The Impact of the European Enlargement and Common Agricultural Policy Reforms on Agricultural Markets: Much Ado about Nothing? Jacinto F. Fabiosa, John C. Beghin, Fengxia Dong, Amani Elobeid, Frank H. Fuller, Holger Matthey, Simla Tokgoz, and Eric Wailes Working Paper 05-WP 382 February 2005 Center for Agricultural and Rural Development Iowa State University Ames, Iowa 50011-1070 www.card.iastate.edu All authors with the exception of Wailes are in the Department of Economics and Center for Agricultural and Rural Development (CARD) at Iowa State University. Eric Wailes is with the Department of Agricultural Economics and Ag Business at the University of Arkansas. The authors thank Julian Binfield, Meritt Cluff, Johan Swinnen, and Pat Westhoff for their comments. This paper is available online on the CARD Web site: www.card.iastate.edu. Permission is granted to reproduce this information with appropriate attribution to the authors. For questions or comments about the contents of this paper, please contact John Beghin, 578D Heady Hall, Iowa State University, Ames, IA 50011-1070; Ph: 515-294-5811; Fax: 515-294-6336; E-mail: [email protected]. Iowa State University does not discriminate on the basis of race, color, age, religion, national origin, sexual orientation, sex, marital status, disability, or status as a U.S. Vietnam Era Veteran. Any persons having inquiries concerning this may contact the Director of Equal Opportunity and Diversity, 1350 Beardshear Hall, 515-294-7612. Abstract Following a historical agreement on the EU enlargement, 10 new member states (NMS) acceded to the European Union on May 1, 2004. Although the European Union has expanded its membership in the past, this enlargement is unique in terms of its scope and diversity of the countries, area, and population involved. Thus, the effects of the EU enlargement on current and future member countries and on world commodity markets require careful consideration as the European Union is a major player in these markets. We analyze the effects of the Common Agricultural Policy (CAP) reform and enlargement on the EU-15, the NMS, and world agricultural markets. We compare three 10-year comprehensive agricultural outlook scenarios. In a “pre-enlargement” scenario, all pre- enlargement policies of the EU-15 are held in place and the 10 NMS maintain their independent economic policies and older technologies as if nothing happens. The second scenario considers the CAP reform in the EU-15. The third scenario is the 2004 Food and Agricultural Policy Research Institute (FAPRI) baseline projection, which incorporates both the CAP reforms and accession of the 10 NMS with the associated domestic and trade policy reforms and some convergence in technology within the EU-25. With prices in most commodities in the acceding countries historically below EU-15 prices, accession leads to a moderate decrease in the EU-15 prices, whereas for the 10 NMS, domestic prices of many commodities increase substantially. Holding income levels constant, consumption levels of agricultural products in these countries decrease in most instances because of higher food prices, while production levels rise. The impact of the two reforms on world markets is moderate to negligible. The CAP reform has a moderate impact on the EU-15. Keywords: CAP reform, Common Agricultural Policy, EU enlargement, European agriculture, New Member States. THE IMPACT OF THE EUROPEAN ENLARGEMENT AND COMMON AGRICULTURAL POLICY REFORMS ON AGRICULTURAL MARKETS: MUCH ADO ABOUT NOTHING? Introduction Following a historical agreement on the EU enlargement, 10 new member states (NMS) (Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia) acceded to the European Union on May 1, 2004. Although the European Union has accepted new countries in the past, this enlargement is without precedent in terms of its scope and diversity of the number of countries, area, population, and large rural sector. Thus, the effects of the EU enlargement on current and future member countries and on world commodity markets require careful consideration as the European Union is a major player in these markets. This analysis is challenging because of the heavily protected nature of the agricultural sector in the EU-15 through the Com- mon Agricultural Policy (CAP) and the importance of the agricultural sectors in the candidate countries. Implementation of the CAP in the NMS will be concluded after a transition period. However, more than half of the funds to support agricultural policy will have to come from non-CAP funds. The NMS have the opportunity to make “top-up” payments (supplemental payments) of 30 percent of the EU-15 level over and above the basic CAP support levels. Aid payments in the EU-15 and the 10 new countries will be aligned by 2010. The agreement also sets other policy parameters (e.g., milk and sugar production quotas for milk and sugar) in the NMS. This study analyzes the effects of the latest CAP reforms and enlargement on the EU-15, acceding countries, and world agricultural markets. It compares three 10-year comprehensive agricultural outlooks scenarios. In a “pre-enlargement” reference sce- nario, all pre-enlargement policies of the EU-15 are held in place and the 10 NMS maintain their independent economic policies and older technologies as if nothing happens. The second scenario considers the midterm review CAP reform in the former 2 / Fabiosa, Beghin, Dong, Elobeid, Fuller, Matthey, Tokgoz, and Wailes EU-15. The third scenario is the 2004 Food and Agricultural Policy Research Institute (FAPRI) baseline projection, which incorporates both the CAP reforms and the accession of the 10 NMS with the associated domestic and trade policy reforms and some conver- gence in technology within the EU-25. We utilize the EU module of the FAPRI model to simulate and analyze the effects of the EU enlargement on production, consumption, and trade of the enlarged European Union and on major players in world agricultural markets. The model is a partial equilibrium model of world agricultural markets, including impor- tant producer and consumer countries in the world livestock and products, dairy, grains, oilseeds and products, cotton, and sugar markets. Countries’ commodity sectors are modeled with structural equations, which incorporate all important policy parameters. We focus on the impacts of these policy changes (CAP reform and enlargement) on produc- tion, consumption, and trade. Our analysis contributes to the recent literature analyzing the integration of new countries into the common European market and the recent series of CAP reforms (Ackrill 2003; Bouamra-Mechemache and Requillart 2004; Fuller et al. 1999, 2002; Matthew 2002; Nahuis 2004; Schrader 2002; among others). Several of these studies looked at specific cases of the candidate countries and/or made early assumptions about agricultural policy reforms in the new member countries. In this paper, we implement the actually agreed-upon framework between the EU-15 and all 10 new member countries and include the latest 2004 midterm CAP reforms. Therefore, we provide an encompass- ing assessment of these most recent changes with updated estimates of their potential impacts on agricultural markets in the original EU-15, the NMS, and world markets. The overal impact of these reforms outside of the European Union is small, hence our title. These two important reforms deemed historical are mainly a European matter. Even within the European Union, the impact of the combined reforms is relatively modest in production and consumption except in dairy and sugar markets. Trade effects within the European Union are significant but not as devastating as one might expect. There are two major reasons why the impacts are limited. First, the reallocation of resources is mostly within the enlarged European Union. Countries had been preparing for these foreseeable reforms through preferential trade agreements such as the Central European Free Trade Agreement (CEFTA), giving preferential duties to CEFTA members. The Impact of the European Enlargement and CAP Reforms / 3 Trade between the EU-15 and Central and Eastern European Countries (CEECs) is gov- erned by the Europe Agreement, with the intent of gradually integrating the CEECs into the EU single market. The only potential substantial surprise would have been for the third countries that have significant trade with the acceding countries. Second, the 2003 CAP reform is the most recent of a series of fundamental reforms initiated 12 years ago, and the incremental effect of this latest policy change is moderate, although the impact of the whole set of reforms since 1992 has certainly been marked. The change in NMS production and consumption is more pronounced since the accession is the first major step into the CAP mode. The results of our analysis suggest several pointers. World markets are little affected by either reform. Agricultural markets in the EU-15 are also marginally affected with a few qualifiers. The major changes occur in the NMS through major changes in grain, meat, and dairy prices and changes in production/marketing quotas in dairy and sugar. The impacts on intra–EU-25 trade are driven by changes in production and consumption, rather than by the lowering of intra–EU-25 protection, which was already low. However, trade of the EU-25 with third countries suffers, as the 10 NMS align their duties to the generally higher duties of the EU-15. Policy Changes and Scenarios A reference baseline is constructed as a business-as-usual scenario (scenario 1), with pre-2004 policies extended in the EU-15, following the Berlin Accord and the candidate countries remaining separated from the European Union. This somewhat contrived scenario is necessary to provide a reference trajectory to estimate the effects of policy reforms later on. Then, our analysis incorporates the major policy changes associated with the 2003 CAP reform that came out of the midterm review (scenario 2). The 2004 enlargement and the accession of the 10 countries (Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia) is then the third scenario and considers associated policy changes in these countries during an implemen- tation period to converge to fully vested CAP recipients (scenario 3). 4 / Fabiosa, Beghin, Dong, Elobeid, Fuller, Matthey, Tokgoz, and Wailes Common Agricultural Policy Reform Reform implementation started in 2004. The essence of the CAP reform is the far- sighted aim of complying with future WTO commitments likely to emerge from the Doha Round of the World Trade Organization (WTO) negotiations and to induce marginal incentives driven by market forces rather than by farm programs. Sugar and dairy are the notable exceptions to this trend. This aim of the recent CAP reform means furthering the decoupling of farm support from production decisions initiated in the 1992 reform and lowering price policy incentives linked to production decisions. Decoupling, when fully implemented, will take the form of a Single Farm Payment (SFP), must be fully in place by 2007, and is likely to satisfy green-box criteria. Since limited coupled elements may be maintained to avoid abandonment of production and because the SFP creates wealth effects, we assume that the SFP has a small supply-inducing effect. The CAP reform also includes commodity-specific measures, especially in dairy. Price cuts occur in the milk sector, as will be further discussed. There is also a reduction of the monthly increments in the cereals sector by one-half, but the current intervention price will be maintained. Other reforms affect rice, durum wheat, and other commodities not covered by the FAPRI (Food and Agricultural Policy Research Institute) baseline. The current intervention price for cereals is maintained, with the exception of rice, for which the price is cut nearly by one-half. Rye is excluded from the intervention system. The supplement for durum wheat will progressively decrease to €285/ha by 2006 and will be included in the SFP. Regarding decoupling, member states are expected to implement CAP reform in dif- ferent ways, therefore resulting in different degrees of decoupling. Because we use an aggregate EU-15 model, we assume partial decoupling for the aggregate European Union phased in between 2005 and 2007. The SFP must be introduced by 2007. Modulation (reduction in direct payments for large farms) rates are set at 3 percent for 2005, 4 percent for 2006, and 5 percent after that. In the EU-15, set-aside is set to 5 percent for 2004 and 10 percent for 2005 and onward. There are reductions in intervention prices. The intervention price for butter is reduced by 25 percent over four years, and the skimmed milk powder price faces a 15 percent reduction over three years. For grains, current intervention prices are maintained. Durum wheat aid is reduced to €313/mt in 2004, €291/mt in 2005, and then €285/mt from 2006 on. Rye intervention is eliminated. The Impact of the European Enlargement and CAP Reforms / 5 Dairy quotas grow anemically in the EU-15, from 118.953 mmt in 2004 to 120.505 mmt in 2009, and then they are assumed to stay at that level until 2013/14. Accession Accession of the NMS took place in May 2004, with policy changes being phased in over time. In general, CAP policies are adopted by the NMS but with some variations to accommodate accession. In the NMS, a single area payment reform begins at the time of entry. There is no financial modulation until support reaches 100 percent, which occurs in 2013 (see Table 1). There are no top-up payments after 2008. Decoupling in the NMS is implemented following the simplified area payment in 2004 and then is switched to the SFP in 2007. There are new direct payments for the NMS: they can provide top-up payments using national finances or funds for rural development given by the European Union until 2006. The assumed top-up payments are shown in Table 1. Set-aside in the NMS starts in 2007 and remains at 10 percent. Dairy production quo- tas in the NMS are set as shown in Table 2. Poland is the largest dairy producer, followed by the Czech Republic, Hungary, and Lithuania. The trade policy regime of the NMS is changed. External duty rates of the NMS are harmonized with the EU-15. Internal rates are set at zero. Price convergence between the EU-15 and EU NMS is assumed to take three to four years, mimicking the decrease of transaction cost with integration and a quality upgrade in the NMS. Table 3 summarizes the important policy parameters. The FAPRI International Model The modeling system approach links a system of submodels organized by commod- ity and connected by intermarket linkages through final and derived demands. Each commodity model is organized by country and covers countries that are major producers, consumers, or trading forces in that market. The models are non-spatial, multi-market models that cover most temperate agricultural products (major grains, oilseeds and products, livestock and products, poultry and products, sugar, and cotton). The models solve for a world equilibrium price by setting world excess demand equal to zero. The world price feeds back into each country model via price tranmission equations and determines the local supply, demand, and trade. The following identity is satisfied for 6 / Fabiosa, Beghin, Dong, Elobeid, Fuller, Matthey, Tokgoz, and Wailes TABLE 1. EU payments and top-up payments in the New Member States Payments 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 (Percent) Top-up 20 27 22 17 7 0 0 0 0 0 EU payments 25 30 35 40 50 60 70 80 90 100 Total 45 57 57 57 57 60 70 80 90 100 TABLE 2. Calendar-year dairy quota allocations for the EU-15 and New Member States Countries 2004 2005 2006 2007 2008 2009 (Million Metric Tons) Cyprus 0.145 0.145 0.145 0.145 0.145 0.145 Czech Republic 2.682 2.682 2.682 2.738 2.738 2.738 Estonia 0.624 0.624 0.624 0.646 0.646 0.646 Hungary 1.947 1.947 1.947 1.990 1.990 1.990 Latvia 0.695 0.695 0.695 0.729 0.729 0.729 Lithuania 1.647 1.647 1.647 1.705 1.705 1.705 Malta 0.049 0.049 0.049 0.049 0.049 0.049 Poland 8.964 8.964 8.964 9.380 9.380 9.380 Slovakia 1.013 1.013 1.013 1.041 1.041 1.041 Slovenia 0.560 0.560 0.560 0.577 0.577 0.577 each country/region and the world: Beginning Stock + Production + Imports = Ending Stock + Consumption + Exports. The FAPRI modeling system assumes that the existing agricultural and trade policy variables will remain unchanged in the outlook period unless these changes are written law, such as WTO commitments to decrease tariffs until 2000 for developed WTO members. Macroeconomic variables, such as gross domestic prod- uct, population, and exchange rates, are exogenous variables that drive the projections of the model. The data sources included in the model are the USDA-FAS (Foreign Agricultural Service) Production, Supply, and Distribution (PS&D) data set. Additional data for area, yield, sugarcane, and sugar beet production are gathered from the Food and Agricultural Organization (FAO) of the United Nations. The International Monetary Funds’ (IMF) The Impact of the European Enlargement and CAP Reforms / 7 TABLE 3. Summary of EU Common Agricultural Policy reform and enlargement Policy 2004 2005 2006 2007 2008 Decoupling (%)a Livestock 0 23 47 70 70 Crops and dairy 0 33 67 100 100 Modulation (%) 0 3 4 5 5 Set-aside (%) EU-15 5 10 10 10 10 EU NMS 0 0 0 10 10 Dairy quota (mmt) EU-15 118.95 119.04 119.30 119.78 120.26 EU NMS 18.33 18.33 18.37 19.00 19.00 Intervention price and premium Durum aid (euros/mt) 313.00 291.00 285.00 285.00 285.00 Butter (euros/mt)b 316.72 293.84 270.98 252.96 246.39 NFD (euros/mt)b 200.38 190.61 180.33 176.69 174.69 Top-up payments (%) 20 27 22 17 7 a A modest crop response to the SFP is assumed because of wealth effects. b Calendar-average prices of marketing-year prices. International Financial Statistics (IFS) provide historical macroeconomic data, whereas Global Insight provides a macro forecast for the outlook part of the model. We use USDA attaché reports, and other sources (WTO, World Bank’s WITS database) for commodity prices and policy information. Parameters in the model such as price and income responses are either directly esti- mated, surveyed from the literature, or obtained from consensus of expert opinions. Details, including parameter values, are provided on the FAPRI Web site (FAPRI 2004a,b). The grain module of the FAPRI international model covers all major feed and food grains (corn, rice, wheat, and other coarse grains). It has links to other models in the FAPRI framework, such as the cotton, dairy, livestock, oilseeds, and sugar models. The grains model interacts with the dairy and livestock models that provide information on feed demand in the countries, and with oilseeds models that provide information on the relative profitability and area harvested for the competing crops. Each country submodel consists of at least one commodity depending on the relative importance of the commod- 8 / Fabiosa, Beghin, Dong, Elobeid, Fuller, Matthey, Tokgoz, and Wailes ity and the relative importance of the country in the world markets as a supplier or a buyer. Grain production is divided into yield and area equations, while consumption is divided into feed and non-feed use. Agricultural and trade policies in each country are included in the model to the extent that they affect the supply and demand decisions of the economic agents. Examples of these include taxes on exports and imports, tariffs, tariff rate quotas, export subsidies, intervention prices, and set-aside rates. The oilseed component of the model treats each respective seed, meal, and oil as a homogeneous commodity. Depending on data availability, domestic prices in the oilseed model can be farm, wholesale, or port prices. Consumer and producer prices are differen- tially specified only in countries that have a deficiency type of producer support or differentiated taxation. This general structure is slightly modified to accommodate policy interventions other than price distortions, such as quantitative restrictions on area, supply, or trade flows. The general structure of each country oilseed submodel includes behavioral equa- tions for area harvested, yield, and production of oilseeds on the supply side, and crush, seed, food, and other consumption as well as ending stocks on the demand side. Planted area is a function of expected prices (a convex combination of lagged and current) and a trend. Yield is a function of prices, area expansion, and a trend. Production is equal to the product of planted area and yield. Ending stocks are a function of current prices. The crush demand is driven by the oil demand and/or by meal demand. Given the joint product of oil and meal and the positive economic value attached to meal, the derived demand from crushing reflects both oil and meal. The derived demand for crush oilseeds is driven by the crush margin. The crush equation constitutes the price and quantity links between the seeds and products markets. We make the usual assumption of fixed proportion in the technology of meal and oil production and price-taking assump- tions in oilseed crushing to describe the crushing cost. As the margin increases, the demand for crush seeds increases. A change in the crush demand affects seed demand and products supply simultaneously. Prices adapt accordingly to re-establish equilibrium. The oil and meal supplies are a function of the crush. Total demand is the sum of consumption, ending stocks, and exports. Imports and exports are not explicitly modeled. Net trade is the difference between total supply and demand. Vegetable oil demand is a