Rising tensions within the ruling coalition, consisting of the Bloc Yulia Tymoshenko (BYT), which holds 156 of the 450 seats in Parliament, and Our Ukraine-People’s Self-Defence (OU-PS) with 72 seats came to a head on 2 September, when the BYT faction together with the opposition factions Party of Regions (175 seats) and the Communists (27 seats) passed several legislative initiatives (including the amendments to the Law on Cabinet of Ministers, a new simplified procedure for impeaching the President, and changes in the nomination procedure of Security Service Chief) substantially weakening presidential powers. Essentially, Prime Minister Yulia Tymoshenko has launched an effective counterattack against President Yushchenko and his allies, who were recently throwing heavy accusations against the Prime Minister and the government, including “high treason” charges and accusations for plotting to murder the President’s Chief of Staff Baloha.

The OU-PS faction immediately reacted to these events by voting to leave the coalition. According to the legal regulations, it takes 10 days from the formal announcement to declare the break-up of the coalition. Then, if a new coalition is not formed within 30 days, the President has the right (but not the obligation) to dissolve the Parliament and call for early elections. President Yushchenko has fiercely criticised the Prime Minister, accusing her of steering the coalition to its doom and indicated that he will call new elections if a new coalition is not formed.

 

Apparently, the presidential ambitions of three main contenders in the race for the presidency (Mr. Yushchenko, Ms. Tymoshenko and Mr. Yanukovych, the leader of Party of Regions), scheduled for early 2010, are at the heart of this political crisis. According to recent polls, Tymoshenko has the support of 24% voters at the moment, followed by Yanukovych with 20%, while only 5% of those polled are behind Yushchenko.

Despite the recent effective cooperation between BYT and Party of Regions, it looks unlikely that Tymoshenko will strike a long-term agreement with Yanukovych, as the latter will be her main rival in the presidential elections and in the last elections she publicly swore not to make any alliance with Yanukovych. However, it is possible that these political forces will cooperate on an ad-hoc basis, by passing decisions which are advantageous to both sides (for example, further trimming away at the authorities of the President or sacking certain Ministers nominated by the OU-PS faction). In the current situation, the President is apparently the weakest player – his electoral support is tiny, while given recent legislative changes the threat of impeachment by joint efforts of Party of Regions, Communists and BYT is obviously rising. Nevertheless, the President may still opt for early elections, even though his party is unlikely to garner more than 5-7% of the vote at these elections. Moreover, we believe early elections will have a disastrous effect for Ukraine’s economy on the back of already deteriorating economic situation (high inflation, sharp increase in current account deficit, plummeting stock prices and ever-widening sovereign credit-default spreads) and result in an even gloomier outlook for the next year.

Therefore, we believe the odds of early elections are rather slim. Instead, the main political players will try to find ways to resolve the latest political crisis within the current format of the ruling coalition and the government. Most likely, the President will have to tone down his harsh criticism of Tymoshenko, and probably sack the most notorious members of his team, while Tymoshenko will be obliged not to cut presidential powers further. Nevertheless, it will not bring a long-awaited political relief and the stalemate is likely to persist until the next round of presidential elections.

 

Markets remain anxious about Ukrainian politics, and the threat of early polls only adds pressure. We see the hryvna possibly coming under pressure again as sales of Ukrainian assets might intensify. Right now, the hryvna is trading at 4.72 to the dollar and 6.85 to the euro, with a downward bias prevailing in the market. A stronger dollar in the major international currency markets also adds pressure on hryvna.

Ukrainian 5-year CDS are trading 10bp wider today, up from 455bp yesterday (market closing). We cannot rule out further widening in Ukrainian CDS as the risk of a protracted political struggle between President Yushchenko and current Prime Minister Yulia Tymoshenko is likely to continue.