VERTICAL INTEGRATION AS A FACTOR OF ECONOMIC GROWTH IN GUUAM AND EURASEC
Valeriy Kuzmenko, Ph.D. (Econ.), a government expert with the Ukrainian National Security and Defense Council National Institute of International Security Studies
In a globalizing economy, mergers and takeovers have become a recurring pattern not only in individual countries but also in international business practice. This is especially characteristic with major transformations, including in post-Soviet markets, during the period of both the economic crises that all CIS states went through and the economic revival that some of them are seeing now. The majority of multinational corporations in fact developed by merging with some firms and acquiring others through their vertical integration (based on production-sharing arrangements) or in the form of conglomerates. Bilateral production-sharing contracts also lead to horizontal integration of enterprises with similar specialization, which helps minimize overall costs and prices of final products.
Decision-making in the production-sharing sphere is always a matter of strategy, key to further transformation of a particular company or multinational corporation. This approach to corporate management helps shape an enterprise’s economic strategy not only for a short and middle term, but also for a longer term, which includes the vertical integration of various enterprises under appropriate production-sharing contracts.
Cooperation between enterprises in EU countries became the prime mover of Europe’s economic integration in the second half of the 20th century. At the same time, in Russian expert estimates made in the first half of the 1990s, the rupture of production-sharing relations between enterprises in the post-Soviet area alone accounted for up to a half of their economic decline. In the Soviet era, Ukraine ran a complete production cycle on approximately 30 percent of industrial goods with 70 percent being contingent on shipments of products under subcontracting arrangements with other Union republics. So the break-up of the Soviet Union and the resultant rupture of production-sharing arrangements between enterprises in the CIS countries made it impossible to produce many types of goods, including innovative, state of the art products, whose production in the Soviet era was concentrated at enterprises of the military-industrial complex.
With a view to restoring old and establishing new production-sharing arrangements between the CIS countries, on 23 December, 1993, an agreement on general terms and mechanisms to support the development of production-sharing programs for enterprises and regions of CIS states was signed, in Ashghabad. The agreement was signed by all CIS countries, and in accordance with the statute on its temporary application, adopted in Moscow on the same day, its provisions began to be formally used in the post-Soviet area as of 15 April, 1994. Ratification of the agreement, however, took about three years. Thus, President Heydar Aliev of Azerbaijan did not approve the corresponding law, passed by the republic’s parliament, until 18 December, 1996. For its part, Ukraine, was the fifth state to sign the ratification instruments, 11 days after Russia—on 1 and 12 September, 1995, respectively, and as of that day the agreement went into force for the Russian Federation and Ukraine.
From the early fall of 1995 until the late spring of 1996, the republic’s Cabinet of Ministers held regular expanded sessions on industrial cooperation, chaired by then-Deputy Prime Minister Anatoliy Kinakh and attended by not only the heads of all ministries, government agencies, and departments but also activists of the cooperation movement, delegated by the republic’s major enterprises. This movement could have become a prime mover that, back at the beginning of the first half of the 1990s, could have lifted the country’s economy out a deep economic crisis.
In late May 1996, then-Prime Minister Evhen Marchuk, who had been trying to secure the most favored treatment for medium-sized business, was dismissed from his post. Many experts linked E. Marchuk’s dismissal with the “beginning of the end” of the medium-sized business in Ukraine, which was not slow in coming.
Coordination of production-sharing arrangements, which, under the Ashghabad Agreement, was regulated on the CIS governmental level, was scaled down as soon as Pavlo Lazarenko took over as prime minister. In the summer of 1996, he abolished industrial cooperation departments in the Cabinet of Ministers and the Economy Ministry, also ordering the closure of the Center for Economic Restructuring and Development under the republic’s government. The latter was directly involved in promoting and fine-tuning effective cooperation between export-capable Ukrainian enterprises and enterprises in other CIS states. What Lazarenko needed was not cooperation between enterprises, based on a sound legal foundation, provided by the aforementioned agreement, but micromanagement whereby he would personally be in charge of granting benefits and breaks to enterprises. At the same time—i.e., several months after E. Marchuk’s dismissal—Deputy Prime Minister A. Kinakh, who oversaw cooperation at the Cabinet of Ministers but, more importantly, was the most serious rival to P. Lazarenko as prime minister, lost his post.
If one had been able to calculate the profit yielded by the restoration of production-sharing arrangements between Ukraine’s enterprises and those of other CIS states in return for the losses and damages caused by P. Lazarenko’s performance, one could have seen that the figure obtained considerably exceeded not only the amount of hard currency that he took to the West but also Ukraine’s foreign debt, over $10 billion, which is equivalent to the country’s annual aggregate budget (52 billion hryvnas in 2001). Surely, this is one of the most serious threats to the republic’s economic security.
Thus, long before Ukrainian Prime Minister V. Pustovoytenko was dismissed (incidentally, A. Kinakh, the current head of government, was first deputy prime minister at the time), a scheduled CIS summit yet again heard a proposal to revisit the idea of creating a free trade zone in the CIS.
It is noteworthy that several years before he was appointed prime minister, A. Kinakh was chairman of the Ukrainian Union of Industrialists and Entrepreneurs, which prior to that, before he was elected the country’s president, had been headed by L. Kuchma. Despite the impediments to production-sharing arrangements between enterprises in the GUUAM member states, the Ukrainian Union of Industrialists and Entrepreneurs has lately intensified contacts with a counterpart organization in Georgia—the Georgian Union of Taxpayers. The leaders of these organizations agreed to create a Ukrainian-Georgian trading house, designed, among other things, to expedite the signing of agreements, including on production-sharing arrangements between enterprises. Expansion of contacts between Ukrainian and Georgian businessmen considerably facilitates the creation of joint ventures: By 2001, there were more than 300. Ukraine has boosted deliveries of ferrous metals to Georgian machine-building enterprises as well as engineering and chemical products. For its part, Georgia has increased shipments of ferrous-metal products under subcontracting arrangements to Ukrainian metallurgical and machine-building enterprises. These are good examples of a mutually beneficial vertical integration of enterprises in the two countries—i.e., production sharing.
There are plans to establish direct links between Ukrainian metallurgic enterprises and Georgia’s Chiaturmarganets and Zestafonskiy Ferrosplavnyy Zavod joint-stock companies. In the foreseeable future, they will be joined by food-processing enterprises since there are plans to create joint ventures in the fish-processing industry and the agro-industrial sector.
There are also good prospects for cooperation between Ukrainian and Azerbaijani industrial enterprises. A business forum, held in 2001, in Baku, and attended by representatives of the governments and business circles of these countries, focused on the development of trade and economic relations. The Azerbaijani government plans to convert a part of local grain producers to cotton production, considerably increasing Ukrainian grain import. The Ukrainian side said it was still interested to participate in building distilleries, sugar-refineries, and other enterprises in Azerbaijan. In addition, a contract to build two vessels for the Caspian Sea Shipping Company was signed. The sides also reached preliminary agreement that Ukrainian shipyards will take part in a tender for building another eight vessels.
Cooperation has also been growing between Ukrainian and Uzbek enterprises. Ukraine ships mainly machinery and electrical products to Uzbekistan while the latter mainly exports raw materials and semi-finished products. In particular, there are good prospects for large-scale cotton deliveries since Ukraine has several high-capacity cotton processing enterprises. For its part, Uzbekistan is interested in shipments of Ukrainian metal, including cathode copper, and other products. All of these are examples of successful vertical integration between enterprises in countries that are located rather a long way away from each other. The main lines for further cooperation are as follows: creation of joint ventures, transit, industrial cooperation, industrial leasing, trade, cotton export through Ukrainian territory and ports to third countries, participation of Ukrainian specialists in road building projects in Uzbekistan, and so forth. Furthermore, it is planned to invigorate investment activity by creating financial-industrial groups, trading houses and joint ventures in various sectors of the economy, including in the metallurgical, chemical, and light industry, processing of agricultural produce, instrument and machine building, transport, and communication. A number of agreements on cooperation between specific firms and companies have been signed. These include the Uzselkhozmashkholding company that signed a protocol of intent with the Kharkov tractor plant on co-production of tractors; and the Navoi mining and enrichment combine and the Uzstroymaterialy company, which agreed with their Ukrainian partners on development and shipment to Uzbekistan of excavator equipment. A contract was signed, worth approximately $2 million, for the delivery of Ukrainian made medical preparations to Uzbekistan. Yuzhkabel, a large Kharkov-based joint-stock company, will take part in a tender for delivery of cable products, and other bilateral cooperation projects are pending. In a landmark development for Ukraine, on 3 October, 2001, the Donbass Industrial Union corp. acquired a 39-percent stake in the Uzneftegazstroy company, for $1.15 million. In 2000, the firm’s subsidiaries produced 56.4 billion cubic meters of gas and 7.5 million tonnes of oil and gas condensate (to compare, Ukraine produced less than 18 billion cubic meters of gas and approximately 4 million tonnes of oil and gas condensate).
Cooperation is intensifying not only between member states of the GUUAM, whose creation and recent institutionalization is largely associated with Ukraine’s participation. Almost at the same time as the GUUAM, the Eurasian Economic Community (EurAsEC) emerged in the post-Soviet area, where a leading role is played by Russia. Despite its relatively short history, this association is new in name only: It has existed for several years as the Customs Union, with the same member states. Paradoxically, although the Customs Union was legally a full-fledged organization with an international status, there were neither unified customs tariffs with respect to third countries nor a free trade zone with no customs barriers for all five of its member states.
In the course of a meeting with President Leonid Kuchma of Ukraine and President Mikhail Voronin of Moldova (April 2002, Odessa), Russian President Vladimir Putin invited these countries to join the EurAsEC. Then, at a meeting with Ukrainian Prime Minister Anatoliy Kinakh, RF Prime Minister Mikhail Kasianov proposed lifting VAT on Russian oil shipments to Ukraine, “contingent on its entry into the EurAsEC.” This proposal drew a mixed reaction. Especially given that controlling stakes in the majority of Ukrainian oil refineries belong to Russian companies, which have already emerged as multinational corporations.
At the end of the past April, the Ukrainian and Russian foreign-policy departments compared notes, in a rather tough and categorical form, on two sensitive issues—demarcation of a common border and EurAsEC membership, which Moscow seeks to impose on Kiev. It is encouraging that after a protracted silence on the demarcation issue or (at best) incoherent comments to the effect that “we are currently working on delimitation,” Ukraine’s high-ranking trio—Foreign Minister Anatoliy Zlenko, National Security Council Secretary Evhen Marchuk, and Foreign Ministry Deputy Secretary of State Vladimir Elchenko—formulated the republic’s position in no uncertain terms: The Ukrainian-Russian border will be demarcated no matter what. This was brought about by a recent statement by Russian Deputy Foreign Minister Valeriy Loshchinin, who said that Moscow was opposed to demarcation of the state border between the two countries. In his opinion, demarcation of the state border will lead to a large number of problems, affecting economic cooperation between RF and Ukrainian border regions, while some “hot heads” would like to perpetuate the fences and barriers between our countries. This strange vision of the demarcation process by a high-ranking Russian diplomat prompted V. Elchenko to set the record straight and explain that demarcation is a part and parcel of the process of fixing state borders in accordance with rules of international law.
Furthermore, E. Marchuk told a news conference that Ukraine hopes, within the second quarter of this year, to finalize delimitation of the sea border with Russia. According to the secretary of the Ukrainian National Security Council, agreement was reached to the effect that preparation of a draft agreement on the state border should be completed and appropriate documents submitted to the presidents within the same period. In addition, E. Marchuk stressed, Ukraine does not intend to confine itself to border delimitation, and when the procedure is over, will go ahead with its demarcation. After all, the border problem cannot be resolved conclusively without demarcation.
The debate on Ukraine’s participation (or non-participation) in the EurAsEC was equally heated. It is noteworthy that soon after top Russian leaders came out with statements on the issue, Alexander Chalyy, state secretary of the Ukrainian Foreign Ministry for European integration, said in no uncertain terms that the republic will not be in a position to “endure two integrations” while accession to the EurAsEC will mean a deviation from Ukraine’s strategic line toward full-scale integration into the EU, as proclaimed by the country’s president. Viktor Chernomyrdin, the Russian ambassador to Ukraine, who continues to irk everyone with his less-than-diplomatic rhetoric and still feels the governor-general of Ukraine, described the high-ranking Ukrainian diplomat as “an obtuse person,” suggesting that he had expressed his personal opinion.
To his credit, A. Zlenko did not overlook the rude comment by the Russian “diplomat,” pointing out that it was “overemotional.” Thus the minister supported his subordinate, who said that Ukraine’s course toward integration into the EU is incompatible with its EurAsEC membership, not only repeating but even reinforcing the point that was first made by A. Chalyy: “Ukraine has opted for integration with the EU and cannot be a member of another union. No country can be a member of several unions at once, but can only chose one. Ukraine has chosen the European Union.”1
Our republic’s relations with EurAsEC member countries are already regulated by a system of multilateral agreements within the framework of the CIS and bilateral treaties. Some of the most important CIS documents in this sphere are as follows: the Agreement on the Creation of a Free Trade Zone (not as yet ratified by Russia) with a Protocol thereto (15 April, 1994); the Agreement on Principles of Formation of a Unified Transport Area and Interaction in the Sphere of Transport Policy (9 October, 1997); the Agreement on a Common Agricultural Market (6 March, 1998); and others. Furthermore, Ukraine signed bilateral agreements with EurAsEC member countries on industrial cooperation, free trade (with a number of provisos), and others. This list, which could be easily continued, shows that the EurAsEC largely repeats existing CIS accords, only on the subregional level. So there is good reason to say that relations between the “Group of Five” and Ukraine have a firm base in international law while the potential of the agreements that have been signed has yet to be tapped to the full. Ukraine is interested in EurAsEC markets, the Russian market being the most attractive to it. On the whole, Ukraine’s foreign trade today is characterized by a reorientation of export from the CIS market to other markets while in import, the share of former Soviet republics remains fairly high.2
Integration of Ukrainian and Russian enterprises proceeds on the micro-level, without tapping the mechanisms of various subregional associations. A case in point is the Siberian Aluminum company, whose core enterprise, the Sayansk Aluminum Plant, can produce approximately 400,000 tonnes of raw aluminum a year. In 1997-1999, it incorporated the capacities of the Sayano-Shushensk hydroelectric power station, the Pavlodar Aluminum Plant (Kazakhstan), and the Nikolaev Alumina Plant (Ukraine). All the indications are that this group has emerged as a multinational corporation. Siberian Aluminum also comprises such processing enterprises as Sayanskaya Folga, the main producer of aluminum strip, foil, and packaging materials, and the Samara Metallurgical Plant, the key producer of rolled aluminum and semi-finished products in the CIS. The group has also been joined by Rostara, Russia’s first manufacturer of aluminum cans for the food industry, accounting for up to 50 percent of these products nationwide; and the Abakanvagonmash plant (special-purpose refrigerating rail containers and freight cars). Finally, in 2000, the merging of Siberian Aluminum; Sibneft-affiliated aluminum enterprises; the Achinsk Alumina Combine; three aluminum plants—in Krasnoiarsk, Bratsk, and Novokuznetsk, and a number of rolled aluminum and aluminum foil enterprises led to the creation of the Russkiy Aluminum concern. The concern acquired a 45-percent stake in the Nikolaev Alumina Plant. Given that by the time Siberian Aluminum already held 30 percent of its stock, today Russkiy Aluminum controls 75 percent of stock in an enterprise that is strategically important for the Ukrainian economy. Incidentally, according to the latest reports, Russkiy Aluminum now holds close to 100 percent of its stock.
This period also saw a trend toward a merging of enterprises in the oil-refining and petrochemical sectors of the three largest CIS countries: the Russian Federation, Kazakhstan, and Ukraine. This project (Alliance) is based on an interstate agreement between Ukraine and Kazakhstan on acquisition by the latter of a stake in the Kherson oil refinery, guaranteeing continuous oil supplies to the refinery. Despite the fact that Zia Bazhaev, a leading project manager, was killed in an air accident in early 2000, the plan is being successfully implemented. The following enterprises are affiliated with Alliance, with an external-management status: Variega neftegaz, providing consulting services (commissioned by the administration of the Khanty-Mansi Autonomous District); Vostoksibugol (consulting services, the administration of the Irkutsk Region); the Tomsk petrochemical combine (managing assets and liabilities of the Siberian chemical company, which is under the jurisdiction of the RF Ministry of Atomic Energy); and the Khabarovsk oil refinery with five retailer enterprises (their stock, under an agreement with the Rosinvestneft company, may be bought out). Finally, a controlling stake in the Kherson oil refinery was bought out (under the project, it is to develop comprehensively with Kazakhstani oil producing and oil transportation companies).
In some cases restoration of production-sharing arrangements between CIS enterprises is necessitated by the fact that, in the face of economic difficulties, it is impossible to compensate for the broken (but still vital) co-production links with the industrial capacity of any one state in the post-Soviet area. For this reason (despite the fact that the Ashghabad Agreement is still in force), in an effort to advance cooperation and implement joint programs and projects, on 24 April, 1998, the RF government and the Ukrainian cabinet of ministers signed a production-sharing agreement. Art 2 of the agreement provides that the itemized lists and volumes of shipments of products under subcontracting arrangements as well as economic entities providing these shipments are to be established on a yearly basis by a corresponding protocol which is part and parcel of the agreement. To stimulate producers in both countries to sign contracts for the shipment of goods under the protocol, Art 3 of the agreement provides that these goods (services) will not be subject to VAT or excise duties.
Creation of Ukrainian-Russian joint ventures or the acquisition by Russian companies of Ukrainian plants through their privatization and reorganization as joint-stock companies is becoming common practice. A case in point is vertical integration in the process of production sharing between enterprises in the RF oil and gas sector. Oil and gas companies are expanding their sphere of activity with the participation of corresponding enterprises in inter-branch financial-industrial groups whose interests go beyond Russia. The fact is that not all Russian companies had an opportunity to set up a complete production cycle—from raw materials to final products—on its territory. Thus, the Tatneft company failed to acquire a single oil refinery among the RF oil refining enterprises. So it set up a Ukrainian-Russian joint venture, called Ukrtatnafta. On the Ukrainian side, it includes the Kremenchug oil refinery, which has in effect become the only Ukrainian oil refinery that has performed more or less successfully in the last few years.
Other Russian companies, even though they have their own oil refineries in Russia, have in recent years also been actively acquiring oil refineries closer to Central and Western European markets. Thus, LUKoil acquired oil refineries in Romania and the Czech Republic as well as assets in the Baltic region and Ukraine, including a controlling stake in the Odessa oil refinery. LUKoil is modernizing the latter to provide a deeper refining of Russian oil and export oil products to non-CIS countries. Furthermore, this Russian major is creating a network of gas stations in the south of Ukraine, with a view to establishing a complete production cycle in the country.
In 2000, the Tiumen Oil Company acquired a 67.41 percent stake in the Lisichansk oil refinery (establishing the TNK-Ukraine joint venture). It is the most technologically advanced oil refinery in Ukraine, built in the early 1970s; in the early 1990s, it underwent partial modernization (with German credits). Even so, in February-March 2001, TNK-Ukraine received two loans (the largest in Ukraine’s modern history)—$300 million and $600 million—from ABN AMRO, a Dutch bank, to carry out a comprehensive modernization program. Given that in May of the same year, the Tiumen Oil Company signed an agreement with Deutsche Bank to draw another $250 million in credits to realize environment protection programs, the aggregate sum of credits in 2001 exceeded $1 billion. The credit policy pursued by Alfa Group, the owner of TNK-Ukraine, therefore, arouses concern since consortium President Mikhail Fridman has never made a secret of his nature as a “speculative investor, whose main task is to buy cheap and resell dear.” In addition, just like LUKoil, this consortium has begun building up its own network of gas stations—this time in central and eastern parts of Ukraine (in the Donetsk, Lughansk, Kirovograd, and Kiev regions) to be able to market the final product to end consumers in the country. And since Alfa Group’s debts are at least double its assets, the company created by this consortium with all of its gas stations could one fine day end up under the control of Western oil multinationals. The process transferring the property to the latter could effectively stop the Lisichansk plant, as a result of which its consumers, as well as the budget of Ukraine, could sustain heavy losses, which would far exceed profits from the sale of the firm.
Meanwhile, considering the emerging trend in the redistribution of roles of players on the world’s geo-economic chessboard, Ukraine has a good chance of occupying a deserving place here.
1 “Na granitse zarosli koliuchi. Ne rasti tam provoloke koliuchei?” Zerkalo nedeli, No. 16, 27 April, 2002, p. 4.
2 See: A.V. Burakovskiy, “Evraziiskoie ekonomicheskoie soobshchestvo: namereniia i perspektivy,” Zerkalo nedeli, No. 16, 27 April, 2002, p. 6.