Ukraine’s Free Trade Deal Was Just a Start

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(Bloomberg – – Leonid Bershidsky – May 11, 2016)

Ukraine’s free trade agreement with the European Union was so controversial that it caused the former Soviet republic’s break with Russia, which had opposed the closer ties with Europe. Several months in, it looks like the deal is benefiting the EU more than it is helping Ukraine.

That doesn’t mean it wasn’t worth doing. It does suggest, however, that if Kiev wants to reap the longer term benefits of free trade, it will need to adopt some changes at home.

Europe and Ukraine started negotiating an association deal in 2008, and it took its more or less final shape by 2012. A year later, President Viktor Yanukovych refused to sign it under pressure from Moscow; President Vladimir Putin wanted Ukraine to join his own pet project, now called the Eurasian Economic Union. Yanukovych’s decision gave rise to mass protests in Kiev, and three months later, he was forced to flee the country.

The new pro-European government hastened to sign the deal, which commits Ukraine to bringing its laws and regulations in line with the EU framework, and which lowers or eliminates most tariffs between the two parties.

The trade part of the deal came into effect from January 2016, and the first data on its implementation are not encouraging for Ukraine. According to the Ukrainian government statistical agency, in the first two months of 2016, the volume of goods traded with the EU slightly decreased, with exports falling more than imports. I weighted these data by volume and found that the weighted average year-on-year increase in exports to EU countries reached 2.1 percent in January and February; but the weighted average increase in imports was 10.4 percent.

In other words, apart from angering Russia, which has raised trade barriers with Ukraine in response to the EU deal and caused both exports and imports to plummet, the agreement is making a negative net contribution to Ukraine’s trade balance — not particularly welcome news for a country whose international reserves, at $13.2 billion, cover less than three months of imports.

Taken at face value, as a deal on tariffs and quotas, the Ukraine-EU agreement is skewed in favor of European companies. The EU has imposed tight annual quotas on some of Ukraine’s most desirable export goods, and by April 1, some of the quotas for 2016 — for honey, sugar, corn, grape and apple juice and certain cereals — were already filled. The quota for ethanol was almost gone, too. By May 1, the oats quota had run out, too, and wheat and barley exports were also approaching the limits set for the year.

Apart from agricultural products, Ukraine exports metals. The trade agreement didn’t change the rules of that trade, which has been free since Ukraine joined the World Trade Organization in 2008. Steel prices rose sharply at the beginning of the year, causing the Ukrainian hryvnia to appreciate unexpectedly against the dollar; in April, the uptick should have improved the country’s trade balance, though the numbers are not out yet. But since the end of April, steel prices dropped back to late March levels. Statistics for the second half of the year are likely to show an expansion of Ukraine’s trade deficit with Europe, because the agricultural quotas will be gone and there will be nothing to balance out the decline in these exports.

Conditions in EU trade deals with less-developed countries often favor Europe. The 1995 customs union with Turkey, for example, doesn’t provide Turkish firms with equal access to some markets with which the EU has negotiated free trade agreements and gives Turkey no control over those deals. Twenty years after the deal was made, Turkey has a large negative trade balance with Europe. That effect, however, is mitigated by an enormous flow of European investment into Turkey: In 2014, for example, it stood at 64.9 billion euros ($74 billion), while Turkish investment in the EU only reached 8.3 billion euros. This asymmetry helped Turkey create jobs and develop critical expertise in its export sectors that has served it well in markets outside Europe.

European bureaucrats have told Ukrainians not to expect instant benefits from the association deal. The more pessimistic, such as Nicholas Burge, head of the trade section of the European Commission’s delegation to Ukraine, speak of improvements in five to 10 years. The more optimistic ones, like the delegation’s head Jan Tombinski, cut that down to two to four years. Either way, time is necessary for European companies to discover Ukraine — at this point, mainly as a source of cheap, but relatively well-trained labor — and build operations there.

Ukraine, however, is far from ready to receive them. Apart from the destabilizing presence of Russian-supported rebels in the country’s east — something that will not end even if the fighting stops and elections are held in the rebel regions — the biggest obstacles are massive corruption and a business climate that makes it hard to make a profit while following all the rules.

While there’s no evidence that Poroshenko did anything illegal, the Panama Papers do lay bare a crony network that run the country. But the decision of Ukraine’s elites to park money, and conduct business, outside Ukraine speaks to bigger problems: high taxes, unreasonable regulations and insecure property rights. No wonder Cyprus — a traditional tax haven — is responsible for 27 percent of foreign direct investment in Ukraine. Or that the British Virgin Islands (where Poroshenko had set up a structure to help him sell his confectionery business) has “invested” almost as much in Ukraine’s economy as the U.K. and more than France. That investment is not really foreign — it comes mainly from local oligarchs, including Poroshenko.

Ukraine can only benefit from its deal with the EU if it draws up, and enforces, transparent and reasonable rules for European investors. Otherwise the deal will merely be a drag on the trade balance, preventing business with Russia and favoring European exporters over Ukrainian ones.

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