The Russian government has been increasing pressure on Ukraine to join the Customs Union of Russia, Belarus, and Kazakhstan and halt the process of negotiating the Deep and Comprehensive Free Trade Area (DCFTA) with the EU, expected to be completed by year’s end. While the Ukrainian delegation holds the talks on the EU-Ukraine association agreement in Brussels this week, expected Prime Minister Putin’s visit to Kyiv next week could offer both a “stick” and a “carrot” for Ukraine. A closer look reveals that the risk of a trade war with Russia is not critical, while the benefits of strategic flexibility and strong degree of economic sovereignty are more beneficial for Ukraine.
On 16 March, Vladimir Putin said that “Russia may proceed to tighten up its borders if the free trade zone between Ukraine and the EU goes ahead.” Alongside the threat of trade sanctions, Russia may also present certain economic preferences encouraging Ukraine to suspend the process of EU trade agreement and join the Customs Union.
Ukrainian officials’ responses have emphasized the priority of reaching agreement on DCFTA with the EU and finding a plausible solution on cooperation with Russia and the Customs Union through entering the CIS Free Trade Area Agreement, which according to consensus estimates could be signed in May.
Russia’s most radical offering would be the reduction of the natural gas price and the levy of export duties for the exports of Russian oil and fuel products to Ukraine. The levy of oil export duty according to Ukrainian Ministry of Economy estimates could create $3-3.5 billion per year benefits for Ukraine and halving the Russian price would result in $4.5 billion benefit. It is likely that Russia could take such costly steps, if at all, only demanding substantial commitments from Ukraine, which would decrease the degree of strategic flexibility and economic sovereignty that the country presently enjoys.
According to official statistics, Ukraine’s energy imports, including coal imports from Russia accounted for a 67% share of all imports 2010 from this country. Even though the energy dependency on Russia is very heavy, in the external oil supplies Ukraine reduced the share of Russian oil imports from 92% to 75% in 2010, with Azerbaijan accounting for the second largest 21% share in oil imports. Ukraine imported around 6 mln tons of crude oil from Russia, produced 2.3 mln tons domestically, and imported 1.6 mln tons of oil from Azerbaijan and 0.6 mln tons from Kazakhstan in 2010. The diversification of oil supplies could be even higher in 2011 and beyond, as the government is streamlining the management of state oil company, Ukrnafta, and plans to additionally produce more than 1 mln tons of oil from the projects in Egypt and on the Black Sea. It also seeks to upgrade oil deposits in Western Ukraine. Similarly, the diversification is proceeding in the natural gas sector through the options of building the LNG terminal on the Black Sea coast and developing shale gas and coal bed methane projects.
While Gazprom will continue to hold a grip on the supply of the largest share of Ukraine’s pipeline gas in the short-term, pricing tension was partially alleviated though gas-for-fleet Kharkiv deal.
The proposal of gas price reduction is valuable for Ukraine, but most likely incommensurate with the prospects of ceding national economic sovereignty to Russia through participation in the Customs Union’s supranational bodies, which would deprive Ukraine of the power to enter trading agreements with other countries. In fact, Ukraine’s geo-economic flexibility is perhaps its key asset and competitive advantage in today’s international affairs.
Widespread quantitative assessments of the economic benefits of the Customs Union are also questionable. Russian scholar Vladislav Inozemtsev wrote recently that to reach even a half of the highly acclaimed $400 billion increase in Russian exports to Kazakhstan and Belarus by 2015, the exports will have to surge 45-60% annually, which is highly unlikely. Likewise, the World Bank Lúcio Vinhas de Souza’s January 2011 note “An Initial Estimation of the Economic Effects of the Creation of the EurAsEC Customs Union on Its Members” states that the Customs Union “would be a GDP-reducing framework in which the negative trade-diversion effects surpass positive trade-creation ones”
As concerns the threat of trade sanctions, steel pipes, railroad car manufacturing, confectionery and cheese production are among the most vulnerable Ukrainian industries that may suffer from Russia’s trading sanctions. These products accounted for a combined 12% share of Ukraine’s $13.4 billion exports to Russia in 2010. In the case of railroad cars, Prime Minister Putin already threatened “antidumping” measures in February 2011, but it would be rather difficult in the short term to impose such measure against the key supplier as Ukrainian railroad cars account for some 40% share of the Russian market and technologically fit to the requirements of CIS railroads. Major Ukrainian confectionary producers Roshen and Konti have production facilities in the Russian market. Even the utterance of trade barriers’ possibility makes Ukrainian companies’ management look for ways to mitigate the negative impact through market diversification and productivity improvement.
Ukraine’s political and business elite seems to be largely united in their attitude towards strategic economic integration issues aiming to expand the EU trade and enjoy the benefits of increased investment, economic factor and reforms encouragement, while at the same time leverage existing and future potential of economic ties with the CIS countries. Reaching this goal will attest to Ukraine’s important economic and political role in today’s affairs.
 Ukraine’s reaction to Russian threats: http://www.easternpartnership.org/daily-news/2011-03-21/ukraine-s-reaction-russian-threats
 “Решение об интеграции в Таможенный союз нужно принимать уже в первой половине 2011 года”. http://kommersant.ua/doc.html?docId=1615189
 Иноземцев Владислав. Чем прекрасен наш союз. Журнал «Огонек» №13 (5172) 04.04.2011. http://www.kommersant.ru/doc/1611870
 Lúcio Vinhas de Souza. An Initial Estimation of the Economic Effects of the Creation of the EurAsEC Customs Union on Its Members. http://siteresources.worldbank.org/INTPREMNET/Resources/EP47.pdf