Implications of the Ukrainian Crisis for Trade

Relationships of the EU with Russia

Economic Policies of the European Union

Gartnar Marko

19486522

Marmai Martina

19131311

Mladenovi Kosta

19821606

Economic Policies of the European Union

Executive Summary
The aim of this research assignment is to provide an assessment of the effects on trade
relationships between the EU and Russia stemming from the so-called Ukrainian crisis. The
term points at the Russian military intervention in Ukraine, and the public response that this
event generated. In particular, the analysis will regard the repercussions on Euro-Russian trade
due to the Councils diplomatic reply to the violent annexation of the Crimean peninsula by the
Russian Federation.
Since March 16th, when - with the unconditional support of Russia - the referendum for
the independence of Crimea took place, the events in Ukraine escalated, giving rise to a number
of restrictive provisions which, increasing in scope and gravity, aimed on one side to discourage
military intervention by Russia, while on the other punished illegal misappropriation of
Ukrainian public property.
Such sanctions may not have played an important role, were it not for the current shaky
state of the Russian economy. Nevertheless, that of sanctions is a two-sided sword, and the
European Union, barely stepping on the road to recovery, cant exactly afford being too picky
when it comes to deciding who to do business with.
The high level of interconnectedness and dependence on each others economy seem to
drive these two players into a situation of stalemate: hurting the other without hurting themselves
appears to be almost impossible, as both have lots to lose from a bilateral trade reduction.
To conclude, things may take a decisive turn only if one of the participants were to
somehow succeed in neutering the effect of the others sanctions, hence becoming more
independent from the other.

Economic Policies of the European Union

Table of contents
1. Introduction
1.1 Economic relationship between the European Union and the Russian Federation
1.2 Imports from Russia to the European Union
1.3 Exports from The European Union to Russia
1.4 Investment
1.5 Role of the World Trade Organization
1.6 Timeline of the Ukrainian conflict
2. The Sanctions
2.1 On Sanctions Imposed by the EU
2.2 The Context
2.3 The Sanctions
3. Effect of European Sanctions
3.1 The financial sector
3.2 The real market
3.3 Gripping onto Natural Resources
3.4 Effect of Russian Sanctions
4. Conclusion
References
Appendix

Economic Policies of the European Union

1. Introduction
1.1 Economic relationship between the European Union and the Russian
Federation
Before we examine the impact of the Ukrainian crisis we need to understand the
economic relationship that existed between the European Union and Russia before the conflict
began. This section provides the overview of economic cooperation between the two partners.
We chose to emphasize certain aspects of that relationship, that have been most affected by the
crisis in Ukraine or are likely to be affected in the future. This information can help us estimate
where the effects of this crisis will be felt the most. We also review certain other areas that may
become relevant.
The European Union and Russia have a close relationship in terms of trade and
investment. Bilateral trade is important for both sides. Russia ranks as EU's third trading partner
(after the United States and China) and the EU accounts for about half of all Russian foreign
trade (Permanent Mission of the Russian Federation to the European Union, 2014). Trade
between Russia and EU member states increased dramatically leading up to the year 2008. Then,
this trend was interrupted and volume of trade sharply decreased. Nevertheless, the international
trade returned to pre-crisis levels in 2012 (338 billion Euros). The following year total trade
reached 326 billion. The EU ran a significant foreign trade deficit (European Commission,
2014). These numbers are broken down below.
1.2 Imports from Russia to the European Union
In 2013 the EU imported about 206 billion euros worth of goods from Russia. EU
imports are generally dominated by the supply of energy. Various fossil fuels and related
products accounted for about 160 billion or about 78 per cent of all imports. Unclassified goods
come in as a distant second at around 8 per cent. The imports of energy have actually increased
quite sharply from only about 89 billion euros in 2009. The imports of of fuel have therefore
increased by nearly 80 per cent in four years (European Commission, 2014).
The EU has become increasingly dependent on the supply of fuel from Russia. Since the
year 2006 Russia has been the main supplier of solid fuel and retains its leading role in the
supply of crude oil and natural gas (Eurostat 2014). In 2012 imports from Russia accounted for
34 per cent of all crude oil (European Commission, 2014) and 23 per cent of all natural gas
(Eurogas, 2013) used in the EU. But the dependence is not one sided. Russia is heavily
dependent on the revenues from energy exports to Europe. We can take the example of crude oil.
In the year 2013 all Russian exports of this commodity were worth about 131 billion euros (Bank
of Russia, 2014). In the same period EU imports of crude oil from Russia reached the value of
around 99 billion EUR (European Commission, 2014). That means that over three quarters of
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crude oil exports were sold to the European markets. Any reduction of supply would therefore
severely impact the Russian economy. This point is emphasised by the fact that about half of the
revenues of the Russian federal budget are provided by the mineral extraction taxes and export
duties on the exports of gas and oil (United States Energy Information Administration, 2014).
The above figures give us an idea of Europes dependence on Russian energy. But they
are aggregate numbers, that tell us about energy imports for the Union as a whole. But they mask
important differences among individual countries. Some (like Estonia, Latvia, Lithuania,
Finland) import all of their gas from Russia. Certain other countries import no gas from Russia
(Eurogas, 2013). This means, that some countries may be disproportionately affected if Russia
decides to use natural gas as a diplomatic tool. In the graph below we show the countries, that are
most dependent on Russian gas supply.

Source: Eurogas
1.3 Exports from The European Union to Russia
In 2013 the EU exports to Russia reached the value of 120 billion euros. EUs exports to
Russia are significantly more diverse than its imports. The largest share of exports is provided by
machinery and transport equipment at 47.4 per cent of total exports. Cars represent a large share
of those exports. Chemical and related products account for 16.8 per cent.
Food and live animals (as an item in the SITC classification) come in at fifth place at 7.3
per cent. They generate about 8.8 billion euros of exports. Trade with Russia represents 11.6 per
cent of all EUs exports in these commodities. These supplies are important for Russia because it
is a net importer of food. The gap between imports and exports reached 20 billion euros in 2013
4

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(European Commission 2014). Russia relies heavily on foreign supplies of many product such as
fruit and vegetables, meat, cheese.
1.4 Investment
Companies from the EU have invested heavily in Russia. Currently about 75 per cent of
all foreign direct investment in Russia originates in one of the EU member states (European
Commission, 2014).
In the last few years Russia experienced very high growth in foreign investment. Just in
2013 FDI inflows to Russia rose by more than 80 per cent. This made Russia the third largest
FDI recipient in the world behind The US and China. This latest increase was largely fueled by
the acquisition of a significant stake in Rosneft by British Petroleum. Estimates, made before the
current crisis, predicted that this trend would continue (United Nations Conference on Trade and
Development, 2014).
According to Ernst & Young (2013) in 2012 about 21 per cent of projects were in the
automotive sector, 13 per cent in business services in 11 per cent in chemicals. European car
manufacturers made significant investments into production capacity in recent years. This is
most apparent in the city of Kaluga, where several European car manufacturers (Volkswagen,
Volvo Trucks and a joint venture between Peugeot-Citron and Mitsubishi) have recently opened
factories (Crouch, 2013). These investments within Russian borders may shield them against the
possible future ban on imports of cars from abroad (Golubkova, 2014).
1.5 Role of the World Trade Organization
The WTO is an organization that promotes the liberalization of trade and maintains a set
of trade rules. It is also provides a platform for governments to negotiate trade deals and settle
trade disputes. The EU has been a member of the WTO since the its inception in 1995. All EU
member states also maintain their separate WTO memberships (World Trade Organization, n.d.).
Russia became a member of WTO in 2012 after almost two decades of negotiations. The
European Union welcomed Russias accession. It did so because this would reduce Russian
import duties and other barriers to trade. Also, the Russian government and Russian businesses
would need to follow common rules. WTO rules would also provide European investors in
Russia with a more predictable legislative framework and an overall favorable business climate
(European Commission, 2014).
The first year of WTO membership was rather disappointing for Russia. Exports decreased and
imports increased. Liberalization of trade was quite damaging particularly to Russian agricultural
producers. They are just not yet efficient enough to compete with foreign competition. Therefore
a significant increase in imports of some agricultural products was recorded within the first year.
But these negative consequences had been predicted and were a part of Russias calculation.
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Economic analysts have predicted that Russia would not begin to feel the positive effect before
the year 2016 (Balibouse, 2013). But this date may be further delayed by the current political
crisis and overall economic conditions.
Since its accession the EU and Russia have both filed several trade disputes against each
other (WTO, n.d.). Most of them predate the current crisis. However, since the beginning of the
crisis both sides have imposed sanctions on the other. Russia maintains that EU sanctions are
illegal under WTO rules (Astakhov, 2014). Sanctions and their effects are discussed in more
detail below.
1.6 Timeline of the Ukrainian conflict
In this section we briefly summarise the events of the current crisis. Sources for this
information are Aljazeera (2014) and the BBC (2014).
On November 21 2013 Ukrainian President abandons an association agreement with the
EU. Under the agreement the EU would drop its tariffs on Ukrainian imports. Ukraine
would be expected to gradually lower tariffs over time. However, Ukraine would not be
able to join the customs union of the Commonwealth of independent States as some of
its members are not members of WTO.
The rejection of the treaty immediately provokes large scale and sometimes violent
protest. Protesters occupy municipal buildings and clash with police. Meanwhile Russia
agrees to buy Ukrainian debt and reduce gas prices.
In January The Ukrainian government adopts amnesty for protesters in an effort to deescalate the situation. Ukrainian prime minister resigns for the same reason.
Nevertheless, the protest continue into February when many protesters and police are
killed. On February 21th The government and the opposition reach a deal to end the
violence. Shortly after the president flees the capital and is dismissed by parliament. The
opposition leaders adopt leadership positions in government.
Later that month Russian soldiers gradually take control of Crimea. The EU strongly
condemns Russian actions and calls on them to withdraw. In March a referendum is
organized in Crimea on joining the Russian Federation. The proposal is adopted, but only
Russia recognizes the referendum as valid. Russia then annexes the peninsula while
Ukraine vows never to recognize this unilateral act. The EU and the US enact sanctions
against Russia in the form of asset freezes and travel bans for certain Russian officials.
In April and May Pro-Russian separatist occupy government buildings in eastern Ukraine
and declare independence. Ukraine responds with military force.
In June Ukraine finally signs the originally rejected Association agreement with the EU.
The Ukrainian and the European parliament ratify the agreement at the same time. The
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agreement is set to come into force in January of 2016. Until then Ukraine will enjoy
duty-free trade with CIS countries. Russia seeks to adjust the deal. However, their
initiative is rebuffed because this is a bilateral agreement.
In July a civilian plane is shot down over the separatist regions prompting international
condemnation. Following this event western powers decide to expand Russian sanctions.
On September 5th a deal between the pro-Russian rebels and Ukraine is struck in Minsk.
Negotiations take place in the presence of representatives from Russia and the
Organisation for Security and Cooperation in Europe. However Ukrainian President
expresses little confidence in the deal. Hostilities resume soon after.

2. The Sanctions
2.1 On Sanctions Imposed by the EU
According to the press office of the Council of the European Union, Sanctions are one
of the EU's tools to promote the objectives of the Common Foreign and Security Policy. In its
April 29th, 2014 Updated Factsheet on Restrictive Measures, the Council specifies that such tools
should not aim at punishing the country they target, but should rather act as a strong incentive for
the target subject to change its practices or policies. With respect to sanctions, the difficulty
consists in designing measures that will hit only the target and only with regard to the
controversial activity, without impacting negatively the rest of the civilian population or
disrupting other legitimate activities conducted by the same agent.
Imposed by the Council through specific CFSP decisions, which must be adopted by
unanimity, the restrictive measures are for arms embargoes and travel bans implemented
directly by Member States, else, in case of economic measures such as asset freezes or export
bans, implementation requires additional regulations by the Council. The measures apply to the
territory of the Union and any entity under the jurisdiction of a Member State, on the nationals of
Member States, be it natural or legal persons.
Sanctions may be of different kinds. They may forbid the trade in arms, and more in
general, items included in the EU common military list, annex services being banned as well.
Besides arm embargoes, sanctions may encompass visa or travel bans when a specific group of
people is denied entry at the external borders of the Union (but individual Member States may
grant exemptions) or asset freezes, in order to outlaw economic activity of targeted entities on
the territory of the Union.
2.2 The Context
In the context of the Ukrainian crisis, Catherine Ashton, the then-High Representative of
the Union for Foreign Affairs and Security Policy, called for an extraordinary Foreign Affairs
Council session which adopted a first Conclusion on February 10th 2014, immediately followed
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by another one on February 20th. The documents expressed the growing concern of the Union's
headquarters with the deteriorating situation of human rights in Ukraine, as well as the intention
of the European Union to extend peace talks in order to avoid conflict by all means.
Besides responding to the escalating violence in Ukraine, the Foreign Affairs Council
restated the commitment of the international community to assist Ukraine on the way out of its
difficult economic conditions, and the aim of the Union to keep on pursuing the path towards the
Association Agreement with Ukraine, with a view to going beyond its original scope i.e. the
establishment of a Deep and Comprehensive Free Trade Area eventually even welcoming
Ukraine in the EU. In this view, observing the unprecedented Ukrainian support for the EU
voiced by the Euromaidan (literally: European Square) demonstrations in Kiev (BBC 2013),
the Councils February 10th conclusions emphasized the right of all sovereign states to make
their own foreign policy decisions without undue external pressure hinting at Moscows
involvement in sparking the events that would eventually develop into the current situation.
What at first appeared as tensions due to conflicting interests between the EU and Russia,
later turned into a real diplomatic crisis following the referendum in Crimea and its subsequent
occupation by Russian troops. In response to the aggression, the Council adopted a series of
measures outlined in a Decision taken on March 17th, 2014 (Council Decision 2014/145/CFSP)
which were later implemented and amended in compliance with the legal procedure for
sanctions. To the present date, the above decision has been amended on a monthly base; the
latest amendment - the eighth - was issued on Nov 18th (Council Decision 2014/801/CFSP).
Parallel to that first Decision, a Regulation with the necessary specifications for asset freezes and
trade bans was issued on the same date (Council Regulation No 269/2014). These provisions
have been amended several times in the past months, adding new entities to the target list or
increasing the severity of the measures.
2.3 The Sanctions
In the context previously depicted, the Council was concerned with sanctioning on one
side the Russian threat to the territorial integrity and sovereignty of Ukraine, and on the other the
misappropriation of Ukrainian public property. The provisions defined the criteria for listing (last
amended by Council Decision 2014/801/CFSP of November 18th 2014), while periodically
amending the list of target entities, together with, for each entity, the specific reason behind the
listing. Lester (2014) illustrates the measures, consisting of: for natural persons, mainly travel
bans and asset freezes, whereas legal entities face a vast variety of measures, such as bans on the
trade of military equipment with the involved parties, prohibition for EU financial institutions to
provide financial services to Russian banks defence and energy companies, together with import
bans for goods originated in the Crimea/Sevastopol region, the prohibition to invest or develop
infrastructure and industry in that region, restrictions on access to European capital markets,
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restrictions on trade with regard to oil technologies, and prohibition on associated services for
the Russian oil industry.
Russia, on its part, replied soon after with a ban on food products originated in the EU.
As reported by the Financial Times, the EU - and besides, the US, Australia, Canada and Norway
- have been banned for a year from exporting meat, fish, seafood, dairy products, vegetables,
fruit, milk, to Russia (see also appendix). Threats of further measures, like protecting specific
industrial sectors or banning European and American airlines from the Russian air space have
not yet found implementation.

3. Effect of European Sanctions

3.1 The financial sector
As described in the context, according to the press office of the Council of the European
Union, the first wave of sanctions was imposed by the EU against the Russian federation on
March 17th 2014. Sanctions included travel bans and asset freezes against senior Russian and
Ukraine officials. The official list includes 119 persons, all placed in administrative positions in
Ukraine and Russia (among them there are also people from the Crimean peninsula, which were
actively involved in facilitating the Russian aggression). This first round of sanctions also lead to
the cancellation of the G8 summit, which was to be held in the Russian town Sochi. Instead, a
G7 summit was implemented in Brussels (as reported by the European Union Newsroom, all
members were invited except Russia).
All ground war activities which played a role in the destabilization of Ukraine, as a
consequence, lead to another round of sanctions by the EU against the Russian federation. The
US Department of State announced that further sanctions have been imposed by the US as well:
however, analysing in detail the effects of those measures would be beyond the scope of this
research assignment. This second round of EU sanctions, which was implemented on September
12th 2014 is still in place today. These have had a much bigger impact on the EU Russia
economic relationship because they affected the three main Russian industries. The newly
imposed sanctions have widened their scope to finance, energy and the military sector (Council
Decision 2014/659/CFSP).
As a result of the restrictive measures implemented due to the Ukrainian crisis, the five
biggest Russian banks were forbidden to obtain debt financing in the EU on long term bases. In
practice, this implied the impossibility for banks to issue bonds for their operating activities. As
consequence, the value of the Euro against the Russian rouble soared abnormally (the same
happened with respect to the US Dollar: overall, the Rouble fell by 23% in three months, as
reported by The Economist). From the aspect of equity financing one could wonder why they
have not started issuing new shares. The reason lies probably with the fact that the Russian state
is the biggest shareholder in those banks, and it may not be interested in diluting its share of
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ownership - which, for Sberbank, Gazprombank, VTB, VEB exceeds 50%, as stated by their
financial reports.
The five banks targeted by sanctions are Sberbank, VTB, Gazprombank, Bank of
Moscow (a subsidiary of the VTB Group) and VEB. Besides the ban on new issues of long term
bonds, they were also restricted from long term interbank offered financing in the EU and
suspended from services of brokerage houses.

Chart 1: Russian roubles for 1 Euro. (Source: bloomberg.com)

Chart 1 illustrates the results of those sanctions. While demand for foreign currency (in
our case EUR and USD) has increased rapidly, in the meantime, the supply of foreign currency
has dropped, causing the Russian rouble to lose 31% of its value over the past twelve months, as
reported by The Economist. The most significant drop was registered from the date of imposition
of the second round of sanctions.
This loss of value of the rouble against the Euro and the prohibition of long term
financing was also reflected in other areas of capital markets. Since the Russian government
retains the majority of ownership in banks (proof of that can be found in these institutions
financial statements), the yield to maturity as well as the coupon interest rate on government 10year bonds has surged. That meant that Russia has to pay more interests on government bonds if
they are issued. Chart 2 shows this dynamic, but it must be noted that the increase was not as
rapid as it was in the currency case.

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Chart 2: Yield on 10yr Russian government bonds. (Source: bloomberg.com)

The increase in government bond interest rates brought about a further increase in the
bank lending rate, which rose by 2 percentage points. The bank lending rate is connected to the
government coupon rate as the state is a major shareholder in the financial institutions targeted
by the measures. The faster increase in lending rates compared to government coupon rates is
depicted in chart 3.

Chart 3: Russian bank lending rate. (Source: tradingeconomics.com | IMF)

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3.2 The real market

To date, it is maybe too early to fully assess the real effects of the Roubles drop against
the Euro and the US Dollar, and these will probably take some time to show, mainly due to the
amount of wealth Russia is endowed with, in terms of natural resources. In the long run,
however, things may take a different turn. Russia is a large and populous country: it was home to
over 140 million inhabitants according to the 2012 OECD statistical profile, yet very little value
is added to GDP by agricultural activities, while at the same time total long term unemployment
reached 30% in that same year. This fact casts doubt on whether its economy will be able to
satisfy its own domestic demand. Reading from the 2012 OECD statistical profile, a significant
portion of durable and nondurable products has to be imported: the value of imports of goods
was over 300 billion USD in 2012, balanced by massive exports of goods, presumably fossil
fuels. When an importing country sees the value of its currency drop, imports will become more
costly to its nationals. The facts examined suggest this is the case, and it is reasonable to expect
most Russians will experience lower living standards in the following months, as the cost of
living increases.

Source: tradingeconomics.com | Federal State Statistics Service.

3.3 Clinging onto Natural Resources

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Chart 4: Crude oil prices time series (per barrel). (Source: bloomberg.com)

As chart 4 shows, over the last four years crude oil was selling at an average price of 104
USD, which is much higher than the average of the previous ten years. Public data shows that
until the end of 2013 Russia has been the worlds largest producer of crude oil, with
10.003.000,00 barrels per month, accounting for approximately 16% of the total world
production (Russia Crude Oil Production). In absolute terms, Russia has been earning a revenue
of around 380 billion USD every year from exporting crude oil1. Previously high oil prices
granted Russia a significant increase of foreign currency reserves (mainly in USD), a fact that is
now likely to play a major role in Moscows ability to limit the negative effects of sanctions.

Figure obtained multiplying the quantity produced by the average price over the last four years.

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Chart 5: Foreign exchange reserves of

tradingeconomics.com | Central Bank of Russia)

the

Russian

central

bank

(USD

millions)

(Source:

Having been banned from obtaining debt financing in the territory of the EU, suffering
from the drop in the value of the rouble, and with an industry facing higher interest rates for
lending, the Russian government decided to intervene through its central bank: The Economist
pointed out how over the past months the Kremlin has been buying roubles to sustain a given
level of foreign currency in the domestic market, in an effort to prevent prices from rising
excessively. This activity on the side of the central bank can be traced in chart 5. Russia spent
around 100 billion USD of its own reserves to keep currency and inflation under control, and
besides missing the goal, it ended up lowering dramatically its foreign exchange reserves. The
appropriateness of such behaviour is now being increasingly put into question, as a simplistic
look on the matter would suggest that the loss in value of the rouble will have a positive impact
on exports. However, with the exception of oil and military equipment, Russia is not a big
exporter of goods and services, and the general fall in prices of oil might erode the benefits of a
cheaper currency. Moreover, a devaluation of the rouble would become a nightmare for Russian
firms, who have some $130 million of debt payable by 2015 (The Economist). This casts the
Federations immediate future in a bad light, and would explain president Vladimir Putins
recent announcement regarding the intention to let the rouble float (Kelly 2014).
3.4 Effect of Russian Sanctions
Intending to reply to the measures adopted by the European Union and by the United
States, and pressed by the above described issues, the Kremlin has announced their set of
sanctions against EU, US, Canada, Norway and Australia. Sanctions are imposed on imports of
meat, dairy products, vegetables, fruit and milk (see detailed table in appendix).
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The total worth of the sanctions imposed by Russia on the EU has been estimated to be around
5.064 million, which accounts for 0,03% of the EU-28 GDP in 20132. Some consequences for
Russia of the implementation of such a strategy are depicted in chart 6.

Chart 6: Food inflation in Russia (Source: tradingeconomics.com | Federal State Statistics Service)

The increase in the prices of food in Russia doubled on annual level, soaring from 5,73%
to 11,5 %. This would make the sale of goods in russia even more lucrative, and that is likely one
of the reasons why, as EuroActive reported, European producers have tried to bypass the ban by
establishing joint ventures with counterparts in non EU countries such as Turkey, Serbia,
Belarus, Bulgaria or Switzerland. Out of all the above listed countries, only Switzerland has
taken an open stance against this kind of activity and actually blocked it - and it did so both
ways, also preventing Russia from bypassing European sanctions.

4. Conclusion
Summing up all the gains and losses presented in this paper both for Russia and the
European Union, and considering the high level of connectedness of the two countries, the data
available seems to suggest that the former has more to lose from trade restrictions than the latter.
No matter how are these imposed, the Russian real and financial markets will be heavily
impacted. On the other hand, the crippled European economy will be affected by counter
measures as well, but not with the same impact which Russia is experiencing. However, Europe
currently finds itself in extraordinary conditions, and refusing trade opportunities may end up
causing larger damages than under economic equilibrium. Especially since it has been shown
that Member States have heterogeneous interests at stake: some are heavily dependent on
2

The Statistical office of the European Union, Eurostat, estimated the GDP for the EU-28 in 2013 in the amount of
13,075,000 mln EUR. (2013).

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Russian fuels, while others rely heavily on exports of goods to Russia. Therefore, if the Kremlin
was to implement also restrictions on oil trade, the Member States would be hit asymmetrically,
a fact that could further propel the current euroscepticism.
At this point, it appears to be a matter of time before Russia will be forced to retreat and
come to agreements with the rest of the world, especially now that its economy is weak and
crude oil prices are plummeting. Nevertheless, there may be more in store for Moscow: a
massive player left out in this analysis is China, which has and will not remain passive.
Bloomberg reported (Paton, 2014) that on November 10th, 2014 the Russian Federation and
China have signed a gas deal worth 400 billion USD, which, besides granting China a gas supply
for the next 30 years, lessens Russias dependence on the European market. Further agreements
of this kind would lessen the interdependence of the two economies, making Russia immune to
EU sanctions while leaving European trade in shambles.

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Appendix

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Economic Policies of the European Union

23