What the IMF Doesn't Know About Ukraine

(Bloomberg View) -- The conflict between Ukraine and Russia entered a new phase on Wednesday. The separatist, pro-Russian "people's republics" of eastern Ukraine announced they were taking over Ukrainian oligarchs' assets on their territory. Few people outside Ukraine know that throughout the three-year hostilities, these factories and mines paid Ukrainian taxes, and their output was counted toward Ukraine's gross domestic product. If the takeover stands, Ukraine won't see the predicted economic growth.

Unlike the military action and its geopolitical consequences, the economic side of the conflict in eastern Ukraine has never received much attention. It was assumed that Ukraine simply lost the industry of the separatist-controlled parts of the Donetsk and Luhansk regions. The October 2016 International Monetary Fund report on the state of the IMF's $17.5 billion rescue program for Ukraine had a chart showing the eastern regions as a slice taken out of Ukraine's economic pie.

The self-declared people's republics in the Donetsk and Luhansk regions are run by a volatile mix of local gangsters and warlords and Russian military and intelligence officers, all of whom must seek the Kremlin's approval for any major action. The unrecognized status of these self-declared people's republics means they don't have full-service banks, a normal tax system or law and order in the ordinary sense. Lost industrial production from the region contributed to the 9.9 percent drop in Ukraine's GDP in 2015. But some 20 large factories and mines, with around 75,000 workers, continued operating in the rebel-held areas under a flimsy arrangement. Their output was counted as Ukrainian; part of it was exported via Ukraine, providing much needed foreign currency revenue.

It's not easy to determine how much the companies contribute to Ukraine's GDP, because their place of registration is not their actual location. The IMF, which has reportedly signed a new memorandum with the Ukrainian authorities to confirm the release of a fresh $1 billion loan, doesn't have the data. But these are important assets. Ukrainian legislator Natalya Veselova recently requested information from the government about how much eight of the factories and mines paid in Ukrainian taxes. The number she was given for 2016 was 1.3 billion hryvnias ($47 million). The entire Ukrainian-registered industry of the eastern regions likely provided more than 1 percent of Ukraine's 2016 tax revenue.

The "people's republics" rely on Moscow for most of the funding they need to function -- hundreds of millions of dollars a year. It's a drag on the strained Russian budget. Moscow has paid up, but pressured the "republics" to squeeze more revenue from local business. In recent weeks, Ukraine gave the separatists a pretext to move on the Ukraine-registered industries.

On Jan. 25, groups of Ukrainian military veterans blockaded the railroads and highways between the separatist-held areas and Ukraine, demanding that the government stop trading with the rebels. Much of the trade involved the production chains of vertically integrated holding companies: The rebel-held areas, for example, supplied coal to power plants and steel factories in government-controlled territory. The government was immediately unhappy with the blockade, explaining that buying coal elsewhere would sharply increase costs and, in any case, would take time. Since Feb. 17, the Ukrainian energy system has been under a blockade-induced state of emergency.

The Kiev government doesn't dare try to lift the blockade by force. That would be hugely unpopular and, worse, could provoke riots and perhaps a new forcible regime change. "It's impossible to imagine anything worse than an armed conflict among Ukrainians close to the front line," Andriy Sadovyi, the popular mayor of Lviv in Western Ukraine, wrote on Facebook recently.

Dragon Capital, a Kiev-based investment bank, has calculated that the blockade could shave 0.6 percentage points off Ukraine's GDP this year. That doesn't include any damage from the rebels' takeover of the industrial. If both the blockade and a more or less complete "nationalization" of these assets persist through 2017, it's not likely that Ukraine will see growth at all, much less the 2.5 percent predicted by the Bloomberg consensus forecast. And the IMF will have to explain, as it did in last year's assessment, that the economic predictions on which its assistance to Ukraine was based had been too rosy. 

Most of the steel works and mines in this part of Ukraine belong to Rinat Akhmetov, a Donetsk native and Ukraine's richest man, who has developed relationships with both local authorities and the Kiev government. Akhmetov has learned to stay on the good side of officials and regulators, and Petro Poroshenko's government has been careful not to attack him; that's what made the arrangement work for the past three years. His money has smoothed the humanitarian woes of the rebel regions, and his companies provide much of the heating and electricity to Ukraine's homes. A minority of eastern Ukraine's industrial assets belong to other Ukraine-based oligarchs, such as Serhiy Taruta and Vadim Novinsky. They, too, learned the balancing act.

Akhmetov and the other oligarchs will fight to keep their assets from being "nationalized." They will, however, have a hard time, even if Ukraine somehow succeeds in ending the blockade. Moscow has approved the takeover. "We're talking about the lives of several million people," President Vladimir Putin's press secretary Dmitri Peskov said. "People need to survive." Poroshenko has announced that he'll demand additional international sanctions against those profiting from the "nationalization," but new anti-Russian sanctions are not a popular idea in Europe today.

The Kremlin is serious about putting an economic squeeze on Ukraine. About 2.1 million Ukrainians live and work in Russia; this large diaspora is the biggest single source of remittances to Ukraine; according to the World Bank, Ukraine is the most remittance-dependent country in Europe and Central Asia, deriving 6 percent of its GDP from that source. Last October, Ukraine banned Russian remittance systems; in response, a bill now going through the Russian parliament bans the use of foreign payment systems such as Western Union to transfer money from Russia to Ukraine.

The remaining economic ties between Russia and Ukraine, including the arrangement for Ukrainian companies to operate in the rebel-held east, have been the only obstacles to an all-out war. As they are severed, the probability of armed unrest in Ukraine and more direct Russian interference increases. But even if the worst-case scenario doesn't unfold, Ukraine will probably do worse economically this year than its creditors, and its people, expect.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.

To contact the author of this story: Leonid Bershidsky at lbershidsky@bloomberg.net.

To contact the editor responsible for this story: Therese Raphael at traphael4@bloomberg.net.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.