Summary
- Ukrainian defense is strengthening, financed by oligarchs.
- Putin needs to build a land bridge to Crimea.
- The war will intensify because of the economic stakes for Russia.
- Sell Russia's stocks, bonds and currency.
Putin's War on Ukraine.
(click to enlarge)
Stuck in a Kiev traffic jam last month, I could not help but wonder if Ukraine is really at war. I was back in the capital after a week traveling around Ukraine. First, I had gone to elegant Odessa on the Black Sea. From there I drove east, passing Mykolaiv on my way to Kherson, the last city before the stretch southeast to Crimea. Not once did I see any military presence! All the fighting is being done in the eastern regions, seemingly disconnected from what is going on in the rest of the country. If it were not for TV, most Ukrainians would not know they were in a military conflict with so-called pro-Russian rebels.
On the road from Kiev to Odessa and then to Kherson, I encountered neither military checkpoints nor convoys of soldiers. I was not to have a Hemingway moment. The only excitement en route came from recurring police shakedown attempts. (As an "Americano", I always got away without paying by playing dumb.)
One might explain this absence of military activity by Kiev's distance from the eastern front. But Mykolaiv and Kherson are much closer to the action. They are furthermore very strategic ports, the first cities Russian troops would encounter if Putin decided to move towards Kiev. So, why this lack of preparedness?
I turned this question over and over in my mind as I drove through the endless black fields of the southern Ukrainian steppe. Considering Ukraine's long military history, from the Cossacks of yesteryear to the Red Army, I was taken aback by this total absence of military preparedness. How could it turn out that when Putin's stooges invaded Crimea, the Ukrainian army was helpless? Why were they told by the politicians not even to fight?
After two and a half decades of post-Soviet neglect, the Ukrainian army is a mere shadow of its former self. Only a remnant is left to fight on the front, leaving no forces to defend other strategic cities.
The easy annexation of Crimea in March 2014 encouraged President Putin to send his commandos on to eastern Ukraine only days later. There they tried to foment another "uprising", but this time they met unexpected resistance. Powerful oligarchs such as Kolomoisky, Governor of Dnepropetrovsk, rallied to Ukraine's defense, financing both the army and their own private militias. Soon after, another oligarch, "Chocolate King" Poroshenko was elected president and the battle's momentum reversed. Ukraine was well on its way to taking back Donbass when Putin decided to double down. Sophisticated weapons and more Russian troops mysteriously joined the "rebels" and the Ukrainian forces were pushed back once again.
As in Crimea, Putin was not ready to admit his involvement, even after soldiers of Russian nationality were taken captive. He explained their presence with stories only Pravda could print without seeing the humor. Were these soldiers really on vacation? Were they using tanks to drive their families to the Sea of Azov before turning west to liberate Ukraine? Really?
A Temporary Stalemate.
Once the Ukrainian troops were pushed back, they dug in and a stalemate ensued. The West reacted more strongly than Putin had anticipated, imposing credible economic sanctions. In the center of the country, the Kolomoisky Line held. Similarly, the southern seaport of Mariupol stood firm between the Russian backed rebels and Crimea. All the while, Ukraine was rebuilding its army. Parliament voted to quintuple its defense budget to 5% of GDP.
This stalemate turned out to be a victory of sorts for Poroshenko's Ukraine since Putin's annexation strategy was predicated on speed. Connecting Donbass (encompassing the provinces of Donetsk and Luhansk) with Crimea will now require a full-blown war and Ukrainian defenses are getting stronger each day. Putin is facing serious resistance. He may actually have awakened a - small - sleeping giant. As my own observations make clear, Ukrainians are not ready to resist a full invasion. But Ukraine is no Moldova. It is a big country. Its army may be unimpressive today, but it was 780,000 strong in 1991. A military reawakening could make it a formidable force again.
Military Interdependence.
Ukraine's economy in the communist era was built on defense as much as agriculture. In those Soviet times, the military-industrial complex employed a very large portion of Ukraine's workforce. It still has expertise in missile-related technology, guidance systems, radar technology and so forth. Ironically, according to Radio Free Europe, much of the equipment used by the Russian troops in Crimea was produced by Kiev's military industry.*
The imposing shipyards of Mykolaiv, Kherson and Mariupol built the Russian fleet. So what does it profit Putin to "own" the port of Sebastopol where the Russian fleet is stationed if he no longer has access to those strategic shipyards? Where is he going to go for repair and maintenance? Where is he going to build a second aircraft carrier? That's right, the mighty Russian fleet has only one aircraft carrier, and it is old to boot.
Connecting The Dots.
Last weekend's push to take Mariupol is motivated by Russia's awareness that failing to build a land bridge to Crimea would be very costly. The annexation of Crimea and the war in Donbass has not only awakened a newly hostile and potentially formidable Cossack force at its border. It has also failed to connect the economic dots. Mariupol, still under Ukrainian control, is the port from which Donbass' heavy industries are shipped to the world. Crimea relies on the Ukrainian mainland for its water and electricity which could be shut down at any time.
Cynics would even argue that the Russian occupation of loss-making coal mines in Donbass passes to Putin a long-term structural problem. These mines were formerly kept alive at high cost to the Ukrainian government. Now the inevitable massive layoffs are Russian separatists' responsibility.
Putin's Options.
If the master of the Kremlin is the strategic genius sometimes described in the media, this invasion has not been his best moment. Taking Crimea was only meant to be the first phase in regaining "Little Russia". The second phase, connecting Crimea to Russia, has hit big snags. A combination of Ukrainian oligarchs' militias resistance, a revival of the national army, Western sanctions and huge capital outflows forced him to pause and regroup. The collapse of oil prices has only added insult to injury.
He is now left with a choice between a) backing off and restoring relations with the West, b) standing pat while waiting for the West to accept the fait accompli or c) doubling down. Events over the weekend suggest he has made up his mind: it will be war.
The Long Road To A Ukrainian Victory.
The Russian backed rebels' move towards the important industrial cities located on the Sea of Azov threaten Ukrainian oligarchs. These strongmen have divided the country into fiefdoms and will put up a fight. They know they need to ally with others to defend their common interests. We see this in Mariupol where Kolomoisky's militia, the Dnieper Battalion, has joined the Azov Battalion to block the separatists' attempt to link Crimea to Donbass.
The Ukrainian oligarchs have seen how their Russian counterparts have been crushed when refusing to sing to the Kremlin's tune. They have no desire to see this happen to them. Already, their assets in Crimea have been confiscated. Hence, with the exception of those linked to the deposed president Yanukovych, a Putin ally, the leading industrialists are fighting back hard. Do not be mislead, official reports of casualties on both sides are grossly underreported.**
Yet, military victories are not enough. The new democratic regime in Kiev has to win the hearts and minds of the people. For the Ukrainians to win the war for the long run, it is imperative that they develop a strong national identity. This will not be easy. Ukraine gained independence for the first time ever a mere twenty four years ago. Many Ukrainians in the east of the country still consider themselves Russians. The two languages are very similar; the famous Ukrainian writer Gogol, for example, wrote only in Russian.
Historically countries have been greatly helped in forging an identity by the presence of a common enemy. Nothing unites more than a shared threat. Today, Putin fits that bill perfectly. He is already widely hated; on the streets of Kiev I saw for sale toilet paper printed with Putin's portrait.
Corruption.
The fastest way to consolidate Ukrainians' support for the current government would be to eliminate police corruption. It is the most visible face of corruption in every day life in most developing countries. Saakhashvili, the former president of Georgia, understood that. He built his early popularity on reforming the police.
Other reforms are also needed, of course. Corruption exists at every level of government. However, reforming the police would be a good place to start. It would send a very strong message that times have really changed and that a new generation of politicians will behave differently.
The Economy
Poland and Ukraine, which were a single country centuries ago, have managed their economies very differently since rejecting communism. After
the collapse of the Soviet Union, Poland moved swiftly to build a capitalist system. It paid off. Finance minister Balcerowicz' shock therapy lead to rapid economic growth. In twenty years, from 1993 to 2013, Polish GDP per capita went from $2,443 to $13,431. By contrast, Ukraine, lurching along under a series of kleptocracies, saw its GDP per capita rise from $1,258 to $3,900 over the same period.***
The new Ukrainian government may be well inspired to learn from Poland's experience. In addition to cleaning up corruption, a proper land reform is long overdue. Ukraine has to do away with today's lease-based system and introduce land ownership. About 70% of the country is agricultural land, half of which is the very fertile chernozem, or black earth. Such a reform would go a long way to restoring the country's historic role as the bread basket of Europe.
The macro-economic situation is challenging. Inflation is north of 15%, the currency - the hryvnia - is competing with the ruble for the world's weakest currency. The bloated national debt is exacerbated by ongoing war. However, with the right structural reforms and the help of the West, these challenges may be surmountable.
Already signs of entrepreneurship are emerging. My favorite is the Lviv Handmade Chocolate franchise. This chain of European style cafés combines a Viennese version of Starbucks with a Belgian chocolate store! The coffee and the pastries are delicious. But, above all, they make the best hot chocolate in the world.
What is the Investment Take-away?
Some emerging market funds have been lured by the low valuations of Russian stocks. They are betting that Vladimir Putin will wake up one day an economic liberal. They think he will realize the path he has taken is suicidal and reverse course. This, I believe is wildly optimistic. My grandparents once showed me a portfolio of Russian stock certificates dating back to the Tsarist era. Many years later, I unsuccessfully tried to recover those certificates for their historic interest, the only value they had left.
What I mean is that the new generation of investors may have to start paying attention to geopolitical risk beyond passing volatility. It is still not too late to short RSX, the Russian ETF.
As far as Ukraine is concerned, there are no ETFs to invest in and I would not rush to buy stocks on the Kiev stock exchange. A better opportunity may one day present itself if today's politicians prove to be students of my hero Balcerowicz.
Of more immediate importance, events in Ukraine will continue to hang over European markets. A military escalation will lead to more economic sanctions. The Russian crisis is just starting to heat up.
- "Complex Ties: Russia's Armed Forces Depend on Ukraine's Military Industry" by Charles Recknagel, March 28 2014.
** "Ukraine Hides Devastating Losses As Russia-Backed Fighters Surge Forward"by Maxim Tucker, KyivPost January 25 2015
*** Source World Bank
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