1. Master Class in Economics by Dr. Gerald Pech Associate Professor www.geraldpech.net1

2. The Customs Union Game www.geraldpech.net2

3. EurAsian Customs Union Launched in July 2010 between Belarussia, Kazakhstan and Russia with Kyrgyzstan expected to be the next member to join maybe now overtaken by Armenia www.geraldpech.net3

4. Customs Union versus Free Trade Agreements www.geraldpech.net4

5. Free Trade Agreements Parties to free trade agreement abolish tariffs (and non tariff barriers) between members Each country has its own tariff regime against the rest of the world Examples of free trade blocs: NAFTA, CISFTA www.geraldpech.net5

6. Problems with Free Trade Agreements Third country imports – Trade deflection: Imports enter through country with lowest outside tariff, say Kyrgyzstan – But other countries in the free trade bloc often wish to “protect” themselves against third country imports – Border controls have to be maintained to impose the “origin principle”. www.geraldpech.net6

7. Free Trade Agreements www.geraldpech.net7

8. Customs Union A customs union abolishes all tariffs (and non tariff barriers) among the member countries Common tariff is applied to third countries www.geraldpech.net8

9. Customs Union www.geraldpech.net9

10. Customs Union Trade creation effect – CU partners trade more intensively because of reduction of tariff/non tariff cost of trade Trade diversion effect: – as barriers to imports from third countries increase, producers within the customs union are at an advantage www.geraldpech.net10

11. Winners and Losers in CU There are winners … – Within a Customs Union, most industrialized country typically wins: Belarus and losers – Kazakhstan’s imports from CU countries increased more than exports – and consumers are worse off with higher external tariff – Kyrgyzstan would have been a loser too but, as we shall see, it also loses by being non-member www.geraldpech.net11

12. Customs Union and Free Trade Blocs Customs unions and free trade blocs can in principle co-exist – remember that there are border controls which prevent that the free trader becomes the point of entry for imports into the customs union Examples: CISFTA/EurAsian CU, EFTA/EU – In the long term some EFTA members ended up joining the Union (Finland) while others stayed separate (Norway) www.geraldpech.net12

13. Could one country engage in free trade with two customs unions? – why not, as long as origin principle is enforced More Complicated Constructions EU EurAsian CU Ukraine www.geraldpech.net13

14. Could one country (Ukraine) do free trade with one customs union (EU) and be member of another customs union (EurAsian CU)? – difficult unless EurAsian Customs Union would like to engage in free trade with Europe – “cannot” (Barroso) More Complicated Constructions EU EurAsian CU Ukraine www.geraldpech.net14

15. More Complicated Constructions Solution: Second class membership? – Ukraine as free trader with Europe and EurAsian CU member with separate border controls? – This might be the final outcome for Kyrgyzstan with border controls remaining between Kazakhstan and Kyrgyzstan – and maybe for Ireland if Britain leaves the EU? – similarly for independent Scotland if it joins? www.geraldpech.net15

16. The Dynamics of Economic Integration www.geraldpech.net16

17. Which is the Logic behind the Timing of Customs Union Formation Why was Eurasian CU not founded in one step? – Perceived benefits of political decision makers change over time – Institutions and infrastructure take time to build – “Momentum” created by foundation of core customs union www.geraldpech.net17

18. A Historical Precedent Neither was the European Union created in one step nor the other particularly successful customs union – the Zollverein which ultimately resulted in German nationhood www.geraldpech.net18

19. The Zollverein The German Customs Union (Zollverein) was founded in 1833 between independent German states Starting with Prussian drive for economic integration of their own territory in 1819 Smaller German states experienced negative impact on their trade with the emerging union and one after the other joined www.geraldpech.net19

20. The Zollverein www.geraldpech.net20

21. Footnote: How come Prussia was the driving force behind the Zollverein? Prussia did not benefit that much from trading with the smaller states But it gained better a bargaining position when negotiating over trade with big players such as England and France www.geraldpech.net21

22. What creates “momentum”? We have seen that because of trade diversion effects at the first stage of creating a customs union smaller countries will see their trade balance with the union deteriorate and be more willing to join the same seems to happen to Kyrgyzstan www.geraldpech.net22

23. Trade diversion in Kyrgyzstan www.geraldpech.net23

24. The Logic behind the Timing of Customs Union Formation Assume a leading country such as Russia can choose whether to offer Kyrgyzstan immediate membership or second round membership It is aware that Kyrgyzstan needs to be compensated to join such that it is not worse off than before www.geraldpech.net24

25. The Logic behind the Timing of Customs Union Formation Now if Kyrgyzstan is a loser in the customs union it would need compensation when joining in the first round But it also loses by staying out! Once it has realized its losses by staying out, it will be more willing to join for less – i.e. willing to accept less favourable terms of entry than it would have requested in the first round www.geraldpech.net25

26. The Logic behind the Timing of Customs Union Formation In the following diagram we measure as w Kyr and w Rus the welfare for Kyrgyzstan and Russia We further assume that different membership arrangements are differently advantageous for Kyrgyzstan and Russia – moreover, there is a trade-off between advantage for Russia and Kyrgyzstan www.geraldpech.net26

27. core customs union status quo ante B A C A: Immediate Entry Solution: Full Access to CU market, compensation for losses B: Full access to CU market, less some compensation C: “Second class membership” with limited access to CU market, and some compensation www.geraldpech.net27

28. Conclusion and Outlook The “momentum” argument helps understand the process of customs union formation There are other dynamic aspects of interest, such as: – Does customs union lead to ever deeper integration ? www.geraldpech.net28

29. Conclusion and Outlook The EU has experienced ever deeper integration Recall that extension creates winners and losers So if there are losers, they need to be compensated How can this be done? – winners agree to pay some money (not credible in long run) – bargaining over joint institutions (EurAsian EC?) – common budget www.geraldpech.net29

30. Some further reading Alimbekov/Madumarov/Pech (2013), Sequencing in Customs Union Formation, KIMEP, at www.geraldpech.net Jandosov/Sabyrov (2011), Tariff Protection Level in Kazakhstan, RAKURS discussion paper 5.3./5.4. Macho-Stadler/Xue (2006), Winners and Losers from the Gradual Formation of Trading Blocs, working paper, Barcelona. Mattli (1999), The Logic of Regional Integration, Cambridge UP and google-books. www.geraldpech.net30

31. New in the Master of Arts in Economics Program From Fall 2014 Three full professors in economics – PhD’s from US and Australia One health economist! Major in Financial Economics! Expected: Scholarships www.geraldpech.net31

32. Supporting Materials www.geraldpech.net32

33. EurAsian Customs Union 1995: First agreement signed between Belarus, Russia, Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan. – Uzbekistan not interested at the moment – Tajikistan only has land border with Kyrgyzstan 2007: Dushanbe agreement on customs union signed between BY, KZ and RU 2010: Official launch of CU with external tariff at (high) Russian rates – for some goods July 2010, for others July 2011 www.geraldpech.net33

34. Other Organizations CISFTA: Free trade agreement between Armenia, Belarus, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, and Ukraine, signed in October 2011 EurAsian Economic Union: Creation of single economic space between Belarus, Kazakhstan and Russia launched in 2012 www.geraldpech.net34

35. Winners and Losers Economic welfare of a country is sum of – Consumer surplus – Tariff revenue – Profits of home producers – We assume that foreign firms have market power! As a proxy for impact of CU we use – change in current account balance – change consumer surplus of non numeraire good Political benefits and costs! www.geraldpech.net35

36. Tariff Protection simple average 2009 weighted average 2009 Kazakhstan6.78%5.52% Belarus8.00%2.3% Russia8.09%5.9% EU10.6%7.37% from: Jandasov/Sabyrova 2009 www.geraldpech.net36

37. Trade diversion and creation in different CIS countries www.geraldpech.net37 source: CISSTAT

38. Standard and non standard channels Source: Vashakmadze, E., Kaminski, B., Mironova, Y., (2011). www.geraldpech.net38

39. Standard and non standard channels www.geraldpech.net39