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The Economic Future (if Any) of “Novorossiya”

Last May, I posted an item on the economic situation in the rebellious regions of Eastern Ukraine, or “Novorossiya” (New Russia), to use the term increasingly favored by separatists and  their Russian sponsors. Novorossiya was the name of a province of Tsarist Russia that occupied much of the southern part of present-day Ukraine, stretching all the way to Odessa. At present, the separatist “Federal State of Novorossiya,” consisting of parts of Donetsk and Luhansk oblasts, lays claim to only a small slice of historical Novorossiya. As the map shows, expansion of the separatist-held territory toward the south-west would provide Russia with an overland route to Crimea.

 

In that earlier post, I outlined three possible outcomes of the conflict in Ukrainian Donbas, the heavily industrialized area around the cities of Donetsk and Luhansk that is the only part of historical Novorossiya that the separatists control as of early October. One was that Kiev would re-establish full control over the region with minimal concessions to local autonomy. The second was full Russian annexation, as of Crimea. The third was the emergence of yet another zone of frozen conflict like those of Transdniestria, Abkhazia, South Ossetia, and Nagorno-Karabakh.

Although the fighting has not yet entirely stopped, the conflict is rapidly congealing, making the third variant the most likely. It is time for an update, giving closer attention to that outcome. What would be the economic implications of a frozen conflict for the region itself, for the rest of Ukraine, and for Russia?

The economic prospects for the region

Before the current conflict broke out, the economy of the Donbas region centered on the steel industry, along with the coal mines that supplied a part of its energy needs and local steel-using industries that absorbed a part of its output. As explained in more detail in my earlier post, the outlook for steel and related industries in an independent but unrecognized Novorossiya is bleak, for several reasons:

  • Since May, there has been extensive war damage [1] [2], both to steel mills themselves and to key infrastructure, such as electric power and rail systems. With the economies of both Russia and Ukraine weakened by the conflict, neither is going to be eager to foot the bill for reconstruction. Furthermore, it is likely that many former steel workers and managers have been among the hundreds of thousands who have left the region, either for Russia or Western Ukraine. The more skilled those refugees are, the more likely it is that they will find permanent positions in the places to which they have fled, making it all the more difficult to get damaged facilities back into production.
  • Even before the conflict, the Donbas steel mills were only in the early stages of modernization. Modern technologies were beginning to appear, but according to one report, Ukrainian steel remained the second-least energy efficient among major global producers. Much of the completed or planned modernization was dependent on Western investors like Luxembourg-based ArcelorMittal. Those are unlikely to find it attractive to make further investments in a frozen conflict zone.
  • Low energy efficiency left Donbas steel dependent on subsidized energy. Modernization, in part, meant substitution of natural gas for coal, making the steel industry an enormous consumer of the latter fuel. Before the conflict, Ukraine purchased that gas from Russia and then resold it to steel makers at a discount. Kiev is unlikely to be willing or able to continue to be so generous, especially since Russia has now raised its gas export price. It is possible that Russia would be willing at some point to supply the gas directly to an independent Novorossiya on favorable terms, but that is not a done deal, and it would need work on the infrastructure.
  • Finally, even if the steel industry could resume production, who would be its customers? Before the conflict, Eastern Ukraine exported 27 percent of its steel to Western Europe. Much if not all of that business would be lost under conditions of a frozen conflict. Russia took another 20 percent of the region’s output, but with a steel industry of its own that is twice as large as Ukraine’s, those supplies are hardly essential. In the short run, with the Russian economy slowing, continued Russian demand for steel from Ukrainian Donbas is even less certain. Before the conflict, Ukrainian mills also had export customers in the Middle East and Africa, but by now, those will have found other suppliers. Given chronic overcapacity in the global steel industry, lost customers will be hard to win back.

Economic implications for Ukraine

Politically and strategically, the loss of the Donbas region would be a severe blow to the government in Kiev, but economically, less so. Before the conflict, the Eastern provinces were a net drain on the budget of the central government. As documented in my earlier post, net taxes flowed from the central government toward the eastern provinces. As noted earlier, the Ukrainian budget was subject to additional strain from providing subsidized gas to the region. In purely fiscal terms, loss of the Donbas region would be a net gain for Kiev.

The worst possible outcome for the Ukrainian economy would not be the complete loss of the Donbas, but rather, the possibility that political considerations could force the government in Kiev to continue subsidizing the region without re-establishing effective control over it. It is possible to imagine at least two reasons it might do so. One would be a feeling of solidarity arising from nationalistic sentiment and reluctance to admit the final loss of sovereignty. The other would be that Moscow might bully Kiev into accepting a bad peace settlement as the alternative to a steady military expansion of Novorossiya toward the south and west.

Politics aside, a diminished Ukraine without the Donbas would remain an economically viable entity, but there would be a difficult transition period as the many preconflict links between eastern and western regions were restructured.

Economic implications for Russia

What about Russia? For the sake of discussion, let’s assume that geopolitically, Russian President Vladimir Putin views a frozen conflict as a satisfactory outcome, at least for the medium term. For reasons already given, it is clear that a linkup with an independent but unrecognized Novorossiya is not going to be net gain for the Russian economy. The question is, how much of a burden will it be, and is the Russian economy in any shape to bear it?

First, it is important to recognize that even the small part of historical Novorossiya now occupied by separatist forces is far more populous than other Russian-sponsored frozen conflict zones. The preconflict population of Donetsk and Luhansk oblasts was about 6.6 million. That compares with 500,000 for Transdniestria, 200,000 for Abkhazia, and fewer than 100,000 for South Ossetia. Russia heavily subsidizes all of these frozen conflict zones through discounted gas, infrastructure spending, and support for pensions. The sums have been affordable only because the regions are tiny. Crimea, with its 2 million population now incorporated into the Russian Federation, will be much more expensive despite the fact that it had no significant war damage. Subsidies for Novorossiya would be an order of magnitude greater. Economist Paul Gregory estimates that the cost could be 6 to 8 percent of Russia’s annual budget.

Second, the Russian economy itself is in trouble. The strong growth of the first decade of Putin’s tenure, when Russia’s GDP nearly doubled, is a distant memory. Already before the Ukrainian conflict erupted, Russia was sliding toward recession. Under the added pressure of Western sanctions, growth is likely to be no more than half of one percent this year.

What is more, the Russian economy as a whole, and its federal budget in particular, are highly dependent on oil revenues. Recently, slowing demand in China and growing supply in the United States have been pushing prices lower. Urals crude dropped to $90 a barrel last week for the first time since the end of 2010. The price would have to make it back to well over $100 to balance Russia’s budget.

A budget deficit in no way means that the Russian government is bankrupt. It has half a trillion dollars in official foreign exchange reserves and some $92 billion in a rainy day fund, both built up during years of high oil prices. However, those funds are no longer growing. If oil prices average less than $96 in 2015, the ministry of finance says it will have to tap the rainy day fund, for the first time in six years. A tighter domestic budget makes the prospect of financing the reconstruction of Ukrainian Donbas that much less inviting.

The bottom line

Increasingly, it looks like Russia has won the geopolitical phase of the Ukrainian conflict, at least in the short run. In a last-ditch effort, Ukrainian President Poroshenko went to Washington to plead for military assistance. “One cannot win the war with blankets,” he told Congress during an impassioned speech. He then went to the White House where President Obama offered him more blankets. Poroshenko has now openly conceded that Russia has the upper hand militarily. “The more Ukrainian army battalions or brigades are brought up, the more troops there are from the Russian Federation,” he said in a September press conference.

Whether the frozen conflict in Novorossiya is also an economic victory for Putin is less certain. True, he could draw on Russian financial reserves to rebuild Ukrainian Donbas if he chose to do so, but those funds are finite and subject to conflicting claims from interests within Russia itself.

Alternatively, Putin could choose to leave the separatists to fend for themselves. In that case, as Russian political analyst Lillia Shevtsova wrote in a recent Financial Times op-ed, “The irony is that Novorossiya will soon become a problem for the Russian president. The Kremlin will have to contend with heavily armed separatists, embittered by their failure to secure a stipend from Moscow.”

If Shevtsova is right, Novorossiya may turn out to lack the long-term stability of a Transdiestria or an Abkhazia. If the region threatens to turn against Russia or descends  into chaos as winter comes, Putin might be faced with an unpalatable choice. He could make a humiliating geopolitical retreat and leave Kiev to deal with the economic and political problems of a shattered Donbas, or he could plunge forward, completing the Novorossiya land bridge to Crimea and formally incorporating the region into Russia regardless of the cost. The last chapter of this saga has not yet been written.

18 Responses to “The Economic Future (if Any) of “Novorossiya””

windrivenOctober 7th, 2014 at 10:52 am

"I do wonder whether a bad winter with little aid for Russia would lead to splits within"

It likely would, but why would Putin withhold aid? Western sanctions haven't much dissuaded him thus far and the costs are cheap compared to actually taking financial responsibility for the region. I just don't see Putin cutting the rebels loose; what does he have to gain by doing so? It is a low cost way to keep Ukraine struggling and dependent (energy).

windrivenOctober 7th, 2014 at 10:58 am

"The worst possible outcome for the Ukrainian economy would not be the complete loss of the Donbas, but rather, the possibility that political considerations could force the government in Kiev to continue subsidizing the region without re-establishing effective control over it."

The worst possible outcome … and arguably the most likely. It leaves Ukraine a crippled state in constant fear of its neighbor to the east, stuck with a rebellious millstone around its neck and more dependent on Russian energy than ever. Putin leaves Ukraine to slowly twist in the wind.

It is arguably the most likely outcome because Ukraine feels compelled to fight to keep this benighted territory yet lacks the military support from the West to neutralize Putin's "non-intervention" while Putin is under no pressure to deliver the coup de grace (and under modest pressure not to). With all due respect to Ms. Shevtsova, the situation in "Novorossiya" can be allowed to fester indefinitely with Putin titrating the flow of support to keep the rebels going but not victorious.

Ed Dolan EdDolanOctober 7th, 2014 at 11:29 am

I agree that Shevtsova's spin on "Putin's miscalulation" may be too optimistic. However, I do wonder whether a bad winter with little aid for Russia would lead to splits within, and maybe fighting among, separatist factions.

MishaMostovOctober 7th, 2014 at 6:57 pm

As usual, love your analytical reasoning, a rare treat in the sea of irrational hysteria and propaganda that surrounds this conflict. I think you predicted future as well as it could be predicted, with a caveat that "last chapter hasn't yet been written". I expect there will be more twists to the story, one possibility is that what has remained from Ukraine will continue to disintegrate, throwing monkey wrench into economic expectations. I don't expect that euphoria of "revolution" will survive for too long against unchanged reality. At some point the common-folk that lended their ears and support to right-wing leaders of the "revolution", will realize that they have gained nothing, and actually lost quite a bit. I don't know how current Ukrainian authorities will react to popular discontent: will they crumble like the previous corrupted regime, or continue slide toward totalitarian state, relying on force to quell opposition. With this in mind, who knows what will be the reaction of western investors to continuing uncertanity?

DiranMOctober 8th, 2014 at 8:34 am

The ignorance and hostility of American academia against Russia is mind-boggling! Not a peep of criticism of Victoria Nuland and US State Department policies over the Ukraine!!! No real understanding of the Ukraine and its history…..

Facts are that Ukraine has been a failed state since inception, ruled by oligarchs with their private armies, etc. The Maidan movement and the current debacle has made things far worse, the Kiev government has been bombing and destroying its most productive areas. Gas bills unpaid, food crops destroyed and winter coming shortly. Such is the chaos whenever Beltway policy makers get involved in foreign countries….

As the US knows and has to live with their Mexican neighbors for good or bad, so the Russians have to live with their troublesome neighbor. The Ukraine is part of their national history just as Mexico is an indelible part of US history. Plenty of Mexican economic immigrants just as Ukrainian workers in Russia, etc…

Until Nuland put her foot in the Ukraine, the previous leadership was negotiating with both EU and RF for money and trade agreements. The Russian were willing to give Ukraine far more money than the EU and continuation of the relationship would not have led to the civil war and turmoil in the Donbass, closely tied to Russia.

Conversely, the EU in any rational sense with all its own problems does not need another basket case like the Ukraine which will simply be an endless drain on their resources when they already have most of their Periphery in deep recession and double digit unemployment.

Like most poor countries, the Ukraine is basically looking for whoever will give them the biggest handouts with the oligarchs running off with the lion share of the money. That is their attraction to the EU bootstrapping, which might take several hundred years to have any effect and cost EU taxpayers plenty in the process, dragging them even further down and making hapless EU subjects poorer collectively in the process. Instead of leaving the damaged goods with the Russians, who do not really have other options, the Brussels idiots decided with Nuland prodding to take the Ukraine on their backs, something that most EU voters would have rejected if they had any say in the matter!

The EU has far more to gain with its commercial and energy deals with Russia, where it has considerable gain than to take on the Ukrainian failed state, get into destructive trade sanctions with Russia. Further since the US and EU do not have either money or popular support on their side with the Ukraine debacle, their only way out is to cooperate with Russia and share expenses. The Ukraine has no other options either.

DiranMOctober 8th, 2014 at 8:59 am

Technically the Ukraine is really two or three countries. It is the result of piecemealed administration during Soviet times, commingling different nationalities, religions, etc. The Maidan nationalism is really false and artificial. It is repulsive to many sections of the Ukraine.

Most of the pro-Western/ EU crowd are the Uniate Catholics from areas bordering Poland. They have a visceral hatred for Russians and Orthodox Christians. Many were rabid Nazi sympathizers in WW2, when the Germans invaded the Soviet Union. Perhaps the easiest way to bring better stability to the Ukraine would be to let this part merge with Poland, leaving a more homogeneous and Orthodox population, who could put together a coherent state.

It is very difficult for Americans to understand the primordial hatred between Catholics and Orthodox Christians. This was first illustrated in the Yugoslavian tragedy where Germany ran to recognize Catholic Croatia, who like their Uniate counterparts were rabid Nazi sympathizers and the Germans, exhibiting all their hatred and spite against the Serbs, who were the Yugoslavian resistance.

Kosovo was touted by the US and EU as a fantastic success story, but is anyone shouting about this today???

US commentators severely undestimate the Russian economy and its potential with its Euroasian links. The Ukraine is more likely to have better growth prospects in this direction rather than towards the moribund EU in its current morass. Even Turkey now is moving more towards Eurasia and Russia as well as the Middle East space and distancing themselves from the EU as well as generally making fools of the US by playing both sides with ISIS.

So one may be an admirer of Vicky Nuland and Madeleine Albright and their failed policies, but it is most likely that history will be on the side of the Russians and the Orthodox Christians in this part of the world, which belongs to them. Nuland would do better to deal with more mundane matters like all the US issues with Mexico, etc.

Ed Dolan EdDolanOctober 8th, 2014 at 11:54 am

I am familiar with the arguments you are advancing, but I think you are missing some of their implications. Here are some comments:

(1) "Facts are that Ukraine has been a failed state since inception, ruled by oligarchs with their private armies, etc."

Much the same could be said about Russia itself. Yes, Ukraine has massive problems with corruption, but calling on Russia to cure them is absurd.

(2) "As the US knows and has to live with their Mexican neighbors for good or bad, so the Russians have to live with their troublesome neighbor."

Yes, I think you have a good point here. It has been a long time since the US invaded Mexico. The last time it acquired a chunk of Mexican territory, it did so by purchase (Gadsen Purchase, 1853). I don't think anyone would have objected if Russia had followed that model in acquiring Crimea. As you say, the US has long since learned to live with Mexico for good or bad. Someday Russia may mature to the point where it can do the same.

(3) "Technically the Ukraine is really two or three countries. It is the result of piecemeal administration during Soviet times, commingling different nationalities, religions, etc. The Maidan nationalism is really false and artificial. It is repulsive to many sections of the Ukraine."

Yes, there are a lot of countries in the world that include many nationalities, religions, and cultures, some of whom hate the others. Often such countries were created artificially by outside forces, for example, Iraq, Czechoslovakia, etc. In other cases the origins were more historically complex (Spain, the UK, Belgium) but the result similar. There are internationally recognized procedures for reorganizing such states, e.g., the velvet divorce of Czechoslovakia, the independence of Norway from Sweden. If some of the Ukrainian regions want to secede, they should have followed the playbook of the Slovaks, Scots, or Catalans.

Thanks for your contribution to the discussion.

Ed Dolan EdDolanOctober 9th, 2014 at 8:03 am

I appreciate your willingness to participate in this thread, but you are departing rather far from the subject of this post. Please keep your comments calm and on topic.

DiranMOctober 9th, 2014 at 8:32 am

Your reply verifies my original point that US academia is bigotted towards Russia and shows nothing but contempt toward them. There the hubris that Americans see everyone else as immature children and know more about their part of the world than they do.

The US wants to impose its policies on others as it sees fit. It cannot recognize any other country as a sovereign state (unless they accept to be vassals…). If US policy makers do not like foreign governments, then it is regime change. I do not think that you can understand the bitterness of non-Americans about this.

Small wonder that Putin's approval rating is close to 90% with US academia's beloved Obama at around 30%…..

1.) Russia is a European great power and cannot be compared to the Ukraine any more than the US to Mexico. If US academia believes otherwise, this can only be explained by ignorance or bigotry. Under Putin, Russia has made considerable progress in reorganizing its economy after the Soviet collapse. Russian living standards have improved. Russia has been reclassified as a developed from medium income country.

2.) Russia has done more to keep the Ukraine afloat and preserve stability than any other country. It was willing to put US$ 15 billion prior Maidan, which dwarfs what the EU was offering. It has repeatedly called for a new constitution and federal system to maintain reconciliation. Since Vicky Nuland and US policy makers moved in with EU counterparts, the country is a shambles. US/EU policy makers have contributed to making the black hole even bigger, supporting a dreadful government that had the insane idea of bombing the Donbas into submission, destroying one of the most productive regions of Ukraine.

Congress voted US$ 58 million for the Ukraine whereas IMF is now estimating needs of US$ 50-60 billion of which there no appetite either in the US or the EU to fund this??? The US also takes joy also in trying to destablize the Russian economy as well as overturn the Putin leadership. The EU is now moving into another recession as a result of this mess as side damage. The Ukrainian economy is very tied to the Russian economy, so this is only increasing economic collapse in Ukraine.

3.) The Crimea was taken by the Russians from the Ottoman Empire and it had also to fight with the British and French, who tried to block their access to the Black Sea just as the US today is playing its new Grand Game in Ukraine.

Ukrainian involvement was never with the will of Crimean people. It was forced on them by the Soviets. Just Lenin created the Ukraine in the first place and included the Donbas by force, not popular will.

Now the US wants to punish Crimeans, who voted to join Russia. Is that a sign of democratic tolerance? Or is it traditional Western bigotry towards Russians?

On the other hand, the US/ EU did not have any problem to bombard savagely Serbia for more than month and kill civilians and destroy infrastructure in order to parcel out Kosovo and then recognize independence without any popular vote. There is more EU bureaucracy in Kosovo than any place outside of Brussels. What was the end result? It is still a hellhole – like most foreign countries where the US has left its hand and more and more of the EU under the Brussels bureaucracy.

My question to you is what can the US do that is positive instead of bringing destruction, death and economic damages on others? What gives US policy makers and academic elite the right to lecture the Russians, who have been involved in the Ukraine for centuries?

Ed Dolan EdDolanOctober 9th, 2014 at 11:57 am

Having lived many years in Russia, and despite understanding the language well, I continue be amazed at the difficulties in communication between Russians and Americans. All too often, discussions end up at a point where each party is saying something that is the exact mirror image of what the other party thinks. Your comments supply a perfect example of that when you say:

"The US wants to impose its policies on others as it sees fit. It cannot recognize any other country as a sovereign state (unless they accept to be vassals…). If US policy makers do not like foreign governments, then it is regime change. I do not think that you can understand the bitterness of non-Americans about this."

I think that you are probably aware that many Americans have exactly that view of Russia.

randyfmcdonaldNovember 19th, 2014 at 9:58 am

Judging by the recent decision of the Ukrainian government to stop distributing pension and other funds to people living in "Novorossiya", alongside the separation of the regions from the Ukrainian financial system and the imposition of passport controls and an internal borders, it looks like the Ukrainian government has decided to write off the Donbas after all.

randyfmcdonaldNovember 24th, 2014 at 11:13 pm

Ukraine can still be kept struggling if the twin Donbas republics remain militarized and separate from Kyiv's rule. Who says that they have to be made prosperous, too?

windrivenNovember 25th, 2014 at 10:24 am

"Who says that they have to be made prosperous, too?"

No one. I think you've missed my point. The rebel controlled areas are likely to remain militarized for the foreseeable future. Seriously, under what scenario would they be disarmed? Putin will feed the militarization but will likely limit other aid to create the impression that Kiev isn't taking care of the people in those areas – a perfect PR play. No one is going to worry about the prosperity of the rebel regions any time soon.

randyfmcdonaldNovember 25th, 2014 at 11:27 am

"Putin will feed the militarization but will likely limit other aid to create the impression that Kiev isn't taking care of the people in those areas"

So, you agree with me, then?

windrivenNovember 25th, 2014 at 11:42 am

Randy, I'm not clear on your exact point but I don't think we disagree.

You said: "Ukraine can still be kept struggling if the twin Donbas republics remain militarized and separate from Kyiv's rule."

Yes, I would absolutely agree with this. Not only can be kept struggling but likely will be kept struggling – intentionally by Mr. Putin.

And you said: "Who says that they have to be made prosperous, too?"

I'm not sure where that question came from. But I would argue that no one says that and no one intends to do anything to help them become prosperous, at least in the near term.

But whether or not I agree is almost beside the point. My analysis is personal rather than professional, informed by little more than the same news everyone can get, and my sense of the perceived interests and strategies of the powers involved.

randyfmcdonaldNovember 25th, 2014 at 12:09 pm

"I'm not sure where that question came from."

That was a rhetorical question.

I can imagine Putin providing enough aid for the DNR and LNR to suirvive. I can't imagine him providing enough aid for the two republics to do much more than that.