Tamas David
Head of Research, Budapest Economics, Hungary
The creation of a common economic space or a free-trade zone between Russia and the rest of Europe has been on the agenda since the political transition accelerated a decade ago. However, not much has been achieved in that time. This paper will argue that, for Europe, this delay is costly. This may not seem so at first glance: Russia’s gross domestic product (GDP) is only 3.5% that of the European Union (EU). Nevertheless, Russia can offer Europe much more than the oil, gas and energy products that currently dominate trade between the two economies. If integrated successfully into the core of the European economy, its vast stock of human capital – a well-educated but cheap labour force – could provide Europe with an important boost to its competitiveness as a complex global economy emerges. Furthermore, the EU can draw on its experience of integrating the countries of Central and Eastern Europe (CEE) for guidance as to the optimal policy to adopt in regard to Russia. Although Russia’s political integration into the EU will be much weaker than that of the CEE transition states, the experience of the first wave of new members provides an important lesson of how best to pursue economic integration, as well as a reminder of the benefits available to both the EU and Russia.
Europe’s Russia strategy depends on its global strategy
To assess what Europe’s interest towards Russia will be in 15 years, one should be aware of what Europe itself will want to be at that time. This is far from a matter of consensus. This paper will apply the conceptual framework of economic structures and structural change to the EU economy in order to shape our view on Europe’s future role in the world.
During the globalisation process, a new economic organisational level is emerging. The nation state is no longer the main organising principle for economic activity, and, in line with this, the EU’s aim is not to become a nation state but rather to succeed as an actor in the global economy. One of the most important phenomena associated with the global economy is its continually increasing complexity, as the economic agents form an increasingly complicated network, resulting in an interdependence of markets, actors and sectors. The acceleration of technological change is a key feature of the growing complexity of the global system. Those countries and regions that are able to base their economic development on rapid adaptation to technological progress will dominate the globalisation process and be the main winners. This is why human capital, which allows economies to make the most of new technologies, will become increasingly important in coming years.
Europe’s economic environment fifteen years from now will be the global economy. The competitiveness of the European economy will be measured against other global players: the other two major economic regions, North America and East Asia.
For the three main regional players in the global economy, the best strategy to maintain competitiveness is to build up a complex economic core with a high degree of openness towards the global economy.
EU enlargement will add a further layer of complexity as a result of the integration of member states’ human capital.The successful economic integration of the Czech Republic, Estonia and Hungary into the EU in recent years (their total trade with the EU is higher than their respective GDP) largely reflects their cheap well-educated labour reserves, rather than any cultural commonality with West European nations. As this East European economic periphery further integrates with the rest of Europe, its pool of human capital will provide Europe with an edge in the global economy. Hence, Europe’s prospects of building a complex economic core – the most important factor in relation to the technology intensiveness of the entire European economic system – will substantially improve. Europe’s long-term interest towards the largest of the East European transition countries, Russia, similarly depends on its ability to gain access to its human capital, and to integrate its human capital-intensive industries into the European economy.
Europe needs not only a complex economic structure and a rich pool of human capital, but also some minimum prerequisites for growth, such as a stable energy supply. Predictable and stable access to Russian oil and energy products will thus remain a crucial component of the EU’s interest in Russia. However, in the technology-driven global economy, the complexity of the economic structure is more important than economic expansion in the traditional sense – that is, growth driven by natural resources and the exploitation of energy reserves.
Since Russia plays a key role in ensuring the provision of stable security and an environmental base for Europe too, Europe’s interests in Russia are somewhat less straightforward. Europe must also aim to foster political stability, by supporting the continuation of the democratisation process, and environmental security (including a commitment to reducing environmental hazards). These stability conditions, though, should be seen as necessary preconditions for economic integration, not as an end in themselves. The right long-term mixture for Europe’s policy towards Russia is to maximise the benefits offered by abundant supplies of Russian human capital while ensuring that the stability conditions are met.
Europe’s interest: a complex pattern of trade with Russia
The only way to exploit the Russian human capital base successfully is to integrate it into the European economy. In this way, the separate cores of the European and Russian economies will merge, effectively creating one system and leading to far more efficient use of their total economic resources. This same process, on a much smaller scale, has been the main course of economic integration in the CEE transition countries. Although many doubted at the beginning of the transition process that the CEE labour force would be able to meet the requirements of the Western economies, it proved to be a good match. Education in the Soviet system guaranteed a good base for the programme of technology catch-up that was central to the transition miracle that occurred in Estonia and Hungary in the second half of the 1990s. There is no reason to believe that the Russian (or the Bulgarian, or the Serbian) labour force would be any different.
The network that links the economic agents will become more dense from the integration process. The European and Russian economies are already connected in many ways. These economic links not only permit trade, but also generate change in local economic activities, in line with the classical view of foreign trade. The higher the number and the greater the intensity of these trade links, the denser the network among a variety of trade partners, and the more the two economies will adapt to one another. At the extreme, the pattern of trade becomes so complex and deep that the two economies cease to be separate systems and, rather, function as a new, common system, which utilises the economic resources of the two economies most fully and efficiently.
Where integration takes place between a larger developed economy, such as the European economy, and a smaller (although still substantial) transition economy, such as Russia, it is clearly of benefit to both sides. Russia is able to integrate into a much larger and more advanced economy, bringing advantages in terms of new markets, technology transfer and foreign capital, while Europe gains access to Russian resources.
The most often discussed Russian resources are oil and gas products, which have frequently been regarded in the past as the prime reason for economic integration. However, there are three problems with focusing on Russia’s energy exports. First, allowing them to dominate trade relations during the transition process reduces the complexity of overall trade, since other sectors of the economy are excluded. Second, these industries tend to be more capital- than technology-intensive, and hence the complexity of activity within the industries themselves cannot easily be increased - the rapid technology development that characterises the turn of the millennium has only a relatively limited effect on the oil industry. Third, energy products are homogenous and easy to monopolise within Russia, meaning that the sector is prone to domination by a few companies, further reducing the potential for integration with other economic actors.
More important for a complex European core is Russia’s abundant human capital stock. This is not only more dispersed than oil and energy resources, and by its very nature more difficult to centralise, but also - because of its role in permitting adaptation to technology - it allows a much more complex level of economic activity and corresponding pattern of trade to be established.
What is the current rate of complexity in regard to Russian–European trade relations? There are several indicators.
• The volume of trade relative to the size of the economy signals the level of mutual economic dependence. Countries with high openness indices typically have a history of adaptation to each other, and, therefore, are highly dependent on the presence of one another.
• The variation in the intensity of trade relations across different industries is typically lower when a high number of industries are engaged in trade compared to when just a few industries dominate. In the case of the Russian–EU pattern of trade, the dominance of oil would suggest a high variation – some industries (oil and energy) trade intensely, while others scarcely trade at all.
• The technology intensity of the industries active in the trade pattern is a sign of the complexity of economic relations. Foreign trade in mining or agricultural products is typically low-tech in nature, while communication and information-technology (CIT) services require cooperation in a wide range of areas, such as to ensure compatibility of standards and technologies.
Combining these three measures, a gauge of export complexity can be created as presented in the chart below.
The export complexity index of Budapest Economics reflects these three main components: openness; inter-industry variation in export volume; and the estimated technology intensity of exports. A higher degree of openness, lower inter-industry variation in export volumes and higher technology intensity of exports all lead to a greater index value. The time period was chosen on the basis of the quality of data (hence the 1997 starting point) and access to comparable industry-level trade data (hence the 2001 end point).
In the graph, Western Europe includes France, Germany and the UK, while Central and Eastern Europe refers to the Czech Republic, Hungary and Poland. All aggregations are volume weighted. The graph shows that both the large European developed economies and the largest (although considerably smaller) CEE transition countries have a substantially higher level of export complexity than Russia. This is due to two main factors. First, the oil and energy industries, with low technology intensity, dominate Russian exports. Second, the exports of Russia’s human capital-based industries fall well short of meeting their potential.
A very similar pattern characterises trade between Russia and the wider European economy, although a lack of comparable time-series data at the industry level prevented us from generating the relevant export complexity indices. Nevertheless, it is clear that, while Russian exports to wider Europe amount to 42% of total exports (according to 2002 data – up from 39% in 1996, but down from the 48% achieved in 2001, largely owing to the slowdown in the European economy), this activity is dominated by oil and gas exports. This compares with 70% of CEE exports going to the EU in the same year, of which a large part was from technology-intensive industries, such as machinery and electronics. EU exports to Russia (primarily machinery, food and chemical products) are much more balanced than imports from Russia (primarily oil); EU exports to Russia demonstrate a much higher complexity than EU imports from Russia.
Perceptions of Russia by old and new EU members
If the CEE transition experience is any kind of guide to the potential of Russian economic integration into Europe, the above graph suggests that the EU currently fails to exploit the possible benefits. Although political integration is rather unlikely in the case of Russia, there is no reason why this should hinder economic integration.
However, more rapid development of trade relations with Russia would require a change in perception among European decision-makers. Since the collapse of the rouble and the financial crisis of 1998, and spurred on by the accelerated reforms since 2000, European businesses have begun to realise the potential of the Russian economy. While the slowdown in the European economy has delayed this process, the likely transition success in Russia in coming years, coinciding with a revival of the global economy, will probably further help to improve European perceptions about economic opportunities in Russia. A very similar process occurred in Central and Eastern Europe. Foreign direct investors initially treated the region in the same way that they treat the ‘Third World’, focusing primarily on the relatively low cost of labour and investing in low value-added industries. But, by the fifth to eighth year of transition, investors had begun to recognise that the high level of human capital in the region allowed for the introduction of higher-technology production processes. European businesses can similarly be expected to shift their investment interests in Russia from oil to CIT. They would do so much more quickly, though, if European policymakers were to take the lead and signal that they regard Russia as a key future economic partner.
European perceptions of Russia will probably change somewhat as a result of the accession of the CEE candidate states to the EU in 2004. Despite their historical (Soviet era) baggage, the new members enjoy a host of economic links with Russia, as well as mutual interests and common understandings. Poland is the most likely to pursue closer economic ties with Russia (while Hungary will more likely join Greece and Italy in promoting the accelerated integration of the Balkans). The corresponding trade policies towards Russia, sponsored by the new members, will vary, too. While Poland would probably open the door as wide as possible, competitors (such as Slovakia in the steel industry, for instance) are less likely to pursue the same policy. At the same time, the Baltic States are expected to maintain their cautious foreign-policy stance towards their giant northeastern neighbour, engendering an equally guarded trade policy.
During the first decade of transition, the CEE countries’ economic relationship with Russia changed rapidly. The early 1990s saw the disintegration of the communist trading bloc, resulting in the collapse of the excess heavy industrial capacity of Central and Eastern European countries, which had been directed at meeting soviet demand, as well as the decline of exports from civilian sector industries like agriculture and pharmaceuticals. Meantime, the CEE nations remained dependent on Russia for oil, gas and electricity supplies, although at market prices much higher than the heavily distorted lower prices during the communist era. The overall effect of falling CEE exports to Russia while the price of imports from Russia rose was a rapidly growing trade deficit.
More than a decade into the transition process, the pattern of trade has altered. Now that the structural change is complete in the CEE, the attention of their policymakers and business executives is turning back to the opportunities offered by the Russian economy. At the same time, the acceleration of its own reforms has resulted in Russia emerging as a student of CEE reforms and also as a major investor in the CEE in Hungary for example.
In addition, building complex trade relations with Russia would not only benefit Europe by providing access to a large pool of cheap and well-educated labour, but it would also help to promote stability. This effect is beyond the mere spur to economic growth and hence enhancement of social stability. In Central and Eastern Europe, we have seen that integration into the European economy, especially in regard to technology-intensive industries, has impeded the capture of the state by various vested interests. Profitable industries have emerged with clear ties to the West, and without ties to the network of the post-communist élite.
Building a complex pattern of trade with Russia involves further opening up these economies to each other, leading to increased trade flows in both directions, as well as forging intensive trade relations between a greater variety of industries, the best example being the technology intensive sectors, such as high-tech manufacturing and processing, or the CIT sectors. The latter point is crucial. Without moving away from oil-dominated trade relations towards a more balanced position – by increasing trade through diversification into non-energy sectors rather than by reducing trade in oil and gas - it will not be possible to employ the human capital that, for the most part, currently lies idle.
EU policy: more action, please
The EU’s decision to create a Common European Economic Area (CEEA) with Russia at the EU–Russia Summit of May 2001 was a step in the right direction (just as was the Partnership and Cooperation Agreement (PCA) in 1994 and the EU Common Strategy in 1999). Nevertheless, it has failed to bring about a substantive change in policy. To date, the EU has adopted a cautious approach, given questions about Russia’s economic stability and the absence of any prospect of full political integration. This article, in contrast, proposes that more rapid and real opening up of the two economies would result in a more economically and politically stable Russia. Europe should not let the lack of political integration prevent it from efficiently utilising Russia’s economic resources. Both sides have much to gain from a more active approach.
Russia’s accession to the World Trade Organization (WTO) is consistent with this argument: it provides an impetus to improve industry and trade regulations on the Russian side, while making an effective (and very real) common economic space more operationally feasible. Through WTO membership, the European strategy of moving cautiously towards a free-trade zone with Russia would be implemented. So far, it has been implied in numerous political documents but has remained more or less absent from actual policy.
With regard to EU support for private-sector and economic development, the EU should take stock of the CEE transition experience and help to apply it to Russia. The lessons cannot be transferred to the Russian economy wholesale, but there are significant opportunities to learn from the CEE countries and for the EU to provide technical assistance in this regard. The most important lesson is that management of the transition involves much more than a list of reforms and privatisations. Rather, it requires management of a fundamental structural change in the economy in all sectors from agriculture to heavy industry towards a modern high-tech economy. Importantly, all of the economic-policy dogma and received wisdom of the previous era consequently becomes inappropriate and a new set of tools must be mastered.
Russia could be an important destination for European investment and has much to gain from attracting it. Free trade and stability are the most important conditions for attracting foreign direct investment (FDI) in the early years of the transition. Explicit incentives to investors, such as tax allowances or tailor-made subsidies, would play a role only at a later stage, once free trade and stability are a reality. For the time being, though, Russia is not an attractive or significant market for European goods. But this should not be a key factor in determining EU policy. To allow this to shape EU policy towards Russia would create inappropriate incentives for the Russian economy with the potential to distort the economic structure in the longer term. Although a market for technology-intensive products will emerge as transition proceeds, this will be important more in terms of investment for Russia than as a market opportunity for EU firms. The CEE experience suggests that allowing a transition country to become a market for foreign goods mostly results in a deteriorating current-account balance. There would not be the technology transfer that FDI aimed at producing for Western markets would bring.
Poland is perhaps the best example. Before the 1998 Russian financial crisis, most foreign investors regarded Poland as a large market to be tapped, and a base for their presence in the Commonwealth of Independent States (CIS). As a result, the technology heavy FDI stayed away (favouring the much smaller Hungary), and the structural adjustment to make the economy resemble developed market economies did not take place. The situation changed dramatically after 1998. Not only were the Eastern markets wiped out as a result of the collapse of the rouble and the decline in investor confidence in Russia, but new FDI – this time aiming at production for the EU markets – flowed in. Just like similar investments in Estonia and Hungary, this new type of FDI brought world-class technology to Poland and generated the structural change typical of successful transition, as well as corresponding complex integration into the European economy.
Conclusion
Europe’s long-term strategy regarding Russia must be viewed in the context of the EU’s potential role in the global economy. To be successful, the EU needs to build an economy with a large and complex core and technologically advanced industries. To do this, it needs to draw on relevant resources on its economic periphery. The integration of the CEE transition countries was only the first step. Europe should now do the same with Russia, although giving precedence to economic rather than political integration.
Greater economic integration means building a complex pattern of trade with the Russian economy. This would allow not only utilisation of the abundant Russian human capital stock – to the mutual benefit of the EU and Russia – but would also improve conditions for economic stability and aid the ongoing process of democratisation.
