Customs Union: the next great trading blocPavel Melnikov

Grayling Russia

Summary

July 1, 2011 Russia, Kazakhstan and Belarus will embark on a customs union that touches the borders of both Europe and China. Goods will move freely from country to country and the economies of the three countries will be subject to unified basic regulation.

This is the start. Kyrgyzstan, Tajikistan and Uzbekistan may join the Union soon.

If it sounds familiar, so it should for it was in 1958 that six countries formed the European Economic Community, later rebranded as the European Union, now with 27 member states that, between them, make up a quarter of the world’s GDP.

Is this the future of the Russo customs union? Time will tell but it is reasonable to suggest that Russia’s long term game plan is to create a trading bloc that can compete with Europe, America (meaning NAFTA of course), and China/Japan. Whether that game plan comes to fruition depends on many things, including continuing reform, investment in infrastructure, a reduction in social security contributions, and less corruption. It also, to a considerable extent, depends on the stability of Russian government.

The ultimate prize is Ukraine. Which way will she jump? It will take many years but we expect Ukraine will probably become part of the Russo customs union, which we would expect to operate more along the lines of NAFTA than the EU. Indeed, it was recently announced that Ukraine is trying to negotiate a free-trade agreement with the Union. We expect Russia to become more aggressive on disputes over gas supplies, as leverage to force Ukraine into the Union.

Long term the political and economic impact of the nascent Customs Union has the potential to be very significant.

In the shorter term, there are trade opportunities, but also some meaningful risks.

Indeed we expect the next 1-2 years to present major challenges to foreign investors, mostly in Russia.

Constant regulatory monitoring will be vital as change may come fast and unexpectedly, and it will be vital to maintain or build strong relationships with local regulators and people of influence.

Opportunities

Free movement of goods. Goods produced in Kazakhstan, Belarus and Russia are supposed to move freely within the Union. Generally this will happen, but there will be some complications, including some stipulated by the Union’s regulations.

Certificate of origin of goods will eventually be eliminated. Again, we urge caution, because this has not come into effect yet..

Customs duties and taxes are paid in four months (instead of 15 days). Alterations to customs declarations can be made before and after the manufacturing of goods. This, we believe, could be very helpful for trade.

International firms contemplating localizing in Russia might consider other options, namely Kazakhstan or Belarus. Theoretically, this is possible. Belarus, for example, has a very low cost of labor. Realistically, however, it makes no sense to manufacture for Russia in Belarus or anywhere else now. Investment in Russia is at least as much political as it is economic. Companies, especially large operations, need federal and provincial goodwill if they are to avoid business disruption. In 10, 15 or maybe 20 years the situation might look different. Today its value is more theory, but it can be used as an argument when negotiating terms of investment with the Russian authorities.

We do know of one large multinational that is closing down all of its Russian operations and will ship from its factory in Kazakhstan. Technically there is nothing to prevent this. At this time, however, we judge it to be a courageous decision.

If the cupboard seems a little bare, that’s because it is. This is the start of a very long process that will take decades to conclude but, for those companies with strong regulatory oversight and connections, opportunities do exist and can be leveraged.

Risks

There are national and supranational bodies for managing and addressing customs-related issue and it is not yet clear where the real power will lie. This complicated management structure makes the possibility of corruption-related interference quite possible.

Some countries -- Belarus is most likely -- may increase protectionism under the guise of hastily produced technical regulation intended to ease the Customs Union. Some FMCG companies have already discovered, for example, that package sizes are redefined to suit local producers and fence off foreign competition.

There is also some evidence to suggest that food & beverage manufacturers in Russia -- both local and international -- may face some challenging new additive regulations, again dressed as a Customs Union issue.

The question of WTO membership has not been settled and have the potential to disrupt Union harmonization.

WTO accession talks with Russia have been on again, off again for 17 years. There is some reason to think that there is now a chance for real progress. As our office in Washington D.C., Dutko-Grayling, reports, President Obama seem to have made a personal commitment to do so. However, there are some difficult bi-lateral issues concerning industrial assembly regimes, intellectual property, agricultural subsidies and veterinary and sanitary control. .

Ultimately, Russia accession to the WTO requires a vote by the US Congress, which would have to amend the Jackson-Vanik amendment to make it possible for the US to support Russia's membership.

Recent comments made by Dmitry Medvedev and Economics Development Minister Elvira Nabiulllina suggest that Russia has assumed a “now or never approach”, claiming that it has already done many things and is not ready to make every possible trade-off to access WTO.

There are differences in regulating advertising in the countries. This need not be a problem. It took the EU years to get around to regulating advertising. We doubt much will change here soon, though it remains a possibility.

Common antimonopoly legislation might bring some unpleasant surprises such as an instant monopolistic position for some companies. Again, we would rate this as low risk. There are far easier ways to disrupt business.

Intellectual property rights are not developed even in the framework of countries separately, let alone in the Customs Union. This remains a major problem. In time, the Customs Union might force the countries to address the issue.

An accelerated pace of adopting new legislation, in order to comply with the requirements of the Customs Union, will almost certainly result in many omissions and discrepancies -- in other words, bad legislation. The unified Customs Code, itself, has hundreds of referrals to national codes because of unresolved issues between the three countries. We present some other cases in Appendix 1

Different indirect taxation rates may cause additional difficulties and create grey areas such as transit through Kazakhstan. With the entry of the Customs Code into force, member states are not expected to change indirect taxation rates, which are likely to be left at 12%, 18% and 20% for Kazakhstan, Russia and Belarus correspondingly.

This is unlikely to change in the near term. While the EU has a minimum VAT rate, member states are free to set higher levels, and do.

Adopting technical regulations in the interests of all the parties concerned is difficult given that Russia would have to adopt numerous Kazak regulations that are not necessarily in the economic interests of Russia.

Realistically, however, we expect most of the momentum to come from Russia.

Such prospects as the free movement of labor and capital should be finalized by July 2012, while a common currency is more of a long-term question. By way of a comparison, the Euro was introduced when overall trade turnover within the union reached 64%. Today, the trade turnover of Russia with both Belarus and Kazakhstan represents less than 8% of trade with other countries.

Politically we suspect that Russia would like the ruble to be adopted by all members of the Union. How soon this might happen is impossible to quantify, but not in the next few years.

Recommendations

It is difficult to navigate in this complex changing environment. However, there are a number of simple things that we stick to in consultations with our international clients.

It makes sense to proactively explore all potential opportunities of the Customs Union. However, one should consider implementing a form of 360’ analysis, evaluating and prioritizing external risks vs. opportunities to fully comprehend how the Customs Union can influence your business.

Informally and regularly engage with national stakeholders to discern any early threat of protectionist technical regulation and other measures limiting access to the market and the ability to operate day-to-day.

We do believe it makes sense for FDIs to negotiate better conditions on site selection within the territory of the union, taking into account opportunities for further expansion.

It is clear, however, that any such negotiations would require substantial skill in terms of navigating through political and “soft” arguments of local government officials.

Implications for the national

economies

Kazakhstan. Participation in the

Customs Union (CU) has it benefits

for Kazakhstan since it has limited

access to the high seas and its

export relies on its neighbors,

especially when oil and gas are

concerned.

Moreover, Kazakhstani key export

partners are already China (16.3%),

the EU (about 50%). Import partners

are nearly the same Russia (28.5%),

China (26.7%), the EU (27%).

Belarus. Belarus is currently in the

midst of financial crisis and heavily

relies on Russia in export (33.6%)

and import (56.42%). To say nothing

about the oil duties removed in

December 2010, when Belarus,

Russia and Kazakhstan formed a

Common Economic Space. The CU

is a one way ticket for President

Lukashenko giving him some

additional political and economic

leverage to keep himself in

Presidential post as long as

possible.

Russia. The CU cannot substantially

change the structure of Russian

export-import operations, since the

EU (more than 55%) and China

(5.7%) are also Russian key export

partners. The same is true for

Russia’s imports: the EU (46%) and

China (14%).

About Grayling

Grayling provides public, government and investor relations services to clients, including major foreign investors, active in Russia, Belarus, Kazakhstan. We have offices in 70 locations in 40 countries across Europe, the US, the Middle East and Asia Pacific. We are the second largest independent PR firm in the world. Grayling is part of Huntsworth plc. Further information can be found at www.grayling.com

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Appendix 1: Unresolved Regulatory Issues Within the Customs Union

Country of origin of the products

‒ At present when a vehicle crosses the Belarus-Russian or Kazakhstan-Russia border the customs authority may request (under point 1 of the Customs Union Committee decision dated 17.08.2010 №335) commercial and commodity/goods transport documents, which verify the country of origin of the products.

‒ The customs authorities determine whether the products originate from the customs union member countries or from third party countries on the basis of the provided package of documents.

‒ Some companies complain that the status verification procedure takes too long and part of the consignment (up to 20%) is often being placed at the temporary storage warehouses.

‒ In this situation the procedure is being intentionally complicated, which results in unnecessary delays and queues at the border crossings.

‒ The issue will be resolved only after the establishment of the common economic space, which is supposed to happen after July 2012.

Preliminary customs declaration

‒ According to the part 1 of article 193 of the customs union Customs Code the customs entry report on foreign goods can be submitted before their import to the customs territory of the customs union.

‒ As the Code does not imply any other options for submitting the customs declaration the Russian customs

authorities often refuse to register the preliminary customs declaration if the goods have already crossed the customs border of the customs union.

‒ It remains unclear how the internal customs authority control the moment of the factual crossing since the Joint Import Control System is still in the early stages of design.

‒ It is worth noting that the article 193 of the Code does not forbid submissions of preliminary customs declarations nor does the Russian Administrative Code.

Obtaining permissive documentation

‒ At present the companies face a lot of difficulties when attempting to obtain permissive documentation (e.g. registration certificates and compliance certificates) under new Joint forms, approved by the Customs Union Committee.

‒ There are also additional issues regarding the necessity of obtaining certificates for different types of goods due to the silence position of some of the authorities including the Ministry of Industry and Trade.

Issues with the investments to the charter capital

‒ The Customs Code of CU contains a new provision, which was supposed to resolve the issue of determining the status of conditionally released goods within the customs union (e.g. imported as investments to the charter capital).

‒ In accordance with the article 211 of the Code any tax and customs duties breaks for specific types of imported goods with disposal limitations are annulled after five years from the date of manufacture.

‒ Under part 4 of article 200 of the Code these types of goods are considered conditionally released before the requirement for tax and customs duties is removed, such goods will obtain the status of ordinary customs union goods after five years.

‒ However this is true only for those goods, which have been imported to the charter capital after 01.07.2010 (under article 366 of the Code). Therefore owners those goods, which have been imported to the charter capital before 01.07.2010, will have to pay full customs duties in the case of alienation of these goods.