Assessing the Impact of Russia’s War against Ukraine on Eastern Partner Countries

5. Policy responses

Abstract

This chapter suggests policy responses to ease the impact of the shocks of war in the EaP region, providing targeted support to the most vulnerable, supporting the refugee crisis, maintaining open markets, diversifying trade partners, and strengthening energy policies.

Measures to ensure a stable macroeconomic framework should be at the top of policy priorities for EaP countries. Poor macroeconomic policy responses would accentuate the shocks of the war and further harm well-being in the short-term, as well as future prospects for resilience and recovery. The fiscal stance, which was set to tighten in 2022 and 2023 due to the gradual withdrawal of pandemic-related support measures, may have to accommodate some targeted interventions to cushion the effects of the war and inflation on the most vulnerable. A return to prudent management of public finances and compliance with each country’s fiscal rules, in many cases suspended during the COVID-19 pandemic, should also be considered. Monetary policy should also remain cautious, and policy rate reductions before inflation durably converges towards the central banks’ targets should be avoided.

Nevertheless, short- and medium-term interventions to support households and firms to cope with the shocks of the war will require substantial public expenditures. International donors have already stepped in by pledging or supplying funds. The EU has mobilised around EUR 4.1 billion since late February to support Ukraine’s overall economic, social and financial resilience (European Commission, 2022[116]). The EU is also providing considerable financial support to Moldova: as of late May, EUR 213 million to help the country meet its external financing needs and provide adequate resources to welcome Ukrainian refugees (European Commission, 2022[117]).

The EBRD has announced a Resilience and Livelihoods Framework of up to EUR 2 billion for Ukraine, to support trade finance, emergency liquidity finance and payment deferrals, and neighbouring countries taking in refugees (including Moldova) (EBRD, 2022[118]). The World Bank is preparing a USD 3 billion package of support for Ukraine, having already mobilised USD 723 million to assist Ukraine with critical services such as wages for hospital workers. It is also preparing additional support to neighbouring countries receiving Ukrainian refugees to assist with the provision of public services and labour market access for refugees (The World Bank, 2022[119]).

Help, protect and integrate refugees

The Russian full-scale invasion of Ukraine is first and foremost a major humanitarian crisis, and the massive flows of refugees and displaced persons from Ukraine require an adequate and timely policy response.

In the short-term, governments (particularly Moldova and Ukraine’s) will need to provide emergency humanitarian assistance to the refugees upon their arrival to ensure that their basic needs are fulfilled. Efforts should be focused on guaranteeing new arrivals access to shelter, food and drinking water, hygiene and cleaning items, primary health care services, and emergency telecommunication services (OCHA, 2022[120]). Moreover, scaling up programmes that identify unaccompanied children should be established to ensure basic protection and services (Katsiaficas and Segeš Frelak, 2022[121]).

Short-term assistance should be complemented by support to ensure that refugees can be efficiently and successfully integrated in the society and the labour market of the destination country. This is of paramount importance to preserve refugees’ human capital, while also stimulating their potentially positive impact on local economies, as the inflow of people can boost demand through increased private consumption, as well as expand the labour force. To this end, governments should consider initiatives aimed at overcoming language barriers targeted at both children and adults, incorporating new arrivals into education systems at different levels, providing vocational and study guidance, and finally initiatives specifically targeted at providing opportunities to integrate in local labour market (see below) (Katsiaficas and Segeš Frelak, 2022[121]; European Commission, 2017[122]). The speed at which refugees will be granted the right to work will be an important aspect of integration policies, as having the right of working upon arrival in the host countries will certainly improve not only their immediate access to the labour market, but also their long-term employment prospects (OECD, 2022[123]).

Shield local populations and businesses from the economic impact of the war

Governments across the EaP region should implement policies to protect their citizens from accelerating inflation, in particular of food and energy. To this end, they should provide timely and targeted support, especially to the most vulnerable low-income households, who spend a large fraction of their income on basic needs such as food, water, heating and electricity and are therefore hit harder by price increases (OECD, 2022[56]). Protecting vulnerable households might require targeting criteria that go beyond standard means-testing, such as housing location and quality, household composition and access to public transport (OECD, 2022[124]). Viable policy options include the use of targeted safety net interventions, such as cash and food in-kind transfers, as well as tax reductions. At the same time, governments should try to avoid measures to cushion the shock that serve to encourage greater consumption, such as subsidies or price controls. The preferred solutions require substantial public expenditures, which might pose considerable challenges. However, most EaP countries’ fiscal positions appear favorable and resilient.

Timely, targeted, and means-tested assistance is also needed in support of businesses, and in particular of SMEs, which tend to have less resources and capacity to withstand the crisis and face economic depression. This applies to Ukrainian SMEs, ravaged by the war, but could also be considered by other EaP governments for businesses operating in those sectors most seriously affected by loss of export revenues and disruptions to global supply chains. Relevant initiatives could include (donor funded) job retention programmes aimed at preserving existing jobs and businesses, thus establishing the foundations for a rapid post-war economic recovery. Other instruments could include voucher schemes to encourage international co-operation between EU-based firms and local SMEs in EaP countries, with the development of business partnerships and networking. Additional and more conventional instruments could include temporary tax reductions, as well as loan and mortgage repayments freezes. More broadly, in line with the OECD Recommendation on SME and Entrepreneurship Policy, governments should consider mainstreaming SMEs policies across their policy actions. This could be achieved by including an SME angle in new policy proposals in different areas (e.g. tax reforms, credit guarantees) and ensuring that implications for SMEs and entrepreneurs are considered across the diverse policy areas that influence their prospects, in order to enhance policy synergies, address potential trade-offs and reduce administrative burdens (OECD, 2022[125]).

With inflation on the rise and central banks tightening across the region, governments could consider measures to ease the impact on borrowing costs, especially for SMEs. Credit guarantee schemes have proven an effective tool to support access to bank financing for SMEs during the COVID pandemic (e.g., in Georgia). These could be complemented by temporary subsidies on interest rate payments on bank loans, possibly limited to funding projects with high share of capital expenditure vs. current expenditure to incentivise long-term planning and investment. Similarly, in order to incentivise lending in local currencies, such support mechanisms could be limited to financial transactions denominated in the national currencies of EaP countries.

Maintain open markets and promote diversification

Governments should avoid cascading export restrictions and pursue trade openness and diversification. In the attempt to shield domestic consumers from price surges, policymakers can be tempted to restrict trade and curb exports. However, attempts to reduce the transmission of international food price shocks to domestic markets through protectionist policies risk compounding the volatility of world prices and have proved unsatisfactory in the past (World Bank, 2022[126]). In fact, while export restrictions can temporarily mitigate pressures on domestic food markets, they divert supplies from the world market, consequently inducing a further surge in world prices and triggering a multiplier effect (Espitia et al., 2022[127]). Moreover, the more governments attempt to use such policies to export price pressures to the external sector, the worse off all will be – the classic paradox of such “beggar-thy-neighbour” policies. The experience of both the 2008 food-price crisis and the COVID pandemic shows that export restrictions should be avoided, given their potential snowball effects in already strained markets.

The right response is to facilitate trade, which can enhance food security globally. Governments could consider abolishing import duties from countries without a free trade agreement to diversify import sources. Advanced economies can also strengthen food security by providing the assistance necessary to facilitate the planting of new crops, including in Ukraine, and to address as quickly as possible the logistical barriers limiting food supply to those most at risk. Increasing transparency around trade in food and critical minerals, using tools like the inter-agency Agricultural Market Information System can also help.

EaP governments could also increase their marketing efforts and resources for trade representations to reorient and diversify their export markets. In particular, governments could consider additional measures to reorient exports to new markets, including the EU’s, for instance by further aligning regulatory requirements with EU standards. To complement this, more support could be provided to businesses to comply with quality standards and regulations of target countries, including awareness-raising, advisory and training activities. More could also be done to address institutional and limitations in the quality infrastructure (European Commission, 2016[128]). Digitalisation could also be leveraged in several ways, both to help reduce regulatory and administrative barriers to trade (by streamlining procedures, increasing transparency and facilitating exchanges) and to reach new customers via e-commerce practices.

In order to encourage trade with the EU single market, EU policymakers could also temporarily increase tariff rate quotas for selected products exported by DCFTA countries into the EU, thus increasing the pre-determined quantity of a product that can be imported at lower import duty rates than the ones normally applicable. In a similar vein, the European Commission recently proposed to suspend for one year import duties on all Ukrainian exports to the European Union, in an attempt to help boost Ukraine's exports to the EU and alleviate the difficult situation of Ukrainian producers and exporters in the face of Russia's military invasion (European Commission, 2022[129]).

Further, better integration into GVCs should remain a priority, although achieving such goal will require longer-term efforts. Policies seeking to integrate SMEs into GVCs should include programmes supporting them to better identify new opportunities and exploit their comparative advantage in the production of intermediate goods and services, promote domestic and international production linkages and integrate, directly or indirectly, into regional and global value chains (López González, 2017[130]).

Seize potential opportunities arising from a changing economic landscape

EaP policymakers could take action to strengthen the business environment to benefit from increasing arrivals of people and businesses. As individuals and businesses relocate to escape sanctions, EaP countries, especially in the Caucasus, could position themselves as valid destinations.

The influx of migrants, particularly of educated and skilled workers, represents an opportunity for receiving countries to expand and enrich the labour force. On this account, governments should implement initiatives aimed at best integrating migrants in local labour markets. Relevant measures can include early assessment initiatives to promptly test the experience, skills, and motivation of newly arrived immigrants, as well as employment matching services (Katsiaficas and Segeš Frelak, 2022[121]; European Commission, 2017[122]).

There is also evidence of numerous businesses, mostly Russian, relocating to the EaP countries to evade the sanctions and keep their activities operational. Armenia in particular appears to be an interesting destination, especially for companies operating in the IT sector (Azatutyun.am, 2022[131]). This is due to elements such as geographical proximity, diffusion of Russian language, and lower cost of living (Eurasianet, 2022[132]). With the necessary due diligence, Armenia and all EaP countries should encourage and facilitate the influx of new businesses. Initiatives specifically targeted at assisting entrepreneurs seeking to relocate and guiding them navigate the red tape, e.g., the development of guidelines and FAQs to establish a business, should go hand in hand with efforts to promote investment and improve the overall business environment.

EaP countries could advance on their digital transformation and seize emerging opportunities to develop their services sector. Given the recent growth trends observed in the IT sectors across the EaP region and the relocation of IT specialists in particular to Armenia and Georgia, policy makers have an opportunity to capitalise on the influx of human capital to further grow their IT industries and advance the digital transformation of their SME sectors. In order to achieve this, countries should improve both their “framework conditions” for the digital economy (i.e. broadband connectivity, competitive markets, digital skills) as well as their institutional arrangements and specific support measures for the digitalisation of SMEs operating in “traditional” sectors (OECD, 2021[133]).

South Caucasus countries could also help to develop alternatives solutions to global trading routes. In the context of heavily disrupted overland trade networks connecting Europe and Asia, the South Caucasus has considerable potential to gain an increasingly relevant role. Given the uncertainty and challenges related to transporting goods through Russia into Europe, the trans-Caspian “middle corridor” – connecting East Asia to Europe through Kazakhstan, Azerbaijan and Georgia – is emerging as a valid alternative to the historically more important yet currently unviable Northern Corridor through Russia (see Box 5.1). On this account, South Caucasus countries have an opportunity to foster intra-regional co-operation to co-ordinate potential investment and reform efforts in order to fully realise the potential of this transport route in the coming years.

Box 5.1. Trans-Caspian International Transport Route

The Trans-Caspian International Transport Route (TCITR), also known as the “Middle Corridor”, is a multi-modal transport network that is currently used mainly for petroleum products and other commodities, making up 45% of Georgian Railway’s cargo traffic volume in 2020 (Georgian Railway, 2021[134]). It has, however, the potential to gain a larger share of the containerised trade between China and the EU, which is currently transported by sea and overland through the northern route via Russia. The Middle Corridor’s development would support growth across the region, both through the jobs created in the transport and logistics sector and indirect regional trade effects.

The current capacity of the Middle corridor is estimated to be at most 5% of the volumes transiting the northern route (Rail Freight, 2022[135]). As such, it cannot absorb all the demand for transport services resulting from the disruptions to shipping routes traditionally passing through Russia. Nevertheless, while the Middle Corridor is structurally less competitive than the overland routes via Russia or maritime transport in terms of cost and travel times (Table 5.1), it could present a viable option for exporters and transport operators seeking to diversify their shipment routes.

Table 5.1. Cost and time estimates for main EU-China corridors

Per 40-foot container, from Chengdu, China

	Cost range (USD)	Average time (days)	Northern Europe time (days)	Central Europe time (days)	Balkans time (days)
Northern corridor	2 800 – 3 200	14 – 18	16	15 – 16	20
Middle corridor	3 500 – 4 500	16 – 20	18	17	14
Maritime route	1 500 – 2 000	28 – 40	28 – 40	28 – 40	28 – 40

Source: (World Bank, 2020[136])

There are, however, many challenges to overcome if the South Caucasus is to realise its potential as a transit option. Some of these extend westwards towards Europe and beyond the South Caucasus along the entire Middle Corridor. These involve the need for upgrading both “hard” transport infrastructure and “soft” procedures to facilitate movements of cargo across borders.

The “hard” infrastructure investments include improving capacity in ports, railways and highways across the region. Specifically, there is a need for greater investment in the Caspian Sea ports to ensure they can meet the capacity of the railway freight trade coming from China. The main recipient port in Azerbaijan, the Baku International Sea Trade Port (Alat Terminal) has an annual capacity of 15 million tons of bulk cargo freight, whereas the corresponding ports in Kazakhstan have a combined capacity of 23.7 million tons (Aktau and Quryq) (UNECE, 2019[137]). Additional vessels in the Caspian Sea would also be needed to meet the increasing demand (Rail Freight, 2022[135]). Another key problem for the Middle Corridor is its multi-modal nature, requiring loading and unloading for ferry journeys in the Caspian and Black Seas. This latter switch can be avoided with rail transport through Türkiye, but the rail infrastructure on this route would need to be further developed. Additional bottlenecks could be encountered in Europe, as rail connections would have to pass through Serbia which, as a non-EU member, would entail further border formalities, as well as rail speeds as low as 20-40km/h (Kenderdine and Bucsky, 2021[138]).

The “soft” reforms involve harmonising regulations and border controls to allow for international containerised trade, ensuring transparent and competitive tariff structures, improving the institutional framework for effective regulations. These reforms are required to reduce issues of visa bottlenecks and opaque tariff systems deterring trade (ADB, 2021[139]) as well as the additional benefits of bringing Georgia and Azerbaijan closer to EU standards on regulation.

Strengthen climate and energy policies

EaP countries reliant on Russian energy face a complex set of incentives. On the one hand, these countries may have access to discounted energy imports, and thus weakened incentives to conserve energy or invest in renewables. On the other hand, however, price volatility and political uncertainty in their relations with Russia emphasise the risk of dependency on fossil fuel imports from a single supplier and constitute a huge economic vulnerability.

This situation leads to the emergence of a “new energy security paradigm”, whereby energy importing countries might be better off by replacing fossil imports with domestic energy production through renewable energy sources. Even countries currently maintaining good relations with Russia face incentives to decarbonise in order to improve their long-term security of supply.

The new energy security paradigm, high long-term fossil fuel prices, and increased price uncertainty are expected to continue driving the expansion of renewable energy sources in the medium- to long-term. Although none of the EaP countries, with the exception of Moldova and Ukraine, have policies officially aimed at reducing their dependence on fossil fuels from Russia, many are working to strengthen their energy independence. Increasing energy efficiency efforts and domestic energy production, in particular from renewable energy sources, provide an attractive alternative (OECD, 2022[50]).