AgroInvest Analysis: Impact of the Russian Federation’s Potential Trade Restrictions on the Export of Ukrainian Dairy Products

Preparation of this report was preconditioned by the expectation of signing the European Union Association Agreement, including the Deep and Comprehensive Free Trade Area Agreement (DCFTA) between the EU and Ukraine. It was widely believed that the signing of this agreement would prompt the imposing of restrictions on the export of Ukrainian dairy products by the Russian Federation specifically and other Customs Union member countries in general. Despite the current uncertainty with signing of the Association Agreement, numerous aspects of the dairy industry’s development are, and will continue to be, of paramount importance for Ukraine. The most systemic problems must be solved immediately regardless of whatever further steps Ukraine may take toward international economic integration.

The milk market in Ukraine plays a significant role in developing agricultural production, providing employment in rural areas, and generating income for agricultural enterprises and rural citizens as well as enabling the rural population to sustain itself with food products. According to official statistics, milk production in Ukraine is valued at UAH 33 billion per year. As a significant level of this production takes place in households, the milk industry is critically important for securing production performance and the stability of socio-economic conditions in rural areas.

Milk production and processing in Ukraine are characterized by the following trends:

  • During the last two years the milk production volumes have stabilized at approximately 11.5 million tons due to two key factors: (1) the state provided subsidies to preserve heifers; (2) productivity of milk production has steadily increased and is expected to approach 5,000 tons per cow per year in 2013.
  • Up to 5.7 million tons is consumed in households or sold by households through available marketing channels (i.e. directly from households or through open markets, etc.). As a higher selling price can be obtained through these marketing channels, self-consumption is encouraged over selling the milk to industrial processors who offer a lower price.
  • Dairy exports have reached 1 million tons but have demonstrated a downward trend that has been particularly visible after the introduction of trade restrictions by key trade partners of Ukraine.

The percentage of exported produce in the total milk production output is significant and ranges between 7% and 9%. At the same time, the exported produce accounts for 16% to 21% of the total volume of industrial processing. Therefore, it is the processing industry that is highly dependent on the trade regime of export markets. This influence poses a large challenge due to the following:

  • In the event of a decrease in export demand, processing enterprises prefer to reduce the volume of milk purchased from households rather than agricultural enterprises. Price reductions for milk from households results in both economic and social consequences.
  • Processing enterprises export their products with value added and any potential restriction have significant negative effect on foreign trade balance.
  • As a result of the special regime of taxation for milk processing enterprises, VAT from the sales of products by such enterprises is not paid to the budget. It is instead used for subsidies to milk suppliers (50% of VAT amount in 2014) and forming a special fund of the State budget (the remaining 50% of VAT amount). A potential decrease in the volume of milk exported and its industrial processing therefore carries the risk of reducing the volume of cash earnings of the special fund of the State budget, and as a result, contracting the possibilities of the government to finance the development of milk cattle breeding.

In terms of value, the largest share of dairy products exported is cheese. In 2009, the total value of dairy product exports was equal to $285.6 million USD, of which 76% was cheese. Milk and condensed cream accounted for 18% of the export revenues and other types of dairy products accounted for one to three percent in the export structure. Over the five years analyzed, while the volumes of exports of dairy products and their prices have changed, the export cost structure has changed as well. For the first eight months of 2013, $308.1 million USD worth of dairy products was exported. The amount of cheese accounted for in this period has already decreased to 73%. In the last five years, the share of the cost of whey increased from 2% to 9%, and the share of milk and condensed cream decreased to 14%.

Cheese is the most important export product for Ukrainian dairy sector, and the largest share of Ukrainian cheese is delivered to Russia. In 2009, Ukraine exported cheese of all types in the amount of $301 million USD. UAH 250 million of cheese was sold to Russia and accounted for 83% of the cost of all exported cheeses. For the first eight months of 2013, the cost of exported cheese amounted to $195 million USD, which was lower than the indicators of the previous year by 12%, and shows the income obtained from foreign trade in cheese has been declining steadily. In 2013, the share of export of cheese to Russia was equal to 86%; yet dependence on the Russian sales market has increased. This testifies to the limited opportunities for diversification of sales markets.

Russia imposed restrictions on Ukrainian dairy products many times during the recent years. Russia substantiates its restrictions based on its perceived use of palm oil by Ukrainian milk processors (which allegedly export milk containing products under the guise of dairy products), accusations of poor quality Ukrainian cheeses, and criticisms of the Ukrainian food quality and safety system. It should be noted in this connection that Ukraine seeks to harmonize its food safety and quality assurance system with that of the EU whereas Russia insists on harmonization of this system with the Customs Union rules.

The effect of partial restrictions on the export to the Russian Federation can be estimated based on historical experience. The comparison used in this report was based on the assumption that Ukrainian produce competes with Polish produce at the Russian market. During the last 4 years, prices for milk on the Ukrainian market were higher compared to milk prices on the Polish market. Therefore, when imposing trade restrictions on the export of Ukrainian dairy products to Russia, the difference between the prices for Ukrainian milk in comparison to Polish milk should narrow.

The calculation of this effect allows us to make the following conclusions:

  1. The discount in procurement prices for milk during the period when Russia applied trade restrictions (from January 2009 through October 2012) is 27 kopecks per kg. This discount has a form of a reduced difference in the price for Ukrainian milk as compared to the price for Polish milk.
  2. The effect from reduced premium is less tangible in the period of January 2009 through September 2013. In this case, the premium discount is as small as 11 kopecks per kg. The reduction of cheese exports to levels below the monthly average between October 2012 and September 2013 was due to lower competitiveness of Ukrainian products in the Russian market compared to other countries’ products rather than due to export restrictions under high procurement prices for milk in Ukraine.

Lower competitiveness of Ukrainian products at the Russian markets (inter alia, because prices for milk in Ukraine are higher compared to milk prices in Poland) means that one should not expect milk prices to increase. Another risk factor is a potential increase in dairy product imports to Ukraine. Under such conditions, it is particularly important to improve the performance of milk producers and ensure that they can and do utilize government support measures properly.

Introduction of import duties envisaged by Russia’s commitments to WTO in case of signing the DCFTA remains the main scenario for the Russian Federation. Therefore, if Russian imposes import duties on the entire Ukrainian dairy industry at the level of WTO obligations rather than restrictions on selected enterprises, Ukrainian cheese exporters will have to pay the 20% import duty in Russia in 2014 which will be gradually reduced to 15% in 2016. As Ukrainian milk processors have no other ways to optimize production costs they will have to reduce procurement prices for milk by 20%, thus reducing the average profitability of milk production to zero. In this situation, the milk production sector will no longer be attractive for those who invest or wish to invest in the Ukrainian agricultural sector.

Steps towards neutralizing the negative impact of Russia’s imposition of restrictive measures on Ukrainian dairy products should be subdivided into several key areas.

  1. Negotiations with Russia (the Customs Union) on rationalizing restrictive steps. Possible areas for compromise are (a) using tariff barriers only in the case of actual growth in the volume of product exports to the Customs Union market (e.g., in the form of special duties) and (b) improved collaboration in adopting product certificates of origin in order to block the export of products with Ukrainian origin.
  2. Prerequisites for possible compensation to economic agents for their losses from the drop in milk prices. One of the key elements of such a policy could involve continuation of the existing (through January 01, 2015) special taxation regime for dairy plants, which would allow dairy companies to (a) set the level of procurement milk prices incorporating a 50% payment of VAT amount to milk suppliers, and (b) receive the remaining 50% of VAT amount for implementing the activities of direct budget support to milk producers at the expense of a special fund in the State budget.
  3. Preconditions for self-organization of small players on the milk market, mainly, tool of association of small producers into cooperatives. In Ukraine, unfortunately, the process of setting proper economic preconditions for this, primarily, at the level of taxation, have not been finalized.
  4. Diversification of export destinations for dairy produce. Attempts of dairy plants to diversify their markets by entering the promising markets of Asia are met with some specific requirements of this region, in particular, different tastes and consumer traditions. Therefore, expanding the markets is primarily possible through Ukraine’s gaining opportunities of exporting dairy produce to the European Union market. This opportunity is extremely important in the context of the DCFTA with the EU, which would give the Ukrainian producers opportunities for unlimited export of some types of produce to the EU market (e.g., export of cheeses without quotas and import duty).
  5. Attracting foreign investors in dairy production who are interested in exporting Ukrainian dairy products to countries of the investors’ origins is a potential means of expanding the existing trade market. A number of investors from Arab countries are ready to develop commercial dairy farms in Ukraine. In so doing, they are also willing to lease agriculture land for fodder production purposes. They, however, face uncertainty with land lease agreements in Ukraine and expect the government to create more favorable conditions by, e.g., signing long-team lease agreements for state- and communally-owned agricultural land. Existing enterprises in Ukraine face similar problems with investment attraction and the execution of long-term state-owned land leases under investment obligations and/or long-term communal-owned land leases under obligations to preserve jobs could be solutions to these problems.
  6. Developing a proper enabling regulatory environment. In a situation where the Government has limited capacities for providing financial support to milk producers, development of a proper enabling regulatory environment becomes particularly important. For instance, producers complain on an inappropriate procedure for setting waste disposal standards leading to imposition of financial sanctions by Ukraine’s environmental inspection authorities, delays with issuance of water intake permits, etc. Resolution of these and other similar issues does not require any funding and could improve the business environment in the industry significantly.
  7. Developing qualified personnel. Dairy producers face a shortage of qualified staff and, consequently, find it difficult to implement modern production technologies and improve their economic performance. The Government should promote internship programs for faculties from educational and training institutions. There needs to be support of private professional training initiatives at existing enterprises, likely with the engagement of donors and international organizations. Attention should be paid to OECD recommendations on implementing student internship programs similar to those existing in other countries whereby students are enabled to work in enterprises during several months (initially – on a voluntary basis).
  8. Focus on public/private development of the dairy sector. The available experience shows that projects in cooperative development and/or development of small holdings up to the medium-sized business level are most successful when they are funded by private investors and/or donors. The synergy from combining funding and consulting will ensure successful implementation of such projects. From the government policy perspective, it is a matter of priority to finance projects where alternative sources of funding exist (processing enterprise, cooperative’s or producer’s own funds, donor’s funds, etc.)

Although most of the above are difficult to implement and take time, they are absolutely essential, even outside the context of possible trade barriers to Ukrainian dairy products on the part of the Russian Federation and the Customs Union. The said risks must become a catalyst for positive changes in both the legislation and dairy business practices in order to bring the industry’s  performance to a new level.

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