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29 June, 2020  ▪  Lyubomyr Shavalyuk

Halfway to Europe

Gains and losses from the institution of a free trade zone between Ukraine and the EU

January 1 marked four years since Ukraine’s free trade agreement with the EU came into effect. These were a time of intense work to implement the Ukraine-EU Association Agreement, including the Deep and Comprehensive Free Trade Agreement (DCFTA) as its key component. The results are twofold. On one hand, exports of Ukrainian goods to the EU were worth 59% more in dollar terms in 2019, than four years earlier and services were worth 46% more.On the other, Ukraine’s press has complained frequently about the FTA, claiming that Ukraine had not prepared or protected domestic producers well and that the European market was not letting Ukrainian producers in. So what prevails in Ukraine’s free trade arrangement with the EU: benefits or problems?

Impressive numbers

The numbers speak for themselves. A 50% growth in dollar-based revenues from Ukrainian exports to the EU over four years is one indisputable accomplishment. True, Ukraine started from a low base due to the war-driven deep economic crisis of 2014-2015. However, this does not diminish the efforts of those who ensured this dynamic growth. Some producers benefitted more, others less, but everyone has had opportunities. The good results of the more successful ones should spur the rest to try more.

Ukrainian producers did often struggled in the first years of the FTA because they didn’t know the rules for entering EU markets. At that point, Ukraine and the EU joined efforts to set up a system to inform them of the opportunities and requirements available in that market. Today, there is far less complaining about such basic issues. This suggests that Ukrainian producers will increasingly focus on and export to the EU.

Apart from these obvious results, FTA offers many bonuses that are hard to quantify but should not be underestimated. Word from early 2019 was that 207 new plants were built in Ukraine, most of them probably as a result of the Association Agreement, which had set out clear prospects for interaction with the huge EU market. This mapped out a macro business plan for potential investors and many found attractive opportunities to invest capital in Ukraine.

The less visible impact has been the acculturation of Ukrainian producers, introducing them to the rules of western markets and allowing them to learn to comply. For many Ukrainian entrepreneurs, improved business culture is actually a critical impact of the FTA. Those who learn to work in a well-organized market like the EU will not get lost in any market across the globe.

Finally, the political factor. The implementation of the Association Agreement and the launch of the FTA called for building a strong bureaucratic system based on European principles of work and staffed with specialists that make it possible to meet complex eurointegration objectives. Since the new Ukrainian government tends to dilute human resources across government agencies, having such a system in place and keeping employees in their positions should ensure that at least some of the most qualified performers will remain in Ukraine no matter what.

No more pampering producers

In reality, Ukraine is at the very beginning of the long eurointegration process. It should not expect a instant avalanche of economic benefits on this path, but the long-term result should be impressive. The economic performance of Ukraine’s neighbors who signed association agreements in the 1990s confirms this, although each of them used the opportunities presented by eurointegration differently. Poland was the most successful, with its real GDP growing over 2.5 times after its FTA with the EU was launched in 1994.

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Some analysts question the role of eurointegration in the development of Central and Eastern European economies, claiming that normal governments, adequate policies and a favorable situation on global markets prior to the 2008-2009 crisis were enough to ensure these results. Still, these economies have very close trade ties with the EU today. Its share in their imports and exports ranges from 70% to over 80%, so it’s odd to overlook this degree of eurointegration as a factor in their economic success.

Clearly, eurointegration and free trade with the EU are dynamic processes. Some producers gain, while others lose from it, and some will vanish from the economic map altogether. But consumers definitely win, as does the efficiency of the overall domestic economic system. That was certainly the case with Ukraine’s neighbors and there’s no reason for it not to be the case for Ukraine.

Generally, free trade means wealthier consumers and a more efficient economy. Debates about the choice between free trade and protectionist policies for domestic producers often overlook one subtle, but important nuance: states tend to close their domestic markets and nurture weak domestic producers so that they grow, get strong and can ultimately compete in the international market. This traditional pattern seems quite reasonable. But nobody guarantees that a weak producer will actually improve thanks to the protection the government provides. In Ukraine, the opposite tends to happen, as producers move windfall profits offshore and exploit their capital assets until they turn into scrap metal, rather than investing profits back into the business. In this kind of situation, protectionism makes no sense and its fans are often corrupt, working with the poor business models mostly favored by oligarchs.

This is another reason why free trade is better for Ukraine, by creating market incentives for domestic producers, giving them what the state cannot really provide through protectionism or in any other way. The experience of Ukraine’s western neighbors illustrates this point amply.

Some lessons from Poland

The Poland-EU Association Agreement came into force in early 1994. Just as with Ukraine, free trade was a key component scheduled to be launched after a 10-year transition period. When it came into force, Poland abolished import duties on nearly 1,300 goods, including around 800 produced by its machine-building industry. Virtually all other categories—around 10,000, even though fewer were actually traded actively—were covered by the transition conditions that gradually cut import/export duties to 80% over the three years after the agreement came into force, 60% in Year 4, 40% in Year 5, 20% in Year 6 and 0% in Year 7.These special conditions applied to some categories produced by the car industry. The transition period for this group was extended to eight years, and tariffs were cut more gradually in the first years: by around 14% of the base in the Years 1 and 2.

Poland introduced quotas for imports of some categories of EU-made cars. At the same time, it banned the imports of used cars more than 10 years old and trucks over 6 years old.At the time, this move seemed reasonable. Poland had a fairly well-developed car-making industry at the beginning of its eurointegration, with a dozen factories specialized in different components. That industry needed protection at first, but looking back at the situation with hindsight, the situation looks very different. Today, Poland has more than a dozen car plants, half of them built in the years after the Association Agreement was signed, but most of the plants that were in operation when it was signed no longer exist today. What does this mean? Whether a state protects its national producer or not, it cannot avoid having weak companies that are unable to grow and change with the times and these will be killed by the market, sooner or later. It also has companies that can take care of themselves and these don’t really need government support.

The integration of Poland’s farm sector with the EU was mapped out with special care. Poland cut import duties on nearly 250 categories of EU goods by 10% right after the Association Agreement came into effect. It did not produce most of the foods on the list, including dairy products, cheeses, fresh and canned edible fruit and nuts, juices and wines. At the same time, it opened its market much more slowly to animal and plant products that it produced in large quantities. Over 100 categories ended up on a 5-year schedule of mutual quota- and tariff-cutting between Poland and the EU. More in-depth analysis might tell how necessary this precaution was. But given the current state of Poland’s agriculture, it is fair to say that it now specializes in the goods it barely produced 25 years ago, thanks to eurointegration. The market has profoundly restructured Poland’s economic landscape in agriculture and shifted resources, including land and workforce, from the subindustries protected by the Association Agreement. The companies that enjoyed protectionism proved too weak at the end of the day.

How other countries fared

The EU’s Association Agreement with the Czech Republic came into effect in 1995. The FTA it introduced launched a 10-year transition period, too. It cancelled import tariffs on nearly 900 subgroups, which is one level up from category, from Day One. Another 2,200 items enjoyed a gradual cut from 80% of the base tariff on the first day of the FTA to 40% in Year 3 and full abolition in Year 5. The longest transition was for 700 items that saw import duty cut to 80% of the base rate in Year 3 after the FTA came into effect, followed by another 20pp in Years 5 and 7 to 0% in Year 9. Metallurgy and the clothing industry were best represented in this list. What do we know about those Czech industries today? Not much.

Hungary opened its market to EU goods very slowly. Its transition began in 1994 and lasted until 2001 for nearly 2,100 categories of goods: duties were cut to 90% in 1995, then down by 15pp every year. For a few other goods, duties were abolished in Year 3. As a result, Hungary ended up among the countries with the lowest GDP growth after the launch of the Association Agreement with the EU. The slow opening of its market may have been a reason.

Import duties in Romania for over 1,300 categories of EU goods were abolished right after the Association Agreement came into effect, followed by another 600 categories by Year 5 after the transition period began. Just like Poland, Romania decided to protect its car makers, offering them a longer transition period. That help did not prove effective and production of passenger cars dropped from 93,000 in 1995 to 57,000 by 2001. The industry was only reinvigorated when Renault acquired Dacia in 1999 and Ford acquired Automobile Craiova, left by South Korea’s bankrupt Daewoo in 2008. 

This simply illustrates, once more, that protectionism for domestic producers is rarely effective.

Pointers for Ukraine

The Ukraine-EU Association Agreement is different from similar agreements signed by its neighbors over 25 years ago in two respects. Firstly, Ukraine has a DCFTA, which focuses much more on non-tariff aspects of trade and economic interactions. The soft power of the DCFTA has had a massive positive impact on Ukraine, regardless of actual trade turnover with the EU, ranging from billions of euros in financial assistance to a major shift in mentality. This is an undeniable benefit for Ukraine, even if critics of the DCFTA are not quite able to appreciate it properly.

Secondly, Ukraine’s Association Agreement does not contain commitments to bring duties down to 0% after the transition period. Given political conditions more then 25 years ago, both the EU and the CEE countries focused on rapid eurointegration, full mutual opening of markets within 10 years, comprehensive harmonization of legislation, and so on. So their agreements called for all tariffs to be dropped after transition. Ukraine does not have to. In many cases, it committed to cutting import duties just a little, such as from 10% to 7% or from 5% to 3%, while the EU de factonarrowed down the list of protected industries to the farm sector. Some say that Ukraine cannot compete with EU producers in any other area. Meanwhile, Ukraine could built hundreds offactories with the latest technology that would be in a position to compete with anyone after 10 years of transition.

The eurointegration experience of Central and Eastern European countries proves that protecting domestic producers is not always useful. Market forces will, sooner or later, kill the weak or lead to their acquisition by outsiders while dramatically changing the country’s economic landscape in a way that cannot be predicted when the agreement is signed.

Ukraine protected its domestic producers well in its Association Agreement with the EU. On one hand, it signed the agreement as a WTO member, so its import duty is under 5% for many items and cutting it to 3% does not change much for EU goods. On the other, Ukraine did not commit to zero duty for many groups of goods. Moreover, the reduction of tariffs for 239 subgroups in agriculture, a strong industry in Ukraine, has been extended to five years and more. Meanwhile, Ukraine introduced EU-style quotas for many imported agricultural products.

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Do Ukraine’s producers really need this protection? Many believe so. The experience of Ukraine’s neighbors belies this conviction and raises the question whether the Kremlin is leading an information war in Ukraine to discredit free trade with the EU. On the other hand, it really is difficult to distinguish between the individual problems of weak players and systemic challenges in the country’s economy, and informational chaos fueled by Russia. For now, there’s no clear answer to this question.

Art. 29.4 of the Association Agreement says that Ukraine and the EU should look at speeding and scaling up bilateral tariff cuts five years after it comes into effect. Ukraine should make use of this opportunity. For one thing, it has far more information to support such a decision now than did its neighbors when they opened their markets almost blind, more than 25 years ago.


Translated by Lidia Wolanskyj

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