Political events in Ukraine and diplomatic tensions with Russia are filling the headlines this week, but behind these recent developments is a story of persistent economic weakness. Although a change of government in Kiev may eventually bring needed reforms, in the short run it can only worsen the economic situation. Bloomberg reports that Ukraine's interim president, Oleksandr Turchynov, has said that the country's economy is "spinning out of control" and has entered a "pre-default situation." All this raises the question of whether economic collapse in the Ukraine will drag the already faltering Russian economy down with it.
Let's look at some data. The first chart below shows annual growth rates of real GDP for the two countries, including IMF preliminary data for 2013 and forecasts, made before the latest crisis, for 2014. As we see, both countries prospered in the early and mid-2000s but suffered sharp recessions during the global financial crisis. Neither has managed to return to its previous growth rate. In the past two years, growth has slowed further. The IMF thinks final data for both countries will show slight positive growth for 2013, but some other sources suggest that both are in or close to actual recession. Before the latest events, the IMF was moderately optimistic about recovery in 2014, but that hope seems less likely now.
Energy is a big part of the nexus between Russia and Ukraine. Russia is the world's largest exporter of oil and natural gas. Ukraine is one of the world's most energy-dependent economies, and one of the least energy efficient. Data from the World Resources Institute show that Ukraine uses 3.5 times more energy per dollar of GDP than Germany, 2.5 times more than the United States, and about 10 percent more than its also inefficient neighbor to the north.
As a result, both countries are highly sensitive to movements in world oil prices, but in opposite directions. Higher prices boost the Russian economy but weaken that of Ukraine, and vice versa. As the next chart shows, energy prices have trended moderately downward over the past two years.
Unfortunately for Ukraine, the prices it pays for Russian energy are influenced as much by politics as by economics. A lose-lose scenario could develop if a continued downtrend in prices placed a drag on the Russian economy, while Russia, displeased by political events in Ukraine, failed to pass along lower world prices to its neighbor. The prices Ukraine pays could rise sharply if Russia were to cancel a concessionary gas deal it recently concluded with now-ousted Ukrainian President Viktor Yanukovych.
Another complicating factor is the weak budgetary position of both countries, shown in the next chart. Ukraine's budget has been in the red as long as anyone can remember, but Russia's federal coffers used to overflow. The combination of high oil prices, rapid growth and plenty of money to spend explain a big part of Vladimir Putin's political popularity in the early 2000s. In the last couple of years, however, Russia's budget has come under strain. The budgetary effect of stagnant global oil prices has been compounded by a steady rise in the cost of developing new reserves offshore and on land in remote Arctic regions. Bloomberg estimates that the country needs a Brent crude price of $118 per barrel to balance its budget, but Brent has not hit that level for a couple of years now.
The geostrategic upshot is that Russia could suffer whichever way political events in the Ukraine turn out. If a pro-Russian regime were to return to power, Putin would almost certainly have to pour in cash to prop it up. On the other hand, if a pro-Western government takes hold, Putin could put it under an energy squeeze and tighten controls on Ukrainian imports, as it already did for a time last fall. Neither scenario would do the Russian economy any good. Compete chaos in Ukraine - competing governments in the East and West, or, heaven forbid, military intervention - would be even more harmful to the Russian economy.
Recent trends in currency markets reflect the pessimistic short-term outlook. Both the Russian ruble and the Ukrainian hryvnia have recently reached new lows, as shown in our final chart. Ukraine's central bank was forced to float the hryvnia last week, explaining that currency's sharp plunge, but the ruble has followed it down despite the efforts of the Russian central bank.
Currency markets, of course, are highly sensitive to short-term developments. Over the longer term, Ukraine's prospects look brighter. If political stability returns under a pro-Western government, Ukraine could quickly enter into a broad agreement with the European Union. Such a pact was negotiated and ready to sign last fall, before Yanukovych backed out, touching off the current political crisis.
In the weeks following Yanukovych's about face, the EU refused to get into a bidding war with Russia over who would offer the best aid package. However, it seems likely that a new pro-EU government in Kiev would be able to strike an aid deal. U.S. Treasury Secretary Jacob J. Lew is reported to have said that the U.S. was prepared to help Ukraine return to a path of democracy, stability and growth. U.K. Chancellor of the Exchequer George Osborne has agreed. "We are here ready to help just as soon as there is someone at the end of the telephone," Osborne said in an interview Saturday in Sydney. "We should be there with a checkbook to help the people of Ukraine rebuild their country."
If reforms improve Ukraine's economic climate, private investment should also pour in. Some of it would go toward development of Ukraine's tantalizing reserves of shale gas, perhaps ending its energy dependence on Russia. However, any such favorable developments remain speculative until a new, fully legitimate government takes firm root in Kiev.