Simple and Deep FTA scenarios

In the case of a Simple FTA the additional welfare gains from the removal of remaining industrial tariffs and halving of remaining agricultural tariffs in the EU-Georgia trade rises to 1.09%, i.e. only 0.11% more than that being achieved by the 2006 liberalisation (column (2) – column (1) in Table 9.6 or column 2 in Table 1 in

Appendix 8 CGE Model Results – Georgia). This is not surprising given that in 2006 Georgian tariffs are almost all zero and Georgia enjoys free access to the EU market. The welfare changes for other regions are negligible. The changes in wages are slightly higher, and again unskilled workers gain relatively more.

Column 3 in Table 9.6 presents results for a Simple FTA BIS with full liberalisation of agricultural and food products. However, the results are very similar to the Simple FTA. The Simple FTA scenario assumes already a 50%

reduction on tariffs on agro-food products; hence the additional benefits from the removal of the remaining tariffs are not a significant policy change. The trade weighted post-Simple FTA EU tariffs on Georgian major agricultural exports are zero and hence a Simple FTA BIS does not lead to any improvement in the access of Georgian exports to the EU market. On the Georgian side, the only sector where the post- Simple FTA tariffs are quite high i.e. 5.8% (see Table 9.1) is livestock, which constituted less than 1% of Georgian imports from the EU in the benchmark 2004. Another noticeable improvement in the access of EU products to the Georgian market is for food, beverages and tobacco where barriers decrease from post-Simple FTA level of 2.7% to zero. Despite low tariffs in this sector, the impact of their reduction is significant for two reasons i.e. Georgia is a net-importer of food products and imported food constituted 35% of domestic consumption in 2004.

Therefore this is the major change that impacts on the welfare implications of the Simple FTA BIS scenario as compared to Simple FTA. As tables in the Appendix 8 CGE Model Results – Georgia indicate the domestic production is crowded out by imports and domestic output falls further as compared to Simple FTA. Since we have a single representative consumer in the model, the loss of tariff revenue and a smaller increase in factor rewards outweigh the gains from lower consumer prices and increased efficiency of production. This points out that again tariff barriers are not the major obstacle to the expansion on Georgian exports to the EU, only quality improvements and reductions of non-tariff barriers can lead to significant benefits for the agro-food sector.

An FTA+ combines a Simple FTA with a consolidation of the domestic reforms that took place in Georgia over the recent years in a binding agreement. The FTA+

could consolidate measures such as unilateral recognition of EU and international product standards and facilitation of customs procedures. The FTA+ could impact on the perception of Georgia as a safe place to invest. These effects are very difficult to quantify, but one way to analyse this kind of implications is to look at a reduction in the cost of capital. This is interpreted as a lowering of risk premium associated with locating the capital in Georgia. A similar approach has been adopted in the

study on the Eastern EU Enlargement (Baldwin, Francois, Portes, 1997) and in the feasibility study for the EU-Ukraine FTA (CEPS, 2006), where a reduction of the price of capital of 10% was assumed. Clearly a deep and comprehensive FTA could result in a strong boost to the investors’ confidence in Georgia, but even an FTA+

might to some extent affect the investors’ expectations. It is not possible to estimate with certainly the extent to which the investment risk will be affected by an FTA+, but to illustrate its possible consequences we study the implications of a 2.5%

reduction in the cost of capital. We designate this scenario as FTA+, since it goes significantly beyond a classic Simple FTA by including some obligations on domestic policy and consolidation of the acceptance of EU standards for imports.

The results the FTA+ scenario are presented in column 4 in Table 9.6. Our results indicate an increase of welfare by 3.35% of GDP or 2.38 percentage points above the 2006 liberalization scenario. This is associated with an increase of wages of skilled workers by 4.45% and 5,11% for unskilled workers. The capital stock increases by 6.70% in response to the lowering of the risk to invest.

There are several reasons why we should expect the elimination of NTBs to be beneficial to Georgia and the EU. The reductions in barriers to trade and transport costs decrease the prices of goods for consumers, as well as prices of intermediates and capital goods for producers. The extent of these gains depends on the amount of trade between the trading partners and the trade creation and trade diversion effects. Apart from increased efficiency of resource allocation, as demand shifts to regions with the lowest cost suppliers, additional gains stem from increased competition. However all gains from trade also involve adjustment costs and may be associated with potentially painful restructuring in Georgia and significant redistribution effects.

Furthering the level of integration via a Deep FTA would involve a more complete elimination of barriers to trade and investment. This would result in a more extensive commitment to the reform of domestic policies in the direction of EU standards in Georgia. We operationalize this scenario by looking at the effects of the removal of NTBs such as border and standard costs and barriers to foreign provision of services as defined above. The estimates of the magnitude of those barriers in Georgia are not perfect, yet they provide a useful tool to gain insight into the magnitude and direction of changes in trade, prices and output by sectors. Our results indicate that the impact of a Deep FTA here narrowly defined as only the removal of NTBs would bring significant benefits to Georgia. In the long run the increase in welfare rises to 2.74%

of GDP or 1.76 percentage points over the impact of the 2006 reform. The impact of

a Deep FTA on the EU27 is still lower than 0.1% of GDP, but this is to be expected given that the share of Georgia in total EU imports and in total EU exports is less than 1%. The implications for other regions are also negligible.

Finally, the comprehensive set of reforms resulting from the Deep FTA along with more wide-ranging flanking measures e.g. on competition and corruption could lead to a re-branding of Georgia as a favourable investment location. This is our scenario Deep FTA+ (column 6) where we assume that Georgia would achieve a notable reduction in the perceived risk premium on investment, reflecting a sustained re-branding of Georgia as a favorable and safe place to invest. We illustrate this by assuming a 5% decrease in the price of capital. In this scenario the welfare implications increase to 7.51% of GDP i.e. the net effect of 6.54% over the 2006 liberalization scenario.

Again in the Deep FTA+ scenario output of unskilled labour intensive sectors is growing faster than output of sectors where skilled workers are used more intensively and wages of unskilled workers grow relatively faster (increase by 9.27%

compared to 7.92% for wages of skilled workers). This is mainly explained by the expansion of unskilled labour-intensive sectors such as textiles and wearing apparel; metal and metal products; wood and wood products. Increase in real wages stems from a more efficient allocation of resources as tariff and non-tariff barriers are being eliminated. However it is also related to the nature of the experiment. As we allow the capital stock to increase by 15% in response to changes in return to capital following a Deep FTA+ holding total employment fixed, the higher capital to labour ratio leads to an increase in wages. This is coupled with falling prices across the majority of sectors due to lowering of tariffs and several NTBs leading to an even sharper increase in real wages.

The sectoral impacts on prices, output and trade are displayed in the Appendix 8 CGE Model Results – Georgia. Prices fall across majority of sectors with the impact on selected industries now being determined by changes in standards costs, border costs, by changes in relative barriers to foreign providers of transport, financial and communication services and their trade intensity and factor shares intensity. The impact of the liberalisation of the access to services sector seems to be very small. The majority of sectoral output changes seem to be determined by changes in border and standards costs. Output of many sectors increases dramatically e.g. textiles and wearing apparel or metal and metal products.

However, the increases of the order of 46-56% are not that impressive given that the base production level was very small (less than 2% of the total value added was

generated in each of those sectors in 2004). Other industries experiencing output growth are wood products; mining and quarrying and chemical, rubber and plastic products. The biggest fall in output is recorded in paper and paper products; leather goods; machinery and equipment and manufactures NEC, food sector. The production of those sectors is replaced by imports.

Trade changes are highly correlated with changes in output. A decrease in domestic production is often associated with an expansion of imports to replace domestic production. Exports increases are highest in sectors where prices fall the most, hence the products become much more competitive on the world markets.

9.5. Conclusions

These simulations have presented a series of scenarios for EU-Georgian free trade. They begin with the effects of the 2006 unilateral free trade measures adopted by Georgia combined with the EU’s granting it GSP+ under its new GSP scheme. These effects will however take years still to fully mature. They could be consolidated and completed in a formal FTA with the EU. The Simple FTA and Simple FTA BIS scenarios might not add much, since only the remaining agro-food tariffs would be halved or dismantled. However this simulation ignores possible confidence and synergy effects that could come from the binding in of the multiple liberalization and reform measures that Georgia has made in the recent past. These confidence effects can be modeled as reductions in the perceived risk premium attached to investment in Georgia, which noticeably enhances the result. We call this scenario FTA+, given that it stands for measures going beyond Simple FTA (i.e.

only tariff reductions). The Deep FTA scenario also adds significant benefits as a result of a more complete elimination of a comprehensive definition of barriers to trade and investment. And finally we present a variant, which is the closest to the definition of a deep and comprehensive FTA as understood throughout the report which complements the elimination of NTBs with several additional flanking measures related to competition policy, corruption etc. - Deep FTA+. This scenario involves a larger reduction of the risk premium associated with a major strengthening of investment climate and improved perceptions of Georgia’s business climate, reputation and re-branding along with the significant reduction of NTBs. The Deep FTA+ scenario sees the highest gains for the Georgian economy.

Which of these scenarios will materialize, or over what time horizon, of course cannot be forecast. All depends on the actual content of the agreement signed and

the ability of the Georgian government to take the policy measures that underlie the scenario computations. At the same time it is evident that the ultimate benefits for Georgia of an effectively implemented Deep FTA+ with the EU could be substantial.

This chapter explores the prospects of selected important sectors in Georgia in terms of trade expansion and foreign direct investment (FDI), highlights potential issues and discusses the likely implications of free trade agreements with the EU.

Based on a descriptive statistical analysis including production and foreign trade data, it focuses on domestic capacity constraints, domestic and regional policies, and issues not covered under the regulatory convergence and investment climate chapter. The selected sectors are the agro-food sector and energy sectors.

10.1. Agro-food sector

10.1.1. General Performance and Current Issues

Georgia possesses favourable conditions for the production of a wide range of annual and perennial crops, making agriculture one of the key sectors of the country’s economy. However, while the long-term development of the agro-food sector in Georgia remains a potentially attractive undertaking, agriculture is currently experiencing structural difficulties and sectoral growth has been a mixed picture thus far.

Agriculture is a key sector in Georgia, though its relative importance is declining. Real value added for the sector “Agriculture, Forestry, Fishing” from 1996 to 2006, based on figures from Statistics Georgia, as well as agricultural or food production from 1992 to 2006, based on figures from FAOSTAT, remained steady (Figure 10.1 and Figure 10.2). Meanwhile, the share of real value added in GDP fell from 34.1% in 1996 to 18.8% in 2006 (Figure 10.1).