EU and BRICs: Challenges and opportunities for

European competitiveness and cooperation

Industrial Policy and Economic Reform Papers No. 13

Peter Havlik Roman Stöllinger Olga Pindyuk Gábor Hunya Bernhard Dachs Carolina Lennon Marcos Poplawski Ribeiro Jayati Ghosh Waltraut Urban Vasily Astrov Edward Christie

Enterprise and Industry Directorate-General European Commission

EU and BRICs: Challenges and opportunities for

European competitiveness and cooperation

Peter Havlik1 Roman Stöllinger1 Olga Pindyuk1 Gábor Hunya1 Bernhard Dachs2 Carolina Lennon1 Marcos Poplawski Ribeiro3 Jayati Ghosh4 Waltraut Urban1 Vasily Astrov1 Edward Christie1

10 July 2009

1) Wiener Institut für Internationale Wirtschaftsvergleich (wiiw), the Vienna Institute for International Economic Studies, Rahlgasse 3, A-1060 Wien. Contacts: [email protected] and [email protected]

2) Austrian Institute of Technology (AIT), Donau-City-Strasse 1, A-1220 Wien. Contact: [email protected] 3) Centre d’Etudes Prospectives et d’Informations Internationales (CEPII), rue Georges Pitard 9, F-75740 Paris Cedex 15. Contact: [email protected] 4) Centre for Economic Studies and Planning, Jawahartal Nehru University, New Mehrauli Road, 110067 New Delhi, India Contact: [email protected]

Industrial Policy and Economic Reforms Papers are written by the staff of the Directorate General for Enterprise and Industry or by experts working in association with them. This publication series aims to raise the awareness and stimulate the debate on issues in the areas of industrial policy and economic reforms. Views expressed in these papers represent the positions of the authors and do not necessarily reflect those of the European Commission.

Contact information European Commission Enterprise and Industry Directorate-General Unit B4 – "Economic Analysis and Evaluation"

B-1049 Brussels Tel: (32-2) 295 49 39 Fax: (32-2) 297 41 23 E-mail: [email protected] Web page: http://ec.europa.eu/enterprise/newsroom/cf/itemshortdetail.cfm?item_id=3479

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ISBN-13: 978-92-79-10448-0 ISSN: 1831-0672 DOI: 10.2769/36796 Luxembourg: Publications Office of the European Union, 2009

© European Communities, 2009 Reproduction is authorised provided the source is acknowledged. Abstract

This study explores the opportunities and competitive challenge that the BRIC countries – Brazil, Russia, India and China – represent for the EU. The BRICs show many common features (big land size, large population, fast economic growth etc.) but important differences as well, due to their different models of economic development. Examples are differences in income levels, in their degree of openness and in their economic and trade structures, which are described in detail in section two of the study. In the first section we analyse trade in goods and services, FDI and knowledge flows between the BRICs and the EU in 1995-2007. The emergence of the BRICs as major exporters on international markets is one of the driving forces behind the industrialized countries’ loss of global market shares. China has clearly become the most serious challenge to the EU’s industrial competitiveness. But the BRICs also provide formidable opportunities for exports. EU-BRICs services trade is much less important than goods trade and the BRICs seem to have only few strong advantages at the EU market in this field. Knowledge flows between the EU and the BRICs are gaining significance. Regarding FDI, the EU emerges as the main or one of the main investors in all BRICs while competitive pressure on the EU market via FDI from the BRICs is not very strong yet. In EU-BRICs energy relations, analysed in section three, rising and potentially competing demand for oil and, to a lesser extent, for gas is coming especially from China, but India as well. Russia and Brazil are relevant suppliers of energy (oil, gas, biofuel) – with Russia being a less prominent supplier of oil to the EU than of gas.

Key words: competitiveness, FDI, trade in goods, trade in services, knowledge flows, energy, EU, Brazil, Russia, India, China

JEL codes: F14, F21, G01, O52, O53, O54, O57, Q41, Q42

Contents

Introduction ...... 1

1 Trade in goods and services, FDI and knowledge flows...... 2 1.1 Trade in goods...... 2 1.1.1 Introduction and summary ...... 2 1.1.2 Global trade in goods ...... 3 1.1.3 Bilateral trade relations between Triad countries and the BRICs...... 4 1.1.4 Country-specific patterns of EU-BRICs trade...... 8 1.1.5 Sectoral composition of EU-BRICs goods trade...... 12 1.1.6 Specialization patterns in EU-BRICs manufacturing industry trade...... 14 1.1.7 Revealed comparative advantages of BRICs and the EU...... 17 1.1.8 Vertical integration of trade with China ...... 24 1.1.9 Impact of the global crisis on goods trade ...... 29 References...... 30 Annex 1 ...... 31 1.2 Trade in services ...... 33 1.2.1 Summary...... 33 1.2.2 Introduction ...... 34 1.2.3 Geographical structure of services trade...... 35 1.2.4 Sectoral structure of services trade ...... 38 1.2.5 Trade balances and specialization indices ...... 41 References...... 43 1.3 Foreign Direct Investment flows between the EU and the BRICs...... 44 1.3.1 Introduction ...... 44 1.3.2 FDI data analysis ...... 46 1.3.3 Investment project database analysis...... 64 1.3.4 Impact of the crisis on the EU–BRICs FDI relations...... 72 1.3.5 Summary and Conclusions ...... 74 References...... 78 1.4 Knowledge flows between the BRICs and the EU...... 80 1.4.1 Introduction ...... 80 1.4.2 Royalties and licence fees ...... 82 1.4.3 Enrolments of foreign students in tertiary education ...... 84 1.4.4 International mobility of professionals ...... 87 1.4.5 Cross-border patents between the EU and the BRICs ...... 90 1.4.6 Summary...... 94 References...... 95 2 Different models of BRICs’ economic development, implications for EU policies97 2.1 Introduction...... 97 2. 2 Brazil ...... 98 2. 2.1 Political, economic and social structure...... 98 2.2.2 The Brazilian Development Model at a glance...... 101 2.2.3 Sectoral analysis ...... 104 2.2.4 Future prospects and challenges ...... 107 2.2.5 EU-Brazil relations...... 110 2.2.6 Conclusions ...... 112 References...... 112 2.3 Russia ...... 114 2.3.1 Introduction...... 114 2.3.2 GDP growth and the ambivalent role of energy...... 115 2.3.3 Future prospects and challenges ...... 119 2.3.4 Challenges for EU-Russian relations...... 124 2.3.5 Directions of EU-Russia relations ...... 126 References...... 128 2.4 India...... 130 2.4.1 Background...... 130 2.4.2 Recent patterns of economic growth ...... 132 2.4.3 Employment and the labour market...... 134 2.4.4 Education and employability ...... 135 2.4.5 Economic policies ...... 136 2.4.6 External trade and investment...... 137 2.4.7 Infrastructure...... 139 2.4.8 Telecom ...... 140 2.4.9 Future prospects ...... 140 2.4.10 EU-India relations ...... 142 References...... 143 2.5 China ...... 144 2.5.1 Background...... 144 2.5.2 Relative size of the Chinese economy ...... 144 2.5.3 Strong fragmentation of the economy ...... 144 2.5.4 Model of economic development ...... 146 2.5.5 A more detailed picture of the Chinese economy at sectoral level...... 153 2.5.6 Future prospects and challenges ...... 155 2.5.7 EU-China relations...... 158 References ...... 159 2.6 Future challenges and opportunities for EU competitiveness ...... 160 2.7 Summary results and policy implications ...... 162 2.7.1 Summary results...... 162 2.7.2 Implications for EU policies ...... 164 Annex 2 ...... 168 3 The role of BRICs in EU’s future energy needs: partners and competitors.....171 3.1 Oil, gas and the EU-Russia energy relationship...... 171 3.1.1 Global oil and gas demand...... 171 3.1.2 EU net import demand and the 20-20-20 Initiative...... 172 3.1.3 Russian oil and gas reserves and production...... 174 3.1.4 A Russian perspective on the EU-Russia energy relationship...... 178 3.1.5 The EU-Russia energy relationship from an EU perspective ...... 181 3.2 Biofuels and the EU-Brazil energy relationship ...... 185 3.2.1 Biofuels and biofuels trade...... 185 3.2.2 Biofuels in the European Union...... 188 3.2.3 Biofuels in Brazil...... 190 3.3 Conclusions and policy discussion...... 193 References ...... 194

List of Tables, Figures and Boxes Table 1.1.1 Overview of the total EU goods trade...... 9 Table 1.2.1 Services exports and imports in 2007, % of GDP ...... 34 Table 1.2.2 Services export and import in 2007, EUR billion...... 35 Table 1.2.3 Geographical structure of services imports in 2007, %...... 36 Table 1.2.4 Geographical structure of services exports in 2007, % ...... 37 Table 1.2.5 Sectoral structure of services exports, 2007, % ...... 39 Table 1.2.6 Change in sectoral structure of services exports, 2000 to 2007, in p.p...... 39 Table 1.2.7 Sectoral structure of services imports, 2007, %...... 40 Table 1.2.8 Change in sectoral structure of services imports, 2000 to 2007, in p.p...... 40 Table 1.2.9 Trade balances in 2007, EUR billion ...... 41 Table 1.2.10 Specialization indices in trade with the EU15, 2007 ...... 42 Table 1.2.11 Specialization indices in trade with the NMS12, 2007...... 43 Table 1.3.1 Major EU investor countries in the BRICs. average annual outflow (2004- 2007) and outflows in 2007 (EUR million)...... 51 Table 1.3.2 EU outward stocks in the BRICs by economic activity (2006), in EUR million ...... 54 Table 1.3.3 EU inward stocks owned by the BRICs by economic activity (2006), in EUR million...... 61 Table 1.3.4 Investment projects in the BRICs, by year...... 64 Table 1.3.5a Investment projects in the BRICs, by source country ...... 65 Table 1.3.5b EU investment projects in the BRICs, by source country ...... 65 Table 1.3.6a Investment projects in individual BRICs ...... 66 Table 1.3.6b EU15 investment projects in individual BRICs...... 67 Table 1.3.7 Motives of EU15 investors in the BRICs...... 68 Table 1.3.8 Investment projects in the BRICs by economic sectors ...... 69 Table 1.3.9 Investment projects in the BRICs by major business activities...... 70 Table 1.3.10 FDI in the EU15 from the BRICs, number of projects and invested capital 72 Table 1.4.1 Absorptive capacity of the BRICs...... 81 Table 1.4.2 Trade in royalties and licence fees, 2006 (USD million) ...... 83 Table 1.4.3 Enrolment of foreign students in tertiary education (2003), Triad countries detail ...... 84 Table 1.4.4 Enrolments in tertiary education (2003), BRIC countries detail...... 86 Table 1.4.5 Enrolment of foreign tertiary students in the EU (2006)...... 86 Table 1.4.6 Foreign-born by country of residence, year 2000...... 87 Table 2.4.1 Structural change in the Indian economy...... 133 Table 2.4.2 Growth rates of employment (per cent change per annum) ...... 134 Table 2.4.3 Infrastructure deficits by sector and Eleventh Plan physical targets...... 139 Table 2.5.1 Structure of manufacturing industry in China and in the EU27, 2006/2007154 Table A2.1 BRICs List of Indicators. Year 2007 (if not mentioned otherwise) ...... 168 Table 3.2.1a World Bioethanol Exports (2002-2006) ...... 186 Table 3.2.1b World Bioethanol Imports (2002-2006) ...... 186 Table 3.2.2 Projected consumption and exports of Brazilian ethanol ...... 192

Figure 1.1.1 Global market shares in goods exports ...... 3 Figure 1.1.2 Global shares in goods imports ...... 3 Figure 1.1.3 Shares of the Triad in goods imports of BRICs, in % of total imports ...... 5 Figure 1.1.4 Contribution of the BRICs to the trade deficits of the EU and the USA, in %6 Figure 1.1.5 Imports of the BRICs by broad economic categories (2007)...... 7 Figure 1.1.6 Diversity in EU exports to BRICS, 2007 (deviations from EU average share in exports, in pp)...... 10 Figure 1.1.7 Diversity in EU imports to BRICS, 2007 (deviations from EU average in imports, in pp)...... 11 Figure 1.1.8 Structure of EU imports from BRICs, 2007 by NACE sectors, In %...... 13 Figure 1.1.9a Structure of EU manufacturing exports to BRICs by NACE 2-digit industries (differences to total exports in pp, 2007)...... 15 Figure 1.1.9b Structure of EU manufacturing imports from BRICs by NACE 2-digit industries (differences to total imports in pp, 2007, note different scale).... 15 Figure 1.1.10a EU27: Imports by industry groups (Taxonomy I) ...... 16 Figure 1.1.10b EU27: Imports by industry groups (Taxonomy II)...... 16 Figure 1.1.11 Revealed Comparative Advantages of the BRICs in trade with the Triad .. 19 Figure 1.1.12a EU27: RCAs by industry groups (Taxonomy I)...... 20 Figure 1.1.12b EU27: RCAs by industry groups (Taxonomy II) ...... 20 Figure 1.1.13a Competition on EU market in labour-intensive industries, changes in import prices and market shares, 2000-02 compared to 2005-07 ...... 22 Competition on EU market in technology driven industries, changes in import prices and market shares, 2000-02 compared to 2005-07 ...... 22 Figure 1.1.13b Competition on EU market in low-skill industries, changes in import prices and market shares, 2000-02 compared to 2005-07...... 23 Competition on EU market in high-skill industries, changes in import prices and market shares, 2000-02 compared to 2005-07...... 23 Figure 1.1.14 China’s trade structure according to broad economic categories (1995-2007) (in % of total trade in goods, balances in billion EUR)...... 25 Figure 1.1.15 China’s major trading partners in Parts and Components (1995-2007) (in % of total trade in goods) ...... 25 Figure 1.1.16 Total Chinese goods exports and Chinese goods exports of foreign invested firms (share in percentage – right scale)...... 26 Figure 1.1.17 Bilateral trade balances of the EU, Japan and the USA with China, EUR billion (industries classified by factor inputs) ...... 27 Figure 1.1.18 RCA of China in technology driven goods and share of foreign firms, in total Chinese industry output for respective industry (right scale, in % of total, year 2007) ...... 29 Figure 1.2.1 Services exports (total and to the EU27) in 2007, index, 2000=100...... 37 Figure 1.2.2 Services imports (total and from the EU27) in 2007, index, 2000=100 ...... 38 Figure 1.3.1 Outward (left) and inward (right) FDI flows of the EU, the United States and Japan (EUR billion) ...... 45 Figure 1.3.2 EU outward FDI flows to the BRICs (EUR billion) – left Share of the BRICs in the EU’s extra-EU FDI stocks (in %) – right...... 47 Figure 1.3.3 Comparison of returns on FDI of EU FDI in the BRICs and new EU member states (2007) ...... 48 Figure 1.3.4 Share of EU FDI in the BRICs’ inward FDI, average flows 2004-2007, in % – left; Comparison of FDI outflows from the EU, the USA and Japan to the BRICs, average 2005 2007, EUR million – right ...... 49 Figure 1.3.5 BRIC global FDI outward flows (left) and bilateral flows to the EU (right) (in EUR billion) ...... 57 Figure 1.3.6 Comparison of FDI inflows from the BRIC countries into the EU and the USA (average flows 2005-2007) in EUR million ...... 58 Figure 1.3.7 Goods imports from the BRICs and sales of BRIC foreign affiliates in manufacturing in the respective economy (2006), EUR million ...... 63 Figure 1.3.8 Goods exports to the BRICs and sales of foreign affiliates in manufacturing of the respective country in the BRICs (2006), EUR million ...... 63 Figure 1.4.1 Distribution of BRIC students among main destinations ...... 85 Figure 1.4.2 Distribution of BRIC students among main destinations (2003), detail by BRIC countries ...... 85 Figure 1.4.3 Distribution of BRIC highly educated workers among main destinations, year 2000...... 88 Figure 1.4.4 Highly educated foreign workers in the EU by country of birth, year 2000 89 Figure 1.4.5 Share of active cross-border patent inventions of the EU27 with selected partner regions on all applications, 1999-05 ...... 91 Figure 1.4.6 Share of active cross-border patent inventions of the EU 27 with selected partner countries on all applications, 1999-05...... 92 Figure 1.4.7 Passive cross-border patents of the BRICs; PCT filings, applications at the USPTO and EPO, period averages...... 93 Figure 2.2.1 Population and economic geographical concentration ...... 98 Figure 2.2.2 Brazilian official interest rate and exchange rate...... 102 Figure 2.3.1 Selected economic achievements of Putin’s era ...... 116 Figure 2.3.2 Russia’s external sector and oil prices...... 116 Figure 2.3.3 Russian GDP growth and contributions of main components ...... 117 Figure 2.3.4 Nominal and real rouble exchange rates ...... 118 Figure 2.3.5 Economic growth by sectors, 2002-2008 (2002 = 100) ...... 120 Figure 2.3.6 Unit Labour Costs (ULC) in Russia: growth and contributions of key components, annual averages in %, 2000-2008 ...... 123 Figure 2.5.1 GDP, exports and imports of China , 1978 = 100...... 149 Figure 3.1.1 Oil and gas consumption scenarios, mtoe, 2020-2030 ...... 172 Figure 3.1.2 EU net import scenarios for 2020 – crude oil and solid fuels ...... 173 Figure 3.1.3 EU net import scenarios for 2020 – natural gas (bcm)...... 174 Figure 3.1.4 Russian oil production and exports (mbd) ...... 175 Figure 3.1.5 Russian natural gas production and exports (bcm)...... 176

Box 1.1.1 Unit value ratios to calculate quality positioning...... 21 Box 1.3.1 Methodological approaches...... 46 Box 1.3.2 Is Mauritius really investing more in India than the EU?...... 52 Box 1.3.3 Holding companies, SPEs and the industry distribution of FDI ...... 56 Box 2.5.1 Managing China’s foreign exchange reserves ...... 151

EU and BRICs: Challenges and opportunities for European competitiveness and cooperation∗

Introduction The term BRICs, first used in 2001 by Jim O’Neill, chief economist at the investment bank Goldman Sachs, puts under a common label the four largest fast growing emerging countries (Brazil, Russia, India and China, see Goldmann Sachs, 2003). The BRICs’ common features include large territory and population, low income levels but also fast economic growth resulting in the emergence of a prosperous local middle class. Notwithstanding the current global crisis, their catching-up process is expected to continue, creating additional new opportunities as well as numerous challenges for the rest of the world and for the European Union (EU) in particular. This study shows that beyond their common features the individual BRIC countries are rather heterogeneous, posing quite different challenges and calling for specific policy responses on the side of their partners, especially the EU. Opportunities for trade and investment in the large and rapidly expanding BRIC markets are obvious and companies from the EU are already well positioned there. Major challenges include the cost competition in product markets, changing patterns in global commodity flows (energy, metals and food), non-tariff barriers to trade, regulative deficiencies e.g. concerning intellectual property rights and various institutional impediments to foreign investment. Distinct political systems, especially regarding state interference in the economy, also require different policy responses towards individual BRICs.

This study is organized as follows. Section 1 deals with foreign trade in goods and services, FDI and knowledge flows between the BRICs and the EU. For comparative purposes, the corresponding flows between the BRICs and the rest of the world, in particular with the USA and Japan are reported as well. Section 2 presents the key elements of the individual BRICs’ ‘models of economic development’ and points out the major challenges and opportunities for EU competitiveness as well as some implications for EU policies. Section 3 focuses on Russia and Brazil and their respective roles in the EU’s energy import needs.

∗ This Background Study was edited by Peter Havlik and Waltraut Urban, both wiiw. The individual sections were prepared by Peter Havlik and Roman Stöllinger (section 1.1), Olga Pindyuk (section 1.2) as well as Gábor Hunya and Roman Stöllinger (section 1.3), all wiiw. Section 1.4 was prepared by Carolina Lennon (wiiw) and Bernhard Dachs (ARC). Section 2 is based on contributions from Marcos Poplawski Ribeiro (CEPII, section 2.2), Peter Havlik (section 2.3), Jayati Ghosh (section 2.4) and Waltraut Urban (sections 2.5 and 2.6). Section 3 relies on contributions from Edward Christie (sections 3.1.1, 3.1.2, 3.1.5 and 3.3), Vasily Astrov (sections 3.1.3 and 3.1.4), both wiiw, and Marcos Poplawski Ribeiro (section 3.2).

1 1 Trade in goods and services, FDI and knowledge flows

1.1 Trade in goods

Peter Havlik and Roman Stöllinger, wiiw

1.1.1 Introduction and summary This section analyses the external trade in goods between the EU and the BRICs. We start with the global position of the EU and the BRICs in world trade (using the IMF DOT and UN COMTRADE databases) and move subsequently to the more detailed analysis of regional (individual EU countries’ trade with BRICs), commodity and industry-specific trade specialization patterns using Eurostat Comext database.

The key findings of this section can be summarized as follows: – the EU is the biggest world exporter; in imports it ranked second after the USA (year 2007); – Triad countries have lost market shares both globally and in the markets of the BRICs, this has been linked to the emergence of new players in international trade; – the EU has been relatively successful in defending its market shares, especially during the period 2000-2007; – the EU plays a more important role in BRICs‘ trade than vice versa; – the EU has trade deficits with all BRICs (with the exception of India); – among BRICs, Russia has been the most important EU export partner, China is the largest import partner; – there is a lot of diversity in EU-BRICs trade: in general, NMS trading patterns with BRICs differ from the rest of the EU and BRICs trading patterns also differ from each other; – among BRICs, only China is emerging as a serious challenge to EU’s industrial competitiveness because of its dynamic export performance and the composition of its exports which is closer to a developed country than to countries of its peer income group; – technological upgrading found in Chinese manufacturing exports is to some extent the result of Triad’s foreign companies operating in and exporting out of China; – revealed comparative advantages of China are also partly shaped by the comparative advantages of foreign firms that decided to establish subsidiaries in China as well as the high share of processing trade in China’s imports and exports – the global crisis resulted in a sharp fall of BRICs’ goods exports and imports in the first quarter of 2009, but signs of a recovery are already visible. Among BRICs, Russia was hit particularly hard.

2 1.1.2 Global trade in goods The EU is the world’s leading exporter of goods. In 2007, extra-EU exports amounted to EUR 1200 billion – about 17% of total world exports - not including intra-EU dispatches. With imports of EUR 1370 billion (18.1% of the world total - not including intra-EU dispatches), the EU is also the second largest importer, only closely behind the United States whose imports totalled EUR 1500 billion in 2007 (18.5%) – see Figures 1.1.1 and 1.1.2. The rapid growth of Chinese exports over the past two decades has made China advance to rank two in the global list of world exporters (11.8% of total; including Hong Kong even 15.3%), overtaking both the USA and Japan (Figure 1.1.1). In terms of imports, China is still behind the EU and the USA but ahead of Japan (Figure 1.1.2).

Figure 1.1.1 Global market shares in goods exports

1995 2000 2005 2007

25 s 20 port x e

15

d goods 10

5 of worl %

0 EU USA Japan Brazil Russia India China Hong Triad BRICs Kong

Source: IMF, Directions of Trade, wiiw calculations. Calculation of market shares based on extra-EU exports only.

3

Figure 1.1.2 Global shares in goods imports

1995 2000 2005 2007 25 s

ort 20 p x e

s 15

10 world good

f 5 o %

0 EU USA Japan Brazil Russia India China Hong Triad BRICs Kong

Source: IMF, Directions of Trade, wiiw calculations. Calculation of market shares based on extra-EU imports only.

Differing growth rates in exports and imports over the last two decades have caused a significant reallocation of market shares between countries of these two country groupings, mainly from the Triad to the BRICs.1 Figure 1.1.1 shows that the export market shares of the Triad have all significantly decreased over the period 1995 to 2007. In the case of the EU, the share in global exports decreased from 19% in 1995 to 17% in 2007 with the strongest decline in the period 1995-2000.2 In fact, the EU global export market shares seem to have stabilized since then and even show a slight increase between 2000 and 2007. The loss in export market shares over the last two decades is more pronounced in the case of the USA and Japan. Market shares declined to 11.3% in the case of the USA, down more than 4 percentage points (pp) compared to 1995. Japan recorded a loss of 5pp of its share in global exports, leaving it with a market share of 7% in 2007. Comparing the losses in market shares of the Triad countries, the EU was relatively successful in defending its market share.

The decline of global market shares in goods exports of industrialized countries, which reached its peak around 1993 (WTO – World Trade Report, 2008), coincides with the emergence of new players on the world markets. These new players include all four BRIC countries. With regards to merchandise trade, the pre-eminent role of China as an exporter stands out. During the period 1995-2007 China’s market share in global exports almost tripled, from 4% to 11.8%. Parallel to – and mainly caused by – the rise of China as a world class export power, the market share of Hong Kong (including re-exports) decreased

1 All growth rates, market shares, etc. are calculated from nominal values due to the lack of appropriate deflators. This affects mainly Russian exports and the related trade surpluses due to fluctuating energy prices. 2 Since the interest here is with the EU as an aggregate global export shares are calculated based on world trade excluding intra-EU trade.

4 steadily over the 1995-2007 period. This is explained by the development of special economic zones (SEZ) in Southern China and the relocation of export-orientated manufacturing production from Hong Kong to these Chinese SEZ. Furthermore, China made intensive use of Hong Kong’s port for the dispatchment of its exports. With the development of the ports in Shanghai and Shenzhen the role of Hong Kong as entrepôt for the trade of mainland China decreased (Klau and Fung, 2006). Nevertheless Hong Kong’s re-exports are still significant, totalling around EUR 240 billion (3.3% of total) in 2007.

1.1.3 Bilateral trade relations between Triad countries and the BRICs The EU’s leading role in international trade also survives when bilateral relations between the Triad and the BRICs are regarded. The comparison of shares in total imports of the BRICs reveals that the EU has the highest market shares among the Triad countries – with the notable exception of China (Figure 1.1.3). In China, Japan accounts for roughly 15% of imports, compared to 12.8% of the EU (and 8% of the USA). This can be explained by the high degree of trade integration in Asia. In Russia, the EU had an impressive import market share of 44% in 2007, up from 40% in the year 2000, and far ahead of the USA and Japan which are not major trading partners for Russia. Japan also has a higher market share in Hong Kong’s imports, for the same reason as for China, but in both cases the EU has still a larger market share than the USA. Interestingly, the EU also occupies a higher market share in Brazilian imports than then USA, with the differential in market share increasing from less than 3 pp in 2000 to approximately 6.5 pp in 2007. Both the EU and the United States experienced a decline of their market share in Brazilian imports over the 2000-2007 period which is in line with the general tendency in the BRICs. Notable exceptions are the rise of the EU’s import market share in Russia and the stabilization of the US share in the India’s import market.

5

Figure 1.1.3 Shares of the Triad in goods imports of BRICs in % of total imports

1995 2000 2007 50 45 40 35 30 25 20 15 10 5 0 EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN Brazil Russia India China Hong Kong BRICs

Source: UN Comtrade, wiiw calculations.

It appears that the EU companies make intensive use of the trade channel to serve the markets of the BRICs and are also rather successful compared to the USA and Japan, which are less favourable positioned in most of the BRICs in terms of import market shares.

Despite falling market shares in the BRICs, their importance as trading partners for the Triad countries is on the rise – the result of much faster export and import growth rates of these countries. On the export side Russia has become the main export partner of the EU among the BRICs, absorbing 7.1% of extra-EU exports, slightly ahead even of China (5.8%). For the USA and Japan, in contrast, Russia is less significant as an export market. For them, China is the major export destination among the BRICs. All Triad countries have in common that their shares of both exports destined for and imports from China have increased between 2000 and 2007, with a higher share occupied in imports, surpassing 20% in the case of Japanese imports (2007). In the EU and USA, imports from China have exploded, rising by 8.8 pp and 8.3 pp to reach 16.4% and 16.9% of total imports respectively (2007). On the export side, the increase of the relative importance of China as a trading partner is muss less pronounced, reaching approximately 5.8% of total EU as well as total US exports. For the EU and the USA, a by-product of these developments is the increasing trade deficit, especially with China. In 2007, the bilateral trade with China and Russia contributed 84% to the total trade deficit of the EU, up from 56% in the year 2000 (Figure 1.1.4). The US trade deficit exceeded EUR 700 billion and was much larger than the EUR 260 billion deficit recorded by the EU.3 US trade deficit was considerably less

3 The EUR 260 billion are the trade deficit for extra-EU trade as calculated from UN Comtrade. Extra-EU trade was derived by deducting intra-EU exports and imports from trade with the world. The EUR 260 billion might exaggerate the extra-EU trade deficit

6 biased towards the BRICs (though bilateral trade with China still accounted for 29% of the total US trade deficit).

Figure 1.1.4 Contribution of the BRICs to the trade deficits of the EU and the USA, in %

Brazil Rus si a India Chi na Hong Kong 100

80

60

40

20

0 EU USA EU USA -20 2000 2007

Source: UN Comtrade, wiiw calculations.

There are several factors contributing to China’s strong export performance. One of the factors is that the Triad countries provided China with the necessary capital goods, technology and know-how to diversify and upgrade domestic industrial and export capacities. An indication for this is the very high share of capital goods in China’s imports from the Triad countries, especially from the EU (Figure 1.1.5). The same is also true for Chinese imports from the United States (although less so for imports from Japan).

because reported intra-EU exports are higher than reported imports. The EU trade deficit as reported by IMF’s Directions of Trade database amounted to EUR 159 billion in 2007. The deficit of the United States is also lower according to this dataset (EUR 623 billion).

7 Figure 1.1.5 Imports of the BRICs by broad economic categories (2007)

Primary Semi-finished Brazil Parts and Components Consumption Capital

100

80

60

40

20

0 EU27 USA Japan World

Russia

100

80

60

40

20

0 EU27 USA Japan W orld

India

100

80

60

40

20

0 EU27 USA Japan W orld

China

100

80

60

40

20

0 EU27 USA Japan World Source: UN Comtrade. BEC Classification. Motor spirits are not allocated to any of the BEC categories and are therefore omitted.

8 The import of capital goods, however, cannot be the sole catalyst for China’s exceptional trade performance as the other BRICs have at least equally high shares of capital goods from the Triad countries. A distinctive feature of Chinese trade is the high share of parts and components (P&C), particularly on the import side. The trade in P&C constitutes a deep form of economic integration because it entails the geographic separation of the production process of goods. In contrast, this form of trade integration is much less developed in Russia and also India.4 The split-up of the trade according to broad economic categories, which reflect different stages of production, also shows that China’s and India’s trade is characterised by a very low share of imports of consumption goods. Consumption goods only account for 4.4% of China’s and 4.6% of India’s aggregate goods imports. Compared to these very low shares, both China and India import relatively more consumption goods from the EU (10.7% and 6% respectively). In contrast, consumption goods are the major category in Russian imports accounting for 36% of total imports in trade with the world and only slightly less in bilateral trade with the EU.

1.1.4 Country-specific patterns of EU-BRICs trade With a share of 17%-18% in world trade the EU is indeed a trading giant. Yet about two thirds of EU trade represent intra-EU dispatches (intra-EU exports and imports) which are not included in the above percentages; for the EU new member states (NMS) which joined in 2004 and 2007 respectively the share of intra-EU trade is even higher (and that of BRICs correspondingly lower).5

Table 1.1.1 provides an overview of the overall EU trade with individual BRICs, the Triad and the rest of the world (RoW), separately for EU15 (‘old’ EU member states prior to 2004 enlargement) and the NMS12, during the period 2000-2008. Altogether, the BRICs accounted for just 6% of total EU exports in 2008 – less than exports to the USA (6.2%) – but their share doubled since the year 2000. The growing importance of BRICs is even more visible in EU imports: an increase of import shares from 6.3% in 2000 to 11.6% of total EU imports in 2008, largely thanks to a growing importance of imports from China which accounts for half of EU imports from BRICs. The BRICs gained market shares in the EU mainly at the expense of the USA and Japan (especially in EU imports). Generally, EU exports to BRICs are less important than imports: the latter account for a bigger share of overall EU imports and explain also EU trade deficits.

4 For an analysis of the role of trade in parts and components in shaping Chinese trade patterns see section 1.1.8. In a similar contrast to China, the role of intra-industry trade in Russia is extremely low – see Fertö and Soos (2008). 5 The rest of this section is based mainly on Eurostat Comext database. The subsequent analysis covers total EU trade (both intra- and extra) since we are interested not only in the EU as a whole but in the performance of individual EU countries (e.g. NMS relative to BRICs) as well.

9

Table 1.1.1 Overview of the total EU goods trade

EU15 Exports Imports Trade Balance EUR bn shares EUR bn shares EUR bn Partne 2000 2007 2008 2000 2007 2008 2000 2007 2008 2000 2007 2008 2000 2007 2008 r Brazil 16.6 20.7 25.5 0.7 0.6 0.7 17.6 31.3 34.1 0.7 0.9 0.9 -1.0 -10.6 -8.6 Russia 19.9 74.0 85.1 0.8 2.1 2.4 45.7 109.0 126.0 1.8 3.1 3.4 -25.8 -35.0 -40.9 India 13.4 28.4 30.1 0.5 0.8 0.8 12.4 24.9 27.5 0.5 0.7 0.8 1.0 3.5 2.6 China 25.5 69.2 75.3 1.0 2.0 2.1 70.3 211.0 223.7 2.8 6.0 6.1 -44.8 - - 141.8 148.4 BRICs 75.4 192.3 216.0 3.0 5.5 6.1 146.0 376.2 411.3 5.8 10.7 11.3 -70.6 - - 184.0 195.3 Japan 44.9 42.5 41.0 1.8 1.2 1.1 87.1 72.0 68.3 3.5 2.0 1.9 -42.2 -29.5 -27.3 USA 232.5 253.3 241.0 9.3 7.3 6.8 199.0 175.2 179.5 7.9 5.0 4.9 33.4 78.0 61.5 RoW 477.6 675.8 710.9 19.0 19.4 19.9 513.4 685.3 739.9 20.3 19.4 20.2 -35.8 -9.5 -29.0 EU15 1556. 2065. 2073. 62.1 59.2 58.1 1478. 2012. 2014. 58.6 57.0 55.1 77.5 52.4 58.9 1 2 9 7 8 9 NMS1 121.3 260.7 277.3 4.8 7.5 7.8 100.2 215.5 231.0 4.0 6.1 6.3 21.1 45.2 46.0 2 EU27 1677. 2324. 2359. 66.9 66.6 66.1 1578. 2223. 2255. 62.5 62.9 61.7 98.5 101.4 103.9 4 5 8 9 1 9 exEU2 830.4 1163. 1208. 33.1 33.4 33.9 945.6 1308. 1399. 37.5 37.1 38.3 - - - 7 8 9 7 0 115.2 144.9 190.1 WORL 2507. 3488. 3568. 100.0 100.0 100.0 2524. 3531. 3654. 100.0 100.0 100.0 -16.6 -43.5 -86.2 D 9 2 7 5 8 9 NMS12 Exports Imports Trade Balance EUR bn shares EUR bn shares EUR bn Partne 2000 2007 2008 2000 2007 2008 2000 2007 2008 2000 2007 2008 2000 2007 2008 r Brazil 0.3 0.6 0.9 0.2 0.2 0.2 1.0 1.4 1.5 0.5 0.3 0.3 -0.8 -0.8 -0.6 Russia 2.8 15.1 20.1 1.9 3.8 4.6 18.1 35.0 47.3 9.5 7.5 9.1 -15.2 -19.9 -27.2 India 0.3 1.1 1.4 0.2 0.3 0.3 0.5 1.4 1.9 0.3 0.3 0.4 -0.2 -0.3 -0.5 China 0.4 2.7 3.1 0.2 0.7 0.7 4.4 20.6 24.0 2.3 4.4 4.6 -4.0 -17.8 -20.9 BRICs 3.7 19.5 25.5 2.5 4.9 5.8 23.9 58.3 74.7 12.6 12.5 14.4 -20.2 -38.8 -49.2 Japan 0.6 1.3 1.4 0.4 0.3 0.3 5.0 6.2 6.5 2.6 1.3 1.3 -4.4 -4.8 -5.1 USA 5.7 8.1 8.3 3.9 2.0 1.9 7.3 6.1 6.9 3.8 1.3 1.3 -1.5 2.1 1.4 RoW 19.0 56.4 64.6 12.8 14.2 14.6 23.4 54.9 63.7 12.3 11.8 12.3 -4.4 1.6 0.9 EU15 99.0 236.2 252.7 67.1 59.3 57.2 111.2 267.6 281.5 58.7 57.4 54.3 -12.2 -31.4 -28.8 NMS1 19.6 76.9 88.6 13.3 19.3 20.1 18.8 74.1 84.3 9.9 15.9 16.3 0.8 2.8 4.3 2 EU27 118.7 312.8 341.8 80.4 78.6 77.4 130.0 341.0 366.4 68.6 73.1 70.7 -11.4 -28.2 -24.6 exEU2 29.0 85.4 99.8 19.6 21.4 22.6 59.5 125.4 151.8 31.4 26.9 29.3 -30.5 -40.0 -52.0 7 WORL 147.6 398.3 441.6 100.0 100.0 100.0 189.5 466.5 518.2 100.0 100.0 100.0 -41.9 -68.2 -76.6 D EU27 Exports Imports Trade Balance EUR bn shares EUR bn shares EUR bn Partne 2000 2007 2008 2000 2007 2008 2000 2007 2008 2000 2007 2008 2000 2007 2008 r Brazil 16.9 21.3 26.3 0.6 0.5 0.7 18.7 32.7 35.5 0.7 0.8 0.9 -1.8 -11.4 -9.2 Russia 22.7 89.1 105.2 0.9 2.3 2.6 63.8 144.0 173.3 2.3 3.6 4.2 -41.0 -54.9 -68.2 India 13.7 29.5 31.5 0.5 0.8 0.8 12.8 26.3 29.4 0.5 0.7 0.7 0.8 3.2 2.1 China 25.9 71.9 78.4 1.0 1.9 2.0 74.6 231.6 247.6 2.7 5.8 5.9 -48.8 - - 159.6 169.2

10 BRICs 79.1 211.8 241.4 3.0 5.4 6.0 169.9 434.6 485.8 6.3 10.9 11.6 -90.8 - - 222.8 244.4 Japan 45.5 43.8 42.4 1.7 1.1 1.1 92.1 78.1 74.8 3.4 2.0 1.8 -46.6 -34.4 -32.4 USA 238.2 261.4 249.4 9.0 6.7 6.2 206.3 181.3 186.3 7.6 4.5 4.5 31.9 80.1 63.1 RoW 496.6 732.2 775.4 18.7 18.8 19.3 536.8 740.1 803.7 19.8 18.5 19.3 -40.2 -7.9 -28.3 EU15 1655. 2301. 2326. 62.3 59.2 58.0 1589. 2280. 2296. 58.6 57.0 55.0 65.3 21.0 30.1 2 4 6 9 4 5 NMS1 140.9 337.6 365.8 5.3 8.7 9.1 119.0 289.6 315.5 4.4 7.2 7.6 21.9 48.0 50.3 2 EU27 1796. 2637. 2701. 67.6 67.9 67.4 1708. 2564. 2621. 63.0 64.1 62.8 87.2 73.2 79.8 1 3 7 9 1 9 exEU2 859.4 1249. 1308. 32.4 32.1 32.6 1005. 1434. 1550. 37.0 35.9 37.2 - - - 7 2 6 1 1 7 145.7 184.9 242.1 WORL 2655. 3886. 4010. 100.0 100.0 100.0 2714. 3998. 4172. 100.0 100.0 100.0 -58.5 - - D 5 5 3 0 2 6 111.7 162.3 Source: Eurostat-Comext, wiiw calculations. Note: EU15 and NMS12 do not add to EU27 due to reporting errors.

From the perspective of EU trade policies, the analysis of trade statistics shows that China and Russia are the main EU trading partners among BRICs and thus represent key challenges (though, as will be shown below, both for markedly different reasons).

11 Figure 1.1.6 Diversity in EU exports to BRICS, 2007 (deviations from EU average share in exports, in pp)

Brazil Russia India China

Austria

Belgium

Bulgaria

Cyprus

Czech Republic

Denmark

Estonia

Finland

France

Germany

Greece

Hungary

Ireland

Italy

Latvia

Lithuania

Lux em bourg

Malta

Netherlands

Poland

Portugal

Romania

Slovakia

Slovenia

Spain

Sweden

United Kingdom

EU15

NMS12

-4-202468101214 Source: Eurostat Comext, wiiw calculations.

12 Figure 1.1.7 Diversity in EU imports to BRICS, 2007 (deviations from EU average in imports, in pp)

Brazil Russia India China

Austria

Belgium

Bulgaria

Cyprus

Czech Republic

Denmark

Estonia

Finland

France

Germany

Greece

Hungary

Ireland

Italy

Latvia

Lithuania

Luxembourg

Malta

Netherlands

Poland

Portugal

Romania

Slovakia

Slovenia

Spain

Sweden

United Kingdom

EU15

NMS12

-15 -10 -5 0 5 10 15 20

Source: Eurostat Comext, wiiw calculations.

13 EU trade with BRICs grew faster than average during the period 2000-2008, especially regarding exports to Russia and India (EU exports to Brazil were rather sluggish). Again, NMS exports have been more dynamic than the EU average. In particular, NMS exports to China and Russia were growing rather fast. Also EU imports from the BRICs (again mainly from China and Russia) were rapidly rising with NMS’ imports increasing more than EU average (Table 1.1.1).

Except for India, the EU has trade deficits with all BRICs (EUR 245 billion in 2008). The largest (and rising) trade deficits have been recorded in trade with China and Russia (the latter is fluctuating in line with energy prices). The NMS have trade deficits with all BRICs and their main BRICs’ trading partner has not been China (as it is the case for EU15) but Russia (with respect to both exports and imports).

In general, the NMS have been trading relatively less with the BRICs than EU15 countries do (except NMS’ trade with Russia). Indeed, a higher share of BRICs in some EU countries’ exports and imports results largely from their more trade exposure towards Russia (e.g. the three Baltic States, Finland, Bulgaria, Poland, Slovakia, Slovenia and Germany – see Figures 1.1.6 and 1.1.7). There is much less diversity in EU’s trade exposure regarding other BRICs: Finland, Germany and Luxembourg export relatively more (than EU average) to China. Luxembourg, the Netherlands, Hungary and the United Kingdom import relatively more from China. However, the divisive role of Russia in EU member states trade is exceptional in this respect (crucial for some EU countries, negligible for others). Imports from China are relatively important for Hungary, the Netherlands and United Kingdom yet the differences with respect to other EU countries are much smaller than in the case of Russia (Figure 1.1.7).

Obviously, the above differences in relative trade exposure of individual EU member states towards individual BRIC countries have important implications for the formulation of common EU policies: EU member states with lower trade exposure have a lower stake in policy formulation regarding particular BRIC and/or may be guided less by commercial interests than by other issues (security and environmental concerns, human rights, etc).6

1.1.5 Sectoral composition of EU-BRICs goods trade The bulk of overall EU exports – about 91% of the total – represent manufacturing industry products. In exports to BRICs, the EU’s focus on manufacturing is even more pronounced: about 95% of EU exports to BRICs are manufacturing products. The only exception are exports to India where the share of manufacturing amounted to just 78% of total EU exports in 2007; exports of mining and quarrying accounted for 18.7% of the total (in 2000 even

6 Baltic States and several other NMS may serve as an example: despite their strong trade exposure to Russia they are less prone to compromise trade for other policy issues.

14 33.6% of the total).7 Exports of other industries are small (e.g. agriculture, hunting and forestry: 2.6% of EU exports – mostly to Russia) or virtually non-existent.

EU imports from BRICs are somewhat more diversified, although manufacturing industry products prevail as well, especially in imports from India and China (Figure 1.1.8). Apart from manufacturing industry, imports of mining and quarrying products are important – in particular from Brazil (17.8% of EU imports in 2007, mostly non-energy mining products to Belgium, the Netherlands and Germany) and especially imports from Russia (52.1% of EU imports from Russia – mostly crude oil and natural gas). It is interesting to note that imports from China (and Japan) consist almost exclusively of manufacturing products; agriculture plays a more prominent role only in EU imports from Brazil (18.9% of the total – see Figure 1.1.8).

Figure 1.1.8 Structure of EU imports from BRICs, 2007 by NACE sectors In %

Brasil Rus si a India Chi na World

120 Manufacturing 100

80

60 Mining

40 Other Agriculture 20 n/a

0 ABC DEKOX

Note: including intra-EU trade. A-X represent NACE sectors. Source: Eurostat Comext, wiiw calculations.

There is not much difference in broader sectoral structures of NMS and EU15 trade with BRICs. However, the NMS’ exports are in general even more specialized on manufacturing industry, this specialization pattern is even more pronounced in their trade with the BRICs. As far as imports are concerned, the striking feature are relatively low NMS’ manufacturing imports from Russia (less than 20% of total NMS imports from Russia in 2007) and the correspondingly high share of mining and quarrying products – especially of crude oil and natural gas. This pattern did not change much in the last couple of recent years: the share of manufacturing in NMS’ imports from Russia even declined between 2000 and 2007.8

7 These are predominantly non-energy mining products exports from Belgium (presumably diamonds). 8 However, at the end of 1980s – before transition – the NMS (at that time members of the Soviet-dominated Council of Mutual Economic Assistance) imported much more manufactured products from the USSR (Russia) – see Havlik, 1990). Russia complains that its declining share of manufacturing in NMS’ imports is one of the adverse consequences of their EU (pre)accession trade policies and EU enlargement – see Glinkina and Kulikova in Grinberg et al (2008).

15 Together with declining import shares from Brazil, this is a unique development regarding not only the structure of NMS overall imports, but also contrasting with the structure of imports from China and India.

1.1.6 Specialization patterns in EU-BRICs manufacturing industry trade Owing to its overwhelming role, the rest of this section will focus on EU-BRICs manufacturing industry trade. We start with the analysis of commodity composition of manufacturing exports and imports at 2-digit NACE level, and then move on to more detailed specialization patterns (at NACE 3-digit industry-group level) while trying to identify EU competitive strengths and weaknesses with respect to the BRICs.

EU manufacturing trade has been fairly diversified, yet the following 3 industries (at 2-digit NACE level) play the leading role in both EU exports and imports: chemicals (NACE 24), machinery and equipment (NACE 29) and motor vehicles (NACE 34). Besides, trade with food products and beverages (NACE 15), basic metals (NACE 27) and electrical machinery (NACE 31) is also fairly important in the overall EU trade.9

Figures 1.1.9a and 1.1.9b show the relative specialization patterns in EU’s manufacturing trade with the BRICs and the rest of the world (extra-EU). In exports to BRICs, the EU is underrepresented (in terms of differences in individual industries’ shares in exports to BRICs relative to the structure of overall EU exports – Figure 1.1.9a) mainly in food products and beverages (NACE 15 – except Russia), in coke and refined petroleum (NACE 23), and in chemicals (NACE 24, except Brazil). Besides, with a difference in export share of about -10 pp, there was very little EU exports of motor vehicles (NACE 34) to India. On the other hand, the EU has a huge positive specialization (above average export shares) with regard to BRICs in exports of machinery and equipment (NACE 29 – especially to India and China), and in other transport equipment (NACE 35, except exports to Russia). China represents also an important market for EU exporters of electrical machinery and apparatus (NACE 31 – see Figure 1.1.9a).

The structure of EU imports from BRICs is much more focused on just a few industries (Figure 1.1.9b; note the different scale of the two figures). Food and beverages (NACE 15) dominate EU imports from Brazil, coke and refined petroleum (fuels: NACE 23) as well as basic metals (NACE 27) EU imports from Russia (note that this is in addition to unprocessed energy products such as oil and gas). The office machinery (NACE 30) and radio, TV, communication equipment (NACE 32) dominate imports from China. EU imports from India display a relative specialization on textiles (NACE 17), wearing apparel (NACE 18) and other manufacture, including furniture, games and toys, sports goods and

9 The structure of extra-EU trade is rather similar except that extra-EU exports concentrate even more on chemicals (NACE 24), machinery and equipment (NACE 29), and other transport equipment (NACE 35) whereas extra-EU imports focus less on machinery (NACE 29), motor vehicles (NACE 34) and more on wearing apparel (NACE 18), coke and refined petroleum (NACE 23), office machinery (NACE 30) and instruments (NACE 33) – see Annex I.

16 jewellery (NACE 36). In relative terms, EU imports much less motor vehicles from the BRICs. Already at this level of detail one can see an impressive technological upgrading of China’s exports (i.e. EU imports from China) compared to other BRICs and also compared to the rest of the world (including USA and Japan); we shall illustrate this feature with more detailed arguments below.

Figure 1.1.9a Structure of EU manufacturing exports to BRICs by NACE 2-digit industries (differences to total exports in pp, 2007)

Brazil Russi a India China EU-extra

15 Mhi 10 Transport eq. 5

0

-5

-10 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36

Source: Eurostat Comext, wiiw calculations.

Figure 1.1.9b Structure of EU manufacturing imports from BRICs by NACE 2-digit industries (differences to total imports in pp, 2007, note different scale)

Brazil Russia India China EU-extra

50

40

30 Metals

20

10 Cars. 0

-10

-20 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36

Source: Eurostat Comext, wiiw calculations.

17 Figure 1.1.10a EU27: Imports by industry groups (Taxonomy I)

1. Mainstream 2. Labour intensive industries 3. Capital intensive industries 4. Marketing driven industries 5. Technology driven industries 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 Brazil Russia India China Japan USA RoW EU27 World

Source: Eurostat Comext, wiiw calculations.

Figure 1.1.10b EU27: Imports by industry groups (Taxonomy II)

1. Low skill industries 2. Medium skill/blue collar workers

3. Medium skill/white collar workers 4. High s kill industries 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 Brazil Russia India China Japan USA RoW EU27 World

Source: Eurostat Comext, wiiw calculations.

The analysis of EU trade at the more detailed (NACE 3-digit) level employs the classification of industries according to factor inputs (Taxonomy I) and labour skills (Taxonomy II) inputs (see Peneder, 2003).10 Figure 1.1.10a shows the structure of EU imports from BRICs, Japan, USA, the rest of the world and the EU (intra-EU trade) by industry groupings classified according to factor inputs and the shares of individual

10 The list of 3-digit NACE industries and their allocation to industry groupings according to both taxonomies is in Annex 1.

18 groupings in total imports (Taxonomy I).11 In EU imports from Brazil (and even more so in imports from Russia) the capital-intensive industries prevail, just as labour-intensive industries prevail (though their share is diminishing) in imports from India. However, the share of this group of industries in EU imports from China is much lower whereas the technology-driven industries increasingly dominate: the share of this group of industries in EU imports from China was in 2007 already higher than in intra-EU imports. Needless to say, the shares of this group of industries are even higher in EU imports from Japan and USA, but – in contrast to China – they both have declined between 2000 and 2007.

Regarding the industry classification by labour skills (Taxonomy II), the low-skill industries dominate in EU imports from Brazil and India (Figure 1.1.10b), medium-skill industries in imports from Russia (refined petroleum is included here). EU imports from China are divided into low- and medium-skill industries (both with declining shares) while the group of high-skill industries recorded rapidly rising shares between 2000 and 2007 - again providing evidence for Chinese technological upgrading. The labour skills structure of EU imports from China is becoming similar to the structure of intra-EU trade.

1.1.7 Revealed comparative advantages of BRICs and the EU The diversification and upgrading of exports from the BRIC countries have resulted in their comparative advantage gains.12 Although all BRICs maintain revealed comparative advantages (RCAs) in Triad’s trade in labour-intensive industries,13 the positive RCAs are not limited to these. Trade data of the BRICs indicate that they have comparative advantages (positive RCAs) also in marketing driven industries (except for Russia in trade with the EU and the United States and Brazil in trade with Japan; Russia’s positive RCAs in marketing driven industries in trade with Japan can be largely attributed to fish product exports), which are predominantly food and beverages. In the case of China, the RCA calculations for 2007 already points towards a (small) comparative advantage in technology driven industries. In contrast to trade developments with other BRIC countries, the RCAs of

11 We do not discuss here the structures of EU exports because there are not larger differences among BRICs and other regions (technology driven, capital intensive and mainstream industries prevail in EU exports). 12 The RCA analysis here is again based on industry classification by (Peneder, 2003). Not captured is the possibility that within, for example, a technology-driven industry, the labour-intensive steps of productions are located in the BRICs with the intention to re-export. UN Comtrade database is used for computing BRICs’ RCAs. ⎛ X ⎞ ⎜ ci ⎟ ⎜ M ci ⎟ RCAs are calculated according to the Balassa’s formula RCAci = 100 ⋅ ln⎜ ⎟ ; where X (M) are exports (imports), c ∑ X ci ⎜ i ⎟ ⎜ ∑ M ci ⎟ ⎝ i ⎠ denotes a partner country and i the respective industry-grouping (RCAs were calculated from individual 3-digit NACE industry trade data) – see Balassa (1965). ). Positive (negative) RCA values indicate a comparative (dis)advantage. The use of a different version of RCA index (e.g. Lafay’s – see Baumann and di Mauro, 2007) would lead to similar conclusions regarding comparative advantages. 13 Russia is an exception among BRICs in this respect since it has a comparative disadvantage also in labour-intensive industries in trade with the EU and the United States.

19 the Triad countries are frequently shrinking in trade relations with China between 2000 and 2007; in the case of the EU this part of RCAs has already been lost. This may explain the worries about the EU’s capacity to keep its competitive edge in high tech products (cf. European Commission, 2008).

The above analysis has shown that BRICs trading and trade specialization patterns are far from identical: Brazil has positive RCAs in marketing-driven (food processing) and, though less so, labour-intensive (textiles) industries (Figure 1.1.11). Russia has positive RCAs only in capital-intensive industries, mostly due to strong exports of refined petroleum and diverse metal products. This indicates that Russia was much less successful in diversifying its exports than the other BRICs. There are highly negative RCAs in mainstream and especially in technology-driven industries in Russia. Note that positive RCAs in labour- intensive industries’ trade with the EU and the USA disappeared by 2007 – perhaps a consequence of the rapidly rising unit labour costs in Russia). China’s RCA patterns are less pronounced, but there is a comparative disadvantage in capital-intensive industries with all Triad countries, whereas China holds positive RCAs in labour-intensive industries (e.g. wearing apparel) and marketing-driven industries (e.g. games and toys, sports goods). Chinese negative RCAs in technology driven industries are much smaller than those observed in other BRICs; comparative disadvantages in trade with the USA disappeared in this group of industries; in trade with the EU it became even positive by 2007. This feature of Chinese trade, i.e. the relative strength in exporting technology-driven industries, may be surprising but is fully in line with the literature on Chinese trade which found that China’s exports are indeed technologically more advanced than its level of income would suggests (Rodrik, 2006) and that its export bundle is more similar to those of developed countries than those of countries with similar levels of income (Schott, 2006). India’s distribution of RCAs is very similar to those of Brazil (except the former slightly negative RCAs in capital-intensive industries, especially in trade with the USA).

From the EU point of view (and using the same definition of RCAs), but this time using again trade data from the Eurostat Comext database), the RCA patterns in EU trade with BRICs are also rather diverse (Figure 1.1.12a and 1.1.12b). There were positive RCAs in mainstream and technology driven industries in EU trade with Brazil and India (Figure 1.1.12a). There were also positive RCAs in all industry groupings – except capital-intensive industries – in EU trade with Russia (and still an overall trade deficit). Last but not least, negative RCAs in both labour-intensive and marketing-driven industries persisted in EU trade with China. Moreover, the (small) positive RCA in technology-driven industries turned negative between the years 2000 and 2007 – another sign of Chinese technological upgrading. As shown in Figure 1.1.12b, the latter can be traced virtually in all groups of industries classified by labour skills. In contrast to other BRICs, the EU’s RCAs in trade with China (and less so with India) are diminishing – this is true even for EU’s positive RCAs in medium- and high-skill industries. Nevertheless, the EU still enjoyed positive

20 RCAs in trade with BRICs in these two groups of industries – in contrast to the EU trade with both Japan and the USA where RCAs were negative.

Figure 1.1.11Revealed Comparative Advantages of the BRICs in trade with the Triad Brazil RCA2000 RCA2007 Mainstream Labour int.ind. Capital int.ind. Marketing driv.ind. Technol. driven 400

300

200

100

0

-100

-200

-300

-400 EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN Russia RCA2000 RCA2007

400 300

200

100

0

-100

-200

-300

-400 EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN India RCA2000 RCA2007

400

300

200

100

0

-100

-200

-300

-400 EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN

21 China RCA2000 RCA2007

400

300

200

100

0

-100

-200

-300

-400 EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN EU27 USA JPN Source: UN Comtrade, wiiw calculations.

Figure 1.1.12a EU27: RCAs by industry groups (Taxonomy I) 1. Mainstream 2. Labour intensive industries 3. Capital intensive industries 4. Marketing driven industries 5. Technology driven industries 400

300

200

100

0

-100

-200

-300 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 Brazil Russia India China Japan USA

Source: Eurostat Comext, wiiw calculations.

22

Figure 1.1.12b EU27: RCAs by industry groups (Taxonomy II)

1. Low skill industries 2. Medium skill/blue collar workers 3. Medium skill/white collar workers 4. High skill industries 350 300 250 200 150 100 50 0 -50 -100 -150 -200 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 2000 2007 Brazil Russia India China Japan USA Source: Eurostat Comext, wiiw calculations.

Last but not least, we analyse also patterns of competition at EU markets by looking at changes in import prices (so-called unit value ratios – UVR – see Box 1.1.1 the definition) and market shares during the period 2000-2007 by the same industry groupings used above. We compare the performance of individual BRICs with Japan, USA, NMS and the EU15 on the overall EU market (consisting of both extra and intra-EU trade). It is often claimed that BRICs (especially China) compete at EU markets mainly with low prices and correspondingly low quality products (that means with below average prices and thus negative UVRs) and in this way increase their market shares. On the other hand, if both prices (positive UVRs) and market shares increase, one can speak of successful quality competition (see Landesmann and Wörz, 2006). In this purpose, we have calculated the average changes in UVRs and market shares for each country for the periods 2000-2002 and 2005-2007 in order to smooth out possible outliers. The results for selected industry groupings by Taxonomy I are shown in Figure 1.1.13a (labour-intensive and technology-driven industries) and in Figure 1.1.13b (Taxonomy II: low-skill and high-skill industries –see Annex 1).

In labour-intensive industries, there was a uniform trend of declining import prices at the EU market – except for imports from ‘old’ EU member states (EU15) where UVRs increased above average. At the same time, only China (and so India) gained market shares whereas the USA and Japan (and even more so EU15) suffered considerable market share losses. India, and even more China, gained both market shares in the EU in labour-intensive industries with a successful price competition. Brazil and Russia just kept their market shares despite falling prices of their labour-intensive exports. In technology driven industries, EU imports from the BRICs (except Russia) became also much cheaper during the period with falling UVRs, but only China enjoyed a sizeable market share gain (also the NMS recorded market share gain with unchanged UVRs). In contrast, Brazil and India’s

23 market shares did not change, and both the USA and Japan lost market shares, despite falling export prices, in the EU. Russia (and even more so the EU15) managed to gain market shares in the EU with rising export prices.

Box 1.1.1 Unit value ratios to calculate quality positioning

Source: Landesmann and Wörz (2006).

24 Figure 1.1.13a Competition on EU market in labour-intensive industries changes in import prices and market shares, 2000-02 compared to 2005-07

Brazil China EU15 India Japan NMS Rus s ia USA 0.5

0 NMS Brazil China -0.5 R UV

n i

e -1 g n a

Ch -1.5 India

-2 Rus s ia

-2.5 -2 -1 0 1 2 3 4 5 6 Change in market share

Competition on EU market in technology driven industries changes in import prices and market shares, 2000-02 compared to 2005-07

Brazil China EU15 India Japan NMS Rus sia USA 0.4

Russ ia 0.2

0 NMS R UV

n i

e -0.2 g n a

Ch India -0.4 Brazil

-0.6 China

-0.8 -4 -3 -2 -1 0 1 2 3 4 5 6 Change in market share Source: Eurostat Comext, wiiw calculations.

25 Figure 1.1.13b Competition on EU market in low-skill industries changes in import prices and market shares, 2000-02 compared to 2005-07

Brazil China EU15 India Japan NMS Russia USA

0.2

0.1 Russia NMS 0 R

V Brazil

U -0.1 in e g

n -0.2 a India h C -0.3

China -0.4

-0.5 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5 Change in market share

Competition on EU market in high-skill industries changes in import prices and market shares, 2000-02 compared to 2005-07

Brazil China EU15 India Japan NMS Rus s ia USA

0.2

0

-0.2 Brazil R V U in

e -0.4

g NMS n a h C -0.6 India

Russia -0.8 China

-1 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 Change in market share

Source: Eurostat Comext, wiiw calculations.

26 China, but also India and even Russia (as well as the NMS) have been successful in the price competition also in high-skill industries and gained market shares in the EU whereas both Japan and USA lost market shares – the former despite declining export prices of its high-skill products (Figure 1.1.13b).14

China has been quite successful in the price competition on the EU market as it recorded the most impressive market share gains in virtually all industry groupings with falling UVRs. Moreover, China has been also quite successful in the technological upgrading of exports and emerges as the most serious competitive challenge for the EU.

1.1.8 Vertical integration of trade with China China has gained the reputation of being the workshop of the world (Sauvant, 2005) meaning that China is an attractive location for multinational firms (MNCs) to perform labour-intensive steps of the production process because of the abundant supply of relatively cheap labour. As a consequence, China has become a major platform for re- exports of international firms. The unbundling of the value chain implied by the described off-shoring strategy of MNCs results in the creation of intra-industry trade, that is, countries exchange goods of the same industry but in different stages of production. Countries engaging in this type of trade are then said to be vertically integrated.

A possibility to track the intensity of the vertical trade integration of China is to decompose Chinese trade by broad economic categories (BEC), which include primary goods, semi- finished goods, parts and components, consumption goods and capital goods. The centre of interest in the context of vertical trade integration is the share and development of parts and components (P&C) in total trade (Gaulier et al., 2007). In the case of China, the trade in (P&C) is clearly on the rise, both in exports and imports (Figure 1.1.14). It has a more prominent role, however, in imports, where together with semi-finished goods it is the main economic category, accounting for 27% of total imports. The higher share of P&C in imports is explained by the fact that final assembly in many industries is a labour-intensive process and therefore often located in a low-wage country. For China’s trade structure this implies strong imports of P&C and relatively more exports of final goods, especially consumption goods but increasingly also capital goods. Consumption goods in turn, are China’s most important economic category on the export side, although losing ground to capital goods and P&C. China’s trade structure, including the trade balance, confirms China’s role as a manufacturing base for re-exports.

14 Needless to say, EU import prices from Japan and USA (as well as import prices from EU15) are much higher than average import prices in virtually all groups of industries.

27 Figure 1.1.14 China’s trade structure according to broad economic categories (1995-2007) (in % of total trade in goods, balances in billion EUR)

China - Exports according to BEC China - Impor ts a ccordin g to BEC China - trade balances according to BEC(in 60 50 250 EUR billion) 45 200 50 40 150 35 40 30 100 30 25 50

20 0 20 15 -50 10 10 5 -100 0 0 -150 1995 1997 1999 2001 2003 2005 2007 1995 1997 1999 2001 2003 2005 2007 1995 1997 1999 2001 2003 2005 2007

Primary Semi-finished Parts & Components Consumption Capital Goods Source: UN Comtrade, wiiw calculations.

Figure 1.1.15 China’s major trading partners in Parts and Components (1995-2007) (in % of total trade in goods)

Exports Imports

60 60

40 40

20 20

0 0 1995 1997 1999 2001 2003 2005 2007 1995 1997 1999 2001 2003 2005 2007

EU USA Japan Indien Dragons Tigers World Source: UN Comtrade, wiiw calculations.

A concept closely related to vertical trade integration is that of processing trade. Processing trade consists of the import of intermediate inputs which are further processed or finished and the re-export. Processing exports may include intermediate goods (semi-finished goods, P&S) as well as final goods. In the case of China, processing exports accounted for more than half of Chinese total exports in 2007 (China Statistical Yearbook, 2008).

Going back to the analysis of trade by economic categories and using trade with P&C as an indicator for the degree of vertical trade integration, one finds that this form of international division of labour is most advanced in regional trade, i.e. trade between South-East Asian trading partners (Figure 1.1.15). For exports as well as imports, China’s trade in P&C is most intensive with the Asian Dragons (Hong Kong, Singapore, South Korea and Taiwan),

28 followed by the Asian Tigers (Malaysia, Philippines, Thailand) and Japan. In comparison to China’s Asian trading partners, the EU and the USA seem to make lesser use of China as a location for assembling and other labour-intensive tasks. This is in line with the finding of the section on foreign direct investment (FDI) that EU FDI in China (as well as in the other BRICs) is mainly market seeking and only to a lesser extent efficiency seeking.

The finding of strong vertical trade integration in South East Asia is also in line with the results of other studies on this issue which also find evidence for the existence of an Asian network of intermediate goods suppliers to China (see for example Dean et al., 2008 and Gaulier et al., 2007). With respect to the extent of vertical trade integration between China and the EU, there is evidence that increased trade is not mainly driven P&C. Whereas many middle income economies including many European countries increased their market share in the EU and did so by expanding exports in semi-finished goods, P&C and final goods, the increased share of China in total EU imports is mainly driven by final goods and to a much lesser extent by P&C (Landesmann – Stehrer, 2009). This leads to the conclusion that vertical integration and off-shoring of individual tasks of the production chain has a geographical component, so that in the case of the EU, China is not the primary candidate as an off-shoring destination.

Figure 1.1.16 Total Chinese goods exports and Chinese goods exports of foreign invested firms (share in percentage – right scale)

Total exports Exports of foreign invested enterprises Foreign invested enterprises' share in total Chinese exports

1000 60

50 s t r

40 o R p U x E E l

n 500 30 ta to illio

f b 20 o % 10

0 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: China Statistical Yearbook (2008).

The intra-industry trade created by the unbundling of the production process is interrelated with the revealed comparative advantages of China. Since the more developed Asian economies, including Japan and to a lesser extent also the EU and the United States use China as an export-platform, a high share of Chinese goods exports are on the account of foreign invested firms (Figure 1.1.16) or constitute processing trade. There is a close link

29 between Chinese exports by foreign invested firms and the notion of processing trade because processing trade is carried out largely by foreign invested enterprises (Dean et al., 2009).

Chinese data document that since 2002 more than half of Chinese exports can be attributed to the activity of foreign invested firms, with a peak in 2005 where their share increased to almost 60%. In 2007, the share of foreign invested firms in Chinese exports was still 57%. This high value as such already serves as an indication that the activities of foreign invested firms in China are strongly influencing Chinese trade patterns.

The impact of the activities of MNCs on the Chinese foreign trade has to be borne in mind when interpreting export patterns. In the context of competitiveness it certainly makes a difference whether EU firms loose – or actually relocate – export shares to their Chinese affiliates or whether these market shares are truly lost to ‘genuine’ Chinese manufacturers.

Figure 1.1.17 Bilateral trade balances of the EU, Japan and the USA with China, EUR billion (industries classified by factor inputs)*

balance1995 balance2000 balance2007

Japan Technology- driven USA industries EU27 Marketing- Japan driven USA industries EU27 Capital- Japan intensive USA industries EU27

Labour- Japan intensive USA industries EU27 Japan Mainstream Industries USA EU27

-70 -60 -50 -40 -30 -20 -10 0 10 20

* Industry classification according to Peneder (2003). Source: UN Comtrade, wiiw calculations.

Indeed, much evidence points in the direction that China’s bilateral trade balances and RCAs to a large extent reflect the comparative advantages and competitiveness of foreign firms exporting out of China. Reflecting shifts in RCAs that have occurred over the past twelve years, the EU’s and the United States’ bilateral trade deficits with China of the EU and the United States are no longer the result of negative balances in labour-intensive industries but are increasingly due to a negative balance in technology-driven industries

30 (Figure 1.1.17). In 2007, the EU and the United States both had the largest deficit in trade with China in the exchange of goods attributed to technology driven industries. This feature of EU-China trade relations (which is not found for bilateral trade with Russia, India and Brazil) is, apart from the sheer size of the deficit, another source of concern for the EU.

In order to get an idea of what might drive the development of the trade balances in technology driven industries and underlying RCAs, a comparison between Chinese (global) RCAs in technology driven industries and the importance of foreign invested firms in these Chinese industries is endeavoured. Due to the fact that a geographical split-up of foreign invested firms operating in China is not available, this type of comparison can only be made for China’s aggregate trade. Chinese industry data allows calculating the share of foreign invested firms in total industry output in several industry or industry clusters. For the NACE industries most relevant for technology-driven industries (NACE 30 and NACE 32-35), the share of foreign invested firms in total industry output can be calculated for a computer and electronics cluster (including NACE divisions 30, 32 and 33) and for manufactures of transport equipment (including NACE divisions 34 and 35). The RCAs of the technology- driven industries within these NACE divisions15 show that, although far from giving a perfect match, the RCAs that China occupies in technology-driven industries are found in the computer and electronics cluster where foreign firms account for the bulk, 82%, of total industry output16 (Figure 1.1.18). In contrast, China still maintains a revealed comparative disadvantage in manufacture of vehicles (341) and manufacture of aircraft and spacecraft (353), the two technology-driven industries within the transport industry where the share of output of foreign invested firms, although still considerable, is much lower (45%) than in the computer and electronics cluster. Assuming that foreign invested firms rather export a higher than a lower share of their output, we read this as an evidence that the improving RCA of China in technology-driven industries are to a large extent driven by the exporting activities of foreign invested firms. This in turn means that the technological upgrading of ‘genuine’ Chinese exports might have been be less pronounced than suggested by RCAs of trade statistics.

This result also fits well with the finding from other studies that processing trade is not only carried out predominantly by foreign-invested companies but also concentrated within technologically relatively advanced products (Dean et al., 2009). Estimates suggest that 25%-46% of every dollar’s worth of Chinese merchandise exports are made up by previously imported intermediate inputs. The share of the foreign content varies considerably from industry to industry with the highest shares found in electronic computers, telecommunication equipment, computer peripheral equipment, electronic

15 The classification used here is based on 3-digit NACE industries, whereas the share of foreign firms in total Chinese industry output is available on the level 2-digit NACE industries or clusters thereof. 16 The technology-driven industries in computer and electronics cluster where China has a comparative advantage in trade with the world are office machinery and computers (300), manufacture of TV and radio transmitters (322) and manufacture of TV and radio receivers (323).

31 elements and devices, radio /TV/other communication equipment. As can easily be seen, these industries coincide with those for which Figure 1.1.18 indicates a RCA for China.

Figure 1.1.18 RCA of China in technology driven goods and share of foreign firms in total Chinese industry output for respective industry (right scale, in % of total, year 2007)

RCA RCA Share of foreign firms in industrial Output

300 85

80 200 75

100 70

65 0 60

-100 55

50 -200 45

-300 40 300 321 322 323 331 332 334 341 353

Computer & electronics cluster (NACE 30, 32, 33) Transport equipment (NACE 34, 35) Source: UN Comtrade, China Statistical Yearbook (2008).

Previous work on the analyses of ‘genuine’ Chinese exports, that is excluding exports by foreign invested firms, suggest that their skill content has not changed substantially so that China in some sense is continuing to specialize mainly in labour-intensive goods (Amiti and Freund, 2008). Certainly, when analysing bilateral trade figure between countries, total exports must be considered, because from a balance of payments perspective the ownership status of exporting firm does not matter. It is, however, interesting to see that a considerable part of Chinese economic activity in manufacturing is on the account of foreign owned firms and that these may influence the developments of revealed comparative advantages.

1.1.9 Impact of the global crisis on goods trade Initial hopes that the BRICs will be able to ‘de-couple’ from the global crisis have not materialized. The main mechanisms of transmission are rapidly declining exports and the respective multiplier effects, decreasing FDI and plummeting stock markets. The immediate impact of the global crisis was a deep contraction in BRICs’ foreign trade, visible in the data for the first quarter of 2009 (for the year 2008 as a whole, EU’s trade with the BRICs still grew much faster than average – see Table 1.1.1 above). During the first three months of 2009, BRICs’ exports and imports shrank by double digit rates (especially in Russia, but

32 in China as well), though there are some recent signs of bottoming out since April (the same applies to stock markets). Another effect of the global crisis has been growing protectionist tendencies for supporting domestic industry worldwide and in the BRICs in particular, such as the imposition of higher import tariffs on used cars (and a delayed accession to WTO) by Russia and the ‘buy Chinese’ initiative in China.

References Amiti, M. and C. Freund (2008), ‘The anatomy of China's export growth’, Policy Research Working Paper Series 4628, The World Bank. Balassa, B., (1965), “Trade Liberalisation and Revealed Comparative Advantage”. The Manchester School of Economic and Social Studies, No. 33, pp. 99-123. Baumann, U. and di Mauro, F. (2007), ‚Globalisation and Euro Area Trade. Interactions and Challenges’. Occasional Paper Series, European Central Bank, No. 55, March. China Statistical Yearbook (2008). Dean, J, Fung, K.C., Wang, Z., (2009) ‘How vertically specialized is Chinese trade? ‘, BOFIT Discussion Papers 31/2008, Bank of Finland, Institute for Economies in Transition. European Commission (2008), Global Europe. EU performance in the global economy, Directorate General for Trade, Brussels. Fertö, I. and Soos, K. A (2008)., “Intra-Industry Trade Between the Old EU and the NMS Before Enlargement”. In Grinberg et al. (2008), pp. 95-118. Gaulier, G., F. Lemoine and D. Unal-Kesenci (2007), ‘China's emergence and the reorganisation of trade flows in Asia’, China Economic Review, Vol. 18, No. 3, Elsevier, pp. 209-243. Glinkina, S. and Kulikova, N., (2008), ‘Impact of EU Enlargement on Economic Restructuring in Russia’. In Grinberg, R., P. Havlik and O. Havralyshyn (eds) (2008), Economic Restructuring and Integration in Eastern Europe. Experiences and Policy Implications, Nomos, Baden-Baden, pp. 321-356. Havlik, P., (1990), ‘Disintegration of the CMEA and Its Consequences’. OECD, Paris. Klau, M. and S.S. Fung (2006), ‘The new BIS effective exchange rate indices’, BIS Quarterly Review, March. Landesmann, M. A. and J. Wörz (2006), ‘Competitiveness of the CEECs in a Global Context’, wiiw Research Reports, No. 327, The Vienna Institute for International Economic Studies (wiiw), Vienna. Landesmann, M. A. Stehrer, R. (2009), Trade and Growth: ‘South-North“ Integration, Outsourcing and Skills in International Trade & Domestic Growth: Determinants, Linkages and Challenges‘, in Workshops – Proceedings of OeNB Workshops N°14, Vienna. Peneder, M. (2003), ‘Industry Classifications. Aim Scope and Techniques’, Journal of Industry, Competition and Trade, Vol. 3, No. 1-2, pp. 109-129. Rodrik, D., (2006) ‘What’s so special about China’s Exports? ‘, NBER Working Paper N° 11947.

33 Schott, P.K., (2006). ‘The Relative Sophistication of Chinese Exports‘, NBER Working Papers 12173, WTO (2008), “World Trade Report 2008. Trade in a Globalizing World”, Geneva.

34 Annex 1 Taxonomy used in industry classifications (by factor and skill intensities) Taxonomy Taxonomy I II NACE factor labour rev.1 inputs skills Meat products 151 4 1 Fish and fish products 152 4 1 Fruits and vegetables 153 4 1 Vegetable and animal oils and fats 154 4 1 Dairy products; ice cream 155 4 1 Grain mill products and starches 156 4 1 Prepared animal feeds 157 4 1 Other food products 158 4 1 Beverages 159 4 1 Tobacco products 160 4 1 Textile fibres 171 3 1 Textile weaving 172 2 1 Made-up textile articles 174 2 1 Other textiles 175 1 1 Knitted and crocheted fabrics 176 1 1 Knitted and crocheted articles 177 1 1 Leather clothes 181 2 1 Other wearing apparel and accessories 182 2 1 Dressing and dyeing of fur; articles of fur 183 2 1 Tanning and dressing o f leather 191 4 1 Luggage, handbags, saddlery and harness 192 4 1 Footwear 193 4 1 Sawmilling, planing and impregnation of wood 201 2 2 Panels and boards of wood 202 2 2 Builders' carpentry and joinery 203 2 2 Wooden containers 204 2 2 Other products of wood; articles of cork, etc. 205 2 2 Pulp, paper and paperboard 211 3 3 Articles of paper and paperboard 212 1 3 Publishing 221 4 3 Printing 222 4 3 Coke oven products 231 Refined petroleum and nuclear fuel 232 3 3 Nuclear fuel 233 Basic chemicals 241 3 3 Pesticides, other agro-chemical products 242 5 3 Paints, coatings, printing ink 243 1 3 Pharmaceuticals 244 5 4

35 Detergents, cleaning and polishing, perfumes 245 4 3 Other chemical products 246 5 3 Man-made fibres 247 3 3 Rubber products 251 1 1 Plastic products 252 1 1 Glass and glass products 261 1 1 Ceramic goods 262 2 1 Ceramic tiles and flags 263 3 1 Bricks, tiles and construction products 264 2 1 Cement, lime and plaster 265 3 1 Articles of concrete, plaster and cement 266 1 1 Cutting, shaping, finishing of stone 267 2 1 Other non-metallic mineral products 268 1 1 Basic iron and steel, ferro-alloys (ECSC) 271 3 1 Tubes 272 1 1 Other first processing of iron and steel 273 3 1

36

Taxonomy Taxonomy I II NACE factor labour rev.1 inputs skills Basic precious and non-ferrous metals 274 3 1 Structural metal products 281 2 2 Tanks, reservoirs, central heating radiators and boilers 282 4 2 Steam generators 283 2 2 Cutlery, tools and general hardware 286 4 2 Other fabricated metal products 287 1 2 Machinery for production, use of mech. Power 291 1 4 Other general purpose machinery 292 1 4 Agricultural and forestry machinery 293 1 4 Machine-tools 294 2 4 Other special purpose machinery 295 1 4 Weapons and ammunition 296 1 4 Domestic appliances n. e. c. 297 1 3 Office machinery and computers 300 5 4 Electric motors, generators and transformers 311 1 3 Electricity distribution and control apparatus 312 5 3 Isolated wire and cable 313 1 3 Accumulators, primary cells and primary batteries 314 1 3 Lighting equipment and electric lamps 315 1 3 Electrical equipment n. e. c. 316 2 3 Electronic valves and tubes, other electronic comp. 321 5 3 TV, and radio transmitters, apparatus for line telephony 322 5 3 TV, radio and recording apparatus 323 5 3 Medical equipment 331 5 3 Instruments for measuring, checking, testing, navigating 332 5 3 Optical instruments and photographic equipment 334 5 3 Watches and clocks 335 4 3 Motor vehicles 341 5 2 Bodies for motor vehicles, trailers 342 2 2 Parts and accessories for motor vehicles 343 3 2 Ships and boats 351 2 2 Railway locomotives and rolling stock 352 2 2 Aircraft and spacecraft 353 5 4 Motorcycles and bicycles 354 1 2 Other transport equipment n. e. c. 355 1 2 Furniture 361 2 2 Jewellery and related articles 362 2 2 Musical instruments 363 4 2 Sports goods 364 4 2

37 Games and toys 365 4 2 Miscellaneous manufacturing n. e. c. 366 4 2

Taxonomy I factor inputs 1..Mainstream 2..Labour intensive industries 3..Capital intensive industries 4..Marketing driven industries 5..Technology driven industries Taxonomy II labour skills 1..Low skill industries 2..Medium skill/blue collar workers 3..Medium skill/white collar workers 4..High skill industries Source: Peneder (2003).

38

1.2 Trade in services

Olga Pindyuk, wiiw

1.2.1 Summary Trade in services is much less important than trade in goods, measured by both absolute volumes and shares in GDP. BRICs’ share in global services trade is much lower than of the EU27; in the EU15 and NMS12 the shares of BRICs in services import are only about 4%, which is less than their shares in goods import. However, if we compare BRICs services trade with extra-EU imports of the EU27, than the share of BRICS in the EU27 import increases to about 9%. Among BRICs, it’s China and India, which are the biggest services traders – together they account for about 60% of total BRICs services export.

The situation of low market shares of BRICs may change in the future, as all the BRICs (apart from Hong Kong) have been increasing their services exports much faster than the EU27, US or Japan. India is the absolute leader in terms of growth rates – its annual services export increased during 2000-2007 by more than 5 times. Services export of China and Russia increased during that period by 4 times.

The EU has been quite an important market for service exporters of all BRICs apart from India (shares of the EU27 range from 13% for China to 40% for Russia), and the share of the EU27 in services export of China and Hong Kong has been growing. On the other hand, importance of BRICs (in particular, of China, India, and Russia) for the EU service exporters has been increasing as well; in 2007, the share of BRICs in the total EU27 services export exceeded the NMS12 share (4.6% versus 4.2%), while the share of BRICs in extra-EU services exports has reached 11%.

BRICs have rather diverse services structures, however a similar trend for all the countries can be observed – they have in general decreased shares of traditional services in their exports. New patterns of specialization have been developing in Brazil and China, which increased significantly their shares of other business services, and also in India – where computer and other information services gained a lot of importance for exports.

So far, BRICs appear to have quite few strong advantages at the EU market. China, Hong Kong and Russia specialize in transportation services at the EU15 market, with Russia having created additional strong specialization over 2000-2007 in construction services. The current pattern of BRICs’ specialization at the NMS12 market is similar to one at the market of the old member states. However, in contrast to the EU15, the pattern of specialization changed noticeably at the NMS12 market since 2000, when China, Hong Kong and India specialized in export of other business services.

39 1.2.2 Introduction In this section we analyse developments of services trade of BRICs. In our analysis we use the database of international trade and FDI in services (Trade in Services Database – TSD), compiled from a number of sources (Eurostat, OECD, IMF), as well as data from national banks and statistical offices.

Trade in services is much less important than trade in goods, measured by both absolute volumes and shares in GDP (less than 10% of GDP in the case of services trade compared to 32% in goods trade on EU average). Services are characterized by lower tradability than goods, thus shares of services trade in GDP are usually much lower than goods’ ones, even though services nowadays account for the bulk of GDP. Ceteris paribus, big countries tend to have lower shares of services trade than small ones since most of the trade occurs inside the countries (much higher shares of services trade in the EU15 and NMS12 as compared to the US and Japan are explained by high degree of the intra-EU trade – around 60% of total services trade). Hong Kong is an outlier among BRICs in terms of services trade openness, which reflects the peculiar nature of the country’s economy.17 India ranks second in terms of services openness, and the fact that services export ratio to GDP of the country exceeds indicators of the USA and Japan more than twice clearly indicates global specialization of India’s economy in services. Brazil, on the other hand, has quite low share of services export in GDP – only 1.7%; the country is more open to services import which share in GDP is 2.6%, but still lags behind all the other BRICs countries (see Table 1.2.1).

Table 1.2.1 Services exports and imports in 2007, % of GDP

Hong NMS1 Brazil China Kong India Russia EU27 EU15 2 Japan USA Services exports 1.7 3.6 40.9 8.2 3.0 9.5 9.5 9.8 2.9 3.6 Services imports 2.6 3.8 20.6 4.7 4.6 8.3 8.3 8.0 3.4 2.7 Source data: TSD, NSOs and central banks.

The share of BRICs in global services trade is much lower than that of the developed countries in the benchmark: e.g., total BRICs services export is about 4.5 times smaller than that of the EU27 (see Table 1.2.2). However, it is worth noting that most of the EU27 services trade is concentrated mostly inside the EU, and if we compare BRICs services trade with extra-EU trade, than the difference is significantly smaller.

17 Hong Kong has high degree of re-exports of goods (about 90% of merchandise imports), and as a consequence high level of related services trade.

40 China and India are the biggest services traders among BRICs – together they account for almost 60% of total BRICs services export and import.

Table 1.2.2 Services export and import in 2007, EUR billion

Services Services exports imports Brazil 17.4 27.0 China 88.9 94.6 Hong Kong 61.8 31.1 India 65.5 38.2 Russia 28.7 43.0 Total BRICs 262.2 233.9 EU27 1177.7 1024.7 NMS12 85.2 69.1 EU15 1092.6 955.6 EU27-extra EU 513.3 427.0 NMS12-extra EU 23.5 19.7 EU15-extra EU 489.8 407.3 US 359.8 275.9 JPN 110.9 115.7 Source data: TSD.

1.2.3 Geographical structure of services trade With regard to BRICs market shares, Japan is the only country where the share of BRICs in services imports is relatively high – about 10% in 2007, mostly due to imports from China and Hong Kong (see Table 1.2.3). In the EU27 and US the shares of BRICs in services import are only about 4%. However, if we compare BRICs services trade with extra-EU imports of the EU27, than the share of BRICS in the EU27 import increases to about 9% (since most of the EU27 services trade is concentrated inside the EU).

The NMS12 import relatively more services from BRICs than the old member states: the share of BRICs in total NMS12 services import is 4.2%, which is 0.5 p.p. higher than in the EU15.

However, the situation of low market shares of BRICs may change in the future, as all the BRICs (apart from Hong Kong) have been increasing their services exports much faster than the EU27, US and Japan. India is the absolute leader in terms of growth rates – its services export increased during 2000-2007 by more than 5 times; China and Russia increased their services exports during that period by 4 times, and Brazil by 2.5 times.

41 The EU27 has been increasing its services exports noticeably faster than the US and Japan, however this increase occurred due to the intra-EU trade, while extra-EU trade during the period analysed has grown twice slower in case of the EU15 and declined in case of the NMS12. Enlargement of the EU, which lead to lower barriers in services trade between the old and new member states, may provide partial explanation of this trend.

Table 1.2.3 Geographical structure of services imports in 2007, %

Importers Hong NMS1 by columns Brazil China Kong* India Russia Japan US EU27 EU15 2 Brazil - … 0.4 … 0.0 0.2 0.8 0.4 0.4 0.1 China … - 23.7 … 0.3 5.1 0.0 1.0 1.1 1.0 Hong Kong … 25.8 - … 0.1 3.8 1.4 0.8 0.8 0.2 India … … 0.9 - 0.4 0.4 2.0 0.5 0.6 0.1 Russia … … 0.2 … - 0.3 0.0 0.9 0.8 2.8 Total … 25.8 25.2 … 0.8 9.7 4.2 3.7 3.7 4.2 BRICs Japan 1.6 6.4 7.6 2.2 0.5 - 5.3 1.3 1.4 1.0 US 26.8 7.9 13.2 18.2 5.2 27.2 - 12.5 12.9 6.5 EU27 23.7 18.8 12.6 19.5 43.5 16.7 38.7 63.3 72.2 63.9 EU15 23.3 18.6 12.5 19.2 34.7 16.0 37.4 59.0 59.2 57.1 NMS12 0.5 0.2 0.1 0.3 8.8 0.8 1.2 4.9 4.2 15.1 Other 48.3 41.2 41.6 60.4 58.7 47.1 53.1 23.5 22.9 31.2 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 * Data are for 2005. Source data: TSD.

An analysis of the current geographic structure of services exports shows (see Table 1.2.4), that the EU27 is more important market than the US or Japan for Brazil, China and Russia, while in Hong Kong and India the US has higher shares in the exports structures than the EU. Russia is the most dependent on the EU as a market for its services export – the EU27 share in Russia’s services exports exceeds 40%.

It is China and Hong Kong where the shares of the EU in services exports are likely to increase in the future if the trends of recent years – growth of exports to the EU outpacing significantly total services export growth – continue (see Figure 1.2.1). In India, Brazil and Russia other destinations but the EU account for increased services exports.

If we look at the markets for the EU27 services exports among BRICs countries, it’s China and Russia which have the highest shares in the EU services export among BRICs.

42

Shares of the EU27 in services imports of China, Russia, and India have been increasing (see Figure 1.2.2) – during 2000-2007, growth of services imports from the EU27 was higher than growth of total services imports by 1.5 times in China and by 1.4 times in Russia. Thus the EU is likely to continue increasing its market share in China and Russia in the future.

Figure 1.2.1 Services exports (total and to the EU27) in 2007, index, 2000=100

600 Total To EU27 500

400

300

200

100

0 Brazil China Hong Kong India Russia EU27 US JPN Source data: TSD.

43

Table 1.2.4 Geographical structure of services exports in 2007, %

Exporters by Brazi Hong NMS1 columns l China Kong* India Russia Japan US EU27 EU15 2 Brazil - … 0.2 … 0.0 0.4 2.0 0.5 0.6 0.1 China … - 20.2 … 1.4 5.4 0.0 1.6 1.6 0.8 Hong Kong … 26.9 - … 0.3 0.2 1.2 0.7 0.7 0.1 India … … 0.7 - 0.6 0.8 1.9 0.6 0.7 0.1 Russia … … 0.1 … - 0.3 0.0 1.2 1.1 2.3 Total BRICs … 26.9 21.2 … 2.3 7.1 5.1 4.6 4.7 3.3 Japan 1.1 6.7 5.5 0.6 1.5 - 8.3 1.6 1.7 0.8 US 17.0 5.7 15.8 10.8 8.1 23.0 - 11.8 12.3 5.3 EU27 24.0 12.9 12,6 8.3 40.3 12.5 35.5 56.6 55.4 72.4 EU15 23.7 12.2 12.5 8.1 30.3 11.8 34.2 52.4 51.7 60.2 NMS12 0.4 0.7 0.1 0.1 10.0 0.6 1.2 4.2 3.6 12.2 Other 58.2 48.5 45.0 80.5 57.8 58.1 52.3 29.6 29.5 30.5 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 * Data are for 2005. Source data: TSD.

Figure 1.2.2 Services imports (total and from the EU27) in 2007, index, 2000=100

600 Total From EU27 500

400

300

200

100

0 Brazil China Hong Kong India Russia EU27 US JPN

Source data: TSD.

44 1.2.4 Sectoral structure of services trade In this section we look at the sectoral structure of services trade, distinguishing between traditional services (tourism and transportation), and commercial services (such as financial, communication, and computer services, royalties and license fees), which are producer- related and have been increasing their shares in global services trade significantly over the last years.

BRICs have rather diverse structures of services exports. China and Russia have their services exports being dominated by traditional transportation and travel services – similar to NMS12, which services export structure differs drastically from the EU15 one (see Table 1.2.5). Hong Kong has the highest specialization in financial services export among all the countries analysed; India specializes in exports of computer and information services; Russia exports relatively much of construction services. Interestingly, all the BRICs countries apart from India have relatively high shares of other business services – which comprise of such types of services as merchanting and other trade-related services, accounting, legal, advertising, architectural, engineering services and some others. Other types of producer-related services are exported by BRICs at a relatively low scale (with exception of financial services in Hong Kong).

Over the period 2000-2007, BRICs countries have in general decreased shares of traditional services in their exports, with exception of Brazil and China – for transportation services, and Hong Kong – for travel services (see Table 1.2.6)). New patterns of specialization have been developing in Brazil and China, which increased significantly their shares of other business services, and also in India – where computer and other information services gained a lot of importance for exports.

45

Table 1.2.5 Sectoral structure of services exports, 2007, %

Hong Brazil China Kong India Russia Japan US EU27 EU15 NMS12 200 TOTAL SERVICES 100 100 100 100 100 100 100 100 100 100 205 Transportation 17.2 25.6 30.2 11.1 30.0 27.7 15.6 21.4 20.8 29.5 236 Travel 20.7 30.5 16.2 12.6 24.4 21.0 24.2 22.7 21.9 32.1 245 Communication services 1.2 1.0 2.7 3.2 0.4 1.7 2.0 1.9 3.2 249 Construction 0.1 4.4 8.8 6.8 1.3 2.2 2.1 3.1 253 Insurance 2.3 0.7 0.6 1.8 1.0 0.9 2.1 1.7 1.8 0.3 260 Financial services 4.6 0.2 14.7 3.6 3.0 4.1 11.8 5.6 5.8 3.7 Computer and information 262 services 0.7 3.6 44.7 2.8 0.6 2.6 4.6 4.7 3.3 266 Royalties and license fees 1.3 0.3 1.0 15.3 16.8 2.7 2.9 1.3 268 Other business services 42.1 33.1 30.1 18.6 24.4 21.7 16.7 21.3 21.4 19.9 Personal, cultural and 287 recreational services 0.3 0.0 0.7 0.1 3.1 0.7 0.6 2.6 291 Government services 5.6 0.5 0.8 1.4 4.2 1.4 1.4 0.8 Other 3.0 0.2 6.0 3.5 0.0 0.0 0.0 13.7 14.7 0.2 Source data: TSD.

Table 1.2.6 Change in sectoral structure of services exports, 2000 to 2007, in p.p.

Hong NMS1 Brazil China Kong India Russia Japan US EU27 EU15 2 205 Transportation 2.4 13.6 -1.4 -0.7 -7.2 -9.3 -1.3 -1.7 -2.2 4.7 236 Travel 1.6 -22.9 1.6 -8.1 -11.5 16.2 -6.9 -8.6 -8.3 -15.0 245 Communication services 0.8 -3.5 -0.9 -0.8 -0.8 0.4 0.1 0.0 1.1 249 Construction -2.3 2.4 7.0 -1.6 0.5 -0.1 -0.2 0.9 253 Insurance -1.0 0.4 -0.5 0.3 0.6 0.6 0.9 -0.1 -0.1 -0.5 260 Financial services 0.6 -0.1 3.9 1.9 1.9 0.0 6.4 0.1 0.1 1.6 Computer and information 262 services 0.3 2.4 16.4 2.2 -1.6 0.7 1.3 1.2 2.0 266 Royalties and license fees -46.8 0.0 0.1 0.5 2.3 -0.5 -0.5 0.7 268 Other business services 41.4 7.9 -9.3 -6.2 6.2 -3.9 0.5 -2.6 -3.2 6.0 Personal, cultural and 287 recreational services -5.3 0.0 0.7 -0.1 0.9 -0.4 -0.5 1.0 291 Government services 5.6 -0.5 0.8 0.0 -0.7 -0.1 0.0 -0.6 Other 3.0 0.2 -2.6 3.5 0.0 0.0 -3.7 12.6 13.7 -1.9 Source data: TSD.

46

Table 1.2.7 Sectoral structure of services imports, 2007, %

Hong NMS1 Brazil China Kong India Russia Japan US EU27 EU15 2

200 TOTAL SERVICES 100 100 101 100 100 100 100 100 100 100 205 Transportation 22.9 33.3 32.7 21.9 15.8 30.9 25.3 23.4 23.2 26.6 236 Travel 22.1 22.9 35.3 17.6 37.6 21.9 21.4 25.4 25.4 26.3 245 Communication services 0.3 0.8 1.6 2.2 0.6 2.1 2.4 2.3 3.5 249 Construction 0.0 2.2 10.9 5.0 0.5 1.7 1.6 2.9 253 Insurance 3.5 8.2 1.7 2.0 1.4 2.6 11.3 1.9 1.9 1.8 260 Financial services 2.2 0.4 6.6 6.0 2.5 2.3 5.0 4.1 4.1 4.6 Computer and information 262 services 6.1 1.7 5.8 1.6 2.3 3.9 2.7 2.6 3.7 266 Royalties and license fees 6.1 0.0 4.7 10.5 6.6 4.6 4.6 5.1 268 Other business services 10.3 23.4 7.3 31.8 19.6 22.0 13.8 23.9 24.1 21.8 Personal, cultural and 287 recreational services 1.8 0.0 1.3 0.8 0.4 1.2 1.1 2.0 291 Government services 6.7 0.0 2.3 1.1 9.6 1.2 1.2 1.3 Other 13.2 5.1 11.9 9.6 0.0 0.0 0.0 7.4 7.9 0.3 Source data: TSD.

Table 1.2.8 Change in sectoral structure of services imports, 2000 to 2007, in p.p.

Hong Brazil China Kong India Russia Japan US EU27 EU15 NMS12

205 Transportation -3.0 4.4 7.4 -23.4 1.4 2.0 -4.1 -0.6 -0.9 4.2 236 Travel -1.3 -13.5 -15.3 3.6 -16.9 -5.8 -8.4 -5.4 -5.5 -3.6 245 Communication services 0.1 0.2 1.1 0.4 -0.4 -0.6 0.0 -0.1 0.7 249 Construction 0.0 -0.5 8.4 1.5 0.3 -0.1 -0.1 0.5 253 Insurance 1.6 1.3 -0.5 -2.2 -1.1 0.8 6.3 0.8 0.9 -0.8 260 Financial services -1.9 0.2 3.3 -0.7 2.3 0.6 2.8 1.4 1.4 1.0 Computer and information 262 services -0.8 1.0 2.8 -1.3 -0.4 3.2 0.5 0.4 1.7 266 Royalties and license fees -2.4 -3.6 4.3 1.0 -0.7 -0.6 -0.7 1.4 268 Other business services -10.3 4.1 -3.7 9.3 -1.1 0.9 -1.5 -1.5 -1.3 -4.4 Personal, cultural and 287 recreational services -0.4 -0.1 1.3 -0.3 0.3 -0.7 -0.7 0.0 291 Government services 0.1 -0.5 2.3 0.0 2.3 -0.4 -0.4 -0.3 Other 13.2 5.1 11.9 9.6 0.0 0.0 0.0 6.6 7.1 -0.3 Source data: TSD.

47

BRICs have a quite diverse services import structures as well (see Table 1.2.7). Transportation services have relatively high shares in imports of China and Hong Kong, while travel services are more intensively imported by Russia and Hong Kong. Russia appears to import relatively much of construction services (which also have high share in its exports). India outperforms others in terms of other business services import – their share in its import is 32%.

The share of other business services in India’s imports increased significantly during 2000-2007, primarily at the cost of major decline in share of transportation services (see Table 1.2.8). Brazil, on the other hand, has experienced decline in the share of other business services in its import. All the BRICs countries apart from India recorded a decline in the share of transportation services.

1.2.5 Trade balances and specialization indices An analysis of the sectoral trade balances allows a first glance at the countries’ competitiveness in different services (see Table 1.2.9). Among the BRICs, only Hong Kong and India are net exporters of services. All BRICs countries except India have positive balances in other business services. India, as it may be expected, has a positive balance in trade of computer and information services. Hong Kong and Russia are net exporters of transportation services, with Hong Kong also having a positive balance in trade of financial services.

Table 1.2.9 Trade balances in 2007, EUR billion

Hong Brazil China Kong India Russia Japan US EU27 EU15 NMS12

200 TOTAL SERVICES -9.6 -5.7 30.7 27.3 -14.3 -5.0 83.9 153.0 137.0 16.0 205 Transportation -3.2 -8.7 8.5 -1.1 1.8 -5.1 -13.4 12.4 5.7 6.7 236 Travel -2.4 5.4 -0.9 1.5 -9.2 -2.0 27.8 6.1 -3.0 9.1 245 Communication services 0.1 0.1 1.1 0.0 -0.3 0.5 -0.7 -1.0 0.3 249 Construction 0.0 1.8 -2.2 1.7 3.4 8.7 8.1 0.6 253 Insurance -0.6 -7.1 -0.2 0.4 -0.3 -2.0 -23.7 0.5 1.4 -1.0 260 Financial services 0.2 -0.2 7.0 0.1 -0.2 1.9 28.7 23.7 23.7 0.0 Computer and information 262 services -1.5 1.6 27.1 0.1 -1.9 -1.5 26.9 26.6 0.2 266 Royalties and license fees -1.4 0.2 -1.8 4.8 42.0 -15.2 -12.8 -2.4 268 Other business services 4.5 7.3 16.3 0.0 -1.4 -1.4 21.9 5.3 3.4 1.9 Recreational, cultural and 287 recreational services -0.4 -0.3 -0.8 9.9 -3.5 -4.3 0.9 291 Government services -0.8 0.4 -0.8 0.3 -11.6 4.1 4.3 -0.2 Other -3.0 -4.7 0.0 -1.3 0.0 0.0 0.0 84.7 84.7 0.0 Source data: TSD.

48

To assess the countries’ specialization on the EU market, we estimate specialization indices (SIs) for the years 2000 and 2007, in order to find out which sectors gained or lost market shares (see Tables 1.2.10 and 1.2.11). We estimate the indicators separately for the EU15 and NMS12 to see whether the patterns of BRICs specialization differ in those two markets.18 (Since the EU27 services trade is dominated by the EU15 – the share of which exceeded 90% both in exports and imports in 2007 – specialization patterns of BRICs in the EU27 as a whole are approximately the same as in the EU15).

In general, BRICs appear to have quite few strong advantages at the EU market. China, Hong Kong and Russia turn out to have high SIs in transportation services at the EU15 market, with Russia having created additional strong specialization over 2000-2007 in construction services. Brazil and India do not have any strong SIs at the EU15 market. There were no major changes in SIs of BRICs at this market over 2000-2007.

The current pattern of SIs of BRICs at the NMS12 market is similar to one at the market of the old member states: China and Hong Kong have strong SIs in transportation services, Russia – in construction (but not in transportation). Brazil turns out to have strong specialization in one sector at the NMS12 market – personal, cultural, and recreational services.

Table 1.2.10 Specialization indices in trade with the EU15, 2007

Hong Brazil China Kong India Russia 205 Transportation 1.8 2.5 2.0 1.2 2.6 236 Travel 1.4 0.8 0.2 1.5 0.5 245 Communication services 0.6 0.4 0.7 0.7 1.0 249 Construction 1.2 1.5 0.4 1.2 2.1 253 Insurance 0.4 0.7 0.2 0.2 0.7 260 Financial services 0.1 0.1 1.1 0.1 0.2 262 Computer and information services 0.3 0.3 0.1 2.6 0.2 266 Royalties and license fees 0.1 0.5 0.5 0.3 0.3 268 Other business services 1.1 0.9 1.0 1.0 0.9 Personal, cultural and recreational 287 services 1.5 0.3 1.0 0.4 0.5 Source: TSD; wiiw calculations.

18 We calculate the specialization index (SI) for country i good j at the market k as SIijk = (Xijk /Xitk)/( Xkj /Xkt), where t = total for all goods. The index compares the composition of exports of one country to a certain market with the composition of total exports that are absorbed by the market; it can be considered a relative market size measure and thus a measure of countries’ specialization revealed by trade flows. Sectors in which the share of a given sector in a country’s export noticeably exceeds the share of this sector at the given market (usually the index value being equal to 2 is selected as a benchmark) are considered to have strong specialization at this market.

49

However, in contrast to the EU15, the pattern of SIs changed more significantly at the NMS12 market over 2000-2007. In 2000, strong SIs had only China, Hong Kong and India – in other business services. Over 7 years they lost their specialization in these services; instead China and Hong Kong developed specialization in transportation services. Besides, Russia strengthened its position at the construction services market, and Brazil created strong SIs in personal, cultural, and recreational services.

Table 1.2.11 Specialization indices in trade with the NMS12, 2007

Hong Brazil China Kong India Russia

205 Transportation 1.8 2.7 2.0 1.2 1.7 236 Travel 0.4 0.3 0.1 0.5 0.5 245 Communication services 0.4 0.6 0.7 1.3 0.6 249 Construction 0.0 0.1 0.1 0.0 2.6 253 Insurance 0.0 0.1 0.2 0.0 1.7 260 Financial services 0.0 0.2 0.1 0.2 0.2 262 Computer and information services 0.4 0.1 0.3 1.2 0.3 266 Royalties and license fees 0.1 0.1 0.1 0.3 0.3 268 Other business services 0.4 0.3 1.4 1.6 1.0 Personal, cultural and recreational 287 services 4.4 0.1 1.4 0.2 0.2 Source: TSD; wiiw calculations.

These trends (together with much faster development of intra-EU services trade than extra- EU one – with extra-EU trade of the NMS12 having actually fallen during 2000-2007) may reveal that the recent EU integration has resulted so far in stronger services trade diversion effects than trade creation ones – possibly due to relative increase of barriers to services trade with the rest of the world in the NMS12 after the EU accession.

References: Chanda, R. (2006). Inter-Modal Linkages and Services Trade. OECD Trade Policy Working Paper No. 30. De, P., Raychaudhury, A. (2007). UNESCAP Research Workshop,10-12 December 2007, Macao. Hussain, M., Faes-Cannito, F. (2008). Surplus in EU trade in services with BRIC countriesin 2006. Statistics in focus, 40. Kox, H., Nordas, H.K. (2007). Services Trade and Domestic Regulation. OECD Trade Policy Working Paper No. 49.

50 Lipsey, R. (2006). Measuring International Trade in Services. NBER Working Paper 12271. OECD (2008). Globalization and Emerging Economies. Brazi, Russia, India, Indonesia, and South Africa. Panagariya, A. (2006). Trade and Foreign Investment: Comparing India and China. Paper presented at the Stanford Pan Asia Conference, October. Pindyuk, O., Woerz, J. (2008). Trade in Services: Note on the Measurement and Quality of Data Sources. FIW Research Report series, Nr. 001, June.

51 1.3 Foreign Direct Investment flows between the EU and the BRICs

Gábor Hunya and Roman Stöllinger, wiiw

1.3.1 Introduction Foreign direct investment (FDI) has become the major pillar of internationalization for firms. Albeit global FDI flows are still much lower than trade flows, FDI can be seen as the main channel of international competition. Firms undertake FDI primarily to expand and compete with domestic and other firms on the respective markets. An adequate measure of the relative importance of international trade and FDI in the international competition of firms is the ratio of sales of foreign subsidiaries (affiliates) established by multinational companies (MNCs) in foreign markets to exports. Such a comparison shows that sales of foreign affiliates surpass by far world exports (Sauvant, 2005). For the United States the ratio between sales of foreign affiliates abroad and exports stood at over 2.5 in 2006 and in the case of Germany (still holding the title of the world export champion) outward foreign affiliate sales clearly surpass exports of goods and services.19

In the case of services, a local presence often represents the sole possibility to enter a market because of the high degree of personal contact required (e.g. retail banking, restaurants, hotellery etc.). A local presence, however, might also turn out to be essential for manufacturing firms because the size of the market share that can be conquered by exporting is typically limited. Further gains in market shares often requires some form of local presence such as a subsidiary which ensures production of products adapted to local needs and preferences. FDI activities are therefore an important indicator for international competitiveness as MNCs not only compete internationally via exports but increasingly by setting up or acquiring subsidiaries abroad.

The magnitude of EU outward FDI flows reflects the capability and propensity20 of EU firms to internationalize their business activities. It is therefore a valuable indicator for the corporate competitiveness, that is, the relative productivity of firms in the EU vis-à-vis foreign competitors. On a global level, the EU emerges as the most important FDI investor, also if considering extra-EU outflows only. In 2007 extra-EU FDI reached EUR 484 billion. In comparison, FDI by US and Japanese firms amounted to EUR 229 billion and EUR 54 billion respectively (Figure 1.3.1, left). Since 2005 the EU has also been the largest

19 Important EU investors such as the United Kingdom, France, Spain and the Netherlands do not report outward foreign affiliate sales (FAS) to Eurostat yet. FAS will be available for all EU member states as of 2009. 20 A firm’s capacity to undertake FDI is determined by its profits, access to and cost of outside finance, the technological sophistication of its products and managerial skills. The propensity to invest means the extent to which a firm finds it advantageous to invest abroad which typically depends on the attractiveness of potential host markets (market size and growth, political risk, investment climate) but also home market factors such as the regulatory regime. The capacity to invest is closely related to ownership advantages in the terminology of Dunning (2005), whereas the propensity to invest relates to internalization advantages.

52 recipient of FDI, attracting EUR 360 billion from outside its territory in 2007, more than twice the amount of the inflows into the US economy (Figure 1.3.1, right)21.

Figure 1.3.1 Outward (left) and inward (right) FDI flows of the EU, the United States and Japan (EUR billion)

EU Extra-EU USA Japan EU Extra EU USA Japan 1200 1200

600 600

0 0 2001 2002 2003 2004 2005 2006 2007 2001 2002 2003 2004 2005 2006 2007

Remark: EU is EU27 for 2004-2007 and EU25 for 2001-2003. Source: Eurostat, US Bureau of Economic Analysis.

The link between inward FDI and competitiveness is a complex issue. The presence of foreign firms in the EU market likely means some loss of market shares for domestic firms in their home market and some firms also risk being taken over by MNCs. From a macro- economic perspective, however, the entry of foreign firms increases average productivity in the industry concerned, thereby creating a more competitive environment. Since the competitiveness of the EU depends decisively on the corporate competitiveness of both domestic and foreign firms operating in the EU market, there is a positive relationship between inward FDI and the competitiveness of the EU as an economy. Moreover, inward FDI is a potential source of technology spillovers for the EU economy. In the case of new investments and extensions of existing production facilities, FDI also constitutes additional employment and investment opportunities22.

The second subsection of this section will present the FDI relations between the EU and the BRICs based on FDI statistics, the third subsection will analyse company data. (for methodologies see Box 1.3.1). In the subsection four we investigate the possible impacts of the global crisis on FDI in the BRICs, and in the final subsection we summarize our findings and draw conclusions.

21 If intra-EU FDI flows are included, the FDI of the EU exceeds by far those of all other countries, totalling EUR 1130 billion outflows and EUR 952 billion inflows in 2007. 22 The impact on employment of mergers and acquisitions may be very different.

53 Box 1.3.1 Methodological approaches This chapter on FDI relies on two main data sources. The first one is the Eurostat Foreign Direct Investment Database (henceforth ‘Eurostat’) which provides consistent data on aggregate and bilateral FDI flows and stocks. Eurostat data are based on national data compiled by EU member states following balance of payments principles and international benchmark definitions of foreign direct investment. Eurostat data are used for the analysis of both inward and outward bilateral FDI relations between the EU (and also the United States and Japan) and the BRIC. Eurostat data allow for a comparison between the FDI of the EU, the United States and Japan. For the United States, data from the US Bureau of Economic Analysis are used in some instances to get more up-to-date data. Eurostat provides a sectoral split-up of the EU’s bilateral FDI with the BRICs. Unfortunately, this sectoral break-up is not available for the United States and Japan and also for the EU it is not very detailed. Moreover, there are no long time series available for sectoral data that is why this report uses only FDI stocks for the most recent year, 2006. The second major data source tapped for this chapter is ‘FDI Intelligence from Financial Times Ltd’ (http://www.fdimarkets.com), called the fDi database, which allows for the most up-to-date analysis of FDI flows possible. The information are based on press reports thus the data can be taken as investment commitments. They refer to individual investment projects by source and destination country which are then added up to countries and regions. The number of investment projects is especially important for information about services with low capital intensity which often fall out from the balance-of-payments- statistics. FDI Intelligence data differ principally and significantly from the FDI data reported in the balance of payments. While balance of payments data are published with one or two years delay and are backward looking, the fDi database is continuously updated and it is forward looking. The fDi database is incomplete concerning the amount of investments and the employment generated by FDI as this kind of data are only sporadically reported. In most cases, only the new equity investment projects enter the database, therefore the UNCTAD World Investment Report uses the fDi data for information on greenfield investments. Another feature of the database is that it operates with a different industry classification than Eurostat nomenclature, which is in many respects more detailed especially in terms of services and corporate functions. Each of the two main data sources – Eurostat and the fDi database – has its merits and shortcomings. We are confident that the parallel use of these two high quality but methodologically very distinct data sources helps to arrive at a realistic picture of FDI relations of the EU with the BRIC countries. Sporadic reference is made to other data sources such as OECD foreign affiliate trade statistics (FATS). UNCTAD data on FDI are used to calculate the share of the EU, the USA and Japan in total inward FDI of the BRIC countries.

54

1.3.2 FDI data analysis 1.3.2.1 EU FDI in the BRICs and comparison to FDI by the United States and Japan Bilateral investment flows document the coincidence of two ways of competitiveness: it requires corporate competitiveness, i.e. high relative productivity of firms on the side of the source country and locational competitiveness, i.e. the relative attractiveness of an economy for investors, on the side of the host country. In the case of the BRICs, large domestic markets coupled with very high growth rates over the last years and efforts – albeit in varying degrees – to improve the investment climate in their economies advanced them to the top five of the most attractive locations for FDI in recent UNCTAD surveys23. The EU, on the other hand, is the world’s most important provider of FDI and has 55 of the 100 largest non-financial MNCs domiciled in its territory (UNCTAD, 2008b)24, far more than any other economy. Consequently, EU FDI flows to the BRICs have increased steadily over the period 2001-2007, especially to Russia and Brazil, where flows reached EUR 16.7 billion and EUR 15.3 billion in 2007 respectively. The growth path of flows to India and China is flatter and flows remained at a low level in 2007 (Figure 1.3.2, left).

Figure 1.3.2 EU outward FDI flows to the BRICs (EUR billion) – left Share of the BRICs in the EU’s extra-EU FDI stocks (in %) – right

Brazil Russia 2002 2007 3.41 India China 3.11 18 2.78 15 2.33 2.33 12

9 1.23 1.05 6 0.54 0.61 3 0.34 0 -3 Brazil Russia India China Hong 2001 2002 2003 2004 2005 2006 2007 Kong

Remark: EU is EU27 for 2004-2007 and EU25 for 2001-2003. China excludes Hong Kong. Source: Eurostat.

23 According to UNCTAD (UNCTAD, 2008a) China is perceived as the most attractive location for FDI by investors globally, followed by India. As the sole non-BRIC country among the top 5 destinations, UNCTAD lists the United States in third position, followed by Russia and Brazil which occupy rank 4 and 5 respectively. China’s lead in locational competitiveness rests upon two pillars. The first is that MNCs take advantage of China’s large supply of cheap labour and use China as a manufacturing platform for labour-intensive parts of production. The second is that high growth rates led to the emergence of a Chinese middle class in the order of 300 million which makes China also an attractive destination for market-seeking investment. The latter seems to gain in importance as rising wages in China’s coastal regions have significantly reduced China’s cost advantage in labour-intensive manufacturing (Bartlett, 2008). 24 Ranking according to foreign assets in 2006 including assets owned by EU firms in other EU member states than their country of incorporation.

55 The share of the BRICs in extra-EU FDI stocks has not increased strongly in recent years, with the notable exception to Russia. Over five years, the combined share of the BRICs plus Hong Kong in extra-EU outward FDI stocks increased only by 2.5 percentage points to 10% in 2007 (Figure 1.3.2, right). Hong Kong’s share in extra-EU FDI decreased between 2002 and 2007 which can be explained by the increased attractiveness of China as a destination for FDI so that the detour via Hong Kong is not necessary anymore. China’s share in extra-EU stocks increased only marginally, to 1.23% in 2007, the combined share of China and Hong Kong actually declined slightly to 4% in 200725. Thus one can consider this country with rapidly increasing inward investment a place where EU companies were relatively reluctant in their FDI activities.

The slow pick-up of the BRIC’s share in EU outward FDI stocks is indeed surprising and it can only partially be explained by attractive investment opportunities elsewhere, such as in the close-by new EU member states. The overwhelming majority of FDI stocks continues to be in the advanced countries with high asset prices and a long history of FDI. This can change only very gradually by flows shifting to emerging economies. Other explanations for relatively low EU FDI in the BRICs can be associated with the risks and obstacles related to FDI in the individual BRIC countries.

Figure 1.3.3 Comparison of returns on FDI of EU FDI in the BRICs and new EU member states (2007)

20

15

10

5

0 l i h d a d y a a g U . l i ia i ia z r c r 10 n r n n p k s E i d a - nia a e - a o a a l a S a In v wo Re Br lg r ng Ch K Cz t o u Rus Po g NM B n Hu Sl Rom Ex Ho New EU member states BRICs Extra-EU World

Remark: EU is EU27. NMS10 includes Czech Republic, Hungary, Poland, Slovakia, Slovenia, Estonia, Latvia, Lithuania, Cyprus and Malta. China excludes Hong Kong. Returns on FDI in 2007 are calculated as the ratio of FDI income in 2007 to FDI stocks at the end 2006. FDI includes income on FDI equity and interest payable on inter-company debt. Income on equity consists of dividends due for payment to the direct investor, gross of

25 The same pattern is found for the US FDI stocks in China and Hong Kong, where the combined share of the two territories dropped from 3.15% to 2.71% between 2002 and 2007. The share of US stocks held in the BRICs stagnated at around 5.2% between 2002 and 2007.

56 withholding taxes, plus the direct investor’s share of the investment company’s reinvested earnings. Source: Eurostat, wiiw-calculations.

FDI is driven to some extent by returns on investments and the BRICs are very attractive in this respect (Figure 1.3.3). Taking the ratio of income earned on EU FDI abroad in 2007 to accumulated stocks until end of 2006 as a crude measure for the returns on FDI, FDI in the BRICs appear to be more profitable than FDI in the new EU member states. In 2007 EU firms earned returns on their FDI engagements above 13% in China and Hong Kong, well above the average of EU-extra FDI but also above the returns achieved in the most profitable new member states, Bulgaria and Slovakia. Profitability of EU FDI in Russia and Brazil is somewhat lower, 11.3% and 11.8% respectively, which is similar to the returns on FDI in the most profitable new member states but well above their average26. With returns on FDI exceeding 18%, India emerges as the by far most profitable location among the BRICs for EU firms.

Locational factors such as the perception of country risk27, which was found to be a decisive factor for FDI in emerging markets (Frenkel, Funke and Stadtmann, 2004), may explain the modest increase of EU FDI especially in the Asian BRICs. This would suggest that in several cases EU firms consider risk adjusted returns on FDI to be higher in the new EU member states (which also provide good investment opportunities because of privatization programmes) than in the BRICs. Other locational factors are specific to individual BRICs. For example, inefficient bureaucracy and a poorly developed infrastructure figure among the most important barriers for FDI in India (Bartlett, 2008). In China, investors’ concerns about property rights and remaining restrictions and caps to foreign ownership in the service sectors restrict EU investments in banking and telecommunications. Another factor favouring FDI in the new EU member states vs. the BRICs is geographic proximity in combination with industry structure. Especially small and medium sized enterprises tend to limit their FDI engagement in geographically close countries (Hunya, 2008).

26 NMS10 includes the Czech Republic, Hungary, Poland, Slovakia, Slovenia, Estonia, Latvia, Lithuania, Cyprus and Malta. 27 In Russia, for example, anxieties about the foreign investment conditions in the natural resources sectors prevail and even deepened after the dispute over the ownership structure in the Sakhalin-2 oil field project (Bartlett, 2008). In addition, FDI in sectors considered to be of strategic interest by the Russian government is restricted.

57

Figure 1.3.4 Share of EU FDI in the BRICs’ inward FDI, average flows 2004-2007, in % – left; Comparison of FDI outflows from the EU, the USA and Japan to the BRICs, average 2005-2007, EUR million – right

EU USA Japan

Brazil 57 12000 60 53 50 6000 40 31 Hong Kong Russia 30 21 0 20 10 10 0 Brazil Russia India China Hong China India Kong

Remark: EU is EU27 for 2004-2007. China excludes Hong Kong. Source: Eurostat, UNCTAD, US Bureau of Economic Analysis.

While the share of EU FDI going to the BRICs remains small, the EU is an important source of FDI for all BRICs. This constellation mirrors trade, as the EU is a more important trading partner for the BRICs than vice versa. In terms of FDI flows, the EU is by far the most important investor in Russia and Brazil accounting on average for 57% and 53% of the total FDI going to these countries in the period 2004-2007 (Figure 1.3.4, left).

In the Asian BRIC economies the share of the EU in inward FDI is much lower, ranging from 31% in India to only 10% in China. This is explained by the large intra-regional FDI flows in South and South-East Asia. In the case of China, Hong Kong stands out as the largest investor accounting for 37% of total inflows in the period 2004-2007. FDI flows originating from Singapore, Taiwan and South Korea make up another 13%28. The high share of intra-regional FDI in Asian countries is linked to the high degree of vertical trade integration. In the case of Hong Kong, however, a part of the FDI flows to China constitutes ‘round-tripping capital’, i.e. Chinese investments taking a detour via Hong Kong for tax or other reasons (Poncet, 2008). This phenomenon is also found in India and Russia. Since round-tripping inflates a country’s aggregate FDI, the role of the EU as a provider of FDI to India and China might be higher than suggested by the statistics; in the case of Russia the situation is different because much of Russian round-tripping capital enters via Cyprus which is an EU member state (see Box 1.3.2). Regardless of the precise share of EU member states in Russia’s inward FDI, EU firms show a very high presence in Russia. A major reason for this is Russia’s proximity which is one of the major determinants of the intensity of bilateral FDI flows to emerging markets (Frenkel, Funke and Stadtmann, 2004).

28 The shares of Asian countries in total inward FDI of China are from Chinese sources and therefore not entirely comparable to the indicated EU share of 10% which is based on Eurostat data (see Box 1.3.2).

58

The EU emerges as the largest provider of FDI among the Triad countries in each of the BRICs (Figure 1.3.4, right). In Russia and Brazil, the amount invested by EU firms equalled seven to eight times the amount of FDI undertaken by US firms in these countries (average 2005-2007). The average annual FDI flow from the EU to China in 2005-2007 amounted to EUR 6.6 billion, more than twice the amount pouring in from the United States. Japan, which has a strong Asian focus in its outward FDI, recorded on average EUR 4.9 billion to China during the same period. In Hong Kong, the magnitude of FDI flows from the EU and the United States are on a more similar level amounting to EUR 4.9 billion and EUR 3.7 billion respectively. EU flows to India were the lowest among the BRIC countries amounting to EUR 3.9 billion on average for the period 2005-2007, albeit the EU is the number one investor in India if Mauritius is neglected (see Box 1.3.2). Whereas the strong FDI links between the EU and Russia could be expected due to the proximity of the two markets and was also found in the trade in goods and services, the favourable position of EU firms in Brazil compared to US firms is more surprising and in contrast with the result found in services trade. The strong position of EU firms in the BRICs is mainly the result of FDI from Spain which has close historical links with South America29 and Germany which is a major and geographically well diversified provider of FDI.

Table 1.3.1 Major EU investor countries in the BRICs Average annual outflow (2004-2007) and outflows in 2007 (EUR million)

Brazil Russia 2004- 200 2004- 200 2007 7 2007 7 620 669 Spain 2946 Spain 1 Germany 2190 Germany 9 176 259 France 1331 France 0 Netherlands 2075 Austria 7 114 United United 195 Germany 1102 Germany 6 Kingdom 1287 Kingdom 8 United United 105 123 Kingdom 553 Kingdom 4 Austria 985 Belgium 1 108 Belgium 502 Netherlands 559 Sweden 804 Sweden 4 Share in EU Share in EU total 83% total 76% India China 2004- 200 2004- 200 2007 7 2007 7

29 Portugal which is the former colonial power in Brazil does not show up as a major investor in Brazil in terms of values but has several smaller MNC operating in Brazil.

59 172 United 166 Germany 883 Germany 1 Germany 1934 Kingdom 9 United United United 153 Kingdom 608 Kingdom 975 Kingdom 972 Germany 1 143 France 281 Netherlands 495 France 758 France 3 Netherlands 276 France 366 Denmark 434 Denmark 752 Sweden 102 Sweden 192 Netherlands 395 Finland 499 Share in EU Share in EU total 86% total 82% Hong Kong BRIC (including Hong Kong) 2004- 200 2004- 200 2007 7 2007 7 United United 254 United 118 Kingdom 3770 Kingdom 8 Kingdom 7190 Germany 13 182 United 820 France 650 Netherlands 3 Germany 6684 Kingdom 4 715 Netherlands 581 France 937 Spain 3879 Spain 0 521 Germany 575 Germany 716 Netherlands 3730 France 4 276 Spain 567 Spain 567 France 3604 Austria 9 Share in EU Share in EU total 94% total 78% Remark: EU is EU27. China excludes Hong Kong. BRIC includes Hong Kong in this table. Source: Eurostat.

A closer look at the individual EU member states’ investment engagement in the BRICs and Hong Kong (Table 1.3.1) reveals that in 2007 Germany was the most important investor thanks to strong involvement in all five markets with FDI flows ranging from EUR 716 million in Hong Kong to EUR 6.7 billion in Russia. Germany figures among the top 5 investors in all BRICs and Hong Kong. FDI by France and the Netherlands to the BRICS is rather diversified by target country, whereas Spain’s FDI activities are highly concentrated in Brazil. The United Kingdom, traditionally the largest investor among the EU member states in the BRICs with average FDI flows of EUR 7.2 billion during the period 2004-2007, has a focus on Asian, especially on Hong Kong. The United Kingdom is also among the top five EU investors in the remaining BRICs. Next to the activities of the five top EU investors mentioned, there is some important FDI from Austria, Belgium and Sweden going to Russia.

60

Box 1.3.2 Is Mauritius really investing more in India than the EU? In the balance of payments FDI flows are recorded according to the principle of residence. This means that flows are allocated to the countries where the two entities that engage in a direct transaction are domiciled. This is at the origin of the possible discrepancy between the actual (ultimate) source of an FDI transaction and the source country recorded in statistics based on balance of payments principles such as Eurostat.

In the case of Russia, India and China the use of holding companies and special purpose entities (SPE) in arranging FDI transactions drives a wedge between the recorded source country of FDI and the ultimate source country. In Russia, for example, Cyprus, one of the smallest EU member states, is among the top investors according to Russia’s Federal State Statistics Service. The ‘Cyprus-effect’ inflates the EU’s share in Russian inward FDI to approximately three thirds. This is a much higher share than recorded by Eurostat because investments through some SPEs in Cyprus (in particular empty holding companies with no economic activity in Cyprus) are not covered by Eurostat. Since a part of Cypriote FDI into Russia is expected to be round- tripping capital, that is capital from Russian sources invested via the detour of Cyprus for tax or other reasons, Eurostat data better reflect the role of EU firms as FDI investors in Russia. The differences between Eurostat data and national data sources can be seen by comparing Figure 1.3.4 with the Figure below which shows the country-break down of inward FDI for India, China and Russia based on national data sources. Inward FDI flows by main investors (average 2004-2007) India China Russia

ot h e r other EU 27 Singapore 16 % Mauritius 9% 7% Japan 44% 8% EU 7% 74% USA Virgin Isl. Singapore off -shore 4% 3% 8% 26% Switzerl. 4% Japan USA 3% 3%

USA 8% Asian Hong EU NI Cs Kong 21% 13% 34% Remark: For India figures are average flows for April 2000 to November 2008 In Russian figures EU includes only United Kingdom, Cyprus, the Netherlands, Luxembourg, Germany, France. Off-shore centres include Virgin Islands, Cayman Islands, Barbados, Bahamas, Samoa. Asian NICs (Newly- industrialized countries) include Singapore, Taiwan, Korea Source: Department of Industrial Policy & Promotion for India, China Statistical Yearbook, Rosstat for Russia.

Round-tripping capital also inflates inward FDI figures of China and India, primarily through inflows from Hong Kong and Mauritius, respectively. In the case of India, Mauritius shows up as the number one investor country accounting for 44% of the inward FDI. Different treatment of these flows can explain some of the existing differences between Eurostat data and national data sources. As in the case of round-tripping capital, the use of holding companies and SPEs domiciled in off-shore centres can make important investor countries ‘disappear’ in bilateral FDI statistics. For example, an US MNC might find it advantageous to use a SPE in Barbados to finance the acquisition of a Chinese firm. The acquisition of the Chinese company in this case is recorded as an Chinese inflow from Barbados. The use of holding companies and SPEs is clearly on the rise. For the US, foreign affiliates abroad classified as holding companies already accounted for 33% of the US outward stock in 2007 (Ibarra and Koncz, 2008). These problems do not appear in the fDi database of the FDI Intelligence from Financial Times Ltd which records the home country of the investor and not the financial intermediate.

61

1.3.2.2 Sectoral structure of EU FDI in the BRICs Global EU outward FDI takes place predominantly in service industries accounting for more than three thirds of the EU’s total outward FDI stock in 2006. The dominance of services over manufacturing is in line with the structure of the EU economy but in stark contrast to the relative importance of these two broad sectors in international trade. While the ratio between the EU's global goods exports and services exports stands at over 3 (3.3 in 2007), the ratio between FDI flows in goods producing sectors30 to FDI flows in services sectors is just over one third. (0.36 in 2006). So the relative importance of goods and services are precisely reversed in the context of FDI when compared to trade.

The EU’s FDI stocks in the BRICs are skewed to the service sector as well, but the manufacturing sector occupi es a much larger share relative to global and extra-EU FDI stocks. In India and China manufacturing and service industries both account for approximately half of the total stock (Table 1.3.2). In the case of India and China the relatively high share of manufacturing can to some extent be explained by restrictions to FDI, includi ng limitations of foreign ownership in industries considered as ‘strategic’, which are more severe in serv ices industries and infrastructure such as electricity, transport and telecommunication (Koyama and Golub, 2006). The sectoral composition of EU FDI stocks in Brazil resembles very much the structure of FDI in industrialized economies with roughly two thirds attributab le to services. Investments in the primary sector only play a marginal role in Brazil, India and China. In Russia, the large FDI stock in the primary sector which includes exploration of oil and gas stands out. It represents 18% of the EU’s FDI stock in Russia, leaving 30% to manufacturing and 50% to services. The significance of the primary sector in inward FDI in Russia, however, is expected to have declined after the adoption of the new law on ‘strategic sectors’ in April 2008. In Hong Kong, the situation is very diffe rent from China and t he other BRICs. Basically the entire FDI stock, amounting to EUR 86 billion, owned by EU firms is attributed to the service sector.

30 Goods producing sectors include agriculture and fishing, mining and quarrying, manufacturing and electricity, gas and water.

62 Table 1.3.2 EU outward stocks in the BRICs by economic activity (2006), in EUR million

Brazil Russia India China Hong Kong Agriculture and fishing 36 23 2 5 1 Mining and quarrying 714 9268 376 1223 121 Manufacturing 21898 15376 5901 15214 2447 Food products 4307 2682 1177 825 109 Textiles and wearing apparel 409 45 37 194 84 Wood, publishing and printing 299 916 177 483 39 Refined petroleum products and other treatments 652 7777 632 384 220 Manufacture of chemicals and chemicals products 2986 823 1120 2796 182 Rubber and plastic products 1004 509 107 696 153 Metal products 4234 344 210 975 141 Mechanical products 1591 236 807 2169 1055 Office machinery and computers 13 -5 35 108 77 Radio, television, communication equipments 360 89 208 1166 13 Vehicles and other transport equipment 4406 825 573 2973 146 Electricity, gas and water 863 270 146 278 10 Construction 386 380 22 55 97 Services 52877 24492 5559 14797 83333 Trade and repairs 2015 2867 356 1958 2551 Hotels and restaurants 216 357 251 18 61 Transport and storage 1254 89 294 577 109 Telecommunications 205 913 88 28 1285 Post and courier activities 148 53 77 6 -402 Financial intermediation 26572 12664 3413 6771 72345

63 Real estate an d business activities 21908 7164 1026 5363 7209 Real estate 241 312 8 167 91 Renting of machinery and equipment 92 76 1 15 4836 Computer activities 195 146 323 123 143 Research and development 381 8 18 313 3 Other business activities 20997 6621 677 4742 2134 Total 78330 50226 12308 32329 86401 Remark: EU is EU27. China excludes Hong Kong. Economic activities according to Eurostat nomenclature. Numbers do not add up to Total because of non-allocat ed activities.. FDI outward stocks are classified according to the activities of the non-resident enterprise, i.e. the enterprise in the respective BRIC country. Source: Eurostat.

64 Financial intermediation is the most important FDI activity for EU firms in the BRICs with its share ranging from approximately 20% in China to one third in Brazil (Table 1.3.2). In Brazil and in Russia, where financial intermediation accounted for 25% of total stocks in 2006, the dominant position of the financial sector is the result of the internationalization of European banks, also in retail banking31. EU banks are less dominant in the banking sectors of India and China, mainly because of ownership restrictions in these countries. Financial intermediation is nevertheless the leading industry in these countries mostly due to the wholesale financial sector and the emergence of new financial centres such as Shanghai or Mumbai. In Hong Kong essentially all FDI activities of EU firms is in financial services reflecting Hong Kong’s role as a global financial centre.

Real estate & business activities and trade & repairs follow financial services in terms of EU FDI stocks in all BRICs. This may be less the result of similar strategies of EU MNCs or similarities of economic structures on the side of the BRICs than the low level of disaggregation of data in the category of business services, albeit in the case of India the focus on computer activities stands out.

There is more variation within the manufacturing sector. Similar patterns across BRICs, however, also exist in manufacturing not only because capital-intensive industries usually get more FDI than others, but also due to the competitive advantages of EU firms. The section on trade revealed a huge positive specialization of the EU on machinery and equipment and other transport equipment in bilateral exports to the BRICs reflecting the EU’s comparative advantages. Therefore machinery and equipment32 and transport equipment are also found among the top five industries in each of the BRICs in terms of FDI stocks in 2006 (with the exception of machinery and equipment in Russia.) The same is true for the chemical industry, another stronghold of EU firms and globally the most important sector for the EU in terms of FDI.

Reflecting the match of some large EU MNCs and a large and growing market size, the food industry is among the top five manufacturing industries in Brazil, Russia and India. In the latter the EU food industry has even accumulated the largest FDI stocks within manufacturing. In Russia, the FDI stocks owned by EU firms also reveal the high dependency of Russia on its natural resources. Natural resources, comprising mining and quarrying – which in turn includes oil and gas exploration – and refined petroleum account for EUR 17 billion or one third of the total EU FDI stocks in Russia33. The major role of petroleum in EU-Russia relations is also highlighted by the fact that 8% of the global EU FDI stock in refined petroleum is located in Russia (2006).

31 In the case of banks, the set-up or acquisition of an affiliate bank abroad generally induces large FDI flows since inter-company loans are recorded as FDI. This means that all loans provided by EU parent banks to their foreign affiliates are recorded as FDI and add to the EU’s FDI stock abroad. Although this is also the case for all other enterprises, loans between affiliated banks are of a much higher magnitude because typically foreign affiliates have their parent banks as an important refinancing source for their entire banking operations. 32 Machinery and equipment (NACE division 29) is the equivalent to mechanical products (2900) which is the terminology used in the Eurostat nomenclature for FDI. 33 The large share of FDI related to natural resources in the EU’ FDI outward stock in Russia mainly reflects 2-3 large projects by leading EU petroleum companies.

65 Box 1.3.3 Holding companies, SPEs and the industry distribution of FDI Some caution is warranted when interpreting data on FDI stocks by industry. Much like in the case of the geographical split-up of FDI, the structuring of FDI transaction can drive a wedge between the actual industry in which a firm undertakes FDI and the industry under which the transaction is recorded. In line with international guidelines (IMF, Balance of Payments Manual), the allocation of an FDI transaction to a specific economic activity is made on the basis of the direct transaction, not the entity that is ultimately acquired. The complex company structures of MNCs and the possibility to create ‘empty holding companies’ or special purpose entities (SPEs) can easily blur the relative importance of industries for both inward and outward EU stocks as reported by Eurostat. In the case of EU inward FDI stocks the FDI transactions undertaken by enterprises from the BRICs are recorded according to the activity of the direct investment enterprise, i.e. the EU entity which is acquired or established. In case such a transaction, for example the acquisition of an EU manufacturing company by a Russian enterprise, is made via an SPE in Luxembourg, it would be recorded under ‘financial intermediation’ unless the reporting authority can group the SPE to the investor company. Likewise, the EU’s outward FDI stocks are allocated according to the economic activity of the acquired company (direct investment enterprise), i.e. the enterprise located in the BRICs. Structuring the transaction via an SPE or a holding company may obscure the economic activity the FDI transaction is really related to, i.e. the industry in which the acquired company ultimately operates. Finally, complex company structures ‘create’ significant and increasing amounts of FDI that neither relate to mergers or acquisitions nor to a new project (greenfield investment). All cross- border transactions that entail a change in ownership between affiliated companies are equally recorded as FDI. In case of EU inward FDI, if the direct investment enterprise is a financial holding, this kind of transaction is recorded under financial intermediation. If the direct investment enterprise is a holding company providing management functions, this transaction is recorded under ‘other business activities’. The bottom line is that FDI data by sectors and industries may be biased towards services (financial intermediation and business activities) because of the underlying methodology for allocating transactions and stocks to industries. The relatively bigger importance of manufacturing in the FDI relations between the BRICs and the EU found in the analysis of investment projects (see below) also point in this direction. The fDi database does not have the bias of the balance of payments statistics, although its reliability is weakened by relying on incomplete information provided by companies.

1.3.2.3 FDI of the BRICs in the EU in comparison to the United States and Japan Outward foreign direct investment undertaken by MNCs of emerging markets including the BRICs is a rather new phenomenon. FDI outflows from the BRICs picked up in the early 1990s and its growth accelerated markedly only with the beginning of the new millennium (Figure 1.3.5, left). This gives all of the BRICs, excluding Hong Kong, a latecomer status with regards to outward FDI. Rapid growth of outward FDI flows since the beginning of the decade has made Russia the most important FDI investor among the BRIC countries in 2007. Brazilian global outward FDI is rather volatile but shows a clear positive trend and a strong pick-up is observable

66 for China and India. Much less of an upward trend is discernible in the FDI flows of the BRICs directed towards the EU, with the important exception of Russia (Figure 1.3.5, right). Rather than a steady upward trend, the EU inflows originating from Brazil, India and China show single peaks in different years such as Brazil with EUR 4 billion in 2004. Russian FDI flows to the EU, amounting to EUR 9 billion in 2007, constituted the largest inflow recorded from any of the BRICs during the period 2001-2007. Hong Kong used to be an active FDI investor in the markets of the EU but has lost this position due to disinvestments over the last three years.

Figure 1.3.5 BRIC global FDI outward flows (left) and bilateral flows to the EU (right) (in EUR billion)

Brazil Russia Brazil Russia 40 India China 10 India China 8 30 6 20 4 10 2

0 0

-10 -2 1 5 07 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 20 2006 2007 200 2002 2003 2004 2005 2006 20 Remark: EU is EU27 for 2004-2007 and EU25 for 2001-2003. China excludes Hong Kong. Source: UNCTAD, Eurostat.

The BRICs are not a major source of FDI for the EU. Flows from the BRICs and Hong Kong taken together, on average, accounted for only 5.5% of extra-EU inward FDI flows during the period 2002-2007. Moreover, their share is not really increasing, mainly because of falling flows from Hong Kong34. This makes the BRIC countries underrepresented in the EU market in terms of FDI flows when compared to their share in global FDI which stood at 7.1% in 2007. The same is true for inflows received by the US from the BRICs. BRIC FDI flows including those from Hong Kong as recorded by the United States started from insignificant levels in 2002 (0.11% of total US FDI inflows), reached a peak of 2.8% in 2005 due to a mixture of very low total US inflows and an increase of FDI received from the BRICs, but declined again to 0.58% of total inflows in 2007.

The comparison between FDI inflows to the EU and the United States originating from the BRICs shows that Russia and Brazil invested on average much larger amounts in the EU than in the United States during the period 2005-2007 (Figure 1.3.6). The same is true for China but not for Hong Kong because of Hong Kong’s disinvestments in the EU in recent years. Finally, FDI flows suggest that Indian investors have a preference for the United States which received on average

34 FDI flows from the BRICs, excluding Hong Kong, accounted for 3.5% of extra-EU inflows into the EU over the 2002-2007 period. But even their share show no clear upward trend. The significance of the BRICs as an investor for the EU is even smaller when stocks are considered because of the late start of any sizeable outward FDI by the BRIC countries.

67 EUR 945 million annually in the period 2005-2007. This represents the highest inflow from any of the BRIC countries to the United States, whereas Indian average annual flows to the EU were only EUR 628 million during the same period, the least among all of the BRICs.

Figure 1.3.6 Comparison of FDI inflows from the BRIC countries into the EU and the USA (average flows 2005-2007) in EUR million

EU 27 USA

Brazil 4000

2000 Hong Kong Russia

0

China India

Remark: EU is EU27. China excludes Hong Kong. Source: Eurostat, US Bureau of Economic Analysis.

Recalling the three major objectives for firms to undertake FDI distinguished by FDI theory, i.e. market seeking investment, resource-seeking investment and efficiency-seeking investment (UNCTAD, 1998) gives a first hint on why the EU is of rather low priority in the BRICs’ outward FDI activities. First of all, resource-seeking FDI which aims at securing needed raw materials and other natural resources is a major investment motive for the BRICs, in particular for China and India. In volume terms China’s outward FDI is dominated by state-controlled enterprises in natural resources or telecommunication most of which enjoy a monopoly or monopoly-like situation in the Chinese economy (Morck et al., 2008). Obviously, resource-seeking type of FDI by the BRICs is directed predominantly to resource-rich countries of Africa, South America and Asia and not to the EU. Secondly, no significant efficiency-seeking FDI can be expected to pour into the EU from the BRICs as labour-costs are generally much higher in the EU than in the BRICs35. This means that access to new markets remains as the major motive, supplemented by additional motives such as access to new technologies36 (Holtbrügge and Kreppel, 2008). In the

35 In general, efficiency-seeking is not the major motive for outward FDI by the BRICs but there is anecdotic evidence for such investments. For example, Chinese companies have started to transfer the production of some of its low-tech manufacturing products to countries with lower wages such as the offshoring to Indonesia of the production of DVDs (Sauvant, 2005). 36 FDI motivated by the access to new technologies or the acquisition of an existing brand name is often subsumed under resource- and asset- seeking FDI. Assets in this context refer to values created by firms in contrast to raw materials or natural resources.

68 case of Russia the geographical diversification of investment also appears as an investment motive (Deutsche Bank, 2008).

Outward FDI activities of the BRICs have a strong regional focus. Especially in Asia a lot of so- called ‘South-South’ investment, meaning FDI between developing or emerging markets, is taking place. The same applies to Brazil which is a big investor in South America, and Russia which is an important investor in the Commonwealth of Independent States (CIS). The major reason for this pattern is the role of geographical distance which, as mentioned earlier, is an important determinant of bilateral FDI flows. Hence – as is the case for most MNC in the EU, the US and Japan – many firms from the BRICs start their internationalization strategies in neighbouring countries where culture and the legal and administrative environment are more similar. The Russian telecom provider Vimpelkom which has nation-wide licences in a series of CIS-countries such as Kazakhstan, Tajikistan, Ukraine, Uzbekistan, Georgia and Armenia but is not present in the EU can serve as examples in this respect. In some instances the regional focus may also be grounded by the lack of competitiveness, i.e. of the capability to successfully enter the highly competitive markets of developed countries.

Finally, FDI flows from the BRICs to the EU may also be hampered by restrictions to FDI on the side of the EU. Albeit the EU in general appears to be very open towards inward FDI according to OECD’s FDI regulatory restrictiveness index (Golub, 2003, Koyama – Golub, 2006), restrictions do exist, mainly in infrastructure sectors such as electricity, transport and telecommunications but also in finance. According to the OECD index, in EU member states (and other OECD countries, including the United States and Japan) the predominant form of restrictions is screening and approval procedures. In contrast, most EU member states maintain hardly any formal limitations to foreign ownership. A shortcoming of the OECD index is that it mainly captures overt restrictions but miss informal and tacit forms of restrictions such as procedural delays or lack of transparency on the award procedure in public tenders. National resentments and anxieties against foreign investors as, for instance, those of the activities of sovereign wealth funds (SWF)37 in the EU increase the possibility of informal ways of discrimination against unwanted foreign direct investors. Moreover, several EU member states including Germany, the United Kingdom and France have legal frameworks that enable them to block FDI projects in sectors deemed as strategic for national safety or security reasons. The same, however, also applies to the United States and Japan (UNCTAD, 2008b).

1.3.2.4 Sectoral structure of BRICs FDI in the EU The late start of outward FDI undertaken by MNCs from the BRICs and the mediocre priority given to the EU as a target country means that as of 2006 stocks owned by BRICs firms in the EU are modest. Accumulated stocks of Brazil and Russia, both equal to approximately EUR 15 billion each, are much larger than those of China and India which amount to

37 Russia (Stabilization Fund and National Welfare Fund), China (China Investment Corporation) and Hong Kong (Hong Kong Monetary Authority Exchange Fund) all have significant SWFs.

69 EUR 3.6 billion and EUR 2.2 billion, respectively. All BRICs have in common that their outward FDI in the EU is highly concentrated in the service sector (Table 1.3.3).

Hong Kong’s outward FDI stock in the EU is mainly in telecommunications. This is explained by the activities of Hutchison Whampoa, the largest MNC in emerging markets in terms of foreign assets (UNCTAD, 2008b) which, within the EU, is active in Austria, Denmark, Ireland, Italy, Sweden and the United Kingdom. In the case of Brazil, Russia and India industries related to business activities have accumulated the largest outward FDI stocks in the EU as of 2006 (Table 1.3.3).

For India the dominant role of business activities in outward FDI towards the EU is to some extent the result of the increasing internationalization of the Indian IT and software cluster, led by firms such as Tata Infotech and Infosys Technologies. Computer services account for EUR 286 million or 39% of the EUR 741 million FDI stocks in real estate and business activities owned by Indian firms. In Brazil also a sizeable number of IT and software development firms (such as Itautec) have emerged and started to go abroad (Gouvea, 2007) but the FDI stock owned in the EU in business activities are predominantly the result of Brazilian business and management consultancy firms that – within the EU – concentrate their activities in Spain38. The second most important service industry for Brazil, Russia and India in bilateral FDI relations with the EU is financial intermediation. In the case of Russia, a part of the FDI stock owned in the EU can be attributed to the activities of Vneshtorgbank (VTB), the second largest bank in the country. VTB’s has wholly owned subsidiaries in Austria, Cyprus and subsidiaries (majority-owned) in France, Germany and the United Kingdom. The internationalization strategy of VTB in the EU is to follow CIS companies on the European market. For China, financial intermediation is by a wide margin the dominant industry in terms of outward stocks in the EU as of 2006. This can partly be attributed to the fact that major banks such as Commercial Bank of China, Bank of China, China Construction Bank, Bank of Communications all have established branches or representative offices in several EU member states39.

38 Business and consultancy services include activities of holding companies with active management functions. 39 The importance of the financial sector in the BRIC’s outward FDI activities in the EU is nevertheless surprising. Part of the explanation may be the bias towards services in the recording of FDI stocks (see Box 1.3.3).

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Table 1.3.3 EU inward stocks owned by the BRICs by economic activity (2006), in EUR million

Hong Brazil Russia India China Kong Agriculture and fishing 2 4 -1 1 -7 Mining and quarrying 12 -5 6 5 17 Manufacturing 344 540 590 420 340 Food products 212 31 408 31 -17 Textiles and wearing apparel 5 3 -2 19 69 Wood, publishing and printing 2 41 -1 24 46 Refined petroleum products and other treatments 1390 29 Manufacture of chemicals and chemicals products 20 80 120 6 -122 Rubber and plastic products 7 12 -7 32 -35 Metal products 29 135 14 13 5 Mechanical products 108 23 12 27 94 Office machinery and computers -58 13 1 236 44 Radio, television, communication equipments 6 109 3 8 97 Vehicles and other transport equipment 3 69 29 19 -6 Electricity, gas and water 2 903 -2 1 -6 Construction 85 289 -3 13 2 Total services 14168 12143 1463 3101 16317 Trade and repairs 1939 1122 150 312 352 Hotels and restaurants 5 43 1 5 38 Transport and storage 48 116 10 98 284 Telecommunications 8 18 28 24 10283 Post and courier activities 6 4 -21 2 599 Financial intermediation 4004 3921 523 2452 2301 Real estate and business activities 8130 6368 741 197 2386 Real estate 105 559 15 42 377 Renting of machinery and equipment 8 20 8 21 26 Computer activities 8 -3 286 3 99 Research and development 2 1 -2 -18 -6 Other business activities 8006 5789 435 150 1888 Total 14625 14571 2222 3566 17461 Remark: EU is EU27. China excludes Hong Kong. Economic activities according to Eurostat nomenclature. Numbers do not add up to Total because of non-allocated activities.. FDI inward stocks are classified according to the activities of the resident enterprise, i.e. the EU enterprise. Source: Eurostat. EU is EU27.

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There is very little outward FDI undertaken by BRIC manufacturing firms with the exception of India. In several cases, the existing stocks match well with a documented single transaction. For example, the food industry is the most important manufacturing sector in the Indian FDI stocks in the EU (EUR 408 million) due to the takeover of a British tea company (Tetley Tea) by Indian Tata Tea in 2000 (Sauvant, 2005). The growing Indian pharmaceutical industry, which is a major player in producing generic drugs, expanded into the EU via the acquisition of RPG Aventis in France by Ranbaxy Technologies. In case of China most manufacturing FDI in the EU is in the computer industry which matches well with the activities of the Chinese top notch computer manufacturer Lenovo. The company has, for instance, established a production facility in Poland.40

Russian manufacturing outward FDI in the EU is very limited. The Russian investment activities in electricity, gas and water, with Gazprom being the main investing company, led to the accumulation of EU inward stocks from Russia of EUR 900 million which easily exceeds the FDI stocks accumulated in all manufacturing industries.

1.3.2.5 FDI and competitive positions A local presence of firms from the BRICs in the EU market is still more the exception than the rule. Despite single examples, overall, MNCs from the BRICs exert only very limited competitive pressure via subsidiaries established in the EU and competition is much fiercer via the trade channel. For the manufacturing sector this can be seen by comparing the manufacturing sales of foreign affiliates of BRIC MNCs in the EU member states, as recorded by the OECD Foreign Affiliates Trade Statistics (FATS), with the imports of goods from the BRICs into the EU. In many EU member states, the sales of BRIC foreign affiliates in their domestic market are reported to be zero41. In all cases where positive foreign affiliate sales (FAS) of BRIC firms are recorded such as Indian (EUR 360 million) and Chinese affiliates’ sales (EUR 751 million) in France, Indian affiliates’ sales in the United Kingdom (EUR 316 million) or Russian affiliates’ sales in Italy (EUR 481 million), these amounts are minuscule in comparison with the imports of these EU member states from the respective BRIC country (Figure 1.3.7). This suggests that in manufacturing, companies from the BRICs rely largely on exports in the competition for market shares in the EU and hardly compete via affiliates established there. The almost complete absence of foreign affiliates of the BRICs in the EU market can be seen as a competitive advantage for EU manufacturing firms in their home market. At the same time, however, this also means that the BRICs’ FDI activities hardly create any additional employment opportunities in the EU. The same is true for BRICs’ MNCs on the Japanese and the US markets.

40 Lenovo has expressed interest in the takeover of the Siemens shares in the Fujitsu Siemens Computer joint venture (EE Times Europe, 2008). This intention is of course not reflected in Eurostat data. 41 Information of sales of foreign affiliates is not yet obtainable for all EU member states. Member states such as Germany, Spain or the Netherlands do not provide this kind of information. It is therefore not possible to arrive at an EU aggregate.

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Figure 1.3.7 Goods imports from the BRICs and sales of BRICs’ foreign affiliates in manufacturing in the respective economy (2006), million EUR

Brazil Russia India China Hong-Kong 243532 94398 60000

50000

40000

30000

20000

10000

0 Imports FAS* Imports FAS** Imports FAS Imports FAS*** ImportsFAS****ImportsFAS*****

France Italy Sweden United Kingdom United States Japan

Remark: China excludes Hong Kong. Companies are considered as foreign affiliates if a foreign firm holds majority ownership. * value for Russia 2005. ** values are 2005. *** values 2005 except for India. **** value for China 2005. ***** value for India 2005. Source: UN Comtrade, OECD Foreign Affiliate Trade Statistics.

Figure 1.3.8 Goods exports to the BRICs and sales of foreign affiliates in manufacturing of the respective country in the BRICs (2006), million EUR

Brazil Russia India China Hong Kong 73885 60000

50000

40000

30000

20000

10000

0 Exports FAS Exports FAS Exports FAS Exports FAS Finland Germany United States Japan

Remark: China excludes Hong Kong. Companies are considered as foreign affiliates if a foreign firm holds majority ownership. Source: UN Comtrade, OECD Foreign Affiliates Trade Statistics.

73 In contrast, EU FDI in the BRICs has led to a strong local presence of EU firms in these markets and EU firms seem to compete intensively via the sales of affiliates in the markets of the BRICs. Comparing FAS of EU MNCs in the BRICs with EU exports to these markets shows that in several instances FDI has become the primary mode of entry and channel of competition for EU firms. Sales of German affiliates in Brazil, for example, exceed by far the volume of German merchandise exports to Brazil, and the same is true for Finish FAS in China (Figure 1.3.8). FAS play an extremely important role for US MNCs as well, particularly in Brazil and China. For Japanese firms exports to and sales of Japanese affiliates in China, Hong Kong and India are both important. In China and Hong Kong exports still exceed FAS but the reverse is already true in Japan’s trade and investment relations with India.

1.3.3 Investment project database analysis This section is based on the fDi database which covers overseas investment projects recorded by between 2003 and 2008. First we look at the FDI of the world in the BRICs (Brazil, Russia, India, China and Hong Kong), than at the investments of the EU15 in these countries. Compilation of data for other EU members failed due to methodological problems, but it is quite sure that the overwhelming majority of EU27-related projects are covered. (For detailed methodological notes see Box 1.3.1.)

Table 1.3.4 Investment projects in the BRICs, by year

EU in total From EU, EU in total Total no. of From EU, Year FDI EUR mn projects % FDI EUR FDI % projects projects mn 2003 2,582 122,129 828 32.1 40,917 33.5 2004 3,010 107,687 937 31.1 30,127 28.0 2005 2,642 64,279 905 34.3 21,489 33.3 2006 3,089 107,491 1110 35.9 38,161 35.5 2007 2,546 92,525 1016 39.9 30,163 32.6 2008 3,449 97,527 1311 38.0 38,879 39.9 Total 17,318 591,638 6,107 35.3 199,736 33.8 Source: FDI Intelligence from Financial Times Ltd.

1.3.3.1 Global and EU15 investments in the BRICs resilient to global crisis until 2008 The BRICs received more than 17.5 thousand FDI projects in the past six years out of a world- total of 73.6 thousand projects registered in the fDi database (Table 1.3.4). The highest number of projects was recorded in 2008; this was also the year with the most significant increase compared to the previous. As to the amount of investment in reporting projects, the total was EUR 592 billion over six years. The highest amount was achieved in 2003, highest growth in 2006. Annual fluctuations like the setback in 2005 followed global trends. But the expansion of FDI in the BRICs in 2008 was against the world-wide trend. The impacts of the crisis came to these

74 countries with some delay and less intense than to other parts of the world. The BRICs may have attracted investors in search of still expanding markets.

Table 1.3.5a Investment projects in the BRICs, by source country

Source country 2003 2004 2005 2006 2007 2008 2009 Total USA 705 882 843 957 732 926 41 5,086 Japan 366 487 281 273 194 332 12 1,945 Germany 212 216 224 259 242 289 13 1,455 UK 145 202 170 259 201 259 22 1,258 France 117 135 133 183 161 227 10 966 Italy 66 85 80 77 71 108 6 493 South Korea 80 90 83 84 69 83 3 492 Taiwan 88 70 43 78 62 64 405 Netherlands 65 66 46 63 68 90 1 399 Hong Kong 85 50 46 65 62 81 6 395 Source: FDI Intelligence from Financial Times Ltd.

Table 1.3.5b EU investment projects in the BRICs, by source country

Source 2003 2004 2005 2006 2007 2008 2009 Total country Germany 212 216 224 259 242 289 13 1,455 UK 145 202 170 259 201 259 22 1,258 France 117 135 133 183 161 227 10 966 Italy 66 85 80 77 71 108 6 493 Netherlands 65 66 46 63 68 90 1 399 Sweden 51 57 67 64 44 57 3 343 Finland 43 28 70 67 64 48 2 322 Spain 26 37 21 29 51 90 7 261 Austria 15 32 26 41 36 35 3 188 Belgium 19 29 24 29 33 42 4 180 Denmark 32 26 27 21 21 30 157 Portugal 20 17 3 3 6 15 64 Luxembourg 5 4 6 8 8 6 37 Ireland 4 2 7 3 4 11 31 Greece 8 1 1 4 6 4 1 25 EU Total 828 937 905 1,11 1,016 1,311 72 6,179 Source: FDI Intelligence from Financial Times Ltd.

75 1.3.3.2 Major investors in the BRICs: role of EU increasing The major source of FDI in the BRICs is by a large distance the US with more than 5 thousand investment projects, 29% of the total (Table 1.3.5). The highest number of investments occurred in 2006 followed by 2008. Last year the share of US projects was lower than before while that of Japan, second in the overall ranking, increased. The main EU investors, Germany, the UK, France and Italy occupy the ranks 3 to 6, with Germany coming close to Japan. The joint share of the four largest EU economies amounts to 24% for the whole observed period and 26% in 2008 which is a slight increase in concentration. The share of the EU15 increased from 32% in 2003 to 38% in 2008 which points to a growing importance of the EU among the investors in the BRICs.

In terms of reported investment capital the lead of the USA is much smaller than for the number of projects, with 15% for the whole observed period and only slightly higher in 2008. Germany comes second while Japan is further down the list. Investing countries with relatively high amounts of investments relative to the number of projects include Korea and Hong Kong. Those with relatively small sums per project are France and Italy. Still, the share of the four leading EU investors is 22%, higher than that of the USA for the whole observed period, reaching as much as 27% in the year 2008. As to the EU15, their share in the invested sum increased from 33% in 2003 to 40% in 2008. This is another strong argument supporting the increasing role of the EU investors in the BRICs.

1.3.3.3 Most foreign projects in China, for the EU also Russia and India important Almost half of the FDI projects realized in the BRICs went to China, together with Hong Kong 54.5% of the total (Table 1.3.6). The second target was India with half as many projects as China, than again with great distance Russia and finally Brazil. 2008 was the peak year for all the countries and 2007 was the weakest year. As all BRIC destinations and all major investing countries show the same fluctuation in the number of projects over time, the fluctuations must have to do with general and not country specific processes.

As to the amount of invested capital, the lead of China is smaller than in terms of the number of projects, and the investments in Hong Kong is of very small size. Russia has received the second largest amount of FDI. The relatively large size of investments in Russia can be linked to the capital-intensive oil and gas sector. Low capital intensity in Hong Kong and in India is a characteristics of the services sectors.

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Table 1.3.6a Investment projects in individual BRICs

Destination country 2003 2004 2005 2006 2007 2008 2009 Total China 1,323 1,545 1,244 1,402 1,190 1,483 64 8,251 India 452 694 590 983 690 958 56 4,423 Russia 427 383 513 397 368 561 24 2,673 Brazil 289 261 170 149 152 245 13 1,279 Hong Kong 91 127 125 158 146 202 11 860 Total 2,582 3,010 2,642 3,089 2,546 3,449 168 17,486 Source: FDI Intelligence from Financial Times Ltd.

European investment projects in the BRICs differ from the global first of all because EU15 countries invest relatively less in China and more in Russia than the rest of the world. China is the most important destination for EU investors but they give only 29% of the projects and 25% of the invested capital in that country in 2003-2008. But the EU share has been on the rise and in 2008 almost 35% of the projects in China came from the EU15. The picture we get on EU FDI in China from the fDi database largely differs of what we get from the Eurostat statistics. This may have primarily methodological reasons.

Table 1.3.6b EU15 investment projects in individual BRICs Destination 2003 2004 2005 2006 2007 2008 2009 Total country China 298 367 371 435 427 481 19 2,398 India 139 202 160 346 264 358 28 1,497 Russia 216 217 270 212 211 303 17 1,446 Brazil 140 115 66 57 58 107 5 548 Hong Kong 35 36 38 60 56 62 3 290 Overall Total 828 937 905 1,11 1,016 1,311 72 6,179 Source: FDI Intelligence from Financial Times Ltd.

For Russia, the EU is more important than for China: more than half of the projects and 40% of the invested capital came from the EU and the trend is increasing. India is almost as important as Russia for the European investors both in terms of project number and investment capital. But India receives also lots of projects from other countries and the share of the EU there is rather low.

1.3.3.4 Investors target mainly local and regional markets Of the more than six thousand EU investment projects 1382 provided information concerning the markets their activities serve. One third of these investment projects targeted only the domestic market of the host country, another one third the Asia-Pacific market, and 7% had global destination. Only 63 projects had the aim to serve European markets, which shows that the role of

77 outsourcing is rather small. Most projects serving the EU market were in Russia, the geographically nearest of the BRICs.

The motives of EU investments in the BRICs were related to the market conditions in the host country and the direction of sales (Table 1.3.7). Of the 1445 projects which supplied information 45% chose the location due to the growth potential of the destination market, 17% due to the proximity to customers and only 7% due to low costs. The motivation of investors and the markets of their products reveal that European FDI in the BRICs is primarily market seeking. It is the growth of the market, less the production cost which motivates investments. This structure of motivations suggests that when in the wake of economic growth wages will increase, this will not deter investors due to rising costs, but rather attract them due to growing demand.

Table 1.3.7 Motives of EU15 investors in the BRICs

Location determinants (motives) Projects % of projects Domestic Market Growth Potential 644 44,6 Proximity to markets or customers 251 17,4 Lower Costs 104 7,2 Skilled workforce availability 94 6,5 Industry Cluster / Critical Mass 76 5,3 Infrastructure and logistics 67 4,6 Regulations or business climate 62 4,3 Presence of Suppliers or JV Partners 33 2,3 IPA or Government support 23 1,6 Natural Resources 22 1,5 Attractiveness / Quality of Life 14 1,0 Universities or researchers 13 0,9 Language Skills 12 0,8 Finance Incentives or Taxes or Funding 10 0,7 Technology or Innovation 8 0,6 Facilities Site or Real Estate 8 0,6 ICT Infrastructure 4 0,3 Total January 2003 – January 2009 1445 100,0 Source: FDI Intelligence from Financial Times Ltd.

1.3.3.5 EU strong in financial services and manufacturing, weak in IT According to the distribution of projects (all investors) in the BRICs by economic sectors (Table 1.3.8) the software and IT services are in the first place and financial services in the second42. Services together including also business services and real estate, account for 37% of the projects. The rest are in manufacturing branches, most importantly in the automotive industry (original equipment manufacturing, OEM and car component industry together), machinery and equipment, chemicals and food. As to the investors from the EU, financial services are in the first

42 In this classification there are no data for wholesale and retail trade, thus the manufacturing branches cover not only production but also distribution.

78 place by the number of projects. These are followed by manufacturing industries like machinery, textiles and automotive. Software and IT services rank only fourth and also electronic components and communication have lower shares than the average. This allows to conclude that EU investors are relatively weak in the most modern services and products.

There are some remarkable changes over time like the shift of total FDI towards services. But this does not relate to all activities. In the software and IT sector the peak years were 2004-2007. Financial service projects had the highest number in 2008 after steady growth for five years. A similar trend can be observed for machinery and equipment manufacturing, business services and especially the real estate sector which became the fifth most important activity in 2008 after having occupied place 15 in 2003. The automotive OEM had its peak in 2004 and the components industry in 2008, a clear shift from the one to the other type of car component production. In the case of EU investors the shift to services is weaker, especially to IT while it is more pronounced in business services and real estate. There is also a strong shift to machinery and textiles industries which are less frequented by investors from other parts of the world.

Table 1.3.8 Investment projects in the BRICs by economic sectors

World EU15 investors % of % of Total % of FDI Total % of FDI Sector no. Total capital no. total capital Software & IT services 1,913 10.9 1.1 342 5.5 0.9 Financial Services 1,446 8.3 0.7 547 8.9 0.1 Machinery, Equipment 991 5.7 1.3 423 6.8 2.0 Business Services 965 5.5 0.2 330 5.3 0.2 Chemicals 870 5.0 7.2 341 5.5 12.5 Food & Tobacco 773 4.4 2.5 319 5.2 3.7 Textiles 689 3.9 0.6 423 6.8 0.6 Electronic Components 681 3.9 3.2 193 3.1 1.4 Metals 680 3.9 13.8 253 4.1 20.1 Communications 679 3.9 1.7 235 3.8 1.4 Consumer Products 661 3.8 1.5 329 5.3 3.6 Transportation 647 3.7 7.6 255 4.1 3.9 Automotive Components 640 3.7 1.8 267 4.3 2.7 Real Estate 571 3.3 12.5 185 3.0 5.7 Automotive OEM 559 3.2 7.8 234 3.8 9.1 Source: FDI Intelligence from Financial Times Ltd

By the amount of invested capital, the capital-intensive sectors lead the list: metals (14% of total), real estate, oil and gas (10%), automotive OEM (7.8%). For the EU these shares are even more pronounced, 20% for the metal sector and 12.5% for chemicals. Services have only low shares as they are not capital-intensive. Financial services have especially low equity, although they may transmit high amounts of investments in the form of credits.

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Another classification is by business activity (Table 1.3.9) which contains broad categories for the functions of the investment project. Manufacturing, separated from the related wholesale and retail activity, still comprises the largest category with one third of the projects and 59% of the invested capital invested in the BRICs from the world and 35% of the projects and 68% of the capital invested from the EU. This outlines the strength of EU investors in production while other investors are stronger in sales, and construction. Typical offshore services, like call and support centres are also less common with European investors. At any rate, the fDi database seems to provide a more realistic and more divers picture about the specialization of EU investments in the BRICs. The role of manufacturing is higher and that of financial and business services more constrained.

Table 1.3.9 Investment projects in the BRICs by major business activities

Investe EU Total d EU invested Total Numbe Capital EU number capital Business Activity number r % % number % % Manufacturing 5914 33.8 59.0 2188 35.4 68.4 Sales, Marketing & Support 3045 17.4 0.4 931 15.1 0.4 Business Services 1819 10.4 0.6 677 11.0 0.9 Retail 1701 9.7 2.6 892 14.4 5.4 Design, Development & Testing 1137 6.5 1.9 239 3.9 2.0 Construction 819 4.7 15.9 302 4.9 7.7 Logistics, Distribution & Transportation 775 4.4 8.9 305 4.9 5.5 Research & Development 609 3.5 1.1 145 2.3 1.0 Headquarters 391 2.2 0.4 126 2.0 0.9 Extraction 247 1.4 5.2 75 1.2 4.9 Shared Services Centre 174 1.0 0.1 47 0.8 0.1 Education & Training 164 0.9 0.1 53 0.9 0.1 ICT & Internet Infrastructure 159 0.9 0.6 39 0.6 0.4 Maintenance & Servicing 156 0.9 0.1 62 1.0 0.1 Technical Support Centre 141 0.8 0.1 24 0.4 0.0 Customer Contact Centre 137 0.8 0.0 40 0.6 0.0 Electricity 80 0.5 2.8 31 0.5 2.2 Recycling 18 0.1 0.1 3 0.0 0.0 Overall Total 17486 100.0 100.0 6179 100 100.0 Source: FDI Intelligence from Financial Times Ltd

The specialization of the EU investors in the BRICs follows the general comparative advantage of each country (see highlight reports below). Manufacturing activities are most prominent in Brazil and China, less in Russia and India. Trade and distribution are most widespread in Russia and China. The Software and IT sector is concentrated in India. The largest EU companies are the

80 main investors first of all from Germany, except in Brazil where a Portuguese real estate developer is the top investor.

1.3.3.6 EU FDI highlights in individual BRIC countries43 Brazil Report Highlights • Between January 2003 and December 2008, fDi Markets recorded a total of 539 investment projects from 306 EU15 companies • The leading sector was Chemicals, which accounted for 8% of projects. • The leading business activity was manufacturing, which accounted for 46% of projects. • The top ten companies accounted for 18% of all investment projects with Sonae (Portugal), Fiat (Italy) and Akzo Nobel (Netherlands) among the top 10 companies. • The key influencing factors behind the location of investment projects were Domestic Market Growth Potential and Proximity to markets or customers, cited by 42% and 38% of companies respectively.

Russia Report Highlights • Between January 2003 and January 2009, fDi Markets recorded a total of 1446 investment projects from 696 EU15 companies • The leading sector was Food & Tobacco, which accounted for 10% of projects. • The leading business activity was manufacturing, which accounted for 33% of projects. • The top ten companies accounted for 17% of all investment projects with Metro (Germany), IKEA (Sweden) and Raiffeisen Zentrabank (Austria) among the top 10 companies. • The key influencing factors behind the location of investment projects were Domestic Market Growth Potential and Proximity to markets or customers, cited by 76% and 20% of companies respectively.

India Report Highlights • Between January 2003 and January 2009, fDi Markets recorded a total of 1497 investment projects from 709 EU15 companies • The leading sector was Software & IT services, which accounted for 11% of projects. • The leading business activity was manufacturing, which accounted for 33% of projects. • The top ten companies accounted for 11% of all investment projects with Deutsche Post (Germany), cargo-partner (Austria) and Volkswagen (Germany) among the top 10 companies. • The key influencing factors behind the location of investment projects were Domestic Market Growth Potential and Proximity to markets or customers, cited by 61% and 20% of companies respectively.

43 Results based on FDI Intelligence from Financial Times Ltd.

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China Report Highlights • Between January 2003 and January 2009, fDi Markets recorded a total of 2398 investment projects from 1108 EU15 companies • The leading sector was Financial Services, which accounted for 9% of projects. • The leading business activity was manufacturing, which accounted for 40% of projects. • The top ten companies accounted for 13% of all investment projects with HSBC (UK), Siemens (Germany) and Carrefour (France) among the top 10 companies. • The key influencing factors behind the location of investment projects were Domestic Market Growth Potential and Proximity to markets or customers, cited by 65% and 24% of companies respectively.

1.3.3.7 BRICs expand to Europe All BRICs are on an international expansion course for some years now (Table 1.3.10). By the number of projects India is ahead of China: Not only in the 2003-2008 period as a whole, but also in 2008 Indian companies established more project in the EU15 than Chinese. For instance, the Tata Group has IT and telecom services centres in several larger European cities. As to the invested capital, Russia is the largest investor ahead of China and Hong Kong; all in all very few projects report the amount of investment.

Table 1.3.10 FDI in the EU15 from the BRICs, number of projects and invested capital

Source Country 2003 2004 2005 2006 2007 2008 2009 Total India 24 33 40 48 36 64 9 254 China 12 22 37 22 57 55 3 208 Russia 8 17 18 15 18 17 2 95 Hong Kong 10 15 15 15 12 22 3 92 Brazil 5 9 5 7 5 14 3 48 Total 59 96 115 107 128 172 20 697

The main target countries of BRICs investments are the UK (248 projects), Germany (118) and France (75); in 2008 also Spain. The UK is on the top due to its business and language links and serves as distribution centre to the rest of the EU.

1.3.4 Impact of the crisis on the EU–BRICs FDI relations World trade and FDI have developed hand in hand in recent decades, with FDI outpacing trade in boom periods, and declining more than trade in slowdown or recession periods. Much of the international trade is a result of FDI, generated by the intra-firm trade of multinational companies. The question is what happens to the FDI in the current global economic contraction?

82 According to the World Bank (2009), global industrial production contracted by 20% in the last quarter of 2008. In 2009 advanced economies are estimated to contract by at least 2% and their imports by 3%. This will trigger the contraction of close to 1% of the exports from emerging and developing economies. In addition, trade finance has shrunk by some 40% and its costs increased substantially. Countries dependent on exports to the US are especially hard hit. In December 2008 Brazil reported 29% plunge of exports and a trade deficit first time in this decade.

According to a more recent forecast issued by the OECD (2009), the global economic decline will be as much as 2.7% while the OECD members will contract by 4.3% in 2009. In the Euro-area, GDP is going to drop by 4.1% in 2009 and 0.3% in 2010. World trade is going to contract by as much as 13% in 2009. The crisis will not only be deeper but it will also last longer than assumed earlier. Among the BRICs the Russian economy is expected to contract by 5.6%, but Brazil only by 0.3%, while India will grow by 4.3% and China by 6.3% according to OECD. Although the two largest emerging economies will grow much less than earlier, their results will be the bright spot.

What can be expected for FDI under there circumstances? Economic decline will most likely trigger a drop in FDI due to falling global demand, excess capacities, difficulties of investment financing, drop of subsidiary profits, etc. Overcapacities will hinder FDI and cause its volume to shrink perhaps even more than the volume of global trade. Export oriented industries, many of them foreign subsidiaries are already cutting output and putting their capacities idle. Tight credit conditions will also diminish FDI. This will happen in two ways, credit-type FDI will shrink and the financing of equity FDI will become more rare and costly. Ongoing projects can be cancelled or delayed due to the lack of affordable financing. In additions, FDI in the oil, gas and metals industries decline due to low commodity prices. An important part of FDI is reinvested profits, and when profit shrinks, less can be reinvested. In addition, profits may be withdrawn by parent companies from more affluent locations to finance losses elsewhere. On a sectoral dimension, the drop in FDI flows is expected to be most significant in financial services, automotives industries and building materials (UNCTAD, 2009).

The BRICs may have a privileged position in many respects. First of all they are large economies where FDI is mainly attracted by the local markets with growth expectations above world average, with the possible exception of Russia. Local economic growth will allow for FDI to grow if companies from crisis-hit countries are in the position to invest there. Larger multinationals may just concentrate on the very few countries in the world where they can expand sales such as China, India, Brazil and shift investments there. Also for European companies the expansion to the BRICs remains a major attraction if economic growth continues there. Due to the size of the BRICs and their distance to Europe, only larger or more specialized investors may benefit from this opportunity.

A major driving force of global FDI in recent years has been mergers and acquisitions. European banks, telecom companies, etc. have acquired positions in Brazil and elsewhere. M&A deals usually flourish when capital is abundant and relatively cheap and they are to contract in times of

83 falling stock markets and high costs of financing. Due to the current crisis, there will be a lack of capital in European companies for expansion. One can expect the number and even more the value of M&As to contract. If BRICs companies fare better than Europeans and their financial situation stays more robust, they will even invest in relatively cheap EU companies. Thus outward FDI from the BRICs may increase44.

The decline of global FDI may come with some delay following the decline of output and trade. This was shown by OECD quarterly figures for 2008 (OECD 2009a). OECD FDI inflows declined by 25% per quarter in 2008 but outflows only by 5%; they even increased in the last quarter. This shows that developed countries still had the capital to invest and found attractive targets, most probably in the BRICs. The same source refers to the expectation that FDI will be more resilient than other capital flows to developing countries. It also concludes that global M&A may increase especially from developing countries.

Current economic growth and FDI forecasts suggest that competitiveness of EU companies will not be endangered by US or Japanese firms as the declines there will be at least as harsh as in Europe. In the BRIC economies developed countries will compete with each other and also with domestic and other BRIC companies.

1.3.5 Summary and Conclusions On a global level, the EU emerges as the most important foreign direct investor, also if considering extra-EU investments only. This reflects the capability and propensity of EU firms to internationalize their business activities. The size and specialization of both inward and outward FDI of the EU shows the results of internationalization, the strong and weak points in terms of competitiveness. A joint analysis of two methodologically very distinct databases, Eurostat FDI data and the ‘fDi database’ on investment projects (FDI Intelligence from Financial Times Ltd.) made it possible for the period 2001-2007 and 2003-2008, respectively, to reveal several facts and trends concerning the competitive position of EU firms in the BRICs and vice versa. Many findings of the two databases are similar. In other cases the results complement each other.

One of the most robust results is that the EU is among the main investors in each of the BRICs and the dominant investor in Brazil and Russia. According to Eurostat the EU provided on average 53% and 57% of the FDI inflows in Brazil and Russia, respectively (2004-2007 average). This dominant role is confirmed by the number of projects as reported in the fDi database, 42% in Brazil and 54% in Russia. In China and India, the EU has less weight. But after correcting for particularities in FDI data, such as the prominent role of Hong Kong and off-shore centres in Chinese FDI and of Mauritius in Indian FDI, the EU ranks higher also in these countries. The

44 In Brazil the expectation is that, in three to five years, five banking giants will control 85% of the market, one public bank (Banco do Brasil), two Brazilian-owned private banks (Itaú Unibanco and Bradesco), and two foreign banks (Santander and HSBC) (see: http://www.latinbusinesschronicle.com/app/article.aspx?id=3049). There are two potential consequences that may arise as a result of such a significant merger: a stronger wave of consolidation in Brazil, and an international expansion. Itaú Unibanco, now the 17th largest company in the world, declared plans to become the first Brazilian financial institution to become a global player, starting with Latin America. The company anticipates its first move out of the region in five years, after consolidating its position in Latin America, where Itaú already has operations in Argentina. Similar trends can be seen in the case of larger companies from other BRICs.

84 analysis of the number of projects confirms this finding, the role of the EU in China is much greater (29% of all reported projects in the country) than those suggested by FDI data. China emerges as the main BRICs target for EU projects, but in terms of FDI inflows China occupies rank three after Russia and Brazil. Divergent results can be explained by a small number of very large projects in the natural resource sector of Russia and the great number of finance and trade related small investments in China.

The magnitude of EU FDI flows to the BRICs relative to the United States and Japan suggests that EU firms are well positioned to compete with other MNCs in the BRICs: among the Triad countries, the EU is the leading FDI investor in each single BRIC country, in the case of Brazil and Russia by a wide margin. The EU is even better positioned in the BRICs when it comes to internationalization via FDI than via trade in goods and services. Moreover, the magnitude of sales by foreign affiliates in comparison to exports suggests that, in some cases, FDI has become the major entry strategy of EU firms into the BRICs markets. FDI is important for entering into the markets of the BRICs for US and Japanese firms as well.

EU FDI flows to the BRICs have increased steadily over the period 2001-2007. However this growth was more or less in line with the overall expansion of EU FDI. The share of the BRICs in the EU’s outward FDI stocks increased by only 2.5 percentage points over the 2002-2007 period to reach approximately 10% in 2007, more slowly than what the growth performance of the BRICs would suggest. The exception is Russia, where EU outward stocks increased rapidly, while the share of China plus Hong Kong even declined. It is difficult to find reasons why the EU is not more prominently present in China. Returns on EU FDI in the BRICs is higher than in the new EU member states thus low profitability or better investment opportunities elsewhere (such as in the new EU member states) cannot explain the slow pick-up of the BRICs’ weight in EU outward stocks. But the fDi database paints a somewhat different picture with a very dynamic increase in the number of projects in all BRIC countries. The share of the EU-15 in the total number of projects to these countries increased from 32% in 2003 to 38% in 2008. This points to a growing importance of the EU as an investors in the BRICs. Half of the EU FDI projects went to China and Hong Kong all through the 2003-2008 period. Methodological differences explain to a large extend why the two databases give such diverging picture of EU FDI in China, but also the country of origin and the sectoral structure play some role.

The larger countries of the EU account for the bulk of FDI flows. These are, in sequence of importance the United Kingdom, Germany, France, Spain, and the Netherlands. Especially the United Kingdom and Spain have strong focus of their FDI activities on the BRICs. In the case of the United Kingdom, Hong Kong is the primary target whereas for Spain it is Brazil. As to the number of new projects, Germany and United Kingdom lead the list. Italy emerges to be very involved in new projects, whereas Spain much less. Such differences can be connected to the size and industry structure of investors in the two countries. For similar reasons, Portugal emerges by the number of projects as the top investor in Brazil (numerous real estate projects), while it is absent from the top five list in terms of invested capital.

85 The split-up of EU investment in the BRICs by economic activities reveals that approximately one third of the EU FDI is in manufacturing and about 60% in the services industry. This distribution across broad economic sectors is similar in both databases but major differences emerge at a more detailed level. Especially, the role of financial services, which is the dominant industry for EU FDI in each of the BRICs, is suggested to be much smaller according the number of projects in the fDi database than in terms of FDI flows. A good part of this difference can be explained by the fact that Eurostat data contain other capital flows, including intercompany loans which are typically very important between affiliated banks and not covered by the fDi database. The latter, in turn, mark trade and distribution activities very important especially in Russia and China.

In terms of EU FDI stocks in China and India, services and manufacturing are of equal importance. In both countries existing barriers to FDI are most prominent in service and infrastructure industries that may contribute to the relatively large share of manufacturing. As to the number of projects, manufacturing is strongest in China and Brazil. The analysis of fDi data also reveals that EU firms have more projects in manufacturing industries than other investors. They are strong in machinery and chemical industries but relatively weak in IT. EU investments in the IT and software sector is concentrated in India but also there their investments fall behind those of the USA.

Concerning the motives for FDI, the fDi database reveals that EU investors target mainly the local and regional markets of the BRICs, thus they can be considered as market seeking. Exporting the products of the investments back to the EU is negligible, although manufacturing investors usually follow a mixed strategy. This structure of motivations suggests that when in the wake of economic growth wages increase, this will not deter investors due to rising costs, but rather attract them due to growing demand. Balance of payments data are unable to identify the motives for FDI but the industry distribution of FDI as it emerges from Eurostat, in particular the strong focus on services, makes the market-seeking motive plausible.

It is also important to stress that global and EU-15 investments in the BRICs, as measured by the number of investment projects, were resilient to the global crisis until 2008. With regards to the current economic downturn and the expected drop in global FDI, the BRICs may find themselves in a privileged position in several respects. First of all they are large economies where FDI is mainly attracted by the local markets with growth expectations above world average, although not in Russia. Local economic growth especially in China and India will allow for FDI to grow if companies from crisis-hit countries will be in the position to invest. Larger multinationals may increasingly concentrate on the very few countries in the world where they can expand sales such as China, India, Brazil and shift investments there. Also for European companies the expansion to the BRICs remains a major attraction. Due to the size of the BRICs and their distance to Europe, only larger or more specialized investors may benefit from this opportunity.

86

Turning to the FDI activities of the BRICs in the EU, the most important conclusion is that the investment activities of the BRICs remain at a low level. All BRICs are on an international expansion course recently. By the number of outward FDI projects India is ahead of China. The EU is not the primary destination of the expansion as confirmed by both databases. The share of the BRICs (including Hong Kong) in total EU inward FDI flows is small, amounting to only 5.5% on average during the period 2002-2007 with no clear trend over time. This is lower than their share in global FDI which stood at 7.1% in 2007. One major explanation for this pattern is that a large part of the BRICs’ FDI is resource-seeking, particularly of China and India which targets Asia and Africa. Brazil is still rather a regional than a global player. For Russia the neighbouring EU is a major outward FDI target region, and by the amount of invested capital it is the most important BRIC investor there.

The main EU target countries of BRICs investments are the United Kingdom, Germany and France; in 2008 also Spain by the number of projects. The United Kingdom is on the top due to its business and language links and serves as distribution centre to the rest of the EU. The services sector is very dominant leaving only marginal amounts to manufacturing (with the partial exception of India). Business services and financial intermediation emerge as the major industries.

The low level of FDI activity of the BRICs in the EU leads to the conclusion that the preferred channel of competition for BRICs’ firms in the markets of the EU (but also the US and Japanese markets) remains exports. For the EU this means that EU firms experience only very limited competition from the BRICs via the FDI channel. The downside of this is that the BRICs as FDI investors only create limited additional investment and employment opportunities.

The main conclusion based on the statistical analysis is that the EU is well positioned as a direct investor both on the global level and in the BRICs. In the fast growing markets of China and India, however, the share of EU firms in total FDI is rather low and not particularly dynamic. As investments in such geographically more distant places are mainly realized by large corporations and SMEs typically limit their foreign operations to nearby countries, policy levers may be necessary to expand EU presence there. This is all the more desirable as China and India have high market potential and EU firms can expect high returns on FDI.

Policy obstacles to EU FDI in the BRICs exist in the form of various restrictions. FDI is limited in several industries important to the EU investors, such as finance or telecommunication. EU trade policy should seek to eliminate such obstacles, including caps to foreign ownership. Restriction of foreign ownership can also not be in the interest of the BRICs in instances where it blocks the transfer of technology. The EU is a much more open economy to FDI than the BRICs but obstacles to investment nevertheless exist. Critical in this respect is the informal discrimination against investors from the BRICs. Especially asset-seeking FDI is considered strategic and undesirable because it would give investors access to EU technologies and cause dependence. As China’s outward FDI is dominated by state-controlled enterprises in natural resources or telecommunication most of

87 which enjoy a monopoly or monopoly-like situation in the Chinese economy their expansion abroad may distort fair competition. The guidance for EU policy has been its strong commitment to open markets and fair competition and this may prevail over other concerns when dealing with investment issues of the BRICs. The EU may thus be interested in a process of further mutual and balanced liberalization in the area of FDI to eliminate obstacles on both sides.

References Bartlett, D. (2008), ‘Economic Trends in the BRIC Countries’, 7 April, http://www.the-financedirector.com/features/feature1710/ Deutsche Bank (2008), ‘Russia’s outward investment’, Current Issues, Deutsche Bank Research, 30 April. Dunning, J. H. (ed.) (2005), Foreign Direct Investment and Governments: Catalyst for Economic Restructuring, Routledge Studies in International Business and the World Economy, 3, Taylor & Francis Ltd. Frenkel, M., Funke, K., Stadtmann, G. (2004), A Panel Analysis of Bilateral FDI Flows to Emerging Economies, Economic Systems, Vol. 28, 2004, 281 – 300. Golub, Stephen S. (2003), Measures of Restrictions on Inward Foreign Direct Investment for OECD Countries, OECD Economic Studies, No. 36 Gouvea, R. (2007) ‘The Transnationalization of Brazil’s Software Industry’, Transnational Corporations Journal (TNCJ), Unctad, Vol.16, No.1, April, p.145-164., April 2007 Holtbrügge, D., Kreppel, H. (2008), Determinants of Outward Foreign Direct Investment from BRIC countries. An explorative Study, University of Erlangen-Nuremberg, Department of International Management, Working Paper No. 1/2008, Nürnberg 2008 Hunya, G. (2008), Austrian FDI by main Countries and Industries, FIW Study N° 015. Ibarra, M., Koncz, J. (2008) Direct Investment Positions for 2007. Country and Industry Detail, Survey of Current Business, BEA, July 2008. Koyama, T., Golub, S. (2006), ‘OECD's FDI Regulatory Restrictiveness Index: Revision and Extension to more Economies’, OECD Economics Department Working Papers, No. 525, OECD Publishing. ‘Lenovo mulls Fujitsu Siemens investment’, EE Times Europe, 13.10.2008. London Economics (2008), The Importance of Wholesale Financial Services to the EU Economy 2008, July 2008, London. Morck, R., Yeung, B., and Zhao, M. (2008), Perspectives on China’s outward foreign investment, Journal of International Business Studies, 39(3): 337-350. Nowak, O. (2009), The United States was the main location of EU-controlled affiliates. International activities of EU-controlled foreign affiliates, Eurostat Statistics in focus, n° 21/2009 OECD (2009), OECD Economic Outlook, Interim Report, March 2009. OECD (2009a), Investment News, Issue 9, March 2009 Poncet, S. (2008), Inward and Outward Investment in China, in Greenaway, D. et. al. (ed.) China and the World Economy: consequences and challenges. Edited by David Greenaway Palgrave. London.

88 Sauvant, K. P. (2005), ‘New Sources of FDI: The BRICs. Outward FDI from Brazil, Russia, India and China’, Journal of World Investment & Trade, vol 6, no 5, pp. 639–709. UNCTAD (1998), World Investment Report. Trends and determinants, Geneva. UNCTAD (2008a), World Investment Prospects Survey 2008-2010, New York and Geneva. UNCTAD (2008b), World Investment Report. Transnational Corporations and the Infrastructure Challenge, Geneva. UNCTAD (2009), Assessing the impact of the current financial and economic crisis on global FDI flows, January 2009-04-08 http://www.unctad.org/en/docs/webdiaeia20091_en.pdf World Bank (2009), Swimming Against the Tide: How Developing Countries are Coping with the Global Crisis. Background Paper for G-20 meeting March 13-14

89 1.4 Knowledge flows between the BRICs and the EU

Bernhard Dachs and Carolina Lennon, ARC and wiiw

1.4.1 Introduction The ongoing integration of the BRIC countries into the world economy has also increased knowledge flows between the BRICs and the EU27. This is, at first, a consequence of more foreign trade and more foreign direct investment, which have also raised demand for various types of knowledge at both sides. Exporters to the BRICs have to know about regulation, consumer preferences, environmental conditions to adapt their products. Moreover, increasing knowledge flows also indicate that scientific and technological capabilities of the BRICs have increased considerably in recent years.

Before we examine knowledge flows between the BRICs and the EU, it is important to say a few words about some characteristics of knowledge as well as the way they affect knowledge flows. Knowledge, like information, is partly non-rival and non-excludable (Foray 2004, p. 91 ff). Despite its public good character, the transfer and reproduction of knowledge is a far more expensive process than the reproduction of information for two reasons; first, it involves learning, which is time-consuming and often needs proximity and interaction between people. Second, knowledge is context-specific, local and ‘tacit’ to some extent. Tacitness results from the fact that cognitive capabilities and abstract concepts are not easy to articulate explicitly and to transfer between people (Cowan et al., 2000; Breschi and Lissoni, 2001). Tacitness both allows and limits the transferability of knowledge. It makes the transfer and reproduction of knowledge easy within a group of people (‘epistemic community’) who share a common vocabulary or ‘codebook’, but increases the cost of transferring it to outsiders (Cowan et al., 2000). The creation of such an epistemic community is a long process and involves mutual learning, for example, in master- apprentice relations.

The tacit, local, and context-related characteristics of knowledge require specific channels for international knowledge flows. We will analyse four of these channels: the mobility of students; migration of highly skilled people; transborder payments for royalties and licence fees; and cross- border patent inventions. Transborder licensing is an alternative way, besides exports and foreign production, to commercialize knowledge at international markets and represents flows of codified knowledge. Migration mirrors the fact that knowledge is embodied in people and travels with them. The common cultural background of migrant communities enables them to transfer knowledge at very low cost over distance. Moreover, staff mobility is an important means to exchange knowledge within multinational enterprises (MNEs). The mobility of students creates knowledge flows from the host country to the country or origin of students; moreover, it is an important pre-requisite to build epistemic communities and allow future knowledge transfer. Finally, cross-border patent inventions indicate overseas innovative activities of MNEs, which are a major source of spillovers, and knowledge flows between MNEs and organizations in the host country.

90 The magnitude of the knowledge transfer strongly depends on the capabilities of individuals; in order to make the most of the international knowledge flows, individuals need to be able to understand, internalize and exploit knowledge developed elsewhere (Cohen and Levinthal, 1989, 1990). Gertler (2003, p. 81) notes that ‘the ability of workers and firms to absorb tacit and codified knowledge may depend inter alia on their prior investments in research and development, training, and the general level of education and skill of the workforce. Without this prior investment, individual workers and firms will likely be poorly prepared for engaging in learning by doing and interacting.’ These previous investments in R&D and education have been commonly referred in the literature as the countries´ absorptive capabilities.

Turning to Table 1.4.1, we can observe that BRIC countries have increased their absorptive capacity considerably in recent years. BRIC countries present a growing large pool of new tertiary students. In 2003, national enrolments in tertiary education in Brazil, Russia, India and China more than doubled the number of tertiary enrolments in the European Union; moreover, over 2001-2003, BRIC’s enrolment growth rate surpassed that of the European Union. However, in per capita terms and with the exception of Russia, the BRICs are still far behind the European averages. In this context, the proportion of the BRIC’s total population aged 25-64 with tertiary education was of 11.4% in India, 9.5% in China, and 7.8% in Brazil, while the European average was 24%, which was only surpassed by Russia 54.6%. Similarly, the ratio of researchers to labour force in India, China, and Brazil are still far behind the European average.

Table 1.4.1 Absorptive capacity of the BRICs

Percentage of population Total Rate of tax Tertiary Tertiary aged 25-64 researchers Gross expenditure subsidies education education with per 10 000 on R&D as a % of Targets for R&D for USD 1 enrolments enrolment tertiary persons GDP spending of R&D (thousands) growth rate degree employed Target (2001- 1996 2006 Target 2008 2003 date 2003) 10.07 Brazil 0.72 1.02 0.254 3,579 13% 7.8 (2004) (2004) 2.0% of 15.84 China 0.57 1.42 GDP 2010 0.339 15,186 11% 9.5 (2004) (2006) India 0.65 0.71 0.266 11,295 9% 11.4 (2004) 3.07 (2000) 2.0% of 62.58 Russia 0.97 1.08 GDP 2010 8,671 9% 54.6 (2003) (2006) 3.0% of 57.52 EU 1.66 1.76 GDP 2010 16,594 3% 24 (2006) (2006) Source: OECD (2008a).

Even though during the last decade (1996-2006) R&D intensity (the ratio of R&D expenditure to GDP) in each of the BRIC countries has been increasing, the R&D growth rate in China has been particularly impressive. China’s R&D expenditure increased at an annual average rate of 19% in real terms, situating it as the third R&D spender worldwide (in purchasing power parity) after the

91 United States and Japan. Moreover, as the R&D expenditure of China has been increasing much faster than its economy, then its R&D expenditure intensity has more than doubled over the 1996- 2006 period, almost catching-up with the EU level.

Regarding national measures intended to boost investment in R&D; Brazil, China and India has currently in place tax incentive schemes to facilitate business R&D as well as to enhance attractiveness for R&D-related foreign direct investment (OECD 2008a). Additionally, China and Russia have set targets to increase their R&D intensity to 2% by 2010. In this context, given the Chinese R&D growth pace over the last ten years, it is highly likely for this country to achieve its R&D objective by 2010. Differently, for the case of Russia, relatively more affected by the current crises, it is uncertain whether it would be able to attain its R&D objective.

1.4.2 Royalties and licence fees The United States is the main exporter of Royalties and Licence Fees (RLF) 45 in the world followed by the EU46 and Japan. In 2006 the total exports of the United States represented USD 62 billion, while total EU exports attained USD 49 billion (of which USD 20 billion represented intra-trade exports), and Japan’s exports reached USD 20 billion47. BRICs’ exports in RLF were worth USD 766 million, representing a relative small share (less than 1%) in RLF world exports.

While the EU was a net importer of RLF over the 2003 to 2006 period, the USA and Japan presented trade surpluses. In 2006, EU trade balance of RLF presented a deficit of USD 17 billion, whereas the USA and Japan presented surpluses of USD 35.9 billion and USD 4.6 billion respectively. Over the period, each of the BRIC countries presented trade deficits in its RLF trade balance. In total, BRIC countries imported 15 times as much of RLF as they exported in 2006; moreover, their trade balance worsened by an annual rate of 21%. With respect to the EU, BRIC countries were also net importers in RLF. In 2006 they imported 20 times as much as they exported to the region and their trade deficit with respect to the EU increased by 35% over 2003- 2006.

Although the BRIC countries’ share in EU exports of RLF is relative small, it has been increasing. Over the 2003 to 2006 period, EU exports of RLF increased on average by 12%, while the EU exports of RLF to BRIC countries increased by 31%. This resulted in a raise of the BRIC countries´ share to 4.5% in 2006 up from 2.6% in 2003. Moreover, as total BRIC imports expanded at a lower rate (21%) than BRIC imports from the EU (31%); therefore, over the period, the EU was relative more successful in attracting the growing BRIC’s international demand for RLF.

45 Royalties and license fees cover the exchange of payments and receipts between residents and non-residents for the authorized use of intangible, non-produced, non-financial assets and proprietary rights (such as patents, copyrights, trademarks, industrial processes, franchises, etc.) and with the use, through licensing agreements, of produced originals or prototypes (such as manuscripts and films). Source: Balance of payment statistics, OECD (2008). 46 EU25. 47 World receipts of royalties and licence fees amounted to USD 155 billion in 2006 representing about 11% of world exports of ‘other commercial services’.

92

Table 1.4.2 Trade in royalties and licence fees, year 2006 (USD million)

Share in Exports Trade the Exports Exports growth rate balance Partner Triad 2006 share 2006 (2003-2006) 2006 EU 25 World 37% 49,334 100% 12% -16,922 EU25 19,881 40% 10% BRIC 2,238 4.5% 31% 2,128 Brazil 364 0.7% 30% 350 China 1,342 2.7% 33% 1,301 India 230 0.5% 23% 204 Russia 302 0.6% 29% 273 Japan World 15% 20,104 100% 16% 4,608 BRIC 1,565 7.8% 28% 1,531 Brazil 161 0.8% 51% 161 China 1,171 5.8% 28% 1,144 India 220 1.1% 32% 215 Russia 13 0.1% 13% 11 USA World 47% 62,378 100% 9% 35,946 BRIC Brazil 921 1.5% 12% 910 China 1,443 2.3% 20% 1,390 India 300 0.5% 32% 269 Russia ...... Source: OECD Statistics on International Trade in Services (OECD 2008b), own calculations

Among BRIC countries, China is the main recipient of EU exports and it is also the destination presenting the highest growth rate. In 2006, China accounted for 60% of the total EU RLF exports to BRIC countries, up from 57% in 2003, and EU exports to China grew by 33% on average over 2003-2006. Finally, it is interesting to note that the USA and Japan have also seen their exports to China increase but they have grown at a slower pace (20% and 28% respectively).

EU total imports of RLF attained USD 66 billion in 2006. The BRICs’ contribution to EU imports is small and declining to 0.17% in 2006 from 0.29% in 200348. Before 2004, the Russian Federation was the main supplier of RLF to the region, but since then it had been surpassed by China, which saw its contribution to EU imports to BRIC countries increase from 24% in 2003 to 37% in 2006.

48 EU imports from BRIC countries decreased on average by 10% annually over the period 2003-2006.

93 1.4.3 Enrolments of foreign students in tertiary education In 2003, the USA, the EU49 and Japan registered together 1.64 millions new enrolments of foreign students50 in tertiary education. From Table 1.4.3 we can observe that a growing number of BRIC students are attending tertiary programs in universities hosted in the Triad. During 1999-2003, the number of students from BRIC countries in the Triad grew by 20%, while the total number of foreign students in those countries grew by 8%. This, in turn, resulted in an increase of BRIC’s enrolment share in the Triad from 13% in 1999 to 21% in 2003.

In 2003, the EU was the main destination for foreign students in tertiary education, accounting for 972 thousand new enrolments51. However, BRIC students still prefer more often to enrol in American universities. In 2003, the United States hosted 53% of the BRIC students, followed by the European Union (32%) and Japan (15%).

Table 1.4.3 Enrolment of foreign students in tertiary education (2003),52 Triad countries detail

From all Share of Distribut Distrib nationalities From BRIC countries BRIC ion ution of students of BRIC Annua Annua in total foreign student Annual l l foreign students s growth growth growt students among among Number rate Number rate h rate hosted main main Host of 1999- of 1999- 1999- by destinati destinat country Students 2003 Students 2003 2006 countries ons ions EU 971,778 8% 108,791 28% 23% 11% 59% 32% United States 586,316 7% 182,003 16% 31% 36% 53% Japan 86,505 11% 52,640 17% 17% 61% 5% 15% 1,644,59 TOTAL 9 8% 343,434 20% 21% 100% 100% Source: OECD Foreign Student Enrolment Database, own calculations.

The growth rate of BRIC student enrolments in the European Union was higher than that of the United States and Japan. Then, even though the USA remained the preferred destination for BRIC students, the EU has been succeeding in attracting an increasing proportion of BRIC enrolments. In this context, the share of BRIC student preferring European universities with respect to American and Japanese universities has increased from 22% in 1999 to 32% in 2003.

49 The EU countries included in the analysis are: Austria, Belgium, the Czech Republic, Germany, Denmark, Spain, Finland, France, the United Kingdom, Italy, the Netherlands, Poland and Sweden. 50 Source: OECD Foreign student enrolment database. 51 Figures include intra-EU student mobility. 52 As there is no information on US foreign students’ enrolments for the past few years, any comparison involving the Triad countries is restrained to 2003; however, with respect to EU enrolment details, for which more recent data are available, we use the year 2006.

94 Regarding the destination of students from the point of view of individual BRIC countries, Russian students tend to choose European institutions to carry their tertiary studies abroad; European Institutions hosted 74% of Russian students in the Triad in 2003. Differently, students from India, China, and Brazil tend to choose the United States as their main destination; in 2003, The United States hosted 82% of Indian students abroad, 54% of the Brazilian students, and 44% of the Chinese students.

Figure 1.4.1 Figure 1.4.2

Distribution of BRIC students Distribution of BRIC students among among main destinations main destinations (2003), detail by BRIC countries

1999 2003 EU JAPAN USA Brazil 61% 75%

53% 54% 50%

25% 32% 74% 44% Russia 0% China 22% 17% 15%

82% EU USA JAPAN India

Source: OECD Foreign Student Enrolment Database, wiiw, own calculations.

Among the BRIC countries, China presented the highest number of enrolments in the Triad followed by India. In 2003, to its own, China accounted for 62% of the BRIC students enrolled abroad and India for 26%. These two countries presented also the highest enrolment growth rate; Chinese enrolments abroad increased by 22% over the 2001-2003 period and that of India by 16%. If we contrast this information to the national student enrolments in tertiary education in BRIC countries, we can obtain an indicator for the mobility of highly educated students. China presented the highest mobility ratio; per every 71 tertiary students enrolled in Chinese institutions one Chinese student was enrolled in the Triad. India presented the second highest mobility ratio, where per every 125 students in national institutions one student was enrolled in the Triad. Moreover, as for these two countries the growth of foreign enrolments was higher than that of national enrolments; therefore, the mobility of their highly educated students has increased over the 2001-2003 period.

95

Table 1.4.4 Enrolments in tertiary education (2003), BRIC countries detail

National National enrolment Foreign Enrolment enrolments growth in Foreign vs. enrolments growth in BRIC BRICs national in the Triad Share (2001-2003) countries (2001-2003) enrolment Brazil 15,455 5% -6% 3,579,252 13% 232 China 212,443 62% 22% 15,186,219 11% 71 India 90,532 26% 16% 11,295,041 9% 125 Russia 25,004 7% 3% 8,671,052 9% 347 BRIC 343,434 100% 17% 38,731,564 10% 113 Source: OECD Foreign Student Enrolment Database, own calculations

BRIC students accounted for a relatively small portion of the total foreign students hosted in the EU (compared not only to the share of BRIC students in Japan and in the United States but also to intra-EU student mobility). However, during 1999-2006, enrolments of BRIC students have increased much faster than foreign student enrolments in EU countries. Then, the share of BRIC students in the EU has increased to 14% in 2006, up from 11% in 2003, and 5 % in 1999.

Similarly to the trend observed in the Triad, also in the case of Europe, China accounted for the highest number of enrolments among BRIC countries, followed by India. In 2006, China absorbed 63% of BRIC students enrolled in the EU and India for 18%. Additionally, the number of students coming from these two countries has remarkably increased over 1999-2006. Enrolments of Chinese students in Europe grew on average by 29% annually and that of Indian did by 24%.

Table 1.4.5 Enrolment of foreign tertiary students in the EU (2006)

Enrolment Enrolment Enrolment Share in growth growth growth Enrolments BRIC (1999-2006) (1999-2003) (2003-2006) Brazil 9,334 5% 9% 7% 11% China 109,855 63% 29% 39% 16% India 31,406 18% 24% 25% 23% Russia 25,145 14% 13% 16% 10% BRICs 175,740 100% 23% 28% 16% All countries 1,244,563 8% 8% 8% Source: OECD Foreign Student Enrolment Database, own calculations

96 Among the EU countries, the United Kingdom hosted the highest number of BRIC students, absorbing 46% of BRIC new enrolments in Europe in 2006, followed by Germany with 26% and France with 13%. In particular, the United Kingdom received the bulk of Indian students in Europe (76%) as well as Chinese (47%).

1.4.4 International mobility of professionals The international payments of royalties and licences fees as well as the mobility of students might help to illustrate the amount of codified international knowledge flows between countries. However, they are only modestly instructive in depicting international flows of ‘tacit’ knowledge. For this reason, we make use of information on highly qualified migration53 to describe the part of knowledge that could only be delivered trough face-to-face communication. Moreover, through creation of international networks, mobility of professional might not only allow contemporary knowledge transfer, but also facilitate future international knowledge flows. A more general and thorough discussion of implications of highly skilled migration for the EU can be found in a separate chapter of this report.

Table 1.4.6 Foreign-born by country of residence, year 2000

All nationalities (Millions of migrants) BRIC (Thousand of migrants) Share Share Highly of Ratio Highly of qualifi highly of qualifi highly Ratio Country ed qualifi highly Numb ed qualifi of of foreign ed in qualifi er of foreign ed highly residenc Foreig worker the ed to foreign worker worker qualifi e n- born Share s Triad total -born Share s s ed EU 21 39% 2.8 32% 13% 1,105 27% 183 15% 17% USA 31 59% 5.9 66% 19% 2,575 63% 994 80% 39% Japan 1 2% 0.2 2% 18% 393 10% 66 5% 17% Triad 54 100% 8.9 100% 17% 4,073 100% 1,243 100% 31% Source: OECD Migration Database, own calculations.

Unfortunately, since information on skilled migration in the Triad is only available for the year 2000, then we are not able to glean any trend from it. At the end of this sub-section, we try to overcome this limitation by the use of EUROSTAT labour surveys database, but we do it at the cost of reducing the number of EU countries considered (Germany among them) along with losing the benchmark information on inwards migration in the Triad.

53 The present information was obtained from OECD.Stat – migration database; this database was originally constructed using information on Census and Labour surveys around the year 2000. The countries for which we have information are Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany (partial information), Greece, Hungary, Ireland, Italy, Luxembourg, Poland, Portugal, Slovak Republic, Spain, Sweden, United Kingdom, United States and Japan.

97 The Triad recorded 54 millions of immigrants in 200054, of which only 4 millions were born in a BRIC country. Additionally, only a minority of migrants were highly educated (holding at least a tertiary diploma) as well as employed in one of the countries of the Triad (17%). It is worth noting that migration from BRIC countries was relatively more educated than the total migration in the Triad; 31% of the migrants from BRIC countries were highly qualified and employed, while they were only 17% for the average migrant.

The USA not only hosted the highest number of migrants (59%), but also its migration was relative more educated, and the later was especially true for the case of migration coming from BRIC countries. The proportion of highly educated foreign workers to total migration in the USA was 19% and the proportion of highly educated BRIC workers to inward BRIC migration in the USA was 39%; that is, migrants coming from BRIC countries were twice as much educated as the average immigrant in the USA.

Additionally, the USA hosted the bulk of the foreign skilled workers in the Triad, hosting 66% of the highly qualified foreign workers and 80% of the highly qualified BRIC workers. The position of EU countries stayed far behind, especially with respect to BRIC migrants. The EU hosted 32% of the highly qualified foreign workers in the Triad and only 15% of the highly qualified foreign workers from BRIC countries.

From the point of view of individual BRIC countries, the USA was, except for Russia, the preferred location of highly educated workers, attracting 83% of the highly qualified Chinese workers, 82% of the Indians, and 50% of the Brazilian. Differently, Russian workers tended to locate in Europe (especially in Germany).

54 Information on Germany was excluded for the total figures since only information on labour surveys was available and it does not provide any information on immigrants from Brazil and India. However, for the individual country analysis, in the case of China and Russia, it was included.

98

Figure 1.4.3 Distribution of BRIC highly educated workers among main destinations, year 2000

Europe USA Japan

Brazil 75%

50% 50%

25% 56% 83%

Russia 0% China

82% India Source: OECD Migration Database, own calculations

Compared to the Triad figures, BRIC’s share in EU highly qualified foreign workers was relatively small; while the share of BRIC highly educated migrants in the Triad was 14%, it was only 7% in the EU. Indeed, most of the highly qualified foreign workers in the EU came from other European countries (42%). Among the BRIC countries, India was the major country of origin of the highly qualified workers both in the Triad and in the EU. China was the second country of origin in the Triad and Russia was the second in the EU.

Figure 1.4.4 Highly educated foreign workers in the EU by country of birth, year 2000

Source: OECD Migration Database, own calculations

99 BRIC migration is not evenly distributed in the EU, and it is clearly determined by cultural, language and proximity considerations. Among EU countries, the United Kingdom absorbed most of the highly qualified Indian workers in the EU (88%), followed far away by France (3%). More than a half of the Chinese highly qualified workers were located in the United Kingdom (36%) and in Germany (21%), Brazilians tended to locate in Portugal (29 %), and Russians mainly in Germany (75%).

Using information on EUROSTAT labour surveys, we can obtain some trends for the European inward migration of the highly qualified workers form BRICS countries. Unfortunately, we have comparable data only for 10 European countries55, and information on migration to Germany and the rest of the Triad countries are not provided. Over the period 2000-2007, BRIC skilled migration employed in the EU grew at an annual average rate of 10%. Migration from Brazil presented the highest annual growth rate (21 %), followed by that from China (12%) and Russia (12%). Among European countries, Spain experienced the highest annual growth rate of inward BRIC migration of highly qualified workers (27%), followed by Belgium (17%) and France (15%).

1.4.5 Cross-border patents between the EU and the BRICs Finally, we measure transborder knowledge flows between the EU27 and BRIC countries with patent data. Patents are intellectual property rights issued to protect a technological invention. One specific feature made patent data increasingly popular for studies of the internationalization of innovation in recent years (Patel and Pavitt, 1991; Patel and Vega, 1999; le Bas and Sierra, 2002; Criscuolo et al., 2005): Patent documents contain information on the location of the applicant (owner) and on the inventor’s place of residence. By comparing these two locations, we derive a measure for the ownership of cross-border patent inventions, which can be used as an indicator for the internationalization of R&D activities between two countries. We speak of a cross-border patent (CBP) when the applicant and at least one inventor reside in different countries. Patents owned by EU residents invented in the BRICs will be counted as active CBPs; patents owned by BRICs applicants invented in the EU are passive CBPs for this report.

Cross-border patent innovations originate mostly from the activities of multinational enterprises who locate innovation activities abroad. The motives for these overseas operations are twofold (Kuemmerle, 1999; Narula and Zanfei, 2005); first, enterprises focus on adapting existing products to local needs and supporting local production for the host markets. Overseas innovation activity is therefore a by-product of the internationalization of production and sales. Second, enterprises create new knowledge and technologies abroad because they benefit from spillovers from competitors, clients, universities, or public research centres and other favourable framework conditions for innovation in the host country.

55 The European countries considered in the analysis were: the United Kingdom, Spain, France, Greece, Netherlands, Sweden, Austria, Belgium, Denmark and Luxembourg.

100 Patent data has a number of advantages such as availability for a large number of countries, easy access, and the possibility to work with firm-level data. There are, however, also some limitations of patent data which may lead to an over- or underestimation of knowledge flows. We therefore suggest to consider results based on patent indicators as lower bounds rather than as an unbiased proxy for the extent of knowledge exchange. The first limit of patent indicators is the fact that not every invention necessarily leads to a patent. The propensity to patent varies considerably between sectors (Cohen et al. 2000; Blind et al. 2006); firms in some sectors only rarely patent but rely on secrecy, lead time or other protection mechanisms. In other sectors, firms increasingly apply ‘strategic patenting’ and use patents to block competitors, which boost the number of patent applications for a given invention. Moreover, overseas inventions of MNEs are, to a considerable degree, concerned with adaptations of existing products to the host country market. The results of these activities may only be protected at the host country patent office or not protected at all. Cross-border mergers and acquisitions are another factor that may lead to an underestimation because ownership change is not reflected in patent files.

Data for this analysis have been retrieved from the European Patent Office and cover the period 1999 – 2005. Total numbers for 2004 and 2005, however, seem less reliable than for previous years because a number of patent applications from these years are still under examination and not yet published as final grants.

A first important result from the analysis is the fact that knowledge creation is still much less internationalized than the production of goods. Patents owned by EU27 organizations are also predominantly invented in the EU27 (Figure 1.4.5). This holds also true at the level of individual EU member states (OECD 2007). Only less than 10% of all EU27 patent applications originate from outside the Union. The most important partner country of the EU27 for these overseas innovation activities is – by far – the US, followed by Switzerland, Japan, and Canada. About 6% of all EU27 patents are invented in the US, we find similar share for US patent applications invented in Europe. US-EU integration in science and technology has intensified considerably during the last decade and US based innovation activities have become an important source of European competitiveness, contrary to the belief that the US should be regarded as a rival to Europe in science and technology.

101

Figure 1.4.5 Share of active cross-border patent inventions of the EU27 with selected partner regions on all applications, 1999-2005

7%

6% s

n 5% io t a c i pl

4% nt ap

e BRICS t US-CA pa NON EU EUROPE EU

3% l NON-BRICS ASIA of al e r

2% Sha

1%

0% 1999 2000 2001 2002 2003 2004 2005

Source: European Patent Office, own calculations.

The role of the BRICs as source for EU27 patent applications, in contrast, is small. EU27 patents with at least one inventor from a BRIC country account for less than one per cent of all EU27 patent applications. This is considerable less than the share of EU27 patents invented in European non-EU countries (mainly Switzerland and Norway) on all EU27 patent applications. The importance of the BRICs as host countries for EU overseas innovation activities, however, is growing considerably, as can be seen from Figure 1.4.5. Their share on all EU27 patent applications has nearly doubled since 1999 and already equals the share of other non-BRIC Asian countries including Japan. We take a closer look at this development in Figure 1.4.6 where the important host countries of EU27 overseas patent inventions are compared at the country level. The share of the US (5.6% in 2005) is not shown in Figure 1.4.6 to improve readability. The illustration reveals that gains of the BRICs on the share of foreign-invented EU patents can be attributed to China for the most part. EU cross-border patent activities with Brazil, India, and the Russian Federation, in contrast, have changed only little in relative terms since 1999. In 2005, China’s significance as a host country for overseas innovative activities of EU organizations is similar to that of Japan or Canada. The data do not allow concluding that China has already overtaken these countries because there is considerable time lag between application and final grant of a patent and many patents applied for in 2005 are still under examination. It is, however, fair to say that China will pass these countries in the next years and also the other BRIC countries will increase their shares in the future. The vast majority of foreign-owned innovation activities in the BRICs are still relatively young compared to similar activities in the US or other European countries. Building up innovative

102 capacities takes time since corporate innovation processes are inherently uncertain, complex, and cumulative (Pavitt, 2005) and need time to establish links to the local innovation systems.

Figure 1.4.6 Share of active cross-border patent inventions of the EU 27 with selected partner countries on all applications, 1999-2005

1,4%

1,2%

BRA: Brazil

s 1,0% n CHN: China o i t a

c IND: India i pl RUS: Russian Federation ap t 0,8% n

e AUS: Australia t

pa CAN: Canada EU l

l ISR: Israel a

l 0,6% l JPN: Japan

on a KOR: Korea e

ar MYS: Malaysia Sh 0,4% NOR: Norway

SGP: Singapore

CHE: Switzerland 0,2%

0,0% 1999 2000 2001 2002 2003 2004 2005 Source: European Patent Office, own calculations

We now turn to passive cross-border patent applications and the question how attractive the EU is as a host location for foreign-based innovative activities of the BRICs vis-à-vis other countries, in particular the US. An important issue in such cross-country comparisons of patent data is the choice of the patent office (Hinze and Schmoch, 2004). Enterprises, universities, as well as private inventors tend to apply for a patent in their home country first. Therefore, a comparison of country shares based on data from the US Patent and Trademark Office (USPTO) will look very differently from a similar exercise with data from the EPO. To overcome this home office bias we will use patents filed through the Patent Cooperation Treaty (PCT) of the World Intellectual Property Organization (WIPO) in addition to USPTO and EPO data (Differences are explained in detail in OECD 2009). The PCT is not a patent office, but an alternative way to apply for a patent. After filing by the PCT (international phase), applications enter a national phase of examination at a national patent office or the EPO. The PCT allows a patent applicant to obtain patent protection in some or all of the 138 PCT member states by a single procedure with a single patent office. PCT applications are therefore much less distorted by the home office bias than applications originally filed a national patent office.

Figure 1.4.7 depicts overseas patent inventions of the BRIC countries for PCT, USPTO and EPO data. We have calculated the ratio between patent inventions located in the EU and US owned by various BRIC countries to reveal the relative attractiveness of the EU27 vis-à-vis the US (value greater than one indicates that the EU is a more important host country than the US). Hong Kong

103 has been included in the analysis as a location of various holding companies with noticeable patent portfolios related to Chinese enterprises.

Figure 1.4.7 Passive cross-border patents of the BRICs; PCT filings, applications at the USPTO and EPO, period averages

2,5

2,0 s n o

i 1,5 t n

ve Brazil n i

S China /U

U Hong Kong E

o India ti

a 1,0 Russian Fed. R

0,5

0,0 PCT (1997/06) USPTO (1997/04) EPO (1997/04)

Source: European Patent Office, US Patent and Trademark Office, OECD, own calculations

The data reveal a consistent ranking of the four BRIC countries; Brazil and the Russian Federation are more oriented towards the EU, while India and China tend to apply more inventions made in the US. We conclude that the US is a more attractive location for Indian and Chinese overseas innovation activities than the EU. The number of overseas patent inventions owned by BRIC countries, however, is still very small. China files only about 200 patents based on overseas inventions each year at the EPO, compared to a total number of 150,000 patents applied for at the EPO each year. Our conclusion is therefore based on very few patents. Organizations from Brazil and the Russian Federation apply two EU-invented patents for every US-invented patent. This ratio is even higher if we look at the EPO, but considerably lower if we go to the USPTO. This reflects the fact that patents invented in the US or the EU are also commercialized and protected there.

1.4.6 Summary By and large, knowledge transfer ties between the EU and BRIC countries are becoming increasingly important (though they started from very low levels). BRIC countries have also been preparing themselves by investing in R&D and education to benefit from the global pool of knowledge. Particularly impressive has been the case of China. China has become one of the major investors in R&D in the world in absolute terms. Moreover, the country has also remarkably intensified its knowledge ties with the world as well as with the EU. Even though knowledge ties between each of the BRIC countries and the EU have become stronger, the

104 impressive pace of China and, at lesser extent, of India, has resulted in an increase in their relative importance with respect to the EU, outpacing, in turn, the traditional privileged position of Russia.

Regarding trade in royalties and licence fees (RLF), the USA was the main provider of the world as well as a net exporter of RLF. Differently, the EU, the second biggest provider of RLF, was a net importer. However, with respect to BRIC countries, the EU presented growing surpluses, implying that most of the knowledge flows, through the RLF channel, mainly originated in the EU to be supplied to the BRICs. Additionally, EU imports of RLF from BRIC countries have been declining (from a very low level), while EU exports to the BRICs have been increasing. Even though the BRICs represented a relative small share in EU exports (4.5%), the EU has been succeeding in attracting a higher portion of the growing demand for RLF of the BRICs. The latter was largely due to the EU’s success in attracting China’s demand, which, among the BRIC countries, has been the major purchaser of EU RLF, as well as the EU export destination presenting the highest growth rate.

Turning to the international mobility of tertiary students, the EU was the main destination for foreign tertiary students, though BRIC students still prefer more often to enrol in American universities. In particular, the USA hosted the bulk of the Indian, Chinese and Brazilian students in the Triad. However, this pattern might change in the future since the EU has succeeded in attracting an increasing proportion of BRIC’s enrolments. BRIC students demand for tertiary education in the Triad has increased at the impressive annual average rate of 20%. Among BRIC countries, China registered the highest number of enrolments, the highest growth rate, and the highest mobility ratio in the Triad. Among European countries, the UK hosted the largest number of BRIC students, especially from India and China.

With respect to the international mobility of professionals, the USA is undoubtedly the preferred country of residence of highly qualified foreign workers in the Triad; this fact especially applies to the BRIC migration. The USA was, except for Russia, the preferred location of highly educated BRIC workers, attracting 83% of the highly qualified Chinese workers, 82% of the Indians, and 50% of the Brazilian in the Triad.

Among the BRIC countries, India was the major country of origin of the highly qualified workers both in the Triad and in the EU (mainly in the UK for the latter). The lack of regular and comparable data on the international mobility of professionals impedes us to glean sound conclusions on the trend of this type of migration, however, using EUROSTAT labour surveys we observed that BRIC skilled migration employed in the EU grew at an annual average rate of 10%. Mainly due to the increase in skilled migration employed in Spain and originated from Brazil. Given the importance of professional mobility in explaining ‘tacit’ knowledge transfer, it would be advisable for statisticians and policymakers to address the need of developing an international comparable data on this area.

105

Finally, we analyse the overseas innovation activities of MNEs. We measure these flows by patents where the country of the owner (applicant) differs from the country of the inventor. The data reveal that the majority of patents owned by EU27 organizations are also invented in the EU27; knowledge creation is still much less internationalized than the production of goods. EU patents invented outside the European Union mostly originate from the US, Switzerland, Canada, and Japan. The share of the BRICs on all patent inventions of the EU27 is one per cent, but rises fast. This increase is mainly due to activities in China.

The share of the other BRIC countries on EU patent inventions, in contrast, remained constant over the last years. Patents owned by BRIC countries invented in the EU27 are still rare and conclusions are based on small numbers; will all due care, we conclude that Brazil and the Russian Federation are more oriented towards the EU, while India and China tend to apply more inventions made in the US.

References Blind, K., J. Edler, R. Frietsch, and U. Schmoch (2006). Motives to patent: Empirical evidence from Germany. Research Policy, 35(5): 655-672. Breschi, S., and F. Lissoni (2001). Knowledge Spillovers and Local Innovation Systems: A Critical Survey. Industrial and Corporate Change, 10(4): 975-1005. Cohen, W. M., and D. Levinthal (1989). Innovation and Learning: the Two Faces of R&D. Economic Journal, 99(September): 569-596. Cohen, W. M., and D. Levinthal (1990). Absorptive Capacity: A New Perspective on Learning and Innovation. Administrative Science Quarterly, 35: 128-152. Cohen, W. M., R. R. Nelson, and J. Walsh (2000). Protecting Their Intellectual Assets: Appropriability Conditions and Why U.S. Manufacturing Firms Patent (or Not). NBER Working Paper, 7552. Cowan, R., P. A. David, and D. Foray (2000). The Explicit Economics of Knowledge Codification and Tacitness. Industrial and Corporate Change, 9(2): 211-253. Criscuolo, C., R. Narula, and B. Verspagen (2005). Role of home and host country innovation systems in R&D internationalisation: a patent citation analysis. Economics of Innovation and New Technology, 14(5): 417-433. Foray, D. (2004). The Economics of Knowledge. Cambridge [Mass], London: MIT Press. Gertler, M. S. (2003). Tacit knowledge and the economic geography of context, or The undefinable tacitness of being (there). Journal of Economic Geography, 3(1): 75-99. Hinze, S., and U. Schmoch (2004). Opening the Black Box. In H. F. Moed, W. Glänzel, & U. Schmoch (eds.), Handbook of Quantitative Science and Technology Research: 215-235. Dordrecht: Kluwer Academic Publishers. Keller, W. (2004). International Technology Diffusion. Journal of Economic Literature, 42(3): 752-758. Kuemmerle, W. (1999). Foreign Direct Investment in Industrial Research in the Pharmaceutical and Electronics Industries - Results from a Survey of Multinational Firms. Research Policy, 28(2- 3): 179-193.

106 le Bas, C., and C. Sierra (2002). 'Location versus Home Country Advantages' in R&D Activities: Some Further Results on Multinationals' Locational Strategies. Research Policy, 31(4): 589-609. Narula, R., and A. Zanfei (2005). Globalisation of Innovation: The Role of Multinational Enterprises. In J. Fagerberg, D. C. Movery, & R. R. Nelson (eds.), The Oxford Handbook of Innovation: 318-348. Oxford: Oxford University Press. OECD (2007). OECD Science, Technology and Industry Scoreboard. Innovation and Performance in the Global Economy. Paris: Organisation for Economic Co-operation and Development. OECD (2008a). OECD Science, Technology and Industry Outlook 2008. Paris: Organisation for Economic Co-operation and Development. OECD (2008b). Statistics on International Trade in Services 2008, Volume II, Detailed Tables by Partner Country. Paris: Organisation for Economic Co-operation and Development. OECD (2009). OECD Patent Statistics Manual. Paris: Organisation for Economic Co-operation and Development. Patel, P., and K. Pavitt (1991). Large Firms in the Production of the World's Technology: An Important Case of "Non-Globalisation". Journal of International Business Studies, 22(1): 1-22. Patel, P., and M. Vega (1999). Patterns of Internationalisation of Corporate Technology: Location vs. Home Country Advantages. Research Policy, 28(2-3): 145-155. Pavitt, K. (2005). Innovation Processes. In J. Fagerberg, D. C. Movery, & R. R. Nelson (eds.), The Oxford Handbook of Innovation: 86-114. Oxford: Oxford University Press. Keller, W. (2004). International Technology Diffusion. Journal of Economic Literature, 42(3): 752-758. OECD (2008). Statistics on International Trade in Services 2008, Volume II, Detailed Tables by Partner Country. Paris: Organisation for Economic Co-operation and Development.

107 2 Different models of BRICs’ economic development, implications for EU policies

2.1 Introduction

The BRICs show many similarities in their interactions with the EU, but significant differences as well. The major reason behind the latter is that they are following different models of economic development. In brief, Brazil is a domestically oriented service economy; Russian economic development is heavily dependent on energy and raw material resources; the Indian economy is essentially service-led, supported by exports; and China’s economic development is driven by manufacturing exports and investment. Nevertheless, looking at the more recent policies of the BRICs and their development plans for the future, a certain ‘convergence’ of strategies across all of them can be observed. The different characteristics of the models of economic development in the individual BRICs lead to different challenges and opportunities for EU competitiveness and respective policy implications.

In this section, we analyse the economic characteristics and major determinants of economic development for each individual BRIC country, with a focus on parameters relevant to external relations, in particular with the EU. These include, for instance, market size, income levels and distribution, age structure, the role of the government, the institutional framework, exports and imports, the foreign direct investment regime, the exchange rate system, the relative importance of private consumption and investment and of different sectors in the economy, labour markets, the education and research system and the quality of infrastructure. Special emphasis is put on future developments, and the impacts of the current global financial and economic crisis are taken into account as well. A special subsection points out the major future challenges and opportunities for EU competitiveness. After summarizing the results, some implications for EU policies are discussed. Annex 2 provides an extensive list of indicators for the individual BRICs, allowing for cross-country comparisons at a glance.

108 2.2 Brazil

Marcos P. Ribeiro, CEPII

2.2.1 Political, economic and social structure Macro level Brazil is a key emerging world economic power, being the fifth largest country in the world, both in terms of territory (8.5 million km²) and of population (with an estimated 189 million inhabitants in 2006). Its population is predominantly young56 and mostly concentrated on or near the Atlantic coast of the Southeastern and Northeastern States (see Figure 2.2.1).57 Since about 1970 there has been intense migration from the Northeast to the Southeast, as well as from rural to urban areas.58

Figure 2.2.1 Population and economic geographical concentration

North Region GDP - Regional Distribution in 2005

North 5% Northeast Region Northeast 13% Center-West 9%

Southeast South 56% 17%

Central-West Region Population - Regional Distribution in 2005

Northeast North 28% Southeast Region 8%

Center-West 7%

South 15% Southeast 42%

South Region

Source: IPEA and authors’ calculations.

Political structure Brazil is a Federal Republic made up of 26 States, one Federal District (Brasília), and 5560 municipalities. It is a stable and representative democracy with developed political bodies

56 In 2004 62% of Brazilians were less than 29 years of age. 57 Brazil’s Amazon rainforest is located in the North of the country and makes up 30% of the world’s remaining tropical forests, providing shelter to at least one-tenth of the world’s plant and animal species, and being a vast source of freshwater (Brazil holds 12% of the world’s available freshwater). 58 In 1940, 31% of the Brazilian population lived in towns. Today more than 80% of the population live in urban areas.

109 and institutions, even though some limitations persist having a negative effect on governance, human rights and citizens’ security.

The country’s President acts simultaneously as Head of State and of the Federal Government.59 Each State has a State legislature and a directly elected Governor, who heads the State executive and appoints its members. The Constitution provides for an independent judiciary.

In recent years, Brazil has been implementing an increasingly assertive foreign policy, playing an active role in multilateral fora and positioning itself as a representative of emerging countries and as a staunch defender of poorer countries, particularly in Africa. The country is a member of the G-20 group of richest nations, leading the reforms and global responses to the current financial crisis.

Brazil plays further a key political role within Mercosur – and the EU-Mercosur association negotiations – pushing for the negotiation of free trade agreements with third countries and for the extension of Mercosur. The country has been an active promoter of the South American Community of Nations,60 and has signed trade agreements with Mexico. Further agreements of this type are planned with countries such as Morocco and Egypt.

Brazil has also diversified its bilateral relations, establishing closer links with other regional powers such as India, China, Russia or South Africa but also with Arab or African countries, while maintaining balanced relations with the USA and the European Union.

Economic situation Brazil is classified as an upper-middle-income country with a GDP of EUR 973 billion and a GDP per capita of approximately EUR 5140 (EUR 7839 measured at PPP) in 2007, being the world’s 8th largest consumption market in 2007. In that year the Brazilian economy ranked 10th worldwide. Services accounted for about 66% of Brazil’s GDP, industry for 28% and agriculture for 6%.

From 2000 to 2007, the average GDP growth rate has been around 3.4%.61 Although this average rate is low compared to those of other BRICs, for more than two decades the country has not experienced such an extended period of stable and continuous growth (Hausmann, 2008). In 2008, even with the impact of the financial crisis in the last quarter, the Brazilian GDP grew by 5.2%.

59 Brazil’s current President is Luiz Inacio ‘Lula’ da Silva, who was first elected in 2003. He is in his second mandate, ending in 2010. 60 The South American Community of Nations was established at the 3rd South American Nations Summit in Cuzco in December 2004. This new regional integration system brings together all the countries of the South American continent, i.e. all Mercosur and Andean Community (CAN) member countries plus Chile, Suriname and Guyana. 61 This rate has been higher more recently. The Brazilian growth rate of real GDP was 5.7% in 2007 and 5.18% in 2008.

110

In recent years, the country has also recorded significant trade surpluses and exports have contributed positively to Brazil’s GDP growth (net exports corresponded to 3% of GDP in 2007). This export expansion has been accompanied by a rising importance of non-traditional export markets such as China, whose market share trebled from the year 2000 to reach more than 6%. Exports have been led mainly by agricultural commodities, meat, transport equipment (including automotive and aircraft),62 and iron and steel. Significant productivity gains have been made in the agricultural sector turning Brazil into a major agricultural power.63

Regional trade, however, is far below its potential with a strong disequilibrium favouring Brazil (MDIC, 2008). After the Brazilian devaluation of 1999 and even more so after the Argentinean abandonment of its currency-board foreign exchange regime, Mercosur’s share in Brazilian exports fell to 5.5% in 2002 and increased again to 9.1% in 2004. There exist some projects of industrial cooperation with Venezuela and Cuba, but with most of the countries the production networks are undeveloped and the regional scale potential underutilized. Moreover, infrastructure in the region is deficient, limiting the trade expansion.

Regarding foreign direct investment (FDI), Brazil is the second largest recipient of net FDI among the emerging markets just after China. In 2007 the total amount of FDI inflows reached EUR 24.6 billion and in 2006 EUR 17.8 billion. The US is the country with the highest inward stock (EUR 37.5 billion), but the EU is the largest foreign investor in the country, with a stock of EUR 88 billion. Brazil invested in the EU EUR 1.1 billion in 2006 and has an outward stock of FDI of EUR 43 billion.

Most of the inward FDI at the beginning of the 1990s occurred via M&As due to privatizations, mainly in public services and telecommunications. Thus, they were not focused on industrial production. However, in the second half of the 1990s (from 1996 to 1999) the inflow of FDI to the Brazilian industry jumped from EUR 1.24 billion to EUR 5.11 billion. Brazil is also Latin America’s largest energy consumer, accounting for over 40% of the region’s consumption. Its energy mix is one of the cleanest in the world, and the country is expected to continue to rely on hydropower to meet most of its power-generation needs.64 In 2005, Brazil was the world’s 15th largest oil producer, with proven reserves of 11.2 billion barrels (IEA, 2006); whereas bioethanol represented 40% of the light fuels consumed. Oil reserves increased nearly eightfold from 1980 to 2005. About 85% of them are located in offshore fields, increasingly from deep- and ultra-deep waters, which have yielded significant recent discoveries (IEA, 2006).65

62 EMBRAER is one of the world leaders for the design, manufacturing and sale of aircraft for the commercial and defence markets. 63 Brazil is the world’s No 1 producer and exporter of sugar, coffee and orange juice, a leading exporter of tobacco, bovine meat and poultry, and No 2 soy exporter. 64 According to FAO (2007) currently more than 45% of all energy consumed in Brazil comes from renewable sources, reflecting the combined use of hydroelectricity (14.5%), and biomass (30.1%). See also Poplawski Ribeiro and Sgard (2008). 65 Brazil has also the seventh largest uranium reserves in the world, of which 57% are ‘reasonably assured’.

111 2.2.2 The Brazilian Development Model at a glance After a period of economic stability and growth in the 1970s – the period of the so-called ‘Brazilian Miracle’ – the country suffered from hyperinflation and macroeconomic volatility in the ‘Lost Decade’ of the 1980s due to the external debt crisis in 1982.

At the beginning of the 1990s, growth was again erratic and the period was marked again by instability and inflation. In 1994, however, Brazil adopted the ‘Plano Real’ and succeeded in controlling inflation, aligning its currency, the real, with the US dollar. However, the combination of the fixed exchange rate with a loose fiscal policy in the second half of the 1990s caused a persistent deterioration of the trade balance, culminating in a major balance of payments crisis in January 1999.

The country was then forced to negotiate an adjustment programme with the IMF and launched a package of structural reforms to restore macroeconomic balances. These included the adoption of a floating exchange system for the real, an inflation-targeting regime, and a tight fiscal policy including a Fiscal Responsibility Law.

The new administration that came to power in 2003 is maintaining the prudent macroeconomic policy that Brazil has been implementing since 1999. The new government committed itself to keeping a firm grip on inflation, and managed to achieve high primary surpluses.

Lower inflation rates have permitted a partial reduction in interest rates (see Figure 2.2.2)66, which, in turn, set in motion a significant credit expansion in the country. This credit boom, allied by successful social programmes implemented by Mr. Lula da Silva, increased the purchasing power of the poorest strata of Brazilian society.

66 Note, however, that at the end of 2008 the Brazilian real interest rate was at 7.5% – the 13.75% target (nominal) interest lending rate minus the annual inflation of 6.25% – thus still being the second highest of the world. Turkey had the world's highest real interest rate at 7.55%. In March 2009 the nominal interest rate fell to 11.25%.

112 Figure 2.2.2 Brazilian official interest rate and exchange rate

Official Interest Rate (Selic) Exchange Rate (R$/US$)

45 4.5

40 4

35 3.5 %) ) $ (in c

30 3 S i l U / e $ S

- 25 2.5

(R

te te a 20 2 a R R t e s g re n

15 1.5 a te h n I c

l x a E

i 10 1 Lula'sFirs tfir Lust lprea's sprideesindtialen cial ffic electionelecti onand a nfidscal fisc crisial crsisis O 5 0.5 SpeculaSpeculattivivee attaAttackck andand floatfloat of of the Brazilian currency 0 the Brazilian currency 0 6 6 7 7 7 8 8 8 9 9 9 0 0 0 0 1 1 1 2 2 2 3 3 3 4 4 4 5 5 5 6 6 6 7 7 7 7 99 99 99 99 99 99 99 99 99 99 99 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / 07 10 02 06 10 01 05 09 01 05 09 01 04 08 12 04 08 12 04 07 11 03 07 10 02 06 10 02 06 09 01 05 09 01 05 08 12 / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / 1 2 8 7 7 9 9 2 8 7 8 3 7 1 5 2 7 3 1 4 3 2 8 8 9 7 8 2 1 2 7 6 6 5 3 4 0 0 2 1 1 0 2 2 2 1 1 0 0 2 2 1 1 0 0 0 2 1 1 0 2 1 1 0 0 0 2 1 1 0 0 0 2 2 working day

Source: Brazilian Central Bank.

The resulting rise in household consumption together with an increase in investment and public spending explain to a large part the recent steady and positive GPD growth in Brazil. The external demand for Brazilian products, in particular for its commodities, and the increase of their international price have also been main determinants of the GDP growth.

The cautious economic policy also prompted a steep fall in the public debt/GDP ratio (to 35.8% in December 2008), allowing Brazil to repay all its liabilities to the IMF. The structure of its debt has also improved, with a smaller share of total debt now being denominated in foreign currency. However, the government’s primary surpluses have been achieved mainly by raising revenues, i.e. increasing the tax burden.67

For the country, the success of President Lula’s economic policy has meant a very important change. A great problem Brazil had been facing for many years was the ever present spectre of a change of government that could suddenly turn economic policy upside down. This threat has disappeared and wider horizons for long-run economic decision making are being open, as a major political risk has been left behind (Paiva Abreu and Werneck, 2008).

However, several problems still persist. The sustainable rate of growth in Brazil at present is below 5%. For Hausmann (2008) this is surprisingly low, in particular given the nearly 2% increase in the working-age population; the rise in female labour force participation; the advancing urbanization; and the trend towards greater average schooling of the labour force.

67 Brazil’s fiscal revenue ratio was close to 35% of GDP in 2005.

113

Public investment in infrastructure is also low. It has decreased in relative terms to GDP, particularly for transport. Between 1995 and 2003, it fell from 2.5% of GDP to just over 1%. According to the World Competitiveness Report, Brazil lags behind other Latin American countries in terms of road and port infrastructure (Hausmann, 2008).

The social situation Key social indicators have improved over the past decades.68 The current government has assigned high priority to social development programmes. In this context, the government has streamlined the existing social transfer programmes into a unified conditioned social cash-transfer Programme ‘Bolsa Familia’ for the most disadvantaged families, offering financial subsidies as well as a combined access to basic social rights (e.g. healthcare, food, education and social assistance).

However, much remains to be done to address rural, urban, gender and racial inequalities and to ensure that access to goods and services benefit all social groups. In 2007 Brazil ranked 70th out of 177 in the UN Human Development Index, a rather modest position compared with the country’s levels of economic development and technological sophistication. Access to education69 and health indicators70 have improved over recent years, but there are still regional imbalances between the Northeast and the South and Southeast regions.

In 2005, 30.7% of the Brazilian population were poor (approximately 57 million people), while extreme poverty affected 11.4% of the population, i.e. 21 million people.71 Brazil is also one of the world’s most unequal societies: in 2002 the poorest 20% accounted for 4.2% of Brazil’s national income or consumption.72 However, due to the social programmes, in 2007 – for the first time in Brazilian history – the middle class represented more than 50% of Brazilian society (94.7 million people). Since 2002 the Gini index has also marginally decreased to 0.56.

The decrease in the unemployment rate in recent years is another encouraging indicator (a fall from 11.1% in January 2002 to 7.4% in December 2007), but job creation continues to be an important challenge for Brazil. Informality (reaching practically 40% of the labour force in December 2007) is another big issue.

68 Since 1990, life expectancy has increased by five years and the years of schooling of the labour force by four years. 69 In 2002, 93.8% of children aged 7 to 14 attended elementary school, 40% of children aged 15 to 17 attended secondary school and 9.8% of the youngsters went on studying. 70 In 2002, Brazil spent 7.9% of its GDP on health, an amount close to the OECD average (8.72%). 71 The poorest of the poor in Brazil have traditionally been in the Northeast Region (see Figure 2.2.1). In 2002, 25.2% of its inhabitants were in extreme poverty or indigence. But poverty exists in most of the country, mainly concentrated in metropolitan and depressed agricultural areas. 72 Inequality in Brazil is also related to race; 65% of the poorest 10% are blacks or mulattos, while 86% of the wealthiest 1% are whites.

114 2.2.3 Sectoral analysis In the course of its recent history, Brazil has adopted industrial policies several times. In the past, those policies were integrated in the strategic plans of development. The most successful plans were the ‘Plano de Metas’ (Targets Plan) in the second half of the 1950s and the ‘Plano Nacional de Desenvolvimento – PND’ (National Plan of Development), in particular the Second PND in the 1970s. All of these plans focused on the industrial sector and were decisive to the development and integration of the Brazilian industry.

During that period the targets were related to the balance of payments, concentrating on import substitution, and in the 1970s to the expansion of manufactured exports. This setup of the industrial structure and infrastructure organized economic power in Brazil in the famous triple: State (infrastructure and basic industries), foreign capital (dynamic industries), and national capital (traditional industries and niches of dynamic industries).

In the 1980s and 1990s, the development plans were left aside and replaced by the macroeconomic stabilization plans. In this context, little was done with regard to industrial policy. On the contrary, economic authorities believed that macroeconomic stability would create the necessary and sufficient conditions for the development of the productive sectors (DIEESE, 2005).73

The exception was the ‘Plano Collor’ (1990-1992), which reduced import tariffs, opening the economy and forcing a restructuring in large parts of the Brazilian industry.74 This plan also initiated the process of privatization, deepened under the subsequent government. In the meantime, sector-specific policies were implemented, such as the Sectorial Chamber of the Automotive Sector, mainly providing tax incentives to boost sectors with ineffective results.

In the mid-1990s privatization proceeded and included public utilities. Sales involved huge companies such as Companhia Vale do Rio Doce, a world leader in iron ore exports, and also public enterprises whose privatization required a major overhaul of the regulatory framework, especially in the telecommunications and electricity supply sectors. New agencies were created to regulate activities in the oil, electricity and telecommunication industries, with much more autonomy than had been the case in the past.75

The Brazilian industry restructured itself in an impressive way during that period. It downsized its operational structures, improved its quality and increased productivity,76 turning more towards international markets. The share of industry in total GDP and the number of employees in that

73 Suzigan and Furtado (2006) point to the lack of a clear industrial policy as one of the reasons for the weak performance of industry, and the consequent delay in economic development of Brazil in the past two and a half decades. 74 Matias-Pereira et al. (2006) claim, however, that this opening did not follow criteria that could be considered as part of a consistent and reasonable industrial policy. 75 Paiva Abreu and Werneck (2008) argue that the least satisfactory policies in this period involved the energy sector, with the government failing to define a clear regulatory framework able to stimulate new investments. 76 Particularly in the privatized enterprises (see Eid Jr. and Poplawski Ribeiro, 2004).

115 sector declined (Pichon, 2008). A new power structure emerged: a regulatory state, dominant foreign capital in key technological sectors, and private national groups restructured and with limited financial capital, particularly in new technologies.

Industrial structure Even though Brazil has diversified industrial activities,77 the industrial structure is still very concentrated. In 2004 SMEs represented 99% of the number of firms and 65% of all formal employment in the country, but its value added reached only 35%. By comparison, the USA showed a similar ratio of SMEs in the number of firms (98%), but their valued added corresponded to 65% (FIESP, 2005).78

Productivity and innovation in Brazil is also low. The Brazilian economy is currently less productive than 20 years ago, with this reduction originating mainly from two periods characterized by extreme productivity declines: 1980-1982 and 1988-1989 (Pichon, 2008).

In terms of innovation from 1998 to 2002, only 31% of the firms introduced innovations. Further, only 1.7% of the firms (1199) introduced product innovation and product differentiation (Erber, 2005). R&D expenditures represented 1.1% of GDP in 2005, resulting in 6500 patents (FIESP, 2005). The world share of scientific papers produced in Brazil increased from 0.44% in 1981 to 1.92% in 2006.

Nevertheless, the Brazilian industry is competitive in some high-tech sectors such as aerospace, in which the country holds the third position in the world market of commercial aircrafts. It is also the second biggest exporter of ethanol, being the technological leader in this product. Further, the automotive sector is one of the biggest industries in the country, accounting for about 10% of total revenues and 6% of employment in the industry (De Negri et al., 2008).

The new Brazilian industrial policy In March 2004, the current federal administration announced its first industrial policy after decades. It was called ‘Política Industrial, Technológica e de Comércio Exterior – PITCE’ (Industrial, Technological and External Trade Policy) and established the Brazilian Agency of Industrial Development, responsible to execute it.

The PITCE guidelines advocated that the state should create a favourable environment for industrial development and facilitate entrepreneurship, while holding firm to its commitment to macroeconomic stability. In the short term, the government should reduce the external restrictions of the country to increase efficiency. In the medium to long term, it should foster the development of key activities and technologies that would allow Brazil to increase its competitiveness in the international markets (DIEESE, 2005), for instance by simplifying trade procedures, seeking new markets, stimulating the creation of distribution centres for Brazilian companies abroad and

77 For a detailed description of the main Brazilian economic activities, see MDIC (2008). 78 For the companies starting in 2005, the survival rate was 78%.

116 supporting and consolidating the image of Brazil and Brazilian trademarks overseas. The focus on the international market is one of the differences between this industrial policy and the ones in previous decades .79

Suzigan and Furtado (2006) already assess as positive the simple fact of the existence of an industrial policy after so many years but they also argue that this industrial policy fails as an economic development policy tool due to, (i) its incompatibility with the macroeconomic policy; (ii) the inconsistencies of the policy instruments; (iii) the deficiencies in infrastructure and in the R&D and innovation system; and (iv) the lack of coordination and political drive.

More recently, in May 2008, the Brazilian government announced new tax measures and goals for its industrial policy. The policy includes tax incentives for investment, R&D and exports summing up to EUR 7.9 billion until 2011. Further, the National Bank for Economic and Social Development (BNDES) will provide EUR 78 billion in finance for innovation projects in industrial and services sectors.80 This plan is much more extensive than the previous one from 2004, giving priority to twenty-five subsectors instead of only four and to innovation in SMEs.

Further on, the programme contains four macro targets: (i) to increase the ratio of investment over GDP; (ii) to stimulate innovation via an increase in private R&D; (iii) to increase the share of Brazilian exports in the world exports; and (iv) to increase the number of SME exporters. These targets should be reached via three levels of policies: (a) systemic actions at the horizontal level, focused on sources of positive externalities to the entire industrial structure; (b) sectoral structural programmes for the Brazilian industry, oriented by strategic objectives to increase the competitiveness in main sectors of the national industry; (c) public policies focused on strategic themes, selected according to their importance to the long-term development of the country, such as strengthening SMEs, integration with South and Latin America with emphasis on Mercosur, integration with Africa etc.81

In a first assessment, IEDI (2008) observed as positive the focus of this new industrial policy on the coordination of actions. The measures to supp ort investment financing are also seen favourably, in particular the creation of a Sovereign Wealth Fund by the Brazilian government with resources coming from the primary surpluses.

2.2.4 Future prospects and challenges Short-term challenges: Brazil in the financial crisis82 Brazil has so far been more resilient to the crisis than many developed nations. Nevertheless, it was also strongly affected. After showing the highest gain in value among all world stock markets in 2007, the Brazilian stock market, Bovespa, suffered one of the world’s biggest losses from May

79 The main measures announced in the context of the PITCE industrial policy can be found in DIEESE (2005). 80 In the period 1996 to 2004, the share of BNDES in total investment in the country was on average 11% (FIESP, 2005). 81 For details of the new industrial policy see MDIC (2008) or IEDI (2008). 82 This section is mainly based on Poplawski Ribeiro (2008).

117 to November 2008, losing practically half of its value. At the beginning of May 2009 however, the index largely recovered – gaining 37% (+50% in USD terms) compared to the beginning of the year (see The Economist, 9th May 2009).

In parallel, Brazil, as most of the emerging markets, was facing massive capital outflows in 2008. This has been accompanied by a sudden freeze of all credit lines (including trade credit). Such a hasty run to the exit was mainly triggered by external reasons, but pointed to an increase in the uncertainty of foreign investors about the short-term future of the Brazilian economy as well (Canuto, 2008).

Brazil’s currency (the real) dropped more than 35% against the US dollar between August 2008 when reaching its highest value in nine years and March 2009. The depreciation of the real was the second largest (after the Russian rouble) among seven important currencies. Nevertheless, this depreciation can be seen as positive for the country by increasing the competitiveness of its exports. Exports dwindled as the biggest consumers of Brazilian goods saw their own economies go down the path of recession. In January 2009, the export volume fell by 29% in comparison to December 2008 and by 26% in comparison to January 2008. This was the largest monthly fall in exports since January 1985.

For the agricultural sector, the 2009 projections made by the Ministry of Agriculture in January show that exports may record their first fall in ten years. This contraction is directly related to the fall in the prices of main Brazilian commodities, forecasted at 11% this year.

The Brazilian response to the crisis has also been strong.83 The response on the part of the monetary authorities has been twofold. On the exchange rates side, the Brazilian Central Bank (BCB) engaged in several auctions on the foreign exchange markets, raising liquidity. On the domestic credit side, besides extending its rediscount policies, the BCB has eased its long-held stiff reserve requirements, in a series of moves that according to estimates ended up liberating an amount of liquidity potentially higher than 5.7% of GDP and 5.6% of total bank assets.

On the part of the government, the main response to the crisis has been the adoption of the provisional measure bill which eases the constraints on public banks to acquire capital of private financial institutions. At the end of March 2009, the government also reduced the tax on industrial products for the construction sector for three months. This will reduce prices for the final consumer of these products by approximately 8%.

Moreover, additional policies should be pursued. The credit expansion is one of the pillars of the upsurge of the Brazilian economy and, therefore, deserves special attention at this moment. The system has to be provided with sufficient sources of liquidity, favouring in particular smaller institutions. The BCB should also further reduce the interest rate, given that inflation forecasts for 2009 are below the target.

83 See IPEA (2009) for a comprehensive summary of the measures taken until recently by the government to tackle the crisis.

118 If most of these measures are taken, Brazil should be entering 2010 in a recovery mode, implying a soft landing of its economy in the face of the global financial crisis. However, in the medium term, the crisis demands other efforts to reduce the dependency of the Brazilian economy on commodity prices, on external financing and on credit demand stimulus.

IMF forecasts from July 2009 suggest a growth rate of -1.3% for the Brazilian economy in 2009 (see Table A2.1 in Annex 2). However, national and some other mid-year forecasts are more optimistic as several indicators suggest that the Brazilian economy, like that of India and China, might be bottoming out earlier than the advanced economies, whereby government stimulus measures seem to play a crucial role. In the first quarter of 2009, investment in Brazil was up 19%, sales of durable consumer goods have returned to pre-crisis levels, money from abroad begans flowing in again and the Brazilian currency started to appreciate in April 2009. Also, a significant rebound of stock prices is observed. On the supply side construction is doing well and industry is recovering. Medium- and longer-term challenges Giambiagi (2007) enumerates six medium-term challenges to be faced by the Brazilian government in its fiscal policy: (i) increase public investment; (ii) reform the tax system in order to make it fairer, isonomic, and favourable to production; (iii) slow down the expansion of internal debt; (iv) obtain nominal surpluses in the coming years; (v) curb the enlargement of government expenses; and (vi) improve the fiscal statistical indicators of the country, which date from approximately 25 years ago.84

Regarding the tax reform, FIESP (2005) proposes, in particular, an expansion of the tax base by reducing the informal sector in the country, and a simplification of the tax system to facilitate supervision and to avoid tax evasion.

For Giambiagi (2007) the risk of not pursuing those fiscal reforms is not an explosion of the public debt, but a lower potential of public investment, particularly in key areas such as infrastructure, which would affect the potential growth of the Brazilian economy.

Another major challenge identified by Matias-Pereira et al. (2006) is to define correct strategies oriented towards increasing productivity. For Hausmann (2008) augmenting domestic savings seems also a key priority.85 That would allow a greater level of domestic investment without relying excessively on external savings, which may prove unsustainable and could further appreciate the real exchange rate, bias growth towards non-tradeables, and accentuate the skills constraint.

84 Giambiagi (2007) defends a migration to a system similar to those of advanced countries, in which the Central or General Government results are the most important indicators. 85 Financial credit in Brazil accounted for 25.8% of GDP in 2005, which is still a bit more than a third of the rate (89.1%) in advanced countries (FIESP, 2005).

119

Regarding the political and social challenges in Brazil, the European Commission (2007) enumerates: (a) the difficulty of putting together stable parliamentary majorities in the framework of the current political system; (b) the relatively fragile links between the three levels of government (Federal, State and municipal), which make it difficult to define and implement policies and reforms nationwide; (c) the frequent cases of corruption and unlawful use of public resources;86 (d) the legal and regulatory complexity and the need to improve the functioning of the judiciary system; (e) the need to improve effective implementation of the existing legislation in the field of human rights;87 (f) violence,88 which is particularly serious in big cities and frequently associated with (illegal) drug trafficking and social exclusion.

Moreover, a law reform and, in particular, a labour reform should be pursued to provide more flexibility in the labour market and reduce informality and unemployment rates.

Nevertheless, even without the implementation of those much needed reforms in the Brazilian economy, Ernst & Young (2008) argue that the country is already in a sustainable growth path. Prior to the financial crisis, Ernst & Young (2008) – in association with the Fundação Getúlio Vargas – estimated that Brazil would grow by an average 4% per year in the period 2007-2030. In the first ten years the average growth rate would be 4.3%, and from 2017 onwards, that rate would decline to 3.8%. Brazil would then become the world’s 8th largest economy, reaching a GDP of EUR 1.6 trillion in 2030; and the world’s 5th largest consumption market. The IEA (2006), in turn, assumes an average annual growth rate of 3% for Brazil between 2007 and 2017 when calculating its scenarios of energy demand for the country.

Therefore, the most accepted scenario is that Brazil will grow between 3% and 4% per year over the next ten years. The implementation of the reforms discussed above would increase that average to levels between 4% and 5%.

2.2.5 EU-Brazil relations The EU and Brazil established diplomatic relations in 1960. The present relationship is governed by the EC-Brazil framework co-operation agreement (1992),89 EU-Mercosur Framework Co- operation Agreement (1995) and the Agreement for scientific and technological cooperation (2004).

The European Commission (2007) underlines that on many major world issues Brazil’s views converge with the EU’s. Thus, in May 2007 the EU recommended a strategic partnership to further deepen its ties with Brazil. The first ever Brazil-EU Summit was held in Lisbon in July 2007. On the Second Brazil-EU Summit in December 2008, leaders of both countries agreed to set

86 In 2004 Transparency International ranked Brazil 59th out of 146 countries in its corruption perception index. 87 Excessive use of force by law enforcement officials, limited access to justice for the poorest and most vulnerable sectors of society, and abuse against indigenous people are other major causes of concern. 88 In 2007 one homicide occurred about once every 12 minutes in Brazil. 89 See European Commission, COM (92)209 of 30.6.1992.

120 up a comprehensive strategic partnership by: (i) promoting peace and comprehensive security through an effective multilateral system; (ii) enhancing the economic, social and environmental partnership to promote sustainable development; (iii) promoting regional cooperation; (iv) promoting science, technology and innovation; and (v) promoting people-to-people exchanges. 90

EU-Brazil bilateral relations are supported via several EU projects and funds. The sector that, historically, has absorbed most financial resources is the environment, mainly through the pilot programme for the protection of the Brazilian rainforests (PPG7). Economic cooperation has also been an important part of EU cooperation with Brazil, mainly in the form of participation by Brazil in horizontal programmes such as Al-Invest29 or the EU Research Framework Programmes.91

Close to EUR 64 million were allocated by the EU to the bilateral EU-Brazil cooperation for the period 2002-2006 to three priority sectors: 1) economic reform (EUR 30 million or 47% of the indicative budget); 2) social development (EUR 15 million or 23%) and 3) the environment (EUR 6 million or 9%). Further, a total of EUR 61 million is earmarked for Brazil in the Brazil Country Strategy paper 2007-2013 with the two focal areas: enhance bilateral relations and environment.

Science and technology in general is another important dimension of the bilateral relations. In 2004 the project ‘Rede de Centros Tecnológicos e Apoio às Pequenas e Médias Empresas Brasileiras’ (Technological Centres Network and Support to Brazilian SMEs) was implemented.92 It aims to contribute to the reinforcement of the international competitiveness of Brazilian SMEs, by promoting bigger and more dynamic technological and commercial interfaces between enterprises and technological centres from Brazil and Europe in the plastic and electro-electronic sectors. This project will last until June 2010.

Moreover, the EU/Brazil S&T Cooperation Agreement, together with the new possibilities for international participation in the EU’s Seventh Research Framework Programme (FP7) for 2007- 2013, provide a basis for increasing the existing cooperation and improving participation by Brazilian scientists in FP research projects and fellowships on a mutually beneficial basis.93

90 For further information see ‘Brazil-European Union Strategic Partnership Joint Action Plan’, 2nd Brazil-European Union Summit, Rio de Janeiro, 22 December 2008. 91 Under the Fifth Framework Programme, 46 projects with Brazilian participation were approved, making Brazil the leading participant by far in Latin America. 92 For more information see the website of the Brazilian Ministry of Development, Industry and External Trade: www.mdic.gov.br 93 Brazil was, for example, invited to participate in Galileo, the European satellite navigation system. Last December, Summit leaders also highlighted the launching of negotiations for a cooperation agreement in the field of research on fusion energy between Brazil and the European Atomic Energy Community (EURATOM) which would, among others, facilitate supporting the interest of access by Brazil to the International Thermonuclear Experimental Reactor (ITER) project.

121

Nevertheless, additional measures should be taken to further strengthen EU-Brazil relations. In political terms, their strategic partnership should be boosted, increasing their joint voice in the international fora in the many issues of common interest, such as peace, sustainable development and climate change.

In economic terms, three main issues should be tackled. First, with the current failure of the Doha round, the EU-Brazil and EU-Mercosur trade agreements should be speeded up and concluded, promoting an increase in bilateral trade and the full exploitation of their comparative advantages. That could also help to alleviate the negative economic effects of the current financial crises in both regions. Second, investment flows between the EU and Brazil could be further augmented. Brazil is in urgent need of investments in sectors in which Europe has an international comparative advantage, such as infrastructure (in particular transport), energy, and green technologies. Thus, given the growth prospects of the country, returns in those fields could be high for both sides.

Finally, cooperation between the EU and Brazil in the field of biofuels could be deepened. As discussed in section 3 (on energy), that would clarify European concerns about Brazilian biofuels, and help both sides to achieve a more clean and sustainable energy mix.

2.2.6 Conclusions Brazil is in a unique situation in Latin America. While most countries are in search of products through which they can integrate with the global economy, Brazil is innovative in a number of high-tech activities in agriculture, energy, aircraft, mining products, design, machinery and automobiles, among many others. The country has many possibilities through which it can sustain growth for many years to come. In addition, Brazil benefits from close and strong economic and political relations with Europe, with the two sides having several complementarities.

Therefore, this section suggests that Brazil could be seen as a sustentative brick in the European search for further competitiveness in international markets and vice versa.

References Canêdo-Pinheiro, M., P. C. Ferreira, S. A. Pessôa and L. G. Schymura (2007), ‘Does Brazil Need an Industrial Policy?’, Ensaios Econômicos da EPGE, No. 644, March. Canuto, O. (2008), ‘Emerging Markets and the Systemic Sudden Stop’, Boletim de Informações da FIPE, November. De Negri, F., L. Bahia, L. Turchi and J. A. De Negri (2008), ‘Determinantes da acumulação de conhecimento para inovação tecnológica nos setores industrias do Brasil: setor automotivo’, Estudos Setoriais de Invação, ABDI, Brasília, December. DIEESE – Departamento Intersindical de Estatística e Estudos (2005), ‘Política Industrial no Brasil: o que é a nova política industrial?’, Nota Técnica, No. 11, December. Eid Jr., W. and M. Poplawski Ribeiro (2004), ‘Fatos e Lendas da Privatização’, in T. Wood (ed.), Gestão Empresarial: Finanças – volume 1, Chapter 6, Editora Vivali, São Paulo.

122 Erber, F. (2005), ‘The Brazilian Industrial Policy’, Paper presented at the 2nd Annual Meeting of the Latin American Economics and Business Association (LAEBA), Institute for the Integration of Latin America and the Caribbean (INTAL), IADB, 28-29 November. Ernst & Young (2008), ‘Sustainable Brazil: Economic Growth and Consumption Potential’, Análises & Perspectivas – Brasil. European Commission (2007), ‘Brazil: Country Strategy Paper (2007-2013)’, Document E/2007/889, Brussels, 14 May. FAO – Food and Agriculture Organization of the United Nations (2007), ‘A review of the current state of Bioenergy development in G8+5 countries’, Global Bioenergy Partnership (GBEP) Report, GBEP Secretariat, Rome. FIESP – Federação das Indústrias do Estado de São Paulo (2005), ‘A Competitividade e o Desenvolvimento Econômico: algumas sugestões para reflexão’, DECOMTEC Report, October. Giambiagi, F. (2007), ‘Dezessete anos de política fiscal no Brasil: 1991-2007’, IPEA Texto para Discussão, No. 1309, November. Hausmann, R. (2008), ‘In search of the chains that hold Brazil back’, Center for International Development Working Paper, No. 180, Harvard University, August. IEA – International Energy Agency (2006), World Energy Outlook 2006, Paris, France. IEDI – Instituto de Estudos para o Desenvolvimento Industrial (2008), ‘A Política de Desenvolvimento Productivo’, IEDI Report, May. IPEA – Instituto de Pesquisa Econômica Aplicada (2009), ‘Crise internacional: reações na América Latina e canais de transmissão no Brasil’, Report of the Brasilian President Cabinet, No. 17, February. Matias-Pereira, J., G. Fernandes-Marcelino and I. Kuglianskas (2006), ‘Brazilian new patterns of an industrial, technological and foreign trade policy’, Journal of Technology Management & Innovation, Vol. 1, Issue 3, pp. 17-28. MDIC – Ministry of Development, Industry and Foreign Trade (2008), ‘Inovar e Investir para Sustentar o Crescimento’, Presentation of the Brazilian Industrial Policy, Brasília, retrieved from: http://www.desenvolvimento.gov.br/pdp/index.php/sitio/inicial. Paiva Abreu, M. and R. L. F. Werneck (2008), ‘The Brazilian economy from Cardoso to Lula: An interim view’, in L. Bethell (ed.), The Cambridge History of Latin America, Cambridge University Press, Cambridge, V.IX. Pichon, A. M. (2008), ‘Les liens entre gains de productivité et ouverture au Brésil’, CEPII Report, September. Poplawski Ribeiro, M. (2008), ‘Brazil in the financial crisis: decoupling or hard landing?’, Banque Stratégie, No. 265, pp. 20-24, December. Poplawski Ribeiro, M. and J. Sgard (2008), ‘Quelques réflexions sur l’économie brésilienne’, Compte Rendu of the Réunion: ‘Le Brésil, grande économie émergente dans la globalisation après a stabilisation?’, Club du CEPII, Paris, 26 February. Suzigan, W. and J. Furtado (2006), ‘Política Industrial e Desenvolvimento’, Revista de Economia Política, Vol. 26, No. 2 (102), pp. 163-185.

123 2.3 Russia

Peter Havlik, wiiw

2.3.1 Introduction Nearly 20 years after the collapse of the Soviet Union and despite the considerable structural changes that have occurred during the transition to a market economy, Russia is still very much affected by the heritage of the former one-party political and centrally planned economic system. The effects (we mention here only the most important and EU-relevant ones) range from the disintegration of the Soviet Union and the CMEA with the related disruptions of traditional economic linkages (including inter alia oil and gas pipeline networks), the loss of the superpower status perceived by Russia (including the loss of both former allies in Central and Eastern Europe and the former Soviet republics which are now either members of the EU, such as the Baltic states, or which aspire for EU membership, such as Ukraine, Georgia and Moldova). The heavy reliance on energy and raw materials resources, particularly in exports, and – despite severe setbacks suffered during the early transition period – the fairly advanced defence- and space industry-related high-tech sectors represent another structural feature of the Russian economy that is associated with the Soviet heritage.

In designing EU policies towards Russia it is therefore important to understand the diverging views on many issues related to the political and economic transition in Central and Eastern Europe and to Russian perceptions of the European integration. The reality is that many (if not most) Russians agree with V. Putin, who views the collapse of the Soviet Union as the ‘greatest tragedy of the 20th century’ (the contrast to prevailing views in the Baltics on this event can hardly be bigger). The prevailing Russian view also sees the outcome of the transition-related industrial restructuring very much connected with the ‘primitivization’ of the Russian economy, whereas in the new EU member states economic restructuring – despite the current setback – is viewed as a success (Grinberg et al., 2008). Last but not least, there is the Russian perception of EU enlargement and EU Neighbourhood (Eastern) Policy as a ‘Western’ (i.e. EU, NATO, USA) intrusion into traditional spheres of Russian influence (former CMEA allies, ‘near abroad’, etc.). Notwithstanding possible disagreements, these perceptions have to be taken seriously, especially when Russia feels itself in a position of gaining economic and political strength and behaves accordingly.

Regarding the evolution of Russia’s ‘economic development model’, even in the broadly defined terms of transition from the centrally planned to a market economy the model has underwent marked changes in the past two decades. It moved from prevalently liberal approaches (the initial focus was on the liberalization of prices and external trade, mass privatization, delayed institutional developments and devolution of powers from the centre to regions, with the threat of the country’s disintegration) which had been applied roughly between early 1992 and the crisis of August 1998, to the subsequent backtracking towards re-centralization and a strengthening role of the state, associated mainly with Putin’s presidency after 2000. Taming the oligarchs and stressing the rule of law needed for regulating the invisible (some say chaotic) hand of the markets

124 represented the first steps correcting the initial liberal model. The application of Industrial Policy (IP) principles over free market approaches, the use of public-private ownership investment schemes, etc. were the economic development model guidelines designed at the end of Putin’s presidency – to be implemented by his chosen successor Dmitry Medvedev. The global financial crisis and its outbreak in Russia since late 2008 will require further adjustments of the model; these are most likely to go in the direction of more centralization and state interventionism while some of the ambitious investment and modernization programmes will have to be scaled down due to the lack of finance. An important element of the model’s correction was a changed approach to European economic integration: any considerations of potential EU membership, perhaps even the blueprints of Russian-EU ‘Common Spaces’ considered at the turn of the century, were scrapped. EU relations with Russia became frosty – especially after the EU’s eastern enlargement, EU’s support of ‘colour” revolutions in Ukraine and Georgia, the expiry of the PCA agreements, the war in Kosovo and in Georgia, and the recent energy disputes with Ukraine and Belarus.

2.3.2 GDP growth and the ambivalent role of energy The Russian economy has been booming during the past decade and most analysts have been busy repeatedly revising GDP growth forecasts upwards, largely owing to surging energy prices. Russian GDP growth exceeded 8% in 2007, driven by a double-digit expansion of household consumption and even faster growth of investments. Even in 2008, when the global financial turmoil started to bite, GDP growth still reached 5.6%. During the past five years, real GDP increased by more than 40%. At purchasing power parity (PPP), Russia’s GDP amounted to EUR 1900 billion in 2008 – about 15% of the aggregate EU27 GDP. In per capita terms, the Russian PPP-based GDP reached EUR 13,500 in 2008 – about 54% of the EU average – and the speed of catching up to the average per capita GDP level in the EU has been impressive: about 15 percentage points since the year 2000 (this was more than the NMS achieved during the same period).

There have been a lot of other economic achievements of Putin’s era which help to explain his extraordinary domestic popularity: surging incomes and average wages and decreasing poverty levels, rising employment (and declining unemployment), nearly full repayment of the government’s external debt, ballooning foreign exchange reserves, etc. Figure 2.2.1 provides some graphical illustration of the relevant indicators in the years 2000 and 2008. At the same time, the Russian population has been declining due to a combination of high mortality rates and declining birth rates. Indeed, the adverse demographic developments and latent labour shortages are among the major challenges that Russia will be facing in the near future. And whereas the number of Russians with incomes below the official poverty threshold nearly halved between 2000 and 2006 (to 21.6 million, that is 15.3% of the population in 2006), the income differentiation increased substantially.

125

Figure 2.3.1 Selected economic achievements of Putin’s era

2000 2008

Population (mn)

Employment (mn)

Mont hly wages (EUR)

Poverty rate (%)

FDI inflow (EUR bn)

Current account in GDP (%)

Forex reserves (EUR bn)

External debt in GDP (%)

GDP/cap (00's EUR at PPP)

GDP/cap (00's EUR at ER)

0 50 100 150 200 250 300 350 400 450

Source: Rosstat, CBR, own calculations.

Figure 2.3.2 Russia’s external sector and oil prices

Exports, EUR bn of which: oil & gas, EUR bn Impo rts, EUR bn Current account, % of GDP (right scale) 350 Oil price, USD/bbl (right scale) 80

300 70

60 250 50 200 40 150 30 100 20

50 10

0 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Rosstat, CBR, own calculations.

The recent economic boom has been explained to a large degree by surging world market commodity prices, in particular those of energy. Figure 2.3.2 shows how the development of Russian exports has been closely linked to rising oil prices. Indeed, the surging revenues from energy exports have accounted for a major (and growing) share of total export revenues. During 1995-1998, energy export revenues fluctuated around EUR 25 billion per year (around 40% of

126 total export revenues), compared to more than EUR 200 billion (and 66% of total export revenues) in 2008.

Russia was awash in money until late 2008: both foreign exchange reserves and capital inflows were at record levels (the inflow of FDI in 2008 amounted to some EUR 40 billion; foreign exchange reserves reached EUR 290 billion as of end-2008), the government budget was still in a large surplus (4.9% of GDP) and public foreign debt has largely been repaid. The shadow side of the recent economic boom was – apart from growing assertiveness, nationalism and a revival of some ugly remnants of Soviet stereotypes – the return of double-digit inflation and strong rouble appreciation in real terms (the latter trend was reversed in November 2008 after the collapse of oil prices).

Figure 2.3.3 Russian GDP growth and contributions of main components

Private consumption State consumption Gross capital formation Net exports GDP growth in % (right scale)

15 10

9

10 8

7

5 6

5

0 4

3

-5 2

1

-10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Rosstat, own calculations.

The appreciation pressure remained strong until late 2008 given the huge inflows of foreign exchange and despite some relief provided by the Reserve and National Welfare Funds (formerly Stabilization Fund) which accumulate part of energy-related windfall export revenues. The managed peg exchange rate regime (the rouble is pegged to a basket of US dollar and euro, with the share of the latter gradually increasing) and the full liberalization of capital account transactions (since June 2006) require massive currency interventions. The rapid growth of the money supply makes meeting the CBR inflation target extremely difficult. Besides, consumer price inflation was fuelled by rising prices for food, energy and housing as well as by administered tariff adjustments.

127 Figure 2.3.4 Nominal and real rouble exchange rates

nominal RUB/EUR, left scale real, Jan 2000=100 (CPI based, right scale) 50 40

45 50

40 60

35 70

30 80

25 90

20 100 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Note: Ascending line indicates real appreciation. Source: wiiw Monthly Database, Rosstat, CBR, own calculations.

These factors translated into double-digit annual inflation (14.1% in 2008) and to a sizeable appreciation of the rouble against the euro in real terms. From the beginning of 2000, the rouble appreciated by about 50% against the euro until October 2008 (Figure 2.3.4; appreciation against the US dollar was even more pronounced). The appreciation pressure was reversed only after November 2008: with sharply declining oil prices and export revenues, the rouble started to depreciate – despite massive interventions by the CBR which spent around USD 200 billion of its reserves to support the rouble within the three subsequent months.

Thanks to large windfall gains from high world market energy prices, the Russian government was able not only to repay nearly all outstanding public external debts (although private foreign debts increased), but to raise salaries in the public sector and pensions as well. Besides, several national development projects (targeting infrastructure, housing, the health sector, education and agriculture) were initiated. The three-year budget plan for the period 2008-2010, adopted in May 2007, reflected some important changes in economic policies. First, future budget revenues were to depend less on energy proceeds (apart from the Stabilization Fund, which was renamed Reserve Fund to be maintained at 10% of GDP; another part of windfall proceeds from oil and gas exports had been accumulated in the newly established National Welfare Fund – see Astrov, 2007). As a result, the share of budget revenues in GDP was to decline by about 5 percentage points between 2007 and 2010. Second, government expenditures should increase (even as a share of GDP) with state-sponsored priority programmes to benefit most. The long-discussed controversial idea of an Industrial Policy (IP) thus apparently gained official blessing. The

128 government-sponsored IP should offer targeted support to various public-private partnership projects (PPP) in the automotive, aviation, shipbuilding and selected high-tech industries (such as nano, nuclear and space technologies). Some of these initiatives were mentioned afterwards as the key priorities in the economic programme of the new Russian President Dmitry Medvedev in early 2008. The efficiency of implementing various IP and PPP raises serious doubts – not least due to widespread corruption and other institutional bottlenecks. Needless to say, the global financial crisis and related revisions of the federal budget in March 2009 will most likely result in reduced financing of a number of previously planned projects.

2.3.3 Future prospects and challenges The main challenge for the Russian economy in the medium and long run is whether it will succeed in replacing energy exports as the key growth driver by the development of other sectors (diversification towards manufacturing, high-tech branches, services, etc.), and how it will cope with the acute demographic crisis (the population is projected to decline by nearly 10 million in the coming decade). The officially endorsed long-term development programme, prepared by the Ministry of Economic Development and Trade in 2007, envisaged in its ‘innovation scenario’ an ambitious economic diversification away from the current heavy reliance on energy. A gradual switch to innovation-based development, supported by the above-mentioned IP instruments, as well as the completion of reforms which aim at an improved climate for investments and entrepreneurship was planned. Growing investments in transport infrastructure, education, health and R&D should help to generate an average annual GDP growth rate above 6% over the next decade. In this scenario, the Russian economy should restructure, become more efficient, modern and competitive. Alternative scenarios, based on continued heavy reliance on energy resources, lower oil prices and less investments would generate GDP growth rates around 4-5% whereas the Urals oil price at last year’s level (USD 70 per bbl) would help to keep GDP growth at 7% in 2008 – see Dashkeyev (2008).

The range of GDP growth forecasts for the year 2009 fluctuates between -8% and +2%, largely depending on assumptions regarding the level of energy prices (Development Centre, 2009). As shown in Figure 2.3.3 above, since 2004 the Russian GDP growth has been driven mainly by booming private consumption and, increasingly, also by expanding investments. The contributions of real net exports to GDP growth has become negative as the volume of exports was growing only at a modest pace (less than 10% per year) whereas import volumes were surging by more than 20% per year. On the supply side, the major part of the overall GDP growth resulted from booming trade, financial services, telecoms and construction activities whereas manufacturing industry and agriculture expanded less than the overall gross value added (Figure 2.3.5).

129 Figure 2.3.5 Economic growth by sectors, 2002-2008 (2002 = 100)

Total GVA Agriculture Manufacturing Construction Trade Hot el s& rest Transport Finance Real estate

100 120 140 160 180 200

Source: Rosstat, own calculations.

In 2008, the Russian economic growth still reached nearly 6%; fixed investments grew by 13% and real money incomes by 8%. Export revenues grew by 24% (imports by 22%, both in euro terms) and the current account surplus increased as well. However, GDP growth virtually collapsed in the fourth quarter of 2008 and the first quarter of 2009 while inflation remains high and may even accelerate as a consequence of the recent government rescue measures and the depreciation of the rouble.

Despite strong economic fundamentals, Russia has been seriously hit by the global crisis, especially after September 2008. The stock market dropped by more than 70% between May 2008 and January 2009 – one of the largest declines among the emerging markets – yet it recovered thereafter. Market capitalization declined by about USD 1000 billion over the same period. For the whole of 2008, net capital outflows reached nearly USD 140 billion (net capital inflows exceeded USD 80 billion during 2007). The stocks of a number of Russian blue chip companies (such as Gazprom, Rosneft, Lukoil, Sberbank, Norilsk Nickel) were hit particularly hard, reflecting partly investors’ overreaction, although fundamental factors played a role given the recent decline in the world prices for oil and metals and high exposure to short-term foreign debts. The adverse external shocks that triggered these events may have been compounded by domestic political factors, such as the Mechel and TNK-BP affairs of early summer 2008, the war in Georgia and the gas conflict with Ukraine at the beginning of 2009. However, the shallow depth and relative immaturity of the domestic stock market should keep repercussions on the real economy in check. The current stock market developments probably reflect more of a temporary

130 overreaction on the part of the market participants rather than a lasting deterioration of the domestic investment climate.94 Medium- and long-term prospects for economic growth are not bad.

Indeed, potentially more serious than the dismal and volatile performance of the stock market – especially as far as repercussions on the real economy are concerned – is the tightening of credit conditions. There is no doubt that several large Russian companies (such as Mr Deripaska’s Basic Element) and especially smaller Russian banks have been facing difficulties servicing and refinancing their outstanding foreign debts. The lack and/or dearth of domestic, especially long- term credit financing – a by-product of past restrictive monetary policies in Russia and easy credits abroad – have motivated Russian companies, even the state-owned or state-controlled ones such as Gazprom or Rosneft, to seek external financing. Private foreign debt reached some USD 400 billion as of end-2008 with short-term obligations declining (to 16% of the total at the beginning of 2009).

Similar to the USA and the EU, the Russian government has adopted various rescue and stimulation packages in order to improve the liquidity of the banking sector and restore confidence. The Central Bank released more than USD 100 billion out of its reserves in order to provide additional liquidity and to support the rouble exchange rate. New loans to the banking sector with a maturity of up to six months will be provided via the state-owned Vneshekonombank (VEB) with no collateral required. In addition, the VEB will provide credit for refinancing short-term foreign loans, while acquiring shares in those companies as collateral. The bank guarantee on private deposits was raised to RUB 700,000 (EUR 20,000). Altogether, more than USD 200 billion of state assistance in various forms were earmarked in an endeavour to ease liquidity in the financial sector. Critics point to the usual dangers of misappropriation and corruption; they also expect that in the main the large (or well-connected) banks stand to gain disproportionately from this facility. They wonder in fact whether the money will reach the companies facing the liquidity squeeze. It is to be expected that a number of small and medium- sized banks will eventually collapse, the banking sector will be streamlined and the state will exert greater influence on companies seeking financial help.

With lower export revenues and reduced investments, GDP growth will be negative in 2009; the trade and especially current account surpluses will diminish. A number of ambitious future spending and investment plans will have to be scaled down and government revenue will drop markedly following lower export duties on oil. If the level of federal expenditures is maintained, the federal budget will turn from a surplus in 2008 to a large deficit in 2009. Taken together, a substantial slowdown of GDP growth will now definitely materialize. The outcome, however, may be much worse: until a few months ago, the range of GDP growth forecasts for the year 2009 fluctuated around 4-6% – largely depending on assumptions regarding the level of energy prices. Most current forecasts of Russian GDP reckon with negative growth for 2009 (up to -6% according to the IMF), with some acceleration possible in 2010 (Development Centre, 2009). Owing to the limited role of credits in financing both consumption and investments (the latter are

94 The stock market increased by +50% between January and end-April 2009 – see The Economist, 9 May 2009, p. 94.

131 still largely financed from own resources or by the government), any effect of the financial crisis should be relatively modest and short-lived. The domestic financial market may stabilize and even recover fairly soon, yet the investment climate (including financing and the climate for investments in general) will remain difficult. Nominal exports will contract substantially; the volume of exports and imports will also decline in 2009.

The expected GDP growth slowdown appears inevitable also in the medium term, at least until the end of the decade, before any (uncertain) modernization efforts start to bear fruit. Our forecast for 2010 is based on a modest recovery of oil prices (Urals costing not more than USD 70 per barrel) and limited impact of the current financial market turmoil. Both private consumption and investments are expected to grow faster than GDP; real exports will continue to be sluggish since the volumes of exported oil and gas will hardly increase, while imports will expand rapidly – roughly in line with private consumption and investments. This implies an ongoing negative (albeit diminishing) contribution of real net exports to GDP and, in nominal terms, a gradual reduction of trade and current account surpluses. In fact, the current account surplus, which leapt to EUR 70 billion in 2008 (about 6% of GDP), will disappear. Inflation will remain above 10% in 2009 and stubbornly close to 10% thereafter.

More than the direct effects of the global financial crisis, the oil price in particular constitutes a crucial variable for Russia in the short, medium and possibly even long term. The current global turmoil notwithstanding, the main challenge for the Russian economy is whether it will succeed in replacing energy exports as the key growth driver by developing other sectors (diversifying towards manufacturing, high-tech branches, services, etc.) and the manner in which it will cope with the acute demographic crisis. The major challenges for the Russian economy – institutional developments, economic diversification and modernization – thus remain unchanged.

132 Figure 2.3.6 Unit Labour Costs (ULC) in Russia: growth and contributions of key components, annual averages in %, 2000-2008

Wages GDP Employment Exchange rate RUR/EUR ULC growth (right scale) ULC level, Austria=100 (right scale) 100% 45

38.3 38.2 40 80%

35 60% 30

40% 22.9 25 20.5 18.1 20% 20 15.9 15.3 12.1 15 0% 10

-20% 5 0.1 -40% 0 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Rosstat, CBR, Eurostat and own calculations.

A potentially even more serious barrier to future sustainable economic growth and successful diversification is related to the danger of Dutch Disease and the gradual erosion of cost competitiveness. This results from a combination of factors such as the real currency appreciation, rapid growth of wages and only sluggish improvements in labour productivity (Figure 2.2.6). Average gross wages exceeded EUR 470 per month in 2008 which represents a nominal increase by 21% year on year. During 2004-2008, Russian unit labour costs were rising by nearly 20% per year and their level is now already higher than in some Central European new EU member states (e.g. Bulgaria – see Gligorov, Hunya, Pöschl et al., 2009 for detailed comparisons). Given the competition from Central and Eastern Europe (including Ukraine) and especially from China, Russia may soon become a location too expensive (and thus non-competitive) for export-oriented manufacturing. Rising local production costs may distract even such investments, in particular FDI, which are oriented at the (rapidly expanding) domestic market since the respective imports are cheaper. The expected (and repeatedly delayed) accession to WTO and the related reduction of import tariffs may even aggravate these problems (see also Chapter 7 in OECD, 2008). It is not clear either whether the above-mentioned envisaged IP tools may not be conflicting with the accession to WTO.

133

Russia’s greatest untapped potential lies in efficiency-seeking FDI. With its technological capabilities and human skills, Russia could become a major international engineering hub. But the success may prove inadequate under a scenario of intense global competition for FDI projects, in which case the country would also need to upgrade its investment promotion efforts, including the liberalization of FDI and the provision of targeted incentives. If that happens, Russia could multiply its inward FDI stock within a relatively short period of time – despite the restrictions on FDI in strategic sectors that were adopted in 2008 (Vinhas de Souza, 2008). One important caveat is that, before this happens, Russia could become a location too expensive for export-oriented FDI projects. Besides, the size of the Russian economy, national security concerns and the abundance of natural resources will doubtlessly shape FDI flows differently from the patterns observed in the NMS. Furthermore, the role, patterns and effects of outward Russian FDI – especially in the CIS countries – is becoming an increasingly hot topic which requires additional research.95 The above aspects have again important implications for the potential relocation of production to Russia, the attempted economic diversification, adequate business strategies of foreign companies and for EU-Russian economic relations.

2.3.4 Challenges for EU-Russian relations Several key problem areas will affect the evolution of future EU-Russia relations in the context of broader European economic integration. In this section, only two aspects are briefly addressed: EU-Russian trade (including energy and FDI) and the contest between the EU and Russia for the influence on the post-Soviet space.96

Apart from energy issues, it is probably the EU (and NATO) Eastern enlargement as well as the EU’s Neighbourhood (Eastern) Policy (ENP) vis-à-vis the CIS countries (in particular Ukraine and Georgia) which are creating tensions between Russia and the EU. The ENP is perceived by Russia as an unwelcome foreign inroad into Russia’s traditional spheres of influence – the ‘near abroad’ in Russian terminology. The ENP aims to create a ‘ring of friends’ in the EU neighbourhood by providing various incentives such as reform support, economic assistance, technical advice, trade concessions – without offering to these countries the potentially biggest incentive, namely EU membership. At the same time, Ukraine and Georgia aspire for full EU membership, and other former Soviet republics (Moldova, potentially even Belarus) may voice similar aspirations in the future. However, the Western support of the ‘colour’ revolutions in several CIS countries is perceived by Russia as a deliberate attempt at regime change, ultimately aiming at the reduction of Russian influence in the CIS.

Simultaneously, there is a number of integration projects on the post-Soviet space such as the Commonwealth of Independent States (CIS), involving all former Soviet republics except the three Baltic states (which became EU members in 2004), the Common Economic Space (CES) involving Russia, Belarus, Ukraine and Kazakhstan with the aim to establish at least a Customs

95 See Libman and Kheyfets (2006) on Russian investments in the CIS and Kuznetsov (2007) on Russian FDI in the EU. 96 Other areas of EU concern such as migration, the fight against organized crime, environmental issues, human rights and ‘common values’, etc. – all likely to be dealt with in the future EU-Russia partnership or strategic agreement – are beyond the scope of the present paper.

134 Union (the latter is opposed by Ukraine and was used by Russia as a pretext to delay WTO accession), the Central-Asian Cooperation, the Union State of Russia and Belarus, etc. – all involving Russia as a dominant partner.97 So far these integration efforts have not been very effective. However, Russia is considering its ‘near neighbourhood’ as its traditional sphere of influence; the new President Dmitry Medvedev has declared relations with the CIS as top priority.

Intra-CIS trade declined dramatically during the 1990s after the dissolution of the USSR (Havlik, 2007). Yet in contrast to the relatively small role of the CIS in the foreign trade of Russia (in 2007 only 15% of Russian exports and imports were traded within the CIS), the share of the CIS (and of Russia in particular) remains still high in the foreign trade of smaller CIS republics, including both Ukraine and Belarus – especially as far as imports of energy are concerned.98 Belarus’ and Ukraine’s dependence on Russian energy deliveries is a well-known fact (reiterated by the recent gas price disputes). However, not less important is the CIS (and here again Russia in particular) for these countries as a market for their exports, especially of manufactured products which otherwise would not be competitive elsewhere.99

Owing to its rising economic strength, Russia is again becoming a more important trading partner for the CIS republics – and this tendency is being reinforced by increasing Russian investment flows, particularly in the energy, metals and telecom sectors (see Libman and Kheyfets, 2006; Zashev et al., 2007 for details). Under ‘normal’ conditions, also economic theory (gravity models) provides some evidence that Russia would remain the key trading partner for neighbouring smaller CIS economies, albeit below the shares which existed previously under the autarky Soviet system (see Vavilov and Viugin, 1993).

2.3.5 Directions of EU-Russia relations European integration is at a crossroads. After the recent EU enlargements by the former socialist countries of Central and Eastern Europe, as well as the stalemate following the rejection of a draft EU Constitutional Treaty by referenda in France and the Netherlands in 2005, the EU has been preoccupied with internal debates. Future EU enlargements are moving forward slowly while the EU Neighbourhood Policy (ENP) is in disarray and remains largely toothless. The design, scope and conduct of the ENP has become more controversial as several NMS (in particular Poland and the Baltic states) are bringing new accents.100 The ENP’s implementation has been complicated also by disappointments in the actual developments of the ‘Orange’ revolution in Ukraine, the crisis in EU relations with Belarus and – last but not least – by a marked deterioration of EU- Russia relations. The evolution of the EU-Russia Strategic Partnership is unclear after the Partnership and Cooperation Agreement (PCA) expired in November 2007 (the PCA has been

97 The only integration project on the post-Soviet space without Russia is GUAM, which comprises Georgia, Ukraine, Azerbaijan and Moldova. For more details on the various integration projects on the post-Soviet space see, for example, Pankov (2007). 98 In 2007, 46% of Belarus’ exports (and 66% of imports) were traded with the CIS. The corresponding figures for Ukraine were 38% (exports) and 43% (imports) – see CIS in 2007, CISSTAT, Moscow, 2008, pp. 146-147. For more details see Havlik (2007) and Pindyuk (2007). 99 There is a wide dichotomy between the commodity composition of exports to the CIS and the EU, in particular regarding Belarus – see Havlik and Astrov (2007). 100 For recent assessment see, for example, Emerson (2007), Emerson et al. (2009) and Barisch (2007).

135 automatically prolonged). For all these policy directions new initiatives and sustained efforts of both the EU and Russia are badly needed (Emerson et al., 2009).

Meanwhile, the trade integration of the European economy continues to increase: not only is intra- EU trade of key importance especially for the NMS, but the EU (especially so after the recent enlargements) has become the leading trading partner in particular for Russia (55% of Russian exports go to the EU), and also for Ukraine (28%) and even Belarus (45% of exports). The European economic integration is thus progressing ‘from the bottom’, driven by both the accession process (in the NMS and less clearly also in the Western Balkans) and by growing business interests in rapidly expanding lucrative markets further East (especially in Russia). EU trade and investments in these dynamic markets are growing despite the difficult and unclear contractual environment. The institutional framework for doing business in the wider Europe is in a clear mismatch with economic reality, challenging not only future European integration but also its competitiveness in a global economy. The next integration steps are complicated not only by internal EU disputes, but also by Russia’s growing assertiveness linked to its growing economic strength and attempts to restore influence on the post-Soviet space where it views EU inroads as an unwelcome intrusion in its traditional sphere of influence. This, in turn, is viewed with suspicion by several NMS (in particular Poland and the Baltic states) where the distrust in Russian intentions is especially strong. However, some recent Russian actions vis-à-vis its ‘near abroad’ (the energy price disputes with Ukraine and Belarus leading to the interruption of supplies, trade sanctions against Georgia and Moldova, restrictions on migrant workers) have been at least in part apparently politically motivated, they are not instrumental to the promotion of economic cooperation within the region either.

Closer economic integration between the enlarged EU, the CIS and Russia in particular requires a stronger political commitment of all parties involved as well as further mutual trade liberalization and encouragement of cooperation in various fields such as industry, transport infrastructure and research. The EU – the stronger side – should be expected to lead the process.101 A contrasting view, increasingly popular in Russia, is that Russia is different from both the NMS and other CIS: it is big and does not wish, or need, to integrate with the EU. According to this view, Russia should develop its own integration space encompassing the bulk of the post-Soviet area (the Common Economic Space). Integration within that space should create an economy that would be multi-country, multi-sector but basically inward-oriented. However, before that were to happen, Russia would have to change its sturdy behaviour towards its potential integration partners, offering incentives for such an integration project instead of threats when the potential partners are hesitant.

Despite considerable differences among the individual EU member states regarding policy approaches towards Russia (which go beyond the divisions between ‘old’ and ‘new’ member states – see Leonard and Popescu, 2008) more engagement of the EU is definitely needed. There is a broad agreement among economists that the relationship between the enlarged EU and the CIS requires a more intensive search for constructive approaches to the interaction within the

101 This argument was emphasised also by Tsoukalis (2007).

136 triangle of Russia – EU – CIS countries. Turning the space of the common ‘near abroad’ of both Russia and the EU into a conflict area would be deplorable. Both Russia and the EU should develop coordinated ‘neighbourhood’ policies which should recognize the futility of ‘competing integrations’ in relation to the CIS with Russia trying hard to involve its major partners in the Customs Union of the ‘Four’ (Belarus, Russia, Kazakhstan and Ukraine) and the EU hindering this process while offering those countries no clear prospect of deeper EU economic integration. The Single Economic Space integration should be an ‘interface’ project between the enlarged EU and the CIS, as part of the gradually evolving Common European Economic Space.102 These (and many other) issues should be addressed in a new (Partnership or Strategic) Agreement between Russia and the EU, which is currently under negotiation.

References Astrov, V. (2007), ‘The Russian Oil Fund as a tool of stabilization and sterilization’, wiiw Monthly Report, No. 7, pp. 1-8. Astrov, V. and P. Havlik (2005), ‘The Enlarged European Union and Its Eastern Neighbourhood’, in: K. Liuhto and Z. Vincze (eds), Wider Europe, Esa Print Oy 2005, pp. 169-195 (published also in Journal of East-West Business, Vol. 11, No. 1/2, pp. 13-44). Astrov, V. and P. Havlik (2007), ‘Ukraine, Belarus and Moldova: Economic Developments and Integration Prospects’, in: D. Hamilton and G. Mangott (eds), The New Eastern Europe: Ukraine, Belarus & Moldova, Center for Transatlantic Relations, Johns Hopkins University, Washington DC, pp. 127-147. Barisch, K. (2007), ‘Russia, realism and EU unity’, Policy Brief, Centre for European Reform, London, July. Cheng Jian (2008), ‘Relations between Russia and Europe from the Perspective of Energy Strategy’, IFSH Hamburg, Heft 150, February. Dashkeyev, V. V. (2008), ‘Scenarios of macroeconomic development in 2008’ (in Russian), Institute of the Economy in Transition, Moscow, January. Development Centre (2009), “Macroeconomic Forecasts for Russia”, Moscow, April. Dollar, D., M. Hallward-Driemeier and T. Mengistae (2006), ‘Investment Climate and International Integration’, World Development, Vol. 34, No. 9, pp. 1498–1516. Emerson, M. (2007), ‘The wider neighbourhood is in not such good shape’, European Neighbourhood Watch, No. 29, CEPS, Brussels, July. Emerson, M. et al., (2009), ‘Synergies vs. Spheres of Influence in the Pan-European Space’, CEPS, Brussels, April. Gligorov, V., G. Hunya, J. Pöschl et al., (2009), ‘Differentiated Impact of the Global Crisis’, wiiw Current Analyses and Forecasts, No. 3, February, Vienna. Glinkina, S. and N. Kulikova (2007), ‘The Impact of EU Enlargement on Economic Restructuring in Russia and Future Relations between Russia and the European Union’, wiiw Research Reports, No. 338, Vienna, March. Goldthau, A. (2008), ‘Russia’s energy weapon is a fiction’, in: Europe’s World, Brussels, Spring, pp. 36-41.

102 See Glinkina, S., Kulikova, N. (2007); Havlik and Astrov (2005), Yurgens, I. (2008).

137 Grinberg, R., P. Havlik and O. Havrylyshyn (eds) (2008), Economic Restructuring and Integration in Eastern Europe. Experiences and Policy Implications, Nomos, Baden-Baden. Hamilton, C. B. (2005), ‘Russia’s European economic integration. Escapism and realities’, Economic Systems, Vol. 29, pp. 294-306. Havlik, P. (2003), ‘Russia and the European Union’, Contemporary Europe. Social and Political Research Journal (in Russian), No. 1, institute of Europe, Moscow, pp. 32-38. Havlik, P. (2004), ‘Russia, European Union and EU Eastward Enlargement’, in: G. Hinteregger and H.G. Heinrich (eds), Russia – Continuity and Change, Springer, Vienna – New York, pp. 363-378. Havlik, P. (2007), ‘Structural Change and Trade Integration on EU-NIS Borders’, wiiw Research Reports, No. 340, Vienna, May. Jensen, C. (2006), ‘Foreign Direct Investment and Economic Transition: Panacea or Pain Killer?’, Europe-Asia Studies, Vol. 58, No. 6, September, pp. 881-902. Kaufmann, D., A. Kraay and M. Mastruzzi (2006), ‘Governance Matters V: Aggregate and Individual Governance Indicators for 1996–2005’, WPS 4012, The World Bank, Washington DC. Kuznetsov, A. V. (2007), ‘Russian direct investments in EU countries’ (in Russian), Conterporary Europe, No. 1, IE RAN, Moscow, pp. 37-50. Leonard, M. and N. Popescu (2008), ‘A five-point strategy for EU-Russian relations’, Europe’s World, Brussels, Spring, pp. 20-30. Libman, A. M. and B. A. Kheyfets (2006), Expansion of Russian Capital in the CIS Countries (in Russian), Ekonomika, Moscow. Maincent, E. and L. Navarro (2006), ‘A Policy for Industrial Champions: from picking winners to fostering excellence and the growth of firms’, Industrial Policy and Economic Reforms Papers, No. 2, EU DG Enterprise and Industry, Brussels, April. OECD (2008), Globalisation and Emerging Economies. Brazil, Russia, India, Indonesia, China and South Africa, Paris. Pankov, V., (2007), ‘Integration and Disintegration on the Post-Soviet Area’ (in Russian), Mir Peremen, No. 3, Moscow, pp. 128-132. Sakwa, R. (2008), ‘New Cold War or twenty years’ crisis? Russia and international politics’, International Affairs, No. 2, pp. 241-267. Shleifer, A. and D. Treisman (2000), Without a Map. Political Tactics and Economic Reform in Russia, MIT Press, Cambridge, Massachusetts. Tsoukalis, L. (2007), ‘Global, Social & Political Europe’, ELIAMEP, Athens, July. Vinhas de Souza, L., (2008), ‘A Different Country. Russia’s Economic Resurgence’. Centre for European Policy Studies, Brussels. Vavilov, A. and O. Viugin (1993), ‘Trade Patterns After Integration Into the World Economy’, in: J. Williamson (ed.), Economic Consequences of Soviet Disintegration, Institute for International Finance, Washington DC, pp. 99-174. Yurgens, I. (2008), ‘Forget politics; What Russia and the EU need is a shared economic space’, Europe’s World, Brussels, Spring, pp. 43-47.

138 Zashev, P., P. Vahtra and K. Luihto (2007), ‘Outward FDI of Russian enterprises: lessons and policy recommendations’, in: V. Kaartemo (ed.), New role of Russian enterprises in international business, PEI, Turku (see also : http://www.wiiw.ac.at/indeunis). Zhuravskaya, E. (2007), ‘Whither Russia? A Review of Andrei Shleifer’s A Normal Country’, Journal of Economic Literature, Vol. XLV, March, pp. 127-146.

139 2.4 India

Jayati Ghosh

2.4.1 Background India has a large, highly diverse and extremely complex economy. Although it remains essentially a poor country, in recent years it has experienced relatively rapid economic growth and become one of the more attractive destinations for foreign investment in the developing world. It has a huge population of nearly 1.2 billion people and is projected to overtake China as the most populous nation in the world in the foreseeable future. 73% of the population lives in rural areas, and the rate of urbanization over the 1990s actually declined in the 1990s compared to the 1980s.

GDP was EUR 2339 billion in PPP terms, making India the fourth largest economy in the world, while in terms of nominal exchange rates, the GDP amounted to EUR 759 billion in 2007.103 Per capita GDP in 2007 was EUR 2108 at PPPs, or EUR 684 in nominal exchange rates.

The diversity of India encompasses many different features. The economy includes various different production and distribution systems: from traditional village farming by peasant households, shifting cultivation and pastoralism in some areas to modern mechanized agriculture; from labour-intensive handicraft production to a wide range of modern industries at different levels of technological development; from low-productivity informal service activities to highly skilled and capital-intensive ‘new’ services. Geographically the sub-continent covers a huge range from mountainous and cold or temperate regions to sub-tropical monsoon-fed (most of peninsular India) to arid desert conditions. Linguistically India has the most diverse population in the world, with 14 official languages other than English (which is widely used in government, the organized sector and for inter-state communication) as well as 250 minor languages and several thousand dialects. In terms of religion, all the major religions of the world are represented in the population. The Census of India (2001) indicated that 80.2% of the population is officially described as Hindu, 13.4% as Muslims, 2.3% Christians, 1.9% Sikh, and the remaining 1.9% consists of Buddhists, Jains, Zoroastrians and various other religions. Within each of these, of course, there are further divisions by sect.

Social divisions extend beyond religious and ethnic groups to caste divisions, which in India are not confined to Hindus but are also implicitly recognized and practised in other communities. The caste structure is extremely complex, much more so than can be expressed by the four category ‘varna’ system that is well known abroad: there are several thousand castes, many of which exist only in certain regions of the country. While endogamy is the defining feature, there are many other social practices relating to caste that unfortunately persist even in supposedly ‘modern’ spaces. There were hopes and expectations that such divisions would reduce or disappear in the course of economic development, this has not really happened to the anticipated extent, even in more advanced urban areas. Instead, caste awareness is increasingly reflected in identity politics

103 Data for Indian typically relate to the financial year 1 April to 31 March. Therefore all annual data presented here refer to the period from April of the year mentioned to March of the following year.

140 that has led the political process to force some policy changes as well. Scheduled Castes (SC: 16.2% of the population) and Scheduled Tribes (ST: 8.2%) were explicitly recognized in the Constitution as being particularly deprived and were given reservation in official employment and higher education (15% for SCs and 7.5% for STs). Nevertheless the actual share of both remains low, well below their mandated levels, largely because reservations have not been effectively enforced and affirmative action has not taken any other forms such as asset redistribution or ensuring good quality school education that would more than proportionately benefit such groups. More recently, Other Backward Castes (OBCs) have been awarded reservation in both government employment and higher education, although this policy remains hotly contested. There are proposals to extend such reservation to the private sector, although that has not yet been legislated. Private employers are being encouraged to take affirmative action for such social groups on their own initiative. In addition, it has been noted that Muslims are also significantly deprived educationally and marginalized occupationally, and there may be attempts to rectify this through official policy in the future – indeed some states already have some measures in place.

Diversity extends to economic inequality as well. The Gini coefficient according to National Sample Survey data relating to 2004 was 0.38, but this is generally accepted to be an underestimate because the data cover consumption expenditure rather than income and because the survey is known to underestimate the tails of the distribution (Ghosh, 2009). The lowest decile of the population accounts for only 3.6% of estimated aggregate consumption, while the top decile accounts for 31.1% (NSSO, 2006). Rural-urban income differentials are large: urban per capita consumption is more than twice that in rural areas (NSSO, 2006) and per capita GDP gaps are even larger, with urban per capita income estimated to be around three times rural per capita income in 2004 (Sen and Himanshu, 2005). Regional differences are also significant and have increased recently: the ratio of the per capita State Domestic Product of the richest major state (Punjab) to that of the poorest major state (Bihar) increased from 2.2 in 1980 to 4.8 in 2004 (Pal and Ghosh, 2007).

The Constitution created a federal system of government, with states that were originally organized on the basis of language but have since evolved and been divided to result in 30 States and 5 Union Territories (which are under the control of the Central Government). Economic powers are shared between central and state governments, with the Centre controlling all monetary policy and significant elements of fiscal policy. All direct taxes and taxes on international trade, as well as taxes on services are collected by the Centre. States are allowed to collect their own Value Added Tax (which is in the process of being unified under an agreement between the Centre and different state governments) and property taxes. The Reserve Bank of India (the central bank) can determine and constrain the borrowing limits of the state governments, thereby constraining their fiscal policies. State governments that borrow from international organizations such as the World Bank and the Asian Development Bank require the prior permission of the central government. The central government as well as many states have passed fiscal responsibility legislation that puts limits of 2% of GDP on the fiscal deficit. However, these have been explicitly relaxed during the recent crisis, and even in the past they

141 have generally been honoured more in the breach, through the internationally familiar method of moving several items of expenditure off-budget.

India has a dominantly young population, which has led many to argue in favour of the potential of the demographic dividend it can reap in the near future. India is and for some time will remain one of the youngest countries in the world. It is still in that phase of the demographic transition in which the death rate is falling more sharply than the birth rate, although both are declining. A third of India’s population was below 15 years of age in 2000 and close to 20% were young people in the 15-24 years age group. The population in the 15-24 years age group grew from around 175 million in 1995 to 190 million in 2000 and 210 million in 2005, increasing by an average of 3.1 million a year between 1995 and 2000 and 5 million between 2000 and 2005. In 2020, the average Indian will be only 29 years old, compared with 37 years in China and the US, 45 years in Western Europe and 48 years in Japan.

The essential source of this demographic dividend is seen to be the decline in dependency ratios and the increase in worker-population ratios which, even in the extreme (and unlikely) case of little or no increase in labour productivity, would lead to improved output performance and growth potential. However, India’s ability to take advantage of this demographic dividend will depend crucially on its ability to educate and find productive employment for this bulge of young people.

2.4.2 Recent patterns of economic growth The country has sustained a high and accelerating rate of growth over the past 25 years. According to official figures, real GDP growth has accelerated from its ‘Hindu rate’ origins of around 3.5% per year in the 1960s and 1970s to average annual rates of 5.4% in the 1980s, 6.3% during the decade starting 1992-1993 and around 9% since 2003. The government had targeted a further rise to even 10% over the ‘Eleventh Plan’ period, but that appears unlikely now that the effects of the global economic and financial crisis are becoming apparent.

142 Table 2.4.1 Structural change in the Indian economy

Per cent of GDP Period (average of Investment growth years) in % Primary Secondary Tertiary 1950-52 15.5 59 13.4 27.6 1960-62 19.4 53.1 17.3 29.6 1970-72 23.8 46.6 20.4 33.0 1980-82 22.0 41.3 21.8 36.9 1990-92 26.0 34.4 24 41.6 2000-02 26.2 26.1 24.7 49.2 2004-06 29.3 22.0 24.0 54.0 2006-08 35.9 17.8 26.4 55.8 Source: CSO, National Accounts Statistics, various issues.

The phase of higher growth which began in the 1980s has been associated with some amount of structural change, although perhaps not as much as might be expected. Investment rates have increased over time, and have move up especially rapidly in the current decade; they are now around 36%. Meanwhile, the share of agriculture in GDP has fallen along predictable lines in the course of development, but there has been little increase in the share of the secondary sector, which has hardly changed since the early 1990s. Rather, the share of the tertiary sector has increased dramatically, to the point where it now accounts for more than half of national income (see Table 2.4.1).

Thus recent Indian economic growth has essentially been service-led, as the rate of growth of services GDP has been much higher than the rate of growth of overall GDP. More than 60% of the increment in GDP during the period 1993 to 2007 was due to an increase in GDP from services, which have contributed significantly to the recent acceleration of the growth rate as well. This boom in services was not on account of the public sector, where the share of services has remained stable at around 60%. It is in private activity that the share of services has gone up, from around 29% at the start of the 1980s to more than 55% by 2007. This sharp increase in the share of services in GDP in India has occurred at a much lower level of per capita income than characterized the developed countries when they experienced a similar expansion.

This has been at least partly due to the increase in the exports rather than domestic supply (and consumption) of services, in particular software and IT-enabled services. Exports of software and IT-enabled services amounted to around 15% of GDP in services and 66% of all services exports in 2006. However, despite the rapid growth, the absolute size of the sector in India remains small (less than 6% of GDP). The vast mass of differentiated but largely low productivity unorganized services still accounts for half the GDP and most of the employment in the services sector. Further, the sector’s contribution to employment does not compare with its role in the generation of income and foreign exchange. The total IT industry, including both hardware and software elements, as well as IT-enabled services, still employs only around 2 million workers, out of an

143 estimated total workforce in India of more than 450 million, and urban workforce of around 120 million. Total employment in this sector is far short of even the annual increment in the youth workforce. This mismatch between the sector’s contribution to GDP and its contribution to employment suggests that despite its high growth, this sector can make only a marginal difference to employment even of the more educated groups in urban areas.

2.4.3 Employment and the labour market Aggregate employment growth (as measured by the large official labour force surveys) accelerated in the early part of this decade after the preceding period in which it had slowed considerably, as evident from Table 2.4.2. This reflected an increase in labour force participation rates for both men and women, incorporating declining rates of labour force participation among the youth, that is the age group 15-29 years, and a rise for the older age cohorts. Therefore, despite the growth of employment, unemployment rates have also been increasing, and are now the highest ever recorded. Unemployment measured by current daily status, which describes the pattern on a typical day of the previous week, accounted for 8% of the male labour force in both urban and rural India, and for 9-12% of the female labour force. This is unprecedented, given that there is really nothing resembling unemployment benefit or insurance (Ghosh, 2009).

Table 2.4.2 Growth rates of employment (per cent change per annum)

Rural Urban 1983 to 1987 1.36 2.77 1987 to 1993 2.03 3.39 1993 to 1999 0.66 2.27 1999 to 2004 1.97 3.22 Source: Ghosh (2008), based on NSSO and Census of India.

The same data sources indicate that there has been a significant decline in wage employment in general, which includes both regular contracts and casual work. The sharpest decline was in agriculture, where wage employment fell at a rate of more than 3% per year between 1999 and 2004. But even for urban male workers, total wage employment is now the lowest that it has been in at least two decades, driven by declines in both regular and casual paid work. For women, in both rural and urban areas, the share of regular work has increased but that of casual employment has fallen so sharply that the aggregate share of wage employment has fallen as well. The lack of adequate opportunities for wage employment is probably why there has been a very significant increase in self-employment among all categories of workers in India. The increase was sharpest among rural women, where self-employment now accounts for nearly two-thirds of all jobs. But it was also very high for urban workers, both men and women, among whom the self-employed currently constitute 45% and 48% respectively, of all usual status workers.

144 Only a tiny minority (around 5-6% according to recent estimates) of India’s workforce operates according to formal work contracts in the organized sector, and it is only this small group that gets the benefit of any workers protection, including minimum wages and protection from easy dismissal. In general there is a high degree of informalization even among the workforce in the organized sector, and it has been estimated that around half of the workers in the organized sector operate on the basis of informal or casual contracts without job security. Both public and private employers, even in the corporate sector, increasingly engage in outsourcing of specific functions as well as hiring of contract labour and periodic removal and re-employment of casual workers. These practices effectively allow them to circumvent the labour laws that are relatively strict with respect to hire and fire rules for workers who have been employed for more than 190 days continuously.

2.4.4 Education and employability Education is one area in which the government’s interventions have been clearly insufficient and inadequate. The spread of literacy has been slow during the years of globalization and even in 2004 the country was far short of achieving total literacy even in the more developed urban areas, with national average literacy rates of 75% for males and 54% for females. Further, a significant proportion of nearly one-third of the population aged 15-29 years are still functionally illiterate. This age group is likely to remain in the labour force for another two decades at least, which raises serious concerns about the skill level of the workforce in the future as well as its employability.

In 2004, only 21.1% of rural males and 10.2% of rural females of 15 years and above had a minimum education of secondary school and above. In urban areas, the education level was slightly better with 48.3% of urban males and 35.6% of urban females with at least that much education. However, only around 1.5% of persons aged 15 years or more in urban areas and less than 5% in rural areas had technical qualifications of even the most rudimentary kind.

There is the further problem that even those who have been educated find it hard to get jobs, whether these jobs are appropriate to their skills or otherwise. Between 2000 and 2005, educated employment declined slightly for men, but was still around 6% for those with secondary school degrees and 7% for graduates. Unemployment among educated women was much higher and also increased, reaching rates of 34% for rural female graduates, and 20% for urban women with high school and above.

Vocational training appears to be doing little to resolve this problem. To begin with, even in 2004 only a very small proportion of youth, less than 4%, had received any sort of vocational training. But also most such training apparently does not increase employability: the proportion that has received some sort of vocational training is significantly higher among the unemployed than the employed youth.

145

Therefore, India cannot currently be characterized as a knowledge economy in any meaningful sense. However, the government is aware of this problem and has recently significantly increased the public resources for both school and higher education. It has also created a Skills Development Mission with the specific mandate of making vocational training and technical training more relevant, applicable and useful for changing employment possibilities. The positive results of these initiatives are likely to be felt within five to ten years.

Despite these fundamental problems, India’s population is sufficiently large as to make even a small minority of the educated workforce appear to be significant by international standards. There are at least a hundred million actual or potential young workers in urban and semi-urban areas with some skills or qualifications who can be tapped for productive work, and this must constitute a huge advantage for the economy in the future. In particular, because so much higher education is conducted in English, there is a significant body of educated workers who have both verbal and written English proficiency. This has been a major advantage in the IT-enabled Business Process Outsourcing sector. It has also been found that even other foreign language skills are prevalent among some trained youth, who are currently in demand both nationally and internationally for translation and interpretation from English to other foreign languages such as Spanish, French, German, Japanese, which they can accomplish at much lower cost.

2.4.5 Economic policies Over the 1990s and the early part of this decade, the Indian government undertook a number of policies designed to liberalize the economy both internally and externally. These included: – reduction in direct state control in terms of administered prices and regulation of economic activity; – privatization of some state assets, but leaving a substantial proportion still under state control; – rationalization and reduction of direct and indirect tax rates, and move to VAT rather than spate-specific sales taxes; – attempts to reduce fiscal deficits which usually involved cutting back on public productive investment as well as certain types of social expenditure, reducing subsidies to farmers and increasing user charges for public services and utilities; – trade liberalization, involving shifts from quantitative restrictions to tariffs and typically sharp reductions in the average rate of tariff protection, as well as withdrawal of export subsidies; – financial liberalization involving reductions in directed credit, freeing of interest rate ceilings and other measures which raised the real cost of borrowing, including for the government; – shift to market determined exchange rates and liberalization of current account transactions; – some capital account liberalization, including easing of rules for foreign direct investment (FDI), permissions for non-residents to hold domestic financial assets, easier access to foreign commercial borrowing by domestic firms, and later even freedom for domestic residents to hold limited foreign assets.

146

2.4.6 External trade and investment India’s integration with the world economy increased rapidly in the 1990s, associated with the various economic reform measures outlined above. Trade to GDP ratios in India increased from 11% in 1995 to 24% in 2007. However, unlike China where much of the export expansion was on account of manufactures, export growth in India has been principally due to services. In the merchandise trade area, India’s recent export success has been restricted to a few sectors, in particular chemicals and pharmaceuticals and engineering goods. The most dramatic increase in manufacturing exports has been to China, as India became a (relatively small) player in the relocative capital based export expansion of the Asian region, supplying metals and other intermediates to China for further processing for the US and European markets. However, India’s merchandise trade balance with China remained negative, and indeed the overall trade balance has also been negative. Furthermore, it has deteriorated very sharply as the global economic crisis has been spreading, with exports declining by 16% in the period October-November 2008 compared to the same months in the previous year. To some extent the implications of the widening trade deficit have been mitigated by the neutralizing effects of exports of services and remittance inflows.

In services exports, India has been much more successful, becoming the topmost exporter of computer and information services in the international economy since 2005, with its share in world exports of computer and information services placed at 17% in 2006 (WTO, quoted in Reserve Bank of India, 2009). However, there is a high degree of concentration of such exports to a few countries, with the US accounting for 61% and the UK for 18% of India’s IT-BOP export revenues in 2006-2007 (NASSCOM104 figures quoted in Reserve Bank of India, 2009). While the effects of these are yet to be felt in the Indian balance of payments because of the weight of legacy contracts, these are also likely to slow down in 2009. Meanwhile remittances from Indian workers abroad, which amounted to more than USD 45 billion (EUR 30 billion) in 2008, are also likely to decline in 2009.

With respect to FDI, there has been a significant amount of liberalization, with the government moving from fairly strict controls on the extent and proportion of shares held, sectors, need for permission and constraints on profit repatriation and foreign exchange balancing, to a much more liberal regime based on relatively easy permissions and a small negative list. FDI policy in India is reckoned to be among the most liberal in emerging economies. Higher limits on foreign direct investment were permitted in a few key sectors, such as telecommunications. FDI up to 100% is now allowed under the automatic route, without prior approval, in most sectors and activities. There is a small negative list of industrial sectors in which FDI is not permitted: arms and ammunition, atomic energy, railway transport, coal and lignite, and the mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper, zinc.

104 NASSCOM: National Association of Software Services Companies.

147 Portfolio flows have dominated in India’s foreign investment inflows. FDI has been low at around EUR 2.7 to 4 billion annually, and only in the past two years it increased to any significant level, crossing EUR 10 billion in the year ending March 2008. However, much of that was not greenfield investment, but rather acquisition by private equity firms, so it was essentially portfolio investment. Meanwhile portfolio investment proper soared especially in the period April 2006 to June 2008 but fell dramatically from June 2008 onwards as investors booked their profits in India and moved back to the US and other locations to cover their losses in markets there. What has made things worse in the last quarter of 2008 is a related decline in FDI and banking capital inflows, such that the entire capital account turned to deficit in October – December 2008.

As a result of these movements, the Indian rupee depreciated sharply, especially with respect to the US dollar, with the rupee (INR) falling by more than 30% within just 15 months, from INR 39 to the US dollar in January 2008 to INR 51.50 to the US dollar in March 2009. The exchange rate regime can be broadly defined as a managed (or dirty) float, with the floating more evident than the management in recent months. While India had built up a reasonable level of foreign exchange reserves in the course of the previous boom, it was a fragile hoard since it was based largely on the inflow of hot and easily reversible capital inflows like portfolio capital and external commercial borrowing. Foreign exchange reserves fell from EUR 202 billion in early June 2008 to EUR 199 in March 2009.

India was a signatory to the GATT agreements of 1994 and therefore a founding member of the WTO. It is also involved in some regional arrangements: it is a member of the South Asian Free Trade Agreement (which has not done much real trade integration yet) and has signed bilateral free trade agreements (FTAs) with Thailand and Sri Lanka. It is negotiating a trade agreement with the EU and is attempting to find a place at the table at the ASEAN Free Trade Area.

Table 2.4.3 Infrastructure deficits by sector and Eleventh Plan physical targets

Sector Deficit Eleventh Plan Targets (2007-2011) Roads/High 65590 km of national highways 6-lane 6500 km in Golden ways comprise only 2% of network; Quadrilateral (linking the 4 major carry 40% of traffic; 12% 4-laned; metros Mumbai-Chennai-Kolkata- 50% 2-laned; and 38% single-laned Delhi); 4-lane 6736 km North South – East West; 4-lane 20000 km; 2-lane 20000 km; 1000 km expressway Ports Inadequate berths and rail/road New capacity: 485 mn metric tons connectivity in major ports; 345 mn metric tons in minor ports Airports Inadequate runways, aircraft Modernize 4 metro and 35 non- handling capacity, parking space metro airports; 3 greenfield in and terminal buildings North East Region; 7 other greenfield airports Railways Old technology; saturated routes; 8132 km new rail; 7148 km gauge slow speeds conversion; (freight: 22 kmph;

148 passengers: 50 kmph); low modernize 22 stations; dedicated freight corridors; payload to tare ratio (2.5) Power 13.8% peaking deficit; 9.6% Add 78577 MW; access to all rural energy shortage; 40% transmission households and distribution losses; absence of competition Irrigation 1123 bn cubic metres utilizable Develop 16 mn hectares major and water resources; yet near crisis in minor works; 10.25 mn hectares per capita availability and storage; Command Area Development (area only 43% of net sown area irrigated served under major irrigation project), 2.18 mn hectartes flood control Telecom/IT Only 18% of market accessed; Reach 600 mn subscribers—200 obsolete hardware; acute human mn in rural areas; 20 mn resources’ shortages broadband; 40 mn Internet Source: Planning Commission (2008:255)

2.4.7 Infrastructure The recent rapid growth of the economy placed increasing stress on physical infrastructure such as electricity, railways, roads, ports, airports, irrigation, and urban and rural water supply and sanitation. Since all of these already suffered from substantial shortages and lack of capacity in the past, this had made the physical infrastructure deficit even more evident. Total infrastructure investment amounted to around 5% of GDP in 2007 according to the Planning Commission (2008), which also estimated that this ratio would need to rise to 9% to get at least somewhat closer to meeting the required infrastructure needs of the economy and society. The estimated needs for the next few years are briefly described in Table 2.3.3.

2.4.8 Telecom India's telecom sector has been possibly the biggest success story of the market-oriented reforms. Deregulation and liberalization of telecommunications laws and policies have prompted rapid growth in this sector. With more than 270 million connections, India's telecommunication network is currently the third largest in the world, and the second largest among the emerging economies of Asia. The total number of telephones has increased from 76.53 million on March 31, 2004 to 272.88 million on December 31, 2007. At present more than 8 million telephone connections are being added every month, and the frenetic pace of expansion continues despite the economic slowdown.

Local and long distance service provided throughout all regions of the country, with services primarily concentrated in the urban areas. Teledensity has increased from 12.7% in March 2006 to an estimated 30% by December 2008, but the ratio is much lower for rural areas. Further, the share of wireless phones has also increased from 24.3% in March 2003 to 85.6% in December 2007. In fact there has been extremely rapid growth of cellular services combined with modest

149 declines in fixed lines. Clearly there is scope for much more and rapid expansion in this sector, despite the already high growth rates.

The domestic mobile cellular service was introduced in 1994 and organized nationwide into four metropolitan areas and 19 telecom circles, each with around three private service providers and one state-owned service provider. Recently significant trunk capacity has been added in the form of fibre-optic cable and one of the world's largest domestic satellite systems, the Indian National Satellite system (INSAT), with 6 satellites supporting 33,000 very small aperture terminals (VSAT). International services have been encouraged by a number of major international submarine cable systems, including Sea-Me-We-3 with landing sites at Cochin and Mumbai (Bombay), Sea-Me-We-4 with a landing site at Chennai, Fibre-Optic Link Around the Globe (FLAG) with a landing site at Mumbai (Bombay), South Africa – Far East (SAFE) with a landing site at Cochin, the i2i cable network linking to Singapore with landing sites at Mumbai (Bombay) and Chennai (Madras), and Tata Indicom linking Singapore and Chennai (Madras). All of these provide a significant increase in the bandwidth available for both voice and data traffic. In addition there are satellite earth stations – 8 Intelsat (Indian Ocean) and 1 Inmarsat (Indian Ocean region) as well as 9 gateway exchanges operating from Mumbai (Bombay), New Delhi, Kolkata (Calcutta), Chennai (Madras), Jalandhar, Kanpur, Gandhinagar, Hyderabad, and Ernakulam (2008).

2.4.9 Future prospects Short-term challenges: India and the global economic crisis Just like many other developing countries, India has been adversely – and quite sharply – affected by the global economic crisis. The mechanisms of transmission have been rapidly declining exports, reversal of private capital flows and worsening fiscal balances of both the central and state governments. This obviously constrains the immediate prospects for growth, although the impact thus far has been one of slowing down the growth process rather than recession or negative output growth. However, it should be noted that in the previous boom, the Indian economy was substantially dependent on the rapid expansion of private credit to sustain growth. The earlier emphasis on public spending as the principal stimulus for growth was in the 1990s substituted with debt-financed housing investment and private consumption of the elite and burgeoning middle classes. This required a relaxation of the terms on which, and the volumes in which debt was available to households and the private sector, and therefore made the country’s financial system more vulnerable to default at various levels. Yet the Indian government’s attempts at recovery have not tried to substitute for this unsustainable pattern of demand expansion through more direct spending, but instead have focussed on coaxing, cajoling and forcing banks into lending even more, in the hope that there would be enough borrowers who would use that credit to revive flagging domestic demand and make up for sluggish exports. In addition, the strategy pushes infrastructural investment financed not only with domestic debt, but also with external commercial borrowing. While this may have some immediate effects in terms of creating some growth revival, especially in an international context in which other sources of economic growth globally are rather limited, it does involve some potential problems for the future. Thus, it adds to the debt spiral, and may involve a currency mismatch inasmuch as

150 infrastructural projects are unlikely to yield foreign exchange revenues that can be used to meet interest and amortization commitments payable in foreign exchange.

IMF forecasts from July 2009 suggest a growth rate of 5.4% for the Indian economy in 2009 (see Table A2.1 in Annex 2). However, national and some other mid-year forecasts are more optimistic as several indicators suggest that the Indian economy, like that of Brazil and China, might be bottoming out earlier than the advanced economies, whereby government stimulus measures seem to play a crucial role. In the second quarter of 2009, the Indian industry was already showing some signs of revival, while the government is continuing with tax cuts and other incentives introduced earlier during the peak of the crisis and has announced several more incentives for corporates in its 2009/2010 budget. As in the other BRICs, a significant rebound of stock prices was observed. Moreover, expectations were boosted by pronouncements in the Annual Economic Survey released just before the budget, that the government will undertake some privatization of public sector enterprises, opening up insurance and defence (!) industries to more foreign investment, and deregulation/privatization of the public pension system.

Medium- and long-term outlook There are several reasons to be optimistic about the medium term outlook for the Indian economy. Firstly, there are basic strengths defined by the potentially huge domestic mass market, which is just beginning to expand. Also; several new government programmes will act as cushions for the income of the poor and as demand stimulus especially for the rural economy. The National Rural Employment Guarantee Act, which has now been extended to cover all districts of India, promises 100 days of employment to every rural household. Despite various teething problems and regional variations, it has already shown its enormous potential and the possibility of very large positive multiplier effects in several parts of India. The Bharat Nirman programme is devoted to expanding rural infrastructure, which also has strong and direct linkages with private consumption and investment. There are already calls for extending the Employment Guarantee to the urban areas, which may create a demand stimulus for mass consumption items there. And the significant increase in funding for education at all levels will also have a positive effect. Thus, while the global crisis is definitely taking its toll on India, there are other forces within the economy that suggest that faster recovery and more positive future growth patterns are possible. To a large extent, this is a tribute to the vibrancy of Indian democracy, which will be evident once again during the general elections in the coming month.

2.4.10 EU-India relations India has a longstanding relation with the EU, going back to the early 1960s. In 1994, the current legislative framework for cooperation, the ‘Cooperation Agreement between the European Community and the Republic of India on partnership and development’ was signed which took bilateral relations beyond merely trade and economic cooperation and paved the way for annual EU-India Summits and regular ministerial and expert level meetings. In 2004, the EU-India relationship was ‘upgraded’ to the level of a ‘Strategic Partnership’ and in 2005 an ‘EU-India Action Plan’ (revised in 2008) was jointly elaborated to further extend bilateral relations to non- economic areas (e.g. security policy, education and academic exchanges, cultural cooperation),

151 but to promote economic relations as well, by initiating a broader dialogue on various economic issues of common interest (e.g. cooperation in science and technology, environmental issues, transport) and by tackling important issues, such as the protection of intellectual property rights and non-tariff barriers to trade. Finally, a High Level Trade Group was established to explore ways and means to deepen and widen the bilateral trade and investment relationship, including the possible launch of bilateral negotiations on a broad-based trade and investment agreement.

In June 2007, negotiations for a broad EU-India Free Trade Agreement (FTA) started. From the EU side, the move towards a FTA has to be seen in the light of her new ‘Global Europe’ trade policy, launched in 2006. The new generation FTAs go far beyond traditional trade policy. With the broad aim to improve the market access for European companies abroad, they also address tariff and non-tariff barriers to trade, issues related to foreign direct investment, restrictions on the access of resources (e.g. energy), subsidies, intellectual property rights, trade in services and procurement. From the side of India, there exist a lot of reservations with regard to the new FTA with the EU, officially but from non-governmental organizations (NGOs) as well, which are drawing out the negotiations. Representatives of trade unions, people’s movements and civil society organizations complained in particular about the lack of transparency, public debate and democratic process of the ongoing negotiations with the EU105. Nevertheless, at the last EU-India Summit in September 2008, Indian Prime Minister Manmohan Singh informed the press that the two parties agreed to work towards the conclusion of the new FTA by the end of 2009106.

References Ghosh, Jayati (2008), ‘Growth and employment dynamics in India’, Working Paper No. 92, Policy Integration and Statistics Department, ILO, Geneva. Ghosh, Jayati (2009), Poverty reduction in China and India: The policy implications of recent trends, UN-DESA, New York. National Sample Survey Organ (NSSO) (2006), Employment and Unemployment Situation in India, CSO, New Delhi. NCEUS (2008), ‘Report on Conditions in the informal sector in India’, National Commission for Enterprises in the Unorganized Sector, Government of India, New Delhi. Pal, Parthapratim and Jayati Ghosh (2007), ‘Inequality in India: A survey of recent trends’, in K. S. Jomo and Jacques Baudot (eds), Flat World, Big Gaps: Economic liberalization, globalization, poverty and inequality, Zed Books, London. Planning Commission (2008), Eleventh Five Year Plan, Government of India, New Delhi. Reserve Bank of India (2009), ‘India's Foreign Trade: 2008-09 (April to December)’, Reserve Bank of India Bulletin, March, pp. 495-507. Sen, Abhijit and Himanshu (2005), ‘Poverty and inequality in India: getting closer to the truth’, in Angus Deatin and Valerie Kozel (eds), Data and Dogma: The great Indian poverty debate, Macmillan, New Delhi.

105 http://www.bilaterals.org/article.php3?id_article=133317. 106 New Europe, The European Weekly, 2 November 2008, http://www.neurope.eu/articles/90214.php as of 2 November 2008.

152 2.5 China

Waltraut Urban, wiiw

2.5.1 Background In brief, the Chinese economy can be characterized as a hybrid economy, combining elements of a developing country, a transition country and a ‘newly industrializing country’ within the institutional and political framework of a ‘Socialist Market Economy’, which gives the state significant influence on the basically market-driven system.

2.5.2 Relative size of the Chinese economy China’s major attraction for European companies is its large and fast growing market. Being the most populous country of the world, China’s population stands now at 1312 million people (see Table A2.1 in Annex 2). Economic growth over the past 30 years has been unprecedentedly high, reaching an average annual rate of 9.8%. But starting from a very low level, China’s GDP per capita is still relatively small and amounted to only EUR 1867 (8% of the EU27 average) in 2007, which classifies China as a ‘lower middle income country’ according to the World Bank’s definition. However, converted at purchasing power parities (PPP), GDP per capita is significantly higher, reaching EUR 4464 (18% of the EU27 average). When looking at China as a market for European exports, conversion at exchange rates seems more appropriate, but when planning direct investments to target the Chinese market from within the country, conversion at PPP probably gives the better picture. In 2007, the Chinese GDP converted at exchange rates amounted to EUR 2467 billion, reaching approximately the size of the German economy and one fifth of the total EU27 GDP; but measured at PPP, the Chinese GDP was equivalent to nearly one half of the EU27 GDP.

Because of the one-child policy proclaimed by the Chinese government at the beginning of the 1980s, population growth in China is much lower than in other countries at a similar stage of economic development (2007: 0.6%), and only slightly higher than in the EU27. Similar to the EU, China faces the problem of a rapidly ageing population and rising dependency ratios which will have an important influence on consumption as well as production in the future. It is estimated that the Chinese population at working age will reach a maximum in 2015 (European Commission, 2004, p. 236).

2.5.3 Strong fragmentation of the economy The Chinese economy is highly fragmented as is typical of large, fast growing developing countries. There exist huge regional disparities, a large gap between urban and rural incomes and wide disparities of personal incomes in general, having important consequences for European companies selling or operating in China.

153 Regional disparities The Chinese mainland is divided into 31 major administrative regions (provinces, autonomous regions and municipalities).107 Except for Beijing, the richest and most advanced regions are situated in the east of China, bordering the Pacific Ocean. The least developed and poorest regions can be found among the central and western regions. In 2007, the top ten coastal provinces including Beijing hosted about 40% of China’s population, but produced more than 60% of its GDP, accounted for more than 90% of China’s foreign trade and attracted about 80% of foreign direct investment. Also, these provinces rank top when judged by different location factors such as human resources, foreign language skills, availability of inputs, quality of infrastructure, logistics etc. (Urban, 2008). There are topographical and historical reasons for this phenomenon, but most decisive was the early establishment of so-called ‘Special Economic Zones’ (SEZs) and the advantage of nearby seaports. These two factors together attracted export-oriented foreign direct investment which became the nucleus of modern industrial development in China. For historical and geographical reasons, Hong Kong and Taiwanese investors are concentrated in the south, Japanese and Korean companies take an over-proportionate share in the northern coastal provinces and European companies cluster around Shanghai and the Yangtze river. But recently ‘agglomeration disadvantages’ such as relatively high wages and rents, lack of professionals, problems with power supply, etc. are driving investors further inland.

Incomplete urbanization Within each province, autonomous region and municipality, there is a big gap between the urban and the rural population. On average, urban per capita income is three times that of the rural population. The rural population in China is still very large, which is considered one of the reasons for the relatively small share of consumption in GDP (< 50%). Urbanization is delayed because of the ‘hukou’ (residence permit) system, which was used as an instrument for migration control from rural to urban areas under Mao Zedong. Although ‘softened’ after 1980, the system still constrains the free movement of people in China.108 In 2007, according to official statistics, the rural population stood at 727 million (55% of the total population). However, this includes a significant number of the more than 200 million migrant workers who have no valid residence permit for the city they work in. Judging by the share of people depending on incomes from agriculture, the ‘factory of the world’ is still an agricultural country.

107 Hong Kong and Macao, which returned to China in1997 and 1999 respectively, both remained a customs area of their own, according to the model of ‘one country, two systems’. However, by concluding the ‘Closer Economic Partnership Agreement’ (CEPA) which became effective on 1 January 2004, a kind of free trade area was established between China – Hong Kong and China – Macao, facilitating not only the trade in goods, but in particular the trade in services with mainland China. 108 Each Chinese citizen has a ‘hukou’ (permanent residence permit), basically for the place he/she is born. Persons staying at a place for which they have no hukou cannot send their children to school and do not receive free medical treatment nor other government benefits. To obtain another hukou is very difficult, except after marriage or graduation from university. For some time now there has been the option of obtaining a temporary residence permit which, however, is expensive.

154

Affluent middle class Given the relatively low average income level in China, the upper income classes are the main target for European suppliers of final consumer goods, which – because of the very unequal income distribution in China – take an overproportionate share of incomes. In 2004 (latest data available), the top 10% of households earned 35% of all incomes and the top 20% disposed of more than 50% of all incomes earned (see Table A2.1). These data are consistent with studies which estimate that the affluent middle class in China comprises about 300 million people.

2.5.4 Model of economic development Officially, the Chinese economic model is termed ‘Building socialism with Chinese characteristics’ or a ‘socialist market economy’, where markets take the pivotal role for the functioning of the economy, but public ownership, direct government interference and state-led industrial policies remain an integral part of the system. China further adopted an export-led development strategy, following the model of other successful ‘Newly Industrializing Economies’ in Asia.

Building socialism with Chinese characteristics The market-oriented reform of the Chinese command economy began after Mao Zedong’s death, under the leadership of Deng Xiaoping in 1978. It was a gradual process – as opposed to the ‘shock therapy’ taken by the Central and East European countries ten years later – which left the state with substantial power. The reform started in the agricultural sector, proceeded to the industrial sector after 1985, and took hold of the services sector only after China’s entry into the World Trade Organization in 2001.109 But a number of reform steps are still not completed, such as the rules for the acquisition and transfer of ‘land use rights’ (all land in China is owned by the state), the price reform (prices of important agricultural products such as grain are still regulated and prices of energy and other utilities are also set by the state authorities), and establishing a new social security and health system and an adequate legal system. A particular weakness in China is the enforcement of laws and the procedural law.

Role of the state in the economy The state has a dual function as the owner of large public enterprises and as a powerful regulator of the economy.

The public enterprise sector in China is very heterogeneous: public enterprises may be controlled either by the central government or by local governments or they are collectively owned. Some are fully state-owned and in others the state has a controlling stake. Because of the difficulty to determine which enterprises are state-controlled, considerable uncertainty surrounds any estimate

109 For a concise desription of the process of economic reform in China see, for instance, Wang and Fan (2009).

155 of the size of the Chinese public sector110, but most estimates indicate that 30% to 40% of the GDP are currently produced by public enterprises.

Remarkably, there has never been a proper process of ‘privatization’ in China. In the beginning, private enterprises simply ‘outgrew’ the inefficient public sector. Only after 1997, a comprehensive ‘state-owned enterprise reform’ (SOE reform) was launched and rather quietly large numbers of small enterprises were sold off by various methods (including auctions), sent bankrupt or merged with bigger ones. Only the important big SOEs were retained and restructured. Many were turned into joint stock companies and accepted private partners. Some became listed on the stock exchange. No enterprises were sold to foreigners as was the case in the Central and Eastern European countries. But in most Sino-foreign joint ventures, the Chinese partner is a state-owned enterprise (a prominent example is the automotive industry). Informally, SOEs enjoy certain advantages such as better access to capital (loans, stock exchange) and probably to public procurement as well. On the other hand, they may be prompted to actively support government policies, e.g. by keeping employment high to rein in unemployment, by supplying products despite loss making prices, by investing abroad to secure strategic raw materials etc.111 In return, they may receive subsidies. The ‘Guidelines for state-owned enterprise reform’ from December 2006 give a list of sectors in which the state should be the sole owner or have a majority share. These include power generation and distribution, oil, petrochemicals and natural gas, telecommunications and armaments. The state must have a controlling stake in the coal, aviation and shipping industries.

To regulate the economy, the government applies market-conform measures such as interest rate adjustments, tax policy etc., but also uses more direct measures, for example credit controls, export restrictions and licensing. Apart from the long-term development plans and the ‘five-year plans’, which provide a broad framework for government policy, sectoral policies such as energy plans, plans for industrial development and for important individual industries, e.g. the automotive sector, play an important role.

Drawing on the presumed privileges of SOEs and the relatively high degree of government influence, China is still classified as a ‘non-market economy’ (NME) by the EU (and by the US as well), which has certain disadvantages for China when its companies become subject to anti- dumping investigations. Therefore, in the current negotiations with the EU for a new ‘Partnership and Cooperation Agreement’ (PCA), it is an important aim for China to reach ‘market economy status’ as soon as possible.

110 See OECD (2005), pp. 80 and 81. 111 This was the case, for instance, in 2007/2008 when the price for crude oil shot up but the government-controlled petrol and diesel prices were kept constant to contain inflation.

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Centralism versus federalism Under constitutional law China is a centralist state, but during the economic reforms it has become more decentralized, albeit on an informal basis, in that provinces have reached wider discretion to implement policy goals set by the central government. However, the Communist Party of China has remained the all-embracing power. Of the government expenditures, which are relatively low by international standards (20% of GDP), about half is spent by the central government and the other half by local governments. The (general) government deficit and the public debt are relatively low, reaching -0.6% and 20% of GDP respectively in 2007.

Export-led development strategy In parallel to the market-oriented reforms starting in 1978, China was gradually opening up its almost entirely closed, self-supporting economy. In doing so, the Chinese government followed the model of the Asian ‘Newly Industrializing Economies’ in the 1970s112, which by attracting labour-intensive, export-oriented FDI from more advanced economies (Japan, USA), mainly in the field of textiles & clothing and electrical machinery & apparatus, had successfully speeded up their industrial development process.

In a first step, so-called ‘Special Economic Zones’ (SEZs) were established in the south of China to attract export-oriented foreign direct investment (FDI) from nearby Hong Kong and Taiwan, not only with low wage costs, but also by supplying modern infrastructure, and granting tax privileges and tariff exemptions. Because of their success, more and more ‘special zones’ were established in other coastal provinces as well. In 1990, the ‘Pudong New Area’ was established as a ‘super SEZ’ in Shanghai. Further on, by means of a ‘joint venture law’, the Chinese authorities followed a ‘market for technology’ strategy: In exchange for the access to the highly protected Chinese market, foreign producers were expected to transfer advanced technology to their Chinese partners. In many sectors (e.g. automobiles) no controlling stakes or wholly foreign- owned companies were allowed.

In a second step, after 1992, the system of SEZs was extended to the in inland provinces and more and more Chinese enterprises were allowed to engage in foreign trade as well. Tariff rates for intermediate inputs and investment goods were reduced, but remained high for final products. As a consequence FDI, also from outside Asia, was surging. China became the second most important recipient of FDI after the USA and trade started to expand faster than GDP (see Figure 2.5.1). To support exports, the Chinese currency was significantly devalued and made convertible on the current account, but capital controls stayed in place and FDI remains subject to government approval until now.

112 Including the ‘Four Tigers’ (Hong Kong, Singapore, Taiwan and the Republic of Korea), Indonesia, Malaysia and Thailand; see Urban (1992).

157 Figure 2.5.1 GDP, exports and imports of China 1978 = 100

GDP exports imports

16100

14100

12100

10100

8100

6100

4100

2100

100 1978198019821984198619881990199219941996199820002002200420062008 Source: China Statistical Yearbook 2008, China Monthly Statistics 2009/1.

Along with the proceeding reforms, regional disparities in China increased dramatically. To narrow the gap and to accelerate growth in the backward western provinces, the so-called ’Go- West Policy’ was launched (2000). By stepping up infrastructure investment and providing tax breaks and incentives for certain industries, the government tried to lure investors to these regions113.

The Asian financial and economic crisis unfolding in 1997/1998 became a milestone for China’s outward relations. The Chinese monetary authorities decided not to follow the massive devaluations of other countries in the region, but to peg the yuan to the US dollar instead, which strengthened China’s role as a ‘growth pole’ in the region and also its position at the global level and had a positive impact on EU-China relations as well.114 The third and most decisive step in China’s opening-up policy is the country’s entry into the World Trade Organization (WTO) in December 2001. Hundreds of Chinese regulations were adjusted to comply with WTO rules; tariffs which stood still high for certain products (e.g. cars) were significantly reduced, many restrictions for foreign invested enterprises including local content requirements were lifted to conform with the ‘national treatment’ principle, the protection

113 The targeted regions are: Xinjiang, Qinghai, Tibet, Gansu, Ningxia, Shaanxi, Sichuan, the Autonomous City of Chongqing, Yunnan, Guangxi and Guizhou. Ningxia, Qinghai and Gansu. 114 In April 1998, on the occasion of the Second Asia-Europe Meeting (ASEM) in London, the first EU-China Summit between China’s President Jiang Zemin and European Commission President Jacques Santer took place. In June, the Foreign Ministers Council of the EU approved a New China Policy, outlined in a document by the Commission, ‘Building a comprehensive partnership with China’ (Communication from the Commission, 25 March 1998). At a regional level, the ASEAN plus 3 (China, Japan, Korea) and ASEAN plus 1 (China) consultation process was started, which has to be seen as a cornerstone in regional economic integration and as a first step towards the Free Trade Zone between China and ASEAN to be completed in 2010. The China-ASEAN free trade area, which will comprise China, Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam, is expected to be one of the biggest free trade areas in the world. Already on 1 January 2009 a Free Trade Agreement between China and Singapore became effective.

158 of intellectual property was improved, and the services sector was opened up to trade and FDI step by step. But on the other hand, existing advantages for foreign enterprises, such as a lower corporate income tax and certain privileges granted in the SEZs, were phased out. Also, with lower tariffs, non-tariff barriers to trade gained importance. Notably, China has not yet joined the ‘Agreement on Government Procurement’ (GPA) in the framework of WTO.

After WTO entry, both Chinese exports and imports expanded strongly, but exports rose much faster, leading to massive trade surpluses (and corresponding bilateral trade deficits of the USA and the EU with China)115 and to a huge accumulation of exchange reserves. As a consequence, in July 2005 the Chinese monetary agency abandoned the dollar peg and shifted to a system of managed float, with reference to a basket of currencies, allowing daily fluctuations of +/- 0.3% against the central parity defined in USD and +/- 1.5% against other important currencies such as the euro, yen etc.116 The loosening of the dollar peg led to a moderate revaluation of the yuan in terms of USD in the following years, but because of the strengthening of the euro against the US dollar in the second half of 2006, the Chinese currency significantly depreciated versus the euro, making Chinese imports cheaper and European exports to China more expensive, thereby aggravating the existing imbalances.

‘Go abroad policy’ In 2002, a new dimension was added to the Chinese development model by allowing and actively promoting outward direct investment of Chinese enterprises. The so-called ‘go-abroad’ policy aimed at various targets: to make efficient use of foreign exchange reserves, to secure resources, to acquire technology, to gain access to established distribution networks, and to reduce the risk for Chinese enterprises of getting caught by non-tariff barriers to trade. In a longer-term perspective, the goal of the Chinese government is to generate a group of 30 to 50 big transnational companies. So far, the most spectacular Chinese investments have been made outside Europe, mainly to acquire raw material sources, but there are examples for acquisitions of European companies as well117. Probably, the low asset prices due to the current global financial and economic crisis will make European companies more attractive for Chinese investors.

Domestic investment as a major driver of growth Investment in fixed assets is unusually high in China, reaching 50% of GDP in 2007, and investment has been the most important driver of growth over the past couple of years. About half of the investment is private, the other half is public. Private consumption, on the other hand, is relatively low by international standards, due to the still low incomes of a large part of the population and a high saving rate of the rest. For this reason, China has so far been a larger and more dynamic market for investment goods than for consumer goods.

115 It has to be mentioned, however, that Chinese exports to the EU were especially pushed up by the phasing-out of the Textile & Clothing Agreement at the end of 2004, leading to the abolishment of all existing quantitative trade restrictions between WTO members in this field, and the end of the bilateral quota agreement on trade with shoes between the EU and China, also in 2004. 116 This band was further extended to +/- 3% in September 2005. In May 2007, the band towards the USD was extended as well, to +/- 0.5%. 117 TCL Group (consumer electronics) bought the TV business from Thomson and the mobile handset from Alcatel; Nanjing Automotive took over MG Rover; Dalian Machine Tool took 70% of Zimmermann AG (Germany).

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Box 2.5.1 Managing China’s foreign exchange reserves Persistent large trade surpluses and strong foreign direct investment inflows have led to an enormous accumulation of foreign exchange reserves in China. In February 2006, China surpassed Japan as the world’s largest holder of forex reserves; at the end of 2008, they reached EUR 1384 billion (USD 1946 billion). Reportedly, 70% of these reserves are held in dollar- denominated assets, out of which USD 744.2 billion are US Treasury bonds, making China the biggest creditor of the US government. However, early in March 2009, China’s Premier Wen Jiabao voiced his concerns that the US government’s massive stimulus package was increasing the risk of inflation, which may lead to a depreciation of the US dollar and thus a lower value of China’s reserves. As a consequence, China may reduce its holdings of US Treasuries gradually. Later, China’s Central Bank Governor Zhou Xiaochuan expressed the idea of replacing the US dollar with a super-sovereign reserve currency, suggesting that the IMF’s Special Drawing Rights (SDRs) could be used. This idea is supported by the other BRICs and, for instance, the Republic of Korea and South Africa as well, although it is considered a long-term solution rather. Also, with the aim to invest its forex reserves more effectively, the Chinese government set up a so-called ‘sovereign wealth fund’ in September 2007, following the examples of various oil- exporting countries, but e.g. Hong Kong and Singapore as well. The ‘China Investment Corporation’ (CIC) is endowed with a capital of USD 200 billion, two thirds of which should be invested in China and one third abroad. As in the case of similar sovereign wealth funds, this has roused a certain fear in other countries that investment policies will favour the wider strategic goals of the Chinese government rather than commercial business interests. However, the most prominent acquisitions of CIC known so far are substantial investments in Morgan Stanley and in the private-equity company Blackstone. Alternative attempts to make an efficient use of forex reserves include the promotion of outward private investment and the investment of state-owned enterprises abroad, respectively (see ‘go-abroad’ policy) and the stocking of gold or other raw materials (in particular oil). According to the World Gold Council, the gold reserves of China stood at 1054t at the end of 2008, ranking 5th in the world. Hoarding of other raw materials is limited by adequate storage capacities. Accelerated revaluation of the Chinese currency to reduce trade imbalances is not considered a viable option for the moment, as export industries are suffering from the global crisis anyway. However, certain measures have been taken recently to make the yuan fully convertible step by step, by allowing major export hubs (e.g. Shanghai, Guangzhou) to use the yuan in overseas trade settlements.

A new model of qualitative growth? During the Ninth Five-Year Plan (1996-2000) already, the question of qualitative instead of quantitative growth was raised. Nevertheless, in 2001, the long-term development goal for China was still formulated in quantitative terms, namely ‘to quadruple the per capita value of the 2000 GDP by 2020’, implying an average growth rate of 8%. It was only the next generation of Chinese leaders under Hu Jintao coming into power in 2003, who proclaimed a sustainable growth path and clearly emphasized qualitative instead of quantitative growth. To secure sustainability, more emphasis should be put on tackling social problems, the reduction of regional disparities, environmental protection and energy efficiency. Finally, the export-led development

160 model should be phased out and transformed into a more domestic-market oriented growth model. In line with these goals, the Chinese economy should become more balanced between agricultural and industrial development and the industry should be restructured away from low value added export-intensive industries towards high value added, technology-intensive industries.

To support this policy, a revised ’Industrial Restructuring Catalogue’ was drafted and a revised ‘Foreign Investment Catalogue’, indicating the sectors where foreign direct investment is welcome and where not, came into force in December 2007. The new sectoral policies and revised regulations concerning FDI will be presented in more detail below. The new ‘Labour Contract Law’, which took effect on 1 January 2008, strengthening the rights of workers on the one hand and increasing the cost of labour on the other, will also support restructuring towards higher value added industries.

Changing FDI policy The new development model is putting strong emphasis on the quality of FDI that China should absorb, which may, ceteris paribus, reduce the overall size of FDI inflows in the future. In 2006, new restrictive rules on mergers and acquisitions (M&A) became effective, the new rules on foreign investment in the banking sector from December 2006 are also fairly restrictive, and the new ‘Investment catalogue for foreign enterprises’ from December 2007 is ‘encouraging’ technology-intensive investment mainly. Finally, in January 2009, a new ‘Monopoly Law’ entered into force, which may also be used to control sino-foreign mergers & acquisitions. On the other hand, for a better protection of intellectual property rights, a major amendment to the Patent Law was adopted in December 2008, which will take effect on 1 October 2009. In view of the desired upgrading of FDI, China is now also looking for more investment from the EU and from the US than from neighbouring Asia, because the former are home to the high-tech companies China wishes to attract.

2.5.5 A more detailed picture of the Chinese economy at sectoral level The secondary sector, which comprises mining, manufacturing, the supply of utilities and construction, is the biggest sector in China, generating nearly 50% of GDP in 2007, followed by services (40%) and agriculture (11%) (see Table A2.1). Within the secondary sector, manufacturing takes the lion’s share with 34% of GDP, which is very high by international standards. That is partly a ‘socialist’ legacy but a consequence of China’s export-oriented growth strategy as well. For the same reasons, the services sector is relatively undersized. Agricultural value added is also relatively small when taking into account the still large rural population and the fact that 40% of the persons employed still work in agriculture (314 million) – which points to very low productivity in this field. Mining generates about 6% of total GDP, but reaches a share of more than 30% in certain provinces (Xinjiang, Heilongjiang). It comprises mainly coal mining and the extraction of oil & natural gas. Although of minor importance, the exploration and mining of ores is considered of national interest and belongs to the industries where foreign direct investment is either prohibited (e.g. tungsten, molybdenum, tin) or restricted (e.g. precious metals). The share of construction in GDP reaches about 6%.

161 Within the manufacturing industry, measured by output value, the basic metals industry is the biggest industry (see Table 2.5.1). The ICT industry ranks second (12.3%), followed by the chemical industry (10.5%), food and beverages (8.1%), machinery (8.2%) and the transport equipment industry (7.7%). The high share of the ICT industry – also very high by international standards and significantly higher than in the EU (8.5%) – is obviously related to the specialization of exports in this field. The clothing industry and the leather & shoe industry on the other hand, which also figure prominently in Chinese exports, take only relatively small shares in Chinese manufacturing, but a larger share than in the EU27 as well. The prominent position of basic metals reflects China’s development from the biggest importer of steel to a major exporter of steel. In contrast, the shares of the food & beverages industry, the printing industry and the transport equipment industry in China are relatively small by international standards. As illustrated in Table 2.5.1, the share of enterprises with foreign funds (FIEs) is particularly high in the ICT industry (82%), but has an over-proportionate share in the low-wage, export-oriented industries (e.g. wearing apparel, leather & leather products, furniture & other manufactured goods n.e.c.) and in the transport equipment industry.

Size structure Similar to other countries, most manufacturing enterprises in China are small (89%) or medium- sized enterprises (10%). However, large enterprises, with a share of only 1% of all enterprises, produce 35% of total output. Most of these are state-owned, state-controlled or collectively owned, but there exist some big private enterprises as well (e.g. Jiangsu Shagang Group, the 5th largest steel company, Geely holding, a major car producer).

Table 2.5.1 Structure of manufacturing industry in China and in the EU27, 2006/2007

Code Industry China (2007) EU27 (2006) Share of FIEs in (NACE rev.1) output shares output shares Chinese manuf. in % in % output (2007) in % 15 Food and beverages 8.1 12.7 31.6 16 Tobacco products 1.1 0.9 0.2 17 Textiles 5.3 1.6 23.8 18 Wearing apparel 2.1 1.2 45.1 19 Leather and leather products 1.5 0.7 50.2 20 Wood and wood products 1.0 2.0 18.9 21 Paper and paper products 1.8 2.5 34.8 22 Printing and publishing 0.6 4.0 30.7 23 Coke and refineries 5.0 4.3 14.8 24 Chemicals and chemical 10.5 10.3 27.8 products 25 Rubber and plastic 3.3 4.0 38.3 26 Non-metallic mineral products 4.4 3.6 18.4 27 Basic metals 14.6 5.9 14.9

162 28 Fabricated metal products 3.2 7.2 34.8 29 Machinery and equipment 8.2 9.3 27.3 31 Electrical machinery and 6.8 4.2 37.3 apparatus 30+32+3 Office mach., radio, TV, med. 12.3 8.5 81.9 3 and opt. instr. 34+35 Transport equipment 7.7 13.6 45.5 36 Furniture; other manufactured 2.2 2.6 47.0 goods n.e.c. 37 Recycling 0.2 0.5 21.5 D Total manufacturing 100 100 35.0 Note: Industrial enterprises above designated size only (annual revenue from principal business over 5 million yuan (= 480,000 euro); FIEs: foreign invested enterprises. Source: China Statistical Yearbook 2008, Eurostat SBS.

Guidelines for industrial restructuring In line with the new development model outlined above, a new ‘Catalogue for Guiding Industrial Restructuring’ was drafted in 2007. Industries classified as ‘encouraged’ will be given support through preferential credit and taxation policies; those listed in the ‘restricted’ category will not get government approval and financial institutions are not allowed to grant loans to them. New industries in the ‘encouraged’ category are, for instance, the development of financial services (e.g. credit card services, SME guarantee services); the prospecting, exploitation and transportation of various kinds of energy (including unconventional energy resources); the renovation of sewage treatment plants; and the construction of eco-friendly and alternative fuel cars. Changes in the restricted category refer, for instance, to the length of cars allowed in different categories, small coal mines and small thermal power generators working below a certain efficiency threshold. Certain types of old, inefficient or heavily polluting thermal power stations were added to the list of technologies to be ‘eliminated’ in the next couple of years.

New guidelines for foreign direct investment In December 2007, a new ‘Catalogue for the guidance of foreign investment industries’ became effective instead of the 2004 Catalogue. The catalogue classifies industries for potential investment as prohibited or restricted (for instance, only permitted in a joint venture with a Chinese partner) or encouraged (investments the government wants to support, sometimes with incentives). Investment that does not fit into one of these three categories is considered permissible, but there are no policy incentives applicable to it. The new catalogue is in line with the policy change from export-led growth to quality investment supporting domestic market-led growth and also reflects China’s WTO commitments to open up its services sector.

New industries on the list of encouraged FDI are, for instance, modern agricultural methods, resource conservation and environmental protection (e.g. recycling, renewable energy, clean production), services outsourcing and modern logistics, advanced or new technologies and new materials. On the other hand, FDI in certain kinds of basic manufacturing that China has clearly mastered (e.g. clothing) will be permitted, but no longer encouraged. Foreign investments in

163 highly energy- or resource-intensive and highly polluting projects are now either restricted or have been added to the prohibited category, which also includes mainly strategic and sensitive industries such as mining of certain minerals (e.g. tungsten, rare earths). The restricted category includes, for instance, the smelting of various metals, telecommunication companies, printing of publications and the construction and operation of high-grade real estate.

Supplementary to the foreign investment catalogue, a new ‘Central-Western Area Foreign Investment Advantage Industry Catalogue’ was issued in January 2009, which should help to expand foreign investment to so far neglected areas. ‘Encouraged’ investments will enjoy tax breaks, low-interest loans and cheap rent on industrial purpose land. They include investments in agriculture, environmental protection, services, infrastructure and upgrading of existing industries.

2.5.6 Future prospects and challenges Impacts of the current crisis The current global financial and economic crisis reached China in November last year. GDP growth fell from 9.9% during the first three quarters of 2008 to 6.8% in the last quarter and reached only 6.1% in the first quarter of 2009. However, the transmission of the crisis did not take place via the financial sector, which is still rather closed in China, but via declining exports due to sluggish external demand, which then triggered a slowing-down of industrial production and investments.118 With some delay, because of falling incomes and rising unemployment respectively, private consumption lost steam as well.119 Also, China was not spared from the global contraction of foreign direct investment, with FDI inflows staying below the respective previous year’s levels since October 2008. Real estate investment contracted particularly strongly in the first quarter of 2009. Stock prices were falling dramatically until the end of 2008.

To contain the crisis, the Chinese government announced a massive ‘stimulus package’ in November 2008, providing additional funds of more than EUR 400 billion for 2009 and 2010 (equivalent to some 7% of GDP per annum). The funds will be spent mainly on infrastructure (37.5%; highways, railways, airports and rural infrastructure); reconstruction of earth quake hit areas (25%); affordable housing (10%); improvement of villages (9.25%); public health and education (3.75%); and restructuring of industry (14.5%). The latter measures are concentrated on 11 specified industries that are considered to be hit particularly hard by the crisis.120 Of the total, only one third will come from the central government, the rest will be put up by local governments, state-owned enterprises and banks. In addition, a wide range of measures designed to stimulate the economy or certain parts thereof in a more direct manner have been adopted. These include increased VAT refunds for exporters, the government instructing banks to extend

118 While at the beginning of the crisis China was successful in penetrating new markets including the other BRICs to substitute for declining demand from the Triad (EU, USA, Japan), this strategy was no longer sustainable with the crisis turning global. 119 In recent years, China’s exports of goods have ranged close to 30%, but more than half of the country’s exports are classified as ‘processing trade’, major components of which are imported; hence the value added of exports and the contribution of net exports to GDP is markedly less. 120 Steel, shipbuilding, textiles, machinery, IT, light industry (food, home appliances, paper making), petrochemicals, non-ferrous metals, logistics and the automobile industry.

164 loans to small and medium-sized private enterprises and consumers, lowering of thresholds on mortgage loans for private households, cutting the sales tax on cars with engines of 1.6 litres or less, and consumer subsidies granted to farmers when buying household appliances such as TV sets, washing machines, microwaves, mobile telephones etc. but small cars, minivans and small trucks as well.

Thanks to its huge domestic market and its massive and timely stimulus policies, China appears to be the BRIC which is least affected by the crisis and its economy seems to bottom out earlier than the advanced economies, similar to that of Brazil and India. GDP growth in the second quarter of 2009 reached 7.9%. The strongest support came from fixed asset investment, pushed up by public expenditures. Private consumption was picking up too, although moderately. On the supply side, industry, which had suffered the heaviest slump of all sectors, was on the rise as well. Stock prices gained more than 60% during the first half of the year.

IMF forecasts from July 2009 suggest a growth rate of 7.5% for the Chinese economy in 2009 (see Table A2.1). National and some other forecasts are even more optimistic.

In the medium term, the major question is whether the Chinese government will continue its policy of qualitative rather than quantitative growth in the face of the current global financial crisis, with exports and FDI shrinking worldwide. Also, with China’s growth decelerating and probably falling below the targeted growth rate of 8%, it will be difficult to absorb the workers laid off from the low value added, labour-intensive export industries in other sectors of the economy. Already, contrary to the proclaimed policy, export rebates (VAT refunds) to these industries have been increased recently as part of the stimulus measures, and the textile and clothing industry is one of the 11 industries that will be supported under the government’s special support programme to fight the crisis. Also, the construction industry – which is very energy- intensive and a big polluter (cement, glass, aluminium) – will be particularly favoured by the government’s ‘stimulus package’. Perhaps some ‘qualified return’ to the export-led model will occur, implying that support for labour-intensive, low-tech manufacturing will return as well as support for purely export-oriented manufacturing; however, industries listed as restricted or prohibited in the ‘Industrial restructuring catalogue’, such as high-pollution, high-waste and highly energy-intensive industries, will continue to be restricted or prohibited.

Long-term prospects Some years ago, numerous forecasts predicted an ‘imminent collapse’ of the Chinese economy, often by authors clearly in favour of a free market system (Agresano, 2008, p. 335). The main reasons given were poor decisions made by Chinese policy makers, particularly regarding investment, a collapse of the banking system because of an overload with nonperforming loans, an uncompetitive public enterprise sector, corruption and social unrest due to rising inequalities.121 More recently, environmental problems, resource constraints, including energy, and related price hikes, social security, a rapidly ageing population, rising labour costs and

121 See, for instance, Chang (2001) and Gang (2003).

165 unsustainable imbalances in foreign trade are considered major challenges to further rapid growth of the Chinese economy. These challenges have also been taken up by the Chinese government when proclaiming a policy of qualitative growth in 2003. But there is a long list of opportunities in support of high growth as well, including urbanization (migration from agriculture to more productive activities in the industrial and services sectors); further expansion of the private economy; improvement of the institutional and regulatory framework; restructuring and technological upgrading of industry; new fields for industrial activity (energy-saving technology, pollution control equipment, waste treatment); becoming a pioneer in developing and using renewable energy resources; innovative practices in traditional farming; and increased regional trade because of closer regional economic cooperation. Depending on the weights attached to the different challenges and opportunities, different assessments of the future outlook for the Chinese economy will result. However, in recent years, most estimates for China’s long-term economic development until 2020 have been in the range between 6% and 9% average annual growth of GDP122, which is also in line with the Chinese government’s target of 7% to 8%. The question is whether the current global crisis will affect these estimates. If the crisis is over in one or two years, little will change, but if the world slides into a prolonged recession, China’s transition from an export-led to a domestically oriented economy will have to proceed faster than envisaged and FDI inflows and technology transfer will also be slower than expected, probably resulting in about one to two percentage points less growth than otherwise. But there is no doubt that China will move from a developing to a developed country and from a regional to a global economic power in the years to come.

2.5.7 EU-China relations The first ‘Trade Agreement’ between China and the European Economic Community (EEC) was concluded in 1978. It was substituted by the ‘EEC-China Trade and Economic Cooperation Agreement’ in 1985, which is still in force. However, in September 2006, the two parties started negotiations on a new comprehensive ‘Partnership and Cooperation Agreement’ (PCA) to replace the 1985 trade agreement, which should take account of the highly increased bilateral trade and investment relations since that time and China’s and the EU’s rise as political powers as well. On the side of the EU, the negotiations are regarded as part of the wider ‘Global Europe’ trade policy, launched in October 2006123, which goes well beyond traditional trade policy. With the broad aim to improve the market access for European companies abroad, the new trade policy addresses tariff and non-tariff barriers to trade, issues related to foreign direct investment, restrictions on the access to resources (e.g. energy), subsidies, intellectual property rights, trade in services and public procurement. On the side of China, the Chinese and the EU economies are considered highly complementary, implying broad prospects for bilateral trade and economic and technological cooperation. But there are major concerns as well. The EU arms embargo (in force since 1989) and related restrictions on European high-tech exports to China (dual use

122 The International Monetary Fund estimated a growth rate of 7.6% of GDP for the period 2002-2020 (IMF, 2004, p. 98); Justin Lin Yifu, chief economist of the World Bank, forecasted a long-term growth rate of about 8%, when he was still head of Beijing University’s China Center for Economic Research in 2007 (Harvard Business Review’s Chinese edition, quoted in China Daily, 2-4 May 2008). 123 European Commission, Communication ‘Global Europe: Competing in the World. A contribution to the EU’s Growth and Jobs Strategy’, [COM (2006) 567 final], 4 October 2006 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2006:0567:FIN:EN:PDF

166 technologies) should be lifted; full ‘market economy status’ should be granted as soon as possible; the EU should reduce antidumping and other discriminatory policies and practices against China. To discuss these issues and to support the ongoing negotiations for the new ‘Partnership and Cooperation Agreement’, a ‘High Level Economic and Trade Dialogue’ was established in Spring 2008. In addition, a working group with members of the People’s Bank of China (PBoC), China’s central bank, and the European Central Bank (ECB) will deal with bilateral exchange rate issues.

References Angresano, James (2008), ‘The State of China’s economy 2009’, Real-world Economics Review, No. 48. Chang, Gordon G. (2001), The Coming Collapse of China, Random House, New York. European Commission (2004), ‘The Challenge to the EU of a rising Chinese Economy’, European Competitiveness Report, Commission staff working document SEC (2004) 1397, Enterprise and Industry publications, Chapter 5, pp. 235-277. Gang, Lin (2003), ‘China’s Economy: Will the Bubble Burst?’, Asia Program Special Report, Woodrow Wilson International Center, Washington DC, June. IMF – International Monetary Fund (2004), World Economic Outlook, April. OECD (2005), ‘China’, Economic Surveys, Volume 2005/13, September. Urban, Waltraut (1992), ‘Economic Lessons for the East European Countries from Two Newly Industrializing Countries in the Far East?’, wiiw Research Reports, No. 182, The Vienna Institute for International Economic Studies (wiiw), April. Urban, Waltraut (2008), ‘Eastern Europe and China as alternative locations for outward investment of Austrian manufacturing companies’, Final Report, research supported by the Jubilee Fund of the Austrian National Bank, May. Wang, Xiaolu and Gang Fan (2009), ‘The road to China’s economic transformation: past, present and future’, wiiw Monthly Report, No. 6, The Vienna Institute for International Economic Studies (wiiw), June.

167 2.6 Future challenges and opportunities for EU competitiveness

Rising demand for consumer goods. The ongoing catching-up process in the BRICs and the rising population (the latter except in Russia) will lead to an over-proportionate demand for more sophisticated and high-quality consumer goods, which will provide ample opportunities for EU exports and market-seeking FDI in these fields. Thus, the currently skewed export structure, focusing on investment goods and intermediates (again except in Russia) is expected to become more balanced.

Technological upgrading. Competition from the BRICs in high value added and technology- driven manufacturing products will increase on the EU market and on third markets, in particular in other emerging economies. China has already entered this path (see Section 1). The new outward-looking policy in Brazil and the new industrial policy in India with ambitions to become part of the ‘Asian supplier network’ will support this development. To stay ahead, EU companies will have to accelerate their technological development.

Expanding R&D. Due to rising expenditures for R&D in the BRICs, competitive pressure on the EU may also increase in certain high-tech areas where the individual BRICs choose to specialize. But on the other hand, new opportunities for technical & scientific cooperation and for knowledge flows between the EU and the BRICs will emerge.

Broadening of supply/demand. There are several signs that the BRICs will broaden the range of their supplies on their home markets as well as abroad. China will advance its relatively undersized services sector, also promoting outsourcing activities, and will spur the modernization of agriculture; Brazil, India and Russia intend to further diversify their industrial structure. This will widen the competition from the BRICs, but will also open up new opportunities for EU enterprises on the BRICs markets in these fields.

Stronger demand for investment goods. The envisaged restructuring and technological upgrading of the BRICs will absorb a large amount of investment goods, where the EU has shown a comparative advantage with respect to the BRICs already and is expected to do so in the future as well.

Focus on infrastructure. All BRICs have ambitious plans to increase infrastructure investment – such as for transport infrastructure in Brazil, Russia and India; for increasing energy efficiency and protecting the environment in China; and for power generation and telecommunications in India. This will open up many new opportunities for EU suppliers specialized in these fields.

Large distances. For some business areas, a large distance between supplier and customer, as it is the case between the EU and the BRICs, is considered a serious obstacle. Furthermore, when economic relations become more complex, the local presence of EU enterprises is gaining importance. However, there are still various restrictions on FDI in the BRICs (in particular in

168 China and Russia). Also, SMEs typically face more problems in investing in more distant places than larger companies.

Regionalism. Regional economic cooperation agreements give the individual BRICs a relative advantage compared to the EU in the respective region. This is particularly relevant in Asia, where regionalism is on the rise. In 2010, a free trade agreement between China and ASEAN will become effective, and India is seeking closer links to the ASEAN Free Trade Area (AFTA) as well. Brazil holds a privileged position within Mercosur, but this will fade when the ongoing negotiations for an FTA between the EU and Mercosur are concluded successfully. A number of challenges with respect to Russia exist in shaping EU relations with its Eastern neighbours (Belarus, Moldova, Ukraine, etc.).

Changing roles. China has propagated to follow a more domestically orientated development model in the future, which is expected to somewhat reduce its competitive pressure in international markets. Brazil, India and Russia, on the other hand, are striving for a more outward oriented policy in the years to come, which may increase competitive pressure from their side.

169 2.7 Summary results and policy implications

2.7.1 Summary results Starting with the common features, all BRICs are characterized by a big land size, a large population (between 1321 million in China and 143 million in Russia), but lower incomes, wages and productivity than the EU. In 2007, GDP per capita at PPP ranged from 50% of the EU average in Russia to only 8.5% in India. All BRICs show great personal and regional income differentials (Gini coefficients between 0.37 in India and 0.57 in Brazil); nevertheless, a sizeable prosperous middle class is emerging (reaching, for instance, about 300 million persons in China and probably 100 million in Brazil). The role of the state in the BRICs’ economies is substantial and their scores with regard to regulatory quality, rule of law, control of corruption and political stability are typically low. BRICs represent important regional economic powers and are also global players in certain fields (e.g. Brazil in biofuels, Russia in energy supply, India in IT services and China in manufacturing). BRICs economies are typically expanding faster than the advanced industrialized countries, including the EU, with average growth rates for the period 2000-2007 ranging between 3.4% for Brazil and 10.1% for China. In the medium term their catching-up process is expected to continue. However, to achieve this growth, the individual BRICs have been pursuing different models of economic development:

Brazil followed the model of a domestically oriented, service-driven economy, with a relative large private sector (>80% of GDP) and foreign direct investment playing an important role. On the negative side there are poor infrastructure, high informality, low productivity and little innovation. The services sector takes the biggest share (66% of GDP), supplying services for the domestic economy mainly. Major manufacturing industries include aerospace, bio-ethanol and automotives. Since 2004, a more outward looking policy has been propagated by the government, promoting exports and fostering technological development to increase international competitiveness. In 2008, additional tax incentives for investment, R&D and exports were introduced.

Russia, when transforming from a centrally planned economy to a market economy, has liberalized first and ‘re-centralized’ later. In 2007, the private sector accounted only for 65% of GDP. FDI helped to support growth, but its stock is still relatively low, due to many impediments. On the negative side of high economic growth there are high inflation, strong appreciation of the rouble without increases in productivity, and a declining population and labour force. Economic development is highly dependent on the extraction and export (price!) of mineral oil and gas. In 2007, a new long-term development programme and a new industrial policy, respectively, was launched, aiming at the diversification of the production structure towards (high-tech) manufacturing by improving the investment climate, promoting ‘public private partnership’ and investing more in infrastructure. The ambitious investment plans will have to be scaled back in view of the global crisis. India’s economic development is essentially service-led, supported by exports of services (especially IT-enabled services); manufacturing exports are relatively small and are concentrated on a few sectors only. The share of agriculture in GDP is still very high (16%). After

170 liberalization, starting in 1980, the private sector is currently generating more than 80% of GDP. Rules for FDI have been eased as well, yet the FDI stock is still small. Wages are very low, but the overall education level, particularly with respect to technical qualifications, is very low as well. A major stumbling bloc to further development is the underdeveloped infrastructure. A new government programme has been launched recently to expand rural infrastructure and to increase funding for education and infrastructure in general.

China refers to its system as a ‘socialist market economy,’ with markets taking a pivotal role, but public ownership, direct government interference and industrial policy measures representing an integral part of the system. Currently, the private sector is estimated to generate about 65% of GDP. China’s economic development is driven by manufacturing exports and by investments (including infrastructure). FDI plays an important role, especially for exports. Recently outward FDI, mainly to secure raw materials, has been increasing. Although generating fast growth for over 30 years, the system has come under criticism recently because of rising income inequalities, environmental degradation, rapidly increasing energy demand and external imbalances. Therefore, a new model of ‘qualitative growth’ is propagated by the Chinese government since 2003, emphasizing domestically oriented growth, industrial restructuring towards higher value added industries, cleaner and more energy-efficient technologies and more balanced regional and sectoral development; FDI should support these goals.

Looking at the more recent policies and future development plans of the BRICs, a certain ‘convergence’ of their development strategies can be observed: More export orientation and state- led industrial policy in Brazil; greater industrial diversification and promotion of investment in Russia; more emphasis on the development of other sectors than services, higher expenditures on infrastructure investment in India; and a gradual switch from export-oriented to more domestic- market oriented growth with less dominance of manufacturing in China.

Also common to all BRICs is the aim to upgrade their industrial structures towards higher value added and high-tech products respectively, frequently supported by government programmes, and the trend towards increased expenditures for R&D.

Impacts of the crisis Initial hopes that the BRICs would be able to ‘de-couple’ from the economic slowdown in the Triad countries have not materialized. The main mechanism of transmission is represented by rapidly declining exports and the respective multiplier effects, decreasing FDI and plummeting stock prices; in some countries (Russia, India and Brazil), a significant outflow of financial capital occurred as well. To fight the crisis, all countries have taken certain financial and/or fiscal measures. Brazil has focused on financial measures to shelter its currency and to secure credit supply but has introduced cuts in taxes on capital goods and durable consumer goods to stimulate domestic demand as well. Russia has launched a comprehensive rescue package for domestic banks, supports the exchange rate and consumption by drawing on accumulated reserves and raising new debt. The various forms of rescue and stimulation measures are estimated to cost around 10% of GDP. India tries to keep the credit supply alive in order to support domestic

171 demand and to speed up infrastructure investments. China has adopted a massive fiscal stimulus package and various rescue measures including increased expenditures for infrastructure, consumer subsidies and support for its ailing export industries. Russia is so far the most affected economy because of both declining demand and lower prices of oil, China appears to be least affected due to its massive stimulus policies and the huge domestic market. In the short term, the crisis may delay restructuring processes in the BRICs, but in the medium and longer term it will rather reinforce existing development plans and make these economies stronger and more independent.

The latest IMF forecasts from July 2009 suggest a growth rate in 2009 of -1.3% for Brazil, -6.5% for Russia, 5.4% for India and 7.5% for China. National forecasts are more optimistic for Brazil, India and China (the reverse is the case for Russia). Several statistical indicators suggest that the three BRICs economies might be bottoming out earlier than the advanced economies, with government stimulus measures seeming to play a crucial role. In the case of Brazil, for instance, sales of durable consumer goods have returned to pre-crisis levels, investment in the first quarter of 2009 is up 19%, and money from abroad is flowing in again. On the supply side, construction is doing well and industry is recovering. In India, industry is showing signs of revival as well and the government is continuing with tax cuts and other incentives for corporations. In China, the strongest positive signal comes from fixed asset investment, pushed up by public expenditures. Investment has increased by about 30% in the first quarter of this year, faster than in the same period last year. Private consumption, which showed a significant deceleration at the beginning of the year, is picking up as well. Industry, which suffered the heaviest slump of all sectors in the economy, seems to have hit the bottom eventually. A significant rebound of stock prices can be observed in all BRICs countries.

2.7.2 Implications for EU policies Both the increasing weight of the BRICs economies and their more intensive and varying scope of interactions with the EU call for special policy treatment, in particular regarding industrial and trade policies, energy security, intellectual property rights, etc.124 The type and scale of the challenges for EU policies are largely shaped by the BRICs’ models of economic development; both are significantly different among the individual BRICs.

Currently, the foremost challenge for the EU is the strong state interference in the BRICs’ economies (taking the form of various subsidies, privileged access to bank loans or raw materials, tax preferences – particularly for the state-owned enterprises), which makes BRICs’ exports to the

124 This is reflected in the numerous EU strategies and policy papers related to individual BRICs, and the ongoing negotiations for a ‘Partnership and Cooperation Agreement’ (PCA) with China, for a ‘Strategic Partnership’ (SP) with Brazil and the aim to upgrade or replace the existing PCA with Russia to an SP. With India, after forming an SP in 2004, the ‘Free Trade Agreement’ is under negotiation since 2007. In addition, various joint committees, high-level dialogues and negotiations as well as scientific and technical cooperation programmes exist. The EU’s New Industrial Policy, ‘Implementing the Community Lisbon Programme: A policy framework to strengthen EU manufacturing – towards a more integrated approach for industrial policy’ (COM(2005) 474 final), includes several cross-sectoral initiatives on competitiveness, energy and the environment, intellectual property rights, better regulation, industrial research and innovation, market access, skills and managing structural change. In addition, the Commission brought forward seven new initiatives targeted at specific sectors, e.g. information and communication technologies, mechanical engineering and biotechnology, with the aim to support adaptability and structural change in order to boost the competitiveness of EU manufacturing ‘especially in the light of increasing strong competition from China and Asia’.

172 EU more competitive and impairs EU companies’ competitiveness on both home and third markets. State interference is particularly high in Russia and China, and has increased recently also as a reaction to the global crisis. Dumping on EU and on third markets is a greater challenge in the case of an export-driven economy like China, while in domestically oriented economies like India and Brazil, unfair competition on the home markets figures prominently. These issues have to be raised emphatically in the ongoing dialogues with the BRICs, in particular within the negotiations of a new ‘Partnership and Cooperation Agreement’ between the EU and China, the new EU-Russia ‘Strategic Partnership’, etc.

Other challenges arise from the weak regulatory framework and various institutional impediments which exist in the BRICs, such as the uneven enforcement of laws, non-tariff barriers to trade including certification procedures and standards, and environmental regulations and labour laws which often discriminate against foreign (EU) companies. Thus, the implementation of rules rather than the rules themselves poses a major challenge for EU policy. Prominent examples are intellectual property rights in China, labour legislation in India and Russia, and environmental regulations in both Russia and China. To improve the situation, the existing experience of the EU in these fields and methods of implementation should be communicated to the BRICs.

Despite the fact that average tariff levels in the BRICs are relatively low, substantial tariff peaks restraining EU imports still exist, which could be negotiated (the standard deviation of tariffs is particularly high in India – see Table A2.1). However, along with lower tariffs, non-tariff barriers to trade gain importance, such as unnecessarily trade-restricting regulations and procedures and different norms and standards. The BRICs should be encouraged to adopt existing international standards or to accept mutual recognition of national standards where possible. Although FDI is welcome in all BRICs, there are still many impediments for doing business, in particular in sectors that are considered less advanced, where there exists a state monopoly or which are declared as ‘strategically’ important. Typically, the services sector (in particular banking, insurance and telecommunications), raw materials (oil, mining of minerals) and certain high-tech sectors related to defence (e.g. airplane, space, nuclear technologies in Russia) pose the biggest problems. Restrictions on FDI are frequently linked to ‘National Development Plans’, to a national ‘Industrial Policy’ such as in China, or ‘national security’ such as in Russia. Existing restrictions should be addressed by the EU authorities in bilateral negotiations with the BRICs. Recently, new comprehensive industrial policies have been launched in both Brazil and Russia which intend to use Public-Private Partnership (PPP) tools. In India, new ambitious development programmes have been implemented which will unfold their impacts in the years to come. These plans offer opportunities for EU companies as well.

Particularly small and medium-sized European enterprises (SMEs) may lack the appropriate information on far-away markets and they also typically face more problems to invest in more distant places than larger companies. Thus, special SME support with regard to market research

173 and investment similar to that provided in the EU Asia-Invest programme would be most beneficial with respect to the BRICs.125

Judged by the relative weight of the sectors, the biggest challenge for EU policies is probably industry (in particular manufacturing) in the case of China, business services in India, agriculture (and biofuels) in Brazil, and energy imports and transit (especially gas) in relations with Russia. But manufacturing is going to play an increasing role in the relations with India, Brazil and probably Russia as well, and outsourcing of services will gain importance with China.

In a longer-term perspective, efforts at ‘industrial upgrading’ in all BRICs poses the most serious challenge for EU policies, including R&D policies at the national and at the bilateral level. Infrastructure investment and related policy areas, such as public procurement, and the above- mentioned public private partnerships (particularly in Russia), will gain importance in the light of the BRICs’ new development plans and industrial policies, with a focus on improving infrastructure and diversification of the economy. BRICs’ environmental regulations and energy policy issues may play a role in this context as well. However, foreign enterprises are often discriminated in the public procurement processes. The EU should thus support China’s accession to the WTO Government Procurement Agreement (GPA) as soon as possible. In the case of Russia, which is no WTO member yet, the EU Commission could negotiate the opening of public procurement markets on a reciprocal basis and push for WTO accession. Finally, enhanced regional economic cooperation, which gives the BRICs a relative advantage compared to the EU in the respective region, is posing new challenges for EU policies in the future. This is relevant not only in Asia, where regionalism is clearly on the rise, but also with respect to the EU’s Eastern Neighbourhood and Latin America. Geopolitical strategies, in particular the contest for influence on the post-Soviet space, will play an important role in shaping EU relations with Russia, and the successful conclusion of the ongoing negotiations for a Free Trade Agreement between the EU and Mercosur will not only facilitate economic relations with Brazil but also challenge Brazil’s privileged position in Latin America. Besides, the ongoing bilateral negotiations between the EU and the individual BRICs could be used to alleviate the impending trade-diversion effects from their regional cooperation agreements.

125 The Asia–Invest Programme was launched in 1997 as an initiative of the European Union to promote and support business cooperation between the EU member states and Asia.

174 Annex 2 – BRICs List of indicators Table A2.1 BRICs List of Indicators Year 2007 (if not mentioned otherwise)

MACRO INDICATORS Brazil Russia India China 1) Size of the economy Landsize in 1000 sq km 8515 17075 3288 9600 Population, average, mn 189 2006 143 2006 1110 2006 1321 2006 Population aged 0-14, % of total 27.6 2006 14.9 2006 32.5 2006 21.1 2006 Population aged 15-64, % of total 66.2 2006 71.4 2006 62.4 2006 71.1 2006 Population aged 65 and above, % of total 6.3 2006 13.7 2006 5.0 2006 7.8 2006 Population, growth, % 1.3 2006 -0.5 2006 1.4 2006 0.6 2006 GDP in EUR at exchange rates, EUR bn 973 946 759 2467 GDP in EUR at exchange rates, EU 27=100 7.9 7.7 6.2 20.0 GDP in EUR at PPP, EUR bn 1484 1758 2339 5898 GDP in EUR at PPP, EU 27=100 12 14 19 48 GDP in EUR at exchange rates per capita 5142 6700 2007 684 1867 GDP in EUR at PPP per capita 7839 12400 2108 4464 GDP in EUR at PPP per capita, EU 27=100 31.5 49.8 8.5 17.9 GDP in EUR at exchange rates per person employed 11200 13973 1688 3204 GDP in EUR at PPP per person employed 17075 25965 5198 7661 GDP in EUR at PPP per person employed, EU 27= 100 30.2 46.0 9.2 13.6

Distribution Gini coefficient (based on all household incomes) 0.56 2006 0.40 2002 0.37 2005 0.47 1st income quintile (lowest), % of total 2.9 2005 6.1 2002 8.1 2005 4.3 2004 2nd income quintile, % of total 6.5 2005 10.5 2002 11.3 2005 8.5 2004 3rd income quintile, % of total 11.1 2005 14.9 2002 14.9 2005 13.7 2004 4th income quintile, % of total 18.7 2005 21.8 2002 20.4 2005 21.7 2004 5th income quintile (highest), % of total 60.8 2005 46.6 2002 45.3 2005 51.9 2004 Top 10% income earners, % of total 44.9 2005 30.6 2002 31.1 2005 34.9 2004

Role of the state Private sector, % of GDP 83 2) 2006 65 80 65 Employees in private enterprises, % of total 96. 2006 56 95 75.

Demand side factors, foreign trade Distance Brussels - capital of respective BRICs country 8978 2255 6438 7968 Exports of goods, % of GDP 12.0 27.4 9.6 36.0 Imports of goods, % of GDP 9.0 17.3 14.5 28.3 Exports of services, % of GDP 1.7 2006 3.0 8.2 3.6 Imports of services, % of GDP 2.6 2006 4.6 4.7 3.8 Current account, % of GDP 0.1 5.9 1.6 11.0 Investment, % of GDP 17.7 24.7 39.7 42.3 Final consumption, % of GDP 80.7 66.5 46.0 48.8 Effectively applied tariff 12.2 8.3 14.0 8.8 Weighed tariff 6.83 6.00 10.42 4.30 Standard deviation of tariffs 7.0 6.5 14.9 6.6

Foreign direct investment Inward FDI stock, EUR bn 172 34 52 516 Inward FDI stock, % of GDP 19.0 3.6 7.3 22.5 Outward FDI stock, EUR bn 43 . 21 54 Number of companies in the world's top 500 10 2008 12 13 2008 25 2008

Table A2.1 (continued)

MACRO INDICATORS

175 Brazil Russia India China 1) Human resources and research Economically active population, mn 96 2005 75 467 786 Participation rate (15-64, %) 76.7 2005 . 42.0 83.7 Average gross wages, monthly, EUR 418 388 71 207 Adult literacy, male, aged 15 and above, % 88 2005 100 2005 75 2004 95 2005 Adult literacy, female, aged 15 and above, % 89 2005 99 2005 54 2004 87 2005 School enrolment secondary, % of relevant age group 106 2006 91 2006 54 2006 76 2006 School enrolment tertiary, % of relevant age group 24 2006 70 2006 11 2006 22 2006 Total researchers per 10000 persons employed 10 2004 63 2006 3 2000 16 R&D, % of GDP 1.11 1.07 2006 0.75 1.49 IT expenditure, % of GDP 6.4 2006 3.2 2006 6.1 2006 5.4 2006 Royalty and license fees, payments (BoP), current EUR bn 1324 2006 1593 2006 755 2006 5279 2006 Royalty and license fees, receipts (BoP), current EUR bn 120 2006 238 2006 89 2006 163 2006

Physical Infrastructure Roads, total network, km per 1000 sq km 188 2006 55 1020 373 Raillines, total route km per 1000 sq km 3 5 33 8 Air transport, registered carrier departures worldwide, mn 560838 2006 421170 2006 453921 2006 1542564 2006 Renewable freshwater resources per capita, cubic metres 28999 2005 30127 2005 1152 2005 2156 2005 Fixed and mobile phone subscribers per 100 population 84 146 23 69 Internet subscribers per 100 people 4 21 1 11

Institutional and policy framework Regulatory quality (score (-2.5 to + 2.5) -0.04 -0.44 -0.22 -0.24 Rule of Law (score (-2.5 to + 2.5) -0.44 -0.97 0.10 -0.45 Government effectiveness (score -2.5 to + 2.5) -0.12 -0.40 0.03 0.15 Control of corruption (score -2.5 to + 2.5) -0.24 -0.92 -0.39 -0.66 Political stability index (score -2.5 to + 2.5) -0.22 -0.75 -1.01 -0.33 Economic freedom index (score 0-100; top=100) 3) 56.7 50.8 54.4 53.2 Country risk ranking, (1-157), rank 4) 63 61 59 54

SECTORAL INDICATORS

Output structure Agriculture, %of GDP 6.0 4.1 16.3 11.3 Mining, % of GDP 2.2 9.0 2.1 5.7 2006 Manufacturing, % of GDP 17.4 16.3 15.3 33.6 2006 Utilities (electr., gas and water), % of GDP 3.6 2.7 2.1 3.8 2006 Construction, % of GDP 4.8 5.1 7.2 5.6 Services, % of GDP 66.0 51.1 55.7 40.1 Proportion of market services in total services, % 66.0 77.5 75.0 61.0 Number of persons employed in primary sector, mn 18 5) 2005 7 246 314 Number of persons employed in secondary sector, mn 19 6) 2005 20 54 206 Number of persons employed in tertiary sector, mn 50 7) 2005 41 150 249 Number of persons employed, total, mn 87 68 450 770

176 Table A2.1 (continued)

DEVELOPMENT INDICATORS Brazil Russia India China Population projection for 2020 Total population, mn 209 135 1367 1431 Population aged 0-14 , % of total 20.1 16.7 26.7 18.7 Population aged 15-64, % of total 70.4 67.9 67.0 69.6 Population aged 65 and above, % of total 9.6 15.4 6.3 11.7 Average annual growth rates, % GDP (1995-2007) 2.9 4.5 6.9 9.7 GDP(2000-2007) 3.4 5.3 7.6 10.1 Agriculture (1995-2007) 4.1 1.4 3.2 3.9 Industry (1995-2007) 2.3 4.3 6.1 11.2 Services (1995-2007) 2.9 . 8.7 10.2 GDP growth, 2009 (IMF forecast, July 2009), % -1.3 -6.5 5.4 7.5 Notes 1) Excluding Hong Kong and Macao.- 2) Total revenues of private enterprises, share in %.-. 3) 100-80: free; 79.9-70:mostly free; 69.9-60:moderately free; 59.9-50: mostly unfree; 49.9-0 repressed.- 4) Euromoney country risk rating, March 2008. Rank 1 representing the lowest and rank 157 the highest risk.- 5) Working Population in primary sector.- 6) Working Population in secondary sector.- 7) Working Population in services. Sources General Sources: World Bank, World Development Indicators (WDI) and Worldwide Governance Indicators, 2008 Heritage Foundation Euromoney Country Risk Rating, March 2008 International Telecommunication Union (ITU) World Integrated Trade Solution (WITS) Trains database Financial Times UN, Population database, UN World Population Prospects, 2008 Revision wiiw estimates and calculations Sources for Brazil: Instituto Brasileiro de Geografia e Estatística, Sistema de Contas Nacionais Referência 2000 (IBGE/SCN 2000 Anual) [National Account] Instituto Brasileiro de Geografia e Estatística, Pesquisa Industrial da Empresa (Enterprises annual survey) Perfil das Empresas Estatais (2006) Fundação Centro de Estudos do Comércio Exterior Brazilian Ministry of Science and Technology - Indicators Institute for Scientific Information Brazilian Central Bank Departamento Intersindical de Estatística e Estudos Sócio-Econômicos, Anuário Estatístico dos Trabalhadores Instituto Brasileiro de Geografia e Estatística, Pesquisa Mensal do Emprego (Employment monthly survey) Departamento Nacional de Infra-Estrutura de Transportes, Anuario Estatístico do Transporte Terrestre (2007) Agência Nacional dos Transportes Terrestres Instituto Brasileiro de Geografia e Estatística, Demografia das Empresas - 2006 [Enterprises Demography - 2006] Instituto Brasileiro de Geografia e Estatística

177 Sources for Russia: Russian Statistical Yearbook 2008, Federal Bureau of Statistics (Rosstat), Moscow. Sources for India: Handbook of Statistics on Indian Economy World Investment Report, 2008 National Accounts Statistics National Sample Survey Report N. 515, 61st round, 2004-2005 India Railway Year Book 2006-07 (World Bank website) Sources for China: China Statistical Yearbook 2008, China Monthly Statistics, Chinese Academy of Social Sciences (CASS),

178 3 The role of BRICs in EU’s future energy needs: partners and competitors

Vasily Astrov, Edward Christie, wiiw and Marcus Poplawski Ribeiro, CEPII

3.1 Oil, gas and the EU-Russia energy relationship

3.1.1 Global oil and gas demand The global picture with respect to oil and gas consumption by world region is shown in Figure 3.1.1, including observed levels in 2006 and IEA scenario projections for 2020 and 2030. These scenario projections are based on the IEA’s World Energy Model (WEM), using data and policies adopted or enacted up to mid-2008. It does not include policies thought to be likely but not yet adopted at the cut-off date. In particular, the recent EU commitment to the 20-20-20 Initiative was not included (see below). WEM is a large-scale energy-economy simulation model with econometrically calibrated behavioural equations126. The model is based on exogenous assumptions concerning population and GDP growth by world region. These result in energy demand, which is balanced with energy supply. The supply side is modelled as a function of the available reserves and current and forecast extraction and transportation capacities.

As is shown in Figure 3.1.1, global consumption for both crude oil and natural gas (especially the latter) are projected to rise substantially up to 2030. The most striking differences between regions are as follows. China and India together currently consume less oil than the EU, and considerably less than the US. This is projected to change substantially, with the sum of the oil consumption of the two Asian giants roughly doubling by 2030, while EU consumption should fall slightly, and US consumption stay roughly the same. For gas the impact of China and India should however be considerably smaller. The two countries consume very little natural gas at present, and while this is projected to rise, even by 2030 China and India together should be consuming less than half the volume of natural gas consumed by the EU or the US, the latter two having roughly equal volumes. The other phenomenon which is visible from Figure 3.1.1 is the special role played by major oil and gas producers, namely Russia and the Middle East. Together these two world regions should be consuming roughly as much oil in 2030 as the EU. For gas the picture is even more striking, as Russia and the Middle East are projected to be consuming almost as much natural gas in 2030 as the EU and the US put together. In other terms, when there is talk of China and India potentially competing for resources with the EU and the US, this is in fact only the case for crude oil, not for natural gas. For natural gas, the competing consumers for the EU and the US are the large gas-producing regions, chiefly Russia and the Middle East (including Iran). Finally, it bears notice that the world’s relative energy mix is projected to shift in favour of natural gas, though crude oil will remain more important in absolute terms.

126 Detailed descriptions of WEM can be accessed from www.worldenergyoutlook.org.

179 Figure 3.1.1 Oil and gas consumption scenarios, mtoe, 2020-2030

5500 5000 4500 4000 RoW 3500 RU+ME 3000 CN+IN 2500 US 2000 EU (25) 1500 1000 500 0 Oil 2006 Oil 2020 Oil 2030 Gas 2006 Gas 2020 Gas 2030

Source: IEA (2008) Codes: RoW = Rest of World; RU+ME = Russia and Middle East; CN+IN = China and India; US = United States; EU (25) = European Union with membership as of 2006.

As is well-known, the EU has very low (and falling) domestic reserves of both crude oil and natural gas, and is therefore very significantly dependent on imports for both energy products. As total consumption is projected to decrease only slightly for oil, and to increase slightly for natural gas, the consensus until very recently was that the EU would require very large volumes of imported natural gas in the near future. However, the EU’s recent commitment to the 20-20-20 Initiative could have a substantial mitigating effect on those trends. This brings us to Section 3.1.2.

3.1.2 EU net import demand and the 20-20-20 Initiative The 20-20-20 Initiative foresees that, by the year 2020, the EU should achieve a 20% cut in greenhouse gas emissions as compared to 1990 levels, a 20% improvement in energy efficiency, and a share of renewables in the energy mix of 20%. Taken together these commitments imply substantially lower outcomes for the EU’s demand for imported fossil fuels as compared to a ‘baseline scenario’ without the 20-20-20 Initiative. Projected EU net import demand levels are presented in Figure 3.1.2 for oil and solid fuels (essentially coal), and in Figure 3.1.3 for natural gas. Both figures are based on simulations from the PRIMES model, which is the main energy- economy simulation model used by the European Commission.

180 Figure 3.1.2 EU net import scenarios for 2020 – crude oil and solid fuels

800 700 600 500 Oil (mtoe) 400 Solids (mtoe) 300 200 100 0 2005 Base $61 Base Policy $61 Policy oil $100 oil oil $100 oil

Source: European Commission: COM(2008) 744/3 (Annex 1) Units: mtoe: millions of tonnes of oil equivalent

The first two scenarios are baseline scenarios (‘Base’), assuming that the 20-20-20 initiative is not implemented. Of these, the first scenario assumes a relatively low average oil price of USD 61 per barrel over 2008-2020; the second scenario assumes an average oil price of USD 100 per barrel. The last two scenarios (‘Policy’) assume that the 20-20-20 initiative is adhered to, with two variants for the oil price assumptions as mentioned. Given that the 20-20-20 initiative has now been committed to, one should focus on the last two scenarios.

The projected effects of the 20-20-20 initiative are remarkable. The strongest relative effect would be for demand for imported coal, which would double without the new policy, but not change substantially with the policy. For crude oil the policy would likewise cause import demand to be similar in 2020 to what it was in 2005, slightly higher with high oil prices, slightly lower with low oil prices. Lastly, but most importantly in the context of EU-Russia energy relations, demand for imported natural gas without the new policy and with low oil prices would increase by around 150 bcm per year by 2020, but only by around 30 bcm with the new policy and with low oil prices. With the new policy and with high oil prices the projections suggest that demand would be lower in 2020 than it was in 2005, a remarkable achievement given the decrease in domestic gas production. This result represents a substantial break from the expectations (both private and public) that have dominated the European energy policy debate in the last few years, see e.g. EC (2006a) and related publications. Most of all, the result represents a potential reduction in expected future import demand of up to 150 bcm, a volume which is larger than the planned capacities of Nord Stream, South Stream and Nabucco put together. At the most basic level this suggests that the general energy strategies of EU member states need to be re-evaluated. At the same time more detailed projections, covering the intervening years as well as the period after

181 2020 (bearing in mind probable commitment to ever deeper cuts in greenhouse gas emissions) are needed and should be made public, together with a careful sensitivity analysis.

Figure 3.1.3 EU net import scenarios for 2020 – natural gas (bcm)

500 450 400 350 300 250 200 150 100 50 0 2005 Base $61 oil Base $100 oil Policy $61 oil Policy $100 oil

Source: European Commission: COM(2008) 744/3 (Annex 1) Units: bcm: billions of cubic metres

3.1.3 Russian oil and gas reserves and production The availability of reserves is crucial to assessing the energy potential of any country or region. According to BP (2008), at the end of 2007 Russia commanded 79 billion barrels of proven oil reserves (6.4% of the world total) and 45 trillion cubic meters of proven natural gas reserves (25.1% of the world total).127 Thus, Russia’s role as a potential supplier in the long run – whether to the EU or elsewhere – is far greater for natural gas than for oil. (In the latter case, Russia is overshadowed by Saudi Arabia and other Middle East countries.)

Also, Russia is the world’s biggest gas producer and the second biggest oil producer (behind Saudi Arabia) – see Figures 3.1.4 and 3.1.5. Besides, Russia is by far the largest oil producer and exporter outside OPEC. However, it accounts for just some 10% of the world oil production and is thus essentially a price taker in the world oil market (unlike OPEC128 which controls over 40% of the world production and is generally able to manipulate prices by adjusting production quotas). At the same time, Russia has been an important driving force behind the recent global expansion of oil production, benefiting greatly from staying outside OPEC and taking full

127 ‘Proven reserves’ are defined as reserves which can be recovered with reasonable certainty (assuming 90% probability) given current geological knowledge, current technology, and current prices. Therefore, the definition of proven reserves is based on both geological and economic considerations. Thus, a sustained higher price level and/or advances in available extraction technology can make hydrocarbon production economically profitable in the hitherto challenging (technologically, climatically or otherwise) geographic regions, e.g. in Eastern Siberia or off-shore on the Arctic shelf, thereby automatically leading to an upward revision of ‘proven reserves’. 128 Currently, OPEC includes Algeria, Angola, Ecuador, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela.

182 advantage of the soaring oil prices up until mid-2008. In particular, between 2001 and 2005 Russia was expanding its oil output by some 10% per year and accounted for nearly half of the increase in global oil production in those years (almost all of it was channelled to exports, while Russia’s own oil consumption has been nearly stagnant).

However, as illustrated in Figure 3.1.4, over the last few years the pace of expansion by the Russian oil sector declined markedly, and, after reaching a peak of 9.44 million barrels per day (mbd) in 2007, in 2008 the country’s oil production fell slightly, to 9.36 mbd. Thus the turnaround came before the current financial crisis took full swing and the global oil prices plunged dramatically in the second half of 2008. The reasons for this are widely disputed129; it appears however that it reflects a combination of technological and institutional factors. In particular, the vibrant production growth in the previous years had been enabled by access to relatively cheap deposits (primarily in Western Siberia) and the existing infrastructure dating back to Soviet times: maintaining that pace would require large-scale investments in more distant and technologically and climatically challenging locations (notably in Eastern Siberia).

Figure 3.1.4 Russian oil production and exports (mbd)

10 9 8 7 6 5 4 3 2 1 0

2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7

9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0

9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0

1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2

Domestic consumption Exports (net)

Source: US Energy Information Administration and own calculations Units: mbd: millions of barrels per day

Changes in the structure of the Russian oil sector over time played a role as well. The Russian oil sector had been almost entirely privatized during the 1990s, largely in the wake of the controversial ‘loans-for-shares’ schemes, bringing the share of public sector in oil production from 80% in 1995 to just 13% in 2003-2004, and private oil companies were eager to maximize their profits by expanding production. However, after the biggest oil company Yukos (of Mr. Khodorkovsky) had gone bankrupt, with its assets largely taken over by the state-owned Rosneft, and another big private company Sibneft (of Mr. Abramovich) had been acquired by the state-

129 See, e.g., C. Gaddy and B. Ickes, ‘Russia’s slowing production: policy failure or strategic decision?’, in: Centre for European Reform, Pipelines, politics and power: the future of EU-Russia energy relations, October 2008, pp. 61-70.

183 owned Gazprom, the state share rose markedly, reaching 52% by 2008. This partial (re- )nationalization has reduced the (short-term) profit-maximizing incentives and has hampered the efficiency of the Russian oil sector, thereby contributing to its less impressive performance over the last few years.

Inefficiencies are even more characteristic of the strongly monopolized Russian natural gas sector, which is dominated by the state-owned Gazprom (accounting for over 80% of the Russian and some 20% of the world gas production). Although Russia’s overall gas production has been marginally growing over the last few years, Gazprom’s production has remained fairly stagnant at around 550 bcm per year. The capacity bottleneck is resulting from the massive under-investment in gas exploration in the past years, while the two main fields in Western Siberia – Yamburg and Urengoy, which have so far accounted for more than half of Gazprom’s production – are largely depleted and have reported falling production volumes since 1999.

Figure 3.1.5 Russian natural gas production and exports (bcm)

700 600 500 400 300 200 100 0 2 3 4 5 6 8 9 1 2 4 5 7 03 06 997 000 199 199 199 199 199 1 199 199 2 200 200 20 200 200 20 200

Domestic consumption Exports (net)

Source: US Energy Information Administration and own calculations Units: bcm: billion cubic metres

So far, this decline has been offset by the output growth in the relatively new Zapolyarnoe field, as well as by Gazprom’s takeovers of the so-called ‘independent’ gas producers (such as Purgaz)130. However, according to the projections of the Oxford Institute for Energy Studies, as a result of recent under-investment, Gazprom’s production might plunge markedly in the next decade, to as low as 340 bcm in 2020 – if no new big deposits are put into operation. The latter are on Gazprom’s agenda for the next decade: according to current plans131 production from the new vast deposits on the Yamal peninsula is due to start in 2011 (reaching 140-180 bcm per year),

130 The biggest ‘independent’ producers are Novatek and some large oil companies such as Rosneft, Lukoil, TNK-BP, and Surgutneftegaz. 131 Gazprom, ‘Gazprom v voprosakh i otvetakh’, 2008.

184 while the big off-shore Shtokman field on the shelf of the Barents Sea is to be put in operation132 in 2013. Even assuming these projects are implemented on time (a rather optimistic scenario), there have been increasing concerns – both within and outside Russia – that a gas supply crunch might materialize in the years to come, meaning that Gazprom might not be able to come up with enough gas to meet both its export commitments and domestic needs133.

The current financial crisis puts the possibility of a supply crunch in a longer-term perspective. In the short run, the decline in general economic activity and particularly in industry drives the demand for gas downwards. However, the lower gas export price and lower production volumes (in 2009, according to Gazprom’s own estimates, its production will fall by at least 10%, to 492 bcm) mean less revenue for Gazprom and thus undermine the company’s investment programme134, potentially jeopardizing the timely start of operation of new deposits in the medium and long run, after the effects of the financial crisis on the real economy (hopefully) have died out and global demand for energy picks up again.

The concerns over Russia’s gas supply crunch might be of relevance for the EU, since the current gas pipeline infrastructure (dating back to Soviet times) ties the European consumers to Russia (and vice versa) and makes it difficult to substitute for alternative gas sources. At the same time, there are a number of factors speaking against the ‘supply crunch’ scenario: the possibility of increasing supplies from Central Asia (although for that, the pipeline linking Central Asia with Russia, which was constructed during Soviet times, has to be modernized)135; the sizeable potential for energy saving within Russia as domestic gas tariffs are gradually adjusted to external levels and the economy restructures136; the possibility of reducing leakages from the Russian gas pipeline system and the extent of gas flaring137; and – last but not least – the likely increased readiness of Gazprom to attract foreign capital, technology and know how as the current crisis is biting into the company’s own financial resources.

132 To develop the vast Shtokman deposit, Gazprom has formed a joint venture with Total of France and StatoilHydro of Norway, as it generally lacks relevant expertise in both developing offshore deposits and producing liquefied natural gas (LNG). 133 As demonstrated by Figure 3.1.5, nearly three quarters of Russian gas is consumed domestically (contrary to oil, which is predominantly exported), given that natural gas accounts for over half of electricity generation in Russia. 134 Gazeta.ru, 2 April 2009. Because of the worsened financial conditions, the USD 26.2 billion worth investment programme of Gazprom for this year is planned to be cut by USD 4 billion, largely at the expense of off-shore deposits (except Shtokman). 135 Currently, some 30% of the Russian gas exported by Gazprom represents gas from Central Asia, notably Turkmenistan and Kazakhstan, which is transited via the Russian territory. 136 For 2009, gas tariff hikes of 20-25% are envisaged, and by 2011 domestic tariffs should be broadly in line with the EU levels. The purpose of the measure is to bring down the country’s very high energy intensity by providing energy-saving incentives and inducing the substitution of gas by other fuels, particularly coal and nuclear fuel. In line with the government programme, the share of nuclear energy in electricity generation is to be raised from 16 to 25%, although for that, Russia will have to import even greater volumes of uranium, mostly from Kazakhstan. According to wiiw estimates based on the earlier experience of other Central and East European countries which underwent ‘energy price shocks’ of a similar magnitude, the planned domestic tariff hikes may reduce up to one-quarter of natural gas consumed in the Russian residential sector, thus ceteris paribus freeing up these volumes for exports. Also, the planned modernization and restructuring of industry could bring additional energy savings. 137 According to IEA estimates, some 50 billion cm of gas is being flared away by independent producers facing discriminatory access conditions to Gazprom’s pipeline network.

185 3.1.4 A Russian perspective on the EU-Russia energy relationship The recent price disputes between Russia, on the one hand, and the transit countries Ukraine and Belarus, on the other hand, and the related episodes of disruptions in energy flows to the EU have given additional ground to concerns over the reliability of Russia (and the transit states alike) for the supply of energy and gave rise to aspirations (at least in some EU member states) to diversify the EU energy supplies away from Russia.

Meanwhile, the geographical proximity and the existing pipeline infrastructure largely constructed during the Soviet times largely explain the mutual dependence of Russia and the EU, as far as energy trade is concerned. Currently, all Russian exports of natural gas and a big portion of its oil exports to Europe go via pipelines, although oil is also shipped in tankers from ports on the Baltic and the Black Sea. The exports of gas are typically carried out within the framework of long-term contracts138, often concluded for several decades: these contracts usually only set the gas volumes, while the price is tied via a special formula to the price of oil products, typically with a 4-6 months lag.

Despite the strong mutual dependence in energy trade between Russia and the EU, the extent of bilateral investments in the energy sector has been so far relatively limited. Although Russia signed the EU Energy Charter back in 1994, it has never ratified it, giving ground to claims that the country is not bound by its provisions. This effectively closes the Russian pipeline network to foreign investments;139 besides, the energy sector in Russia is defined as ‘strategic’, imposing official limits on the foreign participation. Similarly, the expansion of Russian investments in the EU energy sector has been generally constrained for political reasons, especially when it comes to investments by Gazprom, which is often (rightly) viewed as the extended arm of the Kremlin.

Still, there are examples of both European investments in the Russian energy sector (such as the already mentioned joint-venture between Gazprom, Total and StatoilHydro to develop the Shtokman offshore gas deposit; the production-sharing agreement Sakhalin-2, involving Royal Dutch Shell; the participation of German EON in the development of Yuzhno-Russkoe gas deposit; and TNK-BP – the second biggest private oil company in Russia) and of Russian energy investments in Europe (the participation of Gazprom in the gas sector of Hungary and Slovakia, in gas distribution networks in Germany and Italy, the acquisitions of Italian refinery by the Russian oil company Lukoil, etc.) Most visible is the cooperation between the Russian and EU companies in the construction of new gas pipelines such as Nord Stream (a joint-venture between Gazprom, EON and BASF of Germany, and Gasunie of the Netherlands) and South Stream (a joint-venture between Gazprom and ENI of Italy).

138 The first Western country to import Russian (Soviet) gas under such a long-term contract was Austria starting in 1967. 139 The only pipeline in Russia not belonging to the Russian state is the Caspian Pipeline Consortium (CPC) oil pipeline from Kazakhstan to the Black Sea port of Novorossiysk.

186

The existing problems of investment cooperation in energy (reflecting ultimately the insufficient level of political trust between Russia, on the one hand, and some of the EU member states, largely those in Central and Eastern Europe, on the other hand) apart, the potential problem areas of institutional nature in the Russia-EU energy dialogue are currently largely focused around three topical issues: (1) the possible creation of a ‘gas OPEC’; (2) the possibility of Russia’s cooperation with OPEC in the current environment of low oil prices; and (3) Russia’s efforts towards diversifying its energy exports away from Europe to Asia.

(1) The existing infrastructure, the still very modest role of LNG (the only Russian LNG from Sakhalin is currently sold to Asian markets rather than to the EU) and the prevalence of long-term supply contracts pre-determine the nature of gas trade between Russia and the EU and limit the chances for creation of any ‘gas OPEC’ – despite the recent statements from some Russian and Iranian officials suggesting that a natural gas cartel (e.g. comprising Russia, Iran and Qatar), which would be able to manipulate prices by adjusting supply volumes, might be in the pipeline. Due to regional fragmentation of the market for natural gas, any worldwide gas cartel is unfeasible, while any cartel confined to Europe would require numerous (and difficult) renegotiations of existing long-term contracts.

(2) Similarly, Russia’s participation in OPEC proper (the oil cartel) is almost equally problematic. The recent history of Russia-OPEC relations has been essentially a history of non-cooperation. Russia has never been an OPEC member, although it holds there a status of observer and at the turn of this century occasionally gave in to OPEC pressure to cut oil exports to stabilize global prices (more often, though, it was ‘free-riding’ on the OPEC production cuts). After 2003, the relations between OPEC and Russia changed fundamentally, as the booming oil prices increasingly exceeded the official ‘price corridor’ targeted previously by OPEC (USD 22-28 per barrel), and the growing oil output by Russia was welcomed by OPEC.

The dramatic turnaround in the world oil market since the middle of 2008 in the wake of the global financial crisis has brought production cuts back on the OPEC’s agenda once again, and OPEC members have been recently pressing Russia to co-operate. Although the recent stagnation of oil output in Russia is effectively playing in the hands of OPEC, as argued above, it has been the outcome of unfavourable technological and institutional developments rather than of deliberate production cuts, at least so far. Apart from certain political considerations (many of the OPEC members are Muslim, while Russia, with its own Muslim population has led its own ‘war on terror’ in Chechnya), the policy of restricting oil supply in Russia might be more difficult to implement than e.g. in Saudi Arabia. As mentioned above, half of the Russian oil industry is privately-owned140 which makes it more difficult (though not impossible) for the government to co-ordinate its efforts with those of the OPEC governments, while the idea of a strategic oil

140 Of the eight vertically-integrated companies dominating Russia’s oil sector, only two – Rosneft and Gazpromneft (the subsidiary of Gazprom) – are majority-owned by the federal government, while another two – Bashneft and Tatneft – are controlled by regional governments (Bashkortostan and Tatarstan, respectively).

187 reserve – put forward recently by Russian deputy prime-minister Igor Sechin141 – is reportedly receiving a cool response from the Russian oil industry.

(3) The EU’s current efforts to decrease its energy dependence on Russia (involving most notably the controversial Nabucco gas pipeline project) are partly mirrored in Russia’s publicly stated aspirations to diversify its energy exports away from Europe – most notably to Asia and particularly China, which is viewed as a potentially huge and fast-growing export market lacking sufficient energy resources of its own. According to the Russian official projections, the share of the Asian-Pacific region in Russian energy exports will rise from 3% to 15% by 2015.

However, this target appears unrealistic for a number of reasons – the recent (in February 2009) launch of LNG exports from Sakhalin to Japan notwithstanding. The Chinese market remains largely untapped, not least because of the currently poor export infrastructure towards China. At the moment, there are no gas exports and only minor oil exports to China (some 0.3 mbd, less than 5% of Russia’s total oil exports), although an oil pipeline linking the fields of East Siberia with the Russian Pacific coast is currently under construction, with a projected branch going to China. The prospects of Russian gas exports to China are less encouraging. At the moment, there are no supplies of Russian gas to China not only because of the missing pipeline infrastructure, but also because of the price disagreement: China has been insisting on a border price well below the break-even price at the Kovykta gas field in East Siberia, which could potentially be the main supply source for China.142

3.1.5 The EU-Russia energy relationship from an EU perspective EU-Russia energy relations are comparatively simple on the Russian side, particularly for natural gas: there is only one company to deal with, as state-owned Russian gas giant Gazprom is by law the only authorized exporter of gas out of the Russian Federation, and it is well-known that important (strategic) decisions involve the highest levels of Russia’s political leadership. On the European side the picture is far more complex. The EU’s gas market is de facto segmented along national lines. In the general case, a member state has a small number of gas companies that operate domestically and that are both importers of foreign gas and distributors to domestic end- users. Competition is therefore limited, while the extent of vertical integration is high. This segmentation is strengthened by the structure of bilateral relations with Russia and other major suppliers, i.e. due to the domination of pipeline-bound imports and long-term supply contracts. This structure yields a lock-in effect which makes liberalization of the EU’s internal gas market difficult to achieve, as a blocking minority143 of member state governments (after lobbying by domestic and foreign energy companies) feels that liberalization would make their situation less favourable.

141 According to a recent statement by Mr Sechin, the country’s oil output might be partly channelled to the specially created state reserve, which could be operated in OPEC-like manner. 142 A higher gas price would be reportedly uninteresting to China, given the availability of cheap coal which could serve as an alternative for electricity generation. Also, the Chinese government which is concerned with national security considerations has announced that it will put emphasis on developing own power-generation capacities based on coal, gas and nuclear fuel rather than on energy imports. 143 As detailed in Zyuzev (2008), the blocking minority in late 2007 / early 2008 was made up of the following eight member states: Germany, France, Austria, Greece, Luxembourg, Slovakia, Latvia and Bulgaria.

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This is what happened when the Commission, supported by several other member states, attempted to introduce ownership unbundling (also called full unbundling or full ownership unbundling) – as well as the ‘third country clause’ – into Community legislation in September 2007 as part of the EU’s 3rd Internal Energy Market package. The idea was to force both EU and non-EU energy companies to split gas distribution activities (i.e. direct sales to end-users) from production and/or imports. Quite naturally full unbundling was to be applied to Gazprom as well. However a coalition against key elements of the reform arose. That coalition was made up of major continental European energy companies (Gaz de France was particularly active), some member states (particularly France and Germany) as well as Gazprom and the Russian government, and it was therefore somewhat predictable that the proposals would be watered down, see e.g. Christie (2007).

The compromise solution currently under discussion foresees giving each member state a choice between three options: full ownership unbundling, independent system operator (ISO) and independent transmission operator (ITO). The ISO option allows the energy company to retain ownership of transmission and distribution systems, though these must be operated by an independent entity. The confusingly named ITO implies only modest change for vertically- integrated energy companies: they may continue to own and operate both mid-stream and downstream assets, but under certain supervision and compliance conditions. The key result is that member states will not be forced into full ownership unbundling, nor will there be a third country clause controlled by the Commission. Instead, only those member states who opt for full unbundling will apply the unbundling clause to third countries. In all likelihood, therefore, Germany, France, Austria and other like-minded countries will continue to allow some downstream investment on the part of Gazprom, while attempting to negotiate with the Russian Federation on a bilateral basis about upstream investments in Russia (see previous section for examples). In other terms, the already emerging pattern of privileged relations between Russia and the aforementioned member states will continue without major changes. The key outstanding question is which member states will opt for full unbundling, which would lead to forced sales of Gazprom downstream stakes in those countries. More generally, the EU is evolving towards a cementing of existing market segmentation and a confirmation of the primacy of bilateral relations with Russia over relations between Union-level institutions and Russia.

The Second Strategic Energy Review144 is another major institutional development on the EU side. The Commission has developed a comprehensive vision for improving the EU’s energy security position and the EU’s internal energy solidarity. The main areas to be developed are: infrastructure and diversification; external energy relations; oil and gas stocks and crisis response; energy efficiency; and better use of indigenous (EU) energy resources. Many aspects of the Review have the prospect of further disruptions of Russian supplies firmly in mind, and the particularly vulnerable New Member States occupy a place of choice in the Commission’s vision for infrastructure investments. The most relevant components are the Baltic Interconnection Plan, the North-South gas and electricity interconnections within Central and South-East Europe, and,

144 See ‘An EU Energy Security and Solidarity Action Plan’, COM(2008) 744/3.

189 implicitly, the LNG Action Plan. The necessity for such investments was clearly illustrated by the heavy economic losses145 incurred by Bulgaria during the latest supply cut-off in January 2009, when the Russian Federation decided to halt all deliveries through the Ukrainian Corridor. Bulgaria suffered from a particularly unfavourable combination of circumstances: it has no other source of supplies and low storage capacity and, as a result, it had a very low security stockholding at a time of high demand (low winter temperatures). Investment in interconnections with neighbouring countries, as well as with other sources of supplies (for example LNG, whether the terminal is in Bulgaria or elsewhere in the region) would therefore seem useful. Increased storage capacity would also be attractive, though quite costly. All in all, there is strong political demand in the New Member States for such investments and strong support for them by the Commission. The key question is financing. At present only a very modest budget allocation is foreseen for the infrastructure investment part of the Review: a part of the TEN-E budget, which currently amounts to 22 million Euros per year. The scope of the vision described suggests that costs would be several hundred times higher than that figure. While more financing from joint EU budgets may be possible, the bulk of the effort will probably have to come from the individual member states. In this respect the case of the Czech Republic’s investment in a new oil pipeline from Ingolstadt (Germany) in the 1990s offers an important lesson for other New Member States. As a result of that investment, the Czech Republic was able to weather a substantial cut in Russian oil supplies in July 2008 without incurring substantial losses, see e.g. Socor (2008).

However the January 2009 gas supply disruption did more than just strengthen the case for pre- existing policy objectives: it led to a strategic decision on the part of the European Commission to intervene and invest directly in the upgrade and expansion of the transit capacity of the Ukrainian Corridor. The Joint Declaration146 signed on 23 March 2009 between the European Commission, the Government of Ukraine, the EBRD, the EIB and the World Bank is far-reaching. It represents a major new development in the EU-Russia energy relationship, and a truly significant EU external energy policy intervention of a kind that had so far been lacking, see e.g. De Jong and Van Der Linde (2008). Most importantly, the agreement is a potential win-win solution for the EU-Russia relationship. It is favourable for Russia if one assumes that the Russian side is only interested in commercial profits. Indeed, the risks inherent to transit through Ukraine have been uneasily split between the EU and Russia so far. By moving into the Ukrainian gas system and purchasing gas directly at the Russian border, EU companies would take on the responsibility of dealing with the Ukrainian partners (including negotiating and paying transit fees). In other terms the transit risks will be entirely taken over by the EU, a solution which is clearly preferable than the status quo for both parties. Ultimately Ukraine should turn into a more reliable transit country and ultimately make transit avoidance pipelines such as Nord Stream and South Stream unnecessary, while posing no threat to Russia’s market shares in the EU, in Ukraine or elsewhere. From the point of view of the EU as whole the agreement is also very favourable, as the option of upgrading the Ukrainian Corridor is less costly than other options, also given the fact that a

145 An estimate of 250 million Euros (roughly 0.9% of GDP) was cited in the media, see e.g. ‘Bulgarian president to talk gas compensation during Russia visit’, RIA Novosti, 2 February 2009. This is a considerable economic shock given that the absence of supplies lasted only 2 weeks. 146 Available from: http://ec.europa.eu/external_relations/energy/events/eu_ukraine_2009/index_en.htm

190 broader set of member states and energy companies will have an interest in sharing the cost burden than is the case with other pipeline projects. In a more general sense, a clear distribution of transit risks will also be far preferable for the EU side in general and should considerably reduce the likelihood and severity of supply disruptions through the Ukrainian Corridor.

In spite of these elements, however, the Russian Federation has strongly criticized the EU- Ukraine agreement, and has in essence argued that it makes little sense to make far-reaching decisions on gas transit infrastructure without the agreement of the supplier, in this case Russia, see e.g. CEPS (2009). In particular, Prime Minister Putin has suggested that Russia may not agree to supply Europe through the Ukrainian Corridor to the extent that the EU-Ukraine agreement implicitly foresees. At the time of writing it was difficult to predict any final outcome. However the following framework may be useful. In theory it is possible for a coalition of the EU and Ukraine to impose a transit solution on the Russian Federation where the only options that would remain for Russia would be compliance or exit, i.e., either accept the transit agreements or substantially reduce EU-Russia gas trade volumes by diversifying supplies away from Europe. However if the EU-Ukraine coalition crumbles, Russia would regain leverage by using bilateral solutions with individual EU member states instead. The key question, therefore, is whether the EU-Ukraine coalition will hold, or whether a blocking minority of EU states (not necessarily in the sense of Council votes) will break ranks and privilege bilateral energy relations with Russia instead. Germany has already signalled some support for the Russian position. A process resembling what occurred with the ownership unbundling debate can therefore not be ruled out. The key unknown in the public domain is the extent to which member state governments are committed to the vision underscoring the EU-Ukraine agreement.

191 3.2 Biofuels and the EU-Brazil energy relationship

3.2.1 Biofuels and biofuels trade Bioenergy is among the renewable energy sources often considered to play a key role in the short run to reduce carbon emissions, improve global energy efficiency, and exploit less carbon intensive energy sources. It is generated from organic substances usually referred to as biomass. The feedstocks for bioethanol are starch and sugar, whereas biodiesel is based on vegetable oils derived from oilseed crops. Bioenergy provides about 10% of the world’s total primary energy supply.147 A full 97% of biofuels are made of solid biomass, 71% of which used in the residential sector (FAO, 2007). However, growth in demand for biomass used to generate gaseous and liquid fuels has been significant over the last ten years.148

Four key factors drive the current interest in bioenergy: high energy prices, in particular oil prices; energy security; climate change; and rural development. The rural development factor is more central to the BRICs and developing countries, and it is often aligned with a poverty alleviation agenda.149

Global production of biofuels amounted to 62 billion litres or 36 million tons of oil equivalent (Mt) in 2007 – equal to about 1.8% of total global transport fuel consumption in energy terms. Brazil and the United States account together for almost three-quarters of global biofuels supply.

The share of biofuels in total transport-fuel demand in 2007 was about 20% in Brazil while in the US it represented only 3% of transport fuels. In the EU consumption of biofuels for transport was less than 2%, although the shares in a few individual Member States such as Germany and Sweden were higher.150 Regarding bioethanol, total world production reached 51.3 billion litres in 2006. The United States was the leader in global production with an output of 20 billion litres. Brazil was the world’s second largest producer with an output of 17.8 billion litres of bioethanol derived from sugar cane.151 Bioethanol production in 2006 for Asia was recorded at 6.5 billion litres with China and India as regional leaders, whereas Malaysia and Indonesia have started substantial biodiesel programmes. In the EU, fuel bioethanol production was 1.6 billion litres in 2006.

147 Bioenergy contributed to the total primary energy supply (TPES) by almost 30% in the case of Brazil and India from 1995 to 2005. In the UK and Russia its contribution was a meagre 1%, while for Canada, France, Germany and US it accounted for between 3% and 4% of TPES (FAO, 2007). 148 Nevertheless liquid biofuels are likely to replace only a small share of global energy supplies and cannot alone eliminate world’s dependence on fossil fuels (FAO, 2008). 149 Several developing countries have specifically targeted poor households and small farms in setting up biofuel programmes. 150 In 2007 the International Energy Agency (IEA) projects that biofuels will meet 2.3% of world road-transport fuel demand by 2015 and 3.2% by 2030 (Zuurbier and van de Vooren, 2008). 151 In 2007 those two countries remained the world’s largest bioethanol producers with 48% and 31% (18 billion litters) of global bioethanol production, respectively, while the European Union accounted for about 60% of global biodiesel production (OECD, 2008).

192

Most of the bioenergy consumed in G8 and BRIC countries is produced locally. For example, international trade in bioethanol represented just 9% (a little less than 5 billion litres) of global bioethanol production in 2006 (OECD, 2008). Nevertheless, specialists consider that bioethanol can be one of the fastest growing markets in the next thirty years, with the US and other countries being expected to substitute up to 15% of its domestic demand for gasoline by bioethanol in one decade (Tripartite Task Force Brazil, EU and the US, 2007).

The volume of bioethanol traded worldwide grew to around 7.8 billion litres in 2006, compared with 5.9 billion in 2005 and 3.2 billion in 2002 (see Table 3.2.1). The rise is mostly attributed to the noticeable increase in trade reported in Brazil when 2006 exports reached 3.5 billion litres, up 0.9 billion litres from 2005, a threefold increase over 2002 figures. Despite record levels of shipments from Brazil, the world market share of the North and South America remained around 60%, while Asia-Pacific gained market footing to 17%, up 7% from 2005. European exports accounted for less than 20% of the world market while Africa contributed 4% of all bioethanol shipments (Table 3.2.1a).

Table 3.2.1a World Bioethanol Exports (2002-2006) Region / Year 2002 2003 2004 2005 2006 bn bn bn bn bn litres % litres % litres % litres % litres % Total Americas 1.48 46.0 1.57 41.2 3.20 64.5 3.54 59.7 4.66 59.7 Total Africa 0.18 5.6 0.20 5.3 0.17 3.4 0.38 6.4 0.33 4.2 EU 0.90 28.0 1.09 28.6 0.98 19.8 1.26 21.3 1.31 16.8 Asia 0.58 18.0 0.84 22.1 0.50 10.1 0.61 10.3 1.34 17.2 World 3.22 100 3.81 100 4.96 100 5.93 100 7.81 100 Source: FAO (2007) and own calculations Units: (1) billions of litres; (2) per cent

Table 3.2.1b World Bioethanol Imports (2002-2006) Region / 2002 2003 2004 2005 2006 Year bn % bn % bn % bn % bn % litres litres litres litres

Total 0.86 30.1 1.32 38.8 1.59 34.4 1.57 29.4 3.72 51.0

193 Americas Total Africa 0.09 3.2 0.10 2.9 0.16 3.5 0.22 4.1 0.15 2.1 EU 1.05 36.7 1.13 33.2 1.60 34.6 2.00 37.4 2.36 32.4 Asia 0.86 30.1 0.86 25.3 1.25 27.1 1.55 29.0 1.05 14.4 World 2.86 100 3.40 100 4.62 100 5.35 100 7.29 100 Source: FAO (2007) and own calculations Units: (1) billions of litres; (2) per cent

In contrast, the US imported more than half the bioethanol traded. Of the 2.7 billion litres imported by the US, about 1.7 billion litres were imported directly from Brazil, while much of the remainder was imported from countries which are members of the Caribbean Basin Initiative (CBI) and which enjoy preferential access to the US market.152 These countries in turn import (hydrated) bioethanol from Brazil, dehydrate it and re-export to the US (OECD, 2008).

Many different forms of policies and support are provided at various stages of biofuel production around the world.153 Nonetheless, three major categories of support can be identified: (i) budgetary support measures: either tax concessions for biofuel producers (refineries), retailers or users, or direct support to biomass supply, biofuel production capacities, output, specific infrastructure or equipment for biofuel users; (ii) blending or use mandates,154 which require biofuels to represent a minimum share or quantity in the transport fuel market; and (iii) trade restrictions,155 mainly in the form of import tariffs, which protect the less cost-efficient domestic biofuel industry from competition from lower-cost foreign suppliers.

Analysing the impact of those policies, OECD (2008) finds that, globally, the use of biodiesel is much more dependent on public support than the use of bioethanol. Without support, world biodiesel use would be cut by half and bioethanol use would decline only by 14%. In particular, biodiesel demand in the EU and the US would be reduced by 87% and 55%, respectively. Therefore, OECD (2008) shows that biofuel support policies remain crucially important in many countries. A removal of these policies would substantially affect the (private) profitability of biofuel production and use in those countries where production costs are particularly high. Bioethanol production would be less affected given the more efficient industries in the US and in particular in Brazil, even without public support. In contrast, world biodiesel production (dominated by the EU industry) would decline by more than a quarter after removal of all support policies and grow much more slowly thereafter.

152 In 2006, total imports from CBI countries in the CBI Group amassed to 780 million litres or 77% of the total tariff rate quota, which was an improvement of 43% in 2005, and 37% in 2004 (OECD, 2008). 153 OECD (2008) estimates support to the US, EU and Canadian biofuel supply and use in 2006 at about EUR 8.76 billion per year, projected to rise to EUR 20 billion in the medium term. 154 In 2002, China started a program to promote production and use of fuel bioethanol by mandating the blending into gasoline in several big cities. A compulsory use of a 10% blend was introduced in several provinces in October 2004, and extended to 27 other cities in 2006. In India, the government set a 20% biofuels consumption target for 2017. 155 Countries with large markets (the United States, Japan and the EU) present a major constraint to exporters since they are completely or partially inaccessible due to trade barriers.

194 Even without a removal of domestic support policies, a liberalization of trade in biofuels could have significant effects. Although global production and use of biofuels would change only little, an elimination of import tariffs would cause higher bioethanol prices in international trade and some relocation particularly of bioethanol production and use across countries, with increased exports particularly from Brazil balanced by higher imports from the US, Canada and particularly from the EU. In consequence, production of grain-based bioethanol would decline, while cane- based bioethanol would expand.

Regarding biofuels international arrangements and agreements, in February 2007 a conference was organized by the European Commission and the European Committee for Standardization (CEN), with the active participation of the U.S. National Institute of Standards and Technology (NIST) and the Brazil’s National Institute of Metrology, Standardization, and Industrial Quality (INMETRO). In this meeting the participants identified that differing standards for biofuels were another potential handicap to the free circulation of biofuels among the three regions.

Subsequently, the International Biofuels Forum (IBF) – a governmental initiative among Brazil, China, the European Commission, India, South Africa, and the United States – was launched in March 2007 to promote the sustained use and production of biofuels around the globe. The IBF also concluded that trade will play an increasing role in providing adequate supplies of biofuels to the markets where the energy demand for transport fuel is rising at an accelerated rate. A Biofuels Standards Roadmap was then developed in April 2007 that delineated the necessary steps that needed to be undertaken by the U.S., Brazil, and EU to achieve greater compatibility among existing biofuel standards. Particularly concerning trade regulation, the WTO does not have yet a trade regime specific to biofuels: trade in those products falls under the rules of the General Agreement on Tariffs and Trade (GATT 1994), as well as under the rules of other relevant WTO Agreements.156

Finally, regarding the environmental impacts of biofuels, OECD (2008) finds that bioethanol based on sugar cane generally reduces GHG emissions by 80% or more over the whole production and use cycle, relative to emissions from fossil fuels. In contrast, biofuels produced from wheat, sugar beet or vegetable oils rarely provide GHG emission savings of more than 30% to 60%, while corn (maize) based bioethanol generally allows for savings of less than 30%. However the current total effect on emissions is minor. Given current budgetary support, mandates and trade restrictions, current biofuels use reduces net GHG emissions by less than 1% of total emissions from transport.

156 According to some WTO members, renewable energy products - which could include bioethanol and biodiesel and related products, such as parts and components of biodiesel and bioethanol plants and ‘flexi fuel’ engines and vehicles - could be classified as environmental goods, and, therefore, could benefit from Paragraph 31 (iii) of the Doha Development Agenda, which may eliminate tariffs and non-tariff barriers to environmental goods and services.

195 3.2.2 Biofuels in the European Union The main biofuel produced in Europe is biodiesel, representing 80% of the production.157 Europe is the world’s biggest producer accounting for almost two-thirds of world output, although biodiesel use varies from country to country. Germany, France and Italy are the largest biodiesel producers and users.

The biofuel sector has undergone very rapid growth with a 28.2% annual production increase since the year 2000.158 In 2005, 3.9 million tons of biofuel were produced. In 2006, the production of biodiesel was of 6 million tons. More than half of this value comes from Germany (52.4%) that gives tax incentives for its production. The main feedstock used is rapeseed (about 80%). The rest is mainly obtained from sunflower oil and soybean oil. Besides liquid biofuels and the use of solid biomass, biogas is also a growing market in the EU. Biogas production reached nearly 5.3 million tons oil equivalent in 2006, representing a 13.6% increase with respect to 2005 (Schlegel and Kaphengst, 2007). Bioethanol accounts only for 18.5% of total production of biofuels. In the EU, it is produced from cereals and beet. In 2007 EU’s production of bioethanol increased to 1.6 billion of litters. France is the largest producer in the EU followed by Germany.

Total exports of bioethanol from the EU rose to 1.31 billion litres in 2006 (Table 3.2.1a). In that year France was the largest European exporter with a total of 320 million litres. Spain was the second largest with a more than fivefold increase of shipments to almost 190 million litres due to domestic oversupply. The European Union also represents the second-largest import region, with about half of its 2006 imports originating from Brazil. The EU imported more than 250 million litres of bioethanol during the period 2002-2004 with 30% of this volume imported as normal Most Favoured Nation trade and subject to specific import duties. Germany was the largest importer of bioethanol in 2006 with 430 million litres. With a trend of growing imports and the largest gasoline market, Germany is likely to continue to be the most active bioethanol consumer in the coming years in the region. Sweden also realized a growth in its bioethanol imports with total arrivals of 257 million litres in 2006, compared to 169 million litres the year before.

Currently, locally produced biofuels are not cost-competitive in the EU. Consequently, the competitiveness of EU-produced biofuels will depend on subsidies and in the case of bioethanol on import tariffs as well. EU’s biofuel legislation consists of three main Directives. The first pillar is Directive 2003/30/EC for promotion of biofuels market in the European Union. In order to encourage biofuel use competing against less costly fossil fuels the Directive set a voluntary ‘reference target’ of 2% biofuel consumption (on the basis of energy content) in 2005 and 5.75% by 31 December 2010. It obliged Member States to set national indicative targets for the share of biofuels, in line with the references of the Directive, although leaving them free to choose a strategy to achieve these targets.159 The second pillar is Directive 2003/96/EC, which allows application of favourable tax deduction on biofuels. The third pillar relates to environmental

157 One of the reasons for the large share of biodiesel is that the majority of the cars in the EU use diesel. 158 Between 1994 and 2005 production increased more than 20 times. 159 Member States must also report to the European Commission before 1 July of each year on the measure taken to promote the use of biofuels and, if needed, the reasons why the targets have not been met.

196 specifications for fuels indicated in Directive 2003/17/EC. It set limits on biodiesel blending to no more than a 5% share by volume for technical reasons. This directive was recently revised to help reaching the 5.75% target by 2010 of Directive 2003/30/EC.

A new Directive on Bioenergy, published as a Commission Proposal in 2008, includes an increased and mandatory target of 10% of transport fuels to be replaced by biofuels by 2020. Furthermore, the Directive states minimum requirements for biofuels receiving public support and accounting to the mandatory incorporation share with respect to several sustainability criteria including, among others, their life-cycle greenhouse gas balances.

Two main types of subsidies are provided from the EU to support the biofuels industry and foster consumption in Member States: tax exemptions on biofuels and subsidies to agricultural producers given within the Common Agriculture Policy framework. Tax concessions are another measure widely applied in EU Member States. These concessions partly result in biofuels sold with not excise tax in some countries, while tax rates are reduced in others. Differences are partly made between biofuels used in low-level blends with fossil fuels and pure biofuels. On average, the tax for bioethanol and biodiesel is about 50% lower than the rates for gasoline and fossil diesel (OECD, 2008).

Nevertheless, the EU will not have the required available cultivation area, and therefore not the sufficient feedstocks, to reach a 6.6% biodiesel blend by 2012. In addition, the costs associated with the production of biodiesel in the EU are still high. So, all these factors should promote a larger proportion of biodiesel or vegetable oil imports in the EU.

The main imports would be rape and sunflower oil because the use of soy and palm oils are restricted by EU biodiesel production standards. Rape oil is primarily exported by developed countries (Canada, the U.S.) and China. But sunflower oil might be imported from Argentina, Russia, and Ukraine. Limited quantities of palm and soy oil will be imported from Indonesia, Malaysia, Argentina, and Brazil. The EU will also need to import vegetable oils for human consumption in substitution for rape oil used for biodiesel. Jank et al. (2007) see in this category the major export opportunities for developing countries.

3.2.3 Biofuels in Brazil Over the last 30 years, the use of bioethanol as a substitute for gasoline has accounted for savings of over one billion barrels of oil equivalent, which corresponds to about 22 months of Brazil’s current oil production.160 Its use during the period from 1970 to 2005 also avoided the emission of

644 million metric tonnes of CO2. Accordingly, the Brazilian energy mix is one of the cleanest in the world and according to FAO (2007) currently more than 45% of all energy consumed in Brazil comes from renewable sources, reflecting the combined use of hydroelectricity (14.5%), and biomass (30.1%).161

160 Only in the last eight years, the savings in oil imports were of approximately EUR 48.5 billion. 161 See also Poplawski Ribeiro and Sgard (2008).

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In 2005 bioethanol represented 40% of the light fuels consumed (gasoline plus bioethanol). The use of sugar cane in the internal renewable energy supply also increased from 31% in 2005, to 32.2% in 2006, representing 14.5% of total internal energy supply (Jank et al., 2007).

In 2005, 320 sugar and bioethanol mills existed in Brazil, with a total installed processing capacity in excess of 430 million tonnes of sugar cane. Together they could produce up to 30 million tonnes of sugar and 18 billion litres of bioethanol.162

Furthermore, that industry employs a substantive number of workers in Brazil. Although mechanization is gradually reducing employment in sugar cane plantations, the sugar and bioethanol industry provides one million jobs, and at a higher rate of pay than the rural average (Martin, 2007).

The country has also received a huge inflow of FDI in this sector. From 2002 to 2007 more than EUR 1.6 billion were invested by foreigners in the Brazilian bioethanol sector. Foreign investors participated in 12% of the sugarcane production processes in 2006/2007 compared to the previous year when they only participate by 5.7% (Ramos, 2007).

Before the financial crisis, investments around EUR 6.5 billion were expected for the coming years. The foreign groups already present in the domestic market are the Argentinean group Adeco Agropecuária, the Americans Cargill and Globex, the Noble Group (with headquarter in Hong Kong), the French groups Tereos and Louis Dreyfus163, the Spanish Abengoa, and the group Infinity Bio-Energy (a foreign fund with stock negotiated in the London Stock Exchange). Moreover, the French group Bioenergy Development Fund (BDF, which has as partner the Bank Société Générale) has started projects in the country as well.

Nevertheless, the current global financial crisis has slowed the expansion of projects in the Brazilian sugar and bioethanol sector. According to Agra FNP (2008), until November 2008, 47 new mills projects have been put back. The sector also faced lower prices in the 2007/8 harvest, shrinking its profit margins. Yet, the most recent projections show that bioethanol consumption and export will more than triple in the coming ten years (see Table 3.2.2).

162 The Brazilian regions that produce sugarcane are the North/North-East (15% of sugarcane production) and the Center/South (85% of sugarcane production), especially concentrated in the São Paulo state (60% of sugarcane production) (see Ramos, 2007). 163 In 2008 the group Louis Dreyfus invested more than EUR 290 million in the acquisition of a bioethanol mill in Brazil able to produce 4.5 million of tons of sugar cane.

198

Table 3.2.2 Projected consumption and exports of Brazilian ethanol Ethanol, millions of litres 2006 2018 Consumption 12,295 40,908 Share in private transportation 40% 54% Exports 3,502 13,700 Source: Nassar et al. (2008)

Moreover, bioethanol use is still supported by tax reductions in the country, and benefits from other advantages in a complex tax system, both on federal and state levels. Blending of bioethanol to gasoline fuels is regulated, with a required bioethanol content of between 20% and 25% bioethanol depending on government decision (which itself depends on market conditions). A 2% blending of biodiesel to diesel fuels from 2008, and a 5% blending from 2013 has also been mandated recently.

Rothkopf (2007) develops four pillars as a new challenge for the future Brazilian leadership. The first one is related to innovation. Brazil needs to attract new investors. At the same time, the country should also sell technology, expertise and knowledge through different collaboration projects with other countries. The second pillar corresponds to the enlargement of Brazilian production capacity. Biofuels production capacity in Brazil is growing at a lower rate, compared to its competitors. The challenge is to expand production in an environmental sustainable way. The third one talks about infrastructure improvement. The last pillar is to build up an international market such as the domestic one. Brazil should attempt to harmonize biofuels commodity standards, reduce institutional and regulatory barriers in order to achieve of potential international trade in biofuels.

Answering to the previous challenges, the Agricultural Ministry of Brazil presented the Plano Nacional de Agroenergia 2006-2011. This plan is based on the exploitation of the Brazil advantages: the possibility to increase non-alimentary agriculture without harming agriculture oriented to food sectors; climatic advantages for the bioenergy production (high level of sun radiation); modern technology and very dynamic biofuel sector; great domestic market; very competitive sector in the world market (EMBRAPA, 2006).164

Brazil has also received large investments and established cooperation relations with the EU in R&D. In 2004 the EU and Brazil signed a scientific and technological cooperation agreement that could facilitate exchanges on biofuels (Rothkopf, 2007). Further, Brazil is offering support to India to produce bioethanol and the two countries signed an agreement in September 2006 to increase cooperation. The Brazilian government believes that increasing the number of suppliers in developing countries will expand the global bioethanol market (IEA, 2006).

164 Petrobras, for example, is planning to invest in 20 bioethanol plants with the objective to product 4 billion litters in 2012, not only to respond to the increasing domestic market but also to intensify bioethanol exports to Japan and the United States.

199 3.3 Conclusions and policy discussion

Taking the constraints of external energy policy, environmental policy and global energy markets as given, the key for the competitiveness of EU firms and industries is to have reliable access to energy resources from a competitive internal energy market. Reliability inside the EU is best promoted by a combination of sufficient interconnection infrastructure and clear price signals that can convert supply shocks into price shocks, thus naturally incentivizing redistribution of scarce resources. In other words, the EU needs an integrated and competitive internal gas market. While ownership unbundling will not be universally adopted in the Union for the moment, further steps to foster competition and transparency in natural gas distribution would be helpful. The general policy debate on this issue is ongoing, see e.g. Noel (2008) and Buras and Graetz (2009).

More broadly, the key problem so far with respect to the EU’s nascent energy policy has been the extent to which member states have defined completely different and separate national energy strategies in the past and, to some degree, continue to do so. This has prevented the emergence of a strong and, most of all, coherent external energy policy, notably with respect to Russia, but also with respect to other actual or potential suppliers, for instance Iran. In this respect it may be interesting to consider whether non-standard forms of policy coordination and formulation between member states could be useful. For instance, German conservative politician Eckart von Klaeden (CDU) has suggested the creation of a special steering committee to deal with EU-Russia relations. The steering committee he suggests would include Germany, France, Italy, the UK and Poland. This composition would be sufficient to represent all the major EU viewpoints, and should in principle operate considerably faster and more efficiently than a discussion among all 27 member states. Other arrangements could be considered as well, based on the same type of reasoning, i.e. improving the effectiveness of the policy formulation process while reducing the scope for strictly national interests to prevail over collective EU interests. Energy relations with Brazil, while considerably less controversial, should also be part of that discussion. Member states are already significantly different from one another in terms of their interest in renewable energy in general and in biofuels in particular. External energy policy coordination will therefore be necessary for EU-Brazil relations as well.

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