The Importance of Deep Integration in Preferential Trade Agreements: The Case of a Successfully Implemented Ukraine-Turkey Free Trade Agreement

Abstract

We construct a 45-sector model of Ukraine with Turkey and six other regions to estimate the impacts on Ukraine of deep integration with Turkey in their potential Free Trade Agreement (FTA). Our central model contains foreign direct investment (FDI) in business services with endogenous productivity effects from additional varieties of goods or services in imperfectly competitive sectors. We model deep integration to include reduction of: (i) barriers against FDI in business services; (ii) non-tariff barriers in goods; and (iii) time in trade costs. We innovatively estimate the ad valorem equivalents of the three types of deep integration instruments we model, and we construct an 85-sector input-output table of Ukraine. We estimate that this FTA will increase welfare in Ukraine by 2.72 percent, with the deep integration aspects responsible for about 56 percent of the gains; but preferential tariff reduction by Ukraine alone contributes less than one percent of the gains. We show including these deep integration features and imperfect competition produce estimated gains 3.5 times larger than a model of perfect competition focusing on only a narrow agreement limited to tariff elimination. We estimate that a reduction of non-discriminatory barriers against both FDI and Ukrainian investment in business services would add an additional 2.0 percent of real household income to the estimated gains.