Ukraine: The Investor’s View from Kiev

Due to the tense standoff between Russia and Ukraine in the Crimea, and the increased pressure this has put not only on far-reaching international relations, but on Ukraine’s energy security and its critical energy independence ambitions, this week we take you straight to Kiev for on-the-ground insight.

First, to recap the events of the past several weeks:

Ukrainian President Viktor Yanukovych was ousted in February after months of street protests in Kiev, sending the country into a chaotic struggle for a new administration—with the energy portfolio one of the prime pieces of political real estate. But the ensuing chaos was sidelined by another crisis of an international nature when Russia moved to seize Ukraine’s Crimea region, where it harbors its Black Sea Fleet. The standoff here continues between Ukrainian troops and pro-Russian troops holding the Belbek airbase. The US has threatened a variety of sanctions on Russia, and US Secretary of State John Kerry hit the ground in Kiev in a show of support for the new administration and promises of an economic assistance package. On Monday, we saw panic in the markets, but that panic subsided when Russian President Vladimir Putin made a live TV appearance saying that military action would be a last resort to protect its “compatriots” from the “terror” in the aftermath of what Russia perceives as a coup. After a day of panic on Monday, Putin’s comments on Tuesday gave the Russian bond markets a bit of a reprieve. But for now, all attention has shifted from Kiev to Crimea, and with Gazprom threatening to reverse a discount on gas prices in April over the ouster of Yanukovych, energy is again the axis around which everything is spinning.

Energy expert Robert Bensh offered us some exclusive insight into the extremely dynamic events on the ground in Ukraine. Mr. Bensh is the majority shareholder in Cub Energy—a key oil and gas operator in Ukraine—and has been intricately involved in Ukraine’s national energy policy. Speaking from Kiev on Tuesday, Mr. Bensh shared his thoughts on where this might go and what it means for energy:

First, Putin seems to have blinked after his controversial intervention in Ukraine, pulling troops back from exercises close to the Ukrainian border.

In response to the overthrow of his ally Yanukovych, and victory by the Maidan (protest movement), Putin has thrown everything at Ukraine over the past few days, intervening directly in Crimea, threatening to intervene more generally in other regions of the country, pulling aid, threatening to raise gas prices, and threatening trade restrictions. And yet despite all of this, his strategy has been far from successful.

Efforts to destabilize oblasts in Eastern Ukraine seem to have largely failed, with demonstrations of several thousand in support of Russia, but nothing really to rival the Maidan protests and threaten regime change.

The results of the above have been pretty minimal; in fact, if anything the above seems to have served to rally the Ukrainian population (perhaps with the exception of ethnic Russians in Crimea) behind the government in Kiev and against foreign (Russian) intervention. Even prominent oligarchs, who stood on the fence throughout the Maidan protests, have now come out against foreign intervention, and two were even appointed regional governors in oblasts in eastern Ukraine. Hence, alleged threats to encourage further splits in Ukraine appear to have largely failed.

In explaining this about-turn by Putin, it would appear that he has been taken aback by the lack of real traction in support of Russia on the ground (beyond Crimea), the unwillingness of the government in Kyiv to respond with force (which would surely have been an excuse for further Russian intervention), and Western threats (and real potential) of sanctions. The latter I think are particularly worrying to the Putin regime, as they suggest a very significant threat to the stability of the Russian economy when it is already looking decidedly anemic.

Second, and noted above, the response of the authorities in Kyiv to a hugely challenging threat from Moscow has been balanced, measured and moderate. They have avoided rash action, and instead appealed to the international community, winning much support for their moderation, and appearing as the underdogs.

Third, the international community has rallied behind Ukraine against what is widely perceived in the West at least as Russian aggression. Russia struggled to defend itself at Monday’s UN Security Council hearing. There is also now a real chance that Russian aggression will finally unlock major financial assistance for Ukraine-- with talk of IMF financing arriving even before presidential elections in May.

Fourth, I am a great believer in "what does not kill you makes you stronger." Herein there is little doubt that Ukraine still faces huge challenges on the economic front. However, I am encouraged that the Yatseniuk government realizes that time is not on its side, and seems prepared to accept the IMF prescription of reforms, "off the shelf" with no attempt to negotiate. This will be difficult and brutally painful--lower budget spending, higher taxes, privatization, increased energy prices. However, at least this government can explain this as required because of: a) the well-documented excesses of the previous regime (see photos of Yanukovych's residence); b) foreign aggression, and the need to ensure and defend Ukraine's sovereignty; c) the need to cement Ukraine's European orientation, and the drive to speedily sign the AA/DCFTA. On this latter note I am still encouraged that both the new government in Kyiv, and also the EU are signaling their intention to sign this agreement at the earliest opportunity, and likely soon after the presidential elections.

The AA/DCFTA could be transformational for Ukraine. It might now be argued that the best strategy for Putin would be simply to step back and leave the reformers to their own devices, assuming they would inevitably squabble and split--maybe, but perhaps this time around will be different.

The Ukrainian economy was/is in a dire situation. The challenges are enormous still--both domestic and external. However, Ukraine is in need of radical reform, and often countries need crisis situations to respond with meaningful reforms. The current crisis and reforms, if implemented, could still be transformational for the country. This is a huge, perhaps a generational opportunity to reform, supported by the West, and with little alternative now to pursue anything less. The agenda is reform or fail, from an economic perspective and perhaps also in terms of sovereignty.

Despite this upbeat scenario, though, what is clear is that Ukraine still faces hugely difficult macro challenges, domestic political tensions (track record of unity within the reform parties is less than inspiring) but also the likelihood of strong headwind from a less-than constructive approach from Russia. However, we finally see a faint glimmer of light at the end of the tunnel --let's hope this is the exit and not a Russian truck coming the other way.

As something of a footnote to the above a key question for investors is whether any Western bailout will be with or without PSI, and what form this could take, including a haircut, an extension of maturity for short duration debts falling due or some other more innovative solution. Or, perhaps even no PSI.

Opinion in official circles remains somewhat mixed with moral -hazard issues at play, but also the need for a timely assistance program, and mindful of debt sustainability considerations. Key in determining the way forward will be the on-going IMF mission which will shape the current state of play, macro framework and the financing needs. We should have a better picture herein over the next couple of weeks.