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. Last Updated: 07/27/2016

Kremlin's Ukraine Play Sours Investors

Sending operatives into Ukraine to try to manufacture public discontent with neighboring Poland for political gain is not the kind of behavior foreign investors like to encourage. But that's exactly the kind of game Russia has been playing as it seeks to secure the Ukrainian presidency for its favored candidate, Viktor Yanukovych, according to the Kremlin's own spin doctors.

With the Kremlin's hard-line stance on the hotly contested political race creating new political divisions between Russia and most of the Western world, many investors, analysts and economists are increasingly worried that the fallout may spill into the economic realm, stifling Russia's growing role in global trade.

Although most observers say they do not expect economic ties with the West to be severely damaged, signs are emerging that Western investors' appetite for Russia has waned since the standoff began 10 days ago.

"Banks are more concerned with Russia's attitude toward Ukraine than [the attack on Yukos]," said Hans-J?rg Rudloff, chairman of Barclay's Capital, the investment banking arm of the British financial giant.

"If Russia takes a confrontational approach toward the West, behaving in Ukraine no better than in Soviet times ... it will have a huge influence on political and commercial relations with Russia," Rudloff said by telephone from London.

"If anyone thinks business is not linked to politics, they are wrong -- look at how long China was isolated after Tiananmen Square," Rudloff said. "If you are sitting in my position and have to approve loans, clearly you will think again."

Richard Hainsworth, a former Citibank official and the founder and CEO of RusRating, an agency that rates Russian banks, said that while Russia's stance on Ukraine might have an economic knock-on effect, it cannot yet be compared to the damage done to the investment climate by the 16-month legal assault on the nation's largest oil exporter.

"The greatest factor in this is still the fallout from Yukos, but obviously political adventures abroad that misfire are also negative," Hainsworth said.

"The whole point with lenders is their comfort level," he said. "If they feel that suddenly this change of policy has reduced their understanding of Russia, then their level of comfort will fall and their lending desires will fall."

Optimists countered that political tensions over Ukraine might spook financial investors with little commitment to Russia, but that those who are heavily invested will not scare so easily.

"Financial investors for whom Russia is only a small part of their portfolio could be selling out," said Peter Hakansson, chairman of East Capital, which manages about $600 million in Russia. "That's the biggest risk for Russia [from the turmoil], from what we can see at the moment."

The dollar-denominated RTS index, which many foreigners prefer to the ruble-denominated MICEX, has slumped by almost 5 percent since hundreds of thousands of supporters of opposition candidate Viktor Yushchenko took to the streets of Kiev on Nov. 21 to protest against Yanukovych's victory.

Russian bonds have also been hit.

"The [bond] market is taking a heavy beating, especially on the eurobond side," said Igor Kotlyarchuk, head of fixed-income sales at Troika Dialog.

Barring civil war or secession by the pro-Russian eastern half of Ukraine -- an idea that has been floated by the Yanukovych camp -- most analysts and bankers polled said they expect the ongoing market jitters and strained relations with the West to be temporary.

Another area of concern is the growing bilateral trade between Ukraine and Russia, which hit $12 billion last year.

Peter Westin, chief economist at Aton Capital, said that about 6 percent of Russia's exports, worth $7.6 billion, went to Ukraine in 2003, while 7.7 percent of its imports, worth $4.4 billion, came from Ukraine.

Few outside observers believe there is any real threat to Russia's most strategic interest in Ukraine -- pipelines. State-controlled Gazprom, Russia's biggest company and largest taxpayer, supplies Western Europe with more than a quarter of its gas needs, and the vast majority of it, about 80 percent, goes through Ukraine.

Nevertheless, sources inside both Ukraine and Russia's state-owned gas companies sounded notes of alarm this week.

"I am worried," Konstantin Borodin, spokesman for NAK Naftogaz, Ukraine's state-owned oil and gas company, said Tuesday, according to Bloomberg. "We are keeping Gazprom's regime up at the moment, but I'm not certain how long that's going to last."

An unnamed official in Gazprom's export arm told Reuters earlier this week that turning off gas supplies to Europe would evaporate European support for Yushchenko. "It would immediately provoke an international scandal -- the last thing the Western-oriented opposition needs right now," Reuters quoted the official as saying.

But Gazprom is unlikely to go to such an extreme, said Jonathan Stern, director of gas research at the Oxford Institute for Energy Studies.

"This year Gazprom stands to make $18.5 billion from the export of gas to Europe," Stern said. "The last thing Gazprom wants to do is precipitate a crisis in Ukraine."

Even in extreme civil unrest, the pipelines will likely remain safe, Stern said. "It's harder to damage gas pipelines than you'd think. I haven't personally tried, but I've seen a lot of people try."

Ironically, over the long term many analysts say that a Yushchenko victory would be better for Russian business -- despite President Vladimir Putin's very public support for Yanukovych, the current prime minister.

Yanukovych's tenure has been marked by privatization deals that favored Ukraine's business elite over Russian or Western investors, while Yushchenko, a former prime minister himself, is thought to favor a more level playing field in privatization auctions.

Tomas Fiala, managing director of Dragon Capital, Ukraine's largest brokerage by volume, said Putin's continued support for Yanukovych could make him even more beholden to Russia -- potentially giving the Kremlin a powerful back channel into Ukrainian economic policy if he wins.

"Putin has probably reached some sort of agreement with Yanukovych," Fiala said. "In exchange for [Putin's] support and his help in covering up the falsifications during the election, Russia will likely receive some assets that it's most interested in."

Key issues for Russia include a new gas pipeline through Ukraine, a deal on Russia's naval base in Sevastopol on the Black Sea, and the upcoming privatization of Ukrtelekom, Ukraine's telecom monopoly.

But even if Yanukovych wanted to repay a political debt to Putin using economic means, Fiala said he would probably be limited by the fierce opposition to his administration from Yushchenko supporters in the country.

Staff Writer Catherine Belton contributed to this report.