Trade Liberalization Strategies
What Could South Eastern Europe Learn From Cefta and Bfta?
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Authors’ E-Mail Addresses: aadam@aueb.gr; kosma@aueb.gr; jmchugh@imf.org

This paper explores the effectiveness of the Central European Free Trade Area (CEFTA) and the Baltic Free Trade Area (BFTA). Estimates from a gravity model and bilateral trade data support the view that both CEFTA and BFTA helped expand regional trade and limit the emergence of a "hub-and-spoke" relationship between the CEECs and the European Union (EU). These empirical conclusions carry some important policy implications for the "second wave" of prospective EU members among Southeastern European Countries (SEECs). The paper argues that the SEECs should reconsider their bilateral approach to trade liberalization and move towards a multilateral free-trade area as exemplified by both the CEFTA and BFTA.

Abstract

This paper explores the effectiveness of the Central European Free Trade Area (CEFTA) and the Baltic Free Trade Area (BFTA). Estimates from a gravity model and bilateral trade data support the view that both CEFTA and BFTA helped expand regional trade and limit the emergence of a "hub-and-spoke" relationship between the CEECs and the European Union (EU). These empirical conclusions carry some important policy implications for the "second wave" of prospective EU members among Southeastern European Countries (SEECs). The paper argues that the SEECs should reconsider their bilateral approach to trade liberalization and move towards a multilateral free-trade area as exemplified by both the CEFTA and BFTA.

I. Introduction

During the early 1990s, the Central and Eastern European Countries (CEECs)2 created two free-trade agreements known as the Central European Free Trade Area (CEFTA) and the Baltic Free Trade Area (BFTA). Both agreements were created in response to a perceived weakness in the case for the eastern enlargement of the European Union (EU). The EU member states were initially skeptical about the CEECs’ ability to cope with the cooperative and multilateral structures of the EU. Furthermore, there was an understandable fear that the EU accession process would redirect CEEC exports towards the EU and therefore render the CEECs more vulnerable to adverse shocks coming from the EU (Baldwin, 1993, 1994, 1995). Thus, the CEFTA and BFTA had two objectives. First, they were an early and important test of the CEECs’ capacity to work together within cooperative trade arrangements. Second, they hoped to counter the growing dependence of the CEECs on EU markets by re-establishing regional trade flows.

How effective were the CEFTA and BFTA in achieving these two objectives? In terms of the first objective, this paper offers a generally positive assessment. Throughout the 1990s, both the CEFTA and BFTA became the main vehicles for regional trade liberalization. From an original membership of three, the CEFTA gradually enlarged to cover most of Central Europe. Although BFTA membership did not increase, the agreement was gradually expanded to cover a number of the politically sensitive areas, including agriculture and fisheries. However, the agreements had only a limited effect on reducing the CEECs’ dependence on the EU. In regard to their impact on trade flows, estimates from our gravity model show that both arrangements had a positive effect on regional bilateral trade. Furthermore, intraregional trade increased and complemented the rapid increase in trade with the EU. Intraregional market shares held up well within CEFTA and actually increased in BFTA. Yet despite their success in promoting regional trade, the EU remained the dominant trading partner for the CEECs.

What lessons could the Southeastern European Countries (SEECs)3 learn from the experiences of the CEFTA and BFTA? In contrast to their northern neighbors, the SEECs did little during the 1990s to foster regional trade integration. Unsurprisingly, their export performance throughout the decade was extremely disappointing. Obviously, a large part of the explanation lies in the horrific conflicts that plagued the region throughout the decade which, along with the terrible humanitarian consequences, limited regional integration. These conflicts subsided after the 1999 Kosovo crisis; and, since then, the SEECs have tried to reinvigorate regional trade integration. However, for a variety of political reasons, the SEECs did not take a multilateral approach. Instead, they started to negotiate a network of bilateral free-trade agreements in the hope of creating a “virtual” regional free-trade area. This project is nearly completed. Although it is still too early to tell how successful this bilateral approach will be, it is fairly clear that the approach has some severe limitations, which may curb further trade reform in the future.

In the light of the CEECs’ experience, this paper strongly argues that the SEECs should reexamine their trade-liberalization strategy and adopt a more multilateral approach. The SEECs are now in the same approximate position as the CEECs were during the early 1990s. Through the Stability and Association Agreements, the EU is offering the SEECs highly preferential trade agreements and the possibility of EU accession. Yet the EU member states have serious doubts about the SEECs’ capacity to build sustainable and peaceful economic and political relations with their neighbors. Greater regional integration could provide a valuable test for the SEECs and demonstrate that they are capable of sustaining a closer political and economic relationship with the rest of Europe.

There are three options available to the SEECs to develop regional integration. First, the CEFTA could be enlarged to include the SEECs. Second, the current system of bilateral free-trade arrangements could be harmonized and developed further to cover difficult trade issues such as agriculture, services, and “behind-the-border” issues like public procurement. Third, the SEECs could develop their own comprehensive multilateral free-trade agreement along the lines of the CEFTA and BFTA. Overall, we believe that a new multilateral free-trade agreement—the South East European Free Trade Area—is the most viable.

II. Trade Liberalization in Central and Eastern European Countries

During the early stages of transition, the CEECs moved quickly to liberalize their trade and exchange regimes. The newly democratized countries quickly discarded the old Soviet-led trade agreement, the Council for Mutual Economic Assistance (CMEA). International trade was conducted at world prices and settled in convertible currencies. Tariff rates were lowered. Furthermore, the CEECs removed the plethora of restrictions that had characterized trade in the socialist economies; import and export controls were abolished, licensing regimes were liberalized, and foreign direct investment was permitted. However, these reforms were initially accompanied by a dramatic short-term collapse in regional trade flows.

While the transition led to a sharp fall in regional trade, it had also opened up the possibility of EU accession. However, the EU member states were wary of the idea of an eastern enlargement. The EU member states felt that it would take a considerable length of time before the CEECs had reached a sufficient level of economic and political development to ensure that enlargement would be a success. The EU member states were also worried that the newly democratized governments lacked experience of closely cooperating with their neighbors on economic and trade issues. Therefore, the EU pushed hard for the CEEC countries to establish closer political and economic relationships as a precursor to EU enlargement (for a discussion see Richter, 1998).

The CEECs responded quickly to the EU’s challenge. They initiated a variety of economic, political, and diplomatic initiatives to enhance regional cooperation. The region took particular note of the EU’s stress on re-establishing regional trade flows. Both the Visegrad and Baltic countries started discussions on creating regional free-trade agreements. In December 1992, Hungary, Poland, and Czechoslovakia signed the Central European Free Trade Agreement (CEFTA).4 The original members envisaged the creation of a free-trade area by 2001. The Baltic States launched their Free Trade Agreement slightly later than the CEFTA. They signed the BFTA in 1993, and it took effect in April 1994.

Despite its early reluctance, by the mid-1990s the EU had formulated a road map for the eastern enlargement. In particular, the EU developed an institutional mechanism for preparing CEEC candidate countries for EU membership—the Europe Agreements. These agreements provided for closer political and economic cooperation with the EU. They also specified a timetable for tariff reductions and prepared the candidate countries for accession through technical assistance, legal approximation to the acquis communitaire, and financial assistance.

However, asymmetric trade-liberalization was the main innovation of the Europe Agreements. The EU member states would eliminate trade restrictions faster than the candidate countries. Notwithstanding these generally favorable terms, a number of sensitive areas, such as agriculture and textiles, were exempt from the agreements. In general, these were sectors in which the CEECs had comparative advantages (for a discussion of this issue, see Lavigne, 1995).5 Nevertheless, these agreements were beneficial for the CEECs, and both EU trade and foreign direct investment increased rapidly.

However, the Europe Agreements suffered from a serious weakness; they did nothing to encourage and foster intra-CEEC trade. Many economists quickly recognized that asymmetric liberalization could create a “hub-and-spoke” problem (see Baldwin 1994). The Europe Agreements would divert trade flows along a “spoke” between the CEECs and the “hub” comprising of the EU member states. The CEECs would become satellite economies orbiting around the EU, with little intraregional trade. This raised the danger that, as trade became increasingly centered on the EU, the CEECs would become vulnerable to adverse shocks from the EU. Furthermore, there was an additional fear that the lack of intraregional trade-liberalization would tend to restrict intra-CEEC competition.

Ultimately, these hub-and-spoke considerations may have forced the CEEC countries to accelerate their plans to develop regional trade integration. As more CEEC countries signed Europe Agreements, it became increasingly clear that the EU enlargement would incorporate the majority of eastern European countries. The CEFTA was progressively enlarged to include Romania, Bulgaria, and Slovenia. The Czech Republic and Slovakia automatically became members as successor states to Czechoslovakia. Throughout the 1990s, the coverage of both agreements were progressively expanded. The original CEFTA agreement eliminated duties on approximately 40 percent of industrial goods. Through a series of additional protocols, mostly signed in 1994 and 1995, trade in industrial goods and some agricultural products was further liberalized. By 1997, the CEFTA had abolished duties on all industrial goods, apart from a minor list of sensitive goods. The BFTA did not increase its membership, but the coverage of the agreement was expanded. The Baltic States had always intended to include agriculture and fish products. However, extending the agreement proved more difficult than anticipated, largely because financial support for agriculture was more significant in Lithuania compared to Estonia and Latvia. Nevertheless, by January 1997, the Baltic countries extended the agreement to cover these politically difficult areas. Indeed, the BFTA was the first free-trade area that had provided for completely liberalized trade in agricultural and food products prior to the formation of a customs union and the harmonization of domestic support and foreign trade policies (Kazlauskiene and Meyers, 1999).

The Europe Agreements, CEFTA, and BFTA laid the basis for a period of exceptional CEEC export growth (see Table 1). Between 1993 and 2001, BFTA total export receipts increased by almost 400 percent, while the CEFTA’s receipts benefited from a marginally less impressive growth rate of 250 percent. Between 1993 and 2001, the BFTA achieved a three-fold increase in exports to the EU, while the CEFTA achieved a two-fold increase (see Table 2). Furthermore, both the CEFTA and BFTA countries managed to increase their market share within the EU. Over the same period, the BFTA’s market share increased from 0.11 percent to 0.26 percent, while the CEFTA increased its market share from 2.13 percent to 4.08 percent (see Table 3).6

Table 1.

Central and Eastern Europe: Total Exports, 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEE denotes Southeastern European countries.
Table 2.

Central and Eastern Europe: Exports to European Union (EU), 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEE denotes Southeastern European countries.
Table 3.

Central and Eastern Europe: Market Share of EU Imports, 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; SEE denotes Southeastern European countries; and EU denotes the European Union.

Intraregional trade expanded in both the CEFTA and BFTA. Between 1993 and 2001 intraregional trade within the CEFTA doubled, while market share7 fell slightly from 11 percent to just under 10 percent (see Tables 4 and 5). However, performance varied within the group. Both the Czech Republic and Slovakia experienced a significant drop in intraregional market share. However, this was due to a decline in bilateral trade, after Czechoslovakia was dissolved. Hungary, Poland, and Romania all increased their share of intraregional trade, while Bulgaria and Slovenia largely maintained their respective shares. Both intraregional trade and market share increased in the BFTA area. Between 1993 and 2001, intraregional export receipts increased four-fold, while intraregional market share increased from 8.4 percent to 9.6 percent (see Tables 6 and 7).

Table 4.

Central and Eastern Europe: Exports to Central European Free Trade Area (CEFTA) Markets, 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEE denotes Southeastern European countries.

Exports of CEFTA member countries to other CEFTA members

Exports of BFTA and SEE to CEFTA members

Table 5.

Central and Eastern Europe: Market Share of CEFTA Countries’ Imports, 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEE denotes Southeastern European countries.
Table 6.

Central and Eastern Europe: Exports to Baltic Free Trade Area (BFTA) Markets, 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEEC denotes Southeastern European Countries.

Exports of BFTA member countries to other BFTA members

Exports of CEFTA and SEE to BFTA members

Table 7.

Central and Eastern Europe: Market Share of BFTA Countries’ Imports, 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEE denotes Southeastern European countries.

While the CEFTA and BFTA sustained and developed intraregional trade, they did not prevent the CEECs from becoming increasingly dependent on EU markets. In 1993, CEFTA exports to the EU were 56 percent of total exports; by 2001, that figure had reached 68 percent. In the BFTA, that trend was less marked. In 1993, 50 percent of BFTA exports went to the EU; by 2001, that figure had risen to 55 percent (see Table 8). Ultimately, the asymmetric liberalization embedded in the Europe Agreements provided to be too strong to prevent the CEECs’ growing dependence on the EU.

Table 8.

Central and Eastern Europe: Exports to European Union (EU), 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEE denotes Southeastern European countries.

III. Trade Liberalization in Southeastern European Countries

As far as SEEC trade policy reform was concerned, the 1990s were a lost decade. As the former Socialist Federal Republic of Yugoslavia (SFRY) dissolved, the successor countries introduced restrictive trade regimes, each with their own tariff schedules and border controls. Moreover, the various wars that plagued the region during the first half of the 1990s disrupted several important transportation links. Consequently, regional trade flows virtually ceased. As the 1990s progressed, the successor states of the SFRY did little to reverse the decline in regional trade. Authoritarian and nationalist governments dominated the two largest countries in the region—Croatia and Serbia—and they had little interest in reforming regional trade arrangements. Furthermore, both countries were isolated internationally, albeit by different degrees of intensity. Consequently, the region failed to negotiate preferential trade agreements with the EU. After the Dayton agreement, the political environment prevented any rehabilitation of old trading relationships.

Regional trade data reflects this lack of progress. Between 1996 and 2001, the SEECs only managed to increase their total export receipts by 18 percent (see Table 1). Of course, we should treat pre-1996 trade data for the SEECs with some caution. For extended periods of time, Serbia and Montenegro were placed under sanctions and the data cannot account for unrecorded sanctions-busting trade. Military conflict played the major role in depressing trade performance, but its significance should not be overstated. The periods when conflict had subsided—for example 1996–99 and 2000–01—were not marked by a recovery in trade. Intraregional export receipts and market share fell every year between 1997 and 2000 (see Table 9). Furthermore, the SEEs had little success penetrating the CEFTA and BFTA markets (see Tables 3 and 7). The SEECs only made progress in the EU markets, where export receipts increased by 31 percent during 1996–2001, albeit from a comparatively low level.

Table 9.

Central and Eastern Europe: Exports to Southeastern European (SEE) markets, 1993–2001

article image
Source: IMF, Direction of Trade database.Notes: CEFTA denotes the Central European Free Trade Area; BFTA denotes the Baltic Free Trade Area; and SEE denotes Southeastern European countries.

Exports of SEE countries to other SEE countries

Exports of CEFTA and BFTA to SEE members

The aftermath of the 1999 Kosovo crisis marked the first serious attempt to rebuild regional trade relationships. In June 1999, the international community created the Stability Pact for Southeastern Europe. Both the SEEC governments and the international community were determined to make trade-liberalization one of the main pillars of the post-conflict recovery of the region. The pact established a “working table” on economic reconstruction, which was given responsibility for regional economic cooperation. The Stability Pact envisaged a two-stage process. During the first stage, the SEECs would eliminate administrative barriers to trade, put a standstill on any new measures to restrict trade, and coordinate a reduction in trade barriers towards each other. During the second stage, the SEECs would accede to the WTO and establish a free-trade area that covered both the region and the EU (Michalopoulos 2002).

In order to meet its commitments under the Stability Pact, the EU launched the Stabilization and Association Process. The EU are now negotiating Stability and Association Agreements (SAAs) with each of the SEECs which, like the earlier Europe Agreements, provide an institutional framework for closer political and economic integration.8 Like their earlier counterparts, the SAAs also provide for asymmetric trade-liberalization. Even before negotiating the SAAs, the EU revised its trade preferences with the SEECs and unilaterally offered more generous market access. The new arrangement, known as Autonomous Trade Preferences, allowed duty and quota-free access for the majority of SEEC exports. Nevertheless, quotas remain on a few sensitive areas such as agriculture, wine, and textiles. These agreements can potentially create a hub-and-spoke problem directly comparable to that created by the Europe Agreements.

The Stability Pact led directly to the SEECs signing a Memorandum of Understanding (MoU)9 on trade liberalization in June 2001. Instead of immediately starting work on creating a regional free-trade area, the SEECs decided to create a network of limited bilateral agreements. During the discussions on the MoU, the option of a single comprehensive free-trade agreement was proposed. Despite its compelling logic, the SEEC representatives were not persuaded. They believed that the political will to develop a unified agreement did not exist at the time and that a network of bilateral agreements was a less risky and potentially more productive option (see Wijkman 2003). The memorandum set a target date of December 2002 to finish this work. As of March 2003, out of a total of 21 potential agreements, ten are now fully operational (see Table 10). As for the remaining agreements, four are signed and will shortly become fully operational, and seven agreements are initialed and await ratification. Nevertheless, in the case of those agreements not yet fully operational, tariffs on many items have been already lowered or abolished as a precursor to the agreements becoming effective.

Table 10.

Southeastern Europe: Status of June 2002 Memorandum of Understanding on Bilateral Free-Trade Agreements

(As of March 14, 2003)

article image
Source: Stability Pact.Notes: CEFTA denotes the Central European Free Trade Area.

Serbia and Montenegro started negotiation process when it was know as FR Yugoslavia; therefore, both names may appear in the agreements.

The bilateral approach is problematic. Potentially, each bilateral agreement could be different and therefore this approach could create rather tangled, spaghetti-like trading relationships. The coverage of tariff lines could vary widely and each agreement may have a different liberalization timetable. The MoU did try to partly address this issue. It laid down some general guidelines which each agreement should adhere to. Most importantly, the memorandum set two targets: tariff rates should be abolished for at least 90 percent of all tariff lines, and tariff liberalization should cover at least 90 percent of bilateral trade by value. By spring 2003, most bilateral free-trade agreements had come close to fulfilling these targets. Messerlin and Miroudot (2003) reported that eleven ageements have already met the 90 percent targets, while in seven cases bilateral trade flows have reached 85 percent. These early successes in meeting the targets must be interpreted with care. As Messerlin and Miroudot point out, these 90 percent targets are easy to achieve when intraregional trade flows are still very low and comprise of a comparatively small number of products. This problem is particularly pressing in the case of agriculture, which is still heavily protected. The 90 percent targets have not created sufficient incentives for liberalizing trade in agricultural goods. Agriculture is comprised of a very small number of tariff lines and, because of the intense protection, is not traded much within the SEECs. Therefore, countries can easily meet these liberatization targets without any significant reduction in effective protection for their respective agricultural sectors.

Despite this progress, a number of problems remain. The effort to harmonize the agreements has inevitably meant that some important issues have been ignored. In particular, “behind-the-border” issues such as public procurement and services have been excluded. In general, the more recently signed bilateral agreements have been broadly similar in terms of their provisions. However, some free-trade agreements existed prior to the memorandum and differ signficantly with the general framework outlined in the memorandum. Furthermore, each agreement contains its own specific list of protected items. The bilateral approach does not offer any mechanism for harmonizing and ultimately reducing the list of protected goods. This will eventually put a break on any further trade reform.

More importantly, it is still unclear how the SEECs will move from the current bilateral framework to a more comprehensive free-trade area with the EU, which was envisaged in the Stability Pact. Thus, while the MoU certainly accelerated regional trade liberalization, the project is now coming to an end. If liberalization is to proceed further, then a more ambitous multilateral approach will be required. Three options are available to the SEECs: 1) joining the CEFTA; 2) harmonizing and extending the coverage of the current bilateral agreements, possibility on the basis of a new MoU; or 3) creating a new regional free-trade agreement. But before considering these options in detail, it is useful to further assess the impact of the CEFTA and BFTA on regional trade flows, using an estimated gravity model. As we shall see, the empirical evidence supports the hypothesis that the asymmetric liberalization reorientates trade towards the EU but that regional trade agreements can, to some extent, limit that tendency.

IV. Econometric Results

In an effort to assess the contribution of the CEFTA and BFTA to the strong export performance in the CEECs, we estimated a gravity model comprising of 37 countries for the period 1996–2000. These 37 countries—primarly OECD, Eastern European and CIS countries—were the main trading partners of the CEECs and SEECs and therefore capture virtually all the export markets for these two regions. The time period was chosen to exclude the conflicts that afflicted the former Yugoslavia. Despite its simplicity, the gravity model is widely used in empirical trade theory; it fits well to any theory of international trade from Hecksher Ohlin to new trade theories (for a discussion see Deardorff, 1995).

Previous authors have examined trade performance in transition economies using gravity models. However, the emphasis has tended to be on the effectiveness of the Europe Agreements, rather than on the CEFTA and BFTA (for an example see, Enders and Wonnacott, 1996). Some authors have looked at the underlying motivations for the CEFTA and BFTA. For example, Paas (2002) found that, for the Baltic countries, cultural proximity with its neighbors played an important role in re-establishing regional trade relationships. Others have used gravity models to examine why SEEC trade performance has been so poor. For example, Christie (2002) used a gravity model to examine SEEC trade performance. He found that in many cases, intraregional trade was much lower than what his estimated gravity model predicted.

We estimated an equation with the following functional form:10

EXPijt=βo+β1|GDPCAPitGDPCAPjt|+β2(GDPit+GDPjt2)+β3SIMijt+β5DISTij+β6Dummies+eit(1)

Where:

article image

Size, similarity, and proximity are the starting points for gravity models. The larger and closer two countries are, the more they trade. Therefore trade flows are primarily explained by differences in GDP per capita, the average of GDP of the two countries, distance, and factors proxying for similarity.

The GDP per capita term of each country is a proxy for the capital-labor ratio. By implication, the absolute difference in GDP per capita between two countries captures the difference in capital-labor ratios and therefore relative factor endowments. If this difference is large, then inter-industry trade predominates (for a more general discussion, see Hummels and Levinsohn 1995). Moreover, the closer two economies are to each other, the lower the transportation costs and the higher the bilateral trade. The distance variable is a proxy for transportation costs. It measures the distance in kilometers between the two capital cities.

Our specification also allows for the Linder hypothesis, which suggests that countries with similar demand patterns are more likely to trade with each other (Linder, 1961). In particular, countries with similar manufacturing sectors will typically produce similar products. Therefore, each country produces goods that are demanded by consumers in other countries. The Linder hypothesis is often cited as an explanation for the prevalence of trade between OECD countries, much of which tends to be intra-industry trade. In order to capture the Linder hypothesis, we constructed a similarity index that controls for the relative size of partner countries in terms of output and hopefully captures the bilateral intra-industry trade (see Egger, 2000). The index is defined as:

SIMijt=[1(GDPitGDPit+GDPjt)2(GDPjtGDPit+GDPj