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12 June, 2014  ▪  Oleksandr Kramar

Breaking Away From Eurasia

Previous trade rows with Russia have pushed Ukraine to reorient its key exports to the EU and other markets. This should save it from the disastrous effect of a looming trade war from Russia

On 29 May, the agreement on the Eurasian Economic Union was signed in Astana, Kazakhstan. After it enters into force on 1 January 2015, integration in the current Customs Union of Russia, Belarus and Kazakhstan will deepen with the free movement of not only goods but also services, capital and workforce and coordinated policy in the key economic sectors: energy, industry, agriculture, transport, etc.

Despite Vladimir Putin’s all-out efforts, Ukraine has so far managed to resist being pulled into a modern version of the Russian Empire, if only economically. Instead, Ukraine has good chances of fixing itself in the European orbit. Ukraine may sign the economic part of the Association Agreement which envisages a comprehensive Free Trade Zone (FTZ) and harmonization of a number of standards in line with European, rather than Russian-Eurasian norms, as soon as on 27 June when Moldova and Georgia are scheduled to do so. (Immediately after Petro Poroshenko’s victory in the presidential election became clear, Göran Färm, head of the European Parliament’s delegation, confirmed the EU’s readiness to sign the document as soon as possible.)

Moreover, the European Union unilaterally opened its market to Ukrainian goods and services on May 15 by cancelling some 98% of sales duties in line with the Free Trade Agreement (FTA). According to expert estimates, the FTA with the EU can save Ukraine’s producers nearly EUR 500mn in duties on the goods that are already being exported to the EU. Even if this advantage is viewed as an analogue of relieving the tax pressure on exporters by UAH 8-8.5bn, it is a serious economic boost.

But there is more in the Free Trade Zone with the EU for the future of Ukraine’s economy and strengthening its independence from the Russia-dominated Eurasian Union – an opportunity to increase exports to the European market with its nearly 580mn consumers. Over 45% of all Ukrainian goods sold abroad already go precisely to this market.

At the same time, as soon as Ukraine signs the economic part of the Association Agreement, it should brace itself for another flare-up of a trade war with Russia. Moscow does not conceal its intention to resume the customs blockade it imposed on Ukraine in August 2013, as well as raise duties and essentially suspend the CIS Free Trade Agreement in regard to Ukraine. However, despite posing a significant threat to some Ukrainian enterprises, this kind of Russian reaction to Ukraine’s economic rapprochement with Europe and the barriers likely to be set up by the Eurasian Customs Union will not spell disaster for Ukraine’s economy.

Coercion to independence

Wise after the experience of the past years, the Ukrainian business is now much more prepared to face trade wars than it was a year or two ago. That Russia or the Customs Union are the biggest sales market for Ukrainian producers is a stereotype still bandied about by the media, but it no longer has anything to do with reality. In the past years, Ukraine’s export volume to Russia and its closest economic allies, Belarus and Kazakhstan, took a nosedive. Paradoxically, Ukraine’s economic dependence on the Customs Union market has decreased largely thanks to Putin’s policy of coercing Ukraine to join in.

Trade wars forced Ukrainian producers to seek alternatives to the Russian and Kazakh markets, and they have had moderate success. In just two years, from Q1’2012 until Q1’2014, Russia’s share in Ukraine’s goods exports dropped from 28 to 19%. This was compensated by an increase in exports to the EU from 23 to 34%.

As a result, in Q1’ 2014, Ukraine’s exports to the EU exceeded those to Russia by 1.8 times. The EU Customs Union, including Turkey as a significant importer of Ukrainian products in addition to EU member-states, has reached 41% in Ukraine’s total exports, while the share of the Customs Union of Russia, Belarus and Kazakhstan fell to 23%. Exports to just four European countries (Turkey, Poland, Italy and Hungary) outweighed the “vitally important” Russian market (see No markets are irreplaceable).

After permanent trade wars in the past two years, Ukraine’s exports to Russia went downhill: meat and meat byproducts, confectionaries, vehicles, railway transport, products of the shipbuilding industry and aircraft fell 60-80%; products of the ferrous metallurgy 40%, and dairy products and eggs 23%. In most cases, the losses on the Russian market were quite successfully set off by exports to other markets, particularly to Europe. On balance, total exports either slightly dropped or even grew (dairy products, eggs and the products of the shipbuilding industry), while Russia’s share in it plummeted (see Casting off economic shackles).

In 2013, the exports of Ukrainian goods to Russia accounted for a mere 8% of Ukraine’s GDP. Even in the worst-case scenario, which is losing over half of its exports to Russia, Ukraine’s GDP may fall an additional 2-3%. This will definitely be palpable but in no way catastrophic – Ukraine survived a 15% reduction during the 2009 crisis.

Ukraine is also becoming less dependent on Russia in terms of exported services. At present, Russia still accounts for more than a third of Ukraine’s total in this category, but most of these services are payments for gas transit to the EU countries – USD 650mn out of the total USD 1.05bn in services exported to Russia in the Q1’2014. However, the sale of Russian gas on the Ukraine-EU border, rather than Russia-Ukraine, despite the fact that Ukraine is a member of the Energy Community with the EU, is a vestige of the Soviet system that has to be scrapped as soon as possible. This will guarantee, among other things, energy security to Ukraine and Europe in general.

Ukrainian government officials regularly bring up this issue in negotiations with the EU. As soon as Gazprom is forced to sell gas on the Russia-Ukraine border, its further transportation and storage in Ukraine will become the concern of the European buyers, and a lion’s share of Russia-bound services will de jure become what they de factor are now – services exported to the EU. Russia’s share in this category will then fall to a figure comparable to that in goods exports.

Other countries of the Eurasian Customs Union are of little significance for Ukraine’s exports. Kazakhstan, which receives 1.5% of Ukraine’s exports, stands next to such small countries as Israel (1.3%) and Moldova and Azerbaijan (1.1% each). In its relations with Belarus, Ukraine has the obvious trump card of importing 2.5 times more than exporting. The Ukrainian market is much more important for Belarus than the other way around. Moreover, Belarusian products are non-critical imports that can be easily and rapidly replaced with imports from other countries in the case of war. Thus, supporting the Kremlin’s trade war on Ukraine would hurt Minsk first, as Belarusian producers may lose USD 2-4bn a year. Clearly, Moscow will have a hard time compensating it with additional preferences on gas and oil. With this being not the least reason on his mind, Alexander Lukashenko tries to stick to an independent course on these issues.

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Ukraine’s sore spots

Ukraine’s metallurgy and chemical sectors already little depend on the Russian market, even though its share in the exports of several foodstuffs and machine building products is still large. However, these industries and subindustries are not, with a few exceptions, heavily export-oriented.

Ukrainian producers of meat, dairy products, eggs, sweets and other foodstuffs that keep running into Russia-imposed barriers now sell them primarily on the domestic market. Ukraine’s car industry still exports 47.8% of its products to the Russian market, but because this industry works primarily for domestic consumers, Russia’s share in car sales is less than 16%. The same goes for professional equipment. The shipbuilding, aircraft and electric machinery industries sell a mere 15-35% of their products to Russia.

In machine building, Ukraine imports from Russia nearly as much as it exports there: USD 430mn and USD 190mn, respectively, in the car industry, USD 0.8bn and USD 1.1bn in electric machinery, USD 36mn and USD 46mn in aircraft and USD 100mn and USD 140mn in professional equipment.

A marked dependence on Russia and its Customs Union and the biggest challenges in diversifying sales markets are experienced by Soviet-era enterprises that together with other plants were links in closed production cycles in the USSR. The producers of locomotives, nuclear reactors, boilers and machinery indeed export up to two-thirds and sell nearly half of their production to Russia, with the rest going largely to other Customs Union member states.

Rail transport manufacturing is the biggest subindustry of Ukraine’s machine building and economy in general which totally depends on Russia’s market (USD 1.74bn in exports in 2013) and has failed to significantly diversify its sales markets since independence. However, in the future these enterprises may be involved in co-operation with the leading world companies, in the programmes to replace the rolling stock of the Ukrainian railways and metros, something that is long overdue.

In the face of a permanent threat to Ukraine’s territorial integrity and sovereignty emanating from Russia, it is a matter of national security for Ukraine to discontinue any co-operation with the Russian Federation in the military industrial complex. Its products have traditionally accounted for a large part of Ukraine’s exports of machinery to Russia. This industry needs to be re-oriented, where possible, to the needs of the Ukrainian army or co-operation with NATO countries.

READ ALSO: Money of the Donbas

European integration of the Donbas

Despite the widespread stereotypical perception that both oblasts of the Donbas region are pro-Russian, Europe is already much more important to them than the Customs Union of Russia, Belarus and Kazakhstan.

This is especially evident in Donetsk Oblast. For example, in Q1’2014 it exported more (14%) to the relatively distant Italian market than to Russia (13%). Turkey (11%) and Egypt (10%) were not far behind, either. Moldova, a small country which is now getting ready, just like Ukraine, to join the comprehensive Free Trade Zone with the EU, or the far-away Spain bought more from Donetsk Oblast than did Kazakhstan, the second most powerful market in the Eurasian Customs Union. In total, Donetsk sold 2.5 times more to Europe than to the Moscow-dominated Customs Union in Q1’2014.

Likewise, Luhansk Oblast sells more than half of its exports on the European market. Russia’s share (35%) here is similar to that of Hungary, Poland, Slovakia and Romania, whose total population is half of that of Russia (see The solid facts). Luhansk Teplovoz, the locomotive producer, is essentially the only completely Russia-dependent large plant in the oblast. If it is factored out, Luhansk Oblast’s remaining exports to Russia are close to Ukraine’s average. Noteworthily, the oblast exported railway locomotives worth some USD 660mn to Russia, which is less than what its coalmining industry received from Kyiv in direct subsidies. If these subsidies become unavailable, this may hurt the oblast much worse than even a complete cutoff of locomotive exports to Russia, which is unlikely in the medium-term and even long-term perspective for objective reasons.

Only Kharkiv Oblast exports to Russia and the Russian-led Customs Union more than any other eastern region of Ukraine with 45% and 53% respectively. This is 3-3.5 times more than it sells to Europe. However, this heavy dependence on Russia must be viewed in context: Kharkiv Oblast exports accounted for a mere 20% of its gross product in 2012. So, even if it loses half of its current exports to the Customs Union, there will be no disaster – its gross product may fall no more than 2-3%.

In general, claims of Ukraine’s critical dependence on the markets of Russia and its Customs Union are greatly exaggerated. They are an outdated stereotype that has less and less to do with reality with each passing month. Ukraine would not benefit from a trade war with Russia, but nor would it suffer apocalyptic consequences that Russian propaganda likes to paint and that cause serious fears even in Ukraine’s pro-European wing. Previous trade blockades aimed at forcing Ukraine to join the Russia-led Customs Union actually helped it build up the necessary immunity and encouraged producers to look elsewhere. Even in the case of the Donbas, whose production is largely export-oriented, the biggest threat is not losing access to the Russian market, but barriers to the European and world markets which are sure to arise if the region turns into a breakaway grey zone.


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