Ukraine enters the EU free trade area

Arseniy Yatsenyuk, Prime Minister of Ukraine (European Council, CC BY-NC-ND)

Prime Minister Arseniy Yatsenyuk is considering entering the path of a trade war with Russia, as it opposes the trade part of the EU-Ukraine Association Agreement which was initially supposed to become effective a year ago.

Refusal to sign the association agreement with the European Union by at that time Ukrainian president Viktor Yanukovych was the reason for the protests which began on the Independence Square in Kiev in November 2013 and have led to what was later dubbed as the “Revolution of Dignity”. Those Ukrainians who couldn’t imagine the future of their country without this agreement, almost immediately gathered in the city’s central square to express their opposition to the President’s decision. The agreement was ultimately signed, and its main trade part takes effect at the beginning of 2016.

Difficult negotiations

The first, political part of the agreement was signed in March 2014, in a gesture of support for the Kiev authorities amid the growing tensions with Russia. The agreement hasn’t been physically divided into two parts; however the leaders signed a final act, in which they stipulated that their signatures only related to the chapters concerning political relations. The more extensive part of the agreement, governing economic and trade issues, was put off until after the presidential elections and the formation of a new government.

The second part of the agreement – the Deep and Comprehensive Free Trade Agreement (DCFTA) – was signed in June 2014. This part includes the establishment of a free trade area, and co-operation in the fields of economy, justice and internal affairs. The agreement will open up the EU market for Ukraine through the gradual elimination of tariffs and quotas, and through the harmonization of the laws and standards in various sectors. The agreement will allow the UE and Ukraine to eliminate trade barriers.

Russia’s firm opposition

From the very beginning, Russia has been expressing the opinion that the association agreement would harm its interests. Consequently, it announced that if the provisions of the agreement were to enter into force on November 2014, as planned, it would immediately respond with economic sanctions imposed on Ukraine. Russia’s objection caused the implementation of the economic part of the association agreement to be postponed for 14 months.

Despite the passage of time and the regular meetings held in the trilateral format (European Union – Ukraine – Russia), the Kremlin continues to oppose Ukraine’s accession to the free trade agreement. Russia’s basic, formal complaint formulated against the agreement is that it would enable the duty-free importation of goods produced in the European Union to Russia through Ukraine. Representatives of Brussels have unsuccessfully tried to convince Russia that this risk was only theoretical, as international trade treaties already provide rules intended to mitigate such danger. The rules of origin of goods, which bind all WTO members including Russia, Ukraine and the European Union as a whole, apply in this case.

Under the provisions of the DCFTA, goods exported from the EU to Ukraine will be exempt from customs duties, but will still be treated as produced in the EU and therefore will be subject to Russian import tariffs that apply to goods manufactured in the EU.  The only exception would apply to imported semi-finished products, which may undergo far-reaching modification in Ukraine and as a result would be treated as if they originated in Ukraine, and thus would benefit from duty relief provided by Russia’s free-trade agreement with Ukraine.

Russia, however, is not persuaded by reference to the general principles binding the members of the WTO. Moscow wouldn’t even acknowledge the analyses of its own researchers from the scientific institute operating under the aegis of the Russian Academy of Sciences, who reported in 2014, that the illegal importation of goods, which could result from the implementation of the provisions of the association agreement, would amount to USD500m per year at the most.

Russia also fears that once Ukraine adapts its technical standards to EU standards, they will no longer be in line with the expectations of Russian customers. This is an odd argument, considering that in the future Russia (and the entire Eurasian Economic Union, which Russia is leading) will also be adapting to the standards applicable in the EU, which are otherwise consistent with standards of international organizations, including in particular the World Trade Organization.

The standardization of norms only applies to certain categories of goods and is not required immediately – Kiev has three to five years to implement it, depending on the product group. By that time, Russia may well have adopted these international standards itself.

Anyway, Ukraine’s exports to Russia dropped substantially even before the DCFTA was implemented. While in 2012 Ukraine sold goods for nearly USD23bn to its eastern neighbor, in 2014 it was only USD13bn USD and this year’s result will be even lower.

There are groups of products that Russia – regardless of the political situation – has traditionally acquired from Ukrainian businesses, as it is still not able to produce them independently (e.g. steam turbines manufactured by a plant in Kharkiv). However, for over a year now it has been trying to replace the Ukrainian suppliers with partners from i.a. South America or China. This also works the other way around, as the Ukrainians are becoming less willing to buy goods with a tag reading “Made in Russia” – this applies to both advanced technologies, as well as everyday items which the Ukrainians are simply ignoring on the hypermarket shelves.

Numerous obligations

Representatives of the European Union, such as the Commissioner for Trade Cecilia Malmström, who hosted the trilateral consultations, have announced that there is no turning back from the implementation of the treaty.

Although the conclusion of an association agreement in itself should never be interpreted as a guarantee of a country’s future entry into the European Union (while being the first step in the process), it results in deep integration with the EU and leads to an increase in foreign investment. Ukraine will adopt a number of regulations in force in the EU, primarily in the area of energy and intellectual property protection, and will undertake to adapt its production to the sanitary standards in force in the EU.

It is estimated that Ukraine will include 80-90 per cent of the EU trade legislation in its legal system, as it is not starting from the scratch. In 2008 Ukraine became a member of the WTO (Russia joined the organization in 2011, following 18 years of negotiations) and had already begun the process of adapting its trade legislation to the practices applicable in the European Community.

In addition to adapting the trade legislation, Ukraine will also have to ensure greater transparency of the general principles of doing business. This is a big challenge for the highly corrupt  state in which monopolies play an important role, and the parliament used to adopt laws dictated by the oligarchs – although it has to be acknowledged that the new government is doing a lot to curb such behavior.

The DCFTA also includes a requirement of improvements in energy efficiency – the bar has been placed very high in this regard, if we consider the fact that Ukraine is one of the most energy-intensive economies in the world. The Polish Institute of International Affairs (PISM) published a report in 2014 which indicated that the country’s energy intensity ratio was nine times higher than the OECD’s average (for comparison: Poland’s ratio is five times lower than Ukraine’s). As a result, Ukraine consumes much more energy than developed countries in order to manufacture goods, which reduces its competitiveness. The high demand for energy also perpetuates the country’s dependence on foreign gas supplies, mainly from Russia.

The authorities are aware of the dangers of low energy efficiency and want to change this – for example, by encouraging private businesses to participate in the modernization of the obsolete heat and power infrastructure in the framework of public-private partnership.

The need to implement the stringent provisions of the DCFTA is therefore a great challenge but also an opportunity.

Tangible benefits

The implementation of the provisions of the agreement will require Ukraine to adopt more than 300 EU directives and regulations. The harmonization of the law will make it easier for the Ukrainian manufacturers to access the markets of the EU countries, while the improved standards of their production will also encourage partners from outside the EU. Piotr Kościński, an analyst at the PISM think-tank, emphasizes that the most important benefits that Ukraine will reap in connection with the adoption of the agreement are the long-term gains, such as the adaptation of the legislation to EU standards and ensuring greater transparency in its application. “Today, investing in Ukraine is associated with high risk, additionally increased due to the war in the Donbas region, but fundamentally stemming from vague legislation, massive corruption and the ineffectiveness of legal authorities and courts,” says Kościński.

In the PISM Bulletin he also points out the favorable long transition periods, which should allow Ukraine to introduce changes in the legislation, but also modernize its industrial plants. “On the one hand, association with the EU will entail costs amounting to tens of billions of euros in the long run (the Institute for Economics and Forecasting of the National Academy of Sciences of Ukraine estimated the costs at up to EUR160bn), on the other hand, this is necessary spending on reforms and modernization, without which the prospects for the Ukrainian economy would be very poor.”

However, we should not ignore the possible negative effects of the implementation of the agreement. In addition to a deterioration of the trade and political relations with Russia (and consequently – a further decline in exports), there is also a real danger that after the Ukrainian market opens more widely for companies from EU countries, local manufacturers will not survive the competition and will not only fail to expand to the Western markets, but will also be crushed at home.

Joachim Becker from the Vienna University of Economics and Business believes, that the agreement is not in the best interest  of the Ukrainian people. He invokes the example of the Balkan countries, which, in his assessment, have not benefited from the association agreements. Becker says that the associations doesn’t necessarily have to lead to modernization: “In 2012 the GDP of Ukraine still posted less than 70 per cent of the GDP from the year 1990. Adjusted for purchasing power, the country’s GDP per is only about 25 per cent of the EU average. These are the territories Europe is now entering. It is opening them up for its goods, and enforces structural reforms which are rational from the point of view of the Community market, but not necessarily from the point of view of those peripheral countries,” said Becker in an interview with the Krytyka Polityczna magazine.

The danger that Ukrainian companies will not cope with competition from foreign companies is real, but didn’t the Polish industry have similar concerns before Poland’s entry into the EU? In light of the European aspirations of the Ukrainians, the association agreement simply has to enter into force. Ukrainian businessmen are cooperating with partners from the West even without the privileges that will be granted by the association agreement, therefore we should not assume a negative scenario that it will somehow stop being profitable after January 1st.

Scenario of growing tensions

What will Russia do? The last round of talks, which took place on December, provided no resolution. Russia’s Minister of Economic Development Alexey Ulyukaev proposed that Ukraine postpone the implementation of the technical and phytosanitary standards for a decade, which was flatly rejected by the Ukrainian Prime Minister Arseniy Yatsenyuk. In order to resolve the deadlock, various politicians have been offering their proposals on how to solve the problem, that is, how to persuade Russia to accept the agreement.

Berlin came out with a proposal for a joint EU-Russia declaration, which would offer to Moscow the long-expected investment and energy concessions. “By the content of this declaration we could respond to Russia’s wishes and begin a closer exchange of views on energy and investment protection issues, even if the EU-Ukraine trade deal does not directly touch on them,” wrote the German Foreign Minister Frank-Walter Steinmeier in a letter to Cecilia Malmström.

Germany’s proposal was not well received, either by Russia, which is still calling for a tripartite agreement, or by the countries of Central Europe and the Baltic states, which are concerned about the possible renewed intensification of EU-Russia cooperation.

On December 18th, 2015 Brussels decided to extend the economic sanctions against Russia. In this situation, talks about a new framework for economic and energy cooperation will be much more difficult, if not downright impossible.

Speaking  at a government meeting in Moscow Prime Minister Dmitry Medvedev confirmed that Russia would introduce a duty on Ukrainian goods and an embargo on food products. Russia’s free-trade agreement with Ukraine would also be suspended from January 2016. Ukraine will likely respond in kind – Prime Minister Yatsenyuk has already recommended the preparation of a draft law that will enable a quick response to Russia’s actions.

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