Ukraine on the Edge

At the beginning of 2015 Ukraine faced a plethora of obstacles and enemies, first and foremost Russian President Vladimir Putin, who was determined to destabilize the country and use the might of the Russian army to crush it. He violated Russian law by using conscripts outside the borders of the country without their written authorization. Accounting for Russian soldiers who were killed and disposing of their bodies caused him a great deal of difficulty and embarrassment.

But he succeeded in defeating the valiant Ukrainian soldiers defending Donetsk airport in January. This led to the agreement called Minsk II, signed on February 11, which was negotiated by Ukraine under military duress. Ukraine had to concede the territorial gains that the separatist enclaves had made since the Minsk I agreement, signed in September 2014. Even so, the Russians kept up the military pressure on the town of Debaltseve, which was evacuated by the Ukrainian army seven days after the signing of Minsk II.

After that, the direct involvement of the Russian army diminished and Putin reverted to waging a proxy war. He also kept the main provisions of the Minsk agreement deliberately vague. Taking advantage of his negotiating position, he insisted that Ukraine fulfill all of Minsk II’s requirements before Russia would be obliged to relinquish control of its border with the separatist enclaves. This left the conditions under which those enclaves would hold elections undecided.

Ukraine insisted that the elections should be held under Ukrainian law, but Putin wanted to create problems for Ukrainian President Petro Poroshenko by requiring the Ukrainians to negotiate the conditions for the elections directly with the separatists. German Chancellor Angela Merkel and French President François Hollande took a neutral position and eventually put pressure on Ukraine, weakening its negotiating position even further. In the end Putin relented, and negotiations have been taking place in the so-called “Normandy format,” a diplomatic group that includes representatives from the Ukrainian, French, German, and Russian governments.

The third obstacle Ukraine encountered was the lack of adequate financial, political, and military support from its allies. By holding Ukraine on a tight financial leash, Germany was in danger of making the same mistake it had made with Greece. Greece had much in common with the old Ukraine: it had an economy dominated by oligarchs and a civil service that exploited the people instead of serving them. To add to Ukraine’s woes, at the beginning of 2015 the government’s authority was directly challenged by the most powerful oligarch, Igor Kolomoisky—who dominated the financial sector—and by various other oligarchs acting individually or together.

Under these pressures, Ukraine’s economy collapsed in the first part of 2015. The exchange rate of the currency plummeted by 50 percent in a few days and the National Bank of Ukraine had to inject large amounts of money to rescue the banking system. But the new Ukraine proved remarkably resilient; it resisted the forces that wanted to turn it into the old Ukraine.

The climax was reached on February 25. The central bank introduced import controls and raised its interest rate to 30 percent, and President Poroshenko’s intervention brought the exchange rate back to a level near the one on which Ukraine’s 2015 budget was based. The parliament rushed through a set of radical reforms in record time in order to meet the March 11 deadline set by the International Monetary Fund.

In retrospect, that was the turning point. Since then the reform program has gathered momentum and slowly become visible both to the Ukrainian public and to the European authorities. Russia’s proxy warfare using Ukrainian separatists did not yield significant territorial gains either in Russia or elsewhere. Oil prices did not recover from the nosedive they took at the end of 2014 and the sanctions against Russia began to bite. The lack of financing prevented Russia’s development of new oil fields and the lack of spare parts started to affect production from existing oil fields. For the first time in many years, both the quantity and quality of Russian output declined between the two peak months of June and July.

Putin gradually came to the conclusion that he had not enough to gain in Ukraine to offset the gradual erosion in his support that was bound to occur at home. His attention turned to fresher fields. He managed to surprise the world by intervening militarily in Syria at the end of September. Whether he is successful in the long run or not, he has certainly taken advantage of his ability to make the first move in an international military confrontation and to regain momentum in the short term.

These developments deserve to be recognized as a victory for the new Ukraine. Merely to have survived against overwhelming odds counts as an accomplishment. The Minsk agreement is here to stay, even if it cannot be fully implemented in the original time frame, which called for a final agreement by the end of 2015. Indeed, the timetable was extended by the mutual agreement of all participants into 2016. Whether it is ever fully implemented or not, Putin will not be in a position to revert to large-scale warfare with Ukraine in the foreseeable future. This fulfills the first condition of a winning strategy: a lasting cease-fire. To drive that strategy home, Ukraine’s allies ought to take full advantage of Putin’s preoccupation with his engagement elsewhere and refocus their attention on Ukraine.

Unfortunately, the people and leadership of Europe are also distracted by other problems, the refugee crisis and the wave of terrorist attacks in Paris foremost among them. As a firm believer in the original concept that led to the formation of the European Union, I share these concerns. My foundations and I personally are as deeply involved in helping the refugees as we are in helping the new Ukraine. We have developed a comprehensive asylum policy for the European Union that is under active consideration by the authorities. So I feel I am in a strong position to remind Europe of the importance of the new Ukraine. Europe is badly in need of a success and Ukraine can provide one.

I published what I called a “winning strategy” for Ukraine in February 2015 and updated it in October.^* That strategy called for a robust commitment from the West “to do whatever it takes” to help the new Ukraine. I should emphasize that the wholehearted commitment I am advocating does not give the Ukrainian people or government any kind of carte blanche; it is contingent on the implementation of radical reforms.

To remind the reader, my strategy was predicated on reactivating and enlarging the Macro-Financial Assistance program, which has already been used by the European Commission to finance its contribution to the IMF program. That would open the way to the crucial step: a wholehearted commitment by the European Union to help Ukraine not just to survive but to flourish and become an attractive destination for investment. The new date for announcing that commitment is the end of January 2016, when the existing sanctions against Russia expire.

The central point of my strategy is that the European sanctions against Russia have to be matched by a wholehearted commitment to Ukraine. Sanctions are a necessary evil: necessary because Russia cannot be allowed to replace the rule of law with the rule of force; evil because sanctions hurt everyone—both those on whom they are imposed and, indirectly, also those who impose them.

Putin has developed a very effective political story 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, in his view, 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 that the sanctions cause. The hardships—which include financial instability and shortages—actually reinforce his argument. The only way to prove Putin wrong is by establishing a better balance between sanctions against Russia and large-scale support for Ukraine.

That brings me to the situation I found when I came to Ukraine on November 8. It took me less than a week to realize that the situation is not as promising as I had thought from the outside. The electorate voted very perceptively in the first round of the local elections, held at the end of October. The only populist critic who gained votes was the former prime minister Yulia Tymoshenko, whose party is formally a part of the ruling coalition; but she did not exceed the vote for President Poroshenko. In effect, the voters endorsed the ruling coalition yet made it clear that they were dissatisfied both with living conditions and with the pace of reforms. Their endorsement has the character of a payment in advance. It is now up to the ruling coalition to live up to the expectations of the public—and that is where the problems lie.

The new Ukraine performed miraculously when it was unified by an outside threat, Putin’s implacable hostility. Now that Putin is preoccupied with Syria, that danger has diminished. After years of hardship and sacrifice, people are eager to relax and pursue their personal or political interests. This is opening up fault lines that were previously held together by the pressure emanating from Russia. I see a real possibility that the objective that Putin could not achieve by military means may fall into his lap as a result of a lasting cease-fire.

The ruling coalition has very little choice. The country cannot afford either new national elections or a change in the ruling coalition. Both would disrupt the Ukrainian government for several months and the country faces a fiscal emergency. It has not met the conditions imposed by the IMF and it will not receive the next installments of payments until it does so. Prime Minister Arseniy Yatsenyuk has become very unpopular and his party did not participate in the local elections. Yet President Poroshenko cannot afford to replace him because of the large voting bloc Yatsenyuk controls.

The only way forward is for President Poroshenko to commit himself to continued cooperation with the prime minister and jointly persuade the parliament to pass a budget that will satisfy the IMF. That is what they did at the beginning of 2015 and it worked. The trouble this time is that the president has been reluctant to make that commitment and the ruling coalition is in disarray. Legislation that needs to be passed is either not submitted or defeated in the parliament. Time is running out. The sooner President Poroshenko commits himself to the only course that is open to him, the better the chances that he can regain control of the ruling coalition and avoid a fiscal calamity that could destroy the new Ukraine. He needs to reaffirm his commitment to the radical reforms that the public demands.

Here I will examine the reform process in some detail, taking economic reforms first. The most important project, the linchpin of economic reforms, is the reorganization of the energy sector and particularly the gas sector. It is in very good hands under the current leadership of the state-owned enterprise Naftogaz. What is needed is to move the price of natural gas closer to the market prices prevailing in Europe. This is necessary in order to stop the enormous drain on the national budget represented by the hidden subsidies now provided to the public by Naftogaz; but stopping that drain poses a serious political challenge.

The government introduced a substantial increase in gas prices but many millions of households simply cannot pay them on top of all the other hardships they have had to absorb. They have to be compensated by direct subsidies. Such payments will require an extensive operation, and although the government is fully committed to making it a success, many things can go wrong. Think of all the things that went wrong with the introduction of Obamacare in the United States. The government has recognized that the best way to guard against a possible breakdown is to promise households that their application for a subsidy will be easily approved for the current heating season. This will give the authorities nearly a year to correct any errors.

But that is only the first half of the necessary gas sector reform. As things stand now, households are required to pay not only for the gas they consume but also for the gas that is lost in transmission. This should be corrected. Starting in 2016, the companies that supply the consumers, like the pipeline oligopoly controlled by Dmytro Firtash, should be responsible for the gasses that are lost. If they fail to do so, they should go bankrupt and their businesses taken over by more competent operators.

The privatization of the gas and electricity sectors will also be full of pitfalls. There are many rumors about various oligarchs obtaining or reestablishing oligopolies but, paradoxically, I find these rumors reassuring. If I heard them, so did others, and there are enough genuine reformers in the parliament and the government and eventually in the anticorruption agencies to stop them.

There is one major economic reform toward which little progress has been made: tax reform. This is now at the top of the agenda of the finance minister, Natalie Jaresko, and since I regard her as one of the true reformers, it has become my top priority as well. People need to have some certainty about their future tax liabilities in order to make long-term investments. A tax reform package that removes uncertainty, ensures fairness, and reduces corrupt practices is absolutely necessary.

Currently there are several different tax reform measures being debated in the parliament. I strongly endorse the finance minister’s plan, partly because it is the only one that meets the requirements of the IMF. It introduces a uniform flat tax of 20 percent to replace a tax code that is so complex it breeds corruption. But the plan faces an uphill battle. It will add a significant additional burden to the budget of 60 billion hryvnia (about $3 billion) because the IMF will not recognize the additional revenues it will produce until they materialize. Even the IMF advises against introducing the plan at this late stage but the finance minister insists because she recognizes the public clamor for meaningful reforms.

Reform of the civil service—often both inefficient and corrupt—is second only to tax reform. The first reading of comprehensive legislation to reform the system already took place in April. Both the president and the prime minister must ensure that the final legislation will be passed this year. The European Commission has reserved considerable funds to raise government salaries but predicated payment on the passage of the bill and adoption of a new strategy. As the EU ambassador to Ukraine noted, the EU will support and give assistance “to get the new Ukrainian civil service on its feet.” But the amount of money allocated, reported as ninety million euros, is not enough and there is a fatal flaw in the current design: the salaries of members of the government and parliament are limited to about two hundred euros. This is an invitation for corruption. This is one of the issues on which the president and prime minister need to work together in asserting party discipline and pushing the coalition to act.

Judiciary reform is another priority. An important event occurred on October 23 when the Council of Europe’s Venice Commission ignored the appeal of high-level Ukrainian judges to uphold the status quo that conferred immunity on current judges regardless of previous wrongdoings.

Impressively, two fundamental components of judicial reforms were recently introduced by the Ukrainian National Reform Council. They will permit the wholesale reorganization of the judicial system, and open the way to a thorough professional and personal reexamination of the judges. If these measures are approved by the parliament, they will amount to a breakthrough.

I believe that the prime minister and president are close to agreeing on some necessary personnel changes in the Cabinet of Ministers. This will remove the currently prevailing uncertainties and give the reform process new momentum. Both the people and the supporters of the new Ukraine abroad are looking to the president to take charge of the reform process. Having met him, I am hopeful that he is ready to do so and when he acts, the country will follow him.

—November 16, 2015