The real threat to Europe lies in Ukraine rather than Greece

I have written much about the euro in recent years, and warned of the danger of an insufficient policy response. But the most dangerous threat to the future of the EU right now is not euro-related. The biggest threat to its geostrategic and long-term economic interests stems from a collapse of Ukraine, not Greece. Whatever we might think of Grexit, a failed Ukrainian state or further annexation of its territory by Russia would be of a different category. It would signal to the world that the EU is chronically incapable of defending its common interests.

Grexit would be a calamity for Greece and a huge financial and reputational loss for the EU. The EU should try to prevent it. but Grexit would not destroy the monetary union, and may even improve it in the long run. But success or failure of EU policy towards Russia and Ukraine could make or break the EU.

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The latest economic data show a fall in Ukraine's industrial output by 21.1 per cent in March, compared with March 2014 when Russia annexed Crimea. The Ukrainian central bank estimates gross domestic product in the first quarter of 2015 to have fallen 15 per cent against the same period last year. The forecast for annual inflation is 35 per cent. By the time the first tranche of a programme by the International Monetary Fund arrived in March, foreign reserves were down to a mere $5bn.

The central bank sees some economic stabilisation ahead, but that will depend on the fate of the ceasefire agreement.

The good news - from the EU's perspective - is that the government of Arseniy Yatseniuk, prime minister, is the most pro-reform administration in Ukraine's history. It is a fully paid up member of the EU's policy consensus whereby all economic bliss comes from structural reforms.

I do not agree with this view in general, but a country has no choice but to prioritise reforms if it lacks the basic infrastructure of a modern economy. The new government is clearly determined to set up such an infrastructure, and has made progress in the fight against corruption. But the economic costs of the war in eastern Ukraine and the economic mismanagement of previous administrations has left Ukraine on the brink of insolvency.

Two things now need to happen. First, Ukraine will need to negotiate a hard debt restructuring. Natalie Jaresko, the American-born finance minister, has argued that a simple maturity extension of the outstanding debt would not bring about enough debt relief to achieve a return to solvency. To achieve this, there would need to be a reduction in the nominal value of the debt as well. Anna Gelpern of Georgetown University and an expert on Ukrainian debt, has written about the ways this needs to be accomplished. She calls a debt restructuring the second-biggest potential source of income for Ukraine after the loan programmes. As always, there are a lot of complications, among them a high concentration of creditors. Franklin Templeton Investments, the US-based investment company, is Ukraine's single largest creditor, followed by the Russian government and various Russian banks. The EU, too, should have a strategy in place for when the moment arrives when Ukraine defaults on Russia.

Second, Ukraine will need more financial assistance from the EU - not only loans, but also grants because even a debt restructure will not get this war-torn country back on track. So far, the EU has dispensed €1.6bn in what it calls macro-financial assistance, and €250m in grants for fiscal stabilisation. A marginally higher amount of assistance has been approved for later disbursement. By comparison, the total of the two Greek programmes has been €195bn so far - about 100 times as much. Greece is, of course, a member of the EU and the eurozone, but this is gap is still disproportionate. Of the two, Ukraine is the bigger country - in terms of population, land mass, and economic output.

Anders Aslund of the Peterson Institute for International Economics in Washington makes the point in a book that Ukraine would be a candidate for a Marshall Plan type package, of the kind Germany and other west European countries received after the second world war. Ukraine has geostrategic importance to the EU, as Germany did to the US after 1945. And Ukraine has a government willing to undertake reforms.

With a debt restructuring, and an unwavering commitment of support by the EU, Ukraine might pull through. For the EU, Ukraine constitutes not only a potentially good investment but, more importantly, a unique opportunity to strengthen its geostrategic role.

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