The Big Loser in Ukraine's Rebuff of Europe? Ukraine

Ukraine could have faced a miserable winter if it hadn’t cozied up to Russia and turned its back on a trade deal with the European Union. Moscow had hinted it would tighten the screws on Ukraine’s gas supply if the EU deal went through. It has already slapped restrictions on trade with Ukraine, which now sends about one-quarter of its exports to Russia.

But in opting for short-term relief, Ukraine may have condemned itself to long-term status as Europe’s worst economic basket case.

Twenty years ago, per capita incomes in Ukraine were about the same as in nearby countries such as Bulgaria, Latvia, and Romania. No more. Ukraine is now by far the region’s poorest country (apart from tiny Moldova), with incomes averaging no more than half the level of its neighbors.

Beset by corruption and political turmoil, the country of 45 million has fallen far behind its neighbors in adopting difficult structural reforms. Now it’s paying the price. The economy is stagnating, budget and trade deficits are ballooning, and the central bank is running low on reserves.

Just last month, the World Bank cut its 2013 growth forecast to zero and warned that Ukraine faced severe risks—including further economic contraction and inflation ballooning to 18 percent by 2015—if the government did not act quickly on reforms.

Prime Minister Mykola Azarov blamed the scrapping of the EU trade agreement on the International Monetary Fund, which he said was making unreasonable demands on Ukraine in exchange for a bailout. Among other things, the IMF wants Ukraine to slash government spending and curtail gas subsidies, which would lead to higher utility rates.

With presidential elections coming up in 2015, such reforms would be “very costly politically for the current government,” says Liza Ermolenko, an economist at Capital Economics in London. What’s more, the EU has been pushing Kiev to release imprisoned opposition leader Yulia Tymoshenko, which would add to political pressure on President Viktor Yanukovych’s government.

Russian President Vladimir Putin, for his part, accused Europe of “pressuring and blackmailing” Ukraine.

While allying with Russia is an easy solution for the government, “it makes little sense long-term,” Ermolenko says. The EU trade agreement wouldn’t have produced windfall gains for Ukraine, she says. “But being closer to Europe would serve as an anchor for political and economic reform” that could help Ukraine start to catch up with its neighbors.

In the end, Ukraine could have a miserable winter anyway. Thousands of protesters took to the streets of Kiev after the government announced the scrapping of the EU talks, and opposition parties are calling for more protests on Nov. 24. A recent poll shows that 58 percent of Ukrainians want their country to join the EU. “If Yanukovych leads Ukraine into a customs union [with Russia], we will face a serious risk to the country’s unity,” Volodymyr Fesenko, head of the Penta Political Analysis Center in Kiev, told Bloomberg News.

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