What Will Happen to Russian-Ukrainian Trade after the War in Donbass

Published in RBC Daily, Moscow

October 3, 2014

In July and August 2013, Russia launched all kinds of trade sanctions against Ukraine, notably against imports of agricultural goods and steel. These sanctions have gradually intensified in 2014. Gazprom has also played around with the price for gas exported to Ukraine, suddenly raising it in early April from $268.50 per 1,000 cubic meters to $485 per 1,000 cubic meters. Ukraine responded by not paying, and on June 16 Gazprom stopped supplying gas to Ukraine, which has hit its total sales and profits. In September, Ukraine responded by extensive sanctions, essentially curbing exports of armaments to Russia.

The question today is what will happen to Russian-Ukrainian trade both in the short term and in the medium term of five years. Considering that a limited war is taking place between the two countries, neither is likely to ease their sanctions. Western sanctions against Russia are another matter of little consequence for this trade. In 2013, Russia and the European Union each received about one-quarter of Ukraine's exports. Both have had a persistent large trade surplus with Ukraine, reflecting that they have been more protectionist than Ukraine in their bilateral trade.

Suddenly, Ukraine's trade conditions have changed significantly. On the one hand, the European Union has opened its market completely to 98 percent of Ukraine's goods from May 1 as a consequence of the deep and comprehensive free trade agreement (DCFTA) with Ukraine. On the other hand, Russia's trade sanctions will reduce its market access there. The obvious consequence should be a substantial turn of Ukraine's trade from Russia to Europe. In order to assess the potential for change, we are best advised by countries with similar experiences and an examination of the commodity structure of Ukraine's trade with Russia and the European Union, respectively.

Many countries have had similar experiences. In the early 1990s, all the Central and Eastern European countries, especially the Baltic countries, swiftly turned their trade flows from Russia to the European Union. In 2006, Russia hit Moldova and Georgia with more severe trade sanctions than it has against Ukraine as yet. Moldova saw its share of exports to Russia plummet from 40 percent in 2005 to 16 percent in 2007, but even so its total exports actually increased primarily thanks to rapid expansion of its exports to Europe by 13 percentage points. Georgia was not equally dependent on Russia, but the share of its exports going to Russia fell from 18 percent in 2005 to 4 percent in 2007, while its total exports actually surged by 42 percent.

In terms of dependence on Russia, Ukraine is closer to Georgia and Moldova, and it has a much more diversified economy. Moreover, unlike both those countries at that time Ukraine has free trade with Europe, and especially for Georgia the disruption of trade with Russia greatly helped the Mikheil Saakashvili government to combat corruption. Thus, the Ukrainian government should not be too concerned about Russian trade sanctions, while individual businessmen will of course be hard hit.

A switch of markets will also change the goods structure of Ukraine's exports, exactly as was the case in Central and Eastern Europe. Somewhat simplified, we can argue that we are really only discussing trade of four goods—Ukrainian exports of steel, machinery, and agricultural goods and Russian exports of natural gas—because these dominate.

In 2013, the goods structure of Ukraine's exports to Russia and the European Union differed substantially. One-third of Ukraine's exports to Russia consists of machinery, but only 11.5 percent of its exports to the European Union. Today, the Ukrainian government is trying to stop the Ukrainian armaments exports to Russia. Why should a country arm its aggressor?

The machinery exports to Russia comprise largely parts for the military-industrial complex and some railway cars and locomotives. Skilled engineers are great assets for economic development, while the old Soviet armaments producers that are still largely state-owned are not likely to take off. These assets can presumably be mobilized for new production, as has happened in Central and Eastern Europe, but that requires Schumpeterian creative destruction, that is, the old state corporations need to be closed down while their assets—human capital and factories—need to be deployed in new enterprises under new management.

Steel accounts for 37 percent of Ukraine's exports to the European Union and 20 percent to Russia. Ukrainian steel exports are likely to decline in the short term. Steel producers have benefited from very low gas and coal prices, which should rise. Only two Ukrainian steelworks have modernized, Alchevsk belonging to the Industrial Union of Donbass and Interpipe's newly built Dniprosteel, while the others are far too energy-intensive. The steel industry is concentrated in the Donetsk region, which has suffered badly from the war with Russia. Steel production was down by 30 percent in August and coal production by 50 percent because of the war. Presumably, Ukraine can stay a competitive steel producer with its evident comparative advantages, but only after substantial modernization, which requires big investment.

The third big export industry is agriculture, accounting for 24 percent of Ukraine's exports to Europe and 9.5 percent to Russia. Agriculture is currently the boom industry in Ukraine. These volumes will rise sharply and they are likely to go to Europe and the Middle East. As with steel, Russia is a direct competitor exporting the same goods. Increasingly, Ukraine is likely to sell ever more processed foods, whose production will attract a lot of foreign direct investment as is already the case.

Ukraine's fourth traditional export commodity is chemicals, which account for 9 percent of its exports to Russia but hardly anything to Europe. Ukraine's chemical industry looks like a sunset industry. It consists primarily of fertilizers, whose production is based on cheap Russian gas, which is not likely to reemerge. The fertilizer plants have not been modernized, and the share of chemicals in Ukraine's exports has fallen.

Overall, steel and chemicals are likely to decline in Ukraine's exports, though some steel production may be modernized. Agriculture and food processing are currently the boom industries, as Ukraine is restoring its position as the bread basket of Europe.

In the future, Ukraine's production and export growth is likely to be driven by integration into the European, primarily German, supply chain, putting Ukraine on the same economic and structural path of development that Central Europe has already gone through. This is how the Central European countries have developed. If the Ukrainian state reduces its interference in the business of enterprises and instead provides more security of property rights, Ukraine should be able to thrive as the new link in the European supply chain. Foreign direct investment from Europe and North America will give impetus to this development, but almost everywhere most investment comes from the country itself. Ukraine also has a promising hi-tech industry of software and information technology, which requires the rule of law.

Many institutions—mainly Polish and Ukrainian institutes, the World Bank, and the Eurasian Development Bank—have made quantitative assessments of the effects on the Ukrainian economy of Ukraine's accession to the Customs Union versus implementation of the DCFTA. Using standard gravity and computable general equilibrium models, all but the Eurasian Development Bank have obtained very similar results.

Veronika Movchan and Ricardo Giucci have offered the most complete recent mainstream study of the effects on Ukraine of both the DCFTA and the Customs Union. They concluded that in the long term, the DCFTA would add 11.8 percent to Ukraine's GDP, while the Customs Union would reduce it by 3.7 percent. The DCFTA would substantially increase trade (both exports and imports), whereas the Customs Union would reduce trade. Other studies offer similar numbers.

The DCFTA will decrease or eliminate existing trade barriers between Ukraine and the European Union, leading to increased mutual trade. The main advantages for Ukraine will be better access to the vast EU market, which is ten times as large as the Russian market; increased inflow of foreign direct investment, which will modernize the Ukrainian economy, restructure enterprises, and create jobs; and harmonization of regulatory and institutional standards, which will improve the business environment and rule of law in Ukraine. The first indication is that Ukraine's exports to the European Union increased by 15 percent in the first half of 2014.

Meanwhile, the end of Gazprom's gas sales to Ukraine is likely to force the Ukrainian government to finally raise gas prices to a market-oriented level, which lead to both massive energy savings and increased Ukrainian production of gas. By all analysis, Ukraine can be self-sufficient in energy in about five years. At the same time, Russia is cutting its oil and gas transit through Ukraine.

The natural consequence of all these measures is that Russian-Ukrainian trade falls substantially by half or so within two years until the military aggression somehow has been mitigated. Then, the mutual trade is likely to recover gradually as has happened with Central and Eastern Europe, but the trade will be quite different.