Andreas Schwabe at Raifeissen Research sees more destabilisation in Ukraine

The latest developments in the eastern parts of Ukraine lend further weight to the idea that the country is becoming destabilised to the point where it represents significant downside risk to previous economic forecasts, says Andreas Schwabe, analyst at Raifeissen Research.

Background: Separatist activity in Eastern Ukraine going on for more than a week – Already a week ago, pro-Russian separatists occupied administrative buildings in three Eastern Ukraine regions – Donetsk, Kharkiv and Luhansk.

While Ukrainian authorities peacefully removed occupants in Kharkiv, protesters remained in control over the administrative buildings in Donetsk and Luhansk – in case of Donetsk declaring the establishment of the “Donetsk people’s republic” and putting forward demands on organizing local referendum on extending the autonomy of the regions and recognizing the Russian language as an official one.

While the number of separatists is relatively small (only a few thousand), their impact should not be underestimated. The Ukrainian central government did not resort to the use of large-scale force in recent days, fearing that bloodshed would give Russia the pretext to send troops in defence of the ethnic Russian minority in the region (according to NATO, Russia concentrated 40,000 of troops at the Ukrainian border). At the same time, control by Kiev over local power structures seems weak and local oligarchs (with strong business ties to Russia) seem to play their own games, apparently aimed at preserving political and business influence and retaining the control over assets (some of which were privatized in contested legal manner under the previous administration).

Recent escalation: Ukrainian government ultimatum after deaths in occupied town of Slavyansk – The situation escalated this weekend as armed separatists (labelling themselves as local pro-Russian militia, albeit there are signs on the involvement of regular Russian Army) took the control over administrative buildings in a number of towns in Donetsk region. The most dangerous stand-off took place in Slavyansk, a town of 100.000 inhabitants in the Donetsk region.

Clashes with Ukraine’s Special Forces led to casualties on both sides (reportedly, one death and several wounded on each side). This seems to have triggered a change in strategy by Kiev. Ukraine has given the separatists a Monday morning deadline to disarm or face a “full-scale anti-terrorist operation” by its armed forces, raising the risk of a military confrontation with Moscow. While we do not expect separatists to give in, it has yet to be seen how decisive the government will (and can) act. According to latest news reports, separatists did not show signs of complying as the deadline passed.

Political reactions: Ukraine, Western governments and NATO see indications of Russian forces involved; Russia finds itself alone in condemning Ukraine for the escalation – NATO voiced concerns over what the alliance described as the appearance of men with specialised Russian weapons and identical uniforms without insignia – as previously worn by Moscow’s troops when they seized Crimea. Russia denoted the planned Ukrainian operation against separatists as “criminal” and asked for a meeting of the UN Security Council on Sunday evening. However, during the meeting Russian claims were not supported by other countries – US, UK, France, Australia and Lithuania, as expected, put blame for the escalation on Russia, while others (led by China) took a neutral stance, but urged for the immediate de-escalation. Also, the US threatened to step up economic sanctions against Russia- A new round of U.S. sanctions could target Russian business sectors such as mining, banking and energy, the US envoy to the UN said.

Interpretation and outlook

First, Russia seems to follow a strategy of destabilisation of Eastern Ukraine ahead of presidential elections. In our opinion, the most likely objective of Russia with regard to Ukraine is to interfere with the scheduled Ukrainian presidential elections on May 25. If orderly elections in Eastern Ukraine become impossible (given revolts, loss of control by central authorities or even civil war like clashes), a new President would possess only limited legitimacy in the East and South and thus for the whole of Ukraine. Such a situation could be seen in line with recent Russian proposals to effectively break-up the Ukrainian state by a strong form of “federalization”.

Given the pressure, the Kiev government already shows willingness to increase regional autonomy going forward, promising less radical “decentralisation”. If this is the case, the turmoil will continue at least to the election date in late May.

Second, an outright repetition of the Crimea scenario, i.e. occupation and annexation, would be more difficult to implement in Eastern Ukraine – the condition in case of Crimea were rather specific, with a Russian naval base and an ethnic Russian majority in the population. Both is not the case in Eastern Ukraine, where a majority of the population is in favour of wider autonomy (the current provisional government enjoys not much popularity), but not of joining Russia. The latest polls, conducted in Donetsk reveal that only 18% are in favour of joining Russia, while another 15% support federalisation of the country.

Thus, a Crimea scenario looks still not too likely. However, Russian support for internationally unrecognized break-away provinces in neighbouring states would be nothing new (given the precedents of Transnistria, South Ossetia and Abkhazia).

Third, the Western strategy of very limited sanctions and continued proposals to Russia to negotiate (albeit sometimes it seems unclear what to negotiate at all) may be increasingly seen as non-functioning and failing, especially given the alleged Russian support for the turmoil in Eastern Ukraine. Thus, proponents of a harsher stance towards Russia may see their position confirmed and the discussion on stronger economic sanctions by the US and EU gets back on the agenda, with the Americans likely pushing the Europeans forward.

Moreover, with precedents in Ukraine created, chances for substantial success of diplomatic efforts this week diminished. EU’s Ashton is due to meet officials from the United States, Russia and Ukraine in Geneva on Thursday. We think that Europeans are yet not prepared (i.e. have not agreed) to go for stronger sanction in the short term, but another round of targeted sanctions could come later this week or next week (asset freezes and travel bans on individuals/officials). Real economic sanctions (no total trade embargoes, but some partial measures; financial sector restrictions), might follow on a 1-2 month horizon, if there is no de-escalation.

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