Customs Union in the CIS

1. Customs Union in the CIS Prepared for the World Bank Institute Course in Moscow, Russia “Trade Policy and WTO Accession for Development in Russia and the CIS”  March 28-April 8, 2005 Constantine Michalopoulos and David G. Tarr The World Bank *The views expressed are those of the authors and do not necessarily reflect those of the World Bank or its Executive Directors.

2. Participating in a free trade area or customs union does not necessarily mean that the country has moved toward a free and open trade regime that we recommend. These arrangements are called "preferential trade areas" because they lower protection against some trade partners but exclude other trade partners. The excluded partners are not favored (discriminated against) by the trade regime and this can hurt the country participating in the preferential trade regime.

3. Post World War II experience with preferential trade areas in the developing world has been discouraging. • The Central American common market is the best example: trade diversion dominated the trade.

4. They developed new inefficient industries and sold high priced products to each other that they could not sell elsewhere. Eventually these industries collapsed as the governments refused to allocate foreign exchange for high price goods.

5. Lesson: unless aligning with a large bloc with much internal competition, preferential trade agreements are dangerous because they can encourage partners to sell products from inefficient industries and even develop inefficient industries.

6. But low external tariffs can avoid problems with preferential trade arrangements. So best to lower tariffs against third parties to be safe when participating in preferential trade arrangements. • We have a model in the appendix to the paper that should help to put this in perspective.

7. We decompose the analysis into three types of countries : • Non-members who have a trade regime with lower tariff protection than the customs union, e.g., Armenia and the Kyrgyz republic; • Non-member countries who have tariff protection that is more protectionist than the customs union; • Russia, Belarus and Kazakhstan: the customs union members.

8. Policy Conclusions • For countries outside the Customs Union with a more liberal trade regime: Joining the existing Customs Union of Russia, Belarus and Kazakstan for such a CIS member assuming no change in the external tariff of the Customs Union would be costly. If the Customs Union external tariff were to be modified and replaced with a low and uniform tariff, the costs of joining would be dramatically reduced. Joining the WTO with a low and uniform tariff is the first best policy choice for trade policy.

9. Rationale • When a small country imposes high tariffs it hurts itself and its prospects for growth. Joining a Customs Union with higher tariffs will be even more inefficient and costly than simply raising tariffs to the rest of the world without exempting partner countries from the tariff for the following reasons.

10. Why? • The tariff structure of the present Customs Union is diverse and protects selected manufacturing products produced within the Customs Union. It is likely that consumers in the country with the more liberal trade regime would pay higher prices for imports from partner countries on these products that are highly protected under the Customs Union tariff structure because partner country suppliers can raise prices under the tariff umbrella of preferential protection. …../

11. These kinds of costs would be greatly reduced, however, if the Customs Union were to lower its external tariff and especially to make it more uniform, thereby not discriminating against the products of the producers outside the presently constituted Customs Union.

12. Potential members of the Customs Union are not likely to obtain improved access to the markets of the Customs Union. Since the CIS countries already have a Free Trade Agreement with the present members of the Customs Union, they already have tariff free access to these markets (i.e., there is no gain to the exporters of the CIS countries that are not members of the Customs Union on their sales in these markets).

13. Access to diverse and modern technologies, which is crucial to a small transition economy, would be impaired by the Customs Union, since trade in many intermediate products would be diverted toward Customs Union members and away from Western suppliers.

14. An effective customs will will likely complicate and delay the accession to the World Trade Organization, since the country loses sovereignty over its trade regime as part of a Customs Union.

15. For countries outside the Customs Union with a more protectionist trade regime: Joining the WTO with low and uniform tariff bindings would also be the first best choice in trade policy. Joining the Customs Union with the present external tariff structure of the Customs Union has both advantages and disadvantages, but the disadvantages are likely to dominate. If the external tariff of the Customs Union is modified to become low and more uniform, the costs of joining the Customs Union will be dramatically reduced.

16. Rationale • For countries with a higher average external tariff than that of the Customs Union (CU), the results of joining the CU are more ambiguous. On the one hand, there will be a welfare gain if the external tariff is lowered on average because there will be some trade creation from additional imports from rest of the world suppliers (partner country suppliers already have tariff free access due to the FTA so no additional trade creation is likely from CIS partners).

17. On the other hand, the tariff of the CU is not uniform; rather it tends to favor production of those products produced in the CU. Substitution of the CU tariff will shift the tariff structure so that it favors the producers of the CU, i.e., tariffs will likely be high on the products presently produced in the CU and low on the products produced in the new country joining. …../

18. This will allow partner country producers to charge higher prices under the protection of higher tariffs on third country producers, a significant welfare loss that is likely to dominate. These costs would be dramatically reduced if the tariff of the Customs Union were to be modified so that it is on average lower and more uniform.

19. A choice available to a country in this circumstance is to lower its tariff on third countries, without joining the CU. This option offers the gains from the trade creation, without the losses of the trade diversion from having to pay higher prices to inefficient partner country suppliers. Moreover, it would facilitate joining the WTO and more easily allow access to imported technologies from the rest of the world. This is the first best choice.

20. For countries presently members of the Customs Union: Joining the WTO with a low and uniform tariff is again the first best choice. These countries will experience short run gains from the Customs Union, but the Customs Union may retard their long run growth and impede the import of needed Western technologies.

21. Rationale • Since the present tariff structure tends to favor production in Russia, Kazakstan and Belarus, then as more countries join the Customs Union, in the short run producers in these countries will gain additional profits and exports from the additional protection they receive against rest of world imports in the new partner country markets. Since the costs of protecting home producers will be borne in part by consumers in partner countries, the strategy has an initial appeal in the countries whose producers receive the protection. However, it is not likely to be sustainable in the long run as the countries bearing the costs will withdraw or fail to implement the common external tariff.

22. Moreover, these short run gains mask long-term costs of not opening up trade to the rest of the world. That is, even the entire CIS is not collectively large enough to substitute for world competition. Thus, a strategy of widening the protection of domestic producers through a Customs Union of a set of the CIS countries, is really an import substitution policy based on protection of a slightly larger market—a strategy that has repeatedly failed and is now widely discredited.

23. Most CIS countries recognize their need to open up to international competition and to be competitive on world markets. International competition will induce a reorientation of production, but will allow them to import badly needed new technologies. The Customs Union in the CIS serves to preserve the old structure of production in the countries whose producers are protected, and thereby retards the necessary adjustment toward an open economy.

24. The benefits and costs derived from joining the customs union depend on the level and composition of protection in each prospective member relative to the customs union external tariff. If the potential new members are able to influence the external tariff by lowering the overall level and modifying its structure so that it reflects their own interests as producers and potential exporters then they could improve the prospects of obtaining some benefits from joining the CU. …../

25. In practice, smaller countries, with smaller markets, have found it difficult to affect the overall protective structure of a customs union, and the overall tariff level and structure —while reflecting some compromises among the producing interests in various countries, tends to reflect primarily the interest of the largest and more industrially advanced members. This is why it is almost always the case that small countries are much better off in establishing low and uniform protection, outside a customs union framework.

26. Converting a Free Trade Area to a Customs Union with a High Common External Tariff