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Apr 19, 2017 | 09:14 GMT

7 mins read

Russia Parts Ways With a Longtime Trade Partner

Russia Parts Ways With a Longtime Trade Partner
Forecast Highlights

  • The tight political, security and economic links between Ukraine and Russia will continue to unravel in the years ahead.
  • Their parting of ways will be particularly pronounced in the economic realm, thanks to Kiev's imposition of a blockade against cargo traffic from Donbas and its implementation of sanctions against Russian bank subsidiaries in Ukraine.
  • Though the two economies will not sever all ties, Ukraine's reduced dependence on and integration with Russia will give Kiev more freedom to diversify its foreign policy options.

Until about three years ago, Ukraine and Russia were thick as thieves. Their close friendship dated back centuries, to Ukraine's incorporation into the Russian Empire in the 17th century. Through the years, the two countries forged deep ties across every field imaginable, from agriculture and energy to infrastructure and defense. Even after Ukraine gained its independence in the wake of the Soviet Union's collapse, those links held strong. Russia remained Ukraine's biggest trade partner, and Kiev relied on Moscow for nearly all of its energy imports. It also counted on the Kremlin to buy its primary exports, including agricultural goods, steel and military equipment.

But all of that changed when the Euromaidan uprising swept across Ukraine in February 2014. The overthrow of Ukraine's pro-Russia president, Viktor Yanukovich, and his replacement with an ally of the West upended Kiev's relationship with Moscow. It wasn't the first time Ukraine had given Russia the cold shoulder; in the 2004-05 Orange Revolution, the country had likewise swung away from Moscow and toward the West. But this shift was fundamentally different, and the Kremlin knew it. Rather than applying economic and political pressure on Kiev, as it did during the Orange Revolution, Russia annexed the Crimean Peninsula and supported a separatist rebellion in eastern Ukraine, the country's industrial heartland. Since then, Ukraine's political and economic ties to Russia have significantly deteriorated, and they appear all but certain to continue degrading in the years ahead.

Trading Barbs

The conflict in Ukraine's east has dealt a particularly heavy blow to its economic relationship with Russia. Much of Ukraine's industrial production was taken offline as its separatist rebellion escalated into a full-fledged war. The country lost a sizable share of its exports, while its gross domestic product saw a double-digit contraction. Kiev, along with the European Union and United States, slapped Russia with sanctions for its actions in Crimea and Donbas; Moscow responded in kind, leveling its own punitive measures against Ukraine and its Western backers.

Around the same time, the Ukrainian government began to draw down its imports of Russian natural gas in response to a pricing dispute, and it started looking for new energy partners elsewhere. To that end, it began importing reverse-flow natural gas supplies from neighboring EU states such as Poland, Hungary and Slovakia. (Though these supplies still technically originated from Russia, they weren't subject to the same contractual conditions as direct imports from Russia.) By the beginning of 2016, Ukraine had halted all of its natural gas imports from its looming eastern neighbor.

Together, these moves have cut deeply into cross-border trade between the two countries. In 2013, just before the Euromaidan protests reached their peak, Ukraine exported some $15 billion worth of goods to Russia each year. The following year, that figure fell to $9.8 billion, dropping again in 2015 to $4.8 billion. By 2016, Ukraine sent only $3.6 billion in exports to its eastern border, and they amounted to only 8 percent of its total exports. The European Union, on the other hand, grew to account for over 37 percent of Ukraine's exports in the same year.

Ukrainian Exports to Russia and Europe

That trend has only picked up pace in 2017. At the start of the year, far-right activists and Donbas war veterans imposed an informal blockade on rail and cargo traffic — including anthracite coal shipments — flowing from the separatist territories to Ukraine proper. (Anthracite coal makes up around 15 percent of Ukraine's electricity generation, and over 37 percent of the country's annual consumption is met with coal from Donbas.) The leaders of the self-declared autonomous republics of Donetsk and Luhansk then retaliated by seizing control of Ukrainian plants and companies operating in their regions, bringing them under "external management." In response, Kiev erected an official blockade against the two republics, and virtually all economic activity between Ukraine and the rebel regions ground to a halt.

Though the country's anthracite coal reserves have dropped by about 15 percent since the start of the blockade, the situation hasn't reached a crisis point yet. Instead, the Ukrainian government has moved away from thermoelectric generation and upped the amount of nuclear power in its energy mix from 50 to 62 percent. In early April, Kiev announced that it would begin stockpiling anthracite coal and forcing generators reliant on anthracite coal to shut down for the summer to undergo upgrades. Ukraine has also begun to import coal from other nearby countries, such as Poland, and is exploring similar trade deals with the United States and South Africa. Such deals, however, could drive up import costs — and by extension, utility costs.

If the blockade is kept in place, however, it will eventually come with its own price tag. Experts estimate that the blockade will lead to a 1.3 percent loss in GDP this year if it lasts through December. If accurate, this would eliminate more than half the country's projected GDP growth of 2.3 percent in 2017. Moreover, the International Monetary Fund — which has promised $17 billion in financial aid to Ukraine — delayed the disbursement of its latest tranche of $1 billion to assess the damage the blockade will do to the country's economic outlook. (The tranche was later released on April 3.) Ukraine's central bank is optimistic about its prospects: It believes that the consequences of the blockade will last only a year and that most businesses will be able to diversify their coal, coke and other energy supplies by 2018, leading to a more robust GDP growth forecast of 3.2 percent next year.

In addition to the blockade, Ukraine has gone after the subsidiaries of five major Russian banks operating within its borders. On March 16, Kiev passed sanctions against them, just weeks after Russian President Vladimir Putin signed an order requiring Russian authorities to recognize the identification documents of residents in Ukraine's separatist regions. Sberbank announced on March 27 that it would sell off its Ukrainian subsidiaries to a consortium led by Latvia's Norvik Bank and a private Belarusian firm, though the sale is still under review by antitrust regulators.

Breaking Ties

By all appearances, the Ukrainian and Russian economies seem certain to keep drifting apart in the years ahead. Though it is unlikely that all economic activity between Donbas and Ukraine proper will cease — practical arrangements such as electricity swaps, for example, will be maintained — most legal railway and cargo trade will be terminated. As a result, the country's separatist territories will have little choice but to turn to Russia for help.

Free of its own historical dependence on Russia, Ukraine will look to other markets, especially Europe, for new export destinations and energy supplies. Unencumbered by concerns of political blowback from Moscow, which in the past often came in the form of natural gas cutoffs, Kiev will begin diversifying its diplomatic partnerships abroad as well. In fact, Ukraine has already started to build up its economic and defense relationships with Poland and the Baltic states. And though Russia will always pose a very real military threat to Ukraine, Kiev will have more and more room to pursue an assertive foreign policy of its own as Russia's role in its economy dwindles.

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