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Unit 21 : Static and Dynamic Effects of a Custom Union and Free Trade Organization

the financial system and the overall stability and effectiveness of economic policies that improve the Notes
climate of investment; (c) by providing an incentive to foreign direct investment to locate and produce
in the countries of the Union as opposed to exporting goods and services.
Unfortunately, it is difficult to make a credible case that these effects would be positive in the case of
a customs union in the CIS. First, it is likely that the cost of imported capital would actually increase
especially for some of the smaller members, as they could obtain capital goods more cheaply from
third countries. Second, while there are plans for greater integration of the financial systems and
economic policies of members which may have a positive impact on the climate of investment in the
future, there is very little chance that any of this will happen in the immediate future. In fact, premature
integration without adequate multilateral institutions may resurrect some of the problems of the
recent past which contributed to instability. For example, the common ruble area of 1992-1993, without
monetary coordination of the multiple central banks was a root cause of inflation and the problems of
trade. The key challenge in all countries is how to improve the national environment for private
sector development through the establishment of policies and institutions ( for example better
enforcement of contractual obligations) that improve the investment climate--policies that may best
be pursued unilaterally in the near term. Third, it is possible that as result of the establishment of the
customs union, there may be a positive effect on foreign investment that comes in to "jump" the
common external tariff. How big this effect will be is hard to predict simply because there are so
many other factors that constrain the inflow of foreign direct investment which countries need to
address first and which are likely to have a far greater impact on foreign direct investment than the
stimulus provided by the establishment of a customs union. More importantly, foreign direct
investment which is in response to tariff jumping can cause the welfare and growth rate of the capital
importing country to decline. The reason is tht foreign investment responds to the private return to
capital, and the foreigners will repatriate profits based on their private returns; but when the sector is
highly protected, the social return to investment in the sector is much lower than the private return.
In sum, while the dynamic effects of establishing or joining a customs union and of the exisiting Free
Trade Area in the CIS are difficult to demonstrate, they are likely to be negative, especially because of
the adverse effect of the preferential arrangements on technology and productivity improvements.
The Threat of the Loss of the Free Trade Agreement: In the event that a CIS country fails to join the
customs union, there is some possibility that the members of the customs union would apply the
common external tariff to the exports of that CIS country; that is, they may revoke their Free Trade
Agreements. Although we must be cautious since the effects will vary from country to country and
we do not have precise estimates, the net welfare impact of participation in the Free Trade Agreement
is likely to be negative for most CIS countries; consequently, the threat of exposure to the common
external tariff of the customs union is not an event that should be feared for most CIS countries.
The reasons are as follows: If Russia, Kazakstan and Belarus, withdraw from the Free Trade
Agreements and apply the negotiated common external tariff of the customs union to exports from
the other CIS countries, there would be economic impacts on both the imports and the exports of
these CIS countries. Regarding imports, as explained in detail in the appendix, applying tariffs on
imports from former partner countries in the CIS results in displacement of partner country imports
by rest of world supply. This results in a gain in tariff revenue on these sales. Moreover, since partner
country suppliers are likely, in many products, to lower their prices to the extent of reduction of the
tariff on rest of world products (since marginally inefficient partner country suppliers will be forced
out of the market as competition from rest of world producers becomes more intense), CIS consumers
will be able to pay less to partner suppliers by the amount of the tariff, and this is a gain to their
economic welfare. Moreover, permitting efficient imports from the rest of the world as opposed to
preserving inefficient imports from partners in the former Soviet Union, is very productive in terms
of breaking away from the outdated and inefficient technology of the Soviet past.
Weighed against this potential gain in welfare from application of tariffs on imports in the CIS is the
loss in welfare from lost preferential access to the markets of countries in the Customs Union. Exporters
from the CIS countries outside the Customs Union would no longer be able to obtain higher prices
than producers from the rest of the world on exports to the countries in the Customs Union, since like

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