Astana Summit delayed; Ukraine faces difficult domestic challenges

The Kremlin's recent calls, at least publicly, for a diplomatic resolution to the Ukrainian crisis begs the question: are sanctions and economic troubles forcing Moscow to the negotiating table? We believe this is not the case. Last night's cancellation of peace talks planned for Thursday in Kazakhstan supports our view that Russia is stalling for time and preparing for renewed economic, political, and military pressure on Ukraine. Meanwhile, Ukraine enters 2015 faced with three Herculean tasks: avoid default (we are cautiously bullish), deliver reforms (the prospects are uncertain), and mitigate public discontent (again, we are cautiously bullish).

The loud headline number of USD 48/bbl-and-falling Brent crude, combined with a lull in overt aggression from Russia in Ukraine's east and somewhat more diplomatic language coming out of the Kremlin, begs the question: are sanctions and macro troubles finally starting to force Moscow's hand?

Perhaps. Perhaps not. As many commentators have noted, the "softer" Russia of late could be a product of temporary factors: initial shock at the sharp drop in oil prices or the winter conditions that have made a military or quasi-military strategy less attractive for the next few months.

While there is no question the Russian economy is a house of cards that has been shaken by the oil and ruble weakness, we tend to take the view that the Kremlin has adopted a holding pattern, awaiting more favourable weather conditions and allowing the economic dust to settle and to take stock of its positions (economic, political, and military) come spring.

The result of that holding pattern is a more diplomatic Kremlin, which has recently renewed calls for a political resolution to the crisis (although the Kremlin's line is still unpalatable to the strong majority of Ukrainians and it continues to bear the hallmarks of a power that falsely believes it to have a say in the internal politics of another sovereign state).

That diplomacy, in turn, was to have taken centre stage this Thursday in Astana, with four-way talks between Ukraine, Russia, Germany, and France. Late last night, however, in the aftermath of a meeting of the foreign ministers of the four states, the mini-summit was postponed for "a few weeks" owing to a lack of progress.

The meeting was to have focused on a re-commitment to the Minsk Accords, which have failed to institutionalize peace in Ukraine. Even a cursory glance at the interests and motivations of each of the four states that were unable to move peace talks forward would suggest the blame for the failure of the peace talks lies squarely with Russia. Last night's developments support our view that Russia is stalling, with no intention to seek a resolution that doesn't meet its goals. In turn, Russia's unwillingness to make real progress would suggest that sanctions will remain in place – last week, both French President Francois Hollande and Germany Vice Chancellor Sigmar Gabriel had called for a softening of the sanctions, which could have had legs had Russia adopted a more constructive position.

In the meantime, the Ukrainian government's domestic task early in 2015 can be boiled down to three simple goals, which are simultaneously three massive undertakings. First – avoid default. Second – institute broad and deep reforms. Third – mitigate public discontent.

The first is dependent on international creditors. As we note in today's economic monthly, we estimate Ukraine will need to raise USD 21 bln to repay external debt, cover the current account gap, and maintain FX market stability; about USD 15 bln seem to already be secured. Against that backdrop, George Soros visited Ukraine yesterday and met with Ukrainian MPs, to whom he stressed the need for reforms and especially progress on fighting corruption. The meeting comes on the heels of a New York Times editorial by Soros last week in which the famed investor lobbied for a USD 50 bln financial package for Ukraine, essentially to take the question of a default off the table to allow the Ukrainian side time to enact real reforms. Although Soros' package looks ambitious, we do believe foreign creditors will likely piece together another USD 6 bln needed to maintain macro stability in Ukraine.

Soros' plan calls for a financial rescue to preface actual progress on reforms, not come on the heels of reform. The plan is idealistic and perhaps great on paper, but in reality it will face difficulty gaining traction, in our view. Nevertheless, the governing parliamentary coalition did set out an ambitious reform program in the coalition agreement signed at the end of 2014. With the first sitting session of parliament taking place today, it is too early to make conclusions on the prospects for a real push towards reforms.

Curbing public discontent will depend to a degree on Ukraine's ability to avoid default and to pursue reforms. It will also depend on the government's commitment to deliver on the demands of the Maidan. Yesterday, Interior Minister Arsen Avakov revealed that Interpol has put out international arrest warrants for former President Yanukovych, former PM Azarov, and others. The move should please Maidan activists, although they shouldn't hold out for an actual arrest on any former Ukrainian officials, most of which are seeking refuge inside Russia. In all, we do believe the public's discontent can be held in check, especially given the unprecedented unity currently on display. We do note, however, that isolated incidents have the potential to cause the winds to shift rather quickly given the volatile environment in Ukraine at the moment.