CIAO DATE: 05/03

Foreign Trade Policy Strategy for Ukraine

Anders Aslund

March 2003

Carnegie Endowment for International Peace

Executive Summary

Ukraine has proceeded far in its postcommunist economic transformation. In recent years, its exports have surged soundly, and they are now driving the country’s economic growth. Access to foreign export markets has become a key question for Ukraine’s economic future. Trade policy has gained such importance for Ukraine’s aspiration’s for accelerated growth and reaching its Millenium Development Goals that it should be Ukraine’s predominant economic policy and international policy priority. This is an attempt at a formulation of a strategy for foreign trade policy for Ukraine.

The main tenet of Ukraine’s trade policy must be to gain early accession to the World Trade Organization (WTO). A realistic but ambitious target is 2004. That requires the Ukrainian government to concentrate single-mindedly on resolving all the outstanding issues. The primary focus should be to accelerate the composition and adoption of a final report on Ukraine’s trade regime and adopt all the requisite legislation for entry into the WTO. Second, remaining bilateral issues need to be resolved to complete the seven remaining bilateral negotiations, notably with the US and Moldova. Third, Ukraine should formulate a clear policy on agricultural subsidies and reach agreement with its WTO partners. For Ukraine, swift entry into the WTO is far more important than the exact conditions of accession, because its membership of the WTO is the only plausible basis of its trade policy. The WTO should be seen as a universal tool for all trade policy rather than an end in itself.

As soon as Ukraine has joined the WTO, it should try to improve its market access to key markets by concluding free trade agreements with the other eleven Commonwealth of Independent States (CIS) countries, the European Union (EU), the US and other key countries.

Ukraine has concluded and ratified a free trade agreement with all the CIS countries. This could serve as a basis for its future trade relations with these states, but this free trade agreement should be based on WTO rules and standards. Ukraine has no reason to waste time on discussing a customs union with any CIS countries, because such an agreement cannot be implemented, and a customs regime designed for countries with very different economic structures will not be beneficial to Ukraine’s economic interest. The idea of a currency union in the CIS appears absurd given the devastating failure of the recent currency union and the absence of any advantageous preconditions. Any coordination with CIS countries in Ukraine’s accession to the WTO could only complicate and delay it for years. When both Russia and Ukraine have become members of the WTO, they should be able to resolve their many bilateral trade disputes more effectively. To Ukraine, Russia’s current discrimination against it in gas pricing is unacceptable and reconcilable with a free trade regime. Russia’s export tariffs on natural gas must be abolished or waived, and Russian Gazprom’s price discrimination against Ukraine needs to be alleviated.

Ukraine is subject to extreme trade discrimination from the EU. It is not recognized as a market economy, it is not member of the WTO, and it has no free trade agreement with the EU, while its Partnership and Cooperation Agreement (PCA) with the EU has turned out to be almost empty. It suffers badly, having little trade with the EU and enjoying comparative advantages in products, whose importation the EU resists. Ukraine should focus on requesting a comprehensive free trade agreement with the EU rather than a complex and nebulous agreement on a Common European Economic Area. First, however, it must become a member of the WTO.

Ukraine has approximately the same problems on the US market as on the EU market, though the US is less important for its trade since it is more distant. Also with the US, Ukraine should aim at a comprehensive free trade agreement, which requires that it first become a member of the WTO.

Ukraine needs to persuade the EU and the US to declare Ukraine a market economy, which it actually is, with free prices, small subsidies, few trade quotas and low import tariffs. The status of a market economy is important for antidumping investigations. Non-market economies have few chances of winning antidumping cases, and as a consequence prohibitively high tariffs are slammed on them. Antidumping cases tend to focus on steel and chemicals, which account or half of Ukraine’s exports. This procedure is independent of the WTO accession and bilateral trade negotiations. Both the US and the EU have already acknowledged Kazakhstan and Russia as market economies. The US steel lobby, however, holds back this status for Ukraine, arguing that its steel industry benefits from tax exemptions, but that is no longer the case. The EU complaint about an excessive role of the state in the Ukrainian economy, which is less tangible and thus harder to counter, but it does not appear a relevant objection.

 

Introduction

In recent years, Ukraine has passed most of the hurdles of postcommunist economic transformation. Macroeconomic stabilization was accomplished long long. Prices and trade are liberalized. Privatization has proceeded so that about two-thirds of GDP arises in the private sector. For the last three years, Ukraine has had a sound average economic growth of over 6 percent a year, and it is likely to stay around 6-8 percent a year for the foreseeable future.

A fast economic restructuring is taking place. Industries in which Ukraine appears to have comparative advantages have grown particularly fast: steel, food processing, agriculture, and light industry. Within each sub-industry a desirable consolidation of 3-5 leaders is apparent. Although a few oligarchic groups hold out, they are becoming more normal conglomerates, and a sizeable number of new large and medium-size corporations have emerged. While corruption and repression remain problems, business surveys undertaken by the European Bank for the Reconstruction and Development (EBRD) and the World Bank in 1999 and 2002 suggest great improvements. Ukraine’s transition to a market economy has succeeded.

In this situation, foreign trade attracts new attention for many reasons. First, with an official GDP at current exchange rates of about $40 billion, the Ukrainian economy is rather limited, and access to export markets is critical for future economic growth. In recent years, Ukrainian exports have expanded fast by slightly over 10 percent a year and are driving economic growth, but clearly much more can and should be accomplished. The old adage “trade rather than aid” describes what Ukraine needs now.

Second, the Ukrainian economy is very open with exports corresponding to about half of GDP, and exports have increased at over ten percent a year for the last three years. Exports comprise the growth engine in the Ukrainian economy.

Third, while the domestic market in Ukraine appears to work reasonably well, regional distortions in foreign trade are all too apparent. The most recent statistics for 2002 demonstrate that as little as 19 percent of Ukraine’s exports went to the European Union (EU). According to the gravity model, which assesses how much countries should trade with one another, given the size of their economies and the distance between them, it should have been about 60 percent. Meanwhile, the share of Ukrainian exports going to Russia has fallen steadily to only 17 percent last year. Instead, Ukraine is increasingly exporting to all kinds of new distant Third World markets in Asia and the Far East, notably China, and the Middle East, which are more open. It is more important that exports grow than where they go, but this is not a normal development. With little doubt, this represents trade distortion, and Ukraine would benefit if it were able to export more to big markets in its neighborhood. Although Ukraine is a very open economy, agriculture is considered to be 93 percent self-sufficient, suggesting substantial sectoral distortions as well.

Fourth, Ukraine suffers from a predominance of so-called sensitive products in its exports, that is, goods that are particularly exposed to protectionist measures by other countries. They account for about three-quarters of Ukraine’s total exports. Steel comprises 40 percent of Ukraine’s exports, while each of the three sensitive commodity groups, agricultural goods, chemicals and textiles, account for over 10 percent. According to the WTO, Ukraine came in the 10th place in the world in terms of suffering from actual antidumping measures from January 1995 to June 2002, with no less than 37 antidumping measures concluded by various countries.

Fifth, Ukraine is now facing critical changes in its foreign trade agreements. Its negotiations about accession to the World Trade Organization (WTO) are approaching their final stage. The EU is suggesting that its Partnership and Cooperation Agreement (PCA) with Ukraine should be replaced with an agreement on a Common European Economic Area (EEA). The Presidents of Russia, Ukraine, Kazakhstan and Belarus just signed a declaration of their intention to negotiate a free trade zone. Thus, Ukraine is facing monumental decisions on its foreign trade relations in all directions.

Yet, sixth, although Ukraine is facing so many important problems and decisions in foreign trade, trade issues have been all but ignored in the country until recently. The preoccupation with getting the domestic market economic reforms has been so great. In the mid-1990s, Ukrainians had a tendency to blame the outside world for their hardships. Now, on the contrary, Ukrainians tend to blame themselves for whatever problems they encounter. While an admirably humble attitude, it does not necessarily reflect the truth.

This paper draws on continuous study of the postcommunist Ukrainian economy and reading of relevant literature. Its main inspiration, however, is meetings and conversations with senior representatives for the Ukrainian government, business, Ukrainian non-governmental organizations, academics, international organizations, foreign embassies, and foreign enterprises during a mission to Ukraine March 10-21. Its main intentions are twofold: to assess the critical foreign trade problems and to suggest a foreign trade policy strategy for the Ukrainian government. As agriculture tends to be of particular importance in all trade policy, this study lends special focus to the agricultural sector. The purpose is not to be comprehensive but to concentrate on key issues.

There are always many barriers to trade. This paper aims at focusing on the most important issues. First, everybody mentions the problem for exporters to obtain a value-added tax refund. Another query is what the Ukrainian economy looks like at enterprise level, but it appears a rather normal market economy. Then, the three big trade issues come, trade relations with the EU, trade with Russia and WTO accession. The EU should be Ukraine’s main export market, but its imports from Ukraine remain surprisingly low, while Ukrainian exports to Russia are swiftly dwindling. WTO accession appears to be the key to Ukraine’s trade policy. Agricultural concerns are a topic on their own, but they appear to be less severe than widely presumed. The last section is an attempt to formulate a foreign policy strategy for Ukraine.

This study is based on talks with a large number of people, including First Deputy Prime Minister and Minister of Finance Nikolai Azarov, Deputy Prime Minister for Agriculture Ivan Kirillov, Minister of Economy Valery Khoroshkovsky, Chairman of the National Bank Serhyi Tyhypko, presidential advisors Anatoly Halchynski, Vasyl Rohovyi and Ihor Yushko, former Deputy Prime Minister for Agriculture Leonid Kozakhsenko (now President of the Ukrainian Agrarian Confederation), State Secretary Olexander Chalyi, former State Secretary Andrei Goncharuk, parliamentarians Viktor Pinchuk, Viktor Yushchenko, Yulia Timoshenko, Olexander Moroz, Viktor Pynzenyk, Yuri Yekhanurov, Oleh Rybachuk, Boris Tarasiuk, and Ivan Tomych, Ukrainian businessmen Gennady Bogoliubov, Privatbank, Alexander Kirichko, InterPipe, Agrosoiuz, Carl and Lolo Sturen, Chumak, Nikolai Kompanets, W.J. Grain, Serhyi Cherchenko, ZAT Remburse, six private farmers, Fredrik Svinhufvud, Tetra Pak, US Ambassador Carlos Pascual, EU Ambassador Norbert Jousten, several European Ambassadors, the Japanese Ambassador, Roger Lawrence, Resident Trade Expert on WTO Accession at the Ministry of Economy and European Integration, Lorenzo Figliuoli, IMF, Alexander Kaliberda, World Bank, Christopher Crowley, USAID, Ebbe Johnson, IFC, the deputy governors for agriculture in Kherson and Dnepropetrovsk, and many others. I spoke on Ukraine’s trade policy at seminars at the Agrarian Policy Forum at the UNDP, repeatedly with European diplomats, with students and academics at the Economic Education an Research Consortium at the Kyiv-Mohyla Academy, with a broad Ukrainian elite at the National Institute of Strategic Research, with businesmmen at the European Business Association, and I concluded with a press conference at the UNDP, and I gave a number of interviews to journalists. I also visited Anatoliy Grystenko and Anatolyi Rachok, the Razumkov Center, the German-Ukrainian Institute for Economic Research and Policy, and the CASE Ukraine Foundation (see attached program).

I want to thank the UNDP Office in Kyiv, and its staff who made this mission possible, UN Resident Coordinator Douglas Gardner, his Deputy Manoj Basnyat and Andrey Pogrebniak. I was accompanied much of the time by Olexander Shevtsov, Head of the Secretariat of the Government Agrarian Policy Coordination Council, and Tamara Zykova also from the Secretariat, and the program was organized by Liudmila Shovkoplias at the UNDP.

 

Problems with Value-Added Tax Refunds for Exporters

A dominant problem, mentioned by virtually all Ukrainian and foreign exporters, is to get value-added tax (VAT) refunds after export. By law, exporters should get the 20 percent VAT in their exports back from the state, but hardly anybody does. Thus, the VAT functions as a 20 percent penalty tax on exports, which is impermissible. The reasons for this problem are many, but the main cause appears to be that Ukrainian officials do not give enterprises money without commission. This raises a serious query whether VAT can function within the foreseeable future in Ukraine.

The IMF has long been engaged in sorting the problem with VAT refunds out. The issues are many, and several have been resolved, but still everybody complains, and no fundamental change is apparent. Originally, one problem was that one authority received VAT payments, while another was supposed to pay refunds. This problem has been mitigated, though not fully resolved. Another problem is that the government tends to budget too little money for VAT refunds, or that VAT refunds are subject to sequestering. Many see this as key, but it appears rather a symptom than the cause. A third problem is widespread exemptions from VAT. Although it is illegal, many who did not pay VAT in the first place anyhow claim refunds. Ukraine has twenty free economic zones, which deprive the state of VAT revenues, while they seem to do little to stimulate the economy. Similarly, agriculture and much of the energy sector is exempt from VAT. The malfunctioning free economic zones should preferably be phased out as a part of the preceding tax reform. However, if agriculture became subject to VAT, the tax inspectors would most likely devastate the current agricultural revival with their bureaucratic power, and energy is politically very difficult to handle.

The VAT system remains patently inconsistent, so full of loopholes that it is more akin to a Swiss cheese than a comprehensive system. Yet, none of these problems appear central. Sitting down talking to many exporters, all recognize the problems with VAT refunds, from which even Ukraine’s biggest businessmen suffer, but three different answers are apparent. Some exporters complain that they receive VAT refunds too late, after three-six months, imposing extra credit costs. Another group never receives VAT refunds, meaning that VAT amounts to a 20 percent tax on their exports. A third group of export producers sells their goods to an intermediary that cashes the VAT refund for a fee.

This problem appears to be profoundly systemic, because all the twelve CIS countries suffer from it. The intended automatic VAT refunds are simply not socially accepted. The Ukrainian state, as other CIS states, has no practice of giving substantial amounts of money to enterprises without being paid commission. For that reason, enterprise subsidies are always connected with corruption in these states and have therefore been minimized. It appears utopian to believe that the Ukrainian state would accept to disburse large amounts of money regularly to enterprises in VAT refunds. Worse, the handling of VAT refunds seems a major source of corrupt revenues of the government administration. As a rule, VAT appears only to be refunded for bribes at a going rate of one-fifth of the VAT refund, that is, a bribe tax on exports of 4 percent, amounting to a possible total of about $800 million a year. To this should be added an interest cost, which is at least as large, given that a refund delay of four months appears standard. Thus, legal exporters pay an export tax of 20 percent and bribing exporters pay an export tax of 8-10 percent. This is a substantial distortion in favor of traders with more liberal conscience.

One big exporter solved his problem with VAT refunds for exports through an alternative legal scheme. He imported raw materials with VAT included, but these imports cost about ten percent more than the same inputs cost on the market in Ukraine, so the VAT refund still cost him ten percent extra, while it also prompted him to boost unjustified imports.

VAT has now been tried for over a decade in twelve CIS states, and refunds for exporters do not function in any single state. It is supposed to enhance transparency by offering an incentive to everybody to ask for legal receipts with VAT included. However, if the final payer needs to pay a bribe to acquire a VAT refund, VAT would be corrupting rather than legalizing. A decade in twelve countries with similar preconditions appears sufficient time to suggest a conclusion. To believe that VAT can function in a CIS state is no longer reasonable, although it works in Central-Eastern Europe, including the Baltics. It might help a bit if the VAT were lowered, as the government now suggests, to 15 percent, though that would only reduce the potential bribe tax from $800 million to $600 million, which is hardly sufficient to bring about a systemic breakthrough. A lower VAT and a reduction of the loopholes may be tried, but a more reasonable decision appears to be to abolish the VAT. To some extent, it could be replaced by an ordinary retail sales tax, which has the disadvantage that it is in theory more distortionary than a VAT, but that is hardly true in the CIS countries. A retail sales tax can hardly be made higher than 10 percent for that reason, but it has the advantage of not being applied to exports, which would level the playing field between honest and dishonest exporters.

 

A Look at the Enterprise Level

In economic development, an industry typically develops first within a country, expanding its share of the domestic market at the expense of foreign producers, thanks to raising quality. As competition increases, a handful of leading enterprises come to dominate and they start exporting to the most accessible markets, with exports being their engine of growth. Some of the leading exporters are often foreign-owned.

By and large, this development is apparent in Ukraine, but much debris of the Soviet economy remains and the speed could be faster. Immediately after communism, Ukraine had both too many and too bad enterprises in most industries. In a large number of industries, a consolidation to three-five sophisticated and mutually competitive enterprises has now occurred, providing a basis for competitive economic development. The leaders in each industry are expanding fast. Having taken over the domestic market, they are reaching out to foreign markets. Domestic trade barriers and transportation do not appear serious impediments, though people complain about excessive monopolistic railway tariffs.

Foreign direct investment rose to a new high of about 2 percent of GDP in 2002, and further growth is likely, though this is only one third of the East-Central European level. The standard complaint is Ukraine’s poor investment climate, but another reason for foreigners not to invest in Ukraine is the country’s limited market access, notably to the EU. Foreign investors often export to their home markets, but strikingly few European businessmen do that from Ukraine. They are few in Ukraine, while the barriers to export to the EU appear insurmountable to many. Meanwhile, incentives are slight to develop the sophistication of production. The problem of foreign direct investment and investment climate appears a chicken-egg question. If foreign investment and exports increase, they will require a better investment climate, but without market access, neither may occur.

Oddly, in spite of all the trade barriers they are facing, few Ukrainian businessmen seem to think about trade policy. They seem to perceive a glass wall in the West that they do not even think of breaking. Rather than dealing with trade policy, Ukrainian businessmen seek new markets. For instance, the steel industry is selling to China after other markets have been closed. Only Interpipe, Ukraine’s dominant producer of steel pipes, appears to have a full grasp of international trade policy.

 

Trade Relations with the EU

Since 1996, Ukraine has repeatedly stated that it wants to become a member of the European Union at the highest official level. The EU has however cold-shouldered them, although Article 49 of the Treaty of the European Union stipulates that any European state may apply to become a member of the European Union. Many European politicians and EU commissioners have publicly ruled out Ukrainian membership of the EU, but formally the question remains open. A broad Ukrainian opinion favors the country’s “European choice,” though its implications are usually left open.

The institutional cooperation between the European Union and Ukraine has been rudimentary. The EU offered Partnership and Cooperation Agreements (PCA) to the CIS countries, which were little but a codification of WTO principles for non-WTO members. They do not offer any trade concessions beyond what the EU accords to its WTO partners, while the EU has concluded free trade agreement with many other countries. Ukraine has been treated as one CIS country among many. The Ukrainian PCA was concluded in 1994, but it did not come into force until 1997. It is valid for ten years and can be prolonged. Although it is comprehensive, covering political dialogue, trade in goods and services, economic, environmental, scientific, cultural and legal matters, it contains little of substance. The EU’s only subsequent trade policy advance to Ukraine is its conclusion of a textile agreement that eliminated its import quota system.

The contrast between the development of exports to the EU from the ten post-communist EU candidate members in Central-Eastern Europe (CEE) and the CIS countries is huge. Barely half of the exports from the former went to the EU in 1989, rising to 67 percent in 2000. By contrast, 33 percent of Soviet exports went to the EU in 1989, but by 2000 that share had fallen slightly to 31 percent, according to IMF statistics. With exports to the EU of only 16 percent of its total exports in 2000, Ukraine was especially disadvantaged in spite of its vicinity to the EU. Given economic geography – Ukraine’s location, transportation routes and the relative size of adjacent economies – the EU should be Ukraine’s all-dominant export market buying 60 percent of its exports. Through regression analysis, Peter Christoffersen and Peter Doyle have established that the growth of potential export markets has been one of the most important determinants of growth in the transition countries.

One reason for the disparity in EU trade between the CEE and the CIS countries has been slower economic reforms in the CIS countries, but another reason has been diverse EU trade regulations. The EU has developed an elaborate hierarchy of trade treaties, ranging from simple trading partner to full member-state. As countries on the way to be full members, the CEE countries are close to the top of this hierarchy, while the CIS countries are at the bottom. The EU offered favorable Europe Agreements to the CEE early on, which committed all parties to eliminate tariff and non-tariff barriers on industrial products by the end of a ten-year period, which ended in 2001 or 2002. They were asymmetric to the benefit of CEE. Agricultural products are subject to preferential treatment under tariff quotas. On January 1, 1998, the EU lifted quantitative restrictions on imports of textiles and clothes from CEE.

The CEE countries are considered market economies by the EU (and the US), which means that an antidumping investigation is based on their own prices. The CIS countries, on the contrary, have been labeled “economies in transition” by the EU, which signifies that they are treated as state-trading countries and an antidumping investigation is based on a hypothetical country’s (much higher) prices. Recently, Russia and Kazakhstan have been recognized as market economies of the EU and the US, and Ukraine should be able to make that grade very soon. The last EU objection is that the state plays too great a role in the Ukrainian economy, while the US last year rejected Ukraine as a market economy because of tax benefits for the steel industry, which have since been abolished.

Unlike the Central European economies, the major CIS countries are not members of the WTO. To date, four small CIS countries have become members of the WTO, the Kyrgyz Republic, Georgia, Moldova and Armenia, while all the others are at various stages of their accession.

Altogether, there is a world of difference in EU treatment of the CEE and CIS countries, respectively. CEE is about to become EU members, while the CIS countries have no associate status, no customs union or free trade arrangement. Largely, they are not even members of the WTO or recognized as market economies by the EU. Their trade status is reminiscent of “open season,” and the US offers similar treatment.

These differences in status are reflected quite consistently in trade treatment and their total effect is significant. Even before their entry into the EU, the CEE countries get 80 percent of lines duty free to compare with, while 54 percent of lines for the CIS countries as GSP beneficiaries. GSP (Generalized System of Preferences) are trade benefits designed for developing countries, but they are not very beneficial for the CIS countries. For very sensitive goods – textiles, metals and many agricultural goods, most-favored nation (MFN) duty rates are reduced by only 15 percent, and for sensitive goods – chemicals, many agricultural goods, footwear, plastics, rubber, leather goods, wood, wood products, paper, glass copper, etc. – MFN tariffs are reduced by 30 percent. Only non-sensitive goods, which are not very significant in Ukraine’s export, are duty-free. Moreover, the GSP regime suffers from many weaknesses. The supposed beneficiaries do not conclude any contract and therefore have no recourse to any dispute settlement conflict. The rules of origin are onerous, while special simplified agreements have been reached with CEE. GSP tariff reductions are less than those the EU accession countries get. Besides, Ukraine is so developed that it can easily be deprived of GSP because of too high economic development. Strikingly, nobody even talks about GSP in Ukraine.

Patrick Messerlin assessed EU Protection by industry in 1999. He put the level of overall protection for the whole of the EU economy at almost 12 percent. EU protection however varies by commodity, with rates of overall protection exhibiting wide differences by sector. Messerlin studied ordinary customs tariffs, major border non-tariff barriers (quantitative restrictions and antidumping measures), while he has ignored all the non-border barriers, that is, an array of norms and standards.

The simple average of all existing EU tariffs on goods was 7 percent in 1999. They are not very high, but protection is much higher for goods that Ukraine would like to export. Besides, if other costs in the CIS countries are similar to CEE countries, even small barriers can rule out imports from the CIS countries. The CIS countries generally have a cost advantage compared to the CEE countries through lower wages, but this is counteracted by higher transportation and other costs.

EU trade policy is more restrictive than simple average tariffs indicate, especially for the sensitive products, agriculture, steel, textiles, clothes and chemicals. Non-tariff barriers include variable levies in agriculture, voluntary export restraints in industrial sectors (notably in textiles and clothing), quotas on imports from centrally planned economies (to which the EU counts Ukraine) and antidumping measures. The peaks of overall protection are very high. The maximum tariffs exceed prohibitive 200 percent for certain agricultural goods. Also these EU measures are persistently milder for CEE countries than CIS countries. For instance, the number of antidumping cases that the EU instigated against the CEE countries from 1990-99 was 42, admittedly almost equal to the 41 initiated against the CIS countries, but the duties imposed against the CIS countries were about twice as high as those levied on the CEE countries (Messerlin 2001, p. 353).

EU agriculture is particularly well protected. The simple average tariff is estimated at 17.3 percent (WTO 2000, p. xix), but the actual protection is often prohibitive for the CIS countries because of variable levies and technical standards. In addition, the EU is reluctant to give any preferences for farm goods from temperate countries and food products, that Ukraine produces and would like to export (Messerlin 2001, p. 28). EU minimal market access commitments in cereals under the Uruguay round prompted bilateral agreements on a duty-free quota of 300,000 tons of wheat essentially from the CEE, while the major grain producers in the CIS, not being members of the WTO, were left without access. The CEE countries are allowed to export meat, fruit and vegetables to the EU, and the EU has reciprocal protection through bilateral agreements with Bulgaria, Hungary and Romania, the main wine producers in CEE (WTO 2000, pp. 87, 91). As a result, EU imports of agricultural goods from the twelve CIS countries decline from1.5 billion euro in 1995 to 1.3 billion euro in 1998, while EU imports from the 13 EU candidate members were three times larger and rose somewhat, according to the EU Trade Directorate. The CIS country suffering the most from this EU protectionism is Moldova, but Ukraine comes next with major comparative advantages in agriculture, though only 11 percent of its total exports originate from that sector, with a minimum going to the EU.

In general, EU steel imports are subject to moderate protection, but Ukraine steel exports face severe protectionism. The GATT-bound tariff is only 4.8 percent but the antidumping protection of 16.3 percent lead to an overall protection of 21.9 percent. The Europe Agreements initially abolished the EU tariffs on steel exports from CEE, but a regime of tight monitoring of steel imports from the region prevails, and it can lead to antidumping actions. For Russia, Ukraine and Kazakhstan, which are major producers and exporters of steel, restrictive EU import quotas were imposed from 1995. These have become ever more cumbersome, as steel capacity has recovered swiftly, while domestic demand has plummeted. In addition, antidumping measures remain a severe and permanent threat (Messerlin 2001, pp. 278, 282; WTO 2000, p. 55). Russia, Ukraine and Kazakhstan are far greater producers and exporters of steel than the CEE countries, with obvious comparative advantages. Even so, they barely manage to increase their exports to the EU, and CEE exports to the EU remained twice as large in 2000, although Russia and Ukraine are two of the world’s biggest steel exporters. The open-ended threat of antidumping provisions discourages investments in capacity to export to Europe.

Within the Ukrainian steel industry, the relatively advanced production of steel pipes has been particularly exposed to protectionism. It faces stiff quotas in the EU, the US and Russia motivated by dumping concerns. Ukraine’s dominant producer of steel pipes is Interpipe, which has a sophisticated trade policy. Interpipe has raised its quality, received all necessary certifications and fought antidumping cases with international lawyers, intentionally as well as spread its exports to various countries to avoid excessive disruption by sudden antidumping allegations. Simpler steel production has avoided some problems with protectionism by focusing on large and relatively open steel markets in the Far East, primarily China. Ukrainian steel producers seem to encounter more protectionism, if they refine their products further, trapping the producers in low quality commodity steel.

The trade regime for chemicals is similar to that of steel. The average MFN tariff of industrial chemicals is moderate at 5.7 percent, but antidumping measures are common and severe with an average antidumping rate of 24.5 percent (Messerlin 2001, pp. 22-23). Ukraine is one major CIS producer. The CIS has not been able to catch up with the CEE countries in exports to the EU in this highly protected product group, seeing a slight decline in these exports from 1995 to 1998, and CEE exports to the EU remain more than twice as large. As the large chemical industries in Russia and Ukraine have seen a major revival, antidumping measures have probably hit chemicals more than any other product group.

The differences in trade regimes for textiles and clothing have been great. In January 1998, the EU lifted quantitative restrictions on imports of textiles and clothes from all CEE countries, and they account for more than one-tenth of CEE exports to the EU. All the candidate members are considered to have comparative advantages in their production. The CIS countries were subject to low quotas unilaterally imposed by the EU. As most of the CIS countries are not members of the WTO, these are inspired by but go beyond the Uruguay Agreement on Textiles and Clothing, which succeeded the Multi-Fiber Agreement, but the textile quotas for Ukraine were lifted for Ukraine two years ago, which amounts to a substantial liberalization. Yet, antidumping actions are common also for textiles.

EU protection tends to be concentrated to so-called sensitive goods, especially agricultural goods, textiles, steel and chemicals. These goods account for three-quarters of Ukrainian exports, in which Ukraine appears to have a comparative advantage. They tend to be labor-intensive and Ukraine is about half as wealthy as the EU accession countries. A quantitative analysis of Ukraine’s exports to the EU finds that they consist of very few products – steel, metal scrap, clothes and oil seeds, all sensitive goods. While the EU accession countries succeeded in switching their exports to the EU to labor-intensive products early on, Ukraine only saw a rise in these in the mid-1990s. This could be a reflection of slow domestic reforms, effects of outside protectionism or both.

EU advocates argue that Ukraine should raise the degree of processing of its export goods to avoid EU barriers. However, it is difficult to jump one stage in processing. One common pattern is that exports take off with raw materials and intermediary goods, such as steel and chemicals, which function as cash cows for investment in the next stage of processing. A recent survey of enterprises in Ukraine found that export orientation, especially orientation of sales towards non-CIS markets, drive enterprise restructuring.

Furthermore, in a transition country, the interests of progressive exporters, pushing for more progressive market reforms, tend to take over after a few years. External protection means that it takes longer for the progressive exporters to acquire the critical weight, delaying systemic reform.

Several studies have assessed the effects of EU enlargement on trade and real income. The CIS countries seem to benefit somewhat because of less protection in Poland and the unification of the European market. For Ukraine, however, the impact is not obvious, as neighboring markets may become more closed for sensitive goods. The main benefit of the EU enlargement for Ukraine is likely to lie in EU analysis and policymaking. At long last, the EU will hopefully be able to develop a substantial policy toward Ukraine.

The EU did adopt a common strategy for Ukraine in 2000, but it did not amount to much. Most novel was the idea that the EU conclude an agreement on a Common European Economic Area (EEA) with Ukraine. Originally, the EU offered such agreements to the members of the European Free Trade Association (EFTA), which later might become members of the EU, and Austria, Finland and Sweden did join in 1994. Currently, Norway, Iceland and Liechtenstein have such agreements, but none is satisfied, and Switzerland rejected its EEA in a referendum. The EEA has three major flaws from Ukraine’s point of view. First, it is asymmetric, compelling Ukraine to adopt thousands of pages of EU legislation without giving it any say. Second, much of the EU legislation amounts to regulation of little or no benefit to Ukraine. EU environmental and social legislation would be premature, while EU labor market and agricultural legislation requires profound reform, etc. Third, it is unclear what market access Ukraine would obtain through the EEA, and it would probably only occur after Ukraine had adopted all this legislation and thus delay the opening of EU markets. The EEA concept is vague and may be interpreted to mean something rather different, but that is a drawback rather than an advantage. Instead, Ukraine requires specific and early remedies to its limited access to the EU market.

The obvious solution to Ukraine’s trade problems with the EU is an ordinary bilateral free trade agreement between Ukraine and the EU. Unlike Ukraine, all the Southern Mediterranean countries have free trade agreements with the EU, now meant to be expanded to include the services sector as well as the goods sector more fully. The only other neighbors of the EU without free trade agreements are Moldova, Belarus and Russia, although both Moldova and Ukraine are European countries that have repeatedly expressed their desire to join the EU. In its PCA with Ukraine the EU commits itself to start negotiations on a free trade agreement with Ukraine. That would require Ukraine to become becomes a member of the WTO first, but it could be concluded much faster than an EEA agreement and thus opening of the European market. Besides, such a Ukrainian strategy would put the onus on the EU. It would facilitate further integration efforts between the EU and Ukraine, as Ukrainian access to the EU market appears the weakest link.

On March 11, 2003, the European Commission issued a communication to the European Council and the European Parliament on “Wider Europe – Neighborhood. A New Framework for Relations with our Eastern and Southern Neighbors.” Ukrainians appears greatly disappointed. Although only Ukraine and Moldova are European and have persistently asked for EU membership, they are treated as members of the pack, together not only Russia and Belarus but a whole lot of North African and Middle Eastern countries.

In short, Ukraine is subject to extreme trade discrimination from the EU. A glass wall appears to block its businessmen from even thinking of exporting to the EU, concealing this protectionism. As Ukraine complaints little, Europeans stay unaware. Ukraine is suffering from not being recognized as a market economy, not being member of the WTO, and not having a free trade agreement with the EU, while its PCA with the EU is pretty futile. As a result, Ukraine has little trade with the EU, as it enjoys comparative advantages in products, whose importation the EU strongly opposes. Ukraine needs to cut its Gordion knot of trade problems with the EU with a simple free trade agreement, but first it must become a member of the WTO. In parallel, it should ascertain that the EU recognizes Ukraine as a market economy.

The same policy should be pursued towards the US, though the US will be a less important market for Ukraine, as it is so much further away with higher transportation costs.

 

Trade Relations with Russia and the CIS

Ukraine has an ambivalent relationship with the Commonwealth of Independent States (CIS). On the one hand, Ukraine wants to mark its independence from Russia. On the other, it needs a functioning trade system and good political relations. The question is how to hit the right balance. Ukraine’s ambivalence to the CIS is rooted in the CIS’s dual nature, being both a means of abolishing the Soviet Union and the embodiment of imperial dreams of restoring the Soviet Union. This ambivalence has made the CIS pretty dysfunctional. Typically, Russia pushes for closer relations than any other CIS member desires. Still, a handful of CIS countries anxious to maintain a close relationship with Russia sign such agreements, while others, including Ukraine, refuse. However, even those countries that sign CIS agreements tend not to ratify them, so the CIS is littered with hundreds of agreements that have been partially signed but never ratified and thus not into force. Three trade issues appear central, free trade agreement, customs union and currency union.

The CIS concluded an Agreement on the Creation of a Free Trade Zone in 1994, which has been the basis of trade between the CIS countries, although ratifications have been late in coming. Arguably, it is the only important CIS agreement with some real impact. The free trade agreement was amended and improved in 1999. Yet, trade among the CIS countries is not very free. Whenever a company or industry in one CIS country is successfully exporting to another CIS country, the importing country tends to clamp down with a sudden quota or prohibitive import tariff without any legal foundation, for example, Ukraine’s exports of vodka to Russia in 1996. The CIS lacks any conflict-solving mechanism, so the countries concerned have to settle the trade dispute in bilateral negotiations. However, not being guided by any principles, many conflicts are not resolved. This is a highly inefficient trading system, and the number of trade disputes only accumulates. The problem is not the free trade zone itself, but its absence of conflict-solving mechanism. Many well-functioning regional free trade areas exist around the world, for example, EFTA (the European Free Trade Association) or NAFTA (the North American Free Trade Area), but hey are all based on WTO rules and standards. The WTO also has a mechanism for conflict solution with an arbitration court and a penalty mechanism that are universally recognized. The CIS countries should hurry up to become members of the WTO and base their mutual trade on WTO principles as everybody else.

Instead of doing so, CIS countries have unfortunately gone ahead, suggesting ever more dysfunctional trading schemes with no prospect of success. The outstanding example is the so-called CIS Customs Union, originally set up by Russia, Belarus and Kazakhstan in 1995, and later extended to Kyrgyzstan and Tajikistan. Both in a free trade zone and a customs union, the countries are supposed to pursue free trade with one another, but in a customs union the countries are liable to have the same customs policy towards other countries. The Customs Union has been a total failure. First, it has not delivered any more free trade than the CIS free trade zone. The members of the Customs Union are raising prohibitive tariffs and quotas against one another without hesitation. Second, none of the countries involved has harmonized their customs with anybody else, because they have different foreign trade interests. Small countries with a limited range of production, such as Kyrgyzstan and Tajikistan, have little interest in protection but want few quotas and low import tariffs, while the bigger countries Russia and Kazakhstan, with a wide range of production, have some protectionist interests. For instance, the Russian automotive and aviation industries insist on high import tariffs, while none of the other four countries in the Customs Union produces cars or airplanes. Russian import tariffs on cars would amount to an unjustified hefty consumer tax in the other countries. Moreover, Russia is reluctant to accept the sovereignty of the other members, just wanting to impose its customs policy on them, which they do not accept. Third, the CIS Customs Union is not recognized as a customs union internationally. None of its members has applied for membership in the WTO as a member of the CIS Customs Union, but they have all done so individually, and Kyrgyzstan joined the WTO in 1998. Even so, queries about the Customs Union in the WTO are delaying the entry of Kazakhstan and Belarus.

It is obvious that the CIS Customs Union does not work, is never going to work, and is in no interest of any member. The logical conclusion would be to abolish this dysfunctional and redundant institution, but instead a year ago its members decided to rename it to the Eurasian Economic Community, which of course does not change anything. Its nominal ambition is to mimic the European Economic Community, but the fundamental difference is that in the CIS Russia still appears to think it can dictate conditions to other countries. The necessary political consensus for the creation of a true CIS community is missing. Russia should have learned from the last decade that bullying other CIS countries only distances it from its goals. Yet, a common interest in a functioning free trade zone exists, and that should be the focus.

Disregarding all experience, Russia has recently suggested the formation of a currency union of Belarus, Kazakhstan, Russia and Ukraine. All twelve CIS countries had a currency union in 1992 and 1993, but it was an utter and unmitigated disaster. The fundamental problem was that each country had a central bank that issued ruble credits, whereas no country was prepared to accept a central, effectively Russian, control over monetary emission. As a result, hyperinflation, that is, more than 50 percent inflation in a month, flared up in ten of the twelve CIS countries. In Ukraine, inflation peaked at 10,155 percent in 1993. Why would anybody want to repeat such an experience a mere decade later? None of the political preconditions has changed. No CIS country would accept Russian monopoly on the emission of a common currency, and without a central monopoly on the issue of money a currency union cannot work. Again, the EU is totally different from the CIS, because no EU country is so large that it automatically would dominant over the others. Nor is the EU a post-colonial construct as the CIS.

Even if a currency union could work technically, it would make little sense for Ukraine to have the same currency as Russia. First, even when pegging of the exchange rate of a currency, the dominant currency in the country’s foreign trade should be used, but Russia accounts for only about a quarter of Ukraine’s foreign trade turnover. Second, a currency should only be tied to a currency with a substantial record of stability. Russia has no such record, even if its current macroeconomic policy is reassuring. Third, a currency union should only be undertaken with a large differentiated economy with substantial financial depth, not to fall victim to all kinds of vagaries. Fourth, the members of a currency union should have similar economic structures or at least be moving in parallel with business cycles. Given Russia’s dependence on exports of oil and natural gas, while Ukraine is a major energy importer, Russia and Ukraine are on the contrary likely to move in opposite directions in business cycles. Whereas Russia would require devaluation when oil prices fall, Ukraine would benefit and could even consider a revaluation. Such doubts persists even within the European Monetary Union whether Germany and Ireland should belong to the same currency area with their very different growth rates. Finally, before a currency union were to be considered, a pegged exchange rate should be in place for years. In short, none of the ordinary prerequisites for a currency union is in place, and the only rationale appears to be Soviet imperial nostalgia.

The CIS tendency to propose a new ever more complex scheme rather than solve basic problems came to a head with the declaration on February 23 in Moscow by the Presidents of Russia, Ukraine, Kazakhstan and Belarus to start negotiations on the establishment a new free trade zone. Apparently, this is meant to be a customs union, a currency union and a coordination of the four countries entry into the WTO. As discussed above, neither a customs union nor a currency union makes sense or is likely to work. Any coordination in entering the WTO is likely to delay that entry of all the countries concerned. Moreover, this harebrain scheme takes time, energy and policymaking capacity away from the two important tasks that these countries need to resolve, namely their entry into the WTO and their making their mutual free trade functioning on the new basis of WTO rules and standards.

Apart from many trade disputes with Russia, Ukraine has one overarching bilateral concern, namely the price of natural gas. The domestic wholesale price of natural gas is $20 per 1000 cubic meters in Russia but $60 in Ukraine. The price differential between Russia and Ukraine is determined by two factors. First, Russia charges an export tariff, which does not appear compatible with free trade. Second, the Russian semi-state monopoly Gazprom charges higher prices on exports than on the domestic market, where the Russian government controls prices. This price control does not appear compatible with a free trade agreement either. If this artificial price differential is maintained, much of Ukraine’s heavy industry, notably metallurgy and chemical industry, is likely to be artificially noncompetitive.

In conclusion, the CIS countries should focus on the essence of their economic relations and make their free trade agreement work, which requires that they become members of the WTO and base their free trade on WTO rules and standards. Irrelevant and harmful ideas, such as customs union and currency union, are best forgotten. Russia must accept that its state regulation of the important natural gas prices is not compatible with free trade, but the EU is pursuing that case in Russia’s entrance negotiations for the WTO.

 

WTO Accession

Ninety-five percent of world trade is carried out among the 145 members of the World Trade Organization (WTO). The most important trading nations outside the WTO are Russia, Ukraine, Kazakhstan, Iran and Algeria, which are all scrambling to enter. In comparison with other international organizations, such as the UN, the IMF or the World Bank, the WTO is rather limited in its activities, resources and staff. Essentially, it fulfills three functions. First, it is the world forum where countries meet to negotiate multilateral trade issues. Second, it is a depositary of international trade conventions, which contain WTO rules and standards used throughout the world. Third, the WTO is an arbitration court for countries with trade conflicts. It is the only world trade court, and non-members are effectively left outside the rule of international trade law.

Ukraine applied for membership of the World Trade Organization (WTO) in November 1993, but it has not become a member as yet. Part of the reason is that the WTO is operating very slowly. It set up a working party for Ukraine’s accession in December 1993, which has met only ten times, just over once a year. Another explanation is that Ukraine has not treated the WTO as a political issue but as a technical issue and therefore not been taken seriously by several WTO members. Recently, Ukraine has really elevated early WTO entry to a political priority ad its efforts have intensified. An important wake-up call has been that Russia has speeded up is negotiations to entry the WTO since 2000. No country opposes Ukraine’s entry to the WTO in principle, offering it a substantial opportunity.

Ukraine badly needs to accede to the WTO urgently. As long as it is not a member, it remains an outcast in international trade. Ukraine can do nothing if a country prohibits imports from Ukraine. Nor can it conclude a meaningful free trade agreement before it joins the WTO. It does not become easier but more difficult to join the WTO over time, because more and more countries join the WTO, and they can pose ultimative conditions on new applicants, because all WTO decisions are made with consensus among all the members, giving each country an effective veto. Ukraine is now facing demands from Moldova and Lithuania, which must be taken seriously, because either country can block Ukraine’s entry to the WTO, as both have recently joined that organization. By contrast, Russian or Kazakh concerns cannot influence Ukraine’s accession, as long as they are not members.

Obviously, Ukraine has a strong interest in entering the WTO before Russia or at least simultaneously, because otherwise Russia could make its many bilateral issues with Ukraine conditions for Ukraine’s entry. Conversely, Russia has a great interest in joining the WTO before Ukraine. Russia has even demanded that Ukraine should accommodate its WTO entry to Russia so that they join together. Ukraine has no interest in doing so. First, Ukraine would surrender to Russian trade demands based on special interests rather than any sound principles, not solving its trade problems with Russia. Second, any coordination with another country would complicate and delay Ukraine’s entry to the WTO for years, as it would mean a totally new negotiation, while Ukraine has already done much of its negotiations. Specifically, Russia demands that Ukraine revokes the eleven bilateral protocols on trade access that it has already signed. Third, ultimately, this might mean that Ukraine gives up much of its national sovereignty for no apparent gain. The threat of what Russia and Ukraine could demand from the other could be an effective incentive for both to enter the WTO as fast as possible, which would be to global benefit.

A WTO entry is a complicated negotiation, which is partly multilateral and partly bilateral. Three major packages of issues are market access, trade regime and state support for agriculture. A working party for Ukraine’s accession was set up by the WTO in 1995. Anyone of WTO’s currently 145 members who has interest in a country can join the working party. At present, it has 48 members, of whom 22 have specific demands on Ukraine. By contrast, the WTO working party for Russia has 67 members, all with specific demands. Therefore, the Ukrainian negotiations are much easier than the Russian. Generally, it is easier for small countries to join the WTO, because they have less trade and thus fewer trade disputes. Therefore, the small CIS countries Kyrgyzstan, Georgia, Moldova and Armenia have already joined the WTO, while the bigger CIS countries are lagging behind.

Ukraine has given priority to the first block of market access in its negotiation about WTO accession. These bilateral negotiations with 22 countries are very advanced. Eleven bilateral protocols have already been signed, including the very important protocol with the EU, which was signed on March 17. Four additional protocols have been concluded and should be signed shortly. Thus, only seven bilateral negotiations are open, of which five raise concerns. The most high-profile case is with the US, which has concerns about access of its chicken legs to the Ukrainian market and about the state of intellectual property rights. Moldova complains about Ukraine imposing its high import tariff of 100 percent on sugar, which Moldova appears to produce more efficiently than Ukraine. Ukraine will have to concede. Lithuania has a more limited concern about the distribution of quotas for the Ukrainian exports of hides to Lithuania in the winding down of the Lithuanian-Ukrainian free trade agreement (because Lithuania joins the EU). Australia is more in principle concerned about the lacking access to Ukraine’s sugar markets because of Ukrainian quotas. Norway has a complaint about access to the fish market. Yet, the outstanding concerns are limited and manageable. All these issues could be resolved within half a year.

The second bloc is the country’s trade regime and that negotiation is multilateral in its nature. The working party needs to conclude a final report on Ukraine’s trade regime and specify Ukrainian commitments to conform to the WTO trade regime. This is the most neglected area of Ukraine’s accession to the WTO. While Russia has just concluded the third draft of its final report, Ukraine is only now ready to start writing its first draft. In this report the whole trade regime must be specified and clarified, including customs tariffs, quotas and procedures, intellectual property rights, antidumping legislation, certification and sanitary regulations. Ukraine needs to focus on these tasks and speed up the work.

In principle, Ukraine’s trade regime is quite liberal, but in practice it is too individualized. Various exemptions and privileges must be abolished. While Ukraine has adopted tens of laws to facilitate its entry to the WTO, it is not possible to establish at present exactly how many more laws that are needed. The number of new laws or legal amendments needed is substantial, perhaps 20-30 laws, but no authoritative list has been established as the negotiations have not proceeded far enough. Obviously, additional legislation on intellectual property rights, primarily copyright, is needed to fulfill the US demands. At least one more year of work seems to be required here, and this part appears the most complicated.

The specific problems with the customs regime are few and well known. The most important problem is the trade regime for sugar, which involves an import tariff by weight of about 100 percent and the state distribution of production quotas for sugar refineries. This appears an unjustified throwback to the centrally planned economy. In 1995, an export tax on hides was introduced to the benefit of Ukrainian leather and shoe producers. It is difficult to see that this minor irritant is needed after the Ukrainian leather and shoe industry has taken off. Similarly, sunflower seed has long been subject to an export tariff, currently of 17 percent, to encourage its refining in Ukraine. After substantial development of the sunflower oil production, it should be possible to abolish this trade impediment meant to support an infant industry. A more recent issue is an export tariff on metal scrap of 30 percent to secure metal scrap for the Ukrainian steelworks. However, domestic shortage continues, suggesting that it is not very effective.

The third block of issues in the WTO accession is agricultural subsidies. The basis for permitted subsidies should be the last three years. However, Ukraine has got bogged down in the negotiations demanding that 1994-96 should be the baseline and not 1997-99, when the subsidies were lower. Now, the other parties appear to be ready to move ahead to 2000-02. The Ukrainian position makes little sense and is not likely to gain support, in particular as Ukraine has no medium-term agricultural policy, which is required for WTO entry. The domestic Ukrainian policy battle appears to work like this. On the one hand, the agrarians want to keep the opportunity open to extract more subsidies in the future, although they cannot get them today. The Ministry of Finance, on the other hand, knows that it can limit agricultural subsidies today, but that objective would be complicated by any long-term discussion. The agricultural and economic arms of the government need to sit down and agree on an agricultural policy for the next five years or so to enable Ukraine to enter the WTO. This could be done quickly, but the current stalemate may also be maintained for long. This is entirely a matter of political will. Russia suffers from exactly the same stalemate.

Services can be looked upon as a fourth block. Ukraine has made a good offer to the WTO on services, and the problems here appear solvable, because the service sector in Ukraine remains so rudimentary.

On the whole, Ukraine’s entry to the WTO looks pretty straightforward. It is mainly a question of political will. The bilateral block on market access is well advanced, and the main problem is to reach an agreement with the US on chicken standards. Everything could be solved within half a year. The main stumbling block is the final report on trade regime, which will require at least one year of hard work and substantial legislation. On agriculture, the government bodies concerned need to sit down and hammer out their consensus. The main query is whether the Ukrainian parliament will be able to adopt so much legislation in a year before presidential elections. Yet, leading politicians from various political parties assess that the trade policy is not such a hot political topic that relevant legislation will necessarily be blocked after the summer of 2003. Ukraine’s entry into the WTO in 2004 is a realistic opportunity, but it requires that the government single-mindedly focuses on it.

 

Agricultural Concerns

Agriculture is usually the most sensitive sector in foreign trade negotiations, attracting special interest. It is obvious that Ukraine should be a major agricultural producer and exporter. Few countries are endowed with such large areas of fertile soil and receive a suitable amount of rain in a temperate climate. Ukraine has a long tradition of agricultural prominence and 14 percent of its population lives in the countryside. The Soviet system, however, was particularly badly suited to agriculture, devastating work morale and misallocating resources, while maximizing waste. It was a big question what would happen when agriculture finally recovered after communism, and now we can discern the first signs.

In the last three years, Ukrainian agriculture has seen a remarkable economic revival. Several critical preconditions have come into place. The most important is the land reform of 2000, which formally put an end to state ownership and collective agriculture and transferred the property rights of the land to the peasants. Another important change has been the development of free trade with free prices in agriculture, which has evolved since 1995 with temporary setbacks caused by administrative interference by the regional authorities. A third positive factor has been the tax regime. Since 1998, agriculture enjoys a simplified and beneficiary tax regime with a single fixed land tax. It includes social taxes, while value-added tax is not applied to agriculture.

As elsewhere, food processing is the engine in agricultural development. It has taken off since 1999, and its demand drives farmers. In most branches of food processing, three-five major producers dominate the domestic market. They are competing intensely with one another over market shares, swiftly increasing output, while raising the sophistication of processed food and increasing the demand for agricultural inputs. Some processed foods have reached international standards and is being exported, primarily to the open markets in Russia and the Middle East, but some producers are ready to expand to more sophisticated and protected international markets.

The first agricultural sector to take off was, not surprisingly, grain production, which is relatively easy and in line with traditional production. In 2002, Ukraine exported some 12 million tons of grain out of a harvest of 40 million tons. The grain was purchased from the farmers mainly by eight large private grain traders, some Ukrainian some international. The grain is transported by rail or truck to Ukraine’s Black Sea ports, mostly Odessa, and then shipped all over the world. A major complaint of the farmers is that the prices the grain traders offer them are too low in comparison with world prices, and four months after the harvest, they had doubled. The farmers are squeezed, partly because they lack credit to keep the grain for a longer period, partly because of a lack of reliable storage. A conversation with a few leading Ukrainian grain traders revealed considerable commercial sophistication, while they saw no reason to engage in trade policy as they just sold on the grain internationally to the best price. Last year, Ukraine exported about 3 million tons of grain to the EU, but from January 1, 2003, the EU introduced a strict grain quota of nearly 3 million tons of which about 600,000 tons were reserved for the US and Canada. It remains an open question how large Ukraine’s quota will be, but 300,000 tons has been mentioned as a likely outcome. Amazingly, this staggering negative development has attracted minimal attention in Ukraine and no businessman seems to be directly concerned, while the farmers complain that prices have fallen not realizing that prices depend on the demand available.

Other early sectors of agriculture to take off are sunflower seeds and vegetables, notably tomatoes and cucumbers. Animal husbandry is developing more slowly, but modern large-scale poultry farming has multiplied in a few years, and pig farming is taking off. Cattle, both milk and meat production, are developing tardily. Sixty percent of meat and milk production comes from small private household plots, while the alternative producers are family farms with 40-100 cows or large agroholdings with thousands of cows.

The most problematic agricultural sector is the sugar industry. It has all the characteristics of a Soviet white elephant. It is large with 192 refineries, which still employ 70,000 people, although only some 20 factories are in reasonable shape. The refineries are surrounded by sugar beet producers and highly concentrated to a few oblasts, notably Poltava and Vinnitsa. Sugar is protected with a high import tariff of about 100 percent. Even so, it is in steady output decline, lossmaking, run down and without any apparent future. Ukraine has gone from being a major sugar exporter to becoming an importer. As a result, sugar is the focus of plenty of bilateral trade disputes, as cheaper sugar is imported from numerous countries illegally, while various countries demand quotas to export to Ukraine. The question is whether the Ukrainian sugar industry lacks comparative advantages altogether and should be phased out, or whether there is anything that can be reconstructed. In any case, the current policy of severe protectionism can only kill this sector off. A reasonable policy would be to reduce the import tariff gradually over a number of years to give the sugar industry an opportunity to adjust or dwindle as a part of its WTO accession. The restructuring of such a concentrated industry will require social support.

The second protectionist concern of agrarians is often stated as meat and vegetable production, but the real issue is rural poverty. Their fear is that a freer trade in meat and vegetables would reduce these prices, thus harming poor people living from subsistence agriculture on small household plots. The current large production of meat and vegetables on the small household plots can only be considered a temporary post-Soviet phenomenon. These units are not viable in the longer term, and the quality of their meat and milk is poor. Private household plots that occupy 15 percent of Ukraine’s agricultural land and are extremely important for the standard of living of the very poor, but the poverty problem should be resolved through economic growth and the elaboration of a social safety net. Besides, Ukrainian import of meat and vegetables is quite free today.

Many problems in agriculture have been resolved, but the complaint runs that seventy percent of farms are unprofitable. The number might be disputed, because the fixed agricultural tax means that no affirmative statistics are available, but a profit squeeze is apparent for five market failures. First, financing is scarce and expensive. Second, the relationship between traders and farmers is not very equitable. Third, government certification necessary for exports involves large costs. Fourth, the railway and port tariffs are monopolistic, and fifth access to markets is scant.

The main concern expressed by new private farmers is financing. Little financing is available, and it is expensive and very short term, usually about six months, from sowing to harvest. Obviously, many problems need to be resolved to make long-term credit available and affordable. First, private property rights to land must become more complete. Agricultural land can only be sold legally by 2005. A new law on collateral is needed. Most land and their property rights are not registered in cadastres as yet. Second, the judicial system needs to improve through judicial reform. While judges are considered to have become more independent of regional governors, they are instead perceived as becoming more corrupt, as the value of their judgments rises with the market economy. The collection of collateral is unreliable. Third, the bank system remains tiny, and in spite of fast expansion credit remains scarce and thus expensive. Several international donors, such as the World Bank and the EBRD, are considering various schemes to increase the volume of credit to small and medium-sized enterprises in agriculture, which seems laudable at present.

Over the years, serious concerns have repeatedly been raised over interference in the agrarian markets by the regional authorities, but the practitioners no longer appear worried. Regional authorities may want to interfere, but they have lost the levers and capacity to do so. A major market distortion people complain about is the high costs to take grain from a village to the high sea. First, about ten expensive certifications are needed for exports. Second, railway tariffs are perceived as monopolistic and excessive. Third, the ports are a bottleneck and competition between them is insufficient boosting the shipping costs. In general, too few commercial companies operate in the countryside. Farmers could benefit from setting up farmers cooperatives for purchases and sales as is so common in the world, though communism might have left cooperatives with too much stigma to be socially acceptable as yet.

A peculiarity in the of Ukraine’s current agricultural development is the emergence of many large agroholdings of mostly 5,000-15,000 hectares, while the biggest appears to be 250,000 hectares. Why is this happening and is it a healthy market economic development? The agroholdings tend to be owned by private Ukrainian individuals, who have made their money in other business. Formally, the land is mostly leased for a long term, but it will become their private property with the full privatization of land. One reason for the agroholdings is that large former kolkhozy have more or less died and their land is on the market. Large-scale agriculture has a long Soviet tradition and appears natural on Ukraine’s huge fertile fields with large-scale equipment such as extensive irrigation systems. Another consideration is that Ukrainian agriculture is likely to be profitable, and land prices are low now. In general, ownership in Ukraine appears concentrated and financial intermediation is poor, rendering it natural that money is transferred between sectors through conglomerates rather than through financial markets. The main drawback, however, is that a major reason for agroholdings is that a predominantly agricultural enterprise is liable only to the low fixed agricultural land tax and can avoid ordinary taxation. This form of taxation should be limited to real family farms. Foreign observers note that Ukraine has ample technical knowledge, while management skills are scarce. Then, family farms appear more prospective than huge estates. Yet, if only taxation is reasonable, the market should take care of this issue.

 

A Foreign Trade Policy Strategy for Ukraine

From the perspective on this report, it appears pretty obvious what kind of trade policy Ukraine requires.

· Trade policy has now gained such importance that it should be Ukraine’s predominant economic policy and international policy priority.

· The main tenet of Ukraine’s trade policy must be to gain early accession to the WTO. A realistic but ambitious target is 2004. That requires the Ukrainian government to concentrate single-mindedly on resolving all the outstanding issues. The primary focus should be to accelerate the composition and adoption of a final report on Ukraine’s trade regime and adopt all the requisite legislation for entry into the WTO. Second, remaining bilateral issues need to be resolved to complete the seven remaining bilateral negotiations, notably with the US and Moldova. Third, Ukraine should formulate a clear policy on agricultural subsidies and reach agreement with its WTO partners. For Ukraine, swift entry into the WTO is far more important than the exact conditions of accession, because its membership of the WTO is the only plausible basis of its trade policy. The WTO should be seen as a universal tool for all trade policy rather than an end in itself.

· As soon as Ukraine has joined the WTO, it should try to improve its market access to key markets by concluding free trade agreements with the other eleven CIS countries, the EU, the US and other key countries.

· Ukraine has concluded and ratified a free trade agreement with all the CIS countries. This could serve as a basis for its future trade relations with these states, but this free trade agreement should be based on WTO rules and standards. Ukraine has no reason to waste time on discussing a customs union with any CIS countries, because such an agreement cannot be implemented, and a customs regime designed for countries with very different economic structures will not be beneficial to Ukraine’s economic interest. The idea of a currency union in the CIS appears absurd given the devastating failure of the recent currency union and the absence of any advantageous preconditions. Any coordination with CIS countries in Ukraine’s accession to the WTO could only complicate and delay it for years. When both Russia and Ukraine have become members of the WTO, they should be able to resolve their many bilateral trade disputes more effectively. To Ukraine, Russia’s current discrimination against it in gas pricing is unacceptable and reconcilable with a free trade regime. Russia’s export tariffs on natural gas must be abolished or waived, and Russian Gazprom’s price discrimination against Ukraine needs to be alleviated.

· Ukraine is subject to extreme trade discrimination from the EU. It is not recognized as a market economy, it is not member of the WTO, and it has no free trade agreement with the EU, while its PCA with the EU has turned out to be almost empty. It suffers badly, having little trade with the EU and enjoying comparative advantages in products, whose importation the EU resists. Ukraine should focus on requesting a comprehensive free trade agreement with the EU rather than a complex and nebulous agreement on a Common European Economic Area. First, however, it must become a member of the WTO.

· Ukraine has approximately the same problems on the US market as on the EU market, though the US is less important for its trade since it is more distant. Also with the US, Ukraine should aim at a comprehensive free trade agreement, which requires that it first become a member of the WTO.

· Ukraine needs to persuade the EU and the US to declare Ukraine a market economy, which it actually is, with free prices, small subsidies, few trade quotas and low import tariffs. The status of a market economy is important for antidumping investigations. Non-market economies have few chances of winning antidumping cases, and as a consequence prohibitively high tariffs are slammed on them. Antidumping cases tend to focus on steel and chemicals, which account or half of Ukraine’s exports. This procedure is independent of the WTO accession and bilateral trade negotiations. Both the US and the EU have already acknowledged Kazakhstan and Russia as market economies. The US steel lobby, however, holds back this status for Ukraine, arguing that its steel industry benefits from tax exemptions, but that is no longer the case. The EU complaint about an excessive role of the state in the Ukrainian economy, which is less tangible and thus harder to counter, but it does not appear a relevant objection.