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December 12, 2013

Ukraine's Trade Deal About-Face From EU to Russia Fraught With Risk

When Ukraine President Viktor Yanukovich said last month that he would not be pursuing a trade/political agreement with the EU that the two entities had been negotiating for six years, the news was not well received by the West or by a large portion of Ukraine's citizens.

Demonstrations broke out, likely far exceeding any protests Yanukovich might have expected, and the dispute rages on even after an early December meeting between Yanukovich and Russian President Vladimir Putin to discuss deepening ties with the country's former Soviet master.

Politics, however, isn't the only concern investors should have. Aside from the failure of an agreement that took so many years to broker, there are other worries that range from downgrades to industries to a possible default.

Russia had not been happy at the possibility of Ukraine's defection to the West, and Putin brought pressure to bear on Ukraine that ranged from sticks—the possible cutoff of natural gas in the midst of a Ukrainian winter (something Russia has already done repeatedly, so no idle threat) and constraints on Ukrainian exports to Russia on which the smaller country depends—to carrots: debt forgiveness to Gazprom in the amount of $1.3 billion, duty-free imports, and subsidies.

While Russia and Yanukovich's spokesman both insist that a deal between the two has not yet been inked, it's all but certain that it will. That is unless protests turn the tide. Not only were Yanukovich's attempts to meet EU requirements for the agreement desultory, at best, but the Ukrainian president also began to push for more from the EU: more money, more concessions, a standby loan of $15 billion from the International Monetary Fund with no strings attached rather than just the possibility of loans conditional on gas price reforms. The EU refused to budge from the already-negotiated agreement, and Yanukovich simply walked away.

Although he has since said that he wants to keep the door open to closer ties with the EU, and even suggested three-way talks among Ukraine, Brussels and Moscow, the EU has nixed the idea, saying that the agreement it had brokered with Ukraine was bilateral and Russia had nothing to do with it.

Should Yanukovich sign a customs union agreement with Russia it will severely curtail his country's ability to make any trade agreement with the EU or any other entity. The EU agreement, on the other hand, would have left Ukraine free to pursue some sort of agreement with Russia regardless.

The massive protests that erupted in Ukraine after the news broke were met with violence by law enforcement. But instead of dispersing, demonstrators are now threatening Yanukovich's hold on power, particularly since the protesters now say they will not negotiate with Yanukovich unless he fires his government and installs one that is actually committed to pursuing closer ties with Europe instead of Russia. They are also demanding new elections.

Demonstrators toppled a statue of Lenin and broke it up with hammers, in a symbolic attack on Moscow; also during the weekend, both European Commission President Jose Manuel Barroso and U.N. Secretary-General Ban Ki-moon spoke with Yanukovich about the situation in the country.

Repercussions are echoing throughout the Ukrainian economy. Not only has Russia acted to ban imports of chocolate from Roshen, a Ukrainian producer, but it has tightened border checks on other imports from the country. Its steelmakers are worried over the abandonment of the EU deal, since the EU was one of its key markets and Russian steelmakers have sought to have imports of Ukrainian steel limited to protect their own production.

Bond yields are up, on concerns that the country could default—its cash reserves are only equal to about three months' worth of its scheduled debt payments—and its credit default swaps are up as well. Currency took a hit as protests swelled, providing the potential for a second "Orange Revolution". The first took place in 2004–2005 and there is also the potential for capital curbs, which would make it difficult even for bondholders to receive coupon payments if hard currency is limited or halted from leaving the country.

While all appears bleak on the economic front for Ukraine at present, amid all the turmoil is a bright spot, as pointed out by Charles Seville, director, sovereigns at Fitch Ratings. In research Seville said, "Ukraine's announcement that it was halting preparations to sign an Association Agreement with the European Union threatens to leave in limbo a process that, if fully implemented, would strengthen Ukraine's credit profile,” according to Fitch Ratings. But the retreat may also reduce the more immediate risk of Russian economic retaliation, which has already affected Ukraine's exports in 2013, said Fitch.

Still, there are troubled waters ahead. Fitch had already downgraded Ukraine's credit outlook to negative months ago, saying, "Ukraine has one of the lowest external liquidity ratios among 'B' rated sovereigns and this is a key credit weakness." It also downgraded Ukraine "to 'B-' from 'B' this month. This reflected the sovereign's fragile external financing position and constraints on its ability to borrow in foreign currency to refinance heavy external debt repayments in 2014-2015, in the absence of an IMF agreement. These remain key rating drivers, and the risks they present are reflected in the continuing Negative Outlook on the rating."

While the EU agreement would have brought progress on a number of fronts, there is a lessening of negatives to the country's turning its back on the EU at present. "Signing and implementing the EU agreement, which includes a deep and comprehensive free trade agreement (FTA), would be positive for Ukraine's sovereign credit profile. The FTA includes ambitious reforms in areas such as standards and public procurement that could unlock efficiency savings, promote FDI [and therefore ease pressure on reserves], and boost flagging exports to Europe. These benefits would exceed those of Customs Union membership," said Seville.

However, by not signing the EU deal, Ukraine probably avoids additional Russian pressure on its exports and its current account deficit, which stood at 8.2% of GDP in September, according to Seville.  Russia's share of Ukraine's exports dipped in the first nine months of 2013, as a result of trade disputes. Last year, goods exported to Russia were worth USD17.6bn, slightly exceeding exports to the whole of Europe, which were worth USD17.4bn (including exports to non-EU member states). Russia takes most of Ukraine's higher value-added goods, Seville said.

"Ukraine could be offered another opportunity to sign the EU Association Agreement at some point. Its call for three-way talks involving the EU and Russia indicates that the government wants to keep an EU deal as an option and capitalize on the legislative preparations it has already made,” he said, warning that such an event was not likely to occur for some time, thanks to European Parliamentary elections in 2014 and Ukraine's own presidential election set for April of 2015.

That is, unless the demonstrators get their way.

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