The EU-Ukraine Deep and Comprehensive Free Trade Agreement and the importance of FDI

Ukraine's revolution, Russia's continued aggression in Eastern Ukraine and the annexation of Crimea have drawn the world community's attention. Being in a situation of political and economic crises with high external and public debt, Ukraine is now in receipt of urgent and necessary economic assistance from the US, the EU, as well as various international organizations such as the International Monetary Fund (IMF) and the World Bank. The EU aims to strengthen Ukraine by integrating it to its huge common market. The already signed and ratified Association Agreement/Deep and Comprehensive Free Trade Area (AA/DCFTA) gives Ukraine a chance to increase its competitiveness on the world markets, attract new investments and get better access to the European market. However, a large number of reforms as well as economic modernization of Ukraine is needed for the implementation of this new type of agreement which involves more than just bilateral import tariff elimination. It additionally envisages the harmonization of Ukraine's regulations on competition policy, state aid, public procurement, sanitary and phyto-sanitary measures, technical regulations and service trade liberalization. In this paper we conduct a comprehensive analysis of the DCFTA's potential effects. Therefore, we look not only at tariff and nontariff measures (trade facilitation and non-tariff barriers), but also at liberalization of barriers to foreign direct investments in services in order to consider the full implications of the DCFTA and stress the importance of FDI. The analysis is helpful in providing the parties with valuable information about the transitional impacts. Furthermore, this will help to resolve the misunderstandings concerning the implementation of the DCFTA during the ongoing consultations between Ukraine, Russia and the EU, which are planned due to Russia's concerns to be negatively affected by this agreement. Analyzing different potential FTAs between Ukraine and the EU, Emerson et al. [2006], Ecorys & CASE-Ukraine [2007] and Maliszewska et al. [2009] show that the DCFTA would have a stronger positive impact on Ukraine's welfare compared to the simple one (incorporating tariff reductions only) where the effects are small or even slightly negative. Movchan & Giucci [2011] find a positive welfare effect up to 11.8% from the DCFTA with the EU, while the customs union with Russia, Belarus and Kazakhstan is unfavorable with a welfare loss of up to 3.7%. In the most recent study Balistreri & Olekseyuk [2014] analyze the potential effects of the DCFTA by implementing the following trade structures for services and manufactured goods: a. ) a standard specification of perfect competition based on the Armington [1969] assumption of regionally differentiated goods; b. ) monopolistic competition among symmetric firms consistent with Krugman [1980]; and c. ) a competitive selection model of heterogeneous firms consistent with Melitz [2003]. This study illustrates a novel result that there is little danger of deindustrialization dominating the overall welfare gains as the welfare results under monopolistic competition are substantially lower compared to the standard Armington structure. This occurs because Ukraine intensifies production and exports of agriculture and other sectors which it has a traditional comparative advantage in, while the increasing returns sectors (producing under monopolistic competition) shrink in the face of the EU based import competition. However, the majority of previous studies does not include the liberalization of barriers to FDI in services. According to Tarr [2012], it is important to have a modeling framework which allows for analysis of this kind of liberalization due to the growing importance of services trade and FDI in services. Summarizing the results from different studies he finds that liberalization of barriers against FDI in services yields welfare gains several times larger than the usual estimates from traditional CGE models, which focus on goods trade. This occurs due to the fact that a reduction or elimination of FDI barriers in services sectors (e.g. telecommunication, banking, insurance, transportation and other business services) improves domestic firms' access to high-quality services and, consequently, leads to a reduction of costs of doing business, increases firms' productivity and improves the economy's competitiveness on the world markets (e.g. Ruthherford & Tarr [2006], Jensen & Tarr [2011]). Regarding Ukraine, Jensen et al. [2005] indicate that the aggregate welfare gains from Ukraine's WTO accession are mainly driven by the FDI reforms. They find a welfare increase of 2.3% from the reduction of barriers that discriminate against foreign services providers, whereas the average welfare effect amounts to 4.7%. Moreover, Shepotylo & Vakhitov [2012] show a strong positive impact on the productivity of Ukrainian firms from better access to services and from services liberalization. In particular, a standard deviation increase in services liberalization is associated with a 9% increase in the total factor productivity. Following this literature, we contribute to the ongoing discussion by analyzing the DCFTA between Ukraine and the EU in the new modeling framework combining the latest developments in trade theory (i.e., Melitz [2003]) with explicit consideration of foreign direct investments in business services. For this purpose we extend the GTAP based multi-region general-equilibrium simulation model developed by Balistreri & Olekseyuk [2014] allowing for the presence of multinational firms providing business services in Ukraine. This means that while in manufacturing foreign firms supply Ukrainian markets only on a cross-border basis, business services can be supplied by foreign firms both operating in Ukraine (FDI case) and abroad (cross-border supply). Therefore, we take not only the traditional gains from trade into account, but also: a. ) the additional gains from new varieties due to monopolistic competition; b. ) the aggregate productivity growth due to within industry reallocation of resources (according to the Melitz trade structure); c. ) the productivity growth of the manufacturing sectors due to increased access to business services. This framework gives us a chance to find out whether the FDI consideration can mitigate or even eliminate the deindustrialization impact found by Balistreri & Olekseyuk [2014]. As EU firms are strongly engaged in the FDI flows to Ukraine (77.6% of Ukrainian FDI inflows are coming from the EU member countries), we find that simulating the DCFTA in this framework leads to an increase of the number of EU varieties while increasing demand for workers in Ukraine, which mitigates the aforementioned deindustrialization impact. Thus, our analysis illustrates the importance of the FDI part of the agreement and, therefore, gives some guidelines for the future reforms.