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Conflict Economics: Eastern Europe 2020

George Anjaparidze

Policy pulse - George Anjaparidze - 28 January 2020

Belgrade – Pristina: cautious optimism for 2020

Economic costs continued to mount in 2019

Kosovo’s consumers continued to be harmed by the 100% tariffs imposed by Pristina on Serbian imports. The indecision of the EU on enlargement, especially with respect to North Macedonia, was perhaps the most discouraging development of 2019. By making EU enlargement in the Balkans more elusive the EU diminished prospects for normalization of relations between Pristina and Belgrade. The prospect of EU membership, in particular the eventual access to EU structural funds, is a major economic incentive for normalizing relations between Pristina and Belgrade. Access to EU structural funds would result in about a 20-fold increase in public finance flows from the EU.

There is room for cautious optimism in 2020 for restarting negotiations but economic incentives are still needed

2020 holds greater promise. At the local level, annual data will soon be available that will make it possible to assess the negative impacts of tariffs on consumers in Kosovo. Such an assessment would empower the incoming Kosovo government with evidence on the economic benefits of suspending the tariffs. Given the solid nationalist credentials of the likely incoming government, suspending the tariffs would unlikely be perceived by the public as appeasement to Belgrade.

Internationally, a greater US involvement is likely to yield results. President Trump’s appointment of US Ambassador to Germany as US special envoy for talks between Belgrade and Pristina can be a source of positive leverage. The agreement to in principle resume direct rail and air services is evidence of US effectiveness. Furthermore, the new EU Foreign Policy Chief, Josep Borrell, could play a key role by putting on the table the promise of near-term economic support for parties to resume dialogue. This could be done credibly given the on-going review of the methodology for EU enlargement. The updated methodology, in part, aims to front load the economic benefits to candidate countries from EU integration.

Ukraine – Russia: in need of a rebalance?

The situation in Ukraine continues to impose economic costs on all parties

The conflict in Ukraine imposes significantly higher costs on Ukraine (compared to Russia) in both relative and absolute terms. External estimates from academics indicate that output in the Donbass region has fallen by about 50% due to factors directly attributable to armed conflict. In comparison, like for like estimates point to a fall in economic activity of about 15% in the rest of Ukraine. There are no readily available like for like comparison for assessing the impacts on Russia. However, the range of estimates of the relative impact of Western sanctions on Russia, suggest that sanctions have lowered economic output by 0.5 - 1.5%.

The cost of waging war is also lower for Russia. For most of the conflict, Russia’s direct military resource commitment has been relatively small (estimated at one battalion plus tactical operations combined with positional warfare and indirect fire). In contrast, Ukraine has incurred major losses while having to approximately double its military expenditure. This means Russia is able to perpetuate the conflict at a fraction of the cost incurred by Ukraine. While Ukraine’s recently improved readiness has enhanced its ability to increase costs for Russia, Ukraine’s ability to deploy this capability at scale is constrained by overall Russian military superiority and the threat of a massive invasion of Ukraine.

Rebalancing the cost equation of the Ukraine conflict and introducing a “Marshall Plan for Donbass” can help normalization

Under these circumstances, the outcome of negotiations in 2020 is unlikely to be successful or at best will be extremely unbalanced (disproportionately favoring Russia). In terms of economic instruments, there are two important steps that should be considered by Ukraine’s Western partners. First, there is a need to rebalance the cost dynamic (e.g. new rounds of more intense sanctions). Second, predictable and long-lasting resources need to be provided on an unprecedented scale that will economically integrate the Donbass region into Ukraine and Europe. A “Marshall Plan for Donbass” needs to be committed to ahead of further Zelensky - Putin negotiations. This should give confidence to Ukraine that with time the region will be integrated into Ukraine, even if in the short-term Russia continues to hold sway. Crimea is a more complex issue, with conditions in 2020 unlikely to be conducive for dialogue. However, there may be attempts to bundle the Crimea issue as part of the Donbass negotiations.

Georgia – Russia: from bad to worse

Georgia – Russia relationship goes from bad to worse in 2019

2019 saw the Georgia – Russia relationship hit lows not seen since Russia’s 2008 invasion of Georgia. Georgia still does not have diplomatic relations with Russia. Nevertheless, in recent years, relations improved with resumption of direct flights and more trade. However, in June 2019 an error of protocol sparked mass protests in Georgia against continued Russian occupation of two Georgian territories. In response, President Putin issued a decree banning all direct flights between Russia and Georgia. As a result, Russian airlines and consumers have incurred the biggest absolute losses. The impacts on the Georgian tourism sector were to a large extent mitigated due to good connectivity available through regional hubs such as Minsk, Riga, Almaty and Istanbul. In a more strategic context, the flight ban is a missed opportunity for Russia to recover its soft power potential and makes it more difficult to forge closer economic and human to human ties.

Political volatility is expected in 2020 but economic initiatives can create opportunities for collaboration

2020 is an election year in Georgia, with an uncertain outcome. According to the latest polling data, no political party has more than 20% of public support. The ruling party still leads but current polls suggest it is unlikely to win an outright majority. However, there is high uncertainty in the polling data as about 1 in 3 survey participants either refused to answer or do not support any political party. During the period in the lead up to elections, Georgia is particularly vulnerable to external meddling. For example, Russia may give a platform and engage in dialogue with fringe political groups in Georgia to resolve an engineered crisis or credit them with a removal of the ban on direct flights. There is also continued concerns about how Russia might react to any developments related to Georgia’s closer integration with NATO.

On a more optimistic note, Georgia’s closer cooperation with the EU on economic issues has not been a source of confrontation with Russia. The joint statement, by foreign ministers of Georgia, Moldova and Ukraine, calling for an enhancement of integration with the EU could also create opportunities for cooperation with Russian investors and business community.

Kosovo: disappointing economic data to come?

George Anjaparidze

Policy Pulse - 19 June 2019 - George Anjaparidze

Last week, Pristina hosted foreign dignitaries in celebration of 20 years since the departure of troops of former Serbian President Milocevic. It was also an occasion to showcase Kosovo’s progress in recent years across a number of critical areas. According to the World Bank 2019 Doing Business report, Kosovo was ranked as the 44th easiest place to do business, scoring higher than the Eastern European regional average. Life expectancy has risen from 69.2 in 2007 to 71.9 years in 2017. Despite these successes, there have also been misguided policy interventions. In particular, the decision in November 2018 to impose a 100% tariff on goods originating from Serbia is particularly damaging to Kosovo’s economy.

As a result of these tariffs, we forecast a significant reduction in the purchasing power of Kosovo consumers. Our impact analysis (How harmful are trade tariffs to Kosovo consumers?) estimates a reduction in purchasing power by 6.4% due to 33% higher import costs on goods impacted by tariffs (mid-range estimate). The chart above presents a sensitivity analysis on the range of cost impacts on goods covered by these tariffs. The chart also offers a breakdown on drivers behind the higher import costs. The analysis is top down in nature and assesses the expected future short-to-medium term impacts.

Domestic production in Kosovo is not well suited to offer effective substitutes for imports impacted by tariffs. Our analysis (Kosovo status quo has a high cost) highlights the lack of competitiveness of domestic production. This is consistent with the findings of a bottom-up assessment produced by the GAP Institute, which concludes that domestic production has not seen an increase in activity since the introduction of tariff measures.

The GAP institute uses Kosovo Customs commodity level and country of origin data to assess impacts. Perhaps the most surprising finding of the GAP Institute report is that 12% of exports from Serbia continue to be imported by Kosovo despite the 100% tariff. This points to the difficulty of finding effective import substitutes from other trading partners. While Veritas Global does not have access to this data, we find the GAP Institute assessment is a useful preliminary retroactive review of impacts. Once new data becomes available, we expect results will converge with our mid-range estimate of impacts.

Annex: Further details on sensitivity analysis on import costs from tariff measures

Logistics and weak transit system

On average, global logistics costs make up about 13% of the value of trade. Although, landlocked economies and those with less developed transit infrastructure have much higher costs, which can be as high as 25%. For purposes of being conservative, this assessment uses the global average of 13% as the basis of the estimate for logistics costs for imports into Kosovo. To estimate the impact of having to substitute imports for tariff impacted goods from more distant markets, the high-range estimate assumes a doubling in logistics cost for these goods. Meaning that an additional 13% in cost will be incurred. Sensitivity analysis is used to present a mid-range scenario whereby logistics cost will add 8.7% to import costs and low-range scenario of 6.5%. We consider this range to be appropriate, given the research findings from the World Bank on transport economics in landlocked countries.

Rent-seeking due to lower competition

The product markets for imported goods into Kosovo are best characterized as monopolistic competition. On average, the "monopolistic component" is likely to be significantly higher in Kosovo compared to economies that are well integrated into global trade. This is due to higher transaction costs, smaller market size and higher operational barriers. Therefore, in the short-to-medium term, the goods markets covered by tariffs will result in increase in rent-seeking behavior from existing supplies (non-tariff impacted suppliers). Evidence from rapid market exit (due to liquidation) in the US airline industry shows that following disorderly market exit an increase in fares of 12% was observed. The impact on fares was found to be persistent over time. For purposes of being conservative, this impact is estimated based on the share of the value of imports impacted by the tariffs rather than all products in impacted product markets. For the high-range estimate an additional 12% in cost is modelled. 8% and 6% is used for the mid and low-range estimates respectively.

Search and switching costs

In the context of the tariffs imposed by Kosovo, search costs are the costs incurred by importers in identifying an alternative market from which to source products impacted by the tariffs (for example staff time, travel expenses, relationship building etc.). Switching costs are the costs incurred by importers from changing suppliers (for example the need to make new currency conversions, open new accounts, draft new and close existing contracts etc.). It may not always be practical to distinguish between search and switching costs. Empirical research from Loughborough University highlights the need to look at search and switching costs together. Additional search and switching costs may also be incurred by consumers in the process of familiarizing themselves with substitute products.

Empirical evidence on search and switching costs suggest a significant range. For the high-range estimates this assessment uses findings on search and switching costs in the US auto insurance industry, where these costs are estimated at about 18%. Sensitivity analysis is used to present a mid-range estimate of 12% and low-range estimate of 9%. The unplanned and immediate effect with which the tariffs were introduced suggests that the range presented in the sensitivity analysis is appropriate. It is important to note that search and switching costs will dissipate over time as new trading relationships are established.

Delay and disruption

Delay and disruption costs will arise given the unplanned and immediate nature in which Kosovo introduced the tariffs. These are likely to arise as importers look for substitutes and establish new supply routes for products from other import markets. Empirical evidence on the impact of delay and disruption costs suggests a wide range. For example, an assessment of the Niigata-Chuetsu earthquake quantifies economic loss resulting from lower intra and interregional trade due to seismic transport network disruption in the range from 20-40%. Given the high variability and context specific factors, a conservative approach has been taken for estimating the short-run delay and disruption costs. For the high-range estimate an additional 6.5% in cost is modelled. 4.3% and 3.3% is used for the mid and low-range estimates respectively. It is important to note that delay and disruption costs are likely to be more immediate in nature and will dissipate over time.

#kosovo #economics #tradetariffs #serbia #balkans

How harmful are trade tariffs to Kosovo consumers?

George Anjaparidze

Policy Pulse - 12 June 2019 - George Anjaparidze

This week, Kosovo celebrated the 20th anniversary of the departure of troops of former Serbian President Milosevic. Despite two decades since the end of the worst of the violence and bloodshed, Kosovo remains troubled by its past. So much so that its past has clouded its judgement on economic policy today.

In November 2018, Kosovo announced 100% tariffs on all goods originating from Serbia. Based on 2017 data from the Kosovo Agency of Statistics, this tariff would impact €449.9 million or 14.8% of goods imported into Kosovo. As a result, this could decrease the purchasing power of Kosovars by €149.8 million or 6.4%. This is the equivalent of having Kosovars forego 23 days of consumption per year (See Chart).

What makes the tariffs particularly damaging for Kosovo is its poor integration into the global trading system. It is a landlocked territory with relatively weak logistics infrastructure and small domestic market. This means that, in the short-to-medium term, it will find it costly to substitute goods originating from Serbia with imports from other countries.

The World Bank estimates that landlocked territories have higher trade costs, which include higher costs of logistics, high degree of unpredictability in transportation time, widespread rent-seeking activities and weak transit systems. Furthermore, empirical research from Loughborough University points to the existence of high search and switching costs related to finding alternative suppliers, this will also contribute to driving up costs of substitutes. In addition, there may also be higher costs for the goods themselves. The combination of these factors will increase the cost of importing these goods, which, in the short-to-medium term, would lead to an increase in costs of these imports by about 33%.

There are several channels through which the tariffs will have an economic impact, two are highlighted below. First, if the bundle of goods imported are finished products that are consumed domestically in Kosovo, the impacts will be most directly felt by consumers. This is the scenario quantified in this assessment. Assuming these costs are passed through to consumers, they will face having to replace their consumption with higher cost substitutes, reduce consumption or switch to inferior substitutes. For purposes of this scenario analysis these impacts have been modeled to be of equivalent scale and on average equal to 33% of the value of goods imported (See Table 1). Second, if the bundle of goods imported are used as inputs in production processes, the impacts will be first felt by businesses unless they are able to pass through these costs to consumers or through the supply chain. The higher production costs may be even more damaging to the Kosovo economy. It will reduce competitiveness of businesses in Kosovo, thereby reducing activity and output, which will have a negative impact on employment and consumption.

The only economic rationale for this policy is if it is motivated by a desire to redistribute the gains of trade to a new set of entities (middlemen or producers) engaged in importing. Alternatively, the policy may be motivated by retaliation for blocking Kosovo membership in Interpol as well as emotive reasons, rooted in its troubled past. In either case, it is the consumers and businesses in Kosovo that pay the price for this ill-advised economic policy.