Plumes of smoke darken the sky above a sunflower seed crushing factory outside Donetsk, the largest stronghold of the Russian-backed separatists surrounded by Ukraine’s advancing army. “It was hit by Grad missiles,” says a rebel waving his machinegun as he guards a checkpoint next to a bullet-riddled bus.

The $80m plant, opened in 2000 by Cargill, was one of the first big greenfield investments into independent Ukraine, a symbol of a new era of more open markets and future prosperity. It was abandoned by the US agriculture group’s employees after being stormed by pro-Russian gunmen. Now ablaze, it is testament to the vast damage done to a war-torn and bureaucracy-choked economy slipping deeper into recession.

While the international focus in recent months has been on the armed strife in eastern Ukraine and the geopolitical stand-off with Moscow, another dilemma is looming large for Kiev and its western backers: Ukraine’s economy is in tatters.

At best, the International Monetary Fund and other western backers are likely to have to step in with more loans to help the government staunch its fiscal deficit. At worst, the $17bn IMF programme signed in April could fall apart, possibly forcing the country to default and restructure its debts. That would further deepen the economic turmoil in Ukraine and stain the reputation and credibility of the fund in the wake of its problematic Greek programme.

“If the conflict lingers for another several months in its current form the cost for the Ukrainian economy would be huge,” says Vitaliy Vavryshchuk, analyst at Kiev-based SP Advisors.

IMF officials based their bailout on the initial assumption that Ukraine’s economy would shrink 5 per cent this year before bouncing back in 2015. The Kiev government’s debt to gross domestic product ratio – a popular if imperfect gauge of sustainability – would climb from just over 40 per cent to 62 per cent, a steep but arguably manageable rise. The IMF therefore decided not to require Ukraine to restructure its debts.

Officials visited and made their assessments shortly after Russia had annexed Crimea and just as separatists were seizing control in eastern Ukraine. They did not therefore fully factor in the economic damage that was to follow. Even at the time, however, their judgments were questioned intensely by some economists.

Soon after the programme was signed, Timothy Ash, a senior strategist at Standard Bank, called the IMF report on Ukraine a “thing of sheer beauty . . . Beautifully crafted and written, but unfortunately in my view more a work of fiction than fact”.

Dragon Capital, a local brokerage, estimates that the loss of Crimea alone would cut Ukraine’s GDP by 3.7 per cent. The eastern industrial base is even more important. Alexander Valchyshen, head of research at Investment Capital Ukraine, says the restive provinces of Donetsk and Lugansk accounted for about 16 per cent of GDP, and a quarter of exports and industrial goods and services.

Even if Kiev reasserts full control of the eastern region and Russia backs off, the economic damage wrought by the conflict will be severe. The trouble has destroyed much regional infrastructure in the industrial heartland, including roads, railways, utility lines and the airport at Donetsk that was upgraded when Ukraine co-hosted the Euro 2012 football championship.

The latest data indicate that the Ukrainian economy contracted almost 5 per cent year-on-year by the middle of the year. The final toll is impossible to gauge, not least because half of the economy remains in the shadow.

Ukrainian officials do not expect agriculture – previously a pivotal engine of growth – to continue to compensate for the struggling eastern steel and machinery sectors as it has in recent years. “Thanks personally to [Vladimir] Putin, we lost 15 per cent of the gross harvest,” Arseniy Yatseniuk, the prime minister, said this week. “The Russian Federation, which transformed from a neighbour to an enemy, aims to destroy Ukraine politically as well as economically.”

The IMF last month adjusted its economic forecast to a more realistic 6.5 per cent shrinkage for 2014. Even this could be optimistic. Gabriel Sterne, head of macro research at Oxford Economics, predicts it will contract by at least 8 per cent.

To add to the worries, the Ukrainian currency is endangering the banking sector. The IMF’s own risk assessment warns that if the hryvnia falls to UAH12.5 to the dollar then the stresses on bank balance sheets would require a bailout of at least 5 per cent of GDP. The hryvnia is now even weaker, at about UAH13.

The cumulative effects of the crisis could shred Ukraine’s finances. Mr Sterne says debt-to-GDP is rising towards 87 per cent by 2018. That is more than twice the level of earlier this year and enough for the IMF to struggle to argue that it is highly confident Ukraine’s debts are sustainable – a requirement for disbursement.

Other complications are looming. One $3bn Ukrainian bond is owed to Russia as part of a support package for the previous pro-Moscow government of Viktor Yanukovich. Russia structured the loan as a normal eurobond with a significant tweak. If Ukraine’s debt-to-GDP goes above 60 per cent, as is now inevitable, Moscow can demand immediate repayment. Because of cross-default provisions, Kiev cannot renege on this bond in isolation, handing Mr Putin a potent economic weapon against the country.

The economic reforms required for the IMF to disburse aid are also a risk. Mr Yatseniuk threatened to resign after failing to push through several laws it needed to pass. Parliament swiftly performed a volte-face, but the imbroglio underlined the difficulties of implementing the austerity and governance measures.

Ukraine has a dismal record of adhering to past programmes, and this one is by far the most ambitious. Yet it this week called for the next two IMF tranches of $2.2bn to be paid together by the end of this year.

Dmitry Sologoub, head of research at Raiffeisen Aval Bank in Kiev, says that relative to previous programmes the government’s performance has been “stellar”, but he is still disappointed with the pace and extent of reforms. “Of course I recognise the authorities are very busy with the war,” he says. “But the situation is dramatic. The country is fighting for survival. Unfortunately so far there is not much change.”

Some analysts worry that Ukraine’s IMF programme could go the way of the ill-fated initial attempts to rescue Greece. Overly optimistic economic forecasts unravelled quickly, and the eventual result was a painful €200bn debt restructuring made worse by initial denial and procrastination. Ukraine could be headed towards a similar predicament, says Mr Sterne.

“We think the Ukraine economy and the IMF programme face such difficulties that a default is likely, possibly imminent,” he wrote in a recent report. “It could take the form of a ’precautionary’ default in which debt falling due over the next three years is forcibly rolled over. If there is a full-blown Russian invasion then deeper haircuts may be required.”

One western banker in Ukraine suggests that there is a 30 per cent chance Kiev restructures its sovereign debt this year or next. “If they want to do it, they have a perfect excuse,” he says.

Some experts argue that the IMF should have sought debt relief early on rather than hand over taxpayer-backed money to repay in full Ukraine’s foreign creditors: primarily banks, asset managers, Russia and a slew of hedge funds that snapped up its bonds.

With the programme now in place, Kiev’s western backers will be loath to destabilise Ukraine further by seeking a restructuring. Yet the IMF will find itself in a predicament if its economists cannot state confidently that its debts are sustainable, especially since it is lobbying to change policies to address mistakes made in Greece, and reflect concerns that restructurings are often too little and too late.

Many specialists say Ukraine would have been an ideal testing ground for the fund’s new “reprofiling” policy being discussed by its board. This would have stretched out repayments but left the overall debt untouched – still a default and restructuring but a soft one that prevents the fund’s money from bailing out private creditors, throwing good money after bad.

The political pressure on the IMF will be intense. Defaults are typically triggered by big looming repayments. Ukraine faces many tough decisions, but there are scant signs foreign debt repayment will trip it up soon as long as the Fund keeps faith.

The first big, potentially problematic repayment is Russia’s $3bn bond in December 2015. Moscow is likely to fiercely resist any restructuring, which would render an orderly process impossible, Mr Sterne warns. In fact, the biggest payments in the coming years are to the IMF itself: on the new loans that will be gradually repaid from 2016, as well as more immediate repayments on the previous fund programme.

In depth Crisis in Ukraine Pro-Moscow separatists in eastern Ukraine have escalated the political turmoil that threatens to tear the country apart



Further reading

“In all cases we make an unbiased assessment of the macroeconomic outlook based on the current information. Of course, downside risks related to the conflict prevail in the current environment,” says Nikolay Gueorguiev, the IMF mission chief for Ukraine. “Difficult times call for difficult measures. And we see that this government is committed to reforms.”

Tomas Fiala, chief executive of Dragon Capital, predicts that if the conflict calms down by this autumn the IMF programme should remain intact. He argues that excluding its loans, Ukraine’s debt-to-GDP ratio is still relatively low and access to bond markets could be re-established.

If the fighting subsides soon and the threat of direct Russian intervention disappears, there could be an economic “peace dividend” from the boost to confidence, pent-up private investments and reconstruction in the east. The west of the country has remained relatively resilient. Even with one of his plants in flames, Andreas Rickmers, head of Cargill’s European grain and oilseeds business, says: “Cargill has been active in Ukraine for over 20 years and we remain firmly committed.”

When Mr Yatseniuk’s stand-off forced the Ukrainian parliament to pass the legislation required by the IMF programme, he promised the country would not follow in the footsteps of Argentina and renege on its debts. “There are two pieces of news today. The first is that Argentina has defaulted, and the second is that Ukraine has not defaulted and never will,” he told an applauding chamber.

Cynics will recall Greek, European and IMF officials repeatedly promised the same before the world’s biggest debt restructuring became a fact.

Additional reporting by Andrew Jack

Wasteful use undermines the economy

Ukraine’s greatest economic vulnerability is its energy consumption. Russia’s Gazprom, which provides more than half the country’s gas, severed supplies in June, writes Christian Oliver. Ukrainians face a bitter winter unless the EU can break a deadlock between Moscow and Kiev to agree a fair price.

Günther Oettinger, EU energy commissioner, is due to attend a meeting between the Russians and Ukrainians in Minsk on August 26, giving a chance to revive negotiations.

One obstacle has been Ukraine’s demand that Russia make payments for the loss of Chernomorneftegaz, the Black Sea energy company with 2.2bn cubic metres of gas reserves seized when Russia invaded Crimea.

Even the resumption of gas supplies would offer only temporary relief because far deeper energy reforms are needed to save the Ukrainian economy. Kiev is one of the world’s most wasteful energy consumers and imports have been a heavy drain on the treasury.

Ukraine has been paying fuel subsidies equivalent to 7.5 per cent of GDP. Its energy intensity – the ratio of energy used to economic output – is twice that of Russia and 10 times the OECD average. Hence the IMF $17bn bailout is contingent on energy reforms. Fuel bills will have to rise, although Kiev says it will still offer a cushion for pensioners and the poor. Measures will also have to be taken to stop industries illegally siphoning off gas at highly subsidised household rates.

Most critically, dilapidated Soviet-era urban heating networks, often black holes for energy consumption, will have to be renovated. Ukrainians in apartment blocks often have little control over when hot water is piped into their buildings and have to open the windows if their flats overheat.

The IMF reforms are designed to lead to upgrades of the country’s heating, with more efficient boilers, greater insulation and more accurate metering so people can take responsibility for their own levels of consumption.

As Carl Bildt, Sweden’s foreign minister, put it: “If Ukraine improved its energy efficiency to reasonably EU levels, I doubt it would need to import any energy at all.”