Firefighters attempt to extinguish a fire at an industrial building in the eastern Ukrainian town of Slovyansk after a mortar attack on Sunday. Associated Press
KIEV—Ukraine's new president, Petro Poroshenko, has inherited a deadly separatist insurgency in the country's east, but the billionaire tycoon faces another, equally challenging problem: a deeply broken economy.
Ukraine's gross domestic product is expected to contract 5% to 7% in 2014. Experts warn those projections could worsen, should the pro-Russia rebellion grow and further cripple output in the Donetsk and Luhansk regions, the heart of heavy industry and metals extraction in Ukraine. Together those regions account for nearly 16% of Ukraine's gross domestic product.
Mr. Poroshenko pledged to stop the violence after holding talks Sunday with Russia's ambassador to Ukraine and representatives from Germany and the Organization for Security and Cooperation in Europe.
"We must end the fighting this week," Mr. Poroshenko said in a statement released on the presidential website after the talks. "Every day people are dying, and every day Ukraine is paying such a high price, and it's unacceptable." He said a first step would be for Ukraine to secure the border with Russia.
Follow the continuing conflict in and around eastern Ukraine.
Mr. Poroshenko accused the separatists of dealing a blow to the fragile economy of those regions at his inauguration on Saturday. "They, in addition to their looting and their abuse of peaceful civilians, have driven an already crisis-stricken regional economy to the brink of complete catastrophe," the new president said.
In addition to the conflict in the east, Ukraine's economy faces other points of instability. Kiev remains locked in a thorny dispute with Moscow over the price of its natural gas imports from Russia, with talks in Brussels scheduled to continue Monday.
European officials helping broker the negotiations have urged both sides to come to an agreement. Any disruption to gas supplies resulting from failed talks—something Ukraine witnessed in 2009—could further cripple the economy.
Russia also accounts for about 25% of Ukraine's exports. A large portion of them are industrial products such as railway cars and defense components that Ukrainian factories sell to Russian state entities. Moscow has shown a willingness to bar Ukrainian products on technical grounds amid tensions between the two countries in the past, including a ban it placed last year on candy from Mr. Poroshenko's Roshen confectionary firm. Russia could raise import tariffs for Ukrainian goods.
Olena Bilan, chief economist at Kiev's Dragon Capital, said the conflict in the east, the possible disruption to gas supplies and the potential for deteriorated trade all threaten the economy.
"They are three major risks, all of them somehow related to Russia," Ms. Bilan said.
Mr. Poroshenko met Russian President Vladimir Putin at a D-Day memorial ceremony in France on Friday, their first encounter since Mr. Poroshenko was elected. Mr. Putin said he liked the new Ukrainian leader's attitude and planned to work with him, but the Russian president also signaled possible trouble on the trade front.
Kiev's pledge to follow through on signing a trade pact with the European Union as early as this month has rankled Moscow, which wanted Ukraine to join its own economic union with former Soviet republics. On Friday, Mr. Putin said Russia would "take steps to protect its market" should Ukraine join a customs union with the EU, but he didn't elaborate.
To turn around its economy, Ukraine is relying on a $17-billion bailout from the International Monetary Fund and an additional $15 billion in aid from the World Bank, the EU and bilateral donors. The IMF has predicted that Ukraine's real GDP will decline 5% this year and rebound 2% in 2015, should the country comply with its plan.
The measures have all but locked in the new government's economic policy.
Already, Ukraine has put through some of the toughest overhauls demanded by the IMF. It ended the National Bank of Ukraine's long-standing intervention in the foreign exchange market to prop up its currency, the hryvnia, which depleted reserves to crisis-level amounts. It also cut long-standing energy subsidies that made gas and heat cheap but burdened Ukraine's budget.
Mr. Poroshenko displays the presidential seal during his inauguration Saturday Reuters
As a result, the hryvnia has depreciated about 30% against the U.S. dollar since the start of the year. Inflation has jumped more than 10%. Average gas prices for Ukrainian households began increasing by more than 50% starting in May. Heating prices are expected to climb by about 40% on average starting in July.The poorest households, however, are due to receive subsidies to compensate for the increase, part of a broad overhaul of Ukraine's energy sector.
"It looks like people are ready to accept this decline in living standards," said Vitaliy Vavryshchuk, head of research at Kiev-based investment house SP Advisors. But he said Ukrainians eventually will expect economic improvement. "Patience is not unlimited," he said.
Ukraine is instituting austerity measures and extra revenue-boosting actions to reduce its budget deficit. To shore up revenue, the government already scrapped planned decreases in corporate and value-added tax rates and raised excise taxes on alcohol and tobacco. It plans to freeze government wages, reduce the number government workers, cancel scheduled discretionary pension increases and take a range of additional budget-tightening measures, all of which could prove unpopular.
The conflict in the southeast, which has crippled many businesses there, could put the national budget under more pressure. Ukraine said it collected only 88% of targeted tax and customs revenues for May from Donetsk and only 75% of targeted income from neighboring Luhansk. The numbers could deteriorate as production falls amid continued violence.
"If there's a peaceful resolution to this conflict, the support of the IMF is sufficient," said Alexander Valchyshen, chief economist at Investment Capital Ukraine. "The question is how the Ukrainian authorities can bring this under control."