The collapse of Ukraine's ruling coalition at a time of rising divisions over the country's stance towards Russia and the West has worried markets and leaves the immediate future uncertain.
On September 3, President Viktor Yushchenko announced that he was seeking a new governing coalition and threatened to call a snap election if one could not be formed. His move may have brought to a head months of tension between the president and his prime minister, Yulia Tymoshenko, who have been engaged in a war of words over the country's direction.
The news saw stocks in Kiev fall 4%, and the country's credit default swap rate (the cost of debt insurance) increase to 576 basis points above that of the US Treasury, a record high, according to RBC Capital Markets, the corporate and investment banking division of Royal Bank of Canada. This indicates increased yield on debt owing to mounting fear of risk, to which Ukraine is relatively exposed.
The country "tends to be a fringe, exotic market, so it's more vulnerable to bouts of risk aversion," Paul Biszko, senior emerging markets analyst at RBC Capital Markets, told the international press. "Any type of political volatility will trigger dumping of Ukrainian assets," he added.
Yushchenko and Tymoshenko are former allies in the "Orange Revolution" of 2004-2005, which brought them to power in what was widely portrayed as a triumph for pro-Western forces over politicians aligned with Moscow.
Once again, though, relations broke down. The duo have attacked one another over a range of issues, including methods used to rein in Ukraine's runaway inflation (which hit 30% in April), who holds certain executive powers, and accusations and counter-accusations of electioneering for the 2010 Presidential election, which both are expected to contest.
The current crisis was finally precipitated by the five-day war between Russia and Georgia in August. Yushchenko threw his weight solidly behind Georgia and its Western allies, seeming willing to compromise ties with Russia as a result. Tymoshenko, however, kept a low profile, presumably to avoid giving the impression that Ukraine was choosing sides between its powerful neighbour and the EU and NATO, which it aspires to join. The President's forces have in turn accused the Prime Minister of betraying Ukraine's interests.
On September 2, the coalition appeared to have split, possibly irrecoverably, with Tymoshenko's parliamentary bloc voting with the opposition - including communists and the Party of the Regions, which is generally seen as broadly pro-Moscow - to curtail the President's powers. The dispute could intensify political divisions and exacerbate political instability by increasing political bargaining. However, the Party of the Regions officially stated that its alliance with Tymoshenko's bloc was temporary while the latter said it remained loyal to Yushchenko's Our Ukraine (OU) party.
"Yesterday a political and constitutional coup began in parliament," Yushchenko said in a speech the following day. "I consider the events in the Ukrainian parliament a formal beginning of the formation of a new parliamentary coalition," he added.
From the moment of the government's formal dissolution, President and parliament have 30 days to form a new government. Should these efforts fail, a new election will have to be called. What result this would bring is uncertain, but it seems unlikely that any of the three main parties - the Party of the Regions, the Yulia Tymoschenko Bloc and the Our Ukraine -People's Self-Defense Bloc, which is aligned with Yushchnko - would win an outright majority. Each relies to some extent on a specific geographical vote base, and none is likely to command more than 50% of the vote.
Yushchenko may be hoping that his unequivocal stance on the Georgia issue will win him back some nationalist and pro-Western voters. However, the markets' reaction to this stance may not be encouraging. An unnamed Russian official was quoted in the Russian press as saying that Moscow may change its terms of trade with Kiev, potentially putting up barriers to imports from Ukraine. Some 20% of Ukraine's exports go to Russia, generating around 8% of Gross Domestic Product (GDP), according to Danske Bank.
"Russian economic retaliation would be a major blow to the Ukrainian economy, and would lead to a further deterioration in its balance of payments," said Lars Rasmussen, an analyst at Danske Bank. "It also increases risks of a very hard landing for the consumption-driven Ukrainian economy," he added.
Another possibility cited in some quarters of the international press is a pro-Moscow government coming to power in uncomfortable cohabitation with Yushchenko, with uncertain consequences for the country's prospective membership of the EU and NATO (though the Party of the Regions is theoretically committed to the former at least).
For the time being, Ukraine seems likely to see an increase in investors' wariness due to the stronger risk of political deadlock and serious fall-out from tension with Russia. It is worth noting that a market retreat has not taken the shape of wholescale capital flight, indicating the market is now deeply oversold - it has fallen over 50% since the beginning of 2008 - and reflecting confidence that the politicians will muddle through without severe damage to what is still a fast growing economy. But Ukraine's immediate political future remains uncertain.