poorly than that of most of its neighbours. This was a function of both institutional and political shortcomings. Poland, by contrast, which also emerged from the end of the Cold War in a terrible economic shape, benefitted enormously from relatively cohesive politics which were informed by shared enthusiasm for that country’s Western vocation. Poland luckily enjoyed a membership prospect within the EU, and its security situation improved dramatically once it had acceded to NATO. Another neighbour, Turkey, enjoyed NATO membership, had a long tradition of statehood and no communist legacy, and like Poland, it had used the prospect of EU accession to discipline its reform process, even though that prospect was more remote. Despite its many deficiencies, even the Russian economy enjoyed more sustained growth than Ukraine’s, although this was largely premised on the development of its energy potential and limited market reforms, which nonetheless represented a dramatic rationalization in comparison to the old Soviet economic system. Russia, however, is now moving in the opposite direction as the Kremlin and the security sector inner-core around President Putin are now subverting the last vestiges of market autonomy. Particularly in comparison to a country like Poland, which quickly and unambiguously clarified its Euro-Atlantic ambitions after the fall of the Berlin Wall, Ukraine undertook reforms that were at best partial. Corruption remained rampant, the nascent state was weak and the country lacked an enduring consensus about its relationships with the West and with Russia.

15. Ukrainian governments had long promised reform, but all had failed to deliver. After his election in 2010, Viktor Yanukovych even vowed to embark upon substantial economic reforms, and there were indications that he would do so with support from both the IMF and the EU. The IMF accordingly concluded a stand-by arrangement with Ukraine for 15 billion USD. But it never fully implemented that loan as the government swiftly deviated from the liberalizing agenda it had promised. The IMF had expected Ukraine to lower gas subsidies, which had both distorted Ukraine’s pricing system and created enormous opportunities for corruption. The IMF had also-called for a significant reduction of Ukraine’s budget deficits, which were linked to these very expensive subsidies as well as an unsustainably costly pension system characterized by excessively low retirement ages. Ultimately the government only partly addressed the pension issue and neglected the other core challenges, giving the IMF no choice but to call off the programme.

16. Over the following two years, Ukraine’s situation only worsened as growth contracted. The level of public debt ballooned to 38% of GDP by September 2013, while the current account deficit rose to 6% of GDP. The hryvnia remained pegged to the dollar and this penalized Ukrainian exports and required the government to maintain high interest rates, which, in turn, made the cost of capital prohibitive. Reserves fell from a peak of 38 billion USD to 21.7 billion USD by August 2013, which was sufficient to cover only 2.7 months of imports (Aslund, 2013). In this macro-economic setting, bank reserves declined to dangerously low levels.

17. Ukraine’s economy was thus already heading for a hard landing in the run up to the Maidan revolution, and undoubtedly the country’s very poor economic performance along with entrenched and costly corruption had stoked deep public disillusionment with the Yanukovych government. Its last-minute decision to reject an Association Agreement with the EU proved a culmination of what many, although certainly not all Ukrainians judged to be an inexcusable series of missed opportunities.

18. The paradox of what has transpired in Ukraine over the past year is that while a new government has finally and unambiguously decided to deepen its integration with the West and to adopt a serious reform agenda, it is being compelled to pay a very high price for this decision in the form of the loss of Crimea and a Russian-driven and supported insurgency in the east.

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Despite these setbacks, the new government has managed to advance an impressive reform agenda.

19. On 1 April 2015, gas prices were raised by 330% to align them more closely to global prices. The international community has strongly supported this initiative, and some have characterized it as the single most important economic reform yet taken. Gas subsidies were an enormous source of corruption and led to a tremendous degree of parasitic rent seeking and economic price distortions. Subsidized prices were the primary reason Ukraine used energy so inefficiently, leaving the country highly dependent on Russian energy imports and subject to all manner of external political manipulation. The government introduced gas price hikes in the spring of 2015 to allow consumers and producers time to adjust to scarcity pricing before the return of winter. It is important to note that there will be financial support offered to the destitute to help cover basic heating costs.

20. The government has also eliminated myriad inspection agencies, permit licenses and certifications that blocked the path for those with entrepreneurial ambition and protected favoured oligarchs while creating a fecund environment for the corrupt (Wolf). That new government, however, has also just announced that it must dedicate over 5% of national GDP to bolster its military capacity and it is not at all clear how it can manage reform and war simultaneously without very substantial international backing (Jaresko).

21. As suggested above, the Ukrainian government signed the agreement with the EU in March 2014 from which Yanukovych had decided to walk away, but the economic situation remains dire and may now be worsening. Ukraine’s economy contracted 6.7% in 2014, and unexpectedly fell even further in the first quarter of 2015—17.6% compared to the first quarter in 2014. This sharp deterioration is largely attributed to the uncertainty and costs of war and has raised questions as to whether the IMF’s 17.5 billion USD four year extended Fund Facility bailout will now be sufficient to turn things around (Focus Economics). By early January 2015, Ukrainian bond prices had sunk to record lows driven by investor concerns about a possible default. Foreign currency reserves fell from 16.3 billion USD in November 2014 to 9 billion USD in May 2015. This was the lowest level of Ukrainian foreign exchange reserves in ten years. Reserves had depleted primarily due to debt servicing obligations and government efforts to defend the currency peg (Olearchyk, 6 February 2015).

22. As of May 2015, Ukraine’s public debt stood at roughly 100% of GDP. Moreover, much of this is denominated in foreign currency. In the first quarter of 2015, Ukraine’s GDP fell by 18% from the previous year. Ukraine will have 6 billion USD in debt repayment due next year and still has less than 10 billion USD in foreign exchange reserves. The IMF, which signed an extended Fund Facility in March 2015 has been very clear in its expectations. It wants the government to slash public debt to GDP ratio below 71% by 2020. The IMF has asked the government to establish a financing objective under which it will keep annual gross financing to an average of 10% of GDP between 2019 and 2025 without exceeding 25% in any given year. In order to reach this difficult goal, Ukraine will have to make a deal with its creditors but it has so far failed to strike an agreement. Ukraine seeks to push back repayment schedules and reduce the total debt while its creditors are only willing to extend maturity dates. An agreement would be necessary for the release of a pending 2.5 billion USD tranche of the IMF loan (The Economist).

23. In difficult talks in May 2015, Ukraine rejected a debt restructuring deal tabled by international creditors holding 9 billion USD of Ukrainian bonds. The government has agreed to reduce the debt burden by 15.3 billion USD over the next four years, but creditors would like this target raised to 15.8 billion USD. Restructuring would involve bundling the country’s international debt into one or two bonds and extending the repayment schedule by as much as a decade. All interest payments due over the next four years would be delayed and bonds would be structured

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for a staggered repayment schedule. Ukraine’s Finance Minister, Natalia Jaresko, wants Ukraine’s debt holders to accept a reduction on the principal they are owed and has also asked for maturity extensions and coupon reductions. Ukraine’s creditors oppose this “haircut” and believe it will delay the country’s return to global capital markets while driving up the long-term costs of capital. So far, Ukraine has not defaulted on any of the nine bonds and loans linked to its restructuring programme. It is worth noting that Russia, which holds a bond due for repayment in December, has not entered into these negotiations (More and Buckley).

24. The government is also planning tax reforms and spending cuts to help put the debt on a sustainable foundation. It is estimated that fifty percent of the Ukrainian economy operates out of reach of tax authorities. Efforts will be needed to bring the shadow economy into the formal economy. One way to do this is to improve government services so the public understands that their taxes are actually underwriting worthwhile undertakings rather than corruption. An electronic VAT system will make evasion more difficult and a tax amnesty is drawing out some tax evaders who have been operating in the shadows. As a result of these policy innovations, tax revenues began to increase. Efforts are also underway to further reduce pension system costs, which have already fallen from 18% to 14% of GDP.

25. Ukraine has also confronted serious monetary difficulties. In February 2015, following a clear degradation of the security situation in the east, the hryvnia fell by 30% in one day to a record low against the dollar. This occurred directly after the central bank abandoned efforts to prop up the currency. In February 2015, the central bank increased its key interest rate to 19.5% as it abandoned the peg and sought instead to gain the upper hand over inflation. This was bound to slow economic growth and, indeed, it has. By the end of April 2015, the hryvna had fallen by two thirds against the US dollar since January of the same year.

26. Many of Ukraine’s banks have been overloaded with unserviceable debt and have long suffered from poor management and corruption. Nadra Bank, the 11 th largest bank in terms of assets, declared insolvency in early 2015 and others will likely follow suit if the economy remains mired in recession. Needless to say, potential investors now confront very daunting risk premiums. Ukrainian bonds are now trading at a very deep discount and there are concerns that holders of this debt will eventually have to accept write-downs (Olearchyk and Buckley). The new government has announced plans to broaden the tax base by raising taxes on the wealthiest, eliminating a range of tax loopholes and moving more of the extensive shadow economy into the taxable formal economy.

27. There is also recognition that the government itself needs to be rationalized and layoffs of some of those working in the bloated and highly ineffective public sector now seem inevitable. The government will also establish new standards on social policy and will employ more accurate means testing to assess which citizens truly require public support. This effort will coincide with the dramatic reductions in energy subsidies that are already underway and which most economists have identified as essential both to begin the process of economic rationalization and to clear away a highly corrupt legacy. Deregulation, further privatizations, and antitrust enforcement are also likely. The World Bank suggests that such structural measures represent the best means of countering exogenous shocks to the economy related to the collapse of security in the east.

28. It is estimated that military operations are currently costing the Ukrainian government 5 to 10 million USD a day (Herszenhorn), but the damage to the country’s infrastructure, the loss of commercial relations, and grave security and economic uncertainty have exacted a far greater cost. Throughout the conflict, the government has provided heat, electricity and water to the separatist-controlled regions at a cost of more than 1 billion USD a year, and these regions are no longer paying taxes to the Ukrainian state. As a result of the Minsk agreement, Kyiv has promised to reinstate government salaries and pensions in the east, while providing a range of

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other services in the east. If implemented, this could place further burdens on an already highly stretched budget but there are very obvious obstacles to making payments in the region. There are 650 thousand internally displaced people registered in the government system who are receiving social support, and UNICEF reports that 1.7 million children have been affected by the fighting. The human costs of the conflict are thus considerable and will pose an enduring burden on the Ukrainian state (Jaresko).29. The war is also undermining Ukraine’s industrial foundations. Countless factories have been damaged or destroyed in the region. A new 80 million USD Cargill plant near Donetsk, one of the largest commercial investments in Ukraine, was shut down when pro-Russian gunmen entered the building. It was subsequently destroyed in the fighting (Wigglesworth and Olearchyk). The Merefa Glass factory, which once employed 2,000 people, has now closed as a result of equipment breakdowns and the loss of key suppliers in Crimea. The Yuzhmash missile and high tech firm, which once supplied the Russian military, has closed as it can no longer serve the Russian market, and the Mryia Agro Holding Company, one of Ukraine’s largest agricultural firms, is on the verge of bankruptcy with over 1 billion USD in debt (Herszenhorn). President Poroshenko has maintained that Ukrainian insurgents and Russian units operating in the Donbas have illegally appropriated certain factories and have even dismantled the capital stock and shipped it back to Russia. These are just examples of a broad crisis sweeping across Ukraine’s industrial landscape, which is putting many firms and the region’s economy at risk of failure.

30. Indeed, the situation in the Donbas is desperate. According to the United Nations, two million of the enclave’s 5 million people have left since March 2014. Those who have departed include most of the region’s middle class, professional and educated people, leaving behind very vulnerable groups including many pensioners and children. Industrial production in the region fell by more than a third in 2014 and has continued to collapse. The region is also plagued by water, electricity and gas shortages and less than a third of the population enjoys a steady wage. The level of corruption is astounding and this, combined with extensive fighting, has all but killed off normal economic activity there. The region has become an economic basket case and a particular burden on Russia, which is now occupying it in all but name. This burden will only increase over time. There are indications that the separatists are failing to attract new recruits particularly as the movement has brought disaster to the region and appears to be suffering from a high casualty rate (an estimated 3,000 dead: 1,750 confirmed and an estimated 1,250 missing in action and presumed dead) (Motyl). Partly for this reason, the role of Russian “volunteers” is on the rise and this is fomenting local resentment while imposing rising burdens on Russia itself, including the burden of maintaining the fiction that its forces are not directly engaged in this war.

31. Ukraine’s loses in Crimea are substantial. The Russian occupation and the illegal and unrecognized annexation of the peninsula raises questions about the control of an important part of the Black Sea continental shelf and the exclusive economic zones linked to that control. Russia will very likely lay claim to parts of Ukraine’s continental shelf and exclusive economic zone with potentially large hydrocarbon resources. Other Black Sea countries and most of the international community will not recognize the legality of any Russian effort to extend its maritime jurisdiction into these disputed waters, although Russian military reinforcements in Crimea will make it difficult to directly challenge these claims. On the other hand, international investors will certainly not play a role in these waters in light of the sanctions and the grave uncertainty regarding their ultimate status. Russia, for example could seek to renegotiate Ukraine’s existing demarcation agreements with other Black Sea littoral countries, but very few countries and no European or North American countries have recognized Russian sovereignty over what remains legally Ukrainian territory (Allison).

32. Not surprisingly therefore, the short term forecast for Ukraine is hardly rosy. The World Bank is now anticipating a GDP contraction of 7.5% in 2015 well over initial forecasts of a 2.3% decline and worse than the current IMF forecast of a 5.5% decrease (Deutsche Welle). The Bank sees the conflict in the East as the principal driver of this decline. Stability and banking system

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recovery are needed to put this country back on track. The IMF has argued that Ukraine needs 40 billion USD to keep the economy afloat.

III. RELATIONS WITH THE EU

33. Ukraine has confronted a more daunting transition challenge than many other former Communist counties. First of all, it had not enjoyed a sovereign status in the Soviet system, and this deprived it of the basic experience and institutions that statehood would have conferred and that countries like Poland and Hungary conserved despite their enforced location in the Soviet orbit. After the Soviet Union’s collapse, few in Europe considered Ukraine a ready candidate for accession to the EU as it was challenged simply to lay out the architecture of a viable state and to develop the habits essential for administering it. This proved something of a Catch-22 because without an accession prospect, Ukraine lacked both the external support and the internal drivers that might have reinforced that state building project. Even as Ukraine enjoyed relatively high growth rates between 2002 and 2008, its governance structures remained exceedingly weak, and this, in turn, left the entire system vulnerable to political and economic shocks, corruption, and external meddling.

34. Ukraine had first expressed an interest in acceding to the European Union in 1995, but the EU essentially placed the matter on the back burner. The EU was already sufficiently challenged to manage the accession of more proximate members, Ukraine had very far to move in terms of meeting the requirements for membership and there was also a sense among many that Europe also had to come to some kind of accommodation with Russia as it too adjusted to life after the Soviet Union. In 2003, the EU initiated the European Neighbourhood Policy (ENP) that offered a new vehicle for deepening ties with Russia, Ukraine, Belarus, Azerbaijan, and the Republic of Moldova, in part, by offering these countries greater access to European markets. Russia, however, chose not to participate and eventually agreed to a different status through the EU-Russia Common Spaces Initiative. Ukraine, along with Armenia, Azerbaijan and Georgia, ultimately signed up for the ENP.

35. Following the Orange Revolution which began in November 2004, Ukraine concluded an action plan with the EU designed to prepare it for an even closer relationship with that institution. That plan largely focused on internal reforms, most of which Ukraine needed to undertake simply to compete in the world economy and to gain accession to key economic clubs like the WTO. The EU began to negotiate a Deep and Comprehensive Free Trade Area (DCFTA) agreement with Ukraine and in May 2009, it initiated the Eastern Partnership to facilitate ever-closer integration between the EU and six partner countries in Eastern Europe (Aslund, 2013). Relations between these countries and the EU were to be enhanced through the Stabilization and Association process designed to help these countries adopt key elements of the EU’s acquis communautaire which, in turn, would both improve governance and facilitate their integration into European and, by extension, global markets.

36. Ukraine continued the DCFTA negotiations after Viktor Yanukovych’s election to the presidency in 2010, although the EU eventually refused to sign the final agreement because of deep concerns about the human rights situation in Ukraine under Yanukovych. The arrest and incarceration of former Prime Minister Yulia Tymoshenko proved a key sticking point. The EU did, however, initial that agreement in July 2012 while holding up ratification until the human rights situation in Ukraine improved. When there were signs of improvement on this front, the two sides moved quickly to finally sign an ambitious DCFTA agreement.

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37. It is not at all accidental that the current crisis with Russia began after then-President Viktor Yanukovych, under enormous pressure from the Kremlin, announced in November 2013 that his government had decided not to sign the Ukraine-European Union Association Agreement. The announcement came on the eve of the Vilnius summit where the treaty was to be signed. When Yanukovych ultimately ceded to intense Russian pressure, the Maidan protests began, culminating in his mysterious flight to Russia in February 2014, the creation of an interim government led by Arseniy Yatsenyuk and the initiation of Russian military actions in Crimea and later the Donbas region.

38. The question of Ukraine’s sovereign right to negotiate a trade pact with the European Union and, by extension, to conduct its own national economic policy, thus lies at the very heart of the current crisis. Russian leaders and the narrative they promulgated that the revolution sparked on the Maidan was rooted in Western meddling and support for a pro-European faction (which the Kremlin blithely associated with Fascism). They further suggested that if Ukraine’s leaders were, in fact, going to sign trade pacts with the EU, this would effectively give Russia a green light first to annex Crimea and then to work to destabilize Eastern Ukraine and, in effect, create a frozen conflict there. Russia has done precisely this, but its actions hardly curbed Kyiv’s desire to establish a closer partnership with the European Union. If anything, Russian behaviour has rallied public support for a deeper relationship with the EU, one that Ukrainians increasingly feel would correlate with much needed institutional, political and economic reform.

39. Indeed, the EU-Ukraine Association Agreement signed on 21 March 2014 with additional sections signed on 27 June 2014 calls for a degree of convergence in economic policy, legislation, and regulation across a broad range of areas, including workers’ rights, visa-free movement of people, justice, the modernization of Ukraine's energy infrastructure and Ukrainian access to the European Investment Bank. For its part, Ukraine has committed to move toward the adoption of EU technical and consumer standards, while the EU will provide financial and technical support and extend preferential access to its markets. It envisions the establishment of a Deep and Comprehensive Free Trade Area (DCFTA) which presents a liberal framework for upgrading the trading relationship while extending Ukraine greater market access through the progressive removal of tariffs and quotas as well as through legal and regulatory harmonization across a range of trade-related sectors. The agreement also calls for Ukrainian convergence with the EU’s Common Security and Defence Policy and the European Defence Agency’s policies while establishing regular summit meetings as well as a litany of formal bilateral meetings among ministers, senior officials and policy experts. It is premised on common values including full respect for democratic principles, the rule of law, good governance, human rights and fundamental freedoms. The Association Agreement goes into force once all member states and Ukraine have ratified it. It will replace the old EU-Ukraine Partnership and Cooperation Agreement as the legal framework for the bilateral relationships (European Union External Action Service Webpage).

40. As suggested above, Moscow has expressed its very strong reservations about the agreement, but its posture is highly convoluted. A number of trade measures it has taken in response to the agreement likely violate its obligations under the WTO. Already in July 2013, in violation of its WTO obligations, Russia launched trade sanctions against Ukraine to pressure it to reject the DCFTA and join its Customs Union with Belarus and Kazakhstan. It is worth noting that the DCFTA with the EU does not preclude Ukrainian trade agreements with third parties which would not be the case were it to join the Eurasian Union, which would require Ukraine to cede sovereignty on trade matters. In August 2013 Russian authorities determined that all Ukrainian companies were “high risk” and would therefore be subject to time-consuming checks at the border—a procedure that essentially blocked Ukrainian goods from entering the Russian market. Russia later formally lifted these restrictions, but problems at the border persist—not the least because Russia is effectively denying Ukraine control over that border. Russia has consistently

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used access to its own market to apply pressure on Ukraine to back away from forging any special trading arrangements with the EU and to come to terms with the Eurasian Union.

41. The prospect of entering into a Russian-dominated customs union offers Ukraine little solace and holds out even fewer potential economic benefits. Upon joining that Union, for example, Kazakhstan was compelled to raise its average customs tariffs from 6.7% to 11.1% on an unweighted basis, and it essentially forfeited its capacity to negotiate a separate accession deal with the WTO. The Swedish economist Anders Aslund has surveyed various studies weighing the costs and benefits of Ukrainian accession to the Eurasian Economic Union versus the DCFTA. One study by Movchan and Giucci, for example, suggests that the DCFTA could add up to 11.8% to Ukraine’s GDP over the long term as a result both of trade creation and the structural reforms prescribed in the agreement, while joining the Eurasian Customs Union would likely reduce it by 3.7% due to trade diversion effects that would essentially undercut the normal benefits linked to trade. In other words, once it joined a Russian-dominated trading system, Ukraine would be compelled to import from high-cost producers and would lose opportunities to sell in high price markets (Aslund, 2013). A Eurasian Customs Union would thus likely reduce Ukraine’s trade in absolute terms. Moreover, it is highly doubtful that such a trading arrangement would ever undergird domestic liberal reform because this is precisely what the Kremlin fears most.

42. This contrasts sharply with the potential impact of a deepening link to the European Union, which, among other things, would create trade as a result of enhanced Ukrainian access to the large EU market, increased foreign direct investment, a degree of regulatory harmonization with a global engine of trade and an improved business climate linked to the reform process which the agreement advances. All of this would better position Ukraine to compete in global markets and, importantly, none of this would proscribe continued trade relations with Russia, despite Russian claims to the contrary.

43. A recently issued Eurasian Development Bank report has challenged the conclusions of most trade studies pointing to the benefits to Ukraine of a closer trading relationship with the EU. Anders Aslund has suggested, however, that this is essentially a political tract with no foundation in contemporary trade theory. Kremlin officials tend to see international trade in a highly mercantilist fashion and as a wooden zero-sum game rather than a dynamic win-win proposition. Open trade and the kinds of domestic adjustments that global markets demand lie at the very foundation of post-World War II prosperity in Europe, North America and Asia. Russia seems to be opting out of this logic and is increasingly inclined to impose this very narrow vision of trade on neighbouring states. Ukraine has decided to resist and Russia now wants Kyiv to pay a very high price for challenging its regional strategy.

44. Membership in the Eurasian Customs Union would also have prevented Ukraine from signing free trade agreements with non-members and thus left Ukraine far more dependent on Russia in a costly trading order expressly designed to ensure Russian regional hegemony. Not surprisingly, polls in Ukraine suggested that there was a clear public preference for the Western-global option. Caught between domestic public sentiment and Russian pressure, Yanukovych sought to split the difference by abandoning the agreement with the EU while continuing to refuse to join the Eurasian Union. This ended up satisfying neither the Ukrainian people nor Vladimir Putin.

45. Ukraine has thus assumed a central place in the Kremlin’s aspirations to create a Eurasian Union, and Russia has accordingly trotted out an array of other objections to Ukraine’s agreement with the EU. For example, it has charged that the DCFTA would unleash a massive inflow of EU goods from Ukraine into Russia. This argument, however, ignores WTO rules of origin which would prevent goods produced in the EU from simply being resold into Russia under the false

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pretense that they were Ukrainian goods. This would only be possible for a very limited number of intermediate goods.

46. Russia has also charged that the adoption of EU product standards would prevent Ukraine from manufacturing to Russian standards. This is misleading at best. The product standards included in the EU-Ukrainian agreement cover goods that Ukraine does not sell in Russia in any meaningful way, and nothing would prevent it from selling Russia goods made to Russian standards. Russia has also argued that by extending Ukraine privileged market access, the EU will compel Ukraine to discriminate against Russian goods. This too is a non-issue insofar as such arrangements are fully permissible under WTO rules to which both Ukraine and Russia theoretically adhere. Moreover, Russia’s exports to Ukraine are heavily weighted in the energy field and would not be affected by Ukraine’s trading relationship with the EU (Emerson). In 2012 roughly one quarter of Ukrainian exports were sold in Russia and one quarter in the EU and each accounted for about 30% of Ukrainian imports (Aslund, 2013). IV. INTERNATIONAL STRATEGIES FOR ASSISTING UKRAINE

47. Both Europe and the United States have stated that Ukraine’s economic and institutional transformation represents an essential goal in their dealings with the country. But this is nothing new, although such ambitions in the past have been disappointed. In the wake of the Crimean crisis and in the midst of fighting in the eastern region of the country, the EU, the United States and Canada have increased their political and financial support for Ukraine and now stress that the very future of that country rests, in part, on its capacity and willingness to carry out deep and long-lasting reforms.

48. As part of the EU’s support to the Ukrainian government, the Commission launched two Macro-Financial Assistance programme loans in 2014 valued at 1.612 billion EUR with the final disbursement of 250 million EUR expected for the spring of 2015 contingent upon Ukraine making progress on its reform agenda (European Commission). In January 2015 the EU pledged an additional 1.8 billion EUR in assistance to Kyiv. The initial objective has been to back Ukraine financially while encouraging essential structural reforms to enhance governance, foster conditions for sustainable growth and support legislative harmonization with the EU. The programme focuses on public finance management, anti-corruption, trade and taxation, the energy sector and the financial sector.

49. For its part, the United States government has expressed its firm commitment to support Ukrainian efforts to establish security and stability, respond to humanitarian and reconstruction needs, conduct democratic elections, carry out constitutional reforms, fight corruption and restore its economy. As of September 2014 it had provided 291 million USD in assistance for the year and a 1 billion USD loan guarantee. This included 46 million USD in non-lethal security assistance directed to Ukraine’s military and border guards (Whitehouse.gov). The US Administration pledged 2 billion USD in new financial assistance for Ukraine for 2015, but this, combined with the EU’s pledge and other international support programmes is not sufficient to help Ukraine meet its real needs over the coming year (Donnan). US officials have stated that they may come up with an additional 1 billion USD once it is evident that Ukraine is complying with the terms of new IMF loans (see below).

50. The IMF is now poised to offer Ukraine another bailout package and will have to move quickly if Ukraine is to stave off a financial disaster. In early 2014, the IMF offered a 17 billion USD loan package to help it counter the impact of a recession and cope with a burgeoning balance of payments crisis. But that loan was abandoned after fighting broke out in eastern Ukraine. By the end of 2014, it appeared that Ukraine needed an additional 15 billion USD after Kyiv lost control of a significant amount of its eastern territory. Donetsk and Lugansk alone have typically accounted for 16% of Ukraine’s GDP (Wolf). After the departure of Victor Yanukovych, the IMF assumed that the economy would contract by 5% in 2014. The IMF has revised that

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figure to 6.5%, but the actual number may ultimately lie between 8% and 10% (Wigglesworth). The country’s debt to GDP ratio will likely approach 90% in 2015, or more than double the 2013 level. The IMF judges this level of debt as unsustainable and has suggested that Ukraine needs another 15 billion USD simply to prevent a default.

51. The current IMF lending programme is contingent upon a general judgment that Ukrainian authorities have put the country’s finances on a sustainable foundation. Many experts now argue that this is not the case. But unless Ukraine receives a significant injection of capital from international donors, it could be compelled to default. By January 2015 this prospect had triggered a flight from Ukrainian bonds and a collapse in their price (Wigglesworth).

52. The IMF’s 2014 18 billion USD loan agreement required that the government of Ukraine allow the currency to float. It also established yardsticks to ensure a sustained effort to reduce corruption and bureaucratic red tape, and demanded substantial reductions in massive energy subsidies. The deal was announced concurrently with the adoption of new measures to freeze the minimum wage and increase corporate taxes. At the time, the government estimated that it needed 35 to 40 billion USD to cover basic needs over the coming years while meeting the country’s substantial debt obligations. The changes the IMF has demanded are challenging, particularly at a moment of national crisis and war, but Ukraine’s international supporters and many in the government generally accept the idea that these are essential reforms and can no longer be postponed (Erlanger et al.). It is worth noting that the government has appointed a head for the new National Anti-Corruption Bureau.

53. On 12 February 2015, Christine Lagarde, the managing director of the IMF, announced that the IMF team in Kyiv had reached a staff level agreement with the Ukrainian government on a new economic reform programme that would be supported by an Extended Fund Facility of 12.35 billion SDR (special drawing rights, equivalent to roughly 17.5 billion USD, or 15.5 billion EUR) from the IMF and additional resources from the international community at large including bilateral donors. Christine Lagarde announced that she would recommend the four-year programme to the IMF Executive Board. The new programme will support immediate economic stabilization efforts in Ukraine and help underwrite an ambitious set of policy reforms that aim to put Ukraine on a long-term growth path that should ultimately raise living standards in the country. The new IMF programme contains a number of “front-loaded” measures including bank restructuring, governance reforms of state owned institutions, and legal changes to enhance the government’s essential anti-corruption and judicial reform agenda. This 17.5 billion USD package, however, is not sufficient to plug the expected 40 billion USD budgetary shortfall that Ukraine will likely confront over the next four years. And it does not include the huge obligations the private sector is incurring in this crisis let alone the kinds of investments these firms will need to undertake if they are to meet European standards and sell in global markets at a time when commercial opportunities in Russia are vanishing. 54. In endorsing the latest programme, Christine Lagarde noted that Ukraine has managed to undertake a number of ambitious reforms over the past year that point to a high degree of commitment to move forward on a reform agenda. The 2014 deficit of 4.6% of GDP was well below the target of 5.8% despite the terrible security conditions the country confronts. Ukraine also finally adopted a flexible exchange rate regime although it has adopted capital controls to stabilize the currency. The government has begun in earnest the painful process of adjusting gas and heating prices. Household gas prices moved to 56% of import prices and heating prices to roughly 40% of the import price in 2014. This substantially lowered pressure on the public budget, but obviously Ukraine has more to do on this front and will nonetheless need to provide an energy safety net of some kind for the most destitute. The IMF programme will assist in the design and funding of these programmes.

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55. The new programme also represents a change from a previous Stand-By Arrangement to an Extended Fund Facility and will thus provide more funding than the previous arrangement. It will also provide Ukraine more time to repay the loans, greater flexibility in spending the funds, and improved financing terms. The IMF also noted that the Ukrainian government will eventually need to sit down with those institutions that hold its sovereign debt in order to improve medium term financial sustainability. Taken together, this package could be valued at 40 billion USD over its four-year span. The IMF has been conservative in its estimates and has noted that the security situation in the east constitutes the greatest risk factor Ukraine confronts, as war could undermine investor confidence and the proper functioning of the Ukrainian market. Resolution of the conflict in the east would lead to a substantially sunnier outlook than the one employed by the IMF in its assessment (IMF).

56. On 12 February 2015, the World Bank announced that it would be providing 2 billion USD to Ukraine in 2015 including budget support, public investment and help in underwriting the reform agenda. This credit follows 3 billion USD it provided in 2014, largely to help finance basic public services including water, sanitation, heating, power, roads, health care and social services. The Bank has made it a priority to undertake projects designed to assist the poor, support institutional reforms in the gas and banking sectors, improve governance, fight corruption and nurture the business environment. The World Bank is closely coordinating this effort with the IMF. It is also managing a long-term 4.5 billion USD budget support and investment programme in Ukraine to support structural reforms, improve basic public services, protect the poor and encourage private sector development. Since 1992 the World Bank has provided roughly 9 billion USD in support of the country (World Bank).

57. It is nonetheless evident that a number of Ukraine’s international supporters are very concerned about persistent and deeply rooted corruption and are seeking to identify means to help the state reduce it. Transparency International ranks Ukraine 142nd on its corrupt states list. Effort to close procurement loopholes by demanding transparency should make a difference, but there are many other areas where the problem persists. The legal system, torn between modern European civil traditions and old Soviet law codes, is highly inefficient and penetrated by interest groups and has become a particular source of concern (The Economist).

V. THE ENERGY DIMENSIONS OF THE CRISIS

58. More than half of Ukraine’s primary energy supply comes from domestic uranium and coal supplies, although natural gas plays a very important role in its energy mix. At 694 billion cubic feet (Bcf), domestic gas production accounted for approximately 37% of the total consumption in 2012. The remainder of supply is made up by Russian natural gas, imported through the Bratstvo and Soyuz pipelines (US Energy Information Administration). Ukraine also imports substantial amounts of oil from Russia although payment disputes have halted or delayed some deliveries.

59. Despite its domestic energy endowments, Ukraine’s gas sector is a huge fiscal liability. In 2014 the state gas monopoly Naftogaz ran a deficit equivalent to 5.7% of GDP as a result of a highly irrational and costly subsidy system. Ukrainian consumers only pay for one fifth of the real cost of gas and this has generated enormous distortions as well as a serious fiscal drag. The gas pricing system has also constituted the leading source of corruption in Ukraine and the EU has urged the government to build meters to measure how much gas is actually flowing from Russia to avoid discrepancies between official and real imports. The decisions to cut this deficit by quadrupling the price consumers pay for gas will undoubtedly impose hardship on a country which has had its share of hard times in recent years. But with IMF support, the government intends to increase social spending by 30% in 2015 although this may not keep pace with inflation (currently running at 60%) and could be undercut by unseen economic and strategic circumstances.

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60. Energy markets in Ukraine have long been opaque and inefficient. Throughout most of the post-Cold War period, Russia provided roughly half of the natural gas consumed in Ukraine, but it was also willing to cut those supplies abruptly in the midst of pricing and political disputes, even when these affected supplies in eastern and southern Europe. Ukraine’s dependence on Russian energy clearly left it vulnerable to Russian political interference while corruption associated with this industry gravely subverted the autonomy and strength of the Ukrainian state. Russian leaders used this leverage to discourage Ukrainian development of its own substantial energy resources. Had Ukraine managed to boost domestic energy production, it might have gained greater political and economic autonomy. The many shadowy energy deals between Ukraine and Russia provided ample opportunity to corrupt the Ukrainian political elite.

61. Obviously the situation is far more perilous today and energy matters cut to the very core of the tension between the two countries. On 16 June 2014 Russia cut off all gas exports to Ukraine, compelling the latter to import gas from both Poland and Hungary. Subsequently both Ukraine’s Naftogaz and Russian Gazprom filed cases against each other with the Arbitration Institute of the Stockholm Chamber of Commerce asking it to interpret existing contracts and to establish who owes what to whom. Naftogaz sought to cancel the take or pay provisions in these arrangements, alter the gas price calculation system and recover 6 billion USD of overpayment for gas supplied since 2010. Naftogaz has also argued that the 2009 gas contract with Gazprom is not compliant with Ukrainian law, which is now aligning with the EU’s so-called Third Energy Package. It is seeking compensations for short falls in gas transit volumes and the same treatment that Gazprom has extended to other European customers which has allowed them to move closer to spot market pricing instead of old oil index formulas. Gazprom has counter claimed that Naftogaz owes it 4.5 billion USD in unpaid debt for previously supplied gas (Radchenko). It is worth mentioning that the financial position of Naftogaz has long burdened state finances and clearly must be restructured. Ukraine has also demanded that Russia compensate it for the loss of Chernomorneftegaz, a Crimean Black Sea Energy company with 2.2 billion cubic meters of gas reserves that Ukraine lost when Russia seized the peninsula. The arbitration procedures between Naftogaz and Gazprom are likely to endure for years and the situation will remain very tense given the situation in the east.

62. Ukraine is one of the world’s most inefficient users of fuel. This is a structural legacy of Soviet irrational pricing and post-Cold War energy price subsidies (costing nearly 7.5% of GDP) that have distorted the real opportunity costs of energy use. But it also reveals a failure of the post-Soviet Ukrainian state and the political class to address this very serious set of problems. Not coincidentally, Ukraine’s industry has also ranked among the world’s most energy intensive, and the ratio of energy use to output is nearly twice that of Russia’s and ten times the OECD average (Wigglesworth and Olearchyk). Ukraine’s profligate energy policies long obfuscated the real opportunity and security costs of relying on a high level of gas imports from a sole supplier. Obviously the country is now confronting that cost as are a number of European countries.

63. President Poroshenko has recognized Ukraine’s energy problem as a fundamental economic and geo-political challenge and has promised to address it. As suggested above, the IMF has made its new lending to Ukraine contingent on fundamental energy market reforms including a sharp reduction in fuel subsidies, rebuilding highly wasteful Soviet era home heating networks and lowering industrial energy consumption rates. For years, the household price of gas in Ukraine covered only 15% of the recovery cost, although this figure has risen throughout 2014. Moving towards unsubsidized pricing will significantly lower gas consumption in the country and trigger a welter of other efficiencies while spurring development of Ukraine’s domestic energy resources, including its substantial non-conventional oil and gas reserves. Artificially low prices and political interference have long hindered the development of the domestic energy sector (Aslund, 2014). The current break with Russia makes it imperative for Ukraine to begin this work. Efforts will also be needed to break old habits such as those that encouraged industries to siphon

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off gas at highly subsidized household rates for use in the manufacturing process (Wigglesworth and Olearchyk). All of this would confer serious long-term economic benefits by rationalizing price signals, encouraging a significantly higher degree of energy efficiency, lowering the subsidy burden on government budgets and drastically reducing the level of Ukrainian dependence on Russian energy. Of course, short- term shocks will also be involved, and this is why international support is required. Energy market rationalization could provide Ukraine with far greater strategic leeway while representing an impetus to industrial modernization.

64. Ukraine is also challenged to better integrate itself into European energy systems in order to diversify its supply base and thus improve its energy security position. Ukraine has great potential as a European gas storage center and eventually could become one of the gas hubs that Europe needs to restructure gas markets. If properly outfitted with reverse flow switches, Europe’s pipeline network could help Ukraine emerge as an important gas hub in a restructured European market (Wieczorkiewicz and Genoese).

VI. CONCLUSIONS

65. It is telling that the current crisis between the West and Russia over Ukraine began when the Yanukovych government refused to sign a treaty with the EU that it had long promised and that most Ukrainians welcomed. That decision led directly to the Maidan rebellion, the flight of Yanukovych to Russia and the emergence of a new government which quickly signed an agreement with the EU. Russia, of course, welcomed none of this. It had applied enormous pressure on Yanukovych to abandon the European project and then responded militarily when Yanukovych fell, although there is clear evidence that Putin had long planned to seize Crimea. Russia’s greatest fear, however it seems, may well be a liberal and democratic Ukraine on its border, tightly linked to Europe, open to the world, and prospering in its own right. That kind of Ukraine would represent a rebuke to the far more opaque and authoritarian order that Vladimir Putin has constructed in Russia itself. And yet, a liberal, democratic and open Ukraine would also offer hope to those increasingly marginalized Russians who believe that their own country has missed countless possibilities to start down its own reform path (Wolf).

66. Ukraine’s challenge today is not only to defend its territorial integrity and sovereignty, which Russia is clearly intent on subverting, it must also firmly establish and entrench a democratically achieved rule of law, transparent and effective governance mechanisms, a higher level of openness to the global economy and a closer relationship with Europe. That would be a very tall order even in peacetime; it is all the more daunting given the military operations underway in the east. Ukraine, however, has no choice but to begin this reform process now, despite the prevailing crisis conditions.

67. Despite the difficult situation it faces - the occupation of Crimea, the horrific treatment of the Tatar community there, including mass and unwarranted arrests, torture and intimidation, fighting in eastern regions, and a serious debt problem - Ukraine is a country of significant economic potential. Unlike countries such as Poland and the Czech Republic, until recently Ukraine had not implemented the kind of reforms that ultimately translate into real transition and modernization although it had moved in fits and starts in that direction. It has made great progress in recent months, but current crisis conditions are hardly propitious. The pace of reform has accelerated with important changes in energy markets, market regulation, governance, and shareholder rights. This should give momentum for even deeper reforms supported by the government and the international community.

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68. Fundamental economic reform is never easy and can seem impossible in wartime. It is perhaps Ukraine’s reform agenda that Vladimir Putin most fears because it represents an explicit indictment of the kind of order he has constructed in Russia and wants to extend to Russia’s so-called ‘near abroad’ - an expression that in itself expresses a certain disdain for the sovereignty of these countries. But Ukraine cannot undertake this agenda alone, and for the foreseeable future will require a high level of international support and solidarity. For their part, the Ukrainian government and people must remain dedicated to a bold reform agenda, even in the face of a very serious internal and international threat. This will doubtlessly have short -term costs but it will reap great rewards in the longer term. The Ukrainians must move as quickly as possible on this reform agenda. The Russian government and those advancing its agenda inside of Ukraine want to eliminate the possibility of liberal democratic and market reform in Ukraine and they want to do so quickly. This is central to Russia’s military strategy in eastern Ukraine.

69. As a first order of priority, the Ukrainian government needs to continue to improve economic governance of the national economy if it is ever to kick off a more comprehensive and enduring transition. It must scrap the complex and often conflicting rules governing domestic markets that for so long only created opportunities for corruption and mismanagement. The new government also needs to foster an environment that encourages the creation of new companies and industries. Judicial and legal reform is also essential. Judicial reform should remain a fundamental priority. Ukraine’s legal system has long been suspended between western legal codes and Soviet legal traditions which has created a hopelessly corrupt and ineffective judicial order. That systems now needs to be fundamentally rebuilt and international support here will be critical. A trusted legal structure will help the country in countless ways to get market forces on track. The more swiftly it moves on these fronts, the better.

70. The energy sector in Ukraine has been a particularly opaque and corrupt foundation of the Ukrainian economy and long opened avenues for Russian meddling in domestic Ukrainian economic and political matters. That sector requires wholesale reform. Part of this effort should include a dramatic reduction of consumer and industrial energy subsidies - a policy that is already underway. Infrastructure modernization is essential to build a more efficient market in which energy is treated like the scarce commodity that it is. This will go far to reducing Ukrainian dependence on a Russian supplier that has blatantly used its market position for political leverage. The benefits to Ukraine of such a reform would be both strategic and economic. Europe can help by increasing its stock of pipeline interconnectors with reverse flow capabilities and by finding ways to make Ukraine one of the potential beneficiaries of a system capable of seamlessly moving emergency supplies from west to east in the event of supply shocks.

71. The introduction of rational energy pricing better reflecting real supply and demand conditions will also stimulate Ukraine’s domestic oil and gas industries, which were long undercut by shady deals with Russia and price fixing. Ukraine has tremendous energy potential, and there are both economic and strategic reasons why this potential must now be tapped. Already in 2013, the Yanukovych government had laid out a plan to achieve energy self-sufficiency by 2030. That was a very ambitious goal. But it is not outside the realm of possibility if Ukraine moves with alacrity on this front. At the time of writing, Gazprom has announced that it has halted deliveries of natural gas to Ukraine, once again because of a pricing dispute although political tensions are very apparently the real reason.

72. It is also important for Ukraine to recover stolen assets and funds generated through corrupt practices, not only to replenish the treasury, but also to deter future abuse. This would also send a signal to the international donor and lender communities that the new Ukraine is intent on establishing far higher governance standards in the country and that a return to the old ways is simply beyond contemplation. Although recovering stolen Ukrainian assets does not, in itself, constitute a panacea for Ukraine’s economic woes, doing so is important as it allows the country to confront both its past and those who subverted public trust and the solidity of the Ukrainian

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state. International support is critical here as well and international banking centers ought to be prepared to freeze the assets of those actors whose political and economic activities have essentially focused on swindling the Ukrainian people.

73. A successful anti-corruption drive is central to Ukraine’s effort to liberate itself from direct Russian meddling in its domestic affairs. Public procurement has been a long-standing arena for corruption in Ukraine, and it is imperative that the government adopt the highest standards of transparency and accountability in this particular arena in order to generate much-needed budgetary savings while ensuring the autonomy and strength of the state itself. This is essential if Ukraine wants to achieve its European ambitions. Europe and North America should stand ready to provide all manner of assistance, nurture the attitudes and know-how that make accountable governance possible. There is overwhelming evidence that public and private actors have long relied on bribery and all manner of pay-offs to subvert the state’s capacity for autonomous decision making. These practices reached a kind of crescendo during the Yanukovych administration, but the problem was also apparent in previous governments, and it persists today. If Ukrainian officials are serious about building up a strong and autonomous state capable of defending Ukraine’s national interest, they will need to take on the problem of corruption in a very dedicated manner. This is far easier said than done, but if the government continues to show the will to move in this direction, it should be able to count on international support. This particular struggle may be as important as the battles unfolding in the eastern regions of the country.

74. Ukraine currently faces a very serious debt crisis and, at the time of writing, is asking creditors to accept a 40% write-down. It urgently requires a very significant injection of capital to keep the state running. But it will need additional support to enact a genuine transition and to foster an environment that will encourage private sector investment (Levy and Soros). North American and European governments will need to backstop the IMF loan with generous additional funding for Ukraine to provide relief from private creditors and to help the country begin to invest for the future. This is both economically and politically essential and it would convey a high degree of solidarity with the besieged government. A range of private-public partnership are needed to help Ukraine both manage a very difficult moment in its history and seize the opportunity the Maidan has bequeathed it to build an open, democratic and ultimately prosperous country. Some degree of debt relief would also be helpful, and it might even be helpful to allow Ukraine to repudiate some of the debt Yanukovych assumed from Russia as part of the sanctions strategy. This could well be justified given that Russia has stolen myriad assets from Ukraine in Crimea and is fueling instability in the east. There is a precedent of countries legally walking away from so-called “odious debts” owed to countries engaged in military campaigns against the borrower (Gelpern).

75. Russia is not only sending military equipment to pro-Russian separatists in eastern Ukraine but also appears to be deploying troops in unmarked vehicles into that country. On 13 February 2015, the US State Department spokesperson ended the pretense that these deployments might not directly involve Russian military assets when he said: “The Russian military has deployed a large amount of artillery and multiple rocket launcher systems around Debaltseve where it is shelling Ukrainian positions… We are confident these are Russian military not separatist systems. The Russian military also has air defense systems deployed near Debaltseve. We are also confident these are Russian military not separatist systems.” In adding Russian defense officials and two ranking generals to its official blacklist for “supporting the deployment of Russian troops in Ukraine” and for being “involved in shaping and implementing the military campaign of the Russian forces in Ukraine”, the EU’s High Representative for Foreign Affairs and Security Policy, Federica Mogherini, has now publically come to the same conclusion (Gregory). There is recent evidence of active-service Russian soldiers operating in Ukraine and this is undermining the cease fire agreements signed in Minsk, according to a recent UN Human Rights office report (Cumming-Bruce). The number of cease-fire violations are on the rise and include increased use of mortar and tank fire which is driving OSCE observers out of certain contested regions and

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leading some to conclude that the geographical scope of the conflict may be about to widen (Herszenhorn, 2015).

76. These secretive Russian deployments are emblematic of a hybrid warfare strategy Russia is using to destabilize Ukraine and thwart its liberalizing agenda, while denying it is doing so. Although Western governments are rightly reluctant to enter into a proxy war with Russia, they are increasingly appalled by this brazen and illegal violation of Ukrainian sovereignty and are responding to it. It is important to note here that Russia recognized Ukraine’s sovereignty in the Budapest Memoranda on Security Assurances of 1994, under which Ukraine gave up its nuclear weapons in exchange for a guarantee of its borders, a set of agreements that benefitted Russia as much as the West (Perry and Shultz). The illegal annexation of Crimea was a grotesque and indefensible violation of this commitment. Despite Russian denials of involvement, its deployment of heavy weapons and troops in eastern Ukraine are reprehensible and illegal. Ukraine has a right to defend its territory from these violations, and it is in the interest of European peace and security that it does so. If Russian military intervention persists, Western governments may need to consider providing the Ukrainian military with the kind of training and equipment it needs to defend Ukraine’s sovereignty. The international community may also need to ratchet up sanctions on Russia, and perhaps even eject it from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network that enables financial institutions across the world to send and receive information about financial transactions in a secure environment. Such a measure has proven particularly burdensome for Iran. This would hardly be a welcome development and there are very apparent risks in providing direct military support to Ukraine and cutting Russia off from the world’s banking system. But the dangers of allowing Russia to unilaterally rip apart the post-Cold War settlement in Europe are far more worrisome and must be stopped.

77. Indeed, Western countries should never accede to Russian claims that it somehow enjoys a special privilege to exercise a check over Ukrainian sovereign decision making, particularly when those decisions reflect fundamental Ukrainian interests linked to economic restructuring and enhancing the capacity of the Ukrainian state. Russia certainly has interests regarding its neighbourhood, but there are ways to gain assurances that do not involve illegal annexation, destabilization and opposition to internal reform. Ukraine’s concerns about Russian behaviour are thus utterly valid and are shared by Europe and North America as well. Russia has no veto on Ukraine’s economic and foreign policy choices, and it must be dissuaded from the illusion that it does. Communicating this point, however, requires great solidarity and very close co-operation with the Ukrainian government. This should not rule out discussions with Russia about its legitimate concerns, but those discussions should never become a means of undermining the Ukrainian state and the choices it makes in a democratic fashion.

78. The great irony at the heart of the current crisis is that Russia actually has an interest in Ukraine’s long-term economic development, its political stability and its integration in the global economy even if the current leadership fails to see this. All of that would bring benefits to Russia itself. Russia’s current strategy of destabilizing its borderlands seems incredibly shortsighted and prone to backfire. It is increasingly evident that Russia is seeking to carve a puppet state out of eastern Ukraine - something that promises to destabilize not only Ukraine but the entire region. The international community must resist this Russian effort as it is contrary to principals of a Europe whole, free and at peace and will lead to enduring conflict and tension in Ukraine and beyond.

79. Russia’s escalation in the east and the emerging debate in the West about whether to provide military support to Ukraine suggest that for now, both sides are digging in. In unambiguously supporting pro-Russian separatists’ forces violating the Minsk II ceasefire, Putin may now be forfeiting tactical flexibility in favor of establishing a permanent beachhead in eastern Ukraine. If this is indeed the case, the West must gird itself to help Ukraine thwart that ambition.

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80. In the long run though, Russia itself will need a prospect for a more comprehensive economic transition and an enduring foundation for stable relations with its neighbours and the international community. What happens in Ukraine will thus have very serious implications for the direction in which Russia itself is heading. The vision of a more harmonious and integrated European order, from which Russia can position itself to derive enormous benefit, must be kept alive, even in these very dark times. A flourishing Ukraine increasingly integrated with Europe and the world economy will do precisely this.

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Aslund, Anders, “Ukraine can now fix its economy, if it moves fast,” Financial Times, 25 February 2014.

Aslund, Anders, “Ukraine’s Choice: European Association Agreement of Eurasian Union,” Policy Brief, The Peterson Institute, September 2013.

“A tactical pause in Putin’s Assault on Ukraine,” Financial Times, 12 February 2015.Balcerowicz, Leszek, “With the right reforms, Ukraine can still thrive,” Financial Times,

27 March 2014.Carnegie Institution, “Corruption: The Unrecognized Threat to Security,” Carnegie Endowment

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Charap Samuel, “Ukraine: Seeking an Elusive New Normal,” Survival, Vol. 56, No. 3, June/July 2014.

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Cumming-Bruce, Nick, “Fighting in Ukraine eases, But abuses continue on both sides, U.N says,” New York Times, 1 June 2015.

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Documents

2015 ESCTD Draft Report on Ukraine - NATO PA - 172 E… · Web viewAccording to conservative U.N estimates, 6,417 people had been killed in the fighting as of 15 May 2015 and nearly