metadata: authors: 0: author: von Cramon-Taubadel, Stephan
1: author: Hess, Sebastian
2: author: Brummer, Bernhard
count: EU Accession Countries,Ukraine
docna: 0: docna: A preliminary analysis of the impact of a
            Ukraine-EU free trade agreement on agriculture
docty: Policy Research Working Paper
subtopic: Agricultural Economics,International Trade and Trade Rules,Agricultural Trade,Food Security,World Trade Organization,Trade and Agriculture
teratopic: Law and Development,Private Sector Development,Macroeconomics and Economic Growth,International Economics and Trade
abstracts: cdata!: Agriculture including food products is
            of particular interest for Ukraine. However, in free trade
            agreements involving the European Union, agriculture is
            always given special treatment and subject to less and
            slower liberalization than other sectors. This paper employs
            the standard Global Trade Analysis Project model in order to
            assess how World Trade Organization accession affects
            agriculture in Ukraine, and how potential bilateral tariff
            cuts may interact with potential productivity gains within
            Ukrainian agriculture. The results indicate that, due to
            trade liberalization, Ukraine can expect gains from a more
            efficient allocation of its resources in line with
            comparative advantage, leading to an increase of production
            and exports of wheat, other grains, and oilseeds, but also
            of several processed food products that benefit from less
            expensive intermediate inputs. However, Ukraine's
            exports are concentrated on a small number of destinations,
            especially Russia and some other Former Soviet Union
            countries because they fail to meet quality standards
            elsewhere. When Ukrainian production of these products
            increases due to increased allocative efficiency, exports to
            Russia increase further and prices there fall, generating
            negative terms of trade effects that largely offset the
            allocative gains. Ukrainian imports of agricultural products
            increase as well, partly because Ukrainian consumers switch
            to higher quality imported goods even though domestic
            production increases. Regarding free trade agreement
            negotiations with the European Union, these results
            highlight for Ukraine the fact that improved agricultural
            productivity will help to get most out of improved market
            access. However, the results also highlight for Ukraine the
            great importance of adopting internationally accepted
            quality standards in order to diversify its export structure.
geo_reg_key: 80475,80457,107233,80461
repnme: repnme: A preliminary analysis of the impact of a
            Ukraine-EU free trade agreement on agriculture
display_title: A preliminary analysis of the impact
            of a Ukraine-EU free trade agreement on agriculture
listing_relative_url: /research/2010/04/12053136/preliminary-analysis-impact-ukraine-eu-free-trade-agreement-agriculture
topicv3: Agriculture and Food Security m1326205 435,Trade m1326924 698,Agricultural Trade m1327604 192,Food Trade m1504267 2559,World Trade Organization Accession
            m1504273 2568
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Law and Development,Private Sector Development,Macroeconomics and Economic Growth,International Economics and Trade
no_of_pages: 69
model_extractions: WPS5264 Policy Research Working Paper 5264 A Preliminary Analysis of the Impact of a Ukraine-EU Free Trade Agreement on Agriculture _Stephan von Cramon-Taubadel Sebastian Hess Bernhard Brümmer_ The World Bank Development Research Group Agriculture and Rural Development Team & Europe and Central Asia Region April 2010
Policy Research Working Paper 5264

# **Abstract**

Agriculture including food products is of particular interest for Ukraine. However, in free trade agreements involving the European Union, agriculture is always given special treatment and subject to less and slower liberalization than other sectors. This paper employs the standard Global Trade Analysis Project model in order to assess how World Trade Organization accession affects agriculture in Ukraine, and how potential bilateral tariff cuts may interact with potential productivity gains within Ukrainian agriculture. The results indicate that, due to trade liberalization, Ukraine can expect gains from a more efficient allocation of its resources in line with comparative advantage, leading to an increase of production and exports of wheat, other grains, and oilseeds, but also of several processed food products that benefit from less expensive intermediate inputs. However, Ukraine’s exports are concentrated on a small number of destinations, especially Russia and some other Former Soviet Union countries because they fail to meet quality standards elsewhere. When Ukrainian production of these products increases due to increased allocative efficiency, exports to Russia increase further and prices there fall, generating negative terms of trade effects that largely offset the allocative gains. Ukrainian imports of agricultural products increase as well, partly because Ukrainian consumers switch to higher quality imported goods even though domestic production increases. Regarding free trade agreement negotiations with the European Union, these results highlight for Ukraine the fact that improved agricultural productivity will help to get most out of improved market access. However, the results also highlight for Ukraine the great importance of adopting internationally accepted quality standards in order to diversify its export structure.

This paper—a product of the Agriculture and Rural Development Team, Development Research Group; and Europe and Central Asia Region—is part of a larger effort by the Bank to support Ukraine’s further regional and global economic integration. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at scramon@gwdg.de.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# A Preliminary Analysis of the Impact of a Ukraine-EU Free Trade Agreement on Agriculture

Stephan von Cramon-Taubadel*, Sebastian Hess** and Bernhard Brümmer* This paper disseminates the findings of work in progress to encourage the exchange of ideas about trade related issues. This work was undertaken as a preparatory stage in the context of the Bank's support to the FTA negotiations between Ukraine and EU at the request of the Ukrainian government. It was funded by The Europe and Central Asia Region of The World Bank. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.

- Department of Agricultural Economics and Rural Development, Georg-AugustUniversity Göttingen, Germany

- ** Department of Economics, Swedish University of Agricultural Sciences, Uppsala
# **Context and Acknowledgements**

This work was prepared in the course of a dialog with agricultural policy makers in Ukraine who are involved in the free trade agreement (FAT) negotiation process with the EU. The purpose of this paper is to support the FTA negotiations through identification of key issues for the Ukrainian policy makers who will be involved in FTA negotiations with the EU.

Following this Preface and an Executive Summary in chapter I, this paper comprises four chapters. Chapter II presents background information on FTAs in general and a qualitative look at some FTAs that the EU has negotiated with other countries. This overview provides insights into the strategies that the EU is likely to pursue in FTA negotiations with Ukraine. One key result is that agriculture always receives special treatment in the form of less ambitious and less rapid liberalization of trade in FTAs involving the EU. Another important fact is that the EU applies a wide range of stringent quality standards to agricultural raw materials and processed food products. Policy makers in the EU are especially sensitive to food safety issues, and the EU cannot be expected to negotiate any relaxation of its quality standards with Ukraine.

Chapter III provides an introduction to trade policy modeling in general, and the Global Trade Analysis Project (GTAP) model in particular. The GTAP model is used in subsequent chapters to provide quantitative assessments of Ukrainian agricultural trade policy options. GTAP is a state-of-the-art computable general equilibrium (CGE) simulation model that is linked to an up-to-date trade database that, in its most recent version (GTAP-7), includes Ukraine as a separate country for the first time. GTAP distinguishes between 57 products/sectors, including 20 agricultural and food products. This is a considerably higher level of agricultural disaggregation than is commonly available in CGE models. Hence, GTAP is well-suited to the task of providing numerical assessments of the impact on agriculture of an FTA between the Ukraine and the EU.

Chapter IV presents the results of simulations of the impact of highly stylized Ukraine/EU FTA scenarios. The results of this pilot study indicate that both Ukraine and the EU would benefit from an FTA, and they highlight the importance of improving the productivity of Ukrainian agriculture so that Ukraine is able to draw the greatest possible benefit from the opportunities provided by increased access to EU markets.

On May 16, 2008, Ukraine became a member of the WTO. WTO membership changes the initial conditions (for example, Ukraine’s tariff levels) that are the point of departure for the Ukraine/EU FTA negotiations. Chapter V is therefore devoted to updating the GTAP-7 database to incorporate Ukraine’s WTO accession commitments, and to quantitatively assessing how WTO accession will affect agriculture in Ukraine. We are grateful to Janine Pelikan and Martina Brockmeier for giving us access to their tariff aggregation software. The results once again highlight the importance that Ukraine will have to attach to meeting quality standards if it wishes to reap the full benefits of WTO membership in agriculture.

Chapter VI closes with an outlook. The work presented here has established an up-to date modeling platform as a basis for more detailed analysis of FTA options in the future. Both the creation of this modeling platform and the simulations carried out with its have been subject to ongoing peer review by World Bank experts John Nash and Will Martin, and we are very grateful for their many constructive and insightful comments. Finally, we are very grateful to Matthias Grueninger for his great patience and many helpful suggestions and comments in leading the work that went into this paper.

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# **I. Summary**

## **i) Past experience with FTAs involving the EU**

Agriculture (including food products) is of particular interest for Ukraine. However, in FTAs involving the EU, agriculture is always given special treatment and subject to less and slower liberalization than other sectors. Even the very comprehensive FTA between Chile and the EU did not liberalize agriculture very deeply. The only FTAs involving the EU that had a major agricultural component were the Europe Agreements with the countries of Central and Eastern Europe. But these were tailored towards EU accession from the very beginning, so they cannot serve as blueprints for possible negotiation outcomes involving Ukraine. For agriculture, the EU is unlikely to offer Ukraine more than it has already offered in the course of the ongoing Doha Round negotiations.

The cases of Chile and EUROMED (e.g. Morocco) show that the EU’s preferred instrument for agriculture in FTAs is the tariff rate quota. A partner country’s agricultural exports to the EU can increase as a consequence of an FTA, if the country succeeds in filling the quotas it receives. This highlights the importance of food safety and quality standards and certification systems. Whenever tariff rate quotas are applied, the question of how to distribute the associated quota rents arises. This highlights the importance of transparency and governance issues.

Tariffs are important, but they should not be overestimated. Non-tariff barriers, incomplete information and security barriers are often just as or more important determinants of trade between industrialized countries. The rise of the EU as a trading partner for Chile is indicative in this regard. The broad scope of the EU’s FTA with Chile has helped to substantially to deepen trade relations between the two partners. Trade facilitation ranging from reduction in red tape, to speedier handling of exports and imports, and to better market information systems is a potentially fruitful area in which Ukraine might be able to receive support from the EU. However, deep integration (‘FTA plus’) takes time to negotiate (four years in the case of the FTA with Chile, despite a long tradition of agreements between EU and Chile).

Ukraine should explore the possibility of securing assistance from the EU along the lines of the SAPARD program for EU accession candidates, which provided valuable technical support for the restructuring of the agri-food industries and improving the institutional framework for agriculture. Furthermore, it would be advisable to include a ‘rendezvousclause’ that provides for flexible response to possible imbalances in an FTA that become apparent as it is implemented, or to changes in external conditions that influence the functioning of an FTA (e.g. changes on world markets).

## **ii) Generating quantitative estimates of the impact of trade liberalization**

Trade liberalization creates economic opportunities and political challenges. Careful numerical simulations of the possible outcomes of trade liberalization both before and during negotiations can help policy makers take advantage of opportunities and anticipate and appropriately respond to the challenges.

Trade policy simulations can be produced by a variety of modeling tools, ranging from simple single-market models, to multi-market models, to computable general equilibrium models (CGEs). Multi-market and CGE models use the single market model as a basic building block. Multi-market models capture links between markets (e.g. substitution effects between grains and oilseeds both in production and consumption). CGEs go one step further and capture economy-wide impacts of changes on individual markets. When agriculture plays an 3
important role in the overall economy (e.g. in a country such as Ukraine), these impacts should be considered.

The numerical simulations reported in this paper are produced using the Global Trade Analysis Project (GTAP) model. GTAP has emerged as the largest and most dynamic global network of modeling experts and policy makers worldwide, and the GTAP model is used by numerous governments, ministries of agriculture and research institutions. GTAP offers a relatively disaggregated depiction of agriculture (12 farm and 8 processed food products) and the most recent GTAP database includes Ukraine for the first time. Hence, GTAP provides a useful platform for the planned Ukraine-EU FTA analysis.

# **iii) Assessing the impact of stylized Ukraine-EU FTA scenarios**

The first scenarios that are presented in this paper are not meant to be realistic, because it is too early in the FTA negotiating process to know exactly what the negotiating parties will bring to the table. Instead, these first scenarios are used as simple examples to illustrate how the GTAP model can be utilized to guide analytical discussions about potential trade policy changes. These scenarios are especially meant to provide transparency with regard to the use of the GTAP model, the types of results it can produce, and its limitations.

Two scenarios are simulated. The first assumes that all bilateral tariffs between the EU and Ukraine are reduced by a rate of 50%. The second scenario is identical to the first except that it also includes a 5% exogenous boost in technical change in Ukrainian agriculture.

The results indicate that both Ukraine and the EU would benefit from trade liberalization. They highlight the importance of improving the productivity of Ukrainian agriculture so that Ukraine is able to draw the greatest possible benefit from the opportunities provided by increased access to EU markets, and to stand up better to the increased competition that goes hand-in-hand with this access. In agriculture, the key change is an increase in production of wheat and other grains in Ukraine, and corresponding increases in Ukraine’s exports of these products to the EU.

The simulation of these stylized FTA scenarios is based on a database that does not reflect Ukraine’s WTO commitments. Since Ukraine became a member of the WTO on May 16, 2008, the basis (e.g. Ukraine’s tariff levels) upon which FTA negotiations with the EU will take place has changed since the data incorporated into the GTAP 7 database. Hence, in a next step we have focused on incorporating Ukraine’s final WTO commitments into the GTAP database to provide an up-to-date platform for the future assessment of more detailed and realistic FTA scenarios.

# **iv) Assessing the impact of Ukraine’s accession to the WTO**

To provide a quantitative assessment of how WTO accession affects agriculture in Ukraine, four scenarios are simulated. Scenario 1a assesses the impact of Ukraine’s immediate WTO accession commitments, which will presumably be implemented in 2009. Scenario 2a considers Ukraine’s final WTO commitments, of which the last must be implemented by 2013. Scenarios 1b and 2b are equivalent to 1a and 2a, respectively, but assess how improvements in the production efficiency of primary agriculture in Ukraine would modify the impact of WTO accession.

Simulation results indicate that Ukraine can expect gains from a more efficient allocation of its resources following WTO accession. More efficient allocation of resources in line with comparative advantage will spur Ukrainian production and exports of products such as wheat, other grains, and oilseeds, but also of several processed food products that benefit from less expensive intermediate inputs. However, overall gains are modest.

4
The modest estimates presented here do not account for growth effects that are likely to occur as a result of WTO accession. Such effects include technological spillovers from intensified trade in specific sectors, capital accumulation, and the facilitation of trade and investment. Scenarios 1b and 2b, which include the impact of exogenous productivity improvements, generate much larger simulated benefits than the pure accession Scenarios 1a and 2a.

Ukraine’s allocative gains from WTO accession are largely offset by terms of trade losses for exports of grains, vegetable oils and some processed foods such as dairy products and beef, sheep and goat meat. The cause of these losses is that Ukraine is economically speaking a ‘large country’ for these products. If Ukraine produces and exports more wheat as a result of allocative improvements that are triggered by WTO accession, then prices for wheat on world markets will fall as a result, offsetting some of the allocative gains.

In the case of processed products such as beef and milk it may sound odd that Ukraine is a ‘large country’ because it actually has quite a small share of overall world trade. However, Ukraine’s exports of these products are concentrated on a small number of destinations, especially Russia. Many of the products in question can only be exported to Russia and some other FSU countries because they fail to meet quality standards elsewhere. When Ukrainian production of these products increases due to increased allocative efficiency, exports to Russia increase further and prices there fall, generating negative terms of trade effects. If Ukraine’s export structure was more diversified, increased production and exports could be spread over a larger number of markets and would not generate these negative effects. This highlights the great importance of adopting internationally accepted quality standards. The benefits of WTO accession especially for processed food products will hinge to a large extent on whether Ukraine succeeds in this regard.

Ukrainian exports of agricultural products to the EU, North America, Eastern Europe and Russia increase according to the simulations presented here, but imports especially from South America increase as well. For some products, imports grow because Ukrainian consumers switch to higher quality imported goods even though domestic production increases. As a result, exports must increase as well, and this can exacerbate the terms of trade problem mentioned above. For this reason, improving food quality is not just a matter for exports, but also for the domestic market in Ukraine.

5
# **II. Other Countries’ Experiences with Free Trade Agreements with the EU: Insights for Ukraine**

# **II.1. Introduction**

The aim of this paper is to derive insights for Ukraine from the experiences that other countries have gathered from free trade agreements (FTA) with the EU, with an emphasis on agriculture. The number of regional trade agreements in force has grown almost exponentially since the end of the Uruguay Round; as of April 2008, the cumulated number of such agreements notified in Geneva amounted to 208 (WTO 2008). On the supply side, lackluster recent progress in the multilateral trading system, most notably sluggish progress in the WTO Doha Round negotiations in Geneva, is probably the most important cause of this rise in more regionally-oriented trade agreements. On the demand side, preferences for the scope and nature of integration agreements have shifted towards ‘deep integration’ approaches in which standards related to labor or the environment, general political issues, and other non-trade concerns receive more attention than in the past. These new preferences for deep integration are easier to incorporate in bilateral or regional than in multilateral trade agreements.

The experiences that other countries have gathered from their FTAs with the EU can only provide useful insights for Ukraine's policy makers if i) the FTAs in question involve countries which are similar to Ukraine in terms of trade, economic structure, comparative advantage, or other key economic factors, and ii) the particular situations and objectives associated with the selected FTAs are taken into account.

Beyond the multilateral trading system as negotiated in the WTO agreements, the EU organizes most of its external trading relationships as part of its Generalized System of Preferences (GSP), which (in most cases) unilaterally grants countries preferential status mainly based on the state of their economic development. Bilateral agreements supplement the basic GSP, depending on the partner country's relationship with and strategic importance to the EU. In effect, the EU applies WTO most favored nation (MFN) treatment to only a small number of industrialized countries, and even here, amendments and exceptions for individual sectors – especially agriculture – play an important role.

The EU uses FTAs in various areas:

- To grant development assistance (aid for trade);

- To pave the way for EU accession (Europe Agreements);

- As an integral part of the EU neighborhood policy (ENP); and

- To stabilize and improve bilateral relationships and economic well-being for both partners in an agreement (the ‘standard’ FTA).

The first category is rarely used on a pure symmetrical basis, and usually has the goal of further developing a trade relationship based on the GSP, from unilateral preferential access for the partner country to the EU's market to a more balanced relationship. Since the partner countries in question are generally least developed countries, this category cannot generate many insights for Ukraine.

The Europe Agreements in the second category, however, are relevant for Ukraine, even if the perspective of accession to the EU in the near future is missing. This is because there are similarities between Ukraine and some of the Central and Eastern European countries 6
(CEECs) that benefited from Europe Agreements (similar initial situations, similar economic and agricultural structures).

Strictly speaking, the proposed FTA between the EU and Ukraine belongs to the third category (ENP). However, existing FTAs with other EU neighbors (under the EuroMediterranean Partnership, which is to evolve into a full-fledged Euro-Mediterranean FTA by 2010) are of limited relevance to Ukraine due to the vast differences in conditions between Ukraine and these Mediterranean neighbors (e.g. Morocco). Nevertheless, the role of tariff rate quotas for agricultural products in these agreements (which most likely will show up in the negotiations between Ukraine and EU, too) might convey some lessons.

Finally, it is possible to derive insights for Ukraine – in particular with regard to the treatment of non-trade issues – from some FTAs in the fourth category (e.g. the EU’s FTA with Chile).

Based on these considerations, we focus this paper on the following FTA experiences:

1. The Europe Agreement with Hungary;

2. The EUROMED Association Agreements with Morocco; and 3. The EU’s FTA with Chile.

We begin by presenting some background information on the characteristics of FTAs and their possible advantages and disadvantages in section 2. Sections 3 to 5 contain reviews of the Europe Agreements with Hungary, the Partnership Agreement with Morocco, and the FTA with Chile, respectively. Section 6 closes with a list of insights that can be derived from these experiences.

# **II.2. Background**

## **_II.2.1. Multilateral agreements versus FTAs?_**

FTAs are a specific form of regional trade agreements, which are usually classified according to the degree of integration. The literature (e.g., Jovanovic, 2005) usually distinguishes the following four ‘idealized’ types of economic integration:

1. FTA: Removal of all restrictions on bilateral trade in goods and services. Each partner maintains separate border protection policies;

2. Customs union: FTA plus common border protection; 3. Common market: Customs union plus free factor mobility; and 4. Economic and monetary union: Common market plus harmonization of economic and monetary policy.

Regional trade agreements such as FTAs automatically entail the maintenance of discrimination<sup>1</sup> against third countries. For this reason, when evaluated against the benchmark of full multilateral trade liberalization, all regional trade agreements, even if they generate benefits for the countries involved, are inferior from a global welfare point of view.

> 1 Regional agreements might even increase discrimination against third countries, but under WTO Article 24, negatively affected third countries can claim compensation in such a case.

7
Economists and trade policy specialist have long – and without arriving at a universal consensus – debated whether the proliferation of FTAs is a boon or a hindrance to the process of multilateral trade liberalization (e.g, Panagariya 1999). The image of ‘spaghetti bowls’ (or ‘noodle bowls’ for the Asian case) is frequently employed to illustrate the dangers of increasing regionalism: Trade relations are more complex, the confusion about which rules and regulations are important for which of the _n_ ( _n_ -1)/2 bilateral pairs in a regional agreement with _n_ partners might lead to implicit protection of domestic firms. On the other hand, the increasing importance of non-tariff barriers in international trade (since tariffs themselves have been lowered considerably in past GATT/WTO rounds), implies that further liberalization requires a specific focus on standards and procedures in trade. Hence, trade _facilitation_ is nowadays seen as being at least as important as further reductions in average tariffs. Regional agreements may be better suited to achieving trade facilitation because the partners tend to have more homogeneous interests and initial economic conditions. Some analysts see the world moving towards three large trading blocs (Europe, the Americas, and Asia) within which regional partners are achieving degrees of trade liberalization and facilitation that have proven increasingly difficult to achieve multilaterally. Pessimists worry that these blocs could become fortresses; optimists hope that increased integration within the blocs will be a stepping-stone to better multilateral trading relationships.

Ultimately, this is an empirical question which will only be answered by future developments. Substantially protected sectors such as agriculture, however, are unlikely to benefit from the proliferation of FTAs because they are very often exempted (or at least treated with much more caution) in these agreements. Hence, agricultural trade liberalization will likely require progress in the multilateral trading system.

# **_II.2.2. Trade creation versus trade diversion_**

The economic analysis of preferential trade agreements dates back to Viner (1950), who distinguished between ‘trade creation’ and ‘trade diversion’ effects of regional trade agreements.

Trade creation takes place when the reduction in tariff barriers between partners in an FTA leads to the substitution of higher-cost domestic production in one participating country by lower-cost production in another. Trade diversion takes place when the reduction in tariff barriers between partners leads to the substitution of lower-cost production in a third, nonparticipating country by higher-cost production in a partner country. Even though the partner country’s production may be lower-cost than domestic production, the crowding out of even lower-cost international competitors that trade diversion entails reduces net global welfare. Furthermore, the displacement of imports from a third country (subject to tariffs) by imports from a partner country (duty-free) means that trade diversion also reduces fiscal revenues. If governments need to replace these revenues using a distorting tax, this further increases the costs resulting from trade diversion.

An FTA is more likely to lead to trade creation if the participating countries have differing comparative advantages. Trade diversion becomes more likely when the countries forming a FTA are ‘too’ similar in terms of comparative advantages, and retain substantial external protection against third countries.

8
# **_II.2.3. Shallow versus deep integration_**

The traditional analysis of trade creation and trade diversion focuses exclusively on tariff barriers and largely ignores other important border-related trade barriers. Anderson and van Wincoop (2005) decompose border-related barriers according to their causes into tariff and non-tariff policy measures, differences in language, in currency, information costs, and security. According to their results, for industrialized countries, on average only about 11% of trade costs due to border-related barriers are caused by tariffs, while another 6% are caused by non-tariff barriers to trade. The most important border-related barriers are language (48%) and currency differences (16%), followed by information costs (14%). Security barriers are least important, accounting for the remaining 5%. Obviously, language and currency differences cannot be addressed by means of an FTA. However, the importance of information costs and non-tariff border-related barriers necessitates a more comprehensive design of FTAs, if these barriers are to be effectively reduced.

The concept for addressing these issues in trade negotiations has been labeled 'deep integration', as opposed to a simple reduction of tariffs on bilateral trade flows which is labeled 'shallow integration'. Deep integration has been favored by the US and the EU in recent years in virtually all of their regional trade agreements. When the EU negotiates selective trade preferences under the GSP, these preferences are usually coupled to a set of broadly defined policy guidelines. Failure to comply with these guidelines usually means that the trade preferences are withheld for some or all imports into the EU. FTAs involving the EU have also been characterized by deep integration. An imperfect but suggestive indicator of the increasing role of deep integration is the steady increase in the length of the legal texts that describe the contents of FTAs. For example, the texts on the EU-Chile FTA comprise over 1400 pages (including the tariff schedules).

The importance of quality and safety standards, both in terms of agreement on and in capability of compliance with, cannot be underestimated. In the EU, these standards constitute an important part of the non-negotiable _acquis communautaire_ that all prospective members must adopt in full as a precondition to full access to the single European market. The number of standards notified to the WTO under the TBT and SPS agreements is not particularly high in the EU compared with other OECD countries, but “these measures [in the EU] are more trade-impeding than the ones adopted by other OECD countries” (Disdier, et al., 2008). Deep integration will ‘export’ these standards at least partially to the partner country with its previously lower level of standards, where potential exporting firms will still face similar nontariff barriers to trade through the higher standards as before. Therefore, standards are an important determinant of the success of an FTA for the partner country in such a setting.

Whether or not deep integration is always better than alternatives based on shallow integration is an empirical question. All other things being equal, an FTA that successfully reduces information costs, incorporates trade facilitation, foresees a dispute settlement procedure, etc. will be superior to an FTA that only addresses tariffs. However, deep integration often comes in a package with special and differential treatment of some sectors. While this type of special treatment is at a first glance independent of the depth of the integration agreement, there are two good reasons to fear more exceptions from the basic rules in a deep integration agreement. First, some of the concerns to be addressed by a deep integration approach, such as compliance with environmental or social standards, might be abused by one of the partners to grant targeted protection for some of its industries. Second, the complexity of a deep integration agreement makes it more likely that special treatment of a sector slips into the negotiation, e.g., as part of some package deal. Such exceptions might be justified in some cases, but too often the reason is successful lobbying by an import-competing industry which 9
fears negative impacts from a FTA, for example because the FTA threatens monopoly power that it has hitherto enjoyed on the domestic market.

## **_II.2.4. Static versus dynamic effects_**

The economic analysis of the welfare impacts of FTAs has traditionally focused on once-off static effects. However, the dynamic effects of increasing trade and integration between two countries or trading blocs can be much more important. It makes sense to distinguish between economic and political impacts. The latter are possibly more difficult to quantify, but in the long-run they can have vital feedback effects on the former.

An important dynamic impact of an FTA in direct economic terms takes place via increased foreign investment. A considerable body of evidence indicates that foreign direct investment (FDI) can trigger significant productivity gains in the receiving country (see, for example, Arnold and Javorcik, 2005). FDI is a key mechanism for transferring sophisticated technologies across borders. FDI also ensures that experienced human capital is not a limiting factor for the implementation of these new technologies in the receiving country. Foreign direct investors have a strong incentive to supervise and monitor appropriately the new technology packages that they provide. This supervision also contributes to the successful management of labor quality and monitoring issues.

Furthermore, an FTA might be a useful instrument for reducing domestic market power in certain sectors. If market power stems from increasing returns to scale, a FTA might be doubly helpful: By increasing the size of the market, it reduces average production costs for firms that can become active in partner markets, while limiting their scope for strategic pricing behavior.

Another dynamic effect involves reactions to trade diversion. If an FTA leads to trade diversion, and this is (correctly) perceived to be a problem by domestic policy makers, the obvious solution is to reduce tariffs on imports from low-cost third countries. This will trigger opposition by the affected industries, but one the FTA has been established these industries will likely be located in partner countries and not at home (after all, trade diversion results when lower – but not lowest – cost production in partner countries replaces higher-cost domestic production). To the extent that this is true, it will be politically easier to reduce the level of protection vis-à-vis third countries post-FTA than it was pre-FTA when the negatively affected industries were located at home.

The main political impact of an FTA is an addition to credibility. By entering into an FTA, a country voluntarily reduces its ability to exercise discretionary trade policy; the _ad hoc_ introduction of barriers to trade with its partner countries is no longer possible or at least circumscribed. A deep integration FTA can further add to a country’s credibility by underscoring its commitment to democratic reforms, improvements in labor rights, social standards, etc.

# **II.3. Europe Agreements**

The Europe Agreements, which were the main instrument for paving the way to the EUaccession of the Central and East European Countries (CEECs), were not classical regional trade agreements that focus solely on dismantling tariffs. Instead, they were designed to facilitate the adoption of the _aquis communautaire_ , and to prepare domestic industries in the candidate countries for expected competitive pressure in the aftermath of accession.

10
In this sense, the impact of the Europe Agreements on bilateral trade flows cannot be directly extrapolated for an EU-Ukraine FTA. Nevertheless, a glance at the overall development since 1995 is useful because Ukraine and the CEECs share similar legacies in economic and agricultural structures, and because Ukraine has stated that it intends to harmonize key elements of its agricultural policy with that of the EU.<sup>2</sup> The natural candidate for comparison in terms of agriculture is Hungary (Poland’s agricultural structures being very different), so we present the development of total (Table 2-1) and agricultural trade (Table 2-2) between the EU and Hungary below.

**Table 2-1: Development of total EU trade with Hungary (1995-2007, in million €)**

||Imports by the<br>EU|Exports to<br>Hungary|Total trade|Annual change|Balance|
|---|---|---|---|---|---|
|1995|7610|8731|16341||1120|
|1996|8847|10028|18875|15.5%|1181|
|1997|11684|13596|25281|33.9%|1912|
|1998|14655|16863|31519|24.7%|2208|
|1999|17624|18442|36066|14.4%|817|
|2000|22046|23039|45086|25.0%|993|
|2001|24825|23878|48703|8.0%|-947|
|2002|25268|25030|50298|3.3%|-238|
|2003|26033|26228|52260|3.9%|195|
|2004|27938|27974|55912|7.0%|37|
|2005|30204|29714|59917|7.2%|-490|
|2006|33470|34268|67738|13.1%|798|
|2007|38285|36930|75215|11.0%|-1355|

_Source: Comext Database_ The Europe Agreements for Hungary were signed in 1991, and effective since 1994. They involved full tariff dismantling for about 80% of all industrial goods. This dismantling was asymmetric in that the speed of tariff reductions was higher for the EU than for Hungary. Trade with agricultural goods was either exempted from gradual liberalization, or preferential treatment was granted subject to quantitative restrictions. The agreements were substantially extended for agricultural goods in order to prepare the accession process and to align CEEC agricultural policy with the CAP. In 2000, the so-called _Double Zero_ agreements were introduced by implementing zero tariffs with zero quantitative restrictions for selected goods, most notably pork and poultry. In 2003, the _Double Profit_ agreements opened quotas with zero tariffs even for the most sensitive agricultural products, i.e., those with unlimited intervention in the EU such as wheat, coarse grains, beef and dairy. In effect, 95% of all Hungarian trade with the EU was liberalized by 2003.

Besides the gradual phasing in of trade preferences up to almost complete liberalization, the Europe Agreements involved also technical help and investment aids. In agriculture, Support for Pre-Accession Measures for Agriculture and Rural Development (SAPARD) was the

> 2 The economic program of the Government of Ukraine includes the following among its “priority tasks” for agricultural policy: “implementation of the European principles of state support of agricultural producers taking into account the size of cultivated land, the unit of products and the unit of exported products”.

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relevant EU-funded program. These programs helped industries in the CEECs to restructure in order to prepare them for accession – in particular to prepare them for competition from EU producers – and helped establish trade facilitating infrastructure such as certification and quality control systems in the CEECs. A comparable instrument could prove very useful for Ukraine.

**Table 2-2: Development of trade in food and live animals (SITC 1) of the EU-27 with Hungary (1995-2007, in million €)**

||Imports by the<br>EU|Exports to<br>Hungary|Total trade|Annual change|Balance|
|---|---|---|---|---|---|
|1995|874|346|1220||-528|
|1996|950|289|1239|1.5%|-660|
|1997|922|359|1281|3.4%|-563|
|1998|951|377|1328|3.7%|-574|
|1999|998|341|1339|0.8%|-657|
|2000|1062|433|1495|11.7%|-629|
|2001|1200|528|1728|15.6%|-673|
|2002|1303|595|1898|9.9%|-708|
|2003|1325|629|1953|2.9%|-696|
|2004|1381|835|2216|13.4%|-546|
|2005|1605|1175|2780|25.4%|-429|
|2006|1779|1379|3158|13.6%|-401|
|2007|2117|1588|3705|17.3%|-530|

_Source: Comext Database_ The total volume of trade between Hungary and the EU increased substantially in the second half of the 1990s, by about 25 % per annum. However, this substantial growth slowed after the millennium, and recovered around the date of accession in 2004. The last column indicates EU exports to Hungary grew slower than imports from Hungary, so that the EU’s trade balance with Hungary is now negative. However, the balance is small relative to the overall volume of trade and changes from year to year. It is, however, striking that total trade picked up considerably after accession even although the Europe Agreements had already granted full access to the EU prior to accession. This highlights the importance of deep integration beyond pure tariff reduction.

The agricultural trade data in Table 2-2 reinforces this notion. Agricultural trade grew only insignificantly until 2000, picked up speed in 2000 and 2001, lost momentum once more, and picked up after accession. The agricultural trade balance between the EU and Hungary has remained constantly in surplus for the EU. The accelerated growth after accession is again probably caused by the elimination of non-tariff barriers to trade. Another likely cause is connected to the steady improvements in trading relations, which now take place under a largely harmonized framework.

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# **II.4. European Neighborhood Policy: EUROMED**

The ENP comprises more than just trading relations between the EU and her neighbors. Instead, trade policy is seen as an important building block in overall external relations. The Mediterranean countries within the ENP are usually abbreviated as EUROMED-9: Algeria, Egypt, Gaza and Jericho, Israel, Jordan, Lebanon, Morocco, Syria, and Tunisia.<sup>3</sup> Formal relationships date back to the second half of the 1970s when cooperation agreements with all nine countries (except Palestine) were signed. The next milestone was the substantial expansion of trade preferences in the aftermath of Spain’s and Portugal’s accession to the EU in 1986. A new quality in the relationships with the Mediterranean countries was targeted with the introduction of the Barcelona process based on the Conference of Barcelona in 1995.

Three pillars constitute the foundation of the Barcelona progress: i) dialogue on policy and security in order to increase the stability of the region; ii) partnership in social and cultural terms to deepen the understanding of the people and to strengthen civil society; and iii) partnership in economic and financial terms in order to achieve unhampered trade in the Mediterranean area. FTAs with all countries are to be used as an instrument for this latter objective, which is to be achieved by 2010. Negotiations for the Association Agreements have been concluded for EUROMED-9 between 1995 and 2004, and are in force for all countries except Algeria and Syria. With regard to agriculture, however, most Association Agreements have postponed free trade to some future date. A notable (albeit partial) exemption is the agreement with Morocco.

Negotiations on the Association Agreement with Morocco were concluded in 1996 but only came into force in March 2000. Moroccan exports of industrial goods are granted free entry into EU, while tariffs on industrial imports by Morocco from the EU are to be gradually reduced. The provisions for agricultural trade were originally mostly based on very small tariff rate quotas and entry price quotas. However, some improvements in agricultural trade liberalization between EU and Morocco were agreed upon in 2003, and came into force in 2004. Furthermore, the so-called ‘rendezvous clause’ – an interim meeting to address possible difficulties in EU-Moroccan trade relations – foresees additional agricultural liberalization talks as of 2007.

> 3 Adding Turkey to the list, the acronym EUROMED-10 is also used. Turkey, however, is a candidate country for EU accession. Hence, the agreements with Turkey are of a different quality.

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Table 2-3 indeed points to a strong impact of the FTA on total trade in the first year of implementation (2000), followed by stagnation until 2004. Total trade then showed substantial growth in 2004-2005. However, EU imports from Morocco fell by more than 20% in 2006, and have not yet fully recovered. Average annual growth rates of total trade were twice as high before 2000 as after. The partial recovery in 2007 may be due to negotiations under the ‘rendezvous-clause’.

For agricultural products, new trade concessions in form of additional tariff rate quotas have been in force since 2004, but full liberalization is not scheduled. Trade in food (Table 2-4) increased continuously since 2004 at an average annual growth rate of almost 10 % through 2007.

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**Table 2-3: Development of total EU trade with Morocco (1995-2007, in million €)**

||Imports by the<br>EU|Exports to<br>Morocco|Total trade|Annual change|Balance|
|---|---|---|---|---|---|
|1995|4017|4728|8745||711|
|1996|4233|4699|8932|2.1%|467|
|1997|4750|5329|10079|12.8%|579|
|1998|5334|6603|11937|18.4%|1269|
|1999|5553|6627|12180|2.0%|1075|
|2000|6015|7736|13751|12.9%|1720|
|2001|6241|7476|13717|-0.2%|1236|
|2002|6295|7697|13993|2.0%|1402|
|2003|6228|8072|14300|2.2%|1843|
|2004|6472|8754|15226|6.5%|2282|
|2005|8971|11578|20549|35.0%|2608|
|2006|7031|10160|17191|-16.3%|3130|
|2007|7614|11837|19451|13.1%|4222|

_Source: Comext Database_

**Table 2-4: Development of trade in food and live animals (SITC 1) of the EU-27 with Morocco (2000-2007, in million €)**

||Imports by the<br>EU|Exports from<br>Morocco|Total trade|Annual change|Balance|
|---|---|---|---|---|---|
|1995|876|482|1358||-394|
|1996|994|338|1332|-1.9%|-655|
|1997|975|303|1278|-4.0%|-672|
|1998|957|395|1352|5.8%|-562|
|1999|1079|416|1495|10.6%|-663|
|2000|1152|621|1773|18.6%|-531|
|2001|1236|519|1755|-1.1%|-717|
|2002|1400|494|1894|7.9%|-907|
|2003|1393|492|1885|-0.5%|-901|
|2004|1418|490|1909|1.3%|-928|
|2005|1628|562|2190|14.7%|-1067|
|2006|1718|520|2238|2.2%|-1197|
|2007|1772|821|2593|15.9%|-951|

_Source: Comext Database_ The experience with the EU-EUROMED agreement in agriculture, as exemplified by Morocco, illustrates that quantitative import restrictions (i.e. granting limited tariff rate quotas) are the EU’s preferred instrument for integrating agriculture in an (otherwise free) trade arrangement. The effect on trade can be positive, provided the partner country is able to 15
fill the quotas it receives. However, tariff rate quotas raise the question of quota rents and their distribution in the recipient countries. If quotas are auctioned to exporters, the government of the recipient country can collect quota rents and invest them, for example, in improving quality testing and certification systems for the products in question. In many countries, however, quotas are simply given to traders in a non-transparent manner, fostering corruption and waste. For example, potential license holders might attempt to bribe the government officials who are in charge of distributing tariff rate quotas.

For Morocco, tomatoes are an important agricultural product whose export to the EU is regulated by a tariff rate quota. Chemnitz and Grethe (2005) find that the quota binding, and generates a rent of about 25% of the total export value. This distribution of rents favors Moroccan exporters. The 2004 trade agreements involved an additional 30,000 t (from 190,000 t) tariff rate quota. The quota system is a complex construct, involving monthly quotas, an entry price system, and regulations to ensure that out-of-quota exports to the EU are penalized in following years. In consequence, the export sector for tomatoes in Morocco is highly organized, with specialized institutions in order to ensure that rents from the tariff rate quotas are maximized.

# **II.5. Latin American FTAs: The case of Chile**

The FTA between Chile and the EU became effective in 2003, after successful completion of negotiations in the year before. It is just one pillar of a broader Association Agreement, which includes political association and economic cooperation as additional pillars. The negotiations had started in 1999; ten negotiation rounds were necessary before the details of the Association Agreement were accepted. With a total of more than 206 articles, augmented by 18 annexes, this FTA is an example of the extent of the details which are included in a deep integration FTA. Trade is just one of five parts in the FTA itself, the others dealing with general provisions, dialogue on policy, all other aspects of cooperation, and final provisions. The ultimate goal is complete liberalization of trade, and this is already planned for industrial goods. For agriculture, however, the FTA provides for permanent exemptions for nearly 20% of the tariff lines at the HS-6 level.

Chile is of particular interest because it had already liberalized almost all of its trade on an MFN basis before signing the FTA (Association Agreement) with the EU. From the EU viewpoint, there was therefore little point in negotiating a shallow FTA because there were essentially no tariffs left which could have been subject to further reduction. Hence, the EU position was clearly oriented towards deep integration. Within the EU, there was strong domestic political pressure to establish environmental and social standards in the Association Agreement with Chile. For Chile on the other hand, the primary goal of the negotiations was to increased market access by securing tariff concessions from the EU.

All reductions in import tariffs were either effective immediately, or were to be phased over at most three (manufactured goods) or ten years (agriculture). For agricultural goods, as a precondition for successful completion of the negotiations, various alternatives to full liberalization were implemented:

- Tariff reduction of only 50% instead of full liberalization (e.g. peanut butter);

- Liberalization of _ad valorem_ tariffs while maintaining specific tariffs (citrus fruits);

- Liberalization of specific tariffs while maintaining _ad valorem_ tariffs (selected dairy products);

- No liberalization for selected products of designated origin (wine); and

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 Tariff rate quotas (selected bovine meats).

**Table 2-5: Development of total trade of the EU-27 with Chile (2000-2007, in million €)**

||Imports by the<br>EU|<sup>Exports to Chile</sup>|Total trade|Annual change|Balance|
|---|---|---|---|---|---|
|2000|5215|3498|8713||-1718|
|2001|5197|3731|8928|2.5%|-1466|
|2002|4911|3172|8083|-9.5%|-1739|
|2003|5001|2962|7964|-1.5%|-2039|
|2004|7354|3120|10474|31.5%|-4233|
|2005|8157|3919|12075|15.3%|-4238|
|2006|12489|4281|16770|38.9%|-8207|
|2007|12576|4684|17260|2.9%|-7891|

_Source: Comext Database_

**Table 2-6: Development of trade in food and live animals (SITC 1) of the EU-27 with Chile (2000-2007, in million €)**

||Imports by the<br>EU|<sup>Exports to Chile</sup>|Total trade|Annual change|Balance|
|---|---|---|---|---|---|
|2000|736|70|806||-666|
|2001|938|66|1004|24.6%|-872|
|2002|964|67|1031|2.6%|-897|
|2003|1038|66|1104|7.1%|-972|
|2004|1157|49|1206|9.2%|-1108|
|2005|1374|56|1430|18.6%|-1318|
|2006|1605|65|1670|16.7%|-1540|
|2007|1645|84|1729|3.5%|-1561|

_Source: Comext Database_ Since the FTA between the EU and Chile came into force in 2003, the total volume of trade between the partners has more than doubled (Table 2-5). EU imports from Chile have grown by a factor of 2.5 (compared with 2002), while EU exports to Chile increased by about one third. Hence, Chile seems to have gained more than the EU both in relative and absolute terms. The EU-27 is now Chile's most important trading partner, just ahead of the US and China.

Trade in agricultural products was subject to less liberalization than in any other category. As a result, growth in agricultural trade was substantially lower than for trade overall (Table 2-6). Nevertheless, total trade in food and live animals between Chile and the EU grew on average by 11.9% per annum between 2000 and 2007.

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# **II.6. Conclusions**

Several conclusions are supported by the discussion in this paper. The difficulty in drawing a coherent picture from other countries’ experiences is a result of the ambition of the negotiations: Deep integration is the only scenario which the EU is willing to use as a basis for talks. Many issues involved in a deep integration agreement are vague and difficult to quantify, and areas such as competition, trade facilitation, etc. are highly conditional on the specific institutional framework in the partner countries.

The main messages which are supported from our analysis can be grouped as follows:

- Agriculture (including food products) is of particular interest for Ukraine. However, in FTAs involving the EU, agriculture is always given special treatment and subject to less and slower liberalization than other sectors. Even the very comprehensive FTA between Chile and the EU did not liberalize agriculture very deeply. The only FTAs involving the EU that had a major agricultural component were the Europe Agreements with the countries of Central and Eastern Europe. But these were tailored towards EU accession from the very beginning, so they cannot serve as blueprints for possible negotiation outcomes involving Ukraine. For agriculture, the EU is unlikely to offer Ukraine more than it has already offered in the course of the ongoing Doha Round negotiations.

- The credibility of reform steps in Ukraine further increases if FTA negotiations with the EU are pushed forward on top of recent WTO accession. But deep integration (‘FTA plus’) takes time to negotiate (four years in the case of the FTA with Chile, despite a long tradition of agreements between EU and Chile). Establishing standards which help ensure access to EU (and other OECD) markets without exhausting the adjustment capacity of Ukrainian firms, will be a long-run boon to economic transition in Ukraine. Dynamic impacts in the form of FDI attraction provide an additional bonus.

- The cases of Chile and EUROMED (e.g. Morocco), show that the EU’s preferred instrument for agriculture in FTAs is the tariff rate quota. A partner country’s agricultural exports to the EU can increase as a consequence of an FTA, if the country succeeds in filling the quotas it receives. This highlights the importance of food safety and quality standards and certification systems. Whenever tariff rate quotas are applied, the question of how to distribute the associated quota rents arises. This highlights the importance of transparency and governance issues.

- Tariffs are important, but they should not be overestimated. Non-tariff barriers, incomplete information and security barriers are often just as or more important determinants of trade between industrialized countries. The rise of the EU as a trading partner for Chile is indicative in this regard. The broad scope of the EU’s FTA with Chile has helped to substantially to deepen trade relations between the two partners. Trade facilitation ranging from reduction in red tape, to speedier handling of exports and imports, and to better market information systems is a potentially fruitful area in which Ukraine might be able to receive support from the EU. However, deep integration (‘FTA plus’) takes time to negotiate (four years in the case of the FTA with Chile, despite a long tradition of agreements between EU and Chile).

- Ukraine should explore the possibility of securing assistance from the EU along the lines of the SAPARD program for EU accession candidates, which provided valuable support for the restructuring of the agri-food industries and improving the institutional framework for agriculture. Furthermore, it would be advisable to include a

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‘rendezvous-clause’ that provides for flexible response to possible imbalances in an FTA that become apparent as it is implemented, or to changes in external conditions that influence the functioning of an FTA (e.g. changes on world markets).

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# **III. Exploring Trade Policy Options with a General Equilibrium Model**

# **III.1. Introduction**

The World Trade Organization (WTO) is the international body that coordinates the determination and implementation of the rules of trade between nations. On February 5, 2008, the WTO General Council approved accession terms for Ukraine, and subsequent ratification by Ukraine’s parliament led to Ukraine formally joining the WTO on May 16, 2008. WTO membership, in turn, is a precondition for formal negotiations on a free trade agreement (FTA) with the EU, which are expected to begin in the coming months. Both WTO accession and an FTA with the EU will require Ukraine to liberalize its agricultural trade.

Trade liberalization is one of the most promising and at the same time one of the most challenging tasks for policy makers. Economists stress the gains in economic welfare that can result from trade liberalization. At the same time, affected interest groups typically oppose changes to policies that protect their economic activities. Liberalization of _agricultural_ markets has traditionally been among the most critical and controversial issues in trade negotiations.

An important task for applied economists is to provide policy makers and other stakeholders with quantitative assessments of the regional and sectoral distribution of potential gains and losses from agricultural and other market liberalization. The state of the art tool for the generation of such assessments is the Computable General Equilibrium (CGE) model. CGE models have evolved as powerful tools for the simulation of policy changes on the basis of real world data (van Tongeren, van Meijl and Surry 2001; Hertel 1999). CGE models have moved out of economists’ computing laboratories (Hertel, 1999) and have become an integral part of the complex process of public decision making (Devarajan and Robinson 2002). Of course, any model is an approximation and can be misleading if implemented or interpreted without due regard to its limitations.

In this chapter we provide a condensed introduction to applied trade models in general and the specific model that will be used to produce specific simulations for discussion and presentation in later chapters and subsequent work. Following this introduction, the next section will discuss applied trade models in general. Section 3 then introduces the Global Trade Analysis Project (GTAP) model that will be used to analyze Ukraine-EU FTA scenarios. Section 4 concludes.

# **III.2. Applied trade models: synthesizing theory and data**

## **_III.2.1 Partial Equilibrium Models_**

The basic building block of economic market and trade policy analysis is the single market model (Figure 3-1). According to this model, quantities supplied and quantities demanded adjust together with prices to clear the market in equilibrium. In the initial situation depicted in Figure 3-1, an export tax is applied to the product in question (e.g. oilseeds in Ukraine). Because of this tax, the domestic price (PD) is lower than the world market price (PW). As a 20
<!-- Start of picture text --> Price :<br>Demand Supply Pd<br>t ae Fe exer tax=T<br>, ot ed<br>1 Le ae '<br>oo Exports with tak '<br>ee Quantity<br>Exports without tax<br><!-- End of picture text -->
Multi-market models incorporate these links between related factor and product markets. A multi-market model is composed of a series of single market models such as that depicted in Figure 3-1, one for each relevant market. These are linked by parameters that depict how price or quantity changes on one market will affect supply and demand curves on other markets. For example, in a multi-market model, the depiction of the oilseed market in Ukraine in Figure 3-1 would include parameters that shift the supply and the demand curves up if grain prices rise. Similarly, supply and demand on grain markets would also depend on oilseed prices, and livestock supply would respond to grain and oilseed price changes, etc. Such multi-market models can depict and link as many as several dozen single markets, depending on what markets and linkages are relevant in a given country, and what questions the modeler and the policy makers for whom he is working are interested in.

# **_III.2.2 General equilibrium models_**

The single and multi-market models that have been discussed so far are referred to as partial <u>equilibrium</u> models because they do not account for what are referred to as <u>general equilibrium</u> effects. General equilibrium effects are the impacts that changes in prices and quantities on individual markets can have on all other variables within the economy, for example macro-economic variables such as the income, savings and investment. If the markets in question account for only a small share of total economic activity – as is the case for agriculture in many industrialized economies – general equilibrium effects can often be considered negligible. If Figure 3-1 depicted the EU oilseed market, for example, then one could safely assume that the increase in exports that results from the elimination of the export tax has no significant impact on any macro-economic variables because oilseed production and exports account for only a fraction of a percent of total economic activity in the EU. In other countries and settings, however, individual agricultural products or the sector as a whole can have significant macro-economic impacts. In the case of Ukraine, general equilibrium effects can be important in simulations of agricultural trade liberalization because food products account for over 50% of consumer expenditure. Hence, liberalization that reduces food prices will increase real incomes, with consequent effects on total spending, savings and investment in the economy.

To account for such general equilibrium effects, economists have developed CGE models. Figure 3-2 illustrates how computable general equilibrium models move beyond partial market analysis. Following a top-down approach, CGE models disaggregate the world into countries (or regions) and sectors, and within each country/region into households and firms. Private and public households sell factors such as labor to firms that use these factors to produce goods and services. These goods and services, in turn, are sold back to the households. These movements of factors, goods and services are depicted in red in Figure 3-2. Households receive income such as wages from firms in return for the factors they sell, and they use this income to buy goods and services, providing the firms with revenue. These flows of factor payments and sales revenues are depicted in green in Figure 3-2. Households can also purchase goods and services produced by foreign firms (imports), and domestic firms can also employ foreign factors and sell their goods and services abroad (exports). Furthermore, households save part of their income, and these savings can be channeled into investment undertaken by firms (depicted in blue in Figure 3-2).

The CGE framework depicted in Figure 3-2 divides the world into one country/region and the rest of the world (ROW). Depending on the use to which a model is to be put, this basic framework can be disaggregated. For example, ROW can be disaggregated into a number of 22
<!-- Start of picture text --> Receive Household Goods and Services<br>Income (spending)<br>Savings = Investment<br>Sell Goods and Services<br>Factors (value)<br>Rest of World (ROW)<br><!-- End of picture text -->
Ukrainian and EU markets separately, and it should probably also be able to depict other important trading partners for Ukraine (e.g. Russia). Furthermore, it should also consider agriculture at a relatively high level of disaggregation, so that policy changes for individual agricultural products that are of importance to Ukraine (e.g. grain, oilseeds, milk, etc.) can be analyzed separately.

Over the years, many research teams have dedicated tremendous scientific resources to the development of applied trade models. Often, however, this work by different teams has been uncoordinated, which has both advantages and disadvantages. An element of competition between different modeling groups and models is useful because it can lead to innovation and ultimately the development of better models. However, lack of coordination can also mean duplication of effort. Furthermore, for many model end-users – such as policy makers – complex models are essentially ‘black boxes’. When different models produce different results, policy makers and other users have scant basis for determining which results to trust more.

For our analysis of the potential impacts of a Ukraine-EU FTA, we have chosen to work with the Global Trade Analysis Project (GTAP) modeling framework. GTAP, at home at Purdue University in the United States, can be seen as a global effort to bundle the experience that has been accumulated in the field of applied trade modeling. Many countries have contributed to the GTAP project, and many different modeling approaches and data innovations are now part of GTAP. As a result of this effort, a common database and a multi-purpose, flexible general equilibrium trade model have been developed and are maintained and distributed through the GTAP centre. Almost 5000 members from all over the world are now part of the GTAP network, making it truly a global effort with the goal to constantly improve modelbased trade analysis (GTAP 2008).

This by no means implies that all other models are inferior to GTAP. Rather, the GTAP network should be seen as a platform for communication. This platform links a peer group of experts who represent a large share of the combined experience in applied trade analysis that is currently available world-wide. This ensures that potential improvements in modeling techniques and data are subject to expert scrutiny and, if found useful, are rapidly made available to a large group of members worldwide. Transparency ensures that anyone can look into the GTAP ‘black box’ and decide for himself whether the model is useful or needs to be changed to enable a specific application. The size of the GTAP network ensures that many people are acquainted with the model and its strengths and weaknesses. In the present context, for example, World Bank experts who have worked extensively with GTAP in the past will be able to provide on-going quality control for the policy dialog on the Ukraine-EU FTA.

GTAP data and GTAP models are available in the two technically most advanced algebraic computer modeling languages: GEMPACK and GAMS. In addition, a wide range of technical extensions and special data collections are available through the GTAP network. Important examples are, for example, the carbon emissions database and the GTAP energy model that enable the analysis of trade policy changes within the political framework of global reduction in carbon emissions and CO2 certificate trade. The network also facilitates discussions though yearly short courses and global conferences. In addition, new research teams frequently join the network and contribute new ideas and technical solutions.

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# **_III.3.2. The GTAP database: A joint, global effort_**

GTAP data are currently the most comprehensive and up-to-date data source for the purpose of applied trade policy analysis. We will be working with the GTAP-7 database. GTAP-7 is based on observed prices, trade flows and protection levels (applied, trade-weighted tariffs) from the year 2004. The entire world economy is represented in GTAP-7, but some countries are aggregated into supra-national regions. Altogether 105 individual geographical regions are represented, and in each of these regions up to 57 individual sectors can be modeled. Of the 57 sectors, 12 represent primary agricultural products, and 8 represent processed foods. This is, in comparison with many other CGE models, a relatively high level of agricultural disaggregation that makes it possible to consider detailed agricultural liberalization scenarios. Tables C1 and C2 in the Appendix C provide complete lists of the available regions and sectors in GTAP-7.

GTAP-7 is the first GTAP database that considers Ukraine, Kazakhstan, and Russia as separate countries, which is a significant advantage for our purposes. As is always the case when a country is added to the GTAP database, the GTAP centre has organized the collection, harmonization and compilation of the data for Ukraine into one single, consistent database, with the help of Ukrainian experts. Many other modeling frameworks do not consider Ukraine separately (but rather as part of some aggregate such as the ‘Former Soviet Union’), and existing models that do consider Ukraine separately tend to be stand-alone models that have been developed for some specific application involving Ukraine but are not widely available and have not been subjected to the sort of scrutiny that the GTAP network provides.

# **_III.3.3. The standard GTAP Model_**

The standard GTAP model is a comparative-static CGE model that assumes constant returns to scale and perfect competition in all markets. The model and all its equations are described in detail in Hertel (1997). The production side of this model is represented through a set of nested constant elasticity of substitution functions (CES). These functions combine primary and intermediate inputs for the production of final goods. Consumption of private households is modeled as a constant difference of elasticity (CDE) function.

Import demand follows the specification proposed by Armington (1969). According to this specification, a further set of nested CES functions determines to what extent imports from various sources substitute for one another to form bundles of imports, and to what extent these bundles of imports substitute for domestically produced goods to satisfy final demand. The Armington assumption implies that all traded goods in a category of products are weakly separable substitutes distinguished by country of origin. For instance, the Armington assumption implies that in tractors trade between Ukraine and the EU, ‘EU tractors’ constitute a slightly different product than ‘Ukrainian tractors’, and that consumers of tractors in either country choose between domestic versus imported tractors according to the exogenously specified Armington substitution parameter.

For many applications, the assumptions just mentioned provide a reasonable approximation of reality. In some instances, however they must be handled with care. For example, the Armington specification is a typical feature of modern CGE models. But it is based on parameters that are difficult to estimate, and it is known to have a strong impact on the results of trade policy simulations (Hess and von Cramon-Taubadel, 2008). In some cases, the 25
assumptions of perfect competition and/or constant returns to scale are questionable, and the GTAP platform allows them to be modified.

# **III.4. Conclusions**

There is no one-fits-all solution to trade policy simulation. Instead, using a complex model for policy analysis requires a precise definition of the policy changes that are being considered, careful implementation of these policies in the model, and careful evaluation of simulation results. This is an iterative procedure that functions best when accompanied by an intensive dialog between policy makers and modelers.

For the purpose of analyzing Ukraine-EU FTA scenarios, a general equilibrium approach has important advantages, especially since the focus of the foreseen policy dialog will be on agriculture which accounts for a significant share of production, employment and consumer spending in Ukraine. The general equilibrium modeling framework developed by the Global Trade Analysis Project is a flexible and well-known tool for the assessment of trade policy changes. It also offers a comparatively high level of especially agricultural disaggregation. The most recent database that is available for this framework (GTAP-7) includes Ukraine for the first time, thus making GTAP ideally suited to the analysis of Ukraine-EU FTA issues in agriculture.

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# **IV. Ukraine-EU FTA Outcomes: An Illustration of Stylized Results**

# **IV.1. Introduction**

The purpose of this chapter is to illustrate how the GTAP model introduced above can be employed in the course of a policy dialog Ukraine-EU trade liberalization in agriculture. It is intended to illustrate sorts of questions the model can be used to analyze, what sorts of results it can produce, and how these results can be interpreted.

It must be emphasized that the purpose of this paper is _not_ to present simulated results for specific, realistic Ukraine-EU FTA scenarios. Instead, two stylized Ukraine-EU FTA scenarios are simulated using the GTAP model. These scenarios and results are meant to serve as a starting point to familiarize decision makers and administrative officials – especially those who are not experts in trade modeling or related quantitative analysis – with the model and its capabilities and limitations. These simulations are preliminary because important experimental settings have not yet been incorporated into the model. In particular, the commitments that Ukraine has made in order to join the WTO are not yet reflected in the initial tariff levels (compare Figure 3-1). Work that is described in the next chapter addresses this issue with a view to formulating a baseline and scenarios that provide a more realistic basis for the analysis of FTA options. Even in its present preliminary form, however, the model is able to highlight important topics and generate insights into fundamental issues that are at stake in Ukraine-EU FTA negotiations.

In the following section, the aggregation of the GTAP model and the policy scenarios that are analyzed are specified. Section 3 presents key results from the simulation of these scenarios, and Section 4 concludes. The Appendix B contains 4 tables that provide basic information about the Ukrainian agri-food sector as well as Ukraine agricultural trade.

# **IV.2.** Specifying the GTAP model aggregation and the policy scenarios

## **_IV.2.1. Aggregation_**

Before a simulation can be carried out, the modeler must make several decisions about key aspects of the model. One of these aspects concerns the level of sector and country/region aggregation. The 105 country/region and 57 sector GTAP-7 database can be adjusted to whatever level of aggregation the modeler chooses by combining countries/regions and sectors into corresponding aggregates using software that is part of the modeling package. For the scenarios presented below, an aggregation of the GTAP database into the 26 sectors outlined in Table 4-1 and the 27 countries/regions outlined in Table 4-2 has been chosen. The country/region aggregation has been chosen to depict most of Ukraine’s important trade partners individually, and the sector aggregation is designed to take full advantage of all the agri-food products available in GTAP (only rice and processed rice are aggregated into one product) while simplifying the rest of the economy considerably. These aggregations can be modified in future applications of the model.

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**Table 4-1: The sector aggregation employed**

|1. Rice paddy and processed|14. Animal products, miscellaneous|
|---|---|
|2. Wheat|15. Wool & silk|
|3. Other grains|16. Vegetable oils & fats|
|4. Vegetables, fruit, nuts|17. Sugar|
|5. Oilseeds|18. Other processed food products|
|6. Sugar beet and cane|19. Beverages & tobacco|
|7. Plant-based fibers|20. Textiles and wearing apparel|
|8. Other crops|21. Extraction|
|9. Livestock|22. Light manufacturing|
|10. Raw milk|23. Heavy manufacturing|
|11. Meat: cattle, sheep, goats, horses|24. Utility and consumption|
|12. Meat: pork & poultry|25. Transport & communication|
|13. Dairy products|26. Other services|

**Table 4-2: The country/region aggregation employed**

|1. Oceania|15. Bulgaria|
|---|---|
|2. East Asia|16. Romania|
|3. South East Asia|17. Croatia|
|4. South Asia|18. Albania|
|5. North America|19. Rest of Eastern Europe|
|6. Latin America|20. Kazakhstan|
|7. Iran|21. Kyrgyzstan|
|8. Middle East and North Africa|22. Armenia|
|9. Sub Sahara Africa|23. Russia|
|10. Switzerland|**24. Ukraine**|
|11. Turkey|25. Azerbaijan|
|12. Rest of EFTA|26. Georgia|
|13. Rest of Europe|27. Rest of Former Soviet Union|
|14. EU_25||

Given the aggregation in Tables 4.1 and 4.2 has been chosen, GTAP-7 calculates the bilateral _ad valorem_ tariffs depicted in Figure 4-1. Figure 4-1 shows for each sector the tariffs levied by the EU on imports from Ukraine, and vice-versa the import tariffs that Ukraine levies on imports from the EU. These _ad valorem_ tariff rates are calculated according to a tradeweighting procedure that combines applied tariffs from the MacMap tariff database into the much more aggregated scheme of the GTAP database. Prior to the simulation of more detailed and more realistic scenarios in subsequent work, these tariffs will checked carefully and updated to account for Ukraine’s WTO accession commitments (see chapter VI below).

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**Figure 4-1: Applied tariffs between the EU and Ukraine at the chosen level of aggregation**

<!-- Start of picture text --> Applied Average Bilateral Import Tariffs (Ukraine, EU)<br>Sugar refined<br>OtherGrains<br>Wheat<br>Beverages and Tobacco<br>Other Processed Food<br>Dairy Products<br>Textiles<br>Other Crops<br>EU_25 for Imports from<br>Meat Cattle Sheep Goats Ukraine<br>Vegetable Oils and Fats<br>Meat Livestock<br>Vegetables, Fruit, Nuts<br>Animal Products Misc.<br>Light Manufacturing<br>Meat pigs and poultry Ukraine for Imports from<br>Heavy Manufacturing EU_25<br>Mining and Extraction<br>Wool and Silk<br>Utilities Consumption<br>Transport Communications<br>SugarBeet / Cane<br>Rice<br>Raw Milk<br>Plant-based Fibers<br>Other Services<br>Oilseeds<br>0 20 40 60 80 100 120 140 160 180<br>Ad Valorem Tariff (per cent)<br>Sector<br><!-- End of picture text --> _Source: Own calculations._

# **_IV.2.2. Scenarios_**

Scenario 1 assumes that the EU and Ukraine uniformly reduce the tariffs displayed in Figure 4-1 by 50%. These simulated tariff cuts are undertaken at a percent rate, implying that all tariffs, regardless their initial level, are reduced by the same 50% rate. Hence, a tariff of 80% is reduced to 40%, while a tariff of 20% is reduced to 10%. To avoid confusion, percent rate cuts must be distinguished from percentage point cuts according to which, for example, a cut of 50 percentage points reduces a tariff of 80% to 30%, while an initial tariff of 50% is reduced to zero. Confusion can also arise when reductions in the so-called power of tariffs are discussed in trade negotiations. A tariff of 80% has a power of 1.8. A 50% rate cut will reduce this tariff to 40%, and its power to 1.4; i.e. the power of the tariff is reduced by 22%.

Scenario 2 differs from Scenario 1 in only one respect; it assumes that over the simulation horizon of approximately 3-5 years Ukraine improves the technical efficiency of its agricultural production by 5%. This means that by the end of the simulation horizon, Ukraine is able to produce 5% more output from a given volume of inputs than before. This is implemented in the model through a shock to output that augments technical change by 5%. Scenario 2 is therefore a very stylized attempt to address the fact that Ukrainian agriculture is known to have a large potential for improvements in efficiency and productivity. At first glance, productivity issues appear unrelated to the question of an FTA with the EU. However, Scenario 2 provides a means of analyzing other measures that policy makers in Ukraine can use, along with trade policy, to influence the development of domestic agriculture. Trade liberalization will increase the exposure of Ukrainian farmers to international competition and 29
therefore increase the importance of measures that enhance their productivity. Important domestic measures that could contribute to a 5% increase in technical efficiency include increased investments in agricultural research and education, improved extension services, investments in storage and transport facilities for agricultural products, etc.

# **IV.3. Results**

The results from scenario 1 show that Ukraine and the EU can expect moderate gains from a 50% reduction in all bilateral tariffs (left panel of Figure 4-2). In Figure 4-2, the welfare benefits of tariff reduction are measured in million US$. In absolute terms the EU benefits more, but measured in terms of GDP (not displayed in Figure 4-1), Ukraine clearly benefits the most as its economy is considerably smaller than that of the EU. Figure 4-2 also breaks down the total welfare benefits into <u>allocative efficiency (benefits due to a better use of</u> domestic resources following the removal of tariff distortions), technical change (benefits due to any additional changes in productivity that are assumed to take place), and terms of trade (TOT; benefits due to higher prices received by exporters and lower prices paid by importers following tariff reduction). Figure 4-2 shows that TOT gains outweigh gains from a more efficient allocation of resources between sectors in both countries. For example, Ukraine, which is a net importer of agricultural machinery, benefits from the fact that it pays less for the machinery that it imports from the EU following tariff reduction, while the EU benefits from lower prices for the feed grains that it imports from Ukraine.

**Figure 4-2: Simulated welfare effects from scenario 1 (left) and scenario 2 (right)**

<!-- Start of picture text --> 1200 All bilateral tariffs are cut by All bilateral tariffs are cut by 50% and<br>50% Agricultural Sectors in Ukraine increase<br>Technical Efficiency by 5%. Ukraine<br>1000<br>Ukraine<br>800<br>600<br>EU_25<br>400 EU_25<br>EU_25<br>EU_25<br>EU_25<br>200<br>EU_25<br>Ukraine<br>Ukraine Ukraine Ukraine Ukraine<br>Ukraine EU_25 EU_25<br>0<br>Alloc.Eff. Tech. Change ToT Total Alloc.Eff. Tech. Change ToT Total<br>Change in Million US$<br><!-- End of picture text --> _Source: Own calculations._ Scenario 2 highlights the result that trade liberalization would be more beneficial if it was accompanied by domestic reforms that enhance the productivity of potentially competitive industries. In other words: productivity-enhancing policies can provide lever which multiplies the gains from trade liberalization. In scenario 2 the assumed 5% increase in technical change in agriculture makes Ukraine benefit much more from tariff reduction than is the case in scenario 1.

Figure 4-2 shows that these benefits of technical change outweigh allocation and TOT benefits for Ukraine. However, allocative benefits for Ukraine do increase in scenario 2 vis-à30
<!-- Start of picture text --> Rice, Paddy and Processed |_____-.-_-_-- Tp ep en tee eel<br>Vegetables,OtwesGramsFruit,NutsWheat |ooneee ess sere cecewsaysnnnnsec MMMM as ees So SSC a aaa aneeaap cea eae eeeeeeeeneeneeeeee<br>Oilseeds [ooeee<br>PiperOther ar Cooma ia Igeea ac en cect ner susrcesesciomegse mest<br>Plant-based Fibers Crops [ooo[oooonooo ooo eee nee enn OUkraine (eeaecemaeenniesealaaenutanaeNUSTES<br>TivestOck — [esoscecssencamreer merane pseu, Pect e ne rere acemre mprenttaeyornc<br>AnimalproductsRawMise. (1 oo ooeeePememecomma erm |caupcaasemcaaneeaul<br>INDCHtWatLEPSHEep AYCoe)Gate BorsMilk |[ooocecennna re BEU_25= ArseSereeereeteeen ene<br>Meat Geshe) 1 | aa<br>VegetablePork, Poultry OilsandFats (_|<br>Dairy Products |<br>Sugar |<br>Other Processed Food Products (ooo ooeeeeeenene eee renee eeeeeeeeeeeeeneeeeneeeeneeeeeeeneeseneenee<br>Beveragesand Tobacco |<br>Textiles and Wearing Apparel | ec re a a eee ee eae reece<br>Light ManufacturingExtraction joo|____________cco cee ne rceetet enn nenneneeneenenneneneeeeenerernceeeenee!<br>UtilityHeavyand Manutactuein Consumptiongs |[ocr ou!lees Uri ceca nec ancpeeraene<br>Transport and Communication [oone<br>Other Services _Se<br>-400 -200 0 200 400 600 800 1000<br>Million US$<br><!-- End of picture text -->
<!-- Start of picture text --> Rice, Paddy and ProcessedWheat |<br>Vegetables,Other Fruit, GrainNut s |<br>Oilseeds<br>SugarBeet and Cane OUkraine to EU25<br>Other Crops :<br>Plant-based Fibers OTotal Change in Ukrainian Exports<br>Livestock yer<br>Animalproducts Misc. mus fo\UEranie<br>Raw Milk B Total Change in EU Exports<br>Meat Cattle, Sheep, Goats, Horses<br>Wool and Silk<br>Meat Pork, Poultry<br>Vegetable Oils and Fats<br>Dairy Products<br>Sugar<br>Other Processed Food Products<br>Beverages and Tobacco<br>Textiles and Wearing Apparel<br>Extraction<br>Light Manufacturing<br>Heavy Manufacturing<br>Utility and Consumption<br>Transport and Communication<br>Other Services<br>-200 0 200 400 600 800 1000 1200<br>Million US$<br><!-- End of picture text -->
# **V. A General Equilibrium Assessment of the Impact of WTO Accession on Ukrainian Agriculture**

# **V.1. Introduction**

On May 16, 2008, Ukraine became a member of the WTO. In this chapter we provide a numerical assessment of the impact that WTO accession will have on agriculture in Ukraine. The previous two chapters have introduced the GTAP modeling framework as a publicly available analytical tool that is widely used by trade economists and governments around the world as a standard platform for systematic, numerical trade policy analysis. An assessment of the impact of WTO accession on agriculture in Ukraine is clearly interesting in its own right. However, the modifications to the GTAP model that are required to generate this assessment are also important for future work on FTA scenarios, because whatever is agreed to between Ukraine and the EU in their FTA negotiations will take the post-WTO accession situation in Ukraine as a starting point. In the following Section 2 we outline the data preparations and projections that are needed to establish a realistic baseline, and the formulation of WTO accession scenarios. In Section 3, simulation results are presented and discussed. Section 4 concludes. A detailed Appendix D with a broader selection of sectoral and national simulation results is also provided.

# **V.2. Establishing a realistic baseline and relevant policy scenarios**

## **_V.2.1. Adjusting GTAP-7 for an analysis of Ukraine's WTO accession_**

To simulate the impact of a trade policy change such as WTO accession, modelers compare two scenarios. The first is the baseline scenario which depicts the situation that is expected if the trade policy change does not take place. The second is the change scenario that depicts the situation that is expected if the trade policy change does take place. The difference between the baseline and the change scenarios is attributed to the trade policy change. This type of analysis is often referred to as ‘comparative static’ because it involves comparing two static ‘snapshots’ of an economy, one with and one without a policy change. In the present context, for example, we wish to compare scenarios that simulate the Ukrainian economy with and without WTO accession, to see what impact accession is expected to have on key variables such as production, prices and trade.

The GTAP-7 pre-release data that we are using are a consistent input-output database account of the world economy and benchmarked to the base year 2004. Thus, these data, although they are the currently most up-to-date source for modeling of larger trade policy changes, do not take Ukraine’s recent WTO commitments into account. Instead, the GTAP-7 data reflect applied tariffs, production and trade volumes from around the year 2004. Ratification of WTO accession is expected to take place in Ukraine in mid-2008. Therefore, to establish a realistic baseline, changes that have taken place in the Ukrainian economy and the rest of the world since 2004 have to be incorporated into the GTAP-7 data.

33
Starting from the GTAP-7 base data, the world economy is projected according to regional growth rates between 2004 and 2008. Growth rates for this projection (GDP and population) are obtained from the World Bank **.** The result is baseline data that approximates the size of the world economy in 2009. Into this baseline we also incorporate updated applied tariffs<sup>4</sup> and trade flows to reflect changes that have taken place in Ukraine and elsewhere since 2004. This **baseline** thus constitutes an updated database that reflects the economic situation in Ukraine and the rest of the world as they would likely be at the time of expected accession in 2009.

# **_V.2.2. Policy scenarios_**

Altogether, four WTO accession scenarios are compared with the baseline described above. These scenarios are labeled 1a and 1b, and 2a and 2b. Table 5-1 summarizes the experimental setting and these scenarios.

- Scenario 1a – Immediate accession commitments (IAC): In this scenario, applied tariffs are reduced for all products to the bound rates specified in Ukraine’s initial WTO accession commitments that would presumably take effect in 2009.

- Scenario 1b – IAC plus technical change: This scenario is identical to Scenario 1a except that it also assumes (similar to the simulations presented in chapter V) a 5% improvement in technical efficiency in Ukrainian primary agriculture.

- Scenario 2a – Final accession commitments (FAC): This scenario takes the results of scenario 1a as a baseline and simulates the additional impact of the full implementation of all of Ukraine’s WTO accession commitments that are scheduled to occur by 2013.

- Scenario 2b – FAC plus technical change: Analogous to Scenario 1b, this scenario is identical to Scenario 2a except for the assumption of an additional 2% improvement in technical efficiency in Ukrainian primary agriculture relative to the IAC scenario 1b. Thus, results from this scenario 2b include in total a simulated technical efficiency change of 5% + 2% = 7% relative to the baseline 2009.

Scenarios 1a and 2a therefore model the impact of the commitments that Ukraine has made in order to join the WTO in two steps, while 1b and 2b are corresponding stylized attempts to address the fact that Ukrainian agriculture is known to have a large potential for improvements in efficiency and productivity. As discussed in chapter V, the scenarios with technical change assumptions provide an indirect means of analyzing other measures that policy makers in Ukraine can use, along with trade policy, to influence the development of domestic agriculture. Trade liberalization will increase the exposure of Ukrainian farmers to international competition, and will therefore increase the importance of measures to enhance their productivity. Important domestic measures that could contribute to an (modest) increase in technical efficiency of 5% + 2% = 7% by the time that all WTO commitments have been implemented after 2013 include increased investments in agricultural research and education, improved extension services, investments in storage and transport facilities for agricultural products, etc.

> 4 Updating tariffs is a complex process that involves taking information on tariffs at the HS10 level and aggregating it to match the 56 products groups that are defined in GTAP. More information on this process is presented in Appendix A.

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**Table 5-1: Simulation steps undertaken to assessment Ukraine's WTO accession.**

**GTAP-7 data Baseline Effect of Ukraine's immediate 2009 accession commitments (IAC)**

**Effect of Ukraine’s final accession commitments (FAC)**

Applied All countries/ **<u>Scenario 1a – IAC:</u>** tariffs for all regions Applied tariffs in baseline 2009 sectors of the projected to cut according to Ukraine’s world 2009 immediate accession economy, according to commitments anticipated in 2009. base data year observed and 2004. projected If WTO commitments are not Ukraine's regional binding for a specific product, the WTO growth rates. corresponding baseline tariff commitments applies. Applied HS6 not included. tariffs for Ukraine **<u>Scenario 1b – IAC + TC:</u>** aggregated to GTAP As Scenario 1a, but in addition it sectors. is assumed that Ukraine improves its productivity in agriculture by 5%.

## **<u>Scenario 2a – FAC:</u>**

Applied tariffs in Scenario 1a are cut further to fulfill Ukraine’s final accession commitments, scheduled to take place by 2013 (earlier for some products).

## **<u>Scenario 2b – FAC + TC:</u>**

As Scenario 2a, but in addition it is assumed that Ukraine improves its productivity in agriculture by 2%.

# **_V.2.3. Aggregation_**

Before a simulation can be carried out, the modeler must make several decisions about key aspects of the model. One of these aspects concerns the level of sector and country/region aggregation. Some aggregation is unavoidable, because standard personal computers are, despite ongoing technical advances, not able to solve the GTAP model with a full disaggregation of 57 sectors and 105 countries/regions. Furthermore, for most applications, the full disaggregation would provide unnecessary detail that obscures key issues. For the scenarios presented below, an aggregation into the 27 countries/regions outlined in Table 5-2 has been chosen. The sectors have been retained at the most disaggregated level possible (57 sectors, see Table 5-3) in order to provide as much information as possible on changes within Ukrainian agriculture and the rest of the Ukrainian economy.

**Table 5-2: The country/region aggregation employed**

|1.|Oceania|15. Bulgaria|
|---|---|---|
|2.|EastAsia|16. Romania|
|3.|South EastAsia|17. Croatia|
|4.|South Asia|18. Albania|
|5.|North America|19. Rest of Eastern Europe|
|6.|Latin America|20. Kazakhstan|
|7.|Iran|21. Kyrgyzstan|
|8.|MiddleEast and North Africa|22. Armenia|
|9.|Sub SaharaAfrica|23. Russia|
|10.|Switzerland|**24. Ukraine**|
|11.|Turkey|25. Azerbaijan|
|12.|Rest of EFTA|26. Georgia|
|13.|Rest of Europe|27. Rest of Former Soviet Union|
|14.|EU_25||

35
**Table 5-3: The agricultural sector aggregation employed (sectors in bold type are subject to the simulated increases in productivity in scenarios 1b and 2b)**

|1.|Rice paddy and processed|14.|Animalproducts,miscellaneous|
|---|---|---|---|
|2.|Wheat|15.|Wool& silk|
|3.|Othergrains|16.|Vegetable oils &fats|
|4.|Vegetables,fruit,nuts|17.|Sugar|
|5.|Oilseeds|18.|Otherprocessedfood products|
|6.|Sugarbeet and cane|19.|Beverages & tobacco|
|7.|Plant-basedfibers|20.|Forestry|
|8.|Othercrops|21.|Fisheries|
|9.|Livestock|||
|10.|Raw milk|In ad|dition: 36 sectors industry and services.|
|11.|Meat: cattle,sheep, goats,horses|Resul|ts for these sectors are not discussed in|
|12.|Meat:pork &poultry|detail<br>|in this paper but can be found in<br>|
|13.|Dairy products|Appe|ndix D.|

# **V.3. Results: WTO accession and agriculture in Ukraine**

The GTAP model generates a huge range of outputs including simulated changes in production and trade for each combination of products and country/regions, and simulated changes in input use for each product in each country/regions. The scenarios simulated here produce literally hundreds of thousands of numbers, far too many to be discussed exhaustively in the available space. In the following we present and interpret a number of key results that provide policy makers with a sound quantitative overview of key strategic issues. Appendix D contains tables that present a selection of more detailed results. These tables and others that can be extracted from GTAP can provide a basis for in-depth analysis of specific WTO accession impacts (i.e. employment and input use changes in individual sectors, changes in trade flows between specific countries for individual products).

## **_V.3.1. Regional and global effects_**

Table 5-4 presents the sources of simulated aggregate changes in economic welfare as a result of WTO accession (figures are measured in million US$ unless stated otherwise). As outlined in chapter V, Table 5-4 breaks the total welfare changes down into changes due to allocative <u>efficiency</u> (benefits due to a better use of domestic resources following the removal of tariff distortions), technical change (benefits due to any additional changes in productivity that are assumed to take place), and terms of trade (benefits due to higher prices received by exporter and lower prices paid by importers following tariff reduction). The following key results are of note: <u>First, Table 5-4 only contains results from Scenarios 1a and 1b (impact of immediate</u> accession commitments) because the corresponding results for Scenarios 2a and 2b (final accession commitments, not shown) are almost identical.

36
**Table 5-4: Simulated economic benefits due to Ukraine’s WTO accession**

|**_Country/region_**|**_Scenario 1a:_**<br>**_IAC_**<br>**_Allocative_**<br>**_efficiency_**|**_Scenario 1b:_**<br>**_IAC+5%_**<br>**_productivity_**<br>**_change_**<br>**_Allocative_**<br>**_efficiency_**|<br>**_Scenario 1a:_**<br>**_IAC_**<br>**_Technical_**<br>**_efficiency_**|**_Scenario 1b:_**<br>**_IAC+5%_**<br>**_productivity_**<br>**_change_**<br>**_Technical_**<br>**_efficiency_**|<br>**_Scenario 1a:_**<br>**_IAC_**<br>**_Terms-of-_**<br>**_trade_**|**_Scenario 1b:_**<br>**_IAC+5%_**<br>**_productivity_**<br>**_change_**<br>**_Terms-of-_**<br>**_trade_**|
|---|---|---|---|---|---|---|
|Oceania|-0,05|-0,04|0|0|-0,43|-10,93|
|East Asia|-1,30|5,76|0|0|-5,48|14,50|
|South East Asia|-0,36|-0,27|0|0|-1,78|-1,51|
|South Asia|-0,23|1,88|0|0|-2,64|-4,91|
|North America|-0,44|14,34|0|0|-18,58|-46,38|
|Latin America|0,79|0,33|0|0|39,21|18,41|
|EU 25|-23,84|52,15|0|0|-9,80|18,49|
|Middle East & N. Africa|3,57|19,61|0|0|11,00|34,19|
|Sub Sahara Africa|0,38|-0,19|0|0|1,51|0,25|
|Russia|-3,65|0,42|0|0|31,60|40,24|
|**Ukraine**|**72,69**|**97,58**|**0**|**517,49**|**-71,60**|**-104,12**|
|Rest of Eastern Europe|0,46|0,32|0|0|8,66|14,88|
|Rest of FSU|0,07|0,26|0|0|0,83|-0,32|
|Armenia|-0,31|-0,44|0|0|1,09|1,72|
|Azerbaijan|-0,19|-0,24|0|0|1,54|1,79|
|Georgia|-0,10|0,10|0|0|2,36|4,69|
|Iran|-0,71|-0,56|0|0|-0,53|1,57|
|Turkey|1,18|3,55|0|0|5,04|7,71|
|Kyrgyztan|-0,03|-0,04|0|0|0,10|0,16|
|Kazakhstan|-0,59|-0,28|0|0|1,86|0,90|
|Switzerland|1,30|3,41|0|0|0,71|3,37|
|Rest of EFTA|0,78|1,44|0|0|4,33|4,56|
|Albania|-0,07|-0,04|0|0|-0,14|0,02|
|Bulgaria|0,40|0,46|0|0|1,64|1,08|
|Croatia|0,00|0,14|0|0|-0,26|-0,65|
|Romania|0,21|0,20|0|0|0,17|1,23|
|Rest of Europe|-0,34|-0,34|0|0|-0,54|-1,25|
|**Total**|49,64|199,53|0,00|517,49|-0,11|-0,33|

This implies that most of the impact of WTO accession will be triggered by the immediate commitments that are anticipated to be implemented in 2009, and that the later commitments that are implemented after 2009 through to 2013 will have comparatively small impacts.

<u>Second, the results from Scenario 1a in Table 5-4 show that Ukraine can expect moderate</u> gains from WTO accession due to a more efficient allocation of its domestic resources. Both primary inputs (such as land, capital, skilled and unskilled labor) and intermediate inputs (such as fertilizer, pesticides and machinery, both from domestic and imported sources) move from less to more competitive sectors and branches of the economy as a result of trade liberalization. As is discussed in greater detail below, this spurs Ukrainian production of some key agricultural products (e.g. wheat, other grains, oilseeds), but also of some processed food products, (such as beef, sheep and goat meat, and dairy products), which benefit from less expensive intermediate inputs.

However, <u>third, allocative gains are largely offset by terms of trade losses that occur in the</u> form of falling prices for Ukrainian exports of grains, vegetable oils and some processed foods such as dairy products and beef, sheep and goat meat. The cause of these losses is that Ukraine is economically speaking a ‘large country’ for these products. If Ukraine produces 37
and exports more wheat as a result of allocative improvements that are triggered by WTO accession, then prices for wheat on world markets will fall as a result, offsetting some of the allocative efficiency gains.

In the case of processed products such as beef and milk it may sound odd that Ukraine is a ‘large country’ because it actually has quite a small share of overall world trade. For these products, however, questions of quality and product differentiation play an important role. Table 5-5 helps to explain this issue. Table 5-5 highlights seven product groups that together account for 66% of the total terms of trade loss in Scenario 1a. As the export share data in Table 5-5 illustrate, Ukraine’s exports of these products are concentrated on a small number of destinations. Russia plays an especially important role, absorbing 54% of Ukraine’s dairy product exports, and 94% of Ukraine beef, sheep and goat meat exports, and 41% of Ukraine’s exports of other food products. Many of the exports in question can only be exported to Russia and some other FSU countries because they fail to meet quality standards in other markets such as the EU.

**Table 5-5: Identifying the main sources of Ukraine’s terms of trade losses due to WTO accession in Scenario 1a**

|**Product group**|**Share of**<br>**terms of**|**Share of**|**destination i**<br>**the produc**|**n Ukrainia**<br>**t in questio**|**n exports of**<br>**n**|
|---|---|---|---|---|---|
||**trade loss**<br>**(%)**|EU 25|Russia|Turkey|Switzerland|
|Food productsnec|18.50|13.2|40.9|3.3|0.3|
|Dairy products|16.76|18.8|54.3|0.7|0|
|Vegetable oils andfats|10.40|33.2|12.8|5.2|16.6|
|Beverages and tobacco products|7.51|10.6|56.8|2.2|0.1|
|Forestry|5.78|45.4|0.1|44.8|0|
|Meat: cattle, sheep, goats,horse|5.20|2.9|94.1|0|0.1|
|Cerealgrainsnec|2.31|11.8|10.1|4.7|0|
|Sum: Share oftotal ToT loss|66.47|||||

When Ukrainian production of these products increases due to increased allocative efficiency, exports to Russia increase further and prices there fall, generating negative terms of trade effects. If Ukraine’s export structure was more diversified, increased production and exports could be spread over a larger number of markets and would not generate such large negative terms of trade effects. Indeed, if the GTAP model is manipulated in a way that permits a diversification of Ukraine’s export structure, the terms of trade losses in the WTO accession scenarios quickly turn into gains.<sup>5</sup> This highlights the great importance of adopting internationally accepted quality standards and certification systems. The benefits of WTO accession especially for processed food products will largely hinge on whether Ukraine succeeds in this regard.

A similar source of terms of trade losses for Ukraine is the structure of its imports: Table 5-4 indicates that especially Latin America experiences a positive terms of trade effect as a result of Ukraine’s WTO accession (Scenario 1a). Latin America currently supplies a large share of Ukraine’s imports of processed meat, and Ukraine’s tariff cuts due to WTO accession are substantial for these import flows (-41%; see Table D1 in Appendix D). Therefore, Ukraine’s

> 5 This can be demonstrated by adding to the GTAP model an exogenous import augmenting technical change shock for countries other than Ukraine’s current main trading partners for the products in question. Detailed results are not shown here but are available from the authors on request.

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demand for imports of processed meat products from Latin America will increase as a result of WTO accession, causing terms of trade to improve for Latin America due to rising prices for meat exports to Ukraine. This, however, also implies a deterioration of Ukraine’s terms of trade with regard to Latin America.

<u>Fourth, the simulated benefits in Table 5-4 are relatively small in absolute terms. This is not</u> surprising because Ukraine already has quite low tariffs for most products and WTO accession will therefore not lead to many major changes in protection. However, these benefits do not account for growth effects that are likely to occur as a result of WTO accession. Such effects include technological spillovers from intensified trade in specific sectors, capital accumulation, and the facilitation of trade and investment. For these reasons, the simulation results presented here constitute a conservative, lower bound estimate of overall WTO accession effects on the Ukrainian economy.

<u>Fifth</u> and finally, Scenario 1b highlights the fact that trade liberalization is much more beneficial if it is accompanied by domestic reforms that enhance the productivity of potentially competitive industries. In Scenario 1b the benefits of the assumed 5% increase in agricultural productivity outweigh allocation and terms of trade effects of WTO accession considerably. Gains from a 5% improvement of agricultural productivity would amplify gains from a more efficient allocation of resources after WTO accession by more than 30%. Furthermore, technical efficiency gains would be five times larger than the corresponding terms of trade losses.

# **_V.3.2. Sectoral effects in Ukrainian agriculture – trade_**

In Figure 5-1, changes in Ukraine’s export volume in million US$ after completion of final accession commitments (Scenarios 2a and 2b) are presented for each sector. We see that Ukrainian exports of wheat and other grains increase because of the allocative gains caused by tariff cuts. At the same time, the volume of exports for processed foods increases because prices for intermediate inputs from domestic and imported sources decline, which makes these products relatively more competitive on their export markets. However, as outlined above, this leads to negative terms of trade effects unless Ukraine is able to diversify its export structure and reduce its dependence especially on Russia as a destination for key processed food products.

Figure 5-2 takes import changes into account as well and summarizes changes in Ukrainian net trade for agricultural products after final implementation of all WTO commitments. These changes all refer to Ukraine’s initial net trade position of Ukraine in the 2009 baseline (for reference, see Figure D1 in the Appendix D). Across all agricultural products, exports and net exports increase as a result of WTO accession (with the exception of beef and other meat); in most cases increases in exports and net exports are considerably larger if additional technical change is assumed. Indeed, increased production efficiency together with WTO accession instead would significantly increase Ukraine’s net exports of all major agricultural and food products, with the strongest increase projected for wheat exports.

Figure 5-3 shows what changes in Ukraine’s net trade with other countries/regions would result from the changes in net exports depicted in Figure 5-2. The main export growth is towards the EU, North America and Russia, while imports from South America (mainly processed meat products) increase by roughly 150 million US$.

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**Figure 5-1: Simulated changes in the value of agricultural exports due to implementation of final accession commitments (Scenarios 2a and 2b) in million US$**

<!-- Start of picture text --> Paddy rice<br>Wheat<br>Cereal grains nec<br>Vegetables, fruit, nuts<br>Oil seeds<br>Sugar cane, sugar beet<br>Plant-based fibers<br>Crops nec Change due to final WTO implementation and +7%<br>Cattle,sheep,goats,horses productivity change primary agriculture<br>Animal products nec<br>Raw milk Change due to final WTO implementation<br>Wool, silk-worm cocoons<br>Forestry<br>Fishing<br>Meat: cattle,sheep,goats,horse<br>Meat products nec<br>Vegetable oils and fats<br>Dairy products<br>Processed rice<br>Sugar<br>Food products nec<br>Beverages and tobacco products<br>0 50 100 150 200<br>Change in exports in US$ mill.<br><!-- End of picture text --> <!-- Start of picture text --> Source: Own calculations.<br><!-- End of picture text -->

**Figure 5-2: Simulated changes in Ukrainian net agricultural trade due to implementation of final accession commitments (Scenarios 2a and 2b) in million US$**

<!-- Start of picture text --> Paddy rice<br>Wheat<br>Cereal grains nec<br>Vegetables, fruit, nuts<br>Oil seeds<br>Sugar cane, sugar beet<br>Plant-based fibers<br>Crops nec<br>Cattle,sheep,goats,horses<br>Change due to final WTO implementation<br>Animal products nec and +7% productivity change primary<br>Raw milk agriculture<br>Wool, silk-worm cocoons<br>Forestry Change due to final WTO implementation<br>Fishing<br>Meat: cattle,sheep,goats,horse<br>Meat products nec<br>Vegetable oils and fats<br>Dairy products<br>Processed rice<br>Sugar<br>Food products nec<br>Beverages and tobacco products<br>-50 0 50 100 150 200<br>Change in net trade (change in exports - change in imports) in US$ mill.<br><!-- End of picture text --> _Source: Own calculations._ 40
**Figure 5-3: Simulated changes in Ukrainian net trade (change in exports – change in imports) by region as a result of scenario 1 and 2 (final WTO accession) in million US$**

<!-- Start of picture text --> EU 25<br>North America<br>Russia<br>Rest of Eastern Europe<br>Turkey<br>South Asia<br>South East Asia<br>Iran<br>Kazakhstan<br>Switzerland WTO final accession plus 7%<br>Bulgaria productivity change primary<br>Rest of Former Soviet Union agriculture<br>Armenia<br>Sub Sahara Africa WTO final accession<br>Croatia<br>Romania<br>Albania<br>Rest of Europe<br>Kyrgyztan<br>Azerbaijan<br>Georgia<br>Oceania<br>East Asia<br>Rest of EFTA<br>Middle East and North<br>Latin America<br>-200 -150 -100 -50 0 50 100 150 200 250 300 350<br>Net trade in US$ mill.<br><!-- End of picture text --> _Source: Own calculations._

# **_V.3.3. Sectoral effects in Ukrainian agriculture – output and domestic consumption_**

Figure 5-4 presents simulation results for changes in the value of output as a result of Scenarios 2a and 2b. The output of most agricultural products increases as a result of WTO accession, especially in Scenario 2b with additional technical change. However, in Scenario 2a without additional technical change, output of fruits and vegetables, beef, sheep- and goat meat, and the category ‘meat products nec’ (largely pork and poultry) falls, and in the latter category output falls even with additional technical change.

What would be the impact of these changes on the domestic market for food products in Ukraine? Figure 5-5 displays the simulated change in the composition of domestic consumption as a result of WTO accession (Scenario 1a). Consumption changes as a result of WTO accession because the relative prices of product change, causing consumers to shift their expenditure from products that become relatively more expensive to those that become less so. Consumption also changes because trade liberalization changes income levels, and as incomes grow, consumption typically shifts away from staple foods such as grains to livestock products such as meat and milk.<sup>6</sup>

> 6 Consumption also changes if consumers’ preferences change, even if prices and incomes remain unchanged. Preferences are assumed to be constant in the simulations presented here, however.

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# **Figure 5-4: Simulated changes in the value of output by sector in Scenarios 2a and 2b (final implementation of WTO commitments) in million US$**

<!-- Start of picture text --> Paddy rice<br>Wheat<br>Cereal grains nec<br>Vegetables, fruit, nuts<br>Oil seeds<br>Sugar cane, sugar beet<br>Plant-based fibers<br>Crops nec<br>Cattle,sheep,goats,horses Change due to final WTO implementation and +7%<br>Animal products nec productivity change primary agriculture<br>Raw milk<br>Wool, silk-worm cocoons Change due to final WTO implementation<br>Forestry<br>Fishing<br>Meat: cattle,sheep,goats,horse<br>Meat products nec<br>Vegetable oils and fats<br>Dairy products<br>Processed rice<br>Sugar<br>Food products nec<br>Beverages and tobacco products<br>-100 -50 0 50 100 150 200 250 300<br>Change in US$ mill.<br><!-- End of picture text --> _Source: Own calculations._ Figure 5-5 provides some insight into the complexity of these effects. It turns out that within some categories of food products (e.g. beef, sheep and goat meat), Ukraine exports individual products or varieties of lower quality, and simultaneously imports products of higher quality, and that WTO accession will reinforce this pattern. Hence, in Figure 5-5 we see that consumption of imported products in the category ‘beef, sheep and goat meat’ increase as a result of WTO accession – this is mainly a reflection of increased imports from South America. At the same time, consumption of domestic products from the same category decreases. Some of this reduction in consumption of domestic products corresponds to the reduction in domestic production noted above (see Figure 5-4), but at the same time, exports of these products actually increase (see Figure 5-1) – it can be shown that this is mainly a reflection of increased exports of lower quality products (e.g. offal) to Russia, exports that trigger the negative terms of trade effects discussed earlier. <u>Net</u> exports of products in the category ‘beef, sheep and goat meat’ fall (see Figure 5-2) because the increased imports of higher quality products from South America to satisfy consumer demand outweigh the increased exports of lower quality products primarily to Russia.

This example (similar mechanisms are at play for the categories ‘vegetable oils and fats’ and ‘dairy products’ – see Figure 5-5) highlights the fact that producing quality is not only of importance for the export market, and that the quality challenge faced by Ukrainian agriculture and food processing is not just a question of dealing with high standards in markets such as the EU (regardless of whether these are perceived as being ‘fair’). As their incomes continue to grow, Ukrainian consumers themselves will increasingly demand quality. Therefore, Ukrainian agriculture will not only face difficulties on international markets if it fails to deal with quality issues, it will also lose domestic market share.

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**Figure 5-5: Simulated changes in the composition of consumers’ expenditure in Scenario 1a (initial accession commitments) in million US$**

<!-- Start of picture text --> Paddy rice<br>Wheat<br>Cereal grains nec<br>Vegetables, fruit, nuts<br>Oil seeds<br>Sugar cane, sugar beet<br>Plant-based fibers Consumption of imported<br>Crops nec goods: change<br>Cattle,sheep,goats,horses Consumption of domestic<br>Animal products nec goods: change<br>Raw milk<br>Wool, silk-worm cocoons<br>Forestry<br>Fishing<br>Meat: cattle,sheep,goats,horse<br>Meat products nec<br>Vegetable oils and fats<br>Dairy products<br>Processed rice<br>Sugar<br>Food products nec<br>Beverages and tobacco products<br>-100 -50 0 50<br>US$ mill.<br><!-- End of picture text --> _Source: Own calculations._

# **_V.3.4. Effects on the cost structure of Ukrainian firms_**

Table 5-6 illustrates how the use of primary inputs (land, skilled labor, unskilled labor and capital) changes in agriculture and the economy as a whole in Scenarios 1a and 1b. These changes are measured in million US$ and provide an overview of the adjustment processes that take place in Ukraine. Table D7 in Appendix D provides a much more detailed breakdown of these changes for individual agricultural and processed food products, and also contains information on the use of intermediate inputs (i.e. the fact that wheat production also makes use of wheat as seed, etc.).<sup>7</sup>

**Table 5-6: Changes in expenditure on primary inputs (million US$)**

|NVFA|Scenario 1a:<br>primary inputs<br>for agriculture|Scenario 1a:<br>economy wide<br>effects|Scenario 1b:<br>primary inputs<br>for agriculture|Scenario 1b:<br>economy wide<br>effects|
|---|---|---|---|---|
|Land|-8.987|-8.987|21.703|21.703|
|Unskilled labor|-5.507|27.816|49.930|144.518|
|Skilled labor|0.335|0.293|5.547|55.205|
|Capital|-0.942|40.023|20.854|166.896|

_Source: Own calculations._

> 7 These tables are available for all sectors in the model and can be broken down to distinguish between changes in the use of imported and domestic inputs. All tables are available from the authors on request.

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Table 5-6 shows that initial WTO commitments reduce expenditure on land, capital and unskilled labor in agriculture, but slightly increase expenditure on skilled labor. These effects (except for land) are offset by WTO accession effects outside of agriculture where less is spent on skilled workers and expenditure on unskilled labor and capital increases considerably. If a 5% increase in agricultural productivity is added to the WTO accession commitments (Scenario 1b), all sectors increase their expenditure on all inputs. This demonstrates the powerful economy wide multiplier effects that increases in agricultural productivity can have.

# **V.4. Conclusions and implications**

Ukraine’s WTO accession will on aggregate have moderate static effects on the Ukrainian economy as a whole. As tariffs are already relatively low for most products, further tariff reductions do not have a major impact on the economy. Most changes occur soon after accession as a result of the immediate accession commitments that Ukraine has made. The remaining commitments up to final implementation, presumably in 2013, have little additional impact.

Positive effects of WTO accession due to increased allocative efficiency are reduced considerably by negative terms of trade effects. In other words, WTO accession makes the Ukrainian economy more efficient as resources are shifted from less to more competitive industries and products. At the same time however, increased Ukrainian production, and the fact that domestic consumers increasingly prefer higher quality imports in some product categories, lead to increased exports. If Ukraine has a large world market share for the products in question (e.g. wheat) increased exports lead to lower prices on world markets, which offsets some of the allocative benefits mentioned above. For some of the products in question (e.g. dairy products, beef, other processed foods), Ukraine does not have a large world market share, but due to quality problems it is only able to export to a small number of other countries (Russia figures prominently). Hence, Ukraine effectively has a large share of the markets in these countries, and when it attempts to export more into these markets, prices fall there as well. This also offsets allocative gains, in some cases strongly.

If Ukraine succeeds in improving the quality of its agricultural products, as well as its quality testing and certification procedures, then it will be able to diversify its agricultural export structure and avoid these negative terms of trade effects. It will also be able to capture a large part of the increasingly discerning domestic food market in Ukraine. To the extent that policy in Ukraine successfully addresses this challenge, the net benefits of WTO accession could be much larger than indicated by the simulations presented in this chapter.

As demonstrated by Scenarios 1b and 2b, even moderate improvements in the efficiency of production in primary agriculture have the potential to significantly amplify gains from WTO accession and to more than offset terms of trade losses. While the conditions of WTO accession are now a given, agricultural policy makers can implement many steps to encourage improvements in productivity. In the long run, such steps, if taken, will have a much larger impact than Ukraine’s WTO accession commitments themselves.

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# **VI. Outlook**

Ukraine joined the WTO on May 16, 2008, and has initiated negotiations on an FTA with the EU. The chapters in this paper provide background information on the experience that other countries have gathered from their own FTAs with the EU, and first empirical assessments of the impact that trade liberalization can be expected to have on Ukrainian agriculture. A stateof-the-art modeling platform (GTAP) is introduced and used to simulate two very stylized Ukraine-EU FTA scenarios. This platform is then updated to incorporate Ukraine’s very recent WTO accession commitments.

The work presented here establishes a framework for future work that could accompany Ukraine’s negotiators as they discuss FTA options with the EU, providing them with detailed assessments of the impact of specific FTA scenarios and options.

Quantitative trade simulation models primarily capture the impact of ‘traditional’ trade policy instruments, in particular tariffs. The analysis above has shown that non-tariff trade restrictions, and in particular the strict quality standards and certification requirements that the EU applies to agricultural and food products, will play a key role in determining what benefits Ukraine can derive from an FTA with the EU. The EU’s food quality standards are not negotiable; what will drive outcomes is the extent to which Ukraine succeeds in adjusting its production, processing and certification systems to meet these standards so that Ukrainian producers are able to take advantage of the opportunities (e.g. tariff rate quotas) that the EU agrees to.

This highlights the importance of accompanying the trade policy modeling documented in this paper with more detailed and disaggregated work on domestic agricultural policies in Ukraine. Such complementary work can help to identify the domestic policy measures that Ukraine can take to ensure that agriculture derives the greatest possible benefit from the opportunities presented by WTO membership, FTA with the EU, and any other liberalization of trade with neighbors.

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