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New engines for growth of trade

Ben Aris reports from Kiev on the benefits that the new eastern bloc CES alliance is expected to bring and on the country’s growing relationship with the EU.The leaders of the four biggest countries in eastern Europe gathered in the Crimean resort of Yalta in May to create their answer to the EU: the Common Economic Space (CES). The new free trade zone is designed to feed flourishing economic growth in Russia, Ukraine, Kazakhstan and Belarus.
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The CES is broadly modelled on the Common Market, the forerunner of the EU, and will harmonise tariffs and trade regulations of the four countries that together account for 95% of the GDP of the 12 countries of the former Soviet Union.

There have been several attempts to unite these countries’ trade. One was the Commonwealth of Independent States, which was set up a week after Ukraine declared independence on December 1, 1991 at a meeting between Russian president Boris Yeltsin, Ukraine’s new president Leonid Kravchuk and Belarus’s first leader Stanislav Shushkevich. None of the attempts have come to much.

Expectations raised

This time, however, the four leaders think things will be different. “Our aim is to create a new union which will be an engine of growth in Eurasia,” Russia’s president, Vladimir Putin, said at the start of the talks. “We can achieve concrete results by 2005 to 2006.”

Mr Putin has been trying to coax Russia’s neighbours into an economic bloc for several years and, with a population of 50 million against Russia’s 150m, a bloc that does not include Ukraine would be meaningless.

However, Ukraine has been pulled both east and west. There is strong domestic resistance to cosying up to Russia, for historical reasons, while there are good economic reasons for getting closer to Russia, which is now Ukraine’s biggest trade and investment partner (see table 1).

Ukraine’s president, Leonid Kuchma, is driving a hard bargain. Ukraine is firmly in Europe and interested in joining the EU, Ukraine’s biggest donor, but not at any price.

President of the European Commission Romano Prodi was dangling carrots under Ukraine’s nose only days before the Yalta summit, saying that the EU was on the edge of granting Ukraine the sought after “market economy” status that would improve trade conditions and Ukraine’s chances for joining the World Trade Organization. The EU is afraid of overwhelming competition and has been putting pressure on Ukraine to raise prices before wider access to trade is granted. Ukraine’s economics and European integration minister, Mykola Derkach, promised that all these issues would be resolved before the EU’s July 8 summit.

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Rough edges

Low prices are also causing problems with the Russians. Most of Russia’s oil and gas runs to the lucrative western markets through Ukrainian pipelines that were built when Ukraine was a region of the former USSR. Mr Putin was pragmatic enough to admit during the Yalta summit that there were still “rough edges” to the relations between the would-be members of the CES. The main sticking point is energy: Russia has uniform rules for levying indirect taxes for all commodities except oil and gas, on which VAT is levied on the basis of the country-of-origin principle.

“We are managing to polish rough edges, which apparently always appear, and I hope they will always be vigorously eliminated,” said Mr Putin. “There have been unjustified obstacles to the access of goods but I also know that there is certain progress in resolving this problem.”

As Mr Kuchma cannot ignore Russia, the VAT issue was already resolved by the start of June. With EU membership at least six or seven years away, he has decided to take Russia’s offer now rather than wait for the EU negotiations to finish later.

“Everyone must give up something to gain something else. If we think only of our national interests, we will all be losers,” Mr Kuchma said after the talks were over.

The four CES members are now supposed to set up a governing body to harmonise their customs regimes and tariffs, which is unlikely to be functional before 2007, after a supranational body with broad powers is formed.

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Macro boom

The CES stands a better chance of becoming an effective body than its predecessors because three of the four members’ economies are booming – unreformed Belarus being the exception.

For most of the past decade, staying on their feet was all the governments of the newly minted countries could do. Now, as the economies across the region are clearly on the path to sustained growth, they all need bigger markets and improved trade ties if they are to keep the double-digit growth rates up. And they need them now.

The strength of Ukraine’s economic growth has surprised everyone. The government started the year with a modest 4.8%-8% target and the IMF with a compromise of 6.5%. No-one expected the annualised economic growth rates to increase every year but since January it has picked up pace again, topping 11.8% in March. Even the state committee for statistics’ revised estimate of 9.4% for the end of the year is starting to look conservative.

Soaring exports (especially steal and agriculture) are pouring cash into the economy, adding fuel to the already blazing domestic consumer demand. These are fuelling growth. Nearly every economic indicator was in double figures by the end of the first quarter: industrial production was up a stellar 19.6%; exports had increased by 44.4% year-on-year to $4.47bn, easily outpacing the rise in imports of 37.2% to $3.86bn; fixed investment has been growing every year and was more than 18%; and retail turnover is booming, rising by almost 20%.

“Between 1990 and 1999 our GDP was falling every year, but the problems were not uniform. The budget sphere was worst hit but underneath these negative numbers the commercial part of the economy was growing all the time,” says Boris Timonkin, CEO of Ukrstosbank. “It built a basis for the current strong growth driven by the new market-orientated companies.”

Oleksandr Sorokin, the chairman of Ukreximbank, says that although more than half of Ukraine’s GDP goes to export, the final production of some industries, aviation for example, are made using inputs, 80% of which are imported and much of them from Russia.

Ukraine’s traditional dependence on agriculture and lack of oil has been a blessing, protecting the average people from much of the pain of transition. Although the economy fell hard in the years immediately after the country was created, it hit bottom in about 1994 and has been recovering steadily since. However, only in the past four years have economic growth figures moved back into positive numbers.

A virtuous circle has set in: high commodity prices have primed the pump and remonetarised the economy. Enough internal restructuring has been done for companies to be able to respond to soaring internal and external demand, which in turn is leading to more investment and rising incomes.

The general prosperity has spilled over into public finances: tax revenues were above target in the first quarter and the state ran a small 0.3% GDP deficit. The pace of privatisations will be increased this year to support the growth and draw in more investment.

The only bugbear is the reappearance of inflation. After a slight deflation of 0.6% last year, prices rose by 8.3% over the first quarter of this year. However, as most of that increase was due to a bad harvest and rising food prices, economists are not unduly worried.

Investors arrive

As the non-stop stream of good news begins to leak out, investors are arriving to set up shop. Inflows of foreign direct investment (FDI) into Ukraine doubled last year to $1.4bn, up from the $600m that Ukraine has average in a good year previously. But FDI per capita remains very low at $25 per person – one of the lowest in the CIS – while the cumulative stock of FDI is now $6.7bn, also low by transition country standards (see table 2).

“FDI should take off next year as Ukraine starts to catch up with its neighbours, like Czech Republic which is receiving about $4bn-$5bn a year. Light industry is already moving out of these countries, where wages have risen to $400 a month plus, and going east to countries like Ukraine, where the skills are the same but wages are only $100 a month,” says Tamash Fiala, CEO of Kiev-based investment bank Dragon Capital.

Light industry is in the vanguard of incoming investors that are hoping to capitalise on Ukraine’s cheap and plentiful skilled labour. Singapore-based Flextronics, a multinational producer of consumer electronics, has set up a factory in Ukraine. So, too, has German firm Leoni, a wire and car component manufacturer. They are joined by a growing number of multinationals targeting the domestic market, like German wholesale retailer Metro and Proctor & Gamble.

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Elections risk

The only cloud on the horizon for both the future of the CES and Ukraine’s economic revival is the political risk from the presidential elections, slated for the end of October. After a 10-year stint in office, Mr Kuchma has promised to stand down, leaving the running to prime minister Viktor Yanukovych, the head of the Rada’s (parliament) pro-government fraction, and Mr Kuchma’s arch-enemy Viktor Yushchenko, leader of the opposition Our Ukraine Rada faction.

Ukraine has a bad image among Western investors, who see the elections as a titanic struggle between the forces of good and evil. But local businessmen are much more sanguine – they argue that the country has already progressed to the point where there is no debate on the basic tasks that the government faces: continuing reform and accelerating growth.

“The government and the opposition both have a bourgeois economic view; this is not a competition between the liberals and the socialists. The economic risk under Yanukovych or Yushchenko is not that different,” says Mr Timonkin. “In the early days, government connections made the difference but now it is about straightforward commercial business.”

Mr Yushchenko is the foreign investors’ favourite. As governor of the National Bank of Ukraine, the central bank, in the second half of the 1990s and then prime minister for a year in 2000, he is credited with laying the foundations of the current economic growth. On the other hand, investors see Mr Yanukovych as representing the status quo and big business’ interests, which are divided between three regional “clans”. The race is still wide open – it is also possible that Mr Kuchma may change his mind at the last moment and stand for a third term.

Mr Yushchenko was leading opinion polls in May with 25.7% to Mr Yanukovich’s 16.7%. But the opposition is battling against voters’ cynicism: half the population said they would not vote for incumbent Mr Yanukovych but 35% said they thought he would win anyway.

Democracy can still be rough in Ukraine as recent mayoral elections in the western town of Mukacheve show: the winner, mayor Ernest Nuser, had to resign on May 28 after Our Ukraine’s claims that the vote was rigged to deprive its candidate, Viktor Baloha, of a landslide victory were backed up by international election monitors.

Votes for normalisation

The businessmen are more pragmatic. They point out that Ukraine is a young country and far from perfect. However, they see more profit in normalisation than in a return to the chaos of the first 10 years of independence. “It is difficult to say who will be elected but there will be no fundamental change regardless of who is elected president. It is not a choice between the communists and the liberals,” says Alexander Dubilet, the chairman of PrivatBank in Dnipropetrovsk.

“We need to distance ourselves from politics, which is why we are concentrating on retail banking. It is still possible for politics to interfere with the decisions of big companies but no government can tell our seven million retail customers which bank to use.”

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Read more about:  Central & Eastern Europe , Ukraine