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ETLA ELINKEINOELÄMÄN TUTKIMUSLAITOS THE RESEARCH INSTITUTE OF THE FINNISH ECONOMY Lönnrotinkatu 4 B Helsinki Finland Tel Telefax World Wide Web: Keskusteluaiheita

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ETLA ELINKEINOELÄMÄN TUTKIMUSLAITOS THE RESEARCH INSTITUTE OF THE FINNISH ECONOMY Lönnrotinkatu 4 B Helsinki Finland Tel Telefax World Wide Web: Keskusteluaiheita Discussion papers No Ville Kaitila FREE TRADE BETWEEN THE EU AND RUSSIA: SECTORAL EFFECTS AND IMPACT ON NORTHWEST RUSSIA This discussion paper is part of the project Opening of the Russian Economy and Its Integration with the European Union. I would like to thank Kari Alho, Leena Kerkelä, Paavo Suni, Risto Vaittinen, Mika Widgrén, and the participants of the seminars of the project group, of the BOFIT Summer Workshop in June 2006 in Helsinki, and of the session of the Russia in Flux Research Programme in Turku in September 2006 for helpful comments. The usual disclaimer applies. Financial support (Grant No of the Russia in Flux Research Programme) from the Academy of Finland is gratefully acknowledged. ISSN KAITILA, Ville, FREE TRADE BETWEEN THE EU AND RUSSIA: SECTORAL EFFECTS AND IMPACT ON NORTHWEST RUSSIA. Helsinki: ETLA, Elinkeinoelämän Tutkimuslaitos, The Research Institute of the Finnish Economy, 2007, 23 p. (Keskusteluaiheita, Discussion papers, ISSN ; No. 1087). ABSTRACT: We analyse the implications of free trade between the EU25 and Russia using GTAP, a computable general equilibrium model. We review the sectoral effects by countries and make a tentative assessment of the impact on the regions in northwest Russia. Free trade on its own would have a negative terms-of-trade effect in Russia and cause a small decline in welfare. If coupled with an increase in productivity, welfare would increase. This emphasises the importance of reforms in the Russian economy. The quantity of production in Russia in ferrous and non-ferrous metallurgy, machine building and metal working, and wood and paper are the principal declining sectors with free trade. Production in capital goods, fuel industry, and services increases. Thus there are some symptoms of Dutch disease. Due to its production structure the northwest would seem to benefit slightly less than Russia on average in terms of the volume of gross regional product. In this respect there are differences between the regions of northwest Russia. KEY WORDS: EU, Russia, free trade, integration JEL CODES: F15, F17 KAITILA, Ville, VAPAAKAUPPA EU:N JA VENÄJÄN VÄLILLÄ: TOIMIALAVAI- KUTUKSET JA VAIKUTUKSET LUOTEIS-VENÄJÄLLÄ. Helsinki: ETLA, Elinkeinoelämän Tutkimuslaitos, The Research Institute of the Finnish Economy, 2007, 23 s. (Keskusteluaiheita, Discussion papers, ISSN ; nro 1087). TIIVISTELMÄ: Tässä tutkimuksessa analysoidaan EU25-maiden ja Venäjän välisen vapaakaupan vaikutuksia yleisen tasapainon GTAP-mallin avulla. Tutkimuksessa tarkastellaan myös toimialakohtaisia vaikutuksia eri maissa ja tehdään arvio vaikutuksista Luoteis-Venäjän eri alueilla. Vapaakauppa itsessään heikentää Venäjän vaihtosuhdetta ja alentaa hieman hyvinvointia. Kun vapaakauppaan yhdistetään pieni tuottavuuden paraneminen, hyvinvointi kasvaa. Tämä korostaa uudistusten merkitystä Venäjän talouskehityksen kannalta. Tuotannon määrä metallien jalostuksessa, metallituotteiden valmistuksessa, koneiden ja laitteiden valmistuksessa sekä puu- ja paperiteollisuudessa vähenee. Sen sijaan investointitavaroiden, öljy- ja kaasusektorin sekä palvelualojen tuotanto kasvaa. Siten vapaakaupasta aiheutuu Venäjällä Hollannin taudin oireita. Bruttokansantuotteen osalta Luoteis-Venäjä hyötyy keskimäärin hieman vähemmän kuin koko Venäjä. Tämä johtuu tuotantorakenteesta. Eri Luoteis-Venäjän alueiden välillä on kuitenkin tässä suhteessa eroja. AVAINSANAT: EU, Venäjä, vapaakauppa, integraatio JEL-LUOKAT: F15, F17 1 INTRODUCTION A Partnership and Co-operation Agreement (PCA) between the European Union and Russia entered into force in December Among other things, the agreement established as an objective to create the necessary conditions for the future establishment of a free trade area between the Community and Russia covering substantially all trade in goods between them, as well as conditions for bringing about freedom of establishment of companies, of crossborder trade in services and of capital movements. However, reaching this objective as well as the other ones listed in the agreement has been relatively sluggish, if not inexistent. Still, free trade between the EU and Russia would be a positive step for the whole continent. It is thus important to analyse the effects of free trade. We follow in the footsteps of Sulamaa and Widgrén (2004, 2005) who analysed the effects of free trade between the EU25 and Russia using the GTAP model. They also included an increase in the rate of substitutability between imported and domestically produced goods, that is higher Armington elasticities, and an increase in total factor productivity. Our analysis differs from Sulamaa and Widgrén s in that we do not liberalise trade in agricultural produce or foodstuffs, just everything else. This is because despite the wording in the PCA we think that full liberalisation of trade in these goods is relatively unlikely for political reasons in both the EU and Russia. We also do not change the Armington elasticities. Instead, we include an analysis of sectoral effects along with a tentative assessment of the possible impact of trade liberalisation on the ten regions in northwest Russia. We use the GTAP model, same as Sulamaa and Widgrén. The GTAP database 6.0 has been constructed with 2001 as the base year. This means that the EU still has 15 member countries. In order to bring the data more up to date with the enlargement of the EU in 2004, we need to assimilate the ten new member countries (EU10). 2 This is done in our baseline scenario. After that we analyse two simulation scenarios which are compared with the results from the baseline scenario. Baseline scenario: Free trade within the EU25 region with Common External Tariffs implemented for the new member countries; 3 Scenario 1: Free trade between the EU25 and Russia in all products except agricultural produce and foodstuffs; and Scenario 2: Free trade between the EU25 and Russia in all products except agricultural produce and foodstuffs and a 1 per cent increase in productivity in Russia for all inputs and in all sectors (see Section 2.2 about the productivity increase). According to our results, free trade between the EU25 and Russia would have a small negative effect on welfare in Russia due to a deterioration in Russia s terms of trade. Following the removal of tariffs, the volume of Russian imports would grow twice as much as that of exports. Combining free trade with a small increase in productivity in Russia, welfare would increase substantially despite the deterioration in the terms of trade. The increase in productivity would also lead to an increase in the quantity of output. The quantity of production in Russia in ferrous and non-ferrous metallurgy, machine building and metal working, and wood and paper are the principal declining sectors with free trade. Production in capital goods, fuel industry, and services increases. Thus there are symp- 1 The EU has PCAs with other CIS countries, also. 2 We will ignore the 2007 enlargement. 3 We do not take into account other implications of EU membership of which CAP-related and other income transfers are a major one, see further discussion in Section 4.1. 2 toms of Dutch disease with the fuel industry growing and manufacturing shrinking. Taking into account the local production structure, the northwest of Russia would seem to benefit slightly less than Russia on average in terms of the volume of gross regional product. There are considerable differences between the regions in the northwest depending on the local production structure. We emphasise the importance of economic reforms coupled with increasing competition where the presence of foreign companies through trade and investment would be beneficial. In Section 2, we will discuss the changes that we make in the tariffs and the positive productivity shock that we introduce. Section 3 includes a presentation of the GTAP model. Section 4 shows the results from the simulation scenarios and Section 5 concludes. Appendix 1 shows the sectoral aggregation that we use. Appendix 2 shows the readjustments we have made to official economic data of the structure of Russia s GDP and the northwest regions. The readjustments make the regional data more in line with the GTAP database and thus improves the results. 2 CHANGES IN TARIFFS AND PRODUCTIVITY 2.1 Changes in Tariffs and Subsidies The changes that we make in the import and export tariffs and subsidies drive the results we get in the free trade scenarios. The baseline scenario requires us to remove all the remaining barriers in trade between the EU15 and the new member countries (EU10). In 2001, there were not a lot of these left, mainly just in agricultural produce and foodstuffs. The common external tariffs of the EU15 countries are then used for the EU10 countries. Furthermore, non-eu25 countries will start to use those tariffs that they have with the EU15 countries also in their trade with the EU10 countries. These are done at the level of aggregation of sectors and regions discussed in Section 3.6. As far as trade in textiles is concerned, we do not take into account the end of the WTO Agreement on Textiles and Clothing which was in place during (see the end of Section 4.3, however). Also the very likely Russian WTO membership is not considered. In addition to the changes made in the baseline scenario, Scenario 1 will remove all tariffs in trade between the EU25 countries and Russia in all except agricultural produce and foodstuffs. Russia s tariffs with non-eu25 countries will remain unchanged. Compared with the Union, Russia has relatively high import tariffs. Table 1 shows the weighted averages of Russia s average applied import MFN tariff rates on non-agricultural and non-fuel products. Table 2 shows the pre-shock trade barriers between the EU and Russia according to the GTAP database. These are all nullified in Sections 4.2 and 4.3 apart from the trade barriers in agricultural produce and foodstuffs, which are left unchanged. The nullified tariffs and subsidies are shown in bold. We see that the largest changes will have to be made by Russia. On the EU side, no export subsidies need to be removed. However, the EU has to remove some tariffs in its imports from Russia. This will make Russian products more competitive. As for Russia, it needs to remove duties in its exports to the EU, which also will make Russian products more competitive. Finally, Russia needs to remove the tariffs it charges in its imports from the EU. These measures will all tend to increase trade between the EU and Russia. Looking at the mere percentages, Russian tariffs in its imports are larger than those in its exports. Ceteris paribus, we may therefore expect there to be a larger increase in Russia s imports from the EU25 than in its exports there. 3 Table 1 Average applied import MFN tariff rates on non-agricultural and non-fuel products in Russia, weighted averages Year Total of nonagricultural and non-fuel products Of which Ores and metals Manufactured products Of which Chemical products Machinery and transport equipment Other manufactured products Source: UNCTAD Handbook of Statistics Table 2 Tariffs and subsidies in trade between the EU and Russia, % Sector Export subsidy in exports from the EU to Russia, paid in the EU rtxs(i, EU, s); Positive values indicate a subsidy Import tariffs in imports from Russia to the EU, levied in the EU rtms(i, r, EU); Positive values indicate a tariff Export duties in exports from Russia to the EU, levied in Russia rtxs(i, r, EU); Negative values indicate a tariff Import tariffs in imports from the EU to Russia, levied in Russia rtms(i, EU, s); Positive values indicate a tariff Agricultural produce Electric power industry Fuel industry Ferrous metallurgy Non-ferrous metallurgy Chemical and petroleum products Machine building and metal working Wood and paper Building materials Textiles Food processing Manufacturing, n.e.c Services Rutherford and Tarr (2006) construct a computable general equilibrium model of the regions of Russia to estimate the effects of the country s accession to the WTO. According to their results, the average gain in welfare as a percentage of GDP for the whole country is 4.3 per cent, but the northwest will gain 6.2 per cent and St. Petersburg 5.7 per cent, that is more than Russia on average. This is because these regions are expected to attract more foreign direct investment (especially in business services) than Russia on average. The FDI inflows are assumed to increase productivity. Some three-quarters of the total positive effect comes from FDI liberalisation. The results differ from our results which indicate that the northwest would benefit slightly less than Russia on average from free trade with the European Union. The setup is of course different, because Rutherford and Tarr s research question concerns the effects of Russia s WTO membership. Furthermore, they expect the northwest to receive above-average FDI inflows which are the driving force behind the increase in productivity. 4 Even so their results indicate that the northwest would benefit more than Russia on average from a halving of Russia s import tariffs. On the other hand, they do not change Russia s export taxes as we do. They of course also cut the import tariffs for all Russian imports, not just in trade with the EU. 2.2 Change in productivity Production and productivity have increased considerably in Russia in recent years. This is largely due to a rise in capacity utilisation from its lows in the late 1990s and an increase in employment. Presently and in the near future, investment activity will need to pick up to support production capacity and productivity growth. Otherwise GDP growth is likely to slow down. It is slightly difficult to argue where the positive productivity shock that we introduce in Scenario 2 comes from and even more difficult to decide how large it should be. 4 The increase in productivity could be due to an increase in competition and better functioning of the markets. Foreign direct investment could be a driver here especially if the investment originates in a more developed country, thus probably raising the level of technological as well as business and managerial know-how in the receiving country. We will take a closer look at empirical evidence on FDI-induced productivity growth. Other possible channels are mostly ignored here. The OECD (2003) argues that foreign corporate presence may 1) act as a trigger for transfers of technology and know-how, 2) assist enterprise development and restructuring (especially in connection with privatisation), 3) contribute to fuller international (trade) integration, 4) bolster business sector competition, and 5) support human capital formation in the host country. Saggi (2002), for example, is a survey of the literature dealing with the role of trade and FDI in technology transfer. The firm that makes the business investment, say purchases and improves upon an old manufacturing company or builds a totally new one, is likely to invest in the stock of machinery and equipment in the plant, maybe not state-of-the-art equipment, but still more modern and labour-saving equipment than what was used in the old plant. This will have a small positive effect on the average quality of equipment in that sector of manufacturing. The firm is also likely to bring in more modern business management, especially relative to what has been used in developing countries or transition economies. Increased competition may also force less efficient local firms to close down or to sharpen up. The latter may also start to imitate the products as well as production and other practices of foreign companies. But how large an effect, if any, can we presume FDI to have on the economy or a sector on average. Besides, in many cases the first investments in transition countries have been assembly lines etc. that have rather low value added with only a small contribution to GDP. Furthermore, the case for the positive effects of FDI inflows is far from evident on the basis of empirical research. Javorcik (2004) uses firm-level data for Lithuania and finds positive productivity spillovers arising from the contacts between foreign affiliates and their local suppliers, that is in connection with vertical backward linkages. According to the results, these effects arise in projects with shared local and foreign ownership, but not with fully foreign-owned foreign investments. A number of other micro-level studies have failed to find positive effects from spillovers in transition countries. The results for industrialised countries show a more positive impact (see the references in, for example, Javorcik, 2004, and Görg and Greenaway, 4 The shock we will introduce is a primary factor augmenting technical change (variable afeall in GTAP) of 1 per cent in all factors and all sectors in Russia. The shock is also introduced in those sectors, agriculture and foodstuffs industries, that are not opened up to free trade. Sulamaa and Widgrén (2004, 2005) use a 6 per cent shock in total factor productivity. 5 2002). Javorcik argues that the spillovers are more likely to be vertical than horizontal. She finds no robust evidence of either horizontal or vertical forward linkages. Alfaro et al. (2006) find that if financial markets in the host country work well, backward linkages between foreign and domestic firms create positive FDI spillovers. Financially welldeveloped economies experience much higher GDP growth rates than economies with weak financial markets. Furthermore, other local conditions such as market structure and human capital are also important for the effect of FDI on economic growth. Mencinger (2003) does not find evidence of FDI having a positive impact on GDP growth in the Central and Eastern European countries that joined the EU in In fact, he finds a negative correlation between GDP growth and FDI inflows. He argues that this is because of the characteristics of the FDI inflows and of the EU10 countries. The FDI inflows have mainly been acquisitions following large-scale privatisations. Acquisitions have not automatically resulted in investments in real assets, as proceeds of the sales have been spent on consumption and imports. Mencinger argues that this is shown by the absence of a relationship between FDI and gross fixed investment and a positive relation between FDI and the current-account deficit. Sohinger (2005) argues in favour of the positive effects from FDI for the European transition economies, but the article does not include any econometric analysis. She argues that FDI increased the capital stock and is making it possible for these countries to move from product imitation to innovation. However, she admits that an initially low level of technological development still causes the general absorptive capacity of local companies to be low. An empirical microanalysis of a developed country is presented in Aghion et al. (2004). They conclude that after the UK economy opened up in the 1980s more entry as measured by a higher share of industry employment in foreign firms led to faster total factor productivity growth in incumbent domestic firms and faster growth in aggregate productivity in the economy. 5 They argue that entry stimulates growth in the incumbents by inducing those close to the technological frontier to innovate. 6,7 They also present other possibilities, namely that the entrants may force the incumbents with low productivity and growth to exit the market, or that the entrants demonstrate new business methods and products to the incumbents and these better methods then spill over to the latter. Figure 1 shows that the inward stock of FDI relative to the
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