Ukraine & Europe: What Should Be Done?

Because of the structural defects of the euro, the European authorities have had to become masters of the art of muddling through one crisis after another. This practice is popularly known as kicking the can down the road although it would be more accurate to describe it as kicking the can uphill so that it keeps coming back. But Europe now faces at least five crises at the same time: four internal ones—the euro, Greece, migration, and the British referendum on whether to remain in the EU—and an external one, Russian aggression against Ukraine. The various crises tend to reinforce one another. Both the public and the authorities are overwhelmed. What can be done to arrest and reverse the process of disintegration?

Obviously five crises cannot all be solved at the same time. There is a need to give preferential treatment to some of them without neglecting any. I have been strenuously arguing that Ukraine should be given top priority. The internal crises tend to divide the European Union into debtor and creditor countries, the UK and the Continent, as well as “arrival” and “destination” countries. By contrast, an external threat like the Russian aggression against Ukraine ought to unite the European Union.

There is a new Ukraine that is determined to become the opposite of the old Ukraine. The old Ukraine had much in common with the old Greece that proved so difficult to reform: an economy that was dominated by oligarchs and a political class that exploited its position for private gain instead of serving the public. The new Ukraine, by contrast, is inspired by the spirit of the Maidan revolution in February 2014 and seeks to radically reform the country. By treating Ukraine like a second-class Greece that is not even a member of the European Union, Europe is in danger of turning the new Ukraine back into the old Ukraine. That would be a fatal mistake because the new Ukraine is one of the most valuable assets that Europe has, both for resisting Russian aggression and for recapturing the spirit of solidarity that characterized the European Union in its early days.

I feel I am in a strong position to make this argument because I have an intimate knowledge of the new Ukraine through both my Ukrainian foundation and my own involvement in the country. At the beginning of this year, I developed what I called “a winning strategy for Ukraine” and circulated it among the European authorities. I also outlined this strategy in these pages.^*

I argued that sanctions against Russia are necessary but not sufficient. President Vladimir Putin has developed a very successful interpretation of the current situation with which to defend himself against the sanctions. He claims that all of Russia’s economic and political difficulties are due to the hostility of the Western powers, who want to deny Russia its rightful place in the world. Russia is the victim of their aggression. Putin’s argument appeals to the patriotism of Russian citizens, and asks them to put up with the hardships—which include financial instability and shortages—that the sanctions cause. The hardships actually reinforce his argument. The only way to prove Putin wrong is by establishing a better balance between sanctions against Russia and support for Ukraine.

My “winning strategy” advocates effective financial assistance to Ukraine, which would combine large-scale budgetary support with affordable political risk insurance, along with other incentives for the private sector. Coupled with the radical economic and political reforms that the new Ukraine is eager to introduce, these measures would turn it into an attractive place for investment. The linchpin of economic reforms is the restructuring of the state gas monopoly, Naftogaz, moving from the current artificially low prices for gas to market-determined prices and providing direct subsidies for gas purchases to needy households.

The political reforms center on establishing an honest, independent, and competent judiciary and media, combating corruption, and making the civil service serve the people instead of exploiting them. These reforms would also appeal to many people in Russia, who would demand similar reforms. That is what Putin is afraid of. That is why he has tried so hard to destabilize the new Ukraine.

If Ukraine’s allies combined the sanctions against Russia with effective assistance for the new Ukraine, no amount of propaganda could obscure the fact that Russia’s economic and political problems are caused by Putin’s policies. He could, of course—in clear violation of the Minsk II agreement of February 11, 2015—prevent the new Ukraine from succeeding by launching a large-scale military offensive. But that would be a political defeat for Putin. It would reveal the falsehood of his interpretation of the conflict with Ukraine; and a military conquest of part of eastern Ukraine would place a heavy economic and political burden on Russia.

President Putin has gained a temporary tactical advantage over Ukraine because he is willing to risk large-scale and even nuclear war while Ukraine’s allies are determined to avoid a direct military conflict with Russia. This has allowed him to alternate between hybrid war and hybrid peace at will, and he has exploited this advantage to the full. Ukraine cannot prevail over Russia militarily because President Putin can mobilize more and better-armed forces than Ukraine and its allies on the battlefield. Ukrainian President Petro Poroshenko had to learn this lesson at great cost. But surely Europe and the US can outbid Russia financially.

This argument for European and American support had some impact among Ukraine’s allies but my assertion about their willingness to provide large-scale financial support proved to be wrong, at least until now. I attribute this to two factors. One is the Greek crisis, which was an outgrowth of the euro crisis and set a bad example for the European Union to follow in Ukraine. The other is the Minsk agreement itself that, for reasons explained below, induced the European authorities to continue keeping Ukraine on a tight financial leash.

The euro crisis has created an acute shortage of funds for budgetary purposes. The EU budget of €145 billion is only about one percent of the GDP of the member states, but Europe is barely growing and member states are clamoring to reduce their contributions to the EU budget. The shortage of funds is particularly acute in the eurozone, which has no budget of its own.

The European authorities under German leadership mishandled the Greek crisis. They started out by providing emergency loans to Greece at punitive interest rates; they imposed their own program of reform and micromanaged it instead of allowing Greece to take ownership and control of the reforms; and they always lent too little too late. The Greek authorities are far from blameless but the primary responsibility lies with Germany because it was in charge. The Greek national debt has become unsustainable but the European authorities are now unwilling to write down their loans to Greece.

A dispute over this point between them and the IMF has greatly complicated the recent and current negotiations. The authorities have corrected some of their mistakes—for instance, they insist on “bailing in” rather than “bailing out” bondholders (bailing in requires bondholders to write down the value of their bonds). But they repeat others. The biggest mistake has been to treat Ukraine in the same way as Greece. The new Ukraine seeks to be the opposite of Greece and, although it is not a member, it is actively defending the European Union against a military and political threat from Russia.

As I argued in my original case for a winning strategy, helping Ukraine should be treated as a defense expenditure. Seen in this light, the current €3.4 billion contribution from the European Union to the IMF-led rescue package for Ukraine is wholly inadequate. The European Union has the appropriate fiscal tool—the Macro-Financial Assistance mechanism (MFA)—that, with appropriate modifications, could be used to overcome the shortage of funds in the EU budget. The MFA allows the European Union to borrow funds from the financial markets, making use of its almost completely unused triple-A credit.

The EU budget has to allocate only 9 percent of the amount lent to Ukraine as a noncash reserve requirement against the possibility of a future default. In comparison, US budget rules imposed a 44 percent noncash reserve requirement on the latest $1 billion credit guarantee the US gave Ukraine, so the budgetary burden of the $2 billion US contribution to the IMF-led assistance package is actually greater than that of the European Union. But the MFA framework agreement expired in 2009 when the Lisbon Treaty was introduced and needs to be renewed in order to be used on a larger scale. Allocating 1 percent of the EU budget to the defense of Ukraine seems appropriate; this would allow the European Union to contribute as much as €14 billion annually to the IMF-led assistance program—a contribution that would be large enough to allow for the European Union to do “whatever it takes” to help Ukraine succeed.

The Minsk II agreement of February 2015 followed a major military defeat inflicted on Ukraine by the separatists, strongly assisted by Russia. Ukraine was desperate for a cease-fire and negotiated under duress. The Minsk II agreement guaranteed a special status to the separatist enclaves in the Donbas region of eastern Ukraine and implied that Ukraine would subsidize them. President Putin exploited his advantage by keeping the text of the agreement deliberately ambiguous. It called for the Ukrainian government to negotiate with representatives of the Donbas region without specifying who they are.

The agreement was signed by Presidents Putin, Poroshenko, and François Hollande, and by Chancellor Angela Merkel. This has set a trap for the last two. They wanted an agreement bearing their signatures to hold; if it fails it must be Russia that scuttles it, not Ukraine. They were also anxious to avoid a military confrontation. This attitude led them to tolerate Russian and separatist violations of the cease-fire yet to insist that Ukraine should observe it to the letter. By taking a neutral position on the question of how President Poroshenko would meet the requirements of the ambiguous agreement, they reinforced President Putin’s advantage.

After the agreement was reached, Ukraine came close to financial collapse because of delays in delivering the second IMF-led rescue package until March 11, 2015. The low point was reached in February when the Ukrainian public lost confidence in the national currency, the hryvnia. Official transactions were suspended and the hryvnia traded on the black market between thirty and forty to the dollar that day. Since then the currency has recovered to about twenty to twenty-five hryvnia to the dollar. A precarious financial stability has been reestablished but only at the cost of accelerated economic contraction. The sudden drop in the exchange rate led to higher inflation, a substantial drop in living standards, and a large reduction in imports; this has helped to narrow the trade deficit. At the same time, the budget has benefited from lower expenditures on social benefits for the general public and on the wages of government employees.

When I visited Ukraine this April, I found a troubling contradiction between objective reality, which was clearly deteriorating, and the reformist zeal of the new Ukraine that was under tremendous economic, political, and military pressure but still moving forward with its reforms, which were having a cumulative effect.

During 2014, the reform program for a new Ukraine was in the planning stage; only in 2015 did it result in a large number of laws being passed to meet the requirements of the IMF and, more recently, the Minsk agreement. Even so, the oligarchs—industrialists who use political influence to enrich themselves—were more experienced in defending their interests than the reformers were in curbing them. Just when the economy was on the brink of collapse and political tensions were at a peak, the government had to face a challenge from the most powerful oligarch, Igor Kolomoisky, who tried to use his militia to retain his control over a subsidiary of Naftogaz. The government was forced to resist this and managed to defeat him.

That was a turning point. Since then, the central bank has been exercising strict control over the banking system, although recapitalizing the banks will take time. Other oligarchs, notably Dmytro Firtash and Rinat Akhmetov, are being reined in. Regrettably, this happens on a case-by-case basis and not yet by the application of the rule of law. Efforts to reform the police and introduce online services in government and transparency in official procurement have made more progress. But the reformers are encountering resistance at every step and the general population is increasingly dissatisfied both with the slow speed of reforms and the continued decline in living standards. So the stress under which the reformers operate continues to increase and may reach a breaking point at any time.

The Greek crisis greatly intensified Ukraine’s problems by diverting the attention of the European authorities from Ukraine and reinforcing their tendency to treat it as yet another Greece. The effect on Chancellor Merkel has been especially detrimental. She had behaved as a truly European leader in standing up to President Putin but remained hesitant about giving wholehearted support to Ukraine. When it came to Greece, she abandoned her characteristic caution in order to prevent a Greek exit from the euro. This brought her into conflict with her own party and her minister of finance, Wolfgang Schäuble, who had the backing of her party. While she managed to keep Greece in the eurozone, at least for the time being, she used up much of her political capital in the process. The loss will be sorely felt by the new Ukraine, which needs all the support it can get in complying with the Minsk agreement.

The ambiguity of the Minsk agreement has forced the two sides into a charade where the task is to pass the obligation to make the next move to the other side. Kiev has been a fast learner. Under prodding from its allies it established the special status of the Donbas enclaves by passing a law that quoted the ambiguous text of the Minsk agreement verbatim. This has created a financial problem for President Putin by starving the enclaves of funds until they are willing to hold elections in accordance with Ukrainian law.

But it would be risky for Ukraine’s allies to push President Poroshenko too far in making unilateral concessions to the separatists. As the recent bloodshed in front of the Ukrainian parliament demonstrated, ultranationalist elements are on the verge of rebellion. In short, the political and economic condition of the new Ukraine is extremely precarious.

A critical examination of the recent Greek negotiations reveals where they went wrong. Greece should not have taken precedence over Ukraine and Ukraine should not have been treated as yet another Greece. A similar examination of the Minsk agreement leads to a more equivocal conclusion. Ukraine’s European allies fell into a trap, but the current impasse has brought one important benefit: it has stopped Russia from carrying its cease-fire violations beyond the point where it can deny them. It would be a pity to lose this advantage.

This analysis leads logically to a new winning strategy for Ukraine. Ukraine still should be reinstated as the top priority of the European Union because the new Ukraine is one of its great assets. Every effort should be made not only to preserve the new Ukraine but to assure its success. If by helping Ukraine the European Union could effectively rebuff the Russian menace, then most of the European Union’s other priorities would fall into place; if it fails, the other objectives would be pushed further out of reach.

How can the success of the new Ukraine be assured? The analysis on which the original winning strategy was based remains valid. It was and is clear that President Putin can always show Russia to be stronger than Ukraine and its allies by escalating its use of force. Ukraine cannot militarily prevail over Russia. This means that it cannot regain its territorial integrity, at least in the short term, but it can maintain its moral and political integrity. When it comes to a choice, the latter is by far the more important. The new Ukraine is eager to undertake radical economic and political reforms. It has a large population and a battle-tested army willing to defend the European Union by defending itself. Moreover, the spirit of volunteerism and self-sacrifice on which the new Ukraine is based is a highly perishable good: if it is depleted it will take a generation to replace it.

Chancellor Merkel has put the political and moral integrity of the new Ukraine under tremendous stress by pushing President Poroshenko to observe the Minsk agreement to the letter even if President Putin does not. This brought the benefit, however, of keeping the military conflict within bounds, an achievement that needs to be preserved. Attaining some degree of political and military stability has to be one of the objectives of a winning strategy.

It is the second part of the winning strategy that is missing. Ukraine’s allies have to decide and declare that they will do “whatever it takes” to enable Ukraine not only to survive but to introduce far-reaching economic and political reforms, and to flourish in spite of President Putin’s opposition. This approach would require significantly more money than is available within the current budget of the European Union. The two prongs of this updated winning strategy—keeping military conflict within bounds and providing Ukraine with adequate financial support to carry out radical reforms—have to be carefully reconciled because they are liable to interfere with each other.

The original strategy called for Ukraine’s allies to declare their commitment to do “whatever it takes” at the end of June in conjunction with extending the sanctions on Russia. The European Union missed that deadline. The next opportunity will arise at the end of the year and it should be combined with a promise to reduce the sanctions on Russia if it fulfills its obligations under the Minsk agreement. This will greatly enhance the chances of success by offering a significant material reward to Russia for abiding by the Minsk agreement as well as a face-saving way out of its conflict with Ukraine.

The prospects of the Minsk agreement holding have greatly improved over the past few months. The weakness of oil prices and the further downward slide of the ruble have put renewed pressure on the Russian economy. But the decisive factor has been the decline in Russian oil production. Output has been falling year over year, and for the first time, both the quantity and quality of the petroleum output fell this year between the months of June and July. This means that the sanctions are biting and the lack of spare parts is accelerating the depletion of existing oil fields. Putin could compensate his cronies for their financial losses by allowing them to take over the properties of the less reliable oligarchs; but the only way he can arrest a general decline of the oil industry is by having some of the Western sanctions lifted. This consideration now outweighs the threat that the eventual prosperity of the new Ukraine poses. The fact that the period of maximum danger has passed without a large-scale military attack indicates that Putin has chosen to rely on more subtle means to destabilize the new Ukraine.

It is all the more important that Ukraine’s allies should embrace the modified winning strategy outlined here. The change in Putin’s attitude gives them more leeway to do so. They can provide some immediate financial support to Ukraine in order to relieve the financial and political stress without provoking countermeasures from Russia. And they must prepare the ground for a declaration at the end of the year promising to do “whatever it takes” to help the new Ukraine to succeed. That means that they must start to establish an MFA framework agreement now because the process will take several months to complete. It cannot begin without prior approval from the German Ministry of Finance.

There are some welcome signs that Chancellor Merkel is moving in the right direction. She moved far ahead of the German public and business community when she used her leadership position to forge European unanimity in imposing sanctions on Russia. It was only after the downing of the Malaysian airliner in Ukraine that the German public caught up with her. She took an uncharacteristic political risk in order to keep Greece in the eurozone. She faced intense internal opposition, but that did not stop her from taking another bold step by announcing that Germany will process as many as 800,000 asylum seekers in 2015.

By doing so Germany has set a positive example for other member states to follow; it also has implicitly abandoned the Dublin Regulation, which requires asylum seekers to register and remain in the country of arrival and has been a source of friction between the “arrival” and “destination” countries. This has brought about a dramatic shift in public attitudes toward asylum seekers. There has been an outpouring of sympathy that started in Germany and spread to the rest of Europe. If this trend gained momentum, it could lead to a positive resolution of the migration crisis.

Chancellor Merkel has correctly recognized that the migration crisis could destroy the European Union, first by causing a breakdown of the Schengen Treaty, which allows free movement within Europe, and eventually by undermining the common market. It would be an appropriate continuation of her recent risk-taking actions if she now combined firmness toward Russia with greater trust and support for Ukraine. The United States is already more firmly committed to the new Ukraine than most European governments; President Obama could therefore play a constructive role in persuading Chancellor Merkel to move in this direction. With their joint support, the new winning strategy for Ukraine has a realistic chance of success. And success in Ukraine should give the European Union enough momentum to find a positive resolution of the various other problems it faces.

Chancellor Merkel’s bold initiative toward asylum seekers could have far-reaching effects. She has challenged the German anti-euro party, but that party was already divided in its opposition to immigrants and is likely to collapse under the weight of public sympathy for asylum seekers. This may encourage President Hollande to take on the National Front in France, which is split by the animosity between its founder and his daughter; and it may encourage Prime Minister Cameron to successfully challenge the anti-immigrant agitation of UKIP. This could transform the political landscape of the European Union.

There is a danger that Europe’s preoccupation with the migration crisis could once again divert attention from what in my judgment is an even more fundamental issue: the fate of the new Ukraine. This would be a tragic error. As I have argued here, the new Ukraine is the most valuable asset that Europe has. Losing it would cause irreparable harm: it could create a failed state of more than 40 million people and become another source of refugees. But by helping the new Ukraine, the European Union could save itself. By doing “whatever it takes” to enable the new Ukraine not only to survive but to flourish, the European Union would achieve a dual objective: it would protect itself from Putin’s Russia and it would recapture the spirit of cooperation and solidarity that used to fire people’s imagination in its early days. Chancellor Merkel has already rekindled that spirit toward asylum seekers. Saving the new Ukraine would truly transform the political landscape in Europe.