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A Further Trend Towards Integration: Analyzing the Impact of a Ukraine-EU DCFTA on Eastern European Transition Economies

This section will focus on the economic relationship between Ukraine and the European Union and the Deep and Comprehensive Free Trade Agreement (DCFTA) recently agreed upon by the two countries1. To understand this development, we must first know the basic economic history of Ukraine. Ukraine is a former Soviet State located in Eastern Europe, bordering Russia to the west. Its traditionally agriculture-based economy transitioned into an industrialized, mining and manufacturing focused economy under Soviet rule made possible by imports of Soviet energy at below-market rates. After the fall of the USSR, Ukraines transition to a market economy was marred by disorganization and corruption, and the results were extremely painful for its citizens. GDP fell annually between 9.7% and 22.7% during the first five years of privatization, figures nearly unheard of for peacetime countries. The country experienced hyperinflation and massive unemployment, and the economic system collapsed into one based on a shadow economy and the barter system. Post-Soviet Ukraine did not experience economic growth until 2000.2 Today, the Ukrainian economy is performing much better, and is classified as a middle income economy, and its Real GDP adjusted for Purchasing Power Parity ranks 37th in the world, according to the IMF. Ukraine and the EU are important trade partners, with a total volume of 37.7 billion traded between the two regions in 2012, a figure that accounted for 31.0% of Ukraines total trade volume. Ukraines exports to the EU consist mainly of agricultural products, fuels and mining products, iron and steel, and chemicals. EUs exports to Ukraine are mostly machinery, transportation equipment, and other manufactured and semimanufactured goods.3 With such a large volume of trade between the two regions, classical

1 2

The European Union is not a country, but will be referred to as such in this paper for the purposes of simplicity. Sutela, Pekka. The Underachiever: Ukraines Economy Since 1991. Carnegie Endowment for International Peace. http://carnegieendowment.org/2012/03/09/underachiever-ukraine-s-economy-since-1991/a1nf# (accessed October 29, 2013) 3 Ukraine: EU Bilateral Trade and Trade with the World. European Commission. http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113459.pdf (accessed October 29, 2013)

economics will predict that it would be mutually advantageous to eliminate barriers to trade, which is essentially what the DCFTA does. The DCFTA, negotiated for over four years and scheduled to be signed in late November, will eliminate substantially all tariffs and import duties for EU exports to Ukraine and Ukrainian exports to EU, reduce technical barriers to trade (regulations, conformity requirements, etc.), and insure the free movement of capital between the two countries.4 To explore the potential consequences of this agreement, we will now turn to the academic model of a customs union. Baldwin and Wyplosz present and interesting and comprehensive model of a Customs Union (CU) in The Economics of European Integration. To understand the economic theory behind a CU, we will first look at a unilateral preferential trade liberalization scenario with three countries: Home, Partner, and Rest of Word (RoW). Assume the following scenario: Partner and RoW each export the same good to Home; each have the same supply curves and, obviously, face the same demand curves in the Home market. Home imposes an equal tariff on Partner and RoW. Home subsequently eliminates the tariff on imports from Partner, but not from RoW. Because the cost of the tariff was originally shared by the exporters and the consumers, Partners border price, or the price it actually receives from consumers, will rise, even as the market price falls. As RoW competes in the same market as Partner, the price of its goods sold in Home must fall to match the market price. However, because they are still paying the tariff, RoWs border price will fall. The effects for Partner and RoW are obvious: Partner sells more goods at a higher price, and will experience a net gain from the arrangement; RoW sells fewer goods at a lower price, and will experience a net loss from the arrangement. The consequences for Home are harder to predict. With the partial liberalization, Homes imports will increase. This causes a
4

EU-Ukraine Deep and Comprehensive Free Trade Area. European Comission. http://trade.ec.europa.eu/doclib/docs/2013/april/tradoc_150981.pdf (accessed October 29, 2013)

gain in welfare. The goods that are still being imported from RoW have fallen in price, so Home will experience a gain in welfare on these goods as well. However, Home is now paying more for its imports from Partner, so it will have a loss in welfare from this development. As we can see, from a unilateral preferential trade liberalization, Partner will necessarily win, RoW will necessarily lose, and Home may win or may lose, depending on the specific amounts that prices and quantities were affected by the liberalization policy.5 The model of a CU, where trade is liberalized reciprocally, i.e., both Home and Partner remove import tariffs and other barriers to trade for the others goods, but not for RoW, assumes a hypothetical three country three good trade pattern where each country exports two goods and imports one good. I have diagrammed this trade pattern model in Fig. 1 in the Appendix. When Home and Partner join a CU, they eliminate import tariffs for trade between the two countries but not for trade with RoW. The results are quite similar to those of the unilateral trade liberalization. Once again, Home importers have a gain in welfare from the increased import volume, a decline in welfare from the higher prices paid to Partner, and a further gain in welfare from the lower prices paid to RoW. Moreover, its exporters will gain in the same way that Partner benefited in the first example, from the higher prices received combined with higher volumes. Because of the reciprocal nature of the CU, Partner will have the exact same welfare changes as Home. Due to its exclusion from the CU, RoW will receive a lower price for both Good 1, which it exports to Home, and Good 2, which it exports to Partner. We can see then that, although it is still unclear whether either Home or Partner will experience a net gain from the CU, its gain in welfare will be larger (or loss in welfare will be smaller) than Homes welfare change in the unilateral example, because both importers and exporters benefit from the CU.
5

Baldwin, Richard, and Charles Wyplosz. The Economics of European Integration. 4 ed. London: McGraw-Hill Higher Education, 2010. 140-145. Welfare effects shown graphically on p. 147.

th

Moreover, RoW experiences a loss in welfare that is exactly double the loss in welfare they received when they were excluded only from the unilateral liberalization agreement. 6 Now that the basic model of a CU has been set up, we must see if this model represents the situation currently faced by Ukraine, the EU, and the third key player involved in Eastern European export markets, Russia. Upon the signing of the DCFTA, Ukraine and EU, will become Home and Partner in the model (the distinction between the two is irrelevant, as I have shown above) and Russia, left hung out to dry, becomes RoW. We must see if the three-country three-good assumption is accurate. As mentioned before, EUs exports to Ukraine consist primarily of transportation equipment and other manufactured goods, while Ukrainian exports to the EU are mostly foodstuffs, energy, and semi-manufactured goods such as chemicals. The assumption is somewhat challenged as Russia enters the picture, as Russia has essentially one category of export goods energy.7 Russias reliance (a strong argument can be made for use of the word overreliance) on crude oil and natural gas exports is over 100 years in the making and goes far beyond the simple fact that Russia has the largest oil and gas reserves in the world but this is a topic for another paper. We can make the model basically work, however, by making the EU Home, Ukraine Partner, and making Good 1 be natural gas, which both Ukraine and Russia export to the EU in large volumes. According to the model outlined in the paragraph above, the outcomes of the DCFTA should be approximately as follows: The EU will benefit from cheaper and larger quantities of Ukrainian natural gas, foodstuffs, and chemicals Ukraine will benefit from cheaper transportation equipment and manufactured goods from the EU

6 7

Ibid, 150-152. Russia: EU Bilateral Trade and Trade with the World. European Commission. http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113459.pdf (accessed October 30, 2013)

Russia will lose by having to charge less for natural gas in its exports to both Ukraine and the EU

Will this in fact be the outcome? Many, not least of whom Vladimir Putin and his advisors, give an emphatic no. As this class focuses on European integrations impact on Russia, I will now analyze the DCFTA from the Russian perspective. Russias primary objection to the treaty is of course a desire to avoid the third consequence shown above namely, facing a lower market price on suddenly liberalized natural gas markets in both the EU and Ukraine. The Kremlins objections to the DCFTA run far deeper than this, though. As I mentioned in the introduction, Ukraine was a vital part of the Soviet economy for much of the late 20th century, but it was also a strong part of the social and cultural scenes as well. This close relationship has led many Russians to view Ukraines spurning of Russia as somewhat of a betrayal a final rejection of shared Soviet roots. Russias overall economic objection, though, is simply that Ukraines forming a pact with the EU essentially stops in its tracks Russias goal of forming an EU-esque economic bloc among the former Soviet states.8 Russia, Belarus, and Kazakhstan formed a CU in 2010, and Kyrgyzstan, Tajikistan, and Uzbekistan have been invited to join along with Ukraine. According to Ukrainian economist Olga Shumylo-Tapiola, one of the architects of the DCFTA, Ukraines decision to side with the EU would represent a death sentence for Russias CU for two reasons. First, Ukraine is the second largest market among the post-Soviet states, a population of nearly 50 million, and is also Russias third largest trade partner. The loss of such an important trade partner precludes Russia from realizing the gains achieved by Home in the CU model as discussed above. Secondly, and perhaps more importantly, Ukraines decision not to join will have immense political

Liborious, Soren, and Guilluame Durand. Russias Major Challenges. Lecture, EU Delegation Visit, Moscow, st October 21 , 2013.

consequences for the CU, likely encouraging other post-Soviet states to side toward the EU, or at least away from Russia.9 The Kremlin has been vocal in their opposition to this Ukrainian defection and will likely move in the opposite direction, de-liberalizing trade with Ukraine through increased inspection at borders and other technical barriers to trade if and when President Yanukovych signs the DCFTA later this month. A senior economic advisor to Putin went as far as to call Ukraines decision suicidal, and threatened Russia would hit back with massive trade restrictions.10 This de-liberalization has already begun, with both Russia and Belarus instituting a ban on Ukrainian-made chocolate this summer.11 Having looked at Russias primarily self-interested objections to the DCFTA, we will turn back to the Ukrainian perspective to examine some of the risks involved with this deal. While economic models are usually quite good at explaining past events and situations, their predictive power is somewhat limited, due to simplified assumptions and, of course, unforeseen events. With that in mind, we can look at what might cause the outcome of the DCFTA to deviate from what is predicted by the model. The first issue with the application of the textbook CU model to the Ukraine-Russia-EU situation, with natural gas as the good in question, is that while Ukraine is a major producer of natural gas, with 5.4 trillion cubic meters of it underground, the majority of its natural gas exports is Russian natural gas being transported to Europe through Ukrainian pipelines. Thus, Ukrainian gas exporters will not necessarily benefit as predicted from the DCFTA, as they will likely still be paying the same (or even higher) prices to import the gas from Russian state-owned-enterprise Gazprom. The distinction of Ukraines
9

Shumylo-Tapiola, Olga. Ukraine at the Crossroads: Between the EU DCFTA & Customs Union. Russia NEI Report 11 (2012): 1-27. 22. 10 Trade suicide: Russia prepares to tighten borders in Ukraine signs on with EU RT Business. RT. st http://rt.com/business/trade-war-ukraine-russia-656/ (Accessed November 1 , 2013). 11 Belarus and Russia in a chocolate war against Ukraine. RT. http://rt.com/business/russia-ukraine-roshenst ban-053/ (Accessed November 1 , 2013).

primary gas supplier being controlled by the government is important, because it means that gas prices are set not in a free market, but under advisory of the Kremlin, which takes into account political as well as economic factors. To mitigate this risk, Ukraine has already begun to diversify its natural gas suppliers.12 However, Ukraine is facing larger problems than the question of where its going to buy its gas problems that will almost certainly be exacerbated by a sudden elimination of protectionist trade policies. US-born economist and Forbes contributor Mark Adomis outlines the essential problems facing Ukraine. Put very simply, Ukraine is running a large and growing current account deficit, which the Ukrainian Central Bank is not helping with its policy of keeping a strong hryvnia. This deficit is financed through the issuance of large amounts of sovereign debt the continued access to which is very uncertain given Ukraines sub-investment grade credit rating.13 To make this worse, Ukraine is experience both negative GDP growth and negative population growth.14 When Ukraine signs the DCFTA and immediately becomes tariff-free trade partners with the massive, advanced economies of the EU member states, the consequences according to trade theory are quite easy to understand. In the short-term, it seems likely that Ukrainian producers, long the beneficiaries of protectionist trade policies, will be out-competed in the suddenly free market by their new German, French, and British rivals. Imports will rise further, increasing the trade deficit and forcing Ukraine to borrow more money. I have given an overview of the DCFTA, analyzed it using the academic model of a customs union, shown some potential benefits and risks of the agreement, and the impact it will

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Kyivs Gas Strategy. OSW. http://www.osw.waw.pl/en/publikacje/osw-commentary/2013-07-15/kyiv-s-gasnd strategy-closer-cooperation-gazprom-or-a-genuine-div (Accessed November 2 , 2013). 13 Adomis, Mark. Ukraine is not dead yet, but its about to go bankrupt. Quartz. http://qz.com/107248/ukrainend is-not-yet-dead-but-its-about-to-go-bankrupt/ (Accessed November 2 , 2013). 14 According to data compiled by www.tradingeconomics.com

on Russia. As for what will actually happen, only time will tell. Here are my general concluding thoughts: 1. Its reasonable to assume that Ukrainian producers will be damaged in the short term from an integrated European export market. 2. Ukrainian exporters will be hurt by the newly imposed trade restrictions from Russia. This should be negated by the gains from liberalized trade with Europe. 3. If Ukraine continues to increase its trade deficit at a massive rate, it is possible that it will have to default or receive an IMF bailout. I do not believe this is a likely scenario; although Ukraine has a poor credit rating its government debt to GDP is only around 40%, far less than many EU member states.15 4. The economic integration of Ukraine with Europe will end Russias dream of Eurasian integration distinct from Europe, and the trend towards European integration will likely continue. 5. In the long run, Ukraines increased access to (and essentially becoming a part of) the worlds single largest market will reap the benefits predicted by the academic model. It seems highly likely that there will be some pain, perhaps a great deal of it, in the short term. Ukraines recession will continue for the time being, unemployment will rise, and there will be continued migration out of the country. However, if Ukraine can manage to make it through this period without defaulting on its sovereign debt, which would have disastrous consequences (see: Argentina) I believe the net gain from free trade with Europe will be positive. This is not necessarily just from receiving a higher border price for natural gas exports, as was discussed in the context of the model, but more generally from having a more open economy, able to trade with economic powerhouses such as Germany and England without restriction. On a higher level, Ukraines choice of the EU over Russia has an important cultural and geopolitical, as well as economic message: Ukraine is a European country not a post-Soviet country. Russias relationship with Ukraine has been strikingly similar to the arrangement under the USSR: Ukraine gets cheap energy from Russia, leading to a less diversified economy highly dependent on Russia. Ukraines decision to sign the DCFTA shows that they are finally moving away from

15

Ibid.

this Soviet model and into the 21st century. This last sentence will offend many Russians, but I truly believe that as the dominos continue to fall more and more Eastern European nations becoming economically integrated with the EU total European economic integration will become inevitable, eventually encompassing even Russia.

Appendix. Fig.1. Illustrative Three Country Trade Model


Good 1

Home
Good 1

Good 2 Good 2

Partner

Good 3

RoW

Good 3

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