Economic rationality behind a Free Trade Agreement between the European Union and Ukraine

Transcription

1 THESIS For MSc in EU Business and Law Economic rationality behind a Free Trade Agreement between the European Union and Ukraine Author: Vitaliy Teslya Academic Adviser: JØRGEN ULFF-MØLLER NIELSEN Associate Professor Department of Economics Aarhus, Denmark 2010

2 TABLE OF CONTENTS INTRODUCTION... 4 CHAPTER 1. Theoretical background Economic effects of Free Trade Agreement from a traditional perspective Determinants of successful FTAs Non-traditional aspects of FTA. Hub and spokes structure History and forms of FTAs CHAPTER 2. Impact of WTO CHAPTER 3. Analysis of EU-Ukraine Free Trade Agreement Introduction to EU-Ukraine FTA Economic effect of the FTA on stakeholders Volume of trade Level of tariffs Revealed Comparative Advantages Determinants of FTA Dynamic effects of EU-Ukraine FTA Hub-and-spokes system applied to the EU-Ukraine FTA CONCLUSIONS BIBLIOGRAPHY APPENDIXES

3 TABLE OF FIGURES TABLE 1. Tariff rates of Ukraine TABLE 2. Tariff rates of the EU TABLE 3. Revealed comparative advantage indexes of the EU on Ukrainian market, based on 3-digit SITC level TABLE 4. Revealed comparative advantage indexes of Ukraine on the EU market, based on 3- digit SITC level TABLE 5. Capital-labour ratio of Ukraine, EU and their main trade partners TABLE 6. Skilled labour / Unskilled labour ratio of Ukraine, the EU and some of their main trade partners TABLE 7. Intra-industry trade of Ukraine with its main trading partners, GL index, based on 3- digit SITC data TABLE 8. Grubel-Lloyd index of IIT between Ukraine and the EU TABLE 9. Relative shares of horizontal and vertical intra-industry trade in total intra-industry trade FIGURE 1. Difference between customs union and FTA... 6 FIGURE 2. Welfare effects of FTA... 8 FIGURE 3. Specific motives of bilateral agreements FIGURE 4. Geographical structure of Ukrainian export, FIGURE 5. Geographical structure of Ukrainian import, FIGURE 6. Geographical structure of the EU export, FIGURE 7. Geographical structure of the EU import, FIGURE 8. Ukraine and its main trade partners factor endowments FIGURE 9. The EU, Ukraine and some of their main trade partners effective factor endowments FIGURE 10. Intra-industry trade between EU and CEEC ( ) FIGURE 11. Cross-Border Mergers & Acquisitions FIGURE 12. FDI as a percent of GDP FIGURE 13. FDI inflow to Ukraine in 2008 by countries, percent

4 INTRODUCTION Ukraine became a member of WTO in May Approximately at the same time it had been granted a status of a country with market economy from both the United States and the European Union. This all resulted in starting negotiations of an enhanced FTA between the EU and Ukraine in September Next round of the negotiations is planned for October 2010, and, obviously is far from its end, due to a high number of debatable issues from both sides. For the EU, creation of the FTA with Ukraine is a next logical step of its traditional foreign and trade policy towards its neighbour countries. On the other hand, this FTA is extended to Customs cooperation, free trade is services and harmonization of both partners regulatory basis. This makes the EU-Ukraine FTA very promising in a context of trade liberalization and economic integration of both countries (of course, the EU is not a country, but here and further for the sake of simplicity, it will be called so). In their turn, Ukrainian authorities and mass media paid increased attention to the FTA, especially in the context of probability of integration into the European Union in future and choosing appropriate political vector for Ukraine. However, political perspective is only one minor side of the EU-Ukraine FTA. What is more important is to determine whether there are any economic benefits and potential disadvantages of the agreement for both sides, what immediate and long-term consequences of the FTA will be for such participants as governments, traders, producers and consumers; and finally, to observe effects of the EU-Ukraine agreement in the context of relationships with other countries. Several scientific researches were analyzing potential impact of the FTA between Ukraine and the EU. For example, International Center for Policy Studies (2007) made an assessment of enhanced EU-Ukraine FTA, mainly descriptive in its nature, in order to help Ukrainian government to prepare for future negotiations. The paper concentrated on the aspects of the enhance part: trade in services, public procurement, competition policy etc. Also it made a comparison of the FTA with former EU FTAs: with Poland, Croatia and Chili. Another highly analytical paper that estimated influence of the FTA between Ukraine and the EU was prepared by research and consulting organization ECORYS in Basing on a Computable General Equilibrium model, it estimated economic, social and environmental impact of the FTA, along with deep analysis of main Ukrainian industries. In their Global Analysis Report, ECORYS made a forecast of changes in a majority of Ukrainian economic sectors after the implementation of the FTA. 4

5 Finally, Harbuzyuk and Lutz (2008) analyzed possible effects of a Customs Union between Ukraine and the EU, using a GTAP multi-country simulation model. There main finding was that agricultural sector should have been excluded from trade liberalization, in order to be the most effective for Ukraine. As we can see, all these papers were concentrated either on the actual aspects of a potential agreement, or measurement of its effects for Ukrainian industries, using CGE or GTAP models. But none of them aimed to explain the impact of the FTA basing on traditional and nontraditional theories of Free Trade Agreements. So, my theses can fill this gap; to some extend it will be an adaptation of theoretical knowledge about FTAs to a specific EU-Ukraine FTA. So, the problem statement of this paper is, basing on traditional and non-traditional theories of Free Trade Agreements, is to find and analyze economic rationality behind the EU-Ukraine FTA and present the impact of the agreement for the participants and both countries welfare. The thesis is based on either traditional or non-traditional approaches that explain effects of FTAs. For the sake of better illustration of presented data, my paper is filled with tables and figures. All data is taken from either world public databases (World Bank, UNCTAD, WTO and others) or national databases (State Statistics Committee of Ukraine, Eurostat etc.). The thesis is organized in three chapters; which are divided into a high number of subsections. The first chapter starts with a literature review, then gives a theoretical explanation of traditional and non-traditional effects of FTA, and provides information about determinants, history and forms of Free Trade Agreements. In the second chapter impact of WTO is shown. And finally, the third chapter analyses economic gains for both the EU and Ukraine from the FTA. It contains sections about static and dynamic effects of the FTA, determinants of successful FTAs and Huband-spokes structure applied to the EU-Ukraine FTA. Limitations of the thesis include analysis of trade in services, public procurement, competition policy and other specific features of an enhanced FTA, because they are extensively presented in other papers, mentioned above. 5

6 CHAPTER 1. THEORETICAL BACKGROUND 1.1 ECONOMIC EFFECTS OF FREE TRADE AGREEMENT FROM A TRADITIONAL PERSPECTIVE Free Trade Agreements (FTAs) are one of the forms of organizing integration between different countries. During last few decades the number of FTAs grew significantly and now occupies the majority of world trade. Modern Free Trade Agreements include many different economical and political issues, which differ from trade in goods, such as competition, public procurement, subsidies etc. Though, originally, just in term of international trade, Free Trade Agreement - is a group of countries, which agreed to eliminate tariffs between them, but keep the tariffs with the rest of the world. Most Favoured Nation (MFN) principle states, that: every country, which belongs to the WTO/GATT, should be treated equally; but Free Trade Agreements, Customs Unions (CU) and other forms of integration contradict that statement, because some countries are treated better than others. And because of that reason, those agreements are sometimes called preferential trade agreements (PTA) and they are discriminative by definition. However, even according to the rules of WTO, PTAs are allowed. The reason is simple: the goal of WTO - is a global trade without barriers, and despite PTAs are in some way favourable, it serves the same goal freer trade and liberalization. Figure 1. Difference between customs union and FTA Customs Union Free Trade Agreement Free Trade Agreement Home Partner Home Partner Home Partner ROW ROW ROW Source: own figure 6

7 Traditional theory of preferential trading was first discussed by Jacob Viner (1950). He analyzed effects of Customs Unions and this theory can be also applied to the Free Trade Agreements. However, despite the fact that Customs unions and FTAs are examples of preferential trade, there are important priory differences between them, which could be illustrated by figure 1. Members of a Customs Union have one Common External Tariff for Rest of the world (ROW) and free trade between themselves (left side of figure 1). In their turn, countries, which form FTA, also have liberalized trade with each other, though can maintain different tariffs with ROW (middle graph of figure 1). In this case, there may happen a situation, when in order to avoid high tariffs of Home country, external countries could use lower-tariff partner for entering Home market. This process is called trade deflection (right side of figure 1). In order to prevent it, Rules of origin (ROO) are used, which mean that only products created by a partner (or when the major part of value-added is produced by a partner) can enter Home market freely. Free Trade Areas are usually considered to be more politically attractive than Customs Unions, because they mean higher political independence and do not require costs for supporting common external tariff and supranational structures 1. However, low-cost FTA members have an incentive to repackage goods from ROW and sell them in a high-cost country market, and this automatically means necessity of Rules of origin, effective control of goods origin and costs, associated with this. Harmonized system of classification could be a good tool for distinguishing between products that have been just repackaged, from those, which have been transformed within FTA. Before Viner, it was generally believed that Customs Unions, Free Trade Areas or other Preferential Trade Agreements were improving welfare of involved countries and ROW just by definition. The intuition behind this thought was that PTA reduce or destroys barriers to trade, which leads to freer trade between countries, increased competition and, as a result, higher welfare for all parties. However, Viner (1950), whose research has been mainly devoted to the problem of trade creation and trade diversion, proved that it is not necessarily so. According to that theory, implementation of a Customs Union affects trade in two ways. Countries gain from trade in a way that higher-cost domestic production is partially or completely substituted by lower-cost partner. This effect is known as trade creation. But on the other hand, members of a Customs Union lose from it, because they switch from lower-cost Rest of the world, countries outside the customs union that have comparative advantages to more expensive source within the union - partner. Viner s theory of a customs union was based on three assumptions: fixed proportions in consumption (demand curves are inelastic), no economies of scale and that the members of customs union are small countries (have no influence on a world price). Welfare 1 Baldwin, R., Economics of European Integration 7

8 effects of FTA could be illustrated basing on the Viner s theory, but two important extensions should be made. The first one: a notion of positive consumption effects of a CU was originally proclaimed by Meade (1955), Gehrels (1956) and further developed by Lipsey (1960). According to Lipsey (1960), effects of CU can be divided into two groups: substitution of countries and goods. The latter effect represents both production and consumption effects of a Customs Union. Viner s original paper was focused on a substitution of countries, while Meade, Gehrels and Lipsey argued that trade between countries that form a Customs Union changes by the means of substitution of goods, rather than switching suppliers. Practical difference between this concept and the one developed by Viner was elastic demand curve, which means that if a Customs Union leads to lower prices for consumers, a positive consumption effect takes place (demand and consequently consumer surplus rises). The second extension is related particularly to a FTA and differs from Customs Union. When countries do not have common external tariff, even with the existence of rules of origin there (no possibility of trade deflection), may happen a situation, when a country with lower tariff towards ROW exports all its products to its FTA partner and substitutes them by products, imported from ROW. This effect is called indirect trade deflection. Let s try to illustrate this and also effects of trade creation, diversion and positive consumption on a figure 2 (Viners assumptions of perfect competition, one product, two small countries are valid). Figure 2. Welfare effects of FTA P D H Home S H P Partner D P T H T p =P FTA a b S H+P T p S P p w c S W p w d S W O A X Y B Q O C D Q Source: adapted from Robson (1998) 8

9 Before FTA: On a figure 2 we can see that price on the Home market was world price Pw + Home tariff PwT H, products are produced and sold internally at a price T H. Before FTA, Home production constituted OX, while its demand was higher OY, so Home imported a quantity of XY from the lowest-cost supplier, which was Rest of the world. Partner produced and consumed OD and implemented tariff PwT P for foreign products, which prohibited Partner from import. After FTA: A Free trade agreement between Home and partner made a circulation of product between them tariff-free, while each country kept their own external tariffs towards ROW. Rules of origin are implemented in order to prevent trade deflection. Home country starts to import from Partner at a price T P, which becomes an internal price inside FTA. The supply curve of the FTA is now S H+P a horizontal sum of both countries supply curves. At the price of T P Home produces OA and the rest of its demand (AB) is imported from Partner. In its turn, Partner exports CD to Home, which equals a quantity of AB. In order to satisfy its own demand OD, Partner imports the amount of CD from ROW at a price P W, which is effective for Partner, because its government gains revenue (Area d). This substitution for ROW import is actually called indirect trade deflection. Talking about Home country, it gains from switching from its own high-cost production into lower-cost Partner s (Area a). This is effect of trade creation. Area b illustrates positive consumption effect for Home. On the other hand, Home imports a quantity of XY from higher-cost Partner instead of lower-cost ROW. Such difference (Area c) represents the effect of trade diversion. But what is a total effect of FTA for both Home and Partner? In case of our example (figure 2), Partner and ROW are both net winners: Partner s government collects revenue of Area d, while producers and consumers keep dealing with the same quantities, as before FTA; ROW is a net winner, because it exports higher quantity to Partner in order to satisfy increased demand of Home, than before FTA export to Home. Welfare effects of FTA for Home country are ambiguous: it gains Areas a and c (trade creation and consumption effects), but losses Area b (diversion), the net result effects may be positive or negative; it depends on the size of tariffs and slopes of supply and demand curves. According to Viner s theory of a Customs Union, with inelasticity of demand, effect of a Customs Union will be positive, when trade creation overcomes trade diversion. In other words, creation is a positive effect of a CU, diversion negative. However, Gehrels (1956) and Lipsey (1957a,b, 1960) argue 9

10 that pure diverting Customs Unions (and, analogically, FTAs) still may have net positive impact on a diverting country by the means of positive consumption effect (as opposite to only production effects, analyzed by Viner). According to Meade (1955), trade diversion can be a positive effect of itself, when it is compared to complete autarchy, where there is no trade at all. In this case diversion can be welfare-enhancing. Viner (1950) illustrated three interesting options, which may arise from the creation of Customs Union 2 : a) both countries that form CU are non-producers, and import product from ROW; in case of CU implementation the situation stays unchanged; b) country A is non-producer, while country B is inefficient producer under protective tariff; if country s B tariff is high enough to prevent competition from ROW, and in case of CU country s B tariff becomes CU external tariff, it will be sufficient to protect country A from importing from ROW (for FTA case - country A tariff should be high enough to prefer inefficient import from country B, than that from ROW). In this case, trade diversion will be the result. c) both countries A and B are inefficient producers with high tariffs that protect their markets from lower-cost import from ROW; so in case of CU (or FTA) free trade between A and B makes sure that country, which is more efficient, will survive in the extended market of two countries. In this case, the result will be pure trade creation. So, in general, if anyone wants to foreseen the effects of a Customs Union or FTA, forces that cause trade creation and trade diversion should be taken into account. Some of recent studies of the effects of FTAs witness that trade diversion is not so frequent to take place, as it was thought before. For example, a study of OECD in 1995 concluded that there was no evidence of trade diversion created by FTAs 3. Another similar study of the Department of Foreign Affairs and Trade of the impact of NAFTA claimed the absence of diversion effects in NAFTA. Vinerian approach was important for proving that Preferential Trade Agreements could not be considered in a straightforward way, it helped to overestimate the effects of PTA: they are not necessarily positive, because they lead to free trade, but can be either positive or negative due to trade creation and trade diversion. However, Viner s theory did not answer a question, if there is 2 Lipsey The theory of Customs Union: general survey. 3 An Australia USA Free Trade Agreement: Issues and implications,

11 a possibility to form such a PTA that would be necessarily welfare-enhancing under any circumstances for involved countries and not harmful for ROW. Papers of Kemp (1964), Vanek (1965) and joint paper of Kemp and Wan (1976) partially answered this question: it is always possible to make such a PTA that will have positive welfare effect for all involved parties. Kemp-Wan-Vanek theorem proved, that if countries, which form CU remove all trade barriers between themselves and choose appropriate common external tariff, that will freeze their pre-cu level of trade with ROW, it will be necessarily welfare-improving for members of the CU and neutral for external countries. A contribution of mentioned above papers was crucial for trade relations between different countries, because it guarantied that constructed in a right way Customs Union will be welfare enhancing. However, due to existence of common external tariff, it was related only to CUs and Free Trade Areas, with their members different trade policies and was not covered by the theorem. Moreover, due to higher complexity of FTAs comparing to CUs, this problem was not solved for several decades after Kemp-Wan-Vanek approach was created. A paper of Panagariya and Krishna (1999) had similar impact on FTAs, as Kemp-Wan-Vanek theorem had on CUs. It claimed that FTAs could also be necessarily welfare enhancing. But if for Customs Union proper choosing of common external tariff is vital, then an appropriate choice of Rules of origin is crucial for Free Trade Agreement. According to the paper, if countries want to form a FTA, which is about to improve the welfare of its members and do not decrease the welfare of ROW, two important conditions must be satisfied: - Goods imported by the low-tariff member are not permitted to cross over to the high-tariff member country duty-free, unless they have gone some transformation 4. In other words, free trade between FTA members should be allowed only in goods, which contain substantial value-added of exporting FTA member; if a product is new, it should contain 100% of value-added of sending FTA member and if a good is produced in external country, it should be substantially transformed within the FTA. - Countries that form FTA should implement such tariffs, which their trade with ROW does not change from pre-fta level. In case, if two mentioned above conditions are fulfilled, newly created FTA will be effective for all participants. 4 Panagariya, A., Krishna, P., On necessarily welfare-enhancing Free Trade Areas 11

12 Choice of proper Rules of origin is a crucial factor for successful FTA. But in general, a question of whether ROO are welfare-enhancing or not is not so obvious. Duttacupta and Panagariya (2007) analyzed the effects of ROO and claimed that they may either improve or worsen joint welfare of FTA. They argue that if FTA in final good is welfare-creating, Rules of Origin will be a negative factor, because they diminish trade creation. On the other hand, if FTA in final good is diverting, ROO will be welfare-improving, due to limitation of trade diversion. Trade creation, diversion, indirect deflection and positive consumption are all static effects of Free Trade Agreements; they have only short-term impact on countries involved. However, static effects do not cover all aspects of economic impact of FTA. In the long-time perspective, dynamic effects are probably even more important. Balassa (1961) was the first one, who analyzed dynamic effects of preferential trade agreements. He argued that regional trade agreements could influence involved countries welfare through economies of scale, increased competition and economic growth. In real life it s not only countries, who are participants of regional integration, but in broader sense, companies, which may benefit from economies of scale, learning-by-doing effect. Domestic companies, influencing by foreign competition, will be forced to provide new technologies, increase efficiency and investment. Even further, multinational companies can create knowledge spillovers in other countries; bring new technologies or way of conducting business. Khor (2006) argues that North-South FTAs 5 usually bring more Foreign Direct Investment and technology transfer towards developing country. This can by explained by the activity of multinational companies, which, looking for a new market, cheaper labour or higher efficiency, make investments into a partner s economy, following by additional working places and knowledge spillovers. One more important dynamic effect of FTA is Investment, both internal (domestic) and external (Foreign Direct Investment or FDI). When FTA is established, sometimes, especially in majority of modern FTAs, not only trade, but also investments barriers are reduced. Investment not only increases the productivity of a capital, but also can influence countries welfare indirectly by bringing a new technology into economy. According to Dunning (1998), Free Trade Agreements cause two types of effects on investment, which are quite similar to effects on trade: investment creation and investment diversion. Eliminated and reduced investment barriers, better investment climate, transparent rules and procedures are not only a good incentive for internal investment, but for FDI as well, both from FTA partners and rest of the world. This inflow of Foreign Direct Investment is actually an investment creation. 5 between developed and developing countries, where North means developed and South non-developed country 12

13 1.2 DETERMINANTS OF SUCCESSFUL FTAS In this section I will briefly explain economic factors, which could determine to what extend potential FTA will be successful. According to traditional theory of preferential trading, such factors are usually referred to the size of trade creation and diversion, in other words, they may show whether FTA creates or diverts trade. In general, basing on pure logic, the value of trade creation and trade diversion depends on the size and extend of trade barriers; the logic is simple: higher number and size of tariffs more significant effect from removing them. One more important factor of effective FTA is the level of every trade partner economic importance and size of trade between partners. Traditional theory argues that trade creation will be higher, if countries are important trade partners before FTA. Wannacott and Lutz (1989) argue that, if countries forming PTA are natural partners 6 trade creation will be higher, than trade diversion and such PTA will be welfare-improving. However, Bhavati and Panagariya (1996) responded that such argument is inconsistent and should be rejected. On the other hand, according to Baier and Bergstrand (2001) classification 7, there are 3 main groups characteristics of economic determinants, which form the FTA: - Economic geography factors Geographical factors are significant in forming an FTA. The closer partner countries are - the greater is a trade creation, and the distant trading countries are from the rest of the world - the less is a diversion. In other words, an FTA will be most likely welfare decreasing, when potential partner countries are situated on separate continents or are geographically distant one from each other. This point of view is supported by Krugman (1991) and Frankel (1995); they argue that natural trading partners according to small distance between them and respectively low transport costs, can be a positive factor for creating FTA. As could be seen from the real world, FTAs are usually formed between neighbouring countries, especially multilateral FTAs. For example: EFTA, NAFTA, Australia-New-Zealand FTA, bilateral FTAs between EU and the majority of its neighbours. 6 Natural trading partners - are considered countries with common border or close geographically and high pre- PTA volume of trade 7 Baier, Bergstrand, Economic determinants of Free trade agreement 13

14 - Intra-industry trade determinants FTA between countries with similar economic sizes leads to greater trade creation. In addition, trade diversion is less, when economic size of the ROW is smaller. In other words, it could be claimed, that due to the fact that economic size usually reflects the extension of countries economic development (with some exceptions, such as China, that has relatively high GDP, but low GDP per capita, and is not considered as developed), North-North or South-South FTAs are supposed to be more effective, than North-South FTAs. However, Vicard (2009) argues that it is not true, and North-South FTAs does not create lower volume of trade. - Inter-industry trade determinants Trade creation is bigger in the case, when two countries are more abundant in relative factor endowments. The less is difference in factor endowments between FTA partners and Rest of the World, the less is a trade diversion. 1.3 NON-TRADITIONAL ASPECTS OF FTA. HUB AND SPOKES STRUCTURE Traditional theory of regional integration does not cover all possible areas of preferential trade. Non-traditional views are mainly concentrated on political economy issues, strategies of involved countries and motivation of less developed countries to benefit from regional integration. Hoekman (2005) made an analysis of motives, which lead developing countries to integrate with developed countries. Traditional approach to preferential trade argues that trade agreements will be more successful, when signed between North-North or South-South countries. However, Hoekman proves that it is not necessarily so. He argues that in North-South agreements less developed countries tend to participate in regional trade agreements even when they face potential welfare loss. Main reasoning in this case is an acceleration of economic reforms, development of investment climate, removing of trade barriers, including technical barriers to trade. In a huge number of cases, South can have a high level of access to North market, but due to the lack of own economic and infrastructural development, keeps high tariffs and non-tariff barriers, which is a negative factor e.g. for consumers, and welfare effects can not be maximized, especially in the long-term period. 14

15 Khor (2006) outlines main issues, which are important in North-South agreements for developed countries and are usually included in, especially, modern FTAs. When designing FTA with developing countries, USA, EU or Japan typically pays increased attention to the following aspects 8 : 1. Market access in goods 2. Services 3. Specific services sectors (e.g., financial sector, telecommunications) 4. Intellectual property rights 5. Rules on the non-trade issues, such as - Investment - Government procurement - Competition policy 6. Labour standards and environment issues. According to Khor (2006), only the first issue is included in pure FTA, while services and intellectual property rights were added only after WTO Uruguay Round and are actually the issues, taken now by WTO. So-called Singapore issues (investment, competition policy and procurement) were implemented after 1996 WTO meeting in Singapore, and used to be criticized by developing countries for being binding in modern FTAs. However, there can be one important type of non-traditional gains from FTA, where due to more complicated structure of trade relationships, not only direct parties but also their other trading partners are affected by potential FTA. Such structure is called Hub and Spokes (H&S), and, as practice shows, the amount of hub and spokes systems in the world grows constantly 9. If there is a bloc of countries in a free-trade area, each member of FTA has a right to negotiate with other countries outside. And if one of them concludes a new FTA, so that country becomes a hub, and every partners of that country (new ones and previous) are called spokes. For instance, when USA already has a bilateral FTA with Canada, and then signs one more FTA with Chile, as a result USA becomes a hub, Canada and Chile spokes. 8 Khor, M., The main issues in the North-South Free Trade Agreements 9 Mukunoki, H., Tachi, K., Multilateralism and Hub-and-Spoke Bilateralism 15

16 Taking into consideration the existence of such structure, and in the light of creating new FTA it is important to find out economical effects for each party (hub, older and new spokes). At first sight, there is an economical threat of the welfare effects of hub and spokes system, because it partially overlaps the existent FTA. Wonnacott (1996a) argues that the H&S system has more trade barriers that remain, because older and new spokes do not have free trade between themselves, so that arrangement will generate less profit for participants, than multilateral agreement. However, the hub country benefits, because it has duty-free access to markets of all other countries. On the other hand, the spoke country may not get benefit of the new system, because it would get smaller part of the whole income. So, the spokes will lose and, therefore, become not as attractive as an investment location. According to Wonnacott (1996a), in comparison with the hub, spoke-spoke trade suffers the most, because of the discrimination in other s markets, as it is hard to compete with hub s firms, which have duty-free inputs of other spokes. Moreover, spokes face problems in the hub s market, if the hub negotiates new more preferable arrangement with new spokes. At the same time, any hub may become the spoke, if one of the spokes makes a new arrangement, where it will be the hub, and previous hub becomes the spoke in that case. One more interesting fact about H&S is that it causes not a standard trade diversion, but double diversion 10. If there are many spokes, each of them will be diverting a part of its import to the hub. One more negative reason of H&S system is that every spoke thinks that they participate in regional trade liberalization, but as the matter of fact, only the hub does it. Generally, almost all discussions about hub and spokes economic effects of FTAs have a negative view, because of its discriminating nature, however, in Europe hub and spokes system has become the favourable format of trade and current EU spoke countries in Eastern and Central Europe, Mediterranean countries gain as they have appropriate income s effects of open access to the high-tech and wealthy EU hub, which is to a high extend positive for spokes. One of the explanations, why such type of relations between countries is popular, could be explicated by individual characteristics of FTAs, which form H&S system. Kowalczyk (1992) argue that any FTA can be considered as a substitute or complement for existing FTAs. If new FTA shrinks imports from other countries, it is a substitute; respectively, when it increases imports from other countries or at least leaves it at the same level, it can be seen as a complement. For example, when new FTA partner produces a good, which is unique, and after 10 Wonnacott, R., Free-Trade Agreements for better or worse 16

17 exporting it will increase Home s demand for similar goods, it could be considered as complement. On the other hand, if produced goods are the same, as from other countries, it will leave Home s demand at the same level and will be substituted. Taking into consideration all mentioned above, it would be interesting to make a comparison of H&S system and multilateral RTA: to what extend will the effects of H&S system be different from those, taken by one multilateral RTA? Wannacott (1996b) argues that all participating members under the FTA will gain a greater collective income, because they removed all trade barriers; while in H&S system only part of the barriers will be removed, as a result - less opportunity for competition and consequently less potential from liberalized trade. According to Wonnacott, the total income in H&S system is less. This can be explained that, in general, only hub country gets benefit, because of its preferences in access to every spoke market, while spoke countries suffer form the absence of such an access. Therefore, this arrangement generates less collective income for all members. It is obvious that the hub gets a larger percentage of the total income, while the spokes get a smaller part. Moreover, in H&S system the hub will acquire preferential and other benefits, which are not available in an FTA, such as benefit from the preference of getting in the market of each spoke; attracts more FDI; and duty-free inputs from each spoke into the hub s firms. In a multilateral FTA spokes will face none of these problems, so spokes would prefer an FTA to the hub and spokes system. Simultaneously, H&S would be preferred by the hub, as it gets preferential benefits. One more argument against H&S formation is that it is much more complex network than FTA, especially in a developed hub and spokes system rent-seeking and administrative waste exists, when firms try to settle a domestic monopoly position by making rules for entrance of competitors stricter. Out of the comparison mentioned above, it becomes clear that H&S system has more negative consequences, than multilateral RTA, first of all, because of the spoke-spoke efficiency loss. However, in the long run, H&S could anyway result in freer trade 11. The logic is the following: in order not to become a spoke, especially when there is a threat of a new FTA of a hub, spokes are forced to sign FTA between themselves, and in such a way change H&S into de-facto multilateral FTA. But this process is not so short and easy, so hub can benefit in the short-run period, especially when political issues, like lobbying of producers or some kind of political constraints from the hub s side, take place. 11 Mukunoki, H., Tachi, K., Multilateralism and Hub-and-Spoke Bilateralism 17

18 1.4 HISTORY AND FORMS OF FTAS During the last decades, there has been a huge increase in the number of FTAs around the world. According to WTO, at the beginning of 2009 there were more than 400 FTAs notified to WTO, with more than a half of them still into force. Nowadays, trade agreements are found in all regions of the world, for examples in such combinations, like the United States and Morocco, Japan and Mexico, or EU and Chile. According to OECD (2005) 55% of world trade was operating under trade agreements. However, it has not always been like this. Estevadeornal and Suominen (2008) argue that all trade agreements and other cooperation agreements could be divided into three main phases of their historical development. The first one took its beginning in the nineteenth century and ended with the beginning of First World War. During this period there were formed many bilateral agreements by such countries, as: Italy, France, Latin American states and Great Britain. Those countries formed trade agreements with each other and with United States as well. In 1834 were also found agreements, which were formed by German Zollverein. The second phase includes all bilateral agreements formed by Western European countries (Germany, Great Britain, Denmark, Iceland, Belgium, Finland, Norway, Sweden, Portugal and the Netherlands) in the period between world wars with each other and with Eastern European countries. The third phase of trade agreements began after the Second World War by the countries of Western hemisphere and European countries. Whalley (2008) states that, when in 1947 the GATT came into force, there were no formally trade agreements in the world trading system, but for systems of trade preferences. The XXIV article of the GATT supported members to participate in regional agreements, however, with the condition that there should be no barriers raised against third country participating in regional agreements and that at least 80% trade between partners would be covered. The creation of EEC (further EU) in 1957 was one of the cornerstones of future understanding of regional integration. The agreements of first two phases were not as complex and comprehensive, as the third phase agreements. In those trade agreements relatively limited issues were included, such as navigation and general commerce, while modern trade agreements includes issues concerning trade in services, competition policy, investment and government procurement. It can be seen from the example of the EU: in the 1990s development efforts of EU were focused on assistance and aid, and through many partnership agreements, EU reached in the regional agreements for partner countries to adopt similar to EU laws and policy. Now agreements with EU cover labour practices, intellectual property, investment, culture, competition policy and persons movement 18

19 to the EU 12. Also the 1987 Canada-US agreement consists of 23 chapters and includes such items as: energy security, anti-dumping and countervailing duties, wine and spirits, financial services and compensation for losses from government actions to foreigners 13. What is interesting in this is that the way of thinking in the EU and US differs a lot. United States concentrated on gradual reduction of tariffs and liberalization in specific services, such as banking or insurance; while the EU was trying to occupy different non-trade issues, such as: investment, competition, technical standards, SPS measures etc. One more difference of modern FTAs is that earlier trade agreements were mostly formed with a high degree of discrimination of the third parties, while latest trade agreements are mainly formed in a way to reduce preferential and most-favoured nation duties by partner countries. Mentioned above historical background, lead to existence of different forms of preferential trade. For example, according to one classification of trade agreements by a level of integration, they can by divided to 14 : - Preferential Trade Area (lowest level of regional integration, characterized by differences in trade barriers for various countries); - Free Trade Area (elimination of trade barriers between members of FTA, different tariffs, Rules of origin); - Customs Union (no tariff and non-tariff barriers inside CU, one common external tariff); - Common market (same as CU plus harmonization and mobility of factors of production); - Economic Union (same as Common Market plus fixed exchange rate and policy coordination); - Economic and Monetary Union (all above plus single currency, central bank and economic policy). Economic Union and Common market is considered to be more efficient type of integration due to a number of reasons. For example, in FTAs there is a need for government of different countries to maintain customs, which is costly and, as a result, can be a burden for tax payers; existence of customs can lead to delays in trade and disadvantage for small enterprises to trade 12 Francios, J EU-Developing Country FTA s: Owerview and Analysis 13 Whalley, J., Recent regional agreements: why so many, why so much variance in form, why coming so fast, and where are they headed? 14 Baldwin, R. & Wyplosz, C The Economics of European Integration 19

20 abroad. Increased competition and effective public procurement are also advantages of Common market and Economic Union. Due to another classification, trade agreements can be classified according to number of countries involved in three group 15 s: a) bilateral trade agreements or BTA (two parties); b) multilateral agreements (sixteen or more parties); c) plurilateral agreements (three-fifteen parties). The so called post-war era enabled the most distant countries to form a bilateral agreement in order to cooperate with each other. For example, less than 70% of agreements of countries like United Kingdom, Germany and France are multilateral agreements. In a period of 1875 and 2006 finds 13,562 international agreements among 251 states. 94 % of them are bilateral, 5% are plurilateral and only 1% - multilateral 16. There is no one explanation why bilateral FTAs prevail. Usually each country has its own reason to be involved into FTA; however, all motives could be divided into three groups 17. One of them is a disappointment of the pace of multilateral liberalization. Besides, it is much easier to negotiate and agree on specific issues on a bilateral level. For example, two countries decide to include competition, Intellectual Property Rights or investment into agreement. In bilateral negotiations it is not difficult to achieve, while in multilateral structure other members could not agree, and this may create an obstacle and require more time and resources to solve. Doha Round of WTO showed that adding non-trade points into agenda, such as: competition policy, environment or government procurement, as a result could lead to increased. Besides, BTAs are usually more reliable from political point of view. Political and mass-media pressure is lower, than in multilateral agreements. Another general reason why BTAs increase their popularity is so-called Domino effect. Baldwin (1993) argues that during 1990-ies appeared a large amount of BTAs, especially in East Asia region, which made other countries of the region feel at disadvantage, which, in its turn, lead to further growing number of BTAs. No country wanted to stay away from this process, which eventually lead to significant increasing number of BTAs. Finally, a large part of BTAs is politically motivated by individual politicians or parties. 15 Menon, J., Bilateral Trade Agreements 16 Menon, J., Bilateral Trade Agreements 17 Menon, J., Bilateral Trade Agreements 20

21 Menon (2007) also analyzed specific motives of creation BTAs. All of them can be divided into three groups: economic, strategic and event-driven (figure 3). Figure 3. Specific motives of bilateral agreements Specific factors Economic Strategic Event driven Sector driven Market access PTA Political Sector expan ding Sector excluding Market restoring Market creating Lobby driven Terror driven PTA facilitation PTA integration WTO accession Political integration Political disintegration Source: Menon, J., Bilateral Trade Agreements Economically motivated BTAs can be separated in sector driven and market access. Sector driven BTAs could be motivated by one or few key sectors. It means that such BTAs could expand liberalization into sectors, which has not been taken by multilateral agreements before; or exclude important sectors from liberalization. Sector expanding agreements can be much easier negotiated on a bilateral level, because when negotiating only between two countries, a lot of obstacles can be avoided. Such agreements can reach higher level of integration, than on a multilateral level, that s why they are sometimes called WTO plus of New Age agreements. Japan-Singapore could be an example of sector expanding BTA (for example, it covers e- commerce liberalization). Many of Singapore issues, such as competition policy, government procurement or rules for investment, were removed from WTO agenda and are only present in sector-expanding BTAs 18. Sector excluding BTAs are usually connected to agriculture, which is very sensitive sector for many countries. In majority BTAs of EU or Japan agriculture is excluded or significantly protected. Market restoring BTAs are motivated by renewal of economic links by countries, which became a part of trade blocks with the countries that stayed outside multilateral agreements, though previously used to be traditional trading partners. Many 18 Menon, J., Bilateral Trade Agreements 21

22 BTAs of NAFTA members, especially US with non-nafta countries can be example of such agreements. Market creating BTAs are usually signed between countries that had high protective barriers and the absent or low level of trade relations between themselves. For example, when highly protected countries eventually reduce tariffs in a multilateral agreement, it can be a good motive for even higher liberalization through bilateral integration. Also market creating BTAs could happen if e.g. non-expected economic growth, rapid increasing of demand or other issues, that can facilitate trade, take place in one of the countries. Strategically motivated BTAs, analyzed by Menon (2007), have mainly political context and cover important foreign policy issues of developed countries, such as US or EU. Lobby driven BTAs are usually created, when some sensitive issues, such as environmental and labour standards can not be achieved on a multilateral level. In this case, countries of the North can include those issues in their BTA, attracting South countries by their large markets and other benefits. Event driven BTAs is separated into three groups: Plurilateral Trade Agremment (PTA) motivated, WTO driven and political. PTA driven agreements can be PTA facilitating and PTA integrating. Former are created between member and non-member of PTA in order to strengthen its trade relations and accelerate its moving pace into the bloc. PTA integration BTAs are between countries, which are members of the same PTA. The real motivation is to deeper liberalization and broadening of PTA integration. Ukraine can be an example of such type of agreements. Being a member of Commonwealth of Independent States (CIS), it signed bilateral agreements with the majority of CIS members. Final goal of WTO driven BTAs is achieving support from influential WTO members and, as a result, easier accession into WTO. For example, BTAs with US are often being negotiated and signed prior to WTO negotiations. Politics can either be directed to increasing integration (for example, BTAs between China and Hong Kong) or disintegration between countries (CIS could also be a good example). 22

23 CHAPTER 2. IMPACT OF WTO International trade in goods is covered by the General Agreement on Tariffs and Trade (GATT). It was signed in 1947 and in 1994 it was transformed into the World Trade Organization (WTO). Main website of WTO states that since the 1 st of January 1995 The European Union has been a WTO member and 27 member States of the EU are member of WTO, as well, as in their own rights 19. On the other hand, Ukraine is also a member of WTO, but it was accepted only on the 16 th of May 2008 (Ukraine was the 152 member of WTO). The main principle of GATT (GATT Article I) is called the Most Favoured Nation principle, which states, that if one member country of WTO grants the other country member trade advantages, it must grant all other members as well. In other words, countries should have the same treatment for all WTO members, regarding trade issues. It is applied for trade in goods, services and protection of Intellectual Property Rights (IPR). Discriminated under MNF principle country, as a result can accept countervailing measures to protect its trade 20. One of exclusions from the MNF principle is that developed countries can give unilateral trade preferences for developing countries. It is a basis for General System of Preferences (GSP). According to World Bank 2004 study of Ukrainian trade policy, Ukrainian export to the EU is taken by the GSP since Being a subject of GSP is beneficial for Ukraine, because tariffs can be reduced up to 2%, which is lower that MFN tariffs. However, Ukrainian exporters did not use such preferences fully. Low level of knowledge about what GSP actually is, differences connected to identifying Rules of origin were main reasons why such preferences were not used to a full extend, especially in clothing, agriculture and furniture industries, where a lack of large companies makes approval of ROO costly. European Union s General System of Preferences is applied for 10 years and is a subject to renewal. For all beneficiary countries, including Ukraine, non-sensitive commodities get customs-free access and sensitive goods have a reduction up to 30% for a specific duty 21. Except exclusion for different treatment of developing countries, MNF principle has one more exception, which is very important in our case. It claims that two or more members of the WTO can make a preferential trade agreement, which will provide that 22 : 19 Baldwin, R. & Wyplosz, C The Economics of European Integration International center of policy studies, Creskoff, S., Walkenhorst, P Implications of WTO Disciplines for Special Economic Zones 23