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European Journal of Scientific Research ISSN 1450-216X Vol.20 No.2 (2008), pp.356-361 © EuroJournals Publishing, Inc. 2008 http://www.eurojournals.com/ejsr.htm Trade Diversion and Trade Creation the Case of Turkey Establishing Customs Union with the European Union Veysel Ulusoy Department of Economics, Bahcesehir University E-mail: vulusoy@bahcesehir.edu.tr Ahmet Sözen Department of International Relations, Eastern Mediterranean University E-mail: ahmet.sozen@emu.edu.tr Abstract This paper explores the logical and empirical determinants of the Custom Union membership of Turkey with European Union effective in 1996 and reflects on the potential of trade creation and trade diversion effects of this membership. The paper applies a gravity model to estimate such trade effects. The gravity model offers a good application of the spatial interaction method. Results show that trade has been diverted by this membership for the first five years. JEL Classification Codes: F15, F17 1. Introduction In the field of international economics the correlation/causality between trade liberalization and gains from trade is still a widely debated issue. The empirical evidence in this area is far from unanimous. This issue is of interest for a multitude of reasons. One important presumed benefit of trade liberalization is the possible favorable effect on the developing nations in the forms of technological diffusion, productivity increase, new product developments, and commodity standardization. On the other hand, some scholars have argued that any form of a custom union deteriorates the terms of trade in developing nations, suggesting that the prices of their exports relative to their imports have fallen. Scholars have pointed out that exports of developing countries are concentrated in primary products (agricultural goods, raw materials, textiles, etc.) implying that they generally maintain accrue disproportionately to the industrial nations. This paper explores the logical and empirical determinants of the Custom Union membership of Turkey with European Union in 1996 and reflects on the potential of trade creation and trade diversion effects of this membership. 1 Throughout the analysis, we review the economic effects of such an agreement on the Turkish economy and lay down the political implications. The corresponding effects include the benefits and costs of trade creation and trade diversion, as well as gains or loss from scale and competition. 1 Trade creation effect is caused by the extra output produced by the member countries. This extra output is generated due to freeing up of trade between them. Increased specialization and economies of scale should increase productive efficiency within member countries. The trade diversion effect, however, exists where low-cost production in the rest of the world is displaced by higher-cost production in the partner country.
Trade Diversion and Trade Creation the Case of Turkey Establishing Customs Union with the European Union 357 International trade theory suggests that the formation of a free trade area or custom union agreement improves the welfare of member countries if the volume of trade by those countries increases. In other words, when trade creation among members exceeds the diversion of trade away from nonmember countries, the country will gain from such a partnership. The application is based on the Turkish economy. Turkey’s Customs UniNon (CU) agreement with the European Union (EU) in 1996 has been a very controversial issue in Turkey. The issue attracted extra attention and interest due to the fact that only the member countries of the EU have a CU with the EU and that Turkey is the only non-member country that has a CU with the EU. 2 Section 2 provides some general information and stylized statistical facts regarding trade diversion and creation effect of custom unions. Section 3 investigates the trade creation and/or trade diversion effects of Turkey’s membership empirically using 2-digit harmonized system manufacturing export data. Section 4 draws some policy implications and concludes. 2. Trade Diversion and Trade Creation In a pioneering study, Viner (1950) drew the distinction between the trade creating and trade diverting effects of regional integration agreements. It is accepted that free trade allows consumers and producers to obtain the goods and services from the cheapest sources of supply. Viner, however, emphasizes that corresponding benefits should be complete not partial for welfare to improve. 3 Since Viner’s seminal analysis, trade creation and diversion have been treated as virtually synonymous with the impact of custom unions and other regional integration arrangements on economic welfare. Accordingly, many empirical and quantitative studies have sought to estimate trade creation and diversion on either ex ante (before the fact) basis or ex post (afterwards) basis (DeRosa, p. 9). Lipsey (1951) argued that joining with countries that are already one’s largest trading partners is unlikely to lead to diversion, since the fact that the countries were originally the largest trading partners suggest that they are the lowest cost source of supply. On the consequences of regional integration, Venables (2000) suggests two main points. The first is that changes in trade flows may change world prices, possibly improving the terms of trade of member countries, although this gain arises at the expense of outside countries. The second is that changes in tariffs and trade volumes will lead to loss of government tariff revenue. This can occur directly and as a consequence of trade diversion as imports are diverted away from external, tariff inclusive, source of supply. Kruger (1999) empirically examined the changing patterns of trade flows and noted that the trade relationship among the North American Free Trade Agreement (NAFTA) countries intensified in the 1990s. This research follows the methodology that is used in gravity model in international trade. We use two-digit trade data in Harmonized System classification to look for the evidence of the benefit and costs of Turkey’s membership to CU with EU. 2 The public opinion in Turkey regarding the CU with the EU have always been polarized along the same line with the public opinion regarding the full membership of Turkey to the EU. In other words, people who oppose Turkey’s CU with the EU and claim that the CU is working for the disadvantage of Turkey, are generally the ones who believe that the EU will never accept Turkey as a full member to the Union. Hence, this group claims that Turkey made a badly negotiated deal with the EU regarding the CU. On the other hand, people who support Turkey’s CU with the EU and claim that the CU is working for the benefit of Turkey, are the ones who believe that the EU will finally accept Turkey as a full member of the Union. Hence, the CU with the EU was an important step (to the benefit of Turkey) in finalizing Turkey’s full membership to the EU. 3 As in Venables (2000), if partner country production displaces higher cost domestic production then there will be gainstrade creation. But it is possible that trade partner country production may displace lower cost imports from the rest of the world, and that is welfare reducing trade diversion.
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