Country in a state of civil war as economy implodes.
This article originally appeared at Forbes.com.
Ukraine is the very definition of the word “inevitable” — that which cannot be avoided.
Ukraine is going broke.
It may lose more of its territory.
Investors are running for the door, betting that things are going to get worse. All of this is now unavoidable.
The market used to think the Ukraine crisis would cool down by the December. All bets for that outcome are now off the table.
Ukraine is shrinking, in more ways than one.
On March 16, 2014, Ukraine saw a large chunk of its territory annexed by Russia. The Crimea peninsula, then an autonomous region of the country, voted to secede after a perceived anti-Russia government took over Kiev. Crimea is dominated by ethnic Russians.
Now, two regions continue to keep Ukraine in the news: Luhansk and Donetsk. Leaders there have decided it is best to become autonomous republics too. Like Crimea, this may very well be another way of saying goodbye to Kiev, if not Ukraine altogether.
Even if territorial integrity remains, Ukraine’s finances are deteriorating. The nation’s currency, the hryvnia, has lost 46.92% of its value so far this year, falling rapidly after the Central Bank decided on Nov. 4 to abandon its 12.95 peg to the dollar. The BNY Mellon Ukraine Index is down 40.18% year-to-date, much of it coming after the Bank’s decision. It’s panic time for Ukrainian money.
“Economically, Ukraine is being transmogrified into a failed state,” says Vladimir Signorelli, co-founder and senior international economist at Bretton Woods Research in New Jersey.
Prime Minister Arseniy Yatsenyuk has stuck with his policy of austerity since taking over the country in February. He has followed the International Monetary Fund’s prescription of shock therapy policies of tax increases, devaluation and spending cuts.
Monetarily, “Ukraine is beginning to look like an IMF basket-case from South America or Africa from the 1970s and 80s,” Signorelli says, adding he expects inflation to go even higher than the 19.8% levels hit last month.
According to Reuters, one third of Ukraine’s deposits have been withdrawn from the banking system since Sept. 21, or nearly $6.8 billion. Ukraine’s foreign reserves stand at a mere $12.6 billion as of October.
Not surprisingly, the probability of Ukraine defaulting during the next five years, according to the credit default swaps market, is now greater than 70%.
To make matters worse, Ukraine still owes Russia’s state owned natural gas company, Gazprom , $1.6 billion by year-end. Meanwhile, the IMF’s next loan tranche — of its $17 billion dollar bailout program – is expected to be delayed, possibly into next year. So where is this country going to get money to keep its government afloat?
Russia reportedly holds about one fifth of Ukrainian sovereign bonds, with frontier markets giant Franklin Templeton owning about 40% of Ukraine’s debt.
A default scenario for Ukraine, which was not among the assumptions in the European Central Bank’s recent stress tests of 130 banks, would create significant market volatility and introduce the threat of contagion in the E.U.
Back in April, European banks owned nearly $1.4 trillion of loans to Eastern European countries. Loans to Eastern Europe comprise approximately 35% of total foreign loans by Austrian banks, 27% by Italian banks, and 18% to 20% by Greek and Portuguese banks.
“A Ukraine default scenario could become analogous to the Mexican Crisis in 1982. Similar to the way Fed Chairman Paul Volcker was able to monetize Mexico’s debt in 1982, thereby quickly reflating the dollar and taking off the table a sovereign default by the Mexican government, we believe there is the potential for a similar monetization by the ECB should Ukraine teeter on the brink of default,” Signorelli says.
Crimea is now part of the Russian map. A number of regions along the eastern Ukraine border, starting with Luhansk and Donetsk, are on the verge of following in Crimea’s footsteps.
Last week, the top U.S. commander for NATO said Russia was effectively working to re-draw the Ukrainian border. U.S. Air Force General Philip Breedlove said on Nov. 3 that “Hybrid war is what we are coming to call what Russia has done clearly in Crimea and in eastern Ukraine. I’m concerned that the conditions are there that could create a frozen conflict,” one that ultimately sees more regions either become autonomous from Kiev, with greater allegiances to Russia, or building on a civil war that will eventually lead to a secession.
Over 4,000 people have been killed in military skirmishes between pro-Russia fighters and the Ukrainian military. Russia denies funding the militants, thoughWashington insists on evidence of Russian troop movement heading into Ukraine. Russia usually says the vehicles are carrying humanitarian aid.
One thing is certain: Russia, Ukraine and the E.U. cannot agree on how to stop fighting. The Sept 5 cease-fire agreement between Ukrainian president Petro Poroshenko and Vladimir Putin is basically dead. Instead of broader negotiations, escalation appears to be at hand with separatists unwilling to recognize Kiev
On Nov. 4, Poroshenko ordered more troops to the eastern cities despite the fact that the U.S., E.U. and Russia have agreed that the disposition of the eastern provinces cannot be resolved on the battlefield.
Meanwhile, Poroshenko has also suspended all budget subsidies earmarked for the territories, basically starving them of a federal lifeline.
Yatsenyuk announced this week that $2.6 billion in state support, including benefits and pension payments to retirees, would be withheld from Donetsk and Luhansk until the fighting ceases. The move is unlikely to pacify those already against the government.
A partition of the country is becoming more likely. If so, it could stretch from Luhansk in the northeast all the way down to the Kherson province in the southeast, on the Crimean border.
Ukraine’s problems may be bad for European banks and frontier market bond holders like Templeton. It is even worse for Russia.
The Ukrainian crisis has led to a direct weakening of the Russian ruble — down 41% year to date. Sanctions on Russian banks and energy companies like Gazprom became active on June 28, hurting business sentiment and sending the Market Vectors Russia (RSX) exchange traded fund down 21.09%.
“We want to see this crisis end, too, ” Putin told a gathering of more than 1,500 investors and executives during last month’s Russia Calling! investor conference in Moscow. “ We consider the Ukrainians close family. We share cultural and religious history and want to remain a close ally to Ukraine,” he said.
Even worse for Russia has been the coincident decline in oil prices, which appears to be reflecting the collision of increased supply and falling demand in China and Europe. Falling oil prices has added another risk to the Russian economy, which is highly reliant on oil for public finances.
Meanwhile, an escalation of the Ukraine crisis is more inevitable than not.
This will also hurt Russian investor, but will surely push Ukraine’s finances to the brink and possibly redraw the Ukrainian map longer term.