Master Class in Economics by Dr. Gerald Pech Associate Professor

The Customs Union Game

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

Customs Union versus Free Trade Agreements

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

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”.

Free Trade Agreements

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

Customs Union

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

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

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)

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

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

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?

The Dynamics of Economic Integration

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

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

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

The Zollverein

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

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

Trade diversion in Kyrgyzstan

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

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

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

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

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 ?

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

Some further reading Alimbekov/Madumarov/Pech (2013), Sequencing in Customs Union Formation, KIMEP, at 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.

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

Supporting Materials

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

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

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!

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

Trade diversion and creation in different CIS countries source: CISSTAT

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

Standard and non standard channels