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Russia-Ukraine: An Unlikely Union

by | January 10th, 2014 | 07:46 pm
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Russia’s recent promise of $15 billion in assistance, coupled with cheap gas—both blandishments in exchange for Ukraine turning its back on deeper integration with the European Union—have raised the specter of Russia and Ukraine forming a customs union. Indeed, news sources initially claimed that customs union membership was part of the deal presented by Moscow. Though both governments have denied it, many analysts still believe a customs union is on the horizon. Expanding the Eurasian Agreement, as the customs union is called, would align perfectly with Putin’s goal of reviving at least some aspects of the Soviet Union.

A customs union already exists between Russia and two other former Soviet states, Belarus and Kazakhstan. Though Ukraine’s joining appears unlikely today because of the political turmoil surrounding President Viktor Yanukovych’s balancing act in Kiev, the concern is that economic ties will intensify as a result of the new deal, making a customs union between Russia and Ukraine feasible, perhaps even desirable, in the future. It is coming; the question is when. Political resolve on both sides would have to intensify, however, because economic considerations make a customs union less likely than the politics would suggest.

First, trade between the two countries has declined steadily since Ukraine’s independence. Russia’s share of Ukraine’s exports fell from 40 percent in 1994 (the first year exports were independently recorded) to 26 percent last year. Ukraine’s share of Russia’s exports fell from 11 percent to 3 percent over the same period. The current agreement, which does little to expand trade, is unlikely to reverse this trend.

Second, a customs union would demand that Russia significantly lower trade barriers faced by non-members. In a customs union, members harmonize external tariffs at the same level; this is distinct from a free trade area, where countries unilaterally set external tariffs. In order to comply with the rules of a customs union, Russia would have to lower its tariffs to Ukraine’s levels, or Ukraine would have to raise its tariffs to Russia’s levels, or some combination of the two. This is what happened with Belarus and Kazakhstan, the newest member, which raised tariffs to join.

Were a Russia-Ukraine customs union to come into effect, rules established by the World Trade Organization (WTO), would prevent Russia from dictating the level of protection. (Both Russia and Ukraine are members of the WTO, and upon joining they committed to ceiling levels for many tariff lines—so-called bound rates.) Ukraine’s WTO commitments rule out any upward adjustment of its bound tariffs. And, though the WTO allows trade blocs, it has strict rules to prevent them from raising external tariffs and becoming stumbling blocks to free trade. Specifically, Article XXIV requires that duties in a customs union shall not on the whole increase. This means that unless WTO rules are flagrantly violated, which could invoke costly retaliation from the rest of the world, a customs union between Russia and Ukraine would require significant liberalization by Russia. 

Russia, in turn, would find it nearly impossible to lower tariffs on products from other trading partners, as welcome as that might be for the rest of the world.

Ukraine’s industrial tariffs are bound at 4.95 percent on average, compared with 7.3 percent in Russia. A customs union would thus require an additional 50 percent liberalization beyond Russia’s WTO commitments, to which Russia is still having a difficult time adjusting. Russian and Ukrainian tariffs are also structured differently. Russia’s maximum average ad valorem tariff is 80 percent, compared with 50 percent in Ukraine. Looking at 5000+ products, Ukraine has only 9 that face specific tariffs, compared with nearly 500 in Russia. Specific tariffs, which charge a price per import as opposed to a percent, tend to be far more restrictive than ad valorem tariffs.

The sectors most affected by an expanded customs union would be strategic ones: steel, chemicals, and agriculture. Ukraine’s simple average of its bound tariffs in steel is 1.6 percent, as compared with 7.1 percent in Russia. While ad valorem tariffs on chemicals and agriculture are similar in the two countries, Russia has a number of specific tariffs and nontariff measures, such as import/activity licenses that restrict competition. 

A Russia-Ukraine customs union would pry open the Russian goods market for exporters, but it would be even more valuable to the rest of the world if it were able to claw back restrictions in the service sectors, especially energy and banking, which were largely exempted from Russia’s WTO commitments. Ukraine is more open, but it remains to be seen whether and how energy and financial services would be liberalized in a potential customs union.

It is difficult to see economic developments progressing to the extent that a customs union between Russia and Ukraine becomes more economically feasible over the next few years. Achieving such an agreement would require a reversal in export trends and significant additional Russian liberalization, far beyond current WTO commitments.

This suggests what should have been obvious all along—that Putin’s motive in recent negotiations with Yanukovych has been primarily to prevent closer ties between Ukraine and the European Union. Petty perhaps, but successful, for now. Of course, without a deeper agreement, Ukraine may look to the European Union after the 2015 Presidential election, offering a second chance for the protestors looking West.