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Ukraine’s Heavy Industry : Glittering Prize or White Elephant?

According to some accounts, the conflict in Eastern Ukraine is a tug of war over the region’s mines, steel mills and other heavy industry. The website European Dialog, for example, tells us the region is “crucial to Russia,” which “values Ukraine because of industries, like steel and agriculture, that have served as vital inputs for Russia’s economy from the Soviet era to the present.”

Others view Eastern Ukraine’s heavy industry as more of a liability than a prize, and see the current conflict as a geopolitical one that can have no good outcome for the population. Speaking to a reporter from The Guardian, coal miner Igor Yefremov expressed his fear that “If we join the European Union our mines and factories will shut down.” At the same time, he acknowledged, “Already the orders from Russia are drying up. Russia doesn’t want us because of the chaos in Kiev.”

So where does the truth lie? Is Eastern Ukraine’s heavy industry a glittering economic prize or a white elephant? Or is it simply irrelevant to a conflict that is fueled more by Vladimir Putin’s testosterone and popular nostalgia for a vague but warmly remembered Soviet past?

As steel goes, so goes the region

Steel provides a natural focus for addressing these questions. A healthy, profitable steel industry could support local coal and iron ore mines while supplying inputs to makers of everything from equipment for Russia’s oil fields to girders for autobahn bridges. A failing steel sector could, instead, drag down both its suppliers and customers. If it died a slow death by subsidy instead of a fast one by bankruptcy, it could pull the government into a fiscal black hole along with it. With little exaggeration, we can say that as steel goes, so goes the economy of the region.

In some ways, Ukraine’s steel industry is fairly healthy. According to information presented by the Ukrainian Ministry of Industrial Policy, Ukraine is the world’s eleventh largest producer of steel. It produces a respectable 2 percent of global output, just behind Brazil and Turkey and about half that of Russia.

Ukrainian steel also has a well-diversified base of export customers. The EU is the largest, taking 27 percent of Ukraine’s total exports. CIS countries, including Russia, take 20 percent and other European countries 15 percent. Africa, Asia, and the Middle East take most of the rest.

Furthermore, the Ukrainian steel sector has undergone significant modernization. Over just the past seven years, the share of steel produced by older open hearth technology has decreased by more than half, to be replaced by more energy-efficient methods like electric furnaces, oxygen blown converters, and pulverized coal injection.

That’s the good news, but there is bad news as well.

First, despite some progress, the Ukrainian steel industry is far from a leader in terms of efficiency and productivity. A report from ABB ranks it next to last among major producers in terms of energy efficiency; only Russia does worse. Energy used per ton of steel produced is nearly double the levels achieved in the EU, South Korea, or Japan.

The second bit of bad news is that the global steel industry as a whole has a glut of excess capacity. According to McKinsey & Company, Western Europe has 20 percent more capacity than it needs, and developed Asia has 25 percent more, yet emerging markets continue to add plants even while global demand is falling. That puts the least efficient producers, including many plants in Ukraine, in a bind. McKinsey suggests than 40 percent of all steel producers are under severe financial stress, with no clear path to recovery.

Subsidies

To make the financial situation of Eastern Ukraine’s heavy industry all the more precarious, the current crisis threatens crucial subsidies that have kept the region afloat up to now. Those subsidies come in two main forms.

First, there are energy subsidies. In addition to local coal, the steel industry uses vast amounts of imported natural gas. Even before the recent crisis, Russia’s Gazprom sold the fuel to Ukraine at a price that was far higher than it charged to domestic customers. Now it has raised prices again. The Ukrainian government, meanwhile, sells the gas along to consumers and industry for half or less of the import price.

For Russia, it is a clever trick: Sell overpriced gas, then get the Ukrainian government to subsidize sales of gas to its steel mills, then import the subsidized steel at a bargain price. The trouble is, this can’t go on. The fragile government in Kyiv is now dependent on financial aid from the IMF, and the IMF has set an increase in domestic gas prices as condition number one for its rescue package.

Second, Eastern Ukraine has long depended on a net inflow of tax revenue from the rest of the country. The Ukrainian publication Investgazeta provides the following map of net tax flows among Ukrainian regions. Those in dark red show the largest net subsidies, more than 1,000 hrvinya (about $120) per capita for 2013. The heavily subsidized regions include Donetsk and Luhansk along the Eastern border with Russia, which together comprise the Donbas, the heartland of Ukrainian heavy industry. That has been the area most heavily affected by the current unrest. The green tax-surplus regions of Kharkiv and Dnipropetrovsk, just to the west of them, have so far been relatively quiet.

What does the future hold for Eastern Ukraine?

Taking energy subsidies and tax flows together, then, we see that industrial regions at the center of the current crisis, far from being a source of wealth for the rest of Ukraine, are a net burden on it. That fact has ominous implications for the future, regardless of how the geopolitical struggle that is now underway comes out. Consider three scenarios.

First, suppose that Putin backs down, the IMF and EU come through, and Ukraine remains unified under a pro-Western government. In some ways, that would be the best outcome for Eastern Ukraine. It would continue to benefit from investments undertaken by companies like Luxembourg-based Arcelor Mittal, the world’s largest steel producer. That firm has invested millions of euros modernizing its plant in Kryvyi Rih, the largest in the Ukraine. A pro-Western outcome would also cement ties with the single largest export market for Ukrainian steel. However, this scenario comes with one big negative for the Eastern regions, namely, the  IMF-imposed end to energy subsidies. Deprived of that life support, many smaller firms in the region, lacking deep-pocket Western investors, would probably have to close their doors. Even those that did get Western upgrades would experience large job losses as productivity improved—a process already under way in Kryvyi Rih.

Second, suppose Ukraine remains technically unified but politically split between East and West. One variant would be a federal arrangement with Eastern regions electing local governments that are politically at odds with Kyiv. A more extreme variant could see the evolution of the Donbas into an unrecognized, de facto independent statelet like Transdnistria in Moldova. That outcome would be even less favorable to the region. It would lose subsidies from Kyiv, it would become less attractive to Western investors, and it would lose customers in Western Europe. It would probably receive some ad hoc Russian energy assistance, as does Transdnistria, but Moscow would be under no obligation to raise salaries or pensions to the Russian level.

Finally, suppose Russia were to annex the Donbas, or a larger swathe of Eastern Ukraine, as it has already done with Crimea. It is clear what the pro-Russian demonstrators in the region would hope from such an outcome: secure jobs, with wages and pensions raised to the higher levels prevailing in Russia. The question is, could Russia realistically deliver on those hopes?

Writing for Forbes, Paul Roderick Gregory calculates what such an annexation would mean for Russia:

With a Russian budget of 38 percent of GDP, or slightly less than one trillion dollars (Moscow’s Gaidar Institute), the annexation of just the Donbass region of eastern Ukraine [population 8 million] would eat up between 6 and 8 percent of the Russian budget each year – as compared with 12 percent for the military. This is $60 to $80 billion less for investment, military expenditures, modernization, and other state activities.

If Putin were to annex the whole of east Ukraine (about 15 million population), the cost would double to $120 to $160 billion – to an untenable share of the budget.

Those costs would have to be borne out of a budget under strain from a Russian economy that is already at a standstill, not allowing for an impact of further Western sanctions or damage to its reputation as a place to do business. Gregory speculates that in the event of an actual annexation of Eastern Ukraine, Putin would have to renege on his implicit promises regarding jobs, wages, and pensions. Such an outcome seems even more likely if we take into account the need for Russia to defend its own heavy industry against the threats of overcapacity, falling demand, and energy inefficiency. With neither enough demand nor enough investment to go around, why would Putin let Donetsk get in line ahead of Magnitogorsk, or Donbas ahead of Kuzbas?

The bottom line

The three scenarios represent very different outcomes geopolitically, but they have one thing in common: they all end with dashed hopes for the industrial workforce of Eastern Ukraine. A pro-Western outcome might bring foreign investment and modernization, but only at the expense of layoffs and lost subsidies. Annexation would likely end in unfulfilled promises and disappointed expectations. The limbo of unrecognized and unsubsidized independence would be even more of a dead end.

To  answer the question with which we began, then, Eastern Ukraine with its heavy industries  looks like more of a liability than a prize, at least in economic terms. People in the streets of Donetsk and Luhansk may be motivated by real economic concerns, but it is not clear that anyone is going to be able fully to assuage them—neither Moscow nor Kyiv nor the EU nor the IMF.

And what does Putin himself think of all this? Has he deluded himself that recapturing this historically important chunk of the lost Soviet empire will make Russia economically stronger? What do his economic advisers think? Are they, too, deluded, or have they spoken truth to power, only to be ignored? Perhaps Putin recognizes the economic costs of absorbing Eastern Ukraine, but accepts them in the expectation that his troops will be welcomed in the streets with flowers, as the Americans expected to be in Iraq. Or perhaps he has simply succumbed to the age-old urge to demonstrate his prowess by ruling over unwilling neighbors. Maybe we will get a clue as matters unfold, but for now, we can only speculate.

 

 

10 Responses to “Ukraine’s Heavy Industry : Glittering Prize or White Elephant?”

windrivenMay 5th, 2014 at 11:15 am

Fascinating post today, Dr. Dolan. A few items really hit me.

1. China produces 49% of the world's steel, the US 6%. Like it or don't, steel is a strategic material and while the US may (or may not) have excess capacity that would allow it to ramp up production quickly if required, modern history moves much faster than it did a century ago. Disturbing.

2. "Even those [smaller steel producers] that did get Western upgrades would experience large job losses as productivity improved—a process already under way in Kryvyi Rih." But not as large as those losses would be if the Ukrainian steel industry collapsed.

3. Your analysis of the cost to Russia if it annexes eastern Ukraine is really enlightening. The question then boils down to what Putin's larger strategy is. He has already solved the naval issue by annexing Crimea and no one seems particularly interested in relitigating that. If eastern Ukraine is an industrial white elephant then is it simply irredentism and if so what other countries will find themselves in Putin's crosshairs? And if that is the point, how does Putin expect to make this future whole more valuable than the sum of its parts?

All of this seems out of character for a guy who understands hardball and that suggests to me that the objective isn't Eastern Ukraine, it is the whole of Ukraine with its considerable agricultural resources. Russia has historically been a net importer of agricultural products. His calculus may be that western pressure will be temporary and worth the cost as Mr. Obama is unlikely to challenge another annexation militarily and especially not at the end of his term. Similarly, Europe has its own reasons for speaking loudly and leaving the stick in the closet.

Ed Dolan EdDolanMay 5th, 2014 at 11:59 am

You ask, Is it simply irredentism and if so what other countries will find themselves in Putin's crosshairs?

IMHO yes, it is mostly irredentism, so any former Soviet republic with substantial Russian population is potentially in the crosshairs. But like the old Soviet union, no, there is in fact no guarantee that the whole would be worth more than the sum of its parts. Yes, Putin "understands hardball" as you put it, but that is on the tactical level. It does not necessary mean that his objectives are economic.

windrivenMay 5th, 2014 at 1:30 pm

Does that mean that you discount Ukraine's agricultural sector in Putin's thinking? Have I misunderstood the strength of that sector in Ukraine or Russia's needs for ag imports?

"Yes, Putin "understands hardball" as you put it, but that is on the tactical level."

He seems to have won a strategic victory in Crimea and seems likely to win one in Syria, keeping his preferred leader in power and vastly improving Russia's standing and influence in the region.

In any event, Putin seems likely to continue to be successful so long as he avoids a direct confrontation with a NATO member. A move on Latvia as the WSJ worries today (http://online.wsj.com/news/articles/SB10001424052702304163604579531713356133936?mod=%3C%25mst.param%28LINKMODPREFIX%29&mg=reno64-wsj) would require a blistering response – or the dissolution of NATO as a meaningful actor.

Ed Dolan EdDolanMay 5th, 2014 at 10:44 pm

I don't think agriculture is a big factor in the Russia-Ukraine equation. Both countries export grain and vegetable oils, and both import mainly meat, so there is no sense in which Ukraine meets Russia's needs for imports.

I totally agree with you about Latvia. "Blistering response or end of NATO" is about it.

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Bill of Sale Contract for Province of Crimea
Ukraine
By: Ukraine

Sold To: Russia
For the sum of 250,000,000,000 Euro's payable to Ukraine

This contact is binding in perpetuity and Russia agrees to pay by the act of annexing Crimea.