**Terms of trade index: index of export prices / index of import prices.
An increase means that export prices grow more than import prices; these changes originate from tariff changes and subsequent relative price changes.
In the second calculation, we determine if the trade flows between Russia, other CIS countries and Europe operate in the right way or not.9 Normally trade levels should reflect the relationship between economic sizes of the trading partners allowing for effects of distance. If real flows do not tally with these virtual normative exchanges, it is likely that some distortion of trade is occurring due to administrative manipulations, leading to welfare loss. We used gravity equation methodology, which suggested that theoretically, the creation of the CEES could lead to six-fold reduction of trade between Russia and the CIS, and four-fold increase of trade between Russia and EU countries. Macroeconomic modelling proved that there is strong potential for trade through the CEES. Gravity measurement showed that mutual trade between the EU and Russia could be multiplied by several times. Realisation of this potential is not basically detrimental to trade between Russia and other CIS countries, although Russia-CIS trade is now higher than is economically justifiable.
In a second step we added additional variables to the gravity equations: an extra effect of 80% trade increase was demonstrated, mostly due to decline of the black market and improvement in protection of property rights. Overall, therefore, institutions influence trade in the expected way: more freedom attracts foreign partners and stimulates bilateral trade flows. Higher tariff and non-tariff barriers constitute an impediment to mutual trade. By contrast, legislation, which limits restrictions on foreign ownership of business and land, and on repatriation of earnings, treating foreign and domestic companies equally, leads to larger trade volumes. Trade is positively and significantly affected by existence of a well-functioning financial and banking system, which can efficiently finance trade business. Higher wage and price flexibility produces higher bilateral trade, and better protection of property rights raises incentives to engage in bilateral trade activities. Finally the extent of the black market influences trade in the expected way: more informal, unregistered activity reduces the level of official, registered trade.
It is interesting to note that another simulation of CEES was made with the same purpose by CEPS (Brussels), using the same tools (gravity equations and GTAP model) with different methodology.10 The conclusion of that simulation was that the economic impact of a Russia-EU free trade agreement which is both broad, in terms of sector coverage, and deep, in terms of addressing regulatory constraints upon trade, will be large relative to an agreement that is limited to the removal of tariff restrictions on trade in goods. A broad and deep FTA could have a profound effect on the level of income and the rate of growth in Russia through increasing flows of trade, investment and technology, via improvements in the efficiency of services and by providing a foundation for the locking in and intensification of market reforms. The message is clear: positive effects from FTA agreements between the EU and CIS countries require more than mere trade liberalisation. Positive effects are only obtained when the FTA is complemented by intensive capital and know-how flows. The RECEP White Book showed that these flows may take the form of foreign direct investments, but in the case of commodity exporters accruing huge capital sums (Russia, Kazakhstan), the flows may be achieved by mere purchase of know-how and equipment or even the acquisition of EU companies. The CEPS study showed also that a free-trade agreement with Russia could have adverse consequences on other European CIS countries and most notably Ukraine if structural changes do not take place. This confirms our second conclusion, according to which bilateral FTAs have negative crowding out side effects.