The rationale for building a Common Economic Space between the Russian Federation and the European Union, the contours of which were outlined in one of the four Road Maps adopted at the Russia-EU Moscow Summit in May 2005, presupposes the future establishment of a free trade area. In 1998, both parties started joint studies on this issue in the framework of the Russia-EU Partnership and Cooperation Agreement, due to expire on December 1, 2007. Since that time, however, no practical moves have been made on this project.

Following the end of World War II, international experience was gained in building free trade areas – for example, the European Free Trade Association (EFTA), the South American Common Market (Mercosur), and the North American Free Trade Agreement (NAFTA) – by the member countries of the General Agreement on Tariffs and Trade (GATT), which later was replaced by the World Trade Organization (WTO). This experience suggests that until Russia officially joins the WTO, negotiations on a free trade area cannot be included in the political agenda between Russia and the European Union.

On November 19, 2006, Moscow and Washington signed a protocol on U.S. support for Russia’s admission to the WTO. In a best-case scenario, procedures for formalizing Russia’s membership in this organization could be completed by the end of 2007. Official negotiations between Russia and the European Union on a free trade area will doubtfully start before 2008, even if the parties display the political will for such a move.

At the same time, the Russian Federation is not economically prepared to make major steps toward the creation of a free trade area with the EU. Moreover, considering the failure of the latest Russia-EU summit in November 2006, when Poland blocked negotiations on a new long-term agreement between the parties, the free trade area issue seems to have lost its importance.
Meanwhile, the 8th Round Table of Russian and EU industrialists, which brought together the Russian Union of Industrialists and Entrepreneurs (RSPP) and the Union of Industrial and Employers’ Confederations of Europe (UNICE), set down a proposal that the vice president of the RSPP, Igor Yurgens, described as a “bold breakthrough.” The event, which was held in Helsinki at the same time as the abovementioned Russia-EU summit, called for a “broad-based [Russia-EU] agreement with extensive provisions on free cross-border trade.” According to Western mass media reports, officials from both delegations – and at a very high level – even spent time in the lobby discussing the issue of a free trade area.

The RSPP’s position, as stated by Yurgens, came as a total surprise to this author. A large proportion of Russian businesses (at least those in the manufacturing industry, let alone agriculture and the services sector) are very cautious about or openly opposed to even the prospect of Russia’s membership in the WTO. However, WTO membership presupposes a much more moderate liberalization of Russia’s foreign trade, especially in terms of imports, as compared with the sort of liberalization expected within a free trade area with the European Union.

THE INTERESTS AND POSITIONS OF THE PARTIES

Obviously, the European Union, as the stronger economic actor, will only gain from the creation of a free trade area with Russia. The latter’s gains will be less obvious, as its competitive positions with regard to its hypothetical partners in the free trade area are very vulnerable. Moscow can expect positive results not earlier than in the medium term, while the negative results will be felt immediately. By contrast, the EU will quickly see the benefits from a free trade area with Russia and without any risks.

The European Union will receive asymmetric competitive advantages due to the short-term exemption of industrial goods from various tariff and non-tariff restrictions. For Russia, the balance of expected consequences will most likely be negative.

As EU exports to Russia consist mostly of equipment and other finished, high value-added products, the lowering of tariff and non-tariff barriers will spark an increase in volume and cost. This will increase competitive pressure on Russia’s manufacturing industry. As a result, Russia’s surplus in trade with the EU will decrease and may even turn into a deficit under an unfavorable scenario (the higher growth rate of Russian imports from the European Union in recent years, as compared with Russian exports to the EU, already strengthens this trend). These developments will deliver a heavy blow to Russia’s solvency, budget system and hard currency reserves.

Other negative results may come from the abolition of export duties (incompatible with free trade area rules) on Russian fuels and other raw materials exported to the European market, especially oil and gas. In addition to the reduction of customs duties, this move will markedly reduce aggregate customs revenues, which now account for about 40 percent of national budget receipts.
Russian exports to the European Union largely comprise hydrocarbon and other commodities, as well as finished, low value-added products (e.g. fertilizers and other products of large-capacity chemistry). Therefore, about 80 percent of Russian exports enter the EU duty-free or on favorable terms. Thus, given this structure of trade, Russia does not need a free trade area.

The gradual formation of a free trade area could help solve a crucial strategic foreign-economic task – diversifying Russian exports through a sharp increase of the percentage of finished goods, most importantly high-tech and other machine-building products. At the same time, a free trade area will not provide any guarantees to Russian businesses, but only additional opportunities for development.

The greatest opportunity for increasing the export of Russian finished goods lays not in the European market, but the markets of other regions, primarily the Asia-Pacific Region. Germany, for example, the leading economic power in the European Union, has almost no prospects for Russia in this respect (there may be only minor breakthroughs into insignificant niches).

Since 1992, Germany has invariably been the world’s main exporter of tangible products, which is due to its leadership in such areas as general machine-building, electrical engineering, and chemistry. Furthermore, it is one of the world’s few car-making giants. For the first time over the last quarter of a century, the progress of its general machine-building production has been continuing for four years already, and experts predict its further growth in 2007. Production capacities in the country have hit 86 percent. Companies operating in this field are difficult to compete with even for contractors from other EU countries and member states of the Organization for Economic Cooperation and Development – not to mention Russian machine-builders. Although conditions for expanding Russian machine-building exports to other EU countries – especially to the post-Communist ones – are more favorable, they are still better beyond the European Union.
Russia’s accession to the WTO will allegedly promote the diversification of its exports in general and to the European market in particular. In the Asia-Pacific Region, the same role – apparently to no lesser degree – will be played by a free trade area, planned to start by 2020 in the frameworks of the Asia-Pacific Economic Cooperation (APEC). Full liberalization of mutual trade is planned to start in 2010 for developed APEC member states, and in 2020 for developing members. Russia, as an APEC member, could take advantage of this opportunity.

The European Union now accounts for about one half of Russia’s foreign trade. During the next 10-15 years, this figure will gradually decrease (probably to 40 percent). Meanwhile, the share of Russia’s foreign trade to Northeast Asia (China, South Korea, and Japan) may double from the present 12.5 percent.

The Asia-Pacific Region not only has more favorable conditions for the growth of Russian exports of finished goods. Energy consumption and the demand for imported energy resources in Asia-Pacific countries, such as India, China, the U.S., and others, in the next decade will be growing much faster than in the EU. This situation is largely due to the comparatively low economic dynamics of the European Union in the future, anticipated by the majority of experts. In the period from 2006 to 2017, according to a forecast made by the Center for World Economic Ties of Russia’s Research Institute for Foreign Economic Ties (VNIIVS), global GDP will increase by an average of 3.1-3.3 percent a year, while Russia’s growth will be 6.6-6.8 percent. Meanwhile, U.S. GDP is expected to grow 2.9-3.1 percent, while the EU by just 2.3-2.5 percent.

Moreover, in Germany, for example, which is one of the largest importers of Russian energy resources, the consumption of oil products will decrease by 1.7 percent by the year 2010, compared with 2006 (according to a forecast made by experts of the German Union of Entrepreneurs of the Oil and Oil-Refining Industries and published in August 2006). As a result, the demand for crude oil for the production of oil products will also remain at the 2005-06 levels, which will cause a decrease in the demand for imported oil (in physical volume).

Importantly, the Asia-Pacific countries attach less importance to the diversification of energy supplies than the EU, which continues to emphasize its allegedly excessive dependence on Russian energy supplies while declaring the desire to reorient itself to other suppliers. In light of these developments, Russia deems it expedient to gradually increase the share of its energy exports to the Asia-Pacific Region from the current 3 percent to 30 percent. However, these plans will become feasible economically and technically only after 2017, since such a change will require Russia to redirect to the East not less than 60 million tons of oil and 65 billion cubic meters of gas a year.

ROAD MAP TO FREE TRADE AREA

After Russia joins the WTO, it must first fulfill its obligations for the transitional (adaptation) period. As regards a hypothetical free trade area with the European Union, its formation may be completed by the end of the next decade if the parties devise, sign and ratify a corresponding agreement in 2008-2010. In other words, a Russian-EU free trade area will appear simultaneously with an APEC free trade area.

When analyzing the prospects for a free trade area, it is useful to look back at the development of the European Free Trade Association in 1961-1970. The Stockholm Convention on the establishment of the EFTA, which came into force in 1961, includes the following four major provisions:

1. The reduction and ultimate elimination of import duties (with some exceptions) in one decade at a rate of 10 percent a year (Article 3).

2. The raising of import quotas up to 100 percent by 1970, which means the elimination of quantitative restrictions on imports in mutual trade.

3. The establishment of uniform rules for determining the country of origin of particular goods. This is required to prevent the application of the Area Tariff Treatment on goods produced outside the EFTA. Goods eligible for tariff treatment include:
- goods wholly produced within the EFTA;
- certain goods produced within the EFTA that follow the qualification process;
- goods produced within the EFTA; however, the value of any materials imported from outside the EFTA, or from a place of undetermined origin, which have been used at any stage in the production of the goods, must not exceed 50 percent of the export price of the goods (Article 4).

The EFTA has no foreign-trade tariff for third countries, that is, the element of the EU’s customs policy that makes it a customs union. Furthermore, the EFTA does not exceed the frameworks of a free trade area, and its member countries have full customs autonomy with regard to other states.

4. If there is a deflection of trade due to the reduction of import duties by a member state, which results in increased imports into the territory of this member state and which causes serious injury to it, the EFTA takes measures to deal with the causes of the deflection of trade (Article 5).

Other important provisions of the EFTA’s Stockholm Convention involve the reduction of export subsidies on agricultural goods (Article 24); the mutual granting by the EFTA members of the freedom of operation of economic enterprises by nationals of other member states (Article 16); the elimination of fiscal charges applied to imported goods so as to afford effective protection to like domestic goods, and of any effective protective elements in internal taxes or other internal charges, as well as the prohibition of export duties in mutual trade (Articles 6, 8); and the reduction of restrictions on competition within the Area of the Association (Article 15).

Any EFTA member state may temporarily restrict imports in cases when the decrease in import duties or the elimination of quantitative restrictions on imports has a damaging effect on the balance of payments or results in an appreciable rise in unemployment (Articles 19, 20). In the area of agriculture, the Convention provided for working out special provisions (Articles 21-28).

If Russia and the EU follow the EFTA’s positive experience, it may result in the creation of a preferential trade area between the two parties within the first few years after their free trade area agreement comes into force. This preferential trade area will serve as a forerunner of a free trade area. Commitments under the free trade area agreement will have to be harmonized with Russia’s commitments under the Russia-Belarus Union Treaty and those stemming from its membership in the Eurasian Economic Community (EurAsEC) which is moving toward the establishment of a customs union.

All international legal documents on free trade area status, adopted after World War II, provided for a stage-by-stage transition to free trade only in tangible industrial products, while establishing special rules for liberalizing mutual trade in “sensitive” items (textiles, ferrous metals, etc.). Those documents did not apply to trade in agricultural products.
It would seem logical that Moscow and Brussels will inevitably take the same path in building a free trade area. The most Russia could hope for in the field of agriculture is preferential trade, with due coordination of issues pertaining to state support for agriculture.

PROSPECTS AND POSSIBLE CONSEQUENCES

A so-called “tariff disarmament” that would necessarily accompany a Russia-EU free trade area would probably last 7 to 10 years and, as was the case with the EFTA, will proceed through annual gradual reductions in tariffs on finished goods. Also, as in the EFTA in the 1960s, the free trade area agreement must provide for a possible temporary freeze on – or possibly even an increase in – tariffs if there emerge imbalances on individual goods markets, thereby jeopardizing national production and employment. The same action must be taken in case of serious disproportions in the balance of payments.

If the free trade area brings positive results with regard to industrial goods, eventually there will arise an issue of mutual liberalization in the movement of services. This will take much more time and will require stage-by-stage conclusion of corresponding agreements for each specific kind of services (transport, insurance, tourism, etc.).

In estimating the customs value of goods and determining the state of goods’ origin, the EU abides by the rules of the World Trade Organization and has not yet introduced any specific regulations in this field. The future Russia-EU free trade area must be a realm where corresponding WTO rules are applied. Russia’s goal is committed adherence to these rules, which, to date, has not been fully achieved. It would be expedient to borrow from the EFTA’s experience in applying uniform rules for determining the state of origin of goods.

If in the course of building a free trade area, Russia and the European Union liberalize their mutual trade, the parties in many cases will have no other way to protect their national production, markets, employment and social stability than by taking measures that involve non-tariff regulation. Therefore, any future agreement between Russia and the EU must include rules for taking such measures by the parties in the spirit of consistent trade liberalization.

In the field of non-tariff regulation, the EU, as a rule, also abides by WTO international legal norms. If the proposed Russia-EU free trade area agreement has references to corresponding WTO documents that would suffice. However, the agreement must contain special instructions and regulations on some non-tariff restrictions where the European Union applies its own norms and rules. This concerns anti-dumping measures, technical and ecological standards and norms, and measures of sanitary and phytosanitary control.

If a free trade area does become a reality, the EU will eventually demand equal conditions for participating in competitive biddings, along with Russian companies; this would include Russian state orders for the supply of goods and services and for construction projects in Russia. If this issue arises (which will happen most likely in the long term), Russia must address it on the basis of the principles of reciprocity and mutual benefit.

International free trade experience, above all in the EFTA, shows that the liberalization of trade in finished goods – especially machines and equipment – in the course of building a free trade area promotes specialization and cooperation in research and production between the parties. On this basis, there is a stimulation of investment cooperation, mainly in mutual direct investment. The liberalization of trade will also provide the EU with cheaper direct investment in the Russian Federation when establishing branches of European companies and joint ventures, and will reduce their production and marketing costs (including in the area of components supply).

At the same time, however, opening up the Russian market will mean the direct export of products – via European firms – produced in other countries, which will weaken interest in investment in Russia as a way to penetrate its domestic market. But on the whole, the formation of a free trade area will increase direct investment from the European Union, most importantly in the manufacturing industry.

To this end, Moscow will need to conduct active negotiations with the European Union. The EU will start deriving immediate benefits from the free trade area, while Russia will first have to overcome difficulties caused by economic restructuring. Therefore, Moscow has all grounds to expect commensurate concessions and privileges from Brussels. This would include investment cooperation, as well as the introduction of a visa-free regime that would provide easy access for Russian manpower to labor markets in EU member countries on the basis of temporary contracts.

It must be emphasized that immigration restrictions and the strict Schengen regime apply to Russian citizens in full measure. The usual allegations by leading European politicians and high-ranking officials from Brussels and Strasbourg, which say that Russia is denied visa-free travel due to its so-called instability, are absolutely unconvincing considering Russia’s real situation. Meanwhile, the EU offers visa-free entry to citizens of about 60 other countries, including much less stable states than Russia (for example, Argentina). Such discrimination contradicts the very idea for creating a Russia-EU free trade area and, moreover, a Common Economic Area.

From the very beginning of the free trade area negotiations, Russia should have sought a framework agreement on the regulation of labor migration in the future Common Economic Area. On the basis of such a document, Moscow would be in the position to conclude corresponding bilateral agreements with participating countries. Such agreements must ensure equal rights for Russian labor migrants – at least with labor migrants from third countries (Turkey, etc.). They also must regulate their employment, employment quotas, social issues (such as remuneration of labor, health services, pension schemes, and unemployment insurance), and the duration of labor contracts. Full account must be given to Russia’s interests.

The formation of a Russia-EU free trade area is impossible without the free movement of Russian citizens and shipments across “European” land, that is, between the Kaliningrad exclave and mainland Russia. It is important that this movement be essentially simplified already at the initial stage of the future free trade area negotiations.

In international practice, rules for transit between two separated areas of the same state are based on international legal precedents. The Alaskan Highway, for example, which is 2,394 kilometers long, was made possible through a bilateral agreement between the U.S. and Canada. The highway, which was opened on October 25, 1942, provides free transit via Canadian territory between mainland America and its exclave state. The Russian Federation has as much right to access its Kaliningrad exclave.

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Throughout the entire post-Soviet period, the European Union has been Russia’s main partner in trade and economy and will remain so at least until 2015-2020. The further expansion of trade with the EU is necessary for Russia in developing its entire complex of foreign-economic relations (already now it accounts for not less than 35-40 percent of the country’s GDP).

Russia is ready to guarantee that it will provide for the energy needs of the European Union; Moscow is interested in consolidating this strategic partnership. The European Union, we believe, shares these same interests.

At the same time, by virtue of the aforementioned circumstances, the creation of a free trade area between the Russian Federation and the EU cannot be a top priority, the more so an immediate task in improving Russia’s foreign trade and implementing its foreign policy.

In drafting a free trade area agreement, both Russia and the EU must avoid both unjustified pessimism and excessive expectations, not to mention euphoria. The drafting of such an agreement is going to be a long-term process, which Russia should enter only after careful and intensive preparations.