Following the dramatic collapse of the pro-Russia government in Ukraine over the weekend, the Ukraine parliament is working on establishing a coalition government and seeking a much-needed international financial aid package. The challenges confronting Ukraine and those seeking to assist the country are daunting. Mark Leonard, director of the European Council on Foreign Relations is quoted in the Sunday New York Times saying, “Nobody wants to end up owning all the problems that Ukraine faces. The country is bankrupt, it has a terrible, broken system of government and insane levels of corruption.” Nevertheless, as Zbigniew Brzezinski wrote in the Financial Times, “As chaos explodes in Ukraine and the threat of Russian intervention persists, the responsibility of the west to help attain a constructive outcome becomes more self-evident.”
Ukraine, with a population of 46 million, is the second largest country in Europe after Russia. Politically, it straddles the fault line between Western/Central and Eastern Europe, with Poland, Hungary, and the Slovak Republic on its western border and Russia and Belarus to the east and north. In the south, the autonomous republic of Crimea is home to Russia’s Black Sea Fleet. A significant portion of the population, about one third, speaks Russian as their first language; and the historical ties with Russia are strong, particularly in the eastern half of the country. At the same time, cultural and commercial ties to Central and Western Europe have a long history and have been strengthened since the breakup of the Soviet Union and the “Orange Revolution” in 2005, which put pro-West politicians in power.
The Ukrainian revolution marks a critical moment, not only for that country but also for Europe and for Russia. It follows a year in which intensive efforts by the EU to negotiate a trade and political deal, and IMF negotiations on a financial aid package – both of which would have tied Ukraine more closely with the West – were countered by a Russian offer of a $15 billion bond-buying arrangement, which President Yanukovych accepted, rejecting the EU deal. The tide, however, has now turned against Russia, with the Europeans, the US, and the IMF scrambling to help the Ukraine to stabilize and shore up its economy.
The Russian response is not clear at this time. It has halted its bond-buying payments, with Finance Minister Siluanov saying, “Now we must wait until a new government is formed before a decision can be made.” He also appeared to be open to an IMF bailout. Now that Russia is unlikely to be able to pressure Ukraine to reject closer economic and political ties to Europe, adding to its already heavy ($28 billion) exposure to Ukrainian bonds isn’t very attractive. Standard & Poor’s cut Ukraine’s bond rating on February 21 to CCC.
Bond investors are taking a more positive view after the weekend’s events, with the yield dropping to 211 basis points in the last three days and then backing up 30 basis points today. A bailout package does look likely, led by the EU and the IMF, with US support, but the terms remain unclear. Acting Ukraine Finance Minister Yurly Kolobov said that a $35 billion financing package is needed for this year and next. This is more than double the $15 billion bailout that was being negotiated with the IMF starting in 2012. Those talks stalled when Ukraine rejected some of the conditions being demanded by the IMF, including a cut in household heating subsidies. The change in government and the new situation in the Ukraine make it much more likely that an agreement can be struck.
The $176 billion Ukraine economy is also divided along East-West lines, with critical pressure points Russia could use to try to influence political developments. Heavy industry, built in the years under Soviet rule, is concentrated in the eastern part of the country. Heavy-industry exports suffered greatly during the 2008-9 global recession. Ukraine has a long history as a major agricultural producer and particularly as an exporter of wheat. Ukraine’s exports of wheat (mainly to the Middle East and the EU) remained strong in 2013 and are expected to play a leading role in the economic recovery once it gets underway. Of Ukraine’s total exports, 25.7% went to Russia and 24.9% to the European Union in 2012. Ukraine’s exports to Russia are now at risk, however, as Russia could apply some form of trade restrictions (which then surely would be challenged as contrary to the trade rules of the WTO).
The greater risk for Ukraine comes from the gas pipelines that are the main fuel transit routes to Europe from Russia as well as the supply source for the domestic economy. Vladimir Putin has demonstrated in the past his willingness to use the gas price and even the supply to apply political pressure. However, it is encouraging to see reports that Russian Prime Minister Dmitry Medvedev has said Russia will honor all its agreements with Ukraine, including an accord for cut-price gas shipments (a 30% cut in the gas price). Other comments by Medvedev were less encouraging, including his assertion that the interim authorities in Kiev had conducted “armed mutiny” and that “there is a real threat to our interests and the lives of our citizens.” Ukraine has wisely been actively seeking alternatives to its current dependence on Russia for gas and oil supplies.
We don’t know how this situation will play out. Putin’s vision of forging a Eurasian Union has been dealt a setback. Pro-democratic elements in other former members of the Soviet Union and probably in Russia as well may have been encouraged. Were Putin to counter militarily in Ukraine, the results would be disastrous for Ukraine and extremely dangerous for its neighbors and the West. Countries in Central and Eastern Europe correctly fear any strong-handed attempt by Russia to force Ukraine into its orbit.
The new Ukraine government and the West should be careful not to overplay their hands. To again quote Brzezinski, the West “…needs to play a constructive role in forestalling the potential explosion of regional violence in Ukraine, abetted from Russia. That will take concerted action by the US and the EU.” It will also take the cooperation of Russia, with the shared objective of an “independent and territorially undivided Ukraine” with “wide-ranging economic relations with Russia and the EU.” The country should remain unaligned in East-West security terms.
The investment implications for equity markets are largely in the area of geopolitical risk. Should there be a serious confrontation between Russia and the West over Ukraine, political risk premia would rise in Russia and in Europe and would likely lead to a general pullback in global equity markets. Absent such a development, the long-evident, serious economic situation in the Ukraine, its years of economic mismanagement, its very low bond rating, and the small size of its financial market mean that it has limited potential to deliver a negative surprise sufficient to produce financial contagion in markets. That said, the treatment of bondholders in the context of the expected bailout will be a critical point to watch.
The Ukraine equity market itself is very small, and there is no Ukraine ETF available on the US markets. Indeed the two available Eastern Europe regional ETFs, SPDR S&P Emerging Europe (GUR) and MSCI Emerging Markets Eastern Europe (ESR) do not appear to have any Ukraine holdings.
Of the former states of the Soviet Union and other states that once lay behind the Iron Curtain, only Poland, Hungary, the Czech Republic, and Russia have significant equity markets and hence are of potential interest for Cumberland Advisors’ International and Global Equity Portfolios. We currently do not hold positions in any of these markets. Since we use only ETFs in our equity portfolios, neither the Czech Republic nor Hungary are presently in our “investment universe,” as there are no individual country ETFs presently available for these markets.
We have not held Russian ETFs in our accounts for some time, since we are no fans of Putin and the unacceptable governance standards in Russia. Russia’s economic growth has stagnated at a little over 1% per annum while inflation remains stubbornly high, with the consumer price index advancing at a 6.4% rate in the fourth quarter of last year. Staying out of the Russian market has proven to be wise. According to the MSCI Russia Index, that market is down 8.42% year-to-date,-12.21% over the past 12 months, and -10.25% over the past three years.
Instead, we have favored Poland in the past and will likely do so again. Poland has generally followed sound economic policies. Its economy now appears to be on a gradually accelerating growth path following last year’s slowdown. It does have relatively high short-term external financial liabilities that make it vulnerable to any reduction in capital flows to emerging markets. Reserves equal to about six months of imports provide some insurance, but more would be desirable. Further insurance is provided by an IMF potential credit line. The most important factor, however, is its sovereign credit ranking of A/A2 that permits it to borrow at very favorable rates. Poland is considered to be one of the safest emerging markets.
Poland’s equity market trended down in the last quarter of 2013 and in January. It has been recovering so far in February. The MSCI Poland Index rose 11.87% in February-to-date, or 5.41% year-to-date, and 11.27% over the past 12 months. This is not only dramatically better than the Russian market; it also outperformed the emerging markets benchmark, which is still down -4.42% year-to-date and -9.02% over the past 12 months. Further, it tops the German market’s year-to-date performance of just +0.77%, but not Germany’s 12-month performance of +28.34%.
For investing in the Polish market there are two ETFs, the iShares MSCI Poland ETF (EPOL), and Market Vectors Poland ETF (PLND). We prefer EPOL, which is by far the most liquid of the two. It is interesting to note that both rose Monday in the first market day following the ousting of the Ukraine president. Only time will tell if the market’s optimistic view of developments in Ukraine are warranted.
