Kazakhstan in the Customs Union: Losses or Gains?

In 2010, Kazakhstan entered into a customs union with Belarus and Russia. The first, relatively easy step in the implementation of the customs union was accomplished in 2010 with the adoption of a common external tariff, with varying exceptions in each of the three member countries. It is the intention of the customs union to eliminate the exceptions, in phases, by 2015. International experience has shown, however, that successful preferential trade arrangements are frequently based on “deep integration,” that is, integration that goes beyond the tariff preferences (1). In fact, the goals of the customs union are much more ambitious than implementation of the common external tariff. The governments of the member countries are working to achieve deep integration in key areas.

One area where the governments are working to deepen integration is in trade facilitation. It is the announced intention of the governments to eliminate customs posts between Russia and Kazakhstan and to reduce the costs of other aspects of trade between the countries - such as the number of required documents and the difficulty of obtaining them.

Another key area where the governments are working to deepen integration is in the reduction of nontariff barriers (NTBs). Technical regulations, including sanitary and phyto-sanitary (SPS) measures, are cited by exporters in Kazakhstan as significant cost-increasing barriers on their exports to Russia. The governments are working to harmonise technical regulations and to introduce mutual recognition agreements.

Clearly, successfully addressing the challenge of reducing trade-facilitation costs and nontariff barriers is a major task that requires significant institutional development both in Kazakhstan and in the other member countries of the customs union. It is very difficult, however, to assess the probability of success that the customs union will have with the reduction of these costs. We therefore present estimates of three possible outcomes for Kazakhstan.

Customs Union Current:

First, we estimate the impact of what has actually been implemented as of the spring of 2011. Kazakhstan has implemented the common external tariff with exceptions, but has made very little progress on trade facilitation or NTBs. Kazakhstan had free trade with Russia and Belarus prior to the customs union, so the only change is the implementation of the common external tariff (2). In particular, since the initial common external tariff was essentially the Russian tariff, Kazakhstan does not get a terms-of-trade improvement in Russia.

Customs Union Future:

Pessimistic Outlook: In one extreme (a pessimistic extreme) we assume that Kazakhstan will fully implement the common external tariff by eliminating the remaining exceptions but does not realise any reduction of its trade-facilitation costs and NTBs are not reduced.

Optimistic Outlook: In the other extreme, we assume that Kazakhstan fully implements the common external tariff and that trade-facilitation costs and NTBs are substantially reduced in the customs union.

Impacts of the Scenarios

Customs Union Current: We estimate that, under spring 2011 conditions, Kazakhstan is losing about 0.2% in real income per year as a result of participation in the customs union (3). This is due to its increasing its external tariffs to implement the common external tariff, with exceptions, to the levels that prevail in the spring of 2011. As a result of implementing the common external tariff of the customs union with exceptions, the tariffs of Kazakhstan have increased from an average of 6.7% to 11.1% on an unweighted basis (and 5.3% to 9.5% on a trade-weighted basis). We also estimate that collected tariff revenues in Kazakhstan approximately double, that the costs to businesses and consumers of imports increase, and that under the tariff umbrella resources are shifted to areas of inefficient production. Consequently, we estimate that the customs union has depressed real wages by 0.5% and depressed the real return on capital in Kazakhstan by 0.6%. Kazakhstan trades less with the rest of the world and more with Russia, Belarus, and the rest of the CIS, resulting in less imported technology from the more technologically advanced European Union and other countries - leading to a loss of productivity gains in the long run. Regarding expanding and contracting sectors, almost all service sectors decline, since they do not benefit from the increased protection and they become relatively less profitable compared with the sectors receiving increased protection. But we estimate that most of the manufacturing sectors expand, with wearing apparel, furniture, machinery and equipment, motor vehicles, and transport equipment expanding the most due to the increased protection (4). The tobacco sector declines slightly due to lower protection. The sector changes imply some reallocation of capital and labour between sectors. Around 0.2% of the labour force will have to find jobs in another sector.

Customs Union Future:

Pessimistic Outlook: We estimate that Kazakhstan will lose about 0.3% in real income per year as a result of fully implementing the common external tariff (compared to its 2009 tariffs). That is, eliminating the exceptions to the common external tariff will increase the losses. This is due to the fact that eliminating the exceptions will require that Kazakhstan further increase its external tariff rates to the non-CIS countries (5). Then, real wages and the real return to capital fall by more and the costs to consumers and businesses of their purchases increases by more than in our first scenario. The sector changes for imports and output are similar to the scenario with current 2011 tariffs. We estimate that a larger diversion of imports from the EU and the rest of the world results from imports from the customs union and the CIS and by domestic production, especially in agriculture and chemicals. Employment changes are also similar to the scenario with current 2011 tariffs. Again, 0.2% of the labour force moves to jobs in another sector.

Optimistic Outlook: In this scenario we make an optimistic assessment of how much the customs union may lower the trade-facilitation costs in importing to or exporting from Kazakhstan (to customs union members and to third countries) and how much Kazakhstan may benefit from a reduction of NTBs in the customs union. Among the NTBs that we consider are sanitary and phyto-sanitary conditions, which have been reported as significant barriers for exporters of Kazakhstan to Russia. We also assume that the common external tariff is fully implemented. We estimate that the real income of Kazakhstan would increase by about 1.5% of consumption per year in this scenario. We decompose our estimate into its components and find that our estimated real income (welfare) gains from reduced trade-facilitation costs are the largest component - they are rather substantial at about 1.4% of the value of Kazakhstani consumption. These estimated gains from reduced trade-facilitation costs are large since the reduced costs apply to both imports and exports as well as to existing and additional trade, and to some extent will apply on trade with third countries as well. The gains from reduced NTBs roughly offset the losses from the full implementation of the common external tariff, leaving the trade-facilitation impacts as the net impact in our optimistic scenario.

The output expansion in manufacturing is somewhat larger at the sector level due to lower trade-facilitation costs in importing to or exporting from Kazakhstan (to customs union members and to third countries) and to lower NTBs in the customs union. The chemical and leather products sectors expand much more than in the earlier scenarios. On the other hand, some manufacturing sectors contract that had expanded in the Pessimistic Scenario - including wood products, paper and printing, and rubber and plastic products. The larger sectoral impacts also imply larger adjustment costs for labour. Around 0.5% of the labour force will change employment to another sector.

Diversification

Although some modest diversification of the economy of Kazakhstan is achieved by the import-substitution industrialisation of the higher common external tariff, repeated international experience has shown that this is not a successful strategy for growth and economic development (6). Diversification of the Kazakhstan economy is a worthy goal. However, to achieve diversification, institutional reform to improve the business climate is necessary. Kazakhstan's ranking on some of the key indices of institutional development are as follows: it ranks 59 out of 183 on the Doing Business index; 62 out of 155 on the Logistics Performance Index; and 105 out of 178 on the Transparency International Corruption Perceptions Index. Small and medium enterprises depend crucially on the institutional environment for doing business. Further improvement in these areas is crucial for the diversifi cation effort.

Summary

We estimate that implementation of the common external tariff of the customs union is a cost to Kazakhstan of joining the union - a cost that it has already begun to pay. The cost, however, could potentially be overcome and the customs union could produce a net benefi t, provided the union can achieve a successful outcome on trade facilitation and NTBs, including SPS conditions (7). Crucially, we do not assume that these extremes will occur with equal probability or that any outcome between these extremes occurs with equal probability. Implementation of the common external tariff is the least difficult aspect of implementation of the customs union. Achievement of progress in trade facilitation and reduction in NTBs will require a serious commitment to improving institutions, which in some member countries in some sectors are plagued by rent seeking. But these results indicate that in order for Kazakhstan to achieve a positive outcome from participating in the customs union, it is crucial for it to work together with its partners on the reduction of trade-facilitation and border cost barriers as well as on the reduction of NTBs, including SPS conditions as NTBs.

This article is part of the World Bank Report No. 65977-KZ ‘Assessment of Costs and Benefi ts of the Customs Union for Kazakhstan’ published inJanuary 2012.

1. See, for example, Schiff and Winters (2003)
2. Since Kazakhstan had free trade with Russia and Belarus prior to the customs union, the tariffs on trade among the member countries did not change. In our analysis,we assume that Kazakhstan had a regime of free trade with the countries of the Commonwealth of Independent States (CIS) plus Georgia and that this will continueafter the formation of the customs union. Kazakhstan had a bilateral free trade agreement with Russia, signed on October 22, 1992; approved by Cabinet of Ministersdecree #374 on May 7, 1993; and effective on July 7, 1998. It had a bilateral free trade agreement with Belarus signed on September 23, 1997. In addition, the CISagreement of 1994 stipulated free trade among the signatories, which included all the CIS states. Finally, the Eurasian Economic Community, under which free tradeamong the members was agreed, included Belarus, Russia, Kazakhstan, Kyrgyzstan, and Tajikistan (Uzbekistan dropped out).
3. Vinhas de Souza (2011) found a similar result.
4. A multiregion model that models Russia endogenously might find that some of these sectors contract rather than expand. The reason is that agglomeration externalitiesin Russia might allow the Russian firms to produce at lower costs and expand exports further.
5. Major examples of goods with transition periods are antibiotic medicine, where the tariff rate increases from 0% to 15%; apples (from 5% to 37.5%); and certain electricalparts (from 0% to 15%). When aggregated to the sectors of the model, the tariff rates increase by up to 4 percentages point in the agricultural and chemical sectors.
6. For example, China and India began to experience rapid economic growth only after they liberalised.
7. In principle, both trade facilitation and NTBs could be addressed without the common external tariff or a customs union agreement. But the customs union agreementhas energised these negotiations, and it may be what is required to get serious engagement by Russia on these issues. The question is, will there be enough progress inthese areas to compensate Kazakhstan for the costs of the common external tariff?