I have started innumerable draft posts about Ukraine over the past few weeks, but there was little room for anything but speculation. The tensions and factors underlying the ‘Crimean Crisis’ were pretty clear to see, but the interplay was too fast, and Russia’s actions and reactions were largely inscrutable. As of this moment, I believe that the constraints that Russia is operating under are clear enough that the path to a resolution for Ukraine is emerging from the mists.
I think it is pretty clear to all that Russia has fomented a state of insecurity, first in Crimea, and now in the Eastern and Southern regions of Ukraine. It is equally obvious that the ethnically Russian ‘seperatists’ in Donetsk, Luhansk, etc. are not supported by a majority, or even a plurality of their Russian and Ukrainian speaking populace. There is the telling fact that Russia is back-pedalling furiously on their thinly veiled threats to ‘intervene’ on behalf of Russian speakers in the East. The Separatist protesters appear to have been left hanging by Russia, and Arseny Yatsenyuk has neatly disarmed them by meeting what appears to be their main demand, that Kiev cede ‘Economic Independence’ to the Region, along with taxation powers.
The Moscow Times reported that “DONETSK/LUHANSK — Ukraine’s prime minister on Friday offered to boost local powers in the regions in an effort to undercut pro-Russia separatists who have occupied official buildings in Russian-speaking cities in eastern Ukraine.”. This is a genuine offer, with Machiavellian implications. When the USSR collapsed, Ukraine’s inheritance included a huge Soviet era coal mining Industry, and a number of creaking heavy Industries based upon Soviet era products and industrial processes. The only world market for the shoddy Industrial production was Russia. There was (and is) no market for the expensive and low-grade coal mined in the Donbass, so Ukraine’s Government was faced with a stark choice. Either subsidise the East with massive energy subsidies, and State support of the coal mining sector, or face mass un-employment and economic collapse in the East. With the Presidency of Ukraine in Eastern hands, Ukraine’s national Government conceived of two measures to support the Eastern economy. The State owned Coal mines were kept on life support, despite massive ongoing losses. The State owned gas utilities fixed the price of Natural gas at 20% of the ‘market’ rates charged by their friendly Russian neighbors. yes, that’s right, Natural gas enjoyed an 80% subsidy in a Nation that could not afford hospitals, schools, and the things that actually support viable economic development.
Ukraine has been reaping the bitter harvest of politically driven subsidies ever since. There is a gaping hole in Ukraine’s budget, that cannot possibly be stopped so long as energy is so expensive to buy, and sells at such a deep discount. With subsidies in place, Ukraine consumes about 55 billion cubic meters of natural gas in a ‘normal’ year. About 20 billion cubic meters are domestically produced, and the balance is imported from Russia and Turkmenistan. With the cost of gas imported from Gazprom sitting at $0.50 per cubic meter, the effective subsidy to Ukraine’s Industry is about $8billion per annum, the subsidy to households is about $6 billion, the subsidy to Government and co-operatives is about $4 billion, and about 9% of total gas used is wasted through ‘leakage’ (presumably including un-metered gas stolen by the Oligarchs). The value of the ‘leaked’ gas is about $2.75 billion. The total costs to the Kiev Government should be on the order of $20 Billion per annum. The coal subsidies are inscrutable. Aside from direct subsidies, every lump of coal sold, every tool or machine purchased for the mines passes through the hands of well-connected ‘middlemen’ who take a piece of the action, or simply fake invoices and pocket the cash. The Ukraine signed a deal for loan guarantees from the EU in March that requires Ukraine to eliminate half the gas subsidy immediately. When you consider the costs of the subsidy, and the parlous state of Ukraine’s finances, that is no surprise.
What Yatsenyuk has offered to the separatists suddenly takes on a new light. The interim Government has to balance their books if they want to have any hope of taking advantage of the EU eliminating tariffs on Ukrainian goods. They have a huge political problem standing in their way. The only way they can avoid ongoing insolvency is if they kill the subsidies that keep the Donbass economy afloat. Under the current division of powers in Ukraine, Kiev would face accusations of deliberately undermining the East’s economy should they unilaterally cancel subsidies. I bet that Yatsenyuk couldn’t believe his luck when Russian supported separatists demanded a devolution of economic and taxation powers from the Kiev Government. It is true that the separatists are not representative of the East, but Russia has set them up on a pedestal as freedom fighters and loyal Russians. That provides abundant cover for Yatsenyuk to position Kiev as a very moderate consensus seeking regime. He can reject outright the demands for referendum on separation, and do so in the knowledge that Russian speakers who do not want separation will agree. He can accede to the demands for economic independence by exercising a neat political trick I first saw used by the Mike Harris PC Government in Ontario. Jim Flaherty prepared a wonderful gift to the city of Toronto by transferring several $Billion worth of social housing to the City Government. It looked mighty generous of him, but of course the value of an asset you cannot sell is not $billions, it is zero (or less). Toronto was obliged to take on the costs of maintaining and providing subsidized housing to tens of thousands of people, and it has been a quarter billion hole in Toronto’s budget ever since. For Ukraine, the calculus is similar. Eastern Oligarchs, and would be regional governors will look no further than the enormous opportunity for corruption presented on a platter. The populace will be mollified by the ‘gift’ of $Billions worth of coal mines, and control of local gas utilities. The fiscal fig leaf of transferred taxation powers to the region will hide the transfer of subsidies from the entire nations tax base to the region directly receiving the most subsidies. Kiev will draw a sigh of relief, and wash their hands of the expense, and responsibility for the East’s well-being.
What about Russia? By reading the papers, and world-wide media, one would believe that the ‘chess master’ in the Kremlin holds all the cards, and wants to score some kind of geopolitical ‘win’ by securing direct control of Eastern Ukraine. I beg to differ. The Kremlin is constrained by their own propaganda. Vladimir Putin had approval ratings of about 32% two months ago. In 8 short weeks, the Kremlin has asserted control over virtually all the Russian language media, and promoted Russia’s role as guarantor of Russian minorities in the former USSR. This was instrumental in winning massive approval ratings for Putin in the wake of Crimea’s annexation. The direct economic price is high, with annual subsidies to Crimea expected to top $5.5 billion per year, but you cannot make an omelette without breaking a few eggs. In addition, Russia has signaled their intention to make Ukraine pay for the Crimea by upping their gas charges by a comparable amount. The direct cost to Russia of annexing Eastern Ukraine is an order of magnitude higher though. This is the root of Putin’s current dilemma. The Russian people expect no less than the annexation of swathes of Ukraine in support of separatists and protestors. Russia cannot possibly meet the expectations of Russian speakers in Donetsk. Russian media reported on the EU sanctions that would be imposed on Russia if Russia’s military crosses the borders. They will cripple the value of the Ruble by trashing capital flows in and out of Russia, and cause the deepest recession Russia has seen since Yeltsin was in power. Putin is waaay out on a shaky limb. His regimes survival could well depend upon a face-saving measure to step back from the morass. Yatsenyuk can hand a lifeline to him by ‘accommodating’ separatist demands for economic independence. The painful phasing out of Ukraine`s gas subsidies can be blamed with much justice on the Gazprom gas price hikes, rather than the EU’s loan conditions. Russia can bluster and make political demands of Ukraine, but what leverage do they really possess? The threat of military conquest? Ukraines response can effectively be ‘Do your Worst’. Either Russia will invade and be left holding the baby whilst fending off economic sanctions, or Russia will accede to a devolution of economic control and the baby will be left holding itself. Win-Win for the Interim Government and its successor in Kiev.