WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

Johannes Hahn, the Commissioner for European Neighbourhood Policy & Enlargement Negotiations has floated the idea of a customs union for the Western Balkans. Almost synonymously, a common market has been mentioned. Both ideas have been endorsed and possibly prompted in the first place by Aleksandar Vučić, President of Serbia. What might they have in mind?

Let me take a simple case first – the Western Balkans entering into a customs union with the EU. That would mean two things. One is that all Western Balkan countries would adopt the customs regime of the EU. The second is that they would move to tariff free trade with the EU. The latter would mean that countries which are yet to fully implement their Stabilisation and Association Agreements with the EU (Bosnia and Herzegovina, Kosovo, and Albania) speed up the process of tariff reduction. A Western Balkans’ customs union with the EU would mean that all the other free trade agreements that these countries have with third parties would be voided.

This policy was proposed, by me among others, to the Commission before CEFTA, the regional free trade agreement of the Western Balkan countries (plus Moldova), came into being. The Commission then went for CEFTA on the basis that these countries can make good use of tariffs in the process of the negotiation and implementation of their SAAs plus in trade with third countries.

CEFTA is intended to gradually liberalise trade not only in goods and then services but also in investment and employment. So, by intention, CEFTA is to develop into a common market, but not into a customs union until the Western Balkan countries join the EU. Therefore, while the idea of the customs union was to facilitate the introduction of the common market, the idea of CEFTA has been to create a common market without a customs union.

The problem with both strategies has been that the Western Balkan countries are at various stages of EU integration, so their trade regime with the EU influences their regional trade. That in turn means that non-tariff measures and other policies will be used to even out the regional free trade area. However, this problem is temporary until all the countries liberalise their trade with the EU completely.

In the interim, there is now an idea of a currency union for the Wetsern Balkans usually coupled with that of the common market for the same region. That is sometimes suggested as a way to prepare the countries to their eventual membership in the EU.

Harmonising trade relations with third parties will be very difficult

There is, however, the rest of the world. That provides the idea of the customs union for the Western Balkans with two problems. One is that not all the countries are members of the WTO (Bosnia and Herzegovina, Kosovo, and Serbia). So, tariffs with the rest of the world can vary significantly. The other problem is that Western Balkan countries have free trade agreements with third countries. Those would obviously have to be adjusted if a customs union, which is to say common tariff regime with the rest of the world, is to be created. Free trade agreements with Turkey may not prove a problem, because those could be extended to the region as the whole. There is clearly some loss for those who now have such an agreement over the others who do not, but that loss should be set against the possible gains from the customs union. Turkey itself in all probability would be willing to enter into a free trade agreement with the region as a whole. Similarly, free trade agreements with Ukraine that some countries have should not prove an obstacle, one assumes.

However, Serbia has a free trade agreement with Russia. Montenegro also inherited such a free trade agreement from Yugoslavia, but is currently considering whether to abandon it. Clearly, once Serbia accedes to the EU, it will take over the tariff regime of the EU with Russia. The whole of the Western Balkans would also have to adopt EU tariffs on Russia if it were to enter into a customs union with the EU. A Western Balkans customs union will also have to have a unified tariff regime with Russia. And, again, either nobody will have a free trade agreement or everybody will have. The latter requires Russia to sign a free trade agreement with the customs union of the Western Balkans.

That is highly unlikely. In addition, Serbia is interested in an agreement with the Eurasian Union. Other countries are not. So, a Western Balkan customs union requires that Serbia gives up on its free trade agreement with Russia. From an economic point of view, that may not be much of a cost. However it is not clear that there is the required political will to do so. At the moment of joining the EU, that may be unproblematic because this has been known since the process of negotiations with the EU started. But that may not be the case with the Western Balkan customs union.

Several challenges to deepening CEFTA

Further deepening of CEFTA is a different matter. The main advantage would be to reduce barriers to trade between CEFTA countries. As tariffs with the rest of the world differ, borders between CEFTA member states matter. So, even though intra-CEFTA trade in goods and increasingly in services is tariff free and is liberalised in most other respects, border checks are still necessary in order to implement rules of origin - thus, long lines at the border, representing costs to trade. That can be partly alleviated with border integration, which is to say that goods and people are checked only once and not twice, but the border crossing problem remains. A customs union would take care of intra-union borders. It would also support the deepening of the common market.

However, there are also three challenges to CEFTA integration. The first problem has to do with policy divergence. Already the Regional Cooperation Council in Sarajevo is working on policy coordination within its SEE 2020 programme. However, some of the macro policies are difficult to coordinate. Taxes have been mentioned, but those are only part of the problem. In fact, given that most of the Western Balkan countries rely on VAT and in particular on that levied on imports, as imports are large or very large, VAT rates clearly cannot be harmonised. Luckily, they do not have to be, because they are applied to imports as well as to domestically produced goods, meaning that they are not the same thing as tariffs. They do not distort either investment or trade in favour of the locals as opposed to the foreigners. Other taxes and other types of levies could be made to apply to everybody irrespective of country of origin.

Second, there is an issue around exchange rate regimes and monetary policy. Two countries in the region have a more flexible exchange rate regimes, Serbia and Albania, and have relied on devaluations to support their external balances in the past. Other countries have strict fixed exchange rate regimes or use the euro. It would be difficult to harmonise these regimes. That problem is hard to deal with and is thus quite an obstacle both to the customs union and to the common market.

Finally, customs unions and common markets are trade and investment diverting arrangements. A concrete example is trade after 2008. Intra-CEFTA trade hardly increased, while exports to the EU grew strongly. Regional integration within a customs union may not have been a problem because of the free trade regime with the EU. Effectively, the region would have been in a customs union with the EU, which is pretty much what the case is already.

An advantage of the Western Balkan common market would be that it might prove more attractive to foreign investments. In terms of population, the region is roughly the size of Romania. The difference is that there are so many borders to cross, and those are not internal EU borders. This has proved to be a problem particularly for infrastructure investments, which in turn has stand in the way of large scale investments in manufacturing or energy in particular. A common market could prove helpful in that as would a customs union.

Those are however not problems that market and customs integration alone can solve. Those are political issues that need to be solved politically. That also goes for the Serbian free trade agreement with Russia, which is a major obstacle to the creation of the customs union even if it is seen as being useful.