Chapter 4

Regional trade integration: benefits and challenges

Regional economic integration can bring multiple benefits.

First, lower tariff and non-tariff trade barriers should increase trade and enhance consumer choice. In the case of the Eurasian Customs Union, the immediate "trade creation" effects would mainly reflect the elimination of administrative barriers as customs checks are removed from internal borders (since most trade between the member countries was already subject to zero customs duties). Improvements in cross-border regional infrastructure might also play an important role.

Second, producers within a regional integration grouping can benefit from increased market size. Market size, in turn, is an important factor facilitating innovation, the fixed costs of which can be spread across a larger customer base.⁷ At the same time, consumers will also benefit from greater competition in product markets. These effects crucially depend not just on the creation of a single customs area, but also on the elimination of barriers to market access. Important progress has been made in this respect in Belarus, Kazakhstan and Russia where, with a few exceptions, firms have equal access to public procurement contracts in all three countries.

Third, exporting within a regional area may serve as a first step towards the expansion of exports worldwide – by initially building export capacity taking advantage of low tariff and non-tariff barriers within a union, and then leveraging this capability to achieve competitive advantage in exporting to other countries. For Kazakhstan and Russia, developing such export capability is a particularly challenging task given their existing relatively narrow, natural resource-focused export bases.⁸

+ - Box 4.1 Comparative advantage through regional integration – the case of ASEAN Click to collapse

The ASEAN Free Trade Area (AFTA) is a trade bloc agreement set up by the Association of Southeast Asian Nations to increase their export competitiveness. It was originally signed in 1992 by six countries – Brunei, Indonesia, Malaysia, Philippines, Singapore and Thailand – and subsequently by Vietnam in 1995, Laos and Myanmar in 1997 and Cambodia in 1999.

AFTA's primary mechanism is the Common Effective Preferential Tariff (CEPT), which caps tariffs for goods originating within ASEAN to between 0 and 5 per cent. Unlike the European Union, AFTA does not apply a common external tariff to goods imported from outside the region. ASEAN's vision was to leverage intra-regional division of labour and specialisation to encourage exports to the rest of the world by eliminating tariff and non-tariff barriers to movement of goods along the supply chain within the region.

Using regional integration as a springboard for export growth is sometimes referred to as the "flying geese paradigm".³ The metaphor derives from the idea that the less-developed nations, with lower labour costs, can be aligned successively in a wild-geese-flying pattern behind the advanced industrial nations according to their different stages of development. As the comparative advantages of the "lead goose" cause it to shed its labour-intensive production in favour of more capital-intensive activities, the low-productivity function is transferred further down the chain to upper-middle-income countries, then lower-middle-income countries and so on. Foreign direct investment and multinational corporations (MNCs) meanwhile facilitate the transfer of technologies among member states.⁴

Within ASEAN, Singapore emerged as the "lead goose" intermediating a large share of trade between the region and the rest of the world. Regional integration was essentially led by industries such as electrical and electronic products and industrial machinery. These industries developed a high degree of vertical specialisation, where intermediate components and semi-finished products were traded within the ASEAN region and final products were exported to the rest of the world. Intermediate goods account for as much as 40 per cent of intra-ASEAN trade, while dependence on Japan as a source of intermediate inputs has declined sharply.⁵ This model has helped the ASEAN countries to leverage the substantial existing differences in per capita income and skills and achieve dynamic growth in the region as a whole.⁶

Fourth, countries within a regional integration area can build cross-border production chains by leveraging each other's comparative advantages and subsequently exporting the finished product outside that area (see Box 4.1 for an example of such integration in the Association of Southeast Asian Nations). Links through foreign direct investment (FDI) typically play a prominent role in this scenario, as they did in the 1990s when CEB countries became increasingly integrated in European production chains.

Fifth, deeper regional economic integration can help member countries to strengthen their economic and political institutions. As some competencies are delegated to newly created supranational bodies, and other areas of economic policy undergo cross-country synchronisation, the opportunity arises to review and revise laws and regulations and to strengthen their implementation, in turn promoting business environment improvement and liberalisation. Accession to the European Union undoubtedly played a key role in enhancing institutions in the CEB countries, and the longer-term viability of CIS regional integration will depend largely on whether the Eurasian Economic Community can create institutions stronger than those of any of its member states.

Lastly, integration can encourage the liberalisation of services markets, which tend to be subject to greater regulation and protection compared with those for goods (and even within the European Union they remain fragmented to some extent). Nevertheless, in the context of Eurasian integration there is great potential for efficiency gains in these markets which could be realised by lowering entry barriers for firms and investors from other countries.⁹

Regional economic integration also comes with a number of challenges, the most important of which is to minimise negative effects on economic links with outside countries. Such effects typically occur through trade diversion, whereby a relative change in tariff barriers can divert trade from more efficient external exporters to less efficient ones.¹² For example, should the introduction of a common external tariff by a regional bloc result in a relative increase in the import tariff for country A outside the region compared with that for country B inside the region, one would expect an increase in imports from country B and a drop in imports from country A. As a result, however, consumers must buy goods from the less efficient producer.

Concerns about trade diversion have been raised in the context of the Eurasian Customs Union. Its common tariff, which was formulated in the crisis environment of 2009, was also used in part as a tool of industrial policy to promote selected import substitution through an increase in tariffs (for example, in the case of the automotive sector). The common tariff's introduction resulted in significant changes to the import tariff structure in each constituent country, with tariff lines adjusted upwards and downwards. Kazakhstan's schedule underwent the most extensive changes, affecting more than 50 per cent of tariff lines (see Chart 4.1) and mostly in an upward direction. The empirical impact of these changes is examined in the next section.

+ - Chart 4.1 - Change in import tariffs in Kazakhstan Click to collapse

Source: World Bank (2011).
Note: This chart depicts the change in the average effective tariff rate at the industry level before and after the Customs Union came into force, inclusive of transitional provisions. Total refers to an overall average.

Another concern, and particularly in relation to the Eurasian bloc, is asymmetry. The disparity in the economic size of the largest state, Russia, and that of the other members is perhaps greater than in any other regional economic grouping. Kazakhstan's population and gross domestic product (GDP) are around one-tenth of those of Russia, and those of Belarus are lower still. While comparisons with other integration ventures which include dominant countries (for example, Brazil in Mercosur – see Box 4.2) suggest that the benefits of regional integration are still substantial, asymmetries can become an obstacle. It is important to ensure that the decisions of supranational bodies are implemented by all member countries, and that dispute resolution mechanisms at the supranational level work well.

+ - Box 4.2 Asymmetries in regional trade integration – the case of Mercosur Click to collapse

Mercosur is an economic and political agreement among Argentina, Brazil, Paraguay, Uruguay and Venezuela. Founded in 1991 under the Treaty of Asunción, which was later amended and updated by the 1994 Treaty of Ouro Preto, it is a full customs union, which represents a significant stage in Latin American integration.

As with the Customs Union of Belarus, Kazakhstan and Russia, Mercosur members are very different in terms of their economic size. Brazil accounts for over 70 per cent of the region’s population, territory and GDP, while Uruguay and Paraguay each account for less than 5 per cent. However, Brazil is not richer in income per capita terms than Argentina or Uruguay, and in fact includes Mercosur’s poorest regions.

Given these disparities, Mercosur members have sometimes found it difficult to agree on common policies. The common external tariff (CET) is the cornerstone of the common trade policy, but only covers around 80 per cent of products. Further convergence has perhaps been hampered by the fact that the CET is often perceived as favouring Brazilian interests ahead of those of the smaller members.¹⁰ The common tariff varies between 0 and 20 per cent, with higher tariffs levied on final consumption goods.¹¹ Many exemptions for smaller countries still remain, especially those covering capital goods and computing and telecommunication equipment, as do exceptions under bilateral trade agreements. Furthermore, member-state policies on investment, export promotion and anti-dumping protection are not necessarily coordinated.

Despite these difficulties, Mercosur appears to have had regional benefits. In particular, there is evidence that it has promoted, rather than impeded, trade with countries outside the region. For a number of industries, including automotive manufacturing, certain petrochemicals and plastics, Mercosur has served as an initial platform for Argentine and Brazilian exporters, enabling them to further improve their productive capacity and organisation and to promote their goods to the rest of the world. Although the smaller member countries of Mercosur have more open and specialised economies, a substantial proportion of their total trade remains within the bloc as the other members represent a relatively large market for their products.

+ - Box 4.3 A union of commodity exporters – the case of the Gulf Cooperation Council Click to collapse

The Gulf Cooperation Council (GCC), formed in 1981, is the political and economic union of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE). Much like the Eurasian Customs Union and Mercosur, it is characterised by a significant asymmetry between Saudi Arabia, the largest state, and the other members. Saudi Arabia has about 70 per cent of the total GCC population and accounts for more than half of total GCC GDP, while the UAE, the next largest, produces roughly 20 per cent of GDP. However, Saudi Arabia's income per capita is lower than that of most of the other countries.

An interesting feature of the GCC is its members' common reliance on oil and gas exports, mainly to Asia and the United States. For example, hydrocarbons account for over 90 per cent of the total exports of Saudi Arabia. As a result, intra-regional trade remains fairly limited; only Oman sends more than 10 per cent of its total exports to other GCC members. Also, although Oman imports machinery from the UAE and Bahrain imports oil and fuel products from Saudi Arabia, other GCC countries source less than 15 per cent of their imports from within the grouping.

This heavy reliance on oil and gas exports has shaped the evolution of the GCC and some of its unique features. The GCC has a high degree of infrastructure integration, including a unified pipeline network to distribute natural gas among the six member states, an integrated railway system and a unified power grid. It has also created a common market, launched at the start of 2008 to allow the unrestricted movement of goods, capital and labour. As a result, there has been a marked increase in cross-border investment, often involving mergers and acquisitions (M&A) and targeted largely at the service sector (notably telecommunications). Since December 2010 companies based in one GCC country have been able to set up branches in other member states. The distribution of cross-border direct investment has been fairly balanced, with Kuwait among the key sources and also key recipients of M&A flows.

However, the implementation of a customs union, first announced in 2003, has been postponed until at least 2013. Also, labour mobility has been slow to expand despite the fact that the common market grants the same economic rights to all GCC citizens, allowing them to work in the private and public sectors in each member state and to receive any applicable welfare benefits such as pension and social security payments. By 2010 only around 21,000 nationals (around 0.05 per cent of the total population) had taken up permanent employment in a GCC state other than their country of origin. All GCC economies nevertheless remain important employers of foreign labour due to a perceived shortage of manpower in the region.

Overall, given the limitations of trade links among these major oil and gas exporters in the short term, economic integration in the GCC has focused on common infrastructure, investment flows and liberalisation of mutual access to services markets. Over time, the structure of its constituent economies, and the GCC itself, may evolve as the natural resource endowments of the member states run out at different rates.

At current production levels, oil reserves will last for less than two decades in Bahrain and Oman, but for more than 100 years in Kuwait and the UAE.

In a regional union dominated by commodity exporters, a further challenge is to leverage the benefits of economic integration. Partly due to the fact that Kazakhstan and Russia predominantly export oil and other commodities, the Customs Union is less economically integrated than commonly perceived: Belarus and Kazakhstan account for under 7 per cent of Russia's export and import trade, although Belarus, as a net energy importer, sources over half of its total imports from Kazakhstan and Russia. The Gulf Cooperation Council (GCC) is a similar example of a regional economic union dominated by major oil exporters (see Box 4.3). Regional integration does present substantial challenges in the case of outward-oriented commodity exporters (not least the challenge of harmonising approaches to taxation of commodity exports). Nevertheless, these countries can still benefit from cooperation in many areas, including the development of cross-border infrastructure, cross-border investment and the liberalisation of mutual access to services markets.

Lastly, while deeper economic integration may yield substantial benefits, it can also aggravate the macroeconomic vulnerabilities of member states. As production chains become more integrated, shocks to world trade (such as that in 2008) permeate quickly through regional economic blocs. Producers of intermediary goods may be particularly badly affected as suppliers of final goods cut orders and run down their existing stocks of input materials.¹³ As a result, output contractions can be amplified through close trade linkages and so affect the strength of subsequent recovery.

³ The paradigm was originally developed in the 1930s and is best summarised in Akamatsu (1962). It originally referred to the economic integration in east Asia and the role of Japan.

⁴ See Menon (1996) for a discussion of the role of MNCs.

⁵ See Fujita (2001).

⁶ See Ng and Yeats (1999).

⁷ See EBRD (2010) for a discussion of the relationship between exports and innovation.

⁸ See EBRD (2008) and EBRD (2012).

⁹ See, for instance, Jensen et al. (2007) and Tarr and Volchkova (2010) in the context of Russia.

¹⁰ See Olarreaga and Soloaga (1998). See also Laursen (2010) for a discussion of political aspects of integration.

¹¹ See Kume and Piani (2001).

¹² The term trade diversion was coined by Viner (1950). See Venables (2003) for a detailed discussion of the issue.

¹³See Zavacka (2012) for a discussion of this so-called “bullwhip effect”.