JUNE 2020 Research Report 447 Economic Challenges and Costs of Reintegrating the Donbas Region in Ukraine Peter Havlik, Artem Kochnev and Olga Pindyuk The Vienna Institute for International Economic Studies Wiener Institut für Internationale Wirtschaftsvergleiche Economic Challenges and Costs of Reintegrating the Donbas Region in Ukraine PETER HAVLIK ARTEM KOCHNEV OLGA PINDYUK Peter Havlik is Senior Research Associate at The Vienna Institute for International Economic Studies (wiiw). Artem Kochnev is PhD student at Johannes Kepler University (JKU) Linz and at the University of Innsbruck (UIBK), Austria. Olga Pindyuk is Economist at wiiw. The conclusions and recommendations developed in this report represent a compromise formulation on which the research team could agree. As such, they should not be directly attributed to individual authors of the report. The authors wish to thank Richard Grieveson, wiiw Deputy Director, for valuable comments on an earlier draft and Alexandra Bykova, wiiw statistician, for excellent statistical assistance. Abstract This study provides a systematic assessment of the costs of the ongoing armed conflict in the Donbas region of Ukraine. By combining the pre-war geographical distribution of fixed capital with data on battle intensity, survey evidence on household damage in the conflict-affected areas and novel data on the macroeconomy of certain areas of the Donetsk and Luhansk regions, the report estimates the minimum reconstruction costs of the region at USD 21.7 billion. On the basis of the composition of the costs, the study argues that the government’s main focus should be on restoring the basic institutions that are usually taken for granted in most economies: the markets and state capacity. The study proposes the key features of a reconstruction plan to help achieve this goal. This plan – assuming a lasting ceasefire is being observed – involves a continuation of the reform path in order to achieve sustainable and inclusive economic growth, to attract both foreign and domestic investments, improve the well-being of Ukrainian citizens and increase the opportunity costs of conflict. The systematic collection and dissemination of data on the Donbas region is essential. Ukraine should strive for balanced trade with the rest of the world. Last but not least, ensure that the peace settlement is durable. In the case of the Donbas this would mean an additional agreement that would not substitute the Minsk II Agreement but would both help to implement and complement it. Keywords: conflict economics, political economy, international conflict, Ukraine, restoration, Donbas JEL classification: F50, F51, H12, H56, O52, I38, Q34 CONTENTS The implications of COVID-19 for this study.................................................................................................. 1 References .................................................................................................................................................3 Executive summary .................................................................................................................................................. 4 Introduction ................................................................................................................................................................. 6 Overview of the Donbas conflict .......................................................................................................................... 7 The war in Donbas: a long view ..................................................................................................................7 Current state ...............................................................................................................................................9 Policies of Ukraine around the conflict ......................................................................................................10 Mediation efforts .......................................................................................................................................11 Summary ..................................................................................................................................................13 The war in Donbas and the economy ............................................................................................................... 14 The macroeconomy of Ukraine .................................................................................................................14 The economy of ‘Certain Areas of Donetsk and Luhansk Regions’ .........................................................19 Lessons from other conflict regions ............................................................................................................... 25 Conflict trends and conflict effects ............................................................................................................25 Paths to conflict resolution ........................................................................................................................26 Summary ..................................................................................................................................................30 Estimates of conflict and reconstruction costs ........................................................................................... 31 Existing estimates .....................................................................................................................................31 Effects of the armed conflict on capital stocks ..........................................................................................32 Effects of the armed conflict on human capital .........................................................................................35 Effects of the armed conflict on the environment......................................................................................37 Conclusions................................................................................................................................................................. 40 Policy recommendations ...................................................................................................................................... 42 Outline of the reconstruction plan .............................................................................................................43 Financing and coordination.......................................................................................................................44 General recommendations .......................................................................................................................45 Selected references .................................................................................................................................................. 47 Annexes ........................................................................................................................................................................ 56 Annex 1: Statistical data ........................................................................................................................... 56 Annex 2: Supporting graphs ..................................................................................................................... 60 Annex 3: International assistance ............................................................................................................ 63 Annex 4: Methodology of capital stock losses estimates ......................................................................... 64 Annex 5: Methodology of human capital losses estimates ...................................................................... 69 Annex 6: Results of the lawsuits between Ukraine and the Russian Federation ..................................... 70 Annex 7: Estimation of disbursement of funds for the restoration ............................................................ 71 TABLES AND FIGURES Table 1 / Estimated humanitarian needs and funding for Ukraine, 2015-2020.........................................22 Table 2 / Distribution of recorded conflict episodes, by number of fatalities .............................................26 Table 3 / Estimated direct damage to capital stocks, USD billion, 2018 prices ........................................34 Figure 1 / Areas of Ukraine not under government control .........................................................................7 Figure 2 / Number of fatalities of the UAF during the conflict. Left panel: complete sample; Right panel: sample since March 2015 ......................................................................................8 Figure 3 / Evolution of the ‘uncontrolled’ territories.....................................................................................8 Figure 4 / Number of ceasefire violations under Poroshenko and Zelensky ............................................10 Figure 5 / Index of GDP growth, 2013=100 ..............................................................................................14 Figure 6 / Index of goods exports, 2013=100 ...........................................................................................14 Figure 7 / Ukraine’s export partners .........................................................................................................15 Figure 8 / Ukraine’s import partners .........................................................................................................15