WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

by Vasily Astrov and Peter Havlik

The Russia-Ukraine conflict escalated on 25 November, this time in the Azov Sea near Crimea. On their way to the Azov Sea, three Ukrainian Navy vessels entered the Kerch Straits (which Russia considers its territorial waters after the annexation of Crimea in 2014) and, after refusing to accept the Russian escort, were fired on and seized by the Russian army, resulting in 23 Ukrainian crew members being arrested and three of them reportedly wounded. The incident prompted Ukrainian President Petro Poroshenko to impose martial law, which became effective on 28 November for a period of 30 days and is valid on the territory of ten provinces, most of which border either Russia or Moldova’s breakaway region of Transnistria, and are predominantly Russian-speaking.

Officially, the imposition of the martial law was in response to an increased military threat from Russia. This was the first direct confrontation between the Russian and Ukrainian militaries. However, irrespective of who is to blame for the latest Kerch Straits incident (and, not surprisingly, there are disputed narratives), it is hardly the real reason for the imposition of martial law in Ukraine. After all, Ukraine has been in a state of de factowar (or semi-frozen conflict more recently) with the Russian-backed separatists in Donbas for more than four years already, resulting, according to official sources, in more than ten thousand casualties and many more wounded. Both Donbas and Crimea have been facing increased economic blockade by Ukraine since mid-2014, but martial law has never been imposed until now. 

Martial law is to be seen in the pre-election context in Ukraine

More likely, the imposition of the martial law in Ukraine is to be seen in the context of forthcoming presidential elections, now scheduled for 31 March 2019. According to most recent polls, President Poroshenko is unlikely to be re-elected: he may not even make it into the second round and will in any case have little chance in the run-off against the current front-runner, the former Prime Minister Yuliya Tymoshenko. One reason for Mr Poroshenko’s unpopularity is the legacy of his government’s controversial economic policies (such as the transition to a flexible exchange rate, repeated hikes in gas tariffs for households and fiscal austerity in general, particularly under former Prime Minister Arseniy Yatsenyuk), which have made life harder for large segments of the population. In addition, the track record with other (including institutional and judiciary) reforms has been mixed at best. 

Another reason, however, which might be more relevant in this context, is that Mr Poroshenko has been often subject to criticism from the populist-nationalistic corner of political spectrum, including Ms Tymoshenko, for being ‘too soft’ on Russia. For instance, he supported the Minsk-II ceasefire agreements, which envisage extensive autonomy for Donbas and are thus seen by many in Ukraine as a betrayal of national interests. Mr Poroshenko has also opposed the idea of a visa regime for Russian citizens and was reluctant to cut trade ties with the separatist-controlled territories of Donbas, pointing (rightly) to the resulting economic losses (although he eventually imposed a trade embargo under the pressure from civil activists). In addition, the fact that he still owns a chocolate factory in Russia has helped little to change this ‘oligarch’ image.

Against this background, the latest incident in the Kerch Straits and the imposition of martial law in the face of allegedly increased threat from Russia are likely to be an attempt by President Poroshenko to win over parts of the nationalistic electorate ahead of the elections. However, we do not see this as an attempt by Mr Poroshenko to cancel elections altogether – something which he will not be able to get away with, given the strength of Ukraine’s civil society and paramilitary groups in particular.

For the Russian leadership, on the other hand, the political benefits of the incident in the Kerch Straits are less clear-cut. Although President Putin’s rating has plunged recently to around 50% (mainly on account of the pension reform), there are no elections in Russia in the foreseeable future, and Russia is hardly interested in more western sanctions without a clear offsetting political dividend. This is not to say that Mr Putin may not also see a bounce in his domestic popularity as a result of the incident, but we doubt whether it will be very significant. 

Economic consequences: Ukraine likely to be affected more than Russia

The Kerch Straits incident has had some immediate economic impact on both Russia and Ukraine, as the incident was seen as a sign of further geopolitical escalation in the region. However, much more important would be the medium-term economic impact, which is likely to be more severe in the case of Ukraine. 

In the case of Russia, the immediate impact of the incident has been very short-lived. After an initial dip, the Russian rouble has by now recovered to previous levels, and the Russian government placed on 27 November new sovereign Eurobonds worth EUR 1 billion at a 3% interest rate, of which three quarters were purchased by non-residents. At the same time, the Kerch Straits incident will likely see the United States impose a further round of sanctions on Russia. So far, the sanctions put in place by the US, EU and their allies since the Russian annexation of Crimea have been estimated to have cost Russia some 0.5 pp of annual economic growth. Potential targets for new sanctions thereby could be Russian sovereign debt, energy projects, and – in the worst case scenario – Russia’s access to the SWIFT payment system. Barring the worst case scenario, any of these sanctions will add to rouble depreciation (potentially by another 10-15%), resulting in higher inflation and diminishing purchasing power of Russian households. Also, the Russian Central Bank will likely raise the key interest rate from the current level of 7.5% at its next board meeting in December. All in all, the officially declared growth target of above 3% appears utterly unrealistic in these circumstances. At the same time, the rouble depreciation will also make the Russian economy more competitive and further boost its current account surplus (despite the recent slight drop of the oil price), while higher inflation will improve the budget performance. Both these factors will contribute towards Russia’s economic resilience to external pressure, albeit at the expense of the living standards of its population. 

For Ukraine, potential consequences could be arguably much more severe. Within two days of the Kerch Straits incident, the Ukrainian hryvnia weakened noticeably, by up to 10%, although the situation has started to stabilise more recently. In the medium run, increased checks on Ukrainian cargo ships by Russia in the Kerch Straits will slow down export shipments, which will have some economic costs. Even more importantly, the perceived risks of investing in Ukraine will go up further – even if the country will continue to enjoy both Western political and economic support, including cooperation with the IMF (the latter has already declared that martial law is in no way an impediment to such cooperation). Badly-needed inflows of foreign direct investment have so far remained disappointingly low: at about EUR 1,000 per capita, they are five times less than in neighbouring Poland, four times less than in Romania and even two times less than in Belarus.This, in turn, means that the desired goal of economic modernisation – despite the Association and Deep and Comprehensive Free Trade Agreements with the EU – will be less likely to be attained.

photo: iStock.com/Yakobchuk