The EU and Russia: both important for Ukraine

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In this note, we argue that under the current circumstances, a full membership of Ukraine in the CU (as suggested by Russia) would be incompatible with its free trade regime with the EU. Besides, it would be problematic given Ukraine’s WTO membership. However, preserving close trade links with Russia – as well as deepening those with the EU – would be essential for Ukraine. In the longer run, Ukraine’s membership in a CU with Russia might be feasible and perfectly compatible with a DCFTA with the EU provided that Russia and the EU advance their own integration. This outcome would represent a ‚first-best‘ solution for Ukraine not only in economic, but also in political terms, as it would reduce incentives for the often futile geopolitical competition between Russia and the EU on the post-Soviet space.

The benefits to Ukraine from closer trade integration with the EU might be potentially huge. In this respect, the earlier experience of former COMECON countries from Central Europe, but also to some extent Romania and Bulgaria, might provide a useful reference. In these countries, trade integration with the EU was advancing rapidly in the course of the nineties and became an important – though not the only – factor behind massive inflows of foreign direct investments from the ‚old‘ EU countries and particularly Germany. In many instances, these investments have brought new technologies, higher quality standards, know-how in management and marketing, and – last but not least – were crucial in raising the energy efficiency of the recipient countries‘ economies (which remains an important challenge for Ukraine). In this way, the former COMECON countries have successfully restructured their industrial sector, which in many cases became competitive on the European scale and has been increasingly gaining market shares.

Although in the case of Ukraine – unlike in the above-mentioned countries – one important factor behind this success story, namely the ‚carrot‘ of prospective EU membership, is missing and is unlikely to be in place any time soon, the country could still at least partially replicate these developments via closer EU integration. Ukraine is offering a combination of proximity to EU markets, some of the best soil in the world, a cheap but generally well-educated labour force, and now also a higher degree of political stability. It is also likely to become a more attractive target for foreign direct investments, as producing in the more ‚traditional‘ recipient countries of Central Europe will be increasingly expensive.

These developments do not rule out that Ukraine maintains close trade links with Russia, e.g. via a preservation of the current free trade regime (albeit with ‚exemptions and limitations‘). On the contrary, Ukraine – where wages are standing at around half of the Russian level – could potentially attract European investments into production destined for the Russian market. The Russian market is important for Ukraine for several reasons. First, Russia is Ukraine‘s single most important export destination: its share (~25%) is roughly the same as that of the entire EU. Second, and probably more importantly, Russia is the principal export market for Ukraine’s more sophisticated products such as machinery and equipment, not least thanks to the technological links inherited from the Soviet times and revived following the victory of Mr Yanukovych in the presidential elections. (In contrast, Ukraine’s exports to the EU are heavily concentrated on raw materials and manufactured goods with low value-added, such as basic metals and fertilizers.) Finally, Russia as an ‚emerging‘ economy will in the medium and long run almost certainly post higher growth rates than (at least) the ‚old‘ EU countries, and its import demand – including that for Ukrainian products – is likely to rise accordingly.

In this context, if Russia indeed reconsiders the free trade regime with Ukraine – as it has threatened recently, facing the prospects of a DCFTA between Ukraine and the EU, – this could be potentially painful for Ukraine. On the other hand, the ‚carrot‘ of lower gas prices offered by Russia to Ukraine if it joins the CU should not be over-interpreted. Even if Ukraine’s import price will indeed be adjusted to the currently low Russian domestic level, this level is unlikely to be sustained, given that domestic gas tariffs in Russia are planned to be progressively raised in order to induce energy-saving behaviour and facilitate the implementation of energy-saving technologies. The stated objective of the Russian government, e.g. as reflected in the most recent Energy Strategy, is to ensure in the medium term ‚netback parity‘ between Russian domestic and export gas prices, i.e. the domestic price should equal the export price net of the transportation costs and the export duty. This will inevitably imply higher prices for Ukraine, since it is difficult to imagine that Gazprom will be prepared to sell Ukraine gas at prices below what it charges domestic customers.

Gas prices apart, Ukraine’s membership in a CU with Russia, Belarus and Kazakhstan is currently rather unlikely for a more important reason: Ukraine’s WTO membership since 2008. If Ukraine’s raises its customs duties for imports from the third countries to the current CU level, these countries – most of which are WTO members – will likely demand compensations. Of course, this problem would not arise if the import tariffs of the CU were adjusted to the Ukrainian level (rather than the other way around) – but the latter is highly unlikely to happen. From the point of view of trade integration with the EU, Ukraine’s membership in the CU is even more problematic. It would be problematic even in the latter case, i.e. when Ukraine’s duties for imports from the third countries do not change and stay at their currently relatively low level, given that DCFTA with the EU would generally require zero duties. In fact, the preliminary EU-Ukraine DCFTA agreement envisages no import duties on the Ukrainian side, with the exception of the automotive industry (and potentially agricultural products).

However, while under the current circumstances, Ukraine’s membership in free trade area with the EU and in a Customs Union with Russia appear to be mutually exclusive, this does not need to be the case forever. Clearly, closer trade integration between Russia and the EU would relieve Ukraine from having to make a difficult choice with respect to the direction of integration. For instance, should Russia and the EU enter a free trade agreement, the possibility of which is envisaged in the current EU-Russia Partnership and Cooperation Agreement (PCA), Ukraine’s participation in both DCFTA and CU could become perfectly feasible. Of course, for that to become possible, a number of difficult problems would have to be solved. First, in order to start free trade negotiations with the EU, Russia will need to join the WTO first, although this target appears now realistic. Second, a free trade agreement with Russia would require also free trade with both Kazakhstan and Belarus, which in the latter case appears particularly problematic, primarily (but not only) for political reasons.