Ukraine : playing hard to get

Moscow has announced a potentially lucrative offer to Kiev if it decides to walk away from on-going negotiations to sign a Free Trade Agreement (FTA) with the EU, and joins the Customs Union between Belarus, Kazakhstan and Russia which came into effect earlier this year. Officials in Moscow have indicated that should Ukraine opt to join the CIS Customs Union it could get cut-price gas, potentially saving the economy USD8bn per year, equivalent to around 6% of GDP.

First, the figure of USD8bn sounds too large. Historically Ukraine imported around 50-55 billion cu metres of gas from Russia, but this dropped dramatically through the global crisis, to around 35-37 bcm. In April 2010 Ukraine and Russia agreed that Moscow would provide a USD100 per 1,000 cu metres discount sold to Ukraine, in exchange for extending the lease on the Russian Black Sea Feet until 2042. In effect Ukraine paid around USD260 per 1,000 cu metres for gas supplies in 2010, which reduced to around USD235 per 1,000 cu metres in Q1 2011. Assuming that Ukraine ends up paying Russian prices for gas, i.e. USD50-80 per 1000 cu metres, this would still only deliver a saving of around USD6bn annually, but presumably Moscow is working on the assumption of rising Ukrainian gas consumption as the economy recovers, plus also higher global gas prices, as demand in Asia in particular increases (Chinese consumption is expected to rise to 400 bcm annually over the next decade or so).

A gain of USD6bn is nevertheless not to be sniffed at as it represents the equivalent of 4% of GDP, and would likely push the current account back into surplus. It would also clearly provide a huge, and much needed boost to Ukrainian industry. On the political front, it would also ease pressure on the government to push forward with the very sensitive issue of liberalising domestic gas prices.

Second, the benefits of Ukraine's entry into such a CIS Customs Union would accrue also to Russian energy companies, as presumably they would improve their ability to sell to clients in Ukraine, and hence increase their overall reach/dominance across the CIS economic space. This would presumably lead to questions as to the future of domestic gas suppliers. Note that the Ukrainian government has recently held out the option of pushing ahead with the partial privatisation of the state-owned gas transit company, for which there would likely be strong interest from Russia, givenm it views the pipeline as hugely strategic.

Third, this is far from being a "done deal", as Ukraine is a class act in terms of "milking both cows", i.e. extracting maximum concessions from the West and Moscow as its plays on the country's geopolitical significance to both through its energy transit hub position. Ukraine has continued to play "hard to get" with Moscow, with President Yanukovych suggesting over the past few days that it is still eager to seek a deal on an Association Agreement with the EU this year, with a FTA being part of that process. Negotiations on the FTA are already well in advance, but Moscow has made it clear that it could impose sanctions on Ukraine if Kiev presses ahead with these plans.

Ukraine might feel more comfortable moving to a "3+1" agreement with Moscow over its own Customs Union, given that Moscow has indicated that it is eager to secure WTO entry this year, and ahead of Belarus and Kazakhstan. Ukraine is already a WTO member, and arguably would see Moscow's membership as providing some defence in terms of possible trade-related disputes as part of a wider agreement over a Customs Union. Yanukovych has also spoken about a FTA with Moscow, rather than full membership of the CIS Customs Union.

Fourth, politically in Ukraine a move to EU accession, or deepening relations with the EU, is probably still seen as more palatable than varying degrees of "economic" re-integration with Moscow. Herein, while NATO membership has clearly been put on the back burner, the population does still seem to appreciate the democratic anchor provided by the goal of EU accession - even though in Ukraine's case (perhaps similar to Turkey) the accession process would likely be very long moving. As a result, even President Yanukovych, previously seen to lean more to Moscow, has put
much effort into deepening the relationship with Brussels, and negotiations over a FTA have been part and parcel of that project.

Ultimately all this may well have just been part of the strategy of extracting maximum concessions from both the West
and Moscow, while keeping Ukraine's options open. For Yanukovych, in particular, note that he is currently entering into potentially difficult negotiations with the IMF, as he seems set in stalling key pension reform this side of parliamentary elections; pension reform is regarded by the IMF as the key for maintaining disbursements under the current IMF programme. Perhaps the Yanukovych regime assumes that a dalliance again with Moscow might see leverage exerted on the IMF from Western governments/EU to cut the government some slack on the reform front.

Timothy Ash the author is a senior analyst at RBS, who issue all sorts of investment warnings with this sort of thing. So BEWARE.