ECONOMIC CHALLENGES
by Vasily Astrov and Peter Havlik
Transitions Online
nguage=1&IdPublication=4&NrIssue=294&N rSection=3&NrArticle=20186
Nov 7 2008
Czech Republic
TOL SPECIAL BOOK EXCERPT: Despite, or because of, past bonds, the
countries around the Black Sea have failed to forge strong economic
ties.
The recent conflict between Georgia and Russia has drawn renewed
attention to the Black Sea region.
The region has long been affected by the competing interests of the
European Union and Russia, which has its own blueprints aiming at the
reintegration of the post-Soviet space. An additional dimension of
the potentially conflicting interests in the region is its importance
as a transit corridor for energy resources from the Caspian Basin
to Europe. Recent EU efforts to diversify energy supplies (and
particularly to reduce its energy dependence on Russia) help explain
the rising interest in the Black Sea region and the resulting rivalry
between the EU and Russia.
However, the consequences of the recent Russian-Georgian conflict go
beyond the energy trade. An important issue here is the heightened
perception of risk that further conflict in Georgia – and the South
Caucasus in general – could be detrimental to the regional investment
climate. With the de facto formation of two new states on the regional
map, the already high economic and political fragmentation has risen
further, and although the prospects for one of them (Abkhazia) now
seem to be brighter, the deterioration in relations between Russia
and the West is likely to further impede regional cooperation and
integration prospects.
– Vasily Astrov
Vasily Astrov and Peter Havlik’s chapter, "Economic Developments in
the Wider Black Sea Region," from which the following is excerpted,
appears in The Wider Black Sea Region in the 21st Century: Strategic,
Economic and Energy Perspectives, edited by Daniel Hamilton and
Gerhard Mangott (Center for Transatlantic Relations, 2008).
REGIONAL INTEGRATION
The presently rather low level of regional integration of Black Sea
countries can be attributed to their economic heterogeneity as well
as to political issues. Formally, economic cooperation between the
countries of the region is carried out within the framework of the
Black Sea Economic Cooperation organization (BSEC). The BSEC was
established in 1992, has its headquarters in Istanbul, and since
1999 enjoys the legal status of an international organization. It
encompasses twelve member states: the eight countries covered in
this chapter [Bulgaria, Romania, Ukraine, Russia, Georgia, Armenia,
Azerbaijan, and Turkey] as well as Moldova, Greece, Albania and
Serbia. However, in spite of the existence of BSEC, in reality
multilateral cooperation in the Black Sea region is overshadowed by
the relations between these countries and the European Union. In other
words, regional cooperation generally proceeds only to the extent to
which it is compatible with the format of these countries’ relations
with the EU. … [T]his format differs widely between individual
countries of the region. EU relations with these countries can be
grouped into three broad types:
1. EU membership (Bulgaria and Romania) and EU accession (Turkey
being an official candidate);
2. European Neighborhood Policy (all other Black Sea countries,
except Russia); and
3. "Four Common Spaces" and Strategic Partnership (Russia).
In addition, relations with the EU within the first two types take
place almost exclusively on a bilateral basis – despite regular
"synergy meetings" between BSEC and the EU. This is in stark contrast
to EU initiatives in other geographic regions, which were conceived
from the very beginning in regional – rather than bilateral – format
and have been partly institutionalized. The bilateral approach
preferred by the EU with respect to the Black Sea countries results
not least from the fact that BSEC is often perceived in the EU as an
organization confining itself to mere declarations. This is due in
part to bilateral tensions between some of the Black Sea countries,
most notably between Armenia and Azerbaijan, Armenia and Turkey, and
Turkey and Greece. In fact, multilateral cooperation of the Black Sea
countries with the EU is largely confined to sectoral initiatives
such as Interstate Oil and Gas Transport to Europe (INOGATE), the
Transport Corridor Europe-Caucasus-Asia (TRACECA), the Black Sea
Pan-European Transport Area (PETrA), and the Danube-Black Sea Task
Force (DANBLAS). As a result, the EU fails to act as a "center of
gravity" promoting deeper regional integration for the Black Sea
region as a whole.
At the same time, multilateral integration in the Black Sea region
under the auspices of Russia, which, given its economic size, could
potentially serve as an alternative "gravity center," appears to
be equally problematic. This holds true even for Ukraine, Armenia
and Azerbaijan, all of which belong to the CIS [Commonwealth of
Independent States, which Georgia left in August]. Although there
is a formal CIS-wide free-trade agreement, a number of important
commodities are exempted, and there are frequent frictions and even
occasional bans on imports into Russia of selected (primarily food)
products from these countries, such as wines from Georgia (or Moldova,
for that matter) or dairy and meat products from Ukraine. Another
example is quotas and anti-dumping measures against the import of
Ukrainian steel products into Russia. Furthermore, Georgia and Armenia
have been WTO [World Trade Organization] members for several years
(since 2000 and 2003, respectively), Ukraine joined the WTO in May
(and is negotiating a "deep" free trade agreement with the EU), while
Russia and Azerbaijan – both aspiring to WTO membership – are still
negotiating. The unequal speed of WTO accession complicates regional
trade integration and investment issues even further, as it provides
countries which joined earlier with a possibility to put forward extra
demands to the applicant countries, enabling them to negotiate better
market access terms for themselves or block the applicant country’s
accession altogether (Georgia’s veto on Russia’s WTO accession is a
relevant example).
The prospects of closer economic integration between the CIS and the
non-CIS Black Sea countries potentially involve problems of an even
greater dimension. Bulgaria and Romania are EU members. Therefore,
any integration steps with these countries would necessarily require
deeper integration with the EU as a whole. Besides, Turkey is also a
longstanding member of a customs union with the EU, which means that
the Turkish trade regime for imports from third countries is unified
with that of the European Union. An additional problem concerns
bilateral trade relations between Turkey and Armenia (both countries
remain deeply split over the "genocide issue"), Armenia and Azerbaijan
(the frozen conflict in Nagorno-Karabakh), Georgia and Russia (the
latter supporting separatists in Abkhazia and South Ossetia), which are
hampered by the strained political relations. Therefore, as long as the
integration prospects between the EU and Russia – energy apart – remain
bleak, and bilateral relations between several Black Sea countries
are low-profile, any far-reaching economic integration encompassing
the Black Sea region as a whole will be highly unlikely. At the same
time, with growing economic strength, Russian capital increasingly
dominates important sectors in the region (such as energy, metals and
telecommunications), thus possibly fostering regional integration from
"below."
REGIONAL ECONOMIC CHALLENGES AND OUTLOOK
As demonstrated by the above brief analysis, the Black Sea region
comprises a widely heterogeneous group of countries which face
vastly different economic problems and find themselves at different
levels of development – even if all of them have enjoyed recent high
economic growth, accompanied by an impressive surge in bilateral trade
flows. Yet, many challenges remain, which differ among individual
countries.
In Bulgaria and Romania, the economic outlook is stable thanks to their
firm anchor in the European Union and the sizeable transfers they are
receiving from Brussels. At the same time, the risks of overheating
cannot be ignored. Booming domestic demand, largely financed by loans
from foreign-owned banks, is increasingly facing supply constraints,
which, on the one hand, contribute to inflationary pressures and,
on the other hand, spill over into soaring imports. Due to sizeable
inflation, both countries suffer from real currency appreciation which
threatens their trade competitiveness. Widening external imbalances
make these countries increasingly vulnerable to sentiments in world
financial markets, raising the risk of a "hard landing" (credit crunch)
in the case of a sudden outflow of short-term speculative capital. Over
the last two years, speculative capital has been particularly targeting
Romania – in contrast to Bulgaria, where the very high external
deficits have been so far largely financed by the inflows of FDI
[foreign direct investment]. However, in the longer run, should FDI
inflows subside and a financial crisis break out, Bulgaria may find
it more difficult to cope with external shocks. Unlike Romania, it is
operating a fixed exchange-rate regime to the euro within the framework
of a "currency board." Therefore, any currency devaluation – which
might be required to improve the country’s competitiveness and thus
reduce external deficits – would be very difficult to implement. This
would imply leaving the currency board with the resulting credibility
loss for the country’s monetary authorities.
The issue of overheating also applies to some extent to Georgia and
Armenia, although the financial vulnerability of these very small
economies does not seem to be excessively exposed at the moment. In
fact, Georgia and Armenia are primarily facing structural – rather
than macroeconomic – problems. In both countries, poverty is still a
big issue. According to the World Bank definition, it affects around
30 percent of the population on average, but is typically worse in
the countryside. The reasons for this are multiple, but an important
explaining factor has been the virtual dismantling of the social safety
network in the wake of economic transition. The latter is manifested
inter alia in the small size of government, particularly in Armenia,
where general government expenditures hover around 20 percent of
GDP. This is not only far below what is common in EU countries
(generally above 40 percent), but even e.g. in Russia and Ukraine
(30-35 percent).
The limited ability of the Armenian government to spend is partly due
to low tax morale and the widespread activities of the shadow economy,
and also to the fact that some of the most dynamic economic sectors
(such as construction) used to be exempted from taxation. Another
problem for Armenia is the relative isolation of its economy primarily
because of problematic relations with its neighbors Turkey and
Azerbaijan. As a result, its foreign trade turnover stands below 50
percent of GDP (and exports at just 16 percent of GDP) – much lower
than what the country’s small size would suggest. The costs of this are
manifold: not only do missing export opportunities imply losses for
the economic agents involved; the redirection of cargo shipments via
sub-optimal transport routes means eroding profit margins for exporters
and higher domestic prices of imported goods. Similar problems can
be observed in Georgia, whose transport links to Russia are largely
blocked due to the unresolved status of Abkhazia and South Ossetia.
Another issue of concern for Armenia (and, as a matter of fact,
for Ukraine, whereas Georgia’s export structure is, paradoxically,
more diversified) is the narrow specialization in commodities whose
world prices are subject to sharp and unpredictable fluctuations –
which partly translates into the volatility of these countries’
growth paths. In Ukraine, some 40 percent of exports is represented
by metals, particularly steel; in Armenia about 60 percent of exports
is represented by diamonds and non-ferrous metals such as copper and
molybdenum. As exemplified by the recent successful experience of
numerous East European countries (including Romania and Bulgaria),
attracting FDI into industrial branches producing (and exporting)
more sophisticated products (as well as potentially in tourism) helps
improve the economic structure and thus represents a remedy to this
problem. However, a prerequisite for that would be improvement in the
investment climate, which would require inter alia the settlement
of existing "frozen" conflicts (in the South Caucasus) and greater
political stability in general (in Ukraine). The latter two factors
explain why foreign investors have largely avoided these countries
so far.
In Russia and Azerbaijan, narrow specialization in energy resources
is potentially dangerous – even though in the short and medium
run oil prices are expected to stay stubbornly high, so that the
risk of a crisis currently appears to be low. The necessity of
diversifying the economy away from energy is generally understood
by the countries’ authorities. Therefore, the biggest policy
challenge for these countries is how to take advantage of the
current oil "bonanza" in the most efficient way in order to pursue
the goal of diversification. Following the experience of many other
energy-exporting countries, both countries set up "oil funds":
Azerbaijan in 1999 and Russia in 2004. However, channeling energy
revenues exclusively into oil funds for the benefit of future
generations (as has been largely happening so far in Russia,
and in line with the policy pursued e.g. by Norway) – rather than
spending them on a current basis – runs the risk of depriving the
economy of badly needed investments, including in infrastructure
and the social sphere (in so-called human capital). Indeed, it is
fairly obvious that the development needs of both Azerbaijan and
Russia are quite different from those of Norway. On the other hand,
boosting government expenditures on a current basis (the strategy
currently pursued by Azerbaijan), if driven to the extreme, may fuel
inflation, leading to higher production costs and thus undermining
the competitiveness of the non-energy tradable sector (the so-called
Dutch disease) – thus making the goal of economic diversification even
more difficult. Therefore, the policy challenge for the authorities
under the current circumstances is to find a reasonable compromise
by tempering the pace of fiscal expansion in order to avoid excessive
"overheating." Another challenge is to keep corruption in check.
Turkey faces two main economic challenges. First, despite the
remarkable reform progress reached over the last few years and the
much sounder banking system nowadays, the country’s persistently
high current account deficits (around 8 percent of GDP in 2006-2007)
and underlying trade deficits are still a concern. The domestic price
level, which stands at around two-thirds of the EU average, seems to
be much higher than justified by the country’s level of development,
and creates problems for the country’s goods-exporting sector,
particularly such less productive segments as textiles. Second,
the reform efforts of the government – however impressive thus far –
largely owe their success to the country’s EU membership aspirations
and may subside markedly in response to the increasingly skeptical
attitude towards Turkey’s EU accession on the part of European
policymakers and the broader public.
Despite these problems, the outlook for the Black Sea countries
is largely positive, with annual GDP growth in excess of 5 percent
in the medium and long run being feasible – not least owing to the
considerable catch-up potential of all countries concerned. Apart
from sound economic policies – which should go beyond the standard
stabilization, liberalization and privatization tasks (all of
them largely completed by now) – it is especially the fostering of
institutional reforms and related improvements of investment climate
that will be indispensable for a lasting and sustainable economic
development in the Black Sea region. More decisive steps towards
regional and EU economic integration would undoubtedly further
contribute to the favorable economic prospects of the countries
involved. However, as demonstrated by our analysis, such integration
would require significant changes in the stance of regional (and
EU) policymakers, a higher level of mutual trust, and a solution to
"frozen conflicts," and ultimately hinges on prospects for cooperation
between Russia and the EU.
Vasily Astrov is an economist at the Vienna Institute for International
Economic Studies. Peter Havlik is the institute’s deputy director.
This excerpt appears with the kind permission of the Center for
Transatlantic Relations. © 2008 Center for Transatlantic Relations,
The Johns Hopkins University/Austrian Institute for International
Affairs.
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