Despite War, Ukraine And Russia’s Economic Ties Continue

Two interesting stories about Ukraine’s economic ties to Russia came to light this week. First, it emerged that the Ukrainian State Railroad Company had purchased $500,000 worth of spare parts from Russia. Second, a Polish official revealed that his country had bought coal mined in the occupied territories in eastern Ukraine. This suggests that, despite the ongoing de facto war between the two countries, and Russia’s trade war with Ukraine, economic ties between Russia and Ukraine continue — as do covert ties between the occupied Donbas and Europe.

To Volodymyr Vakhitov, Professor at the Kyiv School of Economics, it is unsurprising that Ukraine and Russia have maintained an economic relationship: “When we think about trade, the trade is not between countries. The trade is between firms, the trade is between individuals, and not all individuals support the idea that we are at war with Russia,” he told Hromadske.

However, today’s trade between Russia and Ukraine is actually significantly lower than it was before the war began in 2014. Russia received 10% of Ukraine’s total exports in 2016 — the last full year — down from 26% in 2012. Imports have declined even more so. In 2012, 32% of Ukraine’s imported goods came from Russia, whereas in 2016 the figure was only 13%.

While the war in Ukraine’s Donbas region has exerted a negative impact on the country’s economy overall, it may have opened up new trade opportunities for Ukraine. According to Vakhitov, some Ukrainian firms have begun to realize that “the world is much bigger than Russia,” and started looking for trade partners elsewhere.

He told Hromadske: “Only the most productive firms can find outer markets easier. So, in some sense, this war might become either the grave or the good future for some companies, depending on whether they are more productive or not.”  

Hromadske spoke to Volodymyr Vakhitov, Raiffeisen Bank Professor at the Kyiv School of Economics, to get his expert opinion on the current economic relationship between Ukraine and Russia.

What do you think about the news about the railway spare parts and coal?

I think that they are absolutely not surprising, because, if you think about the railroads, the railroads in Ukraine and Russia are essentially the same; the same by technology, the same by standards, the same by all technical characteristics. And, it's kind of obvious that Ukraine buys those spare parts from Russia because it might be possible that Russia was pretty much the only country that would produce those spare parts. And, about the coal from "DNR"- I think this is also not very surprising. I suppose the "DNR" is desperately looking for outer markets, and, once they have found the market in Poland and if somebody in Poland decided to buy coal cheaply, I think this is kind of obvious that those countries started to trade. Cases of this has been found throughout the history of wars, many times, dozens of times.

So do you that these cases are not isolated and there are many more similar cases in the Ukrainian situation?

Yes, of course because when we think about trade, the trade is not between countries, the trade is between firms, the trade is between individuals, and not all individuals support the idea that we are at war with Russia. Not all individuals support [the idea that] all economic ties should break down and some individuals would like to see some profits from this conflict. And this is very obvious that once there are some opportunities for profits, some people would be willing to grab these opportunities.

Do you think that the Ukrainian state should react somehow to impose sanctions over these particular subjects that are trading?

I think that if the Ukrainian state could impose something, the sanctions would have already been imposed. It looks like the Ukrainian state doesn't have enough capacity to impose those sanctions. This is number one. Number two: once we have some trade with Russia, we obtain some hard currency in exchange for our goods, right? And this is hard currency, this is a substantial part of the Ukrainian GDP. I could be mistaken on the numbers, but I think three to five percent of Ukrainian GDP is obtained through trade with Russia. This is a substantial amount of money and Ukraine faces an option to forget about this money altogether, but, in this case, we are going to have a substantial budget hole. And now the question is: What is the source for the pensions? What is source for the salaries for the budgetary service? What is the source for the money for reforms? This could be a kind of bearable compromise.

This is probably a question that has been raised throughout history, right? So the dilemma is, either you gain economic benefit, or, the moral choice that you don't trade with the aggressor. Are there similar cases throughout history?

Yes, of course. For example, during the civil war between the north and south in the United States. The south was famous for producing cotton, and cotton was the major item of exports from the United States to Britain, Britain was actually willing to obtain this cotton for their manufacturing and for their trade, and they were threatening the north that they would recognize the south as a separate state if the trade in cotton was somehow interrupted. So since the north blocked the southern ports, all the trade with Britain was coming through Boston, and other northern ports, and, as a result, there should be some trade between north and south. So even though this trade was not very much recognized, and not very much allowed or cherished, this trade was still taking place and this was a substantial amount. Moreover, the price of cotton in the south was like seven times lower than in the north. So, just imagine some businessman who would face an opportunity to earn 700%.

Let's come back to the Ukrainian-Russian situation.

We see that in 2016 Russia was Ukraine's biggest trade partner: imports - 32% and exports - 26%. And then, the war started in 2014 and over the years we have seen a decline: exports are only 10% and imports - 13%. How can we explain this? Can the situation with the war explain this? Can we explain this with the Russian trade war with Ukraine, or by other means?

The Russian trade war started somewhere around [2013], so this was approximately when the first embargo on cheese and agriculture products started.

Was it only on Ukrainian agriculture? Or against machinery and other goods?

First of all, it was against Ukrainian agriculture and food products, processed agriculture as well. Later on it was against machinery as well, but it looks like Russia first faced some sanctions, and Russian cannot right now openly buy whatever they want from the western countries. And secondly, it looks like Russian could not substitute Ukrainian goods with their own. There are several industries which are critical for Russia and Russia does not have any substitutes as well. So this, for example, could be engines for ships and shipbuilding, this could be some reservoirs, this could be those metal rods which are used in construction. Right now, over the several last few years, it looks like the entire construction in Moscow is based on those Ukrainian metal rods.

Is this the legacy of Soviet economy?

This is the legacy of the Soviet economy and it was much cheaper to buy this stuff in Ukraine, which is why nobody would care much about producing this in Russia on their own, so they face the consequences of their own actions right now as well. And again, there is some holes in the border, there are some holes in the legislation. We do not have open declared war, we have some kind of conflict and "conflict" is a very vague word, which is why there is still some trade, some partnerships going on, there is some trade with Russia. I think this is something which is going to be replaced, the Russian markets will be replaced by some other markets for Ukrainian exporters.

Is there anything that anything that Russia exports to Ukraine that is irreplaceable for Ukraine?

Right now, it could be. As I said, those part for the railroad, they are probably irreplaceable. It's hard to [talk about] this item by item, but, from the volume of trade it looks like we trade from Russia with the goods which, even though they might be replaceable, they are still cheaper to buy in Russia than elsewhere. For example, both Russia sells some shoes to Ukraine, and Ukraine sells some shoes to Russia. This is not something which is not replaceable but it looks [like] for some particular markets, some particular shoes could be cheaper here, some particular shoes could be cheaper there, which is why countries trade in goods which is actually the same. This is like the trend and economic theory as well, so that countries trade in good which are similar, not absolutely different.

What are the key items that still exist in Ukraine-Russia trade?

As far as I can remember, imports from Ukraine to Russia - this is firstly, the production of machinery, this is some reservoirs, this is - what I said - metal rods or whatever it is, and, this is basically something which is produced by machine building and metal producing. Russia sells to Ukraine - if I'm not mistaken - some fertilizers, and fertilizers are key for Ukrainian agriculture, and they are probably replaceable but much more expensive elsewhere, since Russia has extremely low internal prices for gas, the fertilizers in Russia turns out much less expensive than anywhere else. So in some sense, the trade is still mutually beneficial for both countries and for businesses in both countries.

The role of Russian markets is still shrinking in Ukraine. Where does the Ukrainian business go if it's not going to Russia? What are the alternative markets?

It looks like after Russia has imposed embargo on Ukrainian goods, Ukrainian markets firms started to look for some outer markets in Europe, for example. And it looks like, for example, Ukrainian butter became a very important, critical import in Europe, Ukraine became the first or second trading partner in butter for the European Union.

You mean sunflower oil?

Butter. Sunflower oil finds their producers elsewhere. We are talking about new markets for what is called "egg powder" - I think it's something like that. They found lots of markets in Asia for egg powder and powdered milk. It looks like some firms in machinery, they produce some [...] or pipes - I don't remember the exact name of that item - they have found a pretty nice market in Bangladesh and they basically replaced the Russian market with the Bangladeshi market. Again, now we are talking about those kind of stories which are individual, but the latest research we ran with my students from the Kyiv School of Economics this spring has found that the most productive firms can get to the outer markets easier and replace Russia with somebody else. Moreover, it looks like those most productive firms can diversify easier, they can find more trade partners. So if the firm that trades with Russia has approximately three to four trade partners on average, more productive firms that trade with somebody else have more trading partners - like seven or eight on average.

Does this mean maybe a provocative idea that the Russian trade war has had a positive impact on Ukrainian economy because it helped it to diversify?

The overall impact is probably still negative, so I think it would be too naive or maybe too brave to talk about the positive impact of the war. However, for some companies the war has become this impulse, has given this impulse to find trade partners outside and they found out that the world is much bigger than Russia itself. So they have found trade partners outside. But this drives competition within Ukraine and it boosts productivity because only the most productive firms can find outer markets easier. So in some sense, this war might become either the grave or the good future for some companies, depending on whether they are more productive or not.