13.05.2007
Free Trade Between Russia and the EU: Pros and Cons
№2 2007 April/June

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.

*  * 
*

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.