A way out of the Ukrainian quagmire

Thorvaldur Gylfason, Inmaculada Martínez-Zarzoso, Per Magnus Wijkman, 14 June 2014

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At the Vilnius Summit in November 2013, President Yanukovich chose not to sign the Deep and Comprehensive Free Trade Agreement (DCFTA) with the EU that Ukraine had spent five years negotiating.1 His decision was dictated both by Ukraine’s failure to fulfil the political conditions for signature set by the EU and by strong pressure by Russia on Ukraine to join the Eurasian Customs Union instead.2 His refusal to sign unleashed events in Ukraine that within six months led to the President’s flight to Russia, the installation of a new provisional government, the detachment of Crimea from the rest of the country and its inclusion in the Russian Federation, the election of a new President, and an escalating civil war.

The conflict between the central government in Kiev and armed separatist forces in Eastern Ukraine is increasingly violent. Its outcome will determine who controls Ukraine’s eastern territories. Values as well as territories are involved. The separatists are openly supported by the Russian government and Russian troops. The battle now involves several parties, directly or indirectly, whether they like it or not. While some EU member states may view the transfer of additional territory from Ukraine to Russia as no skin off their noses, they have an existential interest in upholding fundamental international rules of conduct in the European Neighbourhood.

The EU has a strong interest in resolving this conflict in a way that ensures that ‘might does not make right’. What are their options? Consider four complementary measures in turn:

  1. Create a free trade area encompassing several Eastern Partnership States, the EU, and in due course also Russia.
  2. Engage both the EU and Russia in resolving historic conflicts in the Eastern Partnership region – conflicts in which Russia is a key actor.
  3. Encourage Russia and Eastern Partnership countries to participate in the Deep and Comprehensive Free Trade Agreement.
  4. Utilise Pan-European and international organisations and regional security arrangements to ensure free and fair elections, human rights, and the security of individuals.

Create an economic entity through free trade

Foundations for a secure peace in the region require that a contentious ‘near abroad’ be converted into a shared neighbourhood. This can be done through free trade. For the Eastern Partnership countries, the choice is not between free trade with the EU and free trade with Russia. They can have both.3 Free trade is the best policy. The second-best policy for the Eastern Partnership States, and especially for Ukraine, is free trade agreements with their two major markets – Russia and the EU. Besides, Ukraine would enjoy the benefits of a preferential tariff on these markets (Kowalzyck 2000). Of the two markets, the EU is the more important for most of the Eastern Partnership States (Figure 1).

Figure 1. Direction of trade in former Soviet Republics, 2012 (% of total)

Source: European Commission.

In Gylfason, Martínez-Zaroso, and Wijkman (2014), we use a gravity model to estimate the effects of deep and shallow free trade agreements for the Eastern Partnership states with Russia and EU.4 We show that the Eastern Partnership States – and here Ukraine is by far the largest – gain significantly from free trade agreements with the EU, but gain little from free trade agreements with Russia and possibly even lose (Table 1).

Table 1. Estimated one-off trade gain for Eastern Partnership countries from FTAs

 
EU
Eastern Partnership
Russia
Shallow FTA
+ 938%
+ 293 %
Insignificant
Deep FTA
+ 86%
-
Insignificant

Source: Gylfason, Martínez-Zarzoso, and Wijkman (2014).

A deep FTA with the EU will increase trade by some 86%, whereas a DCFTA with Russia (RUSdeep) will not result in any significant increase in trade for the Eastern Partnership countries considered. As regards the shallow FTAs, the EU trades almost 10 times more with countries with whom it has a shallow FTA than with countries without any agreement.5 The fact that the EU market is five times larger than the Russian market speaks strongly in favour of free trade agreements with the EU. The fact that the EU has a framework for deep and comprehensive free trade – already negotiated – while Russia does not also makes the EU the more attractive trade partner.

Finally, the benefits of free trade between the Eastern Partnership States themselves are significant (roughly a tripling) – neighbours tend to trade with each other and greatly benefit from reductions in trade barriers. Once two Eastern Partnership states have DCFTAs with the EU, they can easily implement identical agreements with each other. The potential for increased trade between, e.g., Moldova and Ukraine or Georgia and Armenia is significant and should be realised. It is expected that lowering trade costs created by behind-the-border trade barriers – such as time to cross a border or differences in regulatory policies – will generate much larger gains than elimination of import tariffs. However, for these gains to materialise requires institutional changes that deter corruption and eliminate red-tape trade costs, as explained below.

Resolving conflicts

Historically, the EU has viewed free trade and economic integration as a means to prevent conflicts. These are rife in the region (Transnistria, Nagorno-Karabakh, South Ossetia, Abkhazia). Russia is involved in virtually all of them, but is not included in the Eastern Partnership since it specifically requested and received a special relationship with the EU. Thus, the EU does not require – as it did in the Western Balkans – that any two partner countries have free trade agreements with each other if they have a free trade agreement with the EU.6 Russia’s active participation is all the more essential to solve these conflicts now that Russia is so deeply involved, albeit as yet mainly by proxy, in the conflicts in Ukraine. Prospects for conflict resolution could be improved should the EU offer to negotiate a DCFTA with Russia. Free trade agreements with the EU and with the Eastern Partnership countries would be far more beneficial for Russia than the proposed Eurasian Customs Union. Further, it would enable Russia to avoid the considerable costs and consequences of the current confrontation.

Filling the institutional vacuum through a DCFTA

Campos (2013) has stressed that many of the Eastern Partnership States suffered after independence from an institutional vacuum that prevents them from modernising their economies and participating in economic integration. In Gylfason, Martímez-Zaroso, and Wijkman (2014), we present measures of institutional quality – including democracy, free press, market economy, corruption, ease of doing business, and trust – all essential for the ability to implement a deep and comprehensive trade agreement. Most Eastern Partnership countries appear too similar to Russia in terms of these key characteristics to have good prospects. Georgia and Moldova, which initialled their DCFTA in spite of Russian pressure, are the best performers. They are the only democracies with a partly free press, and they have reasonably well-functioning market economies. Further, after 2005 Georgia evidenced significantly improved ease of doing business and reduced corruption. Moldova has experience of deep free trade through its participation in the Central European Free Trade Agreement in 2006.

Figure 2. Corruption in former Soviet Republics, 1996–2013

Source: Transparency International.

Note: The higher the index, the less corrupt the country is perceived to be.

The other four Eastern Partnership countries resemble Russia in that they are borderline democracies without a free press, and have high levels of corruption, complex procedures for doing business, and poorly functioning market economies with huge ‘institutional vacuums’. We illustrate this by the key variable corruption (Figure 2). The three Baltic States and Georgia are in a class by themselves – a pattern that is repeated in other variables.

Overall, Belarus and Azerbaijan score poorly and do not qualify for a DCFTA since they are not WTO members. Ukraine and Armenia are poor scorers as well but have been moving in the right direction, albeit slowly, each marred by serious internal and external conflicts. Both are highly dependent on Russia – Armenia on Russia’s security guarantee for the Armenian population in Nagorna Karabahk, and Ukraine on Russian gas supplies to and through Ukraine. It was, therefore, perhaps to be expected that these two governments would give in to Russian pressure. Even so, the population of Ukraine rose against Yanukovich’s decision. It wanted something else!

The EU must sign the DCFTAs with Georgia and Moldova in June 2014 and assist them to implement the agreements. It has assured the Ukrainian people that the door to the EU’s internal market remains open. So it must be prepared to sign the Association Agreement as soon as the new government is in place and after an internationally supervised referendum there allowing the various regions to express their views in a democratic way.

Soft vs. hard power

The EU’s soft power has been met by Russian hard power in Ukraine. Unless the EU is prepared to abandon important principles and policies, it must counter that hard power with the assistance of others. Institutions that can contribute to a solution are the Council of Europe, the Organization for Security and Co-operation in Europe, the UN, and – if push comes to shove – NATO. Given the growing cross-border hostilities and civil tensions, significant international surveillance is needed to restore stability in everyday life and ensure effective elections that reflect public opinion better than the Crimean referendum did.

It is necessary for EU Member States to agree on a common policy and to seek support from others to execute this policy. In particular, the EU and the US will need to coordinate their policies in order to exercise both soft power and hard power in the region. To date, their response has been too little, too late.

Footnotes

1. The DCFTA was part of an Association Agreement. Armenia did not initial the Association Agreement it had negotiated with the EU, but Georgia and Moldova did.

2. This Union was formally signed by Russia, Belarus, and Kazakhstan on 30 May 2014.

3. Ukraine and Armenia cannot, however, be members of the Eurasian Customs Union and have a free trade agreement with the EU. That would require the Eurasian Customs Union to negotiate a DCFTA with the EU, which is unlikely.

4. The model is applied to bilateral trade data from 1995 to 2012 for 34 exporters and 150 importers. The estimation method is a Multinomial Pseudo Poisson Maximum Likelihood (MPPML) model based on Eaton, Kortum, and Sotelo (2012) and Head and Mayer (2014) that accounts for zero trade flows.

5. While the results obtained for the rest of the FTAs considered are quite stable using alternative estimation techniques, the results for shallow FTAs with the EU are less stable. The reported effect could be biased upward, as alternative techniques give lower effects. Using PPML estimation instead, the effect is an increase in trade of only 26%.

6. One reason for this is that the countries in the Western Balkans had a prospect of membership following the Thessaloniki Declaration at the EU Summit in June 2003. The EU would not accept as members countries that had a conflict with other members or with non-member neighbours. See Wijkman (2009) and Gylfason and Wijkman (2011).

References

Campos, Nauro (2013), “What drives protests in the Ukraine? This time it is institutions,” VoxEU.org, 22 December.

Eaton, J, S Kortum, and S Sotelo (2012), “International trade: Linking micro and macro”, NBER Working Paper 17864.

Head, K and T Mayer (2014), “Gravity equations: Workhorse, toolkit, and cookbook”, in G Gopinath, E Helpman, and K Rogoff (eds.), Handbook of International Economics, Vol. 4, Amsterdam, Elsevier-North Holland (forthcoming).

Gylfason, Thorvaldur and Per Magnus Wijkman (2011), “Economic integration as a Balkan peace project”, VoxEU.org, 1 January.

Gylfason, Thorvaldur and Per Magnus Wijkman (2014), “Meeting Russia’s challenge to EU’s Eastern partnership”, VoxEU.org, 25 January.

Gylfason, Thorvaldur, Inmaculada Martínez-Zarzoso, and Per Magnus Wijkman (2014), “Can and should the EU’s Eastern Partnership be saved?”, CESifo Working Paper (forthcoming).

Hoekman, Bernhard, Jesper Jensen, and David Tarr (1913), “Ukraine’s trade policy: Addressing supply-chain frictions”, VoxEU.org, 29 November.

Kowalczyk, C (2000), “Welfare and integration”, International Economic Review, 41(2): 483–494.

Wijkman, Per Magnus (2009), Frihandel för fred: Exemplet Balkan, SNS, Stockholm.

Topics: EU policies, Europe's nations and regions, International trade
Tags: civil war, diplomacy, EU, free trade agreements, Russia, Ukraine

Thorvaldur Gylfason
Professor of Economics, University of Iceland and CEPR Research Fellow
Invited Professor of Economics, University of Göttingen, and Professor of Economics, Universidad Jaime I.
Former Director of Economic Affairs at EFTA and adjunct professor of international economic policy at University of Göteborg