Project description - Opening of the Russian Economy and Its Integration with the EU

Project leader: Director Kari Alho, ETLA. The Research Institute of the Finnish Economy, Lönnrotinkatu 4 B, Helsinki, tel +358 (0)9 60990220, ka(at)etla.fi, www.etla.fi

1 Background

Political dialogue between Russia and the European Union has increased during the past few years. This has also been reflected in their bilateral trade relations, which have intensified considerably. According to their proclaimed objectives, Russia and the EU will aim at a common European economic space (CEES). This concept is still vague, but may include the removal of trade barriers, a free-trade area, and in the long term possibly an EEA-type of institutional arrangement as currently exists between the EU and, for example, Norway. In the first phase, Russia is seeking membership in the WTO.

The EU has a central role in the integration of Russia in the global economy as over half of Russia's exports go to the enlarged Union. Russia is also quite important for Finland as Russia's share is considerably larger in Finland's total exports than in the other EU countries' exports. From the point of view of future developments it is important to analyse how Russia's closer integration with the EU may help to sustain economic growth in Russia.
EU enlargement will change European trade relations significantly. The major part of the continent will belong to the EU's trade policy regime. Consequently, the question, how the enlarged EU will organise its trade relations with the rest of the continent, will become more important. A full membership of Russia in the EU is not an option but in order to avoid Russia's marginalisation the EU should adopt an open attitude towards the rest of the continent in its external commercial policy.

The integration of the Russian economy with the international economy takes place largely through the exports of oil, oil products and of other raw materials. The EU seeks increasingly to build its economic strategy on Russia on the imports of energy commodities. On the other hand, the pricing of these commodities inside Russia differs considerably from their pricing in the international market, because oil commodities are subsidised inside Russia. According to the theory of international trade, this results in a deviation from the optimal use of resources. This is also one important issue in Russia's entrance to the WTO. The subsidising of energy products supports the real incomes of the poorer people and of energy-intensive sectors in Russia. Were the domestic price deregulated, there would be a need for large compensations throughout the country and the macroeconomic stability as regards to inflation could be jeopardised. A closer analysis of this dual situation is needed from the point of view of the opening of the Russian economy and its long-term growth prospects.

From the point of view of Finland and of the EU's co-called Northern Dimension it is important to consider the economic performance of the near-by regions of North-West Russia as a part of the general analysis of the Russian economy. The difference in living standards between North-West Russia and Finland is large. A central question is how economic integration between these two via trade and foreign direct investment will support economic growth in North-West Russia.

The development of Finnish industrial clusters may have a great significance for the economy of North-West Russia. At present, we can see prerequisites in North-West Russia for the formation of similar clusters that could substantially surpass the Finnish ones in size. One can definitely single out potential clusters that are based on the forest industry (including forestry, as well as mechanical and chemical wood-processing), metallurgy and metal-working (ferrous and non-ferrous), fuel and energy sector, food and beverage industries and the information and telecommunication sector. Besides this, potential for emerging clusters can be observed in machine-building (primarily, in defence industry and shipbuilding), the production of pharmaceutical and medical equipment, cosmetics, chemicals industry, construction materials industry, and transportation.

This increases opportunities for the development of Russian-Finnish cross-border cooperation, including not only the exchange of resources, technology and know-how, but also subcontracting and subsequent formation of cross-border clusters. A favourable investment and business climate, which should intensify competition and help to create a common information space, will drive deepening regional and technological specialisation. Furthermore, the emergence of an attractive investment climate could promote the creation of new business models that are likely to contribute to mutual competitiveness and growth and could prove vital for the sustainable development of the North-West Russian economy. A major step in investigating these issues has been made in the course of a number of research projects carried out jointly by researches from Solid Invest (St. Petersburg) and ETLA.

2  The objectives of the project

The aim of the research project is to analyse the opening of the Russian economy and its integration with, and economic links to, the EU and especially Finland. There are three main focal points in the project: 1) the future prospects of the economic relations between Russia and the EU and their impact on Russia, 2) Russia's economic growth that is largely based on the extraction of raw materials, and the importance of the difference between their domestic and international prices, and 3) economic convergence of North-West Russia towards income levels in the EU and the importance of economic links between North-West Russia and Finland in this process.

The Eastern enlargement of the European Union is likely to affect Russian trade in three ways at least. First, lower trade barriers within the Internal Market (IM) of the EU-25 area divert imports from Russia to intra-IM trade. This is because lower trade barriers within the IM favour IM-based exporters in terms of relative prices. This hurts Russian exporters but also from the viewpoint of the EU member states it creates a welfare loss. The effect is likely to be rather small, though, since trade between the current member states and the accession countries is already relatively free due to Europe Agreements. Therefore, the impact of expanding EU membership should not contribute significantly to trade diversion. Second, as Russian exporters are hit by the relative price changes and as the IM is an important market area for them, it is likely that without any further liberalisation of trade Russian exporters face a negative terms-of-trade effect. This yields a welfare gain for the EU and a loss for the Russian economy. Third, within the IM, lower trade barriers create trade. This gives an additional welfare gain for the EU countries but might also contribute positively to the Russian economy. In fact, there is some evidence that EU-integration has created trade also externally through increased demand. In the case of eastern enlargement this effect is likely to be boosted by the fact that the current EU member states pursue a more liberal trade policy towards Russia than the candidate countries that will adopt the EU norm after the enlargement. The direct total effect on the Russian economy is the sum of these three effects.

The aim in the first part of the project is to analyse, through successive simulations by the GTAP model, the various stages of further integration between Russia and the EU, and their effects on the partners. The convergence between Russia and the EU is analysed by studying the different factors in the integration between these two in part one of the project. These are Russia's WTO membership, a possible free-trade area between Russia and the EU, the removal of non-tariff barriers to trade, and the possible institutional convergence within an EEA type arrangement.

In addition to the analysis of the general opening of Russia (WTO-membership and EU-relations), also economic relations between Finland and Russia will be analysed. This will be a continuation and deepening of a study, recently completed at ETLA, on the economic relations between Finland and Russia. The aim of this study is to find out the determinants of trade between the countries, as based on specialisation, general economic developments such as growth, competitiveness and specific factors of supply and demand in different sectors of the two countries. Thereby, the aim is to find out the significance of the mutual integration to both countries.

In this part, there will also be a sub-project titled "Russia-EU trade within the context of Russian accession to WTO: price convergence". Department of World Economy in St. Petersburg State University has recently investigated the issue of Russian accession to the WTO as well as various developments in regionalism. Several articles and monographs have been published by the staff on both subjects. It is well known that one significant possible implication of Russia's accession to the WTO directly relates to the prospects of economic cooperation between Russia and its major trading partner, the EU. In this sub-project one possible research topic might be an analysis of the effects of trade liberalisation on price convergence. Differences in price levels may be used as an indicator of integration: the lower the differences, the stronger are the mutual economic ties between national (or regional) economies.

Price differentials are one of the reasons for international trade, along with the absence of national production of some commodities and goods and variations in the quality of goods. It means that diminishing price differentials may decrease the level of trade between the respective countries. In the case of Russia a probable rise in gas and electricity prices would decrease the price competitiveness of Russian producers in such energy-intensive industries as metallurgy and fertilisers. On the other hand, prices are also affected by the level of factor mobility; Our hypothesis is that prices depend on incomes, factor endowments, taxes and import duties. Trade and factor mobility enhance the convergence of price levels. At the same time, different factor costs, non-tradability of many goods and institutional factors (different tax systems, etc.) explain the remaining differences in prices. It might be interesting to investigate contemporary differences in prices (especially wholesale, but retail prices as well) between the EU countries and Russia (or North-West Russia). An assessment of the magnitude and pace of price convergence within the EU, on the one hand, and factors, that may influence price change in Russia, on the other hand,  might help to estimate the speed of price convergence between the EU countries and Russia under scenarios of WTO accession and/or Free Trade Agreement between the EU and Russia in the future.

Thus, the following sub-tasks can be specified:

• a) Based on the literature and surveys of price differentials among the EU countries, an
  investigation of these links between Russia and the EU, but also within Russia, by a
  comparison of incomes and price levels between regions of the Russian Federation.
• b) An estimation of the effects of rising incomes and  decreasing (in the case of WTO
  accession or even EU-Russia FTA formation) international trade barriers on price levels
  in Russian regions, especially in the North-West.
• c) A preliminary assessment of possible effects from rising price levels in Russia on
  trade with its neighbours in the EU.

In part two of the project the objective is to study the integration of Russia being extensively based on its energy reserves and the domestic policies in relation to this fact. The utilisation of Russia's raw material base has a dual effect on the economy. On the one hand, it gives a possibility to increase consumption. On the other hand, the tying of resources into the extraction of raw materials weakens other industrial sectors and productivity growth (called in the literature the Dutch disease). We intend to expand the international research on the Dutch disease by taking into account the difference between pricing in the domestic and international markets (the domestic price subsidies) and the effect that this has on the efficiency of resource allocation and the growth rate of the Russian economy.

Convergence of the North-West regions and a decrease in the income gap between Russia and the EU is the third major research topic in the project. We intend to deepen the current monitoring project of North-West Russia, where ETLA, Solid Invest and St. Petersburg State University work together, by analysing quantitatively the factors that determine economic developments in these regions and their dependence on the general developments in Russia and on the foreign economic links especially with Finland. This part of the project analyses economic linkages between Finland and North-West Russia. On the basis of these linkages and a separate analysis using growth accounting techniques we will make an assessment of the prospects of convergence in income levels between Finland and North-West Russia.

Regional data for Russia are acquired for Saint-Petersburg, the Leningrad and Murmansk regions, and Karelia. Background information is provided by a structural breakdown of GDP by economic activity and, if possible, of manufacturing industries. Some rough measures of labour productivity could be calculated on the basis of these. Domestic fixed investment and foreign direct investment play an important role in updating Russia's obsolete industries and infrastructure. For the latter, also intra-Russian budgetary flows and possible EU structural funding are of importance. We will also discuss what impact closer economic links with the EU, notably Finland, may have on economic growth, trade, and the location of production. Results from a gravity model explaining trade relations can be used to estimate the potential for cross-border trade and investment flows.

An assessment of the prospects of GDP growth is attempted by using growth accounting techniques. While Russian economic statistics do not provide the best possible basis for this kind of an approach, the approach can be utilised as a framework in which the economy is analysed on the basis of the development of the factors of production (capital, natural resources and labour).

Furthermore, using the breakdown of regional GDP and manufacturing industry, we shall an attempt to assess the regional effects on the basis of the general results from both the simulations on EU-Russia integration, as produced by the simulations of the GTAP model in part one of the project, and the overall growth performance of the Russian economy. This will provide more insight into the regional impacts from the opening of the Russian economy.
In his dissertation, as an element of part 3 in the project, the aim of Pavel Filippov from Solid Invest is to analyse how the Finnish and North-West Russian industrial clusters can increase their efficiency through deeper cooperation. The plan is to develop a wide picture of the opportunities for cooperation and to investigate them in more detail using the energy cluster as an example. In the framework of his activity in Finland he will be able to collect the valuable facts and figures at the micro level and form a useful data and reference base for the whole project. It is important that in the course of the research he is able to partially exploit the resources and knowledge of Solid Invest.

In Finland, Filippov would have an opportunity to collect necessary information, discuss and analyse the structure and development of Finnish clusters and the role of Russian resources and customers in their future. He plans to carry out five case studies (from different industries/segments) and analyse opportunities, attractive models and impediments for cooperation. During the course of the research it is also important to understand and summarise the Finnish industrialists' and economists' views on the intensification of cooperation between Russia and Finland and make preliminary assessment of the feasibility of different models of such cooperation for actors in both countries. For this purpose Filippov plans to study the latest publications in this field and carry out a series of discussions and interviews both in Finland and Russia. The post graduate studies to be carried out in the project by Pavel Filippov will be supervised by Professor Sergei Sutyrin from St. Petersburg State University, also a member of the project team.

Igor Bobrow from St. Petersburg State Polar Academy will also carry out his PhD studies in the project on the determinants of the developments of the North-West Russia, and one of  its two sub-regions (Leningrad oblast or Arkhangelsk region), about its growth prospects and integration with the EU.

3 Methods

The GTAP modelling framework will be used for the analysis of part one. The GTAP model is a multi-region, computable general equilibrium (CGE) model.  For the proposed study a new GTAP database version (6.0) will be utilised where Russia is available as its own region. Also the Baltic states are disaggregated from the FSU block. The rest of the FSU is still as one region. As for the Central European Associates block, the new database will allow for a disaggregation of this block as well (Bulgaria, Croatia, the Czech Republic, Romania, Slovakia, and Slovenia are new primary regions). We take account of the sectoral variation in the reduction of trade costs. It seems that the enlargement of the internal market has disproportional effects on some industries. Within the CEE countries, there also exist some remarkable differences.

The use of a computable general equilibrium modelling framework for the analysis is relevant, given that the opening of trade is bound to have longer-term structural effects. The structural changes are reflected in the rapid evolution of the specialisation of the economies of the accession countries in the recent period, as measured by their revealed comparative advantage (defined as the contribution of each sector to the trade balance).

The GTAP analysis will consider various policy simulations concerning the stages of further integration of Russia with the EU. The basic simulations are done with the standard GTAP model using the new database. Also, the effects of imperfect competition can be investigated in the simulations.

The study on the economic relations between Russia and Finland will be based on the extensive time-series material gathered by ETLA in its various projects on Russia, the first of them being done already in the 1980s. First, a theoretical framework of the specialisation of two countries bearing the main characteristics of Finland and Russia will be built, and economic specialisation between these countries after the opening of Russia will be analysed.  The modelling work will start with the modern theories of foreign trade and economic specialisation. In the study of the opening up of the relations, also the GTAP model will be used. Second, empirical analyses concerning the past development of foreign trade and investment between the two countries will be conducted. Third, policy conclusions for the development of economic relations between Finland and Russia will be drawn.

In part two we intend to analyse the extraction of Russia's raw materials by extending a model of endogenous economic growth. In addition to separating not just the exports of commodities but also their domestic use and the possible difference in pricing between these two. We also evaluate the consequences of such a liberalisation from the point of price stability in Russia.

In part three, the analysis of the convergence of the near-by regions is based on growth accounting with a decomposition of growth. First, we will analyse what factors have determined growth in these regions and therefore what is the importance of economic links, especially foreign trade and foreign direct investment, with Finland. We intend to analyse whether it is possible to and, in what ways, to narrow down the income gap between North-West Russia and Finland. This question is important for the development of economic and other relations between the two countries.

Pavel Filippov plans to use qualitative methods of the research i.e. case studies and interviews. His dissertation will essentially be based on an extensive number of cluster studies, carried out by Solid Invest in recent years together with ETLA, on the economy of North-Wesrt Russia (see the references). 

Igor Bobrow will study in his dissertation the following topics: what perspectives of integration with EU are actual for the region, taking in account the existing preconditions, what gains may be obtained from the process of integration of this region with Europe, and who, how and why may oppose the process.

4 Participants and resources

The research group is as follows. In Finland: The Research Institute of the Finnish Economy ETLA: Research Director, Dr.Soc.Sc. (Econ.), docent Kari E.O. Alho (project leader); Head of Unit, Dr.Soc.Sc. (Econ.) Markku Kotilainen; PhD. (Econ.), Research Fellow Pekka Sulamaa; Research Fellow, Lic.Soc.Sc. (Econ.) Ville Kaitila; and Research Fellow, M.Sc. (Econ.) Paavo Suni; Turku School of Economics and Business Administration: Professor Mika Widgrén.

In Russia: Solid Invest (St. Petersburg), Managing Director, M. Sc. Grigory Dudarev and Director M. Sc. Pavel Filippov; Petersburg State University, Professor Sergei Sutyrin and Associate Professor Vladimir G. Sherov-Ignatiev; and St. Petersburg State Polar Academy, Research Fellow, M.Sc. Igor Bobrow.

The overall research project starts in January 2004 and lasts until December 2006. The combined labour input is 58 person months.

5 Expected output and results

The project will produce a number of important publications, which not only have scientific significance but are also relevant for the discussion of Russia's international position and its economic and integration policies. The research group is very experienced and has analysed Russia and European integration for a long time. Consequently, the project has a strong basis and a high probability of success.

Overall, there shall be prepared 10 research documents in the project. The main contributions will also a published in a final report of the project.

The research team will also organise an international final seminar in order to disseminate the results and have intense contacts with a wider international research community on Russia. We shall invite to this final conference key researchers on Russia from the research community in other EU countries. A part of the total budget will be allocated to it.

In the first stage (12-16 months after the start of the project) the team at the St. Petersburg State University will prepare 1-2 articles for publication in the scientific journal of St. Petersburg State University. In the second stage (about 12 months after the completion of the first stage) the initial ideas and results will be elaborated into a chapter of monograph on development of regional integration.

In the course of the project the following research documents will be produced by Pavel Filippov:

• article  "Finnish and North-West Russian Energy Clusters: Cooperation and Economic Convergence"
• results of the case studies, to be published in a dissertation.

Igor Bobrow will prepare key elements of his dissertation within the project.