Crisis in Ukraine

Since November, Ukraine has experienced widespread civil unrest. In late November, Ukrainian President Yanukovych decided not to join an EU-sponsored trade pact called the Eastern Partnership. This led to protests from Ukrainians who desired closer relations with Europe. As protests continued, Yanukovych tried repressive measures. These acts seemed to spur even more unrest. Recently, the Ukrainian president tried to placate the protestors by offering the prime minister’s job to opposition leaders. This offer was rejected. At present, there is no end in sight to this turmoil.

In this report, we will begin by discussing the geopolitics of the nations involved, examining how nations have adjusted their policies over time to changing conditions. We will analyze the risks to the region from current unrest, including a look at the impact on emerging markets. As always, we will conclude with potential market ramifications.

The Geopolitics

The word Ukraine is roughly translated as “border.” Some Russian histories suggest that the origin of Russia began with a grouping of ethnic Slavs who occupied the area including modern-day Kiev and Moscow.


The red area on this map is purported to be the founding area of the Russian state, where the original Slavs gathered to establish a distinct Russian people. Modern-day Ukraine is included in this area.

(Source: University of Texas)

This map shows Ukraine within the continent of Europe. Kiev is only 530 miles from Moscow and its southern plains offer a nearly open path to Russia’s oil fields and other important cities.

Simply put, European Russia is virtually indefensible if Ukraine is held by a hostile power. Hitler’s invasion in 1941 shows Russia’s vulnerability; Hitler used Ukraine as a road to Russia’s oil fields and the Black Sea.


Conversely, a Central or Western European power wanting to reduce Russia’s influence on Europe would work to control Ukraine. Thus, Ukraine has historically been at the crossroads of geopolitical power.

This was evident in the latter stages of WWI. After the Bolshevik revolution, Russia ended its participation in the war. As part of the peace treaty with the new Russian/Soviet government, Germany demanded Ukraine as compensation for granting peace. The Bolsheviks agreed, only to use military force to recapture Ukraine after Germany surrendered.

Over the past millennia, Ukraine has rarely been an independent nation; it was usually controlled by a European power (Poland, Lithuania) or Russia. Because of this, there hasn’t always been a strong sense of Ukrainian nationalism. Rather, this historical pattern created conditions where loyalties have been divided, some parts favoring Russia, others Europe. In fact, the current period of Ukrainian independence (since 1991) has been the longest in its history.

The aforementioned divisions have gradually emerged since Ukraine became independent in 1991. The first two presidents, Leonid Kravchuk and Leonid Kuchma, were Russian loyalists and Ukraine was affiliated with Russia. In 2004, in a blatantly rigged election, Viktor Yanukovych, a Russian supporter, won the presidency.1 Soon after, widespread protests developed which led to new elections and brought Viktor Yushchenko to power; he was supportive of Europe and the West. This event, known as the “Orange Revolution,” was seen by the West as a grassroots uprising of the Ukrainian people against corruption and for true democracy. Russian President Vladimir Putin viewed Yushchenko’s rise to power as a coup engineered by Western intelligence agencies working through non-governmental organizations (NGOs).

Since Yushchenko’s election, Russia has engaged in policies designed to undermine Ukraine’s economy. One of the most famous incidents was Russia’s decision to shut off natural gas sales in the winter of 2005-06. Although an agreement was eventually reached, the disruption affected Europe as well. This situation was repeated in March 2008 and in late 2009.

Ukraine’s weak economy led voters to oust Yushchenko in the 2010 elections. The election became a race between Yulia Timoshenko and Yanukovych. Neither won a majority; however, if Yushchenko had thrown his support to Timoshenko, she would have gained a slim majority. Instead, he refused and Yanukovych won in a runoff. In due time, Yanukovych accused Timoshenko of corruption; she was prosecuted and is currently in prison.

A map of voting in Ukraine offers an interesting insight into Ukraine’s divisions.

(Source: Washington Post)

In the 2010 election, the regions in yellow voted for Ms. Timoshenko and the blue went with Yanukovych. The subsequent map explains the regional division.

(Source: KIIS)

This chart shows the degree of Russian language usage. Yanukovych dominated in the Russian speaking areas while Timoshenko did better where Ukrainian was spoken.

The Evolution of Geopolitical Conditions

Russia, over the centuries, has seen Ukraine as a key region. After WWI, it moved to take control of Ukraine and held it as part of the Soviet Union until it dissolved. Since Ukrainian independence, Russian thinking on Ukraine has moved from wanting direct control to opting for overbearing influence. Putin’s view appears to be that one of the great failures of the Soviet Union was its inability to afford the annexation of Russia’s “near abroad.” From his perspective, Russia simply needs to dominate these areas but should avoid actual control. Putin seems to believe that annexing these areas will be a drain on resources.

The basic stance of the EU elites is that a key goal of the union is expansion. Despite concerns that adding newer, less developed and less democratic states raises the risk that the established nations may be forced to increase transfers to support development, expansion is still seen as a goal of the EU. As the aforementioned WWI example showed, European control of Ukraine gives the EU power over Russia. At the same time, the EU’s ability to back up such expansion economically and militarily depends on U.S. support. And, for the most part, although the U.S. generally sees NATO expansion as favorable, wars in the Middle East and the pivot to Asia mean that America’s “bandwidth” to take on Russia in this area is limited.

To distill this situation to its most fine point, Russia cannot afford a Ukraine aligned with the West. Such an outcome would put Russia at risk. At the same time, Russia doesn’t want to spend too much money to keep Ukraine under its influence. It has no interest in taking control, fearing that the dysfunctional Ukrainian economy will undermine its own. Instead, Putin wants Ukraine to be a member of its Customs Union, a trade grouping of former Soviet states.

Europe also sees Ukraine’s economy as dysfunctional and thus does not want to offer full EU membership at this time. Instead, the EU offered membership in its Eastern Partnership, which is a trade zone, talking shop and venue for institution building. The EU sees it as a way to offer important nations of the former Soviet Union help in building Western economies and political institutions while avoiding the costs and responsibilities of full EU membership.

Europe is not going to expend too much of its political or economic resources on Ukraine. Instead, the EU is using Ukraine as a way to irritate and undermine Russia in Eastern Europe. Since Ukraine is much more important to Russia, the EU can force Putin to expend precious economic and political resources by offering relatively low cost overtures to Ukraine.

In viewing the above maps, it should come as no surprise that Ukraine is divided along these outside influences as well. The eastern, Russian-speaking area of Ukraine is deeply integrated into the Russian economy. If its manufactured products were forced to compete with EU goods, they would rapidly go out of business. The western regions of the country are more economically integrated with Poland and could grow faster in an EU environment.

Although this opposition views Yanukovych as a Russian stooge, that position is probably too simplistic. Instead, it appears that Yanukovych is trying to weave a narrow path between Russia and the EU in order to be in good graces with both. Placating both sides appears to be a good political strategy, except that neither the EU nor Russia will tolerate such a policy. Russia will not let Ukraine have membership in both the Customs Union and the Eastern Partnership; not only would that give the EU a foothold in the Ukraine, it would unleash EU products into Russia’s market. And the EU is demanding the release of Yulia Timoshenko from prison; although she may not have the same power as she used to, Yanukovych cannot accept this requirement as she is a threat to his political power.

The Risks

The geopolitical situation means that the current unrest can go on for a long time. No outside power has enough interest in Ukraine to force closure and Ukrainian society is too divided to easily create an acceptable outcome. At this point, we doubt the unrest will spread to other regions. However, there is a small possibility that domestic order will devolve, creating a civil war. That may force Russia to intervene, which may prove to be an expensive proposition. Russia would like to see Yanukovych quell the protests. Officials within Putin’s government made veiled threats over the weekend that suggested Yanukovych needed to put down the protests by any means necessary or he may face consequences. The threat was that if Yanukovych couldn’t bring the protests to heel, Russia would find a Ukrainian leader who could. Putin has already promised to reduce natural gas costs and $15 bn in additional support. However, he has decided to withhold these promises until conditions stabilize. The fact that President Yanukovych has taken a medical leave means a power vacuum may be developing. If conditions deteriorate further, Russia may be simply forced to intervene.


Given the current fragile conditions across the emerging economies, a civil conflict in Ukraine may raise fears of similar problems in other venues. Thailand is flirting with violent civil unrest, and protests have been seen in Turkey as well. Neither the U.S. nor the EU will likely take steps to quell the violence in Ukraine. In fact, trouble there is supportive for U.S. and EU goals because it forces Russia to expend economic and political resources to control the situation. However, if Russia were to take active measures, like military action, to control unrest, we would not expect the U.S. or the EU to oppose Russia’s move beyond verbal protests.

At this juncture, we expect unrest to continue in Ukraine but probably not worsen. The opposition does appear unified in wanting to remove Yanukovych but have not coalesced around an opposition leader to take his place. Without such leadership, the current unrest will likely continue but probably won’t escalate unless Yanukovych tries overly repressive measures.

For investors, the crisis in Ukraine highlights the risks of emerging market investing. This doesn’t mean investors should not venture into this asset class on occasion, but it makes clear that one takes on potentially significant geopolitical risks in these less developed markets.

Bill O’Grady

February 3, 2014

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

1 Vladimir Putin was the only major world leader to recognize Yanukovych ’s “victory.”

© Confluence Investment Management

© Confluence Investment Management

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