Location: EU

What does the Gas Crisis Reveal About European Energy Security?

Posted on January 24, 2022 | Policy Brief

20220124 Gas Crisis European Energy Image 01

The recent record-high gas prices have triggered legitimate concerns regarding the EU’s energy security, especially with dependence on natural gas from Russia. This brief discusses the historical and current risks associated with Russian gas imports. We argue that decreasing the reliance on Russian gas may not be feasible in the short-to-mid-run, especially with the EU’s goals of green transition and the electrification of the economy. To ensure the security of natural gas supply from Russia, the EU has to adopt the (long-proclaimed) coordinated energy policy strategy.

In the last six months, Europe has been hit by a natural gas crisis with a severe surge in prices. Politicians, industry representatives, and end-energy users voiced their discontent after a more than seven-fold price increase between May and December 2021 (see Figure 1). Even if gas prices somewhat stabilized this month (partly due to unusually warm weather), today, gas is four times as expensive as it was a year ago. This has already translated into an increase in electricity prices, and as a result, is also likely to have dramatic consequences for the cost and price of manufacturing goods.

Figure 1. Evolution of EU gas prices since Oct 2020.

Source:  https://tradingeconomics.com/commodity/eu-natural-gas.

These ever-high gas prices have triggered legitimate concerns regarding the security of gas supply to Europe, specifically, driven by the dependency on Russian gas imports. Around 90% of EU natural gas is imported from outside the EU, and Russia is the largest supplier. In 2020, Russia provided nearly 44% of all EU gas imports, more than twice the second-largest supplier, Norway (19.9%, see Eurostat). The concern about Russian gas dependency was exacerbated by the new underwater gas route project connecting Russia and the EU – Nord Stream 2. The opponents to this new route argued that it will not only increase the EU’s gas dependency but also Russia’s political influence in the EU and its bargaining power against Ukraine (see, e.g., FT). Former President of the European Council Donald Tusk stated that “from the perspective of EU interests, Nord Stream 2 is a bad project.”.

However, neither dependency nor controversial gas route projects are a new phenomenon, and the EU has implemented some measures to tackle these issues in the past. This brief looks at the current security of Russian gas supply through the lens of these historical developments. We provide a snapshot of the risks associated with Russian gas imports faced by the EU a decade ago. We then discuss whether different factors affecting the EU gas supply security have changed since (and to which extent it may have contributed to the current situation) and if decreasing dependence on Russian gas is feasible and cost-effective. We conclude by addressing the policy implications.

Security of Russian Gas Supply to the EU, an Old Problem Difficult to Tackle

Russia has been the main gas provider to the EU for a few decades, and for a while, this dependency has triggered concerns about gas supply security (see, e.g., Stern, 2002 or Lewis, New York Times, 1982). However, the problem with the security of Russian gas supplies was extending beyond the dependency on Russian gas per se. It was driven by a range of risk factors such as insufficient diversification of gas suppliers, low fungibility of natural gas supplies with a prevalence of pipeline gas delivery, or use of gas exports/transit as means to solve geopolitical problems.

This last point became especially prominent in the mid-to-late-2000s, during the “gas wars” between Russia and the gas transit countries Ukraine and Belarus. These wars led to shortages and even a complete halt of Russian gas delivery to some EU countries, showing how weak the security of the Russian gas supply to the EU was at that time.

Reacting to these “gas wars”, the EU attempted to tackle the issue with a revival of the “common energy policy” based on the “solidarity” and “speaking in one voice” principles. The EU wanted to adopt a “coherent approach in the energy relations with third countries and an internal coordination so that the EU and its Member States act together” (see, e.g., EC, 2011). However, this idea turned out to be challenging to implement, primarily because of one crucial contributor to the problem with the security of Russian gas supply – the sizable disbalance in Russian gas supply risk among the individual EU Member States.

Indeed, EU Member States had a different share of natural gas in their total energy consumption, highly uneven diversification of gas suppliers, and varying exposure to Russian gas. Several Eastern-European EU states (such as Bulgaria, Estonia, or Czech Republic) were importing their gas almost entirely from Russia; other EU Member States (such as Germany, Italy, or Belgium) had a diversified gas import portfolio; and a few EU states (e.g., Spain or Portugal) were not consuming any Russian gas at all. Russian natural gas was delivered via several routes (see Figure 2), and member states were using different transit routes and facing different transit-associated risks. These differences naturally led to misalignment of energy policy preferences across EU states, creating policy tensions and making it difficult to implement a common energy policy with “speaking in one voice” (see more on this issue in Le Coq and Paltseva, 2009 and 2012).

Figure 2. Gas pipeline in Europe.

Source: S&G Platt. https://www.spglobal.com/platts/en/market-insights/blogs/natural-gas/010720-so-close-nord-stream-2-gas-link-completion-trips-at-last-hurdle

The introduction of Nord Stream 1 in 2011 is an excellent example of the problem’s complexity. This new gas transit route from Russia increased the reliability of Russian gas supply for EU countries connected to this route (like Germany or France), as they were able to better diversify the transit of their imports from Russia and be less exposed to transit risks. The “Nord Stream” countries (i.e., countries connected to this route) were then willing to push politically and economically for this new project. Le Coq and Paltseva (2012) show, however, that countries unconnected to this new route while simultaneously sharing existing, “older” routes with “Nord Stream” countries would experience a decrease in their gas supply security. The reason for this is that the “directly connected” countries would now be less interested in exerting “common” political pressure to secure gas supplies along the “old” routes.

This is not to say that the EU did not learn from the above lessons. While the “speaking in one voice” energy policy initiative was not entirely successful, the EU has implemented a range of actions to cope with the risks of the security of gas supply from Russia. The next section explains how the situation is has changed since, outlining both the progress made by the EU and the newly arising risk factors.

Security of Russian Gas Supply to the EU, a Current Problem Partially Addressed

Since the end of the 2000s, the EU implemented a few changes that have positively affected the security of gas supply from Russia.

First, the EU put a significant effort into developing the internal gas market, altering both the physical infrastructure and the gas market organization. The EU updated and extended the internal gas network and introduced the wide-scale possibility of utilizing reverse flow, effectively allowing gas pipelines to be bi- rather than uni-directional. These actions improved the gas interconnections between the EU states (and other countries), thereby making potential disruptions along a particular gas transit route less damaging and diminishing the asymmetry of exposure to route-specific gas transit risks among the EU members. Ukraine’s gas import situation is a good illustration of the effect of reverse flow. Ukraine does not directly import Russian gas since 2016, mainly from Slovakia (64%), Hungary (26%), and Poland (10%) (see https://www.enerdata.net/publications/daily-energy-news/ukraine-launches-virtual-gas-reverse-flow-slovakia.html). The transformation of the gas market organization brought about the implementation of a natural gas hub in Europe and change in the mechanism of gas price formation. It is now possible to buy and sell natural gas via long-term contracts and on the spot market. With the gas market becoming more liquid, it became easier to prevent the gas supply disruption threat.

Second, Europe has made certain progress in diversifying its gas exports. According to Komlev (2021), the concentration of EU gas imports from outside of the EU (excluding Norway), as measured by the Herfindahl-Hirschman index, has decreased by around 25% between 2016 and 2020. While the imports are still highly concentrated, with the HHI equal to 3120 in 2020, this is a significant achievement. A large part of this diversification effort is the dramatic increase in the share of liquified natural gas (i.e., LNG) in its gas imports – in 2020, a fair quarter of the EU gas imports came in the form of LNG. An expanded capacity for LNG liquefaction and better fungibility of LNG would facilitate backup opportunities in the case of Russian gas supply risks and improve the diversification of the EU gas imports, thereby increasing the security of natural gas supply.

However, the above developments also have certain disadvantages, which became especially prominent during the ongoing gas crisis. For example, the fungibility of LNG has a reverse side: LNG supplies respond to variations in gas market prices across the world. This change has intensified the competition on the demand side – Europe and Asia might now compete for the same LNG. This is likely to make a secure supply of LNG – e.g., as a backup in the case of a gas supply default or as a diversification device – a costly option.

In turn, new mechanisms of gas price formation in Europe included decoupling the oil and gas prices and changing the format of long-term gas contracts. The percentage of oil-linked contracts in gas imports to the EU dropped from 47% in 2016 to 26% in 2020. In particular, 87% of Gazprom’s long-term contracts in 2020 were linked to spot and forward gas prices and only around 13% to oil prices (Komlev, 2021). This gas-on-gas linking may have contributed to the current gas crisis: Indeed, it undermined the economic incentives of Gazprom to supply more gas to the EU spot market in the current high-price market. Shipping more gas would lower spot prices and prices of hub-linked longer-term contracts for Gazprom. In that sense, the ongoing decline in Russian gas supplies to the EU may reflect not (only) geopolitical considerations but economic optimization.

Similarly, this new mechanism also finds reflection in the ongoing situation with the EU gas storage. The current EU storage capacity is 117 bcm, or almost 20% of its yearly consumption, and thus, can in principle be effective in managing the short-term volume and price shocks. However, the current gas crisis has shown that this option might be far from sufficient in the case of a gas shortage (see, e.g., Zachmann et al., 2021).  One of the reasons for this insufficiency can be Gazprom controlling a sizable share of this storage capacity (see https://www.europarl.europa.eu/doceo/document/E-9-2021-004781_EN.html). For example, Gazprom owns (directly and indirectly) almost one-third of all gas storage in Germany, Austria, and the Netherlands.  Combining this storage market position with a long-term gas contract structure may also lead to strategic behavior for economic (on top of potential political) purposes.

Last but not least, the EU gas market is likely to be characterized by increased demand due to the green transition agenda (see Olofsgård and Strömberg, 2022). Being the least carbon-intensive fossil fuel, natural gas has an important role in facilitating green transition and increasing the electrification of the economy. For example, Le Coq et al. (2018) argues that gas capacity should be around 3 to 4 times the current capacity by 2050 for full electrification of transport and heating in France, Germany, or the Netherlands. In such circumstances, the EU is not likely to have the luxury to diminish reliance on Russian gas.

Conclusions and Policy Implications

Keeping the above discussion in mind, should the EU try to diminish its dependence on Russian gas to improve its energy security? This may be true in theory, but in practice, this might be too costly, at least in the short-to-medium run.

The current situation on the EU gas market suggests that simply cutting gas imports from Russia is likely to lead to high prices both in the energy sector and, later, in other sectors of the economy due to spillovers. Substituting gas imports from Russia with gas from other sources, such as LNG, is likely to be very costly and not necessarily very reliable. Alternative measures, e.g., improving interconnections between the EU Member States or controlling transit issues via the use of reverse flow technology, are effective but have limited impact. Simply cutting down gas demand is not a viable strategy. Indeed, with the EU pushing for a green transition and the electrification of the economy, the EU’s gas imports may have to increase. Russian gas may play an important role in this process.

As a result, we believe that the solution to keep the security issue of Russian gas supply at bay lies in the area of common energy policy. It is essential that the EU implements and effectively manages a coordinated approach in dealing with Russian gas supplies. The EU is the largest buyer of Russian gas, and given Russian dependency on hydrocarbon exports, such a synchronized approach would give the EU the possibility to exploit its “large buyer” power. While the asymmetry in exposure to Russian gas supply risks among the EU Member States is still sizable, the improvements in the functioning of the internal gas market and gas transportation within the EU make their preferences more aligned, and a common policy vector more feasible. Furthermore, recent EU initiatives on creating “strategic gas reserves” by making the Member States share their gas storage with one another would further facilitate such coordination. Implementing the “speaking in one voice” gas import policy will allow the EU to fully utilize its bargaining power vis-à-vis Gazprom and spread the benefits of new gas routes from Russia – such as Nord Stream 2 – across its Member States.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Vaccination Progress and the Opening Up of Economies

Posted on July 5, 2021 | Policy Brief

20210622 Reopening Soon Webinar Image 01

In this brief, we report on the FREE network webinar on the state of vaccinations and the challenges ahead for opening up economies while containing the pandemic, held on June 22, 2021. The current state of the pandemic in each respective country was presented, suggesting that infection rates have gone down quite substantially recently in all countries of the network, except in Russia which is currently facing a surge in infections driven by the delta-version of the virus. Vaccination progress is very uneven, limited by lacking access to vaccines (primarily Ukraine and Georgia) and vaccine scepticism among the population (primarily in Russia and Belarus but for certain groups also in Latvia, Poland and to some extent Sweden). This also creates challenges for governments eager to open their societies to benefit their economies and ease the social consequences of the restrictions on mobility and social gatherings. Finally, the medium to long term consequences for labour markets reveal challenges but also potential opportunities through wider availability of work–from-home policies. 

Background

In many countries in Europe, citizens and governments are starting to see an end to the most intense impact of the Covid-19 pandemic on their societies. Infection and death rates are coming down and governments are starting to put in place policies for a gradual opening up of societies, as reflected in the Covid-19 stringency index developed by Oxford University. These developments are partially seasonal, but also largely a function of the progress of vaccination programs reaching an increasing share of the adult population. These developments, though, are taking place to different degrees and at different pace across countries.  This is very evident at a global level, but also within Europe and among the countries represented in the FREE network. This has implications for the development within Europe as a whole, but also for the persistent inequalities we see across countries.   

Short overview of the current situation

The current epidemiological situation in Latvia, Sweden, Ukraine, and Georgia looks pretty similar in terms of Covid-19 cases and deaths but when it comes to the vaccination status there is substantial variation.

Latvia experienced a somewhat weaker third wave in the spring of 2021 after being hit badly in the second wave during the fall and winter of 2020 (see Figure 1). The Latvian government started vaccinating at the beginning of 2021, and by early June, 26% of the Latvian population had been fully vaccinated.

Sweden, that chose a somewhat controversial strategy to the pandemic built on individual responsibility, had reached almost 15 thousand Covid-19 deaths by the end of June of 2021, the second highest among the FREE network member countries relative to population size. The spread of the pandemic has slowed down substantially, though, during the early summer, and the percentage of fully vaccinated is about to reach 30% of the population.

Figure 1. Cumulative Covid-19 deaths 

Source: Aggregated data sources from the COVID-19 Data Repository by the Center for Systems Science and Engineering (CSSE) at Johns Hopkins University, compiled by Our World in Data.

Following a severe second wave, the number of infected in Ukraine started to go down in the winter of 2020, with the total deaths settling at about 27 thousand in the month of February. Then the third wave hit in the spring, but the number of new daily cases has decreased again and is currently three times lower than at the beginning of the lastwave. However, a large part of the reduction is likely not thanks to successful epidemiological policies but rather due to low detection rates and seasonal variation. 

In June 2021, Georgia faces a similar situation as Ukraine and Latvia, with the number of cumulative Covid-19 deaths per million inhabitants reaching around 1300 (in total 2500 people) following a rather detrimental spring 2021 wave. At the moment, both Georgia and Ukraine have very low vaccination coverage relative to other countries in the region(see Figure 5).

In contrast to the above countries, Russia started vaccinating early. Unfortunately, the country is now experiencing an increase in the number of cases (as can be seen in Figure 2), contrary to most other countries in the region. This negative development is likely due to the fact that the new Covid-19 delta variant is spreading in the country, particularly in Moscow and St. Petersburg. Despite the early start to vaccinations, though, the total number of vaccinated people remains low, only reaching 10.5% of the population.

Figure 2. New Covid-19 cases

Source: Aggregated data sources from the COVID-19 Data Repository by the Center for Systems Science and Engineering (CSSE) at Johns Hopkins University, compiled by Our World in Data.

In some ways similar to Sweden, the government of Belarus did not impose any formal restrictions on individuals’ mobility. According to the official statistics, in the month of June, the rise in the cumulative number of covid-19 deaths and new daily infections has declined rapidly and reached about 400 deceased and 800 infections per one million inhabitants, respectively. Vaccination goes slowly, and by now, around 8% of the population has gotten the first dose and 5% have received the second.

There were two major waves in Poland during the autumn 2020 and spring 2021. In the latter period, the country experienced a vast number of deaths.  As can be seen in Figure 3, the excess mortality P-score – the percentage difference between the weekly number of deaths in 2020-2021 and the average number of deaths over the years 2015-2019 – peaked in November 2020, reaching approximately 115%. The excess deaths numbers in Poland were also the highest among the FREE Network countries in the Spring of 2021, culminating at about 70% higher compared to the baseline. By mid-June, the number of deaths and cases have steeply declined and 36% of the country’s population is fully vaccinated.

Figure 3. Excess deaths

Turning to the economy, after a devastating year, almost all countries are expected to bounce back by the end of 2021 according to the IMF (see Figure 4). Much of these predictions build on the expectations that governments across the region will lift Covid-19 restrictions. These forecasts may not be unrealistic for the countries where vaccinations have come relatively far and restrictions have started to ease. However, for countries where vaccination rates remain low and new variations of the virus is spreading, the downside risk is still very present, and forecasts contain much uncertainty.

 Figure 4. GDP-growth

Vaccination challenges

Since immunization plays such a central role in re-opening the economy and society going back to normal, issues related to vaccinations were an important and recurring topic at the event. The variation in progress and speed is substantial across the countries, though.

Ukraine and Georgia are still facing big challenges with vaccine availability and have fully vaccinated only 1.3% and 2.3% of the population by the end of June, respectively. Vaccination rates have in the recent month started to pick up, but both countries face an uphill battle before reaching levels close to the more successful countries.

Figure 5. Percent fully vaccinated

Other countries a bit further ahead in the vaccine race are still facing difficulties in increasing the vaccination coverage, though not so much due to lack of availability but instead because of vaccine skepticism. In Belarus, a country that initially had bottleneck issues similar to Ukraine and Georgia, all citizens have the opportunity to get vaccinated. However, Lev Lvovskiy, Senior Research Fellow at BEROC in Belarus, argued that vaccination rates are still low largely because many Belarusians feel reluctant towards the vaccine at offer (Sputnik V).

This vaccination scepticism turns out to be a common theme in many countries. According to different survey results presented by the participants at the webinar, the percentage of people willing or planning to get vaccinated is 30% in Belarus and 44% in Russia. In Latvia, this number also varies significantly across different groups as vaccination rates are significantly lower among older age cohorts and in regions with a higher share of Russian-speaking residents, according to Sergejs Gubins, Research Fellow at BICEPS in Latvia.

Webinar participants discussed potential solutions to these issues. First, there seemed to be consensus that offering people the opportunity to choose which vaccine they get will likely be effective in increasing the uptake rate. Second, governments need to improve their communication regarding the benefits of vaccinations to the public. Several countries in the region, such as Poland and Belarus, have had statements made by officials that deviate from one another, potentially harming the government’s credibility with regards to vaccine recommendations. In Belarus, there have even been government sponsored disinformation campaigns against particular vaccines. In Latvia, the main problem is rather the need to reach and convince groups who are generally more reluctant to get vaccinated. Iurii Ganychenko, Senior Researcher at KSE in Ukraine, exemplified how Ukraine has attempted to overcome this problem by launching campaigns specifically designed to persuade certain age cohorts to get vaccinated. Natalya Volchkova, Director of CEFIR at NES in Russia, argued that new, more modern channels of information, such as professional influencers, need to be explored and that the current model of information delivery is not working.

Giorgi Papava, Lead Economist at ISET PI in Georgia, suggested that researchers can contribute to solving vaccine uptake issues by studying incentive mechanisms such as monetary rewards for those taking the vaccine, for instance in the form of lottery tickets. 

Labour markets looking forward

Participants at the webinar also discussed how the pandemic has affected labour markets and whether its consequences will bring about any long-term changes.

Regarding unemployment statistics, Michal Myck, the Director of CenEA in Poland, made the important point that some of the relatively low unemployment numbers that we have seen in the region during this pandemic are misleading. This is because the traditional definition of being unemployed implies that an individual is actively searching for work, and lockdowns and other mobility restrictions have limited this possibility. Official data on unemployment thus underestimates the drop in employment that has happened, as those losing their jobs in many cases have left the labour market altogether. We thus need to see how labor markets will develop in the next couple of months as economies open up to give a more precise verdict.

Jesper Roine, Professor at SITE in Sweden, stressed that unemployment will be the biggest challenge for Sweden since its economy depends on high labor force participation and high employment rates. He explained that the pandemic and economic crisis has disproportionately affected the labor market status of certain groups. Foreign-born and young people, two groups with relatively high unemployment rates already prior to the pandemic, have become unemployed to an even greater extent. Many are worried that these groups will face issues with re-entering the labour market as in particular long-term unemployment has increased. At the same time, there have been more positive discussions about structural changes to the labour market following the pandemic. Particularly how more employers will allow for distance work, a step already confirmed by several large Swedish firms for instance.

In Russia, a country with a labour market that allowed for very little distance work before the pandemic, similar discussions are now taking place. Natalya Volchkova reported that, in Russia, the number of vacancies which assumed distance-work increased by 10% each month starting from last year, according to one of Russia’s leading job-search platforms HeadHunter. These developments could be particularly beneficial for the regional development in Russia, as firms in more remote regions can hire workers living in other parts of the country.

Concluding Remarks

It has been over a year since the Covid-19 virus was declared a pandemic by the World Health Organization. This webinar highlighted that, though vaccination campaigns in principle have been rolled out across the region, their reach varies greatly, and countries are facing different challenges of re-opening and recovering from the pandemic recession. Ukraine and Georgia have gotten a very slow start to their vaccination effort due to a combination of lack of access to vaccines and vaccine skepticism. Countries like Belarus and Latvia have had better access to vaccines but are suffering from widespread vaccine skepticism, in particular in some segments of the population and to certain vaccines. Russia, which is also dealing with a broad reluctance towards vaccines, is on top of that dealing with a surge in infections caused by the delta-version of the virus.

IMF Economic Outlook suggests that most economies in the region are expected to bounce back in their GDP growth in 2021. While this positive prognosis is encouraging, the webinar reminded us that there is a great deal of uncertainty remaining not only from an epidemiological perspective but also in terms of the medium to long-term economic consequences of the pandemic.

Participants

  • Iurii Ganychenko, Senior Researcher at Kyiv School of Economics (KSE/Ukraine)
  • Sergejs Gubins, Research Fellow at the Baltic International Centre for Economic Policy Studies (BICEPS/ Latvia)
  • Natalya Volchkova, Director of the Centre for Economic and Financial Research at New Economic School (CEFIR at NES/ Russia)
  • Giorgi Papava, Lead Economist at the ISET Policy Institute (ISET PI/ Georgia)
  • Lev Lvovskiy, Senior Research Fellow at the Belarusian Economic Research and Outreach Center (BEROC/ Belarus)
  • Jesper Roine, Professor at the Stockholm Institute of Transition Economics (SITE / Sweden)
  • Michal Myck, Director of the Centre for Economic Analysis (CenEA / Poland)
  • Anders Olofsgård, Deputy Director of SITE and Associate Professor at the Stockholm School of Economics (SITE / Sweden)

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Ukraine’s Integration into the EU’s Digital Single Market

Posted on February 15, 2021 | Policy Brief

Blue EU flags in front of European Commission representing Ukraine’s integration into the single market

This brief is based on a study that investigates how Ukraine’s integration into the EU Digital Single Market (DSM) could affect EU-Ukraine bilateral trade as well as Ukraine’s GDP growth.  The major benefits of integration are expected to come from 1) reduction of cross-border regulatory barriers and restrictions to EU-Ukraine digital trade 2) acceleration of the development of Ukraine’s digital economy in line with EU standards. According to the results, enhanced regulatory and digital connectivity between Ukraine and the EU is expected to increase Ukraine’s exports of goods and services to the EU by 11.8-17% and 7.6-12.2% respectively. At the same time, the acceleration of the digital transformation of the Ukrainian economy and society will produce a positive effect on its productivity and economic growth – a 1%-increase in the digitalization of the Ukrainian economy and society may lead to an increase in its GDP by 0.42%.

Background

Integration into the EU has been one of the key topics on Ukraine’s political agenda for a number of years. Recently, more emphasis has been put on an essential component of issue – integration into the EU’s Digital Single Market (DSM). The DSM is a strategy aimed at uniting and enhancing digital markets and applying common approaches and standards in the digital sphere across the EU. The Ukraine-EU Summit, held on October 6, 2020, stressed the paramount importance of the digital sector in boosting its economic integration and regulatory approximation under the EU-Ukraine Association Agreement. Implementation of the provisions of this agreement, in particular the updated Annex XVII-3, would introduce the latest EU standards in the field of electronic communications in Ukraine. The country is also gradually approximating its regulations with regard to other components of the EU DSM – electronic identification, electronic payments and e-payment systems, e-commerce, protection of intellectual property rights on the Internet, cybersecurity, protection of personal data, e-government, postal services, etc. These steps will, in turn, ensure Ukraine’s gradual integration into the EU’s Digital Single Market, which will facilitate digital transformations within the country and open a new window of opportunity for individuals and businesses.

This brief summarizes the results of our recent work (Iavorskyi, P., et al., 2020), in which we estimate the effect that Ukraine’s integration into DSM could have on EU-Ukraine bilateral trade as well as Ukraine’s GDP growth.

Benefits of Integration into the EU DSM

The EU DSM strategy comprises three pillars: (1) better access for consumers and businesses to digital goods and services across Europe; (2) creating the right conditions and a level playing field for digital networks and innovative services to flourish; (3) maximizing the growth potential of the digital economy (EC, 2021).

These goals suggest that the major benefits of Ukraine’s integration into the DSM are likely to come from 1) reduction of cross-border regulatory barriers and restrictions to EU-Ukraine trade, 2) acceleration of the development of Ukraine’s digital economy in line with EU standards.

Indeed, the trade of goods and services is increasingly becoming “digital” – i.e., involving “digitally enabled transactions in goods and services that can be either digitally or physically delivered” (OECD, 2019). Trade digitalization (e.g., electronic contracts, electronic payments, e-customs, etc.) simplifies export and import procedures, reduces trade costs for exporters, and creates new opportunities for trade with the EU, in particular for SMEs. Therefore, the reduction of regulatory restrictions on cross-border digital trade reduces the overall level of restrictiveness of trade in goods and services.

Thus, digitalization is expected to facilitate and intensify the total EU-Ukraine trade in goods and services. It is also anticipated to increase the productivity of Ukraine’s economy which will have a positive impact on the country’s economic growth.

Major benefits include lower prices and greater access to EU online markets for Ukrainian consumers and business, digital innovative products and services, greater online consumer protection, lower transaction costs for businesses, improved quality and transparency of public digital services and e-government as well as an intensification of innovation development in Ukraine.

At the same time, Ukraine’s integration into the DSM entails several obligations: to align national legislation and standards with EU legislation and standards; to ensure institutional and technical capacity as well as interoperability of digital systems. For businesses in Ukraine, this means facing new EU requirements aimed at improving consumer and personal data protection, as well as increased competition from European companies in digital markets. However, these changes are necessary if the country wants to build a common economic space with the EU, especially given the growing impact of digital technologies on international trade and economy.

Ukraine in International Digital Rankings

Many international digital development rankings show that Ukraine lags behind EU countries, including its neighbors that recently joined the EU.

According to the UN e-Government Development Index (EGDI) for 2020, Ukraine ranks 69th among 193 countries and is included in the group of countries with high levels of e-government development. It received the lowest scores for Telecommunications Infrastructure and Online Services, and the highest for Human Capital. Nevertheless, Ukraine is lagging behind its neighboring EU members, – Poland, Hungary, Slovakia, Romania, Bulgaria, Lithuania, etc., – which belong to the group of countries with very high levels of e-government development (UN, 2020).

In the Network Readiness Index (NRI) ranking for 2019, Ukraine ranked 67th among 121 countries. As for the components of the index, Ukraine ranks worst in the following indicators: Future technologies (82nd out of 121), ICT Use by Government and Online Government Services (87th), and Regulatory Environment (72nd). Neighboring EU countries have higher rankings (Poland – 37, Latvia – 39, Czech Republic – 30, Croatia – 44). Other neighboring countries do somewhat better than Ukraine (Turkey is ranked 51st, Russia – 48th) or occupy positions close to Ukraine (Belarus – 61, Moldova – 66, Georgia – 68) (Portulans Institute, 2019).

In 2019, the country ranked 60th among 63 countries included in the World Digital Competitiveness Ranking (WDCR) rating. Just as in the other rankings, Ukraine scored well in the Knowledge component (40th among 63 countries), while in terms of Technology and Future Readiness it was at the bottom (61st and 62nd position respectively) (IMD, 2019).

Hence, it is primarily the technological and regulatory issues, that need to be addressed in order to improve Ukraine’s digital position in the region and the world.

Methodology

Measuring Ukraine’s Digitalization level

In order to estimate the impact of digitalization, a Composite Digitalization Index is calculated for Ukraine, the EU, and other countries included in the model. This index is based on 11 digital indicators, combined into five components that characterize different areas of the digital economy and society – Connectivity, Use of the Internet by citizens, Human capital, Integration of digital technology by businesses, and Digital public services.

Our results confirm that the level of digital development in Ukraine is far below the EU average. It also lags behind the new EU Member States, which have a lower level of digital development compared to the other EU countries. As of 2018, the widest gaps between Ukraine and the EU average are found in Digital Public Services, Connectivity and Use of Internet by citizens. At the same time, Ukraine performed better in Human Capital and Integration of digital technology by businesses.

Measuring Digital Services Trade Restrictiveness in Ukraine

To assess the impact of digital regulatory barriers on trade, we use the Digital Services Trade Restrictiveness Index (Digital STRI) (OECD, 2020). It quantifies the regulatory barriers in five different policy areas (communication infrastructure, electronic transactions, electronic payments, intellectual property, other restrictions) that affect trade in digital services (Ferencz, J., 2019). OECD calculates Digital STRI for OECD countries and some non-OECD countries. As Ukraine is not included in this index, we estimate it for 2016-2018 using the OECD methodology.

Our estimations show that the level of digital services trade restrictiveness in Ukraine is much higher than the EU average. The regulatory differences in the digital sphere between Ukraine and the EU increase the cost of cross-border digital transactions between countries.

For Ukraine, most barriers are related to cross-border electronic payments and settlements, protection of intellectual property rights on the internet, cross-border electronic transactions (for example, the divergence of the national requirements for foreign trade agreements, including electronic ones, from international practices and standards, lack of practical mechanisms for the application of the electronic digital signature in foreign trade contracts, lack of mutual recognition of electronic identification and electronic trust services between Ukraine and major trading partners, etc.), other barriers (requirements for the use of local software and cryptography, etc.). These regulatory restrictions significantly hinder the development of cross-border cooperation and Ukraine’s integration into the European and global digital space.

Ukraine’s integration scenarios

In the event of Ukraine’s integration into the EU DSM, the country’s regulatory environment and digital development are expected to gradually approach the EU averages. We model it through assuming that the regulatory differences between Ukraine and the EU (captured by the Digital STRI Heterogeneity Indices – see OECD, 2020) will be decreasing, and level of digitalization in the country (captured by the Digitalization Index – OECD, 2020) will converge towards that of EU-DSM members.

We considered three integration scenarios that imply high, medium, and low levels of Ukraine’s approximation to the regulatory environment and digital development of the EU. For instance, the high scenario implies the highest level of Ukraine’s digital development and the lowest level of regulatory differences between Ukraine and the EU.

Models

We study the effect of reduced regulatory differences in the digital sphere on Ukraine-EU trade using a gravity model – one of the traditional approaches in the international trade literature. A gravity model predicts bilateral trade flows based on the size of the economy and trade costs between countries (affected by distance, cultural differences, FTAs, tariffs, etc.)

The study uses the following specification of the model for exports of goods and services in 2016-2018:

• Dependent variable – the total export flow of goods and services from country into country j (all possible pairs of countries).

• Independent variables – distance between countries and common characteristics (borders, language, law), existence of a free trade agreement, level of tariff protection (for goods), level of regulatory heterogeneity in the digital sphere between the two countries, and a set of fixed effects for each country.

We also estimate how digital development affects technical modernization, productivity, and economic growth. Technically, we use a Cobb-Douglas production function to describe each country’s output and model its total factor productivity component as a function of digital development (captured by the Digitalization index).

Results

The results suggest that Ukraine’s integration into the EU DSM will be beneficial for both Ukraine and the EU. Under all integration scenarios, bilateral trade between Ukraine and the EU is expected to intensify considerably due to enhanced regulatory and digital connectivity between the two.

Ukraine’s total exports of goods and services to the EU are estimated to grow by 11.8-17% ($2.4-3.4 billion) and 7.6-12.2% ($302.5-485.5 million), respectively – a cumulative increase throughout the period of implementation of reforms aimed at regulatory and digital approximation of Ukraine to the EU.

 Figure 1. The impact of Ukraine’s integration into the EU’s DSM on the exports of services from Ukraine to the EU*: three integration scenarios

Source: Authors’ own calculations. The current level of Ukraine’s exports of services to the EU – as of 2018

Figure 2. The impact of Ukraine’s integration into the EU’s DSM on exports of goods from Ukraine to the EU*: three integration scenarios

Source: Authors’ own calculations. The current level of exports of Ukrainian goods to the EU as of 2018

The EU would increase its exports of goods and services to Ukraine by 17.7-21.7% ($4.1-5 billion) and 5.7-9.1% ($191-305 million), respectively.

The acceleration of Ukraine’s digital development will bring productivity gains that would transform into higher GDP growth. It is estimated that a 1% increase in Ukraine’s digitalization level is expected to raise its GDP by 0.42%. As a result, the country’s gradual approximation to EU levels of digitalization would result in additional Ukraines GDP growth of 2.4-12.1% ($3.1-15.8 billion), depending on the scenario.  

Figure 3. Impact of digitalization on Ukraine’s GDP growth: three digitalization increase scenarios

Source: own calculations. The left axis – GDP growth (%), the right axis – the level of digitalization. The current level of digitalization of Ukraine as of 2018.

Conclusion

According to our estimations, improved digitalization and reduction of regulatory barriers in the digital sphere between Ukraine and the EU will have a positive effect on trade for both Ukraine and the EU. There is also a significant potential for economic growth to be attained in Ukraine by increasing digitalization and productivity of various spheres of the economy and society.

Realization of this potential would, however, require a substantial regulatory approximation on the Ukrainian side to achieve alignment with the EU DSM. The main emphasis needs to be put on electronic identification and transactions, payment systems and electronic payments, protection of intellectual property rights on the internet, cybersecurity, and personal data protection.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

How to Intensify and Diversify Ukrainian Exports? The Case of Bilateral Trade with Germany

Policy Brief

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This policy brief focuses on trade relations between Ukraine and Germany. In particular, it analyses bilateral trade in goods and examines the possibilities for increasing Ukrainian exports to Germany, in both the extensive and the intensive margins. The brief identifies prospective product groups for such increases and discusses potential obstacles to trade intensification. Finally, it provides recommendations for the further trade development.

German-Ukrainian Trade

Germany has recently become one of the most important trading partners for Ukraine. In 2018, Germany was fifth in terms of Ukrainian export destinations and third in terms of its import source countries.  While Ukraine, not surprisingly, is less important for German international trade (in 2018, Ukraine ranked 42nd in terms of Germany’s export and 45th in terms of its import), bilateral trade between Ukraine and Germany showed positive dynamics over the last five years.

Since Germany is a member of the European Union, its trade relations with Ukraine are regulated by legislation common for all EU member states. The EU’s political and economic cooperation with Ukraine is stipulated by the Association Agreement (AA). The AA is a comprehensive agreement provisioning the Deep and Comprehensive Free Trade Area (DCFTA) between Ukraine and the EU. While the provisional application of the AA began in the fall of 2014, the document fully entered into force on September 1, 2017. The abovementioned intensification of trade relations between Ukraine and Germany was to a significant extent driven by the signing of the DCFTA and a loss of a significant share of the Russian market.

The main Ukrainian exports to Germany include ignition wiring sets used in vehicles, aircraft and ships; low erucic acid, rape or colza seeds, iron ores agglomerated, maize, electrical switches etc. (see Table 1). Together, the top-15 product groups at a 6-digit level of the Harmonised System (HS) give 57% of the total exports from Ukraine to Germany.

Table 1. Top-15 Ukrainian product groups by export to Germany as of 2018

Source: UN Comtrade

This brief argues that both countries are likely to gain additional benefits from further intensifying bilateral trade relations. It summarizes the results of the research (Iavorskyi P. at al., 2019) on how to further expand and diversify Ukrainian exports to Germany, it identifies the prospective product groups and obstacles to their exports, and provides policy recommendations for trade development.

Promising Products

In order to find the most promising ways for increasing Ukrainian exports to Germany, this study employs a two-step approach. First, using a normalized revealed comparative advantage (NRCA) index (Run Yu et al, 2009) we distinguish goods, which Ukraine has world-wide comparative advantage in and Germany does not. A positive (negative) NRCA indicates that country’s actual share of a product in national exports is higher (lower) than the world average, – so that the country has a comparative advantage (disadvantage) in this commodity. According to this criterion, product groups with a negative NRCA for Germany and a positive NRCA for Ukraine were selected.

At the second stage, for the goods identified during the first step, a gravity model was estimated. A gravity model predicts bilateral trade flows based on the size of the economy and trade costs between them (such as distance, cultural differences, free trade agreements, tariffs, etc.). Being a general equilibrium model, it captures not only immediate impact of economic and political changes on trade between two countries, but also how it influences trade with other countries. A gap between current and potential export volumes predicted by the model is a potential for exports increase (which we refer to as undertrade).

The gravity model estimates the total undertrade between Ukraine and Germany at $ 500 million in 2016, or 35% of the total exports from Ukraine to Germany in the same year. Moreover, Ukraine has the potential to increase trade in both goods already exported to Germany as well as goods not yet supplied by Ukrainian companies to this market.

As for the structure of our findings, agricultural and mining commodities, as well as products of traditional Ukrainian export industries, such as metallurgy, are widely represented on the top of the undertraded commodity list. For example, more than a half of the estimated undertrade falls on primary food and primary industrial supplies, such as soybeans, barley, tomatoes, grain sorghum, iron ore, zirconium ores, etc. These categories already account for a large share of the current exports composition, and production in these sectors provides for a significant share of employment. Foreign currency inflow stipulated by exporting these products is also important for the Ukrainian economy.

At the same time, the undertrade in categories of final consumption, capital goods and transport is much lower. However, these product groups are important for exports diversification. These, for example, include liquid dielectric transformers, refrigerator cabinets, telescopes, tugs and pusher craft in capital goods, rail locomotives, railway cars, gas turbine engines in transport; automatic washing machines, electric space heaters, fans, coffeemakers, synthetic curtains, and leather apparel in consumer goods. Despite the complex regulation and relatively small amount of estimated undertrade, export diversification from primary to manufactured goods is important for overcoming export instability and long-term economic growth (Cadot at al. 2013), which is why promotion of trade in such areas is important.

Figure 1. Estimated undertrade according to broad economic categories

Source: Own calculations based on UN Comtrade data

Obstacles to Trade

Following the abolition or reduction of EU import duties between Ukraine and the EU under the DCFTA, tariffs do not significantly restrict exports of Ukrainian goods to the EU. Instead, technical regulations, sanitary and phytosanitary measures, geographical indications, licensing, etc. create significant barriers to bilateral trade. Thus, “non-tradability” can be explained, for instance, by the negative effects of various non-tariff barriers (both at European and national levels) or other factors, such as low competitiveness (in terms of price or quality) of Ukrainian goods compared to similar goods supplied by other countries, taste preferences of German consumers, peculiarities of importers’ associations, specific requirements of retailers, etc. Thus, harmonization of Ukrainian regulations with those of the European Union in accordance with the AA will help reduce customs barriers and existing divergences in regulations, and thus simplify the export of Ukrainian goods to the EU and Germany in particular.

Policy Recommendations

Based on the findings of the qualitative and quantitative research carried out, Ukrainian policy makers are advised to:

  • Timely and effectively align Ukrainian legislation, standards and practices with those of the EU, in line with the Action Plan and Commitments undertaken by Ukraine under the DCFTA within the framework of the AA with the EU, in particular in such areas as technical barriers to trade, sanitary and phytosanitary measures, customs, and protection of intellectual property rights.
  • Accelerate preparations for the signing of the ACAA (the Agreement on Conformity Assessment and Acceptance for Industrial Products) for the top three priority sectors of Ukrainian industry, which Ukrainian authorities agreed with European side, namely in the areas of low-voltage equipment, electromagnetic compatibility and machine safety, which will boost industrial technological exports to the EU and other countries.
  • Conduct government level negotiations with the EU and Germany regarding the removal of those barriers to the single market faced by the promising Ukrainian goods that will not be lifted as a result of harmonization of regulations with the European ones.
  • Take advantage of the Regional Pan-Euro-Mediterranean Preferential Rules of Origin Convention (the Pan-Euro-Med Convention), which establishes identical rules of origin for goods between its member-states under free trade agreements, and will facilitate the opening of new production facilities and involvement in regional and international value chains.
  • Provide information and consulting support to local manufacturers and exporters regarding the most promising destination markets, help them find partners on such markets, advise on the best ways to penetrate such markets by organizing trade missions, etc.

Another push to the German-Ukrainian trade promotion may arise from facilitating German FDIs to Ukraine. German entrepreneurs and investors are interested in localizing German production facilities in Ukraine and establishing joint German-Ukrainian enterprises, STIs, in particular in such areas as agriculture, light industry (including textiles), civil engineering, renewable energy, and circular economy (GTAI 2018a, 2018b, 2018c). This form of cooperation also boosts Ukrainian exports, since such enterprises often produce intermediate inputs for German production. In order to promote joint enterprises setup Ukraine should:

  • Establish effective mechanisms for protecting foreign investments, including export-oriented ones.
  • Ensure the rule of law and effective protection of property rights.
  • Create favorable macroeconomic conditions to ensure access to financing for both Ukrainian and foreign businesses.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Trade Induced Technological Change: Did Chinese Competition Increase Innovation in Europe?

Posted on April 29, 2019 | Policy Brief

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The last 30 years has witnessed a shift of the world’s manufacturing core from Europe and North America to China. A key question is what impact this has had on manufacturing workers in other developed economies, and also on innovation, patenting, IT adoption, and productivity growth. While a rigorous data analysis on these variables for developing economies, particularly in Eastern Europe, is not yet available, this brief examines the impact of the rise of China on innovation in Western Europe, and also reviews the evidence on the impact of the rise of China generally. Recent research by Bloom, Draca, and Van Reenen (2016) found that Chinese competition induced a rise in patenting, IT adoption, and TFP by 30% of the total increase in Europe in the early 2000s. Yet, we find numerous problems with the Bloom et al. analysis, and, overall, we do not find convincing evidence that Chinese competition increased innovation in Europe.

Few events have inspired the ire of economists as much as Brexit and the rise of Donald Trump, two events seen as related as both were a seeming reaction to both globalization and slowing economic growth, particularly as some (such as Trump himself) saw the former as a key cause of the latter. Both Brexit and the trade war spawned by Trump do seem to have had negative economic effects – US equities have suffered every time the trade war has escalated, while anecdotal reports and more sophisticated economic analyses seem to suggest that Brexit has cost the UK jobs.

And yet, there is a need for policy makers and economists to hold two ideas in our heads simultaneously: Trump’s trade war and Brexit may be policy disasters, and yet globalization can create both winners and losers, even if it is clear that, generally speaking, the overall gains are likely positive and large. This is likely also true of the rise of China – one of the most dramatic events in international economics in the past 50 years. Figure 1 shows the increase in trade with China from the early 1980s to 2017, a period in which US imports from China grew from 7 to 476 billion dollars.

Figure 1. Chinese Imports (in logs, deflated)

Source: World Bank WITS

The academic literature tends to show that this impact, the rise of China, may have cost the US as much as 2.2 million jobs directly (Autor et al.), and as much as 3 million jobs once all input-output and local labor market effects are included. While approximate, these numbers are large enough for the China shock to have played a role in the initial onset of “secular stagnation” – the growth slowdown which began around 2000 for many advanced nations, including the US and Europe. In addition, Autor et al. (forthcoming) found that Chinese competition also resulted in a decline in patent growth. In the European context, however, other authors have found that although China did do some damage to certain sectors, overall, it does not appear to have been quite as damaging, particularly in Germany, which also benefitted from exporting increased machine tools to the Chinese manufacturing sector. And, in a seminal paper, Bloom, Draca, and Van Reenen (2016) find that Chinese competition actually led to an increase in patents, IT adoption, and productivity in Europe from 1996 to 2005, along accounting for nearly 30% of the increase. This is important, as it implies that without the rise of competition with China, the slowdown in European growth would have been even more pronounced than it was. It also implies that, far from being a source of stagnation, Chinese competition has been a source of strength. It also makes it more likely that the slowdown in growth since 2000 was caused by supply-side factors, such as new inventions becoming more difficult over time, as is perhaps the leading explanation among economists, notably Northwestern University business professor, Robert Gordon (2017), and also supported by others (see this VoxEU Ebook featuring a “who’s who?” among economists). It would also be evidence that contradicts the “Bernanke Hypothesis” that the former US Fed Chair first laid out in a 2005 speech at Jackson Hole, in which he suggested that international factors – particularly the savings glut and US trade deficit – were behind falling interest rates in the US. Since then, Ben Bernanke has followed up with a series of blog posts suggesting that these international factors were the cause of the initial onset of secular stagnation.

Figure 2. European Growth Relative to Trend

Source: World Bank WDI

In this brief, I present new research in which my coauthor and I test the robustness of the research finding that China had a positive impact on innovation in Europe (Campbell and Mau, 2019). We find that these findings are very sensitive to controls for time trends and other slight changes in specification. We also find that the number of patents matched to firms in the sample shrinks over the sample period (from 1996 to 2005). Overall, we conclude that, unfortunately, it is unlikely that the rise led to a significant increase in innovation in Europe, although more research is needed. Our research also sheds light on the so-called “replication crisis” currently gripping the social sciences, as researchers begin to realize that many published findings are not robust.

Trade-Induced Technical Change?

Bloom, Draca, and Van Reenen (2016) – hereafter BDV – tried to isolate the impact of the rise of China on Europe using several methods, using firm-level data for Europe. They placed each firm in a 4-digit sector, where they measured imports from China over time. First, they just looked at changes in patents, IT, and total factor productivity (TFP) at the firm level for sectors in which Chinese imports increased a lot vs. other sectors. But, because economists are always weary of the difficulty of isolating a causal relationship from non-experimental data, the authors, worrying that the sectors which saw increases in Chinese imports might differ systematically from the others, the authors also used what is called an instrumental variable. That is, they used the fact that when China joined the WTO in 2001, they also negotiated a reduction in textile quotas. Thus, BDV reason that textile sectors which had tightly binding quotas prior to removal were likely to have had fast growth in Chinese imports after China’s accession to the WTO. Thus, they end up comparing textile sectors in which the quotas were binding to sectors in which they were not binding. We went back and compared the evolution of patents in these same groups (sectors with binding textile quotas vs. not binding) below in Figure 3.

Figure 3. Patent Growth in China-Competing Sectors (Quota Group) vs. Other Sectors

Notes: The vertical red lines are dates when textile quotas were removed. The blue line shows the evolution of patents in the sectors without binding quotas (non-competing sectors), and the red line is the evolution of patents in the China-competing sectors. The dotted lines are 2 standard deviation error bounds.

What is immediately obvious in Figure 3 is that patents are declining rapidly over the whole period in both groups. The overall level of patents was falling in both groups for the full period. There is a 95.8% decline in patenting for the China-competing group, vs. a 96.2% decline for firms in the non-competing (“No quota”) group. By 2005, average patents per firm are close to zero in both groups (.04 in the China-competing sectors vs. .11 in the others). However, in the “No quota” group, the initial level of patents – close to three per firm per year – was much larger than in the quota group. Since patents are falling rapidly in both groups but bounded by zero, the level of the fall in patents in the non-quota group is larger, but one can easily see that much of this decline happens before quotas are removed. If we control for simple time trends, the effect goes away. Also, given the tendency of patents to decline, we can also remove the correlation between Chinese competition and patent growth in some specifications by simply controlling for the lagged level of patents. The overall declining share of patents in the BDV data also raises questions about data selection issues, as patents granted in the BDV data in the later years were a smaller share of the total patents actually granted in reality.

BDV also look at the impact of the rise of China on IT adoption. However, here they proxied IT adoption by computers per worker, but they did not collect enough data to control for pre-trends properly in the data, so we cannot be sure whether this correlation is causal or not. (For what it is worth, on the data we do have, from 2000 to 2007, including trends in the data renders the apparent correlation between Chinese import growth and computers-per-worker insignificant.)

Lastly, BDV look at the impact of the rise of China on TFP growth. Here, unlike before, we find that their measure is robust across various estimation methodologies. However, when we look at changes in a commonly used alternative measure of productivity, value-added per worker, instead of TFP (as TFP needs to be calculated using strong assumptions about the functional form of technology), we find no impact (see Figure 4 below).

Figure 4. Value-Added per worker Growth: China-competing sectors vs. others

Figure 4 above compares the evolution of value-added per worker in the most China-competing sectors vs. the others. Trends look similar for firms in either group of sectors (China-competing or otherwise), and we do not find a correlation. We also do not find that Chinese competition led to an increase in profits, nor an increase in sales per worker (in fact, we found a significant decrease in most specifications).

Conclusion

All in all, we find that the BDV findings suggesting that the rise of China had a large impact on innovation in Europe is not robust. However, in most specifications, we also don’t find a negative impact as did Autor et al. (forthcoming) for the US. This might have to do with data quality, although it does seem to be closer to other work, such as Dauth et al. (2014), which suggests that the rise of China had a smaller impact in Germany than in the US.

We also felt it was a bit alarming that a simple plot of  the trends in patents for China-competing and not-competing sectors was enough to seriously question the conclusions of BDV, as their paper was published in the Review of Economic Studies, a top 5 journal in academic economics. If influential articles published in the most fancy journals can exhibit such mistakes, this underscores the extent which the profession of economics may suffer from many published “false-positive” results. The reasons why this could be the case are obvious: researchers are under pressure to find significant results, as top journals don’t often publish null results, and replication is exceedingly rare in a field in which one needs to make friends to publish. However, there are signs that replication is becoming more mainstream, and as it does, we can certainly hope that voters around the world will turn back to science.

References

  • Autor, D., D. Dorn, G. H. Hanson, G. Pisano, and P. Shu. Forthcoming. Foreign Competition and Domestic Innovation: Evidence from US Patents. Forthcoming: AEJ:Insights.
  • Bloom, N., M. Draca, and J. Van Reenen. 2016. “Trade Induced Technical Change? The Impact of Chinese Imports on Innovation, IT and Productivity.” The Review of Economic Studies 83 (1): 87–117.
  • Campbell, Douglas and Mau, Karsten. 2019.. Trade Induced Technological Change: Did Chinese Competition Increase Innovation in Europe?”, mimeo
  • Dauth, W., S. Findeisen, and J. Suedekum. 2014. “The Rise of the East and the Far East: German Labor Markets and Trade Integration.” Journal of the European Economic Association 12 (6): 1643–1675.
  • Gordon, R.J., 2017. The rise and fall of American growth: The US standard of living since the civil war (Vol. 70). Princeton University Press.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Agricultural Exports and the DCFTA: A Perspective from Georgia

Posted on February 18, 2019 | Policy Brief

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On June 27, 2014, Georgia and the EU signed an Association Agreement (AA) and its integral part – the Deep and Comprehensive Free Trade Area (DCFTA). In this policy brief, we discuss the changes and analyze the agricultural exports statistics of Georgia since 2014. Furthermore, we will provide the recommendations to capitalize on the opportunities that the DCFTA offers to Georgia.

Georgia is a traditional agrarian country, where agriculture constitutes an important part of the economy. 36.6% of the country’s territory are agricultural lands and 48.2% of the Georgian population live in villages. Although 55% of population are employed in agriculture, Georgia’s agriculture accounts for only 15.8% of its GDP (Geostat, 2019). Agricultural exports constitute an important part of Georgia’s economy, accounting for about 25-30% of total exports.

On June 27, 2014, Georgia and the EU signed an Association Agreement (AA) and its integral part, the Deep and Comprehensive Free Trade Area (DCFTA). On July 1st, 2016, the DCFTA fully entered into force. The DCFTA aims to create a stable and growth-oriented policy framework that will enhance competitiveness and facilitate new opportunities for trade. The DCFTA widens the list of products covered by the Generalized System of Preferences+ (GSP+) and sets zero tariffs on all food categories (only garlic is under quota), including potentially interesting products for Georgian exports – wine, cheese, berries, hazelnuts, etc. (Economic Policy Research Center, 2014).

As July 2018 marked only two years since the implementation of the DCFTA between Georgia and EU, valuable conclusions on its impact cannot be formulated yet. In this policy brief, we will give an overview of Georgia’s agricultural trade statistics, particularly, we will focus on agricultural exports and provide recommendations for capitalizing on opportunities offered by the DCFTA.

Georgia’s agricultural trade

Despite its potential and natural resources, Georgia is a net importer of agricultural products. In 2018, Georgia’s agricultural exports increased by 23.2% (181 million USD), while the respective imports grew by only 15.5% (179 million USD) compared to 2017. Therefore, the trade balance (the difference between exports and imports) remained almost unchanged at (-394) million USD (Figure 1).

Figure 1: Georgia’s Agricultural Trade (2014-2018)

Source: Geostat, 2019

Out of the sharp increase in agricultural exports, 100 million USD are attributed to tobacco and cigars. Since Georgia cultivates very little tobacco, the growth was instigated mostly from the import, slight processing and re-export of tobacco products. Consequently, the export of tobacco and cigars increased by 240% in 2018, and it currently holds second place (after wine) in Georgia’s total food and agricultural exports. It should be mentioned that wine exports contributed to 26 million USD in export growth.

Over the last five-year period, the top export countries for Georgia were mainly neighboring counties (Azerbaijan, Russia, Armenia, Turkey); for imports, we see the same neighboring countries as well as China and Ukraine. Observing the trade statistics over the years, 45% of Georgia’s agricultural exports were destined for markets in countries of the former Soviet Union, so-called Commonwealth of Independent States (CIS), while the EU’s share in Georgia’s total agricultural exports was 24%.

Trade relationships between Georgia and the EU

The EU is one of Georgia’s largest trade partners. The EU’s share of total Georgian imports was 28% in 2018, and for exports, 24%. Total exports have been more or less stable since 2014, except for 2016, when an 11% decrease was observed (Figure 2). Specifically, for agriculture, in 2017, the EU’s share of Georgian imports was 22%, and its share of exports was 19%. During the same period, the top export products were hazelnuts (shelled), spirits obtained by distilling grape wine or grape marc, wine, mineral and aerated waters and jams, jellies, marmalades, purées or pastes of fruit.

Figure 2: Total and Agricultural Exports to the EU (2014-2018)

Source: Geostat, MoF, 2019

In 2015 (before the full enforcement of the DCFTA), Georgia’s agricultural exports to EU countries (including the United Kingdom) increased by 20% compared to the previous year. This positive trend remained in 2016, when the same indicator increased by 5%. In 2017, which was quite a bad year in terms of harvest in Georgia, we observed a 38% decrease in the country’s agricultural export to the EU (Figure 2). This decrease was mainly caused by a significant decrease (64%) in hazelnut exports during the same period. The reason for such a large decrease is that hazelnut production suffered from various fungal diseases due to unfavorable weather conditions in 2017. The Asian Stink Bug invasion worsened the situation, and in the end, hazelnut exports dropped dramatically in both value and quantity. In 2018, Georgia’s agricultural export in EU slightly increased by 6% compared to 2017.

Trade relationships between Georgia and CIS countries

It is interesting to observe agricultural trade within the same time period with CIS countries. In 2018, the CIS’ share of Georgian imports was 51%, and its share of exports was 60%. The top export products to CIS countries were wine, mineral and aerated waters, spirits obtained by distilling grape wine or grape marc, hazelnuts (shelled), and waters, including mineral and aerated, with added sugar, sweetener or flavor, for direct consumption as a beverage. As we can see in both EU and CIS countries, the top export products are more or less the same. However, the main export destination market for Georgian hazelnuts are EU countries, but wine is mostly exported to the CIS countries.

Figure 3: Agricultural Exports to CIS Countries (2014-2018)

Source: Geostat, MoF, 2019

Due to the worsened economic situation in CIS countries, Georgia’s agricultural exports to these countries decreased by 37% in 2015. Such a sharp decrease was mainly driven by a significant decrease in the export of alcoholic and non-alcoholic beverages, hazelnut, and live cattle. However, since 2015, Georgia’s agricultural exports to CIS countries have been increasing; we observed a slight 2% increase in the value of agricultural exports in 2016, while the same indicator was 37% in 2017 (Figure 3). That was mainly caused by the increased exports of alcoholic and non-alcoholic beverages (wine by 61%, spirits by 28%, mineral and aerated waters by 22%). In 2018, Georgia’s agricultural export in CIS countries increased by 12% compared to 2017.

Conclusion

Despite its potential and comparative advantage in agriculture, Georgia is still a net importer of agricultural products and has negative trade balance (-394 mn USD). Two years after the DCFTA came into force, it is challenging to know its impact on Georgia’s agricultural trade due to the insufficient passage of time since. Notwithstanding, we can formulate some conclusions from trade statistics. The diversity of the destinations for Georgia’s agricultural exports has not changed through the years. Georgia’s agricultural exports has increased to the EU, but at a quicker pace to CIS too. Furthermore, Georgia’s share of agricultural exports to CIS countries is still significant (60%).

While it is obvious that Georgia needs to diversify its agricultural export destination markets, there are several challenges facing small and medium size farmers and agricultural cooperatives in Georgia that are not specific to implementation of the DCFTA. As the previous regime (GSP+) with the EU already covered most products, the DCFTA did not represent a significant breakthrough. On the path to European integration, the biggest challenge for Georgia is to comply to non-tariff requirements such as food safety standards and SPS measures. The attention should be paid on providing consultations to farmers regarding certification processes and standards and better information sharing (e.g. developing online platforms).

In Georgia, agri-food value chains are not well-developed and lack coordination among different actors. In order to capitalize on opportunities offered by the DCFTA, government and private sector should work together to improve logistics infrastructure. There is a need for upgrading at every stage of export logistics: warehousing, processing, labeling, regional consolidation, final customer services. In this regard, there are high approximation costs for business that should be considered as long-term investment to modernize agriculture and improve food the safety system in the country. This would boost the export potential not only to the EU, but to other countries with similar requirements as well.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Whistleblower Protections but no Rewards: EU Commission Proposes a New Directive

Posted on June 26, 2018 | Policy Brief, Policy Papers

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On the 17th of April 2018 the European Commission adopted a package of measures to increase protections for whistleblowers (European Commission Newsroom, 2018). This is good news, as whistleblower protection in Europe has been uneven and in some member states non-existent. Transparency International (2013) rated a disappointing four European countries as having adequate or extensive protection. In a report by Wolfe et al (2014), several European countries, including Germany, France and Italy, were judged to have inadequate laws with respect to several aspects of whistleblower protection, although France and Italy recently improved them considerably. Corruption, fraud of various types, and related forms of economic crime are widespread almost everywhere in the world (See e.g. Dyck et al 2014, and Global Crime Survey 2016). Criminal organizations such as drug cartels, have become increasingly sophisticated and their ability to use the international financial markets has made it ever more difficult for law enforcement agencies to discover them with more traditional law enforcement tools (see e.g. Radu 2016 for an overview). Incentivizing whistleblowers through protection and rewards can prove effective at getting information on these hard-to-detect crimes. Whistleblower protection is central for ensuring democratic values such as freedom of speech and fair elections, and recent cases also suggest that it may be central for protecting investigative journalists and their sources.

The Need for Protection and Possibly Rewards

On February 26th 2018 Ján Kuciak, a Slovakian journalist, was murdered in his home for investigating political connections to organized crime in the heart of Europe (Washington Post, 2018); Daphne Caruana Galizia was killed on 16th of October 2017 by a car bomb while she had been writing about corruption in Malta in connection with the Panama papers (Financial Times, 2018a); Maria Efimova, an employee at a private bank that claimed that her employer had illegally moved funds for Maltese politicians, is under an arrest warrant from Malta and Cyprus on seemingly unrelated charges (The Guardian, 2018); and Hervé Falciani, who blew the whistle on the bank he was working for in Switzerland that helped clients evade billions of dollars in taxes, was arrested in April in Spain after an arrest warrant issued by Switzerland on March 19th, though he has now been released on bail (Financial Times, 2018b).

While some EU countries recently improved whistleblower protection, some seem to be heading in the opposite direction. An extreme example is Germany. A provision packed into the German Data Retention Framework of 2015 allows for prison sentences of up to 3 years for the handling of “stolen data”, and journalists are no longer protected against search and seizure (European Digital Rights, 2017). This provision was included despite Germany’s problems with underreporting of corporate crime.  On the need of whistleblowing in the country, consider Volkswagen’s emissions scandal in 2015 when the public learned that the company had installed defeat devices in millions of diesel cars to ‘cheat’ on environmental emissions standards and increase pollution all over the world. The response of management was to blame a set of “rouge engineers” (Congressional Hearing, 2015), while we now know that power points on how to circumvent U.S. emissions tests by a top technology executive circulated within the company as early as 2006 (New York Times, 2016). Excess diesel emissions were associated 38 000 premature deaths in 2015 (Anenberg et al, 2017), implying that whistleblowing could have saved thousands of lives, yet the wrongdoing went on for close to a decade without anyone blowing the whistle. Cheating on emissions tests also turned out to be an industry wide phenomenon.

Germany also has a history of treating whistleblowers poorly. Consider for example the case where a German nurse brought a complaint to her employer in December of 2004 over poor treatment of patients, and she was fired in January 2005. Her employer cited repeated illness as the reason for being fired, the nurse claimed that it was retaliation for speaking out about poor conditions. The nurse then filed a complaint in German Labor Court which was dismissed in August 2005. She then brought the claim to the European Convention of Human Rights, alleging that her right to expression under article 10 of the European Convention of Human Rights had been violated by her employer. She won that case in 2011, and Germany was ordered to pay the nurse 10 000 Euro in non-pecuniary damages, and 5000 for costs and expenses (Heinish V Germany 2011).

Large firms do not appear to be doing better. Even after the Siemens scandal in 2008, when the company was discovered pursuing a long-term, extensive and systematic strategy of bribing foreign governments and purchasing agencies, and promises about a drastic change in corporate governance. Recent cases suggest that the corporate culture at Siemens has not improved. Meng-Lin Liu, a compliance officer at Siemens China, brought attention to alleged kickbacks paid in connection with equipment sales to army hospitals in China to the chief financial officer for healthcare in China. He was fired after reporting internally and filed a claim alleging violations of the Foreign Corrupt Practices Act. Siemens lawyers argued that since he was no longer an employee, he was not entitled to protection under Dodd-Franks definition of “whistleblower” (Forbes, 2014).

The situation in such an important European country like Germany suggests that protection applying across all member states is needed, and the experience of other countries further suggest that protection may not be enough. In the UK, the country recognized to have some of the best protections in the EU (Wolfe 2014, Transparency International 2013), whistleblowers are still experiencing pushback. The recent case of Jes Staley, Barclays Bank’s CEO is enlightening. He ordered his security team to unveil the identity of an uncomfortable whistleblower, going so far as to request video footage of the person who bought the postage for the letter. Yet, the Financial Conduct Authority and the Prudential Regulation Authority (FiCA & PRA) decided to just fine him £642 000 – a small fraction of his pay package that year (Reuters, 2018). Cases like this suggest that the US Congress was right in pushing for rewards. The mild sanctions established by the UK regulators sent a loud and clear message to prospective whistleblowers: even in the UK, where protection was judged as high in the above-mentioned reports, a CEO that violates the law trying to uncover someone reporting his potential mismanagement (probably not to give him a premium), will just have to pay a mild fine, if he is caught of course!

In the following we review the new proposal for whistleblower protections and argue that evidence from the US suggests that financial incentives for whistleblowers may still be needed to ensure an adequate level of reporting. We then consider objections to monetary rewards which are praised by regulators in the US, while EU agencies remains hesitant. Finally, we conclude with suggestions on how to improve the European legislation.

The EU Proposed Directive Versus US Developments

The new Directive includes mandatory establishment of internal reporting channels for firms with more than 50 employees that should allow for anonymous claims (Article 5). It includes prohibition against a wide range of retaliation (Article 14); and the burden of proof is reversed in case of alleged retaliation (Article 15). Who counts as a whistleblower under the Directive is defined widely to encompass subcontractors, trainees, and people associated with a wrongdoing firm in a “work-related context” (Article 2).

The Directive is bound to improve the situation for whistleblowers given the current uneven protection. It bears similarities with the US Sarbanes-Oxley act of 2002 (SOX), but it goes beyond SOX in that it applies more broadly. Since SOX, the legal debate in the US has increasingly focused on rewards to whistleblowers as protections alone are often insufficient to ensure an adequate level of reporting.

After the financial crisis, the US concluded in the Dodd-Frank Act of 2008 that protections were insufficient, and that above and beyond protections, Dodd-Frank allows for rewards to whistleblowers who report wrongdoings in securities trading where the sanction against the wrongdoing party exceeds 1$ million.

The use of rewards was not unfamiliar to the US before Dodd-Frank. They had formerly concluded that in the tax area, whistleblowers who report tax evasion should be eligible for rewards through the Tax Relief and Health Care Act of 2006 which established the Internal Revenue Service “Office of the Whistleblower”. Although previously to 2006 whistleblowers could receive rewards at the IRS, this was entirely up to the agency’s discretion.

In the procurement area, whistleblowers are also eligible for rewards in the US under the False Claims Act (FCA) enacted in 1863. The commitment to rewards was reaffirmed in 1986 when revisions to the act reinvigorated the whistleblower or “qui tam” provisions of act (for an overview of reward programs, see Nyreröd & Spagnolo 2017).

Despite being regarded as having some of the best whistleblower protections in the world (see e.g. Wolfe et al 2014), the US did not settle for protections alone in key regulatory areas. The new EU directive does not address rewards at all which is unfortunate given their law enforcement potential if they are coupled with independent and competent judicial institutions.

Although the US experiment with whistleblower rewards is working, the only EU institution to evaluate reward policies to our knowledge is the UK’s PRA & FiCA on the request of the UK parliament. Their assessment concludes strongly against rewards, yet they do not provide any evidence to back up their negative assessment and make claims that later evidence has refuted. In the following, we review the concerns raised by critics of reward programs, primarily the PRA & FiCA.

Evidence on the Effectiveness of Rewards

Under reward programs in the U.S whistleblowers can receive a percentage of the fine imposed on the wrongdoing firm or person. The range is usually between 15-30% of the sanctions against the firm, and of the money recovered. The exact reward percentage within the range is determined by how central the whistleblowers information was to unearth and sanction the wrongdoing.

One fundamental concern with rewards is their cost effectiveness. Some argue that they can come with a costly government structure and that they attract a lot of meritless claims by opportunist employees, which increase the administrative costs (PRA & FiCA 2014, Ebersole 2011).

On the other hand, many argue that they can be a cost-effective tool in an age when governments are looking for austere economic policies (Engstrom 2014). Some argue that they are at least as efficient as classical “command and control” methods of enforcement, such as selecting random persons or firms for audit. We evaluate cost-effectiveness with respect to three important effects: deterrence, increased quality of claims, and increase quantity of claims.

A significant part of determining cost-effectiveness is the extent to which whistleblowing has any significant deterrence effects on future misbehavior. Johannesen & Stolper (2017) found that whistleblowing had deterrence effects in the off-shore banking sector. They studied the stock market reaction before and after the whistleblower Heinrich Kieber leaked important tax document from the Liechtenstein based LGT Bank. They found abnormal stock returns in the period after the leak, and the market value of banks known to derive some of their revenues from offshore activities decreased.

Wilde (2017) also provide evidence that whistleblowing deters financial misreporting and tax aggressiveness. Using a dataset of retaliation complaints filed with OSHA between 2003 through 2010 on violations of paragraph 806 which outlaw’s retaliation against employees who provide evidence of fraud, he found that firms subject to whistleblower allegations exhibited decreases in financial misreporting and tax aggressiveness.

As for experimental evidence, Abbink and Wu (2017) conducted laboratory experiments studying collusive bribery, corruption, and the effects of whistleblower rewards on deterrence. They find that amnesty for whistleblowers and rewards strongly deter illegal transactions in a one-shot setting, but in repeated interaction the deterrence effect is limited. Their results support a reward mechanism, especially for petty forms of bribery (which are more like one-shot games).

Bigoni et al (2012) conducted laboratory experiments on leniency policies and rewards as tools to fight cartel formation. They find that rewards financed by the fines imposed on the other cartel participants had a strong effect on average price (returning it to a competitive level). In the model setting, this implies that rewards have a deterring and desisting effect on cartel formation.

Another central question is whether rewards increase the quality and quantity of claims. PRA & FiCA (2014) writes that “There is as yet no empirical evidence of incentives leading to an increase in the number or quality of disclosures received by regulators” (PRA & FiCA 2014, p.2).

As for increased quality, there is evidence suggesting that this claim is untrue. Dyck et al (2010) compared whistleblowing in the health care sector where rewards are available through the FCA with non-healthcare sectors where they are not. They found that 41% of fraud cases are detected by employees in the healthcare sector. That number was only 14% for other sectors, a difference highly statistically significant (at the 1% level) despite a small sample size (Dyck et al 2010, p. 2247).

More recently, Call et al (2017) examined empirically the link between whistleblowing and (i) penalties, (ii) prison sentences, and (iii) duration of regulatory enforcement actions for financial misrepresentation. They found that whistleblowers’ involvement in financial misrepresentation enforcement actions was correlated with higher monetary sanctions for the wrongdoing firm and increased jail time for culpable executives. They also found that enforcement proceedings began quicker, and further that whistleblower involvement increased the likelihood that criminal sanctions were imposed by 8.58%, and that criminal sanctions were imposed against the targeted wrongdoer increased by 6.64%.

Another highly contested point is the relation between the quantity and quality of claims and regulatory effectiveness. Some argue that rewards may attract a lot of meritless claims by employees who are either malicious or hope to reap some reward (PRA & FiCA 2014, Ebersole 2011). This does seem to have been the case with some reward programs, but not to the extent many opponents of rewards argue, and this effect does not render rewards a futile or ineffective policy approach, see Nyreröd & Spagnolo (2017) for a thorough discussion.

There are, however, valuable lessons to be learned from the quantity of claims received and the percentage of claims determined to have merit from, for example, the IRS Whistleblower Office. At the IRS there has been a significant backlog of claims, and an exceedingly small number of claimants receive rewards. The IRS program, under 7623(a), does not have a threshold for claims to be considered, and the vast majority of claims fall under 7623(a). These are lessons for optimal design, but not an insurmountable obstacle for effective reward programs. One way around this problem is to have a threshold for claims to be considered. Another is the FCA model, where persons pursue litigation on their own if the Department of Justice declines to join, thereby taking on the risks and costs of losing in court.

Concerns over administrative burden and costly government structures are not salient enough to warrant a rejection of reward policies, as benefit in deterrence and quality outweigh the administrative costs of reviewing even large quantities of incorrect claims.

Entrapment and Malicious Claims

Another central concern has been that “Some market participants might seek to ‘entrap’ others into, for example, an insider dealing conspiracy, to blow the whistle and benefit financially”, FiCA & PRA (2014).

There are presently good ways of preventing this issue, which does not seem to have been salient in the U.S. experience with these policies. Regarding the FCA, for example, when the relator (whistleblower) initiated or planned the wrongdoing, courts can reduce the reward below 15% as they see fit (False Claims Act, 31 U.S.C. §3730 (d) (3)). The IRS has similar restrictions that in cases where the whistleblower planned and initiated the tax evasion, they may considerably reduce or deny any reward. If the whistleblower is convicted of criminal conduct related to the suit, then they should deny her any reward (Internal Revenue Code, 26 U.S.C §7623 (b) (3)).

These restrictions on reward payouts is probably the reason why, judging from the reports by the U.S agencies, entrapment has not emerged as a salient issue in the US experience with the various programs. As for evidence, the National Whistleblower Center (2014) claims they did not find a single case of entrapment in over 10 000 cases in which the planner and initiator of the wrongdoing received an award. Of course this does not exclude the possibility that a poorly run European agency/regulator might mismanage the whistleblower program to the point where this indeed becomes an issue; a sufficiently incompetent administration can generate problems even with the most robust and effective tools.

A related concern is that financial incentives could encourage employees to submit fraudulent claims, e.g. to “fabricate claims of wrongdoing for personal profit” (Howse & Daniels 1995, p.540, see also Rose 2014, p.1283). A similar concern is that: “Financial incentives might lead to more approaches from opportunists and uninformed parties passing on speculative rumors or public information. The reputation of innocent parties could be unfairly damaged as a result” (PRA & FiCA 2014, see also Vega 2012, p.510). There is also the fear that opportunistic whistleblowers will force “corporations into financial settlements in order to avoid the adverse reputational and related effects caused by highly public, albeit ill-founded, accusations” (Howse & Daniels 1995, p.526/27).

Although evidence on this is hard to find, judging from the reports of agencies, fraudulent and malicious has not been a significant issue. This is probably because fraudulent reporting is a crime, and a whistleblower who report fraudulent information exposes him or herself to a legal fight with the falsely accused employer and to sanctions against perjury and defamation. Indeed, in the case of the IRS, the information is submitted under penalty of perjury (Internal Revenue Code, 26 U.S.C §7623 (b)(6)(C)), which is also the case of the SEC if the whistleblower is represented by an attorney (Exchange Act, U.S.C 78u-6(h)). In the case of the FCA, should the whistleblower lie to the court, he risks felony charges punishable by up to five years in jail for perjury, and the possibly of being convicted of other crimes related to lying under oath. Further, the FCA has a reverse fee-shift for obviously frivolous claims (Engstrom 2016, p.10).

Whether fraudulent claims are a concern for the efficacy of a whistleblower reward program depends to a large extent on the precision of the court system. Buccirossi et al. (2017) analyze this concern within a formal economic model. They show that fraudulent reports are entirely irrelevant for countries with sufficiently precise/competent court systems, provided strong sanctions against perjury, defamation and lying under oath are there to balance the incentives generated by large bounties. Where the judicial system makes a lot of mistakes, instead, this may not be sufficient for the scheme to have crime deterrence effects, which may make it preferable not to introduce large rewards for whistleblowers.

Conclusions

Some suggest that the European hesitation over improving whistleblower protection and considering rewards may have partially historical roots, as both Nazi Germany and Soviet Russia relied heavily on citizens reporting on one another (Givati 2016, p.26.). But the lack of voices speaking out against what the Nazi’s were doing should suggest the opposite, and it is not clear how these parallels should be drawn when we are talking about rewarding whistleblowers in the financial offices of private corporations.

It is also the case that most valuable information to law enforcement is often in the hands of higher-ups in the organization, those who have more to lose in the case of whistleblowing (Engstrom 2016), and for whom protections would be an insufficient compensation relative to their current position and salary. The blunt tool that is horizontal protection for whistleblowers who report violations of EU law could be coupled with precise tools such as rewards for violations of specific EU laws whose undermining can be particularly detrimental to financial stability or the environment.

If European countries and their regulatory and law enforcement institutions are not capable of having an open and honest debate, competently based on the available evidence from rigorous research and from previous experiences in other countries, then they would hardly be able to competently design and properly administer a system of rewards for whistleblowers. As argued in Buccirossi et al. (2017), in countries with weak institutions high powered tools like whistleblower rewards should better be avoided, as in the hand of incompetent law makers and corrupt regulators they would likely produce more damage than good.

References

Disclaimer: Opinions expressed in policy papers and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Focus on Investment: A Brief Look at Regulatory Developments in EU Telecommunications

Posted on April 15, 2018 | Policy Brief

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The European Commission recently proposed a revision to its existing regulatory framework for telecommunications, the details of which have been amply discussed and are currently being negotiated. A pivotal theme of the revision is a stronger emphasis on stimulating investments into broadband networks capable of delivering high-speed (100+ Mbps) internet services. This brief highlights and briefly discusses some key changes in that regard.

Introduction

High-speed broadband networks are the backbone of the fast-growing digital economy. Promoting citizens’ access to such networks has been one of the European Commission’s stated policy priorities at least since 2010, when it launched its “Digital Agenda for Europe” (EC, 2014). Its policy mix of choice involves measures and funds facilitating deployment of so-called next-generation access networks on the one hand (commonly taken to mean access networks capable of delivering speeds exceeding 100 Mbps), while on the other hand regulating access to such networks to the extent perceived necessary to deal with potential problems resulting from incumbent network operators’ degree of market power. As regulation may harm incentives to invest in network infrastructure in the first place, a balance between investment promotion and competitive safeguards needs to be struck.

Motivated by what it considers to be a sub-optimally low speed of network upgrading in at least some of the EU’s member states, the Commission has sought to adjust its policy balance in favor of investments by proposing a revision (EC, 2016) of its regulatory framework for electronic communications, called the European Electronic Communications Code (EECC), which defines a standard approach to regulating fixed broadband network operators deemed to possess significant market power. That revision has been commented upon and discussed by the European Parliament and the European Council as well as various private and public stakeholders (Szczepański, 2017). Several amendments have been proposed and further discussion is ongoing to reach a compromise between the European institutions.

Background

Telecommunications networks were until more recently typically owned by vertically integrated, often formerly state-run, national incumbents who even after their privatization and the elimination of most legal barriers to entry were considered to possess significant market power. The EECC’s key remedy to such market power is so-called network unbundling at the wholesale level: considering the retail market for internet service provision potentially competitive, unbundling means granting competing internet service providers regulated access to the incumbent operator’s physical local-area access network, which is commonly regarded as the key bottleneck in internet service provision. Choosing the intrusiveness of the access obligation is up to the national regulatory authority (NRA), ranging from merely demanding that the incumbent publicly post a reference offer, to stricter measures such as non-discrimination, “fair and reasonable” pricing, and ultimately, full-on access price regulation, typically implemented with price caps derived from regulatory costing models. A recommendation from 2013 (EC, 2013) outlines methodological guidelines to national authorities.

Key changes

The proposed EECC revision makes the abovementioned recommendation binding, which may partly be an attempt to further harmonize regulatory practice between member states, with a view to encouraging cross-border investments by operators and service providers. It also encourages NRAs to, where possible, abandon more rigid price regulation in favor of margin squeeze tests. Margin squeeze occurs when a vertically integrated firm with market power in the wholesale segment of a production chain “squeezes” retail competitors by setting high wholesale and low retail prices, to the extent that even equally efficient, or at least reasonably efficient, retail competitors cannot survive if they are dependent on the dominant firm’s wholesale product. Moreover, and more importantly in terms of boosting deployment, the proposal encourages lighter-touch regulation for operators deploying new network infrastructure (Art. 72), and specifically relaxes regulation for deployment projects open to co-investments between operators (Art. 74). It also extends the market review period, i.e. the frequency at which NRAs are expected to update their market analysis and regulatory policy, from three to five years, giving operators a longer planning horizon, and encourages NRAs to consider any existing commercial wholesale offers in their market analysis, which can be interpreted to mean that anything short of full market foreclosure should be looked upon benevolently (Articles 61 and 65). In line with this latter development, which suggests a focus on wholesale access per se, is Article 77. This article exempts so-called wholesale-only networks – non-integrated networks whose very business model is selling access to interested internet service providers – from strict access price regulation, at least ex-ante. Typically, a presumption of consumer harm absent regulation is sufficient for intervention. Article 77 turns the tables on regulatory authorities by requiring evidence of actual consumer harm.

A counterpoint to these deregulatory elements is Article 59.2, which under certain conditions not only allows but obliges NRAs to impose access obligations on owners of existing physical infrastructure “up to the first concentration point”, in practice affecting mostly in-building wiring and cables, even when these owners have not been identified as dominant in any relevant market. In countries such as Sweden, where in-house wiring is often not owned by any operator but rather by the respective building’s owner(s), implementing such obligations may pose a regulatory challenge.

Finally, Article 22 requires NRAs to chart existing infrastructure as well as deployment plans across the country and enables them to define “digital exclusion areas” where no high-speed broadband infrastructure exists or is planned. In such areas, they may organize calls for interest to deploy networks, also with a view to resolving potential coordination problems between operators resulting from so-called “overbuild risk”: deployment in some lower-density areas may only be profitable if most of the customer base in that area can be captured, leading to a standoff between operators who cannot, do not want to, or are not allowed to communicate and coordinate their deployment strategies. As a result, investment is delayed.

A rather piquant detail here is that the proposed code allows NRAs to take action against operators it suspects of “deliberately” providing “misleading, erroneous or incomplete” information about their deployment plans. Included to prevent gaming, this provision carries the risk of suppressing investors’ appetite for the designated exclusion areas lest they be punished in case they change their mind. A minimum of mutual trust between the national regulator and market participants seems crucial for this mechanism to succeed.

Conclusion

The Commission’s proposed new regulatory framework emphasizes investment in, and take-up of, high-speed (100+ Mbps) broadband networks, explicitly defining such enhanced connectivity as a new regulatory objective on equal footing with the existing ones, most notably the promotion of competition. The present brief points out some key regulatory changes aimed at the fulfilment of these respective objectives. In terms of the revision’s impact on high-speed broadband deployment in the EU’s member states, it is difficult to make a general prediction since Europe is somewhat heterogeneous with respect to high-speed broadband penetration. For example, the 2016 EU overall NGA coverage was 75.9 % of households, but coverage rates of individual countries ranged from 99.95 % and 99.86 % in Malta and Belgium respectively to 47.0 % in France and a mere 44.2 % in Greece (EC, 2017). To the extent that the new code encourages investment relative to the old regime, regions with lower current coverage stand to benefit more. To the extent that the lower pace of deployment in those areas is the result of other factors orthogonal to regulation (one example being demand uncertainty), it will have a limited effect.

References

Rewarding Whistleblowers to Fight Corruption?

Posted on October 23, 2017 | Policy Brief

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Whistleblower reward programs, or “bounty regimes”, provide financial incentives to witnesses that report information on infringements, helping law enforcement agencies to detect/convict culprits. These programs have been successfully used in the US against procurement fraud and tax evasion for quite some time, and were extended to fight financial fraud after the recent crisis. In Europe there is currently a debate on their possible introduction, but authorities appear much less enthusiastic than their US counterparts. In this brief, we discuss recent research on two commonly voiced concerns on whistleblower rewards – the risk of increasing false accusations, and that of crowding out other motivations to blow the whistle – and the adaptations these programs may need to fight more general forms of corruption. Research suggests that the mentioned concerns can be handled by an appropriate design and management of the programs, as apparently done in the US, and that these programs can indeed be a cost effective instrument to fight corruption, but only in countries with a sufficient quality of the judicial system and administrative capacity. They may instead be problematic for weak institutions environments.

Corruption and fraud seem to remain highly widespread in almost all countries. For example, a recent survey of over 6,000 organizations across 115 countries shows that one in three organizations, both worldwide and in the US, experienced fraud in the past 24 months, prevalently in the form of asset misappropriation, cybercrime, corruption, and procurement and accounting fraud (Global Crime Survey, 2016).

Whistleblower (protection and) reward programs are a possibly effective tool to combat fraud and corruption, at least in the light of the US successful experience, where for a long time whistleblowers reporting large federal fraud have been entitled to up to 30% of recovered funds and sanctions under the False Claims Act. The US Internal Revenue Service (IRS) also allows whistleblower rewards in the tax area, and the Dodd-Frank Act introduced them for financial and securities fraud, apparently also with success (c.f. Call et al., 2017, and Wilde, 2017).

In Europe and the rest of the world, instead, rewards are absent and whistleblowers are still poorly protected from retaliation from employers. Some countries have taken encouraging legal steps to at least improve protection, and a discussion is ongoing at the G20 level on how to further improve the situation (G20 report, 2011).

Although many praise whistleblowers, there has been a large range of objections raised against introducing rewards (and even against improving whistleblower protection); mostly by corporate lawyers and lobbyists, but also by regulatory and law enforcement agencies (see Nyreröd and Spagnolo, 2017, for an overview).

In the rest of this brief, we focus on two often voiced concerns, the risks of eliciting false/fraudulent reporting and of crowding out of non-financial motivation, on which recent research has shed light that should be taken into account in the current policy debate. We then discuss some problems linked to the use of whistleblower rewards programs in a more general corruption context.

Fraudulent reports

One concern commonly raised in the discussion of whistleblower rewards is that they may create incentives to fraudulently report false or fabricated information in the hope of receiving a reward. Although clearly an important concern to take into account, we only know of very few anecdotal cases of malicious or false reporting, and fraudulent reporting does not appear to have been a major problem in the US (see again Nyreröd and Spagnolo, 2017 for an overview of the empirical evidence).

A recent paper by Buccirossi, Immordino and Spagnolo (2017) analyzes this concern within a formal economic model and shows that it is not a ground (or an excuse) for not introducing appropriately designed and managed protection and reward programs in countries with sufficiently effective court systems. In these countries, stronger sanctions against lying to the court can (and should) be introduced to balance the incentives for manipulation that may be generated by large bounties. Most legal systems already have defamation and perjury laws, which means that a whistleblower is already committing a crime by fraudulently reporting false information, that can easily be strengthened where necessary without giving up whistleblower rewards. According to this study, the balancing of incentives is what allows the US to effectively use large financial incentives for whistleblowers, besides a very strong protection from retaliation, with little problems in terms of fraudulent reports.

However, the study also shows that this is only possible if the precision (effectiveness, independence) of the court system is sufficiently high. Where court systems are imprecise, the interaction between courts’ mistakes in the legal case based on the information reported by the whistleblower and in the following case for perjury/defamation against the whistleblower if the first case is dismissed, incentives for fraudulent reports, and courts’ adaptation of the standard of proof to account for these incentives, make it impossible to appropriately balance the two incentives. Therefore, whistleblower reward programs should not be introduced in environments where the law enforcement system is ineffective, independently from why it is so (bureaucratic slack, incompetence, political interference, corruption, etc.).

Crowding-out non-financial motivation

Another concern is that whistleblower rewards may have a “crowding out” effect on intrinsic motivation. The problem is that “the commodification of whistleblowing via the provision of bounties may render would-be whistleblowers less likely to come forward by reducing the moral valance of the wrongdoing” (Engstrom, 2016:11). Recent experimental evidence suggests that this concern is overstated. In particular, Schmolke and Utikal (2016) investigate the effects of whistleblower rewards in an environment where one subject may increase his payoff at the cost of harming the group, and find rewards to be highly effective in increasing the number of crimes reported. Data from that experiment suggests a little role for crowding out of non-monetary motivation, if any. Another recent study by Butler, Serra and Spagnolo (2017) investigates if and how monetary incentives, expectations of social approval or disapproval, and the salience of the harm caused by the reported illegal activity interact and affect the decision to blow the whistle. Experimental results show that financial rewards significantly increase the likelihood of whistleblowing and do not substantially crowd out non-monetary motivations activated by expectations of social judgment. The study also finds that public scrutiny and social judgment decrease (increase) whistleblowing when the public is less (more) aware (aware) of the negative externalities generated by the reported crime. All in all, most the recent studies we are aware of suggest that crowding-out of non- financial concerns is not a first-order problem for whistleblower reward schemes as long as there is a clear perception of the public harm linked to the illegal behavior reported by the whistleblower.

Whistleblower rewards and corruption

Although whistleblowing can occur in any sector, firm, or government, an area of particular interest is corruption. Corruption in public procurement is estimated to cost the EU 5.3 billion Euros annually. Hence, corruption deterrence through increased whistleblowing could save the EU significant resources annually (EC Report, 2017).

Contrary to fraud, corruption always takes at least two parties, a bribe taker, typically a government official or politician, and a bribe giver, which may be a firm or an individual. The fact that at least one additional party is involved than in the standard case of fraud, should make whistleblower rewards programs even more powerful since they may deter corruption by increasing the fear that a (potential or real) partner in crime may blow the whistle, even when no third party witness observes the illegal act (Spagnolo, 2004).

When the reported wrongdoer is an individual, as is often the case with corruption, there may be an issue in the use of rewards for whistleblowers linked to the funding of the rewards (c.f Nyreröd & Spagnolo, 2017b for an overview).

In the current US schemes, rewards for whistleblowers are ‘self-financing’, as they constitute a fraction of the funds recovered thanks to the whistleblower or/and of the fines paid by the culprits. An individual and a government official involved in a corrupt deal may, however, not be wealthy enough for the fines and the recovered funds to amount to a sufficiently strong incentive to blow the whistle, given the loss of future gains from the corrupt relationships and the various forms of retaliation whistleblowing may lead to. This problem is of course also relevant for fraud when an individual with few or well-hidden assets is the culprit, rather than a corporation, but it seems particularly relevant for corruption.

Whistleblower reward programs are also malleable to the concerns at hand. If the priority is to combat higher-level corruption, then setting a monetary threshold for when a claim is to be considered is appropriate to limit administrative costs for the program. Indeed, a concern with utilizing whistleblower rewards programs for combating lower-level corruption is that the administrative burden required looking through the whistleblower claims and the costs of limiting abuses may outweigh the benefits gained in detection and deterrence. This concern is also valid for small fraud and tax evasion, which is why all the US programs have a minimum size for cases eligible to whistleblower rewards, but the problem is likely to be more relevant to the case of ‘petty’ corruption. These programs are more suited for ‘large cases’ in which the amount of funds recovered is large enough to pay for rewards and administrative costs, making these programs self-financing even without calculating the benefits for the deterrence/prevention of future infringements. However, when focusing on large corruption cases, other issues become relevant.

An issue particularly important for the case of ‘grand’ corruption is how independent the judicial system is from political pressure, and how able it is to protect whistleblowers against politically mandated retaliation. If corrupt politicians can importantly influence courts, the police or other relevant administrative agencies, then protection can hardly be guaranteed and inducing witnesses to blow the whistle through financial incentives may put their life at risk, although sufficiently large rewards can partly compensate for this risk and help escaping part of the retaliation.

Conclusion

On the whole, whistleblower rewards, in general and in the corruption context specifically, remain a promising tool to detect and deter crime. Careful design and implementation are necessary, because as for any powerful tool, these programs can be well used to do great thing, but also misused to do great damage. As the US experience has shown, along with sufficiently independent and precise courts and an effective administration of law enforcement, well designed and administered whistleblower reward programs hold the promise of greatly improving fraud and corruption detection and of being self-financing through recovered funds and fines.

Of course, even in a very good institutional environment, a poor design and/or implementation can lead to poor performance and do more harm than good (c.f. the case of leniency policies in China discussed in Perrotta et al., 2017). Moreover, in poor institutional environments, where the court system is not sufficiently precise and independent and other law enforcement institutions are not effective, even well-designed and implemented whistleblower reward schemes may bring more problems than benefits. Whistleblower rewards, as any other high-powered incentives, need good governance to ensure that the potentially very high benefits they can generate will be realized. Third parties like international courts and organizations could potentially provide for some low institution environments, the independent safe harbor necessary to protect whistleblowers and a check on court effectiveness for the award of financial incentives.

References

  • Global Economic Crime Survey, 2016. Available at: https://www.pwc.com/gx/en/economic-crime-survey/pdf/GlobalEconomicCrimeSurvey2016.pdf
  • Buccirossi, P., Immordino, G., and Spagnolo, G., 2017. “Whistleblower Rewards, False Reports, and Corporate Fraud”. SITE Working Paper No. 42, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2993776
  • European Commission Report, 2017. Estimating the Economic Benefits of Whistleblower Protection in Public Procurement, Milieu Ltd.
  • Engstrom, D., 2016. “Bounty Regimes”, in Research Handbook on Corporate Criminal Enforcement and Financial Misleading (Jennifer Arlen ed., Edward Elgar Press, forthcoming 2016)
  • Butler, J., Serra, D., and Spagnolo G., 2017. “Motivating Whistleblowers.” Unpublished manuscript.   Available at: https://www.aeaweb.org/conference/2017/preliminary/1658
  • Schmolke, K.U., Utikal, V., 2016. “Whistleblowing: Incentives and Situational Determinants.” FAU – Discussion Papers in Economics, No. 09/2016. 2016. Available at: https://ssrn.com/abstract=2820475
  • Call, A.C., Martin, G.S, Sharp, N.Y., Wilde, J.H., 2017. “Whistleblowers and Outcomes of Financial Misrepresentation Enforcement Actions.” Journal of Accounting Research, forthcoming.
  • Wilde, J.H., (2017). “The Deterrent Effect of Employee Whistleblowing on Firms’ Financial Misreporting and Tax Aggressiveness”, The Accounting Review, forthcoming.
  • Nyreröd, T. Spagnolo, G., 2017a “Myths and evidence on whistleblower rewards”, SITE Working Paper No.
  • Spagnolo, G., 2004. “Divide et Impera: Optimal Leniency Programs.” CEPR Discussion Papers 4840, 2004.
  • Nyreröd, T. Spagnolo, G. 2017b. “Whistleblower Rewards in the Fight against Corruption?” (in Portuguese), forthcoming in the book  Corrupção e seus múltiplos enfoques jurídi
  • Berlin-Perrotta, M., Qin, B. and Spagnolo, G., 2017. “Leniency, Asymmetric Punishment and Corruption: Evidence from China,” SITE Working Paper. Available at:https://ssrn.com/abstract=2718181 or http://dx.doi.org/10.2139/ssrn.2718181
  • G20 Anti-Corruption Action Plan, Protection OF Whistleblowers Study on Whistleblower Protection Frameworks, Compendium of Best Practices and Guiding Principles for Legislation, 2011. Available at: https://www.oecd.org/g20/topics/anti-corruption/48972967.pdf
  • Wolfe S., Worth M., Dreyfus S., Brown A.J., 2015. Breaking the Silence, Strengths and Weaknesses in G20 Whistleblower Protection Laws, 2015. Available at: https://blueprintforfreespeech.net/wp-content/uploads/2015/10/Breaking-the-Silence-Strengths-and-Weaknesses-in-G20-Whistleblower-Protection-Laws1.pdf

“New Goods” Trade in the Baltics

Posted on May 22, 2017 | Policy Brief

20170522 Trade in the Baltics Image

We analyze the role of the new goods margin—those goods that initially account for very small volumes of trade—in the Baltic states’ trade growth during the 1995-2008 period. We find that, on average, the basket of goods that in 1995 accounted for 10% of total Baltic exports and imports to their main trade partners, represented nearly 50% and 25% of total exports and imports in 2008, respectively. Moreover, we find that the share of Baltic new-goods exports outpaced that of other transition economies of Central and Eastern Europe. As the International Trade literature has recently shown, these increases in newly-traded goods could in turn have significant implications in terms of welfare and productivity gains within the Baltic economies.

New EU members, new trade opportunities

The Eastern enlargements of the European Union (EU) that have taken place since 2004 included the liberalization of trade as one of their main pillars and consequently provided new opportunities for the expansion of trade among the new and old members. Growth in trade following trade liberalization episodes such as the ones contemplated in the recent EU expansions could occur because of two reasons. First, because countries export and import more of the goods that they had already been trading. Alternatively, trade liberalization could promote the exchange of goods that had previously not been traded. The latter alternative is usually referred to as increases in the extensive margin of trade, or the new goods margin.

The new goods margin has been receiving a considerable amount of attention in the International Trade literature. For example, Broda and Weinstein (2006) estimate the value to American consumers derived from the growth in the variety of import products between 1972 and 2001 to be as large as 2.6% of GDP, while Chen and Hong (2012) find a figure of 4.9% of GDP for the Chinese case between 1997 and 2008. Similarly, Feenstra and Kee (2008) find that, in a sample of 44 countries, the total increase in export variety is associated with an average 3.3% productivity gain per year for exporters over the 1980–2000 period. This suggests that the new goods margin has significant implications in terms of both welfare and productivity.

In a forthcoming article (Cho and Díaz, in press) we study the patterns of the new goods margin for the three Baltic states: Estonia, Latvia and Lithuania. We investigate whether the period of rapid trade expansion experienced by these countries after gaining independence in 1991—average exports grew by more than 700% between 1995 and 2008 in nominal terms, and average imports by more than 800%—also coincided with increases in newly-traded goods by quantifying the relative importance of the new goods margin between 1995 and 2008. This policy brief summarizes our results.

Why focus on the Baltics?

The Baltic economies present an interesting case for a series of reasons. First, along a number of dimensions, the Baltic countries stood out as leaders among the formerly centrally-planned economies in implementing market- and trade-liberalization reforms. Indeed, those are the kind of structural changes that Kehoe and Ruhl (2013) identify as the main drivers of extensive margin increases. Second, unlike other transition economies, as part of the Soviet Union the Baltics lacked any degree of autonomy. Thus, upon independence, they faced a vast array of challenges, among them the difficult task of establishing trade relationships with the rest of the world, which prior to 1991 were determined solely from Moscow. Lastly, as former Soviet republics, the Baltic states had sizable portions of ethnic Russian-speaking population, most of which remained in the Baltics even after their independence. At least in principle, this gave the Baltic economies a unique potential to better tap into the Russian market.

Defining “new goods”

We use bilateral merchandise trade data for Estonia, Latvia and Lithuania starting in 1995 and ending in 2008, the year before the Global Financial Crisis (GFC). The data are taken from the World Bank’s World Integrated Trade Solution database. The trade data are disaggregated at the 5-digit level of the SITC Revision 2 code, which implies that our analysis deals with 1,836 different goods.

To construct a measure of the new goods margin, we follow the methodology laid out in Kehoe and Ruhl (2013). First, for each good we compute the average export and import value during the first three years in the sample (in our case, 1995 to 1997), to avoid any distortions that could arise from our choice of the initial year. Next, goods are sorted in ascending order according to the three-year average. Finally, the cumulative value of the ranked goods is grouped into 10 brackets, each containing 10% of total trade. The basket of goods in the bottom decile is labeled as the “new” goods or “least-traded” goods, since it contains goods that initially recorded zero trade, as well as goods that were traded in positive—but low—volumes. We then trace the evolution of the trade value of the goods in the bottom decile, which represents the growth of trade in least-traded goods.

Findings

For ease of exposition, we present the results for the average Baltic exports and imports of least-traded goods, rather than the trade flows for each country. Results for each individual country can be found in Cho and Díaz (in press). We report the least-traded exports and imports to and from the Baltics’ main trade partners: the EU15, composed of the 15-country bloc that constituted the EU prior to the 2004 expansion; Germany, which within the EU15 stands out as the main trade partner of Latvia and Lithuania; the “Nordics”, a group that combines Finland and Sweden, Estonia’s largest trade partners; and Russia, because of its historical ties with the Baltic states and its relative importance in their total trade.

Least-traded exports

Figure 1 shows the evolution over time of the share in total exports of the goods that were initially labeled as “new goods”, i.e., those products that accounted for 10% of total trade in 1995. We find that the Baltic states were able to increase their least-traded exports significantly, and by 2008 such exports accounted for nearly 40% of total exports to the EU15, and close to 53%, 49% and 49% of total exports to Germany, the Nordic countries, and Russia, respectively. Moreover, we find that the fastest growth in least-traded exports to the EU15 and its individual members coincided with the periods when the Association Agreements and accession to the EU took place. Finally, we discover that the rapid increase in least-traded exports to the EU15 during the late 1990s and early 2000s is accompanied by a stagnation of least-traded exports to Russia. This suggest that, as the Baltics received preferential treatment from the EU, they expanded their export variety mix in that market at the expense of the Russian. Growth in least-traded exports to Russia only resumed in the mid 2000s, when the Baltics became EU members and were granted the same preferential treatment in the Russian market that the other EU members enjoyed.

Figure 1. Baltic least-traded exports

Source: Cho and Díaz (in press).

Least-traded imports

Figure 2 plots the evolution of Baltic least-traded imports between 1995 and 2008. We find that new goods imports also grew at robust rates, but their growth is about half the magnitude of the growth in the least-traded exports—the least-traded imports nearly doubled their share, whereas the least-traded exports quadrupled it. The least-traded imports from the EU15 and its individual members exhibited consistent growth throughout. On the other hand, imports of new goods from Russia—which had also been growing since 1995—started a continuous decline starting in 2003. This change in patterns can be attributed to the Baltics joining the EU customs union. Prior to their EU accession, the average Baltic tariff was in general low. Upon EU accession, the Baltics adopted the EU’s Commercial Common Policy, which removed trade restrictions for EU goods flowing into the Baltics, but—from the perspective of the Baltic countries—raised tariffs on non-EU imports, in turn discouraging the imports of Russian new goods.

Figure 2. Baltic least-traded imports

Source: Cho and Díaz (in press).

Are the Baltics different?

Figure 1 shows that the Baltic states were able to increase their least-traded exports by a significant margin. A natural question follows: Is this a feature that is unique of the Baltic economies, or is it instead a generalized trend among the transition countries?

Table 1: Growth of the share of least-traded exports (percent, annual average)

Source: Cho and Díaz (in press).

Table 1 reveals that the new goods margin played a much larger role for the Baltic states than for other transition economies such as the Czech Republic, Hungary and Poland (which we label as “Non-Baltics”), for all the export destinations we consider. Moreover, we find that while until 2004—the year of the EU accession—both Baltic and Non-Baltic countries displayed high and comparable growth rates of least-traded exports, this trend changed after 2004. Indeed, while there is no noticeable slowdown in the Baltic growth rate, after 2004 the Non-Baltic growth of least-traded exports to the world and to the EU15 all but stops, with the only exception being the Nordic destinations.

Conclusion

The Baltic states, and in particular Estonia, are usually portrayed as exemplary models of trade liberalization among the transition economies. Our results indicate that the Baltics substantially increased both their imports and exports of least-traded goods between 1995 and 2008. Since increases in the import variety mix have been shown to entail non-negligible welfare effects, we expect large welfare gains for the Baltic consumers experienced due to the increases in the imports of previously least-traded goods. Moreover, the literature has documented that increases in export variety are associated with increases in labor productivity. Our findings reveal that the Baltics’ increases in their exports of least-traded goods were even larger than their imports of new goods, thus underscoring the importance of the new goods margin because of their contribution to labor productivity gains.

References

  • Broda, Christian; and David E. Weinstein, 2006. “Globalization and the gains from variety,” Quarterly Journal of Economics, Vol. 121 (2), pp. 541–585.
  • Chen, Bo; and Ma Hong, 2012. “Import variety and welfare gain in China,” Review of International Economics, Vol. 20 (4), pp. 807–820.
  • Cho, Sang-Wook (Stanley); and Julián P. Díaz. “The new goods margin in new markets,” Journal of Comparative Economics, in press.
  • Feenstra, Robert C.; and Hiau Looi Kee, 2008. “Export variety and country productivity: estimating the monopolistic competition model with endogenous productivity,” Journal of International Economics, Vol. 74 (2), pp. 500–518.
  • Kehoe, Timothy J.; and Kim J. Ruhl, 2013. “How important is the new goods margin in international trade?” Journal of Political Economy, Vol. 121 (2), pp. 358–392.