Russia puts squeeze on Ukraine, jacks up natural gas prices 40 percent

Russian natural gas producer Gazprom announced a more than 40 percent increase in the price Ukraine must pay for natural gas, increasing the economic pressure on the country.

Smarting from Ukraine's U-turn towards Europe, Russia is likely to employ every weapon in its economic arsenal to ensure its neighbor's road to financial recovery is as painful as possible, even when paved with billions of dollars in Western aid.

Russia has "the right to use selective protective measures against Ukraine if it creates a free trade zone with a third government, or for example with the European Union," a Russian economy ministry spokesman said in response to a question from Reuters, citing the terms of a 2011 agreement.

On Tuesday, Russian natural gas producer Gazprom announced a more than 40 percent increase in the price Ukraine must pay for natural gas, stepping up economic pressure on Kiev in its political standoff with Moscow.

Ukraine will now have to pay $385.5 per 1,000 cubic meters of gas in the second quarter, an increase form $268.5 that was agreed in December, before the ouster of Ukraine's Moscow-backed president and Russia's annexation of Crimea from Ukraine.

Gazprom's Chief Executive Officer, Alexei Miller, said the increase was needed because Ukraine's debt for unpaid gas bills now stood at $1.7 billion.

"The December discount for gas cannot be applied any more," Miller said, adding that the transportation tariff for Gazprom's gas to Europe via Ukraine was increasing by 10 percent, in line with earlier agreements.

Russian President Vladimir Putin agreed in December to cut the gas price for Ukraine and provide a financial lifeline to Kiev after its abrupt decision not to sign a trade agreement with the European Union and rebuild economic ties with Moscow instead.

The discount was subject to a quarterly review.

After Ukrainian President Viktor Yanukovich was deposed in February following months of anti-government protests, Gazprom and Putin said the gas price discount would be scrapped because of the debt.

Months of anti-government protests and the overthrow of a government blighted by corruption and economic mismanagement, have left Ukraine on the brink of bankruptcy, running wide external deficits and a current account shortfall of over 9 percent of gross domestic product.

On Thursday, the International Monetary Fund threw a financial lifeline, agreeing to stump up $14-18 billion as part of a two-year bailout package in exchange for tough economic reforms.

The deal, combined with Kiev's signing of a cooperation pact linked to closer trade ties with the European Union, represents a serious blow to Russian President Vladimir Putin's dream of Ukraine joining a Eurasian Union of former Soviet states.

Moscow will not make it easy and Ukraine is already feeling some consequences from its break with Russia.

Russia's Gazprom has suggested a new conflict over gas payments and supplies - like disputes in 2006 and 2009 that halted supplies to Ukraine and onward to Europe - could break out, though it added it had no interest in a resumption of such disputes.

"The better off Ukraine is under the new government, the more likely it will integrate into the West," said Nicu Popescu, senior analyst at the EU Institute for Security Studies (EUISS).

"So disrupting the Ukrainian transition in political and economic terms is probably Russia's primary foreign policy goal in the foreseeable future."

Putin's annexation of Crimea, which Kiev and the West say is illegitimate, is likely to push Ukraine's gross domestic product (GDP) down by 5 percent in 2014, according to Simon Mandel, Vice President for Emerging Europe at New York-based brokerage Auerbach Grayson.

While the tens of thousands of Russian troops thought to be massed on the border show no immediate sign of entering other parts of Ukraine, Russia has already flexed its trade muscles to upset the Western-backed Ukrainian recovery plan.

BLOOD AND SWEAT

Last year Putin showed he was prepared to wield restrictions or bans on Ukrainian exports as punishment for attempts by the country of 46 million to move out of Moscow's orbit.

With exports to Russia accounting for nearly a quarter of Ukrainian external trade and contributing around 8 percent of GDP, further moves could significantly inhibit the country's bid for economic renaissance.

It would take a lot of "blood and sweat" for many Ukrainian companies to withstand any Russian trade ban, Vice President of the European Bank for Reconstruction and Development (EBRD) Andras Simor told Reuters.

"They will need to be flexible if circumstances create a need for adjustment," he said. "We will be there to try and help them as much as possible."

Cementing Kiev's historic shift away from Russia, a bilateral free-trade agreement between Ukraine and the European Union is due to come into force later this year, and Russian trade officials have expressed concerns over closer Ukrainian association with the European bloc.

Russia's milk union has asked for a ban on Ukrainian dairy products, and while no bans are in the works, imports from Ukraine are being monitored closely, according to the assistant to the head of Russia's veterinary oversight agency Rosselkhoznadzor.

"There are no plans to impose restrictions on trade, but we must be prepared for the fact that we will impose restrictions if ... Ukraine is not able to fulfil its obligations due to the political situation in the country," Rosselkhoznadzor's Alex Alexeenko told Reuters.

Dairy products account for only a fraction of Ukraine's sales to Russia, but all Ukrainian exporters will be anxiously eyeing Russia's trade stance, particularly industrial producers in the east.

Russia accounts for 13 percent of Ukraine's iron and steel exports, and the political crisis has already hit shipments from Ukrainian steelmakers this year.

Sales of rebar - a steel bar or mesh of steel wires used in reinforced concrete - to the Commonwealth of Independent States (CIS), a bloc of former Soviet states, fell 70 percent to 45,000 tonnes in January compared with the average monthly export figure in the first half of 2013.

Russian steelmakers have aggressively lobbied their government to implement measures to defend domestic producers from Ukrainian imports.

A spokesman for Ukraine's largest steelmaker, Metinvest , which controls about half of the country's steel industry, said expanding its sales markets was a priority.

However, the steel industry has been battling low prices <ST-CRU-IDX> and weaker demand for the past three years, complicating potential diversification efforts.

"Tough competition on the international steel market makes the chance of (steelmakers) expanding their export market presence very low," Eavex Capital metals analyst Ivan Dzvinka said in Kiev.

SOCIAL TENSIONS

The free-trade agreement (FTA) between Ukraine and the European Union, due to be signed after a presidential election on May 25, is unlikely to help many of Ukraine's industrial producers whose output is focused on the Russian market.

Manufacturers of train carts and turbo engines, which together account for 2.5 percent of Ukraine's total exports, will be hit particularly hard.

"Re-orienting these industries to Europe would be nearly impossible without very heavy investment, which means production and exports could be lost in the short term," Nomura analysts said in a note.

However, what Ukraine stands to gain from the EU trade agreement could become apparent in the longer term as it aims to help the country create new businesses and modern industries and become a destination for European manufacture.

"The point of the FTA is not to make it possible for Ukraine to export Soviet-era tractors to Europe. That's not going to happen. But it could eventually lead to Ukraine becoming a producer of Peugeots, Volkswagens, fridges or Nokia telephones," the EUISS's Popescu said.

With most of the country's heavy industry located in eastern Ukraine, recently the focus of violent pro-Russian rallies, any trade restrictions could also have political implications.

"Social tensions could rise if businesses are forced to cut output, leaving people without salaries," said Lydia Shynkaruk of Kiev's Institute of Economic Forecasting.

At the Red October factory in the eastern city of Kharkiv, marketing manager Dmitry Laptev said the facility, which sells 70 percent of the brick factory machinery it produces to Russia, was yet to experience any trouble with exports.

"The only issue would be if they completely shut the border to all Ukrainian products, then that would hit us, of course. It would hit everyone," he said, standing among rusting machinery overshadowed by a Soviet mural with the slogan 'My factory is my honor'. (Additional reporting by Natalia Zinets in Kiev and; Andrey Kuzmin in Moscow, Editing by Timothy Heritage, Will Waterman, Janet McBride)