by Charles Grant

Ukraine is heading for an economic crash. At least that was the message I picked up in the Crimean resort of Yalta earlier this month, at the 'Yalta European Strategy' conference. The point of this annual event is to bring Ukraine closer to the European Union. At last year's conference Gerhard Schröder and Bill Clinton dropped in; this year, Tony Blair and Mikheil Saakashvili urged Ukraine's leaders to push ahead with reforms that would speed up European integration.

But Ukraine's politicians are not listening. The two parties in the governing coalition, President Viktor Yushchenko's Our Ukraine, and the Bloc Yulia Tymoshenko (BYuT), are at daggers drawn with each other. The presidential election due in 2009 dominates politics. Yushchenko fears a challenge from Tymoshenko, who is more popular than him, and each seems to be focused on damaging the image of the other. Meanwhile, the economy is on the brink of collapse but neither politician is prepared to take the unpopular measures that would be required to stabilise it.

The political system is deeply corrupt and there are virtually no neutral state institutions: the electoral commission and the supreme court are packed with party nominees. One of Ukraine's brighter and younger politicians, Rada speaker Arseniy Yatsenyuk, was blunt in Yalta: "Our problem is a lack of political maturity, we have no standards, we don't have a clear idea how to enforce laws or penalise people, we have no strong prosecutor's office, and the judicial system is deteriorating."

Meanwhile the economy, which had picked up in the past few years, with growth of 7 per cent in 2007, faces huge problems. Inflation, at 30 per cent, is the third highest in the world, after Zimbabwe and Venezuela. The government is boosting transfer payments and public sector wages in an effort to buy political support. The trade deficit is running at 12 per cent of GDP. The government has foolishly tied the hryvnia to the dollar, which encourages hot money to flow in and fuel inflation. Ukraine's industries – predominantly metals, chemicals and food processing – are losing competitiveness. Another problem is that Ukraine is locked into one of its regular rows with Russia over the price of gas imports. If, as is likely, Ukraine ends up having to pay a significantly higher price, its gas-dependent heavy industries will suffer.

The question of NATO membership is exacerbating divisions among the political elite. The opposition Regions party, led by Viktor Yanukovich, is strongly against, while Our Ukraine is strongly for. BYuT would in theory like to join NATO in the long term, but does not want to push this for now on the grounds that it would divide the country.

In Yalta, Sergei Glaziev, a senior Russian economist and a former minister, described how Russia would react if Ukraine entered NATO: "Ukraine would lose its free trade area with Russia, we would raise gas prices, Russian companies would cut off co-operation with Ukrainian ones on high technology, and we would impose visa restrictions." That was quite moderate. Last month, at a conference in Moscow, I heard foreign minister Sergei Lavrov say that if Ukraine joined NATO, some Russians would question Ukraine's borders. Yuri Luzhkov, the mayor of Moscow, has explained what that means: Crimea should be chopped off Ukraine and given to Russia.

Such threats show that the Russians are failing to overcome their historic inability to make friends with their neighbours. Ukrainians do not like being bullied. As it happens, only about 20 per cent of them want to join NATO. But Russian threats tarnish the attractiveness of the big eastern neighbour, even in Ukraine's east, where people are naturally sympathetic to Russia. The Russians are wasting their energy when they threaten Ukraine, since there is no chance of it joining NATO in the foreseeable future. The pro-NATO Yushchenko is likely to be out of office in a couple of years, while France and Germany are determined to veto American efforts to give Ukraine a 'membership action plan.'

The question of the EU membership, by contrast, generally unites Ukrainians: easterners and westerners all want to join (Russia does not mind Ukraine joining the EU). The EU and Ukraine are negotiating a 'deep free trade' agreement, meaning one that would remove non-tariff as well as tariff barriers, and foster regulatory convergence. But many Ukrainians worry about the cost of implementing such an agreement. In order to comply with EU standards and therefore be able to export to EU markets, Ukraine would need to spend billions of dollars, say government officials. Yet EU aid to Ukraine totals only €200 million a year. Furthermore, some of Ukraine's oligarchs may resist free trade with the EU; they fear that outside competition could disrupt their cosy cartels.

Given that the EU is not offering Ukraine the carrot of a membership perspective, the political and business elites may be reluctant to embrace the – sometimes painful – reforms that would bring Ukraine closer to the Union. To his credit, France's President Nicolas Sarkozy is trying to get the EU to offer closer political links. Ukraine's deputy prime minister in charge of EU integration, Hrihoriy Nemyria, spelt out in Yalta what Ukraine wanted: "The long term goal of visa-free travel, money from the European Investment Bank, and integration into all EU agencies and programmes."

Fine ideas. But if Ukraine’s political class continues to perform abysmally, and if the economy crashes, there is little chance of the EU wanting to embrace Ukraine. Yatsenyuk told the truth in Yalta: "We're not ready for EU, we should wait five years before we try to get in. In five years there will be a new political elite in charge in Ukraine." Let us hope he is right on that last point.

Charles Grant is Director of the Centre for European Reform

by Tomas Valasek

In two months, at a summit in Prague on May 7th, the European Union will launch a new policy for Eastern Europe – an 'eastern partnership'. It will increase EU assistance to the region, open the EU’s markets to the neighbours’ goods and gradually remove visa requirements, among other things. The idea is to give the neighbouring countries stronger incentives to adopt European norms and rules, to integrate their economies with the EU's, and thus to make the region more prosperous and stable. The concept is sound – but the initiative as well as the EU’s overall policy for Eastern Europe will suffer unless the EU takes more visible steps to assist its neighbours through the economic crisis.

The crisis hit Eastern Europe hard. Ukraine’s currency, the hryvnia, lost over 50 per cent of its value, and economists warn of a possible default. Belarus, too, is in trouble. Much of the economy is driven by exports of machinery to Russia, where demand has collapsed. Armenia, another member of the eastern partnership, is in equal difficulty, and will probably need an IMF emergency loan soon.

The economic crisis poses a three-fold challenge to the EU's eastern policy. The first risk is that of rising nationalism and protectionism on both sides of the EU’s borders, which is hampering economic integration. The European Union and Ukraine are negotiating a new free trade agreement but senior EU officials say that Ukraine has become more protectionist since the crisis broke out. It insists on keeping a number of controversial tariffs, which has caused the talks to stall. The EU, too, is far less open to eastern workers and visitors these days. The member-states are unwilling to ease visa requirements for the partner states, fearing an influx of illegal workers. If the EU and its partners fail to deepen economic integration and make travel to the EU easier, the eastern partnership’s main goal – a gradual alignment of the partner states with the EU – will be in trouble.

The second risk stems from the perception that the EU is not doing enough to help the eastern partners through the crisis. President Vladimir Voronin of Moldova recently dismissed the eastern partnership-related grants as “candy”, suggesting they were not serious enough to warrant attention. He is unfair to the EU: it is not the eastern partnership's purpose to bail out the partners' economies. It has only a modest financial component; its grants amount to a few hundred million euro, and are meant mainly to help improve governance and expand people-to-people contacts. There are other tools the EU can use to assist its eastern neighbours through the crisis, like the International Monetary Fund, which recently made a $15 billion emergency loan to Ukraine. But Voronin’s words signal a broader problem for the EU’s eastern policy: the EU is not perceived to be helping its eastern neighbours; they see the IMF but not Europe. And perceptions are important: if the EU’s eastern partners think that the EU is failing them at the time of their greatest need, most of the goals of the eastern partnership will come to nought.

The third risk relates to the economic weakness of many new EU member-states in Central Europe. It is they who, along with Sweden, have most strongly advocated greater EU engagement with its eastern neighbours. And in the EU, which has many diverse members and interests, an initiative only succeeds when a strong state or a group of states devote serious time and attention to winning EU-wide support for it. But will the new member-states push for more financial assistance for Eastern Europe? It could mean keeping less of the much-needed money for themselves, and that is a tough political decision to make. Will they have the energy to fight the political battles in Brussels with EU governments less interested in Eastern Europe? Some new member-states like Latvia are reducing diplomatic staffs across Europe, and they will find it difficult to pursue multiple foreign policy goals simultaneously. Also at risk are the myriad of small grants which the new member-states' governments give to non-governmental groups in the neighbouring countries, and the training programmes they organise for East European administrators or journalists. These programmes are just as important as the eastern partnership itself: they expand the circle of people in the Eastern Europe who have a vested interest in closer relationship with the EU. So it matters that these activities are now at risk because of recession-related budget cuts.

The economic crisis represents a crisis of sorts for the EU's eastern policy. But there are ways of minimising the damage or even turning a problem into an opportunity.

Some EU government-financed initiatives for eastern neighbours will no doubt fall victim to the economic crisis. But instead of all Central European governments cutting all their training or advisory programmes, they should pool some of the initiatives. For example, rather than recalling advisors who are helping to reform key Ukrainian ministries, the new member-states could agree to withdraw some and co-finance the remaining ones. The same should apply to training programmes in the EU for East European administrators and to the very useful conferences organised in Latvia and Estonia to raise the profile of the EU’s eastern initiatives: some will be cut but there ought to be ways to share resources to save the remaining ones.

The top priority for the EU’s eastern policy, however, must be to take steps to more visibly help its eastern neighbours through the economic crisis. It is simply not true, as president Voronin suggested, that European aid to the east is peanuts – the IMF, in which EU member-states play a strong role, gave a $15 billion loan to Ukraine, and a further $2 billion loan to Belarus. The trouble is that the EU as such is not getting the credit. And in the eyes of the Eastern Europeans, the EU’s perceived stinginess compares unfavourably with the far greater amounts which Russia is willing to spend on bailing out Eastern Europe (it set aside $7.5 billion for the task).

The situation calls for creative solutions. The EU should not compete with the IMF in providing balance-of-payment loans directly to governments: the IMF has a better capacity to raise the necessary funds and to oversee the reforms, which the recipient states undertake in order to qualify for IMF loans. But the EU could expand its €25 billion emergency fund for the new member-states to include the eastern neighbours as well. And it should use the money to co-finance IMF assistance with targeted loans or grants to soften the social impact of the economic crisis. For example, it could finance job retraining programmes in Belarus or Ukraine.

The EU should also speed up the payment of its eastern partnership grants. They are small compared to the amounts disbursed through loans but if targeted well, could have real impact. The EU should direct them towards helping the most vulnerable parts of East European societies and towards regions hardest hit by the crisis. There is a real risk that some of the money could be misdirected or stolen – the ability of East European government to properly ‘absorb’ EU aid is in question. But EU officials have worked with the eastern neighbours for many years now; they have a good idea which parts of their administrations are competent and which are corrupt, and can reduce the risk of theft by targeting the aid carefully.

Building EU-wide support for these proposals will not be easy. All EU governments, including the most prosperous ones, are going to run up massive debt in the coming years. Money will be in very short supply, so the member-states will be reluctant to expand assistance to Eastern Europe. Also, the EU is getting fed up with Ukraine in particular, because the leadership is so weak and divided – the IMF even halted the disbursement of its loan because the government in Kyiv failed to agree the necessary reforms. And because Ukraine has been at the heart of the eastern partnership, its woes undermine support among EU member-states for the whole region.

But the EU has no choice but work with Ukraine; it is the largest and most important country in the eastern partnership. And while the economic crisis will consume most European effort and attention; the EU must be able to pursue different objectives simultaneously. The economic crisis creates an opportunity for the EU's eastern policy. Ukraine and other neighbours will be looking for help to stave off the crisis and lessen the social tensions it will create. The EU should become 'the friend in need', and built lasting loyalties.

Tomas Valasek is director of foreign policy and defence at the Centre for European Reform.

by Katinka Barysch

It is 20 years since the Berlin Wall crumbled and political and economic freedom started spreading through Eastern Europe. Today, however, the region is mired in deep recession. The global economic and financial crisis has hit the Central and East European countries (CEECs) harder than any other emerging market region. In February 2009, I asked whether the savage downturn would make the new EU member-states question their entire transition model of trade opening, financial integration and EU-conforming reforms (‘New Europe and the economic crisis’ http://www.cer.org.uk/pdf/bnote_new_europe_feb09.pdf). This has not happened. Dire predictions did not come true: financial systems did not collapse, the steep fall in exports and industrial output has bottomed out and there has been no mass social unrest. Most people, inside and outside the region, seem to agree that the CEECs need to recalibrate their growth model, rather than ditch it. The crisis may harbour some valuable lessons on how to go forward after 20 years of transition.

The fact that the CEECs had sold almost their entire banking sectors to big finance houses from Austria, Belgium, Germany, Italy or Sweden turned out to be a mixed blessing. During the boom years, financial integration did help the CEECs to grow faster (which is not true of all emerging market regions). When the crisis hit, West European banks did not withdraw all funding from their CEE subsidiaries overnight or let them go bankrupt, as many had feared. These subsidiaries did stop lending, as their parent banks scrambled to rebuild capital – but so did local banks.

There were no big banking crises in Eastern Europe. The hastily assembled ‘Vienna initiative’ – a club consisting of pan-European banks, the regulators of the countries in which they operate and international organisations such as the EU and the World Bank – helped to prevent a run for the exit that could have resulted in financial meltdown. The €25 billion put up by three multilateral lenders in support of ailing CEE banks also helped.

The EBRD, in its latest ‘Transition Report’, claims that countries with a higher share of foreign bank ownership did relatively better in the crisis than those with shaky local institutions that relied on short-term liquidity from abroad. However, the EBRD report also admits that the presence of foreign banks fuelled unsustainable credit booms and brought shoddy lending practices to the CEECs, such as giving mortgages in euros or Swiss francs to people without thorough credit checks.

The crisis showed that home country supervision – the basic principle of EU financial market integration – needs to be improved. The authorities of say, Sweden and Austria, did not pay enough attention to what their banks were getting up to in Latvia or Hungary. Some economists think that this will change now that Swedish and Austrian taxpayers are footing the bills for bank bail-outs abroad. But others argue that only stronger cross-border banking regulation and supervision can prevent similar trouble in the future. At the same time, the governments and regulators of the CEE host countries need to work harder to strengthen local capital markets. For example, unhedged foreign-currency denominated loans are a lousy idea as long as exchange rates are not irrevocably fixed.

Eastern Europe’s exceptional openness to trade was a blessing while global growth was strong. But it also left the region vulnerable. No fiscal stimulus programme would have been big enough to compensate for the collapse of eurozone demand in countries where exports typically account for 50 to 80 per cent of GDP. What is more, the crisis highlighted that some of the new EU members had focused rather too much on one industrial sector – cars. Around half of export revenues and up to 20 per cent of value added is generated by the automotive industry in the Central European countries.

Several car factories in CEECs shut down in late 2008 and early 2009. For a while it looked as if the new members might be the losers from a subsidy race among the bigger, richer EU countries. In the end, however, countries such as the Czech Republic and Slovakia benefited from the scrappage schemes that Germany, Austria, France and other West European countries implemented to boost domestic demand. Single market rules held: these schemes did not discriminate in favour of vehicles made at home. The WIIW, a Vienna economic research outfit, even claims that those CEECs that rely most on exports of machinery and cars have suffered milder contractions.

Most countries are now phasing out their ‘cash for clunkers’ schemes, which will translate into lower demand for vehicles made in Eastern Europe. In the medium term, the need to cut costs and overcapacity in this sector worldwide could work in the CEECs' favour as the big car makers will continue to relocate production to countries with low unit labour costs.

Nevertheless, the economic crisis has served as a reminder that the CEECs need to diversify their industrial structures. Wedged between a high-tech Western Europe and a low-cost Far East, there is only one way to go for the CEECs: move up the value chain. To do this, these countries need to improve their education and training systems, make their markets work better and encourage innovation and entrepreneurship.

Such reforms are needed more urgently than ever now that global competition for capital and markets has become fiercer. The EBRD, which tracks economic change across Eastern Europe, finds that there have been few instances of reforms unravelling since the onset of the crisis; but it also finds that there has been little noticeable progress towards better-functioning market economies. So far, populism has been contained in Eastern Europe. But with lay-offs still rising fast, and governments too cash-strapped to do much about it, the elections due in many CEECs in 2010 and 2011 could result in governments promising protection rather than explaining the need for economic change. The risk remains that the CEECs will draw the wrong lessons from the crisis and endanger the economic success of the last 20 years of transition.

Katinka Barysch is deputy director of the Centre for European Reform.