1

Theme 2. FORMS (STAGES) OF ECONOMIC INTEGRATION

2.1. Free Trade Zone

2.2. Custom Union
2.3. Common Market
2.4. Economic / Monetary / Political Union
2.5. Success factors for economic integration

Processes of economic integration are characterized by stages. By B. Ballasa,

considered as classical one, there are five stages of integration process. Starting
with the simplest regional forms of economic integration, there are followed by: a
free trade zone, customs union, common market, economic and monetary union
and a total integration. Each of mentioned stage is characterized by specific charts.
The main characteristic charts in singular stages, are presented in Table 2.1.

The simplest institutionally form of the integration grouping, is a free trade zone.
Its target is elimination of customs and quantity limits in trade between member
countries and, at the same time, keeping by each member country, a full autonomy
in economic and customs politics, in relations with countries, which are not
members of the zone.

Creation of the free trade zone, in practice, is often preceded by leading

preferential commercial agreements, or automatically removing customs in mutual
trade [26, p.67].

Table 2.1. Institutional forms of regional integrative groupings

Source: [6,p.26 ]

Liberalization of commerce in the free trade zone usually happens in stages -

analytical schedule to abolish customs barriers and quantity limits for singular
groups of goods, is contained in an agreement, signed by countries creating this
 2

zone. Such gradual abolishing limits in the commerce, goes to minimalize negative
effects of exaggerated competition, and allows the right effect for results of
creation and reallocation of commerce, which accompany functioning of free trade
zone.

Subject of an agreement of the free trade zone, can be a whole trade sale between
countries creating the zone, or only chosen groups of goods. In the second case,
usually comes a total abolish of barriers, towards industrial goods, while
liquidation of agricultural goods trade, has a selective and partial character
(customs and quantitative limits for chosen agricultural products are abolished
totally, for others are reduced, and for some stay the same).

After creation the free trade zone, commercial sales between member countries
become more liberal. It means that goods, made by member countries, are cheaper
by abolished customs in the grouping market. While, towards the third countries,
each country uses its own, most often different customs and commercial politics.
In a consequence, in the zone area, goods, coming from countries of its zone, are
treated differently than from other countries.

The higher form of regional grouping, is the customs union. It is thought to be a

stem of integration groupings, and has the most built theory among other forms of
integration groupings. Progress of the customs union theory, is tied with J. Viner
and his book 'The Customs Union Issues', published inl950.

An essence of the customs union is a full liberalization of mutual trade sales,

acceleration a common outside customs tariff and unification of commercial
politics, towards other countries. It means that customs politics of this grouping, is
focused on liberalization of trade between member countries and discrimination
goods from other countries, at the same time.

J. Viner writes that a basic target of the customs union, and a main effect of its
functioning, is reallocation of supply sources into specific goods. Depending on
circumstances, this reallocation can go either, to a place of lower, or to higher
manufacturing costs of these goods [32, p.77].

Abolish customs in mutual trade of countries, creating the union, and keeping
them exchange with other countries, cause specific effects. In the literature, most
often they are divided into static and dynamic ones.

Static effects appear in a short period, so they have another name - short
periodical effects. They appear, when there are not structural changes (changes of
equipment in manufacturing factors, changes in structure of production and
consumption), or technical - technological changes ( changes of a speed of
technical progress and its structure ). Static effects can be divided into commercial,
 3

which appear in the trade zone of goods and services, and outside commercial
effects, which appear in investments, production and consumption zone.

Dynamic effects, called also long periodical ones, appear with reaction and
adaptation of enterprises, governments and labor force, to changes made by
creation of the customs union. A result of these adaptive processes, is a stimulation
of economic development of the member countries of the union.

Commercial static effects, characteristic for the customs union are: effect of
commerce creation and effect of commerce reallocation (changes of commerce
directions). They go to a change of volume and structure of commerce. The first of
them, concerns mutual trade between member countries of the union, the second
one, the commerce of the union members with the third countries. These effects
can also appear after creation of the free commerce zone.

Effect of commerce creation, is a creation new stream (streams) of commerce

between member countries of the union, resulted by abolish of customs and other
limits in the mutual commerce, keeping these barriers in the commerce with
countries, which are not members of the union, at the same time. As a result of
commerce liberalization, products, imported from member countries, become, in
the specific country market, cheaper ( price - related functioning of customs and
other barriers is eliminated ), so they are more competitive, than product made in
this country. As an effect, the country production is replaced by import from a
partner country. A condition to appear the effect of commerce creation, are
differences in manufacturing costs of a specific product in singular countries.

A power of the commerce creation effect depends on following factors:

- price flexibility of demand of the country, which has not imported this good so
far (the higher flexibility of demand is, the more intensive the commerce creation
effect is, while, at a set flexibility, the more intensive creation effect is, the higher
were customs rates between countries of the zone before its creation, and the
bigger are differences in the costs of production of a similar good, in singular zone
countries);

- price flexibility of demand in the country of a cheaper manufacturer;

- keeping a difference in costs and prices.

Liberalization of the commercial exchange in the customs union can cause, that a
steam of it from countries, which are not members of the integration grouping, will
be replaced by supplies of goods from member countries, even if a member
country is characterized by lower production costs. It is connected with preferential
treatment goods from member countries, which price and out price competiveness
rises, thanks to abolition of commercial barriers and discrimination goods, from
 4

countries, which are not members. This phenomenon is called the effect of
commerce reallocation. It means a worse allocation of sources, both on member
countries side, and the whole world economy. This effect will be always
unprofitable for more effective third country. Reallocation of commerce is also
accompanied by production and consumption effects, which, in this case, we can
find in a relation: member countries - countries, which are not members.

A power of the commerce allocation depends on:

- price flexibility of demand in the importing country and price flexibility in the
exporting country;

- outside customs rate;

- reaction of suppliers from the third countries, and reaction of manufacturers

from the countries belonging to the zone.

The following stage, of the integration process, by B. Balassa, is the common

market. It joins elements characteristic for the customs union -liberalization of the
internal trade, a uniform outside customs tariffs and the common economic politics
towards the third countries, with a free flow between member countries, and
factors of production ( labor and capital ) [ 6, p.27 ].

In frames of the common market happens leading, such called rule of four
freedoms, containing the free flow of goods, services, capital and people.

According to the theory of international trade, creation of the common market

leads to an increase the economic effectiveness in the region. It happens, thanks to
the right allocation of production factors - factors reallocate from areas with a
lower final productivity, to areas of the higher final productivity [6 , p.33].

In the literature of the subject, an essence of functioning of the common market,

is explained in various theoretical models. Generally, they can be divided into two
groups - neo classic (concerning the integration of capital market and labor market)
and modern models, containing elements of the theory of international production
(stressing internal diversity of capital - flow of payments, portfolio investments,
direct international investments) [6 , p.33].

The free flow of production factors causes, that factors go out of the country rich
of them, to the country, in which they are relatively rare, and, in which you can get
a higher rate of return with their application. Effects are short periodical
adaptations of supply and prices of production agents, in the integrating countries.

The most mobile agent of production is capital. Flow of capital, especially

productive capital, is accompanied, most often, by migration of technical
 5

knowledge, licenses, patents and international flow of labor, which are correlated
with improving qualifications and cooperation with specialists [6, p.31].

The following stage of the economic integration, is a monetary union. The

monetary union is an important element of the economic integration processes,
because an effective functioning of the customs union, the common market or the
economic union, is impossible without an advanced integration in the monetary
zone.

Theoretically, the monetary union can be realized itself or along to the economic
union. In reality, realization of the monetary union, is an element of the economic
union functioning.

The monetary union contains all elements, characteristic to the common market,
and additionally is characterized by the common capital market (including
financial one) of integrating countries and the full rate union.

Three main premises of the monetary union, mentioned in the literature of

subject, are:

- internal logics of the integration processes (coming to the stage of the common
market, forces a progress in the monetary integration);

- crisis of the international monetary system (it is about the crisis of the system
from Bretton Woods, which became a reason to start actions, going to the monetary
integration, by countries of European Community);

- elimination of the rate risk and costs of monetary exchange. In case of

European Community, reasons, mentioned above, appeared at the

end of the sixties of the 20th century. Then, it became clear, that a farther
progress of economic integration is not possible, without acceleration of the
monetary integration.

For the right functioning of the monetary union, some conditions are necessary.
They are:

- liberalization of the capital sales and providing a freedom of financial service

(integration of the capital market means a full freedom of the capital flow,
portfolio, productive one ) and an income from lending and productive capital);

- elimination of differences in fluctuation of exchange rate or setting a common

currency;

- creation an over national centre of issuing banks, leading the common

monetary politics;
 6

- effective coordination of the economic politics of member countries, to

eliminate essential differences in stage of the economic cycle.

In the literature, besides the monetary union, there are differed also, the rate
union, the union without limited administratively rates and the union with parallel
currency. All mentioned forms of the monetary integration, present a narrower
range than the monetary union.

In case of the rate union, we can speak about the full and the partial rate union
( pseudo union ). In the partial rate union, a member country is obliged to keep its
permanent currency rate, towards the currency of other member countries. It
means, that fluctuation of rates is allowed, only in strictly limited borders. At the
same time, the member country can keep its own currency reserves, and its own
monetary and fiscal system.

The full rate union means, that monetary politics of the whole grouping, is
shaped by the common central bank, which can issue the common currency, and
keeps common currency reserves of the member countries. One of the banks,
creating the union, can takeover functions of the common central bank.

The conception of the union without limited administratively fluctuation of rates,

sets, that coordination of the monetary politics, will contribute to approach of
creation basic sizes of the monetary market, and they will stabilize in the natural
way. The union with parallel currency is the parallel functioning of the common
currency, to the national currency of countries, creating union.

W. Molle presented, a little different from B. Balassa, picture of stages of the

economic integration [19, p.31].

He thinks that economic integration is the process happening on two fields

-market and politics. On the market field, the integration concerns the market of
goods, services and the market of production factors. The integration of markets is
realized by elimination obstacles, which make hard, a free flow of goods, services
and production factors, between member countries. It contributes to improve the
effectiveness of economy. The essence of integration in the political field is the
integration of intervention influence of governments on economy. Integration in
these two fields has, due to the author, (by an author,) a stage character. He differed
following stages in the integration of goods and services:

- the free trade zone - all obstacles in trade between partners, are abolished, and,
at the same time, each country can use its own customs tariffs, towards other
countries; goods in the international trade must have origin certificates;

- not full customs union - obstacles between member countries are abolished, and
towards goods coming from the third countries, it is led the common outside
 7

customs tariff , so, there is no need to show origin certificates on internal borders;
whereas barriers towards some goods are kept,

- the customs union - all obstacles in the trade are abolished and the common
outside customs tariff is led.

By W. Molle, the integration of production factors happens in two stages:

- not full common market - its first element, is not full customs union, there is a
freedom of internal flow of significant segments of labor and capital, in relations
with the third countries, different country regulations can be obligatory -like in the
free trade zone - or common regulations - like in the customs union;

- the common market - is consisted of a domestic market, where a freedom of

flow of goods, services and production factors is obligatory, as well as, common
outside regulations, concerning, both goods, services and production factors. In the
integration in political field, W. Molle differs three stages:

- the economic union - determinates the common market, and a high level of
coordination or unification of the most significant branches of economic politics;

- the monetary union - currency of member countries are tied by steady currency
rates, and, are fully exchangeable, or, in all member countries there is one
obligatory currency, reallocation of capital in the union borders is totally free;

- the economic and currency union joins characteristic charts of monetary union
and economic one, besides, it is characterized by a big cohesion of macroeconomic
and budget politics. To other charts of integration, W. Molle counted:

- political union - in its frames, integration goes out of economic field and
contains branches, like foreign politics, to prevent crimes ( police ) and politics of
safety,- full union - determinates a total unification of joining economies, and
leading a common politics in many important branches, for example: social safety,
income taxes, macroeconomic politics and stabilization politics.
 8

Table 1

Levels of regional economic integration

Levels of Key features

regional
Elimination Elimination Common Free Common
economic
of barriers in of barriers in external movement of economic
integration
trade of trade of all tariff production policy
certain goods and (duty) factors (monetary,
goods and services (capital, currency,
services labor force, tax, etc.)
technology)
Preferential +
Trade Area
Free Trade + +
Area
Customs + + +
Union

Common + + + +
Market

Economic + + + + +
Union

 It is also important to distinguish between integration and cooperation. In the

former, there is a transfer of sovereignty to a higher entity based on the proposed
objectives. In the latter, it is more a case of basing commonly agreed policies on a
set of specific agreements.
 9

2.5. Success factors for economic integration:

a. Preconditions as regards the actual and potential relationship among partners

Existence of genuine common interests. Such common interests can arise in

very diverse areas: a common border, a common river basin or a shared natural
resource. In many cases the common interest is a function of proximity so that
regional integration often starts with neighbouring countries. A common interest
can also take the form of reacting to a common threat as integration makes it
possible to pool resources in order to be better able to cope with a threat, be it
economical or political. The protection of the Amazonian Basin, which has
given rise to the Amazonian Pact, exemplifies the idea of a common interest
resulting from a shared natural resource. The same can be said of the regional
use of water as a building block for peace and cooperation in the Middle East.
Similarly, the struggle against desertification may constitute a stimulus for
integration among several African countries in the Sahelian zone. As the threat
of an extension of Soviet hegemony constituted an important encour-age-ment
for economic integration in Western Europe, the SADC was formed to better
cope with the destabilisation of the apartheid regime. Both the GCC and
ASEAN also rose with the aim of strengthening cohesion because of a security
threat.

Compatible historic, cultural and political patterns. Common interests or even

physical proximity are not a guarantee for integration, or for it to be the best
option for every country. As relations between neighbours such as the countries
of South America, or India and Pakistan, or Israelis and Palestinians, or as Iran
and Iraq show, both culture and history can work as incentives or as
disincentives for regional integration. ECO's relaunching on the basis of Islamic
solidarity and Yugoslavia's breakdown are alternative examples on the role that
a cultural factor such as religion can play, as either a binder or a diluter of
regional initiatives.

b. Preconditions as regards the internal political and economic situation in partner

countries.

Political commitment: Integration calls for a strong political will to that effect.
In addition, this political will should be sustained in order to be credible for
economic actors and trigger self-fulfilling expectations among society at large.
Political commitment also implies the willingness to share certain aspects of
 10

sovereignty.

Peace and security: Progress on regional integration and peace, security and
stability within the members of the grouping are closely interlinked. Lacking
both the resources and the incentives to implement the necessary policy reforms,
countries that suffer from civil strife or conflict will not be able to participate
effectively in integration initiatives. By the same logic, political and economic
migration will transfer some of their problems to their neighbours.

c. Factors that facilitate the success of regional integration.

Rule of law, democracy and good governance are necessary for a meaningful
political dialogue among partners that will ensure the irreversibility of the
process. They are also necessary for giving confidence about the predictability
of policies and of the economic environment. Rule of law and good governance
are essential for the proper functioning of basic economic institutions, while
democratic legitimacy provides the necessary political underpinning. Without
confidence in government there will be no long-term investment, but rather
there will be a tendency towards capital flight and plunder.

Macroeconomic stability: Integration should be accompanied by compatible

economic policy frameworks. These include reasonably stable exchange and
inflation rates, and adequate management of public finances and of the balance
of payments.

It has often been observed that there are important feedback effects, once
integration is successful, to help "lock-in" the above precondi-tions. In other
words, once integration is working it becomes easier for countries to maintain
security and macroeconomic stability. In the European case integration could
only start because peace and security, as well as democracy, were reasonably
assured. However, at the same time, European integration further consolidated
this peace and security as it became inconceiv-able that there would again be a
serious conflict among the EU member states.

The above preconditions and success factors appear not to be satisfied in many
developing countries. Therefore, it is not surprising that the results of integration
efforts have, so far, been disappointing.
11