Four Years of EU–Ukraine Association: Teething Problems or Permanent Crisis?

Even those experts who are clearly against Russia or oppose the multi-vectored policy adopted by Ukraine admit today that the European Union’s association mechanisms are faltering. Despite the fact that the Ukrainian government believes that, since 2017, it has stepped up work to fulfil its obligations under the Association Agreement, the rate at which the Ukrainian authorities are “doing their homework” remains modest at 41 per cent of the plan.

Having received a market of cheap labour, the European Union is in no hurry to further integration with Ukraine. The introduction of a visa-free regime, which would be more correctly called a liberalization of the visa regime, has a number of positive aspects in terms of tourism and saving time, but it can have no strategic effect on the country’s economy.

The results of 2017 and the development prospects for 2018 indicate that, even though Ukraine economy has overcome its collapse, serious growth should not be expected. The problem lies not only in the mechanisms of European integration, but also in the European Union itself. The association process has made the Ukrainian economy more vulnerable, opened up the admittedly weaker market and done absolutely nothing to protect it. In fact, association with the European Union is increasingly turning Ukraine into a raw materials appendage of the West. Ukraine will only start to truly reap the benefits of association with the European Union when exports to the European Union grow significantly, to at least 70 per cent of its total exports.

The Ukraine–European Union Association Agreement came into force in 2017. March 2018 marked four years since the signing of the political provisions of the agreement. This is a long enough period to try and assess, however briefly, Ukraine’s achievements on the difficult path towards association with the European Union. This appears particularly relevant given the fact that the past several years have been the most difficult in Ukraine’s post-Soviet history.

Ukraine’s association with the European Union has caused heated debates both inside the country and abroad. This is quite understandable, because even if we look at the situation in which the agreement was signed and the way the preparatory stage was handled, it becomes obvious that Ukraine was negotiating the matter under pressure both from the West and the East. The previous Ukrainian government largely turned the policy of balance into one of bargaining, giving different promises to different partners, and ended up in a losing position.

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The manoeuvring of Ukraine in 2012–13, which took place in conditions where both Europe and Russia had adopted fairly tough positions, could not lead to success. Especially not under President Viktor Yanukovych. Although, strictly speaking, there had never been a full-fledged, unrestricted free trade zone between Russia and Ukraine. In particular, Russia introduced restrictions on Ukrainian exports of small-diameter pipes and food products. Nevertheless, given the importance of post-Soviet markets to Ukraine, the free trade zone with the CIS was very valuable to the country.

Moscow insisted that the existence of two free trade zones, one with the European Union and another with the CIS, would inevitably hold risks for Russia. The situation deteriorated to such an extent that Russia was on the brink of discontinuing the free trade zone with Ukraine and introducing a simple most favoured nation regime. In the summer of 2013, Russia even introduced an embargo on Ukrainian exports, thus demonstrating to the Ukrainian elites what could happen if the country signed an agreement with the European Union without taking Moscow’s opinion into account. Back then, both within the conciliatory groups and on the sidelines, Ukraine was doing its utmost to force Russia to make the maximum possible concessions. However, Ukraine’s situation was complicated. The country had to pay $7.2 billion in external obligations alone in 2014. It did not have the money to do so.

One may argue that Russia behaved too harshly and failed to act swiftly enough in terms of making concessions in a situation where the European Union was applying pressure on Ukraine. Nevertheless, the agreement signed on December 17, 2013 granted Ukraine a $3 billion tranche out of a total loan of $15 billion. The document also contained an action plan to resolve the restrictions in bilateral trade between Russia and Ukraine for 2013–14. Gazprom and Naftogaz of Ukraine signed addenda to the January 19, 2009 contracts regulating the volumes of natural gas to be delivered and the terms of its transit. Furthermore, the parties signed a plan of events to jointly mark the 200th anniversary of Taras Shevchenko in 2014, an agreement on government support for the resumption of series production of Antonov An-124 aircraft, a protocol on the supply of goods as part of production cooperation, a letter of intent to intensify cooperation on shipbuilding, and an agreement on the joint construction of a transport route across the Kerch Strait. Roscosmos and the State Space Agency of Ukraine signed a memorandum of understanding with regard to cooperation in space rocket development.

This was a compromise, and even a success for Ukraine. Unfortunately, it came too late, was not appreciated by significant portions of society and the elites, and was largely derailed by the substandard quality work of the Ukrainian authorities, which lacked a strategic vision. The main thing was that Ukraine was preparing for association with the European Union. Everybody was aware of this, hoping for positive developments. Kiev had already put its initials on the agreement with the European Union. Having signed with Moscow, Ukraine found itself under even greater pressure from the West. The Ukrainian president was unable to preserve the status quo, and the country increasingly became a ground for confrontation between the two geopolitical poles. Following the victory of Euromaidan in 2014, one of the first steps taken by the new Ukrainian authorities was to implement association with the European Union. This decision defined the future of the Ukrainian economy, and to a large extent its social life, for years to come.

An Economy of Slow Growth and Debts

Even those experts who are clearly against Russia or oppose the multi-vectored policy adopted by Ukraine admit today that the European Union’s association mechanisms are faltering. They often tend to explain this by the hostilities in the East, the loss of part of the country’s territory and the post-Soviet and Soviet mentality of the majority of citizens, who are not prepared to promptly switch to a new, European way of life and thinking. Such experts even blame the population’s poor knowledge of English. All this is, of course, true.

It stands to reason that the situation is being affected by the loss of vitally important territories such as Donbass, as well as corruption, the general drawbacks of the country’s institutional development and post-Soviet social practices. To be fair, however, many of Ukraine’s Western partners fail to understand that post-Soviet countries are characterized by slightly different social mechanisms, and that merely replicating the Western norms within the post-Soviet economic and social systems is fundamentally wrong. Nevertheless, the aforementioned negative factors undoubtedly exist.

Despite the fact that the Ukrainian government believes that, since 2017, it has stepped up work to fulfil its obligations under the Association Agreement, the rate at which the Ukrainian authorities are “doing their homework” remains modest at 41 per cent of the plan. This is a low figure, and there is no way the remaining objectives will be met by 2025. The greatest progress has been made in terms of removing technical barriers to trade and raising the level of responsibility for the safety of products. There is also some progress in the field of energy efficiency. In addition, 71 per cent of the European integration objectives for power generation and the humanitarian policy have been achieved. The lowest amount of progress has been made in healthcare and transportation. One hundred per cent of the objectives in the financial sector and education have been met. Nevertheless, Ukraine lags way behind on a number of important parameters, including consumer rights protection and de-monopolization, despite the fact that the country adopted 23 fundamental European integration laws in 2017.

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Even though there are fairly serious problems in terms of organisational support for association with the European Union, these problems are particularly manifested in the results of the country’s economic “development.” Ukraine’s GDP stood at $177 billion in 2013; in 2017 it barely reached $100 billion. In 2013, Ukrainian exports totalled $63.3 billion; in 2017 the figure declined by a third, to $43.26 billion. This is one of the most serious declines in the modern history of the post-Soviet countries. It cannot be explained solely by military factors, or by the problems associated with the country’s turn from East to West. Moreover, while the absence of institutional progress is an important factor, as mentioned above, the decline cannot be fully explained by these factors alone. One is left to wonder whether the country’s course towards unrelenting European integration and a revolutionary change of the social and economic way of life was a correct one.

Of course, not everything is doom and gloom in the Ukrainian economy. For one, the forecasts of an imminent economic collapse and social upheavals did not prove true. The country’s economy grew by 2.1 per cent in 2017. Trade with the European Union was particularly pronounced that year, growing 29 per cent from the same period the previous year, reaching $17.5 billion (42 per cent of all exports). There are also positive examples with regard to individual types of commodities, primarily agricultural products. Thus, Ukrainian honey enjoys significant demand in Europe, and chicken meat exports are also growing. The Ukrainian currency (the hryvnia) remained relatively stable in 2016, depreciating by just 4 per cent year-on-year, which is not much. Growth was also reported in certain industries, such as gas production. However, given the EU quotas on Ukrainian commodities, the sharp re-orientation of the country’s economy to agriculture, and the de-facto deindustrialization, the general picture does not appear all that optimistic.

The Ukrainian economy grew by 2.1 per cent in 2017, which is not nearly enough to partially mitigate even a small part of the consequences of the 2014–15 decline, which resulted in the reshaping of the economic structure. The figure could arguably have been higher if it were not for the blockade of Donbass, which cost the country around 1 per cent of its economic growth. At this rate, however, even another ten years will not be enough to return to the 2013 level. In addition, it is not only the quantity, but also quality that counts: the economic growth is more likely explained by inflation factors and the accelerated growth of imports, rather than by industrial development. As for growing exports of agricultural products, which are becoming increasingly more important to the country’s economy, these are not represented by highly processed goods. Growth is only observed in individual sectors, such as construction.

Ukraine’s state debt reached $77 billion in 2017, which is 80 per cent of its GDP. In 2018, a third of the budget revenues ($10.8 billion, or 30 per cent of all expenditures) will be used to service debts. Prices grew significantly in 2017, particularly with regard to food products, with this growth outstripping the growth in wages. Inflation during the year amounted to 13.7 per cent, higher than the government’s forecast of 8 per cent.

Growing labour shortages have become a serious problem. Migration bleeds the country’s economy of both skilled and unskilled workers, who prefer to go earn a living in Europe. The ruralization of the economy will be a significant factor in this process in the future. Having received a market of cheap labour, the European Union is in no hurry to further integration with Ukraine. The introduction of a visa-free regime, which would be more correctly called a liberalization of the visa regime, has a number of positive aspects in terms of tourism and saving time, but it can have no strategic effect on the country’s economy. At the same time, both individual EU member states and the European Commission can moderate the parameters of the visa-free regime, which can include cancelling it altogether. Nevertheless, the waiving of visas is not the key factor spurring migration. There are currently around one million Ukrainian citizens living and working in Poland. The majority of them are involved in logistics, manufacturing and trade. Illegal migrants are most often employed in construction and agriculture.

In this situation, it will be fairly difficult to meet the parameters of the 2018 budget, which envisages inflation of 9 per cent against a growth rate of 3 per cent. GDP growth is not likely to exceed 2 per cent in 2018. The government’s forecast of 3 per cent apparently proceeds from the premise that 1 per cent of this growth can be secured thanks to the absence of long winter holidays. As for inflation, it cannot possibly amount to 9 per cent in 2018. The figure will more likely be 13–14 per cent, and the exchange rate of the national currency will stay at around 30 hryvnia to the U.S. dollar.

At the same time, it is important to stress that the Ukrainian economy experienced fairly favourable conditions with regard to global ore prices in 2017, which reached a five-year maximum. It also benefited from a good harvest and excellent climatic conditions. Imports grew at a faster rate than exports, and trade balances worsened. It is unlikely that such a favourable situation will repeat itself in the future, partially due to the Federal Reserve System’s policy on rates. This, in turn, may have a negative impact on developing markets, including that of Ukraine. The Ukrainian government will thus need to expend greater efforts to secure the planned growth rate and maintain the current exchange rate, but the professional level of the cabinet so far does not allow one to state with certainty that it will manage to cope with this task.

Election campaigns are capable of additionally burdening the economy. 2019 and 2020 will be difficult years in terms of repaying external debts. Ukraine will need to return $28.7 billion between 2018 and 2022. EU association has also failed to generate a growth in investment. In previous years, direct foreign investment into the Ukrainian economy reached $10 billion per year. The most recent figures point to $2.5 billion.

The European Union’s programme of macro-financial assistance to Ukraine, launched in 2015, ended in late 2017. Earlier, Kiev received 1.2 billion euros in two instalments, out of a total of $1.8 billion. However, the European Union then refused to allocate 600 million euros because Ukraine had failed to meet all its requirements. In 2016, Ukraine agreed to bring its gas prices up to the prices on external market. In January, the President of Ukraine promised Managing Director of the International Monetary Fund (IMF) Christine Lagarde that he would raise gas prices in his country and meet the other demands set by the IMF. Ukraine stood to receive $1.9 billion from Western creditors, but the cabinet decided to keep the gas price for the population unchanged at 6.9 hryvnia (about 26 cents) per cubic metre. Prime Minister of Ukraine Volodymyr Groysman announced that the gas price would not be raised until year-end, but now the authorities are promising to present a new gas price calculation formula by June 2018.

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The IMF replied that it would then suspend the payment of a loan instalment approved in April 2017. If the gas price for the population goes up by 18 per cent, the budget expenses on subsidies will grow from 70 billion (around $2.7 billion) to 90–100 billion hryvnia (about $3.4–3.8 billion). At the same time, Ukraine will have to repay $7 billion in both 2019 and 2020, which will be extremely difficult to do without the IMF’s support. The situation is exacerbated by the preparations for elections. It is highly unlikely that Ukraine can afford to stop cooperating with the IMF, but one thing is clear: the volume of foreign investment is incomparable with the size of the IMF loans, and Ukraine should at least consider revisiting the nature of its relations with the fund. However, such a revision will hardly be possible without revising the country’s entire macroeconomic policy and strategic vision.

The situation in the Ukrainian banking sector is fairly complicated. The National Bank of Ukraine (whose new head has already announced that he will continue with the policy carried out by his predecessor Valeriya Gontaryeva, who had occupied the position for eight months without actually appearing at work) is increasing its share of securities in gold and foreign currency reserves. This means that statements to the effect that Ukraine holds $19 billion in gold and currency reserves are highly dubious. The National Bank no longer publishes reports about the structure of its securities.

What Next: Development on the Horizon or Survival as a Raw Materials Appendage?

The results of 2017 and the development prospects for 2018 indicate that, even though Ukraine economy has overcome its collapse, serious growth should not be expected. Many economists view privatization as a possible extra source of money, but the thing is that the share of state property on the Ukrainian market stands at just 15 per cent, which is not high at all, even when compared to developed countries. Besides, privatization in and of itself would open the door to corruption in the current Ukrainian reality.

All the above allows us to arrive at the conclusion that the problem lies not only in the mechanisms of European integration, but also in the European Union itself. The association process has made the Ukrainian economy more vulnerable, opened up the admittedly weaker market and done absolutely nothing to protect it. In fact, association with the European Union is increasingly turning Ukraine into a raw materials appendage of the West. For example, Germany purchases ore from Ukraine, but will hardly buy steel and end products. According to Ernst and Young, Ukraine is the most corrupt European country. Moreover, it is the poorest country on the continent: the average monthly income after tax stands at 190 euros.

Even if we talk about the mechanisms of implementing the association with the European Union, experts point to the absence of a proper level of analysis and a clear-cut plan of action. President Poroshenko’s idea to set up a customs union with the European Union looks fairly appealing on paper, but there is no practical sense to it at this stage: for the plan to be implemented, Ukraine needs to fully harmonize its customs system with that of the European Union. Only then will it be possible to achieve something close to the relations Turkey has enjoyed with the European Union since 1995, even though this has not resulted in that country’s accession to the Union. In addition, Ukraine is running the risk of losing the free trade zones with many CIS countries. Ukraine will only start to truly reap the benefits of association with the European Union when exports to the European Union grow significantly, to at least 70 per cent of the country’s total exports.

At present, Ukraine’s foreign trade balance has shrunk by $5 billion. It would appear that the European Union represents the largest market in the world, but it is a hi-tech market and it protects its quality. It is true that certain products are in demand and will continue to be so, but Ukraine will never again be able to claim the role so imprudently predicted by many economists in the early 1990s, who hailed the country as a new France. Ukraine may of course export bees, but with 40 per cent of its metallurgical and 60 per cent of its chemical industry lost, such proposals are hardly a source of optimism. But deindustrialization, the destruction of infrastructure, the loss of scientific potential, the decline in the level of education, and the mass exodus of young people from the country are irreversible processes.

In this connection, one should remember that only an active state economic and industrial policy, in combination with healthy protectionist measures, can resolve the crisis. Such a policy needs to be focused on individual industries which are not overly dependent on raw materials and are not limited to simple assembly operations; it is also important to focus on enterprises capable of hi-tech development, those which are to drive economic growth. However, to implement this plan Ukraine needs first to revise not just the fundamental principles of its economic policy, but also embrace new approaches to understanding its place in international relations and other organizing principles in foreign economic activity that would ensure the country’s diversification.