THE WORLD BANK Work in progress 32530 for public discussion Deeper Integration and Trade in Services in the Euro-Mediterranean Region South/ern DI)11i(eiiosisofwtllt Eii^opeaui p Ne,ighbourhoodPolicy ¢:~~~ _ 4 A I)a//,i(// I/li//( '-.I'/f( 11., / Jointly financedby the European Commission andthe World Bank Deeper Integration and Trade in Services in the Euro-Mediterranean Region Southern Dimensionsofthe EuropeanNeighbourhoodPoligi DanielM,iller-Jentsch THE WORLDBANK EUROPEAN COMMISSION Copyright ( 2005 / The World Bank The International Bank for Reconstruction and Development 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rightsreserved Manufactured in the United States of America First Printing: October 2004 printed on recycled paper 1 2 3 4 5 06 05 04 the resultsof the Bank's work to the development community This World Bank paper is published to communicate with the of this paper has not been prepared in accordance with the least possible delay. 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Vii ACKNOWLEDGMENTS ............................................................. viii ABSTRACT ............................................................. ix ABBREVIATIONS AND ACRONYMS .............................................................. x EXECUTIVE SUMMARY ............................................................. xiii INTRODUCTION ............................................................. xxi 1. DEEPER INTEGRATION .I 1.1 The Continuum of Deeper Integration .3 1.2 The Importance of Backbone Services .5 1.3 Concentric Circles of European Integration .9 1.4 EU Enlargement and Prospects for Euro-Mediterranean Integration .12 2. TRADE IN SERVICES .19 2.1 The Need for Services Sector Reform 11 2.2 The Policy Implications of Trade in Services .22 2.3 Multilateral Liberalization through the GATS .24 2.4 Regional Liberalization in the Euro-Mediterranean .28 3. THE MAIN BACKBONE SERVICES .35 3.1 Transport and Logistics .37 3.2 Financial Services .45 3.3 Telecommunications .52 3.4 Electricity.57 4. OTHER SECTORS AND THEMES .65 4.1 IT-Enabled Services .67 4.2 Business and Professional Services .69 4.3 Distribution Services .71 4.4 Tourism Services .72 4.5 Competition Policy .75 4.6 Public Procurement .77 CONCLUSIONS: FROM STRATEGY TO ACTION ............................................................... 79 ANNEXES ............................................................... 81 Annex A: NAFTA and its Lessons for Deeper Regional Integration ...............................................83 Annex B: Rules of Origin as an Impediment for Deeper Regional Integration ................................86 Annex C: Regional versus Multilateral Liberalization ofTrade in Services .................................... 88 Annex D: Business Trends inthe Textile Industry and their Implications for the MPs ................... 91 Annex E: Glossary of Selected WTO and GATS Terms .............................................................. 93 Annex F: Sector Classification for GATS Schedules Recommended by the WTO ......................... 96 ..i ...........................................97 BIBLIOGRAPHY BoxEs Integration .6 1.1 NAFTA as a Precedent for Deeper North-South Integration .8 1.2 Rules ofOrigin as an Obstacle to Deeper Regional 1.3 The European Neighbourhood Policy.10 1.4 The Planned U.S.-Middle East Free Trade Area .13 ofLast Resort .17 1.5 China's Emergence as the World's Manufacturer Harmonization .24 2.1 Regulatory Convergence versus Regulatory and Development .25 2.2 The European Commission Strategy on Trade 2.3 Regional versus Multilateral Trade Liberalization .27 .29 2.4 Migration and the Temporary Movement of Workers and the Balkans .32 2.5 Trade in Services Liberalization in Latin America Services in the Textile Industry ..38 3.1 Global Competition, Geographic Proximity, and Backbone .41 3.2 Regional Integration and Transport Reform in Mexico Transport Liberalization .43 3.3 The European Neighbourhood Policy and Air in Eastern Europe .47 3.4 Financial Market Reform and Regional Integration Periphery .51 3.5 FDI Spillovers: Two Examples from the European in Latin America .55 3.6 Regional Consolidation between Mobile Phone Operators Telecom "Reference Paper". 57 3.7 Domestic Regulation and Multilateral Disciplines: The .60 3.8 Cross-Border Cooperation between Sector Regulators 3.9 The Baltic SeaElectricity Ring and Power Pool .62 4.1 Health Tourism and Retirement Abroad .74 DIAGRAMS ............................................. xxii Non-oil Exportsand FDI Inflows Compared to Potential Values .3 1.1 Share ofthe EU in MP Trade .5 1.2 Three Cases ofNorth-South Integration Compared the CEE Accession Countries .14 1.3 FDI Flows from the EU to the Arab MPs and for Textile and Garments .17 1.4 MENA and China Share of World Market for Tunisia .23 2.1 Estimated Welfare Gains from Trade Liberalization 39 3.1 Freight Costsfor Imports .. the Arab MPs Compared .42 3.2 State-Ownership in Airlines: South America and 44 3.3 Lebanon Customs Reforms .. .. 47 3.4 Share of MajorityForeign-Owned Banks 50 3.5 Stock Market Capitalization .. iv 3.6 Fixed and Mobile Telephone Connections .54 3.7 Electricity System Losses .58 3.8 Investments in Infrastructure Projects with Private Participation .63 TABLES 1.1 MPs: Population, GNI, and Trade .............................................. 4 1.2 Measurements ofIntegration into Global Production Networks ..............................................8 1.3 CEECs: Population, GNI, and Trade ............................................. 12 2.1 Services Sectors in the MP Economies ............................................. 21 2.2 Sectors Bound under the GATS ............................................. 26 2.3 Services Trade in the MPs ............................................. 28 3.1 South America: Open Skies and Traffic Growth with the USA ............................................ 42 3.2 Financial Services Commitments under the GATS ................. ............................ 48 3.3 Financial Market Indicators ............................................. 49 3.4 Status of Selected Telecom Reforms in the Arab MPs ....................... ...................... 56 4.1 Tourism Statistics ............................................. 73 v FOREWORD This study was prepared in the run up to European Union enlargement and in view of its economic implications for the countries on the southern European periphery. The paper analyzes the importance of trade in services for the integration of non-EU members into the European Single Market. It is a timely contribution to the European Neighbourhood Policy of the European Union, which was launched in March 2003 and is now gaining momentum. The paper's focus on trade in services, also provides a contribution to the ongoing debates on the World Trade Organization's Doha Round and the Doha Development Agenda. The study suggests that further liberalization of trade in services would be a critical factor to deeper integration with the enlarged European Union-which accounts for a quarter of global GDP and foreign direct investment. The urgent need for a trade-driven growth strategy for the countries of the region was highlighted by the World Bank study "Trade, Investment, and Development in the Middle East and North Africa-Engaging with the World," published in 2003. The planned Euro-Mediterranean free trade area for goods is a first step into that direction, but additional measures are needed. The study argues that the liberalization of services trade would be an essential part ofthis integration process. This study analyzes the adjustment needs and policy options associated with deeper integration. Besides a general discussion of deeper integration and trade in services liberalization, the study contains detailed assessments of individual sectors-especially the backbone services (transport, telecommunication, financial markets, electricity) and other sectors of relevance for deeper integration (tourism, IT-enabled services, distribution services). Effective donor coordination is crucial to help realize the ambitious reform strategy that needs to be implemented to take advantage of the opportunities offered by the European Neighbourhood Policy. The European Commission and the World Bank are two key players in the region and have a strong track record of working together. This report was prepared by a joint World Bank-European Commission program and is thus testimony ofsuch partnership in action. Emmanuel Forestier Karl Falkenberg Director Director Finance,PrivateSectorandInfrastructure RegionalandBilateralTradeRelations Middle EastandNorth Africa Region DirectorateGeneral Trade The World Bank EuropeanCommission vii ACKNOWLEDGMENTS ofElisabetta in her capacity as the PPMI This study was written under the supervision Capannelli, meeting presented at the Euro-Mediterranean Program Manager. The research started out as a paper in April Economists' ofExperts on Economic Transition in Brussels and at the Forum in Washington were provided Hauer and Bertin Martens from 2003. During that period, useful comments by Ulrike Capannelli, Maurice Schiff, and Aaditya Mattoo the European Commission (EC) and by Elisabetta then expanded study. Several draft from the World Bank (WB). The paper was into a comprehensive review European Commission and the World Bank, and versions were widely circulated within the from Bartek Peer review comments were gratefully received meetings were held in Brussels. Damien Geradin (University ofLiege), Ulrike Hauer (EC), and Kaminski (University of Maryland), from Paul Brenton (WB), Helena Farrukh Iqbal (WB). Inputs on specific sections or themes came European Francois-Charles Laprevote Tang (WB), Michael Emerson (Centre for Policy Studies), Legoff (OECD). The research for this study was presented (EC), Vicent Grimaud (EC), and Gregory and the at several conferences-including the Marseille conference on Trade, Competitiveness, and 2004-and the author also benefited from the feedback Knowledge Economy in March the help of discussions. During the editing process, suggestions that were raised in the associated Henriette Mampuya was much appreciated. i Meditefmacan (PPM1) is a joint Tbe Programme on Private Paicipatfmion Infimtructure BE s. Its mndabe is to promote World Bank-European Commion program based in of the southern PPMI caxries out infsructue sector refom in the countries Mediteaneanm govemnments; conferences and truning I reseh; provides direct policy advice to organizes prepare and coordinate technical assistance projects seminars; and helps its pirt institutions and private The assessment and | related to infrastructe policies sector development. represent the views of the World recommendations presented in this paper do not necessarily to the economic policy Bank and the European Conmmission, but are meant as a contribution debate in tbe region. by the PPMI program. infonmation, please This is the fouth regional sttdy prepared For further visit the PPMI website at wwwg cog vili ABSTRACT Deeper economic integration with the enlarged European Union-which accounts for a quarter of global GDP and foreign direct investment-could become a main driver for economic development in the southern Mediterranean countries. The planned Euro-Mediterranean free trade area for goods is a first step intothat direction, but additional measures are needed. Especially the liberalization of services trade and the comprehensive domestic reforms this entails would strengthen the linkages with global and European markets. This study analyzes the adjustment needs and policy options associated with deeper integration between the two sides of the Mediterranean Sea. It puts specific emphasis on the dynamics of deeper integration at the company level and their respective policy implications. Besides a general discussion of deeper integration and trade in services liberalization, the study contains detailed assessments of individual sectors-especially the backbone services (e.g. transport, telecommunication, financial markets, electricity) and other sectors of relevance for deeper integration (tourism, IT-enabled services, distribution services).Even though the focus is on regional integration, multilateral liberalization issues are factored into the analysis (e.g. the GATS, the WTO Doha Round) and options for the pursuit of an "open regionalism" are explored. ix ABBREVIATIONS AND ACRONYMS AA Association Agreement des Telecommunications ANRT Agence Nationale de Reglementation ASA air serviceagreement Cooperation Committee Baltrel Baltic Ring Electricity BPO business process outsourcing CEE Central and Eastern Europe country CEEC Central and Eastern European Energy Regulators CEER Council of European Studies CEPS Centre for European Policy CSP Country Strategy Paper DDA Doha Development Agenda WTO) DSB Dispute Settlement Body (of the and Development EBRD European Bank for Reconstruction ECAA European Civil Aviation Area EDI electronic data interchange EEA European Economic Area Association EFTA European Free-Trade Bank EIB European Investment Partnership EMP Euro-Mediterranean Policy ENP European Neighbourhood ofTransmission System Operators ETSO European Association EU European Union Organisation EURATEX European Apparel and Textile FDI foreign directinvestment network forthe southernMediterranean FEMISE EU-sponsored economic research Program FSAP Financial Sector Assessment FTA free trade area Americas FTAA Free Trade Area ofthe Area GAFTA Greater Arab Free Trade on Trade inServices GATS General Agreement on Tariffsand Trade GATT General Agreement GCC Gulf Cooperation Council GDP gross domestic product GNI gross nationalincome GNP gross nationalproduct Agreement (ofthe WTO) GPA Government Procurement x GSM Global System for Mobile Communications (a technical standard) IAS international accounting standard IASC International Accounting Standards Committee ICT information and communication technology IMF International Monetary Fund IPP independent power plant IT information technology ITU International Telecommunication Union JIT just-in-time production MEDA Mesure d'Acccompagnement (EU financial assistance program for the MPs) MEED Middle East Economic Digest MENA Middle East and North Africa MERCOSUR Common Market of the South (Mercado Commuin del Sur) MFN most-favored-nation principle MP Mediterranean Partner NAFTA North American Free Trade Agreement NMS new member state NT national treatment (WTO principle) NTB non-tariff barrier OECD Organization for Economic Cooperation and Development OPT outward processing trade PPMI Programme on Private Participation in Mediterranean Infrastructure PPI private participation in infrastructure PPP purchasing power parity PTA preferential trade agreement QIZ qualified industrial zone ROOs rules of origin SME small and medium enterprise TA technical assistance TNC transnational corporation TRIPS Agreement on Trade-Related Aspects of International Property Rights TSO transmission system operator UCTE Union for the Coordination of the Transmission of Electricity UNCTAD United Nations Conference on Trade and Development U.S. United States of America WTO World Trade Organization xi EXECUTIVE SUMMARY Many countries ofthe Middle East and North Africa (MENA) region have experienced two decades of economic stagnation and marginalization in the global economy. The exports of the region are small, non-dynamic, and poorly diversified. The entire MENA region with its 300 million inhabitants, for instance, has fewer non-oil exports than Finland or Hungary-with 5 and 10 million inhabitants respectively. Foreign direct investment (FDI) accounts for only half a percent of GDP and a mere two percent of Europe's FDI go to its southern neighbors. With the exception of a few countries (e.g. Tunisia, Israel) andmarkets (e.g. textiles), the region has failed to use trade and FDI as an engine for economic development-in stark contrast to countries such as Chile, Malaysia, or Slovakia. EU enlargement to the East and fierce global competition by countries like China or India, threaten to further erode theirinternational competitiveness. The large performance gap between the southern Mediterranean and comparator countries in terms of exports and FDI has, however, an important positive implication. By closing only half of this gap over the coming decade, the region could quadruple its per capita growth rate from one to four percent of GDP. This is urgently needed to raise living standards and to create jobs for a rapidly growing population. To achieve this, the southern Mediterranean countries should develop a strategy for better integration into the global economy. With the neighboring European Single Market accounting for a quarter of world trade and outward investment, deeper integration with the EU should be a core element in any such strategy. This will require the southern Mediterranean countries to implement comprehensive policy reforms as a means to improve the investment climate, raise productivity, and eliminate a host of trade barriers. The Euro-Mediterranean Partnership, launched in 1995 between the European Union (EU) and its 12 Mediterranean Partners (MPs), has not yet translated into better trade and FDI performance for the eight Arab MPs.1 The agreed upon free trade area is for goods only and excludes the two-thirds of total value added that is being generated in the services sectors and in agriculture. Not surprisingly, most studies that have estimated the potential welfare gains of the Euro-Mediterranean free trade area for the MPs, expect static growth effects ofmerely 2 percent of GDP. Even the limited free trade area that has been agreed upon will take about 20 years to implement, as the deadline for its completion is slipping from 2010 to 2015. In contrast, one of the few studies that looked at the potential effects of deeper integration came to the conclusion that they range from 4 to 20 percent of GDP, depending on the depth of integration. The European Neighbourhood Policy (ENP) that the enlarged EU is developing vis-a-vis its neighbors could provide an appropriate framework for a deepening of the Euro-Mediterranean free trade area with the objective to unlock that growth potential. When contemplating integration options, it should be recalled that the ultimate objective is to reap the gains from trade arising from comparative advantage, scale economies, import competition, knowledge spillovers, and FDI flows. Besides tariffs or quotas, a multitude of non-tariff barriers (NTBs) obstruct economic transactions and resource flows across borders. Most ofthese frictions are induced by inefficiencies in the legal, regulatory, and institutional framework. The objective of deeper integration measures is to remove such non-tariff barriers (NTBs) in order to permit economies to mesh at the micro-level (individual firms or markets). As deeper forms of integration l Two MPs have acceded to the EU in May 2004 (Cyprus and Malta) and two have a special status (Turkey has a customs union with the EU and Israel is a high-income country). The focusof this report is the more homogenous group ofthe eight ArabMPs: Morocco, Algeria, Tunisia, Egypt, Jordan,Syria, Lebanon, and West Bank and Gaza. xiii to yield larger welfare gains. However, since remove a wider range of policy distortions, they tend costs, deeper integration should they can also entail significant negotiation, transition, or compliance priority sectors and policy areas and be pursued in a selective manner. Governments should identify economy terms, an advantage of they should deepen integration gradually over time. In political long-term vision (full economic integration with deeper integration is that it provides a compelling selectively (a la carte)and at multiple global and European markets), but that it can be implemented speeds (starting with countries or sectors that are ready to go ahead). The reason is that In principle, multilateral trade liberalization is preferable to regional liberalization. costs; it increases transparency for traders; and it gives it minimizes trade diversion and negotiation mechanisms Trade Organization (WTO). countries recourse to the dispute settlement of the World agreements. They might On the other hand, there are also important arguments in favour ofregional reforms are less advanced; be easier to negotiate; they permit for progress in areas where multilateral or cultural proximity matters. and they are particularly relevant in markets where geographic be North-South integration with industrialized Especially beneficial for developing countries can potential for trade driven by complementary neighbors. These types of agreements offer greater anchoring of domestic resource endowments, knowledge spillovers, FDI flows, and the external the Arab MPs reforms. The Euro-Mediterranean free trade area is such a North-South agreement and The ideal scenario, however, would be a could benefit substantially from deepening this agreement. and type of "open regionalism"-with the MPs giving priority to multilateral liberalization integration efforts at the regional level. complementing it through carefully selected deeper two precedent cases ofNorth- In developing such a strategy, it is useful to draw policy lessons from of Eastern South integration: the North American Free Trade Agreement (NAFTA) and the process its annual trade European enlargement. Thanks to NAFTA and domestic reforms, Mexico tripled 1994 and 2000 alone. during the 1990s (to $280 billion) and attracted $85 billion of FDI between was equally impressive. A good Progress in the Central and Eastern European countries (CEECs) the share ofthe CEECs in total indicator for the dynamics ofNorth-South integration is trade: both between 1994 and 2000 (to 4 and EU imports and the share ofMexico in total U.S. imports doubled to the eight Arab MPs, whose share in total EU 11 percent respectively). This is in stark contrast is not surprising, since both imports stagnated below 1.5 percent during the same period. That than that between the EU NAFTA and European enlargement involved deeper forms of integration products, trade and its southern neighbors. NAFTA liberalized trade in services, trade in agricultural in a few selected areas (e.g. related topublic procurement, and it pursued regulatory harmonization the EU, but they also adopted the product standards). The CEECs not only liberalized trade vis-a-vis In both of these cases of North- entire setof EU rules and regulations (the acquis communautaire). domestic reforms. South integration, the developing partners also implemented far-reaching way to remove Full regulatory harmonization, as required for EU accession, however, is a complex removed through domestic reforms (e.g. a streamlining of non-tariffbarriers. Most NTBs can best be convergence suffice. The MPs customs procedures). In other cases, more limited forms of regulatory areas, where those are in line should only pursue regulatory convergence with EU rules in policy adjustment. Since the with international best practice and could thus facilitate domestic economic economic development, regulatory optimal type of regulation often varies with the level of policy areas where that is not the case. convergence in North-South agreements should be confined to tools to achieve deeper integration have to be Given these and other considerations, the ideal policy integration between the EU and the MPs assessed on a case-by base basis. In economic terms, deeper Market to the South (the can be conceptualized as the extension of the "four freedoms" ofthe Single labor). This, not necessarily require the full movement of goods, services, capital, and however, does CEECs. A targeted removal oftariffand adoption ofthe acquiscommunautaire, as was the case in the xiv non-tariff barriers through trade liberalization, domestic reforms, and partial regulatory convergence would go a long way in achieving this objective.Overall, the large income gap between the EU and the MPs suggests that the NAFTA model of deeper integration is more appropriate than the CEEC model. As the MPs seek to identify priority areas for deeper integration, reforms in the backbone services- such as transport, telecommunications, or financial services-seem particularly urgent. These services facilitate economic transactions and resource flows across borders and thus act as connectors between economies. To appreciate the importance ofbackbone services, it is useful to understand the dynamics ofoutward processing trade (OPT). Due to business trends such as outsourcing and a focus on core competencies, the production process is becoming increasingly fragmented and labor- intensive production stages are being transferred to developing countries. The "production blocks" in these sliced value chains are being connected by "service links" (e.g. communication, logistics, legal and financial services). Participating in the tightly integrated production networks of the global economy-with just-in-time production and sophisticated supply-chain management-requires access to efficient backbone services. So far, however, the Arab MPs barely participate in international production sharing, which partly reflects the deficiencies in their backbone services. For instance, Turkey or Poland each imported as many parts and components in 2000 as all eight Arab MPs taken together, while their exports of parts and components were twice (for Turkey) and four times (for Poland) as high. Furthermore, the combination of EU enlargement and fierce competition in labor-intensive manufacturing by countries such as China, threatens to erode the competitive position of the Arab MPs in the few markets were they still effectively participate. These countries will need to harness new sources of comparative advantage, and their geographic and cultural proximity to European markets seems to be the most promising one. Exploiting that proximity, however, will require deeper integration efforts and especially more efficient backbone services. In tourism and IT-enabled services, for instance, proximity (common time zone, common languages) can create an advantage, but efficient transport and telecom markets are required to exploit this. In time-sensitive manufacturing-like just-in-time delivery of car parts or in-season replenishments in the garment industry-geographic proximity is also critical. Yet again, it only translates into a comparative advantage if combined with state-of-the-art communications and logistics. Being next door to European markets is a great advantage, but effectively participating in these markets will require comprehensive reforms and the improvement ofservices and infrastructure in the MPs. For a number of reasons, trade in services liberalization could become a powerful policy vehicle for trade-driven growth in the MPs. First, services sectors account for an average of 57 percent of GDP in the eight Arab MPs. Many of these sectors have long been shielded from competition and services liberalization could bring important efficiency gains. Second, services are an important input in other economic activities (they tend to account for 10-20 percent of production costs) and a liberalization of trade in goods without liberalization of trade in services would increase effective rates of protection for the latter. Third, the liberalization of trade in services require comprehensive domestic reforms. As most services are non-tangible and non-storable, their exchange usually requires physical interaction between buyer and seller. Most trade barriers thus come in the form of behind-the-border policies. Lifting these barriers will require very similar reforms as those needed for the sake of domestic economic adjustment (e.g. liberalization of market access, elimination ofred tape, breakup of state-owned monopolies). Not surprisingly, the gains from liberalization in services trade usually exceed the gains from liberalization in merchandise trade. Trade in services can occur through four modes of delivery: cross-border supply (e.g. online services), consumption abroad (e.g. tourism), commercial presence (e.g. foreign bank branches or xv overseeing a construction project). supermarkets), and the presence of natural persons (e.g. engineers significantly between services. However, since The relevance of the different modes varies mode, services associated with FDI and commercial presence tends to be the dominant trade is often Consumption abroad is mainly the employment of domestic workers by foreign service suppliers. supply a feasible mode for relevant for tourism, while technological progress is making cross-border of natural the purpose of service delivery an increasing number of services. The presence persons for temporary should not distort should not be confused with migration, as it is ofa nature. Policymakers across modes. the optimal modal mix and thus liberalization should occur General Agreement on At the multilateral level, trade in services is being liberalized through the The GATS entered into force in 1995, Trade in Services (GATS) under the auspices of the WTO. Separate negotiations after the conclusion ofthe Uruguay Round of multilateral trade negotiations. a few on telecommunications and financial services were subsequently completed. Except for liberalization very far and most sectors, such as tourism and telecommunications, has not progressed that they undertaken unilaterally. A countries have only committed to reforms had already commitments thus one of the main broadening and deepening of multilateral under the GATS is was launched in 2001. Each WTO member can objectives of the ongoing WTO Doha Round, which GATS disciplines-such as the most- select those sectors for which it is willing to subject itself to principle, principle, or the favored nation principle, the national treatment the transparency of the WTO. For each of these "bound" sectors, any institutionalized dispute settlement mechanisms explicitly the country's GATS schedule of remaining trade restriction has to be listed in for various sectors and commitments ("positive list"). Schedules consist ofa matrix of commitments sub-sectors, as well as the four modes of supply. has been limited so far. Four of these countries are The GATS commitments ofthe eight Arab MPs and Gaza). Of the other four, not yet WTO members (Algeria, Lebanon, Syria, and West Bank 7, and Jordan 11. Tourism Tunisia has bound only 3 out of 11 possible sectors, Egypt 4, Morocco bound (by four of the eight Arab and financial services are those sectors that were most frequently services (bound by three countries MPs), followed by communications, construction, and transport made by comparator regions each). Overall, the region lags considerably behind the commitments the Doha negotiations, the MPs countries should such as Eastern Europe or the Balkans. As part of they should also deepen their relatively limited not only bind a greater number of sectors, but use of precommitments-in commitments in bound sectors. They should consider to make greater which they plan to implement in the other words inscribe liberalization measures into their schedules, an important signal to investors, it can future. Just like a regular commitment, this can send it discourages to lobby for trade protection. externally anchor domestic reforms, and vested interests free trade not yet extend to any of the At the regional level, the Euro-Mediterranean area does Agreements under the Euro-Med Process foresee an services sectors. While the bilateral Association upon their entry into force, thisdeadline opening of negotiations on services trade within five years A number of regional policy documents call for an has already lapsed for Tunisia and Morocco. and Euro-Mediterranean Ministers of Trade have extension of the free trade area to services policy options. In any case, the most-favored nation established a working group to study different trade agreements at the regional (MFN) obligations of the GATS, limit the scope for preferential an "open regionalism": multilateral level. The best strategy thus seems to be the pursuit of reforms would attention.They could then commitments and the associated domestic receive priority GATS framework is poorly developed be "topped up" by regional integration in sectors where the is needed for deeper integration (e.g. air transport and electricity), or where institutional cooperation recognition of professional (e.g. between electricity regulators, customs authorities, or the mutual cultural and geographic proximity matter, regional patterns qualifications). In services sectors, where xvi are likely to emerge even in the case ofmultilateral liberalization (e.g. regional branch networks of banks or supermarkets). Given the cultural homogeneity of the Arab MPs, there also seems to be significant potential for South-South integration in some services sectors. One priority sector for deeper integration is transport, which is an important facilitator for trade and tourism. The examples of Mexico and Eastern Europe show that regional integration and transport reforms should go hand-in-hand. Currently, transport inefficiencies in the eight Arab MPs impose economic costs between £3 and 7 billion per year. In maritime transport, reforms would involve the liberalization of port services, the concessioning of major terminals to private operators, and the establishment of landlord ports. Priorities in air transport are increasing private sector participation in key airports and in the sector as a whole, the introduction of competition in ground handling, the restructuring of flag carriers, and the liberalization of international traffic rights. The ultimate objective should be the transition towards open skies regimes and the creation of a regional civil aviation area. In land-based transport, priorities should be given to the restructuring of national railway companies, policy coordination along regional corridors, the liberalization of road freight, and harmonization of standards for cross-border traffic. For a seamless integration of the multimodal system, the streamlining of customs procedures, a removal of frictions at modal interfaces, and policies to increase containerization rates are needed. Given the rather limited GATS provisions on transport and the importance of geographic proximity, liberalization in this sector is best pursued through domestic reforms and regional initiatives. Financial services (banking, insurance, capital markets) are also critical for integration into the global economy. In this sector, domestic reforms anchored by multilateral commitments should be priorities for the MPs. There is much less economic rationale for regional policy initiatives than in the case of transport and the EU policy framework in the sector does not seem readily transferable to less developed neighbors. In most MPs, the degree of state-ownership remains high; capital markets are small and immature; and there is relatively little foreign investment in the sector. This contrasts with the situation in Eastern Europe, where comprehensive policy reforms during the 1990s allowed foreign financial institutions to bring new capital, modern management, and competition to the sector. MPs should strengthen prudential regulation, privatize financial institutions, and gradually open financial markets to foreign investors. These domestic reforms should be anchored by a deepening of GATS commitments in the sector. As Latin America and Eastern Europe have shown, scale economies and the importance of cultural proximity are likely to lead to the emergence of regional branch networks and market structures. Another important backbone service-both for economic development and connection to the global economy-is telecommunications. In telecom, just like in financial markets, the GATS framework is well developed and multilateral liberalization, in combination with domestic sector reforms should be the priority. Even though the rules ofthe EU Single Market largely reflect international best practice, there is little need for regulatory coordination or specific infrastructure linkages at the regional level. Telecom happens to be the backbone service, where reforms in the MPs are most advanced. The introduction of private participation and competition in mobile telephony through the tendering of licenses to mostly foreign investors, has been a huge success. This raised fiscal revenues, triggered significant investments in new infrastructure, and brought dynamic competition with falling prices and an explosive growth in the subscriber bases. In several MPs, the number of mobile connections now exceeds that of fixed lines. Several MPs have also established independent regulators, started to privatize national operators, and liberalized value-added services (e.g. internet access). Overall, however, reforms in fixed-wire have lagged considerably behind those in mobile telephony. A strengthening of pro-competitive regulation (e.g. interconnection rules and more autonomous xvii mobile licenses, and regulators), the complete privatization of telecom companies, the issuing ofthird the full liberalization ofvalue added services are needed to complete the reform process. integration in other Electricity is not a backbone service in the sense that it facilitates economic transactions. With the sectors, but in the sense that physical infrastructure is needed for cross-border in most MPs are still at exception of Jordan and to a lesser extent Morocco, electricity sector reforms The sector remains an early stage, if compared to regions like Latin America or Eastern Europe. regulated monopolies. With dominated by vertically integrated, state-owned, and insufficiently years, but so far demand growing rapidly, very large investments will be needed in the coming interconnection is a private participation is limited to a few independent power plants. As physical (e.g. power pools) are only possible precondition for electricitytrade and deeper forms of integration in this sector should primarily be pursued at among neighboring countries, cross-border liberalization sectors where the GATS framework is least the regional level. In any case, electricity is one ofthe level are a necessary condition for trade and developed. Comprehensive reforms at the national sector provide a good deeper forms of integration in the electricity market. EU-internal rules for the cross-border integration and could serve as a template for the dual pursuit of domestic reforms and basis for regional integration efforts. of Euro- Trade in IT-enabled services could become one of the fastest growing segments chain, specialized services (e.g. Mediterranean trade. Similar to the fragmentation ofthe production and relocated to developing accounting, billing, call centers) are increasingly being outsourced IT jobs will be transferred from countries. It has been estimated that up to 25 percent of traditional large European companies will industrialized to developing countries by 2010 and that 30 percent of has most benefited build "offshoring" in their business plans. India is the developing country that already account for $8 from such business process outsourcing so far. IT-related services exports alone. In billion per year and are supposed to triple by 2008, and 100,000 people work in call centers services to principle, the southern Mediterranean countries seem well placed to provide IT-enabled education, and European markets. They have low wages, a large number of unemployed with higher proximity (proficiency in they enjoy both geographic proximity (same time zone) and cultural those sources of European languages). So far, however, the MPs have barely started to exploit a more conducive comparative advantage. To do so, they need a more competitive telecom sector, services. business environment for foreign investments, and full liberalization ofIT-enabled the sector where Tourism is by far the most important services export of most MPs and arguably advanced. Tourism deeper integration between the two shores of the Mediterranean Sea is most and for a high 44 accounts for around 20 percent of total exports in Egypt, Jordan, and Morocco, vast majority of tourists percent in Lebanon. With geographic proximity an important factor, the of $11 billion per year, come from Europe. The eight Arab MPs earn tourist receipts in the magnitude the sector. Tourism also and in Morocco alone 600,000 people are directly or indirectly employed in (few restrictions to happens to be one of the services sectors that is most liberalized across the region far-reaching GATS commitments). foreign entry, low levels of state-ownership, dynamic competition, to proactively develop this sector through While reform needs are few, several MPs are trying of historic sites, or better marketing. Liberalization of infrastructure investments, the rehabilitation air transport would also help to develop this sector. services facilitating economic transactions and Two services that can also be regarded as backbone Efficient business resource flows across borders are distribution services and business services. consulting, an important part of services-including accounting, management or legal advice-are these services are fairly the overall business environment for any country. Generally speaking, and the recognition liberalized in most MPs, but some restrictions regarding rights of establishment xviii of professional qualifications remain (e.g. for lawyers, doctors, or architects). Given the importance of cultural proximity in many business services (e.g. language, business practices, legal traditions), there seems to be substantial potential for South-South integration among the Arab MPs. Mutual recognition agreements and similar reforms would facilitate deeper integration. In distribution services (retailing and wholesaling), most MPs maintain relatively stringent market access restrictions (e.g. for foreign supermarkets or branded retailers). They should consider more far- reaching GATS commitments in this sector. While there is no economic rational for preferential market access, regional patterns (e.g. cross-border networks of retail outlets) are likely to emerge in response to multilateral liberalization. Besides the sectors reviewed above, a number of other policy areas are relevant for deeper integration. Most important of these is perhaps agriculture. While beyond the scope of this analysis, markets for agricultural products remain among the most protected and distorted on both sides of the Mediterranean. Given different resource endowments, the potential gains from trade driven by comparative advantage are substantial once policy restrictions are removed. More effective cross- border competition in public procurement-which accounts for about 10 percent of GDP-would also be an important instrument to deepen integration with global and European markets. Stricter competition policies in the MPs and the harmonization of product standards are other areas where the economic payoffs from domestic reforms and regulatory convergence are likely to be significant. Given this wide range of policy areas, MP governments should start with those sectors and themes where welfare gains are expected to be greatest. They should not pursue cross-border integration for its own sake, but use it strategically to accelerate and anchor economic reforms at the national level. While multilateral liberalization of trade is often the first best option, a well-balanced form of "open regionalism" seems sensible. Geographic and cultural proximity to European markets are an important source of comparative advantage for many MPs and removing non-tariff barriers to these markets-including inefficiencies in the backbone services-is critical to exploit this. Multilateral commitments should be "topped-up" by more far-reaching regional integration measures in policy areas where multilateral negotiations are progressing slowly or in areas where proximity matters. The EU could use its European Neighbourhood Policy to reinvigorate the partnership with its southern periphery and to provide stronger incentives for economic reforms in the Arab MPs. Specific and binding Action Plans, additional financial assistance for fast reforming countries, and the reciprocal exchange of trade concessions (e.g. access to agricultural markets, more temporary working visas), could all be part ofa more highly-geared incentive regime. A clear vision and a well-designed policy framework for regional integration would also facilitate donor coordination. xix INTRODUCTION This study analyzes how the southern Mediterranean countries could use the liberalization of trade in services as a policy vehicle for deeper integration with the global economy-and particularly with the large European market at their doorstep. Two developments have motivated this analysis: The need to reassess the Euro-Mediterranean Partnership in the wake of EU enlargement and the serious marginalization of the Arab countries in the global economy. Integratingthe SouthernMediterraneaninto the GlobalEconomy An increasing number of low and middle income countries have successfully used integration with global markets to attract foreign direct investment, generate export-led growth, and create jobs in trade-related industries. Examples include the East Asian "tiger" economies; Mexico; and the countries of Central and Eastern Europe. The Middle East and North Africa (MENA) region, however, has almost entirely missed out on the opportunities offered by the process of globalization over the past two decades. An extensive World Bank study, published in 2003, analyzes the low level of trade integration of the MENA countries.2 Whereas most regions increased their trade-to-GDP ratio, the one of MENA actually fell in each of the five-year periods between 1985-99.3 Diversification of exports away from petrochemicals and raw materials, measured by different concentration indices, has been slow and lags far behind other regions. "Finland, with 5 million people, has almost twice the non-oil exports of the entire MENA region," with its almost 300 million inhabitants. "And the Czech Republic and Hungary, with populations of about 10 million, each had greater non-oil exports" (World Bank 2003b). Other indicators tell the same story: Intra-industry trade ratios lag considerably behind those of comparator countries and the percentage of dynamic products (i.e. with growth rates over 15 percent) in the region's non-fuel exports fell from 9.8 percent in 1988 to 2.6 percent in 2000. Besides the low levels of trade integration illustrated by these statistics, the MENA countries have also been sidelined with respect to global capital flows. Between 1986 and 1996, foreign direct investment (FDI) accounted for less than half a percent of regional GDP. Many emerging economies achieved a multiple of that figure. Despite geographic proximity, a mere 2 percent of European outward investment goes to the MENA region. The low performance of the southern Mediterranean with regard to exports and FDI inflows becomes obvious, if benchmarked against average figures for countries with similar levels of per capita income, natural resource endowments, and population. Compared to their potential non-oil exports and FDI inflows, virtually all MENA countries underperform significantly (see diagram on the following page).4 "Only Jordan and Morocco had exports close to what would be predicted. The world's three biggest underperformers are MENA countries (Algeria, Egypt, and Islamic Republic of Iran), and the other MENA countries are all underperformers." In 2000, Algeria, Morocco, and Syria attracted negligible amounts of FDI. Egypt, Tunisia, Jordan, and Lebanon also remained significantly below their potential. This is in stark contrast to emerging economies in Eastern Europe or Asia, who have used global integration as a catalyst for economic development. 2 World Bank (2003b). The World Bank definition of the Middle East and North Africa (MENA) region does include the eight Arab MPs-but not Turkey and Cyprus. On the other hand, it extends to several countries that are not part of the EMP-such as Malta, Libya, Iran, Iraq, Djibouti, and thecountries of the Arab peninsula. 3The respective figures were -4.2 (1985-89), -0.2 (1990-94), and -0.8 (1995-99), compared to +2.7, +6.5, and +5.9 percent respectivelyfor Latin America. 4Benchrnarking and calculationof the "potential" levels from a sample of 42 countries (World Bank 2003b). xxi gap could A positive interpretation ofthese structural deficiencies is that a closure of the performance increase that MENA countries lead to a dramatic increase in economic growth and job creation-an income urgently need. "Even ifonly half with their high unemployment rates and stagnating per capita the next 10 years, per capita GDP the region's trade and private investment potential were realized over from more private investment, growth would jump from 1 percent to about 4 percent a year-half would encourage." To achieve such trade-driven and half from the greater productivity that openness countries to reduce tariff and non-tariff growth, however, the southern Mediterranean will need This accelerate the process of economic adjustment. barriers, improve their investment climate, and integration with their large study argues that a liberalization of trade in services and deeper Union, should be core elements ofany such reform strategy. industrialized neighbor, the European Inflows Compared to Potential Values (2000) Diagram: Non-oil Exports and FDI Relative to Potential Non-oil Exports Compared to Potential IDI Inflows 3j 30- .'W J 1 6~~~~~~~~~~~~~~~~2 0.6 IZ. 5 2 _i g ., do - 42. naturl resources,and population);sample size Source: WorldBank (2003). on openness, 1.0 = potentialexport andFDI values(conditioned Reinvigorating the Euro-Mediterranean Partnership (EMP), and following EU Eight years after the launch of the Euro-Mediterranean Partnership Europe (CEE), the time also seems ripe for a reassessment enlargement towards Central and Eastern Partners (MPs). The of the relationship between the European Union and its Mediterranean would lead to the creation of a Barcelona Conference of November 1995 raised hopes that the EMP Sea. So far, however, the "region of shared peace and prosperity" around the Mediterranean limited. While the reasons for this are economic impact on Europe's southern neighbors has been area (FTA) for goods-the many, progress towards the establishment of the regional free-trade been slower The deadline for its economic centerpiece of the partnership-has than expected. as planned, most estimates completion is likely to slip from 2010 to 2015. Even if implemented are rather small-usually below 5 regarding the economic gains from the agreed tariff reductions and social reforms percent ofGDP. Moreover, the EMP has not yet become a catalyst for economic deeper integration and in the southern Mediterranean, as initially hoped for. This study argues that a promising reinvigorating the economic the liberalization of trade in services offer strategy for dimension ofthe Barcelona Process. countries EU enlargement creates additional impetus for a reassessment. In May 2004, eight CEE to the European (Turkey) has and two MPs (Cyprus and Malta) have acceded Union. A third MP is an official accession candidate. Israel, as the only entered into a customs union with the EU and might eventually become part of the European Free Trade high-income economy in the region, xii Association (EFTA). The process of EU enlargement has two key implications for the southern Mediterranean. First, the EMP will largely boil down to a partnership between the EU on the one hand and the eight Arab MPs on the other. With EU membership not a realistic scenario, the question arises of how the partnership could progress beyond the rather limited FTA that is now under implementation. Second, the full integration of eight CEE countries into the European Single Market will make it more difficult for the Arab MPs to compete for European imports and outward investment. They will need to develop mechanisms to better plug into the enlarged Single Market. Deeper forms of economic integration and especially an extension ofthe FTA to the services sectors seems to offer a way forward. The European Neighbourhood Policy, launched by the European Commission in 2003 for countries bordering the enlarged EU, could provide a well-suited policy framework for such an ambitious undertaking. The first chapter ofthis study argues that economic integration-both with regional trading partners and with the global economy-is a continuum between shallow and deeper forms of integration. It explains that the European Single Market is the most deeply integrated block in the world and that a system of concentric circles has emerged around the EU-in which countries closer to the center are more deeply integrated economically, than those on the periphery. Chapter 1 also discusses the implications of EU enlargement for the MPs and it explores policy options for deeper integration between the EU and its southern neighbors. In particular, it looks at the importance of trade-related services for such deeper integration. The second chapter discusses linkages between trade in services liberalization and national regulatory reform. It assesses to what extent the liberalization of services trade could become a vehicle for deeper Euro-Mediterranean integration. In that context, it explores how regional services liberalization through the Barcelona Process and multilateral liberalization through the WTO could be combined to achieve a type of open regionalism. The third and fourth chapters apply the general insights derived from these discussions to key services sectors (e.g. transport, financialmarkets, tourism) and cross-sector policies (e.g. public procurement, competition policy, norms and standards). The geographic focus ofthis study are the eight Arab MPs.5 These countries have a number ofthings in common: they are at a similar level of economic development, they share similar reform challenges, and they all do not yet know how deeply they will eventually integrate with the EU. Despite this emphasis on the Arab MPs, references will also be made to Israel and Turkey. Turkey already has a customs union with the EU and is recognized as an accession candidate. Israel is the only high-income country in the region and could in theory participate in the European Single Market. Whereas these two MPs face different domestic reform challenges and integration options, any comprehensive regional strategy has to take them into account. 5Morocco, Algeria,Tunisia, Egypt, Jordan, Syria, Lebanon, West Bank and Gaza. xxiii Chapter 1 Deeper Integration 1.1 The Continuum of DeeperIntegration 1.2 The Importance of Backbone Services 1.3 Concentric CirclesofEuropean Integration 1.4 EU Enlargement and Prospects for Euro-MediterraneanIntegration I 1. DEEPER INTEGRATION The European Union (EU) is the most important trading partner of the southern Mediterranean countries, accounting for more than half of their trade (see diagram 1.1). Trade integration of the Maghreb countries with the EU is more pronounced than that of the Mashrek. Despite the relatively high EU shares in trade of the Mediterranean Partners (MPs), however, the absolute size and composition of trade flows suggests that much ofthe trading potential between the EU and its Arab neighbors remains unexploited. For example, Turkey and Israel-with their 70 million inhabitants- trade as much with the EU as the ------ eight Arab MPs, with their 160 1 Diagram 1.1 Shareof the EU in MP Trade (%) million inhabitants (see table 1.1) | so_ Moreover, the vast majority of 80 exports from the Arab MPs to the . 70 - Exor E _._..._ EU consist of raw materials (e.g 60 - _ oil, gas, phosphate) and low value 40 added manufactures (e.g 300- - garments). Extreme cases are 2 s 0. a 0 I 1 Algeria and Syria, where 96 and 10 S S u U 1 86 percent respectively of exports o0-S * to Europe are petrochemicals } j I I| S . (Handoussa and Reiffers 2001). In principle, geographic proximity to the world's second largest market and the emerging regional free trade area provide the opportunity to develop trade-driven growth strategies (see page 11 for a map of the region). This, however, would require accelerated economic reforms in the southern Mediterranean countries and with European and global markets. 1.1 The Continuum of Deeper Integration Reducing trade barriers to the outside world can yield significant benefits to a country. Gains from trade can derive from comparative advantage, economies of scale, import competition, knowledge spillovers, and foreign direct investment. In principle, multilateral trade liberalization is the first-best option to reap these gains, but in practice regional trade blocks have often been important building blocks for the global trading system.6 Economic integration between countries can be regarded as a continuum leading from loose integration (e.g. the removal of tariffs and quantitative restrictions) to deep integration (e.g. the removal of legal, regulatory, and institutional barriers). Since deeper forms of integration remove a wider range of distortions between national economies, they tend to yield greater welfare gains than shallow integration. Geographic proximity facilitates economic integration between countries and deeper forms of integration, in particular, can best be achieved at the regional level. Deeper cross-border integration entails domestic policy reforms. Whereas trade liberalization has traditionally been focused on the removal of tariffs and quotas, a range ofnon-tariff barriers (NTBs) can also segment national markets. Product standards, market access restrictions, government procurement rules, and other elements of the regulatory framework can disrupt or distort economic 6The relative merits ofregionaland multilateral liberalizationare discussed in Annex C. 3 Production Networks Table 1.2 Measurements of Integration into Global in maufacture (%) Parts and components in OECD trade ($ m) Parts and components Imports Exports Imports Country Eports 1988 2000 2000 1988 2000 1988 2000 1988 28.3 22.1 943 992 3.2 7.3 Algeria 6 7 3.1 27.9 27.7 1,277 2,026 4.6 Egypt 19 52 23.8 20.4 , 300 254 39.6 13.6 , Jordan 24 20 8.8 13.4 79 238 1.5 2.7 Lebanon 3 8 2.7 16.9 21.4 420 1,224 2.7 Morocco 31 104 1.9 19.5 24.1 148 309 5 .Syria1 7 7.7 18.2 15.7 330 854 6.6 . Tunisia 72 329 5.6 20.5 20.7 3,497 5,897 9.0 Total/Av. 156 527 19.8 18.5 17.7 1,365 3,179 11.2 Israel 610 3,871 6.8 27.0 33.5 1,640 5,512 2.3 Turkey 95 1,103 22.8 21.5 25.0 1,240 6,718 8.0 Malaysia 452 11,282 11.9 13.9 28.6 2,231 15,255 1.9 China 352 25,572 38.9 30.3 6,891 27,134 23.3 23.7 Mexico 3,904 28,626 13.4 13.8 22.1 378 5,306 7.0 Poland 162 2,461 Source: WorldBank, based onOECD data.' are in the region that MP "trading capabilities An OECD study analyzing trade patterns also found with rapid progress countries" and weak in those sectors that are most often associated in developing networks The export bundles ofthese countries with participation in global production (Petri 1997). trade grows disproportionately), not sophisticated (low are not dynamic (few products for which show little compositional change over time (an indicator of proportion ofhigh value-added exports), indicator characterized by low shares of intra-industry trade (an economic transformation), and are the situation in the southern Mediterranean contrasts for deeper integration). As table 1.2 shows, a economies. Malaysia, for instance-with dramatically with Eastern Europe or the East Asian "tiger" more than 20 times as many parts and smaller population than Algeria or Morocco-exports MPs jointly. Moreover, are far greater than components to OECD countries than all the Arab its exports components trade has risen significantly. its imports and the share ofparts and in its manufactures to Deeper Regional Integration Box 1.2 Rules of Origin as an Obstacle production networks (besides inefficient A major impediment for the development of regional party of a preferential from rules oforigin (ROOs). If imports firm one "backbone" services) are frictons arsing from the exporting trade agreement are to qualify fbr tariff exemnpions in another, these goods have to "orginate" content that a good to obtan that status-such as a rninimum country. ROOs define the conditions has to meet steps performed country. The current system of ofdomestic value added or specific processing in the exportmng an important barrier to deeper regional integration and the ROOs in the Euro-Mediterranean constitutes patcbwork regional free trade area is being implemented through a expansion of trade. The problem is that the between used in different agreements. If all trade of bilateral agreements, with incompatibilities the ROOs fragmentation ofthe producton chain, were on a purely bilateralbasis, this would not be a problem. Due to the borders as being processed from raw material to final product. however, many goods cross multiple they are two this entails, different If these rules are incompatible, Depending on the sequence of trdes ROOs apply. supply-chains substanial information and things happen. First, companies involved in cross-border will incur within the free trade area rnay not qualify for taTiff exemptions. even if transaction costs. Second, goods traded The system of ROOs that currently exists across the Mediterranean produced entirely within the region. discourage obstacles to the cumulation of origin unnecessarily hanpers and distorts trade flows. In particular, and industry The need for reforns has been widely the creaion of regional production networks clusts. of the system of meeting of Trade Ministers endorsed an overhaul recognized and in July 2003, a regional area. (For see Annex B.) ROOs within the Euro-Meditffanean free trade a dtiled discussion, 8 13 Concentric Circles of European Integration The European Union, which had 15 member states and 375 million inhabitants in 2003, is by far the most deeply integrated economic block in the world. During its 50-year history, it has gradually moved along the continuum of deeper integration. After liberalizing trade in goods and creating a customs union (1963), it established the European Single Market (1992) with a harmonized regulatory framework and free factor mobility.' 4 Besides its "four freedoms" for the movement of goods, services, labor, and capital, the EU has a joint monetary policy that gradually progressed from a fixed exchange rate system to a single currency (1999). There are also common rules on a wide range ofother economic policies, including tax regimes and fiscal deficits. Some of the most recent economic reforms in the EU have transformed its network industries (telecoms, electricity, gas, transport, postal services) and an ongoing reform package is doing the same for financial markets.'5 The acquis communautaire, the corpus of EU law, comprises a total of about 80,000 pages-covering all policy areas, not just economic policy. In many areas of economic policy, EU regulations have not only facilitated cross-border integration between member states, but also triggered economic reforms at the national level.'6 A unique feature of the EU is the transfer of national sovereignty to supranational institutions-for instance, the European Commission enforces competition and state aid rules and the European Central Bank conducts monetary policy. The EU has not only successively broadened its membership and deepened the integration among members.1 It has 7 also gradually intensified economic integration with neighboring countries. In fact, European economic integration can be compared to a system of concentric circles-in which countries in the inner circles are more deeply integrated, than those in the outer circles.'" The EU member states with their fully integrated Single Market form the core of this regional economic block. The second ring comprises the EFTA countries (Norway, Iceland, Switzerland), which participate in the Single Market and have adopted the majority of EU regulations. The third ring is formed by the accession countries of Central and Eastern Europe (CEECs), which are part of the agreement on Pan-European Rules ofOrigin and which are bringing their laws and regulations in line with those of the EU. The MPs, which have signed bilateral Association Agreements and will enter into a regional free-trade area with the EU, constitute a fourth ring. Turkey and the Balkan countries are somewhat between the CEECs and the MPs in terms of deeper integration. In summary, the closer a country is to the core ofthis system of concentric circles (the EU), the more it has progressed along the continuum ofeconomic integration. There is also a dynamic dimension to this analogy of concentric circles. The inner circles on a water surface set in motion, gradually expand to replace what were formerly the outer circles. A similar development can be observed in the process of European integration. Just as the "hard core" of this regional economic block grows (through successive rounds of EU enlargement) and as the inner layers "harden" (through a deepening of economic reforms), the economic ripple effects of the EU radiate further and further into neighboring regions. Over time, most countries in the EU's proximity have moved towards deeper forms of integration. The majority of former EFTA countries, such as Austria or Sweden, have graduated to EU membership and most of the remaining ones have 14 The "1992 program" consisted of 280 legislative measures to tackle regulatory, tax-based, and other barriers that segmented national narkets. Ten years afterthis "big bang," theframework of the Single Market is stillbeing fine-tuned. 15 European Commission website: (http://europa.eu.int/comm/internal_market/en/finances/general/Ol-J 712.htmn) and (http://europa.eu.int/comm/internal_market/en/finances/actionplan/progressSen.pdf). 16Especially in small member states, more than halfof new legislation is nowadays being initiated atthe EU level. 17 Originally, the EU had six menibers (France, Germany, Belgium, the Netherlands, Luxemburg, and Italy). Great Britain, Ireland, and Denmark joined in 1973; Greece in 1981; Spain and Portugal in 1986; and Sweden, Finland, and Austria in 1995-bringing the membership to 15 countries priorto the May 2004 enlargement. s In the literature,different concepts ofconcentric circles can be found, such as Baldwin (1994) and Emerson (2004). 9 establishment European Economic Area deepened their links to the EU through the of the conmmon Balkan countries are expected to (EEA). Eight CEECs have joined the union in May 2004 and the deeper integration with neighboring eventually follow. What makes the EU a suitable partner for Many ofits common countries is not only its economic size, but also its supranational policy framework. countries.]9 laws, regulations, and institutions can be adopted relatively easily by neighboring that deeper The diversity ofexisting bilateral agreements between the EU and its neighbors illustrates in a selective manner (d la carte). The economic integration with the EU may in principle be pursued Area (EEA), for instance, provide for agreements with the EFTA countries on the European Economic participation academic, and the adoption ofthe Single Market acquis, as well as for in technological, comprehensive package of other cooperation programs. Switzerland decided to negotiate a slightly less the EU's southern neighbors, bilateral agreements with the EU, instead ofjoining the EEA. Among ofthe EU acquis-such as on product Israel and Turkey have agreed to comply with certain provisions Turkey entered into a customs union with the standards or competition and state aid rules. Moreover, it is possible to participate in selected EU in 1995 (Kabaalioglu 1997). These examples show that EU membership. In other parts, or even in the totality ofthe European Single Market, without official Market to the Arab MPs. words, there are precedents for a gradual or partial extension ofthe Single Box 1.3 The European Neighbourhood Polcy Europe-Neighbourhood of March 2003 fle Eunpean Conmiission's Communcation on Wider EU. It proposes that neighboring defined principles for a European Neighbourhood Policy (ENP) of an enlarged prospect of a stake in the EU's Intemal countries not on the road to full membership "should be offered the ofpersons, goods, services and Market and further integration and liberalization to promote the fire movement a comprehensive policy of capital." It "recognized that geographic proximity increases the value of developing the extension offree trade to the services close association" and reiterates that the Barcelona Process envisages tranwsport, energy, and sectors. The document also notes that "efficient border management and interconnected and investment." Itstates that telecommunications networks will become more vital to expanding mutual trade and econornic reform," but does the EU acquis "could serve as a model for countries undertaking institutional To imrplement the agenda of deeper mtegration, the not specify the desirable degree of regulatory convergence. with other donors, conmumjcation calls for "better targeted EU development assistance," a closer partnership for refornm" It calls for Action Plans and additional financial assistance 'conditional on meeting agreed targets Agreements. With the with clear reformn benchmarks, and at a later stage possibly European Neighbourhood the extensive adjustment elaboration of the ENP being coordinated by the Commission's DG Enlargement. experience gained in the enlargement process could become available to the MPs. consequence for Following this communication, further implications of the ENP have emerged.20 One likely MPs 'preferential relations within a differentiated the Barcelona Process is that the EU could offer selected in defined areas, in particular political fifamework which responds to progress made by the partner countries to implement this policy of differentiation will be the and econonmic reform" (EC 2003c). The main instrument strategic policy targeLs, comnmon above-mentioned Action Plans. These should set out "clearly the over-arching key areas. and a timetable for their objectives, political and economDic benchmarks used to evaluate progress in plans for sector- achievement I...]. They should be concise, complemented where necessary by more detailed A communication on a new specific cooperation, and should inform" financial assistance to those countries. and the next of the ENP strategy is the Neighbourhood Instrument has been issued step in the elaboration MPs, after Cyprus and Malta have proposal of specific Action Plans, startng in July 2004. Of the 10 remainig union and accession candidate status). acceded to the EU, Turlkey already enjoys preferential status (a customs Meditenanean, could eventually be offered full Isrel, as the only high-income country in the southern For the eight Arab MPs, the deeper participation ,n the EU Single Market through EEA mnemberhip.2' to the preparation of the Acuon Plans. integrtion strategy developed in this study, could provide useful inputs integration:NAFTA. 19 This is one ofthe main differences to the other precedent for North-South More information can be found on the officialENP website: (http:/teuropa.eu.intlcommAworld/enp/index_en.htm). Verheugen, Commissioner for Enlargement 21 Financial Times (18 June 2003). This possibility was raised by Ginter 10 The Euro-Mediterranean Free-Trade Area m EU MeSbor States mM-etranan Parns - '4i New Mbr SWtae (as of May 2004) - EU AccesionCandidates KINBOOM~ (luidt - f4t;)*? § ,- V¢0 IElft O a. :S I. 4 ' 4. , 5 i' K vw-~~~~~~~~~~~~ RE.AND _ ,- a;''' .44 4. 4 POFrrU - eA7-- -. A6._~- ~ ~ w bALTA ~ ~ ~ ~ CE a. CYPRU~ TUNIeIA LEBANON- . .4L LSRAEL , WEST .WK AND GAZA ; t s ,U. .-. ', ;,; . S -- se.: w r>- <* _L_._ _ .* - * . ^ * - > - , r, + ....1'177 w *fr... ;- *ASi~~~~~~~~~~....... -- r ,, - ,- ,t *r.4'f ",7t - " . . , S.. ... ,, 1h.' ' ' -' 11 how fast they will move The key question for the southern Mediterranean countries is how far and is not on the cards for most within this dynamic system of concentric circles. While EU membership Market. MPs, a number of policy options exist for their increased participation into the Single the most straightforward Domestic reforms combined with a unilateral adoption of certain EU rules is (AAs) would take more time and alternative. Amendments to bilateral Association Agreements generation AAs could determination, but would give external credibility to domestic reforms. Second both sides. For instance, be signed to bundle several amendments into a give-and-take package for products in return for the the MPs could be granted access to EU markets for agricultural and in particular liberalization of trade in services. In addition, the multilateral WTO negotiations, Agreement on Trade in Services (GATS) the national commitment schedules under the General with global and European markets. An should also be used as an instrument for deeper integration and multilateral initiatives would permit for "open appropriate mix of unilateral, regional, policy areas (see chapters 3 regionalism." The optimal mix will vary between individual sectors and and 4 for detailed recommendations). 1.4 EU Enlargement and Prospects for Euro-Mediterranean Integration from 15 to 25 and the In May 2004, enlargement increased the number of EU member states per capita GDP in the total population ofthe economic bloc from 375 to 450 million.22 With average new member states (NMS) less than half of I Table 13 CEECs: Population, GN, Trade that in the EU-15, however, nominal GDP of Pop. GNI Exports Imports the European Union increased by a mere 4 ($ bn) ($ m) ($ m) percent.2 EU (m) enlargement is relevant for the , _ 10 54 40,495 42,049 MPs for at least three reasons. First, the Czech Rep. Estonia 5 4,981 5,190 process of economic integration between the 35,633 Hungary I 10 49 35,778 EU and the NMS during the last decade 4,259 Latvia 2 8 3,403 provides valuable lessons for Euro- Lithuania 3 12 6,046 6,697 Mediterranean integration. Several of these are Poland 39 164 51,419 58,275 being discussed throughout this study. Second, Slovakia 5 20 15,096 16,750 EU enlargement entails trade liberalization 2 19 1 11,420 between the MPs and the accession countries. Slovena Total 72 331 157 18 168,853 Hence, it creates opportunities for increased 8 13 7 8,562 trade between the NMSs and the MPs. Third, Bulgaria 22 39 13,379 16,557. eastern European and southern Mediterranean Romania (=GDP plusnetincomeIIom abroad) countries compete for certain export markets GNI=GTossNational Income and investment flows. EU enlargement is, Source: World Bank(2001figures). likely to shift the balance in this competition to ways to deepen their integration with the EU. Two the detriment of the MPs-unless they also find are increased global factors reinforcing the reform challenge arising from EU enlargement competition in low value-added goods and multilateral trade liberalization. is eroding the economic The combination of EU enlargement and multilateral trade liberalization between an ever larger group relevance ofthe Euro-Mediterranean free trade area. Deeper integration as a trading of countries (EU enlargemnent) reduces the relative attractiveness ofthe MPs (the "outs") Such trade diversion is caused by a change partner and FDI destination of EU countries (the "ins").24 Slovakia, Hungary, Slovema, Malta, andCyprus. 2 The NMSs are Estonia,Latvia, Luania, Poland, theCzech Republic, and a GDP increase in terms ofpurchasing power parity 23 This contraststo a population increase by 20 percent as high as in the MPs (Martens 2003). (PPP) by 9 percent. Average GDP in the NMS is about twice (Baldwin 1994). lies at the heartofthe "domino theory ofregional integration" 24 This nechanism 12 in relative prices for traded goods, resulting from asymmetric changes in tariff and non-tariff barriers.25 At the same time, the value of preferential trade agreements of the southem Mediterranean countries with the EU is being eroded through multilateral trade liberalization, under the General Agreement on Tariffs and Trade (GATT). Since World War II, eight rounds of GATT negotiations have reduced global trade-weighted most-favored nation tariffs of manufactures from about 40 to 4 percent.2 6 This also reduces trade barriers between Europe and countries that do not enjoy preferential trade with the EU. Both developments change relative prices for traded goods to the disadvantage of the MPs. With those changes in the trade environment underway, the MPs' position will deteriorate, unless they strengthen their competitiveness and seek deeper forms ofintegration with the EU. After a decade of trade liberalization, economic adjustment, and regulatory convergence with the rules of the Single Market, most accession countries are already conducting two-thirds oftheir trade with the EU (Piazolo 2001). At the company level, many Eastern European manufacturers have been tightly integrated into EU supply networks and have thus "become part ofthe intra-product division of labor around the EU." Trade in the office and telecommunication equipment, furniture, and car industries-industries which play a central role in manufacturing trade-increased from $6 billion to $28 billion between 1993 and 1998. "In 1989 not a single CEEC had the revealed comparative advantage in assembling [... ]. Czech Republic, Hungary, Slovakia, and Slovenia already acquired it in 1993 and by 1997 Poland and Estonia have also become specialized in assembly operations" (Kaminski and Ng 2001). The same trends are reflected in the share of parts and components in CEEC trade (see table 1.2). This interpenetration between western and eastern European economies poses a challenge for the Arab MPs. Until the fall of the Berlin Wall in 1989, they were the main low-wage region with geographic proximity to the EU, but now the fast-reforming CEECs have emerged as important competitors.2 7 Box 1.4 The Planned U.S.-Middle East Free Trade Area Another regional integration initiative could bring additional momentum to economic reforms in the southern Mediterranean: in May 2003, the U.S. govermnent launched an initiative to create a LU.S.-Middle East free trade area over the coure of the coming decade.21 Unlike the Euro-Mediterranean Partnership, the initiative comprises of lrq and the Gulf countries, but excludes Turkey. In contrst to the Association Agreements of the EU, the United States will ordy offer bilateral free trade agreements to countries that show upfront commitment to economic refonn. In fact, the explicit objective of the initiative is to accelerate economic reforms in one of the most stagnant regions of the world. As an integral part of the scheme, the United States wants to actively support accession to the WTO (only half of the 22 countnes of the Arab League are currently signalones) and to provide more targeted assistance for economic adjustment. The United States already has bilateral agreements with Israel, Jordan. and Morocco. Trade with the latter expanded dramatically from $7 million in 1987 to S420 million in 2002-partly thanlks to the use of qualified industrial zones (QIZs). Products ofjoint ventures between Jordanian and Israeli compames located in these QlZs enjoy pnvileged access to the U.S. market. The United States hopes to emulate the success of trade liberalization with Jordan in other countnes. Negotiations with Morocco were concluded in March 2004: talks with Bahrain and possibly Egypt are to be launched by the end of 2004. 25EU membership will reduce the price of NMS products and services relative to those from the MPs. While most tariffs between the EU and the NMS were already abolished prior to accession, full integration into the EU Single Market will remnove additional non-tariffbarriers. 26 OECD (2001). It should also be noted that the EU has concluded dozens of preferential trade agreements with other countries and thus the MPs are by no means privileged in thisrespect. 27 A FEMISE-sponsored research project, consisting of three papers, analyzed the competition for EU export markets and FDI between the two regions. It found that competition varied widely between sectors and countries. Especially the more advanced MPs, with econornic profiles similar to the CEECs, seem to be exposed. See Alessandrini (2001). 2 S Information in thistext-box from FinancialTimes (22 January, 9 and 10 May, and 24 June 2003). 13 diverted from the southern It is thus not surprising that EU trade and investments are being further have already been Mediterranean to Eastern Europe. As was seen in diagram 1.2, these shifts slightly decreased, dramatic. Between 1993 and 2001, the share of the 8 Arab MPs in EU imports the while that ofthe NMS doubled-in other words, virtually all the relative growth oftrade between in FDI EU and its neighbors occurred at the eastern periphery.29 The same patterns can be found the MPs. In 2000, FDI flows (see diagram 1.3). The NMS have attracted much higher FDI flows than in the MPs. Relative to the inflows were 6.2 percent of GDP in the NMS, but only 2.1 percent attracted £31 billion from the population size, the gap was even higher. In absolute terms, the NMS attracted a mere $5 EU between 1998 and 2000 while the MPs (with a much larger population) much better. billion.30 It should be noted, however, that some MPs (such as Tunisia) perform large privatization deals Moreover, the fact that much ofthe FDI hike around 2000 was due to some change the negative in the telecom sector shows that adequate economic reforms in the MPs could effect through EU trend of the past decade. The potential for the MPs to benefit from a trade creation the MPs and the NMS remains below 4 enlargement appears to be rather low, since trade between trade percent of the total.31 In the longer term, however, there might be potential for increased fruits or tourism services in between the two EU peripheries-for instance southern Mediterranean exchange for cars or machine tools manufactured in Eastern Europe. Whereas Eastern European enlargement is eroding the MP's. Diagram 1.3 FD1I Flows from the MPs and the CEE comparative advantage of geographic proximity vis-i EU to the Arab bn) the EU, fierce global competition in low value-added i Accession Countries (f manufactures is putting the squeeze on their other main source of comparative advantage: cheap labor. Most Arab 12 - MPs are specialized in the export ofraw materials and low E -- M value-added manufactures. Especially the latter segment of world trade, however, is becoming highly competitive. As s countries such as China or India are gaining market share and put further pressure on prices, smaller and slow- reforming developing countries are likely to suffer (see box 1.5). While fast-reforming middle-income countries in - 2. Eastern Europe or East Asia have successfully moved up on the "ladder of dynamic comparative advantage," towards higher value-added activities, the MPs have remained stuck I 1994 19S 1996 197 1998 199 2000 at the lower end. Most Arab MPs are specialized in exports and low value-added manufactures. Source Eurostat.EUFDIYearbook 20011 ofraw materials in labor Eastern European enlargement, multilateral trade liberalization, and global competition of comparative intensive manufactures create the need for the Arab MPs to redefine their sources Europe, but translating advantage. The most obvious ones are geographic and cultural proximity to more those into increased exports will require far-reaching economic reforms and especially in EU markets is also illustratedby 29 The general difficulties of the Arab MPs to compete despite their proximity, was not only the developing region whose the fact that the broader Middle East and North Africa region the decade to 1997, but also the one whose trade with the EU merchandise trade with the world grew slowest in trade grew and with the EU at only 3.6 grew slowest From 1987 to 1997, MENA merchandise at 6.5 percent, Europe and Region (OECD 2001). Another indicator percent-compared to 9.6 percent for the Eastern Central Asia That ofthe exceeds that ofthe MPs: In that tells thesame story is the degree oftrade openness. NMS significantly 2003). 2000, they had a trade-to-GDP ratio of0.3 versus 0.7 (lbiliand Koranchelian (Martens 2003). by 78 percent, while that ofthe MPs declined by 10 percent 3 NMS market share increased 4.1 percent of MP trade for 1.8 percent ofNMS trade, while the NMS accounted for 31 In 2002, the MPs accounted 13 percent) than in the MPs (about 3 (IMF 2002). Intraregional trade was much higher among the NMS (about percent). (Martens 2003). 14 competitive services sectors, as the following examples show.32 Toursm, where geographic proximity matters, is already the main services export for the MPs. Business process outsourcing and other IT-enabled services-where linguistic proximity and a common time zone are relevant-is another potentially significant export industry. The MPs might also have a comparative advantage in higher value-added segments of manufacturing, where short lead times (and thus geographic proximity) are crucial. Examples are the car part industry with its just-in-time production or those segments of the textile industry, where a rapid response to fashion trends and demand fluctuations is important (see Annex D). To compete in these markets with their tightly managed supply-chains, however, the MPs will need much more efficient "backbone" services. The development of a comparative advantage in all these markets will thus require comprehensive services sector reforms.33 Another set of lessons from EU enlargement for the Euro-Mediterranean Partnership concerns the type of assistance instruments deployed to support the process of economic adjustment.34 While the requirement to comply with the acquis created a detailed roadmap for reforms in the NMS, most reform-related provisions in the AAs are non-binding declarations of intent (e.g. regarding regulatory convergence, the harmonization of norms, or the liberalization of trade in services). Whereas the 1997 adoption of the "reinforced pre-accession strategy" focused the EU's financial assistance purely on reforms required for EU membership, the MEDA program remains largely demand-driven and insufficiently focused on measures geared at regional integration. Similarly, the bilateral "Accession Partnerships" for the NMSs created a programming framework that identified clear reform priorities and policy measures to be implemented. In addition, the accession negotiations-subdivided into 31 sectoral and thematic "chapters"-and annual "Progress Reports" for each candidate made the policy dialogue both substantive in content and ambitious in pace. By basing the decision ofwhich CEEC to accept for membership conditional on the reform progress made, the EU created strong incentives to implement structural reforms. Similar mechanisms are now being proposed under the European Neighbourhood Policy: Action Plans, the principle of differentiation, and possibly European Neighbourhood Agreements could provide a suitable framework to develop more effective partnership instruments for the MPs. In this context, an important difference to the enlargement process must be stressed. In the public debate, the four freedoms (goods, services, capital, labor) are often seen as synonymous with the adoption of the acquis communautaire-but this is not the case. In economic terms, full participation in the Single Market entails the four freedoms-and this should be the ultimate objective for enlargement and ENP countries alike. The way to achieve this, in the case of the enlargement process, was the complete adoption of the acquis by the accession candidates. For the countries participating in the European Neighbourhood Policy, however, this would be an unrealistic and possibly dangerous strategy, as explained in more detail below. For these neighbors, the objective should be the removal of the main tariff and non-tariff barriers that obstruct the free flow of goods, services, capital, and labor vis-a-vis the EU. The optimal way to do this depends on the state of economic development in the respective country and the desired degree of deeper integration. It is 32 Geographic distance (measured in kilometers) is only one determinant of economic distance measured in time, (which can be cost, organizational complexity, and reliability of economic transactions between countries). 33 Traditional concepts of comparativeadvantagefocus on a country's given endowment of labor, natural resources. land, capital, and They tend to assume immobility of factors of production (i.e., no FDI), perfect identical technology markets, and or social capital. Hence, the methodology of traditional trade theory does not take dynamics at the account of company level that drive outward processing trade. 'New' trade theory, however, also "role of input trade factors the [...] friction in international trade and investment flows due to geography, institutions, transport, and information costs [...], the transmission of knowledge across borders" and technological analysis. Two important differences into the implications are that geography matters and that policies can undermine comparative advantages or build new (e.g. education, quality of infrastructure, efficiency ofinstitutions). See Ferranti etal.(2002). 34 European Commission. Not dated. European Enlargement-A HistoricOpportunity.Brussels. 15 principle options for achieving the four the objective of this report to review the policy and reform freedoms across the Euro-Mediterranean. A few final words should be said about the geographic constellation of the Euro-Mediterranean rim that is only country of the southern Mediterranean Partnership after EU enlargement. Libya, the in the medium term. As an accession candidate not yet part ofthe EMP, is increasingly likely to join the MPs. However, its economic and non-Arab country, Turkey has long been the odd one out among between Europe and size, privileged relationship with the EU, and geographic location (as the "hinge" hub for the eastern Mediterranean. the Middle East) suggests that it could develop into an economic through the increased adoption In particular, it could become "a force ofmodemization in the region an accentuation of sub-regionalism in the of EU [...] standards. This is likely to entail, however, focus of an increasing liberalization in the Mediterranean with Turkey being the drive towards still focused EU" (Brenton and Manchin Mashrek and with the Maghreb countries on the southern EEA, it successful and Israel became a member ofthe 2002). If the Middle East peace process were role ofTurkey integration are not could fulfill similar functions. But the future and Israel in regional between the Gulf Cooperation the only question to remain unresolved. Discussions are also ongoing As a group ofwealthy Arab countries, Council (GCC) and the EU regarding a free trade agreement. share of FDI Given the potential for further the GCC already accounts for a significant in the MPs. GCC into deeper integration efforts between synergies, strategies should be developed to draw the the EU and the Arab MPs. Deeper integration with the global In summary, the main conclusions ofchapter 1 are the following. with a large neighbor like the EU can economy and especially North-South integration industrialized Trade and FDI flows are increasingly driven by be a powerful catalyst for economic development. needed to participate in international outward processing trade and efficient backbone services are the eight to effectively plug into the production networks. So far, however, Arab MPs have failed Eastern European enlargement global economy at large and into the EU Single Market in particular. threatens to further marginalize and increasing global competition in low value added manufactures for deeper integration with intemational the region. Accelerated structural adjustment and a strategy ofEU enlargement offers guidance and the markets will be needed to reverse that trend. The lessons for the reinvigoration of the Euro- EU's European Neighbourhood Policy provides a framework mechanisms the liberalization of Mediterranean Partnership. As far as implementation are concerned, economic reform and to pursue trade in services could help the MPs to externally anchor domestic deeper integration with the outside world. 16 Box 1.5 China'sEmergence as the World's Manufacturer of Last Resort The global competition in low value added manufactures that forces the MPs to reassess their sources of comparative advantage is dnven by several factors. Yet. China's competitiveness in labor-mtensive goods, its rapid ascend as a key trading nation, and its sheer size are one of them. In terms of purchasing power parity, China is almady the second largest economy in the world and accounts for 12 percent of global GDP." It recorded average GDP gowth of 10 percent between 1980 and 1999 and continues to grow at that pace. China's exports doubled m the past five years. At S322 billion they account fot about 5 percent of world exports and the country had a trade surplus of $30 billion in 2001 alone. In the same year. China became the world's largest recipient of FDI and attracted $53 billion-worth of capital from other countries-rnuch of this into export-related industries. In 2002, China joined the WTO and its full integration into the global trading system should make it an even mnore fornidable competitor for other developing countnes in the years to cone. The phase-out of the Multifibre Arrangement by 2005, for instance, will liberalize global textile markets and the World Bank estimates that China's share of world garment expons will increase from the current 20 percent to 50 percent withm a decade. One of the most striking features of the Chinese economy is its quasi unlimited supply of cheap labor. Out of a population of 1.3 billion, approxinmely 170 million people are currently unemployed. This is mnore than the cotnbmed population, let alone workforce, of the eight Arab MPs. Since 68 percent of the Chinese population still lives in the country-side and since ailing state-owned industries continue Diagram 1.4 MENiAandChinaShareorWorld 1arketror to shed surplus labor, China has a pool Textile and Garments (1980-2001, %) of hundreds of millions of people that still need to be absorbed into the labor i,.- ___ -__ ___ force. "With manufactunng wages in ,, _ Chia averaging about 60 cents an ,. D_ hour-S percent of the Amnerican __ average, and 10 percent of that in .._ _ some -_ neighboring Asian economisle- and a seeniDngly infinite supply of Soun:e WoAd Bank (2003.' workers, China does look as though it could out-compete other economies in the manufacturng of almost anything labor intensive." A Confucian work ethic and enormous scale economies further add to China's competitiveness. Standard trade theory suggests that all economies gain from trade. Even if one country is more competitive in every industry, its trading partners can specialize in those markets, where they have a comparative advantage. For a number of reasons, however, this might not apply to the trade relationship between China and other developing countries. First, the standard theory assumes full factor use. However, with hundreds of millions of unemployed Chinese, the country's economy and exports may continue to grow for a long time, without a nomable increase in real wages. The second potential adjustment mechanisn that could reduce China's international conpetitiveness, the exchange rate, might also fail to create breathing space for other countries, as the govemnment continues to accumulate foreign currency reserves. Third, in a mullilateral trading system that is dominated by a giant low value-added cxporter (China) and some very large high value-added exporters (USA, EU, Japan). smaller economies competing in the low value-added segment might become rnarginalized. Even Mexico (soe box 1.1) is already feeling the heat, as about 300 manufacturing plants have moved to China during the past two years.36 Sources Financial limes (10 Demwbrr 2001, 3 January 2002), 7he Econmust (/i February 2003). Franfurrer.4l1gemewe Zeiun-a (9 February 200'). and World Bank, W4'orld Dnerlopmenr Indicators 2001 35In doHar terms, China is the sixth largesteconomy. 36 The Economist (26 July 2003). Partly thanks to an artificially low exchange rate, labor costs in China are about a quarter of those in Mexico. Global trade libealization and China's WTO accession are eroding the privileged access Mexico enjoys to the U.S. market under NAFTA. The main problem, however, is that Mexico has done too little to counter these threats to its competitive advantage through better education, productivity-enhancing economic reforms, or a better integration ofoutward-processing plants into the local economy (only 1percent of inputs used in the maquiladoraplants comes from Mexican suppliers). (See Annex A for details on NAFTA.). 17 Chapter 2 Trade in Services 2.1 The Need for Services Sector Reform 2.2 The Policy Implications ofTrade in Services 2.3 Multilateral Liberalization through the GATS 2.4 Regional Liberalization in the Euro-Mediterranean share of services trade in services," half ofwhich is intra-EU trade.37 Over the past two decades, the below its true increased from 15 to 20 percent of world exports, but still appears significantly account for more potential. One ofthe fastest growing sources of FDI flows, services sectors already countries than half of total FDI stocks in developed economies and around one-third in developing activities, (UNCTAD 2001). Because services are an important input into most other economic make up policy reforms in these sectors have economy-wide spillover effects. "Typically, services transport, trade 10-20 percent of production costs and all the costs of trading-communications, an OECD report finance and insurance, and distribution services" (Hodge 2002). According to of trade in (2001) on linkages between trade and development, "all studies show that liberalization same magnitude as those services generates substantial welfare gains. These are at least of the This general insight derived from goods liberalization, in some cases exceeding them significantly." in services liberalization on is being confirmed by a modeling exercise regarding the effects oftrade would the Egyptian economy. This study came to the conclusion that a liberalization of import barriers to 21 add 13 percent to GNP and a liberalization of access to EU markets could increase that figure in six percent (Hoekman and Konan 1999). For Tunisia, a study on the effects of trade liberalization expected services sectors calculated gains of more than 5 percent of GDP-three times the benefits from from the liberalization of trade in goods (see diagram 2.1). The largest gains are expected liberalization offinancial services, telecommunications, and transport (Konan and Maskus 2000). 2.2 The Policy Implications of Trade in Services Due to the peculiar nature of services, cross-border liberalization in these sectors entails far- that reaching regulatory reform at the national level. A key difference between goods and services is service the latter are intangible and non-storable. "Non-storability requires that the production ofthe with each and its consumption are simultaneous and the supplier and the consumer must interact flows of other" (Braga and Hoekman 1999). Therefore trade in services tends to involve significant Four modes of capital, people, information, and intellectual property rights between jurisdictions. the auspices delivery are recognized by the General Agreement on Trade in Services (GATS), under ofthe World Trade Organization (WTO): (1) Cross-border supply, where consumer and producer do abroad, not physically interact (back office or computer services transacted online). (2) Consumption presence, whereby the consumer moves to the producer (tourism or port services). (3) Commercial This mode requires whereby the producer comes to the consumer (bank branches or retail outlets). rights of establishment and the flow of foreign direct investment (FDI).38 (4) Presence of natural persons, which entails temporary labor mobility (short-term assignments for engineers or intra- company transferees). between sectors. For The relative importance of the different modes of supply varies considerably (Hodge 2002). instance, mode 2 is a must for tourism, but not an option for construction services and tourism "Commercial presence tends to be the dominant mode of supply for all but transport services; cross-border trade is the next most important. Trade through the presence ofnatural persons nature is typically small for all sectors, and consumption abroad is only significant for tourism." The mix is of trade impediments varies between modes of supply and in many sectors the optimal modal (e.g. the being distorted by trade barriers. Different modes of delivery tend to be complementary need for temporary staff secondments to establish commercial presence) and thus liberalization non-tradable, initiatives should cut across modes. Many services have traditionally been considered technology), changing business but technological progress (e.g. in information and communication (2002). Services trade is difficult these statisticsnormally underestimate the 37Maurer and Chauvet to measure and volume of trade in services (e.g.services imbedded in traded goods are not included). ownership and control, or operations. 38Barriers to FDIcan pertain to establishment, 22 models (e.g. outsourcing of back office functions), and deregulation have considerably increased the scope for services trade. The predominance of commercial presence has three important consequences. First, it makes trade in services liberalization a powerful vehicle for FDI inflows. Second, the replacement ofinefficient domestic suppliers by more efficient foreign suppliers does not automatically lead to a net loss of domestic jobs. Third, FDI tends to be associated with human capital formation and knowledge-spillovers (e.g. demonstration effect of using new management techniques). Whereas the main trade barriers for goods are tariffs and quotas enforced at national borders, restrictions to trade in services come as "behind-the-border" laws, regulations or administrative barriers. These tend to be targeted at the service provider, rather than at the service itself. If cross- border trade in services is to be liberalized, _......** a wide range of domestic policies need to I Diagram 2.1 Estimated Welfare Gains from Trade be reformed. They include rights of Liberalization for Tunisia establishment (e.g. for foreign banks to set up branches); rules for market access (e.g. Merchandise Trade __l network access in telecommunications or AnServires Trade electricity); licensing regimes (e.g. for Finance accountants or medical staff); investment Distrbutina I l rules (e.g. restrictions to foreign ownership . or the repatriation ofprofits); restrictions to *usiesA the temporary movement of workers (e.g. Transport stringent visa requirements); and Cons tructi *I competition policies (e.g. monopolies or Communications, cartels). Policy measures to liberalize trade o in services can be of a 1 2 3 4 5 cross-sector nature 6 (e.g. general rights of establishment or . Source:Konan andMaskus (2002). competition policy) as well as sector- .............. --. specific. Due to the multitude ofregulations affecting services, the negotiation and implementation of liberalization commitments for trade in services is a demanding task for most developing countries. Many of the reforms required for a liberalization of services trade are similar to those required for domestic structural adjustment. The reason is that obstacles to market entry by foreign firms also tend to undermine competition, private sector development, and thus overall economic efficiency at the national level. Examples are legal exclusivity rights, state-owned monopolies, anticompetitive behavior by incumbents, or bureaucratic red tape. Other than tariffs in the case of goods, such restrictions do not generate fiscal revenue and thus entail a high deadweight loss to the economy. The liberalization of trade in services can also help to raise low levels ofFDI, as the successful tendering of GSM licenses to international operators in several MPs has demonstrated. In summary, the liberalization of trade in services has broad implications for domestic reforms, and MP governments should develop integrated reform strategies to address this dual agenda. Such strategies should specify the nature, timing, and sequencing ofreform measures; the scope and nature of external liberalization commitments, and the concessions desired from trading partners. They also need to strike a balance between multilateral trade liberalization, regional integration, and bilateral trade agreements. 23 Box 2.1 Regulatory Convergence versus Regulatory Harmonization The term "deeper integration" generally refers to the removal of non-tariffbarriers (NTBs). which integration tend to arise behind the border as a result of laws, regulations, and institutions. Even though deeper the adoption of unilateml is often understood as a harmonization of policy frameworks between economies, hirough reforms that address NTBs can often be sufficient. An citreme example for deeper integration countries transpose the comprehensive regulatory harmmnization is EU enlargement, in which the accession a degree of entire EU acquis communautaire (corpus of EU law) into their national legal systems. Such for the Arab MPs. In which policy areas, and to harmonization would be unrealistic, and in fact undesimable, basis. In principle, a country what extent hanmonization is needed, has to be assessed on a case-by-case (ii) negotiate a seeking regulatory convergence has the option to (i) take over the rules of the partner country; now set ofrules that both sides adopt; (in) agree with the partner on mutual recognition: (iv) define minimum (e.g. standards that both sides comply with, or (v) agree that both sides should adopt the rules of a third pany international accounting stndards). In the case of the Euro-Mediterranean free trade area, the most realistic options appear to be (i) and (v).39 of regulatory conveqence from an A nunber of considerations can help determne the optimal degree of economic perspective. First, different types of regulation are often appropriate for different levels where development. Regulatory convergence in North-South agreements should be confined to policy areas only be sought if this is not the case.Second, regulatory convergence for the sake ofdeeper integration should the common standards are in line with inunational best practice (i.e. no convergence to sub-optmal policies) that domestic and if they are really needed to remove NTBs. The integration of Mexico into NAFTA shows ofkey NTBs do not have reforms focused on enhancmg efficiency and trade reforns focused on the removal sought to involve a high degree of regulatory convergence. Third, regulatory convergence should only be This is especially relevant for where its benefits outweigh the associated negotiation and compliance costs. are prevented by government with lirmted implementation capacity. Fourth, in cases where domestic refonns of a trading partner may vested interest groups, extenal convergence to the more liberal regulatory regime by the comprehensive reforms that the have important political economy benefits. This effect is demonstrated adoption of the EU ac"quistriggered in the accession countries. For the MPs the above considerations have several implications. They should only adopt EU rules where those non-tariff barners; where they can be are in line vnth best practice; where they help remove significant implemnented at a reasonable cost; and where they help overcome the resistance of vested interests to domestic between sectors rerfoms. This will have to be assessed on a case-by-cem basis and it will vary considerably however, should be avoided. As MP and policy areas. Ilarmoruzation with EU rules for Its own sake, regional integration, and govemments have to simultaneously tackle domestic economic adjustment, multilateral liberalization, integmted reform strategies have to be developed and priontes need to be set. the agenda. Generally speakmg. economic adjustmwnt and multilateral liberalization should be on top of domestic reforms and Measures that promote deeper regional integration could then be factored into in die Single nmultilaterl conmnitmnents. Especially for nore advanced MPs, however, a gradual participation Market trugh a well-defined program ofregulaory convergence seens desirable. 23 Multilateral Liberalization through the GATS global The Uruguay Round ofmultilateral trade negotiations (1986-1994) was a watershed for also trade. GATT commitments led to a worldwide reduction ofquotas and tariffs on goods. Uruguay the establishment of the initiated the liberalization of services under the GATS and culminated in for the vast majority of World Trade Organization in 1995. In early 2004, 147 countries-accounting that EU countries already have in agreeing on EU-internal rules, they are unlikely to 39Given the difficulties MPs, negotiate changes to the acquis with third countries (option (ii)). Due to weak regulatory frameworks in many should be noted the EU will also be reluctant to accept mutual recogition (option (iii)). Regarding option (iv), it that most EU rules actually define minimum standards to be adopted by member states. In other words, they are thus regulatory convergence with Single explicitly designed to be inserted into national policy frameworks and Market rules implies a fair amount of flexibilityregarding the modalities ofimplementation. 24 world trade-were WTO members and more than two dozen were seeking accession. The WTO administers a rules-based framework for trade that includes general principles applicable to all members (e.g. nondiscrimination, transparency); legally binding commitments by individual countries (liberalization schedules); and institutionalized dispute settlement mechanisms. Reciprocity, whereby members exchange trade privileges, has been a driving force behind multilateral tariff dismantling. With all EU countries and about half of the MPs parties to the WTO, the GATT and GATS framework also governs trade between them.40 The Euro-Med Association Agreements explicitly stipulate that all bilateral provisions need to be compatible with WTO rules. The WTO, on the other hand, permits preferential trade agreements (PTAs) between members as long as they are notified and fulfill the criteria as set out in the relevant WTO agreements.4' The GATS liberalization measures for services agreed upon during the Uruguay Round were rather limited. Separate negotiations on telecommunications and financial services were subsequently completed and, especially in the former, most commitments were substantial. Reciprocity has thus far played a more limited role in the GATS process and most countries confined commitments to liberalization measures they had already implemented unilaterally. The new round of multilateral negotiations (Doha Round), launched at the Fourth Ministerial Meeting of the WTO in November 2001, addresses several key issues that were left unresolved by the Uruguay Round. Particularly relevant for the MPs is the further liberalization of trade in services under the GATS; the planned liberalization oftrade in agricultural products; and the Doha Development Agenda (DDA). The DDA seeks to help developing countries integrate trade reforms into their development strategies; to participate more effectively in global trade and investment flows; and to mobilize technical assistance that permits these countries to better negotiate and implement liberalization commitments. WTO Members submitted first commitment proposals in 2003 and the Doha Round was to be concluded by January 2005. This time-table, however, has slipped after the collapse of the WTO Ministerial Conference in Cancun in late 2003 and substantial delays and changes are expected. Bos 2.2 The European CommIssion Strategy on Trade and Development Besides various Euro-Mediterranean policy documents calling for a liberalization of trade in services, there is a broader Comnmssion strategy that is of relevance. The 2002 Communication on Trade and Deielopmen1l reviews the linkages between trade reforms and economic development and it defines the Conumission strategy on how to contribute to the Doha Development Agenda. It stresses that priority should be given to the multilateral track of trade liberalization, but thai regional integration can "reinforce the muhilateral trading system." Ii argues that the value added of such regional agreements "is enhanced when cooperation goes beyond border measures and is extended to deeper integration, including the convergence of domestic policies such as investmnent and competition policies; regulatory convergence and/or the adoption of harmonized [...1 standards." More specifically, the conununication calls for "the development of regional financial services and the coordmated provision of infrastructure such as regional telecommunications, energy and transport networks." It notes that "high transport costs, unreliable utilities, poor telecomrnunication and inefficient financial services" are among the mnain obstacles for developing countries to reap the full gains from trade. The comrnunication also discusses instruments the Comnmission intends to deploy to advance this agenda. It wants to mainistream trade in its assistance strategies for developing countries by factoring its implications into the Country Strategy Papers and Regional Strategy Papers, and by reinforcing the "trade component in the progranming exercise in EU development assistance," such as the MEDA program of financial assistance to the MPs. 40 Turkey, Cyprus, Malta, Israel, Egypt, Tunisia, and Morocco all joined the WTO when it was founded in 1995. Jordan became a member in 2000. In late 2003, Lebanon and Algeria were negotiating accession; West Bank and Gaza is not a sovereign country eligible for membership; and Syria has yet to apply. 41 Preferential liberalization in services is covered by GATS Article V and Vbis. It requires "substantially all trade" between parties to be covered in terms of trade volume, sectoral coverage, and modes of supply. For further details on the multilateral trading systemn, see the glossary of WTO and GATS ternms in Annex E. 25 GATS commitments combine "positive lists" and "negative lists." Each member country specifies sectors, a the sectors to which GATS rules should apply (positive list). For each of these "bound" listed negative list of remaining restrictions is then submitted (only trade barriers that are explicitly may be maintained).42 This considerably increases the transparency of the regulatory framework for (e.g. general rights traders and investors. GATS schedules are divided into horizontal commitments four modes of ofestablishment) and sector-specific commitments. Foreach sector, commitment in all matrix). supply can be made regarding market access and national treatment (a commitment to restrictions). A Countries have the option to make "full" or "partial" commitments (subject to potentially powerful instrument are "precommitments," whereby countries oblige themselves implement specific liberalization measures by a future date. This can send a credible reform signal to the investor community and helps governments to overcome pressure of vested interest groups opposing reforms. So far, however, little use has been made of precommitments under the GATS. stage, GATS Even though the multilateral liberalization of trade in services remains at an early hundred elements schedules already tend to be long and complex. Commitments can include several and that of the EU alone is 90 pages long.43 Table 2.2 Sectors Bound underthe GATS (2002) Israel Turkey WTO* Sector Egpt Jordan Morocco Tunisia Total 2 x x 71% Business x x 3 x x 68% Communications x x x 3 x 51% Construction x x x 36% Distnbution x 1 1 x 32% Education x 1 x _ 37% Enviromnental x x 4 x x 73% Financial x x x x x 33% Health / Social x 1 4 x x 88% Tourism x x x x _1 43% Recreational x 3 x 58% Transport x x x 24/77 5 9 Total 4 11 7 3 members. *percentage ofWTO members with sector commitments.Algeria, Lebanon, Syria andWest Bank andGazaare notyet Source: World Trade Organization. To date, the southern Mediterranean countries have made more limited commitments under the sub- GATS than many other countries at similar levels of economic development. Looking at the 21 and sector level, Tunisia has bound less than 20 sub-sectors; Egypt, Israel, and Morocco between as well as most 60; and only Jordan and Turkey more than 61 (Adlung etal. 2002). In contrast, all EU be Eastern European and Balkan countries fall into the latter category. The same pattern can under the observed at the more general sector level.44 Table 2.2 shows which of the 11 main sectors GATS have been bound by the southern Mediterranean countries. Four ofthe Arab MPs are not yet WTO members (Algeria, Lebanon, Syria, West Bank and Gaza). Morocco has bound 7 sectors, Egypt a mere 4 and Tunisia only 3. Jordan has the most extensive GATS commitments among Arab MPs-which reflects both its liberal policies and the fact that it joined the WTO after 1995. It is As far as interesting to note, that Jordan is also the country with the highest share ofservices in GDP. (www.wto.org). 42The GATS schedules of all WTO member countries can be found the WTO website on behalf 43The European Comnission has the mandate to conduct trade negotiations (bilateral and multilateral) of all EU member states. However, both the EU as awhole andthe individual EU countries are WTO members. 44 See Annex F for WTO sector classifications. 26 individual sectors are concerned, the most far-reaching commitments have been made for tourism- the most frequently committed sector under the GATS. Financial services, communications, transport, and construction are also reasonably well committed, but especially in the former three, the substance of the commitments is still limited. In air and maritime transport as well as in electricity, the GATS framework is less developed and thus unilateral reforms and regional integration measures should receive priority. Business services are among those services, where most MPs maintain rather liberal regulatory regimes, but their GATS schedules do not yet seem to filly reflect this. In distribution services, important for deeper regional integration in goods markets, competition in the southern Mediterranean remains limited and only Jordan has bound this sector. In the Doha Round negotiations, MP governments should generally increase the number of bound sectors, while deepening their commitments. Where restrictions to competition are maintained for public policy objectives, governments should use economic instruments that minimize the associated trade distortions and domestic welfare loss (e.g. auctions of entry licenses instead of quantitative restrictions; gradual phase-out of infant-industry protection). As far as horizontal commitments are concerned, more far-reaching provisions on rights of establishment and cross-border supply ought to be made. GATS commitments should at least reflect the status of domestic refonns and greater use should be made of precommitments. Such external anchoring of implemented or planned domestic reforms is a necessary signaling device for investors, given the large location-specific sunk costs (FDI) in many services sectors. It should not be forgotten, however, that international trade agreements cannot be a substitute for a genuine commitment to domestic economic reforms in the services sectors. The nexus between such unilateral reforms, regional integration, and multilateral liberalization should determine the negotiation strategies ofthe MPs and the substance of their commitments. At the institutional level, this will require that government officials in charge of trade negotiations maintain a tight interface with their colleagues responsible for economic reforms in specific sectors. Box 2.3 Regional versus Multilateral Trade Liberalization As MP governments face limnited implementation capacity in their pursuit of domestic reforms, regional integation, and multilateral tnde liberalization, prionties will have to be sea.This raises the question of the relative mnerits of regional, as compared to multilateral liberalization. In principle the latter can be l ogarded as fit best, since i2reduces negotiation costs, minimizes the risk of trade diversion, permits to reap gais from with the Test of the world, increases tnde ansparency for traders, and gives recoure to the enforcement mechanisms of the multilateral system (e.g. dispute settlement). In practice, however, regional negotiations might be more manageable, can facilitate the use of reciprocity, and may allow for deeper forms of integanon, which are only feasible between neighbors (e.g. regional power pools or cooperation between regulatory authorities). Especially in those services sectors in which the multilateral framework is not yet sufficiently developed (e.g. in air transpon or electricity), regional liberalization may offer an important way forward. If progress at the multilateral level is not forthcoming during the current Doha Round, regional liberalization could also become a second-best substitute. In services sectors where geographic, cultural, and linguistic proximity matters, the balance of the argument is generally tilted towards regional integration. The benefits of regional integration also mcrease if the trading partner is a large. developed economy (such as the EU). Fortunately, the trade-off between regional and multilateral liberalization is less stark than it might seem. As a general rule, domestic economic reforms and multilateral liberalization should be given pnority. Inpolicy areas where geography matters or the multilateral framework is less developed, multilateral commitments can be "topped-up" by additional integration measures at the regional level. Until the success ofthe Doha Round is ensured. MP governments should pursue services negotiaiion at both the regional and at the multilateral level.45 45 More detailed recommendations on the optimal policy mix by sector and theme can be found in chapters 3 and 4. Annex C contains a comprehensive review of the debate on regional versus multilateral liberalization. 27 2.4 Regional Liberalization in the Euro-Mediterranean at the Barcelona Conference in The Euro-Mediterranean Partnership (EMP) was launched Partners. Its 1995 between the 15 countries of the European Union and their 12 Mediterranean decade. economic centerpiece is the establishment a free-trade area (FTA) for goods over the coming Agreements The implementation mechanism for this regional FTA is a series ofbilateral Association agreements between MPs. (AAs) between the EU and each ofthe MPs, combined with South-South and the AAs are now All MPs (except Syria) have successfully completed negotiations with the EU the South-South at different stages of the ratification and implementation process. Regarding four MPs (Tunisia, dimension, more than a dozen bilateral agreements have been signed and in 2001, to participation by Morocco, Jordan, Egypt) launched negotiations for a plurilateral agreement, open the regional FTA other MPs ("Agadir Process"). Ifthe current pace ofthese initiatives is maintained, for goods could be completed around 2015.46 but are confined to Regarding services trade, the AAs contain virtually no binding commitmnents and Services) declarations of intent. In Tunisia's AA, for instance, Title III (Right ofEstablishment to compliance of contains only two articles with less than half a page of text: Article 32 pertains Article 31 is a bilateral commitments with GATS rules (which is a must for all WTO members). the scope of the AA to "rendezvous" clause in which the signatories express their will to extend rights of establishment and services trade. It stipulates that the Association Council should make into force ofthe AA. recommendations, starting with a review no later than five years after the entry For the first MPs (Tunisia and Morocco) this deadline has already lapsed. The lack of momentum with the situation in the regarding the liberalization of trade in services in the Arab MPs contrasts new member states Cyprus and Table 2.3 Services Trade in the MPs (2001) Services Irts Malta as well as Services Exports Others Transport Travel Others enlargement Country Transport Travel (%) l%) $m ( (%) (%) candidate Turkey. $m v@ - . These countries gera 50.1 s 6,356 32.1 17.8 are bringing their E t 8,815 31.1 43.1 25.8 50.3 31.2 1,519 45.9 27.6 26.5, services sector Jordan 1,391 18.5 . policies in line Lebanon 68.2 14.4 1,705 45.9 22.8 31.3 with those of the Morocco 3,787 17.4 6.9 16.6 73.1 10.3 1,46-8 47.5 45.6 Single Market. S1ia ,481 61.9 15.6 1332 49.1 20.5 30.4 Upon accession, Tunisia 2,829 22.6 - - - - they not only have WB&G* - - - 21.0 12,380 39.3 23.3 37.4 to remove barmers Total/Av, 18X03 24.8 54.2 61.7 12,361 36.2 23.8 40.0 . to services trade Israel 11,949 17.8 20.6 50.8 31.2 6,464 31.3 26.9 41.8! with other EU f Turkey 15,913 17.9 members, but they 0 Source: WorldBank. WorldDevelopmentIndicators2003. Wet Bank andGaza ._....... also need to comply with GATS commitments of the European Union vis-a-vis third countries. to one-quarter of total As far as actual trade in services is concerned, this accounts for only one-fifth ofthe Arab MPs MP trade (see table 2.3). Transport and travel make up the bulk of services exports MP and all 15 national EU 46 To enter into force, AAs need to be ratified by the parliaments of the respective in the 4&year and ends in the 12* parliaments-which takes around three years. Tariffreduction generally begin process. The year after entry into force. Negotiations,ratification, and phase-in all make for a very time-consuming Morocco in 2012. 12-year phase-out period fortariffs will end in 2008 for Tunisia,followed by are still to bedetermined. 47 The nmodalitiesofthe compliance ofNMS with EU commitments inthe WTO 28 (about 80 percent). This includes tourism, the main service export for several of these countries. Other services, such as communication, financial or business services, account for a much larger share of imports. Israel is the MP with the highest share of other services in exports (62 percent)- which seems to reflect a higher level of development and more dynamic services sectors. Due to a number of measurement problems, however, statistics on services trade have to be interpreted with caution.48 Nonetheless, the magnitude and pattern of services trade of the MIPs suggests that a significant increase and diversification of exports seem feasible, if the necessary policy reforms were to be implemented. For most Arab MPs, Europe is the primary trading partner and the EU tends to account for half to two-thirds of their trade. For many of these countries, the Euro-Mediterranean free trade area will expose large parts of their economies to import competition and will require comprehensive structural adjustment (mise a niveau). Ifthe MPs liberalize trade in goods without liberalizing trade in services, they risk increasing their effective rates of protection for goods.49 This and the significant trade in services potential with the EU provide further arguments for a broadening (more sectors) and deepening (regulatory reform) of the FTA. In economic terms, such reforms may also be conceptualized as the gradual or partial extension of the Single Market to the South. Especially infrastructure sectors, as "connectors" between economies, and financial markets, appear well suited for deeper integration and a liberalization of trade in services between the EU and its southern neighbors. In this context it should be noted, that the Single Market represents an interesting case for the liberalization of trade in services between sovereign countries. First, two fundamental principles of the Single Market applying to all sectors are the right of establishment and the right to provide services. Second, full capital mobility and an integration of capital markets, as well as labor mobility and a mutual recognition of professional qualifications are in force. Third, comprehensive liberalization programs have opened the network industries (e.g. telecoms, transport, electricity) to foreign investment and competition. Fourth, the EU's strict competition and state aid rules outlaw anticompetitive behavior and government subsidies that could distort cross-border competition between member states. As a consequence of these policies, all modes of supply and most services sectors have been successfully liberalized. Hence, the EU has the most deeply integrated services markets among any group ofsovereign countries in the world. The Single Market experience, however, also highlights a potential problem with deeper integration in the Euro-Mediterranean region, which will need to be resolved: whereas the EU has strong institutional mechanisms to enforce integration commitments between its members, no equivalent mechanisms yet exist within the EMP context. Wherever possible, multilateral enforcement mechanisms should be used for regional integration (another aspect of"open regionalism"). In some cases, the extension of EU-internal enforcement mechanisms to neighboring countries could be considered as part of a the European Neighbourhood Strategy. A third option would be to develop Euro- Mediterranean enforcement instruments, possibly similar to the ones used between EFTA and the EU. Box 2.4 Migration and the Temporary Movement of Workers Presence of natural persons (mode 4) is the most contentious of the four modes of services delivery, but could potentially play an imnportant role for deeper integration. The boundary with migration is somewhat blurred and in fact the two are oflen being confused. Examples of temporary movement of workers for the sake 48For a detailed discussion of these measurement problems, see: Maurer and Chauvet (2002). 49Locally produced services usually constitute a significant part of the cost base for manufacturing companies. In the absence of hlberalization, these services will be more expensive than on the world market. The higher price of these services inputsacts like a tax (or an implicit tariff) on goods produced for export. Together with the tariff on intermediate goods (imported), it might well outweigh the tariff protection on the final goods to be exported. 29 establish commercial presence; of services delivery are the emnployees of foreign firms sent to a couitry to or engineers participating in construction auditors or management consultants serving foreign subsidiaries; modes of delivery and projects abroad. As these examples show, mode 4 is often intrinsically linked to other in different modes. In the the full liberalization of rnany services will require complemnentary commitments with a surplus of cheap labor) press for GATS negotiations. many developing countries (endowed dumping" and unemployment) are liberalization in mode 4, while develoged countnes (who fear "wage to liberalize cross-border supply and reluctant to make such conmitrents. As the EU is more eager progress on mode 4, it might be possible comnercial presece (modes I and 3)and the MPs are more interested in One mechanisms that has been proposed to achieve such to exchange recipcal concessions between modes. temporary work permits trade-ofis are "foreign labor content entitlements"-in other words. MPs could obtain from liberalization in other for their citizens. proportionate to the increase of EU services exports resulting modes (Mattoo 2001). up to ten million people fiom the MPs cunently As far as actual nugration across the Mediternmean is concerned, Mediterranean descent-including 1.5 live in the EU. France alone has three million inhabitants of southem from Turkey; and 100.000 from million from Algena: I million from Morocco; 350,000 from Tunisia; 315,000 states also have Lebanon.51 Germany has two million immigrants from Turkey and several other EU member Turkish emigrants reside in Europe, sizable expatriate communities from the MPs. While most Maghreb and Several hundreds of thousands ofSyrians live those from Egypt and Jordan are concentrated in the Gulfstates. in Jordan, Syria, and Lebanon. The in Lebanon and an even larger number of Palestinans are refugees more Lebanese now live abroad tha Lebanese that have left their country are widely dispersed and supposedly patterns are workers' rmittances. in Lebanon proper. One of the main economic effects of these migmtion Morocco-mostly exceedung FDI These amount to about $1 billion annually in Algeria, Egypt, Jordan, and ofregional transport flows, inflows by a significant margin (World Bank 1999). Another effect is the increase for instance, travel to as migrants travel home for holidays and other occasions. About half a million Tunisians, about twice as high in the case of their country of origin each year. The number is similar for Algeria and Morocco (Eurostat 2001). workers are important catalysts for deeper But there are also other reasons why migrants and temporary the flow of ideas and business integration. They establish border-spanning personal networks that facilitate for foreign companies contacts. Returning migants bring back skills. set up firns, invest in real estate, or work country, they can act as change agents in the with a commercial presence. Having experienced life in another in the region, but efforts should process ofsocio-econonuc modemization. These effects can already be observed pmcess in their be made to more effectively mobilize the resources of MP expatriates for the nuse-A-niveau jobs in their country of home countries. Programs to systematically place emigrant professionals in temnporary to build "viruala" exile birh or to encourage return migration could also be launched. Using the intemet could soon become the most communities for the exchange of information, jobs, and business opportunities of origin. Worldwide. several dozen such mternet powerful tool to reconnect dmigr6s with their countries m EU-intemal exchange networks already exist.52 Another option would be to allow MPs to participate for qualified workers from the progrms for university students and researchers. More temnporary work permits In fact, EU member states have MPs should also be considered (in the past mnost migrants were poorly qualified). up.53 In suummary. asked the Commnission to prepare a study on how an immnigmtion quota system could be set high-skilled and temporary the challenge is to change the conmposition of North-South nugration (towards for the mise-a-niveau process in the MPs. workers) and to better tab the resources of expatriate communities For a detailed discussion on mode 4, see Chanda (2002). July 2001). 51 The Economist(28 Economist, 2 down 41 diaspora networks, tied to 30 different countries." (The 52 Researchers have "tracked gives Thai November 2002). One interesting example is "Ihailand's Reserve Brain Drain project, a website that business and residence regulations, expatriates detailed information about investment incentives and opportunities, andpossible joint-venture partners in their home country." (FinancialTimes, 21 August 2001). creation of an EU-sponsored fund, cofinanced by the 53 Financial Times (15 September 2003). One proposal is the MPs in European firms. private sector,that would offer internships or trainee programs for selected graduates from the ofinformation channels (internet market place) to match A key element ofsuch a program would be the establishment companies and workers. See Diwan etal. (2002). 30 It should also be noted that there might be significant scope for South-South trade in certain services sectors, for several reasons. First, the eight Arab MPs have a similar language and culture. "Commonality of culture provides a strong bonding element in any region. Dominant history, language, and religion facilitate personal interactions, with favorable impact on trading relations, tourism, labor and investment flows" (El-Erian and Fischer 1996). Additional cohesive factors among the Arab MPs are similar legal systems as well as the relative ease of transport and communication via a common sea. Second, the Arab MPs are a group of mostly small economies and a de-segmentation of markets could help them exploit the economies of scale inherent to most service sectors. Third, differences in human capital endowment (e.g. high levels of human capital in countries such as Lebanon and Tunisia) could also give rise to service trade driven by comparative advantage. Before Lebanon's civil war, for instance, the country was the banking center of the region and Egypt has now partly taken over that function.54 South-South integration in the services sectors would also make the region more attractive for foreign investors.55 Given the capital and human capital-intensity of many service sectors, some developing countries fear that developed countries could exploit their comparative advantage to dominate these sectors. However, since commercial presence is the main mode in most sectors, much of this trade would take place via foreign direct investment and thus help upgrade the capital, technology, and skill base of the MPs. Not surprisingly, most studies analyzing the effects of trade in services liberalization expect much more limited adjustment costs than those arising from the liberalization of trade in goods. For Tunisia, it has been calculated that only 3 percent ofthe workforce would have to change sectors as part of the restructuring process-compared to 6.6 percent as a result of goods liberalization. 56 Moreover, a parallel liberalization of access to EU agricultural markets and the removal of remaining restrictions to access in manufactures (e.g. textiles) would permit the MPs to specialize in sectors in which they have a comparative advantage. A broadening and deepening of the Euro-Mediterranean free-trade area could thus bring important benefits to these countries. Especially the liberalization of trade in services provides an opportunity to give the economic dimension ofthe Euro-Mediterranean Partnership new impetus. Even though little liberalization of trade in services has occurred in the southem Mediterranean to date, it is a declared political objective. As mentioned above, the bilateral AAs contain rendezvous clauses for negotiations on this issue and those should soon start in the case of Morocco and Tunisia.57 At the regional level, a Ministerial Conference on Trade launched a working group on trade in services in May 2001. At the follow-up conference in 2002, Ministers "demanded that the working group on trade in services continue to meet in order to exchange experiences, tackle horizontal work, assess the issues at stake, and organize some in-depth examination of various key service sectors. They confirmed that this group [...] should contribute to the preparation of negotiations both at the multilateral level and bilateral level, in the context of the association An exanple for such South-South trade in services is South Africa, which "exports a full range of financial and business services to the southern African region" (a study cited in Hodge, 2002). 55 A related argument for South-South integration is that the regional market can act as a platforn for the participation of MP companies in global markets. It serves as a "classroom" for exporters (e.g. on product design or foreign market penetration), helps them gain scale economies, build reputation, and be exposed to competition LNicita, Olarreaga, and Soloaga 2001). Konan and Maskus (2000). A reallocation of resources (including labor) is inevitable if economic reforms are to unlock efficiency gains. Long term benefits should outweigh these short term transition costs. 57 The AA between Tunisia and the EU, for instance, states under Title III(Right ofEstablishment and Services) that "the parties agree to widen the scope of the Agreement to cover the right of establishment [...] and liberalization of the provision of services" and that "the Association Council will make a first assessment ofthe achievements in this objective no later than five years after the Agreement enters into force." 31 various declarations agreements, thus ensuring good coordination between both levels."58 These indicate a political commitment to liberalize trade in services throughout the Euro-Mediterranean. 59 progress on the ground. The challenge now is to translate political will into tangible Box 2.5 Trade in Services Liberalization in Latin Americs and the Balkans in the Two other developing regions could offer lessons for the liberalization services tmde sub-regional southem Mediterranean. The Latin American experience is instructive because of its various the EU. agreements on services, whereas the Balkans is of interest as another developing region bordering concluded 14 sub-regional agreements Regarding the former, counties in the Westem HenIihem have scope, depth, and the modalities of com.prising disciplines on trade in services since 1994. These vary in lists" (the advantage of liberalization. Some of these agreements use "positive lists," while others use 'negative An interesting the latter is enhanced transparency through a publishing of all relevant trade impediments). feature of the MERCOSUR agreement are annual rounds ofprogressive negotiations with the aim to eliminate the Andean Comnunity started with a all restrictions on services trade over a 10-year period. In contrast, Some of the agreements comprehensive mventory of all measures affecting trade in services among members. of professional services. The address mutual recognition of licenses and certifications for providers standards must MERCOSUR agreement, for example, stipulates that technical, qualifications, and certification contain disciplines be objective and tansparent (similar to the principles of the GATS). Some agreements specific anmexes on prioniy sectors. A Iregarding exclusive service providers and monoolies; others contain to extract lessons for closer analysis of the regional agrenients in Latin Anerica should be conducted liberalization efforts inthe Euro-Mediterranean. and several other countries (Albania, Inthe Balkans, two official accession candidates (Bulgaria and Romania) accede to the EU. Bosnia and Herzegovina, Croatia, Macodonia, Serbia and Montnegro) hope to eventually Most Balkan Five of these countries are already WTO members and the others have applied for nmbership. to liberalize tmde in countries have embarked on broad prograns ofeconomic refonn, which include measures (45 services.61 T'he five countries that are part of the GATS, have mnade an average of 280 commnitments and middle mcome percent of the maximum possible). which is more than double the average for low Commitments countries (16 percent) and alnost as high as the avenge for high income countries (47 percent). services (55 are particularly extensive in construction services (61 percent). communication and distribution 50 and 54 percent). Itshould percent each) as well as tourism business. and environmental services (between reforms, since be noted, however, that these quantitative aggregates are only a crude measure for the status of As part of the EU and they say little about the nature of the cormnitments or the degree of implementation. of World Bank-sponsored regional Stability Pact for the Balkans, seven counties signed a Memoranduni in services trade. Understanding in which they committed themselves to pursue further liberalization measures acquis and thus embrace Those countries gearing up for EU membersp will have to adopt the entire comprehensive services sector liberalization. are the following. Services sectors account for In summary, the main conclusions of this chapter more than half of value added in the MPs and many of these sectors are characterized by a significant liberalization, trade in reform backlog. Given the close linkages between domestic and cross-border structural adjustment in the MPs. services liberalization could act as an important catalyst for respectively) Regional and multilateral liberalization (through the EMP and the WTO frameworks 19 March 2002. 58Euro-Mediterranean Ministenal Conference on Trade (Toledo). "Conclusions ofthe Presidency." Communication "Reinvigorating the 59 This is being reiterated in other key policy documents: The Commission in services Barcelona Process" (2000) notes that "Liberalization of market access and improved regulation of trade Partners." The will form an important dimension of the economic development of the Mediterranean Ministers in Valencia (2002) calls on governments to Communication regarding the Euro-Med meeting of Foreign the progress "identify priorities for bilateral negotiations to liberalize trade inservices [...], taking into consideration also identify needs for technical made in the Doha Round [...]. Mediterranean Partners and the Commission should assistance, inparticular in the field of adopting and harmonizing the regulatory framework." 60 For adetailed review, see Stephenson and Prieto (2002). and Panousopoulos (2002). 61 For a more extensive overview, see Michalopoulos 32 J can be both complements and substitutes. Integrated reform strategies will be needed to achieve the right mix between the two. "Open regionalism" could thus have a number offacets. First, multilateral reform commitments can be "topped-up" by complementary regional agreements (e.g. on regulatory cooperation). Second, even where multilateral liberalization might theoretically be first best, regional liberalization can be a more viable alternative, due to lack of progress in multilateral negotiations (e.g. in air transport or electricity). Third, regional patterns of economic activity might emerge under multilateral liberalization (e.g. regional distribution networks or bank mergers). Such patterns, however, should be determined by market forces and not be preempted by policymakers through preferential trade agreements. 33 I I. Ii I Chapter 3 The Main Backbone Services 3.1 Transport and Logistics 3.2 Financial Services 3.3 Telecommunications 3.4 Electricity - -- - 3. THE MAIN BACKBONE SERVICES Whereas the first two chapters reviewed general policy issues associated with deeper integration and services trade, the following chapters will discuss reform implications for specific sectors and policy themes. Or phrased differently: the first chapter argued that deeper integration was desirable; the second argued that trade in services liberalization at the regional and multilateral level would be an appropriate instruments for pursuing it; and the next two chapters will show how the optimal policy mix differs across sectors and policy areas. Each section discusses the respective best practice in sector policy; reviews the relevant policy framework and reform trends in the European Single Market; analyzes sector performance and reform needs in the MPs; extracts policy lessons from other cases of North-South integration, notably NAFTA and EU enlargement; and assesses the role that GATS commitments could play in the dual process of economic reform and regional integration. Even though perceptions ofwhat constitutes backbone services differ, a broad definition of the term would include transport and logistics, financial services, information and communication services, electricity, business services, and distribution services. One reason why the concept is slightly fuzzy is the fact that there are at least two defining characteristics. First, backbone services can be seen as those "connecting" economies by facilitating cross-border transactions or resource flows (capital, labor, information). Second, one can take a more "physical" view and regard backbone services as those where tangible infrastructure crosses national borders (e.g. roads, railways, power grids, phone lines). In such "network industries," the presence of natural monopolies makes procompetitive regulation necessary.62 The main policy implication for deeper integration in those backbone sectors is thus the fact that it requires regulatory reform and some degree of regulatory cooperation across jurisdictions. Financial markets are another service sector, where market failure (information asymmetries and externalities) necessitate regulation as a complement for cross-border liberalization. Given the ambiguous definition of backbone services, the division into "main" backbone services and "other" services is not clear-cut. However, the main backbone services, analyzed in greater detail in this chapter, have an important thing in common: they all require comprehensive regulatory reform at the national level (to achieve economic efficiency) and a high degree of regulatory cooperation at the cross-border level (to achieve deeper integration). The "other" backbone services, reviewed in chapter 4, are not characterized by structural market failure. In business services and IT enabled services the outstanding reform needs in most MPs are limited. The same holds for tourism, which is not a backbone service, but one ofthe main services traded within the region. In distribution services the reform needs are straightforward (i.e. liberalization of market access and rights of establishment) and involve few cross-border policy issues. 3.1 Transportand Logistics The smooth flow of goods and people across the Euro-Mediterranean free trade area will require a seamlessly integrated multimodal system (air, maritime, rail, and road). As long as cross- border transport remains more costly, time-consuming, or unreliable than domestic transport, it will constitute a non-tariff barrier. A wide range of bottlenecks in individual modes, at modal interfaces, 62High fixed costs make it economically inefficient to construct more than one network. Regulation can help redress the natural monopoly problem through unbundling (vertical separation of the network function from potentially competitive activities); through interconnection rules (giving competitors access to the network for the provision of services); or through price regulation (to prevent the monopolist from extracting monopoly rents). 37 (based on the Convention) have thus framework for air transport Chicago Reforms ofthe multilateral into regional their bilateralASAs or entered far proven elusive, but many countries have hlberalized agreements. The United States, for instance, a set of "open skies" Skies and Traffic has developed Table 3.1 South America: Open to be inserted into the bilateral Growth with the USA (1997-98) j provisions it negotiates. In fact, an interesting TotalTraffic }National Carrier |ASAs liberalization Growth ' precedent for air transport be the . Country | Growth(% between the EU and the MPs might . TraditionalASAs skies agreements between the United 0.5 open 4.5 countries. . Argentina 1 and several Latin American -14.1 , States in Brazil I -0.2 agreements, mostly concluded 6.3 These 3.1). j ,Colombia | 3.4 had impressive effects (see table -7.1 1997, countries with open skies ,Average 1.6 Within a year, of i1997 experienced an average growth 1997 Open SkiesX .~~regimes United States of20.5 . pen ____________ to and from the I traffic countries .Chile 11.8 During the same period, 5.6 ,percent. saw Costa Rica 24.3 maintained restrictive policies, 43.4 'that 42.8 on . El Salvador no traffic growth (1.6 percent -2.9 | virtually that .Guatemala 17.7 Even flag carriers in countries -3.6 average). higher Panama 15.5 air traffic registered -0.6 liberalized Peru 11.2 than those in countries 8.4 growth in turnover Average 20.5 the fact that most without open skies, despite (Februarv 2000). share in a growing Source: Avmark AviationEconomist of them lost market unilaterally adopted an open in Lebanon, the first MP that market. Similar growth dynamics unfolded global air traffic traffic of 20 percent in 2003 (while skies regime. The country experienced growth airline not lose any business.71 stagnated) and the national MEA did the EU itself. air transport liberalization, however, is actually The most ambitious model for regional services were all regulatory distinctions between international and domestic Among its 15 members, to exist. national ownership between countries have ceased And with abolished. Bilateral ASAs "nationality." ownership is still airlines no longer have a Non-EU restrictions practically abolished, limited to 50 percent, but among EU countries State-Ownership in Airlines: no nationality restrictions apply. Moreover, a I Diagram 3.2 Compared (e.g. ground- South America and the Arab MPs common regulatory framework slot allocation) handling regulation, rules for ArabMPs Ara business environment * provides a harmonized This and a level playing field between carriers. now being EU-intemal civil aviation area is extended across the continent. Negotiations accession candidates in between the EU and the of Central and Eastern Europe for the creation the European Civil Aviation Area (ECAA) were i C Totalpublic *Totalprvate to concluded in mid-2001, obliging the CEECs (2002). policies in the Source:DanielMdller-Jentsch comply with all EU-internal extension of the sector. This sector-specific EU accession ofmost of these countries. is now being overtaken by full of a Single Market, however, in the the creation to the MPs might not be realistic short-term, While an extension of ECAA for without for reciprocity. Ticketprices a liberalization of ASA provisions, asking 7' Lebanon offersall partners to Dubai). key destinations have dropped (e.g. to as low as $100 42 less comprehensive Euro-Mediterranean civil aviation area would be desirable. Another option would be to negotiate a new generation of "bilaterals" between the EU and its southern neighbors (see box 3.3). With the EU accounting for 30 to 80 percent of international air traffic of the MPs, such liberalization seems a natural priority (Eurostat 2002). Box 3.3 The European Neighbourhood Policy and Air Transport Liberalization Air transport could become the first service sector, where the European Neighbourhood strategy is being translated into specific policy instruments to deepen integration with neighboring countnes. While bilateral ASAs have been abolished within the Single Market, member state govemnments retained the tightto negotiate them with third countries. A decision of the European Court of Justice in Novemnber 2002. however, curtailed these rights and gave the European Commission a mandate to negotiate certain provisions that fall under Community competence. Since the delmeation of responsibilities remains complex. EU goveniments decided to provide the European Commnission with a more explicit negotiating mandate. This comprises a full mandate for an open skies agreement with the United States (including issues that remain under member state competency) and a "honzontal mandate" to negotiate amendments to existing bilaterals on provisions now under Community competence. For selected third countries, especially those that are participate inthe European Neighbourhood Policy, the Conmmission might soon receive a mandate to negotiate comprehensive "Conununity agreements," replacing the existing patchwork of bilateral agreemnent. While the exact nature of such a mandate and the countries to which it applies are yet tobe determiined, such negotiations could lead to a far-reaching liberalization of air taffic between the EU and its southern neighbours. Morocco has long expressed interest in an open skies agreement with the ELI and it could be one of the first countries with whom the EU negotiates a "Conimunity agreement." In maritime transport, the most urgent reforms in the southern Mediterranean will have to be implemented at the national level. Port inefficiencies are the main source ofbottlenecks in maritime chains and port reforms involve few cross-border policy issues. The creation of landlord ports, as a means to separate operational and commercial functions in major ports, should be a cornerstone of reforms. The introduction of competition and private participation in port services; the concessioning of large container and bulk terminals to private operators; the reduction of border-related red-tape and the improvement of hinterland connections are additional policy issues that most MPs should address. While reform needs are less pronounced for sea-side issues, remaining state-owned shipping lines ought to be privatized, port integration into international route networks be improved, and collusive practices among shipping lines be tackled. As far as land transport is concerned, the markets for road haulage in most MPs are relatively competitive. Nonetheless, additional measures should be implemented to fully liberalize market access and tariffs and to reduce frictions at border crossings. In rail transport, the restructuring of state-owned companies, the opening of major routes for private cargo operators, as well as a reduction of frictions at modal interfaces and border crossings are called for. Besides these reforms in individual modes, modal interfaces, port hinterland connections, and logistics-related banking and insurance services need to be rendered more efficient. Border-related controls ought to be streamlined and documentation requirements reduced. Customs inefficiencies are among the most notorious sources of delays and the example of Lebanon illustrates the benefits of customs reform (see diagram 3.3). Within a year and a half, clearance times were reduced by a third (from 6 to 4 days), while more selective checks permitted a quadrupling of shipments cleared without inspections (the "green line ratio" increased from 10 to 40 percent).73 Another priority should be the creation of a more conducive policy framework for the third-party logistics industry (e.g. 7 2This Council Decision was in response toa Commission Communication (EC 2003a). 73 For a case study on Lebanon's customs reforms, see Daniel Muiller-Jentsch (2002). For a case study on Morocco's customs reforms, see De Wulf and Finateau (2002). 43 integrators), which *Diagra 3.3 Lebanon Customs Reforms freight forwarders, express carriers, plays a critical role in the provision of multimodal also dramatically reduce the time 7 services. Containers 45 with modal transfer and therefore _ _ . and cost associated 40 _ policies geared at increasing the low containerization 35 -,__ .---- -- - - 6 rates in the MPs are needed (e.g. more container- 30 customs procedures, modem transfer 25 7~s;:~~~ - 5 , friendly ports). Given the interdependencies in _ ., equipment in 20 w / sx ,the multimodal network, governments should develop b5 - ~-76- > -_. national transport sector strategies with the explicit ID _4_ . > _: - 4 regional aim of facilitating trade and deeper integration.74 At the regional level, Euro-Med 0 N3o- .. ports and airports, as INo v-97 Aug.98 Mar-99i countries should identify key Au..98 Mar-99 ,..-- (iseen Line Ratio (%) well as a backbone network of roads and railways, and investments are _ Clearance Time (Days) ,along which facilitation measures Source:DanielMaller-Jentsch(2002)/UNDP. coordinated. space seems The role that multilateral liberalization can play in the creation of a regional transport reforms, multilateral rather limited. While the GATS can provide an external anchor for domestic Annex on Air rules for transport sector liberalization remain rudimentary. The coverage ofthe GATS on Transport Services, for instance, is limited. To date, WTO members can only make commitments and marketing, and auxiliary services ("soft rights")-notably aircraft maintenance and repair, selling excluded.7 This computer reservation systems. The critical traffic rights ("hard rights") are explicitly gradual means that the liberalization ofbilateral ASAs ("open skies" agreements) and preferably the strategy for air transition towards a regional civil aviation area with the EU, are the most promising the transport liberalization across the Mediterranean. Maritime transport has not yet been included into table for the Doha GATS (sector negotiations were suspended in 1996) but is back on the negotiating Round (Al Khouri 1999). A distinction is made between shipping, cargo-related services in ports, and port services provided to vessels. Land transport has thus far received little attention under the GATS, addressed at because it is mainly ofinterest to countries that are direct neighbors and is thus best be MPs to have made the bilateral or regional level. Morocco, Egypt, and Jordan are the only Arab GATS commitments in transport. Ofthose three, the commitments ofthe former two are very limited. regional Given these considerations, what does the ideal combination between national reforms and vary considerably initiatives look like in the transport sector? The optimal policy mix seems to sector reforms will suffice between modes. In maritime and land-based transport services, domestic transport and there is little need for regulatory harmonization. The main exception are cross-border be coordinated. In corridors, along which infrastructure investments and facilitation measures should of ASAs, while national-level air transport, cross-border liberalization will require a modification and the liberalization of reforms-such as the restructuring of airlines, the privatization ofairports, removal ground handling-could be anchored through bilateral or regional agreements. As far as the reforms, oftransport frictions at national borders is concerned, much of this is a question of domestic by including the streamlining of customs procedures. However, it should be complemented instance, through juxtaposed border administrative cooperation with neighboring countries-for In the end, however, a controls or an exchange of information between customs authorities. are an importantargument for 74Network externalites and other sources of scale economies in the logistics industry They arise when additional transport sector integration between small economies, such as those of the MPs. or shipping routes). connections to a network increase the value or reduce the costs for existing users (e.g. airline the consent of two-thirds ofall WTO 75Extending the scope of the GATS Annex on Air Transport would require members (i.e. about 100 countries) and might be difficult to achieve. 44 combination between these national and cross-border reforms will be needed to create a common transport space between the two sides ofthe Mediterranean Sea. 3.2 Financial Services Financial sector policies are critical for both economic adjustment and regional integration. Properly functioning financial markets encourage higher savings and investments; supply entrepreneurs and private companies with capital; allocate scarce financial resources to the most promising ventures; help reduce inflation and real interest rates; and ensure the smooth flow of capital across borders (emigrant remittances, foreign investment, government debt). Microfinance (for small-scale entrepreneurs), rural-finance (for farmers and villagers), or low-income housing finance contribute to poverty reduction. If financial markets do not function properly, high lending premiums may impose excess costs on savers and investors. Bad loans can lead to bank insolvencies and costly government bail outs. Systemic banking crises or the crowding out by government debt may starve the private sector of funding. Fragile institutions and inadequate regulation may aggravate macroeconomic shocks-thus triggering inflation, exchange rate volatility, or capital flight. Since the late 1970s, 112 cases of large-scale banking crises were recorded and fiscal costs averaged 14.3 percent in the developing countries sampled (Honohan and Klingebiel 2000). In summary, efficient financial markets are vital for the entire economy. The financial sector is complex and can be divided into several sub-sectors. In most countries, especially in developing economies, the main market segment are banks. Their primary functions as intermediaries between savers and investors are to provide a range of financial instruments (e.g. savings accounts, mortgages, loans) and to manage risk arising in the process. In more mature economies, savers and investors interact directly through capital markets via tradable securities (e.g. bonds, stocks, derivatives). Institutions such as stock markets, clearing houses, and investment banks are needed to facilitate those interactions. Key determinants ofcapital market efficiency is their depth (market capitalization), liquidity (turnover), and diversity (range of financial instruments). A third important sub-sector is the insurance industry (e.g. life and non-life insurance companies, insurance brokers, reinsurance firms). Insurance markets help allocate risk and provide long-term savings instruments. Finally, institutional investors-such as pension funds, mutual funds, or asset managers-play an important role in the development of more sophisticated financial markets. A sound and transparent policy framework is a sine qua non for well functioning financial markets. This involves modern prudential regulation and corporate governance; adequate bankruptcy and accounting laws; independent regulators; a separation between financial and non-financial institutions (to avoid directed credit or politically motivated loans); and a judicial system that permits the enforcement of property rights. Failure to implement such policies can be costly. In Turkey, for instance, poor supervision and political meddling led to a banking crisis in 2001, which cost $47 billion, or 32 percent of GDP.76 Important flanking measures for financial market reforms include pension reforms (to foster the emergence of institutional investors and to increase savings rates); privatization programs (to enhance stock market capitalization and liquidity); as well as fiscal adjustment (streamlined tax regimes, lower deficits). Once a conducive regulatory framework is in place, competition and private management can become the main drivers of efficiency improvements. Ifbanks and other financial institutions have to compete for clients and can no longer rely on a captive market or business generated by government loans, they will be more inclined to provide credit to private firms. In fact, insufficient access to capital for small and medium enterprises (SMEs) is an 76Estimate by the TurkishBanking Regulation and Supervision Agency (FinancialTimes, 17 November 2003). 45 banking important impediment to private sector development in many countries. A well functioning or in off-shore accounts. sector can also help mobilize savings that were previously held in cash priority, but cross-border integration can bring Such reforms at the national level tend to be the main MPs. Regional integration additional benefits, especially for small financial markets as those of the to hold more diversified portfolios and gives increases liquidity and competition. It allows investors scope for financial institutions firms better access to capital. It helps unlock economies of scale and the benefits of (larger banks and stock markets, greater range of financial products). Among of risk, lower prices, and integration are a better match between supply and demand, diversification of enhanced customer choice. One ofthe most beneficial types of cross-border integration is the entry a liberalization of foreign banks. This can be encouraged through a removal ofnationality restrictions, banks can bring technical know-how, such market access, and the sale ofstate-owned banks. Foreign products as modern risk-management. They often raise governance standards, introduce new financial capital than their local peers. (e.g. mortgages, leasing), and tend to have better access to international regulation, since they are being Foreign banks may also'help the MPs to "import" modern prudential and Eastern Europe, scrutinized by the home regulator of the parent institution. In Latin America For instance, the two foreign investors have also driven the process of regional consolidation. banks across Latin America.77 Spanish banks BSCH and BBVA invested $13 billion in 30 major are the removal ofrestrictions to Other policies that facilitate integration between financial markets transactions. crisis and other examples cross-border capital flows or foreign exchange As the Asian dangerous volatility, show, however, the liberalization of a country's capital account can introduce institutions.78 unless it is backed up by comprehensive regulatory reforms and healthy financial of GDP, the reform and In the EU, where financial services account for more than seven percent The cross-border flow of capital was one of the integration of financial markets is well-advanced. between capital markets "four freedoms" ofthe 1992 Single Market program and thus many barriers launched in 1999, facilitates integration by were already removed a decade ago. The Euro, costs. It has also triggered initiatives to further eliminating currency risk and by reducing transaction across the EU. Potential benefits of comprehensive harmonize and streamline sector regulation annually.79 The Financial reforms have been estimated to be 0.5 percent ofEU GDP, or E43 billion financial markets by Services Action Plan of the EC, which spells out a strategy to fully integrate legislation for the wholesale 2005, is under implementation. It contains proposals for 42 pieces of pensions and market; the retail market; prudential regulation; and the harmonization of taxes on financial products.80 Biannual Progress Reports by the Commission monitor the status of financial of national market reforms and identify areas for further action. Three high-level committees to help develop an EU-wide regulators are being established (for securities, banking, and insurance) the nucleus for pan-European regulatory regulatory framework.8' These committees might become Central Bank. structures, which would also include the European but reforms still have a By intemational standards, EU markets are competitive and well integrated, concem that a broad and complex reform long way to go. Industry representatives have voiced report reviews on the economic benefits of FDI in the banking 77World Bank (2002c). This empirical evidence sector of developing countries. on the risksofcapital account liberalization,see Prasad etal. (2003). 78For infornation (2002). 79United Kingdom Chancellor ofthe Exchequer website: (http://europa.eu.int/comm/internal_market/en/finances/general/action.htm). 80 European Commission prospectus, company law and investment services Policy measures for the wholesale market include a revision ofthe funds and a new directiveon distance marketing. directives. Retailmarket measures include revisedrules for investment The Economist(15 February 2003). This is referred to as the "Lamfalussy process. 46 agenda is being implemented in a rush-leading to sub-optimal legislation and additional red tape.82 For two reasons, the EU acquis might not be the adequate template for financial sector reforms in the MPs. First, it is still work in progress and second, developed financial sectors need a different regulatory framework than those of developing countries. Many EU rules, for instance, are complex pieces of legislation for modem securities markets, while basic banking and insurance reforms are the priority for most MPs. Nonetheless, the MPs should try to plug into the Single Market for financial services, by encouraging cross-border linkages between banks, stock markets, and insurance companies. They should also implement comprehensive domestic reforms to prepare their financial markets for the challenges and opportunities of regional integration. More efficient and better integrated financial markets across the region would facilitate deeper integration. Financial services are required for a range ofcross-border transactions, including trade finance and insurance, cross-border direct or portfolio investment, or the transfer of workers' remittances. Box 3.4 Financial Market Reform and Regional Integration InEastern Europe Policy reforms and regional integration inthe financial mawicets of Central and Eastern Europe (CEE) provide a number oflessons for the MPs."l During the transition years of the I990s. most CEE countries lived through banking crises-with economic costs amounting to 10-25 percent of GDP. This triggered far-reaching sector restructunng, including bank privatization, regulatory reforrn, and a harmonization of sector policies with EU rules. Dhagras Cross-border integration 1 4 Shfrt of MaJorlip at the policy level was associated with For.siOwned Nib %tAuiau1 consolidatbon at the company level. About two-thirds of banking sk, un assets are now foreign-owned. Multuational banks have R. "successfully tansnferred * S9 mnanagement know-how--especially __i I .0 skills in marketing and credit control. They are bingmg into the _ region a host of little-known products, such as sophisticated _ _ money-rnanagement operations for corporate clients and everything from credit cards to long-term investment funds for M"'s retil investors.44 A handful of EU banks have driven the lo _ process of cross-border integration (e.g. KBC of Belgium, C RchR i Societ6 G6nerale of France, or Bank Austria). Strong comipetition _ between them drove up pnvatizauon receipts and accelerated market restructunng to the benefit of the host economies. r, 20 40 co go bo Eventually, mergers are also expected among stock markets. Sou EBRD most of which lack critical mass. One option would be the Lreation of a regional stock exchange, but with consolidation also underway in the EU, CEE stock mrarkets might directly be integrated mto broader European structures. As far as assistance to refonns is concerned, the European Bank for Reconstruction and Development (EBRD) played a crucial role in financial market reform. Itinvested in more than 80 banks in trnition countries (usually accompanied by a foreign strategic investor), and channeled EU funds to SMEs via local banks-comnplemented by technical assistance (e.g. training of loan officers) and commercial incentives (subsidies linked to performance of loan portfolios). Replicating such programs in the MPs could play a catalytic role in the reform and integration of financial markets Another example ofthe linkages between regional integration and financial market reform is Mexico. As part of a broad economic adjustment program and its integration into NAFTA, the country restructured its financial sector, but encountered a severe backlash on the way. The first generation reforms were lopsided and led to the banking crisis of 1994-whose fiscal costs alone amounted to 19 percent of GDP.85 The main problem was that rapid deregulation of interest rates and the capital account went hand-in-hand with lax supervision and excessive risk-taking by newly-privatized 82FinancialTimes (26 November and IDecember 2003). S3Infonntion in this text box from The Economist(14 September 2002) and FinancialTimes (18 November 2002). u FinancialTimes (18 November 2002). 85Most information on Mexico in this paragraph from Giugale etal. (2001). 47 infancy), most of the banks. With the sector still largely bank-based (capital markets were in their debt or equity finance. expansion came in the form of short term credit, instead of longer-term was Following the banking crisis and a severe macroeconomic shock, a second generation ofreforms strengthened (stricter risk management, implemented. Banks were recapitalized and supervision as regional enhanced accounting and disclosure standards, tight capital adequacy rules). As far Agreement (NAFTA) relaxed integration in the sector is concerned, the North American Free Trade Mexican bank assets restrictions to foreign ownership in banking. The share of foreign ownership in percent in 2002.86 Cross- increased from 1 percent in 1994, to around 50 percent in 2000, and 85 by increased trade, border consolidation of financial markets has both facilitated and been driven of Mexicans living in the investment flows, and the lucrative business of transferring remittances United States ($10 billion each year). sector under the At the multilateral level, financial services are the second most frequently committed negotiations were GATS (after tourism). Following the Uruguay Round, separate financial services by 97 WTO members-accounting for 95 concluded in 1997. At that time, commitments were made bank activities), percent of global trade in the sector (EC 1998). With a few exceptions (e.g. central mode 1 the entire spectrum of financial services is covered. Mode 3 (commercial presence) and (cross-border supply) are the most relevant for ................................................ have been .Table 3.2 Financial Services Commitments Most commitments , financial markets. under the GATS . in mode 3. Only limited use has been made of The so-called "prudential .______ Banking Insurance Securities precommitments. carve-out" provision, contained in the GATS Algeria Annex on Financial Services, allows regulatory .Egypt 0.21 0.57 0.12 authorities to take measures to ensure the Jordan n.a. n.a. n.a. of the financial system, even if they Lebanon . integrity I restrict trade. There is also a formula for making Morocco 0.20 0.22 0.09 advanced commitments, by adopting the Sy. a Understanding of Commitments in Financial Tunisia 0.44 0.47 0.43 Services, which 31 members have thus far Israel 0.30 0.45 0.28 signed up to (mostly developed countries). Turkey 0.44 0.35 0.41 These add-on liberalization measures entail EU 0.54 0.49 0.50 significant improvements on commercial . Hungary 0.50 049 0.50 presence. Most EU and Eastern European Romania 0.73 0.27 0.52 countries made very far-reaching financial Slovakia 0.21 0.45 0.37 services commitments under the GATS (Mattoo 0=not committed; 1=fully comuitted; - on-member 1999). As table 3.2 shows, thus 87 the MPs have . Source: ...............................................................Valckx.(2002.................................... ....................... Valckx (2002,). Source: ................ ..................... .fa far been more enmratos cautious.7 OnyfuofteAa Only four of the Arab than the EU and MPs are WTO members and even they have generally made weaker commitments are one of the sectors where many of their Eastern European peers. Nonetheless, financial markets the GATS commitments ofthe MPs are relatively liberal. In most southern Mediterranean countries, financial markets remain bank-dominated, while capital priority, are markets are underdeveloped. Banking reforms, which thus constitute a natural policy (with a strong tradition in private-sector well advanced in countries like Morocco or Lebanon ownership remains high in banking), but have barely begun in Syria or Algeria. The degree of public in Egypt, 95 percent in Algeria, most Arab MPs: 46 percent oftotal bank assets in Tunisia, 70 percent (12 October 2002) and FinancialTimes (12 December 2002). 86 The Economist from the methodology developed in the diagram were taken from Valckx (2002). They were adapted 87 The figures to 1(fully committed). inMattoo (1999). The liberalization index rangesfrom 0 (no commitment) 48 and 100 percent in Syria (World Bank 2000b). In Egypt, the four largest commercial banks are state- owned, and on top of this they also own shares in other banks (Ersel 2000). This contrasts with Jordan and Lebanon, where state-ownership is almost absent, or Morocco, where privatization has brought the level down to 27 percent (Grais and Kantur 2003). Another widespread problem are low levels of competition-as illustrated by concentration indices. In the average MENA country, "70 percent of bank assets are owned by the largest five banks, compared to 60 percent in Latin America and 52 percent in Asia" (World Bank 2003d). These figures partly reflect the small size of most domestic markets and highlight the need for greater regional integration. Another indicator for the competitive dynamics and strength of the banking sector is the availability of funding for the private sector. Again, the situation in several Arab MPs is unsatisfactory (see table 3.3). While domestic credit to the private sector in Algeria and Syria is negligible (8 percent of GDP), countries like Morocco or Lebanon have high interest rate spreads (8.2 and 6.3 percent respectively). These problems are due to a crowding out by govemment debt, low levels of competition, or poor bank management (e.g. an inability to offer attractive products or to assess client risk). Foreign ownership has recently increased in some MPs, but remains low: it is nonexistent or close to zero in Algeria, Egypt, and Syria; 12 percent in Tunisia, 18 percent in Morocco, and 30 percent in Lebanon (Lee 2002). ..................................... I.....................................................................................................................................I........... ......................................................... Table 3.3 Financial Market Indicators (2001) Market Listed Domestic Credit Interest Country Capitalization Domestic to Private Sector Rate Spread (Sm) (% GDP) (% traded) Companies (% of GDP) (%) Algeria n.a. n.a. n.a. n.a. 8 3.3 Egypt 26,094 25 16 1,148 62 3.8 Jordan 7,087 72 15 158 76 5.1 Lebanon 1,401 7 5 13 91 6.3 Morocco 8,5911. 27 11 55 54 Syria 8.2 0 0085.0 8 ~~0 5 _______ 0 ~~~~~ 0 Tunisia 2,131 12 14 47 68 n.a. WB&G 723 18 10 24 n.a. n.a. Total/Av. 46,027 23 10 206 52 5 Israel 45,371 53 521 615 96 3.9 Turkey 33,958 32 1631 2881 21 n.a. Source: WorldBank WorldDevelopment Indicators2003. The development of capital markets is another major reform challenge, that the MPs are confronted with. Most southern Mediterranean stock markets are small and total stock market capitalization of the eight Arab MPs with their 164 million inhabitants is about as high as that of Israel, with a population of 6 million (see diagram 3.5). In most Arab MPs, the stock market turnover ratio, an indicator for trading dynamics and liquidity, is between 5 to 16 percent, compared to 30 to 40 percent in most Eastern European countries. One of the most promising strategies to develop stock markets are large privatization programs, as the examples of Jordan and Morocco have shown. The market cap of the Casablanca exchange, for instance, rose from 7 percent of GDP at the beginning of the privatization process to 26 percent by 2002 (Grais and Kantur 2003). Foreign investors provided more than a quarter of privatization proceeds (putting the country on the map of intemational investors) and a range ofmodem financial services institutions developed in the process (investment banks, independent stock brokers, financial services enterprises with research capacity). By international standards, however, MP stock markets remain small and cross-border mergers or alliances between them would be desirable. Such forms of deeper integration are increasingly 49 of cross-border to achieve regional integration. In monopolies require some degree regulation at the national to prepare the sector for cross- financial markets, prudential regulation level is needed ofthe for regulatory convergence. For the time being, much border integration. But there is less need for less developed countries. As MP EU acquis in this sector does not seem appropriate neighboring harmonization with markets mature, however, increased regulatory economies develop and capital the EU should be considered. other sectors, to be significant potential for In financial markets, more than in many there seems of the is the small size ofmost financialinstitutions. "The assets South-South integration. One reason or HSBC those of all Arab banks combined" leading international banks such as Citigroup exceed in the development of more diverse capital (Wilson 2002). A larger regional market could also help world, with the become the corporate bond center of the Arab markets. Dubai, for instance, wants to integration Financial Center. Another argument for South-South creation of the Dubai International Gulf countries, of capital, and between are potential synergies between the oil-rich major exporters the Gulf countries industrialized countries (Arab the Arab MPs. To date, most funds from flow to estimated and in all OECD countries together at $1.3 investments in the EU have been at $365 billion of financial markets among the Arab countries could help billion). The development and integration For that, however, the MPs to the southem Mediterranean countries. redirect some ofthese investments a more conducive business environment. will not only need more developed financial markets, but also 3.3 Telecommunications for the development of amodern economy-in which The significance oftelecommunication play a critical acknowledged. On the one hand, the services, information, and speed role-is widely to its contribution to GDP, employment, foreign telecom sector is important in its own right-thanks On the other serves as an input into most direct investment, and stock market capitalization. hand, it connector economy.95 The telecom other economic activities and as an important to the global the sector and developing countries alike, revolution of the 1990s, which transformed in developed increasing regulatory reform, private investments, and rapidly was driven by technological progress, that emerged past decade includes: the separation demand. The best practice in sector policy over the and the creation regulators; the privatization ofregulatory from operational functions of independent of of the fixed-wire to competition; the tendering of the incumbent and the gradual opening network liberalization services (e.g. data, internet).96 An competing GSM licenses; and the full ofvalue-added framework performance in 86 developing countries analysis oflinks between the policy and sector (Fink etal. 2002). It found that the for the period 1985 to 1999 yielded some important conclusions outweighed technological progress; that effects of policy reformns on sector perforrnance those of performance than partial reforms; that the positive comprehensive reforms increased much more through competition; and that the sequencing ofreforms effects ofprivate participation are reinforced matters, especially introducing competition prior to privatization. package of EU of global telecom reforms. In 1998, an extensive Europe has been at the forefront "big bang" was the of a decade-long process, which legislation came into force. This culmination trade to be correlation communication costs and bilateral 95 Fink etal. (2002). The paper finds the between sellers are made products. "conmections between buyers and significant,especially for non-homogenous For these, results in of proximity and preexisting ties"; it through a search process." This increases the "importance trade more "trading rather than markets";and it makes international transactions to be conducted through networks sensitiveto comnunication costs. overview over best policy practice can be found in the TelecommunicationsRegulationHandbookof 96 An extensive (www. infodev.org/projects/3l4regulationhandbook/). the Information for Development Program (Infodev): 52 included the liberalization of data and satellite services. The 1998 package comprised the abolition of all exclusivity rights; Europe-wide licensing rules (e.g. transparency, non-discrimination, unlimited number of licenses); rules for interconnection (e.g. interoperability, obligation to grant access to competitors at cost-related rates); guidelines for universal services; a directive on number portability (important for retail competition); and an obligation to member states to establish independent telecom regulators. In the mobile phone sector, most national governments licensed three or four GSM operators. In 2001, the local loop was liberalized as the last sub-sector, even though competition was slow to gather pace. The impact ofthese various policies exceeded even optimistic forecasts. Within two years, prices for many services fell by 20 to 50 percent.97 Across the EU, the sector has witnessed a wave of privatizations, extensive restructuring of formerly state-owned companies, explosive traffic growth, unprecedented investments in infrastructure, cross-border consolidation, and the creation of hundreds of new firms. Despite the difficulties the sector experienced since the bursting of the New Economy bubble, the reforms implemented during the 1990s brought enornous benefits to consumers. To consolidate liberalization measures for the C160 billion EU telecom market, the Commission issued streamlined regulations, which became effective in mid-2003. One reason was that a maze of legislation had developed during a decade of reforms. Another was the convergence of technologies (e.g. voice and data, broadcasting and telecommunication), which called for more technology-neutral rules. Moreover, the development of market competition and regulatory capacity allowed for a lighter regulatory regime (mainly general principles to be applied by national regulators). Now, to what extent is the EU acquis in the telecom sector a model for the southern Mediterranean countries? For a number of reasons, it seems of relatively limited relevance in the short term. In most MPs the level of independence and institutional capacity of regulators remains low; the enforcement of regulatory decisions through the legal system tends to be difficult; competition in fixed-wire services is virtually nonexistent and incumbents remain entrenched. Moreover, low penetration rates of fixed-wire and the fixed-to-mobile substitution effect create very specific policy challenges. In other words, the general principles enshrined in the EU acquis and many of the regulatory instruments developed in the Single Market could well be replicated, but given the different levels of development, full regulatory harmonization seem less ofa short-term priority. Morocco, the Arab MP where telecom reforms are most advanced, shows that a combination of domestic policy measures and foreign investment can lead to impressive results. Supported by the World Bank through policy advice, technical assistance, and a sequence of adjustment operations, the country successfully implemented a broad reform program (Wellnius and Rossotto 1999). The telecom sector law, which entered into force in June 1997, lay the foundations for private participation and competition. Inter alia, it defined licensing principles, established the independent regulator ANRT, and provided for the privatization of the incumbent operator. Several implementation decrees, such as interconnection rules or the legal regime for leased lines, fine-tuned the legislative framework. In August 1999, a second mobile phone license was awarded to a consortium led by Telefonica of Spain and Portugal Telecom. Thanks to a transparent and competitive tender, the winning bidder paid $1.1 billion in license fees-equivalent to 6 percent of the country's foreign debt or two years of capital inflows. The prospect of imminent competition induced the incumbent to lower tariffs (by around 50 percent within a year) and to aggressively expand its subscriber-base (a doubling in less than two years). Two years after the issuing of the 97In fixed-wire services,for instance, the number ofproviders offering long-distance callswithin the EU increased by 90 percent to 475 between 1999 and 2000. In the same period, mobile phone penetration increased from 36 to 55 percent (to 194 million subscribers). Average prices for leased lines fell by a third between 1997 and 2000. (European Commission website: http://europa.eu.int/comm/trade/services/nspwO3.htm). 53 users in Morocco.98 The license second license, there were more than 5 million mobile phone competition segments (it granted rights specifications were designed to also stimulate in other market well as an international to provide fixed wireless services and to build long-distance networks as sold 35 percent of Maroc Telecom to a strategic gateway). In December 2001, the Government an option to acquire a further investor, Vivendi Universal of France, for $2.1 billion.99 Vivendi has the GSM license fee and the privatization receipts 16 percent from the government in 2004. Both considerably exceeded the figures of comparator countries. the benefits reforms, but also The Moroccan success story not only illustrates of well-sequenced regulatory and a transparent tender process. highlights the importance of a credible framework institutional resources. This ANRT was given a strong mandate, sufficient autonomy, and adequate and competent early on in the reform process. provided bidders with an independent interlocutor Bank and the European Commission, helped it build Technical assistance, including from the World defined interconnection technical and institutional capacity. As regards the tender process, clearly separation between financial rules and licensing principles facilitated the calculation of bids. The and coverage) channeled competitive offers and technical offers (e.g. targets for service quality on schedule and publishing bid dynamics as to maximize economic benefits. Keeping the process enhanced the credibility ofthe tender. While ANRT evaluation reports on the ANRT website further exercise showed was one ofthe first successful sector regulators in the region, a recent benchmarking independence remains limited that further improvements were possible (Mohammad 2002). ANRT's members also sit on the board of the incumbent) (the prime minister chairs the board and some other government interfere with the and its financial autonomy is incomplete. Moreover, attempts to to undermine hard-won reputation in the operation of the regulator have threatened the country's investor community. 00 the sub-sector where competition and Across the southern Mediterranean region, mobile telephony is and Lebanon have had two competing private participation are most advanced. Jordan, Egypt, operators for years. Algeria tendered Connections in 2001 (for $737 IDiagram 3.6 Fixed and Mobile Telephone a second license Tunisia in 2002 (for (per 1,000 inhabitants) million) and . $450 m). In the latter case, however, 900 observers criticized the tender goo - - _ _ i700 _ process for being insufficiently _ _ _---_ While Lebanon 6 0 0 transparent. 500 __ to use a private duopoly 400 ___ _ __ ._ .managed .00 owned) __ 300 0 _ __ i ___ ____ (both licenses are privately .200 _ _ _ _ 3 1 ,to quickly restart telecom services 100 * -]T [ _ - - war, a high degree of O -_ _ _ _, _,_ _, ,- after the civil uncertainty and political 48 st / i regulatory iinterference have severely damaged !4. ! P @ the country's standing among Source: Source:ITU. WorldETelecommunicationDevelopment Report2002. World 102 The reformn process in - f m~~~~~~~~~~~~ivestors. for example, the govermment retroactively changed the Egypt has also been rather erratic. In 1998, second license. In 2003, the two rules of the game for the first private provider, when it issued a " (1) FinancialTimesAbstracts(1 February 2001). (2) World Bank (2003a). 99 MEED (1 December 2001). 2001). 1 ReutersBusinessBriefings(2 October and 14 December '(1ReutersBusinessBriefings (29 March 2002). clear regulatory politicians to GSM companies started operating without a framework. Efforts by 102 The private fees or taxes have dragged on for several years. change the rules ofthe gane or to levy various on these companies 54 private mobile operators were negotiating to pay Telecom Egypt $170 million each, so it would not use a third GSM license it had obtained-a form of collusion that would be illegal under EU competition law. 1 03 License conditions differ across the region. All three Maghreb countries, for instance, granted international gateway rights, while Tunisia and Algeria also offered extended license duration. Most countries have collected the entire license fees upfront, whereas Egypt emphasized revenue sharing over the licensing period.104 Despite some teething problems in the reform process, most MPs now have two GSM providers and rapidly growing mobile penetration rates-which in several cases already exceed fixed-wire penetration (see diagram 3.6). Box 3.6 Regional Consolidation between Mobile Phone Operators in Latin Amerfrs Both Latin America and the southern Mediterranean region consist of a number of mostly small economies in geographical and cultural proxnmity (e.g. same language and religion). With most Latin iAmerican countries having embraced similar models of economic reforms since the late I980s, the region is mncreasmngly being treated as one entity by intemational investors. Especially in services sectors such as financial markets retail distribution, electricity, media, air transport, or telecommunication there has been a clear trend towards cross-border consolidation at the company level-often dnven by foreign investors seeking economies of scale. In mobile telephony, America Movil- ubsidiary of the privatized Mexican telecom operator Telmex-is leading this type of deeper regional integration. Following an acquisition spree and healthy organic growth, it was servmg 31 million subscribers across the sub-continent by mid-2003----an increase by 37 percent over 2002.105 Besides 20 million customers in its home nmarket, it is a major provider in Argenina, Brazil, Columbia, Brazil, Ecuador, and Guatmiala. In some contries, growth was driven by aggressive distnibuion (large networks ofpoints of sales) and inmovative services (e.g. pre-paid cards). In others, takeovers of existing providers led the expansion. A third means of increasing the company's regional footpnnt has been the acquisition of new wireless licenses-for instance in Nicaragua in September 2002. America Movil's predorminance in Latin America is being contested by Telefonica Moviles. The subsidiary of the Spanish phone company Telefinica serves 10 million customers in the region. In late 2002 it bought Mexico's second largest wire-less provider and m March 2004 it acqLnred stakes m 10 Latin Arnencan mobile operators from BellSouth of the United States for a total of S6 bllhon.1°t Luxemburg-based Milliconm a subsidiary of Sweden's Tele2, has established mobile phone operations m Bolivia, Colombia, Guatemala, El Salvador, Honduras, and Paraguay. Such activities of foreign investors foster deeper regional integration through investments in cross- border infrastructure, the provision of cross-border services (roaming), technology diffusion, and the creation of regional consumer brands--one of the most visible effects of regional integration for the general public. One interesting feature of the mobile phone market, which could provide lessons for other services sectors, is the role that foreign investors are playing in market development. In 1999, Telef6nica of Spain and Portugal Telecom acquired Morocco's second GSM license. In 2001, France Telecom, with its mobile subsidiary Orange, acquired a majority stake in Egypt's MobiNil. The company also holds 40 percent in Jordan Telecom, which operates one ofthe country's two GSM networks. France Telecom has declared the Arab countries its main target for investments in emerging markets and the company plans to use Jordan as a regional hub for its activities. 7 The 1 second provider in Egypt is owned by Britain's Vodafone-the world's largest mobile company, which also has a footprint across the European continent. Both Telecom Italia (which already owns a Turkish mobile operator) and Telefonica participated in the bid for Tunisia's second license. The winner, however, was private Egyptian company Orascom-a conglomerate that is not only a main shareholder in MobiNil, but also won the second license in Algeria. More recently, in a drive to focus its participation on 12 main GSM operators, Orascom decided to shed nine of its sub-Saharan licenses and sold its majority stake 103 FACReutersNews (21 April and 18 May 2003). '0 Reuters BusinessBriefings (29 March 2003). 105 "Latin America: Continental Roaming." FAC/Latin Trade (2 May 2003). '10 FinancialTimes (9 March 2004). 107 FinancialTimes Abstracts (3 January 2001) and MEED (24 July 2002). 55 ofTunisia Orascom as in the Jordanian provider Fastlink to Kuwait's MTC in 2002-108 "The success by Arab skills could set an Arab-Arab venture funded by Arab money and run and managed mostly 1 9 in the Arab As the mobile an example for more Arab investments in Tunisia and elsewhere world."' 0 towards a few large regional phone market in the southern Mediterranean matures, the consolidation providers is likely-similar to trends in Europe or Latin America. in the Arab MPs I Table 3.4 Status of Selected Telecom Reforms Tunisia Algeria Egypt Jordan Morocco .________________________ No No No No Competition in fixed telephony No Yes (1998) Yes (2000) Yes (1999) Yes (2002) Competition in mobile telephony Yes (2001) 2 2 2 2 Number ofmobile operators 2 No No No Partial No Competition in leased lines Yes Yes Yes Yes Internet service providers Yes 2001 1998 1995 1998 Regulator established 2000 No No Yes Partial Ind pendence ofregulator Partial 100% 100% 34% 65% State-ownership in incumbent 100% Source: World Bank(2003), adapted. reform trends in In spite of significant progress in the mobile segment, the Arab MPs still lag global offixed-wire (e.g. long distance and international telecommunications. Especially the liberalization telecom companies needs telephony, leased lines, data services) and the privatization ofstate-owned of the sector, such as mobile to be accelerated. So far, competition is confined to the "margins" southern (see table 3.4; World Bank 2003a). None of the telephony or internet service providers in fixed-wire and only a few of them Mediterranean countries has effectively introduced competition Morocco, Israel). The lopsidedness ofreforms have partially privatized their incumbents (e.g. Jordan, MPs already outnumbers fixed- is illustrated by the fact that the number of mobile phones in several the scope of private participation and wire connections (fixed-to-mobile substitution). Expanding frameworks. While most MPs competition will also require a further strengthening of regulatory capacity needs to be have established sector regulators, their autonomy and institutional by extended GATS commitments strengthened. All these domestic reforms should then be anchored relatively little value added in regional integration in the sector. In telecommunications, there seems of best practice between policymakers and measures at the policy level, except for the exchange sector reforms could act as a regulators. With telecom an important "backbone" service, however, things, it could foster trade in IT- general catalyst for deeper regional integration. Among other intemet portals for the Arab world or enabled services and the cross-border provision ofcontent (e.g. audio-visual services). 110 services where the As far as multilateral liberalization is concemed, telecommunication is one of the the Uruguay Round, most commitments for the GATS negotiations have progressed furthest. In mail, online information and data- sector concemed value-added services (e.g. electronic and voice (e.g. voice telephony, leased lines). Separate base retrieval), but few related to basic services and in 1997 the GATS Fourth Protocol negotiations on basic telecommunications were launched (e.g. a bound service may entered into force. This covers all sub-sectors and it is technology-neutral Briefings (29 March 2002), (27 December 2002). 108 ReutersBusiness FAClReutersNews Fethi Houidi FAC/Reuters News (28 January 2003). 09 Tunisia Orascom chainran Mohamed quoted in in severalGSM tenders by accusations ofconruption. Unfortunately, Orascom's participation has been tainted right, but (ICT) is not only a connector between countries in its own "°Information and communication technology and financial markets. also an important input intoother backbone services, notablytransport 56 be provided via cable, wireless, or satellite). 69 members, accounting for 93 percent of global turnover in the sector, made commitments as part of those negotiations. Ten additional countries (mostly new WTO members) bound the sector since then. Especially for market access, extensive use was made of precommitments. Morocco and Tunisia were among the 27 developing countries that used this important mechanism. Another noteworthy feature of sector negotiations was the inclusion of regulatory principles in the Reference Paper (see box 3.7). Sixty-six members made additional commitments in this regard-including the EU, which adopted the entire paper. One reason for the significant GATS progress made on telecommunication was the global reform momentum in this sector (i.e. multilateral commitments reflected unilateral reforms). Unfortunately, the commitments of most MPs were limited. Especially the core of the sector, fixed-wire services, was barely covered. In other cases, commitments were insufficiently implemented. Egypt for instance, subscribed to the Reference Paper, but the Minister chairs the board of the regulatory authority and also sits on the board of the incumbent. Morocco has formally abolished exclusivity rights in fixed-wire, but the requirement to build an alternative network instead of regulating the conditions for network access, has deterred new entry into the market. Box 3.7 Domestic Regulation and Multtilteral Disciplines: The Telecom "Reference Paper""' In the network services, pro-competitive regulation at the national level is needed to address incidences of market fahlure (natura monopoly elements, vertical integration, anticompetitive behavior by entrenched incumbents) and to ensure market access. The "Reference Paper" that accompanied the 1997 GATS Agreement on Basic Telecommunications was the first time thal multilateral disciplines included explicit provisions on domestic regulatory pnnciples. 60 of the 69 mnembers that made commitments m this sector also subscribed to the Reference Paper (in part or in full). The paper could serve as a precedent for WTO agreements on other sectors and themes where effective regulation is critical (e.g. electncity, transport, competition policy). The Reference Paper covers several major areas of sector policy: the provisions on comnpetiuve safeguards, for instance, require governments to prevent mnajor telecom companies from anti- conmpetitive practices, such as cross-subsidization or an abuse of information (critical for many regulatory issues). With respect to network interconnection, key regulatory pnnciples codified in the agreement are nondiscrimination, transparency, and the cost-relatedness of charges. Such I addressing market failure interconnection is critical in arising from natural monopolies or vertical integration. Regardmg rules on mregulatory independence, the Reference Paper stipulates inmpartiality, as well as full nstitutional separalion ibetween regulator and service providers. The agreement also includes rules on the publication of licensing criteria and the fair allocation of scarce resources (e.g. frequencies. interconnection capacity). A more limited example for GATS conmnitments on regulation are the 'Disciplines on Domestic Regulation in the i Accountancy Sector." They contain a binding provision to ensure that licensing requirements are not being abused to create "unnecessary barriers to trade" (the principle of necessity) inthese services and that 'they are not more trade-restrictive than necessary to fulfill a legitimate objective" (the principle of proportionality). The GATS Reference Paper on regulation in basic telecomnmunications clearly has its limitations. Some of its language remains rather general and to date only two cases related to the regulatory principles it defines have been brought before the WTO dispute settlement body. Nevertheless, it provides an imporant precedent for multilateral agreements on regulatory issues. Itshould be noted that rmost EU directives concerning regulation also pertain to general principles to be incorporated mto national policy frameworks by member states. These international agreements on regulatory principles show that it is possible for the MPs to anchor dornestic services sector reforms through multilateral or regional agreeremnts. 3.4 Electricity Electricity is one of the sectors where deeper forms of integration and more comprehensive liberalization of trade in services can only be achieved at the regional level. To understand why this Most of the information in this box was taken from Mattoo (2002). 57 that electricity markets have is the case, it is useful to first discuss the fundamental transformation sector was long dominated by vertically integrated undergone during the last decade and a half This and state-owned monopolies, but is now seeing the introduction ofcompetition, private participation enhance efficiency, lower costs, and modem regulation. The objectives ofthese reforms has been to number of countries mobilize private investment, and consolidate public finances. As an increasing best practice for the have experimented with different policies and market structures, an intemational includes: design ofthe legal, regulatory, and institutional framework has emerged. This management, balance * the corporatization and restructuring ofstate-owned utilities (e.g. commercial sheet restructuring, more effective metering and billing); and to reduce government transfers; * the rebalancing oftariffs tobring prices in line with costs to prevent an abuse of monopoly power (e.g. * the modernization of the regulatory framework separation ofregulatory and operational functions, the creation ofindependent regulators); generation, transmission, distribution, and trade; * the vertical unbundling ofthe industry into and trade; * the introduction ofcompetition in generation through privatizations and concessions; * the promotion ofprivate sector participation interaction ofbuyers and sellers in an unbundled * the establishment ofpower exchanges for efficient industry (e.g. spot markets, futures markets, power pools); and distortive instruments (e.g. targeted subsidies to * the pursuit of public service objectives through less the poor, instead ofartificially low prices across the board). (about 5years) andthe long amortization Given the long lead times for the construction ofpower plants and transparent periods for infrastructure investments (10-20 years), private investors demand a stable ofparticular importance in this regulatory framework. Moreover, the right sequencing of reforms is can lead to policy "lock-in"). sector (e.g. downstream privatizations prior to upstream policy reforms For these reasons, governments need to develop coherent and long-term reform strategies. reforms are at an early stage In the southern Mediterranean, and especially in the eight Arab MPs, all electricity and the sector is still largely organized according to the traditional model.'"2 Practically utilities remain state- vertically Diagram3.7 Electricity System Losses (% of totaloutput) owned and integrated. Pro- 20 .competitive policies and .8 _ __ _ ___ _ are -s effective competition ____ _ 16 -___||-_ _ _ .conspicuously absent. -- ___ _ _ _ _ __ _ _MPs_,Few have b .0 energy ., 18 VW _established - andthose who _regulators 6 x have, ___ rarely_ - = endowed _=_ _ ' 2- 4 them with the necessary or 0 autonomy, ,mandate, hind Ticy Algera Egypt Jordan Lebanon Morocco Tunisia resources. Private sector 1 . Source: WorldBank. WorldDevelopmentIndicators2003. .. ._ ..... __.__. __ ......... _..__....... . .. _ _,participation iiS confined introduced into unreformed sectors. As to a few independent power plants (IPPs), which were mostly tool to mobilize in the other infrastructure sectors, private participation is mainly seen as a and economic efficiency. The need for investments, and less as an instrument to enhance competition In Lebanon, for instance, the annual further reform is illustrated by various performance indicators. discussion of electricity in the region see Mtiller-Jentsch (2001). 112For a detailed sector policies 58 deficit of the state utility amounted to $464 million. Network losses are estimated at 25 percent in Syria and between 15 and 20 percent in Algeria, Egypt, and Morocco (see diagram 3.7). In Egypt, the arrears of the state-owned electricity companies (i.e. unpaid bills) stood at $2.7 billion. In Algeria, govermment subsidies to the utility Sonelgaz amounted to $1 billion in 1998 alone. In several MPs, prices below costs still induce wasteful over-consumption and low levels ofenergy efficiency. Most governments in the region, however, have at last launched sector reforms to tackle these problems. Jordan has long had private distribution companies, has established a regulatoTy authority, modemized sector legislation, and is tendering its first IPP. Turkey plans to fully unbundle the sector in accordance with EU rules, privatize state-owned assets, and has established an independent regulator. Given the country's track record of past reforms, however, it remains to be seen if these plans will be fully implemented. Algeria has initiated comprehensive electricity sector reforms, with support from the World Bank. Egypt and Lebanon would like to see greater private participation but are hesitant to liberalize the sector. Egypt has unsuccessfully tried to privatize generation and distribution assets,while three IPPs left the government with significant liabilities after a severe currency devaluation. This example illustrates the dangers of introducing private participation without careful preparation through upstream policy reforms. Morocco has privatized about a third of its generation capacity and sold distribution concessions for the main cities to private operators, but the government has shown little interest to introduce broader competition in this sector. Rapidly growing electricity demand and fiscal constraints in most MPs create significant pressure for greater private participation. This makes it even more important to introduce a stable and transparent regulatory framework, which is conducive to private investments and competition. In the European Single Market, the electricity sector was one of the last network industries in which restrictions to competition and cross-border integration were systematically removed. A 1999 directive obliged member states to gradually open the power sectors to competition (by giving customers the right to chose their supplier); to unbundle generation, transmission, and generation; to designate a transmission system operator, and to ensure non-discriminatory access to the transmission network. Even though governments were only obliged to open 33 percent ofthe market to competition by 2003, more than two-thirds had been liberalized by that date. In fact, the minimum standards set by the Commission triggered a process of "competitive liberalization," as governments tried to avoid falling behind in the reform process. Despite formal market opening, however, entrenched incumbents continue to delay unbundling and obstruct competition (e.g. through excessive prices for network access). Hence, national regulators had to be established to translate the general principles of the directive into detailed regulations and to ensure enforcement. All EU countries now have independent energy regulators. The ten new member states that acceded to the EU in May 2004 are also being integrated into the common electricity market. In addition, eight Balkan countries plan to integrate their markets with that of the EU.113 One interesting feature of EU reforms has been their dual objective. Besides the promotion of competition and more transparent regulation, the aim was to remove barriers to cross-border integration. Several institutions help to ensure the latter. The Council ofEuropean Energy Regulators (CEER) was created to facilitate regulatory cooperation and an exchange of best practice between EU countries. Equally important for the integration of national markets is the collaboration between network operators, through the European Association of Transmission System Operators (ETSO). After all, cross-border trade (and thus competition) occurs through interconnections between national transmission systems. ETSO members therefore have to work together on issues such as cross-border 113In November 2002, a total of 12 countries in South-Eastern Europe (including EU and accession countries) signed the AthensMemorandum of Understanding to that effect (www.seerecon.org/infrastructure/sectors/energy). 59 Union for the Coordination of the pricing or congestion management. At the technical level, the the continental European grid. At the Transmission of Electricity (UCTE) ensures the stability of and (worth £20 bn in 1999 and $66 bn in 2002) utility level, cross-border mergers and acquisitions have been the driving forces of integration. The cross-border sales to customers in other countries such as the European Energy Exchange or the Nord development of sub-regional power markets, Pool, has been another element in the creation oftrans-national market structures. Box 3.8 Cross-Border Cooperation between Sector Regulators gas. telecom, water, rail) requires The muroduction ofcompetition in network industries (electricity, regulators is 4 failure. 11 establishment of independent pr-competitive regulation to redress market Hence, the integration in these an integral parL of liberalization progamms in those sectors. Moreover, deeper regional The optimal degree and type of cooperation. masrets requires cooperation between regulatory authorities. the creation networks between regulators however, varies between sectors. Generally speaking, ofinstitutional bencliarking). It thus indirectly facilitates the spread of best practice (through information exchange and convergence. In the electricity helps to level the playing field in cross-border markets through regulatory require much more elaborate fonns of sector, however, deeper forms ofinegration (e.g. regional power pools) rules for cross-border and cross-border markets. In the regulatory cooperation, including conmmon transactions corridor also calls for close regulatory railway sector, network access for private opermiors along wranational been awarded on the basis ofbilateral cooperation. In air tnsport, eross-border traffic rights have traditionally and thus their libealization requires joint regulatory action. air service agreements between governments, cooperation is also needed on Whereas all these examples concern economic regulation. cross-border regard to aireraft or maritime safety, as well technical, safety and environmental regulation-for instance with as for the technical integrity ofinterconnected electricity grids. is particularly the electncity sector. For 50 years, In the EU Single Market, regulatory cooperation elaborate in ofthe continental European grid. ETSO UlCTE has been responsible for mnaitaining the stability and integrity such as cross-bonder congestion management. The coordinates economnic aspects ofinterconnection, pricing or practice (e.g. through eight technical working CEER not only facilitates the exchange of best regulatory an imporlant interlocutor for groups), but it also ensures a consistent application ofEU regulations and acts as also the European Commission.1 55 energy markets All major parties involved in the regulation of European the European Commission, the forum participate in the Florence Regulatory Process. Launched in 1998 by framework. In the telecom sector, convenes twice a year to debate the further development of the regulatory Framework cooperation between EU regulators has also been institutionalized, but to a lesser extent. The to establish sector regulators and to guamntee their Directive for the sector obliges all memiber states regulators takes place through the European Regulators Group independence. Cooperation between national The main role of this forum is to advice the for Electronic Communications Networks and Services. i6 of regulations, and to ensure a Conmmission on the imnplementation and revision to spread best practice, consistent application of common rules across the Single Market. been significant. In most countries, The economic benefits of these policy measures have already by 10 to 20 percent. Since then, prices fell significantly following liberalization-in many cases fuel costs and successful entrenchment by however, part ofthat decrease was reversed, due to higher of cross-border and liberalization has incumbents. Throughout the EU, the dual process integration and widespread privatization of state-owned led to comprehensive restructuring of utilities and new energy companies are companies. In response to competition market opportunities, improved customers. Modern power markets and restructuring, cutting costs, and offering services to failure in electricity in transmission and distribution. Pro-competitive services provision 114 The mnain market are natural monopolies (e.g. network access regulation thus includes the unbundling of network ownership from separation of transmission and distnbution from generation). rerWation) or restrictions to verticalintegration (e.g. ETSO (www.etso-netorg), and CEER (www.ceer-eu.org). " For further information, see: UCTE (www.ucte.org), 29 July 2002 establishing the European Regulators Commission. 2000. "Commission Decision of 116 European (2002/627/EC)." Brussels. Group for Electronic Communications Networks and Services 60 with innovative trading instruments are being developed and previously segmented national markets, rapidly. By the time the Euro- a combined annual turnover of C170 billion, are integrating EU are expected to be fullyliberalized, Mediterranean FTA is completed, energy markets across the and households from lower prices and better privatized, and integrated. Companies should benefit will be internationally competitive due to cost-cutting and services, while European utilities obstacles encountered by the 1999 consolidation. To speed up this process and to overcome for amending in 2002. This introduces competition Directive, the Commission introduced legislation by 2007.117 stricter requirements on all non-households by 2004 and for all households It imposes states to regulators. At the same time, a separate unbundling and obliges all member establish regulation on cross-border trade was adopted. of electricity markets could be substantial in the The economic benefits of deeper integration support and peak demand southern Mediterranean. First, cross-border power transfer for emergency percent ofgeneration capacity). This allows countries to lower expensive reserve margins (around 25 of scale, different reduces investment needs and increases capacity utilization. Second, economies gains from trade (e.g. load profiles, and complementary energy endowments can give rise to further may export electricity). investors tend to be more countries with natural gas resources Third, private however, regional power markets could facilitate willing to invest in large markets. Most significant, The reason is that most domestic reforms in the MPs, especially the introduction of competition. the critical mass ("small systems") to make effective national electricity markets in the MPs lack worthwhile. example shows that domestic competition feasible and unbundling The European are properly can become mutually reinforcing, if reforms liberalization and regional integration countries. designed and coordinated between neighboring Under the single buyer model, There are three basic models for cross-border power markets. electricity from all producers currently used in the southern Mediterranean, a central entity purchases require unbundling, limits competition. and then resells it. This model, which does not necessarily more competitive trading mechanisms. Transmission The open access (third-party) model has directly to distributors or large customers. Most trades, systems are open to generators, who can sell an of long-term A precondition for such however, continue to take place on the basis contracts. of network preferably the unbundling of arrangement is the effective regulation access, and domestic cross-border power markets require complementary transmission. In other words, functioning power markets are power pools, or reforms. The third and most sophisticated type of trans-national for the operation are a well developed regulatory wholesale exchanges. Requirements of a pool a (e.g. spot and future markets, power brokers), as well as framework and institutional structures for effective competition. sufficiently large number ofgenerators of similarsize to permit are physical national grids. With several A prerequisite for trade in electricity links between in recent years, virtually all countries in the southem interconnection projects completed (including to the transmission networks of their neighbors Mediterranean are now hooked up and Spain). of many interconnections is still low submarine cables between Morocco The capacity exchanges) and grids are not as densely meshed as on the (permitting only emergency and peak planned and thus the physical and European continent. Several capacity expansions are being Deeper forms of ofelectricity markets is being put in place. technical basis for regional integration and institutional framework. market integration, however, will require reforms ofthe regulatory in the southern Mediterranean There might in particular be potential for sub-regional power markets a function of geographic distance. (e.g. in the Maghreb and Mashrek), since transmission losses are The Economist (30 November 2002). 7 (26 Novemiber 2002) and 1 FinancialTimes 61 In that context, it is interesting to note that Spain and Portugal have agreed to fully integrate their national power markets in the coming years. Based on the rules of the EU directive, both countries are harmonizing legal frameworks and upgrading physical interconnections. The regulatory agencies of the two countries are cooperating to develop common regulations, while the two transmission system operators are defining modalities for the joint management of the interconnected grid. Morocco, which plans to upgrade its interconnector with Spain, and Algeria (which is interconnected to Spain via Morocco) are already participating on the Spanish spot market. In the medium to long term, it would be conceivable that the Maghreb countries integrate more deeply with the emerging Iberian market, just as the Baltic Republics are integrating with the Nord Pool. Box 3.9 The Bamc Sea Electricity Ring and Power Pool One of the moat anbitious schemes for sub-regional integmtion in the power sector can be found around the Baltic Sea Similar to the Mediterranean Electricity Ring, the emerging Baltic Ring will connect the grids of EU countries (Finland, Sweden, Norway, Denmark, Germany) with txose of tansition economies (Eatonia, Latyia, Lithuania, Belas, Poland) on the other side of a commnon sea. The two miming links that have to be completed are betwen Lithuania and Poland and between Estonia and Finlahd. At the conty level, the Baltic states and Poland have started to libealize and privatize their electricity sectors. At the regional level, there is consensus that physical inte_omection is only a necessary condition for market integrationL The region's energy minister therefore agreed to pursue regulatory integration of power markets. "' To understand these dynamics, it is usefil to first look at what has been happening in the Nordic countries. In 1996, Norway and Sweden ceated Nord Pool as the world's first cross-border power exchange. Finland and Denmark joined soon after. The exchange is jointly owned by the TSOs of Norway and Sweden. The creation of the exchange required the transfer of the inteconnectors to independent TSOs in participating countries. Nord Pool provides a number of trading instruments and services. The Nord Pool spot rarket determines power flows, while national system operators ensure the physical execution through the exchange of balance power. The spot market (Elspot) offen trade in hourly power contra for physical delivery during the following 24-hour period. ElIpot is open to all companies that have signed the necessary agreements and about 200 companies now trade on Nord Pool. The futures market (Eltermin) is a purely fincial market for price hedging, risk rnnagere andatrade m fonvwd and fitures power conua The trading time horiz is divided mnt weeks, blodc, seasns and years. About fiftnbrokers provide services and prducts to the mukeL Nord Pool enters imto all conrcts and reduces counterparty risk through the cleaing of contas via the Nordic Power Exchange. About 20 pament of all lctricity consumned in the region is alrady being traded on Nord Pool. With Nord Pool now firmly established, regional cooperation between the Nordic countries and their Baltic counterpar is being pursued through Balel, whose members ar power companies and utility associations from eleven countries. With financial assistance firm the European Commissiom, Baltel analyzed the status of *networks and regulatory firmeworks; it identified obstcles to the developmt of competitive markets; it Iproposed mmedies to address them; and it is suposed to coordite the inplementation ofagreed measr.s119 Regulatory reform would inchlde the hamonization of standrds and gulations, the creation of a grid code, | and cannon operting rles. As one ofthe first concete steps, regulators from Estonia, Latvia, and Lithuania !sigda prtocol on the comwn Balic energy muiket in November 2002. "The deal aimed to establish intemational electricity trdin in the Baltics, provide third party access, effecfi pricing mechanism and idependemn anmisn system operamors." lThe creation of a fully-fledged power pool in the Baltic region during the next decade thus seems to be a realistic scenrio and could provide interesting lessons for the MPs. The formal definition of what constitutes trade in the electricity sector is difficult and multilateral trade negotiations have thus far played a negligible role in the liberalization of this sector. Trade in energy equipment is covered by GATT. Horizontal GATS commitments on commercial presence (rights of establishment, FDI) might become increasingly relevant for trade via mode 3. However, '18EconomistIntelligence UnitCountry Briefing (27 January 2003). 119 Detailed annual reportsand other information can be found on the Baltrel website (www.baltrel.com). 120 ReutersNews (5 November 2002). 62 Chapter 4 Other Sectors and Themes 4.1 IT-Enabled Services 4.2 Business and ProfessionalServices 4.3 Distribution Services 4.4 Tourism Services 4.5 Competition Policy 4.6 Public Procurement important impediments to cross-border trade in electricity (mode 1)and market integration arise from regulatory issues such as vertical integration, conditions ofnetwork access, and state-owned monopolies. As a result ofelectricity sector unbundling, the distinction between energy goods and energy services is becoming increasingly important. Whereas vertically integrated utilities previously covered the entire value chain (and thus services were only implicitly embedded in energy goods), unbundling has separated goods (e.g. generation and network infrastructure) from services (e.g. transport and distribution of power). Transportation and distribution of energy are considered as services under GATS, if provided independently. However, energy services were not negotiated under the Uruguay Round and it remains unclear to what extent they will be covered in the Doha Round. In summary, electricity sector reforms in the southern Mediterranean countries are at an early stage. Existing inefficiencies and especially rapid demand growth create an urgent need for greater private participation, but given the dangers of poor sequencing (policy "lock-in" as a result of premature privatization), the MPs should focus on upstream policy reforms first (unbundling, competition, regulation). At the same time, deeper Euro-Mediterranean integration in the electricity sector would be desirable from an economic point of view. GATS commitments regarding commercial presence can help to liberalize FDI, but since most MPs already permit foreign investment in generation, the binding constraints for greater foreign participation are government ownership in existing assets, vertical integration, and the absence of pro-competitive regulation. These policy issues are not yet sufficiently being addressed under the GATS framework. Moreover, geography matters in the electricity sector and deeper forms of integration can only be achieved between neighbors-namely trade through cross-border interconnections and the establishment of cross-border markets. For these reasons, domestic liberalization in the MPs and regional agreements (bilateral or plurilateral) appear to be the best vehicles for cross-border integration. The current scope ofthe GATS would allow to anchor certain reform multilaterally and future GATS negotiations might increase the scope for doing so. Diagram 3.8 Investments in InfrastructureProjects with Private Participation($/capita, '90-'01) 60 Telmcom _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 500 - 3.00 L I - -- - - - -- _ __ _ __ _ _* -- _ _ 400 _ _ _ i200| - _ _ - - - - - - - - - - - - - - 3_00 __ *EU 500 2. ---------.... - _____--- _ _ ___*-__ ___- ____ t1*_ .o- ---- 0~~~~~~04 - '~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~-c iSource: WorldBank PPIDatabase. To conclude this chapter, progress in liberalizing the main backbone services remains slow and uneven in the southern Mediterranean. This is reflected in the volume of private investments in telecoms, transport, and energy (see diagram 3.8). While the second half of the 1990s saw higher investments than the first half, the figures for most MPs still lag considerably behind other developing regions, like Latin America. Morocco, Jordan, and Turkey are most advanced, while countries like Algeria, Egypt, Syria, and Israel have very low per capita levels ofprivate investments in infrastructure. Another problem besides the low levels are some of the patterns in investments. In electricity, for instance, they mostly came in form of independent power plants and were not 63 accompanied by regulatory reform. In telecom, reforms in mobile telephony have been substantial, sector, many of the while fixed-wire telephony has seen little liberalization. In the transport and were investments came in the form of stand-alone build-own-operate (BOT) concessions insufficiently embedded in broader sectorreforms. As the MPs simultaneously pursue national economic adjustment, deeper regional integration, and multilateral liberalization, they will need to develop integrated reform strategies. The optimal mix In between these objectives will differ between the backbone services reviewed in this chapter. and there telecommunication and financial markets, the multilateral framework is well advanced since the optimal type of seems little value added in regional integration measures-especially electricity and air transport, the regulation differs between developed and developing countries. In basis for regional integration GATS framework remains weak and EU rules seem a well-suited cross- efforts, as they are in line with international best practice and explicitly designed to address only be border policy issues. In all ofthese sectors, however, regional or multilateral initiatives can Given structural an anchor, but not a substitute for genuine reform efforts at the national level. the network incidences of market failure in all main backbone services-natural monopolies in procompetitive regulation industries and information problems or externalities in financial markets, outlined should be a central ingredient both for domestic adjustment and cross-border integration. The them policy measures will not only help the backbone services become more efficient, but also allow to fulfill theirfunction as catalysts for general deeper integration and economic development. 64 4. OTHER SECTORS AND THEMES Chapter 3 was devoted to the backbone services with the greatest regulatory reform needs. This chapter will review some other important sectors and policy themes. IT-enabled services associated with business process outsourcing seems to offer a great potential for the export of services from the MPs to the EU (section 4.1). Two other backbone services, where reform needs are less pronounced (business services) and less complex (distribution services) are discussed in sections 4.2 and 4.3 respectively. The tourism industry-of vital importance for economic development and trade in services in many MPs-is subject of section 4.4. Other policy areas of relevance for the process of deeper integration in the Euro-Mediterranean include competition policy (section 4.5) and public procurement (section 4.6). 4.1 IT-Enabled Services Analogous to the fragmentation of the production chain in manufacturing, an increasing number of back-office services are being contracted out. Outsourcing is no longer confined to services such as accounting, billing, legal advice, database and payroll management, or call centers. More specialized services like medical transcriptions, frequent flyer programs, or special effects in the film industry are also increasingly subject to business process outsourcing (BPO). The research firm Dun & Bradstreet estimates that BPO accounts for $200 billion per year worldwide and will continue to grow rapidly.'2' Thanks to advances in communication technology, many "IT-enabled services" have become tradable and can be outsourced to economies with lower wages. A study of the consultancy Gartner estimates that up to 25 percent of traditional IT jobs will be relocated from developed to developing countries by 2010. "By 2005, "30 percent ofleading European businesses will include outsourcing IT services to "nearshore" or offshore sites in their business and IT plans."'122 In India, the leading developing country in this respect, IT-related services exports accounted for $8 billion in 2002 (two-thirds of that to the US) and are expected to grow to $21-24 billion by 2008.123 The total turnover ofthe India's IT sector is forecast to increase to $77 billion by 2008.124 The sector already employs 1 million people directly and 2.5 million indirectly.125 It thus seems instructive to take a closer look at the Indian experience. Software development has long been the main IT-enabled service export of India. Two-fifth of the Fortune 500 companies outsource software requirements to India and work related to the year-2000 problem alone earned Indian companies $2.5 billion.'2 6 More recently, however, BPO has been the most dynamic market segment. In 2002, India's IT industry grew 29 percent-faster than in any other country. While classical IT services, such as software development, grew by a "mere" 22 percent, IT-enabled services such as outsourcing expanded by 65 percent.'27 Estimates for individual market segments confirm the potential of further BPO exports. A survey by Deloitte Consulting, for instance, found that the world's 100 largest financial services firms plan to 121Information from Dun & Bradstreet cited in The Economist(5 May 2001). 122FinancialTimes (17 March 2004). 123FinancialTimes (20 September and 22 October 2002). 124Estimate by IT consultancy Gartner cited in FinancialTimes (5 February 2003). 125FinancialTimes (22 October 2002). 126FinancialTimes (3 July 2000). 127FinancialTimes (5 February 2003). 67 under the services heading of the A distinct category of services that are subsumed general business be speaking services tend to GATS are "professional services." Generally business-to-business to trade are few. Professional services, however, are lightly regulated in most countries, and barriers regarding the formal usually governed by a much more complex regulatory regime-especially of professionals. cases lawyers, accountants, qualification, experience, and licensing In most are not only by public authorities, but also auditors, architects, engineers, or doctors being regulated to safeguard professional by their own professional bodies and associations. Even though the need in the presence asymmetries may justify some standards and to protect consumers of information international trade. In fact, they are often being used regulation, they also constitute barriers to purposes.138 of local Examples are restrictions on the creation explicitly or implicitly for protective associations, movement of intra- partnerships, the membership in professional or the temporary corporate transferees. the need to re- treatment to foreign professionals, Even if a government formally grants national prevent trade in these services. The best way to qualify to obtain a national license might effectively recognizes the recognition agreements, whereby a country overcome this barrier are mutual specifically a partner country. qualifications and licenses obtained in In fact, the GATS framework in this regard. GATS Article VII (on recognition of provides for an exception to the MFN principle permits bilateral or regional mutual qualifications, standards, and certification of suppliers) Uruguay Party on Professional Services recognition agreements. During the Round, a Working for these Accountancy services were (WPPS) was established to develop disciplines specific markets. WTO Council adopted the "Disciplines used as a precedent to define multilateral rules. In 1998 the was a "necessity on Domestic Regulation in the Accountancy Sector." One of the main provisions "are not prepared, or applied with a view to, or test" to ensure that licensing requirements adopted trade."139 It should be noted, however, that the with the effect, of creating unnecessary barriers to harmonization accounting services. The key WTO is not the main body for the global of rules in Committee International Federation players are the International Accounting Standards (IASC), the Organization Commissions (IOSCO). In of Accountants (IFAC), and the International of Securities become standards (LASs), which will also May 2000, the IOSCO adopted international accounting market in the EU from 2005 onwards. To enhance financial mandatory for all listed companies of investments, also adopt these standards. transparency and to facilitate the flow the MPs should where the adoption of global standards are the optimal basis for Accounting rules are a policy area regional integration.140 services and their role for regional Now, what are the policy implications of trade in business extend their First, as manufacturers and other companies integration in the Euro-Mediterranean? important service suppliers can "move" with activities across the free trade area, it is that business personal contacts services, geographic proximity (e.g. for their clients. Second, in many of these (e.g. common similar legal systems or between professionals) and cultural proximity language, trade. This should facilitate regional linkages, business culture) are important for cross-border world integration). Third, EU firms are among the especially among the Arab MPs (i.e. South-South and ofEU external services trade falls intothis category) leaders in many business services (one-fifth environment from knowledge spillovers can thus help the MPs to upgrade their business and benefit has Fourth, much ofthe liberalization that would be required (e.g. through the training of local staff). or through the GATS (multilaterally). Only regarding to take place at the national level (unilaterally) other words, well organized but also part of the domestic elite. In countries, professionals 138 In many are not only an abilityto influence policies forrent-seeking purposes. they constitute a vested interestgroup with economic of the next signatories only enter into effectwith the conclusion 1'9 These disciplines will only apply to and will round ofnegotiations. standards, see Van Greuning and Koen (2001) 140 For anoverview ofinternational accounting 70 issues such as mutual recognition, additional integration measures at the regional level seem merited. In summary, MP governments would be well-advised to gradually liberalize most business services and to anchor those domestic reforms through more far-reaching GATS commitments. 4.3 Distribution Services Another economic activity that constitutes a "backbone" service for deeper integration between economies is distribution. Distribution services can mainly be subdivided into wholesaling and retailing, but also include activities such as mail order or franchising. As the final stage of the supply-chain, it is a horizontal activity that cuts across sectors. Without access to distribution networks, foreign companies will have difficulties to sell their wares to potential customers and thus inefficiencies in this market can constitute an important non-tariff barrier in a wide range of industries. Cross-border distribution services are mainly supplied via mode 3 (commercial presence) and to a lesser extend via mode 1 (cross-border supply). Barriers to trade include restrictions regarding the right of establishment, zoning laws for the construction of retail outlets, limitations on the acquisition of real estate by foreigners, or restrictive rules concerning the distribution of certain products (product exclusions).141 Besides its importance for cross-border integration, however, distribution is also a large sector in its own right. Within the EU Single Market, it accounts for about 13 percent of GDP and (being a labor-intensive industry) for 16 percent of employment (EC 1998). Inefficiencies in this industry thus have broader welfare effects. In Japan, for instance, retail sector rigidities have long been blamed for high consumer prices and difficulties encountered by foreign firms to penetrate the Japanese market. Cross-border liberalization of distribution services brings greater competition, substantial investments, and market consolidation-all developments that enhance economic efficiency. It should be noted, however, that it also has social consequences. On the positive side, lower prices and greater choice can bring tangible benefits to large parts of the population-after all, retail margins account for a substantial part of the final price of many consumer products. There might even be positive implications for gender equality. In many countries it is not uncommon for women to spend several hours per day shopping The technical implications for the completion of the Mediterranean Electricity Ring have been studied by a regional MEDA project. for food and other necessities. Liberating them from the burden of those chores will pernit them to spend more time on other activities. The flip side of such improvements, however, is that retail consolidation through large supermarkets or department stores may hurt the myriad of small shops that exist in many developing countries. Given these broad economic and social implications, reforms should be gradual and they should distinguish between market segments. There is a strong case for comprehensive liberalization in wholesale distribution, where economies of scale are large and repercussions on small shop- keepers are small. As far as retailing is concerned, stores serving the urban middle classes would be the obvious place to start (e.g. food, furniture, electronics retailing). Due to significant scale economies, distribution tends to be highly concentrated and competitive in industrialized countries. In many developing economies, however, barriers to market access remain common and especially the retail segment tends to be highly fragmented. This pattern is reflected in the GATS negotiations on distribution services, where low and middle income countries have thus far been very reluctant to make commitments. Only 33 WTO members have bound the distribution 141In several markets, vertical integrationbetween production and distribution means that an inability toopen own- brand retail outletswill prevent certain producers from distributing their goods in a country. Examples are clothing cormpanies H&M and Zara, or the furniture retailer IKEA. Therefore, commitments in this sector should not only apply to distribution comnpanies, but also to foreign manufacturers, as regards the distribution of their own goods. 71 where retail sector under the GATS-one ofthe lowest figures of all sectors. High income countries, domestic retailers have an interest to expand abroad, are liberalization is well advanced and strong made commitments in all sub-sectors and eager to see further progress. The EU, for instance, has (e.g. pharmaceuticals) and only a few restrictions remain. These include certain goods carve-outs stores (mainly urban planning some limited economic needs tests for supermarkets or department however, are transparent and non-discriminatory. restrictions). The criteria for these restrictions, it should EU countries are home to large As far as regional integration is concerned, be noted that Marks & Spencer, IKEA, or global players, such as Carrefour, Metro, Safeway, Ahold, Woolworths, networks across the EU and far into H&M. Many of them have expanded their distribution Europe. In Slovakia, for instance, the six neighboring regions-especially into Eastern and Central The need goods from a multitude of largest retailers in 2003 were from western Europe.'42 to source logistics networks warehouses, frequent suppliers and to maintain complex (e.g. central for regional integration at the company replenishment of supplies) creates an economic rationale and governments ought to level. However, liberalization in this global industry should be multilateral to market forces. Given of the industry, the leave the emergence of regional patterns the nature will not only but also tends to market entry of foreign distribution companies enhance competition, into physical infrastructure (e.g. warehouses, retail outlets, be associated with significant investments logistics or modern marketing techniques), and truck fleets), knowledge spillovers (e.g. just-in-time sector in the MPs human capital formation (training oflocal staff). A liberalization ofthe distribution to the South and thus help to would most likely lead to an extension of European retail networks deepen economic integration in the Euro-Mediterranean region. 4.4 Tourism Services industry that brings Around the shores of the Mediterranean Sea, tourism is a thriving foreign currency and investments to its host significant value added, employment, earnings, arrivals in the twelve MPs total 30.5 million (18.5 million in economies (see table 4.1). International ofinternational these countries come the eight Arab MPs). "On average about 50 percent tourists to for Malta, 72 percent for from the EU. For some countries, this figure is much higher (e.g. 85 percent in the twelve to $22 billion per year Cyprus)" (Eurostat 1999). Total tourist receipts MPs amount $3.8 billion for Egypt, $1.6 billion (half of these from the eight Arab MPs). The exact figures were The dynamics ofthis industry are reflected in high growth for Tunisia, and $2.5 billion for Morocco. increased in Egypt, by 95 percent in rates. Between 1990 and 2001, tourist revenues by 245 percent from a low base, they tripled in Syria (World Bank Morocco, and by 70 percent in Tunisia. Starting for instance, 600,000 people 2003c). The industry is also an important source ofjobs. In Morocco, In Tunisia, tourism accounts for 7 percent of gross are directly or indirectly employed in the sector. and the second largest employer, domestic product. It is "the principle source of foreign currency A drawback of tourism is the seasonal and providing 80,000 jobs directly and 300,000 indirectly."'143 and the terrorist attacks of September volatile nature of the industry-for instance, the wars in Iraq 11 all caused substantial dips in demand. not only stems The comparative advantage of the southern Mediterranean countries in this sector but also from their geographic proximity to from a favorable climate and attractive coastline, tourists in (EC 1998). If the MPs want to Europe-the main source of international the world competitive industry, they will have to offer maintain their market share and high growth rates in this 2004). 42 1 FrankfurterAllgemeine Zeitung (26 April 2001). (2)Eurostat (2001). 43(1) MEED (28 December 72 high quality services at reasonable prices. They also need to build on their geographic proximity to the EU by ensuring efficient air transport connections (the key backbone service needed to for deeper integration in this industry). As mentioned in section 3.1, charter traffic in most MPs with large tourism industries is already mostly liberalized. However, more competition in scheduled passenger traffic, a privatization of key airports, and eventually the creation of a common civil aviation area between the EU and its southern neighbors would further facilitate the flow of tourists between the two sides of the Mediterranean. The success of Lebanon's open skies policies illustrates that point. Better South-South integration oftourism infrastructure (e.g. links between historic sites in Israel, the West Bank, and Jordan) could attract additional tourists. A final point regarding the linkages between tourism and deeper integration should be mentioned: as an important conduit for the exchange of ideas and personal contacts, tourism helps economies to mesh at the micro level. Tourism is not only an important economic sector for many MPs, but also accounts for a significant part of total services trade of these countries. In Jordan, Morocco, and Egypt for instance, tourism amounts to around 20 percent of total exports (see table 4.1). The predominant mode of delivery, a peculiar feature of this economic activity, is consumption abroad (mode 2). However, commercial presence (mode 3) also plays an important role. Especially international chains of hotels and resorts, but also car rental companies and tour operators can be an important source of foreign direct investment. Many MPs have far fewer regulatory restrictions regarding trade in tourism, than they have in other services................. . - sectors.'44 Nonetheless, Table 4.1 Tourism Statistics (2001) some barriers to trade Inbound Tourism As Share EU share of continue totexist. WhIle Tourists (m) Receipts ($ m) of Exports (%) Nights Spent (%) FDI in hotels is generally encouraged, Algena 901 102 1 52 limitations to foreign 4,5380236 Jordan 1,478 700 19 37 ownership and market ! Lebanon 827 837 44 26 access often exist for i Morocco 4,223 2,460 22 82 ancillary services, such Syna 1,318 1,082 16 26 as shuttle services Tunisia 5,387 1,605 17 87 between hotels and I Total 18,491 10,586 20 53 airports, excursions within the country, or i Israel 1,196 2,166 6 56 the intermediary .~ Turkey 10,783 8,932 18 60 services provided by Source: WorldBank, Eurostat(column 4, 1999data). travel agencies. Often.- ---- -.... these are reserved for local companies. Given the high degree of vertical integration through package providers, such restrictions can be disruptive to the operation of foreign tour operators. In fact, the main GATS requests of the EU to the MPs in tourism services concern the removal of such restrictions. Limitations on the temporary movement of workers (mode 4)-such as staff of tour operators looking after customers during the season-can also induce frictions. Despite the economic importance of tourism for many MPs and its large share in regional services trade, further cross-border liberalization in this sector is not necessarily a top priority. The reason is that the economic attractiveness ofthe sector and global competition between tourist destinations has already induced most countries, including the MPs, to reform this sector unilaterally. More than a hundred WTO member states have made commitments regarding tourism services. In recent years, many southern Mediterranean countries have privatized state-owned hotels, opened their markets to 144The vast majority ofWTO memibers have made commitments in tourism (over 114 countries). 73 FDI in hotels and resorts, and implemented other policies to upgrade their tourism industry. Morocco, for instance, launched a comprehensive tourism development strategy in 2001, with the support by the World Bank. It aims at doubling the number of hotel rooms and at quadrupling the number ofannual arrivals by 2010. Cornerstone of the program is the Plan Azur, which foresees 5 also construction of six large resorts by international investors for a total of $4.3 billion.'4 Tunisia is pursuing an ambitious tourism development plan that is meant to double the number of overseas visitors to 10 billion per year in the decade to 2010.146 If they succeed, these plans will both the accelerate economic development and deepen regional integration between the two sides of Mediterranean Sea. Box 4.1 Health Tourism and Retirement Abroad Two developments that are snill in their infancy, but could provide significant oppornmties for services trade and deeper integrtion in the Euro-Mediterranean, are health tourism and the trend to retire abroad. Both can be regarded as specific types of towism that are being driven by the ageing societies of developed countries. Health services account for up to 10 percent of GDP in most European economies and faced with rising cost, many of these countries are looking for cheaper ways to provide such sernices. Examples for health tourism driven by differences in pnce and service quality are Westem Europeans traveling to Hungay for dental care; the renown spas of the Czech Republic; or rich individuals from Arab countnres comning to Europe for high-tecb surgery. The unque climate and water of the Dead Sea has led to the development of a significant health tourism industry for skin-related condibons in Jordan and Israel. A developing nation that has systematically encouraged health tourism is Cuba. Its strong trAdition ofmedical traing and well-developed public health care system pernit the country to offer even advanced treatments to foreigners. Ther are now efforts to actively upgmde the capacity to offer plastic surgery (packaged with convalescence holidays) and the public agency Cubanacan Tutismo y Salud is opening service centers m for Europe to better market health services to foreigners.' 47 In 1995-96, "25,000 patients went to Cuba treatment and 1,500 students went there for traming" (Mattoo 2002). Several MPs have the potential to build similar services industnes for European or Gulf country clients. Delivered via mode 2. the mam constraints to such trade is the portabihty of health insurance. Commitments on this issue could well be part of a trade in services agreement between the EU and MPs (health insurance portability is already possible within the EU). Other examples of liberalization measums geared at facilitating health tourism in the region are the right of establishment for foreign health clinics or ternporary work permits for southern Meditenranean nurses taking care ofelderly people in the EU. Relaied to leisure and health tourism is the retirement of individuals from developed countries (including MP migrants retiring at home), who are attracted by a better climate and lower costs of living. Many northem Europeans have already settled on the Spanish islands, in southern France. or the Italian region of Tuscany. In the United States, Floridahas become the "retrement home" for millions of people and more recently Mexico has energed as a popular destination for pensioners. "If only 3 percent of the 100 million elderly persons living in OECD countries retired to developing countries, they would bring with them possibly S30 billion to $50 billion annually in personal consumption and S10 billion to 515 billion in medical expenditures" (Manoo 2002). The existence of a well developed tourism infiastructure (e.g. tansport connections) and the availability of of services consumed by older people (e.g. health services) are a precondition for this modem forn mipgrtion. One of the main constraints remains the portability of pension entitlements. 14 5MEED (20 December 2002 and 14 February 2003). '46 MEED (28 December 2001). '4 DerSpiegel Online 7 (27 February 2003). 74 4.5 Competition Policy Reflecting the central role that competition plays in dynamic market economies, all OECD countries and a large number of developing countries have adopted competition laws to protect consumers from cartels, restrictive practices, and the abuse of market power.'48 Competition (or antitrust) rules complement other policies that stimulate competition, including deregulation (removing government-imposed constraints to competition); sector-specific regulation (to address incidences of market failure); trade liberalization ("import competition"); and privatization (breakup of state-owned monopolies, separation of commercial and regulatory functions). Sector-specific regulation addresses structural obstacles to competition in a sector-such as the allocation of air traffic rights, the unbundling of port services from port management, or interconnection rules for electricity grids and telecommunication networks.'4 The cross-sectoral 9 nature of competition law, on the other hand, provides for a flexible instrument to tackle anti-competitive behavior on a case-by- case basis. While both the enforcement of sector specific regulations and general competition laws requires the establishment of sufficiently autonomous and technically competent regulators, the more general nature of competition laws tends to put an even greater demand on the limited implementation capacity ofmany developing countries. Besides undermining economic efficiency at the national level, anti-competitive behavior by firms can be an important obstacle to trade. Examples are export cartels or a merger in one country that creates a dominant position in another. As government-imposed barriers to market access have been reduced significantly in recent decades, such private barriers have become more salient. In 1996, the WTO established a working group to analyze linkages between trade and competition policy and to inform the debate about possible multilateral disciplines in this policy area.'50 While the EU has long argued for WTO rules on competition policy, the preference of the United States for bilateral agreements and the reluctance of many other members to move towards multilateral disciplines on this issue, has led the EU to scale down its proposals. The EU would still like to see all its main trading partners adopt national competition laws and for the WTO to define general principles, analogous to the GATS reference paper on basic telecommunications and rules for cooperation between national competition authorities. Key principles would be nondiscrimination (between domestic and foreign companies) and transparency (of decisions and procedures), but could also include other items (e.g. sufficient autonomy and competencies of antitrust authorities). Clear rules and obligations for the exchange of information between national authorities investigating cartels, mergers, etc. would also be included into such multilateral disciplines. The WTO dispute settlement body, however, should only rule on the general consistency of national competition laws with the agreed principles, not on specific cases. So far, however, little concrete progress has been made and the Doha Ministerial Declaration made an opening offormal negotiations conditional on the ability to reach consensus on negotiation modalities. Given the limited role ofmultilateral disciplines on competition policy to date, EU rules might be of greater relevance to the MPs-both as an example for the role that competition policy can play in the process of regional integration and due to the competition provisions contained in the AAs. The EU has established the most elaborate supranational framework for competition law in the world and the strict enforcement of these competition rules by the European Commission (which acts as the EU's competition authority) has been a driving force in the creation of the Single Market. While Articles 81, 82, 86, and 87 of the Treaty of Rome define general principles, detailed implementation 148 For a general overview see Organization for Economic Cooperation and Development and World Bank (1999). 149 Sector regulation and generalcompetition policy can be substitutesor complements, depending on the circumstances. 150 For a good overview over the pros and cons for WTO disciplines on competition policy, as well as the history of this debate, see Holmes (2002). 75 created an elaborate regulations and especially a large body of precedent-setting decisions have other procompetitive policy framework. This is well integrated with sector-specific regulations and activities Single Market policies. Whereas EU rules apply to the entire spectrum ofanti-competitive pricing), the jurisdiction of EU (e.g. cartels, mergers, price fixing, market sharing, predatory institutions is confined to cases that affect cross-border competition. Purely domestic cases are being dealt with by national competition authorities, but nowadays most cases do have some cross-border implications. Another unique feature of EU rules is that they also explicitly apply to government transfers to subsidies that distort competition (Article 87). In fact, the Commission prohibits state private or public enterprises in whatever form (e.g. subsidies, guarantees, tax breaks) and strictly a scrutinizes the behavior of EU governments. Extensive powers of investigation, combined with deter private companies and reputation for independence and strict enforcement that it has built, governments from interfering with the competitive dynamics ofthe Single Market. deeper regional integration. The EU example shows that competition rules can play a major role in neighboring More recently, the effects of the EU competition regime have started to radiate into regions. The EU has created a web of bilateral trade agreements with other countries, and most policies. 151 The most agreements with its neighbors include provisions on competition and state aids (Norway, Iceland, comprehensive are those with EFTA countries participating in the Single Market of EU competition law. The 10 Liechtenstein). These countries fall under the full jurisdiction countries that acceded in May 2004, had already transposed EU rules on competition and state aids and a and they are receiving technical assistance to develop effective enforcement mechanisms As "competition culture." Upon accession, they also come under the jurisdiction ofthe EU regime. part of its customs union with the EU, Turkey committed itself to a far-reaching adoption of EU MPs competition and state aid rules. The competition and state aid provisions of the AAs with other regulations. are much weaker and will only become effective upon the enactment ofimplementation the entry into These are to be drawn up by the bilateral Association Councils, within five years after force of the respective AA. This deadline, however, only seems to be indicative and has already lapsed in the case ofTunisia.152 Analogous to EU-internal rules, bilateral competition and state aids trade. provisions with all these countries only apply to cases affecting cross-border for While multilateral and regional disciplines remain weak or non-existent, national frameworks the new EU member states competition policy are still rudimentary in most MPs.153 Exceptions are developed detailed rules and Cyprus and Malta, as well as Turkey and Israel. These countries have effective competition authorities. Morocco, Algeria, Tunisia, and Jordan have adopted competition in the Arab MPs, rules and set up competition authorities (excluding Morocco). The main problem autonomous (e.g. however, is actual enforcement. Most competition authorities are insufficiently regarding the right to initiate investigation or the ability to enforce decisions) and institutionally weak (few technically qualified staff, insufficient budgets). None of the Arab MPs have effective key parts ofthe economy (e.g. state aids policies and in many cases, competition rules do not apply to reflected in the case-load, the infrastructure sectors, state-owned monopolies). These weaknesses are economic significance ofthe cases investigated, as well as the fines levied. As part oftheir mise-a-niveau process, the MPs will have to determine how fast and how far to move to in the area of competition policy. In many of these economies, more blatant impediments unregulated cases competition still exist (e.g. legal barriers to competition, state-owned monopolies, of market failure in key services sectors) and should be a priority for reforms. Given weak 15' For a detaileddiscussion ofcompetitionpolicies in the MPs, see Geradin (2004). without a start of negotiations or a provision of related technical assistance. This 152 The deadline lapsed in 2002 contrasts with the case of the Europe Agreement, where implementation measures were quickly adopted. country-specific assessment, see (1) Geradin (2004); (2) Lahouel (2003). 153 For a comprehensive regional and a 76 institutional structures and a limited implementation capacity, many southern Mediterranean countries do not yet seem ripe for elaborate competition regimes. Nonetheless, well-designed competition laws and competition authorities can play a useful role. They should initially focus on the main anti-competitive conducts (e.g. cartels, abuse of dominant position) and act as an advocate for the development of a "competition culture" (e.g. advise to governments on competition-related policies or the issuing of public opinions). Their mandate and institutional capacity could then be gradually expanded. The implementation regulations of the AAs could be used as an external anchor for such domestic reforms. As in all other policy areas, however, regulatory harmonization with the EU should not be pursued for its own sake, but only to the extent that it effectively facilitates trade or economic reform in the MPs. Flanking measures would be donor-sponsored capacity building projects, the exchange of best practice through regional networks of competition authorities, or peer reviews. Given the different stages of development across the MPs, a differentiated and gradual approach is called for. 4.6 Public Procurement Cross-border competition for government procurement is an important building block for the creation of a comprehensive free trade area. The purchasing of goods and services by public entities can account for 10 percent ofa country's GDP and the world procurement market has been estimated to exceed $3 trillion per year (excluding compensation of state employees and military expenditure; World Bank 2000a; Evenett 2002).'54 In developed and developing countries alike, discrimination in favor of domestic companies remains widespread. This can take the form of local content rules or residency requirements as well as more implicit forms, such as biased product specifications, non- competitive contract awards, or rigged tenders. Discrimination in public procurement not only constitutes an important non-tariff barrier, but it also reduces welfare at the national level. It creates rents that undermine incentives to increase efficiency at the company level; while increasing costs of purchases for the government and thus taxpayers. An analysis of OECD countries found the "margin of preference" (the premium paid by governments to favored domestic suppliers) to range between 13 and 50 percent.'55 Non-transparent and uncompetitive procurement also creates a fertile breeding ground for corruption-a major impediment for economic development in many southern Mediterranean countries. As far as multilateral disciplines are concerned, the WTO Government Procurement Agreement (GPA) entered into force in 1996. It only binds signatories and has less than 30 members. Virtually all ofthese are high-income countries, including Israel as the only MP. The GPA obliges countries to apply national treatment for procurement to other signatories (principle of reciprocity) and to abide by the most-favored nation principle. The rules ofthe GPA apply to all purchases exceeding a certain volume. It covers all goods unless exemptions have been granted ("negative list"), but it only covers those services explicitly listed in the annexes ("positive list"). In addition to its provisions on nondiscrimination, the GPA defines rules regarding the transparency of the procurement process. Key principles include open access to tenders, the use of objective technical specifications, a publication of tenders, and the notification of relevant regulations to the WTO. The third main pillar of the GPA are enforcement provisions, including the installation of domestic arbitration procedures (to avoid time-consuming court settlements) or the possibility to bring cases to the WTO dispute settlement body. 154Local and provincial governmentstend to spend about halfas muchagain ongoods and servicesas central governments. 55 Francois, Nelson, and Palmeter (1997), quoted in Simon Evenett (2002). 77 it As these multilateral rules increase theefficiency, transparency, and accountability ofprocurement, (e.g. should be in the interest of any country to unilaterally adopt them by passing appropriate laws national procurement law, anti-corruption laws) and by setting up institutional mechanisms to for enforce them (e.g. an independent public procurement agency, credible appeals procedures the EU, public bidders, auditing of procurement contracts). Both in NAFTA and especially in of the EU procurement rules have been an integral part of regional integration efforts. As part enlargement process, many CEECs and three of the MPs (Cyprus, Turkey, Malta) are adopting the started to reform their strict EU directives on public procurement. Several of the Arab MPs have public procurement regimes, in some cases with help from the World Bank. Given the economic importance ofthis matter, they would be well advised to accelerate publicprocurement reform at the commitments. national level and to anchor those reforms through regional and multilateral 78 CONCLUSIONS: FROM STRATEGY TO ACTION Eight years into the Barcelona Process, the Euro-Mediterranean Partnership has not yet led to a notable acceleration of economic reforms or an improvement of economic performance in the southem Mediterranean countries. At the same time, the Arab MPs have been marginalized in the global economy. Increasing global competition for low value-added manufactures and EU enlargement threaten to further erode their competitive position. In order to increase exports, attract FDI, and create jobs for a rapidly growing workforce, these countries need to better leverage a key source of comparative advantage they are endowed with: geographic proximity to the large European markets. The EU accounts for about a quarter of world GDP and foreign direct investment. With the right policies, geographic proximity to these markets could be tumed into a powerful driver of economic development. This requires deeper forms of integration between the two shores of the Mediterranean. The main policy instruments for achieving this would be the liberalization of trade in services and the comprehensive behind-the-border reforms that this entails. Deeper integration is not about regulatory harmonization for its own sake. The ultimate objective is the removal of a wide spectrum of non-tariff barriers that obstruct economic transactions and resource flows across borders. Regulatory harmonization is only one mechanism to achieve that. The wholesale adoption of the rules and regulations of the Single Market (the acquis communautaire) seems neither feasible nor desirable. The focus should rather be on a tailor-made type of "regulatory convergence." As Mexico's integration with the U.S. economy during the 1990s has shown, deeper integration can be achieved with low levels of policy harmonization. What is primarily needed are decisive domestic reforms that enhance productivity, improve the general business climate, and remove non-tariff barriers. Cross-border integration can be an important catalyst and a useful complement for such reforms. The pursuit of deeper integration-which can also be conceptualized as the gradual or partial extension of the Single Market to the South-has a decisive practical advantage. While it formulates a "grand vision" for the region, it can be implemented incrementally and at multiple speeds. As this study has shown, deeper integration may be tackled at different policy levels (national reforms, regional integration, multilateral liberalization) and in a wide range of policy areas (individual sectors and themes). This permits each MP to move at its own pace and according to its own priorities. While the long term goal is clear, there are many ways of getting there. The modular nature of the strategy proposed makes it possible to start with implementation immediately and it allows fast reforming countries to move ahead without waiting for the laggards. At the same time, an overarching and clearly communicated vision-participation in the Single Market and integration into an "wider Europe"-should help overcome vested interests that obstruct individual reforms. As policymakers move from strategy to action, they have a number of implementation instruments at their disposal. In most services sectors, multilateral GATS commitments would be the appropriate tool. This would require WTO accession of some of the Mediterranean Partners and a strengthening of existing commitments for the others. Ifthe Doha Round is not concluded in the foreseeable future, such commitments should be made unilaterally. As regards bilateral instruments, the existing Association Agreements provide for further liberalization of trade in services. The establishment of such economic integration agreements, in the sense of GATS Article V, are being discussed in the Euro-Med working group on services. In addition, protocols could be added to the existing agreements. In some cases, such protocols could be substitutes for multilateral commitments (e.g. in air transport) and in others they could be add-ons (e.g. on regulatory convergence or institutional 79 cooperation). A more ambitious bilateral option would be to bundle various additional commitments type of instrument into European Neighbourhood Agreements (or second generation AAs). Another aviation would be regional agreements between the EU and the MPs as a group (e.g. on a common civil area). While this would require complex negotiations, itmay be considered for specific areas. barriers The most important implementation instrument remain unilateral reforms. Most non-tariff These are and restrictions to trade in services can best be removed through domestic policy measures. efficient very similar to those reforms needed to ensure the partner countries become more for economies (increased competition, increased private sector participation, rights of establishment foreign investors). While commitments (at the bilateral, regional, or multilateral level) bring its additional benefits-such as reciprocal concessions or signals to investors-each MP can deepen front integration with European and global markets unilaterally. A lack of progress on the external well should not be used as an excuse to hold back with reforms at the national level. Overall, a the exact designed mix of instruments would help unlock the synergies between them. Whatever instruments used, they will have to be credible and effective. Mere policy statements and declarations of intent will notsuffice. Moving from strategy to action not only requires the right tools, but also the appropriate incentives gains to be for MP governments. The most important incentive, of course, should be the economic be additional reaped from deeper integration and economic reforms. Another critical incentive would less assistance to slow financial assistance to fast reforming countries-and correspondingly concessions by the EU reforming countries. One of the most powerful incentives could be reciprocal at least be on agriculture or labor mobility. This has long been demanded by the MPs and should granted to fast reformers as a highly-geared incentive. In fact, the bundling of reciprocal concessions be a into give-and-take packages for both sides (European Neighbourhood Agreements) could incentives that have been powerful catalyst for economic reforms. Moreover, there are "soft" the region. These include successfully used in the enlargement process and could be adapted to European benchmarking, national action plans, and annual progress reports. The EU's new The challenge will be to effectively Neighbourhood Policy (ENP) foresees most of these incentives. integrate them into a coherent incentive regime that will help to accelerate reforms. A final ingredient, besides implementation instruments and incentives, is improved donor coordination. could help This has often been talked about, but has remained limited and ad hoc. A "grand vision" a focus donor efforts. This is what happened in the enlargement process: The EU provided Other development paradigm ("enlargement") and an effective policy framework to achieve it. donors then channeled their technical expertise and funding towards the common goal. To achieve of something similar in the MPs, however, all involved parties should agree on an efficient division labor, clearly defined deliverables, and specific time-tables. One scenario for increased donor MPs into policy matrices coordination, could be to translate the ENP Action Plans for fast reforming for multi-donor operations and technical assistance. requires Most importantly, implementing the ambitious reform agenda that deeper integration entails donor significant political will on behalf of governments and concerted assistance efforts by the progress on the community. Translating general commitments to deeper integration into tangible ground will be no easy feat. The potential payoffs, however, would make such efforts worthwhile. 80 ANNEXES Annex A: NAFTA and its Lessons for Deeper Regional Integration Annex B: Rules of Origin as an Impediment for Deeper Regional Integration Annex C: Regional versus Multilateral Liberalization ofTrade in Services Annex D: Business Trends in the Textile Industry andtheir Implications forthe MPs Annex E: Glossary of Selected WTO and GATS Terms Annex F: Sector Classification for GATS Schedules Recommended by the WTO ANNEX A: NAFTA and its Lessons for Deeper Regional Integration The North American Free-Trade Agreement (NAFTA) between Mexico, the United States, and Canada was the first far-reaching case of North-South integration and can provide some useful lessons for the Euro-Mediterranean Partnership.'56 In several respects, NAFTA's core provisions go beyond those of the Association Agreements (AAs) between the EU and the MPs. Over the ten-year period to 2003, trade in goods has been almost completely liberalized. Tariffs are being removed for 99.3 percent of imports from Mexico to the United States and for 98.1 percent of U.S. exports to Mexico. In the case of agricultural goods-thus far excluded in the Euro-Mediterranean agreements-non-tariff barriers are being tarifficated and trade is being liberalized (in some cases a 15-year phase-out period applies).' 57 With respect to public procurement, NAFTA also goes further than the AAs. It includes a positive list of sectors and purchasing entities to which national treatment applies. In a chapter on technical barriers to trade, the agreement also contains some concrete provisions regarding norms and standards, as well as on sanitary and phytosanitary measures. Twenty four committees and working groups were established-each corresponding to a particular clause of the agreement-to ensure implementation, dispute settlement, and close working relationships between governments at the technical level. One major difference between NAFTA and the Euro-Mediterranean AAs is their treatment of trade in services. While the Euro-Med agreements contain no specific commitments in this field, NAFTA liberalizes trade in services to a considerable extent. Except for sectors included in a negative list, the rights of national and most favored nation treatment are granted to service providers and requirements to establish a presence in the other jurisdiction are lifted (Abbott 1995). There are also very liberal provisions concerning investments (mode 3 of supply). Whereas telecommunications, air and maritime transport are largely excluded, banking, construction and engineering, as well as trucking and bus services (most transport flows in NAFTA are land-based) are gradually being opened to foreign companies. Moreover, the economic costs of remaining exemptions are considerably reduced by the fact that most of the excluded sectors have already been liberalized at the national level in all three NAFTA countries. NAFTA entered into force in 1994 and most of its provisions have by now been implemented. Compared to the AAs, NAFTA targets a broader range of economic integration issues, contains stronger provisions on most of them, and puts a clear focus on effective implementation. Whereas NAFTA is comprehensive with regard to economic integration, it is otherwise a "no-frills" agreement. It has no external dimension such as a common external tariff or a common commercial policy vis-a-vis third countries.'58 Its institutional structures are relatively light and it is a purely economic agreement. Besides two rather limited supplementary agreements on environmental and labor issues, NAFTA has no political, cultural, or security dimension-unlike the Euro- Mediterranean Partnership (Sbragia 2001). There is no effort to achieve regulatory convergence, but rather a pragmatic approach to the removal ofnon-tariff barriers. Another important difference is that 156It is sometimes argued that the first case of North-South integration was the EU accession of Greece, Portugal, and Spain. Their GDP per capita relative to that of theother EU members, however, was about five times higher than the respective ratio between Mexico and the US/Canada. 157Mexico's total agricultural exports doubled from $2.4 to $5.3 billion during the 1990s and the stock of U.S. FDI in food processing reached $5.7 billion in 2000 (FinancialTimes, 1July 2003). 158 One exceptions are strict rules of origin (ROOs). They discriminate against third countries, to ensure that most benefits of trade liberalization accrue to companies from NAFTA countries and to prevent the use of Mexico as an export platform to the US. However, ROOs are less of an obstacle for the creation ofregional production networks in the case of NAFTA than in the Euro-Med FTA. First, there is no patchwork of different trade agreements. Second, among large countries cross-border value-chains are more likely to be of a bilateral nature. 83 United States and Mexico, NAFTA is basically a bilateral North-South agreement between the For instance, the whereas the Euro-Med Partnership has more complex plurilateral structures.'59 via regional fora have sectoral policy dialogue of the Euro-Med Partnership (EMP) conducted to be too broad and yielded few tangible results. The group of participants simply seems tensions in the region complicate matters heterogeneous (currently 35 countries), while political as further.' 60 Another problem is the fact that the MPs do not have a clear institutional counterpart, the Commission, the Mexico basically does in the U.S. government. The division ofpower between and the European Parliament makes Member States (represented in the Council of Ministers), decision processes on the EU side slow and complex. however, is the fact that One crucial difference between these two cases of North-South integration, of domestic the implementation of NAFTA was accompanied by a much more ambitious program program of economic reform in adjustment in the southern partner. Mexico launched a far-reaching 1966; Ortiz 1996). Except for 1987, which it consistently pursued for over a decade (Ruiz-Napoles Despite the Peso Crisis, which Tunisia or Jordan, none of the MPs has a comparable track-record. during the occurred less than two years after NAFTA's launch, Mexico's economic performance in 1999. This 1990s has been impressive. Its trade more than tripled from $82 billion in 1990 to $279 made Mexico the translates into an average growth rate of 15 percent (twice the global average) and petroleum products as seventh largest trading nation in the world. 161 Manufactured goods replaced is now intra- the main export item (a sign of changes in comparative advantage) and much trade FDI between 1994 and 2000 industry (a sign of advanced economic integration). Accumulated the United States and 60 percent of amounted to $85 billion.' 62 75 percent ofMexico's exports go to its FDI are coming from there.'63 growth The government estimates that half ofthe average 5percent In sumnmary, achieved in the last four years of the 1990s can be attributed to increased exports. reforms, has economic integration with the vibrant U.S. economy, in conjunction with domestic benefited Mexico greatly. driven by the creation The dramatic growth rates in U.S.-Mexican trade and FDI flows were largely into North American of "cross-border industrial complexes," or rather Mexico's integration maquiladora production networks. Outward processing trade was greatly facilitated by the fact that into being. These assembly plants had been established on the border, long before NAFTA came status. They imported factories were located on Mexican territory, but enjoyed a type of free-zone products were re-exported to the U.S. U.S. components duty-free, under the condition that finished form of trade involving industrial market. "NAFTA was introduced at a time when a particular neighbors had already evolved complexes that span the borders between the United States and its two to expand and extend trade over a period of decades. [...] Thus NAFTA creates an opportunity 2001). As NAFTA relationships that are already well established" (Lakshmanan and Anderson those well- came into force and did away with the tariff advantage the maquiladoras enjoyed, in terms of larger than the MPs in terms of population and GNI. The only MP that comes close 159Mexico is much of $5,830 (Mexico: of 66 mnillion million) and a per capita GNI size is Turkey with a population (Mexico: 99 $8,240). From World Bank (2003c). conducted through Councils, on the other hand, tends to be or a 160The bilateral policy dialogue the Association rather generalnature. 1993 and 2000, to the EU. 2000. "The Mexico-EU Free-Trade Agreement." Brussels. Between 161Mission ofMexico 1July 2003). exports increased from $52 billion (to the US: $43 bn) to $166 billion ($148 bn). (FinancialTimes, increase in exports attributed to NAFTA, but there is evidence 162Not all ofMexico's and FDI during the 1990s can be ofa strong causality (Lederman etal. 2003). the global economy, Deutschland(28 March 2001). Despite the downturn in the United States and in 163FinancialTimes (FinancialTimes, 22 February 2003). FDI was still running at over $12 billion in 2001 and $13.6 billion in 2002 84 established linkages at the company level were extended deep into Mexico proper and thus acted as a catalyst for more comprehensive economic integration. As far as economic reforrms in the backbone services are concemed, vested interests have thus far preserved the state-owned monopoly in electricity and left the telecommunications sector only partially reformed. However, the comprehensive overhaul of the transport sector can be regarded as a successful example of how structural reforms have enabled the Mexican and U.S. economies to mesh at the micro level.'64 Regarding external economic reforms, the government is pursuing further trade liberalization with other countries. In 2000, Mexico signed a far-reaching free-trade agreement with the EU, as well as with Israel and four of its Central American neighbors. In the meantime, negotiations between 34 countries of the western hemisphere are under way to create the Free Trade Area of the Americas (FTAA) by 2005.165 Despite Mexico's stellar performance in the 1990s, the process of export-led growth threatens to run out of steam. Besides the cyclical downturn in the US, the main structural challenge is the fierce competition of China and other Asian countries in labor- intensive manufactures. In the two years since 2001, an estimated 540 maquiladora plants with 200,000 jobs left Mexico in search of cheaper labor.'66 In 2002, China overtook Mexico as the second largest importer to the US. Unless Mexico implements a wave of second generation reforms to enhance productivity, it will find it increasingly difficult to compete.' 67 A final aspect of deeper integration between the United States and its southern neighbors that needs to be mentioned is migration. Thanks to millions of(mostly illegal) immigrants from Latin America, Latinos have replaced blacks as the largest minority group in the US. An estimated 11 million Mexicans alone live north of the border.' 68 As opposed to many other waves of immigrants before them, Latinos are not simply being assimilated into the American "melting pot," but they are also transforming their host country in return. Spanish is already the most commonly spoken second language in the US. In predominantly Hispanic cities like Miami, San Diego, or Los Angeles signs of Latin American culture have become omnipresent. At the same time, Mexicans and other Latin Americans trained at U.S. elite universities have become a driving force of social and economic modernization in their home countries. While some of these developments mirror patterns of emigration from neighboring regions into the EU, flexible labor markets and a decade of rapid economic growth during the 1990s has helped to productively integrate Latinos into the U.S. economy. Annual remittances of Mexicans working in the US, for instance, amount to a staggering $10 billion. With northward migration unabated, the process of interpenetration between the economies ofMexico and the United States is likely to continue for many years to come. '64 A source of conflict remnaintechnical and safety requirements for Mexican trucks crossing intothe United States. 165 In parallel, negotiations between the United States and Mexico's five southern neighbors were launched for a Central American Free-Trade Agreement (US-CAFTA). (The Economist, 15 February 2003). 166FinancialTimes (I July 2003). 167 Examples for such second generation reforms would be a breakup of the oligopolistic structures in telecoms; a privatization of the electricity and oil sectors; or policies that wouldencourage exporters to add more value (e.g. through research and development, or design and branding) instead of merely competing on price. 168The Economist(4 January 2003). 85 Integration ANNEX B: Rules of Origin as an Impediment to Deeper Regional ofgoods, In a world of preferential trade agreements, different tariff rates apply to the same category depending on the country from which they are being imported. To prevent goods from a high-tariff certificates of origin need to be third country being channeled through a preferential trading partner, of origin" provided. These certificates allow the goods to qualify for tariff exemptions. "Rules to "obtain (ROOs) define conditions that a product must satisfy to be granted preferential access-i.e. rules are spelt origin" from the exporting country under the provisions ofa free trade agreement. These out in trade agreements between countries and often account for the bulk of text in such documents. of tariff heading ROOs usually require a minimum percentage of domestic value added; a change goods); or specific processing operations (the processing of imported materials into more advanced changes of tariff that have to be performed within the exporting country. In EU trade agreements, other rules heading tend to be the default rule and annexes specify for which product categories borders, different ROOs are invoked apply. Since intemational value chains often cross multiple frictions this entails, rules of depending on the sequence oftrades involved. Given the administrative the utilization origin can significantly reduce or distort trade flows. In fact, empirical evidence shows rates for preferences in several EU agreements with developing countries to be low-apparently 69 because the costs ofproving conformity exceeds the margin of preference.' are important to allow for the In regional trade blocks, simple and harmonized rules of origin in emergence of border-spanning production networks. Which steps of the value chain are processed origin. An example what country should be determined by comparative advantage and not by rules of Turkey, for such intraregional trade would be cotton harvested in Egypt, processed into yarn in across woven into fabrics in Italy, sewn into apparel in Tunisia, and distributed to final consumers Europe (for the role of ROOs in this industry, see also Annex D). More important than harmonization a trade block. In other words, of ROOs per se is the possibility to "cumulate origin" within products imported processing steps performed in trading partner A, and incorporated in intermediate B, if the resulting into country B for further processing, should be treated as originating from country However, there are different types goods are later exported to other members ofthe same trade block. inputs from the country to of cumulation. In the case of "bilateral cumulation" only intermediate which processed goods are re-exported qualify. An example is the import of electronic components the EU, after labor-intensive from the EU to Tunisia and the re-export of consumer electronics to assembly. "Diagonal cumulation" extends the same privilege to inputs imported from other countries "Full cumulation" within the trade block and thus permits for more complex regional supply chains. content," counts any processing activity from any country in a regional trade block as "qualifying regardless ofwhether it is sufficient to confer originating status to the traded components themselves. have repeatedly Within the Euro-Mediterranean FTA, the current rules of origin are complex and only vary across been identified as a major obstacle to intraregional trade.' 70 The rules of origin not bilateral Association Agreements, but there are also other complications. For instance, Morocco's value added, whereas free-trade agreements with Tunisia and Algeria require 40 percent of domestic between the the one between those two countries uses 50 percent as the threshold. The bilateral AAs origin. For automobiles EU and the three Maghreb countries use a mixture of criteria to determine or EU value added; in and machines, for instance, they require a minimum of 60 percent of domestic weaving and textiles at least two processing stages have to be carried out (spinning and weaving or rate is the percentage of eligible goods receiving preferences. For a discussion ofthis evidence 169The utilization "Rules of Origin, Trade and other ROOs-related issues, see Brenton, Paul and Horishi Imagawa. 2004 forthcoming. and Customs." In de Wulf, Luc and Jose Sokol,eds. CustomsModernizationHandbook.Washington, D.C.: World Bank. 2002. "Trade Facilitation in the Maghreb 170(1) Brenton and Manchin (2002). (2) International Monetary Fund. Economnies." Washington, D.C. IMF. (Draft 8 July, 2002). 86 assembly).17 In regards to cumulation, the AAs only permit diagonal or full cumulation in those cases, where the ROOs among the three Maghreb countries are identical with those defined in the AAs. This is not yet the case and as the rules of origin for many tariff headings differ in the three AAs, it would not even be possible to align all of them simultaneously. Additional incompatibilities arise with the provisions under the emerging Greater Arab Free-Trade Area (GAFTA)-which most ofthe MPs belong to-as well as with the network of bilateral trade agreements among the MPs. This complex system of overlapping rules of origin is non-transparent and imposes significant transaction costs on businesses and traders. It also adds significantly to the work of customs authorities (certifying origin is one of their main tasks) and thus amplifies one of the main bottlenecks in regional supply-chains. Most problematic, however, are obstacles to cumulation- especially given the small size of most MP economies.' 72 Effective diagonal cumulation would encourage South-South trade and make the region more attractive for foreign investors. One way to achieve this would be to harmonize ROOs between different AAs and then to amend the ROOs in South-South agreements, in order to make them compatible with those of the AAs. Another option is to extend the "Pan-European Rules of Origin" to the MPs. These were originally introduced between the EU, the EFTA countries, and the CEE enlargement candidates in 1997. Such an extension would require a replacement of the original protocols in the AAs (and in the corresponding South-South agreements) with those used in agreements with members of the pan-European system. In 2001, Euro-Mediterranean Ministers of Trade established a working group to explore how Pan-European Rules of Origin could be extended to the MPs. This working group produced a new Protocol, which was endorsed by Euro-Mediterranean Trade Ministers in July 2003. 7' It is to be inserted into all existing and future agreements. At the institutional level, the "Pan-European Group of experts"-which deals with technical issues ofimplementation-is to be opened to participation by the MPs. Once implemented, these changes should facilitate trade across the Euro-Mediterranean free trade area, at least when compared to the status quo. However, further reforms would be desirable to address remaining constraints. First, the Pan-European rules only provide for diagonal cumulation and not for full cumulation. Second, important restrictions remain in the form of sufficient processing requirements. Examples are two-stage processing rules for textiles and apparel or 40-50 percent value added rules in some other sectors. Third, administrative costs ofproving compliance need to be reduced to a minimum (e.g. the complex and very detailed product-specific ROOs in the AAs could be simplified). Such costs fall disproportionately on those companies that do not have state-of-the-art accounting systems-in other words, they represent a particularly heavy burden for small and medium sized enterprises in the southern Mediterranean countries. The most comprehensive solution to the ROOs problem would be the creation of a customs union, with all countries having the same external tariff, rules of origin are no longer needed. This, however, would entail comprehensive policy coordination and does not appear to be a realistic scenario for the foreseeable future. 17' Most MPs have a comparative advantage in labor-intensive production stages,which often account for a relatively low share of total value added. Such high thresholds can thus severely discourage outward processing trade between the two shores of the Mediterranean. 172This makes it more difficult to performa sufficient number of processing stepsdomestically. 173 European Commission. 2003. "Conclusions of the Euro-Mediterranean trade ministerial conference: Palermo, 7 July 2003." Brussels. 87 ANNEX C: Regional versus Multilateral Liberalization of Trade in Services What are the arguments for and against regional trade liberalization ("preferential trade"), as compared to multilateral liberalization? The answer differs for trade in goods and trade in services. Generally speaking, the gains from trade to be reaped by a liberalizing country include a more efficient division of labor (driven by comparative advantage); economies of scale; increased competition; knowledge spillovers; and an external anchoring of domestic reforms.174 In the case of goods, regional liberalization is generally seen as second best, as the gains from trade are only being realized vis-a-vis the preferential trading partners, but not vis-a-vis the rest ofthe world (as would be the case through multilateral liberalization). In addition, these more limited gains from trade are at least partially cancelled out by the negative effects arising from "trade diversion": due to a tariff bias, least-cost suppliers from the rest of the world are being crowded out by less efficient suppliers from the preferential trading partner. An additional argument against regional, as opposed to multilateral liberalization, are the greater negotiation costs and the reduced transparency associated with a patchwork of preferential trade agreements.'75 But there are also arguments for regional integration. It may be easier to achieve due to fewer parties involved and greater interdependency resulting from geographical proximity. It can also permit for more efficient bargaining, as it reduces the risk of outsiders free-riding on a reciprocal exchange of concessions.'7 6 On balance, however, there is broad consensus that multilateral liberalization oftrade in goods is the first best option and should receive priority. While many of these considerations also apply to the liberalization of trade in services, there are some important differences. Before turning to the arguments for and against preferential trade, a general feature of trade in services (as compared to goods) should be mentioned. Since trade in services tends to require the interaction between supplier and customer, it involves factor movements (labor and capital).'7 Especially 7 trade via mode 3 (commercial presence), the predominant mode for most services, can considerably increase the net gains from trade accruing to an economy. On the one hand, it can generate a significant influx of FDI and associated knowledge spillovers into a country opening its services sectors to foreign firms. On the other hand, the replacement of high-cost domestic suppliers by more efficient foreign competitors (one of the main conduits for efficiency improvements) leads to less displacement of domestic employees, than in the case of goods. Besides this general benefit of services trade, there are several reasons why preferential trade 78 liberalization might have fewer adverse effects in the case of services than in the case of goods:' of gains from trade: (1) The net gains from trade for a national economy 174 There are two additional determinants also depends on 'location effects'. As production capacity is being moved to regions where productivity is higher thanks to agglomeration or clustering dynamics, an economy might gain or loose, depending on the distribution of those location effects between countries. (2) Dynamic gains from trade often outweigh the static gains, but are harder to measure. They include accelerated growth due to an increased rate of productivity growth; faster physical and human capital formation; or an ability to attractlarger investment projects, for which market size matters. in many developing countries, the issue ofnegotiation 175 Given the institutional capacity constraints of governments costs is a very relevant one. Moreover, a patchwork of preferential trade agreements-as currently exists in the southern Mediterranean-make for a much more comnplex policy regime. This creates considerable information and transaction costs for private comnpanies-as well as administrative costs for governments. principle generally extends concessions to third countries. 176 Under WTO rules, the most-favored nation (MFN) that are being used to analyze gains from trade assume fixed factor endowments. This 177Many economic models assumption is relaxed, if dynamic effects (growth of endowment) or location effects (reallocation of endowment) are taken into account. In the case of services, however, trade via mode 3 (commercial presence) and mode 4 (movement of natural persons) involves a movement of factors ofproduction by definition. of pros and cons for preferential liberalization of trade in services, see Mattoo and 178For a more rigorous analysis Fink (2002). This paper distinguishes between protective instruments according to their effects on variable and fixed costs for foreign suppliers,as well as quantitative restrictions on final sales and on the number ofproviders. 88 * First, most barriers to trade in services are prohibitive (e.g. regulatory restrictions or exclusivity rights) instead ofrevenue generating (as in the case of tariffs for goods). One consequence is that welfare gains from trade for consumers and firms do not have to be netted against a loss in fiscal revenues (increasing the net benefits for the domestic economy). A second implication is the lower risk of trade diversion, because there was no trade to begin with. However, the presence of location-specific sunk costs can create problems analogous to the effects oftrade diversion.' 79 * Second, procompetitive regulation is required to remove tariff barriers for trade in many services, and regulatory cooperation is easier to achieve at the regional level. One example is the cross- border regulation of interconnected electricity grids and power pools. Another case is the cooperation in air traffic control and joint regulatory regimes for common civil aviation areas. However, the need for a harmonization of regulations and the cooperation between regulatory authorities varies considerably between sectors and the nature of the trading partners (e.g. relative differences in the quality ofregulatory regimes or levels ofdevelopment). * Third, cross-border trade (mode 1) in network services requires physical interconnection and geographic proximity-especially in electricity, but also in some transport and telecommunication services. These types of trade can only take place between neighboring countries (i.e. regionally). * Fourth, in several important services sectors multilateral negotiations are at an early stage and little progress is expected in the foreseeable future. Electricity is a case in point. Another example is aviation, where the core ofsector policy (air traffic rights) has not even been incorporated into the GATS framework, but is still governed by the 1944 Chicago Convention.'8 0 In these cases, regional liberalization is the most promising way forward. When assessing the pros and cons of regional services trade liberalization for the MPs, it is important to keep in mind the specific nature of their preferential trading partner: the European Union. There are several features that make the EU a well-suited counterpart for such integration. First, it is a large economic block that accounts for a quarter of world GDP; it is already the main trading partner for most MPs; and it is an economy that is very open to the rest of the world. All these features considerably reduce the risk of trade diversion.' 8 ' Second, geographic and cultural proximity make it a well-suited partners for deeper integration. Third, the supranational policy framework ofthe Single Market (especially in network services) facilitates regulatory cooperation. Fourth, as in other cases of North-South integration, the potential for knowledge spillovers and FDI flows towards the MPs is high. Fifth, a broader vision of deeper integration with the Single Market could help MP governments overcome the resistance of vested interest groups against individual reform measures. 179 In many services, substantial location-specific sunk costs exist (e.g. investments in telecom networks or port infrastructure, development of brand recognition or branch networks for banks). This can create a 'lock-in' effect, where regional liberalization precedes multilateral liberalization: if foreign firms from the preferential trading partner have higher cost, the sunk investments will give them a first-mover advantage vis-a-vis lower-cost suppliers from the rest of the world. The significance of this problem depends on the size of the sunk costs (a sector-specific factor) relative to the gap in costs and quality (a factor depending on the type ofpreferential trading partner). 180 The Chicago Convention is based on the principle of national sovereignty over airspace and a key implication is that international air trafficrights are being regulated through bilateral air service agreements between governments. In other words, the multilateral sector framework has paradoxically led to a complex patchwork ofbilateral regimes. 181 The AAs permit MPs to enter into preferential trade with 25 EU countries, accounting for more than a quarter of global GDP and often more than 50 percent of their trade, through one single agreement. Moreover, the EU's openness to the rest of the world (its weighted mean tariff for all goods is a mere 2.7 percent) implies that EU firms are exposed to global competition and thus their efficiency is close to world standards. 89 Despite these arguments in favor ofregional liberalization among Euro-Med partners, there are also arguments to the contrary. First, in sectors where the GATS negotiations are well advanced, multilateral liberalization remains the first best alternative. In fact, the declared policy of the EU is to give priority to progress in multilateral negotiations. Second, the EMP thus far lacks well-developed Third, the enforcement instruments, if compared to the WTO dispute settlement mechanisms.' 82 for technical assistance provided under the MEDA program has not yet proven to be a strong catalyst the argument will shift economic reforms. Once these problems have been rectified, the balance of further towards regional liberalization. Fourth, a key advantage of regional trade agreements is that been they facilitate mutual exchanges ofpreferences (more efficient bargaining), but so far there has to offer greater little indication of a political willingness to do this.'83 If the EU were willing for instance, the concessions on trade in agricultural products or temporary movement of workers, liberalizing MPs might be willing to deepen their regional integration agreement with the EU by trade in services or by adopting specific EU regulations. liberalization-i.e. the In economic terms, the optimal mix between regional and multilateral desirable type of "open regionalism"-has to be determined on a sector-by-sector basis, and by mode of delivery.184 Generally speaking, multilateral liberalization should be the default option. Hence, WTO membership of all MPs and a strengthening of their GATS commitments should receive priority attention. Regional liberalization should be pursued in markets where regulatory cooperation are is important; in policy areas where the GATS framework is poorly developed; and in sectors that cases, important for the overall process of deeper integration (e.g. in the backbone services). In many by complementary it might be best to "top-up" multilateral commitments (e.g. on market opening) regional agreements (e.g. on cooperation between regulators). In all cases, however, regional agreement agreements need to comply with WTO rules. The bundling of different sectors into one will permit for cross-sectoral reciprocity and can facilitate negotiations. In some sectors, advantages of geographic and cultural proximity are likely to lead to the emergence of regional structures at the company level (e.g. banks or supermarkets with regional branch networks). Such patterns, however, should emerge through the interplay ofmarket forces and not be preempted through preferential trade agreements at the policy level.'85 When choosing between multilateraland regional (plurilateral) reforms are in many liberalization, MP policymakers should keep in mind that unilateral(domestic) it regional or cases the most beneficial of all. Additional benefits of cross-border liberalization-be multilateral-arise from access to FDI, modern technology, regulatory best practice, economies of scale, import competition, and a credible signal to investors that reforms are irreversible (external anchoring through legally binding commitments). The challenge will be to devise integrated sector reformn strategies that develop linkages and synergies between services sector reforms at the national, regional, and multilateral level. very successful enforcement mechanisms within the Single Market, ranging from peer 182 The EU has developed reviews and benchmarking exercises to supranational institutions endowed with strong enforcement mandates. One (i.e. for deeper integration of the main obstacles for the gradual or partial extension of the Single Market to the MPs be among EMP countries) is that more effective enforcement instruments are yet to be developed. One option would possible to extend the to enhance the role of the bilateral Association Councils. In some cases, it might also be but prima membership and mandate of EU-internal institutions to the MPs (e.g. Eurocontrol). A more complicated, regional regulators). facieappealing alternative would be to create South-South supranational structures (e.g. of concessions (without the risk of free-riding of outsiders benefiting from the MFN 183 A mutual exchange principle) can facilitate beneficialbargains between pairs or groups of countries. supply of services can often be more feasible between neighboring countries. 84 For instance, cross-border induce banks to develop regional branch 185 For instance, economnies of scale and a common language might networks of international retailers or for networks across the Arab MPs. The same could hold for the supermarket and to mobile phone operators. However, policymakers should liberalize multilaterally to maximize competition those enjoying preferential access). ensure that these networks are being created by the most suitable companies (not 90 ANNEX D: Business Trends in the Textile Industry and their Implications for the MPs The textiles and clothing industry is of vital economic importance for many MPs in terms of trade, employment, and GDP. Apparel exports amounted to $6.9 billion for Turkey, $2.6 billion for Morocco, and $2.5 billion for Tunisia in 1999-accounting for 25 to 50 percent of total exports in these countries. The EU, which imported a total $71 billion-worth of textiles and clothing in 2000, is by far the most important client (Someya, Shunnar and Srinvasan 2002). While these trades grew considerably during the 1990s, the competitive position of the region is deteriorating. In Morocco, e.g. the textile sector "faces stiff foreign competition and thus its share in exports has declined from 37 percent in 2001 to 34 percent in 2002."'86 The liberalization of global textile trade, in combination with profound changes in the way that clothes are being marketed and sourced will put increasing pressure on the southern Mediterranean countries to redefine their comparative advantage in this important export industry. With the phase-out of the Multifibre Arrangement by 2005, they will find it increasingly difficult to compete with countries like India and China on costs.18 7 Instead, they will have to exploit their geographic proximity to the European market more effectively, by upgrading their transport and ICT links. It is useful to look at some key business trends in the sector to fully appreciate the importance oftrade facilitation.'188 The fundamental problem in apparel retailing is that clothes are seasonal products and fashion items, for which demand is inherently difficult to predict. The accuracy of demand forecast, however, is a major determinant of profitability. If retailers order products which customers do not demand (referred to as "+error"), they have to maintain costly inventory and mark down unsold stock at the end ofthe season. If they order too few items that are in demand ("-error"), they face stockouts and lost sales. Both type of errors are widespread and costly. For each season, retailers go through a learning curve. Seven month prior to a season, they have approximately a third of the forecast information they need. By the start of the season this figure increases to about two-thirds, and three months into the season it reaches 100 percent. Such a steep learning curve creates an important trade- off with regard to the sourcing mix. While traditional up-front ordering (5-8 months prior to the selling season) allows to source in large batches from cheap suppliers in Asia, the long lead times this requires entail high forecasting errors. In-season replenishments, on the other hand, increase forecasting accuracy, but require high-cost sourcing in smaller batches close to home. A study of European retailers found that up-front orders were associated with +errors of 28 percent and -errors of 18 percent, compared to a mere 7 and 8 percent in replenishment orders.1 89 Due to faster fashion cycles, increased competition in retailing, and growing familiarity with just-in- time production, the percentage of in-season replenishments (currently around 10 percent) is increasing dramatically. The high premium this puts on managing information and product flows through tight supply chains is a main driver of another important trend in the textile industry: vertical integration. The dramatic growth ofcompanies like Zara, H&M and GAP-with an emphasis on tight supply-chains and quick responses to fashion trends-epitomize the transformation of the industry. For countries striving to benefit from trade in textiles, in-season replenishments are 186 World Bank. 2003. "Morocco: Economic Monitoring-Spring 2003." Washington, D.C. 187 Ibid. "Largely quota-free and enjoying preferential agreements, MENA country exports of clothing thrived under the earlier MFA quota regime (1984-95) that constrained the dynamic exporters. However, in the recent period, 1995-2000, leading up to the abolition of MFA in 2005, MENA market shares have leveled off signaling a potential decline, if MFA is totally abolished as scheduled." 188 "Changes in the retail regime influence the competitiveadvantage ofdifferent exporters unequally, as non-price factors become an increasingly significant influenceon sourcing decisions." These include quick response times, flexibility, and reliability (Baden 2002). 89 Prof. Heikki Mattila. (notdated). "Towards a Consumer-Driven Clothing Supply-Chain." Tarnpere University, Finland. 91 particularly attractive. It is a market segment with high value added (fashionable items), low cost in-season replenishments are sensitivity (speed is the key variable), and rapid growth. Interestingly, vis-a-vis also the market segment where the MPs can exploit their geographic proximity to Europe as Asian producers-who can only compete on speed using costly air freight (up to 10 times expensive as land or sea transport). highest This, however, will require not only the ability of southern Mediterranean companies to meet logistics standards in terms of flexibility and reliability. It will also require access to state-of-the-art as well as information and communication technology (ICT).'90 Relevant ICT applications include on "bar coding and point-of-sale scanning used to provide immediate and accurate information orders; and product sales; electronic data interchange (EDI) used by the retailer for replenishment and automated distribution centers to handle small replenishment orders."'91 At each cross-border 2-3 inter-firm interface, ICT and logistics services act as facilitators. Compressing lead times to removal of frictions in weeks (the highest standards in the industry) requires a comprehensive get southern information and transport flows. 192 Trade facilitation, however, is not only needed to Mediterranean products to European markets, but also for economic integration among the MPs. The in reason is that textile supply-chains tend to cross borders repeatedly. Raw materials are produced one country; turned into yarn and then fabrics (a highly automated process often performed by then industrialized countries); shipped to low-wage countries for labor-intensive sewing; and for exported to final consumers (e.g. in Europe or the US).193 If a Tunisian apparel manufacturer, both instance, produces a collection for a European retailer, he must be able to effectively manage the upstream supply-chain (dozens of fabrics and other materials sourced from various countries) and As sourcing patterns change each the downstream supply-chain (just-in-time delivery to clients). season, supply-chains must also be highly flexible. only countries that Given the complexity of such supply networks, it is increasingly regions and not mass, compete in this global industry. While large economies like China and India have the critical tightly smaller countries will increasingly be sidelined, unless they manage to become part of integrated regional clusters. Especially three such clusters have emerged: (i) the United States, and the Mexico, and the Caribbean Basin; (ii) East and South Asia; and (iii) the EU, Eastern Europe southern Mediterranean. The MPs will thus have to increasingly rely on tighter regional integration less with the European cluster to compete in world markets. This regional cluster, however, is still integrated than its competitors and the European Apparel and Textile Organization (EURATEX) has called upon policymakers to accelerate the creation of a Pan-Euro-Mediterranean Zone in this sector.'94 More efficient backbone services should be an integral part ofthis process. organization of sourcing, including 190 "Information technologies are also increasingly a feature of retailers' prevalent in harmonized information systems [...] and web based supplier management systems. This trend is more who do not have the United States than in Europe, but is likely to increaseamong larger EU retailers. For suppliers with the capacity to absorb, or work with these systems, this probably means exclusion from direct relationships buyers and relegation to a subcontracting role" (Baden 2002). 191Gary Gereffi (2002). and transfer of point-of-sales information, 14 days to make the fabric, 1 day 192This comprises: 2 days for collection for transport toproduction site, 3days for garment production, and 1day for transport to retailer. specialize on labor intensive apparelmanufacturing. For instance, clothes exports account 193Most MENA countries figures are 32 and 2 for 38 percent ofexports in Tunisia, while textile exports account for a mere 3 percent. The percent for Morocco; 10 and 14 percent for Egypt; and 11 and 3 percent for Jordan. Paper Dated 9th May 194 EURATEX. 2003. "The Pan-Euro-Mediterranean Zone-Update of EURATEX Position 2001." Brussels. 92 ANNEX E: Glossary of Selected WTO and GATS Terms Bound: In their schedules of commitments, WTO members can inscribe self-imposed obligations, which govem their trade with other members. For services, they can select specific sectors that are bound by the disciplines of the GATS (e.g. most-favored-nation or national treatment principles), subject to certain limitations specified inthe commitments. The objective ofsuch binding is to create legal obligations, ensure transparency, and avoid backsliding in the process of progressive liberalization (a reversal of commitments is only permitted under extreme circumstances and generally subject to compensation). With unbound sectors not subject to some GATS provisions (essential market access, national treatment, etc.), however, the GATS makes for a flexible framework. Dispute Settlement: Critical to the enforcement ofa rules-based trading system are institutionalized procedures to settle disputes between members. A country that believes another party to be in violation of its commitments may invoke the WTO dispute settlement procedures. (Since trade agreements are ofan intergovemmental nature, private parties do not have this right.) The first stage in the procedures is the creation of a panel of impartial experts, which has to issue a report within a six months period. To become binding, the report has to be adopted by the Dispute Settlement Body (DSB). If the concemed country fails to comply with the ruling by a given deadline, the complainant can request permission from the DSB to retaliate with a proportionate suspension of its own concessions. Credible dispute settlement mechanisms help prevent unilateral retaliation (illegal under WTO rules) and are particularly important for small countries (who lack negotiation power). GATS: The General Agreement on Trade in Services (GATS) was concluded in 1994 as part of the Uruguay Round and brought the services sector into the realm of the multilateral trading system. Partly due to the complexity of services trade, the GATS is still less developed than the GATT, but it is one ofthe areas where trade liberalization is expected to progress most in the coming years. GATT: The General Agreement on Tariffs and Trade (GATT), negotiated in 1947 among 23 countries, constituted the nucleus and remains a central pillar of the multilateral trading system. Initially confined to tariff negotiations, it increasingly expanded to other trade-related policies. Through successive rounds of multilateral trade negotiations, the GATT led to a dramatic reduction in trade barriers for goods, while expanding its membership to 148 countries by late 2003. Market Access: Trade in services liberalization is largely concerned with effective market access (via the four modes of supply). Article XVI of the GATS defines types of measures restricting market access that are legal under WTO rules. A member may only adopt or maintain those measures if they are specified in its schedule. These include restrictions on the number of service providers, the value of transactions or assets, the quantity of services output, the number of natural persons that may be employed, the type of legal entity through which a service can be provided, and limitations on the participation of foreign equity or the absolute value of foreign investments. Measures: This legal term refers to policy measures affecting trade in services. They can include laws, regulations, or administrative decisions taken at different levels ofgovemment. Such measures are subject to multilateral trade disciplines and the commitments listed in the schedules ofmembers. Modes of Supply: Four modes of trading services are recognized in Article I of the GATS: (1) cross-border supply (only the service crosses the border); (2) consumption abroad (the consumer crosses the border); (3) commercial presence (the provider crosses the border through different types of establishment, such as branches or representative offices); and (4) presence of natural persons (individuals temporarily cross the border for the sake of supplying a service). The term "supply" 93 every bound comprises the production, distribution, marketing, sale and delivery of services. For in turn with service, members can make commitments for each ofthe four modes of supply and then regard to market access and national treatment (giving rise to a matrix of commitments). has to be Most-Favored-Nation (MFN) Principle: Any foreign service or service provider other accorded treatment in terms of trade-related measures "no less favorable" than those from between countries. This principle, enshrined in Article II of the GATS, ensures nondiscrimination be invoked on a foreign providers from different countries. While exemptions to this default rule may subject to one-time basis (listed in an annex to a schedule, in principle limited to 10 years, and gradual convergence to the negotiations in future trade rounds), the MFN principle is meant to ensure with one country are most liberal regime. It also reduces negotiation costs (preferences negotiated a member wishes extended to all). There is a GATS Annex on MFN Exemptions and all exemptions in force, new to maintain have to be included in its MFN Exemption list. Now that the GATS is exemptions need to be approved by three-quarters ofall WTO members. of the National Treatment (NT) Principle: Core WTO principle contained also in Article XVII providers. GATS to ensure nondiscrimination between domestic and foreign services or service a "specific" commitment for Whereas the NT principle is a "general" commitment for goods, it is listed in a country"s services-i.e. it only applies to bound sectors and is subject to limitations within schedule. The MFN and NT principles are the key instruments for ensuring nondiscrimination the multilateral trading system. Round, with New Members: Two dozen countries joined the WTO since the end of the Uruguay close to three dozen additional countries having had applied for WTO membership. For countries that remain binding, joined the WTO at its inception in 1995, commitments made under the Uruguay Round while more stringent conditions tend to be imposed on new members. The reason is that during the accession process, existing members may demand concessions from the applicant in return for their XIX approval.' 95 With "progressive liberalization" a key feature of the multilateral process (Article members alike. ofthe GATS), the Doha Round should help extend the commitments of old and new trades at a specified Precommitment: Governments can inscribe obligations to liberalize certain planned reforms (and thus resist future date in their schedules. This permits them to externally anchor to vested interests lobbying for protection), while granting domestic companies a transition period prepare for competition. To date, little use ofthis mechanism has been made under the GATS. Preferential Trade: The GATS framework permits for preferential trade agreements (PTAs) among All PTAs sub-groups of countries. This is done through Article V and is conditional on certain rules: third have to be notified to the WTO; they must not lead to an increase in protection vis-a-vis countries; they need to have substantial sectoral (and modal) coverage; and they must eliminate substantially all discrimination between or among the parties to such a PTA. to do so. Reciprocity: Whereas the binding ofsectors is voluntary, countries have several incentives Besides the welfare gains from liberalization and the signaling effect to investors, there is the additional benefit ofreciprocity. Reciprocity not only provides "payment" for concessions in terms advantage of pitching of better access to foreign markets, but also had the political economy where domestic export interests against groups lobbying for import protection. Under the GATT, of equivalence, reciprocity has tariffs allow for easy quantification ofbarriers and thus a calculation a lesser role. been the main driving force behind liberalization. Under the GATS it has so far played accession process,see Michalopoulos (2002). 195For a detailed discussion ofthe 94 Trade barriers to services, which tend to come in the form of regulations, are much more difficult to quantify and thus cross-issue linkages might be needed to achieve reciprocity (e.g. between sectors or modes ofsupply). One problem is that the MFN principle limits the scope for reciprocity (creating an incentive for other countries to free-ride). Another difficulty is to devise mechanisms that grand "credit" for services sector reforms unilaterally adopted between multilateral rounds of negotiations. While there is no formal credit rule, such considerations are part of the informal guidelines applied to GATS negotiations (a reference to such mechanisms is made in Article XIX.3). 1 9 6 Schedule of Commitments: For each sector that a member decides to bind (positive list of sectors), the schedule of commitments has to specify all trade restrictions that the government wishes to maintain (negative list). The entry "unbound" indicates that no commitment is made. Governments can make full commitments (by entering "none" in the respective part ofthe commitment) or partial commitments (by specifying restrictions to be maintained). While the GATS proposes a taxonomy of sectors (the classification list-see also Annex F-specifies around 160 sectors and sub-sectors), countries may use their own definition to delineate markets for which they make commitments. Given the signaling effect to investors ofmaking binding GATS commitments, a country's schedule should at least reflect the status of domestic policy reforms already unilaterally adopted. Transparency: The principle of transparency is critical to the maintenance of a rules-based trading system. About 200 notification requirements are enshrined in the various WTO agreements (Hoekman 2002). It reduces uncertainty and information costs for traders, increases the legitimacy of the system, and reduces the burden on dispute settlement mechanisms. Article III of the GATS, for instance, obliges member countries to publish trade-related regulations, notify any relevant changes to the WTO, and to establish a central enquiry point. These obligations are complemented by multilateral surveillance of trade policies by the WTO through periodic, country-specific "trade policy reviews." The WTO further facilitates the exchange ofinformation between members through various committees, working groups, and councils that meet in Geneva on a regular basis. TRIPS: The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) was signed as part ofthe Uruguay Round and is one of the main multilateral trade agreements. WTO: The World Trade Organization (WTO) administers the trade agreements negotiated by its member states-especially the GATS, GATT, and TRIPS. Established in 1995 after the conclusion of the Uruguay Round, the WTO is a member-driven organization with rather light institutional structures. With only a few hundred staff, the Geneva-based secretariat acts as a nodal point in a complex intergovernmental network (there are 40 councils, committees, and working parties). Importantly, the WTO is a "single undertaking"-i.e. all its provisions apply to all members and countries can no longer confine their participation in the global trading system to individual agreements. By late 2003, the WTO had 147 members. The Doha Round, launched in 2001, is the latest round ofmultilateral negotiations is meant to significantly expand the scope of WTO disciplines. '96 For more detailed discussions of the role of reciprocityin the multilateral tradingsystem, see (I) Finger (2002) and (2) Hoeknian and Messerlin (1999). 95 ANNEX F: Sector Classification for GATS Schedules Recommended by the WTO for business services Excluded below are third-level subdivisions, listed in the WTO classification services (33). (46 subdivisions), communication services (21), financial services (16), and transport 1. Business Services development services, (A) professional services, (B) computer and related services, (C) research and services. (D) real estateservices, (E) rental/leasing services without operators, (F) other business 2. Communication Services (A) postal services,(B) courier services, (C) telecommunication services, (D) audiovisual services, (E) other. 3. Construction and Related Engineering Services work for civil engineering, (C) (A) general construction work for buildings, (B) general construction installation and assembly work, (D) building completion and finishing work, (E) other. 4. Distribution Services (C) retailing services, (D) franchising, (A) commission agents' services, (B) wholesale trade services, (E) other. 5. Educational Services services, (D) (A) primary education services, (B) secondary education services, (C) higher education adult education, (E) other education services. 6. Environmental Services (D) other. (A) sewage services, (B) refuse disposal services, (C) sanitation and similar services, 7. Financial Services services, (C) other. (A) all insurance and insurance related services, (B) banking and other financial 8. Health Related and Social Services (A) hospital services,(B) other human health services, (C) social services, (D) other. 9. Tourism and Travel Related Services tourist guides services, (A) hotels and restaurants, (B) travel agencies and tour operator services, (C) (D) other. 10. Recreational, Cultural, and Sporting Services libraries, archives,museums and other (A) entertainment services, (B) news agency services, (C) cultural services,(D) sporting and other recreational services, (E) other. 11. TransportServices (D) (A) maritime transport services, (B) internal waterways transport, (C) air transport services, services, (G) pipeline transport, (H) space transport, (E) rail transport services, (F) road transport services auxiliary to all modes oftransport (I) other transport services. 12. Other Services not Included Elsewhere 96 BIBLIOGRAPHY Abbott, Frederick. 1995. 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