Ukraine: Russia cuts off cheap gas, U.S. arrives with aid

The battle over Ukraine's future is also economic: on Tuesday, Russia cranked up the pressure by ending discounts on its natural gas supplies, while the U.S. and European Union offered quick-fix aid to the beleaguered government.

To help Ukraine in the longer term, International Monetary Fund experts began work here on a plan to stabilize the near-bankrupt country's finances and failing economy. The IMF's help is expected to come with conditions that will be tough, but at this point inevitable.

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"Without the expected financial assistance from Western donors, Ukraine is likely to default," Lilit Gevorgyan of IHS Global Insight says in a research note.

Concerns over Ukraine's financial condition whose treasury account is, by its own admission, almost empty rose after Russian state gas company Gazprom said it would cancel a substantial discount on natural gas granted in December. President Vladimir Putin, meanwhile, noted Ukraine still owes some $2 billion for gas.

The Russian position is a shift from last year, when Moscow tolerated letting Ukraine pile up unpaid bills. The discount was granted under a $15-billion Russian bailout in December that was halted following the ouster of pro-Russian President Viktor Yanukovych by a protest movement by people who want closer ties with the European Union.

To counter Moscow's tougher stance, U.S. Secretary of State John Kerry, who was visiting Kyiv on Tuesday, offered $1 billion in loan guarantees. The European Commission, the European Union's executive arm, will decide on a package of support measures on Wednesday, spokeswoman Pia Ahrenkilde Hansen told reporters in Brussels without providing details. Ukraine's parliament signed off on the terms of 610 million euros from an earlier EU aid package but that money won't be paid until Ukraine seals a bailout deal with the IMF.

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That short-term support is key because a full financial assistance program from the IMF may take time to conclude. Analyst Gevorgyan said that for the IMF to commit any substantial assistance the country would need a more stable government, which was only likely after a new president is elected May 25.

That still leaves Ukraine some time, as major debt repayments are not due until June. The key risk until then is whether Russia demands prompt payment for its gas. That could put more pressure on the country's finances.

Although nerves remained on edge in Crimea, with Russian troops firing warning shots to ward off Ukrainian soldiers, global markets catapulted higher on tentative signals that the Kremlin was not seeking to escalate the conflict.

Markets recover Tuesday

The Russian ruble moved up off its record low set yesterday and Russias markets rebounded by six per cent. Even Ukraine's Eurobondsrecovered, their yield falling 89 basis points to 9.65 per cent.

Both European and North American markets which dropped yesterday were optimistic on Tuesday. The S&P/TSX composite index gained 77.12 points to 14,289.86, led by base metal stocks.

The Dow Jones industrials jumped 227.85 points to 16,395.88, the Nasdaq gained 74.67 points to 4,351.97 and the S&P 500 index ran up 28.18 points to 1,873.91.

A Ukrainian debt default would have a limited impact on economic activity in the rest of Europe, analysts say. But it could hurt stock prices and have an impact on individual banks and countries that are heavily exposed to the region.

Vasyl Yurchyshyn, director of economic programs at the Razumkov Centre research institute in Kyiv, as the IMF likely realizes that circumstances are dire and may provide at least some money within several weeks.

"Here I think you can be an optimist... It's clear the IMF may take a softer position," Yurchyshyn said.

Even then, however, the basic conditions from the past two IMF aid programs will remain: mainly, abandoning the practice of charging consumers only about one-fifth of the price that state gas company Naftogaz pays to Ukraine.

Two previous Ukrainian governments agreed to IMF loan programs only to see the aid cut off after they balked at that condition. The current government, however, will likely comply. "We have no choice," Prime Minister Arseniy Yatsenyuk said Monday.

Higher heating prices ahead

Yurchyshyn noted any IMF deal would likely make the increase in the gas price gradual and offer targeted welfare assistance to the poor, who would be hit hardest. A recent World Bank report said that most of the spending on the gas subsidy benefits people who are above the poverty line. The cheap gas policy costs the Ukrainian government the equivalent of 7.5 per cent of annual economic output.

Raising home heating prices may cost the new government popularity. But economists say Ukraine's decades-old addiction to cheap gas has helped stunt its economy by deterring energy efficiency and supporting older and less efficient industries.

Analyst Timothy Ash at Standard Bank said the Russian demand might ironically help the Yatsenyuk government sell higher gas prices to the public politically: "It can now directly link these to the hike in the import price from Russia thank you Vlad," Ash wrote in an email.