The Vilnius summit is not far away, and the closer it gets the more severe the Ukraine-EU association agreement’s Sword of Damocles hangs over the Ukrainian economy. For now, nobody can say for sure whether the agreement will be signed. That notwithstanding, only the lazy has not yet spoken about its adverse effects on the Ukrainian engineering industry. Analysts and experts are assessing not only and not so much the effects of liberalization of the market with the European Union (here, the majority of them still see more pros than cons) as the possible losses from a tightening of Russia’s customs policy. After all, the preventive measures that have already been demonstrated leave little doubt that this will certainly happen. The question now is whether it will be worse than it is now, and, if it will be worse, by how much.

Transport engineering has always been one of the trump cards of Ukrainian industry. Having assessed the readiness of its four main sectors (the railcar, aircraft, automobile, and shipbuilding sectors) for a possible reduction in demand from Russia and reorientation of their exports to the EU market, one can conclude that these transformations will be most painful for railcar manufacturing companies and least painful for shipbuilding companies. However, it is too early to bury anyone.

Railcars worst affected Railcar manufacturing is perhaps the most vulnerable sector in terms of reduction of demand from Russia and the other member-countries of the Customs Union of the Common Economic Area (the CEA Customs Union). The proportion of the sector’s exports to countries of the Customs Union is the highest among these four sectors (for example, exports to these countries accounted for 89% of the total exports of locomotives in 2012) and the proportion of exports to European countries is the lowest (less than 10% of total exports). The volume of exports is impressive - 3.7 billion per year or 44% of all the exports of engineering products to countries of the CEA Customs Union. Russia has demonstrated that it can cut off the access of Ukrainian railcar manufacturers to its market even without resorting to the instrument of tariff regulation. Analysts estimate that the suspension of the certificates for delivery of railcars from the Kryukov railcar plant, the Azovmash steel plant, and the Dneprovagonmash plant to Russia in early October will result in losses totaling USD 50 million per month.

It is true that the effect of the Association Agreement with the European Union on the railcar business should not be overestimated. The current situation involving restrictions on export of railcars is possibly that rare case when the motive is more economic than political. After all, we are currently dealing with a slump in demand for railcars (registered at the beginning of this year, it exceeded 20% in the first half of this year in Russia, and is forecast to reach 45% by the end of the year). Russian regulators are trying to save Russian manufacturers by shielding the Russian market from Ukrainian railcars. "There is significant competition in the railcar manufacturing industry in the CIS, which was manifested particularly in 2013, when the share of Ukrainian railcar manufacturers fell from 39% in 2012 to 27% in the third quarter of 2013," said Oleksii Andriichenko, a senior analyst with the ART Capital investment group. According to him, most enterprises will have to consider reducing their production capacities or diversify their product lines if the customs regime is tightened.

Russia has demonstrated that it can cut off the access of Ukrainian railcar manufacturers to its market even without resorting to the instrument of tariff regulation

However, it is a double-edged sword. Russia also depends on Ukrainian railcar manufacturers because the capacities of its own enterprises are insufficient during periods of high demand. "Possibly, no more than 20-25% of railcars will be delivered to the CIS market from Ukraine during the period of reduced demand for railcars, as is currently the case. However, further reduction of this share is limited by the existing manufacturing capacities in Russia. According to the most pessimistic forecasts, the market may fall by an additional 15-20%. But if it recovers, Russia will not have time to quickly ramp up its capacity in order to limit supplies from Ukraine to such a low level," said Andriichenko.

Speaking of alternative markets for railcar manufacturers, it is worth remembering that the 1520-mm gauge and an excess of railcars in the European Union limit alternative markets for Ukrainian railcars. However, representatives of some railcar plants have made quite optimistic statements. "We have European ISO quality certificates and the American AAA today. In addition, we recently obtained a certificate for the right to train our company’s employees in the requirements of the IRIS - the International Railway Industry Standard. So far, no other enterprise in the Ukrainian transport engineering industry has it," the Kryukov railcar plant’s President Volodymyr Prykhodko said in an interview on the Business television channel. According to him, this means that the plant has the regulatory framework necessary to supply its products to European markets.

The Stakhanov railcar plant’s Director Vitalii Kasynov does not have such a rosy vision of the future. "As in the past, Kazakhstan, Uzbekistan, and the Baltic countries are interested in purchasing Ukrainian railcars in addition to Russia. But it will be congested for all engineering plants…” he said. The words of Kasynov indicate that he places more hope on the domestic market. "Ukrzaliznytsia could help Ukrainian railcar manufacturers in this difficult situation by placing orders for their freight cars," said the press service of the company.

Analysts are very restrained when speaking about railcar manufacturing companies’ benefits from liberalization of trade with the European Union. "One of the advantages can be considered the opportunity to enter the market of high-speed passenger trains, which will be cheaper in Ukraine if there is a sufficient volume of production. However, this is currently a very distant prospect to which the Kryukov railcar manufacturing plant still has to live to see," said Andriichenko.

Automobiles will enter new markets The automobile manufacturing industry’s dependence on export markets in the member-countries of the CEA Customs Union is high, although not as high as the dependence of the railcar manufacturing industry. According to ART Capital, member-countries of the CEA Customs Union accounted for 83% of Ukraine’s automobile exports back in 2012. "And it will be relatively easy to replace them in these markets because of the availability of cheap Russian and Chinese alternatives," said Andriichenko. Although it is worth mentioning that the proportion of Ukrainian automobile manufacturing enterprises’ exports to Russia is high, the volumes are still significantly smaller than the export volume of railway equipment in absolute terms. Therefore, the share of the automobile industry is not so significant in the overall structure of the export of engineering products. "Ukrainian automobile manufacturers have every reason to expect demand on the domestic market if there is a certain degree of support from the government, which may eventually operate the existing facilities almost at full capacity,” said the expert with ART Capital.

It will be relatively easy to replace Ukrainian automobiles on the markets of the CEA Customs Union because of the availability of cheap Russian and Chinese alternatives

Manufacturers themselves see slightly different positive aspects of the agreement with the European Union. "If we enter a free trade area with Europe, it will allow our government to at least use the tools that the EU uses for protecting domestic producers. This will provide an opportunity to preserve jobs and increase production volumes, but at the same time it will open up new markets to us,” the Bogdan Corporation’s President Oleh Svynarchuk said. Andriichenko adds that in case of establishment of a free trade area between Ukraine and the European Union, foreign manufacturers will have an incentive to use the production facilities at Ukrainian plants to manufacture products for delivery to the European Union, thereby taking advantage of the cheap labor force and the availability of modern production lines in Ukraine. "Moreover, new factories may be opened, particularly for production of components for assembling automobiles in Europe,” the expert said.

By the way, there are also nuances in this industry that suggest that the worst that can be expected from Russia has already happened. "The events of the past year involving the trade wars with the Russian Federation and the introduction of the recycling tax on imported automobiles have resulted in a significant reduction in the volume of supply of KrAZ vehicles to Russia. The proportion of total exports that goes to Russia has fallen to 20%," said Yurii Obloh, the deputy general director of marketing and sales at the AvtoKrAZ automobile manufacturing plant. According to Obloh, this share will not change after the signing of the association agreement with the European Union because of the influence of other positive factors, such as the introduction of the automobile recycling tax for all market participants, including member-countries of the CEA Customs Union.

Ignoring the segments in which AvtoKrAZ has a monopoly, forecasts are more pessimistic. "Everything will depend on the strictness of the customs regime. Automobiles are currently delivered to Russia duty-free. This market will be practically closed if duties increase to 10-25%, and deliveries will fall by an additional 5,000 automobiles per year,” said Andriichenko. If ART Capital estimates the level of risk faced by the railway industry because of dependence on demand in the CEA Customs Union at 8 on a 10-point scale, it estimates the level of risk faced by the automobile manufacturing industry at 7. This scale takes into account such parameters as the absolute volume of exports, the region's share of total exports, the availability of alternative markets, and the level of competition. The situation is better for the automobile manufacturing industry than for the railcar manufacturing industry only in terms of availability of alternative markets.

Aircraft manufacturers exaggerating Experts say that the situation is ambiguous in the aircraft manufacturing industry. Of course, practically all Ukrainian aircraft manufacturing projects are implemented in partnership with Russia and, according to the Antonov aircraft manufacturing company’s head Dmytro Kiva, the company currently has no airplane in production in which the level of Russia's participation is less than 50%. The Motor Sich aircraft engine manufacturer’s President Viacheslav Bohuslaev has already predicted that the domestic aircraft manufacturing industry will die after the association agreement with the European Union is signed. From expert assessments, it can be concluded that such statements are slightly exaggerated. "The absolute volume of the aircraft industry’s products that are supplied to the CEA Customs Union is average and the CEA Customs Union’s share of exports from Ukraine is 22%, which is the lowest among the sectors of the transport engineering industry,” said Andriichenko.

Certain products of the Ukrainian aircraft manufacturing industry do not yet have replacements in Russian industry because of the high level of technology involved in their production and a combination of factors

At the same time, according to him, Russian companies are tied to Ukrainian suppliers of certain products by long-term contracts, such as the contract between Motor Sich and the Russian Helicopters company. "In addition, certain Ukrainian products do not yet have replacements in Russian industry because of the high level of technology involved in their production and a combination of factors,” the expert said. According to him, such products include some engines for the Yak-130, Be-200, An-148, and An-124 airplanes, the Mi-26T helicopter, and components for the An-148 family of airplanes from the Antonov plant and the Kharkov State Aircraft Manufacturing Enterprise. "The process of import substitution in Russia will gain momentum over time, but the Russian-Ukrainian ties in the aircraft manufacturing industry are so deep that automatic replacement cannot happen, unlike the case in the railcar and automobile manufacturing industries,” said Andriichenko. On the risk scale, ART Capital assigns the aircraft manufacturing industry only 4 points out of 10. The highest risk to the industry is posed by the level of availability of alternative markets, but the risk in terms of absolute volumes and the level of competition is considered low.

Shipbuilders full of optimism Finally, the industry that will suffer the least from integration with the European Union (and possibly benefit more than all other industries) is the shipbuilding industry. Experts and market participants agree on this. "We have not concluded any deal with companies in the Russian Federation in the past 10 years. This market is not attractive to us because of its protective features and the dominance of the United Shipbuilding Corporation (a Russian open joint-stock company that unites shipbuilding, repair, and maintenance subsidiaries in Russia to streamline civilian shipbuilding)," said Mykola Kuzmenko, the head of the supervisory board of the Zaliv shipyard. According to him, the shipyard has been exporting 100 % of its products for many years. "We are hoping for a positive effect from deeper integration into the international economy and easier access to commercial and financial markets,” Kuzmenko said when asked about the shipyard’s expectations from the signing of the association agreement. It is a similar situation with the Zaliv shipyard’s competitors – the Smart Maritime Group’s factories. "We have been working with Russia for quite a long time based purely on market terms, and we have equal starting opportunities with manufacturers in other countries. It should be borne in mind that a powerful set of government measures and programs for protecting Russian shipbuilders has been in existence for a long time in Russia and is continuously being improved," said Pavel Konstantynov, the head of the supervisory board of the Smart Maritime Group. According to him, these measures are already limiting the opportunities for shipbuilders on the Russian market quite severely, and this situation can be complicated only be introduction of direct protective duties.

The Russian market is not attractive to Ukrainian shipbuilders because of protective measures and the dominance of the United Shipbuilding Corporation

"From my point of view, the shipbuilding industry is the least vulnerable. Here, the absolute volume of supplies to the CEA Customs Union is low, the CEA Customs Union’s share of the total volume of exports is relatively low at 27%, and there are alternative markets. In particular, there is demand in China, Norway, and other European countries. Moreover, Russian buyers are connected to our manufacturers by uniform standards and the possibility of purchasing equipment at low prices,” said Andriichenko. The expert expects an increase in the number of orders for Ukrainian vessels and hulls for them from European customers if an agreement on establishment of a free trade area is signed with the European Union. According to ART Capital, the level of risk faced by the shipbuilding sector because of dependence on the CEA Customs Union is 2 points out of 10, which is the lowest among the four sectors.

Manufacturers are still being cautious in their forecasts. "We are not only ready, but we have also been working for several years in the markets of the European Union. However, the European customer is focused mainly on China today because of understandable reasons related to price,” said Konstantynov. At the same time, according to him, many potential customers in Europe still have a biased and quite subjective fear of working with the post-Soviet countries that are not members of the European Union. Such stereotypes could be eradicated if steps are taken toward European integration.