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Ukraine has made progress on the integration path with the European Union, having stipulated a free trade agreement due to take effect on January 1, 2016.

This has come at the cost of losing its privileged trade terms with Russia. The Russian parliament has suspended the free trade zone with the country, worrying that a reduction of tariffs between Ukraine and the EU will hurt Russia’s economic interests. More than 20 rounds of three-way talks between Moscow, Kiev and Brussels were held in the past 18 months to iron out differences and concerns, but the parties failed to find an agreement.

“We were quite close in finding some of the practical solutions and I think had there been a will, we would have been able to do that,” said EU trade commissioner Cecilia Malmström at a press conference after the latest meeting with Russian economic development minister Alexei Ulyukayev and Ukrainian foreign minister Pavlo Klimkin. “However, today there was not enough flexibility on the Russian side to do that,” she noted.

The conflict between Russia and Ukraine over the latter’s rapprochement to the EU has had a significant impact on their trade relations already. Ukrainian exports to Russia plummeted by 55.6% between January and September 2015 in annual terms, while imports fell by 47.9% for the same period. “Russia’s decision to cancel the privileged trade terms with Ukraine will depress the bilateral trade figures further, and as before it is expected to hit Ukraine more than Russia,” says Lilit Gevorgyan, senior economist at IHS Global Insight. “Of course, the EU is Ukraine’s largest trading partner but Russia, despite the dramatic fall in trade, still remains the top trading partner country for Ukraine.”

According to Gevorgyan, free trade with the EU is unlikely to compensate for the loss of the Russian market, at least for the next year or two.

The free trade deal with the EU allows the country freer access to its largest trade destination, and will also force Ukraine to modernise its businesses and meet much stricter EU standards of production. “The free trade might be bad news for many Ukrainian Soviet-style ineffective businesses that are capital and labour-intensive and not price-competitive,” says Gevorgyan, adding that not only these firms will have difficulties exporting due to their price competitiveness, but they also risk losing domestic market share to more competitive European exporters. According to her, Ukrainian businesses that are willing to modernise will still face difficulties in raising the capital or investment needed to do so.

“Only the large Ukrainian companies, especially those specialising in commodity exports, could see the benefits of tariff-free trade with the European bloc. As such, currently the Russian market is much more attractive for some of the Ukrainian exports that perhaps are not price-competitive or do not meet much higher EU standards,” says Gevorgyan.

For all these hurdles, and the ongoing conflict in the eastern part of the country, Ukraine’s economy is expected see a double-digit annual contraction in 2015. IHS projects real GDP to shrink by 10.6% in 2015, and by 3.4% in 2016. “Normalising trade relations with Russia will be critical for the recovery of Ukraine’s exports and its overall economic health in the coming years,” says Gevorgyan.

On the Russian side, trade conflicts extend beyond the Ukrainian border. Russia recently imposed sanctions on trade with Turkey following the downing of one of its fighter planes, and also has agricultural sanctions in place against the EU as retaliation for the EU and US sanctions on the country following the annexation of Crimea. Both the EU and the US have extended their sanctions for another semester, with the US adding 34 names to the list of sanctioned individuals.