- All the ingredients are in place for a major conflagration: two world powers pitted against one another with no apparent face-saving exit for either. It won’t happen. But….
- Putin will send troops into Ukraine to “safeguard” Russian-speaking citizens.
- Even if Putin is somehow satisfied, his actions might have launched a civil war in Ukraine.
- Even if Ukraine gets beyond Putin and civil war dangers, the IMF agreement will cause hardship and again threaten political stability.
What Does Putin Want?
I start by using history to speculate on what Putin’s intentions are and what the West could do to put him at rest. Return to the Cold War: The USSR’s “bloc” included the former members of the USSR: Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Tajikistan, Turkmenistan, and Uzbekistan. It also included: Albania, Bulgaria, Czechoslovakia, East Germany, Hungary, Poland, and Romania.
Does Putin feel need to re-establish the USSR? He might. But it is out of the question. Certainly Azerbaijan, Bulgaria, Estonia, Georgia, Hungary, Latvia, Lithuania and Poland would have absolutely no interest in such an alliance.
So let’s consider a more realistic proposition: how about allowing Putin to have a sphere of influence/buffer zone on Russia’s borders? As indicated in the following table, there are nine countries bordering Russia. Of the countries listed, all but Finland were “on Russia’s side” during the Cold War, even China. Western pressures have whittled away this Russian “security blanket”: the first three in the Table are NATO members.
Countries Bordering Russia
Source: International Monetary Fund
Western attempts to “recruit” these countries have made Putin uneasy. Why has the West done this? A continuation of Cold War politics? Well, it has spooked Putin. Why not let Russia establish a new sphere of influence, including Ukraine? Sadly, this won’t happen. At this point, Western nations have staked too much on a Ukraine “democracy” to pull back.
So Putin’s intentions will remain a real danger, threatening an armed conflict with the West. But it won’t happen. While Putin’s intentions are not clear, neither the US nor the European nations have the stomach for a direct armed conflict with Russia.
Russia is Satisfied But….
Let us make the unlikely assumption that Russia will be satisfied with the seizure Crimea. It is quite possible that already, Russia’s actions have let “the genie is out of the bottle” and a Ukrainian civil war will ensue. History has many stories of people who dislike one another being kept at peace by a dictator, e.g., Tito – Yugoslavia, Saddam Hussein – Iraq. But once they were gone, civil wars took place. Think of Yanukovych with Russian backing as the “dictator equivalent” that has kept Ukraine at peace. Once the dictator is gone, chaos – a civil war. And the history of civil wars is not good. And an all out civil war is close in Ukraine.
The IMF Agreement
But let us stretch credulity further and suppose that somehow, Russia is satisfied and the citizens agree to decide their future at the polls. We then have the IMF agreement. What would it mean?
What has happened in Greece is instructive here. In order to get IMF funds, Greece had to reduce its government deficit. So under pressure from the IMF and Germany, the Greek government deficit fell from 15.6% of GDP in 2009 to a projected 3.3% this year. It was understood that this deficit reduction would reduce purchasing power and increase unemployment. In fact, the International Monetary Fund (IMF) did a study of fiscal actions taken to reduce government deficits in 15 advanced countries in the 1980-2009 period. It concluded: a fiscal consolidation equivalent to 1% of GDP led on average to an increase of 0.3 percentage points in the unemployment rate.
What actually happened in Greece? The IMF findings were way off: Greece’s unemployment rate was 9% in 2009. It is now over 27%! The following is taken from the transcript of an IMF press conference:
Questioner: Ms. Lagarde, four years into the program and the citizens of Greece feel that things are going bad and bad and bad and that they have no hope. Sixty percent of the young people are unemployed and they feel that they have no future in Greece. The only thing that we have in our country is austerity, austerity, austerity. Can you give me one reason why the average Greek citizen has to have hope?
Ms. Lagarde: I share your concern and the concern of the Greek people, because I know about those unemployment numbers and I know that it particularly affects young Greek people, those who went to school, went to university, and are just bumping their heads against the wall of unemployment. But we are seeing some improvement. We are finally for the first time seeing positive growth, right?
So how is what happened in Greece applicable to what can be expected in Ukraine? Details of the reforms the IMF will insist on are not yet publicly known. But the leader of the IMF mission to Ukraine highlighted the following at a recent press conference:
- The IMF program will require a reduction in the government deficit;
- The currency peg will have to be removed so the Ukraine currency will weaken;
- Energy subsidies will be reduced/eliminated.
Each of these actions will absorb purchasing power causing aggregate demand to fall and unemployment to increase:
- A government deficit reduction can only happen via lower government expenditures or higher taxes, both of which will reduce aggregate demand and increase unemployment.
- In recent months, the Hryvnia (Ukraine currency – UAH) has weakened against the US dollar. Ukrainians now have to pay 12 UAH for every US dollar whereas a few months ago, a dollar only cost them 8 UAH. This means Ukrainians have to pay more for imports, thereby reducing available purchasing power for other goods causing unemployment to rise.
- Lower energy subsidies will also mean a reduction in purchasing power and higher unemployment.
FocusEconomics estimates that Ukraine’s fiscal deficit now exceeds 5%. It estimates that the country’s unemployment rate is 8%. Implementation of the IMF agreement will cause it to rise substantially. And keep in mind that Ukraine is effectively “at war” now. That is never good for an economy: FocusEconomics reports on what a number of international banks and other institutions are predicting for Ukraine – one prediction is that investment will fall by 11%. It will probably fall more.
In short, implementation of the IMF program in the context of an already slumping economy will make matters worse. And this will mean serious problems for a new government trying to curry favor from its citizens.
Conclusions and Investment Implications
There does not appear to be a good outcome for Ukraine: Putin’s intentions are not clear. Even if he is happy with Crimea, a Ukrainian civil war likely. And even if the IMF gets to implement its program, the government will become extremely unpopular, even in the western parts of the country.
The following ETFs have fallen sharply since the beginning of the Ukrainian crisis: iShares MSCI Emerging Markets Eastern Europe Index Fund (ESR), iShares MSCI Russia Capped Index Fund (ERUS), Market Vectors Russia Small-Cap ETF (RSXJ) and SPDR S&P Russia ETF (RBL). More declines are likely.