Commentary Type

Is It Possible to Salvage the Economy of Donbas?

Op-ed in RBC Daily, Moscow


Since April, Donbas has suffered from a serious rebel movement, which has been supported with Russian arms, irregular troops, and not so irregular "vacationers." According to the United Nations, more than 4,000 people have been killed, and the war damage has been substantial.

The Ukrainian economy was deprived of 3.7 percent of its GDP because of Russia's annexation of Crimea, which is no longer included in official statistics while Donbas is. At present, the occupied territories in the Donetsk and Luhansk oblasts account for 2.6 percent of Ukraine's area, 3.3 million people (7.3 percent of the population), 10 percent of GDP, and 15 percent of industrial output. Most forecasters predict a decline in Ukraine's GDP of 7 to 8 percent in 2014. Roughly two-thirds of this decline derives from the war in Donbas.

Ukraine's current economic crisis can be explained by the war, since heavy industry in the occupied territories in Donbas is largely standing still.

Ukraine's annualized industrial production plunged because of fighting in Donbas—in August by 21.4 percent; in September, 16.6 percent; and October, 16.3 percent. In October, Ukraine's total coal production plunged by as much as two thirds, year-over-year, and steel production has fallen by one third. The third big decline is in the production of fertilizers. Still, Ukraine's agriculture is booming, growing by 7.5 percent in the first ten months of 2014 in comparison with the same period in 2013, partly compensating for the industrial decline. By and large, Ukraine's current economic crisis can be explained by the war, since heavy industry in the occupied territories in Donbas is largely standing still.

Donbas suffers from a severe humanitarian crisis. Russian heavy artillery and rockets have blown up the power stations in Donbas, stopping the pumps in the coal mines, which have been flooded. The two big fertilizer factories in Donbas, Dmytro Firtash's Stirol in Horlovka and Severodonetsk Azot, are standing still. On September 13, Prime Minister Arseniy Yatsenyuk assessed the war damages to physical infrastructure at $9 billion, and they have risen substantially.

The biggest question for Donbas is what the Kremlin really wants to do with the region and the rest of Ukraine. The most obvious interpretation is that it wants the new Ukrainian government to fail economically and thus politically. This version matches an interest to keep Ukraine out of Western alliances. Russia's considerable destruction of Donbas infrastructure then makes sense. Russian forces have bombed bridges and power stations in areas under their control in Donbas, and they have looted at least one armaments factory in Luhansk—the Luhansk electric factory—transferring it to Russia.1 These actions suggest that the Kremlin is not intent on annexing the occupied territories in Donbas. Instead, its two Minsk accords with Ukraine in September seem to aim at putting all the costs for Donbas on Ukraine, while depriving Ukraine of all revenues from this area.

Russia's possible interest in further military advances would be balanced by three factors: the rising cost of Western sanctions against Russia, Ukrainian military resistance, and domestic Russian attitudes to the war with Ukraine. In the interim, Ukraine's three key interests are evident. First, its best option is some kind of demarcation of the line between territories held by Ukraine and the rebels, so that people can gain elementary security. Second, Ukraine wants to maximize its security while minimizing the cost of war. Third, given that Ukraine does not receive any tax revenues or value added from the occupied parts of Donbas, Ukraine should also minimize its costs for this region.

On November 15, President Poroshenko drew the logical conclusion from this reasoning. He signed a decree that cut off all Ukrainian state funding of the occupied territories. This means that Ukrainian pensioners can only receive their pensions if they live in territory that is controlled by the Ukrainian government.

Another logical action is that the Ukrainian government cuts its subsidies to enterprises in Donbas. These savings can be quite substantial given that Donbas is Ukraine's rustbelt. In the Russian part of Donbas—the Rostov oblast—numerous loss-making coal mines have sensibly been closed while their state-owned counterparts still work in Ukrainian Donbas.

In many ways, the occupied part of Ukrainian Donbas is a black hole economically. Until now, Ukraine has paid social benefits but not received any tax revenues from the occupied area. In September 2014, Ukrainian gas consumption had fallen by 30 percent from September 2013, and the consumption for the first nine months had declined by 18 percent. Steelworks and fertilizer factories in occupied Donbas have been standing still since July or August, causing most of the decline. If Ukraine's consumption were cut by 30 percent for the whole of 2015, its gas consumption would fall from 48.5 billion cubic meters in 2013 to 34 billion cubic meters. Then the Ukrainian government could save no less than $5 billion in gas subsidies, while Gazprom would lose $5.5 billion in sales to Ukraine. That would greatly help Ukraine overcome its financial crisis.

The Ukrainian coal sector is also a maze of subsidies and corruption, and most of the corrupt coal sector is located in the Luhansk oblast. In 2013, the state subsidized price of one ton of commercial coal was 480 hryvnia, whereas the production cost in a Donbas state mine was almost three times as high at 1,350 hryvnia. The difference was covered by state subsidies. Under the Yanukovych regime, a Yanukovych family group that controlled a large share of illegal (unofficial) coal mines in Donbas extracted these subsidies meant for loss-making state mines, although their production cost was only about 500 hryvnia per ton. Their protector was Minister of Energy Eduard Stavytsky, who fled abroad after the ouster of Yanukovych and has been sanctioned by the European Union. This could save the Ukrainian government another $2 billion of unjustified subsidies.

It is unclear what the Kremlin wants to do with Donbas, and no good solutions are apparent. This is not only a humanitarian but also an industrial disaster area. The material destruction has gone so far that the economy cannot recover without serious reconstruction, and that cannot take place until a reasonably secure peace has been established. Nor is it evident that the old Soviet industry can be profitably reconstructed. The most probable development is that most of the population will emigrate, as has happened in Abkhazia, Transnistria, and South Ossetia. Donbas is likely to remain a disaster area for years to come.


1. "Lugansky elektromekhanichesky zavod perenosit proizvodstvo v Rossiyu (Luhansk Electrical Plant Is Transfering Its Production to Russia)," Ostrov, September 24, 2014.

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