KYIV BLOG: Dropping export quotas on Ukrainian goods to Europe would fix its worst problems

KYIV BLOG: Dropping export quotas on Ukrainian goods to Europe would fix its worst problems
Ukraine has always run a big trade deficit with the EU
By Ben Aris in Berlin January 31, 2019

It’s not even the end of January and Ukraine has already used up its entire year’s quota for duty free exports to Europe of corn, honey, grapes and apple juice. Quotas on other products are running out fast: starch (17% of the quota used), sugar (38%) and wheat fibre (44%).

Ukraine has a Deep and Comprehensive Free Trade Area (DCFTA) agreement with the EU. But thanks to restrictive quotas that are attached it’s more of a Shallow and Restrictive Not-so-free Trade Area.

Ukraine’s economy is flat on its back and it needs to expand its existing businesses and create new ones. After 20 years of almost no reforms the country has all of the post-Soviet catch-up growth ahead of it whereas most of the other countries in the region have already exhausted these easy gains, but transformed people’s lives in the process.

Starting from such a low base — as bne IntelliNews recently reported in “HEATMAPS: Unemployment is mostly defeated but pay is not high enough” Ukraine has the lowest salaries and GDP per capital in Europe — Ukraine is the best investment story in the Former Soviet Union (FSU) and will boom — eventually.

The problem is that its pivot to the west has come at a very high price. The benefits of this turn, while clear in the long run, are causing a great deal of pain in the short-term.

The collapse of trade with Russia that followed the clash over Crimea has not been compensated with new trade with the EU. Ukraine’s foreign trade grew by 12% last year, hitting $104bn, according to the State Fiscal Service. But exports were up 9% to $47.3bn, while imports were up 15% to $56.8bn, leaving Ukraine with a $9bn trade deficit.

Exports to Europe are growing fast and the EU is now Ukraine’s biggest trade partner accounting for about third of the total. But Ukraine’s exports to the EU are tightly regulated, while imports from Europe are not. Ukraine exported some $14bn of goods to the EU, while it imported over $16bn, leaving a trade deficit of more than $2bn. Indeed, Ukraine has always run a sizeable trade deficit with the EU.

At their peak, Ukrainian exports to Russia reached $11bn in 2011, according to Trading Economics, but trade has all but collapsed since then. Last year, Russia exported to Ukraine $7.2bn worth of goods, up by a robust 20%, which almost double the amount of Ukrainian goods bought by Russia, down by 5% to $3.9bn, according to Ukrstat. That leaves a trade deficit with Russia, a country that Ukraine is at war with in all but name, of over $3bn. This year the deficit will only get worse after Russia expanded a ban on Ukrainian imports in January.

“The EU’s share of Ukrainian exports has reached a historic maximum of 42.5%,” President Petro Poroshenko said on January 5. “The structure of Ukrainian exports has shifted significantly towards value added products, which now account for 43% of exports to the EU.”

The growing trade with the EU is all very well, but more important is the accompanying growing trade deficit; prior to the crisis Ukraine was regularly running a €10bn deficit in trade with the EU. And Ukraine also needs to replace the lost circa $9bn of exports to Russia. Currently, in trade terms, Ukraine is running at a loss and that will likely get worse.

Recently China has started to step into the breach. Sino-Ukraine trade is growing by 20% a year and China may replace Russia as a trading partner as soon as 2020. In the first eleven months of 2018 Ukraine exported $8.82bn worth of goods to the Middle Kingdom, up more than a billion dollars from a year earlier, which has filled a lot of the hole left by Russia’s departure. Shut out of the best part of the EU market, Kyiv has also been actively seeking new markets in the Middle East and North Africa.

More trade with the EU is welcome and part of the country’s new direction, but the trade deficit with the EU is a burden as it has to be paid for. Moreover, the existing trade is not being followed by foreign direct investment (FDI) that usually comes in behind growing trade relations. The rule of thumb is every $8 of trade between two countries generates about $1 of FDI. The current level of trade suggest European companies should be investing some $1.5bn in Ukraine a year, but in 2018 the entire FDI into the country was $1.9bn – from which the biggest investor was Russia, accounting for around $400mn.

Drop the trade quota

If the west really wants to help Ukraine it should drop the quotas on imports from the Ukraine – or at least greatly expand them. Business would boom and investment should flow behind very quickly.

The EU is keen to help Ukraine transform and face down Russia, but its solution has been to turn to the International Monetary Fund (IMF) and other international donors, who are providing loans to bail the government out.

These are debts and need to be paid back. And the burden of paying back these debts ultimately falls on the shoulders of the Ukrainians themselves.

Ukraine’s external debt jumped again in December last year to $78.3bn after the government received the latest tranche under the new stand by agreement (SBA) signed that month. The money was desperately needed – to pay off debt.

“The surge in December state debt was prompted by Ukraine receiving a $1.38bn loan tranche under the 14-month IMF stand-by arrangement. In turn, that enabled the World Bank to provide a $750mn financial guarantee for the loans Ukraine is intending to attract in 2019 from Western financial institutions,” Evgeniya Akhtyrko of Concorde Capital said in a note.

At the end of 2018 Ukraine’s external debt amounted to about 62% of GDP, up from around 35% prior to the crisis, which is not crushing but it is already over the upper limit recommended by the Maastricht treaty that set conditions for joining the EU.

Ukraine’s debt redemptions are about to rise as a debt restructuring deal signed five years is up this year: Ukraine needs to pay off some $17bn of debt in the next two years but has a total of $20bn in currency reserves at the moment.

This debt-based system has another big disadvantage as it distorts democracy. The multilateral lender has been attaching strings to its loans that forces the government to make painful reforms, but in doing so the IMF takes over the agenda. The politicians have to serve two masters: the IMF and the voters. It is notable that two of the leading candidates in the March 2019 presidential race, opposition leader, former prime minister and head of Batkivshchyna (Fatherland) party Yulia Tymoshenko and head of the Opposition Bloc Yuriy Boyko (aka Boiko), are both running on anti-IMF platforms.

And the IMF programmes, while clearly necessary and good for the overall health of the economy, on the whole do not bring immediate relief to the long suffering population. No one is going to set up a factory because the IMF forced a gas tariffs hike on the government.

Dropping the trade quotas on Ukraine would have a much more immediate affect. Able to sell more goods into a huge and lucrative market, where Ukrainian producers can compete on cost, business should flourish. As cash pours in, owners would invest into new modern facilities and hire more workers. Salaries would go up that would spur consumption and that would provide more earnings, more investment, more jobs and more growth. Indeed it is the virtuous circle that was working in Russia in the boom years of the noughties, fuelled by rising oil prices which the government passed on to the public via 10% public sector wage hikes every year for nearly a decade. At base booming trade was responsible for that boom, which saw the Russian economy double in size in under a decade.

Politically this scenario could also work wonders for Ukraine. Firstly there would be a rush of Russian businesses into Ukraine to gain access to the EU market through this newly opened backdoor. Commerce would be the salve for the red-raw relations as the Kremlin’s own powerful oligarchs start to lobby for better relations to protect their burgeoning business ties.

And pressure would come from below too. A Ukraine that became more prosperous than Russia would turn the entire Russian population on the Kremlin. Long used to being the “big brother” in the Russo-Ukrainian relationship, the Russian population would feel the same pangs of jealousy any big brother does if their younger siblings outperform.

Of course nixing the quotas overnight is unworkable. Following WWII Europe’s governments have all decided that producing enough food to feed the country is a national security issue, and that led to the Common Agricultural Policy. The farming and food industry lobby is one of the most powerful in Europe. Ukraine’s egg and poultry sector is large enough and produces at a low enough cost that it could largely destroy the industry in Western Europe. Clearly if quotas are to be lifted it would have to be done in steps. It also means Europe would have to fundamentally change the make-up of its economy and downgrade agriculture. None of that is likely to happen any time soon.

But it should be possible as everyone benefits. Unlike the IMF programmes, it would be Europe’s citizens that bear the cost of Ukraine’s transformation through the money they spend on buying Ukrainian imports (mostly agricultural products). And they should be happy to do so as prices would fall, which would also hold down inflation in the west – an economic boon the EU would receive in compensation for opening its market. It's the basic economic concept of “comparative advantage” at work on a grand scale.

Relaxing the restrictions on Ukrainian exports to Europe would benefit everyone, except the European agricultural lobby, and that makes it a very tough decision to make and implement. In the meantime the Ukrainians suffer and Russia has the upper hand.