CURRENT AND PROSPECTIVE ECONOMIC RELATIONSBETWEEN UKRAINE AND THE CUSTOMS UNION - Executive Summary

EXECUTIVE SUMMARY

CURRENT AND PROSPECTIVE ECONOMIC RELATIONS BETWEEN UKRAINE AND THE CUSTOMS UNION (Russia, Kazakhstan, Belarus) This policy paper has been produced by the UNDP Aid for Trade Project in Ukraine Ukraine, Kyiv, 01021, 1/14 Sadova St., 4th floor Tel.: +38044 2535866, 2535869. Fax: +38044 2535611

Kyiv, 2011

Authors: Tamara Ostashko, Dr. Sc. (Econ.), Project Consultant, Chief Research Associate, NAS of Ukraine Institute of Economics and Forecasting SI; Vitalii Zhyhadlo, Project Consultant, foreign trade expert; Iryna Kobuta, PhD (Econ.), Project Manager, UNDP Aid for Trade Project in Ukraine With the assistance from, and in consultation with, the experts: Vitalii Venher, PhD (Econ.), Senior Research Associate, NAS of Ukraine Institute of Economics and Forecasting SI; Roman Podolets, PhD (Econ.), Sector Manager, Fuel and Energy Complex Development Forecasting Sector, NAS of Ukraine Institute of Economics and Forecasting SI. Under the editorship of Iryna Kobuta, PhD (Econ.), Project Manager, UNDP Aid for Trade Project in Ukraine

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior permission.

This is an independent publication produced by the UNDP Aid for Trade Project in Ukraine. The views expressed in this publication are those of the author(s) and do not necessarily represent those of the United Nations Development Programme or any other UN agency. Š Kyiv, 2011

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Table of contents

1. INTRODUCTION 2. TRENDS IN UKRAINE’S FOREIGN TRADE WITH THE CUSTOMS UNION COUNTRIES (Russia, Kazakhstan, Belarus) 3. IMPACT OF THE WORLD TRADE ORGANIZATION MEMBERSHIP UPON UKRAINE’S POSSIBLE ACCESSION TO THE CUSTOMS UNION (Russia, Kazakhstan, Belarus) 4. UKRAINE’S CURRENT AND PROSPECTIVE ECONOMIC RELATIONS WITH THE CUSTOMS UNION (Russia, Kazakhstan, Belarus) 4.1.1. Economic convergence in the ferrous metallurgy sector 4.1.2. Evaluation and analysis of the metallurgy sector’s trade relations with the Customs Union countries 4.2. FUEL AND ENERGY COMPLEX 4.2.1. Structure dynamics of energy balance 4.2.2. Foreign trade in energy resources 4.2.3. Implications of changes in trade regime for the structure of foreign trade in energy materials 4.3. AGRICULTURE AND FOOD INDUSTRY 4.3.1. Prospects of Ukraine’s economic relations with the Customs Union 4.3.2. Prospects of meat and meat product export to the Customs Union 4.3.3. Prospects of dairy product export expansion 4.3.4. Impact of the Customs Union Commission’s decisions upon the market of hard candies and some other confectionery products 5. CONCLUSIONS

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In 2009, the Russian Federation invited Ukraine to join the Customs Union of Russia, Kazakhstan and Belarus. The Agreement on the Establishment of the Customs Union and the Single Economic Space was signed by Belarus, Kazakhstan, Russia, Kyrgyzstan, and Tajikistan on 26 February 1999. The goal of the Union establishment consisted of integration of the countries’ economies and enhancement of cooperation among them. However, only the former three countries appeared ready for relatively fast integration. The Customs Union of Russia, Belarus and Kazakhstan commenced operating since 1 January 2010. Kazakhstan is to join the Customs Union at a later stage. The Union’s essence is that customs control of the goods destined to be imported in Russia, Belarus and Kazakhstan will be exercised at external borders of the Customs Union countries. In mutual trade among the Customs Union states, import duties, prohibitions or restrictions are not applied, the VAT rate and excises are equal to zero, and customs laws are unified.

For the entire system to become operational, dozens of interstate agreements must be signed in addition to the adopted common Customs Code, uniform technical regulations must be put into effect beginning from 2012, and sanitary and veterinary control principles must be unified.

Any customs union envisages establishing a common customs territory and creating an interstate body to implement such concerted policy measures. In this aspect, therefore, a customs union is a much tougher form of regional integration as compared to a free trade area. The Republic of Belarus, the Republic of Kazakhstan, and the Russian Federation founded the Customs Union Commission – the Union’s only permanent regulatory body that, apart from other functions, coordinates the application of protective, antidumping and antisubsidy measures against goods originating from the third countries, including Ukraine. The supreme body of such a union consists of the Interstate Councils at the level of the heads of state and the heads of government.

Cooperation with the Russian Federation and the Customs Union remains important to Ukraine. The Ukrainian Government emphasizes that economic integration with Russia is beneficial to Ukraine but our country’s membership in the World Trade Organization imposes on Ukraine the need to revise its arrangements with all the WTO member states in case of accession to the Customs Union 1 .

Currently, study of prospective economic relations between Ukraine and the Customs Union, as the closest regional group with which foreign commodity trade totals USD 42 billion, or 38% of Ukraine’s total foreign trade turnover, is considered as more relevant. It is 1

http://focus.ua/politics/198687/

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this form of economic relations that is likely to remain in the future, especially as Ukraine recently signed the Free Trade Area Agreement with the member states of the Commonwealth of Independent States (CIS).

In this paper, its authors analyze general trends in Ukraine’s foreign trade with the Customs Union countries by major commodity groups; consider problems and prospects of economic relations in such sectors as metallurgy, fuel and energy, and agriculture products which account for 65% in mutual trade; assess the Customs Union Commission’s decisions on introducing protective measures against some Ukrainianmade goods, and evaluate their impact on the development of Ukrainian industries.

Besides, the authors conduct assessment of the WTO membership’s effect on the possibility of Ukraine’s accession to the Customs Union of Russia, Kazakhstan and Belarus.

The WTO rules require its member states to adhere, when entering into free trade or customs union agreements, to certain standards as to preferential treatment coverage of the volume of commodity trade and prevention of worse access conditions for third parties, i.e. duties and other trade regulation means must not become higher or more restrictive.

Regular communications on free trade or customs union agreements are submitted by the WTO member states to the WTO Committee on Regional Trade Agreements. With it’s accession to WTO Ukraine undertook to submit communications and copies of its free trade and customs union agreements to the WTO. If understood traditionally, a free trade area means a group of countries that have eliminated among them tariffs for all or most commodities and nontariff measures affecting trade among them. Free trade areas have no single common external tariff. The member countries of an area may apply their own tariffs to third-party countries.

According to Article XXIV GATT, customs unions and free trade areas must eliminate the duties and other restrictive regulations of commerce “on substantially all the trade” between the parties to meet a free trade criterion. Traditionally, free trade agreements set a free trade regime no less than for 90% trade with preferential partner countries. Ukraine already has bilateral free trade agreements with the Russian Federation, Belarus and Kazakhstan that have founded a Customs Union recently. Ukraine has no free trade agreement with the European Union so far. Negotiations with the EU concerning the FTA began in February 2008. During the negotiations for preparation of a free trade area agreement between Ukraine and the EU, both parties provide for liberalization of no less than 95% trade.

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A future free trade area between Ukraine and the EU does not require revision of Ukraine’s existing free trade agreements with other countries. Ukraine may have free trade areas with all member states of CIS and the European Union at the same time. Besides, it may establish new free trade areas in the future, e.g. with Israel or Canada. The EU has free trade agreements with 24 countries and customs unions with some countries. There are also a common market and a common customs policy within the European Union, the policy providing for a common customs tariff in relation to third-party countries.

A customs union is a higher level of integration because, in addition to free trade among the union member countries, it establishes a common external tariff for third-party countries. Customs union members agree to eliminate all the tariffs among them. However, they replace their individual tariffs with common (unified) import tariff rates used by the customs union member countries to non-member ones. According to the WTO rules, such changes may not be used to increase a general level of internal market protection.

According to Article XXIV GATT, WTO members may have a preferential trade regime, particularly for parties to free trade area or customs union agreements in the meaning of Article XXIV GATT and the Understanding on the Interpretation of Article XXIV GATT, 1994. Since 1947 till now, about 100 regional trade arrangements pursuant to Article XXIV, which grants a legislative right to exemption from the need of applying the most favorable treatment (MFT), have been communicated to the GATT/WTO. Ukraine is already a member of the World Trade Organization whereas Kazakhstan and Belarus are in the process of WTO accession negotiations and the Russian Federation has already finalized its negotiations recently. Each country formulates its own commitments and provides its own concessions during the WTO negotiations.

Subject to WTO membership of all these countries, a customs union among them may be established given the following conditions: a common external tariff for third-party countries must not be higher than a bound tariff of one of the four customs union member countries who has agreed it upon at the lowest level when joining the WTO. This way, compliance with Article XXIV:5 GATT will be ensured, namely: if economic integration blocs are established, the duties and other regulations of commerce imposed at the institution of a customs union in respect of trade with third-party countries (not parties to such union) shall not on the whole be higher or more restrictive than the general incidence of the duties and regulations of commerce applicable in the constituent territories prior to the formation of such union. If a contracting party, being a WTO member, which joins a customs union or becomes a party to an interim agreement leading to a formation of a customs union 6

proposes to increase bound customs rates, it must act pursuant to provisions of Article XXVIII GATT concerning modifications of schedules of member country commitments. If a contracting party withdraws tariff concessions at negotiations, previously agreed upon within the WTO framework, the question arises as to securing compensation to the countries whose trade could have suffered losses due to increase of customs rates. Ukraine will have to ensure compliance with this regulation.

Ukraine’s accession to the Customs Union with Russia, Kazakhstan and Belarus would preclude the establishment of a free trade area between Ukraine and the EU because the EU would have to establish a free trade area only with the Customs Union in that case, not with an individual member state of the Union. However, it is also impossible because the main requirement the EU sets for free trade area agreements is the WTO membership. The EU does not practice establishment of free trade areas with any regional grouping of countries that includes WTO non-members (like Russia, Kazakhstan and Belarus in case of the Customs Union). At the same time, establishment of a free trade area between Ukraine and the EU will not hinder Ukraine’s trade relationships with members of the Customs Union consisting of Russia, Belarus and Kazakhstan. The EU’s policy provides for establishment of free trade areas with many countries of the world, hence it can be foreseen that accession of the three countries (Russia, Belarus and Kazakhstan) to the WTO would open a way to negotiations on establishment of free trade areas between them and the European Union.

Hence, it appears that Ukraine’s accession to the Customs Union with Russia, Belarus and Kazakhstan with no serious complication is possible subject to the following conditions being met: − accession of Russia, Belarus, and Kazakhstan to the WTO; − adoption by Russia, Belarus, and Kazakhstan of import duties and other trade barriers to third-party countries at a level not higher than adopted by Ukraine when joining the WTO; − affiliation of Russia, Belarus, and Kazakhstan, already as WTO members, to Ukraine’s negotiations on a free trade area (FTA) with the EU. If Ukraine has already had a FTA with the EU by then, the FTA will be established on the terms agreed between the five countries.

If Ukraine joined the Customs Union with Russia, Belarus and Kazakhstan without the above-listed conditions met, it would mean the following to Ukraine: termination of Ukraine’s existing agreement with the WTO and commencement of talks with the WTO on new terms, and impossibility of concluding a free trade area agreement with the EU. 7

In more detail, the authors of the study illustrate this conclusion with the following example. Ukraine’s agrarian business of some agrofood sectors is interested in revising the concessions granted to other WTO’s members for access to the country’s domestic market at Ukraine’s accession to the WTO, namely bound rates of import tariffs for dairy and meat commodities, towards increase. According to Article XXVIII GATT, it is possible to revise commitments to reduce imports. Ukraine is entitled to apply provisions of the said Article no earlier than three years after its accession to the WTO. However, any change in tariff concessions would result in negotiations with the WTO member states on countervailing concessions on other commodities in order to keep the overall trade level intact.

Analysis has shown that import tariff rates for most dairy and meat commodities according to the Customs Union’s Customs Tariff are higher than Ukraine’s bound rates in the WTO. At the same time, fish, fish products, or tropical fruit could become ‘countervailing’ 2 commodities in case of Ukraine. However, import duty rates for these commodities within the Customs Union are also higher than Ukraine’s bound rates in WTO. For example, import duty rates are as follows: for herrings - 5% in Ukraine and 15% in the Customs Union (CU); for shrimps – 0% (Ukraine) and 20% but at least 2 EUR/kg (CU); for bananas – 0% (Ukraine) and 5% but at least 0.02 EUR/kg (CU); for oranges – 0% (Ukraine) and 5% but at least 0.02 EUR/kg (CU). Hence, fish products or tropical fruit may not be ‘countervailing’ commodities within the Customs Union membership framework unless all the Customs Union member states agree and decide to decrease import duties for these commodities down to the Ukrainian level.

Such commodities as palm oil, cacao paste, or tobacco imported to Ukraine as raw materials for production of food and tobacco products, are also charged with higher import duty rates in the Customs Union than in Ukraine. Raising import duties for these commodities is economically disadvantageous to Ukraine because it would increase the cost of raw materials and reduce processing enterprises’ income.

Key study findings: 1.

Prospects of increasing export of industrial products to the Russian Federation

in the medium-term outlook can be described as optimistic, considering projects already in place and intensification of new ones, e.g. in aircraft building, agricultural machinery

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‘Countervailing’ commodities are commodities through decreasing import duties for which the WTO member states could potentially agree with increase in import duties for specific goods (for example, dairy and meat products).

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production, etc. Ukrainian food supplies to the Russian Federation have good prospects despite periodic restrictions of livestock product imports from Ukraine to Russia.

2.

In the medium-term, we can expect rather slow growth, if any, of the foreign

trade turnover between Ukraine and Belarus. Most likely, it will retain the 2008-2011 level. It is caused mainly by the unstable economic situation in Belarus, by application of a whole range of antidumping measures both by the Belarusian and Ukrainian parties, and by more active import substitution processes in Ukraine. Commodity structure of trade will also not change.

Economic cooperation will be concentrated in traditional areas.

3.

Generally, a broad range of industrial products are supplied from Ukraine to

Kazakhstan: transformers, refrigerating equipment, power battery devices, steam turbines, etc. Considering such close cooperation and Kazakhstan’s further plans of technical upgrading, we can conclude that Ukrainian companies have good chances to enhance cooperation and boost their exports to Kazakhstan. Among Ukrainian agricultural products enjoying great demand in Kazakhstan, especially chocolate and other cacao-containing products, sugar-based confectionery, sunflower oil, bakery products, poultry meat, cheese, etc.

4.

In the metal production sector, all the CU member states are interested in

cooperation with Ukraine, as is Ukraine itself, with simultaneous improvement of collaborative and investment-based forms of further cooperation. This interest is not so much of political as economic nature. That is, medium- and long-term prospects of development of economic relations between Ukraine and the CU member states in metallurgy will be determined mainly by the countries’ economic interests, areas of their realization, and current trends in national metal product markets.

5.

The analysis of Ukraine’s foreign trade in metal products with the Customs

Union countries shows that markets of the CU countries and Ukraine are rather capacious and promising both to domestic and CU manufacturers. Although Ukrainian pipe manufacturers are strong competitors of Russian ones, there is every precondition for keeping exports of Ukrainian-made pipes in the short-term outlook at a high level. That is promoted by advanced development of the Russian Federation oil and gas sector that will demand considerable amounts of Ukrainian-made pipes.

6.

The antidumping measures introduced by the CU concerning Ukrainian-made

pipes apply, apart from Russia, to both Belarus and Kazakhstan. However, the share of Ukrainian pipe exports to those countries is minor. Extending validity of the antidumping 9

measures in the future could have negative impact both on Ukrainian pipe manufacturers and the CU metal makers. To Ukrainian manufacturers, that would mean partial loss of the market. Negative effects to the CU metal makers are explained by the fact that long-term protection of inefficient economic sectors, including metal production in the CU countries, hinders development of the most competitive sectors. Besides, as practice shows, certain enterprises’ benefits from protectionism are always smaller than those of consumers.

7.

Ukraine is an energy dependent state: the share of imports in the structure of

primary energy type supplies, net of fuel for nuclear power plants, has varied between 53% and 72% in different years. Currently, up to 85% of the energy resource imports comes from Russia, including 100% of natural gas import, 76% of crude oil, and 80% of coal, of which coking coal is almost 90%. Energy resource imports from the Customs Union countries make up 92% of their total imports to Ukraine.

8.

Dominating drivers that determine the energy sector’s export potential growth

will still consist of such internal factors as limitation of transport and port infrastructures, power island capacities or the need for using direct-current links for electricity export, surplus of energy resources in the domestic market, etc., as well as favourable conditions in external markets.

9.

In the next years to come in foreign trade between Ukraine and the CU

countries, one should expect growing exports of agricultural and food products traditionally exported to the Customs Union countries. They include sunflower oil, sunflower seeds and oil-cakes and other solid waste obtained in oil extraction from sunflower seeds, and cereals (exported mainly to Belarus), strong and soft drinks, sugar, and confectionery products.

Vegetables and fruit have good prospects for enhanced trade. Despite hardships, which the Ukrainian livestock product exporters encountered in the Russia market, growing export of meat and dairy products, first of all chicken meat and hard cheeses, is also expected..

10.

In the medium-term outlook, annual growth rates of chilled poultry meat

production in Ukraine, being 14% over 2006-2010, will become slower. Due to that, the CU markets, especially Russia and Kazakhstan, will be attractive for Ukrainian poultry producers in the short and medium term. Such a time horizon is explained by the fact that the Russian Federation, enjoying governmental support, plans to reach the poultry meat self-reliance in the next five or seven years to comply with the food security criteria set by law. A potential to boost frozen poultry meat exports to the CU countries is limited because of severe competition of major producer countries, such as the US and Brazil, in this segment. Frozen 10

poultry meat production outputs in Ukraine are less than 20% of the CU tariff quota.

Ukrainian poultry meat supplies to the CU countries are confined to Kazakhstan’s market only, and the situation is not going to change substantially in the future.

11.

Comparing the CU market capacity with pork production outputs by Ukrainian

enterprises shows that opportunities for export to CU ‘s market are more than four times greater than the current production outputs. Hence, boosting pork exports to the Customs Union is possible provided that domestic pork production outputs are increased. At present, pork production in Ukraine is concentrated in large vertically integrated structures having a closed production cycle, and this trend will continue further on. Therefore, opportunities for increasing export deliveries to the CU will appear in Ukraine in the near future, but only if the Customs Union does not apply restrictive measures against the Ukrainian imports.

12.

The national beef market completely depends on export supplies to Russia that

is almost the only export market for beef of Ukrainian origin. A negative trend has been seen recently, namely gradual loss of that market. Export beef deliveries from Ukraine decreased by 29% in physical terms in 2010 year-on-year. Such reduction has resulted from the RFimposed restrictions of veterinary and sanitary nature that are introduced by the RF veterinary service. Inside Ukraine, beef consumption is limited because there is no culture of consumption of this product, it is expensive and people’s purchasing capacity is low.

13.

Determinants for expansion of dairy product exports to the CU countries

include: (1) elimination of the raw milk shortage problem in Ukraine; (2) raw milk price competitiveness; (3) trade policy pursued by Russia as the key consumer of Ukrainian milk products, especially cheese; (4) compliance of products made by Ukrainian enterprises with requirements of the new RF technical regulation. Besides, a considerable threat to development of the Ukrainian dairy sector is posed by decrease in the domestic cow numbers and by low-quality raw milk.

14.

The CU’s special protective measures concerning hard candies and other

confectionery products will yet again drive Ukrainian exporters to their starting positions and make them revert to a hard candy export geography diversification strategy. Factors mitigating the shock caused by restrictions on import of Ukrainian-made hard candies imposed by the Customs Union countries include a diversified geographical structure of exports, and investments in the RF. Permanent presence of Ukrainian confectionery companies in the RF markets is an important factor that will promote fast comeback to the Customs Union markets. Total loss of trade balance in 2011 caused by termination of export 11

of hard candies and other confectionery products to the CU countries – for which a special duty was introduced – can be estimated at USD 44.7 million.

15.

Ukraine signed in October 2011 the Free Trade Area Agreement with the

member states of the Commonwealth of Independent States. In the future, it is this agreement that will determine particularities of regulation of foreign trade between Ukraine and the Customs Union countries – Russia, Kazakhstan, and Belarus, which are at the same time member states of the Commonwealth free trade area. For foreign trade between Ukraine and the Customs Union, these arrangements will prevail over provisions of the Customs Union’s Uniform Customs Tariff and other CU arrangements.

16.

The analysis has shown that economic relations and foreign trade between

Ukraine and the Customs Union countries can develop successfully within the format of the CIS Free Trade Area Agreement. Ukraine’s accession to the Customs Union will entail financial losses in the form of compensations to the WTO member states and certain political complications.

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