A Winning Strategy For Ukraine

"European leaders, in particular, have failed to appreciate Ukraine’s importance. By defending itself, Ukraine is also defending the EU. If Putin succeeds in destabilizing Ukraine, he may then apply the same tactics to divide the EU and win over some of its member states."

BUDAPEST – At the beginning of this year, I proposed a strategy for Ukraine that recognized that sanctions on Russia are not enough. They must be coupled with a political commitment by Ukraine’s allies to do whatever it takes to enable the country not only to survive, but to succeed in implementing far-reaching political and economic reforms, despite the implacable opposition of Russian President Vladimir Putin.

Sanctions, though necessary, are harmful not only to Russia but also to Europe’s economy. By contrast, enabling the Ukrainian economy to flourish would benefit both Ukraine and Europe.

Even more important, sanctions by themselves reinforce Putin’s narrative that Russia is the victim of a Western or Anglo-Saxon plot to deprive it of its rightful place as a great power equal to the United States. All of Russia’s economic and political difficulties, the Kremlin’s propaganda machine argues, have resulted from Western hostility.

The only way to counter this narrative is to combine sanctions with effective support for Ukraine. If Ukraine prospers while Russia declines, no amount of propaganda will be able to conceal that Putin’s policies are to blame.

Unfortunately, Europe’s leaders have chosen a different course. They treat Ukraine as another Greece: a country in financial difficulties – and one that is not even a European Union member state.

This is a mistake. Ukraine is undergoing a revolutionary transformation, and the current government is probably the one best able to deliver radical change.

There are indeed some significant similarities between the “old Ukraine” and Greece: both suffer from a corrupt bureaucracy and an economy dominated by oligarchs. But the new Ukraine is determined to be different. By keeping Ukraine on a short financial leash, Europe is jeopardizing the country’s progress.

In a sense, Europe’s failure to recognize the birth of a new Ukraine is not surprising. Spontaneous uprisings occur frequently; the Arab Spring, for example, spread like a wave across North Africa and the Middle East.

But most revolts do not endure; their energy is exhausted quickly – as with Ukraine’s Orange Revolution a decade ago. Today’s Ukraine is one of the rare cases in which protest is transformed into a constructive, nation-building project. Although I participated in that transformation process, I confess that even I underestimated the new Ukraine’s resilience.

Putin has made the same mistake, but on a much larger scale. He has been so successful in manipulating public opinion that he was unwilling to believe that people could act spontaneously. That has been his Achilles’ heel.

Twice he ordered former Ukrainian president Viktor Yanukovych to use force against the people protesting in the Maidan, Ukraine’s Independence Square. But, instead of fleeing the violence, people rushed to Maidan, willing to sacrifice their lives for their country. The second time, in March 2014, when the protesters faced live ammunition, they turned on the police, and it was the police who ran away. Such an event can become a nation-founding myth.

Putin knows that he is responsible for turning Ukraine from a pliable ally into an implacable opponent, and he has made it a top priority to destabilize the country ever since. Indeed, he has made considerable – though purely temporary – progress on this front. Given that Putin also recognizes that his regime may not survive two or three more years with oil substantially below $100 a barrel, his sense of urgency is understandable.

His progress – measurable by comparing the Minsk II ceasefire agreement with Minsk I – can be attributed partly to his skills as a tactician. More important, whereas he is willing to go to war, Ukraine’s allies have made it clear that they are incapable of responding quickly and unwilling to risk a direct military confrontation with Russia. This has given Putin the first-mover advantage, because he can switch at will from hybrid peace to hybrid war and back again. Ukraine’s allies cannot possibly outbid Russia by military escalation; but surely they can outbid Russia on the financial side.

European leaders, in particular, have failed to appreciate Ukraine’s importance. By defending itself, Ukraine is also defending the EU. If Putin succeeds in destabilizing Ukraine, he may then apply the same tactics to divide the EU and win over some of its member states.

If Ukraine fails, the EU would have to defend itself. The cost, in financial and human terms, would be far greater than the cost of helping Ukraine. That is why, rather than drip-feeding Ukraine, the EU and its member states should treat assistance to Ukraine as a defense expenditure. Framed this way, the amounts currently being spent shrink into insignificance.

The problem is that the EU and its member states are too fiscally constrained to support Ukraine on the scale needed to enable it to survive and prosper. But that constraint could be removed, if the EU’s Macro-Financial Assistance (MFA) facility were redesigned. The MFA already has been used to provide modest assistance to Ukraine; but it needs a new framework agreement to fulfill its potential.

The MFA is an attractive financing instrument because it requires no cash outlay from the EU budget. Instead, the EU borrows the funds from the markets (using its largely untapped triple-A credit rating) and lends these funds to non-member governments. A cash outlay from the EU budget would materialize only if and when a borrowing country defaulted. Under prevailing rules, just 9% of the loan amount is charged to the current budget as a non-cash outlay to ensure against this risk.

A new framework agreement would allow the MFA to be used on a larger scale and in a more flexible manner. At present, the MFA can be used for budgetary support but not to provide political risk insurance and other investment incentives to the private sector. Moreover, each allocation must be approved by the European Commission, the European Council, the European Parliament, and every member state. The EU’s contribution to the International Monetary Fund’s rescue package in February took until May to process.

The strategy for Ukraine that I proposed at the start of the year has run into three roadblocks. First, the debt restructuring that was supposed to account for $15.3 billion of the $41 billion contained in the second IMF-led rescue package has made little progress. Second, the EU has not even started to construct a new MFA framework agreement. And, third, EU leaders have shown no sign that they are willing to do “whatever it takes” to help Ukraine.

German Chancellor Angela Merkel and French President François Hollande are eager to ensure that the Minsk II agreement, which carries their signatures, is successful. The trouble is that the agreement was negotiated by the Ukrainian side under duress, and was left deliberately ambiguous by Russia. It calls for negotiations between the Ukrainian government and representatives of the Donbas region, without specifying who those representatives are. The Ukrainian government wants to negotiate with representatives elected according to Ukrainian law; Putin wants Ukraine’s government to negotiate with the separatists, who took power by force.

The European authorities are eager to break the stalemate. By taking a neutral position on Minsk II’s ambiguity and keeping Ukraine on a tight leash, Europe’s leaders have been unwittingly helping Putin achieve his goal: financial and political crisis across all of Ukraine (as opposed to territorial gains in the east). Drip-feeding Ukraine has brought its economy to the brink of collapse. Precarious financial stability has been achieved at the price of accelerated economic contraction. Although political and economic reforms are still moving ahead, they are in danger of losing momentum.

On a recent visit, I found a troubling contrast between objective reality, which is clearly deteriorating, and the reformist zeal of the “new” Ukraine. When President Petro Poroshenko and Prime Minister Arseniy Yatsenyuk cooperate – usually whenever some external financing is to be obtained (the conditions for the IMF-led program, for example, were met in two days) – they can persuade the Rada (parliament) to follow their lead.

But such opportunities are becoming scarcer. Moreover, Poroshenko and Yatsenyuk will be competitors in local elections in October, when opposition parties associated with oligarchs could, according to current public-opinion polls, make considerable gains.

This would be a setback, because there has been considerable progress in recent months in preventing the oligarchs from stealing large amounts of money from the budget. The government won a sharp confrontation with the worst and most powerful offender, Igor Kolomoisky. And, although an Austrian court failed to extradite Dmytro Firtash to the United States, Ukraine’s authorities are now confiscating some of his assets and reining in his gas-distribution monopoly.

Moreover, although the banking system has not yet been recapitalized and remains vulnerable, the National Bank of Ukraine is exercising effective control. There has also been some progress in introducing e-government and transparency in procurement. Unfortunately, efforts to reform the judiciary and implement effective anti-corruption measures remain disappointing.

The lynchpin of economic reform is the gas sector. A radical makeover could ensure energy independence from Russia, root out the costliest forms of corruption, plug the largest drain on the budget, and make a significant contribution to a unified gas market in Europe.

All of the reformers are determined to move to market pricing as fast as possible. This requires introducing direct subsidies to needy households before the start of the next heating season. Mistakes and delays in registering households could generate a flood of complaints and ruin the governing coalition’s chances in the upcoming local elections.

This danger could be removed by assuring the public that all applications will be approved automatically for one heating season; but that may require additional budgetary support. Worse, many within the government are reluctant to move ahead with market pricing, to say nothing of the oligarchs who profit from the current arrangements. Poroshenko and Yatsenyuk have yet to assume joint personal responsibility and overcome all opposition. Ukraine’s reformist zeal could weaken.

Given the deteriorating external reality, reform exhaustion in Ukraine is all the more likely if the EU persists on its current course. Radical reform of the gas sector may be derailed, a renewed financial crisis will be difficult to avoid, and the governing coalition is liable to lose popular support.

Indeed, in the worst-case scenario, the possibility of an armed insurrection – which has been openly discussed – cannot be excluded. There are more than 1.4 million internally displaced people in Ukraine today; more than two million Ukrainian refugees could flood Europe.

On the other hand, the “new” Ukraine has repeatedly surprised everyone by its resilience; it may surprise us again. But Ukraine’s allies – particularly the EU – can do better. By revising their policies, they can ensure that the new Ukraine will succeed.