A deal that would end the violence in Ukraine appears to be holding. It would produce early elections, a return to the 2004 constitution, and a national unity government. It would also set the stage for an urgent western effort to provide financing supported by an IMF program. Good news on the politics, though, does not equate to good news on the economy.
Last week I blogged on the issues that would need to be confronted if the West were to put together a package. If a government is put in place that can work with the IMF, the international community will need to move fast. Experience with crisis situations and failed states suggest that economic fundamentals deteriorate quickly if unaddressed. Capital flees, growth and trade slows dramatically, and tax receipts plunge as the authority of the state activity weakens. Exchange rate depreciation (see chart) and continued reserve loss exacerbates the risks. Ugly surprises appear on bank balance sheets. The longer a deal is put off, the larger the financing gap and the greater the challenge of filling it. S&P’s decision today to downgrade the sovereign on rising expectations of default highlights these risks. This suggests that the window may be short for an adjustment program that can restore confidence and market access, and is consistent with the financing available. Much depends on the IMF.
How generous should a package be, and with what conditionality? In December, the IMF Board noted some achievements, but also regretted the authorities’ insufficient ownership, which undermined the program. Directors agreed that, "in view of Ukraine’s track record, arrangements with lower access and strong prior actions would be most appropriate." In plain speak, Ukraine has performed badly on past IMF programs, and a large financing program contingent on future economic reform promises is likely to fail again. Renewed funding could in fact could be counter productive.
Of course, the counter argument for a large package is also easy to make. The new government is the best hope in some time for Ukraine, and deserves strong western support if there is to be a credible alternative to Russian financing and the strings attached. A large financing package from the IMF, with politically realistic conditionality, is the best hope to avoid default and chaos. This would mean financing a large fiscal deficit (which was 7.7 percent of GDP last year) and allowing a gradual adjustment of energy prices. This will be a tough package for the IMF (and some creditors worried about moral hazard) to accept. If the West goes in this direction, the Fund will want to see its program as catalyzing other support. I continue to see merit in a "Friends of Ukraine" effort, involving western governments and perhaps major Ukrainian investors and businesses.
Market attention in coming weeks increasingly will focus on whether the Ukraine government will pay upcoming bond maturities. But even more important will be the speed and conditionality of the package the West offers. The contagion to other markets will likely depend on whether investors see this as a failure of the state and unique due to Russia’s role, or rather symptomatic of a broader increase in EM political risk. So far, market commentary has been balanced on this point. How the West responds will matter here too.