The Customs Union Between Turkey and the European Union and Its

THE CUSTOMS UNION BETWEEN TURKEY AND THE EUROPEAN UNION AND ITS

EFFECTS ON THE TURKISH ECONOMY

A thesis presented

Ali Murat PALA

The Department of Economics

In partial fulfillment of the requirements

for the degree of Master of Arts

In the field of

Economics

Northeastern University

Boston, Massachusetts

August, 2011

THE CUSTOMS UNION BETWEEN TURKEY AND THE EUROPEAN UNION AND ITS

EFFECTS ON THE TURKISH ECONOMY

Ali Murat PALA

ABSTRACT OF THESIS

Submitted in partial fulfillment of the requirements

for the degree of Master of Arts in Economics

in the Graduate School of Northeastern University

August, 2011

ABSTRACT

Since the declaration of the Republic in 1923, Turkey has always looked to the

West for its modernization and development processes. Following the Second World

War, several organizations were created among countries in order to maintain joint power against conflicts, including organizations that had just economic reasons. Being a founding member of the United Nations, a member of the North Atlantic Treaty

Organization, the Council of Europe and the Organization of Economic Cooperation and

Development, it was only sensible for Turkey, an ally of the West to follow the modernization and development processes by proving a part of the European Economic

Community formed by six Western European countries in 1957. Making its first application in 1959, Turkey ended up signing the Ankara Agreement also known as the

Association Agreement in 1963 that foresaw how the customs union would be established in order to secure Turkey’s membership to the Community.

As stated by Appleyard (2010), customs union is the second stage of economic integration. Economic integration can be defined as the integration of countries in order to remove trade barriers among themselves. Customs union not only removes the customs tariffs among member countries but also holds a common trade policy towards non-member countries. Customs unions have static and dynamic effects on the countries’ economies.

This study analyzes why the customs union between Turkey and the EU does not manifest the expected static effects, why the trade share of the EU decreased over

time in spite of the customs union agreement and what measures should be taken in order to increase the trade between Turkey and the EU.

In order to identify the problems, Turkey’s trade with the EU, OECD, OIC, BSEC,

CIS, luggage trade with Russia, and the relations with Germany are observed. In addition, a basic econometric analysis is carried out to forecast the trade between

Turkey and the EU.

Following the results of the study, some suggestions are tried to be put forward to enhance the likelihood in achieving a more effective customs union between Turkey and the European Union. In this regard, firstly it is argued that Turkey should create policies towards technological developments and innovations in the manufacturing sector in order to produce at a lower cost than other member countries in the customs union. Secondly, Turkey should pursue a policy of including all of its goods, including agricultural goods, in the customs union agreement with the EU. Thirdly, economic policies to increase income should be carried out. Also, considering the Turkish population in the other customs union member countries, trade policies should be adjusted accordingly. Finally, the luggage trade with Russia should be taken under control in order to reduce its volume to increase the trade with the EU.

In memory of my beloved Mother, Hayriye Pala

ACKNOWLEDGMENTS

I would like to express my deepest gratitude to my supervisor Prof. Oscar T.

Brookins for his valuable comments, advice, and support throughout my research.

Without his encouragement and help, this thesis would be incomplete.

I would also like to thank Prof. Kamran Dadkhah for his support and guidance throughout the preparation of this thesis.

I am also appreciative to the Department of Economics at Northeastern

University for providing an ideal environment for me to pursue my graduate work.

I would also like to express my gratitude to the Prime Minister of Turkey,

Undersecretariat of Customs for their most generous financial support for my education in the United States.

Lastly, I would like to thank my family for their huge support and belief in me throughout my graduate studies at Northeastern University.

TABLE OF CONTENTS

ABSTRACT………………………………………………………………………...... 3

DEDICATION……………………………………………………………………...... 5

ACKNOWLEDGMENTS…………..……………………………………………...... 6

TABLE OF CONTENTS…………………………………………………………...... 7

LIST OF TABLES…………………………………………………………………...... 9

LIST OF GRAPHS………………………………………………………………...... 11

LIST OF ABBREVIATIONS……………………………………………………...... 12

CHAPTER 1 - INTRODUCTION………………………………………………...... 13

CHAPTER 2 - ECONOMIC INTEGRATION…………………………………...... 18

2.1 Definition………………………………………………………………………...... 18

2.2 Customs Union………………………………………………………………...... 21

2.3 Economic Effects of the Customs Union…………………………………...... 23

2.3.1 Static Effects………………………………………………………………...... 24

2.3.2 Dynamic Effects…………………………………………………………...... 28

CHAPTER 3 - HISTORY OF THE FORMATION OF THE CUSTOMS UNION

BETWEEN TURKEY AND THE EUROPEAN UNION………………...... 30

3.1 Establishment of the Customs Union Between Turkey and the EU……...... 32

3.1.1 Introduction…………………………………………………………………...... 32

3.1.2 Ankara Agreement…………………………………………………………...... 34

3.1.3 Additional Protocol…………………………………………………………...... 35

3.1.4 Turkey’s Application for Full Membership in 1987……………………...... 36

3.1.5 Formation of the Customs Union Between Turkey and the EU………...... 38

CHAPTER 4 - EFFECTS OF THE CUSTOMS UNION ON THE TURKISH

ECONOMY…………………………………………………………………………...... 41

4.1 Static Effects of the Customs Union on Turkish Trade…………………...... 43

4.1.1 Trade Creation Effects……………………………………………………...... 43

4.1.2 Trade Diversion Effects……………………………………………………...... 48

4.1.3 Conclusion…………………………………………………………………...... 63

4.2 Dynamic Effects of the Customs Union on Turkish Trade………………...... 66

4.2.1 Turkey’s Trade by Broad Economic Categories………………………...... 67

CHAPTER 5 - FORECASTING THE TRADE BETWEEN TURKEY AND THE EU

WITH AN ECONOMETRIC ANALYSIS………………………………...... 76

5.1 Econometric Model…………………………………………………………...... 76

5.2 Testing for Stationarity………………………………………………………...... 78

5.3 Linear Regression Analysis…………………………………………………...... 81

5.4 Vector Autoregression Analysis……………………………………………...... 83

5.5 Granger-Causality Testing…………………………………………….……...... 85

5.6 Forecasting the Trade………………………………………………………...... 87

CHAPTER 6 - CONCLUSION…………………….……………………………...... 91

BIBLIOGRAPHY…………………………………………………………………...... 98

LIST OF TABLES

Table 4.1 Turkey’s Foreign Trade and EU’s share……………………………………... 45

Table 4.2 Turkey’s Exports by Organizations in Nominal Values…………………….. 50

Table 4.3 Turkey’s Imports by Organizations in Nominal Values…………………….. 51

Table 4.4 Trade by Organizations in Percentages……………………………………... 52

Table 4.5 Luggage Trade with Russia…………………………………………………... 62

Table 4.6 Turkey’s Exports by Broad Economic Categories ……....…………………. 69

Table 4.7 Turkey’s Imports by Broad Economic Categories ……..…………………... 70

Table 4.8 Employment by Agriculture and Manufacturing Sectors…………………… 74

Table 4.9 Educational Status by Agriculture and Manufacturing Sectors…..……….. 74

Table 5.1 Dickey-Fuller General Least Squares Test Values…………………………. 79

Table 5.2 Dickey-Fuller General Least Squares Test Values II………………………. 80

Table 5.3 Linear Regression of the Model………………………………………………. 81

Table 5.4 Vector Autoregression for 10 Optimal Lags of dLex ...... 84

Table 5.5 Vector Autoregression for All Variables with 10 Lags……………………… 85

Table 5.6 Granger Causality Wald Test Results………………………………………... 86

Table 5.7 Pseudo-Out-Of-Sample (POOS) Analysis…………………………………… 88

LIST OF GRAPHS

Graph 4.1 Growth of Exports and Imports……………………………...... 47

Graph 4.2 Exports Percentage…………………………………………………………… 53

Graph 4.3 Imports Percentage……………………………………………………………. 53

Graph 5.1 The Growth of Model Variables ……………………………………………... 78

Graph 5.2 Forecast of the Trade Between Turkey and the EU……………………….. 89

LIST OF ABBREVIATIONS

AIC Akaike Information Criterion

Benelux Belgium, the Netherlands and Luxembourg

BSEC Black Sea Economic Cooperation

CIS Commonwealth of Independent States

EC European Community

EEC European Economic Community

EFTA European Free Trade Association

EU European Union

GATT General Agreement on Tariffs and Trade

GDP Gross Domestic Product

IMF International Monetary Fund

NATO North Atlantic Treaty Organization

OECD Organization for Economic Cooperation and Development

OEEC Organization for European Economic Cooperation

OIC Organization of the Islamic Conference

POOS Pseudo Out-Of-Sample

RMSE Root Mean Square Error

RMSFE Root Mean Square Forecasting Error

UN United Nations

USSR Union of Soviet Socialist Republics

WTO World Trade Organization

CHAPTER 1

INTRODUCTION

Following the Second World War, nations started to seek integration with each other in order to maintain strength against other countries in the world. Several organizations such as North Atlantic Treaty Organization, United Nations, the Council of

Europe and the Organization for European Economic Cooperation were created and

Turkey was among the members of these organizations.

Having been an ally of the West and having had close relations with the West through the policies pursued, it was only natural for Turkey to pursue the goal of joining geographically the most convenient economic integration, the European Union that was formed under the name of the European Economic Community in 1957 by six Western

European countries. Turkey made its first application to join this Community in 1959 but it has not achieved its goal some 50 years later. However, it led Turkey to sign the

Ankara Agreement also known as the Association Agreement in 1963 which foresaw a customs union between Turkey and the Community with an ultimate aim of full membership of Turkey. This was followed by signing the Additional Protocol in 1970 which explained how the customs union would be established. In light of the developments that occurred, Turkey applied for full membership again in 1987, but was rejected again. In spite of the rejection, relations between Turkey and the EU intensified

and developed. And in 1995 the customs union between Turkey and the European

Union was established.

According to Appleyard (2010), a customs union is one of the stages of economic integration and can be described as removal of customs tariffs and other trade barriers on trade among member countries and the application of common customs tariffs to non-member countries. Economic integration refers to the abolishing of all trade barriers among the integrated countries in order to increase their prosperity. It has four stages that are free trade area, customs union, common market and economic union. In a free trade area, member countries abolish customs tariffs among themselves, however a customs union also involves the common customs tariffs policy towards non-member countries. A common market establishes the third stage by providing the free mobility of factors of production among members that already have a customs union agreement.

An economic union can be considered as an economic integration comprising a common market and common economic policies along with a supranational power that makes binding decisions, lessening the power of member countries much further on making their own decisions.

Customs unions have two types of economic effects on countries, static effects and dynamic effects. Static effects are separated into two as trade creation effects and trade diversion effects. Trade creation occurs when the domestic production of a good in a member country is replaced by the imports of the same good from another member country within the customs union because of the lower cost production. Trade diversion occurs when the imports from a non-member country are replaced by the imports of a member country because of the removal of tariffs between members and the application 14

of common customs tariffs to non-member countries. As for dynamic effects, we can identify increased competition, economies of scale, efficient production, and increases in investment.

By 1 January 1996, with the customs union came into effect, Turkey lifted all customs tariffs on industrial goods imported from the European Union and started to apply the common customs tariffs on non-member country goods. The volume of trade between Turkey and the EU increased over the years and made the EU Turkey’s major trading partner.

After the establishment of the customs union, Turkey not only increased its trade volume with the EU but also increased its trade volume with non-member countries and country groups. However, although the EU’s share in Turkey’s total trade decreased over time, it increased significantly with the other country groups. This concludes that there are no trade creation or trade diversion effects of customs union on Turkey’s trade in contrast to what we would have expected.

In this study, we analyze why the customs union between Turkey and the EU does not show the expected static effects, why the trade share of the EU decreased over time in spite of the customs union agreement and what measures should be taken in order to increase the trade between Turkey and the EU.

In order to identify the problems, Turkey’s trade with the EU is examined along with other country groups such as OECD, OIC, BSEC and CIS. Also luggage trade with

Russia, the relations with Germany are observed as both countries prove Turkey’s major trade partners. Furthermore, an econometric analysis is made in order to forecast the trade between Turkey and the EU. 15

According to the results of the study, it is seen that although the EU’s share in

Turkey’s total trade decreased between 1996 and 2010, the forecast shows that it will increase to a stable level in the near future. Therefore, we explain what measures should be taken in order to increase the trade between Turkey and the EU as forecasted and to put forward some policy suggestions in achieving a more effective customs union between Turkey and the European Union that results in significant trade creation and trade diversion effects.

In this regard, firstly it is considered that Turkey should focus on policies increasing technological developments and innovations in the manufacturing sector in order to minimize cost in production so that its products will be less expensive than other member countries in the customs union. Secondly, as a country with comparative advantage in agriculture, Turkey should pursue a policy to make the customs union agreement with the EU include all of its products, including agricultural products as well.

Thirdly, economic policies to increase income and create favorable macroeconomic environment should be carried out. Also, considering the Turkish population in the other customs union member countries, trade policies should be adjusted accordingly. And finally, the luggage trade with Russia should be taken under control in order to limit its off-the-record trade volume.

This thesis is composed of six chapters.

The first chapter is the introduction.

The second chapter comprises the definition of economic integration and the explanation of its five stages. This chapter also includes a thorough description of customs union and explanation of its static and dynamic effects.

This is followed by the history of the establishment of customs union between

Turkey and the EU in the third chapter. This chapter consists of a chronology of

Turkey’s relations with the EU since the late 1950s explaining the most important agreements and applications towards membership until the customs union between

Turkey and the EU was formed.

Chapter 4 consists of analyzing of the static and dynamic effects of the customs union on the Turkish economy. In order to analyze these effects, Turkey’s trade with the

EU, OECD, OIC, BSEC, CIS, luggage trade with Russia, and the relations with

Germany are observed and Turkey’s trade by broad economic categories are examined.

In Chapter 5, an econometric analysis is made with the export, import, inflation, income and exchange rate variables in order to forecast the trade between Turkey and the EU. All the steps of this analysis are explained by also giving brief econometric descriptions.

Chapter 6 is the conclusion and it summarizes the study as a whole. This chapter provides the significant outcomes of this study thoroughly while giving policy suggestions to increase the economic effects of the customs union.

CHAPTER 2

ECONOMIC INTEGRATION

2.1 Definition

Nations have often sought integration with each other especially when they were threatened economically and politically, and when they found themselves weaker and smaller than the countries they are threatened by.

Perhaps every country would be willing to have economic, social and political independence. The ability to gain and maintain independence has never been easy throughout the history of nations. There have been wars and the strong nations have generally remained independent.

The stronger a nation is, the more likely it will resist the powers of the threats surrounding it. The strength of a nation lies in the stability of its economic, social and political system.

However, when the threats come from the nation’s neighbors, when there are conflicts between the nation and its neighbors or close-by states, when there is only one or two big powers in the world, then this nation would seek ways for security. A country that feels the surrounding threat needs to invest in much military spending to provide the security within the borders of itself. Also, this same country may choose

to come into terms with the countries it has conflicts with. That would also provide

the security it looks for with an advantage of redirecting the military expenses to the

development of certain other activities in the country which would be considered

productive.

Coming into terms with other countries could be in a way of a union which

would not only remove the conflicts between the parties but also be useful in order to

resist the other nations in the world. Countries would have the advantage of

becoming more powerful, stronger by having a greater size when they agree to

unite, to integrate with each other. Being part of a union could make a single country

look greater, more robust and more resistant than ever by having the support of

other countries in the union.

According to Fritz Machlup, in economics the phrase ‘economic integration’

was first employed in industrial organization to refer to combinations of business

firms through agreements, cartels, concerns, trusts, and mergers – horizontal

integration referring to combinations of competitors, vertical integration to

combinations of suppliers with customers. In the sense of combining separate

economies into larger economic regions the word integration has a very short

history. 1

The word integration whose Latin origin is ‘integratio’ means the act of

bringing together parts into a whole so that they work together. In the economic

1 Machlup, Fritz. A History of Thought on Economic Integration. New York: Columbia University Press, 1977. 3. 19

literature the term ‘economic integration’ does not have such a clear-cut meaning. It

can be defined as a process and as a state of affairs. 2

However, the term economic integration is used to describe a process of

abolishing the barriers along the borders of the nations.

Nevertheless, a more appropriate definition of economic integration could be

the cooperation between the economies of different countries in eliminating the trade

barriers between them with an objective of increasing wealth. The more trade

between the countries results in a higher Gross Domestic Product (GDP) rate, and

hence greater wealth.

Economic integration takes four forms that represent varying degrees of

integration. These are 3:

a) Free trade area: All members of the group remove tariffs on each

other’s products while each member retains its independence in

establishing trade policies with non-members.

b) Customs union: All tariffs are removed between members and the

group adopts a common external trade policy toward non-members.

c) Common market: In addition to the qualities of a customs union all

barriers to factor movements among the member countries are

removed.

d) Economic union: Includes all features of a common market but also

implies the unification of economic institutions, established

2 Balassa, Bela. The Theory of Economic Integration. Homewood, IL: Richard D. Irwin, Inc., 1961. 1. 3 Appleyard, Dennis R., Alfred J. Field, and Steven L. Cobb. International Economics. Boston, MA: McGraw-Hill/Irwin, 2010. 393-394. 20

supranational institutions whose decisions are binding for all

members.

2.2. Customs Union

As one of the stages of economic integration, a customs union is defined as removal of all tariffs and other types of restrictions on trade between the participating countries and application of common customs tariffs on trade with the non-participating ones.

From the economic point of view customs unions are superior to free trade areas by reason of the deflection of production and investment and the higher costs of administration in the latter. In a free trade area any procedure used to avoid deflections in trade and production will require considerable administration, so that the additional cost of administration can be expected to outweigh the cost savings in the fiscal apparatus that results from the suppression of intra-area tariff barriers. Thus, other things being equal, a free trade area will lead to a less efficient resource allocation than a customs union, and unproductive expenditures will also be higher. 4

In Section 8-a, Article XXIV, Part III of General Agreement on Tariffs and Trade

(GATT) a customs union is defined as 5;

4 Balassa, Bela. The Theory of Economic Integration. Homewood, IL: Richard D. Irwin, Inc., 1961. 74. 5 GATT 1994, http://www.wto.org/english/res_e/booksp_e/analytic_index_e/gatt1994_09_e.htm 21

A customs union shall be understood to mean the substitution

of a single customs territory for two or more customs

territories, so that

(i) duties and other restrictive regulations of commerce

(except, where necessary, those permitted under

Articles XI , XII , XIII , XIV , XV and XX ) are eliminated with

respect to substantially all the trade between the

constituent territories of the union or at least with respect

to substantially all the trade in products originating in such

territories, and,

(ii) subject to the provisions of paragraph 9 ,

substantially the same duties and other regulations of

commerce are applied by each of the members of the

union to the trade of territories not included in the union.

A customs union requires the participating countries to abolish all kinds of trade barriers within themselves and apply a common external tariff on third country imports.

Implying this common external tariff could be explained by the idea that if the participating countries have different tariffs on third country imports, then the importing country would let the goods enter through the borders of another participating country

with lower tariff on the imports of the same goods. That would result in inefficiency

among member states of the customs union as one of the most important aims of

establishing a union is to increase the trade volume, economic efficiency, competition

between members of the union. Eventually, the producer could export to the end

country in the union but they choose to send it to the country with lower tariffs and make

the transfer of the goods to the final destination via that country. The application of

common external tariffs on imports from third countries prevents this.

The effect of the common external policy of trade is to permit free trade within a customs union, whereas all trade restrictions imposed against outsiders are equalized.

A well-known example is Benelux (Belgium, the Netherlands and Luxembourg), formed in 1948. 6 But the most famous example is the European Union which was formed

initially in 1957 as the European Economic Community by Belgium, the Netherlands,

Luxembourg, Italy, France and West Germany. Another example is the Zollverein

established by several German states in 1834.

2.3. Economic Effects of the Customs Union

Customs unions are discriminatory. They mean a lowering of tariffs within the

union and establishing of a joint outer tariff wall. They combine free trade with

protectionism. 7 Lowering tariffs and leading a way to a more liberal trade in the world has been thought to increase the world’s welfare since the time of David Ricardo.

6 Carbaugh, Robert J. International Economics. Belmont, CA: Wadsworth Publishing Company, 1992. 225 . 7 Sodersten, Bo., Geoffrey Reed. International Economics. New York: St. Martin’s Press, 1994. 322. 23

However, members of a customs union that imposed tariffs on the other participants before joining the union are now left with imposing tariffs only on non-member countries and this means that only one part of the trade is liberalized which is the trade within the union. The continuing application of tariffs on imports from third countries constitutes the nonliberal trade and leaves member countries with the uncertainty whether this would increase or reduce the welfare of these member countries and the world’s in sum.

Therefore, in this section we begin with studying the static effects of customs unions which are defined as trade-creating and trade-diverting effects. Increased competition, economies of scale, stimulus to investment, and better utilization of economic resources comprise the dynamic effects.

2.3.1. Static Effects

Static effects of customs unions occur in the short term. These effects were firstly analyzed by Jacob Viner and according to him the static effects of customs unions are trade creating and trade diverting effects.

2.3.1.1. Trade Creation Effects

Trade creation occurs when some domestic production in a nation that is a member of a customs union is replaced by lower-cost imports from another member

nation. Assuming that all economic resources are fully employed before and after the

formation of the customs union, the lower-cost production within the union increases the

welfare of member nations because it leads to greater specialization in production

based on comparative advantage. 8

A trade-creating customs union also increases the welfare of nonmembers because of the increase in its real income spills over into increased imports from the rest of the world.

Trade creation occurs when the member country does not import the same goods from the nonmember countries before as after joining the union. The country produces the same goods in its local firms instead of importing them but when it joins the union it starts importing the goods with lowered or no tariffs from the other member countries whose firms produce the same goods more efficiently and less costly.

Therefore, it is easily observed that the trade creation effect of customs unions leads to efficiency and as a result increased-welfare. And also, since there was no importing of the same goods from outsiders there is no effect on the exports of outsiders to the union. So, there is no reduced-welfare.

In trade-creation, inefficient local production is displaced by more efficient output in another member country. 9 Thus, trade creation, in short, can be defined as the replacement of relatively high-cost domestic production with lower-cost imports from the partner country. 10

8 Salvatore, Dominick. International Economics . New York: John Wiley & Sons, 2001. 328-329. 9 Ingram, James C., Robert M. Dunn Jr. International Economics. New York: John Wiley & Sons Inc., 1993. 165. 10 Sodersten, Bo., Geoffrey Reed. International Economics. New York: St. Martin’s Press, 1994. 324. 25

2.3.1.2. Trade Diversion Effects

A trade-diverting customs union results in both trade creation and trade diversion

and therefore can increase or reduce the welfare of the union members, depending on

the relative strength of these two opposing forces. The welfare of nonmembers can be

expected to decline because of the inefficient utilization of their resources as a result of

the loss of trade diverted away from them. Thus, while a trade-creating customs union

leads only to trade creation and unequivocally increases the welfare of members and

nonmembers. On the other hand, a trade-diverting customs union leads to both trade

creation and trade diversion, and can increase or reduce the welfare of members but it

will reduce the welfare of the rest of the world. 11

In the trade diversion case, a country which imports goods from an outsider before it joins the union starts to import the same goods from another member of the union once it joins the union because the cost of importing the same good from a member country becomes less with zero tariffs between the members even if the same good is produced less efficiently than the outsider. This causes an increase in the welfare of the union as the member country imports from another member country and has to export the same amount to the member country in order to compensate for its imports. However, since the outsider cannot export the same goods to that country as it did before, there occurs a welfare loss in the outsider and hence in the world.

In his infamous Customs Union Issue Jacob Viner states that when the customs

union operates to divert trade from its previous channels rather than to create new

11 Salvatore, Dominick. International Economics . New York: John Wiley & Sons, 2001. 330-331. 26

trade, the partial removal of duties which it involves operates in analogous manner to

increase the protective effect for high-cost producers of the duties which remain, not,

however, by reducing imports into their own national territory but by extending the

operation in their favor of the protective duty to the territory of the other partner of the

customs union.12

In his book, Viner draws the distinction between the trade-creating and the trade-

diverting effects of customs unions. According to him, where the trade-creating force is

predominant, at least one of the members must benefit, both may benefit, the two

combined must have a net benefit, and the customs union at large benefits; but the

outside world loses, in the short-run at least, and can gain in the long-run only as the

result of the general diffusion of the increased prosperity of the customs union area.

Where the trade-diverting effect is predominant, at least one of the member countries is

bound to be injured, both may be injured, the two combined will suffer a net injury, and

there will be injury to the outside world and to the world at large. 13

In his paper ‘The Theory of Customs Unions: Trade Diversion and Welfare’

Richard G. Lipsey discusses mainly the arguments suggested by Viner. His paper begins with discussing Viner’s argument that trade creation is a good thing and trade diversion is a bad one. Lipsey states that customs unions lead to price changes of commodities because of import tariffs. These price changes have two initial effects, one of which is they may influence the world location of production and the other one is that they will have a similar effect on the location of world consumption. Changes of the first type are classified under production effects of union and the second type as

12 Viner, Jacob. Customs Union Issue. Washington, DC: Anderson Kramer Associates, 1961. 13 Ibid. 27

consumption effects of union . Even if the production of the good is fixed, due to the changes in price, there would be changes in the consumption of that good. Considering the effects of customs unions on welfare, one must also consider the location of the customs union, cost of production, and consumption. Therefore, according to Lipsey,

Viner’s distinction of trade-creation as being good and trade-diversion as being bad is no longer valid. 14

2.3.2 Dynamic Effects

With the formation of a customs union trade barriers are removed and there is nothing left to protect the firms within the union from each other’s comparative advantages. This should cause an increase in competition which leads to higher developments in technology and better utilization of resources such as labor and capital.

In his book, International Economics , Salvatore (2001) states that besides having static effects, customs unions might have dynamic effects due to increased competition, economies of scale, stimulus to investment, and better utilization of resources.

The greatest dynamic benefit from the formation of a customs union is increased competition which occurs when a customs union is formed and trade barriers among member nations are eliminated producers in each nation must become more efficient to meet the competition of other producers within the union, merge, or go out of the

14 Lipsey, Richard G. “ The Theory of Customs Unions: Trade Diversion and Welfare”, Economica, 1957.

business. A second benefit is the economies of scale which is likely to result from the enlarged market. Another possible benefit is the stimulus to investment to take advantage of the enlarged market and to meet the increased competition. Finally, in a customs union the free movement of labor and capital is likely to result in better utilization of the economic resources of the entire community. 15

These dynamic gains are presumed to be much greater than the static gains discussed earlier and to be very significant. For instance, the United Kingdom joined the

European Union in 1973 because of the dynamic effects such as increased competition and economies of scale.16

Having understood what economic integration is, what its phases are and the definition of customs union with its static and dynamic effects, it is important to comprehend why Turkey has always been persistent to be a part of an economic integration. The customs union with the EU has been the biggest step but is not the ultimate goal for Turkey; the real target is the integration with the European Union. The history of the formation of the customs union between Turkey and the European Union is explained in the following chapter.

15 Salvatore, Dominick. International Economics . New York: John Wiley & Sons, 2001. 334-335 16 Ibid. 29

CHAPTER 3

HISTORY OF THE FORMATION OF CUSTOMS UNION BETWEEN TURKEY AND

THE EUROPEAN UNION

After the Second World War, there were only two strong powers in the world:

United States and The Union of Soviet Socialist Republics. The states in Europe were

comparatively small and there was not a complete peace between them. For instance,

there were ongoing conflicts between Germany and France. Hence, there was a need

to form a union so that the conflicts would come to an end. This would happen when the

countries constituting the union come to terms with each other, make agreements that

would lead them act together maintaining close relationships between them and thus

removing the conflicts. Countries that join the union would act together against the two

powers of the world. The European Union (EU) was set up with the aim of ending the

wars between neighbors. A few years after the end of World War II the steel industries

of Germany, France, Belgium, the Netherlands, Luxembourg and Italy became the

focus of political attention and as of 1950, the European Coal and Steel Community was

established to unite these countries economically and politically in order to secure

lasting peace. 17

The 1950s were dominated by a cold war between east and west. Protests in

Hungary against the Communist regime were put down by Soviet tanks in 1956, while in

17 Janisch, Vildan. “ An Assessment of Trade Policy in the European Union:The Case of Steel” PhD diss., Northeastern University, 1997. Boston, MA. 30

the following year, the Soviet Union took the lead in the space race when it launched

the first man-made space satellite, Sputnik 1. Also in 1957, the Treaty of Rome created

the European Economic Community (EEC), or ‘Common Market’. 18

The European Union is the most famous of all economic integrations in the world.

Created in the aftermath of the Second World War, the EU is a unique economic and political partnership between 27 European countries as the last stage of economic integration. The first steps of the EU were to foster economic cooperation among countries that traded with one another that were economically interdependent and will thus avoid conflict. 19

It was founded by the six European countries, Belgium, France, West Germany,

Italy, and the Netherlands, that signed the treaty in Rome in 1957. It was then called the

European Economic Community (EEC). The common external tariff was set at the average of the 1957 tariffs of the six nations. 20

In the following decade a total customs union was established, a common agricultural policy was launched and fiscal measures were carried through. 21 EEC membership had expanded by 1973 with Denmark, Ireland and the United Kingdom entering the Community, and in 1986 Spain and Portugal joined the EU bringing membership to 12. The Community continued to enlarge with memberships of Eastern

European countries. In 2011 it has now 27 members with negotiations still ongoing with other nations.

18 http://europa.eu/abc/history/index_en.htm 19 http://europa.eu/about-eu/basic-information/index_en.htm 20 Salvatore, Dominick. International Economics . New York: John Wiley & Sons, 2001. 338. 21 Faulhaber, Gerald R., Gualtiero Tamburini. European Economic Integration. Norwell, MA: Kluwer Academic Publishers, 1991.15. 31

The primary objective of the EEC had been to create an economic union in which

trade and other transactions take place freely among member nations. From its

beginnings, its ultimate goal has been economic and political unity – the establishment

of a ‘United States of Europe’. The first notable success about this unity was made with

the 1957 Treaty of Rome, when member nations agreed in principle to the abolition of

tariffs, quotas and other trade restrictions among each other, imposition of a uniform

external tariff on commodities coming from nonmember nations, free movement of

labor, capital and enterprise within the community, establishment of a common

agricultural policy. 22

3.1. Establishment of the Customs Union Between Turkey and the EU

3.1.1 Introduction

Following the Second World War, several organizations were created mainly because of the insecurity throughout the world and because of the intention or willing of the countries to fight no more wars but to have peace. Certainly, not just military purposes played a role in the creation of these organizations but also economic, political and social purposes were considered. North Atlantic Treaty Organization (NATO),

United Nations (UN), Organization for Economic Cooperation and Development

(OECD), etc. are just to name a few.

22 Carbaugh, Robert J. International Economics. Belmont, CA: Wadsworth Publishing Company, 1992. 229-230. 32

Turkey is a founding member of the UN, a member of the NATO, the Council of

Europe, and the OECD. Turkey has been a reliable ally of the West since World War II

and has always taken the West as an example for its modernization. Turkey began

westernizing its economic, political and social structures in the 19 th century. It chose

Western Europe as the model for its secular structure.23

Having entered into very close cooperation with Western Europe in the political field, it was therefore only natural for Turkey to extend this cooperative spirit into the economic area. Thus, Turkey chose to begin close cooperation with the fledgling EEC in

1959 and made its first application to join. 24 Turkey was not admitted.

This application led Turkey to sign the Association (Ankara) Agreement in 1963 and then the Additional Protocol between the parties, which foresaw how the customs union would be established, was signed in 1970. This was followed by Turkey’s application for full membership in 1987 and then the establishment of the customs union in 1995, despite not getting a favorable decision on its applications.

The customs union has become a part of discussions in Turkey with the signing of the Ankara Agreement between Turkey and the European Economic Community in

1963. In this agreement the customs union was only considered a step towards the full membership to the Community. It did not aim to only secure a customs union between

Turkey and the Community, instead it aimed to secure a customs union in order to use it as an instrument to bring about integration between the two parties. Customs union is one of the stages of integration and for Turkey the customs union is considered a

23 http://www.abgs.gov.tr/index.php?p=111&l=2 24 Ibid. 33

crucial step towards the ultimate goal of being a member of the Community that is full integration.

In the following sections, the history of the establishment of the customs union between Turkey and the EU is explained in the chronological order.

3.1.2 Ankara Agreement

In 1959 Turkey was one of the first countries in Europe seeking close cooperation with the young European Economic Community (EEC). 25 Therefore, Turkey made its application for membership in 1959 following the establishment of the

European Economic Community. However, this led to an association agreement that would regulate the relationship between Turkey and the Community. The reason for the rejection of the application made by Turkey was that Turkey’s development level was not considered to meet the requirements of the full membership.

The cooperation Turkey was seeking was realized in the framework of an

“association agreement” known as the Ankara Agreement which was signed on 12

September 1963. An important element in this plan was establishing a “Customs Union” so that Turkey could trade goods and agricultural products with EEC countries without restrictions. 26

The Ankara Agreement does not limit Turkey-EU relations to free movement of

25 http://www.avrupa.info.tr/DelegasyonPortal/AB_ve_Turkiye/Tarihcesi.html 26 Ibid. 34

goods but also aims to provide free movement of labor, services and capital in order to

integrate Turkey into European Single Market. The Agreement foresaw three stages:

"preparatory stage", "transitional stage" and "final stage". By the end of transitional

stage, completion of the customs union was intended.27

3.1.3 Additional Protocol

When the "preparatory stage" ended the transitional stage was started by the

Additional Protocol that was signed in 13 November 1970 and entered into force on 1

January 1973. The Additional Protocol determined the provisions of the transitional stage and the obligations of both parties and aimed for gradual completion of the customs union. 28

The Additional Protocol of 13 November 1970 set out in a detailed fashion how the customs union would be established. It provided that the EEC would abolish tariff and quantitative barriers on its imports from Turkey (with some exceptions including fabrics) upon the entry into force of the Protocol. Turkey would do the same in accordance with a timetable containing two calendars set for 12 and 22 years, and the

Protocol called for the harmonization of Turkish legislation with that of the EU in economic matters such as competition, taxation, and trade policies.29

Starting from 1 September 1971 the European Community reduced to zero the

27 http://www.dtm.gov.tr/dtmweb/index.cfm?action=detayrk&yayinID=2286&icerikID=2455&dil=TR 28 Ibid. 29 http://www.abgs.gov.tr/index.php?p=111&l=2 35

customs duties on industrial goods that are within the scope of the customs union.

Turkey was committed to reducing the customs duties to zero within a 22-year time

frame, starting from 1973. Turkey has provided the customs reductions until 1978,

however, it demanded to freeze the reductions beginning in 1978. 30

The most significant advantage the Additional Protocol maintained was in

Turkey’s agricultural exports to the Community. Ninety two percent of Turkish agricultural exports in 1971 benefited from this regime. That helped Turkey preserve its position as one of the Community’s most privileged trading partners. 31

3.1.4 Turkey's Application For Full Membership In 1987

In January 1980, Turkey shifted its economic policy from import-substitution

policies to outward looking policies and opened its economy to the operation of market

forces. Following this development in Turkey’s economy, the relations between the

Community and Turkey, which had come to a virtual freeze by the military coup of 12

September 1980, started to revive. In light of these developments, Turkey applied for

full membership in 1987 on the basis of the EEC Treaty's article 237 which gave any

European country the right to do so. 32

The European Commission replied to Turkey's full membership application in

1989 and in its reply, while accepting Turkey's eligibility for being a full member, it

30 http://www.dtm.gov.tr/dtmweb/index.cfm?action=detayrk&yayinID=2286&icerikID=2455&dil=TR 31 Ibid. 32 http://www.abgs.gov.tr/index.php?p=111&l=2 36

recommended that Turkey needed to wait until the EC completed its deepening

process. Turkey was to wait until the Community's next enlargement and the

establishment of the Turkey-EC Customs Union. 33

The importance of this application is that Turkey's request for accession was not filed under the relevant provisions of the Ankara Agreement that is to set up a customs union between Turkey and the Community, but those of the Treaty of Rome that is to set up an economic community. This outcome shows that the application was perceived as an application for full membership and not just for establishing a customs union. The

Council forwarded Turkey's application to the Commission for the preparation of an

Opinion. This has reconfirmed Turkey’s eligibility to apply for full membership to the

Community.34

Although it did not attain its basic objective, Turkey's application revived Turkey-

EC relations. Efforts to develop relations intensified on both sides, the Association's political and technical mechanisms started meeting again and measures to complete the Customs Union in time were resumed. Meanwhile, the Commission's promised cooperation package, known as the "Matutes Package", was unveiled in 1990, but it could not be adopted by the Council due to Greece's objection. 35 The Matutes Package

included four specific measures designed to re-launch Turkey’s relations with the EC:

the intensification of financial cooperation, the completion of the customs union,

industrial and technological cooperation, and the strengthening of political and cultural

33 http://www.dtm.gov.tr/dtmweb/index.cfm?action=detayrk&yayinID=2286&icerikID=2455&dil=TR 34 http://www.abgs.gov.tr/index.php?p=111&l=2 35 http://www.abgs.gov.tr/index.php?p=111&l=2 37

links. 36 Especially because of the Cypriot coups that tried to unite Cyprus with Greece back in 1970s there have developed strong bilateral disputes between Turkey and

Greece over Cyprus and Aegean, resulting in Greece’s disapproval of any matter regarding cooperation with Turkey and blocking all EU aid. Despite all these developments, Customs Union was established in 1995 as envisaged in the Additional

Protocol.37

3.1.5 Formation of Customs Union Between Turkey And The EU

Talks began in 1994 and were finalized on 6 March 1995 at the Turkey-EU

Association Council which is the highest-ranking organ of the association composed of the Foreign Ministers of Turkey and the EU Member States. On that day the Association

Council adopted its decision 1/95 on the completion of the Customs Union between

Turkey and the EU in industrial and processed agricultural goods by 31 December

1995.

Decision No 1/95 requires the elimination of customs duties and quantitative restrictions, approximation of customs law, mutual assistance in customs matters, alignment of Turkey on Community common customs tariff.38

With the establishment of the customs union, Turkey abolished all duties and equivalent charges on imports of industrial goods from the EU. Furthermore, Turkey has

36 http://www.unc.edu/depts/europe/business_media/mediabriefs/Brief4-0803-turkey's-quest.pdf 37 http://www.dtm.gov.tr/dtmweb/index.cfm?action=detayrk&yayinID=2286&icerikID=2455&dil=TR 38 http://ec.europa.eu/taxation_customs/customs/customs_duties/rules_origin/customs_unions/article_414_en.htm 38

been harmonizing its tariffs and equivalent charges on the importation of industrial

goods from third countries with the EU's Common External Tariff. Turkey has been

progressively adapting itself to the EU's commercial policy and preferential trade

arrangements with specific third countries since the establishment of this customs

union. This process is to be completed in five years. 39

As a result of these measures, Turkey's weighted rates of protection for imports

of industrial products originating in EU and EFTA member states have fallen from 5.9%

to 0%, and from 10.8% to 6% for similar goods originating in third countries with the

establishment of a customs union. The latter rates will further drop to 3.5% when the EU

fulfills its obligations under the WTO negotiations. 40

Although basic agricultural products have been excluded from the initial package,

a preferential trade regime for these products was adopted on 1 January 1998. Further

efforts are expected to be made in the same direction. Moreover, Turkey is

progressively adopting many aspects of the Common Agricultural Policy. On the other

hand, under the Customs Union Decision the EU is expected to take as much account

as possible of Turkey's agricultural interests when developing its agricultural policy. 41

The final phase of the relations between the European Community (EC) and

Turkey under the Ankara Association Agreement 1963 was to achieve the EC-Turkey

Customs Union. This final phase was realized on 1 July 1996. 42 The scope of this

customs union, based on the status of goods in free circulation is, however, limited to

industrial products and processed agricultural products. It does not cover:

39 Ibid. 40 http://www.abgs.gov.tr/index.php?p=111&l=2 41 Ibid. 42 http://ec.europa.eu/taxation_customs/customs/customs_duties/rules_origin/customs_unions/article_414_en.htm 39

- agricultural products, as defined in Annex I of the Amsterdam Treaty;

- coal and steel products

These two categories are subject only to preferential agreements based on their originating status.

The customs union between Turkey and the EU constitutes a very important cornerstone regarding Turkey’s integration within the European Union. It is the biggest step towards Turkey’s ultimate goal of membership with the EU. However, it also is the most important economic integration Turkey has with a trading bloc as great as the EU that is also Turkey’s major trade partner. Thereof, in the following chapter we examine the effects of Customs Union on Turkey’s economy.

CHAPTER 4

EFFECTS OF THE CUSTOMS UNION ON THE TURKISH ECONOMY

A customs union between Turkey and the European Union was realized with the

Association Council Decision No 1/95 on 1 January 1996. Since the customs union between the EU and the member states practiced following the integration of the states, the customs union between Turkey and the EU constitutes an exceptional condition. For

Turkey, it was determined that following the customs union there would be European

Union membership. Also, this customs union is loaded with obligations and intentions that exceed a natural customs union’s purpose and content.

The customs union process began especially with the obligations that started to be fulfilled by Turkey in 1973 with the Additional Protocol coming into force. In 1971 the

EU started to abolish tariffs and quantitative barriers on industrial goods from Turkey, however Turkey would remove the trade barriers on imports from the EU within two different set of calendars of 12 and 22 years. Thus, Turkey had a very important advantage of exporting its products to the EU without any barriers, although it continued applying tariffs on the imports from the EU. This would result in cheaper imports for the

EU enabling Turkey to export more to the EU and also since the tariffs are still applied to the EU imports, domestic production of the same goods would increase.

By 1 January 1996, Turkey lifted all customs tariffs on industrial goods imported from the EU and started to apply the same tariff rate as the EU on the goods imported

from third countries. However, agricultural produce was not included in this customs

union decision.

The customs union provided Turkey with the opportunity to begin integrating with

one of the world’s most important trade blocs; the EU. This integration process let

Turkey access the EU market more advantageously than other non-member countries,

but also with this Union Turkey opened its markets to competition from the EU.

Since Turkey is complementing its tariff elimination on the EU imports with tariff

reductions on imports from third countries, it is becoming a rather open economy in the

non-agricultural sectors. 43 Prior to the formation of the EU-Turkey customs union, the

Turkish economy was highly protected. 44

When evaluating the effects of customs union on Turkish trade, it should be noted that Turkey had a time advantage in this process and that during this period of time beginning in 1971 there have been economic, political and financial crises both in

Turkey and the world. So, it would never be sensible to make the evaluations about the effects disregarding both the developments in Turkey and in the world. The economic crisis in Turkey in 1994, crises in Asia and Russia in 1997, the earthquakes that caused so many losses in Turkey in 1999, the crises of November 2000 and February 2001 that happened while it tried to solve the chronic inflation problem and instability in the economy of Turkey, and lastly the global crisis that affected all countries in the world which started to show its effects in 2007-2008 and is still effective.

Turkey has stabilized its economy from 2002 with its new economic policies. A

43 Kuser, Micheal. Doing Business With Turkey. UK: Blue Ibex Ltd.,1999. 149. 44 Togan, Subidey. “ Effects of Turkey-EU Customs Union and Prospects for the Future”, Russian and East European Finance and Trade. Vol. 36, no. 4, July-August, 2000. 5. 42

very tight fiscal policy, better structural reforms and large loans from the International

Monetary Fund (IMF) let Turkey stabilize the interest rates and its currency, have lower inflation rates and provide the confidence in the economy. This maintained an increase in the exports and also the steady continuation of these policies provided Turkey with stronger impacts in trade than before.

The effects of the customs union on the Turkish economy can be separated into two as static and dynamic effects so that we can also observe how positively Turkish economy is affected by the customs union.

4.1. Static Effects of the Customs Union on Turkish Trade

As explained in Chapter 2, static effects of the customs union consist of trade creation and trade diversion effects. In this section, we will evaluate these effects on

Turkey’s trade with the EU with the help of economic data and tables.

4.1.1 Trade Creation Effects

Trade creation is described as the replacement of high-cost production with the lower-cost production within the union. With the lower-cost producer country’s becoming a member of the union, countries in the union import from this member causing the trade volume of this member country to increase. Also, with the removal of tariffs and

other barriers on trade among member countries, the prices of goods decrease resulting in higher consumption of them and a rise in volume of trade.

Table 4.1 lets us analyze the trade creation effects of the customs union between

Turkey and the EU. Nominal values are used in million United States Dollars and the percentage of EU’s share in total trade is provided.

Table 4.1 Turkey’s Foreign Trade and EU’s share

Exports (USD million) Imports (USD million) Years Total EU EU % Total EU EU % 1969 536 331 61.8 801 474 59.2 1970 588 353 60.0 947 520 54.9 1971 676 386 57.1 1170 661 56.5 1972 884 488 55.2 1562 926 59.3 1973 1317 722 54.8 2086 1255 60.2 1974 1532 872 56.9 3777 1997 52.9 1975 1401 744 53.1 4738 2645 55.8 1976 1960 1139 58.1 5128 2741 53.5 1977 1753 1034 59.0 5796 2951 50.9 1978 2288 1393 60.9 4599 2376 51.7 1979 2261 1341 59.3 5069 2621 51.7 1980 2910 1668 57.3 7909 3145 39.8 1981 4702 1807 38.4 8933 3424 38.3 1982 5745 2088 36.3 8842 3088 34.9 1983 5727 2326 40.6 9235 3534 38.3 1984 7133 3070 43.0 10757 4161 38.7 1985 7958 3509 44.1 11343 4535 40.0 1986 7456 3559 47.7 11104 5292 47.7 1987 10190 5269 51.7 14157 6482 45.8 1988 11662 5618 48.2 14335 6730 46.9 1989 11624 5887 50.6 15792 6965 44.1 1990 12959 7485 57.8 22302 10597 47.5 1991 13593 7783 57.3 21047 10675 50.7 1992 14714 8476 57.6 22871 11514 50.3 1993 15345 8272 53.9 29428 14913 50.7 1994 18105 9389 51.9 23270 11643 50.0 1995 21637 12206 56.4 35709 18024 50.5 1996 23224 12563 54.1 43626 24320 55.7 1997 26261 13434 51.2 48558 26118 53.8 1998 26973 14809 54.9 45921 25282 55.1 1999 26587 15424 58.0 40671 22529 55.4 2000 27774 15664 56.4 54502 28526 52.3 2001 31334 17545 56.0 41399 19823 47.9 2002 36059 20415 56.6 51553 25688 49.8 2003 47252 27393 58.0 69339 35140 50.7 2004 63167 36580 57.9 97539 48102 49.3 2005 73476 41364 56.3 116774 52695 45.1 2006 85534 47934 56.0 139576 59400 42.6 2007 107271 60398 56.3 170062 68611 40.3 2008 132027 63390 48.0 201963 74802 37.0 2009 102142 47013 46.0 140928 56587 40.2 2010 113975 52729 46.3 185535 72239 38.9 2011 19666 9483 48.2 34416 12539 36.4 *2011 data is through March. **Source www.tuik.gov.tr

As we see from Table 4.1, even before the customs union between Turkey and the EU, the exports of Turkey to the EU constituted more than half of the total exports of

Turkey for most of the years between 1969 and 2011. The average of the EU’s proportion in total exports between 1969 and 1996 is 52.9% and this rate is 57.3% for the period between 1996-2011. Thus, we see that the average rate of exports to the EU has increased after the customs union. As for the imports, we see that the average rate is 48.9% before the customs union and 50.1% after the customs union proving that the average rate for the imports from the EU has also increased after the establishment of the customs union.

In the table above, we also observe that the EU’s share of exports in Turkey’s total exports decreased from 54.1% in 1996 to 46.3% in 2010, and EU’s share of imports in total imports decreased from 55.7% in 1996 to 38.9% in 2010. Trade creation effect causes the countries in the customs union to increase their volume of trade with each other however according to Table 4.1 we see that the EU’s share of trade in

Turkey’s total trade decreased. Thus, we cannot speak of a trade creation effect of the customs union between Turkey and the EU.

Using the monthly data gathered from the Turkish Statistics Institution website,

Graph 4.1 is generated for the trade between Turkey and the EU for the years between

1980 and 2010.

Graph 4.1 Growth of Exports and Imports

USD Billion

4 EX IM 2 NX

0 1980:01 1984:01 1988:01 1992:01 1996:01 2000:01 2004:01 2008:01 -2

-4

Source: www.tuik.gov.tr

We see that imports have always been above exports indicating that net exports have always been negative, indicating a trade deficit. After 1996, following the establishment of customs union the trade deficit stands out more. However, this should not be seen as a problem caused after customs union. The amount of the trade deficit increased naturally, because Turkey has imported more from the EU than before because of the abolition of customs tariff, but also we should consider that the amount of exports to the EU increased too. The biggest reason for this movement in exports 47

and imports on the graph is that Turkey had the unilateral right to export to the EU with no custom tariffs on industrial goods beginning from 1973 but with the customs union in

1996 the EU had the same right as Turkey. Thus, it is normal to see in this graph that after 1996 the increase in net exports is higher than before. This graph also shows some decrease in trade beginning from 2007 which is the starting point of the global crisis. Both exports and imports fell during that time which reminds us to always consider the political, economic and social happenings around the world when evaluating the data.

4.1.2 Trade Diversion Effects

Common customs tariffs applied on third country goods make them more expensive and hence cause the trade to shift from non-member countries to member countries. This is the trade diversion effect of a customs union. According to the trade diversion effects, there should be a contraction in trade with non-member countries. In this section we will examine the trade diversion effects of the customs union between

Turkey and the EU by analyzing Turkey’s trade with other country groups.

Below are Table 4.2 and Table 4.3 displaying Turkey’s exports/imports to/from certain international economic groups of nations; such as the European Union (EU),

Organization for Economic Cooperation and Development (OECD), European Free

Trade Association (EFTA), Organization of the Islamic Conference (OIC), Black Sea

Economic Cooperation (BSEC) and Commonwealth of Independent States (CIS).

EU: 27 member states including Austria, Belgium, Denmark, Finland, France,

Germany, Greece, Ireland, Italy, The Netherlands, Luxembourg, United Kingdom,

Spain, Portugal, Sweden.

OECD: 34 member states including Austria, Belgium, Denmark, Estonia, Finland,

France, Germany, Greece, Hungary, Ireland, United Kingdom, Spain, Italy,

Luxembourg, The Netherlands, Poland, Portugal, Sweden, Turkey, United States and

Japan

EFTA: Iceland, Liechtenstein, Norway, Switzerland (The founding members of

EFTA were Austria, Denmark, Norway, Portugal, Sweden, Switzerland and the United

Kingdom all of which except Norway joined the EU and ceased to be members.)

OIC: 56 member states including Saudi Arabia, Iran, Albania, Malaysia, Turkey,

Egypt, Maldives, Lebanon and Pakistan

BSEC: Albania, Armenia, Azerbaijan, Bulgaria, Georgia, Greece, Moldova,

Romania, Russia, Turkey and Ukraine

CIS: Armenia, Azerbaijan, Belarus, Kazakhstan, Kyrgyzstan, Moldova, Russia,

Tajikistan, Turkmenistan, and Uzbekistan

Table 4.2 Turkey’s Exports by Country Groups in Nominal Values

Exports (USD million) Years/Organizations 1994 1995 1996 1997 1998 1999 2000 2001 2002 EU 9,389 12,206 12,563 13,434 14,809 15,424 15,664 17,545 20,415 OECD 11,544 14,332 14,921 16,143 17,681 18,578 19,584 21,307 24,498 EFTA 276 293 335 414 356 361 324 316 409 OIC 3,428 3,696 4,142 4,217 4,391 3,961 3,573 4,196 4,725 BSEC 1,636 2,425 2,926 3,824 3,290 2,232 2,466 2,932 3,598 CIS 1,412 2,066 2,663 3,512 2,666 1,532 1,648 1,978 2,278 Total Exports 18,105 21,637 23,224 26,261 26,973 26,587 27,774 31,334 36,059

Exports (USD million) Years/Organizations 2003 2004 2005 2006 2007 2008 2009 2010 EU 27,393 36,580 41,364 47,934 60,398 63,390 47,013 52,729 OECD 31,919 42,648 47,325 54,480 65,674 70,471 54,272 59,380 EFTA 538 666 820 1,189 1,327 3,261 4,335 2,416 OIC 7,204 10,214 13,061 15,007 20,310 32,596 28,626 32,502 BSEC 5,044 6,778 8,619 11,583 16,784 20,867 12,272 14,462 CIS 2,962 3,961 5,056 6,992 10,088 13,938 8,720 11,046 Total Exports 47,252 63,167 73,476 85,534 107,271 132,027 102,142 113,975

Source: www.tuik.gov.tr

Table 4.3 Turkey’s Imports by Country Groups in Nominal Values

Imports (USD million) Years/Organizations 1994 1995 1996 1997 1998 1999 2000 2001 2002 EU 11,643 18,024 24,320 26,118 25,282 22,529 28,526 19,823 25,688 OECD 16,290 25,214 31,919 35,640 34,207 29,053 36,821 26,885 34,154 EFTA 562 892 1,112 1,287 1,169 926 1,155 1,480 2,511 OIC 3,558 4,623 5,587 5,233 4,238 4,078 6,320 5,539 6,071 BSEC 2,166 3,998 3,896 4,495 4,357 4,307 6,746 5,553 6,587 CIS 1,820 3,314 3,074 3,615 3,724 3,733 5,693 4,630 5,554 Total Imports 23,270 35,709 43,626 48,558 45,921 40,671 54,502 41,399 51,553

Imports (USD million) Years/Organizations 2003 2004 2005 2006 2007 2008 2009 2010 EU 35,140 48,102 52,695 59,400 68,611 74,802 56,587 72,239 OECD 45,544 62,308 69,582 77,812 91,856 102,901 75,143 97,703 EFTA 3,395 3,911 4,439 4,522 5,774 6,217 2,780 4,002 OIC 8,195 10,630 14,459 19,110 21,524 29,178 17,969 27,947 BSEC 9,297 15,368 20,480 27,021 34,808 45,632 28,299 33,589 CIS 7,777 12,926 17,252 23,372 31,262 42,613 26,044 30,889 Total Imports 69,339 97,539 116,774 139,576 170,062 201,963 140,928 185,535

Source: www.tuik.gov.tr

Table 4.4 Trade by Country Groups in Percentages

Years/ Exports Organizations 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 EU 52 56 54 51 55 58 56 56 57 58 58 56 56 56 48 46 46 OECD 64 66 64 61 66 70 71 68 68 68 68 64 64 61 53 53 52 EFTA 2 1 1 2 1 1 1 1 1 1 1 1 1 1 2 4 2 OIC 19 17 18 16 16 15 13 13 13 15 16 18 18 19 25 28 29 BSEC 9 11 13 15 12 8 9 9 10 11 11 12 14 16 16 12 13 CIS 8 10 11 13 10 6 6 6 6 6 6 7 8 9 11 9 10

Years/ Imports Organizations 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 EU 50 50 56 54 55 55 52 48 50 51 49 45 43 40 37 40 39 OECD 70 71 73 73 74 71 68 65 66 66 64 60 56 54 51 53 53 EFTA 2 2 3 3 3 2 2 4 5 5 4 4 3 3 3 2 2 OIC 15 13 13 11 9 10 12 13 12 12 11 12 14 13 14 13 15 BSEC 9 11 9 9 9 11 12 13 13 13 16 18 19 20 23 20 18 CIS 8 9 7 7 8 9 10 11 11 11 13 15 17 18 21 18 17

Source: www.tuik.gov.tr

Grap h 4.2 Exports Percentage Graph 4.3 Imports Percentage

Source: www.tuik.gov.tr

In Table 4.2 and 4.3 what we see is exports and imports values in nominal values. However, in order to make better analyses and comments, the percentage values of exports and imports are given on Table 4.4.

In Table 4.4, we observe that Turkey’s trade with the EU decreased significantly while it increased with other country groups such as OIC, BSEC and CIS. This brings us to a conclusion that the customs union did not cause a trade diversion and that Turkey did not lose its markets with the third countries, but maintained an increasing trade pattern with them.

In the following subsections, in order to explain thoroughly whether or not there are trade diversion effects of the customs union, Turkey’s trade with the above- mentioned country groups is analyzed with the help of these tables.

4.1.2.1 Turkey’s Trade with the EU

Textiles and transport equipment dominate EU imports from Turkey, both accounting for about 24% of the total. Other important imports are machinery (17.7%), and agricultural products (7.1%). Main EU exports to Turkey are machinery (32.2%), transport material (18.6%) and chemical products (16.9%). 45 Even though they are linked to each other through a customs union, it does not cover agricultural produce.

Table 4.2 illustrates that there has been a continuous increase in the nominal values of Turkey’s exports to the EU through 2008. In 1994, we see that the value was

$9,389 million and by the time the customs union took place it increased to $12,563

45 http://ec.europa.eu/trade/creating-opportunities/bilateral-relations/countries/turkey/ 54

million. According to Table 4.4, which provides the EU’s share of exports in total exports, we also see an increase from 52% in 1994 to 54% in 1996.

The 1996 value of exports almost quadrupled by 2006. However, in percentages there is only a 2% change for the same period. In 2008, the nominal value of exports was $63,390 million and it decreased to $47,013 million in 2009 followed by a slight increase in 2010 that did not reach to the 2008 value. This is because of the contraction in demand worldwide caused by the global crisis. In percentages for the same period there is no change between 2009 and 2010.

Table 4.3 shows that there has been also a continuous increase in the nominal values of imports from the EU except during the financial crisis of early 2000. The devaluation of Turkish currency as a result of the crisis caused a lower rate of imports in general. The $14,043 million nominal value of imports in 1994 increased to $24,320 million in 1996, with the establishment of customs union. In Table 4.4 we see that the percentage of imports rises from 50% in 1994 to 56% in 1996.

The upward trend in the nominal value of imports ends with a significant fall in

2009 though followed by a substantial increase in 2010.

When we consider the tables above for Turkey’s overall trade with the EU after the establishment of the customs union, we see that exports increased from $12,563 million in 1996 to $52,729 million but the rate of exports to the EU over total exports decreased from 54% in 1996 to 46% in 2010. As for the imports, there is an increase from $24,320 million in 1996 to $72,239 million in 2010. There is a decrease in the rate of imports over total imports from 56% to 39%.

Thus from these data we can conclude that there are no trade creation effects of

the customs union we can speak of with the statistics we observe above.

4.1.2.2 Turkey’s Trade with OECD

Established in 1947 with the name Organization for European Economic

Cooperation (OEEC) to run the US-financed Marshall Plan for reconstruction of a

continent ravaged by war, The Organization for Economic Cooperation and

Development (OECD) was officially born on 30 September 1961 when Canada and the

USA signed the OECD Convention. At present the Organization has 34 member

countries worldwide, including Turkey, which regularly turn to one another to identify

problems, discuss and analyze them, and promote policies to solve them. 46

Turkey’s exports to the OECD follow the same pattern as the EU though with higher values in nominal terms. That is mostly because most of the OECD consists the strongest and largest if not all EU member states.

The nominal value of exports to the OECD increased from $14,921 million in

1996 to $59,380 million in 2010 although exports share over total exports declined from

64% to 52% for the same period.

As for the imports, we observe an increase from $31,919 million in 1996 to

$97,703 million in 2010 although in percentages there is a significant decline from 73% to 53%.

46 http://www.oecd.org/document/25/0,3746,en_36734052_36761863_36952473_1_1_1_1,00.html 56

4.1.2.3 Turkey’s Trade with EFTA

The European Free Trade Association (EFTA) is an intergovernmental

organization set up for the promotion of free trade and economic integration to the

benefit of its member states.47

Exports from Turkey comprise clothing, automobiles, machinery and imports to

Turkey include fish, pharmaceutical products, machinery.48

Turkey’s exports to the EFTA displays an increase from $335 million in 1996 to

$2,416 million in 2010. This increase in nominal values is supported by percentages in exports.

As for the imports, we see from Table 4.3 that there is an increase from $1,112 million in 1996 to $4,002 million in 2010.

4.1.2.4 Turkey’s Trade with OIC

The Organization of the Islamic Conference (OIC) is the second largest intergovernmental organization after the United Nations with 57 member countries worldwide established in 1969 in order to protect the interests of the Muslim world in the spirit of promoting international peace and harmony among various people of the world. 49 As a Muslim country, Turkey is currently a member of OIC.

47 http://www.efta.int 48 http://www.efta.int/free-trade/free-trade-agreements/~/media/Documents/free-trade/Test-trade-statistics/Turkey.pdf 49 http://www.oic-oci.org/page_detail.asp?p_id=52 57

In 2010 the nominal value of exports was $32,502 million and had increase from

its 1996 value of $4,142 million. We observe an increase in exports percentage from

18% to 29% for the same period.

Imports increased in 2010 to a value of $27,947 million from the value $5,587 in

1996. There is also an increase in imports percentage for the same period.

The statistical yearbook of the OIC shows that the GDP per capita of the six

richest OIC members (Turkey, Iran, Indonesia, Saudi Arabia, United Arab Emirates and

Malaysia) exceeds US$10,000 a year, while 46 OIC members have per capita incomes

of less than US$1,000 per year. Also the richest members are not necessarily

developed countries. For instance, Saudi Arabia is one of the richest OIC member

countries with a GDP per capita value of USD 14,979 million but it is also a less-

developed one. These six richest countries produce more than 50% of the total GDP of

all OIC countries. 50

The trade among the OIC countries is focused mainly on oil and oil products,

agriculture and also industrial goods. Turkey’s trade with most of the member countries

is concentrated on agricultural goods and also oil and oil products. 51 Specifically, Turkey

imports mineral fuels and oils, plastics, cereals, animals, cotton and copper and exports

fruits and nuts, vegetables, starch, malt, cereals, salt, carpets, iron and steel, aluminum,

machinery, vehicle and furniture. 52

50 http://www.sesric.org/files/article/384.pdf 51 http://www.dpt.gov.tr/PortalDesign/PortalControls/WebContentGosterim.aspx?Enc=51C9D1B02086EAFBC267B2E 05C5A60AE 52 www.tuik.gov.tr 58

4.1.2.5 Turkey’s Trade with BSEC

Black Sea Economic Cooperation (BSEC) is an organization established for

fostering interaction and harmony among 12 member states as well as to ensure peace,

stability and prosperity encouraging friendly and good-neighborly relations in the Black

Sea region. After the Persian Gulf region, it is the second-largest source of oil and

natural gas along with its rich proven reserves of minerals and metals and it is

becoming Europe's major transport and energy transfer corridor. 53

Turkey imports mineral fuels and oils, cereals, iron and steel and aluminum from

BSEC countries while exporting fruits and nuts, plastics, textile, iron and steel,

machinery and vehicle. 54

In Table 4.2 we observe that the exports to the BSEC member states increased

from $2,926 million in 1996 to $14,462 million in 2010 though the ratio of exports over

GNP remains at the same level of 13%.

The imports rose from $3,896 million to $33,589 million for the same period. We

see that the percentage of exports in total exports doubled to 18%.

53 http://www.bsec-organization.org/Information/Pages/testt.aspx 54 www.tuik.gov.tr 59

4.1.2.6 Turkey’s Trade with CIS

Commonwealth of Independent States (CIS) was created in 1991 with the end of

Soviet Union (USSR) when the to-be-member states signed an Agreement on the

creation of an economic union to form common economic space grounded on free

movement of goods, services, labor force, capital; to elaborate coordinated monetary,

tax, price, customs, external economic policy; to bring together methods of regulating

economic activity and create favorable conditions for the development of direct

production relations. 55

Similar to the trade with BSEC, Turkey mainly imports mineral fuels and oils, iron, steel, copper, aluminum and cereals and exports fruits and nuts, plastics, iron and steel, machinery, vehicle and textile. 56

Exports to CIS countries increased in 2010 to $11,046 million from 1996 value of

$2,663 million. The rate of exports over total exports that is 11% in 1996 decreases to

8% within 10 years and then increases to 10% in 2010.

Imports from CIS states increased almost ten times between 1996 and 2010 in nominal values, from $3,074 million to $30,889 million. This is also accompanied by an increase in the percentage of imports from 7% to 17% for the same period.

55 http://www.cisstat.com/eng/cis.htm 56 www.tuik.gov.tr 60

4.1.2.7 Turkey’s Trade with Russia: ‘Luggage Trade’

As the largest country of both BSEC and CIS member states, Russia is among

the major export and import partners of Turkey.

The modern history of the trade between Turkey and Russia dates back to early

1990s with the collapse of USSR. Most of the trade between them was realized

especially in the way of ‘luggage trade’ or ‘shuttle trade’. Luggage trade is accomplished

by passengers purchasing goods in the country they traveled to, bringing those goods

back home to resell.

From 1996 through 2005, within 10 years, the luggage trade between Turkey and

Russia totaled approximately $41 billion. 57 The center of this luggage trade has been

Laleli, Istanbul.

In Table 4.5 we see that the luggage trade decreases from 1996 through 1999.

The main reason of this is the economic crisis in Russia in 1998. After 1999, it starts to increase again until the Russian government decides to put restrictions on luggage trade such as a maximum weight of 35 kilograms and maximum value of 65,000 Rubles per luggage in order to decrease the volume of this off-the-record trade. 58 We see a

decrease in the nominal values from 2002 through 2005.

57 www.lasiad.org.tr 58 Kirci, Murat, “ Turkiye’deki Bavul Ticareti Gelismeler ve Yeni Alternatifler ” Master’s Thesis, Marmara University, 2007. Istanbul, Turkey.

Table 4.5 Luggage Trade Between Turkey and Russia

Nominal Value s of Luggage Trade Between Years Turkey and Russia (USD million) 1996 8,842 1997 5,849 1998 3,689 1999 2,255 2000 2,944 2001 3,040 2002 4,068 2003 3,954 2004 3,880 2005 2,468 Source: www.lasiad.org.tr

In spite of those restrictions put by Russian government, with the visa exemptions between Turkey and Russia that came into effect in April 2011 it is expected that the volume of luggage trade will increase again soon between these trade partners.

4.1.2.8 Turkey’s Trade with Germany

Back in late 1950s, early 1960s there was a labor shortage in Western Europe, especially in Germany. Turkey, with its high population growth and unemployment, was an ideal candidate to have its people employed in those countries. So, in the beginning of 1960s, a number of Turks migrated to Germany and some other Western European

countries as temporary workers. They were supposed to return to Turkey after a certain

amount of time, however, the economic situation in Turkey, the oil crisis, political crises

made most of them stay in Europe. Currently, approximately 5 million Turks live in

Western Europe with almost 4 million living in Germany. Germany has the highest ratio

of Turkish population in the European Union and this is followed by France and the

Netherlands respectively.59

Perhaps, it is no wonder why a EU and OECD member Germany is one of

Turkey’s major export and import partners. Turkey exports automotive and textiles to

Germany and imports automobiles and pharmaceuticals. Additionally, according to the

April 2011 bulletin published by the Turkish Statistics Institution, Germany ranks first in

April 2011 as both Turkey’s export and import partner. However, Germany is still one of the leading countries opposed to Turkey’s integration within the EU.

4.1.3 Conclusion

When we consider Table 4.2 and Table 4.3, we observe that both exports and imports by organizations increased after the customs union. Since these tables provide the values in nominal terms, we also use the exports and imports percentages. We see that for the OECD and the EU the exports and imports percentages decreased while there are increases in percentages of the trade with OIC, BSEC and CIS.

Abolition of customs tariffs with the EU member states and application of the common tariff rate to third countries caused the volume of Turkey’s trade with all

59 http://www.tisk.org.tr/yayinlar.asp?sbj=ic&id=2158 63

country groups to increase significantly. However, the trade with the EU in percentages decreased in contrast to what would have been expected. As explained above, there are no trade creation effects of the customs union on Turkey’s trade with the EU.

Moreover, we observe that in percentages Turkey’s trade with other country groups such as OIC, BSEC and CIS increased substantially. This states that there are no trade diversion effects of the customs union, either.

However, as stated in Chapter 2 customs unions have trade creation and trade diversion effects. Customs unions are created to increase the members’ trade with each other and reduce their concentration on trading with non-member countries. Then, why do we not observe these effects of the customs union between Turkey and the EU?

First of all, the EU has had great enlargements in the last 7 years with 12 new members joining the Union. Its focus on trade shifted to these new members instead of a long-time candidate country Turkey. This is one of the reasons why the EU’s share of trade with Turkey decreased. But also, the 1999 earthquake followed by 2000 and 2001 financial crises in Turkey, the global crisis in the late 2000s causing a contraction in demand around the world have all affected negatively the trade between these two partners.

However, Turkey’s trade in percentages with the OIC, BSEC and CIS increased significantly over years. We would have expected that this would decrease over time with the establishment of the customs union because of the trade diversion effects of customs union.

Turkey developed better political relations with the other Muslim countries in the region, especially with the conservative Justice and Development Party in charge of

government since 2002. With a Turkish professor being the head of the OIC, Turkey

focused more on having closer ties with the other OIC member countries and this

affected the trade policies of Turkey with these countries.

The trade of Turkey with BSEC and CIS increased substantially because firstly

Turkey achieved one of the most significant joint projects in the world, the Baku-Tbilisi-

Ceyhan pipeline. Turkey also continues to work on pipeline projects, which will bring the energy resources in Central Asia to the international markets causing more increased trade with country groups other than the EU. 60 The effects of those bilateral co- operations and joint projects show on tables above. The volume of trade with the BSEC and CIS continuously increases and the percentage rises significantly. Secondly, as the

EU candidate, Turkey links Middle Eastern, Caucasian and Central Asian countries with the European market. In this sense, it enables Europe’s access to emerging markets in

Central Asia, Caucasia, Middle East and Black Sea. 61 And this does not let the diversion effects of the customs union occur in favor of either Turkey or the EU as neither would be focused on increasing trade with each other but with other countries or country groups. Also, Russia, the greatest member country of both the BSEC and the CIS constitutes an important market for Turkey’s increasing trade with this country.

What we have observed so far is that there are no trade creation or trade diversion effects of the customs union between Turkey and the EU in contrast to what we would have expected. The reasons are stated above and the suggestions will be made in Chapter 6.

60 http://www.dtm.gov.tr/dtmweb/index.cfm?action=detayrk&yayinID=1975&icerikID=2129&dil=EN. 61 Ibid. 65

In the next subsection, we will examine the dynamic effects of the customs union

on the Turkish economy.

4.2. Dynamic Effects of the Customs Union on Turkish Trade

In Chapter 2 we quoted from Salvatore (2001) that customs unions may have

dynamic effects due to increased competition, economies of scale, stimulus to

investment, and better utilization of resources.

The establishment of a customs union brings competition among members with the removal of tariffs on their goods and lower tariff rates on non-member country goods. If a member country which produces more efficiently and hence less costly than other members, then this member country captures more of the market share within the customs union borders. This could be overcome by increased efficiency in production among members as a result of increased competition. Higher competition forces countries to be more efficient in order to be able to sell the same product at a cheaper rate by producing it less costly than before.

Other possible dynamic effects of a customs union are increase in investment,

economies of scale and better utilization of resources.

In the following subsection, we will study Turkey’s trade by broad economic

categories that are capital, intermediate and consumption goods in order to see the

change in the trade structure of Turkey which would also help us understand the

dynamic effects of the customs union between Turkey and the EU.

4.2.1 Turkey’s Trade by Broad Economic Categories

Below are Table 4.6 and 4.7, which displays Turkey’s exports and imports by

broad economic categories such as capital goods, intermediate goods and consumption

goods.

Capital is one of the triad of productive inputs (land, labor, capital). Capital

consists of durable produced goods that are in turn used in production. The major

components of capital are equipment, structures and inventory. 62 We can define capital

goods as produced goods that are used as factor inputs for further production. 63

An intermediate good is a good, which is used at some point in the production

process of other goods, rather than final consumption. 64 Intermediate goods have undergone some manufacturing or processing but have not yet reached the stage of becoming final products. Common examples are steel, yarn and wood. 65

Intermediate goods comprise of unprocessed parts of transportation vehicles, fuels and oils, materials incidental to industry and food and beverages.

Consumption goods include all consumer goods bought and ready for consumption such as food and beverages, automobiles, gasoline, clothing. 66

According to Table 4.6, exports of capital goods seem to have the most notable change among all the other goods exported. We see that the percentage of capital goods in 1994 is 4% and increased to 4.8% in 1996. Between 1996 and 2008 we observe a gradual increase from 4.8% to 12.7% which is $1,120 million to $16,725

62 Samuelson, Paul A., William D. Nordhaus. Economics. New York: McGraw-Hill Book Co., 1989. 63 Pearce, David W. The MIT Dictionary of Modern Economics . Cambridge, MA: The MIT Press, 1992. 49-50. 64 Ibid. 65 Samuelson, Paul A., William D. Nordhaus. Economics. New York: McGraw-Hill Book Co., 1989. 66 Ibid. 67

million in exports. In 2009 this number decreases to $11,116 million, in 2010 it is

$11,774 million with shares 10.9% and 10.3% respectively. The sudden drop in 2009

which is also followed by a small increase in 2010 that is still far behind the value

reached in 2008 could be explained by the contraction in demand caused by the

economic crisis worldwide. For 2011, even though the data collected is only by April, it

is 16.4% in share and $3,233 million of $19,666 million of total exports.

The increase of the share of exports of capital goods in the total exports, that is vital for the productive capacity of an economy, is striking. In 1998 it is 5.2% and within

10 years it increases to 12.7%, more than twice.

As for the exports of intermediate goods, we see that the share is 45.4% in 1994 and decreases to 42.1% in 1996, and in 2007 increases to 46.1%. And in 2010, we observe that it increased to 49.5%. In nominal values of exports, there is an increase from $8,225 million in 1994 to $56,439 million in 2010.

Table 4.6 Turkey’s Exports by Broad Economic Categories

Exports (USD million) Total Capital Goods Share (%) Intermediate Goods Share (%) Consumption Goods Share (%) 1994 18,105 721 4.0 8,225 45.4 9,153 50.6 1995 21,637 830 3.8 8,960 41.4 11,840 54.7 1996 23,224 1,120 4.8 9,767 42.1 12,317 53.0 1997 26,261 1,327 5.1 11,048 42.1 13,860 52.8 1998 26,973 1,411 5.2 11,182 41.5 14,365 53.3 1999 26,587 1,796 6.8 10,840 40.8 13,892 52.3 2000 27,774 2,175 7.8 11,565 41.6 13,986 50.4 2001 31,334 2,658 8.5 13,368 42.7 15,261 48.7 2002 36,059 2,790 7.7 14,657 40.6 18,464 51.2 2003 47,252 4,344 9.2 18,494 39.1 24,125 51.1 2004 63,167 6,350 10.1 25,899 41.0 30,501 48.3 2005 73,476 7,997 10.9 30,289 41.2 34,835 47.4 2006 85,534 9,423 11.0 37,788 44.2 37,790 44.2 2007 107,271 13,754 12.8 49,402 46.1 43,695 40.7 2008 132,027 16,725 12.7 67,733 51.3 47,076 35.7 2009 102,142 11,116 10.9 49,734 48.7 40,733 39.9 2010 113,975 11,774 10.3 56,439 49.5 45,354 39.8

Source: www.tuik.gov.tr

Table 4.7 Turkey’s Imports by Broad Economic Categories

Imports (USD million) Total Capital Goods Share (%) Intermediate Goods Share (%) Consumption Goods Share (%) 1994 23,270 5,220 22.4 16,565 71.2 1,381 5.9 1995 35,709 8,119 22.7 25,077 70.2 2,416 6.8 1996 43,626 10,336 23.7 28,736 65.9 4,424 10.1 1997 48,558 11,108 22.9 32,118 66.1 5,051 10.4 1998 45,921 10,624 23.1 29,562 64.4 5,363 11.7 1999 40,671 8,727 21.5 26,854 66.0 4,820 11.9 2000 54,502 11,365 20.9 36,009 66.1 6,928 12.7 2001 41,399 6,940 16.8 30,300 73.2 3,813 9.2 2002 51,553 8,899 17.3 37,655 73.0 4,898 9.5 2003 69,339 11,325 16.3 49,734 71.7 7,813 11.3 2004 97,539 17,397 17.8 65,549 67.2 12,100 12.4 2005 116,774 20,363 17.4 81,868 70.1 13,975 12.0 2006 139,576 23,347 16.7 99,604 71.4 16,116 11.5 2007 170,062 27,054 15.9 123,639 72.7 18,694 11.0 2008 201,963 28,020 13.9 151,747 75.1 21,489 10.6 2009 140,928 21,462 15.2 99,509 70.6 19,289 13.7 2010 185,535 28,818 15.5 131,441 70.8 24,734 13.3

Source: www.tuik.gov.tr

The exports share of consumption goods increased from 50.6% to 53% between the years of 1994 and 1996. 10 years after the customs union agreement we see a decrease to 44.2% and a continuing fall that results in a share of 39.8% in 2010. The exports of consumption goods increased to $47,076 million in 2008 from $9,153 million in 1994. However, we see a sudden drop to $40,733 million in 2009 followed by an increased value in 2010 which is still less than the value of 2008.

On Table 4.7 we observe Turkey’s imports by broad economic categories. We see that the imports share of capital goods increases with the customs union in 1996 but then shows a significant fall through 2008, from 23.7% in 1996 to 13.9% in 2008.

This is followed by slight increases both in 2009 and 2010.

Imports share of intermediate goods increases by almost 10% between 1996 through 2008, from 65.9% in 1996 to 75.1% in 2008. We see a fall from 75.1% in 2008 to 70.6 in 2009 followed by 0.2% increase in 2010.

And for the consumption goods we observe that in 1994 the imports share was

5.9% and it increased to 10.1% due to the customs union agreement. From 1996 through 2008 there is a consistency in the imports share but in 2009 and 2010 the share goes up by 3%.

We can conclude from Table 4.6 and Table 4.7 that there has been a significant change in the structure of Turkey’s trade. Intermediate goods which have been exported in large amounts earlier have started to be used in the process of capital and consumption goods and their exports. Exports of capital goods increased while their imports decreased over time. Turkey imports great amounts of intermediate goods. This can be explained by Turkey’s importing and then transforming and processing

intermediate goods into final goods and then exporting them. Turkey imports intermediate goods in order to process them, work on them to make final goods and export them. These mostly include laptops, LCD screens, monitors or TVs, automobiles, machinery.

Furthermore, Table 4.8 and Table 4.9 provide us with the data of employment and the educational status in two leading sectors in the Turkish economy for the years between 1994 and 1999. What we observe in the tables, firstly, is that there is an increase both in the employment and in the number of employees with a college degree in the manufacturing sector after the formation of the customs union. This helps explain the fact that skilled-labor required production increased with the expansion in the manufacturing sector. The increase in employment in the manufacturing sector proves that this sector grew substantially. It required skilled workers and we see that there is an increase in the number of workers with college degree in manufacturing sector. This also proves the change in Turkey’s trade structure; processing imported-intermediate goods into final goods to export.

Due to the production of final goods by the processing of intermediate goods,

Turkish producers and exporters have improved their production methods in parallel with worldly standards in order to maintain the same or better quality goods. This increased the competitive power of the domestic firms in Turkey and also increased the investment in research and development activities, technological improvements.

One of the most important dynamic effects of customs union is that the change in competitive power of member countries in trade. The competitive power increases with

the increase in technological developments in order to increase the efficiency in the production of higher quality goods.

For Turkey, the customs union increased the competition level and this resulted in more efficient production with higher technology, higher-skilled labor. Therefore we can conclude that the positive dynamic effects of the customs union will increase in the long term with Turkey’s young population, geographical location, its resources and domestic market.

Table 4.8 Employment by Agriculture and Manufacturing Sectors

Employment (Thousands) Sectors 1994 1995 1996 1997 1998 1999 Agriculture 8,812 9,080 9,259 8,837 9,039 8,856 Manufacturing 3,012 3,027 3,237 3,445 3,463 3,555

Table 4.9 Educational Status by Agriculture and Manufacturing Sectors

Educational Status: Holding A College Degree (Thousands) Sectors 1994 1995 1996 1997 1998 1999 Agriculture 15 19 19 26 31 24 Manufacturing 115 126 150 172 172 197

Source: www.tuik.gov.tr

Throughout this chapter we have examined data that indicates a significant change in the trade structure of Turkey and also that there are significant dynamic effects of the customs union on the Turkish economy. However, we have observed that there are no trade creation or trade diversion effects of the customs union on the

Turkish economy in contrast to what would have been expected. We have stated the reasons why this is the case and in the following chapter, we will do an econometric analysis of Turkey’s trade with the EU with a basic econometric model so that we can forecast whether the trade between Turkey and the EU will increase in the future or keep decreasing.

The suggestions to increase the trade between Turkey and the EU will be made in Chapter 6.

CHAPTER 5

FORECASTING THE TRADE BETWEEN TURKEY AND THE EU WITH AN

ECONOMETRIC ANALYSIS

In the last chapter we have found out that there are no trade creation or trade diversion effects of the customs union between Turkey and the EU. The trade between

Turkey and the EU in percentages actually decreased and the reasons are stated. So, in this chapter we will try to examine if the trade between Turkey and the EU will increase or keep decreasing in the future.

In order to do that, we have set up an econometric model and used data accessed from Turkish government institutions, particularly the Turkish Statistics

Institution, on Stata software which helps perform data analysis, data management, and graphics. The results of the forecast will help us see if the trade between Turkey and the

EU will increase or decrease.

5.1 Econometric Model

Having observed that the trade of structure of Turkey has changed, we can use the imports to predict the exports along with other factors; inflation, income and exchange rate.

Thus, we set up the model as:

LNEX=f(LNIM, LNINF, LNGNP, LNEXCH)

͈͆̿͒ Ɣ ͤ ƍ ͈͇ͥ͆̓ ƍ ͈͈ͦ͆̓̀ ƍ ͈͈ͧ͆́͊ƍ ͈ͨ͆̿͒̽͂

EX: Exports GNP: Gross National Product

IM: Imports EXCH: Exchange Rate

INF :Inflation

Exports is the dependent variable and imports, inflation, GNP and exchange rate are independent variables. Since, these variables are indicated by different units of measurements, accounts (e.g. percentage, millions of dollars), the logarithm of each of them has been taken in order to avoid confusion and any possible complications.

Graph 5.1 The Growth of Model Variables

Source: www.tuik.gov.tr

With the quarterly data gathered, Graph 5.1 is generated. On the graph the most striking of growth of all variables is inflation growth with its several very high rates.

These rates seem to go down by 2003 through 2010 with more stability in Turkish economy.

5.2 Testing for Stationarity

Before doing a regression, we test for stationarity. For a regression analysis of time series data, we use past data to forecast future and if we find out that future is like the past then we can use this relationship in our forecast. But if the future differs from

the past, then this relationship would not be reliable to forecast the future. Stationarity

requires the future to be like the past. 67

We use the Dickey-Fuller test for stationarity and the null hypothesis is

H0: non-stationary against the one-sided alternative H 1: stationary in the regression

The lag length can be estimated using Akaike Information Criterion (AIC), which

is a statistic, used to estimate the number of lagged variables to include in an

autoregression. 68

Table 5.1 Dickey-Fuller General Least Squares Test Values

1% 5% 10% DF-GLS Test Variable Critical Critical Critical Statistic Value Value Value

LNEX -2.198 -3.603 -2.952 -2.668

LNIM -2.004 -3.603 -2.952 -2.668

LNINF -1.680 -3.607 -3.002 -2.713

LNGNP -1.478 -3.603 -2.977 -2.960

LNEXCH -0.406 -3.603 -3.000 -2.711

*DF-GLS stands for Dickey-Fuller – Generalized Least Squares.

From the results above we observe that the test-statistics are less negative than

the critical values, which means that we accept the null hypothesis and conclude that

67 Stock, James H., Mark W . Watson. Introduction to Econometrics. USA: Addison Wesley, 2006. 68 Ibid. 79

none of the variables are stationary. When there is no stationarity, we cannot rely on the past data to forecast the future.

Therefore, we take the first differences of the variables and test for stationarity again.

Table 5.2 Dickey-Fuller General Least Squares Test Values II

Variable 10% (1st DF-GLS Test 1% Critical 5% Critical Critical diff. Statistic Value Value Value taken) dLNEX -2.978 -3.607 -2.952 -2.668 dLNIM -2.828 -3.607 -3.002 -2.713 dLNINF -4.840 -3.610 -2.927 -2.644 dLNGNP -2.937 -3.607 -2.907 -2. 692 dLNEXCH -3.278 -3.607 -3.002 -2.713

From the table above we see that the test statistics are greater in absolute value than the absolute critical values at the 10% critical level. Therefore we can reject the null hypothesis at the 10% critical level and conclude that all of the variables are stationary.

5.3 Linear Regression Analysis

Now, we do the linear regression analysis of the model so that unknown model parameters can be estimated. We achieve the results below:

Table 5.3 Linear Regression of the Model

Independent Variable dLNEX Standard Errors

.2330873 dLNIM .0698715 (3.34)

.0020043 dLNINF .0007019 (2.86)

.0950085 dLNGNP .0769969 (1.23)

-.2312777 dLNEXCH .1182312 (-1.96)

.0312544 Constant .0122093 (2.56)

t-statistics in parentheses

F( 4, 87) = 7.20 Prob > F = 0.0000

R-squared = 0.2488 Adj R-squared = 0.2143 Root

MSE = .12043

dLNEX=0.31+(0.23)dLNIM+(0.002)dLNINF+(0.095)dLNGNP-

(0.23)dLNEXCH

From Table 5.3 we observe that the intercept 0.31 is the predicted exports percentage change if there is no change assumed in other variables values.

The coefficient of imports is 0.233 with a t-statistic of 3.34 which proves that the variable is significant. The coefficient of inflation is 0.002 and the t-statistic is 2.86 which prove that the variable is significant. For GNP and exchange rate, we see that the coefficient is 0.095 and -0.23 respectively and the t-statistic is 1.23 and -1.96.

The t-statistics prove that almost all our variables are significant at the 5% confidence level and the F-statistic which is 7.20 shows that all variables are significant in the model.

Commenting on the results of the regression, we can say that 1% increase in imports causes 0.233% increase in exports. This is what is to be expected from our model. Increase in imports causes an increase in exports as Turkey imports intermediate goods, processes them and exports to the EU.

We see that inflation has also a positive effect on exports. This could be explained by high demand causing an increase in prices resulting in inflation and this causes higher production and an increase in exports. According to Irving Fisher, the difference between nominal and real interest rates is equal to inflation rate. Increase in inflation means increase in nominal interest rates or a decrease in real interest rates.

Since the investors mostly consider real interest rates, we can say that if the real interest rates go down because of a higher inflation rate, then there would be capital

outflow. The move towards selling Turkish Lira causes a depreciation of Turkish Lira making Turkish goods cheaper than before and that would as a consequence increase exports.

Increase in GNP growth by 1% causes exports to increase by 0.095%. GNP increase causes an increase in exports, as expected.

For the exchange rate, we see that there is a negative relationship between exports and exchange rate even though we would expect the opposite based on the trend of a country’s trade balance that in economics is called J-curve. An increase in exchange rate results in the depreciation of the exporting country’s currency and this makes imports expensive and causes an increase in exports. In this model we see that an increase in exchange rate decreases exports. This can be explained by considering that Turkey imports intermediate goods from third countries and processes them within the country and exports them. Importing intermediate goods at a higher price than before because of the exchange rate increases the final prices of the final goods that are to be exported to the EU and this would cause a fall in export volume.

5.4 Vector Autoregression Analysis

We use vector autoregression in order to forecast our variables. According to

AIC, the optimal lag is 10. Then, we vector autoregress our dependent variable dlex for

10 lags and reach the results indicated in the table below.

Table 5.4 Vector Autoregression for 10 Optimal Lags of dLex

... vvvavaaarrrr dddldllleeeexxxx,,,, lllalaaaggggssss((((1111////11110000))))

VVVeVeeeccccttttoooorrrr aaauauuuttttoooorrrreeeeggggrrrreeeessssssiiiioooonnnn

SSSaSaaammmmpppplllleeee:::: 1119199988889999qqqq4444 --- 2220200011110000qqqq2222 NNNoNooo.... ooofofff ooobobbbssss === 88838333 LLLoLooogggg llliliiikkkkeeeelllliiiihhhhoooooodddd === 88878777....66664444666644446666 AAAIAIIICCCC === ---1-111....888844446666999900003333 FFFPFPPPEEEE === ...0.0000099992222444499993333 HHHQHQQQIIIICCCC === ---1-111....7777111188881111116666 DDDeDeeetttt((((SSSSiiiiggggmmmmaaaa____mmmmllll)))) === ...0.0000077770000888844445555 SSSBSBBBIIIICCCC === ---1-111....55552222666633333333

EEEqEqqquuuuaaaattttiiiioooonnnn PPPaPaaarrrrmmmmssss RRRMRMMMSSSSEEEE RRR-R---ssssqqqq ccchchhhiiii2222 PPP>P>>>cccchhhhiiii2222

dddldllleeeexxxx 111111 ...0.00099990000333377771111 000.0...5555777755557777 1111112222....6666111155557777 000.0...0000000000

dddldllleeeexxxx CCCoCoooeeeeffff.... SSStStttdddd.... EEErErrrrr.... zzz PPP>P>>>||||zzzz|||| [[[9[9995555%%%% CCCoCooonnnnffff.... IIInInnntttteeeerrrrvvvvaaaallll]]]]

dddldllleeeexxxx dddldllleeeexxxx LLL1L111...... 1.1110000005555333344441111 ...1.1110000999900005555558888 000.0...99992222 000.0...333355557777 ---.-...111111333322221111113333 ...3.333111144442222777799994444 LLL2L222.... ---.-...11116666661111222288881111 ...1.111000088880000555533335555 ---1-111....55554444 000.0...111122224444 ---.-...3333777777999900009999 ...0.000444455556666555522229999 LLL3L333.... ---.-...111177775555444477773333 ...1.1110000555555222211114444 ---1-111....666666 000.0...000099996666 ---.-...33338888222222999911112222 ...0.000333311113333444455551111 LLL4L444...... 1.111777788880000222200004444 ...1.1110000007777222255558888 111.1...777777 000.0...0000777777 ---.-...0000111199993333999988886666 ...3.333777755554444333399993333 LLL5L555.... ---.-...1111666611110000555500005555 ...1.1110000111199991111444444 ---1-111....55558888 000.0...1111114444 ---.-...33336666000077779999991111 ...0.000333388886666999988881111 LLL6L666.... ---.-...0000333300009999222299991111 ...1.111000044441111333399994444 ---0-000....33330000 000.0...7777666666 ---.-...2222333355550000333388886666 ...1.111777733331111888800004444 LLL7L777.... ---.-...0000999977775555777700006666 ...1.1111177770000222211119999 ---0-000....88883333 000.0...444400004444 ---.-...3333222266669999222299994444 ...1.1113333111177778888882222 LLL8L888...... 2.222999977771111999966667777 ...1.1111177770000444400006666 222.2...55554444 000.0...0000111111 ...0.000666677778888000011113333 ...5.5552222666655559999222222 LLL9L999.... ---.-...22223333330000999966663333 ...1.1111188884444111188889999 ---1-111....99997777 000.0...000044449999 ---.-...4444666655551111999933331111 ---.-...00000000999999995555 LLL1L1110000.... ---.-...1111444499990000333344442222 ...1.1111188880000111166661111 ---1-111....22226666 000.0...222200007777 ---.-...3333888800003333444411115555 ...0.0008888222222777733332222

___c_cccoooonnnnssss ...0.000333399990000111133338888 ...0.000111155559999555577774444 222.2...444444 000.0...000011114444 ...0.00000777777333377779999 ...0.000777700002222888899998888

We see that R-square is 57%, chi-square is significantly high and Root Mean

Square Error (RMSE) is 0.09. Since R-sq tells us how well the model fits the data, we can say the model is a good fit as the R-sq is 57%, the regressors are good at explaining (predicting) the value of the dependent variable.

Table 5.5 Vector Autoregression for All Variables with 10 Lags

... vvvavaaarrrr dddldllleeeexxxx dddldllliiiimmmm dddldllleeeexxxxcccchhhh dddidiiinnnnffff____ccccppppiiii dddldlllggggnnnnpppp,,,, lllalaaaggggssss((((1111////11110000))))

VVVeVeeeccccttttoooorrrr aaauauuuttttoooorrrreeeeggggrrrreeeessssssiiiioooonnnn

SSSaSaaammmmpppplllleeee:::: 11191999990000qqqq1111 --- 2220200011110000qqqq2222 NNNoNooo.... ooofofff ooobobbbssss === 88828222 LLLoLooogggg llliliiikkkkeeeelllliiiihhhhoooooodddd === 2223233333....2222777711118888 AAAIAIIICCCC === ...5.55522229999995555559999 FFFPFPPPEEEE === 333.3...33338888eeee----00006666 HHHQHQQQIIIICCCC === 333.3...555533334444777799992222 DDDeDeeetttt((((SSSSiiiiggggmmmmaaaa____mmmmllll)))) === 222.2...333333eeee----00009999 SSSBSBBBIIIICCCC === 888.8...0000111144442222666666

EEEqEqqquuuuaaaattttiiiioooonnnn PPPaPaaarrrrmmmmssss RRRMRMMMSSSSEEEE RRR-R---ssssqqqq ccchchhhiiii2222 PPP>P>>>cccchhhhiiii2222 dddldllleeeexxxx 55515111 ...0.00077778888000077776666 000.0...88885555553333 444848884444....6666999911113333 000.0...0000000000 dddldllliiiimmmm 55515111 ...1.111444499995555551111 000.0...88883333222222 444040006666....5555444455557777 000.0...0000000000 dddldllleeeexxxxcccchhhh 55515111 ...0.00099992222111122221111 000.0...77774444888888 2224244444....4444222233336666 000.0...0000000000 dddidiiinnnnffff____ccccppppiiii 55515111 11121222....1111222288889999 000.0...99990000009999 777474445555....666688889999 000.0...0000000000 dddldlllggggnnnnpppp 55515111 ...0.0006666888899993333 000.0...99995555550000 1117177744441111....2222777777 000.0...0000000000

Running a VAR analysis; dlex dlim dlexch dinf_cpi dlgnp as dependent variables with 10 lags, we observe that the R-sq and chi-sq values are substantially high. For dlex we see that RMSE is even lower; 0.078, R-sq is 0.8553 and chi-sq is 484.69.

5.5 Granger-Causality Testing

In order to find out if the lags of independent variables have predictive content, we use Granger Causality test.

The Granger causality statistic is the F-statistic testing the hypothesis that the coefficients on all the values of one of the variables in our model are zero. The null hypothesis implies that these regressors have no predictive content for dlex beyond that contained in the other regressors, and the test of this null hypothesis is called the

Granger causality test. 69

69 Stock, James H., Mark W . Watson. Introduction to Econometrics. USA: Addison Wesley, 2006. 547. 85

Table 5.6 Granger Causality Wald Test Results

... vvvavaaarrrrggggrrrraaaannnnggggeeeerrrr

GGGrGrrraaaannnnggggeeeerrrr cccacaaauuuussssaaaalllliiiittttyyyy WWWaWaaalllldddd ttteteeessssttttssss

EEEqEqqquuuuaaaattttiiiioooonnnn EEExExxxcccclllluuuuddddeeeedddd ccchchhhiiii2222 dddfdfff PPPrPrrroooobbbb >>> ccchchhhiiii2222

dddldllleeeexxxx dddldllliiiimmmm 88818111....77771111 11101000 000.0...00000000 dddldllleeeexxxx dddldllleeeexxxxcccchhhh 111111....888899997777 11101000 000.0...222299992222 dddldllleeeexxxx dddidiiinnnnffff____ccccppppiiii 55595999....999933337777 11101000 000.0...00000000 dddldllleeeexxxx dddldlllggggnnnnpppp 66656555....666622229999 11101000 000.0...00000000 dddldllleeeexxxx AAALALLLLL 111616665555....22224444 44404000 000.0...00000000

dddldllliiiimmmm dddldllleeeexxxx 22272777....222211118888 11101000 000.0...0000002222 dddldllliiiimmmm dddldllleeeexxxxcccchhhh 33373777....2222777777 11101000 000.0...00000000 dddldllliiiimmmm dddidiiinnnnffff____ccccppppiiii 11131333....000044448888 11101000 000.0...2222221111 dddldllliiiimmmm dddldlllggggnnnnpppp 55515111....222200003333 11101000 000.0...00000000 dddldllliiiimmmm AAALALLLLL 222121118888....666666 44404000 000.0...00000000

dddldllleeeexxxxcccchhhh dddldllleeeexxxx 44474777....111177776666 11101000 000.0...00000000 dddldllleeeexxxxcccchhhh dddldllliiiimmmm 44464666....8888333333 11101000 000.0...00000000 dddldllleeeexxxxcccchhhh dddidiiinnnnffff____ccccppppiiii 333333....555511118888 11101000 000.0...00000000 dddldllleeeexxxxcccchhhh dddldlllggggnnnnpppp 33303000....444400003333 11101000 000.0...0000001111 dddldllleeeexxxxcccchhhh AAALALLLLL 111515558888....99998888 44404000 000.0...00000000

dddidiiinnnnffff____ccccppppiiii dddldllleeeexxxx 33353555....999955559999 11101000 000.0...00000000 dddidiiinnnnffff____ccccppppiiii dddldllliiiimmmm 44434333....888833332222 11101000 000.0...00000000 dddidiiinnnnffff____ccccppppiiii dddldllleeeexxxxcccchhhh 77707000....66665555 11101000 000.0...00000000 dddidiiinnnnffff____ccccppppiiii dddldlllggggnnnnpppp 33393999....777711113333 11101000 000.0...00000000 dddidiiinnnnffff____ccccppppiiii AAALALLLLL 222828889999....999999 44404000 000.0...00000000

dddldlllggggnnnnpppp dddldllleeeexxxx 999.9...777711112222 11101000 000.0...4444666666 dddldlllggggnnnnpppp dddldllliiiimmmm 22292999....888899991111 11101000 000.0...0000001111 dddldlllggggnnnnpppp dddldllleeeexxxxcccchhhh 222222....999966667777 11101000 000.0...0000111111 dddldlllggggnnnnpppp dddidiiinnnnffff____ccccppppiiii 33323222....1111777777 11101000 000.0...00000000 dddldlllggggnnnnpppp AAALALLLLL 111212225555....888888 44404000 000.0...00000000

We see from the table above that in the equation for dlex; dlim, dinf_cpi and dlgnp granger-cause dlex whereas dlexch does not granger-cause dlex as the chi-sq value 11.897 is lower than the table value of chi-sq. For the variables that granger cause dlex, it does not necessarily mean that a change in them will cause a significant change in dlex but the past values of them contain information that could be useful to forecast changes in dlex.

5.6 Forecasting The Trade

The ultimate test of a forecasting model is its out-of-sample performance, that is, its forecasting performance in real time, after the model has been estimated. Pseudo out-of-sample (poos) forecasting is a method for simulating the real-time performance of a forecasting model. The idea of poos forecasting is simple: we pick a date near the end of the sample, estimate our forecasting model using data up to that date, then use that estimated model to make a forecast. Performing this for multiple dates near the end of our sample yields a series of pseudo forecasts and thus pseudo forecast errors. The pseudo forecast errors can then be examined to see whether they are representative of what we would expect if the forecasting relationship were stationary. 70

For pseudo-out-of-sample analysis, we get results as below: F-statistic is 3.72 that is higher than the table value of F proving our variables in the model are related.

R-square is 0.68 showing our model fits well. 68% of the differences in our variables could be explained with this model. And the Root Mean Square Forecasting

Error (RMSFE) is 0.126.

70 Ibid. 87

Table 5.7 Pseudo-Out-Of-Sample (POOS) Analysis

... pppopooooossss (((9(9994444 mmmimiiissssssiiiinnnngggg vvvavaaalllluuuueeeessss gggegeeennnneeeerrrraaaatttteeeedddd))))

SSSoSooouuuurrrrcccceeee SSSSSS dddfdfff MMMSMSSS NNNuNuuummmmbbbbeeeerrrr ooofofff ooobobbbssss === 33363666 FFF(F((( 11131333,,,, 222222)))) === 333.3...77772222 MMMoMoooddddeeeellll ...1.111555599994444111144441111117777 11131333 ...0.000111122222266662222666622224444 PPPrPrrroooobbbb >>> FFF === 000.0...000000333333 RRReReeessssiiiidddduuuuaaaallll ...0.0007777222255550000444433331111 222222 ...0.00000333322229999555566665555 RRR-R---ssssqqqquuuuaaaarrrreeeedddd === 000.0...6666888877774444 AAAdAdddjjjj RRR-R---ssssqqqquuuuaaaarrrreeeedddd === 000.0...5555000022226666 TTToTooottttaaaallll ...2.22233331111999911118888444422228888 33353555 ...0.0000066666622226666222244441111 RRRoRoooootttt MMMSMSSSEEEE === ...0.0005555777744441111

dddldllleeeexxxx CCCoCoooeeeeffff.... SSStStttdddd.... EEErErrrrr.... ttt PPP>P>>>||||tttt|||| [[[9[9995555%%%% CCCoCooonnnnffff.... IIInInnntttteeeerrrrvvvvaaaallll]]]]

dddldllleeeexxxx LLL1L111...... 1.1116666888844440000555555 ...2.222111155559999333344449999 000.0...77778888 000.0...44444444 ---.-...222277779999444411116666 ...6.666111166662222227777 LLL2L222.... ---.-...00003333666611112222226666 ...2.222333355550000444400007777 ---0-000....11115555 000.0...888877779999 ---.-...5555222233335555666677771111 ...4.444555511113333222211119999 LLL3L333.... ---.-...0000444400005555222244448888 ...2.22233334444333300006666 ---0-000....11117777 000.0...888866664444 ---.-...55552222666644444455556666 ...4.4444455553333999966661111 LLL4L444...... 2.2228888444422229999994444 ...1.111999922220000333322224444 111.1...44448888 000.0...111155553333 ---.-...11111133339999555511113333 ...6.6668888222255555500001111 LLL5L555...... 0.000999944448888555500006666 ...1.111888855557777999988887777 000.0...55551111 000.0...666611115555 ---.-...2222999900004444777722223333 ...4.444888800001111777733334444 LLL6L666...... 1.11111444455559999993333 ...1.111666600001111888855554444 000.0...77772222 000.0...444488882222 ---.-...2222111177776666000044448888 ...4.4444466668888000033334444 LLL7L777.... ---.-...2222222222000088886666 ...1.111777700008888777766665555 ---1-111....33330000 000.0...222200007777 ---.-...5555777766665555888844447777 ...1.111333322221111666677776666 LLL8L888...... 4.444111144442222999977772222 ...1.1115555666633337777555555 222.2...66665555 000.0...000011115555 ...0.00088889999999944443333 ...7.7773333888866660000001111 LLL9L999.... ---.-...3333000066660000666633339999 ...1.1117777333322222277775555 ---1-111....777777 000.0...000099991111 ---.-...66666655553333111155558888 ...0.000555533331111888888 LLL1L1110000.... ---.-...00009999992222888866663333 ...1.111888855554444111100005555 ---0-000....55554444 000.0...555599998888 ---.-...4444888833338888000044441111 ...2.222888855552222333311115555

dddldlllggggnnnnpppp ...0.000666677776666888800001111 ...1.1111166667777444411113333 000.0...55558888 000.0...555566668888 ---.-...111177774444442222666666 ...3.333000099997777888866669999 dddldllleeeexxxxcccchhhh ---.-...0000888877774444777722224444 ...1.111444422226666444400004444 ---0-000....66661111 000.0...555544446666 ---.-...3333888833332222999900005555 ...2.222000088883333444455557777 dddldllliiiimmmm ---.-...00005555999922225555552222 ...0.0006666111111444433334444 ---0-000....99997777 000.0...333344443333 ---.-...1111888866660000555588889999 ...0.000666677775555444488885555 ___c_cccoooonnnnssss ...0.000222277771111555566667777 ...0.000222277772222888866667777 111.1...000000 000.0...3333330000 ---.-...0000222299994444333322225555 ...0.000888833337777444455558888

(((7(7772222 mmmimiiissssssiiiinnnngggg vvvavaaalllluuuueeeessss gggegeeennnneeeerrrraaaatttteeeedddd))))

VVVaVaaarrrriiiiaaaabbbblllleeee OOObObbbssss MMMeMeeeaaaannnn SSStStttdddd.... DDDeDeeevvvv.... MMMiMiiinnnn MMMaMaaaxxxx

dddldllleeeexxxx____eeee 222222 ---.-...0000222266668888000022223333 ...1.111222255559999555544441111 ---.-...4444111155559999777766664444 ...2.222666600001111555577775555

OOOnOnnneeee----ssssaaaammmmpppplllleeee ttt ttteteeesssstttt

VVVaVaaarrrriiiiaaaabbbblllleeee OOObObbbssss MMMeMeeeaaaannnn SSStStttdddd.... EEErErrrrr.... SSStStttdddd.... DDDeDeeevvvv.... [[[9[9995555%%%% CCCoCooonnnnffff.... IIInInnntttteeeerrrrvvvvaaaallll]]]]

dddldllleeeexxxx____eeee 222222 ---.-...0000222266668888000022223333 ...0.000222266668888555533335555 ...1.111222255559999555544441111 ---.-...0000888822226666444477773333 ...0.000222299990000444422226666

mmmemeeeaaaannnn === mmmemeeeaaaannnn((((ddddlllleeeexxxx____eeee)))) ttt === ---0-000....99999988881111 HHHoHooo:::: mmmemeeeaaaannnn === 000 dddedeeeggggrrrreeeeeessss ooofofff fffrfrrreeeeeeddddoooommmm === 22212111

HHHaHaaa:::: mmmemeeeaaaannnn <<< 000 HHHaHaaa:::: mmmemeeeaaaannnn !!!=!=== 000 HHHaHaaa:::: mmmemeeeaaaannnn >>> 000 PPPrPrrr((((TTTT <<< ttt)t))) === 000.0...1111666644448888 PPPrPrrr((((||||TTTT|||| >>> |||t|ttt||||)))) === 000.0...3333222299996666 PPPrPrrr((((TTTT >>> ttt)t))) === 000.0...8888333355552222 (((7(7772222 mmmimiiissssssiiiinnnngggg vvvavaaalllluuuueeeessss gggegeeennnneeeerrrraaaatttteeeedddd))))

VVVaVaaarrrriiiiaaaabbbblllleeee OOObObbbssss MMMeMeeeaaaannnn SSStStttdddd.... DDDeDeeevvvv.... MMMiMiiinnnn MMMaMaaaxxxx

dddldllleeeexxxx____eeee2222 222222 ...0.000111155558888666611117777 ...0.000333388886666999933336666 444.4...111111eeee----00006666 ...1.111777733330000333366664444 RRRMRMMMSSSSFFFFEEEE === ...1.1112222555599994444333322221111

tttitiiimmmmeeee dddldllleeeexxxx dddldllleeeexxxx____ffff dddldllleeeexxxx____eeee

77737333.... 22202000005555qqqq1111 ---.-...00005555777777000088887777 ---.-...0000222211116666444488881111 ---.-...0000333366660000666600006666 77747444.... 22202000005555qqqq2222 ---.-...0000222299991111333322228888 ...0.000555599997777666633332222 ---.-...00008888888899996666 77757555.... 22202000005555qqqq3333 ...0.0001111999911118888222222 ...0.000444477778888000055559999 ---.-...0000222288886666222233337777 77767666.... 22202000005555qqqq4444 ...1.111333311110000222299991111 ...1.1114444448888000011118888 ---.-...00001111333377777722226666 777777.... 22202000006666qqqq1111 ---.-...00006666333333666699998888 ---.-...0000222244448888222255556666 ---.-...00003333888855554444442222

77787888.... 22202000006666qqqq2222 ...1.111114444666666222222 ...0.0001111222277770000002222 ...1.111000011119999666611119999 77797999.... 22202000006666qqqq3333 ---.-...0000111166668888000055556666 ...0.000111122226666333377774444 ---.-...0000222299994444443333 88808000.... 22202000006666qqqq4444 ...1.111333344445555999900001111 ...0.000888833334444999911118888 ...0.000555511110000999988883333 88818111.... 22202000007777qqqq1111 ---.-...00000077774444333366668888 ---.-...0000444433334444777799995555 ...0.000333366660000444422228888 88828222.... 22202000007777qqqq2222 ...1.1111122227777999966668888 ...0.000777755556666333388883333 ...0.000333377771111555588885555

88838333.... 22202000007777qqqq3333 ---.-...0000222200002222000022226666 ---.-...000011115555111166663333 ---.-...00000055550000333399996666 88848444.... 22202000007777qqqq4444 ...1.11166662222888855559999 ...0.000999933332222777755559999 ...0.000666699995555888833331111 88858555.... 22202000008888qqqq1111 ---.-...00002222333333999933336666 ---.-...000022221111333366666666 ---.-...0000002222000022227777 88868666.... 22202000008888qqqq2222 ...0.000555577774444888877775555 ...0.000666677774444555522226666 ---.-...000000999999666655551111 88878777.... 22202000008888qqqq3333 ---.-...000088881111444444 ---.-...00000044442222777711119999 ---.-...00007777771111666688881111

888888.... 22202000008888qqqq4444 ---.-...33331111000011115555559999 ...1.111000055558888222200005555 ---.-...4444111155559999777766664444 88898999.... 22202000009999qqqq1111 ---.-...1111999977776666444455552222 ...0.000003333444499997777 ---.-...222200001111114444222222 99909000.... 22202000009999qqqq2222 ...0.000999933332222000022226666 ...2.222444477772222888877771111 ---.-...1111555544440000888844445555 99919111.... 22202000009999qqqq3333 ...1.11100004444444422226666 ...1.111444477774444000066662222 ---.-...0000444422229999666633336666 99929222.... 22202000009999qqqq4444 ...1.11144445555888855553333 ---.-...11111144443333000044445555 ...2.222666600001111555577775555

99939333.... 2220200011110000qqqq1111 ---.-...111111333333222288889999 ---.-...11115555111111777744448888 ...0.000333377778888444455559999 99949444.... 2220200011110000qqqq2222 ...0.00011115555888877773333 ...0.00055555566666666 ---.-...000033339999777799993333

...

Comparing the dlex and forecasted dlex values on a diagram, we can see that our model is a good one for forecasting the trade flow between Turkey and the EU.

Graph 5.2 Forecast of the Trade Between Turkey and the EU

0.3

0.2

0.1 fcast dlex 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

-0.1

-0.2

-0.3

-0.4

*fcast: forecast values

**Horizontal axis shows the years

Graph 5.2 does not only illustrate that our model is a good forecasting model but also displays the future values of dlex following 2010. The future values show that the change in exports comes to a slow down and stability. We do not observe significant

changes in the future values of dlex. Also, the stability we see in future trade between

Turkey and the EU will increase the static effects of customs union on the Turkish economy.

In the following chapter, we will try to explain what measures should be taken in order to increase the trade between Turkey and the EU as forecasted and put forward some suggestions in terms of the achievement of a more effective customs union between Turkey and the European Union.

CHAPTER 6

CONCLUSION

Following the declaration of the Republic, Turkey looked to the West in its modernization process. The end of the Second World War came with the establishments of some international organization that were mainly created to maintain strength among its members against other countries. One of the founding members of the UN, one of the members of NATO, OECD, and the Council of Europe, Turkey has pursued a goal of having closer relations with the Western countries.

Therefore, it was only natural for Turkey to pursue the goal of joining geographically the most convenient economic integration, the European Union that was formed under the name of the European Economic Community in 1957 by six Western

European countries. Turkey made its first application to join this Community in 1959 but it did not achieve its goal. However, it led Turkey to sign the Ankara Agreement also known as the Association Agreement in 1963 that started a three-stage process. The stages were identified as preparatory, transitional and final stages and final stage would be the establishment of customs union. The transitional stage started with both parties’ signing the Additional Protocol in 1970. The Protocol provided Turkey with an advantage of exporting industrial goods to the EU with no customs tariffs although the

EU earned the same right in 1995 with the establishment of the customs union.

Turkey made another application for full membership to the Community in 1987 but this application did fail to achieve its purpose. However, the relations developed more between these two parties and in 1995 the customs union was established and 91

came into effect on 1 January 1996. Although it does not cover agricultural produce, customs union constitutes a very important step towards Turkey’s integration within the

EU. It is the most important economic integration Turkey has with a trading bloc as great as the EU.

Economic integration provides countries with the removal of trade barriers between each other in order to increase wealth. According to Appleyard (2010), it has four phases, one of which is customs union. The first stage is a free trade area whose member countries remove all trade barriers among themselves and continue to pursue their own trade policy towards non-member countries. As the second stage of economic integration, a customs union involves the application of common customs tariffs on non- member country goods in addition to the abolishing of all trade barriers among member countries. A common market constitutes the third stage of economic integration in which there is the free mobility of factors of production among member countries along with the removal of trade barriers. And the last stage is an economic union which comprises the qualities of common market and common economic policies along with a supranational power that makes binding decisions.

A customs union lessens the domestic control over national sovereignty compared to a free trade area by the application of common customs tariffs on third country goods. However, this also makes a customs union superior to a free trade area as an economic integration because, as free trade area member states apply their own tariffs on third country goods, third countries might try to sneak their goods into the targeted member country through another one that applies a lower tariff on their goods.

There is no possibility of a problem as such to occur in a customs union as all the

participating countries apply the same tariffs.

Customs unions have economic effects. These effects are divided into static effects and dynamic effects. Static effects are also divided into two by trade creation effects and trade diversion effects. Trade creation occurs when the domestic production of a good in a member country is replaced by the imports of the same good from another member country within a customs union because of the lower cost production.

Trade diversion occurs when the imports from a non-member country is replaced by the imports of a member country because of the removal of tariffs between members and the application of common customs tariffs to the non-member countries. As for dynamic effects, we can consider increased competition, economies of scale, efficient production, increase in investment.

By 1 January 1996, when the customs union came into effect, Turkey lifted all customs tariffs on industrial goods imported from the European Union and started to apply the common customs tariffs on non-member country goods. The volume of trade between Turkey and the EU increased over the years and made the EU Turkey’s major trading partner.

However, the EU’s share of trade in Turkey’s total trades decreased between

1996 and 2010 thus we cannot speak of a trade creation effect of the customs union.

We would have expected an increase in trade share between Turkey and the EU especially after the establishment of the customs union. As for reasons, we can consider the 1999 earthquake in Turkey, financial crises of 2000 and 2001 in Turkey which all caused instability in the Turkish economy, devaluation of the Turkish currency, decrease in credibility hence causing capital outflow. The late 2000s global economic 93

crisis caused a contraction in demand worldwide which decreased the exports and imports globally. And also the recent enlargement processes of the EU that made its focus shift to the new members instead of a long-time candidate country Turkey constitute an important reason of why the trade share of the EU in Turkey’s total trade decreased after the customs union.

On the other hand, we see an increase in the shares of Turkey’s trade with other country groups such as OIC, BSEC and CIS.

Turkey developed better political relations with the other Muslim countries in the region, especially with the conservative Justice and Development Party in charge of government since 2002. With a Turkish professor being the head of the OIC, Turkey focused more on having closer ties with the other OIC member countries and this affected the trade policies of Turkey with these countries.

The trade of Turkey with BSEC and CIS increased substantially because firstly,

Turkey achieved one of the most significant joint projects in the world, the Baku-Tbilisi-

Ceyhan pipeline. Turkey also continues to work on pipeline projects, which will bring the energy resources in Central Asia to the international markets causing more increased trade with country groups other than the EU. The effects of those bilateral co-operations and joint projects show on tables above. The volume of trade with BSEC and CIS continuously increases and the percentage rises significantly. Secondly, Turkey links

Middle Eastern, Caucasian and Central Asian countries with the European market. In this sense, it enables Europe’s access to emerging markets in Central Asia, Caucasia,

Middle East and Black Sea. And this does not let the diversion effects of the customs union occur in favor of either Turkey or the EU as neither would be focused on

increasing trade with each other but with other countries or country groups. Also, a member country of both BSEC and CIS, Russia constitutes an important market for

Turkey’s increasing trade with this country.

In Chapter 4 we observe a decrease in percentages of trade between Turkey and the EU and in chapter 5 we see that according to the forecast it increases in the coming future. Moreover, since there is a customs union between Turkey and the EU we expect the trade creation and trade diversion effects of the customs union to occur.

We have already observed that the customs union has positive dynamic effects such as increased competition, efficient production and skilled-labor on the Turkish economy. Therefore, we can put forward the following policy suggestions in terms of the achievement of a more effective customs union between Turkey and the EU in order to increase the EU’s share of trade in Turkey’s total trade.

Firstly, Turkey should create policies that will motivate firms in manufacturing sectors to develop their technologies, invest in cost-minimizing production techniques so that Turkey will have comparative advantage in more amounts of products than before. This would result in the EU’s focus on trade shifting back to Turkish goods causing an increase in the trade creation effects of the customs union.

Secondly, Turkey has a comparative advantage in agricultural produce among the customs union members and because the customs union agreement between

Turkey and the EU does not cover agricultural produce, Turkey should pursue a policy of including all of its goods, including agricultural goods, in the customs union agreement with the EU. Turkey should be persistent on stating that all goods should be

subject to the customs union agreement in every periodical meeting with the EU. This

would shift Turkey’s agricultural produce trade from other countries/country groups such

as OIC to the EU.

Economic policies to increase income should be created. Policies should be

carried out in order to increase the purchasing power and demand in Turkey so that

exports and imports will rise. This will result in increased trade between Turkey and all

other countries in general and with the EU in particular.

For the trade with the EU member countries such as Germany, France and the

Netherlands where a high number of Turkish population live, trade policies that would support the promotion of Turkish origin goods should be created so that the demand for these goods will increase in the EU.

And lastly, luggage trade with Russia, a non-member country, should be taken under control by restrictions of Turkish government, new adjustments in legislation and regulations in order to limit off-the-record volume of trade between Turkey and Russia.

Thus, goods that were subject to luggage trade with no customs tariffs start to be traded with customs tariffs which will make them more expensive. This results in a contraction in the volume of this trade, but the trade of the same goods within the customs union increases.

It is important for Turkey to continue pursuing the goal of membership to the EU.

As a step for this 50-year-old goal, the customs union should be the major country group for Turkey to increase the trade relations with. The economic effects of the customs union should increase, the EU should increase its focus on trade with each

other and Turkey should always look for the right trade and economy policies in order to increase its trade with the EU in a favorable macroeconomic environment. That way,

Turkey can use the increased effects of the customs union in favor of itself for its smoother accession to the EU.

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