Eurasian Economic Union. Advantages and disadvantages

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1 Eurasian Economic Union. Advantages and disadvantages Nurdaulet Abilov ISE, KBTU 8 th June 2014 Everyone likes white beautiful horses but no one wants to become one. - St. Augustine The underlying logic of this citation can be employed to explain many events happening around us, even the events which greatly concern an economy of a whole country. Trying to establish a strong economy with benign institutions without entering unions seems to be almost an impossibility under modern economic circumstances. However, such close ties with only several economies, especially in terms of trade, put the country into a risky situation, which would be hardly resolved if that risk justifies its right. One such close tie is to be established between Kazakhstan, Russia and Belarus at the beginning of 2015 according to the treaty signed on 29 th May of The official name of this association, which is said to be established only for purposes of mutual economic growth, is the Eurasian Economic Union (EaEU). Many politicians argue that even if the aspects concerning political issues were removed from the treaty, it's purpose still remains as a political one, taking into account recent scandals on the international arena about Crimea. It is a rather normative judgment whether Russia is seeking political allies or not. But one has to understand that in modern world, economics and politics are closely interrelated such that they coexist, and sometimes it is laborious to pick up economic or political aspects from a given issue. As a result, we try to focus only on economic aspects of the treaty and how it's formation will affect Kazakhstani economy in terms of advantages and disadvantages - the former is important because people must be able to identify the benefits whereas the latter is important because there are substantial risks associated with the establishment of this union. Advantages There are actually many more benefits of being a member of the EaEU than can be identified by economists and politicians. But it is better to focus only on the essential economic aspects which can be seen as momentous. Economists agree on a set of following advantages of being in the EaEU: 1) greater competition in the markets for commodities and services; 2) new employment opportunities; 3) inflow of investment and support for entrepreneurs. There are, of course, other benefits which are also important, but they can attributed as part of the benefits identified above. So, it is rather convenient to stop at them within the context of advantages which are more relevant. The first immediate effect of the establishment of the EaEU will be reduction and/or removal of tariffs and quotas on imported goods from member countries. As a result, this allows producers to promote their goods more freely in a larger market than before, and the increase of the size of the market allows reduction of prices of the goods. These are definitely beneficial for consumers, but it is wrong to think that producers are going to lose due to the lower prices. The reason lies behind free

2 movement of commodities, labour and capital within the EaEU. The greater the choice the more sensitive buyers are to prices of the good, labour or capital, and the prices will go down. Hence, not only the prices of commodities fall, but so do the prices of inputs such as labour and capital. In this case, it is rational to forecast that prices will fall for two reasons: a) the size of the market increases competition, and lowers prices; b) more input choices available to producers makes the price of inputs lower and reduces the costs of production, and the prices of final goods will go down eventually. The first scenario applies to both, final goods and inputs whereas the latter scenario applies only to final goods. Consequently, both, consumers and producers, benefit from the establishment of a single economic area. Consumers will benefit from lower prices of commodities and services, which, in turn, increases their purchasing power whereas producers will benefit from reduction of costs and ability to produce more, and promote their products in a larger size market. Due to this expectations, it is perfectly correct to expect that the profits of most companies, especially large ones, operating in one of the three member states will increase in the future. If it is true, you must be able to understand the reason for the increase in indexes of KASE and MICEX (2). KASE MICEX Figure 1.1 : Indexes are retrieved as of 8 th June of 2014 for the last 90 days The point is that the larger size market improves competition in the member states by increasing production, thus leading to an increase in GDP. It was stated in the mass media that the estimates are to forecast the increase in GDP of member states of EaEU approximately by 25% by As a result, it might seem to be a good idea of entering the EaEU, but the estimates made by economists do not take into account the events which may turn upside down the whole set of macroeconomic estimates and predictions. As it was argued by an American economist Robert Lucas from Chicago University, parameters of the macroeconomic equations tend to change with different policies and unexpected events, therefore, it is totally incorrect to state that the future would be like it was predicted by the model. The reduction in the costs of production leads to a stronger production capacity of firms. As a result, they can produce more output at a lower cost, which, in turn, leads to hiring more labour - more workers are needed to increase production. In addition, many new industries, which were previously postponed due to the higher costs, might open, creating new job opportunities for unemployed people. Consequently, the decrease in unemployment over time leads to a lower natural unemployment and higher natural level of output. But one might argue that the unemployment rate in the member states of the EU has remained high for so long, and given the similarity with the EaEU, who can guarantee that the unemployment will indeed fall? The answer is (1) - KASE index - MICEX index (2) An expected rise in profits of companies increase their stock prices, because the price of the stock is the present value of future expected dividends. Dividends, in turn, depend on how much companies earn in profit.

3 no one. But given the differences between the structure of the labour market and institutions of the member states of the EU and EaEU, we can ascertain that the unemployment will fall. In all three member states of the EaEU labour markets and institutions are quite different, and maybe the opposite, of that of the EU. Because the protection of workers, labour unions and the system of unemployment insurance are relatively weak in the EaEU. It was far ago stated that the formation of the EaEU will reduce firms' costs of production and leads to a larger size market. Together they decrease the prices of final commodities, which leads to larger a consumption volume by consumers. This is the crucial point, since higher demand for goods and services is what usually attracts new businesses and investors. Entrepreneurs are people who seek sources of profit, and engage in profitable business projects. In this respect, it is highly likely that the EaEU will become attractive place for investment due to the larger consumption by people and lower costs of production. As a result, the EaEU will have advantages of becoming the source of profit for foreign investors, and this, in turn, will strengthen the national currencies of the member states compared to foreign currencies. Now we have finished discussing the three main, commonly agreed by economists, advantages of establishing the Eurasian Economic Union and how they will come into the light. However, everything that has the good side has also the bad side, and it is especially true when considering the economies of different countries. Economists put it in a much more straightforward fashion by acknowledging that there are always trade offs. Disadvantages In 2009 almost all of the countries were suffering from the crisis which had originated in the USA. The main reason for the start of the crisis was the housing price bubble in the market for houses within the USA. However, it spread throughout the world, and the question that usually arises is why the crisis which originates in one can country devastatingly affects all other countries. The main channel of the spread of such crises is the international trade. It has been known for years that Russia and Kazakhstan are one of the closest pair of countries in terms of trade. Consequently, we can identify two main disadvantages for Kazakhstan of being a member of the EaEU: 1) high dependence on Russia with respect to trade; 2) potential formation of a single currency area. Kazakhstan and Russia have been very close trading partners since the collapse of the Soviet Union. The amount of trade between these two countries in 2013 was 23, 492 million USD (1). This is quite significant figure for modern international trade. However, this figure will definitely increase after the establishment of the union. If Kazakhstan starts importing more from Russia, there will be less need to import goods from other countries. It is indeed the case, because as the famous journal Bloomberg Businessweek articulated that, Kazakhstan, by getting close to Russia in terms of trade, is getting away from the EU, because an increase in imports from Russia are maintained by lower imports from the rest of the world through higher quotas and tariffs. As a result, the relative importance of Russian production increases for Kazakhstani economy. This is inherently risky situation, since the slight downward shift of the Russian economy will imply inevitable downturn for the economy of Kazakhstan. Trading more with Russia is like creating a portfolio consisting of securities of which 95% belongs to only one company or, in plain English, "do not put all of your eggs in one basket". Kazakhstan should diversify its trading channels, otherwise being a member of the EaEU or too dependent on Russia in terms of trade may come (1)

4 at a dear cost. For example, in 1998 due to the fall in the prices of oil-energy sector goods Russian economy slumped, and on 17 th August of 1998 defaulted on its debt. The crisis which originated in Russia negatively affected the economy of Kazakhstan, which, reaching the annual growth rate of 8.9% at the beginning of 1998, had negative growth rate of GDP of -9.9% at the end of 1998 (1). Figure 1.2 : Annual growth rate of GDP of Kazakhstan for History teaches us, and it would be foolish to ignore consequences of the mistakes made in the past. However, the EaEU is beneficial for Kazakhstan, assuming that nothing bad will happen to Russian economy. But it is obvious that this is a bad assumption taking into account the recent scandal concerning Crimea and economic sanctions by the West against Russia. Will the Russian economy survive these sanctions? Probably, yes. But even if they do, there is no reason to believe that the economy of Russia will not be hit by the wave of the crisis such as the one in As a result, Kazakhstan should pray for the health of the Russian economy, because they are tied too close to each other in terms of trade. Hence, the membership in WTO becomes not a need anymore for Kazakhstan, it becomes a necessity. Now it is time to turn to the other side of the problem of the membership in EaEU. The presidents of the three member countries signed a declaration on 18 th November of 2011, and the goal of the declaration was "deepening monetary cooperation" or considering common currency area between the member states of the Eurasian Economic Union. The same system works in Eurozone currently. However, as the practice shows it is not a good idea to organize a common currency area unless the countries, which are potential members of the area, satisfy the characteristics of an optimum currency area (OCA). The issue concerning an optimum currency area was first explored by a Canadian economist Robert Mundell. He asserts that to form an optimal currency area, countries must at least satisfy one of the following two conditions: 1) member countries must face similar macroeconomic problems and shocks; 2) high factor (labour) mobility between the member countries. It is critical to note immediately that the Eurozone satisfies none of the conditions above, and that is the reason why they have problems with their economy now. One more essential point to note is that when one country becomes a member of the common currency area, it gives up its powerful tool of manipulating the economy - monetary policy. This is the problem most of the countries in Europe have, they cannot use their monetary policy to stabilize the economy, because (1)

5 the adoption of euro means common monetary policy for all members of the Eurozone. Hence, similarity of economic shocks becomes a relevant factor for member countries of the common currency area. If the member countries of the EaEU organize a common currency area, then it must be clear that Russia, Kazakhstan and Belarus have different macroeconomic problems and shocks. Putting aside Kazakhstan and Belarus, even different regions of Russian Federation have different macroeconomic shocks. As a result, what would happen if these three countries adopt a common currency area, and Kazakhstani economy enters a short-run recession whereas the economies of Russian Federation and Belarus are healthy enough? Undoubtedly, Kazakhstani government would start engaging in expansionary fiscal policy. But would the common central bank engage in expansionary monetary policy? Unlikely. The reason is that the expansionary monetary policy indeed would help the recovery from recession for Kazakhstan, but it would increase the inflation rates in two other countries. It is also unlikely that the common central bank would follow the interests of one country at the expense of the other two. That is what you could observe 2-3 years ago when Greece had problems with slowing down economy. The only way out of recession for Greece was expansionary fiscal policy, which has bad long-run implications through the saving rate. Greece had budget deficit, and was accumulating debt over time. As a result, the government defaulted on its debt and lost confidence of its citizens and foreign countries. The second condition of an optimum currency area is not satisfied as well, at least now. Factor mobility between Russia and Kazakhstan is low due to the significant differences in their culture and religion. In addition, there are some problems with race discrimination in the member countries of the EaEU. Hence, it is not possible to state that the condition of high factor mobility is satisfied between Russia, Kazakhstan and Belarus. High factor mobility helps to form an optimum currency area, because when one country enters a recession and unemployment is high, unemployed people can move to other countries, which are members of the common currency area, and lower unemployment in the country of the origin of the recession. So, there is less need for monetary policy, since the economy self-regulates itself. The previous lesson from Greece economy for Kazakhstan is that there are significant risks if the member states of the EaEU decide to organize common currency area. However, this issue is postponed for later years. The EU was established more than half a century ago, and adopted common currency only at the start of 2000s. Therefore, we can state that the adoption of the common currency area for the EaEU is a matter of time, and it is unlikely to be good for all member countries, including Kazakhstan. Conclusion Key advantages of being a member of the EaEU which have been identified for Kazakhstan are certain ones, and the country will surely benefit from it. Disadvantages are potential threats for the country. They are potential, because they can be sidestepped if Kazakhstan wishes to do so. The first problem of high dependence on trade with Russia can be resolved by joining WTO, which will allow Kazakhstan to diversify its trade channels. The second problem might arise in the future, and it can be simply avoided by the refusal to organize a common currency area. Of course, there might be many more solutions to these problems, and we should never constrain ourselves with the given ones.

6 References: - Blanchard, O., D.R. Johnson Macroeconomics: Updated edition. (Pearson Education, 2013) sixth edition [ISBN ] Starikov, N. Rouble Nationalization: The way to Russia's Freedom (Piter, 2013), [ISBN ]