Playing Ukrainian Dominoes


Douglas Rediker is Director of the New America Foundation/Global Strategic Finance Initiative. Rediker is a capital markets expert who has been focused on the emergence of “state capitalism” as a key feature of the new international economic order. He has now become a regular contributor to The Washington Note.
Playing Ukrainian Dominoes
dominoes.JPGIt’s not often that I can be found arguing that the US should be looking to Austria for guidance on foreign policy, but Austria’s take on the current situation in Ukraine makes this one of those times.
Last week, Austria’s Finance Minister, Josef Proll, warned of economic and political catastrophe if Ukraine’s rapidly deteriorating economic situation is left unaddressed by the West. As he noted “Ukraine is a very important keystone country and we must avoid a domino effect inside the EU, if there is economic and political catastrophe in such a huge neighboring country.” Actually, he was likely understating what’s at risk.
First, here’s what’s happening in Ukraine – its currency, the hryvna, lost roughly half its value since the economic crisis began. Its main stock market fell 75 percent.
Last week’s data showed industrial output fell by more than a third in January. Three banks have already failed. Credit default swaps – contracts that provide a window into the broad market’s assessment of the likelihood of a default by the sovereign – rose to 3500 basis points. The country’s finance minister resigned, warning that “Ukraine’s economic situation is the worst in the world”.
Meanwhile, the President and Prime Minister throw political barbs at one another, each alleging the other presides over a corrupt system, blames the other for the crisis, and both look warily over their shoulders at their next door neighbor, Russia. Get the picture?
There are two big reasons to be worried about Ukraine.
First, many Western European banks have large exposures to Ukraine. A default by Ukraine means that those banks will take a serious hit to their balance sheets at the time they can least afford it. Should these banks get hit, it is likely that the direct and indirect effects will cascade throughout Central and Eastern Europe, as Western European banks withdraw to their home markets, thereby almost ensuring that the crisis widens and spreads across the region. Financial protectionism may, at that point, become a fait accomplis.
Second, when a country is looking over the cliff, it is likely to turn to anyone it can find to save it from falling over. Witness Iceland’s attempts to save itself last autumn by negotiating with Russia for a bilateral loan. At the time, Iceland’s Prime Minister noted that his emergency pleas to NATO allies had gone unanswered, so when his country did not receive support from its friends, it was forced to look for new friends.
Ukraine, which maintains a $16.5 billion stand-by loan facility with the IMF, came away empty-handed last week when the IMF refused to disburse some $1.84 billion in loans to the crisis-stricken government because it doesn’t approve of its proposed budget for 2009. The Ukrainians have proffered a budget with a 3% deficit, while the IMF apparently insists that its budget be balanced and contain a freeze on social spending.
With disaster looming, Prime Minister Tymoshenko announced that her government had sent letters requesting emergency bilateral assistance to the U.S., EU, China, Japan and Russia. Apparently, Russia is the only one (so far) to have responded favorably to the request, as talks were evidently held in Moscow recently regarding the terms of a potential $5 billion bilateral rescue.
What bothers me most about this situation is that I fear that many in Washington don’t recognize what is at stake here. Should Ukraine’s economy be allowed to fail, it will likely be forced into the arms of its Russian neighbor. All those feel-good stories about elections, democracy and the Orange Revolution will become little more than a historical footnote.
And other countries in Russia’s neighborhood will quickly see the writing on the wall and make note of who they can and can’t count on in their time of need.
I am also concerned about the failure of the IMF – which effectively represents the “Washington Consensus” – to have come to Ukraine’s aid. I am not privy to the negotiations, and I am sure that there are very good reasons for them to have walked away and potentially lose a democratic ally to the warm embrace of the Russian bear, but, if press reports of the reasons why are true, then I believe that they ought to re-think their position immediately.
If it is true that the Ukrainian budget being criticized calls for a deficit of 3%, then all one needs to do is flip to the front page of yesterday’s Washington Post and read about President Obama’s proposed budget, which projects a budget deficit of 8.3% – before the effects of the stimulus package are included in the figures. Read on to find that, White House Budget Director Peter Orszag argues that, if all goes well and spending cuts are tax hikes are implemented, and the economy doesn’t go into a total tailspin, then the hoped for best case for the US is that our own budget deficit will be compressed by 2013 to a “manageable” – you guessed it – 3%.
So, it appears that the US will be allowed to run deficits of historic proportions for years to come, but Ukraine is being told that our best case in four years isn’t good enough to help them out of a very big pinch right now. Something’s not right.
The current global crisis isn’t just economic – it’s also geo-political. Ukraine is a major transit country for Russian gas to Europe and it plays a central role in European-Russian pipeline politics. As recently as a few weeks ago a Russian-Ukrainian dispute effectively cut off supplies of natural gas to many countries in Europe in the dead of winter. Similarly, just this past week, as Ukrainian officials met with their Russian counterparts in Moscow to negotiate the terms of potential emergency financial assistance, NATO defense ministers met in Krakow to discuss how to keep Ukraine on track for ultimate NATO membership in spite of strong Russian opposition.
If the US, EU, IMF and others don’t pay a lot more attention to this crisis soon, then Ukraine’s ultimate choice will likely boil down to either letting its economy collapse and bringing down a lot of European banks and economies, or reluctantly falling four-square into Russia’s sphere of influence – at which point NATO discussions and EU-Russian relations will be changed forever.
As the US considers how to deal with the loss of the Manas airbase on the back of Russian financial assistance to Kyrgyzstan, one can only ask, with Ukraine’s economic future at risk – is anyone paying attention?
— Douglas Rediker


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