The IMF-Ukraine deal will lead to Ukrainians paying one fifth of income on heating. There are also other measures which will hurt living standards.
A fragile Ukrainian society is unlikely to withstand this pressure and is likely to tear itself apart.
The result is that the European Union can be left without 1/5 of its gas supplies, leading to economic disaster.
Now that the spectacular part of this crisis is over, with the Crimea situation settled and the new government in Kiev settling in, the spotlight on Ukraine is slowly going to fade. The markets welcomed the news of the IMF deal by lowering the CDS rate for Ukrainian bonds (link). An economic war between Russia and the West is not likely to materialize. I believe the European Union is partially aware of its vulnerability in the event of economic hostilities breaking out.
It is a shame that people will now stop paying attention, because the dangerous part of this crisis is still ahead and policies towards Ukraine coming from the West will contribute to this danger. An Oxford report released a few weeks ago pointed out that military and economic confrontation between Russia and the West is unlikely to reach a point of mutual economic destruction. The main danger comes from Ukraine being unable to pay its bills, including its gas bills, which after the end of the agreement with Russia will increase by about 50% as of April 1. Russia would have no choice but to shut off the gas just as it did in previous situations when Ukraine was unable to make its payments. The Oxford report fails to account for an additional danger and that is the likelihood of Ukraine simply becoming entirely dysfunctional, ungovernable, unstable and eventually slide into civil war. The current IMF deal just ensured that the likelihood of this happening increased dramatically.
The IMF deal:
There is a rush to get $18 billion to Ukraine via an IMF agreement in order to prevent the country from defaulting on its debts this year. The total size of the loan will be about $27 billion when all lender parties are added up (link). This loan will be welcome news on one hand because it prevents the occurrence of a default and the low interest rates on the IMF loan will help by giving some interest relief to the Ukrainian government. On the other hand, the IMF demands that the government stop defending the currency and let it devalue. This means that the foreign currency IMF loan will be more expensive to pay back in hryvnia terms.
The worst part of the deal by far is a demand to end gas subsidies. The subsidies are supposed to be phased out by 2016, leading to a 50% increase in gas prices for residential customers by May of this year already. Non-residential customers will face a substantial hike as well. By 2016 Ukrainian families and businesses are supposed to pay for the full market price of gas, which thanks to the end of Russian subsidies for gas exports to Ukraine, which covered over one third of prevailing European average prices, will be a crushing burden given the low and declining buying power of the average Ukrainian. The thing that seems to me that everyone discounted here is that this deal will never survive to 2016.
A country already on the brink:
The Oxford report is very level headed in pointing to another gas payment dispute between Ukraine and Russia as the main danger to EU gas supplies. I have to agree that the price dispute scenario is the most likely one, but the second most likely scenario is by far the most dangerous one. I believe the second most likely scenario is an eventual social breakdown of Ukrainian society, which is already tense, angry and tired of suffering.
A price dispute can be settled. The EU could just opt to pay for Ukraine's bills, which would not be a happy outcome, but still happier than losing gas supplies transiting through Ukraine indefinitely. An escalation of economic conflict between the West and Russia can be diffused once the realization sets in that there is plenty of pain to go around as a result of it. But once violence breaks out and people on the ground enter the vicious cycle of vengeance that in turn leads to more appetite for vengeance it will no longer matter what Russia and the EU may want, because it will be out of their hands. Not to mention that both will be likely to pick sides, therefore will likely further serve to hurt their own interests rather than try to defuse the situation. I know that this does not make sense, but for reference on why the EU and Russia will most likely act like that, I recommend people read about John Nash's game theory.
Given the current tensions in Ukraine, it will not take much to take that country over the edge. Just to give an example of the mood prevailing at the moment, a phone conversation was intercepted in which Yulia Tymoshenko, Ukraine's former post-orange revolution prime minister and current presidential candidate suggests that Ukraine's eight million ethnic Russians should be killed (link). Yulia Tymoshenko is not considered to be part of the powerful extreme right-wing movement, which spearheaded the protests that ousted Yanukovic. This is what the Ukrainian mainstream looks like.
IMF deal just the thing needed to push Ukraine over the brink:
To be honest, I was baffled by the European Union policies towards Ukraine ever since it offered the partnership deal. They had to know that Ukraine public opinion was split on this issue. They also had to know just how much Ukraine needed that discount deal on gas from Russia. Yet they went ahead and pushed for it. Now they got it. Ukraine is likely to move towards the West. But one would think that given the importance of Ukrainian stability to EU well-being, everything possible would be done to ensure that the road towards the West will be successful.
The IMF deal which was agreed to this week, does the opposite. An increase in residential natural gas prices of 50% starting May 1, as well as other measures which will hurt an already impoverished population, is definitely not the way to go in a country where tensions are already very high and living standards already very low.
Ukraine's per capita GDP is only $3,860 according to IMF data. This is especially hard to take when bordering the European Union with a stagnated but high per capita GDP that is almost ten times bigger. Even Russia's per capita GDP is almost four times bigger. Average monthly wages in Ukraine are in the $300 per month range and jobs are not easy to find, and in addition, the expected depreciation of the country's currency is likely to further cut both wages and GDP per capita. The Ukrainian currency, the hryvnia, depreciated already over 20% year to date, and most people expect this trend to continue, especially given that one of the main demands of the IMF is to stop defending the Ukrainian currency.
Ukrainians did not pay a lot to heat their homes compared to Western Europe counterparts. Ukrainian households paid only 50% of what Polish households paid. The Ukrainian government covered about $12 billion per year in subsidies to make this possible (link). That is about $265 per person every year, or about $700 per household based on 17 million households estimated in 2008. This was a huge burden for the government to carry, but we also have to remember that average yearly household income is only about $5,000 (link), therefore, assuming that the full cost of gas will be passed on to households by 2016, we are looking at people paying almost a fifth of their incomes on heating their homes. This is why I wrote in my last article on Ukraine about the need for a program to get cheap subsidized gas to Ukraine for the next decade or so. There is no way that Ukrainians with plummeting incomes due to IMF measures will be able to afford to stay warm in the winter. We will likely see people out on the streets protesting again by this fall at the latest.
Protests, strikes and more political dysfunction and instability will lead to further negative consequences for Ukraine's economy, making it necessary for the government to cut even deeper. Discontent, anger, disappointment and frustration, mixed in with ethnic and cultural divides and the continued rise of the extreme right will only lead to one possible outcome, which is Ukraine tearing itself apart, and it will not be peaceful. Once the shooting starts, as we saw in Syria and Libya, it matters very little whether we would like peace or not. Events on the ground can take on a life of their own.
The implications for the European Union, which is the world's largest economy, is that it can end up losing about 2.5 trillion cubic feet of natural gas supplies per year, with few alternatives ready to fill the gap. That is almost a fifth of total demand. This time the supply interruption will be indefinite, given that the pipeline system may get destroyed in a probable civil war. The implication for the world is that the world's largest economy which is already very fragile due to lack of growth momentum, high unemployment, and a high debt/GDP ratio may get a shock to the system which it might not survive. That means economic pain all around. In this context, aid to Ukraine in the form of yearly subsidized gas deliveries, with the subsidy receding gradually every year, may be a small price for the West to pay.
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