The successful ouster of Ukraine’s pro-Russian president Viktor Yanukovych, and his replacement with a pro-Western regime headed by Oleksandr Turchynov and Arseniy Yatsenyuk, is only the first chapter in an unfolding story.  The eastern half of Ukraine, including the strategic Crimean peninsula (headquarters of Russia’s Black Sea fleet), is majority Russian.  On Thursday, pro-Russian gunmen seized government offices in the Crimea, and raised the Russian flag over the local parliament.  On Friday, armed soldiers (identified by Ukraine’s new interior minister as Russian troops) occupied Simferopol’s main airport.  Russia has granted its “protection” to Yanukovych, who still claims that he is Ukraine’s valid president after fleeing the country.  Russia has also mobilized troops and is conducting military exercises with them along its border with Ukraine.

Russia views Ukraine (like Belarus and other historic parts of the Russian Empire) as part of the “near abroad,” an area that should certainly fall under its “sphere of influence” if not its outright control.  In recent years, Russia (Ukraine’s largest trading partner) has both subsidized the natural gas it sells to Ukraine, and threatened to cut off supplies when Ukraine appears tempted to wander too far from Russia’s political grasp.  Russia has also been pressuring Ukraine to reject membership in the EU and instead enter a “customs union” that would bind its economy even more tightly to Russia’s.  So it comes as no surprise that a self-identified strongman like Putin would be alarmed and enraged at the latest turn of events.

Ukraine, at the same time, finds itself in a weak (one might say desperate) economic situation.  It has been fast depleting its foreign exchange reserves to support the value of its currency (the hryvnia), which nonetheless has fallen dramatically in recent weeks.  The new government claims it has enough foreign currency to meet its outstanding debt payments for the remainder of the year, but that depends on the unlikely assumption that its reserves won’t be depleted further.  To try to shore up its reserves, the new government has (as of today) imposed capital controls and restrictions on bank withdrawals, but to sustain itself for long, it obviously needs to gain access to foreign credit.  After a deal with the IMF fell through last year, Russia stepped in with a support package.  But only a portion of the promised money has been handed over, and the rest has been suspended.  The EU, the U.S. Treasury, and the IMF are now talking to Ukraine about putting the financing it needs together.

So what will happen, and what does it mean for investors?

• First of all, let’s keep things in perspective.  Ukraine’s had a 2012 GDP of $176 billion.  Its economy is smaller than Greece, Portugal, or Ireland.  It is smaller than the Czech Republic, Algeria, or Peru.  Even for Ukraine’s largest non-Russian trading partners (such as Germany and Poland), Ukraine still accounts for a very minor portion of their exports.  So the direct impact on the global economy, even if Ukraine descended into civil war, would be minimal.  That’s not to minimize at all the humanitarian (or geopolitical) disaster that would result.  But such a worst-case outcome, by itself, is not going to derail or destabilize the rest of the European economy.
• Ukraine probably enjoys the best of both worlds when it comes to the EU:  relevant enough to rescue, but unconstrained by straightjacket of the Euro.  If Ukraine devalues its currency, it will likely get help in meeting its foreign debt obligations, while a more competitive exchange rate should help its economy get back on track.  Plenty of pain, no doubt, but unlike Greece, a path to recovery too.
• Like it or not, any influence Europe or the United States has pales in comparison to the economic and political leverage Russia can exert over Ukraine.  I expect Russia will lean heavily on the new Ukraine government to accept (however grudgingly) an alignment with Russia in exchange for a resumption of Russian “cooperation”.  Yanukovych-in-exile is only a useful tool in this respect.  This may or may not be compatible with assistance from the EU, IMF, or the U.S., depending on whether they, too, are willing to accept such an outcome.  If pressure fails to bring Ukraine into line, I suspect Putin will encourage the Russian majority in eastern Ukraine and Crimea to split away and re-join Russia.  This could lead to civil war, but the intervention (i.e., “protection”) of the Russian military would almost certainly ensure the outcome Putin desires.  It would be a replay of the Russian intervention/invasion in Georgia, but on a much larger scale.  Theoretically, the U.S. could (at great risk) intervene on the other side, and it has certainly been warning Russia not to try, but I suspect Putin is more than willing to call Obama’s bluff over something he sees as absolutely vital to Russian interests and far from vital to the U.S.
• Although the crisis in Ukraine has little direct impact on the global economy, it does cast a destabilizing shadow.  The overthrown of Yanukovych, for example, has encouraged protestors in Thailand to ramp up the intensity (and violence) of their own efforts to kick out their own president.  One might argue the same for Venezuela.  Any direct Russian military intervention to pressure (or break up and annex) a neighboring state might encourage others – China and Japan, for instance – to see state-to-state military conflict (aka “war”) as a less-unthinkable option.

So while the already dramatic events in Ukraine may not directly matter much to the typical investor, they symbolize – along with Arab Spring and the Syrian Civil War, rumblings in the South and East China Seas, and political unrest from Bangkok to Caracas – a growing sense of uncertainty and unpredictability in the world that has investors understandably concerned about what will happen next.

Originally by: Patrick Chovanec, Source: Courtesy of Patrick Chovanec