UNDP-WORLD BANK TRADE EXPANSION PROGRAM OCCASIONAL PAPER 8 22144 June 1992 INTEGRATION AND TRADE POLICY IN THE FORMER SOVIET UNION W. Max Corden This occasional paper is a product of the joint UNDP/World Bank Trade Expansion Program which provides technical and policy advice to countries intending to reform their trade regimes. The views contained herein are those of the authors and do not necessarily reflect those of the United Nations Development Program or the World Bank. FILE COPY INTEGRATION AND TRADE POLICY IN THE FORMER SOVIET UNION W. Max Corden June 1992 Trade Policy Division The World Bank Washington, D.C. Table of contents Preliminaries 1 Definitions 2 Monetary overhang, fiscal deficits and general disequilibrium 4 Extreme specialization 6 Disequilibrium pricing 7 Exchange Rate Policy 10 Exchange rate policy for Russia 10 Relationship between trade policy and exchange rate policy 12 Exchange rate policy for the other republics 13 Monetary integration 14 Trade Policies 16 Trade taxes for revenue 16 Policy instruments to avoid 16 Tariffs for balance-of-payments reasons 18 Is there need for transitional protection? 18 Infant industry protection and a hard tariff path 22 The Free Trade Area Issue 23 Possible arguments against a free trade area 23 Free trade area or customs? 25 Monetary integration and trade integration 26 Some General Principles 27 Appendix 28 Bibliography 31 Notes 32 1. Preliminaries fairly rapidly, and four or five of the central Asian republics to move more slowly, if at all. For the others considerable uncertainty This paper examines several issues remains but all such remarks are merely bearing on future trade policy and economic speculation and they may soon be overcome by integration arrangements of the republics of events.' the former Soviet Union. It looks particularly In looking ahead it is useful to think in at the relation between trade and terms of three time periods or episodes. macroeconomic policies, especially exchange The first is the transition period when a rate policy and convertibility. republic takes the first essential steps to create Some issues are specific to the former a domestic market economy: freeing most Soviet situation, while others are familiar domestic prices and creating incentives for concerns in market economies. While the state-owned and privately owned enterprises to specific issues are not as well understood, and respond in a market way, notably by removing so are discussed in some detail, the more restrictions and providing the necessary legal familiar issues are also important and will framework, taxation system, and so on. become increasingly relevant as the republics Possibly, this stage would require extensive acquire more characteristics of market privatization. There is no shortage of economies. Not all the problems and choices discussion of the characteristics and vast facing the republics are unknown, and for the problems of such a transformation, and here it familiar problems there is much experience will be assumed that it takes place, whether in and analysis to draw upon from market an orderly or a chaotic way. One might economies, both developed and developing. imagine this stage to take two years (but that is Examples are the use of trade policy to just a casual guess!). encourage domestic competition rather than to The second stage is the adjustment period, protect jobs, the infant industry argument for when the economy is adjusting to changes in protection and the relationship between the institutions and rules. During this period the exchange rate and trade policy. economy is mainly a market economy with the From the Soviet Union has emerged one institutions and rules of a new system more or very large economy (Russia), one medium- less installed, but industries and the population sized economy (Ukraine), and thirteen small are going through an extended adjustment ones, at very different stages of development, process involving major resource reallocation, At the time of writing (January 1992) Russia income redistribution, and accumulation of was taking radical steps toward free market new forms of physical and human capital. The pricing, but it was not clear which other economy is adjusting to the changes in former republics would follow. One might institutions and rules. I would expect this stage expect the Baltic republics and Georgia to to last perhaps ten years. move (or try to move) towards the market 1 The third stage is the normality stage, Definitions when the economy has settled into the rhythms of a market economy, with normal (and The meaning of trade policy familiar) problems, and the drastic adjustment process in response to the transition from In the socialist system trade policy socialism clearly behind it. consists of the processes and decisions that This paper says only a few things about determine the quantities of various goods and trade policy during the first period. It is services imported and exported, and the prices concerned mainly with the second period and, at which that trade will take place. This to a lesser extent, with the third. Thus the involves negotiations with foreign suppliers paper really looks ahead-it assumes a and buyers, and then central instructions to successful transition. Nevertheless, most of the domestic suppliers of exports to ensure that the issues discussed are currently relevant for trade commitments are fulfilled. As is well those republics, notably Russia, where there is known, Soviet trade took place through the already a partial transition-since the intermediation of a limited number of foreign foundations for the second period are being trade organizations; there was no direct laid. relationship between Soviet export producers At various points, first-best policies are or users of imported inputs and foreign proposed. But one ought no more to imagine purchasers or suppliers.2 that such policies will consistently be followed, In the market system, the matter is than to imagine that first-best policies from a different. Trade policy does involve national (as distinct from a special interest negotiations between governments over trade point of view) are consistently followed in the restrictions and commitments to various trade major market economies. There has to be a measures (for example, through membership in good deal of second-best analysis. GATT), and to that extent there is some One preliminary warning is perhaps similarity with the Soviet system. But given obvious. A paper that is designed to clarify foreign restrictions, quantities and prices in some issues cannot claim to have simple trade are determined in a decentralized way solutions to problems that everybody knows to and do not necessarily involve "policy" at all. be immense and possibly not solvable by There is no centralized determination of means that are socially or politically quantities traded or of the prices at which trade acceptable. Furthermore, there is complete takes place. Of course, there is still a role for uncertainty about the starting point: what will official guidance on demand and supply the economies look like when coherent trade prospects- for the provision of and exchange rate policies are first information-and for the provision of the basic implemented (at some stage during the infrastructure required for all economic transition)? Nor do we know when this will activities. be. In conventional usage, trade policy refers to various interventions in trade, with the 2 exchange rate as given-tariffs, quantitative Currency convertibility refers to the import restrictions, export subsidies and taxes, ability to convert roubles freely into foreign and sometimes subsidies and taxes for currency. (Outside the former Soviet Union domestic production and consumption that the term "convertibility" refers only to this discriminate among specific tradable goods. If concept). A further distinction is made there is a single, unified exchange rate with between current account convertibility and full current account convertibility (discussed unrestricted convertibility, which includes below), and there are no such interventions, convertibility for capital account transactions. then there is "free trade"-the limiting case of When there are exchange controls on capital a passive trade policy. Much of this paper is account transactions, capital account concerned with exchange rate and exchange convertibility does not exist or is incomplete. control policies-though these are not The former socialist countries of Eastern and conventionally included in the term "trade Central Europe also distinguish between policy" -and with various departures from current account convertibility for domestic free trade, especially in the form of tariffs and residents, called internal convertibility, and export taxes. convertibility for foreigners, called external convertibility. External convertibility concerns mainly remittances of interest and dividends The meaning of convertibility and capital repatriation (which is part of capital account convertibility). In the Soviet economy the distinction was In this paper the simple term made between commodity convertibility and "convertibility" refers to current account currency convertibility. Commodity convertibility for domestic residents, as this is convertibility referred to converting domestic the relevant concept for this discussion of trade currency (roubles) into domestic goods and policy issues. services, a form of convertibility that is taken Two other points need to be stressed for granted in a market system. Commodity about convertibility. First, if a currency convertibility was incomplete for two reasons. becomes convertible, this does not mean that it First, enterprises were not allowed to spend has to be convertible at a fixed exchange rate. ("convert") their savings, held in "enterprise The exchange rate can float or it can be accounts" in banks without special permission. adjusted flexibly. It is often said that Second, generalized shortages of goods often convertibility requires foreign financial prevented households and enterprises (notably support, implying that a republic's foreign cooperatives) that were allowed to spend their exchange reserves might run out because of roubles from doing so. Here it will be assumed speculation (indirect capital movements, that full commodity convertibility is perhaps through leads and lags) or other established during the transition to a market reasons, unless it had adequate reserves of economy, foreign currency to maintain confidence. This would be true if there were a commitment to a 3 fixed exchange rate or if a country wanted to irresponsible policies in 1985 and 1986-the avoid a sharp depreciation of its currency once measures that led to the crisis of 1989 began in convertibility was established. But if there is a 1988, with the Law of State Enterprises. willingness to accept a flexible exchange rate, Aslund (1991, chapt. 7) describes the and thus the possibility of overshooting in the emerging crisis in fascinating detail. While the short run, convertibility can be established deficits of the central government and public without large foreign exchange reserves or enterprises were growing, the financial foreign assistance. balances of the enterprises had become more Second, when a currency is not liquid, so that not only the money supply but completely convertible (for current account also the velocity of circulation increased. This transactions by residents), the effect is much is a simple explanation for the increasing open the same as that of import restrictions. Of inflation in that part of the economy where course, administratively there may be prices have been flexible. But at the end of differences-it all depends on the details. But 1991 the former Soviet Union was not in a if the currency is not completely convertible, typical situation of high inflation. one cannot say that there is free trade even if In a large part of the economy, prices were there are no tariffs or quantitative import fixed, so there was excess demand, generating restrictions. the shortages and queuing that have dominated Since the analysis assumes a successful Soviet urban life. Since many goods were transition to a market economy, complete simply unobtainable (except with much effort), current account convertibility for residents is the incentive to earn more roubles was also assumed. Trade policy thus takes the form reduced, and this appears to have been a major of tariffs, import restrictions, export taxes and element in the contraction of supply. This subsidies, and so on. In addition, there can be problem would disappear if prices were exchange controls for capital account generally freed (or if the size of the market transactions; indeed, it is suggested by many sector were greatly expanded relative to the commentators that such controls should be controlled sector), since repressed inflation maintained, but this issue goes beyond the would be converted into open inflation. This scope of the present paper. process may now be under way-or would be if price liberalization were continued while excessive growth of the money supply to Monetary overhang, fiscal deficits and finance deficits continued. general disequilibrium But there has been a further complication, unique to the Soviet system: roubles credited There was generalized excess demand in to enterprises and deposited in banks have not the former Soviet republics resulting from a been available to them automatically to be massive rapidly increasing monetary overhang, spent freely. Thus, there have been two fed by out-of-control fiscal deficits. While the reasons for lack of commodity convertibility seeds were planted even earlier-by financially and two reasons for a lack of incentives to 4 earn roubles by producing and selling goods. are not available in the former Soviet Union There may be other reasons also for the republics. decline in supplies, given that the command- Nevertheless, high inflation distorts relative and-control system of determining supplies has prices and blocks the signalling role of prices. broken down. But monetary disequilibrium So, unless there is macroeconomic combined with the fixing of major prices stabilization, in addition to domestic price provides sufficient explanation. In any case, liberalization, there is little point in attempting the establishment of a domestic market system coherent trade policies of the kind discussed clearly requires both the freeing of most prices below. Hence, I shall now assume that the and the unblocking of enterprise accounts. overwhelming macro problem has been dealt Price increases could naturally eliminate the with. This does not mean that one has to monetary overhang, though other methods are assume zero inflation and zero fiscal deficits, also possible, such as the conversion of only that they are moderate and under control. currency and monetary deposits into longer- This, of course, is not a forecast, but rather term bonds of some kind (possibly usable the starting point required for coherent trade eventually for the purchase of privatized policy. assets). In addition, fiscal and enterprise Once the economy has been stabilized, deficits clearly need to be eliminated or greatly maintaining fiscal balance and strict monetary reduced. control should be the first concern of all In the absence of macroeconomic policies-all other concerns should be stabilization, the economy would convert into secondary. It must never be forgotten that the high or hyperinflation. As the experience of transformation from stagnation to crisis is various Latin American countries has shown, essentially explained by the failure of fiscal high open inflation will have adverse effects and monetary control.5 This has important on growth, and may even lead to declines in implications for trade policy. output in extreme cases (such as Brazil The fiscal repercussions of policies become recently), but it need not lead to the kind of crucial. There may be a strong revenue precipitous declines in output that have been argument for imposing tariffs, if tariffs are a seen in the former Soviet Union. Thus, the convenient or politically acceptable way of conversion of repressed inflation into open taxing. Such an argument for tariffs or export inflation-and hence the creation of commodity taxes should outweigh a concern with the convertibility- would in itself be beneficial undesired protection of import-competing for supplies.It should be added that Brazil (the industries that would be a by-product. major current example of extremely high Subsidies should be ruled out since so many inflation) has been able to adjust to very high existing subsidies have to be eliminated. The inflation to some extent because of the subsidy habit should be broken. In standard availability of financial institutions and trade theory, a case is often made in favor of indexing arrangements- institutions and subsidies over tariffs or import restrictions for mechanisms that take time to develop and that dealing with "domestic distortions." But for 5 the former Soviet republics, either tariffs (or import or export quotas on trade with each export taxes) should be used or the distortions other could have severe costs and should be should be eliminated or their consequences ruled out. Any measures that smooth or lived with. Furthermore, apart from all other improve the convenience of inter-republic considerations, tariffs should always be trade will be beneficial. Hence there is a preferred to import restrictions because of the strong case for a free trade area. Opening up favorable revenue effects. to outside trade may somewhat reduce the I noted at the beginning of the paper that it interdependence of the republics, but this would discuss some issues that are specific to effect will be limited by the ability to generate the former Soviet Union, and some that are exports to obtain alternative imports from common to market economies as well. Issues abroad. Second, extreme specialization in a connected with open inflation are certainly not free market and in the absence of new special, but those resulting from large-scale competition from outside means that there repressed inflation and hence commodity would be many conditions of near or complete inconvertibility are. This is the first of the bilateral monopoly, leading to difficult special issues. We now turn to two others. bargaining situations that could become politicized and induce trade frictions. Opening up to external trade as a way to increase Extreme specialization competition then becomes particularly desirable. While opening trade to the outside Another special feature of the former Soviet world may not always lead to actg increases republics is the extreme specialization of in that trade, the potential trade provides a production. It resulted from a planning system discipline for both buyers and sellers. It will that placed too much value on economies-of- also be convenient to use international prices scale and none on product variety or instead of bilaterally negotiated prices-as is competition. Reducing the number of happening now for trade with Eastern Europe. enterprises to which the planners sent Third, extreme specialization is likely to instructions was also supposed to make lead to strong pressures to reduce planning easier. The outcome has been a interdependence by pursuing policies of import degree of concentration of production that is substitution within the separate republics. The extraordinary by Western standards.6 argument will be made that import substitution This extreme specialization has a number of is necessary to increase competition, and implications. First, it means that trade between perhaps to avoid exploitation by monopoly the republics will have to continue on a fairly suppliers in other republics. But it is also large scale, even if they have separate trade likely that when the centralized bias to extreme policies and liberalize their trade with the specialization is removed and market forces outside world. In a free market situation, they are allowed to work, local production of are likely to trade more with each other than various products, perhaps differentiated with the outside world. Imposing restrictive somewhat from imports from other republics, 6 will begin even without protection. Hence, recommendation is to remove the domestic there is not necessarily an argument here for distortions and then to introduce free trade, protection. More important, it must be unless there are other arguments for trade remembered that imports from outside the area intervention. Free trade here means complete of the former Soviet Union will also provide convertibility of the currency for current alternative supplies. account transactions and the absence of trade policy interventions, such as tariffs, export taxes, and import quotas. Disequilibrium pricing But it may be that this first-best policy of It is assumed (and indeed seems reasonable removing "domestic distortions" cannot or will to expect) that currency convertibility will be not be implemented. A distortion (such as introduced as a crucial step during the price controls on some basic goods) may be transition and that prices will generally be justifiable for distributional or political freed. Some prices will probably continue to reasons. In that case, trade policy has to take be kept below their market value by price the distortion-creating policy as given and try controls or arbitrary decisions- food and to offset some of its adverse effects. One energy prices are likely examples. There intervention (trade policy) then modifies the would no longer be generalized excess by-product distortions that result from another demand, but there would be excess demand for intervention. It is likely that this consideration particular goods and services. will be important in forming trade policy in A dual economy would thus emerge-a the former Soviet republics, at least during the dominant market economy and a smaller early adjustment stage. nonmarket economy. Up to 1991 the An exportable product-say, energy in controlled economy dominated while the Russia or grain in Ukraine-may be market economy was relatively small. In the underpriced to domestic industrial and new situation the market economy would household consumers. If suppliers were free to dominate but the non-market economy would export as much as they wished, they would be probably still be significant.7 Thus, the third inclined to export more than they would if special feature of the Soviet situation is the prices were flexible. Indeed, if domestic prices likelihood that a significant non-market are rigidly fixed below export prices (allowing sector-much greater proportionally than in for transport costs), all domestic production most developing market economies-would would be exported in the absence of controls. remain. There will thus be relative price Controls on exports, or an adequate export distortions- which optimal trade policy will tax, would then be needed. need to take into account. This case is represented in figure 1. The One branch of the theory of trade policy is world market price is OPI. Without price concerned with the relationship between controls, exports would be LK. With a distortions and trade policy. The standard controlled price of OP2 in the home market 7 and no export controls, everything would be unit. But as noted earlier, that kind of policy exported (OK) at price OP1. has led to the current macroeconomic Further controls are needed to keep some of problems in the former Soviet republics the good at home. There are three possibilities. because of the fiscal costs. It is therefore (1) Controls keep OL at home and exports dismissed as an option. would still be LK, the nonintervention result. This issue is highly relevant because, at the But there would be excess demand at home of time of writing (January 1992), Russia is LIJ. (2) Controls keep OJ at home, avoiding liberalizing prices but the other republics are excess demand at home but leading to not. Despite various controls, there is underexporting of 1J, in the sense that an considerable free trade between the republics. opportunity to export products at a cost less The natural response then is for producers of than the price received would be forgone. (3) price-controlled commodities in, say Ukraine, An export tax of PIP2 is imposed, lowering to export to Russia and keep their home the net price received by exporters to P2, and market short, possibly failing to supply it at causing production to fall to OH and exports to all. The only limits on this large-scale JH. Even without any price control, the price diversion of supplies from Ukraine to Russia to domestic consumers would fall to OP2, so would be transport problems, and controls or that price controls would become redundant taxes that Ukraine is actually able to enforce. (or easily enforceable). There would be no Barring this possibility, Ukraine's only other excess demand at home, but underexporting alternative is to follow Russia with price would be greatest, at IJ+ HK. liberalization. The current policy issue is thus Policy 1 would have the advantage of similar to the more long-term issue discussed avoiding underexporting but it would lead to above. (Thus, price liberalization in Russia excess demand at home. Policy 2 would avoid creates pressure for others to liberalize, a case excess demand at home, but would lead to of a good policy driving out a bad one!) underexporting. Policy 3 would have two Finally, another case of a controlled price advantages. First, it would eliminate the need to domestic consumers-in this case on for price control, with its enforcement importables-may be noted here. The price of problem; it is surely easier to enforce an a particular food product may be underpriced export tax than a control on domestic sales. to domestic consumers because of price Second, it would bring in revenue from the controls. This policy will then lead to export tax (represented by the shaded area), inadequate domestic production, something surely a major attraction. On the negative side, that is beyond the power of pure trade policy it would lead to underexporting not only to deal with. But it will have two other effects. through the diversion of given output to the First (assuming the controls also apply to home market but also through reduced imports), it will lead to lower imports of the production; controlled product than would take place in the There is a fourth possibility, namely, absence of controls, or possibly to none at all. subsidizing home consumption by PIP2 per 8 Figure 1: Exportable Product With and without price and export controls D5 Pr ice P2 II L J H K Quantity igure 1 Second, it will lead to excess demand that is use the revenue to subsidize imports of the satisfied by imports of a substitute product on price-controlled product. which there are no controls. There will then be The general conclusion is that both a distortion in the pattern of imports and disequilibrium pricing should be avoided. It a net increase in total imports as the certainly should not be part of the third consumption of the imported substitute period-the period of normalcy. But for replaces consumption of the locally produced distributional and political reasons, product. One possible second-best approach disequilibrium is likely to be unavoidable (which cannot actually remove the distortion) during the early part of the adjustment period, would be to tax imports of the substitute and and thus some export taxes, and possibly also tariffs, may be needed. 9 2. Exchange Rate Policy not be based on inflationary expectations. But it is highly unlikely that Russia would allow its Exchange rate policy for Russia monetary (and fiscal) policy to be determined so completely by what would appear as In discussing possible exchange rate external considerations. Given that trade with regimes, Russia needs to be distinguished from the outside (non-ex-Soviet) world is, and will the other former Soviet Republics. remain, a small proportion of GDP, one Russia has essentially three alternatives: a cannot believe that the foreign trade tail would firmly fixed exchange rate; a flexible peg, with be allowed to wag the monetary (and hence the exchange rate fixed by intervention of the fiscal) dog. monetary authorities, but frequently or Quite apart from this consideration, there is occasionally adjusted; and a floating rate, with also the well-known disadvantage of a fixed the rate fully determined by the market, rate regime. An instrument of policy is given without intervention. In the fixed rate regime up. There are circumstances when exchange the rate would be fixed to an outside currency, rate adjustment can play a useful policy role, such as the Deutschemark or the dollar, or to a principally when a country suffers an adverse currency basket, such as the European shock-a decline in the terms of trade, a Currency Unit (ECU), the SDR, or a special politically unavoidable rise in the general wage trade-weighted basket calculated specifically level, or a cessation of capital inflow. In such for Russia. The other republics have the circumstances, a rise in the relative price of further alternatives of fixing their exchange tradables to nontradables may be required. rate to the Russian rouble, of forming or This change in relative prices would be joining a monetary union with Russia, and of brought about more easily and quickly by a forming a monetary union with some republics devaluation than by squeezing domestic other than Russia. demand with the hope that eventually domestic It is inconceivable that Russia would prices of nontradables and wages would fall establish a fixed rate regime of the first kind, sufficiently. and it certainly cannot be recommended. For a nation going through a radical Of course, the advantages of such an transition and adjustment process, an additional arrangement are well known. Inflation would consideration is relevant. There is complete be kept down, provided domestic monetary uncertainty about how the economy will policy were adapted to the exchange rate evolve-its capacity to produce once the commitment. A decline in the foreign central macroeconomic problem is dealt with, exchange reserves would compel a policy of its success in foreign trade, its methods of monetary contraction. If the commitment were wage determination, and so on. Thus what the seen to be firm-possibly even embodied in the right exchange rate should be when the new constitution of the country or its central bank- regime is instituted cannot be known. If the speculation on the exchange rate should be rate turns out to be wrong and yet cannot be avoided and domestic wage demands would altered because of a firm commitment to that 10 rate, the domestic level of nominal wages capital market. Finally, he argues that market might need to be adjusted to turn the fixed economies' experience with floating has not nominal exchange rate into the "right" rate. been particularly favorable, with large There would be no problem if the initial rate fluctuations in rates resulting, apparently, from were undervalued, since wages could easily speculative bubbles and sharp variations in rise, but there would be a big problem if the expectations. In any case, for the reason given exchange rate were grossly overvalued. If the above, Russia is likely to find a pure floating exchange rate were finally devalued despite the regime an unacceptable gamble. commitment to keep it fixed, the government's That leaves the fixed-but-adjustable credibility would suffer. exchange rate option. The adjustment might be The alternative of a floating exchange rate frequent, in which case the exchange rate regime can also be dismissed. One can becomes a crawling peg, or it might be conceive of a floating exchange rate for a occasional, in which case it becomes more like limited number of transactions-for example, the Bretton Woods System or the European for tourism and capital movements. But it is Monetary System (EMS). The less frequently improbable that Russia would willingly choose the rate is adjusted, the closer this system a unified floating rate for all its foreign trade comes to the fixed rate regime. The fixed-but- transactions for a prolonged period (i.e., other adjustable regime does not provide as strong a than during a brief transition). The people of barrier against inflation or against speculation Russia are accustomed to price stability and on the exchange rate as the completely (firmly) have a great dislike of "speculation." They are fixed rate regime since an anti-inflationary hardly likely to accept a system in which the commitment by the monetary authorities would exchange rate for important transactions-such be less credible when not backed by a firm as food imports and energy exports-fluctuates fixed exchange rate commitment. Even if day by day, often in ways that mystify even exchange controls on capital movements are the market participants. Such a regime would maintained, as they no doubt will be, there are discourage trade with the outside world when many ways of exporting capital. Thus, the the desirable goal is to expand it. possibility arises of profitable speculation on Williamson (1991, 393) gives other the exchange rate-leading to foreign exchange arguments against floating for the emerging crises followed by devaluation, and hence market economies of Eastern Europe, and losses by central banks. these also apply to Russia. First, he makes the This vulnerability to speculation is the point that a floating rate needs to be associated familiar problem of fixed-but-adjustable with a reasonably predictable monetary policy exchange rate systems. The quicker the (defined by some sort of aggregate), to anchor exchange rate is devalued when there is expectations to some extent. But this is almost speculation against the rouble, the smaller impossible when a monetary system is so new. these losses would be. But the experience of Second, a floating system can only operate many market economies, both developed and efficiently when there is a well-developed developing, shows a reluctance to devalue 11 because of the potential inflationary effects of from the restrictions oppose their removal. devaluation-raising the cost of living and thus Furthermore, removing them later may sti*l reducing real wages, and raising the costs of require some devaluation of the exchange rate, domestic industries that use imported inputs. which is ruled out by a fixed rate system. In One can expect all these problems to arise in the case of the republics of the former Soviet Russia eventually.8 Union, one would expect a ready recourse to restrictions since the republics are, of course, quite familiar with the idea of quantitative Relationship between trade policy and controls while having little notion of the exchange rate policy distorting cost of the restrictions. In any case, it is quite likely that the use of trade Before turning to exchange rate policy for restrictions would be determined to a great the other republics, the relevance of exchange extent by the balance-of-payments situation. rate policy for trade policy (narrowly defined Such restrictions might yield short-term as excluding exchange rate policy) needs to be benefits in maintaining domestic employment, discussed. The main point is simple and but these would be offset by longer-term losses important. from the distortions in resource allocation, What happens when a country's foreign especially from the adverse effects on exports. exchange reserves run down and it can no If an economy were inflating at a faster rate longer readily borrow? If it is committed to a than its trading partners, continuous or fixed exchange rate or, in a flexible rate frequent depreciation of its currency would be regime, if it makes only infrequent and needed to maintain the real exchange rate and reluctant adjustments of the exchange rate, thus the competitiveness of its export and recourse to trade restrictions is almost import-competing industries. But if the inevitable. Such has been the experience of nominal exchange rate is fixed, this is not many market economies at many times in the possible. Yet trade restrictions could be only a past. As standard analysis teaches, if short-term substitute since they could not equilibrium is to be re-established, aggregate maintain the competitiveness of export demand (absorption) has to be reduced. In industries. Eventually a devaluation would addition, some switching of demand from come about. But the experience of many tradables to nontradables and of domestic countries shows that, in the initial stage, trade output in the opposite direction is usually restrictions are indeed often intensified, with desirable to minimize adverse employment adverse effects in distorting and reducing effects domestically. If the exchange rate trade. cannot be used as a switching instrument, or if The conclusion is that the case is strong for there is a reluctance to use it, recourse to flexibility of the rouble exchange rate, restrictions on imports is highly likely. involving frequent adjustments, if necessary, Once in place, such restrictions are often Such flexibility is necessary to forestall the use difficult to remove. Interest groups that benefit of import restrictions for balance-of-payments 12 purposes. A commitment of the government are so uncertain. It may be preferable to start and the monetary authorities to noninflationary with a fixed but adjustable rate, switching later monetary policies must be direct, rather than to a firmly fixed rate. Furthermore, there brought about through commitment to a fixed would still be a danger that trade restrictions exchange rate. would be used at a time of foreign exchange crisis. To repeat: all the doubts mentioned above fixing the exchange rate still apply, but Exchange rate policy for the other republics the weight of various arguments is different than in the case of the large economies of The issues just discussed apply to the other Russia and Ukraine. republics as well. But the smaller the Next, let us consider the case for fixing the economy, the stronger the case for a fixed exchange rate to the Russian rouble. The exchange rate.9 But the question remains: argument in favor, indeed the only argument, fixed to which currency? is that for these smaller economies, trade with To begin, let us consider a small economy, Russia may be very high relative to their trade say Latvia, which is eventually likely to trade with the outside world or with other republics extensively with the European Community. that don't tie their exchange rates to the That country might fix its currency to the ECU rouble. The reason for this is, of course, the or the deutschemark. All the problems of a extreme specialization that was mentioned fixed rate would still arise. But since trade earlier. Here it is important to consider not would be a much higher proportion of GDP only the current flow of trade with than for Russia, it is more plausible to adjust Russia-which in all cases is high because of domestic monetary policy in response to the the extreme specialization-but also the foreign exchange situation: the foreign expected flow of trade during the normality exchange tail would be a lot bigger relative to period. Many republics, notably Ukraine, the the monetary dog than in the case of Russia. Baltic Republics, and Moldava, will surely For the same reason, the gains to the economy expect the pattern of their trade to change from exchange rate stability, which take the drastically in favor of trade with Western form of making foreign trade less costly, Europe. If they did wish to fix their exchange would be greater as well.10 rates-in spite of the various considerations Hence, one might conclude that for Russia noted earlier-they might be wiser to fix it to and Ukraine the case for a flexible exchange the deutschemark or the ECU. rate regime is very strong, but for the other Thus, the high level of trade with Russia thirteen much smaller economies, the provides an argument for fixing to the rouble, possibility of a fixed rate regime, or of a fixed at least for economies that do not expect their but infrequently adjusted rate, should be trade patterns to shift drastically toward the viewed more favorably. These economies West. The crucial qualification to this would still face the difficulty of determining argument is that there is no point in fixing to the correct rate initially, given that prospects the rouble unless Russia succeeds in stabilizing 13 its economy and, furthermore, appears the outside world-would be determined by convincingly able to sustain this stabilization. Russian considerations. It is not conceivable Any republic whose government believes that that Russia would accept anything else, given it could stabilize more successfully on its own that its economy is so much larger than any of should certainly do so. It could operate a fixed the others. But some republics, notably but adjustable exchange rate system, preferably Ukraine, would hardly accept such dominance. adjusting frequently if required by its foreign At this time, at least, the establishment of such exchange situation, and fixing in the short run a union involving joint decisionmaking does to the deutschemark or the ECU. At a later not appear likely on political grounds, quite stage, when Russia has fully stabilized its apart from its economic implications. economy, the republic could switch from a deutschemark to a rouble peg. The second possibility is that a republic operate a "currency board" system with a firmly fixed exchange rate to the rouble and no Monetary integration ability of its monetary authority to create credit. The republic could have its own Finally, for the non-Russian republics, the currency, but it would be fully backed by possibility of monetary integration with Russia roubles. There would, of course, be no should be noted. This option is, of course, an exchange controls between it and Russia or extreme version of a fixed exchange rate other countries with similar currency boards. commitment. And it describes the present Any loss of foreign exchange reserves would situation (January 1992): each republic is still lead to an automatic decline in the money using the rouble, which is the Russian supply. This is similar to the system that currency.11 operates in the African franc zone-the CFA Here there are essentially two possibilities. countries. In practice it differs little from the First, a true monetary union embracing the monetary union described above, except that fifteen republics might be established, with a control over monetary policy is fully handed single central bank subject to control by all over to Russia. If the republic received interest member governments or their appointees. on its rouble reserves, the seigniorage from Seigniorage would be distributed to the money creation would accrue to it; otherwise it member republics in some agreed way. The would accrue to Russia. One cannot imagine a central bank might be quite independent. If its republic agreeing to such a system unless it did constitution required it to pursue a policy of receive interest. price stability, it would be similar to the If a republic is small, if the argument for central bank envisaged in recent proposals for fixing the exchange rate to the rouble is strong a European Monetary Union. because trade with Russia is expected to The problem is that such a union is bound dominate the country's trade for a long time, to be dominated by Russia. Monetary and if Russia is expected to succeed in policy-and hence the exchange rate relative to stabilizing its economy, then the case for going 14 all the way into a monetary union with Russia becomes strong. Perhaps these conditions apply for the central Asian republics. If the intention is to maintain a fixed exchange rate indefinitely, it is better to lock it in through an institutional arrangement and thus avoid any foreign exchange speculation. While a republic would have to accept Russian dominance in a monetary union, it might request representation on the central bank board so that its voice would at least be heard. 15 3. Trade Policies acceptable way of raising revenue-at least as supplements to more desirable consumption Trade policy for a single, small republic and income taxes. But using tariffs to raise will now be considered. (The issue of whether revenue-especially a uniform tariff- should the republics should form, or maintain, a free not be ruled out. trade area is put aside for the moment.) The A modest and uniform tariff is unlikely to following assumptions underlie the discussion: be too distortionary. By contrast, a tariff All measures apply to exports to or imports structure tailored to the needs of particular from all countries with which the republic domestic industries or consumers (a concept trades. The republic concerned has established discussed again later) and continually varied as what is primarily a market economy. There is those needs vary would provide undesirable both commodity and current account opportunities for rent-seeking and bureaucratic convertibility. Any trade restrictions take the meddling. A simple uniform tariff, possibly form of tariffs, import quotas, or export with a few exemptions, is far preferable. controls and taxes, rather than exchange Refunds (drawbacks) to exporters using controls for current account transactions. imported inputs might be provided. If a The remaining issues concerning the use of republic imposes a value-added tax on trade policy interventions are similar to those domestic production, exempting production for discussed in the literature of trade policy for exports (a widely advocated method of market economies, taxation, currently used in the European Community) a complementary tariff would be needed to turn the value-added tax system into Trade taxes for revenue a tax on domestic consumption. By the time of the normalcy period, any taxes that Tariffs and export taxes raise revenue and discriminate against trade should ideally have tend to restrict trade. Provided the exchange been replaced by consumption, value-added or rate is adjusted appropriately, a uniform tariff income taxes as sources of revenue. will have a similar effect to that of a uniform export tax. Both will tend to restrict trade. This is an important equivalence, though it Policy instruments to avoid does depend on exchange rate flexibility.12 During the adjustment period, the republics' Import quotas, exchange controls for fiscal problems are likely to be so important current account transactions, and made-to- that any tax that is politically acceptable and measure tariffs should be avoided. readily collectible will be desirable, provided it does not create excessive distortions. As noted A republic benefits from opening its earlier, budget deficits are the major source of economy to trade for the familiar reasons: monetary disequilibrium. Export taxes may demand and supply conditions in the domestic well be the most convenient and politically market are equilibrated, and the benefits of 16 comparative advantage are obtained. But above the domestic price is insulated from the foreign all, competition is provided for local price. enterprises that would otherwise be able to exploit monopoly positions resulting from the Tariffs, if they are to be used, should not extreme specialization of production. (This was be tailored and adjusted to the specific needs the primary motivation for ending import of particular protected industries. They should controls in Russia in January 1992.) When it is not be reduced when the industry is more impossible to generate domestic competition successful and making higher profits, nor quickly, introducing foreign competition raised when its profits fall. Although such becomes essential. This objective is still adjustment may have a common sense appeal, compatible with moderate tariffs, provided the this "made-to-measure" approach has a tariff levels are fixed and predictable. But all disincentive effect similar to that of a profits quantitative restrictions on trade or on local tax. Furthermore, it introduces elements of currency conversion for trade transactions arbitrariness, makes the tariff system unduly should be avoided. complex, and provides opportunities for rent- Exchange controls on current account seeking, all features of the economic system transactions that discriminate between various that the former Soviet republics are seeking to uses of foreign currency have the same sorts of leave behind. Thus while some nonuniformity effects as quantitative restrictions on trade. of tariffs may be unavoidable, and even The difference between them is more desirable, the general point of the need to administrative than economic, except that avoid such adjustments should be borne in exchange controls can also apply to trade in mind. services, where quantitative restrictions are Nonetheless, it seems quite likely that the more difficult to apply. natural tendency will be to use tariff policy, A tariff that is not so high as to exclude and indeed other interventions, in this way, imports completely, and that is not deliberately since it conforms with the traditional approach varied to maintain the profitability of a local in the Soviet system. This approach has been protected industry, will still allow competitive well described by Litvak (1991, p. 82): pressure from abroad. The price of the Salaries, bonuses, and other imported good in the domestic market . decentralized funds are regulated on a (including the tariff and transport costs) sets an discretionary basis, with the purpose of upper limit to the prices that can be charged for domestically produced goods that are close oriating eess t s from organizations that reveal themselves to be substitutes. The higher the tariff, the higher more productive and guaranteeing normal the price, but as long as there can be potential salaries and bonuses.... imports, some limit is set to the price a The essence of this system is captured by a domestic producer can charge. By contrast, a Russian word that has found its way into the quota shelters the domestic producer much vocabulary of all the Eastern European more, even when some imports are allowed: countries: uravnilovk , which translates as 17 "equalization" or "levelization." ...Inequalities approach that may well appeal to the former are observed and subsequently leveled off. Soviet republics-as it has to many developing countries. But if there is a desire to move A break with this approach is clearly required. permanently away from quantity controls and Rules should replace discretion, complexities toward market incentives, tariffs are a in policy instruments should be avoided, and preferable alternative. firms should be allowed to profit from success One simple approach is to impose a uniform in import competition and exporting. nominal tariff on imports. Set at some modest level for revenue purposes, say 10 percent, the tariff would then be raised temporarily when Tariffs for balance-of-payments reasons there is a balance-of-payments problem. Imports of essential goods would not fall It has already been observed that if the much, if at all, because of their low demand exchange rate is fixed or is devalued only elasticities, while consumers and producers reluctantly in the face of a balance-of-payments would reduce imports of non-essentials, these problem, governments tend to use tariffs or being the goods with the high demand import quotas (in conjunction with a decline in elasticities. Thus the market would domestic expenditure) to equilibrate the automatically discriminate on the basis of balance of payments and maintain demand for consumers' views of what goods are essential. domestic goods. This tendency provides a Possibly exporters might get rebates on tariffs strong argument against fixing the exchange paid on imported inputs. Such a flexible rate and against devaluing only reluctantly. To uniform nominal tariff would not yield a avoid this tendency in a fixed exchange rate uniform effective tariff rate (tariff rate relative regime, nominal wages would need to be to value-added), and it would somewhat favor flexible downward, so that a required import substitution against exporting. Hence, it improvement in the competitiveness of would be an imperfect substitute for a domestic industry would be brought about not devaluation. But its simplicity and flexibility by nominal depreciation, or by tariff increases, are attractive, and it should be considered if but by falling wages. Yet such downward the use of the exchange rate is ruled out. wage flexibility is improbable. Nevertheless, there are some arguments in favor of fixing the exchange rate especially for Is there need for transitional protection? small economies, even when nominal wages are not flexible. In any case, first-best policies It may be argued that if current account are often not followed. Hence, second-best convertibility is introduced and there is little or issues remain. Given that trade restrictions will no protection, most industries would not be be used, what would be the best pattern and able to compete against imports from the method of restrictions? An instinctive response outside world. Transitional tariffs during the is to impose quantitative import restrictions adjustment period, this argument implies, are and to vary them according to the needed to avoid drastic losses of jobs when the "essentiality" of the import. This is a nonprice economy is opened up. Because of low quality, 18 much of domestic industrial output would be Hence, the vertical axis shows the price of uncompetitive under free trade, so that massive foreign currency in terms of domestic unemployment would result from opening up currency. The horizontal axis shows the value the economy. Here the experience of East of exports and imports in foreign currency, Germany may be cited. and it is assumed here that they have to be There is a weakness in this argument, equal. Inequality would result from capital which essentially appears to confuse absolute inflow or outflow, use of foreign exchange and comparative advantage. If a large part of reserves, and aid. S, is the short-run supply domestic industry turns out to be uneconomic curve of exports; it shows that supply is fixed when the economy is opened up, the nominal in the short run so that the value of export exchange rate must have been overvalued income is fixed. S2 is the long-run supply relative to the nominal wage level. If nominal curve: devaluation would increase exports. D, wages are taken as given and if the exchange is the demand curve for imports; it reflects rate is available as an instrument of policy, both the domestic demand for importables there should be a devaluation, possibly a very (imports plus import-competing goods) and the substantial one. This measure would make domestic supply of import-competing many industries competitive again, to the production. point, necessary, where external equilibrium is Thinking now of Russia, we can imagine restored. that the supply curve refers primarily to But there is a complication, which suggests energy exports and the demand curve to that there could be some logic in the argument. imports of manufactures of all kinds (an During the adjustment period the industries of obvious simplification). Over time domestic the former Soviet Union are likely to become manufacturing will become more efficient, so gradually more efficient and hence more that at a constant exchange rate (constant competitive at a given exchange rate and given nominal exchange rate and constant domestic wage level. In a free market the exchange rate nominal wage level, with world prices given) would then tend to appreciate or the domestic domestic output would increase and demand wage level to rise. The question is whether this for imports would fall. This is represented by likelihood might justify transitional tariffs. a gradual movement of the demand curve to The issue is an important one , and it can the left from D, to D2. Such an efficiency be clarified with the help of a diagram (figure improvement would no doubt also take place 2). Several simplifying assumptions are made, in export industries, shifting the supply curve but removing them would not alter the main to the right, a consideration that is ignored in messages. this argument and is an important and limiting The vertical axis shows the real exchange assumption. rate, a movement upward being a real Suppose that convertibility is introduced, devaluation. With a given nominal wage level there are no tariffs, and the exchange rate is and given constant foreign price level, this can adjusted to maintain equilibrium in the current be equated with the nominal exchange rate. 19 Figure 2: Convertibility and transitional tariffs S, Rea I exchange *t rate '*E AF ............... . ........... 0, 0 Value of Exports and imports in Foreign Currency Fgure 2 account (or is allowed to float). The demand curve shifts to the left (to D, the exchange rate curve is still the initial one, D1. The exchange will appreciate, until equilibrium is reached at rate will then initially (i.e., immediately after point C. the currency is made convertible) move to OK, Before convertibility was introduced, the equilibrium at point A. As the export supply exchange rate might have been, say, at OM curve becomes more elastic and the demand (the initial exchange rate at which exporters just covered their costs and at which there was excess demand for imports). Overshooting thus 20 takes place: first, the value of the currency initial exchange rate, moving toward point E. depreciates sharply, and then it gradually Thus, at the given exchange rate OK, a surplus appreciates. Initially, export industries will would emerge. But this would lead to real obtain a windfall gain. Since trade is appreciation that would take away some of the determined by comparative and not absolute improvements in competitiveness for these advantage, the fact that domestic tradable industries again. There will be a manufacturing is very inefficient, at least disappointment of expectations and a initially, does not alter the ability of the temporary misallocation of resources. system to ensure balance-of-payments The suggestion (or implication) is then that equilibrium and the maintenance of the exchange rate should initially be set at a employment. more appropriate long-term, less depreciated, An employment problem would arise only if level. Thus, it might be set at the long-term the real exchange rate could not be altered equilibrium OL. This would encourage from its preconvertibility level, either because exporters to move directly to point C, while the nominal exchange rate were fixed or import-competing producers that foresaw their nominal wages increased to compensate for improvements in efficiency would move to any devaluation. In that case the demand for output levels that yielded a demand for imports imports would rise by HJ as a result of at that level. Yet in the transitional period, convertibility (inconvertibility having limited import-competing producers would make imports to MT). losses. In the absence of a tariff, their output Where is the argument for transitional at the exchange rate OL would fall, yielding tariffs? This could be made in the following demand for imports at G. It follows that an way. In deciding how much to produce, initial tariff equal to KL should be imposed, exporters and import-competing producers are and this should be gradually reduced as the likely to look at the exchange rate that demand curve shifts downward. If domestic becomes established directly after producers are to plan for the correct output convertibility, not at the rate that will level, they should know firmly in advance that eventually emerge. They will not practice the tariff rate will be reduced and eventually "frational expectations." The same applies to eliminated. They would then use the exchange domestic producers who use imported inputs. rate OL as their guide for long-term output But the highly devalued exchange rate that planning. emerges immediately after convertibility is There are some obvious problems here, and introduced sends out a false signal. Not only the policy proposal expounded above is not would it give exporters a windfall (which necessarily one that should be supported. I could be temporarily taxed away) but it would have aimed only to clarify. The proposal lead them to over-expand, aiming for point F assumes that productivity improvements would on the diagram. Similarly, as import- take place primarily in import-competing competing producers become more efficient, industries, not in export industries. they would expand output on the basis of the Furthermore, it is hardly possible to predict 21 the equilibrium exchange rate (i.e., OL) for will exist at all, will be imperfect and credit the end of the adjustment period on which will not readily be obtainable. But the case for current planning would be based. The most giving one industry special treatment relative one can say is that extreme overshooting of the to other industries has still to be made. current exchange rate could be avoided by Hence, the case for providing temporary providing a temporary uniform tariff well infant-industry protection for specific above the basic rate (say 10 percent) industries appears weak, though the case for appropriate for revenue reasons alone. But some general transitory protection, on the such a tariff does discriminate against exports, grounds outlined above, is stronger, at least if and it must of course be temporary. one expects efficiency improvements to be greater in import-competing than in export industries. But whether the temporary Infant industry protection and a hard tariff protection is general or specific, it is vital that path a declining tariff rate path be established and committed to in advance. One might call this a The general point of the preceding hard tariff path. A soft tariff path is one that is discussion is that there can sometimes be a not clearly established in advance, or if a case for temporary protection through tariffs commitment is made, it is not firmly adhered (quite apart from revenue tariffs). But the to. In that case, if an industry fails to fulfills protection of one industry is always at the its promise, tariff making that responds to expense of other industries. In the example just interest group pressures will prevent tariff given, import-competing industry is protected rates from declining predictably as they at the expense of export industries, and the should.13 assumption (not necessarily justified) was that gradual improvements in efficiency would emerge in the former and not the latter. If an industry seeks infant-industry protection to cover a period that would otherwise be loss-making in order to build up experience, markets, and so on for a later profitable period when it would not need protection, it is usually suggested that two questions be asked. First, why is the industry unable to obtain credit from banks or investors to cover its initial losses? second, why are its problems and future prospects different from those of other industries? In the case of the former Soviet republics, it can reasonably be assumed that the capital market, insofar as it 22 4. The Free Trade Area Issue Let us suppose that the problem does not arise for other republics. For a variety of reasons, the former Soviet republics may be tempted to impose The question then is whether the uniform restrictions on trade with each other. Because tariff should apply to all imports or only to of the extreme specialization, the Republics are those from outside the former Soviet Union. now highly integrated, and while the degree of On the one hand, if the competitiveness integration may naturally decline when trade problem is really caused by an inflow of with the outside world is opened up, forcing a imports from outside as the economy is further decline through trade restrictions would suddenly opened up, the problem might be impose undue dislocations and costs. Thus (as dealt with by imposing the tariff only on discussed earlier), there is a strong case for outside imports and preserving free trade with forming a free trade area and committing to it other republics. On the other hand, the for a long period ahead. republic concerned may be becoming much less competitive relative to other republics, thus facing the additional problem of trade Possible arguments against a free trade area deflection (discussed below). If it maintains free trade with other republics, imports may Yet, in practice, a free trade area may not flood in from those republics, whether be established, if only for nationalistic reasons. originating there or in transit from outside the And there are arguments on the other side of former Soviet Union. the issue as well.14 If the exchange rate becomes severely overvalued, the republic may not be able to resist imposing the uniform tariff on all Fixed exchange rate imports, including those from other republics: the free trade area may be endangered. The Suppose that one republic has committed moral is that if individual republics establish a itself to a fixed exchange rate (perhaps fixing firmly fixed exchange rate regime or its currency to the deutschemark) for the deliberately overvalue the rate in the short run, reasons discussed earlier, and soon finds that it real problems can result that endanger the has overvalued its exchange rate, at least in the continuance of a free trade area. Big problems short run. Even without a commitment to a for trade policy are created by a decision to fixed rate, it may have chosen to overvalue forego the exchange rate instrument. rate to avoid a temporary excessive devaluation (overshooting) of the rate. It might then deal with the problem by imposing or Revenue tariff raising a uniform tariff to be reduced as the country's industries become more competitive. A uniform tariff designed to raise revenue could be imposed either on imports from 23 outside only-maintaining a free trade area too high, the trade-creation effects of with the other republics-or on all the maintaining a free trade area while imposing republic's imports. If the tariff is imposed only revenue tariffs on outside imports are likely to on outside imports, the tariff rate will have to outweigh trade diversion effects. The aim be higher to yield the same amount of revenue. should be to maintain the free trade area. A tax on inter-republic trade is clearly a convenient source of revenue, a source that is forgone if a free trade area is to be Tarffs for particular industries maintained. If a free trade area is maintained, trade will be less with countries outside the Republics might impose tariffs to deal with former Soviet Union, but restriction of trade the short-term employment problems of with other republics will be avoided. A bias particular industries when their economies are will be introduced against trading with the opened up to trade with the outside world. The outside world relative to inside trade, (the pressure for such protection is likely to phenomenon of "trade diversion," discussed in become significant once enterprise losses cease the theory of customs unions). Indeed, this to be readily covered by subsidies from the bias against outside trade would exist even if banking system-that is, by money creation. the rate of tariff on imports from outside the Proceeding then to second-best analysis, if a customs union did not have to be increased free trade regime with other republics is when inter-republic tariffs are forgone. maintained, such tariffs might conceivably lead Clearly a high tariff that created excessive to trade diversion, with extra imports from bias against trade with the outside would be other republics replacing imports from outside. undesirable because foreign trade would then While this effect is conceivable, it is unlikely be unable to substantially increase competition to be an important one because of the high in the domestic market-a major benefit of degree of specialization. Insofar as other such opening up. A supplier of a product from republics also produce the product, they may republic B should face competition from have similar short-term competitive problems. imports from outside the former Soviet Union Thus, these special short-term tariffs-if they in the market of republic A. But the starting are used-are probably best imposed only on point-the recent situation, before opening imports from outside while an inter-republic up-is an extreme bias against imports from free trade area is maintained. outside, with no competitive imports. Opening the economy to trade from outside would diminish this bias even with tariffs of 10-20 Price controls and export taxes percent. One might regard the remaining bias as acceptable, given the advantages of A republic may choose to maintain some maintaining free trade-keeping the greater price controls and keep prices of certain goods part of existing inter-republic trade going (and to its domestic consumers below free market keeping costs down). Provided tariffs are not levels. As discussed above, to prevent all of 24 these goods from being exported at world other a low tariff. In a customs union the two prices, export controls or taxes would be republics would need to have the same tariff required to supplement price controls. The rates (and export taxes) on external trade. For question then arises whether export controls or trade policy purposes, they would be more like taxes should also apply to exports to other a single country, with a common external tariff republics. structure. The republics could also form a free trade area for some goods and a customs Clearly, from the point of view of union-in effect, a partial customs union-for preserving a free trade area and getting all its others. Given a desire for free trade between benefits, taxing or controlling exports to other the republics, the choice between free trade republics is undesirable. There would be no area and customs union involves a balance of need for such export taxes or controls if considerations. similar controlled prices applied in the other A free trade area creates the problem of republics. But if some other republics had free trade deflection. If republic A has a low or market prices (or much higher controlled zero tariff on imports from outside, while prices), sales would be diverted from the republic B has a high tariff, goods from domestic market to the other republics in the outside will tend to be imported into republic absence of controls or taxes. Thus, it would be B via republic A, in effect evading republic difficult to avoid export controls or export B's high tariff. From the perspective that low taxes, which would breach the free trade area tariffs or free trade is desirable, this is an principle. To preserve a free trade area, example of good policies driving out bad. But republics would either have to avoid domestic the protectionist republic is unlikely to accept price controls completely or coordinate them this outcome. To avoid trade deflection, trade with the other republics. This is an important barriers between republics A and B would issue at the time of writing (January 1992). have to be set up to check the origin of goods, Republics are under pressure to follow Russia with tariffs levied on goods originating from in price liberalization since export taxes or outside. This process can get very controls are difficult to impose, and also complicated: goods imported into high-tariff undesirable. republic B from low-tariff republic A may have components originally imported from outside but with value added in republic A. A Free trade area or customs union? certificates of origin system is usually used, opening up opportunities for arbitrary So far no distinction has been made between bureaucratic decisionmaking. The problem a free trade area and a customs union. Two would be avoided if the differences in tariff republics that form a free trade area could still levels were small or if transport costs were have distinct policies influencing trade with the high. From this point of view then (unless outside world. One republic might impose a tariffs are low in any case), a customs high tariff on goods imported from outside, the 25 union-where there is no incentive for trade other. This, indeed, has been the position in deflection-is clearly preferable. the European Community." The problem with a customs union is It is also conceivable that two or more political: the republics would have to agree on republics would form an area of monetary the common tariff policy to be applied to integration but not an area of free trade: they outside trade, and this might be difficult. For would maintain fixed exchange rates relative to example, the survival of an industry in one each other, or have a common monetary republic might be threatened by the opening up policy, and still feel free to impose trade of external trade, even though the industry restrictions on each other. For example, for might reasonably be expected to survive if many years up to 1976, Mexico maintained a allowed time for adjustment. Thus, the fixed exchange rate to the dollar and yet republic may want to impose a temporary imposed restrictions on imports of US (and infant-industry tariff. But other republics, as other) goods. And within Canada-an area of net consumers of the product concerned, complete monetary integration-some would benefit from free trade. restrictions have been imposed by the The general conclusion is that all these provinces on imports of goods or services problems would be avoided if the use of tariffs from each other. But the latter case is unusual. (and import restrictions) were minimized, and In any event, it is desirable that an area of if tariffs were kept low. Insofar as tariffs are monetary integration also be a free trade area. used, it would be better to maintain a customs An inability of two countries in a monetary union and to establish some collective union to adjust their exchange rate relative to arrangement among the republics to determine each other is likely to lead to excessive use of the common external tariff. Possibly, the trade restrictions when an adverse shock members of the customs union could agree to occurs that increases local unemployment. establish a semi-independent tariff commission, There has to be some wage flexibility to take whose constitution would include some general over the role of the exchange rate. If the rules about tariffs-for example, that any tariff republics were free to impose tariffs or above a certain rate should be maintained for quantitative restrictions on trade while barred no more than a defined number of years. from altering exchange rates, a high level of restrictions might well result. Finally, while an area of monetary Monetary integration and trade integration integration should also be a free trade area, the case for a free trade area may stand even if the An area of monetary integration need not republics do not form an area of monetary coincide with an area of trade integration. integration. Thus, two republics might have separate currencies and exchange rate policies and still commit themselves to free trade with each 26 5. Some General Principles and diminish in importance for two reasons: supplies from outside may replace supplies One approach to trade policy is, in effect, from other republics, and excessive and to have no trade policy. Currencies would be artificial specialization may be modified or convertible, at least for current account ended as natural market forces lead to transactions, and all use of quotas, tariffs, increased decentralization of production. 16 export taxes, and export subsidies would be But measures deliberately designed to reduce foresworn. Credit would be available for inter-republic trade (possibly for nationalistic export development, as for other activities, on reasons) would, at least, in the short run cause the basis of normal banking principles severe dislocations. practiced in market economies. All enterprises, state-owned and private, would be free to * All quantitative and control measures engage in foreign trade themselves or to use should be avoided so as to minimize rent- any intermediaries they chose-they certainly seeking, bureaucratic decision-making of a would not have to use state trading detailed kind, and the delays that go with such organizations. This would be a true "free measures and raise the costs of trading. Only trade" policy and could well be the most tariffs and export taxes should be used as desirable policy, at least for the normality instruments of trade policy. period. But, as already discussed, there are some 0 Tariff and export tax structures should be reasonable arguments for tariffs and possibly very simple. It might be best if there were just for export taxes, especially to raise revenue. one uniform nominal tariff or export tax for And strong pressure for trade intervention, revenue purposes. Proceeding to second-best particularly for protection from imports possibilities, a uniform tariff might be varied coming from outside the former Soviet Union, over time, since some case can be made for can be expected. It is also probable that the modest variability. Possibly the uniform tariff same forces and attitudes that prevent market might not be applied to all imports. Perhaps it economies from attaining completely free trade might be supplemented by a limited number of (and that, for example, have stood in the way special tariffs, or there might be some of the rapid completion of the Uruguay Round exemptions (drawbacks for imports used as of trade negotiations) will develop in the inputs in export production). If the uniform republics of the former Soviet Union. With tariff rate is kept low-or if it starts high and these factors in view, the following four is gradually lowered-the resulting distortions general principles should be kept in mind. would not be great and would be compensated by the administrative and other advantages of a As far as possible, the republics should simplicity.17 not establish barriers to existing trade. This trade should be encouraged to continue, a Finally, transparency in trade policy is though it may gradually change its character highly desirable. Of course, a simple uniform 27 tariff is indeed transparent and presents no implications of opening up, of introducing problem. But the tariff and export structure current account convertibility and removing might get complicated by various special tariffs any controls on imports? I consider the market or exemptions to the basic uniform tariff. An for a single, potentially import-competing institution such as a tariff commission might product. It should be understood that the be set up to advise on, and possibly to position and slope of any curve such as those determine, the tariff and export tax structure in figure Al would be quite uncertain to and to analyze its economic effects. The participants in the market and may change commission should be independent of the day- rapidly. to-day politics, and its decisionmaking In figure Al Po is the price before processes should be open. If several republics liberalization, DD is the demand curve, and SS agreed on forming a customs union, the tariff is the supply curve. Initially, with neither price commission would have to be a joint one, with nor trade liberalization, output is at point A. If members appointed by the various price liberalization were introduced without governments. Furthermore, it should be trade liberalization and producers were concerned with the interests of consumers, and competitive (I assume that buyers are), output not just producers. would rise to point B. Of course, the price would rise, with inevitable and problem- creating redistributive effects. But that might Appendix be accepted as the cost of inducing increased supplies into the market. This paper has been concerned mainly with Now problem one. Supplies may be the adjustment period, not with the transition monopolized (as they very often are in the period now in progress and whose success is former Soviet republics). It will pay to keep still uncertain. Thus, the paper hardly deals supply below point B in order to raise the with the immediate problems that go well price further. The profit-maximizing price beyond the issues discussed in this paper-such might be at point C, so that supply would as the need for a legal framework for private actually fall, thus defeating the objective of activities and a market, not to speak of major inducing increased supplies. The monopolist, redistributive effects. Indeed, it must be lacking experience of determining market admitted that the paper deals with the easy prices might not have judged the demand issues, and so may seem somewhat unrealistic. elasticity correctly and might have raised the But like the other writings to which I have price so much that it settles on a point like E, referred, it does try to look ahead, perhaps where hardly anything is bought. Anecdotes with an implied optimism. reported in the press tell us that this has been In this appendix I use a simple diagram to happening. No doubt this producer will feel highlight two problems of the transition, out the way towards point C. focusing on this question: assuming that there is price liberalization, what are the 28 Figure Al: Implications of opening up the economy, with price liberalization Ps D Gantity l%ure 3 The apparent solution is to open up the will depend on the pattern of world prices, on economy. A price will eventually be set by the the degree of substitutability of foreign for cost of imports at the prevailing exchange rate, particular domestic goods, and so on, and also also allowing, of course, for transport and on the exchange rate, which brings about a other transaction costs. If this price is below general equilibrium adjustment when many P2, it will achieve the objective of limiting markets are being opened up. Perhaps the monopoly exploitation and if it is at or below import price will be below Po; possibly it will P1, it will eliminate monopoly exploitation be well below. In that case, domestic output completely. That is the standard argument will fall, and perhaps even cease. We now (also given in this paper) for opening up, quite have the familiar unemployment problem. To apart from the comparative advantage cope with the monopoly problem we have argument. created the possibility of a new short-term But now we get problem two. It is quite problem. uncertain where the import price will be. It 29 Bibliography Aslund, Anders. 1991. Gorbachev's Struggle McKinnon, R.I. 1991. "Foreign Trade, for Economic Reform, 2nd ed.Ithaca, NY: Protection, and Negative Value-Added in a Cornell University Press. Liberalizing Socialist Economy." In RI. McKinnon, The Order of Economic Liberalization. Baltimore and London: The -Cooper, R.N. 1991. "Opening the Soviet Johns Hopkins University Press. Economy." In Merton J.Pack et al., eds, What Is to Be Done? New Haven: Yale University Press. Tarr, D. 1991. "Problems in the Transition from the CMEA: Implications for Eastern Corden, W.M. 1971. The Theory of Europe." Washington, D.C.:World Bank. Protection. Oxford: Clarendon Press. pp 2342. Williamson J., ed. 1991. Currency Gros, D., and A. Steinherr. 1991. Economic Convertibility in Eastern Europe. Reform in the Soviet Union: Pas de Deux Washington, D.C.: Institute for between Disintegration and Macroeconomic International Economics. Stabilization. Princeton Studies in International Finance No. 71. Princeton, N.J.: International Finance Section, Princeton University. Havrylyshyn, 0., and D. Tarr. 1991. "Trade Liberalization and the Transition to a Market Economy". PRE Working Paper 700. Washington, D.C.: World Bank. Havrylyshyn, 0., and J. Williamson. 1991. From Soviet DisUnion to Eastern Economic Community? Policy Analyses in International Economics No.35. Washington, D.C.: Institute for International Economics. Litwack, J.M. 1991. "Legality and Market Reform in Soviet-Type Economies." Th Journal of Economic Perspectives 5(4):77- 89. 30 Notes 1. For background on the recent state of the Soviet economy, see International Monetary Fund et al. (1991) and Aslund (1991). Many issues discussed in this paper are also discussed in International Monetary Fund, et al. (1991), in Williamson (1991), and in Havrylyshyn and Williamson (1991); the last deals particularly with monetary stabilization, exchange rate policy, and financing of bilateral payments imbalances, a subject that is not discussed here. See also Tarr (1991), Havrylyshyn and Tarr (1991), Cooper (1991), and Gros and Steinherr (1991). 2. For descriptions of the system, see Aslund (1991) and International Monetary Fund et al. (1991, chap.IV.3). 3. See Williamson (1991, 376-380) for discussion of concepts of convertibility. 4. Like the economist in the famous fable of the can and the can-opener. 5. See Aslund (1991). 6. For details, see International Monetary Fund et al. (1991, pp. 36-38). 7. The theory of dual exchange rates is applicable to studying the implications of such dual economies. Many developing countries have had an official--controlled-exchange rate, and a free or black market rate. Over time the relative importance of the free rate has increased. The economic implications of such arrangements have been much studied (for the theory, see Corden 1971, pp. 87- 92), and the analysis is relevant for the socialist transition societies. 8. The effects of capital movements could be absorbed by a floating exchange rate applying only to capital transactions (and, perhaps, to tourist transactions). In other words, as has been widely suggested, there could be a dual rate system. But this would still require exchange controls to keep the two markets separate-to prevent capital movements taking place at the official rate. 9. This argument derives, essentially, from the theory of optimum currency areas. 10. Perhaps even more important than the gains for trade are the gains for foreign investment. If the Latvian currency, for example, were fixed to the deutschemark, foreign investment from Germany and indeed, from other members of the Exchange Rate Mechanism of the EMS, would surely be encouraged. 11. In the case of Ukraine a process of monetary disintegration is under way, the details of which are not really relevant here. 12. This is A.P. Lerner's "symmetry theorem." It is explained fully in Corden (1971, 119-22). 13. McKinnon (1991) has noted that some industries in the ex-Soviet Union probably produce negative value added at world prices--the cost of energy inputs valued at world prices is greater than gross output valued at world prices. (The concept of "negative value added" is expounded in Corden 1971, 31 51-55.) Such industries have survived because of excessively low domestic energy prices in the Soviet Union. He suggests that if efficiency improvements and reduced energy use would eventually turn them into (sufficiently) positive value-added producers, they should be protected. But this is just an extreme case of the broader issue of whether infant industry protection should be provided. Even industries that produce positive value added may be uneconomic in the short run and yet economic eventually. 14. Gros and Steinherr (1991, pp. 33-38) have an extensive discussion of whether a Soviet customs union should be maintained. They argue that the non-Russian European republics will eventually trade more with the European Community than with Russia, so their interests lie with joining a European rather than a former-soviet customs union. This view implies that the extreme specialization will be greatly modified during the adjustment period. They may well be right. But so far the European Community has been notably unwelcoming to new members from its east (and their exports). 15. In the European Monetary System (EMS), exchange rates have frequently been realigned relative to each other even though certain common rules have been followed and short-term fluctuations have been avoided. Hence, the EMS has not been an area of monetary integration. 16. Once transportation within the former Soviet Union is properly costed some of this specializat;on may also be reduced. 17. A uniform nominal tariff, particularly if it does not apply to all imports, is unlikely to produce a uniform effective tariff structure (the effective tariff rate refers to protection in relation to value added). It is thus likely to yield somewhat uneven incentives for domestic production, favoring industries that get high effective protection, possibly because they use imported inputs on which there are no tariffs or inputs that are also exported, so that their prices are determined by export, not import, prices. 32