Even if E.U. Does Offer the Association Agreement, Why Should Kiev Sign It?

September 10, 2013
Anthony T. Salvia
Director, American Institute in Ukraine

There is much discussion in Ukrainian and Western media about whether the European Union (E.U.) will or should sign an Association Agreement (AA) and Deep and Comprehensive Free Trade Agreement (DCFTA) with Kiev. The discussion usually centers on whether or not the European Commission and E.U. member states are satisfied that Ukraine has met various “conditions,” including electoral and legal reform, notably the release of Yulia Tymoshenko.

Seldom discussed is why the Yanukovych administration would want to sign the AA/DCFTA in the first place. Put simply, what does Ukraine get out of the deal? Ukraine’s most important decision since independence may hang on the answer.

The decision coincides with Ukraine’s deteriorating trade and budget deficits, which make the country, according to the for Ukraine, which the Financial Times of London, “one of the worst-hit emerging markets. ” These problems are expected to worsen if, as expected, the U.S. Federal Reserve proceeds to raise long-term interest rates by curtailing bond purchases. – a process referred in the media as “tapering.”

The net effect of this policy is likely to be rising global interest rates. This will increase borrowing costs for emerging market countries like Ukraine, while harming their ability to export as higher interest rates will inevitably depress demand in many of Ukraine’s most important export markets in the West – which are already down owing to Europe’s prolonged financial crisis.

This would be most unfortunate for Ukraine because, as the FT reports, “the nation’s foreign exchange reserves, which have been declining for the past two years, shrank 7.4 % in the past year, to $22.7 billion, the equivalent of just below 2.8 months of imports, and the lowest level since 2006.”

Kiev, according to the FT, would like to negotiate a new $15 billion loan from the International Monetary Fund to help jump start an economy still mired in its second recession in five years. But the IMF are said to be “increasingly alarmed amid concerns over whether Ukraine will be able to service its debt obligations.”

If Kiev goes that route., the IMF is likely to insist that it raise the eligibility age for pensions, and cut gas subsidies to Ukrainian homes and businesses as a precondition for further lending. The IMF has made these demands in the past, and Kiev has refused to meet them.

With tapering and the IMF’s reluctance to provide further lending, Kiev will have increasing difficulty tapping into global credit markets. When the U.S. Federal Reserve was holding interest rates to near 0 (quantitative easing), Kiev was able to finance its operations, in part, by floating “Eurbonds,” i.e., borrowing dollars, euros and yen on foreign markets. But with tapering in the offing, Kiev’s indebtedness vis-à-vis its creditors is likely to skyrocket as global interest rates rise to counteract the inflationary effects of quantitative easing. Kiev would have to pay back its creditors in dollars, euros and yen considerably more expensive than the ones they borrowed. To make matters worse, rising interest rates will impede whatever nascent recovery is underway in many of Ukraine’s most important export markets, thus harming Ukrainian industry.

It is a real conundrum. The only real way out for Kiev is the one it refuses to countenance – entering the Eurasian Customs Union (E.C.U.). The countries of the E.C.U. are growing at a faster rate than the E.U., have pent up demand for practically everything, and a history and culture of buying Ukrainian goods --- quite unlike Europe. It is not clear what Ukraine produces that Europeans would be interested in buying even under a free trade regime -- agricultural products perhaps, but European farming is heavily protected by the sacrosanct Common Agricultural Program.

Moreover, much of the Ukraine’s increasingly scarce foreign exchange reserves go to paying for imported energy, for which prices are denominated in dollars.

President Yanukovych hinted at a possible way out, when he said recently that Ukraine would integrate with the E.C.U. in all areas not explicitly forbidden by the AA/DCFTA and WTO commitments -- which according to some experts are very few, implying a significant degree of integration. His statement is consistent with Article 39 of the AA, which “shall not preclude the maintenance or establishment of customs unions, free trade areas or arrangements for frontier traffic except insofar as they conflict with trade arrangements provided for in this Agreement."

If Kiev were to invoke its rights under Article 39 and join the E.C.U., how would the E.U. react? Would Brussels refuse to sign and ratify the AA/DCFTA? Or would it simply swallow hard and reluctantly sign the agreement in November in Vilnius anyway? Hard to say, but one thing is for sure: such a move on Kiev’s part would give the Ukrainian economy a much-needed boost in the face of continued global economic malaise.