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A blog about economics in the South Caucasus.

Georgia Caught Between the Russian Rock and the EU Hard Place

“I’m Georgian, and therefore I am European.” These were the words late Georgian Prime Minister Zurab Zhvania chose to express Georgia’s EU aspirations when speaking in front of the Council of Europe in 1999. Reading very much like Martin Luther King’s “I have a dream”, Zhvania’s dramatic statement conveyed twin desires: i) to join the European family of nations and ii) to break out of Russia’s traditional sphere of influence, its political, economic, and cultural domination of Georgia since early 19th century.

On June 27, the European Union plans to sign an Association Agreement (AA) with Georgia, paving the way to closer political integration. Importantly, however, the AA will be accompanied by another document, Deep and Comprehensive Free Trade Agreement (DCFTA), committing Georgia to non-trivial economic and institutional reforms in exchange for greater (though not completely free) access to the European market.

Now, there has been little public discussion, let alone rigorous research, about the perceived costs and benefits of the proposed DCFTA. The reason there has been little research and debate has to do with the way in which the choice facing Georgia is being framed: i) to become a proud member of the European community or ii) go back to the jolly old USSR days. In other words, no choice at all.

This is simply not true.

Economically, as opposed to politically, the choices Georgia faces are not Eurasian Union (back to the USSR) vs. the European Union. The choices are about i) joining one trade block or another, or ii) staying outside competing blocks and pursuing bilateral trade liberalization with Georgia’s main trading partners (at present, these are Azerbaijan, Armenia, Turkey, and Russia). If the former, i.e. a decision is made to join a particularly union, it should be implemented on the basis of careful analysis and discussion with domestic stakeholders, and after tough negotiations, as opposed to a process rushed for political reasons.


THE ECONOMIC BENEFITS OF DCFTA ARE UNCERTAIN

Tarrifs. Georgia already enjoys low tariff barriers in trading with Europe subject to EU's Generalized System of Preferences (GSP+). Thus, Georgia faces zero duties on about 75% of all tariff lines. Yet, Georgia’s ability to take advantage of GSP+ treatment has been extremely limited. In 2013, the country’s total exports to the EU stood at USD 608mln (21% of Georgia’s total exports), of which about $231mln enjoyed GSP+ preferences. Hazelnuts accounted for almost 60% of total GSP+ exports. Other GSP+ exports were fertilizer, ferroalloys and apple concentrate.

DCFTA will abolish tariffs for 100% of product categories, including agricultural products that are of potential interest for Georgian exporters such as wine, cheese, live animals, sheep and goat meat, yogurt, chocolate, animal skins and wool (which have not be covered by GSP+ preferences), berries, fruit and vegetables (included canned and processed), and fruit juices (which enjoyed from partial preferences under GSP+).

While this seems like a significant improvement, the extent to which Georgia can benefit from free trade with the EU depends on whether or not Georgian products can gain market share in Europe (and/or whether Georgian producers will be willing to invest in expensive EU-targeted marketing and branding efforts).

The answer to this question is far from obvious. For example, considering the state of Georgia’s dairy sector - Georgia does not have enough fresh milk to supply its own industry – the country is very unlikely to export significant quantities of cheese and yogurts (to EU or any other region, for that matter). On the other hand, given that traditional Georgian products such as wine, mineral water and tea, are well established brands in much of the vast post-Soviet space, Georgian producers have rather weak incentives to explore other markets. This point is very well illustrated by the current state of Georgia’s wine industry.

The opening of the Russian market in 2013 resulted in significantly increased production volumes (and new vineyards are being planted as I type) with 60% of all Georgian wine exports going to Russia and other (potential) members of the Eurasian Union such as Belarus, Kazakhstan, Tajikistan, and Uzbekistan. In the first four months of 2014, wine exports to Eurasia reached 79%, with the main limiting factor being … Georgia’s production capacity.

This should come as no surprise since Eurasia is the traditional market for wine and many other Georgian products such as tea, mineral water, greens, fruit and veggies. With Russia lifting the ban on imports from Georgia, these sectors are in a frenzy of investment partially financed and promoted by Georgia’s large and powerful diaspora in Eurasia. The acquisition of Borjomi by Russia’s Alfa Group is just the tip of the iceberg.

As if competing with the EU, Russia continues to open up its market for Georgian exports. In June 2013, it lifted restrictions on “low phytosanitary risk products” (such as tea, laurel, dried fruit, nuts, citrus, grapes, apples, pears etc.). High risk products (washed and pre-packed potatoes, tomatoes, cucumbers, cabbage, eggplants, cherries, apricots, peaches, plums, kiwi and berries) have been allowed in just a few weeks ago, on May 26, 2014.

Things look even more “interesting” if allow the possibility of a political settlement between Russia and Georgia over Abkhazia and South Ossetia. If the railway connection via Abkhazia is restored in the future, trade and tourism connections with Russia and Eurasia will further gain in importance.

Investment. The potential of increasing Georgian exports to the EU is clearly limited in the short run, however, one could argue that DCFTA has the potential to trigger a round of foreign investment in Georgia, increasing the country’s export potential in new product categories. To some extent this is already happening under GSP+ preferences. For instance, hazelnut growing and processing has been the target of considerable investment since 2007 (Ferrero’s investment in more than 3,500ha of hazelnut plantations is the largest project of this kind).

Two restrictions stand in the way of more significant investment in capital intensive projects. First, exports from Georgia to the EU will be subject to rigid “rules of origin” limiting the use of inputs originating in third countries that don’t have an FTA with Europe. Yet, not having an FTA with the EU is exactly what gives countries such as Azerbaijan, Iran and China, the incentive to invest in Georgia in the first place (in order to use Georgia as a springboard to the EU market). By limiting the use of inputs from countries that are most likely to invest in Georgia, “rules of origins” thus create a Catch 22 situation.

Second, Georgia is not particularly abundant in high quality (skillful and disciplined) labor force that is needed for investment in sophisticated agribusinesses and manufacturing to make sense. Ironically (or tragically), some of the recent Georgian legislation (moratorium on land acquisition by foreigners, imposition of visas and refusal to renew visas for e.g. Indian investors and workers, the new 90+90 rule for all foreigner visitors) specifically seeks to prevent foreign workers and investors from entering and staying in the country.


THE COSTS OF DCFTA ARE NOT NEGLIGIBLE

The broad public is not aware of the fact that the “standards” imposed by the DCFTA agreement apply not to goods produced in Georgia but to goods sold in the Georgian market, including goods imported from third countries. This will raise consumer prices for many agricultural products, such as meat and dairy. Mind it that this DCFTA clause serves as a means of promoting EU exports to DCFTA countries, rather than promoting the health and wellbeing of DCFTA country citizens. It is not about philanthropy but the business interests of European companies. Georgian companies that want to export to the EU, can do it already today, under GSP+ or otherwise. They have to individually certify their products, but this is doable. Ironically, Georgian companies exporting their products to Russia and other third countries, will not be subject to EU standards.

Nobody asks Georgian citizens whether they would like to pay more for safely produced and better labelled goods. They have no say in the negotiation process. The only way for Georgian citizens to opt out of the expensive “DCFTA standards” will be to avoid the formal distribution channels (supermarkets), and do their shopping in the open air markets (bazrobas) where these regulations are very unlikely to be enforced.

Finally, there is the time dimension and the fine print of the DCFTA – the Georgian government can negotiate different time horizons for different DCFTA measures, different quotas and reference prices for specific products. But it is not clear that the Georgian government has the capacity to fully understand the economic implications of the various regulations and is sufficiently informed to negotiate a good deal.


THE BOTTOM LINE

The above analysis suggests, that DCFTA is a very complicated and rather mixed bag with more or less certain costs and very uncertain benefits. Ironically, the only study of the potentials costs and benefits that is available to Georgian policymakers has been commissioned by the EU and implemented by European organizations that have no presence in Georgia and are clueless about the specifics of the Georgian economy. The “black box” model used in their analysis is a standard off-the-shelf product that certainly does not account for Georgia’s unique position between the Russian rock and the EU hard place.

Georgia will most certainly sign the DCFTA, and the EU will provide technical assistance and funding to offset some of the related costs. Still, it is a pity that Georgia rushed into this agreement without a careful “in-house” analysis of the deal it is getting into. The greatest uncertainly facing Georgia after June 27, is Russia’s next move in the Big Game. Georgia certainly does not want to be completely dependent on Russia and Eurasia for its exports. Hedging is the only right strategy when dealing with the uncertainly of being locked out of the Eurasian market for political reasons. At the same time, we may not want to risk Russia’s immediate (and certain) retaliation for joining a competing trading block.

Georgia may want to be in Europe for political reasons, just like Zurab Zhvania stated a few years back, but dipping into the deep (and comprehensive) FTA with Europe without a careful consideration of national economic interests may backfire. With the costs of AA and DCFTA exceeding its benefits, Eurasia may come back with a vengeance. Politically, as well as economically.

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Guest - NP on Friday, 06 June 2014 14:18

Interesting point of view. I agree especially on the message that the economic, social and geopolitical consequences of all choices (in the short-medium and long run) should always be studied before taking such important steps.

Interesting point of view. I agree especially on the message that the economic, social and geopolitical consequences of all choices (in the short-medium and long run) should always be studied before taking such important steps.
Guest - Hvino. Georgian Wine (@Wine_of_Georgia) on Friday, 06 June 2014 16:42

Thank you for worthy analysis

Thank you for worthy analysis
Guest - Kara Yermukan on Friday, 06 June 2014 18:18

I don't personally see the Catch 22 situation described by the author ("By limiting the use of inputs from countries that are most likely to invest in Georgia, “rules of origins” thus create a Catch 22 situation."). Why attract investors who will take away that special Georgian thing?! Let Georgians develop their agriculture, not foreigners. Then, it'll be Chinese/Azeri/you name it products "made" in Georgia...
Also, the author writes, "second, Georgia is not particularly abundant in high quality (skillful and disciplined) labor force that is needed for investment in sophisticated agribusinesses and manufacturing to make sense." To hell with "sophisticated agribusiness"! Farmers all over the world are suffering from this "sophisticated agribusiness" that makes mass-produced-low-nutrient-smothered with chemicals agri "food". The value and the beauty of places like Georgia is in its traditional way of doing agriculture, that produces the highest quality, truly organic, non-GMO food full of nutrients. Why turn Georgia into another Central Valley, USA, or Holland that sells sterile seeds to the world, or chemical laden chinese stuff?!
"The only way for Georgian citizens to opt out of the expensive “DCFTA standards” will be to avoid the formal distribution channels (supermarkets), and do their shopping in the open air markets (bazrobas) where these regulations are very unlikely to be enforced." ??? and what is wrong with that? some of the best stuff is sold at bazrobas!

I don't personally see the Catch 22 situation described by the author ("By limiting the use of inputs from countries that are most likely to invest in Georgia, “rules of origins” thus create a Catch 22 situation."). Why attract investors who will take away that special Georgian thing?! Let Georgians develop their agriculture, not foreigners. Then, it'll be Chinese/Azeri/you name it products "made" in Georgia... Also, the author writes, "second, Georgia is not particularly abundant in high quality (skillful and disciplined) labor force that is needed for investment in sophisticated agribusinesses and manufacturing to make sense." To hell with "sophisticated agribusiness"! Farmers all over the world are suffering from this "sophisticated agribusiness" that makes mass-produced-low-nutrient-smothered with chemicals agri "food". The value and the beauty of places like Georgia is in its traditional way of doing agriculture, that produces the highest quality, truly organic, non-GMO food full of nutrients. Why turn Georgia into another Central Valley, USA, or Holland that sells sterile seeds to the world, or chemical laden chinese stuff?! "The only way for Georgian citizens to opt out of the expensive “DCFTA standards” will be to avoid the formal distribution channels (supermarkets), and do their shopping in the open air markets (bazrobas) where these regulations are very unlikely to be enforced." ??? and what is wrong with that? some of the best stuff is sold at bazrobas!
Guest - Eric Livny on Friday, 06 June 2014 20:28

Kara, thanks for your comments. You sound very critical, but I think that, in fact, we are in complete agreement as far as the main thrust of this article is concerned. We are arguing against mindlessly dipping into DCFTA because it will not produce the results people expect (growth in exports to the EU, investment, jobs and higher living standards). Some people will be able to avoid higher prices by shifting to the wonderful bazrobas. Others (the "middle class" folks) will end up paying more for EU-style individually packaged but tasteless tomatoes available in supermarkets.

Kara, thanks for your comments. You sound very critical, but I think that, in fact, we are in complete agreement as far as the main thrust of this article is concerned. We are arguing against mindlessly dipping into DCFTA because it will not produce the results people expect (growth in exports to the EU, investment, jobs and higher living standards). Some people will be able to avoid higher prices by shifting to the wonderful bazrobas. Others (the "middle class" folks) will end up paying more for EU-style individually packaged but tasteless tomatoes available in supermarkets.
Guest - David Lee on Friday, 06 June 2014 20:42

The best economic argument is surely to compare the GDP of Poland and Ukraine. Once the same, now Poland is three times higher. Or perhaps to consider the chances that Skype would be the output of Estonia, if the Baltic States were part of the Eurasia Union rather than the European Union. As a last point, when did you last buy something made in Russia that did not involve pumping it into your car or heating your house.

The best economic argument is surely to compare the GDP of Poland and Ukraine. Once the same, now Poland is three times higher. Or perhaps to consider the chances that Skype would be the output of Estonia, if the Baltic States were part of the Eurasia Union rather than the European Union. As a last point, when did you last buy something made in Russia that did not involve pumping it into your car or heating your house.
Guest - Eric Livny on Friday, 06 June 2014 21:54

David, I am not so sure I am buying into your "best economic argument".

Are you suggesting that Georgia will become the next Poland if it signs the DCFTA? But why Georgia's youth need the DCFTA to move into IT, modern agronomy and engineering, develop cool aps, internet of things, robotics and communication solutions? Why aren't they doing it today? Will DCFTA convince German companies to start shifting production from Poland and Slovakia to Georgia? In my view, they will be very unlikely to do so unless Georgia mends fences (or, rather, borders) with Russia. An angry Russia to Georgia's north is not the best starting point for even thinking about investment in long-term, capital-intensive projects.

Talking about Russian products other than oil and gas, I would recommend Kalashnikovs (far more reliable than M16 - coming from a former Israeli paratrooper), vodka, caviar, and Soyuz ST carrier rockets (used by European Space Agency). I would not recommend Kaspersky even though this is a fairly popular global brand. As for the Russian hi-tech sector, here is an interesting BloombergTV http://www.bloomberg.com/video/93176933-ryan-s-russia-hi-tech-industry-boom.html.

David, I am not so sure I am buying into your "best economic argument". Are you suggesting that Georgia will become the next Poland if it signs the DCFTA? But why Georgia's youth need the DCFTA to move into IT, modern agronomy and engineering, develop cool aps, internet of things, robotics and communication solutions? Why aren't they doing it today? Will DCFTA convince German companies to start shifting production from Poland and Slovakia to Georgia? In my view, they will be very unlikely to do so unless Georgia mends fences (or, rather, borders) with Russia. An angry Russia to Georgia's north is not the best starting point for even thinking about investment in long-term, capital-intensive projects. Talking about Russian products other than oil and gas, I would recommend Kalashnikovs (far more reliable than M16 - coming from a former Israeli paratrooper), vodka, caviar, and Soyuz ST carrier rockets (used by European Space Agency). I would not recommend Kaspersky even though this is a fairly popular global brand. As for the Russian hi-tech sector, here is an interesting BloombergTV http://www.bloomberg.com/video/93176933-ryan-s-russia-hi-tech-industry-boom.html.
Guest - Randy on Friday, 06 June 2014 22:26

Small, powerless states do not have the option of playing both side against the middle. There is not a choice between two equivalent "trading partners." There is a stark choice between a world of law, freedom and respect for individuals and another world of corruption, human rights abuses and repression. Georgia must choose and some things are simply more essential to basic human values than even economic interests, although in the long term the evidence that the sort of conditions imposed by the EU charter are key for eventual economic prosperity. Russia remains a gas station with an army. Poland, on the other hand, represents a modern, growing economy with hope for the future.

Small, powerless states do not have the option of playing both side against the middle. There is not a choice between two equivalent "trading partners." There is a stark choice between a world of law, freedom and respect for individuals and another world of corruption, human rights abuses and repression. Georgia must choose and some things are simply more essential to basic human values than even economic interests, although in the long term the evidence that the sort of conditions imposed by the EU charter are key for eventual economic prosperity. Russia remains a gas station with an army. Poland, on the other hand, represents a modern, growing economy with hope for the future.
Guest - Eric Livny on Friday, 06 June 2014 23:28

Randy, I know how you feel about the "gas station with an army". However, I did not know you have so much sympathy for the EU :)

Poland is a great country, to which I have a strong (family) attachment, as you know. The problem is that Georgia is not Poland, and applying the same "DCFTA treatment" to all "powerless states" on Russia's periphery is not necessarily a good thing for these states or Europe.

Randy, I know how you feel about the "gas station with an army". However, I did not know you have so much sympathy for the EU :) Poland is a great country, to which I have a strong (family) attachment, as you know. The problem is that Georgia is not Poland, and applying the same "DCFTA treatment" to all "powerless states" on Russia's periphery is not necessarily a good thing for these states or Europe.
Guest - Henry Kamens on Saturday, 07 June 2014 04:06
http://journal-neo.org/2014/03/11/georgia-ukraine-and-the-eu-the-tale-of-the-wicked-stepmother/
Guest - Randy on Saturday, 07 June 2014 15:30

I don't love the EU but it has clear value over the alternative. War criminals go to jail in Croatia or Serbia. They hold office in Russia. The difference is the imposition of EU norms of basic conduct. If you accept the acquis you do not get what I would regard as the ideal laws and regulations that I would impose if I were the dictator, but what you get is orders of magnitude over what any post-communist country without EU pressure has been able to achieve.

I don't love the EU but it has clear value over the alternative. War criminals go to jail in Croatia or Serbia. They hold office in Russia. The difference is the imposition of EU norms of basic conduct. If you accept the acquis you do not get what I would regard as the ideal laws and regulations that I would impose if I were the dictator, but what you get is orders of magnitude over what any post-communist country without EU pressure has been able to achieve.
Guest - Eric on Friday, 27 June 2014 17:11

This blog post and other views presented on the BBC website: http://www.bbc.com/news/world-europe-28042715

This blog post and other views presented on the BBC website: http://www.bbc.com/news/world-europe-28042715
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