171 ESCEW 06 E - TRANSITION IN UKRAINE

TABLE OF CONTENTS

I.  INTRODUCTION 

II.  POLITICAL DEVELOPMENTS: GOVERNMENTAL CHANGE AND THE ENERGY DIMENSION 

III.  THE ECONOMY 

IV.  PRIVATIZATION 

V.  TRADE AND UKRAINE'S POSITION IN THE GLOBAL DIVISION OF LABOUR 

VI.  UKRAINE'S RELATIONS WITH EUROPE 

VII.  UKRAINE'S RELATIONS WITH THE UNITED STATES, CANADA AND NATO 

VIII.  UKRAINE'S RELATIONS WITH RUSSIA AND THE ENERGY PROBLEM 

IX.  CONCLUSIONS 

X.  BIBLIOGRAPHY 

I. INTRODUCTION

1.  Bismarck reportedly once said of post-Risorgimento Italy that it was little more than a "geographical expression", implying that the national identity of this new European power was somehow suspect. There have been moments when both Russia and the West have appeared to characterize Ukraine in somewhat similar terms. Certainly Ukraine's post-secession failure to launch a genuinely democratic and market-oriented transition seemed to reinforce this rather dismissive view.  For the first decade of Ukraine's post-Soviet national experience, the West seemed to have paid more lip service to Ukraine's European vocation than to have reinforced it. Until recently the West had never fully embraced Ukraine as a potential partner, while many in Russia had never reconciled themselves to genuine Ukrainian independence.  The Orange Revolution and its difficult aftermath, however, have forced many to re-examine the assumptions about Ukraine that they long harboured.

2.  Although western politicians appear not have focused great attention on developments in Ukraine over the past decade, the stakes in Ukraine's transition are now generally understood to be rather high.  Indeed, last year's Orange Revolution affirmed the existence of a genuine democratic impulse in Ukraine, something that certainly had been present in the early years of the transition, but which had never been given a chance to fully express itself.

3.  Although the states of Central Europe were offered the prospect of membership in the EU and NATO as an ultimate reward for the diligent pursuit of democratic and market reforms, no such offer was seriously extended to Ukraine after it declared independence, and this has rendered its transition all the more trying. This reluctance to embrace Ukraine as a potential member of the Western and European family of nations tended to strengthen the hand of those in Ukraine who actually did harbour deep suspicions of the West. Western scepticism thus may well have become a self-fulfilling prophecy.  After a decade of independence, liberal democratic reformers had very little to show for their efforts, and an unhealthy pattern had been unleashed that ultimately widened the gap between the democratic aspirations of many Ukrainians and the reality of daily life.

4.  Moreover, many in the West have long refused to recognize their own strategic stakes in Ukraine's democratic evolution.  Ukraine is a large and potentially prosperous country given its rich natural endowments, strategic location and well-educated population. In some respects, it is more a mis-developed country than an under-developed one.  If it were more deeply integrated in the democratic club of nations, Ukraine could become a vital source of stability in Eastern Europe and a genuine contributor to the prosperity and well being of Europe as a whole. A weak, non-democratic and economically faltering Ukraine, however, poses a series of strategic quandaries that could undermine regional stability. It is hardly surprising, therefore, that countries like Poland, Estonia, Latvia and Lithuania, each of which has been highly successful in orchestrating their own economic and political transition within a Euro-Atlantic framework, have taken a particular interest in Ukraine's transition. They have urged their European partners to engage more closely with Ukraine and have themselves made this a priority of their respective foreign policies.

5.  The concerns of Ukraine's western and northern neighbours are not misplaced. Some have even argued that a democratic and independent Ukraine could even help condition the democratic evolution of Russia itself, (Rihard Piks) while a weak Ukraine would constitute a strategic vacuum in the very heart of Europe.  Some might even see it as a standing invitation to the revival of a kind of greater Russian empire characterized by a decidedly undemocratic orientation. A strong and democratic Ukraine, so the argument goes, would help squelch any revanchiste temptations in Russia and allow Ukraine to serve as a model for other struggling former Soviet Republics including Moldova and thoroughly undemocratic Belarus. It would create a new zone of economic dynamism in Eastern Europe, and its own successes would have munificent spillover effects in political, economic and strategic terms. Thus the stakes in Ukraine's democratic transition are high indeed.

II. POLITICAL DEVELOPMENTS: GOVERNMENTAL CHANGE AND THE ENERGY DIMENSION

6.  Ukraine's post-Soviet political evolution has been slow and painful. The early years of independence were marked by the prominent role played by former Soviet apparatchiks and the persistence of governmental structures, practices and elite attitudes that were antithetical to the development of a modern democracy.  Although Western governments initially greeted Leonid Kuchma's election with warm enthusiasm, this quickly waned because of the persistence of undemocratic practices in what was formally a democracy. These included pervasive corruption, uncontrolled security forces and the use of intimidation and even violence against government opponents. In 2000, Transparency International characterized Ukraine as one of the most corrupt countries in the world, placing it in 88th position out of the 90 listed countries. (Woronowycz)  Even then, in 2004 and 2005 Freedom House rated the quality of Ukraine's democracy at 4.5 on a scale of 1 to 7, with 1 being the highest. (Soloneko)  Its most recent report asserted that it was the freest society in the former Soviet Union outside of the Baltic States and that the trend lines for both political and civil freedom were positive. (http://www.eng.fora.com/news/2006/09/08/140347.html)

7.  The Orange Revolution clearly marked a seismic shift in Ukrainian politics and a fundamental democratic breakthrough. The Yushchenko administration that emerged from these events promised a broad new agenda focused on macroeconomic stabilization, institutional transition, greater integration with the EU and the global marketplace. (Tiffin)  Over the past year, there was a clear improvement in human rights, media freedom and the general openness of the society despite persistent coalitional instability, ongoing corruption problems, the government's failure to initiate a transition agenda and the electoral setback the Orange coalition suffered in recent elections.

8.  The Orange Revolution also ushered in a significant shift in Ukraine's foreign policy. This was quickly reflected in its increasingly friendly relationship with the EU and North America, mounting tensions with Russia and unambiguous pronouncements by government leaders on their commitment to full integration in Euro-Atlantic institutions - goals that the previous Ukrainian government first articulated in 2002. That these changes unfolded at a time when Russian democracy appears to be weakening could become a more serious source of tension in the coming years, but it has unambiguously raised the stakes in the outcome.

9.  For all the positive developments arising out of civil society's powerful demand for democratic accountability, the past year can hardly be characterized by marked political constancy.  Indeed, the situation has been anything but stable. President Yushchenko sacked his erstwhile ally, then Prime Minister Yuliya Tymoshenko, in summer 2005 due to her government's poor handling of the economy and the sense that many of Tymoshenko's allies were aiming to acquire assets previously controlled by Kuchma's supporters through re-privatization. (Kaminiski, December 20, 2005) Tymoshenko had indeed called into question many of the previous government's privatizations - a tactic that while emotionally understandable nevertheless exercised a chilling effect on investors and a divisive effect on the governing coalition.  Tymoschenko had promised to review over 3,000 privatizations, and there were simply no coherent laws to regulate the process.  (NATO PA Secretariat Report, Warsaw, Poland, April 27-28, 2006) The new government of Yury Yekhanurov subsequently provided an important degree of reassurance to a somewhat shell-shocked business community.  But, from the outset, it was operating on borrowed time.  Elections this past spring ultimately brought the opponents of the Orange Revolution back into government, but on terms that, at least on paper, keep alive many of the Orange Revolution's democratic principals. The extent to which these will be defended, however, remains to be seen.

10.  Energy disputes with Russia further undermined Ukraine's political stability by widening internal divisions. The political knives were already being sharpened for last spring's campaign when the government announced that it had agreed to Russian demands to double the price of imported Russian gas. Under a 2001 deal, Gazprom had agreed to sell significant amounts of natural gas to Ukraine at US$50 per thousand cubic meters in return for discounts on fees charged by Ukraine to use pipelines carrying gas to Western Europe.  80% of Russia's gas exports to Western Europe course through pipelines in Ukraine.  In December 2005, Gazprom suddenly demanded that the rate be raised to US$160 and then US$230 while also threatening to cut off shipments as of January 1, 2006 if Ukraine did not accept these terms. (White, December 19, 2005)  Under the final compromise, Ukraine was to buy the Russian (and Central Asian) gas for US$95 per 1,000 cubic metres on average from the Swiss-registered trading company RosUkEnergo, which is half-owned by Gazprom. Gazprom, in turn, was to sell Russian gas to RosUkEnergo for US$230, but the company would also supply Ukraine with much cheaper gas from Turkmenistan.

11.  The final settlement increased prices for Ukrainian households by 30% and allows Russia's gas monopoly to raise prices again this year. (Myers, May 13, 2006) That deal also conferred a gas supply monopoly to a shadowy trading company, RosUkEnergo, whose secretive part-owner, Dmytro Firtash, has been accused of maintaining ties to one of Ukraine's most notorious criminals, Symon Mogilevich, who himself is under indictment in the United States on racketeering, securities fraud, money laundering and other charges. (Tom Warner, "Under scrutiny: how the trade at the centre of Ukraine's gas dispute faces questions about his past", Financial Times, July 14, 2006) 

12.  Needless to say, the public reacted with dismay to the deal the government came to with Gazprom last year, and it was certainly a factor in the government's growing unpopularity during the run-up to the elections.  One of the most vociferous critics of the deal came from within the Orange Coalition. Yulia Tymoschenko used the issue to distance herself from her erstwhile allies in the Our Ukraine party.  Pro-Russian forces suggested that they would have been better placed to negotiate a fair deal with their friends in Moscow. In any event, soon after the terms became apparent, the parliament dismissed the government of Yuri Yekhanurov for what government opponents characterized as its betrayal of Ukrainian interests.  That same cabinet, however, subsequently accepted a mandate to serve three months in a caretaker capacity until the March elections. 

13.  In fact, the burgeoning political crisis was far more about the coming elections than gas prices. Ukraine had enjoyed very little leverage in the talks with Russia. It might well be that Russia's demands were partly timed not only to jack up Russian revenues by aligning gas prices with world market prices - certainly a legitimate ambition insofar as this did not violate previous agreements - but also to bolster the leverage of certain political forces closer to Russia who, as suggested above, claimed to be better positioned to renegotiate gas prices with their Russian friends. (Buckley, Warner) Some of those forces were able to capitalize on public disappointment with the sudden price hike in order to gain political advantage.  Tensions between Russia and Ukraine have an obvious domestic component in a country in which 67% of the population is Ukrainian-speaking and 24% speak Russian at home. (OSCE)

14.  This political drama unfolded at the same time as important constitutional amendments were taking effect in Ukraine.  The new constitutional order shifts some domestic powers away from the presidency and accords much of these to the parliament. (The president retains important prerogatives in foreign and defence policy.) It thus strengthens the hand of the prime minister, and accordingly this raised the stakes in elections last March.  Ukrainian society now confronts a situation in which the loser of last year's presidential elections, Victor Yanukovych, has been selected to head the government and his powers will rival and possibly exceed those of the president.  This makes an important and surprising political change.

15.  As of January 1, 2006, the cabinet became accountable to the parliament rather than to the president.  This aligned Ukraine with the constitutional norms of a number of Central European states, but the sudden change sowed a measure of institutional confusion and almost immediately changed the dynamics of the Orange Revolution. 

16.  These constitutional changes meant that the stakes in the March elections were terribly high, particularly in a country which is so clearly split between forces that want deeper integration with the West and rather liberal economic reform, and those who look to Russia as Ukraine's most important interlocutor and as a potential political, social and economic model. Doubtless for some industrialists the political battle was also about the spoils of political power. Indeed the patronage game has done its part to harden divisions in a politically and economically divided and still fragile society.

17.  Although the initial outcome of the March elections was political deadlock, the conduct of those elections nonetheless suggested a strengthening of the country's democratic institutions. All parties appeared to accept the rules of the game, and international observers reported a clean and open voting process. This is a hopeful sign and one that has been seen elsewhere in formerly Communist Europe. The ouster of undemocratic forces in countries like Slovakia and Croatia, for example, resulted not only in more democratic governments, but also the rise of more democratically oriented opposition forces, even though some of these groups were once associated with authoritarian forces.  The risk in Ukraine lies in the potential instability in the new governing majority, and in the still real possibility that some groups in Ukraine may be tempted to unravel the democratic gains of the past year. 

18.  The election results were, in fact, a signpost of these profound divisions. Not surprisingly, no clear winning coalition emerged.  Viktor Yanukovych's Party of Regions secured 186 of the parliament's 450 seats while the Tymoshenko bloc garnered 129. Mr. Yushchenko's Our Ukraine party finished third in the voting, winning only 86. Four months of political uncertainty and turmoil ensued as the competing coalitions manoeuvred to forge a viable political majority. The always-shaky coalition between Our Ukraine, the Tymoschenko bloc and the Socialists collapsed in July. When the Socialist Party led by Oleksandr Moroz agreed to abandon the Orange coalition and to join a coalition with Yanukovych's Party of Regions and the Communist Party, the impasse was effectively broken.  The president simply had no legal options left and agreed to charge Mr. Yanukovych with the task of forming the new government. (Kramer, August 3, 2006)  Finally, in early August, Ukraine's parliament approved Mr. Yanukovych as prime minister with the support of 273 of the 296 deputies present. This was a comfortable majority, although, perhaps ominously, 154 parliamentarians, many from Tymoshenko's party, boycotted the session.   Mr. Moroz was awarded the speakership of the Rada.

19.  Yanukovych's selection to head the new government marks a rather improbable comeback for a figure who, some believed, had sought to rig the 2004 presidential elections in his own favour - a perception that sparked the Orange Revolution in the first place.  His selection marks an important setback for the leaders of the Orange Revolution, but many independent analysts suggest that the outlook may not be nearly as dire as some might claim.

20.  In the first place, one of the hallmarks of a solid democracy is its capacity to manage the alteration of power. Although forming a government took four torturous months, what was once an opposition coalition has now formed a government in an explicit alliance with the Socialists who broke ranks with the Orange grouping, and in a tacit alliance with the leader of the Orange Revolution, President Yushchenko.  Addressing the parliament just prior to the vote, Mr. Yanukovych noted that the parliament would be voting for "actual unification of two teams, which have been standing on the opposite banks of the Dnieper over the past two years".  The president made similar remarks in justifying his support for the new government. (Myers, August 5, 2006) From this perspective, the new government could manage to bridge some of the more profound fractures in Ukraine's political culture - fractures that until recently were responsible for mounting instability and political paralysis.

21.  In fact, Ukraine could not have tolerated further political stasis. Decision-making in Kyiv had effectively ground to a halt, and the state apparatus was simply not functioning.  With a government in place that must coexist with a president from the opposition, Ukraine might, at least, enjoy a period of stability. The government and the president are positioned to build bridges in a bitterly divided country, and this could create a common foundation for reform.  Any reform agenda will likely be less ambitious than many proponents of the Orange Revolution would have liked, but they might take solace from the fact that the new prime minister has accepted, at least nominally, that Ukraine should continue to seek closer ties with the West.  Mr. Yanukovych also represents a group of eastern industrialists who are, at the very least, interested in broadening their own markets. This could provide the foundation for further market reform. (Peel)

22.  The agreement hammered out between the president and the new prime minister also calls for continued co-operation with NATO. Mr. Yanukovych, whose campaign sometimes took on an anti-NATO tone, has said he wants the decision ultimately put to a referendum. Given the public's antipathy toward NATO, such a referendum would certainly fail were it to be held in the current environment.  Proponents of NATO accession argue that this could change if the public were better informed about the role and function of NATO.  Some government critics openly question whether the new government will even seek an informed debate.  But Mr. Yanukovych's tone has been changing, and he has suggested that the government needs to inform society and engage in more joint projects with NATO. (Forum, www.eng.for-ua.com/news/2006/09/06140938.html)  The parliament recently passed a law permitting joint military manoeuvres on Ukrainian territory in co-operation with NATO. (Olearchyk) So far, the government appears to be approaching the issue with pragmatism.

23.  The new government is also keen on improving relations with Russia. Russian President Vladimir Putin broke protocol by inviting Mr. Yanukovych to join heads of state from the Eurasian Economic Community for a summit meeting in Sochi, even though Mr. Yanukovych is not Ukraine's head of state. Mr. Yanukovych, in turn, has promised to put an end to illegal gas siphoning from Russia's export pipelines, a practice that angered Russia and also left Western Europe vulnerable to Russian retaliation, as occurred last December.

24.  Among the other controversial issues that the government will need to address in the coming months are WTO membership, the privatization of state-owned firms and property, and the sale of agricultural land. All of these have bitterly divided the political class in recent months and the new government will have to manoeuvre delicately to move on any of these fronts.

III. THE ECONOMY

25.  Ukraine has often been characterized as an economy of great potential and failed expectations.  It boasts a skilled, well-educated and relatively low cost though not highly productive labour force; it is certainly well endowed with a range of raw materials; and, it is situated in a strategically important crossroads bordering Russia, the Black Sea, and Central and South-eastern Europe. Ukraine's extraordinary fertile farmlands could theoretically serve as a "breadbasket" for Europe if Europe were to open its food markets to Ukrainian grains, and if Ukrainian farmers had access to investment capital and know-how and were encouraged through government policy to engage in best practices. That is a daunting list of "ifs".

26.  There is, of course, a range of barriers to exploiting Ukraine's myriad potentialities. Most of these relate to institutional and regulatory problems, which have been evident since the early years of Ukraine's transition.  The country is hampered by the absence of strong market-reinforcing institutions such as the rule of law, secure property rights, enforceable contracts and a transparent state capable of mediating conflicting interests in a judicious manner. A recent World Bank report asserts that Ukraine has operated well below maximum efficiency largely because of shortcomings on these fronts. These problems have been more serious for CIS countries than for those of Central Europe and the Baltic States. Over the course of the 1990s, Ukraine confronted great difficulties replacing the old central planning model with market-based alternatives.  Too much economic activity was focused on rent-seeking rather than productive initiatives. Despite inflows of investment funds, Ukraine's output contracted until 2000. (Tiffin) Its growth since then can be linked to an increase in competitiveness, the onset of more solid reforms, the strong economic recovery of its important trading partner Russia, and rising Asian demand for its steel and other commodities. 

27.  Like many transition economies, Ukraine underwent a serious economic contraction in the early years of its transition.  This contraction finally halted in 1999 and was followed by a five-year economic recovery during which growth averaged 8.4%, although admittedly this increase began from a low base after years of economic contraction.  (Blanke) The government, first under the leadership of Mr. Yushchenko, undertook a serious round of general macro- and microeconomic reforms that helped kicked off this growth. (Karatnycky) Although Yushchenko was forced out of office in 2001, growth accelerated during the government of Mr. Yanukovych that followed.  By 2004, the rate of growth had accelerated to double digits, only to fall precipitously in 2005 due to political uncertainties in the wake of the Orange Revolution, the new government's express desire to renationalize recently privatized firms, and certain price administration policies that sent out distorted signals to the economy. (Borys Tarasyuk)

28.  Macroeconomic conditions were also relatively stable during this period, with inflation under control at least until 2002.  Since then, there has been a degree of price volatility, in part driven by high external demand, looser fiscal policies, and because the Central Bank has pursued too many monetary targets with a limited number of tools. Mounting pressures on the national currency over the last year can be linked to gas price hikes and declining world steel prices-a commodity that accounts for 40% of Ukraine's export earnings. The Yanukovych government will confront pressures for greater investment spending and will have to make several tough budgetary decisions as a result. Privatization and foreign lending will help generate some of these funds but Ukraine's fiscal house still needs to be put in order. (The Economist Intelligence Unit Limited, January 2006)

29.  As suggested above, the introduction of a range of economic reforms was clearly instrumental to revivifying economic growth. These first generation reforms ended the system of barter payments and arrears in the energy sector that had greatly facilitated corrupt business practices within the very heart of the state. (Karatnycky)  They fostered a modicum of financial transparency and resulted in more efficient resource allocation. Capital and labour have since moved from less to more productive factors of production, although Ukraine's gradualist and partial approach to reform has slowed down this essential reallocation process. Rigged privatizations, some of which were little more than asset giveaways, prevented the private sector from making more substantial contributions to productivity gains.  (Brown and Earle) Some studies have demonstrated that Ukraine underwent the largest drop in average labour productivity of all transition countries due to efficiency deterioration and massive under-utilization of existing capacities. One study covering the years 1992-2000 revealed that Ukraine's private companies on average were not only more efficient than state-owned firms but also operated more effectively than companies with foreign participation. Indeed foreign firms operating in Ukraine pay a particularly high price when they lack local knowledge in such an opaque economic environment. Those without such knowledge probably confront daunting entry barriers because of excessive bureaucracy and corrupt practices.  (Zelenyuk)

30.  The Tymoshenko-led government that took the reins after the Orange Revolution promised to build on the reforms that had been somewhat hesitantly introduced over the previous five years. But it was exceedingly slow off the mark, and historians will likely focus on the many missed opportunities to enact structural change. In its "Doing Business-2006" Survey, the World Bank ranked Ukraine 124th out of 155 countries in terms of the climate in which business is conducted, well below Russia, Moldova, Kyrgyzstan and Kazakhstan.  Its highest marks were in the area of contract enforcement, credit access and trade. Ukraine's ratings were notably low in property registration and investor protection. Ukraine's tax regulations have remained among the most complex in the world, with Ukrainian firms spending on average 2,185 hours simply to complete the forms needed to put them in compliance with existing tax laws. (http://www.doingbusiness.org)

31.  The persistence of clan-like networks coursing through the public and private sectors in regions like Donetsk also hinder the transition process.  The fact that the party of the new prime minister, Viktor Yanukovych, is a key player in the Donetsk political-industrial complex points to the persistence and power of these structures and could, in itself, act as a break on reform. Personalized networks linking the region's vertically integrated coal, electricity, steel and financial sectors to the regional and national government are hardly ideal for building a more transparent and competitive market. Firms like System Capital Management, which is largely owned by Rinat Akhmetov, one of the wealthiest businessmen in Donetsk and a strong Yanukovych supporter, operate sub-optimally by engaging in a plethora of rent-seeking activities - such companies have prospered on a steady diet of shadowy privatizations and asset stripping.  Whether these firms will be exposed to rigours of open competition and subject to the scrutiny of international accounting standards over the coming years remains an open question. The persistence of these structures and practices has deprived the Ukrainian people of deserved tax revenues and a more efficient and competitive private sector. (Zimmer) But the proof will be found in the pudding. Ukraine's new leaders can ensure greater stability, predictability and transparency by opening up markets and by exercising genuine oversight over these financial and industrial groups. The current structures are not going to help Ukraine's industrial firms compete globally over the long term. 

32.  Ukraine's current account surplus has fallen steadily since achieving a US$ 6,804 million peak in 2004. Indeed, the trade balance turned negative in 2005 due to rising wages and falling steel sales, both of which adversely affected the terms of trade and currency appreciation.  The central bank has allowed the Hrvina to appreciate in order to brake inflation, but this has inevitably raised Ukrainian export prices. (NATO PA Secretariat Report) In the third quarter of 2005 the current account registered a US$200 million deficit and this certainly worsened due to the doubling of gas prices.  This winter, expected increases in domestic investment spending could put further pressure on the current account over the next two years, although the repatriated earnings of Ukrainian workers and pipeline fees will help compensate by bolstering the service sector surplus. There are strong pressures from the steel and commodities sectors to devalue the currency. This will help exports but it could also unleash inflationary pressures.

33.  Germany is currently the leading investor in Ukraine, while Russian investment is surprisingly low, at least in official statistics.  Cyprus and the Virgin Islands are also leading investors, which is indicative of how money from the grey economy is being recycled back into Ukraine. The grey and black market could account for as much as 40% of GDP. Russian money is likely mixed into these grey and black accounts and this may explain why the official figures seen surprisingly low. (NATO PA Secretariat Report)

34.  There remains a litany of other structural problems that are impeding Ukraine's economic development.  Corruption remains endemic and imposes a very high burden on the business sector. Ukraine's legal and judicial system is still unreliable, and legal transparency and reliable court systems are needed. Their absence weakens contract enforcement, undermines property rights and thus leaves investors very wary.  The police and secret services have also been a burden on Ukraine's business climate, while tax collection remains arbitrary and highly inefficient - a condition that infuses the business climate with uncertainties that discourage investment.  All of this constitutes a daunting entry barrier for start-up companies that will be needed to sustain a genuine national economic takeoff.

35.  The post-Orange Revolution government had begun to address some of the problems before political uncertainty and election campaigning put reforms on the back burner. It had initially made reform of the police and security sectors a priority. These reforms, along with promised transparent privatization schemes, improved relations with the EU. Progress in negotiations for WTO membership had begun to reassure foreign investors who greatly prize stability and transparency. As a result of ongoing negotiations, Ukraine had begun to align its trading rules with WTO norms, although work is still needed in areas like standards, intellectual property rights and agricultural subsidies.  The state must also reinforce its capacity to deal with trade issues across ministries and the branches of government, while ensuring that the slate of trade-related laws recently passed are fully implemented.  It will also need to effect administrative and institutional improvements to benefit from the kinds of market access WTO membership will accord it. (Transition, July-September 2005)

IV. PRIVATIZATION

36.  The government that took the reigns after the Orange Revolution was quite determined to move away from the legacy of the Kuchma years. Privatizations undertaken during the Kuchma period were characterized by a lack of transparency and, in a number of notable cases, extraordinarily blatant cronyism and outright corruption.  This was hardly unique to Ukraine, and similar problems have been evident in a number of CIS countries. In Ukraine's case, privatization in the metallurgical, chemical and energy generation sectors were highly suspect to say the least. The desire to correct past mistakes was thus strong and in many ways perfectly justifiable.

37.  The problem, however, was that by calling a broad range of privatizations into question, the Tymoshenko government triggered an alarming degree of uncertainty in the economy and a crisis of confidence in property rights.  Doing so is particularly dangerous in a transition economy.  The resulting plunge in investor confidence was perhaps the most important reason that Ukraine's rate of growth fell from 12% in 2004 to 3% in 2005. While poorly executed privatizations are highly lamentable, seeking to reverse them can have even worse consequences. Doing so opens the entire private sector to doubts about the legal foundations upon which their businesses rely. (Aslund, Beyond Transition, July-September 2005) In such an uncertain climate, investors will simply hold back until they are assured that an assault on private property is not in the offing. It hardly helped that Ms. Tymoshenko, in full populist mode, was not only questioning a range of privatizations, she was also launching ad hominem attacks on key parts of the business sector. Some analysts saw this as a strategy to re-nationalize firms and to sell them back to business leaders close to Tymoshenko, hardly the kind of image an ostensibly reform-minded government wants to project. The effects on the business climate were predictable and unwelcome.

38.  The post-Orange Revolution debate over privatization, combined with the absence of a strong juridical system, thus severely dampened investment activity last year. The investor community simply horded cash and waited for a climatic shift. This partly transpired when Yushchenko dismissed Tymoshenko. The new government then decided that there would be only one outright re-nationalization and resale of a steel firm that had been sold off in a blatantly illegal fashion and on terms clearly detrimental to Ukraine. The government also stated that there would be limited renegotiations on the price paid for certain public assets sold off at outrageously low prices with the promise that there would be no more re-privatizations as such. (Economist Intelligence Unit Limited January, 2006) In fact, many analysts believe that this re-sale of the Kryvorizhstal steel plant to Mittal has been a great success. It was not only open and transparent but it also brought US$4.8 billion into state coffers.

39.  The investor community greeted the government auction of Kryvorizhstal and generally saw it as fair and fully open to international participation.  The Kryvorizhstal case may have established an important new precedent. Ukraine still has significant assets to privatize in the energy, telecommunications and infrastructure sectors. If these assets can be sold off in the same transparent manner as Kryvorizhstal, Ukraine stands to partly compensate for the rather dodgy privatizations previous governments carried out.  How the new government manages this challenge will thus be critical to the country's transition. There will doubtless be a great deal of scrutiny both domestically and internationally of any further privatizations. These will be seen as a litmus test for the Yanukovych government.

40.  One worrying side effect of last year's attack on the business sectors is that the business community has now rushed back into politics.  Anders Aslund, the noted Swedish economist, recently observed at a conference held in the European Parliament that there had been pervasive rumours in the run-up to last spring's elections that a safe seat in parliament costs some five million dollars. He suggested that last year's re-privatization debate brought business leaders directly into politics simply to defend their property interests. Not surprisingly, campaign spending in Ukraine is enormously high and very opaque, and it is worrisome that the business community feels it needs to participate directly in electoral politics in order to defend its interests.  Elections last year saw the Ukrainians spend 100 times more in per capita terms than Americans typically spend on their own elections. (Aslund, European People's Party Conference)

41.  On the other hand, it is important to recognize that Viktor Yanukovych's Party of Regions is not necessarily a statist party. It represents important business interests in eastern and central Ukraine, many of which are in direct competition with Russian firms. The new government has vowed to provide relief to the business community and Mykola Azarov, the new deputy prime minister, has announced a government goal of cutting corporate taxes from 25 to 20% and the VAT from 20 to 18% in 2008. He also announced plans to devalue the currency, which is currently pegged to the US dollar at a rate of 5 to 1.  Devaluation would help eastern steel firms which are highly export dependent and which are the largest generators of foreign exchange in the Ukrainian economy. But this could further stoke inflation. Mr. Azarov has also promised to review the steep price hikes in gas, electricity and trains introduced earlier this year. Energy prices, however, are not set in Kyiv. (Olearchyk)

V. TRADE AND UKRAINE'S POSITION IN THE GLOBAL DIVISION OF LABOUR

42.  Although there is a tendency among some critics of globalization to see China's rise as an unambiguously negative development for developing and transition countries, this is not substantiated by the economic data. Ukraine, for example, has been selling enormous quantities of steel to China. Moreover, while it is true that many textile firms from developing countries have relocated to Asia, Ukraine has registered a rise of foreign textile manufacturers attracted both to Ukraine's relatively low labour costs, high skills and proximity to key markets.  In short, Ukraine has begun to carve itself a niche in the global division of labour. But it would be far better prepared to exploit the opportunities these markets present if its own internal reform process were to accelerate.

43.  A recent study by the Centre for European Policy Studies (CEPS) suggests that Ukraine will not undergo sustained economic growth until it more fully integrates into the global economy and does so by adopting a broad array of best practices.  This will require far deeper reform of its governance systems and a clear break with the corrupt practices of the past.  Indeed persistent corruption and poor governance may well constitute the most daunting barriers to Ukraine's international trading ambitions rather than its tariff structure and exchange rate as such.  (Emerson)

44.  For example, Ukraine's customs system has long been mired in corruption - a situation that imposes enormous costs on both exporters and importers. This will have to change for Ukraine to exploit fully global trading opportunities, and it will require external support as well as internal discipline to undertake relevant reforms. CEPS has suggested that the European Commission should link future trade concessions to tangible reforms in areas like corporate governance and minority shareholder rights. This will strengthen the hand of domestic reformers seeking to modernize the economy. 

45.  But Western protectionism also poses problems. EU trade policies, for example, tend to restrict market access precisely in those so-called sensitive sectors in which Ukraine is most competitive. Ukrainian exports in agricultural products, textiles, steel and chemicals are all subject to sharp EU limits. Recent EU anti-dumping measures have hit Ukrainian steel and chemical exports particularly hard.  To compensate, it has begun to make important inroads in new markets in Asia and the Middle East. While this foray into new markets is certainly welcome, it seems particularly unfair for Ukraine to be shut out from one of its most natural markets, Europe. More generous access to European markets will be essential to a successful transition in Ukraine, and its accession to the WTO should mark an occasion for taking such measures. (Aslund, European People's Party Conference)

46.  Ukraine's large industry flourishes on cheap raw materials, low labour costs and strong export margins. But the country needs to sharply upgrade the quality of its own domestic service and financial sectors to improve its longer-term outlook. This will require not only fundamental regulatory reform but also a greater willingness to open these sectors up to international participation and competition. Banking reform is already under way, and last autumn the Austrian Bank Raiffeaisenbank purchased Ukraine's second largest bank. It is important to recall that several of the most successful transition countries, such as Hungary, rapidly abandoned the idea of defending national banks against foreign buyouts. The presence of large foreign banks, in turn, dramatically reduced the tendency to allocate capital for political or clientalist purposes and deepened the available capital pool. Any such internationalization of Ukraine's banking sector would invariably help insulate the process of capital allocation from the powerful vested interests that have dominated Ukraine's economy over the last decade. It would also put lending policy on a more economic footing while deepening available capital pools needed to finance the transformation of Ukraine's economy.  Reform in this area will represent yet another litmus test for the new government.

47.  Labour market reform is also essential. Recent studies have demonstrated the persistence of a serious gender gap, notably at the higher end of the wage scale. Men earn 45-50% more than women in the 50th, 75th and 90th percentiles of wage distribution, although the gap has narrowed since 1991. Minimum wage laws, for example, have lessened gender wage differentials at the lower end of the wage scale.  Statistics suggest that discrimination may be worse in the public than in the private sector. (Ganguli and Terrel) Studies have also demonstrated that older Ukrainians and women confront more difficulties finding jobs and are more often made redundant. (Kupets)  Privatization has reduced worker job losses and halved dismissal and resignation rates while reducing wage levels by roughly 5%, particularly in worker controlled firms (where it may be that workers have accepted pay cuts rather than endure redundancy).  Unmarried, high-skilled workers and those working in large firms have benefited the most from privatizations. (Lehman and Terrel)

VI. UKRAINE'S RELATIONS WITH EUROPE

48.  The European Union is bound to play an important part in any successful Ukrainian transition. As suggested in the introduction of this report, the European Union has only recently focused its attention on Ukraine in a systematic fashion. This was partly due to the fact that Ukraine was so problem-ridden and its democratic and market structures so weak that it was initially very difficult to conceive of it as a potential future member meriting special attention.  Moreover, in the past decade, the EU was far more focused on consolidating the transition in Central Europe, paving the way for the first, second and third waves of accession and then managing the sudden changes that accession has introduced within the EU itself - a process that is hardly complete, particularly in light of the French and Dutch rejection of the draft Constitution.  An integration strategy for Ukraine had simply not been part of the picture.

49.  But the situation could be changing. First of all, the spontaneous mass assertion of democratic rights on the streets of Kyiv and other major cities in December 2004 seemed to place Ukraine more firmly in the democratic family of nations. It demonstrated that Ukraine's restless civil society harbours profoundly democratic aspirations. The Ukrainian public's democrat vigil defied the expectations of many in the West. Indeed, the Orange Revolution was a mass appeal for the construction a democratic society ruled by law and not whim. In this sense, it communicated to the West that the Ukrainian people, or a least a substantial portion of Ukrainians, shared Western values and were thus prepared to push this society in a direction that would transform this impulse into a new political framework.

50.  The Orange Revolution thus constituted a critical point of departure for the EU's new relationship with Ukraine. Over the past year, there has been a concerted effort to upgrade the EU-Ukrainian relationship, and this has occurred despite persistent political instability in that country as well as evidence that much remains to be done to curb the country's very serious problems. The milestones include: the designation by the EU of Ukraine as a market economy, progress on anti-dumping legislation, efforts to simplify visa rules, and progress in a feasibility study on an eventual free trade agreement. (European Council Press Release)  The Ukrainians are also pushing for a more unified European approach to energy that would engage Ukraine in its deliberations.

51.  Nonetheless there are outstanding problems. Firstly, there is a persistent question among member countries about Europe's ultimate direction. Indeed, the French and Dutch rejection of the proposed EU draft Constitution represents an important setback for future candidates. The outcome of those referenda has left Europe suspended in a kind of limbo, and raises doubts about its political capacity to absorb new members. For Ukraine the political obstacles to membership may now be even more daunting than the economic ones, and Europe has clearly adopted a wait-and-see attitude to the government of Victor Yanukovych before it will even contemplate deepening the relationship. Of course, all of this works both ways. The new government has yet to clarify fully its own ambitions for relations with the EU.

52.  There are some in Europe asking whether the Union should ever consider either Turkey or Ukraine as potential members.  Those who oppose the idea of Ukraine's accession point to the unstable and divided character of its democracy, pervasive corruption, the low level of its economy and its sheer size - the latter would likely pose problems even if advances were made on other fronts.  But there are important and insistent voices in Europe which argue that these problems will only grow more serious if Ukraine is not extended genuine opportunities in the new larger Europe. Poland and the Baltic States have been particularly forthright in making this case but their arguments may fall on deaf ears, particularly in the wake of this summer's tumultuous political developments. (NATO PA Secretariat Report)

53.  Europe's dilemma is that it has a strong interest in fostering serious reform in Ukraine. Its own acquis has played a critical role in the transition of other former Communist countries. Central European leaders used the concrete prospect of accession to discipline their political systems to undertake an array of difficult reforms. This tactic has worked extremely well in most cases.

54.  EU relations with Ukraine have recently been predicated on the Partnership and Co-operation Agreement (PCA) which went into force in 1998 and which was slated to endure for a ten-year period renewable with the consent of the parties. This provides a framework for political dialogue, sets the common objectives in trade and investment, sustainable development, economic, social, financial, civil, scientific and cultural co-operation, while supporting the consolidation of Ukrainian democracy.  The PCA is supposed to assist Ukraine in approximating the EU's legal framework and preparing it for WTO membership.  The structure includes bilateral annual summits engaging the presidents of the EU and Ukraine as well as the President of the European Commission and the EU's High Representative.  It also features annual ministerial/commissioner level meetings, co-operation committees engaging senior civil servants and a range of sub-committees dealing with trade and investment, economic and social affairs, enterprise policy, energy and transport, environment, border co-operation, justice and security, science and technology, culture and education, among other subjects.  Since 1991, EU assistance to Ukraine has totalled more than two billion euros covering the TACIS programme, nuclear safety, cross border co-operation, humanitarian assistance and macro financial assistance, among others.  

55.  The political dialogue covers security threats like terrorism, disarmament and non-proliferation, regional and international issues and democracy and human rights.  The EU has spoken about initiating consultation on an Enhanced Agreement between the EU and Ukraine to replace the PCA once the political priorities of a three-year EU-Ukraine Action Plan to strengthen bilateral ties have been addressed.  The conduct of free elections was made a prerequisite before the EU would consider beginning these discussions.  Talks on such an agreement also hinge on Ukraine's accession to the WTO.  (http://ec.eucopa.eu)

56.  The EU considers Ukraine a "priority partner country" within the European Neighbourhood Policy (ENP) and endorsed a joint EU-Ukraine Action Plan in February of 2005.  This calls for an increasingly close relationship between Ukraine and the EU, leading towards gradual economic integration and deeper political co-operation. It also includes elements that rank among EU strategic priorities including: a readmission policy on those nationals expelled from the EU, and consultations on long-haul air transport needed to give Europe's Security and Defence Policy force projection capacity. (Smith)  It provides for EU assistance in a range of areas including the establishment of the rule of law, regional co-operation with countries like Moldova, deeper collaboration in security policy, a greater degree of economic integration and deeper exchanges on justice and visa matters. Many of these issues were taken up in the EU-Ukrainian summit in autumn 2006, a meeting which the European Commission characterized as its most successful summit to date with Ukraine. (Lleskela)  The TACIS Programme has provided a framework for technical assistance in support of democracy building and market transition. The European Neighbourhood and Partnership Instrument (ENPI) will replace TACIS and several other bilateral programs in 2007. Assistance will cover a wider range of instruments including twinning Ukrainian government offices with member state administrations to advance the acquis communautaire.  There will also be greater information exchange on single market legislation including workshop, seminars and study visits to the EU and member states (The EU's relations with Ukraine, (http://ec.eucopa.eu)

57.  The Neighbourhood Policy groups together 16 other states that are essentially seen as highly unlikely candidates for membership in the foreseeable future. These include Moldova and Belarus, several southern Mediterranean countries and the Caucasian republics. Although the neighbourhood framework is ostensibly multilateral, the relationship between Ukraine and the EU is conducted bilaterally. The goal of the neighbourhood policy as expressed by then Commission President Romano Prodi in 2003 has been to offer "all but institutions" to the neighbours. (Smith)  But at another moment, Mr. Prodi asserted that it would be just as impossible for Ukraine to join the European Union, as it would be for New Zealand. (Aslund, European Affairs) This points to a serious limitation.

58.  The message from Kyiv in the wake of the Orange Revolution was that Europe needed to move from its neighbourhood approach to a genuine integration-based policy with Ukraine. Ukraine's government then was far more pro-European than its predecessors.  Its leaders publicly lamented that some in Europe were still reluctant to embrace their country as a truly European nation and would not even accord it the same treatment as that extended to other countries in Eastern Europe and the Balkans. Some in the European Parliament have made similar arguments. The new government has also signalled that Ukraine should deepen its relationship with the EU and this is also the view of Yanukovych's Party of Regions.

59.  The Commission has also made clear that once Ukraine has acceded to the WTO, it will initiate talks for a more open trading relationship. In autumn 2005 it recognized Ukraine's economy as essentially market driven. That recognition was needed not only to deepen Ukraine's relations with the EU, but was also a precondition for its accession to the WTO. The EU is now Ukraine's largest trading partner and accounts for about 35% of Ukraine's total trade, while representing less than 1% of all EU trade.  Trade is on a most favoured nation basis except in the steel sector, which is governed by a separate set of measures.  The PCA anticipates the creation of a future free trade area between the EU and Ukraine but negotiations for this would only begin after Ukraine accedes to the WTO. (The EU's relations with Ukraine, http://ec.eucopa.eu)

60.  Energy and transport are two issues where the EU and Ukraine have several important overlapping concerns and interests. The Commission recognizes that Ukraine is playing a vital part in Europe's energy distribution network and has indicated that even greater integration is needed on this front. In November of last year, the 25 members states, the two candidate states and 25 other neighbours agreed a Memorandum of Understanding for the construction of a series of transport networks. Ukraine is seen as critical to this network and could garner significant investments for projects ultimately designed to facilitate the movement of goods and people throughout Europe. Plans call for upgrading border control measures and customs systems, the introduction of new systems for managing international freight, document harmonization and greater maritime and air interoperability.

61.  On the energy front, the stakes may be even higher.  EU member states currently import 50% of their energy from non-member states, while 80% of the Russian gas the EU consumes passes through Ukraine. The oil pipeline RISPA coursing through Ukraine will provide Europe with a significant amount of oil and there are important existing plans for European oil to pass through the Ukrainian port of Odessa.  A Memorandum of Understanding on Energy was signed at the EU-Ukraine Summit in December 2005. It established a joint strategy for the progressive integration of the Ukrainian energy market with that of the EU. The road map covers improving the safety and environmental standards of the coal sector, integration of electricity and gas markets, nuclear safety and hydrocarbon supply and transit security.  It also looks forward to agreements on energy efficiency, renewables and climate change. (http://ec.eucopa.eu)

62.  The energy relationship also has a nuclear dimension as the EU has long been engaged in the decommissioning of the Chernobyl plant. A range of EURATOM loans have been made to the country. The EU has a very strong interest in encouraging nuclear safety in Ukraine and has been actively engaged in promoting this. (De Palacio) The Memorandum of Understanding signed in November 2005 included timetables for achieving greater safety standards in Ukraine as well greater gas market integration and upgrading environmental standards in the coal sector.

63.  EU-Ukrainian co-operation in security matters has also improved markedly.  Ukraine has played an extraordinarily positive role in advancing the international dialogue on Moldova, and it is participating in ESDP missions in both Bosnia and the former Yugoslav Republic of Macedonia*.

64.  The Commission suggests that as long as the reform process advances, the possibilities for strengthening this bilateral relationship will be enhanced. Prior to recent elections, both sides seemed determined that Ukraine no longer proceed along the reform path without substantial European support.

65.  There are several uncertainties about Europe's future direction that could impede the Union's capacity to partner with Ukraine. Serious budgetary limits alone are posing barriers to deepening the relationship.  Enlargement fatigue in European societies and Euro-scepticism in Ukraine clearly constitute formidable constraints on the relationship. There is also the problem of "trade deflection". The EU has enlarged to Ukraine's borders, but this has undoubtedly restricted this excluded country's access to certain markets on its borders that are now protected by the Common External Tariff.  Ukraine's leverage on these types of problems is quite limited. Finally, the attitude and ambitions of the new government must be made clear in order to advance the relationship over the coming months.

VII. UKRAINE'S RELATIONS WITH THE UNITED STATES, CANADA AND NATO

66.  Although the United States has been a staunch defender of Ukrainian sovereignty and democracy, US relations with the Kuchma regime worsened steadily in the last years. American officials were particularly displeased with the high level of criminal corruption, and the many signs that this was not only tolerated at the very highest echelons of the state, but was, in fact, facilitated by those echelons.  Pavlo Lazarenko, a politician close to Kuchma, for example, was convicted in a US district court of fraud. He is now serving a 9-year term in a US jail. The Bush administration, however, balanced these concerns with consideration of the fact that Leonid Kuchma consented to send Ukrainian troops to Iraq - America's driving security interest in recent years. Still, US officials did not hesitate to express disapproval of the highly questionable election tactics employed in autumn 2005.  The Bush administration then embraced the Orange Revolution and welcomed the ultimate victory of Viktor Yushchenko, even though he had promised in his campaign to take Ukrainian troops out of Iraq.  It has also championed the notion of Ukrainian accession to NATO and the development of a Membership Action Plan to prepare it for membership, but this has not yet been agreed in the NATO Council. (Karatnycky)  It has reacted quietly to the selection of Victor Yanukovych to head the current government and, like much of Europe, appears to have adopted a wait and see approach.

67.  The United States has been stepping up aid to Ukraine to assist it in its fight against corruption and to support the general effort to build a state governed by laws in that country. It has also offered support to deal with weapons proliferation and human trafficking. The Bush administration pushed to end the application of the Jackson-Vanik amendment to Ukraine, which was terminated in 2005. Like the EU, the United States has accorded Ukraine the status of market economy which again is essential to its ultimate accession to the WTO.  In February 2006, the United States and Ukraine concluded bilateral negotiations on market-access issues, another step toward Ukraine's goal of joining the WTO. American officials have rewarded Ukraine's efforts to improve the enforcement and protection of intellectual property rights by reinstating its membership in the Generalized System of Preferences (GSP), which had been curtailed for three years.

68.  Although the United States is one of the main trading partners with Ukraine outside the New Independent States (NIS) and EU, its trade with Ukraine is marginal (0.06% of US international trade in 2004, ranked 93rd on the list of overall trade turnover in 2004). Yet, over the past three years, it has recorded a steady increase in its exports to Ukraine (from US$177.9 million in 2000 to US$763.6 million in 2004). In 2004, Ukrainian exports to the United States totalled US$1.5 billion. (http://www.ukraineinfo.us/)

69.  For its part, Canada has a very large Ukrainian immigrant community and its perspective on that country is certainly conditioned by Ukrainian-Canadians with strong links to their country of origin. Roughly 1,000 Canadians served last year as election observers in Ukraine, half of them sponsored by the government of Canada. Canadian investment in Ukraine is significant and has focused largely on the energy and manufacturing sectors. There is a strong Canadian interest in developing Ukraine's agriculture potential. (Canadian Trade and Economic Office of Ukraine) Total bilateral trade between the two countries was expected to exceed Can$2 billion in 2005, driven by heavy Canadian imports of Ukrainian coal and steel. (http://www.international.gc.ca)

70.  The Canadian International Development Agency's (CIDA) programme in Ukraine is one of its largest in Eastern Europe. Current projects focus on good governance, democratic development and the strengthening of civil society. Canada is also a large contributor to the Chernobyl Shelter Fund, and supports the Science and Technology Centre in Ukraine, which provides non-military employment for former strategic weapons scientists.

71.  Ukraine has also i, n, tensified its dialogue with NATO, and, as suggested above, a NATO Membership Action Plan has been on the drawing board and might have been tabled at the NATO Riga summit this November.  Until the recent elections, the government had repeatedly insisted that its goal was to accede to NATO, and had promised to undertake the kinds of reforms that would make that possible. Viktor Yanukovych, however, expressed some scepticism regarding NATO membership during the campaign. Yet, one of the conditions placed on the new prime minister by President Yushchenko was that his government should seek "deeper co-operation" with both NATO and the EU.  Moreover, the president tapped Boris Tarasyuk and Anatoly Hrytsenko, the Foreign and Defence ministers, respectively, in the previous government, to serve in those positions in the new government.  Both are dedicated to moving Ukraine closer to the West.  In September President Yushchenko indicated Ukraine would not change its foreign policy priorities and would continue to strive for membership in the European Union and NATO.  Prime Minister Yanukovych subsequently travelled to Brussels to attend both the 10th session of the Ukraine-EU Co-operation Committee and consultations at NATO headquarters.  Although he indicated that Ukraine would continue to pursue full membership in the EU, he also suggested that accession to NATO was not currently a priority given the state of public opinion. "Because of the political situation in Ukraine,' he said, "we will now have to take a pause." (Bilefsky)

72.  Polls suggest that only a minority of Ukrainians want Ukraine in NATO. Foreign Minister Boris Tarasyuk and many leaders of the opposition have argued that a referendum should not be held before 2008, so that an informed discussion can be held. Russia, of course, is very much opposed to Ukraine's deepening relationship with NATO and insists that Ukrainian accession would pose multiple security challenges. Russia can be expected to use its formidable leverage to discourage or at least slow down any movement in this direction. Ultimately, of course, the decision will rest with Ukraine.

VIII. UKRAINE'S RELATIONS WITH RUSSIA AND THE ENERGY PROBLEM

73.  This has been an extraordinary and complex year in Russian-Ukrainian relations. In the first place, the government of Mr. Putin very clearly bet on a Yanukovych victory in the 2004 elections and quickly endorsed his victory despite evidence of gross electoral fraud.  Once the Ukrainian public began to react to that fraud, Russia adamantly opposed the decision to re-run the elections. Some groups in Moscow almost reflexively refuse to recognize Ukraine's full sovereignty, a view that has led some to assume that Russia has a veto right on certain decisions made in Kyiv.  Given this predisposition, the ultimate outcome of the Orange Revolution was seen as a unadulterated defeat by many in Moscow, and it subsequently inspired an almost obsessive determination that such democratic uprisings not unfold elsewhere in Russia's "near abroad" - and most particularly in Moscow itself. The recent Russian law on NGOs might be seen as a manifestation of more deep-seated concerns among elites within the Russian state about the democratic impulse generally and the possible contagion effects of Ukraine's Orange Revolution. 

74.  From this vantage point, last year's Russian-Ukrainian gas crisis becomes an important set piece in a very complex diplomatic puzzle - one that combines legitimate pricing disputes with more problematic questions about the political use of gas and oil.  There is no question that Ukraine's dependence on Russian energy constitutes a strategic Achilles heel.  While Ukrainian leaders have long asserted that a good working relationship with Russia is highly important to them, they also do not want terms dictated to them from Moscow. This position is certainly weakened by the fact that Russia is the sole supplier of most of Ukraine's energy. The Russian government's recent paper on Energy Policy to the year 2020 states that the export of raw materials should be used as a political tool. (NATO PA Secretariat Report) The problem is rendered even more complex by the fact that Russia had long subsidized the price of gas it sold to Ukraine, as it did in several other CIS countries. Ukraine has had a degree of leverage as well, insofar as it hosts several important pipelines through which Russian gas is exported to Europe. Russia, however, is looking to diversify its own pipeline options; the new pipeline to Germany, for example, will lessen its dependence on the Ukrainian network, and by extension, will further erode Ukraine's bargaining leverage.

75.  This provides some of the context of the Russian demand that Ukraine pay a higher price for imported gas. The fact that this demand was tabled in the midst of a bitter cold snap in Eastern Europe and was made in tandem with gas cut-offs was not seen as coincidental in Kyiv and in Western capitals. Some analysts saw it as retribution, an attempt to influence parliamentary elections, and as a highly problematic bargaining technique that indeed raised alarm bells throughout Europe, which is itself quite heavily dependent on Russian gas. Moreover, the day before the gas crisis, Russia banned meat and milk products from Ukraine, and imposed similar trade restrictions on Georgia and Moldova.  Again a number of analysts suggest that this was not a coincidence. (NATO PA Secretariat Report) Defenders of the Russian action counter that Russia was only seeking fair value for its precious export and they note that it has not offered to cut prices to Ukraine even though an allegedly more pro-Russian government is now at the helm in Kyiv. Russia has also been legitimately angered by illegal pipeline tapping in Ukraine.

76.  Perhaps the more central problem in this case involved the timing of the demands and the fact that a previous agreement had set prices until 2007.  Ukrainian negotiators pointed this out to their Russian interlocutors, but to no avail. A deal was finally signed which resulted both in the immediate doubling of the price of imported gas and a halving of the transit fees earned by Ukraine. This was understood as a defeat for the government, sparked the ensuing governmental crisis and handed the opposition a potentially powerful campaign issue which it very capably exploited. It remains to be seen how the new government will deal with these issues. The industrialist backers of the Party of Regions clearly want lower energy prices; price hikes have cut into their profits. It is an open question whether Mr. Yanukovych will be able to deliver on this.

IX. CONCLUSIONS

77.  Although Mr. Yanukovych was portrayed by some in the Orange camp as an anti-democratic candidate in the 2004 presidential elections, he is now that country's legitimately chosen prime minister. Accordingly, the West needs to establish a strong working relationship with him and his government. Mr. Yanukovych has assumed his position through a fair, legal and ultimately democratic process.  His election, in part, reflected the Ukrainian public's frustration with the policies of the previous government and the fact that economic growth had dramatically slowed, reform had stagnated, the fractious coalition of the previous government simply could not agree on a coherent transition strategy, eastern Ukraine felt disenfranchised, and old style corruption persisted. Ukrainian citizens thus exercised their hard won right to demand a change, and ironically the beneficiary this time around was a figure who once seemed determined to impede that very right.  This time around, however, Yanukovych and his allies played by the rules and ran a successful campaign.  This is a sign of progress, and it behoves Western governments to recognize the legitimacy of the current government and offer its support for further democratic strengthening and a sound transition strategy. 

78.  Ukraine's new government may have somewhat different views on NATO and the EU than the previous government, and it may have another approach to economic reform. That is its prerogative, of course, and Western governments need to adjust accordingly. Ukraine's democratically chosen government is best placed to judge the degree and pace of reform, and its sovereign capacity to do so must be respected by all of its neighbours.  Certainly a boisterous opposition will air its views in the Rada, and their voices will sharpen the debate. If properly channelled, this discussion could improve the policy-making climate.  The fact that sharp debate appears to be alive and well in Ukraine is, in itself, cause for some celebration. Moreover, at this writing, the new government seems to be taking a highly pragmatic and positive approach to relations with both the EU and NATO.

79.  Ukraine still needs as much support as the West can muster to carry out an effective transition strategy. It must hold out tangible opportunities to the Ukrainian people and not just words. The perception of Western indifference to Ukraine's tribulations might have been one of several reasons that the government of the Orange coalition proved so short-lived. (The Times, August 2, 2006) For the past decade, the EU has been very focused on enlargement matters, and, in many respects, the challenges posed by Ukraine were not extended the same level of priority. Although the enlargement process is not complete, Europe, in particular, cannot afford to benignly neglect Ukraine. It should not rule out the possibility of Ukraine's full integration into European institutional life, even if that goal will nevertheless take years to implement. It is sheer fiction to believe that Ukraine can continue to evolve in a positive direction without at least the prospect of full membership before it. (Aslund, European Affairs)

80.  Even if Ukrainian membership in the EU is not likely to transpire anytime soon, Europe still needs to create an incentive system that will encourage Ukrainian society to embrace the logic of deeper political and economic reform.  Such a package should include the prospect of developing a more privileged partnership between Ukraine and the EU and greater access to EU markets.  Canada and the United States should move in the same direction.  IMF studies suggest that effective institutional reform could put Ukraine on the path towards rapid economic growth over the coming decade - a development that would have clear economic and strategic benefits throughout Europe.

81.  Supporting reform while denying market access makes no sense. Very little can be accomplished if Ukrainian agricultural production cannot be sold in its natural markets to the West. In this respect, it is important to consider the argument that the Ukrainian hinterland will play an important part in the final shape of Ukraine's transition and could be the lynchpin of ultimate success or failure. All Western countries should lift or sharply reduce import restrictions on the goods that Ukraine produces most competitively as soon as possible.  But they should demand high reform standards and market access in return.

82.  Both North America and the EU need to continue to offer all manner of technical assistance to Ukraine to help it improve its legal, administrative and commercial climate. In some respects the American and Canadian governments have been particularly effective on this front, but Europe's work in helping Central European states take on the highly complex and sophisticated acquis communautaire endows it with highly specialized knowledge in the area of economic and administrative transition. That knowledge needs to be put to good use.

83.  Allied countries should embark on an ambitious effort to help Ukraine nurture the development of its future leaders. University scholarships, exchange programmes, internships and other training opportunities and easier rather than more difficult visa procedures are needed to inculcate Ukraine's young leaders with more global perspectives, and to help ensure that they have the management and administrative skills needed to help Ukraine flourish.  The EU, and particularly its new members, has garnered an enormous amount of knowledge about transition strategies.   New and old members alike should now be putting this knowledge to work as part of an overall strategy to assist the Ukrainian transition.  At the same time, NATO should continue to work with Ukrainian officials to support military reform and to establish the conditions for effective democratic control of its armed forces.

84.  Of course, efforts to engage the Rada in all of these efforts are essential. Ukrainian parliamentarians require more information at their fingertips to draft essential legislation, and they also need the means to exercise proper oversight of an executive branch charged with implementing the laws that it passes.  More bridges to Western parliaments and parliamentarians need to be built. Support for the development of conflict of interest, transparency and election law standards that would apply to parliament would also be extremely helpful. 

85.  In the same way, Western support for legal and judicial training is also needed. The rule of law cannot be ensured without the development of a more autonomous, coherent and transparent judicial system. This is a matter of training but also of systemic reform.  Along these lines, alternative dispute settlement mechanisms should be developed so that the society will not overburden its still fragile court system.

86.  Support for further financial reform is also needed. Here international lending institutions can play a greater role once given the mandate to do so by leading member governments. For their part, the Ukrainians should be encouraged to further open up their financial system. This will deepen available capital pools and generate greater efficiency and transparency in this sector.

87.  It is also important that the West not simply focus on western Ukraine and Kyiv. It should instead extend its outreach efforts to regions that have been more sceptical of deeper integration with the western community of nations.  It would be wise to deepen dialogue with those parties that have been more sceptical of the West and which are now in the governing majority. A diplomatic effort must be undertaken to demonstrate that good relations between Ukraine and the West are not a necessary corollary to poor relations between Ukraine and Russia. This kind of zero sum game is absurd and makes no sense for Ukraine, Russia, Europe or the United States.

88.  Of course, no progress on any of these fronts will be possible if Ukrainian leaders do not advance the reform agenda. There is still a long way to go on this front, and the country's political leaders, at times, may have to stand up to powerful vested interests if they are to render administration less arbitrary, public spending more transparent, and if they are to ensure that judicial rulings are premised on the law rather than on vested interests.  Beyond the continued adoption of fundamental macroeconomic reforms, best practices in state administration are also needed. The World Economic Forum's Partnering against corruption initiative presented a list of initiatives that it urged President Yushchenko to make a top priority. These included:

-  Blacklisting companies that have been caught in bribery;
-   Making future appointments to the civil service and judiciary based on merit and not on political motivation;
-    Raising salaries of civil servants to reduce incentives of corruption;
-  Moving to a new system of public procurement such as an efficient online system, which publicly manages the bidding process;
-    Disclosing salaries and business affiliations of senior members of government, judges and legislators.

This is a daunting list for any transition government and it may prove particularly problematic for Ukraine's new leaders.  Western governments and its private sector need to demonstrate the benefits of pursuing this reform agenda and the formidable costs of not doing so. 

89.  On the energy front, Ukraine will remain a key country in Europe's energy transportation system, and it will also continue to be plagued by vulnerabilities. It has essentially only one gas supplier and much of its domestic energy infrastructure is owned by that supplier, sometimes in a very opaque manner.  This is an economically and politically tenuous situation because Ukraine can quickly be brought to its knees as it was last December.  Europe has its own vulnerabilities on this front although not on the same scale. Still, Europe's weak hand is compounded by Ukraine's situation.  An EU-Ukraine energy dialogue might help alleviate some of these vulnerabilities but even more concrete measures might eventually be in order. One suggestion is that the West should develop a capacity to move oil and gas to Ukraine should it ever suffer an energy cut-off.  In other words, Ukraine should be included in any systematic efforts to improve the redundancies and overall security of Europe's energy networks.

90.  At the same time Ukrainian leaders must also exercise a degree of restraint and pragmatism as they develop new models for economic regulation. Many economists, for example, would argue that certain parts of the EU acquis are overly burdensome to transition countries, and some are hardly models to be emulated.  Fiscal and agricultural policies, in particular, come to mind.  Ukraine should opt for lighter regulatory regimes, keeping in mind that the EU will hopefully have reformed itself by the time its own accession moves up the European agenda. Any road map for ultimate membership that the EU lays out with Ukraine ought to factor in this dynamic; in other words, it should implicitly recognize that not only is Ukraine a moving target, so too is the EU. When the two finally do arrive at some meeting point, both will likely have evolved substantially.

X. BIBLIOGRAPHY

Anders Aslund, "The Rise and Decline of Economic Populism after the Orange Revolution," Beyond Transition, The World Bank, July-September 2005.

Anders Aslund, "The EU Should Welcome Ukraine as a future member," European Affairs, vol 6, numbers 1&2, Winter/Spring 2005.

Anders Aslund, Remarks at the Study Day of the European People's Party and European Democrats on Ukraine, European Parliament, December 8, 2005.

Dan Bilefsky, "Ukraine to pursue EU entry," International Herald Tribune, September 14, 2006.

Jennifer Blanke "Assessing Ukraine's competitiveness amid political change," World Economic Forum, http://www.weforum.org/pdf/ukrainecompetitiveness.pdf

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* Turkey recognises the Republic of Macedonia by its constitutional name