Ukraine tries to find middle way between east and west

By bne IntelliNews April 7, 2011

Tim Gosling in Moscow -

As Ukraine continues negotiations over a free trade agreement (FTA) with the EU, forces both inside and outside the country appear to be trying to frame the issue as a stark choice between Brussels and Moscow. The pressure is building, with Ukraine now eyeing billions of dollars on the table from Russia on one side, and years of negotiations towards EU membership on the other. It wants both.

The situation has developed surprisingly rapidly. No sooner than reports about Russia wanting to invite Ukraine into the Customs Union it set up last year with Belarus and Kazakhstan began appearing, Moscow announced on April 7 it was ready to offer Kyiv up to $8bn a year in discounts on gas supplies if it joined. The same day, Ukrainian President Viktor Yanukovych said Ukraine is ready to cooperate with the Customs Union, although he made it clear he would seek a deal that would also keep open the route to joining the EU.

The talks over the FTA are the first step on that long road towards full EU membership. But with Russian Prime Minister Vladimir Putin due in Kyiv for unspecified talks in mid-April, Moscow is lobbying increasingly hard to pull Ukraine back into its economic orbit. The EU, meanwhile, warns that an FTA is impossible should Kyiv choose to join the Customs Union.

Torn between short- and long-term gains, Yanukovych suggested Ukraine could cooperate with the Customs Union in a "3+1 format". He offered few details, but it's assumed that would mean Kyiv signing an FTA with Moscow, which would leave it free to negotiate independently with other parties, unlike full membership in the Customs Union.

Whilst that would be unlikely to please either Moscow or Brussels, Kyiv needs such a solution. One the one hand, the president has consistently said eventual EU membership is his top priority. On the other, his government has seen its ratings dive in the year or so since it came to power on the back of harsh austerity measures demanded by the International Monetary Fund (IMF) for a bailout package.

The third way

One of the biggest economic hurdles the country faces is the steep price of the gas it imports from Russia. Moscow has been refusing almost weekly requests to renegotiate the supply contract - although it has often offered a cut in the past in return for Kyiv's agreement to merge the state-run Naftogaz Ukrainy with Gazprom, which would give Russia control of Ukraine's gas pipelines, through which around 80% of Russian gas exports to Europe flow.

Kyiv has held out, with the gas transit system seen as a cornerstone of the country's independence. However, it's clearly tempted by the offer announced by Gazprom Deputy Chief Executive Valery Golubev on April 7 that it could benefit from the same gas prices as domestic Russian customers, which is around $50-80 per 1,000 cubic metres (compared with an average of $260 in 2010). Hence, Yanukovych's suggestion of a "third way". As Lilit Gevorgyan of IHS Global Insight puts it: "Ukraine is trying to find a compromise so that it can continue with both the FTA and benefit from the Russian offer on gas."

Timothy Ash of RBS puts the offer in perspective, pointing out it represents the equivalent of 4-6% of Ukraine's annual GDP, and that it "would likely push the current account back into surplus... provide a huge, and much needed boost to Ukrainian industry... and ease pressure on the government to push forward with the very sensitive issue of liberalising domestic gas prices."

Breaking rank

In early April, Putin first made public Russia's concern over the proposed FTA in March, when he threatened that Russia and its partners in the newly created Customs Union would raise trade barriers against Ukraine should it open its borders with the EU.

Ukrainian Prime Minister Mykola Azarov claimed on April 5 that no such proposal had been made. The latest news would seem to contradict that. "The newsflow is surprising, perhaps there have been some initial unofficial discussions already," suggests Olena Bilan of Dragon Capital. "Until today, I didn't think it at all likely that Ukraine would consider joining the Customs Union. All top officials have been talking of the EU for months, but today, it's hard to tell. However, as long as the gas price is below $400 I'd be surprised if Kiev made any real efforts in this direction."

The same day that Azarov denied any talks over gas, government envoy Valery Muntyan claimed Kyiv had indeed put forward several conditions for joining the Russian trade bloc, including a 50% cut in the price of gas and dropping export duties on oil and oil products, a move worth $3.5bn a year, Reuters reported. Asked whether Russia had agreed to those terms, Muntyan said: "There is agreement in principle. But it is too early to talk about agreeing to particular compensation mechanisms, the talks are going on."

Meanwhile, Global Insight's Gevorgyan suggests the Russian offer may not be as straightforward as it appears, with Belarus having been fighting for tariff-free energy imports from Moscow for some time: "Belarus would be very unhappy if Ukraine was offered energy exports free of tariffs."

Such inconsistency encourages strong resistance from some Ukrainian officials to a turn towards Moscow. According to news agency Zik , an unnamed cabinet member complained: "First, our goal is to join the EU, and we are not going to sacrifice it for the sake of ephemeral trade preferences from Russia. Look at Belarus, which is in a non-stop trade war with Russia. Second, the likely losses from the closure of the Russian markets will be compensated by the access to much more hefty European market after the FTA with EU is created."

Another minister apparently agreed the cabinet is not prepared to give up its EU aspirations to get cheaper gas, pointing to Kyiv's recent drive to diversify its energy supplies. "We're not giving up on our plans to join the EU. We will build a terminal near Odesa for receiving [liquefied natural gas] and we will search for shale gas jointly with Americans. This will minimize the dependence on Russia for gas."

However, Reuters reports that not all officials are united. Ukraine's main negotiator with the Russia-led bloc, Valery Muntyan, argued against promoting trade ties with the EU over those with Russia. In an interview with Kommersant Ukraina he said: "In 2010, EU member countries accounted for 29.6% of Ukraine's foreign trade, but trade with [Commonwealth of Independent States] nations accounted for an even larger portion, 40.2%. In my opinion, we must make a decision on joining the Customs Union in the first half of this year and this decision will be made by the country's political leadership."

That split reflects the fine line Kyiv has been trying to walk since Yanukovych assumed office in 2010. The president has consistently professed a strategy of non-alignment, which given Ukraine's strategic geopolitical position offers it leverage with both east and west. Yanukovych's offer on April 7 of a limited cooperation with the Customs Union, which would allow the FTA with the EU to go forwards also, is simply an attempt to continue in this role, while securing the juicy gas benefits from Russia.

It seems unlikely to prove enough for Moscow to give away billions in gas revenues, although as Gevorgyan points out, details of the 3+1 plan are thin on the ground. It seems more probable that it's a delaying tactic in the face of Russian pressure to set an agenda ahead of Putin's visit, analysts agree.

At the same time, Kyiv will also see the Russian offer as a handy prod to try to speed up the talks with Brussels. Officials, including Yanukovych, have expressed unhappiness with the EU's tough stance in talks over its track towards membership.

Whether it will work is another thing. As Gevorgyan says: "The suggestion will not be welcomed in Brussels; Kyiv will have a lot of explaining to do concerning how the plan will not disrupt the FTA." It will also be grist for the mills of those in the West who believe Yanukovych is simply a stooge of Moscow - a picture successfully painted in some quarters by his rival, Yulia Tymoshenko.

Whether Yanukovych will prove more adept at playing both sides off against each other than Belarusian President Alexander Lukashenko has been is an open question. Bilan argues he won't be able to pull it off for that much longer: "Ukraine will delay committing itself one way or the other for the next couple of years," she says, "but sooner or later it will be forced to make a choice. It can't put it off forever."

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